[House Hearing, 105 Congress]
[From the U.S. Government Publishing Office]
REVENUE PROVISIONS IN PRESIDENT'S FISCAL YEAR 1999 BUDGET
=======================================================================
HEARING
before the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTH CONGRESS
SECOND SESSION
__________
FEBRUARY 25, 1998
__________
Serial 105-55
__________
Printed for the use of the Committee on Ways and Means
U.S. GOVERNMENT PRINTING OFFICE
51-685 WASHINGTON : 1999
COMMITTEE ON WAYS AND MEANS
BILL ARCHER, Texas, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
BILL THOMAS, California FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut BARBARA B. KENNELLY, Connecticut
JIM BUNNING, Kentucky WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York SANDER M. LEVIN, Michigan
WALLY HERGER, California BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana JIM McDERMOTT, Washington
DAVE CAMP, Michigan GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota JOHN LEWIS, Georgia
JIM NUSSLE, Iowa RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania KAREN L. THURMAN, Florida
JOHN ENSIGN, Nevada
JON CHRISTENSEN, Nebraska
WES WATKINS, Oklahoma
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
A.L. Singleton, Chief of Staff
Janice Mays, Minority Chief Counsel
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public
hearing records of the Committee on Ways and Means are also published
in electronic form. The printed hearing record remains the official
version. Because electronic submissions are used to prepare both
printed and electronic versions of the hearing record, the process of
converting between various electronic formats may introduce
unintentional errors or omissions. Such occurrences are inherent in the
current publication process and should diminish as the process is
further refined.
C O N T E N T S
__________
Page
Advisory of February 18, 1998, announcing the hearing............ 2
WITNESS
U.S. Department of the Treasury, Hon. Lawrence H. Summers, Deputy
Secretary...................................................... 7
______
SUBMISSIONS FOR THE RECORD
American Bankers Association, statement.......................... 27
America's Community Bankers, statement........................... 30
America's Community Bankers, Independent Bankers Association of
America, New York Clearing House Association, New York, NY, and
Securities Industry Association, joint statement............... 34
American Council for an Energy-Efficient Economy, Howard Geller,
letter and attachments......................................... 37
American Petroleum Institute, statement.......................... 39
American Skandia Life Assurance Corporation, Shelton, CT, Wade
Dokken, and Gordon C. Boronow, joint letter.................... 47
American Wind Energy Association, Jaime Steve, statement......... 48
Blum, Jared O., Polyisocyanurate Insulation Manufacturers
Association, statement......................................... 206
Bond Market Association, statement and attachment................ 50
Boronow, Gordon C., American Skandia Life Assurance Corporation,
Shelton, CT, joint letter...................................... 47
Business Insurance Coalition, John F. Jonas, statement........... 56
Chen, Grace, R&D Credit Coalition, statement and attachments..... 210
Committee of Annuity Insurers, statement and attachment.......... 59
Corporate Property Investors, First Union Real Estate
Investments, Meditrust, Patriot American Hospitality, and
Starwood Hotels & Resorts, joint statement..................... 64
Dokken, Wade, American Skandia Life Assurance Corporation,
Shelton, CT, joint letter...................................... 47
Employer-Owned Life Insurance Coalition, Kenneth J. Kies,
statement...................................................... 68
Enron Wind Corp., Tehachapi, CA, Kenneth C. Karas, statement..... 73
Export Source Coalition, statement and attachments............... 74
Financial Executives Institute, John Porter, statement........... 91
First Union Real Estate Investments, joint statement (See listing
under Corporate Property Investors)............................ 64
FPL Energy, Inc., Michael W. Yackira, statement.................. 97
Geller, Howard, American Council for an Energy-Efficient Economy,
letter and attachments......................................... 37
Guttman, Steven J., National Association of Real Estate
Investment Trusts, statement................................... 157
Hybrid Branch Coalition, statement............................... 99
Independent Bankers Association of America, joint statement (See
listing under America's Community Bankers)..................... 34
INMC Mortgage Holdings, Inc., statement.......................... 105
Interstate Conference of Employment Security Agencies,
Washington, DC, and Service Bureau Consortium, Roseland, NJ,
joint statement................................................ 108
Investment Company Institute, statement.......................... 110
Joint Venture's Council on Tax and Fiscal Policy, San Jose, CA,
statement...................................................... 115
Jonas, John F., Business Insurance Coalition, statement.......... 56
Karas, Kenneth C., Enron Wind Corp., Tehachapi, CA, statement.... 73
Kies, Kenneth J., Employer-Owned Life Insurance Coalition,
statement...................................................... 68
M Financial Holdings Inc., statement............................. 119
Management Compensation Group, statement......................... 125
Massachusetts Mutual Life Insurance Company, Springfield, MA,
statement...................................................... 128
Meditrust, joint statement (See listing under Corporate Property
Investors)..................................................... 64
Merrill Lynch & Co., Inc., statement............................. 133
Multinational Tax Coalition, statement and attachment............ 140
Murray, Fred F., National Foreign Trade Council, Inc., statement. 165
Nabers, Drayton, Jr., Protective Life Insurance Company,
Birmingham, AL, statement...................................... 208
National Association of Manufacturers, statement................. 150
National Association of Real Estate Investment Trusts, Steven J.
Guttman, statement............................................. 157
National Foreign Trade Council, Inc., Fred F. Murray, statement.. 165
National Mining Association, statement........................... 175
National Realty Committee, statement............................. 177
National Structured Settlements Trade Association, statement and
attachments.................................................... 183
Nationwide Insurance Enterprise, statement....................... 200
New York Clearing House Association, New York, NY, joint
statement (See listing under America's Community Bankers)...... 34
Notice 98-11 Coalition, statement................................ 203
Patriot American Hospitality, joint statement (See listing under
Corporate Property Investors).................................. 64
Polyisocyanurate Insulation Manufacturers Association, Jared O.
Blum, statement................................................ 206
Porter, John, Financial Executives Institute, statement.......... 91
Protective Life Insurance Company, Birmingham, AL, Drayton
Nabers, Jr., statement......................................... 208
Ramstad, Hon. Jim, a Representative in Congress from the State of
Minnesota...................................................... 210
R&D Credit Coalition, Grace Chen, statement and attachments...... 210
Regalia, Martin A., U.S. Chamber of Commerce, statement.......... 239
Securities Industry Association, joint statement (See listing
under America's Community Bankers)............................. 34
Service Bureau Consortium, Roseland, NJ, joint statement......... 108
Starwood Hotels & Resorts, joint statement (See listing under
Corporate Property Investors).................................. 64
Steve, Jaime, American Wind Energy Association, statement........ 48
Tax Council, statement........................................... 230
U.S. Chamber of Commerce, Martin A. Regalia, statement........... 239
United States Council for International Business, New York, NY,
statement...................................................... 243
Yackira, Michael W., FPL Energy, Inc., statement................. 97
REVENUE PROVISIONS IN PRESIDENT'S FISCAL YEAR 1999 BUDGET
----------
WEDNESDAY, FEBRUARY 25, 1998
House of Representatives,
Committee on Ways and Means,
Washington, DC.
The Committee met, pursuant to notice, at 1:03 p.m., in
room 1100, Longworth House Office Building, Hon. Bill Archer
(Chairman of the Committee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE COMMITTEE ON WAYS AND MEANS
FOR IMMEDIATE RELEASE CONTACT: (202) 225-1721
February 18, 1998
No. FC-11
Archer Announces Hearing on the Revenue
Provisions in President's Fiscal Year 1999 Budget
Congressman Bill Archer (R-TX), Chairman of the Committee on Ways
and Means, today announced that the Committee will hold a hearing on
the revenue provisions in President Clinton's fiscal year 1999 budget
proposals that are under the jurisdiction of the Committee. The hearing
will take place on Wednesday, February 25, 1998, in the main Committee
hearing room, 1100 Longworth House Office Building, beginning at 1:00
p.m.
In view of the limited time available to hear witnesses, oral
testimony at this hearing will be from Treasury Department witnesses
only. However, any individual or organization not scheduled for an oral
appearance may submit a written statement for consideration by the
Committee and for inclusion in the printed record of the hearing.
BACKGROUND:
On February 2nd, President Clinton submitted his fiscal year 1999
budget to the Congress. This budget submission contains numerous
revenue provisions not included in the Administration's budget
proposals in previous years. The hearing will give the Committee the
opportunity to consider these revenue initiatives more carefully.
In announcing the hearings, Chairman Archer stated: ``This hearing
is an opportunity for the Administration to be an advocate for the
revenue proposals in its budget. Given the public reaction to the
numerous tax increase proposals in the budget, including proposals
which have been rejected previously and new proposals increasing the
tax burden on savings and investment, the Administration has a very
heavy burden to carry.''
FOCUS OF THE HEARING:
The Committee expects to receive testimony on the President's
revenue proposals from the Secretary of the Treasury or his designee,
who also will be asked to discuss general spending trends, and revenue
and deficit projections, including economic trends forecasted by the
Administration.
DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:
Any person or organization wishing to submit a written statement
for the printed record of the hearing should submit at least six (6)
single-space legal-size copies of their statement, along with an IBM
compatible 3.5-inch diskette in ASCII DOS Text or WordPerfect 5.1
format only, with their name, address, and hearing date noted on a
label, by the close of business, Wednesday, March 11, 1998, to A.L.
Singleton, Chief of Staff, Committee on Ways and Means, U.S. House of
Representatives, 1102 Longworth House Office Building, Washington, D.C.
20515. If those filing written statements wish to have their statements
distributed to the press and interested public at the hearing, they may
deliver 300 additional copies for this purpose to the Committee office,
room 1102 Longworth House Office Building, at least one hour before the
hearing begins.
FORMATTING REQUIREMENTS:
Each statement presented for printing to the Committee by a
witness, any written statement or exhibit submitted for the printed
record or any written comments in response to a request for written
comments must conform to the guidelines listed below. Any statement or
exhibit not in compliance with these guidelines will not be printed,
but will be maintained in the Committee files for review and use by the
Committee.
1. All statements and any accompanying exhibits for printing must
be typed in single space on legal-size paper and may not exceed a total
of 10 pages including attachments. At the same time written statements
are submitted to the Committee, witnesses are now requested to submit
their statements on an IBM compatible 3.5-inch diskette in ASCII DOS
Text or WordPerfect 5.1 format. Witnesses are advised that the
Committee will rely on electronic submissions for printing the official
hearing record.
2. Copies of whole documents submitted as exhibit material will not
be accepted for printing. Instead, exhibit material should be
referenced and quoted or paraphrased. All exhibit material not meeting
these specifications will be maintained in the Committee files for
review and use by the Committee.
3. A witness appearing at a public hearing, or submitting a
statement for the record of a public hearing, or submitting written
comments in response to a published request for comments by the
Committee, must include on his statement or submission a list of all
clients, persons, or organizations on whose behalf the witness appears.
4. A supplemental sheet must accompany each statement listing the
name, full address, a telephone number where the witness or the
designated representative may be reached and a topical outline or
summary of the comments and recommendations in the full statement. This
supplemental sheet will not be included in the printed record.
The above restrictions and limitations apply only to material being
submitted for printing. Statements and exhibits or supplementary
material submitted solely for distribution to the Members, the press
and the public during the course of a public hearing may be submitted
in other forms.
Note: All Committee advisories and news releases are available on
the World Wide Web at `HTTP://WWW.HOUSE.GOV/WAYS__MEANS/'.
The Committee seeks to make its facilities accessible to persons
with disabilities. If you are in need of special accommodations, please
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four
business days notice is requested). Questions with regard to special
accommodation needs in general (including availability of Committee
materials in alternative formats) may be directed to the Committee as
noted above.
Chairman Archer [presiding]. The Committee will come to
order.
Our hearing this afternoon has been called to examine the
revenue provisions in the President's budget.
I thank my colleagues in both parties for the comments,
letters, and thoughts that you have shared with me concerning
the administration's plan. And if I hear you right, the
administration's tax hikes have met massive bipartisan
opposition. And the reason is simple: The vast majority of
these proposals are not what we would call loophole closures;
instead they are proposing a series of tax hikes on women,
widows, and middle-income Americans who save--savers--the very
place where I believe we should not be attacking our system.
Taxes would be hiked on millions of airline passengers,
small businesses that create jobs and manufactures that export,
which we desperately need more of. Rather than increasing the
taxation on companies that export, we should be talking about
how we reduce the taxation so that our corporations are not
double taxed and can compete with foreign corporations that
determine how successful they're going to be in creating jobs
and in sales of American products.
I've closed abusive loopholes over the last 3 years--since
becoming Chairman of this Committee--and I'll continue to close
them again. But when it comes to protecting taxpayers, I have
fought tax hikes before and it looks like it is time to fight
them again. Taxes are at the highest level in our Nation's
peacetime history as a percent of GDP, gross domestic product,
and yet President Clinton's budget raises them even higher.
According to an analysis released yesterday by the Joint
Committee on Taxation, the President's budget includes 43
separate tax hikes that raise a total of $38.9 billion over 5
years. The budget also calls for $65 billion from an undefined
increase in tobacco revenues. The 10-year tax hike in this
budget is $236.8 billion.
[The analysis is being held in the Committee files.]
Thirteen of these provisions are reruns that got bad
bipartisan ratings the first time they were sent up. Given the
administration's failure to win support for these proposals in
the past, I question why the White House is trying them again.
When I announced the Committee agenda, I said if the
administration makes the same tax hiking mistakes it made in
previous budgets, those hikes will be dead before arriving. To
protect the taxpayers, let me be clear--and I could not say it
more clearly--these tax hikes remain dead.
As for the rest of the tax hikes, Mr. Rangel and I have
received a letter from virtually every Committee Member urging
our opposition to the proposals that increase taxes on people
who save and invest in life insurance and annuities. At a time
when our Nation should increase incentives to save, I must
question why the administration is raising these taxes.
The budget calls for a $6 billion increase in airline
taxes. Last year's budget agreement provided a long-term,
stable resolution to this thorny issue, yet the administration
now wants to reopen it and to collect more money from the
traveling public. This provision is an old-fashioned tax hike
on millions of traveling Americans, and I oppose it.
On the other side of the ledger, the budget contains a
mind-boggling series of provisions that add further complexity
to the Code. If you think the tax forms are complicated now,
just wait until the IRS gets deeper into your private life so
you can qualify for many of these new proposals.
Targeted tax cuts are a code phrase for let's make the Tax
Code more complex. Now, I have participated myself in putting
provisions in the Code that added to the complexity of the Code
in order to give taxpayers relief from too high a tax burden.
But I would hope that this year we will concentrate on reducing
complexities, on simplification, and make every effort not to
further complicate the Code no matter how desirable some of
these provisions may appear.
And the last thing we need to do is turn the IRS into
another Department of Energy. Didn't we learn in the seventies
when this Committee passed innumerable tax credits on the basis
of ``oh, well we've got an energy crisis,'' only to find that
we had to dismantle all of them in the succeeding years because
we were attempting to micromanage the market system. And here
we go again with the President's proposals in this budget: More
complex effort to micromanage by energy credits of a variety of
kinds.
One of the reasons that I want to change the holding period
on capital gains from 18 months to 12 months is to simplify the
Code. I've just recently looked at schedule D--the new schedule
D--for 1997, and I defy the average citizen to work through
that form. By reducing the 18-month holding period to 12 months
so that it is uniform, will greatly simplify that form.
The President's new complicated loopholes, as they are
called, are a step in the wrong direction and they will be hard
to support. It appears to me that the administration's budget
is beginning to unravel. Unless President Clinton can convince
Congress to raise taxes on the American people, his budget will
be out of balance. Having worked so hard to get the budget into
balance, we must not return to the failed policies of the past.
I intend to protect the taxpayer; and so I urge President
Clinton to abandon his unacceptable tax hikes as well his $123
billion in new government spending. What we should be doing is
working harder to reduce wasteful, inappropriate, and
unnecessary Federal spending. Hard-working taxpayers should not
be stuck with the bill for the return of big government.
[The opening statement follows:]
Opening Statement of Hon. Bill Archer, a Representative in Congress
from the State of Texas
Good Afternoon.
Today's hearing has been called to examine the revenue
provisions in the President's budget.
I want to thank my colleagues in both parties for the
comments, letters, and thoughts you have shared with me
concerning the Administration's plan. If I hear you right, the
Administration's tax hikes have met massive bi-partisan
opposition.
The reason is simple. The vast majority of these proposals
aren't loophole closers. Instead, the President has proposed a
series of tax hikes on women, widows and middle-income
Americans who save; millions of airline passengers; small
businesses that create jobs; and manufacturers that export.
I've closed abusive loopholes before and I'll close them
again. But when it comes to protecting taxpayers, I've fought
tax hikes before and it looks like it's time to fight them
again. Taxes are at the highest level in our nation's peacetime
history, yet President Clinton's budget raises them even
higher.
According to an analysis released yesterday by the Joint
Committee on Taxation, the President's budget includes 43
separate tax hikes that raise a total of $38.9 billion over
five years. The budget also calls for $65 billion from an
undefined increase in tobacco revenues. The ten year tax hike
in this budget is $236.8 billion.
Thirteen of these provisions are reruns that got bad
bipartisan ratings the first time. Given the Administration's
failure to win support for these proposals in the past, I
question why the White House is trying again. When I announced
the Committee agenda, I said if the Administration makes the
same tax hiking mistakes it made in previous budgets, those
hikes will be dead before arrival. To protect the taxpayers,
let me be clear. These tax hikes remain dead.
As for the rest of the tax hikes, Mr. Rangel and I have
received a letter from virtually every Committee member urging
our opposition to the proposals that increase taxes on people
who save and invest in life insurance and annuities. At a time
when our nation should increase incentives to save, I question
why the Administration is raising these taxes.
The budget calls for a $6 billion increase in airline
taxes. Last year's budget agreement provided a long-term,
stable resolution to this thorny issue, yet the Administration
now wants to collect more money from the traveling public. This
provision is an old-fashioned tax hike on millions of traveling
Americans and I oppose it.
On the other side of the ledger, the budget contains a mind
boggling series of provisions that add further complexity to
the code. If you think the tax forms are complicated now, just
wait until the IRS gets deeper into your private life so you
can qualify for many of these new proposals. The last thing we
should do is turn the IRS into another Department of Energy.
Last year's tax law made the code complicated enough. This
year, our efforts should focus on simplifying the code. That's
why I want to modify the new capital gains law that's driving
sixteen million taxpayers crazy as they struggle to fill out
their tax returns. But the President's new, complicated
loopholes are a step in the wrong direction and they'll be hard
to support.
It appears to me that the Administration's budget is
beginning to unravel. Unless President Clinton can convince
Congress to raise taxes on the American people, his budget will
be out of balance.
Having worked so hard to get the budget into balance, we
must not return to the failed policies of the past. I intend to
protect the taxpayers and so I urge President Clinton to
abandon his unacceptable tax hikes as well as his $123 billion
in new government spending. Hard working taxpayers shouldn't be
stuck with the bill for the return of big government.
Chairman Archer. And now, I'm happy to recognize Mr. Rangel
for any statement that he might like to make.
Mr. Rangel. Mr. Chairman, let me join with you in
congratulating the administration for the great job that they
have done in the last several years in improving the economy.
Federal Reserve Chairman Greenspan believes a large part of
that improvement was due to the 1993 Budget Act. But I think we
can get beyond that and recognize this is not a Democratic
victory, but a victory for all of the people of our country.
Indeed, the way things look it may be a victory for the whole
world. We're going through a fantastic economic expansion.
Interest rates, inflation, and unemployment are down and
there's a general feeling of prosperity--or at least the hope
that all Americans will be able to enjoy the benefits of this
economic expansion.
The President now has come forward with some ideas that, I
gather from the Chairman's remarks, about which you have some
reservations. In view of the fact that the President has been
so successful in reducing the deficit and providing us an
opportunity to dedicate the surplus to the improvement of the
Social Security system--and in my opinion, attempting to
provide health care for those people who find themselves unable
to afford it and to reduce class size. It would seem to me
that, notwithstanding the reservations that people may have
about some of these programs, we have to have some assurances
that the President's proposals will have a hearing. I want to
thank you for allowing this process to begin today.
I know your primary concern is sunsetting the Code and the
IRS and pulling it up by the roots and replacing it with a
postcard, simple, flat tax system. But it doesn't look like
we'll be able to do that anytime soon--at least not before the
election.
Between now and the time that we go back home to run for
reelection, the leadership has not provided us with many
working days. This means we will have limited time to review
the program that the Republican leadership has--and that's an
assumption on my part, that there is a program--but even a more
limited time to review the recommendations made by the
President. So, I don't want to take time out today just lauding
you for having this meeting, but I'm taking this time because,
based on the scheduling process, I have no idea as to when we
will be meeting again, whether this month or next.
In any event, I want to thank the administration for its
patience, but do hope at some point in time that the President
would insist that if his recommendations are not passed, that
at least they be considered and debated. Knowing that fairness
and the equity the Chair has demonstrated in the past, there's
no question in my mind that, for those issues that come within
the jurisdiction of this Committee, we should have a time for
debate, to legislate, and to dispose of--one way or the other--
the President's recommendations.
Thank you, Mr. Chairman.
Chairman Archer. We're pleased to have with us today
representing the administration and standing in for Secretary
Rubin his chief right-hand-man, the Deputy Secretary of the
Treasury, Larry Summers.
We're happy to have you with us today to give your
presentation of the President's revenue portions of the budget
proposal. We will be delighted to receive your testimony, and
you may proceed.
STATEMENT OF HON. LAWRENCE H. SUMMERS, DEPUTY SECRETARY, U.S.
DEPARTMENT OF THE TREASURY
Mr. Summers. Thank you very much, Mr. Chairman. And I am
very glad to have the opportunity to appear before this
Committee and speak about the President's budget.
I have a longer statement which I will submit, with your
permission, for the record.
Chairman Archer. Without objection, your entire written
statement will be inserted in the record.
Mr. Summers. I want to make three primary points here this
afternoon, Mr. Chairman. First, the American economy is in far
better shape today than it was 5 years ago because of our
progress in deficit reduction. We are enjoying an economy today
with 4.7 percent unemployment; the creation of 14 million jobs;
a higher share of equipment investment than at any time since
the statistics began to be calculated; real wages starting to
rise for the first time in 20 years; inflation at lower levels
than we have seen in many, many years. That is something that I
think most economists would agree reflects many factors. But
probably no single factor is as important as the profound
progress that we have made in deficit reduction since 1993 that
brought the budget deficit down to $21 billion last year and
puts us on the verge of substantial budget surpluses.
As a consequence of the fiscal actions that the President
entered into in 1993, of course with Congressional support, the
budget deficit reductions will free up nearly $1 trillion that
otherwise would have been invested in government bonds, in
productive equipment, in productive new structures--homes,
factories--for Americans. In our judgment, preserving this
fiscal triumph is priority No. 1.
Second, the best way to preserve and build on the progress
we have made is to put Social Security first, as the President
has suggested. It's the best way, in fiscal terms, because it
helps best to prepare us for the challenge of an aging society.
It is the best way in national economic terms because it
provides for the increased national savings that we need if we
are to meet the challenge of an aging society. And it is the
best way in national social terms given the importance of the
basic benefits that Social Security provides. Nearly half of
Americans over the age of 65 would be in poverty without Social
Security. Now, at a time of very strong economic performance,
when we face a major economic challenge, that is a time to
save. And the best way to save is to preserve the surpluses
until we have resolved the challenges facing the Social
Security system.
Third, a strategy of Social Security first does not
preclude the important new initiatives to address important
national goals. What is crucial, however, is that any such
initiatives be fully paid for and paid for within the budget.
That is the approach that is reflected in the President's
budget. The President's budget provides moderate tax cuts that
are fully paid for and new spending in areas that are crucial
to increasing future productivity and to protecting America's
key national interests.
Let me just highlight a few of the measures contained
within the President's budget.
Increased funding for education--the one national economic
strategy that both increases productivity and increases
equality--including an additional $5 billion to support school
construction and modernization projects, subsidies to recruit
and train more teachers.
Far-reaching measures to make child care more affordable,
including a $5 billion expansion of the child and dependent
care credit that will grant 3 million taxpayers an average
annual tax cut of $330. Helping parents with child care is not
only good for families, it's good for the economy because it
helps all to participate in the workplace to the full extent of
their abilities and wishes.
Measures to promote growth in our inner cities and other
economically distressed areas by increasing the low-income tax
credit and increasing funding for community development banks.
Democratizing the access to capital is a national issue. Our
economy will never achieve its full potential until we equip
the people of these areas to enter the economic mainstream.
Crucial new steps to protect the environment with $3.6
billion and nine tax incentives to promote energy efficiency
and improve the environment. Tax incentives not directed at
encouraging the purchase of goods that are ordinarily on the
market, but encouraging leapfrog technologies such as the major
innovations we've seen in fuel-efficient vehicles.
Mr. Chairman, a beneficial byproduct of our policy to
reduce youth smoking through comprehensive tobacco legislation
is that it will raise revenues for public needs. Our budget
proposes to share these revenues among three uses. First, we'll
return to the States roughly the amount of revenues that they
would have received under the original settlement. A large part
of this money will be unrestricted; States can use it for
whatever purposes they choose. The rest of the money will go to
States for State-administered programs to provide child care
subsidies, reduce class size, and expand coverage of children
by public health insurance. Second, we are providing funding
for a dramatic expansion of health-related research in America
through our research fund. Finally, we divide the remaining
dollars into other uses including cessation programs and farm
support programs to deal with the adjustments associated with
tobacco legislation.
The budget does contain, because of our commitment to
maintaining fiscal discipline and paying in full for any new
initiatives, $23 billion in revenue raising measures--$11.1
billion have been proposed in prior budgets. These items
include: The repeal of the sales source rule; the repeal of the
lower of cost or market inventory method; and repeal of the
percentage depletion for nonfuel minerals mined on Federal
lands; and the reinstatement of the oil spill excise tax.
The budget also provides $11.9 billion from new measures to
eliminate unintended subsidies and other revenue raising
provisions. These include: Several new insurance provisions
which raise approximately $4.6 billion in revenues; three
provisions restricting unintended consequences of the current
REIT, real estate investment trust, rules, which raise
approximately $135 million; and eliminating several unwarranted
subsidies relating to estate and gift taxes, including a
provision to stop nonbusiness valuation discounts, which raises
approximately $1 billion.
Mr. Chairman, these revenue-raising proposals will no doubt
be the subject of debate. But we look forward to working with
the Congress in the process of identifying unwarranted
subsidies where it is necessary to raise revenue in order to
ensure that we maintain the fiscal discipline that has been so
important. What is crucial is that any new expenditure or
reduction in tax burdens be fully paid for. We have finally put
our Nation's fiscal house in order. It is an enormous
achievement we must protect, and it is an enormous opportunity
to seize. As the old saying goes: You fix your roof while the
sun is shining. And that is the approach that the President's
budget takes.
Thank you very much.
[The prepared statement follows:]
Statement of Hon. Lawrence H. Summers, Deputy Secretary, U.S.
Department of the Treasury
Mr. Chairman and members of this committee, it is a
pleasure to speak with you today about the President's FY 1999
budget. This is an historic moment: The President is proposing
a balanced budget for the upcoming fiscal year, the first since
1969. The budget is rooted in fiscal discipline, yet invests in
areas critical to future productivity and the American people.
Perhaps most importantly, this budget provides a clear answer
to the question of how to use the projected budget surpluses.
The President proposes that surpluses be reserved pending
reform of the Social Security system.
This budget carries forward the President's successful
economic strategy. As the President said last month during the
State of the Union, from the beginning of this Administration
we have ``pursued a new strategy for prosperity: fiscal
discipline to cut interest rates and spur growth; investments
in education and skills, in science and technology and
transportation to prepare our people for the new economy; new
markets for American products and workers.''
Before I discuss the specifics of this budget, I think it
is important to review the progress we have made in getting our
fiscal house in order.
When President Clinton entered office in 1993, the federal
debt had quadrupled from 1980 to 1992 and the 1992 deficit was
$290 billion, an all time high. These huge deficits kept
interest rates high, diminished confidence, lowered investment
and stifled growth. Budgets were based on economic assumptions
that were far too optimistic. When these assumptions failed to
materialize, the result was higher deficits than forecast, and
cynicism about the budget process.
In 1993, President Clinton fought for, and Congress
approved, a powerful deficit reduction plan that was based on
conservative economic assumptions and which brought the deficit
down by $500 billion over five years. The deficit reduction
increased confidence, helped bring interest rates down, and
that, in turn, helped generate and sustain the economic
recovery, which, in turn, reduced the deficit further. The
result was a healthy, mutually reinforcing interaction of
deficit reduction policy and consequent economic growth, that
brought the deficit down to $22.3 billion in 1997, and sets the
stage for going to balance.
Today, unemployment is 4.7 percent; it has been under 6
percent for the last three years. Over the last five years, the
economy has generated over 14 million new jobs, inflation and
interest rates are low and real wages are rising, although too
many Americans are still not participating fully in the
economic well-being that most are sharing. Last year's
bipartisan deficit reduction package has further improved our
fiscal picture, even while increasing investments and cutting
taxes for the middle class.
Moreover, for a median income family of four, the federal
income and payroll tax burden will be lower in 1998 than at any
time in the last 20 years. And for a family of four earning
half the median income, in part because of the expansion of the
Earned Income Tax Credit for 15 million families, the federal
income and payroll tax burden is lower than at any time in the
last 30 years. Families' tax burden will fall further next year
when the child credit enacted last year is fully phased in.
Mr. Chairman, the efforts over the past five years have
paid off: the current projection anticipates surpluses well
into the next century, although long-term budget forecasts
inherently involve a great deal of uncertainty. How we use
these surpluses is a critically important issue in the years
ahead, and a key focus of the President's budget.
The overarching point of the President's economic strategy
going forward and his 1999 budget is clear: under no
circumstances can we take any steps that will undo the fiscal
discipline we have worked so hard to achieve. The last few
years clearly demonstrate the economic benefits of a strong
fiscal position and the global financial markets that have
emerged in recent years greatly heighten its importance. The
global capital markets impose swift and strict penalties on
countries with unsound policies as we have seen in recent
months in Asia and confer great benefits on countries with
sound policies.
The surpluses present an enormous opportunity, one that so
many have worked hard to achieve, and one that we must not
squander. Because this nation has a major challenge ahead: the
challenge of moving from a younger society to an older one.
A time of surplus, a time when a major change is coming, is
not a time to spend. It is a time to save. And the best way to
save for our future is to save Social Security. That is why we
believe the surpluses should be reserved until Social Security
is placed on a sound financial footing for the 21st century.
This is the right policy for our nation. It is the right
policy from the standpoint of the economy, which needs to save
more in order to invest and grow fast enough to shoulder the
burdens of the next century. It is the right policy from the
standpoint of our long-term fiscal health, which will otherwise
be placed under growing strain by the costs associated with
aging. And it is the right policy from the standpoint of
individuals, who need to make plans to ensure their long-term
security in retirement, and a substantial proportion of whom
will inevitably rely on Social Security. That is why the
President believes very firmly that nothing should be done with
the surpluses until Social Security reform is addressed.
Of course, as we go forward there will be a need for new
measures to equip our nation for the challenges ahead and to
compete successfully in this new global economy. The
President's commitment to preserving the surpluses does not
preclude undertaking these kinds of initiatives--including
cutting taxes and increasing spending. But what is critical is
that all those initiatives are paid for in full.
We propose moderate targeted tax cuts that are fully paid
for and propose new spending in areas that are critical to
increasing future productivity and to protecting and promoting
America's global economic and national security interests.
Today I would like to focus on just a few significant measures
that reflect those priorities.
First, to enhance productivity and maintain our country's
competitive position in the years ahead, the Administration
proposes:
increased funding for education, including an
additional $5 billion to support school construction and
modernization projects, subsidies to recruit and train more
teachers.
far-reaching measures to make child care more
affordable including a $5.1 billion expansion of the child and
dependent care tax credit that will grant 3 million taxpayers
an average annual tax cut of $330; a new employer credit to
promote employee child care and expand its availability; and
new spending for child-care subsidies for children from poor
families. Helping parents with child care is not only good for
families, it is also good for the economy, because it helps all
to participate in the workforce to the full extent of their
abilities and wishes,
measures to promote growth in our inner cities and
other economically distressed areas, by increasing the low-
income housing tax credit and increasing funding for community
development banks. This is a national economic issue: Our
economy will never achieve its full potential until we equip
the people of these areas to enter the economic mainstream.
Second, our budget proposes major new steps to protect the
environment, with $3.6 billion in nine tax incentives to
promote energy efficiency and improve the environment. These
include: tax credits of up to $4,000 for purchasers of highly
fuel-efficient vehicles and up to $2,000 for buying rooftop
solar equipment; new credits for buying energy-efficient homes
and certain energy-efficient building equipment; and a range of
new incentives to clean up environmentally contaminated sites.
Mr Chairman, a beneficial byproduct of our policy to reduce
youth smoking by increasing the prices of tobacco products is
that we will raise revenues for the government. Our budget
proposes to share these revenues among three sources. First, we
will return to the states roughly the amount of revenues that
they would have received under the original tobacco settlement.
A large part of this money will be unrestricted; states can use
it for whatever purposes they choose. The rest of the money
will go to states for state-administered programs to provide
child care subsidies, reduce class size, and expand coverage of
children by public health insurance. Second, we are providing
funding for a dramatic expansion of health-related research in
America through our Research Fund. Finally, we divide the
remaining dollars into other uses including cessation programs,
farm support programs, etc.
Of the $23 billion in revenue-raising measures we propose,
$11.1 billion have been proposed in prior budgets. These items
include the repeal of the sales source rule ($6.6 billion); the
repeal of the lower-of-cost-or market inventory method ($1.6
billion); repeal of the percentage depletion for non-fuel
minerals mined on Federal lands ($500 million); and the
reinstatement of the oil spill excise tax ($1.2 billion). The
budget also raises approximately $11.9 billion from new
measures to eliminate unintended subsidies and other revenue-
raising provisions. These include several new insurance
provisions, which raise approximately $4.6 billion in revenue;
three provisions restricting unintended consequences of the
current real estate investment trust (REIT) rules, which raise
approximately $135 million; and eliminating several unwarranted
subsidies relating to estate and gift taxes, including a
proposal to stop non-business valuation discounts, which raises
approximately $1 billion.
Mr. Chairman, these revenue-raising proposals will no doubt
be the subject of debate. What is crucial is that any new
expenditure or reductions in tax burdens be paid for. Let me
repeat: all of the initiatives in the President's budget are
fully paid for. This budget is in full accordance with the
Budget Enforcement Act. It does not exceed the discretionary
caps.
We have finally put our nation's fiscal house in order.
That is an enormous achievement we must protect. And it is an
enormous opportunity we must seize. We face significant
challenges in fostering a strong economy and maintaining fiscal
responsibility in the years and decades ahead, particularly
with the coming retirement of the baby boom. So, as the old
saying goes, you fix your roof when the sun is shining.
Mr. Chairman, the President's budget carries forward the
President's economic strategy that has been so central to the
strong economic conditions of the past five years. This budget
preserves the surpluses until we strengthen Social Security,
invests in areas that are critical to the future of this
country, provides for programs that protect and promote our
critical economic and national security interests in the global
economy, and, of absolutely critical importance, it keeps us on
the path of fiscal discipline that is so crucial to our
economic well-being. I look forward to working with all of you
in the days and weeks ahead to approve this budget. Thank you
very much.
Chairman Archer. Thank you, Secretary Summers. I'll try to
keep my inquiry brief and permit adequate time for all the
Members. Do you have a time constraint today? How long?
Mr. Summers. I've got plenty of time, Mr. Chairman.
Chairman Archer. OK, great. You mentioned----
Mr. Summers. I may develop one depending on how the
questioning goes here, but at this point I have plenty of time.
Chairman Archer [continuing]. You mentioned the reduction
in borrowing at the Federal level, which I applaud. Of course,
we're continuing to increase borrowing, but we're reducing the
rate that otherwise would have occurred had we not taken action
against the deficit. Is that fair?
Mr. Summers. Well, starting this year, if as expected the
surplus materializes, we would actually be in a situation where
the Federal Government as a whole would not be involved in net
borrowing from the public and the stock of outstanding debt
held by the public would start to decline.
Chairman Archer. You specifically refer to debt held by the
public. As we see, the Social Security Trust Fund continues to
lend money to the Treasury, money that is not coming from the
public--unless you consider that the payroll taxes paid by the
public into the trust fund is drawn out of the public sector.
But the debt service charges are continuing to increase because
the overall debt is continuing to increase. And the debt
ceiling is going to have to be raised again as proof of that. I
don't want to get into an economic debate with you about
whether the public holds it or the trust funds hold it, because
I understand the differences there. But the point that I want
to make, without belaboring that, is that whereas we have
reached the point--and it's been a cooperative effort, as you
mentioned, between the Congress and the President to get to
this point--to where we've got a balanced budget, that as the
Federal Government's rate of increase of borrowing has gone
down, thereby leaving more money in the private sector, we've
also witnessed a major decline in personal savings in this
country that has offset that. And I wonder if that disturbs
you? I think we're at a virtual historic low in personal
savings, and certainly, of all the industrial countries in the
world, I believe we're right at the bottom.
Mr. Summers. Mr. Chairman, as you know, going back a long
time to the time that I was involved in academic work, I've
been very concerned about the problem of savings in the United
States. I think we can all take some satisfaction from the fact
that the net national savings rate of our country--adding
together personal savings, corporate savings, and government
savings--which was approximately 3.1 percent in 1992, has
increased to 6.5 percent--more than doubled--by 1997, largely,
as a consequence of the reduction in government budget
deficits. Unfortunately, that savings rate is still
substantially lower than our country enjoyed during the high-
growth fifties and sixties, and is still low by international
standards. But I think in the last few years, after a period of
12 years when we saw declining national savings rates, we have
at last started to see the total savings in our country
increase. And I think that's a very important thing on which we
can build.
Chairman Archer. But, I think you share my concern that the
personal savings rate needs to come up.
Mr. Summers. I do.
Chairman Archer. Instead of going down. And that leads me
to the question of why do you want to attack one of the best
sources of individual savings in this country which is the
inside buildup in insurance policies where millions of
Americans buy insurance and depend on ultimately being able to
get a payback from that and the annuities. And yet, the
proposals that you have made directly attack these areas which,
once again, will erode personal savings in this country.
Mr. Summers. Mr. Chairman, it is not our intent, and I
believe it is not the content of our proposals, to attack
inside buildup. There are a number of insurance proposals and
they are somewhat technical in their nature. One of the
proposals, without attacking the basic rule that defers tax on
inside buildup, does provide for parallel treatment in the case
of deferred annuities where investments in contracts or funds
within contracts are realized and switched, parallel with other
financial instruments. These are provisions that do not change
the basic rule that defers tax on inside buildup, and affect
financial instruments that are held by only a very, very small
fraction of Americans.
There are also proposals which address not the taxes on
beneficiaries, because inside buildup is indeed very important
for savings, but affects certain taxes on insurance companies
that are associated with reserving practices that go beyond
what is associated, according to generally accepted accounting
principles, with the measurement of economic income. And there
are provisions which affect the corporate-owned life insurance
case which is primarily a financial devise that is used by
corporations.
But, I would be--I am very much committed to the objective
of increasing savings. And we were very pleased to work with
you last year on the expansion of IRA provisions and other
forms of tax-deferred saving. And I would be very troubled
about anything that interfered in a substantial way with
savings. But I don't believe that these provisions run that
risk. The vast majority of the revenue in the insurance area
comes from things that do not affect taxes on beneficiaries at
all. And the one provision that does is a provision which does
not change the basic rule that defers tax on inside buildup.
Chairman Archer. Well, the net effect of all of these
provisions that raise taxes out of the insurance industry are
going to directly attack savings, no matter how you describe
it.
Now, let me get into another area very quickly, and then
move on to other Members of the Committee. The Joint Tax
Committee has now done an analysis of the recommendations of
the administration, and they have concluded that there is a net
tax increase of $80 billion over 5 years, and $174 billion over
10 years. Now, that is over and above whatever tax benefits
that you have recommended in your proposal. And in your own
budget documents, you cite that in 1997 Federal tax receipts
were 19.9 percent of GDP, and if your administration proposal
is enacted, they would go to 20.1 percent. Now, 19.9 percent is
already a historic, peacetime high for this country. And 20.1
percent increases that to where there will only be 2 years in
the history of this country where the Federal Government's take
of GDP has been higher, and those were both in World War II.
Now, I want to ask you a couple of things after also
referring you back to the President's comment that he made in
my own home city of Houston, Texas, where he agreed that he had
raised taxes too much in the 1993 bill. Well now, considering
all of that, do you now think that the Tax Relief Act of 1997
gave back too much in the way of taxes? And is that the reason
why you are recommending an additional $174 billion net tax
increase over the next 10 years? Do you believe that 19.9
percent is an appropriate percent of GDP for the Federal
Government to take? Do you think that burden is too high on the
American people? And if so, do you have any plans to bring the
net tax burden down?
Mr. Summers. Mr. Chairman, you've asked a number----
Chairman Archer. A lot of questions.
Mr. Summers [continuing]. You've asked a number of
questions. Let me, if I could, just make a few points in
response. First, I very much support the 1997 tax bill, as the
other tax bills that have passed in the last few years, as a
result of which, I think, we can all take a great deal of
satisfaction in the fact that the tax burden, adding in both
income and payroll taxes on median-income Americans, is now
lower than it has been in 20 years. And income tax burden on
median-income Americans is now lower than it has been in 30
years. I think that's an important accomplishment in which we
can all take pride.
Second, on the figures that you referred to, I think I have
a slightly different perspective. There's a technical issue
which is that the 19.9 percent figure is not actually a figure
for tax collections, but includes all receipts, such as fines,
and the profits from the Federal Reserve, and so forth. And if
you look at the share of receipts that go to the Federal
Government, the administration does indeed want to see it go
down, and its budget provides for a measure that you used,
which isn't quite the taxes, for it to go from 19.9 percent
this year to 19.6 percent in 2003. Of course, there are
fluctuations from year to year reflecting changes in profit
shares and things of that kind, but our budget does provide for
that to go down.
Third, on the question of tax increases, the issue, Mr.
Chairman, is largely or entirely due to the treatment of
possible tobacco revenues, which as you know, the
administration regards as being part of the context of a
settlement, and doesn't think should be viewed as a tax
increase. And indeed, it has not been viewed as a tax increase
so far in the context of those settlement discussions. And so
if you take the tobacco out of it, ours is a budget that does
not raise taxes. Ours is a projection that reduces the Federal
share of GNP, gross national product, and ours is a budget that
reduces tax burdens on middle-income families from their
current level, which is lower relative to income than they have
been in 20 years.
Chairman Archer. Well, let me if I may, and I didn't intend
to do this, but since you brought up the cigarette tax, let me
pursue that for just a moment. I'm fortunately one who has
never smoked in my life. I despise cigarette smoke. I wish
everybody in this country would stop smoking--we'd be a much
better Nation. But, a tax on cigarettes is a tax. It's called a
tax, and it is a tax. And for those people who do continue to
smoke, though unwise to their own personal health, they will be
paying that as a tax into the Federal Government, which means
that they will have less money to spend on other items in the
marketplace. So it is clearly a tax. And to call it anything
else, although you may be able to find that it's more popular
than other taxes, is to ignore an economic basic reality that
it is a tax. And it impacts on the economy in the same way
other taxes would, except that it hits lower income people the
hardest. It is one of the most regressive taxes that there is.
And all of the data, whether done by the Treasury, or the Joint
Committee on Taxation, shows that to be true. So it is a tax.
And to say: Well, we can ignore that in determining what the
net tax impact of this bill is, is just not accurate.
But I do appreciate your comments, and I yield to Mr.
Rangel. In fact, I recognize Mr. Rangel.
Mr. Rangel. And I recognize you too, Mr. Chairman.
[Laughter.]
That compassionate display for the poor as it relates to
cigarette tax, is really something that I was moved by. I just
wanted to indicate that.
I know you have a lot of time, but, I hate to raise this,
this election is kind of closing in on me, and I don't know how
much time the President has. I have to agree with the Chairman
that there are some rather provocative tax increases that you
presented. They have brought a degree of bipartisanship, of
opposition. But there are some pretty exciting social programs:
Social Security, education, health care, child care, and the
economic development of inner cities.
Now this is the President's program, and I just got a copy
of the Majority Whip's program, which I share with the Chair,
of course. As I look at this, Mr. Chairman, all the red dates
are days we're not here. So, that's half of February we're not
here. The President will be in Africa in March. We'll be here
for about 5 or 6 days in April; half of May; most of June; half
of July; a little bit in August; half of September; and then,
Tom DeLay, the Majority Whip says that the target adjournment
date is October 9. Now, I haven't added the days that we
actually are going to be working, but has the President or his
representative worked out some type of an agreement with the
Majority so that the President's proposals, as well as the
Majority's--for lack of a better word--legislative program,
would be discussed? I mean is there any timeframe that you know
of that you could share with us?
Mr. Summers. Congressman Rangel, I'm not aware of agreed
legislative timetable. I think we in the administration believe
that the President's budget contains a variety of very
important proposals that are very much in the national
interests. Others, of course, will have a different view. And
our hope is that the proposals will receive full and careful
consideration by the Congress this year. But I don't have a
particular set of timetables to share with this----
Mr. Rangel. Well, let me say this: I'm certain that the
Majority and the Chairman make certain that they're fair in
reviewing the President's proposal. But suppose, just for the
purpose of our discussion, they decided to do nothing with any
of the President's proposals and just decided not to work this
year at all. What happens then? I have no idea how this thing
works, but since we don't see each other that often, what would
the President say or do?
Mr. Summers. I would think that all of us have an
obligation to pass a budget so that the government----
Mr. Rangel. Well let's talk about that----
Mr. Summers [continuing]. So that the government can
continue to function into the next year. I think that if we
passed a status quo budget rather than advanced initiatives of
the kind that are contained in the President's budget, we would
be passing up important opportunities to invest in education,
to invest in child care, to invest in basic medical research,
and we would leave what I feel is a very serious problem: The
million young people who begin smoking each year--nearly
300,000 of whom will die as a result of that smoking--we would
leave that problem unaddressed.
Mr. Rangel. OK, well, just on the question of the budget,
I'm not certain, but don't we have a legal responsibility to
have a budget passed by the 15th of April? Now, if that's so,
and we are only scheduled to work in March, and we're out of
here for April, I don't think we'll be able to do that. So I
hope the President might share with us, Republican and
Democrats, some timetable that you might just recommend so that
when I work with my Republican friends we might be able to fold
in some of the President's proposals in the few days that we
intend to be in session this year.
Thank you, Mr. Chairman.
Chairman Archer. Mr. Crane.
Mr. Crane. Thank you, Mr. Chairman. On the positive side,
the budget did include a provision I've supported and that's
funding for the Conservation Trust Fund for Puerto Rico. And I
want to commend you for that and ask unanimous consent, Mr.
Chairman, that a printed statement I have might be inserted in
the record at this point.
Chairman Archer. Without objection. So ordered.
Mr. Crane. I yield back the balance of my time. Thank you.
[The prepared statement follows:]
Statement of Hon. Philip M. Crane, a Representative in Congress from
the State of Illinois
Mr. Chairman, The Conservation Trust Fund of Puerto Rico is
an organization dedicated to the preservation of the natural
resources of that magnificent island. For the past two years I
have been seeking a solution to an impending financial crisis
that would render the Trust Fund unable to perform its valuable
mission. The termination of the so-called ``Section 936''
provision within the tax code ended the source of the Trust's
funding. This year's FY99 Federal Budget adopts a proposal that
I first put forward last year and incorporates it in the
recovery of excise taxes back to the Commonwealth of Puerto
Rico. By designating 50 cents to the Trust Fund out of the
$13.50 excise tax collected on each gallon of distilled spirits
exported from Puerto Rico, for a period of 5 years, the
recommendation allows the Trust to complete its endowment fund
and perform its work in perpetuity.
The Trust Fund was established in 1968 by a Memorandum of
Understanding between the Secretary of the Interior, Steward L.
Udall and the Governor of the Commonwealth of Puerto Rico,
Roberto Sanchez Velella, and the Administrator of the Economic
Development Administration of Puerto Rico, Sergio Camero, to
protect the natural resources of the island. During the past 29
years the only significant efforts to preserve critical land
resources have been conducted by the Conservation Trust Fund.
Even with this active role, only 5% of the Island of Puerto
Rico is under some protection either by federal or local
conservation agencies or the Trust. This number is half of the
percentage in the United States and less than 25% of Costa
Rica. In the aftermath of Hurricane Hugo, when the island was
devastated, it was the Conservation Trust Fund that led the
reforestation effort of the rain forest. It was the
Conservation Trust Fund that used this opportunity to prepare
critical environmental areas for restoration and at the same
time utilize them as an educational tool for the children and
people of the island.
Mr. Chairman, funding for the Trust was initially provided
through contributions imposed by the Department of Interior in
the Oil Import Allocations of petroleum and petrochemical
companies operating in the island. This lasted for a period of
ten years. Later the Trust became a participant in the QPSII
program within Section 936 of the Internal Revenue Co realized
that the changes being made in Section 936 would call for the
gradual phase out of the program. The Trust embarked on an
aggressive saving campaign. They cut back all capital
expenditures, including land procurement and major improvements
to existing properties. During that time the Trust has been
able to accumulate approximately $30 million in the endowment
fund. The goal was to reach somewhere near $80 million and this
would have been accomplished had Section 936 phased out in the
projected time period.
Two years ago this committee abruptly changed those plans.
With the passage of the Small Business Job Protection Act we
ended Section 936. The Conservation Trust Fund was the
unintended victim of this action. Left without a source for 80
percent of its funds, the Trust has endeavored to work with my
office to find a solution. My staff has discussed this problem
with the committee staff on numerous occasions. The proposal in
the FY99 Budget is a natural outgrowth of a proposal that I
made last year. The support of the Secretary of the Interior
has been critical in shepherding this through the budget maze.
The Governor of Puerto Rico is in support of this proposal and
I urge my colleagues on the Committee to support this effort to
save the endeavors of the Conservation Trust Fund.
Chairman Archer. Mr. Bunning.
Mr. Bunning. Thank you, Mr. Chairman.
Mr. Summers, would you explain the administration's
proposal for the treatment of the budget surplus in reform of
the Social Security system.
Mr. Summers. The President has simply said that in light of
the very great importance of the Social Security issue to the
future well-being of all Americans, that we should not violate
current budget rules and spend the surplus on either new
expenditure programs or tax cuts that are not fully paid for
within the budget until we have reached a resolution with
respect to the long-term future of the Social Security system.
And he----
Mr. Bunning. Does that mean--excuse me.
Mr. Summers. And he has called for a process of national
dialog, including a number of conferences and a number of other
steps during 1998, to set the stage for the process of coming
together on legislation that would begin in January 1999.
Mr. Bunning. Does that mean the President is not proposing
to take the OASDI reserves out of the budget? In other words,
are we going to be able to recycle? As you well know, what
happens now--I don't have to explain this to you, but some
people out here might not understand--is when we bring in the
FICA funds into the Treasury, we bring them into the Social
Security Trust Funds, there are nonnegotiable bonds issued, and
then we recycle the money out and spend it for other reasons,
other purposes of the Federal Government. Would you think that
we would not do that with the surplus, or that we would reissue
bonds, and we would recycle the surplus and spend it for other
purposes?
Mr. Summers. There are a number of possibilities that can
be described in a number of ways. At this point, what the
President has said is that the unified surplus is not something
we should eat into until and unless we have put the Social
Security system on a long-run viable path.
Mr. Bunning. Let me ask you then: Yesterday before the
Senate Budget Committee, you suggested that the surpluses, up
to $100 billion or more, be transferred to the OASDI fund and
invested in Treasury bonds. That means that they could be
recycled and spent for other purposes then. In other words,
under the budget, as it presently is constructed.
Mr. Summers. Congressman Bunning, I didn't make any policy
suggestion----
Mr. Bunning. Am I misquoting you?
Mr. Summers. A little bit, I think.
Mr. Bunning. Oh, really?
Mr. Summers. What I said yesterday was that there were a
variety of possibilities and I had no recommendation. Then I
observed, referring to one of those possibilities, that if $100
billion of money was credited to the Social Security Trust Fund
and allowed to accumulate in the Social Security Trust Fund,
that the result would be to push the expiration date of the
Social Security Trust Fund out by 1 year only, only if we
didn't recycle the money.
Mr. Bunning. Because obviously, if we recycled the money,
we'd be spending it and putting more liability into the trust
fund. Was that what your suggestion was?
Mr. Summers. There was no suggestion. The assumption was,
and I think for the reasons you suggest it's completely right,
that clearly if the trust fund took on an asset of $100 billion
and took on an extra liability of $100 billion, nothing would
be accomplished.
Mr. Bunning. That's correct.
Mr. Summers. And so, that line of thought--which again is
one possibility, it is not a recommendation--would call for
adding $100 billion to the surplus, in effect, transferring the
money from the unified budget to the Social Security Trust Fund
which would strengthen the Social Security Trust Fund and
would, as a byproduct--because the money would then be
allocated there--assure that the unified surplus would be
maintained.
Mr. Bunning. Only if we walled off the surplus and said: No
further use of this money could be used for any other purpose
than the Social Security Trust Fund and you couldn't issue new
debt against that money.
Mr. Summers. In a sense, Congressman, those who think about
that proposal are regarding the transfer of the revenues to the
Social Security Trust Fund as a way of accomplishing exactly
the kind of walling off that you're speaking of.
Mr. Bunning. One more question. What would the budget
deficit be if the Social Security Trust Funds were not used to
offset the budget deficit from now until the year 2008?
Mr. Summers. It would be--the budget would be--certainly
for the next half dozen years and probably a little bit beyond
that, the budget would be in quite significant deficit but for
the unified budget which reflects a unification of the trust
funds. The trust funds are in surplus, the other parts of the
budget are in deficit; together we will emerge with a surplus--
that's the unified surplus--but the non-trust fund budget is,
as your question suggests, in deficit.
Mr. Bunning. Thank you very much.
Mr. Crane [presiding]. Mr. Matsui.
Mr. Matsui. Thank you, Mr. Chairman.
There's a lot of talk about simplification and not wanting
to clutter up the Code, particularly by Chairman Archer. Will
you help me with this because I don't understand it: To go on
the capital gains holding period from 18 months down to 12
months, which is what, I think, a number of Republicans want to
do, does that do anything to decrease the rate from 28 percent?
Does that change the number of lines on the tax form?
Mr. Summers. I think at this point, Congressman Matsui, any
change in the capital gains rules would be, on net,
complicating of the Tax Code for two reasons. First, the IRS,
which I think the Committee is aware, faces a number of very
serious challenges, including the year 2000 problem, including
a reorientation toward customer service, and would, I think,
have a difficult time handling and managing the amendment to
provisions that are only now being phased in. And so a
transitional adjustment would be very complicating in that way.
Second, I think that the, to use the euphemism, I think the
tax bill that we enacted last year reflected a carefully
crafted and balanced set of compromises. And an effort to undo
those compromises in one area will inevitably raise questions
about many other areas.
Mr. Matsui. Let me get to my main point. Obviously you
support the change on the IRS and the restructuring effort. Is
that correct?
Mr. Summers. We very much support it.
Mr. Matsui. You support it. And so, you're no longer
concerned about the fact that we have an independent commission
overseeing the IRS and the whole issue of confidentiality, and
many of the issues that were raised a little earlier.
Mr. Summers. I think we found----
Mr. Matsui. But let me get to my main point, because I
think what I want to do is address the issue of complexity.
Last year we had an additional 824 amendments that were added
to the Internal Revenue Code as a result of the tax bill, and
we had 285 new sections. I've just counted the administration's
proposal here; we have 75 new tax cuts--I don't know whether
these are new sections or new amendments--and we also have 42
new tax increases, and 7 other provisions. So that's about 120
or so new provisions in the Code, coupled with the 285 and the
824. I know that Mr. Rossotti is trying to do a good job, and I
do understand that you are trying to clean up the whole
Internal Revenue Service. I commend you, Mr. Rubin, and
obviously, Mr. Rossotti, and many of those who have preceded
you.
But I guess what I'm troubled by is some of the hypocrisy
here. We're trying to clean up the Code and I keep seeing
amendments being offered. I had somebody do a little research--
one of those LEXIS-NEXIS searches--and Members of this
Committee, Members of the House, who were talking about
simplifying the Code are offering all kinds of credits and
deductions and preferences. And your proposal is just packed
with more of these. You know, I think we have to come to terms,
because we can't go out there and talk about tax reform and
simplifying the Code, and at the same time, quietly, behind
everyone's back, offer literally hundreds of changes in the Tax
Code. I think we're being a little unfair to Mr. Rossotti. I
think we're being unfair to the employees of the Internal
Revenue Service, and certainly I think we're misleading people.
And so, you may want to have a comment on it; you may not
want to have a comment on it. It's not totally your
responsibility. I mean, I think a lot of Members of Congress
last year played a significant role in this particular effort.
It was interesting, at least the 1981 bill had a philosophy: It
wanted to promote economic growth. The 1986 bill had a
philosophy of simplifying the Code. Last year's bill had no
philosophy at all. It was just: Let's just put everybody's tax
cuts together and make that a tax bill, and make everybody
happy. But there was no growth, economic philosophy, or
simplification philosophy to it. And I'm afraid that's what's
going to happen again if you embark upon another tax bill and
at the same time blame it on the IRS.
Mr. Summers. Congressman Matsui, I think you raise a very,
very important issue. We've tried to be very conscious of that
as we tried to balance the various objectives here, and I think
a substantial fraction--more than 40--of the initiatives and
amendments that are contained in the President's budget that
you referred to are Taxpayer Bill of Rights for simplification
items that would have the net effect of reducing burdens on
taxpayers and reducing compliance and striking out other forms
of complexity.
But I do think in looking at the various kinds of
incentives we provide through the Tax Code that we do need, if
you like, to put a higher price on measures which complicate
the Code and try to recognize that each thing we add adds to
the weight of the whole system and that at a certain point the
system might fall of its own weight. And I think that is an
important concern.
Mr. Crane. Mr. Summers, if you'll hang in there, I want to
recess the Committee subject to the call of the Chair, because
we're down to 5 minutes on this vote.
[Recess.]
Mr. Shaw [presiding]. There's going to be another vote
shortly, so we're going to be disrupted again, but I was asked
to start the hearing, so we won't unnecessarily delay the
witnesses.
So Mr. English is recognized
Mr. English. Thank you, Mr. Chairman.
Secretary Summers, I noted that the administration's
proposal includes an exemption for severance pay from the
income tax of up to $2,000 with a variety of restrictions--
after 6 months, applying the severance packages below under
$125,000. I have a couple of questions. One is you would apply
this severance pay exemption specifically for separations from
service that are connected with a reduction in employer's work
force. How would you define that?
Mr. Summers. It's a technical question, and I'm not a tax
lawyer, but I would assume that the employers would qualify
instances of severance based on a comparison of the total size
of the work force in the tax year with the total size of their
work force in the preceding year.
Mr. English. Do you think this provision substantially adds
to the complexity of the Tax Code? Do you think it's a
provision that you would anticipate the administration would
seek to expand down the road?
Mr. Summers. I don't particularly see any plan for
subsequent expansion, and I don't think it adds substantially
to the complexity of the Code. I think it serves an important,
very important function at a time of greater globalization in
the economy, and at a time of greater change in helping people
to adjust to change. I think in that way it allows market
forces to operate more effectively.
Mr. English. Mr. Secretary, I think I understand that part
of the intent, and, again, I presume you're familiar with the
provision. What I wanted to get a feel for--$2,000 seems to be
a fairly arbitrary number and a very small part of any
severance package. I guess, recognizing that there might be
some benefits for this kind of a tax exclusion, I was wondering
if the administration saw this as part of a long-term strategy.
I am judging from your comments probably not. Do you have
anything to add?
Mr. Summers. This is not part of any long-run strategy of
which I am aware to--it is, I think, you know, $2,000, not some
of the severance packages you read about for executives in the
newspaper, but I think for a lot of people who are laid off I
think $2,000 and the tax deductibility on $2,000 makes a real
difference.
Mr. English. Thank you. Let me move on. Under the energy
and environmental tax credits, have you done any studies in-
house on the distributional effects of these proposals?
Mr. Summers. We do not have distributional analyses of
them, and to do the distributional analysis would be very
complex. You think, for example, about, say, the incentive for
purchasing very highly fuel-efficient cars. Part of the
incidence might be on the buyers of those cars, but part of the
incidence would be on the producers and the workers who are
involved in making those cars. So I think to look at an
incentive of that size and do a distributional analysis would
be, our analysts report, very, very difficult.
Mr. English. OK. I notice in your energy and environmental
tax credit proposals you do not include an extension of the
ethanol credit. What is the significance of that?
Mr. Summers. I think the incentives in our energy and
environmental credit are really all measures that are directed
at market-based approaches to----
Mr. English. And ethanol----
Mr. Summers [continuing]. Supporting reductions in carbon
usage, and the fuel from carbon. And so I think a subsidy----
Mr. English. So you don't regard----
Mr. Summers [continuing]. A subsidy to a fossil fuel, I
mean, I think----
Mr. English. You don't regard auto emissions as greenhouse
gas then or----
Mr. Summers [continuing]. Well, I think--certainly carbon
dioxide, which comes from any fossil fuel, is a greenhouse gas,
but the focus of our incentives is on greenhouse gas
reductions.
Mr. English. OK. And I guess a final question: One of the
perennial provisions that comes out of the administration has
to do with changing the deposit requirements for FUTA taxes
from quarterly to monthly. This has been proposed before, and
it's been fairly consistently shot down. Is there any policy
reason why you would be continually proposing this, because it
appears primarily to harass businesses, particularly small
businesses, and does not appear, at least from my perspective,
to generate any real positive effects from the standpoint of
tax enforcement.
Mr. Summers. Let me say, Congressman English, that the
proposal is crafted to include an exclusion for small
businesses in order to respond to the small business concern,
and that the rationale is that it will improve compliance, and
in that way make possible reductions in other taxes, and that
it will more closely match the inflows of money into State
funds with the outflows from State unemployment insurance
funds.
If I might just return to your previous question, I'm told
that the extension of the ethanol provisions is contained in
the administration's ISTEA proposal, the highways proposal, but
that the ethanol provisions do not expire this year. And so we
are providing for that.
Mr. English. OK.
Mr. Summers. It's just not a global greenhouse gas.
Mr. English. I understand the distinction, and I appreciate
that. Thank you very much.
Mr. Summers. Thank you.
Mr. English. Thank you, Mr. Chairman.
Mr. Shaw. Mr. Weller.
Mr. Weller. Thank you, Mr. Chairman, and, Mr. Secretary, I
appreciate your taking time to be with us today.
I represent a pretty diverse district, the south side of
Chicago and the south suburbs, both city suburbs and a lot of
rural areas. I always listen for concerns and thoughts that are
fairly consistent, whether you live in the city, the suburbs,
or country. This past week I had a meeting with a group of
women, entrepreneurs and community leaders, and we talked about
the President's budget. Frankly, they liked what the President
said about Social Security, but they then question why he would
then use the surplus in the Social Security Trust Fund to
offset new spending initiatives. They were concerned about, of
course, the President proposing to raise the tax burden on
Americans to its highest level since World War II, and they
were also very concerned about the President's new proposal for
a tax increase on a retirement vehicle that many of the women
in the group that I met with were using.
I found it interesting. They shared some statistics, and
when it comes to annuities which you propose taxing, a majority
of these annuities that are sold today are held by women.
Ninety percent of them are over 50 years of age, and two-thirds
of the women who purchase these make less than $50,000. They're
middle-class individuals.
What I was just trying--so I can better understand your tax
increase on retirement, I was wondering, how much revenue is
generated by your tax increase on retirement?
Mr. Summers. The annuities provision that you're referring
to I believe has a revenue impact of approximately $1 billion.
Mr. Weller. A year?
Mr. Summers. No, $1 billion over 5 years.
Mr. Weller. So it's a $1 billion tax increase over 5 years
on retirement. Money that would have gone toward retirement,
that instead will come to Washington and be spent on the
President's new spending initiatives?
Mr. Summers. No, Congressman, I think the principal
incidence will be on commissions received by those who sell a
particular class of financial products, and in particular,
those who encourage the churning of those products. Anyone who
purchases a deferred annuity and holds the same investments
inside the deferred annuity will have no change whatsoever in
their tax practice. What will be discouraged is transfers from
one deferred annuity to another. And therefore, those who are
involved in encouraging the churning of the deferred annuities
and who receive--I think it's been well documented--rather
substantial commissions, when those deferred annuities are
churned, will be affected. Again, for someone who purchases a
deferred annuity and holds the same funds inside the deferred
annuity, they will get full inside buildup, with no significant
change in----
Mr. Weller. Let me, Mr. Secretary, let me----
Mr. Summers [continuing]. Tax liability.
Mr. Weller. Then you really raise an issue of fairness. As
a Federal employee, if you're in the Thrift Savings Plan, you
can shift your funds around in your Thrift Savings Plan from
one fund to another, choose options, without a transaction tax
which you're proposing, but you're turning around, and on the
women that I met with last week who are using this as part of
their retirement plan, imposing a tax on their decision to
shift it from one investment option to the other. How is that
fair?
Mr. Summers. Congressman Weller, the Congress has, in
crafting the legislation in this area, established a set of
particular tax preferences for pensions and 401(k)s that are
circumscribed, that include limits on contributions, that
include top-heavy rules to assure that the benefits are equally
shared, and in that category it is, indeed, possible to make
transfers.
Deferred annuities have never been thought of as being
within that category. There are no top-heavy rules; there are
no limits on the quantity of contributions. So I think that is
not usually thought of as the appropriate analogy in looking at
deferred annuity provisions. Deferred annuities investments are
in many ways more like mutual fund investments, although they
are mutual fund investments that are very substantially
preferred because the inside buildup is preferred, is tax-
deferred, unlike the situation with respect to mutual funds.
Mr. Weller. But, Mr. Secretary, you are taxing one of the
choices and one of the options they have, and frankly, I think
from a fairness standpoint, it doesn't make sense to tax one
and not the other. Of course, I don't support your tax, but the
question I have is: You know, in your testimony, you point out
that you're spending initiatives are paid for with these tax
increases that the President's proposing in his budget. And I
was wondering, specifically, which spending initiative does the
President pay for with this tax increase on retirement?
Mr. Summers. No. What I suggested, the spending initiatives
that the President has undertaken are financed through other
spending cuts or are financed through proceeds from the tax
settlement. The President's budget is balanced, essentially
balanced, in the tax area with tax incentives and tax cuts that
are contained in the budget being matched by the revenue-
raisers that are included in the budget.
Mr. Weller. So which spending initiative is matched with
those tax increases on retirement----
Mr. Summers. It's a package. That's not a question--money
is fungible, Congressman. There's a package of revenue-raisers
and a package of tax cuts, and the package of tax cuts is
financed by the package of revenue-raisers.
Mr. Shaw. The time of the gentleman has expired.
Mr. Weller. Thank you, Mr. Chairman.
Mr. Shaw. Mr. McCrery.
Mr. McCrery. Thank you, Mr. Chairman.
Mr. Summers, just to follow up on Mr. Weller's questioning
about the administration's proposals on annuities and variable
life products, clarify, if you will, who is taxed when there
is, say, an exchange for a life insurance policy, for an
annuity? Or if an investor in an annuity, for example, decides
to change the mix of the investment within the annuity, who
exactly is taxed?
Mr. Summers. If you'll pardon me 1 second, I will consult
with the experts behind me and I will give you an answer.
Mr. McCrery. Sure.
Mr. Summers. In the area of the deferred annuity, which is
13 percent of the total set of insurance proposals, the holder
of the annuity who makes a transfer from one asset to another
asset is taxed. A holder who chooses a balanced portfolio and
sticks with that balanced portfolio would not bear any tax
burden.
Mr. McCrery. When you say the ``holder,'' who is that?
Mr. Summers. That's the potential beneficiary.
Mr. McCrery. So that's usually the purchaser of the
annuity, the consumer?
Mr. Summers. That is usually the purchaser of the annuity,
indeed.
Mr. McCrery. So at least in this case you are taxing
directly or imposing a new tax directly on the consumer of
those products, and not the agents or the insurance companies?
Mr. Summers. Well, as I tried to suggest in my answer, this
13 percent of the insurance does affect beneficiaries directly.
It also affects those who are involved in encouraging transfers
from one deferred annuity contract to another. Depending on
what choices are made, it's difficult to sort out the
incidence. In response to this tax, people do not churn their
investments. Then the result will be that the revenue loss will
be to the agents who would have encouraged--would have earned
commissions on the churning. If behavior doesn't change and the
same commissions are paid, then those individuals who are
churning will face a tax treatment on their deferred annuities
that is similar on asset transfers, though not similar with
respect to inside buildup, to the tax treatment with respect to
mutual funds.
Mr. McCrery. But at least on the instance which I
described, and to which you initially responded, it's the
consumer that would experience an increase in taxes. And don't
you think that that is contrary to good public policy that
should encourage people to plan wisely for their retirement? I
mean, if you've got somebody that's 30 years old that enters
into an agreement or contract like this, the mix of his
investment--I'll wait until your staff gets through, so you
could listen. A 30-year-old who enters into one of these
contracts is going to have a different investment mix than he
will have when he's 55 years old. So shouldn't he have the
right to shift those investment choices within that contract
without having to face a tax? That seems to me to be totally
contrary to what we want people to do, which is wisely plan for
their retirement.
Mr. Summers. Well, of course, a 30-year-old who is
following a normal path would be making contributions each
year, and so would not have difficulty in adjusting their
overall mix between stocks and bonds, for example, simply by
adjusting the pattern of their contributions, or could do that
in the areas where there would be tax neutrality between those
within the 401(k)s, within the pensions.
Mr. McCrery. I think you're wrong on that. I don't think
there is enough flexibility to change the mix just on the basis
of new contributions to plans.
Also, before my time is up, I just want to point out that
there is a distinct difference between these types of contracts
and mutual funds. You try to equate the two, and, in fact, on
these kinds of contracts there are penalties for early
withdrawal; there are regulatory barriers to people getting out
of these before they reach retirement age. So they are not the
same as mutual funds, Mr. Summers, are they?
Mr. Summers. They are not the same instruments as mutual
funds, obviously, Congressman, but I think the general
principle is something that we've long recognized in the tax
law, that when an event that is concomitant to, or the same as,
a realization of the sale of an asset takes place, that that is
something that we tax.
I might note, just parenthetically, that most of these
assets are actually marketed to those who have retired or who
are about to retire. So the situation of a changing need over
the life cycle is not one that arises with any great
frequency----
Mr. McCrery. That is changing. That is changing, though,
Mr. Summers. That statistic won't be the same 5 years from now.
Mr. Summers. Well, I'm not sure. I mean, I think these
products have been subject to rather extensive and not wholly
favorable analysis in the financial press just in terms of
relative rates of return. So I'm not sure what the future will
hold for them.
Mr. Shaw. If the gentleman would suspend, the time of the
gentleman has expired.
Mr. Summers, I may inquire as to what your schedule is. We
have a series of votes on the floor which is going to take the
better part of an hour. Can you stay with us?
Mr. Summers. I will have a difficult--I need to get back to
my office for a fairly important, quite important meeting
sometime between 3:30 and 4 o'clock.
Mr. Shaw. Well, if you could stay with us at least until
3:30, we'll try to wrap it up or make arrangements for you to
come back.
Mr. Summers. I'd be delighted to.
Mr. Shaw. Thank you. I appreciate it.
Mr. Summers. Thank you.
Mr. Shaw. The Committee will be in recess for the better
part of an hour, but at the conclusion of the votes that are
scheduled we shall reconvene.
[Recess.]
Mrs. Johnson of Connecticut [presiding]. I'd like to
announce that the hearing is formally adjourned. Mr. Summers
had to depart and has indicated that he will respond promptly
to questions in writing from Members. We thank him for that.
[The following questions submitted by Mr. Houghton, and
Deputy Secretary Summers' responses are as follows:]
Questions Submitted to Deputy Treasury Secretary Summers by
Representative Amo Houghton
(1) Regarding the Foreign Application of the Frequent Flyer Tax:
Last year's tax bill extended the aviation tax to purchases
from air carriers of frequent-flyer award miles by credit card
companies, hotels, rental car companies, and others to be
awarded to their customers. It is my understanding that this
new law is being interpreted as applying to foreign-based
frequent-flyer programs run by both U.S. and foreign companies,
and that foreign application of this tax will have the impact
of taxing frequent flyer miles that may never be used for U.S.
air travel. I also understand that at least 20 foreign
governments have filed protests with the State Department
arguing that the tax should not apply when the ultimate air
travel largely involves points outside the United States.
Would the Treasury Department support a legislative
alternative to apply the tax more directly to travel to and
from the United States, since the current foreign application
of the tax appears to be overly broad, creates collection
problems for the IRS, and will produce revenues that will have
little connection to the use of FAA facilities and programs?
Questions on Revenue Estimate for PS-REIT Elimination:
Can you share with me some of your methodologies concerning
your revenue estimate for the PS-REIT proposal?
The answers provided below should provide you with a
reasonably good understanding of the main assumptions in the
methodology used by the Administration to produce the revenue
estimate for the PS-REIT proposal.
Have you had a chance to review the Joint Tax Committee's
estimate and do you have any comments on it?
Given the large amount of uncertainty in predicting the
growth rate of acquisitions by paired REITs under current law,
the Joint Tax Committee's estimate, although somewhat different
from the Administration estimate, does not seem unreasonable.
In your revenue estimate of the Administration's proposal
to limit the tax benefits of the existing paired REITs, what
assumptions did you make about the growth rate of the paired
REITs under current law?
Despite the recent large acquisitions by paired REITs, we
assumed that growth rates of paired REITs under current law
would in the long run be about 10 percent per year.
What are your assumptions about the revenue loss that
occurs under current policy because the attractiveness of the
paired-share structure induces some businesses to become REITs
that otherwise would have remained C-corporations?
The only firms that can use the paired-share structure are
those that were grandfathered by a provision in the Deficit
Reduction Act of 1984. C-corporations cannot elect to become
paired-share REITs. Our assumptions concerning the effect of
paired-share REITs acquiring C-corporations under current
policy is discussed in the answer to Question 3.
What are your assumptions about the revenue loss that
occurs under current policy due to the fact that paired-share
REITs can achieve income shifting for tax purposes that
ordinary REITs cannot?
We assumed that nearly all of the estimated revenue loss
occurs from paired-share REITs shifting income for tax
purposes.
Assuming the Administration's proposal is implemented, what
percentage of those assets that would otherwise have converted
to paired-REIT staus do you assume will place their real estate
assets in a REIT, and what percentage will continue to operate
as non-REIT C-corporations?
We assumed that nearly all of the assets that would have
acquired by the paired REITs under current law would continue
to operate as non-REIT C-corporations if the Administration's
proposal is implemented.
[Whereupon, at 2:53 p.m., the hearing was adjourned subject
to the call of the Chair.]
[Submissions for the record follow:]
Statement of American Bankers Association
The American Bankers Association (ABA) is pleased to have
an opportunity to submit this statement for the record on
certain of the revenue provisions of the Administration's
fiscal year 1999 budget.
The American Bankers Association brings together all
categories of banking institutions to best represent the
interests of the rapidly changing industry. Its membership--
which includes community, regional and money center banks and
holding companies, as well as savings associations, trust
companies and savings banks--makes ABA the largest banking
trade association in the country.
The Administration's 1999 budget proposal contains several
provisions of interest and concern to banking institutions.
Although we believe that the Administration's revenue plan
contains several significant tax incentive provisions that
would amplify well established policies, we are deeply
concerned with a number of its revenue measures. The subject
revenue provisions would, in fact, impose new and additional
taxes on the banking industry rather than ``closing
loopholes.'' As a package, such revenue measures would, inter
alia, inhibit job creation and the provision of employee and
retiree benefits provided by employers while inequitably
penalizing business.
Our preliminary views on the subject provisions are set out
below.
Revenue Measures
Modify the Corporate-Owned Life Insurance Rules
The ABA strongly opposes the Administration's proposal to
modify the corporate-owned life insurance rules. The subject
provision would effectively eliminate corporate owned life
insurance that is used to offset escalating employee and
retiree benefit liabilities (such as health insurance, survivor
benefits, etc.)--an activity that promotes socially responsible
behavior and should be encouraged rather than discouraged.
Cutbacks in such programs may also lead to the reduction of
benefits provided by employers.
Specifically, the Administration's proposal would eliminate
the exception under the pro rata disallowance rule for
employees, officers and directors. Accordingly, as un-borrowed
cash values increase, the amount of interest deduction would be
reduced. Such modification to current law would have unintended
consequences that are inconsistent with other Congressional
policies, which encourage businesses to act in a prudent manner
in meeting their liabilities to employees.
Corporate owned life insurance as a funding source has a
long history in tax law as a respected tool. Moreover, federal
banking regulators recognize that corporate owned life
insurance serves a necessary and useful business purpose. Their
guidelines confirm that purchasing life insurance for the
purpose of recovering or offsetting the costs of employee
benefit plans is an appropriate purpose that is incidental to
banking.
The Administration's proposal seeks to revisit this issue
irrespective of the fact that business use of corporate owned
life insurance has been closely examined and was, in effect,
confirmed by Congress when it passed the Taxpayer Relief Act of
1997. That law created a specific exception for certain key
employees. The subject provision would impose a retroactive tax
penalty on banking institutions that have fully complied with
established rules and have, in good faith, made long term
business decisions based on existing tax law. They should be
protected from the retroactive effects of legislation that
would result in substantial tax and non-tax penalties. Even
though the provision is applicable on a prospective basis, the
effect is a retroactive tax on policies already written.
We urge you to reject this revenue provision.
Increased Information Reporting Penalties
The ABA strongly opposes the Administration's proposal to
increase information reporting penalties. The banking industry
prepares and files information returns to report items such as
employee wages, dividends, and interest annually, in good
faith, for the sole benefit of the IRS. The Administration
reasons that the current penalty provisions may not be
sufficient to encourage timely and accurate reporting. We
disagree. Information reporting penalties were raised to the
current levels as part of the Omnibus Budget Reconciliation Act
of 1989, P.L. 101-239. The suggestion that this proposal would
raise revenue presumes that corporations are non-compliant, a
conclusion for which there is no substantiating evidence.
Further, penalties typically are intended to discourage
``bad'' behavior and encourage ``good'' behavior, not to serve
as revenue raisers. The Administration's reasoning that
increasing the penalty amounts would decrease the number of
taxpayers that incur penalties suggests that the penalties
could be continually increased, from year-to-year to maintain
the revenue flow. Certainly, the proposed increase in penalties
is unnecessary and would not be based on sound tax policy.
Repeal Tax-Free Conversions of Large C Corporations to S
Corporations
The ABA opposes the proposal to repeal Internal Revenue
Code section 1374 for large S corporations. The proposal would
accelerate net unrealized built-in gains (BIG) and impose a
corporate level tax on BIG assets along with a shareholder
level tax with respect to their stock. The BIG tax would apply
to gains attributable to assets held at the time of conversion,
negative adjustments due to accounting method change,
intangibles such as core deposits and excess servicing rights,
and recapture of the bad debt reserve.
The Small Business Job Protection Act of 1996, P.L. 104-
188, allowed financial institutions to elect S corporation
status for the first time. Effectively, the Administration's
proposal would shut the window of opportunity for those
financial institutions to elect S corporation status by making
the cost of conversion prohibitively expensive. We believe that
such a change would be contrary to Congressional intent to
permit banking institutions to elect S corporation status.
Modify the Treatment of Closely Held REITs
The Administration's proposal to impose additional
restrictions on the ownership of real estate investment trusts
(REITs) would have the unintended consequence of eliminating a
valid method used by banks and thrifts to raise regulatory
capital. The proposal would go beyond the current law 100
shareholder requirement for REITs by prohibiting any one entity
from owning more than 50 percent (measured by both value and
voting power) of a REIT. The proposal appears to be based on
the notion that closely held REITs can be used by taxpayers in
abusive transactions. However, raising bank capital to protect
institutions from future economic downturns is a legitimate use
of a closely held REIT.
Currently, banks and thrifts may transfer real estate
assets, e.g. mortgage loans, in a REIT, with 100 percent of the
common stock of the REIT held by the financial institution and
with preferred stock being issued to at least 100 outside
investors. The funds raised from the preferred stock issuance
count as Tier 1 regulatory capital, which provides a cushion
for the safety of the institution and its depositors. The
closely held REIT preferred stock issuance is an important
alternative for banks to have available as a funding source.
The Federal Reserve Board has approved the use of certain
preferred stock arrangements as a valid method for raising Tier
1 bank capital, because, otherwise, bank holding companies
would be at a competitive disadvantage compared to non-bank
financial companies and foreign-owned banking institutions that
can use tax advantaged structures to raise capital.
The Administration's proposal is overly broad. Closely held
REITs serve valid functions that are consistent with the
underlying purposes of the REIT provisions as well as the
broader concept of sound tax policy. The Service has
demonstrated that it can use regulations and notices to deal
with its concerns about specific investment structures without
asking Congress to restrict legitimate REIT structures.
Repeal the Crummey case rule
The Administration's proposal would overrule the Crummey
decision by amending Section 2503(c) to apply only to outright
gifts of present interests. Gifts to minors under a uniform act
would be deemed to be outright gifts.
The ABA opposes the Administration's proposal to eliminate
the Crummey rule (Crummey v. Commissioner, 397 F.2d 82 (9th
Cir. 1968). Many existing trusts, which are administered by
banks through their trust departments, rely upon the Crummey
rule as a tax planning technique. The Administration asserts,
in the General Explanation of its proposal, that ``[t]ypically
by pre-arrangement or understanding in more recent cases, none
of the Crummey withdrawal rights will be exercised''
[referencing the Estate of Cristofani v. Commissioner, 97 T.C.
74 (1991)].
We believe the Administration's assertion is incorrect. If
there is a pre-arrangement or understanding that the Crummey
rights will not be exercised, the Crummey rule will not be
applied by the courts. In fact, in Cristofani the Tax Court
determined that there was no arrangement or understanding
between the decedent, the trustees, and the beneficiaries that
the decedent's grandchildren would not exercise their
withdrawal rights. The Court said that the question was not
whether the power was exercised, but whether it in fact
existed.
The proposal to legislatively overrule the Crummey case
would not only countermine recent Congressional action to
reduce, if not eliminate, ``death taxes,'' but would also
seriously undermine at least one of the important reasons
taxpayers use trusts for wealth transfer purposes.
Eliminate Dividends-Received Deduction for Certain Preferred
Stock
The Administration proposes to deny the dividends-received
deduction for dividend payments on nonqualified preferred stock
that is treated as taxable consideration in certain otherwise
non-taxable corporate reorganizations. The Administration
argues that such stock is sufficiently free from risk and from
participation in corporate growth that it should be treated as
debt for purposes of denial of the dividend received deduction.
However, such nonqualified preferred stock is not treated as
debt for all tax purposes.
The ABA opposes this Administration proposal in that it
would establish inconsistent tax policy and would amount to an
inequitable tax increase. Certainly, items received in income
and treated as debt to a recipient should, at minimum, be
correspondingly deductible as interest expense to the payor.
The instant proposal would create a ``lose-lose'' tax trap for
corporate taxpayers.
Tax Incentive Proposals
The Administration's budget proposal also contains several
significant tax incentive provisions, which ABA fully supports.
Tax Credits for Holders of Qualified School Modernization Bonds
and Qualified Zone Academy Bonds
The ABA supports the provisions to expand qualified academy
zone bonds and to establish school modernization bonds. Banks
are very interested in Education Zone Academy Bonds because
they could strengthen local communities and benefit the
families that reside there. We also believe these bonds will
attract investment in enterprise and poor communities by
providing tax credits and Community Reinvestment Act credits.
It is important for banks to be involved in all aspects of
our local communities. The banking industry recognizes that
education is a key component of that involvement and that there
is an immediate need for improved infrastructure. We would urge
you to include this proposal in the fiscal year 1999 budget
legislation.
Educational Assistance
The ABA supports the permanent extension of tax incentives
for employer provided education. Many industries, including
banking and financial services, are experiencing dramatic
technological changes. The provision is an important benefit to
many entry level employees and will assist in the retraining of
employees to better face global competition. Employer provided
educational assistance is a central component of the modern
compensation package and is often used to recruit and retain
vital employees.
Research and Experimentation Tax Credit Extended for One Year
The ABA supports the permanent extension of the tax credit
for research and experimentation. The banking industry is
actively involved in the research and development of new
intellectual products, services and technology in order to
compete in an increasingly sophisticated and global
marketplace. The banking industry has a vested interest in
ensuring that the research and experimentation tax credit
remains an appropriate incentive for banking institutions to
improve efficiencies and remain competitive. Banking
institutions increasingly engage in sophisticated and
innovative research activities. These activities are currently
being unreasonably scrutinized and questioned through narrowly
defined Treasury regulations and audit positions, which we
believe is inconsistent with Congressional intent. Along with
the extension of the tax credit, continued availability of the
research and experimentation tax credit in the financial
services industry should be an encouraged and Congressionally
supported incentive.
Contributions of Appreciated Stock to Private Foundations
The ABA supports permanent extension of the full fair
market value income tax deduction for gifts of publicly traded
stock to private foundations. We agree that allowing donors to
deduct the full value of such stock encourages taxpayers to
donate the stock for charitable purposes.
Increase Low Income Housing Tax Credit Per Capita Cap
The ABA supports the proposal to raise the $1.25 per capita
cap and urges its inclusion in the fiscal year 1999 budget
legislation.
Simplify the Foreign Tax Credit Limitation for Dividends from
``10/50'' Companies
The Administration proposal would, inter alia, simplify the
application of the foreign tax credit limitation by applying
the look-through approach immediately to all dividends paid by
a 10/50 company, regardless of the year in which the earnings
and profits out of which the dividend is paid were accumulated.
The ABA supports legislative efforts to simplify
application of the foreign tax credit. We also support
proposals to increase the capacity for taxpayers to claim
foreign credit for the taxes they actually pay. Further, we
support legislative efforts in the foreign tax credit area that
recognize efforts by a taxpayer to reduce foreign taxes.
Access to Payroll Deduction for Retirement Savings
The ABA supports proposals to encourage and facilitate
employee retirement savings. However, it is most important that
providing expanded access to the payroll deduction remain at
the employer's option. We are most concerned that such proposal
could impose unreasonable and overly expensive administrative
burdens on certain employers, which is contrary to recent
Congressional efforts to reduce administrative tax burdens.
Conclusion
We appreciate having this opportunity present our
preliminary views on the tax proposals contained in the
President's fiscal year 1999 budget. We look forward to working
with you in the further development of the revenue proposals to
be contained in the fiscal year 1999 budget.
Statement of America's Community Bankers
Mr. Chairman and Members of the Committee:
America's Community Bankers appreciates this opportunity to
submit testimony for the record of the hearing on the revenue
raising provisions in the Administration's fiscal year 1999
budget proposal. America's Community Bankers (ACB) is the
national trade association for 2,000 savings and community
financial institutions and related business firms. The industry
has more than $1 trillion in assets, 250,000 employees and
15,000 offices. ACB members have diverse business strategies
based on consumer financial services, housing finance, and
community development.
ACB wishes to focus on two provisions included in the
Administration's budget. We urge the Committee to reject the
Administration's proposal to change the rules for business-
owned life insurance. On the other hand, we recommend that the
Committee include in legislation, as soon as possible, the
Administration's proposal to increase the low-income housing
tax credit.
Bank-Owned Life Insurance
ACB strongly disagrees with the Administration's proposal
to disallow deductions for interest paid by corporations that
purchase permanent life insurance on the lives of their
officers, directors, and employees. This disallowance is
retroactive in that it would occur with respect to life
insurance contracts already in force. The Administration's
proposal would revamp a statutory scheme enacted just last
year. In 1997 Congress enacted a provision to disallow a
proportional part of a business's interest-paid deductions on
unrelated borrowings where the business purchases a life
insurance policy on anyone and where the business is the direct
or indirect beneficiary. Integral to this general rule,
however, is an exception for business-owned life insurance
covering employees, officers, directors, and 20 percent or more
owners. The combination of the general rule and its exception
implemented a sensible policy--that the benefits of permanent
life insurance, where they are directly related to the needs of
a business, should continue to be available to businesses
The Administration is now proposing that the implicit
agreement made last year be immediately broken by cutting back
retroactively, for contracts issued after June 8, 1997, the
exception to omit employees, officers, and directors. It would
continue to apply to 20-percent owners. Thus, a portion of the
interest-paid deductions of a business for a year would be
disallowed according to the ratio of the average unborrowed
policy cash values of life insurance, annuities, and endowment
contracts to total assets. Insurance contracts would be
included in this denominator to the extent of unborrowed cash
values. (It also appears that a 1996 exception enacted would be
repealed that permits an interest-paid deduction for borrowings
against policies covering key employees.)
The Administration's proposal would result in a
significantly larger loss of deductions for a bank or thrift
than a similar-sized commercial firm because financial
institutions are much more leveraged than commercial firms.
Financial institutions, because of their statutory capital
requirements, have been under a special constraint to look to
life insurance to fund retirement benefits after the issuance
of FASB Statement 106 in December 1990. FASB 106, which was
effective for 1992, requires most employers to give effect in
their financial statements to an estimate of the future cost of
providing retirees with health benefits. The impact of charging
such an expense to the earnings of a company could be a
significant reduction in capital. Many financial institutions
were faced with the necessity of reneging on the commitments
they had made to their employees or finding an alternative
investment. Many of these institutions have chosen to fund
their pension, as well as retiree health care benefits, using
permanent life insurance.
The banking regulators have permitted financial
institutions to use life insurance to fund their employee
benefit liabilities, but restricted the insurance policies that
may be used to those that do not have a significant investment
component and limited the insurance coverage to the risk of
loss or the future liability. See e.g., the OCC's Banking
Circular 249 (February 4, 1991) and the OTS's Thrift Activities
Regulatory Handbook, Section 250.2. On September 20, 1996, the
OCC issued Bulletin 96-51 which recognized the usefulness of
permanent life insurance in the conduct of banking and granted
banks increased flexibility to use it--consistent with safety
and soundness considerations. The bulletin makes clear that the
necessity to control a variety of risks created by life
insurance ownership (liquidity, credit, interest rate, etc.)
requires a bank to limit its purchases to specific business
needs rather than for general investment purposes. In addition,
bank purchases of life insurance will be limited by the need to
maintain regulatory capital levels. (The other bank regulators
are apparently in agreement with the OCC position and may
shortly formalize similar positions.
The Administration's proposed change in the current law
treatment of business-owned life insurance would require many
financial institutions, because of the extent of their loss of
deductions, to terminate their policies. Policy surrender
would, however, subject the banks to immediate tax on the cash
value and possible cash-in penalties that would reduce capital.
In most cases financial institutions have purchased life
insurance to provide pension and retiree health benefits. If
Congress were to make it uneconomical for businesses to
purchase life insurance contracts, the employee benefits they
fund would inevitably have to be reduced. For the
Administration to make business-owned life insurance
uneconomical, given its usefulness in providing employee
benefits, is inconsistent with the other proposals in the
Administration's budget proposal that would enhance pension an
other retiree benefits.
The Administration's argument that financial intermediaries
are able to ``arbitrage'' their interest-paid deductions on
unrelated borrowings where they own permanent life insurance is
unconvincing. The leveraging of their capital by banks and
thrifts to make loans is a vital component of a strong economy.
The Administration's proposal would punish financial
institutions, simply because they are inherently much more
leveraged, to a much greater extent than similar-sized
commercial firms for making what would otherwise be sound
business decisions--to insure themselves against the death of
key employees or to provide for the retirement health or
security of their employees by means of life insurance.
This is the third year in a row that legislation has been
proposed to limit the business use of life insurance. This has
now become unfair and unsound tax policy. It is disingenuous to
say that the BOLI exception must now be eliminated because
there may have been large recent policy purchases. If taxpayers
have reason to believe that Congress is about to change its
mind with respect to an exception and they rush to act before
an opportunity is lost, as may have happened with BOLI, it is a
case of blaming the victim to then say that the law is being
changed because of taxpayer action. In fact, companies may have
been motivated to act as they otherwise would not have, with
respect to BOLI purchases, because of a perception that the tax
legislative process is fickle. If taxpayers are to focus on
long-term business benefits rather than short-term, tax-
motivated considerations, they must be confident that there is
an implicit premise of consistency in the tax legislative
process.
Low-Income Housing Tax Credit
America's Community Bankers strongly supports the
Administration's proposal to increase the per capita limit on
the low-income housing tax credit from $1.25 to $1.75. As an
important part of the thrift industry's commitment to housing,
ACB's member institutions have been participants, as direct
lenders and, through operating subsidiaries, as investors, in
many low-income housing projects that were viable only because
of the LIHTC. The ceiling on the annual allocation of the LIHTC
has not been increased since the credit was created by the Tax
Reform Act of 1986. Many members institutions have communicated
to ACB that there are shortages of affordable rental housing in
their communities and that, if the supply of LIHTCs were
increased, such housing could be more efficiently be produced
to address this shortage.
The LIHTC was created in 1986 to replace a variety of
housing subsidies whose efficiency had been called into
question. Under Section 42 of the Internal Revenue Code, a
comprehensive regime of allocation and oversight was created,
requiring the involvement of both the IRS and state and local
housing authorities, to assure that the LIHTC is targeted to
increase the available rental units for low-income citizens.
This statutory scheme has been revised in several subsequent
tax acts to eliminate potential abuses.
Every year since 1987, each state has been allocated a
total amount of LIHTCs equal to $1.25 per resident. The annual
per capita limit may be increased by a reallocation of the
unused credits previously allocated to other states, as well as
the state's unused LIHTC allocations from prior years. The
annual allocation must be awarded within two years or returned
for reallocation to other states. State and local housing
authorities are authorized by state law or decree to award the
state's allocation of LIHTCs to developers who apply by
submitting proposals to develop qualified low-income housing
projects.
A ``qualified low-income project'' under Section 42(g) of
the Code is one that satisfies the following conditions. (1) It
must reserve at least 20 percent of its available units for
households earning up to 50 percent of the area's median gross
income, adjusted for family size, or at least 40 percent of the
units must be reserved for households earning up to 60 percent
of the area's median gross income, adjusted for family size.
(2) The rents (including utility charges) must be restricted
for tenants in the low-income units to 30 percent of an imputed
income limitation based on the number of bedrooms in the unit.
(3) During a compliance period, the project must meet
habitability standards and operate under the above rent and
income restrictions. The compliance period is 15 years for all
projects placed in service before 1990. With substantial
exceptions, an additional 15-year compliance period is imposed
on projects placed in service subsequently.
Putting together a qualifying proposal is only the first
step, however, for a developer seeking an LIHTC award. The
state or local housing agency is required to select from among
all of the qualifying projects by means of a LIHTC allocation
plan satisfying the requirements of Section 42(m). The
allocation plan must set forth housing priorities appropriate
to local conditions and preference must be given to projects
that will serve the lowest-income tenants and will serve
qualified tenants for the longest time.
Section 42 effectively requires state and local housing
agencies to create a bidding process among developers to ensure
that the LIHTCs are allocated to meet housing needs
efficiently. To this end the Code imposes a general limitation
on the maximum LIHTC award that can be made to any one project.
Under Section 42(b) the maximum award to any one project is
limited to nine percent of the ``qualified basis'' (in general,
development costs, excluding the cost of land, syndication,
marketing, obtaining permanent financing, and rent reserves) of
a newly constructed building. Qualified basis may be adjusted
by up to 30 percent for projects in a qualified census tract or
``difficult development area.'' For federally subsidized
projects and substantial rehabilitations of existing buildings,
the maximum annual credit is reduced to four percent. The nine
and four percent annual credits are payable over 10 years and
in 1987, the first year of the LIHTC, the 10-year stream of
these credits was equivalent to a present value of 70 percent
and 30 percent, respectively, of qualified basis. Since 1987,
the Treasury has applied a statutory discount rate to the
nominal annual credit percentages to maintain the 70 and 30
percent rates.
The LIHTC has to be taken over 10 years, but the period
that the project must be in compliance with the habitability
and rent and income restrictions is 15 years. This creates an
additional complication. The portion of the LIHTC that should
be theoretically be taken in years 11 through 15 is actually
taken pro rata during the first 10 years. Where there is
noncompliance with the project's low-income units during years
11 through 15, the related portion of the LIHTC that was, in
effect, paid in advance will be recaptured.
Where federally subsidized loans are used to finance the
new construction or substantial rehabilitation, the developer
may elect to qualify for the 70 percent present value of the
credit by reducing the qualified basis of the property. Where
federal subsidies are subsequently obtained during the 15-year
compliance period, the qualified basis must then be adjusted.
On the other hand, certain federal subsidies do not affect the
LIHTC amount, such as the Affordable Housing Program of the
Federal Home Loan Banks, Community Development Block Grants,
and HOME investment Partnership Act funds.
The LIHTCs awarded to developers are, typically, offered to
syndicators of limited partnerships. Because of the required
rent restrictions on the project, the syndications attract
investors who are more interested in the LIHTCs and other
deductions the project will generate than the unlikely prospect
of rental profit. The partners, who may be individuals or
corporations, provide the equity for the project, while the
developer's financial stake may be limited to providing the
debt financing.
The LIHTC is limited, however, in its tax shelter potential
for the individual investor. Individuals are limited by the
passive loss rules to offsetting no more than $25,000 of active
income (wages and business profits) with credits and losses
from rental real estate activities. For an individual in the
28% bracket, for example, the benefit from the LIHTC would be
limited to $7,000. It should also be borne in mind that such
credits are unavailable against the alternative minimum tax
liability of individuals and corporations.
The Chairs of the Ways and Means Committee and its
Subcommittee on Oversight recently requested the GAO to study
the LIHTC program and, specifically, to evaluate: whether the
LIHTC was being used to meet state priority housing needs;
whether the costs were reasonable; and whether adequate
oversight was being performed. The resulting GAO report was
generally favorable. See Tax Credits: Opportunities to Improve
Oversight of the Low-Income Housing Program (GAO/GGD/RCED-97-
55, March 28, 1997). The GAO found that the LIHTC has
stimulated low-income housing development and that the
allocation processes implemented by the states generally
satisfy the requirements of the Code. In fact, the GAO found
that the LIHTC was being targeted by the states to their very
poorest citizens. The incomes of those for whom the credit was
being used to provide housing were substantially lower than the
maximum income limits set in the statute. While the GAO could
find no actual abuses or fraud in the LIHTC program, it did
determine that the procedures that some states use to review
and implement project proposals need to be improved. The report
also recommended a number of changes in the IRS regulations to
ensure adequate monitoring and reporting so that the IRS can
conduct its own verification of compliance with the law.
The only increase in the total amount of LIHTCs since 1987
has been through population growth, which has been only five
percent nationwide over the 10-year period (floor statement of
Senator Alphonse D'Amato, October 3, 1997). Had the $1.25 per
capita limit been indexed for inflation since the inception of
the LIHTC, as is commonly done in other Code provisions, it
would be comparable to the $1.75 limit the Administration is
proposing. According to the Joint Committee on Taxation, the
Consumer Price Index measurement of cumulative inflation
between 1986 and the third quarter of 1997 was approximately 47
percent. Using this index to adjust the per capita limit, it
would now be approximately $1.84. The GDP price deflator for
residential fixed investment indicates 38.1 percent price
inflation, which would have increased the per capita limit to
approximately $1.73. (See Joint Committee on Taxation,
Description of Revenue Provisions Contained in the President's
Fiscal Year 1999 Budget Proposal (JCS-4-98), February 24, 1998)
More affordable low-income housing is currently needed.
``Nearly 100,000 low cost apartments are demolished, abandoned,
or converted to market rate each year. Increasing the LIHTC
would allow states to finance approximately 25,000 more
critically needed low-income apartments each year'' (floor
statement of Senator Alphonse D'Amato, October 3, 1997). ``In
the state of Florida, for example, the LIHTC has used more than
$187 million in tax credits to produce approximately 42,000
affordable rental units valued at over $2.2 billion. Tax credit
dollars are leveraged at an average of $18 to $1. Nevertheless,
in 1996, nationwide demand for the housing credit greatly
outpaced supply by a ratio of nearly 3 to 1. In Florida,
credits are distributed based upon a competitive application
process and many worthwhile projects are denied due to a lack
of tax credit authority'' (floor statement of Senator Bob
Graham, October 3, 1997). ``In 1996, states received
applications requesting more than $1.2 billion in housing
credits--far surpassing the $365 million in credit authority
available to allocate that year. In New York, the New York
Division of Housing and Community Renewal received applications
requesting more than $104 million in housing credits in 1996--
nearly four times the $29 million in credit authority it
already had available'' (floor statement of Senator Alphonse
D'Amato, October 3, 1997).
For all of the foregoing reasons, it seems clear to ACB
that it is time to increase the LIHTC.
Once again, Mr. Chairman, ACB is grateful to you and the
other members of the Committee for the opportunity you have
provided to make our views known on the Administration's tax
proposals. If you have any questions or require additional
information, please contact Jim O'Connor at 202-857-3125 or
Brian Smith at 202-857-3118.
Statement of The New York Clearing House Association, The Securities
Industry Association, Independent Bankers Association of America, and
America's Community Bankers
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 failure to
file correct information returns.
The proposed penalties are unwarranted and place an undue
burden on already compliant taxpayers. It seems clear that
most, if not all, of the revenue estimated to be raised from
this proposal would stem from the imposition of higher
penalties due to inadvertent errors rather than from enhanced
compliance. 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. In addition, 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 Proposal
As included in the President's fiscal year 1999 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.\1\ The increased penalties would not apply if the
aggregate amount that is timely and correctly rlendar 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.
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\1\ A similar proposal was included in President Clinton's fiscal
year 1997 and 1998 budgets.
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Current Penalties are Sufficient
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,\2\ severe sanctions are
imposed for intentional reporting failures. In general, the
current penalty structure is as follows:
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\2\ 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).
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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.\3\
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\3\ 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.
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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.\4\ 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.
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\4\ Also note that, in addition to the domestic and foreign
information reporting and penalty regimes that are currently in place,
for payments to foreign persons, an expanded reporting regime with the
concomitant penalties is effective for payments made after December 31,
1998. See TD 8734, published in the Federal Register on October 14,
1997. The payor community is being required to dedicate extensive
manpower and monetary resources to put these new requirements into
practice. Accordingly, these already compliant and overburdened
taxpayers should not have to contend with new punitive and unnecessary
penalties.
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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.'' \5\ Congress endorsed the IRS Task
Force's conclusions by specifically enumerating them in the
Conference Report to the Omnibus Budget Reconciliation Act of
1989.\6\ 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.
---------------------------------------------------------------------------
\5\ Statement of former IRS Commissioner Gibbs before the House
Subcommittee on Oversight (February 21, 1989, page 5).
\6\ OBRA 1989 Conference Report at page 661.
---------------------------------------------------------------------------
Safe Harbor Not Sufficient
Under the proposal, utilization of a 97 percent substantial
compliance ``safe harbor'' 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,\7\ 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.
---------------------------------------------------------------------------
\7\ For example, Form 1099-C, discharge of indebtedness reporting,
or Form 1042-S, reporting for bank deposit interest paid to certain
Canadian residents.
---------------------------------------------------------------------------
Application of Penalty Cap to Each Payor Entity Inequitable
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.
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).\8\
---------------------------------------------------------------------------
\8\ If the corrected returns were filed after August 1, the
penalties would be capped at $250,000 per plan.
---------------------------------------------------------------------------
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.
Recommendation:
Each affiliated group \9\ should be treated as a single
payor for purposes of applying the penalty cap.
---------------------------------------------------------------------------
\9\ A definition of ``affiliated group'' which may be used for this
purpose may be found in Section 267(f) or, alternatively, Section
1563(a).
---------------------------------------------------------------------------
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
The Securities Industry Association
Independent Bankers Association of America
America's Community Bankers
American Council for an Energy-Efficient Economy
Washington, DC
March 2, 1998
The Hon. Bill Archer
Chairman
Committee on Ways & Means
U. S. House of Representatives
Washington, DC 20515
Dear Mr. Chairman:
Please accept the attached position statement for the record of the
February 25 hearing of the Committee on Ways & Means regarding the
Administration's proposals and assumptions for Fiscal Year 1999. The
Sustainable Energy Coalition is made up of more than 40 national
business, environmental, consumer, and energy policy organizations that
support a strong Federal role in research, development, and deployment
of energy efficiency and renewable energy technologies.
The Administration's proposals for $3.6 billion in tax incentives
over 5 years for the purchase of energy-saving equipment, homes, and
vehicles and renewable energy equipment has drawn a great deal of
interest. Such measures can reduce energy costs for consumers while
contributing to other important national goals, such as improved air
quality, reduced energy imports, and improved competitiveness of
American businesses. We urge the Committee to carefully consider these
proposals in the weeks ahead, and look forward to discussing them
further with you and your staff.
Sincerely,
Howard Geller
Executive Director
Attachment
cc: Hon. Charles B. Rangel, Ranking Minority Member
Members of the Committee on Ways & Means
Statement of Sustainable Energy Coalition
The undersigned members of the Sustainable Energy Coalition
are expressing their support for the concept of providing tax
incentives and other encouragement for a variety of advanced
energy-saving and renewable energy technologies such as:
superefficient cars and light trucks
superefficient homes
highly efficient heating and cooling systems
highly efficient water heaters
fuel cell cogeneration systems
solar photovoltaic and water heating systems
wind and biomass-based electricity generation
combined heat and power systems
Tax incentives along these lines will provide multiple
benefits:
1) They will stimulate technological innovation and reduce
the risk that manufacturers face in introducing and marketing
new technologies.
2) They will save consumers billions of dollars by
stimulating commercialization of cost-effective energy saving
technologies.
3) They will improve air quality, reduce public health
hazards, and cut U.S. greenhouse gas emissions by promoting
energy efficiency and clean energy sources.
4) They will reduce oil imports, improve our balance of
payments, and enhance national security by cutting gasoline
use.
5) They will help U.S. companies compete in what surely
will be enormous worldwide markets in the next century.
While the details of the Administration's tax proposals
have not yet been announced, we urge policy makers to recognize
that tax incentives for advanced energy efficiency and
renewable energy technologies are a ``win-win-win'' strategy
for manufacturers, consumers, and the environment. They are
voluntary, market-based ``no regrets'' measures that will
reduce the cost of energy services such as heating, cooling,
and mobility. They are an economic development strategy as well
as a climate technology strategy. Even those who may not
support the Kyoto climate change agreement should find ample
grounds to support tax incentives for innovative energy
efficiency and renewable energy technologies.
Alliance to Save Energy, American Bioenergy Association,
American Council for an Energy-Efficient Economy, American
Green, American Public Power Association, American Wind Energy
Association, Americans for Clean Energy, Business Council for
Sustainable Energy, Cascade Associates, Center for a
Sustainable Economy, Clean Fuels Foundation, Environmental &
Energy Study Institute, Fuel Cells 2000, Global Biorefineries,
Inc., International District Energy Association, National
BioEnergy Industries Association, Public Citizen, Safe Energy
Communication Council, Solar Energy Industries Association,
Solar Unity Network, SUN DAY Campaign, Union of Concerned
Scientists
[GRAPHIC] [TIFF OMITTED] T1685.001
Statement of American Petroleum Institute
This testimony is submitted by the American Petroleum
Institute (API) for the February 25, 1998 Ways and Means
hearing on the tax provisions in the Administration's fy 1999
budget proposal. API represents approximately 300 companies
involved in all aspects of the oil and gas industry, including
exploration, production, transportation, refining, and
marketing. The U.S. oil and gas industry is the leader in
exploring for and developing oil and gas reserves around the
world.
Our testimony will address the following proposals:
modify rules relating to foreign oil and gas
extraction income;
prescribe regulatory authority to address tax
avoidance through use of hybrids;
reinstate excise taxes and the corporate
environmental tax deposited in the Hazardous Substance
Superfund Trust Fund.
reinstate the oil spill excise tax;
provide tax credits to promote energy efficiency
and alternative energy sources
I. Modify Rules Relating to Foreign Oil and Gas Extraction Income
President Clinton's latest budget proposal includes some
significant changes to the foreign tax credit (FTC) rules
impacting companies with foreign oil and gas extraction income
(FOGEI) as defined by Code Section 907(c)(1) and foreign oil
related income (FORI) as defined by Code Section 907(c)(2).
Specifically, the proposal includes the following provisions:
In situations where taxpayers are subject to a
foreign tax and also receive an economic benefit from the
foreign country, taxpayers would only be able to claim a credit
for such taxes under Code Section 901 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.
Effective for taxable years beginning after the
bill's enactment, new rules would be provided for all foreign
oil and gas income (FOGI). FOGI would be trapped in a new
separate FOGI basket under Code Section 904(d). FOGI would be
defined to include both FOGEI and FORI.
Despite these changes, U.S. treaty obligations
that allow a credit for taxes paid or accrued on FOGI would
continue to take precedence over this legislation (e.g., the
so-called ``per country'' limitation situations.)
A. Introduction and Trade Arguments
This proposal, aimed directly at the foreign source income
of U.S. petroleum companies, seriously threatens the ability of
those companies to remain competitive on a global scale, and
API strongly opposes the proposal. It is particularly troubling
that the Administration would attack the foreign operations of
U.S. oil companies in this way, especially when the proposal
conflicts with the Administration's announced trade policy and
with Commerce and State Department initiatives encouraging
those same companies to participate in exploration and
production ventures in strategic areas around the world.
The Administration has demonstrated an intention to
subscribe to the integration of worldwide trade, with a
continuing removal of trade barriers and promotion of
international investment (e.g., the GATT and NAFTA agreements).
Moreover, because of their political and strategic importance,
foreign investments by U.S. oil companies have been welcomed by
the U.S. government. For example, participation by U.S. oil
companies in the development of the Tengiz oil field in
Kazakhstan was praised as fostering the political independence
of that newly formed nation, as well as securing new sources of
oil to Western nations, which are still too heavily dependent
on Middle Eastern imports. (See the April 28, 1996 Washington
Post, at p. A-20).
This proposed additional tax burden, like other barriers to
foreign investments by U.S. firms, are based on several flawed
premises. For example, there is the perception that foreign
investment by U.S. business is responsible for reduced
investment and employment in the U.S. These investments are
perceived to be made primarily in low wage countries at the
expense of U.S. labor with such foreign investments also
including a shift of research and development (``R&D'')
spending abroad. However, studies like the 1995 review by the
Economic Strategy Institute (Multinational Corporations and the
U.S. Economy [1995]) show these claims to be unfounded. Over a
20-year period, capital outflows from the U.S. averaged less
than 1% of U.S. nonresidential fixed investment, which is
hardly sufficient to account for any serious deterioration in
U.S. economic growth. Instead, affiliate earnings and foreign
loans, not U.S. equity, have financed the bulk of direct
foreign investment.
Contrary to another perception, the principal reason for
foreign investment is seldom cheap labor. Rather, the more
common reasons are a search for new markets, quicker and easier
response to local market requirements, elimination of tariff
and transportation costs, faster generation of local good will,
and other deep rooted host country policies. In this regard,
the bulk of U.S. foreign investment is in Europe, where labor
is expensive, rather than in Asia and Latin America, where
wages are low. According to one study, almost two-thirds of
employment by foreign subsidiaries of U.S. companies was in
Canada, Japan, and Europe, all higher wage areas (Sullivan,
From Lake Geneva to the Ganges; U.S. Multinational Employment
Abroad, 71 Tax Notes 539 [4/22/96]. Although some R&D functions
have been moved abroad, they make up only 15% of domestic R&D,
and are primarily in areas aimed at tailoring products to local
demands.
In the case of natural resource extraction and production,
the reason for foreign investment is obvious. If U.S. oil and
gas concerns wish to stay in business, they must look overseas
to replace their diminishing reserves, since the opportunity
for domestic reserve replacement has been restricted by both
federal and state government policy. A recent API study
demonstrates that despite the fact that production outside the
United States by U.S. companies increased by 300,000 barells/
day over the 10 years 1985-1995, that was not enough to offset
the declines in U.S. production, so that U.S. companies' total
global production over that period actually declined. Over that
same period, production by similar sized oil companies other
than those from OPEC countries expanded nearly 60%. These
recent supply trends need not be permanent features of the U.S.
companies' future role. The opening of Russia to foreign
capital, the competition for investment by the countries
bordering the Caspian Sea, the privatization of energy in
portions of Latin America, Asia, and Africa--all offer the
potential for unprecedented opportunity in meeting the
challenges of supplying fuel to a rapidly growing world
economy. In each of these frontiers U.S. companies are poised
to participate actively. However, if U.S. companies can not
economically compete, foreign resources will instead be
produced by foreign competitors, with little or no benefit to
the U.S. economy, U.S. companies, or American workers.
The FTC principle of avoiding double taxation represents
the foundation of U.S. taxation of foreign source income. The
Administration's budget proposals would destroy this foundation
on a selective basis for foreign oil and gas income only, in
direct conflict with the U.S. trade policy of global
integration, embraced by both Democratic and Republican
Administrations.
B. The FTC Is Intended To Prevent Double Taxation
Since the beginning of Federal income taxation, the U.S.
has taxed the worldwide income of U.S. citizens and residents,
including U.S. corporations. To avoid double taxation, the FTC
was introduced in 1918. Although the U.S. cedes primary taxing
jurisdiction for foreign income to the source country, the FTC
operates by preventing the same income from being taxed twice,
once by the U.S. and once by the source country. The FTC is
designed to allow a dollar for dollar offset against U.S.
income taxes for taxes paid to foreign taxing jurisdictions.
Under this regime, foreign income of foreign subsidiaries is
not immediately subject to U.S. taxation. Instead, the
underlying earnings become subject to U.S. tax only when the
U.S. shareholder receives a dividend (except for certain
``passive'' or ``Subpart F'' income.) Any foreign taxes paid by
the subsidiary on such earnings is deemed to have been paid by
any U.S. shareholders owning at least 10% of the subsidiary,
and can be claimed as FTCs against the U.S. tax on the foreign
dividend income (the so-called ``indirect foreign tax
credit'').
C. Basic Rules of the FTC
The FTC is intended to offset only U.S. tax on foreign
source income. Thus, an overall limitation on currently usable
FTCs is computed by taking the ratio of foreign source income
to worldwide taxable income, and multiplying this by the
tentative U.S. tax on worldwide income. The excess of FTCs can
be carried back 2 years and carried forward 5 years, to be
claimed as credits in those years within the same respective
overall limitations.
The overall limitation is computed separately for various
``separate limitation categories.'' Under present law, foreign
oil and gas income falls into the general limitation category.
Thus, for purposes of computing the overall limitation, FOGI is
treated like any other foreign active business income. Separate
special limitations still apply, however, for income: (1) whose
foreign source can be easily changed; (2) which typically bears
little or no foreign tax; or (3) which often bears a rate of
foreign tax that is abnormally high or in excess of rates of
other types of income. In these cases, a separate limitation is
designed to prevent the use of foreign taxes imposed on one
category to reduce U.S. tax on other categories of income.
D. FTC Limitations For Oil And Gas Income
Congress and the Treasury have already imposed significant
limitations on the use of foreign tax credits attributable to
foreign oil and gas operations. In response to the development
of high tax rate regimes by OPEC, taxes on foreign oil and gas
income have become the subject of special limitations. For
example, each year the amount of taxes on FOGEI may not exceed
35% (the U.S. corporate tax rate) of such income. Any excess
may be carried over like excess FTCs under the overall
limitation. FOGEI is income derived from the extraction of oil
and gas, or from the sale or exchange of assets used in
extraction activities.
In addition, the IRS has regulatory authority to determine
that a foreign tax on FORI is not ``creditable'' to the extent
that the foreign law imposing the tax is structured, or in fact
operates, so that the tax that is generally imposed is
materially greater than the amount of tax on income that is
neither FORI or FOGEI. FORI is foreign source income from (1)
processing oil and gas into primary products, (2) transporting
oil and gas or their primary products, (3) distributing or
selling such, or (4) disposing of assets used in the foregoing
activities. Otherwise, the overall limitation (with its special
categories discussed above) applies to FOGEI and FORI. Thus, as
active business income, FOGEI and FORI would fall into the
general limitation category.
E. The Dual Capacity Taxpayer ``Safe Harbor'' Rule
As distinguished from the rule in the U.S. and some
Canadian provinces, mineral rights in other countries vest in
the foreign sovereign, which then grants exploitation rights in
various forms. This can be done either directly, or through a
state owned enterprise (e.g., a license or a production sharing
contract). Because the taxing sovereign is also the grantor of
mineral rights, the high tax rates imposed on oil and gas
profits have often been questioned as representing, in part,
payment for the grant of ``a specific economic benefit'' from
mineral exploitation rights. Thus, the dual nature of these
payments to the sovereign have resulted in such taxpayers being
referred to as ``dual capacity taxpayers.''
To help resolve controversies surrounding the nature of tax
payments by dual capacity taxpayers, the Treasury Department in
1983 developed the ``dual capacity taxpayer rules'' of the FTC
regulations. Under the facts and circumstances method of these
regulations, the taxpayer must establish the amount of the
intended tax payment that otherwise qualifies as an income tax
payment but is not paid in return for a specific economic
benefit. Any remainder is a deductible rather than creditable
payment (and in the case of oil and gas producers, is
considered a royalty). The regulations also include a safe
harbor election (see Treas. Reg. 1.901-2A(e)(1)), whereby a
formula is used to determine the tax portion of the payment to
the foreign sovereign, which is basically the amount that the
dual capacity taxpayer would pay under the foreign country's
general income tax. Where there is no generally applicable
income tax, the safe harbor rule of the regulation allows the
use of the U.S. tax rate in a ``splitting'' computation (i.e.,
the U.S. tax rate is considered the country's generally
applicable income tax rate).
F. The Proposal Limits FTCs Of Dual Capacity Taxpayers To the
Host Country's Generally Applicable Income Tax
If a host country that had an income tax on FOGI (i.e.,
FOGEI or FORI), but no generally applicable income tax were to
ignore the effect that its tax regime had on the new FTC
position of U.S. companies, the proposal would result in
disallowing any FTCs on FOGI. This would result in inequitable
and destructive double taxation of dual capacity taxpayers,
contrary to the global trade policy advocated by the U.S.
The additional U.S. tax on foreign investment in the
petroleum industry would not only eliminate many new projects;
it could also change the economics of past investments. In some
cases, this would not only reduce the rate of return, but also
preclude a return of the investment itself, leaving the U.S.
business with an unexpected ``legislated'' loss. In addition,
because of the uncertainties of the provision, it would also
introduce more complexity and potential for litigation into the
already muddled world of the FTC.
The unfairness of the provision becomes even more obvious
if one considers the situation where a U.S. based oil company
and a U.S. based company other than an oil company are subject
to an income tax in a country without a generally applicable
income tax. Under the proposal, only the U.S. oil company would
receive no foreign tax credit, while the other taxpayer would
be entitled to the full tax credit for the very same tax.
The proposal's concerns with the tax versus royalty
distinction were resolved by Congress and the Treasury long ago
with the special tax credit limitation on FOGEI enacted in 1975
and the Splitting Regulations of 1983. These were then later
reinforced in the 1986 Act by the fragmentation of foreign
source income into a host of categories or baskets. The earlier
resolution of the tax versus royalty dilemma recognized that
(1) if payments to a foreign sovereign meet the criteria of an
income tax, they should not be denied complete creditability
against U.S. income tax on the underlying income; and (2)
creditability of the perceived excessive tax payment is better
controlled by reference to the U.S. tax burden, rather than
being dependent on the foreign sovereign's fiscal choices.
G. The Proposal Limits FTCs To The Amount Which Would Be Paid
Under the Generally Applicable Income Tax
By elevating the regulatory safe harbor to the exclusive
statutory rule, the proposal eliminates a dual capacity
taxpayer's right to show, based on facts and circumstances,
which portion of its payment to the foreign government was not
made in exchange for the conferral of specific economic
benefits and, therefore, qualifies as a creditable tax.
Moreover, by eliminating the ``fall back'' to the U.S. tax rate
in the safe harbor computation where the host country has no
generally applicable income tax, the proposal denies the
creditability of true income taxes paid by dual capacity
taxpayers under a ``schedular'' type of business income tax
regime (i.e., regimes which tax only certain categories of
income, according to particular ``schedules''), merely because
the foreign sovereign's fiscal policy does not include all
types of business income.
For emerging economies of lesser developed countries, as
for post-industrial nations, it is not realistic to always
demand the existence of a generally applicable income tax. Even
if the political willingness exists to have a generally
applicable income tax, such may not be possible because the
ability to design and administer a generally applicable income
tax depends on the structure of the host country's economy. The
available tax regimes are defined by the country's economic
maturity, business structure and accounting sophistication. The
most difficult problems arise in the field of business
taxation. Oftentimes, the absence of reliable accounting books
will only allow a primitive presumptive measure of profits.
Under such circumstances the effective administration of a
general income tax is impossible. All this is exacerbated by
phenomena which are typical for less developed economies: a
high degree of self-employment, the small size of
establishments, and low taxpayer compliance and enforcement. In
such situations, the income tax will have to be limited to
mature businesses, along with the oil and gas extraction
business.
H. The Proposal Increases The Risk Of Double Taxation
Adoption of the Administration's proposals would further
tilt the playing field against overseas oil and gas operations
by U.S. business, and increase the risk of double taxation of
FOGI. This will severely hinder U.S. oil companies in their
competition with foreign oil and gas concerns in the global oil
and gas exploration, production, refining, and marketing arena,
where the home countries of their foreign competition do not
tax FOGI. This occurs where these countries either exempt
foreign source income or have a foreign tax credit regime which
truly prevents double taxation.
To illustrate, assume foreign country X offers licenses for
oil and gas exploitation and also has an 85% tax on oil and gas
extraction income. In competitive bidding, the license will be
granted to the bidder which assumes exploration and development
obligations most favorable to country X. Country X has no
generally applicable income tax. Unless a U.S. company is
assured that it will not be taxed again on its after-tax profit
from country X, it very likely will not be able to compete with
another foreign oil company for such a license because of the
different after tax returns.
[GRAPHIC] [TIFF OMITTED] T1685.002
Because of the 35% additional U.S. tax, the U.S. company's
after tax return will be more than one-third less than its
foreign competitor's. Stated differently, if the foreign
competitor is able to match the U.S. company's proficiency and
effectiveness, the foreigner's return will be more than 50%
greater than the U.S. company's return. This would surely harm
the U.S. company in any competitive bidding. Only the
continuing existence of the FTC, despite its many existing
limitations, assures that there will be no further tilting of
the playing field against U.S. companies' efforts in the global
petroleum business.
I. Separate Limitation Category For FOGI
To install a separate FTC limitation category for FOGI
would single out the active business income of oil companies
and separate it from the general limitation category or basket.
There is no legitimate reason to carve out FOGI from the
general limitation category or basket. The source of FOGEI and
FORI is difficult to manipulate. For example, FORI is generally
derived from the country where the processing or marketing of
oil occurs. Moreover, Treasury has recently issued regulations
addressing this sourcing issue. Also, any FORI that is earned
in consuming countries and treated like other business income
is very likely taxed currently, before distribution, under the
anti-avoidance rules for undistributed earnings of foreign
subsidiaries.
J. The FTC Proposals Are Bad Tax Policy
Reduction of U.S. participation in foreign oil and gas
development because of misguided tax provisions will adversely
affect U.S. employment, and any additional tax burden may
hinder U.S. companies in competition with foreign concerns.
Although the host country resource will be developed, it will
be done by foreign competition, with the adverse ripple effect
of U.S. jobs losses and the loss of continuing evolution of
U.S. technology. By contrast, foreign oil and gas development
by U.S. companies increases utilization of U.S. supplies of
hardware and technology. The loss of any major foreign project
by a U.S. company will mean less employment in the U.S. by
suppliers, and by the U.S. parent, in addition to fewer U.S.
expatriates at foreign locations. Many of the jobs that support
overseas operations of U.S. companies are located here in the
United States--an estimated 350,000 according to analysts at
Charles River Associates, a Cambridge, Massachusetts-based
consulting firm. That figure consists of: 60,000 in jobs
directly dependent on international operations of U.S. oil and
gas companies; over 140,000 employed by U.S. suppliers to the
oil and gas industry's foreign operations; and, an additional
150,000 employed in the U.S. supporting the 200,000 who work
directly for the oil companies and their suppliers.
Thus, the questions to be answered are: Does the United
States--for energy security and international trade reasons,
among others--want a U.S. based petroleum industry to be
competitive in the global quest for oil and gas reserves? If
the answer is ``yes,'' then why would the U.S. government adopt
a tax policy that is punitive in nature and lessens the
competitiveness of the U.S. petroleum industry? The U.S. tax
system already makes it extremely difficult for U.S.
multinationals to compete against foreign-based entities. This
is in direct contrast to the tax systems of our foreign-based
competitors, which actually encourage those companies to be
more competitive in winning foreign projects. What we need from
Congress are improvements in our system that allow U.S.
companies to compete more effectively, not further impediments
that make it even more difficult and in some cases impossible
to succeed in today's global oil and gas business environment.
These improvements should include, among others, the repeal of
the plethora of separate FTC baskets, the extension of the FTC
carryback/carryover period for foreign tax credits, and the
repeal of section 907.
The Administration's fy 1998 budget included these same
proposals which would have reduced the efficacy of the FTC for
U.S. oil companies. Congress considered these proposals last
year and rightfully rejected them. They should be rejected this
year as well.
II. Regulatory Directive to Address Tax Avoidance Through Use of
Hybrids.
A second fy 1999 budget proposal would adversely affect all
U.S. multinationals' international operations. The
Administration proposes that Congress grant the Treasury broad
new regulatory authority to determine whether the tax
consequences of cross border ``hybrid transactions'' are
``appropriate'' and ``not inconsistent with the purposes of
U.S. law.'' Treasury cites recently issued Notices 98-5 and 98-
11 (``the Notices'')--in which the IRS announced its intention
to issue broad regulations that could significantly impact
existing business arrangements' foreign tax credits and
deferral--as examples of their use of the requested regulatory
authority. The unfettered recognition of hybrid entities is
essential to U.S. companies competing in foreign countries.
Similarly, the utilization of foreign tax credits must not be
subjected to new, unclear and confusing criteria. The Notices,
along with the budget proposal, have already had a chilling
effect on U.S. multinationals' ability to structure their
foreign transactions in the ordinary course of business.
The proposal would give the Treasury broad new authority to
propound legislative regulations without further Congressional
consideration. In developing U.S. international tax policy,
Congress has attempted to balance the competing goals of
capital export neutrality and U.S. international
competitiveness. Treasury appears to be preparing to change
that balance. API recommends that Congress conduct a study of
the trade and tax policy issues associated with Notices 98-5
and 98-11 and place a moratorium on further regulatory action
by Treasury until specific legislative proposals are enacted.
III. Reinstatement of the Excise Taxes and the Corporate Environmental
Tax Deposited in the Hazardous Substance Superfund Trust Fund.
The Administration's proposal would reinstate the Superfund
excise taxes on petroleum and certain listed chemicals as well
as the Corporate Environmental Tax through October 1, 2008. API
opposes imposition of any Superfund taxes without substantial
reform of the underlying Superfund program and the tax system
supporting the fund. It is widely recognized that CERCLA is a
broken program that requires major substantive and procedural
changes. Furthermore, a restructured and improved CERCLA
program can and should be funded through general revenues.
Superfund sites are a broad societal problem, and taxes
raised to remediate these sites should be broadly based rather
than focused on a few specific industries. EPA has found wastes
from all types of businesses at most hazardous waste sites. As
consumers, as residents of municipalities, and as residents and
taxpayers of a nation, our entire economy benefited in the pre-
1980 era from the lower cost of handling waste. To place
responsibility for the additional costs resulting from
retroactive CERCLA cleanup standards on the shoulders of a very
few industries when previous economic benefits were widely
shared is patently unfair.
Petroleum-related businesses are estimated to be
responsible for less than 10 percent of the contamination at
Superfund sites; yet these businesses have historically paid
over 50 percent of the taxes that support the Trust Fund. This
inequity is of paramount concern to our industry and should be
rectified. Congress should first substantially reform the
program and then should fund the program through general
revenues or some other broad-based funding source.
IV. Reinstatement of the Oil Spill Excise Tax.
The Administration proposes reinstating the five cents per
barrel excise tax on domestic and imported crude oil dedicated
to the Oil Spill Liability Trust Fund through October 1, 2008,
and increasing the trust fund full funding limitation (the
``cap'') from $1 billion to $5 billion.
Collection of the Oil Spill Excise Tax was suspended for
several months during 1994 because the Fund had exceeded its
cap of $1 billion. It was subsequently allowed to expire
December 31, 1994, because Congress perceived there was no need
for additional taxes. Since that time, the balance in the Fund
has remained above $1 billion, despite the fact that no
additional tax has been collected. Clearly, the legislated
purposes for the Fund have been accomplished without any need
for additional revenues. The Administration's proposal to
reinstate the tax and eliminate the fund cap is simply a poorly
disguised effort to raise revenues to balance the budget. API
opposes the proposal.
V. Tax Credits to Promote Energy Efficiency and Alternative Energy
Sources.
The Administration's budget includes a number of tax and
spending proposals related to the Kyoto global climate
agreement. API would welcome the opportunity to meet with them
to discuss the costs and benefits of possible approaches for
reducing greenhouse gas emissions. However, we believe it is
premature to present formal tax proposals to begin implementing
the Kyoto agreement before there has been a thorough and open
debate on its implications and before it has been acted on by
the U.S. Senate.
During the ratification process, the prioritization and
implications of steps needed to reduce the growth in emissions
can be clarified--and resulting governmental decisions can then
be made after the views of all interested parties have been
presented in public hearings. Any programs to expand research
and development initiatives should maintain a level playing
field for all energy sources and technology and should rely on
market forces to bring new technology to consumers and
business.
American Skandia Life Assurance Corporation
Shelton, Connecticut
February 27, 1998
The Honorable Congressman Bill Archer
Chairman
Committee on Ways and Means
C/O
A. L. Singleton
Chief of Staff
Committee on Ways and Means
U.S. House of Representatives
1102 Longworth House Office Building
Washington, D.C. 20515
Dear Congressman Archer:
We are writing on behalf of American Skandia Life Assurance
Corporation (``American Skandia''). American Skandia, headquarted in
Shelton Connecticut, is the 6th largest seller of variable annuities in
the United States and has over 200,000 contract owners, with more than
$12 billion in retirement annuities, who will be adversly impacted by
the Administration's budget proposals. We currently employ over 650
people and have an obligation to our employees, our annuity sellers
and, most of all, our annuity customers to vigorously oppose this
recent unwarranted attack on our industry in specific, and long-term
retirement savings in general.
The proposed changes to annuity taxation (deferred annuities, life
insurance and immediate annuities would be affected) will directly harm
the retirement plans of millions of Americans, including our 200,000
plus annuity contract owners. These proposals are not the product of
well thought out public policy, but rather ``quick fixes'' to find
small or illusory amounts of money at the expense of hard-working,
honest people saving for retirement. Tax deferral, one of the important
features provided by annuities, has proven to be a powerful incentive
to middle class Americans to take more responsibility for their
retirement through long-term savings.
It makes the most sense for us to focus our comments on the annuity
proposals, so we will do so.
1. The revenue numbers expected from these changes are illusory.
These proposals are designed to kill the deferred annuity industry in
general and the variable annuity industry in particular. If passed,
they will do just that. There are two key incentives Congress has
provided for long-term savings that have been in place for decades--tax
deferral and tax-free reallocation among funding vehicles. The
Administration's budget proposals attack both.
The first part of the attack--reducing the tax basis of non-
qualified annuities by an imputed insurance expense--will make the
product economically uncompetitive against investments with the benefit
of capital gains treatment and a stepped-up basis at death. This
proposal is also an insult to both market forces and state regulation
of insurance. Market forces have been driving down the expenses within
variable annuities below the proposed 1.25% imputed cost. This proposal
would eliminate any continued incentive to lower costs. It is also a
heavy-handed attempt at Federal rate regulation of products that are
regulated by the states. Lowering the cost basis of any investment
product essentially converts after-tax capital into income or gain,
once again taxable by the government. Under the Administration's
current proposal, the longer the capital is set aside for retirement,
the more it will be taxed again. This sort of double taxation,
particularly of retirement savings, is a questionable approach to
encouraging Americans to save.
The second part of the attack--taxing transfers between investment
options within variable annuities, as well as exchanges between annuity
products--destroys key values for savers. Insurers have gone to great
lengths to provide an array of investment options, build systems
support for asset allocation programs and teach the public about the
wisdom of diversification among investment objectives, investment
styles and investment managers. This type of diversification is prudent
for persons in 401(k) plans, tax-sheltered annuities and IRAs and is
equally smart for persons in tax-deferred annuities. All tax deferred
programs provide value on this basis alone, since customers can engage
in such diversification and risk reduction strategies without incurring
taxes every time money is transferred between investment vehicles.
Another key value for savers is the opportunity to change their
providers. Any provider of tax-deferred saving vehicle knows that if
their performance or service is poor, the customer can go elsewhere
without tax penalty. This puts strong pressure on us to perform well,
consistently. We, as a company, have thrived on this pressure. It has
forced innovation and a constant focus on improving service. This
leverage versus big, sophisticated insurers, mutual funds, brokerage
houses and banks is good for consumers. Why in the world should it be
taken away in the context of variable annuities?
If this two pronged attack is successful, new variable annuity
sales will stop, transfers and exchanges will not occur and the
projected revenues will not come in. We as a country have learned the
hard way that we need to ``pay as we go'' for the services we want from
government. We do not need to go back to budgetary make-believe,
spending revenues that will not really appear.
2. These tax proposals are a bad idea because long-term savings
must be encouraged, not hampered, and because this proposal
discriminates against many working people. Congress tightened up the
tax rules for annuities four times in the 1980's. Those changes made
annuities a good retirement savings vehicle for two main purposes: (a)
supplemental long term savings over and above employer-sponsored plans;
and (b) easy access to tax deferral over and above the IRA contribution
limits for people who were never or are no longer employed by firms
with retirement plans. The Administration's proposals would kill the
product, so it could no longer serve these important purposes. We are
particularly perturbed that with the impact of this proposal on working
people once a working family gets the mortgage paid off and the kids
through school. If a working family gets the mortgage paid off and the
kids through school, the parents or parent now need to put away more
than the inadequate $2,000 a year permitted in an IRA for retirement.
They would not be able to get the benefit of tax deferral on that extra
savings unless their employer provided a plan. Deferred annuities are
an important savings vehicle for middle class Americans. These
proposals are just plain unfair to the people who need this break the
most.
The annuity business is threatened now by the cloud that has been
created by these proposals. I hope the House Committee on Ways and
Means will work to remove that cloud quickly, forcefully and sensibly.
The annuity product is an excellent retirement savings tool for many
Americans. The current tax rules assure that the annuity is not a tax
dodge for the rich. It is an important long-term savings product for
many middle-class Americans, especially those who are not covered by an
employer sponsored retirement plan and need to use these products to
save for their retirement. On behalf of American Skandia, we thank you
for your consideration of our input on this very important matter.
Sincerely,
Wade Dokken
Deputy Chief Executive
Officer
American Skandia Marketing,
Inc.
Gordon C. Boronow
Deputy Chief Executive
Officer
American Skandia Life
Assurance Corporation
Statement of Jaime Steve, Legislative Director, American Wind Energy
Association
The American Wind Energy Association,\1\ or AWEA,
respectfully submits this written testimony in support of a
five-year extension of the existing 1.5 cent per kilowatt-hour
production tax credit (PTC) for electricity produced using wind
energy resources. An immediate extension of this provision is
crucial if we are to see significant growth in the domestic
wind energy industry. We are grateful for the opportunity to
participate in the deliberations of the House Ways and Means
Committee as it considers this important issue.
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\1\ The American Wind Energy Association, or AWEA, was formed in
1974 and has nearly 700 members from 48 states. AWEA represents
virtually every facet of the wind energy industry, including turbine
manufacturers, project developers, utilities, academicians, and
interested individuals.
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The Energy Policy Act of 1992 (EPAct) enacted the PTC as
Section 45 of the Internal Revenue Code of 1986. The credit is
phased out if the price of wind generated electricity is
sufficiently high. In report language accompanying EPAct (H.
Rpt. 102-474, Part 6, p. 42), the Ways and Means Committee
stated, ``The Credit is intended to enhance the development of
technology to utilize the specified renewable energy sources
and to promote competition between renewable energy sources and
conventional energy sources.''
Since its inception, the PTC has supported wind energy
development and production. In the 1980's, electricity
generated with wind could cost as much as 25 cents/kilowatt-
hour. Since then wind energy has reduced its cost by a
remarkable 80% to the current levelized cost of between 4 and 5
cents per kilowatt hour.
The 1.5 cent/kilowatt-hour credit enables the industry to
compete with other generating sources being sold at 3 cents/
kilowatt-hour. The extension of the credit will enable the
industry to continue to develop and improve its technology to
drive costs down even further and provide Americans with
significantly more clean, emissions-free electricity
generation. Indeed, experts predict the cost of wind equipment
alone can be reduced by another 40% from current levels, with
an appropriate commitment of resources to research and
development and from manufacturing economies of scale.
Current Provision: The Production Tax Credit (PTC) provides
a 1.5 cents per kilowatt-hour credit (adjusted for inflation)
for electricity produced from a facility placed in service
after December 31, 1993 and before July 1, 1999 for the first
ten years of the facility's existence. The credit is only
available if the wind energy equipment is located in the United
State and electricity is sold to an unrelated party. Under
current law, the tax credit qualification date would expire on
July 1, 1999. A five-year extension would create a new sunset
date of July 1, 2004.
Status: A five-year extension of this provision--through
July 1, 2004--was introduced in the House (H.R. 1401) by Rep.
Bill Thomas (R-CA). H.R. 1401 has been cosponsored by Ways and
Means Committee members Reps. Jim Nussle (R-IA), Jennifer Dunn
(R-WA), Robert Matsui (D-CA), Jim McDermott (D-WA), John Lewis
(D-GA) and Karen Thurman (D-FL).
As similar bill (S. 1459) has been introduced in the Senate
by Senators Chuck Grassley (R-IA) and James M. Jeffords (R-VT)
joined by Sens. Frank Murkowski (R-AK), Kent Conrad (D-ND) and
Bob Kerrey (D-NE), all members of the Finance Committee. A
five-year extension of the wind tax credit also is contained
within the Clinton Administration's FY 1999 budget proposal. At
present, H.R. 1401 has 20 co-sponsors and S. 1459 has 10 co-
sponsors.
Contributions of Wind Power: Wind is a clean, renewable
energy source which helps to protect public health, secure a
cleaner environment, enhance America's national security
through increased energy independence, and reduce pollution. In
fact, reducing air pollutants in the United States will
necessitate the promotion of clean, environmentally-friendly
sources of renewable energy such as wind energy. Further,
renewable energy technologies such as wind power should play an
important role in a deregulated electrical generation market.
Wind power alone has the potential to generate power to
provide the electric energy needs of as many as 10 million
homes by the end of the next decade. The extension of the PTC
will not only assure the continued availability of wind power
as a clean energy option, but also it will help the wind energy
industry secure its position in the restructured electricity
market as a fully competitive, renewable source of electricity.
Significant Economic Growth Potential of Wind Power: The
global wind energy market has been growing at a remarkable rate
over the last several years and is the world's fastest growing
energy technology. The growth of the market offers significant
export opportunities for U.S. wind turbine and component
manufacturers.
The World Energy Council has estimated that new wind
capacity worldwide will amount to $150 to $400 billion worth of
new business over the next twenty years. Experts estimate that
as many as 157,000 new jobs could be created if U.S. wind
energy equipment manufacturers are able to capture just 25% of
the global wind equipment market over the next ten years. Only
by supporting its domestic wind energy production through the
extension of the PTC can the U.S. hope to develop the
technology and capability to effectively compete in this
rapidly growing international market.
Finally, we must stress that the immediate extension of the
PTC is critical to the continued development of the wind energy
industry. Since the PTC is a production credit available only
for energy actually produced from wind facilities, the credit
is conditioned on permitting, financing and construction of the
facilities. The financing and permitting requirements for a new
wind facility often require two to three years of lead time.
With the credit due, wind energy developers and investors are
reluctant to commit to new projects without the assurance of
the continued availability of the PTC. Moreover, if the credit
is not extended this year, it is extremely unlikely that
Congress will be able to address an extension of the PTC before
its expiration in 1999.
The American Wind Energy Association appreciates the
opportunity to submit written testimony on this matter. We
stand ready to assist the Committee in any way regarding the
five-year extension of the wind energy Production Tax Credit.
Thank you.
Statement of Bond Market Association
The Bond Market Association is pleased to comment on
several of the revenue-raising provisions in the Clinton
Administration's FY 1999 budget. The Association's membership
consists of securities firms and banks that underwrite, trade,
and sell fixed-income securities in the U.S. and international
markets, including nearly all dealers of municipal and
corporate bonds. We take an active interest in tax policy
issues that affect the ability of corporations and governments
to raise capital to finance new investment. As such, we are
pleased that the deficit has finally been eliminated, and we
commend the leadership of Chairman Archer and other members of
the committee in bringing about a balanced federal budget.
Eliminating the deficit has already borne economic fruit.
Interest rates are at historic lows, due at least in part to a
reduction in federal borrowing brought about by eliminating the
deficit. Indeed, one of the most important benefits of
balancing the budget is that it leads to lower interest rates
and encourages more capital investment. We are dismayed and
disappointed, however, that the administration has persisted in
advocating tax increases which would have the opposite effect.
Several tax increases in the administration's budget would
raise capital costs for states, localities and corporations and
discourage new capital investment.
In our testimony before this committee last year, we argued
against several of the tax provisions which have been re-
proposed by the administration. In addition, throughout 1996
and 1997, Congress heard from countless state and local
officials, corporate CEOs, public interest groups, and others
about the negative effect the administration's proposals would
have on borrowing costs and new capital investment. In the end,
Congress wisely rejected the administration's tax increases
which were targeted at capital investment. Indeed, even the
administration itself has retreated from some of the proposed
tax increases aimed at capital investment by corporations.
However, other proposals are back, along with a new proposed
tax increase which would have a particularly negative effect on
state and local government borrowing. Since we have repeatedly
commented on older administration proposals, our comments today
will focus primarily on new aspects of the revenue provisions,
although we will also discuss the others. We urge this
committee and the entire Congress to once again reject these
ill-conceived tax increases.
The proposals we oppose, as described in the ``Summary of
Tax Provisions in President Clinton's FY 1999 Budget'' prepared
by the Ways and Means Committee staff, include:
Increase proration percentage for property and
casualty companies.
Extend pro rata disallowance of tax-exempt
interest expense to financial intermediaries.
Defer original issue discount on convertible debt.
Deny DRD for preferred stock with certain non-
stock characteristics.
Increase proration percentage for property and casualty companies
The administration's proposal to increase the proration
percentage for property and casualty companies appears to be
targeted at the insurance industry. In reality, however, a
significant portion of the new tax would be borne by states and
localities in the form of higher borrowing costs.
The three largest groups of investors in the tax-exempt
bond market, together accounting for over 90 percent of
outstanding bonds, are households, mutual funds and property
and casualty insurance companies (P&Cs). As of September 30,
1997, P&Cs held approximately $180 billion in municipal
securities, or about 14 percent of outstanding tax-exempt
bonds. That significant figure belies their true influence in
the municipal market, however. In the years 1994 through 1996,
households decreased their holdings of municipal bonds by $145
billion. Mutual fund holdings increased by $2 billion. Over the
same period of time, net new investment in municipal securities
by P&Cs increased by $29 billion. Indeed, over the past several
years, P&Cs have been the only major source of new demand for
state and local government bonds. If not for P&C participation
in the municipal market, interest rates faced by states and
localities would be significantly higher than they are today.
[GRAPHIC] [TIFF OMITTED] T1685.003
P&Cs are particularly important in certain sectors of the
municipal market. They tend to invest in medium- to long-term
municipals of relatively high credit quality with maturities of
12-20 years. These bonds are issued for a variety of purposes,
from financing new public school construction to building
roads, bridges, water and sewer systems, airports and a variety
of other traditional government uses. In many cases,
substantial portions of new municipal bond issues are sold to
P&Cs. They often represent the primary factor in determining
the pricing of new issues. Between 1991 and 1997, P&Cs went
from holding 10 percent of all outstanding municipal securities
to 14 percent. A table outlining P&C holdings of municipal
bonds by state of the issuer is included as an appendix to this
statement.
For most investors, interest earned on state and local
government bonds is exempt from federal income taxation, but
that is not entirely so for P&Cs. A P&C is permitted a
deduction for contributions to its reserves for losses. That
deduction is reduced by an amount equal to 15 percent of its
``proration'' income, which includes tax-exempt bond interest,
the deductible portion of dividends earned, and tax-exempt or
tax-deferred income from certain life insurance products. The
application of the deduction disallowance is in effect a 5.25
percent tax on the P&C's ``tax-exempt'' interest income (15
percent disallowance multiplied by a 35 percent marginal tax
rate), known as a ``haircut.'' In addition, 100 percent of
``private-activity'' bond interest and 75 percent of other
municipal bond interest earned by P&Cs is subject to the
corporate alternative minimum tax (AMT). For AMT payers, then,
non-private-activity municipal bond interest is subject to a
15.75 percent tax (75 percent times the 20 percent AMT rate
plus the effect of the ``haircut'').
The administration has proposed raising the loss reserve
deduction disallowance from 15 percent of proration income to
30 percent, thereby doubling the tax rate P&Cs pay on municipal
bond interest from 5.25 percent to 10.5 percent. Under current
market conditions, interest rates on tax-exempt securities
would not be sufficient to continue to attract P&Cs to the
municipal market. Unfortunately, in the market sectors where
P&Cs are most active, there are few other ready buyers at
current interest rates. It is likely that if the
administration's proposal were enacted, once municipal bond
yields rose to fully reflect the proposal's effects, P&Cs would
remain active as municipal market investors. However, interest
rates paid by state and local governments on their borrowing
would be higher than if the proposal had not been enacted. P&Cs
will simply be compensated for their additional tax liability
through higher returns on their municipal bond portfolios. The
effect for state and local governments would be higher
borrowing costs. An analysis by one member firm suggests that
municipal borrowing costs would increase by 10-15 basis points
(0.10-0.15 percentage point) as a result of this proposal.
Implicitly, approximately 40-60 percent--perhaps up to 75
percent--of the tax would be borne not by P&Cs but by state and
local governments in the form of higher borrowing costs.
On a typical $200 million tax-exempt bond issue with an
average maturity of 15 years, the administration's proposal
would cost the state or local issuer $2-3 million in additional
interest expense in present value terms over the life of the
issue. If the administration's proposal had been in place when
the approximately $207 billion in tax-exempt securities were
issued in 1997, it would have cost state and local governments
$2-3 billion in additional interest expense over the life of
their issues, assuming an average maturity of 15 years. This
additional cost would have been related to just one year of
borrowing.
The administration has offered little justification for its
proposal. The arguments in the Treasury Department's ``Green
Book'' \1\ assert only that current law ``still enables
property and casualty insurance companies to fund a substantial
portion of their deductible reserves with tax-exempt or tax-
deferred income.'' The administration's answer, however, simply
raising the tax on municipal bond interest earned by P&Cs, is
an inappropriate response. First, there is no direct connection
between contributions to loss reserves and the amount of
municipal bond interest earned. Second, a deduction
disallowance of 30 percent, as the administration proposes, is
an unjustified, arbitrary figure. Third, as already stated, a
substantial portion of this tax would be borne not by P&Cs but
by state and local governments.
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\1\ Department of the Treasury, General Explanations of the
Administration's Revenue Proposals, February 1998, page 113
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We urge the committee to consider the negative effects this
proposal would have on states and localities and to reject the
provision.
Extend pro rata disallowance of tax-exempt interest expense to
financial intermediaries
Another proposed tax increase in the administration's
budget, while it would nominally apply to corporations, would
again in reality be borne by state and local governments in the
form of higher financing costs. Rather than closing a ``tax
loophole'' for corporations, the proposal would make it more
expensive for state and local governments to finance vital
public services. Taken together with the provision related to
P&Cs, these two proposals represent a significant attack on the
ability of states and localities to finance new investment at
the lowest possible cost.
Under current law, investors, including corporations, are
not permitted to deduct the interest expense associated with
borrowing to finance purchases of tax-exempt securities.
Financial institutions that earn non-qualified tax-exempt
interest are automatically disallowed a portion of their
interest expense deduction in proportion to the ratio of
municipal bond holdings to total assets. Securities firms are
generally bound to the same rules as banks. However, securities
firms are not required to apply the pro rata disallowance to
interest expense which is explicitly traceable to activities
other than buying or holding municipal bonds. Non-bank
corporations that earn tax-exempt interest, in order to avoid a
loss of interest-expense deduction, must demonstrate that they
did not borrow to finance their purchases. Under an IRS
procedure in place since 1972, as long as a corporation's tax-
exempt bond portfolio does not exceed two percent of its total
assets, the IRS does not attempt to determine whether the
corporation borrowed to finance its municipal bond holdings.\2\
This is the so-called ``two-percent de minimis rule.'' The
administration's proposal would effectively repeal this safe
harbor for ``financial intermediaries'' and apply to them the
same rules that now apply to banks.
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\2\ Internal Revenue Service, Revenue Procedure 72-18.
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This provision is similar to one proposed by the
administration in last year's budget request. Last year's pro
rata disallowance proposal would have applied to non-bank
corporations generally, while this year's version is limited to
financial intermediaries. Although the term ``financial
intermediaries'' has yet to be formally defined, it is likely
to include securities firms, finance companies and certain
government-sponsored corporations, among others. The proposal
would have three distinct effects on municipal market
participants.
Securities firms' activities
Securities firms borrow in a very unique way. Securities
firms, including the securities subsidiaries of commercial bank
holding companies, carry large positions in a variety of
securities for various lengths of time. For large firms, the
value of these positions is often in the tens of billions of
dollars. No firm is able to finance such large positions from
its own capital, so all securities firms borrow to finance
their holdings. In most cases, this borrowing is secured by the
securities being held by the firm. This activity is related to
securities firms' unique role as ``market-makers.'' In order to
be prepared to buy or sell securities from or to customers at
any time, firms must be able to efficiently finance their
positions.
For example, in a typical transaction, a securities firm
may buy U.S. Treasury bonds from a customer. Unless the firm is
able to immediately resell the securities to another customer,
it must finance its position. For government securities, this
is most often accomplished through repurchase agreements,
essentially a form of secured borrowing.\3\ Because the
interest paid on a repurchase agreement is directly traceable
to financing the firm's position in Treasury securities, the
interest is not subject to the pro rata deduction disallowance
that applies to all general, non-traceable interest of the
firm. The justification for this treatment is that the interest
expense which is traceable to some specific activity other than
buying or holding municipal securities should not be subject to
a rule designed to prevent interest deductions for borrowing to
finance tax-exempt assets. The same reasoning applies with
respect to other traceable interest expense, such as interest
paid on margin loans. Indeed, given the unique nature of
securities firms' borrowing in many cases, a great deal of
interest expense is traceable and hence not subject to the pro
rata disallowance.
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\3\ Technically, a repurchase agreement is not a loan but a
contract to sell a security and to subsequently repurchase it in the
future at a price agreed upon at the time the contract is executed. The
difference between the sale and purchase price is the interest paid by
the ``borrower'' to the ``lender.'' Repurchase agreements are
recognized as a form of secured lending for virtually all tax purposes.
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The administration's proposal would change the way in which
the pro rata disallowance is applied to securities firms by
applying it to all interest expense, even that which is
directly traceable to activities other than buying municipal
securities. In doing so, the proposal would significantly
increase the cost for securities firms of financing positions
in tax-exempt securities--firms' ``cost of carry'' for
municipal bonds--since under the proposal, tax-exempt bonds
held by a securities dealer would trigger a much larger
interest expense disallowance than under current law. Because
securities firms are highly leveraged companies, i.e., they
have a very high ratio of debt to total capitalization, they
would be hard-hit by the proposal. Estimates of the effects of
the proposal on dealer's costs of carrying municipal bonds in
inventory range from 40 basis points (0.4 percentage point) to
well over a percentage point, depending on the amount of a
dealer's interest which under current law is traceable and not
subject to the pro rata disallowance.
Because the administration's proposal would raise a
dealer's cost of carry for municipal bond inventories, there
would be inevitable consequences for state and local bond
issuers and investors. Much of the increased cost associated
with acting as a market-maker in the municipal market would be
reflected in higher costs of dealer services. For example,
securities firms that underwrite new issues of municipal
securities often carry the bonds in inventory for a period of
time. The administration's proposal would increase the cost
associated with that activity. These costs would likely be
reflected in higher fees paid by states and localities for
underwriting services. The proposal would increase costs for
dealers of buying bonds in the secondary municipal market,
where bonds are bought and sold after they are initially placed
with investors, and could affect market liquidity. These
effects would be particularly profound in the market for
shorter term municipal bonds, where dealers already face a
negative cost of carry and where dealers are particularly
important in providing liquidity under certain market
conditions. Individual investors would likely face higher
transaction costs associated with buying and selling
securities. In short, a significant portion of the new tax
imposed on municipal securities dealers would ultimately be
borne by state and local governments and municipal market
investors.
Housing and student loan bonds
The housing and student loan sectors of the municipal
market would also be negatively affected by the
administration's proposal. State and local governments issue
bonds to finance home mortgage loans for low- and moderate-
income families as well as loans for low-income, multi-family
rental projects. Both these programs provide limited, targeted,
below-market financing for housing. Over the past several
decades, state and local housing bonds have provided tens of
billions of dollars in rental housing for low-income families
and have made home ownership available to families who may not
have been able to finance a home through any other source.
Student loan bonds are issued to finance below-market loans to
college students who may not otherwise be able to obtain
tuition financing.
Together, Fannie Mae, Freddie Mac, Sallie Mae and other
government-sponsored corporations and agencies hold about $9
billion of outstanding municipals. These entities invest
primarily in state and local housing bonds (Fannie Mae and
Freddie Mac) and student loan bonds (Sallie Mae). Indeed, it is
a condition of Fannie Mae's and Freddie Mac's statutory
charters that they help support the market for low- and middle-
income housing, and investing in state and local housing bonds
is one of the ways in which these agencies carry out that
obligation. Under the administration's proposal, these
organizations would simply stop buying municipals. As a result,
the cost of mortgage financing provided through state and local
governments would increase substantially.
Municipal leasing transactions
The proposal would also have profound effects on municipal
leasing. States and localities routinely lease assets and
equipment, such as school buses, police cars, and computers. If
the administration's proposal were adopted, equipment lessors
estimate that their cost of financing for state and local
governments would increase dramatically. After originating
municipal lease transactions, most lessors generally sell their
financing contracts to private funding sources to generate the
capital they need to continue to operate their business. Those
who invest in tax-exempt leasing include corporations,
commercial banks and investment banks. Individuals and mutual
funds, through certificates of participation, also purchase
tax-exempt leases. Although last year's version of the
administration's proposal would not have applied ``to certain
non-salable tax-exempt bonds acquired by a corporation in the
ordinary course of business in payment for goods and services
sold to a state or local government,'' this intended relief was
illusory. The vast majority of equipment manufacturers who sell
to state and local governments prefer not to hold municipal
leases because they do not want to tie up their capital. These
companies generally sell their financing contracts to third
party investors. The administration's proposal would discourage
vendor financing of capital equipment leased to states and
localities. As a direct result, the cost of new capital
investment by state and local governments would rise
substantially.
Because the new taxes imposed by the proposal would be
borne to a significant degree by states and localities, we urge
that the proposal be rejected.
Defer original issue discount on convertible debt
The administration has proposed to change the tax treatment
of original issue discount (OID) on convertible debt
securities. OID occurs when the stated coupon of a debt
instrument is below the yield demanded by investors. The most
common case is a zero-coupon bond, where all the interest
income earned by investors is in the form of accrued OID. Under
current law, corporations that issue debt with OID may deduct
the interest accrual while bonds are outstanding. In addition,
taxable OID investors must recognize the accrual of OID as
interest income. Under the administration's proposal, for OID
instruments which are convertible to stock, issuers would be
required to defer their deduction for accrued OID until payment
was made to investors in cash. For convertible OID debt where
the conversion option is exercised and the debt is paid in
stock, issuers would lose the accrued OID deduction altogether.
Investors would still be required to recognize the accrual of
OID on convertible debt as interest income, regardless of
whether issuers took deductions.
The administration's proposal is objectionable on several
grounds. First, convertible zero-coupon debt has efficiently
provided corporations with billions of dollars in capital
financing. The change the administration proposes would
significantly raise the cost of issuing convertible zero-coupon
bonds, and in doing so would discourage corporate capital
investment. Second, the administration's presumptions for the
proposal are flawed. The administration has argued that ``the
issuance of convertible debt instrument[s] is viewed by market
participants as a de facto issuance of equity.'' \4\ However,
performance does not bear out this claim. In fact, of the
convertible zero-coupon debt retired since 1985, approximately
70 percent has been retired in cash, and only 30 percent has
been converted to stock. Indeed, the market treats convertible
zero-coupon bonds more as debt than as equity.
---------------------------------------------------------------------------
\4\ Department of the Treasury, page 97.
---------------------------------------------------------------------------
Third, and perhaps most important, the administration's
proposal violates the basic tenet of tax symmetry, the notion
that the recognition of income by one party should be
associated with a deduction by a counterparty. This fundamental
principle exists to help ensure that income is taxed only once.
Under the proposal, investors would be taxed fully on the
accrual of OID on convertible zero-coupon debt, but issuers'
deductions would be deferred or denied. The proposal would
compound problems associated with the multiple taxation of
investment income, thereby raising the cost of corporate
capital.
Because the proposal would exacerbate problems of multiple
taxation of corporate income and because it would raise the
cost of corporate capital investment, we urge the rejection of
the administration's proposal.
Deny DRD for preferred stock with certain non-stock characteristics
Under current law, corporate taxpayers that earn dividends
on investments in other corporations are permitted a tax
deduction equal to at least 70 percent of those earnings. The
deduction is designed to mitigate the negative economic effects
associated with multiple taxation of corporate earnings. The
administration has proposed eliminating the dividends-received
deduction (DRD) for preferred stock with certain
characteristics. This proposal would increase the taxation of
corporate earnings and discourage capital investment.
The DRD is important because it reduces the effects of
multiple taxation of corporate earnings. When dividends are
paid to a taxable person or entity, those funds are taxed
twice, once at the corporate level and once at the level of the
taxpayer to whom the dividends are paid. These multiple levels
of taxation raise financing costs for corporations, create
global competitiveness problems, and generally reduce
incentives for capital formation. The DRD was specifically
designed to reduce the burden of one layer of taxation by
making dividends largely non-taxable to the corporate owner.
The administration has argued that certain types of
preferred stock, such as variable-rate and auction-set
preferred, ``economically perform as debt instruments and have
debt-like characteristics.'' \5\ However, the administration
has not proposed that such instruments be formally
characterized as debt eligible for interest payment and accrual
deductions. The administration has sought to characterize
certain preferred stock in such a way as to maximize tax
revenue; it would be ineligible for both the DRD and the
interest expense deduction.
---------------------------------------------------------------------------
\5\ Ibid., page 99
---------------------------------------------------------------------------
Eliminating the DRD for these instruments would exacerbate
the effects of multiple taxation. The change would be
tantamount to a tax increase on corporate earnings since the
minimum deduction available to certain investors would fall.
This tax increase would flow directly to issuers of preferred
stock affected by the proposal who would face higher financing
costs as investors demanded higher pre-tax yields. Amplifying
the competitive disadvantages of multiple taxation of American
corporate earnings would be the fact that many of our largest
economic competitors have already adopted tax systems under
which inter-corporate dividends are largely or completely
untaxed. Eliminating the DRD for preferred stock with certain
characteristics would cut U.S. corporations off from an
efficient source of financing, thereby discouraging capital
investment.
Summary
Government fiscal policy, especially tax policy, can have a
profound effect on the ability of governments and corporations
to undertake capital investment. Tax proposals as seemingly
arcane, technical and focused as ``increasing the proration
percentage for property and casualty companies'' or ``extending
the pro rata interest expense disallowance to financial
intermediaries'' would have effects far beyond what is
apparent. By affecting the choices and preferences of
investors, these proposals would also have a significant
negative effect on the ability of borrowers to finance capital
investments at the lowest possible cost. We share the belief of
many members of this committee that our tax system ought to
encourage and facilitate capital investment. The
administration's proposals outlined above would have the
opposite effect. We urge you to oppose these provisions.
We appreciate the opportunity to present our statement, and
we look forward to working with Ways and Means members and
staff as the budget debate progresses.
Appendix
Municipal Holdings of U.S. Property & Casualty Insurance Companies By State of Issuer As of September 30, 1997
----------------------------------------------------------------------------------------------------------------
State ($000s) State ($000s)
----------------------------------------------------------------------------------------------------------------
Alabama...................................... 2,059,021 Nebraska........................ 1,126,823
Alaska........................................ 1,306,692 Nevada.......................... 2,939,837
Arizona....................................... 4,446,074 New Hampshire................... 674,534
Arkansas...................................... 432,179 New Jersey...................... 4,495,815
California.................................... 10,349,389 New Mexico...................... 951,091
Colorado...................................... 3,323,768 New York........................ 10,633,565
Connecticut................................... 3,538,421 North Carolina.................. 2,532,793
Delaware...................................... 784,556 North Dakota.................... 346,563
District of Columbia.......................... 839,432 Ohio............................ 4,190,349
Florida....................................... 9,657,937 Oklahoma........................ 1,157,219
Georgia....................................... 5,804,654 Oregon.......................... 1,493,789
Hawaii........................................ 2,016,090 Pennsylvania.................... 6,585,177
Idaho......................................... 336,904 Puerto Rico..................... 754,917
Illinois...................................... 11,641,432 Rhode Island.................... 950,926
Iowa.......................................... 4,333,908 South Carolina.................. 2,200,217
Kansas........................................ 787,849 South Dakota.................... 752,454
Kentucky...................................... 1,250,188 Tennessee....................... 2,594,871
Louisiana..................................... 2,108,269 Texas........................... 23,244,490
Maine......................................... 2,291,331 Utah............................ 2,910,860
Maryland...................................... 653,460 Vermont......................... 293,421
Massachusetts................................. 3,699,884 Virginia........................ 4,709,072
Michigan...................................... 6,085,316 Washington...................... 9,888,956
Minnesota..................................... 5,187,175 West Virginia................... 953,235
Mississippi................................... 3,080,033 Wisconsin....................... 4,568,021
Missouri...................................... 1,243,470 Wyoming......................... 433,659
---------------
Montana....................................... 1,534,822 Total........................... 180,405,996
----------------------------------------------------------------------------------------------------------------
Statement of Business Insurance Coalition
Business Insurance Coalition Members
AIG Life Companies (U.S.)
American Council of Life Insurance
American General Corporation
America's Community Bankers
Association for Advanced Life Underwriting
Clarke/Bardes, Inc.
Great West Life and Annuity Insurance Company
Harris, Crouch, Long, Scott, Miller Inc.
The Hartford Financial Services Group
Massachusetts Mutual Life Insurance Company
MetLife
The Mutual of Omaha Companies
National Association of Life Underwriters
National Institute for Community Banking
New York Life Insurance Company
The Newport Group
Pacific Life
Schoenke & Associates
Zurich Centre Group LLC
The Business Insurance Coalition, which is comprised of the
above-listed purchasers, issuers, and sellers of business-use
life insurance, submits this statement opposing the
Administration's FY'99 budget proposal to impose new taxes on
businesses that own or benefit from permanent life insurance.
American businesses, large and small, have for many decades
used life insurance to assure business continuation, provide
employee benefits and attract and retain key employees. There
is no justification for discouraging or eliminating these
traditional business uses of life insurance, and we urge
Members of the Ways and Means Committee to reject the
Administration's efforts to impose a tax penalty that would
strongly discourage the vast majority of employers from
utilizing this important product.
Life Insurance Allows Business Continuation, Protects Employees and
Funds Vital Employee Benefit Programs
Permanent life insurance protects businesses against the
economic losses which could occur after the death of an owner
or employee. Life insurance death benefits provide liquid cash
to pay estate taxes when a business owner dies, to buy out
heirs of a deceased owner or to meet payroll and other ongoing
expenses when an income-producing worker dies, terminates or
retires.
Permanent life insurance purchased with after-tax dollars
smoothes the transition during difficult times, allowing the
business--and its employees--to continue working by preventing
or mitigating losses associated with these disruptions.
Anecdotal evidence of this abounds; every Representative and
Senator will hear from constituents whose jobs still exist
because their employers were protected from financial loss by
life insurance.
Many businesses, both large and small, also use permanent
life insurance to finance employee benefit programs, thus
enabling them to attract and retain their most important asset:
skilled, experienced employees. Insurance-financed benefit
programs are as diverse as the companies that use them, ranging
from those which provide broad-based health coverage for
retirees to individual split-dollar arrangements to non-
qualified pensions and savings benefits.
The Proposal Reverses Recent Congressional Action by Imposing New Taxes
on Business-Use Life Insurance
The Administration's FY'99 budget proposal would severely
impact all of the aforementioned business uses of life
insurance. Under the proposal, any business with any debt
whatsoever would be forced to reduce its deduction for interest
paid on that debt by an amount in relation to the net
unborrowed cash values in policies owned by, or for the benefit
of, the business, unless the policy was on the life of a 20
percent owner. This would impose an indirect tax on
accumulating cash values--as unborrowed cash values increase,
the business' interest deduction disallowance would
correspondingly increase.
The Administration proposal would repeal specific
exceptions to a 1997 rule enacted by Congress which generally
disallows a portion of a business' deduction for interest paid
on unrelated borrowing where the business directly or
indirectly benefits from insurance covering the lives of anyone
but an employee, officer, director or 20 percent or greater
owner. The pending proposal would remove all exceptions except
that applicable to 20 percent owners.
In addition, the proposal apparently would repeal the 1996
rule that allows a limited interest deduction for interest paid
on loans against the life insurance policy itself when that
policy covers a key employee.
The Administration proposal therefore seeks to overturn
current law, which was developed after two years of
Congressional examination into appropriate business uses of
life insurance. It asks Congress to reconsider its August 1997
determination that there is no inappropriate interrelationship
between owning (or benefiting from) life insurance on
employees, officers and directors and general, unrelated
borrowing decisions. More broadly, the proposal seeks to repeal
long-standing tax policy which confers on corporations the
right to enjoy the same important insurance tax benefits that
are available to individuals.
The Administration Proposal Would Severely Impact Businesses That Rely
on Life Insurance
Enactment of the Administration proposal would make it
significantly--in most cases, prohibitively--more expensive for
businesses to own permanent life insurance. This would increase
the number of inadequately protected businesses, which would,
in turn, cause more businesses to fail when their owners and/or
key workers die (a result directly at odds with the effort to
save family-owned businesses as ongoing entities in the estate
tax debate).
The Administration proposal also would stifle business
expansion and job creation by placing a completely arbitrary
tax on normal corporate indebtedness of companies that own life
insurance. The net effect would be to increase the cost of
business expansion and discourage business growth, which is
both bad economic and tax policy.
If enacted, the Administration proposal also would make it
more difficult, perhaps impossible, for many businesses to use
life insurance to finance broad-based employee and retiree
benefits. It would lower the level of retirement income benefit
provided by companies to key workers. It would make it more
difficult for businesses to attract and retain quality
employees.
Finally, the Administration proposal would impose a double
tax penalty on certain business policyholders forced to
surrender or sell their life insurance policies. The first tax
penalty would be paid through reduced interest deductions on
the business' unrelated borrowing. The second tax penalty would
occur upon surrender of the policy, when the business would
again be required to pay tax on the gain generated inside the
policy. Plainly, there is no justification for imposing two
taxes (a proration tax and a tax on policy surrender) with
respect to the same item of income (life insurance inside
build-up).
The Administration's ``Arbitrage'' Justification Is Without Merit
The Administration asserts that tax legislation is needed
to prohibit ``arbitrage'' with respect to cash value life
insurance. This is not the case. Current law (IRC section 264)
disallows the deduction of interest on ``policy indebtedness''
and has always applied to direct borrowing (policy loans) and
indirect borrowing (third party debt) where the debt is
traceable to the decision to ``purchase or carry'' life
insurance.
What remains outside of section 264, then, is solely debt
that is unrelated to a business' decision to ``purchase or
carry'' life insurance, such as a manufacturer's mortgage to
purchase a new plant or a travel agency's loan to buy a new
copy machine. Under the Administration's proposal, these
businesses would be penalized for protecting themselves against
the premature death of key persons or funding retiree health
benefits through life insurance, even if they have neither
borrowed funds to purchase the policies nor taken out loans
against the policies.
Current tax law is designed to capture situations involving
arbitrage with respect to cash value life insurance. The
Administration's attempt to characterize any form of debt as
leverage which renders a business' purchase of life insurance
tax ``arbitrage'' is nothing but smoke and mirrors designed to
hide its true purpose: the imposition of new taxes on business-
use life insurance.
Tax Policy Should Encourage Appropriate Business-Use Life Insurance
Programs
At the heart of the debate over the Administration's
proposal is the issue of whether business uses of life
insurance should be encouraged or discouraged. The Business
Insurance Coalition fundamentally disagrees with the
Administration's position, which threatens all present and
future uses of life insurance by businesses, and its members
firmly believe that business-use life insurance falls clearly
within the policy purposes supporting the tax benefits
presently accorded to life insurance products.
Tax policy applicable to business-use life insurance should
encourage appropriate use of business life insurance by
embodying the following principles:
Businesses, in their use of life insurance, should
have the benefit of consistent tax laws in order to facilitate
reliable and effective long-range planning.
All businesses, regardless of size or structure,
should be able to use life insurance to provide benefits for
their workers. Life insurance is an appropriate method of
facilitating provision of retirement income, medical and
survivorship benefits.
Businesses must be able to use life insurance as
an important part of their financial protection plans, and the
insurance industry should respond to new business needs.
Businesses, like individuals, should be able to
use all products which qualify as life insurance under
applicable federal and state law.
Businesses should use life insurance products in
ways consistent with the public interest and the intent of the
tax laws.
Businesses should be able to use life insurance to
protect against the financial loss of the insured's death, or
to meet other financial needs or objectives, including but not
limited to:
--successful continuation of business operations following
the death of an insured key employee;
--purchase of a business interest, thereby enabling the
insured's family to obtain a fair value for its business
interest and permitting the orderly continuation of the
business by new owners;
--redemption of stock to satisfy estate taxes and transfer
costs of an insured stockholder's estate;
--creation of funds to facilitate benefits programs for
long-term current and retired employees, such as programs
addressing needs for retirement income, post-retirement medical
benefits, disability income, long-term care, or similar needs;
and
--payment of life insurance or survivor benefits to
families or other beneficiaries of insured employees.
Employers should be able to facilitate employee
ownership of and benefit from permanent life insurance death
and retirement income protection through split dollar insurance
arrangements.
Businesses Need Reliable and Predictable Tax Rules to Guide Their
Financial Decisions
Life insurance is a long-term commitment. It spreads its
protection--and premium obligations--over life spans, often 40
or 50 years. Its value base is predicated on the lifetime
income-producing potential of the person insured. Thus, the
process of selecting, using and paying for permanent insurance
is one that contemplates decades of financial planning
implications.
Accordingly, the rules governing the choices inherent in
constructing a business-use life insurance program must be
clear and reliable. Certainty of rules that drive the
configuration of decades-long financial commitments is crucial.
There must be a stable environment that acknowledges long-
established practices.
This need is even more acute today because of the
Congressional actions of 1996 and 1997, which created a virtual
``road map'' for businesses to follow in designing and
implementing their business-use life insurance programs. The
two years of debate addressed business-use life insurance
practices in substantial detail, settling all of the issues
raised by the pending Administration proposal. Thus, businesses
reasonably thought they could proceed with some certainty under
the rules enacted in 1996 and then further refined in 1997. To
reopen these issues--which were addressed and settled just six
months ago--and then to change them would be unconscionably
unfair.
Conclusion: The Administration's Business-Use Life Insurance Proposal
Unfairly and Adversely Affects Every Business with Current or Future
Debt
The Business Insurance Coalition strongly opposes the
Administration's FY'99 budget proposal on business-use life
insurance, which unfairly and adversely affects every business
that has current or future debt unrelated to its ownership of
life insurance. The Business Insurance Coalition has
demonstrated the appropriateness of the current rules governing
business-use life insurance, which underpins business
continuation and employee protection.
Life insurance that protects businesses against the loss of
key personnel and/or facilitates the provision of employee
benefits should not be subject to further changes in applicable
tax law. The question before Congress should be: Do current
uses of business life insurance serve legitimate policy
purposes justifying the tax benefits accorded life insurance
generally? We believe that this question should be answered
with an emphatic ``YES,'' and urge the Committee to reject the
Administration's proposal to impose new taxes on business-use
life insurance.
Submitted by:
John F. Jonas
Patton Boggs, L.L.P.
Counsel to the Business Insurance Coalition
Statement of Committee of Annuity Insurers
The Committee of Annuity Insurers is composed of forty-four
life insurance companies that issue annuity contracts. Our
member companies represent almost two-thirds of the annuity
business in the United States. The Committee of Annuity
Insurers was formed in 1981 to address Federal legislative and
regulatory issues confronting the annuity industry and to
participate in the development of Federal tax policy regarding
annuities. A list of the member companies is attached at the
end of this statement. We thank you for the opportunity to
submit this statement for the record.
The Committee of Annuity Insurers believes that all of the
Administration's proposals relating to the taxation of life
insurance companies and their products are fundamentally
flawed, but the focus of this statement is the Administration's
proposals relating to the taxation of annuities. We believe
that the Administration's proposals relating to the taxation of
annuities represent unsound tax policy, and, if enacted, would
have a substantial, adverse effect on private retirement
savings in America. The Administration evidently does not
understand the important role that annuities play in assuring
Americans that they will have adequate resources during
retirement. We hope that the following will help you come to
the conclusion that the Administration's proposals involving
annuities should be rejected.
Annuities are widely owned by Americans. At the end of
1996, there were approximately 32 million individual annuity
contracts outstanding, an increase from approximately 13
million just ten years before. The premiums paid into
individual annuities, i.e., the amounts saved by Americans,
grew from approximately $26 billion in 1986 to $84 billion in
1996, an increase of 222 percent.
Annuities have unique characteristics that make them
particularly well-suited to accumulate retirement savings and
provide retirement income. Annuities protect individuals
against the risk of outliving their savings by guaranteeing
income payments that will continue as long as the owner lives.
Deferred annuities also guarantee a death benefit if the owner
dies before annuity payments begin.
Non-qualified annuities are a retirement savings product
used primarily by middle-income Americans. According to a
Gallup survey conducted in February 1997, most owners of non-
qualified annuities have moderate annual household incomes.
More than 80 percent have total annual household incomes under
$75,000. Owners of non-qualified variable annuities have
slightly higher household incomes than do fixed annuity owners,
but 74 percent of variable annuity owners have household
incomes under $75,000. Eight in ten owners of non-qualified
annuities state that they plan to use their annuity savings for
retirement income (85%) or to avoid being a financial burden on
their children (84%).
The tax rules established for annuities have been
successful in increasing retirement savings. Eighty-four
percent of owners of non-qualified annuities surveyed by Gallup
in 1997 reported that they have saved more money than they
would have if the tax advantages of an annuity contract had not
been available. Ninety-one percent reported that they try not
to withdraw any money from their annuity before they retire
because they would have to pay tax on the money withdrawn. In
fact, only 15 percent of owners who are not receiving regular
payouts from their annuity contracts reported having withdrawn
money from their annuity contract.
While the tax treatment of annuities is well-targeted to
encourage people to save for retirement, this same tax
treatment makes annuities significantly less attractive than
other investment options for shorter term savings. For
instance, savings invested in annuities are allowed to build on
a tax-deferred basis, but when those savings are used, i.e.,
when the owner receives cash from the annuity contract, all
gains will be subject to tax at ordinary income rates, not
capital gains rates. If an individual invests money in an
annuity for a substantial period, the deferral of tax will be a
very powerful savings tool which can compare favorably to
investments which give rise to long-term capital gain. A recent
study by the Economic Policy Consulting Group of Price
Waterhouse LLP, Variable Annuities After the 1997 Tax Act:
Still Attractive For Retirement Savings, concluded that
variable annuities can be attractive investments for long-term
savers relative to mutual funds. A monograph by Dr. James
Poterba, an economics professor at the Massachusetts Institute
of Technology, that was published in September, 1997, The
History of Annuities in the United States, reached a similar
conclusion.
If an individual takes money out of an annuity before age
59, not only is the amount taxable on an ``income-first''
basis, but it also is subject to an early withdrawal penalty of
10 percent. If an individual wants to borrow from an annuity,
or pledge it as security for a loan, any amount received is
treated as a distribution which is subject to ordinary income
tax, plus the early withdrawal penalty if before age 59. There
are several additional tax rules that make annuities attractive
only as a funding vehicle for long-term savings, but the
essential point is simply that the annuity tax rules have been
carefully crafted by Congress to assure that annuities will be
used for retirement income.
The proposals contained in the Administration's FY 1999
budget greatly upset this carefully balanced set of tax rules
and jeopardize the continued existence of annuities as a method
to save for retirement. The balance of this statement will
address the specific proposals.
1. Proposal to Tax Exchanges of Variable Annuities and Reallocations of
Assets Within Variable Annuities
This proposal applies to ``variable'' annuities. A variable
annuity is a type of annuity where premiums are placed in a
``separate account'' of a life insurance company, and the funds
are invested by the life insurance company in various stocks
and bonds. Variable annuities typically offer the owner a
choice among several diversified investment options with
different, broad investment strategies. These investment
options may include, for example, a domestic equity fund, a
government bond fund, and a balanced fund. Most variable
annuities offer a fixed account investment option as well. The
value of a variable annuity contract is not guaranteed.
Instead, its value will vary according to the performance of
the investment options that the owner has chosen. This allows
the annuity owner to benefit over the long term from the higher
rates of return historically provided by the stock market.
Variable annuity contracts typically provide that owners
may allocate their premium payments among the several different
investment options provided under their contracts. Owners may
also periodically reallocate their account values among these
investment options. Under present law, these reallocations do
not cause the owner to incur a tax so long as the investment
remains in the annuity. This flexibility provides an important
incentive to encourage people to keep their savings in their
annuities to provide for their retirement. Of course, the
earnings in the contract are taxed when the owner takes funds
out of his or her annuity, typically during retirement.
The Administration would reverse over 40 years of sound tax
policy by taxing people before they take money out of their
annuity if they reallocate their annuity savings among the
available investment options or if they exchange their variable
annuity for an annuity issued by another insurer.
There are a number of reasons why Congress should reject
this proposal.
Perhaps the most important is that it ds to retirement
savings merely because their savings needs have changed.
Variable annuities are used for long-term savings. They offer
investment options based on diversified pools of stocks and/or
bonds, just as section 401(k) plans and IRAs do, although no
deduction is ever allowed for a contribution to a non-qualified
variable annuity. All retirement savers periodically need to
shift their savings among different options as they grow older
and in response to changes in the financial markets. Under the
Administration's proposal, annuity owners who, as a result of
growing older or due to concerns over market performance and
the security of their retirement savings, shift their savings
from a stock fund to a government bond fund within a variable
annuity would be immediately taxed.
Second, the Administration's proposal would tax individuals
even though they do not have the proceeds from which to pay the
tax. An individual who reallocates his or her retirement
savings within an annuity contract has not withdrawn any part
of it for current consumption. In fact, it would appear that
such an individual would be forced to incur the 10 percent
penalty tax for early withdrawal if he or she needed to use
part of the amounts invested in a variable annuity to pay this
new tax.
Third, the proposal is a disguised tax increase on retired,
middle income savers. Five consecutive Gallup surveys conducted
since 1992 have shown that more than 80 percent of the owners
of non-qualified annuities have total household incomes under
$75,000. Moreover, the 1997 Survey shows that the average age
of an owner of a non-qualified annuity is 66 and about 60
percent of owners are now retired.
Finally, the proposal undoubtedly would discourage private
retirement savings. Congress in recent years has become ever
more focused on the declining savings rate in America and on
ways to encourage savings and retirement savings in particular.
The variable annuity is a well-designed product that is
successful in encouraging Americans to commit funds to
retirement. As described above, Americans have been saving more
and more in annuities, which alone among non-pension retirement
investments can provide the owner with a guarantee of an income
that will last as long as the owner lives. Taxing annuity
owners when they reallocate their savings among different
investment options will inevitably reduce private savings.
2. Proposal to Reduce the ``Investment in the Contract'' for Mortality
and Expense Charges of Annuities
When the Administration refers to the ``investment in the
contract'' of an annuity contract, it actually is referring to
the tax basis that an individual has in the contract. This
basis generally equals the premiums paid for the contract.
Amounts paid for insurance and other mortality risk and expense
charges are included in the contract's tax basis.
The Administration's budget proposal would reduce a
policyholder's tax basis in a deferred annuity contract for the
mortality and expense charges under the contract. Under the
proposal, these charges are deemed to equal 1.25 percent of the
contract's average cash value each year (regardless of what is
actually paid). Lost basis would be restored only if the
policyholder elected to receive annuity payments for life and
only if the policyholder used the annuitization rates
guaranteed under the contract--even if the insurance company
was currently offering annuitization rates that would give the
policyholder larger annuity income payments.
Again, there are several very good reasons why Congress
should reject this proposal.
First, this proposal is inconsistent with longstanding tax
rules which are based on essential fairness and economic
reality. Generally, under the Federal income tax, if an
individual incurs expenses related to the purchase of an asset,
those expenses are included in the basis of the asset for tax
purposes. For instance, if sales commissions are charged when
an individual buys a share of stock in a company, the
commissions are included in the basis of the asset. When the
asset is sold, the gain realized does not include the costs
incurred to purchase the asset.
Similarly, the tax basis of an asset (e.g., a home or a
car) is not reduced by any personal consumption element
attributable to the asset (e.g., nondeductible depreciation).
The Administration's proposal is equivalent to reducing a
taxpayer's basis in his or her car or home by the annual rental
value of those assets. It is true that the taxpayer has
obtained a benefit from ownership of the car or home, but the
tax that the owner pays on a subsequent sale is not increased
because of that benefit.
The proposal also would increase the tax burden on
retirement savers and create a disincentive to use the valuable
protection provided by annuity contracts.
Annuity contracts are designed to accomplish two important,
and related, purposes: to accumulate retirement savings, and to
insure against mortality-related risks that individuals face
(i.e., outliving one's assets). The insurance features are an
intrinsic and important part of these contracts. Taxes on
income from savings should not be increased just because those
savings are accumulated in annuity contracts, which provide
insurance protection to the owner and his or her family. Such
tax increases would discourage savings by the middle-class
Americans who are the predominant purchasers of non-qualified
annuities.
In addition, the proposal would substantially increase
administrative and compliance costs for little revenue. Under
the proposal, life insurance companies would be required to
calculate and keep track of two different basis amounts for
each annuity contract. One set of basis records would be used
in the event that the policyholder annuitized his or her
contract for life at the guaranteed rates under the annuity and
the other set of basis records would be used if the
policyholder took a distribution in any other form from the
annuity. These calculations would have to be made and
maintained for many years because annuity contracts are used
for long-term savings. The increased costs of designing
computer and administrative systems to implement this proposal
is disproportionate to any revenue gain from what is in all
events a proposal that is contrary to generally applicable tax
rules.
3. Proposal to Deny a Reserve Deduction for Certain Annuity Benefits
Life insurance companies are required by state insurance
law to establish reserves in order to fund the benefits
promised to policyholders under annuity contracts. These
policyholder benefits include the guarantee of an income stream
extending over the annuitant's life, a death benefit if the
annuitant dies prematurely, and a cash surrender value. In
recent years, annuity contract benefits have been expanding and
many contracts now offer larger death benefits, incentives for
annuitization (such as higher interest credits), and
withdrawals without surrender charges if certain conditions
exist (e.g., disability or confinement in a nursing home).
Life insurance companies include in their income all of the
premiums they receive and the investment income they earn, but
are allowed a deduction for their reserve obligations in
recognition of the fact that a substantial part of the premiums
and investment income will be used to pay policyholder
benefits. The reserve for an annuity contract simply represents
the present value of all the future benefits guaranteed to the
policyholder. Under current law, the deduction is allowed for
the greater of (1) the contract's net surrender value, and (2)
a Federal tax reserve computed using a Federally prescribed
interest rate, a prescribed mortality table, and a reserve
method known as the ``Commissioners' Annuity Reserve Valuation
Method'' or ``CARVM.'' CARVM was developed by the National
Association of Insurance Commissioners (NAIC), which is the
association of state officials responsible for regulating
insurance companies. In all events, the deduction is limited to
the reserves required under state law.
The Administration's budget proposal would limit the
deduction for reserves to the lesser of (1) the contract's net
surrender value (plus a small additional percentage that phases
out over seven years), and (2) the Federal tax reserve
describproposal is based on its belief that the new NAIC
actuarial guidelines on CARVM issued in 1997 will result in
annuity reserves being increased ``substantially'' and that
annuity reserves will be ``excessive.''
There are several reasons why Congress should reject this
proposal.
First, the proposal is based on a basic misunderstanding by
the Treasury Department of the new NAIC guidelines. The new
NAIC guidelines did not change the definition of CARVM and did
not require any ``substantial'' increase in annuity reserves.
Rather, the new NAIC guidelines simply clarified the meaning of
a long-standing reserve method. For most companies, the new
NAIC guidelines will have no material effect on their annuity
reserves--most companies already have been calculating their
annuity reserves in the manner described in the new NAIC
guidelines. For those companies whose reserves are affected by
the new NAIC guidelines, the guidelines simply assure that a
company's reserves accurately reflect its liabilities for the
types of benefits guaranteed to its policyholders.
Second, the Administration's proposal would increase the
cost, and thus reduce the availability, of important
policyholder benefits offered under annuity contracts. The
effect of the Administration's proposal is to deny a reserve
deduction for many of these benefits. Without this deduction,
those benefits (which include death benefits, enhanced annuity
payments, and the right to make withdrawals free of surrender
charges) would be more costly to provide to consumers. Yet
those benefits are the very ones being demanded by consumers in
the retirement savings marketplace.
In addition, annuity benefits beyond the ability to take a
lump-sum cash payment represent true liabilities for which a
deduction has been, and should continue to be, allowed. The
Administration's proposal seems to be based on the premise that
a life insurance company's obligations for the insurance
benefits guaranteed under an annuity contract are not true
liabilities. That premise is clearly erroneous. It is beyond
dispute that a life insurance company has a liability to the
purchaser of an immediate life annuity--even though such an
annuity typically has no cash value--an obligation to make
payments to the annuitant for as long as he or she lives.
Likewise, a life insurance company has a liability to provide a
purchaser of a deferred annuity all the benefits promised--not
just the benefit of taking a lump-sum cash payment.
In conclusion, the Committee of Annuity Insurers urges that
the Administration's tax increases involving annuities be
rejected. These tax increases have no basis in good tax policy
and will discourage Americans from taking the initiative to
save for their own retirement.
The Committee of Annuity Insurers
Aetna Inc., Hartford, CT
Allmerica Financial Company, Worcester, MA
Allstate Life Insurance Company, Northbrook, IL
American General Corporation, Houston, TX
American International Group, Inc., Wilmington, DE
American Investors Life Insurance Company, Inc., Topeka, KS
American Skandia Life Assurance Corporation, Shelton, CT
Charter National Life Insurance Company, St. Louis, MO
Commonwealth General Corporation, Louisville, KY
Conseco, Inc., Carmel, IN
COVA Financial Services Life Insurance Co., Oakbrook Terrace, IL
Delta Life and Annuity, Memphis, TN
Equitable Life Assurance Society of the United States, New York, NY
Equitable of Iowa Companies, Des Moines, IA
F & G Life Insurance, Baltimore, MD
Fidelity Investments Life Insurance Company, Boston, MA
Great American Life Insurance Co., Cincinnati, OH
GE Financial Assurance, Richmond, VA
Hartford Life Insurance Company, Hartford, CT
IDS Life Insurance Company, Minneapolis, MN
Integrity Life Insurance Company, Louisville, KY
Jackson National Life Insurance Company, Lansing, MI
Keyport Life Insurance Company, Boston, MA
Life Insurance Company of the Southwest, Dallas, TX
Lincoln National Corporation, Fort Wayne, IN
ManuLife Insurance Company, Boston, MA
Merrill Lynch Life Insurance Company, Princeton, NJ
Metropolitan Life Insurance Company, New York, NY
Minnesota Mutual Life Insurance Company, St. Paul, MN
Mutual of Omaha Companies, Omaha, NE
Nationwide Life Insurance Companies, Columbus, OH
New England Life Insurance Company, Boston, MA
New York Life Insurance Company, New York, NY
Ohio National Financial Services, Cincinnati, OH
Pacific Life Insurance Company, Newport Beach, CA
Phoenix Home Mutual Life Insurance Company, Hartford, CT
Protective Life Insurance Company, Birmingham, AL
ReliaStar Financial Corporation, Seattle, WA
Security First Group, Los Angeles, CA
SunAmerica, Inc., Los Angeles, CA
Sun Life of Canada, Wellesley Hills, MA
Teachers Insurance & Annuity Association of America--College Retirement
Equities Fund (TIAA-CREF), New York, NY
Travelers Insurance Companies, Hartford, CT
Zurich Kemper Life Insurance Companies, Chicago, IL
Statement of Corporate Property Investors
First Union Real Estate Investments
Meditrust
Patriot American Hospitality
Starwood Hotels & Resorts
Introduction
This testimony outlines the concerns of the five
grandfathered paired-share real estate investment trusts
(REITs) over the Administration's FY 1999 Budget proposal that
would ``freeze'' the status of paired-share REITs. Each of the
grandfathered entities strongly opposes the Administration's
proposal. The concerns about this proposal go beyond its harm
to these companies' shareholders, each of whom reasonably
relied on existing law when their investments were made. The
Administration's proposal also would unfairly (i) reverse
Congress' historic efforts to encourage utilization of REITs to
allow all kinds of investors to own real estate, and (ii)
impose unnecessary complexity to the Internal Revenue Code,
without raising any significant revenue or resolving any of the
issues raised by those opposing the existing grandfather rule.
Description of a Paired-Share REIT
Each grandfathered paired-share REIT consists of two
companies, the stock of which are ``paired'' or ``stapled''
together, such that the shares trade as a single investment
unit and are owned by the same shareholders. One of the paired
companies is a REIT, essentially a pass-through entity subject
to the Internal Revenue Code's numerous requirements, including
distributing 95 percent of its taxable income to shareholders
on an annual basis. The other paired company is an operating
company that is subject to the regular corporate federal income
tax, found in subchapter C of the Internal Revenue Code (``C
corporation'').
The paired-share structure is typically used to own and
operate certain types of real property, like hotels and medical
facilities, that cannot be operated by a REIT under the
existing Internal Revenue Code. The paired REIT owns the
properties and leases such assets to its paired operating C
corporation, which operates and manages the properties.
Analysis of the Administration's Proposal
I. The 1960 legislation establishing REITs implemented Congressional
interest in providing all kinds of investors with the same opportunity
to invest in real estate as wealthy investors.
The 1960 legislation establishing REITs (P.L. 86-779) used the
Internal Revenue Code rules for regulated investment companies (RICs)
as a model for the new REIT structure. The legislative history
indicates that Congress wanted to give small investors an opportunity
to invest in professionally managed portfolios of real estate, in the
same manner as permitted for investments in stocks through the RIC
rules. H.R. Rep. No. 2020, 86th Cong., 2d Sess. (1960), 1960-2 C.B.
819, 820.
The Committee report accompanying the 1960 Act drew parallels
between the RIC and REIT investment strategies and noted their common
purpose and structure. Id. In particular, the Report clarified that
both arrangements enable small investors to secure advantages normally
available only to those with greater monetary resources. Such
advantages include: (1) risk spreading through greater diversification
of investments secured through pooling; (2) opportunities to secure the
benefits of expert management advice; and (3) means of collectively
financing projects that individual investors would be unable to
undertake. Id.
During the House Floor debate on the bill, the Chairman of the
House Ways and Means Committee, Wilbur Mills, explained the purpose of
the REIT legislation. In his statement, Chairman Mills indicated that
the bill would not only ``provide equitable treatment of existing real
estate investment trusts but it would provide a reasonable machinery
whereby a large number of small investors would be able to make real
estate investment without incurring the penalty of additional income
tax at the corporate level.'' 106 Cong. Rec. H15017 (daily ed. June 29,
1960).
II. The paired-share structure fulfills the policy goals underlying the
basis for establishment of REITs in 1960.
Congress' 1960 REIT policy is preserved in the paired-share
structure that was sanctioned by the Internal Revenue Service (IRS) in
the 1970s and early 1980s. In those years, the formation and operation
of paired-share REITs were approved by the IRS through the issuance of
several broadly written private letter rulings. See e.g., PLR 8002026
(Oct. 16, 1979); PLR 8013039 (Jan. 4, 1980); PLR 8120107 (Feb. 20,
1981).
The structure, as sanctioned by these rulings, was designed to
ensure that non-REIT, active income is subject to taxable C corporation
treatment. The REIT must operate as a REIT, and the operating C
corporation is treated just like any other taxable C corporation. At
the same time, the paired-share REIT structure has a sound business
purpose unrelated to any tax savings. The structure achieves a better
investment result for the public shareholders of a REIT by allowing the
shareholders to retain the economic benefits of both the lease payments
received by the REIT and the after-tax operating profits realized by
the operating C corporation.
The nature of the business advantage to the paired-share structure
can be understood in part by considering the problems that exist in
management-intensive real estate activities. In the absence of a paired
operating company, where the operating entity and the real estate are
under separate control, the REIT that owns assets such as a hotel is
required to lease such property to an unaffiliated property operator.
This structure presents at least two basic problems.
First, in reaching an agreement on the lease terms between the REIT
and the operating company, the profitability of the operations may be
difficult to determine. In such cases, neither party might wish to
undertake the risk of a long-term contract. Further, each party is
potentially exposed to the risk of agreeing to lease terms too
favorable to the other party. Under a long-term contract, the owner of
the real estate may have an insufficient incentive to undertake
investments that maintain the profitability of the property, unless the
owner believes it is fully compensated for these investments by the
terms of the lease agreement.
Second, in the absence of a long-term contract, the operating
entity may have a reduced incentive to undertake investments that
enhance the long-term value of the operation. The operating entity may
not be assured that it will be the actual beneficiary of these
investments. These investments may take the form of advertising,
capital improvements, and efforts to reward long-term customer loyalty
to the operations. If the operating company decides to undertake these
investments and is successful in enhancing the profitability of the
operation, upon expiration of the initial lease, the real estate owner
(REIT) could capture all of the benefits achieved by the operator by
increasing the rental payments required under the terms of the lease.
Faced with these structural constraints, the paired-share REIT
structure was developed to preserve shareholder value, by eliminating
potential conflicts of interest between the owner of the property (the
REIT) and the tax-paying entity that operates and manages the REIT's
property. Non-paired REITs have responded to these economic and
conflict issues in similar ways, through affiliation with taxable C
corporations using ``preferred stock subsidiary'' and ``paper clipped
REIT'' structures.
Further, the changes made by Congress to the Internal Revenue
Code's REIT provisions have consistently reflected (i) Congress' 1960
policy of providing small investors with access to real estate
ownership via a pass-through entity and (ii) Congress' desire to
improve the operation of the REIT rules through the integration of
ownership and management of real estate. In other words, when the
statute was passed in 1960 based on the RIC paradigm, application of
this model to real estate ownership was not fully appreciated. The REIT
provisions have been amended nine times since 1960, each time to fine
tune this structure for use in the real estate context.
Changes to the REIT rules made over the years indicate that the
Congressional tax writers recognized that the value in real estate,
unlike stock, is inextricably intertwined with the management of the
properties. Without a greater alignment of the owner's and operator's
interests in the real estate, the value of such real estate interests
cannot be maximized as originally envisioned. In particular, the 1986
and 1997 amendments significantly liberalized the extent to which
operational income could be earned by a REIT. See Pub. L. No. 99-514,
Sec. 663 (allowing certain customary management functions and
services); Pub. L. No. 105-34, Sec. 1255 (allowing a small amount of
prohibited services not to taint rental income). Thus, Congress
indicated that it understood how essential it is for REIT owners to
control the management and operations of the properties they own.
In contrast, the 1984 amendment, adding IRC section 269B to limit
future paired-share REITs, ignored the need for certain REIT owners to
control the management and operations of the properties they own. The
provision did not amend the REIT provisions in the Internal Revenue
Code, but was instead part of an effort primarily focused on foreign
corporations stapled to domestic corporations. It therefore was
included in the foreign tax section of the Deficit Reduction Act of
1984. Pub. L. No. 98-369, Sec. 136. When Congress addressed the paired
or stapled structure in this statutory provision, it recognized that
the IRS had sanctioned this structure. H.R. Conf. Rep. No. 432, 98th
Cong., 2d Sess., 1545 (1984). Accordingly, unlike the language
providing relief for the foreign-domestic paired entity, which was
limited to about 2.5 years, the grandfather rule for the paired-share
REITs in existence on the date of introduction of the bill first
imposing these limits (June 30, 1983), was unrestricted. The conference
report for the Act states that the IRS guidance was the rationale for
the unqualified grandfather rule. Id.
III. The paired-share REIT structure meets Congress' expectations, even
when analyzed under concerns raised by others.
A. The paired-share structure does not represent an abuse of the
federal tax laws.--Use of the paired share structure is simply a way to
align ownership and operation of real estate consistently with the
limitations on the kinds of income that a REIT may earn. Most REITs
face economic and investor pressure not to permit third parties to
divert operational income to themselves. REITs use many approaches,
including affiliation with taxable C corporations, to remove the
potential conflict inherent in third party management. The paired share
structure is only one form of C corporation affiliation. The most
prominent alternative forms are use of a ``preferred stock
subsidiary,'' which is a taxable subsidiary of a REIT that uses
multiple classes of stock to comply with REIT rules, and a ``paper
clipped REIT,'' which involves a C corporation that is affiliated with
the REIT through common directors, common managers, contractual
relationships and substantially the same shareholders.
Existing rules applicable to all REITs ensure that transactions
between the paired REIT and an affiliated C corporation are conducted
on an arm's-length basis. These rules, and the low Joint Tax Committee
revenue estimate ($34 million over 5 years/$217 million over 10 years),
demonstrate that the paired-share REIT structure is not abusive.
A study conducted by Price Waterhouse analyzing transfer pricing
risks found no evidence of transfer pricing abuses by paired-share
REITs. See Price Waterhouse LLP, ``Federal Income Tax Effects of the
Paired-Share REIT Structure of Starwood Lodging,'' (Nov. 7, 1997). The
study tested the returns of Starwood, the largest paired-share REIT, to
the compensation ratios of non-paired hotel REITs for the 1995 and 1996
periods. The results of the study indicate that the compensation ratio
from leasing hotel properties to the paired operating C corporation is
no greater than that of non-paired hotel REITs.
REIT provisions defining non-qualifying income also prevent
taxpayers from manipulating the allocation of costs between entities.
IRC Sec. 856(c)(2); Treas. Reg. 1.856-4(b)(3). As a consequence, REITs
are strongly discouraged from taking aggressive tax positions.
Moreover, current law imposes a penalty involving the loss of REIT
status and onerous restrictions on reentry into REIT status. IRC
Sec. 856(g); Treas. Reg. Sec. 1.856-8.
B. The structure does not contribute to ``disincorporation.''--
Historical evidence shows that the existence of the paired-share REIT
structure does not encourage the ``disincorporation'' of U.S.
businesses. Significantly, none of the existing paired-share REIT
companies began as C corporations. Each began its business as a stand-
alone REIT that later added the C corporation management function to
maximize shareholder value, avoid conflicts of interest and incorporate
an ability to manage the properties owned by the REIT.
Disincorporation is discouraged by Internal Revenue Code rules that
impose penalties on conversions of C corporations into REITs. IRS
Notice 88-19, 1988-1 C.B. 486. In particular, these rules impose tax on
the sale of real estate assets to a REIT.
Furthermore, where services and other non-real estate income
provide the greater share of an enterprise's value, a C corporation
would not benefit from the establishment of a REIT. Splitting such a
business's value between its real estate and other operations would
bifurcate important aspects of the business, unless it had a strong
real property component. The mandatory dividend rules applicable to
REITs would prevent the company from reinvesting a substantial portion
of its cash flow, resulting in either cash flow problems or a
substantial change in the capital requirements for that type of
business operation.
C. The paired-share structure does not give an unfair business
advantage.--The tax advantage of paired-share REITs is the same one
enjoyed by every other REIT, namely, that the REIT's taxable income is
taxed once, not twice. However, the corporate level tax on real estate
ownership income, is not unique to the REIT structure. Corporations
taxed under Subchapter C of the Internal Revenue Code often achieve the
substantive equivalent of one layer of taxation on their real estate.
For instance, C corporations have opportunities to reduce double
taxation and otherwise lower the cost of capital by incurring higher
debt and by using depreciation and other business deductions. REITs, on
the other hand, tend to be less leveraged than C corporations to help
ensure sufficient earnings for the payment of required dividend
distributions to shareholders.
Additionally, stock prices, measured as a multiple of earnings, can
be similar for C corporations and non-paired REITs. Such figures
reflect shareholder expectations of growth in the future, including an
assessment of management expertise, superior workforce, name
recognition, infrastructure, customer base, location, as well as any
combination of these or other factors.
Historical evidence reflecting on the successes and failures
between paired-share REITs and other companies without this structure
for acquisitions also demonstrate that such REITs do not have unfair
business advantages over C corporations. One company can have a number
of advantages over another company, regardless of the REIT or non-REIT
structure. For example, two paired-share REITs unsuccessfully bid
against Marriott, a C corporation, last year for the Renaissance hotel
chain; and this year against Bass PLC, a foreign-based lodging and
spirits company, for the Inter-Continental Hotels and Resorts chain.
IV. The Administration's proposal is a totally inappropriate
``solution'' to the concerns relating to paired-share REITs.
The Administration's proposal attempts to ``freeze'' the
grandfathered status of the existing paired-share REITs. Under the
proposal, for purposes of determining whether any grandfathered entity
is a REIT, the paired entity would be treated as one entity with
respect to properties acquired on or after the date of first action by
a Congressional committee, and with respect to activities or services
relating to such properties that are undertaken or performed by one of
the paired entities on or after such date. The proposal would
effectively mean that future acquisitions of certain types of property
by paired-share REITs would generate ``bad income'' under the 95
percent gross income test, if the paired-share REIT were to operate
such property. As a result, enactment of this proposal would severely
limit the ability of paired-share REITs to operate properties that they
traditionally have operated, if such properties are acquired after the
proposed effective date of the proposal.
The Administration proposal is not projected to raise significant
revenue. It represents just one-half of one percent of its overall
revenue package, and fails to take into account factors which suggest
that paired-share REITs may, in fact, be revenue enhancing. First,
since the paired operating C corporation is fully subject to tax, and
the REIT must pay out 95 percent of its taxable income to its
shareholders as dividends (which are than taxable as current, ordinary
income), it is difficult to see how tax revenue is decreased through
the paired-share structure. In fact, because individual tax rates are
higher than corporate tax rates, and as a result of differences in how
REIT dividends are taxed, the profits earned by a REIT may be taxed at
higher effective rates than the profits of a regular C corporation.
Second, paired-share REITs typically have lower levels of debt than C
corporations, which often use interest deductions and depreciation to
minimize Federal taxes, and generally distribute far less than 95
percent of their net earnings to shareholders. Thus, any proposal which
marginally increases real estate holdings in C corporations, while
simultaneously decreasing the level of such assets held by REITs, could
result in a loss of Federal tax revenues. A preliminary analysis by
Price Waterhouse LLP suggests the possibility of this conclusion; a
more thorough study, which is now underway, likely will demonstrate
that paired-share REITs are net contributors to the U.S. Treasury.
The Administration's proposal also would increase the complexity of
the Code, as outlined by the Joint Tax Committee pamphlet. Description
of Revenue Provisions Contained in the President's Fiscal Year 1999
Budget Proposal, JCS-4-98, at 209 (1998). The pamphlet raises a number
of concerns, particularly relating to how a paired-share REIT would be
able to determine when a ``new'' acquisition has occurred and how the
proposal would be applied.
For example, the proposal's use of the term ``property'' is
unclear. Does the term apply to improvements or renovations to existing
properties? If a new roof were placed on a building, the taxpayer
typically would depreciate it as a separate property. If a new item of
property were acquired as part of an existing business operation (e.g.,
a new bed is purchased for a hospital), would the paired-share REIT
have to determine the revenues allocable to the bed? If so, how?
The application of the income tests to the acquisition of a new
property also is unclear. For example, if a new hotel were acquired,
how would revenues and expenses be allocated? In particular, would
there be assumed allocations of overhead, and how would internal
management and franchise fees be treated? Would the rent be treated as
``good'' income or would the entire gross revenue of the property be
treated as ``bad'' income? For purposes of determining the taxable
income and distribution requirements of the REIT, would the net income
from the property be included in the REIT's income (with a
corresponding deduction to the C corporation) or would the single
entity treatment only apply for purposes of the REIT qualification
tests?
These and many other interpretive issues would have to be settled
before the Administration's proposal could be considered. In any event,
any adjustment in the treatment of paired-share REIT entities must be
clear and unambiguous. Clarity is particularly important because REITs
are subject to an all or nothing status test. IRC 856(g). Investors
must be able to determine with a high level of certainty whether REIT
status could be maintained by a paired-share REIT, and the extent to
which the C corporation's operations would be affected.
Conclusion
The Administration's proposal with respect to paired-share
REITs is inconsistent with Congress' historic support for
business structures that allow public investors to own a
diversified portfolio of real estate. Charges that the
structure permits abuse or unfair advantage are simply wrong.
The existing paired-share REITs are prepared to support and
work with Committee staff to develop proposals directly
addressing any actual transfer pricing or other problems
involving transactions between the two paired entities, or to
expand the opportunities for other REITs to operate as paired-
share REITs.
Statement of Employer-Owned Life Insurance Coalition
This statement presents the views of the Employer-Owned
Life Insurance Coalition, a broad coalition of employers
concerned by the provisions in the Administration's fiscal year
1999 budget that would increase taxes on life insurance
policyholders.
Congress Should Reject the Administration's Life Insurance Proposals
The Administration's fiscal year 1999 budget proposal would
increase taxes on life insurance policyholders in three major
respects:
Businesses that purchase insurance on the lives of
their employees would be denied a portion of the deduction to
which they are otherwise entitled for ordinary and necessary
interest expenses unrelated to the purchase of life insurance.
Businesses (and individuals) that exchange
policies or reallocate policy investments would be taxed on the
unrealized appreciation--the inside buildup--because such
exchange or reallocation would be treated as a taxable event.
Taxable gains associated with permanent life
insurance and annuity contracts would be artificially inflated
by denying basis for the portion of the policy premium that
reflects certain mortality charges and expenses.
For the reasons set forth below, we urge the Congress to
reject each of these ill-conceived proposals.
Summary of Opposition
The Administration's proposals drive at the very heart of
traditional permanent life insurance, the so-called ``inside
buildup'' of credits (or cash value) within these policies that
permits policyholders to pay level premiums over the lives of
covered individuals. Each of the proposals would in one way or
another effectively tax inside buildup. This would change the
fundamental tax treatment of level-premium life insurance that
has been in place since the federal tax code was first enacted
in 1913. We believe that the historical tax treatment of these
policies is grounded in sound policy and should not be altered.
This is particularly true in light of the efforts by
Congress and the Administration over the past two decades to
develop strict statutory and regulatory standards designed to
ensure that permanent life insurance policies cannot be used to
cloak inappropriate investments. Policies that are unable to
meet these standards are not eligible for tax treatment as life
insurance under current law. To the extent the buildup of cash
values is permitted under current standards, this
``investment'' feature should if anything be encouraged, not
penalized.
With respect to the proposal to deny a portion of a
policyholder's deduction for unrelated interest expenses, we
find it particularly difficult to comprehend how an otherwise
ordinary and necessary business expense loses its status as
such merely because a business purchases life insurance on its
employees. If the Administration's concern is with the inside
buildup in insurance policies, it should say so--and it should
address the issue directly. The proposed ``tax by proxy'' is
poorly targeted--it would have widely-varying impacts on
similarly-situated taxpayers with identical life insurance
policies. More importantly, it would circumvent Congress's
steadfast refusal for more than 80 years to permit current
taxation of inside buildup.
Disguised Attack on Historical Treatment of Traditional Life Insurance
The Administration's proposals drive at the heart of
permanent life insurance. Although the Treasury Department has
characterized the proposals as targeting certain ``collateral''
uses of life insurance unrelated to its core purpose, in fact,
the proposals go to the very essence of traditional permanent
life insurance: the accumulated cash values inherent in such
policies, commonly referred to as inside buildup. Each of the
Administration's proposals would impose new taxes on
policyholders based on the cash value of their life insurance
policies.
For example, the most pernicious of the Administration's
proposals would deny a portion of a business's otherwise
allowable interest expense deductions based on the cash value
of insurance purchased by the business on the lives of its
employees. Though thinly disguised as a limitation on interest
expenses deductions, the proposal generally would have the same
effect as a tax on inside buildup. Similar to a tax on inside
buildup, the interest disallowance would be measured by
reference to the cash values of the business's insurance
policies--as the cash values increase, the disallowance would
increase, resulting in additional tax.\1\ So while not a direct
tax on inside buildup, the effect would be similar--accumulate
cash value in a life insurance policy, pay an additional tax.
---------------------------------------------------------------------------
\1\ As this Committee, to its credit, has recently brought to light
in connection with its examination of individual tax rates, a deduction
disallowance is a tax increase by another name.
---------------------------------------------------------------------------
The Administration's other insurance proposals are more
direct in their taxation of cash value. One would tax
accumulated cash values in insurance company variable life and
annuity contracts every time the contract is exchanged or
policy investments reallocated. The other would increase the
taxes due on accumulated cash values upon disposition.
Historical Tax Treatment of Permanent Life Insurance is Sound
The Administration's proposals would change the fundamental
tax treatment of traditional life insurance that has been in
place since the federal tax code was first enacted in 1913.
Congress has on a number of occasions considered, and each time
rejected, proposals to alter this treatment. Nothing has
changed that would alter the considered judgment of prior
Congresses that the historical tax treatment of traditional
life insurance is grounded in sound policy and should not be
modified.
Among the reasons we believe that these latest attacks on
life insurance are particularly unjustified, unnecessary and
unwise are--
Cash Value is Incidental to Life Insurance Protection
The cash value of life insurance is merely an incident of
the basic plan called ``permanent life insurance'' whereby
premiums to provide protection against the risk of premature
death are paid on a level basis for the insured's lifetime or
some other extended period of years. In the early years of the
policy, premiums necessarily exceed the cost of comparable term
insurance. These excess premiums are reflected in the ``cash
value'' of the policy. As fairness would dictate, the insurance
company credits interest to the accumulated cash value, which
helps finance the cost of coverage in later years, reducing
aggregate premium costs.
Thus, while a permanent life insurance policy in a sense
has an investment component, this feature is incidental to the
underlying purpose of the policy. The essential nature of the
arrangement is always protection against the risk of premature
death.
The Tax Code Already Strictly Limits Cash Value Accumulations
The Administration's proposals ignore the major overhauls
of life insurance taxation made by Congress over the past 20
years. These reforms have resulted in a set of stringent
standards that ensure that life insurance policies cannot be
used to cloak inappropriate investments.
The most significant reforms occurred in the 1980's, when
Congress and the Treasury undertook a thorough study of life
insurance. It was recognized that while all life insurance
policies provided protection in the event of death, some
policies were so heavily investment oriented that their
investment aspects outweighed the protection element. After
much study, Congress established stringent statutory
guidelines, approved by the Administration, that limit life
insurance tax benefits at both the company and policyholder
levels to those policies whose predominant purpose is the
provision of life insurance protection.
In 1982, Congress first applied temporary
``guideline premium'' limitations to certain flexible premium
insurance contracts;
In 1984, Congress revised and tightened these
limitations and extended them to all life insurance products;
In 1986, the Congress again reviewed these
definitional guidelines, making additional technical and
clarifying changes;
Finally, in 1988, the Congress again addressed
these issues, developing still more restrictive rules for
certain modified endowment contracts and modifying the rules
applicable to life insurance contracts to require that premiums
applicable to mortality charges be reasonable, as defined by
Treasury regulation.
As currently applied to life insurance policies, these
guidelines (set forth in sections 7702 and 7702A of the
Internal Revenue Code) significantly limit the investment
element of any policy by requiring specific relationships
between death benefits and policy accumulations under
complicated technical rules (the so-called cash value test or
the guideline premium/cash value corridor tests). Policies that
cannot meet these limitations were deemed ``investment
oriented'' in the judgment of Congress and are not eligible for
tax treatment as life insurance.
On the other hand, Congress and the Administration clearly
intended that inside buildup within policies satisfying the new
criteria would not be subject to taxation. In fact,
policymakers concluded that with the tightening of the
definition of life insurance and the placing of narrower limits
on the investment orientation of policies, there was all the
more reason for continuing an exemption for inside buildup.
Buck Chapoton, then Assistant Secretary of the Treasury for Tax
Policy testified on this point before a Ways & Means
subcommittee in 1983, explaining that: the treatment of [inside
buildup bears] an important relationship to the definition of
life insurance; that is, to the extent the definition of life
insurance is tightened, thereby placing narrower limits on the
investment orientation of a life insurance policy, there is
more reason for allowing favorable tax treatment to the [inside
buildup] under policies that fall under a tighter definition.
[Tax Treatment of Life Insurance; Hearings Before the
Subcommittee on Select Revenue Measures of the House Committee
on Ways and Means, May 10, 1983, 98th Cong., 1st Sess. 16
(1983).]
Congress proceeded on this basis and, as noted above, in
1984 established a tighter and narrower definition of life
insurance.
In addition to blessing the continuation of tax benefits
for inside buildup within life insurance contracts when it
considered these issues in the 1982, 1984, 1986 and 1988
legislation described above, Congress did so on numerous other
occasions by failing to enact treasury proposals to tax inside
buildup. For example, notwithstanding Treasury proposals to tax
inside buildup contained in the 1978 Blueprints for Tax Reform,
the November, 1984 Treasury Tax Reform proposals, the 1985 Tax
Reform Proposals and various budget proposals in the 90's,
Congress consistently refused to tax inside buildup within life
insurance policies.
Moreover, the Congress implicitly endorsed continuation of
inside buildup in 1996 when it considered and addressed certain
perceived problems with policy loans (repealing the deduction
for interest on policy loans) and in 1997, when it became
concerned that Fannie Mae intended to use its quasi-federal
status and preferred borrowing position to purchase coverage
for its customers (denying a portion of Fannie Mae's otherwise
applicable interest deductions). On both occasions,
conventional life insurance policies were unaffected; tax
preferences for inside buildup were retained.
The 1997 experience is of particular relevance. When
drafting the interest disallowance for Fannie Mae, Congress
distinguished its concerns regarding what was considered to be
Fannie Mae's inappropriate efforts to exploit its preferred
borrowing position from the typical situation involving
employer-owned policies, providing a clear exemption for
policies purchased by a business on employees, officers,
directors and 20-percent owners. In late 1997, Congress further
demonstrated its commitment to preserving tax-favored status
for employer policies by proposing additional technical
corrections to clarify the scope of this intended relief (e.g.
to cover former employees, group contracts, etc.). Those
technical corrections, adopted by the House and attached to the
IRS restructuring bill last fall, are now awaiting Senate
consideration.
Given the detailed 1996-97 review of life insurance
policies, which triggered narrow reforms rather than any
cutback of the core tax benefits afforded with respect to
inside buildup, individuals and employers reasonably relied on
the continued availability of inside buildup with respect to
the policies they previously held, as well as subsequent
purchases. Similarly, carriers reasonably relied on the
continued availability of inside buildup in developing and
marketing insurance policies. Treasury's attempt to reverse
that Congressional decision and undercut policyholder and
carrier reliance through these thinly disguised attacks on
inside buildup is unconscionable and should, consistent with
every prior Congressional decision on this issue, AGAIN be
summarily rejected.
Appreciation in Cash Value Should Not Be Taxed
Long-Term Investment Should be Encouraged, Not Penalized
Permanent life insurance provides significant amounts of long-term
funds for investment in the U.S. economy. These funds are attributable
to permitted levels of policy investment, a portion of which represents
the ``prepayment'' element needed to permit level premium policies
which remain affordable as covered individuals age. Without this
prepayment/investment feature premium costs would increase rapidly with
age, making insurance unaffordable when it is most needed.
The incidental investment element inherent in permanent life
insurance should, if anything, be encouraged, not penalized. Congress
and the Administration have repeatedly emphasized the need to increase
U.S. savings, especially long term and retirement savings. Recent
efforts have used the tax code to encourage savings, not penalize them.
Consider, for example, the recent expansion of IRAs, the introduction
of Roth IRAs and education IRAs, as well as small employer savings
vehicles like the SIMPLE. Given these savings goals, the Administration
proposal to significantly reduce or eliminate savings through life
insurance appears especially misguided.
Unrealized Appreciation Should Not be Taxed
There is another, more fundamental, reason why the incidental
investment inherent in permanent life insurance should not be taxed
currently: accumulating cash values represent unrealized appreciation.
Taxing a policyholder currently on the increase in the cash value of a
life insurance policy would be like taxing a homeowner each year on the
appreciation in value of the home even though the home has not been
sold. This would be inconsistent with historical and fundamental
concepts of the federal income tax and contrary to the traditional
principle that the government should not tax unrealized amounts which
taxpayers cannot receive without giving up important rights and
benefits. Taxing life insurance policyholders on accumulating cash
values would single out life insurance by withdrawing the protection
generally provided against taxation of an amount the receipt of which
is subject to substantial restrictions. Given that much of this
``investment'' actually reflects a prepayment of premiums designed to
spread costs levelly over the insured's life, this would be especially
inappropriate.
Ordinary and Necessary Interest Expenses Should be Deductible
The Administration's proposal to disallow otherwise
deductible interest expenses is inconsistent with fundamental
income tax principles.
Interest Payments are an Ordinary and Necessary Business
Expense
It is difficult to comprehend how an otherwise ordinary and
necessary business expense loses its status as such solely
because a business purchases life insurance on its employees.
For example, few would argue that if Acme Computer borrows
funds to help finance the cost of a new supercomputer assembly
plant, the interest Acme pays on the debt is a legitimate
business expense that is properly deductible. How can it be
that if Acme decides it is prudent to purchase life insurance
on the leader of the team that developed the supercomputer--to
help offset the inevitable transition costs that would follow
the team leader's unexpected death--that a portion of the
interest payments is suddenly no longer considered a legitimate
business expense? This is precisely the effect of the
Administration's proposal.
To fully appreciate this provision, apply the underlying
rationale to an individual taxpayer: Should any homeowner who
purchases or holds life insurance be denied a portion of the
otherwise applicable deduction for mortgage interest? Or,
carrying the analogy a bit further, should any homebuyer who
contributes to an IRA or a section 401(k) plan (thereby
receiving the tax benefits of tax deferral or, in the case of a
Roth IRA, tax exemption) be denied a portion of the otherwise
applicable deduction for mortgage interest?
The Treasury Department asserts that the deduction denial
would prevent tax arbitrage in connection with cash value
policies. However, the proposal does not apply to debt directly
or even indirectly secured by cash values; interest on such
amounts is nondeductible under current law. Section 264 of the
Internal Revenue Code disallows a deduction for interest on
policy loans from the insurer as well as on loans from third
parties to the extent the debt is traceable to the decision to
purchase or maintain a policy. Thus, the only interest
deductions that would be affected by the proposal would be
those attributable to unrelated business debt--loans secured
byThe arbitrage concern is a red herring; the real target is
inside buildup.
If the Administration has concerns about the insurance
policy purchased on the life of the team leader, then it should
say so--and it should address the issue directly. It is
inappropriate to deny instead a legitimate business expense
deduction as an indirect means of taxing inside buildup.
Congress, for sound policy reasons, has steadfastly refused to
enact proposals that more directly attack inside buildup; it
should similarly refuse to enact this proposal.
Disproportionate Impact on Similar Businesses
The Administration's proposal to impose a tax penalty on
businesses that purchase life insurance on their employees
would have a disproportionate impact on highly-leveraged
businesses. This is inconsistent with a fundamental tenet of
the tax laws that, to the extent possible, taxation should be
neutral with respect to core business decisions such as the
appropriate degree of debt. It is also patently unfair and
without policy justification.
To illustrate the disproportionate burden on highly-
leveraged businesses, take the following example: Assume two
competing companies, each with $50 million in assets. Company A
has $2 million in outstanding debt, with an annual interest
expense of $150,000. Company B has $20 million in outstanding
debt, with an annual interest expense of $1.8 million.
If Company A purchases an insurance policy on the
life of its resident genius, Company A would be required to
forego a portion of the interest expense on its outstanding
debt. For example, if the cash value of the policy is $5
million, one-tenth of the annual interest expense, or $15,000,
would not be deductible.
If Company B buys the same policy for its resident
genius, it too would be required to forego one-tenth of its
interest expense deduction. However, for Company B, this
amounts to a foregone deduction of $180,000--12 times the
amount foregone by Company A.
The deduction disallowances illustrated above would occur
each year, compounding the disproportionate impact on Company
B. Over a span of 30 years, Company B could lose interest
deductions in excess of $5.4 million--while Company A might
lose closer to $450,000.
Whatever one's beliefs about the proper tax treatment of
life insurance policies, what possible justification exists for
imposing a tax penalty associated with the purchase of such a
policy that varies with the level of a company's outstanding
debt?
Conclusion
For the reasons explained above, we believe the Congress,
consistent with its long-standing interest in preserving tax
benefits for inside buildup within life insurance contracts,
should reject the Administration's insurance proposals, which
would effectively subject inside buildup to current taxation.
Submitted by:
Kenneth J. Kies
Price Waterhouse LLP
Statement of Kenneth C. Karas, Chairman and CEO, Enron Wind Corp.
My name is Ken Karas, and I am the Chairman and Chief
Executive Officer of Enron Wind Corp., a subsidiary of Enron
Renewable Energy Corporation. Enron Wind Corp., one of the
largest producers in the U.S. wind energy industry, offers a
fully integrated range of services including wind assessment,
project siting, engineering, project finance, turbine
production, construction, and operation and maintenance of wind
energy facilities. Among the projects currently under
development by Enron Wind Corp. are a 112.5 megawatt project in
Iowa and a 107 megawatt project in Minnesota. Upon completion,
these projects will be operated by Enron Wind Corp. and the
power produced will be sold to MidAmerican Energy Company and
Northern States Power Company, respectively. As a committed
member of the wind energy industry, Enron Wind Corp. strongly
endorses the Administration's proposal to extend the Wind
Energy Production Tax Credit (``PTC'') by five years.
The current Wind Energy PTC, first enacted under the Energy
Policy Act of 1992, provides a 1.5-cent-per-kilowatt-hour tax
credit, adjusted for inflation after 1992, for electricity
produced from wind or ``closed-loop'' biomass. The credit is
available for wind energy production facilities placed in
service prior to July 1, 1999, and applies to wind energy
produced for the first ten years after the facilities are
brought on line. The revenue impact of the Administration's
proposal to extend the credit is projected by the Office of
Management and Budget to be only $191 million between fiscal
years 1999 and 2003. The Joint Committee on Taxation has
projected an even lower cost of $144 million over the same
period.
The Administration's proposal is identical in substance to
H.R. 1401 introduced by Representative Bill Thomas (R-CA) in
this Committee in 1997. H.R. 1401 currently has eighteen
cosponsors including Representatives Dunn, Nussle, Matsui,
Ehlers, Fazio, McDermott, Minge, Lewis, Rivers, Schaefer,
Bartlett, Thurman, Shaw, Tauscher, Klug, Skaggs, Woolsey and
Pallone.
Wind energy has made phenomenal advances in the last
fifteen years achieving improvements in reliability,
efficiency, and cost per kilowatt hour. The world market for
wind power continues to grow rapidly having had a $1.3 billion
year in 1996 and a $1.5 billion year in 1997 as new wind power
capacity continued to be installed. However, the U.S. wind
energy industry has seen very little growth in recent years due
in part to uncertainty surrounding deregulation of the electric
power industry. The failure to extend the Wind Energy PTC,
which is now scheduled to expire in little more than a year,
will only add to this uncertainty. As most wind energy projects
require a minimum of two years to develop, extension of the
Wind Energy PTC is critical now to ensure the availability of
long-term, low-cost financing for wind energy projects. Despite
these difficulties, close to 800 megawatts will be installed in
1998 and the first half of 1999, prior to the June 30, 1999
date for expiration of the credit.
Extension of the Wind Energy PTC is a targeted investment
in renewable energy that will provide significant returns to
the country, including:
Continuing to Reduce the Cost of Wind Power:
Dramatic advances have been made in the cost of wind power with
some current projects currently based upon a cost of below 5
cents per kilowatt hour. Stimulating investment through the
Wind Energy PTC will continue to bring these costs down as wind
energy begins to achieve economies of scale;
Achieving Reduced CO2 Emissions: The
Department of Energy has cited wind power as one of the
emerging electricity supply technologies needed to reduce the
emissions of carbon dioxide (CO2) caused by burning
fossil fuels; and
Creating Jobs and Export Revenues: A healthy
domestic wind energy industry creates the momentum to continue
developing wind energy technologies for export abroad into the
booming world market for renewable power, which in turn creates
more jobs at home.
We at Enron Wind Corp. are excited to be at the forefront
of one of the most promising renewable energy technologies
available, and believe that the Wind Energy PTC represents a
sound investment in the American economy, renewable energy and
our environment. I urge your support for this important and
cost-effective initiative.
Statement of Export Source Coalition
The Export Source Coalition is a group of US companies and
associations concerned about the ability of the United States
to compete in world markets. The Coalition includes both large
and small US exporters. A list of our members is attached
hereto as Exhibit #1.
The President has once again proposed changing the export
source rule to an ``activities based rule'' as part of his FY
1999 budget submission to the Congress. Such a change would
effectively repeal this rule which has been in effective for
more than 75 years, and we urge the Committee to reject this
proposal as it did last year.
In March of last year the Committee heard testimony from
two members of the Export Source Coalition, Douglas Oberhelman,
Chief Financial Officer and Vice President of Caterpillar Inc.,
and William C. Barrett, Director of Tax, Export and Customs for
Applied Materials, Inc., who explained in detail how this rule
helps reduce the double taxation companies face competing
overseas, thereby increasing their ability to produce in the US
for export markets. Two noted economists, Gary Hufbauer and
Dean DeRosa, also presented testimony before the Committee
supporting these conclusions and giving specific estimates on
the costs and benefits of the export source rule over the next
five years. A copy of that study is attached hereto as Exhibit
#2.
Increasing exports is vital to the health of the US economy
and fundamental to our future standard of living. There is
virtually no dispute among economists that jobs in export
industries pay approximately 15% higher wages. The 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 as a result of the export related wage premium cited
above.
The complex rules by which the US taxes its companies doing
business in foreign jurisdictions put them at a disadvantage
when competing abroad. The export source rule is one of the few
favorable tax rules which mitigate the harm done by other
distortive US tax rules that cause many US multinationals to
suffer significant double taxation on income earned from their
international operations.
Increasing exports is a bipartisan goal. Given the dangers
posed to our exports by the current crisis in Asia, repeal of a
rule, such as the export source rule, which clearly helps
increase exports would be even more unwise and
counterproductive than it was last year.
Description of the Rule
The export source rule is a technical tax rule which has
been in operation for approximately 75 years. Since 1922,
regulations under IRC section 863(b) and its predecessors have
contained a rule which allows the income from goods that are
manufactured in the U.S. and sold abroad (with title passing
outside the U.S.) to be treated as 50% U.S. source income and
50% foreign source income. This export source rule (sometimes
referred to as the ``title passage'' rule) has been beneficial
to companies who manufacture in the U.S. and export because it
increases their foreign source income and thereby increases
their ability to utilize foreign tax credits more effectively.
Because the U.S. tax law restricts the ability of companies to
get credit for the foreign taxes which they pay, many
multinational companies face double taxation on their overseas
operations, i.e. taxation by both the U.S. and the foreign
jurisdiction. The export source rule helps alleviate this
double taxation burden and thereby encourages U.S.-based
manufacturing by multinational exporters.
Administration Proposal
The President's FY1999 Budget proposal would eliminate the
50/50 rule and replace it with an ``activities based'' test
which would require exporters to allocate income from exports
to foreign or domestic sources based upon how much of the
activity producing the income takes place in the U.S. and how
much takes place abroad. The justification given for
eliminating the rule is essentially that it provides U.S.
multinational exporters that also operate in high tax foreign
countries a competitive advantage over U.S. exporters that
conduct all their business activities in the U.S. The
Administration also notes that the U.S. tax treaty network
protects export sales from foreign taxation in countries with
which we have treaties, thereby reducing the need for the
export source rule. As discussed below, both these arguments
are seriously flawed.
The Export Source Rule Serves As An Effective Export Incentive
The export source rule, by alleviating double taxation,
encourages companies to produce goods in the U.S. and export,
which is precisely the tax policy needed to support the goal of
increasing exports. The effectiveness of the rule as an export
incentive was examined by the Treasury Department in 1993, as a
result of a directive in the 1986 Tax Reform Act. The Treasury
study found that if the rule had been replaced by an activity-
based rule in 1992, goods manufactured in the U.S. for export
would have declined by a substantial amount. The most recent
study of the costs and benefits of the rule by Gary Hufbauer
and Dean DeRosa 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.
The Hufbauer-DeRosa study concludes that the export source rule
furthers the goal of achieving an outward-oriented economy,
with more exports and better paying jobs.
Increasing Exports Is Vital To The Health Of The U.S. Economy
Exports are fundamental to our economic growth and our
future standard of living. Although the U.S. is still the
largest economy in the world, it is a slow-growing and mature
market. As such, U.S. employers must export in order to expand
the U.S. economy by taking full advantage of the opportunities
in overseas markets. The U.S. is continuing to run a trade
deficit (i.e. our imports exceed our exports) of over $100
billion per year. Increasing exports helps to reduce this
deficit.
In 1996, exports of manufactured goods reached a record
level of $653 billion. In recent years, exports have accounted
for about one-third of total U.S. economic growth. Today, 96%
of U.S. firms' potential customers are outside the U.S.
borders, and in the 1990's 86% of the gains in worldwide
economic activity occurred outside the U.S.
Exports Support Better Jobs In The U.S.
According to the Commerce Department, exports are creating
high paying, stable jobs in the U.S. In fact, jobs in export
industries pay 13-18 percent more and provide 11 percent higher
benefits than jobs in non-exporting industries. Exporting firms
also have higher average labor productivity. In 1992, value-
added per employee, one measure of productivity, was almost 16%
higher in exporting firms than in comparable non-exporting
firms.
Over the last several years more than one million new jobs
were created as a direct result of increased exports. In 1995,
11 million jobs were supported by exports. This is equivalent
to one out of every twelve jobs in the U.S. Between 1986 and
1994, U.S. jobs supported by exports rose 63%, four times
faster than overall private job growth. Since the late 1980s,
exporting firms have experienced almost 20% faster employment
growth than those which never exported, and exporting firms
were 9% less likely to go out of business in an average year.
Export Source Rule Alleviates Double Taxation
In theory, companies receive a credit for foreign taxes
paid, but the credit is not simply a dollar for dollar
calculation. Rather it is severely limited by numerous
restrictions in the U.S. tax laws. As a result, multinational
companies often find themselves with ``excess'' foreign tax
credits and facing ``double'' taxation, i.e. taxation by both
the U.S. and the foreign country. How much credit a company can
receive for foreign taxes paid depends not only on the tax
rates in the foreign country, but also on the amount of income
designated as ``foreign source'' under U.S. tax law.
For example, for purposes of U.S. foreign tax credit rules,
a portion of U.S. interest expense, as well as research and
development costs, must be deducted from foreign source income
(even though no deduction is actually allowed for these amounts
in the foreign country). On the other hand, if the company
incurs a loss from its domestic operations in a year, it is
restricted from ever using foreign source earnings in that year
to claim foreign tax credits.
These restrictions in the U.S. tax law, which reduce or
eliminate a company's foreign source income, result in
unutilized or ``excess'' foreign tax credits. The export source
rule, by treating approximately half of the income from exports
as ``foreign source,'' increases the amount of income
designated ``foreign source'' thereby enabling companies to
utilize more of these excess foreign tax credits, thus reducing
double taxation.
Export Source Rule Helps to ``Level the Playing Field''
The export source rule does not provide a competitive
advantage to multinational exporters vis-a-vis exporters with
``domestic-only'' operations. Exporters with only domestic
operations never incur foreign taxes and thus, are not even
subjected to the onerous penalty of double taxation. Also,
domestic-only exporters are able to claim the full benefit of
deductions for U.S. tax purposes for all their U.S. expenses,
e.g., interest on borrowings and R&D costs because they do not
have to allocate any of those expenses against foreign source
income. Thus, the export source rule does not create a
competitive advantage, rather it helps to ``level the playing
field'' for U.S.-based multinational exporters.
Export Source Rule Affects Decision to Locate Production in the U.S.
Just as labor, materials, and transportation are among the
costs factored into a production location decision, so is the
overall tax burden. The export source rule, by alleviating
double taxation, helps reduce this tax cost, thereby making it
more cost efficient to manufacture in the U.S. For example, for
one coalition member, the export source rule was the
determining factor in deciding to fill a German customer order
from a U.S. rather than a European facility making the
identical product. By allowing half the income from the sale to
be considered ``foreign source,'' thereby helping the company
utilize foreign tax credits, the export source rule outweighed
other cost advantages such as transportation, and American
workers filled the customer's order.
FSC Regime and Treaty Network Not Substitutes for Export Source Rule
If the export source rule is eliminated, the FSC regime
will not be a sufficient remedy for companies facing double
taxation because of excess foreign tax credits. Instead of
using a FSC, many of these companies may decide to shift
production to their foreign facilities in order to increase
foreign source income. Since more and more U.S. companies are
finding that they must have production facilities around the
globe to compete effectively, this situation is likely to
become more and more common. The risk that these companies
(which by definition are facing double taxation because they
already have facilities overseas) would shift production abroad
if the rule is repealed is significant and not worth taking.
Our tax treaty network is certainly no substitute for the
export source rule since it is not income from export sales but
rather US restrictions on their ability to credit foreign taxes
paid on their overseas operations, which are the main cause of
the double taxation described above. To the extent the treaty
system lowers foreign taxation, it can help to alleviate the
double tax problem, but only with countries with which we have
treaties, which tend to be the most highly industrialized
nations of the world.
The US treaty network is limited to less than 60 countries,
leaving many more countries (approximately 170) without
treaties with the US. Moreover, many of the countries without
treaties are developing countries, which are frequently high
growth markets for American exports. For example, the US has no
treaty with any Central or South American country.
Conclusion
While this technical tax rule was not originally intended
as an export incentive, it has evolved into one of the few WTO-
consistent export incentives remaining in our tax code. It is
also justified on the basis of administrative convenience. This
50/50 sourcing rule is working as originally intended to avoid
endless disputes and problems which would inevitably arise in
administering an activity-based rule.
Given the acknowledged role of exports in sustaining growth
in the U.S. economy and supporting higher paying U.S. jobs, and
the effectiveness of this tax rule in encouraging exports, any
attempt to reduce or eliminate the rule is counterproductive
and unwise. We urge you to strenuously oppose the provision
contained in the President's FY 1999 budget which would
effectively repeal the export source rule.
Sources:
Fourth Annual Report of the Trade Promotion Coordinating Committee
(TPCC) on the National Export Strategy: ``Toward the Next Century: A
U.S. Strategic Response to Foreign Competitive Practices,'' October
1996, U.S. Department of Commerce, ISBN 0-16-048825-7;
U.S. Department of Commerce, Economics and Statistics
Administration, Office of the Chief Economist.
Gary C. Hufbauer and Dean A. DeRosa, ``Costs and Benefits of the
Export Source Rule, 1996-2000,'' February 1997.
James R. Hines, Jr., ``Tax Policy and The Activities of
Multinational Corporations,'' NBER Working Paper 5589, May 1996.
John Mutti and Harry Grubert, ``The Significance of International
Tax Rules for Sourcing Income: The Relationship Between Income Taxes
and Trade Taxes,'' NBER Working Paper 5526, April 1996.
J. David Richardson and Karin Rindal, ``Why Exports Matter:
More!,'' Institute for International Economics and the Manufacturing
Institute, Washington, DC, February 1996.
[GRAPHIC] [TIFF OMITTED] T1685.004
Exhibit 2
Costs and Benefits of the Export Source Rule, 1998-2002 \1\ by Gary C.
Hufbauer and Dean A. DeRosa
The Export Source Rule of the Internal Revenue Code of 1986
provides U.S. companies, both large and small, with a mechanism
for apportioning their net income from exports between domestic
and foreign sources. Broadly, it permits them to attribute
about 50 percent of their net export income to foreign sources.
Firms that have excess foreign tax credits can utilize the
Export Source Rule to ``absorb'' part of those excess credits,
thereby alleviating the double taxation of foreign income.
---------------------------------------------------------------------------
\1\ This report was prepared for the Export Source Coalition, a
group of U.S. companies and associations concerned about the ability of
the United States to compete in world markets.
---------------------------------------------------------------------------
This report presents our assessment of the costs and
benefits of the Export Source Rule for 1998, with projections
over the 5-year period 1998-2002. As seen in the accompanying
table, our projections indicate that the Export Source Rule
supports significant additional U.S. exports and worker
earnings--all at costs to the U.S. Treasury that are lower than
usually estimated. For example, in 1999, for an adjusted net
tax revenue cost of $1.1 billion, the United States will ship
an additional $30.8 billion of exports and add $1.7 billion to
worker payrolls in the form of the export earnings premium. The
additional exports will support 360 thousand workers in export-
related jobs who in a full employment economy would otherwise
be working in lower paid sectors of the U.S. economy.
Projected Export and Revenue Impact of the Export Source Rule, 1998-2002 (Central projections based on Kemsley
data and parameters)
----------------------------------------------------------------------------------------------------------------
1998 1999 2000 2001 2002
----------------------------------------------------------------------------------------------------------------
Benefits to U.S. Economy
Additional U.S. exports ($ millions)................. 28,223 30,763 33,532 36,550 39,839
Jobs supported by additional exports................. 343,779 360,093 377,182 395,081 413,831
Additional wages and salaries ($ millions)........... 1,572 1,708 1,857 2,018 2,194
Costs to U.S. Treasury ($ millions)
Tax revenue forecasts................................ 891 1,474 1,555 1,750 1,855
Revenue offsets (arising from wage and salary n.a. 367 399 434 472
premiums)...........................................
Adjusted tax revenue forecasts....................... n.a. 1,107 1,156 1,316 1,383
----------------------------------------------------------------------------------------------------------------
Sources and Notes: See Tables 1 and 4 of the report.
The revenue cost estimates are based on the current U.S.
Treasury forecasts of the tax revenue gains associated with
repeal of the Export Source Rule. The Treasury estimates
reflect the likelihood that, if the Export Source Rule is
repealed, erstwhile users of the Export Source Rule among U.S.
firms would instead turn to a Foreign Sales Corporation. Under
the Foreign Sales Corporation legislation, a U.S. exporter can
exclude up to 15 percent of its net export income from U.S.
taxation. Unlike the Treasury estimates, our adjusted revenue
cost estimates also reflect additional tax receipts derived
from individual workers who enjoy premium earnings in export-
related jobs supported by the Export Source Rule.
The benefits of the Export Source Rule are measured in
terms of additional exports, the jobs supported by additional
exports, and the premium on worker earnings in export-related
jobs. These benefits are assessed using three different
analytical approaches from two recent econometric studies, and
one older, more traditional, quantitative study. In all cases,
we assume that, in the absence of the Export Source Rule and
its 50-50 division of export profits between foreign and
domestic source income, U.S. firms would instead sell their
exports through a Foreign Sales Corporation and exclude up to
15 percent of their export profits from U.S. taxation.
Our findings demonstrate that the Export Source Rule
furthers the goal of achieving an outward-oriented economy,
with more exports and better-paying jobs. One key to these
broad conclusions is the fact that export-oriented industries
and jobs are highly productive, partly because U.S. producers
and workers engaged in export production face the considerable
discipline of highly competitive international markets for
traded goods and services. A second key is the sensitivity of
plant location to the tax environment. Not right away perhaps,
but over a period of years a country that penalizes export
production with high taxes will forfeit first investment and
then export sales.
This second point deserves amplification. Recent empirical
research by several scholars--Grubert and Mutti, Hines,
Kemsley, and Wei--indicates far higher response rates of
investment decisions to tax rates than previously believed. The
new evidence is summarized in our report. A one percentage
point increase in the corporate tax rate (e.g., from 18 percent
to 19 percent) apparently induces a decline of 1.5 percent (and
perhaps as much as 3 or 5 percent) in investment committed to
export and import-competing production. The consequent impact,
in terms of lost exports (or higher imports), is much larger
than previously believed. The policy implications of the new
scholarship extend well beyond the Export Source Rule.
Countries that impose high corporate tax rates will
significantly erode their competitive position in the world
economy.
1. U. S. Exports and the Export Source Rule
Continued robust exports by U.S. firms in a wide variety of
manufactures and especially advanced technological products--
such as sophisticated computing and electronic products and
cutting-edge pharmaceuticals--are critical for maintaining
satisfactory rates of GDP growth and the international
competitiveness of the U.S. economy. Indeed, it is widely
acknowledged that strong export performance ranks among the
primary forces behind the economic well-being that U.S. workers
and their families enjoy today, and expect to continue to enjoy
in the years ahead.
The Export Source Rule (Section 863(b) of the Internal
Revenue Code of 1986) plays an important role in supporting
U.S. exports of manufactures and other merchandise, above
levels that would otherwise occur. The rule provides U.S.
companies, both large and small, with a mechanism for
apportioning their net income from exports between domestic and
foreign sources. Under the Export Source Rule, U.S. companies
attribute about 50 percent of their net export income to
foreign sources. Firms that have excess foreign tax credits
utilize the Export Source Rule to enlarge their foreign source
income and ``absorb'' part of those excess foreign tax credits,
thereby alleviating the double taxation of foreign income.\2\
Under such circumstances, the U.S. exporter will pay no
additional U.S. tax on the foreign source portion of its export
earnings. Moreover, as a general rule, foreign countries do not
tax the export earnings of U.S. firms, so long as the
production and distribution activity does not take place within
the foreign territory. Of course, the U.S. firm will pay U.S.
tax at the normal 35 percent rate on the domestic source
portion of its export earnings. The net result, for U.S. firms
with excess foreign tax credits that use the Export Source
Rule, is to pay a ``blended'' tax rate of 17.5 percent on their
export earnings--zero percent on half and 35 percent on half.
---------------------------------------------------------------------------
\2\ Excess foreign tax credits can arise from various
circumstances: higher rates of corporate taxation abroad than in the
United States; U.S. interest, and research and experimentation
allocation rules that attribute a share of these expenses to foreign
source income; U.S. rules that effectively recharacterize domestic
losses as foreign source losses in some circumstances; U.S. rules that
create hermetic ``baskets of income'' so that foreign taxes on one type
of foreign income cannot be attributed to another type of foreign
income; etc.
---------------------------------------------------------------------------
Those U.S. firms that export can also utilize another
provision of the Internal Revenue Code, Section 862(a)(6)
enacted under the Deficit Reduction Act of 1984, which allows
companies to establish a Foreign Sales Corporation (FSC). The
FSC is a successor to the former Domestic International Sales
Corporation (DISC). Under the FSC provisions, U.S. firms can
conduct their export sales through a Foreign Sales Corporation
and exclude a maximum of 15 percent of their net export
earnings from U.S. taxation. In this case, the ``blended'' rate
is 29.75 percent--zero percent on 15 percent of export earnings
and 35 percent on 85 percent of export earnings.
This report assesses the costs and benefits of the Export
Source Rule for 1998, with projections over the 5-year period
1998-2002.\3\ The revenue cost estimates are based on the
current U.S. Treasury forecasts of the tax revenues associated
with the Export Source Rule. (The Joint Committee on Taxation
(JCT) has published very similar revenue forecasts.) These
revenue cost estimates reflect likely changes in corporate
operations in response to a change in the tax laws. Hence, they
assume that, if the Export Source Rule is repealed, erstwhile
users among U.S. exporters would instead turn to the Foreign
Sales Corporation. Our ``adjusted'' revenue cost estimates go
one important step further. Namely, they take into account the
revenues that would be lost to the U.S. Treasury owing to the
loss of premium earnings by manufacturing workers in export-
related jobs supported by the Export Source Rule.
---------------------------------------------------------------------------
\3\ Our projections of costs and benefits are made on a calendar
year basis, even though, strictly speaking, our projections of tax
revenue costs refer to U.S. fiscal years.
---------------------------------------------------------------------------
We measure the benefits of the Export Source Rule in terms
of additional exports, the jobs supported by additional
exports, and the premium on worker earnings. We assess these
benefits using three very different analytical approaches. In
all cases, we assume that, in the absence of the Export Source
Rule and its 50-50 division of export profits between foreign
and domestic source income, U.S. firms would instead sell their
exports through a Foreign Sales Corporation, and that, to an
important extent, they would export less and produce more
abroad.
2. Three Approaches to Estimating Benefits
U.S. exports and jobs supported by the Export Source Rule
are estimated using three different analytical approaches,
first for a base year (1992) and, subsequently, for the 5-year
period 1998-2002. The three approaches to estimating benefits
of the Export Source Rule are based on the findings of two
recent econometric studies of U.S. export levels and investment
location behavior in response to tax rates (Kemsley 1997;
Grubert and Mutti 1996), and a much older study of the former
Domestic International Sales Corporation (DISC) provisions of
the U.S. tax law, carried out by the U.S. Department of the
Treasury (1983).
Direct Estimates Based on Kemsley Parameters
The first approach to estimating the benefits of the Export
Source Rule is based on the findings of Kemsley (1997). The
Kemsley sample data, which are compiled from the financial
statements of U.S. multinational firms, consist of information
on the worldwide assets, U.S. exports, foreign sales, and U.S.
and foreign tax rates of 276 U.S. firms during the 9-year
period 1984-92. As seen in the upper panel of Table 1, these
data may be divided into two sub-samples: data for the
companies with ``binding FTC positions'' and data for the
companies with ``nonbinding FTC positions.'' The companies with
binding foreign tax credit (FTC) positions are companies with
excess foreign tax credits. These corporations are assumed to
use the Export Source Rule. Under the Export Source Rule, half
the profits are characterized as foreign source income, and can
be used to absorb excess foreign tax credits, thereby reducing
the ``blended'' U.S. tax rate on their export profits to 17.5
percent.\4\ The companies in nonbinding FTC positions (i.e.,
without excess foreign tax credits) are assumed to exclude 15
percent of their export profits from U.S. taxation by using a
Foreign Sales Corporation (FSC), thereby reducing the
``blended'' U.S. tax rate on their export profits to 29.75
percent.\5\
---------------------------------------------------------------------------
\4\ A company could be in a ``partially binding FTC position''--
i.e., the company could have excess FTCs, but in an amount less than
the additional FTC ``capacity'' generated by the Export Source Rule. In
those cases, the blended effective tax rate would be higher than 17.5
percent. Our study does not take such intermediate case into account.
\5\ This assumption probably overstates the tax benefits of the
FSC, since many companies are not able to exclude the full 15 percent
of export profits.
---------------------------------------------------------------------------
Kemsley investigated the amount of export sales per company
associated with U.S. export tax rules using an econometric
equation that includes the ``marginal export tax incentive''
facing companies with binding FTC positions and companies with
nonbinding FTC positions as separate explanatory variables. By
the design of his econometric analysis, coupled with his
assignment of companies predominantly utilizing a Foreign Sales
Corporation to the sub-sample of companies with nonbinding FTC
positions, Kemsley associated the estimated coefficient on the
marginal export tax incentive variable for firms with binding
FTC positions with the impact of the Export Source Rule. Based
on Kemsley's coefficients, it can be calculated that the Export
Source Rule supports $42 million additional exports per company
for 140 companies in a binding FTC position.\6\
---------------------------------------------------------------------------
\6\ To make this calculation, we assume that the ``blended'' U.S.
tax rate component of the marginal export tax incentive (METI) variable
for firms with binding FTC positions rises from an average value of
17.5 percent with the Export Source Rule to an average value of 29.75
percent without the Export Source Rule. The hypothetical increase in
U.S. taxation of export earnings, 12.25 percentage points, or 0.1225,
is multiplied by the average ratio of foreign pre-tax income to foreign
sales (ES in Kemsley's notation), or 0.106 for firms with binding FTC
positions, to obtain the relevant value for Kemsley's METI variable,
namely 0.013. This value of METI is multiplied by the estimated
coefficient for the regression variable FTCBIND*METI, 2.437, and also
multiplied by mean foreign sales for firms in a binding FTC position,
$1,332 million, to obtain an estimate of additional exports resulting
from the Export Source Rule, namely $42 million (0.0130 2.437
$1,332 = $42). The methodology is spelled out in footnote 23
of Kemsley's paper.
---------------------------------------------------------------------------
However, this figure is an understatement for an important
reason recognized by Kemsley. His data on exports only count
exports to unaffiliated foreign buyers. According to a survey
by the U.S. Department of Commerce (1996c), exports by U.S.
multinational firms to their foreign affiliates accounted for
38 percent of the total exports of these firms in the year 1994
(this proportion has remained practically constant since 1989).
Assuming that exports to affiliated foreign firms are impacted
to the same extent as exports to unaffiliated firms, the impact
per U.S. parent firm can be calculated at $68 million ($42
million divided by 0.62).
Kemsley's figure of 140 companies in a binding FTC position
represents an average for the entire period 1984-92. However,
for the period after the Tax Reform Act of 1986, Kemsley found
that the Export Source Rule had a stronger positive impact on
exports. The reason is that, with a lower U.S. corporate tax
rate, and with the adoption of various rules that block U.S.
firms from crediting foreign taxes, more companies found
themselves in an excess foreign tax credit position, and thus
more firms made use of the Export Source Rule. Kemsley's data
indicate that 74 of his sample firms had a binding FTC position
before the Tax Reform Act of 1986, and 173 firms had a binding
FTC position after the Act. Even this figure understates the
number of firms that rely on the Export Source Rule. Kemsley
estimates that his sample firms may account for only 70 percent
of all firms that utilize the Export Source Rule. In other
words, the ``true'' average number of impacted firms, during
the period 1987-92, could be about 247 companies (173 divided
by 0.70). Thus, as reported in Table 1, for 1992, the total
value of U.S. exports supported by the Export Source Rule can
be estimated, based on Kemsley's econometric findings, at $16.8
billion ($68 million per company for 247 U.S. firms).
Using a rate of 15.5 thousand jobs supported in the U.S.
economy per $1 billion of goods exported in 1992, as estimated
by the U.S. Department of Commerce (1996b), the number of U.S.
jobs supported by the Export Source Rule can be calculated at
260 thousand jobs for 1992. These jobs might not represent
additional employment in the current circumstances of the U.S.
economy, where the unemployment rate is relatively low.
Instead, additional exports may draw already employed workers
from other jobs, rather than from the ranks of unemployed
workers. Under this assumption--which is usually made by JCT
and Treasury analysts when evaluating tax changes--the Export
Source Rule may not be attributed with creating new jobs.
However, the Export Source Rule does shift the composition
of output--towards more output for export markets and less
output for domestic use. The shift of output towards exports
can be expected to benefit U.S. workers. There is significant
evidence, such as that reported recently by Richardson and
Rindall (1996), that both blue collar and white collar workers
in exporting firms enjoyed earnings that were about 15 percent
higher on average in 1992 than similar workers in non-exporting
firms. The U.S. Department of Commerce (1996b) reports an
earnings advantage of 12 percent for manufacturing workers
supported directly and indirectly by exports in 1994. Hence, a
change in the composition of output can be expected to improve
the earnings of workers, even if they are drawn from other
sectors and not from the ranks of the unemployed. Based on the
Department of Commerce earnings premium of 12 percent, and
average annual earnings of manufactures workers of just over
$30,500 in 1992, the wage and salary premium is $3,660 per
worker in that year. For all workers drawn to export-related
employment by the Export Source Rule, the aggregate wage and
salary premium is estimated at $1.0 billion in 1992. For 1999,
the figure rises to $1.7 billion (see Table 4).
Production Response Approach Based on Grubert-Mutti Parameters
The second approach to estimating the benefits of the
Export Source Rule is based on estimates of the location of
production facilities in response to different tax rates. Our
calculations for this approach rely on the recent econometric
findings of Grubert and Mutti (1996). Grubert and Mutti
investigate the location of investment abroad by U.S.
controlled foreign corporations, typically in manufacturing
facilities to support foreign exports to third-country
destinations. They are interested in changes in investment
location induced by differences in corporate tax rates between
foreign countries. Among other findings, the two authors report
a statistically significant estimate of 3.0 for the elasticity
of total capital invested in individual foreign countries with
respect to the foreign tax rate.\7\ For the purposes of this
report, the Grubert-Mutti elasticity estimate of 3.0 is
multiplied by the incremental inducement provided by the Export
Source Rule, and then applied to total exports per company by
the Fortune 50 Top U.S. Exporters (Fortune 1995). The key
assumption underlying this calculation is that U.S. export
production facilities can be regarded as if they were an
additional overseas location for production of tradable goods
by U.S. multinational firms. Without the Export Source Rule,
firms would shift production abroad: in fact, they would
relocate 3 percent of their production facilities abroad for
each 1 percent increase in the effective U.S. tax rate.\8\
Further, it is assumed that a 10 percentage point decrease in
U.S. production facilities translates into a 10 percentage
point decrease in U.S. exports. Other assumptions should also
be noted. We assume that, without the Export Source Rule,
companies would ship their exports through a Foreign Sales
Corporation. Hence, the calculation of additional exports only
reflects the incremental inducement provided by the Export
Source Rule, beyond the inducement provided by the Foreign
Sales Corporation (12.25 percentage points in the ``blended''
U.S. tax rate). We also assume that only half of the Fortune
Top 50 U.S. Exporters are in a binding FTC position. This is
based on Kemsley's full sample of company years, which reports
half the company-years in a binding position and half in a
nonbinding position. Finally, for this calculation, we assume
that only these 25 large exporters use the Export Source Rule.
---------------------------------------------------------------------------
\7\ An elasticity coefficient indicates the percentage change for
variable x in response to a 1.0 percent change in variable y. In this
case, an elasticity of 3.0 means that total capital invested in a
foreign country is increased three percent for every one percentage
point increase in the profitability (per unit of output) of production
in the country attributable to lower corporate taxation in the country.
\8\ The 3-for-1 response rate reflects an average across a large
number of firms. Some companies will not shift any production in
response to a tax change, other companies will shift big segments of
production.
---------------------------------------------------------------------------
Applying the Grubert-Mutti parameter estimate, with these
supplementary assumptions, leads to the finding that the Export
Source Rule supported $1.2 billion additional exports per
company, or $31.2 billion additional exports for the 25 large
exporters in 1992 (Table 2). With regard to U.S. jobs, the
earnings estimates based on the Grubert-Mutti parameters
indicate that 482 thousand U.S. jobs are supported by the
Export Source Rule. The aggregate earnings premium for U.S.
workers attributable to the Export Source Rule is $1.8 billion
in 1992. The figure for 1999 is $3.2 billion (see Table 4).
Other Estimates of Production Location
The proposition that higher business taxes can prompt the
relocation of production is not new to economics. Ohlin (1933)
and Haberler (1936), among other pioneers in the modern theory
of international trade and investment, were keenly aware of the
impact of taxes. What is new is empirical calculation of the
size of the response.
In a recent paper, Hines (1996a) surveyed the empirical
literature on the response of U.S. direct investment abroad and
foreign direct investment in the United States to different tax
rates. While the 20-odd studies (dating from 1981) surveyed by
Hines cannot be summarized by a single number, a rough
characterization is that a 1 percentage point increase in the
effective business tax rate induces a 1 percent decrease in the
stock of plant and equipment. In other words, the ``modal
study,'' to use an unscientific concept, finds an elasticity
coefficient of 1.0.
However, some scholars detect significantly larger effects.
Grubert and Mutti estimated an elasticity coefficient of 3.0.
In another paper, Hines (1996b) estimates an elasticity
coefficient of 10 for the impact of different state tax rates
on the state-by-state location of foreign direct investment
entering the United States. Finally, in a paper studying the
effect of taxation and corruption on direct investment flows
from 14 countries to 34 ``host'' countries, Wei (1997)
estimates an elasticity of 5 for the impact of the host
country's tax rate on inward foreign direct investment by
multinational firms.
To summarize: production location decisions are highly
sensitive to effective tax rates. We cannot definitely say that
the response rate is 1-for-1, 3-for-1, or higher. In our
judgment, a response rate of 3-for-1 (the Grubert-Mutti
parameter) may be high, but it is not out of the ballpark.
Textbook Approach Based on Export Elasticity Parameters
The last approach is the familiar textbook approach based
on export demand and supply elasticities for estimating the
impact of an exchange rate, price, or tax change on exports.
Our use of this approach to calculate the benefits of the
Export Source Rule is based on the quantitative analysis of the
former Domestic International Sales Corporation (DISC)
undertaken by the U.S. Department of the Treasury (1983). The
DISC was replaced in 1984 by the present-day Foreign Sales
Corporation (FSC). The U.S. Treasury (1993) adopted a similar
approach to evaluate the FSC in the period 1985 to 1988.
The Treasury studies use simple demand-supply balance
models to calculate the impact of tax provisions on U.S.
exports. In this approach, familiar price elasticities of
demand and supply for exports determine the responsiveness of
export sales to changes in after-tax profits. In Table 3, we
assume a profit-to-export-sales ratio of 0.12 for exports.\9\
Also, we assume ``high'' values of the price elasticities of
demand and supply for U.S. exports of manufactures, -10 and 20
respectively, in order to calculate the largest possible
impacts consistent with the export elasticities approach.\10\
Finally, we assume that the Export Source Rule is used by only
25 of the Fortune Top 50 U.S. Exporters (the same assumption
made for the Grubert-Mutti approach).
---------------------------------------------------------------------------
\9\ This figure is based on the following considerations. According
to FSC data for 1985, 1986 and 1987, the ``combined taxable income'' of
parent U.S. corporations and their FSCs averaged about 0.08 of export
sales (U.S. Treasury, 1993). We think export profits in those years
were depressed by the very strong dollar. According to data collected
by Kemsley (1997) over the 9-year period 1984-92, foreign pre-tax
income averaged about 0.12 of foreign sales for his full sample of
firms. In our judgment, this figure better reflects the profit-to-
export sales ratio now prevailing for U.S. firms.
\10\ The reason we calculated ``upper bound'' estimates for the
export elasticity approach was to discover whether there was an overlap
with the production response approach. There was not. Estimates of
long-run price elasticities of demand and supply for U.S. exports,
compiled from the econometric findings of a number of investigators,
are presented in Table 5. It will be seen that the figures we use are
at the upper end of econometric findings. High values for price
elasticities (-10 for demand and 20 for supply) imply a ``multiplier''
of 6.0. This multiplier relates the proportional change in export sales
to the tax-induced change in export income (expressed as a percentage
of export sales) attributable to the Export Source Rule. Even a
multiplier as large as 6.0 does not yield trade effects that are as big
as those suggested by the production response approach.
---------------------------------------------------------------------------
Applying the export elasticities approach to the 25 U.S.
exporters indicates that the Export Source Rule supported $228
million additional exports per company in 1992, or $5.7 billion
additional exports for the 25 firms (Table 3). With regard to
U.S. jobs, the estimates based on the export elasticities
approach indicate that about 88 thousand U.S. jobs were
supported by the Export Source Rule in 1992. The aggregate
earnings premium for U.S. workers attributable to the Export
Source Rule was $0.3 billion in 1992. The figure for 1999 is
$0.6 billion (see Table 4).
3. Comparison of Approaches
In our judgment, the export response suggested by the
Kemsley findings, about $30 billion in 1999 (see Table 4), best
captures the likely long-run contribution of the Export Source
Rule to U.S. export performance. The calculations grounded on
Kemsley's analysis reflect direct empirical observation. Also,
Kemsley explores the impact of the Export Source Rule without
imposing a theoretical framework on his econometric equations,
and he examines a very large number of companies, pooled across
nearly 10 years. Finally, Kemsley also takes into account
factors other than tax rules that affect the export performance
of different companies.
That said, the calculations grounded on Kemsley's analysis
will strike many experts as ``too high.'' The reason for this
impression is that the estimated export effects are much
larger, relative to the loss of tax revenue, than can be
derived by application of the familiar textbook model which
relies on export demand and supply elasticities. In our view,
the fact that Kemsley's findings cannot be squared with
textbook models is a reason for questioning the textbooks, not
an argument for discarding Kemsley's results.
Our view is based on two considerations. In the first
place, the calculations of additional exports that are grounded
on the Grubert-Mutti production response coefficients are even
larger than the Kemsley estimates. The Grubert-Mutti production
response coefficient of 3.0 is somewhat larger, but in the same
range, as production response coefficients estimated by other
scholars. The ``modal'' production response coefficient of 1.0
would indicate export effects one-third the size of the figures
presented for Grubert-Mutti in Table 4, but still about twice
the size of the textbook export elasticities approach.
The second consideration in favor of Kemsley's results is
that the textbook demand and supply elasticity model may be
better suited to the measurement of responses to ``transitory''
fluctuations in exchange rates and inflation rates, than to
``permanent'' (or at least semi-permanent) changes in tax
variables.
4. Cost and Benefit Forecasts, 1998-2002
Forecasts of the U.S. export and employment-related
benefits of the Export Source Rule derived from the three
different approaches to estimating the benefits are presented
for the 5-year period 1998 to 2002 in Table 4. These forecasts
of benefits are based on the estimates for 1992 presented in
Tables 1, 2, and 3. Specifically, the export benefit estimates
for 1992 are projected forward to the years 1998-2002 using the
observed average annual rate of growth of U.S. manufactures
exports during 1992-96 (about 9 percent).\11\ The employment
and earnings benefit estimates for 1992 are projected forward
using observed average annual rates of growth of both U.S.
manufactures exports and U.S. labor productivity during 1992-
1996 (about 4 percent for labor productivity).
---------------------------------------------------------------------------
\11\ The historical and projected values of U.S. total and
manufacturing exports are presented in Table 6.
---------------------------------------------------------------------------
For 1999, the calculated additional exports attributable to
the Export Source Rule range between a high value of $57.1
billion based on the production response approach (Grubert-
Mutti parameters) to a low value of $10.4 billion based on the
textbook approach (export elasticity parameters). Throughout
the 5-year forecast period, the additional exports calculated
using the Kemsley parameters fall about equidistant between the
estimates found using the other two approaches.
The 5-year forecasts of employment and earnings also reveal
the centrality of the jobs and worker earnings calculated using
the Kemsley estimates. Thus, in the year 1999, the Export
Source Rule is forecast to support central figures of nearly
360 thousand manufacturing jobs and about $1.7 billion in
premium wages and salaries for manufacturing workers employed
in export-oriented industries.
Forecasts of the U.S. tax revenue costs attributable to the
Export Source Rule for the 5-year period 1998-2002 are also
presented in Table 4. These tax revenue forecasts, which are
projections by the Treasury (OMB 1997), are supposed to reflect
obvious changes in business behavior.\12\ If the Export Source
Rule is repealed, U.S. companies would exclude up to 15 percent
of their export profits from U.S. taxation by selling exports
through a Foreign Sales Corporation. Accordingly, both Treasury
and JCT revenue forecasts reflect an adjustment for greater use
of Foreign Sales Corporations.
---------------------------------------------------------------------------
\112\ Projections of ``tax expenditures,'' which are regularly
reported by the Administration and Congress (e.g., OMB (1996) and JCT
(1996)), are typically greater in magnitude than tax revenue forecasts
and provide the basis for projecting tax revenues. However, tax
expenditure forecasts assume that business firms do not change their
behavior in response to a change in tax law. Hence, they do not take
into account the recourse that U.S. firms utilizing the 50-50 division
of export profits between domestic and foreign source income under the
Export Source Rule have to excluding up to 15 percent of their export
profits from U.S. taxation by selling exports through a Foreign Sales
Corporation. For discussion on how tax expenditures are estimated by
the U.S. Department of the Treasury and further discussion of the
difference between tax expenditure and tax revenue estimates, see
Rousslang (1994) and JCT (1996) respectively.
---------------------------------------------------------------------------
In our view, the tax revenue forecasts should be further
reduced to reflect the additional revenues the Treasury
collects from individual workers who enjoy premium earnings
attributable to the Export Source Rule. While this is not a
``standard'' adjustment, it is justified by the fact that
export jobs pay higher wages and salaries on average than other
jobs. Therefore, Table 4 presents forecasts of the appropriate
tax revenue offsets and adjusted net U.S. tax revenue for the
4-year period 1999-2002. We start with 1999 because that is the
first year when repeal of the Export Source Rule would have its
full impact. The revenue offsets are estimated by applying the
relevant marginal U.S. income tax rate for individuals (21.5
percent) to the estimates in the table of additional U.S.
earnings supported by the shift in output towards export
industries as a consequence of the Export Source Rule.\13\ The
adjusted revenue forecasts are calculated to be the standard
revenue forecasts minus the revenue offsets.
---------------------------------------------------------------------------
\13\ We estimate the relevant marginal tax rate in the following
manner. In 1998, average manufacturing earnings will be about $38,100
per worker (Table 4). The average premium of 12 percent for workers
directly and indirectly supported by exports would put their average
earnings at $42,700. Currently, a marginal Federal tax rate of 28
percent applies to married couples with taxable income above $36,000
and to single persons with taxable income above $22,000. Below those
cut-off amounts, the marginal tax rate is 15 percent. Taking into
account deductions and exemptions, we assume that half of workers
supported by exports pay marginal tax rates of 28 percent and half pay
15 percent. The relevant ``average marginal tax rate'' is thus 21.5
percent (28 + 15 divided by 2).
---------------------------------------------------------------------------
It is apparent from the estimates presented in Table 4 that
the magnitude of the revenue offsets associated with the Export
Source Rule depends importantly on which method of estimating
U.S. export and employment-related benefits is assumed. Based
on the Kemsley estimates of Export Source Rule benefits, the
tax revenue offsets are estimated at $0.4 billion in 1999,
increasing to $0.5 billion by the year 2002. Based on the
Grubert-Mutti estimates of Export Source Rule benefits, the tax
revenue offsets are estimated at $0.7 billion in 1999,
increasing to $0.9 billion by the year 2002. And finally, based
on the textbook elasticities approach, the tax revenue offsets
are estimated at $0.1 billion in 1999, increasing to $0.2
billion in 2002.
The adjusted revenue forecasts provide the most appropriate
basis for judging the final budgetary costs of the Export
Source Rule to the U.S. Treasury, because the adjusted figures
take into account the substantial tax revenues that will be
collected from individuals who enjoy premium wages and
salaries, so long as the Export Source Rule remains in place.
The adjusted revenue forecasts based on the textbook
elasticities approach are not much different from the standard
Treasury and JCT revenue forecasts. However, the adjusted
revenue forecasts based on the Kemsley estimates and the
Grubert-Mutti estimates are significantly lower than the
standard revenue forecasts--about 25 percent lower in the case
of the forecasts based on the Kemsley estimates and about 50
percent lower in the case of the forecasts based on the
Grubert-Mutti estimates.
5. Conclusions
This report has assessed the medium-term cost and benefits
of the Export Source Rule, based on the findings of two recent
econometric studies, and the older more traditional textbook
approach. Our calculations indicate that, for a plausible range
of estimates, the Export Source Rule supports significant U.S.
exports, jobs, and worker earnings--all at costs to the U.S.
Treasury that are lower than usually estimated. For example, in
the year 1999, for an adjusted net revenue cost of $1.1 billion
(based on Kemsley's estimates), the United States will ship an
additional $30.8 billion of exports, support 360 thousand jobs,
and add $1.7 billion to worker payrolls in the form of the
export earnings premium.
One key to these broad conclusions is the fact that export-
oriented industries and jobs are highly productive, partly
because U.S. producers and workers engaged in export production
face the considerable discipline of highly competitive
international markets for traded goods and services. A second
key is the sensitivity of plant location to the tax
environment. Not right away perhaps, but over a period of years
a country that penalizes export production with high taxes will
forfeit first investment and then export sales.
References
Fortune. 1995. ``The Top 50 U.S. Exporters,'' Fortune, November 13,
1995, pp.74-75.
Goldstein, M., and M. Khan. 1985. ``Income and Price Effects in
Foreign Trade,'' in Handbook of International Economics, Vol. II, eds.,
R.W. Jones and P.B. Kenen (Amsterdam: North-Holland).
H. Grubert, and J. Mutti. 1996. ``Do Taxes Influence Where U.S.
Corporations Invest?,'' Paper prepared for the Conference on Trans-
Atlantic Public Economics Seminar, Amsterdam, Netherlands, May 29-31,
1996 (revised August 1996), mimeo.
Haberler, G. 1936 (Originally published in German, 1933). The
Theory of International Trade with its Applications to Commercial
Policy (London: William Hodge and Co.).
Hines, J.R. 1996a. ``Tax Policy and the Activities of Multinational
Corporations,'' Working Paper 5589, National Bureau of Economic
Research, May 1996.
------, 1996b. ``Altered States: Taxes and the Location of Foreign
Direct Investment in America,'' American Economic Review 86(5),
December 1996.
JCT (Joint Committee on Taxation). 1996. Estimates of Federal Tax
Expenditures for Fiscal Years 1997-2001, November 26, 1996
Kemsley, D. 1997. ``The Effect of Taxes on Production Location,''
Columbia University, January 1997, mimeo.
OMB (Office of Management and Budget). 1996. ``Tax Expenditures,''
Budget of the United States Government: Analytical Perspectives, Fiscal
Year 1997, February 5, 1996.
------. 1997. Budget of the United States Government, Fiscal Year
1998, February 6, 1997.
Ohlin, B. 1933. Interregional and International Trade (Cambridge,
Massachusetts: Harvard University Press).
Richardson, J.D., and K. Rindal. 1996. Why Exports Matter: More!
(Washington, D.C.: Institute for International Economics and The
Manufacturing Institute).
Rousslang, D.J. 1994. ``The Sales Source Rules for U.S. Exports:
How Much Do They Cost?,'' Tax Notes, February 21, 1994.
Stern, R.M., and J. Francis. 1976. Price Elasticities in
International Trade: An Annotated Bibliography (London: Macmillan for
the Trade Policy Research Centre).
U.S. Department of Commerce, Bureau of the Census, Economics and
Statistics Administration. 1996a. Statistical Abstract of the United
States 1996.
------, Economics and Statistics Administration. 1996b. U.S. Jobs
Supported by Exports of Goods and Services 19: 83-94, November 1996.
------, Economics and Statistics Administration. 1996c.
``Operations of U.S. Multinational Companies,'' Survey of Current
Business, December 1996.
U.S. Department of the Treasury. 1983. The Operation and Effect of
the Domestic International Sales Corporation Legislation: 1981 Annual
Report, July 1983.
------. 1993. The Operation and Effect of the Foreign Sales
Corporation Legislation: January 1, 1985 to June 30, 1988, January
1993.
Wei, S. 1997. ``How Taxing is Corruption on International
Investors?'' Kennedy School of Government, Harvard University, January
9, 1997. Mimeo.
Table 1. Calculated Impact of the Export Source Rule in 1992: Direct
Estimates based on Kemsley Parameters
------------------------------------------------------------------------
Companies Companies
with with All
binding nonbinding sample
FTC FTC companies
positions positions
------------------------------------------------------------------------
Sample mean values per company \1\
Total assets ($ millions)3,805.... 2,889 3,254
Foreign sales ($ millions)1,33.... 286 41,100
Foreign tax rate (%).............. 48.63 35.72 42.25
U.S. tax rate (%)................. 35.00 35.00 35.00
U.S. tax rate with ESR or FSC (%) 17.50 29.75 n.a.
\2\..............................
Addenda: No. of companies per 140 136 276
Kemsley..........................
Adjusted no. of companies......... 247 n.a. n.a.
Additional U.S. exports ($ millions)
\3\
Per company....................... 68 0 n.a.
All companies..................... 16,792 0 16,792
Jobs supported by additional exports
\4\
All companies..................... 259,725 0 259,725
Wage and salary premium ($ millions)
\5\
All companies..................... 951 0 951
------------------------------------------------------------------------
Sources: Authors' calculations based on D. Kemsley, ``The Effect of
Taxes on Production Location,'' Columbia University, January 1997,
mimeo; U.S. Department of Commerce, ``U.S. Jobs Supported by Exports
of Goods and Services,'' November 1996; J.D. Richardson and K. Rindal,
Why Exports Matter: More! (Washington, D.C.: Institute for
International Economics and The Manufacturing Institute, 1996); and
Bureau of the Census, Economics and Statistics Administration, U.S.
Department of Commerce, Statistical Abstract of the United States
1996, October 1996.
Notes: Companies with ``binding FTC positions'' are companies in an
excess foreign tax credit (FTC) position; companies with ``nonbinding
FTC positions'' are other companies. The estimates are based on the
assumption that companies with binding FTC positions take advantage of
the Export Source Rule (IRC Section 863(b)); while companies with
nonbinding FTC positions utilize the Foreign Sales Corporation (FSC)
provisions.
\1\ The full pooled cross-sectional sample of data, compiled by Kemsley
(1996) from the financial statements of U.S. multinational companies,
consists of 2,486 manufacturing company-years for the period 1984-92.
For the calculations presented in the table, the sample mean values
are conservatively interpreted as 1992 values.
\2\ It is assumed that companies with binding FTC positions (i.e., with
excess foreign tax credits) exclude half their export profits from
U.S. taxation by using the Export Source Rule. This reduces the
effective U.S. tax rate on such profits from the normal rate of 35
percent to 17.5 percent. It is assumed that companies in nonbinding
FTC positions (i.e., without excess foreign tax credits) exclude up to
15 percent of their export profits from U.S. taxation by using the
Foreign Sales Corporation (FSC) provisions, thereby reducing the
effective U.S. tax rate on such profits from the normal rate of 35
percent to 29.75 percent.
\3\ Estimates are based on econometric findings investigating the
magnitude of exports per company associated with U.S. export tax
incentives reported by Kemsley (1997), adjusted for the larger number
of companies that use the Export Source Rule after the Tax Reform Act
of 1986, and also adjusted for the larger impact per company, taking
into account exports to foreign affiliates (see text).
\4\ These calculations assume that manufacturing exports support
employment at the rate of 15,500 jobs per $1 billion of goods exported
in 1992.
\5\ Calculated as an earnings premium of 12 percent of average
manufacturing earnings ($30,500 per worker) in 1992, or $3,660 per
worker.
Table 2. Calculated Impact of the Export Source Rule in 1992: Production
Response Approach based on Grubert and Mutti Parameters
------------------------------------------------------------------------
Companies Companies
with with All
binding nonbinding sample
FTC FTC companies
positions positions
------------------------------------------------------------------------
Sample mean values per company \1\
Total exports ($ millions)........ 2,585 2,585 2,585
Foreign tax rate (%).............. 48.63 35.72 42.25
U.S. tax rate (%)................. 35.00 35.00 35.00
U.S. tax rate with ESR or FSC (%) 17.50 29.75 n.a.
\2\..............................
Addendum: number of companies..... 25 25 50
Additional U.S. exports ($ millions)
\3\
Per company....................... 1,247 0 n.a.
All companies..................... 31,164 0 31,164
Jobs supported by additional exports
\4\
All companies..................... 482,012 0 482,012
Wage and salary premium ($ millions)
\5\
All companies..................... 1,766 0 1,766
------------------------------------------------------------------------
Sources: Authors' calculations based on D. Kemsley, ``The Effect of
Taxes on Production Location,'' Columbia University, January 1997,
mimeo; H. Grubert and J. Mutti, ``Do Taxes Influence Where U.S.
Corporations Invest?,'' Paper prepared for the Conference on Trans-
Atlantic Public Economics Seminar, Amsterdam, Netherlands, May 29-31,
1996 (revised August 1996), mimeo; U.S. Department of Commerce, ``U.S.
Jobs Supported by Exports of Goods and Services,'' November 1996; J.D.
Richardson and K. Rindal, Why Exports Matter: More! (Washington, D.C.:
Institute for International Economics and The Manufacturing Institute,
1996); Bureau of the Census, Economics and Statistics Administration,
U.S. Department of Commerce, Statistical Abstract of the United States
1996, October 1996; and Fortune, ``The Top 50 U.S. Exporters,''
November 13, 1995.
Notes: Companies with ``binding FTC positions'' are companies in an
excess foreign tax credit (FTC) position; companies with ``nonbinding
FTC positions'' are other companies.
\1\ The figure for total exports per company is based on the experience
of the Fortune Top 50 U.S. Exporters, 1994 data adjusted back to 1992
using the average annual growth rate of U.S. manufactures exports. The
25-25 division of Fortune Top 50 Exporters between those with binding
FTC positions and those with nonbinding FTC positions is based on
Kemsley's full sample which classified 1,258 company-years as binding
and 1,228 company-years as nonbinding.
\2\ It is assumed that companies with binding FTC positions (i.e., with
excess foreign tax credits) exclude half their export profits from
U.S. taxation by using the Export Source Rule to characterize those
profits as foreign source income (thereby absorbing part of their
excess foreign tax credits). This reduces the effective U.S. tax rate
on such profits from the normal rate of 35 percent to 17.5 percent. It
is assumed that companies in nonbinding FTC positions (i.e., without
excess foreign tax credits) exclude up to 15 percent of their export
profits from U.S. taxation by using the Foreign Sales Corporation
(FSC) provisions of the Internal Revenue Code, thereby reducing the
effective U.S. tax rate on such profits from the normal rate of 35
percent to 29.75 percent.
\3\ Grubert and Mutti (1996) estimate an elasticity of 3.0 for total
capital invested by U.S. companies in foreign countries with respect
to foreign tax rates. We assume that the ratio between capital
invested and export sales is constant. Hence, the Grubert-Mutti
elasticity of 3.0 is multiplied by the incremental inducement provided
by the Export Source Rule, and then applied to total exports of
companies with binding FTC positions. The key assumption in this
calculation is that U.S. export production facilities can be regarded
as if they were an additional overseas location for production of
tradable goods by U.S. multinational firms. Further, it is assumed
that, without the Export Source Rule, companies would ship their
exports through a Foreign Sales Corporation. Hence, the calculation of
additional exports only reflects the incremental inducement provided
by the Export Source Rule, beyond the inducement provided by the
Foreign Sales Corporation--i.e., an incremental reduction of 12.25
percentage points in the effective tax rate.
\4\ These calculations assume that manufacturing exports support
employment at the rate of 15,500 jobs per $1 billion of goods exported
in 1992.
\5\ Calculated as an earnings premium of 12 percent of average
manufacturing earnings ($30,500 per worker) in 1992, or $3,660 per
worker.
Table 3. Calculated Impact of the Export Source Rule in 1992: Textbook
Approach based on Export Elasticity Parameters
------------------------------------------------------------------------
Companies Companies
with with All
binding nonbinding sample
FTC FTC companies
positions positions
------------------------------------------------------------------------
Sample mean values per company \1\
Total exports ($ millions)........ 2,585 2,585 2,585
Foreign tax rate (%).............. 48.63 35.72 42.25
U.S. tax rate (%)................. 35.00 35.00 35.00
U.S. tax rate with ESR or FSC (%) 17.50 29.75 n.a.
\2\..............................
Addendum: number of companies..... 25 25 50
Additional U.S. exports ($ millions)
\3\
Per company....................... 228 0 n.a.
All companies..................... 5,700 0 5,700
Jobs supported by additional exports
\4\
All companies..................... 88,163 0 88,163
Wage and salary premium ($ millions)
\5\
All companies..................... 323 0 323
------------------------------------------------------------------------
Sources: Authors' calculations based on D. Kemsley, ``The Effect of
Taxes on Production Location,'' Columbia University, January 1997,
mimeo; U.S. Department of the Treasury, The Operation and Effect of
the Domestic International Sales Corporation Legislation: 1981 Annual
Report (Washington, D.C., July 1983); U.S. Department of Commerce,
``U.S. Jobs Supported by Exports of Goods and Services,'' November
1996; J.D. Richardson and K. Rindal, Why Exports Matter: More!
(Washington, D.C.: Institute for International Economics and The
Manufacturing Institute, 1996); Bureau of the Census, Economics and
Statistics Administration, U.S. Department of Commerce, Statistical
Abstract of the United States 1996, October 1996; and Fortune, ``The
Top 50 U.S. Exporters,'' November 13, 1995.
Notes: Companies with ``binding FTC positions'' are companies in an
excess foreign tax credit (FTC) position; companies with ``nonbinding
FTC positions'' are other companies.
\1\ The figure for total exports per company is based on the experience
of the Fortune Top 50 U.S. Exporters, 1994 data adjusted back to 1992
using the average annual growth rate of U.S. manufactures exports. Tax
rates are from Kemsley. The 25-25 division of Fortune Top 50 Exporters
between those with binding FTC positions and those with nonbinding FTC
positions is based on Kemsley's full sample which classified 1,258
company-years as binding and 1,228 company-years as nonbinding.
\2\ It is assumed that companies with binding FTC positions (i.e., with
excess foreign tax credits) exclude half their export profits from
U.S. taxation by using the Export Source Rule to characterize those
profits as foreign source income (thereby absorbing part of their
excess foreign tax credits). This reduces the effective U.S. tax rate
on such profits from the normal rate of 35 percent to 17.5 percent. It
is assumed that companies in nonbinding FTC positions (i.e., without
excess foreign tax credits) exclude up to 15 percent of their export
profits from U.S. taxation by using the Foreign Sales Corporation
(FSC) provisions of the Internal Revenue Code, thereby reducing the
effective U.S. tax rate on such profits from the normal rate of 35
percent to 29.75 percent.
\3\ Estimates are derived by applying the textbook export elasticities
approach to measuring the trade effects of export tax incentives, as
outlined in U.S. Treasury Department (1983). The profit-to-export-
sales ratio for all companies is assumed equal to 0.12. High values of
the price elasticities of demand and supply for U.S. exports of
manufactures, -10 and 20 respectively, are assumed in order to
calculate the largest possible impacts of the Export Source Rule under
the elasticities approach. These price elasticity estimates imply a
``multiplier'' value of 6.0, relating the proportional change in
export sales to the tax-induced change in export income (expressed as
a percentage of export sales) attributable to the Export Source Rule.
The Export Source Rule saves firms 12.25 percentage points of
taxation; assuming a profit-to-export sales ratio of 0.12, this
translates into additional export income equal to 1.47 percent of
export sales. Applying the ``multiplier'' of 6.0 indicates export
gains of 8.82 percent.
\4\ These calculations assume that manufacturing exports support
employment at the rate of 15,500 jobs per $1 billion of goods
exported.
\5\ Calculated as an earnings premium of 12 percent of average
manufacturing earnings ($30,500 per worker) in 1992, or $3,660 per
worker.
Table 4. Projected Export and Revenue Impact of the Export Source Rule, 1998-2000
----------------------------------------------------------------------------------------------------------------
1998 1999 2000 2001 2002
----------------------------------------------------------------------------------------------------------------
Additional U.S. exports ($ millions)
Based on Kemsley parameters.......................... 28,223 30,763 33,532 36,550 39,839
Based on Grubert-Mutti parameters.................... 52,379 57,093 62,231 67,832 73,937
Based on export elasticities approach................ 9,580 10,443 11,382 12,407 13,523
Employment and earnings Jobs supported by additional
exports
Based on Kemsley estimates........................... 343,779 360,093 377,182 395,081 413,831
Based on Grubert-Mutti estimates..................... 638,013 668,291 700,006 733,225 768,021
Based on export elasticities approach................ 116,695 122,233 128,033 134,109 140,474
Addenda: jobs per $1 bill. of exports \1\ 12,181 11,705 11,248 10,809 10,387
Additional wages and salaries ($ m) \2\
Based on Kemsley estimates........................... 1,572 1,708 1,857 2,018 2,194
Based on Grubert-Mutti estimates..................... 2,917 3,171 3,446 3,746 4,071
Based on export elasticities approach................ 534 580 630 685 745
Addenda: average earnings per worker in manufacturing ($) 38,104 39,538 41,026 42,570 44,171
\1\
Tax revenue forecasts ($ millions) \3\
U.S. Treasury........................................ 891 1,474 1,555 1,750 1,855
Revenue offset ($ millions) \4\
Based on Kemsley parameters.......................... n.a. 367 399 434 472
Based on Grubert-Mutti parameters.................... n.a. 682 741 805 875
Based on export elasticity parameters................ n.a. 125 136 147 160
Adjusted tax revenue forecasts ($ m) \5\
Based on Kemsley parameters.......................... n.a. 1,107 1,156 1,316 1,383
Based on Grubert-Mutti parameters.................... n.a. 792 814 945 980
Based on export elasticity parameters................ n.a. 1,349 1,419 1,603 1,695
----------------------------------------------------------------------------------------------------------------
Sources: Tables 1, 2, and 3; International Trade Administration, U.S. Department of Commerce, U.S. Foreign Trade
Highlights, October 28, 1996; J.D. Richardson and K. Rindal, Why Exports Matter: More! (Washington, D.C.:
Institute for International Economics and The Manufacturing Institute, 1996); U.S. Department of Commerce,
``U.S. Jobs Supported by Exports of Goods and Services,'' November 1996; Bureau of the Census, Economics and
Statistics Administration, U.S. Department of Commerce, Statistical Abstract of the United States 1996,
October 1996; and Office of Management and Budget, Budget of the United States Government, Fiscal Year 1998,
February 6, 1997.
Notes: Projections of additional U.S. exports and employment are based on the estimates for 1992 presented in
Tables 1, 2, and 3. Additional exports are projected using the recorded average annual growth rate of U.S.
exports of manufactures during 1992-96 (9 percent).
\1\ The addenda items reflect an annual growth rate of labor productivity in U.S. manufacturing sectors of 4
percent, based on the record of labor productivity in U.S. industry during 1985-93.
\2\ Additional U.S. wages and salaries in 1992 are estimated using the jobs estimates multiplied by the average
annual earnings of workers in manufacturing industries in that year ($30,500) and by the higher increment to
wages and salaries (12 percent) enjoyed by workers in export manufacturing plants, the latter figure as
reported by the U.S. Department of Commerce (1996). The projections for the years 1998 to 2002 are derived in
the same manner as those for additional exports and employment.
\3\ Tax revenue forecasts are supposed to reflect obvious changes in business behavior that are induced by a
change in the tax law. If the Export Source Rule is repealed, U.S. multinational companies would exclude up to
15 percent of their export profits from U.S. taxation by utilizing the FSC provisions of the Internal Revenue
Code. This change is reflected in the Treasury revenue forecasts (Office of Management and Budget 1997).
\4\ The tax revenue offsets are the additional tax revenues related to the higher earnings enjoyed by the
workers who produce the exports supported by the Export Source Rule. The tax revenue offsets are estimated by
applying the average marginal U.S. income tax rate for individuals in 1996 (calculated at 21.5 percent) to the
estimates in the table of additional U.S. earnings supported by the shift in output towards export industries
as a consequence of the Export Source Rule.
\5\ Under each of the three approaches to estimation of the impact of the Export Source Rule, the adjusted
revenue forecasts are equal to the tax revenue forecasts minus the calculated tax revenue offsets.
Table 5. Estimates of Long-Run Price Elasticities of Demand and Supply
for U.S. Exports
------------------------------------------------------------------------
Investigator Demand Supply
------------------------------------------------------------------------
Manufacturing exports
Stern and Francis (1976)............ -1.24 n.a.
Junz and Rhomberg (1973)............ -3.88 n.a.
Artus and Sosa (1978)............... -0.77 3.10
Lawrence (1978)..................... -1.85 n.a.
Dunlevy (1978)...................... n.a. 2.10
U.S. Treasury (1983)................ -10.00 20.00
Total exports
Houthakker and Magee (1969)......... -1.51 n.a.
Magee (1970)........................ n.a. 11.50
Stern and Francis (1976)............ -1.41 n.a.
Goldstein and Khan (1978)........... -2.32 6.60
Gylfason (1978)..................... n.a. 2.40
Geraci and Prewo (1980)............. n.a. 12.20
------------------------------------------------------------------------
Sources: R.M. Stern and J. Francis, Price Elasticities in International
Trade: An Annotated Bibliography (London: Macmillan for the Trade
Policy Research Centre, 1976); U.S. Department of the Treasury, The
Operation and Effect of the Domestic International Sales Corporation
Legislation: 1981 Annual Report (Washington, D.C.: July 1983); and M.
Goldstein and M. Khan, ``Income and Price Effects in Foreign Trade,''
in Handbook of International Economics, Vol. II, eds., R.W. Jones and
P.B. Kenen (Amsterdam: North-Holland, 1985).
Notes: The price elasticities of demand for U.S. exports reported by
Stern and Francis (1976) are ``mean'' estimates compiled by the two
authors from econometric studies by other investigators. The
elasticities in U.S. Treasury (1983) are assumed values that are
intended to represent ``high'' estimates of price elasticities of
demand and supply for U.S. exports of manufactures.
Table 6. U.S. Merchandise and Manufactures Trade, 1985-2002
(Billions of U.S. dollars, Census basis)
----------------------------------------------------------------------------------------------------------------
Total Goods \1\ Manufactured Goods \2\
Year -----------------------------------------------------------------
Exports Imports Balance Exports Imports Balance
----------------------------------------------------------------------------------------------------------------
1985.......................................... 218.8 336.5 -117.7 168.0 257.5 -89.5
1986.......................................... 227.2 365.4 -138.3 179.8 296.7 -116.8
1987.......................................... 254.1 406.2 -152.1 199.9 324.4 -124.6
1988.......................................... 322.4 441.0 -118.5 255.6 361.4 -105.7
1989.......................................... 363.8 473.2 -109.4 287.0 379.4 -92.4
1990.......................................... 393.6 495.3 -101.7 315.4 388.8 -73.5
1991.......................................... 421.7 488.5 -66.7 345.1 392.4 -47.3
1992.......................................... 448.2 532.7 -84.5 368.5 434.3 -65.9
1993.......................................... 465.1 580.7 -115.6 388.7 479.9 -91.2
1994.......................................... 512.6 663.3 -150.6 431.1 557.3 -126.3
1995.......................................... 584.7 743.4 -158.7 486.7 629.7 -143.0
1996.......................................... 616.6 783.0 -166.4 521.3 653.9 -132.6
1997.......................................... 672.1 568.2
1998.......................................... 732.6 619.4
1999.......................................... 798.5 675.1
2000.......................................... 870.4 735.9
----------------------------------------------------------------------------------------------------------------
Sources: International Trade Administration, U.S. Department of Commerce, U.S. Foreign Trade Highlights, October
28, 1996; and Bureau of Economic Analysis, U.S. Department of Commerce, Commerce News: U.S. International
Trade in Goods and Services, September 1996, November 20, 1996.
Notes: All values for 1996 are extrapolated from reported values for the first nine months. Values of exports
during 1997-2002 are projected, assuming an annual average growth rate of 9 percent.
\1\ Includes nonmonetary gold, military grant aid, special category shipments, trade between the U.S. Virgin
Islands and foreign countries, and undocumented exports to Canada. Adjustments were also carryover. Import
values are based on transaction prices whenever possible
\2\ Manufactured goods include commodity sections 5-9 under SITC Rev. 3. Manufactures include undocumented
exports to Canada, nonmonetary gold (excluding gold ore, scrap, and base bullion), and special category
shipments.
Gary C. Hufbauer is Reginald Jones Senior Fellow, Institute for
International Economics, 11 Dupont Circle, Washington, D.C.
20036. Dean A. DeRosa is Principal Economist, ADR
International, Ltd., 200 Park Avenue, Suite 202, Falls Church,
Virginia 22046. The analysis and conclusions are the work of
the authors and do not reflect the views of their affiliated
institutions.
Statement of John Porter, Tax Director, Financial Executives Institute
Introduction
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 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, 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 credisult
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.
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.
Effective Dates
The FEI would like to voice its view 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.
Provisions that Should not Be Adopted
Sound and paramount when deciding on taxation of business--
not mere revenue needs. In this light, the FEI offers the
following comments on certain specific tax increase proposals
set forth in the Administration's budget:
Repeal of Code Section 863(b)
When products manufactured in the U.S. are sold abroad,
Code Sec. 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
Sec. 863(b) with an allocation based on actual economic
activity will raise $6.6 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 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
cause a behavioral response to increase economic activity in
foreign jurisdictions that could result in more foreign jobs,
investment, and profits.
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.
Limiting Use of ``Hybrid'' Entities
It is troubling that the Administration (i.e., Treasury) feels
compelled to request congressional authority to issue potentially
sweeping legislative regulations after non-specific tax guidance has
been given. If Treasury has specific issues to address, it should do so
through specific legislative proposals. This would permit normal
congressional consideration, including hearings on such proposals.
One such proposal would limit the ability of certain foreign and
U.S. persons to enter into transactions that utilize so-called ``hybrid
entities,'' which are entities that are treated as corporations in one
jurisdiction, but, as branches or partnerships in another jurisdiction.
Although most hybrid transactions do not attempt to generate tax
results that are ``inconsistent with the purposes of U.S. tax law,''
the Administration feels that there are enough taxpayers taking unfair
advantage of the current rules thatxtend the earlier government issued
tax guidance (Notices 98-5 and 98-11) on this subject.
U.S. multinationals compete in an environment wherein foreign
competitors use tax planning techniques to reduce foreign taxes without
incurring home country tax. The use of ``hybrid entities'' allows U.S.
multinationals to compete on a level playing field and promotes
additional U.S. exports. The use of hybrids is consistent with the
initial balance between competitiveness and export neutrality that was
intended by Congress in enacting the ``Subpart F'' rules. Although
Congress specifically enacted a branch rule for foreign base company
sales under Code Sec. 954(d)(3), similar rules were not enacted for
foreign personal holding company income. If enacted, these proposals
would represent an unwarranted extension of legislative authority by
Congress to the Executive Branch to impose new rules by regulation
without Congressional debate.
Notices 98-5 and 98-11 have a chilling effect on the ability of
U.S. companies to structure their foreign operations consistent with
the commercial objective to regionalize businesses. They also adversely
impact companies' abilities to effectively reduce their overall costs
by reducing local taxes in their overseas operations. The Notices are
drafted so broadly and so vaguely that they confuse U.S. taxpayers and
their advisors, and introduce a compelling need to seek clarification
as to whether taxpayers can continue to rely on the simple ``check-the-
box'' regulations issued just last year. All these effects are
exacerbated by the Notices' immediate effective dates.
The world has changed dramatically since enactment of the Subpart F
rules in 1962. We feel that it would be more appropriate for Congress
to request a study regarding the trade and tax policy issues associated
with Notices 98-5 and 98-11. In this regard, a moratorium on further
regulatory action by Treasury should be imposed until enactment of
specific legislative proposals resulting
Foreign Built-In Losses
Another proposal would require the Treasury to issue
regulations to prevent taxpayers from ``importing built-in
losses incurred outside U.S. taxing jurisdictions to offset
income or gain that would otherwise be subject to U.S. tax.''
The administration argues that although there are rules in the
Code that limit a U.S. taxpayer's ability to avoid paying U.S.
tax on built-in gain (e.g., Code Secs. 367(a), 864(c)(7), and
877), similar rules do not exist that prevent built-in losses
from being used to shelter income otherwise subject to U.S. tax
and, as a result, taxpayers are avoiding Subpart F income
inclusions or capital gains tax. We believe that this
directive, which is written extremely broadly, is unnecessary
due to the existence of rules already available in the Code,
e.g., the anti-abuse provisions of Code Secs. 269, 382, 446(b),
and 482. Both this proposal, and the one immediately above
regarding the use of hybrid entities, would severely impact the
ability of U.S. multinationals to compete on an equal footing
against foreign-based companies.
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 on foreign oil and gas income. This
selective attack on a single industry's utilization of the
foreign tax credit 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.
Superfund Taxes
The three taxes that fund Superfund (corporate
environmental tax, petroleum excise tax, and chemical feed
stock tax) all expired on December 3 would reinstate the two
excise taxes at their previous levels for the period after the
date of enactment through September 30, 2008. The corporate
environmental tax would be reinstated at its previous level for
taxable years beginning after December 31, 1997 and before
January 1, 2009. In addition, the funding cap for the Oil Spill
Tax would be increased from the current $1 Billion amount, to a
much higher level of $5 Billion.
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.
Payments to 80/20 Companies
Currently, a portion of interest or dividends paid by a
domestic corporation to a foreign entity may be exempt from
U.S. withholding tax provided the payor corporation is a so-
called ``80/20 Company,'' i.e., at least eighty percent of its
gross income for the preceding three years is foreign source
income attributable to the active conduct of a foreign trade or
business. The Administration believes that the testing period
is subject to manipulation and allows certain companies to
improperly avoid U.S. withholding tax on certain distributions
attributable to a U.S. subsidiary's U.S. source earnings. As a
result, it proposes to arbitrarily change the 80/20 rules by
applying the test on a group-wide (as opposed to individual
company) basis. However, there is little evidence that these
rules have been manipulated on a broad scale in the past and we
do not believe such a drastic change is needed at this time.
Modifying 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.
The difficulty in this area is illustrated by the fact that
the Secretary of the Treasury has yet to comply with Code Sec.
6662(d)(2)(D), which requires thepositions 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 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.
Limiting Mark-to-Market Accounting
Certain trade receivables would no longer be eligible for
treatment under the mark-to-market accounting rules. Under
those rules, certain taxpayers who purchase and sell their own
trade receivables are exempt from the mark-to-market method of
accounting unless they elect to be included. If they do, those
taxpayers can currently write-off certain non-interest bearing
receivables, and account, note, and trade receivables unrelated
to the active business of a security dealer. There appear to be
no tax policy reasons for prohibiting taxpayers from
accelerating their bad debt deductions for these trade
receivables, only government revenue considerations.
Repealing Lower of Cost or Market Inventory Method
Certain taxpayers can currently determine their inventory
values by applying the lower of cost or market method, or by
writing down the cost of goods that are not salable at normal
prices, or not usable because of damage or other causes. The
Administration is proposing to repeal these options and force
taxpayers to recognize income from changing their method of
writing down unusable or non-salable goods somehow
``understates taxable income.'' We strongly disagree with this
unwarranted proposal. In addition, we believe that in the
least, the lower of cost or market method should continue to be
permissible when used for financial accounting purposes, to
avoid the complexity of maintaining separate inventory
accounting systems.
Modification of the Corporate-Owned Life Insurance (``COLI'') Rules
The Administration proposes to substantially change the
taxation of business-owned life insurance by disallowing a pro-
rata portion of a business' general deduction for interest
expense. Moreover, the Administration has proposed retroactive
application of the new tax to existing life insurance
contracts. This proposal should not be adopted.
Life insurance has long been used by businesses to protect
against financial loss caused by the death of key employees and
to finance the soaring cost of employee benefits, especially
post-retirement health benefits. Life insurance provides a
secure and stable source of financing for such employee
benefits, and it is particularly well suited to this purpose
because its long-term nature matches the correspondingly long-
term nature of the liabilities. The Administration's proposal
would have a devastating effect on employee benefit programs
and key-person protection by effectively taxing life insurance
contracts out of existence. Businesses should not be
discouraged from providing employee health benefits or from
seeking to protect themselves from key-person losses.
Moreover, the Administration's proposal would apply
retroactively to existing life insurance contracts that were
purchased by businesses in good faith, based on existing law.
There can be no question of abuse: business use of life
insurance is well known and the taxation of insurance contracts
has been settled for many years. In addition, Congress has
reviewed the taxation of business-owned life insurance in each
of the last two yearrved the existing taxation of business-
owned life insurance on the lives of employees. The
Administration's proposal represents the worst kind of
retroactive tax--it would not only cause the termination of
most or all existing contracts, but, would also have the effect
of taxing past earnings under those contracts.
Deferral of OID on Convertible Debt
The Administration has included a number of past proposals
aimed at financial instruments and the capital markets, which
were fully rejected during the last session of Congress. These
reintroduced proposals should again be rejected out of hand.
One proposal would defer deductions by corporate issuers for
interest accrued on convertible debt instruments with original
issue discount (``OID'') until interest is paid in cash. The
proposal would completely deny the corporation an interest
deduction unless the investors are paid in cash (e.g., no
deduction would be allowed if the investors convert their bonds
into stock). Investors in such instruments would still be
required to pay income tax currently on the accrued interest.
In effect, the proposal defers or denies an interest deduction
to the issuer, while requiring the holder to pay tax on the
interest currently.
The FEI opposes this proposal because it is contrary to
sound tax policy and symmetry that matches accrual of interest
income by holders of OID instruments with the ability of
issuers to deduct accrued interest. There is no justifiable
reason for treating the securities as debt for one side of the
transaction and as equity for the other side. There is also no
reason, economic or otherwise, to distinguish a settlement in
cash from a settlement in stock.
Moreover, the instruments in question are truly debt rather
than equity. Recent statistics show that over 70 percent of all
zero-coupon convertible debt instruments were retired with
cash, while only 30 percent of these instruments were
convertible to common stock. Re-characterizing these
instruments as equncorrect and will put American companies at a
distinct disadvantage to their foreign competitors, who are not
bound by such restrictions. These hybrid instruments and
convertible OID bond instruments have allowed many U.S.
companies to raise tens of billions of dollars of investment
capital used to stimulate the economy. Introducing this
imbalance and complexity into the tax code will discourage the
use of such instruments, limit capital raising options, and
increase borrowing costs for corporations.
Eliminating the ``DRD'' for Certain Preferred Stock
Another proposal would deny the dividend received deduction
(``DRD'') for certain types of preferred stock, which the
Administration believes are more like debt than equity.
Although concerned that dividend payments from such preferred
stock more closely resembles interest payments than dividends,
the proposal does not simultaneously propose to allow issuers
of such securities to take interest expense deductions on such
payments. Again, the Administration violates sound tax policy
and, in this proposal, would deny these instruments the tax
benefits of both equity and debt.
The FEI opposes this proposal as not being in the best
interests of either tax or 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.
Pro Rata Disallowance
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,he 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.
Positive Tax Proposals
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.
Accelerating Effective Date of 10/50 Company Change
Another proposal would accelerate the effective date of a
tax change made in the 1997 Tax Relief Act affecting foreign
joint ventures owned between ten and fifty percent by U.S.
parents (so-called ``10/50 Companies''). This change will allow
10/50 Companies to be treated just like controlled foreign
corporations by allowing ``look-through'' treatment for foreign
tax credit purposes for dividends from such joint ventures. The
1997 Act, however, did not make the change effective for such
dividends unless they were received after the year 2003 and,
even then, required two sets of rules to apply for dividends
from earnings and profits (``E&P'') generated before the year
2003, and dividends from E&P accumulated after the year 2002.
The Administration's proposal will, instead, apply the look-
through rules to all dividends received in tax years after
1997, no matter when the E&P constituting the makeup of the
dividend was accumulated.
This change will result in a tremendous reduction in
complexity and compliance burdens for U.S. multinationals doing
business overseas through foreign joint ventures. It will also
reduce the competitive bias against U.S. participation in such
ventures by placing U.S. companies on a much more level playing
field from a corporate tax standpoint. This proposal epitomizes
the favored policy goal of simplicity in the tax laws, and will
go a long way toward helping the U.S. economy by strengthening
the competitive position of U.S. based multinationals.
Netting of Underpayments and Overpayments
The proposal to requiyments and underpayments for purposes
of calculating interest (commonly referred to as ``global
interest netting'') is a large step forward towards fairness
and equity. A new interest rate would be added to Code Sec.
6621 that equalizes interest in cases of overlapping periods of
mutual indebtedness for tax periods not barred by an expiring
statute of limitations. In other words, no interest would
accrue on a deficiency to the extent that a taxpayer is owed a
refund in the same amount, during periods that both are
outstanding. We suggest that this change be made to apply to
all open tax years, consistent with Congress' long-stated
position on this issue.
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.
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 Michael W. Yackira, President, FPL Energy, Inc.
Mr. Chairman and members of the Committee, my name is
Michael W. Yackira, and I am the President of FPL Energy, Inc.
I thank you for the opportunity to submit this statement on
behalf of my company on the importance of extending the wind
energy production tax credit (PTC) for an additional five
years.
FPL Energy, an affiliate of Florida Power & Light Company
and subsidiary of FPL Group, Inc., has interests in over 700
megawatts of operating wind power facilities located in
California and Northern Ireland. This makes FPL Energy the
largest owner/producer of wind generated electric energy in the
United States. FPL Energy also has interests in more than 375
megawatts of utility scale wind power generation facilities
under construction or development in Iowa, Minnesota, Texas,
Oregon, and California. We are committed to clean energy
sources and believe that, among renewable energy technologies,
wind energy has the greatest future potential to economically
satisfy large scale demand across the largest geographic
regions in the United States.
I want to commend Representatives Bill Thomas and Bob
Matsui, and all of the cosponsors of H.R. 1401, and Senators
Charles Grassley and Kent Conrad, and all of the cosponsors of
S. 1459, for their leadership in supporting legislation to
extend the wind energy PTC until the year 2004. I also want to
commend President Clinton for including, and funding, a five-
year extension of the wind energy PTC in the Administration's
FY 1999 Budget.
I hope the Congress will take swift action to extend the
wind energy PTC by enacting the provisions of H.R. 1401--S.
1459 before the end of the second session.
I. Background of the Wind Energy PTC
The wind energy PTC, enacted as part of the Energy Policy
Act of 1992, provides an inflation-adjusted 1.5 cents/kilowatt-
hour credit for electricity produced with wind equipment for
the first ten years of a project's life. The credit is
available only if the wind energy equipment is located in the
United States and electricity is generated and sold. The credit
applies to electricity produced by a qualified wind energy
facility placed in service after December 3, 1993, and before
July 1, 1999. The credit is set to expire on July 1, 1999.
II. Why do we Need a Wind Energy PTC?
A. The wind energy PTC supports wind energy development and production.
The credit assists wind-generated energy in competing with fossil
fuel-generated power. In the 1980s, electricity generated with wind
could cost as much as 25 cents/kilowatt-hour. Since that time, the
efficiency of wind energy production has increased by over 80% to the
current cost of 4.5 cents/kilowatt hour. The 1.5 cent/kilowatt-hour
credit enables the industry to compete with other generating sources
being sold at 3 cents/kilowatt-hour. The extension of the credit will
enable the industry to continue to develop and improve its technology
so it will be able to fully stand on its own in only a few short years.
Indeed, experts predict the cost of wind equipment alone can be reduced
by another 40% from current levels. This is exactly what Congress
envisioned when it enacted the wind energy PTC, the development and
improvement of wind energy technology.
B. Wind power will play an important role in a deregulated electrical
market.
The electrical generation market is going through radical changes
as a result of efforts to restructure the industry at both the Federal
and State levels. If the wind energy PTC is extended, renewable
energies such as wind power are certain to play an important role in a
deregulated electrical generation market. Wind power alone has the
potential to generate power to as many as 10 million homes by the end
of the next decade. Extending the credit will help the wind energy
industry secure its position in the deregulated marketplace as a fully
competitive, renewable source of electricity.
C. Wind power contributes to the reduction of greenhouse emissions.
Wind-generated electricity is an environmentally-friendly form of
renewable energy that produces no greenhouse gas emissions. ``Clean''
energy sources such as wind power are particularly helpful in reducing
greenhouse gas emissions. The reduction of greenhouse gas emissions in
the United States will necessitate the promotion of clean,
environmentally-friendly sources of renewable energy such as wind
energy. The extension of the wind energy PTC will assure the continued
availability of wind power as a clean, renewable energy source.
D. Wind power has significant economic growth potential.
1. Domestic.--Wind energy has the potential to play a meaningful
role in meeting the growing electricity demand in the United States. As
stated above, with the appropriate commitment of resources to wind
energy projects, wind power could generate power to as many as 10
million homes by the end of the next decade. There currently are a
number of wind power projects operating across the county. These
projects are currently generating 1,761 megawatts of wind power in the
following states: New York, Minnesota, Iowa, Texas, California, Hawaii
and Vermont.
There also are a number of new wind projects currently under
development in the United States. These new projects will generate 670
megawatts of wind power in the following states: Texas, Colorado,
Minnesota, Iowa, Wyoming and California.
The domestic wind energy market has great potential for future
growth because, as the sophistication of wind energy technology
continues to improve, new geographic regions in the United States
become suitable for wind energy production. The top twenty states for
future wind energy potential include:
1. North Dakota
2. Texas
3. Kansas
4. South Dakota
5. Montana
6. Nebraska
7. Wyoming
8. Oklahoma
9. Minnesota
10. Iowa
11. Colorado
12. New Mexico
13. Idaho
14. Michigan
15. New York
16. Illinois
17. California
18. Wisconsin
19. Maine
20. Missouri \1\
2. International.--The global wind energy market has been growing
at a remarkable rate over the last several years and is the world's
fastest growing energy technology. The growth of the market offers
significant export opportunities for United States wind turbine and
component manufacturers. The World Energy Council has estimated that
new wind capacity worldwide will amount to $150 to $400 billion worth
of new business over the next twenty years. Experts estimate that as
many as 157,000 new jobs could be created if United States wind energy
equipment manufacturers are able to capture just 25% of the global wind
equipment market over the next ten years. Only by supporting its
domestic wind energy production through the extension of the wind
energy PTC can the United States hope to develop the technology and
capability to effectively compete in this rapidly growing international
market.
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\1\ Source: An Assessment of the Available Windy Land Area and Wind
Energy Potential in the Contiguous United States, Pacific Northwest
Laboratory, 1991.
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E. The immediate extension of the wind energy PTC is critical.
Since the wind energy PTC is a production credit available only for
energy actually produced from new facilities, the credit is
inextricably tied to the financing and development of new facilities.
The financing and permitting requirements for a new wind facility often
require up to two to three or more years of lead time. With the credit
due to expire in less than a year and a half (July 1999), wind energy
developers and investors are concerned about the cost impact of halting
and restarting new wind development. Moreover, if the credit is not
extended this year, it is extremely unlikely Congress will be able to
address an extension of the wind energy PTC before its expiration in
1999. The immediate extension of the wind energy PTC is therefore
critical to the continued development of the wind energy market.
III. Conclusion
Extending the wind energy PTC for an additional five years
is critical for a number of reasons. The credit enables wind-
generated energy to compete with fossil fuel-generated power,
thus promoting the development of an industry that has the
potential to meet the electricity demands of millions of homes
across the United States. If the wind energy PTC is extended,
wind energy is certain to be an important form of renewable
energy in a deregulated electrical market, and also is an
environmentally-friendly energy source that could aid in the
reduction of greenhouse gas emissions. The economic
opportunities of the wind energy market are significant, both
domestically and internationally. As such, I recommend that
Congress act quickly to extend the wind energy PTC until the
year 2004 so that the industry can continue to develop this
important renewable energy resource.
Statement of Hybrid Branch Coalition \1\
Overview
The Hybrid Branch Coalition (the ``Coalition'') is composed
of U.S. companies representing a broad cross-section of
industries that are competing in the global marketplace. The
Coalition opposes the proposal in the President's budget that
would grant Treasury broad regulatory authority to ``address
tax avoidance through the use of hybrids.'' To a large extent,
the President's proposal requests from Congress the legal
authority needed to issue regulations implementing two notices
issued by the IRS, one in December of 1997 and the other in
January of 1998. In addition, the proposal would give the IRS
legislative authority to issue regulations well beyond the
scope of the two notices.
---------------------------------------------------------------------------
\1\ This testimony was prepared by Arthur Andersen on behalf of the
Hybrid Branch Coalition.
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The two notices describe in very general terms the content
of regulations that the IRS plans to issue, and contain a few
examples illustrating the intended application of those
regulations. The notices provide that the regulations are
intended to apply to certain transactions retroactively to the
date the notices were issued. The Coalition strongly believes
that the IRS has no current authority to issue these
retroactive regulations, and opposes any request for
legislation that would allow retroactive effect.
More fundamentally, however, the Coalition believes that
the regulations described in the notices would be misguided and
out of step with traditional and long-standing U.S. tax
principles. The regulations would also inhibit a wide range of
legitimate business transactions in which the only perceived
abuse is a reduction of foreign taxes, a result that U.S. tax
policy has historically favored. The Coalition therefore
opposes any grant of regulatory authority along the lines
proposed. Instead, Congress should enact legislation codifying
the current rules.
Introduction
In Notice 98-11 and Notice 98-5, the Internal Revenue
Service and the Treasury Department announced their intention
to issue retroactive regulations that would reverse long-
standing fundamental principles underlying the U.S. taxation of
international transactions. These notices are nothing less than
an attempt to add new provisions to the Internal Revenue Code--
a task that is not within the regulatory purview of either
agency. According to the notices, the regulations will seek to
define ``appropriate tax results'' when transactions involve a
hybrid entity (an entity classified in one jurisdiction as a
corporation and in another as a partnership or branch) or a
hybrid security (an instrument treated as debt in one
jurisdiction and as equity in another).
Following the issuance of the notices, the executive branch
sought statutory authority to support its retroactive
initiatives. The Administration's fiscal 1999 Budget Proposal
asks Congress to give the IRS regulatory authority to determine
unilaterally the ``appropriate tax results with respect to
hybrid transactions.''
This standard is far too vague to be worthy of
Congressional endorsement. In its analysis of the President's
request for regulatory authority in this area prepared the in
conjunction with this hearing, the Joint Committee on Taxation
(``JCT'') stated that a broad grant of regulatory authority to
specify the tax consequences of hybrid transactions may not be
appropriate.\2\ Furthermore, said the JCT, broad regulatory
authority without specific parameters could severely impact
transactions entered into in the ordinary course of business
operations. We agree with both conclusions.
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\2\ Joint Committee on Taxation, Description of Revenue Provisions
Contained in the President's Fiscal Year 1999 Budget Proposal, JCS-4-
98, February 24, 1998, at 197.
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The regulations described by the notices, if promulgated,
would drastically depart from long-accepted principles
underlying the U.S. taxation of taxpayers operating overseas.
Notice 98-11 seeks to impose current U.S. tax on transactions
where the benefit derived by the taxpayer is the reduction of
its foreign tax liability--a policy previously encouraged by
Treasury because the resulting reduced foreign tax credit
increases the ultimate U.S. tax. This result would be reached
by giving tax effect to payments between branches or divisions
of a single taxpayer, an approach that until now has been
almost unheard of in U.S. tax policy. Notice 98-5 seeks to
impose a nebulous ``economic return'' prerequisite for claiming
foreign tax credits, although one searches the Code in vain for
any such requirement.
One of the responsibilities of the IRS and Treasury is to
provide guidance to U.S. taxpayers. These notices provide no
guidance. Rather, they undermine previously settled guidance
and introduce substantial and needless uncertainty into
international taxation. If the government is concerned about
abusive transactions, there are a number of anti-abuse rules
already in the Code that have so far provided ample ammunition
to attack such arrangements. If Congress believes additional
anti-abuse provisions are needed, they should be carefully and
narrowly drafted to clearly distinguish the targeted abuse from
normal business transactions. The proposed rules are extremely
vague and go farther than anti-abuse; they upset the balance,
stability, and certainty in tax matters that U.S. companies
must have to remain competitive in the global marketplace.
In this testimony, we will review the genesis of the
notices--the so-called ``check-the-box'' regulations that
facilitated the use of hybrids in the international setting. We
will show that the Treasury adopted these regulations only
after careful thought, taxpayer input, and full consideration
of the U.S. tax policy concerns that the regulations might
raise. We will then describe how the notices not only reverse
substantial portions of Treasury's own ``check the box''
regulation but also fundamentally alter bedrock assumptions on
which the U.S. international tax regime rests.
The Long History of Hybrids
Hybrids are not new to U.S. tax law. Regulations issued in
1960 established a four-factor test for determining whether an
entity is a partnership or a corporation for U.S. tax purposes;
these factors were drawn from a 1954 decision of the Court of
Appeals for the Ninth Circuit.\3\ The long-standing position of
the IRS was (and is) that the classification of a foreign
entity as a corporation, partnership, or branch must be
determined under U.S. tax principles, not under foreign law.
---------------------------------------------------------------------------
\3\ United States v. Kintner, 216 F.2d 418 (9th Cir. 1954).
---------------------------------------------------------------------------
The application of these principles is illustrated in a
1977 revenue ruling. Rev. Rul. 77-214 \4\ examined the
treatment of a German Gesellschaft mit beschrankte Haftung
(``GmbH''), a business entity that is governed by flexible
provisions of German law. The ruling examined the legal
relationships established by the corporate charter of the GmbH
at issue and concluded that the entity was a corporation for
U.S. tax purposes because it met the regulatory tests for
corporate status.
---------------------------------------------------------------------------
\4\ 1977-1 C.B. 408.
---------------------------------------------------------------------------
The clear implication of the ruling is that the GmbH would
have been a partnership for U.S. purposes had it failed those
tests, even though its status as a corporation (Gesellschaft)
under German law would be unchanged. (Rev. Rul. 93-4 \5\
subsequently modified the application of the four-factor test
in this situation, but left unchanged the general premise that
the GmbH could be either a corporation or a partnership for
U.S. tax purposes.)
---------------------------------------------------------------------------
\5\ 1993-1 C.B. 225.
---------------------------------------------------------------------------
Many private letter rulings issued during the years before
1995 confirm that foreign hybrids were possible and even
common. Authority also existed to support the proposition that
a single-owner entity could be disregarded for tax purposes
under the four-factor test.\6\
---------------------------------------------------------------------------
\6\ LTR 8533003 (GCM 39395) and LTR 8737100. See also Lombard
Trustees, Ltd. v. Commissioner, 136 F.2d 22 (9th Cir. 1943) and Hynes
v. Commissioner, 74 T.C. 1266, 1279-81 (1980).
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Check-the-Box: Tax Simplification, Not Tax Avoidance
As the corporate and partnership laws of the various U.S.
states and of foreign countries evolved, the four-factor test
grew less and less relevant. Partnerships and other
unincorporated organizations were allowed to have
characteristics traditionally associated only with corporations
(for example, limited liability). For these reasons, Treasury
ultimately concluded that an elective regime would add
certainty to entity classifications and eliminate the need for
artificial provisions in organizational documents that bore
little relevance to the purpose of the four-factor test as it
was originally conceived.
The genesis of the check-the-box regulations was Notice 95-
14, which was issued on March 29, 1995. This notice invited
public comments on hybrid transactions, an early indication
that the government was fully aware of the potential effects of
hybrids on U.S. tax. The notice explained that new entity
classification regulations were being considered because of the
continuing erosion of non-tax, legal distinctions between
partnerships and corporations.
After review and consideration of the public comments
submitted in response to this request, the IRS and Treasury
issued a notice of proposed rulemaking on May 13, 1996. The
proposed regulations adopted an elective entity classification
regime in both the domestic and international context. Certain
entities, both foreign and domestic, were deemed to be per se
corporations; these were entities that in the government's view
could never have qualified as partnerships or branches under
the four-factor test. All other entities were eligible to elect
their U.S. tax classification.
The IRS made a second request for public comments on the
proposed regulations. After considering the comments received,
both in writing and at a public hearing, Treasury issued final
entity classification regulations on December 17, 1996,
establishing the new simplified regime for classifying both
foreign and domestic entities.
It is clear from all of these pronouncements that Treasury
and the IRS were aware that the new regulations would
facilitate the creation of hybrid entities. After thoughtful
consideration of the issues raised by hybrids in the
international context, the final regulations allowed taxpayers
to choose hybrid treatment for any eligible entity. The
preamble to the final regulations noted that ``future
monitoring of partnerships'' might be appropriate, but
otherwise was silent on hybrids.
There is a good reason why the check-the-box regulations
did not create special rules for hybrid entities in the foreign
context. Both the entity classification rules and the anti-
deferral rules were highly complex prior to the issuance of the
regulations. Addressing hybrid issues would have significantly
increased complexity in both areas without a commensurate
benefit to the government. Simplification was felt to be the
more desirable goal. Congressional efforts to simplify the
anti-deferral provisions have continued with the repeal of the
tax on excess passive assets held offshore and the elimination
of the overlap between the passive foreign investment company
rules and the controlled foreign corporation rules.
In contrast, the notices and the legislation requested in
the budget proposal would add tremendous complexity to the
subpart F and foreign tax credit rules. In effect, hybrid
arrangements would be subject to a special set of rules under
those provisions, but would continue to be treated under old
rules for all other purposes of the Code. Nothing in the
pronouncements issued by the government to date justifies this
heavy extra burden at a time when simplification of the Code is
a top priority of both the legislative and administrative
branches.
Notice 98-11
Subpart F contains provisions that impose current U.S.
income tax on United States persons who control a foreign
corporation. If the subpart F requirements are met, the U.S.
shareholders are taxed on their proportionate shares of the
``subpart F'' income earned by the controlled foreign
corporation (``CFC''). Subpart F income is composed of many
elements, but two principal categories are (1) foreign personal
holding company income--passive income such as dividends,
interest, rents, and royalties, and (2) foreign base company
income--certain kinds of active income earned outside the CFC's
country of incorporation. The subpart F provisions are intended
to prevent U.S. taxpayers from deferring tax on ``portable''
income by moving it to a low-taxed foreign jurisdiction.
Other kinds of active business income are not taxed to the
U.S. shareholder until the CFC actually distributes the
earnings as a dividend. Such income is normally subject to tax
in the foreign country where it is earned; the dividend to the
U.S. shareholder carries with it a right to a credit for the
foreign taxes paid. The United States collects any tax still
payable on the dividend after the allowance of the credit.
Thus, a lower foreign tax rate results in more money actually
paid to the U.S. treasury.
Notice 98-11 addresses situations where a CFC reduces its
foreign income tax liability by making tax-deductible payments
(interest, rents, or royalties) to a related party in another
country. The income received by the related party is subject to
a low tax rate in its home country. If the related party is
also a CFC, this passive income would normally be subpart F
income currently taxed to the U.S. shareholder. However, if the
recipient is treated as a branch of the paying CFC, it will be
ignored for U.S. tax purposes, and the transaction (loan,
license, or lease) will also be ignored. No subpart F income
would result, because for U.S. tax purposes the paying CFC is
still the owner of the funds. This result is consistent with
the U.S. tax result with respect to the first CFC's income had
it never entered into the structure to reduce foreign taxes.
Notice 98-11 requires that the disregarded entity be
treated as a separate corporation when determining whether the
payment is subpart F income. Under this approach, the
transaction just described would create such income, subjecting
the U.S. shareholder to immediate taxation. The notice applies
similar treatment to a payment made by the CFC to a branch of a
brother-sister CFC that (absent the notice) would be excluded
from subpart F income by an exception for payments to CFCs
organized in the same country as the paying CFC.
Notice 98-11 cites no authority for these conclusions other
than ``the policies and rules of subpart F.'' This is not
surprising, because no authority appears to exist.
Nevertheless, the notice adds that similar transactions
involving partnerships and trusts may be subject to rules of
this sort in separate regulations.
Notice 98-11 Overturns the Basic Premise that Branch Transactions are
Ignored
The inherent problem with Notice 98-11 and the legislation
requested in the budget proposal is that they seek to overturn
the fundamental premise that transactions between a branch and
its home office generally are ignored for U.S. income tax
purposes. The check-the-box regulations unambiguously state
that if an entity is disregarded, its activities will be
treated in the same manner as those of a sole proprietorship,
branch, or division of its owner. This long-standing premise
has recently been reaffirmed in several related areas,
including the new withholding tax regulations, the transfer
pricing regulations, the global dealing regulations, notional
principal contract rules, and interest allocation rules. There
is no reason to disturb this principle, and every reason to
retain it.
The U.S. tax system is founded on the concept of income--
that is, an accretion in wealth. The Internal Revenue Code
imposes tax on the income of ``persons,'' a term that is
clearly defined and that does not include a branch or division.
When a single taxable entity transfers money from one part of
the entity to another, no wealth is created and no income
arises. As early as 1920, the United States Supreme Court \7\
announced this principle in affirming the separate taxable
identity of a corporation and its shareholders:
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\7\ Eisner v. Macomber, 252 U.S. 189 (1920).
---------------------------------------------------------------------------
``Did we regard corporation and stockholders as altogether
identical, there would be no income except as the corporation
acquired it .... [I]f there were entire identity between [the
shareholders] and the company they could not be regarded as
receiving anything from it, any more than if one's money were
to be removed from one pocket to another.''
This reasoning applies fully to transactions between
branches of a single corporation. Absent a limited exception
for currency transactions, income is not created when money is
moved from one branch to another.
There are other objections to the abandonment of this
cardinal tenet of U.S. tax law. First, the proposed rule would
be limited to determinations under subpart F. The treatment of
such a payment under all other provisions of the Code would
remain the same, raising the possibility of inconsistent tax
treatment of the same transaction. Second, the proposed rule
would run counter to decades of established precedent and
practice. Years of uncertainty could ensue while the limits and
effects of the proposed rule were established through
examinations, rulings, and court decisions. Finally, the
subpart F rules already contain a carefully crafted, limited
branch rule enacted by Congress to deal with a narrowly
perceived problem. The presence of this rule argues strongly
that Congress did not intend to create any other branch rules.
If a new branch rule is required, it is for Congress to create
it.
Hybrid Branch Transactions Reduce Foreign Taxes on Offshore Income
The principal effect (and, in many cases, the principal
purpose) of the transactions described in Notice 98-11, and
others like them, is a reduction of foreign income taxes.
Because such taxes are ordinarily creditable against U.S.
income taxes, a reduction of foreign tax means an increase in
U.S. taxes. Therefore, it has been the long-standing policy of
the U.S. government to encourage taxpayers to reduce their
foreign tax liability in order to reduce foreign tax credits
and increase U.S. tax receipts.
For example, the foreign tax credit regulations
affirmatively require taxpayers to interpret foreign tax law in
a way that reduces foreign tax liability, and to exhaust
available remedies for credits or refunds, in order to qualify
for a foreign tax credit. In addition, the legislative history
of the Tax Reform Act of 1986 (``TRA 86'') confirms that
Congress specifically encourages companies to make payments
that are deductible under foreign law. Under TRA 86, interest,
rent, and royalty payments qualify for the taxpayer-favorable
foreign tax credit ``look-through'' rules applicable to
dividends. Congress reasoned that since interest, rents, and
royalties were generally deductible under foreign law, while
dividends were not, these payments would reduce the local
country tax liability. Consequently, less foreign tax would be
available to reduce the taxpayer's ultimate U.S. tax liability.
In contrast to this sound and long-standing policy, Notice
98-11 penalizes taxpayers for tax planning strategies that
allow significant reductions in foreign tax. The U.S.
government should not be concerned over reductions in the tax
base of a foreign country; indeed, as discussed above, it
should welcome such reductions and the corresponding increases
in U.S. tax payments. The Code should not appoint the IRS as
the ``tax police'' to ensure that U.S. companies pay the
highest possible tax to other countries.
Good Faith Reliance Should Not Be Penalized
As discussed above, the check-the-box regulations were
adopted after a long period of deliberation, the receipt of
public comments, and a clear acknowledgement of the issues
presented by hybrids. The final regulations represent a
considered policy decision that the benefits of simplification
outweighed any possible difficulties presented by hybrids, and
a confidence that abuses, if any, could be adequately dealt
with.
Notice 98-11 upsets this balanced decision. If the Treasury
were to issue far-reaching regulations limiting--or even
preventing--the use of hybrid arrangements to reduce foreign
taxes after the issuance of the final check-the-box
regulations, taxpayers that relied on the regulations in good
faith (and incurred substantial costs in often irreversible
restructuring) would be severely penalized. This is unfair.
Taxpayers acted in response to the regulations as they should
have been expected to act. There is no way that taxpayers could
have reasonably foreseen that ``the policies of subpart F''
could be invoked to override long-standing principles of law in
situations where the chief benefit of a transaction is the
reduction of foreign tax.
Congress, Not the Treasury, Should Make a Decision of this Magnitude
The Constitution assigns to Congress the power to enact
legislation. The Treasury's responsibility is to interpret,
administer, and enforce these laws under statutorily prescribed
procedures. The proposed regulations would make significant
changes in fundamental principles of U.S. tax law. Changes of
this magnitude are beyond the scope of administrative
``interpretation.'' If Congress is concerned over the effect of
hybrids on the policies of subpart F, it should speak to those
concerns itself.
JCT is Concerned about the Administration's Proposal To Grant Treasury
Regulatory Authority
Congressional staff have already indicated that they share
in the concerns we have presented. In its description of the
revenue provisions of the Administration's proposal on hybrid
entities, the JCT observed that a grant of broad regulatory
authority to prescribe the tax consequences of hybrid
transactions may not be appropriate. The JCT stated that the
lack of definition of the scope of such rules could have a
profound impact on business operations in the global market-
place: ``Granting broad authority, without further enumerating
the reach of the authority, could create an environment of
uncertainty that has the potential for stifling legitimate
business transactions.''
The JCT stated that additional information would be
required in order to evaluate the scope and content of the
regulations. Insufficient information also prevented the JCT
from estimating the revenue to be raised by the
Administration's proposal. Finally, the JCT stated that it was
not clear how the Administration's proposal on hybrid
arrangements would interact with Notice 98-11.
These IRS Actions Undermine the Self-Assessment System
Fair and impartial administration of the tax law is the
cornerstone of a self-assessment system. Taxpayers are required
to follow, and therefore entitled to rely on, interpretive
guidance published by the Internal Revenue Service and the
Treasury Department. If the rules and regulations that give
this guidance are not supported by statutory authority, or are
not issued in a manner that allows for the execution of
ordinary business transactions, then respect for these rules is
eroded, and so is voluntary compliance.
For more than a decade, Congress has worked to improve and
protect taxpayer's rights. The first Taxpayer Bill of Rights
was passed by Congress in 1988. The bill provided taxpayers
with rights and procedures that must be observed in dealing
with the IRS. The Taxpayer Bill of Rights 2 followed in 1996,
which established the Office of Taxpayer Advocate in order to
ensure that taxpayer rights were receiving attention at the
highest level. The Taxpayer Advocate reports directly to the
Deputy Commissioner of the IRS.
Yet in 1997, the IRS Restructuring Commission still found
``serious deficiencies in governance, management, performance
measures, training, and culture'' at the IRS.\8\ The Commission
recommended the appointment of an independent board of
directors to oversee the IRS and ensure implementation of ``the
fundamental reforms necessary to make the IRS a respected,
stable institution that everyday Americans find to be fair and
efficient.'' \9\ In subsequent hearings conducted by the Senate
Finance Committee, Treasury Secretary Rubin agreed with the
findings of the Commission and acknowledged the need for these
reforms.\10\
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\8\ National Commission on Restructuring the Internal Revenue
Service, A Vision for a New IRS, June 25, 1997, at 11.
\9\ Id. at 1.
\10\ Unofficial Transcript of Senate Finance Committee Hearing on
IRS Restructuring on January 28, 1998, Tax Notes Today, 98 TNT 24-61,
para. 196.
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Despite these continuing efforts to improve the fairness of
the system, the IRS and Treasury have once again failed in
their responsibility to administer our tax laws in an objective
and equitable manner. As we have outlined, Notice 98-11 exceeds
the authority granted to the IRS and Treasury by Congress,
seeks to overturn fundamental U.S. tax principles, and proposes
to do so without proper regard for established regulatory
processes.
Notice 98-5 Suffers from the Same Infirmities as Those of Notice 98-11
Notice 98-11 was issued shortly after Notice 98-5, which
deals with the impact of hybrid arrangements on foreign tax
credits. Although different provisions of the Code are
involved, the two notices are similar in their overall lack of
authority and their disregard of long-standing U.S. tax
policies.
Notice 98-5 states that the IRS and Treasury will seek to
deny U.S. credits for otherwise creditable foreign income taxes
where ``the expected economic profit is insubstantial compared
to the foreign tax credits generated.'' The notice then gives
five examples of arrangements where this result is believed to
occur. However, the applicability of the notice beyond these
five enumerated transactions is vague at best, and the notice
purports to give the IRS extremely wide latitude in deciding on
the amount of expected economic profit and how it compares to
the foreign tax credits.
Because of this vagueness, Notice 98-5 provides little real
guidance and generates enormous uncertainty. The notice could
be read, for example, to disallow foreign tax credits simply
because of differences between the computation of the tax base
under U.S. law and foreign law. This would represent a
significant departure from long-established U.S. tax
principles.
Because the U.S. subjects to tax the worldwide income of
its citizens and residents, the foreign tax credit is a vital
mechanism for ensuring that American businesses do not pay
double tax and remain competitive in the global marketplace.
For this reason, Treasury should not be granted broad
regulatory authority without a clear delineation of the scope
and purpose of the regulations to be promulgated. Congress must
ensure that Treasury regulations will be consistent with, and
limited to, Congressional intent behind the statute. The
Treasury and IRS already have at their disposal tools
sufficient to combat foreign tax credit abuses, including the
recently enacted economic ownership requirements, along with
the judicially developed sham transaction doctrine and
substance-over-form principles.
Relief Requested
(1) Congress should reject the President's budget proposal
to grant to the IRS broad regulatory authority to interfere in
legitimate business transactions where the perceived abuse is
the reduction of foreign taxes.
(2) Congress should enact legislation codifying the
application of the final check-the-box regulations to single-
member entities and clarifying that intra-company transactions
do not generate income that is taxed to U.S. shareholders.
(3) Congress should enact a moratorium on the issuance of
regulations under Notice 98-5, with a postponement of the
effective date of that notice, until Treasury demonstrates to
Congress the need for regulatory action and provides a specific
regulatory proposal.
Statement of INMC Mortgage Holdings, Inc.
INMC Mortgage Holdings, Inc. appreciates the opportunity to
respond to the Chairman's request for testimony to the
Committee on Ways and Means on the revenue-raising provisions
of the Clinton Administration's FY 1999 budget plan. We are
testifying to express our strong opposition to the
Administration's proposal to restrict businesses indirectly
conducted by real estate investment trusts (REITs), in
particular with respect to the portion of the proposal dealing
with preferred stock subsidiaries.
Mortgage Conduit Business
INMC Mortgage Holdings, Inc. (``INMC''), based in Pasadena,
California, is the largest publicly traded mortgage REIT \1\ in
terms of stock market capitalization. INMC is a diversified
lending company with a focus on residential mortgage products,
and is active in residential and commercial construction
lending, manufactured housing lending, and home improvement
lending. INMC is a NYSE-traded company with $6 billion in
assets and 900 employees.
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\1\ A mortgage REIT invests primarily in debt secured by mortgages
on real estate assets. An equity REIT, by contrast, invests primarily
in equity or ownership interests directly in real estate assets.
---------------------------------------------------------------------------
As one of its most important business activities, INMC and
its affiliate, IndyMac, Inc., operate as one of only a small
number of private ``mortgage conduits'' in this country. While
small in number, mortgage conduits play a vital financing role
in America's residential housing market, essentially acting as
the intermediary between the originator of a mortgage loan and
the ultimate investor in mortgage-backed securities (MBSs). The
conduit first purchases mortgage loans made by financial
institutions, mortgage bankers, mortgage brokers, and other
mortgage originators to homebuyers and others. When a conduit
has acquired sufficient individual loans to serve as collateral
for a loan pool, it creates an MBS or a series of MBSs, which
then is sold to investors through underwriters and investment
bankers. After securitization, the conduit acts as a servicer
of the loans held as collateral for the MBSs, meaning that the
conduit collects the principal and interest payments on the
underlying mortgage loans and remits them to the trustee for
the MBS holders.
Perhaps the best-known mortgage conduits are the
government-owned Government National Mortgage Association
(Ginnie Mae) and the government-sponsored Fannie Mae and
Freddie Mac. These government sponsored enterprises (GSEs) act
as conduits for loans meeting specified guidelines that pertain
to loan amount, product type, and underwriting standards, known
as ``conforming'' mortgage loans. Private conduits such as INMC
play a similar role for ``nonconforming'' mortgage loans that
do not meet GSE selection criteria. Mortgage loans purchased by
INMC include nonconforming and jumbo residential loans, sub-
prime loans, manufacturing housing loans, and other mortgage-
related assets. Many of INMC's borrowers are low-income and
minority consumers who are not eligible for programs currently
offered by the GSEs or Ginnie Mae. In sum, INMC and its
affiliate IndyMac, through their conduit activities, play a
critical role in providing liquidity to our nation's housing
markets.
INMC's Business Structure
INMC's mortgage conduit business is conducted primarily
through two entities: INMC itself (hereafter referred to as
``IndyMac REIT'') and its taxable affiliate, IndyMac, Inc.
(hereafter referred to as ``IndyMac Operating''). IndyMac REIT
owns all of the preferred stock and 99 percent of the economic
interest in IndyMac Operating, a C corporation. IndyMac
Operating is thus a ``preferred stock'' affiliate of INMC that
would be adversely impacted by one part of the Administration's
REIT proposals.
IndyMac REIT is the arm of the conduit business that
purchases mortgage loans. IndyMac Operating is the arm of INMC
that securitizes and services the loans acquired by IndyMac
REIT and others. In order to control the interest rate risks
associated with managing a pipeline of loans held for sale,
IndyMac Operating also conducts hedging activities. In
addition, IndyMac Operating performs servicing for all loans
and MBSs owned or issued by it. IndyMac Operating is liable for
corporate income taxes on its net income, which is derived
primarily from gains on the sale of mortgage loans and MBSs and
servicing fee income.
Use of this ``preferred stock'' structure for conducting
business is in part a product of the tax law. IndyMac REIT, by
itself, effectively is unable to securitize its loans through
the most efficient structure, a real estate mortgage investment
conduit (``REMIC''). This is because the issuance of REMICs by
a REIT in effect would be treated as a sale for tax purposes;
such treatment in turn would expose the REIT to a 100-percent
prohibited tax on ``dealer activity.'' In like fashion, IndyMac
Operating would be unable to deduct certain hedging losses
related to its loans held for sale. Similarly, we note that the
ability to service a loan is critical to owning a loan, and
that IndyMac REIT would be subject to strict and unworkable
limits on engaging in mortgage servicing activities. Such
activities would generate nonqualifying fee income under the
95-percent REIT gross income test, \2\ potentially
disqualifying IndyMac REIT from its status as a REIT. It is
critical to keep in mind that all net income derived by IndyMac
Operating from its business activities is subject to two tiers
of taxation at state and federal levels.
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\2\ The 95-percent test generally limits REITS to receiving income
that qualifies as rents from real property and, to a lesser degree,
portfolio income.
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In business terms, INMC's use of the preferred stock
structure aligns its ``core competencies,'' which has allowed
it to compete in the mortgage conduit business. This alignment
makes available the benefits of centralized management, lowers
costs, provides operating efficiencies, and allows INMC to
respond to market changes, such as trends toward
securitization. It is important to note that INMC's structure
does not involve the type of ``stapled REIT'' arrangement that
has given rise to other legislative proposals advanced by
Treasury.
Impact of Administration Proposal on INMC
The Administration's FY 1999 budget includes a proposal
aimed at eliminating use of the preferred stock subsidiary
structure. Specifically, the proposal would amend section
856(c)(5)(B) of the Internal Revenue Code to prohibit REITs
from holding stock possessing more than 10 percent of the vote
or value of all classes of stock of a corporation.
The Administration's FY 1999 budget proposal would force
IndyMac REIT to reduce, to below 10 percent of value, its
ownership of IndyMac Operating stock. This effectively would
force INMC to end IndyMac REIT's preferred stock affiliation
with IndyMac Operating.
The proposal therefore would force INMC to consider less
efficient structures, such as spinning off IndyMac Operating as
a wholly separate entity. Conducting a mortgage conduit
business through two unrelated companies would eliminate the
benefits and efficiencies of centralized management. This split
also potentially would lead to conflicts, as one company would
be responsible for servicing loans on behalf of an unrelated
MBS trustee that may have different interests. The result would
be lower returns for INMC's investors and higher borrowing
costs for the homeowners for whom INMC's mortgage conduit
business has meant lower mortgage interest rates.
The Treasury proposal also would jeopardize INMC's ability
to compete in the mortgage business, which has hinged on its
ability to align the two arms of its mortgage conduit business.
In all likelihood, mortgage originators and other parties
transacting in the mortgage conduit business would curtail
significantly their business with INMC and other mortgage
REITs. Moreover, partnerships would continue to be able to
perform these activities and be subject to only one level of
tax, giving them a significant competitive advantage. If the
proposal were to be adopted, INMC might not be able to serve
those borrowers ineligible for programs offered by the GSEs or
Ginnie Mae.
We also should note that the ``grandfather relief''
proposed by Treasury would not apply to INMC.\3\ Specifically,
INMC would not be able to meet the requirement that IndyMac
Operating could not acquire ``substantial new assets'' after
the specified date. While IndyMac Operating is not an acquirer
of companies or businesses, its securitization of an ever-
rotating pool of loans would appear to violate this test. If
the proposal were to be adopted, one alternative grandfather
test might involve a cap on total assets.
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\3\ The proposal would be effective with respect to stock acquired
on or after the date of first committee action. Stock acquired before
such date would become subject to the proposal when the corporation in
which stock is owned engages in a trade or business in which it does
not engage on the date of first committee action or if the corporation
acquires substantial new assets on or after such date.
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Treasury's Flawed Rationale
Treasury's ``Green Book'' description of the
Administration's FY 1999 budget states its reasoning behind the
proposal. Treasury argues that a preferred stock subsidiary of
a REIT often is significantly leveraged with debt held by the
REIT; this generates interest deductions intended to eliminate,
or significantly reduce, the taxable income of the affiliate
corporation. Treasury also argues that the operating income of
the corporation effectively is ``transmuted'' into interest
paid to the REIT, and thus is not subject to corporate-level
tax.
INMC takes exception to these arguments. First, we believe
the income-shifting argument is significantly overstated. The
REIT rules strictly regulate the types and amount of income
that may be earned by a REIT. INMC and others in the REIT
industry are strongly discouraged from taking aggressive tax
positions, given the severity of potential tax penalties,
including loss of REIT status and the 100-percent prohibited
transactions tax. Moreover, a recent Price Waterhouse LLP study
found no evidence of transfer pricing abuse in situations where
a REIT is ``paired'' with a management company, a situation
similar to the combined activities of IndyMac REIT and IndyMac
Operating. We believe Treasury should offer this reason for a
legislative change only if it can document evidence, rather
than perception, of abuse.
Second, we reject Treasury's inference that preferred stock
subsidiaries like IndyMac Operating are in existence primarily
to be loaded up with debt. IndyMac Operating had pre-tax income
of $32.7 million and $31.6 million in 1997 and 1996,
respectively; tax liability of $13.9 million and $13.5 million
in 1997 and 1996, respectively; and net income of $18.8 million
and $18.1 million in 1997 and 1996, respectively. This
aggregated to a return on equity of 34.4 percent and 36.4
percent in 1997 and 1996, respectively.
Moreover, IndyMac Operating is careful to use market-based
rates for intercompany debt, and the vast majority of financing
for IndyMac Operating comes from unrelated third-party lenders.
INMC does not engage in earnings stripping because to do so
would jeopardize INMC's status as a REIT.
Policy Objectives Underlying REITs
The Administration proposal is fundamentally at odds with
Congressional intent in enacting the REIT rules and updating
them to respond to changing market realities.
Congress enacted the REIT rules in 1960 to allow small
investors the same access to real estate markets available to
larger investors, just as regulated investment companies
(mutual funds) allow small investors greater access to equity
markets. Benefits of the REIT structure, as envisioned by
Congress, included diversification of investments and thus
minimization of risk, expert advice on investments, and means
for individuals on a collective basis to finance larger
projects.
INMC's alignment of a REIT with a related active business
is entirely consistent with these original policy goals. State-
of-the-art mortgage lending requires the use of all the tools
and techniques available in the financial marketplace,
including the use of hedging, securitization, and investment in
derivative mortgage instruments such as mortgage servicing
rights. Without access to these tools and techniques, a
mortgage entity will not be able to maximize profits to its
investors and will be exposed to a level of market risks to
which other traditional and non-traditional lenders are not
exposed. The result would be an entity that is inefficient in
the marketplace and that ultimately will not be able to
compete.
Mortgage REITS also have helped to fill a significant void
in the mortgage investment industry that GSEs have been unable
to fill. The benefits of our business to American homeowners at
all income levels and with a wider variety of credit histories
should not be overlooked.
Recommendations
As an initial matter, INMC respectfully urges the Congress
to reject the Administration proposal to restrict businesses
indirectly conducted by REITs. The proposal would penalize the
investors whom the REIT provisions originally were enacted to
benefit. The Administration prescribes an overly broad
``remedy''--effectively banning the alignment of a REIT with a
related active business--to address unfounded allegations of
abuse relating to debt and income shifting. Moreover, the
revenues estimated to be raised by the proposal (a total of $19
million over the FY 1998-2003 period) are relatively small when
judged against its harsh impact on our industry and the
availability of financing to segments of the housing industry
not currently served by GSEs.
It seems to us that a more proper point of inquiry for the
Congress, taking into account the original pro-shareholder
objectives underlying enactment of the REIT provisions, would
be to consider ways to facilitate the ability of REITs to
compete. Indeed, the Congress has amended the REIT statute at
least nine times since 1960--most recently in 1997--to reflect
the dramatic changes that have taken place in the real estate
marketplace.
INMC strongly believes the REIT rules as they relate to our
industry should encourage, rather than discourage, the
alignment of a mortgage REIT with the core competencies of
servicing and securitizing mortgage loans. We are prepared to
work with Congress to develop solutions in this regard.
Statement of the Service Bureau Consortium and the Interstate
Conference of Employment Security Agencies
The Interstate Conference of Employment Security Agencies
(ICESA) is the national organization of state administrators of
unemployment insurance, employment and training services, and
labor market information programs. The Service Bureau
Consortium (SBC) represents businesses providing payroll
processing and employment tax services directly to employers.
SBC members serve more than 600,000 employers and are
responsible for more than one-third of the private sector
payroll. Together, these organizations represent both those who
collect UI taxes and those who process the tax payments.
SBC and ICESA oppose the Administration's proposals to
change the frequency of collections under the Unemployment Tax
Act (``FUTA'') and believe that any restructuring of the FUTA/
State Unemployment Insurance (``SUI'') tax rules should only be
considered in the context of broad-based UI programmatic
reforms. Furthermore, we believe any reform of the UI system
should include a streamlining of the FUTA/SUI collection
system, thereby creating greater efficiencies and reduced costs
for the federal and state governments and for employers.
We are deeply concerned that the FUTA proposals contained
in the Administration's FY 1999 budget would create substantial
new burdens for both taxpayers and state government
administrators.
The Administration's FY 1999 UI Proposals
The Administration's FY 1999 budget would accelerate, from
quarterly to monthly, the collection of most federal and state
UI taxes beginning in the year 2004.
Accelerating the collection of existing federal and state
UI taxes is a device that generates a one-time artificial
revenue increase for budget-scoring purposes and real, every
year increases in both compliance costs for employers and
collection costs for FUTA and SUI tax administrators. The
Administration's proposal is fundamentally inconsistent with
every reform proposal that seeks to streamline the operation of
the UI system and with its own initiatives to reduce paperwork
and regulatory burdens.
The proposal would increase federal revenues in FY 2004, as
taxes scheduled to be collected in FY 2005 are accelerated into
the previous year.\1\ No new revenues would be collected by the
federal or state governments by virtue of this proposal--the
federal government would simply record, in FY 2004, revenues
that would otherwise be received a year later.
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\1\ Ironically, the amount of revenue recorded through this one-
time accounting speed-up results from yet another budgeting device.
State UI tax revenues are included as assets of the federal government
for budget-scoring purposes, notwithstanding the fact that the federal
government does not mandate the rate of this tax, collect it, or even
have the right to use the proceeds. All state monies in these Trust
Fund Accounts are automatically transferred back to the states to pay
UI benefit obligations as they occur. In the interim, they cannot be
used by the federal government for any other purpose.
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This proposal is even more objectionable than other tax
speed-up gimmicks considered in the past. For example,
proposals that might move an excise tax deposit date forward by
one month into an earlier fiscal year make little policy sense,
but also do not create major additional administrative burdens.
This particular proposal would result directly in significant
and continuing costs to taxpayers and to the federal and state
governments. By tripling the number of required UI tax
collection filings from 8 to 24 per affected employer each
year, the proposal would substantially raise costs to employers
and both federal and state UI tax administrators. Tripling the
required number of deposits can only dramatically escalate the
cost to employers inherent in the current separate FUTA/SUI
quarterly collection practices--now estimated to cost employers
up to $500 million a year.
Furthermore, the one-time, budget score-keeping gain will
be far more than offset by the real, every year administrative
costs of additional FUTA tax collection to the IRS and SUI tax
collection to the states. Monthly submission requirements can
only increase the $100 million the IRS now receives annually
from the UI trust funds to process and verify the quarterly
FUTA deposits. In addition, since the federal government is
required to reimburse states for their UI administrative costs,
reimbursement of states for the added costs of monthly SUI
collection is another hidden federal outlay cost in this ill-
conceived proposal.\2\ To the extent the federal government
does not reimburse the states for these higher SUI collection
costs, the states will experience yet another form of unfunded
mandate.
---------------------------------------------------------------------------
\2\ The Administration's budget does not appear to factor in such
increased federal and state collection costs as an outlay offset to the
increased FUTA revenues projected.
---------------------------------------------------------------------------
The Administration implicitly recognizes that the added
federal and state deposit requirements would be burdensome, at
least for small business, since the proposal includes an
exemption for certain employers with limited FUTA liability.
Many smaller businesses that add or replace employees or hire
seasonal workers would not qualify for the exemption since new
FUTA liability accrues with each new hire, including
replacement employees. Further, this new exemption would add
still another distinction to the many already in the tax code
as to what constitutes a ``small'' business. This deposit
acceleration rule makes no sense for businesses large or small,
and an exception for small business does nothing to improve
this fundamentally flawed concept.
Conclusion
UI reform should focus on simplifying the system, reducing
the burden of our employers and reducing the costs of
administration to federal and state governments. Adopting the
revenue raising provisions in the Administration's FY 1999
budget proposal would take the system in exactly the opposite
direction, creating even greater burdens than the current
system.
We urge the Committee to reject the speed-up in collection
of FUTA and SUI taxes proposed in the Administration's budget.
Any consideration of tax collection issues should take place
only in the context of system-wide reform. We believe that such
consideration will demonstrate that FUTA/SUI tax collection
should be simplified, not further complicated as the
Administration has proposed.
Statement of Investment Company Institute
The Investment Company Institute (the ``Institute'') \1\
submits for the Committee's consideration the following
comments regarding proposals to (1) exempt from withholding tax
all distributions made to foreign investors in certain
qualified bond funds, (2) enhance retirement security, (3)
modify section 1374 of the Internal Revenue Code \2\ to require
current gain recognition on the conversion of a large C
corporation to an S corporation, and (4) increase the penalties
under section 6721 for failure to file correct information
returns.
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\1\ The Investment Company Institute is the national association of
the American investment company industry. Its membership includes 6,860
open-end investment companies (``mutual funds''), 441 closed-end
investment companies and 10 sponsors of unit investment trusts. Its
mutual fund members have assets of about $4.419 trillion, accounting
for approximately 95% of total industry assets, and have over 62
million individual shareholders.
\2\ All references to ``sections'' are to sections of the Internal
Revenue Code.
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I. Withholding Tax Exemption for Certain Bond Fund Distributions
Background
Individuals around the world increasingly are turning to
mutual funds to meet their diverse investment needs. Worldwide
mutual fund assets have increased from $2.4 trillion at the end
of 1990 to $7.2 trillion on September 30, 1997. This growth in
mutual fund assets is expected to continue as the middle class
continues to expand around the world and baby boomers enter
their peak savings years.
U.S. mutual funds offer numerous advantages that could be
attractive to foreign investors. The expertise of the
industry's portfolio managers and analysts, for example, could
provide superior fund performance, particularly with respect to
U.S. capital markets. Moreover, the U.S. securities laws
provide strong shareholder safeguards that foster investor
confidence in our funds.
While the U.S. fund industry is the world's largest, with
over half of the world's mutual fund assets, foreign investment
in U.S. funds is low. Today, less than one percent of all U.S.
fund assets are held by non-U.S. investors.
One significant disincentive to foreign investment in U.S.
funds is the manner in which the Code's withholding tax rules
apply to distributions to non-U.S. shareholders from U.S. funds
(treated for federal tax purposes as ``regulated investment
companies'' or ``RICs''). Under U.S. law, foreign investors in
U.S. funds receive less favorable U.S. withholding tax
treatment than they would receive if they made comparable
investments directly or through foreign funds. This withholding
tax disparity arises because a U.S. fund's income, without
regard to its source, generally is distributed as a
``dividend'' subject to withholding tax.\3\ Consequently,
foreign investors in U.S. funds are subject to U.S. withholding
tax on distributions attributable to two types of income--
interest income (on ``portfolio interest'' obligations and
certain other debt instruments) and short-term capital gains--
that would be exempt from U.S. withholding tax if received
directly or through a foreign fund.
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\3\ Dividends paid to foreign investors are subject to U.S.
withholding tax at a 30 percent rate, although that rate may be
reduced, generally to 15 percent, by income tax treaty.
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A U.S. fund may ``flow through'' the character of the
income it receives only pursuant to special ``designation''
rules in the Code. One such character preservation rule permits
a U.S. fund to designate distributions of long-term gains to
its shareholders (both U.S. and foreign) as ``capital gain
dividends.'' As capital gains are exempt from U.S. withholding
tax, foreign investors in U.S. funds are not placed at a U.S.
tax disadvantage with respect to distributions of funds' long-
term gains.
Legislation introduced in every Congress since 1991 would
permit all U.S. funds also to preserve, for withholding tax
purposes, the character of interest income and short-term gains
that would be exempt from U.S. withholding tax if received by
foreign investors directly or through a foreign fund. The
Institute strongly supports these ``investment
competitiveness'' bills.
Proposal
Under the President's Fiscal Year 1999 budget proposal,
distributions to foreign investors by a U.S. fund that invests
substantially all of its assets in U.S. debt securities or cash
generally would be treated as interest exempt from U.S.
withholding tax. A fund's distributions would remain eligible
for this withholding tax exemption if the fund invests some of
its assets in foreign debt instruments that are free from
foreign tax pursuant to the domestic laws of the relevant
foreign countries. The taxation of U.S. investors in U.S. funds
would not be affected by the proposal.
Recommendation
The Institute urges enactment of this proposal as an
important first step toward eliminating all U.S. tax incentives
for foreign investors to prefer foreign funds over U.S. funds.
The imposition of U.S. withholding tax on distributions by U.S.
funds, where the same income would be exempt from U.S. tax if
the foreigners invested directly or through foreign funds,
serves as a very powerful disincentive to foreign investment in
U.S. funds. By providing comparable withholding tax treatment
for our bond funds, the proposal would enhance the competitive
position of U.S. fund managers and their U.S.-based work force.
As noted above, the Administration's proposal would exempt
from U.S. withholding tax distributions by a U.S. fund that
also holds some foreign bonds that are free from foreign tax
under the laws of the relevant foreign countries. This is in
recognition of the fact that U.S.-managed bond funds may hold
some foreign bonds. These can include ``Yankee Bonds,'' which
are U.S. dollar-denominated bonds issued by foreign companies
that are registered under the U.S. securities laws for sale to
U.S. investors, and other U.S. dollar-denominated bonds that
may be held by U.S. investors (e.g., ``Eurobonds''). The
Institute urges appropriate standards ensuring that U.S. funds
seeking foreign investors may continue to hold them.
The Institute supports drawing a distinction between a
foreign bond (such as a Yankee Bond or a Eurobond) that is
exempt from foreign withholding tax under the domestic law of
the relevant foreign country and one that is exempt only
pursuant to an income tax treaty with the U.S. By treating
investments in foreign bonds that are exempt from withholding
tax pursuant to treaty as ``nonqualifying'' for purposes of the
``substantially all'' test, the proposal prevents foreign
investors from improperly taking advantage of the U.S. treaty
network.
II. Retirement Security Initiatives
The U.S. mutual fund industry serves the needs of American
households saving for their retirement and other long-term
financial goals. By permitting millions of individuals to pool
their savings in a diversified fund that is professionally
managed, mutual funds provide an important financial management
role for middle-income Americans.\4\ Mutual funds also serve as
the investment medium for employer-sponsored retirement
programs, including small employer savings vehicles like the
new Savings Incentive Match Plan for Employees (``SIMPLE'') and
section 401(k) plans, and for individual savings programs such
as the traditional and Roth IRAs. As of December 31, 1996,
mutual funds held over $1.24 trillion in retirement assets.\5\
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\4\ An estimated 37 million households, representing 37% of all
U.S. households, owned mutual funds in 1996. See Brian Reid, ``Mutual
Fund Developments in 1996,'' Perspective, Vol. 3, No. 1 (Investment
Company Institute, March 1997).
\5\ Reid and Crumrine, Retirement Plan Holdings of Mutual Funds,
1996. (Investment Company Institute, 1997).
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The Institute has long supported legislative efforts to
enhance retirement savings opportunities for Americans. It
strongly advocates legislation to increase small employer
retirement plan coverage and make retirement savings more
portable, thus enabling Americans to more easily manage their
retirement savings. Our prescriptions for attaining these
goals, however, differ in some respects from the
Administration's.
A. Small Employer Retirement Plan Coverage
Background.--Retirement plan coverage is a matter of
serious public concern. Coverage rates remain especially low
among small employers. Less than one-half of employers with 25
to 100 employees sponsored retirement plans. More starkly,
under 20 percent of employers with fewer than 25 employees
offer their employees a retirement plan.\6\ The enactment of
legislation creating SIMPLE plans was a major first step toward
improving coverage, but more remains to be done.
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\6\ In 1993, the most recent year for which data is available, only
19 percent of employers with fewer than 25 employees sponsored a
retirement plan. EBRI Databook on Employee Benefits. Employee Benefit
Research Institute, 1997.
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Recommendations.--Congress should (1) improve the SIMPLE
plan program for small employers by raising the salary deferral
limitation, (2) eliminate or modify regulations, such as the
``top-heavy'' rule, that continue to retard small employer plan
formation and (3) assure that new small employer plan
initiatives provide effective incentives for plan establishment
and do not undermine currently successful programs.
1. Raise the SIMPLE Plan Deferral Limitation.--In 1996,
Congress created the successful SIMPLE program. The SIMPLE is a
simplified defined contribution plan available to small
employers with fewer than 100 employees. In just the first
seven months of its availability, an Institute survey of its
largest members found that no less than 18,250 SIMPLE plans had
been established, covering over 95,000 employees. Virtually all
(97 percent) SIMPLE plan formation is among the smallest of
employers--those with fewer than 25 employees. Indeed,
employers with 10 or fewer employees established about 87
percent of these plans. For the first time, significant numbers
of small employers are able to offer and maintain a retirement
plan for their employees.
Presently, however, an employee working for an employer
offering the SIMPLE may save only up to $6,000 annually in his
or her SIMPLE account. Yet, an employee in a 401(k) plan,
typically sponsored by a mid-size or larger employer, is
permitted to contribute up to $10,000. Congress can readily
address this inequity by amending the SIMPLE program to permit
participating employees to defer up to $10,000 of their salary
into the plan, that is, up to the limit set forth at section
402(g) of the Internal Revenue Code. This change would enhance
the ability of many individuals to save for retirement and,
yet, would impose no additional costs on small employers
sponsoring SIMPLEs.
2. Reduce Unnecessary, Costly Regulations, Such as The Top-
Heavy Rule, That Retard Small Employer Plan Formation.--
Congress could raise the level of small employer retirement
plan formation if it reduced the cost of plan formation and
maintenance. One way to reduce these costs is for the federal
government to subsidize them. The Administration has proposed a
``start-up tax credit'' for small employers that establish a
retirement plan in 1999. Such a tax incentive may induce
certain small employers to establish retirement plans.
Another approach would be to seek the actual reduction of
on-going plan costs attributed to regulation. For example,
repeal or modification of the ``top-heavy'' rule \7\ may lead
to more long-term plan formation than a one-time tax credit
program. A 1996 U. S. Chamber of Commerce survey showed that
the top-heavy rule is the most significant regulatory
impediment to small businesses establishing a retirement
plan.\8\
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\7\ Section 416 of the Internal Revenue Code. The top-heavy rule
looks at the total pool of assets in a plan to determine if too high a
percentage (more than 60 percent) of those assets represent benefits
for ``key'' employees. If so, the employer is required to (1) increase
the benefits paid to non-key employees, and (2) accelerate the plan's
vesting schedule. Small businesses are particularly effected by this
costly rule, because ``key'' employees include individuals with an
ownership interest in the company. Small businesses are more likely to
have concentrated ownership and individuals with ownership interests
working at the company and in supervisory or officer positions, each of
which exacerbates the impact of the rule.
\8\ Federal Regulation and Its Effect on Business--A Survey of
Business by the U.S. Chamber of Commerce About Federal Labor, Employee
Benefits, Environmental and Natural Resource Regulations, U.S. Chamber
of Commerce, June 25, 1996.
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Finally, Congress certainly should avoid discouraging plan
formation by adding to the cost of retirement plans. Thus, the
Institute strongly urges that Congress not enact the
Administration's recommendation that a new mandatory employer
contribution be required of employers permitted to use design-
based safe harbor formulas in their 401(k) plans beginning in
1999.
3. New Programs For Small Employers Should Provide
Effective Incentives For Plan Establishment and Not Undermine
Currently Successful Programs.--The Administration has also
proposed enhancing the ``payroll deduction IRA'' program and
creating a new simplified defined benefit plan program for
small employers. In considering these proposals, it is
important to assure that incentives are appropriately designed
to induce program participation and that the programs do not
undermine current retirement plan options.
For instance, the Administration would create an additional
incentive to use the payroll deduction IRA program by excluding
payroll deduction contributions from an employee's income.
Accordingly, they would not be reported on the employee's Form
W-2. As the success of the 401(k) and SIMPLE programs
demonstrate, payroll deduction provides an effective,
disciplined way for individuals to save, and its encouragement
is a laudable policy goal. However, simplifying tax reporting
may not add sufficient incentive for employers to establish a
payroll deduction IRA program. More importantly, the
interaction of an expanded payroll deduction IRA program with
the new and successful SIMPLE program should be carefully
considered. As noted above, the SIMPLE plan program has been
extremely attractive to the smallest employers, exactly those
for whom a payroll deduction IRA program is designed. Any new
program expansion should not undermine already existing,
successful small employer programs. Because the maximum IRA
contribution amount is $2,000 (an amount not increased since
1981), it may not be appropriate to induce small employers to
use that program rather than the popular SIMPLE program, which
would permit employees a larger plan contribution. Similar
considerations should be made with regard to any simplified
defined benefit program.
B. Retirement Account Portability
Background.--Because average job tenure at any one job is
under 5 years,\9\ individuals are likely to have at least
several employers over the course of their careers. As a
result, the portability of retirement plan assets is an
important policy goal. The Administration advocates an
accelerated vesting schedule for 401(k) plan matching
contributions to address this issue. Consideration should be
given to a broader approach to portability that would enhance
the ability of all individuals to move their account balances
from employer to employer when they change jobs.
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\9\ The Changing World of Work and Employee Benefits, Employee
Benefit Research Institute, Issue Brief No. 172 (April 1996).
---------------------------------------------------------------------------
Under current law, an individual moving from one private
employer to another, where both employers provide section
401(k) plan coverage, generally may roll over his or her vested
account balance to the new employer. Where an individual moves
from a private employer to a university or hospital or to the
government sector, however, such account portability is not
permitted. The problem arises because each type of employer has
its own separate type of tax-qualified individual account
program. Neither the university's section 403(b) program nor
the governmental employer's ``457 plan'' program may accept
401(k) plan money, and vice versa. Moreover, with the exception
of ``conduit IRAs,'' moving IRA assets into an employer-
sponsored plan is prohibited.
Recommendation.--Legislation to permit portability amongst
these retirement plans would enable individuals to bring
retirement savings with them when they change jobs, consolidate
accounts and more readily manage retirement assets. Congress
should amend the tax laws pertaining to all individual account-
type retirement plans to permit individuals to roll over
retirement account balances as they move from employer to
employer, regardless of the nature of the employer.
C. Variable Annuities
Background.--The Administration has proposed imposing new
taxes on the owners of variable annuity contracts. Proposals
include taxing owners upon the exchange of one contract for
another and in the event of a reallocation of contract savings
from one investment option to another under the variable
annuity contract.
Recommendation.--The Institute opposes these proposals,
because they would tax many individuals who save for retirement
through variable annuities.
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
regulated investment company (``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.
Proposal
The President's Fiscal Year 1999 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.
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.
IV. 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.\10\ 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.
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\10\ 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.
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Proposal
The President's Fiscal Year 1999 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.
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.\11\ The current penalty
structure provides adequate, indeed very powerful, incentives
for RICs to promptly correct any errors made.
----------
\11\ 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).
Statement of Joint Venture's Council on Tax and Fiscal Policy
Reasons Why the Export Source Rule Should Not Be Replaced with an
Activity-Based Rule \1\
Executive Summary
High-technology industries comprise integrated industries
with numerous companies occupying critical niches. Product
cycles of 1-5 years are not uncommon and successful companies
at each stage of the high-tech food chain must adapt and
constantly improve their product lines. As these cycles repeat
and new products and markets are created, residual markets from
prior product cycles remain and as a result, the absolute
market size and opportunity increases.
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\1\ These comments were prepared by Tax Policy Group member Bill
Barrett, Director: Tax, Export & Customs, Applied Materials, Inc. These
comments are an updated version of comments on this proposal that were
submitted to the Senate Finance Committee in April 1997.
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High-tech industries are heavily export oriented. Recent
statistics show that Silicon Valley's exports grew 9 percent in
1996 to $39.7 billion. For many Silicon Valley companies,
exports exceed 50 percent of total sales. Much of this exported
product is manufactured in the United States and because of the
nature of high-tech industries and their product cycles, a
tremendous amount of research and development accompanies the
manufacturing function. The linkage between research and
manufacturing is very strong within high-tech industries.
The export source rule helps to mitigate the double
taxation faced by many U.S. exporters when income is taxed both
in the United States and in a foreign country, and as a result,
can have a direct effect on a high-tech company's global tax
burden. The export source rule only applies when goods are
manufactured in the United States and exported. In high tech
industries, significant U.S. research and research related jobs
accompany the U.S. manufacturing function. Repeal of the export
source rule would place upward pressure on the after tax cost
of performing the manufacturing and related research activity
in the United States.
Capital investment decision-making is influenced by both
tax and non-tax factors. However, as global infrastructure and
education levels improve, non-tax factors become increasingly
less important in the capital investment decision-making and,
therefore, U.S. tax laws that increase the after-tax cost of
doing business could have a profound impact on location of
investment. This will in turn have a direct impact on exports
and export-related jobs not only for companies that respond
quickly to after-tax returns, but also supplier companies that
support the U.S. manufacturing and research activities. The
various sectors within high-tech industries tend to be very
closely linked and interdependent so that investment decisions
by one sector will have a multiplier effect on where future
geographic income will be earned.
U.S. high-tech industries are innovative, highly
profitable, drive academic institution curriculum and
excellence, produce high-paying jobs, produce a tremendous
volume of exports, and serve as a model to the world. Repeal of
the export source rule would serve to discourage these U.S.-
based activities.
Marketing and Sales, Not Tax, Drives Multinational Corporate Structures
A Silicon Valley high-tech start up company begins with an
innovative idea. This idea may or may not have large market
potential in the early life cycle of the company. Those
companies destined to become successful will either have a
product that is ready for the current market[s] or the product
idea will create a new market. High-tech products change every
1-5 years because industry innovation and global markets are
constantly evolving. Successful companies at each stage of the
high-tech food chain must adapt and constantly improve their
product lines. High-tech companies that do not adapt or evolve
their product lines do not survive.
High-technology represents integrated industries with
numerous companies occupying critical niches. For example,
semiconductor equipment companies supply the semiconductor chip
companies and the chipmakers in turn provide the means for
computers to perform complex software functions ranging from
number crunching to multimedia. The explosion of the Internet
and networking companies that link computers has been a more
recent evolution in high-tech industries. Computer software
companies have been both pushing the semiconductor industry as
well as adapting new software applications to existing computer
capability. At each component stage, companies must keep pace
with evolution and product cycles to survive. As these cycles
repeat and new products and markets are created, residual
markets from prior product cycles remain and as a result, the
absolute market size and opportunity increases.
The profile of a high-tech multinational company is no
different from the above description, but for the fact that it
either competes in or develops markets in multiple countries.
To be successful in countries outside the U.S., the
multinational must understand different markets and adapt its
corporate structure to accommodate those markets. A not
uncommon profile as product lines evolve and/or the
multinational adapts to foreign markets, is that specific
segments of manufacturing may be located offshore.\2\ These
segments may be older product lines or components of a product
that are produced more efficiently offshore. In most cases,
newer product lines, and the requisite research and development
remain in the U.S. and close to development centers.
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\2\ A successful company locates offshore to increase its global
sales revenue and market share. Often, this raison d'etre is lost in
political rhetoric. If a company is less competitive in the global
marketplace (i.e., does not increase its global market share) because
of higher tax rates, that company will naturally evaluate where it
places manufacturing and R&D capability. Similarly, import tariffs will
influence global investment patterns. For example, the European Union
in 1992 effectively placed a European manufacturing content requirement
through imposition of duties on non-European manufactured
semiconductors. United States and Asian semiconductor manufacturers now
dominate the European semiconductor industry, which illustrates how
investment decisions can be altered to reduce government imposed costs
of doing business.
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Silicon Valley high-tech companies do not structure their
global operations solely on the basis of local country tax
rates. For example, as high-tech product lines mature,
investment in alternate manufacturing sites is a natural
process of growth and diversification of risk. However, this
statement should not be interpreted to mean tax rates do not
play a significant role. An increase in U.S. tax increases the
cost of business in the U.S. and if a company is to maintain an
after-tax shareholder return, it must evaluate lower cost site
locations. Popular rhetoric often characterizes U.S. industries
as intent on the wholesale migration of manufacturing to
offshore locations with the sole purpose of minimizing
corporate income tax when in reality, companies are trying to
remain competitive in a global market and taxes represent only
one, albeit a significant, cost of doing business.
An analysis of a new manufacturing location will involve a
comparison of factors, such as the following:
Labor skills, consistent with the demands of
product technical requirements.
Labor productivity.
Cost of labor.
Cost of land and construction costs.
Financial and physical infrastructure (e.g.,
highway and airport).
Proximity to customers and the market.
Protection of intellectual property.
Tax rates.
In reviewing this list, the superordinate goal of
generating additional sales revenue and global market share may
be overlooked. Any successful high-tech company is in the
business of selling product and increasing financial return to
its investors and when tax rates reduce potential return, they
play an increased role in the decision-making process. A
company that makes sensible investment decisions based on
after-tax returns that improve the ability to competitively
price product stands a good chance to improve its market share.
There are Fundamental Flaws in the Administration's Export Source
Proposal
President Clinton's FY 1999 budget proposal contains a
provision that would eliminate the export source rule, which
allows 50 percent of the income from the sale of goods
manufactured in the U.S. and exported to be considered
``foreign source income.'' The proposal would instead source
income from export sales under an ``activity based'' standard--
effectively eliminating the export source rule. ``Activity
based'' sourcing is not defined in the proposal, but might be
patterned after a current income tax regulation example.\3\ For
U.S. exporters with excess foreign tax credits, the export
source rule alleviates double taxation, and thereby operates as
an export incentive for U.S. multinationals. The foreign source
income rule only applies if companies manufacture goods in the
U.S. and export them. In the case of high-tech companies this
usually means the company is also performing substantial R&D in
the U.S.
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\3\ Treas. Reg. Sec. 1.863-3(b)(2) Ex. 1. The Tax Court in both
Phillips Petroleum Co., 97 T.C. 30 (1991) and Intel Corp., 100 T.C. 616
(1993), found that the fact pattern in the regulations example did not
apply to the facts of these cases. The facts in these cases are typical
of most exporters and therefore, under current law ``activity based''
sourcing as described in Example 1 would rarely produce any foreign
source income. The result, using an ``activity based'' model, would be
zero percent foreign source income on exported U.S. manufactured
product, which increases the global tax burden on this income.
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The Administration makes the following argument in support
of repeal:
The existing 50/50 rule provides a benefit to U.S.
exporters that also operate in high-tax foreign countries.
Thus, U.S. multinational exporters have a competitive advantage
over U.S. exporters that conduct all their business activities
in the United States.\4\
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\4\ General Explanations of the Administration's Revenue Proposals,
February 1998, page103; http://www.ustreas.gov/press/releases/
grnbk98.htm.
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There are at least three flaws in this argument. First,
companies without foreign operations do not face the double
taxation the export source rule is designed to alleviate. Thus,
the rule does not create a competitive advantage; instead, it
levels the playing field. Double taxation increases the cost of
doing business offshore and therefore, the multinational with
foreign operations becomes less competitive without benefit of
the foreign source income rule. Second, a company without
foreign operations may be a start-up that has not entered
global markets. This new company cannot be compared to a large
and well-established multinational. As the new company grows
into global markets, it too will benefit from the export source
rule. Finally, the argument in favor of eliminating the foreign
source income rule fails to take into account additional [non-
tax] expenses that will be incurred by the multinational with
foreign operations. Selling, marketing, administrative expenses
associated with a foreign location, and product adaptation to
local market, all must be incurred to support the local market.
The conclusion is inescapable that establishing foreign
operations will produce additional operating costs. Although
operating costs will increase with foreign operations, the
reality is that a U.S. manufacturing company cannot compete for
global market share without establishing offshore operations.
The resulting increased global market share increases high--
paying R&D and manufacturing jobs in the U.S.
Tax Treaties are No Substitute for the Export Source Rule
The Administration has stated that the United States income
tax treaty network protects export sales income from tax in the
foreign country where the goods are sold and thus, protects
companies from double taxation. Treasury argues that the export
source rule is no longer necessary as a result of this treaty
protection.
The tax treaty network is not a substitute for the export
source rule, but even if it was, the treaty network is far from
complete. The U.S. treaty network is limited to 56 countries,
leaving many more countries (approximately 170) without
treaties with the U.S. Moreover, many of the countries without
treaties are developing countries, which are frequently high-
growth markets for American exporters. For example, the U.S.
has no treaty with any Central or South American country.
With or without a tax treaty, under most foreign countries'
tax laws, the mere act of selling goods into the country,
absent other factors such as having a sales or distribution
office, does not subject the United States exporter to income
tax in the foreign country. Thus, export sales are not the
primary cause of the excess foreign tax credit problem that
many companies face in trying to compete overseas.
The real reason most multinational companies face double
taxation is that U.S. tax provisions unfairly restrict their
ability to credit foreign taxes paid on these overseas
operations against their U.S. taxes. Requirements to allocate a
portion of the costs of U.S. borrowing and research activities
against foreign source income (even though such allocated costs
are not deductible in any foreign country), cause many
companies to have excess foreign tax credits, thereby
subjecting them to double tax, i.e., taxation by both the U.S.
and the foreign jurisdiction.
As previously explained, the export source rule alleviates
double taxation by allowing companies who manufacture goods in
the United States for export abroad to treat 50 percent of the
income as ``foreign source,'' thereby increasing their ability
to utilize their foreign tax credits. Thus, the rule encourages
these companies (facing double taxation as described above) to
produce goods in the U.S. for export abroad.
As an effective World Trade Organization-consistent export
incentive, the export source rule is needed now more than ever
to support quality, high-paying jobs in U.S. export
industries.\5\ Exports have provided the spark for much of the
growth in the U.S. economy over the past decade. Again, the
existence of tax treaties does nothing to change the importance
of this rule to the U.S. economy.
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\5\ Studies have shown that average exporting plants have higher
blue-collar and white-collar wages, and that average workers at
exporting plants have higher benefits. J. David Richardson and Karin
Rindal, Why Exports Matter: More!, The Institute for International
Economics and The Manufacturing Institute, February 1996, page 11.
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The decision to allow 50 percent of the income from export
sales to be treated as ``foreign source'' was in part a
decision based upon administrative convenience to minimize
disputes over exactly which portion of the income should be
treated ``foreign'' and which should be ``domestic.'' The rule
still serves this purpose, and neither the tax treaty network
nor the Administration's proposal to adopt an ``activities-
based'' test for determining which portion of the income is
``foreign'' and which is ``domestic'' addresses this problem.
Moreover, adopting an ``activities-based'' rule would create
endless factual disputes similar to those under the Section 482
transfer pricing regime.
Tax treaties are critically important in advancing the
international competitiveness of U.S. companies' global
operations and trade. In order to export effectively in the
global marketplace, most companies must eventually have
substantial operations abroad in order to market, service or
distribute their goods. Tax treaties make it feasible in many
cases for business to invest overseas and compete in foreign
markets. Foreign investments by U.S.-based multinationals
generate substantial exports from the United States. These
foreign operations create a demand for U.S. manufactured
components, service parts, technology, etc., while also
providing returns on capital in the form of dividends, interest
and royalties.
Tax treaties are not a substitute for the export source
rule. They do not provide an incentive to produce goods in the
United States. Nor do they address the most significant
underlying cause of double taxation--arbitrary allocation
rules--or provide administrative simplicity in allocating
income from exports.
Capital Export Neutrality Model As A Guide For Tax Simplification
In an ideal income tax system, income tax would not
influence how a company structures transactions or where the
company decides to build a manufacturing plant. Investment
decisions would be influenced by other economic factors such as
those listed above. To eliminate income tax from the investment
location decision it would be necessary to structure the system
such that the global tax rate on income earned anywhere in the
world is no different than the domestic rate of tax. A system
patterned after the ``capital export neutrality'' (CEN) concept
would achieve this result.\6\
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\6\ CEN is also referred to as a classical tax system. In addition
to the United States, Japan and the United Kingdom loosely base their
tax systems on this concept. An alternative concept is ``capital import
neutrality'' (CIN). Under CIN, the global rate of tax on foreign income
does not exceed the foreign tax rate. In other words, under CIN income
earned outside the home country is not taxed in the home country when
received as a dividend or when the foreign operation is sold.
``Territorial'' based tax systems are patterned after the CIN concept.
The Netherlands and France apply the ``territorial'' concept. Germany,
Canada, and Australia apply the concept pursuant to income tax treaty
with certain trading partners. For a detailed description of these
principles, see Factors Affecting The International Competitiveness Of
the United States, prepared by the Joint Committee on Taxation (JCS-6-
91), Part 2. III.
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The CEN concept holds that an item of income, regardless of
where it is earned, will not suffer a global rate of tax higher
than the U.S. tax rate. Dividends received from both high and
low tax countries suffer a double rate of tax first in the
country in which the income was earned and second in the United
States when received. The credit for foreign tax paid is
designed to mitigate this double taxation. The export source
rule operates to increase the credit for foreign taxes paid
which in turn operates to more closely align the United States
tax system with the concept of CEN. With sufficient foreign
source income, the global rate of income tax on income earned
in high tax countries approaches 35 percent.
A classical tax system that diverges from the CEN concept
will increase the importance of income tax in plant location
decision-making. If the foreign source income rule is repealed,
the double taxation of U.S. multinationals that export from the
United States will increase and for many high-tech companies
this increase in taxes, and corresponding reduction in return
to shareholders, will alter plant investment decisions. Many
companies will be forced to invest offshore rather than build
new plants in the U.S. to remain competitive and maintain
shareholder rate of return. Foreign investment decisions will
have a ripple effect within high-tech industries because they
are so closely interrelated. For example, a natural consequence
of additional offshore investment by a semiconductor
manufacturer will be that equipment suppliers will increase
their offshore presence to meet the demands of their customers.
This dynamic will be repeated in other industry segments
creating a foreign investment multiplier effect.
The Proposal Would Tend To Encourage Manufacturing Outside of the U.S.
The elimination or scale back of the foreign source income
rule will have a negative tax impact on U.S. multinationals
that export U.S. manufactured product. For many companies this
will result in a tax disincentive to manufacture in the U.S.
vis-a-vis other countries with lower tax rates and is contrary
to a ``capital export neutrality'' model, which holds that
income tax should play a minor role in plant location decision-
making. Repeal of the foreign source income rule would elevate
the importance of taxes in offshore plant location decision-
making and is contrary to tax simplification within a ``capital
export neutral'' model.\7\
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\7\ As income earned offshore increases as a result of additional
foreign plant investment, history suggests complicated tax laws will be
introduced in an attempt to tax this income before it is remitted back
to the U.S., contrary to efforts towards a more simplified income tax
mode. PFIC and subpart F, as it relates to operating income earned from
related party sales, are examples of this type of legislation.
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Summary
United States high-tech industries are innovative, highly
profitable, drive academic institution curriculum and
excellence, produce high-paying jobs, produce a tremendous
volume of exports, and serve as a model to the world.\8\ U.S.
government policies that discourage these U.S.-based activities
risk impeding very desirable attributes and drivers in the U.S.
economy. Government policies that encourage these attributes
will obviously promote these attributes. Therefore, the
Administration's export sourcing proposal should not be
enacted.
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\8\ Studies have documented the impact exports have in job
creation. Hufbauer and DeRosa project that in 1999, exports will
increase $30.8 billion and $2.3 billion of additional wage income. In
addition, the effect of the rule and the exports it generates will
support 360,000 workers in export-related jobs, which also tend to be
higher paying jobs (Costs and Benefits of the Export Source Rule, 1998-
2002, Gary Hufbauer and Dean DeRosa, February 19, 1997). In Silicon
Valley, it is estimated that over 200,000 jobs were added since 1992.
Also, in 1997 the average real wage, after accounting for inflation,
grew about 2.2 percent compared to a wage increase of 1.2 percent at
the national level (Joint Venture's Index of Silicon Valley, 1998,
prepared by Joint Venture: Silicon Valley Network). The Joint Venture
study also reported that in 1996, Silicon Valley exports grew 9 percent
to $39.7 billion, while California exports grew 4 percent and U.S.
exports grew 6 percent.
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Statement of M Financial Holdings Incorporated
Overview
The President's budget proposal calls for unwarranted tax
increases on American life insurance policyholders and products
that would discourage long-term investment and saving. Several
provisions of the budget would prevent life insurance products
from continuing to provide effective solutions to long-term
benefit, savings, and retirement security needs. This
unfortunate proposal drastically undermines the government's
decades-long policy of encouraging individuals and businesses
to provide for their own and their employees' financial
security. At a time when long-term financial planning is
encouraged of all Americans, the President's budget takes away
several key methods of providing for that financial security.
In many cases, the proposals result in a retroactive tax
increase on middle-class working Americans.
The provisions in the 1999 Administration budget that
particularly concern us include the following:
COLI Proposal--Increased taxation on companies
that own life insurance policies on their officers and
employees. This tax increase could significantly reduce the
level of funding for employee-related benefits, undermining
employee security associated with these benefits and the
financial protection of families and businesses. The proposal
particularly hurts small businesses who rely on life insurance
policies to provide benefits and incentives to their employees.
Investment in Contract Proposal--Elimination of
annual cost of insurance and expense charges from the insurance
owner's basis in the contract. This proposal contradicts the
well-established tax principle that a return of invested funds
is not taxed. Furthermore, it reduces the effectiveness of the
savings element of the policies.
Variable Life Insurance and Annuities Proposal--
Taxation of gains in variable policies at the time values are
moved among investment options within one policy or transferred
between similar policies. This tax increase effectively
eliminates the use of these products as long-term retirement
investments, thereby making it harder for millions of Americans
to save for retirement
Crummey Proposal--Elimination of the Crummey
provisions to obtain the gift tax annual exclusion. This tax
increase would reduce the availability of life insurance
proceeds to provide funds to pay future estate taxes on many
closely held business interests.
These proposals will reduce the financial protection being
provided to millions of Americans and thousands of businesses
of all sizes. The provisions would adversely affect the
economic viability of existing life insurance policies and
severely limit new insurance policy purchases, thus reducing
overall savings. Furthermore, the proposals would reduce
private retirement savings by increasing the administrative and
tax expense associated with owning these products. Taken
together, the proposals also could cause thousands of employees
to lose their jobs. Particularly hard hit would be U.S. small
businesses.
Given the uncertain economic impact, it is reasonable to
expect that these Budget proposals may have a negative effect
on general revenue. These proposals also seem to
disproportionately isolate and disadvantage insurance
businesses. The reduced purchase of insurance as a result of
these proposals would produce a corresponding reduction in
certain federal and state tax revenue. By example, in 1996,
approximately $1.8 billion in revenue was paid by the insurance
industry in state premium taxes on life insurance.
Additionally, approximately $1 billion was generated at the
federal level just from the ``DAC'' tax on life insurance
premiums. The current level of revenue generated at both the
state and federal level would be threatened by this set of
proposals.
M Financial Group
M Financial Group is a marketing and reinsurance
organization comprised of over 100 independently owned firms,
located across the country, that focus on providing financial
security and solutions to the estate and benefit planning needs
of individuals and businesses.
Collectively, these firms manage life insurance policies in
force for their clients representing over $1 billion of annual
life insurance premiums, over $10 billion of policyholder
account values, and over $40 billion of total death benefit
protection.
These policies provide benefits for a variety of needs that
enhance individual
Allowing businesses an effective vehicle to fund
benefit liabilities for employee retirement income payments,
salary continuance for employees' spouses, and other post-
retirement benefits.
Providing for financial liquidity to families at
time of death to pay estate taxes. Many families' assets are in
illiquid forms such as family owned real estate or small
businesses. Life insurance helps families meet their estate tax
and business continuity needs without having to sell the
underlying asset. Life insurance provides a liquid source of
funds to meet the liability without disrupting families and
small businesses, allowing them to continue into the next
generation and continue to provide jobs to their employees.
Providing businesses with a financial means to
continue operation upon death of a key executive, allowing the
business to continue operations while replacing the key
individual.
Providing individuals with the ability to provide
survivors with death benefit protection while supplementing
retirement savings.
Life insurance is a particularly effective and efficient
vehicle to defray the costs of these benefits and provide
individuals and employers with a future income stream to offset
various unpredictable future needs, such as untimely death or
long-term medical needs. The impact of the proposal on the
ability to use life insurance on all of these areas is
devastating.
In addition, the proposed retroactive application of
several provisions to policies already purchased and owned by
millions of Americans makes effective tax-planning virtually
impossible. A precedent of retroactive application of tax
increases to existing contracts is inherently unfair and
reduces the potential for tax law to provide effective long-
term incentives for establishing any private savings programs.
Moreover, retroactive tax increases reduce compliance with our
Federal Tax system at a time when the system is already under
broad attack. We applaud the strong opposition to
retroactivity, as expressed recently by Chairman Archer, who
made the following statement related to the Administration's FY
1999 Budget:
``I do not intend to put my name on anything that is
retroactive.''
The balance of this document provides specific background
on the impact of these proposals on certain uses of life
insurance that help provide financial security to millions of
Americans.
Proposal: Repeal of the exception for employees, officers, and
directors under the Corporate Owned Life Insurance (COLI) proration
rules.\1\
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\1\ The written statement addresses the negative impact of the
Administration's Proposal on traditional COLI plans, and does not
address Bank-Owned Life Insurance (BOLI). We are aware that in addition
to the use of traditional COLI plans, there has also developed a use of
life insurance products as pure financial vehicles, used to take
advantage of tax deferred investment or tax arbitraged nature of the
products. Congress has been concerned about the use of COLI as a
``pure'' investment vehicle without the appropriate insurance elements
and has in the past enacted legislation to limit the attractiveness of
such uses. Of particular concern today is the use of COLI by financial
institutions that borrow funds at low cost and invest the funds in tax
deferred investments, thus creating additional tax leverage due to the
deductibility of the borrowing costs while the offsetting investment is
tax deferred. These plans are commonly referred to as BOLI.
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Background:
COLI policies have long been used as a tool by businesses
to provide employee and retirement benefits. COLI helps promote
the long-term financial security of employees, provide
employees an incentive to save for their own retirement, and
help corporations effectively manage financial consequences of
the untimely death of a key employee.
The need to use COLI to provide employee and retirement
benefits arises from prior legislative initiatives such as
ERISA, TEFRA, and DEFRA, which have limited a company's use of
pension arrangements. Over time, these limitations have made
the use of traditional pension arrangements more complex and
less effective. Hit most hard are middle-level executives, as
defined by the Department of Labor. The popularity of non-
qualified plans has increased commensurate with the compression
on qualified plans and corporate desire to provide the
restoration of such benefits.
In the interest of enabling employees with a means to
provide themselves and their families with long-term financial
security benefits, corporations have created non-qualified
plans to provide long-term benefits. The use of these plans is
an effective vehicle for increasing the personal savings rate
at a time when Americans are living longer and there is more
uncertainty of the ability of other social programs to support
these benefits. These plans have long-term emerging liabilities
and actuarial risk, which are well suited to funding with life
insurance. This use of COLI serves a valid social and economic
purpose in financing these plans. Some examples of the many
employee and retirement benefit beneficial programs and other
business needs funded by COLI are:
Supplements retirement income and survivor
benefits beyond those available under qualified plan limits.
These benefits promote the financial security of millions of
Americans.
The ability for employees to contribute after-tax
dollars to enhance their retirement and survivor benefits.
The ability for businesses to provide benefits
needed to attract and retain key employees.
Supports the ability, particularly for small
businesses, to withstand the significant financial loss
resultant from the premature death of a key employee.
Provides business continuity in circumstances that
could otherwise result in failure and significant economic
hardship for all employees.
To accomplish these purposes, many corporations use COLI as
a tool to effectively manage the liabilities related to
employee and retirement benefits. Defraying the costs of these
liabilities with after-tax dollars in COLI policies is
consistent with Federal retirement savings incentives and is
good public policy.
Effect of Proposal:
The changes to COLI increase current taxes for all
businesses that own or are beneficiaries of a life insurance
policy. This proposal would seriously curtail the availability
of the benefits these policies fund, reduce personal savings,
and increase the risk of business failure from loss of a key
employee. Most hard hit by the proposal is small businesses and
their employees.
The proposed changes to IRC Sec. 264 increase taxes by
disallowing a portion of the company's interest deduction for
unrelated debt. This proposal would affect all business uses of
life insurance, not just abusive uses. To preserve the
motivation and opportunity for private saving, it is important
to preserve the ability for businesses to purchase life
insurance to provide an array of benefits to their employees.
At a time when Congress is increasing incentives for employee-
based savings through the expansion of Roth IRAs and other
provisions, it is contradictory to tax the use of life
insurance to fund the same benefits.
Current law already limits potential abuses in COLI
applications used to defray the costs of the types of
liabilities previously mentioned: Qualified plan limits
restrict the amount of insurance that can be purchased by an
employer on a currently deductible basis. IRC Sec. 7702 and IRC
Sec. 7702A require corporate-owned policies to provide a
reasonable amount of true death benefit protection. IRC
Sec. 264 prevents leverage arbitrage from tax deductible
borrowing against a corporate-owned life insurance policy. All
these provisions combine to provide reasonable protection that
the COLI may be used to defray the costs of real benefit
liabilities in a manner consistent with tax policy.
Unfortunately, the effect of the COLI proposal in the
Administration's Budget would be to limit wholly appropriate
business uses of life insurance--such as assuring that
employees receive the retirement benefits they have been
promised and are counting on getting--by making the cost of
insurance products economically unfeasible. The proposal would
unnecessarily deny the benefits of COLI to millions of
Americans.
Moreover, the Administration's rationale for the COLI
proposal is fundamentally flawed and unjustified. The
Administration believes that allowing a taxpayer a deduction
for interest incurred on indebtedness in the operation of a
business is wrong if the business owns life insurance on its
employees, even if the business indebtedness is completely
unrelated to the insurance. This belief flies in the face of
fundamental principals of tax law, which allow for ordinary and
necessary business expenses.
Under recent changes in current law, interest on
indebtedness directly related or ``traced'' to corporate owned
life insurance is already subject to disallowance. The new COLI
proposal would go well beyond current law and deny deductions
for interest that is completely unrelated to the insurance.
This is not only unjustified, but is overbroad and creates
inequities between businesses that rely on debt financing and
those that are equity financed.
In cases where a business provides insurance-financed
benefit programs such as broad-based health coverage for
retirees, non-qualified pensions, or savings benefits, a
``tax'' would now be imposed if the business had any
indebtedness on its books. This resulting ``tax'' will most
likely cause the business to rethink and scale back its benefit
programs, causing harm to the long-term health and security of
its employees. Across the country, this would have a
devastating impact on many small and mid-sized businesses who
rely on insurance to fund such programs.
By indirectly ``taxing'' retirement and benefit programs,
the COLI proposal moves in the complete opposite direction of
recent efforts by the Administration and Congress to provide
incentives to increase U.S. savings (e.g. expansion of IRAs,
Roth IRAs, SIMPLE IRAs). The COLI proposal undermines these
initiatives and is contradictory to the goals of the
Administration and Congress.
Finally, the effective date of the COLI proposal would
create a retroactive tax increase on millions of businesses and
middle-class working Americans by denying an interest deduction
on policies that have been in place for years. Businesses that
relied on existing tax laws would be penalized and employees
who relied on benefits funded by existing insurance policies
would be unconscionable harmed.
While we understand the concern in Congress regarding
perceived abusive transactions, we believe the Administration's
proposal is overbroad, unjustified and inconsistent with
Congressional incentives to encourage retirement savings and
employee benefits. Accordingly, the COLI proposal should be
rejected out of hand.
Proposal: Reduce the life insurance and annuity policy owner's
``investment in the contract'' (basis) for mortality and expense
charges.
Background:
Cash value life insurance and deferred annuities allow
individuals to provide for future financial security for
themselves and their dependents through benefits paid to
survivors at death or lifetime income benefits paid during
retirement. Premiums paid for these benefits are usually made
with after-tax dollars. The public policy reason for
encouraging such insurance purchases is directly linked to the
social value the benefits provided, both in terms of quality of
life for surviving beneficiaries and additional retirement
income available to further reduce demands that may fall on
publicly funded social insurance programs. For this reason, the
``inside build-up'' of life insurance and annuity policy cash
values has served a beneficial and socially justified purpose.
Effect of Proposal:
This proposal would reduce the effectiveness of life
insurance and annuity policies as long-term financial security
vehicles. The proposal would reduce retirement savings by
reducing a policy owner's basis each year by internal mortality
and expense charges for cash value life insurance and deferred
annuity contracts for the purpose of calculating investment in
the contract under IRC Sec. 72.
This proposal is contrary to the notion of not paying tax
on the amount invested in an asset. Policyholders pay premiums
with after-tax dollars, and they should not be subject to a
second tax on the return of their investment amount. The long-
term cumulative effect of the proposed reduction in
policyholder basis is the reduction of cash values available to
Americans upon retirement.
The proposal actually operates to the detriment of
responsible Americans who hold their annuity investments until
retirement. The proposal would add back reductions to the
policyholder's basis only if the contract is annuitized for
life at the guaranteed rate in the contract, even if the
guaranteed rate is less favorable than other rates then
available. The logic of requiring retiring individuals to
receive less than the amount they otherwise could receive is
far from clear.
It is reasonable to consider taxing gains from contracts
that are surrendered without ever providing the intended death
and retirement benefits, but current law already accomplishes
that purpose. Not only is ordinary income tax paid on the total
difference between cash value and premium paid when a policy is
surrendered, but there are several situations where a penalty
tax also applies to such transactions. Those situations include
all surrenders of deferred annuity policies or life insurance
Modified Endowment Contracts before the policy owner reaches
age 59\1/2\. Thus, current law already taxes and provides tax
penalties on cumulative gains that are withdrawn without being
used for the intended long-term financial security benefits of
insurance.
The existing penalty taxes for withdrawals from Modified
Endowment and annuity contracts apply only to withdrawals
before the insured reaches age 59\1/2\. That age limit
recognizes the multiple financial needs that can arise in the
retirement years and increases the availability of life
insurance and annuity values to address life changes at that
time. The proposed basis changes would penalize life insurance
and annuity owners who need to make withdrawals from their
policies for other financial security reasons, such as the
payment of nursing home costs, at any age.
The proposal would also introduce a high degree of
additional and unnecessary complexity to supporting tax
regulations and to the record-keeping and reporting
requirements of insurers and individual policyholders. The
impact of this complexity would ultimately be borne by the
individual taxpayers, through the added costs and time involved
in preparing their own returns and higher insurance company
administrative costs passed through to policy owners, thus
reducing the amount of their retirement savings.
Proposal: Tax Certain Exchanges of Insurance Contracts and
Reallocations of Assets within Variable Insurance Contracts
Background:
As described previously in the discussion of proposed
reductions in basis, tax law has encouraged individuals to
provide for the financial needs of their survivors and their
retirement years through purchase of life insurance and annuity
contracts. To accomplish this result, cash value is allowed to
accumulate in life insurance and annuity policies without being
subject to current income taxation.
Furthermore, public policy has recognized that there are a
number of different types of insurance contracts available in
the market, and that it may sometimes be in the consumer's best
interest to exchange one policy for another. For that reason
IRC Sec. 1035 has long permitted transfers of value from one
annuity or life insurance contract to another without taxation
on the growth in cash values up to that time.
During the last decade, there has been increasing use of
variable life insurance and variable annuity policies. These
contracts provide the same basic financial security features of
more traditional contracts, but they allow individuals greater
flexibility in the general investment strategy of the assets
backing policy cash values through access to equity returns.
This opportunity generally allows individuals to lower the
overall cost of their benefits, while enhancing long-term
security. For example, a relatively young individual wishing
permanent death benefit protection and the opportunity to save
for retirement income may choose a variable product that allows
allocation of current cash values to an equity-based fund. This
fund may have the potential of providing higher long-term
returns than the traditional fixed income investments of an
insurer's general account. As retirement age approaches, that
individual might wish to reallocate the cash values to a fund
with less risk than equities, minimizing the volatility risk
when the benefits are needed most.
Effect of Proposal:
This proposal would penalize individuals who seek to use
life insurance and annuity contracts to save for retirement.
Specifically, the proposal has two parts. First, it eliminates
IRC Sec. 1035-exchange treatment for transfers between any
contract and a variable contract. Therefore all variable policy
exchanges would be subject to tax on any gain in the contract.
Secondly, it treats each separate account of a variable
contract as a separate contract, so any transfer between
accounts within a variable contract would be a taxable event.
The elimination of Sec. 1035 exchange treatment would
discourage individuals from changing from one policy to another
with more attractive features or cost. The ability to make such
exchanges without current tax impact is one factor that
encourages insurers to offer policyholders increasingly
favorable terms to keep their products competitive. Thus, this
change would harm policyholders by reducing the natural
marketplace incentive to maximize policy performance.
The second part of the proposal--taxing interim gains at
the time funds are moved between separate account options
within a single variable policy--also creates an unwarranted
and inconsistent penalty to the individual who wishes to use
his contractual rights most efficiently. Given the public
policy of encouraging the use of life insurance and annuity
contracts to facilitate the ability of individuals to provide
for their own financial security, there is no reason to apply
taxes to interim gains upon internal asset reallocations.
Annuity and life insurance contracts already contain
restrictions on transfers and liquidity. Policy owners may not
withdraw funds from their account values without reducing or
eliminating the long-term death or retirement income benefits
that will be provided. As long as funds remain inside a policy
that will provide those benefits, the gains should not be
taxed.
This proposal would also increase the cost of variable
products due to significantly more complexity in administration
and record keeping for insurers and for buyers of variable
products who reallocate assets among sub-accounts. These costs
would be passed along to policy owners. Many details would need
to be clarified through further complex regulations.
Proposal: Repeal the so-called ``Crummey Rule'' for gifts after 1998.
Background:
As Congress intended, the $10,000 gift tax annual exclusion
is widely used and encouraged to provide a mechanism for
relatively small gifts to be made to individuals, primarily
family members, without gift or estate tax consequences.
The ``Crummey Rule'' has, since 1968, been a widely used
approach to appropriately utilize the gift tax annual
exclusion. This long-established and well-recognized rule
relies on the legal power of the beneficiaries of the Crummey
power to withdraw amounts contributed to the trust for their
benefit. It is primarily used to make gifts to family members
and, more particularly minor children and grandchildren, while
at the same time, providing them the protections of a trust to
help safeguard their interests.
Frequently, the trust is used to purchase life insurance in
order to provide family members liquidity for estate taxes
without use of the insured's unified credit. This helps avoid
unnecessary liquidation at the insured's death of important
family assets such as a business and the displacement of
employees, which would result therefrom.
Effect of Proposal:
The proposal substantially hurts families wanting to make
appropriate use of the annual gift tax exclusion in order to
make gifts in trust which protect family members, provide
liquidity, and safeguard important family assets. The proposal
would apply to all future gifts, including those which would be
made to previously existing trusts. In a large percentage of
those situations, life insurance has been utilized and those
plans would be substantially disrupted or discontinued. This
would frustrate the taxpayer's reasonable expectations of
having irrevocably gifted their policies and having the law in
effect at the time continue to apply.
Statement of Management Compensation Group
I. Introduction
We appreciate the opportunity to submit this statement for
the record of the Committee's hearing on the revenue proposals
included in the President's FY 1999 Budget. We are Management
Compensation Group, a group of independently owned firms
located across the country, dedicated to assisting businesses
to provide retirement, health and other benefits to their
employees. We help small, medium and larger businesses finance
benefit plans through the purchase of corporate-owned life
insurance (``COLI''). The use of COLI serves a valid social and
economic purpose in financing these benefit plans.
We strenuously OBJECT to the President's proposal to apply
the proration rule adopted in the Taxpayer Relief Act of 1997
(P.L. 105-34) to virtually all COLI, by eliminating exceptions
to the rule for employees, officers and directors (the ``COLI
proposal''). In this statement, we will provide background on
the legitimate business uses of COLI, and the history of tax
issues associated with COLI. We will then discuss the
President's COLI proposal and explain why we think it should be
rejected outright by Congress.
II. Background
1) Permanent Life Insurance For Business
The use of permanent life insurance in a business setting first
arose as a means to protect against the premature death of key
employees. The savings element in permanent life insurance also allowed
for the accumulation of value for use in the buyback of stock or to
protect against business interruption.
As businesses saw a need to fund for pension and other benefit
liabilities that fell outside of their qualified plans, COLI in its
current use evolved. The combination of predictable premiums, long-term
asset accumulation and protection against death benefit liabilities
makes COLI an ideal funding vehicle for these programs.
In these arrangements, businesses purchase COLI in an amount
necessary to match the emerging liabilities for benefits outside of
qualified plans. The COLI asset is typically placed in a trust, and
specific arrangements are made to eliminate excess assets from building
up within the trust. While such assets remain available to creditors
should bankruptcy occur, they are otherwise pledged and held in trust
for the sole purpose of extinguishing corporate liability associated
with the benefit plans.
Funds used to purchase COLI are paid with after-tax dollars. The
tax-deferred growth of these funds only serves to help the plans keep
pace with the emerging liability. The company foregoes a current
deduction, unlike qualified pension plans, and provides a dedicated
buffer for future pension payments. Funding under these plans is
typically limited to those eligible for participation in these
programs.
2) History Of Tax Changes Related To COLI
In the past, Congress has been concerned about the use of COLI as a
pure investment vehicle without appropriate insurance elements. As a
consequence, it has acted to restrict COLI and certain investment-
oriented insurance products, while protecting the tax-deferred nature
of permanent life insurance.
The 1954 Code contained a provision limiting interest deductions on
loans taken out directly or otherwise to purchase insurance (Code
section 264). Since then, Congress has strengthened this provision
several times. Most recently, in the Taxpayer Relief Act of 1997 (the
``1997 Act''), Congress eliminated a broad range of exceptions and
generally disallowed any interest on indebtedness ``with respect to''
the ownership of a life insurance contract. This disallowed any direct
and ``traceable'' interest. A limited exception for ``key person''
policies under $50,000 remained in place.
The 1997 Act also added a new ``proration'' rule which denied
interest deductions on indebtedness ``unrelated'' to the ownership of
insurance policies. An exception to the proration rule was provided for
insurance purchased on lives of employees, officers, directors, and 20
percent owners (Code section 264(f)). This exception is the subject of
the President's COLI proposal.\1\
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\1\ Other changes impacting insurance products occurred over the
years. Certain investment-oriented insurance products called ``modified
endowments'' were restricted by Congress in 1988. This class of
policies loses many or some of the favorable treatment available to
other contracts under Code section 72. Congress in 1990 imposed another
limitation on insurance policies with the enactment of the deferred
acquisition cost provision (Code section 848)(the ``DAC tax''). This
provision limits the ability of insurance companies to deduct
immediately the costs incurred in issuing a policy. The economic effect
of the DAC provision has been to impose a federal premium tax.
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III. The President's COLI Proposal
Under current law, businesses are generally allowed a tax
deduction for interest on indebtedness incurred in their trade
or business. Businesses often own life insurance policies on
the lives of their employees, officers and directors. These
policies meet a number of business needs, including: (1)
providing financial liquidity; (2) allowing businesses to fund
employee and retirement benefits; (3) providing continuation of
business operations upon the death of a key executive; and (4)
providing survivors with death benefit protections.
Recent changes to the tax laws deny an interest deduction
on any indebtedness WITH RESPECT TO life insurance policies.
Therefore, any interest which is directly related or
``traceable'' to a life insurance policy is already denied
under current law. If there is no relationship between the
indebtedness and a corporate-owned life insurance policy on an
employee, officer or director, then there is no denial of
interest.
The President's FY 1999 Budget plan contains a proposal
which would change the current COLI rules, resulting in the
denial of interest deductions on indebtedness incurred by a
business completely UNRELATED to the ownership of insurance on
an employee, officer or director. The Administration believes
this would prevent unwarranted tax arbitrage benefits. This
proposal would have a devastating impact on businesses and
employees throughout the country.
IV. Discussion
The President's COLI proposal is seriously flawed,
inequitable, overly broad, and unjustified. It must be REJECTED
by Congress.
1) ``Tax Arbitrage'' Is A Smoke-Screen
While the Administration suggests that traditional COLI
provides unwarranted tax arbitrage, the argument is not
persuasive and is nothing but a smoke screen to mask its
attempt to tax inside build up of life insurance--a proposal
that has been resoundingly rejected in the past.
There are legitimate tax policy reasons for allowing
ordinary and necessary tax deductions for businesses that incur
indebtedness and pay interest expenses. Similarly, there is a
valid tax policy reason for allowing businesses to own
permanent life insurance and for allowing the growth of these
policies to be tax-deferred.
To arbitrarily tie these two fundamental tax concepts
together as a means of raising revenue is disingenuous. If
denying a deduction for an expense completely unrelated to an
item of income were acceptable, we would have complete chaos in
the tax code.
An example of how ill-conceived this policy would be is the
case of a taxpayer who earns tax-deferred income in a ROTH IRA
and also makes tax deductible mortgage interest payments. If
the taxpayer's mortgage interest deduction were denied on the
theory that he/she has ``tax arbitrage'' from unrelated tax-
deferred earnings in the ROTH IRA, the entire tax code would
have to be reviewed and the deductibility of deductions would
always be in question. The purpose of the tax deferral, in this
case to increase the ability of Americans to save for
retirement and the interest deduction, to promote home
ownership, are completely unrelated. There is no connection
between the ROTH IRA and the mortgage indebtedness just as
there is no connection here between the business indebtedness
and the COLI policy. In the business setting, the analogy would
be to deny an interest deduction on the purchase of office
equipment solely because a business purchased key man life
insurance.
Importantly, current law has safe guards for interest that
is related or ``traceable'' to the ownership of life insurance,
denying such interest deduction in such cases. The President's
proposal attempts to disallow deductions for unrelated
interest. The Administration apparently believes that allowing
a taxpayer a deduction for interest incurred on indebtedness in
the operation of a business is wrong if the business owns life
insurance on its employees, officers, or directors, even if the
business indebtedness is completely unrelated to the insurance.
This belief is contrary to fundamental principals of tax policy
as well as the social objectives such deductions are meant to
achieve.
2) The COLI Proposal is Inequitable
By denying interest deductions on businesses that own life
insurance, the President's COLI proposal creates unjustified
inequities between businesses that rely on debt financing and
those that are equity-financed. Under the proposal, two
taxpayers in the same industry would be treated differently for
tax purposes depending on whether they incurred debt in the
operation of their business or whether they relied on equity
investments.
In addition, businesses in different industries would be
treated differently as a result of the proposal. Many capital
intensive industries rely heavily on debt and would be
disproportionately disadvantaged because the proposal would
deny their interest deductions. This would occur even though
the debt-financed businesses would own the same amount of life
insurance and provide the same amount of employee and
retirement benefits as their equity-financed competitors.
3) Back Door Tax Increase on Cash Value and Unrealized
Appreciation in Business Assets
The President's FY 1999 budget proposal would apply the
1997 proration rules to all COLI and BOLI. Effectively, this
would result in a backdoor taxation of cash values on all
business life insurance.
As stated above, permanent life insurance has traditionally
been a tax-favored investment for good social and tax policy
reasons. The essential element of the insurance--to protect
against the premature death of a key employee--and the use of
the ``cash value'' savings element--to protect against business
interruption or to fund pension and retirement benefits--have
long been recognized as worthy goals.
By denying an interest deduction to businesses that own
such policies and tying the denial to the ``pro-rated'' amount
of ``unborrowed cash value,'' the Administration is indirectly
``taxing'' the cash value on permanent insurance owned by a
taxpayer. Traditional concepts of fairness should prevent the
Administration to do indirectly what they choose not to do
directly.
Moreover, this indirect tax increase on the cash value of a
life insurance policy results in a tax on the ``unrealized
appreciation'' in a taxpayer's asset. This result would be
similar to taxing a homeowner each year on the appreciation of
his/her home.
Fundamental concepts of tax policy dictate that taxes
generally should be incurred on the ``recognition'' of a
taxable event, such as a sale or exchange of property. To now
impose a tax on ``unrealized appreciation'' would not only
violate traditional concepts of tax policy, but could result in
huge administrative burdens on taxpayers and the government if
followed in other areas of the law.
4) Unjustified Elimination of Funding for Employee and
Retirement Benefits
The President's COLI proposal would increase current taxes
on all businesses that own or are the beneficiaries of a
permanent life insurance policy. It would seriously curtail the
availability of the benefits these policies fund and increase
the risk of business failure from loss of a key employee. While
there is a clear relationship between the providing of
insurance and the funding of benefits, there is no relationship
between interest on business indebtedness and unrelated
insurance used to fund benefits.
Current rules already limit potential abuses in traditional
COLI applications. Code section 264 prevents leveraged
arbitrage from tax-deductible borrowing ``related to'' a
corporate-owned life insurance policy. Code section 7702 and
7702A require corporate-owned policies to provide a reasonable
amount of death benefit protection. And qualified plan limits
restrict the amount of insurance that can be purchased by an
employer on a currently deductible basis. It is not clear what
public purpose extending these rules to cover unrelated
interest deductions would serve.
The effect of the President's COLI proposal would be to
limit wholly appropriate business uses of life insurance by
making the cost of insurance products economically infeasible.
Eliminating business owned life insurance could result in the
elimination or reduction in the amount of employer-provided
employee and retirement benefits. Such a change would put
unnecessary and undue pressure on Social Security and public
financing of benefits. At a time when the country faces
significant funding problems with Social Security, there is no
sound policy reason to put additional burdens on financing of
employee benefits and retirement savings.
In attempting to correct perceived abuses of COLI, the
proposal unnecessarily deprives businesses of the legitimate
benefits of COLI to protect against business interruption, loss
of a key employee, or to fund employee benefits. The COLI
proposal is overly broad and imposes restrictions far beyond
those needed to address any perceived abuse. If there are
abuses to be corrected, they should be addressed in a more
narrow manner.
5) COLI Proposal is Inconsistent with Well-founded Savings and
Retirement Policies
At the very same time that the President and Congress are
calling for more tax incentives for personal savings and
directing attention to the impending retirement security
crisis, the President is proposing a provision that would
ultimately reduce personal savings.
The President and Congress have repeatedly called for new
long-term savings provisions (e.g., ROTH IRAs, Education IRAs,
SIMPLE IRAs) and expansions of existing savings provisions
(e.g., increases in traditional IRA limits). By indirectly
``taxing'' life insurance which funds retirement and benefit
programs, the COLI proposal moves in the complete opposite
direction of such efforts. By undermining these initiatives,
the COLI proposal stands out as a stark example of inconsistent
and contradictory tax and retirement policy.
6) Retroactive Tax Increase
Finally, the effective date of the COLI proposal would
create a retroactive tax increase on millions of businesses and
middle-class working Americans by denying an interest deduction
on policies that have been in place. Businesses that relied on
existing tax laws would be penalized and employees who relied
on benefits funded by existing insurance policies would be
unconscionable harmed.
We applaud the strong opposition by the Committee to
retroactive tax increases, as expressed most recently by
Chairman Archer, who made the following statement regarding the
Administration's FY 1999 Budget:
``I do not intend to put my name on anything that is
retroactive.''
A precedent of retroactive application of tax increases to
existing contracts, particularly in the case where there is no
attempt at ``tax avoidance'' or ``tax abuse,'' is inherently
unfair and would reduce the incentives provided in the tax code
for establishing private savings by injecting significant
uncertainty into long-term planning.
V. Conclusion
We urge the Committee to reject in its entirety the
President's COLI proposal. The COLI proposal is seriously
flawed, inequitable, overly broad, and unjustified. Moreover,
it goes well beyond any perceived abuses raised by the
Administration.
We would be happy to provide the Committee with additional
information about the legitimate business uses of life
insurance at any time.
Statement of Massachusetts Mutual Life Insurance Company
Massachusetts Mutual Life Insurance Company is the seventh
largest mutual life insurance company in the United States,
doing business throughout the nation. The Company offers life
and disability insurance, deferred and immediate annuities,
pension employee benefits, mutual funds and investment
services. Massachusetts Mutual serves more than two million
policyholders nationwide and, with its subsidiaries and
affiliates, has more than $130 billion in assets under
management. We are very concerned about the proposals in the
President's Fiscal Year 1999 Budget which would significantly
alter the tax treatment of life insurance and annuity products.
We appreciate the opportunity to offer testimony with respect
to these critical areas of concern.
Exchanges Involving Variable Life and Annuity Contracts
The President's Budget proposals would tax any exchange of
contracts involving either a variable life insurance policy or
a variable annuity contract. In addition, the President's
proposals would treat as a taxable exchange the internal
reallocation of values among the different funds offered under
a variable insurance or annuity contract. Currently, a
policyholder can avoid tax on the surrender of a life insurance
or annuity contract by exchanging it for a new contract in
accordance with the limitations of Section 1035 of the Internal
Revenue Code. On a Section 1035 exchange, the contract gain is
deferred until it is withdrawn or otherwise distributed from
the new policy. The tax-deferral offered by Section 1035 is
available for all cash value life insurance and annuity
contracts, whether fixed, traditional policies or variable
contracts.
Variable life insurance and annuity contracts represent an
increasing percentage of MassMutual's business. The Company has
over 74,000 individual variable life insurance policies in
force, with approximately $14 billion of death benefits.
Variable contracts represent the preponderance of the Company's
annuity sales with $10.9 billion of assets under all of its
variable annuities. The average account balance for our non-
tax-qualified variable annuity contracts is $45,000.
Variable insurance and annuity products give policyholders
an effective means to tailor long-term financial plans to their
own specific needs and those of their families. By taxing
exchanges that involve variable contracts or the transfer of
funds within a variable contract, the Administration would gut
the usefulness of these products for most taxpayers. A
policyholder would be bound to his or her initial investment
decision regardless of the subsequent performance of the
insurance or annuity contract or the funds underlying the
contract.
The Administration has indicated that current taxation of
exchanges or fund reallocations would place variable contracts
on a par with other investments. This is simply not correct.
Federal tax law already subjects variable insurance and annuity
contracts to numerous stringent requirements that do not apply
to other assets. For instance, a life policy that is overly
investment-oriented will fail the definition of life insurance
set out in Code Section 7702. Even if a life policy meets that
definition, too rapid premium payments will cause it to become
a modified endowment contract, subjecting loans and other
distributions during the life of the insured to harsh income
tax rules. A ten percent distribution penalty tax also applies
to modified endowment contracts and annuities.
Furthermore, the underlying investments of variable life
and annuity contracts must meet specific diversification
requirements under Code Section 817 and its regulations, and
must comply with the investor control rules articulated by the
Internal Revenue Service. However long the owner holds a
variable contract, any gain distributed is always taxed as
ordinary income not as capital gains. In contrast to other
assets, the gift transfer of an annuity contract is taxable as
income to the original owner and may trigger the additional 10%
penalty tax. Moreover, there is no step-up in the cost basis of
an insurance or annuity contract when the policyholder dies. In
fact, while the tax laws do not mandate liquidation of other
investments on the owner's death, annuity contracts must begin
distributions when the policyholder dies.
The Administration's proposal is in direct conflict with
its stated commitment to private savings and personal
responsibility for retirement income. Within the restrictions
already imposed by the tax laws, life insurance and annuity
contracts provide a valuable means for achieving those goals.
There is no justifiable basis for penalizing exchanges that
involve variable contracts or transfers of funds among the
investment options offered within a variable contract. Code
Section 1035 was enacted for the express purpose of enabling
policyholders to replace, without tax liability, those
insurance and annuity contracts that no longer met their
particular needs. Congress long ago recognized the validity and
merit of variable life and annuity contracts as integral
components to prudent survivor and retirement planning. The
Administration's proposal would penalize variable contract
owners who tried to protect their insurance and retirement
income.
Business Owned Life Insurance
In the past two years, Congress created appropriate
limitations on a business' ability to deduct interest on debt
when it has cash value life insurance. Following amendments
enacted in 1996, federal law allows a business to take an
interest deduction for loans against only those insurance
policies covering the life of either a 20% owner of the
business or another key person. No more than 20 individuals may
qualify as key persons and the business can deduct interest on
no more than $50,000 of policy debt per insured life. A special
rule grandfathers policies issued before June 21, 1986. The
1997 tax act limited the interest a business can deduct on
general debt if the business also has cash value life insurance
on a person other than its employee, officer, director and 20%
owner (or a 20% owner and spouse). To determine its allowable
interest deductions, a business must reduce its general debt by
the unborrowed cash value in policies covering insureds who do
not come within these exceptions. This ``pro to policies issued
or materially changed after June 8, 1997.
The President's Budget proposals would destroy the
carefully crafted limitations set by the 1996 and 1997
amendments. First, the proposals would eliminate the ability of
a business to deduct interest on loans against a policy
insuring any person other than an individual who owned at least
20% of the business. Second, the Administration would extend
the pro rata disallowance rule to all business owned life
insurance policies except those covering a 20% owner. Further,
the proposals apparently would not grandfather policies
purchased under prior laws.
The proposals would make cash value life insurance
prohibitively expensive for all businesses. By excepting only
policies that insure 20% owners, the Administration proposals
ignore the fact that business life insurance serves many
legitimate, non-tax purposes. Clearly, life insurance provides
a means for businesses to survive the death of an owner,
offering immediate liquidity for day-to-day maintenance or the
funds for co-owners to purchase the decedent's interest from
heirs who are unwilling or incapable of continuing the
business. However, although insurance to fund business buy-outs
serves an important function, businesses use life insurance for
many other equally meritorious purposes.
A business must protect itself from the economic drain and
instability caused by the loss of any major asset. More than
any machinery, realty or tangible goods, the particular talents
of its key personnel sustain a business as a viable force. Life
insurance provides businesses with the means to protect the
workplace by replacing revenues lost on the death of a key
person and by offsetting the costs of locating and training a
suitable successor. Businesses also use life insurance to
provide survivor and post-retirement benefits to their
employees, officers and directors. As part of a supplemental
compensation package, these benefits help attract and retain
talented and loyal personnel, the very individuals who are
crucial to the ongoing success of any business.
In 1996, Congress revised the rules for deducting for
deducting interest on policy loans to impose sharp limits on
the number of insureds and policy debt. The new rules
successfully curtailed the abusive sale of life insurance for
tax leverage and there is no reason to change the rules yet
again. However, businesses need to retain the ability to borrow
against policies on key persons without incurring a tax
penalty. Although buying key person insurance makes sound
business sense, the decision to do so requires a long-term
commitment of capital. The business must have the flexibility
to borrow against such policies in times of need without
adverse tax consequences. The current key person exception is
especially important to smaller businesses that have less
access to alternative sources of borrowing.
Last year, Congress examined the tax treatment of unrelated
debt where a business also happened to hold cash value life
insurance. Based on this review, it created a tax penalty for
companies that hold life insurance on their debtors, customers
or any insureds other than their own employees, officers,
directors or 20% owners. The Administration would now set aside
this careful analysis and overturn a provision approved by the
President only a few months ago. The legitimate needs for
workplace protection insurance have not altered in that short
span of time. The business need for life insurance will not
disappear if Congress extends the pro rata disallowance rule to
policies covering any insured other than 20% owners, but the
resulting costs for businesses will increase. Generally, term
insurance does not provide businesses with a reasonable
alternative to cash value life insurance. While often
appropriate for temporary arrangements, term insurance is both
costly and unsuitable for long-range needs. The loss of
interest deductions on unrelated borrowing is an exceedingly
harsh punishment to impose on a business for taking prudent
financial measures to protect its valuable human assets or to
provide benefits for its employees and retirees.
Reduction in Cost Basis
The Administration's proposals would reduce a
policyholder's cost basis in any life insurance or annuity
contract by the total mortality and expense charges
attributable to the protection offered under the contract. With
respect to annuity contracts, the Administration would assume
annual charges equal to 1.25% of the contract's average cash
value for the year, regardless of the actual charges imposed by
the insurer. The proposed reductions in a contract's cost basis
would create phantom income for all policyholders. Although a
policyholder would receive no more cash on any distribution
from a contract, a larger portion would be taxable as income.
Reducing a policy's cost basis would unfairly penalize one
particular form of asset and would greatly increase the cost of
annuities and cash value life insurance. There is no similar
cutback in a taxpayer's basis to reflect the use and enjoyment
of other assets. Thus, homeowners do not reduce their cost
basis by the annual value of their residence on the property.
Moreover, many other assets qualify for an automatic increase
in cost basis when their owner dies. This ``step-up'' rule can
raise cost basis to the value of the asset on the date of the
owner's death; if the heirs or the estate subsequently sell the
property, only the sale proceeds in excess of the stepped-up
basis would be taxed as income. No step-up in basis is
available when the owner of a life insurance or annuity
contract dies before the insured. Indeed, as opposed to its
treatment of other assets, the tax law, with limited
exceptions, actually requires liquidation of an annuity
contract to begin after the owner's death.
While the proposal to reduce cost basis would adversely
affect all policyholders, it would most severely hit those
policies insuring older individuals and those policies
maintained for the longest periods of time. As an insured ages,
mortality charges associated with his coverage necessarily
increase. The cumulative adjustments to reflect mortality and
expense charges could deplete a policy's cost basis simply
because the insured lived too long. Since mortality charges can
also vary with the insured's gender and health, the charges for
many insureds will consume cost basis more rapidly than for
others. Income taxes should not punish taxpayers for their age,
gender or state of health.
The proposal to deduct mortality and expense charges from
the cost basis of an annuity contract is in direct opposition
to the Administration's rhetorical commitment to encourage
private savings and funding for retirement. The longer a
policyholder kept an annuity contract in force, the less basis
there would be to recover when the contract began
distributions. With an automatic annual reduction equal to
1.25% of the annuity contract's average cash value for the
year, the proposal would also effectively dock the
policyholder's basis by a portion of the earnings on the
contract. For no other asset does the tax law require a
reduction in basis to reflect its appreciation in value.
With the proposed reduction in basis, a policyholder who in
fact held an annuity contract as a long-term retirement vehicle
would find a larger portion of his distributions includible in
gross income than if he had withdrawn the same amount at an
earlier date. The Internal Revenue Code already imposes a 10%
penalty tax on early withdrawals from annuity contracts as a
disincentive to using them as short-term investments. The new
proposal would also penalize a policyowner for holding an
annuity contract too long. The proposal would allow a taxpayer
to recover the lost basis only by annuitizing the contract over
life, a limited exception that would force individuals to lock
into an arrangement that may not best suit their private needs.
In any effort to revitalize personal savings for future income
needs, a rule that increases tax on such savings and dictates
the form of payout will at best be counterproductive.
Taxation of Annuity Contract Reserves
An insurance company is allowed a federal tax deduction for
its annuity reserves, which are the amounts it must set aside
to pay its policyowners in the future. To protect
policyholders, state insurance regulators set guidelines for an
insurer to compute the minimum reserves it must hold. The
Internal Revenue Code specifies how an insurer would compute
its tax deduction for annuity reserves, using as a base the
state method of calculation that produces the minimum amount of
reserves (called CARVM) and making certain adjustments. Under
current tax law, an annuity contract's net surrender value is
the least amount that can be taken as a reserve deduction.
The President's Budget proposals would limit an insurer's
reserve deduction for annuity contracts to the lesser of (1)
the CARVM reserve (again, the minimum reserve amount required
under state law), or (2) the contract's net surrender value
plus a declining percentage of net surrender value phased out
over seven years. The Administration would effectively limit
the reserve deduction to a contract's net surrender value,
regardless of the minimum reserve required under state law.
State reserve requirements are designed specifically to
protect policyholders by providing some safeguard that the
insurer will be able to meet its long-term obligations. Given
the increases in longevity, the National Association of
Insurance Commissioners (NAIC) is reviewing an update of the
mortality tables used to determine annuity reserves. The longer
an annuitant is expected to live, the greater the insurer's
financial commitment and the larger the reserve it must set
aside to meet that commitment. With updated mortality tables,
state laws would then require insurers to increase their
annuity reserves. However, the Administration proposal would
restrict the insurer's tax deduction to only that portion of
the reserves equal to an annuity contract's net surrender
value. It is inappropriate to limit the deduction to an
annuity's net surrender value, a measure that does not take
into account the risks that reserves are intended to meet.
State insurance regulators are better able than the federal
tax authorities to determine the reserves needed to satisfy
obligations to policyholders. The states do not set their
reserve requirements in order to provide insurers with
excessive federal tax deductions. The federal government should
not use the tax laws to usurp the states' authority to
prescribe appropriate financial guidelines to protect their
policyholders.
The Administration has characterized this proposal as an
increase in the income tax burden for insurers, not for annuity
policyholders. Nevertheless, insurers will ultimately pass the
tax cost on to their policyholders, making annuities more
expensive for the many individuals who try to save for their
personal retirement needs. As with the other tax proposals for
insurance and annuity products, the increased tax on annuity
reserves is completely at odds with the Administration's stated
goals of fostering private savings and financial
responsibility.
Crummey Withdrawal Right
Under the combined federal estate and gift tax laws, a
single donor can make annual gifts of up to $10,000 per
recipient without triggering a tax liability; married donors
may give up tts made through a trust qualify for the gift tax
exclusion if the trust agreement grants the beneficiary what is
called a ``Crummey'' withdrawal right, essentially the right to
withdraw gifts made into a trust on his behalf. Since the trust
beneficiary could demand immediate distribution, a gift in
trust is treated as an outright gift eligible for the gift tax
exclusion.
The Administration's Budget proposal would disqualify gifts
in trust from the gift tax exclusion, whether or not the trust
agreement granted the beneficiaries any withdrawal rights. Only
outright gifts would remain eligible for the exclusion.
Effective for gifts made after 1998, the proposal would not
grandfather any existing trust arrangements.
Given the fact that federal gift and estate taxes are
inter-linked, a change in the treatment of lifetime gifts
increases the donor's ultimate estate tax burden. The
Administration proposal would effectively raise federal death
taxes at a time when many members of Congress have indicated
that the tax is already too onerous.
There is no sound reason for taxing gifts to a Crummey
trust differently from outright gifts. The Internal Revenue
service and the courts have established strict guidelines to
ensure that Crummey rights have substance and are not mere
``legal fictions,'' as described by the Administration. The
trust agreement must require the trustee to provide prompt
written notice to a beneficiary that a gift has been made on
his behalf; the trust must grant the beneficiary a reasonable
period to request a withdrawal; and, the trustee must maintain
sufficient liquidity to satisfy any such requests made during
the withdrawal period. As a result, there is no material
difference between a gift made to a Crummey trust and an
outright gift.
For thirty years, the law has recognized contributions to a
Crummey trust as eligible for the gift tax exclusion. Virtually
all irrevocable trusts grant beneficiaries Crummey withdrawal
rights. A change in the tax treatment of gifts to such trusts
would disrupt the long-term estate plans of many American
families. Since the trusts are irrevocable, their provisions
cannot be revised to match a change in the tax law.
Trusts created to hold life insurance policies almost
universally rely on Crummey provisions to avoid tax on the
annual gifts in trust to pay premiums. Over 30,000 MassMutual
life insurance policies are currently held in such trusts. If
those gifts no longer qualify for the exclusion, families would
have to choose between paying the tax or lapsing the policy. As
a practical matter, life insurance trusts are designed to
provide liquidity on the insured's death, including funds to
meet estate taxes. The proposal to tax gifts in trust would
thus inflate the cost of making prudent arrangements to pay
estate taxes.
Conclusion
The revenue provisions contained in the President's Budget
proposed for fiscal year 1999 would unduly increase the tax
burden on holders of life insurance and annuity contracts. The
proposals would effectively penalize taxpayers who try to
provide for their future financial needs, as well as those of
their families and their businesses. By radically altering
well-established tax laws, the Administration proposals would
disrupt the long-term plans of individuals and businesses. The
proposals are particularly unsettling at a time when both
Congress and the Administration agree that there should be a
significant increase in the amount Americans save for their
future financial needs.
Statement of Merrill Lynch & Co., Inc.
Merrill Lynch is pleased to provide this written statement
for the record of the February 25, 1998 hearing of the
Committee on Ways & Means on ``Revenue Provisions in the
President's Fiscal Year 1999 Budget Proposal.'' \1\
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\1\ Merrill Lynch also endorses the comments submitted to the
Committee on these provisions by the Securities Industry Association
and The Bond Market Association.
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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 efforts
of this Congress to finally reach the commendable goal of
balancing the budget.
While Merrill Lynch applauds the efforts of many to balance
the federal budget, it is unfortunate that some of the tax
changes proposed by the Administration in its FY 1999 Budget
would raise the costs of capital and discourage capital
investment--policies contradictory to the objective of a
balanced budget. The Administration's FY 1999 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.
Moreover, many of these proposals have previously been
fully considered and rejected out-of-hand by this same
Congress. On many prior occasions, Merrill Lynch has spoken out
against the negative impact such proposals would have on our
Nation.
Merrill Lynch agrees with comments by Chairman Bill Archer
in announcing these hearings, where he stated:
``Given the public reaction to the numerous tax increase
proposals in the budget, including proposals which have been
rejected previously and new proposals increasing the tax burden
on savings and investment, the Administration has a very heavy
burden to carry.''
These remarks are consistent with Chairman Archer's prior
statement to President Clinton when many of these same
proposals were being considered for inclusion in prior budgets.
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.''
Based on these and other serious concerns by Congress, many
of the capital market proposals which the Administration is now
reproposing were rejected outright in prior years. We see no
legitimate reason to now reconsider these unsound policies.
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.
Merrill Lynch remains 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,\2\ our comments in this
written statement will be limited to the proposals that:
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\2\ Other anti-business, anti-growth proposals include the tax on
certain exchanges of insurance contracts (the ``annuities'' proposal),
the increase in the proration percentage for property & casualty (P&C)
insurance companies, and the real estate investment trust (``REIT'')
proposals. There is no inference of support for proposals not mentioned
in this written statement.
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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). This proposal is nearly identical to ones
proposed by the Administration in its FY '97 and FY '98 budget
plans, which were rejected by Congress.
Eliminate the dividends-received deduction
(``DRD'') for certain preferred stock. This proposal would deny
the 70-and 80-percent DRD for certain types of preferred stock.
The proposal would deny the DRD for such ``nonqualified
preferred stock'' where: (1) the instrument is putable; (2) the
issuer is required to redeem the securities; (3) it is likely
that the issuer will exercise a right to redeem the securities;
or (4) the dividend on the securities is tied to an index,
interest rate, commodity price or similar benchmark. This
proposal is also nearly identical to ones proposed in previous
budgets, which were rejected by Congress.
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:
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.
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.
At a time when the budget is balanced and 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 1999 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. Similar proposals were proposed and rejected by
Congress a number of times in the past two years.
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 1998) (the ``Green Book''):
In many cases, the issuance of convertible debt with OID is
viewed by market participants as a de facto purchase of equity.
Allowing issuers to deduct accrued interest and OID is
inconsistent with this market view.''
This is the same justification used in Treasury's February
1997 Green Book and rejected by Congress.
Merrill Lynch strongly opposes the Administration's
proposal to defer 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 erroneous and inconsistent
with clearly observable facts;
In an attempt to draw a distinction between OIDCDs
and traditional convertible debt, Treasury has in prior years
misstated current law with regard to the deduction of accrued
but unpaid interest on traditional convertible debentures, and
apparently continues to rely on such misstatements;
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.
Finally, this proposal has been fully considered
by this same Congress and rejected in prior years.
A. Treasury's Conclusion That The Market Treats OIDCD As De
Facto Equity Is Erroneous And Inconsistent With Clearly
Observable Facts.
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.
The instruments in question are truly debt rather than
equity. An analysis of all 97 liquid yield option notes
(``LYONs'') sold in the public market since 1985, shows that 57
of those issued had already been retired (as of December 1997).
Of those 57, only 15 were finally paid in stock. The other 42
were paid in cash. The remaining 40 of the 97 issues were still
outstanding as of December 31, 1997. If those 40 securities
were called, only 19 of them would have converted to stock and
the other 21 would have been paid in cash. In other words, the
conversion features of only 19 of the 40 issues remaining
outstanding are ``in the money.'' Overall, only 35% of the
public issuances of LYONs had been (or would be if called) paid
in stock. Thus, in only 35% of these OIDCD issuances had the
conversion feature ultimately controlled.
On the other hand, an analysis of 669 domestic issues of
``typical'' convertible debt retired since 1985 shows just the
opposite result (as of December 1997). Seventy-three percent
(73%) of these offerings converted to the issuer's common
stock. Accordingly, based on historical data, typical
convertible debt is significantly more likely to be retired
with equity than cash, as compared to LYONs.
The Treasury's proposal is clearly without demonstrable
logic. It makes no sense to say that an instrument that has
approximately a 30% 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 over a 70% probability of conversion should be treated
for tax purposes as debt.\3\ We would be happy to provide this
data, and any other relevant information, to the Administration
and Congress.
---------------------------------------------------------------------------
\3\ 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.
B. Prior Misstatements of Current Law Continue to Be Relied
---------------------------------------------------------------------------
Upon
In prior year's Budget proposals, Treasury's has made
statements of ``Current Law,'' which apparently continue to be
relied upon in the FY 1999 Budget plan. These statements
misstate the law regarding interest that is accrued but unpaid
at the time of the conversion. The Treasury has in the past
suggested 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).
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.
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
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.
More precisely on point, the 1982 Tax Act added section
108(e)(8) \4\ 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)(8) 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.
---------------------------------------------------------------------------
\4\ All section references are to the Internal Revenue Code of
1986, as amended.
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.
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 a tax policy that
Treasury had adopted after nearly a decade of study and replace
it with a policy previously rejected by Congress on a number of
occasions.
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:
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 Reduce the DRD, Modify the DRD Holding Period, and
Eliminate the DRD on Certain Limited Preferred Stock
The Administration has proposed to deny the 70- and 80-
percent DRD for certain types of preferred stock. The proposal
would deny the DRD for such ``nonqualified preferred stock''
where: (1) the instrument is putable; (2) the issuer is
required to redeem the securities; (3) it is likely that the
issuer will exercise a right to redeem the securities; or (4)
the dividend on the securities is tied to an index, interest
rate, commodity price or similar benchmark. A similar proposal
was proposed and rejected by Congress a number of times in the
past two years.
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 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.
From an economic standpoint, Merrill Lynch believes that in
addition to exacerbating multiple taxation of corporate income,
the Administration's proposal is troubling for a number of
reasons and would have a number of distinct negative impacts:
Dampen Economic Growth. If the DRD elimination
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.
Limit Competitiveness of U.S. Business. The
elimination of the DRD would also further disadvantage U.S.
corporations in raising equity vis-a-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 ``have taken
advantage of the benefit of the dividends received deduction
for payments on instruments that, while treated as stock for
tax purposes, economically perform as debt instruments.'' 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 eliminating the DRD
goes beyond addressing inappropriate transactions and
unnecessarily penalizes legitimate corporate investment
activity.
While the overall revenue impact of the DRD proposal may be
positive, Merrill Lynch believes the revenue gains 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. Eliminating 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:
(1) A multi-billion dollar 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 elimination of the 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.
(2) A multi-billion dollar 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 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 deferral of legitimate interest
deductions and the 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.
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. 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 AGAIN be rejected in total.
Statement of the Price Waterhouse LLP Multinational Tax Coalition
The Multinational Tax Coalition (``MTC''), a coalition of
U.S. companies in a wide range of industries competing in world
markets, appreciates 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
FY 1999 budget plan.
Specifically, we are testifying in opposition to the
Administration's proposal to expand the Treasury Department's
regulatory authority to address the tax consequences of
``hybrid'' transactions. This proposal is the latest in a
series of international tax initiatives undertaken by the
Clinton Administration that would penalize cross-border
business operations that support U.S. exports and American
jobs.
In our testimony, we explain our chief tax policy concerns
over the Administration's proposal and related Treasury
pronouncements (IRS Notices 98-11 and 98-5). We also weigh
these initiatives from an economic viewpoint, taking into
account their impact on U.S. competitiveness. We conclude that
these initiatives, taken together, represent fundamental
changes in U.S. international tax policy that properly should
be considered by Congress.
MTC members include AES Corporation, Caterpillar Inc.,
Chrysler Corporation, Citicorp, The Clorox Company, Coty Inc.,
DuPont, Emerson Electric Co., General Electric, General Mills,
Inc., Hallmark Cards, Inc., Hewlett-Packard Company, IBM
Corporation, J.P. Morgan, Morgan Stanley, Dean Witter & Co.,
NationsBank Corporation, PepsiCo, Inc., Philip Morris
Companies, Inc., and Tupperware Corporation. Price Waterhouse
LLP serves as consultant to the group.
Background
The Administration's FY 1999 budget, submitted to Congress
on February 2, includes a proposal to direct the Treasury
Department to prescribe regulations clarifying the tax
treatment of hybrid transactions, effective on the date of
enactment. Treasury's ``Green Book'' description of the
proposal defines ``hybrid transactions'' generally as
transactions that utilize ``hybrid entities'' (i.e., entities
that are treated as corporations in one jurisdiction and as
branches or partnerships in another jurisdiction), ``hybrid
securities'' (e.g., securities that are treated as debt or
royalty rights for U.S. tax purposes and as equity interests
for foreign purposes), or other types of hybrid structures.
The Treasury proposal states that the regulations ``would
set forth the appropriate tax results under hybrid transactions
in which the taxpayer's intended results are not consistent
with the purposes of U.S. law.'' Treasury anticipates that this
regulatory authority would be used, in part, to ``deny tax
benefits or results arising in connection with various types of
tax arbitrage transactions, including transactions that
circumvent the purposes of the U.S. Subpart F rules, U.S. tax
treaty provisions, and the U.S. foreign tax credit rules.'' The
Green Book describes some of the broad areas in which the
expanded regulatory authority might be used:
``use of hybrid entities and hybrid securities
that, contrary to the purposes of the Subpart F rules, result
in deductions for foreign tax purposes with respect to certain
cross-border payments that do not generate Subpart F income.''
``use of hybrid securities and other hybrid
transactions in order to achieve results that can not be
achieved through the use of hybrid entities'' because of
section 894(c) and the regulations thereunder.\1\
---------------------------------------------------------------------------
\1\ Section 894(c) denies treaty benefits for certain payments
through hybrid entities.
---------------------------------------------------------------------------
``inappropriate foreign tax credits that arise in
connection with certain hybrid transactions.''
The Green Book notes that the extent of Treasury's current
authority to issue regulations in these areas is unclear in
some instances.
The Treasury proposal comes on the heels of two Internal
Revenue Service pronouncements (Notice 98-11 \2\ and Notice 98-
5 \3\) that discuss similar issues. In Notice 98-11, the IRS
announced that Treasury regulations will be issued to prevent
the use of certain ``hybrid branch'' arrangements deemed
contrary to the policies and rules of Subpart F. Notice 98-11
states that the regulations would apply to hybrid branch
arrangements entered into (or substantially modified,
including, for example, by acceleration of payments or
increases in principal) on or after January 16, 1998.
---------------------------------------------------------------------------
\2\ 1998-6 Internal Revenue Bulletin, February 9, 1998.
\3\ 1998-3 Internal Revenue Bulletin, January 20, 1998.
---------------------------------------------------------------------------
At issue, Notice 98-11 states, are hybrid branch
arrangements generally involving the use of deductible payments
to reduce the taxable income of a CFC and the creation in a
hybrid branch of low-taxed, passive income that is not taxed
under Subpart F. Notice 98-11 states that the creation of
hybrid branches in these arrangements has been facilitated by
recent entity classification (``check-the-box'') regulations.
Notice 98-11 also states that Treasury and the IRS are
aware that the Subpart F issues raised by hybrid branches also
may be raised by certain partnership or trust arrangements.
Notice 98-11 states that Treasury and the IRS intend to address
these issues in separate ``ongoing'' regulations projects.
In Notice 98-5, the IRS has announced that regulations will
be issued to disallow U.S. foreign tax credits for taxes
generated in certain ``abusive arrangements.'' According to the
Notice, arrangements generally will be considered abusive where
the ``reasonably expected economic profit is insubstantial
compared to the value of the foreign tax credits'' claimed.
Five examples of these arrangements are provided. The Notice
states that the regulations will be effective with respect to
taxes paid or accrued on or after December 23, 1997.
In addition, Notice 98-5 indicates that the IRS will begin
scrutinizing foreign tax credit claims in connection with the
types of transactions described by the notice as abusive and
may disallow credits under ``existing law,'' independently of
the regulations to be issued. The Notice suggests that such
challenges based on existing law may seek to deny credits for
taxes paid or accrued before the effective date of the notice.
Finally, Notice 98-5 identifies several other areas in
which Treasury and IRS are considering guidance to limit the
availability of foreign tax credits. These include situations
involving high withholding taxes, ``mismatches'' between the
timing of payment of foreign taxes and recognition of foreign
source income, and portfolio hedging strategies.
Tax Policy Concerns
The MTC is seriously concerned about the application of
Notices 98-11 and 98-5 to legitimate business transactions and
about the breadth of the regulatory authority requested by
Treasury in its FY 1999 budget proposal. The stated goal of
these initiatives is to prevent certain transactions that
Treasury and the IRS consider to be ``inconsistent with the
purposes of U.S. tax law (including tax treaties).'' Apart from
a few examples, however, neither the budget proposal nor the
Notices specify which transactions will be affected, or how and
when this determination will be made. These open-ended
initiatives have created significant uncertainty for taxpayers
and already have had a chilling effect on normal business
operations.
We also are troubled by the retroactive impact of Notices
98-5 and 98-11. The regulations contemplated by these Notices
would fundamentally alter the treatment of existing
arrangements entered into by taxpayers in reliance on current
law. Notice 98-5 was issued on December 23, 1997, to deny
foreign tax credits for amounts due to accrue eight days later
under binding contracts. It remains unclear, after almost three
months, precisely which transactions would be affected by this
measure. Similarly, in circumstances yet to be specified,
Notice 98-11 would prohibit the adoption of certain business
structures as of January 16, 1998, the date on which it was
issued. In addition, Notice 98-11 would require many
businesses, including businesses that relied on the recent
``check-the-box'' regulations, to complete major restructuring
by June 30, 1998, again without any guidance to date regarding
its exact reach. We believe these Notices represent a
questionable use of the limited exceptions to the general
prohibition on retroactive regulations enacted by Congress in
1996.
In addition to these procedural fairness concerns, we have
fundamental policy concerns regarding the new initiatives. At
one level, Notice 98-5 and Notice 98-11 appear to be motivated
by opposite concerns. Notice 98-5 expresses concern regarding
reduction of U.S. tax, while Notice 98-11 is concerned about
reduction of foreign tax. The common suggestion is, however,
that the United States generally should impose tax where an
adequate tax is not imposed by the foreign country. This
thinking raises major tax policy issues that are not addressed
by the stated rationales for these initiatives.
Notice 98-11 targets ``hybrid branch'' arrangements on the
grounds that such arrangements ``circumvent the purposes of
Subpart F.'' Without citing specific statutory provisions or
legislative history, Notice 98-11 presents a broad account of
Congress' intent in enacting Subpart F in 1962. According to
Notice 98-11, one of the purposes of Subpart F is to prevent
controlled foreign corporations from earning ``low-or non-taxed
income on which United States tax might be permanently
deferred'' as a result of inconsistencies between U.S. and
foreign tax systems.
Subpart F clearly does not presume that U.S. tax should be
imposed currently wherever a certain level of foreign tax is
not. If Congress had meant to provide such a rule, it
presumably would have enacted an effective tax rate test.
Instead, Congress enacted a general deferral regime, and chose
to impose U.S. tax currently only on specified types of income.
Even under Subpart F, U.S. tax generally is deferred without
regard to whether the income is earned in a high-tax or low-tax
jurisdiction. It is clear that Congress considered the issue of
foreign tax rates in this context, because Subpart F provides a
broad exception for income subject to high foreign tax.
Treasury and the IRS would now do the converse, by denying
deferral for income subject to low foreign tax. But they would
do so administratively, where Congress has declined to do so
legislatively. And they seek to do so without indicating what
they would consider to be an appropriate tax burden.
Notice 98-11's account of the legislative intent underlying
Subpart F diverges in important respects from the official
legislative history provided by Congress. First, Subpart F does
not focus on inconsistencies between U.S. and foreign law. In
fact, neither the statute nor the legislative history even
mentions such inconsistencies. Subpart F focuses solely on the
issue of when U.S. tax should be imposed on certain types of
income. Apart from the taxpayer-favorable exception noted
above, Subpart F does not condition deferral on whether or how
foreign tax is imposed on that income.
Second, while the legislative history indicates that
Congress sought to strike a balance in enacting Subpart F, it
gave far more weight to competitiveness concerns than is
suggested by the account provided by Treasury and the IRS. This
is evidenced clearly by both the House and Senate reports,
which cite preservation of the international competitiveness of
U.S. business as the major reason for rejecting the
Administration's bid to repeal deferral. It also is evidenced
by the resulting statute, which clearly retains deferral as the
general rule, not the exception.
If anything, competitiveness concerns have become even more
important since Subpart F was enacted in 1962. First, the Tax
Reform Act of 1986 greatly expanded the reach of Subpart F to
encompass more types of active business income and imposed
numerous new limitations (``baskets'') on the foreign tax
credit. Second, U.S. businesses face far more intense
competition around the world than was the case in 1962. With
the increasing globalization of the economy, it has become
critical for businesses to compete internationally if they wish
to remain competitive in their home markets. If U.S. businesses
are to succeed in the global economy, they will need a U.S. tax
system that permits them to compete effectively against
foreign-based companies. This requires a system that permits
broad deferral for active business income and provides a full
foreign tax credit to prevent double taxation. The new Treasury
and IRS initiatives would move in the opposite direction.
Notice 98-5 similarly oversteps its statutory bounds. Like
the budget proposal, it rests on a vision of the foreign tax
credit regime that is not evidenced by--and, indeed, is
inconsistent with--the statute.
According to Notice 98-5, the purpose of the foreign tax
credit is ``to preserve neutrality between U.S. and foreign
investment and to minimize the effect of tax consequences on
taxpayers' decisions about where to invest and conduct
business.'' It objects that allowing a foreign tax credit in
``abusive'' cases would serve ``no statutory purpose.'' Notice
98-5 further contends that allowing a foreign tax credit in
such cases would be incompatible with ``the existence of the
detailed foreign tax credit provisions and cross-crediting
limitations enacted by Congress.'' Notice 98-5 is premised,
therefore, on a broad vision of the role of the foreign tax
credit regime, coupled with a narrow reading of the cross-
crediting permitted by that regime.
There is no evidence, however, that Congress ever intended
the foreign tax credit to do anything other than remove a
disincentive to foreign investment by U.S. companies, which
would otherwise be subject to double taxation under our
worldwide tax system. It is true that Congress has imposed some
limitations on the use of the foreign tax credit, such as
separate ``baskets'' for certain types of income, but those
limitations are specified in great detail in the statute, as
Notice 98-5 itself acknowledges.
The cross-crediting to which Notice 98-5 objects is an
integral part of our foreign tax credit regime. The Notice
concedes that the U.S. foreign tax credit regime generally
permits taxpayers to cross-credit by using foreign taxes
imposed on high-taxed foreign source income to offset residual
U.S. tax on low-taxed foreign source income. Indeed, the Notice
acknowledges that such cross-crediting is allowed because it is
viewed as ``consistent with the interrelated quality of
multinational operations of U.S. persons.''
In seeking to deny credits in cases they regard as
``abusive,'' Treasury and the IRS would move the foreign tax
credit regime carefully constructed by Congress away from a
system that explicitly permits cross-crediting to average high-
and low-taxed foreign income towards an item-by-item limitation
that would deny taxpayers the ability to cross-credit. It would
accomplish this major change by administrative action--a
significant and burdensome restriction on the foreign tax
credit that Congress has declined to enact by statute. This
would depart from the long-established procedure of having
Congress consider fundamental changes to our foreign tax credit
laws--a procedure acknowledged by Treasury only last year in
its efforts to impose certain holding period requirements (see
section 901(k)(4)).
These concerns are exacerbated by the unacceptable
vagueness of Notice 98-5 and the budget proposal. While Notice
98-5 signals the view that certain transactions are
``abusive,'' it provides no clear basis for distinguishing
``abusive'' transactions from transactions for which a foreign
tax credit should be allowed. According to the Notice, certain
types of transactions will be considered abusive wherever the
expected economic profit is ``insubstantial'' compared to the
foreign tax credits involved. The Notice does not define the
term ``insubstantial,'' and Treasury officials have publicly
commented that the regulations to be issued under the Notice
will not define the term.
Compounding this uncertainty is the fact that a finding of
``abuse'' would not require any demonstration of tax
motivation. In this regard, Notice 98-5 and the budget proposal
venture far beyond accepted anti-abuse principles. In fact, it
is clear that they would reach even transactions entered into
by a taxpayer in the ordinary course of conducting its
business. For example, they would deny credits for foreign
withholding taxes incurred by U.S. securities dealers in
connection with routine hedging positions taken in the ordinary
course of their business. This is contrary to the intent of
legislation enacted by Congress only last year. In adding
section 901(k)(4) to the Code, that legislation provided a
broad ordinary-course exception to its general holding period
requirements, which Treasury and the IRS would now simply
disregard in many cases. As Congress recognized in enacting
section 901(k)(4), ordinary-course exceptions are essential if
U.S. business is to remain competitive in the world
marketplace.
In sum, it is clear that Notice 98-5 seeks to impose extra-
statutory limits on the foreign tax credit, while Notice 98-11
seeks to limit deferral in a manner that Congress has declined
to do. These initiatives would seriously undermine the
competitiveness of U.S. businesses. However, Treasury and the
IRS present the Notices and the budget proposal as measures
designed to preserve the existing principles of the U.S.
international tax regime. They take the view that the balance
that has been established by Congress should be interpreted
more restrictively than either the legislative history or the
statute would require.
The MTC respectfully suggests that, if anything, our
Subpart F and foreign tax credit rules should be relaxed rather
than tightened. They contain a number of restrictions that have
become unworkable or outmoded. For example, unlike the law of
other countries, Subpart F continues to deny deferral for
active income earned by financial services companies. And the
foreign tax credit system has reached a level of complexity
that is daunting for taxpayers and tax administrators alike.
While the basic framework of our law remains solid, it needs to
be updated to ensure that U.S. businesses will remain able to
compete in the 21st century. This role properly is that of
Congress, however, not Treasury or the IRS.
Initiatives Override Long-standing Doctrines
The Administration's initiatives conflict with long-
standing U.S. tax law doctrines. First and foremost, Notice 98-
11 and the budget proposal are based on the premise that
transactions are abusive if they allow U.S. multinationals to
reduce their foreign tax burden in a manner perceived as
inconsistent with Subpart F. As discussed above, we do not
agree with the Treasury/IRS reading of Subpart F. In any event,
however, the IRS and the courts have recognized that a
reduction of foreign tax is a legitimate business purpose for a
transaction. See, e.g., Rev. Rul. 89-101 and Betty M. Ellis v.
Commissioner, 50 T.C.M. 1202 (1985). In fact, if U.S.
multinationals pay less in foreign taxes, they can be expected
over the long term to claim fewer foreign tax credits--and thus
to pay more residual U.S. tax. In short, there does not appear
to be any valid policy reason why the United States should
insist that its multinationals pay more foreign taxes than
their foreign competitors.
Second, by making the Subpart F or other U.S. tax
consequences depend on how the foreign taxing jurisdiction
treats a transaction, Notice 98-11 and the budget proposal
would overturn the principle that the foreign tax law treatment
of a transaction should not dictate the U.S. tax results. See
Biddle v. Commissioner, 302 U.S. 573 (1938); United States v.
Goodyear Tire and Rubber Co. et al., 493 U.S. 132 (1989).
Third, by preventing taxpayers from conducting their
overseas operations in a form that will be considered a branch
for all purposes of the Internal Revenue Code, Notice 98-11 and
the budget proposal would overturn the principle that taxpayers
are free to choose the form in which they will do business. See
Higgins v. Smith, 308 U.S. 473 (1940) (``A taxpayer is free to
adopt such organization for his affairs as he may choose.'').
Fourth, Subpart F currently contains a branch rule that is
set forth in the statute and that is limited to foreign base
company sales income. In Notice 98-11, Treasury effectively
seeks to create a new Subpart F branch rule, for foreign
personal holding company income (and perhaps other categories
of Subpart F income as well), despite a lack of similar
statutory authority. Given that Congress saw fit to create only
one branch rule, and to limit it to foreign base company sales
income, it seems clear that Treasury lacks the authority to
create additional branch rules.
Finally, the branch rule that Treasury seeks to create is
fundamentally different from the existing Subpart F branch
rule. Whereas the existing branch rule merely recharacterizes
income derived from transactions with other parties, Treasury's
new branch rule would actually create income where the CFC has
not entered into a transaction with another party (for example,
by treating a remittance from the corporate home office to a
branch as ``income,'' as in Example 2 of Notice 98-11). By
creating income where none exists under general U.S. tax
principles, this new rule would represent a radical departure,
beyond the bounds of Subpart F. While allowing the
recharacterization of existing income under certain
circumstances, the rules of Subpart F do not give Treasury and
the IRS the authority to create income.
Economic Concerns
Competitiveness
From an income tax perspective, particularly since the Tax Reform
Act of 1986, the United States currently has become one of the least
attractive countries in which to locate the headquarters of a
multinational corporation. As a result, U.S.-based multinationals tend
to be disadvantaged relative to non-U.S. multinationals in competing
around the world. The Administration's proposal would further burden
U.S.-based multinationals.
First, it should be noted that many of our major trading partners
(12 of the 24 OECD countries as of 1990) operate under the principle of
``territorial'' taxation, under which a parent company is not subject
to tax on the active income earned by a foreign subsidiary.\4\ By
contrast, the United States taxes income earned through foreign
corporations when it is repatriated or deemed to be repatriated under
various ``anti-deferral'' rules in the tax code.
---------------------------------------------------------------------------
\4\ Organization for Economic Cooperation and Development, Taxing
Profits in a Global Economy, 1991.
---------------------------------------------------------------------------
Second, among countries that tax income on a worldwide basis, the
active business income of a foreign subsidiary is generally not subject
to tax before it is remitted to the parent.\5\ This differs from the
U.S. treatment of foreign base company sales and service income and
financial services income, and certain other types of active business
income, which are subject to current U.S. tax even if reinvested
abroad.
---------------------------------------------------------------------------
\5\ Organization for Economic Cooperation and Development,
Controlled Foreign Company Legislation, 1996.
---------------------------------------------------------------------------
Third, other countries with worldwide tax systems generally have
fewer restrictions on the use of foreign tax credits than the United
States.\6\
---------------------------------------------------------------------------
\6\ A variety of U.S. rules limit the crediting of foreign taxes
against U.S. tax liability. These include multiple separate ``baskets''
for calculating tax credits, the apportionment of interest and certain
other deductions against foreign source income, and the attribution to
a foreign subsidiary of a larger measure of income for U.S. purposes
(``Earnings and Profits'') than used by other countries. See Taxation
of U.S. Corporations Doing Business Abroad: U.S. Rules and
Competitiveness Issues, Price Waterhouse LLP (Financial Executives
Research Foundation, 1996).
---------------------------------------------------------------------------
Fourth, most of the major trading partners of the United States
provide for some form of integration of the corporate and individual
income tax systems, which reduces or eliminates the extent to which
corporate income is double taxed--at both the corporate and shareholder
level.\7\
---------------------------------------------------------------------------
\7\ Organization for Economic Cooperation and Development, Taxing
Profits in a Global Economy, 1991.
---------------------------------------------------------------------------
The net effect of these tax differences is that a foreign
subsidiary of a U.S. corporation frequently pays a greater share of its
income in foreign and U.S. tax than a similar foreign subsidiary owned
by a company headquartered outside of the United States.\8\ This makes
it more expensive for U.S. companies to operate abroad than their
foreign-based competitors.
---------------------------------------------------------------------------
\8\ Organization for Economic Cooperation and Development, Taxing
Profits in a Global Economy, 1991.
---------------------------------------------------------------------------
A decline in activity of U.S. companies abroad can have important
negative consequences for the U.S. economy. For example, foreign
affiliates of U.S.-owned companies are responsible for a significant
amount of exports from the United States.\9\ As another example, a
reduction in foreign activity would reduce headquarter-based
activities, such as research and development, that tend to provide high
wages and enhance U.S. productivity.\10\
---------------------------------------------------------------------------
\9\ Survey of Current Business, October 1997, p. 50.
\10\ See Irving Kravis and Robert Lipsey, ``Sources of
Competitiveness of the United States and of its Multinational Firms,''
Review of Economics and Statistics, May 1992, for a discussion of the
relationship between R&D intensity and human capital intensity and
worldwide trade shares of U.S. multinationals.
---------------------------------------------------------------------------
Equity
One argument for the Administration's budget proposal is equity.
For instance, if some taxpayers are able to reduce foreign taxes
through the use of certain hybrid arrangements, while other taxpayers
do not make use of these arrangements, then there may be an inequity.
As the Joint Committee on Taxation notes in its analysis of the
Administration's proposal, however: ``hybrid transactions are not
inherently inequitable. Any business may choose to organize itself to
take advantage of the benefits of these structures.'' \11\
---------------------------------------------------------------------------
\11\ Joint Committee on Taxation, Description of Revenue Provisions
Contained in the President's Fiscal Year 1999 Budget Proposal (JCS-4-
98), February 24, 1998, p. 197.
---------------------------------------------------------------------------
Given the general applicability of hybrid arrangements, any concern
about disparate treatment of similarly situated taxpayers appears to be
unfounded.
Efficiency
The JCT analysis of the Administration's proposal raises the
possibility that hybrid arrangements may result in three types of
economic inefficiencies.
1. Potential misallocation of investment.--First, if some
international activities can make use of hybrid arrangements while
other international activities cannot, then there may be a concern that
too much investment will be directed to the relatively tax-favored
activity. However, since the opportunity to make use of hybrid
arrangements is generally available, there is little reason to suggest
that these structures create a misallocation of investment resources
among alternative international activities.
2. Potential for inefficient increase in administrative costs.--A
second efficiency concern is that the use of hybrid arrangements causes
real resources to be expended merely to achieve tax savings.
In fact, the ``check the box'' regulations under which many hybrid
arrangements operate were motivated by a concern for reducing
administrative costs relative to the costs required to achieve similar
tax effects through more complex legal structures. The recent notices
issued by the IRS on a retroactive basis will cause taxpayers to incur
substantial costs to modify structures adopted in reliance on present
law. Moreover, the testing of individual transactions for economic
substantiality, as contemplated in Notice 98-5, would be an enormous
compliance burden on taxpayers that engage in large numbers of
transactions.
3. Potential for inefficient increase in foreign investment.--A
third efficiency concern is that if hybrid arrangements facilitate the
reduction of foreign taxes, there may be an incentive for U.S.
multinationals to increase foreign investment relative to domestic
investment. This would be inefficient if, on a pre-tax basis, domestic
investment were more productive than foreign investment.
Academic research and government data on the foreign direct
investment of U.S. multinationals suggest that increased foreign
investment is efficiency enhancing and results in important benefits to
the U.S. economy.
For example, research by Martin Feldstein concludes that an
additional dollar of foreign direct investment by U.S. multinationals
leads to an increase (in present value) of $1.72 in interest, dividend
receipts, and tax payments to the United States, relative to $1 of such
receipts on domestic investment.\12\
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\12\ Martin Feldstein, ``Tax Rules and the Effect of Foreign Direct
Investment on U.S. National Income,'' in Taxing Multinational
Corporations, eds. Martin Feldstein, James R. Hines, Jr., and R. Glenn
Hubbard (University of Chicago Press, 1995).
---------------------------------------------------------------------------
Tax Revenue Effects
The official revenue estimate by the Joint Committee on Taxation
shows that enactment of the proposal would result in no change in
revenues in any year over the fiscal year 1998-2008 period.
Aspects of the Administration proposal can even be seen to reduce
U.S. tax collections if the Treasury Department were to use its grant
of regulatory authority to restrict the use of hybrid arrangements.
Current use of hybrid arrangements often results in a reduction in
foreign taxes paid. A reduction in foreign taxes increases the after-
tax return (in present value) to the United States from foreign
investment. A reduction in foreign taxes also increases the amount of
taxes paid to the U.S. government when the income is repatriated, since
a smaller amount of foreign taxes would be creditable against U.S. tax
liability.
Treasury concerns about the creditability of withholding taxes
levied by third countries with respect to financial instruments held
abroad appears misplaced. Foreign governments generally allow these
withholding taxes to be credited against their income taxes. In these
cases, the withholding tax does not add to the total foreign tax burden
borne by U.S. investors.
The Administration's proposal can be seen to harm U.S. investors
and ultimately reduce U.S. tax collections. Again, it should be noted
that other countries do not tax the transactions that the
Administration proposes to tax under this proposal.
Capital Export Neutrality
One theoretical principle that is sometimes invoked in discussions
of international tax policy is capital export neutrality (CEN). Under
this principle, taxes would not affect the investment location
decisions of multinational corporations.
One way to achieve CEN would be to tax worldwide income on a
current basis (whether or not repatriated) with an unlimited foreign
tax credit. No country has adopted a pure CEN tax system. The U.S. tax
system can be seen as a compromise: by providing only a limited foreign
tax credit, total tax paid on certain foreign source income exceeds
that paid on domestic source income, while deferral of U.S. taxation on
certain unremitted active business income can result in a lower rate of
tax.
Many countries follow the principle of capital import neutrality
(CIN) with respect to active business income. Under this principle, an
investment in a foreign country is subject to the same amount of tax
regardless of the nationality of the investor. CIN is obtained by
exempting foreign source income from domestic tax.
The Administration's proposal does not move the U.S. tax system
closer to either location neutrality (CEN) or competitiveness (CIN). By
restricting the use of hybrid arrangements, taxes on foreign source
income are increased both by further limiting the use of foreign tax
credits and by further restricting deferral on active foreign income.
Of course, more important than adherence to an abstract principle
is to evaluate directly whether U.S. living standards are increased by
tax policies which encourage foreign direct investment by U.S.
multinationals.\13\ As discussed earlier and in the next section, the
evidence is quite strong that foreign direct investment by U.S.
multinationals increases U.S. living standards in a number of different
ways.
---------------------------------------------------------------------------
\13\ Joint Committee on Taxation, Factors Affecting the
International Competitiveness of the United States, JCS-6-91, May 30,
1991.
---------------------------------------------------------------------------
Effects of Foreign Investment on the U.S. Economy
The primary motivation for U.S. multinationals to operate abroad is
to better compete in foreign markets, not domestic markets. A large
body of research has documented that U.S. operations abroad on balance
increase exports of goods and services from the United States. In 1995,
U.S.-controlled foreign corporations contributed a net surplus of $27
billion to the U.S. trade balance.\14\
---------------------------------------------------------------------------
\14\ Survey of Current Business, October 1997, p.50.
---------------------------------------------------------------------------
Foreign direct investment is one means by which U.S. multinationals
can increase their return on firm-specific assets, including patents,
skills, and technologies. As noted by Robert Lipsey, the ability to
earn an enhanced return on these firm-specific assets through foreign
direct investment provides an incentive to increase investment in the
activities that generate these assets, such as research and
development.\15\ These and other high-value activities are
disproportionately undertaken by U.S. multinationals in the United
States. For example, over the past 20 years, between 43% and 62% of
total U.S. R&D was performed by or for U.S. multinationals.\16\
---------------------------------------------------------------------------
\15\ Robert Lipsey, ``Outward Direct Investment and the U.S.
Economy,'' in The Effects of Taxation on Multinational Corporations,
eds. Martin Feldstein, James R. Hines, Jr., and R. Glenn Hubbard
(University of Chicago Press, 1995).
\16\ Bureau of Economic Analysis and National Science Foundation
data.
---------------------------------------------------------------------------
Other research has focused on the effect of foreign direct
investment on U.S. employment and U.S. wages and salaries. This
research finds little or no evidence of an adverse effect on the U.S.
labor market.\17\ In 1995, approximately 80 percent of new foreign
affiliate assets and employees of U.S. multinationals were located in
high-wage foreign countries. These and other findings suggest that
foreign investment is primarily undertaken to pursue market
opportunities abroad rather than to substitute low-cost foreign labor
for U.S. operations.
---------------------------------------------------------------------------
\17\ See, e.g., S. Lael Brainard and David Riker, ``Are U.S.
Multinationals Exporting U.S. Jobs?'' National Bureau of Economic
Research Working Paper 5958, March 1997.
---------------------------------------------------------------------------
Conclusion
Treasury's FY 1999 budget proposal and the issuance of
Notice 98-11 and 98-5 are the latest in a series of Clinton
Administration anti-competitive international tax initiatives
that have been blocked by Congress. For example, Congress in
1997 rejected Treasury proposals to eliminate the export sales
source rules under section 863(b), which help support U.S.
exports. In addition, Congress in 1996 repealed ill-conceived
limitations on deferral, under section 956A, that had been
proposed by the Administration in 1993. The MTC applauds the
Congress for having provided a counterbalance with respect to
these initiatives, and would urge Congress to continue its
vigilance.
We have two requests. First, in light of strong concerns
and uncertainty over the regulatory authority requested by
Treasury in the Administration's FY 1999 budget, we ask
Congress not to adopt this proposal. Policy changes of the
scope envisioned by Treasury should be made by the Congress
after input from all interested constituencies, not by notice
or regulation.
Second, we respectfully ask the Congress to limit the
Treasury's ability to take preemptive active in the areas
discussed in Notice 98-11 and Notice 98-5. Specifically, we ask
that Congress consider the possibility of a moratorium on
regulations to be promulgated pursuant to Notices 98-11 and 98-
5 until Congress, with input from the Treasury and Commerce
Department, has an appropriate opportunity to study the issues
involved and the ramifications for the ability of American
businesses to compete in world markets.
The MTC stands ready to work with Congress and the Treasury
Department to reach a resolution of these issues.
[GRAPHIC] [TIFF OMITTED] T1685.005
Statement of National Association of Manufacturers
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 provisions in the
Administration's FY 1999 budget proposal. The NAM is the
nation's oldest and largest broad-based industrial trade
association. Its more than 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 Administration's FY 1999 Budget proposal jeopardizes
last year's balanced-budget agreement and threatens to revive
big government with proposals to increase new spending by $21
billion financed by a $25 billion tax hike. The majority of the
included tax proposals are anti-growth and bad tax policy, with
a few notable exceptions. Overall, the proposals run counter to
the NAM's goal of maintaining sustained economic growth to
enhance living standards for all Americans. Although this is
not an exhaustive list, following are the NAM's comments on
some of the specific provisions.
Pro-Growth Proposals
Accelerating the Effective Date of Look-Through Treatment for
10/50 Companies
This proposal would accelerate the effective date of a tax
change made in the 1997 Tax Relief Act affecting foreign joint
ventures owned between 10 and 50 percent by U.S. parents (so-
called ``10/50 companies''). This change will allow 10/50
companies to be treated similarly to controlled foreign
corporations by allowing ``look-through'' treatment for foreign
tax credit purposes for dividends from such joint ventures.
Under the 1997 Act, the change is effective only for dividends
received after the year 2003 and, even then, two sets of rules
are required to be applied: one for dividends from earnings and
profits (E&P) generated before 2003 and another for dividends
from E&P accumulated after 2002. The Administration's proposal
will instead apply the look-through rules to all dividends
received in tax years after 1997, regardless of when the E&P
constituting the dividend were accumulated.
This change will result in a tremendous reduction in
complexity and compliance burdens for U.S. multinationals doing
business overseas through foreign joint ventures. It will also
reduce the competitive bias against U.S. participation in such
ventures by placing U.S. companies on a much more level playing
field from a corporate tax standpoint. This proposal epitomizes
the favored policy goal of simplicity in the tax laws and will
go a long way toward helping the U.S. economy by strengthening
the competitiveness of U.S.-based multinationals.
Extending the Research and Experimentation (R&E, commonly known
as R&D) Tax Credit
Technology progress accounts for nearly one-third of
economic growth over the long run because of the direct
correlation between technology progress and increased
productivity. Although the credit's benefits are many, a
principal benefit of the credit is its effect on lowering the
cost of investing in technology. Thus, the NAM commends the
President for recognizing the importance of the credit's
contribution to sustaining our robust economic growth by
including a one-year, seamless extension of the credit.
NAM economic analysis shows that a perminant R&D tax credit
would, over time, actually increase the rate of GDP growth over
the long term, as opposed to a one-time shift in the level of
GDP. This is an important distinction from most policy
initiatives, which have no effect on the rate of long-term
economic growth. Since manufacturers are the principal parties
engaging in U.S.-based R&D activities and many of our nation's
foreign trade competitors offer permanent tax and financial
incentives for R&D, the credit helps mitigate this unfair
competitive disadvantage to U.S. companies. The Congress and
the President are urged to work together to end the continuing
15-plus year saga of temporary lapses of the credit with
extensions that may or may not be retroactive to the expiration
date. Thus, the NAM strongly supports ending the uncertainty of
credit extensions by making the R&D tax credit permanent.
``Global'' Interest Netting on Underpayments and Overpayments
The NAM supports this long-overdue taxpayer simplification
proposal and urges speedy enactment. Specifically, this
proposal will allow global interest netting for income taxes by
adding a new interest rate to Internal Revenue Code section
6621. Thus, this proposal will allow netting an overpayment, or
interest thereon, against a prior deficiency of tax or interest
that has already been paid in full by the taxpayer, or
conversely netting an underpayment against a prior refund (of
tax or interest) that has already been paid by the IRS.
Tax Incentives To Promote Energy Efficiency and Improve the
Environment
In general, the NAM supports a voluntary approach to
improving energy efficiency and the environment rather than
federal mandates. While the NAM generally approves of the
thrust of the Administration's tax incentive proposals
pertaining to energy efficiency, the manufacturing community
would prefer a general, permanent extension of the R&D tax
credit to better allow the market to allocate limited
resources.
Growth-Inhibiting Proposals
Repeal of the 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 United States 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 make use of 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 United States 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 that would add administrative burdens and create
controversies. The NAM strongly urges Congress to retain the
current export source rule.
Estate and Gift Tax Provisions
In the area of estate and gift taxes, the Administration
proposes to scrap the techniques that allow a business owner to
move illiquid assets out of the estate first. Forcing business
owners to delay transfer of business ownership until death will
result in an even higher failure rate for family-owned
businesses.
The best example of this is the Administration's proposal
to eliminate the ``Crummey'' rule. The Crummey rule allows
transfer of ownership in an orderly fashion during the donor's
lifetime. Since the case was decided nearly 30 years ago,
thousands of estate plans have been built on the decision. The
revenue gains from its elimination are small because gifting
can and will continue. This change would make it harder to give
business assets to children in the business and non-business
assets to children outside the business. The Crummey rule
allows movement of illiquid assets outside of the estate;
without it, the estate will most likely be drained of its
liquid assets first, leaving the family business to face the
maximum tax with the minimum of resources.
The Qualified Terminable Interest Property Trust (QTIP) was
designed by Congress to allow both spouses to use their full
individual unified credits. QTIPs were expressly set up to
prevent the estate tax from impoverishing a surviving spouse.
Disallowing QTIPs would force an estate to choose between
losing the unified credit, breaking up the business, or
divesting the surviving spouse of cash, leaving the ``second to
die'' holding the illiquid assets.
Personal Residence Trusts are significant tools for estate
planners only because the family home is another illiquid
asset. Allowing parents to give the family home to their
children at a future date while retaining the parent's right to
live in the house for as long as they desire permits a planner
to give the estate the maximum liquidity to deal with the death
tax bill.
Finally, the rules on minority valuation again produce
little revenue gain, but they allow the IRS to decide whether
the cash or cash equivalents of an active business exceed the
``reasonable working capital needs of the business.'' This test
is already defined under the accumulated earnings tax, and it
has been the subject of much litigation already. Courts often
side with the corporations, but too many companies are already
in court fighting the IRS's unrealistic formula.
Fewer than one-third of family businesses survive to the
second generation. These proposals offer minimal revenue and
would drive down the survival rate even further. The Treasury
Department derides these estate-planning tools as legal
fictions. But estate and gift taxes themselves are bad. Family-
owned businesses should not need to resort to legal fictions to
stay in business. Federal estate and gift taxes should be
abolished, not raised.
Repeal Tax-Free Conversions of Large C-Corporations to S-
Corporations
This proposal would repeal Internal Revenue Code Section
1374 that governs the tax treatment of C-corporations that
convert to S-corporation status. Specifically, these
conversions would be treated as taxable liquidations by
repealing the method of taxing built-in gains such that it
would be harmful to small and medium-size companies. Small and
medium-size companies, many of which are S-corporations (4000
of which are NAM members), are central to the growth of our
economy. About one-fourth of our national income is generated
by small and medium-size companies. The Congress has recognized
the integral and productive contribution of S-corporations to
our economy, as evidenced by the Small Business Job Protection
Act of 1996 that encouraged the formation of new S-corporation
entities. If passed, this proposal would be a barrier to many
businesses desiring to operate as S-corporations. Thus, the NAM
opposes this ill-conceived provision that has been proposed
repeatedly without success. S-corporation rate-relief
legislation, introduced by Representative Phil Crane (R-IL-8)
(H.R. 2884) would help mitigate some of the remaining
deterrents for companies to convert to S-corporation status.
Limiting Use of ``Hybrid'' Entities
The NAM is very concerned about the Administration's
request for congressional authority to issue potentially
sweeping legislative regulations to implement non-specific tax
guidance. If the Administration feels that a specific abuse is
being perpetrated, it should be addressed through relevant
legislation. This would permit normal congressional
consideration, including hearings on such legislation.
One specific Administration proposal would limit the
ability of certain foreign and U.S. persons to enter into
transactions that use so-called ``hybrid entities,'' which are
entities that are treated as corporations in one jurisdiction
but as branches or partnerships in another. Although most
hybrid transactions do not attempt to generate tax results that
are ``inconsistent with the purposes of U.S. tax law,'' the
Administration feels that there are enough taxpayers taking
unfair advantage of the current rules that it is necessary to
codify and extend the earlier government issued tax guidance
(Notices 98-5 and 98-11) on this subject.
U.S. multinationals compete in an environment wherein
foreign competitors use tax-planning techniques to reduce
foreign taxes without incurring home country tax. The use of
``hybrid entities'' allows U.S. multinationals to compete on a
level playing field and promotes additional U.S. exports. The
use of hybrids is consistent with the initial balance between
competitiveness and export neutrality that was intended by
Congress in enacting the ``Subpart F'' rules. Although Congress
specifically enacted a branch rule for foreign base company
sales under Code section 954(d)(3), similar rules were not
enacted for foreign personal holding company income. If
enacted, these proposals would represent an unwarranted
extension of legislative authority by Congress to the executive
branch to circumvent congressional debate by imposing new rules
through regulation.
Notices 98-5 and 98-11 have a chilling effect on the
ability of U.S. companies to structure their foreign operations
consistently with the commercial objective of regionalizing
their businesses. They also adversely impact companies'
abilities to effectively reduce their overall costs by reducing
local taxes in their overseas operations. The notices are
drafted so broadly and so vaguely that they confuse U.S.
taxpayers and their advisors, and introduce a compelling need
to seek clarification as to whether taxpayers can continue to
rely on the simple ``check-the-box'' regulations issued just
last year. All these effects are exacerbated by the notices'
immediate effective dates.
The world has changed dramatically since enactment of the
Subpart F rules in 1962. The NAM feels it would be more
appropriate for Congress to request a study regarding the trade
and tax policy issues associated with Notices 98-5 and 98-11.
In this regard, a moratorium on further regulatory action by
the Treasury Department should be imposed until enactment of
specific legislative proposals resulting from well-reasoned
analysis and debate.
Foreign Built-in Losses
Another proposal would require the Treasury Department to
issue regulations to prevent taxpayers from ``importing built-
in losses incurred outside U.S. taxing jurisdictions to offset
income or gain that would otherwise be subject to U.S. tax.''
The Administration argues that, although there are rules in the
Code that limit a U.S. taxpayer's ability to avoid paying U.S.
tax on built-in gain (e.g. Code 367(a), 864(c)(7), and 877),
similar rules do not exist that prevent built-in losses from
being used to shelter income otherwise subject to U.S. tax,
and, as a result, taxpayers are avoiding Subpart F income
inclusions or capital gains tax. We believe that this
directive, which is written extremely broadly, is unnecessary
due to the existence of rules already available in the Code.
Both this proposal and the one immediately above regarding the
use of hybrid entities would severely impact the ability of
U.S. multinationals to compete on an equal footing against
foreign-based companies.
Superfund Taxes
The Superfund program has historically been funded by the
following taxes--the corporate environmental income tax and
excise taxes on petroleum, chemical feed stock, and imported
chemical substances--all of which expired as of Dec. 31, 1995.
The Administration's budget proposal would reinstate the excise
taxes at their previous levels for the period after the date of
enactment until Oct. 1, 2008. The corporate environmental
income tax would be reinstated at its previous level for
taxable years beginning after Dec. 31, 1997 and before Jan. 1,
2009.
Under the ``pay-go'' rules of the federal budget laws, any
Superfund reauthorization bill that includes spending
provisions must also include provisions to reinstate the former
Superfund taxes or provide equivalent revenues ``within the
four corners of the bill'' to keep it revenue neutral. Thus, as
a practical matter, if Congress were to extend the Superfund
taxes separate from a Superfund reauthorization bill, then such
action would end the prospects for major legislative reform of
the Superfund program during the period for which the taxes are
re-enacted. Furthermore, an additional revenue offset would be
needed because the taxes collected would be scored for general
revenues to balance the budget. The use of such tax revenues
for deficit-reduction purposes should be rejected. The NAM
urges that the decision to reinstate these taxes dedicated to
financing Superfund should instead be made only as part of
comprehensive programmatic changes to a Superfund reform bill.
The Administration's proposal to reinstate the Superfund taxes
without Superfund reform is merely an attempt to raise revenue
for new spending programs.
Foreign Oil and Gas Income Tax Credits
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 on such income. This selective attack
on a single industry's use of the foreign tax credit 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 double taxation, which
will severely hinder U.S. oil companies in the global oil and
gas exploration, production, refining, and marketing arena. The
NAM is particularly opposed to this provision because it
undermines the entire foreign tax credit system and sets a very
bad tax-policy precedent by making the recoupment of double
taxation costs contingent on the industry in which a company is
engaged.
Payments to 80/20 Companies
Currently, a portion of interest or dividends paid by a
domestic corporation to a foreign entity may be exempt from
U.S. withholding tax, provided the payor corporation is a so-
called ``80/20 company,'' i.e., at least 80 percent of its
gross income for the preceding three years is foreign-source
income attributable to the active conduct of a foreign trade or
business. The Administration believes that the testing period
is subject to manipulation and allows certain companies to
improperly avoid U.S. withholding tax on certain distributions
attributable to a U.S. subsidiary's U.S. source earnings. As a
result, it proposes to arbitrarily change the 80/20 rules by
applying the test on a group-wide (as opposed to individual
company) basis. However, there is little evidence that these
rules have been manipulated on a broad scale in the past and we
do not believe such a drastic change is needed at this time.
Dividends-Received Deduction for Certain Preferred Stock
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's revenue-raising proposal would result
in asymmetrical tax treatment between a payor and payee of what
purports to be a dividend is not appropriate tax policy. Thus,
the NAM objects to this provision.
Limiting Mark-to-Market Accounting
Certain trade receivables would no longer be eligible for
treatment under the mark-to-market accounting rules. Under
those rules, certain taxpayers who purchase and sell their own
trade receivables are exempt from the mark-to-market method of
accounting unless they elect to be included. If they make the
election, those taxpayers can currently write-off certain non-
interest bearing receivables, and account, note, and trade
receivables unrelated to the active business of a securities
dealer. There appear to be no tax policy reasons for
prohibiting taxpayers from accelerating their bad debt
deductions for these trade receivables, only government revenue
considerations.
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.
Deferral of Original Issue Discount (OID) on Convertible Debt
The Administration has included a number of past proposals
aimed at financial instruments and the capital markets, which
were fully rejected during the last session of Congress. These
reintroduced proposals should again be rejected. One proposal
would defer deductions by corporate issuers for interest
accrued on convertible debt instruments with original issue
discount (OID) until interest is paid in cash. The proposal
would completely deny the corporation an interest deduction
unless the investors are paid in cash (e.g. no deduction would
be allowed if the investors convert their bonds into stock).
Investors in such instruments would still be required to pay
income tax currently on the accrued interest. In effect, the
proposal defers or denies an interest deduction to the issuer,
while requiring the holder to pay tax on the interest
currently.
The NAM opposes this proposal because it is contrary to
sound tax policy and symmetry that matches accrual of interest
income by holders of OID instruments with the ability of
issuers to deduct accrued interest. There is no justifiable
reason for treating the securities as debt for one side of the
transaction and as equity for the other side. There is also no
reason, economic or otherwise, to distinguish a settlement in
cash from a settlement in stock.
Moreover, the instruments in question are truly debt rather
than equity. Recent statistics show that more than 70 percent
of all zero-coupon convertible-debt instruments were retired
with cash, while only 30 percent of these instruments were
convertible to common stock. Recharacterizing these instruments
as equity for some purposes is fundamentally incorrect and will
put American companies at a distinct disadvantage to their
foreign competitors, who are not bound by such restrictions.
These hybrid instruments and convertible OID bond instruments
have allowed many U.S. companies to raise tens of billions of
dollars of investment capital used to stimulate the economy.
Introducing this imbalance and complexity into the tax code
will discourage the use of such instruments, limit capital
raising options, and increase borrowing costs for corporations.
Modifying Corporate-Owned Life Insurance (COLI) Rules
The Administration proposes to substantially change the
taxation of business-owned life insurance by disallowing a pro-
rata portion of a business' general deduction for interest
expense. Moreover, the Administration has proposed retroactive
application of the new tax to existing life insurance
contracts. This proposal should not be adopted.
Life insurance has long been used by businesses to protect
against financial loss caused by the death of key employees and
to finance the cost of employee benefits, especially post-
retirement health benefits. Life insurance provides a secure
and stable source of financing for such employee benefits, and
it is particularly well suited to this purpose because its
long-term nature matches the correspondingly long-term nature
of the liabilities. The Administration's proposal would have a
devastating effect on key-person protection by effectively
taxing life insurance contracts out of existence. Businesses
should not be discouraged from providing employee health
benefits or from seeking to protect themselves from key-person
losses.
Moreover, the Administration's proposal would apply
retroactively to existing life insurance contracts that were
purchased by businesses in good faith, based on existing law.
There can be no question of abuse: business use of life
insurance is well known and the taxation of insurance contracts
has been settled for many years. In addition, Congress has
reviewed the taxation of business-owned life insurance in each
of the last two years and, in each case, has carefully
preserved the existing taxation of business-owned life
insurance on the lives of employees. The Administration's
proposal represents the worst kind of retroactive tax--it would
not only cause the termination of most or all existing
contracts but would also have the effect of taxing past
earnings under those contracts.
Tax Insurance Contract Exchanges or Reallocate Assets with
Variable Insurance Contracts
Annuity contract investments are a valuable retirement and
investment tool. Currently, owners of variable annuity
contracts can allocate their investments in a contract among
different investment options (e.g. a bond fund, a stock fund,
and a balanced fund). Owners may reallocate their account
values within the contract among the various options without
incurring a current tax, so long as the investment remains
committed to a retirement annuity. This flexibility provides an
important savings incentive for retirement. A taxable event
occurs when funds are taken out of an annuity. Regardless, the
Administration proposes to tax any exchange of a life
insurance, endowment, or annuity contract, for a variable
contract, or vice versa. In addition, any reallocation among
accounts within the same variable life or annuity contract
would result in a taxable event, even though no funds were
taken out of the contract. An exchange of contracts, without
tax liability, is a long-standing proviso of the Code.
The NAM opposes this provision as a tax increase on middle-
class Americans and retirement savers. Moreover, the proposal
completely contradicts the President's recent statements to
``save Social Security first.'' Any new tax on private
retirement savings puts further strain on the overall private
and public retirement system. Variable life and annuity
contracts are used respectively to insure against premature
death and for long-term retirement savings. Like other
retirement-saving vehicles, including defined contribution and
defined benefit plans, annuities allow savings to grow tax-free
until they are needed for retirement. All retirement savers
periodically shift their savings among different options as
they grown older and more conservatives, or as the market
changes. Under this proposal, annuity owners who shift accounts
would be taxed immediately, thereby forcing them to keep bad
investments or pay a tax on undistributed funds.
Recent surveys have shown that more than 80 percent of the
owners of deferred annuity contracts have total annual
household incomes of under $75,000. Such middle income savers
rely on these well-designed products to encourage them to
commit funds to retirement. At a time when Congress and the
President are concerned about saving social security, the last
thing that they should do is tax private retirement savings
options.
Reduction in Basis (Investment in the Contract) for Mortality-
Related Charges
The Administration's proposal would reduce a policy-
holder's tax basis in an insurance or annuity contract for
certain charges under the contract by subtracting these charges
include the cost of the insurance and related expenses. For
deferred annuity contracts, the assumed mortality and expenses
charges, which must be subtracted, are deemed to equal the
contract's average cash value during the year multiplied by
1.25 percent. This proposal is nothing but a tax on private
retirement savings. Increasing the cost of such savings
vehicles by reducing a product's tax basis creates a
disincentive to use these important savings tools. Life
insurance and annuity contracts are designed to both accumulate
retirement savings and insure against premature death (e.g.
mortality-related risks). Taxes on income from the savings
element of such contracts should not be increased just because
those contracts also provide insurance protection.
This provision will likewise result in a tax increase on
middle-class Americans and retirement savers. In addition, the
proposal is inconsistent with general tax rules relating to the
determination of tax basis and will further increase the
complexity of the tax code with no recognizable benefit. Under
the proposal, life insurance companies would be required to
maintain additional records to keep track of two different
basis amounts for annuity contracts. This will undoubtedly
result in increased administrative burdens and compliance
costs, which most likely will be passed on to Americans trying
to save for retirement.
Tightening the Substantial Understatement Penalty for Large
Corporations
The NAM opposes this anti-business proposal because the
percent test of 10 percent is appropriate for all size
companies. This proposal would treat a corporation's deficiency
of more than $10 million as substantial for purposes of the
substantial understatement penalty, regardless of whether it
exceeds 10 percent of the taxpayer's total tax liability. There
is no need to discriminate against large, multinational, and
publicly-held companies by inserting into the tax code an
absolute dollar amount based on their proportionately higher
tax liabilities and greater tax ambiguities faced by these
companies.
Effective Dates
Finally, certain proposed revenue raising provisions
contained in the Administration's FY 1999 budget proposal would
have retroactive effective dates. The NAM believes that the
effective dates of any new revenue raising proposals should not
disrupt market activities and normal business transactions. In
this regard, the completion of many contractually binding
business transactions 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 the effective date,
even though the transactions were contractually bound prior to
that time. 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 affect pending business transactions in this way.
Accordingly, the NAM urges that if Congress adopts any revenue
raisers, whatever effective date it chooses, it should include
an exception for pending transactions that are publicly
announced, subject to binding contracts or contingent upon
necessary third party approvals.
Conclusion
The NAM fully supports a balanced federal budget and, in
fact, believes it is necessary to the economic health of the
country. However, 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 corporate alternative minimum tax (AMT)
reform, estate tax repeal, permanent extension of the R&D tax
credit, and S-corporation rate relief, combined with
substantive social security reform and spending reductions,
would help maintain robust economic growth concurrent with a
low rate of inflation.
Statement of Steven J. Guttman, NAREIT Chair and Chairman and Chief
Executive Officer, Federal Realty Investment Trust; on behalf of
National Association of Real Estate Investment Trusts
As requested in Press Release No. FC-11 (February 18,
1998), 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 Committee
as part of the Administration's Fiscal Year 1999 Budget.
NAREIT's comments will address the Administration proposals
to (1) 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; (2) restrict real estate
investment trusts (``REITs'') from owning more than 10 percent
of the value of so-called ``subsidiary service corporations;''
(3) modify treatment of closely held REITs; and (4) freeze the
grandfather status of stapled (or paired-share) REITs. We
appreciate the opportunity to present these comments.
NAREIT is the national trade association for real estate
companies. Members are REITs and other public businesses that
own, operate and finance income-producing real estate, as well
as those firms and individuals who advise, study and service
these businesses. REITs are companies whose income and assets
are mainly connected to income-producing real estate. By law,
REITs regularly distribute most of their taxable income to
shareholders as dividends. NAREIT represents over 250 REITs or
other public real estate companies, as well as over 2,000
investment bankers, analysts, accountants, lawyers and other
professionals who provide services to REITs.
Background on REITs
A REIT is essentially a corporation or business trust
combining the capital of many investors to own and, in most
cases, operate income-producing real estate, such as
apartments, shopping centers, offices and warehouses. Other
REITs also are engaged in financing real estate. REITs must
comply with a number of requirements, some of which are
discussed in detail in this statement, but the most fundamental
of these are as follows: (1) REITs must pay at least 95 percent
of their taxable income to shareholders; (2) REITs must derive
most of their income from real estate held for the long term;
and (3) REITs must be widely held. In exchange for satisfying
these requirements, REITs (like mutual funds) benefit from a
dividends paid deduction so that most, if not all, of a REIT's
earnings are taxed only at the shareholder level. On the other
hand, REITs pay the price of not having retained earnings
available to expand their business. Instead, capital for growth
must come from new money raised in the investment marketplace
from investors who have confidence in the REIT's future
prospects and business plan.
Congress created the REIT structure in 1960 to make
investments in large-scale, significant income-producing real
estate accessible to the smaller investor. Based in part on the
rationale for mutual funds, Congress decided that the only way
for the average investor to access investments in larger-scale
commercial properties was through pooling arrangements. In much
the same ways as shareholders benefit by owning a portfolio of
securities in a mutual fund, the shareholders of REITs can
unite their capital into a single economic pursuit geared to
the production of income through commercial real estate
ownership. REITs offer distinct advantages for smaller
investors: greater diversification by investing in a portfolio
of properties rather than a single building and expert
management by experienced real estate professionals.
Despite the advantages of the REIT structure, the industry
experienced very little growth for over 30 years mainly for two
reasons. First, at the beginning REITs were handcuffed. REITs
were basically passive portfolios of real estate. REITs were
permitted only to own real estate, not to operate or manage it.
This meant that REITs needed to use third party independent
contractors, whose economic interests might diverge from those
of the REIT's owners, to operate and manage the properties.
This was an arrangement the investment marketplace did not
accept warmly.
Second, during these years the real estate investment
landscape was colored by tax shelter-oriented characteristics.
Through the use of high debt levels and aggressive depreciation
schedules, interest and depreciation deductions significantly
reduced taxable income--in many cases leading to so-called
``paper losses'' used to shelter a taxpayer's other income.
Since a REIT is geared specifically to create ``taxable''
income on a regular basis and a REIT is not permitted to pass
``losses'' through to shareholders like a partnership, the REIT
industry could not compete effectively for capital against tax
shelters.
In the Tax Reform Act of 1986 (the ``1986 Act''), Congress
changed the real estate investment landscape in two important
ways. First, by limiting the deductibility of interest,
lengthening depreciation periods and restricting the use of
``passive losses,'' the 1986 Act drastically reduced the
potential for real estate investment to generate tax shelter
opportunities. This meant, going forward, real estate
investment needed to be on a more economic and income-oriented
footing.
In addition, as part of the 1986 Act, Congress took the
handcuffs off REITs. The Act permitted REITs to operate and
manage--in addition to owning--most types of income-producing
commercial properties by providing ``customary'' services
associated with real estate ownership. Finally, for most types
of real estate (other than hotels, health care facilities and
some other activities that consist of a higher degree of
personal services), the economic interests of the REIT's
shareholders could be merged with those of the REIT's operators
and managers.
Despite Congress' actions in 1986, significant REIT growth
did not begin until 1992. One reason was the real estate
recession in the early 1990s. During the late 1980s banks and
insurance companies kept up real estate lending at a
significant pace. Foreign investment, particularly from Japan,
also helped buoy the marketplace. But by 1990 the combined
impact of the Savings and Loan crisis, the 1986 Act,
overbuilding during the 1980s by non-REITs and regulatory
pressures on bank and insurance lenders, led to a depression in
the real estate economy. During the early 1990s commercial
property values dropped between 30 and 50 percent. Credit and
capital for commercial real estate became largely unavailable.
As a result of this capital crunch, many building owners
defaulted on loans, resulting in huge losses by financial
institutions. The Resolution Trust Corporation took over the
real estate assets of insolvent financial institutions.
Against this backdrop, starting in 1992, many private real
estate companies realized that the best and most efficient way
to access capital was from the public marketplace through
REITs. At the same time, many investors decided that it was a
good time to invest in commercial real estate--assuming
recovering real estate markets were just over the horizon. They
were right.
Since 1992, the REIT industry has attained astounding
growth as new publicly traded REITs infused much needed equity
capital into the over-leveraged real estate industry. Today
there are over 200 publicly traded REITs with an equity market
capitalization exceeding $150 billion. These REITs are owned
primarily by individuals, with 49 percent of REIT shares owned
directly by individual investors and 37 percent owned by mutual
funds, which are owned mostly by individuals. Today's REITs
offer smaller real estate investors three important qualities
never accessible and available before: liquidity, security and
performance.
Liquidity. REITs have helped turn real estate liquid.
Through the public REIT marketplace of over 200 real estate
companies, investors can buy and sell interests in portfolios
of properties and mortgages--as well as the management
associated with them--on an instantaneous basis. Illiquidity,
the bane of real estate investors, is gone.
Security. Because real estate is a physical asset with a
long life during which it has the potential to produce income,
investors always have viewed real estate as an investment
option with security. But now through REITs small investors
have an added level of security never available before in real
estate investment. Today's security comes from information.
Through the advent of the public REIT industry (which is
governed by SEC and securities exchange-mandated information
disclosure and reporting), the flow of available information
about the company and its properties, the management and its
business plan, and the property markets and their prospects are
available to the public. As a result, REIT investors are
provided a level of security never available before in the real
estate investment marketplace.
Performance. Since their inception, REITs have provided
competitive investment performance. Both over the past two
years and the past twenty years, REIT market performance has
been comparable to that of the S&P 500 and has greatly exceeded
the returns from fixed income and direct real estate
investments. Because REITs annually pay out almost all of their
taxable income, a significant component of total return on
investment reliably comes from dividends. In 1997, REITs paid
out over $8 billion in dividends to their shareholders. Just as
Congress intended, today through REITs small investors have
access to large-scale, income producing real estate on a basis
competitive with large institutions and wealthy individuals.
But REITs don't just benefit investors. The lower debt
levels associated with REITs compared to real estate investment
overall has a positive effect on the overall economy. Average
debt levels for REITs are 35 percent of market capitalization,
compared to leverage of 80 percent and higher used by privately
owned real estate (which have the effect of minimizing tax
liabilities). The higher equity capital cushions REITs from the
severe effects of fluctuations in the real estate market that
have traditionally occurred. The ability of REITs to better
withstand market downturns has a stabilizing effect on the real
estate industry and lenders, resulting in fewer bankruptcies
and work-outs. The general economy benefits from lower real
estate losses by federally insured financial institutions.
NAREIT believes the future of the REIT industry will see an
acceleration in the shift from private to public ownership of
U.S. real estate. At the same time, future growth may be
limited by the competitive pressures for REITs to be able to
provide more services to their tenants than they are currently
allowed to perform. Although the 1986 Act took off the
handcuffs and the Taxpayer Relief Act of 1997 included
additional helpful REIT reforms, REITs still must operate under
significant, unnecessary restrictions. NAREIT looks forward to
working with Congress and the Administration to further
modernize and improve the REIT rules so that REITs can continue
to offer smaller investors opportunities for rewarding
investments in income-producing real estate.
I. Section 1374
The Administration's Fiscal Year 1999 Budget proposes to
amend section 1374 to treat an ``S'' election by a C
corporation valued at $5 million or more as a taxable
liquidation of that C corporation followed by a distribution to
its shareholders. This proposal was also included in the
Administration's Fiscal Year 1997 and 1998 proposed budgets.
A. Background and Current Law
Prior to its repeal as part of the Tax Reform Act of 1986,
the holding in a court case named General Utilities permitted a
C corporation to elect S corporation, REIT or mutual fund
status (or transfer assets to an S corporation, REIT or mutual
fund in a carryover basis transaction) without incurring a
corporate-level tax. With the repeal of the General Utilities
doctrine in 1986, such transactions arguably would have been
subject to tax but for Congress' enactment of Internal Revenue
Code section 1374.\1\ 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.
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\1\ Hereinafter all references to ``section'' are to the Internal
Revenue Code of 1986 (as amended).
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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 regulated investment
companies (``RICs,'' i.e. mutual funds). In addition, the IRS
noted that those regulations would permit the REIT or RIC to be
subject to rules similar to the principles of section 1374.
Thus, C corporations can elect REIT status and incur a
corporate-level tax only if the REIT sells assets during the
10-year ``recognition period.''
In a release issued February 18, 1998, 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.
Because of the Treasury Department's intent to extend the
proposed amendment of section 1374 to REITs, these comments
address the proposed amendment as if it applied to both S
corporations and REITs.
B. Statement in Support of the Current Application of Section
1374 to REITs
As stated above, the Administration proposal would limit
the use of the 10-year election to REITs valued at $5 million
or less. NAREIT believes that this proposal 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. 3-4 (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.
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 100 percent REIT prohibited transactions tax \2\
complements the 10-year election mechanism.
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\2\ I.R.C. Sec. 857(b)(6).
---------------------------------------------------------------------------
Second, while S corporations may have no more than 75
shareholders, a REIT faces no statutory limit on the number of
shareholders it may have, is 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.
The consequence of the Administration 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. 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.
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 owners of such
properties. The capital intensive nature of REIT's makes the $5
million threshold essentially 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. Due to 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 [sic] conversion of a C corporation 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, REITs cannot (and have never been able
to) pass through losses to their investors. Further, REITs can
and do pay corporate level income and excise taxes. Simply put,
REITs are C corporations. Thus, REITs are not susceptible to
the tax avoidance concerns raised by the 1986 repeal of the
General Utilities doctrine.
C. 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's two level tax
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.
II. Subsidiary Service Corporations
As part of the asset diversification tests applied to
REITs, a REIT may not own more than 10 percent of the
outstanding voting securities of a non-REIT corporation
pursuant to section 856 (c)(5)(B). The shares of a wholly-owned
``qualified REIT subsidiary'' (``QRS'') of the REIT are ignored
for this test. The Administration's Fiscal Year 1999 Budget
proposes to amend section 856(c)(5)(B) to prohibit REITs from
holding stock possessing more than 10 percent of the vote or
value of all classes of stock of a non-REIT corporation (other
than a wholly owned QRS).
A. Background and Current Law
The activities of REITs are strictly limited by a number of
requirements that are designed to ensure that REITs serve as a
vehicle for public investment in real estate. First, a REIT
must comply with several income tests. At least 75 percent of
the REIT's gross income must be derived from real estate, such
as rents from real property, mortgage interest and gains from
sales of real property (not including dealer sales).\3\ In
addition, at least 95 percent of a REIT's gross income must
come from the above real estate sources, dividends, interest
and sales of securities.\4\
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\3\ I.R.C. Sec. 856(c)(3).
\4\ I.R.C. Sec. 856(c)(2).
---------------------------------------------------------------------------
Second, a REIT must satisfy several asset tests. On the
last day of each quarter, at least 75 percent of a REIT's
assets must be real estate assets, cash and government
securities. Real estate assets include interests in real
property and mortgages on real property. As mentioned above,
the asset diversification rules require that a REIT not own
more than 10 percent of the outstanding voting securities of an
issuer (other than a QRS). In addition, no more than 5 percent
of a REIT's assets can be represented by securities of a single
issuer (other than a QRS).
REITs have been so successful in operating their properties
and providing permissible services to their tenants that they
have been asked to provide these services to non-tenants,
building off of expertise and capabilities associated with the
REIT's real estate activities. The asset and income tests,
however, restrict how REITs can engage in these activities. A
REIT can earn only up to 5 percent of its income from sources
other than rents, mortgage interest, capital gains, dividends
and interest. However, many REITs have had the opportunity to
maximize shareholder value by earning more than 5 percent from
third party service income.
Starting in 1988, the Internal Revenue Service issued
private letter rulings to REITs approving a structure to
facilitate a REIT providing a limited amount of services to
third parties.\5\ These rulings sanctioned a structure under
which a REIT owns no more than 10 percent of the voting stock
and up to 99 percent of the value of a non-REIT corporation
through nonvoting stock. Usually, managers or shareholders of
the REIT own the voting stock of the ``Third Party Service
Subsidiary'' (``TPSS,'' also known as a ``Preferred Stock
Subsidiary''). The TPSS typically provides unrelated parties
services already being delivered to a REIT's tenants, such as
landscaping and managing a shopping mall in which the REIT owns
a joint venture interest. The REIT receives dividends from the
TPSS that are treated as qualifying income under the 95 percent
income test, but not the 75 percent income test.\6\
Accordingly, a REIT continues to be principally devoted to real
estate operations. In addition, while the IRS has approved
using TPSSs for services to third parties and ``customary''
services to tenants the REIT could otherwise provide, the IRS
has not permitted the use of these subsidiaries to provide
impermissible, non-customary real estate services to REIT
tenants.\7\
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\5\ PLRs 9440026, 9436025, 9431005, 9428033, 9340056, 8825112. See
also PLRs 9507007, 9510030, 9640007, 9733011, 9734011, 9801012.
\6\ The REIT does not qualify for a dividends received deduction
with respect to TRSS dividends. I.R.C. Sec. 857(b)(2)(A).
\7\ But see PLR 9804022.
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The Administration proposes to change the asset
diversification tests to prevent a REIT from owning securities
in a C corporation that represent either 10 percent of the
corporation's vote or value. The proposal would apply with
respect to stock acquired on or after the date of first
committee action. In addition, to the extent that a REIT's
ownership of TPSS stock is grandfathered by virtue of the
effective date, the grandfather status would terminate if the
TPSS engages in a new trade or business or acquires substantial
new assets on or after the date of first committee action. This
proposal is only expected to raise $19 million over five years.
B. Statement Against Administration Proposal to Limit REIT
Investments in Service Subsidiaries
The REIT industry has grown significantly during the 1990s,
from an equity market capitalization under $10 billion to a
level exceeding $150 billion. The TPSS structure is used
extensively by today's REITs and has been a small, but
important, part of recent industry growth. These subsidiaries
help ensure that the small investors who own REITs are able to
maximize the return on their capital by taking full economic
advantage of core business competencies developed by REITs in
owning and operating the REIT's real estate. By halting the
expansion of TPSSs, the Administration proposal would curtail
REIT growth at a time when the industry is just realizing
Congress' vision of making publicly owned, income-producing
real estate accessible for small investors. Since the profits
of the TPSS are taxable at the corporate level today, NAREIT
sees no reason to restrain their future use and growth.
The REIT asset rules are patterned loosely after the asset
diversification rules applicable to mutual funds, with the REIT
rules being significantly more restrictive.\8\ In contrast to
the REIT rules, a mutual fund can own 100 percent of any one
issuer so long as not more than 25 percent of the value of the
fund's total assets are invested in that issuer. The REIT
provisions do not provide the same flexibility. A REIT cannot
own more than 10% of the voting securities of a non-REIT
corporation, and securities of a non-REIT corporation cannot be
worth more than 5 percent of the REIT's assets. The
Administration proposal would further restrict REIT investment,
in contrast with the flexibility afforded to mutual funds.
---------------------------------------------------------------------------
\8\ Compare I.R.C. Sec. Sec. 851(b)(3) and 856(c)(4).
---------------------------------------------------------------------------
Over the years, Congress has modified and refined the REIT
rules several times to ensure that REITs can continue to
effectively fulfill their mission to promote investment by
individuals in income-producing real estate. These
modifications helped shift the focus of real estate investment
generally from the tax loss orientation of the 1970s and 1980s
to the taxable, income-oriented REIT environment today. Most
recently, Congress reviewed the REIT rules and enacted the
constructive REIT Simplification Act of 1997.
NAREIT believes strongly that the Administration proposal
limiting REIT investment in TPSSs is a noticeable step
backwards in thinking at a time when policymakers should
seriously consider additional forward-thinking steps to make
income-based real estate investments easily and economically
accessible to small investors everywhere. To ensure REITs
remain competitive in the real estate marketplace, an important
step forward in this area is to enable REITs in the future to
provide more services to both tenants and customers under
appropriate tax rules.
While NAREIT strongly disagrees with the Administration
proposal, we do believe that the TPSS approach is not an ideal
solution to making certain that REITs can provide competitive
services in the real estate marketplace. NAREIT looks forward
to working with the Administration and Congress to formulate
appropriate rules to enable REITs to serve their tenants and
customers and thereby effectively compete with other real
estate companies.
C. Summary
NAREIT strongly opposes the Administration proposal as it
will only further restrict REITs from fulfilling their mission
of making investment in large-scale, income-producing real
estate accessible to small investors. NAREIT encourages
Congress and the Administration to work towards a solution that
will enable REITs to better serve their tenants and customers,
thereby maximizing returns to REIT shareholders. For REITs to
compete effectively with other real estate investors, they must
be able to manage and operate their properties, including
providing a wide range of customer services. There is no reason
why REITs should not be able to provide noncustomary services
to tenants as well as services to non-tenant customers on a
basis taxable at the corporate level.
III. Closely Held REITs
The Administration's Fiscal Year 1999 Budget proposes to
add a new rule, creating a limit of 50 percent on the vote or
value of stock any entity could own in any REIT.
A. Background and Current Law
As discussed above, Congress created REITs to make real
estate investments easily and economically accessible to the
small investor. To carry out this purpose, Congress mandated
two rules to ensure that REITs are widely held. First, five or
fewer individuals cannot own more than 50% of a REIT's
stock.\9\ In applying this test, most entities owning REIT
stock are ``looked through'' to determine the ultimate
ownership by individuals of the stock. Second, at least 100
persons (including corporations and partnerships) must be REIT
shareholders.\10\ Both tests do not apply during a REIT's first
taxable year, and the ``five or fewer'' test only applies in
the last half of all taxable years.\11\
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\9\ I.R.C. Sec. 856(h)(1).
\10\ I.R.C. Sec. 856(a)(5).
\11\ I.R.C. Sec. Sec. 542(a)(2) and 856(h)(2).
---------------------------------------------------------------------------
The Administration appears to be concerned about non-REITs
establishing ``captive REITs'' and REITs doing ``step-down
preferred'' transactions used for various tax planning purposes
it finds abusive. The Administration proposes changing the
``five or fewer'' test by imposing an additional requirement.
The proposed new rule would prevent any ``person'' (i.e., a
corporation, partnership or trust) from owning stock of a REIT
possessing more than 50 percent of the total combined voting
power of all classes of voting stock or more than 50 percent of
the total value of shares of all classes of stock. Certain
existing REIT attribution rules would apply in determining such
ownership, and the proposal would be effective for entities
electing REIT status for taxable years beginning on or after
the date of first committee action.
B. Statement Providing Limited Support for Administration
Proposal on Closely Held REITs
NAREIT shares the Administration's concern that the REIT
structure not be used for abusive tax avoidance purposes, and
therefore NAREIT welcomes the intent of the proposal. We are
concerned, however, that the Administration proposal casts too
broad a net, prohibiting legitimate and necessary use of
``closely held'' REITs. A limited number of exceptions are
necessary to allow certain entities to own a majority of a
REIT's stock. NAREIT would like to work with Congress and the
Administration to ensure that any action to curb abuses does
not disallow legitimate and necessary transactions.
First, an exception needs to be made so that a REIT may own
more than 50 percent of another REIT's stock. For example, in
the course of an acquisition, a REIT may need to own more than
50 percent of another REIT's stock while conducting a tender
offer for the target REIT's shares. Also, in structuring a
joint venture a REIT may desire to own a majority, controlling
interest in another REIT. Neither of these situations raises
abuse concerns. After all, the ``control'' REIT must comply
with the full panoply of REIT rules--including any new ones--to
ensure the private REIT is truly widely held.
Second, an exception should be allowed to enable a REIT's
organizers to have a single large investor for a temporary
period, such as in preparation for a public offering of the
REIT's shares. Such ``incubator REITs'' sometimes are majority
owned by its sponsor to allow the REIT to accumulate a track
record that will allow it to go public. The Administration
proposal would prohibit this important approach which, in turn,
could curb the emergence of new public REITs in which small
investors may invest.
In addition, there is no reason why a partnership, mutual
fund or other pass-through entity should be counted as one
entity in determining whether any ``person'' owns 50 percent of
the vote or value of a REIT. A partnership, mutual fund or
other pass-through entity is usually ignored for tax purposes.
The partners in a partnership and the shareholders of a mutual
fund or other pass-through entity should be considered the
``persons'' owning a REIT for purposes of any limits on
investor ownership.
C. Summary
NAREIT supports a change in the REIT rules to prevent
abusive use of closely held REITs, but is concerned that the
Administration proposal is overly broad. NAREIT looks forward
to working with Congress and the Administration to craft a
solution that will prevent such abuses without impeding
legitimate and necessary transactions, such as those mentioned
above.
IV. Paired Share REITs
The Administration's Fiscal Year 1999 Budget proposes to
freeze the ``grandfathered'' status of the existing paired
share REITs.
A. Background and Current Law
In order to actively manage their properties within the
strictures of the REIT rules, in the 1970s and early 1980s a
handful of REITs sought and received permission from the IRS to
establish a ``paired'' relationship with other companies that
would manage the REIT-owned properties. A ``paired-share''
company is actually two companies the stock of which is
``paired'' or ``stapled'' such that they trade as a single
unit. As a result, the two companies are owned by the same
shareholders. One company, the REIT, owns real estate and, in
some cases, may lease it to the second operating company. The
operating company is typically organized as a C corporation
with the accompanying corporate level tax. The operating
company is unrestricted in the businesses it may operate,
meaning it may operate those businesses, such as hotels or golf
courses, which require a high level of services be provided to
customers.
In 1984, Congress adopted section 269B in the Deficit
Reduction Act of 1984 (``the Act'') which requires that in
applying the tests for REIT status, all stapled entities are
treated as one entity.\12\ In connection with considering and
restricting the use of ``paired share'' entities by non-REIT
U.S. corporations operating overseas, Congress decided in 1984
to ``grandfather,'' or apply prior law to, a very limited
number of REITs that earlier had received IRS permission to
adopt a ``paired share'' structure.\13\ Congress crafted this
exception for the paired share REITs out of a concern for
fairness to these companies and their shareholders who made
their investments on the basis of existing law. No doubt the
same fairness issues apply today.
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\12\ I.R.C. Sec. 269B(a)(3).
\13\ Over 200 publicly traded REITs are active in today's real
estate marketplace. Of these, four are so-called ``paired share''
REITs.
---------------------------------------------------------------------------
The Administration proposes to limit the tax benefits of
the existing paired share REITs that qualify under the 1984
Act's grandfather rules. Pursuant to the proposal, the general
rules treating the REIT and the stapled C corporation as a
single entity for purposes of the REIT qualification tests
would be applied to properties acquired by grandfathered
entities on or after the effective date and activities or
services relating to such properties performed on or after the
effective date.
B. Statement Concerning Freezing the Grandfathered Status of
Stapled REITs
NAREIT does not support the Administration proposal out of
concern for the shareholders who reasonably relied on existing
law when investments were made.
If enacted, the Administration proposal would cause
investors in some of these entities to experience adverse
consequences. The shareholders reasonably relied on Congress'
grandfathering of the stapled REITs and the previous IRS
rulings approving of their status. This authority should not be
reversed without careful consideration of the extent to which
the REITs, their investors and others have made long-term
financial commitments in reasonable reliance on such authority.
C. Summary
NAREIT does not support the Administration proposal out of
concern for fairness to the stapled REITs and their
shareholders who made their investments on the basis of
existing law.
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 1999 budget proposals.
The NFTC is an association of businesses with some 550
members, founded in 1914. It is the oldest and largest U.S.
association of businesses devoted exclusively to international
trade matters. Its membership 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.
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.\1\ 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.\2\ 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.
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\1\ U.S. Department of Commerce, ``Survey of Current Business,''
April 1996.
\2\ U.S. Department of Commerce, ``U.S. Multinational Companies:
Operations in 1993,'' June 1995, at 39.
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Foreign trade is fundamental to our economic growth and our
future standard of living.\3\ 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.\4\
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\3\ ``Continued robust exports by U.S. firms in a wide variety of
manufactures and especially advanced technological products--such as
sophisticated computing and electronic products and cutting-edge
pharmaceuticals--are critical for maintaining satisfactory rates of GDP
growth and the international competitiveness of the U.S. economy.
Indeed, it is widely acknowledged that strong export performance ranks
among the primary forces behind the economic well-being that U.S.
workers and their families enjoy today, and expect to continue to enjoy
in the years ahead.'' 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.
\4\ 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, D.C., February 1996.
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The Council's Comments and Concerns
The NFTC believes that certain of the President's proposals
related to international business are beneficial to the
nation's export sector and to its economy; but, it also
believes that certain of the proposals are not in the nation's
interest. For example, the NFTC supports extension of the tax
credit for research, as well as accelerating the effective date
of the rules regarding look-through treatment for dividends
received from ``10/50 Companies.'' These provisions will serve
to improve the competitive position of U.S. multinational
companies.
However, in devising many of its other tax proposals, the
Administration replaced sound tax policy with a short sighted
call for more revenue. 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: \5\
---------------------------------------------------------------------------
\5\ See, Financial Executives Research Foundation, Taxation of U.S.
Corporations Doing Business Abroad: U.S. Rules and Competitiveness
Issues, 1996, Ch. 9.
---------------------------------------------------------------------------
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 impose less tax on foreign
source income and are less complex than their U.S.
counterparts.
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.
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 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. \6\
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\6\ 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, D.C., 1994).
---------------------------------------------------------------------------
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.\7\ 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.
---------------------------------------------------------------------------
\7\ Id.
---------------------------------------------------------------------------
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 for American Competitiveness
Act of 1997, H.R. 1783, introduced by Mr. Houghton (R-NY) and
Mr. Levin (D-MI) of this Committee, and many of the provisions
of which were enacted in the Taxpayer Relief Act of 1997. The
NFTC continues to strongly support similar efforts in this
session of the 105th Congress.
In the light of this background, the NFTC would today like
to specifically address some of the President's Fiscal Year
1999 proposals as follows: (1) Accelerating the effective date
of the ``look-through'' rules relating to noncontrolled section
902 corporations (``10/50 Companies''); (2) Extension of the
Research Tax Credit; (3) Modification of the Export Source Rule
(also known as the ``Inventory Sales Source Rule,'' and
sometimes as the ``Title Passage Rule''); (4) Modification of
foreign tax credits applicable to to foreign oil and gas
income; (5) Certain others of the foreign proposals affecting
foreign operations. We would also comment on a proposal from
last year's budget submission that is being separately
considered in the Senate that relates to a modification of the
rules relating to foreign tax credit carrybacks and carryovers.
Proposals Supported
Accelerating the Effective Date of the ``Look-Through'' Rules
Relating to 10/50 Companies
Description of Current Law.--U.S. companies may credit
foreign taxes against U.S. tax on foreign source income. The
foreign tax credit is a fundamental requirement of the U.S.
system of worldwide taxation because it eliminates double
taxation of income. The amount of foreign tax credits that can
be claimed in a year is subject to a limitation that prevents
taxpayers from using foreign tax credits to offset U.S. tax on
U.S. source income. Separate limitations are applied to
specific categories of income under section 904.
``Look-through'' treatment provides that income is
apportioned to a foreign tax credit limitation category in
proportion to the ratio of the earnings and profits
attributable to income in such foreign tax credit limitation
category to the total earnings and profits.
Under changes made by the Taxpayer Relief Act of 1997, U.S.
parent corporations that own at least 10 percent but not more
than 50 percent of the stock of a corporation will be able to
use ``look-through'' treatment in computing indirect foreign
tax credits under section 902 for the taxes paid by the owned
corporation and attributable to the parent's ownership. Prior
to such change, a separate limitation applied to each 10/50
Company owned by the parent corporation, irrespective of the
amount and source of income of the subsidiary.
This structure is important to U.S. multinational groups
because many foreign joint ventures are structured in this
way--the parent has less than a majority interest and is not
therefore subject to the controlled foreign corporation rules
that apply look-through treatment--and in many cases
multinationals own many hundreds of these ventures. The
Taxpayer Relief Act of 1997 changed these rules to allow 10/50
Companies to be treated like controlled foreign corporations by
allowing ``look-through'' treatment for foreign tax credit
purposes for dividends from such joint ventures. The 1997 Act,
however, did not make the change effective for such dividends
unless they were received after the year 2002: Dividends paid
by a 10/50 Company in taxable years beginning after December
31, 2002, from earning and profits (``E&P'') accumulated in
taxable years beginning before January 1, 2003, are subject to
a single foreign tax credit limitation for all 10/50 companies.
Dividends paid by a 10/50 company in taxable years beginning
after December 31, 2002, from E&P accumulated in taxable years
beginning after December 31, 2002, are treated as income in a
foreign tax credit limitation category under look through
treatment. Therefore, two different sets of rules apply for
dividends from E&P generated before the year 2003 and dividends
from E&P accumulated after the year 2002. Dividends paid by a
10/50 Company in taxable years beginning before January 1,
2003, are subject to a separate foreign tax credit limitation
for each 10/50 Company (prior law).
The 1997 provision effects a significant simplification
over current law, but is delayed in effective date and is still
overly complex.
The Administration's Proposal.--The proposal would
accelerate the effective date of the 1997 changes affecting
foreign joint ventures owned between ten and fifty percent by
U.S. parents (so-called ``10/50 Companies''). This change will,
instead, apply the look-through rules to all dividends received
in tax years after 1997, no matter when the E&P constituting
the makeup of the dividend was accumulated.
This change will result in a tremendous reduction in
complexity and compliance burdens for U.S. multinationals doing
business overseas through foreign joint ventures. It will also
reduce the competitive bias against U.S. participation in such
ventures (the minority position in such ventures is many times
dictated by local law) by placing U.S. companies on a more
level playing field.
The NFTC supports even further simplification of these
rules by extension of them beyond the Administration's proposal
to income other than dividends, including interest, rents,
royalties, and gains from the sale of interests in partnerships
and lower-tier subsidiary companies.
Extending the R&E Tax Credit
Description of Current Law.--The research credit generally
applies on an incremental basis to a taxpayer's ``qualified
research'' expenses for a taxable year. The credit is equal to
20 percent of the amount by which the taxpayer's qualified
research expenses for the taxable year exceed a base amount.
The Small Business Job Protection Act of 1996 provided an
alternative incremental research credit.
The research credit expired on June 30, 1995. In the 1996
Act, the research credit was extended in modified form for
eleven months to May 31, 1997. The credit was subsequently
extended by the 1997 Act to apply to expenses incurred from
June 1, 1997 to June 30, 1998. The 1997 Act also modified the
alternative incremental research credit regime to permit
taxpayers to elect the regime for any taxable year beginning
after June 30, 1996.
The Administration's Proposal.--The research tax credit
would be extended for twelve months, from July 1, 1998, through
June 30, 1999 under the Administration's proposal. The NFTC
supports this proposal to extend the research tax credit for
another year. The credit 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. 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 NFTC encourages both the
Administration and the Congress to make the research tax credit
permanent.
Proposals Not Supported or Opposed
Modification of the Export Source Rule
Description of the Rule.\8\--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 is instead found in Treasury Regulations
Sec. 1.863-3(b), and has been there or in its predecessor
provisions for more than 70 years.
---------------------------------------------------------------------------
\8\ Parts of the following discussion of the rule were abstracted
from material prepared for the Export Source Coalition.
---------------------------------------------------------------------------
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).
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.\9\
---------------------------------------------------------------------------
\9\ 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 five year limitation causes
them to ``expire.''
---------------------------------------------------------------------------
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.)
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.\10\
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\10\ The source of gross income derived from inventory property
that is purchased by an exporter in the U.S. and sold outside the U.S.
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.
---------------------------------------------------------------------------
The source of income derived from the sale of property
produced \11\ 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'').\12\
---------------------------------------------------------------------------
\11\ Section 864 of the Code provides that ``produced property''
includes property that is ``created, fabricated, manufactured,
extracted, processed, cured, or aged.''
\12\ 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.
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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.
EXAMPLE: \13\
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\13\ 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.
---------------------------------------------------------------------------
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):
----------------------------------------------------------------------------------------------------------------
U.S. Production
-------------------------------- Czech
With Export Without Export Production
Source Rule Source Rule
----------------------------------------------------------------------------------------------------------------
Sales Price..................................................... $100.00 $100.00 $100.00
Cost of Goods Sold.............................................. ($90.00) ($90.00) ($88.00)
-----------------------------------------------
Pre-tax Income.................................................. $10.00 $10.00 $12.00
-----------------------------------------------
U.S. tax........................................................ $3.50 $3.50 $4.20
Czech tax....................................................... -- -- $4.20
Foreign Tax Credit.............................................. ($1.75) -- ($4.20)
-----------------------------------------------
Net tax......................................................... $1.75 $3.50 $4.20
-----------------------------------------------
After-tax Income................................................ $8.25 $6.50 $7.80
----------------------------------------------------------------------------------------------------------------
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.
For example, the following two structures result with and
without the Export Source Rule:
------------------------------------------------------------------------
With Export Without Export
Source Rule Source Rule
------------------------------------------------------------------------
Sales Price............................. $100.00 $102.69
Cost of Sales........................... 90.00 90.00
-------------------------------
Profit.................................. $10.00 $12.69
-------------------------------
Net tax................................. $3.50 $4.44
Less: Foreign Tax Credit................ ($1.75) --
-------------------------------
Net tax................................. $1.75 $4.44
-------------------------------
After-tax profit........................ $8.25 $8.25
------------------------------------------------------------------------
The Administration's Proposal.--The President's Fiscal Year
1999 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,\14\ 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.
---------------------------------------------------------------------------
\14\ ``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.
---------------------------------------------------------------------------
The Export Source Rule does not provide a competitive
advantage to multinational exporters vis-a-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.\15\
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\15\ ``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.
---------------------------------------------------------------------------
Although the FSC regime of the Code \16\ 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.\17\
---------------------------------------------------------------------------
\16\ The Foreign Sales Corporation (``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.
\17\ 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.
---------------------------------------------------------------------------
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-nine.\18\ 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.\19\ 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.
\20\ 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.
---------------------------------------------------------------------------
\18\ The United States has in force some forty-nine 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 sixty years to
negotiate, sign, and approve the treaties that form the current
network.
\19\ A number of new agreements are being negotiated by the
Treasury Department.
\20\ 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 a relatively small percentage 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.
---------------------------------------------------------------------------
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.\21\
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\21\ Hufbauer, DeRosa, Id., at 1.
Limitation of Foreign Tax Credits from Foreign Oil and Gas
---------------------------------------------------------------------------
Income
The Administration's Proposals.--The President's Fiscal
Year 1999 Budget contains a proposal to modify the rules
affecting foreign tax credits for all ``foreign oil and gas
income.'' Such income 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. Potential abuses of 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.\22\ The Administration has not demonstrated that
these provisions of law and regulation are not adequate and
should be amended.
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\22\ 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% (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. Sec. 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); or (2) 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 I.R.S. promulgated the ``dual capacity''
regulations (Treas. Reg. Sec. 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. Sec. 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).
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The proposals create significant new limitations on the
foreign tax credits attributable to foreign oil and gas income,
and represent significant limitations on the foreign tax
credits available to this specific industry. This proposal will
significantly increase the cost of capital in that industry and
make U.S. companies even less competitive vis-a-vis their
foreign competitors. 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.
Other Foreign Proposals: Amend 80/20 Company Rules; Prescribe
Regulatory Directive to Address Tax Avoidance Involving
Foreign-Built-In Losses; Prescribe Regulatory Directive to
Address Tax Avoidance Through Use of Hybrids; Modify Foreign
Office Material Participation Exception Applicable to Inventory
Sales Attributable to Nonresident's U.S. Office
In each of these proposals the Treasury seeks legislative
or regulatory authority to address perceived abuses. The NFTC
is also concerned that current law not be subject to
unwarranted abuse of statutory provisions in ways that
undermine Congressional intent.
However, the General Explanations of the Administration's
Revenue Proposals (the ``Green Book'' explanations) issued by
the Treasury give little detail of the perceived abuses.
Further, the changes to the statutes affected by the
proposals--in some case statutes that have been settled law for
many years--and the regulatory authority sought are very broad.
Still further, recent notices issued by the Treasury that
amplify certain of these proposals have created considerable
uncertainty as to the intent of the Treasury in regard to its
announced intent to issue legislative regulations in the very
near future in these areas--given the breadth of the notices,
and their application to a number of legitimate transactions
that have been planned and in some cases implemented under
current law and regulations. Lastly, NFTC is troubled by recent
indications that Treasury is apparently seeking to broadly
address efforts by U.S. taxpayers to legitimately reduce their
foreign taxes under provisions of foreign law that do not
affect U.S. tax receipts.
Therefore, the NFTC does not support these changes until a
better analysis of these issues and perceived abuses can be
produced by the Treasury, and until more specific legislation
is crafted that better serves the interests of the U.S. by
separating legitimate transactions from those not favored by
current U.S. law.
Notice 98-5, and Notice 98-11 in particular, have had a
chilling effect on the ability of U.S. companies to structure
their foreign operations consistent with legitimate commercial
objectives. They also adversely impact companies' abilities to
effectively reduce their overall costs by reducing local taxes
in their overseas operations. The Notices are drafted so
broadly and so vaguely that they confuse U.S. taxpayers and
their advisors, and introduce a compelling need to seek
clarification as to whether taxpayers can continue to rely on
the simple ``check-the-box'' regulations issued just last year.
All these effects are exacerbated by the Notices' immediate
effective dates.
U.S. multinationals compete in an environment wherein
foreign competitors use tax planning techniques to reduce
foreign taxes without incurring home country tax. It would
appear that at least some of the concerns sought to be
addressed are not inconsistent with the balance between
competitiveness and export neutrality that was intended by
Congress in enacting the ``subpart F'' rules. NFTC believes
that it would be more appropriate for Congress to request a
study regarding the trade and tax policy issues associated with
Notices 98-5 and 98-11. In this regard, a moratorium on further
regulatory action by Treasury should be imposed until enactment
of specific legislative proposals resulting from well reasoned
analysis and debate.
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.\23\
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\23\ See footnote 9.
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The Administration's Proposal.--The President's Fiscal Year
1998 Budget contained 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. This
proposal is currently being considered in the Senate as a
revenue raiser for one or more pending bills. The NFTC strongly
opposes this proposal.
As noted by the Joint Committee on Taxation,\24\ 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.
---------------------------------------------------------------------------
\24\ JCX-10-97, Id., at 62.
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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.
Statement of 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 1999 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 1998, 1997, 1996 or
1995.
Mining directly employs over 300,000 workers. Nearly five
million Americans have jobs as a result of the mining
industry's contribution to personal, business and government
income throughout the nation. The headquarters of NMA member
company operations are located in nearly every state of the
Union and some form of mining represented by the NMA occurs in
all 50 states.
The President's Proposal
Of primary concern to our industry is the Administration's
budget proposal to repeal the percentage depletion allowance
for minerals mined on federal and former federal lands where
mining rights were originally acquired under the Mining Law.
The mining industry is adamantly opposed to this proposal. The
President included this provision in his 1997 and 1998 budget
proposals. It was a bad idea then, it is a bad idea now.
Repeal of the allowance is a major tax increase on
companies whose mines are 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.
The U.S. Department of Labor reports that the mining
industry provides some of the highest paying nonsupervisory
jobs in the United States. The average mining wage in 1996 was
$47,612 (not including benefits)--far above the national
average wage of $28,945. We believe that tax policy should
foster the creation of more of these high-paying jobs.
Unfortunately, the Administration's proposal places many of
these jobs, principally in economically vulnerable rural areas
in the West, at risk.
Mining and the Mining Law
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 advocate 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 President's proposal to increase the tax burden
on certain hardrock mines would appear to be part of a
sustained and coordinated effort to accomplish that goal.
It is a serious misconception to think that minerals mined
on federal lands are free for the taking--that mining companies
receive something for nothing and are therefore recipients of
so-called ``corporate welfare.'' The NMA wishes to set the
record straight.
Minerals have no worth if left in the ground undiscovered
in the hundreds of millions of acres of unused land controlled
by the federal government. They only attain value after they
are discovered and produced. And they won't be produced unless
there is significant investment and a financial risk shouldered
by the mining industry.
The pamphlet prepared by the Joint Committee on Taxation
describing the President's fiscal 1999 tax proposals (Joint
Committee on Taxation, Description of Revenue Provisions
Contained in the President's fiscal Year 1999 Budget Proposals
(JCS-4-98), February 24, 1998) states that: Once a claimed
mineral deposit is determined to be economically recoverable,
and at least $500 of development work has been performed, the
claim holder may apply for a ``patent'' to obtain full title to
the land for $2.50 or $5.00 per acre.
The Committee should note that considerable funds must be
expended in order to demonstrate to the satisfaction of the
federal government that the claim contains an ``economically
recoverable'' mineral deposit. The Nevada office of the Bureau
of Land Management reports that: In Nevada, mineral patent
applications have contained from one to 500 claims/sites per
application. At a minimum it will cost an applicant $37,900 in
direct costs to process a single claim or mill site. Cost can
and do go much higher.
The $2.50 or $5.00 per acre fee note in the pamphlet is
merely a patent application fee. The costs a mining company
must incur to get to the patenting phase usually run in excess
of $2,000 per acre, or $40,000 per 20-acre claim. It is
impossible to obtain a patent simply by writing a check to the
government for $2.50 or $5.00 per acre--a fact conveniently
overlooked by mining's critics. Obtaining a patent is an
expensive, time-consuming, laborious and by no means guaranteed
process.
With or without a patent, a significant amount of capital
must then be invested to develop the mine and build the
necessary infrastructure to process raw ore into an acceptable
product. 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 Importance of the Domestic Mining Industry
The President's proposal coupled with other legislative and
regulatory initiatives is effectively placing much federally
controlled land off-limits to mineral exploration and is making
the United States an increasingly hostile business environment
for mining investment. As mining companies must continuously
search for new reserves or literally mine themselves out of
business, this negative environment is increasingly forcing
them to look overseas for new exploration projects.
The NMA believes it is in the vital interest of the United
States to have a viable domestic mining industry. A study
prepared by the Western Economic Analysis Center reports that
the domestic mining industry, directly and indirectly, accounts
for significant economic activity--$524 billion in 1995 alone.
It is beyond a doubt that continued economic growth and
improvements in the standard of living for all Americans will
depend upon a reliable supply of energy and raw materials. The
U.S. mining industry has the potential to provide much of our
resource needs--if it is allowed to do so.
Impact of Repeal
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 worldwide supply and demand factors,
mining companies cannot recover higher costs by raising prices.
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 a company's ability to
make the necessary investment in existing operations to improve
production efficiencies and respond to constantly changing
environmental, reclamation, health and safety standards.
Investment in new projects will decline. This
change to long-standing tax policy will adversely affect the
economics of new projects. Many new projects will become
uneconomic, resulting in lost opportunities for new jobs and
tax revenues.
Clearly, 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
then be satisfied by imports of minerals mined by overseas by
foreign workers. U. S. exports will become jobs and many areas
of the country will experience economic decline and an erosion
of state and local tax bases.
Despite the continued overall growth of the economy, the
copper and gold metals mining industry (the primary target of
the Administration's proposal) has entered into a serious
cyclical decline. The price of gold is at its lowest point in
18 years (having declined over 25% in the last year) and the
price of copper has declined over 30% in less than one year.
Many mining companies are struggling to remain profitable and
keep mines open and miners working to weather this downturn.
Indeed, several companies have already announced mine closures
and significant layoffs in the past six months.
The Depletion Allowance
The mining industry is characterized by relative rarity of
commercially viable mineral deposits, high economic risks,
geologic unknowns, high capital requirements 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.
The Need for Tax Reductions
The mining industry (and other capital-intensive
industries) already pay high average 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. 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.
Conclusion
We urge the Committee and the Congress to reject this job-
killing and self-defeating tax increase 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.
Statement of National Realty Committee
National Realty Committee appreciates the opportunity to
submit comments for the record of the February 25, 1998 hearing
of the House Committee on Ways and Means regarding the revenue
provisions of the Administration's fiscal year 1999 budget
proposal.
National Realty Committee serves as Real Estate's
Roundtable in Washington on national issues affecting real
estate. Its members are America's leading public and private
real estate owners, advisors, builders, investors, lenders and
managers. The Administration's budget contains proposals that
could significantly affect the real estate industry, some
positively and others negatively, and we look forward to
working with the Committee as it deliberates on these
proposals.
Revenue Increases in President's Budget Proposal
Real Estate Investment Trust (REIT) Proposals
The Administration's proposed fiscal year 1999 budget includes four
proposals that could substantially affect important aspects regarding
the formation, operation and management of Real Estate Investment
Trusts (REITs). The securitization of real estate through REITs that
has occurred in the 1990s has been an important factor in the recovery
of the real estate industry which itself is making a significant
contribution to the strength of the overall economy. We are greatly
concerned with the impact the Administration's proposals could have on
capital flows to real estate and the potential resulting negative
effect on asset values and jobs. Therefore, we urge you to carefully
review these proposals to determine fully the nature and scope of any
true abuses concerning REITs and act only to the extent required to
address those specific problems.
Before discussing the Administration's individual proposals, we
believe it would be useful to provide the Committee with some context
and background concerning the important role of REITs in the real
estate marketplace, their benefit to overall economic growth, and the
general policy approach to this vehicle that we would urge.
The Real Estate Crisis of the Late 1980s and Early 1990s
Today's real estate markets, as a whole, are in overall good
health. Interest rates and inflation are low; availability of capital
and credit is good; and demand for work and shopping space, in most
regions, is relatively strong. In the late 1980s and early 1990s,
however, the economy was teetering on a recession and the real estate
industry itself was close to experiencing a depression. During this
period, the demand for building space had fallen with the fortunes of
the economy. Over-building that occurred in the 1980s flooded some
markets, driving vacancy rates up even further. Exacerbating the
situation was the ``credit crunch'' that the commercial real estate
industry faced. Many owners of commercial real estate properties
experienced difficulties in obtaining reasonable financing, including
the refinancing of existing properties--whether or not the property was
performing. This dearth of capital contributed to a severe nationwide
drop of property values, dampened investment returns, increased
bankruptcies and foreclosures, and caused tremendous job losses. In
turn, this resulted in a material erosion in state and local tax bases,
which adversely impacted community services.
The Role of REITs in the Recovery of Real Estate and the Economy
One of the primary catalysts in real estate's recovery in the 1990s
has been the emergence of the REIT as a broad-based public ownership
entity. The REIT, along with the development and growth of the
commercial mortgage-backed securities market, has provided real estate
with access to much-needed funding via the public debt and equity
markets. Such access to capital enabled billions of dollars of real
estate to be recapitalized--thus stabilizing asset values nationwide
and easing the tremendous negative pressure being placed on lenders'
portfolios. These positive actions contributed significantly toward
setting the nation on a course of job-creating economic growth.
REITs, in effect, act as real estate mutual funds by securitizing
real estate equity and providing investors with a liquid investment in
a diversified pool of real estate assets. Like stock mutual funds, this
lowers the risk to investors, which in turn lowers the cost of capital
to the REIT. The growth of REITs also increased the number and types of
real estate investors, thereby opening new capital sources to real
estate and reassuring traditional lending sources.
Today, REITs are the fastest growing form of real estate
investment. In the last five years, the market value of REITs has
increased from $10 billion to almost $150 billion. There are a total of
210 publicly traded REITs, approximately 45 of which have
capitalizations exceeding $1 billion. This represents an extraordinary
growth rate that has been positive for real estate values, whether
publicly-held or privately-held.
Because real estate represents about 12 percent of America's gross
domestic product, this in turn has produced positive ripple effects for
the overall economy. Real estate accounts for nearly 9 million jobs in
America. About $293 billion in tax revenues is generated annually by
real estate, and almost 70% of all tax revenues raised by local
governments come from real property taxes. Unquestionably, real estate
is a vital and major contributor to the nation's economy and REITs play
a significant, and growing, role in the real estate industry.
In short, the real estate markets and the nation's economy are
being well served by the current capital formation and operational
flexibility of REITs. This flexibility should be preserved--
particularly in anticipation of an inevitable economic downturn during
which challenges to capital formation will be magnified.
REITs Pay Significant Level of Tax Relative to Market Capitalization
Contrary to the perception prevalent in a number of news articles
and editorials, REITs are not a vehicle for tax avoidance. This
misunderstanding presents a serious concern because of its potential to
misinform policymakers and the public. Although REITs do not,
themselves, pay Federal corporate level tax (so long as they distribute
95 percent of their taxable income annually), they are responsible,
directly and indirectly, for a significant amount of tax revenues
relative to their market capitalization. In 1997, REITs distributed $8
billion in dividends which are taxable to their shareholders for
Federal and state income tax purposes. REITs themselves also pay
substantial amounts in state and local taxes and payroll taxes.
Congress's Proper Approach toward REITs
Over the years, REIT tax laws have been modified and refined by
Congress and the Treasury Department to ensure that REITs are able
effectively to fulfill their mission in a changing economic and
business environment. Federal tax policy should continue to provide
this type of flexibility and reflect an understanding of the benefits
REITs provide to the vitality of today's real estate markets and the
overall economy.
Congress, and notably this Committee, has avoided any dramatic
policy shifts affecting REITs, particularly during their recent
proliferation and expansion. Your approach toward REIT policy has been
measured and thoughtful, as evidenced by: (i) the liberalization of the
independent contractor requirement by the Tax Reform Act of 1986, which
enabled REITs to avoid the unnecessary expense of hiring independent
contractors for routine management functions; (ii) the amendment of the
closely held rules, in the Revenue Reconciliation Act of 1993, to allow
a ``look through'' for pension funds investing in REITs; and (iii) the
enactment of the REIT simplification provisions as part of the Taxpayer
Relief Act of 1997. Collectively, these changes modernized the REIT tax
regime, resulting in enhanced ability to raise capital, more efficient
organization and improved flexibility to provide services to tenants,
thereby maintaining the overall competitiveness of REITs.
This carefully thought-through and deliberative course of action
should be continued. Therefore, as you consider the Administration's
REIT proposals, and REIT policies in general, we urge you to proceed
carefully. REITs are an important capital source for real estate that
should not be impaired. Although none of the individual REIT proposals
in the President's budget proposal would alone cripple REITs, the
policy goal embedded in them appears aimed at undermining the capital
formation flexibility of REITs. We do not agree with that policy. We
believe it is important for this Committee to continue its leading role
in preserving the organizational, operational and capital formation
flexibility currently afforded REITs. Our recommendations concerning
the Administration's specific proposals follow.
President's Budget REIT Related Proposals
Restrict impermissible businesses indirectly conducted by
REITs. Current law prohibits REITs from owning more than 10% of the
voting stock of another corporation (other than another REIT as a
qualified REIT subsidiary). The Administration proposes that this
ownership restriction be amended so that REITs be prohibited from
holding stock representing more than 10 percent of the voting rights or
value of the corporation.
Recommendation: In our view, the Administration's proposal is
unnecessarily heavy-handed. It would effectively end the use of all
preferred stock subsidiaries in order to correct a narrow concern. The
REIT structure established by Congress allows REITs to own securities
which are not considered real estate assets, so long as such securities
represent not more than 25 percent of the total REIT assets and certain
limitations are met. The third party preferred stock subsidiary fits
within this structure.
The Administration contends that the preferred stock subsidiary is
often significantly leveraged with debt held by the REIT, which
generates interest deductions intended greatly to reduce or eliminate
the taxable income of such subsidiary. However, these third party
subsidiaries typically are service providers and do not, by their
nature, require large amounts of operating capital and, thus,
significant leveraging. In these cases, the Administration's concern is
minimized, if non-existent.
We would emphasize that there are a number of provisions already
existing in the Internal Revenue Code that effectively prevent REITs
from using these preferred stock subsidiaries in ways that avoid
taxation on the subsidiary's earnings. Some of these provisions
include: the rules under Section 482 affecting the allocation of income
and deductions among taxpayers; Section 269 disallowing deductions or
credits relating to acquisitions made to evade or avoid taxation; and
the requirements under Section 162 for deduction of rental payments and
business expenses. Further, although now discontinued, the IRS,
beginning in 1988, issued favorable rulings on these subsidiaries.
Congress also has been aware of these subsidiaries and found no reason
to act upon them even though it recently enacted a number of REIT
reforms.
Since it is not clear that abuses exist in any magnitude, we must
oppose this proposal. In the event there are abuses with preferred
stock subsidiaries, they should be specified and corrective action
taken only to the extent they cannot otherwise be addressed under
existing anti-tax abuse laws. National Realty Committee looks forward
to working with the Committee and the Administration in this regard.
Modify the treatment of closely held REITs. Under this
proposal--which would constitute an additional requirement for REIT
qualification--any ``person'' (that is, corporation, partnership or
trust) would be prevented from owning stock in a REIT if the person
controls more than 50 percent of the total combined voting power of all
classes of voting stock or more than 50 percent of the total value of
shares of all classes of stock.
Recommendation: It is fundamental to the concept of REITs that they
be widely held entities, easily and economically accessible by small
investors. National Realty Committee is in full agreement with this.
The Administration's enunciated reason for proposing the additional
qualification requirement is a concern about possible tax avoidance
transactions involving the use of closely held REITs. However, the
Administration's explanation of the proposal provides little
description of the transactions at issue. Before National Realty
Committee can constructively comment on this provision, and certainly
before Congress should consider the proposal, further clarification
should be provided as to the perceived abuses targeted by the proposal.
So called ``incubator REITs'' sometimes have a majority shareholder
corporation for a transition period in order to prepare the REIT for
going public by allowing it to develop a track record. Corporate
majority shareholders of private REITs are also used for legitimate
state and local income and real property tax planning purposes and as a
vehicle for legitimate foreign investment in real estate. We do not
believe these structures lend themselves to tax abuse, and any proposal
on this issue should clarify the same.
Importantly, it also needs to be clarified that this proposal would
not affect a REIT's ability to own interests in another REIT or to have
a qualified REIT subsidiary. A special ``look-through'' rule (as in the
case with respect to qualified trusts under section 401(a) of the Code)
should apply in determining whether a REIT owning an interest in
another REIT meets the 100 or more shareholders requirement.
National Realty Committee believes that before this Committee takes
any action, the tax avoidance transactions involving the use of closely
held REITs generally referred to in the Administration's proposal need
to be more clearly and specifically set forth. This will help qualify
the issue and quantify the extent, if any, remedial action is needed.
Also, it would help insure that legitimate transactions important to
real estate capital formation not be unduly affected.
Repeal tax-free conversions of C corporations to S
corporations (or REITs). Under current law (Section 1374 of the Code),
a C corporation that converts or merges into an S corporation does not
pay tax on ``built-in'' gains (the excess of asset value at such time
over tax basis), unless the asset is sold within 10 years of the
conversion or merger. The Administration proposes repealing Section
1374 for large corporations (valued at over $5 million), so that a
converting or merging corporation would, immediately thereupon, pay a
tax as if it had at that moment sold its assets and distributed the
proceeds to its shareholders, producing an immediate second level of
tax. The Administration's proposal also would apply to C corporations
that convert into or merge with REITs.
Recommendation: National Realty Committee, together with a broad
coalition of industry and small business organizations, opposed this
proposal when it was put forth by the Administration in each of the
last two budget proposals. Our position is unchanged--the proposal
should be rejected. The current rules taxing the ``built-in'' gain of
assets sold within a 10-year period of electing S corporation or REIT
status is a fair standard that effectively prevents tax avoidance.
Imposing two levels of tax on built-in gains likely would affect the
economics of most transactions so significantly that they simply would
not go forward. Thus, many C corporations would be precluded from
converting or merging into an S corporation or REIT. The effect would
be to negate the revenue-raising impact of the provision and to impede
the continuing recapitalization of commercial real estate through the
access to public capital markets that REITs provide.
Freeze the grandfathered status of stapled (also known as
paired-share) REITs. This proposal would allow stapled REITs to
continue to operate in their stapled form for properties held by the
REIT as of ``the first date of congressional committee action on this
proposal.'' Properties acquired on or after the first date of committee
action would not be allowed to be operated by the company paired with
the REIT.
Recommendation: We believe the Committee should continue to follow
for this specific company issue the historically deliberative and
carefully thought-through approach it has followed in making REIT
policy in general. We are opposed to any retroactive legislative
measures that would undercut someone's reasonable reliance on existing
law. This issue has a long and somewhat convoluted history and, as a
result, most Members of Congress have a limited understanding of REITs
and, more particularly, the stapled REITs. Therefore, before any action
is taken on the Administration's proposal, we believe it advisable for
the Committee to study further and hold hearings on this issue to
determine what, if any, remedial changes are warranted to the stapled
structure.
Other Real Estate-Related Revenue Provisions
Eliminate non-business valuation discounts (for family
limited partnerships). The budget proposal asserts that family limited
partnerships are being used to take ``illusory'' valuation discounts on
marketable assets. The proposal contends that taxpayers are making
contributions of these assets to limited partnerships, gifting minority
interests in the partnerships to family members, and then claiming
valuation discounts based on the interest being a minority interest of
a non-publicly traded business. The proposal would eliminate such
valuation discounts except as they apply to ``active'' businesses.
Recommendation: National Realty Committee opposes this proposal in
concept because it increases the estate tax burden and specifically
because it defines marketable assets as including ``real property.''
The reference to real property, which lacks any elaboration, could be
interpreted broadly to include much of the nation's directly or
indirectly family-owned real estate. In all events, further
clarification by the Administration is needed to determine the
definition of ``real property.''
Nevertheless, National Realty Committee does not believe that real
property or interests in real property should be included in a proposal
targeted at truly passive investments, such as publicly traded stocks
and bonds. We applaud the Committee for its work last year to reduce
the estate and gift tax burden and its continuing efforts to that end.
This proposal would take a number of steps backward and increase the
estate tax burden. As a result, successors in family-owned real estate
businesses could be faced with the troubling scenario of having to sell
real property in the estate (often at distressed value prices) in order
to pay death taxes.
We also would point out that the Internal Revenue Service itself,
in Revenue Ruling 93-12, and the courts throughout the Nation, in a
large number of recent cases, have recognized that minority interests
as limited partners in closely held limited partnerships do not have
the same value, by any means, as would a tenant in common in the
underlying assets, irrespective of the nature of the assets.
Furthermore, on a related matter, it should be clarified that, for
purposes of the estate tax exclusion for qualified family-owned
businesses, owning rental real estate is considered a trade or business
so long as the required ownership percentage requirements are met. This
would place small, family-owned real estate businesses on a level
playing field with other small businesses for purposes of the up to
$1.3 million unified credit amount enacted last year.
Disallow financial institutions' ability to deduct
interest expense for tax-exempt investments. Under this proposal, a
financial institution that invests in tax-exempt obligations would not
be allowed to deduct a portion of its interest expense in proportion to
its tax-exempt investments.
Recommendation: National Realty Committee opposed a similar
proposal last year and opposes this proposal because it would reduce
corporate demand for tax-exempt securities, such as industrial
development and housing bonds. Reducing corporate demand for these
important investment vehicles would increase the borrowing costs of
municipalities throughout the country--thus, hindering urban
reinvestment activity--and it would discourage corporate investment in
state and local housing bonds issued to finance housing for low and
middle income families.
Clarify the meaning of ``subject to'' liabilities under
Section 357(c). For transfers of assets to corporations, the
distinction between the assumption of a liability and the acquisition
of an asset ``subject to'' a liability would be eliminated and a facts-
and-circumstances determination would be made. In general, if
indebtedness is secured by more than one asset, and any of the assets
securing the indebtedness are transferred subject to the indebtedness,
the transferee shall be treated as assuming an allocable portion of the
liability, based on relative fair market values.
Recommendation: Historically, court cases have provided specific
guidelines under Section 357. In National Realty Committee's view,
introducing a facts-and-circumstances determination criterion without
providing safe harbors would create considerable uncertainty and result
in increased transaction costs. The Code as now written, combined with
the present Regulations and judicial authority, should provide
sufficient comfort to the Service.
Modify the depreciation of tax-exempt use property. Under
current law, ``tax-exempt use property'' is defined as property leased
by a tax-exempt entity under lease terms designed to transfer the
benefits of tax deductions that the entity would not be eligible for if
it, in fact, owned the property. Currently, such property is
depreciated using the straight-line method over a period equal to the
greater of the property's class life (40 years for non-residential real
property) or 125 percent of the lease term. The Administration contends
that current law may allow depreciation deductions to accrue more
rapidly than economic depreciation. Therefore, the budget proposes that
tax-exempt property be depreciated using the straight-line method over
a period equal to 150 percent of the property's class life (60 years).
The proposal would affect property that is placed in service, becomes
tax-exempt or becomes subject to a new lease after December 31, 1998.
Recommendation: We believe the current depreciation rules
adequately prevent tax abusive transactions involving the sale and
leaseback of real property of tax-exempt organizations. The current law
minimum 40-year depreciation period in no way provides a recovery of
costs faster than economic depreciation. On its face, the proposal
appears punitive and not grounded in sound economic or tax policy. The
Administration needs to demonstrate its position more clearly and
convincingly.
Tax Incentives in the Budget Proposal
Tax credit for energy-efficient building equipment. The
Administration's budget proposes a 20 percent tax credit for the
purchase of certain highly-efficient building equipment, including fuel
cells, electric heat pump water heaters, advanced natural gas and
residential size electric heat pumps, and advanced central air
conditioners. Specific technology criteria would have to be met to be
eligible for the credit. The credit would apply to purchases made
between 1999 and 2004.
Recommendation: National Realty Committee believes the immediate
objective of this proposal--encouraging energy efficiency in
buildings--has merit. In preparing for the 21st century, the real
estate industry, like other major industries, is looking for ways to
improve its overall performance from an economic and environmental
perspective. National Realty Committee has taken notice of statistics
from the Department of Energy identifying office buildings as consuming
about 27% of the nation's electrical supply. If this is an accurate
assessment, we are surprised that, of the six specific tax credit
proposals for energy efficient building equipment, only one (fuel
cells) has any practical application to commercial office buildings.
More specifically on the matter of the fuel cell credit, while the
amount of the incentive is not insignificant, it is not yet sufficient
to encourage the use of this technology except in rare circumstances.
In addition to providing incentives to the acquisition of specific
building technologies, the Administration's budget seeks to encourage
the development of energy efficient homes. A credit for this purpose is
targeted to single family homes where there are recognized standards by
which the efficiency of these structures can be readily measured. Such
standards also exist, however, for energy efficiency in commercial
office buildings. Given the high energy usage by this division of the
building sector, it makes sense to consider analogous credits for
highly efficient commercial buildings.
Expensing of brownfield remediation costs. The
Administration proposes to make permanent the deduction for brownfield
remediation costs. This deduction was enacted as part of last year's
budget and tax law and is scheduled to expire after December 31, 2000.
Recommendation: National Realty Committee supports this proposal.
However, the deductibility of clean-up expenses applies only to
brownfields in specifically targeted areas, such as empowerment zones.
We understand the social and economic policy goals intended to be
furthered by this targeted clean-up provision. However, there are
almost 450 brownfields across the nation, most of which are outside of
these targeted areas. Allowing some type of deductibility or
amortization of clean-up costs for all of these brownfields would help
restore brownfields across America to viable and productive use. We
acknowledge that allowing full deductibility of these expenses could
have a substantial revenue cost. Therefore, we propose modifying the
Administration's proposal by treating the clean-up costs in non-
targeted areas as start up expenses under Section 195 of the Code,
thereby allowing them to be amortized over 60 months. This would lessen
the revenue cost to the Treasury, while providing a valuable incentive
to nationwide brownfield restoration. We look forward to the
opportunity to work with the Committee on this important social,
economic and environmental issue.
Low-income housing tax credit expansion. The budget
proposes a major expansion of the low-income housing tax credit, which
could facilitate the construction of 150,000-180,000 new affordable
housing units over five years. Under the White House proposal, the
annual state low-income housing credit limitation would be raised from
$1.25 per capita to $1.75 per capita, beginning January 1, 1999.
Recommendation: National Realty Committee supports this proposal.
We also support related legislation, S. 1252 in the Senate and H.R.
2990, introduced by Mr. Ensign and cosponsored by Mr. Rangel and
several other Members of the Committee on a bipartisan basis. We are
very encouraged by the consensus developing between the Administration
and key Members of Congress on the need for increasing the amount of
low income housing tax credits allocated to the states. Since its
inception in 1986, this credit program has encouraged private ownership
of affordable rental housing by authorizing state and local agencies to
allocate tax credits to owners of low-income rental properties. The
program has enabled the construction and rehabilitation of more than
120,000 rental units annually and is used in approximately 35 percent
of newly constructed rental units nationally. Demand for the housing
credit nationwide has exceeded its supply, and this proposal will help
states respond to the increasing demand for decent and affordable
rental housing.
Conclusion
Again, we thank Chairman Archer and the Committee for the
opportunity to comment on the record regarding the revenue proposals in
the President's fiscal 1999 budget. We are encouraged by the proposals
to increase the low income housing tax credit, make permanent the
deductibility of brownfield clean-up costs and implement credits for
energy-efficient improvements for buildings. The REIT proposals cause
us considerable concern, particularly with respect to preferred stock
subsidiaries, closely held REITs and C corporation conversions and
mergers, and we urge that you reject such proposals outright.
We look forward to working with the Committee to ensure that the
provisions of the Code dealing with REITs do not lead to abuses, yet
allow REITs effectively to fulfill their mission in a continually
changing economic and business environment.
Finally, while we object to the proposal to eliminate realistic
valuation discounts in the non-business, family limited partnership
situation, we strongly believe that, in all events, including real
property in such proposal is ill-advised and should be dropped from any
further consideration.
Statement of National Structured Settlements Trade Association
A Stringent Excise Tax on Secondary Market Companies That Purchase
Structured Settlement Payments from Injured Victims Should Be Adopted,
Subject to a Limited Exception for Genuine Court-Approved Hardship, to
Protect Structured Settlements and the Injured Victims
I. Background and Policy of the Structured Settlement Tax Rules
The National Structured Settlements Trade Association
(NSSTA) is an organization composed of more than 500 members
which negotiate and implement structured settlements of tort
and worker's compensation claims involving persons with
serious, long-term physical injuries. Structured settlements
provide the injured victim with the financial security of an
assured payout over time. Founded in 1986, NSSTA's mission is
to advance the use of structured settlements as a means of
resolving physical injury claims.
A. Background
Structured settlements in wide use today to
resolve physical injury tort claims
Structured settlements are used to compensate seriously-
injured, often profoundly disabled, tort victims. A lump sum
recovery used to be the standard in tort cases. All too often,
this lump sum was prematurely dissipated by the victim or his
or her relatives. When the money was gone, the victim was left
still disabled and still unable to work. In such cases, the
State Medicaid system and welfare system were left holding the
bag to care for this disabled person.
Structured settlements provide a better approach. A
voluntary agreement is reached between the parties under which
the injured victim receives damages in the form of a stream of
periodic payments tailored to his or her future medical
expenses and basic living needs from a well-capitalized,
financially-secure institution. Often this payment stream is
for the rest of the victim's life to make sure that future
medical expenses and the family's basic living needs will be
met, and the victim will not outlive his or her compensation.
Structured settlements provide crucial financial
protection to seriously-injured tort victims
--Protection against premature dissipation by injured
victims unable to handle the financial responsibilities and
risks of managing a large lump sum to cover a substantial,
ongoing stream of medical and basic living expenses for a
lengthy period.
--Payout tailored to the needs of the particular victim.
--Avoids shift of responsibility for care to the public
sector.
Congress has adopted special tax rules to
encourage and govern structured settlements
Congress has adopted a series of special rules in sections
130, 104, 461(h), and 72 of the Internal Revenue Code to govern
the use of structured settlements by providing that the full
amount of the periodic payments constitutes tax-free damages to
the victim and that the liability to make the periodic payments
to the victim may be assigned to a structured settlement
assignment company that will use a financially-secure annuity
to fund the damage payments.
In the Taxpayer Relief Act of 1997, in a provision co-
sponsored by a majority of the House Ways and Means Committee,
Congress recently extended the structured settlement tax rules
to the worker's compensation area to cover physical injuries
suffered in the workplace.
B. Structured Settlement Tax Rules Were Adopted by Congress to
Protect Victims from Pressure to Squander Their Recoveries
Congressional Policy.--In introducing the legislation that
enacted the structured settlement tax rules, Sen. Max Baucus
(D-Mont.) pointed to the concern over squandering of a lump sum
recovery by injured tort victims or their families:
``In the past, these awards have typically been paid by
defendants to successful plaintiffs in the form of a single
payment settlement. This approach has proven unsatisfactory,
however, in many cases because it assumes that injured parties
will wisely manage large sums of money so as to provide for
their lifetime needs. In fact, many of these successful
litigants, particularly minors, have dissipated their awards in
a few years and are then without means of support.''
[Congressional Record (daily ed.) 12/10/81, at S15005.]
By contrast, Sen. Baucus noted: ``Periodic payments
settlements, on the other hand, provide plaintiffs with a
steady income over a long period of time and insulate them from
pressures to squander their awards.'' (Id.)
Thus, the federal tax rules adopted by Congress to govern
structured settlements reflect a policy of insulating injured
victims and their families from pressures to squander their
awards.
In addition, Congress was concerned that the injured victim
not have the ability to exercise such control over the periodic
payments that he or she would be deemed to have received a lump
sum recovery that was then invested on his or her behalf,
destroying the fully tax-free nature of the periodic payments
to the injured victim. The House Ways and Means and Senate
Finance Committee Reports adopting the structured settlement
tax rules both state: ``Thus, the periodic payments as personal
injury damages are still excludable from income only if the
recipient taxpayer is not in constructive receipt of or does
not have the current economic benefit of the sum required to
produce the periodic payments.'' (H.R. Rep. No. 97-832, 97th
Cong., 2d Sess. (1982), 4; Sen. Rep. No. 97-646, 97th Cong., 2d
Sess. (1982), 4.)
Reflecting this Congressional policy of protecting injured
victims from pressure to squander their recoveries and the need
to avoid any risk of constructive receipt of a lump sum by the
victim, the structured settlement tax rules prohibit the victim
from being able to accelerate, defer, increase, or decrease the
periodic payments. (I.R.C. Sec. 130(c)(2)(B)). In addition, the
periodic payments must constitute tax-free damages in the hands
of the recipient. (I.R.C. Sec. 130(c)(2)(D)).
In compliance with these Congressional requirements and
consistent with State insurance and exemption statutes,
including ``spendthrift'' statutes that restrict alienation of
rights to payments under annuities and under various types of
claims (e.g., worker's compensation and wrongful death claims),
structured settlement agreements customarily provide that the
periodic payments to be rendered to the injured victim may not
be accelerated, deferred, increased or decreased, anticipated,
sold, assigned, pledged, or encumbered by the victim.
As the Treasury Department has noted, ``Consistent with the
condition that the injured person not be able to accelerate,
defer, increase or decrease the periodic payments, [structured
settlement] agreements with injured persons uniformly contain
anti-assignment clauses.'' (U.S. Department of the Treasury
General Explanations of the Administration's Revenue Proposals
(Feb. 1998), at p. 122).
II. Purchases of Structured Settlement Payments by Secondary Market
Companies Directly Undermine the Important Public Policies Served by
Structured Settlements
A. Background
Over the past year, there has been dramatic growth in a
transaction, variously known as a ``factoring,'' ``secondary
market,'' or ``gray market'' transaction, that effectively
takes the structure out of structured settlements.
In such a factoring transaction, the injured victim who is
receiving periodic payments of damages for physical injuries
under a structured settlement sells his or her rights to future
periodic payments to a secondary market company. In exchange,
the injured victim receives from the secondary market company a
sharply discounted lump sum payment.
This is a transaction that the injured victim enters into
with a third party, completely outside of the structured
settlement and generally without even the knowledge of the
other parties to the structured settlement. The secondary
market company is not in the structured settlement business.
In an effort to avoid the anti-assignment provisions in the
structured settlement agreements, the secondary market
companies typically have the injured victim simply present the
structured settlement company with a change of address to a
post office box under the control of the secondary market
company to accomplish the redirection of payments to the
secondary market company. Thus, the structured settlement
company obligated to make the periodic payment damages under
the structured settlement is not a party to the factoring
transaction and most often has no notice of it at all.
B. Rapid Growth in Secondary Market Purchases of Structured
Settlement Payments
Secondary market companies use extensive advertising and
telemarketing, as well as direct appeals to plaintiffs' lawyers
coupled with a finder's fee, to solicit new business. For
example, one major secondary market company, J.G. Wentworth,
stated in a recent SEC filing that during the first 9 months of
1997 alone, it ran 56,000 television commercials. Wentworth
runs a telemarketing call center with 200 telemarketing
stations operating 24 hours a day, 6 days a week.
The secondary market companies direct considerable
advertising at the plaintiffs' bar, promising the injured
victim's lawyer a second fee on the same case--this time by
unwinding the structured settlement. For example, an ad by
Stone Street Capital states:
``You helped your clients once by winning them a structured
settlement. Now you can help them again by showing them how to
convert all or a portion of their settlement to a lump-sum
payment.
``For each of your clients who exercise this exciting new
option, your firm will be compensated for legal fees by
facilitating the standardized processing of an annuity purchase
agreement. On average, these fees amount to about $2,000 per
conversion. [Emphasis in original].''
The secondary market business is a rapidly growing one.
According to SEC filings, during the first 9 months of 1997
J.G. Wentworth alone undertook 3,759 structured settlement
purchase transactions. These purchased structured settlement
payments had a total undiscounted maturity value of $163.6
million and were purchased for $74.4 million. Blocks of
purchased structured settlement payments are now being
``securitized'' by the secondary market companies and marketed
on Wall Street.
C. Public Policy Concerns Created by Secondary Market
Transactions
Secondary market purchases of structured settlement
payments create serious problems affecting all participants in
structured settlements.
Secondary market purchases of structured
settlement payments trigger the very same dissipation risks
that structured settlements are designed to avoid
By selling future structured settlement payments to the
secondary market companies, the injured victim receives an
immediate lump sum payment. Just as lump sum tort recoveries
are frequently dissipated, all too often this lump sum from the
secondary market company can be quickly dissipated, and the
injured person finds himself or herself in the very predicament
which the structured settlement was intended to avoid.
Having factored away their only assured source of future
financial support and then dissipating the cash received, these
injured victims may face the prospect of public assistance to
cover their future medical expenses and basic living needs.
Secondary market purchases often are made at sharp
discounts
In many cases the injured victim's dissipation risks are
magnified because the lump sum payment that the injured victim
receives in the factoring transaction is so sharply discounted.
While factoring transactions apparently reflect a range of
discounts, it is not uncommon for an injured victim to receive
a lump sum payment of less than 50 percent of the present value
of the structured settlement payments being sold.
In one recent case, a 20-year-old structured settlement
recipient who was receiving monthly payments from a tort action
when she was a child was persuaded to sell a series of her
future payments for approximately 36 percent of their present
discounted value. A few months later, she was persuaded to sell
additional future payments for approximately 15 percent of
their discounted present value.
Based on this case and many similar examples, it is clear
that in secondary market transactions structured settlement
recipients often are persuaded to sell future payments for far
less than the payments are worth.
Secondary market transactions create serious
Federal income tax uncertainties for the original parties to
the structured settlement
The structured settlement tax rules require that the
periodic payments constitute tax-free damages on account of
personal physical injuries in the hands of the recipient of
those payments. (I.R.C. Sec. Sec. 130(c)(2)(D); 104(a)(2)).
Following the factoring away by the injured victim, the
periodic payments now would be received by the secondary market
company and its investors and would not constitute tax-free
damages in their hands. This creates serious Federal income tax
uncertainties under the structured settlement tax rules for
both the victim and the company funding the structured
settlement.
Injured victim
The injured victim not only loses the benefit of
the future tax-free damage payments, but also runs a risk of
being taxed on the lump sum received from the secondary market
company if such payment is treated as received on account of
the sale of the victim's future payment rights and not on
account of the original injury.
If the structured settlement payments were freely
assignable by the injured victim and a ready market of
financial institutions was available to acquire such payments,
the victim might be deemed in constructive receipt of the
present value of the future payments just as if the payments
could be accelerated. In that case, from the outset of the
settlement a portion of each periodic payment would be treated
as taxable earnings, rather than tax-free damages.
Company funding the structured settlement.--Under the
structured settlement tax rules, the settling defendant (or its
liability insurer) assigns its periodic payment liability to a
structured settlement company in exchange for a payment which
is excluded from the structured settlement company's income if
the structured settlement tax rules under I.R.C. Sec. 130 are
satisfied and such payment is reinvested in either an annuity
or U.S. Treasury obligations precisely matched in amount and
timing to the periodic payment obligation to the injured
victim. The structured settlement company's income from the
payments under the annuity or Treasuries is matched by an
offsetting deduction for the damage payment to the victim.
The factoring transaction raises the concern that
the structured settlement tax rules no longer may be satisfied
and the risk that the structured settlement company may be
required to recognize and pay tax on amounts previously
excluded from its income or to pay tax on the ``inside build-
up'' under the annuity, for which there is no cash distribution
to pay the tax.
The structured settlement company may face an
obligation to report the payments made to the secondary market
company as taxable income even though in many cases the
identity of the purchaser or even the existence of the
factoring transaction itself is unknown.
Secondary market transactions create risks of
double liability for the structured settlement companies
While factoring transactions normally involve only the
injured victim and the secondary market company, the underlying
structured settlements typically involve multiple parties such
as family members, defendants, liability insurers, and state
workers' compensation authorities in workers' compensation
cases. Because structured settlement agreements prohibit
transfers of payments, if the structured settlement company
makes the payments--even unwittingly--to the secondary market
company, the structured settlement company may become subject
to later claims that it paid the wrong party and could still be
required to make the payments as originally required under the
settlement.
In many cases this risk of double liability is magnified by
state statutes that (i) in more than 20 states give statutory
effect to contract provisions prohibiting transfers of annuity
benefits and (ii) in nearly all States directly restrict or
prohibit transfers of recoveries in various types of cases
(e.g., workers' compensation, wrongful death, medical
malpractice).
The uncertainties created by secondary market
transactions may discourage future use of structured
settlements
These tax risks and double liability risks raised by the
factoring transaction are risks that the structured settlement
company specifically sought to avoid through the anti-
assignment provisions in the structured settlement agreement
and is not in a financial position to absorb, years after the
original structured settlement transaction was entered into.
These uncertainties and unforeseen risks could jeopardize
the continued ability of structured settlement companies to
fund settlements in the future. The structured settlement
company's participation is necessary to enable structured
settlements to be undertaken in the first instance by
satisfying the objectives of both sides to the claim: the
injured victim needs the long-term financial protection that
the structured settlement company's funding arrangement
provides, and the settling defendant wishes to close its books
on the liability rather than bearing an ongoing payment
obligation decades into the future.
III. A Stringent Excise Tax on Secondary Market Purchasers, Subject to
a Limited Exception for Genuine, Court-Approved Hardship, Protects
Structured Settlements, the Injured Recipients, and the Congressional
Policy Underlying Structured Settlements
A. Gravity of Problem Requires Strong Action by Congress
In acting to address the concerns over secondary market
companies that purchase structured settlement payments from
injured victims the Treasury Department noted that: ``Congress
enacted favorable tax rules intended to encourage the use of
structured settlements--and conditioned such tax treatment on
the injured person's inability to accelerate, defer, increase
or decrease the periodic payments--because recipients of
structured settlements are less likely than recipients of lump
sum awards to consume their awards too quickly and require
public assistance.'' (U.S. Department of the Treasury, General
Explanations of the Administration's Revenue Proposals (Feb.
1998), p. 122).
Treasury then observed that by enticing injured victims to
sell off their future structured settlement payments in
exchange for a heavily discounted lump sum that may then be
dissipated: ``These `factoring transactions' directly undermine
the Congressional objective to create an incentive for injured
persons to receive periodic payments as settlements of personal
injury claims.'' (Id., at p. 122 [emphasis added].)
The Joint Tax Committee's analysis of the issue echoes
these concerns: ``Transfer of the payment stream under a
structured settlement arrangement arguably subverts the purpose
of the Code to promote structured settlements for injured
persons. (Joint Committee on Taxation, Description of Revenue
Provisions Contained in the President's Fiscal Year 1999 Budget
Proposal (JCS-4-98), (February 24, 1998), p. 223).
While noting that the States traditionally have been the
province of consumer protection, the Joint Committee's analysis
reasons that there is a clear role for the Federal tax law to
address the policy concerns raised by sales of structured
settlement payments: ``On the other hand, the tax law already
provides an incentive for structured settlement arrangements,
and if practices have evolved that are inconsistent with its
purpose, addressing them should be viewed as proper.'' (Joint
Committee Description, supra, at p. 223).
B. Administration Proposal
The Treasury Department in the Administration's FY 1999
Budget has proposed a 20-percent excise tax on secondary market
companies that purchase structured settlement payments from
injured victims.
Under the Administration's proposal, ``any person
purchasing (or otherwise acquiring for consideration) a
structured settlement payment stream would be subject to a 20
percent excise tax on the purchase price, unless such purchase
is pursuant to a court order finding that the extraordinary and
unanticipated needs of the original recipient render such a
transaction desirable.'' (Treasury General Explanation, at p.
122). The proposal would apply to transfers of structured
settlement payments made after date of enactment.
The Administration's proposal represents a serious,
constructive step to address the policy concerns raised by the
purchases of structured settlement payments and to protect
injured victims.
C. An Even Stronger Solution Is Necessary to Fully Protect
Structured Settlements and Injured Victims: A Stringent Excise
Tax Rate on the Discount Subject Only To a Limited Exception
for a Genuine, Court-Approved Hardship
1. Stringent excise tax to address serious public policy
concerns raised by factoring transactions
In its analysis of the Administration's proposal, the Joint
Committee notes the potential concern that in some cases the
imposition of a 20-percent excise tax may result in the
secondary market company reducing even further the already-
heavily discounted lump sum paid to the injured victim for his
or her structured settlement payments. The Joint Committee
notes that ``[o]ne possible response to the concern relating to
excessively discounted payments might be to raise the excise
tax to a level that is certain to stop the transfers (perhaps
100 percent) . . . .'' (Joint Committee Description, supra, at
p. 223).
Secondary market purchases of structured settlement
payments so directly subvert the Congressional policy
underlying structured settlements and raise such serious
concerns for structured settlements and the injured victims
that it is appropriate to impose on the secondary market
company a more stringent excise tax rate on the amount of the
discount reflected in the secondary market purchase. Thus,
unlike the Administration's proposed tax imposed on the
purchase price, this excise tax imposed on the secondary market
company would use a more stringent tax rate and would apply to
the difference between the total face amount of the structured
settlement payments purchased by the secondary market company
and the heavily discounted lump sum paid to the injured victim.
As a possible alternative, the more stringent excise tax rate
could be applied against a tax base that is the greater of (i)
the amount of the discount (the difference between the total
face amount of payments purchased by the secondary market
company and the lump sum paid to the victim), or (ii) the
present value as determined under I.R.C. Sec. 7520 (interest
rate for annuity valuation for estate tax purposes) of the face
amount of the payments being purchased by the secondary market
company.
2. Limited exception for genuine, court-approved hardship
This stringent excise tax would be coupled with a limited
exception for genuine, court-approved financial hardship
situations. Drawing upon the hardship standard enunciated in
the Treasury proposal, the excise tax would apply to secondary
market companies in all structured settlement purchase
transactions except in the case of a transaction that is
pursuant to a court order finding that ``the extraordinary,
imminent, and unanticipated needs of the structured settlement
recipient or his or her dependents render such a transaction
appropriate and a further finding that the proposed transfer is
not expected to subject the structured settlement recipient or
his or her dependents to undue financial hardship in the
future.''
This exception is intended to apply only to a limited
number of cases in which a genuinely ``extraordinary, imminent,
and unanticipated'' hardship actually has arisen (e.g., serious
medical emergency for a family member) has been demonstrated to
the satisfaction of a court, as well as a showing that
transferring away such payments will not leave the injured
victim and his or her family exposed to undue financial
hardship in the future when the structured settlement payments
no longer are available.
3. Need to protect the tax treatment of the original
structured settlement
In the limited instances of extraordinary and unanticipated
hardship determined by court order to warrant relief, adverse
tax consequences should not be visited upon the claimant or the
other parties to the original structured settlement.
Accordingly, the proposal would clarify in the statute or the
legislative history that in those limited instances in which
the extraordinary, imminent, and unanticipated hardship
standard is found to be met by a court, the original tax
treatment of the structured settlement under I.R.C.
Sec. Sec. 104, 130, 72, and 461(h) would be left undisturbed.
That is, the periodic payments already received by the
claimant prior to any factoring transaction would remain tax-
free damages under Code section 104. The assignee's exclusion
of income under Code section 130 arising from satisfaction of
all of the section 130 qualified assignment rules at the time
the structured settlement was entered into years earlier would
not be challenged. Similarly, the settling defendant's
deduction under Code section 461(h) of the amount paid to the
assignee to assume the liability would not be challenged.
Finally, the status under Code section 72 of the annuity being
used to fund the periodic payments would remain undisturbed.
Despite the anti-assignment provisions included in the
structured settlement agreements and the applicability of a
stringent excise tax on the secondary market company, there may
be a limited number of non-hardship factoring transactions that
still go forward. If the structured settlement tax rules under
I.R.C. Sec. Sec. 130, 72, and 461(h) had been satisfied at the
time of the structured settlement and the applicable structured
settlement agreements included an anti-assignment provision,
the original tax treatment of the other parties to the
settlement--i.e., the settling defendant and the Code section
130 assignee--should not be jeopardized by a third party
transaction that occurs years later and likely unbeknownst to
these other parties to the original settlement.
Accordingly, the proposal also would clarify in the case of
a non-hardship factoring transaction, that if the structured
settlement tax rules under I.R.C. Sec. Sec. 130, 72, and 461(h)
had been satisfied at the time of the structured settlement and
the applicable structured settlement agreements included an
anti-assignment provision, the section 130 exclusion of the
assignee, the section 461(h) deduction of the settling
defendant, and the Code section 72 status of the annuity being
used to fund the periodic payments would remain undisturbed.
Finally, the proposal would clarify the tax reporting
obligations of the annuity issuer and section 130 assignee in
the event of a factoring transaction. In the case of a
factoring transaction, either on a court-approved hardship
basis or a non-hardship basis, of which the annuity issuer has
actual notice and knowledge, assuming that a tax reporting
obligation otherwise would be applicable, the annuity issuer
would be obligated to file an information report with the
I.R.S. noting the fact of the transfer, the identity of the
original payee, and the identity where known of the new
recipient of the factored payments. No reporting obligation
would exist where the annuity issuer (or section 130 assignee)
had no knowledge of the factoring transaction.
Conclusion
The imposition on secondary market companies of a stringent
excise tax on the amount of the discount reflected in the
purchase of structured settlement payments, subject to a
limited exception for ``extraordinary, imminent, and
unanticipated'' hardship, fully protects structured
settlements, the injured victims, and the Congressional policy
underlying structured settlements. The proposal should be
enacted as part of any tax legislation considered by Congress
this year.
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Statement of Nationwide Insurance Enterprise
The Nationwide Insurance Enterprise, headquartered in
Columbus, Ohio, is a group of insurance companies providing a
wide range of insurance products from personal automobile and
homeowners insurance, to commercial coverage for small and
large businesses, to health insurance, life insurance and
annuities. Our companies are licensed to engage in the business
of insurance in all 50 states. We are deeply concerned about
the heavy tax increases on insurance contained in President
Clinton's Budget Proposal for Fiscal Year 1999, and we submit
this statement in opposition to these proposals.
The Administration singles out for punitive tax increases
both the insurance industry and those who acquire its vital
products for their retirement savings and for protection of
their assets and lives. We strongly urge that the Congress
reject these misguided proposals.
These proposals, and their anticipated revenue effects as
determined by Joint Committee on Taxation for the years 1998-
08, are as follows:
Increase taxes on annuities by decreasing annuity tax $ 8,532,000,000
reserve deductions..................................
Penalize corporate-owned life insurance by reducing $ 4,821,000,000
interest deductions.................................
Tax exchanges of variable annuity contracts and $ 3,982,000,000
reallocations between investment options............
Increase property and casualty insurance company $ 1,274,000,000
taxes for companies that buy municipal bonds........
Increase taxes of life insurance and annuity $ 442,000,000
policyholders by disallowing part of their cost
basis...............................................
Raise taxes on insurance companies that issue credit $ 198,000,000
life insurance contracts by requiring such companies
to capitalize 7.7% of net premiums..................
------------------
Total............................................ $19,249,000,000
In addition to the above proposals that directly hit
insurance companies, their policyholders, or both, the
Administration would discourage sales of life insurance by
eliminating the ``Crummey'' rule which for many years has
prevented the imposition of transfer taxes upon gifts of
$10,000 a year or less if the donee were given a right to
withdraw the amount transferred. Joint Committee on Taxation
estimates that this proposal would increase revenues by $555
million over a 10-year period.
Our specific comments on the more significant proposals
follow.
Increase Taxes on Annuities by Decreasing Annuity Tax Reserve
Deductions
The Administration proposal would curtail the tax deduction
for annuity contract reserves by limiting reserves to the
lesser of (1) the present reserve, based on a state-law reserve
method (CARVM), or (2) the contract's net cash surrender value
plus a declining small percentage. In order to examine the
impact of this change and why it should be rejected, it is
important to understand the purpose of reserving, the
requirements of state insurance laws to insure solvency, and
the misunderstandings of the Administration about recent
changes made by the National Association of Insurance
Commissioners.
Reserves are used to pay policyholders the benefits for
which they contracted. Thus, an annuity reserve is the amount
of money an insurer must set aside in escrow today to meet its
obligations to contractholders, both today and in the future.
Reserving at adequate levels is necessary to protect
contractholders and to protect insurers against insolvency.
Maintaining sufficient annuity reserves is even more necessary
now that individuals live longer and the insurer's obligation
is correspondingly greater.
A tax deduction is allowed for reserves. Basically, a life
insurance company pays taxes on its gross income less the
amount used for reserves. The current deduction for annuity
reserves is provided by Section 807 of the Internal Revenue
Code. It is based on the minimum reserves state insurance
regulators require companies to hold to meet their obligations
to policyholders. As such, current law permits state
regulators, rather than the IRS, to provide the basic method
for determining reserves. The Administration's proposal is an
unprecedented and inappropriate attempt to supplant the
professional expertise and judgment of state insurance
regulators over the reserves necessary to fulfill policyholder
obligations.
Under the current Code reserves for any annuity contract
are the greater of the net surrender value of the contract or
the reserve determined using the Commissioner's Annuities
Reserve Valuation Method (CARVM) prescribed by the National
Association of Insurance Commissioners (NAIC), but not more
than the annual statement reserve. The Administration's
proposal would change this calculation by making it the lesser
of the net surrender value of the contract or the reserve as
determined by CARVM.
The Administration attempts to justify this change by
noting that the NAIC adjusted its guidelines for calculating
CARVM reserves for annuity contracts in 1997, characterizing
the NAIC actions as ``conservative'' and as an inaccurate
measurement of income. However, the NAIC made these adjustments
to recognize all future benefits in computing reserves and to
address minimum death benefits under deferred annuity
contracts. The NAIC should be commended for trying to make sure
that the reserves set aside to pay obligations to policyholders
are sufficient to meet such obligations. This change in
calculation by the NAIC was not intended to create excessive
reserves for federal tax purposes, but instead to reflect
proper reserving for future benefits due to policyholders.
The Administration's proposal is both bad law and bad
policy. Annuities are the only investment that assure
individuals that they will not outlive their income. Raising
taxes on reserves which are used to make payments under
annuities will inevitably lead to higher prices for these
essential products and thus undermine Americans' private
retirement savings efforts.
Penalize Corporate-owned Life Insurance by Reducing Interest Deductions
Another misguided Administration proposal would place an
additional tax on companies that borrow for any purpose if
those companies also own life insurance, including key employee
insurance. This proposal is anti-business and fails to
recognize the vital role of insurance in fostering the survival
and growth of small and closely-held businesses.
Under the proposal, the mere ownership of a whole life
insurance policy on the president of a company could result in
a tax penalty on unrelated borrowing. This additional tax would
be imposed against loans that bear no relation to any borrowing
from a life insurance policy but instead result from normal
business borrowing for expansion and other fundamental
purposes.
In 1996 Congress reviewed the taxation of policy loans
borrowed directly from life insurance policies and placed
substantial restrictions on this type of borrowing, limiting it
to coverage on key employees. The new proposal ignores this
history and would craft a new and more draconian limitation. No
principle supports this abandonment of the key person
exception.
Employers purchase life insurance for the same reason
individuals purchase life insurance--to protect against the
untimely loss of an income earner and to provide for long term
financial needs. Just as businesses rely on insurance to
protect against the loss of property, they need life insurance
to minimize the cost of losing other valuable assets such as
key employees, those responsible for the survival and success
of the enterprise.
Also corporate-owned life insurance helps employers finance
employee benefits of all types. Corporations frequently use
life insurance to fund various employee benefits, such as
retiree health care and deferred compensation plans. The loss
of interest deductions for unrelated borrowing would likely
force many companies to reduce employee and retiree benefits
currently funded through business life insurance.
In short, this proposal would hurt small businesses and
their employees, disrupt financial plans, impair employee
benefits and should be rejected.
Tax Exchanges of Variable Annuity Contracts and Reallocations Between
Investment Options
Under Section 1035 of the Internal Revenue Code, a
policyholder can exchange without any tax any life insurance
contract for another life insurance contract, a life insurance
contract for an annuity, and an annuity for another annuity.
This long-established rule is based on sound public policy:
individuals should be able to take changed circumstances into
account in their insurance and annuity programs but should not
be taxed until they take their money out of their insurance or
annuity.
The current treatment of life insurance and annuity product
exchanges rests on the basic proposition that the policyholder
has continued his or her interest in one insurance product
through the use of a new insurance product better suited for
his or her current needs. Variable insurance products offer
life insurance and annuity benefits which reflect the
performance of financial markets, and thus are able to keep
pace with inflation. Policyholders need to be able to modify
their contracts in order to shift more conservative investment
options as they grow older, accommodate to changes in their
retirement and insurance protection needs, and respond to
changes in the financial markets. The Administration's proposal
is to treat such exchanges and reallocations as if the
individuals sold all of these assets and withdrew from their
plans in total. This is simply wrong.
The Administration appears to believe that variable
annuities are simply a type of mutual fund. This is far from
the truth. Annuities are subject to severe tax restrictions
under current law that mutual funds escape. These include
penalties on early distribution, no basis step-up at death,
severe diversification restrictions, and, most significant,
taxation at full, rather than capital gains, rates.
Suppose a worker contributed $5,000 to a variable annuity
plan when he is 40 years old and chose a particular stock fund
option. Supposed 10 years later his fund has grown to $12,000
and he wants to switch to a bond fund option in the same
annuity because he feared a stock market decline. The
Administration would tax the entire accumulation above the
original $5,000,1 which is $7,000, as ordinary income. The tax,
at full rates, would be taken out of the worker's $12,000 in
retirement funds simply because he shifted his investment
option.
It is ironic that these tax increases would fall on middle
income households, especially on women. Recent surveys have
shown that over 80% of deferred annuity contract policyholders,
and 74% of variable annuity contract policyholders, have total
household incomes under $75,000. Many of these policyholders
work for employers who do not offer, or who have terminated,
qualified retirement plans. Particularly, for such
policyholders, annuities are the essential source of retirement
savings.
Annuity tax legislation was first enacted in the late 1930s
to allow individuals to provide for themselves needed
retirement income above that obtained through social security.
The Administration's proposal would strike a heavy blow against
that sound policy.
Increase Taxes of Insurance and Annuity Policyholders by Disallowing
Part of Their Cost Basis
The Administration proposes to increase taxes on
individually-owned life insurance and annuities by reducing the
tax basis of these contracts. Specifically, the proposal would
require policyholders to reduce their investment in the
contract (premiums paid) by the amount of mortality or expense
charges deemed to be associated with the contract. Under
current law, policyholders pay tax on any gain in a life
insurance or annuity contract if the contract is surrendered or
amounts are distributed (other than at death under a life
insurance contract). The amount of gain traditionally has been
the excess of the amount received over the total premiums paid
in (investment in the contract). There has never been a
statutory or regulatory requirement that the investment in the
contract must be reduced by the amount of contract mortality
and expense charges. Current law for life insurance and
annuities is consistent with the treatment of other assets,
such as homes, cars, mutual funds and bank accounts, where no
reduction is required for benefits resulting from ownership,
e.g., the imputed rental value of a car or house.
Apparently, the theory behind the proposed reduction in
basis is that since the policyholder is obtaining the insurance
coverage, its cost must be a benefit and should therefore
reduce basis like any other benefit, such as partial
withdrawals and policyholder dividends. However, using as a
mortality charge the maximum permitted under Section 7702 is
not justified. Also, it creates questions for contracts
qualifying as life insurance under the cash value test. For
annuities, reducing tax basis by a mortality charge makes even
less sense. Except for guaranteed minimum death benefits, the
only mortality component of these contracts is associated with
payout and, unlike life insurance, is not actually realized by
policyholders until annuity payments actually occur. In
addition, the higher the worth of the guarantee, the higher the
eventual payments. Since higher payments generate higher
potential tax, reducing the basis for the underlying guarantee
that produces such income appears to tax the same thing.
In the case of expenses, expenses or costs of maintaining
investments are generally added to basis if paid by investors.
Since expense charges on life and annuity contracts are
typically not paid in cash, they should not increase basis--
however, neither should they decrease it. If this treatment is
adopted, logic would seem to require that it apply to expenses
associated with any investment. If so, mutual fund management
fees should reduce basis of such investments.
Also, this ill-advised proposal would confuse policyholders
and significantly increase their costs and time in maintaining
correct information about the investment in their life
insurance and annuity contracts. Life insurance companies would
be required to keep two sets of books for cash value life
insurance and annuity contracts, requiring extensive systems
changes.
Since mortality costs increase as an insured ages, this
proposal would particularly harm older policyholders, some of
whom plan to surrender their policies as their needs for life
insurance death protection decreases. Since life insurance and
annuities promote family financial security, it is
irresponsible to enact a penalty on what the nation should
encourage.
Increasing Property and Casualty Insurance Company Taxes for Companies
that Buy Municipal Bonds
By doubling present law's curtailment of deductions for
loss reserves, the Administration proposes to extract an
additional $400 million in income taxes from property and
casualty insurance companies that invest in municipal bonds.
This blow against an essential industry that is already fully
taxed would harm insurers and their policyholders and would
also force insurers to desert the market for tax exempt bonds.
Serious damage to states and municipalities could result. As
the Bond Market Association has pointed out, the exodus of the
property/casualty industry from the municipal bond market would
drive up borrowing costs for states and localities. Property/
casualty companies routinely purchase the majority of new
issues of government grade bonds, bonds with maturities of 10-
20 years, general obligation and government revenue bonds, and
municipal securities that help states and localities meet such
vital needs as school construction, water, sewer facilities,
roads and other projects. Higher borrowing costs for these
infrastructure and governmental uses would either be passed on
to state and local taxpayers, or would prevent certain needs
from being met at all.
Increase Gift Taxes by Eliminating ``Crummey'' Rule
Current gift tax law permits a donor to transfer up to
$10,000 per year to another person without any gift tax if the
gift is of a present interest. Since the 1968 decision of
Crummey v. Commissioner, the gift could be placed in a trust
and still qualify as long as the donee had the right to
withdraw the transferred amount. Thus, under a Crummey trust, a
parent is able to transfer funds for the benefit of a child or
grandchild in a responsible manner without the imposition of a
gift tax.
The Administration proposes to repeal the Crummey trust
rule and limit the gift tax exemption to only outright
transfers. This would hurt many parents who wish to establish
trusts for specific needs of their children, such as home
education, home purchases and future security.
This proposal discourages responsible gifts and increases
gift taxes. It marches backward from last year's determination
by Congress that gift and estate taxes should be decreased and
transfers of property from one generation to another should be
encouraged.
Statement of Washington Counsel, P.C., Attorneys-at-Law, and Ernst &
Young LLP, on behalf of the Notice 98-11 Coalition
Introduction
The Administration's FY99 Budget Proposal (``Budget
Proposal'') includes an exceedingly broad request for
regulatory authority to prescribe the ``appropriate tax
results'' of ``hybrid transactions.'' Hybrid transactions are
defined to include entities that are treated as corporations
under one country's tax system and as branches or partnerships
in another, as well as securities that are treated as debt or
royalties in one country and as equity in another. Treasury's
``General Explanation'' cites regulations to be issued pursuant
to Notice 98-11 and Notice 98-5 (the ``Notices'') as areas in
which the Treasury would be expected to use the requested
regulatory authority.
The Notice 98-11 Coalition (the ``Coalition'') is concerned
that, under the guise of the Notices and the Budget Proposal,
Treasury is seeking to launch a major new initiative in the
international tax area that will undermine the ability of U.S.
multinationals to compete in the global marketplace. In
requesting the ability to unilaterally define ``appropriate
results,'' Treasury is seeking the authority to make
fundamental changes in existing law, a prerogative of the
Congress. Moreover, the Notices and the Budget Proposals have
created a chilling effect on the ability of U.S. multinationals
to enter into transactions in the ordinary course of business.
The Issues Raised By The Administration's Proposal On Hybrids Raise
Fundamental Tax Policy Concerns That Should be Addressed by The
Congress.
As recognized by the Internal Revenue Service (``IRS'') in
describing the background of Notice 98-11, ``U.S. international
tax policy seeks to balance the objective of neutrality of
taxation as between domestic and foreign business enterprises
(seeking neither to encourage nor to discourage one over the
other, [referred to as ``capital export neutrality'']) with the
need to keep U.S. business competitive.'' The legislative
history of Subpart F \1\ is clear that capital export
neutrality is not the only policy goal, but the IRS has only
paid lip service to that fact. In reality, the Administration's
position (as evidenced by the Notices and the Budget Proposal)
would elevate the policy of capital export neutrality over
international competitiveness. Even if capital export
neutrality were the only consideration, it is questionable
whether the expansion of Subpart F as envisioned by Notice 98-
11 is consistent with capital export neutrality.
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\1\ ``Subpart F'' refers to the anti-deferral regime prescribed by
Sections 951-964 of the Internal Revenue Code of 1986, as amended (the
``Code''); all references to ``Sections'' hereinafter are to the Code.
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The basic structure of the U.S. international tax regime
dates from the early 1960s when the U.S. economy was so
dominant that it accounted for over half of all multinational
investment in the world. The decades that followed saw a
migration from domestically-based to globally-competitive
markets. With this transformation comes new challenges for
Congressional policy makers interested in helping U.S.
companies remain competitive. Indeed, the Congress has adopted
trade laws that recognize both the need for expanded markets
and the reduction of trade barriers. In like manner, it is for
the Congress to determine whether to alter the extent to which
international tax rules bolster or hinder the competitiveness
of U.S. companies in global markets.
The Congress is the only proper forum for determining
whether to revisit the balance that has been struck between the
competing U.S. tax goals of international competitiveness
versus capital export neutrality. Further, by raising this
issue by Notices and proposed legislation that grant Treasury
open-ended authority to prescribe rules, Treasury is seeking to
usurp the legislative process. Any change in law should be made
through substantive statutes enacted prospectively by the
Congress, not Notices issued retroactively by Treasury.
Notice 98-11 and Notice 98-5 Represent Attempts By Treasury To
``Legislate by Notice,'' Regulating Well Beyond the Interpretive
Authority Granted By The Congress.
As an example, many taxpayers in good faith structured
specific foreign operations to take into account the final
regulations issued on December 17, 1996, for the elective
entity classification regime referred to as ``check-the-box.''
The check-the-box regulations sanctioned the creation of hybrid
branches that are respected as separate entities for purposes
of foreign tax law but not U.S. purposes. In Notice 98-11,
however, Treasury indicates that regulations will prevent the
use of check-the-box to create ``hybrid branches'' in the
international context where the result ``is contrary to the
policies and rules of Subpart F....'' Although an IRS
``Notice'' does not involve the same depth of consideration as
temporary or proposed regulations, the issuance of Notice 98-11
had an immediate ``chilling effect'' by casting doubt on the
ability of taxpayers to rely with certainty on their check-the-
box elections and the IRS's own check-the-box regulations, as
well as the viability of structures that were put in place
before the check-the-box regulations were finalized.
The fundamental change announced in Notice 98-11 (that is,
the treatment of hybrid branches for purposes of Subpart F)
should be the prerogative of the Congress not the IRS. The
check-the-box regulations did not enlarge Treasury's general
interpretive authority. Treasury itself recognized that ``there
[was] considerable flexibility under the [old] rules to
effectively change the classification of an organization at
will.'' Notice 95-14, 1995-1 C.B. 297, 298. The final check-
the-box regulations simply replaced the ``increasingly
formalistic rules under the [old] regulations with a much
simpler approach that generally is elective.'' P-S-43-95, 1996-
1 Adv. Sh. Ed. C.B. 937, 938. Similarly, as described by the
staff of the Joint Committee on Taxation, the ``major change
made by the check-the-box regulations is to allow tax
classification ... to be explicitly elective....'' Joint
Committee on Taxation, Review of Selected Entity Classification
and Partnership Tax Issues (JCS-6-97), April 8, 1997, page 11.
The Budget Proposal would, in effect, authorize Treasury to
issue any regulations it believes are appropriate to prevent
results that it deems to be inconsistent with Subpart F or any
other provision of U.S. tax law. Accordingly, the combined
effect of the Notices and the Budget Proposal is to prevent
taxpayers from structuring many transactions that were clearly
permitted before and after publication of the check-the-box
regulations.
Neither the Notices nor the Budget Proposal sets forth the
expected content or scope of proposed regulations. Thus,
taxpayers will not even know what the law actually is until
regulations are written. \2\ The practical effect of the
Administration's Budget Proposal would be to sanction
``legislation by notice.'' Moreover, publication of vague
Notices violates the spirit of the Taxpayer Bill of Rights 2
(``TBOR2'') requirement that regulations generally be effective
only on a date that a notice ``substantially describing the
expected contents'' of regulations is released to the
public.\3\
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\2\ Pending the issuance of regulations, taxpayers will not even be
able to query the IRS on the possible consequences of a hybrid
transaction--the IRS recently revised it's ``no rulings'' list to
specifically include (1) the issue ``whether an entity is treated as
fiscally transparent by a foreign jurisdiction for purposes of Section
894,'' ``to reflect the fact that the [IRS] is studying the
issue....;'' and (2) ``any transaction or series of transactions that
is designed to achieve inconsistent tax consequences or classifications
under the tax laws of the U.S. and the tax laws of a treaty partner.''
Rev. Proc. 98-7, 1998-1 I.R.B. 222.
\3\ This prohibition, which is found in Section 7805(b)(1), only
applies to regulations issued pursuant to statutes enacted after the
1996 enactment of TBOR2.
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The Budget Proposal on Hybrids and the Related Notices Have a
Widespread Impact on Legitimate U.S. Economic Activity.
The Coalition includes over thirty U.S. multinationals that
are greatly concerned about the Treasury's position as
evidenced by the Budget Proposal and the Related Notices.
Because the Administration failed to articulate a comprehensive
analytical framework for the results foreshadowed by the
Notices, these companies have no way of determining the tax
treatment of ongoing international operations that occur in the
ordinary course of business (including transactions and
structures that relied on the rules in effect prior to check-
the-box).
The most immediate examples of this activity occurs in
Europe. Consistent with the implementation of European Union
(``EU'') directives, U.S. multinationals are reorganizing their
European operations from what had been a country-by-country
subsidiary model to a regionally focused cross-border business.
This involves shifts of activities to better manage capacity,
centralization of distribution activities and consolidation of
regional support centers for functions such as cash management,
billing, quality control, etc.. The move to a single European
currency is further accelerating the trend and compelling
additional consolidation of activity.
Hybrid treatment for U.S. tax purposes of European
subsidiaries is consistent with the manner in which companies
are reorganizing their operations in Europe. The ability to
elect hybrid treatment facilitates U.S. companies in achieving
their desired regional operating structures, by allowing such
conversions to be done free of U.S. tax consequences. It also
enables U.S. companies to accomplish such reorganizations in a
manner that is most tax effective in the foreign countries
involved.
The Notices seem to be grounded in the notion that U.S.
multinationals should be penalized for employing tax planning
strategies that reduce foreign income taxes. The result
obtained in each of the examples described in the Notices is to
impose a U.S. ``Soak Up Tax,'' whenever a U.S. taxpayer manages
to reduce a foreign tax payment by use of hybrids. The
rationale for this result is unclear, unless one believes that
the United States should be the ``Tax Police'' for the world.
There is no (apparent) overriding policy reason for inhibiting
the ability of U.S. businesses to compete in foreign markets
against foreign competitors, especially where there is no cost
to the U.S. fisc (and potentially increased U.S. tax revenues,
over time, due to reductions in foreign tax credits).
Unless The Congress Acts, Taxpayers Will face Economic Losses Arising
From Their Detrimental Reliance On Express Provisions Of Current Law.
Regulations to be issued pursuant to Notice 98-5 would be
effective for taxes paid or accrued on or after December 23,
1997. The general effective date stated in Notice 98-11 is
January 16, 1998, with a June 30, 1998 effective date for
hybrid branches that were in existence on January 16th.
The relevant Notices place taxpayers in the untenable
position of having to determine the tax treatment of
transactions pursued in the ordinary course of business, in
advance of receiving any specific guidance, and before having
any opportunity to comment on (as yet undefined) proposals.
Taxpayers who acted in reliance on existing law will suffer
economic losses due to the perceived need to react to
Treasury's stated intention to issue retroactive regulations.
The Administration's Proposal Will Add Complexity to the Tax Law in the
International Area, Contrary to Recent Congressional Simplification
Efforts.
While the Administration itself touted the check-the-box
regulations as a major simplification initiative, the issuance
of regulations pursuant to Notice 98-11 would add additional
complexity because it would appear that foreign entities would
be treated as branches for some purposes but not for others. As
a result, taxpayers would be required to maintain two sets of
U.S. tax books to account for the international operations of
hybrid branches both as corporations for some U.S. tax purposes
and as branches for others.
The Notices and the Budget Proposal are contrary to recent
Congressional efforts to simplify the anti-deferral provisions
of the Code. For example, the Congress reduced complexity by
repealing the Section 956A tax on excess passive earnings in
1996. Again, in 1997, the Congress repealed the application of
the Passive Foreign Investment Company regime to U.S.
shareholders of Controlled Foreign Corporations because of the
complexity involved in applying both regimes. Additionally, the
Congress passed a host of other foreign tax simplifications in
1997, including, as previously proposed by Ways and Means
Committee members Houghton and Levin in H.R. 1783, provisions
to reduce a buyer's Subpart F income by the amount of a
seller's deemed dividend under Section 1248, repeal the
separate foreign tax credit limitations for Section 902
noncontrolled foreign corporations, and prevent the creation of
deemed dividends under Subpart F on account of specified
ordinary course transactions of securities dealers.
Conclusion
The Notices and the Budget Proposal represent an attempt by
Treasury to ``legislate by notice,'' violating the spirit of
TBOR 2. The Notices and the Budget Proposal squarely present
the issue whether the Congress or the Treasury should be the
arbiter of U.S. tax policy in the international arena. The
Congress should prevent Treasury from issuing broad Notices
that have immediate effective dates, without articulating with
any specificity the content of future regulations. Whether to
change the application of Subpart F and other international tax
rules to hybrids and other transactions goes to the heart of
the competing considerations underlying the current
international tax regime. The Congress is the proper forum for
making such policy decisions.
This statement is presented by LaBrenda Garrett-Nelson and Mark
Weinberger on behalf of Washington Counsel, P.C., and David
Benson and Henry Ruempler on behalf of Ernst & Young LLP. The
Coalition consists of over 30 U.S. multinational corporations
representing a broad cross-section of American industries.
Statement of Jared O. Blum, President, Polyisocyanurate Insulation
Manufacturers Association
The Polyisocyanurate Insulation Manufacturers Association
(PIMA) is pleased to submit these written comments on the
revenue provisions in the President's fiscal year 1999 Budget.
PIMA is the trade association of the rigid polyiso foam
insulation industry, a product that is used in over 60 percent
of new commercial roof construction, in 40 percent of new
residential construction, and in most re-insulation of existing
commercial building roofs.
I. Introduction
We support efforts to improve the energy efficiency of new
buildings. Currently, residential and commercial buildings
represent more than a third of the total U.S. energy
consumption, and account for two thirds of all electricity used
in the country. In addition, the energy consumed in buildings
is responsible for 35 percent of total U.S. carbon dioxide
(CO2) emissions (our most significant greenhouse
gas) and substantial amounts of other pollutants as well (e.g.,
sulfur dioxide, nitrogen oxides, and particulate matter).
Improving the energy efficiency of buildings is a cost
effective strategy for reducing emissions of greenhouse gases
and other harmful air pollutants and for improving the our
country's energy security. The President's proposed energy tax
credits are a step in the right direction, but we believe
changes could be made that would significantly increase their
impact.
II. Tax Credit for the Purchase of New Energy Efficient Homes
A tax credit for purchasing new energy efficient homes is
an effective way to attract energy-efficient technologies and
building practices into the market-place. However, we believe
that requiring new homes to be at least 50 percent more
efficient than the Model Energy Code (MEC) is a threshold that
is too high and would undermine the intent of the credit. Few
homes can be built to this standard cost-effectively, and those
that are built would be expensive ``showcase'' homes. This
outcome would have only a minor impact on changing long-term
construction practices in the home building industry.
Putting cutting-edge technology in a few showcase homes
will do little to address the most important obstacle to
building energy-efficient homes: market barriers to common,
every day energy-efficient technologies. There are a wide array
of energy-efficient technologies currently available on the
market. However, a number of market barriers discourage the use
of these technologies. One of these is the problem of split
incentives where landlords have little reason to invest in
efficiency measures when the energy bill is passed on to
tenants, whereas tenants rarely make such investments because
their tenure in the building is typically uncertain. Likewise,
given far-from-perfect information among consumers, speculative
builders are less likely to invest up front in premium-cost,
high-efficiency measures because the builder will not pay for
energy use in the building after its purchase. As a result, for
both commercial and residential construction, the overriding
incentive is to reduce up-front costs with little regard for
operating costs. Tax incentives would help overcome these
market barriers, but they need to be structured in a way that
will attract less esoteric building technologies that will have
greater market penetration and can be sustained after the tax
credit has ended.
A more realistic and achievable threshold would be a 30
percent improvement over MEC. In addition, meeting this
threshold, although lower than the 50 percent threshold, still
represents a significant improvement over current building
practices. Currently, there are several market programs
intended to encourage the purchase of homes that are 30 percent
more efficient than MEC, such as EPA's Energy Star Homes
program and several utility programs. Even with these programs
in place, however, fewer than 2 percent of the new homes built
each year meet the 30 percent threshold. A tax credit for homes
that are 30 percent more efficient than the MEC would
complement EPA's Energy Star program, resulting in a greater
market penetration of homes with superior energy-efficiency and
achieving greater environmental benefits compared to a credit
that uses a 50 percent threshold.
Using a 30 percent threshold would have the practical
effect of providing a tax cut for lower and middle income
families, whereas the 50 percent threshold would effect only
higher income families. This is because achieving a 50 percent
increase in energy-efficiency would be common only in more
expensive homes, whereas the technology required to achieve a
30 percent improvement, such as better insulation, tighter
ducts, high-efficiency heating and air conditioning, and high
performance windows, can be used in homes in every price range.
In addition, a tax credit for homes meeting the 30 percent
threshold is more likely to make housing more affordable for
middle and lower income families. Not only do these houses cost
less to operate, but the additional upfront cost of the
increased energy-efficiency will be offset by the tax credit.
III. Tax Credits for Energy-Efficient Building Equipment
The President has proposed tax credits to encourage the
purchase of certain high-efficiency building technologies, many
of which are used to heat or cool buildings. We are surprised
that with this emphasis on the heating and cooling of buildings
there was no consideration given to insulation. To achieve the
full potential of these technologies, the building envelope
must be adequately insulated. Providing a tax credit for the
use of superior levels of insulation would help to achieve the
greatest environmental benefit from the President's proposed
policies.
Currently, a large percentage of new commercial and
residential buildings fail to comply with even the minimum
state and local building energy codes, an important component
of which is insulation. A 1995 study by the American Council
for an Energy-Efficient Economy that reviewed code compliance
studies performed by state and local jurisdictions, as well as
by electric utilities, concluded that compliance rates are
typically on the order of 50 to 80 percent. The Department of
Energy's Pacific Northwest National Laboratory estimates an
even lower rate of compliance of about 40 percent for both
residential and commercial buildings. A tax credit for
insulation would be a very effective incentive for builders not
only to comply with building energy codes, but also to surpass
the minimum standards for installing insulation.
According to the Pacific Northwest National Laboratory, if
compliance with state and local building energy codes were
improved ten percent over what it would otherwise be, 41
trillion Btus would be saved annually and carbon emissions
would be reduced 900,000 tons per year by 2010. It is hoped
that the effect of an insulation tax credit would do more than
simply encourage builders to comply with state and local
building energy codes, but these figures provide an idea of the
magnitude of the benefits that could result from such a tax
credit.
Statement of Protective Life Insurance Company
In accordance with the provisions of a February 18, 1998
advisory from the Committee on Ways and Means of the United
States House of Representatives, Protective Life Insurance
Company (``Protective Life'') submits this written statement
for the Committee's consideration in conjunction with its
review of President Clinton's Fiscal Year 1999 Budget. This
statement is limited in scope to a single topic concerning
capitalization of policy acquisition expenses as applied to
group credit life insurance. The Clinton Administration has
proposed an amendment to section 848 of the Internal Revenue
Code that would increase, from 2.05 to 7.7 percent of net
premiums, the amount of group credit life policy acquisition
expenses subject to the capitalization requirement. Protective
Life opposes this proposal and offers the following comments
for your consideration.
Protective Life is the primary operating subsidiary of
Protective Life Corporation (``PLC'') PLC is a publicly held
holding company whose shares are registered with the New York
Stock Exchange. At December 31, 1997, its assets were $10.5
billion. PLC is headquartered in Birmingham, Alabama. PLC and
its subsidiaries have offices in several other states,
including California, Illinois, Ohio, Indiana, North Carolina,
Tennessee and Alabama.
Protective Life was founded in 1907 and is now a Tennessee
domestic insurance company. Protective Life produces,
distributes and administers various insurance products either
directly or through its subsidiaries. Among these are life
insurance products, including group credit life insurance.
Group credit life products are generally offered to consumers
who receive credit from facilities such as financial
institutions and automobile dealers. The credit facilities
generally purchase group credit life insurance from insurers
such as Protective Life. At the same time, individuals
associated with the credit facilities function as agents who
enroll individual debtors i premiums received.
Policy acquisition expenses arising from the sale of group
credit life insurance are currently subject to a capitalization
requirement that was instituted in 1990. The tax effect
resulting from this requirement is commonly called the deferred
acquisition cost, or DAC, tax. The DAC tax provisions require a
ten-year amortization for policy acquisition expenses above the
first $5 million in a taxable year. The first $5 million may be
amortized over five years.
Currently, the DAC tax applies to acquisition expenses up
to 2.05 percent of the net premiums from the sale of group
credit life insurance. This 2.05 percent level applies for all
group life insurance contracts, which is defined to include
group credit life insurance. Thus, the DAC tax requirement for
group credit life insurance is currently capped at an amount
equivalent to 2.05 percent of net premiums.
As noted above, the Administration has proposed an
amendment to the Code that would subject a greater proportion
of group credit life policy acquisition expenses to the DAC tax
capitalization requirement. This would be accomplished by
shifting the cap from 2.05 to 7.7 percent of net premiums. This
7.7 percent level is one that currently applies to all
insurance contracts not falling with the definitions of either
group life insurance or annuities. This includes individual
life insurance.
Protective Life understands that the Administration has
based its proposal upon the fact that acquisition expenses for
group credit life insurance are higher than most other group
life insurance products and are comparable to the acquisition
expenses for individual life insurance. This suggests a belief
that group credit life insurance should not be treated as the
group insurance that it is because it resembles individual life
insurance in one respect. Protective Life respectfully submits
that this reasoning fails to consider the several respects in
which group credit life insurance differs from individual life
insurance.
State regulations effectively place a cap on credit
insurance premium rates. Most states utilize so-called prima
facie rate provisions that grant blanket approval for rates
that do not exceed a certain level. Notably, these rates were
established prior to the 1990 institution of the current 2.05
percent DAC tax, which insurers were forced to absorb. Although
an insurer can apply for approval to charge a higher rate, most
state regulators restrict premium increases to those justified
by an insurer's increased loss ratios, not increased expenses.
Thus, premium revenues from the sale of credit insurance are
effectively capped at the prima facie rates. Whereas sellers of
individual life insurance products can adjust premiums to
account for changes in the tax laws, sellers of group credit
life insurance cannot. These sellers have already been forced
to accept the 2.05 percent DAC tax, and are now faced with the
possibility of having to absorb an increase up to a level
equivalent to 7.7 percent of net premiums.
For legislators seeking a politically acceptable source of
increased tax revenues, the box into which the sellers of group
credit life insurance have been placed could be viewed as a
positive. Absent a change in state regulations increasing the
prima facie rates, these insurers would effectively be barred
from passing along to consumers the proposed increase in the
DAC tax. This restriction, however, merely creates pressures in
other respects, and thus threatens the continued marketability
of quality group credit insurance products to all consumers.
This is particularly significant in light of an important
distinction between group credit life insurance and individual
life insurance.
Unlike most individual life insurance products, group
credit life insurance tends to serve demographically lower
income consumers. It provides an important source of protection
against financial risks for individuals who are generally not
in a position to purchase individual life insurance coverage.
Obviously, if the prima facie rate structure were to change to
account for the this tax would be felt primarily by these lower
income consumers through an increase in the cost of group
credit insurance.
Alternatively, if group credit life insurers are forced to
do business under the current rate structures, the proposed DAC
tax increase might have a different adverse effect on these
lower income consumers through limiting the quality or
availability of this type of insurance. Unless insurers were to
decrease the commissions paid to credit facilities functioning
as agents, which is a highly unlikely scenario in the current
competitive marketplace, these insurers would have to suffer
further erosion of what are already thin margins of return.
Several measures could be instituted to minimize the effects of
this erosion, but none would benefit the consumer.
Insurers would be pressured to decrease claims expenses
through such mechanisms as greater reliance on restrictions for
coverage or on policy exclusions. This would diminish the
availability and quality of the products now offered to a wide
range of lower income consumers. To maximize per-policy
premiums, some insurers might shift the marketing of this
product away from insurance sold in connection with smaller
loans. Used automobile dealers and other credit facilities that
routinely finance smaller dollar purchases might not be able to
offer group credit life insurance. This would result in group
credit life insurance becoming less available to the lowest of
lower income consumers and those in the greatest financial need
of this product. Finally, some insurers would simply
discontinue the marketing of group credit insurance. This would
likely limit the availability of the product or have other
anti-competitive effects that could adversely affect lower
income consumers.
Despite policy acquisition expense data that have
apparently caused the Administration to regard group credit
life insurance as may more closely resembling individual life
insurance than other group insurance, group credit life
insurance cannot appropriately be regarded as comparable to
individual life insurance. In Protective Life's experience, the
average term of group credit life is significantly shorter than
that of individual life insurance and may even be sorter than
many other forms of group life insurance. Indeed, it is shorter
than the five-year amortization period that applies under the
DAC tax for the first $5 million in acquisition expenses
incurred in a taxable year, and much shorter than the ten-year
period that applies thereafter. Under these circumstances,
there is no justification in the tax laws for requiring any
group credit life acquisition expenses to be capitalized over a
five-year period, much less over a ten-year period.
Protective Life could mount an argument that the current
2.05 percent DAC tax is unfair in light of the existing
amortization periods and the average term of group credit life
insurance, but it will save that argument for another day. For
the present, it is sufficient to state that an increase in the
DAC tax level from 2.05 to 7.7 percent is unjustified. Such an
increase would have an undue, adverse effect on the continued
availability of quality group credit life products to lower
income consumers. Accordingly, the Administration's proposed
change in the tax laws should be rejected.
Respectfully submitted,
Drayton Nabers, Jr.
Chairman of the Board
Statement of Hon. Jim Ramstad, a Representative in Congress from the
State of Minnesota
Mr. Chairman, thank you for convening this hearing to
examine the revenue provisions in the President's proposed FY99
budget.
I must say I'm concerned by some of the so-called
``unwarranted benefits'' targeted by the Administration. Some
are recycled from past years, and some are new surprises.
I'm troubled by the conflicting messages some of these
proposals are sending. At at a time the Administration claims
it wants to encourage long-term savings and retirement
security, the very businesses and products that provide long-
term savings opportunities are being attacked. At a time we
should be encouraging exports and improving the balance of
trade, American businesses that export are being penalized. And
at a time of devolution when we are asking more from state and
local governments, we have a proposal that would likely raise
their borrowing costs.
Because I am so troubled by the inconsistencies, I'm
grateful for this opportunity to hear from Mr. Summers about
the Administration's proposals.
Again, Mr. Chairman, thank you for providing us this forum
to explore the Administration's budget proposals in detail.
Statement of Grace Chen, Chief Executive Officer, e-CommLink, Inc.,
Houston, Texas, on behalf of the R&D Credit Coalition
Mr. Chairman and members of the Committee, my name is Grace
Chen, and I am the Chief Executive Officer of e-CommLink, Inc.
of Houston, Texas. I thank you for the opportunity to submit
this statement on behalf of the R&D Credit Coalition on the
importance of making permanent the research and experimentation
tax credit (commonly referred to as the ``R&D'' credit). The
R&D Credit Coalition is a broad-based coalition of 30 trade
associations and approximately 750 small, medium and large
companies, all united in seeking the permanent extension of the
R&D credit. The members of the R&D Credit Coalition represent
many of the most dynamic and fastest growing companies in the
nation and include the entire spectrum of R&D intensive
industries: aerospace, biotechnology, chemicals, electronics,
information technology, manufacturing, pharmaceuticals and
software. (I have attached to this statement a letter from the
members of the R&D Credit Coalition to President Clinton
concerning including the R&D credit in the Administration's FY
1999 Budget.)
e-CommLink, Inc., founded in 1996, is a privately owned
high technology company located in Houston, Texas. The company
has developed a pioneering technology using Web-enabled middle
processing applications to facilitate on-line information
management and dynamic interactivity between vendors,
customers, and business partners. This technology offers an
economical and scaleable connectivity solution. Rapid new
product development is essential to success in our industry.
The company has grown to 45 employees and anticipates
substantial growth in the future.
I want to commend Representatives Nancy Johnson and Bob
Matsui, and the original cosponsors of H.R. 2819, and Senators
Hatch and Baucus, and the original cosponsors of S. 1464, for
introducing legislation to permanently extend the R&D credit. I
also want to commend President Clinton for including, and
funding, an extension of the R&D tax credit in the
Administration's FY 1999 Budget.
This year the accounting firm of Coopers & Lybrand has
completed a new study, Economic Benefits of the R&D Tax Credit,
(January 1998), that dramatically illustrates the significant
economic benefits provided by the credit and further reinforces
the need to make the credit permanent. According to the study
(executive summary attached) making the R&D credit permanent
would stimulate substantial amounts of additional R&D, increase
national productivity and economic growth almost immediately,
and provide U.S. workers with higher wages and after-tax
income. I hope the Congress will take swift action to
permanently extend the R&D credit by enacting the provisions of
H.R. 2819--S. 1464 before the credit expires once again on June
30, 1998.
I. R&D Credit Legislative History
The R&D credit was enacted in 1981 to provide an incentive
for companies to increase their U.S. R&D activities. As
originally passed, the R&D credit was to expire at the end of
1985. Recognizing the importance and effectiveness of the
provision, Congress decided to extend it. In fact, since 1981
the credit has been extended eight times. In addition, the
credit's focus has been sharpened by limiting both qualifying
activities and eligible expenditures. With each extension, the
Congress indicated its strong bipartisan support for the R&D
credit.
In 1986, the credit lapsed, but was retroactively extended
and the rate cut from 25 percent to 20 percent. In 1988, the
credit was extended for one year. However, the credit's
effectiveness was further reduced by decreasing the deduction
for R&D expenditures by 50% of the credit. In 1989, Congress
extended the credit for another year and made changes that were
intended to increase the incentive effect for established as
well as start-up companies. In the 1990 Budget Reconciliation
Act, the credit was extended again for 15 months through the
end of 1991. The credit was again extended through June 30,
1992, by the Tax Extension Act of 1991. In OBRA 1993, the
credit was retroactively extended through June 30, 1995.
In 1996, as part of the Small Business Job Protection Act
of 1996, the credit was extended for eleven months, through May
31, 1997, but was not extended to provide continuity over the
period July 1, 1995 to June 30, 1996. This one-year period,
July 1, 1995 to June 30, 1996, was the first gap in the
credit's availability since its enactment in 1981.
In 1996, the elective Alternative Incremental Research
Credit (``AIRC'') was added to the credit, expanding the
availability of the credit to R&D intensive industries which
could not qualify for the credit under the regular criteria.
The AIRC adds flexibility to the credit to address changes in
business models and R&D spending patterns which are a normal
part of a company's life cycle. The sponsors of H.R. 2819 and
S. 1464 recognize the importance of the AIRC. Their
legislation, in addition to making the credit permanent,
provides for a modest increase in the AIRC rates that will
bring the AIRC's incentive effect more into line with the
incentive provided by the regular credit to other research-
intensive companies.
Most recently, the Congress approved a thirteen month
extension of the R&D credit that was enacted into law as part
of the Taxpayer Relief Act of 1997. The credit was made
available for expenditures incurred from June 1, 1997 through
June 30, 1998, with no gap between this and the previous
extension.
According to the Tax Reform Act of 1986, the R&D credit was
originally limited to a five-year term in order ``to enable the
Congress to evaluate the operation of the credit.'' While it is
understandable that the Congress in 1981 would want to adopt
this new credit on a trial basis, the credit has long since
proven over the sixteen years of its existence to be an
excellent investment of government resources to provide an
effective incentive for companies to increase their U.S.-based
R&D.
The historical pattern of temporarily extending the credit,
combined with the first gap in the credit's availability, works
to reduce the incentive effect of the credit. The U.S. research
community needs a stable, consistent R&D policy in order to
maximize its incentive value and its contribution to the
nation's economic growth and sustain the basis for ongoing
technology competitiveness in the global arena.
II. Why Do We Need A R&D Credit?
A. Credit offsets the tendency for under investment in R&D
The single biggest factor driving productivity growth is
innovation. As stated by the Office of Technology Assessment in
1995: ``Much of the growth in national productivity ultimately
derives from research and development conducted in private
industry.'' Sixty-six to eighty percent of productivity growth
since the Great Depression is attributable to innovation. In an
industrialized society R&D is the primary means by which
technological innovation is generated.
Companies cannot capture fully the rewards of their
innovations because they cannot control the indirect benefits
of their technology on the economy. As a result, the rate of
return to society from innovation is twice that which accrues
to the individual company. This situation is aggravated by the
high risk associated with R&D expenditures. As many as eighty
percent of such projects are believed to be economic failures.
Therefore, economists and technicians who have studied the
issue are nearly unanimous that the government should intervene
to increase R&D investment. The most recent study, conducted by
the Tax Policy Economics Group of Coopers & Lybrand, concluded
that ``absent the R&D credit, the marketplace, which normally
dictates the correct allocation of resources among different
economic activities, would fail to capture the extensive
spillover benefits of R&D spending that raise productivity,
lower prices, and improve international trade for all sectors
of the economy.'' Stimulating private sector R&D is
particularly critical in light of the decline in government
funded R&D over the years. Direct government R&D funding has
declined from 57% to 36% of total R&D spending in the U.S. from
1970 to 1994. Over this same period, the private sector has
become the dominant source of R&D funding, increasing from 40%
to 60%.
B. The credit helps U.S. business remain competitive in a world
marketplace
The R&D credit has played a significant role in placing
American businesses ahead of their international competition in
developing and marketing new products. It has assisted in the
development of new and innovative products; providing
technological advancement, more and better U.S. jobs, and
increased domestic productivity and economic growth. This is
increasingly true in our knowledge and information-driven world
marketplace.
Research and development must meet the pace of competition.
In many instances, the life cycle of new products is
continually shrinking. As a result, the pressure of getting new
products to market is intense. Without robust R&D incentives
encouraging these efforts, the ability to compete in world
markets is diminished.
Continued private sector R&D is critical to the
technological innovation and productivity advances that will
maintain U.S. leadership in the world marketplace. Since 1981,
when the credit was first adopted, there have been dramatic
gains in R&D spending. Unfortunately, our nation's private
sector investment in R&D (as a percentage of GDP) lags far
below many of our major foreign competitors. For example, U.S.
firms spend (as a percentage of GDP) only one-third as much as
their German counterparts on R&D, and only about two-thirds as
much as Japanese firms. This trend must not be allowed to
continue if our nation is to remain competitive in the world
marketplace.
Moreover, we can no longer assume that American companies
will automatically choose to site their R&D functions in the
United States. Foreign governments are competing intensely for
U.S. research investments by offering substantial tax and other
financial incentives. Even without these tax incentives, the
cost of performing R&D in many foreign jurisdictions is lower
than the cost to perform equivalent R&D in the U.S.
An OECD survey of sixteen member countries found that
thirteen offer R&D tax incentives. Of the sixteen OECD nations
surveyed, twelve provide a R&D tax credit or allow a deduction
for more than 100% of R&D expenses. Six OECD nations provide
accelerated depreciation for R&D capital. According to the OECD
survey, the U.S. R&D tax credit as a percentage of industry-
funded R&D was third lowest among nine countries analyzed.
Making the U.S. R&D credit permanent, however, would
markedly improve U.S. competitiveness in world markets. The
1998 Coopers & Lybrand study found that, with a permanent
credit, annual exports of goods manufactured here would
increase by more than $6 billion, and imports of goods
manufactured elsewhere would decrease by nearly $3 billion.
Congress and the Administration must make a strong and
permanent commitment to attracting and retaining R&D investment
in the United States. The best way to do that is to permanently
extend the R&D credit.
C. The credit provides a targeted incentive for additional R&D
investment, increasing the amount of capital available for
innovative and risky ventures.
The R&D credit reduces the cost of capital for businesses
that increase their R&D spending, thus increasing capital
available for risky research ventures.
Products resulting from R&D must be evaluated for their
financial viability. Market factors are providing increasing
incentives for controlling the costs of business, including
R&D. Based on the cost of R&D, the threshold for acceptable
risk either rises or falls. By reducing the costs of R&D, you
make it possible to increase R&D efforts. In most situations,
the greater the scope of R&D activities, or risk, the greater
the potential for return to investors, employees and society at
large.
The R&D credit is a vital tool to keep U.S. industry
competitive because it frees-up capital to invest in leading
edge technology and innovation. It makes available additional
financial resources to companies seeking to accelerate research
efforts. It lowers the economic risk to companies seeking to
initiate new research, which will potentially lead to enhanced
productivity and overall economic growth.
D. Private industrial R&D spending is very responsive to the
R&D credit, making the credit a cost effective tool to
encourage economic growth
Economic studies of the credit, including the Coopers &
Lybrand 1998 study, the KPMG Peat Marwick 1994 study, and the
article by B. Hall entitled: ``R&D Tax Policy in the 1980s:
Success or Failure?'' Tax Policy and the Economy (1993), have
found that a one-dollar reduction in the after-tax price of R&D
stimulates approximately one dollar of additional private R&D
spending in the short-run, and about two dollars of additional
R&D in the long run. The Coopers & Lybrand study predicts that
a permanent R&D credit would lead U.S. companies to spend $41
billion more (1998 dollars) on R&D for the period 1998-2010
than they would in the absence of the credit. This increase in
private U.S. R&D spending, the 1998 study found, would produce
substantial and tangible benefits to the U.S. economy.
Coopers & Lybrand estimated that this permanent extension
would create nearly $58 billion of economic growth over the
same 1998-2010 period, including $33 billion of additional
domestic consumption and $12 billion of additional business
investment. These benefits, the 1998 study found, stemmed from
substantial productivity increases that could add more than $13
billion per year of increased productive capacity to the U.S.
economy. Enacting a permanent R&D credit would lead U.S.
companies to perform significantly more R&D, substantially
increase U.S. workers' productivity, and dramatically grow the
domestic economy.
E. Research and Development is About Jobs and People
Investment in R&D is ultimately an investment in people,
their education, their jobs, their economic security, and their
standard of living. Dollars spent on R&D are primarily spent on
salaries for engineers, researchers and technicians.
When taken to market as new products, incentives that
support R&D translate to salaries of employees in
manufacturing, administration and sales. Of exceptional
importance to e-CommLink, Inc. and the other members of the R&D
Credit Coalition, R&D success also means salaries to the people
in our distribution channels who bring our products to our
customers as well as service providers and developers of
complementary products. And, our customers ultimately drive the
entire process by the value they put on the benefit to them of
advances in technology. Benefits that often translate into
improving their ability to compete. By making other industries
more competitive, research within one industry contributes to
preserving and creating jobs across the entire economy.
My experience has been that more than 75 percent of
expenses qualifying for the R&D credit go to salaries for
researchers and technicians, providing high-skilled, high-wage
jobs to U.S. workers. Investment in R&D, in people working to
develop new ideas, is one of the most effective strategies for
U.S. economic growth and competitive vitality. Indeed, the 1998
Coopers & Lybrand study shows improved worker productivity
throughout the economy and the resulting wage gains going to
hi-tech and low-tech workers alike. U.S. workers' personal
income over the 1998-2010 period, the 1998 study predicts,
would increase by more than $61 billion if the credit were
permanently extended.
F. The R&D credit is a market driven incentive
The R&D credit is a meaningful, market-driven tool to
encourage private sector investment in research and development
expenditures. Any taxpayer that increases their R&D spending
and meets the technical requirements provided in the law can
qualify for the credit. Instead of relying on government-
directed and controlled R&D spending, businesses of all sizes,
and in all industries, can best determine what types of
products and technology to invest in so that they can ensure
their competitiveness in the world marketplace.
III. The R&D Credit Should Be Made Permanent To Have Maximum Incentive
Effect
Research projects cannot be turned off and on like a light
switch. If corporate managers are going to take the benefits of
the R&D credit into account in planning future research
projects, they need to know that the credit will be available
to their companies for the years in which the research is to be
performed. Research projects have long horizons and long
gestation periods. Furthermore, firms generally face longer
lags in adjusting their R&D investments compared, for example,
to adjusting their investments in physical capital.
In order to increase their R&D efforts, businesses must
search for, hire, and train scientists, engineers and support
staff. They must often invest in new physical plant and
equipment. There is little doubt that a portion of the
incentive effect of the credit has been lost over the past
seventeen years as a result of the constant uncertainty over
the continued availability of the credit.
If the credit is to provide its maximum potential incentive
for increased R&D activity, the practice of periodically
extending the credit for short periods, and allowing it to
lapse, must be eliminated, and the credit must be made
permanent. Only then will the full potential of its incentive
effect be felt across all the sectors of our economy.
IV. Conclusion
Making the existing R&D credit permanent best serves the
country's long term economic interests as it will eliminate the
uncertainty over the credit's future and allow R&D performing
businesses to make important long-term business decisions
regarding research spending and investment. Private sector R&D
stimulates investment in innovative products and processes that
greatly contribute to overall economic growth, increased
productivity, new and better U.S. jobs, and higher standards of
living in the United States. Moreover, by creating an
environment favorable to private sector R&D investment, jobs
will remain in the United States. Investment in R&D is an
investment in people. A permanent R&D credit is essential for
the United States economy in order for its industries to
compete globally, as international competitors have chosen to
offer direct financial subsidies and reduced capital cost
incentives to ``key'' industries. The R&D Credit Coalition
strongly supports the permanent extension of the R&D credit and
urges Congress to enact the provisions of H.R. 2819--S. 1464
before the credit expires on June 30, 1998.
Attachments: Letter from members of R&D Credit Coalition to
President Clinton
Executive Summary of 1998 Coopers & Lybrand study ``Economic
Benefits of the R&D Tax Credit''
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Statement of 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 over one hundred 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 extension of the tax credit
for research, as well as accelerating the effective date of the
rules regarding look-through treatment for dividends received
from ``10/50 Companies.'' These provisions will go a long way
toward increasing our declining savings rate and improving the
competitive position of U.S. multinational 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 latest Budget
proposals introduced by the Administration 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 (1) extend Superfund taxes without
attempting to improve the cleanup programs, (2) repeal the use
of ``lower of cost or market'' inventory accounting, (3)
arbitrarily change the sourcing of income rules on export sales
by U.S. based manufacturers, (4) provide the Treasury Secretary
with blanket authority to issue regulations in the
international area that could conceivably allow it to attack
legitimate tax planning by U.S. companies, for example, by
severely restricting the ordinary business operations of
foreign affiliates by no longer allowing a U.S. company to
characterize its foreign affiliate as a branch for U.S. tax
purposes, (5) inequitably limit the ability of so-called ``dual
capacity taxpayers'' (i.e., multinationals engaged in vital
petroleum exploration and production overseas) to take credit
for certain taxes paid to foreign countries, and (6) restrict
taxpayers from having the ability to mark-to-market certain
customer trade receivables.
In its efforts to balance the budget, the Administration is
unwise to target publicly held U.S. multinationals doing
business overseas, and the Tax Council urges that such
proposals be seriously reconsidered. 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 improving
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, the Administration should instead
do all it can to make the U.S. tax code more friendly and
consistent with the Administration's more enlightened trade
policy. Rather than engaging in gimmicks that reward some
industries and penalize others, the Administration's budget
should be written with the goal of reintegrating sounder 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 arbitrarily denying a
deduction for such expenses 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.
Corporate tax incentives like the research tax credit 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
The Administration has proposed several tax provisions that
will have a positive impact on the economy. Three good examples
are:
Accelerating Effective Date of 10/50 Company Change
One proposal would accelerate the effective date of a tax
change made in the 1997 Tax Relief Act affecting foreign joint
ventures owned between ten and fifty percent by U.S. parents
(so-called ``10/50 Companies''). This change will allow 10/50
Companies to be treated just like controlled foreign
corporations by allowing ``look-through'' treatment for foreign
tax credit purposes for dividends from such joint ventures. The
1997 Act, however, did not make the change effective for such
dividends unless they were received after the year 2003 and,
even then, required two sets of rules to apply for dividends
from earnings and profits (``E&P'') generated before the year
2003, and dividends from E&P accumulated after the year 2002.
The Administration's proposal will, instead, apply the look-
through rules to all dividends received in tax years after
1997, no matter when the E&P constituting the makeup of the
dividend was accumulated.
This change will result in a tremendous reduction in
complexity and compliance burdens for U.S. multinationals doing
business overseas through foreign joint ventures. It will also
reduce the competitive bias against U.S. participation in such
ventures by placing U.S. companies on a much more level playing
field from a corporate tax standpoint. This proposal epitomizes
the favored policy goal of simplicity in the tax laws, and will
go a long way toward helping the U.S. economy by strengthening
the competitive position of U.S. based multinationals.
Extending the Research Tax Credit
The proposal to extend the research tax credit for another
year is also 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.
Nevertheless, The Tax Council recommends that both the
Administration and Congress work together to make the research
tax credit a more permanent part of the tax laws.
Netting of Underpayments and Overpayments
The proposal to require the IRS to net overpayments and
underpayments for purposes of calculating interest (commonly
referred to as ``global interest netting'') is a large step
forward towards fairness and equity. A new interest rate would
be added to Code Sec. 6621 that equalizes interest in cases of
overlapping periods of mutual indebtedness for tax periods not
barred by an expiring statute of limitations. In other words,
no interest would accrue on a deficiency to the extent that a
taxpayer is owed a refund in the same amount, during periods
that both are outstanding. This proposal would apply only
prospectively, to periods of overlapping mutual indebtedness
occurring after the enactment date. We suggest that this change
also be made effective retroactively, to apply to all open tax
years, consistent with Congress' long-stated position on this
issue.
Provisions that Should Be Reconsidered
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 Tax Credits
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.
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 on such income. This selective attack
on a single industry's utilization of the foreign tax credit 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.
Repeal of the Export Source Rule
Since 1922, regulations under Code Sec. 863(b) and its
predecessors have contained a rule which allows the income from
goods that are manufactured in the U.S. and sold abroad (with
title passing outside the U.S.) to be treated as 50% U.S.
source income and 50% foreign source income. This export source
rule has been beneficial to companies who manufacture in the
U.S. and export abroad because it increases their foreign
source income and thereby increases their ability to utilize
foreign tax credits more effectively. Because the U.S. tax law
restricts the ability of companies to get credit for the
foreign taxes which they pay (e.g., through the interest and
R&D allocations), many multinational companies face double
taxation on their overseas operations, i.e., taxation by both
the U.S. and the foreign jurisdiction. The export source rule
helps alleviate this double taxation burden and thereby
encourages U.S.-based manufacturing by multinational exporters.
The President proposes to eliminate the 50/50 rule and
replace it with an ``activities based'' test, which would
require exporters to allocate income from exports to foreign or
domestic sources based upon how much of the activity producing
the income takes place in the U.S. and how much takes place
abroad. The justification given for eliminating the 50/50 rule
is that it provides U.S. multinational exporters operating in
high tax foreign countries a competitive advantage over U.S.
exporters that conduct all their business activities in the
U.S. The Administration also notes that the U.S. tax treaty
network protects export sales from foreign taxation in
countries where we have treaties, thereby reducing the need for
the export source rule. Both of these arguments are seriously
flawed.
The export source rule does not provide a competitive
advantage to multinational exporters vis-a-vis exporters with
``domestic-only'' operations. Exporters with only domestic
operations never incur foreign taxes and, thus, are not even
subjected to the onerous penalty of double taxation. Also,
domestic-only exporters are able to claim the full benefit of
deductions for U.S. tax purposes for all their U.S. expenses,
e.g., interest on borrowings and R&D costs, because they do not
have to allocate any of those expenses against foreign source
income. Thus, the export source rule does not create a
competitive advantage; rather, it helps to ``level the playing
field'' for U.S.-based multinational exporters. Our tax treaty
network is certainly no substitute for the export source rule
since it is not income from export sales, but rather foreign
earnings, that are the main cause of the double taxation
described above. To the extend the treaty system lowers foreign
taxation, it can help to alleviate the double tax problem, but
only with countries with which we have treaties, which tend to
be the most highly industrialized nations of the world. We have
few treaties with most of the developing nations, which are the
primary targets for our export growth in the future.
Exports are fundamental to our economic growth and our
future standard of living. Over the past three years, exports
have accounted for about one-third of total U.S. economic
growth. The export source rule also operates to encourage
companies to produce their goods in their U.S. plants rather
than in their foreign facilities. Repeal on cutbacks in the
export source rule will reduce exports and jeopardize high
paying jobs in the United States. Given the danger that the
current Asian crisis poses to our exports, repeal of the rule
would be especially unwise and counterproductive.
Limiting Use of ``Hybrid'' Entities
It is troubling that the Administration (i.e., Treasury)
feels compelled to request congressional authority to issue
potentially sweeping legislative regulations after non-specific
tax guidance has been given. If Treasury has specific issues to
address, it should do so through specific legislative
proposals. This would permit normal congressional
consideration, including hearings on such proposals.
One such proposal would limit the ability of certain
foreign and U.S. persons to enter into transactions that
utilize so-called ``hybrid entities,'' which are entities that
are treated as corporations in one jurisdiction, but, as
branches or partnerships in another jurisdiction. Although most
hybrid transactions do not attempt to generate tax results that
are ``inconsistent with the purposes of U.S. tax law,'' the
Administration feels that there are enough taxpayers taking
unfair advantage of the current rules that it is necessary to
codify and extend the earlier government issued tax guidance
(Notices 98-5 and 98-11) on this subject.
U.S. multinationals compete in an environment wherein
foreign competitors use tax planning techniques to reduce
foreign taxes without incurring home country tax. The use of
``hybrid entities'' allows U.S. Multinationals to compete on a
level playing field and promotes additional U.S. exports. The
use of hybrids is consistent with the initial balance between
competitiveness and export neutrality that was intended by
Congress in enacting the ``Subpart F'' rules. Although Congress
specifically enacted a branch rule for foreign base company
sales under Code Sec. 954(d)(3), similar rules were not enacted
for foreign personal holding company income. If enacted, these
proposals would represent an unwarranted extension of
legislative authority by Congress to the Executive Branch to
impose new rules by regulation without Congressional debate.
Notices 98-5 and 98-11 have a chilling effect on the
ability of U.S. companies to structure their foreign operations
consistent with the commercial objective of regionalizing their
businesses. They also adversely impact companies' abilities to
effectively reduce their overall costs by reducing local taxes
in their overseas operations. The Notices are drafted so
broadly and so vaguely that they confuse U.S. taxpayers and
their advisors, and introduce a compelling need to seek
clarification as to whether taxpayers can continue to rely on
the simple ``check-the-box'' regulations issued just last year.
All these effects are exacerbated by the Notices' immediate
effective dates.
The world has changed dramatically since enactment of the
Subpart F rules in 1962. We feel that it would be more
appropriate for Congress to request a study regarding the trade
and tax policy issues associated with Notices 98-5 and 98-11.
In this regard, a moratorium on further regulatory action by
Treasury should be imposed until enactment of specific
legislative proposals resulting from well reasoned analysis and
debate.
Foreign Built-In Losses
Another proposal would require the Treasury to issue
regulations to prevent taxpayers from ``importing built-in
losses incurred outside U.S. taxing jurisdictions to offset
income or gain that would otherwise be subject to U.S. tax.''
The administration argues that although there are rules in the
Code that limit a U.S. taxpayer's ability to avoid paying U.S.
tax on built-in gain (e.g., Code Sec. Sec. 367(a), 864(c)(7),
and 877), similar rules do not exist that prevent built-in
losses from being used to shelter income otherwise subject to
U.S. tax and, as a result, taxpayers are avoiding Subpart F
income inclusions or capital gains tax. We believe that this
directive, which is written extremely broadly, is unnecessary
due to the existence of rules already available in the Code,
e.g., the anti-abuse provisions of Code Sec. Sec. 269, 382,
446(b), and 482. Both this proposal, and the one immediately
above regarding the use of hybrid entities, would severely
impact the ability of U.S. multinationals to compete on an
equal footing against foreign-based companies.
Payments to 80/20 Companies
Currently, a portion of interest or dividends paid by a
domestic corporation to a foreign entity may be exempt from
U.S. withholding tax provided the payor corporation is a so-
called ``80/20 Company,'' i.e., at least eighty percent of its
gross income for the preceding three years is foreign source
income attributable to the active conduct of a foreign trade or
business. The Administration believes that the testing period
is subject to manipulation and allows certain companies to
improperly avoid U.S. withholding tax on certain distributions
attributable to a U.S. subsidiary's U.S. source earnings. As a
result, it proposes to arbitrarily change the 80/20 rules by
applying the test on a group-wide (as opposed to individual
company) basis. However, there is little evidence that these
rules have been manipulated on a broad scale in the past and we
do not believe such a drastic change is needed at this time.
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, 2008. The corporate environmental tax would be
reinstated at its previous level for taxable years beginning
after December 31, 1997 and before January 1, 2009. Moreover,
the funding cap for the Oil Spill Tax would be increased from
the current $1 Billion amount to the obscenely high level of $5
Billion.
These taxes, which were previously dedicated to Superfund,
would instead be used to generate revenue to balance the
budget. This use of taxes for deficit reduction purposes, when
historically dedicated to funding specific programs 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.
Modifying the ``Substantial Understatement'' Penalty
The Administration proposes to make any tax deficiency
greater than $10 million ``substantial'' for purpose of the
Code Sec. 6662 substantial understatement penalty, rather than
applying the existing test that such tax deficiency must exceed
ten percent of the taxpayer's liability for the year. The
penalty is twenty percent of the tax underpayment, unless the
taxpayer had ``substantial authority'' for the position
producing the underpayment, or the relevant facts are disclosed
on the return and there is a reasonable basis for the position.
There is no basis for the Administration's assertion that
large corporate taxpayers are ``playing the audit lottery''
because of the purportedly high threshold amount at which the
substantial understatement penalty applies. Large publicly-held
corporations spend enormous amounts on tax related advice and,
for security law and other reasons, generally document the
basis for every major tax return position. Unfortunately,
because of the complexity of both modern business transactions
and the tax laws, as well as the relative dearth of regulatory
or other guidance, the proper tax treatment of many items in a
large corporation's return is far from clear. Also unclear is
whether the ``substantial authority'' standard is met where a
position is supported by well-reasoned legal analysis but there
are no relevant cases, rulings, or other precedents, a
situation encountered all too frequently by the corporate
taxpayers targeted by this proposal. Indeed, the standard's
vagueness is apparently evidenced by the continuing failure of
Treasury to comply with the mandate of Code Sec. 6662(d)(2)(D),
requiring it to publish and periodically update a list of
positions for which it is believes substantial authority is
lacking.
We believe that the ultimate impact of this proposal to
expand the substantial understatement penalty will be an
expansion of lengthy and costly litigation to properly
interpret the substantial authority standard. Taxpayers seeking
protection from this penalty by disclosing uncertain positions
will face almost certain proposed adjustments from IRS agents,
no matter how reasonable their position, resulting in lengthy
administrative controversy and litigation. Moreover, there is
no evidence that the existing penalty and interest provisions
are inadequate, so we strongly urge Congress to reject this
ill-advised proposal.
Increased Penalties for Failure To File Returns
The Administration 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 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.
Limiting Mark-to-Market Accounting
Certain trade receivables would no longer be eligible for
treatment under the mark-to-market accounting rules. Under
those rules, certain taxpayers who purchase and sell their own
trade receivables are exempt from the mark-to-market method of
accounting unless they elect to be included. If they do, those
taxpayers can currently write-off certain non-interest bearing
receivables, and account, note, and trade receivables unrelated
to the active business of a security dealer. There appear to be
no tax policy reasons for prohibiting taxpayers from
accelerating their bad debt deductions for these trade
receivables, only government revenue considerations.
Repealing Lower of Cost or Market Inventory Method
Certain taxpayers can currently determine their inventory
values by applying the lower of cost or market method, or by
writing down the cost of goods that are not salable at normal
prices, or not usable because of damage or other causes. The
Administration is proposing to repeal these options and force
taxpayers to recognize income from changing their method of
accounting, on the specious grounds that writing down unusable
or non-salable goods somehow ``understates taxable income.'' We
strongly disagree with this unwarranted proposal. In addition,
we believe that in the least, the lower of cost or market
method should continue to be permissible when used for
financial accounting purposes, to avoid the complexity of
maintaining separate inventory accounting systems.
Modifying Corporate-Owned Life Insurance (``COLI'') Rules
The Administration proposes to substantially change the
taxation of business-owned life insurance by disallowing a pro-
rata portion of a business' general deduction for interest
expense. Moreover, the Administration has proposed retroactive
application of the new tax to existing life insurance
contracts. This proposal should not be adopted.
Life insurance has long been used by businesses to protect
against financial loss caused by the death of key employees and
to finance the soaring cost of employee benefits, especially
post-retirement health benefits. Life insurance provides a
secure and stable source of financing for such employee
benefits, and it is particularly well suited to this purpose
because its long-term nature matches the correspondingly long-
term nature of the liabilities. The Administration's proposal
would have a devastating effect on employee benefit programs
and key-person protection by effectively taxing life insurance
contracts out of existence. Businesses should not be
discouraged from providing employee health benefits or from
seeking to protect themselves from key-person losses.
Moreover, the Administration's proposal would apply
retroactively to existing life insurance contracts that were
purchased by businesses in good faith, based on existing law.
There can be no question of abuse: business use of life
insurance is well known and the taxation of insurance contracts
has been settled for many years. In addition, Congress has
reviewed the taxation of business-owned life insurance in each
of the last two years and, in each case, has carefully
preserved the existing taxation of business-owned life
insurance on the lives of employees. The Administration's
proposal represents the worst kind of retroactive tax--it would
not only cause the termination of most or all existing
contracts, but, would also have the effect of taxing past
earnings under those contracts.
Deferral of OID on Convertible Debt
The Administration has included a number of past proposals
aimed at financial instruments and the capital markets, which
were fully rejected during the last session of Congress. These
reintroduced proposals should again be rejected out of hand.
One proposal would defer deductions by corporate issuers for
interest accrued on convertible debt instruments with original
issue discount (``OID'') until interest is paid in cash. The
proposal would completely deny the corporation an interest
deduction unless the investors are paid in cash (e.g., no
deduction would be allowed if the investors convert their bonds
into stock). Investors in such instruments would still be
required to pay income tax currently on the accrued interest.
In effect, the proposal defers or denies an interest deduction
to the issuer, while requiring the holder to pay tax on the
interest currently.
The Tax Council opposes this proposal because it is
contrary to sound tax policy and symmetry that matches accrual
of interest income by holders of OID instruments with the
ability of issuers to deduct accrued interest. There is no
justifiable reason for treating the securities as debt for one
side of the transaction and as equity for the other side. There
is also no reason, economic or otherwise, to distinguish a
settlement in cash from a settlement in stock.
Moreover, the instruments in question are truly debt rather
than equity. Recent statistics show that over 70 percent of all
zero-coupon convertible debt instruments were retired with
cash, while only 30 percent of these instruments were
convertible to common stock. Re-characterizing these
instruments as equity for some purposes is fundamentally
incorrect and will put American companies at a distinct
disadvantage to their foreign competitors, who are not bound by
such restrictions. These hybrid instruments and convertible OID
bond instruments have allowed many U.S. companies to raise tens
of billions of dollars of investment capital used to stimulate
the economy. Introducing this imbalance and complexity into the
tax code will discourage the use of such instruments, limit
capital raising options, and increase borrowing costs for
corporations.
Eliminating the ``DRD'' for Certain Preferred Stock
Another proposal would deny the dividend received deduction
(``DRD'') for certain types of preferred stock, which the
Administration believes are more like debt than equity.
Although concerned that dividend payments from such preferred
stock more closely resembles interest payments than dividends,
the proposal does not simultaneously propose to allow issuers
of such securities to take interest expense deductions on such
payments. Again, the Administration violates sound tax policy
and, in this proposal, would deny these instruments the tax
benefits of both equity and debt.
The Tax Council opposes this proposal as not being in the
best interests of either tax or 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.
Pro Rata Disallowance
Another proposal is also somewhat similar to the ``pro
rata'' budget proposal that was rejected by Congress last year.
It would effectively eliminate the ``two-percent de minimis
rule'' and disallow a portion of interest expense deductions
for certain entities that earn tax-exempt interest. While last
year's proposal was designed to apply to corporations
generally, this year's proposal would apply only to ``financial
intermediaries.'' Under the proposal, financial intermediaries
that earn tax-exempt interest would lose a portion of their
interest expense deduction based on the ratio of average daily
holdings of municipals to average daily total assets.
The Tax Council strongly opposes the Administration's
proposal to extend the ``pro rata'' disallowance of tax-exempt
interest expense to financial intermediaries. These companies
play an important role in the markets for municipal leases,
housing bonds, and student loan bonds. By eliminating this
significant source of demand for municipal securities, the
Administration's proposal would force state and local
governments to pay higher interest rates on the bonds they
issue, significantly increasing their costs of capital. The
cost of public facilities, such as school construction and
housing projects, would be increased. This proposal is entirely
inconsistent with tax incentive programs for some of the same
state and local projects. At a time when the state and local
governments are asked to do more, Congress should not make it
more costly for them to achieve their goals.
Increasing the Proration Percentage for Property and Casualty (``P&C'')
Insurance Companies
In 1986, Congress enacted a provision taxing fifteen
percent (the proration percentage) of otherwise tax exempt
interest of P&C companies attributable to municipal obligations
acquired after 1986. It is now proposed to increase this
proration to thirty percent for obligations acquired after
enactment. Although a number of specious arguments are made in
support of this proposal, it appears to be primarily revenue
driven. The Tax Council believes that States will continue to
finance their activities through bonds, but this proposal will
make it more costly for P&C companies to buy them. Thus, States
must either raise their interest rates or find individuals to
buy the bonds, resulting in an even greater revenue loss to the
Treasury (individuals have no proration percentage).
Tax Insurance Contract Exchanges or Reallocate Assets with Variable
Insurance Contracts
Annuity contract investments are a valuable retirement and
investment tool. Currently, owners of variable annuity
contracts can allocate their investments in a contract among
different investment options (e.g. a bond fund, a stock fund,
and a balanced fund). Owners may reallocate their account
values within the contract among the various options without
incurring a current tax so long as the investment remains
committed to a retirement annuity. This flexibility provides an
important savings incentive for retirement. A taxable event
does occur when funds are taken out of an annuity. The
Administration proposes to tax any exchange of a life
insurance, endowment, or annuity contract, for a variable
contract, or vice versa. In addition, any reallocation among
accounts within the same variable life or annuity contract
would result in a taxable event, even though no funds were
taken out of the contract.
The Tax Council adamantly opposes this provision as a tax
increase on middle-class Americans and retirement savers.
Moreover, this proposal completely contradicts the President's
recent statements to ``Save Social Security First.'' Any new
tax on private retirement savings puts further strain on the
overall private and public retirement system. Variable life and
annuity contracts are used respectively to insure against
premature death and for long-term retirement savings. Like
other retirement saving vehicles, including defined
contribution and defined benefit plans, annuities allow savings
to grow tax-free until they are needed for retirement. All
retirement savers periodically shift their savings among
different options as they grow older and more conservative, or
as the market changes. Under this proposal, annuity owners who
shift accounts would be taxed immediately, thereby forcing them
to keep bad investments or pay a tax on undistributed funds.
Recent surveys have shown that more than 80 percent of the
owners of deferred annuity contracts have total annual
household incomes of under $75,000. Such middle income savers
rely on these well-designed products to encourage them to
commit funds to retirement. At a time when Congress and the
President are concerned about saving Social Security, the last
thing that they should do is tax private retirement savings
options.
Reduction in Basis (``Investment in the Contract'') for Mortality-
Related Charges
The Administration's proposal would reduce a policyholder's
tax basis in an insurance or annuity contract for certain
charges under the contract by subtracting mortality and
associated expense charges. In the case of life insurance
contracts, these charges include the cost of the insurance and
related expenses. For deferred annuity contracts, the assumed
mortality and expenses charges, which must be subtracted, are
deemed to equal the contract's average cash value during the
year multiplied by 1.25 percent. This proposal is nothing but a
tax on private retirement savings. Increasing the cost of such
savings vehicles by reducing a product's tax basis creates a
disincentive to use these important savings tools. Life
insurance and annuity contracts are designed to both accumulate
retirement savings and insure against premature death (e.g.
mortality-related risks). Taxes on income from the savings
element of such contracts should not be increased just because
those contracts also provide insurance protection.
This provision will likewise result in a tax increase on
middle-class Americans and retirement savers. In addition, the
proposal is inconsistent with general tax rules relating to the
determination of tax basis and will further increase the
complexity of the tax code with no recognizable benefit. Under
the proposal, life insurance companies would be required to
maintain additional records to keep track of two different
basis amounts for annuity contracts. This will undoubtedly
result in increased administrative burdens and compliance
costs, which most likely will be passed on to Americans trying
to save for retirement.
Modifying the Reserve Rules for Annuity Contracts
Currently, reserves for annuity contracts equal the greater
of the contract's net surrender value or an amount based on the
Commissioner's Annuities Reserve Valuation Method (``CARVM'').
Under the Administration's proposal, reserves for all annuity
contracts with cash surrender values would equal the lesser of
the amount computed under CARVM or the contract's ``adjusted
account value.'' The adjusted account value would equal the net
cash surrender value plus a specified percent (e.g., plus 5.5%
in the first year).
The Tax Council opposes this proposal as another attack on
middle-class Americans and retirement savers who use annuity
contracts as their preferred savings vehicle. The proposal
would make it unduly expensive for insurance companies to
administer an annuity contract in its early years. While aimed
at accounting and reserve methods of insurers, the real targets
are the users of these products who will eventually bear the
increased costs and burdens resulting from such a change. By
increasing the costs of annuity contracts, use of such vehicles
will be reduced, thereby straining the entire public and
private retirement system. At a time when Americans are trying
to increase retirement savings, this proposal moves in the
opposite direction and makes it more costly for them to achieve
their goal.
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 Martin A. Regalia, Ph.D., Vice President and Chief
Economist, U.S. Chamber of Commerce
The U.S. Chamber appreciates this opportunity to express
our views on the revenue provisions in President Clinton's
Fiscal Year 1999 budget proposal. The U.S. Chamber is the
world's largest business federation, representing more than
three million businesses and organizations of every size,
sector and region. This breadth of membership places the U.S.
Chamber in a unique position to speak for the business
community.
The President's Budget Would Increase Business Taxes
President Clinton's budget proposal contains numerous new
spending initiatives, and pays for them by increasing taxes on
businesses. It would increase gross taxes on American
businesses by $106 billion over five years (including $65.5
billion in receipts from tobacco legislation), and raise
government receipts, as a percentage of GDP, from an already-
high 19.8 percent to 20.1 percent.
The President's proposal contains dozens of provisions
which would raise taxes on the business community. Many of
these provisions were included in his earlier budget proposals
and were summarily rejected by Congress, while others are being
offered for the very first time.
The proposal also asserts that many of these provisions are
needed to close unwarranted tax benefits or ``loopholes.''
However, these so-called loopholes are, in fact, legitimate,
equitable, and longstanding business tax provisions, and should
remain in the Internal Revenue Code.
The most onerous provisions in the President's budget
proposal would:
Replace the Export Source Rule with an Activity-Based Rule
Currently, U.S.-based multinational exporters can treat 50
percent of their export income as U.S. source income and 50
percent as foreign source income. This rule is beneficial to
companies that manufacture products in the U.S. and export
abroad because it increases their ability to utilize foreign
tax credits and, therefore, alleviate double taxation.
The President's proposal would replace the existing export
source rule with an economic activity-based rule. The proposed
rule could increase U.S. taxes on these companies, and,
therefore, encourage them to produce their goods overseas,
rather than in this country. Since exports have played an
important role in our nation's recent economic growth, any
proposal weakening the longstanding export source rule could
have a significant, negative effect on our economy.
Convert Airport Trust Fund Taxes to a Cost-Based User Fee
System
Currently, excise taxes are imposed on commercial and
noncommercial aviation to finance programs administered through
the Airport and Airway Trust Fund. These taxes were modified
and extended through September 30, 2007 by the Taxpayer Relief
Act of 1997 (``1997 Act'').
The President's proposal would phase-out these excise taxes
beginning in Fiscal Year 1999 through Fiscal Year 2003, and
replace them with cost-based user fees. While the proposal does
not contain details of this provision, it is estimated to raise
almost $6 billion over the next five years. A $6 billion tax
increase on the business community and the public-at-large,
especially before the issue of whether existing excise taxes
should be replaced by cost-based user fees is fully debated, is
unacceptable and should be thwarted immediately.
Modify the Reserve Rules for Annuity Contracts
Under current law, life insurance reserves for any annuity
contract equal the greater of the contract's net surrender
value or an amount determined using the Commissioner's
Annuities Reserve Valuation Method (``CARVM''). Under the
President's proposal, reserves for any annuity contract with a
cash surrender value would equal the lesser of the amount
computed under CARVM or the contract's ``adjusted account
value.'' The adjusted account value for a contract would equal
the net cash surrender value of the contract, plus a percentage
of the net cash surrender value of the contract (e.g., 5.5
percent in the first year, 5.0 percent in the second year).
This provision would make it unduly expensive for insurance
companies to administer annuity contracts in their early years.
Ultimately, individuals saving for retirement would have to
absorb the increased costs and burdens associated with the
proposed change in reserve rules. At a time when Americans need
to increase retirement savings, this proposal moves in the
opposite direction by making saving more costly and burdensome.
Reinstate the Superfund Excise Taxes
The four taxes that funded the Hazardous Substance
Superfund Trust Fund (``Superfund'') expired on December 31,
1995. The President's proposal would reinstate the three
expired excise taxes from the date of enactment through
September 30, 2008, and the expired corporate environmental
income tax for tax years beginning after December 31, 1997, and
before January 1, 2009.
The business community believes that the various Superfund
taxes should be thoroughly examined and evaluated before they
are reinstated. Furthermore, if these taxes are reinstated,
they should be part of a comprehensive plan to reform the
entire Superfund program.
Modify the Corporate-Owned Life Insurance Rules
The President's proposal would impose additional taxes on
businesses that borrow for any purpose if they also own life
insurance, including key employee life insurance. Specifically,
the provision would eliminate the exception under the pro-rata-
interest-disallowance rule for employees, officers and
directors. The exception for 20-percent owners would be
retained, however.
This provision could have a devastating effect on life
insurance products that protect businesses, especially small
businesses, against financial loss caused by the death of key
employees and allows them to provide benefits, including
retiree health benefits, to their employees. Furthermore, the
provision would unfairly apply retroactively to existing life
insurance contracts that were purchased under current law.
Repeal the ``Lower-of-Cost-or-Market'' Inventory Accounting
Method
Currently, taxpayers that maintain their inventories under
the ``first-in-first-out'' (``FIFO'') method may determine the
value of ending inventory under a ``lower-cost-or-market''
method. Under this method, the value of ending inventory is
written down if its market value is less than its cost.
Similarly, under the subnormal goods method, any goods that are
unsalable at normal prices, or unusable because of damage or
other causes, may be written down to reflect their lower market
values.
The President's proposal would repeal these valuation
methods for taxpayers whose average annual gross receipts over
a three-year period exceed $5 million. This provision could
increase taxes on those businesses that use FIFO, or cause them
to switch to the ``last-in-first-out'' method of valuation for
both tax and financial statement purposes.
Eliminate Various Estate Tax Planning Techniques
Instead of further reducing the estate and gift tax burden
on Americans, as Congress did last year in the 1997 Act, the
President's proposal would increase estate taxes on the middle-
class by eliminating or curtailing the use of several popular
estate tax planning devices.
Specifically, the proposal would: (1) repeal the
``Crummey'' rule which would stifle the use of insurance
trusts; (2) eliminate ``valuation discounts'' for minority-
owned interests of family limited partnerships (except for
active businesses); and (3) reduce the attractiveness of
``personal residence trusts'' by requiring the trust to make
certain payments to the homeowner or else value the retained
interest at zero. If enacted, these provisions would make it
more difficult for business owners to develop estate plans
which would keep their businesses intact, and their employees
working, after their deaths.
Modify the Exchange Rules for Insurance and Annuity Contracts
Life insurance and annuity contracts have proven to be
valuable retirement and savings devices. Under current law, one
can exchange a life insurance, endowment or annuity contract
for a variable contract, or vice versa, without triggering tax.
Likewise, one can reallocate investment assets within a
variable life or annuity contract without incurring tax.
The President's proposal would repeal the tax-free status
of the above-mentioned exchanges, even if no funds are actually
withdrawn from the contracts. This provision would impose an
additional tax on many Americans who are trying to save for
retirement. The tax-free benefits of life insurance and annuity
contracts should be maintained in order to encourage greater
personal saving and responsibility.
Eliminate the Dividends-Received Deduction for Certain
Preferred Stock
Currently, a corporation can deduct 100 percent of the
``qualifying'' dividends it receives from a domestic
corporation if it owns over 80 percent of the stock of the
dividend-paying corporation. The percentage is reduced to 80
percent if the corporation owns at least 20 percent, but no
more than 80 percent, of the stock of the dividend-paying
corporation, and to 70 percent if the corporation owns less
than 20 percent of the stock of such corporation.
The President's proposal would eliminate the dividends-
received deduction for certain types of preferred stock,
subjecting corporate earnings to even higher amounts of tax.
The dividends-received deduction should be increased, not
decreased, in order to lessen the effects of multiple taxation
on corporations and shareholders.
Repeal Tax-Free Conversions of ``Large'' C Corporations to S
Corporations
Under current law, the ``built-in'' gains of assets of a C
corporation that converts, or merges, into an S corporation is
not subject to tax so long as such assets are not disposed of
within 10 years after conversion. The President's proposal
would repeal these tax-free conversions for ``large'' S
corporations, defined as those corporations whose stock has a
value of more than $5 million at the time of conversion.
As a result, this provision would require immediate gain
recognition by such ``large'' corporations with respect to
their appreciated assets, as well as by their shareholders with
respect to their stock upon conversion to S-corporation status.
If enacted, this provision would decrease the desirability of
the Subchapter S election for those C corporations that are
eligible to convert.
Require Employers to Deposit Unemployment Taxes Monthly
Generally, employers deposit their federal and state
unemployment tax liabilities quarterly. The President's
proposal would require that most employers, beginning in 2004,
pay their federal and state unemployment taxes on a monthly
basis. This provision would significantly increase the
administrative burden on businesses by increasing the number of
annual unemployment tax deposits from four to 12.
More Tax Relief is Needed for Businesses
Instead of increasing taxes on the business community, the
President's budget proposal should lead the way in reducing
business taxes. The U.S. Chamber believes tax relief is needed
in the following areas:
Alternative Minimum Tax (``AMT'')
While the 1997 Act exempted ``small'' corporations from AMT
and provided some relief for other corporations, repeal of the
harmful corporate and individual AMT is needed. If repeal is
not feasible, significant reforms should be enacted. Such
reforms should include: providing a ``small business''
exemption for individuals; completely eliminating the
depreciation adjustment; increasing the individual AMT
exemption amounts; allowing taxpayers to offset their current
year AMT liabilities with their accumulated minimum tax
credits; and making the AMT system less complicated and easier
to comply with.
Capital Gains Tax
While the 1997 Act reduced the maximum capital gains tax
rate for individuals from 28 percent to 20 percent (10 percent
for those in the 15-percent income-tax bracket), it also
lengthened the holding period for long-term capital gains from
12 months to 18 months. This holding period should revert back
to 12 months, and rates should be further reduced, if possible.
In addition, capital gains tax relief is still needed for
corporations, whose capital gains continue to be taxed at
regular income tax rates.
Equipment Expensing
In 1998, businesses can generally expense up to $18,500 of
equipment purchased. This amount will gradually increase to
$25,000 by 2003. This expensing limit needs to be further
increased, and at a faster pace, in order to promote capital
investment, economic prosperity, and job growth.
Estate and Gift Tax
While the 1997 Act provided some estate tax relief, the
federal estate tax should be completely repealed. If repeal is
not feasible, significant reforms should be implemented. Such
reforms include further increasing the unified credit, reducing
overall tax rates, increasing and expanding the newly created
``family-owned business interest'' exclusion to encapsulate
more businesses, and broadening the installment payment rules.
Foreign Tax Rules
While the 1997 Act included some foreign tax relief and
simplification measures, our foreign tax rules need to be
further simplified and reformed so American businesses can
better compete in today's global marketplace.
Individual Retirement Accounts (``IRAs'')
While the 1997 Act expanded deductible IRAs and creates
nondeductible Roth IRAs, both types of IRAs need to be further
expanded (e.g., increase contribution limits, eliminate phase-
out ranges) in order to promote saving and personal
responsibility.
Internal Revenue Service (``IRS'') Restructuring and Reform
The overall management, oversight and culture at the IRS
needs to be changed in order to make it a more efficient,
accountable and taxpayer-friendly organization. We support
legislation which the House overwhelmingly passed in November
and look forward to working with Congress towards its
enactment.
Research and Experimentation Tax Credit
While the 1997 Act extended this credit through June 30,
1998, it needs to be extended permanently, and further
expanded, so businesses can better rely on and utilize the
credit.
S Corporation Reform
While the Small Business Jobs Protection Act of 1996
contained many needed reforms for S corporations, such as
increasing the maximum number of shareholders from 35 to 75,
there are many other important reforms which still need to be
enacted, such as allowing preferred stock to be issued and
creating family attribution rules.
Self-Employed Health Insurance Deduction
This deduction is scheduled to increase from 40 percent in
1997 to 100 percent in 2007. We believe this timetable should
be accelerated to give self-employed individuals a full
deduction as soon as possible.
Work Opportunity Tax Credit
This credit, which encourages employers to hire individuals
from several targeted groups, needs to be permanently extended
beyond its June 30, 1998 sunset date.
Worker Classification Rules
The current worker classification rules are too subjective
and restrictive, and need to be simplified and clarified. We
support the creation of a more objective safe harbor for
independent contractors, while leaving the current 20-factor
test and Section 530 safe harbors intact.
Conclusion
The revenue-raising provisions contained in President
Clinton's Fiscal Year 1999 budget proposal would further
increase taxes on businesses and reduce savings and investment.
The U.S. Chamber urges that these provisions be rejected as bad
tax policy, and not included in final budget legislation for
Fiscal Year 1999.
Hidden among the dozens of tax increases in the President's
proposal are a few provisions which would marginally benefit
businesses. For example, the proposal would temporarily extend
the research and experimentation tax credit, work opportunity
tax credit and the employer-provided educational assistance
exclusion, enhance taxpayers' rights, and extend and modify the
Puerto Rico Tax Credit.
These provisions, however, would not provide businesses
with significant or long-term tax relief. For example, the tax
extender provisions would not be made permanent, and are
overshadowed by the numerous tax increasing provisions.
Furthermore, needed relief in other areas, such as the
alternative minimum tax and the estate and gift tax, is not
provided for anywhere in his proposal.
Our long-term economic health depends on sound economic and
tax policies. The federal tax burden on American businesses is
too high and needs to be significantly reduced. In addition,
our tax code wrongly favors consumption over savings and
investment. As we prepare for the economic challenges of the
next century, we must orient our current tax policies in a way
that encourages more savings, investment, productivity growth,
and, ultimately, economic growth.
Statement of United States Council for International Business (USCIB)
Introduction
The United States Council for International Business
(USCIB) is pleased to take this opportunity to comment with
respect to the international provisions included among the tax
proposals offered in the Administration's budget statement.
The USCIB advances the global interest of American business
both at home and abroad. It is the American affiliate of the
International Chamber of commerce (ICC), the Business and
Industry Advisory Committee (BIAC) to the OECD, and the
International Organisation of Employers (IOE). As such, it
officially represents U.S. business positions in the main
intergovernmental bodies, and vis-a-vis foreign business and
their governments.
We noted, and appreciate, in the international area the
proposal to accelerate the implementation date of the ``look-
through'' treatment for dividend from 10/50 companies. Too many
of the international tax proposals, however, reflect a
misguided emphasis on raising revenue at the expense of sound
tax policy. Most of the revenue raisers found in the budget
proposals which affect the international area lack a sound
policy foundation. Although they may be successful in raising
revenue, they do nothing to achieve the objective of expanding
and/or retaining U.S. jobs to make the U.S. economy stronger.
Examples, include the proposals (1) to arbitrarily change the
sourcing of income rules on export sales by U.S. based
manufacturers, (2) to provide the Treasury Secretary with
blanket authority to issue regulations in the international
area that could conceivably allow it to attack legitimate tax
planning by U.S. companies, (for example, by severely
restricting the ordinary business operations of foreign
affiliates through no longer allowing a U.S. company to
characterize its foreign affiliate as a branch for U.S. tax
purposes), and (3) to limit the ability of so-called ``dual
capacity taxpayers'' (i.e., multinationals engaged in vital
petroleum exploration and production overseas) to take credit
for certain taxes paid to foreign countries. These proposals,
if enacted, would be totally counter productive.
The Administration is unwise, in its efforts to balance the
budget, to target U.S. multinationals doing business overseas,
and we urge that such proposals be reconsidered and withdrawn.
The predominant reason that businesses establish overseas
operations is to serve local markets to be able to compete more
effectively. Investments abroad provide a platform for the
growth of exports and, indirectly, create jobs in the U.S., not
to mention improving the U.S. balance of payments. The
creditability of foreign income taxes has existed in the
Internal Revenue code for almost 80 years to 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 vis-a-vis foreign-based
companies.
So that U.S. companies can better compete with foreign-
based multinationals, the Administration should, instead, do
all it can to make the U.S. tax law more user friendly,
consistent with the Administration's more enlightened trade
policy. Rather than engaging in gimmicks that reward some
industries and penalize others, the Administration's budget
should be written with the goal of reintegrating sounder tax
policy into decisions regarding 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 tax system, and arbitrarily denying a deduction
for such an expense 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 workers. We comment below on the specific
proposals impacting the international area.
Accelerating the Effective Date of 10/50 Company Change
We commend the Administration for its proposal to
accelerate the effective date of a tax change made in the 1997
Tax Relief Act affecting foreign joint ventures owned between
ten and fifty percent by U.S. parents (so-call ``10/50
Companies''). This change will allow 10/50 Companies to be
treated just like controlled foreign corporations, by allowing
``look-through'' treatment for foreign tax credit purposes for
dividends from such joint ventures. The 1997 Act, however, did
not make the change effective to dividends for such entities
unless they were received after the year 2003 and, even then,
required separate rules to apply, on the one hand, to dividends
from earning and profits (``E&P'') generated before the year
2003, and, on the other hand, to dividends from E&P accumulated
after the year 2002. The Administration's proposal will,
instead, apply the look-through rules to all dividends received
in tax years after 1997, no matter when the E&P constituting
the dividend was earned and accumulated.
This change will result in an enormous reduction in
complexity and compliance burdens for U.S. multinationals doing
business overseas through foreign joint ventures. It will also
reduce the competitive bias against U.S. participation in such
ventures by placing U.S. companies on a much more level playing
field from a corporate tax standpoint. The proposal is the type
of provision that promotes the desirable policy goal of
simplicity in the tax law.
Foreign Tax Credits relating to Foreign Oil And Gas Income
The USCIB strongly believes that, in general, a full
foreign tax credit should be restored and the complexities of
current law, particularly the multiplicity of separate
``baskets,'' should be eliminated.
Unfortunately, the proposal relating to foreign oil and gas
income moves quite in the opposite direction, by limiting use
of the foreign tax credit on foreign oil and gas income. This
selective attack on a single industry's utilization of the
foreign tax credit 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
subjected to double taxation which will severely hinder U.S.
oil companies in their global oil and gas exploration,
production, refining and marketing activities.
Repeal of the Export Source Rule
The regulations under Code 863(b) (and its predecessors)
have long contained a rule which allows the income from goods
that are manufactured in the U.S. and sold abroad (with title
passing outside the U.S.) to be treated as 50% U.S. source
income and 50% foreign source income. This export source rule
has been beneficial to companies who manufacture in the U.S.
and export abroad because it increases their foreign source
income and thereby increases their ability to utilize foreign
tax credits. Because the U.S. tax law restricts the ability of
companies to fully utilize credits for the foreign income taxes
which they incur (e.g., through the interest and R&D
allocations), many multinational companies face double taxation
on their overseas operations. The export source rule helps
alleviate this double taxation burden and thereby encourages
U.S.-based manufacturing by multinational exporters.
The proposal would 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 abroad, respectively.
The justification given for eliminating the 50/50 rule is that
it provides U.S. multinational exporters operating in high tax
foreign countries a competitive advantage over U.S. exporters
that conduct all their business activities in the U.S. The
administration also notes that the U.S. tax treaty network
protects export sales from foreign taxation in countries where
we have treaties, thereby reducing the need for the export
source rule. Both of these arguments are erroneous.
The export source rule does not provide a competitive
advantage to multinational exporter vis-a-vis exporters with
``domestic-only'' operations. Exporters with only domestic
operations never incur foreign taxes and, thus, are not
subjected to the onerous penalty of double taxation. Also,
domestic-only exporters are able to claim the full benefit of
deductions for U.S. tax purposes for all their U.S. expenses,
e.g., interest on borrowings and R&D costs, because they do not
have to allocate any of those expenses against foreign source
income. Thus, the export source rule does not create a
competitive advantage; rather, it helps to ``level the playing
field'' for U.S.-based multinational exporters. Our tax treaty
network, although of great significance to U.S. businesses
operating abroad is certainly no substitute, for the export
source rule since it is not earnings from export sales, but
rather other foreign earnings, that are the main cause of the
double taxation described above. To the extent that the treaty
network lowers foreign taxes, it can help to alleviate the
double tax problem, but only with countries with which we have
treaties, which tends to be the other industrialized nations of
the world. We have few treaties with the developing nations,
which will undoubtedly be the primary targets areas for our
export growth in the future.
Exports are fundamental to our economic growth and our
future standard of living. Over the past three years, exports
have accounted for about one-third of total U.S. economic
growth. The export source rule also operates to encourage
companies to produce their goods in their U.S. plants rather
than in their foreign facilities. Repeal of, or a cutback in,
the export source rule will reduce exports and jeopardize high
paying jobs in the United States. Given the danger that the
current Asian crisis poses to our exports, repeal of the rule
would be especially unwise and counterproductive.
Limiting Use Of ``Hybrid'' Entities
We deplore the fact that the Administration (i.e.,
Treasury) feels compelled to request congressional authority to
issue potentially sweeping legislative regulations after non-
specific tax guidance has been given. If Treasury has specific
issues to address, it should do so through specific legislative
proposals. This would permit normal congressional
consideration, including hearings on such proposals.
We refer in particular to the proposal which would limit
the ability of certain foreign and U.S. persons to enter into
transactions that utilize so-called ``hybrid entities,'' which
are entities that are treated as corporations in one
jurisdiction but as branches or partnerships in another
jurisdiction. Although most hybrid transactions do not attempt
to generate tax results that are ``inconsistent with the
purposes of U.S. tax law,'' the Administration feels that there
are enough taxpayers taking unfair advantage of the current
rules that it is necessary to codify and extend earlier
government issued tax guidance on this subject (i.e., Notice
98-5 and 98-11).
U.S. multinationals compete in an environment in which
foreign competitors use tax planning techniques to reduce
foreign taxes without incurring home country tax. The use of
``hybrid entities'' allows U.S. multinationals to compete on a
level playing field and, in fact, promotes additional U.S.
exports. The use of hybrids is consistent with the initial
balance between competitiveness and export neutrality that was
intended by Congress in enacting the ``Subpart F'' rules.
Although Congress specifically enacted a branch rule for
foreign base company sales under Code 954(d)(3), similar rules
were not enacted for foreign personal holding company income.
If enacted, these proposals would represent an unwarranted
extension of legislative authority by Congress to the Executive
Branch to impose new rules by regulation without Congressional
debate.
Notices 98-5 and 98-11 have chilling effect on the ability
of U.S. companies to structure their foreign operations
consistent with the commercial objective of regionalizing their
businesses. They also adversely impact the ability of U.S.
multinationals to effectively reduce their overall costs by
reducing local taxes in their overseas operations. The Notices
are drafted so broadly and so vaguely that they will confuse
U.S. taxpayers and their advisors, and introduce a compelling
need to seek clarification as to whether taxpayers can continue
to rely on the simple ``check-the-box'' regulations issued just
last year. All these effects are exacerbated by the Notices'
immediate effective dates.
The world has changed dramatically since enactment of the
Subpart F rules in 1962. We feel that it would be more
appropriate for Congress to request a study regarding the trade
and tax policy issues associated with Notices 98-5 and 98-11.
In this regard, a moratorium on further regulatory action by
Treasury should be imposed until enactment of specific
legislative proposals resulting from a well reasoned analysis
and debate.
Foreign Tax Credits Relating to Foreign Oil and Gas Income
Another proposal would require the Treasury to issue
regulations to prevent taxpayers from ``importing built-in
losses incurred outside U.S. taxing jurisdictions to offset
income or gain that would otherwise be subject to U.S. tax.''
The administration argues that although there are rules in the
Code that limit a U.S. taxpayer's ability to avoid paying U.S.
tax on built-in gains (e.g., Code 367(a), 8664(c)(7), and 877),
similar rules do not exist that prevent built-in losses from
being used to shelter income otherwise subject to U.S. tax,
and, as a result, taxpayers are avoiding subpart F income
inclusions or capital gains tax. We believe that this
directive, which is written extremely broadly, is unnecessary
due to the existence of rules already available in the code,
e.g., the anti-abuse provisions of Code 269, 382, 446(b), and
482. This is another example of the type of provision that
would seriously erode U.S. competitiveness.
Payments To 80/20 Companies
Under current rules, a portion of the interest or dividends
paid by a domestic corporation to a foreign entity may be
exempt from U.S. withholding tax provided the payor corporation
is a so-called ``80/20 Company,'' i.e., at least eighty percent
of its gross income for the preceding three years is foreign
source income generated in the active conduct of a foreign
trade or business. The Administration believes that the testing
period is subject to manipulation and allows certain companies
to improperly avoid U.S. withholding tax on certain
distributions attributable to a U.S. subsidiary's U.S. source
earnings. As a result, it proposes to arbitrarily change the
80/20 rules by applying the test on a group-wide (as opposed to
individual company) basis. However, there is little evidence
that these rules have been manipulated on a broad scale in the
past, and, accordingly, we do not believe such a drastic change
is needed.