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Committee Reports

108th Congress (2003-2004)

House Report 108-548 - Part 1

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AMERICAN JOBS CREATION ACT OF 2004

29-006

2004
108TH CONGRESS 2D SESSION
HOUSE OF REPRESENTATIVES
Rept. 108-548

Part 1

AMERICAN JOBS CREATION ACT OF 2004

R E P O R T

of the

COMMITTEE ON WAYS AND MEANS

HOUSE OF REPRESENTATIVES

to accompany

H.R. 4520

together with

DISSENTING AND ADDITIONAL VIEWS

[Including cost estimate of the Congressional Budget Office]

[Graphic image not available]

June 16, 2004- Committed to the Committee of the Whole House on the State of the Union and ordered to be printed

29-006

108TH CONGRESS

Rept. 108-548

HOUSE OF REPRESENTATIVES

2d Session

Part 1

--AMERICAN JOBS CREATION ACT OF 2004

June 16, 2004- Committed to the Committee of the Whole House on the State of the Union and ordered to be printed

Mr. THOMAS, from the Committee on Ways and Means, submitted the following

R E P O R T

together with

DISSENTING AND ADDITIONAL VIEWS

[To accompany H.R. 4520]

[Including cost estimate of the Congressional Budget office]

CONTENTS Page
I. Summary and Background 112
Title I--End Sanctions and Reduce Corporate Tax Rates for Domestic Manufacturing and Small Corporations 113
A. Repeal of Exclusion for Extraterritorial Income (sec. 101 of the bill and secs. 114 and 941-943 of the Code) 113
B. Reduced Corporate Income Tax Rate for Domestic Production Activities Income (sec. 102 of the bill and sec. 11 of the Code) 115
C. Reduced Corporate Income Tax Rate for Small Corporations (sec. 103 of the bill and sec. 11 of the Code) 117
Title II--Corporate Reform and Growth Incentives for Manufacturers, Small Businesses, and Farmers 119
A. Small Business Expensing 119
1. Extension of increased section 179 expensing (sec. 201 of the bill and sec. 179 of the Code) 119
B. Depreciation 121
1. Recovery period for depreciation of certain leasehold improvements and restaurant property (sec. 211 of the bill and sec. 168 of the Code) 121
2. Modification of depreciation allowance for aircraft (sec. 212 of the bill and sec. 168 of the Code) 123
3. Modification of placed in service rule for bonus depreciation property (sec. 213 of the bill and sec. 168 of the Code) 126
C. S Corporation Reform and Simplification (secs. 221-231 of the bill and secs. 1361-1379 and 4975 of the Code) 127
1. Members of family treated as one shareholder; increase in number of eligible shareholders to 100 128
2. Expansion of bank S corporation eligible shareholders to include IRAs 129
3. Disregard of unexercised powers of appointment in determining potential current beneficiaries of ESBT 130
4. Transfers of suspended losses incident to divorce, etc. 130
5. Use of passive activity loss and at-risk amounts by qualified subchapter S trust income beneficiaries 131
6. Exclusion of investment securities income from passive investment income test for bank S corporations 131
7. Treatment of bank director shares 132
8. Relief from inadvertently invalid qualified subchapter S subsidiary elections and terminations 133
9. Information returns for qualified subchapter S subsidiaries 133
10. Repayment of loans for qualifying employer securities 134
D. Alternative Minimum Tax Relief 136
1. Foreign tax credit under alternative minimum tax; expansion of exemption from alternative minimum tax for small corporations; income averaging for farmers not to increase alternative minimum tax (secs. 241-243 of the bill and secs. 55-59 of the Code) 136
E. Restructuring of Incentives for Alcohol Fuels, Etc. 137
1. Reduced rates of tax on alcohol fuel mixtures replaced with an excise tax credit, etc. (secs. 251 and 252 of the bill and secs. 4041, 4081, 4091, 6427 and 9503 of the Code) 137
F. Stock Options and Employee Stock Purchase Plan Stock Options 144
1. Exclusion of incentive stock options and employee stock purchase plan stock options from wages (sec. 261 of the bill and secs. 421(b), 423(c), 3121(a), 3231, and 3306(b) of the Code) 144
G. Incentives to Reinvest Foreign Earnings in the United States (sec. 271 of the bill and new sec. 965 of the Code) 145
H. Other Provisions 147
1. Special rules for livestock sold on account of weather-related conditions (sec. 281 of the bill and secs. 1033 and 451 of the Code) 147
2. Payment of dividends on stock of cooperatives without reducing patronage dividends (sec. 282 of the bill and sec. 1388 of the Code) 149
3. Capital gains treatment to apply to outright sales of timber by landowner (sec. 283 of the bill and sec. 631(b) of the Code) 150
4. Distributions from publicly traded partnerships treated as qualifying income of regulated investment company (sec. 284 of the bill and secs. 851 and 469(k) of the Code) 151
5. Improvements related to real estate investment trusts (sec. 285 of the bill and secs. 856, 857 and 860 of the Code) 153
6. Treatment of certain dividends of regulated investment companies (sec. 286 of the bill and secs. 871 and 881 of the Code) 161
7. Taxation of certain settlement funds (sec. 287 of the bill and sec. 468B of the Code) 167
8. Expand human clinical trials expenses qualifying for the orphan drug tax credit (sec. 288 of the bill and sec. 45C of the Code) 168
9. Simplification of excise tax imposed on bows and arrows (sec. 289 of the bill and sec. 4161 of the Code) 170
10. Repeal excise tax on fishing tackle boxes (sec. 290 of the bill and sec. 4162 of the Code) 171
11. Repeal of excise tax on sonar devices suitable for finding fish (sec. 291 of the bill and secs. 4161 and 4162 of the Code) 171
12. Income tax credit for cost of carrying tax-paid distilled spirits in wholesale inventories (sec. 292 of the bill and new sec. 5011 of the Code) 172
13. Suspension of occupational taxes relating to distilled spirits, wine, and beer (sec. 293 of the bill and new sec. 5148 of the Code) 174
14. Exclusion of certain indebtedness of small business investment companies from acquisition indebtedness (sec. 294 of the bill and sec. 514 of the Code) 175
15. Election to determine taxable income from certain international shipping activities using per ton rate (sec. 295 of the bill and new secs. 1352-1359 of the Code) 176
16. Charitable contribution deduction for certain expenses in support of native Alaskan subsistence whaling (sec. 296 of the bill and sec. 170 of the Code) 181
Title III--Tax Reform and Simplification for United States Businesses 182
A. Interest Expense Allocation Rules (sec. 301 of the bill and sec. 864 of the Code) 182
B. Recharacterization of Overall Domestic Loss (sec. 302 of the bill and sec. 904 of the Code) 186
C. Reduction to Two Foreign Tax Credit Baskets (sec. 303 of the bill and sec. 904 of the Code) 188
D. Look-Through Rules to Apply to Dividends from Noncontrolled Section 902 Corporations (sec. 304 of the bill and sec. 904 of the Code) 192
E. Attribution of Stock Ownership Through Partnerships to Apply in Determining Section 902 and 960 Credits (sec. 305 of the bill and secs. 901, 902, and 960 of the Code) 193
F. Foreign Tax Credit Treatment of Deemed Payments Under Section 367(d) (sec. 306 of the bill and sec. 367 of the Code) 195
G. United States Property Not to Include Certain Assets of Controlled Foreign Corporation (sec. 307 of the bill and sec. 956 of the Code) 196
H. Election Not to Use Average Exchange Rate for Foreign Tax Paid Other Than in Functional Currency (sec. 308 of the bill and sec. 986 of the Code) 198
I. Repeal of Withholding Tax on Dividends from Certain Foreign Corporations (sec. 309 of the bill and sec. 871 of the Code) 200
J. Provide Equal Treatment for Interest Paid by Foreign Partnerships and Foreign Corporations (sec. 310 of the bill and sec. 861 of the Code) 201
K. Look-Through Treatment of Payments Between Related Controlled Foreign Corporations Under Foreign Personal Holding Company Income Rules (sec. 311 of the bill and sec. 954 of the Code) 202
L. Look-Through Treatment Under Subpart F for Sales of Partnership Interests (sec. 312 of the bill and sec. 954 of the Code) 203
M. Repeal of Foreign Personal Holding Company Rules and Foreign Investment Company Rules (sec. 313 of the bill and secs. 542, 551-558, 954, 1246, and 1247 of the Code) 204
N. Determination of Foreign Personal Holding Company Income with Respect to Transactions in Commodities (sec. 314 of the bill and sec. 954 of the Code) 205
O. Modifications to Treatment of Aircraft Leasing and Shipping Income (sec. 315 of the bill and sec. 954 of the Code) 208
P. Modification of Exceptions Under Subpart F for Active Financing (sec. 316 of the bill and sec. 954 of the Code) 211
Title IV--Extension of Certain Expiring Provisions 213
A. Extend Alternative Minimum Tax Relief for Individuals (sec. 401 of the bill and sec. 26 of the Code) 213
B. Extension of the Research Credit (sec. 402 of the bill and sec. 41 of the Code) 214
C. Extension and Modification of the Section 45 Electricity Production Credit (sec. 403 of the bill and sec. 45 of the Code) 217
D. Indian Employment Tax Credit (sec. 404 of the bill and sec. 45A of the Code) 218
E. Extend the Work Opportunity Tax Credit (sec. 405 of the bill and sec. 51 of the Code) 219
F. Extend the Welfare-To-Work Tax Credit (sec. 406 of the bill and sec. 51A of the Code) 220
G. Extension of the Above-the-line Deduction for Certain Expenses of Elementary and Secondary School Teachers (sec. 407 of the bill and sec. 62 of the Code) 221
H. Extension of Accelerated Depreciation Benefit for Property on Indian Reservations (sec. 408 of the bill and sec. 168(j) of the Code) 222
I. Extend Enhanced Charitable Deduction for Computer Technology and Equipment (sec. 409 of the bill and sec. 170 of the Code) 223
J. Extension of Expensing of Certain Environmental Remediation Costs (sec. 410 of the bill and sec. 198 of the Code) 224
K. Extension of Archer Medical Savings Accounts (`MSAs') (sec. 411 of the bill and sec. 220 of the Code) 225
L. Taxable Income Limit on Percentage Depletion for Oil and Natural Gas Produced from Marginal Properties (sec. 412 of the bill and sec. 613A of the Code) 227
M. Qualified Zone Academy Bonds (sec. 413 of the bill and sec. 1397E of the Code) 228
N. Extension of Tax Incentives for Investment in the District of Columbia (sec. 414 of the bill and secs. 1400, 1400A, 1400B, and 1400C of the Code) 230
O. Extend the Authority to Issue Liberty Zone Bonds (sec. 415 of the bill and sec. 1400L of the Code) 231
P. Disclosure to Law Enforcement Agencies Regarding Terrorist Activities (sec. 416 of the bill and sec. 6103 of the Code) 233
Q. Disclosure of Return Information Relating to Student Loans (sec. 417 of the bill and sec. 6103(l) of the Code) 235
R. Extension of Cover Over of Excise Tax on Distilled Spirits to Puerto Rico and Virgin Islands (sec. 418 of the bill and sec. 7652 of the Code) 236
S. Extension of Joint Review (sec. 419 of the bill and secs. 8021 and 8022 of the Code) 237
T. Parity in the Application of Certain Limits to Mental Health Benefits (sec. 420 of the bill and sec. 9812 of the Code) 238
U. Disclosure of Tax Information to Facilitate Combined Employment Tax Reporting (sec. 421 of the bill) 239
V. Extension of Tax Credit for Electric Vehicles and Tax Deduction for Clean-Fuel Vehicles (sec. 422 of the bill and secs. 30 and 179A of the Code) 239
Title V--Deduction of State and Local General Sales Taxes 240
A. Deduction of State and Local General Sales Taxes (sec. 501 of the bill and sec. 164 of the Code) 240
Title VI--Revenue Provisions 242
A. Provisions to Reduce Tax Avoidance Through Individual and Corporate Expatriation 242
1. Tax treatment of expatriated entities and their foreign parents (sec. 601 of the bill and new sec. 7874 of the Code) 242
2. Excise tax on stock compensation of insiders in expatriated corporations (sec. 602 of the bill and secs. 162(m), 275(a), and new sec. 4985 of the Code) 246
3. Reinsurance of U.S. risks in foreign jurisdictions (sec. 603 of the bill and sec. 845(a) of the Code) 250
4. Revision of tax rules on expatriation of individuals (sec. 604 of the bill and secs. 877, 2107, 2501 and 6039G of the Code) 251
5. Reporting of taxable mergers and acquisitions (sec. 605 of the bill and new sec. 6043A of the Code) 257
6. Studies (sec. 606 of the bill) 258
B. Provisions Relating to Tax Shelters 260
1. Penalty for failure to disclose reportable transactions (sec. 611 of the bill and new sec. 6707A of the Code) 260
2. Modifications to the accuracy-related penalties for listed transactions and reportable transactions having a significant tax avoidance purpose (sec. 612 of the bill and new sec. 6662A of the Code) 262
3. Tax shelter exception to confidentiality privileges relating to taxpayer communications (sec. 613 of the bill and sec. 7525 of the Code) 266
4. Statute of limitations for unreported listed transactions (sec. 614 of the bill and sec. 6501 of the Code) 267
5. Disclosure of reportable transactions by material advisors (sec. 615 of the bill and secs. 6111 and 6707 of the Code) 268
6. Investor lists and modification of penalty for failure to maintain investor lists (secs. 616 and 617 of the bill and secs. 6112 and 6708 of the Code) 271
7. Penalty on promoters of tax shelters (sec. 618 of the bill and sec. 6700 of the Code) 273
8. Modifications of substantial understatement penalty for nonreportable transactions (sec. 619 of the bill and sec. 6662 of the Code) 274
9. Modification of actions to enjoin certain conduct related to tax shelters and reportable transactions (sec. 620 of the bill and sec. 7408 of the Code) 274
10. Penalty on failure to report interests in foreign financial accounts (sec. 621 of the bill and sec. 5321 of Title 31, United States Code) 275
11. Regulation of individuals practicing before the Department of the Treasury (sec. 622 of the bill and sec. 330 of Title 31, United States Code) 276
12. Treatment of stripped interests in bond and preferred stock funds, etc. (sec. 631 of the bill and secs. 305 and 1286 of the Code) 277
13. Minimum holding period for foreign tax credit on withholding taxes on income other than dividends (sec. 632 of the bill and sec. 901 of the Code) 280
14. Disallowance of certain partnership loss transfers (sec. 633 of the bill and secs. 704, 734, and 743 of the Code) 281
15. No reduction of basis under section 734 in stock held by partnership in corporate partner (sec. 634 of the bill and sec. 755 of the Code) 285
16. Repeal of special rules for FASITs, etc. (sec. 635 of the bill and secs. 860H-860L of the Code) 287
17. Limitation on transfer of built-in losses on REMIC residuals (sec. 636 of the bill and sec. 362 of the Code) 292
18. Clarification of banking business for purposes of determining investment of earnings in U.S. property (sec. 637 of the bill and sec. 956 of the Code) 294
19. Alternative tax for certain small insurance companies (sec. 638 of the bill and sec. 831 of the Code) 296
20. Denial of deduction for interest on underpayments attributable to nondisclosed reportable transactions (sec. 639 of the bill and sec. 163 of the Code) 297
21. Clarification of rules for payment of estimated tax for certain deemed asset sales (sec. 640 of the bill and sec. 338 of the Code) 297
22. Exclusion of like-kind exchange property from nonrecognition treatment on the sale or exchange of a principal residence (sec. 641 of the bill and sec. 121 of the Code) 298
23. Prevention of mismatching of interest and original issue discount deductions and income inclusions in transactions with related foreign persons (sec. 642 of the bill and secs. 163 and 267 of the Code) 299
24. Exclusion from gross income for interest on overpayments of income tax by individuals (sec. 643 of the bill and new sec. 139A of the Code) 302
25. Deposits made to suspend the running of interest on potential underpayments (sec. 644 of the bill and new sec. 6603 of the Code) 304
26. Authorize IRS to enter into installment agreements that provide for partial payment (sec. 645 of the bill and sec. 6159 of the Code) 307
27. Affirmation of consolidated return regulation authority (sec. 646 of the bill and sec. 1502 of the Code) 308
28. Reform of tax treatment of certain leasing arrangements and limitation on deductions allocable to property used by governments or other tax-exempt entities (secs. 647 through 649 of the bill, secs. 167 and 168 of the Code, and new sec. 470 of the Code) 312
C. Reduction of Fuel Tax Evasion 319
1. Exemption from certain excise taxes for mobile machinery vehicles (sec. 651 of the bill, and secs. 4053, 4072, 4082, 4483 and 6421 of the Code) 319
2. Taxation of aviation-grade kerosene (sec. 652 of the bill and secs. 4041, 4081, 4082, 4083, 4091, 4092, 4093, 4101, and 6427 of the Code) 321
3. Mechanical dye injection and related penalties (sec. 653 of the bill and sec. 4082 and new sec. 6715A of the Code) 327
4. Authority to inspect on-site records (sec. 654 of the bill and sec. 4083 of the Code) 330

5. Registration of pipeline or vessel operators required for exemption of bulk transfers to registered terminals or refineries (sec. 655 of the bill and sec. 4081 of the Code) 330
6. Display of registration and penalties for failure to display registration and to register (secs. 656 and 657 of the bill, secs. 4101, 7232, 7272 and new secs. 6717 and 6718 of the Code) 331
7. Penalties for failure to report (sec. 657 of the bill and new sec. 6725 of the Code) 332
8. Collection from Customs bond where importer not registered (sec. 658 of the bill and new sec. 4104 of the Code) 333
9. Modification of the use tax on heavy highway vehicles (sec. 659 of the bill and secs. 4481, 4483 and 6165 of the Code) 334
10. Modification of ultimate vendor refund claims with respect to farming(sec. 660 of the bill and sec. 6427 of the Code) 336
11. Dedication of revenue from certain penalties to the Highway Trust Fund (sec. 661 of the bill and sec. 9503 of the Code) 336
12. Taxable fuel refunds for certain ultimate vendors (sec. 662 of the bill and secs. 6416 and 6427 of the Code) 337
13. Two party exchanges (sec. 663 of the bill and new sec. 4105 of the Code) 339
14. Simplification of tax on tires (sec. 664 of the bill and sec. 4071 of the Code) 340
D. Nonqualified Deferred Compensation Plans 341
1. Treatment of nonqualified deferred compensation plans (sec. 671 of the bill and new sec. 409A and sec. 6051 of the Code) 341
E. Other Revenue Provisions 348
1. Qualified tax collection contracts (sec. 681 of the bill and new sec. 6306 of the Code) 348
2. Modify charitable contribution rules for donations of patents and other intellectual property (sec. 682 of the bill and secs. 170 and 6050L of the Code) 351
3. Require increased reporting for noncash charitable contributions (sec. 683 of the bill and sec. 170 of the Code) 355
4. Require qualified appraisals for charitable contributions of vehicles (sec. 684 of the bill and sec. 170 of the Code) 356
5. Extend the present-law intangible amortization provisions to acquisitions of sports franchises (sec. 685 of the bill and sec. 197 of the Code) 358
6. Increase continuous levy for certain Federal payments (sec. 686 of the bill and sec. 6331 of the Code) 360
7. Modification of straddle rules (sec. 687 of the bill and sec. 1092 of the Code) 361
8. Add vaccines against hepatitis A to the list of taxable vaccines (sec. 688 of the bill and sec. 4132 of the Code) 365
9. Add vaccines against influenza to the list of taxable vaccines (sec. 689 of the bill and sec. 4132 of the Code) 366
10. Extension of IRS user fees (sec. 690 of the bill and sec. 7528 of the Code) 367
11. Extension of customs user fees (sec. 691 of the bill) 367
Title VII--Market Reform for Tobacco Growers (secs. 701-725 of the bill) 369
Title VIII--Trade Provisions 371
A. Suspension of Duties on Ceiling Fans (sec. 801 of the bill) 371
B. Suspension of Duties on Nuclear Steam Generators (sec. 802 of the bill) 371
C. Suspension of Duties on Nuclear Reactor Vessel Heads (sec. 802 of the bill) 372
II. Votes of the Committee 372
III. Budget Effects of the Bill 375
IV. Other Matters To Be Discussed Under the Rules of the House 398
V. Changes in Existing Law Made by the Bill, as Reported 399
VI. Dissenting Views 400

SECTION 1. SHORT TITLE; ETC.

Sec. 1. Short title; etc.
TITLE I--END SANCTIONS AND REDUCE CORPORATE TAX RATES FOR DOMESTIC MANUFACTURING AND SMALL CORPORATIONS
Sec. 101. Repeal of exclusion for extraterritorial income.
Sec. 102. Reduced corporate income tax rate for domestic production activities income.
Sec. 103. Reduced corporate income tax rate for small corporations.
TITLE II--JOB CREATION TAX INCENTIVES FOR MANUFACTURERS, SMALL BUSINESSES, AND FARMERS
Subtitle A--Small Business Expensing
Sec. 201. 2-year extension of increased expensing for small business.
Subtitle B--Depreciation
Sec. 211. Recovery period for depreciation of certain leasehold improvements and restaurant property.
Sec. 212. Modification of depreciation allowance for aircraft.
Sec. 213. Modification of placed in service rule for bonus depreciation property.
Subtitle C--S Corporation Reform and Simplification
Sec. 221. Members of family treated as 1 shareholder.
Sec. 222. Increase in number of eligible shareholders to 100.
Sec. 223. Expansion of bank S corporation eligible shareholders to include IRAs.
Sec. 224. Disregard of unexercised powers of appointment in determining potential current beneficiaries of ESBT.
Sec. 225. Transfer of suspended losses incident to divorce, etc.
Sec. 226. Use of passive activity loss and at-risk amounts by qualified subchapter S trust income beneficiaries.
Sec. 227. Exclusion of investment securities income from passive income test for bank S corporations.
Sec. 228. Treatment of bank director shares.
Sec. 229. Relief from inadvertently invalid qualified subchapter S subsidiary elections and terminations.
Sec. 230. Information returns for qualified subchapter S subsidiaries.
Sec. 231. Repayment of loans for qualifying employer securities.
Subtitle D--Alternative Minimum Tax Relief
Sec. 241. Foreign tax credit under alternative minimum tax.
Sec. 242. Expansion of exemption from alternative minimum tax for small corporations.
Sec. 243. Income averaging for farmers not to increase alternative minimum tax.
Subtitle E--Restructuring of Incentives for Alcohol Fuels, Etc.
Sec. 251. Reduced rates of tax on gasohol replaced with excise tax credit; repeal of other alcohol-based fuel incentives; etc.
Sec. 252. Alcohol fuel subsidies borne by general fund.
Subtitle F--Stock Options and Employee Stock Purchase Plan Stock Options
Sec. 261. Exclusion of incentive stock options and employee stock purchase plan stock options from wages.
Subtitle G--Incentives to Reinvest Foreign Earnings in United States
Sec. 271. Incentives to reinvest foreign earnings in United States.
Subtitle H--Other Incentive Provisions
Sec. 281. Special rules for livestock sold on account of weather-related conditions.
Sec. 282. Payment of dividends on stock of cooperatives without reducing patronage dividends.
Sec. 283. Capital gain treatment under section 631(b) to apply to outright sales by landowners.
Sec. 284. Distributions from publicly traded partnerships treated as qualifying income of regulated investment companies.
Sec. 285. Improvements related to real estate investment trusts.
Sec. 286. Treatment of certain dividends of regulated investment companies.
Sec. 287. Taxation of certain settlement funds.
Sec. 288. Expansion of human clinical trials qualifying for orphan drug credit.
Sec. 289. Simplification of excise tax imposed on bows and arrows.
Sec. 290. Repeal of excise tax on fishing tackle boxes.
Sec. 291. Sonar devices suitable for finding fish.
Sec. 292. Income tax credit to distilled spirits wholesalers for cost of carrying Federal excise taxes on bottled distilled spirits.
Sec. 293. Suspension of occupational taxes relating to distilled spirits, wine, and beer.
Sec. 294. Modification of unrelated business income limitation on investment in certain small business investment companies.
Sec. 295. Election to determine taxable income from certain international shipping activities using per ton rate.
Sec. 296. Charitable contribution deduction for certain expenses incurred in support of Native Alaskan subsistence whaling.
TITLE III--TAX REFORM AND SIMPLIFICATION FOR UNITED STATES BUSINESSES
Sec. 301. Interest expense allocation rules.
Sec. 302. Recharacterization of overall domestic loss.
Sec. 303. Reduction to 2 foreign tax credit baskets.
Sec. 304. Look-thru rules to apply to dividends from noncontrolled section 902 corporations.
Sec. 305. Attribution of stock ownership through partnerships to apply in determining section 902 and 960 credits.
Sec. 306. Clarification of treatment of certain transfers of intangible property.
Sec. 307. United States property not to include certain assets of controlled foreign corporation.
Sec. 308. Election not to use average exchange rate for foreign tax paid other than in functional currency.
Sec. 309. Repeal of withholding tax on dividends from certain foreign corporations.
Sec. 310. Provide equal treatment for interest paid by foreign partnerships and foreign corporations.
Sec. 311. Look-thru treatment of payments between related controlled foreign corporations under foreign personal holding company income rules.
Sec. 312. Look-thru treatment for sales of partnership interests.
Sec. 313. Repeal of foreign personal holding company rules and foreign investment company rules.
Sec. 314. Determination of foreign personal holding company income with respect to transactions in commodities.
Sec. 315. Modifications to treatment of aircraft leasing and shipping income.
Sec. 316. Modification of exceptions under subpart F for active financing.
TITLE IV--EXTENSION OF CERTAIN EXPIRING PROVISIONS
Sec. 401. Allowance of nonrefundable personal credits against regular and minimum tax liability.
Sec. 402. Extension of research credit.
Sec. 403. Extension of credit for electricity produced from certain renewable resources.
Sec. 404. Indian employment tax credit.
Sec. 405. Work opportunity credit.
Sec. 406. Welfare-to-work credit.
Sec. 407. Certain expenses of elementary and secondary school teachers.
Sec. 408. Extension of accelerated depreciation benefit for property on Indian reservations.
Sec. 409. Charitable contributions of computer technology and equipment used for educational purposes.
Sec. 410. Expensing of environmental remediation costs.
Sec. 411. Availability of medical savings accounts.
Sec. 412. Taxable income limit on percentage depletion for oil and natural gas produced from marginal properties.
Sec. 413. Qualified zone academy bonds.
Sec. 414. District of Columbia.
Sec. 415. Extension of certain New York Liberty Zone bond financing.
Sec. 416. Disclosures relating to terrorist activities.
Sec. 417. Disclosure of return information relating to student loans.
Sec. 418. Cover over of tax on distilled spirits.
Sec. 419. Joint review of strategic plans and budget for the Internal Revenue Service.
Sec. 420. Parity in the application of certain limits to mental health benefits.
Sec. 421. Combined employment tax reporting project.
Sec. 422. Clean-fuel vehicles.
TITLE V--DEDUCTION OF STATE AND LOCAL GENERAL SALES TAXES
Sec. 501. Deduction of State and local general sales taxes in lieu of State and local income taxes.
TITLE VI--REVENUE PROVISIONS
Subtitle A--Provisions to Reduce Tax Avoidance Through Individual and Corporate Expatriation
Sec. 601. Tax treatment of expatriated entities and their foreign parents.
Sec. 602. Excise tax on stock compensation of insiders in expatriated corporations.
Sec. 603. Reinsurance of United States risks in foreign jurisdictions.
Sec. 604. Revision of tax rules on expatriation of individuals.
Sec. 605. Reporting of taxable mergers and acquisitions.
Sec. 606. Studies.
Subtitle B--Provisions Relating to Tax Shelters
Part I--Taxpayer-Related Provisions
Sec. 611. Penalty for failing to disclose reportable transactions.
Sec. 612. Accuracy-related penalty for listed transactions, other reportable transactions having a significant tax avoidance purpose, etc.
Sec. 613. Tax shelter exception to confidentiality privileges relating to taxpayer communications.
Sec. 614. Statute of limitations for taxable years for which required listed transactions not reported.
Sec. 615. Disclosure of reportable transactions.
Sec. 616. Failure to furnish information regarding reportable transactions.
Sec. 617. Modification of penalty for failure to maintain lists of investors.
Sec. 618. Penalty on promoters of tax shelters.
Sec. 619. Modifications of substantial understatement penalty for nonreportable transactions.
Sec. 620. Modification of actions to enjoin certain conduct related to tax shelters and reportable transactions.
Sec. 621. Penalty on failure to report interests in foreign financial accounts.
Sec. 622. Regulation of individuals practicing before the Department of the Treasury.
Part II--Other Provisions
Sec. 631. Treatment of stripped interests in bond and preferred stock funds, etc.
Sec. 632. Minimum holding period for foreign tax credit on withholding taxes on income other than dividends.
Sec. 633. Disallowance of certain partnership loss transfers.
Sec. 634. No reduction of basis under section 734 in stock held by partnership in corporate partner.
Sec. 635. Repeal of special rules for FASITs.
Sec. 636. Limitation on transfer of built-in losses on REMIC residuals.
Sec. 637. Clarification of banking business for purposes of determining investment of earnings in United States property.
Sec. 638. Alternative tax for certain small insurance companies.
Sec. 639. Denial of deduction for interest on underpayments attributable to nondisclosed reportable transactions.
Sec. 640. Clarification of rules for payment of estimated tax for certain deemed asset sales.
Sec. 641. Recognition of gain from the sale of a principal residence acquired in a like-kind exchange within 5 years of sale.
Sec. 642. Prevention of mismatching of interest and original issue discount deductions and income inclusions in transactions with related foreign persons.
Sec. 643. Exclusion from gross income for interest on overpayments of income tax by individuals.
Sec. 644. Deposits made to suspend running of interest on potential underpayments.
Sec. 645. Partial payment of tax liability in installment agreements.
Sec. 646. Affirmation of consolidated return regulation authority.
Part III--Leasing
Sec. 647. Reform of tax treatment of certain leasing arrangements.
Sec. 648. Limitation on deductions allocable to property used by governments or other tax-exempt entities.
Sec. 649. Effective date.
Subtitle C--Reduction of Fuel Tax Evasion
Sec. 651. Exemption from certain excise taxes for mobile machinery.
Sec. 652. Taxation of aviation-grade kerosene.
Sec. 653. Dye injection equipment.
Sec. 654. Authority to inspect on-site records.
Sec. 655. Registration of pipeline or vessel operators required for exemption of bulk transfers to registered terminals or refineries.
Sec. 656. Display of registration.
Sec. 657. Penalties for failure to register and failure to report.
Sec. 658. Collection from customs bond where importer not registered.
Sec. 659. Modifications of tax on use of certain vehicles.
Sec. 660. Modification of ultimate vendor refund claims with respect to farming.
Sec. 661. Dedication of revenues from certain penalties to the Highway Trust Fund.
Sec. 662. Taxable fuel refunds for certain ultimate vendors.
Sec. 663. Two-party exchanges.
Sec. 664. Simplification of tax on tires.
Subtitle D--Nonqualified Deferred Compensation Plans
Sec. 671. Treatment of nonqualified deferred compensation plans.
Subtitle E--Other Revenue Provisions
Sec. 681. Qualified tax collection contracts.
Sec. 682. Treatment of charitable contributions of patents and similar property.
Sec. 683. Increased reporting for noncash charitable contributions.
Sec. 684. Donations of motor vehicles, boats, and aircraft.
Sec. 685. Extension of amortization of intangibles to sports franchises.
Sec. 686. Modification of continuing levy on payments to Federal venders.
Sec. 687. Modification of straddle rules.
Sec. 688. Addition of vaccines against hepatitis A to list of taxable vaccines.
Sec. 689. Addition of vaccines against influenza to list of taxable vaccines.
Sec. 690. Extension of IRS user fees.
Sec. 691. COBRA fees.
TITLE VII--MARKET REFORM FOR TOBACCO GROWERS
Sec. 701. Short title.
Sec. 702. Effective date.
Subtitle A--Termination of Federal Tobacco Quota and Price Support Programs
Sec. 711. Termination of tobacco quota program and related provisions.
Sec. 712. Termination of tobacco price support program and related provisions.
Sec. 713. Liability.
Subtitle B--Transitional Payments to Tobacco Quota Holders and Active Producers of Tobacco
Sec. 721. Definitions of active tobacco producer and quota holder.
Sec. 722. Payments to tobacco quota holders.
Sec. 723. Transition payments for active producers of quota tobacco.
Sec. 724. Resolution of disputes.
Sec. 725. Source of funds for payments.
TITLE VIII--TRADE PROVISIONS
Sec. 801. Ceiling fans.
Sec. 802. Certain steam generators, and certain reactor vessel heads, used in nuclear facilities.

TITLE I--END SANCTIONS AND REDUCE CORPORATE TAX RATES FOR DOMESTIC MANUFACTURING AND SMALL CORPORATIONS

SEC. 101. REPEAL OF EXCLUSION FOR EXTRATERRITORIAL INCOME.

SEC. 102. REDUCED CORPORATE INCOME TAX RATE FOR DOMESTIC PRODUCTION ACTIVITIES INCOME.

SEC. 103. REDUCED CORPORATE INCOME TAX RATE FOR SMALL CORPORATIONS.

`If taxable income is:
The tax is:
Not over $50,000
15% of taxable income.
Over $50,000 but not over $75,000
$7,500, plus 25% of the excess over $50,000.
Over $75,000 but not over $20,000,000
$13,750, plus 32% of the excess over $75,000.
Over $20,000,000
$6,389,750, plus 35% of the excess over $20,000,000.

`If taxable income is:
The tax is:
Not over $50,000
15% of taxable income.
Over $50,000 but not over $75,000
$7,500, plus 25% of the excess over $50,000.
Over $75,000 but not over $5,000,000
$13,750, plus 32% of the excess over $75,000.
Over $5,000,000 but not over $10,000,000
$1,589,750, plus 34% of the excess over $5,000,000.
Over $10,000,000
$3,289,750, plus 35% of the excess over $10,000,000.

`If taxable income is:
The tax is:
Not over $50,000
15% of taxable income.
Over $50,000 but not over $75,000
$7,500, plus 25% of the excess over $50,000.
Over $75,000 but not over $1,000,000
$13,750, plus 32% of the excess over $75,000.
Over $1,000,000 but not over $10,000,000
$309,750, plus 34% of the excess over $1,000,000.
Over $10,000,000
$3,369,750, plus 35% of the excess over $10,000,000.

`If taxable income is:
The tax is:
Not over $50,000
15% of taxable income.
Over $50,000 but not over $75,000
$7,500, plus 25% of the excess over $50,000.
Over $75,000 but not over $1,000,000
$13,750, plus 33% of the excess over $75,000.
Over $1,000,000 but not over $10,000,000
$319,000, plus 34% of the excess over $1,000,000.
Over $10,000,000
$3,379,000, plus 35% of the excess over $10,000,000. 



---------------------------------------------------------------------------------------------------------------


 `In the case of any taxable year  beginning during: The applicable amount is: The maximum increase amount is: 


---------------------------------------------------------------------------------------------------------------


2005, 2006, or 2007                                                 $1,000,000                         $21,000 


2008, 2009, or 2010                                                 $1,000,000                         $30,250 


2011 or 2012                                                        $5,000,000                       $110,250. 


---------------------------------------------------------------------------------------------------------------




















TITLE II--JOB CREATION TAX INCENTIVES FOR MANUFACTURERS, SMALL BUSINESSES, AND FARMERS


Subtitle A--Small Business Expensing


SEC. 201. 2-YEAR EXTENSION OF INCREASED EXPENSING FOR SMALL BUSINESS.




Subtitle B--Depreciation


SEC. 211. RECOVERY PERIOD FOR DEPRECIATION OF CERTAIN LEASEHOLD IMPROVEMENTS AND RESTAURANT PROPERTY.
















































   `(E)(iv)
39   


   `(E)(v)
39'.  






SEC. 212. MODIFICATION OF DEPRECIATION ALLOWANCE FOR AIRCRAFT.










































SEC. 213. MODIFICATION OF PLACED IN SERVICE RULE FOR BONUS DEPRECIATION PROPERTY.
















Subtitle C--S Corporation Reform and Simplification


SEC. 221. MEMBERS OF FAMILY TREATED AS 1 SHAREHOLDER.






































SEC. 222. INCREASE IN NUMBER OF ELIGIBLE SHAREHOLDERS TO 100.






SEC. 223. EXPANSION OF BANK S CORPORATION ELIGIBLE SHAREHOLDERS TO INCLUDE IRAS.






























SEC. 224. DISREGARD OF UNEXERCISED POWERS OF APPOINTMENT IN DETERMINING POTENTIAL CURRENT BENEFICIARIES OF ESBT.










SEC. 225. TRANSFER OF SUSPENDED LOSSES INCIDENT TO DIVORCE, ETC.












SEC. 226. USE OF PASSIVE ACTIVITY LOSS AND AT-RISK AMOUNTS BY QUALIFIED SUBCHAPTER S TRUST INCOME BENEFICIARIES.














SEC. 227. EXCLUSION OF INVESTMENT SECURITIES INCOME FROM PASSIVE INCOME TEST FOR BANK S CORPORATIONS.












SEC. 228. TREATMENT OF BANK DIRECTOR SHARES.


















 `For treatment of certain distributions with respect to restricted bank director stock, see section 1368(f).'.













SEC. 229. RELIEF FROM INADVERTENTLY INVALID QUALIFIED SUBCHAPTER S SUBSIDIARY ELECTIONS AND TERMINATIONS.




















SEC. 230. INFORMATION RETURNS FOR QUALIFIED SUBCHAPTER S SUBSIDIARIES.






SEC. 231. REPAYMENT OF LOANS FOR QUALIFYING EMPLOYER SECURITIES.








Subtitle D--Alternative Minimum Tax Relief


SEC. 241. FOREIGN TAX CREDIT UNDER ALTERNATIVE MINIMUM TAX.










SEC. 242. EXPANSION OF EXEMPTION FROM ALTERNATIVE MINIMUM TAX FOR SMALL CORPORATIONS.






SEC. 243. INCOME AVERAGING FOR FARMERS NOT TO INCREASE ALTERNATIVE MINIMUM TAX.








Subtitle E--Restructuring of Incentives for Alcohol Fuels, Etc.


SEC. 251. REDUCED RATES OF TAX ON GASOHOL REPLACED WITH EXCISE TAX CREDIT; REPEAL OF OTHER ALCOHOL-BASED FUEL INCENTIVES; ETC.




























































































SEC. 252. ALCOHOL FUEL SUBSIDIES BORNE BY GENERAL FUND.














Subtitle F--Stock Options and Employee Stock Purchase Plan Stock Options


SEC. 261. EXCLUSION OF INCENTIVE STOCK OPTIONS AND EMPLOYEE STOCK PURCHASE PLAN STOCK OPTIONS FROM WAGES.












































Subtitle G--Incentives to Reinvest Foreign Earnings in United States


SEC. 271. INCENTIVES TO REINVEST FOREIGN EARNINGS IN UNITED STATES.




`SEC. 965. TEMPORARY DIVIDENDS RECEIVED DEDUCTION.






















































































































`Sec. 965. Temporary dividends received deduction.'.





Subtitle H--Other Incentive Provisions


SEC. 281. SPECIAL RULES FOR LIVESTOCK SOLD ON ACCOUNT OF WEATHER-RELATED CONDITIONS.






















SEC. 282. PAYMENT OF DIVIDENDS ON STOCK OF COOPERATIVES WITHOUT REDUCING PATRONAGE DIVIDENDS.






SEC. 283. CAPITAL GAIN TREATMENT UNDER SECTION 631(b) TO APPLY TO OUTRIGHT SALES BY LANDOWNERS.












SEC. 284. DISTRIBUTIONS FROM PUBLICLY TRADED PARTNERSHIPS TREATED AS QUALIFYING INCOME OF REGULATED INVESTMENT COMPANIES.






































SEC. 285. IMPROVEMENTS RELATED TO REAL ESTATE INVESTMENT TRUSTS.




















































































































































































SEC. 286. TREATMENT OF CERTAIN DIVIDENDS OF REGULATED INVESTMENT COMPANIES.






































































































































SEC. 287. TAXATION OF CERTAIN SETTLEMENT FUNDS.






















SEC. 288. EXPANSION OF HUMAN CLINICAL TRIALS QUALIFYING FOR ORPHAN DRUG CREDIT.








SEC. 289. SIMPLIFICATION OF EXCISE TAX IMPOSED ON BOWS AND ARROWS.










































SEC. 290. REPEAL OF EXCISE TAX ON FISHING TACKLE BOXES.






SEC. 291. SONAR DEVICES SUITABLE FOR FINDING FISH.








SEC. 292. INCOME TAX CREDIT TO DISTILLED SPIRITS WHOLESALERS FOR COST OF CARRYING FEDERAL EXCISE TAXES ON BOTTLED DISTILLED SPIRITS.




`SEC. 5011. INCOME TAX CREDIT FOR WHOLESALER'S AVERAGE COST OF CARRYING EXCISE TAX.






































`Sec. 5011. Income tax credit for wholesaler's average cost of carrying excise tax.'.





SEC. 293. SUSPENSION OF OCCUPATIONAL TAXES RELATING TO DISTILLED SPIRITS, WINE, AND BEER.




`SEC. 5148. SUSPENSION OF OCCUPATIONAL TAX.














`Sec. 5148. Suspension of occupational tax.

`Sec. 5149. Cross references.'.





SEC. 294. MODIFICATION OF UNRELATED BUSINESS INCOME LIMITATION ON INVESTMENT IN CERTAIN SMALL BUSINESS INVESTMENT COMPANIES.
























SEC. 295. ELECTION TO DETERMINE TAXABLE INCOME FROM CERTAIN INTERNATIONAL SHIPPING ACTIVITIES USING PER TON RATE.




`SUBCHAPTER R--ELECTION TO DETERMINE TAXABLE INCOME FROM CERTAIN INTERNATIONAL SHIPPING ACTIVITIES USING PER TON RATE




`Sec. 1352. Alternative tax on qualifying shipping activities.

`Sec. 1353. Taxable income from qualifying shipping activities.

`Sec. 1354. Qualifying shipping tax election; revocation; termination.

`Sec. 1355. Definitions and special rules.

`Sec. 1356. Qualifying shipping activities.

`Sec. 1357. Items not subject to regular tax; depreciation; interest.

`Sec. 1358. Allocation of credits, income, and deductions.

`Sec. 1359. Disposition of qualifying shipping assets.



`SEC. 1352. ALTERNATIVE TAX ON QUALIFYING SHIPPING ACTIVITIES.






`SEC. 1353. TAXABLE INCOME FROM QUALIFYING SHIPPING ACTIVITIES.
















`SEC. 1354. QUALIFYING SHIPPING TAX ELECTION; REVOCATION; TERMINATION.
































`SEC. 1355. DEFINITIONS AND SPECIAL RULES.
































































































`SEC. 1356. QUALIFYING SHIPPING ACTIVITIES.














































`SEC. 1357. ITEMS NOT SUBJECT TO REGULAR TAX; DEPRECIATION; INTEREST.


























`SEC. 1358. ALLOCATION OF CREDITS, INCOME, AND DEDUCTIONS.
















`SEC. 1359. DISPOSITION OF QUALIFYING SHIPPING ASSETS.




























SEC. 296. CHARITABLE CONTRIBUTION DEDUCTION FOR CERTAIN EXPENSES INCURRED IN SUPPORT OF NATIVE ALASKAN SUBSISTENCE WHALING.
























TITLE III--TAX REFORM AND SIMPLIFICATION FOR UNITED STATES BUSINESSES


SEC. 301. INTEREST EXPENSE ALLOCATION RULES.




































































































SEC. 302. RECHARACTERIZATION OF OVERALL DOMESTIC LOSS.




































SEC. 303. REDUCTION TO 2 FOREIGN TAX CREDIT BASKETS.










































































































SEC. 304. LOOK-THRU RULES TO APPLY TO DIVIDENDS FROM NONCONTROLLED SECTION 902 CORPORATIONS.
















































SEC. 305. ATTRIBUTION OF STOCK OWNERSHIP THROUGH PARTNERSHIPS TO APPLY IN DETERMINING SECTION 902 AND 960 CREDITS.










SEC. 306. CLARIFICATION OF TREATMENT OF CERTAIN TRANSFERS OF INTANGIBLE PROPERTY.






SEC. 307. UNITED STATES PROPERTY NOT TO INCLUDE CERTAIN ASSETS OF CONTROLLED FOREIGN CORPORATION.
























SEC. 308. ELECTION NOT TO USE AVERAGE EXCHANGE RATE FOR FOREIGN TAX PAID OTHER THAN IN FUNCTIONAL CURRENCY.














SEC. 309. REPEAL OF WITHHOLDING TAX ON DIVIDENDS FROM CERTAIN FOREIGN CORPORATIONS.








SEC. 310. PROVIDE EQUAL TREATMENT FOR INTEREST PAID BY FOREIGN PARTNERSHIPS AND FOREIGN CORPORATIONS.








SEC. 311. LOOK-THRU TREATMENT OF PAYMENTS BETWEEN RELATED CONTROLLED FOREIGN CORPORATIONS UNDER FOREIGN PERSONAL HOLDING COMPANY INCOME RULES.








SEC. 312. LOOK-THRU TREATMENT FOR SALES OF PARTNERSHIP INTERESTS.












SEC. 313. REPEAL OF FOREIGN PERSONAL HOLDING COMPANY RULES AND FOREIGN INVESTMENT COMPANY RULES.


























































































































































































SEC. 314. DETERMINATION OF FOREIGN PERSONAL HOLDING COMPANY INCOME WITH RESPECT TO TRANSACTIONS IN COMMODITIES.
































SEC. 315. MODIFICATIONS TO TREATMENT OF AIRCRAFT LEASING AND SHIPPING INCOME.
























SEC. 316. MODIFICATION OF EXCEPTIONS UNDER SUBPART F FOR ACTIVE FINANCING.














TITLE IV--EXTENSION OF CERTAIN EXPIRING PROVISIONS


SEC. 401. ALLOWANCE OF NONREFUNDABLE PERSONAL CREDITS AGAINST REGULAR AND MINIMUM TAX LIABILITY.
















SEC. 402. EXTENSION OF RESEARCH CREDIT.










SEC. 403. EXTENSION OF CREDIT FOR ELECTRICITY PRODUCED FROM CERTAIN RENEWABLE RESOURCES.






SEC. 404. INDIAN EMPLOYMENT TAX CREDIT.




SEC. 405. WORK OPPORTUNITY CREDIT.






SEC. 406. WELFARE-TO-WORK CREDIT.






SEC. 407. CERTAIN EXPENSES OF ELEMENTARY AND SECONDARY SCHOOL TEACHERS.






SEC. 408. EXTENSION OF ACCELERATED DEPRECIATION BENEFIT FOR PROPERTY ON INDIAN RESERVATIONS.




SEC. 409. CHARITABLE CONTRIBUTIONS OF COMPUTER TECHNOLOGY AND EQUIPMENT USED FOR EDUCATIONAL PURPOSES.






SEC. 410. EXPENSING OF ENVIRONMENTAL REMEDIATION COSTS.






SEC. 411. AVAILABILITY OF MEDICAL SAVINGS ACCOUNTS.


























SEC. 412. TAXABLE INCOME LIMIT ON PERCENTAGE DEPLETION FOR OIL AND NATURAL GAS PRODUCED FROM MARGINAL PROPERTIES.






SEC. 413. QUALIFIED ZONE ACADEMY BONDS.






SEC. 414. DISTRICT OF COLUMBIA.






















SEC. 415. EXTENSION OF CERTAIN NEW YORK LIBERTY ZONE BOND FINANCING.




SEC. 416. DISCLOSURES RELATING TO TERRORIST ACTIVITIES.














SEC. 417. DISCLOSURE OF RETURN INFORMATION RELATING TO STUDENT LOANS.




SEC. 418. COVER OVER OF TAX ON DISTILLED SPIRITS.






SEC. 419. JOINT REVIEW OF STRATEGIC PLANS AND BUDGET FOR THE INTERNAL REVENUE SERVICE.












SEC. 420. PARITY IN THE APPLICATION OF CERTAIN LIMITS TO MENTAL HEALTH BENEFITS.










SEC. 421. COMBINED EMPLOYMENT TAX REPORTING PROJECT.






SEC. 422. CLEAN-FUEL VEHICLES.












TITLE V--DEDUCTION OF STATE AND LOCAL GENERAL SALES TAXES


SEC. 501. DEDUCTION OF STATE AND LOCAL GENERAL SALES TAXES IN LIEU OF STATE AND LOCAL INCOME TAXES.


















































TITLE VI--REVENUE PROVISIONS


Subtitle A--Provisions to Reduce Tax Avoidance Through Individual and Corporate Expatriation


SEC. 601. TAX TREATMENT OF EXPATRIATED ENTITIES AND THEIR FOREIGN PARENTS.




`SEC. 7874. RULES RELATING TO EXPATRIATED ENTITIES AND THEIR FOREIGN PARENTS.






















































































































`Sec. 7874. Rules relating to expatriated entities and their foreign parents.'





SEC. 602. EXCISE TAX ON STOCK COMPENSATION OF INSIDERS IN EXPATRIATED CORPORATIONS.




`CHAPTER 45--PROVISIONS RELATING TO EXPATRIATED ENTITIES




`Sec. 4985. Stock compensation of insiders in expatriated corporations.



`SEC. 4985. STOCK COMPENSATION OF INSIDERS IN EXPATRIATED CORPORATIONS.
























































































`Chapter 45. Provisions relating to expatriated entities.'





SEC. 603. REINSURANCE OF UNITED STATES RISKS IN FOREIGN JURISDICTIONS.






SEC. 604. REVISION OF TAX RULES ON EXPATRIATION OF INDIVIDUALS.








































































































































































SEC. 605. REPORTING OF TAXABLE MERGERS AND ACQUISITIONS.




`SEC. 6043A. RETURNS RELATING TO TAXABLE MERGERS AND ACQUISITIONS.














































`Sec. 6043A. Returns relating to taxable mergers and acquisitions.'.





SEC. 606. STUDIES.








Subtitle B--Provisions Relating to Tax Shelters


Part I--Taxpayer-Related Provisions


SEC. 611. PENALTY FOR FAILING TO DISCLOSE REPORTABLE TRANSACTIONS.




`SEC. 6707A. PENALTY FOR FAILURE TO INCLUDE REPORTABLE TRANSACTION INFORMATION WITH RETURN.
















































`Sec. 6707A. Penalty for failure to include reportable transaction information with return.'











SEC. 612. ACCURACY-RELATED PENALTY FOR LISTED TRANSACTIONS, OTHER REPORTABLE TRANSACTIONS HAVING A SIGNIFICANT TAX AVOIDANCE PURPOSE, ETC.




`SEC. 6662A. IMPOSITION OF ACCURACY-RELATED PENALTY ON UNDERSTATEMENTS WITH RESPECT TO REPORTABLE TRANSACTIONS.


































































































































`SEC. 6662. IMPOSITION OF ACCURACY-RELATED PENALTY ON UNDERPAYMENTS.'






`Sec. 6662. Imposition of accuracy-related penalty on underpayments.

`Sec. 6662A. Imposition of accuracy-related penalty on understatements with respect to reportable transactions.'





SEC. 613. TAX SHELTER EXCEPTION TO CONFIDENTIALITY PRIVILEGES RELATING TO TAXPAYER COMMUNICATIONS.


















SEC. 614. STATUTE OF LIMITATIONS FOR TAXABLE YEARS FOR WHICH REQUIRED LISTED TRANSACTIONS NOT REPORTED.












SEC. 615. DISCLOSURE OF REPORTABLE TRANSACTIONS.




`SEC. 6111. DISCLOSURE OF REPORTABLE TRANSACTIONS.












































`Sec. 6111. Disclosure of reportable transactions.'





`SEC. 6112. MATERIAL ADVISORS OF REPORTABLE TRANSACTIONS MUST KEEP LISTS OF ADVISEES, ETC.




















`Sec. 6112. Material advisors of reportable transactions must keep lists of advisees, etc.'





`SEC. 6708. FAILURE TO MAINTAIN LISTS OF ADVISEES WITH RESPECT TO REPORTABLE TRANSACTIONS.'






`Sec. 6708. Failure to maintain lists of advisees with respect to reportable transactions.'













SEC. 616. FAILURE TO FURNISH INFORMATION REGARDING REPORTABLE TRANSACTIONS.




`SEC. 6707. FAILURE TO FURNISH INFORMATION REGARDING REPORTABLE TRANSACTIONS.






























SEC. 617. MODIFICATION OF PENALTY FOR FAILURE TO MAINTAIN LISTS OF INVESTORS.












SEC. 618. PENALTY ON PROMOTERS OF TAX SHELTERS.






SEC. 619. MODIFICATIONS OF SUBSTANTIAL UNDERSTATEMENT PENALTY FOR NONREPORTABLE TRANSACTIONS.












SEC. 620. MODIFICATION OF ACTIONS TO ENJOIN CERTAIN CONDUCT RELATED TO TAX SHELTERS AND REPORTABLE TRANSACTIONS.




















`SEC. 7408. ACTIONS TO ENJOIN SPECIFIED CONDUCT RELATED TO TAX SHELTERS AND REPORTABLE TRANSACTIONS.'






`Sec. 7408. Actions to enjoin specified conduct related to tax shelters and reportable transactions.'





SEC. 621. PENALTY ON FAILURE TO REPORT INTERESTS IN FOREIGN FINANCIAL ACCOUNTS.




































SEC. 622. REGULATION OF INDIVIDUALS PRACTICING BEFORE THE DEPARTMENT OF THE TREASURY.


















Part II--Other Provisions


SEC. 631. TREATMENT OF STRIPPED INTERESTS IN BOND AND PREFERRED STOCK FUNDS, ETC.












 `For treatment of stripped interests in certain accounts or entities holding preferred stock, see section 1286(f).'





SEC. 632. MINIMUM HOLDING PERIOD FOR FOREIGN TAX CREDIT ON WITHHOLDING TAXES ON INCOME OTHER THAN DIVIDENDS.










































SEC. 633. DISALLOWANCE OF CERTAIN PARTNERSHIP LOSS TRANSFERS.










































































`SEC. 743. SPECIAL RULES WHERE SECTION 754 ELECTION OR SUBSTANTIAL BUILT-IN LOSS.'






`Sec. 743. Special rules where section 754 election or substantial built-in loss.'



















 `For regulations to carry out this subsection, see section 743(d)(2).'







`SEC. 734. ADJUSTMENT TO BASIS OF UNDISTRIBUTED PARTNERSHIP PROPERTY WHERE SECTION 754 ELECTION OR SUBSTANTIAL BASIS REDUCTION.'






`Sec. 734. Adjustment to basis of undistributed partnership property where section 754 election or substantial basis reduction.'















SEC. 634. NO REDUCTION OF BASIS UNDER SECTION 734 IN STOCK HELD BY PARTNERSHIP IN CORPORATE PARTNER.














SEC. 635. REPEAL OF SPECIAL RULES FOR FASITS.




























































SEC. 636. LIMITATION ON TRANSFER OF BUILT-IN LOSSES ON REMIC RESIDUALS.














SEC. 637. CLARIFICATION OF BANKING BUSINESS FOR PURPOSES OF DETERMINING INVESTMENT OF EARNINGS IN UNITED STATES PROPERTY.






















SEC. 638. ALTERNATIVE TAX FOR CERTAIN SMALL INSURANCE COMPANIES.
















SEC. 639. DENIAL OF DEDUCTION FOR INTEREST ON UNDERPAYMENTS ATTRIBUTABLE TO NONDISCLOSED REPORTABLE TRANSACTIONS.








SEC. 640. CLARIFICATION OF RULES FOR PAYMENT OF ESTIMATED TAX FOR CERTAIN DEEMED ASSET SALES.






SEC. 641. RECOGNITION OF GAIN FROM THE SALE OF A PRINCIPAL RESIDENCE ACQUIRED IN A LIKE-KIND EXCHANGE WITHIN 5 YEARS OF SALE.








SEC. 642. PREVENTION OF MISMATCHING OF INTEREST AND ORIGINAL ISSUE DISCOUNT DEDUCTIONS AND INCOME INCLUSIONS IN TRANSACTIONS WITH RELATED FOREIGN PERSONS.


























SEC. 643. EXCLUSION FROM GROSS INCOME FOR INTEREST ON OVERPAYMENTS OF INCOME TAX BY INDIVIDUALS.




`SEC. 139B. EXCLUSION FROM GROSS INCOME FOR INTEREST ON OVERPAYMENTS OF INCOME TAX BY INDIVIDUALS.












`Sec. 139B. Exclusion from gross income for interest on overpayments of income tax by individuals.'.





SEC. 644. DEPOSITS MADE TO SUSPEND RUNNING OF INTEREST ON POTENTIAL UNDERPAYMENTS.




`SEC. 6603. DEPOSITS MADE TO SUSPEND RUNNING OF INTEREST ON POTENTIAL UNDERPAYMENTS, ETC.








































`Sec. 6603. Deposits made to suspend running of interest on potential underpayments, etc.'.









SEC. 645. PARTIAL PAYMENT OF TAX LIABILITY IN INSTALLMENT AGREEMENTS.


















SEC. 646. AFFIRMATION OF CONSOLIDATED RETURN REGULATION AUTHORITY.








Part III--Leasing


SEC. 647. REFORM OF TAX TREATMENT OF CERTAIN LEASING ARRANGEMENTS.


















SEC. 648. LIMITATION ON DEDUCTIONS ALLOCABLE TO PROPERTY USED BY GOVERNMENTS OR OTHER TAX-EXEMPT ENTITIES.




`SEC. 470. LIMITATION ON DEDUCTIONS ALLOCABLE TO PROPERTY USED BY GOVERNMENTS OR OTHER TAX-EXEMPT ENTITIES.






































































































































`Sec. 470. Limitation on deductions allocable to property used by governments or other tax-exempt entities.'.



SEC. 649. EFFECTIVE DATE.


















Subtitle C--Reduction of Fuel Tax Evasion


SEC. 651. EXEMPTION FROM CERTAIN EXCISE TAXES FOR MOBILE MACHINERY.






























































SEC. 652. TAXATION OF AVIATION-GRADE KEROSENE.




































































































































































`Subpart A. Motor and aviation fuels.

`Subpart B. Special provisions applicable to fuels tax.'.





`Subpart A--Motor and Aviation Fuels'.




`Subpart B--Special Provisions Applicable to Fuels Tax'.




























SEC. 653. DYE INJECTION EQUIPMENT.










`SEC. 6715A. TAMPERING WITH OR FAILING TO MAINTAIN SECURITY REQUIREMENTS FOR MECHANICAL DYE INJECTION SYSTEMS.
































`Sec. 6715A. Tampering with or failing to maintain security requirements for mechanical dye injection systems.'.





SEC. 654. AUTHORITY TO INSPECT ON-SITE RECORDS.








SEC. 655. REGISTRATION OF PIPELINE OR VESSEL OPERATORS REQUIRED FOR EXEMPTION OF BULK TRANSFERS TO REGISTERED TERMINALS OR REFINERIES.












SEC. 656. DISPLAY OF REGISTRATION.
















`SEC. 6717. FAILURE TO DISPLAY TAX REGISTRATION ON VESSELS.












`Sec. 6717. Failure to display tax registration on vessels.'.









SEC. 657. PENALTIES FOR FAILURE TO REGISTER AND FAILURE TO REPORT.










`SEC. 6718. FAILURE TO REGISTER.
















`Sec. 6718. Failure to register.'.







`SEC. 6725. FAILURE TO REPORT INFORMATION UNDER SECTION 4101.
















`Sec. 6725. Failure to report information under section 4101.'.





SEC. 658. COLLECTION FROM CUSTOMS BOND WHERE IMPORTER NOT REGISTERED.




`SEC. 4104. COLLECTION FROM CUSTOMS BOND WHERE IMPORTER NOT REGISTERED.










`Sec. 4104. Collection from Customs bond where importer not registered.'.





SEC. 659. MODIFICATIONS OF TAX ON USE OF CERTAIN VEHICLES.






















SEC. 660. MODIFICATION OF ULTIMATE VENDOR REFUND CLAIMS WITH RESPECT TO FARMING.










































SEC. 661. DEDICATION OF REVENUES FROM CERTAIN PENALTIES TO THE HIGHWAY TRUST FUND.














SEC. 662. TAXABLE FUEL REFUNDS FOR CERTAIN ULTIMATE VENDORS.














SEC. 663. TWO-PARTY EXCHANGES.




`SEC. 4105. TWO-PARTY EXCHANGES.


















`Sec. 4105. Two-party exchanges.'.





SEC. 664. SIMPLIFICATION OF TAX ON TIRES.












`SEC. 4073. EXEMPTIONS.












`Sec. 4073. Exemptions.'





Subtitle D--Nonqualified Deferred Compensation Plans


SEC. 671. TREATMENT OF NONQUALIFIED DEFERRED COMPENSATION PLANS.




`SEC. 409A. INCLUSION IN GROSS INCOME OF DEFERRED COMPENSATION UNDER NONQUALIFIED DEFERRED COMPENSATION PLANS.








































































































































`Sec. 409A. Inclusion in gross income of deferred compensation under nonqualified deferred compensation plans.'.















Subtitle E--Other Revenue Provisions


SEC. 681. QUALIFIED TAX COLLECTION CONTRACTS.






`SEC. 6306. QUALIFIED TAX COLLECTION CONTRACTS.




































 `(1) For damages for certain unauthorized collection actions by persons performing services under a qualified tax collection contract, see section 7433A.

 `(2) For application of Taxpayer Assistance Orders to persons performing services under a qualified tax collection contract, see section 7811(a)(4).'.











`Sec. 6306. Qualified Tax Collection Contracts.'.







`SEC. 7433A. CIVIL DAMAGES FOR CERTAIN UNAUTHORIZED COLLECTION ACTIONS BY PERSONS PERFORMING SERVICES UNDER QUALIFIED TAX COLLECTION CONTRACTS.


















`Sec. 7433A. Civil damages for certain unauthorized collection actions by persons performing services under qualified tax collection contracts.'.













SEC. 682. TREATMENT OF CHARITABLE CONTRIBUTIONS OF PATENTS AND SIMILAR PROPERTY.


























`Taxable Year of Donor



 Ending on or After
Applicable


 Date of Contribution:
Percentage:


1st
100


2nd
100


3rd
90


4th
80


5th
70


6th
60


7th
50


8th
40


9th
30


10th
20


11th
10


12th
10.






























`SEC. 6050L. RETURNS RELATING TO CERTAIN DONATED PROPERTY.














































`Sec. 6050L. Returns relating to certain donated property.'.















SEC. 683. INCREASED REPORTING FOR NONCASH CHARITABLE CONTRIBUTIONS.
































SEC. 684. DONATIONS OF MOTOR VEHICLES, BOATS, AND AIRCRAFT.
























SEC. 685. EXTENSION OF AMORTIZATION OF INTANGIBLES TO SPORTS FRANCHISES.




















SEC. 686. MODIFICATION OF CONTINUING LEVY ON PAYMENTS TO FEDERAL VENDERS.








SEC. 687. MODIFICATION OF STRADDLE RULES.


























































SEC. 688. ADDITION OF VACCINES AGAINST HEPATITIS A TO LIST OF TAXABLE VACCINES.












SEC. 689. ADDITION OF VACCINES AGAINST INFLUENZA TO LIST OF TAXABLE VACCINES.
















SEC. 690. EXTENSION OF IRS USER FEES.






SEC. 691. COBRA FEES.


























































TITLE VII--MARKET REFORM FOR TOBACCO GROWERS


SEC. 701. SHORT TITLE.




SEC. 702. EFFECTIVE DATE.




Subtitle A--Termination of Federal Tobacco Quota and Price Support Programs


SEC. 711. TERMINATION OF TOBACCO QUOTA PROGRAM AND RELATED PROVISIONS.




























































































SEC. 712. TERMINATION OF TOBACCO PRICE SUPPORT PROGRAM AND RELATED PROVISIONS.






















SEC. 713. LIABILITY.




Subtitle B--Transitional Payments to Tobacco Quota Holders and Active Producers of Tobacco


SEC. 721. DEFINITIONS OF ACTIVE TOBACCO PRODUCER AND QUOTA HOLDER.
















SEC. 722. PAYMENTS TO TOBACCO QUOTA HOLDERS.






































SEC. 723. TRANSITION PAYMENTS FOR ACTIVE PRODUCERS OF QUOTA TOBACCO.






















SEC. 724. RESOLUTION OF DISPUTES.




SEC. 725. SOURCE OF FUNDS FOR PAYMENTS.








TITLE VIII--TRADE PROVISIONS


SEC. 801. CEILING FANS.








--------------------------------------------------------------------------------------------------------------------------------------------------


--------------------------------------------------------------------------------------------------------------------------------------------------


` 9902.84.14 Ceiling fans for permanent installation (provided for in subheading 8414.51.00) Free No change No change On or before 12/31/2006  '. 


--------------------------------------------------------------------------------------------------------------------------------------------------




SEC. 802. CERTAIN STEAM GENERATORS, AND CERTAIN REACTOR VESSEL HEADS, USED IN NUCLEAR FACILITIES.










----------------------------------------------------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------------------------------------------------


` 9902.84.03 Reactor vessel heads for nuclear reactors (provided for in subheading 8401.40.00) Free No change No change On or before 12/31/2008  '. 


----------------------------------------------------------------------------------------------------------------------------------------------------








I. SUMMARY AND BACKGROUND


A. PURPOSE AND SUMMARY


The bill, H.R. 4520, as amended, (the `American Jobs Creation Act of 2004') repeals the exclusion for extraterritorial income (the `ETI' regime) and provides a reduced corporate income tax rate for domestic production activities and other corporate reform and growth incentives.

The bill provides net tax reductions of over $21.136 billion over fiscal years 2004-2008.

B. BACKGROUND AND NEED FOR LEGISLATION


The provisions approved by the Committee comply with the World Trade Organization holding that the ETI regime constitutes a prohibited export subsidy under the relevant trade agreements. The provisions approved by the Committee provide other corporate reform and growth incentives. The estimated revenue effects of the provisions comply with the most recent Congressional Budget Office revisions of budget projections.

C. LEGISLATIVE HISTORY


The Committee on Ways and Means marked up the American Jobs Creation Act of 2004 on June 14, 2004, and ordered the bill, as amended, favorably reported by a roll call vote of 27 yeas and 9 nays (with a quorum being present).

TITLE I--END SANCTIONS AND REDUCE CORPORATE TAX RATES FOR DOMESTIC MANUFACTURING AND SMALL CORPORATIONS


A. REPEAL OF EXCLUSION FOR EXTRATERRITORIAL INCOME


(Sec. 101 of the bill and secs. 114 and 941-943 of the Code) 1

PRESENT LAW


The United States

 [Footnote]  has long provided export-related benefits under a series of tax regimes, including the domestic international sales corporation (`DISC') regime, the foreign sales corporation (`FSC') regime, and the extraterritorial income (`ETI') regime. Each of these regimes has been found to violate U.S. obligations under international trade agreements. In 2000, the European Union (`EU') succeeded in having the FSC regime declared a prohibited export subsidy by the WTO. In response to this WTO ruling, the United States repealed the FSC rules and enacted a new regime under the FSC Repeal and Extraterritorial Income Exclusion Act of 2000. The EU immediately challenged the ETI regime in the WTO, and in January of 2002 a WTO Appellate Body held that the ETI regime also constituted a prohibited export subsidy under the relevant trade agreements.

[Footnote 1: Section references are to the Internal Revenue Code of 1986, as amended (the `Code'), unless otherwise indicated.]

Under the ETI regime, an exclusion from gross income applies with respect to `extraterritorial income,' which is a taxpayer's gross income attributable to `foreign trading gross receipts.' This income is eligible for the exclusion to the extent that it is `qualifying foreign trade income.' Qualifying foreign trade income is the amount of gross income that, if excluded, would result in a reduction of taxable income by the greatest of: (1) 1.2 percent of the foreign trading gross receipts derived by the taxpayer from the transaction; (2) 15 percent of the `foreign trade income' derived by the taxpayer from the transaction 2

 [Footnote] ; or (3) 30 percent of the `foreign sale and leasing income' derived by the taxpayer from the transaction. 3

 [Footnote]

[Footnote 2: `Foreign trade income' is the taxable income of the taxpayer (determined without regard to the exclusion of qualifying foreign trade income) attributable to foreign trading gross receipts.]

[Footnote 3: `Foreign sale and leasing income' is the amount of the taxpayer's foreign trade income (with respect to a transaction) that is properly allocable to activities that constitute foreign economic processes. Foreign sale and leasing income also includes foreign trade income derived by the taxpayer in connection with the lease or rental of qualifying foreign trade property for use by the lessee outside the United States.]

Foreign trading gross receipts are gross receipts derived from certain activities in connection with `qualifying foreign trade property' with respect to which certain economic processes take place outside of the United States. Specifically, the gross receipts must be: (1) from the sale, exchange, or other disposition of qualifying foreign trade property; (2) from the lease or rental of qualifying foreign trade property for use by the lessee outside the United States; (3) for services which are related and subsidiary to the sale, exchange, disposition, lease, or rental of qualifying foreign trade property (as described above); (4) for engineering or architectural services for construction projects located outside the United States; or (5) for the performance of certain managerial services for unrelated persons. A taxpayer may elect to treat gross receipts from a transaction as not foreign trading gross receipts. As a result of such an election, a taxpayer may use any related foreign tax credits in lieu of the exclusion.

Qualifying foreign trade property generally is property manufactured, produced, grown, or extracted within or outside the United States that is held primarily for sale, lease, or rental in the ordinary course of a trade or business for direct use, consumption, or disposition outside the United States. No more than 50 percent of the fair market value of such property can be attributable to the sum of: (1) the fair market value of articles manufactured outside the United States; and (2) the direct costs of labor performed outside the United States. With respect to property that is manufactured outside the United States, certain rules are provided to ensure consistent U.S. tax treatment with respect to manufacturers.

REASONS FOR CHANGE


The Committee believes it is important that the United States, and all members of the WTO, comply with WTO decisions and honor their obligations under WTO agreements. Therefore, the Committee believes that the ETI regime should be repealed. The Committee believes that it is necessary and appropriate to provide transition relief comparable to that which has been included in the past in measures taken by WTO members to bring their laws into compliance with WTO decisions and obligations.

The Committee also believes that it is important to use the opportunity afforded by the repeal of the ETI regime to reform the U.S. tax system in a manner that makes U.S. businesses and workers more productive and competitive than they are today. To this end, the Committee believes that it is important to provide tax cuts to U.S. domestic manufacturers and to update the U.S. international tax rules, which are over 40 years old and make U.S. companies uncompetitive in the United States and abroad.

EXPLANATION OF PROVISION


The provision repeals the ETI exclusion. For transactions prior to 2005, taxpayers retain 100 percent of their ETI benefits. For transactions after 2004, the provision provides taxpayers with 80 percent of their otherwise-applicable ETI benefits for transactions during 2005 and 60 percent of their otherwise-applicable ETI benefits for transactions during 2006. However, the provision provides that the ETI exclusion provisions remain in effect for transactions in the ordinary course of a trade or business if such transactions are pursuant to a binding contract 4

 [Footnote]  between the taxpayer and an unrelated person and such contract is in effect on January 14, 2002, and at all times thereafter.

[Footnote 4: This rule also applies to a purchase option, renewal option, or replacement option that is included in such contract and that is enforceable against the sellor or lessor. For this purpose, a replacement option will be considered enforceable against a lessor notwithstanding the fact that a lessor retained approval of the replacement lessee.]

In addition, foreign corporations that elected to be treated for all Federal tax purposes as domestic corporations in order to facilitate the claiming of ETI benefits are allowed to revoke such elections within one year of the date of enactment of the provision without recognition of gain or loss, subject to anti-abuse rules.

EFFECTIVE DATE


The provision is effective for transactions after December 31, 2004.

B. REDUCED CORPORATE INCOME TAX RATE FOR DOMESTIC PRODUCTION ACTIVITIES INCOME


(Sec. 102 of the bill and sec. 11 of the Code)

PRESENT LAW


A corporation's regular income tax liability is determined by applying the following tax rate schedule to its taxable income.



TABLE 1- MARGINAL FEDERAL CORPORATE INCOME TAX RATES FOR 2004


[Percent of taxable income]


------------------------------------


Taxable income      Income tax rate 


------------------------------------


$0-$50,000                       15 


$50,001-$75,000                  25 


$75,001-$10,000,000              34 


Over $10,000,000                 35 


------------------------------------


The benefit of the first two graduated rates described above is phased out by a five-percent surcharge for corporations with taxable income between $100,000 and $335,000. Also, the benefit of the 34-percent rate is phased out by a three-percent surcharge for corporations with taxable income between $15 million and $18,333,333; a corporation with taxable income of $18,333,333 or more effectively is subject to a flat rate of 35 percent.

Under present law, there is no provision that reduces the corporate income tax for taxable income attributable to domestic production activities.

REASONS FOR CHANGE


The Committee believes that creating new jobs is an essential element of economic recovery and expansion, and that tax policies designed to foster economic strength also will contribute to the continuation of the recent increases in employment levels. To accomplish this objective, the Committee believes that Congress should enact tax laws that enhance the ability of domestic businesses, and domestic manufacturing firms in particular, to compete in the global marketplace.

The Committee believes that a reduced tax burden on domestic manufacturers will improve the cash flow of domestic manufacturers and make investments in domestic manufacturing facilities more attractive. Such investment will create and preserve U.S. manufacturing jobs.

EXPLANATION OF PROVISION


In general

The bill provides that the corporate tax rate applicable to qualified production activities income may not exceed 32 percent (34 percent for taxable years beginning before 2007) of the qualified production activities income.

Qualified production activities income

`Qualified production activities income' is the income attributable to domestic production gross receipts, reduced by the sum of: (1) the costs of goods sold that are allocable to such receipts; (2) other deductions, expenses, or losses that are directly allocable to such receipts; and (3) a proper share of other deductions, expenses, and losses that are not directly allocable to such receipts or another class of income. 5

 [Footnote]

[Footnote 5: The Secretary shall prescribe rules for the proper allocation of items of income, deduction, expense, and loss for purposes of determining income attributable to domestic production activities. Where appropriate, such rules shall be similar to and consistent with relevant present-law rules (e.g., secs. 263A and 861).]

Domestic production gross receipts

`Domestic production gross receipts' generally are gross receipts of a corporation that are derived from: (1) any sale, exchange or other disposition, or any lease, rental or license, of qualifying production property that was manufactured, produced, grown or extracted (in whole or in significant part) by the corporation within the United States; 6

 [Footnote]  (2) any sale, exchange or other disposition, or any lease, rental or license, of qualified film produced by the taxpayer; or (3) construction, engineering or architectural services performed in the United States for construction projects located in the United States. However, domestic production gross receipts do not include any gross receipts of the taxpayer derived from property that is leased, licensed or rented by the taxpayer for use by any related person. 7

 [Footnote]

[Footnote 6: Domestic production gross receipts include gross receipts of a taxpayer derived from any sale, exchange or other disposition of agricultural products with respect to which the taxpayer performs storage, handling or other processing activities (other than transportation activities) within the United States, provided such products are consumed in connection with, or incorporated into, the manufacturing, production, growth or extraction of qualifying production property (whether or not by the taxpayer). Domestic production gross receipts also include gross receipts of a taxpayer derived from any sale, exchange or other disposition of food products with respect to which the taxpayer performs processing activities (in whole or in significant part) within the United States.]

[Footnote 7: It is intended that principles similar to those under the present-law extraterritorial income regime apply for this purpose. See Temp. Treas. Reg. sec. 1.927(a)-1T(f)(2)(i). For example, this exclusion generally does not apply to property leased by the taxpayer to a related person if the property is held for sublease, or is subleased, by the related person to an unrelated person for the ultimate use of such unrelated person. Similarly, the license of computer software to a related person for reproduction and sale, exchange, lease, rental or sublicense to an unrelated person for the ultimate use of such unrelated person is not treated as excluded property by reason of the license to the related person.]

`Qualifying production property' generally is any tangible personal property, computer software, or property described in section 168(f)(4) of the Code. `Qualified film' is any property described in section 168(f)(3) of the Code (other than certain sexually explicit productions) if 50 percent or more of the total compensation relating to the production of such film (other than compensation in the form of residuals and participations) constitutes compensation for services performed in the United States by actors, production personnel, directors, and producers.

Under the bill, an election under section 631(a) made by a corporate taxpayer for a taxable year ending on or before the date of enactment to treat the cutting of timber as a sale or exchange, may be revoked by the taxpayer without the consent of the IRS for any taxable year ending after that date. The prior election (and revocation) is disregarded for purposes of making a subsequent election.

EFFECTIVE DATE


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

C. REDUCED CORPORATE INCOME TAX RATE FOR SMALL CORPORATIONS


(Sec. 103 of the bill and sec. 11 of the Code)

PRESENT LAW


A corporation's regular income tax liability is determined by applying the following tax rate schedule to its taxable income.



Table 1- MARGINAL FEDERAL CORPORATE INCOME TAX RATES FOR 2004


[Percent of taxable income]


------------------------------------


Taxable income      Income tax rate 


------------------------------------


$0-$50,000                       15 


$50,001-$75,000                  25 


$75,001-$10,000,000              34 


Over $10,000,000                 35 


------------------------------------


The benefit of the first two graduated rates described above is phased out by a five-percent surcharge for corporations with taxable income between $100,000 and $335,000. Also, benefit of the 34-percent rate is phased out by a three-percent surcharge for corporations with taxable income between $15 million and $18,333,333; a corporation with taxable income of $18,333,333 or more effectively is subject to a flat rate of 35 percent.

REASONS FOR CHANGE


The Committee believes that reducing the tax burden on small and medium sized businesses will enable them to continue to create and maintain new jobs in the United States. A reduced tax burden on smaller businesses simultaneously makes investments by small businesses more attractive and improves the cash flow of such businesses, thus facilitating the financing of investments. New investment by small business is responsible for substantial job creation in the economy and provides the foundation for new industries, new technology, and the future of the U. S. economy.

EXPLANATION OF PROVISION


Under the provision, a corporation's regular income tax liability is determined by applying the following tax rate schedules to its taxable income.



TABLE 2- MARGINAL FEDERAL CORPORATE INCOME TAX RATES FOR 2013 AND THEREAFTER


[Percent of taxable income]


------------------------------------


Taxable income      Income tax rate 


------------------------------------


$0-$50,000                       15 


$50,001-$75,000                  25 


$75,001-$20,000,000              32 


Over $20,000,000                 35 


------------------------------------


The benefit of the graduated rates described above is phased out by a three-percent surcharge for corporations with taxable income between $20 million and $40,341,667; a corporation with taxable income of $40,341,667 or more effectively is subject to a flat rate of 35 percent.



TABLE 3- MARGINAL FEDERAL CORPORATE INCOME TAX RATES FOR 2011-2012


[Percent of taxable income]


---------------------------------------


Taxable income         Income tax rate 


---------------------------------------


$0-$50,000                          15 


$50,001-$75,000                     25 


$75,001-$5,000,000                  32 


$5,000,001-$10,000,000              34 


Over $10,000,000                    35 


---------------------------------------


The benefit of the first three graduated rates described above is phased out by a five-percent surcharge for corporations with taxable income between $5,000,000 and $7,205,000. Also, the benefit of the 34-percent rate is phased out by a three-percent surcharge for corporations with taxable income between $15 million and $18,333,333; a corporation with taxable income of $18,333,333 or more effectively is subject to a flat rate of 35 percent.



TABLE 4- MARGINAL FEDERAL CORPORATE INCOME TAX RATES FOR 2008-2010


[Percent of taxable income]


---------------------------------------


Taxable income         Income tax rate 


---------------------------------------


$0-$50,000                          15 


$50,001-$75,000                     25 


$75,001-$1,000,000                  32 


$1,000,001-$10,000,000              34 


Over $10,000,000                    35 


---------------------------------------


The benefit of the first three graduated rates described above is phased out by a five-percent surcharge for corporations with taxable income between $1,000,000 and $1,605,000. Also, the benefit of the 34-percent rate is phased out by a three-percent surcharge for corporations with taxable income between $15 million and $18,333,333; a corporation with taxable income of $18,333,333 or more effectively is subject to a flat rate of 35 percent.



TABLE 5- MARGINAL FEDERAL CORPORATE INCOME TAX RATES FOR 2005-2007


[Percent of taxable income]


---------------------------------------


Taxable income         Income tax rate 


---------------------------------------


$0-$50,000                          15 


$50,001-$75,000                     25 


$75,001-$1,000,000                  33 


$1,000,001-$10,000,000              34 


Over $10,000,000                    35 


---------------------------------------


The benefit of the first three graduated rates described above is phased out by a five-percent surcharge for corporations with taxable income between $1,000,000 and $1,420,000. Also, the benefit of the 34-percent rate is phased out by a three-percent surcharge for corporations with taxable income between $15 million and $18,333,333; a corporation with taxable income of $18,333,333 or more effectively is subject to a flat rate of 35 percent.

EFFECTIVE DATE


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

TITLE II--CORPORATE REFORM AND GROWTH INCENTIVES FOR MANUFACTURERS, SMALL BUSINESSES, AND FARMERS


A. SMALL BUSINESS EXPENSING


1. Extension of increased section 179 expensing (sec. 201 of the bill and sec. 179 of the Code)

PRESENT LAW


Present law provides that, in lieu of depreciation, a taxpayer with a sufficiently small amount of annual investment may elect to deduct such costs. The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003 8

 [Footnote]  increased the amount a taxpayer may deduct, for taxable years beginning in 2003 through 2005, to $100,000 of the cost of qualifying property placed in service for the taxable year. 9

 [Footnote]  In general, qualifying property is defined as depreciable tangible personal property (and certain computer software) that is purchased for use in the active conduct of a trade or business. The $100,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $400,000. The $100,000 and $400,000 amounts are indexed for inflation.

[Footnote 8: Pub. L. No. 108-27, sec. 202 (2003).]

[Footnote 9: Additional section 179 incentives are provided with respect to a qualified property used by a business in the New York Liberty Zone (sec. 1400L(f)), an empowerment zone (sec. 1397A), or a renewal community (sec. 1400J).]

Prior to the enactment of JGTRRA (and for taxable years beginning in 2006 and thereafter) a taxpayer with a sufficiently small amount of annual investment could elect to deduct up to $25,000 of the cost of qualifying property placed in service for the taxable year. The $25,000 amount was reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $200,000. In general, qualifying property is defined as depreciable tangible personal property that is purchased for use in the active conduct of a trade or business.

The amount eligible to be expensed for a taxable year may not exceed the taxable income for a taxable year that is derived from the active conduct of a trade or business (determined without regard to this provision). Any amount that is not allowed as a deduction because of the taxable income limitation may be carried forward to succeeding taxable years (subject to similar limitations). No general business credit under section 38 is allowed with respect to any amount for which a deduction is allowed under section 179.

Under present law, an expensing election is made under rules prescribed by the Secretary. 10

 [Footnote]  Applicable Treasury regulations provide that an expensing election generally is made on the taxpayer's original return for the taxable year to which the election relates. 11

 [Footnote]

[Footnote 10: Sec. 179(c)(1).]

[Footnote 11: Treas. Reg. sec. 1.179-5. Under these regulations, a taxpayer may make the election on the original return (whether or not the return is timely), or on an amended return filed by the due date (including extensions) for filing the return for the tax year the property was placed in service. If the taxpayer timely filed an original return without making the election, the taxpayer may still make the election by filing an amended return within six months of the due date of the return (excluding extensions).]

Prior to the enactment of JGTRRA (and for taxable years beginning in 2006 and thereafter), an expensing election may be revoked only with consent of the Commissioner. 12

 [Footnote]  JGTRRA permits taxpayers to revoke expensing elections on amended returns without the consent of the Commissioner with respect to a taxable year beginning after 2002 and before 2006. 13

 [Footnote]

[Footnote 12: Sec. 179(c)(2).]

[Footnote 13: Id.]

REASONS FOR CHANGE


The Committee believes that section 179 expensing provides two important benefits for small businesses. First, it lowers the cost of capital for property used in a trade or business. With a lower cost of capital, the Committee believes small businesses will invest in more equipment and employ more workers. Second, it eliminates depreciation recordkeeping requirements with respect to expensed property. In JGTRRA, Congress acted to increase the value of these benefits and to increase the number of taxpayers eligible for taxable years through 2005. The Committee believes that these changes to section 179 expensing will continue to provide important benefits if extended, and the bill therefore extends these changes for an additional two years.

EXPLANATION OF PROVISION


The provision extends the increased amount that a taxpayer may deduct, and other changes that were made by JGTRRA, for an additional two years. Thus, the provision provides that the maximum dollar amount that may be deducted under section 179 is $100,000 for property placed in service in taxable years beginning before 2008 ($25,000 for taxable years beginning in 2008 and thereafter). In addition, the $400,000 amount applies for property placed in service in taxable years beginning before 2008 ($200,000 for taxable years beginning in 2008 and thereafter). The provision extends, through 2007 (from 2005), the indexing for inflation of both the maximum dollar amount that may be deducted and the $400,000 amount. The provision also includes off-the-shelf computer software placed in service in taxable years beginning before 2008 as qualifying property. The provision permits taxpayers to revoke expensing elections on amended returns without the consent of the Commissioner with respect to a taxable year beginning before 2008. The Committee expects that the Secretary will prescribe regulations to permit a taxpayer to make an expensing election on an amended return without the consent of the Commissioner.

EFFECTIVE DATE


The provision is effective on the date of enactment.

B. DEPRECIATION


1. Recovery period for depreciation of certain leasehold improvements and restaurant property (sec. 211 of the bill and sec. 168 of the Code)

PRESENT LAW


A taxpayer generally must capitalize the cost of property used in a trade or business and recover such cost over time through annual deductions for depreciation or amortization. Tangible property generally is depreciated under the modified accelerated cost recovery system (`MACRS'), which determines depreciation by applying specific recovery periods, placed-in-service conventions, and depreciation methods to the cost of various types of depreciable property (sec. 168). The cost of nonresidential real property is recovered using the straight-line method of depreciation and a recovery period of 39 years. Nonresidential real property is subject to the mid-month placed-in-service convention. Under the mid-month convention, the depreciation allowance for the first year property is placed in service is based on the number of months the property was in service, and property placed in service at any time during a month is treated as having been placed in service in the middle of the month.

Depreciation of leasehold improvements

Depreciation allowances for improvements made on leased property are determined under MACRS, even if the MACRS recovery period assigned to the property is longer than the term of the lease (sec. 168(i)(8)). 14

 [Footnote]  This rule applies regardless of whether the lessor or the lessee places the leasehold improvements in service. 15

 [Footnote]  If a leasehold improvement constitutes an addition or improvement to nonresidential real property already placed in service, the improvement is depreciated using the straight-line method over a 39-year recovery period, beginning in the month the addition or improvement was placed in service (secs. 168(b)(3), (c), (d)(2), and (i)(6)). 16

 [Footnote]

[Footnote 14: The Tax Reform Act of 1986 modified the Accelerated Cost Recovery System (`ACRS') to institute MACRS. Prior to the adoption of ACRS by the Economic Recovery Tax Act of 1981, taxpayers were allowed to depreciate the various components of a building as separate assets with separate useful lives. The use of component depreciation was repealed upon the adoption of ACRS. The Tax Reform Act of 1986 also denied the use of component depreciation under MACRS.]

[Footnote 15: Former sections 168(f)(6) and 178 provided that, in certain circumstances, a lessee could recover the cost of leasehold improvements made over the remaining term of the lease. The Tax Reform Act of 1986 repealed these provisions.]

[Footnote 16: If the improvement is characterized as tangible personal property, ACRS or MACRS depreciation is calculated using the shorter recovery periods, accelerated methods, and conventions applicable to such property. The determination of whether improvements are characterized as tangible personal property or as nonresidential real property often depends on whether or not the improvements constitute a `structural component' of a building (as defined by Treas. Reg. sec. 1.48-1(e)(1)). See, e.g., Metro National Corp v. Commissioner, 52 TCM (CCH) 1440 (1987); King Radio Corp Inc. v. U.S., 486 F.2d 1091 (10th Cir. 1973); Mallinckrodt, Inc. v. Commissioner, 778 F.2d 402 (8th Cir. 1985) (with respect to various leasehold improvements).]

Qualified leasehold improvement property

The Job Creation and Worker Assistance Act of 2002 17

 [Footnote]  (`JCWAA'), as amended by JGTRRA, generally provides an additional first-year depreciation deduction equal to either 30 percent or 50 percent of the adjusted basis of qualified property placed in service before January 1, 2005. Qualified property includes qualified leasehold improvement property. For this purpose, qualified leasehold improvement property is any improvement to an interior portion of a building that is nonresidential real property, provided certain requirements are met. The improvement must be made under or pursuant to a lease either by the lessee (or sublessee), or by the lessor, of that portion of the building to be occupied exclusively by the lessee (or sublessee). The improvement must be placed in service more than three years after the date the building was first placed in service. Qualified leasehold improvement property does not include any improvement for which the expenditure is attributable to the enlargement of the building, any elevator or escalator, any structural component benefiting a common area, or the internal structural framework of the building.

[Footnote 17: Pub. L. No. 107-147, sec. 101 (2002), as amended by Pub. L. No. 108-27, sec. 201 (2003).]

Treatment of dispositions of leasehold improvements

A lessor of leased property that disposes of a leasehold improvement that was made by the lessor for the lessee of the property may take the adjusted basis of the improvement into account for purposes of determining gain or loss if the improvement is irrevocably disposed of or abandoned by the lessor at the termination of the lease. This rule conforms the treatment of lessors and lessees with respect to leasehold improvements disposed of at the end of a term of lease.

REASONS FOR CHANGE


The Committee believes that taxpayers should not be required to recover the costs of certain leasehold improvements beyond the useful life of the investment. The present law 39-year recovery period for leasehold improvements extends well beyond the useful life of such investments. Although lease terms differ, the Committee believes that lease terms for commercial real estate typically are shorter than the present-law 39-year recovery period. In the interests of simplicity and administrability, a uniform period for recovery of leasehold improvements is desirable. The Committee bill therefore shortens the recovery period for leasehold improvements to a more realistic 15 years.

The Committee also believes that unlike other commercial buildings, restaurant buildings generally are more specialized structures. Restaurants also experience considerably more traffic, and remain open longer than most retail properties. This daily assault causes rapid deterioration of restaurant properties and forces restaurateurs to constantly repair and upgrade their facilities. As such, restaurant facilities have a much shorter life span than other commercial establishments. The Committee bill reduces the 39-year recovery period for improvements made to restaurant buildings and more accurately reflects the true economic life of the properties by reducing the recovery period to 15 years.

EXPLANATION OF PROVISION


The provision provides a statutory 15-year recovery period for qualified leasehold improvement property placed in service before January 1, 2006. 18

 [Footnote]  The provision requires that qualified leasehold improvement property be recovered using the straight-line method.

[Footnote 18: Qualified leasehold improvement property continues to be eligible for the additional first-year depreciation deduction under sec. 168(k).]

Qualified leasehold improvement property is defined as under present law for purposes of the additional first-year depreciation deduction (sec. 168(k)), with the following modification. If a lessor makes an improvement that qualifies as qualified leasehold improvement property such improvement shall not qualify as qualified leasehold improvement property to any subsequent owner of such improvement. An exception to the rule applies in the case of death and certain transfers of property that qualify for non-recognition treatment.

The provision also provides a statutory 15-year recovery period for qualified restaurant property placed in service before January 1, 2006. 19

 [Footnote]  For purposes of the provision, qualified restaurant property means any improvement to a building if such improvement is placed in service more than three years after the date such building was first placed in service and more than 50 percent of the building's square footage is devoted to the preparation of, and seating for, on-premises consumption of prepared meals. The provision requires that qualified restaurant property be recovered using the straight-line method.

[Footnote 19: Qualified restaurant property would become eligible for the additional first-year depreciation deduction under sec. 168(k) by virtue of the assigned 15-year recovery period.]

EFFECTIVE DATE


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

2. Modification of depreciation allowance for aircraft (sec. 212 of the bill and sec. 168 of the Code)

PRESENT LAW


In general

A taxpayer is allowed to recover, through annual depreciation deductions, the cost of certain property used in a trade or business or for the production of income. The amount of the depreciation deduction allowed with respect to tangible property for a taxable year is determined under the modified accelerated cost recovery system (`MACRS'). Under MACRS, different types of property generally are assigned applicable recovery periods and depreciation methods. The recovery periods applicable to most tangible personal property range from 3 to 25 years. The depreciation methods generally applicable to tangible personal property are the 200-percent and 150-percent declining balance methods, switching to the straight-line method for the taxable year in which the depreciation deduction would be maximized.

Thirty-percent additional first year depreciation deduction

JCWAA allows an additional first-year depreciation deduction equal to 30 percent of the adjusted basis of qualified property. 20

 [Footnote]  The amount of the additional first-year depreciation deduction is not affected by a short taxable year. The additional first-year depreciation deduction is allowed for both regular tax and alternative minimum tax purposes for the taxable year in which the property is placed in service. 21

 [Footnote]  The basis of the property and the depreciation allowances in the year of purchase and later years are appropriately adjusted to reflect the additional first-year depreciation deduction. In addition, there are generally no adjustments to the allowable amount of depreciation for purposes of computing a taxpayer's alternative minimum taxable income with respect to property to which the provision applies. A taxpayer is allowed to elect out of the additional first-year depreciation for any class of property for any taxable year. 22

 [Footnote]

[Footnote 20: The additional first-year depreciation deduction is subject to the general rules regarding whether an item is deductible under section 162 or subject to capitalization under section 263 or section 263A.]

[Footnote 21: However, the additional first-year depreciation deduction is not allowed for purposes of computing earnings and profits.]

[Footnote 22: A taxpayer may elect out of the 50-percent additional first-year depreciation (discussed below) for any class of property and still be eligible for the 30-percent additional first-year depreciation.]

In order for property to qualify for the additional first-year depreciation deduction, it must meet all of the following requirements. First, the property must be (1) property to which MACRS applies with an applicable recovery period of 20 years or less, (2) water utility property (as defined in section 168(e)(5)), (3) computer software other than computer software covered by section 197, or (4) qualified leasehold improvement property (as defined in section 168(k)(3)). 23

 [Footnote]  Second, the original use 24

 [Footnote]  of the property must commence with the taxpayer on or after September 11, 2001. Third, the taxpayer must acquire the property within the applicable time period. Finally, the property must be placed in service before January 1, 2005.

[Footnote 23: A special rule precludes the additional first-year depreciation deduction for any property that is required to be depreciated under the alternative depreciation system of MACRS.]

[Footnote 24: The term `original use' means the first use to which the property is put, whether or not such use corresponds to the use of such property by the taxpayer. If, in the normal course of its business, a taxpayer sells fractional interests in property to unrelated third parties, then the original use of such property begins with the first user of each fractional interest (i.e., each fractional owner is considered the original user of its proportionate share of the property).]

An extension of the placed-in-service date of one year (i.e., January 1, 2006) is provided for certain property with a recovery period of ten years or longer and certain transportation property. 25

 [Footnote]  Transportation property is defined as tangible personal property used in the trade or business of transporting persons or property.

[Footnote 25: In order for property to qualify for the extended placed-in-service date, the property must be subject to section 263A by reason of having a production period exceeding two years or an estimated production period exceeding one year and a cost exceeding $1 million.]

The applicable time period for acquired property is (1) after September 10, 2001 and before January 1, 2005, but only if no binding written contract for the acquisition is in effect before September 11, 2001, or (2) pursuant to a binding written contract which was entered into after September 10, 2001, and before January 1, 2005. 26

 [Footnote]  For property eligible for the extended placed-in-service date, a special rule limits the amount of costs eligible for the additional first year depreciation. With respect to such property, only the portion of the basis that is properly attributable to the costs incurred before January 1, 2005 (`progress expenditures') is eligible for the additional first-year depreciation. 27

 [Footnote]

[Footnote 26: Property does not fail to qualify for the additional first-year depreciation merely because a binding written contract to acquire a component of the property is in effect prior to September 11, 2001.]

[Footnote 27: For purposes of determining the amount of eligible progress expenditures, it is intended that rules similar to sec. 46(d)(3) as in effect prior to the Tax Reform Act of 1986 shall apply.]

Fifty-percent additional first year depreciation

JGTRRA provides an additional first-year depreciation deduction equal to 50 percent of the adjusted basis of qualified property. Qualified property is defined in the same manner as for purposes of the 30-percent additional first-year depreciation deduction provided by the JCWAA except that the applicable time period for acquisition (or self construction) of the property is modified. Property eligible for the 50-percent additional first-year depreciation deduction is not eligible for the 30-percent additional first-year depreciation deduction.

In order to qualify, the property must be acquired after May 5, 2003, and before January 1, 2005, and no binding written contract for the acquisition can be in effect before May 6, 2003. 28

 [Footnote]  With respect to property that is manufactured, constructed, or produced by the taxpayer for use by the taxpayer, the taxpayer must begin the manufacture, construction, or production of the property after May 5, 2003. For property eligible for the extended placed-in-service date (i.e., certain property with a recovery period of ten years or longer and certain transportation property), a special rule limits the amount of costs eligible for the additional first-year depreciation. With respect to such property, only progress expenditures properly attributable to the costs incurred before January 1, 2005 are eligible for the additional first-year depreciation. 29

 [Footnote]

[Footnote 28: Property does not fail to qualify for the additional first-year depreciation merely because a binding written contract to acquire a component of the property is in effect prior to May 6, 2003. However, no 50-percent additional first-year depreciation is permitted on any such component. No inference is intended as to the proper treatment of components placed in service under the 30-percent additional first-year depreciation provided by the JCWAA.]

[Footnote 29: For purposes of determining the amount of eligible progress expenditures, it is intended that rules similar to sec. 46(d)(3) as in effect prior to the Tax Reform Act of 1986 shall apply.]

REASONS FOR CHANGE


The Committee believes that certain non-commercial aircraft represent property having characteristics that should qualify for the extended placed-in-service date accorded under present law for property having long production periods. This treatment should be available only if the purchaser makes a substantial deposit, the expected cost exceeds certain thresholds, and the production period is sufficiently long.

EXPLANATION OF PROVISION


Due to the extended production period, the provision provides criteria under which certain non-commercial aircraft can qualify for the extended placed-in-service date. Qualifying aircraft would be eligible for the additional first-year depreciation deduction if placed in service before January 1, 2006. In order to qualify, the aircraft must:









 [Footnote]  by a purchaser who, at the time of the contract for purchase, has made a nonrefundable deposit of the lesser of ten percent of the cost or $100,000; and

[Footnote 30: For this purpose, the Committee intends that the term `purchase' be interpreted as it is defined in sec. 179(d)(2).]



EFFECTIVE DATE


The provision is effective as if included in the amendments made by section 101 of JCWAA, which applies to property placed in service after September 10, 2001. However, because the property described by the provision qualifies for the additional first-year depreciation deduction under present law if placed in service prior to January 1, 2005, the provision will modify the treatment only of property placed in service during calendar year 2005.

3. Modification of placed in service rule for bonus depreciation property (sec. 213 of the bill and sec. 168 of the Code)

PRESENT LAW


Section 101 of JCWAA provides generally for 30-percent additional first-year depreciation, and provides a binding contract rule in determining property that qualifies for it. The requirements that must be satisfied in order for property to qualify include that (1) the original use of the property must commence with the taxpayer on or after September 11, 2001, (2) the taxpayer must acquire the property after September 10, 2001 and before September 11, 2004, and (3) no binding written contract for the acquisition of the property is in effect before September 11, 2001 (or, in the case of self-constructed property, manufacture, construction, or production of the property does not begin before September 11, 2001). In addition, JCWAA provides a special rule in the case of certain leased property. In the case of any property that is originally placed in service by a person and that is sold to the taxpayer and leased back to such person by the taxpayer within three months after the date that the property was placed in service, the property is treated as originally placed in service by the taxpayer not earlier than the date that the property is used under the leaseback. JCWAA did not specifically address the syndication of a lease by the lessor.

JGTRRA provides an additional first-year depreciation deduction equal to 50 percent of the adjusted basis of qualified property. Qualified property is defined in the same manner as for purposes of the 30-percent additional first-year depreciation deduction provided by the JCWAA except that the applicable time period for acquisition (or self construction) of the property is modified. Property with respect to which the 50-percent additional first-year depreciation deduction is claimed is not also eligible for the 30-percent additional first-year depreciation deduction. In order to qualify, the property must be acquired after May 5, 2003 and before January 1, 2005, and no binding written contract for the acquisition can be in effect before May 6, 2003. With respect to property that is manufactured, constructed, or produced by the taxpayer for use by the taxpayer, the taxpayer must begin the manufacture, construction, or production of the property after May 5, 2003.

REASONS FOR CHANGE


The Committee believes that the rules relating to 30-percent additional first-year depreciation should be clarified to reflect the legislative intent that syndicated property, if sold within three months of the date it was originally placed in service, be eligible for the additional first-year depreciation deduction. Further, the Committee is aware that certain syndication arrangements are entered into with respect to multiple units of property (such as rail cars) that, for logistical reasons, must be placed in service over a period of time that exceeds three months. In such cases, it would be impractical for the sale of the earlier produced units to occur within three months of its placed-in-service date. Thus, the Committee deems it appropriate to provide a special rule with respect to the syndication of multiple units of property that will be placed in service over a period of up to twelve months.

EXPLANATION OF PROVISION


The provision provides that if property is originally placed in service by a lessor (including by operation of the special rule for self-constructed property), such property is sold within three months after the date that the property was placed in service, and the user of such property does not change, then the property is treated as originally placed in service by the taxpayer not earlier than the date of such sale. The provision also provides a special rule in the case of multiple units of property subject to the same lease. In such cases, property will qualify as placed in service on the date of sale if it is sold within three months after the final unit is placed in service, so long as the period between the time the first and last units are placed in service does not exceed 12 months.

EFFECTIVE DATE


The provision is generally effective as if included in the amendments made by section 101 of JCWAA (i.e., generally for property placed in service after September 10, 2001, in taxable years ending after that date). However, the special rule in the case of multiple units of property subject to the same lease applies to property sold after June 4, 2004.

C. S CORPORATION REFORM AND SIMPLIFICATION


(Secs. 221-231 of the bill and secs. 1361-1379 and 4975 of the Code)

OVERVIEW


In general, an S corporation is not subject to corporate-level income tax on its items of income and loss. Instead, an S corporation passes through its items of income and loss to its shareholders. The shareholders take into account separately their shares of these items on their individual income tax returns. To prevent double taxation of these items when the stock is later disposed of, each shareholder's basis in the stock of the S corporation is increased by the amount included in income (including tax-exempt income) and is decreased by the amount of any losses (including nondeductible losses) taken into account. A shareholder's loss may be deducted only to the extent of his or her basis in the stock or debt of the S corporation. To the extent a loss is not allowed due to this limitation, the loss generally is carried forward with respect to the shareholder.

REASONS FOR CHANGE


The bill contains a number of general provisions relating to S corporations. The Committee adopted these provisions that modernize the S corporation rules and eliminate undue restrictions on S corporations in order to expand the application of the S corporation provisions so that more corporations and their shareholders will be able to enjoy the benefits of subchapter S status.

The Committee is aware of obstacles that have prevented banks from electing subchapter S status. 31

 [Footnote]  The bill contains provisions that apply specifically to banks in order to remove these obstacles and make S corporation status more readily available to banks.

[Footnote 31: See, for example, GAO/GGD-00-159, Banking Taxation, Implications of Proposed Revisions Governing S-Corporations on Community Banks (June 23, 2000).]

The bill also revises the prohibited transaction rules applicable to employee stock ownership plans (`ESOPs') maintained by S corporations in order to expand the ability to use distributions made with respect to S corporation stock held by an ESOP to repay a loan used to purchase the stock, subject to the same conditions that apply to C corporation dividends used to repay such a loan.

1. Members of family treated as one shareholder; increase in number of eligible shareholders to 100

PRESENT LAW


A small business corporation may elect to be an S corporation with the consent of all its shareholders, and may terminate its election with the consent of shareholders holding more than 50 percent of the stock. A `small business corporation' is defined as a domestic corporation which is not an ineligible corporation and which has (1) no more than 75 shareholders, all of whom are individuals (and certain trusts, estates, charities, and qualified retirement plans) 32

 [Footnote]  who are citizens or residents of the United States, and (2) only one class of stock. For purposes of the 75-shareholder limitation, a husband and wife are treated as one shareholder. An `ineligible corporation' means a corporation that is a financial institution using the reserve method of accounting for bad debts, an insurance company, a corporation electing the benefits of the Puerto Rico and possessions tax credit, or a Domestic International Sales Corporation (`DISC') or former DISC.

[Footnote 32: If a qualified retirement plan (other than an employee stock ownership plan) or a charity holds stock in an S corporation, the interest held is treated as an interest in an unrelated trade or business, and the plan or charity's share of the S corporation's items of income, loss, or deduction, and gain or loss on the disposition of the S corporation stock, are taken into account in computing unrelated business taxable income.]

EXPLANATION OF PROVISION


The bill provides that all family members can elect to be treated as one shareholder for purposes of determining the number of shareholders in the corporation. A family is defined as the lineal descendants (and their spouses) of a common ancestor. The common ancestor cannot be more than three generations removed from the youngest generation of shareholder at the time the S election is made (or the effective date of this provision, if later). Except as provided by Treasury regulations, the election may be made by any family member and the election remains in effect until terminated.

The bill increases the maximum number of eligible shareholders from 75 to 100.

EFFECTIVE DATE


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

2. Expansion of bank S corporation eligible shareholders to include IRAs

PRESENT LAW


An individual retirement account (`IRA') is a trust or account established for the exclusive benefit of an individual and his or her beneficiaries. There are two general types of IRAs: traditional IRAs, to which both deductible and nondeductible contributions may be made, and Roth IRAs, contributions to which are not deductible. Amounts held in a traditional IRA are includible in income when withdrawn (except to the extent the withdrawal is a return of nondeductible contributions). Amounts held in a Roth IRA that are withdrawn as a qualified distribution are not includible in income; distributions from a Roth IRA that are not qualified distributions are includible in income to the extent attributable to earnings. A qualified distribution is a distribution that (1) is made after the five-taxable year period beginning with the first taxable year for which the individual made a contribution to a Roth IRA, and (2) is made after attainment of age 59 1/2 , on account of death or disability, or is made for first-time homebuyer expenses of up to $10,000.

Under present law, an IRA cannot be a shareholder of an S corporation.

Certain transactions are prohibited between an IRA and the individual for whose benefit the IRA is established, including a sale of property by the IRA to the individual. If a prohibited transaction occurs between an IRA and the IRA beneficiary, the account ceases to be an IRA, and an amount equal to the fair market value of the assets held in the IRA is deemed distributed to the beneficiary.

EXPLANATION OF PROVISION


The bill allows an IRA (including a Roth IRA) to be a shareholder of a bank that is an S corporation, but only to the extent of bank stock held by the IRA on the date of enactment of the provision. 33

 [Footnote]

[Footnote 33: Under the bill, the present-law rules treating S corporation stock held by a qualified retirement plan (other than an employee stock ownership plan) or a charity as an interest in an unrelated trade or business apply to an IRA holding S corporation stock of a bank.]

The bill also provides an exemption from prohibited transaction treatment for the sale by an IRA to the IRA beneficiary of bank stock held by the IRA on the date of enactment of the provision. Under the bill, a sale is not a prohibited transaction if: (1) the sale is pursuant to an S corporation election by the bank; (2) the sale is for fair market value (as established by an independent appraiser) and is on terms at least as favorable to the IRA as the terms would be on a sale to an unrelated party; (3) the IRA incurs no commissions, costs, or other expenses in connection with the sale; and (4) the stock is sold in a single transaction for cash not later than 120 days after the S corporation election is made.

EFFECTIVE DATE


The provision takes effect on the date of enactment of the bill.

3. Disregard of unexercised powers of appointment in determining potential current beneficiaries of ESBT

PRESENT LAW


An electing small business trust (`ESBT') holding stock in an S corporation is taxed at the maximum individual tax rate on its ratable share of items of income, deduction, gain, or loss passing through from the S corporation. An ESBT generally is an electing trust all of whose beneficiaries are eligible S corporation shareholders. For purposes of determining the maximum number of shareholders, each person who is entitled to receive a distribution from the trust (`potential current beneficiary') is treated as a shareholder during the period the person may receive a distribution from the trust.

An ESBT has 60 days to dispose of the S corporation stock after an ineligible shareholder becomes a potential current beneficiary to avoid disqualification.

EXPLANATION OF PROVISION


Under the bill, powers of appointment to the extent not exercised are disregarded in determining the potential current beneficiaries of an electing small business trust.

The bill increases the period during which an ESBT can dispose of S corporation stock, after an ineligible shareholder becomes a potential current beneficiary, from 60 days to one year.

EFFECTIVE DATE


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

4. Transfers of suspended losses incident to divorce, etc.

PRESENT LAW


Under present law, any loss or deduction that is not allowed to a shareholder of an S corporation, because the loss exceeds the shareholder's basis in stock and debt of the corporation, is treated as incurred by the S corporation with respect to that shareholder in the subsequent taxable year.

EXPLANATION OF PROVISION


Under the bill, if a shareholder's stock in an S corporation is transferred to a spouse, or to a former spouse incident to a divorce, any suspended loss or deduction with respect to that stock is treated as incurred by the corporation with respect to the transferee in the subsequent taxable year.

EFFECTIVE DATE


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

5. Use of passive activity loss and at-risk amounts by qualified subchapter S trust income beneficiaries

PRESENT LAW


Under present law, the share of income of an S corporation whose stock is held by a qualified subchapter S trust (`QSST'), with respect to which the beneficiary makes an election, is taxed to the beneficiary. However, the trust, and not the beneficiary, is treated as the owner of the S corporation stock for purposes of determining the tax consequences of the disposition of the S corporation stock by the trust. A QSST generally is a trust with one individual income beneficiary for the life of the beneficiary.

EXPLANATION OF PROVISION


Under the bill, the beneficiary of a qualified subchapter S trust is generally allowed to deduct suspended losses under the at-risk rules and the passive loss rules when the trust disposes of the S corporation stock.

EFFECTIVE DATE


The provision applies to transfers made after December 31, 2004.

6. Exclusion of investment securities income from passive investment income test for bank S corporations

PRESENT LAW


An S corporation is subject to corporate-level tax, at the highest corporate tax rate, on its excess net passive income if the corporation has (1) accumulated earnings and profits at the close of the taxable year and (2) gross receipts more than 25 percent of which are passive investment income.

Excess net passive income is the net passive income for a taxable year multiplied by a fraction, the numerator of which is the amount of passive investment income in excess of 25 percent of gross receipts and the denominator of which is the passive investment income for the year. Net passive income is defined as passive investment income reduced by the allowable deductions that are directly connected with the production of that income. Passive investment income generally means gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities (to the extent of gains). Passive investment income generally does not include interest on accounts receivable, gross receipts that are derived directly from the active and regular conduct of a lending or finance business, gross receipts from certain liquidations, or gain or loss from any section 1256 contract (or related property) of an options or commodities dealer. 34

 [Footnote]

[Footnote 34: Notice 97-5, 1997-1 C.B. 352, sets forth guidance relating to passive investment income on banking assets.]

In addition, an S corporation election is terminated whenever the S corporation has accumulated earnings and profits at the close of each of three consecutive taxable years and has gross receipts for each of those years more than 25 percent of which are passive investment income.

EXPLANATION OF PROVISION


The bill provides that, in the case of a bank (as defined in section 581), a bank holding company (as defined in section 2(a) of the Bank Holding Company Act of 1956), or a financial holding company (as defined in section 2(p) of that Act), interest income and dividends on assets required to be held by the bank or holding company are not treated as passive investment income for purposes of the S corporation passive investment income rules.

EFFECTIVE DATE


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

7. Treatment of bank director shares

PRESENT LAW


An S corporation may have no more than 75 shareholders and may have only one outstanding class of stock. 35

 [Footnote]

[Footnote 35: Another provision of the bill increases the maximum number of shareholders to 100.]

An S corporation has one class of stock if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds. Differences in voting rights are disregarded. 36

 [Footnote]

[Footnote 36: Sec. 1361(c)(4). Treasury regulations provide that buy-sell and redemption agreements are disregarded in determining whether a corporation's outstanding shares confer identical distribution and liquidation rights unless (1) a principal purpose of the agreement is to circumvent the one class of stock requirement and (2) the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of, or below, the fair market value of the stock. Treas. Reg. sec. 1.1361-1(l).]

National banking law requires that a director of a national bank own stock in the bank and that a bank have at least five directors. 37

 [Footnote]  A number of States have similar requirements for State-chartered banks. Apparently, it is common practice for a bank director to enter into an agreement under which the bank (or a holding company) will reacquire the stock upon the director's ceasing to hold the office of director, at the price paid by the director for the stock. 38

 [Footnote]

[Footnote 37: 12 U.S.C. secs. 71-72.]

[Footnote 38: See Private Letter Ruling 200217048 (January 24, 2002) describing such an agreement and holding that it creates a second class of stock. Nonetheless, the ruling concluded that the election to be an S corporation was inadvertently invalid and that an amended agreement did not create a second class of stock so that the corporation's election was validated.]

EXPLANATION OF PROVISION


Under the bill, restricted bank director stock is not taken into account as outstanding stock in applying the provisions of subchapter S. 39

 [Footnote]  Thus, the stock is not treated as a second class of stock; a director is not treated as a shareholder of the S corporation by reason of the stock; the stock is disregarded in allocating items of income, loss, etc. among the shareholders; and the stock is not treated as outstanding for purposes of determining whether an S corporation holds 100 percent of the stock of a qualified subchapter S subsidiary.

[Footnote 39: No inference is intended as to the proper tax treatment under present law.]

Restricted bank director stock is stock in a bank (as defined in section 581), a bank holding company (within the meaning of section 2(a) of the Bank Holding Company Act of 1956), or a financial holding company (as defined in section 2(p) of that Act), registered with the Federal Reserve System, if the stock is required to be held by an individual under applicable Federal or State law in order to permit the individual to serve as a director of the bank or holding company and which is subject to an agreement with the bank or holding company (or corporation in control of the bank or company) pursuant to which the holder is required to sell the stock back upon ceasing to be a director at the same price the individual acquired the stock.

A distribution (other than a payment in exchange for the stock) with respect to the restricted stock is includible in the gross income of the director and is deductible by the S corporation for the taxable year that includes the last day of the director's taxable year in which the distribution is included in income.

EFFECTIVE DATE


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

8. Relief from inadvertently invalid qualified subchapter S subsidiary elections and terminations

PRESENT LAW


Under present law, inadvertent invalid subchapter S elections and terminations may be waived.

EXPLANATION OF PROVISION


The bill allows inadvertent invalid qualified subchapter S subsidiary elections and terminations to be waived by the IRS.

EFFECTIVE DATE


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

9. Information returns for qualified subchapter S subsidiaries

PRESENT LAW


Under present law, a corporation all of whose stock is held by an S corporation is treated as a qualified subchapter S subsidiary if the S corporation so elects. The assets, liabilities, and items of income, deduction, and credit of the subsidiary are treated as assets, liabilities, and items of the parent S corporation.

EXPLANATION OF PROVISION


The bill provides authority to the Secretary to provide guidance regarding information returns of qualified subchapter S subsidiaries.

EFFECTIVE DATE


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

10. Repayment of loans for qualifying employer securities

PRESENT LAW


An employee stock ownership plan (an `ESOP') is a defined contribution plan that is designated as an ESOP and is designed to invest primarily in qualifying employer securities. For purposes of ESOP investments, a `qualifying employer security' is defined as: (1) publicly traded common stock of the employer or a member of the same controlled group; (2) if there is no such publicly traded common stock, common stock of the employer (or member of the same controlled group) that has both voting power and dividend rights at least as great as any other class of common stock; or (3) noncallable preferred stock that is convertible into common stock described in (1) or (2) and that meets certain requirements. In some cases, an employer may design a class of preferred stock that meets these requirements and that is held only by the ESOP. Special rules apply to ESOPs that do not apply to other types of qualified retirement plans, including a special exemption from the prohibited transaction rules.

Certain transactions between an employee benefit plan and a disqualified person, including the employer maintaining the plan, are prohibited transactions that result in the imposition of an excise tax. 40

 [Footnote]  Prohibited transactions include, among other transactions, (1) the sale, exchange or leasing of property between a plan and a disqualified person, (2) the lending of money or other extension of credit between a plan and a disqualified person, and (3) the transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the plan. However, certain transactions are exempt from prohibited transaction treatment, including certain loans to enable an ESOP to purchase qualifying employer securities. 41

 [Footnote]  In such a case, the employer securities purchased with the loan proceeds are generally pledged as security for the loan. Contributions to the ESOP and dividends paid on employer securities held by the ESOP are used to repay the loan. The employer securities are held in a suspense account and released for allocation to participants' accounts as the loan is repaid.

[Footnote 40: Sec. 4975.]

[Footnote 41: Sec. 4975(d)(3). An ESOP that borrows money to purchase employer stock is referred to as a `leveraged' ESOP.]

A loan to an ESOP is exempt from prohibited transaction treatment if the loan is primarily for the benefit of the participants and their beneficiaries, the loan is at a reasonable rate of interest, and the collateral given to a disqualified person consists of only qualifying employer securities. No person entitled to payments under the loan can have the right to any assets of the ESOP other than (1) collateral given for the loan, (2) contributions made to the ESOP to meet its obligations on the loan, and (3) earnings attributable to the collateral and the investment of contributions described in (2). 42

 [Footnote]  In addition, the payments made on the loan by the ESOP during a plan year cannot exceed the sum of those contributions and earnings during the current and prior years, less loan payments made in prior years.

[Footnote 42: Treas. Reg. sec. 54.4975-7(b)(5).]

An ESOP of a C corporation is not treated as violating the qualification requirements of the Code or as engaging in a prohibited transaction merely because, in accordance with plan provisions, a dividend paid with respect to qualifying employer securities held by the ESOP is used to make payments on a loan (including payments of interest as well as principal) that was used to acquire the employer securities (whether or not allocated to participants). 43

 [Footnote]  In the case of a dividend paid with respect to any employer security that is allocated to a participant, this relief does not apply unless the plan provides that employer securities with a fair market value of not less than the amount of the dividend is allocated to the participant for the year which the dividend would have been allocated to the participant. 44

 [Footnote]

[Footnote 43: Sec. 404(k)(5)(B).]

[Footnote 44: Sec. 404(k)(2)(B).]

EXPLANATION OF PROVISION


Under the provision, an ESOP maintained by an S corporation is not treated as violating the qualification requirements of the Code or as engaging in a prohibited transaction merely because, in accordance with plan provisions, a distribution made with respect to S corporation stock that constitutes qualifying employer securities held by the ESOP is used to repay a loan that was used to acquire the securities (whether or not allocated to participants). This relief does not apply in the case of a distribution with respect to S corporation stock that is allocated to a participant unless the plan provides that stock with a fair market value of not less than the amount of such distribution is allocated to the participant for the year which the distribution would have been allocated to the participant.

EFFECTIVE DATE


The provision is effective for distributions made with respect to S corporation stock after December 31, 2004.

D. ALTERNATIVE MINIMUM TAX RELIEF


1. Foreign tax credit under alternative minimum tax; expansion of exemption from alternative minimum tax for small corporations; income averaging for farmers not to increase alternative minimum tax (secs. 241-243 of the bill and secs. 55-59 of the Code)

PRESENT LAW


In general

Under present law, taxpayers are subject to an alternative minimum tax (`AMT'), which is payable, in addition to all other tax liabilities, to the extent that it exceeds the taxpayer's regular income tax liability. The tax is imposed at a flat rate of 20 percent, in the case of corporate taxpayers, on alternative minimum taxable income (`AMTI') in excess of a phased-out exemption amount. AMTI is the taxpayer's taxable income increased for certain tax preferences and adjusted by determining the tax treatment of certain items in a manner that limits the tax benefits resulting from the regular tax treatment of such items.

Foreign tax credit

Taxpayers are permitted to reduce their AMT liability by an AMT foreign tax credit. The AMT foreign tax credit for a taxable year is determined under principles similar to those used in computing the regular tax foreign tax credit, except that (1) the numerator of the AMT foreign tax credit limitation fraction is foreign source AMTI and (2) the denominator of that fraction is total AMTI. Taxpayers may elect to use as their AMT foreign tax credit limitation fraction the ratio of foreign source regular taxable income to total AMTI.

The AMT foreign tax credit for any taxable year generally may not offset a taxpayer's entire pre-credit AMT. Rather, the AMT foreign tax credit is limited to 90 percent of AMT computed without any AMT net operating loss deduction and the AMT foreign tax credit. For example, assume that a corporation has $10 million of AMTI, has no AMT net operating loss deduction, and has no regular tax liability. In the absence of the AMT foreign tax credit, the corporation's tax liability would be $2 million. Accordingly, the AMT foreign tax credit cannot be applied to reduce the taxpayer's tax liability below $200,000. Any unused AMT foreign tax credit may be carried back two years and carried forward five years for use against AMT in those years under the principles of the foreign tax credit carryback and carryover rules set forth in section 904(c).

Small corporation exemption

Corporations with average gross receipts of less than $7.5 million for the prior three taxable years are exempt from the corporate AMT. The $7.5 million threshold is reduced to $5 million for the corporation's first 3-taxable year period.

Farmer income averaging

An individual taxpayer engaged in a farming business (as defined by section 263A(e)(4)) may elect to compute his or her current year regular tax liability by averaging, over the prior three-year period, all or portion of his or her taxable income from the trade or business of farming. Because farmer income averaging reduces the regular tax liability, the AMT may be increased. Thus, the benefits of farmer income averaging may be reduced or eliminated for farmers subject to the AMT.

 REASONS FOR CHANGE


The Committee believes that the AMT is merely a prepayment of tax. The corporate AMT requires businesses to prepay their taxes when they can least afford it, during a business downturn. The Committee believes that increasing the gross receipts cap for companies exempt from corporate AMT from $7.5 million of gross receipts to $20 million of gross receipts will relieve many taxpayers of the financial burden of having to prepay their tax when they can least afford it. The provision also will relieve many taxpayers of the administrative cost and compliance burden of having to calculate their taxes under two separate income tax systems. The Committee also believes that taxpayers should be permitted full use of foreign tax credits in computing the AMT. The Committee believes that farmers should be allowed the full benefits of income averaging without incurring liability under the AMT.

 EXPLANATION OF PROVISION


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

The provision increases the amount of average gross receipts that an exempt corporation may receive from $7.5 million to $20 million.

The provision provides that, in computing AMT, a farmer's regular tax liability is determined without regard to farmer income averaging. Thus, a farmer receives the full benefit of income averaging because averaging reduces the regular tax while the AMT (if any) remains unchanged.

EFFECTIVE DATE


The provision relating to the foreign tax credit applies to taxable years beginning after December 31, 2004.

The provision relating to the small corporation exemption applies to taxable years beginning after December 31, 2005.

The provision relating to farmers' income averaging applies to taxable years beginning after December 31, 2003.

E. RESTRUCTURING OF INCENTIVES FOR ALCOHOL FUELS, ETC.


1. Reduced rates of tax on alcohol fuel mixtures replaced with an excise tax credit, etc. (secs. 251 and 252 of the bill and secs. 4041, 4081, 4091, 6427 and 9503 of the Code)

PRESENT LAW


Alcohol fuels income tax credit

The alcohol fuels credit is the sum of three credits: the alcohol mixture credit, the alcohol credit, and the small ethanol producer credit. Generally, the alcohol fuels credit expires after December 31, 2007. 45

 [Footnote]

[Footnote 45: The alcohol fuels credit is unavailable when, for any period before January 1, 2008, the tax rates for gasoline and diesel fuels drop to 4.3 cents per gallon.]

A taxpayer (generally a petroleum refiner, distributor, or marketer) who mixes ethanol with gasoline (or a special fuel 46

 [Footnote] ) is an `ethanol blender.' Ethanol blenders are eligible for an income tax credit of 52 cents per gallon of ethanol used in the production of a qualified mixture (the `alcohol mixture credit'). A qualified mixture means a mixture of alcohol and gasoline, (or of alcohol and a special fuel) sold by the blender as fuel, or used as fuel by the blender in producing the mixture. The term alcohol includes methanol and ethanol but does not include (1) alcohol produced from petroleum, natural gas, or coal (including peat), or (2) alcohol with a proof of less than 150. Businesses also may reduce their income taxes by 52 cents for each gallon of ethanol (not mixed with gasoline or other special fuel) that they sell at the retail level as vehicle fuel or use themselves as a fuel in their trade or business (`the alcohol credit'). The 52-cents-per-gallon income tax credit rate is scheduled to decline to 51 cents per gallon during the period 2005 through 2007. For blenders using an alcohol other than ethanol, the rate is 60 cents per gallon. 47

 [Footnote]

[Footnote 46: A special fuel includes any liquid (other than gasoline) that is suitable for use in an internal combustion engine.]

[Footnote 47: In the case of any alcohol (other than ethanol) with a proof that is at least 150 but less than 190, the credit is 45 cents per gallon (the `low-proof blender amount'). For ethanol with a proof that is at least 150 but less than 190, the low-proof blender amount is 38.52 cents for sales or uses during calendar year 2004, and 37.78 cents for calendar years 2005, 2006, and 2007.]

A separate income tax credit is available for small ethanol producers (the `small ethanol producer credit'). A small ethanol producer is defined as a person whose ethanol production capacity does not exceed 30 million gallons per year. The small ethanol producer credit is 10 cents per gallon of ethanol produced during the taxable year for up to a maximum of 15 million gallons.

The credits that comprise the alcohol fuels tax credit are includible in income. The credit may not be used to offset alternative minimum tax liability. The credit is treated as a general business credit, subject to the ordering rules and carryforward/carryback rules that apply to business credits generally.

Excise tax reductions for alcohol mixture fuels

Generally, motor fuels tax rates are as follows: 48

 [Footnote]

[Footnote 48: These fuels are also subject to an additional 0.1 cent-per-gallon excise tax to fund the Leaking Underground Storage Tank Trust Fund. See secs. 4041(d) and 4081(a)(2)(B). In addition, the basic fuel tax rate will drop to 4.3 cents per gallon beginning on October 1, 2005.]





----------------------------------------------------------


----------------------------------------------------------


Gasoline                 18.3 cents per gallon.           


Diesel fuel and kerosene 24.3 cents per gallon.           


Special motor fuels      18.3 cents per gallon generally. 


----------------------------------------------------------


Alcohol-blended fuels are subject to a reduced rate of tax. The benefits provided by the alcohol fuels income tax credit and the excise tax reduction are integrated such that the alcohol fuels credit is reduced to take into account the benefit of any excise tax reduction.

Gasohol

Registered ethanol blenders may forgo the full income tax credit and instead pay reduced rates of excise tax on gasoline that they purchase for blending with ethanol. Most of the benefit of the alcohol fuels credit is claimed through the excise tax system.

The reduced excise tax rates apply to gasohol upon its removal or entry. Gasohol is defined as a gasoline/ethanol blend that contains 5.7 percent ethanol, 7.7 percent ethanol, or 10 percent ethanol. For the calendar year 2004, the following reduced rates apply to gasohol: 49

 [Footnote]

[Footnote 49: These rates include the additional 0.1 cent-per-gallon excise tax to fund the Leaking Underground Storage Tank Trust Fund. These special rates will terminate after September 30, 2007 (sec. 4081(c)(8)).]





----------------------------------------------


----------------------------------------------


5.7 percent ethanol  15.436 cents per gallon. 


7.7 percent ethanol  14.396 cents per gallon. 


10.0 percent ethanol 13.200 cents per gallon. 


----------------------------------------------


Reduced excise tax rates also apply when gasoline is purchased for the production of `gasohol.' When gasoline is purchased for blending into gasohol, the rates above are multiplied by a fraction (e.g., 10/9 for 10-percent gasohol) so that the increased volume of motor fuel will be subject to tax. The reduced tax rates apply if the person liable for the tax is registered with the IRS and (1) produces gasohol with gasoline within 24 hours of removing or entering the gasoline or (2) gasoline is sold upon its removal or entry and such person has an unexpired certificate from the buyer and has no reason to believe the certificate is false. 50

 [Footnote]

[Footnote 50: Treas. Reg. sec. 48.4081-6(c). A certificate from the buyer assures that the gasoline will be used to produce gasohol within 24 hours after purchase. A copy of the registrant's letter of registration cannot be used as a gasohol blender's certificate.]

Qualified methanol and ethanol fuels

Qualified methanol or ethanol fuel is any liquid that contains at least 85 percent methanol or ethanol or other alcohol produced from a substance other than petroleum or natural gas. These fuels are taxed at reduced rates. 51

 [Footnote]  The rate of tax on qualified methanol is 12.35 cents per gallon. The rate on qualified ethanol in 2004 is 13.15 cents. From January 1, 2005 through September 30, 2007, the rate of tax on qualified ethanol is 13.25 cents.

[Footnote 51: These reduced rates terminate after September 30, 2007. Included in these rates is the 0.05-cent-per-gallon Leaking Underground Storage Tank Trust Fund tax imposed on such fuel. (sec. 4041(b)(2)).]

Alcohol produced from natural gas

A mixture of methanol, ethanol, or other alcohol produced from natural gas that consists of at least 85 percent alcohol is also taxed at reduced rates. 52

 [Footnote]  For mixtures not containing ethanol, the applicable rate of tax is 9.25 cents per gallon before October 1, 2005. In all other cases, the rate is 11.4 cents per gallon. After September 30, 2005, the rate is reduced to 2.15 cents per gallon when the mixture does not contain ethanol and 4.3 cents per gallon in all other cases.

[Footnote 52: These rates include the additional 0.1 cent-per-gallon excise tax to fund the Leaking Underground Storage Tank Trust Fund (sec. 4041(d)(1)).]

Blends of alcohol and diesel fuel or special motor fuels

A reduced rate of tax applies to diesel fuel or kerosene that is combined with alcohol as long as at least 10 percent of the finished mixture is alcohol. If none of the alcohol in the mixture is ethanol, the rate of tax is 18.4 cents per gallon. For alcohol mixtures containing ethanol, the rate of tax in 2004 is 19.2 cents per gallon and 19.3 cents per gallon for 2005 through September 30, 2007. Fuel removed or entered for use in producing a 10 percent diesel-alcohol fuel mixture (without ethanol), is subject to a tax of 20.44 cents per gallon. The rate of tax for fuel removed or entered for use to produce a 10 percent diesel-ethanol fuel mixture is 21.333 cents per gallon for 2004 and 21.444 cents per gallon for the period January 1, 2005 through September 30, 2007. 53

 [Footnote]

[Footnote 53: These rates include the additional 0.1 cent-per-gallon excise tax to fund the Leaking Underground Storage Tank Trust Fund.]

Special motor fuel (nongasoline) mixtures with alcohol also are taxed at reduced rates.

Aviation fuel

Noncommercial aviation fuel is subject to a tax of 21.9 cents per gallon. 54

 [Footnote]  Fuel mixtures containing at least 10 percent alcohol are taxed at lower rates. 55

 [Footnote]  In the case of 10 percent ethanol mixtures, for any sale or use during 2004, the 21.9 cents is reduced by 13.2 cents (for a tax of 8.7 cents per gallon), for 2005, 2006, and 2007 the reduction is 13.1 cents (for a tax of 8.8 cents per gallon) and is reduced by 13.4 cents in the case of any sale during 2008 or thereafter. For mixtures not containing ethanol, the 21.9 cents is reduced by 14 cents for a tax of 7.9 cents. These reduced rates expire after September 30, 2007. 56

 [Footnote]

[Footnote 54: This rate includes the additional 0.1 cent-per-gallon tax for the Leaking Underground Storage Tank Trust fund.]

[Footnote 55: Secs. 4041(k)(1) and 4091(c).]

[Footnote 56: Sec. 4091(c)(1).]

When aviation fuel is purchased for blending with alcohol, the rates above are multiplied by a fraction (10/9) so that the increased volume of aviation fuel will be subject to tax.

Refunds and payments

If fully taxed gasoline (or other taxable fuel) is used to produce a qualified alcohol mixture, the Code permits the blender to file a claim for a quick excise tax refund. The refund is equal to the difference between the gasoline (or other taxable fuel) excise tax that was paid and the tax that would have been paid by a registered blender on the alcohol fuel mixture being produced. Generally, the IRS pays these quick refunds within 20 days. Interest accrues if the refund is paid more than 20 days after filing. A claim may be filed by any person with respect to gasoline, diesel fuel, or kerosene used to produce a qualified alcohol fuel mixture for any period for which $200 or more is payable and which is not less than one week.

Ethyl tertiary butyl ether (ETBE)

Ethyl tertiary butyl ether (`ETBE') is an ether that is manufactured using ethanol. Unlike ethanol, ETBE can be blended with gasoline before the gasoline enters a pipeline because ETBE does not result in contamination of fuel with water while in transport. Treasury regulations provide that gasohol blenders may claim the income tax credit and excise tax rate reductions for ethanol used in the production of ETBE. The regulations also provide a special election allowing refiners to claim the benefit of the excise tax rate reduction even though the fuel being removed from terminals does not contain the requisite percentages of ethanol for claiming the excise tax rate reduction.

Highway Trust Fund

With certain exceptions, the taxes imposed by section 4041 (relating to retail taxes on diesel fuels and special motor fuels) and section 4081 (relating to tax on gasoline, diesel fuel and kerosene) are credited to the Highway Trust Fund. In the case of alcohol fuels, 2.5 cents per gallon of the tax imposed is retained in the General Fund. 57

 [Footnote]  In the case of a taxable fuel taxed at a reduced rate upon removal or entry prior to mixing with alcohol, 2.8 cents of the reduced rate is retained in the General Fund. 58

 [Footnote]

[Footnote 57: Sec. 9503(b)(4)(E).]

[Footnote 58: Sec. 9503(b)(4)(F).]

Taxes from gasoline and special motor fuels used in motorboats and gasoline used in the nonbusiness use of small-engine outdoor power equipment

The Aquatic Resources Trust Fund is funded by a portion of the receipts from the excise tax imposed on motorboat gasoline and special motor fuels, as well as small-engine fuel taxes, that are first deposited into the Highway Trust Fund. As a result, transfers to the Aquatic Resources Trust Fund are governed in part by Highway Trust Fund provisions. 59

 [Footnote]

[Footnote 59: Sec. 9503(c)(4) and 9503(c)(5).]

A total tax rate of 18.4 cents per gallon is imposed on gasoline and special motor fuels used in motorboats. Of this rate, 0.1 cent per gallon is dedicated to the Leaking Underground Storage Tank Trust Fund. Of the remaining 18.3 cents per gallon, the Code currently transfers 13.5 cents per gallon from the Highway Trust Fund to the Aquatics Resources Trust Fund and Land and Water Conservation Fund. The remainder, 4.8 cents per gallon, is retained in the General Fund. In addition, the Sport Fish Restoration Account of the Aquatics Resources Trust Fund receives 13.5 cents per gallon of the revenues from the tax imposed on gasoline used as a fuel in the nonbusiness use of small-engine outdoor power equipment. The balance of 4.8 cents per gallon is retained in the General Fund. 60

 [Footnote]

[Footnote 60: The Sport Fish Restoration Account also is funded with receipts from an ad valorem manufacturer's excise tax on sport fishing equipment.]

REASONS FOR CHANGE


Highway vehicles using alcohol-blended fuels contribute to the wear and tear of the same highway system used by gasoline or diesel vehicles. Therefore, the Committee believes that alcohol-blended fuels should be taxed at rates equal to gasoline or diesel. The Committee believes that present law provides opportunities for fraud because individuals can buy gasoline at reduced tax rates for blending with alcohol, but never actually use the gasoline to make an alcohol fuel blend. The Committee believes that eliminating the reduced tax rate on gasoline prior to blending with alcohol will reduce such opportunities for fraud. The Committee also believes that providing a tax credit based on the gallons of alcohol used to make an alcohol fuel and eliminating the various blend tiers associated with reduced tax rates for alcohol-blended fuels will simplify present law.

EXPLANATION OF PROVISION


Overview

The provision eliminates reduced rates of excise tax for alcohol-blended fuels and imposes the full rate of excise tax on alcohol-blended fuels (18.4 cents per gallon on gasoline blends and 24.4 cents per gallon of diesel blended fuel). In place of reduced rates, the provision permits the section 40 alcohol mixture credit, with certain modifications, to be applied against excise tax liability. The credit may be taken against the tax imposed on taxable fuels (by section 4081). To the extent a person does not have section 4081 liability, the provision allows taxpayers to file a claim for payment equal to the amount of the credit for the alcohol used to produce an eligible mixture. Under certain circumstances, a tax is imposed if an alcohol fuel mixture credit is claimed with respect to alcohol used in the production of any alcohol mixture, which is subsequently used for a purpose for which the credit is not allowed or changed into a substance that does not qualify for the credit. The provision eliminates the General Fund retention of certain taxes on alcohol fuels, and credits these taxes to the Highway Trust Fund.

 Alcohol fuel mixture excise tax credit and payment provisions

ALCOHOL FUEL MIXTURE EXCISE TAX CREDIT


The provision eliminates the reduced rates of excise tax for alcohol-blended fuels and taxable fuels used to produce an alcohol fuel mixture. Under the provision, the full rate of tax for taxable fuels is imposed on both alcohol fuel mixtures and the taxable fuel used to produce an alcohol fuel mixture.

In lieu of the reduced excise tax rates, the provision provides that the alcohol mixture credit provided under section 40 may be applied against section 4081 excise tax liability (hereinafter referred to as `the alcohol fuel mixture credit'). The credit is treated as a payment of the taxpayer's tax liability received at the time of the taxable event. The alcohol fuel mixture credit is 52 cents for each gallon of alcohol used by a person in producing an alcohol fuel mixture for sale or use in a trade or business of the taxpayer. The credit declines to 51 cents per gallon after calendar year 2004. For mixtures not containing ethanol (renewable source methanol), the credit is 60 cents per gallon. As discussed further below, the excise tax credit is refundable in order to provide a benefit equivalent to the reduced tax rates, which are being repealed under the provision.

For purposes of the alcohol fuel mixture credit, an `alcohol fuel mixture' is a mixture of alcohol and gasoline or alcohol and a special fuel which is sold for use or used as a fuel by the taxpayer producing the mixture. Alcohol for this purpose includes methanol, ethanol, and alcohol gallon equivalents of ETBE or other ethers produced from such alcohol. It does not include alcohol produced from petroleum, natural gas, or coal (including peat), or alcohol with a proof of less than 190 (determined without regard to any added denaturants). Special fuel is any liquid fuel (other than gasoline) which is suitable for use in an internal combustion engine. The benefit obtained from the excise tax credit is coordinated with the alcohol fuels income tax credit. For refiners making an alcohol fuel mixture with ETBE, the mixture is treated as sold to another person for use as a fuel only upon removal from the refinery. The excise tax credit is available through December 31, 2010.

Payments with respect to qualified alcohol fuel mixtures

To the extent the alcohol fuel mixture credit exceeds any section 4081 liability of a person, the Secretary is to pay such person an amount equal to the alcohol fuel mixture credit with respect to such mixture. These payments are intended to provide an equivalent benefit to replace the partial exemption for fuels to be blended with alcohol and alcohol fuels being repealed by the provision. If claims for payment are not paid within 45 days, the claim is to be paid with interest. The provision also provides that in the case of an electronic claim, if such claim is not paid within 20 days, the claim is to be paid with interest. If claims are filed electronically, the claimant may make a claim for less than $200.

The provision does not apply with respect to alcohol fuel mixtures sold after December 31, 2010.

Alcohol fuel subsidies borne by General Fund

The provision eliminates the requirement that 2.5 and 2.8 cents per gallon of excise taxes be retained in the General Fund with the result that the full amount of tax on alcohol fuels is credited to the Highway Trust Fund. The provision also authorizes the full amount of fuel taxes to be appropriated to the Highway Trust Fund without reduction for amounts equivalent to the excise tax credits allowed for alcohol fuel mixtures, and the Trust Fund is not required to reimburse any payments with respect to qualified alcohol fuel mixtures.

Motorboat and small engine fuel taxes

The provision eliminates the General Fund retention of the 4.8 cents per gallon of the taxes imposed on gasoline and special motor fuels used in motorboats and gasoline used as a fuel in the nonbusiness use of small-engine outdoor power equipment.

EFFECTIVE DATES


The provisions generally are effective for fuel sold or used after September 30, 2004. The repeal of the General Fund retention of the 2.5/2.8 cents per gallon of tax regarding alcohol fuels and the repeal of the 4.8 cents per gallon General Fund retention of the taxes imposed on fuels used in motorboats and small engine equipment is effective for taxes imposed after September 30, 2003. The provision regarding the crediting of the full amount of tax to the Highway Trust Fund without regard to credits and payments is effective for taxes received after September 30, 2004, and payments made after September 30, 2004.

F. STOCK OPTIONS AND EMPLOYEE STOCK PURCHASE PLAN STOCK OPTIONS


1. Exclusion of incentive stock options and employee stock purchase plan stock options from wages (sec. 261 of the bill and secs. 421(b), 423(c), 3121(a), 3231, and 3306(b) of the Code)

PRESENT LAW


Generally, when an employee exercises a compensatory option on employer stock, the difference between the option price and the fair market value of the stock (i.e., the `spread') is includible in income as compensation. In the case of an incentive stock option or an option to purchase stock under an employee stock purchase plan (collectively referred to as `statutory stock options'), the spread is not included in income at the time of exercise. 61

 [Footnote]

[Footnote 61: Sec. 421. For purposes of the individual alternative minimum tax, the transfer of stock pursuant to an incentive stock option is generally treated as the transfer of stock pursuant to a nonstatutory option. Sec. 56(b)(3).]

If the statutory holding period requirements are satisfied with respect to stock acquired through the exercise of a statutory stock option, the spread, and any additional appreciation, will be taxed as capital gain upon disposition of such stock. Compensation income is recognized, however, if there is a disqualifying disposition (i.e., if the statutory holding period is not satisfied) of stock acquired pursuant to the exercise of a statutory stock option.

Federal Insurance Contribution Act (`FICA') and Federal Unemployment Tax Act (`FUTA') taxes (collectively referred to as `employment taxes') are generally imposed in an amount equal to a percentage of wages paid by the employer with respect to employment. 62

 [Footnote]  The applicable Code provisions 63

 [Footnote]  do not provide an exception from FICA and FUTA taxes for wages paid to an employee arising from the exercise of a statutory stock option.

[Footnote 62: Secs. 3101, 3111 and 3301.]

[Footnote 63: Secs. 3121 and 3306.]

There has been uncertainty in the past as to employer withholding obligations upon the exercise of statutory stock options. On June 25, 2002, the IRS announced that until further guidance is issued, it would not assess FICA or FUTA taxes, or impose Federal income tax withholding obligations, upon either the exercise of a statutory stock option or the disposition of stock acquired pursuant to the exercise of a statutory stock option. 64

 [Footnote]

[Footnote 64: Notice 2002-47, 2002-28 I.R.B. 97.]

REASONS FOR CHANGE


To provide taxpayers certainty, the Committee believes that it is appropriate to clarify the treatment of statutory stock options for employment tax and income tax withholding purposes. The Committee believes that in the past, the IRS has been inconsistent in its treatment of taxpayers with respect to this issue and did not uniformly challenge taxpayers who did not collect employment taxes and withhold income taxes on statutory stock options.

Until January 2001, the IRS had not published guidance with respect to the imposition of employment taxes and income tax withholding on statutory stock options. Many taxpayers relied on guidance published with respect to qualified stock options (the predecessor to incentive stock options) to take the position that no employment taxes or income tax withholding were required with respect to statutory stock options. It is the Committee's belief that a majority of taxpayers did not withhold employment and income taxes with respect to statutory stock options. Thus, proposed IRS regulations, if implemented, would have altered the treatment of statutory stock options for most employers.

Because there is a specific income tax exclusion with respect to statutory stock options, the Committee believes it is appropriate to clarify that there is a conforming exclusion for employment taxes and income tax withholding. Statutory stock options are required to meet certain Code requirements that do not apply to nonqualified stock options. The Committee believes that such requirements are intended to make statutory stock options a tool of employee ownership rather than a form of compensation subject to employment taxes. Furthermore, this clarification will ensure that, if further IRS guidance is issued, employees will not be faced with a tax increase that will reduce their net paychecks even though their total compensation has not changed.

The clarification will also eliminate the administrative burden and cost to employers who, in the absence of the Committee bill, could be required to modify their payroll systems to provide for the withholding of income and employment taxes on statutory stock options that they are not currently required to withhold.

EXPLANATION OF PROVISION


The provision provides specific exclusions from FICA and FUTA wages for remuneration on account of the transfer of stock pursuant to the exercise of an incentive stock option or under an employee stock purchase plan, or any disposition of such stock. Thus, under the provision, FICA and FUTA taxes do not apply upon the exercise of a statutory stock option. 65

 [Footnote]  The provision also provides that such remuneration is not taken into account for purposes of determining Social Security benefits.

[Footnote 65: The provision also provides a similar exclusion under the Railroad Retirement Tax Act.]

Additionally, the provision provides that Federal income tax withholding is not required on a disqualifying disposition, nor when compensation is recognized in connection with an employee stock purchase plan discount. Present law reporting requirements continue to apply.

EFFECTIVE DATE


The provision is effective for stock acquired pursuant to options exercised after the date of enactment.

G. INCENTIVES TO REINVEST FOREIGN EARNINGS IN THE UNITED STATES


(Sec. 271 of the bill and new sec. 965 of the Code)

PRESENT LAW


The United States employs a `worldwide' tax system, under which domestic corporations generally are taxed on all income, whether derived in the United States or abroad. Income earned by a domestic parent corporation from foreign operations conducted by foreign corporate subsidiaries generally is subject to U.S. tax when the income is distributed as a dividend to the domestic corporation. Until such repatriation, the U.S. tax on such income generally is deferred, and U.S. tax is imposed on such income when repatriated. However, under anti-deferral rules, the domestic parent corporation may be taxed on a current basis in the United States with respect to certain categories of passive or highly mobile income earned by its foreign subsidiaries, regardless of whether the income has been distributed as a dividend to the domestic parent corporation. The main anti-deferral provisions in this context are the controlled foreign corporation rules of subpart F 66

 [Footnote]  and the passive foreign investment company rules. 67

 [Footnote]  A foreign tax credit generally is available to offset, in whole or in part, the U.S. tax owed on foreign-source income, whether earned directly by the domestic corporation, repatriated as a dividend from a foreign subsidiary, or included in income under the anti-deferral rules. 68

 [Footnote]

[Footnote 66: Secs. 951-964.]

[Footnote 67: Secs. 1291-1298.]

[Footnote 68: Secs. 901, 902, 960, 1291(g).]

REASONS FOR CHANGE


The Committee observes that the residual U.S. tax imposed on the repatriation of foreign earnings can serve as a disincentive to repatriate these earnings. The Committee believes that a temporary reduction in the U.S. tax on repatriated dividends will stimulate the U.S. domestic economy by triggering the repatriation of foreign earnings that otherwise would have remained abroad. The Committee emphasizes that this is a temporary economic stimulus measure.

EXPLANATION OF PROVISION


Under the provision, certain dividends received by a U.S. corporation from a controlled foreign corporation are eligible for an 85-percent dividends-received deduction. At the taxpayer's election, this deduction is available for dividends received either: (1) during the first six months of the taxpayer's first taxable year beginning on or after the date of enactment of the bill; or (2) during any six-month or shorter period after the date of enactment of the bill, during the taxpayer's last taxable year beginning before such date. Dividends received after the election period will be taxed in the normal manner under present law.

The deduction applies only to dividends and other amounts included in gross income as dividends (e.g., amounts described in section 1248(a)). The deduction does not apply to items that are not included in gross income as dividends, such as subpart F inclusions or deemed repatriations under section 956. Similarly, the deduction does not apply to distributions of earnings previously taxed under subpart F, except to the extent that the subpart F inclusions result from the payment of a dividend by one controlled foreign corporation to another controlled foreign corporation within a certain chain of ownership during the election period. This exception enables multinational corporate groups to qualify for the deduction in connection with the repatriation of earnings from lower-tier controlled foreign corporations.

The deduction is subject to a number of limitations. First, it applies only to repatriations in excess of the taxpayer's average repatriation level over three of the five most recent taxable years ending on or before March 31, 2003, determined by disregarding the highest-repatriation year and the lowest-repatriation year among such five years (the `base-period average'). In addition to actual dividends, deemed repatriations under section 956 and distributions of earnings previously taxed under subpart F are included in the base-period average.

Second, the amount of dividends eligible for the deduction is limited to the greatest of: (1) $500 million; (2) the amount of earnings shown as permanently invested outside the United States on the taxpayer's most recent audited financial statement which is certified on or before March 31, 2003; or (3) in the case of an applicable financial statement that fails to show a specific amount of such earnings, but that does show a specific amount of tax liability attributable to such earnings, the amount of such earnings determined in such manner as the Treasury Secretary may prescribe.

Third, dividends qualifying for the deduction must be invested in the United States pursuant to a plan approved by the senior management and board of directors of the corporation claiming the deduction.

No foreign tax credit (or deduction) is allowed for foreign taxes attributable to the deductible portion of any dividend received during the taxable year for which an election under the provision is in effect. For this purpose, the taxpayer may specifically identify which dividends are treated as carrying the deduction and which are not; in the absence of such identification, a pro rata amount of foreign tax credits will be disallowed with respect to every dividend received during the taxable year.

In addition, the income attributable to the nondeductible portion of a qualifying dividend may not be offset by net operating losses, and the tax attributable to such income generally may not be offset by credits (other than foreign tax credits and AMT credits) and may not reduce the alternative minimum tax otherwise owed by the taxpayer. No deduction under sections 243 or 245 is allowed for any dividend for which a deduction is allowed under the provision.

EFFECTIVE DATE


The provision is effective for a taxpayer's first taxable year beginning on or after the date of enactment of the bill, or the taxpayer's last taxable year beginning before such date, at the taxpayer's election.

H. OTHER PROVISIONS


1. Special rules for livestock sold on account of weather-related conditions (sec. 281 of the bill and secs. 1033 and 451 of the Code)

PRESENT LAW


Generally, a taxpayer realizes gain to the extent the sales price (and any other consideration received) exceeds the taxpayer's basis in the property. The realized gain is subject to current income tax unless the gain is deferred or not recognized under a special tax provision.

Under section 1033, gain realized by a taxpayer from an involuntary conversion of property is deferred to the extent the taxpayer purchases property similar or related in service or use to the converted property within the applicable period. The taxpayer's basis in the replacement property generally is the same as the taxpayer's basis in the converted property, decreased by the amount of any money or loss recognized on the conversion, and increased by the amount of any gain recognized on the conversion.

The applicable period for the taxpayer to replace the converted property begins with the date of the disposition of the converted property (or if earlier, the earliest date of the threat or imminence of requisition or condemnation of the converted property) and ends two years after the close of the first taxable year in which any part of the gain upon conversion is realized (the `replacement period'). Special rules extend the replacement period for certain real property and principle residences damaged by a Presidentially declared disaster to three years and four years, respectively, after the close of the first taxable year in which gain is realized.

Section 1033(e) provides that the sale of livestock (other than poultry) that is held for draft, breeding, or dairy purposes in excess of the number of livestock that would have been sold but for drought, flood, or other weather-related conditions is treated as an involuntary conversion. Consequently, gain from the sale of such livestock could be deferred by reinvesting the proceeds of the sale in similar property within a two-year period.

In general, cash-method taxpayers report income in the year it is actually or constructively received. However, section 451(e) provides that a cash-method taxpayer whose principal trade or business is farming who is forced to sell livestock due to drought, flood, or other weather-related conditions may elect to include income from the sale of the livestock in the taxable year following the taxable year of the sale. This elective deferral of income is available only if the taxpayer establishes that, under the taxpayer's usual business practices, the sale would not have occurred but for drought, flood, or weather-related conditions that resulted in the area being designated as eligible for Federal assistance. This exception is generally intended to put taxpayers who receive an unusually high amount of income in one year in the position they would have been in absent the weather-related condition.

REASONS FOR CHANGE


The Committee is aware of situations in which cattlemen sold livestock in excess of their usual business practice as a result of weather-related conditions, but have been unable to purchase replacement property because the weather-related conditions have continued. The Committee believes it is appropriate to extend the time period for cattlemen to purchase replacement property in such situations.

EXPLANATION OF PROVISION


The provision extends the applicable period for a taxpayer to replace livestock sold on account of drought, flood, or other weather-related conditions from two years to four years after the close of the first taxable year in which any part of the gain on conversion is realized. The extension is only available if the taxpayer establishes that, under the taxpayer's usual business practices, the sale would not have occurred but for drought, flood, or weather-related conditions that resulted in the area being designated as eligible for Federal assistance. In addition, the Secretary of the Treasury is granted authority to further extend the replacement period on a regional basis should the weather-related conditions continue longer than three years. Also, for property eligible for the provision's extended replacement period, the provision provides that the taxpayer can make an election under section 451(e) until the period for reinvestment of such property under section 1033 expires.

EFFECTIVE DATE


The provision is effective for any taxable year with respect to which the due date (without regard to extensions) for the return is after December 31, 2002.

2. Payment of dividends on stock of cooperatives without reducing patronage dividends (sec. 282 of the bill and sec. 1388 of the Code)

PRESENT LAW


Under present law, cooperatives generally are entitled to deduct or exclude amounts distributed as patronage dividends in accordance with Subchapter T of the Code. In general, patronage dividends are comprised of amounts that are paid to patrons (1) on the basis of the quantity or value of business done with or for patrons, (2) under a valid and enforceable obligation to pay such amounts that was in existence before the cooperative received the amounts paid, and (3) which are determined by reference to the net earnings of the cooperative from business done with or for patrons.

Treasury Regulations provide that net earnings are reduced by dividends paid on capital stock or other proprietary capital interests (referred to as the `dividend allocation rule'). 69

 [Footnote]  The dividend allocation rule has been interpreted to require that such dividends be allocated between a cooperative's patronage and nonpatronage operations, with the amount allocated to the patronage operations reducing the net earnings available for the payment of patronage dividends.

[Footnote 69: Treas. Reg. sec. 1.1388-1(a)(1).]

REASONS FOR CHANGE


The Committee believes that the dividend allocation rule should not apply to the extent that the organizational documents of a cooperative provide that capital stock dividends do not reduce the amounts owed to patrons as patronage dividends. To the extent that capital stock dividends are in addition to amounts paid under the cooperative's organizational documents to patrons as patronage dividends, the Committee believes that those capital stock dividends are not being paid from earnings from patronage business.

In addition, the Committee believes cooperatives should be able to raise needed equity capital by issuing capital stock without dividends paid on such stock causing the cooperative to be taxed on a portion of its patronage income, and without preventing the cooperative from being treated as operating on a cooperative basis.

EXPLANATION OF PROVISION


The provision provides a special rule for dividends on capital stock of a cooperative. To the extent provided in organizational documents of the cooperative, dividends on capital stock do not reduce patronage income and do not prevent the cooperative from being treated as operating on a cooperative basis.

EFFECTIVE DATE


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

3. Capital gains treatment to apply to outright sales of timber by landowner (sec. 283 of the bill and sec. 631(b) of the Code)

PRESENT LAW


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

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


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

EFFECTIVE DATE


The provision is effective for sales of timber after December 31, 2004.

4. Distributions from publicly traded partnerships treated as qualifying income of regulated investment company (sec. 284 of the bill and secs. 851 and 469(k) of the Code)

PRESENT LAW


Treatment of RICs

A regulated investment company (`RIC') generally is treated as a conduit for Federal income tax purposes. In computing its taxable income, a RIC deducts dividends paid to its shareholders to achieve conduit treatment (sec. 852(b)). In order to qualify for conduit treatment, a RIC must be a domestic corporation that, at all times during the taxable year, is registered under the Investment Company Act of 1940 as a management company or as a unit investment trust, or has elected to be treated as a business development company under that Act (sec. 851(a)). In addition, the corporation must elect RIC status, and must satisfy certain other requirements (sec. 851(b)).

One of the RIC qualification requirements is that at least 90 percent of the RIC's gross income is derived from dividends, interest, payments with respect to securities loans, and gains from the sale or other disposition of stock or securities or foreign currencies, or other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to its business of investing in such stock, securities, or currencies (sec. 851(b)(2)). Income derived from a partnership is treated as meeting this requirement only to the extent such income is attributable to items of income of the partnership that would meet the requirement if realized by the RIC in the same manner as realized by the partnership (the `look-through' rule for partnership income) (sec. 851(b)). Under present law, no distinction is made under this rule between a publicly traded partnership and any other partnership.

The RIC qualification rules include limitations on the ownership of assets and on the composition of the RIC's assets (sec. 851(b)(3)). Under the ownership limitation, at least 50 percent of the value of the RIC's total assets must be represented by cash, government securities and securities of other RICs, and other securities; however, in the case of such other securities, the RIC may invest no more than five percent of the value of the total assets of the RIC in the securities of any one issuer, and may hold no more than 10 percent of the outstanding voting securities of any one issuer. Under the limitation on the composition of the RIC's assets, no more than 25 percent of the value of the RIC's total assets may be invested in the securities of any one issuer (other than Government securities), or in securities of two or more controlled issuers in the same or similar trades or businesses. These limitations generally are applied at the end of each quarter (sec. 851(d)).

Treatment of publicly traded partnerships

Present law provides that a publicly traded partnership means a partnership, interests in which are traded on an established securities market, or are readily tradable on a secondary market (or the substantial equivalent thereof). In general, a publicly traded partnership is treated as a corporation (sec. 7704(a)), but an exception to corporate treatment is provided if 90 percent or more of its gross income is interest, dividends, real property rents, or certain other types of qualifying income (sec. 7704(c) and (d)).

A special rule for publicly traded partnerships applies under the passive loss rules. The passive loss rules limit deductions and credits from passive trade or business activities (sec. 469). Deductions attributable to passive activities, to the extent they exceed income from passive activities, generally may not be deducted against other income. Deductions and credits that are suspended under these rules are carried forward and treated as deductions and credits from passive activities in the next year. The suspended losses from a passive activity are allowed in full when a taxpayer disposes of his entire interest in the passive activity to an unrelated person. The special rule for publicly traded partnerships provides that the passive loss rules are applied separately with respect to items attributable to each publicly traded partnership (sec. 469(k)). Thus, income or loss from the publicly traded partnership is treated as separate from income or loss from other passive activities.

REASONS FOR CHANGE


The Committee understands that publicly traded partnerships generally are treated as corporations under rules enacted to address Congress' view that publicly traded partnerships resemble corporations in important respects. 70

 [Footnote]  Publicly traded partnerships with specified types of income are not treated as corporations, however, for the reason that if the income is from sources that are commonly considered to be passive investments, then there is less reason to treat the publicly traded partnership as a corporation. 71

 [Footnote]  The Committee understands that these types of publicly traded partnerships may have improved access to capital markets if their interests were permitted investments of mutual funds. Therefore, the bill treats publicly traded partnership interests as permitted investments for mutual funds (`RICs').

[Footnote 70: H.R. Rep. No. 100-391, pt. 2 of 2, at 1066 (1987).]

[Footnote 71: Id.]

Nevertheless, the Committee believes that permitting mutual funds to hold interests in a publicly traded partnership should not give rise to avoidance of unrelated business income tax or withholding of income tax that would apply if tax-exempt organizations or foreign persons held publicly traded partnership interests directly rather than through a mutual fund. Therefore, the Committee bill requires that present-law limitations on ownership and composition of assets of mutual funds apply to any investment in a publicly traded partnership by a mutual fund. The Committee believes that these limitations will serve to limit the use of mutual funds as conduits for avoidance of unrelated business income tax or withholding rules that would otherwise apply with respect to publicly traded partnership income.

EXPLANATION OF PROVISION


The provision modifies the 90-percent test with respect to income of a RIC to include income derived from an interest in a publicly traded partnership. The provision also modifies the lookthrough rule for partnership income of a RIC so that it applies only to income from a partnership other than a publicly traded partnership.

The provision provides that the limitation on ownership and the limitation on composition of assets that apply to other investments of a RIC also apply to RIC investments in publicly traded partnership interests.

The provision provides that the special rule for publicly traded partnerships under the passive loss rules (requiring separate treatment) applies to a RIC holding an interest in a publicly traded partnership, with respect to items attributable to the interest in the publicly traded partnership.

EFFECTIVE DATE


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

5. Improvements related to real estate investment trusts (sec. 285 of the bill and secs. 856, 857 and 860 of the Code)

PRESENT LAW


In general

Real estate investment trusts (`REITs') are treated, in substance, as pass-through entities under present law. Pass-through status is achieved by allowing the REIT a deduction for dividends paid to its shareholders. REITs are generally restricted to investing in passive investments primarily in real estate and securities.

A REIT must satisfy four tests on a year-by-year basis: organizational structure, source of income, nature of assets, and distribution of income. Whether the REIT meets the asset tests is generally measured each quarter.

Organizational structure requirements

To qualify as a REIT, an entity must be for its entire taxable year a corporation or an unincorporated trust or association that would be taxable as a domestic corporation but for the REIT provisions, and must be managed by one or more trustees. The beneficial ownership of the entity must be evidenced by transferable shares or certificates of ownership. Except for the first taxable year for which an entity elects to be a REIT, the beneficial ownership of the entity must be held by 100 or more persons, and the entity may not be so closely held by individuals that it would be treated as a personal holding company if all its adjusted gross income constituted personal holding company income. A REIT is required to comply with regulations to ascertain the actual ownership of the REIT's outstanding shares.

Income requirements

In order for an entity to qualify as a REIT, at least 95 percent of its gross income generally must be derived from certain passive sources (the `95-percent income test'). In addition, at least 75 percent of its income generally must be from certain real estate sources (the `75-percent income test'), including rents from real property (as defined) and gain from the sale or other disposition of real property.

Qualified rental income

Amounts received as impermissible `tenant services income' are not treated as rents from real property. 72

 [Footnote]  In general, such amounts are for services rendered to tenants that are not `customarily furnished' in connection with the rental of real property. 73

 [Footnote]  Special rules also permit amounts to be received from certain `foreclosure property' treated as such for three years after the property is acquired by the REIT in foreclosure after a default (or imminent default) on a lease of such property or an indebtedness which such property secured.

[Footnote 72: A REIT is not treated as providing services that produce impermissible tenant services income if such services are provided by an independent contractor from whom the REIT does not derive or receive any income. An independent contractor is defined as a person who does not own, directly or indirectly, more than 35 percent of the shares of the REIT. Also, no more than 35 percent of the total shares of stock of an independent contractor (or of the interests in net assets or net profits, if not a corporation) can be owned directly or indirectly by persons owning 35 percent or more of the interests in the REIT.]

[Footnote 73: Rents for certain personal property leased in connection with the rental of real property are treated as rents from real property if the fair market value of the personal property does not exceed 15 percent of the aggregate fair market values of the real and personal property.]

Rents from real property, for purposes of the 95-percent and 75-percent income tests, generally do not include any amount received or accrued from any person in which the REIT owns, directly or indirectly, 10 percent or more of the vote or value. 74

 [Footnote]  An exception applies to rents received from a taxable REIT subsidiary (`TRS') (described further below) if at least 90 percent of the leased space of the property is rented to persons other than a TRS or certain related persons, and if the rents from the TRS are substantially comparable to unrelated party rents. 75

 [Footnote]

[Footnote 74: Sec. 856(d)(2)(B).]

[Footnote 75: Sec. 856(d)(8).]

Certain hedging instruments

Except as provided in regulations, a payment to a REIT under an interest rate swap or cap agreement, option, futures contract, forward rate agreement, or any similar financial instrument, entered into by the trust in a transaction to reduce the interest rate risks with respect to any indebtedness incurred or to be incurred by the REIT to acquire or carry real estate assets, and any gain from the sale or disposition of any such investment, is treated as income qualifying for the 95-percent income test.

Tax if qualified income tests not met

If a REIT fails to meet the 95-percent or 75-percent income tests but has set out the income it did receive in a schedule and any error in the schedule is due to reasonable cause and not willful neglect, then the REIT does not lose its REIT status but instead pays a tax measured by the greater of the amount by which 90 percent 76

 [Footnote]  of the REIT's gross income exceeds the amount of items subject to the 95-percent test, or the amount by which 75 percent of the REIT's gross income exceeds the amount of items subject to the 75-percent test. 77

 [Footnote]

[Footnote 76: Prior to 1999, the rule had applied to the amount by which 95 percent of the income exceeded the items subject to the 95 percent test.]

[Footnote 77: The ratio of the REIT's net to gross income is applied to the excess amount, to determine the amount of tax (disregarding certain items otherwise subject to a 100-percent tax). In effect, the formula seeks to require that all of the REIT net income attributable to the failure of the income tests will be paid as tax. Sec. 857(b)(5).]

Asset requirements

75-percent asset test

To satisfy the asset requirements to qualify for treatment as a REIT, at the close of each quarter of its taxable year, an entity must have at least 75 percent of the value of its assets invested in real estate assets, cash and cash items, and government securities (the `75-percent asset test'). The term real estate asset is defined to mean real property (including interests in real property and mortgages on real property) and interests in REITs.

Limitation on investment in other entities

A REIT is limited in the amount that it can own in other corporations. Specifically, a REIT cannot own securities (other than Government securities and certain real estate assets) in an amount greater than 25 percent of the value of REIT assets. In addition, it cannot own such securities of any one issuer representing more than 5 percent of the total value of REIT assets or more than 10 percent of the voting securities or 10 percent of the value of the outstanding securities of any one issuer. Securities for purposes of these rules are defined by reference to the Investment Company Act of 1940.

`Straight debt' exception

Securities of an issuer that are within a safe-harbor definition of `straight debt' (as defined for purposes of subchapter S) 78

 [Footnote]  are not taken into account in applying the limitation that a REIT may not hold more than 10 percent of the value of outstanding securities of a single issuer, if: (1) the issuer is an individual, (2) the only securities of such issuer held by the REIT or a taxable REIT subsidiary of the REIT are straight debt, or (3) the issuer is a partnership and the trust holds at least a 20 percent profits interest in the partnership.

[Footnote 78: Sec. 1361(c)(5), without regard to paragraph (B)(iii) thereof.]

Straight debt for purposes of the REIT provision 79

 [Footnote]  is defined as a written or unconditional promise to pay on demand or on a specified date a sum certain in money if (i) the interest rate (and interest payment dates) are not contingent on profits, the borrower's discretion, or similar factors, and (ii) there is no convertibility (directly or indirectly) into stock.

[Footnote 79: Sec. 856(c)(7).]

Certain subsidiary ownership permitted with income treated as income of the REIT

Under one exception to the rule limiting a REIT's securities holdings to no more than 10 percent of the vote or value of a single issuer, a REIT can own 100 percent of the stock of a corporation, but in that case the income and assets of such corporation are treated as income and assets of the REIT.

Special rules for Taxable REIT subsidiaries

Under another exception to the general rule limiting REIT securities ownership of other entities, a REIT can own stock of a taxable REIT subsidiary (`TRS'), generally, a corporation other than a real estate investment trust 80

 [Footnote]  with which the REIT makes a joint election to be subject to special rules. A TRS can engage in active business operations that would produce income that would not be qualified income for purposes of the 95-percent or 75-percent income tests for a REIT, and that income is not attributed to the REIT. For example a TRS could provide noncustomary services to REIT tenants, or it could engage directly in the active operation and management of real estate (without use of an independent contractor); and the income the TRS derived from these nonqualified activities would not be treated as disqualified REIT income. Transactions between a TRS and a REIT are subject to a number of specified rules that are intended to prevent the TRS (taxable as a separate corporate entity) from shifting taxable income from its activities to the pass-through entity REIT or from absorbing more than its share of expenses. Under one rule, a 100-percent excise tax is imposed on rents, deductions, or interest paid by the TRS to the REIT to the extent such items would exceed an arm's length amount as determined under section 482. 81

 [Footnote]

[Footnote 80: Certain corporations are not eligible to be a TRS, such as a corporation which directly or indirectly operates or manages a lodging facility or a health care facility, or directly or indirectly provides to any other person rights to a brand name under which any lodging facility or health care facility is operated. Sec. 856(l)(3).]

[Footnote 81: If the excise tax applies, then the item is not reallocated back to the TRS under section 482.]

Rents subject to the 100 percent excise tax do not include rents for services of a TRS that are for services customarily furnished or rendered in connection with the rental of real property.

They also do not include rents from a TRS that are for real property or from incidental personal property provided with such real property.

Income distribution requirements

A REIT is generally required to distribute 90 percent of its income before the end of its taxable year, as deductible dividends paid to shareholders. This rule is similar to a rule for regulated investment companies (`RICs') that requires distribution of 90 percent of income. If a REIT declares certain dividends after the end of its taxable year but before the time prescribed for filing its return for that year and distributes those amounts to shareholders within the 12 months following the close of that taxable year, such distributions are treated as made during such taxable year for this purpose. As described further below, a REIT can also make certain `deficiency dividends' after the close of the taxable year after a determination that it has not distributed the correct amount for qualification as a REIT.

Consequences of failure to meet requirements

A REIT loses its status as a REIT, and becomes subject to tax as a C corporation, if it fails to meet specified tests regarding the sources of its income, the nature and amount of its assets, its structure, and the amount of its income distributed to shareholders.

In the case of a failure to meet the source of income requirements, if the failure is due to reasonable cause and not to willful neglect, the REIT may continue its REIT status if it pays the disallowed income as a tax to the Treasury. 82

 [Footnote]

[Footnote 82: Secs. 856(c)(6) and 857(b)(5).]

There is no similar provision that allows a REIT to pay a penalty and avoid disqualification in the case of other qualification failures.

A REIT may make a deficiency dividend after a determination is made that it has not distributed the correct amount of its income, and avoid disqualification. The Code provides only for determinations involving a controversy with the IRS and does not provide for a REIT to make such a distribution on its own initiative. Deficiency dividends may be declared on or after the date of `determination'. A determination is defined to include only (i) a final decision by the Tax Court or other court of competent jurisdiction, (ii) a closing agreement under section 7121, or (iii) under Treasury regulations, an agreement signed by the Secretary and the REIT.

REASONS FOR CHANGE


The Committee believes that a number of simplifying and conforming changes should be made to the `straight debt' provisions that exempt certain securities from the rule that a REIT may not hold more than 10 percent of the value of securities of a single issuer, as well as to the TRS rules, the rules relating to certain hedging arrangements, and the computation of tax liability when the 95-percent gross income test is not met.

The Committee also believes it is desirable to provide rules under which a REIT that inadvertently fails to meet certain REIT qualification requirements can correct such failure without losing REIT status.

EXPLANATION OF PROVISION


The provision makes a number of modifications to the REIT rules.

Straight debt modification

The provision modifies the definition of `straight debt' for purposes of the limitation that a REIT may not hold more than 10 percent of the value of the outstanding securities of a single issuer, to provide more flexibility than the present law rule. In addition, except as provided in regulations, neither such straight debt nor certain other types of securities are considered `securities' for purposes of this rule.

Straight debt securities

As under present law, `straight-debt' is still defined by reference to section 1361(c)(5), without regard to subparagraph (B)(iii) thereof (limiting the nature of the creditor).

Special rules are provided permitting certain contingencies for purposes of the REIT provision. Any interest or principal shall not be treated as failing to satisfy section 1361(c)(5)(B)(i) solely by reason of the fact that the time of payment of such interest or principal is subject to a contingency, but only if one of several factors applies. The first type of contingency that is permitted is one that does not have the effect of changing the effective yield to maturity, as determined under section 1272, other than a change in the annual yield to maturity, but only if (i) any such contingency does not exceed the greater of  1/4  of one percent or five percent of the annual yield to maturity, or (ii) neither the aggregate issue price nor the aggregate face amount of the debt instruments held by the REIT exceeds $1,000,000 and not more than 12 months of unaccrued interest can be required to be prepaid thereunder.

Also, the time or amount of any payment is permitted to be subject to a contingency upon a default or the exercise of a prepayment right by the issuer of the debt, provided that such contingency is consistent with customary commercial practice. 83

 [Footnote]

[Footnote 83: The present law rules that limit qualified interest income to amounts the determination of which do not depend, in whole or in part, on the income or profits of any person, continue to apply to such contingent interest. See, e.g., secs. 856(c)(2)(G), 856(c)(3)(G) and 856(f).]

The provision eliminates the present law rule requiring a REIT to own a 20 percent equity interest in a partnership in order for debt to qualify as `straight debt'. The bill instead provides new `look-through' rules determining a REIT partner's share of partnership securities, generally treating debt to the REIT as part of the REIT's partnership interest for this purpose, except in the case of otherwise qualifying debt of the partnership.

Certain corporate or partnership issues that otherwise would be permitted to be held without limitation under the special straight debt rules described above will not be so permitted if the REIT holding such securities, and any of its taxable REIT subsidiaries, holds any securities of the issuer which are not permitted securities (prior to the application of this rule) and have an aggregate value greater than one percent of the issuer's outstanding securities.

Other securities

Except as provided in regulations, the following also are not considered `securities' for purposes of the rule that a REIT cannot own more than 10 percent of the value of the outstanding securities of a single issuer: (i) any loan to an individual or an estate, (ii) any section 467 rental agreement, (as defined in section 467(d)), other than with a person described in section 856(d)(2)(B), (iii) any obligation to pay rents from real property, (iv) any security issued by a State or any political subdivision thereof, the District of Columbia, a foreign government, or any political subdivision thereof, or the Commonwealth of Puerto Rico, but only if the determination of any payment received or accrued under such security does not depend in whole or in part on the profits of any entity not described in this category, or payments on any obligation issued by such an entity, (v) any security issued by a real estate investment trust; and (vi) any other arrangement that, as determined by the Secretary, is excepted from the definition of a security.

Safe harbor testing date for certain rents

The provision provides specific safe-harbor rules regarding the dates for testing whether 90 percent of a REIT property is rented to unrelated persons and whether the rents paid by related persons are substantially comparable to unrelated party rents. These testing rules are provided solely for purposes of the special provision permitting rents received from a TRS to be treated as qualified rental income for purposes of the income tests. 84

 [Footnote]

[Footnote 84: The provision does not modify any of the standards of section 482 as they apply to REITs and to TRSs.]

Customary services exception

The provision prospectively eliminates the safe harbor allowing rents received by a REIT to be exempt from the 100 percent excise tax if the rents are for customary services performed by the TRS 85

 [Footnote]  or are from a TRS and are for the provision of certain incidental personal property. Instead, such payments are free of the excise tax if they satisfy the present law safe-harbor that applies if the REIT pays the TRS at least 150 percent of the cost to the TRS of providing any services.

[Footnote 85: Although a REIT could itself provide such service and receive the income without receiving any disqualified income, in that case the REIT itself would be bearing the cost of providing the service. Under the present law exception for a TRS providing such service, there is no explicit requirement that the TRS be reimbursed for the full cost of the service.]

Hedging rules

The rules governing the tax treatment of arrangements engaged in by a REIT to reduce certain interest rate risks are prospectively generally conformed to the rules included in section 1221. Also, the defined income of a REIT from such a hedging transaction is excluded from gross income for purposes of the 95-percent of gross income requirement.

95-percent of gross income requirement

The provision prospectively amends the tax liability owed by the REIT when it fails to meet the 95-percent of gross income test by applying a taxable fraction based on 95 percent, rather than 90 percent, of the REIT's gross income.

Consequences of failure to meet REIT requirements

Under the provision, a REIT may avoid disqualification in the event of certain failures of the requirements for REIT status, provided that (1) the failure was due to reasonable cause and not willful neglect, (2) the failure is corrected, and (3) except for certain failures not exceeding a specified de minimis amount, a penalty amount is paid.

Certain de minimis asset failures of 5-percent or 10-percent tests

One requirement of present law is that, with certain exceptions, (i) not more than 5 percent of the value of total REIT assets may be represented by securities of one issuer, and (ii) a REIT may not hold securities possessing more than 10 percent of the total voting power or 10 percent of the total value of the outstanding securities of any one issuer. 86

 [Footnote]  The requirements must be satisfied each quarter.

[Footnote 86: Sec. 856(c)(4)(B)(iii). These rules do not apply to securities of a TRS, or to securities that qualify for the 75 percent asset test of section 856(c)(4)(A), such as real estate assets, cash items (including receivables), or Government securities.]

The provision provides that a REIT will not lose its REIT status for failing to satisfy these requirements in a quarter if the failure is due to the ownership of assets the total value of which does not exceed the lesser of (i) one percent of the total value of the REIT's assets at the end of the quarter for which such measurement is done or (ii) 10 million dollars; provided in either case that the REIT either disposes of the assets within six months after the last day of the quarter in which the REIT identifies the failure (or such other time period prescribed by the Treasury), or otherwise meets the requirements of those rules by the end of such time period. 87

 [Footnote]

[Footnote 87: A REIT might satisfy the requirements without a disposition, for example, by increasing its other assets in the case of the 5 percent rule; or by the issuer modifying the amount or value of its total securities outstanding in the case of the 10 percent rule.]

Larger asset test failures (whether of 5-percent or 10-percent tests, or of 75-percent or other asset tests)

Under the provision, if a REIT fails to meet any of the asset test requirements for a particular quarter and the failure exceeds the de minimis threshold described above, then the REIT still will be deemed to have satisfied the requirements if: (i) following the REIT's identification of the failure, the REIT files a schedule with a description of each asset that caused the failure, in accordance with regulations prescribed by the Treasury; (ii) the failure was due to reasonable cause and not to willful neglect, (iii) the REIT disposes of the assets within 6 months after the last day of the quarter in which the identification occurred or such other time period as is prescribed by the Treasury (or the requirements of the rules are otherwise met within such period), and (iv) the REIT pays a tax on the failure.

The tax that the REIT must pay on the failure is the greater of (i) $50,000, or (ii) an amount determined (pursuant to regulations) by multiplying the highest rate of tax for corporations under section 11, times the net income generated by the assets for the period beginning on the first date of the failure and ending on the date the REIT has disposed of the assets (or otherwise satisfies the requirements).

Such taxes are treated as excise taxes, for which the deficiency provisions of the excise tax subtitle of the Code (subtitle F) apply.

Conforming reasonable cause and reporting standard for failures of income tests

The provision conforms the reporting and reasonable cause standards for failure to meet the income tests to the new asset test standards. However, the provision does not change the rule under section 857(b)(5) that for income test failures, all of the net income attributed to the disqualified gross income is paid as tax.

Other failures

The bill adds a provision under which, if a REIT fails to satisfy one or more requirements for REIT qualification, other than the 95-percent and 75-percent gross income tests and other than the new rules provided for failures of the asset tests, the REIT may retain its REIT qualification if the failures are due to reasonable cause and not willful neglect, and if the REIT pays a penalty of $50,000 for each such failure.

Taxes and penalties paid deducted from amount required to be distributed

Any taxes or penalties paid under the provision are deducted from the net income of the REIT in determining the amount the REIT must distribute under the 90-percent distribution requirement.

Expansion of deficiency dividend procedure

The provision expands the circumstances in which a REIT may declare a deficiency dividend, by allowing such a declaration to occur after the REIT unilaterally has identified a failure to pay the relevant amount. Thus, the declaration need not await a decision of the Tax Court, a closing agreement, or an agreement signed by the Secretary of the Treasury.

EFFECTIVE DATE


The provision is generally effective for taxable years beginning after December 31, 2000.

However, some of the provisions are effective for taxable years beginning after the date of enactment. These are: the new `look through' rules determining a REIT partner's share of partnership securities for purposes of the `straight debt' rules; the provision changing the 90-percent of gross income reference to 95 percent, for purposes of the tax liability if a REIT fails to meet the 95-percent of gross income test; the new hedging definition; the rule modifying the treatment of rents with respect to customary services; and the new rules for correction of certain failures to satisfy the REIT requirements.

6. Treatment of certain dividends of regulated investment companies (sec. 286 of the bill and secs. 871 and 881 of the Code)

PRESENT LAW


Regulated investment companies

A regulated investment company (`RIC') is a domestic corporation that, at all times during the taxable year, is registered under the Investment Company Act of 1940 as a management company or as a unit investment trust, or has elected to be treated as a business development company under that Act (sec. 851(a)).

In addition, to qualify as a RIC, a corporation must elect such status and must satisfy certain tests (sec. 851(b)). These tests include a requirement that the corporation derive at least 90 percent of its gross income from dividends, interest, payments with respect to certain securities loans, and gains on the sale or other disposition of stock or securities or foreign currencies, or other income derived with respect to its business of investment in such stock, securities, or currencies.

Generally, a RIC pays no income tax because it is permitted to deduct dividends paid to its shareholders in computing its taxable income. The amount of any distribution generally is not considered as a dividend for purposes of computing the dividends paid deduction unless the distribution is pro rata, with no preference to any share of stock as compared with other shares of the same class (sec. 562(c)). For distributions by RICs to shareholders who made initial investments of at least $10,000,000, however, the distribution is not treated as non-pro rata or preferential solely by reason of an increase in the distribution due to reductions in administrative expenses of the company.

A RIC generally may pass through to its shareholders the character of its long-term capital gains. It does this by designating a dividend it pays as a capital gain dividend to the extent that the RIC has net capital gain (i.e., net long-term capital gain over net short-term capital loss). These capital gain dividends are treated as long-term capital gain by the shareholders. A RIC generally also can pass through to its shareholders the character of tax-exempt interest from State and local bonds, but only if, at the close of each quarter of its taxable year, at least 50 percent of the value of the total assets of the RIC consists of these obligations. In this case, the RIC generally may designate a dividend it pays as an exempt-interest dividend to the extent that the RIC has tax-exempt interest income. These exempt-interest dividends are treated as interest excludable from gross income by the shareholders.

U.S. source investment income of foreign persons

In general

The United States generally imposes a flat 30-percent tax, collected by withholding, on the gross amount of U.S.-source investment income payments, such as interest, dividends, rents, royalties or similar types of income, to nonresident alien individuals and foreign corporations (`foreign persons') (secs. 871(a), 881, 1441, and 1442). Under treaties, the United States may reduce or eliminate such taxes. Even taking into account U.S. treaties, however, the tax on a dividend generally is not entirely eliminated. Instead, U.S.-source portfolio investment dividends received by foreign persons generally are subject to U.S. withholding tax at a rate of at least 15 percent.

Interest

Although payments of U.S.-source interest that is not effectively connected with a U.S. trade or business generally are subject to the 30-percent withholding tax, there are exceptions to that rule. For example, interest from certain deposits with banks and other financial institutions is exempt from tax (secs. 871(i)(2)(A) and 881(d)). Original issue discount on obligations maturing in 183 days or less from the date of original issue (without regard to the period held by the taxpayer) is also exempt from tax (sec. 871(g)). An additional exception is provided for certain interest paid on portfolio obligations (secs. 871(h) and 881(c)). `Portfolio interest' generally is defined as any U.S.-source interest (including original issue discount), not effectively connected with the conduct of a U.S. trade or business, (i) on an obligation that satisfies certain registration requirements or specified exceptions thereto (i.e., the obligation is `foreign targeted'), and (ii) that is not received by a 10-percent shareholder (secs. 871(h)(3) and 881(c)(3)). With respect to a registered obligation, a statement that the beneficial owner is not a U.S. person is required (secs. 871(h)(2), (5) and 881(c)(2)). This exception is not available for any interest received either by a bank on a loan extended in the ordinary course of its business (except in the case of interest paid on an obligation of the United States), or by a controlled foreign corporation from a related person (sec. 881(c)(3)). Moreover, this exception is not available for certain contingent interest payments (secs. 871(h)(4) and 881(c)(4)).

Capital gains

Foreign persons generally are not subject to U.S. tax on gain realized on the disposition of stock or securities issued by a U.S. person (other than a `U.S. real property holding corporation,' as described below), unless the gain is effectively connected with the conduct of a trade or business in the United States. This exemption does not apply, however, if the foreign person is a nonresident alien individual present in the United States for a period or periods aggregating 183 days or more during the taxable year (sec. 871(a)(2)). A RIC may elect not to withhold on a distribution to a foreign person representing a capital gain dividend. (Treas. Reg. sec. 1.1441-3(c)(2)(D)).

Gain or loss of a foreign person from the disposition of a U.S. real property interest is subject to net basis tax as if the taxpayer were engaged in a trade or business within the United States and the gain or loss were effectively connected with such trade or business (sec. 897). In addition to an interest in real property located in the United States or the Virgin Islands, U.S. real property interests include (among other things) any interest in a domestic corporation unless the taxpayer establishes that the corporation was not, during a 5-year period ending on the date of the disposition of the interest, a U.S. real property holding corporation (which is defined generally to mean a corporation the fair market value of whose U.S. real property interests equals or exceeds 50 percent of the sum of the fair market values of its real property interests and any other of its assets used or held for use in a trade or business).

Estate taxation

Decedents who were citizens or residents of the United States are generally subject to Federal estate tax on all property, wherever situated. 88

 [Footnote]  Nonresidents who are not U.S. citizens, however, are subject to estate tax only on their property which is within the United States. Property within the United States generally includes debt obligations of U.S. persons, including the Federal government and State and local governments (sec. 2104(c)), but does not include either bank deposits or portfolio obligations, the interest on which would be exempt from U.S. income tax under section 871 (sec. 2105(b)). Stock owned and held by a nonresident who is not a U.S. citizen is treated as property within the United States only if the stock was issued by a domestic corporation (sec. 2104(a); Treas. Reg. sec. 20.2104-1(a)(5)).

[Footnote 88: The Economic Growth and Tax Relief Reconciliation Act of 2001 (`EGTRRA') repealed the estate tax for estates of decedents dying after December 31, 2009. However, EGTRRA included a `sunset' provision, pursuant to which EGTRRA's provisions (including estate tax repeal) do not apply to estates of decedents dying after December 31, 2010.]

Treaties may reduce U.S. taxation on transfers by estates of nonresident decedents who are not U.S. citizens. Under recent treaties, for example, U.S. tax may generally be eliminated except insofar as the property transferred includes U.S. real property or business property of a U.S. permanent establishment.

REASONS FOR CHANGE


Under present law, a disparity exists between foreign persons who invest directly in certain interest-bearing and other securities and a foreign person who invests in such securities indirectly through U.S. mutual funds. In general, certain amounts received by the direct foreign investor (or a foreign investor through a foreign fund) may be exempt from the U.S. gross-basis withholding tax. In contrast, distributions from a RIC generally are treated as dividends subject to the withholding tax, notwithstanding that the distributions may be attributable to amounts that otherwise could qualify for an exemption from withholding tax. U.S. financial institutions often respond to this disparate treatment by forming `mirror funds' outside the United States. The Committee believes that such disparate treatment should be eliminated so that U.S. financial institutions will be encouraged to form and operate their mutual funds within the United States rather than outside the United States.

Therefore, the Committee believes that, to the extent a RIC distributes to a foreign person a dividend attributable to amounts that would have been exempt from U.S. withholding tax had the foreign person received it directly (such as portfolio interest and capital gains, including short-term capital gains), such dividend similarly should be exempt from the U.S. gross-basis withholding tax. The Committee also believes that comparable treatment should be afforded for estate tax purposes to foreign persons who invest in certain assets through a RIC to the extent that such assets would not be subject to the estate tax if held directly.

EXPLANATION OF PROVISION


In general

Under the bill, a RIC that earns certain interest income that would not be subject to U.S. tax if earned by a foreign person directly may, to the extent of such income, designate a dividend it pays as derived from such interest income. A foreign person who is a shareholder in the RIC generally would treat such a dividend as exempt from gross-basis U.S. tax, as if the foreign person had earned the interest directly. Similarly, a RIC that earns an excess of net short-term capital gains over net long-term capital losses, which excess would not be subject to U.S. tax if earned by a foreign person, generally may, to the extent of such excess, designate a dividend it pays as derived from such excess. A foreign person who is a shareholder in the RIC generally would treat such a dividend as exempt from gross-basis U.S. tax, as if the foreign person had realized the excess directly. The bill also provides that the estate of a foreign decedent is exempt from U.S. estate tax on a transfer of stock in the RIC in the proportion that the assets held by the RIC are debt obligations, deposits, or other property that would generally be treated as situated outside the United States if held directly by the estate.

Interest-related dividends

Under the bill, a RIC may, under certain circumstances, designate all or a portion of a dividend as an `interest-related dividend,' by written notice mailed to its shareholders not later than 60 days after the close of its taxable year. In addition, an interest-related dividend received by a foreign person generally is exempt from U.S. gross-basis tax under sections 871(a), 881, 1441 and 1442.

However, this exemption does not apply to a dividend on shares of RIC stock if the withholding agent does not receive a statement, similar to that required under the portfolio interest rules, that the beneficial owner of the shares is not a U.S. person. The exemption does not apply to a dividend paid to any person within a foreign country (or dividends addressed to, or for the account of, persons within such foreign country) with respect to which the Treasury Secretary has determined, under the portfolio interest rules, that exchange of information is inadequate to prevent evasion of U.S. income tax by U.S. persons.

In addition, the exemption generally does not apply to dividends paid to a controlled foreign corporation to the extent such dividends are attributable to income received by the RIC on a debt obligation of a person with respect to which the recipient of the dividend (i.e., the controlled foreign corporation) is a related person. Nor does the exemption generally apply to dividends to the extent such dividends are attributable to income (other than short-term original issue discount or bank deposit interest) received by the RIC on indebtedness issued by the RIC-dividend recipient or by any corporation or partnership with respect to which the recipient of the RIC dividend is a 10-percent shareholder. However, in these two circumstances the RIC remains exempt from its withholding obligation unless the RIC knows that the dividend recipient is such a controlled foreign corporation or 10-percent shareholder. To the extent that an interest-related dividend received by a controlled foreign corporation is attributable to interest income of the RIC that would be portfolio interest if received by a foreign corporation, the dividend is treated as portfolio interest for purposes of the de minimis rules, the high-tax exception, and the same country exceptions of subpart F (see sec. 881(c)(5)(A)).

The aggregate amount designated as interest-related dividends for the RIC's taxable year (including dividends so designated that are paid after the close of the taxable year but treated as paid during that year as described in section 855) generally is limited to the qualified net interest income of the RIC for the taxable year. The qualified net interest income of the RIC equals the excess of: (1) the amount of qualified interest income of the RIC; over (2) the amount of expenses of the RIC properly allocable to such interest income.

Qualified interest income of the RIC is equal to the sum of its U.S.-source income with respect to: (1) bank deposit interest; (2) short term original issue discount that is currently exempt from the gross-basis tax under section 871; (3) any interest (including amounts recognized as ordinary income in respect of original issue discount, market discount, or acquisition discount under the provisions of sections 1271-1288, and such other amounts as regulations may provide) on an obligation which is in registered form, unless it is earned on an obligation issued by a corporation or partnership in which the RIC is a 10-percent shareholder or is contingent interest not treated as portfolio interest under section 871(h)(4); and (4) any interest-related dividend from another RIC.

If the amount designated as an interest-related dividend is greater than the qualified net interest income described above, the portion of the distribution so designated which constitutes an interest-related dividend will be only that proportion of the amount so designated as the amount of the qualified net interest income bears to the amount so designated.

Short-term capital gain dividends

Under the bill, a RIC also may, under certain circumstances, designate all or a portion of a dividend as a `short-term capital gain dividend,' by written notice mailed to its shareholders not later than 60 days after the close of its taxable year. For purposes of the U.S. gross-basis tax, a short-term capital gain dividend received by a foreign person generally is exempt from U.S. gross-basis tax under sections 871(a), 881, 1441 and 1442. This exemption does not apply to the extent that the foreign person is a nonresident alien individual present in the United States for a period or periods aggregating 183 days or more during the taxable year. However, in this circumstance the RIC remains exempt from its withholding obligation unless the RIC knows that the dividend recipient has been present in the United States for such period.

The aggregate amount qualified to be designated as short-term capital gain dividends for the RIC's taxable year (including dividends so designated that are paid after the close of the taxable year but treated as paid during that year as described in sec. 855) is equal to the excess of the RIC's net short-term capital gains over net long-term capital losses. The short-term capital gain includes short-term capital gain dividends from another RIC. As provided under present law for purposes of computing the amount of a capital gain dividend, the amount is determined (except in the case where an election under sec. 4982(e)(4) applies) without regard to any net capital loss or net short-term capital loss attributable to transactions after October 31 of the year. Instead, that loss is treated as arising on the first day of the next taxable year. To the extent provided in regulations, this rule also applies for purposes of computing the taxable income of the RIC.

In computing the amount of short-term capital gain dividends for the year, no reduction is made for the amount of expenses of the RIC allocable to such net gains. In addition, if the amount designated as short-term capital gain dividends is greater than the amount of qualified short-term capital gain, the portion of the distribution so designated which constitutes a short-term capital gain dividend is only that proportion of the amount so designated as the amount of the excess bears to the amount so designated.

As under present law for distributions from REITs, the bill provides that any distribution by a RIC to a foreign person shall, to the extent attributable to gains from sales or exchanges by the RIC of an asset that is considered a U.S. real property interest, be treated as gain recognized by the foreign person from the sale or exchange of a U.S. real property interest. The bill also extends the special rules for domestically-controlled REITs to domestically-controlled RICs.

Estate tax treatment

Under the bill, a portion of the stock in a RIC held by the estate of a nonresident decedent who is not a U.S. citizen is treated as property without the United States. The portion so treated is based upon the proportion of the assets held by the RIC at the end of the quarter immediately preceding the decedent's death (or such other time as the Secretary may designate in regulations) that are `qualifying assets'. Qualifying assets for this purpose are bank deposits of the type that are exempt from gross-basis income tax, portfolio debt obligations, certain original issue discount obligations, debt obligations of a domestic corporation that are treated as giving rise to foreign source income, and other property not within the United States.

EFFECTIVE DATE


The provision generally applies to dividends with respect to taxable years of RICs beginning after December 31, 2004. With respect to the treatment of a RIC for estate tax purposes, the provision applies to estates of decedents dying after December 31, 2004. With respect to the treatment of RICs under section 897 (relating to U.S. real property interests), the provision is effective after December 31, 2004.

7. Taxation of certain settlement funds (sec. 287 of the bill and sec. 468B of the Code)

PRESENT LAW


In general, section 468B provides that a payment to a designated settlement fund that extinguishes a tort liability of the taxpayer will result in a deduction to the taxpayer. A designated settlement fund means a fund which is established pursuant to a court order, extinguishes the taxpayer's tort liability, is managed and controlled by persons unrelated to the taxpayer, and in which the taxpayer does not have a beneficial interest in the trust.

Generally, a designated or qualified settlement fund is taxed as a separate entity at the maximum trust rate on its modified income. Modified income is generally gross income less deductions for administrative costs and other incidental expenses incurred in connection with the operation of the settlement fund.

The cleanup of hazardous waste sites is sometimes funded by environmental `settlement funds' or escrow accounts. These escrow accounts are established in consent decrees between the Environmental Protection Agency (`EPA') and the settling parties under the jurisdiction of a Federal district court. The EPA uses these accounts to resolve claims against private parties under Comprehensive Environmental Response, Compensation and Liability Act of 1980 (`CERCLA').

Present law provides that nothing in any provision of law is to be construed as providing that an escrow account, settlement fund, or similar fund is not subject to current income tax.

REASONS FOR CHANGE


The Committee believes that these environmental escrow accounts, established under court consent decrees, are essential for the EPA to resolve or satisfy claims under the Comprehensive Environmental Response, Compensation and Liability Act of 1980. The tax treatment of these settlement funds may prevent taxpayers from entering into prompt settlements with the EPA for the cleanup of Superfund hazardous waste sites and reduce the ultimate amount of funds available for the sites' cleanup. As these settlement funds are controlled by the government, the Committee believes it is appropriate to establish that these funds are to be treated as beneficially owned by the United States.

EXPLANATION OF PROVISION


The provision provides that certain settlement funds established in consent decrees for the sole purpose of resolving claims under CERCLA are to be treated as beneficially owned by the United States government and therefore, not subject to Federal income tax.

To qualify the settlement fund must be: (1) established pursuant to a consent decree entered by a judge of a United States District Court; (2) created for the receipt of settlement payments for the sole purpose of resolving claims under CERCLA; (3) controlled (in terms of expenditures of contributions and earnings thereon) by the government or an agency or instrumentality thereof; and (4) upon termination, any remaining funds will be disbursed to such government entity and used in accordance with applicable law. For purposes of the provision, a government entity means the United States, any State of political subdivision thereof, the District of Columbia, any possession of the United States, and any agency or instrumentality of the foregoing.

EFFECTIVE DATE


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

8. Expand human clinical trials expenses qualifying for the orphan drug tax credit (sec. 288 of the bill and sec. 45C of the Code)

PRESENT LAW


Taxpayers may claim a 50-percent credit for expenses related to human clinical testing of drugs for the treatment of certain rare diseases and conditions, generally those that afflict less than 200,000 persons in the United States. Qualifying expenses are those paid or incurred by the taxpayer after the date on which the drug is designated as a potential treatment for a rare disease or disorder by the Food and Drug Administration (`FDA') in accordance with section 526 of the Federal Food, Drug, and Cosmetic Act.

REASONS FOR CHANGE


The Committee observes that approval for human clinical testing, and designation as a potential treatment for a rare disease or disorder, require separate reviews within the FDA. As a result, in some cases, a taxpayer may be permitted to begin human clinical testing prior to a drug being designated as a potential treatment for a rare disease or disorder. If the taxpayer delays human clinical testing in order to obtain the benefits of the orphan drug tax credit, which currently may be claimed only for expenses incurred after the drug is designated as a potential treatment for a rare disease or disorder, valuable testing and research time will have been lost and Congress's original intent in enacting the orphan drug tax credit will have been partially thwarted.

By submitting an application with the FDA for designation as a treatment of certain rare diseases and conditions, the taxpayer is indicating that he or she intends to examine the drug as a potential treatment for a qualifying disease or condition in approved clinical trials. The FDA is required to approve drugs for human clinical testing before testing can commence. The Committee believes the application for designation as a potential treatment for a rare disease or disorder can create a starting point from which human clinical testing expenses can be measured for purposes of the credit. For those cases where the process of filing an application and receiving designation as a potential treatment for a rare disease or disorder occurs sufficiently expeditiously to fall entirely within the taxpayer's taxable year plus permitted return filing extension period, the Committee finds it appropriate to eliminate the potential financial incentive to delaying clinical testing by permitting testing expenses paid or incurred prior to designation to qualify for the credit. The Committee recognizes that while such an outcome may well describe most applications, in some cases, particularly for applications filed near the close of a taxpayer's taxable year, in other cases the application and designation of the drug will not be made within the requisite period. The Committee chooses not to expand qualifying expenses to include those expenses paid or incurred after the date on which the taxpayer files an application with FDA for designation of the drug as a potential treatment for a rare disease or disorder, in the case when the designation is approved with respect to a taxable year subsequent to the year in which the application is filed, because to do so may create the additional taxpayer burden of requiring the taxpayer to file an amended return to claim credit for qualifying costs related to expenses incurred in a taxable year prior to designation.

EXPLANATION OF PROVISION


The provision expands qualifying expenses to include those expenses related to human clinical testing paid or incurred after the date on which the taxpayer files an application with the FDA for designation of the drug under section 526 of the Federal Food, Drug, and Cosmetic Act as a potential treatment for a rare disease or disorder, if certain conditions are met. Under the provision, qualifying expenses include those expenses paid or incurred after the date on which the taxpayer files an application with the FDA for designation as a potential treatment for a rare disease or disorder if the drug receives FDA designation before the due date (including extensions) for filing the tax return for the taxable year in which the application was filed with the FDA. As under present law, the credit may only be claimed for such expenses related to drugs designated as a potential treatment for a rare disease or disorder by the FDA in accordance with section 526 of such Act.

EFFECTIVE DATE


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

9. Simplification of excise tax imposed on bows and arrows (sec. 289 of the bill and sec. 4161 of the Code)

PRESENT LAW


The Code imposes an excise tax of 11 percent on the sale by a manufacturer, producer or importer of any bow with a draw weight of 10 pounds or more. 89

 [Footnote]  An excise tax of 12.4 percent is imposed on the sale by a manufacturer or importer of any shaft, point, nock, or vane designed for use as part of an arrow which after its assembly (1) is over 18 inches long, or (2) is designed for use with a taxable bow (if shorter than 18 inches). 90

 [Footnote]  No tax is imposed on finished arrows. An 11-percent excise tax also is imposed on any part of an accessory for taxable bows and on quivers for use with arrows (1) over 18 inches long or (2) designed for use with a taxable bow (if shorter than 18 inches). 91

 [Footnote]

[Footnote 89: Sec. 4161(b)(1)(A).]

[Footnote 90: Sec. 4161(b)(2).]

[Footnote 91: Sec. 4161(b)(1)(B).]

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


The provision increases the draw weight for a taxable bow from 10 pounds or more to a peak draw weight of 30 pounds or more. 92

 [Footnote]  The provision also imposes an excise tax of 12 percent on arrows generally. An arrow for this purpose is defined as a taxable arrow shaft to which additional components are attached. The present law 12.4-percent excise tax on certain arrow components is unchanged by the bill. In the case of any arrow comprised of a shaft or any other component upon which tax has been imposed, the amount of the arrow tax is equal to the excess of (1) the arrow tax that would have been imposed but for this exception, over (2) the amount of tax paid with respect to such components. 93

 [Footnote]  Finally, the provision subjects certain broadheads (a type of arrow point) to an excise tax equal to 11 percent of the sales price instead of 12.4 percent.

[Footnote 92: Draw weight is the maximum force required to bring the bowstring to a full-draw position not less than 26 1/4 -inches, measured from the pressure point of the hand grip to the nocking position on the bowstring.]

[Footnote 93: A credit or refund may be obtained when an item was taxed and it is used in the manufacture or production of another taxable item. Sec. 6416(b)(3). As arrow components and finished arrows are both taxable, in lieu of a refund of the tax paid on components, the provision suspends the application of sec. 6416(b)(3) and permits the taxpayer to reduce the tax due on the finished arrow by the amount of the previous tax paid on the components used in the manufacture of such arrow.]

EFFECTIVE DATE


The provision is effective for articles sold by the manufacturer, producer, or importer after December 31, 2004.

10. Repeal excise tax on fishing tackle boxes (sec. 290 of the bill and sec. 4162 of the Code)

PRESENT LAW


Under present law, a 10-percent manufacturer's excise tax is imposed on specified sport fishing equipment. Examples of taxable equipment include fishing rods and poles, fishing reels, artificial bait, fishing lures, line and hooks, and fishing tackle boxes. Revenues from the excise tax on sport fishing equipment are deposited in the Sport Fishing Account of the Aquatic Resources Trust Fund. Monies in the fund are spent, subject to an existing permanent appropriation, to support Federal-State sport fish enhancement and safety programs.

REASONS FOR CHANGE


The Committee observes that fishing `tackle boxes' are little different in design and appearance from `tool boxes,' yet the former are subject to a Federal excise tax at a rate of 10-percent, while the latter are not subject to Federal excise tax. This excise tax can create a sufficiently large price difference that some fishermen will choose to use a `tool box' to hold their hooks and lures rather than a traditional `tackle box.' The Committee finds that such a distortion of consumer choice places an inappropriate burden on the manufacturers and purchasers of traditional tackle boxes, particularly in comparison to the modest amount of revenue raised by the present-law provision, and that this burden warrants repeal of the tax. The excise tax also adds unwarranted complexity to the Code, by requiring taxpayers and the IRS to make highly factual determinations as to which similar-use items are subject to tax and which are not. 94

 [Footnote]

[Footnote 94: The Joint Committee on Taxation has cited the tackle box issue as an example of the complexity of the sport fishing excise tax, and has recommended the elimination of the sport fishing equipment excise tax. See Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986, (JCS-3-01), Vol. II, Recommendations of the Staff of the Joint Committee on Taxation to Simplify the Federal Tax System, at 499-500, April 2001.]

EXPLANATION OF PROVISION


The provision repeals the excise tax on fishing tackle boxes.

EFFECTIVE DATE


The provision is effective for articles sold by the manufacturer, producer, or importer after December 31, 2004.

11. Repeal of excise tax on sonar devices suitable for finding fish (sec. 291 of the bill and secs. 4161 and 4162 of the Code)

PRESENT LAW


In general, the Code imposes a 10 percent tax on the sale by the manufacturer, producer, or importer of specified sport fishing equipment. 95

 [Footnote]  A three percent rate, however, applies to the sale of electric outboard motors and sonar devices suitable for finding fish. 96

 [Footnote]  Further, the tax imposed on the sale of sonar devices suitable for finding fish is limited to $30. A sonar device suitable for finding fish does not include any device that is a graph recorder, a digital type, a meter readout, a combination graph recorder or combination meter readout. 97

 [Footnote]

[Footnote 95: Sec. 4161(a)(1).]

[Footnote 96: Sec. 4161(a)(2).]

[Footnote 97: Sec. 4162(b).]

Revenues from the excise tax on sport fishing equipment are deposited in the Sport Fishing Account of the Aquatic Resources Trust Fund. Monies in the fund are spent, subject to an existing permanent appropriation, to support Federal-State sport fish enhancement and safety programs.

REASONS FOR CHANGE


The Committee observes that the current exemption for certain forms of sonar devices has the effect of exempting almost all of the devices currently on the market. The Committee understands that only one form of sonar device is not exempt from the tax, those units utilizing light-emitting diode (`LED') display technology. The Committee understands that LED devices are currently not exempt from the tax because the technology was developed after the exemption for the other technologies was enacted. In the Committee's view, the application of the tax to LED display devices, and not to devices performing the same function with a different technology, creates an unfair advantage for the exempt devices. Because most of the devices on the market already are exempt, the Committee believes it is appropriate to level the playing field by repealing the tax imposed on all sonar devices suitable for finding fish. The Committee believes this is a more suitable solution than exempting a device from the tax based on the type of technology used.

EXPLANATION OF PROVISION


The provision repeals the excise tax on all sonar devices suitable for finding fish.

EFFECTIVE DATE


The provision is effective for articles sold by the manufacturer, producer, or importer after December 31, 2004.

12. Income tax credit for cost of carrying tax-paid distilled spirits in wholesale inventories (sec. 292 of the bill and new sec. 5011 of the Code)

PRESENT LAW


As is true of most major Federal excise taxes, the excise tax on distilled spirits is imposed at a point in the chain of distribution before the product reaches the retail (consumer) level. Tax on domestically produced and/or bottled distilled spirits arises upon production (receipt) in a bonded distillery and is collected based on removals from the distillery during each semi-monthly period. Distilled spirits that are bottled before importation into the United States are taxed on removal from the first U.S. warehouse where they are landed (including a warehouse located in a foreign trade zone).

No tax credits are allowed under present law for business costs associated with having tax-paid products in inventory. Rather, excise tax that is included in the purchase price of a product is treated the same as the other components of the product cost, i.e., deductible as a cost of goods sold.

REASONS FOR CHANGE


Under current law, wholesale importers of distilled spirits are not required to pay the Federal excise tax on imported spirits until after the product is removed from a bonded warehouse for sale to a retailer. In contrast, the tax on domestically produced spirits is included as part of the purchase price and passed on from the supplier to wholesaler. It is the Committee's understanding that in some instances, wholesalers can carry this tax-paid inventory for an average of 60 days before selling it to a retailer. To provide equivalent tax treatment of domestic and imported product, the Committee believes it is appropriate to provide an income tax credit to approximate the interest charge--more commonly referred to as float--that results from carrying tax-paid distilled spirits in inventory.

EXPLANATION OF PROVISION


The provision creates a new income tax credit for eligible wholesale distributors of distilled spirits. An eligible wholesaler is any person who holds a permit under the Federal Alcohol Administration Act as a wholesaler of distilled spirits.

The credit is calculated by multiplying the number of cases of bottled distilled spirits by the average tax-financing cost per case for the most recent calendar year ending before the beginning of such taxable year. A case is 12 80-proof 750-milliliter bottles. The average tax-financing cost per case is the amount of interest that would accrue at corporate overpayment rates during an assumed 60-day holding period on an assumed tax rate of $22.83 per case of 12 750-milliliter bottles.

The credit only applies to domestically bottled distilled spirits 98

 [Footnote]  purchased directly from the bottler of such spirits. The credit is in addition to present-law rules allowing tax included in inventory costs to be deducted as a cost of goods sold.

[Footnote 98: Distilled spirits that are imported in bulk and then bottled domestically qualify as domestically bottled distilled spirits.]

The credit cannot be carried back to a taxable year beginning before January 1, 2005.

EFFECTIVE DATE


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

13. Suspension of occupational taxes relating to distilled spirits, wine, and beer (sec. 293 of the bill and new sec. 5148 of the Code)

PRESENT LAW


Under present law, special occupational taxes are imposed on producers and others engaged in the marketing of distilled spirits, wine, and beer. These excise taxes are imposed as part of a broader Federal tax and regulatory engine governing the production and marketing of alcoholic beverages. The special occupational taxes are payable annually, on July 1 of each year. The present tax rates are as follows:





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Producers: 99                                                                  


Distilled spirits and wines (sec. 5081)          $1,000 per year, per premise. 


Brewers (sec. 5091)                              $1,000 per year, per premise. 


Wholesale dealers (sec. 5111):                                                 


Liquors, wines, or beer                          $500 per year.                


Retail dealers (sec. 5121):                                                    


Liquors, wines, or beer                          $250 per year.                


Nonbeverage use of distilled spirits (sec. 5131) $500 per year.                


Industrial use of distilled spirits (sec. 5276)  $250 per year.                


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The Code requires every wholesale or retail dealer in liquors, wine or beer to keep records of their transactions. 100

 [Footnote]  A delegate of the Secretary of the Treasury is authorized to inspect the records of any dealer during business hours. 101

 [Footnote]  There are penalties for failing to comply with the recordkeeping requirements. 102

 [Footnote]

[Footnote 99: A reduced rate of tax in the amount of $500 is imposed on small proprietors. Secs. 5081(b), 5091(b).]

[Footnote 100: Secs. 5114, 5124.]

[Footnote 101: Sec. 5146.]

[Footnote 102: Sec. 5603.]

The Code limits the persons from whom dealers may purchase their liquor stock intended for resale. Under the Code, a dealer may only purchase from:







 [Footnote]

[Footnote 103: Sec. 5117. For example, purchases from a proprietor of a distilled spirits plant at his principal business office would be covered under item (2) since such a proprietor is not subject to the special occupational tax on account of sales at his principal business office. Sec. 5113(a). Purchases from a State-operated liquor store would be covered under item (3). Sec. 5113(b).]

In addition, a limited retail dealer (such as a charitable organization selling liquor at a picnic) may lawfully purchase distilled spirits for resale from a retail dealer in liquors. 104

 [Footnote]

[Footnote 104: Sec. 5117(b).]

Violation of this restriction is punishable by $1,000 fine, imprisonment of one year, or both. 105

 [Footnote]  A violation also makes the alcohol subject to seizure and forfeiture. 106

 [Footnote]

[Footnote 105: Sec. 5687.]

[Footnote 106: Sec. 7302.]

REASONS FOR CHANGE


The special occupational tax is not a tax on alcoholic products but rather operates as a license fee on businesses. The Committee believes that this tax places an unfair burden on business owners. However, the Committee recognizes that the recordkeeping and registration authorities applicable to wholesalers and retailers engaged in such businesses are necessary enforcement tools to ensure the protection of the revenue arising from the excise taxes on these products. Thus, the Committee believes it appropriate to suspend the tax for a three-year period, while retaining present-law recordkeeping and registration requirements.

EXPLANATION OF PROVISION


Under the provision, the special occupational taxes on producers and marketers of alcoholic beverages are suspended for a three-year period, July 1, 2004 through June 30, 2007. Present law recordkeeping and registration requirements will continue to apply, notwithstanding the suspension of the special occupation taxes. In addition, during the suspension period, it shall be unlawful for any dealer to purchase distilled spirits for resale from any person other than a wholesale dealer in liquors who is subject to the recordkeeping requirements, except that a limited retail dealer may purchase distilled spirits for resale from a retail dealer in liquors, as permitted under present law.

EFFECTIVE DATE


The provision is effective on the date of enactment.

14. Exclusion of certain indebtedness of small business investment companies from acquisition indebtedness (sec. 294 of the bill and sec. 514 of the Code)

PRESENT LAW


In general, an organization that is otherwise exempt from Federal income tax is taxed on income from a trade or business that is unrelated to the organization's exempt purposes. Certain types of income, such as rents, royalties, dividends, and interest, generally are excluded from unrelated business taxable income except when such income is derived from `debt-financed property.' Debt-financed property generally means any property that is held to produce income and with respect to which there is acquisition indebtedness at any time during the taxable year.

In general, income of a tax-exempt organization that is produced by debt-financed property is treated as unrelated business income in proportion to the acquisition indebtedness on the income-producing property. Acquisition indebtedness generally means the amount of unpaid indebtedness incurred by an organization to acquire or improve the property and indebtedness that would not have been incurred but for the acquisition or improvement of the property. Acquisition indebtedness does not include, however, (1) certain indebtedness incurred in the performance or exercise of a purpose or function constituting the basis of the organization's exemption, (2) obligations to pay certain types of annuities, (3) an obligation, to the extent it is insured by the Federal Housing Administration, to finance the purchase, rehabilitation, or construction of housing for low and moderate income persons, or (4) indebtedness incurred by certain qualified organizations to acquire or improve real property. An extension, renewal, or refinancing of an obligation evidencing a pre-existing indebtedness is not treated as the creation of a new indebtedness.

Special rules apply in the case of an exempt organization that owns a partnership interest in a partnership that holds debt-financed income-producing property. An exempt organization's share of partnership income that is derived from such debt-financed property generally is taxed as debt-financed income unless an exception provides otherwise.

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


The provision modifies the debt-financed property provisions by excluding from the definition of acquisition indebtedness any indebtedness incurred by a small business investment company licensed under the Small Business Investment Act of 1958 that is evidenced by a debenture (1) issued by such company under section 303(a) of said Act, and (2) held or guaranteed by the Small Business Administration. The exclusion shall not apply during any period that any exempt organization (other than a governmental unit) owns more than 25 percent of the capital or profits interest in the small business investment company, or exempt organizations (including governmental units other than any agency or instrumentality of the United States) own, in the aggregate, 50 percent or more of the capital or profits interest in such company.

EFFECTIVE DATE


The provision is effective for small business investment companies formed after the date of enactment.

15. Election to determine taxable income from certain international shipping activities using per ton rate (sec. 295 of the bill and new secs. 1352-1359 of the Code)

PRESENT LAW


The United States employs a `worldwide' tax system, under which domestic corporations generally are taxed on all income, including income from shipping operations, whether derived in the United States or abroad. In order to mitigate double taxation, a foreign tax credit for income taxes paid to foreign countries is provided to reduce or eliminate the U.S. tax owed on such income, subject to certain limitations.

Generally, the United States taxes foreign corporations only on income that has a sufficient nexus to the United States. Thus, a foreign corporation is generally subject to U.S. tax only on income, including income from shipping operations, which is `effectively connected' with the conduct of a trade or business in the United States (sec. 882). Such `effectively connected income' generally is taxed in the same manner and at the same rates as the income of a U.S. corporation.

The United States imposes a four percent tax on the amount of a foreign corporation's U.S. gross transportation income (sec. 887). Transportation income includes income from the use (or hiring or leasing for use) of a vessel and income from services directly related to the use of a vessel. Fifty percent of the transportation income attributable to transportation that either begins or ends (but not both) in the United States is treated as U.S. source gross transportation income. The tax does not apply, however, to U.S. gross transportation income that is treated as income effectively connected with the conduct of a U.S. trade or business. U.S. gross transportation income is not treated as effectively connected income unless (1) the taxpayer has a fixed place of business in the United States involved in earning the income, and (2) substantially all the income is attributable to regularly scheduled transportation.

The taxes imposed by sections 882 and 887 on income from shipping operations may be limited by an applicable U.S. income tax treaty or by an exemption of a foreign corporation's international shipping operations income in instances where a foreign country grants an equivalent exemption (sec. 883).

Under present law, there is no provision that provides an alternative to the corporate income tax for taxable income attributable to international shipping activities.

REASONS FOR CHANGE


In general, operators of U.S.-flag vessels in international trade are subject to higher taxes than their foreign-based competition. The uncompetitive U.S. taxation of shipping income has caused a steady and substantial decline of the U.S. shipping industry. The Committee believes that this provision will provide operators of U.S.-flag vessels in international trade the opportunity to be competitive with their tax-advantaged foreign competitors.

EXPLANATION OF PROVISION


In general

The provision generally allows corporations to elect a `tonnage tax' on their taxable income from certain shipping activities in lieu of the U.S. corporate income tax. Accordingly, a corporation's income from qualifying shipping activities is no longer taxable under sections 11, 55, 882, 887 or 1201(a) under the regime, and electing entities are only subject to tax at the maximum corporate income tax rate on a notional amount based on the net tonnage of a corporation's qualifying vessels. However, a foreign corporation is not subject to tax under the tonnage tax regime to the extent its income from qualifying shipping activities is subject to an exclusion for certain shipping operations by foreign corporations pursuant to section 883(a)(1) or pursuant to a treaty obligation of the United States.

Taxable income from qualifying shipping activities

Generally, the taxable income of an electing corporation from qualifying shipping activities is the corporate income percentage 107

 [Footnote]  of the sum of the taxable income from each of its qualifying vessels. The taxable income from each qualifying vessel is the product of (1) the daily notional taxable income 108

 [Footnote]  from the operation of the qualifying vessel in United States foreign trade, 109

 [Footnote]  and (2) the number of days during the taxable year that the electing entity operated such vessel as a qualifying vessel in U.S. foreign trade. 110

 [Footnote]  A `qualifying vessel' is described as a self-propelled U.S.-flag vessel of not less than 10,000 deadweight tons used in U.S. foreign trade.

[Footnote 107: The `corporate income percentage' is the least aggregate share, expressed as a percentage, of any item of income or gain of an electing corporation, or an electing group (i.e., a controlled group of which one or more members is an electing entity) of which such corporation is a member from qualifying shipping activities that would otherwise be required to be reported on the U.S. Federal income tax return of an electing corporation during any taxable period. A `controlled group' is any group of trusts and business entities whose members would be treated as a single employer under the rules of section 52(a) (without regard to paragraphs (1) and (2) and section 52(b)(1)).]

[Footnote 108: The `daily notional taxable income' from the operation of a qualifying vessel is 40 cents for each 100 tons of the net tonnage of the vessel (up to 25,000 net tons), and 20 cents for each 100 tons of the net tonnage of the vessel, in excess of 25,000 net tons.]

[Footnote 109: `U.S. foreign trade' means the transportation of goods or passengers between a place in the United States and a foreign place or between foreign places. As a general rule, the temporary operation in the U.S. domestic trade (i.e., the transportation of goods or passengers between places in the United States) of any qualifying vessel is disregarded. However, a vessel that is no longer used for operations in U.S. foreign trade (unless such non-use is on a temporary basis) ceases to be a qualifying vessel when such non-use begins.]

[Footnote 110: If there are multiple operators of a vessel, the taxable income of such vessel must be allocated among such persons on the basis of their ownership and charter interests or another basis that Treasury may prescribe in regulations.]

An entity's qualifying shipping activities consist of its (1) core qualifying activities, (2) qualifying secondary activities, and (3) qualifying incidental activities. Generally, core qualifying activities are activities from operating vessels in U.S. foreign trade and other activities of an electing entity and an electing group that are an integral part of the business of operating qualifying vessels in U.S. foreign trade. Qualifying secondary activities generally consist of the active management or operation of vessels in U.S. foreign trade and provisions for vessel, container and cargo-related facilities or such other activities as may be prescribed by the Secretary (which are not core activities), and may not exceed 20 percent of the aggregate gross income derived from electing entities and other members of its electing group from their core qualifying activities. Qualifying incidental activities are activities that are incidental to core qualifying activities and are not qualifying secondary activities. The aggregate gross income from qualifying incidental activities cannot exceed one-tenth of one percent of the aggregate gross income from the core qualifying activities of the electing entities and other members of its electing group.

Items not subject to corporate income tax

Generally, gross income from an electing entity does not include the corporate income percentage of an entity's (1) income from qualifying shipping activities in U.S. foreign trade, (2) income from money, bank deposits and other temporary investments which are reasonably necessary to meet the working capital requirements of its qualifying shipping activities, and (3) income from money or other intangible assets accumulated pursuant to a plan to purchase qualifying shipping assets. 111

 [Footnote]  Generally, the corporate loss percentage 112

 [Footnote]  of each item of loss, deduction, or credit is disallowed with respect to any activity the income from which is excluded from gross income under the provision. The corporate loss percentage of an electing entity's interest expense is disallowed in the ratio that the fair market value of its qualifying shipping assets bears to the fair market value of its total assets.

[Footnote 111: `Qualifying shipping assets' means any qualifying vessel and other assets which are used in core qualifying activities.]

[Footnote 112: `Corporate loss percentage' means the greatest aggregate share, expressed as a percentage, of any item of loss, deduction or credit of an electing corporation or electing group of which such corporation is a member from qualifying shipping activities that would otherwise be required to be reported on the U.S. Federal income tax return of an electing corporation during any taxable period.]

Allocation of credits, income and deductions

No deductions are allowed against the taxable income of an electing corporation from qualifying shipping activities, and no credit is allowed against the tax imposed under the tonnage tax regime. No deduction is allowed for any net operating loss attributable to the qualifying shipping activities of a corporation to the extent that such loss is carried forward by the corporation from a taxable year preceding the first taxable year for which such corporation was an electing corporation. For purposes of the provision, section 482 applies to a transaction or series of transactions between an electing entity and another person or between an entity's qualifying shipping activities and other activities carried on by it. The qualifying shipping activities of an electing entity shall be treated as a separate trade or business activity from all other activities conducted by the entity.

Qualifying shipping assets

If an electing entity sells or disposes of qualifying shipping assets in an otherwise taxable transaction, at the election of the entity no gain is recognized if replacement qualifying shipping assets are acquired during a limited replacement period except to the extent that the amount realized upon such sale or disposition exceeds the cost of the replacement qualifying shipping assets. In the case of replacement qualifying shipping assets purchased by an electing entity which results in the nonrecognition of any part of the gain realized as the result of a sale or other disposition of qualifying shipping assets, the basis is the cost of such replacement property decreased in the amount of gain not recognized. If the property purchased consists of more than one piece of property, the basis is allocated to the purchased properties in proportion to their respective costs.

The election not to recognize gain on the disposition and replacement of qualifying shipping assets is not available if the replacement qualifying shipping assets are acquired from a related person except to the extent that the related person (as defined under section 267(b) or 707(b)(1)) acquired the replacement qualifying shipping assets from an unrelated person during a limited replacement period.

Election

Generally, any qualifying entity may elect into the tonnage tax regime by filing an election with the qualifying entity's income tax return for the first taxable year to which the election applies. However, a qualifying entity, which is a member of a controlled group, may only make an election into the tonnage tax regime if all qualifying entities that are members of the controlled group make such an election. Once made, an election is effective for the taxable year in which it was made and for all succeeding taxable years of the entity until the election is terminated. An election may be terminated if the entity ceases to be a qualifying entity or if the election is revoked. In the event that a qualifying entity elects into the tonnage tax regime and subsequently revokes the election, such entity is barred from electing back into the regime until the fifth taxable year after the termination is effective, unless the Secretary of the Treasury consents to the election.

A qualifying entity means a trust or business entity that (1) operates one or more qualifying vessels and (2) meets the `shipping activity requirement.' 113

 [Footnote]  The shipping activity requirement is met for a taxable year only by an entity that meets one of the following requirements: (1) in the first taxable year of its election into the tonnage tax regime, for the preceding taxable year on average at least 25 percent of the aggregate tonnage of the qualifying vessels which were operated by the entity were owned by the entity or bareboat chartered to the entity; (2) in the second or any subsequent taxable year of its election into the tonnage tax regime, in each of the two preceding taxable years on average at least 25 percent of the aggregate tonnage of the qualifying vessels which were operated by the entity were owned by the entity or bareboat chartered to the entity; or (3) requirements (1) or (2) above would be met if the 25 percent average tonnage requirement was applied on an aggregate basis to the controlled group of which such entity is a member, and vessel charters between members of the controlled group were disregarded.

[Footnote 113: An entity is generally treated as operating any vessel owned by or chartered to the entity. However, an entity is treated as operating a vessel that it has chartered out on bareboat basis only if: (1) the vessel is temporarily surplus to the entity's requirements and the term of the charter does not exceed three years or (2) the vessel is bareboat chartered to a member of a controlled group which includes such entity or to an unrelated third party that sub-bareboats or time charters the vessel to a member of such controlled group (including the owner). Special rules apply in an instance in which an electing entity temporarily ceases to operate a qualifying vessel.]

EFFECTIVE DATE


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

16. Charitable contribution deduction for certain expenses in support of native Alaskan subsistence whaling (sec. 296 of the bill and sec. 170 of the Code)

PRESENT LAW


In computing taxable income, individuals who do not elect the standard deduction may claim itemized deductions, including a deduction (subject to certain limitations) for charitable contributions or gifts made during the taxable year to a qualified charitable organization or governmental entity. Individuals who elect the standard deduction may not claim a deduction for charitable contributions made during the taxable year.

No charitable contribution deduction is allowed for a contribution of services. However, unreimbursed expenditures made incident to the rendition of services to an organization, contributions to which are deductible, may constitute a deductible contribution. 114

 [Footnote]  Specifically, section 170(j) provides that no charitable contribution deduction is allowed for traveling expenses (including amounts expended for meals and lodging) while away from home, whether paid directly or by reimbursement, unless there is no significant element of personal pleasure, recreation, or vacation in such travel.

[Footnote 114: Treas. Reg. sec. 1.170A-1(g).]

REASONS FOR CHANGE


The Committee believes that subsistence bowhead whale hunting activities are important to certain native peoples of Alaska and further charitable purposes. The Committee believes that certain expenses paid by individuals recognized as whaling captains by the Alaska Eskimo Whaling Commission in the conduct of sanctioned whaling activities conducted pursuant to the management plan of that Commission should be deductible expenses.

EXPLANATION OF PROVISION


The provision allows individuals to claim a deduction under section 170 not exceeding $10,000 per taxable year for certain expenses incurred in carrying out sanctioned whaling activities. The deduction is available only to an individual who is recognized by the Alaska Eskimo Whaling Commission as a whaling captain charged with the responsibility of maintaining and carrying out sanctioned whaling activities. The deduction is available for reasonable and necessary expenses paid by the taxpayer during the taxable year for: (1) the acquisition and maintenance of whaling boats, weapons, and gear used in sanctioned whaling activities; (2) the supplying of food for the crew and other provisions for carrying out such activities; and (3) the storage and distribution of the catch from such activities. The Committee intends that the Secretary shall require that the taxpayer substantiate deductible expenses by maintaining appropriate written records that show, for example, the time, place, date, amount, and nature of the expense, as well as the taxpayer's eligibility for the deduction, and that such substantiation be provided as part of the taxpayer's income tax return, to the extent provided by the Secretary.

For purposes of the provision, the term `sanctioned whaling activities' means subsistence bowhead whale hunting activities conducted pursuant to the management plan of the Alaska Eskimo Whaling Commission.

EFFECTIVE DATE


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

TITLE III--TAX REFORM AND SIMPLIFICATION FOR UNITED STATES BUSINESSES


A. INTEREST EXPENSE ALLOCATION RULES


(Sec. 301 of the bill and sec. 864 of the Code)

PRESENT LAW


In general

In order to compute the foreign tax credit limitation, a taxpayer must determine the amount of its taxable income from foreign sources. Thus, the taxpayer must allocate and apportion deductions between items of U.S.-source gross income, on the one hand, and items of foreign-source gross income, on the other.

In the case of interest expense, the rules generally are based on the approach that money is fungible and that interest expense is properly attributable to all business activities and property of a taxpayer, regardless of any specific purpose for incurring an obligation on which interest is paid. 115

 [Footnote]  For interest allocation purposes, the Code provides that all members of an affiliated group of corporations generally are treated as a single corporation (the so-called `one-taxpayer rule') and allocation must be made on the basis of assets rather than gross income.

[Footnote 115: However, exceptions to the fungibility principle are provided in particular cases, some of which are described below.]

Affiliated group

In general

The term `affiliated group' in this context generally is defined by reference to the rules for determining whether corporations are eligible to file consolidated returns. However, some groups of corporations are eligible to file consolidated returns yet are not treated as affiliated for interest allocation purposes, and other groups of corporations are treated as affiliated for interest allocation purposes even though they are not eligible to file consolidated returns. Thus, under the one-taxpayer rule, the factors affecting the allocation of interest expense of one corporation may affect the sourcing of taxable income of another, related corporation even if the two corporations do not elect to file, or are ineligible to file, consolidated returns.

Definition of affiliated group--consolidated return rules

For consolidation purposes, the term `affiliated group' means one or more chains of includible corporations connected through stock ownership with a common parent corporation which is an includible corporation, but only if: (1) the common parent owns directly stock possessing at least 80 percent of the total voting power and at least 80 percent of the total value of at least one other includible corporation; and (2) stock meeting the same voting power and value standards with respect to each includible corporation (excluding the common parent) is directly owned by one or more other includible corporations.

Generally, the term `includible corporation' means any domestic corporation except certain corporations exempt from tax under section 501 (for example, corporations organized and operated exclusively for charitable or educational purposes), certain life insurance companies, corporations electing application of the possession tax credit, regulated investment companies, real estate investment trusts, and domestic international sales corporations. A foreign corporation generally is not an includible corporation.

Definition of affiliated group--special interest allocation rules

Subject to exceptions, the consolidated return and interest allocation definitions of affiliation generally are consistent with each other. 116

 [Footnote]  For example, both definitions generally exclude all foreign corporations from the affiliated group. Thus, while debt generally is considered fungible among the assets of a group of domestic affiliated corporations, the same rules do not apply as between the domestic and foreign members of a group with the same degree of common control as the domestic affiliated group.

[Footnote 116: One such exception is that the affiliated group for interest allocation purposes includes section 936 corporations that are excluded from the consolidated group.]

Banks, savings institutions, and other financial affiliates

The affiliated group for interest allocation purposes generally excludes what are referred to in the Treasury regulations as `financial corporations' (Treas. Reg. sec. 1.861-11T(d)(4)). These include any corporation, otherwise a member of the affiliated group for consolidation purposes, that is a financial institution (described in section 581 or section 591), the business of which is predominantly with persons other than related persons or their customers, and which is required by State or Federal law to be operated separately from any other entity which is not a financial institution (sec. 864(e)(5)(C)). The category of financial corporations also includes, to the extent provided in regulations, bank holding companies (including financial holding companies), subsidiaries of banks and bank holding companies (including financial holding companies), and savings institutions predominantly engaged in the active conduct of a banking, financing, or similar business (sec. 864(e)(5)(D)).

A financial corporation is not treated as a member of the regular affiliated group for purposes of applying the one-taxpayer rule to other non-financial members of that group. Instead, all such financial corporations that would be so affiliated are treated as a separate single corporation for interest allocation purposes.

REASONS FOR CHANGE


The Committee observes that the United States is the only country that currently imposes harsh and anti-competitive interest expense allocation rules on its businesses and workers. The present-law interest expense allocation rules result in U.S. companies allocating a portion of their U.S. interest expense against foreign-source income, even when the foreign operation has its own debt. The tax effect of this rule is that U.S. companies end up paying double tax. The practical effect is that the cost for U.S. companies to borrow in the United States is increased and it becomes more expensive to invest in the United States. The Committee believes that these rules should be modified so that U.S. companies are not discouraged from investing in the United States. To this end, U.S. companies should not be required to allocate U.S. interest expense against foreign-source income (and thereby incur double taxation) unless their debt-to-asset ratio is higher in the United States than in foreign countries.

EXPLANATION OF PROVISION


In general

The provision modifies the present-law interest expense allocation rules (which generally apply for purposes of computing the foreign tax credit limitation) by providing a one-time election under which the taxable income of the domestic members of an affiliated group from sources outside the United States generally is determined by allocating and apportioning interest expense of the domestic members of a worldwide affiliated group on a worldwide-group basis (i.e., as if all members of the worldwide group were a single corporation). If a group makes this election, the taxable income of the domestic members of a worldwide affiliated group from sources outside the United States is determined by allocating and apportioning the third-party interest expense of those domestic members to foreign-source income in an amount equal to the excess (if any) of (1) the worldwide affiliated group's worldwide third-party interest expense multiplied by the ratio which the foreign assets of the worldwide affiliated group bears to the total assets of the worldwide affiliated group, 117

 [Footnote]  over (2) the third-party interest expense incurred by foreign members of the group to the extent such interest would be allocated to foreign sources if the provision's principles were applied separately to the foreign members of the group. 118

 [Footnote]

[Footnote 117: For purposes of determining the assets of the worldwide affiliated group, neither stock in corporations within the group nor indebtedness (including receivables) between members of the group is taken into account. It is anticipated that the Treasury Secretary will adopt regulations addressing the allocation and apportionment of interest expense on such indebtedness that follow principles analogous to those of existing regulations. Income from holding stock or indebtedness of another group member is taken into account for all purposes under the present-law rules of the Code, including the foreign tax credit provisions.]

[Footnote 118: Although the interest expense of a foreign subsidiary is taken into account for purposes of allocating the interest expense of the domestic members of the electing worldwide affiliated group for foreign tax credit limitation purposes, the interest expense incurred by a foreign subsidiary is not deductible on a U.S. return.]

For purposes of the new elective rules based on worldwide fungibility, the worldwide affiliated group means all corporations in an affiliated group (as that term is defined under present law for interest allocation purposes) 119

 [Footnote]  as well as all controlled foreign corporations that, in the aggregate, either directly or indirectly, 120

 [Footnote]  would be members of such an affiliated group if section 1504(b)(3) did not apply (i.e., in which at least 80 percent of the vote and value of the stock of such corporations is owned by one or more other corporations included in the affiliated group). Thus, if an affiliated group makes this election, the taxable income from sources outside the United States of domestic group members generally is determined by allocating and apportioning interest expense of the domestic members of the worldwide affiliated group as if all of the interest expense and assets of 80-percent or greater owned domestic corporations (i.e., corporations that are part of the affiliated group under present-law section 864(e)(5)(A) as modified to include insurance companies) and certain controlled foreign corporations were attributable to a single corporation.

[Footnote 119: The provision expands the definition of an affiliated group for interest expense allocation purposes to include certain insurance companies that are generally excluded from an affiliated group under section 1504(b)(2) (without regard to whether such companies are covered by an election under section 1504(c)(2)).]

[Footnote 120: Indirect ownership is determined under the rules of section 958(a)(2) or through applying rules similar to those of section 958(a)(2) to stock owned directly or indirectly by domestic partnerships, trusts, or estates.]

In addition, if an affiliated group elects to apply the new elective rules based on worldwide fungibility, the present-law rules regarding the treatment of tax-exempt assets and the basis of stock in nonaffiliated ten-percent owned corporations apply on a worldwide affiliated group basis.

The common parent of the domestic affiliated group must make the worldwide affiliated group election. It must be made for the first taxable year beginning after December 31, 2008, in which a worldwide affiliated group exists that includes at least one foreign corporation that meets the requirements for inclusion in a worldwide affiliated group. Once made, the election applies to the common parent and all other members of the worldwide affiliated group for the taxable year for which the election was made and all subsequent taxable years, unless revoked with the consent of the Secretary of the Treasury.

Financial institution group election

The provision allows taxpayers to apply the present-law bank group rules to exclude certain financial institutions from the affiliated group for interest allocation purposes under the worldwide fungibility approach. The provision also provides a one-time `financial institution group' election that expands the present-law bank group. Under the provision, at the election of the common parent of the pre-election worldwide affiliated group, the interest expense allocation rules are applied separately to a subgroup of the worldwide affiliated group that consists of (1) all corporations that are part of the present-law bank group, and (2) all `financial corporations.' For this purpose, a corporation is a financial corporation if at least 80 percent of its gross income is financial services income (as described in section 904(d)(2)(C)(i) and the regulations thereunder) that is derived from transactions with unrelated persons. 121

 [Footnote]  For these purposes, items of income or gain from a transaction or series of transactions are disregarded if a principal purpose for the transaction or transactions is to qualify any corporation as a financial corporation.

[Footnote 121: See Treas. Reg. sec. 1.904-4(e)(2).]

The common parent of the pre-election worldwide affiliated group must make the election for the first taxable year beginning after December 31, 2008, in which a worldwide affiliated group includes a financial corporation. Once made, the election applies to the financial institution group for the taxable year and all subsequent taxable years. In addition, the provision provides anti-abuse rules under which certain transfers from one member of a financial institution group to a member of the worldwide affiliated group outside of the financial institution group are treated as reducing the amount of indebtedness of the separate financial institution group. The provision provides regulatory authority with respect to the election to provide for the direct allocation of interest expense in circumstances in which such allocation is appropriate to carry out the purposes of the provision, prevent assets or interest expense from being taken into account more than once, or address changes in members of any group (through acquisitions or otherwise) treated as affiliated under this provision.

EFFECTIVE DATE


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

B. RECHARACTERIZATION OF OVERALL DOMESTIC LOSS


(Sec. 302 of the bill and sec. 904 of the Code)

PRESENT LAW


The United States provides a credit for foreign income taxes paid or accrued. The foreign tax credit generally is limited to the U.S. tax liability on a taxpayer's foreign-source income, in order to ensure that the credit serves the purpose of mitigating double taxation of foreign-source income without offsetting the U.S. tax on U.S.-source income. This overall limitation is calculated by prorating a taxpayer's pre-credit U.S. tax on its worldwide income between its U.S.-source and foreign-source taxable income. The ratio (not exceeding 100 percent) of the taxpayer's foreign-source taxable income to worldwide taxable income is multiplied by its pre-credit U.S. tax to establish the amount of U.S. tax allocable to the taxpayer's foreign-source income and, thus, the upper limit on the foreign tax credit for the year.

In addition, this limitation is calculated separately for various categories of income, generally referred to as `separate limitation categories.' The total amount of the foreign tax credit used to offset the U.S. tax on income in each separate limitation category may not exceed the proportion of the taxpayer's U.S. tax which the taxpayer's foreign-source taxable income in that category bears to its worldwide taxable income.

If a taxpayer's losses from foreign sources exceed its foreign-source income, the excess (`overall foreign loss,' or `OFL') may offset U.S.-source income. Such an offset reduces the effective rate of U.S. tax on U.S.-source income.

In order to eliminate a double benefit (that is, the reduction of U.S. tax previously noted and, later, full allowance of a foreign tax credit with respect to foreign-source income), present law includes an OFL recapture rule. Under this rule, a portion of foreign-source taxable income earned after an OFL year is recharacterized as U.S.-source taxable income for foreign tax credit purposes (and for purposes of the possessions tax credit). Unless a taxpayer elects a higher percentage, however, generally no more than 50 percent of the foreign-source taxable income earned in any particular taxable year is recharacterized as U.S.-source taxable income. The effect of the recapture is to reduce the foreign tax credit limitation in one or more years following an OFL year and, therefore, the amount of U.S. tax that can be offset by foreign tax credits in the later year or years.

Losses for any taxable year in separate foreign limitation categories (to the extent that they do not exceed foreign income for the year) are apportioned on a proportionate basis among (and operate to reduce) the foreign income categories in which the entity earns income in the loss year. A separate limitation loss recharacterization rule applies to foreign losses apportioned to foreign income pursuant to the above rule. If a separate limitation loss was apportioned to income subject to another separate limitation category and the loss category has income for a subsequent taxable year, then that income (to the extent that it does not exceed the aggregate separate limitation losses in the loss category not previously recharacterized) must be recharacterized as income in the separate limitation category that was previously offset by the loss. Such recharacterization must be made in proportion to the prior loss apportionment not previously taken into account.

A U.S.-source loss reduces pre-credit U.S. tax on worldwide income to an amount less than the hypothetical tax that would apply to the taxpayer's foreign-source income if viewed in isolation. The existence of foreign-source taxable income in the year of the U.S.-source loss reduces or eliminates any net operating loss carryover that the U.S.-source loss would otherwise have generated absent the foreign income. In addition, as the pre-credit U.S. tax on worldwide income is reduced, so is the foreign tax credit limitation. Moreover, any U.S.-source loss for any taxable year is apportioned among (and operates to reduce) foreign income in the separate limitation categories on a proportionate basis. As a result, some foreign tax credits in the year of the U.S.-source loss must be credited, if at all, in a carryover year. Tax on U.S.-source taxable income in a subsequent year may be offset by a net operating loss carryforward, but not by a foreign tax credit carryforward. There is currently no mechanism for recharacterizing such subsequent U.S.-source income as foreign-source income.

For example, suppose a taxpayer generates a $100 U.S.-source loss and earns $100 of foreign-source income in Year 1, and pays $30 of foreign tax on the $100 of foreign-source income. Because the taxpayer has no net taxable income in Year 1, no foreign tax credit can be claimed in Year 1 with respect to the $30 of foreign taxes. If the taxpayer then earns $100 of U.S.-source income and $100 of foreign-source income in Year 2, present law does not recharacterize any portion of the $100 of U.S.-source income as foreign-source income to reflect the fact that the previous year's $100 U.S.-source loss reduced the taxpayer's ability to claim foreign tax credits.

REASONS FOR CHANGE


The Committee believes that it is important to create parity in the treatment of overall foreign losses and overall domestic losses in order to prevent the double taxation of income. The Committee believes that preventing double taxation will make U.S. businesses more competitive and will lead to increased export sales. The Committee believes that this increase in export sales will increase production in the United States and increase jobs in the United States to support the increased exports.

EXPLANATION OF PROVISION


The provision applies a re-sourcing rule to U.S.-source income in cases in which a taxpayer's foreign tax credit limitation has been reduced as a result of an overall domestic loss. Under the provision, a portion of the taxpayer's U.S.-source income for each succeeding taxable year is recharacterized as foreign-source income in an amount equal to the lesser of: (1) the amount of the unrecharacterized overall domestic losses for years prior to such succeeding taxable year, and (2) 50 percent of the taxpayer's U.S.-source income for such succeeding taxable year.

The provision defines an overall domestic loss for this purpose as any domestic loss to the extent it offsets foreign-source taxable income for the current taxable year or for any preceding taxable year by reason of a loss carryback. For this purpose, a domestic loss means the amount by which the U.S.-source gross income for the taxable year is exceeded by the sum of the deductions properly apportioned or allocated thereto, determined without regard to any loss carried back from a subsequent taxable year. Under the provision, an overall domestic loss does not include any loss for any taxable year unless the taxpayer elected the use of the foreign tax credit for such taxable year.

Any U.S.-source income recharacterized under the provision is allocated among and increases the various foreign tax credit separate limitation categories in the same proportion that those categories were reduced by the prior overall domestic losses, in a manner similar to the recharacterization rules for separate limitation losses.

It is anticipated that situations may arise in which a taxpayer generates an overall domestic loss in a year following a year in which it had an overall foreign loss, or vice versa. In such a case, it would be necessary for ordering and other coordination rules to be developed for purposes of computing the foreign tax credit limitation in subsequent taxable years. The provision grants the Secretary of the Treasury authority to prescribe such regulations as may be necessary to coordinate the operation of the OFL recapture rules with the operation of the overall domestic loss recapture rules added by the provision.

EFFECTIVE DATE


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

C. REDUCTION TO TWO FOREIGN TAX CREDIT BASKETS


(Sec. 303 of the bill and sec. 904 of the Code)

PRESENT LAW


In general

The United States taxes its citizens and residents on their worldwide income. Because the countries in which income is earned also may assert their jurisdiction to tax the same income on the basis of source, foreign-source income earned by U.S. persons may be subject to double taxation. In order to mitigate this possibility, the United States provides a credit against U.S. tax liability for foreign income taxes paid, subject to a number of limitations. The foreign tax credit generally is limited to the U.S. tax liability on a taxpayer's foreign-source income, in order to ensure that the credit serves its purpose of mitigating double taxation of cross-border income without offsetting the U.S. tax on U.S.-source income.

The foreign tax credit limitation is applied separately to the following categories of income: (1) passive income, (2) high withholding tax interest, (3) financial services income, (4) shipping income, (5) certain dividends received from noncontrolled section 902 foreign corporations (`10/50 companies'), 122

 [Footnote]  (6) certain dividends from a domestic international sales corporation or former domestic international sales corporation, (7) taxable income attributable to certain foreign trade income, (8) certain distributions from a foreign sales corporation or former foreign sales corporation, and (9) any other income not described in items (1) through (8) (so-called `general basket' income). In addition, a number of other provisions of the Code and U.S. tax treaties effectively create additional separate limitations in certain circumstances. 123

 [Footnote]

[Footnote 122: Subject to certain exceptions, dividends paid by a 10/50 company in taxable years beginning after December 31, 2002 are subject to either a look-through approach in which the dividend is attributed to a particular limitation category based on the underlying earnings which gave rise to the dividend (for post-2002 earnings and profits), or a single-basket limitation approach for dividends from all 10/50 companies that are not passive foreign investment companies (for pre-2003 earnings and profits). Under section 304 of the bill, these dividends are subject to a look-through approach, irrespective of when the underlying earnings and profits arose.]

[Footnote 123: See, e.g., sec. 56(g)(4)(C)(iii)(IV) (relating to certain dividends from corporations eligible for the sec. 936 credit); sec. 245(a)(10) (relating to certain dividends treated as foreign source under treaties); sec. 865(h)(1)(B) (relating to certain gains from stock and intangibles treated as foreign source under treaties); sec. 901(j)(1)(B) (relating to income from certain specified countries); and sec. 904(g)(10)(A) (relating to interest, dividends, and certain other amounts derived from U.S.-owned foreign corporations and treated as foreign source under treaties).]

Financial services income

In general, the term `financial services income' includes income received or accrued by a person predominantly engaged in the active conduct of a banking, insurance, financing, or similar business, if the income is derived in the active conduct of a banking, financing or similar business, or is derived from the investment by an insurance company of its unearned premiums or reserves ordinary and necessary for the proper conduct of its insurance business (sec. 904(d)(2)(C)). The Code also provides that financial services income includes income, received or accrued by a person predominantly engaged in the active conduct of a banking, insurance, financing, or similar business, of a kind which would generally be insurance income (as defined in section 953(a)), among other items.

Treasury regulations provide that a person is predominantly engaged in the active conduct of a banking, insurance, financing, or similar business for any year if for that year at least 80 percent of its gross income is `active financing income.' 124

 [Footnote]  The regulations further provide that a corporation that is not predominantly engaged in the active conduct of a banking, insurance, financing, or similar business under the preceding definition can derive financial services income if the corporation is a member of an affiliated group (as defined in section 1504(a), but expanded to include foreign corporations) that, as a whole, meets the regulatory test of being `predominantly engaged.' 125

 [Footnote]  In determining whether an affiliated group is `predominantly engaged,' only the income of members of the group that are U.S. corporations, or controlled foreign corporations in which such U.S. corporations own (directly or indirectly) at least 80 percent of the total voting power and value of the stock, are counted.

[Footnote 124: Treas. Reg. sec. 1.904-4(e)(3)(i) and (2)(i).]

[Footnote 125: Treas. Reg. sec. 1.904-4(e)(3)(ii).]

`Base difference' items

Under Treasury regulations, foreign taxes are allocated and apportioned to the same limitation categories as the income to which they relate. 126

 [Footnote]  In cases in which foreign law imposes tax on an item of income that does not constitute income under U.S. tax principles (a `base difference' item), the tax is treated as imposed on income in the general limitation category. 127

 [Footnote]

[Footnote 126: Treas. Reg. sec. 1.904-6.]

[Footnote 127: Treas. Reg. sec. 1.904-6(a)(1)(iv).]

REASONS FOR CHANGE


The Committee believes that requiring taxpayers to separate income and tax credits into nine separate tax baskets creates some of the most complex tax reporting and compliance issues in the Code. Reducing the number of foreign tax credit baskets to two will greatly simplify the Code and undo much of the complexity created by the Tax Reform Act of 1986. The Committee believes that simplifying these rules will reduce double taxation, make U.S. businesses more competitive, and create jobs in the United States.

EXPLANATION OF PROVISION


In general

The provision generally reduces the number of foreign tax credit limitation categories to two: passive category income and general category income. Other income is included in one of the two categories, as appropriate. For example, shipping income generally falls into the general limitation category, whereas high withholding tax interest generally could fall into the passive income or the general limitation category, depending on the circumstances. Dividends from a domestic international sales corporation or former domestic international sales corporation, income attributable to certain foreign trade income, and certain distributions from a foreign sales corporation or former foreign sales corporation all are assigned to the passive income limitation category. The provision does not affect the separate computation of foreign tax credit limitations under special provisions of the Code relating to, for example, treaty-based sourcing rules or specified countries under section 901(j).

Financial services income

In the case of a member of a financial services group or any other person predominantly engaged in the active conduct of a banking, insurance, financing or similar business, the provision treats income meeting the definition of financial services income as general category income. Under the provision, a financial services group is an affiliated group that is predominantly engaged in the active conduct of a banking, insurance, financing or similar business. For this purpose, the definition of an affiliated group under section 1504(a) is applied, but expanded to include certain insurance companies (without regard to whether such companies are covered by an election under section 1504(c)(2)) and foreign corporations. In determining whether such a group is predominantly engaged in the active conduct of a banking, insurance, financing, or similar business, only the income of members of the group that are U.S. corporations or controlled foreign corporations in which such U.S. corporations own (directly or indirectly) at least 80 percent of total voting power and value of the stock are taken into account.

The provision does not alter the present law interpretation of what it means to be a `person predominantly engaged in the active conduct of a banking, insurance, financing, or similar business.' 128

 [Footnote]  Thus, other provisions of the Code that rely on this same concept of a `person predominantly engaged in the active conduct of a banking, insurance, financing, or similar business' are not affected by the provision. For example, under the `accumulated deficit rule' of section 952(c)(1)(B), subpart F income inclusions of a U.S. shareholder attributable to a `qualified activity' of a controlled foreign corporation may be reduced by the amount of the U.S. shareholder's pro rata share of certain prior year deficits attributable to the same qualified activity. In the case of a qualified financial institution, qualified activity consists of any activity giving rise to foreign personal holding company income, but only if the controlled foreign corporation was predominantly engaged in the active conduct of a banking, financing, or similar business in both the year in which the corporation earned the income and the year in which the corporation incurred the deficit. Similarly, in the case of a qualified insurance company, qualified activity consists of activity giving rise to insurance income or foreign personal holding company income, but only if the controlled foreign corporation was predominantly engaged in the active conduct of an insurance business in both the year in which the corporation earned the income and the year in which the corporation incurred the deficit. For this purpose, `predominantly engaged in the active conduct of a banking, insurance, financing, or similar business' is defined under present law by reference to the use of the term for purposes of the separate foreign tax credit limitations. 129

 [Footnote]  The present-law meaning of `predominantly engaged' for purposes of section 952(c)(1)(B) remains unchanged under the provision.

[Footnote 128: See Treas. Reg. sec. 1.904-4(e).]

[Footnote 129: See H.R. Rep. No. 99-841, 99th Cong., 2d Sess. II-621 (1986); Staff of the Joint Committee on Taxation, 100th Cong., 1st Sess., General Explanation of the Tax Reform Act of 1986, at 984 (1987).]

The provision requires the Treasury Secretary to specify the treatment of financial services income received or accrued by pass-through entities that are not members of a financial services group. The Committee expects these regulations to be generally consistent with regulations currently in effect.

`Base difference' items

Creditable foreign taxes that are imposed on amounts that do not constitute income under U.S. tax principles are treated as imposed on general limitation income.

EFFECTIVE DATE


The provision is effective for taxable years beginning after December 31, 2006.

Taxes paid or accrued in a taxable year beginning before January 1, 2007, and carried to any subsequent taxable year are treated as if this provision were in effect on the date such taxes were paid or accrued. Thus, such taxes are assigned to one of the two foreign tax credit limitation categories, as appropriate.

The Treasury Secretary is given authority to provide by regulations for the allocation of income with respect to taxes carried back to pre-effective-date years (in which more than two limitation categories are in effect).

D. LOOK-THROUGH RULES TO APPLY TO DIVIDENDS FROM NONCONTROLLED SECTION 902 CORPORATIONS


(Sec. 304 of the bill and sec. 904 of the Code)

PRESENT LAW


U.S. persons may credit foreign taxes against U.S. tax on foreign-source income. In general, the amount of foreign tax credits that may be claimed in a year is subject to a limitation that prevents taxpayers from using foreign tax credits to offset U.S. tax on U.S.-source income. Separate limitations are also applied to specific categories of income.

Special foreign tax credit limitations apply in the case of dividends received from a foreign corporation in which the taxpayer owns at least 10 percent of the stock by vote and which is not a controlled foreign corporation (a so-called `10/50 company'). Dividends paid by a 10/50 company that is not a passive foreign investment company out of earnings and profits accumulated in taxable years beginning before January 1, 2003 are subject to a single foreign tax credit limitation for all 10/50 companies (other than passive foreign investment companies). 130

 [Footnote]  Dividends paid by a 10/50 company that is a passive foreign investment company out of earnings and profits accumulated in taxable years beginning before January 1, 2003, continue to be subject to a separate foreign tax credit limitation for each such 10/50 company. Dividends paid by a 10/50 company out of earnings and profits accumulated in taxable years after December 31, 2002 are treated as income in a foreign tax credit limitation category in proportion to the ratio of the 10/50 company's earnings and profits attributable to income in such foreign tax credit limitation category to its total earnings and profits (a `look-through' approach).

[Footnote 130: 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.]

For these purposes, distributions are treated as made from the most recently accumulated earnings and profits. Regulatory authority is granted to provide rules regarding the treatment of distributions out of earnings and profits for periods prior to the taxpayer's acquisition of such stock.

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


The provision generally applies the look-through approach to dividends paid by a 10/50 company regardless of the year in which the earnings and profits out of which the dividend is paid were accumulated. 131

 [Footnote]  If the Treasury Secretary determines that a taxpayer has inadequately substantiated that it assigned a dividend from a 10/50 company to the proper foreign tax credit limitation category, the dividend is treated as passive category income for foreign tax credit basketing purposes. 132

 [Footnote]

[Footnote 131: This look-through treatment also applies to dividends that a controlled foreign corporation receives from a 10/50 company and then distributes to a U.S. shareholder.]

[Footnote 132: It is anticipated that the Treasury Secretary will reconsider the operation of the foreign tax credit regulations to ensure that the high-tax income rules apply appropriately to dividends treated as passive category income because of inadequate substantiation.]

EFFECTIVE DATE


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

The provision also provides transition rules regarding the use of pre-effective-date foreign tax credits associated with a 10/50 company separate limitation category in post-effective-date years. Look-through principles similar to those applicable to post-effective-date dividends from a 10/50 company apply to determine the appropriate foreign tax credit limitation category or categories with respect to carrying forward foreign tax credits into future years. The provision allows the Treasury Secretary to issue regulations addressing the carryback of foreign tax credits associated with a dividend from a 10/50 company to pre-effective-date years.

E. ATTRIBUTION OF STOCK OWNERSHIP THROUGH PARTNERSHIPS TO APPLY IN DETERMINING SECTION 902 AND 960 CREDITS


(Sec. 305 of the bill and secs. 901, 902, and 960 of the Code)

PRESENT LAW


Under section 902, a domestic corporation that receives a dividend from a foreign corporation in which it owns ten percent or more of the voting stock is deemed to have paid a portion of the foreign taxes paid by such foreign corporation. Thus, such a domestic corporation is eligible to claim a foreign tax credit with respect to such deemed-paid taxes. The domestic corporation that receives a dividend is deemed to have paid a portion of the foreign corporation's post-1986 foreign income taxes based on the ratio of the amount of the dividend to the foreign corporation's post-1986 undistributed earnings and profits.

Foreign income taxes paid or accrued by lower-tier foreign corporations also are eligible for the deemed-paid credit if the foreign corporation falls within a qualified group (sec. 902(b)). A `qualified group' includes certain foreign corporations within the first six tiers of a chain of foreign corporations if, among other things, the product of the percentage ownership of voting stock at each level of the chain (beginning from the domestic corporation) equals at least five percent. In addition, in order to claim indirect credits for foreign taxes paid by certain fourth-, fifth-, and sixth-tier corporations, such corporations must be controlled foreign corporations (within the meaning of sec. 957) and the shareholder claiming the indirect credit must be a U.S. shareholder (as defined in sec. 951(b)) with respect to the controlled foreign corporations. The application of the indirect foreign tax credit below the third tier is limited to taxes paid in taxable years during which the payor is a controlled foreign corporation. Foreign taxes paid below the sixth tier of foreign corporations are ineligible for the indirect foreign tax credit.

Section 960 similarly permits a domestic corporation with subpart F inclusions from a controlled foreign corporation to claim deemed-paid foreign tax credits with respect to foreign taxes paid or accrued by the controlled foreign corporation on its subpart F income.

The foreign tax credit provisions in the Code do not specifically address whether a domestic corporation owning ten percent or more of the voting stock of a foreign corporation through a partnership is entitled to a deemed-paid foreign tax credit. 133

 [Footnote]  In Rev. Rul. 71-141, 134

 [Footnote]  the IRS held that a foreign corporation's stock held indirectly by two domestic corporations through their interests in a domestic general partnership is attributed to such domestic corporations for purposes of determining the domestic corporations' eligibility to claim a deemed-paid foreign tax credit with respect to the foreign taxes paid by such foreign corporation. Accordingly, a general partner of a domestic general partnership is permitted to claim deemed-paid foreign tax credits with respect to a dividend distribution from the foreign corporation to the partnership.

[Footnote 133: Under section 901(b)(5), an individual member of a partnership or a beneficiary of an estate or trust generally may claim a direct foreign tax credit with respect to the amount of his or her proportionate share of the foreign taxes paid or accrued by the partnership, estate, or trust. This rule does not specifically apply to corporations that are either members of a partnership or beneficiaries of an estate or trust. However, section 702(a)(6) provides that each partner (including individuals or corporations) of a partnership must take into account separately its distributive share of the partnership's foreign taxes paid or accrued. In addition, under section 703(b)(3), the election under section 901 (whether to credit the foreign taxes) is made by each partner separately.]

[Footnote 134: 1971-1 C.B. 211.]

However, in 1997, the Treasury Department issued final regulations under section 902, and the preamble to the regulations states that `[t]he final regulations do not resolve under what circumstances a domestic corporate partner may compute an amount of foreign taxes deemed paid with respect to dividends received from a foreign corporation by a partnership or other pass-through entity.' 135

 [Footnote]  In recognition of the holding in Rev. Rul. 71-141, the preamble to the final regulations under section 902 states that a `domestic shareholder' for purposes of section 902 is a domestic corporation that `owns' the requisite voting stock in a foreign corporation rather than one that `owns directly' the voting stock. At the same time, the preamble states that the IRS is still considering under what other circumstances Rev. Rul. 71-141 should apply. Consequently, uncertainty remains regarding whether a domestic corporation owning ten percent or more of the voting stock of a foreign corporation through a partnership is entitled to a deemed-paid foreign tax credit (other than through a domestic general partnership).

[Footnote 135: T.D. 8708, 1997-1 C.B. 137.]

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


The provision clarifies that a domestic corporation is entitled to claim deemed-paid foreign tax credits with respect to a foreign corporation that is held indirectly through a foreign or domestic partnership, provided that the domestic corporation owns (indirectly through the partnership) ten percent or more of the foreign corporation's voting stock. No inference is intended as to the treatment of such deemed-paid foreign tax credits under present law. The provision also clarifies that both individual and corporate partners (or estate or trust beneficiaries) may claim direct foreign tax credits with respect to their proportionate shares of taxes paid or accrued by a partnership (or estate or trust).

EFFECTIVE DATE


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

F. FOREIGN TAX CREDIT TREATMENT OF DEEMED PAYMENTS UNDER SECTION 367(D)


(Sec. 306 of the bill and sec. 367 of the Code)

PRESENT LAW


In the case of transfers of intangible property to foreign corporations by means of contributions and certain other nonrecognition transactions, special rules apply that are designed to mitigate the tax avoidance that may arise from shifting the income attributable to intangible property offshore. Under section 367(d), the outbound transfer of intangible property is treated as a sale of the intangible for a stream of contingent payments. The amounts of these deemed payments must be commensurate with the income attributable to the intangible. The deemed payments are included in gross income of the U.S. transferor as ordinary income, and the earnings and profits of the foreign corporation to which the intangible was transferred are reduced by such amounts.

The Taxpayer Relief Act of 1997 (the `1997 Act') repealed a rule that treated all such deemed payments as giving rise to U.S.-source income. Because the foreign tax credit is generally limited to the U.S. tax imposed on foreign-source income, the prior-law rule reduced the taxpayer's ability to claim foreign tax credits. As a result of the repeal of the rule, the source of payments deemed received under section 367(d) is determined under general sourcing rules. These rules treat income from sales of intangible property for contingent payments the same as royalties, with the result that the deemed payments may give rise to foreign-source income. 136

 [Footnote]

[Footnote 136: Secs. 865(d), 862(a).]

The 1997 Act did not address the characterization of the deemed payments for purposes of applying the foreign tax credit separate limitation categories. 137

 [Footnote]  If the deemed payments are treated like proceeds of a sale, then they could fall into the passive category; if the deemed payments are treated like royalties, then in many cases they could fall into the general category (under look-through rules applicable to payments of dividends, interest, rents, and royalties received from controlled foreign corporations). 138

 [Footnote]

[Footnote 137: Sec. 904(d).]

[Footnote 138: Sec. 904(d)(3).]

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


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

EFFECTIVE DATE


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

G. UNITED STATES PROPERTY NOT TO INCLUDE CERTAIN ASSETS OF CONTROLLED FOREIGN CORPORATION


(Sec. 307 of the bill and sec. 956 of the Code)

PRESENT LAW


In general, the subpart F rules 139

 [Footnote]  require U.S. shareholders with a 10-percent or greater interest in a controlled foreign corporation (`U.S. 10-percent shareholders') to include in taxable income their pro rata shares of certain income of the controlled foreign corporation (referred to as `subpart F income') when such income is earned, whether or not the earnings are distributed currently to the shareholders. In addition, the U.S. 10-percent shareholders of a controlled foreign corporation are subject to U.S. tax on their pro rata shares of the controlled foreign corporation's earnings to the extent invested by the controlled foreign corporation in certain U.S. property in a taxable year. 140

 [Footnote]

[Footnote 139: Secs. 951-964.]

[Footnote 140: Sec. 951(a)(1)(B).]

A shareholder's income inclusion with respect to a controlled foreign corporation's investment in U.S. property for a taxable year is based on the controlled foreign corporation's average investment in U.S. property for such year. For this purpose, the U.S. property held (directly or indirectly) by the controlled foreign corporation must be measured as of the close of each quarter in the taxable year. 141

 [Footnote]  The amount taken into account with respect to any property is the property's adjusted basis as determined for purposes of reporting the controlled foreign corporation's earnings and profits, reduced by any liability to which the property is subject. The amount determined for inclusion in each taxable year is the shareholder's pro rata share of an amount equal to the lesser of: (1) the controlled foreign corporation's average investment in U.S. property as of the end of each quarter of such taxable year, to the extent that such investment exceeds the foreign corporation's earnings and profits that were previously taxed on that basis; or (2) the controlled foreign corporation's current or accumulated earnings and profits (but not including a deficit), reduced by distributions during the year and by earnings that have been taxed previously as earnings invested in U.S. property. 142

 [Footnote]  An income inclusion is required only to the extent that the amount so calculated exceeds the amount of the controlled foreign corporation's earnings that have been previously taxed as subpart F income. 143

 [Footnote]

[Footnote 141: Sec. 956(a).]

[Footnote 142: Secs. 956 and 959.]

[Footnote 143: Secs. 951(a)(1)(B) and 959.]

For purposes of section 956, U.S. property generally is defined to include tangible property located in the United States, stock of a U.S. corporation, an obligation of a U.S. person, and certain intangible assets including a patent or copyright, an invention, model or design, a secret formula or process or similar property right which is acquired or developed by the controlled foreign corporation for use in the United States. 144

 [Footnote]

[Footnote 144: Sec. 956(c)(1).]

Specified exceptions from the definition of U.S. property are provided for: (1) obligations of the United States, money, or deposits with persons carrying on the banking business; (2) certain export property; (3) certain trade or business obligations; (4) aircraft, railroad rolling stock, vessels, motor vehicles or containers used in transportation in foreign commerce and used predominantly outside of the United States; (5) certain insurance company reserves and unearned premiums related to insurance of foreign risks; (6) stock or debt of certain unrelated U.S. corporations; (7) moveable property (other than a vessel or aircraft) used for the purpose of exploring, developing, or certain other activities in connection with the ocean waters of the U.S. Continental Shelf; (8) an amount of assets equal to the controlled foreign corporation's accumulated earnings and profits attributable to income effectively connected with a U.S. trade or business; (9) property (to the extent provided in regulations) held by a foreign sales corporation and related to its export activities; (10) certain deposits or receipts of collateral or margin by a securities or commodities dealer, if such deposit is made or received on commercial terms in the ordinary course of the dealer's business as a securities or commodities dealer; and (11) certain repurchase and reverse repurchase agreement transactions entered into by or with a dealer in securities or commodities in the ordinary course of its business as a securities or commodities dealer. 145

 [Footnote]

[Footnote 145: Sec. 956(c)(2).]

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


The provision adds two new exceptions from the definition of U.S. property for determining current income inclusion by a U.S. 10-percent shareholder with respect to an investment in U.S. property by a controlled foreign corporation.

The first exception generally applies to securities acquired and held by a controlled foreign corporation in the ordinary course of its trade or business as a dealer in securities. The exception applies only if the controlled foreign corporation dealer: (1) accounts for the securities as securities held primarily for sale to customers in the ordinary course of business; and (2) disposes of such securities (or such securities mature while being held by the dealer) within a period consistent with the holding of securities for sale to customers in the ordinary course of business.

The second exception generally applies to the acquisition by a controlled foreign corporation of obligations issued by a U.S. person that is not a domestic corporation and that is not (1) a U.S. 10-percent shareholder of the controlled foreign corporation, or (2) a partnership, estate or trust in which the controlled foreign corporation or any related person is a partner, beneficiary or trustee immediately after the acquisition by the controlled foreign corporation of such obligation.

EFFECTIVE DATE


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

H. ELECTION NOT TO USE AVERAGE EXCHANGE RATE FOR FOREIGN TAX PAID OTHER THAN IN FUNCTIONAL CURRENCY


(Sec. 308 of the bill and sec. 986 of the Code)

PRESENT LAW


For taxpayers that take foreign income taxes into account when accrued, present law provides that the amount of the foreign tax credit generally is determined by translating the amount of foreign taxes paid in foreign currencies into a U.S. dollar amount at the average exchange rate for the taxable year to which such taxes relate. 146

 [Footnote]  This rule applies to foreign taxes paid directly by U.S. taxpayers, which taxes are creditable in the year paid or accrued, and to foreign taxes paid by foreign corporations that are deemed paid by a U.S. corporation that is a shareholder of the foreign corporation, and hence creditable in the year that the U.S. corporation receives a dividend or has an income inclusion from the foreign corporation. This rule does not apply to any foreign income tax: (1) that is paid after the date that is two years after the close of the taxable year to which such taxes relate; (2) of an accrual-basis taxpayer that is actually paid in a taxable year prior to the year to which the tax relates; or (3) that is denominated in an inflationary currency (as defined by regulations).

[Footnote 146: Sec. 986(a)(1).]

Foreign taxes that are not eligible for translation at the average exchange rate generally are translated into U.S. dollar amounts using the exchange rates as of the time such taxes are paid. However, the Secretary is authorized to issue regulations that would allow foreign tax payments to be translated into U.S. dollar amounts using an average exchange rate for a specified period. 147

 [Footnote]

[Footnote 147: Sec. 986(a)(2).]

REASONS FOR CHANGE


The Committee believes that taxpayers generally should be permitted to elect whether to translate foreign income tax payments using an average exchange rate for the taxable year or the exchange rate when the taxes are paid, provided the elected method continues to be applied consistently unless revoked with the consent of the Treasury Secretary.

EXPLANATION OF PROVISION


For taxpayers that are required under present law to translate foreign income tax payments at the average exchange rate, the provision provides an election to translate such taxes into U.S. dollar amounts using the exchange rates as of the time such taxes are paid, provided the foreign income taxes are denominated in a currency other than the taxpayer's functional currency. 148

 [Footnote]  Any election under the provision applies to the taxable year for which the election is made and to all subsequent taxable years unless revoked with the consent of the Secretary. The provision authorizes the Secretary to issue regulations that apply the election to foreign income taxes attributable to a qualified business unit.

[Footnote 148: Electing taxpayers translate foreign income tax payments pursuant to the same present-law rules that apply to taxpayers that are required to translate foreign income taxes using the exchange rates as of the time such taxes are paid.]

EFFECTIVE DATE


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

I. REPEAL OF WITHHOLDING TAX ON DIVIDENDS FROM CERTAIN FOREIGN CORPORATIONS


(Sec. 309 of the bill and sec. 871 of the Code)

PRESENT LAW


Nonresident individuals who are not U.S. citizens and foreign corporations (collectively, foreign persons) are subject to U.S. tax on income that is effectively connected with the conduct of a U.S. trade or business; the U.S. tax on such income is calculated in the same manner and at the same graduated rates as the tax on U.S. persons (secs. 871(b) and 882). Foreign persons also are subject to a 30-percent gross basis tax, collected by withholding, on certain U.S.-source passive income (e.g., interest and dividends) that is not effectively connected with a U.S. trade or business. This 30-percent withholding tax may be reduced or eliminated pursuant to an applicable tax treaty. Foreign persons generally are not subject to U.S. tax on foreign-source income that is not effectively connected with a U.S. trade or business.

In general, dividends paid by a domestic corporation are treated as being from U.S. sources and dividends paid by a foreign corporation are treated as being from foreign sources. Thus, dividends paid by foreign corporations to foreign persons generally are not subject to withholding tax because such income generally is treated as foreign-source income.

An exception from this general rule applies in the case of dividends paid by certain foreign corporations. If a foreign corporation derives 25 percent or more of its gross income as income effectively connected with a U.S. trade or business for the three-year period ending with the close of the taxable year preceding the declaration of a dividend, then a portion of any dividend paid by the foreign corporation to its shareholders will be treated as U.S.-source income and, in the case of dividends paid to foreign shareholders, will be subject to the 30-percent withholding tax (sec. 861(a)(2)(B)). This rule is sometimes referred to as the `secondary withholding tax.' The portion of the dividend treated as U.S.-source income is equal to the ratio of the gross income of the foreign corporation that was effectively connected with its U.S. trade or business over the total gross income of the foreign corporation during the three-year period ending with the close of the preceding taxable year. The U.S.-source portion of the dividend paid by the foreign corporation to its foreign shareholders is subject to the 30-percent withholding tax.

Under the branch profits tax provisions, the United States taxes foreign corporations engaged in a U.S. trade or business on amounts of U.S. earnings and profits that are shifted out of the U.S. branch of the foreign corporation. The branch profits tax is comparable to the second-level taxes imposed on dividends paid by a domestic corporation to its foreign shareholders. The branch profits tax is 30 percent of the foreign corporation's `dividend equivalent amount,' which generally is the earnings and profits of a U.S. branch of a foreign corporation attributable to its income effectively connected with a U.S. trade or business (secs. 884(a) and (b)).

If a foreign corporation is subject to the branch profits tax, then no secondary withholding tax is imposed on dividends paid by the foreign corporation to its shareholders (sec. 884(e)(3)(A)). If a foreign corporation is a qualified resident of a tax treaty country and claims an exemption from the branch profits tax pursuant to the treaty, the secondary withholding tax could apply with respect to dividends it pays to its shareholders. Several tax treaties (including treaties that prevent imposition of the branch profits tax), however, exempt dividends paid by the foreign corporation from the secondary withholding tax.

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


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

EFFECTIVE DATE


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

J. PROVIDE EQUAL TREATMENT FOR INTEREST PAID BY FOREIGN PARTNERSHIPS AND FOREIGN CORPORATIONS


(Sec. 310 of the bill and sec. 861 of the Code)

PRESENT LAW


In general, interest income from bonds, notes or other interest-bearing obligations of noncorporate U.S. residents or domestic corporations is treated as U.S.-source income. 149

 [Footnote]  Other interest (e.g., interest on obligations of foreign corporations and foreign partnerships) generally is treated as foreign-source income. However, Treasury regulations provide that a foreign partnership is a U.S. resident for purposes of this rule if at any time during its taxable year it is engaged in a trade or business in the United States. 150

 [Footnote]  Therefore, any interest received from such a foreign partnership is U.S.-source income.

[Footnote 149: Sec. 861(a)(1).]

[Footnote 150: Treas. Reg. sec. 1.861-2(a)(2).]

Notwithstanding the general rule described above, in the case of a foreign corporation engaged in a U.S. trade or business (or having gross income that is treated as effectively connected with the conduct of a U.S. trade or business), interest paid by such U.S. trade or business is treated as if it were paid by a domestic corporation (i.e., such interest is treated as U.S.-source income). 151

 [Footnote]

[Footnote 151: Sec. 884(f)(1).]

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


The provision treats interest paid by foreign partnerships in a manner similar to the treatment of interest paid by foreign corporations. Thus, interest paid by a foreign partnership is treated as U.S.-source income only if the interest is paid by a U.S. trade or business conducted by the partnership or is allocable to income that is treated as effectively connected with the conduct of a U.S. trade or business. The provision applies only to foreign partnerships that are predominantly engaged in the active conduct of a trade or business outside the United States.

EFFECTIVE DATE


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

K. LOOK-THROUGH TREATMENT OF PAYMENTS BETWEEN RELATED CONTROLLED FOREIGN CORPORATIONS UNDER FOREIGN PERSONAL HOLDING COMPANY INCOME RULES


(Sec. 311 of the bill and sec. 954 of the Code)

PRESENT LAW


In general, the rules of subpart F (secs. 951-964) require U.S. shareholders with a 10-percent or greater interest in a controlled foreign corporation to include certain income of the controlled foreign corporation (referred to as `subpart F income') on a current basis for U.S. tax purposes, regardless of whether the income is distributed to the shareholders.

Subpart F income includes foreign base company income. One category of foreign base company income is foreign personal holding company income. For subpart F purposes, foreign personal holding company income generally includes dividends, interest, rents and royalties, among other types of income. However, foreign personal holding company income does not include dividends and interest received by a controlled foreign corporation from a related corporation organized and operating in the same foreign country in which the controlled foreign corporation is organized, or rents and royalties received by a controlled foreign corporation from a related corporation for the use of property within the country in which the controlled foreign corporation is organized. Interest, rent, and royalty payments do not qualify for this exclusion to the extent that such payments reduce the subpart F income of the payor.

REASONS FOR CHANGE


Most countries allow their companies to redeploy active foreign earnings with no additional tax burden. The Committee believes that this provision will make U.S. companies and U.S. workers more competitive with respect to such countries. By allowing U.S. companies to reinvest their active foreign earnings where they are most needed without incurring the immediate additional tax that companies based in many other countries never incur, the Committee believes that the provision will enable U.S. companies to make more sales overseas, and thus produce more goods in the United States.

EXPLANATION OF PROVISION


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

EFFECTIVE DATE


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

L. LOOK-THROUGH TREATMENT UNDER SUBPART F FOR SALES OF PARTNERSHIP INTERESTS


(Sec. 312 of the bill and sec. 954 of the Code)

PRESENT LAW


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

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


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

EFFECTIVE DATE


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

M. REPEAL OF FOREIGN PERSONAL HOLDING COMPANY RULES AND FOREIGN INVESTMENT COMPANY RULES


(Sec. 313 of the bill and secs. 542, 551-558, 954, 1246, and 1247 of the Code)

PRESENT LAW


Income earned by a foreign corporation from its foreign operations generally is subject to U.S. tax only when such income is distributed to any U.S. persons that hold stock in such corporation. Accordingly, a U.S. person that conducts foreign operations through a foreign corporation generally is subject to U.S. tax on the income from those operations when the income is repatriated to the United States through a dividend distribution to the U.S. person. The income is reported on the U.S. person's tax return for the year the distribution is received, and the United States imposes tax on such income at that time. The foreign tax credit may reduce the U.S. tax imposed on such income.

Several sets of anti-deferral rules impose current U.S. tax on certain income earned by a U.S. person through a foreign corporation. Detailed rules for coordination among the anti-deferral rules are provided to prevent the U.S. person from being subject to U.S. tax on the same item of income under multiple rules.

The Code sets forth the following anti-deferral rules: the controlled foreign corporation rules of subpart F (secs. 951-964); the passive foreign investment company rules (secs. 1291-1298); the foreign personal holding company rules (secs. 551-558); the personal holding company rules (secs. 541-547); the accumulated earnings tax rules (secs. 531-537); and the foreign investment company rules (secs. 1246-1247).

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


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

EFFECTIVE DATE


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

N. DETERMINATION OF FOREIGN PERSONAL HOLDING COMPANY INCOME WITH RESPECT TO TRANSACTIONS IN COMMODITIES


(Sec. 314 of the bill and sec. 954 of the Code)

PRESENT LAW


Subpart F foreign personal holding company income

Under the subpart F rules, U.S. shareholders with a 10-percent or greater interest in a controlled foreign corporation (`U.S. 10-percent shareholders') are subject to U.S. tax currently on certain income earned by the controlled foreign corporation, whether or not such income is distributed to the shareholders. The income subject to current inclusion under the subpart F rules includes, among other things, `foreign personal holding company income.'

Foreign personal holding company income generally consists of the following: dividends, interest, royalties, rents and annuities; net gains from sales or exchanges of (1) property that gives rise to the foregoing types of income, (2) property that does not give rise to income, and (3) interests in trusts, partnerships, and real estate mortgage investment conduits (`REMICs'); net gains from commodities transactions; net gains from foreign currency transactions; income that is equivalent to interest; income from notional principal contracts; and payments in lieu of dividends.

With respect to transactions in commodities, foreign personal holding company income does not consist of gains or losses which arise out of bona fide hedging transactions that are reasonably necessary to the conduct of any business by a producer, processor, merchant, or handler of a commodity in the manner in which such business is customarily and usually conducted by others. 152

 [Footnote]  In addition, foreign personal holding company income does not consist of gains or losses which are comprised of active business gains or losses from the sale of commodities, but only if substantially all of the controlled foreign corporation's business is as an active producer, processor, merchant, or handler of commodities. 153

 [Footnote]

[Footnote 152: For hedging transactions entered into on or after January 31, 2003, Treasury regulations provide that gains or losses from a commodities hedging transaction generally are excluded from the definition of foreign personal holding company income if the transaction is with respect to the controlled foreign corporation's business as a producer, processor, merchant or handler of commodities, regardless of whether the transaction is a hedge with respect to a sale of commodities in the active conduct of a commodities business by the controlled foreign corporation. The regulations also provide that, for purposes of satisfying the requirements for exclusion from the definition of foreign personal holding company income, a producer, processor, merchant or handler of commodities includes a controlled foreign corporation that regularly uses commodities in a manufacturing, construction, utilities, or transportation business (Treas. Reg. sec. 1.954-2(f)(2)(v)). However, the regulations provide that a controlled foreign corporation is not a producer, processor, merchant or handler of commodities (and therefore would not satisfy the requirements for exclusion) if its business is primarily financial (Treas. Reg. sec. 1.954-2(f)(2)(v)).]

[Footnote 153: Treasury regulations provide that substantially all of a controlled foreign corporation's business is as an active producer, processor, merchant or handler of commodities if: (1) the sum of its gross receipts from all of its active sales of commodities in such capacity and its gross receipts from all of its commodities hedging transactions that qualify for exclusion from the definition of foreign personal holding company income, equals or exceeds (2) 85 percent of its total receipts for the taxable year (computed as though the controlled foreign corporation was a domestic corporation) (Treas. Reg. sec. 1.954-2(f)(2)(iii)(C)).]

Hedging transactions

Under present law, the term `capital asset' does not include any hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered into (or such other time as the Secretary may by regulations prescribe). 154

 [Footnote]  The term `hedging transaction' means any transaction entered into by the taxpayer in the normal course of the taxpayer's trade or business primarily: (1) to manage risk of price changes or currency fluctuations with respect to ordinary property which is held or to be held by the taxpayer; (2) to manage risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer; or (3) to manage such other risks as the Secretary may prescribe in regulations. 155

 [Footnote]

[Footnote 154: Sec. 1221(a)(7).]

[Footnote 155: Sec. 1221(b)(2)(A).]

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


The provision modifies the requirements that must be satisfied for gains or losses from a commodities hedging transaction to qualify for exclusion from the definition of subpart F foreign personal holding company income. Under the provision, gains or losses from a transaction with respect to a commodity are not treated as foreign personal holding company income if the transaction satisfies the general definition of a hedging transaction under section 1221(b)(2). For purposes of this provision, the general definition of a hedging transaction under section 1221(b)(2) is modified to include any transaction with respect to a commodity entered into by a controlled foreign corporation in the normal course of the controlled foreign corporation's trade or business primarily: (1) to manage risk of price changes or currency fluctuations with respect to ordinary property or property described in section 1231(b) which is held or to be held by the controlled foreign corporation; or (2) to manage such other risks as the Secretary may prescribe in regulations. Gains or losses from a transaction that satisfies the modified definition of a hedging transaction are excluded from the definition of foreign personal holding company income only if the transaction is clearly identified as a hedging transaction in accordance with the hedge identification requirements that apply generally to hedging transactions under section 1221(b)(2). 156

 [Footnote]

[Footnote 156: Sec. 1221(a)(7) and (b)(2)(B).]

The provision also changes the requirements that must be satisfied for active business gains or losses from the sale of commodities to qualify for exclusion from the definition of foreign personal holding company income. Under the provision, such gains or losses are not treated as foreign personal holding company income if substantially all of the controlled foreign corporation's commodities are comprised of: (1) stock in trade of the controlled foreign corporation or other property of a kind which would properly be included in the inventory of the controlled foreign corporation if on hand at the close of the taxable year, or property held by the controlled foreign corporation primarily for sale to customers in the ordinary course of the controlled foreign corporation's trade or business; (2) property that is used in the trade or business of the controlled foreign corporation and is of a character which is subject to the allowance for depreciation under section 167; or (3) supplies of a type regularly used or consumed by the controlled foreign corporation in the ordinary course of a trade or business of the controlled foreign corporation. 157

 [Footnote]

[Footnote 157: For purposes of determining whether substantially all of the controlled foreign corporation's commodities are comprised of such property, it is intended that the 85-percent requirement provided in the current Treasury regulations (as modified to reflect the changes made by the provision) continue to apply.]

For purposes of applying the requirements for active business gains or losses from commodities sales to qualify for exclusion from the definition of foreign personal holding company income, the provision also provides that commodities with respect to which gains or losses are not taken into account as foreign personal holding company income by a regular dealer in commodities (or financial instruments referenced to commodities) are not taken into account in determining whether substantially all of the dealer's commodities are comprised of the property described above.

EFFECTIVE DATE


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

O. MODIFICATIONS TO TREATMENT OF AIRCRAFT LEASING AND SHIPPING INCOME


(Sec. 315 of the bill and sec. 954 of the Code)

PRESENT LAW


In general, the subpart F rules (secs. 951-964) require U.S. shareholders with a 10-percent or greater interest in a controlled foreign corporation (`CFC') to include currently in income for U.S. tax purposes certain income of the CFC (referred to as `subpart F income'), without regard to whether the income is distributed to the shareholders (sec. 951(a)(1)(A)). In effect, the Code treats the U.S. 10-percent shareholders of a CFC as having received a current distribution of their pro rata shares of the CFC's subpart F income. The amounts included in income by the CFC's U.S. 10-percent shareholders under these rules are subject to U.S. tax currently. The U.S. tax on such amounts may be reduced through foreign tax credits.

Subpart F income includes foreign base company shipping income (sec. 954(f)). Foreign base company shipping income generally includes income derived from the use of an aircraft or vessel in foreign commerce, the performance of services directly related to the use of any such aircraft or vessel, the sale or other disposition of any such aircraft or vessel, and certain space or ocean activities (e.g., leasing of satellites for use in space). Foreign commerce generally involves the transportation of property or passengers between a port (or airport) in the U.S. and a port (or airport) in a foreign country, two ports (or airports) within the same foreign country, or two ports (or airports) in different foreign countries. In addition, foreign base company shipping income includes dividends and interest that a CFC receives from certain foreign corporations and any gains from the disposition of stock in certain foreign corporations, to the extent the dividends, interest, or gains are attributable to foreign base company shipping income. Foreign base company shipping income also includes incidental income derived in the course of active foreign base company shipping operations (e.g., income from temporary investments in or sales of related shipping assets), foreign exchange gain or loss attributable to foreign base company shipping operations, and a CFC's distributive share of gross income of any partnership and gross income received from certain trusts to the extent that the income would have been foreign base company shipping income had it been realized directly by the corporation.

Subpart F income also includes foreign personal holding company income (sec. 954(c)). For subpart F purposes, foreign personal holding company income generally consists of the following: (1) dividends, interest, royalties, rents and annuities; (2) net gains from the sale or exchange of (a) property that gives rise to the preceding types of income, (b) property that does not give rise to income, and (c) interests in trusts, partnerships, and REMICS; (3) net gains from commodities transactions; (4) net gains from foreign currency transactions; (5) income that is equivalent to interest; (6) income from notional principal contracts; and (7) payments in lieu of dividends.

Subpart F foreign personal holding company income does not include rents and royalties received by a CFC in the active conduct of a trade or business from unrelated persons (sec. 954(c)(2)(A)). The determination of whether rents or royalties are derived in the active conduct of a trade or business is based on all the facts and circumstances. However, the Treasury regulations provide certain types of rents are treated as derived in the active conduct of a trade or business. These include rents derived from property that is leased as a result of the performance of marketing functions by the lessor if the lessor (through its own officers or employees located in a foreign country) maintains and operates an organization in such country that regularly engages in the business of marketing, or marketing and servicing, the leased property and that is substantial in relation to the amount of rents derived from the leasing of such property. An organization in a foreign country is substantial in relation to rents if the active leasing expenses 158

 [Footnote]  equal at least 25 percent of the adjusted leasing profit. 159

 [Footnote]

Also generally excluded from subpart F foreign personal holding company income are rents and royalties received by the CFC from a related corporation for the use of property within the country in which the CFC was organized (sec. 954(c)(3)). However, rent, and royalty payments do not qualify for this exclusion to the extent that such payments reduce subpart F income of the payor.

[Footnote 158: `Active-leasing expenses' are section 162 expenses properly allocable to rental income other than (1) deductions for compensation for personal services rendered by the lessor's shareholders or a related person, (2) deductions for rents, (3) section 167 and 168 expenses, and (4) deductions for payments to independent contractors with respect to leased property. Treas. Reg. sec. 1.954-2(c)(2)(iii).]

[Footnote 159: Generally, `adjusted leasing profit' is rental income less the sum of (1) rents paid or incurred by the CFC with respect to such rental income; (2) section 167 and 168 expenses with respect to such rental income; and (3) payments to independent contractors with respect to such rental income. Treas. Reg. sec. 1.954-2(c)(2)(iv).]

REASONS FOR CHANGE


In general, other countries do not tax foreign shipping income, whereas the United States imposes immediate U.S. tax on such income. The uncompetitive U.S. taxation of shipping income has directly caused a steady and substantial decline of the U.S. shipping industry. The Committee believes that this provision will provide U.S. shippers the opportunity to be competitive with their tax-advantaged foreign competitors.

In addition, the Committee believes that the current-law exception from foreign base company income for rents and royalties received by a CFC in the active conduct of a trade or business from unrelated persons is too narrow in the context of the leasing of an aircraft or vessel in foreign commerce. The Committee believes the provision of the safe harbor under the bill will improve the competitiveness of U.S.-based multinationals engaging in these activities.

EXPLANATION OF PROVISION


The provision repeals the subpart F rules relating to foreign base company shipping income. The bill also amends the exception from foreign personal holding company income applicable to rents or royalties derived from unrelated persons in an active trade or business, by providing a safe harbor for rents derived from leasing an aircraft or vessel in foreign commerce. Such rents are excluded from foreign personal holding company income if the active leasing expenses comprise at least 10 percent of the profit on the lease. This provision is to be applied in accordance with existing regulations under sec. 954(c)(2)(A) by comparing the lessor's `active leasing expenses' for its pool of leased assets to its `adjusted leasing profit.'

The safe harbor will not prevent a lessor from otherwise showing that it actively carries on a trade or business. In this regard, the requirements of section 954(c)(2)(A) will be met if a lessor regularly and directly performs active and substantial marketing, remarketing, management and operational functions with respect to the leasing of an aircraft or vessel (or component engines). This will be the case regardless of whether the lessor engages in marketing of the lease as a form of financing (versus marketing the property as such) or whether the lease is classified as a finance lease or operating lease for financial accounting purposes. If a lessor acquires, from an unrelated or related party, a ship or aircraft subject to an existing FSC or ETI lease, the requirements of section 954(c)(2)(A) will be satisfied if, following the acquisition, the lessor performs active and substantial management, operational, and remarketing functions with respect to the leased property. If such a lease is transferred to a CFC lessor, it will no longer be eligible for FSC or ETI benefits.

An aircraft or vessel will be considered to be leased in foreign commerce if it is used for the transportation of property or passengers between a port (or airport) in the United States and one in a foreign country or between foreign ports (or airports), provided the aircraft or vessel is used predominantly outside the United States. An aircraft or vessel will be considered used predominantly outside the United States if more than 50 percent of the miles during the taxable year are traversed outside the United States or the aircraft or vessel is located outside the United States more than 50 percent of the time during such taxable year.

The Committee expects that the Secretary of the Treasury will issue timely guidance to make conforming changes to existing regulations, including guidance that aircraft or vessel leasing activity that satisfies the requirements of section 954(c)(2)(A) shall also satisfy the requirements for avoiding income inclusion under section 956 and section 367(a).

The Committee anticipates that taxpayers now eligible for the benefits of the ETI exclusion (or the FSC provisions pursuant to the FSC Repeal and Extraterritorial Income Exclusion Act of 2000), will find it appropriate, as a matter of sound business judgment, to restructure their business operations to take into account the tax law changes brought about by the bill. The Committee notes that courts have recognized the validity of structuring operations for the purpose of obtaining the benefit of tax regimes expressly intended by Congress. The Committee intends that structuring or restructuring of operations for the purposes of adapting to the repeal of the ETI exclusion (or the FSC regime) will be considered to serve a valid business purpose and will not constitute tax avoidance, where the restructured operations conform to the requirements expressly mandated by Congress for obtaining tax benefits that remain available. For example, the Committee intends that a restructuring undertaken to transfer aircraft subject to existing FSC or ETI leases to a CFC lessor, to take advantange of the amendments made by this bill, would serve as a valid business purpose and would not constitute tax avoidance, for purposes of determining whether a particular tax treatment (such as nonrecognition of gain) applies to such restructuring. The Committee intends, for example, that if such a restructuring meets the other requirements necessary to qualify as a `reorganization' under section 368, the transaction will also be deemed to meet the `business purpose' requirements under section 368, and thus, qualify as a reorganization under that section.

EFFECTIVE DATE


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

P. MODIFICATION OF EXCEPTIONS UNDER SUBPART F FOR ACTIVE FINANCING


(Sec. 316 of the bill and sec. 954 of the Code)

PRESENT LAW


Under the subpart F rules, U.S. shareholders with a 10-percent or greater interest in a controlled foreign corporation (`CFC') are subject to U.S. tax currently on certain income earned by the CFC, whether or not such income is distributed to the shareholders. The income subject to current inclusion under the subpart F rules includes, among other things, foreign personal holding company income and insurance income. In addition, 10-percent U.S. shareholders of a CFC are subject to current inclusion with respect to their shares of the CFC's foreign base company services income (i.e., income derived from services performed for a related person outside the country in which the CFC is organized).

Foreign personal holding company income generally consists of the following: (1) dividends, interest, royalties, rents, and annuities; (2) net gains from the sale or exchange of (a) property that gives rise to the preceding types of income, (b) property that does not give rise to income, and (c) interests in trusts, partnerships, and REMICs; (3) net gains from commodities transactions; (4) net gains from foreign currency transactions; (5) income that is equivalent to interest; (6) income from notional principal contracts; and (7) payments in lieu of dividends.

Insurance income subject to current inclusion under the subpart F rules includes any income of a CFC attributable to the issuing or reinsuring of any insurance or annuity contract in connection with risks located in a country other than the CFC's country of organization. Subpart F insurance income also includes income attributable to an insurance contract in connection with risks located within the CFC's country of organization, as the result of an arrangement under which another corporation receives a substantially equal amount of consideration for insurance of other country risks. Investment income of a CFC that is allocable to any insurance or annuity contract related to risks located outside the CFC's country of organization is taxable as subpart F insurance income (Treas. Reg. sec. 1.953-1(a)).

Temporary exceptions from foreign personal holding company income, foreign base company services income, and insurance income apply for subpart F purposes for certain income that is derived in the active conduct of a banking, financing, or similar business, or in the conduct of an insurance business (so-called `active financing income'). 160

 [Footnote]

[Footnote 160: Temporary exceptions from the subpart F provisions for certain active financing income applied only for taxable years beginning in 1998. Those exceptions were modified and extended for one year, applicable only for taxable years beginning in 1999. The Tax Relief Extension Act of 1999 (Pub.L. No. 106-170) clarified and extended the temporary exceptions for two years, applicable only for taxable years beginning after 1999 and before 2002. The Job Creation and Worker Assistance Act of 2002 (Pub.L. No. 107-147) extended the temporary exceptions for five years, applicable only for taxable years beginning after 2001 and before 2007, with a modification relating to insurance reserves.]

With respect to income derived in the active conduct of a banking, financing, or similar business, a CFC is required to be predominantly engaged in such business and to conduct substantial activity with respect to such business in order to qualify for the exceptions. In addition, certain nexus requirements apply, which provide that income derived by a CFC or a qualified business unit (`QBU') of a CFC from transactions with customers is eligible for the exceptions if, among other things, substantially all of the activities in connection with such transactions are conducted directly by the CFC or QBU in its home country, and such income is treated as earned by the CFC or QBU in its home country for purposes of such country's tax laws. Moreover, the exceptions apply to income derived from certain cross border transactions, provided that certain requirements are met. Additional exceptions from foreign personal holding company income apply for certain income derived by a securities dealer within the meaning of section 475 and for gain from the sale of active financing assets.

In the case of insurance, in addition to temporary exceptions from insurance income and from foreign personal holding company income for certain income of a qualifying insurance company with respect to risks located within the CFC's country of creation or organization, temporary exceptions from insurance income and from foreign personal holding company income apply for certain income of a qualifying branch of a qualifying insurance company with respect to risks located within the home country of the branch, provided certain requirements are met under each of the exceptions. Further, additional temporary exceptions from insurance income and from foreign personal holding company income apply for certain income of certain CFCs or branches with respect to risks located in a country other than the United States, provided that the requirements for these exceptions are met.

REASONS FOR CHANGE


The Committee believes that the rules for determining whether income earned by an eligible CFC or QBU is active financing income should be more consistent with the rules for determining whether a CFC or QBU is eligible to earn active financing income.

EXPLANATION OF PROVISION


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

EFFECTIVE DATE


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

TITLE IV--EXTENSION OF CERTAIN EXPIRING PROVISIONS


A. EXTEND ALTERNATIVE MINIMUM TAX RELIEF FOR INDIVIDUALS


(Sec. 401 of the bill and sec. 26 of the Code)

PRESENT LAW


Present law provides for certain nonrefundable personal tax credits (i.e., the dependent care credit, the credit for the elderly and disabled, the adoption credit, the child tax credit, 161

 [Footnote]  the credit for interest on certain home mortgages, the HOPE Scholarship and Lifetime Learning credits, the IRA credit, and the D.C. homebuyer's credit).

[Footnote 161: A portion of the child credit may be refundable.]

For taxable years beginning in 2003, all the nonrefundable personal credits are allowed to the extent of the full amount of the individual's regular tax and alternative minimum tax.

For taxable years beginning after 2003, the credits (other than the adoption credit, child credit and IRA credit) are allowed only to the extent that the individual's regular income tax liability exceeds the individual's tentative minimum tax, determined without regard to the minimum tax foreign tax credit. The adoption credit, child credit, and IRA credit are allowed to the full extent of the individual's regular tax and alternative minimum tax.

The alternative minimum tax is the amount by which the tentative minimum tax exceeds the regular income tax. An individual's tentative minimum tax is an amount equal to (1) 26 percent of the first $175,000 ($87,500 in the case of a married individual filing a separate return) of alternative minimum taxable income (`AMTI') in excess of an exemption amount that phases out and (2) 28 percent of the remaining AMTI. The maximum tax rates on net capital gain used in computing the tentative minimum tax are the same as under the regular tax. AMTI is the individual's taxable income adjusted to take account of specified preferences and adjustments. The exemption amounts are: (1) $58,000 ($45,000 in taxable years beginning after 2004) in the case of married individuals filing a joint return and surviving spouses; (2) $40,250 ($33,750 in taxable years beginning after 2004) in the case of other unmarried individuals; (3) $29,000 ($22,500 in taxable years beginning after 2004) in the case of married individuals filing a separate return; and (4) $22,500 in the case of an estate or trust. The exemption amounts are phased out by an amount equal to 25 percent of the amount by which the individual's AMTI exceeds (1) $150,000 in the case of married individuals filing a joint return and surviving spouses, (2) $112,500 in the case of other unmarried individuals, and (3) $75,000 in the case of married individuals filing separate returns or an estate or a trust. These amounts are not indexed for inflation.

REASONS FOR CHANGE


The Committee believes that the nonrefundable personal credits should be useable without limitation by reason of the alternative minimum tax. This will result in significant simplification and will enable individuals to fully benefit from the credits.

EXPLANATION OF PROVISION


The bill extends the provision allowing an individual to offset the entire regular tax liability and alternative minimum tax liability by the personal nonrefundable credits for taxable years beginning in 2004 and 2005.

EFFECTIVE DATE


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

B. EXTENSION OF THE RESEARCH CREDIT


(Sec. 402 of the bill and sec. 41 of the Code)

PRESENT LAW


General rule

Section 41 provides for a research tax credit equal to 20 percent of the amount by which a taxpayer's qualified research expenses for a taxable year exceed its base amount for that year. The research tax credit is scheduled to expire and generally will not apply to amounts paid or incurred after June 30, 2004.

A 20-percent research tax credit also applies to the excess of (1) 100 percent of corporate cash expenses (including grants or contributions) paid for basic research conducted by universities (and certain nonprofit scientific research organizations) over (2) the sum of (a) the greater of two minimum basic research floors plus (b) an amount reflecting any decrease in nonresearch giving to universities by the corporation as compared to such giving during a fixed-base period, as adjusted for inflation. This separate credit computation is commonly referred to as the university basic research credit (see sec. 41(e)).

Computation of allowable credit

Except for certain university basic research payments made by corporations, the research tax credit applies only to the extent that the taxpayer's qualified research expenses for the current taxable year exceed its base amount. The base amount for the current year generally is computed by multiplying the taxpayer's fixed-base percentage by the average amount of the taxpayer's gross receipts for the four preceding years. If a taxpayer both incurred qualified research expenses and had gross receipts during each of at least three years from 1984 through 1988, then its fixed-base percentage is the ratio that its total qualified research expenses for the 1984-1988 period bears to its total gross receipts for that period (subject to a maximum fixed-base percentage of 16 percent). All other taxpayers (so-called start-up firms) are assigned a fixed-base percentage of three percent. In computing the credit, a taxpayer's base amount may not be less than 50 percent of its current-year qualified research expenses.

Alternative incremental research credit regime

Taxpayers are allowed to elect an alternative incremental research credit regime. 162

 [Footnote]  If a taxpayer elects to be subject to this alternative regime, the taxpayer is assigned a three-tiered fixed-base percentage (that is lower than the fixed-base percentage otherwise applicable under present law) and the credit rate likewise is reduced. Under the alternative credit regime, a credit rate of 2.65 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of one percent (i.e., the base amount equals one percent of the taxpayer's average gross receipts for the four preceding years) but do not exceed a base amount computed by using a fixed-base percentage of 1.5 percent. A credit rate of 3.2 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of 1.5 percent but do not exceed a base amount computed by using a fixed-base percentage of two percent. A credit rate of 3.75 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of two percent. An election to be subject to this alternative incremental credit regime may be made for any taxable year beginning after June 30, 1996, and such an election applies to that taxable year and all subsequent years unless revoked with the consent of the Secretary of the Treasury.

[Footnote 162: Sec. 41(c)(4).]

Eligible expenses

Qualified research expenses eligible for the research tax credit consist of: (1) in-house expenses of the taxpayer for wages and supplies attributable to qualified research; (2) certain time-sharing costs for computer use in qualified research; and (3) 65 percent of amounts paid or incurred by the taxpayer to certain other persons for qualified research conducted on the taxpayer's behalf (so-called contract research expenses). 163

 [Footnote]

[Footnote 163: Under a special rule enacted as part of the Small Business Job Protection Act of 1996, 75 percent of amounts paid to a research consortium for qualified research is treated as qualified research expenses eligible for the research credit (rather than 65 percent under the general rule under section 41(b)(3) governing contract research expenses) if (1) such research consortium is a tax-exempt organization that is described in section 501(c)(3) (other than a private foundation) or section 501(c)(6) and is organized and operated primarily to conduct scientific research, and (2) such qualified research is conducted by the consortium on behalf of the taxpayer and one or more persons not related to the taxpayer. Sec. 41(b)(3)(C).]

To be eligible for the credit, the research must not only satisfy the requirements of present-law section 174 (described below) but must be undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and substantially all of the activities of which must constitute elements of a process of experimentation for functional aspects, performance, reliability, or quality of a business component. Research does not qualify for the credit if substantially all of the activities relate to style, taste, cosmetic, or seasonal design factors (sec. 41(d)(3)). In addition, research does not qualify for the credit: (1) if conducted after the beginning of commercial production of the business component; (2) if related to the adaptation of an existing business component to a particular customer's requirements; (3) if related to the duplication of an existing business component from a physical examination of the component itself or certain other information; or (4) if related to certain efficiency surveys, management function or technique, market research, market testing, or market development, routine data collection or routine quality control (sec. 41(d)(4)). Research does not qualify for the credit if it is conducted outside the United States, Puerto Rico, or any U.S. possession.

Relation to deduction

Under section 174, taxpayers may elect to deduct currently the amount of certain research or experimental expenditures paid or incurred in connection with a trade or business, notwithstanding the general rule that business expenses to develop or create an asset that has a useful life extending beyond the current year must be capitalized. 164

 [Footnote]  However, deductions allowed to a taxpayer under section 174 (or any other section) are reduced by an amount equal to 100 percent of the taxpayer's research tax credit determined for the taxable year (Sec. 280C(c)). Taxpayers may alternatively elect to claim a reduced research tax credit amount under section 41 in lieu of reducing deductions otherwise allowed (sec. 280C(c)(3)).

[Footnote 164: Taxpayers may elect 10-year amortization of certain research expenditures allowable as a deduction under section 174(a). Secs. 174(f)(2) and 59(e).]

REASONS FOR CHANGE


The Committee acknowledges that research is important to the economy. Research is the basis of new products, new services, new industries, and new jobs for the domestic economy. Therefore the Committee believes it is appropriate to extend the present-law research credit.

EXPLANATION OF PROVISION


The provision extends the present-law research credit to qualified amounts paid or incurred before January 1, 2006.

EFFECTIVE DATE


The provision is effective for amounts paid or incurred after June 30, 2004.

C. EXTENSION AND MODIFICATION OF THE SECTION 45 ELECTRICITY PRODUCTION CREDIT


(Sec. 403 of the bill and sec. 45 of the Code)

PRESENT LAW


An income tax credit is allowed for the production of electricity from either qualified wind energy, qualified `closed-loop' biomass, or qualified poultry waste facilities (sec. 45). The amount of the credit is 1.5 cents per kilowatt hour (indexed for inflation) of electricity produced. The amount of the credit is 1.8 cents per kilowatt hour for 2004. The credit is reduced for grants, tax-exempt bonds, subsidized energy financing, and other credits.

The credit applies to electricity produced by a wind energy facility placed in service after December 31, 1993, and before January 1, 2004, to electricity produced by a closed-loop biomass facility placed in service after December 31, 1992, and before January 1, 2004, and to a poultry waste facility placed in service after December 31, 1999, and before January 1, 2004. The credit is allowable for production during the 10-year period after a facility is originally placed in service. In order to claim the credit, a taxpayer must own the facility and sell the electricity produced by the facility to an unrelated party. In the case of a poultry waste facility, the taxpayer may claim the credit as a lessee/operator of a facility owned by a governmental unit.

Closed-loop biomass is plant matter, where the plants are grown for the sole purpose of being used to generate electricity. It does not include waste materials (including, but not limited to, scrap wood, manure, and municipal or agricultural waste). The credit also is not available to taxpayers who use standing timber to produce electricity. Poultry waste means poultry manure and litter, including wood shavings, straw, rice hulls, and other bedding material for the disposition of manure.

The credit for electricity produced from wind, closed-loop biomass, or poultry waste is a component of the general business credit (sec. 38(b)(8)). The credit, when combined with all other components of the general business credit, generally may not exceed for any taxable year the excess of the taxpayer's net income tax over the greater of (1) 25 percent of net regular tax liability above $25,000, or (2) the tentative minimum tax. For credits arising in taxable years beginning after December 31, 1997, an unused general business credit generally may be carried back one year and carried forward 20 years (sec. 39). To coordinate the carryback with the period of application for this credit, the credit for electricity produced from closed-loop biomass facilities may not be carried back to a tax year ending before 1993 and the credit for electricity produced from wind energy may not be carried back to a tax year ending before 1994 (sec. 39).

REASONS FOR CHANGE


The Committee recognizes that the section 45 production credit has fostered additional electricity generation capacity in the form of non-polluting wind power. The Committee believes it is important to continue this tax credit by extending the placed in service date for such facilities to bring more wind energy to the U. S. electric grid. The Committee further believes that, to encourage entrepreneurial exploration of alternative sources for electricity generation, it is appropriate to extend the present-law provision relating to facilities that use closed-loop biomass as an energy source.

EXPLANATION OF PROVISION


The provision extends the placed in service date for wind facilities and closed-loop biomass facilities to facilities placed in service after December 31, 1993 (December 31, 1992 in the case of closed-loop biomass facilities) and before January 1, 2006. The provision does not extend the placed in service date for poultry waste facilities.

EFFECTIVE DATE


The provision is effective for facilities placed in service after December 31, 2003.

D. INDIAN EMPLOYMENT TAX CREDIT


(Sec. 404 of the bill and sec. 45A of the Code)

PRESENT LAW


In general, a credit against income tax liability is allowed to employers for the first $20,000 of qualified wages and qualified employee health insurance costs paid or incurred by the employer with respect to certain employees (sec. 45A). The credit is equal to 20 percent of the excess of eligible employee qualified wages and health insurance costs during the current year over the amount of such wages and costs incurred by the employer during 1993. The credit is an incremental credit, such that an employer's current-year qualified wages and qualified employee health insurance costs (up to $20,000 per employee) are eligible for the credit only to the extent that the sum of such costs exceeds the sum of comparable costs paid during 1993. No deduction is allowed for the portion of the wages equal to the amount of the credit.

Qualified wages means wages paid or incurred by an employer for services performed by a qualified employee. A qualified employee means any employee who is an enrolled member of an Indian tribe or the spouse of an enrolled member of an Indian tribe, who performs substantially all of the services within an Indian reservation, and whose principal place of abode while performing such services is on or near the reservation in which the services are performed. An employee will not be treated as a qualified employee for any taxable year of the employer if the total amount of wages paid or incurred by the employer with respect to such employee during the taxable year exceeds an amount determined at an annual rate of $30,000 (adjusted for inflation after 1993).

The wage credit is available for wages paid or incurred on or after January 1, 1994, in taxable years that begin before January 1, 2005.

REASONS FOR CHANGE


The Committee believes that extending the wage credit tax incentive will expand employment opportunities for members of Indian tribes.

EXPLANATION OF PROVISION


The provision extends the Indian employment credit incentive for one year (to taxable years beginning before January 1, 2006).

EFFECTIVE DATE


The provision is effective on the date of enactment.

E. EXTEND THE WORK OPPORTUNITY TAX CREDIT


(Sec. 405 of the bill and sec. 51 of the Code)

PRESENT LAW


In general

The work opportunity tax credit (`WOTC') is available on an elective basis for employers hiring individuals from one or more of eight targeted groups. The credit equals 40 percent (25 percent for employment of 400 hours or less) of qualified wages. Generally, qualified wages are wages attributable to service rendered by a member of a targeted group during the one-year period beginning with the day the individual began work for the employer.

The maximum credit per employee is $2,400 (40 percent of the first $6,000 of qualified first-year wages). With respect to qualified summer youth employees, the maximum credit is $1,200 (40 percent of the first $3,000 of qualified first-year wages).

For purposes of the credit, wages are generally defined as under the Federal Unemployment Tax Act, without regard to the dollar cap.

Targeted groups eligible for the credit

The eight targeted groups are: (1) families eligible to receive benefits under the Temporary Assistance for Needy Families (`TANF') Program; (2) high-risk youth; (3) qualified ex-felons; (4) vocational rehabilitation referrals; (5) qualified summer youth employees; (6) qualified veterans; (7) families receiving food stamps; and (8) persons receiving certain Supplemental Security Income (`SSI') benefits.

The employer's deduction for wages is reduced by the amount of the credit.

Expiration date

The credit is effective for wages paid or incurred to a qualified individual who begins work for an employer before January 1, 2004.

REASONS FOR CHANGE


The Committee believes that a temporary extension of this credit will allow the Congress and the Treasury and Labor Departments to continue to examine the effectiveness of the credit in expanding employment opportunities among the eight targeted groups.

EXPLANATION OF PROVISION


The bill extends the work opportunity tax credit for two years (through December 31, 2005).

EFFECTIVE DATE


The provision is effective for wages paid or incurred to a qualified individual who begins work for an employer on or after January 1, 2004, and before January 1, 2006.

F. EXTEND THE WELFARE-TO-WORK TAX CREDIT


(Sec. 406 of the bill and sec. 51A of the Code)

PRESENT LAW


In general

The welfare-to-work tax credit is available on an elective basis for employers for the first $20,000 of eligible wages paid to qualified long-term family assistance recipients during the first two years of employment. The credit is 35 percent of the first $10,000 of eligible wages in the first year of employment and 50 percent of the first $10,000 of eligible wages in the second year of employment. The maximum credit is $8,500 per qualified employee.

Qualified long-term family assistance recipients are: (1) members of a family that has received family assistance for at least 18 consecutive months ending on the hiring date; (2) members of a family that has received family assistance for a total of at least 18 months (whether or not consecutive) after the date of enactment of this credit if they are hired within 2 years after the date that the 18-month total is reached; and (3) members of a family who are no longer eligible for family assistance because of either Federal or State time limits, if they are hired within two years after the Federal or State time limits made the family ineligible for family assistance. Family assistance means benefits under the Temporary Assistance to Needy Families (`TANF') program.

For purposes of the credit, wages are generally defined under the Federal Unemployment Tax Act, without regard to the dollar amount. In addition, wages include the following: (1) educational assistance excludable under a section 127 program; (2) the value of excludable health plan coverage but not more than the applicable premium defined under section 4980B(f)(4); and (3) dependent care assistance excludable under section 129.

The employer's deduction for wages is reduced by the amount of the credit.

Expiration date

The welfare to work credit is effective for wages paid or incurred to a qualified individual who begins work for an employer before January 1, 2004.

REASONS FOR CHANGE


The Committee believes that the welfare-to-work credit should be temporarily extended to provide the Congress and Treasury and Labor Departments a better opportunity to continue to assess the operation and effectiveness of the credit in meeting its goals. These goals are: (1) to provide an incentive to hire long-term welfare recipients; (2) to promote the transition from welfare to work by increasing access to employment for these individuals; and (3) to encourage employers to provide these individuals with training, health coverage, dependent care and ultimately better job attachment.

EXPLANATION OF PROVISION


The bill extends the welfare to work credit for two years (through December 31, 2005).

EFFECTIVE DATE


The provision is effective for wages paid or incurred to a qualified individual who begins work for an employer on or after January 1, 2004, and before January 1, 2006.

G. EXTENSION OF THE ABOVE-THE-LINE DEDUCTION FOR CERTAIN EXPENSES OF ELEMENTARY AND SECONDARY SCHOOL TEACHERS


(Sec. 407 of the bill and sec. 62 of the Code)

PRESENT LAW


In general, ordinary and necessary business expenses are deductible (sec. 162). However, in general, unreimbursed employee business expenses are deductible only as an itemized deduction and only to the extent that the individual's total miscellaneous deductions (including employee business expenses) exceed two percent of adjusted gross income. An individual's otherwise allowable itemized deductions may be further limited by the overall limitation on itemized deductions, which reduces itemized deductions for taxpayers with adjusted gross income in excess of $142,700 (for 2004). In addition, miscellaneous itemized deductions are not allowable under the alternative minimum tax.

Certain expenses of eligible educators are allowed as an above-the-line deduction. Specifically, for taxable years beginning in 2002 and 2003, an above-the-line deduction is allowed for up to $250 annually of expenses paid or incurred by an eligible educator for books, supplies (other than nonathletic supplies for courses of instruction in health or physical education), computer equipment (including related software and services) and other equipment, and supplementary materials used by the eligible educator in the classroom. To be eligible for this deduction, the expenses must be otherwise deductible under section 162 as a trade or business expense. A deduction is allowed only to the extent the amount of expenses exceeds the amount excludable from income under section 135 (relating to education savings bonds), 529(c)(1) (relating to qualified tuition programs), and section 530(d)(2) (relating to Coverdell education savings accounts).

An eligible educator is a kindergarten through grade 12 teacher, instructor, counselor, principal, or aide in a school for at least 900 hours during a school year. A school means any school that provides elementary education or secondary education, as determined under State law.

The above-the-line deduction for eligible educators is not allowed for taxable years beginning after December 31, 2003.

REASONS FOR CHANGE


The Committee recognizes that elementary and secondary educators often incur substantial unreimbursed expenses in the course of their teaching duties, and believes that an extension of the deduction of such expenses is warranted to continue to provide tax relief to educators who incur such expenses on behalf of their students.

EXPLANATION OF PROVISION


The provision extends the availability of the above-the-line deduction for two years, i.e., for taxable years beginning during 2004 and 2005.

EFFECTIVE DATE


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

H. EXTENSION OF ACCELERATED DEPRECIATION BENEFIT FOR PROPERTY ON INDIAN RESERVATIONS


(Sec. 408 of the bill and sec. 168(j) of the Code)

PRESENT LAW


With respect to certain property used in connection with the conduct of a trade or business within an Indian reservation, depreciation deductions under section 168(j) will be determined using the following recovery periods:




Years


3-year property
2


5-year property
3


7-year property
4


10-year property
6


15-year property
9


20-year property
12


Nonresidential real property
22




`Qualified Indian reservation property' eligible for accelerated depreciation includes property which is (1) used by the taxpayer predominantly in the active conduct of a trade or business within an Indian reservation, (2) not used or located outside the reservation on a regular basis, (3) not acquired (directly or indirectly) by the taxpayer from a person who is related to the taxpayer (within the meaning of section 465(b)(3)(C)), and (4) described in the recovery-period table above. In addition, property is not `qualified Indian reservation property' if it is placed in service for purposes of conducting gaming activities. Certain `qualified infrastructure property' may be eligible for the accelerated depreciation even if located outside an Indian reservation, provided that the purpose of such property is to connect with qualified infrastructure property located within the reservation (e.g., roads, power lines, water systems, railroad spurs, and communications facilities).

The depreciation deduction allowed for regular tax purposes is also allowed for purposes of the alternative minimum tax. The accelerated depreciation for Indian reservations is available with respect to property placed in service on or after January 1, 1994, and before January 1, 2005.

REASONS FOR CHANGE


The Committee believes that extending the depreciation incentive will encourage economic development within Indian reservations and expand employment opportunities on such reservations.

EXPLANATION OF PROVISION


The provision extends the accelerated depreciation incentive for one year (to property placed in service before January 1, 2006).

EFFECTIVE DATE


The provision is effective on the date of enactment.

I. EXTEND ENHANCED CHARITABLE DEDUCTION FOR COMPUTER TECHNOLOGY AND EQUIPMENT


(Sec. 409 of the bill and sec. 170 of the Code)

PRESENT LAW


Under present law, a taxpayer's deduction for charitable contributions of computer technology and equipment generally is limited to the taxpayer's basis (typically, cost) in the property. However, certain corporations may claim a deduction in excess of basis for a qualified computer contribution. 165

 [Footnote]  This enhanced deduction is equal to the lesser of (1) basis plus one-half of the item's appreciated value (i.e., basis plus one half of fair market value minus basis) or (2) two times basis. The enhanced deduction for qualified computer contributions expires for any contribution made during any taxable year beginning after December 31, 2003.

[Footnote 165: Sec. 170(e)(6).]

A qualified computer contribution means a charitable contribution of any computer technology or equipment that meets standards of functionality and suitability as established by the Secretary of the Treasury. The contribution must be to certain educational organizations or public libraries and made not later than three years after the taxpayer acquired the property or, if the taxpayer constructed the property, not later than the date construction of the property is substantially completed. 166

 [Footnote]  The original use of the property must be by the donor or the donee, 167

 [Footnote]  and in the case of the donee, must be used substantially for educational purposes related to the function or purpose of the donee. The property must fit productively into the donee's education plan. The donee may not transfer the property in exchange for money, other property, or services, except for shipping, installation, and transfer costs. Property is considered constructed by the taxpayer only if the cost of the parts used in the construction of the property (other than parts manufactured by the taxpayer or a related person) does not exceed 50 percent of the taxpayer's basis in the property. Contributions may be made to private foundations under certain conditions.

[Footnote 166: If the taxpayer constructed the property and reacquired such property, the contribution must be within three years of the date the original construction was substantially completed. Sec. 170(e)(6)(D)(i).]

[Footnote 167: This requirement does not apply if the property was reacquired by the manufacturer and contributed. Sec. 170(e)(6)(D)(ii).]

REASONS FOR CHANGE


The Committee believes that educational organizations and public libraries continue to have a need for computer equipment and that it is appropriate to extend the enhanced deduction for contributions of such equipment to such institutions.

EXPLANATION OF PROVISION


The provision extends the enhanced deduction for qualified computer contributions to contributions made during any taxable year beginning before January 1, 2005.

EFFECTIVE DATE


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

J. EXTENSION OF EXPENSING OF CERTAIN ENVIRONMENTAL REMEDIATION COSTS


(Sec. 410 of the bill and sec. 198 of the Code)

PRESENT LAW


Taxpayers can elect to treat certain environmental remediation expenditures that would otherwise be chargeable to capital account as deductible in the year paid or incurred (sec. 198). The deduction applies for both regular and alternative minimum tax purposes. The expenditure must be incurred in connection with the abatement or control of hazardous substances at a qualified contaminated site.

A `qualified contaminated site' generally is any property that (1) is held for use in a trade or business, for the production of income, or as inventory and (2) is at a site on which there has been a release (or threat of release) or disposal of certain hazardous substances as certified by the appropriate State environmental agency (so called `brownfields'). However, sites that are identified on the national priorities list under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 cannot qualify as targeted areas.

Eligible expenditures are those paid or incurred before January 1, 2004.

REASONS FOR CHANGE


The Committee observes that by lowering the net capital cost of a development project the expensing of brownfields remediation costs promotes the goal of environmental remediation and promotes new investment and employment opportunities. In addition, the Committee believes that the increased investment in the qualifying areas has spillover effects that are beneficial to the neighboring communities. Therefore, the Committee believes it is appropriate to extend the present-law provision permitting the expensing of environmental remediation costs.

EXPLANATION OF PROVISION


The provision extends the present law expensing provision for two years (through December 31, 2005).

EFFECTIVE DATE


The provision is effective for expenses paid or incurred after December 31, 2003, and before January 1, 2006.

K. EXTENSION OF ARCHER MEDICAL SAVINGS ACCOUNTS (`MSAS')


(Sec. 411 of the bill and sec. 220 of the Code)

PRESENT LAW


In general

Within limits, contributions to an Archer MSA are deductible in determining adjusted gross income if made by an eligible individual and are excludable from gross income and wages for employment tax purposes if made by the employer of an eligible individual. Earnings on amounts in an Archer MSA are not currently taxable. Distributions from an Archer MSA for medical expenses are not includible in gross income. Distributions not used for medical expenses are includible in gross income. In addition, distributions not used for medical expenses are subject to an additional 15-percent tax unless the distribution is made after age 65, death, or disability.

Eligible individuals

Archer MSAs are available to employees covered under an employer-sponsored high deductible plan of a small employer and self-employed individuals covered under a high deductible health plan. 168

 [Footnote]  An employer is a small employer if it employed, on average, no more than 50 employees on business days during either the preceding or the second preceding year. An individual is not eligible for an Archer MSA if he or she is covered under any other health plan in addition to the high deductible plan.

[Footnote 168: Self-employed individuals include more than two-perent shareholders of S corporations who are treated as partners for purposes of fringe benefit rules pursuant to section 1372.]

Tax treatment of and limits on contributions

Individual contributions to an Archer MSA are deductible (within limits) in determining adjusted gross income (i.e., `above-the-line'). In addition, employer contributions are excludable from gross income and wages for employment tax purposes (within the same limits), except that this exclusion does not apply to contributions made through a cafeteria plan. In the case of an employee, contributions can be made to an Archer MSA either by the individual or by the individual's employer.

The maximum annual contribution that can be made to an Archer MSA for a year is 65 percent of the deductible under the high deductible plan in the case of individual coverage and 75 percent of the deductible in the case of family coverage.

Definition of high deductible plan

A high deductible plan is a health plan with an annual deductible of at least $1,700 and no more than $2,600 in the case of individual coverage and at least $3,450 and no more than $5,150 in the case of family coverage. In addition, the maximum out-of-pocket expenses with respect to allowed costs (including the deductible) must be no more than $3,450 in the case of individual coverage and no more than $6,300 in the case of family coverage. 169

 [Footnote]  A plan does not fail to qualify as a high deductible plan merely because it does not have a deductible for preventive care as required by State law. A plan does not qualify as a high deductible health plan if substantially all of the coverage under the plan is for permitted coverage (as described above). In the case of a self-insured plan, the plan must in fact be insurance (e.g., there must be appropriate risk shifting) and not merely a reimbursement arrangement.

[Footnote 169: These dollar amounts are for 2004. These amounts are indexed for inflation, rounded to the nearest $50.]

Cap on taxpayers utilizing Archer MSAs and expiration of pilot program

The number of taxpayers benefiting annually from an Archer MSA contribution is limited to a threshold level (generally 750,000 taxpayers). The number of Archer MSAs established has not exceeded the threshold level.

After 2003, no new contributions may be made to Archer MSAs except by or on behalf of individuals who previously had Archer MSA contributions and employees who are employed by a participating employer.

Trustees of Archer MSAs are generally required to make reports to the Treasury by August 1 regarding Archer MSAs established by July 1 of that year. If any year is a cut-off year, the Secretary is required to make and publish such determination by October 1 of such year.

REASONS FOR CHANGE


The Committee believes that individuals should be encouraged to save for future medical care expenses and that individuals should be allowed to save for such expenses on a tax-favored basis. The Committee believes that consumers who spend their own savings on health care will make cost-conscious decisions, thus reducing the rising cost of health care. The Committee believes that Archer MSAs have been an important tool in allowing certain individuals to save for future medical expenses on a tax-favored basis.

The Committee is aware that recently enacted health savings accounts offer more advantageous tax treatment than Archer MSAs and that amounts can be rolled over into a health savings account from an Archer MSA on a tax-free basis. Still, the Committee believes that individuals should be allowed the choice to continue the use of Archer MSAs. Thus, the Committee believes that it is appropriate to extend Archer MSAs.

EXPLANATION OF PROVISION


The provision extends Archer MSAs through December 31, 2005. The provision also provides that the reports required by MSA trustees for 2004 are treated as timely if made within 90 days after the date of enactment. In addition, the determination of whether 2004 is a cut-off year and the publication of such determination is to be made within 120 days of the date of enactment. If 2004 is a cut-off year, the cut-off date will be the last day of such 120-day period.

EFFECTIVE DATE


The provision is generally effective on January 1, 2004. The provisions relating to reports and the determination by the Secretary are effective on the date of enactment.

L. TAXABLE INCOME LIMIT ON PERCENTAGE DEPLETION FOR OIL AND NATURAL GAS PRODUCED FROM MARGINAL PROPERTIES


(Sec. 412 of the bill and sec. 613A of the Code)

PRESENT LAW


Overview of depletion

Depletion, like depreciation, is a form of capital cost recovery. In both cases, the taxpayer is allowed a deduction in recognition of the fact that an asset--in the case of depletion for oil or gas interests, the mineral reserve itself--is being expended in order to produce income. Certain costs incurred prior to drilling an oil or gas property are recovered through the depletion deduction. These include costs of acquiring the lease or other interest in the property and geological and geophysical costs (in advance of actual drilling).

Depletion is available to any person having an economic interest in a producing property. An economic interest is possessed in every case in which the taxpayer has acquired by investment any interest in minerals in place, and secures, by any form of legal relationship, income derived from the extraction of the mineral, to which it must look for a return of its capital. 170

 [Footnote]  Thus, for example, both working interests and royalty interests in an oil- or gas-producing property constitute economic interests, thereby qualifying the interest holders for depletion deductions with respect to the property. A taxpayer who has no capital investment in the mineral deposit does not possess an economic interest merely because it possesses an economic or pecuniary advantage derived from production through a contractual relation.

[Footnote 170: Treas. Reg. sec. 1.611-1(b)(1).]

Cost depletion

Two methods of depletion are currently allowable under the Code: (1) the cost depletion method, and (2) the percentage depletion method. 171

 [Footnote]  Under the cost depletion method, the taxpayer deducts that portion of the adjusted basis of the depletable property which is equal to the ratio of units sold from that property during the taxable year to the number of units remaining as of the end of taxable year plus the number of units sold during the taxable year. Thus, the amount recovered under cost depletion may never exceed the taxpayer's basis in the property.

[Footnote 171: Secs. 611-613.]

Percentage depletion and related income limitations

The Code generally limits the percentage depletion method for oil and gas properties to independent producers and royalty owners. 172

 [Footnote]  Generally, under the percentage depletion method, 15 percent of the taxpayer's gross income from an oil- or gas-producing property is allowed as a deduction in each taxable year. 173

 [Footnote]  The amount deducted generally may not exceed 100 percent of the net income from that property in any year (the `net-income limitation'). 174

 [Footnote]  The 100-percent net-income limitation for marginal wells has been suspended for taxable years beginning after December 31, 1997, and before January 1, 2004.

[Footnote 172: Sec. 613A.]

[Footnote 173: Sec. 613A(c).]

[Footnote 174: Sec. 613(a).]

REASONS FOR CHANGE


Domestic production from marginal wells is an appropriate part of establishing national energy security and reducing dependence on foreign oil. The Committee believes the suspension of the 100-percent net-income limitation for marginal wells should be extended to encourage continued operation of such wells.

EXPLANATION OF PROVISION


The suspension of the 100-percent net-income limitation for marginal wells is extended an additional two years, through taxable years beginning before January 1, 2006.

EFFECTIVE DATE


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

M. QUALIFIED ZONE ACADEMY BONDS


(Sec. 413 of the bill and sec. 1397E of the Code)

PRESENT LAW


Tax-exempt bonds

Interest on State and local governmental bonds generally is excluded from gross income for Federal income tax purposes if the proceeds of the bonds are used to finance direct activities of these governmental units or if the bonds are repaid with revenues of the governmental units. Activities that can be financed with these tax-exempt bonds include the financing of public schools (sec. 103).

Qualified zone academy bonds

As an alternative to traditional tax-exempt bonds, States and local governments are given the authority to issue `qualified zone academy bonds' (`QZABs') (sec. 1397E). A total of $400 million of qualified zone academy bonds may be issued annually in calendar years 1998 through 2003. The $400 million aggregate bond cap is allocated each year to the States according to their respective populations of individuals below the poverty line. Each State, in turn, allocates the credit authority to qualified zone academies within such State.

Financial institutions that hold qualified zone academy bonds are entitled to a nonrefundable tax credit in an amount equal to a credit rate multiplied by the face amount of the bond. A taxpayer holding a qualified zone academy bond on the credit allowance date is entitled to a credit. The credit is includable in gross income (as if it were a taxable interest payment on the bond), and may be claimed against regular income tax and AMT liability.

The Treasury Department sets the credit rate at a rate estimated to allow issuance of qualified zone academy bonds without discount and without interest cost to the issuer. The maximum term of the bond is determined by the Treasury Department, so that the present value of the obligation to repay the bond is 50 percent of the face value of the bond.

`Qualified zone academy bonds' are defined as any bond issued by a State or local government, provided that: (1) at least 95 percent of the proceeds are used for the purpose of renovating, providing equipment to, developing course materials for use at, or training teachers and other school personnel in a `qualified zone academy', and (2) private entities have promised to contribute to the qualified zone academy certain equipment, technical assistance or training, employee services, or other property or services with a value equal to at least 10 percent of the bond proceeds.

A school is a `qualified zone academy' if: (1) the school is a public school that provides education and training below the college level, (2) the school operates a special academic program in cooperation with businesses to enhance the academic curriculum and increase graduation and employment rates, and (3) either (a) the school is located in an empowerment zone or enterprise community designated under the Code, or (b) it is reasonably expected that at least 35 percent of the students at the school will be eligible for free or reduced-cost lunches under the school lunch program established under the National School Lunch Act.

REASONS FOR CHANGE


The Committee believes that the extension of authority to issue qualified zone academy bonds is appropriate in light of the educational needs that exist today.

EXPLANATION OF PROVISION


The bill authorizes issuance of up to $400 million of qualified zone academy bonds annually for calendar years 2004 and 2005.

EFFECTIVE DATE


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

N. EXTENSION OF TAX INCENTIVES FOR INVESTMENT IN THE DISTRICT OF COLUMBIA


(Sec. 414 of the bill and secs. 1400, 1400A, 1400B, and 1400C of the Code)

PRESENT LAW


DC Zone incentives

The Taxpayer Relief Act of 1997 designated certain economically depressed census tracts within the District of Columbia as the District of Columbia Enterprise Zone (the `D.C. Zone'), within which businesses and individual residents are eligible for special tax incentives. The D.C. Zone designation is in effect for the period from January 1, 1998, through December 31, 2003. In addition to the tax incentives generally available with respect to empowerment zones, the D.C. Zone also has a zero-percent capital gains rate that applies to gain from the sale of certain qualified D.C. Zone assets acquired after December 31, 1997, and held for more than five years.

With respect to the tax-exempt financing incentives, the D.C. Zone generally is treated like a Round I empowerment zone; therefore, the issuance of such tax-exempt bonds is subject to the District of Columbia's annual private activity bond volume limitation. However, the aggregate face amount of all outstanding qualified D.C. zone facility bonds per qualified D.C. Zone business may not exceed $15 million (rather than $3 million, as is the case for Round I empowerment zones).

Homebuyers tax credit

First-time homebuyers of a principal residence in the District of Columbia are eligible for a nonrefundable tax credit of up to $5,000 of the amount of the purchase price. The $5,000 maximum credit applies both to individuals and married couples. Married individuals filing separately can claim a maximum credit of $2,500 each. The credit phases out for individual taxpayers with adjusted gross income between $70,000 and $90,000 ($110,000-$130,000 for joint filers). For purposes of eligibility, `first-time homebuyer' means any individual if such individual did not have a present ownership interest in a principal residence in the District of Columbia in the one-year period ending on the date of the purchase of the residence to which the credit applies. The credit is scheduled to expire for property purchased after December 31, 2003.

REASONS FOR CHANGE


The Committee believes that the incentives should temporarily be extended to provide the Congress and the Treasury Department a better opportunity to continue to assess the overall operation and effectiveness of the tax incentives to revitalize the DC Zone and to promote homeownership therein.

EXPLANATION OF PROVISION


DC Zone incentives

The bill extends the D.C. Zone designation and tax-exempt financing incentives for two years (through December 31, 2005). The bill extends the date before which a DC Zone asset must be acquired for purposes of utilizing the zero-percent capital gains rate for two years (to January 1, 2006), and extends the period within which gain is treated as qualified capital gain for two years (through December 31, 2010).

Homebuyers tax credit

The bill extends the first-time homebuyer credit for two years (through December 31, 2005).

EFFECTIVE DATE


The provisions are effective on the date of enactment, except that the provision relating to tax-exempt financing incentives applies to obligations issued after December 31, 2003.

O. EXTEND THE AUTHORITY TO ISSUE LIBERTY ZONE BONDS


(Sec. 415 of the bill and sec. 1400L of the Code)

PRESENT LAW


In general

Interest on debt incurred by States or local governments is excluded from income if the proceeds of the borrowing are used to carry out governmental functions of those entities or the debt is repaid with governmental funds (sec. 103). Interest on bonds that nominally are issued by States or local governments, but the proceeds of which are used (directly or indirectly) by a private person and payment of which is derived from funds of such a private person is taxable unless the purpose of the borrowing is approved specifically in the Code or in a non-Code provision of a revenue Act. These bonds are called `private activity bonds.' The term `private person' includes the Federal Government and all other individuals and entities other than States or local governments.

In most cases, the aggregate volume of tax-exempt private activity bonds that may be issued in a State is restricted by annual volume limits. For calendar year 2004, these annual volume limits are equal to the greater of $80 per resident of the State or $234 million.

Tax-exempt private activity bonds

Interest on private activity bonds is tax-exempt only for qualified bonds. Qualified bonds include: (1) exempt facility bonds; (2) qualified mortgage bonds; (3) qualified veteran mortgage bonds; (4) qualified small-issue bonds; (5) qualified student loan bonds; (6) qualified redevelopment bonds; and (7) qualified 501(c)(3) bonds. A further provision allows tax-exempt financing for `environmental enhancements of hydro-electric generating facilities.' Tax-exempt financing also is authorized for capital expenditures for small manufacturing facilities and land and equipment for first-time farmers (`qualified small-issue bonds'), local redevelopment activities (`qualified redevelopment bonds'), and eligible empowerment zone and enterprise community businesses.

Tax-exempt financing is also allowed for qualified New York Liberty Bonds issued during calendar years 2002, 2003, and 2004. An aggregate limit of $8 billion of tax-exempt private activity bonds to finance the construction and rehabilitation of nonresidential real property 175

 [Footnote]  and residential rental real property 176

 [Footnote]  in a newly designated `Liberty Zone' (the `Zone') of New York City is allowed. 177

 [Footnote]  Property eligible for financing with these bonds includes buildings and their structural components, fixed tenant improvements, 178

 [Footnote]  and public utility property (e.g., gas, water, electric and telecommunication lines). All business addresses located on or south of Canal Street, East Broadway (east of its intersection with Canal Street), or Grand Street (east of its intersection with East Broadway) in the Borough of Manhattan are considered to be located within the Zone. Issuance of these bonds is limited to projects approved by the Mayor of New York City or the Governor of New York State, each of whom may designate up to $4 billion of the bonds authorized under the bill.

[Footnote 175: No more than $800 million of the authorized bond amount may be used to finance property used for retail sales of tangible property (e.g., department stores, restaurants, etc.) and functionally related and subordinate property. The term nonresidential real property includes structural components of such property if the taxpayer treats such components as part of the real property structure for all Federal income tax purposes (e.g., cost recovery). The $800 million limit is divided equally between the Mayor and the Governor.]

[Footnote 176: No more than $1.6 billion of the authorized bond amount may be used to finance residential rental property. The $1.6 billion limit is divided equally between the Mayor and the Governor.]

[Footnote 177: Current refundings of outstanding New York Liberty Bonds bonds do not count against the $8 billion volume limit to the extent that the amount of the refunding bonds does not exceed the outstanding amount of the bonds being refunded. In addition, qualified New York Liberty Bonds may be issued after December 31, 2004 to refund (other than advance refund) qualified New York Liberty Bonds originally issued before January 1, 2005, to the extent the amount of the refunding bonds does not exceed the outstanding amount of the refunded bonds. The bonds may not be advance refunded.]

[Footnote 178: Fixtures and equipment that could be removed from the designated zone for use elsewhere are not eligible for financing with these bonds.]

If the Mayor or the Governor determines that it is not feasible to use all of the authorized bonds that he is authorized to designate for property located in the Zone, up to $1 billion of bonds may be designated by each to be used for the acquisition, construction, and rehabilitation of nonresidential real property (including fixed tenant improvements) located outside the Zone and within New York City. 179

 [Footnote]  Bond-financed property located outside the Zone must meet the additional requirement that the project have at least 100,000 square feet of usable office or other commercial space in a single building or multiple adjacent buildings.

[Footnote 179: Public utility property and residential property located outside the Zone cannot be financed with the bonds.]

Subject to the following exceptions and modifications, issuance of these tax-exempt bonds is subject to the general rules applicable to issuance of exempt-facility private activity bonds:





(3) The special arbitrage expenditure rules for certain construction bond proceeds apply to available construction proceeds of the bonds (sec. 148(f)(4)(C));

(4) The tenant targeting rules applicable to exempt-facility bonds for residential rental property (and the corresponding change in use penalties for violations of those rules) do not apply to such property financed with the bonds (secs. 142(d) and 150(b)(2));

(5) Repayments of bond-financed loans may not be used to make additional loans, but rather must be used to retire outstanding bonds (with the first such retirement occurring 10 years after issuance of the bonds); 180

 [Footnote]  and

[Footnote 180: It is intended that redemptions will occur at least semi-annually beginning at the end of 10 years after the bonds are issued; however, amounts less than $250,000 are not required to be used to redeem bonds at such intervals.]

(6) Interest on the bonds is not a preference item for purposes of the alternative minimum tax preference for private activity bond interest (sec. 57(a)(5)).

REASONS FOR CHANGE


The Committee is committed to aiding the City of New York's economic recovery from the terrorist attacks of September 11, 2001. Therefore, the Committee believes that an extension of the authority to issue New York Liberty Bonds is appropriate.

EXPLANATION OF PROVISION


The bill extends authority to issue New York Liberty Bonds through December 31, 2009.

EFFECTIVE DATE


The provision is effective for bonds issued after the date of enactment and before January 1, 2010.

P. DISCLOSURE TO LAW ENFORCEMENT AGENCIES REGARDING TERRORIST ACTIVITIES


(Sec. 416 of the bill and sec. 6103 of the Code)

PRESENT LAW


Return information includes a taxpayer's identity. 181

 [Footnote]  The IRS may disclose return information, other than taxpayer return information, to officers and employees of Federal law enforcement upon a written request. The request must be made by the head of the Federal law enforcement agency (or his delegate) involved in the response to or investigation of terrorist incidents, threats, or activities, and set forth the specific reason or reasons why such disclosure may be relevant to a terrorist incident, threat, or activity. The information is to be disclosed to officers and employees of the Federal law enforcement agency who would be personally and directly involved in the response to or investigation of terrorist incidents, threats, or activities. The information is to be used by such officers and employees solely for such response or investigation. 182

 [Footnote]

[Footnote 181: Sec. 6103(b)(2)(A).]

[Footnote 182: Sec. 6103(i)(7)(A).]

The Federal law enforcement agency may redisclose the information to officers and employees of State and local law enforcement personally and directly engaged in the response to or investigation of the terrorist incident, threat, or activity. The State or local law enforcement agency must be part of an investigative or response team with the Federal law enforcement agency for these disclosures to be made. 183

 [Footnote]

[Footnote 183: Sec. 6103(i)(7)(A)(ii).]

If a taxpayer's identity is taken from a return or other information filed with or furnished to the IRS by or on behalf of the taxpayer, it is taxpayer return information. Since taxpayer return information is not covered by this disclosure authorization, taxpayer identity so obtained cannot be disclosed and thus associated with the other information being provided.

The Code also allows the IRS to disclose return information (other than taxpayer return information) upon the written request of an officer or employee of the Department of Justice or Treasury who is appointed by the President with the advice and consent of the Senate, or who is the Director of the U.S. Secret Service, if such individual is responsible for the collection and analysis of intelligence and counterintelligence concerning any terrorist incident, threat, or activity. 184

 [Footnote]  Taxpayer identity information for this purpose is not considered taxpayer return information. Such written request must set forth the specific reason or reasons why such disclosure may be relevant to a terrorist incident, threat, or activity. Disclosures under this authority may be made to those officers and employees of the Department of Justice, Treasury, and Federal intelligence agencies who are personally and directly engaged in the collection or analysis of intelligence and counterintelligence information or investigation concerning any terrorist incident, threat, or activity. Such disclosures may be made solely for the use of such officers and employees in such investigation, collection, or analysis.

[Footnote 184: Sec. 6103(i)(7)(B).]

The IRS, on its own initiative, may disclose in writing return information (other than taxpayer return information) that may be related to a terrorist incident, threat, or activity to the extent necessary to apprise the head of the appropriate investigating Federal law enforcement agency. 185

 [Footnote]  Taxpayer identity information for this purpose is not considered taxpayer return information. The head of the agency may redisclose such information to officers and employees of such agency to the extent necessary to investigate or respond to the terrorist incident, threat, or activity.

[Footnote 185: Sec. 6103(i)(3)(C).]

If taxpayer return information is sought, the disclosure must be made pursuant to the ex parte order of a Federal district court judge or magistrate.

No disclosures may be made under these provisions after December 31, 2003.

REASONS FOR CHANGE


The Committee believes that a renewal of this disclosure authority will provide additional time to evaluate the effectiveness of the provision and whether any modifications need to be implemented to enhance the provision.

EXPLANATION OF PROVISION


The provision extends the disclosure authority relating to terrorist activities. Under the provision, no disclosures can be made after December 31, 2005.

The provision also makes a technical change to clarify that a taxpayer's identity is not treated as taxpayer return information for purposes of disclosures to law enforcement agencies regarding terrorist activities.

EFFECTIVE DATE


The provision extending authority is effective for disclosures made on or after the date of enactment. The technical change is effective as if included in section 201 of the Victims of Terrorism Tax Relief Act of 2001.

Q. DISCLOSURE OF RETURN INFORMATION RELATING TO STUDENT LOANS


(Sec. 417 of the bill and sec. 6103(l) of the Code)

PRESENT LAW


Present law prohibits the disclosure of returns and return information, except to the extent specifically authorized by the Code. 186

 [Footnote]  An exception is provided for disclosure to the Department of Education (but not to contractors thereof) of a taxpayer's filing status, adjusted gross income and identity information (i.e., name, mailing address, taxpayer identifying number) to establish an appropriate repayment amount for an applicable student loan. 187

 [Footnote]  The Department of Education disclosure authority is scheduled to expire after December 31, 2004. 188

 [Footnote]

[Footnote 186: Sec. 6103.]

[Footnote 187: Sec. 6103(l)(13).]

[Footnote 188: Pub. L. No. 108-89, sec. 201 (2003).]

An exception to the general rule prohibiting disclosure is also provided for the disclosure of returns and return information to a designee of the taxpayer. 189

 [Footnote]  Unlike the specific Department of Education exception, section 6103(c) disclosures are not subject to use restrictions nor are they subject to statutory safeguards. Because the Department of Education utilizes contractors for the income-contingent loan verification program, the Department of Education obtains taxpayer information by consent under section 6103(c), rather than under the specific exception. 190

 [Footnote]  The Department of Treasury has reported that the Internal Revenue Service processes approximately 100,000 consents per year for this purpose. 191

 [Footnote]

[Footnote 189: Sec. 6103(c).]

[Footnote 190: Department of Treasury, Report to the Congress on Scope and Use of Taxpayer Confidentiality and Disclosure Provisions, Volume I: Study of General Provisions (October 2000) at 91.]

[Footnote 191: Department of Treasury, General Explanations of the Administration's Fiscal Year 2004 Revenue Proposals (February 2003) at 133.]

REASONS FOR CHANGE


The Committee believes that the Department of Education should be provided with access to tax return information to assist it in carrying out the income-contingent repayment program. Thus, the Committee believes that it is appropriate to provide a further extension of this disclosure authority.

EXPLANATION OF PROVISION


The bill extends the disclosure authority relating to the disclosure of return information to carry out income-contingent repayment of student loans. Under the bill, no disclosures can be made after December 31, 2005.

EFFECTIVE DATE


The provision is effective with respect to disclosures made after the date of enactment.

R. EXTENSION OF COVER OVER OF EXCISE TAX ON DISTILLED SPIRITS TO PUERTO RICO AND VIRGIN ISLANDS


(Sec. 418 of the bill and sec. 7652 of the Code)

PRESENT LAW


A $13.50 per proof gallon 192

 [Footnote]  excise tax is imposed on distilled spirits produced in or imported (or brought) into the United States. 193

 [Footnote]  The excise tax does not apply to distilled spirits that are exported from the United States, including exports to U.S. possessions (e.g., Puerto Rico and the Virgin Islands). 194

 [Footnote]

[Footnote 192: A proof gallon is a liquid gallon consisting of 50 percent alcohol. See sec. 5002(a)(10), (11).]

[Footnote 193: Sec. 5001(a)(1).]

[Footnote 194: Secs. 5062(b), 7653(b) and (c).]

The Code provides for cover over (payment) to Puerto Rico and the Virgin Islands of the excise tax imposed on rum imported (or brought) into the United States, without regard to the country of origin. 195

 [Footnote]  The amount of the cover over is limited under section 7652(f) to $10.50 per proof gallon ($13.25 per proof gallon during the period July 1, 1999 through December 31, 2003).

[Footnote 195: Sec. 7652(a)(3), (b)(3), and (e)(1). One percent of the amount of excise tax collected from imports into the United States of articles produced in the Virgin Islands is retained by the United States under section 7652(b)(3).]

Thus, tax amounts attributable to shipments to the United States of rum produced in Puerto Rico are covered over to Puerto Rico. Tax amounts attributable to shipments to the United States of rum produced in the Virgin Islands are covered over to the Virgin Islands. Tax amounts attributable to shipments to the United States of rum produced in neither Puerto Rico nor the Virgin Islands are divided and covered over to the two possessions under a formula. 196

 [Footnote]  Amounts covered over to Puerto Rico and the Virgin Islands are deposited into the treasuries of the two possessions for use as those possessions determine. 197

 [Footnote]  All of the amounts covered over are subject to the limitation.

[Footnote 196: Sec. 7652(e)(2).]

[Footnote 197: Sec. 7652(a)(3), (b)(3), and (e)(1).]

REASONS FOR CHANGE


The Committee believes that the needs of Puerto Rico and the Virgin Islands justify the extension of the cover over amount of $13.25 per proof gallon through December 31, 2005.

EXPLANATION OF PROVISION


The provision temporarily suspends the $10.50 per proof gallon limitation on the amount of excise taxes on rum covered over to Puerto Rico and the Virgin Islands. Under the provision, the cover over amount of $13.25 per proof gallon is extended for rum brought into the United States after December 31, 2003 and before January 1, 2006. After December 31, 2005, the cover over amount reverts to $10.50 per proof gallon.

EFFECTIVE DATE


The provision is effective for articles brought into the United States after December 31, 2003.

S. EXTENSION OF JOINT REVIEW


(Sec. 419 of the bill and secs. 8021 and 8022 of the Code)

PRESENT LAW


The Code required the Joint Committee on Taxation to conduct a joint review 198

 [Footnote]  of the strategic plans and budget of the IRS from 1999 through 2003. 199

 [Footnote]  The Code also required the Joint Committee to provide an annual report 200

 [Footnote]  from 1999 through 2003 with respect to:

[Footnote 198: The joint review was required to include two members of the majority and one member of the minority of the Senate Committees on Finance, Appropriations, and Governmental Affairs, and of the House Committees on Ways and Means, Appropriations, and Government Reform and Oversight.]

[Footnote 199: Sec. 8021(f).]

[Footnote 200: Sec. 8022(3)(C).]













REASONS FOR CHANGE


The Committee believes that a joint review of the IRS should be held for one additional year and that the report provided by the Joint Committee on Taxation should be tailored to the specific issues addressed in the joint review.

EXPLANATION OF PROVISION


The provision requires that the Joint Committee conduct a joint review before June 1, 2005. The provision requires the Joint Committee to provide an annual report before June 1, 2005, but specifies that the content of the annual report is the matters addressed in the joint review. 201

 [Footnote]

[Footnote 201: Accordingly, the provision deletes the specific list of matters required to be covered in the annual report.]

EFFECTIVE DATE


The provision is effective on the date of enactment.

T. PARITY IN THE APPLICATION OF CERTAIN LIMITS TO MENTAL HEALTH BENEFITS


(Sec. 420 of the bill and sec. 9812 of the Code)

PRESENT LAW


The Mental Health Parity Act of 1996 amended the Employee Retirement Income Security Act of 1974 (`ERISA') and the Public Health Service Act (`PHSA') to provide that group health plans that provide both medical and surgical benefits and mental health benefits cannot impose aggregate lifetime or annual dollar limits on mental health benefits that are not imposed on substantially all medical and surgical benefits. The provisions of the Mental Health Parity Act were initially effective with respect to plan years beginning on or after January 1, 1998, for a temporary period. Since enactment, the mental health parity requirements in ERISA and the PHSA have been extended on more than one occasion and currently are scheduled to expire with respect to benefits for services furnished on or after December 31, 2004.

The Taxpayer Relief Act of 1997 added to the Code the requirements imposed under the Mental Health Parity Act, and imposed an excise tax on group health plans that fail to meet the requirements. The excise tax is equal to $100 per day during the period of noncompliance and is generally imposed on the employer sponsoring the plan if the plan fails to meet the requirements. The maximum tax that can be imposed during a taxable year cannot exceed the lesser of 10 percent of the employer's group health plan expenses for the prior year or $500,000. No tax is imposed if the Secretary determines that the employer did not know, and exercising reasonable diligence would not have known, that the failure existed.

The Code provisions were initially effective with respect to plan years beginning on or after January 1, 1998, for a temporary period. 202

 [Footnote]  The Code provisions have been extended on a number of occasions, and expired with respect to benefits for services furnished after December 31, 2003.

[Footnote 202: The excise tax does not apply to benefits for services furnished on or after September 30, 2001, and before January 10, 2002.]

REASONS FOR CHANGE


The provisions of the Mental Health Parity Act in ERISA and the PHSA have been extended to December 31, 2004, while the Code provisions have expired. The Committee recognizes that the Code provisions relating to mental health parity are important to carrying out the purposes of the Mental Health Parity Act. Thus, the Committee believes that extending the Code provisions relating to mental health parity is warranted.

EXPLANATION OF PROVISION


The provision extends the Code provisions relating to mental health parity to benefits for services furnished after the date of enactment and before January 1, 2006. Thus, the excise tax on failures to meet the requirements imposed by the Code provisions does not apply after December 31, 2003, and before the date of enactment.

EFFECTIVE DATE


The provision is effective for benefits for services furnished after the date of enactment.

U. DISCLOSURE OF TAX INFORMATION TO FACILITATE COMBINED EMPLOYMENT TAX REPORTING


(Sec. 421 of the bill)

PRESENT LAW


Traditionally, Federal tax forms are filed with the Federal government and State tax forms are filed with individual States. This necessitates duplication of items common to both returns.

The Taxpayer Relief Act of 1997 203

 [Footnote]  permitted implementation of a demonstration project to assess the feasibility and desirability of expanding combined Federal and State reporting. There were several limitations on the demonstration project. First, it was limited to the sharing of information between the State of Montana and the IRS. Second, it was limited to employment tax reporting. Third, it was limited to disclosure of the name, address, TIN, and signature of the taxpayer, which is information common to both the Montana and Federal portions of the combined form. Fourth, it was limited to a period of five years.

[Footnote 203: Pub. L. No. 105-34, sec. 976.]

The authority for the demonstration project expired on the date five years after the date of enactment (August 5, 2002).

REASONS FOR CHANGE


The Committee believes that authorizing this pilot project for an additional year will provide the Congress with information to assess the usefulness of the program and whether further expansions are warranted.

EXPLANATION OF PROVISION


The provision renews authority for the demonstration project through December 31, 2005.

EFFECTIVE DATE


The provision is effective on the date of enactment.

V. EXTENSION OF TAX CREDIT FOR ELECTRIC VEHICLES AND TAX DEDUCTION FOR CLEAN-FUEL VEHICLES


(Sec. 422 of the bill and secs. 30 and 179A of the Code)

PRESENT LAW


Electric vehicles

A 10-percent tax credit is provided for the cost of a qualified electric vehicle, up to a maximum credit of $4,000 (sec. 30). A qualified electric vehicle is a motor vehicle that is powered primarily by an electric motor drawing current from rechargeable batteries, fuel cells, or other portable sources of electrical current, the original use of which commences with the taxpayer, and that is acquired for the use by the taxpayer and not for resale. The full amount of the credit is available for purchases prior to 2002. The credit phases down in the years 2004 through 2006, and is unavailable for purchases after December 31, 2006.

Clean-fuel vehicles

Certain costs of qualified clean-fuel vehicle may be expensed and deducted when such property is placed in service (sec. 179A). Qualified clean-fuel vehicle property includes motor vehicles that use certain clean-burning fuels (natural gas, liquefied natural gas, liquefied petroleum gas, hydrogen, electricity and any other fuel at least 85 percent of which is methanol, ethanol, any other alcohol or ether). The maximum amount of the deduction is $50,000 for a truck or van with a gross vehicle weight over 26,000 pounds or a bus with seating capacities of at least 20 adults; $5,000 in the case of a truck or van with a gross vehicle weight between 10,000 and 26,000 pounds; and $2,000 in the case of any other motor vehicle. Qualified electric vehicles do not qualify for the clean-fuel vehicle deduction. The deduction phases down in the years 2004 through 2006, and is unavailable for purchases after December 31, 2006.

REASONS FOR CHANGE


The Committee believes it is necessary to continue to provide the full benefit of the tax subsidy to the purchase of these innovative vehicles to enable such vehicles to demonstrate their road-worthiness to the consumer.

EXPLANATION OF PROVISION


The provision suspends the phase down of allowable tax credit for electric vehicles and the deduction for clean-fuel vehicles in 2004 and 2005. Thus, a taxpayer who purchases a qualifying vehicle may claim 100 percent of the otherwise allowable credit or deduction for vehicles purchased in 2004 and 2005. For vehicles purchased in 2006 the credit or deduction remains at 25 percent of the otherwise allowable amount as under present law.

EFFECTIVE DATE


The provision is effective for vehicles placed in service after December 31, 2003.

TITLE V--DEDUCTION OF STATE AND LOCAL GENERAL SALES TAXES


A. DEDUCTION OF STATE AND LOCAL GENERAL SALES TAXES


(Sec. 501 of the bill and sec. 164 of the Code)

PRESENT LAW


An itemized deduction is permitted for certain taxes paid, including individual income taxes, real property taxes, and personal property taxes. No itemized deduction is permitted for State or local general sales taxes.

REASONS FOR CHANGE


The Committee recognizes that not all States rely on income taxes as a primary source of revenue, and that allowing a deduction for State and local income taxes, but not sales taxes, may create inequities across States and may also create bias in the types of taxes that States and localities choose to impose. The Committee believes that the provision of an itemized deduction for State and local general sales taxes in lieu of the deduction for State and local income taxes provides more equitable Federal tax treatment across States, and will cause the Federal tax laws to have a more neutral effect on the types of taxes that State and local governments utilize.

EXPLANATION OF PROVISION


The provision provides that, at the election of the taxpayer, an itemized deduction may be taken for State and local general sales taxes in lieu of the itemized deduction provided under present law for State and local income taxes.

The term `general sales tax' means a tax imposed at one rate with respect to the sale at retail of a broad range of classes of items. However, in the case of items of food, clothing, medical supplies, and motor vehicles, the fact that the tax does not apply with respect to some or all of such items is not taken into account in determining whether the tax applies with respect to a broad range of classes of items, and the fact that the rate of tax applicable with respect to some or all of such items is lower than the general rate of tax is not taken into account in determining whether the tax is imposed at one rate. Except in the case of a lower rate of tax applicable with respect to food, clothing, medical supplies, or motor vehicles, no deduction is allowed for any general sales tax imposed with respect to an item at a rate other than the general rate of tax. However, in the case of motor vehicles, if the rate of tax exceeds the general rate, such excess shall be disregarded and the general rate is treated as the rate of tax.

A compensating use tax with respect to an item is treated as a general sales tax, provided such tax is complimentary to a general sales tax and a deduction for sales taxes is allowable with respect to items sold at retail in the taxing jurisdiction that are similar to such item.

EFFECTIVE DATE


The provision is effective for taxable years beginning after December 31, 2003, and prior to January 1, 2006.

TITLE VI--REVENUE PROVISIONS


A. PROVISIONS TO REDUCE TAX AVOIDANCE THROUGH INDIVIDUAL AND CORPORATE EXPATRIATION


1. Tax treatment of expatriated entities and their foreign parents (sec. 601 of the bill and new sec. 7874 of the Code)

PRESENT LAW


Determination of corporate residence

The U.S. tax treatment of a multinational corporate group depends significantly on whether the parent corporation of the group is domestic or foreign. For purposes of U.S. tax law, a corporation is treated as domestic if it is incorporated under the law of the United States or of any State. All other corporations (i.e., those incorporated under the laws of foreign countries) are treated as foreign.

U.S. taxation of domestic corporations

The United States employs a `worldwide' tax system, under which domestic corporations generally are taxed on all income, whether derived in the United States or abroad. In order to mitigate the double taxation that may arise from taxing the foreign-source income of a domestic corporation, a foreign tax credit for income taxes paid to foreign countries is provided to reduce or eliminate the U.S. tax owed on such income, subject to certain limitations.

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

U.S. taxation of foreign corporations

The United States taxes foreign corporations only on income that has a sufficient nexus to the United States. Thus, a foreign corporation is generally subject to U.S. tax only on income that is `effectively connected' with the conduct of a trade or business in the United States. Such `effectively connected income' generally is taxed in the same manner and at the same rates as the income of a U.S. corporation. An applicable tax treaty may limit the imposition of U.S. tax on business operations of a foreign corporation to cases in which the business is conducted through a `permanent establishment' in the United States.

In addition, foreign corporations generally are subject to a gross-basis U.S. tax at a flat 30-percent rate on the receipt of interest, dividends, rents, royalties, and certain similar types of income derived from U.S. sources, subject to certain exceptions. The tax generally is collected by means of withholding by the person making the payment. This tax may be reduced or eliminated under an applicable tax treaty.

U.S. tax treatment of inversion transactions

Under present law, a U.S. corporation may reincorporate in a foreign jurisdiction and thereby replace the U.S. parent corporation of a multinational corporate group with a foreign parent corporation. These transactions are commonly referred to as inversion transactions. Inversion transactions may take many different forms, including stock inversions, asset inversions, and various combinations of and variations on the two. Most of the known transactions to date have been stock inversions. In one example of a stock inversion, a U.S. corporation forms a foreign corporation, which in turn forms a domestic merger subsidiary. The domestic merger subsidiary then merges into the U.S. corporation, with the U.S. corporation surviving, now as a subsidiary of the new foreign corporation. The U.S. corporation's shareholders receive shares of the foreign corporation and are treated as having exchanged their U.S. corporation shares for the foreign corporation shares. An asset inversion reaches a similar result, but through a direct merger of the top-tier U.S. corporation into a new foreign corporation, among other possible forms. An inversion transaction may be accompanied or followed by further restructuring of the corporate group. For example, in the case of a stock inversion, in order to remove income from foreign operations from the U.S. taxing jurisdiction, the U.S. corporation may transfer some or all of its foreign subsidiaries directly to the new foreign parent corporation or other related foreign corporations.

In addition to removing foreign operations from the U.S. taxing jurisdiction, the corporate group may derive further advantage from the inverted structure by reducing U.S. tax on U.S.-source income through various earnings stripping or other transactions. This may include earnings stripping through payment by a U.S. corporation of deductible amounts such as interest, royalties, rents, or management service fees to the new foreign parent or other foreign affiliates. In this respect, the post-inversion structure enables the group to employ the same tax-reduction strategies that are available to other multinational corporate groups with foreign parents and U.S. subsidiaries, subject to the same limitations (e.g., secs. 163(j) and 482).

Inversion transactions may give rise to immediate U.S. tax consequences at the shareholder and/or the corporate level, depending on the type of inversion. In stock inversions, the U.S. shareholders generally recognize gain (but not loss) under section 367(a), based on the difference between the fair market value of the foreign corporation shares received and the adjusted basis of the domestic corporation stock exchanged. To the extent that a corporation's share value has declined, and/or it has many foreign or tax-exempt shareholders, the impact of this section 367(a) `toll charge' is reduced. The transfer of foreign subsidiaries or other assets to the foreign parent corporation also may give rise to U.S. tax consequences at the corporate level (e.g., gain recognition and earnings and profits inclusions under secs. 1001, 311(b), 304, 367, 1248 or other provisions). The tax on any income recognized as a result of these restructurings may be reduced or eliminated through the use of net operating losses, foreign tax credits, and other tax attributes.

In asset inversions, the U.S. corporation generally recognizes gain (but not loss) under section 367(a) as though it had sold all of its assets, but the shareholders generally do not recognize gain or loss, assuming the transaction meets the requirements of a reorganization under section 368.

REASONS FOR CHANGE


The Committee believes that corporate inversion transactions are a symptom of larger problems with our current uncompetitive system for taxing U.S.-based global businesses and are also indicative of the unfair advantages that our tax laws convey to foreign ownership. The bill addresses the underlying problems with the U.S. system of taxing U.S.-based global businesses and contains provisions to remove the incentives for entering into inversion transactions. Imposing full U.S. tax on gains of companies undertaking an inversion transaction is one such provision that helps to remove the incentive to enter into an inversion transaction.

EXPLANATION OF PROVISION


The bill applies special tax rules to corporations that undertake certain defined inversion transactions. For this purpose, an inversion is a transaction in which, pursuant to a plan or a series of related transactions: (1) a U.S. corporation becomes a subsidiary of a foreign-incorporated entity or otherwise transfers substantially all of its properties to such an entity after March 4, 2003; (2) the former shareholders of the U.S. corporation hold (by reason of holding stock in the U.S. corporation) 60 percent or more (by vote or value) of the stock of the foreign-incorporated entity after the transaction; and (3) the foreign-incorporated entity, considered together with all companies connected to it by a chain of greater than 50-percent ownership (i.e., the `expanded affiliated group') does not conduct substantial business activities in the entity's country of incorporation compared to the total worldwide business activities of the expanded affiliated group.

In such a case, any applicable corporate-level `toll charges' for establishing the inverted structure are not offset by tax attributes such as net operating losses or foreign tax credits. Specifically, any applicable corporate-level income or gain required to be recognized under sections 304, 311(b), 367, 1001, 1248, or any other provision with respect to the transfer of controlled foreign corporation stock or the transfer or license of other assets by a U.S. corporation as part of the inversion transaction or after such transaction to a related foreign person is taxable, without offset by any tax attributes (e.g., net operating losses or foreign tax credits). This rule does not apply to certain transfers of inventory and similar property. These measures generally apply for a 10-year period following the inversion transaction.

In determining whether a transaction meets the definition of an inversion under the provision, stock held by members of the expanded affiliated group that includes the foreign incorporated entity is disregarded. For example, if the former top-tier U.S. corporation receives stock of the foreign incorporated entity (e.g., so-called `hook' stock), the stock would not be considered in determining whether the transaction meets the definition. Similarly, if a U.S. parent corporation converts an existing wholly owned U.S. subsidiary into a new wholly owned controlled foreign corporation, the stock of the new foreign corporation would be disregarded. Stock sold in a public offering related to the transaction also is disregarded for these purposes.

Transfers of properties or liabilities as part of a plan a principal purpose of which is to avoid the purposes of the provision are disregarded. In addition, the Treasury Secretary is granted authority to prevent the avoidance of the purposes of the provision, including avoidance through the use of related persons, pass-through or other noncorporate entities, or other intermediaries, and through transactions designed to qualify or disqualify a person as a related person or a member of an expanded affiliated group. Similarly, the Treasury Secretary is granted authority to treat certain non-stock instruments as stock, and certain stock as not stock, where necessary, to carry out the purposes of the provision.

Under the provision, inversion transactions include certain partnership transactions. Specifically, the provision applies to transactions in which a foreign-incorporated entity acquires substantially all of the properties constituting a trade or business of a domestic partnership, if after the acquisition at least 60 percent of the stock of the entity is held by former partners of the partnership (by reason of holding their partnership interests), provided that the other terms of the basic definition are met. For purposes of applying this test, all partnerships that are under common control within the meaning of section 482 are treated as one partnership, except as provided otherwise in regulations. In addition, the modified `toll charge' provisions apply at the partner level.

A transaction otherwise meeting the definition of an inversion transaction is not treated as an inversion transaction if, on or before March 4, 2003, the foreign-incorporated entity had acquired directly or indirectly more than half of the properties held directly or indirectly by the domestic corporation, or more than half of the properties constituting the partnership trade or business, as the case may be.

EFFECTIVE DATE


The provision applies to taxable years ending after March 4, 2003.

2. Excise tax on stock compensation of insiders in expatriated corporations (sec. 602 of the bill and secs. 162(m), 275(a), and new sec. 4985 of the Code)

PRESENT LAW


The income taxation of a nonstatutory 204

 [Footnote]  compensatory stock option is determined under the rules that apply to property transferred in connection with the performance of services (sec. 83). If a nonstatutory stock option does not have a readily ascertainable fair market value at the time of grant, which is generally the case unless the option is actively traded on an established market, no amount is included in the gross income of the recipient with respect to the option until the recipient exercises the option. 205

 [Footnote]  Upon exercise of such an option, the excess of the fair market value of the stock purchased over the option price is generally included in the recipient's gross income as ordinary income in such taxable year. 206

 [Footnote]

[Footnote 204: Nonstatutory stock options refer to stock options other than incentive stock options and employee stock purchase plans, the taxation of which is determined under sections 421-424.]

[Footnote 205: If an individual receives a grant of a nonstatutory option that has a readily ascertainable fair market value at the time the option is granted, the excess of the fair market value of the option over the amount paid for the option is included in the recipient's gross income as ordinary income in the first taxable year in which the option is either transferable or not subject to a substantial risk of forfeiture.]

[Footnote 206: Under section 83, such amount is includable in gross income in the first taxable year in which the rights to the stock are transferable or are not subject to substantial risk of forfeiture.]

The tax treatment of other forms of stock-based compensation (e.g., restricted stock and stock appreciation rights) is also determined under section 83. The excess of the fair market value over the amount paid (if any) for such property is generally includable in gross income in the first taxable year in which the rights to the property are transferable or are not subject to substantial risk of forfeiture.

Shareholders are generally required to recognize gain upon stock inversion transactions. An inversion transaction is generally not a taxable event for holders of stock options and other stock-based compensation.

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


Under the provision, specified holders of stock options and other stock-based compensation are subject to an excise tax upon certain inversion transactions. The provision imposes a 15-percent excise tax on the value of specified stock compensation held (directly or indirectly) by or for the benefit of a disqualified individual, or a member of such individual's family, at any time during the 12-month period beginning six months before the corporation's expatriation date. Specified stock compensation is treated as held for the benefit of a disqualified individual if such compensation is held by an entity, e.g., a partnership or trust, in which the individual, or a member of the individual's family, has an ownership interest.

A disqualified individual is any individual who, with respect to a corporation, is, at any time during the 12-month period beginning on the date which is six months before the expatriation date, subject to the requirements of section 16(a) of the Securities and Exchange Act of 1934 with respect to the corporation, or any member of the corporation's expanded affiliated group, 207

 [Footnote]  or would be subject to such requirements if the corporation (or member) were an issuer of equity securities referred to in section 16(a). Disqualified individuals generally include officers (as defined by section 16(a)), 208

 [Footnote]  directors, and 10-percent-or-greater owners of private and publicly-held corporations.

[Footnote 207: An expanded affiliated group is an affiliated group (under section 1504) except that such group is determined without regard to the exceptions for certain corporations and is determined applying a greater than 50 percent threshold, in lieu of the 80 percent test.]

[Footnote 208: An officer is defined as the president, principal financial officer, principal accounting officer (or, if there is no such accounting officer, the controller), any vice-president in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions.]

The excise tax is imposed on a disqualified individual of an expatriated corporation (as previously defined in the bill) only if gain (if any) is recognized in whole or part by any shareholder by reason of a corporate inversion transaction previously defined in the bill.

Specified stock compensation subject to the excise tax includes any payment 209

 [Footnote]  (or right to payment) granted by the expatriated corporation (or any member of the corporation's expanded affiliated group) to any person in connection with the performance of services by a disqualified individual for such corporation (or member of the corporation's expanded affiliated group) if the value of the payment or right is based on, or determined by reference to, the value or change in value of stock of such corporation (or any member of the corporation's expanded affiliated group). In determining whether such compensation exists and valuing such compensation, all restrictions, other than a non-lapse restriction, are ignored. Thus, the excise tax applies, and the value subject to the tax is determined, without regard to whether such specified stock compensation is subject to a substantial risk of forfeiture or is exercisable at the time of the inversion transaction. Specified stock compensation includes compensatory stock and restricted stock grants, compensatory stock options, and other forms of stock-based compensation, including stock appreciation rights, phantom stock, and phantom stock options. Specified stock compensation also includes nonqualified deferred compensation that is treated as though it were invested in stock or stock options of the expatriating corporation (or member). For example, the provision applies to a disqualified individual's deferred compensation if company stock is one of the actual or deemed investment options under the nonqualified deferred compensation plan.

[Footnote 209: Under the provision, any transfer of property is treated as a payment and any right to a transfer of property is treated as a right to a payment.]

Specified stock compensation includes a compensation arrangement that gives the disqualified individual an economic stake substantially similar to that of a corporate shareholder. Thus, the excise tax does not apply if a payment is simply triggered by a target value of the corporation's stock or where a payment depends on a performance measure other than the value of the corporation's stock. Similarly, the tax does not apply if the amount of the payment is not directly measured by the value of the stock or an increase in the value of the stock. For example, an arrangement under which a disqualified individual would be paid a cash bonus of $500,000 if the corporation's stock increased in value by 25 percent over two years or $1,000,000 if the stock increased by 33 percent over two years is not specified stock compensation, even though the amount of the bonus generally is keyed to an increase in the value of the stock. By contrast, an arrangement under which a disqualified individual would be paid a cash bonus equal to $10,000 for every $1 increase in the share price of the corporation's stock is subject to the provision because the direct connection between the compensation amount and the value of the corporation's stock gives the disqualified individual an economic stake substantially similar to that of a shareholder.

The excise tax applies to any such specified stock compensation previously granted to a disqualified individual but cancelled or cashed-out within the six-month period ending with the expatriation date, and to any specified stock compensation awarded in the six-month period beginning with the expatriation date. As a result, for example, if a corporation cancels outstanding options three months before the transaction and then reissues comparable options three months after the transaction, the tax applies both to the cancelled options and the newly granted options. It is intended that the Secretary issue guidance to avoid double counting with respect to specified stock compensation that is cancelled and then regranted during the applicable twelve-month period.

Specified stock compensation subject to the tax does not include a statutory stock option or any payment or right from a qualified retirement plan or annuity, tax-sheltered annuity, simplified employee pension, or SIMPLE. In addition, under the provision, the excise tax does not apply to any stock option that is exercised during the six-month period before the expatriation date or to any stock acquired pursuant to such exercise, if income is recognized under section 83 on or before the expatriation date with respect to the stock acquired pursuant to such exercise. The excise tax also does not apply to any specified stock compensation that is exercised, sold, exchanged, distributed, cashed-out, or otherwise paid during such period in a transaction in which income, gain, or loss is recognized in full.

For specified stock compensation held on the expatriation date, the amount of the tax is determined based on the value of the compensation on such date. The tax imposed on specified stock compensation cancelled during the six-month period before the expatriation date is determined based on the value of the compensation on the day before such cancellation, while specified stock compensation granted after the expatriation date is valued on the date granted. Under the provision, the cancellation of a non-lapse restriction is treated as a grant.

The value of the specified stock compensation on which the excise tax is imposed is the fair value in the case of stock options (including warrants or other similar rights to acquire stock) and stock appreciation rights and the fair market value for all other forms of compensation. For purposes of the tax, the fair value of an option (or a warrant or other similar right to acquire stock) or a stock appreciation right is determined using an appropriate option-pricing model, as specified or permitted by the Secretary, that takes into account the stock price at the valuation date; the exercise price under the option; the remaining term of the option; the volatility of the underlying stock and the expected dividends on it; and the risk-free interest rate over the remaining term of the option. Options that have no intrinsic value (or `spread') because the exercise price under the option equals or exceeds the fair market value of the stock at valuation nevertheless have a fair value and are subject to tax under the provision. The value of other forms of compensation, such as phantom stock or restricted stock, is the fair market value of the stock as of the date of the expatriation transaction. The value of any deferred compensation that can be valued by reference to stock is the amount that the disqualified individual would receive if the plan were to distribute all such deferred compensation in a single sum on the date of the expatriation transaction (or the date of cancellation or grant, if applicable). It is expected that the Secretary issue guidance on valuation of specified stock compensation, including guidance similar to the revenue procedures issued under section 280G, except that the guidance would not permit the use of a term other than the full remaining term and would be modified as necessary or appropriate to carry out the purposes of the provision. Pending the issuance of guidance, it is intended that taxpayers can rely on the revenue procedure issued under section 280G (except that the full remaining term must be used and recalculation is not permitted).

The excise tax also applies to any payment by the expatriated corporation or any member of the expanded affiliated group made to an individual, directly or indirectly, in respect of the tax. Whether a payment is made in respect of the tax is determined under all of the facts and circumstances. Any payment made to keep the individual in the same after-tax position that the individual would have been in had the tax not applied is a payment made in respect of the tax. This includes direct payments of the tax and payments to reimburse the individual for payment of the tax. It is expected that the Secretary issue guidance on determining when a payment is made in respect of the tax and that such guidance include certain factors that give rise to a rebuttable presumption that a payment is made in respect of the tax, including a rebuttable presumption that if the payment is contingent on the inversion transaction, it is made in respect to the tax. Any payment made in respect of the tax is includible in the income of the individual, but is not deductible by the corporation.

To the extent that a disqualified individual is also a covered employee under section 162(m), the $1,000,000 limit on the deduction allowed for employee remuneration for such employee is reduced by the amount of any payment (including reimbursements) made in respect of the tax under the provision. As discussed above, this includes direct payments of the tax and payments to reimburse the individual for payment of the tax.

The payment of the excise tax has no effect on the subsequent tax treatment of any specified stock compensation. Thus, the payment of the tax has no effect on the individual's basis in any specified stock compensation and no effect on the tax treatment for the individual at the time of exercise of an option or payment of any specified stock compensation, or at the time of any lapse or forfeiture of such specified stock compensation. The payment of the tax is not deductible and has no effect on any deduction that might be allowed at the time of any future exercise or payment.

Under the provision, the Secretary is authorized to issue regulations as may be necessary or appropriate to carry out the purposes of the provision.

EFFECTIVE DATE


The provision is effective as of March 4, 2003, except that periods before March 4, 2003, are not taken into account in applying the excise tax to specified stock compensation held or cancelled during the six-month period before the expatriation date.

3. Reinsurance of U.S. risks in foreign jurisdictions (sec. 603 of the bill and sec. 845(a) of the Code)

PRESENT LAW


In the case of a reinsurance agreement between two or more related persons, present law provides the Treasury Secretary with authority to allocate among the parties or recharacterize income (whether investment income, premium or otherwise), deductions, assets, reserves, credits and any other items related to the reinsurance agreement, or make any other adjustment, in order to reflect the proper source and character of the items for each party. 210

 [Footnote]  For this purpose, related persons are defined as in section 482. Thus, persons are related if they are organizations, trades or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) that are owned or controlled directly or indirectly by the same interests. The provision may apply to a contract even if one of the related parties is not a domestic company. 211

 [Footnote]  In addition, the provision also permits such allocation, recharacterization, or other adjustments in a case in which one of the parties to a reinsurance agreement is, with respect to any contract covered by the agreement, in effect an agent of another party to the agreement, or a conduit between related persons.

[Footnote 210: Sec. 845(a).]

[Footnote 211: See S. Rep. No. 97-494, 97th Cong., 2d Sess., 337 (1982) (describing provisions relating to the repeal of modified coinsurance provisions).]

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


The bill clarifies the rules of section 845, relating to authority for the Treasury Secretary to allocate items among the parties to a reinsurance agreement, recharacterize items, or make any other adjustment, in order to reflect the proper source and character of the items for each party. The bill authorizes such allocation, recharacterization, or other adjustment, in order to reflect the proper source, character or amount of the item. It is intended that this authority 212

 [Footnote]  be exercised in a manner similar to the authority under section 482 for the Treasury Secretary to make adjustments between related parties. It is intended that this authority be applied in situations in which the related persons (or agents or conduits) are engaged in cross-border transactions that require allocation, recharacterization, or other adjustments in order to reflect the proper source, character or amount of the item or items. No inference is intended that present law does not provide this authority with respect to reinsurance agreements.

[Footnote 212: The authority to allocate, recharacterize or make other adjustments was granted in connection with the repeal of provisions relating to modified coinsurance transactions.]

No regulations have been issued under section 845(a). It is expected that the Treasury Secretary will issue regulations under section 845(a) to address effectively the allocation of income (whether investment income, premium or otherwise) and other items, the recharacterization of such items, or any other adjustment necessary to reflect the proper amount, source or character of the item.

EFFECTIVE DATE


The provision is effective for any risk reinsured after the date of enactment of the provision.

4. Revision of tax rules on expatriation of individuals (sec. 604 of the bill and secs. 877, 2107, 2501 and 6039G of the Code)

PRESENT LAW


In general

U.S. citizens and residents generally are subject to U.S income taxation on their worldwide income. The U.S. tax may be reduced or offset by a credit allowed for foreign income taxes paid with respect to foreign source income. Nonresident aliens are taxed at a flat rate of 30 percent (or a lower treaty rate) on certain types of passive income derived from U.S. sources, and at regular graduated rates on net profits derived from a U.S. trade or business. The estates of nonresident aliens generally are subject to estate tax on U.S.-situated property (e.g., real estate and tangible property located within the United States and stock in a U.S. corporation). Nonresident aliens generally are subject to gift tax on transfers by gift of U.S.-situated property (e.g., real estate and tangible property located within the United States, but excluding intangibles, such as stock, regardless of where they are located).

Income tax rules with respect to expatriates

For the 10 taxable years after an individual relinquishes his or her U.S. citizenship or terminates his or her U.S. residency 213

 [Footnote]  with a principal purpose of avoiding U.S. taxes, the individual is subject to an alternative method of income taxation than that generally applicable to nonresident aliens (the `alternative tax regime'). Generally, the individual is subject to income tax only on U.S.-source income 214

 [Footnote]  at the rates applicable to U.S. citizens for the 10-year period.

[Footnote 213: Under present law, an individual's U.S. residency is considered terminated for U.S. Federal tax purposes when the individual ceases to be a lawful permanent resident under the immigration law (or is treated as a resident of another country under a tax treaty and does not waive the benefits of such treaty).]

[Footnote 214: For this purpose, however, U.S.-source income has a broader scope than it does typically in the Code.]

An individual who relinquishes citizenship or terminates residency is treated as having done so with a principal purpose of tax avoidance and is generally subject to the alternative tax regime if: (1) the individual's average annual U.S. Federal income tax liability for the five taxable years preceding citizenship relinquishment or residency termination exceeds $100,000; or (2) the individual's net worth on the date of citizenship relinquishment or residency termination equals or exceeds $500,000. These amounts are adjusted annually for inflation. 215

 [Footnote]  Certain categories of individuals (e.g., dual residents) may avoid being deemed to have a tax avoidance purpose for relinquishing citizenship or terminating residency by submitting a ruling request to the IRS regarding whether the individual relinquished citizenship or terminated residency principally for tax reasons.

[Footnote 215: The income tax liability and net worth thresholds under section 877(a)(2) for 2004 are $124,000 and $622,000, respectively. See Rev. Proc. 2003-85, 2003-49 I.R.B. 1184.]

Anti-abuse rules are provided to prevent the circumvention of the alternative tax regime.

Estate tax rules with respect to expatriates

Special estate tax rules apply to individuals who relinquish their citizenship or long-term residency within the 10 years prior to the date of death, unless he or she did not have a tax avoidance purpose (as determined under the test above). Under these special rules, certain closely-held foreign stock owned by the former citizen or former long-term resident is includible in his or her gross estate to the extent that the foreign corporation owns U.S.-situated assets.

Gift tax rules with respect to expatriates

Special gift tax rules apply to individuals who relinquish their citizenship or long-term residency within the 10 years prior to the date of death, unless he or she did not have a tax avoidance purpose (as determined under the rules above). The individual is subject to gift tax on gifts of U.S.-situated intangibles made during the 10 years following citizenship relinquishment or residency termination.

Information reporting

Under present law, U.S. citizens who relinquish citizenship and long-term residents who terminate residency generally are required to provide information about their assets held at the time of expatriation. However, this information is only required once.

REASONS FOR CHANGE


The Committee believes there are several difficulties in administering the present-law alternative tax regime. One such difficulty is that the IRS is required to determine the subjective intent of taxpayers who relinquish citizenship or terminate residency. The present-law presumption of a tax-avoidance purpose in cases in which objective income tax liability or net worth thresholds are exceeded mitigates this problem to some extent. However, the present-law rules still require the IRS to make subjective determinations of intent in cases involving taxpayers who fall below these thresholds, as well for certain taxpayers who exceed these thresholds but are nevertheless allowed to seek a ruling from the IRS to the effect that they did not have a principal purpose of tax avoidance. The Committee believes that the replacement of the subjective determination of tax avoidance as a principal purpose for citizenship relinquishment or residency termination with objective rules will result in easier administration of the tax regime for individuals who relinquish their citizenship or terminate residency.

Similarly, present-law information-reporting and return-filing provisions do not provide the IRS with the information necessary to administer the alternative tax regime. Although individuals are required to file tax information statements upon the relinquishment of their citizenship or termination of their residency, difficulties have been encountered in enforcing this requirement. The Committee believes that the tax benefits of citizenship relinquishment or residency termination should be denied an individual until he or she provides the information necessary for the IRS to enforce the alternative tax regime. The Committee also believes an annual report requirement and a penalty for the failure to comply with such requirement are needed to provide the IRS with sufficient information to monitor the compliance of former U.S. citizens and long-term residents.

Individuals who relinquish citizenship or terminate residency for tax reasons often do not want to fully sever their ties with the United States; they hope to retain some of the benefits of citizenship or residency without being subject to the U.S. tax system as a U.S. citizen or resident. These individuals generally may continue to spend significant amounts of time in the United States following citizenship relinquishment or residency termination--approximately four months every year--without being treated as a U.S. resident. The Committee believes that provisions in the bill that impose full U.S. taxation if the individual is present in the United States for more than 30 days in a calendar year will substantially reduce the incentives to relinquish citizenship or terminate residency for individuals who desire to maintain significant ties to the United States.

With respect to the estate and gift tax rules, the Committee is concerned that present-law does not adequately address opportunities for the avoidance of tax on the value of assets held by a foreign corporation whose stock the individual transfers. Thus, the provision imposes gift tax under the alternative tax regime in the case of gifts of certain stock of a closely held foreign corporation.

EXPLANATION OF PROVISION


In general

The bill provides: (1) objective standards for determining whether former citizens or former long-term residents are subject to the alternative tax regime; (2) tax-based (instead of immigration-based) rules for determining when an individual is no longer a U.S. citizen or long-term resident for U.S. Federal tax purposes; (3) the imposition of full U.S. taxation for individuals who are subject to the alternative tax regime and who return to the United States for extended periods; (4) imposition of U.S. gift tax on gifts of stock of certain closely-held foreign corporations that hold U.S.-situated property; and (5) an annual return-filing requirement for individuals who are subject to the alternative tax regime, for each of the 10 years following citizenship relinquishment or residency termination. 216

 [Footnote]

[Footnote 216: These provisions reflect recommendations contained in Joint Committee on Taxation, Review of the Present Law Tax and Immigration Treatment of Relinquishment of Citizenship and Termination of Long-Term Residency, (JCS-2-03), February 2003.]

Objective rules for the alternative tax regime

The bill replaces the subjective determination of tax avoidance as a principal purpose for citizenship relinquishment or residency termination under present law with objective rules. Under the bill, a former citizen or former long-term resident would be subject to the alternative tax regime for a 10-year period following citizenship relinquishment or residency termination, unless the former citizen or former long-term resident: (1) establishes that his or her average annual net income tax liability for the five preceding years does not exceed $124,000 (adjusted for inflation after 2004) and his or her net worth does not exceed $2 million, or alternatively satisfies limited, objective exceptions for dual citizens and minors who have had no substantial contact with the United States; and (2) certifies under penalties of perjury that he or she has complied with all U.S. Federal tax obligations for the preceding five years and provides such evidence of compliance as the Secretary of the Treasury may require.

The monetary thresholds under the bill replace the present-law inquiry into the taxpayer's intent. In addition, the bill eliminates the present-law process of IRS ruling requests.

If a former citizen exceeds the monetary thresholds, that person is excluded from the alternative tax regime if he or she falls within the exceptions for certain dual citizens and minors (provided that the requirement of certification and proof of compliance with Federal tax obligations is met). These exceptions provide relief to individuals who have never had substantial connections with the United States, as measured by certain objective criteria, and eliminate IRS inquiries as to the subjective intent of such taxpayers.

In order to be excepted from the application of the alternative tax regime under the bill, whether by reason of falling below the net worth and income tax liability thresholds or qualifying for the dual-citizen or minor exceptions, the former citizen or former long-term resident also is required to certify, under penalties of perjury, that he or she has complied with all U.S. Federal tax obligations for the five years preceding the relinquishment of citizenship or termination of residency and to provide such documentation as the Secretary of the Treasury may require evidencing such compliance (e.g., tax returns, proof of tax payments). Until such time, the individual remains subject to the alternative tax regime. It is intended that the IRS will continue to verify that the information submitted was accurate, and it is intended that the IRS will randomly audit such persons to assess compliance.

Termination of U.S. citizenship or long-term resident status for U.S. Federal income tax purposes

Under the bill, an individual continues to be treated as a U.S. citizen or long-term resident for U.S. Federal tax purposes, including for purposes of section 7701(b)(10), until the individual: (1) gives notice of an expatriating act or termination of residency (with the requisite intent to relinquish citizenship or terminate residency) to the Secretary of State or the Secretary of Homeland Security, respectively; and (2) provides a statement in accordance with section 6039G.

Sanction for individuals subject to the individual tax regime who return to the United States for extended periods

The alternative tax regime does not apply to any individual for any taxable year during the 10-year period following citizenship relinquishment or residency termination if such individual is present in the United States for more than 30 days in the calendar year ending in such taxable year. Such individual is treated as a U.S. citizen or resident for such taxable year and therefore is taxed on his or her worldwide income.

Similarly, if an individual subject to the alternative tax regime is present in the United States for more than 30 days in any calendar year ending during the 10-year period following citizenship relinquishment or residency termination, and the individual dies during that year, he or she is treated as a U.S. resident, and the individual's worldwide estate is subject to U.S. estate tax. Likewise, if an individual subject to the alternative tax regime is present in the United States for more than 30 days in any year during the 10-year period following citizenship relinquishment or residency termination, the individual is subject to U.S. gift tax on any transfer of his or her worldwide assets by gift during that taxable year.

For purposes of these rules, an individual is treated as present in the United States on any day if such individual is physically present in the United States at any time during that day. The present-law exceptions from being treated as present in the United States for residency purposes 217

 [Footnote]  generally do not apply for this purpose. However, for individuals with certain ties to countries other than the United States 218

 [Footnote]  and individuals with minimal prior physical presence in the United States, 219

 [Footnote]  a day of physical presence in the United States is disregarded if the individual is performing services in the United States on such day for an unrelated employer (within the meaning of sections 267 and 707(b)), who meets the requirements the Secretary of the Treasury may prescribe in regulations. No more than 30 days may be disregarded during any calendar year under this rule.

[Footnote 217: Secs. 7701(b)(3)(D), 7701(b)(5) and 7701(b)(7)(B)-(D).]

[Footnote 218: An individual has such a relationship to a foreign country if the individual becomes a citizen or resident of the country in which (1) the individual becomes fully liable for income tax or (2) the individual was born, such individual's spouse was born, or either of the individual's parents was born.]

[Footnote 219:  An individual has a minimal prior physical presence in the United States if the individual was physically present for no more than 30 days during each year in the ten-year period ending on the date of loss of United States citizenship or termination of residency. However, an individual is not treated as being present in the United States on a day if (1) the individual is a teacher or trainee, a student, a professional athlete in certain circumstances, or a foreign government-related individual or (2) the individual remained in the United States because of a medical condition that arose while the individual was in the United States. Sec. 7701(b)(3)(D)(ii).]

Imposition of gift tax with respect to stock of certain closely held foreign corporations

Gifts of stock of certain closely-held foreign corporations by a former citizen or former long-term resident who is subject to the alternative tax regime are subject to gift tax under this bill, if the gift is made within the 10-year period after citizenship relinquishment or residency termination. The gift tax rule applies if: (1) the former citizen or former long-term resident, before making the gift, directly or indirectly owns 10 percent or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation; and (2) directly or indirectly, is considered to own more than 50 percent of (a) the total combined voting power of all classes of stock entitled to vote in the foreign corporation, or (b) the total value of the stock of such corporation. If this stock ownership test is met, then taxable gifts of the former citizen or former long-term resident include that proportion of the fair market value of the foreign stock transferred by the individual, at the time of the gift, which the fair market value of any assets owned by such foreign corporation and situated in the United States (at the time of the gift) bears to the total fair market value of all assets owned by such foreign corporation (at the time of the gift).

This gift tax rule applies to a former citizen or former long-term resident who is subject to the alternative tax regime and who owns stock in a foreign corporation at the time of the gift, regardless of how such stock was acquired (e.g., whether issued originally to the donor, purchased, or received as a gift or bequest).

Annual return

The bill requires former citizens and former long-term residents to file an annual return for each year following citizenship relinquishment or residency termination in which they are subject to the alternative tax regime. The annual return is required even if no U.S. Federal income tax is due. The annual return requires certain information, including information on the permanent home of the individual, the individual's country of residence, the number of days the individual was present in the United States for the year, and detailed information about the individual's income and assets that are subject to the alternative tax regime. This requirement includes information relating to foreign stock potentially subject to the special estate tax rule of section 2107(b) and the gift tax rules of this bill.

If the individual fails to file the statement in a timely manner or fails correctly to include all the required information, the individual is required to pay a penalty of $5,000. The $5,000 penalty does not apply if it is shown that the failure is due to reasonable cause and not to willful neglect.

EFFECTIVE DATE


The provision applies to individuals who relinquish citizenship or terminate long-term residency after June 3, 2004.

5. Reporting of taxable mergers and acquisitions (sec. 605 of the bill and new sec. 6043A of the Code)

PRESENT LAW


Under section 6045 and the regulations thereunder, brokers (defined to include stock transfer agents) are required to make information returns and to provide corresponding payee statements as to sales made on behalf of their customers, subject to the penalty provisions of sections 6721-6724. Under the regulations issued under section 6045, this requirement generally does not apply with respect to taxable transactions other than exchanges for cash (e.g., stock inversion transactions taxable to shareholders by reason of section 367(a)). 220

 [Footnote]

[Footnote 220: Recently issued temporary regulations under section 6043 (relating to information reporting with respect to liquidations, recapitalizations, and changes in control) impose information reporting requirements with respect to certain taxable inversion transactions, and proposed regulations would expand these requirements more generally to taxable transactions occurring after the proposed regulations are finalized.]

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


Under the bill, if gain or loss is recognized in whole or in part by shareholders of a corporation by reason of a second corporation's acquisition of the stock or assets of the first corporation, then the acquiring corporation (or the acquired corporation, if so prescribed by the Treasury Secretary) is required to make a return containing:









Alternatively, a stock transfer agent who records transfers of stock in such transaction may make the return described above in lieu of the second corporation.

In addition, every person required to make a return described above is required to furnish to each shareholder (or the shareholder's nominee 221

 [Footnote] ) whose name is required to be set forth in such return a written statement showing:

[Footnote 221: In the case of a nominee, the nominee must furnish the information to the shareholder in the manner prescribed by the Treasury Secretary.]







This written statement is required to be furnished to the shareholder on or before January 31 of the year following the calendar year during which the transaction occurred.

The present-law penalties for failure to comply with information reporting requirements are extended to failures to comply with the requirements set forth under this bill.

EFFECTIVE DATE


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

6. Studies (sec. 606 of the bill)

PRESENT LAW


Due to the variation in tax rates and tax systems among countries, a multinational enterprise, whether U.S.-based or foreign-based, may have an incentive to shift income, deductions, or tax credits in order to arrive at a reduced overall tax burden. Such a shifting of items could be accomplished by establishing artificial, non-arm's-length prices for transactions between group members.

Under section 482, the Treasury Secretary is authorized to reallocate income, deductions, or credits between or among two or more organizations, trades, or businesses under common control if he determines that such a reallocation is necessary to prevent tax evasion or to clearly reflect income. Treasury regulations adopt the arm's-length standard as the standard for determining whether such reallocations are appropriate. Thus, the regulations provide rules to identify the respective amounts of taxable income of the related parties that would have resulted if the parties had been uncontrolled parties dealing at arm's length. Transactions involving intangible property and certain services may present particular challenges to the administration of the arm's-length standard, because the nature of these transactions may make it difficult or impossible to compare them with third-party transactions.

In addition to the statutory rules governing the taxation of foreign income of U.S. persons and U.S. income of foreign persons, bilateral income tax treaties limit the amount of income tax that may be imposed by one treaty partner on residents of the other treaty partner. For example, treaties often reduce or eliminate withholding taxes imposed by a treaty country on certain types of income (e.g., dividends, interest and royalties) paid to residents of the other treaty country. Treaties also contain provisions governing the creditability of taxes imposed by the treaty country in which income was earned in computing the amount of tax owed to the other country by its residents with respect to such income. Treaties further provide procedures under which inconsistent positions taken by the treaty countries with respect to a single item of income or deduction may be mutually resolved by the two countries.

REASONS FOR CHANGE


The Committee believes that it is important to evaluate the effectiveness of the current transfer pricing rules and compliance efforts with respect to related-party transactions to ensure that income is not being shifted outside of the United States. The Committee also believes that it is necessary to review current U.S. income tax treaties to identify any inappropriate reductions in withholding tax rates that may create opportunities for shifting income outside the United States. In addition, the Committee believes that the impact of the provisions of this bill on inversion transactions should be studied.

EXPLANATION OF PROVISION


The bill requires the Treasury Secretary to conduct and submit to the Congress three studies. The first study will examine the effectiveness of the transfer pricing rules of section 482, with an emphasis on transactions involving intangible property. The second study will examine income tax treaties to which the United States is a party, with a view toward identifying any inappropriate reductions in withholding tax or opportunities for abuse that may exist. The third study will examine the impact of the provisions of this bill on inversion transactions.

EFFECTIVE DATE


The tax treaty study required under the provision is due no later than June 30, 2005. The transfer pricing study required under the provision is due no later than June 30, 2005. The inversions study required under the provision is due no later than December 31, 2005.

B. PROVISIONS RELATING TO TAX SHELTERS


1. Penalty for failure to disclose reportable transactions (sec. 611 of the bill and new sec. 6707A of the Code)

PRESENT LAW


Regulations under section 6011 require a taxpayer to disclose with its tax return certain information with respect to each `reportable transaction' in which the taxpayer participates. 222

 [Footnote]

[Footnote 222: On February 27, 2003, the Treasury Department and the IRS released final regulations regarding the disclosure of reportable transactions. In general, the regulations are effective for transactions entered into on or after February 28, 2003.]

The discussion of present law refers to the new regulations. The rules that apply with respect to transactions entered into on or before February 28, 2003, are contained in Treas. Reg. sec. 1.6011-4T in effect on the date the transaction was entered into.

There are six categories of reportable transactions. The first category is any transaction that is the same as (or substantially similar to) 223

 [Footnote]  a transaction that is specified by the Treasury Department as a tax avoidance transaction whose tax benefits are subject to disallowance under present law (referred to as a `listed transaction'). 224

 [Footnote]

[Footnote 223: The regulations clarify that the term `substantially similar' includes any transaction that is expected to obtain the same or similar types of tax consequences and that is either factually similar or based on the same or similar tax strategy. Further, the term must be broadly construed in favor of disclosure. Treas. Reg. sec. 1.6011-4(c)(4).]

[Footnote 224: Treas. Reg. sec. 1.6011-4(b)(2).]

The second category is any transaction that is offered under conditions of confidentiality. In general, a transaction is considered to be offered to a taxpayer under conditions of confidentiality if the advisor who is paid a minimum fee places a limitation on disclosure by the taxpayer of the tax treatment or tax structure of the transaction and the limitation on disclosure protects the confidentiality of that advisor's tax strategies (irrespective if such terms are legally binding). 225

 [Footnote]

[Footnote 225: Treas. Reg. sec. 1.6011-4(b)(3).]

The third category of reportable transactions is any transaction for which (1) the taxpayer has the right to a full or partial refund of fees if the intended tax consequences from the transaction are not sustained or, (2) the fees are contingent on the intended tax consequences from the transaction being sustained. 226

 [Footnote]

[Footnote 226: Treas. Reg. sec. 1.6011-4(b)(4).]

The fourth category of reportable transactions relates to any transaction resulting in a taxpayer claiming a loss (under section 165) of at least (1) $10 million in any single year or $20 million in any combination of years by a corporate taxpayer or a partnership with only corporate partners; (2) $2 million in any single year or $4 million in any combination of years by all other partnerships, S corporations, trusts, and individuals; or (3) $50,000 in any single year for individuals or trusts if the loss arises with respect to foreign currency translation losses. 227

 [Footnote]

[Footnote 227: Treas. Reg. sec. 1.6011-4(b)(5). Rev. Proc. 2003-24, 2003-11 I.R.B. 599, exempts certain types of losses from this reportable transaction category.]

The fifth category of reportable transactions refers to any transaction done by certain taxpayers 228

 [Footnote]  in which the tax treatment of the transaction differs (or is expected to differ) by more than $10 million from its treatment for book purposes (using generally accepted accounting principles) in any year. 229

 [Footnote]

[Footnote 228: The significant book-tax category applies only to taxpayers that are reporting companies under the Securities Exchange Act of 1934 or business entities that have $250 million or more in gross assets.]

[Footnote 229: Treas. Reg. sec. 1.6011-4(b)(6). Rev. Proc. 2003-25, 2003-11 I.R.B. 601, exempts certain types of transactions from this reportable transaction category.]

The final category of reportable transactions is any transaction that results in a tax credit exceeding $250,000 (including a foreign tax credit) if the taxpayer holds the underlying asset for less than 45 days. 230

 [Footnote]

[Footnote 230: Treas. Reg. sec. 1.6011-4(b)(7).]

Under present law, there is no specific penalty for failing to disclose a reportable transaction; however, such a failure can jeopardize a taxpayer's ability to claim that any income tax understatement attributable to such undisclosed transaction is due to reasonable cause, and that the taxpayer acted in good faith. 231

 [Footnote]

[Footnote 231: Section 6664(c) provides that a taxpayer can avoid the imposition of a section 6662 accuracy-related penalty in cases where the taxpayer can demonstrate that there was reasonable cause for the underpayment and that the taxpayer acted in good faith. Regulations under sections 6662 and 6664 provide that a taxpayer's failure to disclose a reportable transaction is a strong indication that the taxpayer failed to act in good faith, which would bar relief under section 6664(c).]

REASONS FOR CHANGE


The Committee believes that the best way to combat tax shelters is to be aware of them. The Treasury Department, using the tools available, issued regulations requiring disclosure of certain transactions and requiring organizers and promoters of tax-engineered transactions to maintain customer lists and make these lists available to the IRS. Nevertheless, the Committee believes that additional legislation is needed to provide the Treasury Department with additional tools to assist its efforts to curtail abusive transactions. Moreover, the Committee believes that a penalty for failing to make the required disclosures, when the imposition of such penalty is not dependent on the tax treatment of the underlying transaction ultimately being sustained, will provide an additional incentive for taxpayers to satisfy their reporting obligations under the new disclosure provisions.

EXPLANATION OF PROVISION


In general

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

Transactions to be disclosed

The provision does not define the terms `listed transaction' 232

 [Footnote]  or `reportable transaction,' nor does the provision explain the type of information that must be disclosed in order to avoid the imposition of a penalty. Rather, the provision authorizes the Treasury Department to define a `listed transaction' and a `reportable transaction' under section 6011.

[Footnote 232: The provision states that, except as provided in regulations, a listed transaction means a reportable transaction, which is the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction for purposes of section 6011. For this purpose, it is expected that the definition of `substantially similar' will be the definition used in Treas. Reg. sec. 1.6011-4(c)(4). However, the Secretary may modify this definition (as well as the definitions of `listed transaction' and `reportable transactions') as appropriate.]

Penalty rate

The penalty for failing to disclose a reportable transaction is $10,000 in the case of a natural person and $50,000 in any other case. The amount is increased to $100,000 and $200,000, respectively, if the failure is with respect to a listed transaction. The penalty cannot be waived with respect to a listed transaction. As to reportable transactions, the penalty can be rescinded (or abated) only if rescinding the penalty would promote compliance with the tax laws and effective tax administration. The authority to rescind the penalty can only be exercised by the IRS Commissioner personally. Thus, a revenue agent, an Appeals officer, or any other IRS personnel cannot rescind the penalty. The decision to rescind a penalty must be accompanied by a record describing the facts and reasons for the action and the amount rescinded. There will be no taxpayer right to appeal a refusal to rescind a penalty. 233

 [Footnote]  The IRS also is required to submit an annual report to Congress summarizing the application of the disclosure penalties and providing a description of each penalty rescinded under this provision and the reasons for the rescission.

[Footnote 233: This does not limit the ability of a taxpayer to challenge whether a penalty is appropriate (e.g., a taxpayer may litigate the issue of whether a transaction is a reportable transaction (and thus subject to the penalty if not disclosed) or not a reportable transaction (and thus not subject to the penalty)).]

EFFECTIVE DATE


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

2. Modifications to the accuracy-related penalties for listed transactions and reportable transactions having a significant tax avoidance purpose (sec. 612 of the bill and new sec. 6662A of the Code)

PRESENT LAW


The accuracy-related penalty applies to the portion of any underpayment that is attributable to (1) negligence, (2) any substantial understatement of income tax, (3) any substantial valuation misstatement, (4) any substantial overstatement of pension liabilities, or (5) any substantial estate or gift tax valuation understatement. If the correct income tax liability exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 ($10,000 in the case of corporations), then a substantial understatement exists and a penalty may be imposed equal to 20 percent of the underpayment of tax attributable to the understatement. 234

 [Footnote]  The amount of any understatement generally is reduced by any portion attributable to an item if (1) the treatment of the item is or was supported by substantial authority, or (2) facts relevant to the tax treatment of the item were adequately disclosed and there was a reasonable basis for its tax treatment. 235

 [Footnote]

[Footnote 234: Sec. 6662.]

[Footnote 235: Sec. 6662(d)(2)(B).]

Special rules apply with respect to tax shelters. 236

 [Footnote]  For understatements by non-corporate taxpayers attributable to tax shelters, the penalty may be avoided only if the taxpayer establishes that, in addition to having substantial authority for the position, the taxpayer reasonably believed that the treatment claimed was more likely than not the proper treatment of the item. This reduction in the penalty is unavailable to corporate tax shelters.

[Footnote 236: Sec. 6662(d)(2)(C).]

The understatement penalty generally is abated (even with respect to tax shelters) in cases in which the taxpayer can demonstrate that there was `reasonable cause' for the underpayment and that the taxpayer acted in good faith. 237

 [Footnote]  The relevant regulations provide that reasonable cause exists where the taxpayer `reasonably relies in good faith on an opinion based on a professional tax advisor's analysis of the pertinent facts and authorities [that] * * * unambiguously concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged' by the IRS. 238

 [Footnote]

[Footnote 237: Sec. 6664(c).]

[Footnote 238: Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 1.6664-4(c).]

REASONS FOR CHANGE


Because disclosure is so vital to combating abusive tax avoidance transactions, the Committee believes that taxpayers should be subject to a strict liability penalty on an understatement of tax that is attributable to non-disclosed listed transactions or non-disclosed reportable transactions that have a significant purpose of tax avoidance. Furthermore, in order to deter taxpayers from entering into tax avoidance transactions, the Committee believes that a more meaningful (but not a strict liability) accuracy-related penalty should apply to such transactions even when disclosed.

EXPLANATION OF PROVISION


In general

The provision modifies the present-law accuracy-related penalty by replacing the rules applicable to tax shelters with a new accuracy-related penalty that applies to listed transactions and reportable transactions with a significant tax avoidance purpose (hereinafter referred to as a `reportable avoidance transaction'). 239

 [Footnote]  The penalty rate and defenses available to avoid the penalty vary depending on whether the transaction was adequately disclosed.

[Footnote 239: The terms `reportable transaction' and `listed transaction' have the same meanings as used for purposes of the penalty for failing to disclose reportable transactions.]

Disclosed transactions

In general, a 20-percent accuracy-related penalty is imposed on any understatement attributable to an adequately disclosed listed transaction or reportable avoidance transaction. The only exception to the penalty is if the taxpayer satisfies a more stringent reasonable cause and good faith exception (hereinafter referred to as the `strengthened reasonable cause exception'), which is described below. The strengthened reasonable cause exception is available only if the relevant facts affecting the tax treatment are adequately disclosed, there is or was substantial authority for the claimed tax treatment, and the taxpayer reasonably believed that the claimed tax treatment was more likely than not the proper treatment.

Undisclosed transactions

If the taxpayer does not adequately disclose the transaction, the strengthened reasonable cause exception is not available (i.e., a strict-liability penalty applies), and the taxpayer is subject to an increased penalty rate equal to 30 percent of the understatement.

Determination of the understatement amount

The penalty is applied to the amount of any understatement attributable to the listed or reportable avoidance transaction without regard to other items on the tax return. For purposes of this provision, the amount of the understatement is determined as the sum of (1) the product of the highest corporate or individual tax rate (as appropriate) and the increase in taxable income resulting from the difference between the taxpayer's treatment of the item and the proper treatment of the item (without regard to other items on the tax return), 240

 [Footnote]  and (2) the amount of any decrease in the aggregate amount of credits which results from a difference between the taxpayer's treatment of an item and the proper tax treatment of such item.

[Footnote 240: For this purpose, any reduction in the excess of deductions allowed for the taxable year over gross income for such year, and any reduction in the amount of capital losses which would (without regard to section 1211) be allowed for such year, shall be treated as an increase in taxable income.]

Except as provided in regulations, a taxpayer's treatment of an item shall not take into account any amendment or supplement to a return if the amendment or supplement is filed after the earlier of when the taxpayer is first contacted regarding an examination of the return or such other date as specified by the Secretary.

Strengthened reasonable cause exception

A penalty is not imposed under the provision with respect to any portion of an understatement if it shown that there was reasonable cause for such portion and the taxpayer acted in good faith. Such a showing requires (1) adequate disclosure of the facts affecting the transaction in accordance with the regulations under section 6011, 241

 [Footnote]  (2) that there is or was substantial authority for such treatment, and (3) that the taxpayer reasonably believed that such treatment was more likely than not the proper treatment. For this purpose, a taxpayer will be treated as having a reasonable belief with respect to the tax treatment of an item only if such belief (1) is based on the facts and law that exist at the time the tax return (that includes the item) is filed, and (2) relates solely to the taxpayer's chances of success on the merits and does not take into account the possibility that (a) a return will not be audited, (b) the treatment will not be raised on audit, or (c) the treatment will be resolved through settlement if raised.

[Footnote 241: See the previous discussion regarding the penalty for failing to disclose a reportable transaction.]

A taxpayer may (but is not required to) rely on an opinion of a tax advisor in establishing its reasonable belief with respect to the tax treatment of the item. However, a taxpayer may not rely on an opinion of a tax advisor for this purpose if the opinion (1) is provided by a `disqualified tax advisor,' or (2) is a `disqualified opinion.'

Disqualified tax advisor

A disqualified tax advisor is any advisor who (1) is a material advisor 242

 [Footnote]  and who participates in the organization, management, promotion or sale of the transaction or is related (within the meaning of section 267(b) or 707(b)(1)) to any person who so participates, (2) is compensated directly or indirectly 243

 [Footnote]  by a material advisor with respect to the transaction, (3) has a fee arrangement with respect to the transaction that is contingent on all or part of the intended tax benefits from the transaction being sustained, or (4) as determined under regulations prescribed by the Secretary, has a disqualifying financial interest with respect to the transaction.

[Footnote 242: The term `material advisor' (defined below in connection with the new information filing requirements for material advisors) means any person who provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, or carrying out any reportable transaction, and who derives gross income in excess of $50,000 in the case of a reportable transaction substantially all of the tax benefits from which are provided to natural persons ($250,000 in any other case).]

[Footnote 243: This situation could arise, for example, when an advisor has an arrangement or understanding (oral or written) with an organizer, manager, or promoter of a reportable transaction that such party will recommend or refer potential participants to the advisor for an opinion regarding the tax treatment of the transaction.]

 Organization, management, promotion or sale of a transaction--A material advisor is considered as participating in the `organization' of a transaction if the advisor performs acts relating to the development of the transaction. This may include, for example, preparing documents (1) establishing a structure used in connection with the transaction (such as a partnership agreement), (2) describing the transaction (such as an offering memorandum or other statement describing the transaction), or (3) relating to the registration of the transaction with any federal, state or local government body. 244

 [Footnote]  Participation in the `management' of a transaction means involvement in the decision-making process regarding any business activity with respect to the transaction. Participation in the `promotion or sale' of a transaction means involvement in the marketing or solicitation of the transaction to others. Thus, an advisor who provides information about the transaction to a potential participant is involved in the promotion or sale of a transaction, as is any advisor who recommends the transaction to a potential participant.

[Footnote 244: An advisor should not be treated as participating in the organization of a transaction if the advisor's only involvement with respect to the organization of the transaction is the rendering of an opinion regarding the tax consequences of such transaction. However, such an advisor may be a `disqualified tax advisor' with respect to the transaction if the advisor participates in the management, promotion or sale of the transaction (or if the advisor is compensated by a material advisor, has a fee arrangement that is contingent on the tax benefits of the transaction, or as determined by the Secretary, has a continuing financial interest with respect to the transaction).]

Disqualified opinion

An opinion may not be relied upon if the opinion (1) is based on unreasonable factual or legal assumptions (including assumptions as to future events), (2) unreasonably relies upon representations, statements, finding or agreements of the taxpayer or any other person, (3) does not identify and consider all relevant facts, or (4) fails to meet any other requirement prescribed by the Secretary.

Coordination with other penalties

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

The penalty imposed under this provision shall not apply to any portion of an understatement to which a fraud penalty is applied under section 6663.

EFFECTIVE DATE


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

3. Tax shelter exception to confidentiality privileges relating to taxpayer communications (sec. 613 of the bill and sec. 7525 of the Code)

PRESENT LAW


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

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


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

EFFECTIVE DATE


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

4. Statute of limitations for unreported listed transactions (sec. 614 of the bill and sec. 6501 of the Code)

PRESENT LAW


In general, the Code requires that taxes be assessed within three years 245

 [Footnote]  after the date a return is filed. 246

 [Footnote]  If there has been a substantial omission of items of gross income that totals more than 25 percent of the amount of gross income shown on the return, the period during which an assessment must be made is extended to six years. 247

 [Footnote]  If an assessment is not made within the required time periods, the tax generally cannot be assessed or collected at any future time. Tax may be assessed at any time if the taxpayer files a false or fraudulent return with the intent to evade tax or if the taxpayer does not file a tax return at all. 248

 [Footnote]

[Footnote 245: Sec. 6501(a).]

[Footnote 246: For this purpose, a return that is filed before the date on which it is due is considered to be filed on the required due date (sec. 6501(b)(1)).]

[Footnote 247: Sec. 6501(e).]

[Footnote 248: Sec. 6501(c).]

REASONS FOR CHANGE


The Committee has noted that some taxpayers and their advisors have been employing dilatory tactics and failing to cooperate with the IRS in an attempt to avoid liability because of the expiration of the statute of limitations. The Committee accordingly believes that it is appropriate to extend the statute of limitations for unreported listed transactions.

EXPLANATION OF PROVISION


The provision extends the statute of limitations with respect to a listed transaction if a taxpayer fails to include on any return or statement for any taxable year any information with respect to a listed transaction 249

 [Footnote]  which is required to be included (under section 6011) with such return or statement. The statute of limitations with respect to such a transaction will not expire before the date which is one year after the earlier of (1) the date on which the Secretary is furnished the information so required, or (2) the date that a material advisor (as defined in 6111) satisfies the list maintenance requirements (as defined by section 6112) with respect to a request by the Secretary. For example, if a taxpayer engaged in a transaction in 2005 that becomes a listed transaction in 2007 and the taxpayer fails to disclose such transaction in the manner required by Treasury regulations, then the transaction is subject to the extended statute of limitations. 250

 [Footnote]

[Footnote 249: The term `listed transaction' has the same meaning as described in a previous provision regarding the penalty for failure to disclose reportable transactions.]

[Footnote 250: If the Treasury Department lists a transaction in a year subsequent to the year in which a taxpayer entered into such transaction and the taxpayer's tax return for the year the transaction was entered into is closed by the statute of limitations prior to the date the transaction became a listed transaction, this provision does not re-open the statute of limitations with respect to such transaction for such year. However, if the purported tax benefits of the transaction are recognized over multiple tax years, the provision's extension of the statute of limitations shall apply to such tax benefits in any subsequent tax year in which the statute of limitations had not closed prior to the date the transaction became a listed transaction.]

EFFECTIVE DATE


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

5. Disclosure of reportable transactions by material advisors (sec. 615 of the bill and secs. 6111 and 6707 of the Code)

PRESENT LAW


 Registration of tax shelter arrangements

An organizer of a tax shelter is required to register the shelter with the Secretary not later than the day on which the shelter is first offered for sale. 251

 [Footnote]  A `tax shelter' means any investment with respect to which the tax shelter ratio 252

 [Footnote]  for any investor as of the close of any of the first five years ending after the investment is offered for sale may be greater than two to one and which is: (1) required to be registered under Federal or State securities laws, (2) sold pursuant to an exemption from registration requiring the filing of a notice with a Federal or State securities agency, or (3) a substantial investment (greater than $250,000 and involving at least five investors). 253

 [Footnote]

[Footnote 251: Sec. 6111(a).]

[Footnote 252: The tax shelter ratio is, with respect to any year, the ratio that the aggregate amount of the deductions and 350 percent of the credits, which are represented to be potentially allowable to any investor, bears to the investment base (money plus basis of assets contributed) as of the close of the tax year.]

[Footnote 253: Sec. 6111(c).]

Other promoted arrangements are treated as tax shelters for purposes of the registration requirement if: (1) a significant purpose of the arrangement is the avoidance or evasion of Federal income tax by a corporate participant; (2) the arrangement is offered under conditions of confidentiality; and (3) the promoter may receive fees in excess of $100,000 in the aggregate. 254

 [Footnote]

[Footnote 254: Sec. 6111(d).]

In general, a transaction has a `significant purpose of avoiding or evading Federal income tax' if the transaction: (1) is the same as or substantially similar to a `listed transaction,' 255

 [Footnote]  or (2) is structured to produce tax benefits that constitute an important part of the intended results of the arrangement and the promoter reasonably expects to present the arrangement to more than one taxpayer. 256

 [Footnote]  Certain exceptions are provided with respect to the second category of transactions. 257

 [Footnote]

[Footnote 255: Treas. Reg. sec. 301.6111-2(b)(2).]

[Footnote 256: Treas. Reg. sec. 301.6111-2(b)(3).]

[Footnote 257: Treas. Reg. sec. 301.6111-2(b)(4).]

An arrangement is offered under conditions of confidentiality if: (1) an offeree has an understanding or agreement to limit the disclosure of the transaction or any significant tax features of the transaction; or (2) the promoter knows, or has reason to know, that the offeree's use or disclosure of information relating to the transaction is limited in any other manner. 258

 [Footnote]

[Footnote 258: The regulations provide that the determination of whether an arrangement is offered under conditions of confidentiality is based on all the facts and circumstances surrounding the offer. If an offeree's disclosure of the structure or tax aspects of the transaction are limited in any way by an express or implied understanding or agreement with or for the benefit of a tax shelter promoter, an offer is considered made under conditions of confidentiality, whether or not such understanding or agreement is legally binding. Treas. Reg. sec. 301.6111-2(c)(1).]

Failure to register tax shelter

The penalty for failing to timely register a tax shelter (or for filing false or incomplete information with respect to the tax shelter registration) generally is the greater of one percent of the aggregate amount invested in the shelter or $500. 259

 [Footnote]  However, if the tax shelter involves an arrangement offered to a corporation under conditions of confidentiality, the penalty is the greater of $10,000 or 50 percent of the fees payable to any promoter with respect to offerings prior to the date of late registration. Intentional disregard of the requirement to register increases the penalty to 75 percent of the applicable fees.

[Footnote 259: Sec. 6707.]

Section 6707 also imposes (1) a $100 penalty on the promoter for each failure to furnish the investor with the required tax shelter identification number, and (2) a $250 penalty on the investor for each failure to include the tax shelter identification number on a return.

REASONS FOR CHANGE


The Committee believes that providing a single, clear definition regarding the types of transactions that must be disclosed by taxpayers and material advisors, coupled with more meaningful penalties for failing to disclose such transactions, are necessary tools if the effort to curb the use of abusive tax avoidance transactions is to be effective.

EXPLANATION OF PROVISION


Disclosure of reportable transactions by material advisors

The provision repeals the present law rules with respect to registration of tax shelters. Instead, the provision requires each material advisor with respect to any reportable transaction (including any listed transaction) 260

 [Footnote]  to timely file an information return with the Secretary (in such form and manner as the Secretary may prescribe). The return must be filed on such date as specified by the Secretary.

[Footnote 260: The terms `reportable transaction' and `listed transaction' have the same meaning as previously described in connection with the taxpayer-related provisions.]

The information return will include (1) information identifying and describing the transaction, (2) information describing any potential tax benefits expected to result from the transaction, and (3) such other information as the Secretary may prescribe. It is expected that the Secretary may seek from the material advisor the same type of information that the Secretary may request from a taxpayer in connection with a reportable transaction. 261

 [Footnote]

[Footnote 261: See the previous discussion regarding the disclosure requirements under new section 6707A.]

A `material advisor' means any person (1) who provides material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, or carrying out any reportable transaction, and (2) who directly or indirectly derives gross income in excess of $250,000 ($50,000 in the case of a reportable transaction substantially all of the tax benefits from which are provided to natural persons) or such other amount as may be prescribed by the Secretary for such advice or assistance.

The Secretary may prescribe regulations which provide (1) that only one material advisor has to file an information return in cases in which two or more material advisors would otherwise be required to file information returns with respect to a particular reportable transaction, (2) exemptions from the requirements of this section, and (3) other rules as may be necessary or appropriate to carry out the purposes of this section (including, for example, rules regarding the aggregation of fees in appropriate circumstances).

Penalty for failing to furnish information regarding reportable transactions

The provision repeals the present-law penalty for failure to register tax shelters. Instead, the provision imposes a penalty on any material advisor who fails to file an information return, or who files a false or incomplete information return, with respect to a reportable transaction (including a listed transaction). 262

 [Footnote]  The amount of the penalty is $50,000. If the penalty is with respect to a listed transaction, the amount of the penalty is increased to the greater of (1) $200,000, or (2) 50 percent of the gross income of such person with respect to aid, assistance, or advice which is provided with respect to the transaction before the date the information return that includes the transaction is filed. Intentional disregard by a material advisor of the requirement to disclose a listed transaction increases the penalty to 75 percent of the gross income.

[Footnote 262: The terms `reportable transaction' and `listed transaction' have the same meaning as previously described in connection with the taxpayer-related provisions.]

The penalty cannot be waived with respect to a listed transaction. As to reportable transactions, the penalty can be rescinded (or abated) only in exceptional circumstances. 263

 [Footnote]  All or part of the penalty may be rescinded only if rescinding the penalty would promote compliance with the tax laws and effective tax administration. The authority to rescind the penalty can only be exercised by the Commissioner personally. Thus, a revenue agent, an Appeals officer, or other IRS personnel cannot rescind the penalty. The decision to rescind a penalty must be accompanied by a record describing the facts and reasons for the action and the amount rescinded. There will be no right to appeal a refusal to rescind a penalty. The IRS also is required to submit an annual report to Congress summarizing the application of the disclosure penalties and providing a description of each penalty rescinded under this provision and the reasons for the rescission.

[Footnote 263: The Secretary's present-law authority to postpone certain tax-related deadlines because of Presidentially-declared disasters (sec. 7508A) will also encompass the authority to postpone the reporting deadlines established by the provision.]

EFFECTIVE DATE


The provision requiring disclosure of reportable transactions by material advisors applies to transactions with respect to which material aid, assistance or advice is provided after the date of enactment.

The provision imposing a penalty for failing to disclose reportable transactions applies to returns the due date for which is after the date of enactment.

 6. Investor lists and modification of penalty for failure to maintain investor lists (secs. 616 and 617 of the bill and secs. 6112 and 6708 of the Code)

PRESENT LAW


Investor lists

 Any organizer or seller of a potentially abusive tax shelter must maintain a list identifying each person who was sold an interest in any such tax shelter with respect to which registration was required under section 6111 (even though the particular party may not have been subject to confidentiality restrictions). 264

 [Footnote]  Recently issued regulations under section 6112 contain rules regarding the list maintenance requirements. 265

 [Footnote]  In general, the regulations apply to transactions that are potentially abusive tax shelters entered into, or acquired after, February 28, 2003. 266

 [Footnote]

[Footnote 264: Sec. 6112.]

[Footnote 265: Treas. Reg. sec. 301.6112-1.]

[Footnote 266: A special rule applies the list maintenance requirements to transactions entered into after February 28, 2000 if the transaction becomes a listed transaction (as defined in Treas. Reg. 1.6011-4) after February 28, 2003.]

The regulations provide that a person is an organizer or seller of a potentially abusive tax shelter if the person is a material advisor with respect to that transaction. 267

 [Footnote]  A material advisor is defined as any person who is required to register the transaction under section 6111, or expects to receive a minimum fee of (1) $250,000 for a transaction that is a potentially abusive tax shelter if all participants are corporations, or (2) $50,000 for any other transaction that is a potentially abusive tax shelter. 268

 [Footnote]  For listed transactions (as defined in the regulations under section 6011), the minimum fees are reduced to $25,000 and $10,000, respectively.

[Footnote 267: Treas. Reg. sec. 301.6112-1(c)(1).]

[Footnote 268: Treas. Reg. sec. 301.6112-1(c)(2) and (3).]

A potentially abusive tax shelter is any transaction that (1) is required to be registered under section 6111, (2) is a listed transaction (as defined under the regulations under section 6011), or (3) any transaction that a potential material advisor, at the time the transaction is entered into, knows is or reasonably expects will become a reportable transaction (as defined under the new regulations under section 6011). 269

 [Footnote]

[Footnote 269: Treas. Reg. sec. 301.6112-1(b).]

The Secretary is required to prescribe regulations which provide that, in cases in which two or more persons are required to maintain the same list, only one person would be required to maintain the list. 270

 [Footnote]

[Footnote 270: Sec. 6112(c)(2).]

Penalty for failing to maintain investor lists

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

REASONS FOR CHANGE


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

EXPLANATION OF PROVISION


Investor lists

Each material advisor 271

 [Footnote]  with respect to a reportable transaction (including a listed transaction) 272

 [Footnote]  is required to maintain a list that (1) identifies each person with respect to whom the advisor acted as a material advisor with respect to the reportable transaction, and (2) contains other information as may be required by the Secretary. In addition, the provision authorizes (but does not require) the Secretary to prescribe regulations which provide that, in cases in which two or more persons are required to maintain the same list, only one person would be required to maintain the list.

[Footnote 271: The term `material advisor' has the same meaning as when used in connection with the requirement to file an information return under section 6111.]

[Footnote 272: The terms `reportable transaction' and `listed transaction' have the same meaning as previously described in connection with the taxpayer-related provisions.]

The provision also clarifies that, for purposes of section 6112, the identity of any person is not privileged under the common law attorney-client privilege (or, consequently, the section 7525 federally authorized tax practitioner confidentiality provision).

Penalty for failing to maintain investor lists

The provision modifies the penalty for failing to maintain the required list by making it a time-sensitive penalty. Thus, a material advisor who is required to maintain an investor list and who fails to make the list available upon written request by the Secretary within 20 business days after the request will be subject to a $10,000 per day penalty. The penalty applies to a person who fails to maintain a list, maintains an incomplete list, or has in fact maintained a list but does not make the list available to the Secretary. The penalty can be waived if the failure to make the list available is due to reasonable cause. 273

 [Footnote]

[Footnote 273: In no event will failure to maintain a list be considered reasonable cause for failing to make a list available to the Secretary.]

EFFECTIVE DATE


The provision requiring a material advisor to maintain an investor list applies to transactions with respect to which material aid, assistance or advice is provided after the date of enactment.

The provision imposing a penalty for failing to maintain investor lists applies to requests made after the date of enactment.

The provision clarifying that the identity of any person is not privileged for purposes of section 6112 is effective as if included in the amendments made by section 142 of the Deficit Reduction Act of 1984.

7. Penalty on promoters of tax shelters (sec. 618 of the bill and sec. 6700 of the Code)

PRESENT LAW


A penalty is imposed on any person who organizes, assists in the organization of, or participates in the sale of any interest in, a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, if in connection with such activity the person makes or furnishes a qualifying false or fraudulent statement or a gross valuation overstatement. 274

 [Footnote]  A qualified false or fraudulent statement is any statement with respect to the allowability of any deduction or credit, the excludability of any income, or the securing of any other tax benefit by reason of holding an interest in the entity or participating in the plan or arrangement which the person knows or has reason to know is false or fraudu