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S. Rept. 108-192 - JUMPSTART OUR BUSINESS STRENGTH (JOBS) ACT108th Congress (2003-2004)

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Report Type:	Senate Report
Accompanies:	S.1637
Committees:	Finance

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

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JUMPSTART OUR BUSINESS STRENGTH (JOBS) ACT

_______

November 7, 2003.--Ordered to be printed

_______

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

R E P O R T

together with

ADDITIONAL AND MINORITY VIEWS

[To accompany S. 1637]

[Including cost estimate of the Congressional Budget Office]

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

CONTENTS

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

I. LEGISLATIVE BACKGROUND

OVERVIEW

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

HEARINGS

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

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

A. Repeal of Extraterritorial Income Regime

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

In general

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

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

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

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

EFFECTIVE DATE

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

TITLE II--INTERNATIONAL TAX PROVISIONS

A. International Tax Reform

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

PRESENT LAW

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

U.S. persons may credit foreign taxes against U.S. tax on
foreign-source income. In general, the amount of foreign tax
credits that may be claimed in a year is subject to a
limitation that prevents taxpayers from using foreign tax
credits to offset U.S. tax on U.S.-source income. Separate
limitations are also applied to specific categories of income.
Special foreign tax credit limitations apply in the case of
dividends received from a foreign corporation in which the
taxpayer owns at least 10 percent of the stock by vote and
which is not a controlled foreign corporation (a so-called
``10/50 company''). Dividends paid by a 10/50 company that is
not a passive foreign investment company out of earnings and
profits accumulated in taxable years beginning before January
1, 2003 are subject to a single foreign tax credit limitation
for all 10/50 companies (other than passive foreign investment
companies).\16\ Dividends paid by a 10/50 company that is a
passive foreign investment company out of earnings and profits
accumulated in taxable years beginning before January 1, 2003,
continue to be subject to a separate foreign tax credit
limitation for each such 10/50 company. Dividends paid by a 10/
50 company out of earnings and profits accumulated in taxable
years after December 31, 2002 are treated as income in a
foreign tax credit limitation category in proportion to the
ratio of the 10/50 company's earnings and profits attributable
to income in such foreign tax credit limitation category to its
total earnings and profits (a ``look-through'' approach).
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\16\ Dividends paid by a 10/50 company in taxable years beginning
before January 1, 2003 are subject to a separate foreign tax credit
limitation for each 10/50 company.
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For these purposes, distributions are treated as made from
the most recently accumulated earnings and profits. Regulatory
authority is granted to provide rules regarding the treatment
of distributions out of earnings and profits for periods prior
to the taxpayer's acquisition of such stock.

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

In general

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

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

In general

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

Financial institution group election

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

EFFECTIVE DATE

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

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

PRESENT LAW

Subpart F foreign personal holding company income

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

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

B. International Tax Simplification

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

Nonresident individuals who are not U.S. citizens and
foreign corporations (collectively, foreign persons) are
subject to U.S. tax on income that is effectively connected
with the conduct of a U.S. trade or business; the U.S. tax on
such income is calculated in the same manner and at the same
graduated rates as the tax on U.S. persons (secs. 871(b) and
882). Foreign persons also are subject to a 30-percent gross
basis tax, collected by withholding, on certain U.S.-source
passive income (e.g., interest and dividends) that is not
effectively connected with a U.S. trade or business. This 30-
percent withholding tax may be reduced or eliminated pursuant
to an applicable tax treaty. Foreign persons generally are not
subject to U.S. tax on foreign-source income that is not
effectively connected with a U.S. trade or business.
In general, dividends paid by a domestic corporation are
treated as being from U.S. sources and dividends paid by a
foreign corporation are treated as being from foreign sources.
Thus, dividends paid by foreign corporations to foreign persons
generally are not subject to withholding tax because such
income generally is treated as foreign-source income.
An exception from this general rule applies in the case of
dividends paid by certain foreign corporations. If a foreign
corporation derives 25 percent or more of its gross income as
income effectively connected with a U.S. trade or business for
the three-year period ending with the close of the taxable year
preceding the declaration of a dividend, then a portion of any
dividend paid by the foreign corporation to its shareholders
will be treated as U.S.-source income and, in the case of
dividends paid to foreign shareholders, will be subject to the
30-percent withholding tax (sec. 861(a)(2)(B)). This rule is
sometimes referred to as the ``secondary withholding tax.'' The
portion of the dividend treated as U.S.-source income is equal
to the ratio of the gross income of the foreign corporation
that was effectively connected with its U.S. tradeor business
over the total gross income of the foreign corporation during the
three-year period ending with the close of the preceding taxable year.
The U.S.-source portion of the dividend paid by the foreign corporation
to its foreign shareholders is subject to the 30-percent withholding
tax.
Under the branch profits tax provisions, the United States
taxes foreign corporations engaged in a U.S. trade or business
on amounts of U.S. earnings and profits that are shifted out of
the U.S. branch of the foreign corporation. The branch profits
tax is comparable to the second-level taxes imposed on
dividends paid by a domestic corporation to its foreign
shareholders. The branch profits tax is 30 percent of the
foreign corporation's ``dividend equivalent amount,'' which
generally is the earnings and profits of a U.S. branch of a
foreign corporation attributable to its income effectively
connected with a U.S. trade or business (secs. 884(a) and (b)).
If a foreign corporation is subject to the branch profits
tax, then no secondary withholding tax is imposed on dividends
paid by the foreign corporation to its shareholders (sec.
884(e)(3)(A)). If a foreign corporation is a qualified resident
of a tax treaty country and claims an exemption from the branch
profits tax pursuant to the treaty, the secondary withholding
tax could apply with respect to dividends it pays to its
shareholders. Several tax treaties (including treaties that
prevent imposition of the branch profits tax), however, exempt
dividends paid by the foreign corporation from the secondary
withholding tax.

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

C. Additional International Tax Provisions

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

The provision is effective on the date of enactment.

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

The provision is effective on the date of enactment.

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

PRESENT LAW

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

REASON FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

The provision would be effective on the date of enactment.

TITLE III--DOMESTIC MANUFACTURING AND BUSINESS PROVISIONS

A. Domestic Manufacturing and Business Provisions

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

B. Manufacturing Relating to Films

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

Depreciation

Income forecast method of depreciation

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

C. Manufacturing Relating to Timber

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

PRESENT LAW

Amortization of reforestation costs (sec. 194)

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

Reforestation tax credit (sec. 48(b))

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

REASONS FOR CHANGE

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

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

The provision is effective on date of enactment.

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

In general

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

Income or loss from prohibited transactions

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

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

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

TITLE IV--ADDITIONAL PROVISIONS

A. Provisions Designed to Curtail Tax Shelters

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

PRESENT LAW

In general

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

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

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

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

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

EXPLANATION OF PROVISION

In general

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

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

Non-tax business purpose

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

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

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

Other rules

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

In general

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

Transactions to be disclosed

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

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

EFFECTIVE DATE

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

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

PRESENT LAW

The accuracy-related penalty applies to the portion of any
underpayment that is attributable to: (1) negligence; (2) any
substantial understatement of income tax; (3) any substantial
valuation misstatement; (4) any substantial overstatement of
pension liabilities; or (5) any substantial estate or gift tax
valuation understatement. If the correct income tax liability
exceeds that reported by the taxpayer by the greater of 10
percent of the correct tax or $5,000 ($10,000 in the case of
corporations), then a substantial understatement exists and a
penalty may be imposed equal to 20 percent of the underpayment
of tax attributable to the understatement.\143\ The amount of
any understatement generally is reduced by any portion
attributable to an item if: (1) the treatment of the item is or
was supported by substantial authority; or (2) facts relevant
to the tax treatment of the item were adequately disclosed and
there was a reasonable basis for its tax treatment.\144\
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\143\ Sec. 6662.
\144\ Sec. 6662(d)(2)(B).
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Special rules apply with respect to tax shelters.\145\ For
understatements by non-corporate taxpayers attributable to tax
shelters, the penalty may be avoided only if the taxpayer
establishes that, in addition to having substantial authority
for the position, the taxpayer reasonably believed that the
treatment claimed was more likely than not the proper treatment
of the item. This reduction in the penalty is unavailable to
corporate tax shelters.
---------------------------------------------------------------------------
\145\ Sec. 6662(d)(2)(C).
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The understatement penalty generally is abated (even with
respect to tax shelters) in cases in which the taxpayer can
demonstrate that there was ``reasonable cause'' for the
underpayment and that the taxpayer acted in good faith.\146\
The relevant regulations provide that reasonable cause exists
where the taxpayer ``reasonably relies in good faith on an
opinion based on a professional tax advisor's analysis of the
pertinent facts and authorities [that] * * * unambiguously
concludes that there is a greater than 50-percent likelihood
that the tax treatment of the item will be upheld if
challenged'' by the IRS.\147\
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\146\ Sec. 6664(c).
\147\ Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec.
1.6664-4(c).
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REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

In general

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

Determination of the understatement amount

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

Strengthened reasonable cause exception

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

Coordination with other penalties

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

EFFECTIVE DATE

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

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

PRESENT LAW

An accuracy-related penalty applies to the portion of any
underpayment that is attributable to: (1) negligence; (2) any
substantial understatement of income tax; (3) any substantial
valuation misstatement; (4) any substantial overstatement of
pension liabilities; or (5) any substantial estate or gift tax
valuation understatement. If the correct income tax liability
exceeds that reported by the taxpayer by the greater of 10
percent of the correct tax or $5,000 ($10,000 in the case of
corporations), then a substantial understatement exists and a
penalty may be imposed equal to 20 percent of the underpayment
of tax attributable to the understatement.\154\ The amount of
any understatement is reduced by any portion attributable to an
item if: (1) the treatment of the item is supported by
substantial authority; or (2) facts relevant to the tax
treatment of the item were adequately disclosed and there was a
reasonable basis for its tax treatment.
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\154\ Sec. 6662.
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Special rules apply with respect to tax shelters.\155\ For
understatements by non-corporate taxpayers attributable to tax
shelters, the penalty may be avoided only if the taxpayer
establishes that, in addition to having substantial authority
for the position, the taxpayer reasonably believed that the
treatment claimed was more likely than not the proper treatment
of the item. This reduction in the penalty is unavailable to
corporate tax shelters.
---------------------------------------------------------------------------
\155\ Sec. 6662(d)(2)(C).
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The penalty generally is abated (even with respect to tax
shelters) in cases in which the taxpayer can demonstrate that
there was ``reasonable cause'' for the underpayment and that
the taxpayer acted in good faith.\156\ The relevant regulations
provide that reasonable cause exists where the taxpayer
``reasonably relies in good faith on an opinion based on a
professional tax advisor's analysis of the pertinent facts and
authorities [that] * * * unambiguously concludes that there is
a greater than 50-percent likelihood that the tax treatment of
the item will be upheld if challenged'' by the IRS.\157\
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\156\ Sec. 6664(c).
\157\ Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec.
1.6664-4(c).
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REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

Definition of substantial understatement

An accuracy-related penalty equal to 20 percent applies to
any substantial understatement of tax. A ``substantial
understatement'' exists if the correct income tax liability for
a taxable year exceeds that reported by the taxpayer by the
greater of 10 percent of the correct tax or $5,000 ($10,000 in
the case of most corporations).\162\
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\162\ Sec. 6662(a) and (d)(1)(A).
---------------------------------------------------------------------------

Reduction of understatement for certain positions

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

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

EXPLANATION OF PROVISION

Definition of substantial understatement

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

Reduction of understatement for certain positions

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

Registration of tax shelter arrangements

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

Failure to register tax shelter

The penalty for failing to timely register a tax shelter
(or for filing false or incomplete information with respect to
the tax shelter registration) generally is the greater of one
percent of the aggregate amount invested in the shelter or
$500.\173\ However, if the tax shelter involves an arrangement
offered to a corporation under conditions of confidentiality,
the penalty is the greater of $10,000 or 50 percent of the fees
payable to any promoter with respect to offerings prior to the
date of late registration. Intentional disregard of the
requirement to register increases the penalty to 75 percent of
the applicable fees.
---------------------------------------------------------------------------
\173\ Sec. 6707.
---------------------------------------------------------------------------
Section 6707 also imposes: (1) a $100 penalty on the
promoter for each failure to furnish the investor with the
required tax shelter identification number; and (2) a $250
penalty on the investor for each failure to include the tax
shelter identification number on a return.

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

Disclosure of reportable transactions by material advisors

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

Penalty for failing to furnish information regarding reportable
transactions

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

EFFECTIVE DATE

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

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

PRESENT LAW

Investor lists

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

Penalty for failing to maintain investor lists

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

Investor lists

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

Penalty for failing to maintain investor lists

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

The provision is effective on the date of enactment.

B. Other Corporate Governance Provisions

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

PRESENT LAW

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

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

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

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

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE.

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

Attempt to evade or defeat tax

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

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

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

Fraud and false statements

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

Uniform sentencing guidelines

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

Attempt to evade or defeat tax

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

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

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

Fraud and false statements

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

EFFECTIVE DATE

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

C. Enron-Related Tax Shelter Provisions

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

Importation of built-in losses

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

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

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

EFFECTIVE DATE

The provision applies to transactions after February 13,
2003.

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

PRESENT LAW

In general

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

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

Election to adjust basis of partnership property

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

The provision applies to distributions after February 13,
2003.

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

PRESENT LAW

Financial asset securitization investment trusts

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

Real estate mortgage investment conduits

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

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

EFFECTIVE DATE

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

D. Provisions To Discourage Expatriation

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

PRESENT LAW

Determination of corporate residence

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

U.S. taxation of domestic corporations

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

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

U.S. tax treatment of inversion transactions

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

In general

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

Transactions involving at least 80 percent identity of stock ownership

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

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

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

Partnership transactions

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

EFFECTIVE DATE

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

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

PRESENT LAW

In general

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

Income tax rules with respect to expatriates

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

Estate tax rules with respect to expatriates

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

Gift tax rules with respect to expatriates

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

Other tax rules with respect to expatriates

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

Immigration rules with respect to expatriates

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

In general

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

Individuals covered

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

Election to be treated as a U.S. citizen

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

Date of relinquishment of citizenship

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

Deemed sale of property upon expatriation or residency termination

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

Retirement plans and similar arrangements

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

Deferral of payment of tax

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

Interests in trusts

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

Coordination with present-law alternative tax regime

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

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

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

Information reporting

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

Immigration rules

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

E. International Tax

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

This provision is effective on the date of enactment.

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

PRESENT LAW

A U.S. corporation owned by foreign persons is subject to
U.S. income tax on its net income. In addition, the earnings of
the U.S. corporation are subject to a second tax, when
dividends are paid to the corporation's shareholders.
In general, dividends paid by a U.S. corporation to
nonresident alien individuals and foreign corporations that are
not effectively connected with a U.S. trade or business are
subject to a U.S. withholding tax on the gross amount of such
income at a rate of 30 percent. The 30-percent withholding tax
may be reduced pursuant to an income tax treaty between the
United States and the foreign country where the foreign person
is resident.
In addition, the United States imposes a branch profits tax
on U.S. earnings of a foreign corporation that are shifted out
of a U.S. branch of the foreign corporation. The branch profits
tax is comparable to the second-level taxes imposed on
dividends paid by a U.S. corporation to foreign shareholders.
The branch profits tax is 30 percent (subject to possible
income tax treaty reduction) of a foreign corporation's
dividend equivalent amount. The ``dividend equivalent amount''
generally is the earnings and profits of a U.S. branch of a
foreign corporation attributable to its income effectively
connected with a U.S. trade or business.
In general, U.S. withholding tax is not imposed with
respect to a distribution of a U.S. corporation's earnings to a
foreign corporation in complete liquidation of the subsidiary,
because the distribution is treated as made in exchange for
stock and not as a dividend. In addition, detailed rules apply
for purposes of exempting foreign corporations from the branch
profits tax for the year in which it completely terminates its
U.S. business conducted in branch form. The exemption from the
branch profits tax generally applies if, among other things,
for three years after the termination of the U.S. branch, the
foreign corporation has no income effectively connected with a
U.S. trade or business, and the U.S. assets of the terminated
branch are not used by the foreign corporation or a related
corporation in a U.S. trade or business.
Regulations under section 367(e) provide that the
Commissioner may require a domestic liquidating corporation to
recognize gain on distributions in liquidation made to a
foreign corporation if a principal purpose of the liquidation
is the avoidance of U.S. tax. Avoidance of U.S. tax for this
purpose includes, but is not limited to, the distribution of a
liquidating corporation's earnings and profits with a principal
purpose of avoiding U.S. tax.

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

Income earned by a foreign corporation from its foreign
operations generally is subject to U.S. tax only when such
income is distributed to any U.S. person that holds stock in
such corporation. Accordingly, a U.S. person that conducts
foreign operations through a foreign corporation generally is
subject to U.S. tax on the income from such operations when the
income is repatriated to the United States through a dividend
distribution to the U.S. person. The income is reported on the
U.S. person's tax return for the year the distribution is
received, and the United States imposes tax on such income at
that time. However, certain anti-deferral regimes may cause the
U.S. person to be taxed on a current basis in the United States
with respect to certain categories of passive or highly mobile
income earned by the foreign corporations in which the U.S.
person holds stock. The main anti-deferral regimes are the
controlled foreign corporation rules of subpart F (sections
951-964), the passive foreign investment company rules
(sections 1291-1298), and the foreign personal holding company
rules (sections 551-558).
As a general rule, there is allowed as a deduction all
interest paid or accrued within the taxable year with respect
to indebtedness, including the aggregate daily portions of
original issue discount (``OID'') of the issuer for the days
during such taxable year.\306\ However, if a debt instrument is
held by a related foreign person, any portion of such OID is
not allowable as a deduction to the payor of such instrument
until paid (``related-foreign-person rule''). This related-
foreign-person rule does not apply to the extent that the OID
is effectively connected with the conduct by such foreign
related person of a trade or business within the United States
(unless such OID is exempt from taxation or is subject to a
reduced rate of taxation under a treaty obligation).\307\
Treasury regulations further modify the related-foreign-person
rule by providing that in the case of a debt owed to a foreign
personal holding company (``FPHC''), controlled foreign
corporation (``CFC'') or passive foreign investment company
(``PFIC''), a deduction is allowed for OID as of the day on
which the amount is includible in the income of the FPHC, CFC
or PFIC, respectively.\308\
---------------------------------------------------------------------------
\306\ Section 163(e)(1).
\307\ Section 163(e)(3).
\308\ Treas. Reg. sec. 1.163-12(b)(3). In the case of a PFIC, the
regulations further require that the person owing the amount at issue
has in effect a qualified electing fund election pursuant to section
1295 with respect to the PFIC.
---------------------------------------------------------------------------
In the case of unpaid stated interest and expenses of
related persons, where, by reason of a payee's method of
accounting, an amount is not includible in the payee's gross
income until it is paid but the unpaid amounts are deductible
currently by the payor, the amount generally is allowable as a
deduction when such amount is includible in the gross income of
the payee.\309\ With respect to stated interest and other
expenses owed to related foreign corporations, Treasury
regulations provide a general rule that requires a taxpayer to
use the cash method of accounting with respect to the deduction
of amounts owed to such related foreign persons (with an
exception for income of a related foreign person that is
effectively connected with the conduct of a U.S. trade or
business and that is not exempt from taxation or subject to a
reduced rate of taxation under a treaty obligation).\310\ As in
the case of OID, the Treasury regulations additionally provide
that in the case of stated interest owed to a FPHC, CFC, or
PFIC, a deduction is allowed as of the day on which the amount
is includible in the income of the FPHC, CFC or PFIC.\311\
---------------------------------------------------------------------------
\309\ Section 267(a)(2).
\310\ Treas. Reg. sec. 1.267(a)-3(b)(1), (c).
\311\ Treas. Reg. sec. 1.267(a)-3(c)(4).
---------------------------------------------------------------------------

REASONS FOR CHANGE

The special rules in the Treasury regulations for FPHCs,
CFCs and PFICs are an exception to the general rule that OID
and unpaid interest owed to a related foreign person are
deductible when paid (i.e., under a cash method). These special
rules were deemed appropriate in the case of FPHCs, CFCs and
PFICs because it was thought that there would be little
material distortion in matching of income and deductions with
respect to amounts owed to a related foreign corporation that
is required to determine its taxable income and earnings and
profits for U.S. tax purposes pursuant to the FPHC, subpart F
or PFIC provisions. The Committee believes that this premise
fails to take into account the situation where amounts owed to
the related foreign corporation are included in the income of
the related foreign corporation but are not currently included
in the income of the related foreign corporation's U.S.
shareholders. Consequently, under the Treasury regulations,
both the U.S. payors and U.S.-owned foreign payors may be able
to accrue deductions for amounts owed to related FPHCs, CFCs or
PFICs without the U.S. owners of such related entities taking
into account for U.S. tax purposes a corresponding amount of
income. These deductions can be used to reduce U.S. income or,
in the case of a U.S.-owned foreign payor, to reduce earnings
and profits which could reduce a CFC's income that would be
currently taxable to its U.S. shareholders under subpart F.

EXPLANATION OF PROVISION

The provision provides that deductions for amounts accrued
but unpaid (whether by U.S. or foreign persons) to related
FPHCs, CFCs, or PFICs are allowable only to the extent that the
amounts accrued by the payor are, for U.S. tax purposes,
currently included in the income of all of the direct or
indirect U.S. owners of the related foreign person under the
relevant inclusion rules. Deductions that have accrued but are
not allowable under this provision are allowed when the amounts
are paid. The provision grants the Secretary regulatory
authority to provide exceptions to these rules, including an
exception for amounts accrued where payment of the amount
accrued occurs within a short period after accrual, and the
transaction giving rise to the payment is entered into by the
payor in the ordinary course of a business in which the payor
is predominantly engaged.

EFFECTIVE DATE

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

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

PRESENT LAW

Nonresident alien individuals and foreign corporations
(collectively, foreign persons) are subject to U.S. tax on
income that is effectively connected with the conduct of a U.S.
trade or business; the U.S. tax on such income is calculated in
the same manner and at the same graduated rates as the tax on
U.S. persons.\312\ Foreign persons also are subject to a 30-
percent gross-basis tax, collected by withholding, on certain
U.S.-source income, such as interest, dividends and other fixed
or determinable annual or periodical (``FDAP'') income, that is
not effectively connected with a U.S. trade or business. This
30-percent withholding tax may be reduced or eliminated
pursuant to an applicable tax treaty. Foreign persons generally
are not subject to U.S. tax on foreign-source income that is
not effectively connected with a U.S. trade or business.
---------------------------------------------------------------------------
\312\ Sections 871(b) and 882.
---------------------------------------------------------------------------
Detailed rules apply for purposes of determining whether
income is treated as effectively connected with a U.S. trade or
business (so-called ``U.S.-effectively connected
income'').\313\ The rules differ depending on whether the
income at issue is U.S.-source or foreign-source income. Under
these rules, U.S.-source FDAP income, such as U.S.-source
interest and dividends, and U.S.-source capital gains are
treated as U.S.-effectively connected income if such income is
derived from assets used in or held for use in the active
conduct of a U.S. trade or business, or from business
activities conducted in the United States. All other types of
U.S.-source income are treated as U.S.-effectively connected
income (sometimes referred to as the ``force of attraction
rule'').
---------------------------------------------------------------------------
\313\ Section 864(c).
---------------------------------------------------------------------------
In general, foreign-source income is not treated as U.S.-
effectively connected income.\314\ However, foreign-source
income, gain, deduction, or loss generally is considered to be
effectively connected with a U.S. business only if the person
has an office or other fixed place of business within the
United States to which such income, gain, deduction, or loss is
attributable and such income falls into one of three categories
described below.\315\ For these purposes, income generally is
not considered attributable to an office or other fixed place
of business within the United States unless such office or
fixed place of business is a material factor in the production
of the income, and such office or fixed place of business
regularly carries on activities of the type that generate such
income.\316\
---------------------------------------------------------------------------
\314\ Section 864(c)(4).
\315\ Section 864(c)(4)(B).
\316\ Section 864(c)(5).
---------------------------------------------------------------------------
The first category consists of rents or royalties for the
use of patents, copyrights, secret processes, or formulas, good
will, trademarks, trade brands, franchises, or other similar
intangible properties derived in the active conduct of the U.S.
trade or business.\317\ The second category consists of
interest or dividends derived in the active conduct of a
banking, financing, or similar business within the United
States, or received by a corporation whose principal business
is trading in stocks or securities for its own account.\318\
Notwithstanding the foregoing, foreign-source income consisting
of dividends, interest, or royalties is not treated as
effectively connected if the items are paid by a foreign
corporation in which the recipient owns, directly, indirectly,
or constructively, more than 50 percent of the total combined
voting power of the stock.\319\ The third category consists of
income, gain, deduction, or loss derived from the sale or
exchange of inventory or property held by the taxpayer
primarily for sale to customers in the ordinary course of the
trade or business where the property is sold or exchanged
outside the United States through the foreign person's U.S.
office or other fixed place of business.\320\ Such amounts are
not treated as effectively connected if the property is sold or
exchanged for use, consumption, or disposition outside the
United States and an office or other fixed place of business of
the taxpayer in a foreign country materially participated in
the sale or exchange.
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\317\ Section 864(c)(4)(B)(i).
\318\ Section 864(c)(4)(B)(ii).
\319\ Section 864(c)(4)(D)(i).
\320\ Section 864(c)(4)(B)(iii).
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The Code provides sourcing rules for enumerated types of
income, including interest, dividends, rents, royalties, and
personal services income.\321\ For example, interest income
generally is sourced based on the residence of the obligor.
Dividend income generally is sourced based on the residence of
the corporation paying the dividend. Thus, interest paid on
obligations of foreign persons and dividends paid by foreign
corporations generally are treated as foreign-source income.
---------------------------------------------------------------------------
\321\ Sections 861 through 865.
---------------------------------------------------------------------------
Other types of income are not specifically covered by the
Code's sourcing rules. For example, fees for accepting or
confirming letters of credit have been sourced under principles
analogous to the interest sourcing rules.\322\ In addition,
under regulations, payments in lieu of dividends and interest
derived from securities lending transactions are sourced in the
same manner as interest and dividends, including for purposes
of determining whether such income is effectively connected
with a U.S. trade or business.\323\ Moreover, income from
notional principal contracts (such as interest rate swaps)
generally is sourced based on the residence of the recipient of
the income, but is treated as U.S.-source effectively connected
income if it arises from the conduct of a United States trade
or business.\324\
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\322\ See Bank of America v. United States, 680 F.2d 142 (Ct. Cl.
1982).
\323\ Treas. Reg. sec. 1.864-5(b)(2)(ii).
\324\ Treas. Reg. sec. 1.863-7(b)(3).
---------------------------------------------------------------------------

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

Each category of foreign-source income that is treated as
effectively connected with a U.S. trade or business is expanded
to include economic equivalents of such income (i.e., economic
equivalents of certain foreign-source: (1) rents and royalties;
(2) dividends and interest; and (3) income on sales or
exchanges of goods in the ordinary course of business). Thus,
sucheconomic equivalents are treated as U.S.-effectively
connected income in the same circumstances that foreign-source rents,
royalties, dividends, interest, or certain inventory sales are treated
as U.S.-effectively connected income. For example, foreign-source
interest and dividend equivalents are treated as U.S.-effectively
connected income if the income is attributable to a U.S. office of the
foreign person, and such income is derived by such foreign person in
the active conduct of a banking, financing, or similar business within
the United States, or the foreign person is a corporation whose
principal business is trading in stocks or securities for its own
account.

EFFECTIVE DATE

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

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

PRESENT LAW

U.S. persons may credit foreign taxes against U.S. tax on
foreign-source income. The amount of foreign tax credits that
may be claimed in a year is subject to a limitation that
prevents taxpayers from using foreign tax credits to offset
U.S. tax on U.S.-source income. The amount of foreign tax
credits generally is limited to a portion of the taxpayer's
U.S. tax which portion is calculated by multiplying the
taxpayer's total U.S. tax by a fraction, the numerator of which
is the taxpayer's foreign-source taxable income (i.e., foreign-
source gross income less allocable expenses or deductions) and
the denominator of which is the taxpayer's worldwide taxable
income for the year.\325\ Separate limitations are applied to
specific categories of income.
---------------------------------------------------------------------------
\325\ Section 904(a).
---------------------------------------------------------------------------
Special recapture rules apply in the case of foreign losses
for purposes of applying the foreign tax credit
limitation.\326\ Under these rules, losses for any taxable year
in a limitation category which exceed the aggregate amount of
foreign income earned in other limitation categories (a so-
called ``overall foreign loss'') are recaptured by resourcing
foreign-source income earned in a subsequent year as U.S.-
source income.\327\ The amount resourced as U.S.-source income
generally is limited to the lesser of the amount of the overall
foreign losses not previously recaptured, or 50 percent of the
taxpayer's foreign-source income in a given year (the ``50-
percent limit''). Taxpayers may elect to recapture a larger
percentage of such losses.
---------------------------------------------------------------------------
\326\ Section 904(f).
\327\ Section 904(f)(1).
---------------------------------------------------------------------------
A special recapture rule applies to ensure the recapture of
an overall foreign loss where property which was used in a
trade or business predominantly outside the United States is
disposed of prior to the time the loss has been
recaptured.\328\ In this regard, dispositions of trade or
business property used predominantly outside the United States
are treated as resulting in the recognition of foreign-source
income (regardless of whether gain would otherwise be
recognized upon disposition of the assets), in an amount equal
to the lesser of the excess of the fair market value of such
property over its adjusted basis, or the amount of unrecaptured
overall foreign losses. Such foreign-source income is resourced
as U.S.-source income without regard to the 50-percent limit.
For example, if a U.S. corporation transfers its foreign branch
business assets to a foreign corporation in a nontaxable
section 351 transaction, the taxpayer would be treated for
purposes of the recapture rules as having recognized foreign-
source income in the year of the transfer in an amount equal to
the excess of the fair market value of the property disposed
over its adjusted basis (or the amount of unrecaptured foreign
losses, if smaller). Such income would be recaptured as U.S.-
source income to the extent of any prior unrecaptured overall
foreign losses.\329\
---------------------------------------------------------------------------
\328\ Section 904(f)(3).
\329\ Coordination rules apply in the case of losses recaptured
under the branch loss recapture rules. Section 367(a)(3)(C).
---------------------------------------------------------------------------
Detailed rules apply in allocating and apportioning
deductions and losses for foreign tax credit limitation
purposes. In the case of interest expense, such amounts
generally are apportioned to all gross income under an asset
method, under which the taxpayer's assets are characterized as
producing income in statutory or residual groupings (i.e.,
foreign-source income in the various limitation categories or
U.S.-source income).\330\ Interest expense is apportioned among
these groupings based on the relative asset values in each.
Taxpayers may elect to value assets based on either tax book
value or fair market value.
---------------------------------------------------------------------------
\330\ Section 864(e) and Temp. Treas. Reg. sec. 1.861-9T.
---------------------------------------------------------------------------
Each corporation that is a member of an affiliated group is
required to apportion its interest expense using apportionment
fractions determined by reference to all assets of the
affiliated group. For this purpose, an affiliated group
generally is defined to include only domestic corporations.
Stock in a foreign subsidiary, however, is treated as a foreign
asset that may attract the allocation of U.S. interest expense
for these purposes. If tax basis is used to value assets, the
adjusted basis of the stock of certain 10-percent or greater
owned foreign corporations or other non-affiliated corporations
must be increased by the amount of earnings and profits of such
corporation accumulated during the period the U.S. shareholder
held the stock, for purposes of the interest apportionment.

REASONS FOR CHANGE

The Committee believes that dispositions of corporate stock
should be subject to the special recapture rules for overall
foreign losses. Ownership of stock in a foreign subsidiary can
lead to, or increase, an overall foreign loss as a result of
interest expenses allocated against foreign-source income under
the interest expense allocation rules. The recapture of overall
foreign losses created by such interest expense allocations may
be avoided if, for example, the stock of the foreign subsidiary
subsequently were transferred to unaffiliated parties in non-
taxable transactions. The Committee believes that overall
foreign losses should be recapturedwhen stock of a controlled
foreign corporation is disposed of regardless of whether such stock is
disposed of a non-taxable transaction.

EXPLANATION OF PROVISION

Under the provision, the special recapture rule for overall
foreign losses that currently applies to dispositions of
foreign trade or business assets applies to the disposition of
controlled foreign corporation stock. Thus, dispositions of
controlled foreign corporation stock result in the recognition
of foreign-source income in an amount equal to the lesser of
the fair market value of the stock over its adjusted basis, or
the amount of prior unrecaptured overall foreign losses. Such
income is resourced as U.S.-source income for foreign tax
credit limitation purposes without regard to the 50-percent
limit.

EFFECTIVE DATE

The provision applies to dispositions after the date of
enactment.

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

F. Other Revenue Provisions

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

PRESENT LAW

Assignment of income in general

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

Stripped bonds

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

Stripped preferred stock

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

In general

A ``straddle'' generally refers to offsetting positions
(sometimes referred to as ``legs'' of the straddle) with
respect to actively traded personal property. Positions are
offsetting if there is a substantial diminution in the risk of
loss from holding one position by reason of holding one or more
other positions in personal property. A ``position'' is an
interest (including a futures or forward contract or option) in
personal property. When a taxpayer realizes a loss with respect
to a position in a straddle, the taxpayer may recognize that
loss for any taxable year only to the extent that the loss
exceeds the unrecognized gain (if any) with respect to
offsetting positions in the straddle.\354\ Deferred losses are
carried forward to the succeeding taxable year and are subject
to the same limitation with respect to unrecognized gain in
offsetting positions.
---------------------------------------------------------------------------
\354\ Sec. 1092.
---------------------------------------------------------------------------

Positions in stock

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

Unbalanced straddles

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

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

The Taxpayer Relief Act of 1997 amended sections 351, 354,
355, 356, and 1036 to treat ``nonqualified preferred stock'' as
boot in corporate transactions, subject to certain exceptions.
For this purpose, preferred stock is defined as stock that is
``limited and preferred as to dividends and does not
participate in corporate growth to any significant extent.''
Nonqualified preferred stock is defined as any preferred stock
if (1) the holder has the right to require the issuer or a
related person to redeem or purchase the stock, (2) the issuer
or a related person is required to redeem or purchase, (3) the
issuer or a related person has the right to redeem or
repurchase, and, as of the issue date, it is more likely than
not that such right will be exercised, or (4) the dividend rate
varies in whole or in part (directly or indirectly) with
reference to interest rates, commodity prices, or similar
indices, regardless of whether such varying rate is provided as
an express term of the stock (as in the case of an adjustable
rate stock) or as a practical result of other aspects of the
stock (as in the case of auction stock). For this purpose,
clauses (1), (2), and (3) apply if the right or obligation may
be exercised within 20 years of the issue date and is not
subject to a contingency which, as of the issue date, makes
remote the likelihood of the redemption or purchase.

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

Transfers of partnership interests

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

Distributions of partnership property

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

A taxpayer is allowed a depreciation deduction for the
exhaustion, wear and tear, and obsolescence of property that is
used in a trade or business or held for the production of
income. For most tangible property placed in service after
1986, the amount of the depreciation deduction is determined
under the modified accelerated cost recovery system (MACRS)
using a statutorily prescribed depreciation method, recovery
period, and placed in service convention. For some assets, the
recovery period for the asset is provided in section 168. In
other cases, the recovery period of an asset is determined by
reference to its class life. The class lives of assets placed
in service after 1986 are generally set forth in Revenue
Procedure 87-56.\382\ If no class life is provided, the asset
is allowed a 7-year recovery period under MACRS.
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\382\ 1987-2 C.B. 674 (as clarified and modified by Rev. Proc. 88-
22, 1988-1 C.B. 785).
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Assets that are used in the transmission and distribution
of electricity for sale are included in asset class 49.14, with
a class life of 30 years and a MACRS recovery period of 20
years. Assets class 00.3 provides a class life of 20 years and
a MACRS recovery period of 15 years for land improvements. The
cost of initially clearing and grading land improvements
arespecifically excluded from asset classes 00.3 and 49.14. Prior to
the adoption of the accelerated cost recovery system, the IRS ruled
that an average useful life of 84 years for the initial clearing and
grading relating to electric transmission lines and 46 years for the
initial clearing and grading relating to electric distribution lines,
would be accepted. However, the result in this ruling was not
incorporated in the asset classes included in Rev. Proc. 87-56 or its
predecessors. Accordingly such costs are depreciated over a 7-year
recovery period under MACRS as section 1245 real property for which no
class life is provided.
A similar situation exists with regard to gas utility trunk
pipelines and related storage facilities. Such assets are
included in asset class 49.24, with a class life of 22 years
and a MACRS recovery period of 15 years. Initial clearing and
grade improvements are specifically excluded from this asset
class as well as asset class 00.3, and no separate asset class
is provided for such costs. Accordingly, such costs are
depreciated over a 7-year recovery period under MACRS as
section 1245 real property for which no class life is provided.

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

The provision assigns a class life to depreciable electric
and gas utility clearing and grading costs incurred to locate
transmission and distribution lines and pipelines. The
provision includes these assets in the asset classes of the
property to which the clearing and grading costs relate
(generally, asset class 49.14 for electric utilities and asset
class 49.24 for gas utilities, giving these assets a recovery
period of 20 years and 15 years, respectively).

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

At the election of the taxpayer, start-up expenditures
\387\ and organizational expenditures \388\ may be amortized
over a period of not less than 60 months, beginning with the
month in which the trade or business begins. Start-up
expenditures are amounts that would have been deductible as
trade or business expenses, had they not been paid or incurred
before business began. Organizational expenditures are
expenditures that are incident to the creation of a corporation
(sec. 248) or the organization of a partnership (sec. 709), are
chargeable to capital, and that would be eligible for
amortization had they been paid or incurred in connection with
the organization of a corporation or partnership with a limited
or ascertainable life.
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\387\ Sec. 195
\388\ Secs. 248 and 709.
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Treasury regulations \389\ require that a taxpayer file an
election to amortize start-up expenditures no later than the
due date for the taxable year in which the trade or business
begins. The election must describe the trade or business,
indicate the period of amortization (not less than 60 months),
describe each start-up expenditure incurred, and indicate the
month in which the trade or business began. Similar
requirements apply to the election to amortize organizational
expenditures. A revised statement may be filed to include
start-up and organizational expenditures that were not included
on the original statement, but a taxpayer may not include as a
start-up expenditure any amount that was previously claimed as
a deduction.
---------------------------------------------------------------------------
\389\ Treas. Reg. sec. 1.195-1.
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Section 197 requires most acquired intangible assets (such
as goodwill, trademarks, franchises, and patents) that are held
in connection with the conduct of a trade or business or an
activity for the production of income to be amortized over 15
years beginning with the month in which the intangible was
acquired.

REASONS FOR CHANGE

The Committee believes that allowing a fixed amount of
start-up and organizational expenditures to be deductible,
rather than requiring their amortization, may help encourage
the formation of new businesses that do not require significant
start-up or organizational costs to be incurred. In addition,
the Committee believes a consistent amortization period for
intangibles is appropriate.

EXPLANATION OF PROVISION

The provision modifies the treatment of start-up and
organizational expenditures. A taxpayer would be allowed to
elect to deduct up to $5,000 of start-up and $5,000
oforganizational expenditures in the taxable year in which the trade or
business begins. However, each $5,000 amount is reduced (but not below
zero) by the amount by which the cumulative cost of start-up or
organizational expenditures exceeds $50,000, respectively. Start-up and
organizational expenditures that are not deductible in the year in
which the trade or business begins would be amortized over a 15-year
period consistent with the amortization period for section 197
intangibles.

EFFECTIVE DATE

The provision is effective for start-up and organizational
expenditures incurred after the date of enactment. Start-up and
organizational expenditures that are incurred on or before the
date of enactment would continue to be eligible to be amortized
over a period not to exceed 60 months. However, all start-up
and organizational expenditures related to a particular trade
or business, whether incurred before or after the date of
enactment, would be considered in determining whether the
cumulative cost of start-up or organizational expenditures
exceeds $50,000.

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

In general

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

Delinquency penalties

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

Accuracy-related penalties

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

Fraud penalty

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

Interest Provisions

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

Offshore Voluntary Compliance Initiative

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

Voluntary Disclosure Initiative

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

The provisions are effective upon the date of enactment.

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

In general

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

Use of a deposit to offset underpayments of tax

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

Withdrawal of amounts

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

Limitation on amounts for which interest may be allowed

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

Deposits are not payments of tax

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

The provision is effective on the date of enactment.

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

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

EXPLANATION OF PROVISION

In general

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

Donor's qualified interest

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

Reporting requirements

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

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

EFFECTIVE DATE

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

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

PRESENT LAW

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

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

PRESENT LAW

Filing requirements for children

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

Taxation of unearned income under section 1(g)

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

Parental election to include child's unearned income

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

Taxation of compensation for services under section 1(g)

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

REASONS FOR CHANGE

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

EXPLANATION OF PROVISION

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

EFFECTIVE DATE

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

II. BUDGET EFFECTS OF THE BILL

A. Committee Estimates

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

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

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

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

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

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

B. Budget Authority and Tax Expenditures

Budget authority

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

Tax expenditures

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

C. Consultation with Congressional Budget Office

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

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

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

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

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

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

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

Basis of Estimate

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

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