savings banks, or cooperative banks) are allowed deductions for bad debts under rules
more favorable than those granted to other taxpayers (and more favorable than the rules
applicable to other financial institutions). Qualified thrift institutions may compute
deductions for bad debts using either the specific charge-off method or the reserve method
of section 593. To qualify for this reserve method, a thrift institution must meet an asset
test, requiring that 60 percent of its assets consist of "qualifying assets" (generally cash,
government obligations, and loans secured by residential real property). This percentage
must be computed at the close of the taxable year, or at the option of the taxpayer, as the
annual average of monthly, quarterly, or semiannual computations of similar percentages.

If a thrift institution uses the reserve method of accounting, it must establish and
maintain a reserve for bad debts and charge actual losses against the reserve, and is
allowed a deduction for annual additions to restore the reserve to its permitted balance.
Under section 593, a thrift institution annually may elect to calculate its addition to its bad
debt reserve under either (1) the "percentage of taxable income" method applicable only to
thrift institutions, or (2) the "experience" method that also is available to small banks.

Under the "percentage of taxable income" method, a thrift institution generally is
allowed a deduction for an addition to its bad debt reserve equal to 8 percent of its taxable
income (determined without regard to this deduction and with additional adjustments).
Under the experience method, a thrift institution generally is allowed a deduction for an
addition to its bad debt reserve equal to the greater of: (1) an amount based on its actual
average experience for losses in the current and five preceding taxable years, or (2) an
amount necessary to restore the reserve to its balance as of the close of the base year. For
taxable years beginning before 1988, the "base year" was the last taxable year before the
most recent adoption of the experience method (i.e., generally, the last year the taxpayer
was on the percentage of taxable income method). For taxable years beginning after 1987,
the base year is the last taxable year beginning before 1988. Prior to 1988, computing bad
debts under a "base year" rule allowed a thrift institution to claim a deduction for bad debts
for an amount at least equal to the institution's actual losses that were incurred during the
taxable year.

Bad debt methods of commercial banks

A small commercial bank (i.e., one with adjusted bases of assets of $500 million or
less) may use the experience method or the specific charge-off method for purposes of
computing its deduction for bad debts. A large commercial bank only may use the specific
charge-off method of section 166. Ifa small bank becomes a large bank, it must recapture
its existing bad debt reserve (i.e., include the amount of the reserve in income) through one
of two elective methods. Under the 4-year recapture method, the bank generally includes
10 percent of the reserve in income in the first taxable year, 20 percent in the second year,
30 percent in the third year, and 40 percent in the fourth year. Under the cut-off method,
the bank generally neither restores its bad debt reserve to income nor may it deduct losses
relating to loans held by the bank as of the date of the required change in the method of
accounting. Rather, the amount of such losses are charged against and reduce the existing

-59-



existence as of September 19, 1995.” In addition, the Administration proposal generally would
not apply where the grantor is a controlled foreign corporation, foreign personal holding
company or passive foreign investment company.

In a case where the foreign grantor, who would be treated as the owner of the trust but for
the above rule, actually pays tax on the income of the trust to a foreign country, it is anticipated
that Treasury regulations would provide that U.S. beneficiaries who are subject to U.S. income
tax on that income would be treated for foreign tax credit purposes as having paid the foreign
taxes that were paid by the foreign grantor. Any resulting foreign tax credits would be subject to
applicable foreign tax credit limitations.

The Administration proposal would provide a transition rule for any domestic trust that
has a foreign grantor who is treated as the owner of the trust under present law. If such a trust
becomes a foreign trust before January 1, 1997, or if the assets of such a trust are transferred to a
foreign trust before that date, such trust would be exempt from the excise tax on transfers to a
foreign trust otherwise imposed by section 1491. However, the Administration proposal's new
reporting requirements and penalties would be applicable.

Distributions by foreign trusts through nominees

The Administration proposal would treat any amount paid to a U.S. person, where the.
amount was derived (directly or indirectly) from a foreign trust of which the payor is not the
grantor, as if paid by the foreign trust directly to the U.S. person. This rule would disregard the
role of an intermediary or nominee that may be interposed between a foreign trust and a U.S.
beneficiary. Unlike present law, however, the rule would apply whether or not the trust was
created by a U.S. person. The rule would not apply to a withdrawal from a foreign trust by its
grantor, with a subsequent gift or other payment to a U.S. person.

Effective Date

The proposal would be effective on the date of enactment.

b. Foreign trusts that are not grantor trusts

Interest charge on accumulation distributions

The Administration proposal would change the interest rate applicable to accumulation
distributions from foreign trusts from simple interest at a fixed rate of 6 percent to compound
interest determined in the manner of the interest imposed on underpayments of tax under section
6621(a)(2). Simple interest would continue to accrue at the rate of 6 percent through 1995.

7 The exception would not apply to the portion of any such trust attributable to any
transfers made after September 19, 1995.

-25-



CONTENTS

INTRODUCTION .... 0.2.1.6 cee

L MIDDLE-CLASS BILL OF RIGHTS, TAX COMPLIANCE, AND
SUPERFUND TAX PROVISIONS .........................0.005-

1. Credit for families with young children... 2... ..00220222.00000000-5
2. Deduction for higher education expenses ..............-..000000005
3. Provisions relating to individual retirement plans ...................
4. Eamed income credit provisions ..................02.0.202000000-
5. Revision of tax mules on expatriation ... 2.0.0.0... 0... e cece eee ee

6. Modifications of rules relating to foreign trusts having
one or more United States beneficiaries ...................-..00--.

7. Additional empowerment zones .... 2.02.0... 0 cece eee
8. Intermediate sanctions for tax-exempt organizations .................
9. Reinstatement of authority for undercover operations ................
10. Disclosure of returns concerning cash transactions ..................
11. Extend Superfund excise taxes and corporate environmental income tax . .
I. CORPORATE SUBSIDIES, LOOPHOLE CLOSERS,
AND OTHER MEASURES ......... bbe b ete ete nent e eee
1. Reform depreciation under the income forecast method ..............

2. Phase out preferential treatment for certain large farm
corporations required to use accrual accounting ....................

3. Disallow interest deduction for corporate-owned life
insurance policy loans... 02... cee ee

-ii-

13

15

19

34

36

44

45

46

48

48

50

52


certain stock, including preferred stock. Thus, preferred stock can be received tax-free in a
reorganization, notwithstanding that many preferred stocks are functionally equivalent to
debt securities. Upon the receipt of other property, gain but not loss can be recognized. A
special rule permits debt securities to be received tax-free, but only to the extent debt
securities of no lesser principal amount are surrendered in the exchange. Other than this
debt-for-debt rule, similar rules generally apply to transactions described in section 351.

Description of Proposal

The proposal would amend both sections 351 and 356 (which applies in the case of
reorganizations under section 368) to treat certain preferred stock as “other property"
(boot), subject to certain exceptions. Thus, when a taxpayer exchanges property for this
preferred stock in a transaction that qualifies under either section 351 or 368, gain but not
loss would be recognized.

The proposal would apply to preferred stock (i.e., stock that is limited and preferred
as to dividends and does not participate in corporate growth to any significant extent,
including through a conversion privilege) , where (i) the holder has the right to put the
stock to the issuer or a related party (within the meaning of sections 267(b) and 707(b)),
(ii) the stock is subject to mandatory redemption by the issuer or a related party, (iii) the
issuer (or a related party) has the right to call the stock and, as of the issue date, it is more
likely than not that the right will be exercised, or (iv) 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 (for example, in the case of an adjustable rate stock) or as a practical result of other
aspects of the stock (for example, in the case of auction rate stock). For this purpose,
clauses (i), (ii), and (iii) are not satisfied if the put or call cannot be exercised, or the
redemption cannot occur, within 20 years of the date the instrument is issued.

The following exchanges would be excluded from this gain recognition: (1) an
exchange of preferred stock for comparable preferred stock of the same or lesser value; (2)
an exchange of preferred stock for common stock, (3) an exchange of debt securities for
preferred stock of the same or lesser value as the adjusted issue price of the debt; and (4)
exchanges of stock in certain recapitalizations of family-owned corporations. For this
purpose, a family-owned corporation would be defined as any corporation if at least 50
percent of the total voting power and value of the stock of such corporation is owned by
members of the same family for five years preceding the recapitalization. In addition, a
recapitalization does not qualify for the exception if the same family does not own 50
percent of the total voting power and value of the stock throughout the three-year period
following the recapitalization. Members of the same family would be defined by reference
to the definition in section 447(e). Thus, a family would include children, parents,
brothers, sisters, and spouses, with a limited attribution for directly and indirectly owned
stock of the corporation. Shares held by a family member would be treated as not held by
a family member to the extent a non-family member had a right, option or agreement to
acquire the shares (directly or indirectly, for example, through redemptions by the issuer),

-68-



received in the exchange is equal to the basis of the property transferred, decreased by any
money received by the taxpayer, and further adjusted for any gain or loss recognized on
the exchange.

Description of Pr al

The proposal would provide that personal property located in the United States and
personal property located outside the United States are not "like-kind" properties. For this
purpose, the location of the properties would be determined at the time of the exchange. In
addition, the property surrendered in the exchange must have been used during the 24
months immediately prior to the exchange in predominantly the same use (i.e., foreign or
domestic) as at the time of the exchange. Similarly, for section 1031 to apply, property
received in the exchange must continue in the same use (i.e., foreign or domestic) for the
24 months immediately after the exchange.

Effective Date
The proposal would be effective for exchanges on or after December 7, 1995.
Legislative Background
The present-law provision that requires exchanged real properties to be both
located in or outside the United States for section 1031 to apply was enacted as part of the

Omnibus Budget Reconciliation Act of 1989.

20. Modify net operating loss carryback and carryforward rules

Present Law

The net operating loss ("NOL") of a taxpayer (generally, the amount by which the
business deductions of a taxpayer exceeds its gross income) may be carried back three
years and carried forward fifteen years to offset taxable income in such years. A taxpayer
may elect to forgo the carryback of an NOL Special rules apply to REITs (no carrybacks),
specified liability losses (10-year carryback). excess interest losses (no carrybacks), and
net capital losses of corporations (carryforward limited to five years).

Description of Proposal

The proposal would limit the NOL carryback period to one year and extend the
NOL carryforward period to 20 years.

-79-



Security Act (regarding the issuance of a number to an individual applying for or receiving
Federally funded benefits).

Use mathematical or clerical error procedures for certain omissions

If an individual fails to provide a correct taxpayer identification number, such omission
would be treated as a mathematical or clerical error. If an individual who claims the credit with
respect to net earnings from self-employment fails to pay the proper amount of self-employment
tax on such net earnings, the failure would be treated as a mathematical or clerical error for
purposes of the amount of credit allowed.

Effective Date

The proposal would be effective for taxable years beginning after December 31, 1995.

Legislative Background

A similar proposal was included in the President’s fiscal year 1996 budget proposal (the
the “Tax Compliance Act of 1995,” introduced on February 16, 1995, as H.R. 981 by
Representatives Gephardt and Gibbons and as S. 453 by Senators Moynihan and Daschle).

The BBA of 1995 (H.R. 2491), as vetoed by President Clinton, contained identical
provisions within a set of broader changes to the credit.

5. Revision of tax rules on expatriation

Present Law

USS. citizens and residents generally are subject to U.S. income tax on their worldwide
income. The U.S. tax may be reduced or offset by a credit allowed for foreign income taxes paid
with respect to foreign source income. Nonresident aliens are taxed at a flat rate of 30 percent (or
a lower treaty rate) on certain types of passive income derived from U.S. sources, and at regular
graduated rates on net profits derived from a U.S. business.

A USS. citizen who relinquishes citizenship with a principal purpose of avoiding U.S.
taxes is subject to special tax rules for ten years after expatriation. The determination of who is a
U.S. citizen for tax purposes, and when such citizenship is lost, is governed by the provisions of
the Immigration and Nationality Act, 8 U.S.C. section 1401, et. seq.

An individual who relinquishes U.S. citizenship with a principal purpose of avoiding
U.S. taxes 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 aliens, for ten years after
expatriation. Solely for this purpose, gains on the sale of property located in the United States
and stocks and securities issued by U.S. persons are treated as U.S. source income. This

-15-


Effective Date

The proposal would be effective for taxable years beginning after December 31,
1995. Any section 481(a) adjustment required to be taken into account pursuant to the
change of method of accounting under the proposal would be taken into account ratably
over four taxable years beginning with the first taxable year beginning after December 31,
1995.

Legislative Background

The proposal had been proposed by the Administration in 1994 as a revenue
provision in conjunction with the passage of the General Agreement on Tariffs and Trade
and had been reported favorably by the Senate Finance Committee, but was not included in
the final legislation as passed by the Congress.

b. Repeal components of cost inventory accounting method

Present Law

Taxpayers using the LIFO method to account for inventories may use the "dollar-
value" LIFO method. Under the dollar-value LIFO method, inventory items are expressed
in terms of "base-year" costs and are grouped in inventory pools. Total base-year costs by
pool, rather than the quantity of specific goods, are used to measure inventory increases
and decreases. If ending inventory at base-year costs is greater than beginning inventory at
base-year costs (i.e., there has been an increase in inventory), such increase is valued at
current-year costs. Taxpayers define items in the pool under the "total product cost"
("TPC") method or the "components of cost" ("COC") method. Under the TPC method,
ending inventory is determined by valuing the items in ending inventory by the base-year
cost of producing such items. Under the COC method, taxpayers measure ending
inventory not with reference to the total product cost of producing the items in ending
inventory, but rather treat the units of production (i.e., the amount of material, labor, and
overhead) that were used to produce the inventory as separate items.

The proper application of the COC method to labor and overhead is unclear under
present law.” Accordingly, the COC method as applied by some taxpayers may produce

* The use of the COC method as applied by some taxpayers with respect to labor and
overhead costs is not specifically provided for in the Code or regulations, but such method may
be used for financial accounting purposes. Treasury regulations allow taxpayers to treat raw
materials (and the raw material content of work-in-process and finished goods) as a separate item
under the LIFO method (Treas. reg. sec. 1.472-1(c)). The Internal Revenue Service ("IRS") has
tuled under the particular facts and circumstances of one taxpayer that the application of the
COC method by that taxpayer did not clearly reflect income (Technical Advice Memorandum
9405005).

-74-



a. Inbound foreign grantor trust rules

The BBA of 1995 contains two technical corrections to the Administration proposal with
respect to the inbound foreign grantor trust rules.

As amended by the BBA of 1995, the grantor trust rules apply in determining whether a
foreign corporation is characterized as a passive foreign investment company ("PFIC"). Thus, a
foreign corporation may not avoid PFIC status by transferring its assets to a grantor trust.

As amended by the BBA of 1995, a U.S. beneficiary of an inbound grantor trust that
transferred property to the foreign grantor by gift would be treated as a grantor of a portion of the
trust to the extent of the transfer. This rule applies without regard to whether the foreign grantor
would otherwise be treated as the owner of any portion of such trust.

b. Foreign trusts that are not grantor trusts
Interest charge on accumulation distributions

The BBA of 1995, contains a technical correction to the Administration proposal with
respect to the accumulation distribution rules. As amended by the BBA of 1995, an
accumulation distribution to a U.S. beneficiary of a foreign nongrantor trust is treated as
reducing proportionately the undistributed net income for prior taxable years in which the trust
had undistributed net income and the beneficiary receiving the distribution was a U.S. citizen or
resident. In determining the interest payable with respect to a trust distribution, the distribution is
deemed to be from years in which both such conditions are satisfied.

Use of trust property

The Administration proposal generally would treat the value of the use of trust property
(other than cash or marketable securities) by any U.S. grantor, U.S. beneficiary of the trust, or by
a U.S. person related to such a grantor or beneficiary, as a distribution equal to the fair market
value of the use of the property. The BBA of 1995 does not contain such a provision.

Loans to grantors or beneficiaries
The Administration proposal would treat any loan of cash or marketable securities to any
U.S. grantor or U.S. beneficiary of the trust. or to a U.S. person related to a such a grantor or

beneficiary as a distribution by the trust. The BBA of 1995 grants the Treasury Secretary
regulatory authority to exempt certain arm's-length loans from these rules.

-32-



received by the organization for providing such benefit; and (2) to the extent provided in
Treasury Department regulations, any transaction in which the amount of any economic benefit
provided to, or for the use of, any disqualified person is determined in whole or in part by the
revenues of the organization, provided that the transaction constitutes prohibited inurement
under present-law section 501(c)(3) or under section 501(c)(4), as amended. Thus, “excess
benefit transactions" subject to excise taxes would include transactions in which a disqualified
person engages in a non-fair-market-value transaction with an organization or receives
unreasonable compensation, as well as financial arrangements (to the extent provided in
Treasury regulations) under which a disqualified person receives payment based on the
organization's income in a transaction that violates the present-law private inurement prohibition.
The Treasury Department would be instructed to issue prompt guidance providing examples of
revenue-sharing arrangements that violate the private inurement prohibition, and such guidance
would be applicable on a prospective basis.'*

Existing tax-law standards (see sec. 162) would apply in determining reasonableness of
compensation and fair market value. In applying such standards, it is intended that the parties to
a transaction would be entitled to rely on a rebuttable presumption of reasonableness with
respect to a compensation arrangement with a disqualified person if such arrangement was
approved by an independent board (or an independent committee authorized by the board) that:
(1) was composed entirely of individuals unrelated to and not subject to the control of the
disqualified person(s) involved in the arrangement; (2) obtained and relied upon appropriate data
as to comparability (e.g., compensation levels paid by similarly situated organizations, both
taxable and tax-exempt, for functionally comparable positions; the location of the organization,
including the availability of similar specialties in the geographic area; independent compensation
surveys by nationally recognized independent firms; or actual written offers from similar
institutions competing for the services of the disqualified person); and (3) adequately
documented the basis for its determination (e.g., the record includes an evaluation of the
individual whose compensation was being established and the basis for determining that the
individual's compensation was reasonable in light of that evaluation and data).’® If these three

individual who is a disqualified person with respect to the parent organization, such transaction
would be an excess benefit transaction.

'S Under present law, certain revenue sharing arrangements have been determined not to
constitute private inurement (see e.g., GCM 38283; GCM 38905; and GCM 39674) and, under
the proposal, it would continue to be the case that not all revenue sharing arrangements would be
improper private inurement. However, legislative history would indicate that no inference is
intended that Treasury or the Internal Revenue Service are bound by any particular prior
unpublished rulings in this area.

‘© The fact that a State or local legislative or agency body may have authorized or
approved of a particular compensation package paid to a disqualified person would not be
determinative of the reasonableness of compensation paid for purposes of the excise tax
penalties provided for by the proposal. Similarly, such authorization or approval would not be

-39-


Effective Date

The proposal would be effective for taxable years beginning after December 31,
1995.

10. Deny interest deduction on certain debt instruments
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. 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 the instrument matures. The
holder of such a debt instrument also generally includes the OID in income on an accrual
basis.

Section 385(c) provides rules for when an issuer's characterization of an interest in
a corporation shall be binding on the issuer and the holders.

Description of Proposal

Under the proposal no deduction would be allowed for interest or OID on an
instrument (other than a demand loan) issued by a corporation (or issued by a partnership
to the extent of its corporate partners) that (i) has a maximum term of more than 40 years,
or (ii) is payable in stock of the issuer or a related party (within the meaning of sections
267(b) and 707(b)), including an instrument that is mandatorily convertible or convertible
at the issuer's option. In addition, an instrument would be treated as payable in stock of the
issuer or a related party if it is part of an arrangement designed to result in the payment of
debt with such stock, such as certain issuances of a forward contract in connection with the
issuance of debt, nonrecourse debt that is secured principally by such stock, or certain debt
instruments that are convertible at the holder's option when it is substantially certain that
the right will be exercised.

The proposal would also clarify that for purposes of section 385(c), an issuer will
be treated as having characterized an instrument as equity if the instrument (other than a
demand loan) (i) has a maximum term of more than 20 years, and (ii) is not shown as
indebtedness on the separate balance sheet of the issuer. For this purpose, in the case of an
instrument with a maximum term of more than 20 years (other than a demand loan) issued

-64-



December 21, 1994. As required by law, six empowerment zones are located in urban areas
(with aggregate population for the six designated urban empowerment zones limited to 750,000)
and three empowerment zones are located in rural areas.” Of the enterprise communities, 65 are
located in urban areas and 30 are located in rural areas (sec. 1391). Designated empowerment
zones and enterprise communities were required to satisfy certain eligibility criteria, including
specified poverty rates and population and geographic size limitations (sec. 1392). The
designated areas were selected from among over 500 areas nominated by State and local
governments, which submitted proposed strategic plans to promote economic development in
these areas.

The following tax incentives are available for certain businesses located in empowerment
zones: (1) a 20-percent wage credit for the first $15,000 of wages paid to a zone resident who
works in the zone; (2) an additional $20,000 of section 179 expensing for certain zone business
property (accordingly, certain businesses operating in empowerment zones are allowed up to
$37,500 of expensing); and (3) expanded tax-exempt financing for certain zone facilities. In
contrast, the 95 enterprise communities are eligible for the expanded tax-exempt financing
benefits, but not the other tax incentives available in the nine empowerment zones. In addition
to these tax incentives, OBRA 1993 provided that Federal grants would be made to designated
empowerment zones and enterprise communities.

The tax incentives for empowerment zones and enterprise communities generally will be’
available during the period that the designation remains in effect, i.e., a 10-year period.

Description of Proposal

The Secretary of HUD would be authorized to designate two additional empowerment
zones located in urban areas (thereby increasing to eight the total number of empowerment zones
located in urban areas). The two additional empowerment zones would be subject to the same
eligibility criteria under present-law section 1392 that applied to the original six urban
empowerment zones. In order to permit designation of two additional empowerment zones, the
proposal would increase the present-law 750,000 aggregate population cap applicable to all
empowerment zones located in urban areas to a cap of | million aggregate population for the
eight urban empowerment zones. No additional Federal grants would be authorized.

The six designated urban empowerment zones are located in New York City, Chicago,
Atlanta, Detroit, Baltimore, and Philadelphia-Camden (N.J.).

The three designated rural empowerment zones are located in Kentucky Highlands
(Clinton, Jackson, Wayne counties, Ky.), Mid-Delta Mississippi (Bolivar, Holmes, Humphreys,
Leflore counties, Miss.), and Rio Grande Valley Texas (Cameron, Hidalgo, Starr, Willacy
counties, Texas).

-35-


Effective Date

The proposal would be effective for dividends paid or accrued after January 31,
1996.

Legislative Backgro

A similar proposal was contained in a provision passed by the House in 1988 but
not adopted in the final version of the Technical and Miscellaneous Revenue Act of 1988.
(See, H.R. Rep.100-795, 100th Cong. 2d Sess. at pp. 467-68 and H.R. Rep. 100-1104,
100th Cong. 2d Sess. at p. 120).

b. Modify holding period for dividends received deduction

Present Law

If an instrument issued by a U.S. corporation is classified for tax purposes as
equity, a corporate holder of the instrument generally is entitled to a dividends received
deduction for dividends received on that instrument.

The dividends-received deduction is allowed to a corporate shareholder only if the
shareholder satisfies a 46-day holding period for the dividend-paying stock (or a 91-day
period for certain dividends on preferred stock). The 46- or 91-day holding period
generally does not include any time in which the shareholder is protected from the risk of
loss otherwise inherent in the ownership of an equity interest.

Description of Proposal

The proposal would provide that a taxpayer is not entitled to a dividends-received
deduction if the taxpayer's holding period for the dividend-paying stock is not satisfied
over a period immediately before or immediately after the taxpayer becomes entitled to
receive the dividend.

Effective Date

The proposal would be effective for dividends paid or accrued after January 31,
1996.

13. Treat certain preferred stock as "boot"
Present Law

In reorganization transactions within the meaning of section 368, no gain or loss is
recognized except to the extent "other property" is received, that is, property other than

-67-



and use of proceeds of the operation; (4) a detailed description of the undercover operation
projected to generate proceeds, including the potential violation being investigated, and whether
the operation is being conducted under grand jury auspices; and (5) the results of the operation to
date, including the results of criminal proceedings.

Effective D:
The proposal would be effective on the date of enactment.

Legislative Background

A five-year extension of this provision was contained in the Revenue Reconciliation Act
of 1995 as passed by the House of Representatives.

10. Disclosure of returns concerning cash transactions

Present Law

The Internal Revenue Code prohibits disclosure of tax returns and return information,
except to the extent specifically authorized by the Internal Revenue Code (sec. 6103).
Unauthorized disclosure is a felony punishable by a fine not exceeding $5,000 or imprisonment
of not more than five years, or both (sec. 7213). An action for civil damages also may be
brought for unauthorized disclosure (sec. 7431). No tax information may be furnished by the
IRS to another agency unless the other agency establishes procedures satisfactory to the IRS for
safeguarding the tax information it receives (sec. 6103(p)).

Under section 60501, any person who receives more than $10,000 in cash in one
transaction (or two or more related transactions) in the course of a trade or business generally
must file an information return (Form 8300) with the IRS specifying the name, address, and
taxpayer identification number of the person from whom the cash was received and the amount
of cash received.

The Anti-Drug Abuse Act of 1988 provided a special rule permitting the IRS to disclose
these information returns to other Federal agencies for the purpose of administering Federal
criminal statutes. The special rule originally was to expire after November 18, 1990, and was
extended by the Comprehensive Crime Control Act of 1990 to November 18, 1992.

Description of Proposal

'

The proposal would permanently extend the special rule for disclosing Form 8300
information. Moreover, the proposal would permit disclosures not only to Federal agencies but
also to State, local and foreign agencies and for civil, criminal and regulatory purposes (i.e.,
generally in the same manner as CTRs filed by financial institutions under the Bank Secrecy
Act.) Disclosure, however, is not permitted to any such agency for purposes of tax

-45-


Special rules would apply to the section 936 credit with respect to operations in Guam,
American Samoa, and the Commonwealth of the Northern Mariana Islands. Income
attributable to operations in these possessions would not be taken into account in computing
the cap. During the ten-year transition period, the section 936 credit with respect to operations
in one of these possessions would be available only to corporations that were actively
conducting business in such possession on October 13, 1995 (or are treated as so engaged
under the binding contract rule); for such a corporation, the section 936 credit with respect to
operations in such possession would continue to be computed as under present law for the ten-
year transition period (provided that the corporation does not add a substantial new line of
business).

-87-



3. Provisions relating to individual retirement plans

Present Law

In general

Under certain circumstances, an individual is allowed a deduction for contributions
(within limits) to an individual retirement account or an individual retirement annuity (an
"IRA"). An individual generally is not subject to income tax on amounts held in an IRA,
including earnings on contributions, until the amounts are withdrawn from the IRA. No
deduction is permitted with respect to contributions made to an IRA for a taxable year after the
IRA owner attains age 70-1/2.

Under present law, the maximum deductible contribution that can be made to an IRA
generally is the lesser of $2,000 or 100 percent of an individual's compensation (earned income
in the case of self-employed individuals). A single taxpayer is permitted to make the maximum
deductible IRA contribution for a year if the individual is not an active participant in an
employer-sponsored retirement plan for the year or the individual has adjusted gross income
("AGI") of less than $25,000. A married taxpayer filing a joint return is permitted to make the
maximum deductible IRA contribution for a year if neither spouse is an active participant in an
employer-sponsored plan or the couple has combined AGI of less than $40,000.

If a single taxpayer or either spouse (in the case of a married couple) is an active
participant in an employer-sponsored retirement plan, the maximum IRA deduction is phased out
over certain AGI levels. For single taxpayers, the maximum IRA deduction is phased out
between $25,000 and $35,000 of AGI. For married taxpayers, the maximum deduction is phased
out between $40,000 and $50,000 of AGI

Spousal IRAs

In the case of a married individual whose spouse has no compensation (or elects to be
treated as having no compensation), the $2,000 limit on IRA contributions is increased to the
lesser of $2,250 or the individual's compensation

Nondeductible IRA contributions

Individuals may make nondeductible IRA contributions to the extent deductible
contributions are not allowed because of the AGI phaseout and active participant rules. A
taxpayer may also elect to make nondeductible contributions in lieu of deductible contributions.
Thus, any individual may make nondeductible contributions up to the excess of (1) the lesser of
$2,000 or 100 percent of compensation over (2) the IRA deduction claimed by the individual.
As is the case with earnings on deductible IRA contributions, earnings on nondeductible
contributions are not subject to income tax until withdrawn.

-8-


INTRODUCTION

This document, prepared by the staff of the Joint Committee on Taxation, provides a
description of the tax- and health-related provisions contained in the President's seven-year
balanced budget proposal. This proposal was released on December 7, 1995.

For each of the tax- and health-related provisions in the President's proposal, the
document includes a description of present law, the proposal, the effective date, and any recent
related legislative background. The description of the proposal is based on the Joint Committee's
understanding of Administration materials as of December 14, 1995.

Part I of the document describes the "Middle-Class Bill of Rights" provisions. Part II
describes the provisions in the "Corporate Subsidy, Loophole Closers, and Other Measures"
section of the President's seven-year balanced budget proposal. Part III describes certain health
insurance reform provisions. Part IV shows the estimated budget effects of the tax and health
insurance provisions of the President's proposal.

* This document may be cited as follows: Joint Committee on Taxation, Description of
the Tax and Health Insurance Reform Provisions in the President's Seven-Year Balanced Budget
Proposal Released on December 7, 1995 (JCX-58-95) December 15, 1995.

-l-


based on the organization's gross or net income). Organization managers who participate in an
excess benefit transaction knowing that it is an improper transaction would be subject to a first-
tier penalty tax of ten percent of the amount of the excess benefit (subject to a maximum penalty
of $10,000).

Additional, second-tier taxes could be imposed on a disqualified person if there is no
correction of the excess benefit transaction within a specified time period.” In such cases, the
disqualified person would be subject to a penalty tax equal to 200 percent of the amount of
excess benefit. For this purpose, the term "correction" would mean undoing the excess benefit to
the extent possible and, where fully undoing the excess benefit is not possible, taking such
additional corrective action as is prescribed by Treasury regulations.

The intermediate sanctions for "excess benefit transactions" could be imposed by the IRS
in lieu of (or in addition to) revocation of an organization's tax-exempt status.” If more than one
disqualified person or manager is liable for a penalty excise tax, then all such persons would be
jointly and severally liable for such tax. As under current law, a three-year statute of limitations
would apply, except in the case of fraud (sec. 6501). Under the proposal, the IRS would have
authority to abate the excise tax penalty (under present-law section 4962) if it is established that
the violation was due to reasonable cause and not due to willful neglect and the transaction at
issue was corrected within the specified period.

To prevent avoidance of the penalty excise taxes in cases of private inurement of assets
of a previously tax-exempt organization, the proposal would provide that an organization will be
treated as an applicable tax-exempt organization subject to the excise taxes on excess benefit
transactions if, at any time during the ten-year period preceding the transaction, it was a tax-
exempt organization described in section 501(c)(3) or 501(c)(4), or a successor to such an
organization.

* In determining who is an organization manager, it is intended that principles similar to
those set forth in regulations issued under sections 4946 and 4955 with respect to final authority
or responsibility for an expenditure be applied. (See Treas. Reg. secs. 53.4946-1(f)(1)(ii),
53.4946-1(f)(2), 53.4955-1(b)(2)(ii)(B), and 53.4955-1(b)(2)(iii))

* Correction would be required to be made on or prior to the earlier of (1) the date of
mailing of a notice of deficiency under section 6212 with respect to the first-tier penalty excise
tax imposed on the disqualified person, or (2) the date on which such tax is assessed.

** In general, the intermediate sanctions would.be the sole sanction imposed in those
cases in which the excess benefit does not rise to a level where it calls into question whether, on
the whole, the organization functions as a charitable or other tax-exempt organization. In
practice, revocation of tax-exempt status, with or without the imposition of excise taxes, would
occur only when the organization no longer operates as a charitable organization.

-42-


corporation (with respect to its appreciated assets) and its shareholders (with respect to
their stock) upon the conversion to S corporation status.

For this purpose, a large S corporation is one with a value of more than $5 million
at the time of conversion. The value of the corporation would be the fair market value of
all the stock of the corporation on the date of conversion.

Effective Date
The proposal would be effective for conversions on or after December 7, 1995.
16. Inventory reforms
a. Repeal lower of cost or market inventory accounting method
Present Law

A taxpayer that sells goods in the active conduct of its trade or business generally
must maintain inventory records in order to determine the cost of goods it sold during the
taxable period. Cost of goods sold generally is determined by adding the taxpayer's
inventory at the beginning of the period to purchases made during the period and
subtracting from that sum the taxpayer's inventory at the end of the period.

Because of the difficulty of accounting for inventory on an item-by-item basis,
taxpayers often use conventions that assume certain item or cost flows. Among these
conventions are the "first-in-first-out" ("FIFO") method which assumes that the items in
ending inventory are those most recently acquired by the taxpayer, and the “last-in-first-
out" ("LIFO") method which assumes that the items in ending inventory are those earliest
acquired by the taxpayer.

Treasury regulations provide that taxpayers that maintain inventories under the
FIFO method may determine the value of ending inventory under a (1) cost method or (2)
"lower of cost or market" ("LCM") method (Treas. reg. sec. 1.471-2(c)). Under the LCM
method, the value of ending inventory is written down if its market value is less than its
cost.

Description of Proposal
The proposal would repeal the LCM method. Appropriate wash-sale rules would

be provided. The proposal would not apply to taxpayers with average annual gross
receipts over a three-year period of $5 million or less.

-73-



is defined as foreign personal holding company income.

Under section 1296, a foreign corporation is a passive foreign investment company
("PFIC") if the corporation satisfies either a passive income test or a passive asset test. Any
U.S. person owning stock in a PFIC is subject to an interest charge with respect to certain
distributions from the PFIC and gains on dispositions of the stock of the PFIC, unless the
shareholder elects to include in income currently for U.S. tax purposes its share of the earnings
of the PFIC. For this purpose, passive income is defined by reference to foreign personal
company income.

Description of Proposal

The Administration proposal would add a new category of foreign personal holding
company income for purposes of subpart F to include income from notional principal
contracts. In addition, dividend equivalent payments (i.e., in-lieu-of dividend payments made
pursuant to a securities lending transaction that qualifies under sec. 1058) would be included
in the existing category of foreign personal holding company income that includes interest,
dividends, rents and royalties, and annuities.

An exception from subpart F income would be provided for income derived from
notional principal contracts, forward contracts, options and similar financial instruments -
(including instruments referenced to commodities) by a CFC that is a regular dealer in such
instruments.

Under the proposal, income, gain, deduction or loss from a notional principal contract
entered into to hedge an item of income in a category of foreign personal holding company
income, other than dividends, interest, royalties, rents, annuities or dividend equivalent
payments, would be allocated to that category

Foreign personal holding company income from notional principal contracts and the
transfers of equity securities that are subject to the rules governing securities lending
transactions (sec. 1058) would constitute passive income for purposes of determining whether
a foreign corporation isa PFIC. The notional principal contracts and equity securities subject
to section 1058 that give rise to foreign personal holding company income under the proposal
would constitute passive assets for purposes of sections 956A and 1296.

Effective Date

The proposal would be effective for taxable years beginning after December 31, 1995.

-82-



DESCRIPTION OF THE TAX AND HEALTH INSURANCE REFORM PROVISIONS
IN THE PRESIDENT'S
SEVEN-YEAR BALANCED BUDGET PROPOSAL
RELEASED ON DECEMBER 7, 1995

Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION
December 15, 1995

JCX-58-95



19. Further restrict like-kind exchanges involving personal property ....... .
20. Modify net operating loss.carryback and carryforward rules ...........

21. Improve diesel fuel tax compliance by treating kerosene as diesel fuel
for excise tax purposes... eee eee

22. Expand subpart F provisions regarding income from notional
principal contracts and stock lending transactions ...................

23. Provide rules regarding treatment of captive insurance
arrangements ©... 2.22.0 cece eee e ees

24. Reformulate Puerto Rico and possessions tax credit
(sec. 936) 0 ccc nce cette ene n ten enns

HEALTH INSURANCE REFORM PROVISIONS ..................

1. Deduction for health insurance expenses of self-employed
individuals 60 cece tenet eeee

2. Health care amendments to the Employee Retirement Income
Security Act of 1974 200 e eee

ESTIMATED BUDGET EFFECTS OF THE TAX AND HEALTH
INSURANCE PROVISIONS IN THE PRESIDENT'S SEVEN-YEAR
BALANCED BUDGET PROPOSAL RELEASED ON

DECEMBER 7, 1995.66.62.

~iv-


other property transferred and report information regarding the trustee and beneficiaries of the
foreign trust.

Second, a U.S. person that is treated as the owner of any portion of a foreign trust would
be required to ensure that the trust files an annual report to provide full accounting of all the trust
activities for the taxable year, the name of the U.S. agent for the trust, and other information as
prescribed by the Secretary of the Treasury."' In addition, unless a U.S. person is authorized to
accept service of process as the trust's limited agent with respect to any request by the Treasury
Department to examine records or to take testimony and any summons for such records or
testimony in connection with the tax treatment of any items related to the trust, the Treasury
Secretary would be entitled to determine, in its sole discretion, the amount to be taken into
account under the grantor trust rules (secs. 671 through 679). This limited agency relationship
would not constitute an agency relationship for any other purpose under Federal or State law.

Third, any U.S. person who receives (directly or indirectly) any distribution from a
foreign trust would be required to file a notice to report the name of the trust, the aggregate
amount of the distributions received, and other information that the Secretary of the Treasury
may prescribe.

Monetary penalties for failure to report

Under the Administration proposal, a person who fails to provide the required notice in
cases involving the transfer of property to a new or existing foreign trust, or a distribution by a
foreign trust to a U.S. person, would be subject to an initial penalty equal to 35 percent of the
gross reportable amount. A failure to provide an annual reporting of trust activities would result
in an initial penalty equal to 5 percent of the gross reportable amount. In cases involving a
transfer of property to a foreign trust, the gross reportable amount would be the gross value of
the property transferred. In cases involving the death of a U.S. citizen or resident whose estate
includes any portion of a foreign trust, the gross amount would be the value of the property
includible in the gross estate of the decedent. In cases where annual reporting of trust activities
is required, the gross reportable amount would be the gross value of the portion of the foreign
trust's assets treated as owned by the U.S. grantor at the close of the year, and in cases involving
a distribution to a U.S. beneficiary of a foreign trust, the gross reportable amount would be the
amount of the distribution to the beneficiary. An additional $10,000 penalty would be imposed
for continued failure for each 30-day period (or fraction thereof) beginning 90 days after the
Treasury Department notifies the responsible party of such failure. Such penalties would be
subject to a reasonable cause exception.

" It is intended that the regulations would require the trust to furnish information to U.S.
grantors and beneficiaries concerning income reportable by such persons that is similar to the
items on schedule K-1 of Form 1041.

-30-



coverage").*> These qualifying events include: termination or reduction in hours of

employment, death, divorce or legal separation, eligibility for Medicare, or the end of a
child's dependency under a parent's health plan. The maximum period of COBRA.
coverage that may be elected is 36 months, except in the case of termination of
employment or reduction in hours for which the maximum period is 18 months. An
employer is permitted to charge qualified beneficiaries 102 percent of the applicable
premium for COBRA coverage. COBRA coverage may be terminated before the
maximum 18 or 36 months in the case of certain events. These include: the employer
ceases to maintain any group health plan, the qualified beneficiary fails to pay the
premium, the qualified beneficiary becomes covered under another group health plan with
no preexisting condition limitation or exclusion, or the qualified beneficiary becomes
entitled to Medicare.

The Omnibus Budget Reconciliation Act of 1989, amended the COBRA rules to
extend the 18 month maximum COBRA coverage period to 29 months if the qualified
beneficiary is determined under title II or XVI of the Social Security Act to have been
disabled at the time of the qualifying event and the qualified beneficiary provides notice of
such determination to the employer before the end of the 18-month period. This extended
COBRA coverage for 11 months may be terminated in the month that begins more than 30
days after the date of the final determination under title II or XVI of the Social Security
Act that the qualified beneficiary is no longer disabled. A qualified beneficiary has 60
days to notify the employer of a disability determination and must notify the employer
within 30 days after a determination that the qualified beneficiary is no longer disabled.
During the 11-month period of extended COBRA coverage, the qualified beneficiary may
be charged 150 percent of the applicable premium.

The Code imposes an excise tax of $100 per day if an employer fails to comply
with the COBRA coverage rules (sec. 4980B). The tax applies separately with respect to
each qualified beneficiary for whom a failure occurs. In addition, ERISA imposes a
penalty of up to $100 per day if an employer fails to make certain disclosures regarding
COBRA coverage to employees.

Other than the requirements pertaining to COBRA coverage and certain
requirements relating to group health plan coverage of dependent children in cases of
adoption, ERISA does not generally impose any requirements on employers maintaining
group health plans relating to health care access, portability, and renewability of health
plan coverage.

** Identical provisions are contained in the Code (sec. 4980B).

-89-



Effective Date

The proposal would be effective for taxable years beginning after December 31, 1995.

Legislative Background

The BBA of 1995 includes a provision that would apply a look-through rule in
characterizing for unrelated business taxable income purposes certain subpart F insurance
income of a CFC with respect to a United States shareholder that is a tax-exempt organization.
The look-through rule would apply to amounts that constitute insurance income currently
includible in gross income under the subpart F rules and that are not attributable to the
insurance of risks of (1) the tax-exempt organization itself, (2) certain tax-exempt affiliates
of such organization, and (3) any individual who performs services for the benefit of the tax-
exempt organization (or certain tax-exempt affiliates) provided that the insurance covers
primarily risks associated with the individual's performance of services for the benefit of the
tax-exempt organization (or tax-exempt affiliates).

24, Reformulate Puerto Rico and possessions tax credit (sec. 936)

Present Law

Certain domestic corporations with business operations in the U.S. possessions
(including, for this purpose, Puerto Rico and the U.S. Virgin Islands) may elect the section
936 credit which significantly reduces the U.S. tax on certain income related to their
operations in the possessions. In contrast to the foreign tax credit, the possessions tax credit
is a “tax sparing" credit. That is, the credit is granted whether or not the electing corporation
pays income tax to the possession. Income exempt from U.S. tax under this provision falls
into two broad categories: (1) possession business income, which is derived from the active
conduct of a trade or business within a U.S. possession or from the sale or exchange of
substantially all of the assets that were used in such a trade or business; and (2) qualified
possession source investment income ("QPSII"), which is attributable to the investment in the
possession or in certain Caribbean Basin countries of funds derived from the active conduct
of a possession business.

In order to qualify for the section 936 credit for a taxable year, a domestic corporation
must satisfy two conditions. First, the corporation must derive at least 80 percent of its gross
income for the three-year period immediately preceding the close of the taxable year from
sources within a possession. Second, the corporation must derive at least 75 percent of its
gross income for that same period from the active conduct of a possession business.

A domestic corporation that has elected the section 936 credit and that satisfies these
two conditions for a taxable year generally is entitled to a credit based on the U.S. tax
attributable to the sum of the taxpayer's possession business income and its QPSH. However,
the amount of the credit attributable to possession business income is subject to the limitations
enacted by the Omnibus Budget Reconciliation Act of 1993. Under the economic activity

-84-



Inflation adjustment for IRA contribution limit

The Administration proposal is the same as the BBA of 1995.

Spousal IRAs

The BBA of 1995 provides that contributions of up to $2,000 can be made to an IRA for
each spouse in a married couple.

Nondeductible tax-free IRAs

The BBA of 1995 creates a nondeductible tax-free IRA similar to the Special IRA, called
an AD IRA. An AD IRA is generally subject to the same rules as a deductible IRA, but some
special rules apply. Contributions to an AD IRA are nondeductible. Withdrawals from an AD
IRA are not taxable if made (1) after the 5-taxable year period beginning with the taxable year
for which the individual first made a contribution to an AD IRA and (2) either (a) the individual
has attained age 59-1/2, died, or become disabled, or (b) the withdrawal is a special purpose
withdrawal. Special purpose withdrawals made within the 5-taxable year period are includible in
income (to the extent attributable to earnings), but are not subject to the 10-percent early
withdrawal tax. Other withdrawals are includible in income to the extent attributable to earnings
on contributions and subject to the 10-percent early withdrawal tax.

No more than $2,000 can be contributed annually to all IRAs of an individual. However,
the income limits applicable to deductible IRAs do not apply to AD IRAs.

If an individual converts a present-law IRA into an AD IRA after December 3 1, 1995,
and before January 1, 1998, the amount that would have been includible in income had the
individual withdrawn the amount converted is includible in income ratably over 4 years. The
early withdrawal tax does not apply to such conversions.

Special purpose withdrawals

The Administration proposal is generally the same as the BBA of 1995, except that,
under the BBA of 1995, only first-time home buyer expenses up to $10,000 qualify as a special
purpose withdrawal.

Effective Date

The Administration proposal is the same as the BBA of 1995.

-12-



Any amount included in income during 1996 or 1997, that is received under a
contract described in the proposal on the complete surrender, redemption or maturity of the
contract or in full discharge of the obligation under the contract that is in the nature of a
refund of the consideration paid for the contract, would be includable ratably over the first
four taxable years beginning with the taxable year the amount would otherwise have been
includable.

The proposal would not affect the determination of whether interest is deductible
under present-law rules (including whether interest paid or accrued during the phase-in
period is otherwise deductible), and the IRS would not be precluded from applying
common-law doctrines or statutory or other tax rules to challenge corporate-owned life
insurance plans to which present-law rules apply.

Legislative Background

The proposal is similar to the provision relating to disallowance of the interest
deduction for corporate-owned life insurance policy loans that was included in the BBA of
1995.

4. Require gain recognition for certain extraordinary dividends

Present Law

A corporate shareholder is generally allowed to deduct a certain percentage of
dividends received from another corporation. A corporate shareholder who receives an
"extraordinary" dividend is required to reduce the basis of the stock with respect to which
the dividend was received by the non-taxed portion of the dividend (section 1059).
Whether a dividend is "extraordinary" is determined by reference to, among other things,
the size of the dividend in relation to the adjusted basis of the shareholder's stock. Also, a
dividend resulting from a non prorata redemption or partial liquidation is an extraordinary
dividend. If the reduction in basis of stock exceeds the basis in stock with respect to
which an extraordinary dividend is received, the excess is taxed as gain at the time of a
sale or disposition of such stock.

In general, a distribution in redemption of stock is treated as a dividend, rather than
as a sale of the stock, if it is essentially equivalent to a dividend. A redemption of the
stock of a shareholder generally is essentially equivalent to a dividend if it does not result
in a meaningful reduction in the shareholder's proportionate interest in the distributing
corporation. The determination whether a redemption is essentially equivalent to a
dividend includes a reference to the constructive ownership rules of section 318, including
the option attribution rules of section 318(a)(4). The rules relating to treatment of other
property received in a reorganization contain a similar reference (section 356(a)(2)).

-54-



IV. ESTIMATED BUDGET EFFECTS OF THE PRESIDENT’S 7-YEAR BALANCED BUDGET PROPOSAL
RELEASED ON DECEMBER 7, 1995

Fiscal Years 1996-2005

[Millions of Dollars}
Provision Effective 1996 1997 1998 1999 2000 2001 2002 1996-00 1996-02 1996-05
|, MIDDLE-CLASS BILL OF RIGHTS, TAX COMPLIANCE,
AND SUPERFUND TAX PROVISIONS
1. Credit for families with young children 1/1/96 71,451 -7,228 -7,081 -7,763 -11,096 -11,400 -11,697 -34,619 -57,716 -94,667
2. Deduction for higher education expenses. ............. - 1/1/96 1,736 -5,010 -5,996  -6.679 -6,995 -7,216 -7,452 -26,416 -41,084 -65,512
3. Provisions relating to individual retirement plans 1/1/96 235 A45 -964 -1674 -3,443 -4839 = -5,581 6,290 -16,710 -39,512
4. EIC compliance and self-employment taxes. tyba 12/31/95 13 252 261 265 272 276 282 1,062 1,619 2,505
5. Revision of tax rules on expatriation. .... : 2/6/95 18 29 46 65 86 102 109 244 455 812
6. Modification of rules relating to foreign trusts having
one or more United States beneficiaries 2/6/95 93 162 171 180 188 197 206 794 1,197 1,879
7. Additional empowerment zones.......... . DOE -35 -66 -70 77 -B2 -87 73 -334 -490 -608
8. Intermediate sanctions.......... _ 9/14/95 & 1/1/96 4 4 4 5 5 5 6 22 33 52
9. Reinstatement of authority for undercover |
operations... DOE 11} 1} [t] fy] (t} (} 11) [2] {2} {3}
10. Disclosure of returns concerning ‘cash transactions... DOE - - No Revenue Effect -------------------+------------
11. Superfund tax extension... DOE 860 1,307 959 721 736 752 742 4,582 6,075 6,112

SUBTOTAL: MIDDLE-CLASS BILL OF RIGHTS, TAX COMPLIANCE,
AND SUPERFUND TAX PROVISIONS....

ll, “REVENUE RECONCILIATION ACT OF 1995” PROVISIONS
1. Reform depreciation under the income forecast

71,999 -10,995 -12,670 -14,957 -20,329 -22,210 -23,458 -60,949 -106,618 -188,934

method... ppisa 9/13/95 18 83 29 13 14 16 19 157 192 273
2. Phase out preferential tax deferral for ce

large farm corporations required to use accrual

accounting. eesneeseeenentencsnceenee [4] 26 37 38 39 40 at 42 179 261 392
3. Disallow interest deduction for corporate-owned life

insurance policy loans (Administration version)......... . ipoaa 9/18/95, 383 1,089 1,508 1,674 1,795 1,852 1,880 6,448 10,180 15,993
4. Gain recognition for certain extraordinary dividends

(Seagrams)... da 5/3/95 -56 -100 “71 +33 13 69 104 -247 74 2904
5. Modify basis adjustment rules under section 103 icoa 9/13/95 2 4 7 W 16 23 31 40 94 243
6. Registration of certain confidential corporate tax

SHEETS... eeeseeeeeccseneee seen aiolRSg [2] [2] {2} [2] [2] [21 (2] {5} [5] [6}
7, Require thrifts to account for bad debts in the same :

manner as banks. sreeeieesectnesneesse tyba 12/31/95 63 95 216 280 277 272 260 931 1,462 1,857
8. Extend Oil Spill Liability Trust Fund tax through 9/30/02 1/1/96 = be - 2 = 63 65 a 128 128

SUBTOTAL: "REVENUE RECONCILIATION ACT OF 1995” PROVISIONG.......... 439° «1,211 1,730 1,987 2,158 = 2,339 2,404 7,523 12,264 = 19,210


different results than the TPC method whenever a taxpayer's production processes change
between the base year and the current year. For example, assume that in the base year the
taxpayer can produce an item by applying 5 units of material at $8 a unit, 10 hours of labor
at $10 an hour, and 10 hours of overhead at $5 an hour.‘ Thus, it costs $190 to produce an
item in the base year (5 times $8, plus 10 times $10, plus 10 times $5). Further assume
that: (1) the taxpayer's production processes change such that in the current year it now
takes 5 units of materials, 5 hours of labor, and 5 hours of overhead to produce the same
item; (2) the prices for materials, labor, and overhead have remained constant from the

base year to the current year; and (3) one item of inventory remains at the end of the
current year. Under the TPC method, because prices have remained constant, ending
inventory would be valued at $190 (the total product cost of producing one item in the base
year). Under the COC method as applied by some taxpayers, ending inventory could be
valued at $115 (5 units of materials times $8, plus 5 hours of labor times $10, plus 5 hours
of overhead times $5).

Thus, in this example, application of the COC method in this manner would reduce
taxable income by $75 ($190 less $115) in the current year as compared to the TPC
method. The $75 reduction in taxable income is comprised of the following: (1) $50 of
labor reductions (5 less labor hours times the $10 per hour labor rate) and (2) $25 of
overhead reductions. In this case, the reduction in labor hours is demonstrable. However,
the reduction in overhead results because of the use of the burden rate that allocates
overhead based on labor hours rather than because of a demonstrable reduction of the
appropriate amount of overhead to be applied to inventory. In fact, a reduction of labor
hours in the current year may be attributable to an increased reliance upon overhead costs
in the production process (e.g., reductions in workforce may result because of increased
mechanization.)

Description of Proposal

The proposal would repeal the COC method. The proposal is not intended to affect
the determination of whether the COC method is an appropriate method and the IRS would
not be precluded from challenging its use

Effective Date

The proposal would be effective for taxable years beginning after December 31,
1995. For taxpayers continuing to use a LIFO method of valuing inventory, the proposal
would be applied on a cut-off basis.

** In this example, overhead is allocated to inventory pursuant to a burden rate based on
labor hours. Such allocations are common.

-75-



Effective Date

The proposal would be effective on the date of enactment.

Legislative Background

The proposal is identical to the proposal contained in the President's fiscal year 1996
budget proposal (the "Tax Compliance Act of 1995," introduced on February 16, 1995, as H.R.
981 by Representatives Gephardt and Gibbons and as S. 453 by Senators Moynihan and
Daschle).

8. Intermediate sanctions for certain tax-exempt organizations

Present Law

Private inurement

Charities.--Section 501(c)(3) specifically conditions tax-exempt status for all
organizations described in that section on the requirement that no part of the net earnings of the
organization inures to the benefit of any private shareholder or individual (the so-called “private
inurement test").

Social welfare organizations --A tax-exempt social welfare organization described in
section 501(c)(4) must be organized on a non-profit basis and must be operated exclusively for
the promotion of social welfare. In contrast to section 501(c)(3), however, there is no specific
Statutory rule in section 501(c)(4) prohibiting the net earnings of a social welfare organization
described in section 501(c)(4) from inuring to the benefit of a private shareholder or individual,”

Other organizations.--Other tax-exempt organizations, such as labor and agricultural
organizations described in section 501(c)(5) and business leagues described in section 501(c)(6)
are subject to the private inurement test, as a result of explicit statutory language or Treasury
Department regulations.

Sanctions for private inurement and other violations of exemption standards

Organizations described in section 501(c)(3) are classified as either public charities or
private foundations. Penalty excise taxes may be imposed under the Code when a public charity

3 Even where no prohibited private inurement exists, however, more than incidental
Private benefits conferred on individuals may result in the organization not being operated

“exclusively” for an exempt purpose. See, e.g., American C ampaign Academy v.

Commissioner, 92 T.C. 1053 (1989)

-36-


Il. CORPORATE SUBSIDIES, LOOPHOLE CLOSERS AND OTHER MATTERS
1. Reform depreciation under the income forecast method

Present Law
epreciation and amortization, in general

A taxpayer generally must capitalize the cost of property used in a trade or business
and recover such cost over time through allowances for depreciation or amortization.
Depreciation deductions are allowed under section 167 and the amounts of such deductions
are determined under the modified Accelerated Cost Recovery System ("MACRS") of
section 168 for most tangible property. MACRS determines depreciation by applying
specific recovery periods, placed-in-service conventions, and depreciation methods to the
cost of various types of depreciable property. Intangible property generally is amortized
under section 197, which applies a 15-year recovery period and the straight-line method to
the cost of applicable property.

Treatment of film, video tape, and similar property

MACRS does not apply to certain property, including (1) any motion picture film;
video tape, or sound recording or (2) any other property if the taxpayer elects to exclude
such property from MACRS and the taxpayer applies a unit-of-production method or other
method of depreciation not expressed in a term of years. Likewise, 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 unless acquired as
part of a trade or business. Thus, 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 recovered under either the MACRS depreciation provisions or under the section 197
amortization provisions. The cost of such property may be depreciated under the general
depreciation provision of section 167, which allows deductions for the reasonable
allowance for the exhaustion, wear and tear, or obsolescence of the property.

The “income forecast" method is an allowable method for calculating depreciation
under section 167 for certain property. The income forecast method attempts to match
allocable portions of the cost of property with the income expected to be generated by the
property. Specifically, under the income forecast method, the depreciation deduction for a
taxable year for a property is determined by multiplying the cost of the property (less
estimated salvage value) 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 to be derived from the property during its useful life. The income
forecast method has been held to be applicable for computing depreciation deductions for
motion picture films, television films and taped shows, books, patents, master sound
recordings and video games. The total forecasted or estimated income to be derived from
a property is to be based on the conditions known to exist at the end of the period for

-48-



no part of 4 of the annual premiums due during the first 7 years is paid by means of debt
(the "4-out-of-7 rule") (sec. 264(c)(1)). Provided the transaction gives rise to debt for
Federal income tax purposes and provided the 4-out-of-7 rule is met,” a company may
under present law borrow up to $50,000 per employee, officer, or financially interested
person to purchase or carry a life insurance contract covering such a person, and is not
precluded under section 264 from deducting the interest on the debt, even though the
earnings inside the life insurance contract (inside buildup) are tax-free, and in fact the
taxpayer has full use of the borrowed funds.

Description of Proposal

Under the proposal, no deduction would be allowed for interest paid or accrued on
any indebtedness with respect to one or more life insurance policies or annuity or
endowment contracts owned by the taxpayer covering any individual who is (1) an officer
or employee of, or (2) financially interested in any trade or business carried on by the
taxpayer, regardless of the aggregate amount of debt with respect to policies or contracts
covering the individual.

Effective Date

The proposal generally would be effective with respect to interest paid or accrued
after December 31, 1995 (subject to a phase-in rule). In addition, interest paid or accrued
after September 18, 1995, would be allowable only to the extent the rate of interest does
not exceed the lesser of (1) the borrowing rate specified in the contract as of September 18,
1995, or (2) Moody's Corporate Bond Yield Average--Monthly Average Corporates for the
month the interest is paid or accrued.

The phase-in of the proposal would permit a deduction for 50 percent of the
otherwise deductible interest paid or accrued in 1996 (that would, but for the phase-in, be
disallowed). Interest paid or accrued in 1997 and thereafter would not deductible. The
interest deduction allowed under the phase-in would be for interest on debt incurred before
September 18, 1995, with respect to a life insurance policy that was in effect on that date
and that covers only the individual who was insured under that policy on that date. Only
interest that would have been allowed as a deduction but for the amendment made by the
proposal would be allowed under the phase-in. Interest that is deductible under the phase-
in rule would not include interest on borrowings by the taxpayer with respect to contracts
on the lives of more than 20,000 insured individuals, effective for interest paid or accrued
after December 31, 1995. For this purpose, all persons treated as a single employer would
be treated as one taxpayer.

?§ Interest deductions are disallowed if any of the disallowance rules of section 264(a)(2) -
(4) apply. The disallowance rule of section 264(a)(3) is not applicable if one of the exceptions of
section 264(c), such as the 4-out-of-7 rule (sec. 264(c)(1)) is satisfied. In addition to the specific
disallowance rules of section 264, generally applicable rules of tax law apply.

-53-


which depreciation is claimed. This estimate can be revised upward or downward at the
end of a subsequent taxable period based on additional information that becomes available
after the last prior estimate. These revisions, however, do not affect the amount of
depreciation claimed in a prior taxable year. Thus, unforeseen income that is generated
after the property is fully depreciated is never taken into account under the income forecast
method.

In the case of a film, income to be taken into account under the income forecast
method means income from the film less the expense of distributing the film, including
estimated income from foreign distribution or other exploitation of the film. In the case of
a motion picture released for theatrical exhibition, income does not include estimated
income from future television exhibition of the film (unless an arrangement for domestic
television exhibition has been entered into before the film has been depreciated to its
reasonable salvage value). In the case of a series or a motion picture produced for
television exhibition, income does not include estimated income from domestic
syndication of the series or the film (unless an arrangement for syndication has been
entered into before the series or film has been depreciated to its reasonable salvage value).
The Internal Revenue Service also has ruled that income does not include net
merchandising revenue received from the exploitation of film characters.

Description of Proposal

The proposal would make several amendments to the income forecast method of
determining depreciation deductions.

First, the proposal would provide that income to be taken into account under the
income forecast method includes all estimated income generated by the property. In
applying this rule (and the look-back method described below), a taxpayer generally need
not take into account income expected to be generated more than ten years after the year
the property was placed in service. In addition, pursuant to a special rule, if a taxpayer
produces a television series and initially does not anticipate syndicating the episodes from -
the series, the forecasted income for the episodes of the first three years of the series need
not take into account any future syndication fees (unless the taxpayer enters into an
arrangement to syndicate such episodes during such period). The 10-year rule and the
syndication rule would apply for purposes of the look-back method described below.
Income realized by a taxpayer from a related party with respect to a property subject to the
income forecast method would not be taken into account, but income realized by a related
party from an unrelated party with respect to the party would be taken into account.

In addition, the cost of property subject to depreciation would only include
amounts that satisfy the economic performance standard of section 461(h). Except as
provided in regulations, 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.

~49-


maximum penalty for failure to file correct information returns during any calendar year
($100,000 with respect to small businesses) would continue to apply under the proposal.

The proposal also would provide for an exception to this increase where substantial
compliance has occurred. The proposal would provide that this exception would apply
with respect to a calendar year if the aggregate amount that is timely and correctly reported
for that calendar year is at least 97 percent of the aggregate amount required to be reported
under that section of the Code for that calendar year. If this exception applies, the present-
law penalty of $50 for each return would continue to apply.

The proposal would not affect the following provisions of present law: (1) the
reduction in the $50 penalty where correction is made within a specified period; (2) the
exception for de minimis failures; (3) the lower limitations for persons with gross receipts
of not more than $5,000,000; (4) the increase in the penalty in cases of intentional
disregard of the filing requirement; (5) the penalty for failure to furnish correct payee
statements under section 6722; (6) the penalty for failure to comply with other information
reporting requirements under section 6723; and (7) the reasonable cause and other special
tules under section 6724.

Effective Date

The proposal would apply to information retums the due date for which (without
regard to extensions) is more than 90 days after the date of enactment.

Legislative Background

A similar but narrower proposal was contained in the Health Security Act. That
proposal applied only to returns relating to payments for services under either section 6041
or section 6041A.

19. Further restrict like-kind exchanges involving personal property
Present Law

An exchange of property, like a sale, generally is a taxable event. However, no
gain or loss is recognized if property held for productive use in trade or business or for
investment is exchanged for property of a "like-kind" which is to be held for productive
use in trade or business or for investment (sec. 1031). In general, any kind of real estate is
treated as of a like-kind with other real property as long as the properties are both located
either within or outside the United States. Different types of personal property are not
treated as like-kind unless such properties are of a "like class." In addition, certain types
of property, such as inventory, stocks and bonds, and partnership interests, are not eligible
for nonrecognition treatment under section 1031.

If section 1031 applies to an exchange of properties, the basis of the property

-78-



Il. HEALTH INSURANCE REFORM
1. Deduction for health insurance expenses of self-employed individuals
Present Law

Under present law, self-employed individuals can deduct up to 30 percent of the cost
of health insurance expenses for themselves and their spouse and dependents.

Description of Proposal

The proposal would increase the deduction for health insurance expenses of self-
employed individuals as follows: 35 percent in 1996 and 1997, 40 percent in 1998, 45 percent
in 1999, and 50 percent in 2000 and thereafter.

Effective Date
The proposal would be effective on the date of enactment.
Legislative Background

The Administration proposal is similar to a provision in the BBA. Under the BBA,
the 30-percent deduction would be increased as follows: 35 percent in 1998 and 1999, 40
percent in 2000 and 2001, and 50 percent in 2002 and thereafter.

2. Health care amendments to the Employee Retirement Income Security Act of 1974

Present Law

The Employee Retirement Income Security Act of 1974 ("ERISA"), imposes
certain reporting, disclosure, and fiduciary requirements on employers who maintain group
health plans on behalf of their employees. For example, an employer is generally required
to report certain information about its group health plan to the Internal Revenue Service
and the Department of Labor, an employer is required to provide participants with a
summary plan description containing information regarding a participant's benefits and
rights under the plan, and an employer is required to operate a group health plan in the sole
interest of plan participants and in accordance with the terms of the plan document.
Employers that do not comply with these requirements are subject to civil, and perhaps
criminal, penalties. The Secretary of Labor is primarily responsible for the enforcement of
these requirements. Participants may also take action against an employer to enforce their
rights under a group health plan.

ERISA also requires employers with 20 or more employees who maintain group
health plans to provide certain employees and their dependents the option of purchasing
continued health coverage in the case of certain qualifying events (calied "COBRA

-88-



Effective date.--The provision generally would apply to excess benefit transactions
occurring on or after September 14, 1995. The provision does not apply, however, to any
benefits arising out of a transaction pursuant to a written contract which was binding on
September 13, 1995, and at all times thereafter before such benefits arose, and the terms of
which have not materially changed.

In addition, legislative history would indicate that parties to transactions entered into
after September 13, 1995, and before January 1, 1997, would be entitled to rely on the rebuttable
presumption of reasonableness if, within a reasonable period (e.g., 90 days) after entering into
the compensation package, the parties satisfy the three criteria that give rise to the presumption.
After December 31, 1996, the rebuttable presumption should arise only if the three criteria are
satisfied prior to payment of the compensation (or, to the extent provided by the Secretary of the
Treasury, within a reasonable period thereafter)

Additional filing and public disclosure rules

Reporting of identity of certain disqualified persons, excise tax penalties and excess
benefit transactions.-- Tax-exempt organizations would be required to disclose on their Form
990 the name of each individual who was in a position to exercise substantial influence over the
affairs of the organization (but not their family members and 35-percent owned entities) or such
other information with respect to disqualified persons as the Secretary of the Treasury may:
prescribe. In addition, exempt organizations would be required to disclose on their Form 990
such information as the Secretary of the Treasury may require with respect to "excess benefit
transactions" (described above) and any other excise tax penalties paid during the year under
present-law sections 4911 (excess lobbying expenditures), 4912 (disqualifying lobbying
expenditures), or 4955 (political expenditures), including the amount of the excise tax penalties
paid with respect to such transactions, the nature of the activity, and the parties involved.”

Penalties for failure to file timely or complete return.--The section 6652(c)(1)(A) penalty
imposed on a tax-exempt organization that either fails to file a Form 990 in a timely manner or
fails to include all required information on a Form 990 would be increased from the present-law
level of $10 for each day the failure continues (with a maximum penalty with respect to ariy one
return of the lesser of $5,000 or five percent of the organization's gross receipts) to $20 for each
day the failure continues (with a maximum penalty with respect to any one return of the lesser of
$10,000 or five percent of the organization's gross receipts). Under the proposal, organizations
with annual gross receipts exceeding $1 million would be subject to a penalty under section

5 The penalties applicable to failure to file a timely, complete, and accurate return would
apply for failure to comply with these requirements. In addition, it would be intended that the
IRS implement its plan to require additional Form 990 reporting regarding (1) changes to the
governing board or the certified accounting firm, (2) such information as the Treasury Secretary
may require relating to professional fundraising fees paid by the organization, and (3) aggregate
payments (by related entities) in excess of $100,000 to the highest-paid employees.

-43-


10.

11.

12.

13.

14.

15.

16.

17.

18.

Require gain recognition for certain extraordinary dividends .........

Modify basis adjustment rules under section 1033 ................. ”

Registration of confidential corporate

tax shelters 062 eee ee
Treatment of bad debt deductions of thrift institutions. .............

Reinstate oil spill liability trust fund excise tax ................0..

Repeal percentage depletion for minerals mined on

certain Federal lands... 000... eee eee
Deny interest deduction on certain debt instruments ...............
Defer interest deduction on certain convertible debt ...............
Limit dividends received deduction.....................00.00..
a. Reduce dividends received deduction to 50% .................
b. Modify holding period for dividends received deduction .........

Treat certain preferred stock as "boot" .. 2.0.00... 0.0.0. ee eee eee

Disallowance of interest on indebtedness allocable to tax-exempt

obligations ........... Seen eee eee
Repeal section 1374 for large corporations ...................0-.

Inventory reforms... eee eee

a. Repeal lower of cost or market inventory accounting method

b. Repeal components of cost inventory accounting method ........

Information reporting on persons receiving contracts from certain Federal
agencies ......... bees . eee e cence eee eee

Increase penalties for failure to file correct information returns .......

-iii-

56
58

62

63
64
65
66
66
67

67

69
7h
73
73

74

76

77


date. Under present law, the issuer of such instrument generally cannot deduct such
accrued but unpaid interest.>°

Description of Proposal

The proposal would defer interest deductions on convertible debt until such time as
the ‘interest is paid. For this purpose, payment would not include the conversion of the
debt into equity of the issuer or a related person (as determined under secs. 267(b) and
707(b)). Convertible debt would include debt: (1) exchangeable into the stock of a party
related to the issuer, (2) with cash-settlement conversion features, or (3) issued with
warrants (or similar instruments) as part of an investment unit in which the debt instrument
may be used to satisfy the exercise price of the warrant. Holders of convertible debt would
continue to include the interest on such instruments in gross income as under present law.

Effective Date

The proposal would be effective for debt issued on or after December 7, 1995. The
proposal would not apply, however, to any debt instrument issued pursuant to a
commitment that was binding before December 7, 1995. For this purpose, a binding
commitment includes an underwriting, purchase, distribution, over-allotment option or
merger agreement. In addition, any instrument that was priced before December 7, 1995”
will not be subject to this proposal.

12. Limit dividends received deduction

a. Reduce dividends received deduction to 50 percent

Present Law

If an instrument issued by a U.S. corporation is classified for tax purposes as
equity, a corporate holder of that instrument generally is entitled to a deduction for
dividends received on that instrument. This deduction is 70 percent of dividends received
if the recipient owns less than 20 percent (by vote and value) of stock of the payor. If the
recipient owns more than 20 percent of the stock the deduction is increased to 80 percent.
If the recipient owns more than 80 percent of the payor's stock, the deduction is further
increased to 100 percent for qualifying dividends.

Description of Proposal

Under the proposal, the dividends-received deduction available to corporations
owning less than 20 percent (by vote and value) of the stock of a U.S. corporation would
be reduced to 50 percent of the dividends received.

° See, Rev. Rul. 74-127, 1974-1 C.B. 47 and Scott Paper v. Comm.,74 T.C. 137 (1980).
-66-



3. Disallow interest deduction for corporate-owned life insurance policy loans

Present Law

No Federal income tax generally is imposed on a policyholder with respect to the
earnings under a life insurance contract ("inside buildup").* Further, an exclusion from
Federal income tax is provided for amounts received under a life insurance contract paid
by reason of the death of the insured (sec. 101(a)). The policyholder may borrow with
respect to the life insurance contract without affecting these exclusions, subject to certain
limitations.

The limitations on borrowing with respect to a life insurance contract under present
law provide that no deduction is allowed for any interest paid or accrued on any
indebtedness with respect to one or more life insurance policies owned by the taxpayer
covering the life of any individual who (1) is an officer or employee of, or (2) is financially
interested in, any trade or business carried on by the taxpayer to the extent that the
aggregate amount of such debt with respect to policies covering the individual exceeds
$50,000 (sec. 264(a)(4)).

Further, no deduction is allowed for any amount paid or accrued on debt incurred
or continued to purchase or carry a life insurance, endowment or annuity contract pursuant
to a plan of purchase that contemplates the systematic direct or indirect borrowing of part
or all of the increases in the cash value of the contract.?” An exception to the latter nule is
provided, permitting deductibility of interest on bona fide debt that is part of such a plan, if

© This favorable tax treatment is available only if a life insurance contract meets certain
requirements designed to limit the investment character of the contract (sec. 7702). Distributions
from a life insurance contract (other than a modified endowment contract) that are made prior to
the death of the insured generally are includible in income, to the extent that the amounts
distributed exceed the taxpayer's basis in the contract; such distributions generally are treated
first as a tax-free recovery of basis, and then as income (sec. 72(e)). In the case of a modified
endowment contract, however, in general, distributions are treated as income first, loans are
treated as distributions (i.e., income rather than basis recovery first), and an additional ten
percent tax is imposed on the income portion of distributions made before age 59-1/2 and in
certain other circumstances (secs. 72(e) and (v)). A modified endowment contract is a life
insurance contract that does not meet a statutory "7-pay" test, i.e., generally is funded more
rapidly than seven annual level premiums (sec. 7702A).

* The statute provides that the $50,000 limitation applies only with respect to contracts
purchased after June 20, 1986. However, additional limitations are imposed on the deductibility
of interest with respect to single premium contracts (sec. 264(a)(2)), and on the deductibility of
premiums paid on a life insurance contract covering the life of any officer or employee or person
financially interested in a trade or business of the taxpayer when the taxpayer is directly or
indirectly a beneficiary under the contract (sec. 264(a)(1)).

-52-


Beginning on January 1, 1996, however, compound interest based on the underpayment rate
would be imposed not only on tax amounts determined under the accumulation distribution rules
but also on the total simple interest for pre-1996 periods, if any. For purposes of computing the
interest charge, the accumulation distribution would be allocated proportionately to prior trust
years in which the trust had undistributed net income (and the beneficiary receiving the
distribution was a U.S. citizen or resident), rather than to the earliest of such years. An
accumulation distribution would be treated as reducing proportionately the undistributed income
net income from prior years.

The Administration proposal would include an anti-abuse rule which authorizes the
Secretary of the Treasury to issue regulations, on or after the date of enactment, that may be
necessary or appropriate to carry out the purposes of the rules applicable to accumulation
distributions, including regulations to prevent the avoidance of those purposes.

ins to gran or beneficiaries and use of tr ‘opel

In the case of a loan of cash or marketable securities by the foreign trust to a U.S. grantor
or a U.S. beneficiary (or a U.S. person related to such grantor or beneficiary’), the
Administration proposal would treat the full amount of the loan as distributed to the grantor or
beneficiary, even if the loan bears interest at an adequate rate and is subsequently repaid. In
addition, any subsequent transaction between the trust and the original borrower regarding the
principal of the loan (e.g., repayment) would be disregarded for all purposes of the Code.

In the case of a use of other trust property, the Administration proposal generally would
treat the value of the use of such property by a U.S. grantor or a U.S. beneficiary (or a U.S.
person related to such grantor or beneficiary’) as a distribution to the grantor or beneficiary in an
amount equal to the fair market value of the use of the property.

Effective Date

The proposal to modify the interest charge on accumulation distributions would apply to
distributions after the date of enactment. The proposal with respect to loans to U.S. grantors or
U.S. beneficiaries would apply to loans made after September 19, 1995. The proposal with
respect to use of other trust property by U.S. grantors or U.S. beneficiaries would apply to
transactions after December 31. 1995

® For this purpose, a person generally would be treated as related to the grantor or
beneficiary if the relationship between such person and the grantor or beneficiary would result in
a disallowance of losses under section 267 or 707(b).

° For this purpose, a person generally would be treated as related to the grantor or
beneficiary if the relationship between such person and the grantor or beneficiary would result in
a disallowance of losses under section 267 or 707(b).

-26-



(secs. 652, 662). Distributions from a trust in excess of the trust's DNI' for the taxable year
generally are treatéd as accumulation distributions (sec. 665(b)), subject to the throwback rules.
Under these rules, a distribution by a foreign trust of previously accumulated income generally is
taxed at the beneficiary's average marginal rate for the prior 5 years, plus interest (secs. 666,
667). Interest is computed at a fixed annual rate of 6 percent, with no compounding (sec. 668).

If adequate records of the trust are not available to determine the proper application of
the rules relating to accumulation distributions to any distribution from a trust, the distribution is
treated as an accumulation distribution out of income earned during the first year of the trust
(sec. 666(d)).

Residence of estates and trusts

An estate or trust is treated as foreign if it is not subject to U.S. income taxation on its
income that is neither derived from U.S. sources nor effectively connected with the conduct of a
trade or business within the United States (sec. 7701(a)(31)). Thus, if a trust is taxed in a manner
similar to a nonresident alien individual, it is considered to be a foreign trust. Any other estate or
trust is treated as domestic (sec. 7701(a)(30)).

The Code does not specify what characteristics must exist before a trust is treated as
being comparable to a nonresident alien individual. Internal Revenue Service ("IRS") rulings and
court cases, however, indicate that this status depends on various factors, such as the residence of
the trustee, the location of the trust assets, the country under whose laws the trust is created, the
nationality of the grantor, and the nationality of the beneficiaries.* If an examination of these
factors indicates that a trust has sufficient foreign contacts, it is deemed comparable to a
nonresident alien individual and, thus, is a foreign trust.

Section 1491 generally imposes a 35-percent excise tax on a U.S. person that transfers
appreciated property to certain foreign entities, including a foreign trust.® In the case of a
domestic trust that changes its situs and becomes a foreign trust, it is unclear whether property
has been transferred from a U.S. person to a foreign entity, and, thus, whether the transfer is
subject to section 1491.

* In the case of a foreign trust, DNI also includes foreign-source income net of related
deductions, income that is exempt under treaties, and capital gains reduced (but not below zero)
by capital losses.

* For example, see Rev. Rul. 87-61, 1987-2 C.B. 219, Rev. Rul. 81-112, 1981-1 C.B.
598, Rev. Rul. 60-181, 1960-1 C.B. 257, and B.W. Jones Trust v. Commissioner, 46 B.T.A. 531
(1942), affd, 132 F.2d 914 (4th Cir. 1943).

* In Rev. Rul. 87-61 the IRS held that a U.S. citizen who transferred appreciated
property to a foreign grantor trust is not subject to the section 1491 excise tax because the
grantor continues to own the property for income tax purposes.

-22-



Sanction for failure to appoint limited U.S. agent ¢

Under the Administration proposal, unless a U.S. person is authorized to accept service
of process as the trust's limited agent with respect to any request by the Treasury Department to
examine records or take testimony and any summons for such records or testimony in connection
with the tax treatment of any items related to the trust, the Treasury Secretary would be entitled
to determine, in its sole discretion, the amount to be taken into account under the grantor trust
tules.

Under the BBA of 1995, the Treasury Secretary's exercise of its authority to make such a
determination will be subject to judicial review under an arbitrary or capricious standard, which
accordingly provides a high degree of deference to such determination.

Sanction for failure to maintain adequate records

The BBA of 1995 contains a technical correction to the Administration proposal
regarding a U.S. distribute that fails to provide adequate records to the Treasury Department to
determine the proper treatment of any distributions from a foreign trust. As amended by the
BBA of 1995, when a U.S. distributee does not provide sufficient records, the accumulation
distribution is deemed to come from the trust's average year (i.e., the number of years that the
trust has been in existence divided by 2) for purposes of computing the interest charge applicable
to such distribution.

Penalties for failure to report

The Administration proposal would not provide a cap on penalties imposed for the failure
to report certain transactions between a foreign trust and its U.S. grantor or U.S. beneficiary.
Thus, the penalties could exceed the value of the property involved in the transaction. The BBA
of 1995 limits the amount of monetary penalties to the gross reportable amount (i.e., generally
the value of the property involved in the transaction).

f. Information reporting on foreign gifts

The Administration proposal would not index for inflation the annual amount of gifts or
bequests ($10,000) that are exempt from certain reporting requirements. Under the BBA of, the
$10,000 threshold for such reporting requirement is indexed for inflation.

7. Additional empowerment zones

Present Law

Pursuant to the Omnibus Budget Reconciliation Act of 1993 (OBRA 1993), the
Secretaries of the Department of Housing and Urban Development (HUD) and the Department
of Agriculture designated a total of nine empowerment zones and 95 enterprise communities on

-34-



otherwise protected from disclosure or use. The promoter includes specified related
parties.

Registration will require the submission of information identifying and describing
the tax shelter and the tax benefits of the tax shelter, as well as such other information as
the Treasury Department may require.

Tax shelter promoters are required to maintain lists of those who have signed
confidentiality agreements, or otherwise have been subjected to nondisclosure
requirements, with respect to particular tax shelters. In addition, promoters must retain
lists of those paying fees with respect to plans or arrangements that have previously been
registered (even though the particular party may not have been subject to confidentiality
restrictions).

All registrations will be treated as taxpayer information under the provisions of
section 6103 and will therefore not be subject to any public disclosure.

The penalty for failing to timely register a corporate tax shelter 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 (i.e., this part of the penalty does not apply to fee payments
with respect to offerings after late registration). A similar penalty is applicable to actual
participants in any corporate tax shelter who were required to register the tax shelter but
did not. With respect to participants, however, the 50-percent penalty is based only on
fees paid by that participant. Intentional disregard of the requirement to register by either
a promoter or a participant increases the 50-percent penalty to 75 percent of the applicable
fees.

Effective Date

The proposal would apply to any tax shelter offered to potential participants after
the date the Treasury Department issues guidance with respect to the filing requirements.

Legislative Background
An identical proposal is contained in the BBA of 1995 as passed by Congress.

7, Treatment of bad debt deductions of thrift institutions

Present Law and Background
Reserve method of accounting for bad debts of thrift institutions

Generally, a taxpayer engaged in a trade or business may deduct the amount of any
debt that becomes wholly or partially worthless during the year (the "specific charge-off"
method of sec. 166). Certain thrift institutions (building and loan associations, mutual

-58-



Legislative Background

The proposal had been proposed by the Administration in 1994 as a revenue
provision in conjunction with the passage of the General Agreement on Tariffs and Trade
and had been reported favorably by the Senate Finance Committee, but was not included in
the final legislation as passed by the Congress.

17. Information reporting on persons receiving contracts from certain Federal
agencies

Present Law

A service recipient (i.e., a person for whom services are performed) engaged in a
trade or business who makes payments of remuneration in the course of that trade or
business to any person for services performed must file with the IRS an information retum
reporting such payments (and the name, address, and taxpayer identification number of the
recipient) if the remuneration paid to the person during the calendar year is $600 or more
(sec. 6041A(a)). A similar statement must also be furnished to the person to whom such
payments were made (sec. 6041A(e)). Treasury regulations explicitly exempt from this
Teporting requirement payments made to a corporation (Treas. Reg. 1.6041A-1(d)(2)).

The head of each Federal executive agency must file an information return
indicating the name, address, and taxpayer identification number (TIN) of each person
(including corporations) with which the agency enters into a contract (sec. 6050M). The
Secretary of the Treasury has the authority to require that the returns be in such form and
be made at such time as is necessary to make the returns useful as a source of information
for collection purposes. The Secretary is given the authority both to establish minimum
amounts for which no reporting is necessary as well as to extend the reporting
Tequirements to Federal license grantors and subcontractors of Federal contracts. Treasury
regulations provide that no reporting is required if the contract is for $25,000 or less
(Treas. Reg. 1.6050M-1(c)(1)(i)).

Description of Proposal

The proposal would require reporting of all payments of $600 or more made bya
Federal executive agency to any person (including a corporation) for services. In addition,
the proposal would require that a copy of the information return be sent by the Federal
agency to the recipient of the payment.

Effective Date

The proposal would be effective for returns the due date for which (without regard
to extensions) is more than 90 days after the date of enactment.

-76-



Treatment of former U.S. persons

The Administration proposal would grant broad authority to the Treasury Secretary to
treat any person who was a U.S. person at any time during the existence of the trust as a U.S.
person in determining whether there are U.S. beneficiaries of the trust for purposes of section
679.

Outbound trust migrations

The Administration proposal would apply the rules of section 679 to a U.S. person that
transferred property to a domestic trust if the trust subsequently became a foreign trust while the
transferor was still alive. Such a person would be deemed to make a transfer to the foreign trust
on the date of the migration. The amount of the deemed transfer would be the portion of the
trust (including undistributed earnings) attributable to the property previously transferred.
Consequently, the individual generally would be treated under the rules of section 679 as the
owner of that portion of the trust in any taxable year in which the trust has U.S. beneficiaries.
The Administration proposal's reporting requirements and penalties (discussed below) also
would be applicable.

Effective Date

The proposals described in this part would apply to transfers of property after February 6,
1995.

d. Residence of estates and trusts
Treatment as U.S. person

The Administration proposal would establish a two-part objective test for determining for
tax purposes whether a trust is foreign or domestic. If both parts of the test are satisfied, the trust
would be treated as domestic. Only the first part of the test would apply to estates.

Under the first part of the proposed test, in order for an estate or trust to be treated as
domestic, a U.S. court (i.e., Federal, State, or local) must be able to exercise primary supervision
over the administration of the estate or trust. It is expected that this test would be satisfied by any
trust instrument that specifies that it is to be governed by the laws of any State. In addition, an
estate or trust may be able to subject itself voluntarily to the jurisdiction of a U.S. court through
registration of the estate or trust under a State law similar to Article VII of the American Law
Institute's Uniform Probate Code

Under the second part of the proposed test, in order for a trust to be treated as domestic,
one or more U.S. fiduciaries must have the authority to control all substantial decisions of the
trust. It is expected that this test would be satisfied in any case where fiduciaries who are U.S.
persons hold a majority of the fiduciary power (whether by vote or otherwise), and where no

-28-



The proposal also would require that a special enrollment period be provided (after
any waiting period imposed) to a new employee eligible to enr It in a group health plan.

Prohibition of lifetime limits and specific disease exclusions

An employer-provided group health plan would not be permitted to impose a
catastrophic or lifetime limit with respect to coverage under the plan. Further, although a
group health plan could limit the duration or scope of plan benefits, it could not limit
coverage of services or benefits with respect to specific enumerated diseases, illnesses, or
medical conditions.

Applicability and enforcement of standards

The new provisions contained in the proposal would not prevent a State from
establishing, implementing, or continuing in effect standards and requirements that are not
described in the proposal or relate to the issuance, renewability, or portability of health
insurance, or the establishment or operation of group purchasing arrangements, provided
such standards and requirements are not inconsistent or in direct conflict with the
requirements contained in the proposal and provide better protection or benefits to
participants, beneficiaries, or individuals. Further, the provisions contained in the proposal
would not affect section 514 of ERISA which generally preempts State laws. The proposal -
would also not require a group health plan to provide benefits to a participant (or
beneficiary) in excess of those provided under the terms of the plan.

In general, the requirements contained in the proposal would be enforced by the
Secretary of Labor under the present-law enforcement provisions contained in ERISA.
The Secretary of Labor would be given authority to issue regulations necessary or
appropriate to carry out the proposal.

Technical Amendments to ERISA

The proposal would change the definition of governmental plan in ERISA to mean
a plan established and maintained predominantly for its employees by a Federal, State or
local governmental entity. Under present law, a governmental plan can cover only
government employees. The proposal would also modify the ERISA provision governing
which plans are subject to ERISA's requirements so that ERISA's reporting, disclosure,
and fiduciary requirements apply to group health plans maintained by a church or an
association or convention of churches.

The proposal would also change ERISA's rules regarding the disclosure of
information to participants (and beneficiaries) so that if there is a modification to the terms
of an employee benefit plan, including a group health plan, that results in a material
reduction in covered services or benefits provided under the plan, a summary description
of such modification must be provided to participants (and beneficiaries) no later than 60
days after the date of the adoption of the modification. This requirement could

-94-



Taxation of withdrawals

Amounts withdrawn from IRAs (other than amounts that represent a return of
nondeductible contributions) are includible in income when withdrawn.

To discourage the use of amounts contributed to an IRA for nonretirement purposes,
withdrawals from an IRA prior to age 59-1/2, death, or disability are generally subject to an
additional 10-percent income tax. The 10-percent tax is intended to recapture at least a portion of
the tax benefit of the IRA. The 10-percent tax does not apply to withdrawals that are part of a
series of substantially equal periodic payments made for the life (or life expectancy) of the
taxpayer or the joint lives (or joint life expectancies) of the taxpayer and the taxpayer's
designated beneficiary. A similar early withdrawal tax applies to withdrawals from qualified
retirement plans.

Elective deferrals

Under a qualified cash or deferred arrangement, an individual can elect to have
compensation paid in cash or contributed to a tax-qualified retirement plan. Amounts contributed
at the election of the employee are referred to as elective deferrals. Like other qualified plan
contributions, elective deferrals are not includible in income until withdrawn from the plan.
Qualified cash or deferred arrangements are subject to the same rules applicable to qualified
plans generally, and are also subject to additional requirements. One of these additional
requirements is that the maximum amount of elective deferrals that can be made in a year by an
individual is limited to $9,240 in 1995. This dollar limit is indexed for inflation in $500
increments. A similar limit applies to elective deferrals under similar arrangements (e.g.,
tax-sheltered annuities).

Description of Proposal

In general

In general, the proposal would (1) double the present-law income limits on deductible
TRA contributions and increase the income phase-out range to $20,000 (so that, in 1996, the
income phase-out range would be $80,000 to $100,000 of AGI for married taxpayers and
$50,000 to $70,000 for single taxpayers); (2) index the $2,000 IRA contribution limit in $500
increments; (3) coordinate the IRA contribution limit with the elective deferral limit; (4) create
nondeductible tax-free IRAs called "Special IRAs"; and (5) provide an exception from the 10-
percent early withdrawal tax for IRA distributions used for higher education expenses, first-time
homebuyer expenses, extraordinary medical expenses and distributions to individuals who have
been receiving unemployment compensation for at least 12 weeks.

-9-


18. Increase penalties for failure to file correct information returns

Present Law

Any person that fails to file a correct information return with the IRS on or before
the prescribed filing date is subject to a penalty that varies based on when, if at all, the
correct information return is filed. If a person files a correct information return after the
prescribed filing date but on or before the date that is 30 days after the prescribed filing
date, the penalty is $15 per return, with a maximum penalty of $75,000 per calendar year.
If a person files a correct information return after the date that is after 30 days after the
prescribed filing date but on or before August 1 of that year, the penalty is $30 per return,
with a maximum penalty of $150,000 per calendar year. If a correct information return is
not filed on or before August 1, the amount of the penalty is $50 per return, with a
maximum penalty of $250,000 per calendar year.

There is a special rule for de minimis failures to include the required, correct
information. This exception applies to incorrect information returns that are corrected on
or before August 1. Under the exception, if an information return is originally filed
without all the required information or with incorrect information and the return is
corrected on or before August 1, then the original return is treated as having been filed
with all of the correct required information. The number of information returns that may
qualify for this exception for any calendar year is limited to the greater of (1) ten returns or
(2) one-half of one percent of the total number of information returns that are required to
be filed by the person during the calendar year.

In addition, there are special, lower maximum levels for this penalty for small
businesses. For this purpose, a small business is any person having average annual gross
receipts for the most recent three taxable years ending before the calendar year that do not
exceed $5 million. The maximum penalties for small businesses are: $25,000 (instead of
$75,000) if the failures are corrected on or before 30 days after the prescribed filing date;
$50,000 (instead of $150,000) if the failures are corrected on or before August 1; and
$100,000 (instead of $250,000) if the failures are not corrected on or before August 1.

If a failure to file a correct information return with the IRS is due to intentional
disregard of the filing requirement, the penalty for each such failure is generally increased
to the greater of $100 or ten percent of the amount required to be reported correctly, with
no limitation on the maximum penalty per calendar year (sec. 6721(e)). The increase in
the penalty applies regardless of whether a corrected information return is filed, the failure
is de minimis, or the person subject to the penalty is a small business.

Description of Proposal
The proposal would increase the penalty for failure to file information returns

correctly on or before August 1 from $50 for each return to the greater of $50 or five
percent of the amount required to be reported correctly but no so reported. The $250,000

-77-



23. Provide rules regarding treatment of captive insurance arrangements
Present Law

The term "insurance" is not defined in the Code. In general, courts have held that an
insurance transaction involves risk shifting and risk distribution. See Helvering v. LeGierse,
312 U.S. 531 (1941).

Under the subpart F rules, the United States shareholders (as defined in sec. 951(b))
of a controlled foreign corporation (CFC) are required to include in income currently their
shares of certain income of the CFC, whether or not such income is actually distributed to the
shareholders. This current inclusion rule applies to certain insurance income of the CFC. In
addition, special provisions under the subpart F rules apply to the "related person insurance
income" of a CFC.

Description of Proposal

The proposal would provide that an insurance arrangement between a company and
any other person would be treated as an insurance arrangement for tax purposes if less than
50 percent of the company's net written premiums are attributable to the insurance or
reinsurance of risks of related parties. The rules of subchapter L would apply to a company -
that satisfies this threshold, and amounts paid to the company for the insurance or reinsurance
of risks would be treated as insurance premiums. The subpart F insurance provisions would
apply to a CFC that satisfies this threshold.

The tax treatment of a company that does not satisfy the threshold would be governed
by the general provisions of the Code (including subpart F, where applicable) rather than by
subchapter L. The company would not be eligible for tax exemption under section 501(c)(15).
Amounts paid to the company by related persons for the insurance or reinsurance of risks
would be characterized as payments for risk management services and would not be subject
to the federal insurance premium excise tax. Amounts paid to the company by unrelated
persons for the insurance or reinsurance of risks would be characterized as insurance
premiums and would be subject to the federal insurance premium excise tax. Subpart F would
be amended so that amounts received by a CFC that does not satisfy the threshold would be
included in subpart F income and income from transactions with related persons would be
subject to rules similar to the related party insurance income rules.

For purposes of this provision, related persons would include any 10-percent
shareholder of the company and any person that would be a related person under rules similar
to the rules of section 954(d)(3). For purposes of applying the threshold, net written premiums
would be determined based on a three-year rolling average (excluding premiums written in
taxable years beginning before 1996).

-83-



2. Deduction for higher education expenses
Present Law

Taxpayers generally may not deduct education and training expenses. However, a
deduction for education expenses generally is allowed under section 162 if the education or
training (1) maintains or improves a skill required in a trade or business currently engaged in by
the taxpayer, or (2) meets the express requirements of the taxpayer's employer, or requirements
of applicable law or regulations, imposed as a condition of continued employment (Treas. Reg.
sec. 1,162-5). Education expenses are not deductible if they relate to certain minimum
educational requirements or to education or training that enables a taxpayer to begin working in
a new trade or business. In the case of an employee, education expenses (if not reimbursed by
the employer) may be claimed as an itemized deduction only if such expenses relate to the
employee's current job and only to the extent that the expenses, along with other miscellaneous
deductions, exceed two percent of the taxpayer's adjusted gross income (AGI).

Education expenses that are reimbursed by the employer are excludable from the
employee's gross income as a working condition fringe benefit (sec. 132(d)) if the education
qualifies as work related under section 162. A special rule allowed an employee to exclude from
gross income up to $5,200 paid by his or her employer for educational assistance, regardless of
whether the education maintained or improved a skill required by the employee's current position
(sec. 127). That special rule for employer-provided educational assistance expired after 1994.

Another special rule, section 135, provides that interest earned on a qualified U.S. Series
EE savings bond issued after 1989 is excludable from gross income if the proceeds of the bond
upon redemption do not exceed qualified higher education expenses paid by the taxpayer during
the taxable year.? "Qualified higher education expenses" include tuition and required fees for the
enrollment or attendance of the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer at
certain colleges, universities, or vocational schools. The exclusion provided by section 135 is
phased out for certain higher-income taxpayers, determined by the taxpayer's AGI during the
year the bond is redeemed. To prevent taxpayers from effectively avoiding the income phaseout
limitation through issuance of bonds directly in the child's name, section 135(c)(1)(B) provides
that the interest exclusion is available only with respect to U.S. Series EE savings bonds issued
to taxpayers who are at least 24 years old

Section 117 excludes from gross income amounts received as a qualified scholarship by
an individual who is a candidate for a degree and used for tuition and fees required for the
enrollment or attendance (or for fees, books, supplies, and equipment required for courses of

? If the aggregate redemption amount (i.e., principal plus interest) of all Series EE bonds
redeemed by the taxpayer during the taxable year exceeds the qualified education expenses
incurred, then the excludable portion of interest income is based on the ratio that the education
expenses bears to the aggregate redemption amount (sec. 135(b)).

5.


destined for a nontaxable use or (2) it was removed by a registered aviation dealer for use
as aviation fuel.

To accommodate State safety regulations requiring that only K-1 kerosene be used
in certain space heaters, a new refund procedure would be established under which
registered ultimate vendors would be eligible for refunds of any tax paid earlier in the fuel
distribution chain on kerosene sold for that use.

Effective Date

The proposal would be effective for kerosene removed from terminal facilities after
March 31, 1996. Appropriate floor stocks taxes would be imposed on kerosene held
beyond the point of taxation on April 1, 1996.

22, Expand subpart F provisions regarding income from notional principal contracts
and stock lending transactions

Present Law

Under the rules of subpart F, United States shareholders (as defined in sec. 951(b)) of
a controlled foreign corporation ("CFC") are required to include in income currently certain’ ~
types of income of the CFC, whether or not such income is distributed to the shareholders.
The types of income subject to this current inclusion rule (generally referred to as "subpart F
income") include, among other things, "foreign personal holding company income."

Foreign personal holding company income generally consists of passive income in the
following categories: dividends, interest, royalties, rents and annuities; net gains from sales
or exchanges (a) of property that gives rise to the foregoing types of income, (b) of property
that does not give rise to income, or (c) of an interest in a trust, partnership or REMIC; net
gains from commodities transactions; net gains from foreign currency transactions; and
income that is equivalent to interest. Income from notional principal contracts is treated as
foreign personal holding company income only if it is referenced to commodities, foreign
currency, interest rates, or to indices thereon. In addition, income derived from transfers of
debt securities, but not equity securities, that are subject to the rules governing securities
lending (sec. 1058) is treated as foreign personal holding company income.

A variety of exceptions from foreign personal holding company income are provided
for income earned by a CFC that is a regular dealer in the property that is sold or exchanged,
or income arising out of certain hedging transactions. However, no exception is available for
a CFC that is a regular dealer with respect to financial instruments referenced to commodities.

Under section 956A, United States shareholders of a CFC are required to include in
income currently their shares of the CFC's earnings invested in excess passive assets. A CFC
generally has excess passive assets if its passive assets exceed 25 percent of its total assets.
A passive asset is any asset that produces passive income. For this purpose, passive income

-81-



MOF

under the plan; and (3) does not apply to a pregnancy.” However, under the proposal a
group health plan would be permitted to impose a preexisting condition limitation or
exclusion only to the extent that such service or benefit was not previously covered under
the group health plan or individual health plan® in which the participant (or beneficiary)
was enrolled immediately prior to enrollment in the current group health plan.

The proposal would further limit the ability of a group health plan to apply a
preexisting condition limitation or exclusion to the extent the participant (or beneficiary) is
in a period of previous qualifying coverage as of the date of enrollment under the group
health plan. In such a case, the period of limitation or exclusion would have to be reduced
by one month for each month the participant (or beneficiary) was in the period of previous
qualifying coverage. Further, in such a case no preexisting condition limitation or
exclusion could be applied with respect to a child whose previous qualifying coverage
began within 30 days of birth or placement for adoption during the child's first 12 months
of life or within 12 months after the placement of the child for adoption. Previous
qualifying coverage would mean a continuous period of at least 60 days (without regard to
any waiting period) beginning on the date a participant (or beneficiary) is enrolled under a
group health plan, an individual health plan, or a public or private health plan established
under Federal or State law, and ending on the date the individual is no longer so enrolled.’

In order to facilitate the crediting of previous qualifying coverage, a group health
plan would be required to provide a participant (and beneficiary) whose coverage is
terminated documentation which includes the dates the participant (or beneficiary) was

°° The present law rule prohibiting the application of a preexisting condition limitation or
exclusion to an adopted child adopted while the participant (or beneficiary) is covered under the
group health plan would continue to apply (ERISA sec. 609(c)(2)).

© The term individual health plan would be defined as any contract, policy, certificate,
or other arrangement offered to individuals by a health plan issuer (an entity licensed by a State
to offer a group health plan or an individual health plan) that provides or pays for health benefits
and that is not a group health plan. The term individual health plan specifically does not include:
(1) coverage only for accident or disability income insurance; (2) Medicare supplemental health
insurance; (3) coverage issued as a supplement to liability insurance; (4) liability insurance
(including general and automobile liability insurance). (5) workers' compensation or similar
insurance; (6) automobile medical payment insurance: (7) coverage for a specified disease or
illness; (8) hospital or fixed indemnity insurance; (9) short-term limited duration insurance; (10)
credit-only, dental-only, or vision-only insurance; (1 1).insurance providing benefits for long-
term care, nursing home care, home health care, or community-based care.

‘' The proposal would not preempt any State law (that was not otherwise preempted by
ERISA sec. 514) which allows a participant (or beneficiary) to be considered in a period of
previous qualifying coverage even if such participant (or beneficiary) experiences a lapse in
coverage that is greater than 60 days.

-92-



bad debt reserve; any losses in excess of the reserve are deductible. Any reserve balance
in excess of the balance of related loans is includible in income.

Recapture of bad debt reserves by thrift institutions

Ifa thrift institution becomes a commercial bank, or if the institution fails to satisfy
the 60-percent qualified asset test, it is required to change its method of accounting for bad
debts and, under proposed Treasury regulations,” is required to recapture its bad debt
reserve. The percentage-of-taxable-income portion of the reserve generally is included in
income ratably over a 6-taxable year period. The experience method portion of the reserve
is not restored to income if the former thrift institution qualifies as a small bank. If the
former thrift institution is treated as a large bank, the experience method portion of the
Teserve is restored to income ratably over a 6-taxable year period, or under the 4-year
recapture method or the cut-off method described above.

In addition, a thrift institution may be subject to a form of reserve recapture even if
the institution continues to qualify for the percentage of taxable income method.
Specifically, if a thrift institution distributes to its shareholders an amount in excess of its
post-1951 earnings and profits, such excess is deemed to be distributed from the
institution's bad debt reserve and is restored to income. In the case of any distribution in
redemption of stock or in partial or complete liquidation of an institution, the distribution ~
is treated as first coming out of the bad debt reserves of the institution (sec. 593(e)).

Financial accounting treatment of tax reserves of bad debts of thrift institutions

In general, for financial accounting purposes, a corporation must record a deferred
tax liability with respect to items that are deductible for tax purposes in a period earlier
than they are expensed for book purposes. The deferred tax liability signifies that,
although a corporation may be reducing its current tax expense because of the accelerated
tax deduction, the corporation will become liable for tax in a future period when the timing
item “reverses" (i.e., when the item is expensed for book purposes but for which the tax
deduction had already been allowed). Under the applicable accounting standard
(Accounting Principles Board Opinion 23), deferred tax liabilities generally were not
required for pre-1988 tax deductions attributable to the bad debt reserve method of thrift
institutions because the potential reversal of the bad debt reserve was indefinite (i.e.,
generally, a reversal only would occur by operation of sec. 593(e), a condition within the
control of a thrift institution). However, the establishment of 1987 as a base year increased
the likelihood of bad debt reserve reversals with respect to post-1987 additions to the
reserve and the conferees understand that thrift institutions generally have recorded
deferred tax liabilities for these additions under the current generally accepted accounting
principles.

° Prop. Treas. reg. sec. 1.593-13.
-60-



adjustment for the stock). In addition, the basis of any individual asset would not be
reduced below zero. The basis reduction would be first applied to property that is similar
or related in service or use to the converted property, then to other depreciable property,
and finally to any other property.

The application of these rules can be demonstrated by the following examples:

Example 1.--Assume that a taxpayer owned a commercial building with an adjusted
basis of $100,000 that was involuntarily converted, causing the taxpayer to receive $1
million in insurance proceeds. Further assume that the taxpayer acquires, as replacement
property, all of the stock of a corporation, the sole asset of the corporation is a building
with a value and an adjusted basis of $1 million. Under the proposal, the taxpayer would
reduce his or her basis in the stock to $100,000 (as under present law) and the corporation
would reduce its adjusted basis in the building to $100,000.

Example 2.--Assume the same facts as in Example 1, except that on the date of
acquisition, the corporation has an adjusted basis of $100,000 (rather than $1 million) in
the building. Under the proposal, the taxpayer would reduce his or her basis in the stock to
$100,000 (as under present law) and the corporation would not be required to reduce its
adjusted basis in the building.

Effective Date

The proposal would apply to involuntary conversions occurring after
September 13, 1995.

Legislative Background

The proposal is substantially identical to a provision in the BBA of 1995.
6. Registration of confidential corporate tax shelters
Present Law

An organizer of a tax shelter is required to register the shelter with the Internal
Revenue Service (IRS) (sec. 6111). If the principal organizer does not do so, the duty may
fall upon any other participant in the organization of the shelter or any person participating
in its sale or management. The shelter's identification number must be furnished to each
investor who purchases or acquires an interest in the shelter. Failure to furnish this
number to the tax shelter investors will subject the organizer to a $100 penalty for each
such failure (sec. 6707(b)).

A penalty may be imposed against an organizer who fails without reasonable cause

to timely register the shelter or who provides false or incomplete information with respect
to it. The penalty is the greater of one percent of the aggregate amount invested in the

-56-



have the fair market value provision apply to any specific property, solely for purposes of
determining gain with respect to that property.

AUS. citizen who relinquishes citizenship by formally renouncing his or her citizenship
before a diplomatic or consular officer of the United States would be treated as having
relinquished his or her citizenship on that date, provided that the U.S. Department of State
confirms the renunciation by issuing a certificate of loss of nationality (CLN). A U.S. citizen
who furnishes the State Department with a signed statement of voluntary relinquishment of U.S.
nationality would be treated as having relinquished his or her citizenship on the date the
statement is furnished, provided that the voluntary relinquishment is later confirmed by the
issuance of a CLN. If neither of these circumstances exist, the individual would be treated as
having relinquished citizenship on the date the CLN is issued or a certificate of naturalization is
canceled. A long-term resident would terminate his or her residency by ceasing to be a lawful
permanent resident or by becoming a resident of a foreign country under a treaty tie-breaker rule.

The State Department would be required to provide the Secretary of the Treasury with a
copy of each CLN approved by the State Department. Similarly, the agency administering the
immigration laws would be 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.

Effective Date

The proposal would be effective for U.S. citizens who are treated as having relinquished
their U.S. citizenship on or after February 6, 1995, and for long-term residents who terminate
their U.S. residency on or after February 6, 1995. The tentative tax would not be required to be
paid earlier than 90 days after enactment. The fair market value basis provision would apply to
any deemed dispositions of property resulting from expatriations occurring on or after
February 6, 1995, and any actual dispositions of property after the enactment date.

Legislative Background

The BBA of 1995 included provisions to expand the present law provisions that subject
U.S. citizens who lose citizenship for tax avoidance purposes to special tax rules for ten years
after such loss of citizenship. The bill would extend the expatriation provisions to apply not only
to U.S. citizens who lose citizenship but also to certain long-term residents of the United States
whose U.S. residency is terminated. The bill would subject certain individuals to the
expatriation tax provisions without inquiry as to their motive for expatriating, and would allow
certain categories of citizens to show an absence of tax-avoidance motives only if they request a
tuling from the Secretary of the Treasury. The bill would expand the categories of income and
gains that are subject to tax under the expatriation tax provisions and includes provisions
designed to eliminate the ability to engage in certain transactions that under present law partially
or completely circumvent the reach of the expatriation tax provisions. In addition, the bill

-18-



The Superfund taxes are scheduled to expire after December 31, 1995. However, the
taxes would have terminated earlier if either (1) the unobligated balance in the Superfund Trust
Fund exceeded $3.5 billion on December 31, 1994, and the Treasury Department estimated that
the unobligated balance would exceed $3.5 billion at the end of 1995 (assuming no Superfund
taxes had been imposed during 1995), or (2) the Treasury Department had estimated that more
than $11.97 billion of revenues from these taxes would have been credited into the Superfund
Trust Fund before January 1, 1996.

Description of Administration Proposal

The present-law Superfund excise taxes on petroleum, chemicals, and imported
substances would be extended through September 30, 2002. The corporate environmental
income tax would be extended through taxable years beginning before January 1, 1998.

Effective Date
The proposal would be effective on enactment.
Legislative B round

The proposal was included in the BBA of 1995, as passed by the Senate. The conference~
report on the BBA of 1995 included a similar provision.

-47-


accounting for its farming business unless, for each prior taxable year beginning after
December 31, 1985, such corporation (and any predecessor corporation) did not have gross
receipts exceeding $25 million. A family corporation is one where at 50 percent or more
of the stock of the corporation is held by one (or in some limited cases, two or three)
families.

A family farm corporation that must change to an accrual method of accounting as
a result of the 1987 Act provision is to establish a suspense account in lieu of including the
entire amount of the section 481 adjustment in gross income. The initial balance of the
suspense account equals the lesser of (1) the section 481 adjustment otherwise required for
the year of change, or (2) the section 481 adjustment computed as if the change in method
of accounting had occurred as of the beginning of the taxable year preceding the year of
change.

The amount of the suspense account is required to be included in gross income if
the corporation ceases to be a family corporation. In addition, if the gross receipts of the
corporation attributable to farming for any taxable year decline to an amount below the
lesser of (1) the gross receipts attributable to farming for the last taxable year for which an
accrual method of accounting was not required, or (2) the gross receipts attributable to
farming for the most recent taxable year for which a portion of the suspense account was
required to be included in income, a portion of the suspense account is required to be
included in gross income.

Description of Proposal

The proposal would repeal the ability of a family farm corporation to establish a
suspense account when it is required to change to an accrual method of accounting. Thus,
under the proposal, any family farm corporation required to change to an accrual method
of accounting would restore the section 481 adjustment applicable to the change in gross
income ratably over a 10-year period beginning with the year of change. In addition, any
taxpayer with an existing suspense account would be required to restore the account into
income ratably over a 20-period

Effective Date
The proposal would be effective for taxable years ending after September 13, 1995.

Legisl: Background

The proposal is substantially identical to the provision contained in the BBA of
1995.

-51-


Effective Date 4.
The proposal would be effective for NOLs arising in taxable years beginning after
December 31, 1995.

21. Improve diesel fuel tax compliance by treating kerosene as diesel fuel for excise
tax purposes

Present Law

Diesel fuel used as a transportation motor fuel generally is taxed at 24.4 cents per
gallon (Code sec. 4081). This tax is collected on all diesel fuel upon removal from a
pipeline or barge terminal unless the fuel is indelibly dyed and is destined for a nontaxable
use. Diesel fuel also is commonly used as heating oil; diesel fuel used as heating oil is not
subject to tax. Certain other uses also are exempt from tax, and some transportation uses
(e.g., rail and intercity buses) are taxed at reduced rates. Both exemptions and reduced-
rates are realized through refund claims if undyed diesel fuel is used in a qualifying use.

Non-gasoline aviation fuels are taxed at rates of 21.9 cents per gallon
(noncommercial aviation) or 4.4 cents per gallon (commercial aviation). This tax is
imposed on sale of the fuel by a "producer," typically a wholesale distributor. This tax is
imposed at a level in the distribution chain subsequent to removal from a terminal facility.

Kerosene is used both as a transportation fuel and as an aviation fuel. Kerosene
also is blended with diesel fuel destined both for taxable and nontaxable uses (e.g. as
heating oil) to, among other things, prevent gelling of the diesel fuel in cold temperatures.
Under present law, kerosene is not subject to tax unless it is blended with taxable diesel
fuel or is sold for use as aviation fuel. When kerosene is blended with dyed diesel fuel to
be used in a nontaxable use, the dye concentration of the fuel mixture must be adjusted to
ensure that it meets Treasury Department requirements for untaxed, dyed diesel fuel.

Clear, low-sulphur kerosene (K-1) also is used in space heaters, and often is sold
for this purpose at retail service station pumps Kerosene used in space heaters is not
subject to Federal excise tax.

Wholesale distributors have reported that, because of improved diesel fuel tax
compliance resulting from tax changes enacted by the Omnibus Budget Reconciliation Act
of 1993, greatly increased amounts of kerosene are being blended with diesel fuel for use
in taxable uses without payment of excise tax

Description of Proposal

The Administration proposal would, subject to certain modifications, extend the
diesel fuel tax rules to kerosene. Under these tules, kerosene would be subject to tax
whenever it was removed from a terminal facility unless (1) it was indelibly dyed and

-80-



4. Earned income credit provisions

Present Law

In general

Certain eligible low-income workers are entitled to claim a refundable credit on their
income tax return. The amount of the credit an eligible individual may claim depends upon
whether the individual has one, more than one, or no qualifying children and is determined by
multiplying the credit rate by the taxpayer’s earned income up to an earned income amount. The
maximum amount of the credit is the product of the credit rate and the earned income amount.
For taxpayers with earned income (or adjusted gross income (AGI), if greater) in excess of the
beginning of the phaseout range, the maximum credit amount is reduced by the phaseout rate
multiplied by the amount of earned income (or AGI, if greater) in excess of the beginning of the
phaseout range. For taxpayers with earned income (or AGL, if greater) in excess of the end of
the phaseout range, no credit is allowed.

For taxable years beginning after December 31, 1995, an individual is not eligible for the
credit if the aggregate amount of “disqualified income” of the taxpayer for the taxable year
exceeds $2,350. Disqualified income is the sum of:

(1) _ interest (taxable and tax-exempt),
(2) dividends, and
(3) net rent and royalty income (if greater than zero).

The parameters for the credit depend upon the number of qualifying children the
individual claims. For 1996, the parameters are given in the following table (dollar amounts are
projections expressed in 1996 dollars):

Two or more One qualifying No qualifying
qualifying child— children—
children--

Credit rate 40.00% 34.00% 7.65%
Earned income amount $8,890 $6,330 $4,220
Maximum credit $3,556 $2,152 $323
Phaseout begins $11,610 $11,610 $5,280
Phaseout rate 21.06% 15.98% 7.65%
Phaseout ends $28,495 $25,078 $9,500

-13-


Description of P: 1

The extraordinary dividend rules of section 1059 would be amended to provide that
a corporate shareholder will recognize gain immediately with respect to any redemption
treated as a dividend (in whole or in part) when the nontaxed portion of the dividend
exceeds the basis of the shares surrendered, if the redemption is treated as a dividend due
to options being counted as stock ownership. In addition, immediate gain recognition is
required whenever the basis of stock with respect to which any extraordinary dividend was
received is reduced below zero. Reorganizations or other exchanges involving amounts
that are treated as dividends under section 356(a)(2) of the Code are treated as redemptions
for purposes of applying the rules relating to redemptions under section 1059(e).

Effective Date
The provision is effective generally for distributions after May 3, 1995.
Legislative Background

A substantially similar proposal is contained in the BBA of 1995 as passed by
Congress.

5. Modify basis adjustment rules under section 1033
Present Law

Gain realized by a taxpayer from certain involuntary conversions of property is
deferred to the extent the taxpayer purchases similar property within a specified period of
time. The replacement property may be acquired directly or by acquiring control of a
corporation (generally, 80 percent of the stock of the corporation) that owns similar
replacement property. The taxpayer's basis in the replacement property generally is the
same as the taxpayer's basis in the converted property: In cases in which a taxpayer
purchases stock as replacement property, the taxpayer reduces the basis of the stock, but
does not reduce the basis of the underlying assets. Thus, the reduction in the basis of the
stock generally does not result in reduced depreciation deductions where the corporation
holds depreciable property, and may result in the taxpayer having more aggregate
depreciable basis after the acquisition of replacement property than before the involuntary
conversion.

Description of Proposal

The proposal would provide that where the taxpayer satisfies the replacement
property requirement by acquiring stock in a corporation, the corporation generally would
reduce its adjusted bases in its assets by the amount by which the taxpayer reduces its basis
in the stock. The corporation's adjusted bases in its assets would not be reduced, in the
aggregate, below the taxpayer's basis in its stock (determined after the appropriate basis

-55-


I. MIDDLE-CLASS BILL OF RIGHTS, TAX COMPLIANCE, AND
SUPERFUND TAX PROVISIONS

1. Credit for families with young children

Present Law

In general

Present law does not provide tax credits based solely on the taxpayer’s number of
dependent children. Taxpayers with dependent children, however, generally are able to claim a
personal exemption for each of these dependents. The total amount of personal exemptions is
subtracted (along with certain other items) from adjusted gross income (AGI) in arriving at
taxable income. The amount of each personal exemption is $2,500 for 1995, and is adjusted
annually for inflation. In 1995, the amount of the personal exemption is phased out for taxpayers
with AGI in excess of $114,700 for single taxpayers, $143,350 for heads of household, and
$172,050 for married couples filing joint returns. These phaseout thresholds are adjusted
annually for inflation.

In addition, eligible low-income workers are able to claim a refundable earned income
tax credit. The amount of the credit an eligible taxpayer may claim depends upon whether the
taxpayer has one, more than one, or no qualifying children and is determined by multiplying the
credit rate by the taxpayer’s earned income up to an earned income amount. The maximum
amount of the credit is the product of the credit rate and the earned income amount. For
taxpayers with earned income (or adjusted gross income (AGI), if greater) in excess of the
beginning of the phaseout range, the maximum credit amount is reduced by the phaseout rate
multiplied by the amount of earned income (or AGI, if greater) in excess of the beginning of the
phaseout range. For taxpayers with earned income (or AGI, if greater) in excess of the end of
the phaseout range, no credit is allowed.

Mathematical or clerical errors

The Internal Revenue Service may summarily assess additional tax due as a result of a
mathematical or clerical error without sending the taxpayer a notice of deficiency and giving the
taxpayer an opportunity to petition the Tax Court. Where the IRS uses the summary assessment
procedure for mathematical or clerical errors, the taxpayer must be given an explanation of the
asserted error and a period of 60 days to request that the IRS abate its assessment. The IRS may
not proceed to collect the amount of the assessment until the taxpayer has agreed to it or has
allowed the 60-day period for objecting to expire. If the taxpayer files a request for abatement of
the assessment specified in the notice, the IRS must abate the assessment. Any reassessment of
the abated amount is subject to the ordinary deficiency procedures. The request for abatement of
the assessment is the only procedure a taxpayer may use prior to paying the assessed amount in
order to contest an assessment arising out of a mathematical or clerical error. Once the
assessment is satisfied, however, the taxpayer may file a claim for refund if he or she believes
the assessment was made in error.

-2-


The liquidation of a subchapter C corporation generally is a taxable event to both
the corporation and its shareholders. Corporate gain is measured by the difference
between the aggregate fair market value and the adjusted bases of the corporation's assets.
The shareholder gain is measured by the difference between the value of the assets
distributed and the shareholder's adjusted basis in his or her stock, The conversion of a C
corporation into a partnership or sole proprietorship is treated as the liquidation of the
corporation.

The conversion from C to S corporation status (or the merger of a C corporation
into an S corporation) generally is not a taxable event to either the corporation or its
shareholders.

Certain rules attempt to limit the potential for C corporations to avoid
corporate-level tax by shifting appreciated assets to S corporation status prior to the
recognition of such gains. Specifically, an S corporation is subject to a tax computed by
applying the highest marginal corporate tax rate to the lesser of (1) the S corporation's
recognized built-in gains or (2) the amount that would be taxable income if such
corporation was not an S corporation (sec. 1374). For this purpose, a recognized built-in
gain generally is any gain the S corporation recognizes from the disposition of any asset
within a 10-year recognition period after the conversion from C corporation status or any
income that is properly taken into account during the recognition period that is attributable -
to prior periods. However, a gain is not a recognized built-in gain if the taxpayer can
establish that the asset was not held by the corporation on the date of conversion or to the
extent the gain exceeds the amount of gain that would have been recognized on such date.
In addition, the cumulative amount of recognized built-in gains that an S corporation must
take into account may not exceed the amount by which the fair market value of the
corporation's assets exceeds the aggregated adjusted basis of such assets on the date of
conversion from C corporation status. Finally, net operating loss or tax credit carryovers
from years in which the corporation was a C corporation may reduce or eliminate the tax
on recognized built-in gains.

The amount of built-in gain that is subject to corporate-level tax also flows-through
to the shareholders of the S corporation as an item of income subject to individual-level
tax. The amount of tax paid by the S corporation on built-in gains flows-through to the
shareholders as an item of loss that is deductible against such built-in gain income on the
individual level.

Description of Proposal

The proposal would repeal section 1374 for large S corporations. Thus, aC to S
corporation conversion (whether by a C corporation electing S corporation status or byaC
Corporation merging into an S corporation) would be treated as a liquidation of the C
corporation followed by a contribution of the assets to an S corporation by the recipient
shareholders. Thus, the proposal would require immediate gain recognition by both the

-72-



c. Outbound foreign grantor trust rules

The Administration proposal would make several modifications to the rules of section
679 under which foreign trusts with U.S. grantors and U.S. beneficiaries are treated as grantor
trusts.

Sale or exchange at market value

Present law contains an exception from grantor trust treatment for property transferred by
aU.S. person to a foreign trust in the form of a sale or exchange at fair market value where gain
is recognized to the transferor. In determining whether the trust paid fair market value to the
transferor, the Administration proposal would provide that obligations issued (or, to the extent
provided by regulations, guaranteed) by the trust, by any grantor or beneficiary of the trust, or by
any person related to a grantor or beneficiary" generally would not be taken into account.

Other transfers

Under the Administration proposal, a transfer of property to certain charitable trusts
would be exempt from the application of the rules treating foreign trusts with U.S. grantors and
US. beneficiaries as grantor trusts.

Transferors or beneficiaries who become U.S. persons

The Administration proposal would apply the rules of section 679 to certain foreign
persons who transfer property to a foreign trust and subsequently become U.S. persons. A
nonresident alien individual who transfers property, directly or indirectly, to a foreign trust and
then becomes a resident of the United States within 5 years after the transfer generally would be
treated as making a transfer to the foreign trust at the time the individual becomes a U.S.
resident. The amount of the deemed transfer would be the portion of the trust (including
undistributed earnings) attributable to the property previously transferred. Consequently, the
individual generally would be treated under the rules of section 679 as the owner of that portion
of the trust in any taxable year in which the trust has U.S. beneficiaries. The Administration
proposal's new reporting requirements and penalties (discussed below) also would be applicable.

Under the Administration proposal, a beneficiary would not be treated as a U.S. person
for purposes of determining whether the transferor of property to a foreign trust would be taxed
as a grantor with respect to any portion of a foreign trust if such beneficiary first became a U.S.
resident more than 5 years after the transfer.

'© For this purpose, a person generally would be treated as related to the grantor or
beneficiary if the relationship between such person and the grantor or beneficiary would result in
a disallowance of losses under section 267 or 707(b).

-27-



is disallowed only when indebtedness is incurred or continued for the purpose of
purchasing or carrying tax-exempt obligations.

This purpose may be established either by direct or circumstantial evidence. Direct
evidence of a purpose to purchase tax-exempt obligations exists when the proceeds of
indebtedness are directly traceable to the purchase of tax-exempt obligations or when such
obligations are used as collateral for indebtedness. In the absence of direct evidence, a
deduction is disallowed only if the totality of facts and circumstances establishes a
sufficiently direct relationship between the borrowing and the investment in tax-exempt
obligations.

Two-percent de minimis exception.-- In the case of an individual, interest on
indebtedness generally is not disallowed if during the taxable year the average adjusted
basis of the tax-exempt obligations does not exceed 2 percent of the average adjusted basis
of the individual's portfolio investments and trade or business assets. In the case of a
corporation other than a financial institution or a dealer in tax-exempt obligations, interest
on indebtedness generally is not disallowed if during the taxable year the average adjusted
basis of the tax-exempt obligations does not exceed 2 percent of the average adjusted basis
of all assets held in the active conduct of the trade or business. These safe harbors are
inapplicable to financial institutions and dealers in tax-exempt obligations.

Interest on installment sales to State and local governments.--If a taxpayer sells

property to a State or local government in exchange for an installment obligation, interest
on the obligation may be exempt from tax. Present law has been interpreted to not
disallow interest on a taxpayer's indebtedness if the taxpayer acquires nonsalable
tax-exempt obligations in the ordinary course of business in payment for services
performed for, or goods supplied to, State or local governments.”

Application to financial corporations

In the case of a financial institution, the allocation of the interest expense of the
financial institution (which are not otherwise allocable to tax-exempt obligations) is based
on the ratio of the average adjusted basis of the tax-exempt obligations acquired after
August 7, 1987, to the average adjusted basis of all assets of the taxpayer (Code sec. 265).
In the case of an issuer which reasonably anticipates to issue not more than $10 million of
tax-exempt obligations (other than private activity bonds), only 20 percent of the interest
allocable to such tax-exempt obligations (Code sec. 291(a)(3)).

* R.B. George Machinery Co., 26 B.T.A. 594 (1932) acq. C.B. XI-2, 4; Rev. Proc.
72-18, as modified by Rev. Proc. 87-53, 1987-2 C.B. 669.

-70-



Legislative Bac und
The proposal was included in the BBA of 1995.

9. Repeal percentage depletion for minerals mined on certain Federal lands

Present law

Taxpayers are allowed to deduct a reasonable allowance for depletion relating to
the acquisition and certain related costs of mines or other hard mineral deposits. The
depletion deduction for any taxable year is calculated under either the cost depletion
method or the percentage depletion method, whichever results in the greater allowance for
depletion for the year.

Under the cost depletion method, the taxpayer deducts that portion of the adjusted
basis of the property which is equal to the ratio of the units sold from that property during
the taxable year, to the estimated total units remaining at the beginning of that year.

Under the percentage depletion method, a deduction is allowed in each taxable year
for a statutory percentage of the taxpayer's gross income from the property. The statutory
percentage for gold, silver, copper, and iron ore is 15 percent; the statutory percentage for
uranium, lead, tin, nickel, tungsten, zinc, and most other hard rock minerals is 22 percent.
The percentage depletion deduction for these minerals may not exceed 50 percent of the
net income from the property for the taxable year (computed without allowance for
depletion). Percentage depletion is not limited to the taxpayer's basis in the property; thus,
the aggregate amount of percentage depletion deductions claimed may exceed the amount
expended by the taxpayer to acquire and develop the property.

The Mining Law of 1872 permits U.S. citizens and businesses to freely prospect for
hard rock minerals on Federal lands, and allows them to mine the land if an economically
recoverable deposit is found. No Federal rents or royalties are imposed upon the sale of
the extracted minerals. A prospecting entity may establish a claim to an area that it
believes may contain a mineral deposit of value and preserve its right to that claim by
paying an annual holding fee of $100 per claim. Once a claimed mineral deposit is
determined to be economically recoverable, and at least $500 of development work has
been performed, the claim holder may apply for a "patent" to obtain title to the surface and
mineral rights. If approved, the claimant can obtain full title to the land for $2.50 or $5.00
per acre.

Description of Proposal

The proposal would repeal the present-law percentage depletion provisions for
minerals extracted from any land where title to the land or the right to extract minerals
from such land was originally obtained pursuant to the provisions of the Mining Law of
1872.

-63-



within the first 65 days after the close ofits taxable year as having occurred at the end of the
preceding taxable year.

If a trust makes a loan to one of its beneficiaries, the principal of such a loan is generally
not taxable as income to the beneficiary.

Grantor trust rules

Under the grantor trust rules (secs. 671-679), the grantor of a trust will continue to be
taxed as the owner of the trust (or a portion thereof) if it retains certain rights or powers. A
grantor of a trust generally is treated as the owner of any portion of a trust when the following
circumstances exist:

(1) The grantor has a reversionary interest that has more than a 5-percent probability of
returning to the grantor.

(2) The grantor has power to control beneficial enjoyment of the income or corpus.
Certain powers are disregarded for this purpose--(a) a power to apply income to support a
dependent; (b) a power affecting beneficial enjoyment that can be exercised only after an event
that has a 5 percent or less probability of occurring; (c) a power exercisable only by will; (d) a
power to allocate among charities; (e) a power to distribute corpus under an ascertainable
standard or as an advancement; (f) a power to withhold income temporarily; (g) a power to
withhold income during disability; (h) a power to allocate between corpus and income; (i) a
power to distribute, apportion, or accumulate income or corpus among a class of beneficiaries
that is held by an independent trustee or trustees: and, (j) a power to distribute, apportion, or
accumulate income among beneficiaries that is limited by an ascertainable standard.

(3) The grantor retains any of the following administrative powers--(a) a power to deal at
non-arms' length; (b) a power to borrow trust funds without adequate interest or security; (c) a
borrowing that extends over one taxable year; (d) a power to vote stock of a controlled
corporation held in the trust; (e) a power to control investment of trust funds in a controlled
corporation; and (f) a power to reacquire trust corpus by substituting property with equivalent
value.

(4) The grantor has a power to revoke, unless such power may not be exercised any time
before an event that has a 5-percent or less probability of occurring.

(5) The income is or may be distributed to, held for the future benefit of, or used to pay
for life insurance on the lives of, the grantor or the grantor’s spouse, unless such power may not
be exercised any time before an event that has a S-percent or less probability of occurring. (An
exception is provided for income that may be used to discharge an obligation of support, unless
the income is so used.)

-20-



makes political expenditures (sec. 4955) or excessive lobbying expenditures (secs. 4911 and
4912). However, the Code generally does not provide for the imposition of penalty excise taxes
in cases where a 501(c)(3) public charity or a section 501(c)(4) social welfare organization
engages in a transaction that results in private inurement. In such cases, the only sanction that
specifically is authorized under the Code is revocation of the organization's tax-exempt status. A
transaction engaged in by a private foundation (but not a public charity) is subject to special
penalty excise taxes under the Code if the transaction is a prohibited "self-dealing" transaction
(sec. 4941) or does not accomplish a charitable purpose (sec. 4945).

Filing and public disclosure rules

Tax-exempt organizations (other than churches and certain small organizations) are
required to file an annual information return (Form 990) with the Internal Revenue Service
("IRS"), setting forth the organization's items of gross income and expenses attributable to such
income, disbursements for tax-exempt purposes, plus certain other information for the taxable
year. Private foundations are required to allow public inspection at the foundation's principal
office of their current annual information return. Other tax-exempt organizations, including
public charities, are required to allow public inspection at the organization's principal office (and
certain regional or district offices) of their annual information returns for the three most recent
taxable years (sec. 6104(e)). The Code also requires that tax-exempt organizations allow public
inspection of the organization's application to the IRS for recognition of tax-exempt status, the
IRS determination letter, and certain related documents. In addition, upon written request to the
IRS, members of the general public are permitted to inspect annual information returns of tax-
exempt organizations and applications for recognition of tax-exempt status (and related
documents) at the National Office of the IRS in Washington, D.C. A person making such a
written request is notified by the IRS when the material is available for inspection at the National
Office, where notes may be taken of the material open for inspection, photographs taken with the
person's own equipment, or copies of such material obtained from the IRS for a fee (Treas. Reg.
secs. 301.6104(a)-6 and 301.6104(b)-1).

Section 6652(c)(1)(A) provides that a tax-exempt organization that fails to file a
complete and accurate Form 990 is subject to a penalty of $10 for each day during which such
failure continues (with a maximum penalty with respect to any one return of the lesser of $5,000
or five percent of the organization's gross receipts for the year). Section 6652(c)(1)(C) provides
that tax-exempt organizations that fail to make certain annual returns and applications for
exemption available for public inspection are subject to a penalty of $10 for each day the failure
continues (with a maximum penalty with respect to any one return not to exceed $5,000, and
without limitation with respect to applications). In addition, section 6685 provides a penalty for
willfully failing to make an annual return or application available for public inspection of $1,000
per return or application.

Organizations that have tax-exempt status but that are not eligible to receive tax-

deductible charitable contributions are required expressly to state in certain fundraising
solicitations that contributions or gifts to the organization are not deductible as charitable

-37-


shelter or $500. Any person claiming any tax benefit with respect to a shelter must report
its registration number on her return. Failure to do so without reasonable cause will
subject that person to a $250 penalty (sec. 6707(b)(2)).

A person who organizes or sells an interest in a tax shelter subject to the
registration rule or in any other potentially abusive plan or arrangement must maintain a
list of the investors (sec. 6112). A $50 penalty may be assessed for each name omitted
from the list. The maximum penalty per year is $100,000 (sec. 6708).

For this purpose, a tax shelter is defined as any investment that meets two
requirements. First, the investment must be (1) required to be registered under a Federal or
state law regulating securities, (2) sold pursuant to an exemption from registration
requiring the filing of a notice with a Federal or state agency regulating the offering or sale
of securities, or (3) a substantial investment. Second, it must be reasonable to infer that the
ratio of deductions and 350% of credits to investment for any investor (i.e., the tax shelter
ratio) may be greater than two to one as of the close of any of the first five years ending
after the date on which the investment is offered for sale. An investment that meets these
requirements will be considered a tax shelter regardless of whether it is marketed or
customarily designated as a tax shelter (sec. 6111(c)(1)).

Description of Proposal

The proposal would require a promoter of a corporate tax shelter to register the
shelter with the Secretary. Registration would be required not later than the next business
day after the day when the tax shelter is first offered to potential users. If the promoter is
not a U.S. person, or if a required registration is not otherwise made, then any U.S.
participant would be required to register the shelter. An exception to this special rule
provides that registration would not be required if the U.S. participant notifies the
promoter in writing not later than 90 days after discussions began that the U.S. participant
will not participate in the shelter and the U.S. person does not in fact participate in the
shelter.

A corporate tax shelter is any investment, plan, arrangement or transaction (1) a
significant purpose of the structure of which is tax avoidance or evasion by a corporate
participant, (2) that is offered to any potential participant under conditions of
confidentiality, and (3) for which the tax shelter promoters may receive total fees in excess
of $100,000.

A transaction is offered under conditions of confidentiality if: (a) an offeree (or any
person acting on its behalf) has an understanding or agreement with or for the benefit of
any promoter to restrict or limit its disclosure of the transaction or any significant tax _
features of the transaction; or (b) the promoter claims, knows or has reason to know (or the
promoter causes another person to claim or otherwise knows or has reason to know that a
party other than the potential offeree claims) that the transaction (or one or more aspects of
its structure) is proprietary to the promoter or any party other than the offeree, or is

-57-


Information reporting requirements and associated penalties

Any U.S. person who creates a foreign trust or transfers money or property to a foreign
trust is required to report that event to the Treasury Department (sec. 6048(a)). Current
regulations require reporting of, inter alia, the name, address and identification number (if any)
of the transferor, the trust, the fiduciary and trust beneficiaries; the interest of each beneficiary;
the location of the trust records; and the value of each item transferred (Treas. Reg. sec.
16.3-1(c)). Similarly, any U.S. person who transfers property to a foreign trust that has one or
more U.S. beneficiaries is required to report annually to the Treasury Department (sec. 6048(c)).
In addition, if the transfer of any appreciated property by a U.S. person is subject to section
1491, the transferor is required to report the transfer to the Treasury Department (Treas. Reg.
sec. 1.1494-1(a)).

Any person who fails to file a required report with respect to the creation of, or a transfer
to, a foreign trust may be subjected to a penalty of 5 percent of the amount transferred to the
foreign trust (sec. 6677). Similarly, any person who fails to file a required annual report with
respect to a foreign trust with U.S. beneficiaries may be subjected to a penalty of 5 percent of the
value of the corpus of the trust at the close of the taxable year. The maximum amount of the
penalty imposed under either case may not exceed $1,000. A reasonable cause exception is
available. These civil penalties are determined separately from any applicable criminal penalties.

Description of Proposals

Overview

The Administration proposal would modify certain aspects of the tax treatment of foreign
trusts with U.S. beneficiaries as follows:

a. The grantor trust rules generally would apply only to the extent that they result,
directly or indirectly, in amounts being currently taken into account in computing the income of
a U.S. person. Certain exceptions would apply.

b. Beginning on January 1, 1996, the interest rate applicable to accumulation
distributions from foreign nongrantor trusts would be the rate imposed on underpayment of tax
under section 6621(a)(2), with compounding. The accumulation distribution generally would be
allocated proportionately to prior trust years in which the trust had undistributed net income.

The full amount of a loan of cash or marketable securities by a foreign nongrantor
trust to a U.S. grantor or a U.S. beneficiary (or a U.S. person related to such a grantor or
beneficiary) would be treated as a distribution to the, grantor or beneficiary. In addition, the
value of the use of other trust property by the U.S. grantor, U.S. beneficiary (or a person related
to such a grantor or beneficiary) as a distribution to the grantor or beneficiary in an amount equal
to the fair market value of the use of the property.

-23-


Description of Pi sal

In general

The proposal would create a new part 7 of subtitle B of title I of ERISA. Under
this new part 7, employers sponsoring group health plans* would have to satisfy certain
requirements relating to the availability and renewability of group health plan coverage. In
addition, the proposal would establish rules regarding the portability of group health plan
coverage and the ability of a group health plan to limit or exclude benefits on account of a
preexisting condition. The proposal would also require employer-provided group health
plans to provide special enrollment periods in the case of certain events in which an
employee may enroll or change coverage under a group health plan. Employer-provided
group health plans would be prohibited from maintaining lifetime limits or specific disease
exclusions under the proposal. The Secretary of Labor would generally be given the
authority to enforce the requirements contained in the proposal.

The proposal would also make certain technical changes to ERISA's reporting and
disclosure rules and certain changes to the COBRA coverage rules.

Guaranteed availability of health coverage

Under the proposal, the terms of an employer-provided group health plan could
include eligibility, continuation of eligibility, enrollment, or premium contribution
requirements. However, such requirements generally could not be based on an employee's
health status, medical condition, claims experience, receipt of health care, medical history,
evidence of insurability, or disability. The proposal would allow a group health plan to
provide premium discounts or modify otherwise applicable co-payments or deductibles for
adherence to programs of health promotion or disease prevention. In addition, as
discussed in more detail below, the proposal would permit certain limits or exclusions of
benefits on account of a preexisting condition.

Guaranteed renewability of health coverage

Under the proposal, a participant (or beneficiary, if applicable) generally would
have to be permitted, at his or her option, to renew or continue coverage under a group
health plan if the employer elects to continue to maintain such plan. This requirement
would not apply in the following circumstances: the failure of a participant (or beneficiary)

%6 The term group health plan would be defined as an employee welfare benefit plan
providing medical care (as defined in sec. 213(d)) to participants or beneficiaries directly or
through insurance, reimbursement or otherwise. For purposes of these requirements, the term
specifically would include a group health plan maintained by a church or a convention or
association of churches. However, these requirements would not apply to a group health plan
maintained by a Federal, State, or local governmental entity.

-90-



6652(c)(1)(A) of $100 for each day the failure continues (with a maximum penalty with respect
to any one return of $50,000). As under present law, no penalty may be imposed under section
6652(c)(1)(A) if it were shown that the failure to file a complete return was due to reasonable
cause (sec. 6652(c)(3)).

Effective dates.--The filing and disclosure provisions governing tax-exempt
organizations generally would take effect on January 1, 1996 (or, if later, 90 days after
enactment). However, the provisions regarding the reporting on annual returns of excise tax
penalties and excess benefit transactions would be effective for returns with respect to taxable
years beginning on or after January 1, 1995.

Legislative Background

The Administration's proposal is virtually identical to the intermediate sanction
provisions contained in the BBA of 1995 (sec. 11271) and described in the accompanying
Conference Report, except that the Adminstration proposal would provide that an organization
will be treated as an applicable tax-exempt organization subject to the excise taxes on excess
benefit transactions if, at any time during the ten-year period preceding the transaction, it was a
tax-exempt organization described in section 501(c)(3) or 501(c)(4), or a successor to such an
organization. The BBA of 1995 contains a similar provision, but provides for a two-year, rather
than a ten-year, period.

9. Reinstatement of authority for undercover operations
Present Law

The Anti-Drug Abuse Act of 1988 exempted IRS undercover operations from the
otherwise applicable statutory restrictions controlling the use of Government funds (which
generally provide that all receipts be deposited in the general fund of the Treasury and all
expenses be paid out of appropriated funds). In general, the exemption permits the IRS to
"churn" the income earned by an undercover operation to pay additional expenses incurred in the
undercover operation. The IRS is required to conduct a detailed financial audit of large
undercover operations in which the IRS is churning funds and to provide an annual audit report
to the Congress on all such large undercover operations. The exemption originally expired on
December 31, 1989, and was extended by the Comprehensive Crime Control Act of 1990 to
December 31, 1991. The IRS has not had the authority to chum funds from its undercover
operations since 1991.

Description of Proposal

The proposal would permanently reinstate the IRS's offset authority under section
7608(c). The proposal would amend the IRS annual reporting requirement under section
7608(c)(4)(B) to require the provision of the following data: (1) the date the operation was
initiated; (2) the date offsetting was approved, (3) the total current expenditures and the amount

-44.


limit, the amount of the credit with respect to such income cannot exceed the sum of a portion
of the taxpayer's wage and fringe benefit expenses and depreciation allowances (plus, in
certain cases, possession income taxes). In the alternative, the taxpayer may elect to apply a
limit equal to the applicable percentage of the credit that would otherwise be allowable with
respect to possession business income; the applicable percentage is phased down, beginning
at 60 percent for 1994 and reaching 40 percent for 1998 and thereafter. The amount of the
section 936 credit attributable to QPSII is not subject to these limitations.

Description ‘oposal

The proposal would phase out the section 936 credit determined under the applicable
percentage limit ratably over five years beginning in 1997. Under the proposal, taxpayers
using the applicable percentage limit would continue to be subject to present law for 1996;
accordingly, the section 936 credit attributable to possession business income for 1996 would
be subject to the present-law applicable percentage limit of 50 percent of the amount
otherwise allowed. For 1997, the section 936 credit attributable to possession business income
would be reduced to 80 percent of the present-law applicable 45-percent limit; accordingly,
the section 936 credit attributable to possession business income for 1997 would be limited
to 36 percent of the amount otherwise allowed. For 1998, the section 936 credit attributable
to possession business income would be reduced to 60 percent of the present-law applicable

40-percent limit; accordingly, the section 936 credit attributable to possession business income - «

for 1998 would be limited to 24 percent of the amount otherwise allowed. For 1999, the
section 936 credit attributable to possession business income would be reduced to 40 percent
of the present-law applicable 40-percent limit; accordingly, the section 936 credit attributable
to possession business income for 1999 would be limited to 16 percent of the amount
otherwise allowed. For 2000, the section 936 credit attributable to possession business income
would be reduced to 20 percent of the present-law applicable 40-percent limit; accordingly,
the section 936 credit attributable to possession business income for 2000 would be limited
to 8 percent of the amount otherwise allowed. For 2001 and thereafter, the section 936 credit
determined under the applicable percentage limit would no longer be available.

In addition, the proposal would permit taxpayers whose economic activity limit
exceeds its possession business income for a taxable year to carry forward such excess limit
for up to five years.

Finally, the proposal provides that the revenue attributable to the proposed changes to

the section 936 credit would be used for the purposes of carrying out programs authorized
under the Social Security Act and to promote the creation of jobs.

Effective Date

The proposal would be effective for taxable years beginning after December 31, 1995.

-85-



applicable excess reserves within six, seven, or eight years after the effective date of the
provision.

The "base amount" of a taxpayer would mean the average of the principal amounts
of the residential loans made by the taxpayer during the six most recent taxable years
beginning before January 1, 1996. At the election of the taxpayer, the base amount may be
computed by disregarding the taxable years within that 6-year period in which the
principal amounts of loans made during such years were highest and lowest. The test
would be applied on a controlled group basis. The balance of a taxpayer's applicable
excess reserve would be treated as a tax attribute to which section 381 applies. Thus, if an
institution with an applicable excess reserve is acquired in a tax-free reorganization, the
balance of such reserve would not be immediately restored to income but will continue to
be subject to the residential loan requirement in the hands of the acquirer.

Effective Date

The proposal generally would be effective for taxable years beginning after
December 31, 1995.

Legislative Background

The proposal is substantially similar to a provision in the BBA of 1995.
8. Reinstate oil spill liability trust fund excise tax

Present Law

A five-cents-per-barrel excise tax was imposed on crude oil received at United
States refineries and refined petroleum products imported into the United States before
January 1, 1995. Revenues from this tax were dedicated to the Oil Spill Liability Trust
Fund ("Oil Spill Trust Fund"). In addition to the January 1, 1995 expiration date,
imposition of this tax was suspended during any calendar quarter (before 1995) when the
unobligated balance of the Oil Spill Trust Fund. as of the close of the preceding quarter,
exceeded $1 billion.

Description of Proposal

The five-cents-per-barrel excise tax would be reimposed during the period
January 1, 1996, through September 30, 2002. The $1 billion unobligated balance limit on
the Oil Spill Trust Fund would be retained

Effective Date

The proposal would be effective after December 31, 1995.

~62-



' Legislative Background

The BBA of 1995 would generally repeal section 936 for taxable years beginning in
1996 and thereafter. However, the bill would provide transition rules under which certain
taxpayers would be eligible to claim section 936 credits for a ten-year period.

During the ten-year transition period, the section 936 credit would apply only to
taxpayers that were engaged in the active conduct of a trade or business within a possession
on October 13, 1995, and elected the section 936 credit for the year that includes such date.
A taxpayer that adds a substantial new line of business after such date would cease to be
eligible for section 936 credits during the transition period. A binding contract rule would be
applicable in applying these rules.

In the case of the section 936 credit attributable to possession business income
determined under the economic activity limit, present law would continue to apply for the
first six years of the transition period; for the remaining four years of the transition period, the
possession business income that is eligible for the credit would be subject to a cap. In the case
of the section 936 credit attributable to possession business income determined under the
applicable percentage limit, present law would continue to apply for the first two years of the
transition period; for the remaining eight years of the transition period, the possession business
income that is eligible for the credit would be subject to a cap. A corporation that had elected
to use the applicable percentage limit would be permitted to revoke that election not later than
with respect to its first taxable year beginning in 1997. The section 936 credit attributable to
QPSII could not be claimed for taxable years beginning on or after January 1, 1996.

The cap on a taxpayer's possession business income that is eligible for the section 936
credit during the later years of the transition period generally would be equal to the average
of the taxpayer's possession business income, adjusted by an inflation factor and a growth
factor, for three of the taxpayer's five most recent taxable years ending before October 14,
1995, determined by disregarding the years in which the taxpayer's adjusted possession
business income was highest and lowest. Special rules for computing the cap would apply in
the case of a taxpayer that does not have significant possession business income for each of
such five most recent taxable years. As an alternative, a taxpayer could elect to use as its cap
its adjusted possession business income for its taxable year ending in 1992. As another
alternative, a taxpayer could elect to use as its cap the annualized amount of its possession
business income for the first ten months of calendar year 1995 (calculated by excluding
extraordinary items).

If a corporation's possession business income in a year for which the cap would be
applicable exceeds the cap, then the corporation's possession business income for such year
would be an amount equal to the cap. The corporation's section 936 credit would continue to
be subject to either the economic activity limit or the applicable percentage limit, with such
limit applied to the corporation's possession business income as reduced to reflect the
application of the cap.

-86-



Effective Date

The reporting requirements and applicable penalties generally would apply to reportable
events occurring or distributions received after the date of enactment. The annual reporting
requirement and penalties applicable to U.S. grantors would apply to taxable years of such
persons beginning after the date of enactment.

f. Reporting of certain foreign gifts

The Administration proposal generally would require any U.S. person (other than certain
tax-exempt organizations) that receives purported gifts or bequests from foreign sources totaling
more than $10,000 during the taxable year to report them to the Treasury Department. The
definition of a gift to a U.S. person for this purpose would exclude qualified tuition or medical
payments made on behalf of the U.S. person, as defined for gift tax purposes (sec. 2503(e)(2)). If
the U.S. person fails, without reasonable cause, to report foreign gifts as required, the Treasury
Secretary would be authorized to determine, in its sole discretion, the tax treatment of the
unreported gifts, based on information in its possession or as it may obtain. In addition, the U.S.
person would be subject to a penalty equal to 5 percent of the amount of the gift for each month
that the failure continues, with the total penalty not to exceed 25 percent of such amount.

Effective Date

The proposal would apply to amounts received after the date of enactment.

Legislative Background

The President's fiscal year 1996 budget proposal (referred to as the "1996 budget
proposal") was submitted to the Congress on February 6, 1995. The 1996 budget proposal
includes amendments to the foreign trust provisions; such amendments were included in H.R.
981, introduced by Representatives Gephardt and Gibbons, and S. 453, introduced by Senators
Moynihan and Daschle. Representative Gibbons and Senator Moynihan subsequently
introduced identical bills, H.R. 2356 and S. 1261, on September 19, 1995. These subsequent
bills revised the foreign trust amendments included in the 1996 budget proposal. The provisions
of H.R. 2356 and S. 1261 are resubmitted as the Administration foreign trust proposal described
above. The BBA of 1995, passed by the House and Senate in November 1995, and vetoed by the
President on December 6, 1995, would have further modified the provisions of H.R. 2356 and S.
1261.

The following is a summary of the differences between the Administration foreign trust
proposal and the provisions of the BBA of 1995:

-31-



Any amount taken into account as a qualified educational expense would be reduced by
educational assistance that is not required to be included in the gross income of either the student
or the taxpayer claiming the deduction. Thus, qualified educational expenses would be reduced
by scholarship or fellowship grants excludable from gross income under section 117 (even if the
grants are used to pay expenses other than qualified educational expenses) and any educational
assistance received as veterans' benefits. Similarly, qualified educational expenses would be
reduced by proceeds from Series EE savings bonds that are excludable by the taxpayer under
present-law section 135. However, no reduction would be required for a gift, bequest, devise or
inheritance within the meaning of section 102(a).

Qualified educational expenses would be deductible in the year the expenses are paid,
subject to the requirement that the education commences or continues during that year or during
the first three months of the next year. Qualified educational expenses paid with the proceeds of
a loan generally would be deductible (rather than repayment of the loan itself). Normal tax
benefit rules would apply to refunds (and reimbursements through insurance) of previously
deducted tuition and fees.

The proposal would not affect deductions claimed under any other section of the Code,
except that any amount deducted under another section of the Code could not also be deducted
under this provision. A student would not be eligible to claim a deduction under this provision
on his or her own tax return if that student could be claimed as a dependent of another taxpayer: >

Effective Date

The proposal would be effective for qualified educational expenses paid after
December 31, 1995.

Legislative Background

The proposal is identical to the proposal contained in the President's fiscal year 1996
budget proposal (the "Middle-Class Bill of Rights Tax Relief Act of 1995,” introduced on
February 16, 1995, as H.R. 980 by Representatives Gephardt and Gibbons and as S. 452 by
Senators Moynihan and Daschle).

The BBA of 1995 provided that certain individuals who have paid interest on qualified
education loans could claim an above-the-line deduction for such interest expenses, up to a
maximum deduction of $2,500 per year. In order for the interest to be deductible under this
provision, the indebtedness must have been incurred to pay for the qualified higher education
expenses of the taxpayer or the taxpayer's spouse. The deduction was to have been allowed only
with respect to interest paid on a qualified education loan during the first 60 months in which
interest payments were required. The deduction was phased out ratably over the following
modified adjusted gross income ranges: joint filers ($65,000-$85,000) and unmarried individuals
($45,000-$65,000). For taxable years beginning after 1996, the income phaseout ranges were to
be indexed for inflation.

-7-


administration. The proposal would also (1) extend the dissemination policies and guidelines
under section 6103 to people having access to Form 8300 information, and (2) apply section
6103 sanctions to persons having access to Form 8300 information that disclose this information
without proper authorization.

Effective Date

The proposal would be effective on the date of enactment.

Legislative Background

An identical proposal was contained in the Revenue Reconciliation Act of 1995 as passed
by the House of Representatives.

11. Extend Superfund excise taxes and corporate environmental income tax

Present Law

Four different Superfund taxes are imposed under present law. These are:

(1) An excise tax on petroleum, imposed at a rate of 9.7 cents per barrel, on domestic or
imported crude oil or refined products;

(2) An excise tax on listed hazardous chemicals, imposed at a rate that varies from $0.22
to $4.87 per ton;

(3) An excise tax on imported substances that use as materials in their manufacture or
production one or more of the hazardous chemicals subject to the excise tax described in (2),
above; and

(4) A corporate environmental income tax equal to 0.12 percent of the amount of
modified alternative minimum taxable income of a corporation that exceeds $2 million.

Modified alternative minimum taxable income is defined as a corporation's alternative
minimum taxable income, but determined without regard to the alternative tax net operating loss
deduction and the deduction for the corporate environmental income tax (sec. 59A).

Amounts equivalent to the revenues from these taxes are dedicated to the Hazardous
Substance Superfund Trust Fund ("Superfund Trust Fund"), established in the Trust Fund Code
of the Internal Revenue Code. Amounts in the Superfund Trust Fund generally are available for
expenditures incurred in connection with releases or threats of releases of hazardous substances
into the environment under specified provisions of the Comprehensive Environmental Response,
Compensation, and Liability Act of 1980 (as amended).


instruction) at a primary, secondary, or post-secondary educational institution. The tax-free
treatment provided by section 117 does not extend to scholarship amounts covering regular
living expenses, such as room and board. In addition to the exclusion for qualified scholarships,
section 117 provides an exclusion from gross income for qualified tuition reductions for
education below the graduate level provided to employees of certain educational organizations.

Description of Proposal

A taxpayer would be allowed an above-the-line deduction for qualified educational
expenses paid during the taxable year for the education or training of the taxpayer, the taxpayer's
spouse, or the taxpayer's dependents at an institution of higher education. The deduction would
be allowed in computing a taxpayer's AGI and could be claimed regardless of whether the
taxpayer itemizes deductions. In 1996, 1997, and 1998, the maximum deduction allowed per
taxpayer return would be $5,000. In 1999 and thereafter, the maximum deduction would be
increased to $10,000. The deduction would be phased out ratably for taxpayers with modified
AGI between $70,000 and $90,000 ($100,000 and $120,000 for joint returns). Modified AGI
would inchide taxable Social Security benefits and amounts otherwise excluded with respect to
income earned abroad (or income from Puerto Rico or U.S. possessions). Beginning in 2000, the
income phaseout ranges would be indexed for inflation.

Qualified educational expenses would be defined as tuition and fees required for the
enrollment or attendance of an eligible student (e.g., registration fees, laboratory fees, and extra
charges for particular courses) at an institution of higher education. Charges and fees associated
with meals, lodging, student activities, athletics, insurance, transportation, and similar personal
expenses unrelated to a student's academic course of instruction would not be deductible. The
expenses of education involving sports, games, or hobbies would not be qualified educational
expenses unless the education is part of a degree program (or relate to the student's current
profession).

An "eligible student" would be one who is enrolled or accepted for enrollment in a
degree, certificate, or other program (including a program of study abroad approved for credit by
the institution at which such student is enrolled) leading to a recognized educational credential at
an institution of higher education. The student must pursue a course of study on at least a half-
time basis or must be enrolled in a course which enables the student to improve current job skills
or to acquire new job skills. In addition, the student cannot be enrolled in an elementary or
secondary school, and cannot be a nonresident alien. Educational institutions would determine
what constituted a half-time basis for individual programs.

The term “institution of higher education" would be defined by reference to section 481
of the Higher Education Act of 1965. Such institutions must have entered into an agreement
with the Department of Education to participate in the student loan program. This definition
includes colleges and universities, and certain vocational and proprietary institutions.

-6-


criteria are satisfied, penalty excise taxes could be imposed under the proposal only if the IRS
develops sufficient contrary evidence to rebut the probative value of the evidence put forth by
the parties to the transaction (e.g., the IRS could establish that the compensation data relied upon
by the parties was not for functionally comparable positions or that the disqualified person, in
fact, did not substantially perform the responsibilities of such position). A similar rebuttable
presumption would arise with respect to the reasonableness of the valuation of property sold or
otherwise transferred (or purchased) by an organization to (or from) a disqualified person if the
sale or transfer (or purchase) is approved by an independent board that uses appropriate
comparability data and adequately documents its determination. The Secretary of the Treasury
and IRS would be instructed to issue guidance in connection with the reasonableness standard
that incorporates this presumption.

The proposal would specifically provide that the payment of personal expenses and
benefits to or for the benefit of disqualified persons, and non-fair-market-value transactions
benefiting such persons, would be treated as compensation only if it is clear that the organization
intended and made the payments as compensation for services. In determining whether such
payments or transactions are, in fact, compensation, the relevant factors would include whether
the appropriate decision-making body approved the transfer as compensation in accordance with
established procedures and whether the organization and the recipient reported the transfer
(except in the case of non-taxable fringe benefits) as compensation on the relevant forms (i.e.,
the organization's Form 990, the Form W-2 or Form 1099 provided by the organization to the
recipient, the recipient's Form 1040, and other required returns).'”

Consistent with the rule that payment of personal expenses and benefits to or for the
benefit of disqualified persons and nonfair-market value transactions benefiting such persons are
treated as compensation only if it is clear that the organization intended and made the payments
as compensation for services, any reimbursements by the organization of excise tax liability
would be treated as an excess benefit unless they are included in the disqualified person's
compensation during the year the reimbursement is made. The total compensation package,
including the amount of any reimbursement, would be subject to the reasonableness requirement.
Similarly, the payment by an applicable tax-exempt organization of premiums for an insurance

determinative of whether a revenue sharing arrangement violates the private inurement
proscription.

"” With the exception of nontaxable fringe benefits described in present-law section 132
and other types of nontaxable transfers such as employer-provided health benefits and
contributions to qualified pension plans, an organization could not demonstrate at the time of an
IRS audit that it clearly indicated its intent to treat economic benefits provided to a disqualified
person as compensation for services merely by claiming that such benefits may be viewed as part
of the disqualified person's total compensation package. Rather, the organization would be
required to provide substantiation that is contemporaneous with the transfer of economic benefits
at issue.

-40-


contains information reporting and information sharing provisions to enhance compliance with
the expatriation tax provisions.

6. Modifications of rules relating to foreign trusts having one or more United States
beneficiaries

Present Law
Income taxation of ind their beneficiaries
Taxation of trusts

A trust is treated as a separate taxable entity, except in cases where the grantor (or a
person with a power to revoke the trust) has certain powers with respect to the trust (discussed
below). A trust generally is taxed like an individual with certain modifications. These
modifications include: (1) a separate tax rate schedule applicable to trusts; (2) an unlimited
charitable deduction for amounts paid to charity; (3) a personal exemption of $300 for a trust that
is required to distribute all of its income currently, or $100 for any other trust; (4) no standard
deduction for trusts; and (5) a deduction for distributions to beneficiaries. A trust is required to
use the calendar year as its taxable year. Trusts generally are required to pay estimated income
tax.

Taxation of distributions to beneficiaries

Distributions from a trust to a beneficiary generally are includible in the beneficiary's
gross income to the extent of the distributable net income ("DNI") of the trust for the taxable
year ending with, or within, the taxable year of the beneficiary. DNI is taxable income (1)
increased by any tax-exempt income (net of disallowed deductions attributable to such income),
and (2) computed without regard to personal exemptions, the distribution deduction, capital
gains that are allocated to corpus and are neither distributed to any beneficiary during the taxable
year nor set aside for charitable purposes, capital losses other than capital losses taken into
account in determining the amount of capital gains which are paid to beneficiaries, and (with
Tespect to simple trusts) extraordinary dividends which are not distributed to beneficiaries (sec.
643). The exclusion for small business capital gains under section 1202 is not taken into account
in determining DNI.

Distributions to trust beneficiaries out of previously accumulated income are taxed to the
beneficiaries under a throwback rule (sec. 667). The effect of the throwback rule is to impose an
additional tax on the distribution of previously accumulated income in the year of distribution at
the beneficiary's average marginal rate for the 5 years prior to the distribution. The amount of the
distribution is grossed-up by the amount of the taxes paid by the trust on the accumulated income
and a nonrefundable credit is allowed to the beneficiary for such taxes. In order to prevent trusts
from accumulating income for a year, the fiduciary of a trust may elect to treat distributions

-19-


For years after 1996, the credit rates and the phaseout rates will be the same as in the
preceding table. The earned income amount and the beginning of the phaseout range are indexed
for inflation; because the end of the phaseout range depends on those amounts as well as the
phaseout rate and the credit rate, the end of the phaseout range will also increase if there is
inflation.

In order to claim the credit, an individual must either have a qualifying child or meet
other requirements. A qualifying child must meet a relationship test, an age test, an
identification test, and a residence test. In order to claim the credit without a qualifying child, an
individual must not be a dependent and must be over age 24 and under age 65.

To satisfy the identification test, individuals must include on their tax return the name
and age of each qualifying child. For returns filed with respect to tax year 1996, individuals
must provide a taxpayer identification number (TIN) for all qualifying children born on or before
November 30, 1996. For returns filed with respect to tax year 1997 and all subsequent years,
individuals must provide TINs for all qualifying children, regardless of their age. An
individual’s TIN is generally that individual’s social security number.

Mathematical or clerical errors

The IRS may summarily assess additional tax due as a result of a mathematical or clerical
error without sending the taxpayer a notice of deficiency and giving the taxpayer an opportunity
to petition the Tax Court. Where the IRS uses the summary assessment procedure for
mathematical or clerical errors, the taxpayer must be given an explanation of the asserted error
and a period of 60 days to request that the IRS abate its assessment. The IRS may not proceed to
collect the amount of the assessment until the taxpayer has agreed to it or has allowed the 60-day
period for objecting to expire. If the taxpayer files a request for abatement of the assessment
specified in the notice, the IRS must abate the assessment. Any reassessment of the abated
amount is subject to the ordinary deficiency procedures. The request for abatement of the
assessment is the only procedure a taxpayer may use prior to paying the assessed amount in
order to contest an assessment arising out of a mathematical or clerical error. Once the
assessment is satisfied, however, the taxpayer may file a claim for refund if he or she believes
the assessment was made in error

Description of Proposal
Deny credit to individuals not authorized to be employed in the United States

Individuals would not be eligible for the credit if they do not include their taxpayer
identification number (and, if married, their spouse's taxpayer identification number) on their tax
return. Solely for these purposes and for purposes of the present-law identification test for a
qualifying child, a taxpayer identification number would be defined as a social security number
issued to an individual by the Social Security Administration other than a number issued under
section 205(c)(2)(B)(i)(II) (or that portion of sec, 205(c)(2)(B)(i)(II) relating to it) of the Social

-14-


Description of Proposal

The proposal would provide taxpayers with an income tax credit of $300 for each
qualifying child under the age of 13 (as of the close of the calendar year in which the taxpayer’s
taxable year begins) for taxable years 1996, 1997 and 1998. The amount of the credit would be
increased to $500 for each qualifying child for taxable years beginning after December 31, 1998.

The credit would be phased out ratably for taxpayers with AGI over $60,000 and would
be fully phased out at AGI of $75,000. In the case of a taxable year beginning after calendar year
1999, the maximum credit and the beginning point of the phaseout range would be indexed
annually for inflation. For each year in which the maximum amount of the credit exceeds $500,
the size of the phaseout range would be increased from $15,000 (i.e., $75,000 minus $60,000) to
30 times the maximum amount of the credit in that year. For purposes of all these AGI tests, the
taxpayer’s AGI would be increased by any amount otherwise excluded from gross income under
Code sections 911, 931, or 933 (relating to the exclusion of income of U.S. citizens or residents
living abroad; residents of Guam, the Northern Mariana Islands, and American Samoa; and
residents of Puerto Rico, respectively).

To be a qualifying child, an individual has to satisfy a relationship test, a dependency
test, and an identification test. An individual would satisfy the relationship test if the individual
is a son or daughter of the taxpayer, a stepson or stepdaughter of the taxpayer, or an adopted
child of the taxpayer. An adopted child would include a child who is legally adopted or who is
placed with the taxpayer by an authorized placement agency for adoption by the taxpayer. A
foster child also would satisfy the relationship test if, for the taxpayer’s entire taxable year, the
foster child (1) is a member of the taxpayer’s household and (2) has as his principal place of
abode the home of the taxpayer.

An individual would satisfy the dependency test if the individual is a dependent of the
taxpayer with respect to whom the taxpayer is entitled to claim a dependency deduction.

An individual would satisfy the identification test if the individual’s taxpayer
identification number is included on the taxpayer’s return for such taxable year. Rules similar to
those made applicable by the Administration proposals to the EITC would apply. If a taxpayer
fails to provide a correct taxpayer identification number, such omission would be treated as a
mathematical or clerical error and thus any notification that the taxpayer owes additional tax
because of that omission would not be treated as a notice of deficiency.

The maximum amount of the credit for each taxable year could not exceed an amount
equal to the sum of: (1) the taxpayer’s regular income tax liability (net of applicable credits) less
(2) the sum of the taxpayer’s tentative minimum tax liability and earned income tax credit
allowed.


or with respect to shares as to which a family member has reduced its risk of loss with
respect to the share, for example, through an equity swap. Even though the provision
excepts certain family recapitalizations, the special valuation rules of section 2701 for
estate and gift tax consequences still apply.

The Treasury Secretary would have regulatory authority to (i) apply installment-
sale type rules to preferred stock that is subject to this proposal in appropriate cases, and
Gi) prescribe treatment of preferred stock subject to this provision under other provisions
of the Code (e.g., sections 304, 306 and 318).

Effective Date

The proposal would be effective for transactions on or after the date of
announcement (December 7, 1995). However, preferred stock issued pursuant to a
commitment that was binding before December 7 will not be subject to the proposal.. For
this purpose, a binding commitment includes an underwriting, purchase, distribution, over-
allotment option or merger agreement. In addition, an instrument that was priced before
December 7, or issued pursuant to an exchange offer that was outstanding before
December 7, will not be subject to the proposal.

14. Disallowance of interest on indebtedness allocable to tax-exempt obligations

Present Law

In general

Present law disallows a deduction for interest on indebtedness incurred or
continued to purchase or carry obligations the interest on which is not subject to tax
(tax-exempt obligations) (sec. 265). This rule applies to tax-exempt obligations held by
individual and corporate taxpayers. The rule also applies to certain cases in which a
taxpayer incurs or continues indebtedness and a related person acquires or holds
tax-exempt obligations.)

Application to non-financial corporations

In Rev. Proc. 72-18, 1972-1 C.B. 740, the IRS provided guidelines for application
of the disallowance provision to individuals, dealers in tax-exempt obligations, other
business enterprises, and banks in certain situations. Under Rev. Proc. 72-18, a deduction

3! Section 7701(f) (as enacted in the Deficit Reduction Act of 1984 (sec. 53(c) of Public
Law 98-369)) provides that the Treasury Secretary shall prescribe such regulations as may be
necessary or appropriate to prevent the avoidance of any income tax rules which deal with
linking of borrowing to investment or diminish risk through the use of related persons, pass-
through entities, or other intermediaries.

-69-



c. Anonresident alien who transfers property to a foreign trust and then becomes a U.S.
resident within 5 years after the transfer is treated as making a transfer to the foreign trust on his
residency starting date. In determining whether a foreign trust paid fair market value to the
transferor for property transferred to the trust, obligations issued by the trust, any person related
to any grantor or beneficiary generally would not be taken into account.

d. A two-part objective test would be established for determining whether a trust is
foreign or domestic for tax purposes. If both parts of the test are satisfied, the trust would be
treated as domestic. Only the first part of the test would apply to estates.

e. The Administration proposal would expand the reporting requirements with respect to
foreign trusts if there is a U.S. grantor of the foreign trust or a distribution from the foreign trust
to aU.S. person. The Administration proposal would require the responsible parties to file the
designated information reports with the Treasury Department upon the occurrence of certain
events. A failure to comply with the reporting requirements would result in increased monetary
penalties under the Administration proposal. Unless a U.S. owner of any portion of a foreign
trust appoints a limited agent to accept service of process with respect to requests and summons
by the Treasury Department in connection with the tax treatment of items relating to the trust,
special sanctions would apply.

f. Any U.S. person (other than certain tax-exempt organizations) that receives purported
gifts or bequests from foreign sources totalling more than $10,000 during the year would be
required to report the gift to the Treasury Department. Monetary penalties and certain sanctions
would apply to a failure to comply with the reporting requirement.

The Administration proposals are described below.

a. Inbound foreign grantor trust rules
Foreign grantors not treated as owners

Under the Administration proposal, the grantor trust rules generally would apply only to
the extent that they result, directly or indirectly, in amounts being currently taken into account in
computing the income of a U.S. citizen or resident or a domestic corporation. Thus, the grantor
trust rules generally would not apply to any portion of a trust where their effect would be to treat
a foreign person as owner of that portion. The Administration proposal would provide certain
exceptions to this general rule. The Administration proposal generally would not apply in the
case of revocable trusts and trusts where the only amounts distributable during the lifetime of the
grantor are to the grantor or the grantor's spouse. These exceptions would not apply to the extent
of gifts made by a U.S. beneficiary of the trust to the foreign grantor. The Administration
proposal also would not apply to trusts established to pay compensation, and certain trusts in

-24-



Deductible IRA contributions

The proposal would increase the income limits at which the IRA deduction is phased out
for active participants in employer-sponsored retirement plans. In 1996, the maximum IRA
deduction would be phased out between $80,000 and $100,000 of AGI for married taxpayers and
between $50,000 and $70,000 of AGI for single taxpayers. The income thresholds would be
indexed for inflation in $5,000 increments, beginning after 1996.

The IRA deduction limit would be coordinated with the limit on elective deferrals so that
the maximum allowable IRA deduction for a year could not exceed the excess of the elective
deferral limit over the amount of elective deferrals made by the individual.

The proposal would provide that the exception to the early withdrawal tax for
distributions after age 59-1/2 does not apply to amounts that have been held in an IRA for less
than 5 years.

Inflation adjustment for IRA contribution limit

The $2,000 IRA deduction limit would be indexed for inflation in $500 increments,
beginning after 1996.

Nondeductible tax-free TRAs

Under the proposal, individuals who are eligible to make deductible IRA contributions
would also be eligible to make nondeductible contributions to a Special IRA. Special IRAs
generally would be treated the same as IRAs, but also would be subject to special rules. The IRA
deduction limit and the limit on contributions to Special IRAs would be coordinated. Thus, the
maximum contribution that could be made in a year to a Special IRA would be the excess of the
IRA deduction limit applicable to the individual over the amount of the individual's deductible
IRA contributions. Distributions from Special IRAs would not be includible in income to the
extent attributable to contributions that had been in the Special IRA for at least five years.
Withdrawals of earnings from Special IRAs before five years would be subject to income tax,
and would also be subject to the 10-percent tax on early withdrawals unless used for one of the
special purposes described below (or a present-law exception to the tax, other than the exception
for distributions after age 59-1/2 applies).

An individual whose AGI for a year falls below the upper end of the eligibility thresholds
for deductible IRAs could convert an existing IRA into a Special IRA without being subject to
the 10-percent tax on early withdrawals. The amount transferred from the deductible IRA to the
Special IRA generally would be includible in the individual's income in the year of the transfer.
However, if a transfer is made before 1997, the amount to be included in the individual's income
with respect to the transfer would be spread evenly over four taxable years.

-10-



foreign fiduciary, such as a "trust protector” or other trust advisor, has the power to veto
important decisions of the U.S. fiduciaries. It is further expected that, in applying this test, a
reasonable period of time would be allowed for a trust to replace a U.S. fiduciary who resigns or
dies before the trust would be treated as foreign.

Under the Administration proposal, a foreign estate would be defined as an estate other
than an estate that is determined to be domestic under the court-supervision test. A foreign trust
would be defined as a trust other than a trust that is determined to be domestic under both the
court-supervision test and the U.S. fiduciary test.

Qutbound migration of domesti ts

Under the Administration proposal, if a domestic trust changes its situs and becomes a
foreign trust, the trust would be treated as having made a transfer of its assets to the foreign trust
and would be subject to the 35-percent excise tax imposed by present-law section 1491 unless
one of the exceptions to this excise tax were applicable. The U.S. grantor also would be required
to report the transfer under the reporting requirements described below. Failure to report such a
transfer, or any transfer described in section 1491 (e.g., a transfer to a foreign partnership) would
result in penalties (discussed below).

Effective Date

The proposal to modify the treatment of a trust or estate as a U.S. person would apply to
taxable years beginning after December 31, 1996. In addition, if the trustee of a trust so elects,
the proposal would apply to taxable years ending after the date of enactment. The proposed
amendment to section 1491 would be effective on the date of enactment.

e. Information reporting relating to foreign trusts

The Administration proposal would expand the reporting requirements with respect to
foreign trusts if there is a U.S. grantor of the foreign trust or a distribution from the foreign trust
toa U.S. person. The Administration proposal would require the responsible parties to file the
designated information reports with the Treasury Department upon the occurrence of certain
events. A failure to comply with the reporting requirements would result in increased monetary
penalties under the Administration proposal

Information reporting requirements

First, the Administration proposal would require the grantor, transferor or executor (i.e.,
the "responsible party") to notify the Treasury Department upon the occurrence of certain
reportable events. The reportable events include direct and indirect transfers of property to a
foreign trust and the death of a U.S. citizen or resident if any portion of a foreign trust was
included in the gross estate of the decedent. The required notice would identify the money or

-29-



Page 3

c

Legend and Footnotes:

Legend for "Effective" column: aiolRSg = after issuance of Internal Revenue Service guideline
da = distributions after
dia = debt issued after
date of enactment
lividends paid after
xchanges on or after
interest paid or accrued after
icoa = involuntary conversions occurring after
NOlLgtyba = NOLs generated taxable years beginning after
ppisa = property placed in service after
rda 90 daDOE = returns due after 90 days after date of enactment
tyba = taxable years beginning after

[1] Gain of less than $1 million

[2] Gain of less than $5 million

[3] Gain of less than $10 million.

[4] No new suspense accounts could be established in taxable years ending after 9/13/95. The income in existing suspense accounts would be
recognized in equal installments over a 20-years period beginning with the first taxable year beginning after 9/13/95.

[5] Gain of less than $25 million.

{6] Gain of less than $30 million.

[7] Includes interaction with 50% DRD provision.

[8] Effective for taxable years beginning after 12/31/95 with respect to obligations acquired after 12/7/95.


to timely pay premiums, fraud or misrepresentation by a participant (or beneficiary) with
respect to an application for coverage or a claim for benefits, the termination of the group
health plan, the expiration of eligibility for COBRA coverage under the plan, or the failure
of the participant (or beneficiary) to meet the requirements for continuation of coverage
under the terms of the group health plan. In addition, a network plan (a group health plan
that arranges for the financing and delivery of any health care services through
arrangements with providers) would be permitted to deny continued coverage to
participants (and beneficiaries) who do not live, reside, or work in an area in which such
network plan is offered, provided such denial is applied uniformly, without regard to the
health status or the insurability of participants (or beneficiaries).

The rules relating to the renewability of group health plan coverage would not
permit an individual to decline coverage under a group health plan if such right did not
otherwise exist under the terms of the plan. Further, the rules would not preclude a
multiemployer group health plan from establishing employer contribution rules or group
participation rules that satisfy the requirements of the proposal. The rules relating to the
renewability of group health plan coverage would also not affect any existing right to
COBRA coverage under the group health plan.

If an employer terminates a group health plan, the proposal would require that the
employer notify the Secretary of Labor, and participants (and beneficiaries) covered under.:..
the plan, at least 180 days prior to the date of termination.

Portability of group health plan coverage

The proposal would allow a group health plan to impose a limitation or exclusion
of benefits relating to the treatment of a preexisting condition’’ based on the fact that the
condition existed prior to the coverage of the participant (or beneficiary), provided the
limitation or exclusion: (1) extends for a period of not more than 12 months after the date
of enrollment;** (2) does not apply to an individual who, within 30 days of the date of birth
or placement for adoption (as determined under ERISA section 609(c)(3)(B)), was covered

*” The term preexisting condition would be defined as a condition, regardless of the
cause of the condition, for which-medical advice, diagnosis, care, or treatment was recommended
or received within the six-month period ending on the day before the effective date of coverage
under the group health plan (without regard to any waiting period).

** 18 months in the case of a participant (or beneficiary) enrolling in a group health plan
after the first opportunity to enroll during an enrollment period of at least 30 days has expired,
except enrollments during certain special enrollment periods discussed in more detail below.

-9]-



Special purpose withdrawals

The proposal would provide exemptions from the 10-percent early withdrawal tax for
distributions from IRAs or Special IRAs used for certain special purposes. Penalty-free
withdrawals would be withdrawals (1) for qualified higher education expenses, (2) for
acquisition of a principal residence for a first-time homebuyer, (3) for medical expenses
(including long-term care expenses) in excess of 7.5 percent of AGI, and (4) made by individuals
who have been receiving unemployment compensation for at least 12 consecutive weeks.

Effective Date

The proposal would generally be effective for taxable years beginning after
December 31, 1995. .

Legislative Background

In general

The proposal is the same as the President's budget proposal, as contained in the "Middle-
Class Bill of Rights Tax Relief Act of 1995," introduced on February 16, 1995, as H.R. 980 by
Representatives Gephardt and Gibbons and as S. 452 by Senators Moynihan and Daschle.

The proposal is similar to the provisions of the BBA of 1995 relating to IRAs (secs.
11011 - 11016). The BBA of 1995 would (1) increase the income limits on deductible IRA
contributions and provide that an individual is not an active participant in an employer-
sponsored plan merely because his or her spouse is an active participant; (2) index the $2,000
IRA contribution limit in $500 increments; (3) permit married couples to contribute up to $2,000
to an IRA for each spouse; (4) create nondeductible tax-free IRAs, called American Dream IRAs
("AD IRAs"); and (5) permit penalty-free withdrawals from deductible and nondeductible IRAs
for first-time home purchase, higher education expenses, extraordinary medical expenses
(including long-term care expenses), and persons who have been receiving unemployment
compensation for at least 12 weeks. The provisions of the BBA of 1995 are described in more
detail below.

Deductible IRA contributions

The BBA of 1995 phases up the income limits on deductible IRA contributions in $5,000
increments, and increases the income phase-out range for married couples to $20,000 in $2,500
increments. After the income thresholds are $85,000 for single taxpayers and $100,000 for
married taxpayers, the thresholds are indexed for inflation in $1,000 increments.

In addition, the BBA of 1995 provides that a spouse is not considered an active

participant in an employer-sponsored retirement plan merely because his or her spouse is an
active participant.

-ll-


Page 2

Provision Effective 1996 1997 1998 1999 2000 2001 2002 1996-00 1996-02 1996-05

I, ADDITIONAL TAX PROPOSALS
1. Repeal percentage depletion for non-fuel mineral

mined on Federal lands. tyba 12/31/95 33 61 63 64 66 67 69 287 423 640
2. Deny interest deduction on certain debt instruments. dia 12/7/95 25 76 136 212 262 288 303 711 1,302 2,287
3. Interaction with 50% DRD proposal... o dia 12/7/95 1 3 5 8 "1 12 12 28 52 92
4. Defer original issue discount deduction on convertible
debt. dia 12/7/95 5 17 36 53 64 78 90 175 343 669
5. Limit dividends-received deduction (DRD):
a. Reduce DRD to 50%. dpa 1/31/96 241 383 402 422 443 465 488 1,891 2,844 4,461
b. Modify holding period for DRD fal dpa 1/31/96 6 14 16 17 18 19 20 71 109 174
6. Treat certain preferred stock as "boot 12/7/95 80 147 150 154 160 104 33 692 829 937
7. Extend pro rata disallowance of tax-exempt interest
expense to all corporations. [8] 24 43 49 56 64 70 73 238 381 619
8. Repeal section 1374 for large corporations (65r million
tair market value)... seeseceeeee 12/7/95 ral 42 44 47 49 51 54 203 308 487
9. Inventory reforms:
a. ‘Repeal lower of cost or market method tyba 12/31/95, $1 292 314 320 299 132 65 1,276 1,473 1,625
b. Repeal components of cost method. tyba 12/31/95 59 131 140 150 164 172 183 641 996 1,611
10. Require reporting of payments to corporations
rendering services to Federal agencies... rda 90 daDOE _ 5 7 7 8 9 10 28 48 81
11. Increase penalties for failure to file correct information .
returns. soeeseenee rda 90 daDOE 12 20 21 22 23 24 25 97 147 230
12. Further restrict like-kind exchanges involving foreign
property... e0a 12/31/95 2 5 8 iW 13 15 7 33 71 134
13. Modification of loss carry- -back and carry-t forward
‘tules; restrict to 1-year carry-back. ... NOLgtyba 12/31/95 -155 1,237 1,541 1,095 774 522 410 4.492 5.425 6,513
14. Improve diesel fuel tax compliance by treating kerosene
as diesel fuel for excise tax purposes... 4/1/96 46 44 42 40 38 38 39 210 287 419
15. Expand subpart F provisions regarding | income from
notional principal contracts and stock lending
transactions......... . tyba 12/31/95 11 15 10 10 1 12 12 57 80 119
16. Provide rules regarding treatment of “captive”
insurance arrangements... sees tyba 12/31/95, 65 56 12 31 -25 -20 18 77 39 2
17. Reformulate Puerto Rico and possessions. tax credit
(section 936). + soeeeeenes tyba 12/31/96 = 56 175 308 455 616 718 994 2,328 4,705.

SUBTOTAL: ADDITIONAL TAX PROPOSALS...

IV, HEALTH INSURANCE REFORM PROVISION
1. Increase the self-employed health insurance deduction '
(85% in 1996 and 1997; 40% in 1998; 45% in 1999; and
50% in 2000 and thereafter). cesses

SUBTOTAL: HEALTH INSURANCE REFORM PROVISION...

527) 2,647 3,171 2,965 92,894 2,674 «= 2,603 912,207 «17,485 =. 25,805

tyba 12/31/95, 29 -91 137 267 -422 -549 -596 -945 -2,090 -4.473

+29 91 137 -267 422 549 596 945 2,090 4,173

NET TOTAL. -1,062  -7,228 ~=—-7,906  -10,272 -15,699 -17,746 -19,047 -42,164 -78,959 -148,092

Joint Committee on Taxation

NOTE: Details may not add to totals due to rounding.
{Legend and Footnotes appear on the following page]



to a related party (other than a corporation) that is eliminated in the consolidated balance
sheet that includes the issuer and the holder, the issuer will be treated as having
characterized the instrument as equity if the holder issues a related instrument that is not
shown as indebtedness on the consolidated balance sheet. For this purpose, an instrument
would not be treated as shown as indebtedness on a balance sheet because it is described as
such in footnotes or other narrative disclosures. The proposal would apply only to
corporations that file annual financial statements (or are included in financial statements
filed) with the Securities and Exchange Commission (SEC), and the relevant balance sheet
is the balance sheet filed with the SEC.

The proposal is not intended to affect the characterization of instruments as debt or
equity under current law.

Effective Date

The proposal would generally be effective for instruments issued on or after the
date of announcement (December 7, 1995). However, instruments issued pursuant to a
commitment that was binding before December 7 will not be subject to the proposal. For
this purpose, a binding commitment includes an underwriting, purchase, distribution, over-
allotment option or merger agreement. In addition, an instrument that was priced before
December 7, or issued pursuant to an exchange offer that was outstanding before
December 7, will not be subject to the proposal.

11. Defer interest deduction on certain convertible debt

Present Law

Certain debt instruments contain a feature that allows the holder or the issuer, at
certain future dates, to convert the instrument into shares of stock of the issuer or an
affiliate. Some of these instruments may be issued at a discount and are convertible into a
fixed number of shares of the issuer, regardless of the amount of original issue discount
("OID") accrued as of the date of conversion. Treasury regulations governing the accrual
and deductibility of OID ignore options to convert a debt instrument into stock or debt of
the issuer or a related party or into cash or other property having a value equal to the
approximate value of such stock or debt (Treas. reg. sec. 1.1272-1(c)). Thus, OID ona
convertible debt instrument generally is deductible as interest as such OID accrues,
regardless of whether or not the debt is converted. The treatment of a holder of a discount
instrument is similar to that of the issuer, i.e., a holder includes OID in income on an
accrual basis.

Other convertible instruments may be issued with coupon interest, rather than OID,

and may provide that if the debt is converted into stock, the holder does not receive any
interest that accrued but was unpaid between the latest coupon date and the conversion

~65-



Description of Pro) 1

The Administration proposal would extend to all corporations the rule that applies
to financial institutions that disallows interest deductions of a taxpayer (that are not
otherwise disallowed as allocable under present law to tax-exempt obligations) in the
proportion as the average basis of its tax-exempt obligations bears to the average basis of
all of the taxpayer's assets. The proposal would not extend the $10 million small-issuer
exception to taxpayers which are not financial institutions. Nonetheless, the proposal
would not apply, however, to nonsalable tax-exempt debt acquired by a corporation in the
ordinary course of business in payment for goods or services sold to a State or local
government. Finally, the proposal would apply the interest disallowance provision to all
related persons (within the meaning of section 267(f)). Accordingly, in the case of related
parties that are members of the same consolidated group, the pro rata disallowance rule
would apply as if all the members of the group were a single taxpayer. In the case of
related persons that are not members of the same consolidated group, the tracing rules
would be applied as if the all of the related persons were treated as a single entity.

Effective Date

The proposal would be effective for taxable years beginning after December 31,
1995, with respect to obligations acquired after that December 7, 1995.

Legislative Background

Section 10116 of the Omnibus Budget Reconciliation Act of 1987 as reported by
the Committee of the Budget of the House of Representatives would have disallowed a
deduction for interest on indebtedness allocable to tax-exempt installment obligations. In
addition, that section would have reduced the non-statutory two-percent de minimis test to
the lesser of $1 million or two-percent of the taxpayer's adjusted basis of all of the
taxpayer's assets. That bill passed the House of Representatives, but the provision
disallowing a deduction for interest allocable to tax-exempt obligations was subsequently
deleted in conference.

15. Repeal section 1374 for large corporations
Present Law

The income of a corporation described in subchapter C of the Internal Revenue
Code (a "C corporation") is subject to corporate-level tax when the income is earned and
individual-level tax when the income is distributed. The income of a corporation described
in subchapter S of the Internal Revenue Code (an "S corporation") generally is subject to
individual-level, but not corporate-level, tax when the income is earned. The income of an
S corporation generally is not subject to tax when it is distributed to the shareholders. The
tax treatment of an S corporation is similar to the treatment of a partnership or sole
proprietorship.

-71-



alternative method of income taxation applies only if it results ir ina higher U.S. tax liability than
the amount otherwise determined for nonresident aliens.

Rules applicable in the estate and gift tax contexts expand the categories of items that are
subject to estate and gift taxes in the case of a U.S. citizen who relinquished citizenship with a
principal purpose of avoiding U.S. taxes within the ten-year period ending on the date of
transfer. Certain U.S. property controlled by such individuals and related persons is included in
the individual's estate and gifts of U.S.-situs tangible property by such individuals are subject to
the gift tax.

Description of Proposal

Under the proposal, a U.S. citizen who relinquishes U.S. citizenship generally would be
treated as having sold all of his or her property at fair market value immediately prior to
expatriation. Gain or loss from the deemed sale would be recognized at that time. Further, any
period for the deferral of tax or recognition of income or gain for U.S. tax purposes (e.g., due to
the installment method) would terminate on the date of the deemed sale. The first $600,000 of
net gain recognized on the deemed sale would be exempt from tax.

The tax would not apply to an individual who relinquishes U.S. citizenship before
attaining age 18-1/2 if the individual lived in the United States for less than five taxable years.
The tax would apply to "long-term residents" who cease to be subject to tax as residents of the
United States. The proposal would define a long-term resident as an individual who had been a
lawful permanent resident of the United States (i.e., a green-card holder), other than an
individual who was taxed as a resident by another country under a treaty tie-breaker rule, in at
least eight of the prior fifteen taxable years.

Assets within the scope of the proposal generally would include all property interests that
would be included in the individual's gross estate under the Federal estate tax if the individual
were to die on the day of the deemed sale, plus certain trust interests that are not otherwise
included in the gross estate and other interests specified by the Secretary of the Treasury. U.S.
real property interests, which remain subject to U.S. taxing jurisdiction in the hands of
nonresident aliens, generally would be excepted from the proposal. The exception also would
apply to interests in qualified retirement plans and, subject to a limit of $500,000, interests in
certain foreign pension plans.

Special rules would apply in the case of trust interests. A beneficiary's interest in a trust
would be determined based on all the facts and circumstances. In a case where the ownership of
trust interests cannot be determined under the general facts and circumstances test, any
remaining interests would be allocated to the grantor if the grantor is a beneficiary of the trust,
and otherwise ownership would be determined based on the rules of intestate succession A trust
beneficiary would be deemed to be the sole beneficiary of a separate trust consisting of the assets
allocable to his or her share of the trust, in accordance with his or her interest in the trust. The
separate trust would be treated as selling its assets for fair market value immediately before the

-16-


If the grantor is not treated as the owner of any portion of a trust, another person
generally will be treated as the owner of that portion of the trust if he or she has the power to
revoke that portion of the trust or gave up a power to revoke and retained any of the powers set
forth above, unless the retained power is disclaimed within a reasonable time.

Under the grantor trust rules, a U.S. person who transfers property to a foreign trust
generally is treated as the owner of the portion of the trust comprising that property for any
taxable year in which there is a U.S. beneficiary of any portion of the trust. This treatment
generally does not apply, however, to transfers by reason of death, to sales or exchanges of
property at fair market value where gain is recognized to the transferor, or to transfers made
before the transferor became a U.S. person (sec. 679).

Payments from foreign trusts through nominees

Under a special rule, intermediaries or nominees interposed between certain foreign trusts
and their beneficiaries are disregarded. This special rule treats any amount paid from a foreign
person to a U.S. person, where the amount was derived (directly or indirectly) from a foreign
trust that was created by a U.S. person, as if paid to the recipient directly by the foreign trust
(sec. 665(c)).

Grantor t stablished by non-U.S. person:

Under the grantor trust rules, a grantor generally is treated as the owner of the trust's
assets without regard to whether the grantor is a domestic or foreign person. Under these rules,
U.S. trust beneficiaries can avoid U.S. tax on distributions from a trust where a foreign grantor is
treated as owner of the trust, even though no tax may be imposed on the trust income by any
jurisdiction.?

A special rule applies in the case of a grantor trust with a U.S. beneficiary, where the
grantor trust rules otherwise would treat a foreign person as the owner of a portion of the trust,
and the U.S. beneficiary had made gifts at any time, directly or indirectly, to the foreign person.
In such a case, the U.S. beneficiary generally is treated as the grantor and owner of that portion
to the extent of the gifts to the foreign person (sec. 672(f)).

Foreign trusts that are not grantor trusts

In cases where the grantor trust rules do not apply to a foreign trust, its U.S. beneficiaries
generally are taxable on their respective shares of the income of the trust that is required to be
distributed, as well as any other income of the trust that is paid, credited, or distributed to them

> See Rev. Rul. 69-70, 1969-1 C.B. 182.

-21-


Finally, taxpayers that claim depreciation deductions under the income forecast
method would be required to pay (or would receive) interest based on the recalculation of
depreciation under a "look-back" method. The "look-back" method would be 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
regulations, a "recomputation year" would be 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 period before the close of such years was within 10 percent of the estimated
income from the property for such periods. The Secretary of the Treasury would have the
authority to allow a taxpayer to delay the initial application of the look-back method where
the taxpayer may be expected to have significant income from the property after the third
taxable year after the taxable year the property was placed in service (e.g., the Secretary
may exercise such authority where the depreciable life of the property is expected to be
longer than three years). Property with an adjusted basis of $100,000 or less when the
property was placed in service would not be subject to the look-back method. The
proposal would provide a simplified look-back method for pass-through entities.

Effective Date

The proposal would be effective for property placed in service after September 13,
1995, unless placed in service pursuant to a binding written contract in effect before such
date and all times thereafter.

Legislative Background

The proposal is substantially identical to a provision contained in the BBA of 1995.

2. Phase out preferential treatment for certain large farm corporations required to
use accrual accounting

Present Law

A corporation (or a partnership with a corporate partner) engaged in the trade or
business of farming must use an accrual method of accounting for such activities unless
such corporation (or partnership), for each prior taxable year beginning after December 31,
1975, did not have gross receipts exceeding $1 million. If a farm corporation is required to
change its method of accounting, the section 481 adjustment resulting from such change is
included in gross income ratably over a 10-year period, beginning with the year of change.
This rule does not apply to a family farm corporation.

A provision of the Revenue Act of 1987 ("1987 Act") requires a family corporation
(or a partnership with a family corporation as a partner) to use an accrual method of

-50-


alternatively be satisfied if a summary description is provided to participants (and
beneficiaries) at regular intervals of not more than 90 days. Under present law, a summary
description of such a material modification generally must be provided within 90 days.

COBRA changes

The proposal would modify the rule extending the maximum COBRA coverage
period to 29 months in case of disability by providing that it also applies if a beneficiary-
family member of the covered employee is disabled. In addition, the proposal would
provide the extended coverage if the disability determination is made at any time during
the initial 18-month COBRA coverage period as opposed to requiring the determination to
have been made at the time of the qualifying event as under present law, and would clarify
that the election period for electing COBRA coverage begins on the date of such disability
determination.

The proposal would also coordinate the COBRA rules with the new requirements
contained in the proposal so that COBRA coverage can be terminated if a qualified
beneficiary becomes covered under another group health plan even if such group health
plan contains a preexisting condition limitation or exclusion, provided the preexisting
condition limitation or exclusion does not apply to the qualified beneficiary by reason of
the new requirements contained in the proposal.

The proposal would modify the definition of qualified beneficiary to include a child
born to or placed for adoption with the covered employee during the period of COBRA
coverage. Under present law, qualified beneficiary only includes individuals who were
dependent children of the covered employee at the time of the qualifying event.

The proposal would require a group health plan to notify each qualified beneficiary
who has elected COBRA coverage of the changes to the COBRA rules contained in the
proposal no later than 60 days prior to the date the changes become effective.

Effective Date
The proposal generally would apply to plan years beginning after December 31,

1995. The COBRA changes would apply to qualifying events occurring on or after the
date of enactment for plan years beginning after December 31, 1996.

-95-



c. Outbound foreign grantor trust rules

Sale or exchange at fair market value

The Administration proposal would disregard all obligations issued by the trust, any
grantor or beneficiary of the trust, or by anyone related to a grantor or beneficiary, in
determining whether fair market value is provided in exchange for the property transferred.

Thus, a U.S. person that transfers property to a foreign trust in exchange for such an obligation
would be treated as the owner of the portion of the trust comprising that property for any taxable
year in which there is a U.S. beneficiary, even if the obligation reflects a genuine indebtedness
bearing a market rate of interest. The BBA of 1995 grants the Treasury Secretary regulatory
authority to exempt certain arm's-length loans from these rules.

Treatment of former U.S. persons

The Administration proposal would grant broad authority to the Treasury Secretary to
treat anyone who was a U.S. person at any time during the existence of the trust as a U.S. person
in determining whether there are U.S. beneficiaries of the trust for purposes of section 679. The
BBA of 1995 does not contain such a provision.

d. Residence of estates and trusts

The Administration proposal would impose reporting obligations and penalties for a
failure to report on any outbound transfer subject to section 1491, even though the transaction
does not involve a foreign trust (e.g., a transfer to a foreign partnership). The BBA of 1995
imposes reporting obligations and penalties for a failure to report only transfers involving a
foreign trust (e.g., a transfer from a domestic trust to a foreign trust).

e. Information reporting relating to foreign trusts

Transfers to certain nonexempt trusts

The Administration proposal would require the grantor, transferor, or executor to notify
the Treasury Department upon the occurrence of certain reportable events: the creation of a
foreign trust by a U.S. person, the transfer of money or property to a foreign trust by a U.S.
person, and the death of a U.S. citizen or U.S. resident if any portion of a foreign trust was
included in the gross estate of the decedent. The Administration proposal would exclude from
the definition of reportable events any such occurrence with respect to exempt pension trusts or
certain charitable trusts. The BBA of 1995 excludes from the definition of reportable events any
such occurrence with respect to a nonexempt employees' trust that is described in section 402(b).

-33-



beneficiary expatriates and distributing all resulting income and corpus to the beneficiary. The
beneficiary would be treated as subsequently recontributing the assets to the trust.
Consequently, the separate trust's basis in the assets would be stepped up and all assets held by
the separate trust would be treated as corpus. Constructive ownership rules would apply in the
case of a trust beneficiary that is a corporation, partnership, trust or estate.

The expatriate would be required to pay a tentative tax equal to the amount of tax that
would have been due for a hypothetical short tax year ending on the expatriation date. The
tentative tax would be due on the 90th day after the expatriation date.

The time for payment of the expatriation tax would be permitted to be deferred to the
same extent, and in the same manner, as any estate taxes may be deferred under the present-law
provisions of section 6161 (without regard to the ten-year limitation contained therein). In
addition, the expatriation tax could be deferred on interests in closely-held businesses as
provided in present law section 6166. The expatriation tax could be deferred for reversionary or
remainder interests in property as provided in section 6163. Payment of the expatriation tax
could also be deferred under section 6159 to facilitate the collection of tax liabilities.

An expatriate would be permitted to elect irrevocably, on an asset-by-asset basis, to
continue to be taxed as a U.S. citizen with respect to any assets specified by the taxpayer. The
expatriate would continue to pay U.S. income taxes following expatriation on any income
generated by the asset and on any gain realized on the disposition of the asset, as well as any
excise tax imposed with respect to the asset. In addition, the asset would continue to be subject
to USS. gift, estate, and generation-skipping transfer taxes. However, the amount of any transfer
tax so imposed would be limited to the amount of income tax that would have been due if the
property had been sold for its fair market value immediately before the transfer or death, taking
into account any remaining portion of the expatriate's $600,000 exemption. An expatriate would
be required to waive treaty benefits with respect to the specific asset and to provide adequate
security in order to make this election.

The expatriation tax would be allowed as a credit against any U.S. estate or gift taxes
subsequently imposed on the same property solely by reason of the special rules imposing an
estate or gift tax on property transferred by an individual who relinquished his or her U.S.
citizenship with a principal purpose of avoiding U.S. taxes within ten years prior to the transfer.

A nonresident alien who becomes a citizen or resident of the United States would be
required to utilize a fair market value basis, rather than a historical cost basis, in determining any
subsequent gain or loss on the disposition of any property held on the date the individual became
a US. citizen or resident. The fair market value basis would be equal to the fair market value of
the property on the earlier of (1) the date the individual first became a U.S. citizen or resident, or
(2) the date the property first became subject to U.S. tax because it was used in a U.S. trade or
business or was a U.S. real property interest. The fair market value basis would apply for all
purposes of computing gain or loss on actual or deemed dispositions, but would not apply for
purposes of computing depreciation. An individual could make an irrevocable election not to

-17-


Description of Proposal

Repeal of section 593

The proposal would repeal the section 593 reserve method of accounting for bad
debts by thrift institutions, effective for taxable years beginning after 1995. Under the
proposal, thrift institutions that qualify as small banks would be allowed to utilize the
experience method applicable to such institutions, while thrift institutions that are treated
as large banks are required to use only the specific charge-off method.

Treatment of recapture of bad debt reserves

In general

A thrift institution required to change its method of computing reserves for bad
debts would treat such change as a change in a method of accounting, initiated by the
taxpayer, and having been made with the consent of the Secretary of the Treasury. Any
section 481(a) adjustment required to be taken into account with respect to such change
generally would be determined solely with respect to the "applicable excess reserves" of
the taxpayer. The amount of applicable excess reserves would be taken into account
ratably over a 6-taxable year period, beginning with the first taxable year beginning after
1995, subject to the residential loan requirement described below. In the case of a thrift
institution that becomes a "large bank" (as determined under sec. 585(c)(2)), the amount of
the institution's applicable excess reserves will be the excess of (1) the balance of its
reserves described in section 593(c)(1) (i.e., its supplemental reserve for losses on loans,
its reserve for losses on qualifying real property loans, and its reserve for losses on
nonqualifying loans) as of the close of its last taxable year beginning before January 1,
1996, over (2) the balance of such reserves as of the close of its last taxable year beginning
before January 1, 1988 (i-e., the "pre-1988 reserves"). Similar rules would be provided for
“small banks" and for small banks that subsequently become large banks.

The balance of the pre-1988 reserves would continue to be subject to the provisions
of present-law section 593(e) (requiring recapture in the case of certain excess
distributions to, and redemptions of, shareholders)

Residential Joan requirement

Under a special rule, if the taxpayer meets the "residential loan requirement" for a
taxable year, the recapture of the applicable excess reserves otherwise required to be taken
into account as a section 481(a) adjustment for such year would be suspended. A taxpayer
would meet the residential loan requirement if, for the taxable year, the principal amount
of residential loans made by the taxpayer during the year is not less than its base amount.
The residential loan requirement would be applicable only for taxable years that begin
after December 31, 1995, and before January 1, 1998, and must be applied separately with
respect to each such year. Thus, all taxpayers would be required to recapture their

-61-



Effective Date

The proposal would be effective for taxable years beginning after December 31, 1995.

Legislative Background
H.R. 980 and S. 452

An identical provision was included in the President’s fiscal year 1996 budget proposal
(the “Middle-Class Bill of Rights Tax Relief Act of 1995,” introduced on February 16, 1995, as
H.R. 980 by Representatives Gephardt and Gibbons and as S. 452 by Senators Moynihan and
Daschle).

H.R. 2491

The Balanced Budget Act of 1995 (H.R. 2491 ~ hereinafter referred to as “BBA of
1995”), as passed by the Congress and vetoed by President Clinton, would have allowed
taxpayers a nonrefundable tax credit of $500 for each qualifying child under the age of 18. The
credit amount would not have been indexed for inflation.

To be a qualifying child, an individual would have to have satisfied a relationship test
and a dependency test. The relationship test was the same as in the President’s proposal, except
that an individual could also have been a descendant of a son or daughter of the taxpayer. The
dependency test was the same as in the President’s proposal, except that the term “dependent”
would not have included an individual who was a resident of a country contiguous to the United
States unless (1) that individual was an adopted child of a taxpayer who is a U.S. citizen or
national and (2) for the taxpayer’s entire taxable year, the individual was a member of the
taxpayer’s household and had as his or her principal place of abode the home of the taxpayer.

For taxpayers with AGI in excess of certain thresholds, the allowable child credit would
have been reduced by $25 for each $1,000 of AGI (or fraction thereof) in excess of the threshold.
Thus, the size of the phaseout range would have been proportional to the number of qualifying
children. For married taxpayers filing joint returns, the threshold would have been $110,000.
For taxpayers filing single or head of household returns, the threshold would have been $75,000.
For married taxpayers filing separate returns, the threshold would have been $55,000. These
thresholds would not have been indexed for inflation

The credit would have been effective October 1, 1995. The portion of the child credit

that would have been effective for the period from October 1, 1995, through December 31, 1995,
would have been provided to taxpayers through a special procedure.

-4.


covered under the plan, and the benefits and cost-sharing arrangement available to the
participant (or beneficiary) under the plan. The group health plan would be required to
retain this documentation for at least 12 months following the date the participant (or
beneficiary) ceases to be covered. Upon request, the group health plan would be required
to provide a second copy of such documentation within such 12-month period.

Under the proposal, if a group health plan does not provide for a limitation or
exclusion of benefits relating to the treatment of a preexisting condition, such plan may
impose an affiliation period not to exceed 60 days on a participant (or beneficiary) who
would otherwise be eligible to receive benefits under the plan but for the operation of a
preexisting condition limitation or exclusion. During the affiliation period, the plan would
not be required to provide health care services or benefits and no premium could be
charged to the participant (or beneficiary). The proposal would permit a group health plan
to use alternative methods to address adverse selection, provided they are approved by the
"applicable certifying authority."“?

Special enrollment periods

Under the proposal, if a participant, beneficiary, or family member* experiences a
special event, a group health plan would be required to provide a special enrollment period
(extending for a reasonable time after such event) which would permit the participant to
change the individual or family basis of coverage or to enroll in the plan if the individual
(or beneficiary) had not enrolled during a previous enrollment period. Such a special
enrollment period would be required to deem a child born or placed for adoption as being
covered under the plan as of the date of birth or placement for adoption if such child is
enrolled within 30 days of such date. Under the proposal, a special event would occur if a
participant, beneficiary, or family member: (1) through marriage, separation, divorce,
death, birth, or placement of a child for adoption, experiences a change in family
composition affecting eligibility under a group or individual health plan; (2) experiences a
change in employment status (by termination or by a reduction in hours) that causes the
loss of eligibility for group or individual health plan coverage, other than COBRA ~
coverage; (3) experiences a loss of eligibility under a group or individual health plan
because of a change in the employment status of a family member.

? The term applicable certifying authority would be defined as: (1) with respect to a
group health plan, the Secretary of Labor, and (2) with respect to health plan issuers, the State
insurance commissioner or designated State officials with the authority to enforce the ~
requirements contained in the proposal.

“ The term family member would be defined to include an individual, the individual's
spouse, the children of the individual, and any dependent of the individual (within the meaning
of sec. 152).

-93-



contributions for Federal income tax purposes (sec. 6113). Penalties may be imposed on such
organizations for failure to comply with this requirement (sec. 6710).

Description of Proposal
Extend private inurement prohibition to social welfare organizations

The proposal would amend section 501(c)(4) explicitly to provide that a social welfare
organization or other organization described in that section would be eligible for tax-exempt
status only if no part of its net earnings inures to the benefit of any private shareholder or
individual.

In addition, the proposal would provide that the private inurement rule will not be
violated solely because of an allocation or return of net margins or capital to the members of a
nonprofit association or organization that operates on a cooperative basis in accordance with its
incorporating statute and bylaws (substantially as in existence on the date of enactment) and was
determined to be exempt from Federal income tax under section 501(c)(4) prior to the date of
enactment. However, such cooperative organizations would be subject to the general private
inurement proscription with respect to any other type of transaction.

Effective date.--This provision generally would be effective on September 14, 1995.
However, under a special transition rule, the provision would not apply to inurement occurring
prior to January 1, 1997, if such inurement results from a written contract that was binding on
September 13, 1995, and at all times thereafter before such inurement occurred, and the terms of
which have not materially changed.

Intermediate sanctions for excess benefit transactions

The proposal would impose penalty excise taxes as an intermediate sanction in cases
where organizations exempt from tax under section 501(c)(3) or 501(c)(4) (other than private
foundations, which are subject to a separate penalty regime under current law) engage in an
“excess benefit transaction." In such cases, intermediate sanctions could be imposed on certain
disqualified persons (i.¢., insiders) who improperly benefit from an excess benefit transaction
and on organization managers who participate in such a transaction knowing that it is improper.

An "excess benefit transaction” would be defined as: (1) any transaction in which an
economic benefit is provided to, or for the use of, any disqualified person if the value of the
economic benefit provided directly by the organization (or indirectly through a controlled
entity'*) to such person exceeds the value of consideration (including performance of services)

** A tax-exempt organization could not avoid the private inurement proscription by
causing a controlled entity to engage in an excess benefit transaction. Thus, for example, if a
tax-exempt organization causes its taxable subsidiary to pay excessive compensation to an

-38-


policy providing liability insurance to a disqualified person for excess benefit taxes would be an
excess benefit transaction unless such premiums are treated as part of the compensation paid to
such disqualified person.'*

"Disqualified person" would mean any individual who is in a position to exercise
substantial influence over the affairs of the organization, whether by virtue of being an
organization manager or otherwise.’? In addition, "disqualified persons" include certain family
members and 35-percent owned entities”® of a disqualified person, as well as any person who
was a disqualified person at any time during the five-year period prior to the transaction at issue.
A person having the title of "officer, director, or trustee" would not automatically have the status
of a disqualified person.” In addition, the Secretary of Treasury would have authority to
promulgate rules exempting broad categories of individuals from the category of "disqualified
persons" (e.g., full-time bona fide employees who receive economic benefits of less than a
threshold amount or persons who have taken a vow of poverty).

A disqualified person who benefits from an excess benefit transaction would be subject to
a first-tier penalty tax equal to 25 percent of the amount of the excess benefit (i.e., the amount by
which a transaction differs from fair market value, the amount of compensation exceeding
reasonable compensation, or (under Treasury regulations) the amount of a prohibited transaction

18 In addition, because individuals may be both members of, and disqualified persons
with respect to, a non-exclusive applicable tax-exempt organization (e.g., a museum or
neighborhood civic organization) and receive certain benefits (e.g., free admission, discounted
gift shop purchases) in their capacity as members (rather than in their capacity as disqualified
persons), legislative history would express the expectation that the Treasury Department would
provide guidance clarifying that such membership benefits may be excluded from consideration
under the private inurement proscription and intermediate sanction rules.

1? Under the proposal. a person could be in a position to exercise substantial influence
over a tax-exempt organization despite the fact that such person is not an employee of (and
receives no compensation directly from) a tax-exempt organization, but is formally an employee
of (and is directly compensated by) a subsidiary -- even a taxable subsidiary -- controlled by the
parent tax-exempt organization

20 Family members would be determined under present-law section 4946(d), except that
such members also would include siblings (whether by whole or half blood) of the individual,
and spouses of such siblings. “35-percent owned entities" would mean corporations,
partnerships, and trusts or estates in which a disqualified person owns more than 35 percent of
the combined voting power, profits interest. or beneficial interest.

>! The IRS has issued a general counsel memorandum indicating that all physicians are
considered "insiders" for purposes of applying the private inurement proscription. Legislative
history would express the intent that physicians will be disqualified persons only if they are in a
position to exercise substantial influence over the affairs of an organization.

-41-