DESCRIPTION OF THE CHAIRMAN’S AMENDMENT IN

THE NATURE OF A SUBSTITUTE TO H.R. 2896,

THE “AMERICAN JOBS CREATION ACT OF 2003”

Scheduled for Markup

By the

COMMITTEE ON WAYS AND MEANS

on October 28, 2003

Prepared by

the Staff of the

JOINT COMMITTEE ON TAXATION

October 24, 2003

JCX-94-03
i

CONTENTS

Page

INTRODUCTION ......................................................................................................................... 1

I. CORPORATE REFORM AND GROWTH INCENTIVES ....................................................... 2

A. Reduced Corporate Income Tax Rate for Domestic Production Activities Income

and for Small Corporations (secs. 1001 and 1002 of the bill and sec. 11 of the Code)...... 2

B. Extension of Increased Section 179 Expensing (sec. 1011 of the bill and sec. 179

of the Code)......................................................................................................................... 5

C. Recovery Period for Depreciation of Certain Leasehold Improvements and Restaurant

Property (sec. 1021 of the bill and sec. 168 of the Code)................................................... 7

D. Alternative Minimum Tax Relief...................................................................................... 10

1. Net operating losses and foreign tax credit under the alternative minimum tax

 and expansion of exemption from alternative minimum tax for small corporations

 (secs. 1031-1032 of the bill and secs. 55-59 of the Code)............................................ 10

2. Coordinate farmers income averaging and the alternative minimum tax

 (sec. 1033 of the bill and sec. 55 of the Code).............................................................. 11

E. Proposals Relating to S Corporation Reform and Simplification (secs. 1041-1051

 of the bill and secs. 1361-1379 and 4975 of the Code)..................................................... 12

1. Shareholders of an S corporation.................................................................................. 12

2. Treatment of S corporation shareholders...................................................................... 14

3. Proposals relating to banks ........................................................................................... 15

4. Qualified subchapter S subsidiaries.............................................................................. 17

5. S corporation distributions to an employee stock ownership plan................................ 17

F. Employee Benefits ............................................................................................................ 20

1. Treatment of nonqualified deferred compensation plans (sec. 1061 of the bill

 and new sec. 409A and sec. 6051 of the Code) ............................................................ 20

2. Exclusion of incentive stock options and employee stock purchase plan stock

 options from wages (sec. 1062 of the bill and secs. 421(b), 423(c), 3121(a),

 3231, and 3306(b) of the Code).................................................................................... 26

3. Extension of provision permitting qualified transfers of excess pension assets to

 retiree health accounts (sec. 1063 of the bill and sec. 420 of the Code)....................... 27

G. Treatment of Active Income ............................................................................................. 30

1. Treatment of European Union as one country for purposes of the foreign base

 company sales and services rules (sec. 1071 of the bill and sec. 954 of the Code)...... 30

2. Look-through treatment of payments between related controlled foreign

 corporations under foreign personal holding company income rules (sec. 1072

 of the bill and sec. 954(c) of the Code)......................................................................... 31

3. Look-through treatment for sales of partnership interests (sec. 1073 of the bill

 and sec. 954(c) of the Code) ......................................................................................... 32

4. Repeal of foreign personal holding company rules and foreign investment company

 rules (sec. 1074 of the bill and secs. 542, 551-558, 954, 1246, and 1247 of the

 Code)............................................................................................................................. 33
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5. Subpart F treatment of pipeline transportation income (sec. 1075 of the bill and

 sec. 954(g) of the Code)................................................................................................ 33

6. Determination of foreign personal holding company income with respect to

 transactions in commodities (sec. 1076 of the bill and sec. 954 of the Code).............. 34

7. Repeal controlled foreign corporation rules for foreign base company shipping

 income (sec. 1077 of the bill and sec. 954 of the Code)............................................... 37

8. Modification of exceptions under subpart F for active financing income

 (sec. 1078 of the bill and sec. 954 of the Code)............................................................ 38

9. Partial exclusion for qualified film income (sec. 1079 of the bill and new

 sec. 139A of the Code).................................................................................................. 40

H. Reduction of Double Taxation of Earnings ...................................................................... 43

1. Interest expense allocation rules (sec. 1081 of the bill and sec. 864 of the Code) ....... 43

2. Recharacterization of overall domestic loss (sec. 1082 of the bill and sec. 904

 of the Code)................................................................................................................... 47

3. Reduction to two foreign tax credit baskets (sec. 1083 of the bill and sec. 904

 of the Code)................................................................................................................... 48

4. Look-through rules to apply to dividends from noncontrolled section 902

 corporations (sec. 1084 of the bill and sec. 904 of the Code)....................................... 50

5. Attribution of stock ownership through partnerships to apply in determining

 section 902 and 960 credits (sec. 1085 of the bill and secs. 902 and 901) ................... 51

6. Clarification of treatment of certain transfers of intangible property (sec. 1086

 of the bill and sec. 367(d) of the Code)......................................................................... 53

7. United States property not to include certain assets acquired by dealers in ordinary

 course of trade or business (sec. 1087 of the bill and sec. 956 of the Code)................ 54

8. Election not to use average exchange rate for foreign tax paid other than in

 functional currency (sec. 1088 of the bill and sec. 986 of the Code)............................ 55

9. Repeal of withholding tax on dividends from certain foreign corporations

 (sec. 1089 of the bill and sec. 871 of the Code)............................................................ 56

10. Provide equal treatment for interest paid by foreign partnerships and foreign

 corporations (sec. 1090 of the bill and sec. 861 of the Code)..................................... 58

I. Other Provisions................................................................................................................ 59

1. Special rules for livestock sold on account of weather-related conditions (sec. 1101

 of the bill and secs. 1033 and 451 of the Code)............................................................ 59

2. Payment of dividends on stock of cooperatives without reducing patronage

 dividends (sec. 1102 of the bill and sec. 1388 of the Code) ......................................... 60

3. Add vaccines against hepatitis A to the list of taxable vaccines (sec. 1103 of the

 bill and sec. 4131 of the Code) ..................................................................................... 61

4. Expand human clinical trials expenses qualifying for the orphan drug tax credit

 (sec. 1104 of the bill and sec. 45C of the Code)............................................................ 61

5. Distributions from publicly traded partnerships treated as qualifying income of

 regulated investment company (sec. 1105 of the bill and secs. 851 and 469(k)

 of the Code)................................................................................................................... 62

6. REIT modification provisions (sec. 1106 of the bill and secs. 856 and 857 of the

 Code)............................................................................................................................. 64
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7. Simplification of excise tax imposed on bows and arrows (sec. 1107 of the bill

 and sec. 4161 of the Code)............................................................................................ 70

8. Repeal excise tax on fishing tackle boxes (sec. 1108 of the bill and sec. 4162

 of the Code)................................................................................................................... 71

9. Income tax credit for cost of carrying tax-paid distilled spirits in wholesale

 inventories (sec. 1109 of the bill, new sec. 5011 of the Code)..................................... 71

10. Capital gains treatment to apply to outright sales of timber by landowner

 (sec. 1110 of the bill and sec. 631(b) of the Code)...................................................... 72

11. Repeal of excise tax on sonar devices suitable for finding fish (sec. 1111 of the

 bill, and secs. 4161 and 4162 of the Code)................................................................. 73

12. Taxation of certain settlement funds (sec. 1112 of the bill, sec. 468B of the

 Code)........................................................................................................................... 73

13. Suspension of occupational taxes relating to distilled spirits, wine, and beer

 (sec. 1113 of the bill, sec. 5148 of the Code)............................................................... 74

II. PROPOSALS TO REDUCE TAX AVOIDANCE THROUGH CORPORATE EARNINGS 

STRIPPING AND EXPATRIATION .......................................................................................... 77

A. Reduction in Potential for Earnings Stripping by Further Limiting Deduction for

Interest on Certain Indebtedness (sec. 2001 of the bill and sec. 163(j) of the Code) ....... 77

B. Tax Treatment of Expatriated Entities (sec. 2002 of the bill and new sec. 7874 of the

Code)................................................................................................................................. 80

C. Excise Tax on Stock Compensation of Insiders in Expatriated Corporations

(sec. 2003 of the bill and secs. 162(m), 275(a), and new sec. 4985 of the Code) ............ 84

D. Reinsurance of U.S. Risks in Foreign Jurisdictions (sec. 2004 of the bill and

sec. 845(a) of the Code).................................................................................................... 89

E. Modification of the Tax Treatment of Individual Expatriates (sec. 2005 of the bill

and secs. 877, 2107, 2501 and 6039G of the Code).......................................................... 91

F. Reporting of Taxable Mergers and Acquisitions (sec. 2006 of the bill and new

sec. 6043A of the Code).................................................................................................... 97

G. Studies (sec. 2007 of the bill)............................................................................................ 99

III. PROPOSALS RELATING TO TAX SHELTERS............................................................... 101

A. Taxpayer Related Proposals............................................................................................ 101

1. Penalty for failure to disclose reportable transactions (sec. 3001 of the bill and

 new sec. 6707A of the Code)...................................................................................... 101

2. Modifications to the accuracy-related penalties for listed transactions and

 reportable transactions having a significant tax avoidance purpose (sec. 3002

 of the bill and new sec. 6662A of the Code)............................................................... 104

3. Tax shelter exception to confidentiality privileges relating to taxpayer

 communications (sec. 3003 of the bill and sec. 7525 of the Code) ............................ 108

4. Statute of limitations for unreported listed transactions (sec. 3004 of the bill and

 sec. 6501 of the Code)................................................................................................. 108
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5. Disclosure of reportable transactions by material advisors (sec. 3005 of the bill

 and secs. 6111 and 6707 of the Code) ........................................................................ 109

6. Investor lists and modification of penalty for failure to maintain investor lists

 (secs. 3006 and 3007 of the bill and secs. 6112 and 6708 of the Code)..................... 113

7. Penalties on promoters of tax shelters (sec. 3008 of the bill and sec. 6700 of the

 Code)........................................................................................................................... 115

8. Modifications to the definition of the substantial understatement (sec. 3009 of the

 bill and sec. 6662 of the Code) ................................................................................... 116

9. Actions to enjoin conduct with respect to tax shelters and reportable transactions

 (sec. 3010 of the bill and sec. 7408 of the Code)........................................................ 116

10. Penalty for failure to report interests in foreign financial accounts (sec. 3011

 of the bill and sec. 5321 of Title 31, United States Code)........................................ 117

11. Regulation of individuals practicing before the Department of the Treasury

 (sec. 3012 of the bill and sec. 330 of Title 31, United States Code)......................... 118

B. Other Proposals............................................................................................................... 120

1. Treatment of stripped interests in bond and preferred stock funds (sec. 3021 of the

 bill and secs. 305 and 1286 of the Code)................................................................... 120

2. Minimum holding period for foreign tax credit on withholding taxes on income

 other than dividends (sec. 3022 of the bill and sec. 901 of the Code)........................ 123

3. Disallowance of certain partnership loss transfers (sec. 3023 of the bill and

 secs. 704, 734, and 743 of the Code).......................................................................... 124

4. No reduction of basis under section 734 in stock held by partnership in corporate

 partner (sec. 3024 of the bill and sec. 755 of the Code) ............................................. 127

5. Repeal of special rules for FASITs, etc. (sec. 3025 of the bill and secs. 860H

 through 860L of the Code).......................................................................................... 129

6. Limitation on transfer of built-in losses on REMIC residuals (sec. 3026 of the bill

 and sec. 362 of the Code)............................................................................................ 135

7. Clarification of banking business for purposes of determining investment of

 earnings in U.S. property (sec. 3027 of the bill and sec. 956 of the Code) ................ 136

8. Modify rules related to certain small property and casualty insurance companies

 (sec. 3028 of the bill and secs. 501(c)(15) and 831(b) of the Code)........................... 137

9. Definition of insurance company for property and casualty insurance company

 tax rules (sec. 3029 of the bill and sec. 831(c) of the Code)....................................... 139

10. Denial of deduction for interest on underpayments attributable to nondisclosed

 reportable transactions (sec. 3030 of the bill and sec. 163 of the Code) .................. 141

11. Clarification of rules for payment of estimated tax for certain deemed asset sales

 (sec. 3031 of the bill and sec. 338 of the Code)........................................................ 141

12. Exclusion of like-kind exchange property from nonrecognition treatment on the

 sale or exchange of a principal residence (sec. 3032 of the bill and sec. 121 of the

 Code)......................................................................................................................... 142

13. Prevention of mismatching of interest and original issue discount deductions and

 income inclusions in transactions with related foreign persons (sec. 3033 of the

 bill and secs. 163 and 267 of the Code).................................................................... 143
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14. Exclusion from gross income for interest on overpayments of income tax by

 individuals (sec. 3034 of the bill and new sec. 139A of the Code) .......................... 145

15. Deposits made to suspend the running of interest on potential underpayments

 (sec. 3035 of the bill and new sec. 6603 of the Code).............................................. 146

16. Authorize IRS to enter into installment agreements that provide for partial

 payment (sec. 3036 of the bill and sec. 6159 of the Code)....................................... 149

17. Extension of IRS user fees (sec. 3037 of the bill and sec. 7528 of the Code).......... 150

IV. TRADE ENHANCEMENT AND COMPLIANCE PROVISIONS .................................... 151

A. Repeal of Exclusion for Extraterritorial Income (sec. 4001 of the bill and secs. 114

and 941-943 of the Code)................................................................................................ 151

B. Extension of Customs User Fees (sec. 4002 of the bill)................................................. 153
1

INTRODUCTION

The House Committee on Ways and Means has scheduled a mark up of H.R. 2896, the 

“American Jobs Creation Act of 2003,”1 for October 28, 2003. This document, 2 prepared by the 

staff of the Joint Committee on Taxation, describes the Chairman’s amendment in the nature of a 

substitute to H.R. 2896.

 

1

 For a description of H.R. 2896 as introduced, see Joint Committee on Taxation, 

Technical Explanation of H.R. 2896, the “American Jobs Creation Act of 2003” (JCX-72-03), 

August 13, 2003.

2

 This document may be cited as follows: Joint Committee on Taxation, Description of 

the Chairman’s Amendment in the Nature of a Substitute to H.R. 2896, the “American Jobs 

Creation Act of 2003” (JCX-94-03), October 24, 2003.
2

I. CORPORATE REFORM AND GROWTH INCENTIVES

A. Reduced Corporate Income Tax Rate for Domestic Production Activities

Income and for Small Corporations

(secs. 1001 and 1002 of the bill3 and sec. 11 of the Code)

Present Law

A corporation's regular income tax liability is determined by applying the following tax 

rate schedule to its taxable income.

Table 1.–Marginal Federal Corporate Income Tax Rates for 2003

If taxable income is: Then the income tax rate is:

$0 - $50,000 ......................................... 15 percent of taxable income

$50,001 - $75,000 ................................ 25 percent of taxable income

$75,001 - $10,000,000 ......................... 34 percent of taxable income

Over $10,000,000................................. 35 percent of taxable income

The first two graduated rates described above are phased out by a five-percent surcharge 

for corporations with taxable income between $100,000 and $335,000. Also, the application of 

the 34-percent rate is phased out by a three-percent surcharge for corporations with taxable 

income between $15 million and $18,333,333; a corporation with taxable income of $18,333,333 

or more effectively is subject to a flat rate of 35 percent.

Under present law, there is no provision that reduces the corporate income tax for taxable 

income attributable to domestic production activities.

Description of Proposal

Reduced corporate income tax rate for domestic production activities income

In general

The proposal provides that the corporate tax rate applicable to qualified production 

activities income may not exceed 34 percent (32 percent for taxable years beginning after 2006) 

of the qualified production activities income.

Qualified production activities income

“Qualified production activities income” is the income attributable to domestic 

production gross receipts, reduced by the sum of: (1) the costs of goods sold that are allocable to 

 

3

 All section references are to the Chairman’s Amendment in the Nature of a Substitute 

to H.R. 2896.
3

such receipts; (2) other deductions, expenses, or losses that are directly allocable to such receipts; 

and (3) a proper share of other deductions, expenses, and losses that are not directly allocable to 

such receipts or another class of income.4

Domestic production gross receipts

“Domestic production gross receipts” generally are gross receipts of a corporation that 

are derived from: (1) any sale, exchange or other disposition, or any lease, rental or license, of 

qualifying production property that was manufactured, produced, grown or extracted (in whole 

or in significant part) by the corporation within the United States;5 (2) any sale, exchange or 

other disposition, or any lease, rental or license, of qualified film produced by the taxpayer; or 

(3) construction services or engineering and architectural services for construction projects. 

However, domestic production gross receipts do not include any gross receipts of the taxpayer 

derived from a transaction with any related person.

“Qualifying production property” generally is any tangible personal property, computer 

software, or property described in section 168(f)(4) of the Code. “Qualified film” is any 

property described in section 168(f)(3) of the Code (other than certain sexually explicit 

productions) if 50 percent or more of the total compensation relating to the production of such 

film constitutes compensation for services performed in the United States by actors, production 

personnel, directors, and producers.

Reduced corporate income tax rate for small corporations

The proposal modifies the marginal tax rates applicable to corporations. For taxable 

years beginning in 2004, 2005, and 2006, the proposal provides a 33-percent marginal corporate 

tax rate for taxable incomes in excess of $75,000 and less than or equal to $1 million. For 

taxable years beginning after 2006 and before 2012, the proposal provides a 32-percent marginal 

corporate tax rate for taxable incomes in excess of $75,000 and less than or equal to $1 million 

($5 million for taxable years beginning in 2009, 2010 and 2011). Corporate taxable income in 

excess of $1 million ($5 million for taxable years beginning in 2009, 2010 and 2011) is taxed at 

a 34-percent marginal tax rate, and the benefit of the marginal corporate tax rates less than 34 

 

4

 The Secretary shall prescribe rules for the proper allocation of items of income, 

deduction, expense, and loss for purposes of determining income attributable to domestic 

production activities. Where appropriate, such rules shall be similar to and consistent with 

relevant present-law rules (e.g., secs. 263A and 861).

5

 Domestic production gross receipts include gross receipts of a taxpayer derived from 

any sale, exchange or other disposition of agricultural products with respect to which the 

taxpayer performs storage, handling or other processing activities (but not transportation 

activities) within the United States, provided such products are consumed in connection with, or 

incorporated into, the manufacturing, production, growth or extraction of qualifying production 

property (whether or not by the taxpayer). Domestic production gross receipts also includes 

gross receipts of a taxpayer derived from any sale, exchange or other disposition of food 

products with respect to which the taxpayer performs processing activities.
4

percent is phased out by a five-percent surcharge. The phase-out creates a 39-percent marginal 

tax rate for incomes over $1 million ($5 million for taxable years beginning in 2009, 2010 and 

2011) but less than $1,420,000 ($1,605,000 for taxable years beginning in 2007 and 2008 and 

$7,205,000 for taxable years beginning in 2009, 2010 and 2011). Above the phase-out range, a 

34-percent marginal corporate tax rate applies to taxable incomes up to $10 million.

For taxable years beginning in 2012 and thereafter, the proposal extends the new 32-

percent rate bracket to corporations with taxable incomes in excess of $75,000 and less than or 

equal to $20 million. The 35-percent marginal corporate tax rate applies to taxable incomes over 

$20 million. In addition, beginning at corporate taxable incomes over $20 million, the benefit of 

the 32-percent, 25-percent, and 15-percent marginal tax rates relative to the 35-percent marginal 

tax rate is phased out by a three-percent surcharge. The phase-out creates a 38-percent marginal 

tax rate for incomes over $20 million, but less than $40,341,667. Above the phase-out range, a 

35-percent marginal corporate tax rate applies.

Effective Date

The proposal is effective for taxable years beginning after December 31, 2003.
5

B. Extension of Increased Section 179 Expensing

(sec. 1011 of the bill and sec. 179 of the Code)

Present Law

Present law provides that, in lieu of depreciation, a taxpayer with a sufficiently small 

amount of annual investment may elect to deduct such costs. The Jobs and Growth Tax Relief 

Reconciliation Act (JGTRRA) of 20036 increased the amount a taxpayer may deduct, for taxable 

years beginning in 2003 through 2005, to $100,000 of the cost of qualifying property placed in 

service for the taxable year.7 In general, qualifying property is defined as depreciable tangible 

personal property that is purchased for use in the active conduct of a trade or business. For 

taxable years beginning after 2002 and before 2006, the $100,000 amount is reduced (but not 

below zero) by the amount by which the cost of qualifying property placed in service during the 

taxable year exceeds $400,000. The dollar limitations are indexed annually for inflation for 

taxable years beginning in a calendar year after 2003 and before 2006. The provision also 

includes off-the-shelf computer software placed in service in a taxable year beginning in 2003 

through 2005 as qualifying property. The provision permits taxpayers to revoke expensing 

elections on amended returns without the consent of the Commissioner with respect to a taxable 

year beginning after 2002 and before 2006.

Prior to the enactment of JGTRRA (and for taxable years beginning in 2006 and 

thereafter) a taxpayer with a sufficiently small amount of annual investment may elect to deduct 

up to $25,000 of the cost of qualifying property placed in service for the taxable year. The 

$25,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying 

property placed in service during the taxable year exceeds $200,000. In general, qualifying 

property is defined as depreciable tangible personal property that is purchased for use in the 

active conduct of a trade or business. Prior to the enactment of JGTRRA (and for taxable years

beginning in 2006 and thereafter), an election to expense these items generally is made on the 

taxpayer's original return for the taxable year to which the election relates, and may be revoked 

only with consent of the Commissioner.8

 

6

 Pub. Law No. 108-27, sec. 202 (2003).

7

 Additional section 179 incentives are provided with respect to a qualified property used 

by a business in the New York Liberty Zone (sec. 1400L(f)) or an empowerment zone (sec. 

1397A).

8

 Section 179(c)(2). A taxpayer may make the election on the original return (whether or 

not the return is timely), or on an amended return filed by the due date (including extensions) for 

filing the return for the tax year the property was placed in service. If the taxpayer timely filed 

an original return without making the election, the taxpayer may still make the election by filing 

an amended return within six months of the due date of the return (excluding extensions). Treas. 

Reg. sec. 1.179-5.
6

The amount eligible to be expensed for a taxable year may not exceed the taxable income 

for a taxable year that is derived from the active conduct of a trade or business (determined 

without regard to this provision). Any amount that is not allowed as a deduction because of the

taxable income limitation may be carried forward to succeeding taxable years (subject to similar 

limitations). No general business credit under section 38 is allowed with respect to any amount 

for which a deduction is allowed under section 179.

Description of Proposal

The proposal extends the increased amount that a taxpayer may deduct, and other 

changes that were made by JGTRRA of 2003, for an additional two years. Thus, the proposal 

provides that the maximum dollar amount that may be deducted under section 179 is $100,000 

for property placed in service in taxable years beginning before 2008 ($25,000 for taxable years 

beginning in 2008 and thereafter). In addition, the $400,000 amount applies for property placed 

in service in taxable years beginning before 2008 ($200,000 for taxable years beginning in 2008 

and thereafter). The proposal extends, through 2007 (from 2005), the indexing for inflation of 

both the maximum dollar that may be deducted and the $400,000 amount. The provision also 

includes off-the-shelf computer software placed in service in taxable years beginning before 

2008 as qualifying property. The proposal permits taxpayers to revoke expensing elections on 

amended returns without the consent of the Commissioner with respect to a taxable year 

beginning before 2008.

Effective Date

The proposal is effective on the date of enactment.
7

C. Recovery Period for Depreciation of Certain Leasehold

Improvements and Restaurant Property

(sec. 1021 of the bill and sec. 168 of the Code)

Present Law

A taxpayer generally must capitalize the cost of property used in a trade or business and 

recover such cost over time through annual deductions for depreciation or amortization. Tangible 

property generally is depreciated under the modified accelerated cost recovery system 

(“MACRS”), which determines depreciation by applying specific recovery periods, placed-inservice conventions, and depreciation methods to the cost of various types of depreciable 

property (sec. 168). The cost of nonresidential real property is recovered using the straight-line 

method of depreciation and a recovery period of 39 years. Nonresidential real property is subject 

to the mid-month placed-in-service convention. Under the mid-month convention, the 

depreciation allowance for the first year property is placed in service is based on the number of 

months the property was in service, and property placed in service at any time during a month is 

treated as having been placed in service in the middle of the month. 

Depreciation of leasehold improvements

Depreciation allowances for improvements made on leased property are determined 

under MACRS, even if the MACRS recovery period assigned to the property is longer than the 

term of the lease (sec. 168(i)(8)).9 This rule applies regardless of whether the lessor or the lessee 

places the leasehold improvements in service.10 If a leasehold improvement constitutes an 

addition or improvement to nonresidential real property already placed in service, the 

improvement is depreciated using the straight-line method over a 39-year recovery period, 

beginning in the month the addition or improvement was placed in service (secs. 168(b)(3), (c), 

(d)(2), and (i)(6)).11

 

9

 The Tax Reform Act of 1986 modified the Accelerated Cost Recovery System 

("ACRS") to institute MACRS. Prior to the adoption of ACRS by the Economic Recovery Tax 

Act of 1981, taxpayers were allowed to depreciate the various components of a building as 

separate assets with separate useful lives. The use of component depreciation was repealed upon 

the adoption of ACRS. The Tax Reform Act of 1986 also denied the use of component 

depreciation under MACRS.

10 Former sections 168(f)(6) and 178 provided that, in certain circumstances, a lessee 

could recover the cost of leasehold improvements made over the remaining term of the lease. 

The Tax Reform Act of 1986 repealed these provisions.

11 If the improvement is characterized as tangible personal property, ACRS or MACRS 

depreciation is calculated using the shorter recovery periods and accelerated methods applicable 

to such property. The determination of whether improvements are characterized as tangible 

personal property or as nonresidential real property often depends on whether or not the 

improvements constitute a “structural component” of a building (as defined by Treas. Reg. sec. 

1.48-1(e)(1)). See, e.g., Metro National Corp v. Commissioner., 52 TCM (CCH) 1440 (1987); 
8

Qualified leasehold improvement property

The Job Creation and Worker Assistance Act of 200212 as amended by the Jobs and 

Growth Tax Relief Reconciliation Act of 200313 generally provides an additional first-year 

depreciation deduction equal to either 30 percent or 50 percent of the adjusted basis of qualified 

property placed in service before January 1, 2005. Qualified property includes qualified 

leasehold improvement property. For this purpose, qualified leasehold improvement property is 

any improvement to an interior portion of a building that is nonresidential real property, provided 

certain requirements are met. The improvement must be made under or pursuant to a lease either 

by the lessee (or sublessee), or by the lessor, of that portion of the building to be occupied 

exclusively by the lessee (or sublessee). The improvement must be placed in service more than 

three years after the date the building was first placed in service. Qualified leasehold 

improvement property does not include any improvement for which the expenditure is 

attributable to the enlargement of the building, any elevator or escalator, any structural 

component benefiting a common area, or the internal structural framework of the building.

Treatment of dispositions of leasehold improvements 

A lessor of leased property that disposes of a leasehold improvement which was made by 

the lessor for the lessee of the property may take the adjusted basis of the improvement into 

account for purposes of determining gain or loss if the improvement is irrevocably disposed of or 

abandoned by the lessor at the termination of the lease. This rule conforms the treatment of 

lessors and lessees with respect to leasehold improvements disposed of at the end of a term of 

lease. 

Description of Proposal

The proposal provides a statutory 15-year recovery period for qualified leasehold 

improvement property placed in service before January 1, 2006.14 The proposal requires that 

qualified leasehold improvement property be recovered using the straight-line method. 

Qualified leasehold improvement property is defined as under present law for purposes of 

the additional first-year depreciation deduction (sec. 168(k)), with the following modification. If 

a lessor makes an improvement that qualifies as qualified leasehold improvement property such 

improvement shall not qualify as qualified leasehold improvement property to any subsequent 

owner of such improvement. An exception to the rule applies in the case of death and certain 

transfers of property that qualify for non-recognition treatment.

 

King Radio Corp Inc. v. U.S., 486 F.2d 1091 (10th Cir. 1973); Mallinckrodt, Inc. v. 

Commissioner, 778 F.2d 402 (8th Cir. 1985) (with respect to various leasehold improvements).

12 Pub. Law No. 107-147, sec 101 (2002).

13 Pub. Law No. 198-27, sec. 201 (2003).

14 Qualified leasehold improvement property continues to be eligible for the additional 

first-year depreciation deduction under sec. 168(k).
9

The proposal also provides a statutory 15-year recovery period for qualified restaurant 

property placed in service before January 1, 2006.15 For purposes of the proposal, qualified 

restaurant property means any improvement to a building if such building has been in service 

more than three years and more than 50 percent of the building’s square footage is devoted to the 

preparation of, and seating for, on-premises consumption of prepared meals. The proposal 

requires that qualified restaurant property be recovered using the straight-line method. 

Effective Date

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

 

15 Qualified restaurant property would become eligible for the additional first-year 

depreciation deduction under sec. 168(k) by virtue of the assigned 20-year recovery period.
10

D. Alternative Minimum Tax Relief

1. Net operating losses and foreign tax credit under the alternative minimum tax and 

expansion of exemption from alternative minimum tax for small corporations (secs. 1031-

1032 of the bill and secs. 55-59 of the Code)

Present Law

In general

Under present law, taxpayers are subject to an alternative minimum tax ("AMT"), which 

is payable, in addition to all other tax liabilities, to the extent that it exceeds the taxpayer's 

regular income tax liability. The tax is imposed at a flat rate of 20 percent, in the case of 

corporate taxpayers, on alternative minimum taxable income ("AMTI") in excess of a phased-out 

exemption amount. AMTI is the taxpayer's taxable income increased for certain tax preferences 

and adjusted by determining the tax treatment of certain items in a manner that limits the tax 

benefits resulting from the regular tax treatment of such items.

Net operating loss

Taxpayers generally may use the net operating loss deduction to offset 90 percent of 

AMTI (determined without regard to the net operating loss deduction). A special rule allows a 

net operating loss carryback from, or carryover to, a taxable year ending during 2001 or 2002 to 

offset 100 percent of AMTI.

Foreign tax credit

Taxpayers are permitted to reduce their AMT liability by an AMT foreign tax credit. The 

AMT foreign tax credit for a taxable year is determined under principles similar to those used in 

computing the regular tax foreign tax credit, except that (1) the numerator of the AMT foreign 

tax credit limitation fraction is foreign source AMTI and (2) the denominator of that fraction is 

total AMTI. Taxpayers may elect to use as their AMT foreign tax credit limitation fraction the 

ratio of foreign source regular taxable income to total AMTI.

The AMT foreign tax credit for any taxable year generally may not offset a taxpayer's 

entire pre-credit AMT. Rather, the AMT foreign tax credit is limited to 90 percent of AMT 

computed without any AMT net operating loss deduction and the AMT foreign tax credit. For 

example, assume that a corporation has $10 million of AMTI, has no AMT net operating loss 

deduction, and has no regular tax liability. In the absence of the AMT foreign tax credit, the 

corporation's tax liability would be $2 million. Accordingly, the AMT foreign tax credit cannot 

be applied to reduce the taxpayer's tax liability below $200,000. Any unused AMT foreign tax 

credit may be carried back two years and carried forward five years for use against AMT in those 

years under the principles of the foreign tax credit carryback and carryover rules set forth in 

section 904(c).
11

Small corporation exemption

Corporations with average gross receipts of less than $7.5 million for the prior three 

taxable years are exempt from the corporate alternative minimum tax. The $7.5 million 

threshold is reduced to $5 million for the corporation’s first 3-taxable year period.

Description of Proposal

The proposal phases-out the 90-percent limitation on the use of the net operating loss 

deduction in computing AMTI. The limitation is increased to 92 percent for taxable years 

beginning in 2005, 2006 and 2007; 94 percent for taxable years beginning in 2008 and 2009; 96 

percent for taxable years beginning in 2010; 98 percent for taxable years beginning in 2011; and 

100 percent for taxable years beginning in and after 2012.

The proposal repeals the 90-percent limitation on the utilization of the AMT foreign tax 

credit. 

The proposal increases the amount of average gross receipts that an exempt corporation 

may receive from $7.5 million to $20 million.

Effective Date

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

2. Coordinate farmers income averaging and the alternative minimum tax (sec. 1033 of the 

bill and sec. 55 of the Code)

Present Law

An individual taxpayer engaged in a farming business as defined by section 263A(e)(4) 

may elect to compute his or her current year tax liability by averaging, over the prior three-year 

period, all or portion of his or her taxable income from the trade or business of farming. The 

averaging election is not coordinated with the alternative minimum tax. Thus, some farmers may 

become subject to the alternative minimum tax solely as a result of the averaging election.

Description of Proposal

The proposal coordinates farmers’ income averaging with the alternative minimum tax. 

Under the proposal, a farmer would owe alternative minimum tax only to the extent he or she 

would owe alternative minimum tax had averaging not been elected. This result is achieved by 

excluding the impact of the election to average farm income from the calculation of both regular 

tax and tentative minimum tax, solely for the purpose of determining alternative minimum tax.

Effective Date

The provision is effective for taxable years beginning after December 31, 2002.
12

E. Proposals Relating to S Corporation Reform and Simplification

(secs. 1041-1051 of the bill and secs. 1361-1379 and 4975 of the Code)

Overview

In general, an S corporation is not subject to corporate-level income tax on its items of 

income and loss. Instead, an S corporation passes through its items of income and loss to its 

shareholders. The shareholders take into account separately their shares of these items on their 

individual income tax returns. To prevent double taxation of these items when the stock is later 

disposed of, each shareholder’s basis in the stock of the S corporation is increased by the amount 

included in income (including tax-exempt income) and is decreased by the amount of any losses 

(including nondeductible losses) taken into account. A shareholder’s loss may be deducted only 

to the extent of his or her basis in the stock or debt of the corporation. To the extent a loss is not 

allowed due to this limitation, the loss generally is carried forward with respect to the 

shareholder.

1. Shareholders of an S corporation 

Present Law

In general

A small business corporation may elect to be an S corporation with the consent of all its 

shareholders, and may terminate its election with the consent of shareholders holding more than 

50 percent of the stock. A "small business corporation" is defined as a domestic corporation 

which is not an ineligible corporation and which has (1) no more than 75 shareholders, all of 

whom are individuals (and certain trusts, estates, charities, and qualified retirement plans)16 who 

are citizens or residents of the United States, and (2) only one class of stock. For purposes of the 

75-shareholder limitation, a husband and wife are treated as one shareholder. An "ineligible 

corporation" means a corporation that is a financial institution using the reserve method of 

accounting for bad debts, an insurance company, a corporation electing the benefits of the Puerto 

Rico and possessions tax credit, a Domestic International Sales Corporation (“DISC”) or former 

DISC.

Individual retirement accounts

An individual retirement account (“IRA”) is a trust or account established for the 

exclusive benefit of an individual and his or her beneficiaries. There are two general types of 

IRAs: traditional IRAs, to which both deductible and nondeductible contributions may be made, 

and Roth IRAs, contributions to which are not deductible. Amounts held in a traditional IRA are 

includible in income when withdrawn (except to the extent the withdrawal is a return of 

 

16 If a charity or a qualified retirement plan holds stock in an S corporation, the interest 

held is treated as an interest in an unrelated trade or business, and the charity’s or plan’s share of 

the S corporation’s items of income, loss, or deduction, and gain or loss on the disposition of the 

S corporation stock, are taken into account in computing unrelated business taxable income.
13

nondeductible contributions). Amounts held in a Roth IRA that are withdrawn as a qualified 

distribution are not includible in income; distributions from a Roth IRA that are not qualified 

distributions are includible in income to the extent attributable to earnings. A qualified 

distribution is a distribution that (1) is made after the five-taxable year period beginning with the 

first taxable year for which the individual made a contribution to a Roth IRA, and (2) is made 

after attainment of age 59-1/2, on account of death or disability, or is made for first-time 

homebuyer expenses of up to $10,000.

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

Certain transactions are prohibited between an IRA and the individual for whose benefit 

the IRA is established, including a sale of property by the IRA to the individual. If a prohibited 

transaction occurs between an IRA and the IRA beneficiary, the account ceases to be an IRA, 

and an amount equal to the fair market value of the assets held in the IRA is deemed distributed 

to the beneficiary.

Description of Proposal

In general

The proposal provides that all family members can elect to be treated as one shareholder 

for purposes of determining the number of shareholders in the corporation. A family is defined as 

the lineal descendants of a common ancestor (and their spouses). The common ancestor cannot 

be more than three generations removed from the youngest generation of shareholder at the time 

the S election is made (or the effective date of this proposal, if later). Except as provided by 

Treasury regulations, the election for a family may be made by any family member and remains 

in effect until terminated. 

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

Individual retirement accounts

The proposal allows an IRA (including a Roth IRA) to be a shareholder of a bank that is 

an S corporation, but only to the extent of bank stock held by the IRA on the date of enactment 

of the proposal.17

 

The proposal also provides an exemption from prohibited transaction treatment for the 

sale by an IRA to the IRA beneficiary of bank stock held by the IRA on the date of enactment of 

the proposal. Under the bill, a sale is not a prohibited transaction if: (1) the sale is pursuant to 

an S corporation election by the bank; (2) the sale is for fair market value (as established by an 

independent appraiser) and is on terms at least as favorable to the IRA as the terms would be on 

a sale to an unrelated party; (3) the IRA incurs no commissions, costs, or other expenses in 

 

17 Under the proposal, the present-law rules treating S corporation stock held by a 

qualified retirement plan or a charity as an interest in an unrelated trade or business apply also to 

an IRA holding stock of a bank that is an S corporation.
14

connection with the sale; and (4) the stock is sold in a single transaction for cash not later than 

120 days after the S corporation election is made.

Effective Date

The proposals generally apply to taxable years beginning after December 31, 2003. The 

proposal relating to IRAs takes effect on the date of enactment. 

2. Treatment of S corporation shareholders

(a) Electing small business trusts

Present Law

An electing small business trust (“ESBT”) holding stock in an S corporation is taxed at 

the maximum individual tax rate on its ratable share of items of income, deduction, gain, or loss 

passing through from the S corporation. An ESBT generally is an electing trust all of whose 

beneficiaries are eligible S corporation shareholders. For purposes of determining the maximum 

number of shareholders, each person who is entitled to receive a distribution from the trust 

(“potential current beneficiary”) is treated as a shareholder during the period the person may 

receive a distribution from the trust.

An ESBT has 60 days to dispose of the S corporation stock after an ineligible shareholder 

becomes a potential current beneficiary to avoid disqualification.

Description of Proposal

Under the proposal, powers of appointment to the extent not exercised are disregarded in 

determining the potential current beneficiaries of an electing small business trust.

The proposal increases the period during which an ESBT can dispose of S corporation 

stock after an ineligible shareholder becomes a potential current beneficiary from 60 days to one 

year.

Effective Date

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

(b) Qualified subchapter S trusts

Present Law

Under present law, the share of income of an S corporation whose stock is held by a 

qualified subchapter S trust (“QSST”), with respect to which the beneficiary makes an election, 

is taxed to the beneficiary. However, the trust, and not the beneficiary, is treated as the owner of 

the S corporation stock for purposes of determining the tax consequences of the disposition of 

the S corporation stock by the trust. A QSST generally is a trust with one individual income 

beneficiary for the life of the beneficiary.
15

Description of Proposal

Under the proposal, the beneficiary of a qualified subchapter S trust is generally allowed 

to deduct suspended losses under the at-risk rules and the passive loss rules when the trust 

disposes of the S corporation stock.

Effective Date

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

(c) Transfers of losses incident to divorce, etc.

Present Law

Under present law, any loss or deduction that is not allowed to a shareholder of an S 

corporation, because the loss exceeds the shareholder’s basis in stock and debt of the 

corporation, is treated as incurred by the corporation with respect to that shareholder in the 

subsequent taxable year. 

Description of Proposal

Under the proposal, if a shareholder’s stock in an S corporation is transferred to a spouse, 

or to a former spouse incident to a divorce, any suspended loss or deduction with respect to that 

stock is treated as incurred by the corporation with respect to the transferee in the subsequent 

taxable year.

Effective Date

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

3. Proposals relating to banks

(a) Exclusion of investment securities income from passive income test for bank S 

corporations

Present Law

An S corporation is subject to corporate-level tax, at the highest corporate tax rate, on its 

excess net passive income if the corporation has (1) accumulated earnings and profits at the close 

of the taxable year and (2) gross receipts more than 25 percent of which are passive investment 

income. In addition, an S corporation election is terminated whenever the corporation has 

accumulated earnings and profits at the close of three consecutive taxable years and has gross 

receipts for each of those years more than 25 percent of which are passive investment income. 

Excess net passive income is the net passive income for a taxable year multiplied by a 

fraction, the numerator of which is the amount of passive investment income in excess of 25 

percent of gross receipts and the denominator of which is the passive investment income for the

year. Net passive income is defined as passive investment income reduced by the allowable 
16

deductions that are directly connected with the production of that income. Passive investment 

income generally means gross receipts derived from royalties, rents, dividends, interest, 

annuities, and sales or exchanges of stock or securities (to the extent of gains). Passive 

investment income generally does not include interest on accounts receivable, gross receipts that 

are derived directly from the active and regular conduct of a lending or finance business, gross 

receipts from certain liquidations, or gain or loss from any section 1256 contract (or related 

property) of an options or commodities dealer. 

Description of Proposal

The proposal provides that, in the case of a bank or bank holding company, interest 

income and dividends on assets required to be held by the bank or bank holding company are not 

treated as passive investment income for purposes of applying the excess net passive income 

rules.

Effective Date

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

(b) Treatment of qualifying director shares

Present Law

An S corporation may have only one outstanding class of stock. 

An S corporation has one class of stock if all outstanding shares of stock confer identical 

rights to distribution and liquidation proceeds. Differences in voting rights are disregarded. 

Description of Proposal

Under the proposal, qualifying director shares are not treated as a second class of stock. 

Qualifying director shares means shares in a bank or bank holding company that are held by an 

individual solely by reason of status as a director of the bank or company and which are subject 

to an agreement pursuant to which the holder is required to dispose of the shares upon 

termination of the holder’s status as a director at the same price the individual acquired the 

shares. Qualifying director shares are not taken into account in allocating the S corporation’s 

items of income, loss, etc. Distributions with respect to the shares are deductible by the S 

corporation and includible in the income of the holder.

Effective Date

The proposal applies to taxable years beginning after December 31, 2003.
17

4. Qualified subchapter S subsidiaries

(a) Relief from inadvertently invalid qualified subchapter S subsidiary elections and 

terminations

Present Law

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

waived.

Description of Proposal

The proposal allows inadvertent invalid qualified subchapter S subsidiary elections and 

terminations to be waived by the IRS.

Effective Date

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

(b) Information returns for qualified subchapter S subsidiaries

Present Law

Under present law, a corporation all of whose stock is held by an S corporation is treated 

as a qualified subchapter S subsidiary if the S corporation so elects. The assets, liabilities, and 

items of income, deduction, and credit of the subsidiary are treated as assets, liabilities, and items 

of the parent S corporation.

Description of Proposal

The proposal provides authority to the Secretary of the Treasury to provide guidance 

regarding information returns of qualified subchapter S subsidiaries.

Effective Date

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

5. S corporation distributions to an employee stock ownership plan

Present Law

An employee stock ownership plan (an “ESOP”) is a defined contribution plan that is 

designated as an ESOP and is designed to invest primarily in qualifying employer securities. For 

purposes of ESOP investments, a “qualifying employer security” is defined as: (1) publicly 

traded common stock of the employer or a member of the same controlled group; (2) if there is 

no such publicly traded commo n stock, common stock of the employer (or member of the same 

controlled group) that has both voting power and dividend rights at least as great as any other 

class of common stock; or (3) noncallable preferred stock that is convertible into common stock 

described in (1) or (2) and that meets certain requirements. In some cases, an employer may 
18

design a class of preferred stock that meets these requirements and that is held only by the ESOP. 

Special rules apply to ESOPs that do not apply to other types of qualified retirement plans, 

including a special exemption from the prohibited transaction rules.

Certain transactions between an employee benefit plan and a disqualified person, 

including the employer maintaining the plan, are prohibited transactions that result in the 

imposition of an excise tax. 18 Prohibited transactions include, among other transactions, (1) the 

sale, exchange or leasing of property, (2) the lending of money or other extension of credit, and 

(3) the transfer to, or use by or for the benefit of, the income or assets of the plan. However, 

certain transactions are exempt from prohibited transaction treatment, including certain loans to 

enable an ESOP to purchase qualifying employer securities.19 In such a case, the employer 

securities purchased with the loan proceeds are generally pledged as security for the loan. 

Contributions to the ESOP and dividends paid on employer stock held by the ESOP are used to 

repay the loan. The employer stock is held in a suspense account and released for allocation to 

participants’ accounts as the loan is repaid.

A loan to an ESOP is exempt from prohibited transaction treatment if the loan is 

primarily for the benefit of the participants and their beneficiaries, the loan is at a reasonable rate 

of interest, and the collateral given to a disqualified person consists of only qualifying employer 

securities. No person entitled to payments under the loan can have the right to any assets of the 

ESOP other than (1) collateral given for the loan, (2) contributions made to the ESOP to meet its 

obligations on the loan, and (3) earnings attributable to the collateral and the investment of 

contributions described in (2).20 In addition, the payments made on the loan by the ESOP during 

a plan year cannot exceed the sum of those contributions and earnings during the current and 

prior years, less loan payments made in prior years.

An ESOP of a C corporation is not treated as violating the qualification requirements of 

the Code or as engaging in a prohibited transaction merely because, in accordance with plan 

provisions, a dividend paid with respect to qualifying employer securities held by the ESOP is 

used to make payments on a loan (including payments of interest as well as principal) that was 

used to acquire the employer securities (whether or not allocated to participants).21 In the case of 

a dividend paid with respect to any employer security that is allocated to a participant, this relief 

does not apply unless the plan provides that employer securities with a fair market value of not 

less than the amount of the dividend is allocated to the participant for the year which the 

dividend would have been allocated to the participant. 22

 

18 Sec. 4975.

19 Sec. 4975(d)(3). An ESOP that borrows money to purchase employer stock is referred 

to as a “leveraged” ESOP.

20 Treas. reg. sec. 54.4975-7(b)(5).

21 Sec. 404(k)(5)(B).

22 Sec. 404(k)(2)(B).
19

Description of Proposal

Under the proposal, an ESOP maintained by an S corporation is not treated as violating 

the qualification requirements of the Code or as engaging in a prohibited transaction merely 

because, in accordance with plan provisions, a distribution made with respect to S corporation 

stock that constitutes qualifying employer securities held by the ESOP is used to repay a loan 

that was used to acquire the securities (whether or not allocated to participants). This relief does 

not apply in the case of a distribution with respect to S corporation stock that is allocated to a 

participant unless the plan provides that stock with a fair market value of not less than the 

amount of such distribution is allocated to the participant for the year which the distribution 

would have been allocated to the participant. 

Effective Date

The proposal is effective for distributions made with respect to S corporation stock after 

December 31, 2003. 
20

F. Employee Benefits

1. Treatment of nonqualified deferred compensation plans (sec. 1061 of the bill and

new sec. 409A and sec. 6051 of the Code)

Present Law

In general

The determination of when amounts deferred under a nonqualified deferred compensation 

arrangement are includible in the gross income of the individual earning the compensation 

depends on the facts and circumstances of the arrangement. A variety of tax principles and Code 

provisions may be relevant in making this determination, including the doctrine of constructive 

receipt, the economic benefit doctrine,23 the provisions of section 83 relating generally to 

transfers of property in connection with the performance of services, and provisions relating 

specifically to nonexempt employee trusts (sec. 402(b)) and nonqualified annuities (sec. 403(c)).

In general, the time for income inclusion of nonqualified deferred compensation depends 

on whether the arrangeme nt is unfunded or funded. If the arrangement is unfunded, then the 

compensation is generally includible in income when it is actually or constructively received. If 

the arrangement is funded, then income is includible for the year in which the individual’s rights 

are transferable or not subject to a substantial risk of forfeiture.

Nonqualified deferred compensation is generally subject to social security and Medicare 

taxes when the compensation is earned (i.e., when services are performed), unless the 

nonqualified deferred compensation is subject to a substantial risk of forfeiture. If nonqualified 

deferred compensation is subject to a substantial risk of forfeiture, it is subject to social security 

and Medicare tax when the risk of forfeiture is removed (i.e., when the right to the nonqualified 

deferred compensation vests). This treatment is not affected by whether the arrangement is 

funded or unfunded, which is relevant in determining when amounts are includible in income 

(and subject to income tax withholding).

In general, an arrangement is considered funded if there has been a transfer of property 

under section 83. Under that section, a transfer of property occurs when a person acquires a 

beneficial ownership interest in such property. The term “property” is defined very broadly for 

purposes of section 83.24 Property includes real and personal property other than money or an 

unfunded and unsecured promise to pay money in the future. Property also includes a beneficial 

interest in assets (including money) that are transferred or set aside from claims of the creditors 

of the transferor, for example, in a trust or escrow account. Accordingly, if, in connection with 

the performance of services, vested contributions are made to a trust on an individual’s behalf 

 

23

 See, e.g., Sproull v. Commissioner, 16 T.C. 244 (1951), aff’d per curiam, 194 F.2d 541 

(6th Cir. 1952); Rev. Rul. 60-31, 1960-1 C.B. 174.

24 Treas. Reg. sec. 1.83-3(e). This definition in part reflects previous IRS rulings on 

nonqualified deferred compensation.
21

and the trust assets may be used solely to provide future payments to the individual, the payment 

of the contributions to the trust constitutes a transfer of property to the individual that is taxable 

under section 83. On the other hand, deferred amounts are generally not includible in income if 

nonqualified deferred compensation is payable from general corporate funds that are subject to 

the claims of general creditors, as such amounts are treated as unfunded and unsecured promises 

to pay money or property in the future.

As discussed above, if the arrangement is unfunded, then the compensation is generally 

includible in income when it is actually or constructively received under section 451.25 Income 

is constructively received when it is credited to an individual’s account, set apart, or otherwise 

made available so that it may be drawn on at any time. Income is not constructively received if 

the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. A 

requirement to relinquish a valuable right in order to make withdrawals is generally treated as a 

substantial limitation or restriction.

Rabbi trusts 

Arrangements have developed in an effort to provide employees with security for 

nonqualified deferred compensation, while still allowing deferral of income inclusion. A “rabbi 

trust” is a trust or other fund established by the employer to hold assets from which nonqualified 

deferred compensation payments will be made. The trust or fund is generally irrevocable and 

does not permit the employer to use the assets for purposes other than to provide nonqualified 

deferred compensation, except that the terms of the trust or fund provide that the assets are 

subject to the claims of the employer’s creditors in the case of insolvency or bankruptcy.

As discussed above, for purposes of section 83, property includes a beneficial interest in 

assets set aside from the claims of creditors, such as in a trust or fund, but does not include an 

unfunded and unsecured promise to pay money in the future. In the case of a rabbi trust, terms 

providing that the assets are subject to the claims of creditors of the employer in the case of 

insolvency or bankruptcy have been the basis for the conclusion that the creation of a rabbi trust 

does not cause the related nonqualified deferred compensation arrangement to be funded for 

income tax purposes.26 As a result, no amount is included in income by reason of the rabbi trust; 

generally income inclusion occurs as payments are made from the trust.

The IRS has issued guidance setting forth model rabbi trust provisions.27 Revenue 

Procedure 92-64 provides a safe harbor for taxpayers who adopt and maintain grantor trusts in 

connection with unfunded deferred compensation arrangements. The model trust language 

 

25 Treas. Reg. secs. 1.451-1 and 1.451-2.

26 This conclusion was first provided in a 1980 private ruling issued by the IRS with 

respect to an arrangement covering a rabbi; hence the popular name “rabbi trust.” Priv. Ltr. Rul. 

8113107 (Dec. 31, 1980).

27 Rev. Proc. 92-64, 1992-2 C.B. 422, modified in part by Notice 2000-56, 2000-2 C.B. 

393.
22

requires that the trust provide that all assets of the trust are subject to the claims of the general 

creditors of the company in the event of the company’s insolvency or bankruptcy. 

Since the concept of rabbi trusts was developed, arrangements have developed which 

attempt to protect the assets from creditors despite the terms of the trust. Arrangements also 

have developed which effectively allow deferred amounts to be available to individuals, while 

still meeting the safe harbor requirements set forth by the IRS.

Description of Proposal

Under the proposal, all amounts deferred under a nonqualified deferred compensation 

plan28 for all taxable years are currently includible in gross income to the extent not subject to a 

substantial risk of forfeiture29 and not previously included in gross income, unless certain 

requirements are satisfied. If the requirements of the proposal are not satisfied, in addition to 

current income inclusion, interest at the underpayment rate plus one percentage point is imposed 

on the underpayments that would have occurred had the compensation been includible in income 

when first deferred, or if later, when not subject to a substantial risk of forfeiture. Actual or 

notional earnings on amounts deferred are also subject to the provisions of the proposal.

Under the proposal, distributions from a nonqualified deferred compensation plan may be 

allowed only upon separation from service (as determined by the Secretary), disability, death, a 

specified time (or pursuant to a fixed schedule), change in control in a corporation (to the extent 

provided by the Secretary), or occurrence of an unforeseeable emergency. A nonqualified 

deferred compensation plan may not allow distributions other than upon the permissible 

distribution events and may not permit acceleration of a distribution, except as provided in 

regulations by the Secretary. 

In the case of a specified employee, distributions upon separation from service may not 

be made earlier than six months after the date of the separation from service. Specified 

employees are key employees30 of publicly-traded corporations.

Disability is defined as under the Social Security Act. Under such definition, an 

individual is considered to be disabled if he or she is unable to engage in any substantial gainful 

activity by reason of any medically determinable physical or mental impairment which can be 

expected to result in death or which has lasted or can be expected to last for a continuous period 

 

28 A plan includes an agreement or arrangement, including an agreement or arrangement 

that includes one person. 

29 As under section 83, the rights of a person to compensation are subject to a substantial 

risk of forfeiture if the person’s rights to such compensation are conditioned upon the 

performance of substantial services by any individual.

30 Key employees are defined in section 416(i) and generally include officers having 

annual compensation greater than $130,000 (adjusted for inflation and limited to 50 employees), 

five percent owners, and one percent owners having annual compensation from the employer 

greater than $150,000. 
23

of not less than twelve months. In determining if a participant is disabled, a determination letter 

from the Social Security Administration is not required. It is intended that a nonqualified 

deferred compensation plan provide that the determination whether a participant is disabled must 

be based on the Social Security Administration statutory standard.

Amounts payable at a specified time or pursuant to a fixed schedule must be specified 

under the plan at the time of deferral. Amounts payable upon the occurrence of an event are not 

treated as amounts payable at a specified time. For example, amounts payable when an 

individual attains age 65 are payable at a specified time, while amounts payable when an 

individual’s child begins college are payable upon the occurrence of an event.

Distributions upon a change in the ownership or effective control of a corporation, or in 

the ownership of a substantial portion of the assets of a corporation, may only be made to the 

extent provided by the Secretary. It is intended that the Secretary use a similar, but more 

restrictive, definition of change in control as is used for purposes of the golden parachute 

provisions of section 280G consistent with the purposes of the proposal. The proposal requires 

the Secretary to issue guidance defining change of control within 90 days after the date of 

enactment.

An unforeseeable emergency is defined as a severe financial hardship to the participant 

resulting from a sudden and unexpected illness or accident of the participant, the participant’s 

spouse, or a dependent (as defined in 152(a)) of the participant; loss of the participant’s property 

due to casualty; or other similar extraordinary and unforeseeable circumstances arising as a result 

of events beyond the control of the participant. The amount of the distribution must be limited to 

the amount needed to satisfy the emergency plus taxes reasonably anticipated as a result of the 

distribution. Distributions may not be allowed to the extent that the hardship may be relieved 

through reimbursement or compensation by insurance or otherwise, or by liquidation of the 

participant’s assets (to the extent such liquidation would not itself cause a severe financial 

hardship).

As previously discussed, except as provided in regulations by the Secretary, no 

accelerations of distributions may be allowed. For example, changes in the form of a distribution 

from an annuity to a lump sum are not permitted. The proposal provides the Secretary authority 

to provide, through regulations, limited exceptions to the general rule that no accelerations can 

be permitted. It is intended that exceptions be provided only in limited cases where the 

accelerated distribution is required for reasons beyond the control of the participant. For 

example, it is anticipated that an exception could be provided in order to comply with Federal 

conflict of interest requirements or court-approved settlements.

The proposal requires that the plan must provide that compensation for services 

performed during a taxable year may be deferred at the participant’s election only if the election 

to defer is made during the preceding taxable year, or at such other time as provided in Treasury 

regulations. In the first year that an employee becomes eligible for participation in a 

nonqualified deferred compensation plan, the election may be made within 30 days after the date 

that the employee is initially eligible. 
24

Under the proposal, a plan may allow changes in the time and form of distributions 

subject to certain requirements. A nonqualified deferred compensation plan may allow a 

subsequent election to delay the timing or form of distributions only if: (1) the plan requires that 

such election cannot be effective for at least 12 months after the date on which the election is 

made; (2) except in the case of elections relating to distributions on account of death, disability 

or unforeseeable emergency, the plan requires that the additional deferral with respect to which 

such election is made is for a period of not less than five years from the date such payment 

would otherwise have been made; and (3) the plan requires that an election related to a 

distribution to be made upon a specified time may not be made less than 12 months prior to the 

date of the first scheduled payment. It is expected that the Secretary shall issue guidance 

regarding to what extent elections to change a steam of payments are permissible.

If impermissible distributions or elections are made, or if the nonqualified deferred 

compensation plan allows impermissible distributions or elections, all amounts deferred under 

the plan (including amounts deferred in prior years) are currently includible in income to the 

extent not subject to a substantial risk of forfeiture and not previously included in income. In 

addition, interest at the underpayment rate plus one percentage point is imposed on the 

underpayments that would have occurred had the compensation been includible in income when 

first deferred, or if later, when not subject to a substantial risk of forfeiture.

Under the proposal, in the case of assets held in a trust or set aside (directly or indirectly) 

in another arrangement, as determined by the Secretary, for purposes of paying nonqualified 

deferred compensation, such assets are treated as property transferred in connection with the 

performance of services under section 83 at the time set aside or transferred outside of the United 

States (whether or not such assets are available to satisfy the claims of general creditors). Any 

increases in the value of, or any earnings with respect to, such assets are treated as additional 

transfers of property. Interest at the underpayment rate plus one percentage point is imposed on 

the underpayments that would have occurred had the amounts been includible in income for the 

taxable year such assets were first set aside for purposes of nonqualified deferred compensation. 

The Secretary has authority to exempt arrangements from the provision if the arrangements do 

not result in an improper deferral of U.S. tax and will not result in assets being effectively 

beyond the reach of creditors.

Under the proposal, a transfer of property in connection with the performance of services 

under section 83 also occurs if a nonqualified deferred compensation plan provides that, upon a 

change in the employer’s financial health, assets will be restricted to the payment of nonqualified 

deferred compensation. The transfer of property occurs as of the earlier of when the assets are so 

restricted or when the plan provides that assets will be restricted. Any increases in the value of, 

or any earnings with respect to, such assets are treated as additional transfers of property. 

Interest at the underpayment rate plus one percentage point is imposed on the underpayments 

that would have occurred had the amounts been includible in income for the taxable year such 

assets were first set aside for purposes of nonqualified deferred compensation.

A nonqualified deferred compensation plan is any plan that provides for the deferral of 

compensation other than a qualified employer plan or any bona fide vacation leave, sick leave, 

compensatory time, disability pay, or death benefit plan. A qualified employer plan means a 
25

qualified retirement plan, tax-deferred annuity, simplified employee pension, and SIMPLE.31 A 

governmental eligible deferred compensation plan (sec. 457) is also a qualified employer plan 

under the proposal.

Interest imposed under the proposal is treated as interest on an underpayment of tax. 

Income (whether actual or notional) attributable to nonqualified deferred compensation is treated 

as additional deferred compensation and is subject to the provisions of the proposal. The 

proposal is not intended to prevent the inclusion of amounts in gross income under any provision 

or rule of law earlier than the time provided in the proposal. Any amount included in gross

income under the proposal shall not be required to be included in gross income under any 

provision of law later than the time provided in the proposal. The proposal does not affect the 

rules regarding the timing of an employer’s deduction for nonqualified deferred compensation.

The proposal requires annual reporting to the Internal Revenue Service of amounts 

deferred. Such amounts are required to be reported on an individual’s Form W-2 for the year 

deferred even if the amount is not currently includible in income for that taxable year. Under the 

proposal, the Secretary is authorized, through regulations, to establish a minimum amount of 

deferrals below which the reporting requirement does not apply. The Secretary may also provide 

that the reporting requirement does not apply with respect to amounts of deferrals that are not 

reasonably ascertainable. It is intended that the exception for amounts not reasonable 

ascertainable only apply to nonaccount balance plans and that amounts be required to be reported 

when they first become reasonably ascertainable.32

The proposal provides the Secretary of the Treasury authority to prescribe regulations as 

are necessary to carry out the purposes of proposal, including regulations: (1) providing for the 

determination of amounts of deferral in the case of defined benefit plans; (2) relating to changes 

in the ownership and control of a corporation or assets of a corporation; (3) exempting from the 

provisions providing for transfers of property arrangements that will not result in an improper 

deferral of U.S. tax and will not result in assets being effectively beyond the reach of creditors; 

(4) defining financial health; and (5) disregarding a substantial risk of forfeiture. 

It is intended that substantial risk of forfeitures may not be used to manipulate the timing 

of income inclusion. It is intended that substantial risks of forfeiture should be disregarded in 

cases in which they are illusory or are principally used to postpone the timing of income 

inclusion. For example, if an executive is effectively able to control the acceleration of the lapse 

of a substantial risk of forfeiture, such risk of forfeiture should be disregarded and income 

inclusion should not be postponed on account of such restriction. 

Effective Date

The proposal is effective for amounts deferred in taxable years beginning after December 

31, 2003.

 

31 A qualified employer plan also includes a section 501(c)(18) trust.

32 It is intended that the exception be similar to that under Treas. Regs. sec. 

31.3121(v)(2)-1(e)(4).
26

The proposal does not apply to amounts deferred in a taxable year beginning after 

December 31, 2003, and before January 1, 2005, pursuant to an irrevocable election or binding 

arrangement made before October 24, 2003. Amounts deferred in taxable years beginning after 

December 31, 2004, even if pursuant to an election made before October 24, 2003, are subject to 

the proposal. Earnings on amounts deferred before the effective date are subject to the proposal 

to the extent that such amounts deferred are subject to the proposal.

No later than 90 days after the date of enactment, the Secretary shall issue guidance 

providing a limited period of time during which an individual participating in a nonqualified 

deferred compensation plan adopted on or before December 31, 2003, may, without violating the 

requirements of the proposal, terminate participation or cancel an outstanding deferral election 

with regard to amounts earned after December 31, 2003, if such amounts are includible in 

income as earned.

2. Exclusion of incentive stock options and employee stock purchase plan stock options 

from wages (sec. 1062 of the bill and secs. 421(b), 423(c), 3121(a), 3231, and 3306(b) of the 

Code)

Present Law

Generally, when an employee exercises a compensatory option on employer stock, the 

difference between the option price and the fair market value of the stock (i.e., the “spread”) is 

includible in income as compensation. In the case of an incentive stock option or an option to 

purchase stock under an employee stock purchase plan (collectively referred to as “statutory 

stock options”), the spread is not included in income at the time of exercise.33 

If the statutory holding period requirements are satisfied with respect to stock acquired 

through the exercise of a statutory stock option, the spread, and any additional appreciation, will 

be taxed as capital gain upon disposition of such stock. Compensation income is recognized, 

however, if there is a disqualifying disposition (i.e., if the statutory holding period is not 

satisfied) of stock acquired pursuant to the exercise of a statutory stock option. 

Federal Insurance Contribution Act (“FICA”) and Federal Unemployment Tax Act 

(“FUTA”) taxes (collectively referred to as “employment taxes”) are generally imposed in an 

amount equal to a percentage of wages paid by the employer with respect to employment. 34 On 

June 25, 2002, the IRS announced that until further guidance is issued, it would not assess FICA 

or FUTA taxes, or impose Federal income tax withholding obligations, upon either the exercise 

of a statutory stock option or the disposition of stock acquired pursuant to the exercise of a 

statutory stock option. 35

 

33 Sec. 421. For purposes of the individual alternative minimum tax, the transfer of stock 

pursuant to an incentive stock option is generally treated as the transfer of stock pursuant to a 

nonstatutory option. Sec. 56(b)(3).

34 Secs. 3101, 3111, and 3301.

35 Notice 2002-47, 2002-28 I.R.B. 97.
27

Description of Proposal

The proposal provides specific exclusions from FICA and FUTA wages for remuneration 

on account of the transfer of stock pursuant to the exercise of an incentive stock option or under 

an employee stock purchase plan, or any disposition of such stock. Thus, under the proposal, 

FICA and FUTA taxes do not apply upon the exercise of a statutory stock option. 36 The proposal 

also provides that such remuneration is not taken into account for purposes of determining Social 

Security benefits.

Additionally, the proposal provides that Federal income tax withholding is not required 

on a disqualifying disposition, nor when compensation is recognized in connection with an 

employee stock purchase plan discount. Present-law reporting requirements continue to apply.

Effective Date

The proposal is effective for stock acquired pursuant to options exercised after the date of 

enactment.

3. Extension of provision permitting qualified transfers of excess pension assets to retiree 

health accounts (sec. 1063 of the bill and sec. 420 of the Code)

Present Law

Defined benefit plan assets generally may not revert to an employer prior to termination 

of the plan and satisfaction of all plan liabilities. In addition, a reversion of plan assets to the 

employer may occur only if the plan so provides. A reversion prior to plan termination may 

constitute a prohibited transaction and may result in plan disqualification. Any assets that revert 

to the employer upon plan termination are includible in the gross income of the employer and 

subject to an excise tax. The excise tax rate is 20 percent if the employer maintains a 

replacement plan or makes certain benefit increases in connection with the termination; if not, 

the excise tax rate is 50 percent. Upon plan termination, the accrued benefits of all plan 

participants are required to be 100-percent vested.

A pension plan may provide medical benefits to retired employees through a separate 

account that is part of such plan. A qualified transfer of excess assets of a defined benefit plan to 

such a separate account within the plan may be made in order to fund retiree health benefits.37 A 

qualified transfer does not result in plan disqualification, is not a prohibited transaction, and is 

not treated as a reversion. Thus, transferred assets are not includible in the gross income of the 

employer and are not subject to the excise tax on reversions. No more than one qualified transfer 

may be made in any taxable year.

 

36 The proposal also provides a similar exclusion under the Railroad Retirement Tax Act. 

37 Sec. 420.
28

Excess assets generally means the excess, if any, of the value of the plan’s assets38 over 

the greater of (1) the lesser of (a) the accrued liability under the plan (including normal cost) or 

(b) 170 percent of the plan’s current liability (for 2003),39 or (2) 125 percent of the plan’s current 

liability. In addition, excess assets transferred in a qualified transfer may not exceed the amount 

reasonably estimated to be the amount that the employer will pay out of such account during the 

taxable year of the transfer for qualified current retiree health liabilities. No deduction is allowed 

to the employer for (1) a qualified transfer or (2) the payment of qualified current retiree health 

liabilities out of transferred funds (and any income thereon).

Transferred assets (and any income thereon) must be used to pay qualified current retiree 

health liabilities for the taxable year of the transfer. Transferred amounts generally must benefit 

pension plan participants, other than key employees, who are entitled upon retirement to receive 

retiree medical benefits through the separate account. Retiree health benefits of key employees 

may not be paid out of transferred assets.

Amounts not used to pay qualified current retiree health liabilities for the taxable year of 

the transfer are to be returned to the general assets of the plan. These amounts are not includible 

in the gross income of the employer, but are treated as an employer reversion and are subject to a 

20-percent excise tax.

In order for the transfer to be qualified, accrued retirement benefits under the pension 

plan generally must be 100-percent vested as if the plan terminated immediately before the 

transfer (or in the case of a participant who separated in the one-year period ending on the date of 

the transfer, immediately before the separation). 

In order for a transfer to be qualified, the employer generally must maintain retiree health 

benefit costs at the same level for the taxable year of the transfer and the following four years.

In addition, the Employee Retirement Income Security Act of 1974 (“ERISA”) provides 

that, at least 60 days before the date of a qualified transfer, the employer must notify the 

Secretary of Labor, the Secretary of the Treasury, employee representatives, and the plan 

administrator of the transfer, and the plan administrator must notify each plan participant and 

beneficiary of the transfer.40

No qualified transfers may be made after December 31, 2005.

 

38 The value of plan assets for this purpose is the lesser of fair market value or actuarial 

value.

39 These amounts relate to the full funding limit for defined benefit plans. The current 

liability full funding limit is repealed for years beginning after 2003. Under the general sunset 

provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), the 

limit is reinstated for years after 2010.

40 ERISA sec. 101(e). ERISA also provides that a qualified transfer is not a prohibited 

transaction under ERISA or a prohibited reversion.
29

Description of Proposal

The proposal allows qualified transfers of excess defined benefit plan assets through 

December 31, 2013. 

Effective Date

The proposal is effective on the date of enactment.
30

G. Treatment of Active Income

1. Treatment of European Union as one country for purposes of the foreign base company 

sales and services rules (sec. 1071 of the bill and sec. 954 of the Code)

Present Law

In general, the subpart F rules (secs. 951-964) require U.S. shareholders with a 10-

percent or greater interest in a controlled foreign corporation to include currently in income for 

U.S. tax purposes certain passive and other income of the controlled foreign corporation 

(referred to as “subpart F income”), without regard to whether the income is distributed to the 

shareholders (sec. 951(a)(1)(A)). In effect, the Code treats the U.S. 10-percent shareholders of a 

controlled foreign corporation as having received a current distribution of their pro rata shares of 

the controlled foreign corporation's subpart F income. The amounts included in income by the 

controlled foreign corporation's U.S. 10-percent shareholders under these rules are subject to 

U.S. tax currently. The U.S. tax on such amounts may be reduced through foreign tax credits.

Subpart F income encompasses certain categories of non-passive income, including 

foreign base company sales and services income (sec. 954(a)). Foreign base company sales 

income generally consists of sales income of a controlled foreign corporation located in a 

country that is neither the origin nor the destination of the goods with respect to sales of property 

purchased from or sold to a related person (sec. 954(d)). Foreign base company services income 

consists of income from services performed outside the controlled foreign corporation's country 

of incorporation for or on behalf of a related party (sec. 954(e)). 

A special branch rule applies only for purposes of determining a controlled foreign 

corporation's foreign base company sales income. Under this rule, a branch of a controlled 

foreign corporation is treated as a separate corporation where the activities of the controlled 

foreign corporation through the branch outside the controlled foreign corporation's country of 

incorporation have substantially the same effect as if such branch were a subsidiary (sec. 

954(d)(2)). 

For purposes of the subpart F rules, a related person is defined as any individual, 

corporation, trust, or estate that controls or is controlled by the controlled foreign corporation, or 

any individual, corporation, trust, or estate that is controlled by the same person or persons that 

control the controlled foreign corporation (sec. 954(d)(3)). Control with respect to a corporation 

means ownership of more than 50 percent of the corporation's stock (by vote or value). Control 

with respect to a partnership, trust, or estate means ownership of more than 50 percent of the 

value of the beneficial interests of the partnership, trust, or estate. Indirect and constructive 

ownership rules apply.

Description of Proposal

The proposal treats all of the member states of the European Union as one country for 

purposes of the foreign base company sales and foreign base company services rules. 
31

The current member states of the European Union are Belgium, Denmark, Germany, 

Greece, Spain, France, Ireland, Italy, Luxembourg, The Netherlands, Austria, Portugal, Sweden, 

Finland and the United Kingdom. As of January 1, 2004, the European Union will admit 

Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and 

Slovenia. Bulgaria, Romania and Turkey have applied for admittance.

Effective Date

The proposal is effective for taxable years of foreign corporations beginning after 

December 31, 2008, and taxable years of U.S. shareholders with or within which such taxable 

years of foreign corporations end.

2. Look-through treatment of payments between related controlled foreign corporations 

under foreign personal holding company income rules (sec. 1072 of the bill and sec. 954(c) 

of the Code)

Present Law

In general, the rules of subpart F (secs. 951-964) require U.S. shareholders with a 10-

percent or greater interest in a controlled foreign corporation to include certain income of the 

controlled foreign corporation (referred to as “subpart F income”) on a current basis for U.S. tax 

purposes, regardless of whether the income is distributed to the shareholders.

Subpart F income includes foreign base company income. One category of foreign base 

company income is foreign personal holding company income. For subpart F purposes, foreign 

personal holding company income generally includes dividends, interest, rents and royalties, 

among other types of income. However, foreign personal holding company income does not 

include dividends and interest received by a controlled foreign corporation from a related 

corporation organized and operating in the same foreign country in which the controlled foreign 

corporation is organized, or rents and royalties received by a controlled foreign corporation from 

a related corporation for the use of property within the country in which the controlled foreign 

corporation is organized. Interest, rent, and royalty payments do not qualify for this exclusion to 

the extent that such payments reduce the subpart F income of the payor. 

Description of Proposal

Under the bill, dividends, interest, rents, and royalties received by one controlled foreign 

corporation from a related controlled foreign corporation are not treated as foreign personal 

holding company income to the extent attributable to non-subpart-F earnings of the payor. For 

these purposes, a related controlled foreign corporation is a controlled foreign corporation that 

controls or is controlled by the other controlled foreign corporation, or a controlled foreign 

corporation that is controlled by the same person or persons that control the other controlled 

foreign corporation. Ownership of more than 50 percent of the controlled foreign corporation's 

stock (by vote or value) constitutes control for these purposes. 
32

Effective Date

The proposal is effective for taxable years of foreign corporations beginning after 

December 31, 2006, and taxable years of U.S. shareholders with or within which such taxable 

years of foreign corporations end. 

3. Look-through treatment for sales of partnership interests (sec. 1073 of the bill and

sec. 954(c) of the Code)

Present Law 

In general, the subpart F rules (secs. 951-964) require U.S. shareholders with a 10-

percent or greater interest in a controlled foreign corporation to include in income currently for 

U.S. tax purposes certain types of income of the controlled foreign corporation, whether or not 

such income is actually distributed currently to the shareholders (referred to as "subpart F 

income"). Subpart F income includes foreign personal holding company income. Foreign 

personal holding company income generally consists of the following: (1) dividends, interest, 

royalties, rents, and annuities; (2) net gains from the sale or exchange of (a) property that gives 

rise to the preceding types of income, (b) property that does not give rise to income, and (c) 

interests in trusts, partnerships, and REMICs; (3) net gains from commodities transactions; (4) 

net gains from foreign currency transactions; (5) income that is equivalent to interest; (6) income 

from notional principal contracts; and (7) payments in lieu of dividends. Thus, if a controlled 

foreign corporation sells a partnership interest at a gain, the gain generally constitutes foreign 

personal holding company income and is included in the income of 10-percent U.S. shareholders 

of the controlled foreign corporation as subpart F income.

Description of Proposal

The bill treats the sale by a controlled foreign corporation of a partnership interest as a 

sale of the proportionate share of partnership assets attributable to such interest for purposes of 

determining subpart F foreign personal holding company income. This rule applies only to 

partners owning directly, indirectly, or constructively at least 25 percent of a capital or profits 

interest in the partnership. Thus, the sale of a partnership interest by a controlled foreign 

corporation that meets this ownership threshold constitutes subpart F income under the bill only

to the extent that a proportionate sale of the underlying partnership assets attributable to the 

partnership interest would constitute subpart F income.

Effective Date

The proposal is effective for taxable years of foreign corporations beginning after 

December 31, 2006, and taxable years of U.S. shareholders with or within which such taxable 

years of foreign corporations end. 
33

4. Repeal of foreign personal holding company rules and foreign investment company rules 

(sec. 1074 of the bill and secs. 542, 551-558, 954, 1246, and 1247 of the Code)

Present Law

Income earned by a foreign corporation from its foreign operations generally is subject to 

U.S. tax only when such income is distributed to any U.S. persons that hold stock in such 

corporation. Accordingly, a U.S. person that conducts foreign operations through a foreign 

corporation generally is subject to U.S. tax on the income from those operations when the 

income is repatriated to the United States through a dividend distribution to the U.S. person. The 

income is reported on the U.S. person's tax return for the year the distribution is received, and the 

United States imposes tax on such income at that time. The foreign tax credit may reduce the 

U.S. tax imposed on such income.

Several sets of anti-deferral rules impose current U.S. tax on certain income earned by a 

U.S. person through a foreign corporation. Detailed rules for coordination among the antideferral rules are provided to prevent the U.S. person from being subject to U.S. tax on the same 

item of income under multiple rules.

The Code sets forth the following anti-deferral rules: the controlled foreign corporation 

rules of subpart F (secs. 951-964); the passive foreign investment company rules (secs. 1291-

1298); the foreign personal holding company rules (secs. 551-558); the personal holding 

company rules (secs. 541-547); the accumulated earnings tax rules (secs. 531-537); and the 

foreign investment company rules (secs. 1246-1247). 

Description of Proposal

The bill: (1) eliminates the rules applicable to foreign personal holding companies and 

foreign investment companies; (2) excludes foreign corporations from the application of the 

personal holding company rules; and (3) includes as subpart F foreign personal holding company 

income personal services contract income that is subject to the present-law foreign personal 

holding company rules. 

Effective Date

The proposal is effective for taxable years of foreign corporations beginning after 

December 31, 2006, and taxable years of U.S. shareholders with or within which such taxable 

years of foreign corporations end. 

5. Subpart F treatment of pipeline transportation income (sec. 1075 of the bill and 

sec. 954(g) of the Code)

Present Law

Under the subpart F rules, U.S. 10-percent shareholders of a controlled foreign 

corporation are subject to U.S. tax currently on their shares of certain income earned by the 

foreign corporation, whether or not such income is distributed to the shareholders (referred to as 
34

“subpart F income”). Subpart F income includes foreign base company income, which in turn 

includes foreign base company oil related income (sec. 954(a)).

Foreign base company oil related income is income derived outside the United States 

from the processing of minerals extracted from oil or gas wells into their primary products; the 

transportation, distribution, or sale of such minerals or primary products; the disposition of assets 

used by the taxpayer in a trade or business involving the foregoing; or the performance of any 

related services. However, foreign base company oil related income does not include income 

derived from a source within a foreign country in connection with: (1) oil or gas which was 

extracted from a well located in such foreign country or, (2), oil, gas, or a primary product of oil 

or gas which is sold by the controlled foreign corporation or a related person for use or 

consumption within such foreign country or is loaded in such country as fuel on a vessel or 

aircraft. An exclusion also is provided for income of a controlled foreign corporation that is a 

small producer (i.e., a corporation whose average daily oil and natural gas production, including 

production by related corporations, is less than 1,000 barrels).

Description of Proposal

The bill provides an additional exception to the definition of foreign base company oil 

related income. Under the bill, foreign base company oil related income does not include 

income derived from a source within a foreign country in connection with the pipeline 

transportation of oil or gas within such foreign country. Thus, the exception applies whether or 

not the controlled foreign corporation that owns the pipeline also owns any interest in the oil or 

gas transported. In addition, the exception applies to income earned from the transportation of 

oil or gas by pipeline in a country in which the oil or gas was neither extracted nor consumed 

within such foreign country.

Effective Date

The proposal is effective for taxable years of foreign corporations beginning after 

December 31, 2004, and taxable years of U.S. shareholders with or within which such taxable 

years of foreign corporations end.

6. Determination of foreign personal holding company income with respect to transactions 

in commodities (sec. 1076 of the bill and sec. 954 of the Code)

Present Law

Subpart F foreign personal holding company income

Under the subpart F rules, U.S. shareholders with a 10-percent or greater interest in a 

controlled foreign corporation (“U.S. 10-percent shareholders”) are subject to U.S. tax currently 

on certain income earned by the controlled foreign corporation, whether or not such income is 

distributed to the shareholders. The income subject to current inclusion under the subpart F rules 

includes, among other things, “foreign personal holding company income.”

Foreign personal holding company income generally consists of the following: 

dividends, interest, royalties, rents and annuities; net gains from sales or exchanges of (1) 
35

property that gives rise to the foregoing types of income, (2) property that does not give rise to 

income, and (3) interests in trusts, partnerships, and real estate mortgage investment conduits 

(“REMICs”); net gains from commodities transactions; net gains from foreign currency 

transactions; income that is equivalent to interest; income from notional principal contracts; and 

payments in lieu of dividends.

With respect to transactions in commodities, foreign personal holding company income 

does not consist of gains or losses which arise out of bona fide hedging transactions that are 

reasonably necessary to the conduct of any business by a producer, processor, merchant, or 

handler of a commodity in the manner in which such business is customarily and usually 

conducted by others.41 In addition, foreign personal holding company income does not consist of 

gains or losses which are comprised of active business gains or losses from the sale of 

commodities, but only if substantially all of the controlled foreign corporation’s business is as an 

active producer, processor, merchant, or handler of commodities.42

Hedging transactions

Under present law, the term “capital asset” does not include any hedging transaction 

which is clearly identified as such before the close of the day on which it was acquired, 

originated, or entered into (or such other time as the Secretary may by regulations prescribe) 

(sec. 1221(a)(7)). The term “hedging transaction” means any transaction entered into by the 

taxpayer in the normal course of the taxpayer’s trade or business primarily: (1) to manage risk of 

price changes or currency fluctuations with respect to ordinary property which is held or to be 

 

41 For hedging transactions entered into on or after January 31, 2003, Treasury 

regulations provide that gains or losses from a commodities hedging transaction generally are 

excluded from the definition of foreign personal holding company income if the transaction is 

with respect to the controlled foreign corporation’s business as a producer, processor, merchant 

or handler of commodities, regardless of whether the transaction is a hedge with respect to a sale 

of commodities in the active conduct of a commodities business by the controlled foreign 

corporation. The regulations also provide that, for purposes of satisfying the requirements for 

exclusion from the definition of foreign personal holding company income, a producer, 

processor, merchant or handler of commodities includes a controlled foreign corporation that 

regularly uses commodities in a manufacturing, construction, utilities, or transportation business 

(Treas. Reg. sec. 1.954-2(f)(2)(v)). However, the regulations provide that a controlled foreign 

corporation is not a producer, processor, merchant or handler of commodities (and therefore 

would not satisfy the requirements for exclusion) if its business is primarily financial (Treas. 

Reg. sec. 1.954-2(f)(2)(v)).

42 Treasury regulations provide that substantially all of a controlled foreign corporation’s 

business is as an active producer, processor, merchant or handler of commodities if the sum of its 

gross receipts from all of its active sales of commodities in such capacity and its gross receipts 

from all of its commodities hedging transactions that qualify for exclusion from the definition of 

foreign personal holding company income equals or exceeds 85 percent of its total receipts for 

the taxable year (computed as though the controlled foreign corporation was a domestic 

corporation) (Treas. Reg. sec. 1.954-2(f)(2)(iii)(C)).
36

held by the taxpayer; (2) to manage risk of interest rate or price changes or currency fluctuations 

with respect to borrowings made or to be made, or ordinary obligations incurred or to be

incurred, by the taxpayer; or (3) to manage such other risks as the Secretary may prescribe in 

regulations (sec. 1221(b)(2)(A)).

Description of Proposal

The bill modifies the requirements that must be satisfied for gains or losses from a 

commodities hedging transaction to qualify for exclusion from the definition of subpart F foreign 

personal holding company income. Under the bill, gains or losses from a transaction with 

respect to a commodity are not treated as foreign personal holding company income if the 

transaction satisfies the general definition of a hedging transaction under section 1221(b)(2). For 

purposes of this proposal, the general definition of a hedging transaction under section 

1221(b)(2) is modified to include any transaction with respect to a commodity entered into by a 

controlled foreign corporation in the normal course of the controlled foreign corporation’s trade 

or business primarily: (1) to manage risk of price changes or currency fluctuations with respect 

to ordinary property or property described in section 1231(b) which is held or to be held by the 

controlled foreign corporation; or (2) to manage such other risks as the Secretary may prescribe 

in regulations. Gains or losses from a transaction that satisfies the modified definition of a 

hedging transaction are excluded from the definition of foreign personal holding company 

income only if the transaction is clearly identified as a hedging transaction in accordance with 

the hedge identification requirements that apply generally to hedging transactions under section 

1221(b)(2) (sec. 1221(a)(7) and (b)(2)(B)).

The bill also changes the requirements that must be satisfied for active business gains or 

losses from the sale of commodities to qualify for exclusion from the definition of foreign 

personal holding company income. Under the bill, such gains or losses are not treated as foreign 

personal holding company income if substantially all of the controlled foreign corporation’s 

commodities are comprised of: (1) stock in trade of the controlled foreign corporation or other 

property of a kind which would properly be included in the inventory of the controlled foreign 

corporation if on hand at the close of the taxable year, or property held by the controlled foreign 

corporation primarily for sale to customers in the ordinary course of the controlled foreign 

corporation’s trade or business; (2) property that is used in the trade or business of the controlled 

foreign corporation and is of a character which is subject to the allowance for depreciation under 

section 167; or (3) supplies of a type regularly used or consumed by the controlled foreign 

corporation in the ordinary course of a trade or business of the controlled foreign corporation. 43

Effective Date

This proposal is effective with respect to transactions entered into after December 31, 

2004.

 

43 For purposes of determining whether substantially all of the controlled foreign 

corporation’s commodities are comprised of such property, it is intended that the 85-percent 

requirement provided in the current Treasury regulations (as modified to reflect the changes 

made by the bill) would continue to apply.
37

7. Repeal controlled foreign corporation rules for foreign base company shipping income 

(sec. 1077 of the bill and sec. 954 of the Code)

Present Law

In general, the subpart F rules (secs. 951-964) require U.S. shareholders with a 10-

percent or greater interest in a controlled foreign corporation to include currently in income for 

U.S. tax purposes certain income of the controlled foreign corporation (referred to as "subpart F 

income"), without regard to whether the income is distributed to the shareholders (sec. 

951(a)(1)(A)). In effect, the Code treats the U.S. 10-percent shareholders of a controlled foreign 

corporation as having received a current distribution of their pro rata shares of the controlled 

foreign corporation's subpart F income. The amounts included in income by the controlled 

foreign corporation's U.S. 10-percent shareholders under these rules are subject to U.S. tax 

currently. The U.S. tax on such amounts may be reduced through foreign tax credits.

Subpart F income includes foreign base company shipping income (sec. 954(f)). Foreign 

base company shipping income generally includes income derived from the use of an aircraft or 

vessel in foreign commerce, the performance of services directly related to the use of any such 

aircraft or vessel, the sale or other disposition of any such aircraft or vessel, and certain space or 

ocean activities (e.g., leasing of satellites for use in space). Foreign commerce generally 

involves the transportation of property or passengers between a port (or airport) in the U.S. and a 

port (or airport) in a foreign country, two ports (or airports) within the same foreign country, or 

two ports (or airports) in different foreign countries. In addition, foreign base company shipping 

income includes dividends and interest that a controlled foreign corporation receives from certain 

foreign corporations and any gains from the disposition of stock in certain foreign corporations, 

to the extent the dividends, interest, or gains are attributable to foreign base company shipping 

income. Foreign base company shipping income also includes incidental income derived in the 

course of active foreign base company shipping operations (e.g., income from temporary 

investments in or sales of related shipping assets), foreign exchange gain or loss attributable to 

foreign base company shipping operations, and a controlled foreign corporation’s distributive 

share of gross income of any partnership and gross income received from certain trusts to the 

extent that the income would have been foreign base company shipping income had it been 

realized directly by the corporation. 

Subpart F income also includes foreign personal holding company income (sec. 954(c)). 

For subpart F purposes, foreign personal holding company income generally consists of the 

following: (1) dividends, interest, royalties, rents and annuities; (2) net gains from the sale or 

exchange of (a) property that gives rise to the preceding types of income, (b) property that does 

not give rise to income, and (c) interests in trusts, partnerships, and REMICS; (3) net gains from 

commodities transactions; (4) net gains from foreign currency transactions; (5) income that is 

equivalent to interest; (6) income from notional principal contracts; and (7) payments in lieu of 

dividends.

Subpart F foreign personal holding company income does not include rents and royalties 

received by the controlled foreign corporation in the active conduct of a trade or business from 

unrelated persons (sec. 954(c)(2)(A)). Also generally excluded are dividends and interest 

received by the controlled foreign corporation from a related corporation organized and 
38

operating in the same foreign country in which the controlled foreign corporation was organized, 

and rents and royalties received by the controlled foreign corporation from a related corporation 

for the use of property within the country in which the controlled foreign corporation was 

organized (sec. 954(c)(3)). However, interest, rent, and royalty payments do not qualify for this 

exclusion to the extent that such payments reduce subpart F income of the payor.

Description of Proposal

The bill repeals the subpart F rules related to foreign base company shipping income. 

The bill also amends the foreign base company rules related to foreign personal holding income 

to provide a safe harbor for rents derived from leasing an aircraft or vessel in foreign commerce. 

Such rents are treated as active income if the active leasing expenses comprise at least 10 percent 

of the profit on the lease.

Effective Date

The proposal is effective for taxable years of foreign corporations beginning after 

December 31, 2004, and taxable years of U.S. shareholders with or within which such taxable 

years of foreign corporations end. 

8. Modification of exceptions under subpart F for active financing income (sec. 1078 of the 

bill and sec. 954 of the Code)

Present Law

Under the subpart F rules, U.S. shareholders with a 10-percent or greater interest in a 

controlled foreign corporation (“CFC”) are subject to U.S. tax currently on certain income 

earned by the CFC, whether or not such income is distributed to the shareholders. The income 

subject to current inclusion under the subpart F rules includes, among other things, foreign 

personal holding company income and insurance income. In addition, 10-percent U.S. 

shareholders of a CFC are subject to current inclusion with respect to their shares of the CFC's 

foreign base company services income (i.e., income derived from services performed for a 

related person outside the country in which the CFC is organized).

Foreign personal holding company income generally consists of the following: (1) 

dividends, interest, royalties, rents, and annuities; (2) net gains from the sale or exchange of (a) 

property that gives rise to the preceding types of income, (b) property that does not give rise to 

income, and (c) interests in trusts, partnerships, and REMICs; (3) net gains from commodities 

transactions; (4) net gains from foreign currency transactions; (5) income that is equivalent to 

interest; (6) income from notional principal contracts; and (7) payments in lieu of dividends.

Insurance income subject to current inclusion under the subpart F rules includes any 

income of a CFC attributable to the issuing or reinsuring of any insurance or annuity contract in 

connection with risks located in a country other than the CFC's country of organization. Subpart 

F insurance income also includes income attributable to an insurance contract in connection with 

risks located within the CFC's country of organization, as the result of an arrangement under 

which another corporation receives a substantially equal amount of consideration for insurance 

of other country risks. Investment income of a CFC that is allocable to any insurance or annuity 
39

contract related to risks located outside the CFC's country of organization is taxable as subpart F 

insurance income (Treas. Reg. sec. 1.953-1(a)).

Temporary exceptions from foreign personal holding company income, foreign base 

company services income, and insurance income apply for subpart F purposes for certain income 

that is derived in the active conduct of a banking, financing, or similar business, or in the conduct 

of an insurance business (so-called “active financing income”).44

With respect to income derived in the active conduct of a banking, financing, or similar 

business, a CFC is required to be predominantly engaged in such business and to conduct 

substantial activity with respect to such business in order to qualify for the exceptions. In 

addition, certain nexus requirements apply, which provide that income derived by a CFC or a 

qualified business unit (“QBU”) of a CFC from transactions with customers is eligible for the 

exceptions if, among other things, substantially all of the activities in connection with such 

transactions are conducted directly by the CFC or QBU in its home country, and such income is 

treated as earned by the CFC or QBU in its home country for purposes of such country's tax 

laws. Moreover, the exceptions apply to income derived from certain cross border transactions, 

provided that certain requirements are met. Additional exceptions from foreign personal holding 

company income apply for certain income derived by a securities dealer within the meaning of 

section 475 and for gain from the sale of active financing assets.

In the case of insurance, in addition to temporary exceptions from insurance income and 

from foreign personal holding company income for certain income of a qualifying insurance 

company with respect to risks located within the CFC's country of creation or organization, 

temporary exceptions from insurance income and from foreign personal holding company 

income apply for certain income of a qualifying branch of a qualifying insurance company with 

respect to risks located within the home country of the branch, provided certain requirements are 

met under each of the exceptions. Further, additional temporary exceptions from insurance 

income and from foreign personal holding company income apply for certain income of certain 

CFCs or branches with respect to risks located in a country other than the United States, 

provided that the requirements for these exceptions are met.

Description of Proposal

The proposal modifies the present-law temporary exceptions from subpart F foreign 

personal holding company income and foreign base company services income for income 

derived in the active conduct of a banking, financing, or similar business. For purposes of 

 

44 Temporary exceptions from the subpart F provisions for certain active financing 

income applied only for taxable years beginning in 1998. Those exceptions were modified and 

extended for one year, applicable only for taxable years beginning in 1999. The Tax Relief 

Extension Act of 1999 (P.L. No. 106-170) clarified and extended the temporary exceptions for 

two years, applicable only for taxable years beginning after 1999 and before 2002. The Job 

Creation and Worker Assistance Act of 2002 (P.L. No. 107-147) extended the temporary 

exceptions for five years, applicable only for taxable years beginning after 2001 and before 2007, 

with a modification relating to insurance reserves.
40

determining whether a CFC or QBU has conducted directly in its home country substantially all 

of the activities in connection with transactions with customers, the proposal provides that an 

activity is treated as conducted directly by the CFC or QBU in its home country if the activity is 

performed by employees of a related person and: (1) the related person is itself an eligible CFC 

the home country of which is the same as that of the CFC or QBU; (2) the activity is performed 

in the home country of the related person; and (3) the related person is compensated on an arm’s 

length basis for the performance of the activity by its employees and such compensation is 

treated as earned by such person in its home country for purposes of the tax laws of such 

country.

Effective Date

The proposal is effective for taxable years of foreign corporations beginning after 

December 31, 2004, and taxable years of U.S. shareholders with or within which such taxable 

years of foreign corporations end. 

9. Partial exclusion for qualified film income (sec. 1079 of the bill and new sec. 139A of the 

Code)

Present Law

In general

Present law provides that gross income for U.S. tax purposes does not include 

extraterritorial income. Because the exclusion of such extraterritorial income is a means of 

avoiding double taxation, no foreign tax credit is allowed for income taxes paid with respect to 

such excluded income. Extraterritorial income is eligible for the exclusion to the extent that it is 

“qualifying foreign trade income.” 

Qualifying foreign trade income

“Qualifying foreign trade income” is the amount of gross income that, if excluded, would 

result in a reduction of taxable income by the greatest of (1) 1.2 percent of the “foreign trading 

gross receipts” derived by the taxpayer from the transaction, (2) 15 percent of the “foreign trade 

income” derived by the taxpayer from the transaction, or (3) 30 percent of the “foreign sale and 

leasing income” derived by the taxpayer from the transaction. The amount of qualifying foreign 

trade income determined using 1.2 percent of the foreign trading gross receipts is limited to 200 

percent of the qualifying foreign trade income that would result using 15 percent of the foreign 

trade income. Although these calculations are determined by reference to a reduction of taxable 

income (a net income concept), qualifying foreign trade income is an exclusion from gross 

income. 

Foreign trading gross receipts

“Foreign trading gross receipts” are gross receipts derived from certain activities in 

connection with “qualifying foreign trade property” with respect to which certain “economic 

processes” take place outside of the United States. The threshold for determining if gross 
41

receipts will be treated as foreign trading gross receipts is whether the gross receipts are derived 

from a transaction involving “qualifying foreign trade property.” 

Qualifying foreign trade property is property manufactured, produced, grown, or 

extracted within or outside of the United States that is held primarily for sale, lease, or rental, in 

the ordinary course of a trade or business, for direct use, consumption, or disposition outside of 

the United States. In addition, not more than 50 percent of the fair market value of such property 

can be attributable to the sum of (1) the fair market value of articles manufactured outside of the 

United States, plus (2) the direct costs of labor performed outside of the United States. Certain 

property is excluded from the definition of qualifying foreign trade property, including patents, 

inventions, models, designs, formulas, or processes whether or not patented, copyrights (other 

than films, tapes, records, or similar reproductions, and other than computer software (whether or 

not patented), for commercial or home use), goodwill, trademarks, trade brands, franchises, or 

other like property. Consequently, gross receipts from the license of films for reproduction 

abroad generally constitutes foreign trading gross receipts. 45

Foreign trade income

“Foreign trade income” is the taxable income of the taxpayer (determined without regard 

to the exclusion of qualifying foreign trade income) attributable to foreign trading gross receipts. 

Certain dividends-paid deductions of cooperatives are disregarded in determining foreign trade 

income for this purpose.

Foreign sale and leasing income

“Foreign sale and leasing income” is the amount of the taxpayer’s foreign trade income 

(with respect to a transaction) that is properly allocable to activities that constitute foreign 

economic processes. 

Description of Proposal

The proposal provides an exclusion from gross income for an amount equal to the 

applicable percentage of qualified film income. “Qualified film income" is defined as a 

taxpayer’s gross income from the license of a qualified film for the exploitation or direct use 

 

45 Prior to their repeal, the foreign sales corporation (“FSC”) provisions of the Code 

applied to certain licenses of films for reproduction abroad. On February 24, 2000, the 

Appellate Body of the World Trade Organization (“WTO”) upheld the findings of the WTO 

Dispute Settlement Panel that had found that the FSC provisions of the Code constitute a 

prohibited export subsidy under the WTO Agreement on Subsidies and Countervailing Measures 

and under the Agreement on Agriculture. The WTO Appellate Body later adopted the findings 

of the WTO Dispute Settlement Panel. Congress enacted the FSC Repeal and Extraterritorial 

Income Exclusion Act of 2000 to comply with the recommendations and rulings of the Panel and 

the Appellate Body. Although the legislation repealed the FSC provisions of the Code, it also 

provided certain transitional rules, including for certain binding contractual agreements (e.g., 

license agreements for the reproduction of films abroad). 
42

outside the United States less all associated film costs.46 Qualified film income does not include 

any gross income from the exploitation of characters, soundtracks, designs, scripts, scores, or 

other ancillary intangibles. For example, gross income from the foreign theatrical, home video, 

and television markets would be eligible, whereas gross income from the foreign license of 

characters, scripts, and other ancillary intangibles of such film would not be eligible for the 

proposal. In addition, qualified film income does not include any amount from the license of a 

qualified film to a related person47 unless such film is held for license by such related person to 

an unrelated person for the exploitation or direct use by such unrelated person outside the United 

States. 

For purposes of the proposal, the applicable percentage for taxable years ending in 2007 

is one percent, in 2008 is two percent, in 2009 is three percent, in 2010 is five percent, in 2011 is 

eight percent, in 2012 is nine percent, after 2012 is ten percent.

A “qualified film” is defined as property described in section 168(f)(3) that the original 

use of which commences after December 31, 2006. However, a qualified film does not include 

sexually explicit productions as defined by section 2257 of title 18 of the U.S. Code.

The proposal provides that no foreign tax credit or deduction is allowed with respect to 

the excludible portion of any qualified film income. In addition, the proposal provides a 

taxpayer the ability to elect not to apply the proposal to a qualified film. Such election shall be 

made by the due date (including extensions of time) for the taxable year in which the qualified 

film is placed in service.

Effective Date

The proposal is effective for taxable years ending after December 31, 2006. 

 

46 Associated film costs is defined as any expense properly apportioned and allocated to 

qualified film income, determined as provided under regulations prescribed by the Secretary. 

47 A person is related to another person if such persons are treated as a single employer 

under subsection (a) or (b) of section 52 or subsection (m) or (o) of section 414, except that 

determinations under subsections (a) and (b) of section 52 are made without regard to section 

1563(b). 
43

H. Reduction of Double Taxation of Earnings

1. Interest expense allocation rules (sec. 1081 of the bill and sec. 864 of the Code)

Present Law

In general

In order to compute the foreign tax credit limitation, a taxpayer must determine the 

amount of its taxable income from foreign sources. Thus, the taxpayer must allocate and 

apportion deductions between items of U.S.-source gross income, on the one hand, and items of 

foreign-source gross income, on the other.

In the case of interest expense, the rules generally are based on the approach that money 

is fungible and that interest expense is properly attributable to all business activities and property 

of a taxpayer, regardless of any specific purpose for incurring an obligation on which interest is 

paid. (Exceptions to the fungibility concept are recognized or required, however, in particular 

cases, some of which are described below). The Code provides that for interest allocation 

purposes all members of an affiliated group of corporations generally are to be treated as a single 

corporation (the so-called “one-taxpayer rule”), and that allocation must be made on the basis of 

assets rather than gross income.

Affiliated group

In general

The term “affiliated group” in this context generally is defined by reference to the rules 

for determining whether corporations are eligible to file consolidated returns. However, some 

groups of corporations are eligible to file consolidated returns yet are not treated as affiliated for 

interest allocation purposes, and other groups of corporations are treated as affiliated for interest 

allocation purposes even though they are not eligible to file consolidated returns. Thus, under 

the one-taxpayer rule, the factors affecting the allocation of interest expense of one corporation 

may affect the sourcing of taxable income of another, related corporation even if the two 

corporations do not elect to file, or are ineligible to file, consolidated returns.

Definition of affiliated group -- consolidated return rules

For consolidation purposes, the term “affiliated group” means one or more chains of 

includible corporations connected through stock ownership with a common parent corporation 

which is an includible corporation, but only if: (1) the common parent owns directly stock 

possessing at least 80 percent of the total voting power and at least 80 percent of the total value 

of at least one other includible corporation; and (2) stock meeting the same voting power and 

value standards with respect to each includible corporation (excluding the common parent) is 

directly owned by one or more other includible corporations.

Generally, the term “includible corporation” means any domestic corporation except 

certain corporations exempt from tax under section 501 (for example, corporations organized and 

operated exclusively for charitable or educational purposes), certain life insurance companies, 
44

corporations electing application of the possession tax credit, regulated investment companies, 

real estate investment trusts, and domestic international sales corporations. A foreign 

corporation generally is not an includible corporation.

Definition of affiliated group -- special interest allocation rules

 Subject to exceptions, the consolidated return and interest allocation definitions of 

affiliation generally are consistent with each other.48 For example, both definitions generally 

exclude all foreign corporations from the affiliated group. Thus, while debt generally is 

considered fungible among the assets of a group of domestic affiliated corporations, the same 

rules do not apply as between the domestic and foreign members of a group with the same 

degree of common control as the domestic affiliated group.

Banks, savings institutions, and other financial affiliates

The affiliated group for interest allocation purposes generally excludes what are referred 

to in the Treasury regulations as “financial corporations” (Treas. Reg. sec. 1.861-11T(d)(4)). 

These include any corporation, otherwise a member of the affiliated group for consolidation 

purposes, that is a financial institution (described in section 581 or section 591), the business of 

which is predominantly with persons other than related persons or their customers, and which is 

required by State or Federal law to be operated separately from any other entity which is not a 

financial institution (sec. 864(e)(5)(C)). The category of financial corporations also includes, to 

the extent provided in regulations, bank holding companies, subsidiaries of banks and bank 

holding companies, and savings institutions predominantly engaged in the active conduct of a 

banking, financing, or similar business (sec. 864(e)(5)(D)).

A financial corporation is not treated as a member of the regular affiliated group for 

purposes of applying the one-taxpayer rule to other non-financial members of that group. 

Instead, all such financial corporations that would be so affiliated are treated as a separate single 

corporation for interest allocation purposes.

Description of Proposal

In general

The bill modifies the present-law interest expense allocation rules (which generally apply 

for purposes of computing the foreign tax credit limitation) by providing a one-time election 

under which the taxable income of the domestic members of an affiliated group from sources 

outside the United States generally is determined by allocating and apportioning interest expense 

of the domestic members of a worldwide affiliated group on a worldwide-group basis (i.e., as if 

all members of the worldwide group were a single corporation). If a group makes this election, 

the taxable income of the domestic members of a worldwide affiliated group from sources 

outside the United States is by allocating and apportioning the interest expense of those domestic 

members to foreign-source income in an amount equal to the excess (if any) of (1) the worldwide 

 

48 One such exception is that the affiliated group for interest allocation purposes includes 

section 936 corporations that are excluded from the consolidated group.
45

affiliated group’s worldwide interest expense multiplied by the ratio which the foreign assets of 

the worldwide affiliated group bears to the total assets of the worldwide affiliated group, over (2) 

the interest expense incurred by a foreign member of the group to the extent such interest would 

be allocated to foreign sources if the provision’s principles were applied separately to the foreign 

members of the group.49

For purposes of the new elective rules based on worldwide fungibility, the worldwide 

affiliated group means all corporations in an affiliated group (as that term is defined under 

present law for interest allocation purposes)50 as well as all controlled foreign corporations that 

in the aggregate either directly or indirectly51 would be members of such an affiliated group if 

section 1504(b)(3) did not apply (i.e., in which at least 80 percent of the vote and value of the 

stock of such corporations is owned by one or more other corporations included in the affiliated 

group). Thus, if an affiliated group makes this election, the taxable income from sources outside 

the United States of domestic group members generally is determined by allocating and 

apportioning interest expense of the domestic members of the worldwide affiliated group as if all 

of the interest expense and assets of 80-percent or greater owned domestic corporations (i.e., 

corporations that are part of the affiliated group under present-law section 864(e)(5)(A) as 

modified to include insurance companies) and certain controlled foreign corporations were 

attributable to a single corporation. 

In addition, if an affiliated group elects to apply the new elective rules based on 

worldwide fungibility, the present-law rules regarding the treatment of tax-exempt assets and the 

basis of stock in nonaffiliated ten-percent owned corporations apply on a worldwide affiliated 

group basis.

The common parent of the domestic affiliated group must make the worldwide affiliated 

group election. It must be made for the first taxable year beginning after December 31, 2008, in 

which a worldwide affiliated group exists that includes at least one foreign corporation that 

meets the requirements for inclusion in a worldwide affiliated group. Once made, the election 

applies to the common parent and all other members of the worldwide affiliated group for the 

taxable year for which the election was made and all subsequent taxable years, unless revoked 

with the consent of the Secretary of the Treasury.

 

49 Although the interest expense of a foreign subsidiary is taken into account for 

purposes of allocating the interest expense of the domestic members of the electing worldwide 

affiliated group for foreign tax credit limitation purposes, the interest expense incurred by a 

foreign subsidiary is not deductible on a U.S. return.

50 The bill expands the definition of an affiliated group for interest expense allocation 

purposes to include certain insurance companies that are generally excluded from an affiliated 

group under section 1504(b)(2) (without regard to whether such companies are covered by an 

election under section 1504(c)(2)).

51 Indirect ownership is determined under the rules of section 958(a)(2) or through 

applying rules similar to those of section 958(a)(2) to stock owned directly or indirectly by 

domestic partnerships, trusts, or estates.
46

Financial institution group election

The bill allows taxpayers to apply the present-law bank group rules to exclude certain 

financial institutions from the affiliated group for interest allocation purposes under the 

worldwide fungibility approach. The bill also provides a one-time “financial institution group” 

election that expands the present-law bank group. Under the bill, at the election of the common 

parent of the pre-election worldwide affiliated group, the interest expense allocation rules are 

applied separately to a subgroup of the worldwide affiliated group that consists of (1) all 

corporations that are part of the present-law bank group,52 and (2) all “financial corporations.” 

For this purpose, a corporation is a financial corporation if at least 80 percent of its gross income 

is financial services income (as described in section 904(d)(2)(C)(i) and the regulations 

thereunder) that is derived from transactions with unrelated persons.53 For these purposes, items 

of income or gain from a transaction or series of transactions are disregarded if a principal 

purpose for the transaction or transactions is to qualify any corporation as a financial 

corporation. 

The common parent of the pre-election worldwide affiliated group must make the 

election for the first taxable year beginning after December 31, 2008, in which a worldwide 

affiliated group includes a financial corporation. Once made, the election applies to the financial 

institution group for the taxable year and all subsequent taxable years. In addition, the bill 

provides anti-abuse rules under which certain transfers from one member of a financial 

institution group to a member of the worldwide affiliated group outside of the financial 

institution group are treated as reducing the amount of indebtedness of the separate financial 

institution group. The bill provides regulatory authority with respect to the election to provide 

for the direct allocation of interest expense in circumstances in which such allocation is 

appropriate to carry out the purposes of the provision, prevent assets or interest expense from 

being taken into account more than once, and addressing changes in members of any group 

(through acquisitions or otherwise) treated as affiliated under this provision. 

Effective Date

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

 

52 No inference is intended as to the treatment under present law with respect to financial 

holding companies (within the meaning of section 2(p) of the Bank Holding Company Act of 

1956), as well as subsidiaries of financial holding companies that are predominantly engaged 

(directly or indirectly) in the active conduct of a banking, financing, or similar business. With 

respect to financial holding companies that make a financial institution group election under the 

bill, no inference is intended as to the application of present law to such taxpayers for taxable 

years prior to the taxable year for which such an election is made.

53

 See Treas. Reg. sec. 1.904-4(e)(2).
47

2. Recharacterization of overall domestic loss (sec. 1082 of the bill and sec. 904 of the Code)

Present Law

The United States provides a credit for foreign income taxes paid or accrued. The 

foreign tax credit generally is limited to the U.S. tax liability on a taxpayer’s foreign-source 

income, in order to ensure that the credit serves the purpose of mitigating double taxation of 

foreign-source income without offsetting the U.S. tax on U.S.-source income. This overall 

limitation is calculated by prorating a taxpayer's pre-credit U.S. tax on its worldwide income 

between its U.S.-source and foreign-source taxable income. The ratio (not exceeding 100 

percent) of the taxpayer's foreign-source taxable income to worldwide taxable income is 

multiplied by its pre-credit U.S. tax to establish the amount of U.S. tax allocable to the taxpayer's 

foreign-source income and, thus, the upper limit on the foreign tax credit for the year.

If a taxpayer's losses from foreign sources exceed its foreign-source income, the excess 

(“overall foreign loss,” or “OFL”) may offset U.S.-source income. Such an offset reduces the 

effective rate of U.S. tax on U.S.-source income. 

In order to eliminate a double benefit (that is, the reduction of U.S. tax previously noted 

and, later, full allowance of a foreign tax credit with respect to foreign-source income), present 

law includes an OFL recapture rule. Under this rule, a portion of foreign-source taxable income 

earned after an OFL year is recharacterized as U.S.-source taxable income for foreign tax credit 

purposes (and for purposes of the possessions tax credit). Unless a taxpayer elects a higher 

percentage, however, generally no more than 50 percent of the foreign-source taxable income 

earned in any particular taxable year is recharacterized as U.S.-source taxable income. The 

effect of the recapture is to reduce the foreign tax credit limitation in one or more years 

following an OFL year and, therefore, the amount of U.S. tax that can be offset by foreign tax 

credits in the later year or years.

A U.S.-source loss reduces pre-credit U.S. tax on worldwide income to an amount less 

than the hypothetical tax that would apply to the taxpayer's foreign-source income if viewed in 

isolation. The existence of foreign-source taxable income in the year of the U.S.-source loss 

reduces or eliminates any net operating loss carryover that the U.S.-source loss would otherwise 

have generated absent the foreign income. In addition, as the pre-credit U.S. tax on worldwide 

income is reduced, so is the foreign tax credit limitation. As a result, some foreign tax credits in 

the year of the U.S.-source loss must be credited, if at all, in a carryover year. Tax on U.S.-

source taxable income in a subsequent year may be offset by a net operating loss carryforward, 

but not by a foreign tax credit carryforward. There is currently no mechanism for 

recharacterizing such subsequent U.S.-source income as foreign-source income.

For example, suppose a taxpayer generates a $100 U.S.-source loss and earns $100 of 

foreign-source income in Year 1, and pays $30 of foreign tax on the $100 of foreign-source 

income. Because the taxpayer has no net taxable income in Year 1, no foreign tax credit can be 

claimed in Year 1 with respect to the $30 of foreign taxes. If the taxpayer then earns $100 of 

U.S.-source income and $100 of foreign-source income in Year 2, present law does not 

recharacterize any portion of the $100 of U.S.-source income as foreign-source income to reflect 
48

the fact that the previous year’s $100 U.S.-source loss reduced the taxpayer’s ability to claim 

foreign tax credits.

Description of Proposal

The bill applies a re-sourcing rule to U.S.-source income in cases in which a taxpayer’s 

foreign tax credit limitation has been reduced as a result of a prior overall domestic loss. Under 

the bill, a portion of the taxpayer's U.S.-source income for each succeeding taxable year is 

recharacterized as foreign-source income in an amount equal to the lesser of: (1) the amount of 

the unrecharacterized overall domestic loss, and (2) 50 percent of the taxpayer's U.S.-source 

income for such succeeding taxable year.

The bill defines an overall domestic loss for this purpose as any domestic loss to the 

extent it offsets foreign-source taxable income for the current taxable year or for any preceding 

taxable year by reason of a loss carryback. For this purpose, a domestic loss means the amount 

by which the U.S.-source gross income for the taxable year is exceeded by the sum of the 

deductions properly apportioned or allocated thereto, determined without regard to any loss 

carried back from a subsequent taxable year. Under the bill, an overall domestic loss does not 

include any loss for any taxable year unless the taxpayer elected the use of the foreign tax credit 

for such taxable year.

Any U.S.-source income recharacterized under the bill is allocated among and increases 

the various foreign tax credit separate limitation categories in the same proportion that those 

categories were reduced by the prior overall domestic loss.

It is anticipated that situations may arise in which a taxpayer generates an overall 

domestic loss in a year following a year in which it had an overall foreign loss, or vice versa. In 

such a case, it would be necessary for ordering and other coordination rules to be developed for 

purposes of computing the foreign tax credit limitation in subsequent taxable years. The bill 

grants the Secretary of the Treasury authority to prescribe such regulations as may be necessary 

to coordinate the operation of the OFL recapture rules with the operation of the overall domestic 

loss recapture rules added by the bill.

Effective Date

The proposal applies to losses incurred in taxable years beginning after December 31, 

2005.

3. Reduction to two foreign tax credit baskets (sec. 1083 of the bill and sec. 904 of the Code)

Present Law

The United States taxes its citizens and residents on their worldwide income. Because 

the countries in which income is earned also may assert their jurisdiction to tax the same income 

on the basis of source, foreign-source income earned by U.S. persons may be subject to double 

taxation. In order to mitigate this possibility, the United States provides a credit against U.S. tax 

liability for foreign income taxes paid, subject to a number of limitations. The foreign tax credit 

generally is limited to the U.S. tax liability on a taxpayer’s foreign-source income, in order to 
49

ensure that the credit serves its purpose of mitigating double taxation of cross-border income 

without offsetting the U.S. tax on U.S.-source income. 

The foreign tax credit limitation is applied separately to the following categories of 

income: (1) passive income, (2) high withholding tax interest, (3) financial services income, (4) 

shipping income, (5) certain dividends received from noncontrolled section 902 foreign 

corporations (“10/50 companies”),54 (6) certain dividends from a domestic international sales 

corporation or former domestic international sales corporation, (7) taxable income attributable to 

certain foreign trade income, (8) certain distributions from a foreign sales corporation or former 

foreign sales corporation, and (9) any other income not described in items (1) through (8) (socalled “general basket” income). 

Description of Proposal

The bill reduces the number of foreign tax credit limitation categories to two: passive 

category income and general category income. Income from the eliminated financial services 

income category is treated as general category income in the case of (1) a member of a financial 

services group (i.e., any affiliated group55 that is predominately engaged in the active conduct of 

a banking, insurance, financing, or similar business) or (2) any other person predominantly 

engaged in the active conduct of a banking, insurance, financing, or similar business.56 Income 

from the eliminated shipping, high withholding tax interest, and 10/50 limitation categories falls 

into one of the remaining two categories, as appropriate. For example, shipping income 

generally falls into the general limitation category, whereas high withholding tax interest 

generally could fall into the passive income or the general limitation categories, depending on 

 

54 Subject to certain exceptions, dividends paid by a 10/50 company in taxable years 

beginning after December 31, 2002 are subject to either a look-through approach in which the 

dividend is attributed to a particular limitation category based on the underlying earnings which 

gave rise to the dividend (for post-2002 earnings and profits), or a single-basket limitation 

approach for dividends from all 10/50 companies (for pre-2003 earnings and profits). Under 

section 1115 of the bill, these dividends are subject to a look-through approach, irrespective of 

when the underlying earnings and profits arose.

55 The bill expands the definition of an affiliated group as defined under section 1504(a) 

for these purposes to include certain insurance companies (without regard to whether such 

companies are covered by an election under section 1504(c)(2)) and foreign corporations that are 

generally excluded from an affiliated group under section 1504(b)(2) and section 1504(b)(3) 

respectively. In determining whether an affiliated group is predominately engaged in the active 

conduct of a banking, insurance, financing, or similar business, only the income of members of 

the group that are U.S. corporations or controlled foreign corporations in which such U.S. 

corporations own (directly or indirectly) at least 80 percent of total voting power and value of the 

stock are counted.

56

 The bill requires the Treasury Secretary to specify the treatment of financial services 

income received or accrued by pass-through entities that are not members of a financial services 

group.
50

the circumstances. Dividends from a domestic international sales corporation or former 

domestic international sales corporation, income attributable to certain foreign trade income, and 

certain distributions from a foreign sales corporation or former foreign sales corporation all are 

assigned to the passive income limitation category. Creditable foreign taxes that are imposed on 

amounts that do not constitute income under U.S. tax principles are treated as imposed on 

general limitation income. 

Effective Date

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

4. Look-through rules to apply to dividends from noncontrolled section 902 corporations

(sec. 1084 of the bill and sec. 904 of the Code)

Present Law

U.S. persons may credit foreign taxes against U.S. tax on foreign-source income. The 

amount of foreign tax credits that may be claimed in a year is subject to a limitation that prevents 

taxpayers from using foreign tax credits to offset U.S. tax on U.S.-source income. Separate 

limitations are applied to specific categories of income.

Special foreign tax credit limitations apply in the case of dividends received from a 

foreign corporation in which the taxpayer owns at least 10 percent of the stock by vote and 

which is not a controlled foreign corporation (a so-called “10/50 company”). Dividends paid by 

a 10/50 company that is not a passive foreign investment company out of earnings and profits 

accumulated in taxable years beginning before January 1, 2003 are subject to a single foreign tax 

credit limitation for all 10/50 companies (other than passive foreign investment companies).57 

Dividends paid by a 10/50 company that is a passive foreign investment company out of earnings 

and profits accumulated in taxable years beginning before January 1, 2003, continue to be 

subject to a separate foreign tax credit limitation for each such 10/50 company. Dividends paid 

by a 10/50 company out of earnings and profits accumulated in taxable years after December 31, 

2002 are treated as income in a foreign tax credit limitation category in proportion to the ratio of 

the earnings and profits attributable to income in such foreign tax credit limitation category to 

the total earnings and profits (a “look-through” approach). 

For these purposes, distributions are treated as made from the most recently accumulated 

earnings and profits. Regulatory authority is granted to provide rules regarding the treatment of 

distributions out of earnings and profits for periods prior to the taxpayer's acquisition of such 

stock.

Description of Proposal

The bill applies the look-through approach to all dividends paid by a 10/50 company, 

regardless of the year in which the earnings and profits out of which the dividend is paid were 

 

57 Dividends paid by a 10/50 company in taxable years beginning before January 1, 2003 

are subject to a separate foreign tax credit limitation for each 10/50 company. 
51

accumulated.58 If the Treasury Secretary determines that the taxpayer has not substantiated 

which limitation category applies under the look-through approach with respect to all or a 

portion of the dividend, such portion is treated as passive category income for foreign tax credit 

purposes. 

The bill also provides transition rules regarding the use of pre-effective date foreign tax 

credits associated with a 10/50 company separate limitation category in post-effective date years. 

Look-through principles similar to those applicable to post-effective date dividends from a 10/50 

company apply to determine the appropriate foreign tax credit limitation category or categories 

with respect to carrying forward foreign tax credits into future years. The bill allows the 

Treasury Secretary to issue regulations addressing the carryback of foreign tax credits associated 

with a dividend from a 10/50 company to pre-effective date years. 

Effective Date

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

5. Attribution of stock ownership through partnerships to apply in determining section 902 

and 960 credits (sec. 1085 of the bill and secs. 902 and 901)

Present Law

Under section 902, a domestic corporation that receives a dividend from a foreign 

corporation in which it owns ten percent or more of the voting stock is deemed to have paid a 

portion of the foreign taxes paid by such foreign corporation. Thus, such a domestic corporation 

is eligible to claim a foreign tax credit with respect to such deemed-paid taxes. The domestic 

corporation that receives a dividend is deemed to have paid a portion of the foreign corporation’s 

post-1986 foreign income taxes based on the ratio of the amount of the dividend to the foreign 

corporation’s post-1986 undistributed earnings and profits.

Foreign income taxes paid or accrued by lower-tier foreign corporations also are eligible 

for the deemed-paid credit if the foreign corporation falls within a qualified group (sec. 902(b)). 

A “qualified group” includes certain foreign corporations within the first six tiers of a chain of 

foreign corporations if, among other things, the product of the percentage ownership of voting 

stock at each level of the chain (beginning from the domestic corporation) equals at least five 

percent. In addition, in order to claim indirect credits for foreign taxes paid by certain fourth-, 

fifth-, and sixth-tier corporations, such corporations must be controlled foreign corporations 

(within the meaning of sec. 957) and the shareholder claiming the indirect credit must be a U.S. 

shareholder (as defined in sec. 951(b)) with respect to the controlled foreign corporations. The 

application of the indirect foreign tax credit below the third tier is limited to taxes paid in taxable 

years during which the payor is a controlled foreign corporation. Foreign taxes paid below the 

sixth tier of foreign corporations are ineligible for the indirect foreign tax credit.

 

58 Section 1113 of the bill eliminates the separate basket for dividends from 10/50 

companies. 
52

Section 960 similarly permits a domestic corporation with subpart F inclusions from a 

controlled foreign corporation to claim deemed-paid foreign tax credits with respect to foreign 

taxes paid or accrued by the controlled foreign corporation on its subpart F income.

The foreign tax credit provisions in the Code do not specifically address whether a 

domestic corporation owning ten percent or more of the voting stock of a foreign corporation 

through a partnership is entitled to a deemed-paid foreign tax credit. 59 In Rev. Rul. 71-141,60 the 

IRS held that a foreign corporation’s stock held indirectly by two domestic corporations through 

their interests in a domestic general partnership is attributed to such domestic corporations for 

purposes of determining the domestic corporations’ eligibility to claim a deemed-paid foreign tax 

credit with respect to the foreign taxes paid by such foreign corporation. Accordingly, a general 

partner of a domestic general partnership is permitted to claim deemed-paid foreign tax credits 

with respect to a dividend distribution from the foreign corporation to the partnership.

However, in 1997, the Treasury Department issued final regulations under section 902, 

and the preamble to the regulations states that “[t]he final regulations do not resolve under what 

circumstances a domestic corporate partner may compute an amount of foreign taxes deemed 

paid with respect to dividends received from a foreign corporation by a partnership or other passthrough entity.”61 In recognition of the holding in Rev. Rul. 71-141, the preamble to the final 

regulations under section 902 states that a “domestic shareholder” for purposes of section 902 is 

a domestic corporation that “owns” the requisite voting stock in a foreign corporation rather than 

one that “owns directly” the voting stock. At the same time, the preamble states that the IRS is 

still considering under what other circumstances Rev. Rul. 71-141 should apply. Consequently, 

when adopting the 1997 final regulations, the IRS left uncertainty over whether a domestic 

corporation owning ten percent or more of the voting stock of a foreign corporation through a 

partnership is entitled to a deemed-paid foreign tax credit (other than through a domestic general 

partnership).

Description of Proposal

The bill clarifies that a domestic corporation is entitled to claim deemed-paid foreign tax 

credits with respect to a foreign corporation that is held indirectly through a foreign or domestic 

 

59 Under section 901(b)(5), an individual member of a partnership or a beneficiary of an 

estate or trust generally may claim a direct foreign tax credit with respect to the amount of his or 

her proportionate share of the foreign taxes paid or accrued by the partnership, estate, or trust. 

This rule does not specifically apply to corporations that are either members of a partnership or 

beneficiaries of an estate or trust. However, section 702(a)(6) provides that each partner 

(including individuals or corporations) of a partnership must take into account separately its 

distributive share of the partnership’s foreign taxes paid or accrued. In addition, under section 

703(b)(3), the election under section 901 (whether to credit the foreign taxes) is made by each 

partner separately.

60 1971-1 C.B. 211.

61 T.D. 8708, 1997-1 C.B. 137.
53

partnership, provided that the domestic corporation owns (indirectly through the partnership) ten 

percent or more of the foreign corporation’s voting stock. No inference is intended as to the 

treatment of such deemed-paid foreign tax credits under present law. The bill also clarifies that 

both individual and corporate partners (or estate or trust beneficiaries) may claim direct foreign 

tax credits with respect to their proportionate shares of taxes paid or accrued by a partnership (or 

estate or trust). 

Effective Date

The proposal applies to taxes of foreign corporations for taxable years of such 

corporations beginning after the date of enactment. 

6. Clarification of treatment of certain transfers of intangible property (sec. 1086 of the bill 

and sec. 367(d) of the Code)

Present Law

In the case of transfers of intangible property to foreign corporations by means of 

contributions and certain other nonrecognition transactions, special rules apply that are designed 

to mitigate the tax avoidance that may arise from shifting the income attributable to intangible 

property offshore. Under section 367(d), the outbound transfer of intangible property is treated 

as a sale of the intangible for a stream of contingent payments. The amounts of these deemed 

payments must be commensurate with the income attributable to the intangible. The deemed 

payments are included in gross income of the U.S. transferor as ordinary income, and the 

earnings and profits of the foreign corporation to which the intangible was transferred are 

reduced by such amounts. 

The Taxpayer Relief Act of 1997 repealed a rule of prior law that treated all such deemed 

payments as giving rise to U.S.-source income. Because the foreign tax credit is generally 

limited to the U.S. tax imposed on foreign-source income, the prior-law rule reduced the 

taxpayer’s ability to claim foreign tax credits. As a result of the repeal of the rule, the source of 

payments deemed received under section 367(d) is determined under general sourcing rules. 

These rules treat income from sales of intangible property for contingent payments the same as 

royalties, with the result that the deemed payments may give rise to foreign-source income.62

The Taxpayer Relief Act of 1997 did not address the characterization of the deemed 

payments for purposes of applying the foreign tax credit separate limitation categories.63 If the 

deemed payments are treated like proceeds of a sale, then they could fall into the passive 

category; if the deemed payments are treated like royalties, then in many cases they could fall 

into the general category (under look-through rules applicable to payments of dividends, interest, 

rents, and royalties received from controlled foreign corporations).64

 

62 Secs. 865(d), 862(a).

63 Sec. 904(d).

64 Sec. 904(d)(3).
54

Description of Proposal

The bill specifies that deemed payments under section 367(d) are treated as royalties for 

purposes of applying the separate limitation categories of the foreign tax credit.

Effective Date

The proposal is effective for amounts treated as received on or after August 5, 1997 (the 

effective date of the relevant provision of the Taxpayer Relief Act of 1997).

7. United States property not to include certain assets acquired by dealers in ordinary 

course of trade or business (sec. 1087 of the bill and sec. 956 of the Code)

Present Law

In general, the subpart F rules (secs. 951-964) require U.S. shareholders with a 10-

percent or greater interest in a controlled foreign corporation (“U.S. 10-percent shareholders”) to 

include in taxable income their pro rata shares of certain income of the controlled foreign 

corporation (referred to as “subpart F income”) when such income is earned, whether or not the 

earnings are distributed currently to the shareholders. In addition, the U.S. 10-percent 

shareholders of a controlled foreign corporation are subject to U.S. tax on their pro rata shares of 

the controlled foreign corporation's earnings to the extent invested by the controlled foreign 

corporation in certain U.S. property in a taxable year (sec. 951(a)(1)(B)).

A shareholder’s income inclusion with respect to a controlled foreign corporation's 

investment in U.S. property for a taxable year is based on the controlled foreign corporation’s 

average investment in U.S. property for such year. For this purpose, the U.S. property held 

(directly or indirectly) by the controlled foreign corporation must be measured as of the close of 

each quarter in the taxable year (sec. 956(a)). The amount taken into account with respect to any 

property is the property’s adjusted basis as determined for purposes of reporting the controlled 

foreign corporation’s earnings and profits, reduced by any liability to which the property is 

subject. The amount determined for inclusion in each taxable year is the shareholder’s pro rata 

share of an amount equal to the lesser of: (1) the controlled foreign corporation’s average 

investment in U.S. property as of the end of each quarter of such taxable year, to the extent that 

such investment exceeds the foreign corporation’s earnings and profits that were previously 

taxed on that basis; or (2) the controlled foreign corporation’s current or accumulated earnings 

and profits (but not including a deficit), reduced by distributions during the year and by earnings 

that have been taxed previously as earnings invested in U.S. property (secs. 956 and 959). An 

income inclusion is required only to the extent that the amount so calculated exceeds the amount 

of the controlled foreign corporation’s earnings that have been previously taxed as subpart F 

income (secs. 951(a)(1)(B) and 959).

For purposes of section 956, U.S. property generally is defined to include tangible 

property located in the United States, stock of a U.S. corporation, an obligation of a U.S. person, 

and certain intangible assets including a patent or copyright, an invention, model or design, a 

secret formula or process or similar property right which is acquired or developed by the 

controlled foreign corporation for use in the United States (sec. 956(c)(1)).
55

Specified exceptions from the definition of U.S. property are provided for: (1) 

obligations of the United States, money, or deposits with persons carrying on the banking 

business; (2) certain export property; (3) certain trade or business obligations; (4) aircraft, 

railroad rolling stock, vessels, motor vehicles or containers used in transportation in foreign 

commerce and used predominantly outside of the United States; (5) certain insurance company 

reserves and unearned premiums related to insurance of foreign risks; (6) stock or debt of certain 

unrelated U.S. corporations; (7) moveable property (other than a vessel or aircraft) used for the 

purpose of exploring, developing, or certain other activities in connection with the ocean waters 

of the U.S. Continental Shelf; (8) an amount of assets equal to the controlled foreign 

corporation’s accumulated earnings and profits attributable to income effectively connected with 

a U.S. trade or business; (9) property (to the extent provided in regulations) held by a foreign 

sales corporation and related to its export activities; (10) certain deposits or receipts of collateral 

or margin by a securities or commodities dealer, if such deposit is made or received on 

commercial terms in the ordinary course of the dealer’s business as a securities or commodities 

dealer; and (11) certain repurchase and reverse repurchase agreement transactions entered into by 

or with a dealer in securities or commodities in the ordinary course of its business as a securities 

or commodities dealer (sec. 956(c)(2)).

Description of Proposal

The bill adds a new exception from the definition of U.S. property for determining 

current income inclusion by a U.S. 10-percent shareholder with respect to an investment in U.S. 

property by a controlled foreign corporation. The exception generally applies to securities 

acquired and held by a controlled foreign corporation in the ordinary course of its trade or 

business as a dealer in securities. The exception applies only if the controlled foreign 

corporation dealer: (1) accounts for the securities as securities held primarily for sale to 

customers in the ordinary course of business; and (2) disposes of such securities (or such 

securities mature while being held by the dealer) within a period consistent with the holding of 

securities for sale to customers in the ordinary course of business.

Effective Date

The proposal is effective for taxable years of foreign corporations beginning after 

December 31, 2004, and for taxable years of United States shareholders with or within which 

such taxable year of the foreign corporation ends.

8. Election not to use average exchange rate for foreign tax paid other than in functional 

currency (sec. 1088 of the bill and sec. 986 of the Code)

Present Law

For taxpayers that take foreign income taxes into account when accrued, present law 

provides that the amount of the foreign tax credit generally is determined by translating the 

amount of foreign taxes paid in foreign currencies into a U.S. dollar amount at the average 

exchange rate for the taxable year to which such taxes relate (sec. 986(a)(1)). This rule applies 

to foreign taxes paid directly by U.S. taxpayers, which taxes are creditable in the year paid or 

accrued, and to foreign taxes paid by foreign corporations that are deemed paid by a U.S. 
56

corporation that is a shareholder of the foreign corporation, and hence creditable in the year that 

the U.S. corporation receives a dividend or has an income inclusion from the foreign corporation. 

This rule does not apply to any foreign income tax: (1) that is paid after the date that is two 

years after the close of the taxable year to which such taxes relate; (2) of an accrual-basis 

taxpayer that is actually paid in a taxable year prior to the year to which the tax relates; or (3) 

that is denominated in an inflationary currency (as defined by regulations).

Foreign taxes that are not eligible for translation at the average exchange rate generally 

are translated into U.S. dollar amounts using the exchange rates as of the time such taxes are 

paid. However, the Secretary is authorized to issue regulations that would allow foreign tax 

payments to be translated into U.S. dollar amounts using an average exchange rate for a specified 

period (sec. 986(a)(2)).

Description of Proposal

For taxpayers that are required under present law to translate foreign income tax 

payments at the average exchange rate, the bill provides an election to translate such taxes into 

U.S. dollar amounts using the exchange rates as of the time such taxes are paid, provided the 

foreign income taxes are denominated in a currency other than the taxpayer’s functional 

currency. 65 Any election under this provision applies to the taxable year for which the election is 

made and to all subsequent taxable years unless revoked with the consent of the Secretary. The 

bill authorizes the Secretary to issue regulations that apply the election to foreign income taxes 

attributable to a qualified business unit.

Effective Date

This proposal is effective with respect to taxable years beginning after December 31, 

2004.

9. Repeal of withholding tax on dividends from certain foreign corporations (sec. 1089 of 

the bill and sec. 871 of the Code)

Present Law

Nonresident individuals who are not U.S. citizens and foreign corporations (collectively, 

foreign persons) are subject to U.S. tax on income that is effectively connected with the conduct 

of a U.S. trade or business; the U.S. tax on such income is calculated in the same manner and at 

the same graduated rates as the tax on U.S. persons (secs. 871(b) and 882). Foreign persons also 

are subject to a 30-percent gross basis tax, collected by withholding, on certain U.S.-source 

passive income (e.g., interest and dividends) that is not effectively connected with a U.S. trade or 

business. This 30-percent withholding tax may be reduced or eliminated pursuant to an 

applicable tax treaty. Foreign persons generally are not subject to U.S. tax on foreign-source 

income that is not effectively connected with a U.S. trade or business.

 

65 Electing taxpayers translate foreign income tax payments pursuant to the same 

present-law rules that apply to taxpayers that are required to translate foreign income taxes using 

the exchange rates as of the time such taxes are paid.
57

In general, dividends paid by a domestic corporation are treated as being from U.S. 

sources and dividends paid by a foreign corporation are treated as being from foreign sources. 

Thus, dividends paid by foreign corporations to foreign persons generally are not subject to 

withholding tax because such income generally is treated as foreign-source income. 

An exception from this general rule applies in the case of dividends paid by certain 

foreign corporations. If a foreign corporation derives 25 percent or more of its gross income as 

income effectively connected with a U.S. trade or business for the three-year period ending with 

the close of the taxable year preceding the declaration of a dividend, then a portion of any 

dividend paid by the foreign corporation to its shareholders will be treated as U.S.-source income 

and, in the case of dividends paid to foreign shareholders, will be subject to the 30-percent 

withholding tax (sec. 861(a)(2)(B)). This rule is sometimes referred to as the “secondary 

withholding tax.” The portion of the dividend treated as U.S.-source income is equal to the ratio 

of the gross income of the foreign corporation that was effectively connected with its U.S. trade 

or business over the total gross income of the foreign corporation during the three-year period 

ending with the close of the preceding taxable year. The U.S.-source portion of the dividend 

paid by the foreign corporation to its foreign shareholders is subject to the 30-percent 

withholding tax.

Under the branch profits tax provisions, the United States taxes foreign corporations 

engaged in a U.S. trade or business on amounts of U.S. earnings and profits that are shifted out 

of the U.S. branch of the foreign corporation. The branch profits tax is comparable to the 

second-level taxes imposed on dividends paid by a domestic corporation to its foreign 

shareholders. The branch profits tax is 30 percent of the foreign corporation’s “dividend 

equivalent amount,” which generally is the earnings and profits of a U.S. branch of a foreign 

corporation attributable to its income effectively connected with a U.S. trade or business (secs. 

884(a) and (b)). 

If a foreign corporation is subject to the branch profits tax, then no secondary 

withholding tax is imposed on dividends paid by the foreign corporation to its shareholders (sec. 

884(e)(3)(A)). If a foreign corporation is a qualified resident of a tax treaty country and claims 

an exemption from the branch profits tax pursuant to the treaty, the secondary withholding tax 

could apply with respect to dividends it pays to its shareholders. Several tax treaties (including 

treaties that prevent imposition of the branch profits tax), however, exempt dividends paid by the 

foreign corporation from the secondary withholding tax. 

Description of Proposal

The bill eliminates the secondary withholding tax with respect to dividends paid by 

certain foreign corporations. 

Effective Date

The proposal is effective for payments made after December 31, 2004.
58

10. Provide equal treatment for interest paid by foreign partnerships and foreign 

corporations (sec. 1090 of the bill and sec. 861 of the Code)

Present Law

In general, interest income from bonds, notes or other interest-bearing obligations of 

noncorporate U.S. residents or domestic corporations is treated as U.S.-source income.66 Other 

interest (e.g., interest on obligations of foreign corporations and foreign partnerships) generally 

is treated as foreign-source income. However, Treasury regulations provide that a foreign 

partnership is a U.S. resident for purposes of this rule if at any time during its taxable year it is 

engaged in a trade or business in the United States.67 Therefore, any interest received from such 

a foreign partnership is U.S.-source income.

Notwithstanding the general rule described above, in the case of a foreign corporation 

engaged in a U.S. trade or business (or having gross income that is treated as effectively 

connected with the conduct of a U.S. trade or business), interest paid by such U.S. trade or 

business is treated as if it were paid by a domestic corporation (i.e., such interest is treated as 

U.S.-source income).68

Description of Proposal

The proposal treats interest paid by foreign partnerships in a manner similar to the 

treatment of interest paid by foreign corporations. Thus, interest paid by a foreign partnership is 

treated as U.S.-source income only if the interest is paid by a U.S. trade or business conducted by 

the partnership or is allocable to income that is treated as effectively connected with the conduct 

of a U.S. trade or business. The proposal applies only to foreign partnerships that are principally 

owned by foreign persons. For this purpose, a foreign partnership is principally owned by 

foreign persons if, in the aggregate, U.S. citizens, resident aliens and domestic corporations do 

not own, directly or indirectly, 20 percent (or more) of the capital or profits interests in the 

partnership.

Effective Date

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

 

66 Sec. 861(a)(1).

67 Treas. Reg. sec. 1.861-2(a)(2).

68 Sec. 884(f)(1).
59

I. Other Provisions

1. Special rules for livestock sold on account of weather-related conditions (sec. 1101 of the 

bill and secs. 1033 and 451 of the Code)

Present Law

Generally, a taxpayer recognizes gain to the extent the sales price (and any other 

consideration received) exceeds the seller’s basis in the property. The recognized gain is subject 

to current income tax unless the gain is deferred or not recognized under a special tax provision. 

Under section 1033, gain realized by a taxpayer from an involuntary conversion of 

property is deferred to the extent the taxpayer purchases property similar or related in service or 

use to the converted property within the applicable period. The taxpayer’s basis in the 

replacement property generally is the same as the taxpayer’s basis in the converted property, 

decreased by the amount of any money or loss recognized on the conversion, and increased by 

the amount of any gain recognized on the conversion.

The applicable period for the taxpayer to replace the converted property begins with the 

date of the disposition of the converted property (or if earlier, the earliest date of the threat or 

imminence of requisition or condemnation of the converted property) and ends two years after 

the close of the first taxable year in which any part of the gain upon conversion is realized (the 

“replacement period”). Special rules extend the replacement period for certain real property and 

principle residences damaged by a Presidentially declared disaster to three years and four years, 

respectively, after the close of the first taxable year in which gain is realized. 

Section 1033(e) provides that the sale of livestock (other than poultry) that is held for 

draft, breeding, or dairy purposes in excess of the number of livestock that would have been sold 

but for drought, flood, or other weather-related conditions is treated as an involuntary 

conversion. Consequently, gain from the sale of such livestock could be deferred by reinvesting 

the proceeds of the sale in similar property within a two-year period.

In general, cash-method taxpayers report income in the year it is actually or 

constructively received. However, section 451(e) provides that a cash-method taxpayer whose 

principal trade or business is farming who is forced to sell livestock due to drought, flood, or 

other weather-related conditions may elect to include income from the sale of the livestock in the 

taxable year following the taxable year of the sale. This elective deferral of income is available 

only if the taxpayer establishes that, under the taxpayer’s usual business practices, the sale would 

not have occurred but for drought, flood, or weather-related conditions that resulted in the area 

being designated as eligible for Federal assistance. This exception is generally intended to put 

taxpayers who receive an unusually high amount of income in one year in the position they 

would have been in absent the weather-related condition.

Description of Proposal

The proposal extends the applicable period for a taxpayer to replace livestock sold on 

account of drought, flood, or other weather-related conditions from two years to four years after 

the close of the first taxable year in which any part of the gain on conversion is realized. The 
60

extension is only available if the taxpayer establishes that, under the taxpayer’s usual business 

practices, the sale would not have occurred but for drought, flood, or weather-related conditions 

that resulted in the area being designated as eligible for Federal assistance. In addition, the 

Secretary of the Treasury is granted authority to further extend the replacement period on a 

regional basis should the weather-related conditions continue longer than three years. Also, for 

property eligible for the proposal’s extended replacement period, the proposal provides that the 

taxpayer can make an election under section 451(e) until the period for reinvestment of such 

property under section 1033 expires. 

Effective Date

The proposal is effective for any taxable year with respect to which the due date (without 

regard to extensions) for the return is after December 31, 2002. 

2. Payment of dividends on stock of cooperatives without reducing patronage dividends 

(sec. 1102 of the bill and sec. 1388 of the Code)

Present Law

Under present law, cooperatives generally are treated similarly to pass-through entities in 

that a cooperative is not subject to corporate income tax to the extent the cooperative timely pays 

patronage dividends. In general, patronage dividends are comprised of amounts that are paid to 

patrons (1) on the basis of the quantity or value of business done with or for patrons, (2) under a 

valid enforceable written obligation to the patron that was in existence before the cooperative 

received such amounts, and (3) which are determined by reference to the net earnings of the 

cooperative from business done with or for patrons.

Treasury Regulations provide that net earnings are reduced by dividends paid on capital 

stock or other proprietary capital interests (referred to as the “dividend allocation rule”).69 The 

effect of this rule is to reduce the amount of earnings that a cooperative can treat as patronage 

income and, thus, the amount that the cooperative can deduct as patronage dividends.

Description of Proposal

The proposal provides a special rule for dividends on capital stock of a cooperative. To 

the extent provided in organizational documents of the cooperative, dividends on capital stock do 

not reduce patronage income.

Effective Date

The proposal is effective for distributions made in taxable years beginning after the date 

of enactment.

 

69 Treas. Reg. sec. 1.1388-1(a)(1).
61

3. Add vaccines against hepatitis A to the list of taxable vaccines (sec. 1103 of the bill and 

sec. 4131 of the Code)

Present Law

A manufacturer’s excise tax is imposed at the rate of 75 cents per dose70 on the following 

vaccines routinely recommended for administration to children: diphtheria, pertussis, tetanus, 

measles, mumps, rubella, polio, HIB (haemophilus influenza type B), hepatitis B, varicella 

(chicken pox), rotavirus gastroenteritis, and streptococcus pneumoniae. The tax applied to any 

vaccine that is a combination of vaccine components equals 75 cents times the number of 

components in the combined vaccine.

Amounts equal to net revenues from this excise tax are deposited in the Vaccine Injury 

Compensation Trust Fund to finance compensation awards under the Federal Vaccine Injury 

Compensation Program for individuals who suffer certain injuries following administration of 

the taxable vaccines. This program provides a substitute Federal, “no fault” insurance system for 

the State-law tort and private liability insurance systems otherwise applicable to vaccine 

manufacturers. All persons immunized after September 30, 1988, with covered vaccines must 

pursue compensation under this Federal program before bringing civil tort actions under State 

law.

Description of Proposal

The proposal adds any vaccine against hepatitis A to the list of taxable vaccines. The 

proposal also makes a conforming amendment to the trust fund expenditure purposes. 

Effective Date

The proposal is effective for vaccines sold beginning on the first day of the first month 

beginning more than four weeks after the date of enactment.

4. Expand human clinical trials expenses qualifying for the orphan drug tax credit

(sec. 1104 of the bill and sec. 45C of the Code)

Present Law

Taxpayers may claim a 50-percent credit for expenses related to human clinical testing of 

drugs for the treatment of certain rare diseases and conditions, generally those that afflict less 

than 200,000 persons in the United States. Qualifying expenses are those paid or incurred by the 

taxpayer after the date on which the drug is designated as a potential treatment for a rare disease 

or disorder by the Food and Drug Administration (“FDA”) in accordance with section 526 of the 

Federal Food, Drug, and Cosmetic Act.

 

70 sec. 4131
62

Description of Proposal

The proposal expands qualifying expenses to include those expenses related to human 

clinical testing paid or incurred after the date on which the taxpayer files an application with the 

FDA for designation of the drug under section 526 of the Federal Food, Drug, and Cosmetic Act 

as a potential treatment for a rare disease or disorder. As under present law, the credit may only 

be claimed for such expenses related to drugs designated as a potential treatment for a rare 

disease or disorder by the FDA in accordance with section 526 of such Act.

Effective Date

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

5. Distributions from publicly traded partnerships treated as qualifying income of 

regulated investment company (sec. 1105 of the bill and secs. 851 and 469(k) of the Code) 

Present Law

Treatment of RICs

A regulated investment company (“RIC”) generally is treated as a conduit for Federal 

income tax purposes. In computing its taxable income, a RIC deducts dividends paid to its 

shareholders to achieve conduit treatment (sec. 852(b)). In order to qualify for conduit 

treatment, a RIC must be a domestic corporation that, at all times during the taxable year, is 

registered under the Investment Company Act of 1940 as a management company or as a unit 

investment trust, or has elected to be treated as a business development company under that Act 

(sec. 851(a)). In addition, the corporation must elect RIC status, and must satisfy certain other 

requirements (sec. 851(b)).

One of the RIC qualification requirements is that at least 90 percent of the RIC's gross 

income is derived from dividends, interest, payments with respect to securities loans, and gains 

from the sale or other disposition of stock or securities or foreign currencies, or other income 

(including but not limited to gains from options, futures, or forward contracts) derived with 

respect to its business of investing in such stock, securities, or currencies (sec. 851(b)(2)). 

Income derived from a partnership is treated as meeting this requirement only to the extent such 

income is attributable to items of income of the partnership that would meet the requirement if 

realized by the RIC in the same manner as realized by the partnership (the “look-through” rule 

for partnership income) (sec. 851(b)). Under present law, no distinction is made under this rule 

between a publicly traded partnership and any other partnership.

The RIC qualification rules include limitations on the ownership of assets and on the 

composition of the RIC's assets (sec. 851(b)(3)). Under the ownership limitation, at least 50 

percent of the value of the RIC's total assets must be represented by cash, government securities 

and securities of other RICs, and other securities; however, in the case of such other securities, 

the RIC may invest no more than 5 percent of the value of the total assets of the RIC in the 

securities of any one issuer, and may hold no more than 10 percent of the outstanding voting 

securities of any one issuer. Under the limitation on the composition of the RIC's assets, no 

more than 25 percent of the value of the RIC's total assets may be invested in the securities of 
63

any one issuer (other than Government securities), or in securities of two or more controlled 

issuers in the same or similar trades or businesses. These limitations generally are applied at the 

end of each quarter (sec. 851(d)).

Treatment of publicly traded partnerships

Present law provides that a publicly traded partnership means a partnership, interests in 

which are traded on an established securities market, or are readily tradable on a secondary 

market (or the substantial equivalent thereof). In general, a publicly traded partnership is treated 

as a corporation (sec. 7704(a)), but an exception to corporate treatment is provided if 90 percent 

or more of its gross income is interest, dividends, real property rents, or certain other types of 

qualifying income (sec. 7704(c) and (d)).

A special rule for publicly traded partnerships applies under the passive loss rules. The 

passive loss rules limit deductions and credits from passive trade or business activities (sec. 469). 

Deductions attributable to passive activities, to the extent they exceed income from passive 

activities, generally may not be deducted against other income. Deductions and credits that are 

suspended under these rules are carried forward and treated as deductions and credits from 

passive activities in the next year. The suspended losses from a passive activity are allowed in 

full when a taxpayer disposes of his entire interest in the passive activity to an unrelated person. 

The special rule for publicly traded partnerships provides that the passive loss rules are applied 

separately with respect to items attributable to each publicly traded partnership (sec. 469(k)). 

Thus, income or loss from the publicly traded partnership is treated as separate from income or 

loss from other passive activities.

Description of Proposal

The proposal modifies the 90 percent test with respect to income of a RIC to include 

income derived from an interest in a publicly traded partnership. The proposal also modifies the 

lookthrough rule for partnership income of a RIC so that it applies only to income from a 

partnership other than a publicly traded partnership.

The proposal provides that the limitation on ownership and the limitation on composition 

of assets that apply to other investments of a RIC also apply to RIC investments in publicly 

traded partnership interests.

The proposal provides that the special rule for publicly traded partnerships under the 

passive loss rules (requiring separate treatment) applies to a RIC holding an interest in a publicly 

traded partnership, with respect to items attributable to the interest in the publicly traded 

partnership.

Effective Date

The provision is effective for taxable years beginning after the date of enactment.
64

6. REIT modification provisions (sec. 1106 of the bill and secs. 856 and 857 of the Code)

Present Law

In general

Real estate investment trusts (“REITs”) are treated, in substance, as pass-through entities 

under present law. Pass-through status is achieved by allowing the REIT a deduction for 

dividends paid to its shareholders. REITs are generally restricted to investing in passive 

investments primarily in real estate and securities.

A REIT must satisfy four tests on a year-by-year basis: organizational structure, source of 

income, nature of assets, and distribution of income. Whether the REIT meets the asset tests is 

generally measured each quarter. 

Organizational structure requirements

To qualify as a REIT, an entity must be for its entire taxable year a corporation or an 

unincorporated trust or association that would be taxable as a domestic corporation but for the 

REIT provisions, and must be managed by one or more trustees. The beneficial ownership of the 

entity must be evidenced by transferable shares or certificates of ownership. Except for the first 

taxable year for which an entity elects to be a REIT, the beneficial ownership of the entity must 

be held by 100 or more persons, and the entity may not be so closely held by individuals that it 

would be treated as a personal holding company if all its adjusted gross income constituted 

personal holding company income. A REIT is disqualified for any year in which it does not 

comply with regulations to ascertain the actual ownership of the REIT's outstanding shares.

Income requirements

In order for an entity to qualify as a REIT, at least 95 percent of its gross income 

generally must be derived from certain passive sources (the "95 percent income test"). In 

addition, at least 75 percent of its income generally must be from certain real estate sources (the 

"75? percent income test"), including rents from real property (as defined) and gain from the sale 

or other disposition of real property.

Qualified rental income

Amounts received as impermissible “tenant services income” are not treated as rents from 

real property. 71 In general, such amounts are for services rendered to tenants that are not 

 

71 A REIT is not treated as providing services that produce impermissible tenant services 

income if such services are provided by an independent contractor from whom the REIT does 

not derive or receive any income. An independent contractor is defined as a person who does not 

own, directly or indirectly, more than 35 percent of the shares of the REIT. Also, no more than 

35 percent of the total shares of stock of an independent contractor (or of the interests in net 

assets or net profits, if not a corporation) can be owned directly or indirectly by persons owning 

35 percent or more of the interests in the REIT.
65

“customarily furnished” in connection with the rental of real property. 72 Special rules also 

permit amounts to be received from certain “foreclosure property” treated as such for 3 years 

after the property is acquired by the REIT in foreclosure after a default (or imminent default) on 

a lease of such property or an indebtedness which such property secured. 

Rents from real property, for purposes of the 95-percent and 75-percent income tests, 

generally do not include any amount received or accrued from any person in which the REIT 

owns, directly or indirectly, 10 percent or more of the vote or value.73 An exception applies to 

rents received from a taxable REIT subsidiary (“TRS”) (described further below) if at least 90 

percent of the leased space of the property is rented to persons other than a TRS or certain related 

persons, and if the rents from the TRS are substantially comparable to unrelated party rents.74

Certain hedging instruments

Except as provided in regulations, a payment to a REIT under an interest rate swap or cap 

agreement, option, futures contract, forward rate agreement, or any similar financial instrument, 

entered into by the trust in a transaction to reduce the interest rate risks with respect to any 

indebtedness incurred or to be incurred by the REIT to acquire or carry real estate assets, and any 

gain from the sale or disposition of any such investment, is treated as income qualifying for the 

95-percent income test.

Tax if qualified income tests not met 

If a REIT fails to meet the 95-percent or 75-percent income tests but has set out the 

income it did receive in a schedule and any error in the schedule is due to reasonable cause and 

not willful neglect, then the REIT does not lose its REIT status but instead pays a tax measured 

by the greater of the amount by which 90 percent 75 of the REIT’s gross income exceeds the 

amount of items subject to the 95-percent test, or the amount by which 75 percent of the REIT’s 

gross income exceeds the amount of items subject to the 75-percent test. 76 

 

72 Rents for certain personal property leased in connection are treated as rents from real 

property if the fair market value of the personal property does not exceed 15 percent of the 

aggregate fair market values of the real and personal property

73 Section 856(d)(2)(B).

74 Section 856(d)(8).

75 Prior to 1999, the rule had applied to the amount by which 95 percent of the income 

exceeded the items subject to the 95 percent test. 

76 The ratio of the REIT’s net to gross income is applied to the excess amount, to 

determine the amount of tax (disregarding certain items otherwise subject to a 100-percent tax). 

In effect, the formula seeks to require that all of the REIT net income attributable to the failure of 

the income tests will be paid as tax. Sec. 857(b)(5).
66

Asset requirements

To satisfy the asset requirements to qualify for treatment as a REIT, at the close of each 

quarter of its taxable year, an entity must have at least 75 percent of the value of its assets 

invested in real estate assets, cash and cash items, and government securities (the “75-percent 

asset test”). The term real estate asset is defined to mean real property (including interests in real 

property and mortgages on real property) and interests in REITs.

Limitation on investment in other entities

A REIT is limited in the amount that it can own in other corporations. Specifically, a 

REIT cannot own securities (other than Government securities and certain real estate assets) in 

an amount greater than 25 percent of the value of REIT assets. In addition, it cannot own such 

securities of any one issuer representing more than 5 percent of the total value of REIT assets or 

more than 10 percent of the voting securities or 10 percent of the value of the outstanding 

securities of any one issuer. Securities for purposes of these rules are defined by reference to 

the Investment Company Act of 1940.

“Straight debt” exception

Securities of an issuer that are within a safe-harbor definition of “straight debt” (as 

defined for purposes of subchapter S77 are not taken into account in applying the limitation that a 

REIT may not hold more than 10 percent of the value of outstanding securities of a single issuer, 

if : 1) the issuer is an individual, or 2) the only securities of such issuer held by the REIT or a 

taxable REIT subsidiary of the REIT are straight debt, or 3) the issuer is a partnership and the 

trust holds at least a 20 percent profits interest in the partnership.

Straight debt is defined as a written or unconditional promise to pay on demand or on a 

specified date a sum certain in money if (i) the interest rate (and interest payment dates) are not 

contingent on profits, the borrower’s discretion, or similar factors; (ii) there is no convertibility 

(directly or indirectly) into stock; and (iii) the creditor is an individual (other than a nonresident 

alien), an estate, certain trusts, or a person which is actively and regularly engaged in the 

business of lending money.

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

Under one exception to the rule limiting a REIT’s securities holdings to no more than 10 

percent of the vote or value of a single issuer, a REIT can own 100 percent of the stock of a 

corporation, but in that case the income and assets of such corporation are treated as income and 

assets of the REIT. 

Special rules for Taxable REIT subsidiaries

Under another exception to the general rule limiting REIT securities ownership of other 

entities, a REIT can own stock of a taxable REIT subsidiary (“TRS”), generally, a corporation 

 

77 Section 1361(c)(5), without regard to paragraph (B)(iii) thereof.
67

other than a real estate investment trust78 with which the REIT makes a joint election to be 

subject to special rules. A TRS can engage in active business operations that would produce 

income that would not be qualified income for purposes of the 95-percent or 75-percent income 

tests for a REIT, and that income is not attributed to the REIT. For example a TRS could 

provide noncustomary services to REIT tenants, or it could engage directly in the active 

operation and management of real estate (without use of an independent contractor); and the 

income the TRS derived from these nonqualified activities would not be treated as disqualified 

REIT income. Transactions between a TRS and a REIT are subject to a number of specified 

rules that are intended to prevent the TRS (taxable as a separate corporate entity) from shifting 

taxable income from its activities to the pass through entity REIT or from absorbing more than 

its share of expenses. Under one rule, a 100 percent excise tax is imposed on rents, deductions, 

or interest paid by the TRS to the REIT to the extent such items would exceed an arm’s length 

amount as determined under section 482.79

Rents subject to the 100 percent excise tax do not include rents for services of a TRS that 

are for services customarily furnished or rendered in connection with the rental of real property. 

They also do not include rents from a TRS that are for real property or from incidental 

personal property provided with such real property. 

Income distribution requirements

A REIT is generally required to distribute 90 percent of its income before the end of its 

taxable year, as deductible dividends paid to shareholders. This rule is similar to a rule for 

regulated investment companies (“RICs”) that requires distribution of 90 percent of income. 

Both RICS and REITs can make certain “deficiency dividends” after the close of the taxable 

year, and have these treated as made before the end of the year. Deficiency dividends may be 

declared on or after the date of “determination”. A determination is defined to include only (i) a 

final decision by the Tax Court or other court of competent jurisdiction, (ii) a closing agreement 

under section 7121, or (iii) under Treasury regulations, an agreement signed by the Secretary and 

the REIT. 

Description of Proposal 

The proposal makes several modifications to the REIT rules. 

 

78 Certain corporations are not eligible to be a TRS, such as a corporation which directly 

or indirectly operates or manages a lodging facility or a health care facility or directly or 

indirectly provides to any other person rights to a brand name under which any lodging facility 

or health care facility is operated. Sec. 856((l)(3).

79 If the excise tax applies, the item is not also reallocated back to the TRS under section 

482. 
68

Straight debt modification

The proposal modifies the definition of “straight debt” for purposes of the limitation that 

a REIT may not hold more than 10 percent of the value of the outstanding securities of a single 

issuer, to provide more flexibility than the present law rule. In addition, except as provided in 

regulations, neither such straight debt nor certain other types of securities are considered 

“securities” for purposes of this rule. 

Straight debt securities

“Straight-debt” is still defined by reference to section 1361(c)(5), however, without 

regard to subparagraph (B)(iii) thereof (limiting the nature of the creditor).

Special rules are provided permitting certain contingencies for purposes of the REIT 

provision. Any interest or principal shall not be treated as failing to satisfy section 

1361(c)(5)(B)(i) solely by reason of the fact that the time of payment of such interest or principal 

is subject to a contingency, but only if one of several factors applies. The first type of 

contingency that is permitted is one that does not have the effect of changing the effective yield 

to maturity, as determined under section 1272, other than a change in the annual yield to maturity 

which either (i) does not exceed the greater of 1⁄4 of 1 percent or 5 percent of the annual yield to 

maturity, or (ii) results solely from a default or the exercise of a prepayment right by the issuer of 

the debt. 

The second type of contingency that is permitted is one under which neither the aggregate 

issue price nor the aggregate face amount of the debt instruments held by the REIT exceeds 

$1,000,000 and not more than 12 months of unaccrued interest can be required to be prepaid 

thereunder. 

The proposal eliminates the present law rule requiring a REIT to own a 20 percent equity 

interest in a partnership in order for debt to qualify as “straight debt”. The proposal instead 

provides new “look-through” rules determining a REIT partner’s share of partnership securities, 

generally treating debt to the REIT as part of the REIT’s partnership interest for this purpose, 

except in the case of otherwise qualifying debt of the partnership. 

Certain corporate or partnership issues that otherwise would be permitted to be held 

without limitation under the special straight debt rules described above will not be so permitted if 

the REIT holding such securities, and any of its taxable REIT subsidiaries, holds any securities 

of the issuer which are not permitted securities (prior to the application of this rule) and have an 

aggregate value greater than 1 percent of the issuer’s outstanding securities (determined without 

regard to the new “look-through” rules). 

Other securities

Except as provided in regulations, the following also are not considered “securities” for 

purposes of the rule that a REIT cannot own more than 10 percent of the value of the outstanding 

securities of a single issuer: (i) any loan to an individual or an estate, (ii) any section 467 rental 

agreement, (as defined in section 467(d)), other than with a person described in section 

856(d)(2)(B), (iii) any obligation to pay rents from real property, (iv) any security issued by a 
69

State or any political subdivision thereof, the District of Columbia, a foreign government, or any 

political subdivision thereof, or the Commonwealth of Puerto Rico, but only if the determination 

of any payment received or accrued under such security does not depend in whole or in part on 

the profits of any entity not described in this category, or payments on any obligation issued by 

such an entity, (v) any security issued by a real estate investment trust; (vi) any other 

arrangement that, as determined by the Secretary, is excepted from the definition of a security.

Safe harbor testing date for certain rents

 The proposal provides specific safe-harbor rules regarding the dates for testing whether 

90 percent of a REIT property is rented to unrelated persons and whether the rents paid by 

related persons are substantially comparable to unrelated party rents. These testing rules are 

provided solely for purposes of the special provision permitting rents received from a related 

party to be treated as qualified rental income for purposes of the income tests.80

Customary services exception 

The proposal prospectively eliminates the safe harbor allowing rents received by a REIT 

to be exempt from the 100 percent excise tax if the rents are for customary services performed by 

the TRS81 or are from a TRS and are for the provision of certain incidental personal property. 

Instead, such payments would be free of the excise tax if they satisfy the present law safe-harbor 

that applies if the REIT pays the TRS at least 150 percent of the cost to the TRS of providing any 

services.

Hedging rules

The rules governing the tax treatment of arrangements engaged in by a REIT to reduce 

interest rate risks are prospectively conformed to the rules included in section 1221.

95-percent gross income requirement 

The proposal prospectively amends the tax liability owed by the REIT when it fails to 

meet the 95-percent of gross income test by applying a taxable fraction based on 95 percent, 

rather than 90 percent of the REIT’s gross income. 

Effective Date

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

 

80 The proposal does not modify any of the standards of section 482 as they apply to 

REITS and to taxable REIT subsidiaries. 

81 Although a REIT could itself provide such services and receive the income for them 

without receiving any disqualified income, in that case the REIT itself would be bearing the cost 

of providing the service. Under the present law exception for a TRS providing such service, 

there is no explicit requirement that the TRS be reimbursed for the full cost of the service.
70

However, some of the provisions are effective for taxable years beginning after the date 

of enactment. These are: the new “look through” rules determining a REIT partner’s share of 

partnership securities for purposes of the “straight debt” rules; the provision changing the 90-

percent of gross income reference to 95 percent, for purposes of the tax liability if a REIT fails to 

meet the 95-ercent of gross income test; the new hedging definition; and the rule modifying the 

treatment of rents with respect to customary services. 

7. Simplification of excise tax imposed on bows and arrows (sec. 1107 of the bill and 

sec. 4161 of the Code)

Present Law

The Code imposes an excise tax of 11 percent on the sale by a manufacturer, producer or 

importer of any bow with a draw rate of 10 pounds or more.82 An excise tax of 12.4 percent is 

imposed on the sale by a manufacturer or importer of any shaft, point, nock, or vane designed for 

use as part of an arrow which after its assembly (1) is over 18 inches long, or (2) is designed for 

use with a taxable bow (if shorter than 18 inches).83 No tax is imposed on finished arrows. An 

11-percent excise tax also is imposed on any part of an accessory for taxable bows and on 

quivers for use with arrows (1) over 18 inches long or (2) designed for use with a taxable bow (if 

shorter than 18 inches).84 

Description of Proposal

The proposal increases the draw weight for a taxable bow from 10 pounds or more to a 

peak draw weight of 30 pounds or more. The proposal also imposes an excise tax of 12 percent 

on arrows generally. An arrow for this purpose is defined as a taxable arrow shaft to which 

additional components are attached. The present law 12.4-percent excise tax on certain arrow 

components is unchanged by the proposal. The proposal provides that the 12-percent excise tax 

on arrows will not apply if the arrow contains an arrow shaft upon which the tax imposed on 

arrow components has been paid. Finally, the proposal subjects certain broadheads (a type of 

arrow point) to an excise tax equal to 11 percent of the sales price instead of 12.4 percent.

Effective Date

The proposal is effective for articles sold by the manufacturer, producer, or importer after 

December 31, 2003.

 

82 Sec. 4161(b)(1)(A).

83 Sec. 4161(b)(2).

84 Sec. 4161(b)(1)(B).
71

8. Repeal excise tax on fishing tackle boxes (sec. 1108 of the bill and sec. 4162 of the Code)

Present Law

Under present law, a 10-percent manufacturer’s excise tax is imposed on specified sport 

fishing equipment. Examples of taxable equipment include fishing rods and poles, fishing reels, 

artificial bait, fishing lures, line and hooks, and fishing tackle boxes. Revenues from the excise 

tax on sport fishing equipment are deposited in the Sport Fishing Account of the Aquatic 

Resources Trust Fund. Monies in the fund are spent, subject to an existing permanent 

appropriation, to support Federal-State sport fish enhancement and safety programs.

Description of Proposal

The proposal repeals the excise tax on fishing tackle boxes.

Effective Date

The provision is effective for articles sold by the manufacturer, producer, or importer 

after December 31, 2003.

9. Income tax credit for cost of carrying tax-paid distilled spirits in wholesale inventories 

(sec. 1109 of the bill, new sec. 5011 of the Code)

Present Law

As is true of most major Federal excise taxes, the excise tax on distilled spirits is imposed 

at a point in the chain of distribution before the product reaches the retail (consumer) level. Tax 

on domestically produced and/or bottled distilled spirits arises upon production (receipt) in a 

bonded distillery and is collected based on removals from the distillery during each semimonthly period. Distilled spirits that are bottled before importation into the United States are 

taxed on removal from the first U.S. warehouse where they are landed (including a warehouse 

located in a foreign trade zone).

No tax credits are allowed under present law for business costs associated with having 

tax-paid products in inventory. Rather, excise tax that is included in the purchase price of a 

product is treated the same as the other components of the product cost, i.e., deductible as a cost 

of goods sold. 

Description of Proposal

The proposal creates a new income tax credit for eligible wholesale distributors of 

distilled spirits. An eligible wholesaler is any person who holds a permit under the Federal 

Alcohol Administration Act as a wholesaler of distilled spirits. 

The credit is calculated by multiplying the number of cases of bottled distilled spirits by 

the average tax-financing cost per case for the most recent calendar year ending before the 

beginning of such taxable year. A case is 12 80-proof 750-milliliter bottles. The average taxfinancing cost per case is the amount of interest that would accrue at corporate overpayment 
72

rates during an assumed 60-day holding period on an assumed tax rate of $22.83 per case of 12 

750-milliliter bottles. 

 The credit only applies to domestically bottled distilled spirits85 purchased directly from 

the bottler of such spirits. The credit is in addition to present-law rules allowing tax included in 

inventory costs to be deducted as a cost of goods sold.

The credit cannot be carried back to a taxable year beginning before January 1, 2004.

Effective Date

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

10. Capital gains treatment to apply to outright sales of timber by landowner (sec. 1110 of 

the bill and sec. 631(b) of the Code)

Present Law

Under present law, a taxpayer disposing of timber held for more than one year is eligible for 

capital gains treatment in three situations. First, if the taxpayer sells or exchanges timber that is 

a capital asset (sec. 1221) or property used in the trade or business (sec. 1231), the gain generally 

is long-term capital gain; however, if the timber is held for sale to customers in the taxpayer’s 

business, the gain will be ordinary income. Second, if the taxpayer disposes of the timber with a 

retained economic interest, the gain is eligible for capital gain treatment (sec. 631(b)). Third, if 

the taxpayer cuts standing timber, the taxpayer may elect to treat the cutting as a sale or 

exchange eligible for capital gains treatment (sec. 631(a)). 

Descripion of Proposal

Under the proposal, in the case of a sale of timber by the owner of the land from which the 

timber is cut, the requirement that a taxpayer retain an economic interest in the timber in order to 

treat gains as capital gain under section 631(b) does not apply. Outright sales of timber by the 

landowner will qualify for capital gains treatment in the same manner as sales with a retained 

economic interest qualify under present law, except that the usual tax rules relating to the timing 

of the income from the sale of the timber will apply (rather than the special rule of section 631(b) 

treating the disposal as occurring on the date the timber is cut).

Effective Date

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

 

85 Distilled spirits that are imported in bulk and then bottled domestically qualify as 

domestically bottled distilled spirits.
73

11. Repeal of excise tax on sonar devices suitable for finding fish (sec. 1111 of the bill, and 

secs. 4161 and 4162 of the Code)

Present Law

In general, the Code imposes a 10 percent tax on the sale by the manufacturer, producer, 

or importer of specified sport fishing equipment. 86 A three percent rate, however, applies to the 

sale of electric outboard motors and sonar devices suitable for finding fish. 87 Further, the tax 

imposed on the sale of electric outboard motors and sonar devices suitable for finding fish is 

limited to $30. A sonar device suitable for finding fish does not include any device that is a 

graph recorder, a digital type, a meter readout, a combination graph recorder or combination 

meter readout. 88

Revenues from the excise tax on sport fishing equipment are deposited in the Sport 

Fishing Account of the Aquatic Resources Trust Fund. Monies in the fund are spent, subject to 

an existing permanent appropriation, to support Federal-State sport fish enhancement and safety 

programs.

Description of Proposal

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

Effective Date

The proposal is effective for articles sold by the manufacturer, producer, or importer after 

December 31, 2003.

12. Taxation of certain settlement funds (sec. 1112 of the bill, sec. 468B of the Code)

Present Law

The cleanup of hazardous waste sites is sometimes funded by environmental “settlement 

funds” or escrow accounts. These escrow accounts are established in consent decrees between 

the Environmental Protection Agency (“EPA”) and the settling parties under the jurisdiction of a

Federal district court. The EPA uses these accounts to resolve claims against private parties 

under Comprehensive Environmental Response, Compensation and Liability Act of 1980 

(“CERCLA”).

In general, section 468(B) provides that a payment to a designated settlement fund that 

extinguishes a tort liability of the taxpayer will result in a deduction to the taxpayer. A 

designated settlement fund means a fund which is established pursuant to a court order, 

 

86 Sec. 4161(a)(1).

87 Sec. 4161(a)(2).

88 Sec. 4162(b).
74

extinguishes the taxpayer's tort liability, is managed and controlled by persons unrelated to the 

taxpayer, and in which the taxpayer does not have a beneficial interest in the trust.

Generally, a designated or qualified settlement fund is taxed as a separate entity at the 

maximum trust rate on its modified income. Modified income is generally gross income less 

deductions for administrative costs and other incidental expenses incurred in connection with the 

operation of the settlement fund.

Description of Proposal

The proposal provides that certain settleme nt funds established in consent decrees for the 

sole purpose of resolving claims under CERCLA are to be treated as beneficially owned by the 

United States government and therefore, not subject to Federal income tax. 

To qualify the settlement fund must be: (1) established pursuant to a consent decree 

entered by a judge of a United States District Court; (2) created for the receipt of settlement 

payments for the sole purpose of resolving or satisfying claims under CERCLA; (3) controlled 

(in terms of expenditures of contributions and earnings thereon) by the government or an agency 

or instrumentality thereof; and (4) upon termination, disbursed to the government or an agency 

or instrumentality thereof (e.g., the EPA).

Effective Date

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

13. Suspension of occupational taxes relating to distilled spirits, wine, and beer (sec. 1113 of 

the bill, sec. 5148 of the Code)

Present Law

Under present law, special occupational taxes are imposed on producers and others 

engaged in the marketing of distilled spirits, wine, and beer. These excise taxes are imposed as 

part of a broader Federal tax and regulatory engine governing the production and marketing of 

alcoholic beverages. The special occupational taxes are payable annually, on July 1 of each year. 

The present tax rates are as follows:

Producers89: 

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

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

Wholesale dealers (sec. 5111):

Liquors, wines, or beer $500 per year

 

89 A reduced rate of tax in the amount of $500.00 is imposed on small proprietors (secs. 

5081(b) and 5091(b)).
75

Retail dealers (sec. 5121):

Liquors, wines, or beer $250 per year

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

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

The Code requires every wholesale or retail dealer in liquors, wine or beer to keep 

records of their transactions.90 A delegate of the Secretary of the Treasury is authorized to 

inspect the records of any dealer during business hours.91 There are penalties for failing to 

comply with the recordkeeping requirements.92

The Code limits the persons from whom dealers may purchase their liquor stock intended 

for resale. Under the Code, a dealer may only purchase from: 

(1) a wholesale dealer in liquors who has paid the special occupational tax as such 

dealer to cover the place where such purchase is made; or

(2) a wholesale dealer in liquors who is exempt, at the place where such purchase is 

made, from payment of such tax under any provision chapter 51 of the Code; or

(3) a person who is not required to pay special occupational tax as a wholesale dealer 

in liquors.93

Violation of this restriction in punishable by $1,000 fine, imprisonment of one year, or 

both. 94 A violation also makes the alcohol subject to seizure and forfeiture.95

Description of Proposal

The special occupational taxes on producers and marketers of alcoholic beverages are 

suspended for a three-year period, July 1, 2004 through June 30, 2007. Present law 

recordkeeping and registration requirements will continue to apply, notwithstanding the 

 

90 Secs. 5114 and 5124.

91 Sec. 5146.

92 Sec. 5603.

93 Sec. 5117. For example, purchases from a proprietor of a distilled spirits plant at his 

principal business office would be covered under item (2) since such a proprietor is not subject to 

the special occupational tax on account of sales at his principal business office (sec. 5113(a)). 

Purchases from a State-operated liquor store would be covered under item (3) (sec. 5113(b)).

94 Sec. 5687.

95 Sec. 7302.
76

suspension of the special occupation taxes. In addition, during the suspension period, it shall be 

unlawful for any dealer to purchase distilled spirits for resale from any person other than a 

wholesale dealer in liquors who is subject to the recordkeeping requirements.

Effective Date

The proposal is effective on the date of enactment. 
77

II. PROPOSALS TO REDUCE TAX AVOIDANCE THROUGH CORPORATE 

EARNINGS STRIPPING AND EXPATRIATION

A. Reduction in Potential for Earnings Stripping by Further Limiting

Deduction for Interest on Certain Indebtedness

(sec. 2001 of the bill and sec. 163(j) of the Code)

Present Law

Present law provides rules to limit the ability of U.S. corporations to reduce the U.S. tax 

on their U.S.-source income through earnings stripping transactions. Section 163(j) specifically 

addresses earnings stripping involving interest payments, by limiting the deductibility of interest 

paid to certain related parties (“disqualified interest”),96 if the payor’s debt-equity ratio exceeds 

1.5 to 1 and the payor’s net interest expense exceeds 50 percent of its “adjusted taxable income” 

(generally taxable income computed without regard to deductions for net interest expense, net 

operating losses, and depreciation, amortization, and depletion). Disallowed interest amounts 

can be carried forward indefinitely. In addition, excess limitation (i.e., any excess of the 50-

percent limit over a company’s net interest expense for a given year) can be carried forward three 

years.

Description of Proposal

The bill strengthens the earnings stripping provisions of section 163(j) in several respects. 

The debt-equity threshold is eliminated, carryovers of excess limitation are eliminated, and 

carryovers of disallowed interest are limited to 10 years. 

In addition, the “adjusted taxable income” percentage threshold is lowered from 50 

percent to 25 percent with respect to disqualified interest other than interest paid to unrelated 

parties on debt that is subject to a related-party guarantee (hereinafter referred to as “guaranteed 

debt”).97 Interest on guaranteed debt generally is not subject to the lowered threshold under the 

bill.98 Disallowed interest is treated as interest on related-party debt to the extent thereof, and 

then as interest on guaranteed debt to the extent of any excess, for purposes of determining 

whether a deduction is allowable for such interest when carried forward to another taxable year.

 

96 This interest also may include interest paid to unrelated parties in certain cases in 

which a related party guarantees the debt. 

97 This lowered threshold is phased in over two years. The threshold is 35 percent for a 

taxpayer’s first taxable year beginning after 2003. The remainder of this discussion describes the 

provisions of the bill as fully phased-in.

98 However, a taxpayer can make a one-time election to apply a 30-percent threshold for 

purposes of determining the disallowance amount with respect to all of its disqualified interest, 

in which case no distinction is made between guaranteed debt and other debt. This election is 

not available to taxpayers involved in certain inversion transactions completed after 1996.
78

The bill applies the different percentage thresholds to interest on related-party debt and 

interest on guaranteed debt by disallowing all disqualified interest, subject to a cap equal to the 

sum of “excess interest expense” and “excess related party interest expense.” Excess interest 

expense is defined as the excess of net interest expense over 50 percent of adjusted taxable 

income. Excess related party interest expense is determined by subtracting 25 percent of 

adjusted taxable income from the lesser of: (1) interest on related-party debt, or (2) net interest 

expense. In no event can the disallowance under the provision reduce the taxpayer’s deduction 

for interest expense below the sum of: (1) the amount of interest income included in the gross 

income of the taxpayer, and (2) 25 percent of adjusted taxable income.

The following examples illustrate the basic operation of the bill:

Example 1.–Foreign Parent owns all the stock of U.S. Subsidiary (“U.S. Sub”). U.S. Sub 

has adjusted taxable income of $100, incurs interest expense of $70 on debt owed to Foreign 

Parent, incurs interest expense of $5 on non-guaranteed debt owed to unrelated third parties, and 

has no interest income or other interest expense. Under the bill, U.S. Sub has $70 of disqualified 

interest, the disallowance of which is subject to a cap equal to the sum of excess interest expense 

($75 - $50 = $25) and excess related party interest expense ($70 - $25 = $45), or $70. Under the 

special disallowance limit, however, the provision cannot cause U.S. Sub’s interest expense 

deduction to fall below $25. Thus, only $50 of interest is disallowed, and U.S. Sub can deduct 

its $5 of unrelated-party interest and $20 of its related-party interest.

Example 2.–Same as Example 1, except U.S. Sub incurs $25 of interest expense on nonguaranteed debt owed to unrelated third parties and $30 of interest expense on debt owed to

Foreign Parent. Under the bill, U.S. Sub has $30 of disqualified interest, the disallowance of 

which is subject to a cap equal to the sum of excess interest expense ($55 - $50 = $5) and excess 

related party interest expense ($30 - $25 = $5), for $10 of disallowance.

Example 3.–Same as Example 2, except U.S. Sub also incurs $20 of interest expense on 

debt owed to unrelated third parties, subject to a guarantee by Foreign Parent. Under the bill, 

U.S. Sub has $30 + $20 = $50 of disqualified interest, the disallowance of which is subject to a 

cap equal to the sum of excess interest expense ($75 - $50 = $25) and excess related party 

interest expense ($30 - $25 = $5), for $30 of disallowance. This example illustrates how the bill 

effectively applies the present-law 50-percent threshold to interest on guaranteed debt, subjecting 

only interest on debt owed to related parties to the lowered threshold under the bill.

Example 4.–Same as Example 3, except U.S. Sub also earns $10 of interest income. 

Under the bill, U.S. Sub has $30 + $20 = $50 of disqualified interest, the disallowance of which 

is subject to a cap equal to the sum of excess interest expense ($65 - $50 = $15) and excess 

related party interest expense ($30 - $25 = $5), for $20 of disallowance.

Example 5.–Same as Example 4, except U.S. Sub earns $50 of interest income. Under 

the bill, U.S. Sub has $30 + $20 = $50 of disqualified interest, the disallowance of which is 

subject to a cap equal to the sum of excess interest expense ($25 - $50 = $0) and excess related 

party interest expense ($25 - $25 = $0), thus yielding no disallowance. Examples 4 and 5 

illustrate the operation of the interest-income netting rules.
79

The bill continues the present-law rules in the case of taxable REIT subsidiaries.

Effective Date

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

For purposes of applying the ten-year limit on carryovers of interest, amounts carried to any 

taxable year beginning after December 31, 2003 are treated as having been first disallowed for 

the most recent taxable year beginning before January 1, 2004. For taxpayers involved in certain 

inversion transactions completed after 1996, the proposal is effective for taxable years ending 

after March 4, 2003, with a similar rule for carryovers. In addition, such taxpayers are subject to 

the fully reduced 25-percent threshold immediately, with no phase-in.
80

B. Tax Treatment of Expatriated Entities

(sec. 2002 of the bill and new sec. 7874 of the Code)

Present Law

Determination of corporate residence

The U.S. tax treatment of a multinational corporate group depends significantly on 

whether the parent corporation of the group is domestic or foreign. For purposes of U.S. tax law, 

a corporation is treated as domestic if it is incorporated under the law of the United States or of 

any State. All other corporations (i.e., those incorporated under the laws of foreign countries) 

are treated as foreign.

U.S. taxation of domestic corporations

The United States employs a “worldwide” tax system, under which domestic corporations 

generally are taxed on all income, whether derived in the United States or abroad. In order to 

mitigate the double taxation that may arise from taxing the foreign-source income of a domestic 

corporation, a foreign tax credit for income taxes paid to foreign countries is provided to reduce 

or eliminate the U.S. tax owed on such income, subject to certain limitations. 

Income earned by a domestic parent corporation from foreign operations conducted by 

foreign corporate subsidiaries generally is subject to U.S. tax when the income is distributed as a 

dividend to the domestic corporation. Until such repatriation, the U.S. tax on such income is 

generally deferred. However, certain anti-deferral regimes may cause the domestic parent 

corporation to be taxed on a current basis in the United States with respect to certain categories 

of passive or highly mobile income earned by its foreign subsidiaries, regardless of whether the 

income has been distributed as a dividend to the domestic parent corporation. The main antideferral regimes in this context are the controlled foreign corporation rules of subpart F (sections 

951-964) and the passive foreign investment company rules (sections 1291-1298). A foreign tax 

credit is generally available to offset, in whole or in part, the U.S. tax owed on this foreignsource income, whether repatriated as an actual dividend or included under one of the antideferral regimes.

U.S. taxation of foreign corporations

The United States taxes foreign corporations only on income that has a sufficient nexus to 

the United States. Thus, a foreign corporation is generally subject to U.S. tax only on income 

that is “effectively connected” with the conduct of a trade or business in the United States. Such 

“effectively connected income” generally is taxed in the same manner and at the same rates as 

the income of a U.S. corporation. An applicable tax treaty may limit the imposition of U.S. tax 

on business operations of a foreign corporation to cases in which the business is conducted 

through a “permanent establishment” in the United States.

In addition, foreign corporations generally are subject to a gross-basis U.S. tax at a flat 

30-percent rate on the receipt of interest, dividends, rents, royalties, and certain similar types of 

income derived from U.S. sources, subject to certain exceptions. The tax generally is collected 
81

by means of withholding by the person making the payment. This tax may be reduced or 

eliminated under an applicable tax treaty. 

U.S. tax treatment of inversion transactions

Under present law, a U.S. corporation may reincorporate in a foreign jurisdiction and 

thereby replace the U.S. parent corporation of a multinational corporate group with a foreign 

parent corporation. These transactions are commonly referred to as inversion transactions. 

Inversion transactions may take many different forms, including stock inversions, asset 

inversions, and various combinations of and variations on the two. Most of the known 

transactions to date have been stock inversions. In one example of a stock inversion, a U.S. 

corporation forms a foreign corporation, which in turn forms a domestic merger subsidiary. The 

domestic merger subsidiary then merges into the U.S. corporation, with the U.S. corporation 

surviving, now as a subsidiary of the new foreign corporation. The U.S. corporation’s 

shareholders receive shares of the foreign corporation and are treated as having exchanged their 

U.S. corporation shares for the foreign corporation shares. An asset inversion reaches a similar 

result, but through a direct merger of the top-tier U.S. corporation into a new foreign corporation, 

among other possible forms. An inversion transaction may be accompanied or followed by 

further restructuring of the corporate group. For example, in the case of a stock inversion, in 

order to remove income from foreign operations from the U.S. taxing jurisdiction, the U.S. 

corporation may transfer some or all of its foreign subsidiaries directly to the new foreign parent 

corporation or other related foreign corporations. 

In addition to removing foreign operations from the U.S. taxing jurisdiction, the 

corporate group may derive further advantage from the inverted structure by reducing U.S. tax 

on U.S.-source income through various earnings stripping or other transactions. This may 

include earnings stripping through payment by a U.S. corporation of deductible amounts such as 

interest, royalties, rents, or management service fees to the new foreign parent or other foreign 

affiliates. In this respect, the post-inversion structure enables the group to employ the same taxreduction strategies that are available to other multinational corporate groups with foreign 

parents and U.S. subsidiaries, subject to the same limitations (e.g., sections 163(j) and 482). 

Inversion transactions may give rise to immediate U.S. tax consequences at the 

shareholder and/or the corporate level, depending on the type of inversion. In stock inversions, 

the U.S. shareholders generally recognize gain (but not loss) under section 367(a), based on the 

difference between the fair market value of the foreign corporation shares received and the 

adjusted basis of the domestic corporation stock exchanged. To the extent that a corporation’s 

share value has declined, and/or it has many foreign or tax-exempt shareholders, the impact of 

this section 367(a) “toll charge” is reduced. The transfer of foreign subsidiaries or other assets to 

the foreign parent corporation also may give rise to U.S. tax consequences at the corporate level 

(e.g., gain recognition and earnings and profits inclusions under sections 1001, 311(b), 304, 367, 

1248 or other provisions). The tax on any income recognized as a result of these restructurings 

may be reduced or eliminated through the use of net operating losses, foreign tax credits, and 

other tax attributes. 

In asset inversions, the U.S. corporation generally recognizes gain (but not loss) under 

section 367(a) as though it had sold all of its assets, but the shareholders generally do not 
82

recognize gain or loss, assuming the transaction meets the requirements of a reorganization under 

section 368.

Description of Proposal

The bill applies special tax rules to corporations that undertake certain defined inversion 

transactions. For this purpose, an inversion is a transaction in which, pursuant to a plan or a 

series of related transactions: (1) a U.S. corporation becomes a subsidiary of a foreignincorporated entity or otherwise transfers substantially all of its properties to such an entity after 

March 4, 2003; (2) the former shareholders of the U.S. corporation hold (by reason of holding 

stock in the U.S. corporation) 60 percent or more (by vote or value) of the stock of the foreignincorporated entity after the transaction; and (3) the foreign-incorporated entity, considered 

together with all companies connected to it by a chain of greater than 50-percent ownership (i.e., 

the “expanded affiliated group”) does not conduct substantial business activities in the entity’s 

country of incorporation compared to the total worldwide business activities of the expanded 

affiliated group.

In such a case, any applicable corporate-level “toll charges” for establishing the inverted 

structure are not offset by tax attributes such as net operating losses or foreign tax credits. 

Specifically, any applicable corporate-level income or gain required to be recognized under 

sections 304, 311(b), 367, 1001, 1248, or any other provision with respect to the transfer of 

controlled foreign corporation stock or the transfer or license of other assets by a U.S. 

corporation as part of the inversion transaction or after such transaction to a related foreign 

person is taxable, without offset by any tax attributes (e.g., net operating losses or foreign tax 

credits). This rule does not apply to certain transfers of inventory and similar property. These 

measures generally apply for a 10-year period following the inversion transaction.

In determining whether a transaction meets the definition of an inversion under the 

proposal, stock held by members of the expanded affiliated group that includes the foreign 

incorporated entity is disregarded. For example, if the former top-tier U.S. corporation receives 

stock of the foreign incorporated entity (e.g., so-called “hook” stock), the stock would not be 

considered in determining whether the transaction meets the definition. Similarly, if a U.S. 

parent corporation converts an existing wholly owned U.S. subsidiary into a new wholly owned 

controlled foreign corporation, the stock of the new foreign corporation would be disregarded. 

Stock sold in a public offering related to the transaction also is disregarded for these purposes.

Transfers of properties or liabilities as part of a plan a principal purpose of which is to 

avoid the purposes of the proposal are disregarded. In addition, the Treasury Secretary is granted 

authority to prevent the avoidance of the purposes of the proposal, including avoidance through 

the use of related persons, pass-through or other noncorporate entities, or other intermediaries, 

and through transactions designed to qualify or disqualify a person as a related person or a 

member of an expanded affiliated group. Similarly, the Treasury Secretary is granted authority 

to treat certain non-stock instruments as stock, and certain stock as not stock, where necessary to 

carry out the purposes of the proposal.

Under the proposal, inversion transactions include certain partnership transactions. 

Specifically, the proposal applies to transactions in which a foreign-incorporated entity acquires 
83

substantially all of the properties constituting a trade or business of a domestic partnership, if 

after the acquisition at least 60 percent of the stock of the entity is held by former partners of the 

partnership (by reason of holding their partnership interests), provided that the other terms of the 

basic definition are met. For purposes of applying this test, all partnerships that are under 

common control within the meaning of section 482 are treated as one partnership, except as 

provided otherwise in regulations. In addition, the modified “toll charge” provisions apply at the 

partner level.

A transaction otherwise meeting the definition of an inversion transaction is not treated as 

an inversion transaction if, on or before March 4, 2003, the foreign-incorporated entity had 

acquired directly or indirectly more than half of the properties held directly or indirectly by the 

domestic corporation, or more than half of the properties constituting the partnership trade or 

business, as the case may be.

Effective Date

The proposal applies to taxable years ending after March 4, 2003.
84

C. Excise Tax on Stock Compensation of Insiders in Expatriated Corporations

(sec. 2003 of the bill and secs. 162(m), 275(a), and new sec. 4985 of the Code)

Present Law

The income taxation of a nonstatutory99 compensatory stock option is determined under 

the rules that apply to property transferred in connection with the performance of services (sec. 

83). If a nonstatutory stock option does not have a readily ascertainable fair market value at the 

time of grant, which is generally the case unless the option is actively traded on an established 

market, no amount is included in the gross income of the recipient with respect to the option until 

the recipient exercises the option. 100 Upon exercise of such an option, the excess of the fair 

market value of the stock purchased over the option price is generally included in the recipient’s 

gross income as ordinary income in such taxable year.101 

The tax treatment of other forms of stock-based compensation (e.g., restricted stock and 

stock appreciation rights) is also determined under section 83. The excess of the fair market 

value over the amount paid (if any) for such property is generally includable in gross income in 

the first taxable year in which the rights to the property are transferable or are not subject to 

substantial risk of forfeiture. 

Shareholders are generally required to recognize gain upon stock inversion transactions. 

An inversion transaction is generally not a taxable event for holders of stock options and other 

stock-based compensation.

Description of Proposal

Under the proposal, specified holders of stock options and other stock-based 

compensation are subject to an excise tax upon certain inversion transactions. The proposal 

imposes a 15-percent excise tax on the value of specified stock compensation held (directly or 

indirectly) by or for the benefit of a disqualified individual, or a member of such individual’s 

family, at any time during the 12-month period beginning six months before the corporation’s 

expatriation date. Specified stock compensation is treated as held for the benefit of a disqualified 

individual if such compensation is held by an entity, e.g., a partnership or trust, in which the 

individual, or a member of the individual’s family, has an ownership interest.

 

99 Nonstatutory stock options refer to stock options other than incentive stock options 

and employee stock purchase plans, the taxation of which is determined under sections 421-424. 

100 If an individual receives a grant of a nonstatutory option that has a readily 

ascertainable fair market value at the time the option is granted, the excess of the fair market 

value of the option over the amount paid for the option is included in the recipient’s gross 

income as ordinary income in the first taxable year in which the option is either transferable or 

not subject to a substantial risk of forfeiture.

101 Under section 83, such amount is includable in gross income in the first taxable year 

in which the rights to the stock are transferable or are not subject to substantial risk of forfeiture.
85

A disqualified individual is any individual who, with respect to a corporation, is, at any 

time during the 12-month period beginning on the date which is six months before the 

expatriation date, subject to the requirements of section 16(a) of the Securities and Exchange Act 

of 1934 with respect to the corporation, or any member of the corporation’s expanded affiliated 

group,102 or would be subject to such requirements if the corporation (or member) were an issuer 

of equity securities referred to in section 16(a). Disqualified individuals generally include 

officers (as defined by section 16(a)),103 directors, and 10-percent-or-greater owners of private 

and publicly-held corporations.

The excise tax is imposed on a disqualified individual of an expatriated corporation (as 

previously defined in the bill) only if gain (if any) is recognized in whole or part by any 

shareholder by reason of a corporate inversion transaction previously defined in the bill.

Specified stock compensation subject to the excise tax includes any payment104 (or right 

to payment) granted by the expatriated corporation (or any member of the corporation’s 

expanded affiliated group) to any person in connection with the performance of services by a 

disqualified individual for such corporation (or member of the corporation’s expanded affiliated 

group) if the value of the payment or right is based on, or determined by reference to, the value 

or change in value of stock of such corporation (or any member of the corporation’s expanded 

affiliated group). In determining whether such compensation exists and valuing such 

compensation, all restrictions, other than a non-lapse restriction, are ignored. Thus, the excise 

tax applies, and the value subject to the tax is determined, without regard to whether such 

specified stock compensation is subject to a substantial risk of forfeiture or is exercisable at the 

time of the inversion transaction. Specified stock compensation includes compensatory stock 

and restricted stock grants, compensatory stock options, and other forms of stock-based 

compensation, including stock appreciation rights, phantom stock, and phantom stock options. 

Specified stock compensation also includes nonqualified deferred compensation that is treated as 

though it were invested in stock or stock options of the expatriating corporation (or member). 

For example, the proposal applies to a disqualified individual’s deferred compensation if 

company stock is one of the actual or deemed investment options under the nonqualified deferred 

compensation plan. 

 

102 An expanded affiliated group is an affiliated group (under section 1504) except that 

such group is determined without regard to the exceptions for certain corporations and is 

determined applying a greater than 50 percent threshold, in lieu of the 80 percent test.

103 An officer is defined as the president, principal financial officer, principal accounting 

officer (or, if there is no such accounting officer, the controller), any vice-president in charge of 

a principal business unit, division or function (such as sales, administration or finance), any other 

officer who performs a policy-making function, or any other person who performs similar 

policy-making functions.

104 Under the proposal, any transfer of property is treated as a payment and any right to a 

transfer of property is treated as a right to a payment. 
86

Specified stock compensation includes a compensation arrangement that gives the 

disqualified individual an economic stake substantially similar to that of a corporate shareholder. 

Thus, the excise tax does not apply if a payment is simply triggered by a target value of the 

corporation’s stock or where a payment depends on a performance measure other than the value 

of the corporation’s stock. Similarly, the tax does not apply if the amount of the payment is not 

directly measured by the value of the stock or an increase in the value of the stock. For example, 

an arrangement under which a disqualified individual would be paid a cash bonus of $500,000 if 

the corporation’s stock increased in value by 25 percent over two years or $1,000,000 if the stock 

increased by 33 percent over two years is not specified stock compensation, even though the 

amount of the bonus generally is keyed to an increase in the value of the stock. By contrast, an 

arrangement under which a disqualified individual would be paid a cash bonus equal to $10,000 

for every $1 increase in the share price of the corporation’s stock is subject to the proposal 

because the direct connection between the compensation amount and the value of the 

corporation’s stock gives the disqualified individual an economic stake substantially similar to 

that of a shareholder.

The excise tax applies to any such specified stock compensation previously granted to a 

disqualified individual but cancelled or cashed-out within the six-month period ending with the 

expatriation date, and to any specified stock compensation awarded in the six-month period 

beginning with the expatriation date. As a result, for example, if a corporation cancels 

outstanding options three months before the transaction and then reissues comparable options 

three months after the transaction, the tax applies both to the cancelled options and the newly 

granted options. It is intended that the Secretary issue guidance to avoid double counting with 

respect to specified stock compensation that is cancelled and then regranted during the applicable 

twelve-month period.

Specified stock compensation subject to the tax does not include a statutory stock option 

or any payment or right from a qualified retirement plan or annuity, tax-sheltered annuity, 

simplified employee pension, or SIMPLE. In addition, under the proposal, the excise tax does 

not apply to any stock option that is exercised during the six-month period before the 

expatriation date or to any stock acquired pursuant to such exercise, if income is recognized 

under section 83 on or before the expatriation date with respect to the stock acquired pursuant to 

such exercise. The excise tax also does not apply to any specified stock compensation that is 

exercised, sold, exchanged, distributed, cashed-out, or otherwise paid during such period in a 

transaction in which income, gain, or loss is recognized in full.

For specified stock compensation held on the expatriation date, the amount of the tax is 

determined based on the value of the compensation on such date. The tax imposed on specified 

stock compensation cancelled during the six-month period before the expatriation date is 

determined based on the value of the compensation on the day before such cancellation, while 

specified stock compensation granted after the expatriation date is valued on the date granted. 

Under the proposal, the cancellation of a non-lapse restriction is treated as a grant. 

The value of the specified stock compensation on which the excise tax is imposed is the 

fair value in the case of stock options (including warrants or other similar rights to acquire stock) 

and stock appreciation rights and the fair market value for all other forms of compensation. For 

purposes of the tax, the fair value of an option (or a warrant or other similar right to acquire 
87

stock) or a stock appreciation right is determined using an appropriate option-pricing model, as 

specified or permitted by the Secretary, that takes into account the stock price at the valuation 

date; the exercise price under the option; the remaining term of the option; the volatility of the 

underlying stock and the expected dividends on it; and the risk-free interest rate over the 

remaining term of the option. Options that have no intrinsic value (or “spread”) because the 

exercise price under the option equals or exceeds the fair market value of the stock at valuation 

nevertheless have a fair value and are subject to tax under the proposal. The value of other forms 

of compensation, such as phantom stock or restricted stock, is the fair market value of the stock 

as of the date of the expatriation transaction. The value of any deferred compensation that can be 

valued by reference to stock is the amount that the disqualified individual would receive if the 

plan were to distribute all such deferred compensation in a single sum on the date of the 

expatriation transaction (or the date of cancellation or grant, if applicable). It is expected that the 

Secretary issue guidance on valuation of specified stock compensation, including guidance 

similar to the revenue procedures issued under section 280G, except that the guidance would not 

permit the use of a term other than the full remaining term and would be modified as necessary 

or appropriate to carry out the purposes of the provision. Pending the issuance of guidance, it is 

intended that taxpayers can rely on the revenue procedure issued under section 280G (except that 

the full remaining term must be used and recalculation is not permitted). 

The excise tax also applies to any payment by the expatriated corporation or any member 

of the expanded affiliated group made to an individual, directly or indirectly, in respect of the 

tax. Whether a payment is made in respect of the tax is determined under all of the facts and 

circumstances. Any payment made to keep the individual in the same after-tax position that the 

individual would have been in had the tax not applied is a payment made in respect of the tax. 

This includes direct payments of the tax and payments to reimburse the individual for payment 

of the tax. It is expected that the Secretary issue guidance on determining when a payment is 

made in respect of the tax and that such guidance include certain factors that give rise to a 

rebuttable presumption that a payment is made in respect of the tax, including a rebuttable 

presumption that if the payment is contingent on the inversion transaction, it is made in respect 

to the tax. Any payment made in respect of the tax is includible in the income of the individual, 

but is not deductible by the corporation.

To the extent that a disqualified individual is also a covered employee under section 

162(m), the $1,000,000 limit on the deduction allowed for employee remuneration for such 

employee is reduced by the amount of any payment (including reimbursements) made in respect 

of the tax under the proposal. As discussed above, this includes direct payments of the tax and 

payments to reimburse the individual for payment of the tax. 

The payment of the excise tax has no effect on the subsequent tax treatment of any 

specified stock compensation. Thus, the payment of the tax has no effect on the individual’s 

basis in any specified stock compensation and no effect on the tax treatment for the individual at 

the time of exercise of an option or payment of any specified stock compensation, or at the time 

of any lapse or forfeiture of such specified stock compensation. The payment of the tax is not 

deductible and has no effect on any deduction that might be allowed at the time of any future 

exercise or payment.
88

Under the proposal, the Secretary is authorized to issue regulations as may be necessary 

or appropriate to carry out the purposes of the proposal.

Effective Date

The proposal is effective as of March 4, 2003, except that periods before March 4, 2003, 

are not taken into account in applying the excise tax to specified stock compensation held or 

cancelled during the six-month period before the expatriation date.
89

D. Reinsurance of U.S. Risks in Foreign Jurisdictions

(sec. 2004 of the bill and sec. 845(a) of the Code)

Present Law

In the case of a reinsurance agreement between two or more related persons, present law 

provides the Treasury Secretary with authority to allocate among the parties or recharacterize 

income (whether investment income, premium or otherwise), deductions, assets, reserves, credits 

and any other items related to the reinsurance agreement, or make any other adjustment, in order 

to reflect the proper source and character of the items for each party. 105 For this purpose, related 

persons are defined as in section 482. Thus, persons are related if they are organizations, trades 

or businesses (whether or not incorporated, whether or not organized in the United States, and 

whether or not affiliated) that are owned or controlled directly or indirectly by the same interests. 

The provision may apply to a contract even if one of the related parties is not a domestic 

company. 106 In addition, the provision also permits such allocation, recharacterization, or other 

adjustments in a case in which one of the parties to a reinsurance agreement is, with respect to 

any contract covered by the agreement, in effect an agent of another party to the agreement, or a 

conduit between related persons. 

Description of Proposal

The bill clarifies the rules of section 845, relating to authority for the Treasury Secretary 

to allocate items among the parties to a reinsurance agreement, recharacterize items, or make any 

other adjustment, in order to reflect the proper source and character of the items for each party. 

The bill authorizes such allocation, recharacterization, or other adjustment, in order to reflect the 

proper source, character or amount of the item. It is intended that this authority107 be exercised 

in a manner similar to the authority under section 482 for the Treasury Secretary to make 

adjustments between related parties. It is intended that this authority be applied in situations in 

which the related persons (or agents or conduits) are engaged in cross-border transactions that 

require allocation, recharacterization, or other adjustments in order to reflect the proper source, 

character or amount of the item or items. No inference is intended that present law does not 

provide this authority with respect to reinsurance agreements.

No regulations have been issued under section 845(a). It is expected that the Treasury 

Secretary will issue regulations under section 845(a) to address effectively the allocation of 

income (whether investme nt income, premium or otherwise) and other items, the 

recharacterization of such items, or any other adjustment necessary to reflect the proper amount, 

source or character of the item.

 

105 Sec. 845(a).

106 See S. Rep. No. 97-494, 99th Cong., 2d Sess., 337 (1982) (describing provisions 

relating to the repeal of modified coinsurance provisions).

107 The authority to allocate, recharacterize or make other adjustments was granted in 

connection with the repeal of provisions relating to modified coinsurance transactions.
90

Effective Date

The proposal is effective for any risk reinsured after the date of enactment of the 

proposal.
91

E. Modification of the Tax Treatment of Individual Expatriates

(sec. 2005 of the bill and secs. 877, 2107, 2501 and 6039G of the Code)

Present Law

U.S. citizens and residents generally are subject to U.S income taxation on their 

worldwide income. The U.S. tax may be reduced or offset by a credit allowed for foreign 

income taxes paid with respect to foreign source income. Nonresidents who are not U.S. citizens 

are taxed at a flat rate of 30 percent (or a lower treaty rate) on certain types of passive income 

derived from U.S. sources, and at regular graduated rates on net profits derived from a U.S. trade 

or business. 

An individual who relinquishes his or her U.S. citizenship or terminates his or her U.S. 

residency108 with a principal purpose of avoiding U.S. taxes is subject to an alternative method of 

income taxation for the 10 taxable years ending after the citizenship relinquishment or residency 

termination (the “alternative tax regime”). The alternative tax regime modifies the rules 

generally applicable to the taxation of nonresident noncitizens. For the 10-year period, the 

individual is subject to tax only on U.S.-source income at the rates applicable to U.S. citizens, 

rather than the rates applicable to nonresident noncitizens. However, for this purpose, U.S.-

source income has a broader scope than it does for normal U.S. Federal tax purposes and 

includes, for example, gain from the sale of U.S. corporate stock or debt obligations. The 

alternative tax regime applies only if it results in a higher U.S. tax liability than the liability that 

would result if the individual were taxed as a nonresident noncitizen. 

In addition, the alternative tax regime includes special estate and gift tax rules. Under 

present law, estates of nonresident noncitizens are subject to U.S. estate tax on U.S.-situated 

property. For these purposes, stock in a foreign corporation generally is not treated as U.S.-

situated property, even if the foreign corporation itself owns U.S.-situated property. However, a 

special estate tax rule (sec. 2107) applies to former citizens and former long-term residents who 

are subject to the alternative tax regime. Under this rule, certain closely-held foreign stock 

owned by the former citizen or former long-term resident is includible in his or her gross estate 

to the extent that the foreign corporation owns U.S.-situated assets, if the former citizen or 

former long-term resident dies within 10 years of citizenship relinquishment or residency 

termination. This rule prevents former citizens and former long-term residents who are subject 

to the alternative tax regime from avoiding U.S. estate tax through the expedient of transferring 

U.S.-situated assets to a foreign corporation (subject to income tax on any appreciation under 

section 367). In addition, under the alternative tax regime, the individual is subject to gift tax on 

 

108 The alternative tax regime applies to long-term residents of the United States that 

have terminated their residency with a principal purpose of avoiding U.S. tax. A “long-term 

resident” is any individual who was a lawful permanent resident of the United States for at least 

8 out of the 15 taxable years ending with the year in which such termination occurs. In applying 

the 8-year test, an individual is not considered to be a lawful permanent resident for any year in 

which the individual is treated as a resident of another country under a treaty tiebreaker rule (and 

the individual does not elect to waive the benefits of such treaty). 
92

gifts of U.S.-situated intangibles, such as U.S. stock, made during the 10 years following 

citizenship relinquishment or residency termination. 

Anti-abuse rules are provided to prevent the circumvention of the alternative tax regime. 

Accordingly, the alternative tax regime generally applies to an exchange of property that gives 

rise to U.S.-source income for property that gives rise to foreign source income. In addition, 

amounts earned by former citizens and former long-term residents through controlled foreign 

corporations are subject to the alternative tax regime, and the 10-year liability period is 

suspended during any time a former citizen’s or former long-term resident’s risk of loss with 

respect to property subject to the alternative tax regime is substantially diminished, among other 

measures.

A U.S. citizen who relinquishes citizenship or a long-term resident who terminates 

residency is treated as having done so with a principal purpose of tax avoidance (and, thus, 

generally is subject to the alternative tax regime described above) if: (1) the individual’s average 

annual U.S. Federal income tax liability for the five taxable years preceding citizenship 

relinquishment or residency termination exceeds $100,000; or (2) the individual’s net worth on 

the date of citizenship relinquishment or residency termination equals or exceeds $500,000. 

These amounts are adjusted annually for inflation.109 Certain categories of individuals may 

avoid being deemed to have a tax avoidance purpose for relinquishing citizenship or terminating 

residency by submitting a ruling request to the IRS regarding whether the individual relinquished 

citizenship or terminated residency principally for tax reasons. 

Under present law, the Immigration and Nationality Act governs the determination of 

when a U.S. citizen is treated for U.S. Federal tax purposes as having relinquished citizenship. 

Similarly, an individual’s U.S. residency is considered terminated for U.S. Federal tax purposes 

when the individual ceases to be a lawful permanent resident under the immigration laws (or is 

treated as a resident of another country under a tax treaty and does not waive the benefits of such 

treaty). In view of this reliance on immigration-law status, it is possible in many instances for a 

U.S. citizen or resident to convert his or her Federal tax status to that of a nonresident noncitizen 

without notifying the IRS. 

Individuals subject to the alternative tax regime are required to provide certain tax 

information, including tax identification numbers, upon relinquishment of citizenship or 

termination of residency (on IRS Form 8854, Expatriation Initial Information Statement). In the 

case of an individual with a net worth of at least $500,000, the individual also must provide 

detailed information about the individual’s assets and liabilities. The penalty for failure to 

provide the required tax information is the greater of $1,000 or five percent of the tax imposed 

under the alternative tax regime for the year.110 In addition, the U.S. Department of State and 

other governmental agencies are required to provide this information to the IRS.

 

109 The income tax liability and net worth thresholds under section 877(a)(2) for 2003 are 

$122,000 and $608,000, respectively. See Rev. Proc. 2002-70, 2002-46 I.R.B. 845.

110 The penalty applies for each year of the 10-year period beginning on the date the 

individual ceases to be a U.S. citizen or resident. 
93

Former citizens and former long-term residents who are subject to the alternative tax 

regime also are required to file annual income tax returns, but only in the event that they owe 

U.S. Federal income tax. If a tax return is required, the former citizen or former long-term 

resident is required to provide the IRS with a statement setting forth (generally by category) all 

items of U.S.-source and foreign-source gross income, but no detailed information with respect 

to all assets held by the individual.

Description of Proposal

In general 

The bill provides: (1) objective standards for determining whether former citizens or 

former long-term residents are subject to the alternative tax regime; (2) tax-based (instead of 

immigration-based) rules for determining when an individual is no longer a U.S. citizen or longterm resident for U.S. Federal tax purposes; (3) the imposition of full U.S. taxation for 

individuals who are subject to the alternative tax regime and who return to the United States for 

extended periods; (4) imposition of U.S. gift tax on gifts of stock of certain closely-held foreign 

corporations that hold U.S.-situated property; and (5) an annual return-filing requirement for 

individuals who are subject to the alternative tax regime, for each of the 10 years following 

citizenship relinquishme nt or residency termination. 111

Objective rules for the alternative tax regime

The bill replaces the subjective determination of tax avoidance as a principal purpose for 

citizenship relinquishment or residency termination under present law with objective rules. 

Under the bill, a former citizen or former long-term resident would be subject to the alternative 

tax regime for a 10-year period following citizenship relinquishment or residency termination, 

unless the former citizen or former long-term resident: (1) establishes that his or her average 

annual net income tax liability for the five preceding years does not exceed $122,000 (adjusted 

for inflation after 2003) and his or her net worth does not exceed $2 million, or alternatively 

satisfies limited, objective exceptions for dual citizens and minors who have had no substantial 

contact with the United States; and (2) certifies under penalties of perjury that he or she has 

complied with all U.S. Federal tax obligations for the preceding five years and provides such 

evidence of compliance as the Secretary of the Treasury may require.

The monetary thresholds under the bill replace the present-law inquiry into the taxpayer’s 

intent. In addition, the bill eliminates the present-law process of IRS ruling requests.

If a former citizen exceeds the monetary thresholds, that person is excluded from the 

alternative tax regime if he or she falls within the exceptions for certain dual citizens and minors 

(provided that the requirement of certification and proof of compliance with Federal tax 

obligations is met). These exceptions provide relief to individuals who have never had 

 

111 These proposals reflect recommendations contained in Joint Committee on Taxation, 

Review of the Present Law Tax and Immigration Treatment of Relinquishment of Citizenship and 

Termination of Long-Term Residency, (JCS-2-03), February 2003.
94

substantial connections with the United States, as measured by certain objective criteria, and 

eliminate IRS inquiries as to the subjective intent of such taxpayers. 

In order to be excepted from the application of the alternative tax regime under the bill, 

whether by reason of falling below the net worth and income tax liability thresholds or 

qualifying for the dual-citizen or minor exceptions, the former citizen or former long-term 

resident also is required to certify, under penalties of perjury, that he or she has complied with all 

U.S. Federal tax obligations for the five years preceding the relinquishment of citizenship or 

termination of residency and to provide such documentation as the Secretary of the Treasury may 

require evidencing such compliance (e.g., tax returns, proof of tax payments). Until such time, 

the individual remains subject to the alternative tax regime. It is intended that the IRS will 

continue to verify that the information submitted was accurate, and it is intended that the IRS 

will randomly audit such persons to assess compliance.

Termination of U.S. citizenship or long-term resident status for U.S. Federal income tax 

purposes

Under the bill, an individual continues to be treated as a U.S. citizen or long-term resident 

for U.S. Federal tax purposes, including for purposes of section 7701(b)(10), until the individual: 

(1) gives notice of an expatriating act or termination of residency (with the requisite intent to 

relinquish citizenship or terminate residency) to the Secretary of State or the Secretary of 

Homeland Security, respectively; and (2) provides a statement in accordance with section 

6039G.

Sanction for individuals subject to the individual tax regime who return to the United 

States for extended periods

The alternative tax regime does not apply to any individual for any taxable year during 

the 10-year period following citizenship relinquishment or residency termination if such 

individual is present in the United States for more than 30 days in the calendar year ending in 

such taxable year. Such individual is treated as a U.S. citizen or resident for such taxable year 

and therefore is taxed on his or her worldwide income. 

Similarly, if an individual subject to the alternative tax regime is present in the United 

States for more than 30 days in any calendar year ending during the 10-year period following 

citizenship relinquishment or residency termination, and the individual dies during that year, he 

or she is treated as a U.S. resident, and the individual’s worldwide estate is subject to U.S. estate 

tax. Likewise, if an individual subject to the alternative tax regime is present in the United States 

for more than 30 days in any year during the 10-year period following citizenship relinquishment 

or residency termination, the individual is subject to U.S. gift tax on any transfer of his or her 

worldwide assets by gift during that taxable year.

For purposes of these rules, an individual is treated as present in the United States on any 

day if such individual is physically present in the United States at any time during that day. The 

present-law exceptions from being treated as present in the United States for residency 

purposes112 generally do not apply for this purpose. However, for individuals with certain ties to 

 

112 Sections 7701(b)(3)(D), 7701(b)(5) and 7701(b)(7)(B)-(D).
95

countries other than the United States113 and individuals with minimal prior physical presence in 

the United States,114 a day of physical presence in the United States is disregarded if the 

individual is performing services in the United States on such day for an unrelated employer 

(within the meaning of sections 267 and 707), who meets the requirements the Secretary of the 

Treasury may prescribe in regulations. No more than 30 days may be disregarded during any 

calendar year under this rule. 

Imposition of gift tax with respect to stock of certain closely held foreign corporations

Gifts of stock of certain closely-held foreign corporations by a former citizen or former 

long-term resident who is subject to the alternative tax regime are subject to gift tax under this 

bill, if the gift is made within the 10-year period after citizenship relinquishment or residency 

termination. The gift tax rule applies if: (1) the former citizen or former long-term resident, 

before making the gift, directly or indirectly owns 10 percent or more of the total combined 

voting power of all classes of stock entitled to vote of the foreign corporation; and (2) directly or 

indirectly, is considered to own more than 50 percent of (a) the total combined voting power of 

all classes of stock entitled to vote in the foreign corporation, or (b) the total value of the stock of 

such corporation. If this stock ownership test is met, then taxable gifts of the former citizen or 

former long-term resident include that proportion of the fair market value of the foreign stock 

transferred by the individual, at the time of the gift, which the fair market value of any assets 

owned by such foreign corporation and situated in the United States (at the time of the gift) bears 

to the total fair market value of all assets owned by such foreign corporation (at the time of the 

gift). 

This gift tax rule applies to a former citizen or former long-term resident who is subject to 

the alternative tax regime and who owns stock in a foreign corporation at the time of the gift, 

regardless of how such stock was acquired (e.g., whether issued originally to the donor, 

purchased, or received as a gift or bequest).

 

113 An individual has such a relationship to a foreign country if the individual becomes a 

citizen or resident of the country in which (1) the individual becomes fully liable for income tax 

or (2) the individual was born, such individual’s spouse was born, or either of the individual’s 

parents was born. 

114 An individual has a minimal prior physical presence in the United States if the 

individual was physically present for no more than 30 days during each year in the ten-year 

period ending on the date of loss of United States citizenship or termination of residency. 

However, an individual is not treated as being present in the United States on a day if (1) the 

individual is a teacher or trainee, a student, a professional athlete in certain circumstances, or a 

foreign government-related individual or (2) the individual remained in the United States 

because of a medical condition that arose while the individual was in the United States. Section 

7701(b)(3)(D)(ii). 
96

Annual return

The bill requires former citizens and former long-term residents to file an annual return 

for each year following citizenship relinquishment or residency termination in which they are 

subject to the alternative tax regime. The annual return is required even if no U.S. Federal 

income tax is due. The annual return requires certain information, including information on the 

permanent home of the individual, the individual’s country of residence, the number of days the 

individual was present in the United States for the year, and detailed information about the 

individual’s income and assets that are subject to the alternative tax regime. This requirement 

includes information relating to foreign stock potentially subject to the special estate tax rule of 

section 2107(b) and the gift tax rules of this bill. 

If the individual fails to file the statement in a timely manner or fails correctly to include 

all the required information, the individual is required to pay a penalty of $5,000. The $5,000

penalty does not apply if it is shown that the failure is due to reasonable cause and not to willful 

neglect.

Effective Date

The proposal applies to individuals who relinquish citizenship or terminate long-term 

residency after February 27, 2003.
97

F. Reporting of Taxable Mergers and Acquisitions

(sec. 2006 of the bill and new sec. 6043A of the Code)

Present Law

Under section 6045 and the regulations thereunder, brokers (defined to include stock 

transfer agents) are required to make information returns and to provide corresponding payee 

statements as to sales made on behalf of their customers, subject to the penalty provisions of 

sections 6721-6724. Under the regulations issued under section 6045, this requirement generally 

does not apply with respect to taxable transactions other than exchanges for cash (e.g., stock 

inversion transactions taxable to shareholders by reason of section 367(a)).

Description of Proposal

Under the bill, if gain or loss is recognized in whole or in part by shareholders of a 

corporation by reason of a second corporation’s acquisition of the stock or assets of the first 

corporation, then the acquiring corporation (or the acquired corporation, if so prescribed by the 

Treasury Secretary) is required to make a return containing: 

(1) A description of the transaction;

(2) The name and address of each shareholder of the acquired corporation that 

recognizes gain as a result of the transaction (or would recognize gain, if there 

was a built-in gain on the shareholder’s shares);

(3) The amount of money and the value of stock or other consideration paid to each 

shareholder described above; and

(4) Such other information as the Treasury Secretary may prescribe.

Alternatively, a stock transfer agent who records transfers of stock in such transaction 

may make the return described above in lieu of the second corporation.

In addition, every person required to make a return described above is required to furnish 

to each shareholder (or the shareholder’s nominee115) whose name is required to be set forth in 

such return a written statement showing:

(1) The name, address, and phone number of the information contact of the person 

required to make such return;

(2) The information required to be shown on that return; and

(3) Such other information as the Treasury Secretary may prescribe.

 

115 In the case of a nominee, the nominee must furnish the information to the shareholder 

in the manner prescribed by the Secretary of the Treasury. 
98

This written stateme nt is required to be furnished to the shareholder on or before January 

31 of the year following the calendar year during which the transaction occurred.

The present-law penalties for failure to comply with information reporting requirements 

is extended to failures to comply with the requirements set forth under this bill.

Effective Date

The proposal is effective for acquisitions after the date of enactment.
99

G. Studies

(sec. 2007 of the bill)

Present Law

Due to the variation in tax rates and tax systems among countries, a multinational 

enterprise, whether U.S.-based or foreign-based, may have an incentive to shift income, 

deductions, or tax credits in order to arrive at a reduced overall tax burden. Such a shifting of 

items could be accomplished by establishing artificial, non-arm’s-length (i.e., non-market) prices 

for transactions between group members.

Under section 482, the Secretary of the Treasury is authorized to reallocate income, 

deductions, or credits between or among two or more organizations, trades, or businesses under 

common control if he determines that such a reallocation is necessary to prevent tax evasion or to 

clearly reflect income. Treasury regulations adopt the arm's length standard as the standard for 

determining whether such reallocations are appropriate. Thus, the regulations provide rules to 

identify the respective amounts of taxable income of the related parties that would have resulted 

if the parties had been uncontrolled parties dealing at arm's length. Transactions involving 

intangible property and certain services may present particular challenges to the administration 

of the arm’s length standard, because the nature of these transactions may make it difficult or 

impossible to compare them with third-party market transactions.

Present law also provides rules to limit the ability of U.S. corporations to reduce the U.S. 

tax on their U.S.-source income through earnings stripping transactions. Section 163(j) 

specifically addresses earnings stripping involving interest payments, by limiting the 

deductibility of interest paid to certain related parties (“disqualified interest”),116 if the payor’s 

debt-equity ratio exceeds 1.5 to 1 and the payor’s net interest expense exceeds 50 percent of its 

“adjusted taxable income” (generally taxable income computed without regard to deductions for 

net interest expense, net operating losses, and depreciation, amortization, and depletion). 

Disallowed interest amounts can be carried forward indefinitely. In addition, excess limitation 

(i.e., any excess of the 50-percent limit over a company’s net interest expense for a given year) 

can be carried forward three years.

In addition to the statutory rules governing the taxation of foreign income of U.S. persons 

and U.S. income of foreign persons, bilateral income tax treaties limit the amount of income tax 

that may be imposed by one treaty partner on residents of the other treaty partner. For example, 

treaties often reduce or eliminate withholding taxes imposed by a treaty country on certain types 

of income (e.g., dividends, interest and royalties) paid to residents of the other treaty country. 

Treaties also contain provisions governing the creditability of taxes imposed by the treaty 

country in which income was earned in computing the amount of tax owed to the other country 

by its residents with respect to such income. Treaties further provide procedures under which 

 

116 This interest also may include interest paid to unrelated parties in certain cases in 

which a related party guarantees the debt. 
100

inconsistent positions taken by the treaty countries with respect to a single item of income or 

deduction may be mutually resolved by the two countries.

Description of Proposal

The bill requires the Secretary of the Treasury to conduct and submit to the Congress 

three studies. The first study will examine the effectiveness of the transfer pricing rules of 

section 482, with an emphasis on transactions involving intangible property. The second study 

will examine income tax treaties to which the United States is a party, with a view toward 

identifying any inappropriate reductions in withholding tax or opportunities for abuse that may 

exist. The third study will examine the impact of the provisions of this bill on earnings stripping 

and inversion transactions.

Effective Date

The tax treaty study required under the proposal is due no later than June 30, 2004. The 

transfer pricing study required under the proposal is due no later than June 30, 2004. The 

earnings stripping and inversions study required under the proposal is due no later than 

December 31, 2005.
101

III. PROPOSALS RELATING TO TAX SHELTERS

A. Taxpayer Related Proposals

1. Penalty for failure to disclose reportable transactions (sec. 3001 of the bill and new sec. 

6707A of the Code) 

Present Law

Regulations under section 6011 require a taxpayer to disclose with its tax return certain 

information with respect to each “reportable transaction” in which the taxpayer participates.117 

There are six categories of reportable transactions. The first category is any transaction 

that is the same as (or substantially similar to)118 a transaction that is specified by the Treasury 

Department as a tax avoidance transaction whose tax benefits are subject to disallowance under 

present law (referred to as a “listed transaction”).119 

The second category is any transaction that is offered under conditions of confidentiality. 

In general, if a taxpayer’s disclosure of the structure or tax aspects of the transaction is limited in 

any way by an express or implied understanding or agreement with or for the benefit of any 

person who makes or provides a statement, oral or written, as to the potential tax consequences 

that may result from the transaction, it is considered offered under conditions of confidentiality 

(whether or not the understanding is legally binding).120 

The third category of reportable transactions is any transaction for which (1) the taxpayer 

has the right to a full or partial refund of fees if the intended tax consequences from the 

 

117 On February 27, 2003, the Treasury Department and the IRS released final 

regulations regarding the disclosure of reportable transactions. In general, the regulations are 

effective for transactions entered into on or after February 28, 2003. 

The discussion of present law refers to the new regulations. The rules that apply with 

respect to transactions entered into on or before February 28, 2003, are contained in Treas. Reg. 

sec. 1.6011-4T in effect on the date the transaction was entered into.

118 The regulations clarify that the term “substantially similar” includes any transaction 

that is expected to obtain the same or similar types of tax consequences and that is either 

factually similar or based on the same or similar tax strategy. Further, the term must be broadly 

construed in favor of disclosure. Treas. Reg. sec. 1.6011-4(c)(4).

119 Treas. Reg. sec. 1.6011-4(b)(2).

120 Treas. Reg. sec. 1.6011-4(b)(3).
102

transaction are not sustained or, (2) the fees are contingent on the intended tax consequences 

from the transaction being sustained.121

The fourth category of reportable transactions relates to any transaction resulting in a 

taxpayer claiming a loss (under section 165) of at least (1) $10 million in any single year or $20 

million in any combination of years by a corporate taxpayer or a partnership with only corporate 

partners; (2) $2 million in any single year or $4 million in any combination of years by all other 

partnerships, S corporations, trusts, and individuals; or (3) $50,000 in any single year for 

individuals or trusts if the loss arises with respect to foreign currency translation losses.122

The fifth category of reportable transactions refers to any transaction done by certain 

taxpayers123 in which the tax treatment of the transaction differs (or is expected to differ) by 

more than $10 million from its treatment for book purposes (using generally accepted accounting 

principles) in any year.124

The final category of reportable transactions is any transaction that results in a tax credit 

exceeding $250,000 (including a foreign tax credit) if the taxpayer holds the underlying asset for 

less than 45 days.125

Under present law, there is no specific penalty for failing to disclose a reportable 

transaction; however, such a failure may jeopardize a taxpayer’s ability to claim that any income 

tax understatement attributable to such undisclosed transaction is due to reasonable cause, and 

that the taxpayer acted in good faith. 126 

 

121 Treas. Reg. sec. 1.6011-4(b)(4).

122 Treas. Reg. sec. 1.6011-4(b)(5). IRS Rev. Proc. 2003-24, 2003-11 I.R.B. 599, 

exempts certain types of losses from this reportable transaction category.

123 The significant book-tax category applies only to taxpayers that are reporting 

companies under the Securities Exchange Act of 1934 or business entities that have $250 million 

or more in gross assets.

124 Treas. Reg. sec. 1.6011-4(b)(6). IRS Rev. Proc. 2003-25, 2003-11 I.R.B. 601, 

exempts certain types of transactions from this reportable transaction category. 

125 Treas. Reg. sec. 1.6011-4(b)(7).

126 Section 6664(c) provides that a taxpayer can avoid the imposition of a section 6662 

accuracy-related penalty in cases where the taxpayer can demonstrate that there was reasonable 

cause for the underpayment and that the taxpayer acted in good faith. On December 31, 2002, 

the Treasury Department and IRS issued proposed regulations under sections 6662 and 6664 

(REG-126016-01) that limit the defenses available to the imposition of an accuracy-related 

penalty in connection with a reportable transaction when the transaction is not disclosed.
103

Description of Proposal

In general

The proposal creates a new penalty for any person who fails to include with any return or 

statement any required information with respect to a reportable transaction. The new penalty 

applies without regard to whether the transaction ultimately results in an understatement of tax, 

and applies in addition to any accuracy-related penalty that may be imposed.

Transactions to be disclosed

The proposal does not define the terms “listed transaction” 127 or “reportable transaction,” 

nor does the proposal explain the type of information that must be disclosed in order to avoid the 

imposition of a penalty. Rather, the proposal authorizes the Treasury Department to define a 

“listed transaction” and a “reportable transaction” under section 6011. 

Penalty rate

The penalty for failing to disclose a reportable transaction is $10,000 in the case of a 

natural person and $50,000 in any other case. The amount is increased to $100,000 and 

$200,000, respectively, if the failure is with respect to a listed transaction. The penalty cannot be 

waived with respect to a listed transaction. As to reportable transactions, the penalty can be 

rescinded (or abated) only if rescinding the penalty would promote compliance with the tax laws 

and effective tax administration. The authority to rescind the penalty can only be exercised by 

the IRS Commissioner personally. Thus, a revenue agent, an Appeals officer, or any other IRS 

personnel cannot rescind the penalty. The decision to rescind a penalty must be accompanied by 

a record describing the facts and reasons for the action and the amount rescinded. There will be 

no taxpayer right to appeal a refusal to rescind a penalty. The IRS also is required to submit an 

annual report to Congress summarizing the application of the disclosure penalties and providing 

a description of each penalty rescinded under this provision and the reasons for the rescission.

Effective Date

The proposal is effective for returns and statements the due date for which is after the 

date of enactment.

 

127 The provision states that, except as provided in regulations, a listed transaction means 

a reportable transaction, which is the same as, or substantially similar to, a transaction 

specifically identified by the Secretary as a tax avoidance transaction for purposes of section 

6011. For this purpose, it is expected that the definition of “substantially similar” will be the 

definition used in Treas. Reg. sec. 1.6011-4(c)(4). However, the Secretary may modify this 

definition (as well as the definitions of “listed transaction” and “reportable transactions”) as 

appropriate. 
104

2. Modifications to the accuracy-related penalties for listed transactions and reportable 

transactions having a significant tax avoidance purpose (sec. 3002 of the bill and new sec. 

6662A of the Code)

Present Law

The accuracy-related penalty applies to the portion of any underpayment that is 

attributable to (1) negligence, (2) any substantial understatement of income tax, (3) any 

substantial valuation misstatement, (4) any substantial overstatement of pension liabilities, or (5) 

any substantial estate or gift tax valuation understatement. If the correct income tax liability 

exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 

($10,000 in the case of corporations), then a substantial understatement exists and a penalty may 

be imposed equal to 20 percent of the underpayment of tax attributable to the understatement. 128 

The amount of any understatement generally is reduced by any portion attributable to an item if 

(1) the treatment of the item is supported by substantial authority, or (2) facts relevant to the tax 

treatment of the item were adequately disclosed and there was a reasonable basis for its tax 

treatment. 129 

Special rules apply with respect to tax shelters.130 For understatements by non-corporate 

taxpayers attributable to tax shelters, the penalty may be avoided only if the taxpayer establishes 

that, in addition to having substantial authority for the position, the taxpayer reasonably believed 

that the treatment claimed was more likely than not the proper treatment of the item. This 

reduction in the penalty is unavailable to corporate tax shelters. 

The understatement penalty generally is abated (even with respect to tax shelters) in cases 

in which the taxpayer can demonstrate that there was “reasonable cause” for the underpayment 

and that the taxpayer acted in good faith. 131 The relevant regulations provide that reasonable 

cause exists where the taxpayer “reasonably relies in good faith on an opinion based on a 

professional tax advisor’s analysis of the pertinent facts and authorities [that] . . . unambiguously 

concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will 

be upheld if challenged” by the IRS.132

 

128 Sec. 6662.

129 Sec. 6662(d)(2)(B).

130 Sec. 6662(d)(2)(C).

131 Sec. 6664(c).

132 Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 1.6664-4(c).
105

Description of Proposal

In general

The proposal modifies the present-law accuracy related penalty by replacing the rules 

applicable to tax shelters with a new accuracy-related penalty that applies to listed transactions 

and reportable transactions with a significant tax avoidance purpose (hereinafter referred to as a 

“reportable avoidance transaction”).133 The penalty rate and defenses available to avoid the 

penalty vary depending on whether the transaction was adequately disclosed.

Disclosed transactions

In general, a 20-percent accuracy-related penalty is imposed on any understatement 

attributable to an adequately disclosed listed transaction or reportable avoidance transaction. 

The only exception to the penalty is if the taxpayer satisfies a more stringent reasonable cause 

and good faith exception (hereinafter referred to as the “strengthened reasonable cause 

exception”), which is described below. The strengthened reasonable cause exception is available 

only if the relevant facts affecting the tax treatment are adequately disclosed, there is or was 

substantial authority for the claimed tax treatment, and the taxpayer reasonably believed that the 

claimed tax treatment was more likely than not the proper treatment.

Undisclosed transactions

If the taxpayer does not adequately disclose the transaction, the strengthened reasonable 

cause exception is not available (i.e., a strict-liability penalty applies), and the taxpayer is subject 

to an increased penalty rate equal to 30 percent of the understatement. 

Determination of the understatement amount

The penalty is applied to the amount of any understatement attributable to the listed or 

reportable avoidance transaction without regard to other items on the tax return. For purposes of 

the proposal, the amount of the understatement is determined as the sum of (1) the product of the 

highest corporate or individual tax rate (as appropriate) and the increase in taxable income 

resulting from the difference between the taxpayer’s treatment of the item and the proper 

treatment of the item (without regard to other items on the tax return) 134, and (2) the amount of 

any decrease in the aggregate amount of credits which results from a difference between the 

taxpayer’s treatment of an item and the proper tax treatment of such item. 

 

133 The terms “reportable transaction” and “listed transaction” have the same meanings 

as used for purposes of the penalty for failing to disclose reportable transactions.

134 For this purpose, any reduction in the excess of deductions allowed for the taxable 

year over gross income for such year, and any reduction in the amount of capital losses which 

would (without regard to section 1211) be allowed for such year, shall be treated as an increase 

in taxable income.
106

Except as provided in regulations, a taxpayer’s treatment of an item shall not take into 

account any amendment or supplement to a return if the amendment or supplement is filed after 

the earlier of when the taxpayer is first contacted regarding an examination of the return or such 

other date as specified by the Secretary.

Strengthened reasonable cause exception

A penalty is not imposed under the proposal with respect to any portion of an 

understatement if it shown that there was reasonable cause for such portion and the taxpayer 

acted in good faith. Such a showing requires (1) adequate disclosure of the facts affecting the 

transaction in accordance with the regulations under section 6011,135 (2) that there is or was 

substantial authority for such treatment, and (3) that the taxpayer reasonably believed that such 

treatment was more likely than not the proper treatment. For this purpose, a taxpayer will be 

treated as having a reasonable belief with respect to the tax treatment of an item only if such 

belief (1) is based on the facts and law that exist at the time the tax return (that includes the item) 

is filed, and (2) relates solely to the taxpayer’s chances of success on the merits and does not take 

into account the possibility that (a) a return will not be audited, (b) the treatment will not be 

raised on audit, or (c) the treatment will be resolved through settlement if raised. 

A taxpayer may (but is not required to) rely on an opinion of a tax advisor in establishing 

its reasonable belief with respect to the tax treatment of the item. However, a taxpayer may not 

rely on an opinion of a tax advisor for this purpose if the opinion (1) is provided by a 

“disqualified tax advisor,” or (2) is a “disqualified opinion.”

Disqualified tax advisor

A disqualified tax advisor is any advisor who (1) is a material advisor136 and who 

participates in the organization, management, promotion or sale of the transaction or is related 

(within the meaning of section 267(b) or 707(b)(1)) to any person who so participates, (2) is 

compensated directly or indirectly137 by a material advisor with respect to the transaction, (3) has 

a fee arrangement with respect to the transaction that is contingent on all or part of the intended 

 

135

 See the previous discussion regarding the penalty for failing to disclose a reportable 

transaction.

136 The term “material advisor” (defined below in connection with the new information 

filing requirements for material advisors) means any person who provides any material aid, 

assistance, or advice with respect to organizing, managing, promoting, selling, implementing, or 

carrying out any reportable transaction, and who derives gross income in excess of $50,000 in 

the case of a reportable transaction substantially all of the tax benefits from which are provided 

to natural persons ($250,000 in any other case). 

137 This situation could arise, for example, when an advisor has an arrangement or 

understanding (oral or written) with an organizer, manager, or promoter of a reportable 

transaction that such party will recommend or refer potential participants to the advisor for an 

opinion regarding the tax treatment of the transaction. 
107

tax benefits from the transaction being sustained, or (4) as determined under regulations 

prescribed by the Secretary, has a disqualifying financial interest with respect to the transaction. 

Organization, management, promotion or sale of a transaction--A material advisor is 

considered as participating in the “organization” of a transaction if the advisor performs acts 

relating to the development of the transaction. This may include, for example, preparing 

documents (1) establishing a structure used in connection with the transaction (such as a 

partnership agreement), (2) describing the transaction (such as an offering memorandum or other 

statement describing the transaction), or (3) relating to the registration of the transaction with any 

federal, state or local government body. 138 Participation in the “management” of a transaction 

means involvement in the decision-making process regarding any business activity with respect 

to the transaction. Participation in the “promotion or sale” of a transaction means involvement in 

the marketing or solicitation of the transaction to others. Thus, an advisor who provides 

information about the transaction to a potential participant is involved in the promotion or sale of 

a transaction, as is any advisor who recommends the transaction to a potential participant. 

Disqualified opinion

An opinion may not be relied upon if the opinion (1) is based on unreasonable factual or 

legal assumptions (including assumptions as to future events), (2) unreasonably relies upon 

representations, statements, finding or agreements of the taxpayer or any other person, (3) does 

not identify and consider all relevant facts, or (4) fails to meet any other requirement prescribed 

by the Secretary.

Coordination with other penalties

Any understatement upon which a penalty is imposed under this proposal is not subject to 

the accuracy-related penalty under section 6662. However, such understatement is included for 

purposes of determining whether any understatement (as defined in sec. 6662(d)(2)) is a 

substantial understatement as defined under section 6662(d)(1).

The penalty imposed under this provision shall not apply to any portion of an 

understatement to which a fraud penalty is applied under section 6663.

Effective Date

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

 

138 An advisor should not be treated as participating in the organization of a transaction if 

the advisor’s only involvement with respect to the organization of the transaction is the rendering 

of an opinion regarding the tax consequences of such transaction. However, such an advisor 

may be a “disqualified tax advisor” with respect to the transaction if the advisor participates in 

the management, promotion or sale of the transaction (or if the advisor is compensated by a 

material advisor, has a fee arrangement that is contingent on the tax benefits of the transaction, or 

as determined by the Secretary, has a continuing financial interest with respect to the 

transaction). 
108

3. Tax shelter exception to confidentiality privileges relating to taxpayer communications 

(sec. 3003 of the bill and sec. 7525 of the Code)

Present Law

In general, a common law privilege of confidentiality exists for communications between 

an attorney and client with respect to the legal advice the attorney gives the client. The Code 

provides that, with respect to tax advice, the same common law protections of confidentiality that 

apply to a communication between a taxpayer and an attorney also apply to a communication 

between a taxpayer and a federally authorized tax practitioner to the extent the communication 

would be considered a privileged communication if it were between a taxpayer and an attorney. 

This rule is inapplicable to communications regarding corporate tax shelters.

Description of Proposal

The proposal modifies the rule relating to corporate tax shelters by making it applicable 

to all tax shelters, whether entered into by corporations, individuals, partnerships, tax-exempt 

entities, or any other entity. Accordingly, communications with respect to tax shelters are not 

subject to the confidentiality provision of the Code that otherwise applies to a communication 

between a taxpayer and a federally authorized tax practitioner.

Effective Date

The proposal is effective with respect to communications made on or after the date of 

enactment.

4. Statute of limitations for unreported listed transactions (sec. 3004 of the bill and

sec. 6501 of the Code)

Present Law

In general, the Code requires that taxes be assessed within three years139 after the date a 

return is filed.140 If there has been a substantial omission of items of gross income that total 

more than 25 percent of the amount of gross income shown on the return, the period during 

which an assessment must be made is extended to six years.141 If an assessment is not made 

within the required time periods, the tax generally cannot be assessed or collected at any future 

time. Tax may be assessed at any time if the taxpayer files a false or fraudulent return with the 

intent to evade tax or if the taxpayer does not file a tax return at all.142

 

139 Sec. 6501(a).

140 For this purpose, a return that is filed before the date on which it is due is considered 

to be filed on the required due date (sec. 6501(b)(1)).

141 Sec. 6501(e).

142 Sec. 6501(c).
109

Description of Proposal

The proposal extends the statute of limitations with respect to a listed transaction if a 

taxpayer fails to include on any return or statement for any taxable year any information with 

respect to a listed transaction143 which is required to be included (under section 6011) with such 

return or statement. The statute of limitations with respect to such a transaction will not expire 

before the date which is one year after the earlier of (1) the date on which the Secretary is 

furnished the information so required, or (2) the date that a material advisor (as defined in 6111) 

satisfies the list maintenance requirements (as defined by section 6112) with respect to a request 

by the Secretary. For example, if a taxpayer engaged in a transaction in 2005 that becomes a 

listed transaction in 2007 and the taxpayer fails to disclose such transaction in the manner 

required by Treasury regulations, then the transaction is subject extended statute of limitations.144

Effective Date

The proposal is effective for taxable years with respect to which the period for assessing 

a deficiency did not expire before date of enactment. 

5. Disclosure of reportable transactions by material advisors (sec. 3005 of the bill and

secs. 6111 and 6707 of the Code)

Present Law

Registration of tax shelter arrangements

An organizer of a tax shelter is required to register the shelter with the Secretary not later 

than the day on which the shelter is first offered for sale.145 A “tax shelter” means any 

investment with respect to which the tax shelter ratio146 for any investor as of the close of any of 

the first five years ending after the investment is offered for sale may be greater than two to one 

 

143 The term “listed transaction” has the same meaning as described in a previous 

provision regarding the penalty for failure to disclose reportable transactions.

144 If the Treasury Department lists a transaction in a year subsequent to the year in which 

a taxpayer entered into such transaction and the taxpayer’s tax return for the year the transaction 

was entered into is closed by the statute of limitations prior to the date the transaction became a 

listed transaction, this proposal does not re-open the statute of limitations with respect to such 

transaction for such year. However, if the purported tax benefits of the transaction are 

recognized over multiple tax years, the proposal’s extension of the statute of limitations shall 

apply to such tax benefits in any subsequent tax year in which the statute of limitations had not 

closed prior to the date the transaction became a listed transaction.

145 Sec. 6111(a).

146 The tax shelter ratio is, with respect to any year, the ratio that the aggregate amount of 

the deductions and 350 percent of the credits, which are represented to be potentially allowable 

to any investor, bears to the investment base (money plus basis of assets contributed) as of the 

close of the tax year.
110

and which is: (1) required to be registered under Federal or State securities laws, (2) sold 

pursuant to an exemption from registration requiring the filing of a notice with a Federal or State 

securities agency, or (3) a substantial investment (greater than $250,000 and at least five 

investors).147

Other promoted arrangements are treated as tax shelters for purposes of the registration 

requirement if: (1) a significant purpose of the arrangement is the avoidance or evasion of 

Federal income tax by a corporate participant; (2) the arrangement is offered under conditions of 

confidentiality; and (3) the promoter may receive fees in excess of $100,000 in the aggregate.148 

In general, a transaction has a “significant purpose of avoiding or evading Federal income 

tax” if the transaction: (1) is the same as or substantially similar to a “listed transaction,”149 or 

(2) is structured to produce tax benefits that constitute an important part of the intended results of 

the arrangement and the promoter reasonably expects to present the arrangement to more than 

one taxpayer.150 Certain exceptions are provided with respect to the second category of 

transactions.151

An arrangement is offered under conditions of confidentiality if: (1) an offeree has an 

understanding or agreement to limit the disclosure of the transaction or any significant tax 

features of the transaction; or (2) the promoter knows, or has reason to know that the offeree’s 

use or disclosure of information relating to the transaction is limited in any other manner.152 

Failure to register tax shelter

The penalty for failing to timely register a tax shelter (or for filing false or incomplete 

information with respect to the tax shelter registration) generally is the greater of one percent of 

the aggregate amount invested in the shelter or $500.153 However, if the tax shelter involves an 

arrangement offered to a corporation under conditions of confidentiality, the penalty is the 

 

147 Sec. 6111(c).

148 Sec. 6111(d).

149 Treas. Reg. sec. 301.6111-2(b)(2).

150 Treas. Reg. sec. 301.6111-2(b)(3).

151 Treas. Reg. sec. 301.6111-2(b)(4).

152 The regulations provide that the determination of whether an arrangement is offered 

under conditions of confidentiality is based on all the facts and circumstances surrounding the 

offer. If an offeree’s disclosure of the structure or tax aspects of the transaction are limited in 

any way by an express or implied understanding or agreement with or for the benefit of a tax 

shelter promoter, an offer is considered made under conditions of confidentiality, whether or not 

such understanding or agreement is legally binding. Treas. Reg. sec. 301.6111-2(c)(1).

153 Sec. 6707.
111

greater of $10,000 or 50 percent of the fees payable to any promoter with respect to offerings 

prior to the date of late registration. Intentional disregard of the requirement to register increases 

the penalty to 75 percent of the applicable fees.

Section 6707 also imposes (1) a $100 penalty on the promoter for each failure to furnish 

the investor with the required tax shelter identification number, and (2) a $250 penalty on the 

investor for each failure to include the tax shelter identification number on a return. 

Description of Proposal

Disclosure of reportable transactions by material advisors

The proposal repeals the present law rules with respect to registration of tax shelters. 

Instead, the proposal requires each material advisor with respect to any reportable transaction 

(including any listed transaction) 154 to timely file an information return with the Secretary (in 

such form and manner as the Secretary may prescribe). The return must be filed on such date as 

specified by the Secretary. 

The information return will include (1) information identifying and describing the 

transaction, (2) information describing any potential tax benefits expected to result from the 

transaction, and (3) such other information as the Secretary may prescribe. It is expected that the 

Secretary may seek from the material advisor the same type of information that the Secretary 

may request from a taxpayer in connection with a reportable transaction. 155

A “material advisor” means any person (1) who provides material aid, assistance, or 

advice with respect to organizing, managing, promoting, selling, implementing, or carrying out 

any reportable transaction, and (2) who directly or indirectly derives gross income in excess of 

$250,000 ($50,000 in the case of a reportable transaction substantially all of the tax benefits from 

which are provided to natural persons) or such other amount as may be prescribed by the 

Secretary for such advice or assistance.

The Secretary may prescribe regulations which provide (1) that only one material advisor 

has to file an information return in cases in which two or more material advisors would otherwise 

be required to file information returns with respect to a particular reportable transaction, (2) 

exemptions from the requirements of this section, and (3) other rules as may be necessary or 

appropriate to carry out the purposes of this section (including, for example, rules regarding the 

aggregation of fees in appropriate circumstances).

 

154 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related provisions.

155

 See the previous discussion regarding the disclosure requirements under new section 

6707A.
112

Penalty for failing to furnish information regarding reportable transactions

The proposal repeals the present-law penalty for failure to register tax shelters. Instead, 

the proposal imposes a penalty on any material advisor who fails to file an information return, or 

who files a false or incomplete information return, with respect to a reportable transaction 

(including a listed transaction).156 The amount of the penalty is $50,000. If the penalty is with 

respect to a listed transaction, the amount of the penalty is increased to the greater of (1) 

$200,000, or (2) 50 percent of the gross income of such person with respect to aid, assistance, or 

advice which is provided with respect to the transaction before the date the information return 

that includes the transaction is filed. Intentional disregard by a material advisor of the 

requirement to disclose a listed transaction increases the penalty to 75 percent of the gross 

income. 

The penalty cannot be waived with respect to a listed transaction. As to reportable 

transactions, the penalty can be rescinded (or abated) only in exceptional circumstances.157 All 

or part of the penalty may be rescinded only if rescinding the penalty would promote compliance 

with the tax laws and effective tax administration. The authority to rescind the penalty can only 

be exercised by the Commissioner personally. Thus, a revenue agent, an Appeals officer, or 

other IRS personnel cannot rescind the penalty. The decision to rescind a penalty must be 

accompanied by a record describing the facts and reasons for the action and the amount 

rescinded. There will be no right to appeal a refusal to rescind a penalty. The IRS also is 

required to submit an annual report to Congress summarizing the application of the disclosure 

penalties and providing a description of each penalty rescinded under this provision and the 

reasons for the rescission.

Effective Date

The proposal requiring disclosure of reportable transactions by material advisors applies 

to transactions with respect to which material aid, assistance or advice is provided after the date 

of enactment.

The proposal imposing a penalty for failing to disclose reportable transactions applies to 

returns the due date for which is after the date of enactment.

 

156 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related provisions.

157 The Secretary’s present-law authority to postpone certain tax-related deadlines 

because of Presidentially-declared disasters (sec. 7508A) will also encompass the authority to 

postpone the reporting deadlines established by the provision.
113

6. Investor lists and modification of penalty for failure to maintain investor lists (secs. 3006 

and 3007 of the bill and secs. 6112 and 6708 of the Code)

Present Law

Investor lists

Any organizer or seller of a potentially abusive tax shelter must maintain a list identifying 

each person who was sold an interest in any such tax shelter with respect to which registration 

was required under section 6111 (even though the particular party may not have been subject to 

confidentiality restrictions).158 Recently issued regulations under section 6112 contain rules 

regarding the list maintenance requirements. 159 In general, the regulations apply to transactions 

that are potentially abusive tax shelters entered into, or acquired after, February 28, 2003.160

The regulations provide that a person is an organizer or seller of a potentially abusive tax 

shelter if the person is a material advisor with respect to that transaction. 161 A material advisor is 

defined as any person who is required to register the transaction under section 6111, or expects 

to receive a minimum fee of (1) $250,000 for a transaction that is a potentially abusive tax 

shelter if all participants are corporations, or (2) $50,000 for any other transaction that is a 

potentially abusive tax shelter.162 For listed transactions (as defined in the regulations under 

section 6011), the minimum fees are reduced to $25,000 and $10,000, respectively.

A potentially abusive tax shelter is any transaction that (1) is required to be registered 

under section 6111, (2) is a listed transaction (as defined under the regulations under section 

6011), or (3) any transaction that a potential material advisor, at the time the transaction is 

entered into, knows is or reasonably expects will become a reportable transaction (as defined 

under the new regulations under section 6011).163 

The Secretary is required to prescribe regulations which provide that, in cases in which two or 

more persons are required to maintain the same list, only one person would be required to 

maintain the list.164

 

158 Sec. 6112.

159 Treas. Reg. sec. 301-6112-1.

160 A special rule applies the list maintenance requirements to transactions entered into 

after February 28, 2000 if the transaction becomes a listed transaction (as defined in Treas. Reg. 

1.6011-4) after February 28, 2003.

161 Treas. Reg. sec. 301.6112-1(c)(1).

162 Treas. Reg. sec. 301.6112-1(c)(2) and (3).

163 Treas. Reg. sec. 301.6112-1(b).

164 Sec. 6112(c)(2).
114

Penalties for failing to maintain investor lists

Under section 6708, the penalty for failing to maintain the list required under section 

6112 is $50 for each name omitted from the list (with a maximum penalty of $100,000 per year). 

Description of Proposal

Investor lists

Each material advisor165 with respect to a reportable transaction (including a listed 

transaction)166 is required to maintain a list that (1) identifies each person with respect to whom 

the advisor acted as a material advisor with respect to the reportable transaction, and (2) contains 

other information as may be required by the Secretary. In addition, the proposal authorizes (but 

does not require) the Secretary to prescribe regulations which provide that, in cases in which two 

or more persons are required to maintain the same list, only one person would be required to 

maintain the list.

The proposal also clarifies that, for purposes of section 6112, the identity of any person is 

not privileged for any purpose, such as either under the common law attorney-client privilege or 

under the section 7525 federally authorized tax practitioner rules. 

Penalty for failing to maintain investor lists

The proposal modifies the penalty for failing to maintain the required list by making it a 

time-sensitive penalty. Thus, a material advisor who is required to maintain an investor list and 

who fails to make the list available upon written request by the Secretary within 20 business days 

after the request will be subject to a $10,000 per day penalty. The penalty applies to a person 

who fails to maintain a list, maintains an incomplete list, or has in fact maintained a list but does 

not make the list available to the Secretary. The penalty can be waived if the failure to make the 

list available is due to reasonable cause.167 

Effective Date

The proposal requiring a material advisor to maintain an investor list applies to 

transactions with respect to which material aid, assistance or advice is provided after the date of 

enactment.

 

165 The term “material advisor” has the same meaning as when used in connection with 

the requirement to file an information return under section 6111.

166 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related provisions.

167 In no event will failure to maintain a list be considered reasonable cause for failing to 

make a list available to the Secretary.
115

The proposal imposing a penalty for failing to maintain investor lists applies to requests 

made after the date of enactment. 

The proposal clarifying that the identity of any person is not privileged for purposes of 

section 6112 is effective as if included in the amendments made by section 142 of the Deficit 

Reduction Act of 1984. 

7. Penalties on promoters of tax shelters (sec. 3008 of the bill and sec. 6700 of the Code)

Present Law

A penalty is imposed on any person who organizes, assists in the organization of, or 

participates in the sale of any interest in, a partnership or other entity, any investment plan or 

arrangement, or any other plan or arrangement, if in connection with such activity the person 

makes or furnishes a qualifying false or fraudulent statement or a gross valuation 

overstatement. 168 A qualified false or fraudulent statement is any statement with respect to the 

allowability of any deduction or credit, the excludability of any income, or the securing of any 

other tax benefit by reason of holding an interest in the entity or participating in the plan or 

arrangement which the person knows or has reason to know is false or fraudulent as to any 

material matter. A “gross valuation overstatement” means any statement as to the value of any 

property or services if the stated value exceeds 200 percent of the correct valuation, and the 

value is directly related to the amount of any allowable income tax deduction or credit.

The amount of the penalty is $1,000 (or, if the person establishes that it is less, 100 

percent of the gross income derived or to be derived by the person from such activity). A 

penalty attributable to a gross valuation misstatement can be waived on a showing that there was 

a reasonable basis for the valuation and it was made in good faith.

Description of Proposal

The proposal modifies the penalty amount to equal 50 percent of the gross income 

derived by the person from the activity for which the penalty is imposed. The new penalty rate 

applies to any activity that involves a statement regarding the tax benefits of participating in a 

plan or arrangement if the person knows or has reason to know that such statement is false or 

fraudulent as to any material matter. The enhanced penalty does not apply to a gross valuation 

overstatement.

Effective Date

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

 

168 Sec. 6700.
116

8. Modifications to the definition of the substantial understatement (sec. 3009 of the bill and 

sec. 6662 of the Code)

Present Law

An accuracy-related penalty equal to 20 percent applies to any substantial understatement 

of tax. A “substantial understatement” exists if the correct income tax liability for a taxable year 

exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 

($10,000 in the case of most corporations).169 

Description of Proposal

The proposal modifies the definition of “substantial” for corporate taxpayers. Under the 

proposal, a corporate taxpayer has a substantial understatement if the amount of the 

understatement for the taxable year exceeds the lesser of (1) 10 percent of the tax required to be 

shown on the return for the taxable year (or, if greater, $10,000), or (2) $10 million.

Effective Date

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

9. Actions to enjoin conduct with respect to tax shelters and reportable transactions

(sec. 3010 of the bill and sec. 7408 of the Code)

Present Law

The Code authorizes civil action to enjoin any person from promoting abusive tax 

shelters or aiding or abetting the understatement of tax liability. 170

Description of Proposal

The proposal expands this rule so that injunctions may also be sought with respect to the 

requirements relating to the reporting of reportable transactions 171 and the keeping of lists of 

investors by material advisors.172 Thus, under the proposal, an injunction may be sought against 

a material advisor to enjoin the advisor from (1) failing to file an information return with respect 

to a reportable transaction, or (2) failing to maintain, or to timely furnish upon written request by 

the Secretary, a list of investors with respect to each reportable transaction.

 

169 Sec. 6662(a) and (d)(1)(A).

170 Sec. 7408.

171 Sec. 6707, as amended by other provisions of this bill.

172 Sec. 6708, as amended by other provisions of this bill.
117

Effective Date

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

10. Penalty for failure to report interests in foreign financial accounts (sec. 3011 of the bill 

and sec. 5321 of Title 31, United States Code)

Present Law

The Secretary of the Treasury must require citizens, residents, or persons doing business 

in the United States to keep records and file reports when that person makes a transaction or 

maintains an account with a foreign financial entity. 173 In general, individuals must fulfill this 

requirement by answering questions regarding foreign accounts or foreign trusts that are 

contained in Part III of Schedule B of the IRS Form 1040. Taxpayers who answer “yes” in 

response to the question regarding foreign accounts must then file Treasury Department Form 

TD F 90-22.1. This form must be filed with the Department of the Treasury, and not as part of 

the tax return that is filed with the IRS.

The Secretary of the Treasury may impose a civil penalty on any person who willfully 

violates this reporting requirement. The civil penalty is the amount of the transaction or the 

value of the account, up to a maximum of $100,000; the minimum amount of the penalty is 

$25,000.174 In addition, any person who willfully violates this reporting requirement is subject to 

a criminal penalty. The criminal penalty is a fine of not more than $250,000 or imprisonment for 

not more than five years (or both); if the violation is part of a pattern of illegal activity, the 

maximum amount of the fine is increased to $500,000 and the maximum length of imprisonment 

is increased to 10 years.175

On April 26, 2002, the Secretary of the Treasury submitted to the Congress a report on 

these reporting requirements.176 This report, which was statutorily required,177 studies methods 

for improving compliance with these reporting requirements. It makes several administrative 

recommendations, but no legislative recommendations. A further report was required to be 

submitted by the Secretary of the Treasury to the Congress by October 26, 2002.

 

173 31 U.S.C. 5314.

174 31 U.S.C. 5321(a)(5).

175 31 U.S.C. 5322.

176

 A Report to Congress in Accordance with Sec. 361(b) of the Uniting and 

Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct 

Terrorism Act of 2001, April 26, 2002.

177 Sec. 361(b) of the USA PATRIOT Act of 2001 (Pub. L. 107-56).
118

Description of Proposal

The proposal adds an additional civil penalty that may be imposed on any person who 

violates this reporting requirement (without regard to willfulness). This new civil penalty is up 

to $5,000. The penalty may be waived if any income from the account was properly reported on 

the income tax return and there was reasonable cause for the failure to report.

Effective Date

The proposal is effective with respect to failures to report occurring on or after the date of 

enactment.

11. Regulation of individuals practicing before the Department of the Treasury (sec. 3012 

of the bill and sec. 330 of Title 31, United States Code)

Present Law

The Secretary of the Treasury is authorized to regulate the practice of representatives of 

persons before the Department of the Treasury. 178 The Secretary is also authorized to suspend or 

disbar from practice before the Department a representative who is incompetent, who is 

disreputable, who violates the rules regulating practice before the Department, or who (with 

intent to defraud) willfully and knowingly misleads or threatens the person being represented (or 

a person who may be represented). The rules promulgated by the Secretary pursuant to this 

provision are contained in Circular 230.

Description of Proposal

The proposal makes two modifications to expand the sanctions that the Secretary may 

impose pursuant to these statutory provisions. First, the proposal expressly permits censure as a 

sanction. Second, the proposal permits the imposition of a monetary penalty as a sanction. If the 

representative is acting on behalf of an employer or other entity, the Secretary may impose a 

monetary penalty on the employer or other entity if it knew, or reasonably should have known, of 

the conduct. This monetary penalty on the employer or other entity may be imposed in addition 

to any monetary penalty imposed directly on the representative. These monetary penalties are 

not to exceed the gross income derived (or to be derived) from the conduct giving rise to the 

penalty. These monetary penalties may be in addition to, or in lieu of, any suspension, 

disbarment, or censure of such individual.

The proposal also confirms the present-law authority of the Secretary to impose standards 

applicable to written advice with respect to an entity, plan, or arrangement that is of a type that 

the Secretary determines as having a potential for tax avoidance or evasion.

 

178 31 U.S.C. 330.
119

Effective Date

The modifications to expand the sanctions that the Secretary may impose are effective for 

actions taken after the date of enactment.
120

B. Other Proposals

1. Treatment of stripped interests in bond and preferred stock funds (sec. 3021 of the bill 

and secs. 305 and 1286 of the Code)

Present Law

Assignment of income in general

In general, an “income stripping” transaction involves a transaction in which the right to 

receive future income from income-producing property is separated from the property itself. In 

such transactions, it may be possible to generate artificial losses from the disposition of certain 

property or to defer the recognition of taxable income associated with such property. 

Common law has developed a rule (referred to as the “assignment of income” doctrine) 

that income may not be transferred without also transferring the underlying property. A leading 

judicial decision relating to the assignment of income doctrine involved a case in which a 

taxpayer made a gift of detachable interest coupons before their due date while retaining the 

bearer bond. The U.S. Supreme Court ruled that the donor was taxable on the entire amount of 

interest when paid to the donee on the grounds that the transferor had “assigned” to the donee the 

right to receive the income.179

In addition to general common law assignment of income principles, specific statutory 

rules have been enacted to address certain specific types of stripping transactions, such as 

transactions involving stripped bonds and stripped preferred stock (which are discussed 

below).180 However, there are no specific statutory rules that address stripping transactions with 

respect to common stock or other equity interests (other than preferred stock).181

 

179

 Helvering v. Horst, 311 U.S. 112 (1940).

180 Depending on the facts, the IRS also could determine that a variety of other Codebased and common law-based authorities could apply to income stripping transactions, 

including: (1) sections 269, 382, 446(b), 482, 701, or 704 and the regulations thereunder; (2) 

authorities that recharacterize certain assignments or accelerations of future payments as 

financings; (3) business purpose, economic substance, and sham transaction doctrines; (4) the 

step transaction doctrine; and (5) the substance-over-form doctrine. See Notice 95-53, 1995-2 

C.B. 334 (accounting for lease strips and other stripping transactions).

181 However, in Estate of Stranahan v. Commissioner, 472 F.2d 867 (6th Cir. 1973), the 

court held that where a taxpayer sold a carved-out interest of stock dividends, with no personal 

obligation to produce the income, the transaction was treated as a sale of an income interest.
121

Stripped bonds

Special rules are provided with respect to the purchaser and “stripper” of stripped 

bonds.182 A “stripped bond” is defined as a debt instrument in which there has been a separation 

in ownership between the underlying debt instrument and any interest coupon that has not yet 

become payable.183 In general, upon the disposition of either the stripped bond or the detached 

interest coupons, the retained portion and the portion that is disposed of each is treated as a new 

bond that is purchased at a discount and is payable at a fixed amount on a future date. 

Accordingly, section 1286 treats both the stripped bond and the detached interest coupons as 

individual bonds that are newly issued with original issue discount (“OID”) on the date of 

disposition. Consequently, section 1286 effectively subjects the stripped bond and the detached 

interest coupons to the general OID periodic income inclusion rules.

A taxpayer who purchases a stripped bond or one or more stripped coupons is treated as 

holding a new bond that is issued on the purchase date with OID in an amount that is equal to the 

excess of the stated redemption price at maturity (or in the case of a coupon, the amount payable 

on the due date) over the ratable share of the purchase price of the stripped bond or coupon, 

determined on the basis of the respective fair market values of the stripped bond and coupons on 

the purchase date.184 The OID on the stripped bond or coupon is includible in gross income 

under the general OID periodic income inclusion rules.

A taxpayer who strips a bond and disposes of either the stripped bond or one or more 

stripped coupons must allocate his basis, immediately before the disposition, in the bond (with 

the coupons attached) between the retained and disposed items.185 Special rules apply to require 

that interest or market discount accrued on the bond prior to such disposition must be included in 

the taxpayer’s gross income (to the extent that it had not been previously included in income) at 

the time the stripping occurs, and the taxpayer increases his basis in the bond by the amount of 

such accrued interest or market discount. The adjusted basis (as increased by any accrued 

interest or market discount) is then allocated between the stripped bond and the stripped interest 

coupons in relation to their respective fair market values. Amounts realized from the sale of 

stripped coupons or bonds constitute income to the taxpayer only to the extent such amounts 

exceed the basis allocated to the stripped coupons or bond. With respect to retained items (either 

the detached coupons or stripped bond), to the extent that the price payable on maturity, or on the 

due date of the coupons, exceeds the portion of the taxpayer’s basis allocable to such retained 

 

182 Sec. 1286.

183 Sec. 1286(e).

184 Sec. 1286(a).

185

 Sec. 1286(b). Similar rules apply in the case of any person whose basis in any bond 

or coupon is determined by reference to the basis in the hands of a person who strips the bond.
122

items, the difference is treated as OID that is required to be included under the general OID 

periodic income inclusion rules.186

Stripped preferred stock

“Stripped preferred stock” is defined as preferred stock in which there has been a 

separation in ownership between such stock and any dividend on such stock that has not become 

payable.187 A taxpayer who purchases stripped preferred stock is required to include in gross 

income, as ordinary income, the amounts that would have been includible if the stripped 

preferred stock was a bond issued on the purchase date with OID equal to the excess of the 

redemption price of the stock over the purchase price.188 This treatment is extended to any 

taxpayer whose basis in the stock is determined by reference to the basis in the hands of the 

purchaser. A taxpayer who strips and disposes the future dividends is treated as having 

purchased the stripped preferred stock on the date of such disposition for a purchase price equal 

to the taxpayer’s adjusted basis in the stripped preferred stock. 189

Description of Proposal

The bill authorizes the Treasury Department to promulgate regulations that, in 

appropriate cases, apply rules that are similar to the present-law rules for stripped bonds and 

stripped preferred stock to direct or indirect interests in an entity or account substantially all of 

the assets of which consist of bonds (as defined in section 1286(e)(1)), preferred stock (as 

defined in section 305(e)(5)(B)), or any combination thereof. This provision applies only to 

cases in which the present-law rules for stripped bonds and stripped preferred stock do not 

already apply to such interests.

For example, such Treasury regulations could apply to a transaction in which a person 

effectively strips future dividends from shares in a money market mutual fund (and disposes 

either the stripped shares or stripped future dividends) by contributing the shares (with the future 

dividends) to a custodial account through which another person purchases rights to either the 

stripped shares or the stripped future dividends. However, it is intended that Treasury 

regulations issued under this provision would not apply to certain transactions involving direct or 

indirect interests in an entity or account substantially all the assets of which consist of tax-

 

186 Special rules are provided with respect to stripping transactions involving tax-exempt 

obligations that treat OID (computed under the stripping rules) in excess of OID computed on 

the basis of the bond’s coupon rate (or higher rate if originally issued at a discount) as income 

from a non-tax-exempt debt instrument (sec. 1286(d)).

187 Sec. 305(e)(5).

188 Sec. 305(e)(1).

189 Sec. 305(e)(3).
123

exempt obligations (as defined in section 1275(a)(3)), such as a tax-exempt bond partnership 

described in Rev. Proc. 2002-68,190 modifying and superceding Rev. Proc. 2002-16.191

No inference is intended as to the treatment under the present-law rules for stripped 

bonds and stripped preferred stock, or under any other provisions or doctrines of present law, of 

interests in an entity or account substantially all of the assets of which consist of bonds, preferred 

stock, or any combination thereof. The Treasury regulations, when issued, would be applied 

prospectively, except in cases to prevent abuse.

Effective Date

This proposal is effective for purchases and dispositions occurring after the date of 

enactment.

2. Minimum holding period for foreign tax credit on withholding taxes on income other 

than dividends (sec. 3022 of the bill and sec. 901 of the Code)

Present Law

In general, U.S. persons may credit foreign taxes against U.S. tax on foreign-source 

income. The amount of foreign tax credits that may be claimed in a year is subject to a limitation 

that prevents taxpayers from using foreign tax credits to offset U.S. tax on U.S.-source income. 

Separate limitations are applied to specific categories of income.

As a consequence of the foreign tax credit limitations of the Code, certain taxpayers are 

unable to utilize their creditable foreign taxes to reduce their U.S. tax liability. U.S. taxpayers 

that are tax-exempt receive no U.S. tax benefit for foreign taxes paid on income that they 

receive.

Present law denies a U.S. shareholder the foreign tax credits normally available with 

respect to a dividend from a corporation or a regulated investment company (“RIC”) if the 

shareholder has not held the stock for more than 15 days (within a 30-day testing period) in the 

case of common stock or more than 45 days (within a 90-day testing period) in the case of 

preferred stock (sec. 901(k)). The disallowance applies both to foreign tax credits for foreign 

withholding taxes that are paid on the dividend where the dividend-paying stock is held for less 

than these holding periods, and to indirect foreign tax credits for taxes paid by a lower-tier 

foreign corporation or a RIC where any of the required stock in the chain of ownership is held 

for less than these holding periods. Periods during which a taxpayer is protected from risk of 

loss (e.g., by purchasing a put option or entering into a short sale with respect to the stock) 

generally are not counted toward the holding period requirement. In the case of a bona fide 

contract to sell stock, a special rule applies for purposes of indirect foreign tax credits. The 

disallowance does not apply to foreign tax credits with respect to certain dividends received by 

active dealers in securities. If a taxpayer is denied foreign tax credits because the applicable 

 

190 2002-43 I.R.B. 753.

191 2002-9 I.R.B. 572.
124

holding period is not satisfied, the taxpayer is entitled to a deduction for the foreign taxes for 

which the credit is disallowed.

Description of Proposal

The proposal expands the present-law disallowance of foreign tax credits to include 

credits for gross-basis foreign withholding taxes with respect to any item of income or gain from 

property if the taxpayer who receives the income or gain has not held the property for more than 

15 days (within a 30-day testing period), exclusive of periods during which the taxpayer is

protected from risk of loss. The proposal does not apply to foreign tax credits that are subject to 

the present-law disallowance with respect to dividends. The proposal also does not apply to 

certain income or gain that is received with respect to property held by active dealers. Rules 

similar to the present-law disallowance for foreign tax credits with respect to dividends apply to 

foreign tax credits that are subject to the proposal. In addition, the proposal authorizes the 

Treasury Department to issue regulations providing that the proposal does not apply in 

appropriate cases.

Effective Date

The proposal is effective for amounts that are paid or accrued more than 30 days after the 

date of enactment.

3. Disallowance of certain partnership loss transfers (sec. 3023 of the bill and secs. 704, 734, 

and 743 of the Code)

Present Law

Contributions of property

Under present law, if a partner contributes property to a partnership, generally no gain or 

loss is recognized to the contributing partner at the time of contribution. 192 The partnership takes 

the property at an adjusted basis equal to the contributing partner’s adjusted basis in the 

property. 193 The contributing partner increases its basis in its partnership interest by the adjusted 

basis of the contributed property. 194 Any items of partnership income, gain, loss and deduction 

with respect to the contributed property are allocated among the partners to take into account any 

built-in gain or loss at the time of the contribution. 195 This rule is intended to prevent the transfer 

of built-in gain or loss from the contributing partner to the other partners by generally allocating 

 

192 Sec. 721.

193 Sec. 723.

194 Sec. 722.

195 Sec. 704(c)(1)(A).
125

items to the noncontributing partners based on the value of their contributions and by allocating 

to the contributing partner the remainder of each item. 196 

If the contributing partner transfers its partnership interest, the built-in gain or loss will be 

allocated to the transferee partner as it would have been allocated to the contributing partner.197 

If the contributing partner’s interest is liquidated, there is no specific guidance preventing the 

allocation of the built-in loss to the remaining partners. Thus, it appears that losses can be 

“transferred” to other partners where the contributing partner no longer remains a partner.

Transfers of partnership interests

Under present law, a partnership does not adjust the basis of partnership property 

following the transfer of a partnership interest unless the partnership has made a one-time 

election under section 754 to make basis adjustments.198 If an election is in effect, adjustments 

are made with respect to the transferee partner in order to account for the difference between the 

transferee partner’s proportionate share of the adjusted basis of the partnership property and the 

transferee’s basis in its partnership interest.199 These adjustments are intended to adjust the basis 

of partnership property to approximate the result of a direct purchase of the property by the 

transferee partner. Under these rules, if a partner purchases an interest in a partnership with an 

existing built-in loss and no election under section 754 in effect, the transferee partner may be 

allocated a share of the loss when the partnership disposes of the property (or depreciates the 

property).

Distributions of partnership property

With certain exceptions, partners may receive distributions of partnership property 

without recognition of gain or loss by either the partner or the partnership.200 In the case of a 

distribution in liquidation of a partner’s interest, the basis of the property distributed in the 

liquidation is equal to the partner’s adjusted basis in its partnership interest (reduced by any 

money distributed in the transaction).201 In a distribution other than in liquidation of a partner’s 

interest, the distributee partner’s basis in the distributed property is equal to the partnership’s 

adjusted basis in the property immediately before the distribution, but not to exceed the partner’s 

 

196 If there is an insufficient amount of an item to allocate to the noncontributing 

partners, Treasury regulations allow for reasonable allocations to remedy this insufficiency. 

Treas. Reg. sec. 1.704-3(c) and (d).

197 Treas. Reg. 1.704-3(a)(7).

198 Sec. 743(a).

199 Sec. 743(b).

200 Sec. 731(a) and (b).

201 Sec. 732(b).
126

adjusted basis in the partnership interest (reduced by any money distributed in the same 

transaction).202

Adjustments to the basis of the partnership’s undistributed properties are not required 

unless the partnership has made the election under section 754 to make basis adjustments.203 If 

an election is in effect under section 754, adjustments are made by a partnership to increase or 

decrease the remaining partnership assets to reflect any increase or decrease in the adjusted basis 

of the distributed properties in the hands of the distributee partner (or gain or loss recognized by 

the distributee partner).204 To the extent the adjusted basis of the distributed properties increases 

(or loss is recognized) the partnership’s adjusted basis in its properties is decreased by a like 

amount; likewise, to the extent the adjusted basis of the distributed properties decrease (or gain is 

recognized), the partnership’s adjusted basis in its properties is increased by a like amount. 

Under these rules, a partnership with no election in effect under section 754 may distribute 

property with an adjusted basis lower than the distributee partner’s proportionate share of the 

adjusted basis of all partnership property and leave the remaining partners with a smaller net 

built-in gain or a larger net built-in loss than before the distribution.

Description of Proposal

Contributions of property

Under the proposal, a built-in loss may be taken into account only by the contributing 

partner and not by other partners. Except as provided in regulations, in determining the amount 

of items allocated to partners other than the contributing partner, the basis of the contributed 

property is treated as the fair market value at the time of contribution. Thus, if the contributing 

partner’s partnership interest is transferred or liquidated, the partnership’s adjusted basis in the

property is based on its fair market value at the time of contribution, and the built-in loss is 

eliminated.205 

Transfers of partnership interests

The proposal provides that the basis adjustment rules under section 743 are mandatory in 

the case of the transfer of a partnership interest with respect to which there is a substantial builtin loss (rather than being elective as under present law). For this purpose, a substantial built-in 

loss exists if the partnership's adjusted basis in its property exceeds by more than $250,000 the 

fair market value of the partnership property.

 

202 Sec. 732(a).

203 Sec. 734(a).

204 Sec. 734(b).

205 It is intended that a corporation succeeding to attributes of the contributing corporate 

partner under section 381 shall be treated in the same manner as the contributing partner.
127

Thus, for example, assume that partner A sells his 25-percent partnership interest to B for 

its fair market value of $1 million. Also assume that, immediately after the transfer, the fair 

market value of partnership assets is $4 million and the partnership's adjusted basis in the 

partnership assets is $4.3 million. Under the bill, section 743(b) applies, so that a $300,000 

decrease is required to the adjusted basis of the partnership assets with respect to B. As a result, 

B would recognize no gain or loss if the partnership immediately sold all its assets for their fair 

market value.

Distribution of partnership property

The proposal provides that a basis adjustment under section 734(b) is required in the case 

of a distribution with respect to which there is a substantial basis reduction. A substantial basis 

reduction means a downward adjustment of more than $250,000 that would be made to the basis 

of partnership assets if a section 754 election were in effect.

Thus, for example, assume that A and B each contributed $2.5 million to a newly formed 

partnership and C contributed $5 million, and that the partnership purchased LMN stock for $3 

million and XYZ stock for $7 million. Assume that the value of each stock declined to $1 

million. Assume LMN stock is distributed to C in liquidation of its partnership interest. Under 

present law, the basis of LMN stock in C’s hands is $5 million. Under present law, C would 

recognize a loss of $4 million if the LMN stock were sold for $1 million.

Under the proposal, however, there is a substantial basis adjustment because the $2 

million increase in the adjusted basis of LMN stock (described in section 734(b)(2)(B)) is greater 

than $250,000. Thus, the partnership is required to decrease the basis of XYZ stock (under 

section 734(b)(2)) by $2 million (the amount by which the basis of LMN stock was increased), 

leaving a basis of $5 million. If the XYZ stock were then sold by the partnership for $1 million, 

A and B would each recognize a loss of $2 million.

Effective Date

The proposal applies to contributions, transfers, and distributions (as the case may be) 

after the date of enactment.

4. No reduction of basis under section 734 in stock held by partnership in corporate 

partner (sec. 3024 of the bill and sec. 755 of the Code)

Present Law

In general

Generally, a partner and the partnership do not recognize gain or loss on a contribution of 

property to a partnership.206 Similarly, a partner and the partnership generally do not recognize 

 

206 Sec. 721(a).
128

gain or loss on the distribution of partnership property. 207 This includes current distributions and 

distributions in liquidation of a partner’s interest. 

Basis of property distributed in liquidation

The basis of property distributed in liquidation of a partner’s interest is equal to the 

partner’s tax basis in its partnership interest (reduced by any money distributed in the same 

transaction).208 Thus, the partnership’s tax basis in the distributed property is adjusted (increased 

or decreased) to reflect the partner’s tax basis in the partnership interest.

Election to adjust basis of partnership property 

When a partnership distributes partnership property, generally, the basis of partnership 

property is not adjusted to reflect the effects of the distribution or transfer. The partnership is 

permitted, however, to make an election (referred to as a 754 election) to adjust the basis of 

partnership property in the case of a distribution of partnership property. 209 The effect of the 

754 election is that the partnership adjusts the basis of its remaining property to reflect any 

change in basis of the distributed property in the hands of the distributee partner resulting from 

the distribution transaction. Such a change could be a basis increase due to gain recognition, or a 

basis decrease due to the partner’s adjusted basis in its partnership interest exceeding the 

adjusted basis of the property received. If the 754 election is made, it applies to the taxable year 

with respect to which such election was filed and all subsequent taxable years. 

In the case of a distribution of partnership property to a partner with respect to which the 

754 election is in effect, the partnership increases the basis of partnership property by (1) any 

gain recognized by the distributee partner (2) the excess of the adjusted basis of the distributed 

property to the partnership immediately before its distribution over the basis of the property to 

the distributee partner, and decreases the basis of partnership property by (1) any loss recognized 

by the distributee partner and (2) the excess of the basis of the property to the distributee partner 

over the adjusted basis of the distributed property to the partnership immediately before the 

distribution.

The allocation of the increase or decrease in basis of partnership property is made in a 

manner which has the effect of reducing the difference between the fair market value and the 

adjusted basis of partnership properties.210 In addition, the allocation rules require that any 

increase or decrease in basis be allocated to partnership property of a like character to the 

property distributed. For this purpose, the two categories of assets are (1) capital assets and 

 

207 Sec. 731(a) and (b).

208 Sec. 732(b).

209 Sec. 754.

210 Sec. 755(a).
129

depreciable and real property used in the trade or business held for more than one year, and (2) 

any other property. 211

Description of Proposal

The proposal provides that in applying the basis allocation rules to a distribution in 

liquidation of a partner’s interest, a partnership is precluded from decreasing the basis of 

corporate stock of a partner or a related person. Any decrease in basis that, absent the proposal, 

would have been allocated to the stock is allocated to other partnership assets. If the decrease in 

basis exceeds the basis of the other partnership assets, then gain is recognized by the partnership 

in the amount of the excess. 

Effective Date. 

The proposal applies to distributions after date of enactment.

5. Repeal of special rules for FASITs, etc. (sec. 3025 of the bill and secs. 860H through 860L 

of the Code)

Present Law

Financial asset securitization investment trusts

In 1996, Congress created a new type of statutory entity called a “financial asset 

securitization trust” (“FASIT”) that facilitates the securitization of debt obligations such as credit 

card receivables, home equity loans, and auto loans.212 A FASIT generally is not taxable; the 

FASIT’s taxable income or net loss flows through to the owner of the FASIT.

The ownership interest of a FASIT generally is required to be entirely held by a single 

domestic C corporation. In addition, a FASIT generally may hold only qualified debt 

obligations, and certain other specified assets, and is subject to certain restrictions on its 

activities. An entity that qualifies as a FASIT can issue one or more classes of instruments that 

meet certain specified requirements and treat those instruments as debt for Federal income tax 

purposes. Instruments issued by a FASIT bearing yields to maturity over five percentage points 

above the yield to maturity on specified United States government obligations (i.e., “high-yield 

interests”) must be held, directly or indirectly, only by domestic C corporations that are not 

exempt from income tax.

 

211 Sec. 755(b).

212 Sections 860H through 860L.
130

Qualification as a FASIT

To qualify as a FASIT, an entity must: (1) make an election to be treated as a FASIT for 

the year of the election and all subsequent years;213 (2) have assets substantially all of which 

(including assets that the FASIT is treated as owning because they support regular interests) are 

specified types called “permitted assets;” (3) have non-ownership interests be certain specified 

types of debt instruments called “regular interests”; (4) have a single ownership interest which is 

held by an "eligible holder"; and (5) not qualify as a regulated investment company (“RIC”). 

Any entity, including a corporation, partnership, or trust may be treated as a FASIT. In addition, 

a segregated pool of assets may qualify as a FASIT.

An entity ceases qualifying as a FASIT if the entity's owner ceases being an eligible

corporation. Loss of FASIT status is treated as if all of the regular interests of the FASIT were 

retired and then reissued without the application of the rule that deems regular interests of a 

FASIT to be debt.

Permitted assets

For an entity or arrangement to qualify as a FASIT, substantially all of its assets must 

consist of the following “permitted assets”: (1) cash and cash equivalents; (2) certain permitted 

debt instruments; (3) certain foreclosure property; (4) certain instruments or contracts that

represent a hedge or guarantee of debt held or issued by the FASIT; (5) contract rights to acquire 

permitted debt instruments or hedges; and (6) a regular interest in another FASIT. Permitted 

assets may be acquired at any time by a FASIT, including any time after its formation.

“Regular interests” of a FASIT

“Regular interests” of a FASIT are treated as debt for Federal income tax purposes, 

regardless of whether instruments with similar terms issued by non-FASITs might be 

characterized as equity under general tax principles. To be treated as a “regular interest”, an 

instrument must have fixed terms and must: (1) unconditionally entitle the holder to receive a 

specified principal amount; (2) pay interest that is based on (a) fixed rates, or (b) except as 

provided by regulations issued by the Treasury Secretary, variable rates permitted with respect to 

real estate mortgage investment conduit interests under section 860G(a)(1)(B)(i); (3) have a term 

to maturity of no more than 30 years, except as permitted by Treasury regulations; (4) be issued 

to the public with a premium of not more than 25 percent of its stated principal amount; and (5) 

have a yield to maturity determined on the date of issue of less than five percentage points above 

the applicable Federal rate (“AFR”) for the calendar month in which the instrument is issued.

 

213 Once an election to be a FASIT is made, the election applies from the date specified 

in the election and all subsequent years until the entity ceases to be a FASIT. If an election to be 

a FASIT is made after the initial year of an entity, all of the assets in the entity at the time of the 

FASIT election are deemed contributed to the FASIT at that time and, accordingly, any gain (but 

not loss) on such assets will be recognized at that time.
131

Permitted ownership holder

A permitted holder of the ownership interest in a FASIT generally is a non-exempt (i.e., 

taxable) domestic C corporation, other than a corporation that qualifies as a RIC, REIT, REMIC, 

or cooperative.

Transfers to FASITs

In general, gain (but not loss) is recognized immediately by the owner of the FASIT upon 

the transfer of assets to a FASIT. Where property is acquired by a FASIT from someone other 

than the FASIT’s owner (or a person related to the FASIT’s owner), the property is treated as 

being first acquired by the FASIT’s owner for the FASIT’s cost in acquiring the asset from the 

non-owner and then transferred by the owner to the FASIT.

Valuation rules. In general, except in the case of debt instruments, the value of FASIT 

assets is their fair market value. Similarly, in the case of debt instruments that are traded on an 

established securities market, the market price is used for purposes of determining the amount of 

gain realized upon contribution of such assets to a FASIT. However, in the case of debt 

instruments that are not traded on an established securities market, special valuation rules apply 

for purposes of computing gain on the transfer of such debt instruments to a FASIT. Under these 

rules, the value of such debt instruments is the sum of the present values of the reasonably 

expected cash flows from such obligations discounted over the weighted average life of such 

assets. The discount rate is 120 percent of the AFR, compounded semiannually, or such other 

rate that the Treasury Secretary shall prescribe by regulations.

Taxation of a FASIT

A FASIT generally is not subject to tax. Instead, all of the FASIT’s assets and liabilities 

are treated as assets and liabilities of the FASIT’s owner and any income, gain, deduction or loss 

of the FASIT is allocable directly to its owner. Accordingly, income tax rules applicable to a 

FASIT (e.g., related party rules, sec. 871(h), sec. 165(g)(2)) are to be applied in the same manner 

as they apply to the FASIT’s owner. The taxable income of a FASIT is calculated using an 

accrual method of accounting. The constant yield method and principles that apply for purposes 

of determining original issue discount (“OID”) accrual on debt obligations whose principal is 

subject to acceleration apply to all debt obligations held by a FASIT to calculate the FASIT’s 

interest and discount income and premium deductions or adjustments.

Taxation of holders of FASIT regular interests

In general, a holder of a regular interest is taxed in the same manner as a holder of any 

other debt instrument, except that the regular interest holder is required to account for income 

relating to the interest on an accrual method of accounting, regardless of the method of 

accounting otherwise used by the holder.

Taxation of holders of FASIT ownership interests

Because all of the assets and liabilities of a FASIT are treated as assets and liabilities of 

the holder of a FASIT ownership interest, the ownership interest holder takes into account all of 
132

the FASIT’s income, gain, deduction, or loss in computing its taxable income or net loss for the 

taxable year. The character of the income to the holder of an ownership interest is the same as its 

character to the FASIT, except tax-exempt interest is included in the income of the holder as 

ordinary income.

Although the recognition of losses on assets contributed to the FASIT is not allowed 

upon contribution of the assets, such losses may be allowed to the FASIT owner upon their 

disposition by the FASIT. Furthermore, the holder of a FASIT ownership interest is not 

permitted to offset taxable income from the FASIT ownership interest (including gain or loss 

from the sale of the ownership interest in the FASIT) with other losses of the holder. In addition, 

any net operating loss carryover of the FASIT owner shall be computed by disregarding any 

income arising by reason of a disallowed loss. Where the holder of a FASIT ownership interest 

is a member of a consolidated group, this rule applies to the consolidated group of corporations 

of which the holder is a member as if the group were a single taxpayer.

Real estate mortgage investment conduits

In general, a real estate mortgage investment conduit (“REMIC”) is a self-liquidating 

entity that holds a fixed pool of mortgages and issues multiple classes of investor interests. A 

REMIC is not treated as a separate taxable entity. Rather, the income of the REMIC is allocated 

to, and taken into account by, the holders of the interests in the REMIC under detailed rules.214 

In order to qualify as a REMIC, substantially all of the assets of the entity must consist of 

qualified mortgages and permitted investments as of the close of the third month beginning after 

the startup day of the entity. A “qualified mortgage” generally includes any obligation which is 

principally secured by an interest in real property, and which is either transferred to the REMIC 

on the startup day of the REMIC in exchange for regular or residual interests in the REMIC or 

purchased by the REMIC within three months after the startup day pursuant to a fixed-price 

contract in effect on the startup day. A “permitted investment” generally includes any intangible 

property that is held for investment and is part of a reasonably required reserve to provide for full 

payment of certain expenses of the REMIC or amounts due on regular interests.

All of the interests in the REMIC must consist of one or more classes of regular interests 

and a single class of residual interests. A “regular interest” is an interest in a REMIC that is 

issued with a fixed term, designated as a regular interest, and unconditionally entitles the holder 

to receive a specified principal amount (or other similar amount) with interest payments that are 

either based on a fixed rate (or, to the extent provided in regulations, a variable rate) or consist of 

a specified portion of the interest payments on qualified mortgages that does not vary during the 

period such interest is outstanding. In general, a “residual interest” is any interest in the REMIC 

other than a regular interest, and which is so designated by the REMIC, provided that there is 

only one class of such interest and that all distributions (if any) with respect to such interests are 

pro rata. Holders of residual REMIC interests are subject to tax on the portion of the income of 

the REMIC that is not allocated to the regular interest holders.

 

214

 See sections 860A through 860G.
133

Original issue discount accruals with respect to debt instruments and pools of debt 

instruments subject to acceleration of principal payment

The holder of a debt instrument with original issue discount (“OID”) generally accrues 

and includes in gross income, as interest, the OID over the life of the obligation, even though the 

amount of the interest may not be received until the maturity of the instrument. 215 In general, 

issuers of debt instruments with OID accrue and deduct the amount of OID as interest expense in 

the same manner as the holder.

Special rules for determining the amount of OID allocated to a period apply to certain 

instruments and pools of instruments that may be subject to prepayment. First, if a borrower can 

reduce the yield on a debt by exercising a prepayment option, the OID rules assume that the 

borrower will prepay the debt. In addition, in the case of (1) any regular interest in a REMIC or 

qualified mortgage held by a REMIC, (2) any other debt instrument if payments under the 

instrument may be accelerated by reason of prepayments of other obligations securing the 

instrument, or (3) any pool of debt instruments the yield on which may be affected by reason of 

prepayments, the daily portions of the OID on such debt instruments and pools of debt 

instruments generally are determined by taking into account an assumption regarding the 

prepayment of principal for such instruments. The prepayment assumption to be used for this 

purpose is that which the parties use in pricing the particular transaction.

Description of Proposal

The proposal repeals the special rules for FASITs. The proposal provides a transition 

period for existing FASITs, pursuant to which the repeal of the FASIT rules would not apply to 

any FASIT in existence on the date of enactment to the extent that regular interests issued by the 

FASIT prior to such date continue to remain outstanding in accordance with their original terms.

For purposes of the REMIC rules, the proposal also modifies the definitions of REMIC 

regular interests, qualified mortgages, and permitted investments so that certain types of real 

estate loans and loan pools can be transferred to, or purchased by, a REMIC. Specifically, the 

proposal modifies the present-law definition of a REMIC “regular interest” to provide that an 

interest in a REMIC does not fail to qualify as a regular interest solely because the specified 

principal amount of such interest or the amount of interest accrued on such interest could be 

reduced as a result of the nonoccurrence of one or more contingent payments with respect to one 

or more reverse mortgages loans, as defined below, that are held by the REMIC, provided that on 

the startup day for the REMIC, the REMIC sponsor reasonably believes that all principal and 

 

215 The amount of OID with respect to a debt instrument is the excess of the stated 

redemption price at maturity over the issue price of the debt instrument. The stated redemption 

price at maturity includes all amounts payable at maturity. The amount of OID in a debt 

instrument is allocated over the life of the instrument through a series of adjustments to the issue 

price for each accrual period. The adjustment to the issue price is determined by multiplying the 

adjusted issue price (i.e., the issue price increased by adjustments prior to the accrual period) by 

the instrument’s yield to maturity, and then subtracting the interest payable during the accrual 

period.
134

interest due under the interest will be paid at or prior to the liquidation of the REMIC. For this 

purpose, a reasonable belief concerning ultimate payment of all amounts due under an interest is 

presumed to exist if, as of the startup day, the interest receives an investment grade rating from at 

least one nationally recognized statistical rating agency.

In addition, the proposal makes three modifications to the present-law definition of a 

“qualified mortgage.” First, the proposal modifies the definition to include an obligation 

principally secured by real property which represents an increase in the principal amount under

the original terms of an obligation, provided such increase: (1) is attributable to an advance 

made to the obligor pursuant to the original terms of the obligation; (2) occurs after the REMIC 

startup day; and (3) is purchased by the REMIC pursuant to a fixed price contract in effect on the 

startup day. Second, the proposal modifies the definition to generally include reverse mortgage 

loans and the periodic advances made to obligors on such loans. For this purpose, a “reverse 

mortgage loan” is defined as a loan that: (1) is secured by an interest in real property; (2) 

provides for one or more advances of principal to the obligor (each such advance giving rise to a 

“balance increase”), provided such advances are principally secured by an interest in the same 

real property as that which secures the loan; (3) may provide for a contingent payment at 

maturity based upon the value or appreciation in value of the real property securing the loan; (4) 

provides for an amount due at maturity that cannot exceed the value, or a specified fraction of the 

value, of the real property securing the loan; (5) provides that all payments under the loan are 

due only upon the maturity of the loan; and (6) matures after a fixed term or at the time the 

obligor ceases to use as a personal residence the real property securing the loan. Third, the 

proposal modifies the definition to provide that, if more than 50 percent of the obligations 

transferred to, or purchased by, the REMIC are (1) originated by the United States or any State 

(or any political subdivision, agency, or instrumentality of the United States or any State) and (2) 

principally secured by an interest in real property, then each obligation transferred to, or 

purchased by, the REMIC shall be treated as secured by an interest in real property.

In addition, the proposal modifies the present-law definition of a “permitted investment” 

to include intangible investment property held as part of a reasonably required reserve to provide 

a source of funds for the purchase of obligations described above as part of the modified 

definition of a “qualified mortgage.”

The proposal also modifies the OID rules with respect to certain instruments and pools of 

instruments that may be subject to principal prepayment by directing the Secretary to prescribe 

regulations permitting the use of a current prepayment assumption determined as of the close of 

the accrual period (or such other time as the Secretary may prescribe during the taxable year in 

which the accrual period ends).

Effective Date

Except as provided by the transition period for existing FASITs, this proposal is effective 

for taxable years beginning after December 31, 2003.
135

6. Limitation on transfer of built-in losses on REMIC residuals (sec. 3026 of the bill and 

sec. 362 of the Code)

Present Law

Generally, no gain or loss is recognized when one or more persons transfer property to a 

corporation in exchange for stock and immediately after the exchange such person or persons 

control the corporation. 216 The transferor's basis in the stock of the controlled corporation is the 

same as the basis of the property contributed to the controlled corporation, increased by the 

amount of any gain (or dividend) recognized by the transferor on the exchange, and reduced by 

the amount of any money or property received, and by the amount of any loss recognized by the 

transferor.217

The basis of property received by a corporation, whether from domestic or foreign 

transferors, in a tax-free incorporation, reorganization, or liquidation of a subsidiary corporation 

is the same as the adjusted basis in the hands of the transferor, adjusted for gain or loss 

recognized by the transferor.218

Description of Proposal

The proposal provides that if a residual interest (as defined in section 860G(a)(2)) in a 

real estate mortgage investment conduit (“REMIC”) is contributed to a corporation and the 

transferee corporation’s adjusted basis in the REMIC residual interest would (but for the 

proposal) exceed the fair market value of the REMIC residual interest immediately after the 

contribution, the transferee corporation’s adjusted basis in the REMIC residual interest is limited 

to the fair market value of the REMIC residual interest immediately after the contribution, 

regardless of whether the fair market value of the REMIC residual interest is less than, equal to, 

or greater than zero (i.e., the proposal may result in the transferee corporation having a negative 

adjusted basis in the REMIC residual interest).

Effective Date

The proposal applies to transactions after the date of enactment.

 

216 Sec. 351.

217 Sec. 358.

218 Secs. 334(b) and 362(a) and (b).
136

7. Clarification of banking business for purposes of determining investment of earnings in 

U.S. property (sec. 3027 of the bill and sec. 956 of the Code)

Present Law

In general, the subpart F rules (secs. 951-964) require the U.S. 10-percent shareholders of 

a controlled foreign corporation to include in income currently their pro rata shares of certain 

income of the controlled foreign corporation (referred to as “subpart F income”), whether or not 

such earnings are distributed currently to the shareholders. In addition, the U.S. 10-percent 

shareholders of a controlled foreign corporation are subject to U.S. tax currently on their pro rata 

shares of the controlled foreign corporation's earnings to the extent invested by the controlled 

foreign corporation in certain U.S. property (sec. 951(a)(1)(B)).

A shareholder’s current income inclusion with respect to a controlled foreign 

corporation's investment in U.S. property for a taxable year is based on the controlled foreign 

corporation’s average investment in U.S. property for such year. For this purpose, the U.S. 

property held (directly or indirectly) by the controlled foreign corporation must be measured as 

of the close of each quarter in the taxable year (sec. 956(a)). The amount taken into account with 

respect to any property is the property’s adjusted basis as determined for purposes of reporting 

the controlled foreign corporation’s earnings and profits, reduced by any liability to which the 

property is subject. The amount determined for current inclusion is the shareholder’s pro rata 

share of an amount equal to the lesser of: (1) the controlled foreign corporation’s average 

investment in U.S. property as of the end of each quarter of such taxable year, to the extent that 

such investment exceeds the foreign corporation’s earnings and profits that were previously 

taxed on that basis; or (2) the controlled foreign corporation’s current or accumulated earnings 

and profits (but not including a deficit), reduced by distributions during the year and by earnings 

that have been taxed previously as earnings invested in U.S. property (secs. 956 and 959). An 

income inclusion is required only to the extent that the amount so calculated exceeds the amount 

of the controlled foreign corporation’s earnings that have been previously taxed as subpart F 

income (secs. 951(a)(1)(B) and 959).

For purposes of section 956, U.S. property generally is defined to include tangible 

property located in the United States, stock of a U.S. corporation, an obligation of a U.S. person, 

and certain intangible assets including a patent or copyright, an invention, model or design, a 

secret formula or process or similar property right which is acquired or developed by the 

controlled foreign corporation for use in the United States (sec. 956(c)(1)).

Specified exceptions from the definition of U.S. property are provided for: (1) 

obligations of the United States, money, or deposits with persons carrying on the banking 

business; (2) certain export property; (3) certain trade or business obligations; (4) aircraft, 

railroad rolling stock, vessels, motor vehicles or containers used in transportation in foreign 

commerce and used predominantly outside of the United States; (5) certain insurance company 

reserves and unearned premiums related to insurance of foreign risks; (6) stock or debt of certain 

unrelated U.S. corporations; (7) moveable property (other than a vessel or aircraft) used for the 

purpose of exploring, developing, or certain other activities in connection with the ocean waters 

of the U.S. Continental Shelf; (8) an amount of assets equal to the controlled foreign 

corporation’s accumulated earnings and profits attributable to income effectively connected with 
137

a U.S. trade or business; (9) property (to the extent provided in regulations) held by a foreign 

sales corporation and related to its export activities; (10) certain deposits or receipts of collateral 

or margin by a securities or commodities dealer, if such deposit is made or received on 

commercial terms in the ordinary course of the dealer’s business as a securities or commodities 

dealer; and (11) certain repurchase and reverse repurchase agreement transactions entered into by 

or with a dealer in securities or commodities in the ordinary course of its business as a securities 

or commodities dealer (sec. 956(c)(2)).

With regard to the exception for deposits with persons carrying on the banking business, 

the U.S. Court of Appeals for the Sixth Circuit in The Limited, Inc. v. Commissioner219

concluded that a U.S. subsidiary of a U.S. shareholder was “carrying on the banking business” 

even though its operations were limited to the administration of the private label credit card 

program of the U.S. shareholder. Therefore, the court held that a controlled foreign corporation 

of the U.S. shareholder could make deposits with the subsidiary (e.g., through the purchase of 

certificates of deposit) under this exception, and avoid taxation of the deposits under section 956 

as an investment in U.S. property.

Description of Proposal

The proposal provides that the exception from the definition of U.S. property under 

section 956 for deposits with persons carrying on the banking business is limited to deposits with 

corporations with respect to which a bank holding company (as defined by section 2(a) of the 

Bank Holding Company Act of 1956 (12 U.S.C. 1841(c)) or financial holding company (as 

defined by section 2(p) of such Act) owns directly or indirectly more than 80 percent by vote or 

value of the stock of such corporation.

No inference is intended as to the meaning of the phrase “carrying on the banking 

business” under present law or whether this phrase was correctly interpreted by the Sixth Circuit 

in The Limited.

Effective Date

This proposal is effective on the date of enactment.

8. Modify rules related to certain small property and casualty insurance companies

(sec. 3028 of the bill and secs. 501(c)(15) and 831(b) of the Code)

Present Law

A property and casualty insurance company generally is subject to tax on its taxable 

income (sec. 831(a)). The taxable income of a property and casualty insurance company is 

determined as the sum of its underwriting income and investment income (as well as gains and 

other income items), reduced by allowable deductions (sec. 832).

 

219 286 F.3d 324 (6th Cir. 2002), rev’g 113 T.C. 169 (1999).
138

A property and casualty insurance company is eligible to be exempt from Federal income 

tax if its net written premiums or direct written premiums (whichever is greater) for the taxable 

year do not exceed $350,000 (sec. 501(c)(15)).

A property and casualty insurance company may elect to be taxed only on taxable 

investment income if its net written premiums or direct written premiums (whichever is greater) 

for the taxable year exceed $350,000, but do not exceed $1.2 million (sec. 831(b)).

For purposes of determining the amount of a company's net written premiums or direct 

written premiums under these rules, premiums received by all members of a controlled group of 

corporations of which the company is a part are taken into account. For this purpose, a morethan-50-percent threshhold applies under the vote and value requirements with respect to stock 

ownership for determining a controlled group, and rules treating a life insurance company as part 

of a separate controlled group or as an excluded member of a group do not apply (secs. 

501(c)(15), 831(b)(2)(B) and 1563).

Description of Proposal

The proposal modifies the requirements for a property and casualty insurance company to 

be eligible for tax-exempt status, and to elect to be taxed only on taxable investment income. 

Under the proposal, a property and casualty insurance company is eligible to be exempt 

from Federal income tax if (a) its gross receipts for the taxable year do not exceed $600,000, and 

(b) the premiums received for the taxable year are greater than 50 percent of its gross receipts. 

For purposes of determining gross receipts, the gross receipts of all members of a controlled 

group of corporations of which the company is a part are taken into account. The proposal 

expands the present-law controlled group rule so that it also takes into account gross receipts of 

foreign and tax-exempt corporations. 

A company that does not meet the definition of an insurance company is not eligible to be 

exempt from Federal income tax under the proposal. For this purpose, the term "insurance 

company" means any company, more than half of the business of which during the taxable year 

is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by 

insurance companies (sec. 816(a)). A company whose investment activities outweigh its 

insurance activities is not considered to be an insurance company for this purpose.220 It is 

intended that IRS enforcement activities address the misuse of present-law section 501(c)(15).

The proposal also provides that a property and casualty insurance company may elect to 

be taxed only on taxable investment income if its net written premiums or direct written 

premiums (whichever is greater) do not exceed a specified amount (without regard to whether 

such premiums exceed $350,000) (sec. 831(b)). The proposal increases from $1.2 million to 

$1.89 million the upper limit on net (or direct) written premiums for purposes of such election. 

The $1.89 million amount is indexed for inflation for taxable years beginning in calendar years 

after 2004. As under present law, for purposes of determining the amount of a company's net 

 

220

 See, e.g., Inter-American Life Insurance Co. v. Comm'r, 56 T.C. 497, aff'd per curiam, 

469 F.2d 697 (9th Cir. 1972). 
139

written premiums or direct written premiums under this rule, premiums received by all members 

of a controlled group of corporations (as defined in section 831(b)) of which the company is a 

part are taken into account.

It is intended that regulations or other Treasury guidance provide for anti-abuse rules so 

as to prevent improper use of the provision, including, for example, by attempts to characterize 

as premiums any income that is other than premium income.

Effective Date

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

9. Definition of insurance company for property and casualty insurance company tax rules 

(sec. 3029 of the bill and sec. 831(c) of the Code)

Present Law

Present law provides specific rules for taxation of the life insurance company taxable 

income of a life insurance company (sec. 801), and for taxation of the taxable income of a 

company other than a life insurance company (sec. 831) (generally referred to as a property and 

casualty insurance company). For Federal income tax purposes, a life insurance company means 

an insurance company that is engaged in the business of issuing life insurance and annuity 

contracts, or noncancellable health and accident insurance contracts, and that meets a 50-percent 

test with respect to its reserves (sec. 816(a)). This statutory provision applicable to life insurance 

companies explicitly defines the term "insurance company" to mean any company, more than 

half of the business of which during the taxable year is the issuing of insurance or annuity 

contracts or the reinsuring of risks underwritten by insurance companies (sec. 816(a)).

The life insurance company statutory definition of an insurance company does not 

explicitly apply to property and casualty insurance companies, although a long-standing Treasury 

regulation221 that is applied to property and casualty companies provides a somewhat similar 

definition of an "insurance company" based on the company's "primary and predominant 

business activity."222 

 

221 The Treasury regulation provides that "the term 'insurance company' means a 

company whose primary and predominant business activity during the taxable year is the issuing 

of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. 

Thus, though its name, charter powers, and subjection to State insurance laws are significant in 

determining the business which a company is authorized and intends to carry on, it is the 

character of the business actually done in the taxable year which determines whether a company 

is taxable as an insurance company under the Internal Revenue Code." Treas. Reg. section 

1.801-3(a)(1). 

222 Court cases involving a determination of whether a company is an insurance company 

for Federal tax purposes have examined all of the business and other activities of the company. 

In considering whether a company is an insurance company for such purposes, courts have 

considered, among other factors, the amount and source of income received by the company 
140

When enacting the statutory definition of an insurance company in 1984, Congress stated, 

“[b]y requiring [that] more than half rather than the 'primary and predominant business activity' 

be insurance activity, the proposal adopts a stricter and more precise standard for a company to 

be taxed as a life insurance company than does the general regulatory definition of an insurance 

company applicable for both life and nonlife insurance companies . . . Whether more than half 

of the business activity is related to the issuing of insurance or annuity contracts will depend on 

the facts and circumstances and factors to be considered will include the relative distribution of 

the number of employees assigned to, the amount of space allocated to, and the net income 

derived from, the various business activities.”223

Description of Proposal

The proposal provides that, for purposes of determining whether a company is a property 

and casualty insurance company, the term "insurance company" is defined to mean any 

company, more than half of the business of which during the taxable year is the issuing of 

insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. 

Thus, the proposal conforms the definition of an insurance company for purposes of the rules 

taxing property and casualty insurance companies to the rules taxing life insurance companies, so 

that the definition is uniform. The provision adopts a stricter and more precise standard than the 

"primary and predominant business activity" test contained in Treasury Regulations. A company 

whose investment activities outweigh its insurance activities is not considered to be an insurance 

company under the provision. 224 It is not intended that a company whose sole activity is the run-

 

from its different activities. See Bowers v. Lawyers Mortgage Co., 285 U.S. 182 (1932); United 

States v. Home Title Insurance Co., 285 U.S. 191 (1932). See also Inter-American Life 

Insurance Co. v. Comm'r, 56 T.C. 497, aff'd per curiam, 469 F.2d 697 (9th Cir. 1972), in which 

the court concluded that the company was not an insurance company: "The ... financial data 

clearly indicates that petitioner's primary and predominant source of income was from its 

investments and not from issuing insurance contracts or reinsuring risks underwritten by 

insurance companies. During each of the years in issue, petitioner's investment income far 

exceeded its premiums and the amounts of earned premiums were de minimis during those years. 

It is equally as clear that petitioner's primary and predominant efforts were not expended in 

issuing insurance contracts or in reinsurance. Of the relatively few policies directly written by 

petitioner, nearly all were issued to [family members]. Also, Investment Life, in which [family 

members] each owned a substantial stock interest, was the source of nearly all of the policies 

reinsured by petitioner. These facts, coupled with the fact that petitioner did not maintain an 

active sales staff soliciting or selling insurance policies . . ., indicate a lack of concentrated effort 

on petitioner's behalf toward its chartered purpose of engaging in the insurance business. . . . For 

the above reasons, we hold that during the years in issue, petitioner was not 'an insurance 

company . . . engaged in the business of issuing life insurance' and hence, that petitioner was not 

a life insurance company within the meaning of section 801." 56 T.C. 497, 507-508.

223 H.R. Rep. 98-432, part 2, at 1402-1403 (1984); S. Prt. No. 98-169, vol. I, at 525-526 

(1984); see also H.R. Rep. No. 98-861 at 1043-1044 (1985) (Conference Report).

224

 See Inter-American Life Insurance Co. v. Comm'r, supra. 
141

off of risks under the company's insurance contracts be treated as a company other than an 

insurance company, even if the company has little or no premium income. 

Effective Date

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

10. Denial of deduction for interest on underpayments attributable to nondisclosed 

reportable transactions (sec. 3030 of the bill and sec. 163 of the Code)

Present Law

In general, corporations may deduct interest paid or accrued within a taxable year on 

indebtedness.225 Interest on indebtedness to the Federal government attributable to an 

underpayment of tax generally may be deducted pursuant to this provision. 

Description of Proposal

The proposal disallows any deduction for interest paid or accrued within a taxable year 

on any portion of an underpayment of tax that is attributable to an understatement arising from 

an undisclosed reportable avoidance transaction or an undisclosed listed transaction. 226

Effective Date

The provision is effective for underpayments attributable to transactions entered into in taxable 

years beginning after the date of enactment.

11. Clarification of rules for payment of estimated tax for certain deemed asset sales

(sec. 3031 of the bill and sec. 338 of the Code)

Present Law

In certain circumstances, taxpayers can make an election under section 338(h)(10) to treat 

a qualifying purchase of 80 percent of the stock of a target corporation by a corporation from a 

corporation that is a member of an affiliated group (or a qualifying purchase of 80 percent of the 

stock of an S corporation by a corporation from S corporation shareholders) as a sale of the 

assets of the target corporation, rather than as a stock sale. The election must be made jointly by 

the buyer and seller of the stock and is due by the 15th day of the ninth month beginning after the 

month in which the acquisition date occurs. An agreement for the purchase and sale of stock 

often may contain an agreement of the parties to make a section 338(h)(10) election. 

 

225 Sec. 163(a). 

226 The definitions of these transactions are the same as those previously described in 

connection with the provision elsewhere in this bill to modify the accuracy-related penalty for 

listed and certain reportable transactions.
142

Section 338(a) also permits a unilateral election by a buyer corporation to treat a qualified 

stock purchase of a corporation as a deemed asset acquisition, whether or not the seller of the 

stock is a corporation (or an S corporation is the target). In such a case, the seller or sellers 

recognize gain or loss on the stock sale (including any estimated taxes with respect to the stock 

sale), and the target corporation recognizes gain or loss on the deemed asset sale. 

Section 338(h)(13) provides that, for purposes of section 6655 (relating to additions to tax 

for failure by a corporation to pay estimated income tax), tax attributable to a deemed asset sale 

under section 338(a)(1) shall not be taken into account. 

Description of Proposal

The proposal clarifies section 338(h)(13) to provide that the exception for estimated tax 

purposes with respect to tax attributable to a deemed asset sale does not apply with respect to a 

qualified stock purchase for which an election is made under section 338(h)(10).

Under the proposal, if a transaction eligible for the election under section 338(h)(10) 

occurs, estimated tax would be determined based on the stock sale unless and until there is an 

agreement of the parties to make a section 338(h)(10) election.

Thus, if at the time of the sale there is an agreement of the parties to make a section 

338(h)(10) election, then estimated tax is computed from the date of the sale, based on an asset 

sale. If the agreement to make a section 338(h)(10) election is concluded after the stock sale, 

such that the original computation was based on a stock sale, estimated tax is recomputed based 

on the asset sale election. 

No inference is intended as to present law.

Effective Date

The proposal is effective for transactions that occur after the date of enactment of the 

provision.

12. Exclusion of like-kind exchange property from nonrecognition treatment on the sale or 

exchange of a principal residence (sec. 3032 of the bill and sec. 121 of the Code)

Present Law

Under present law, a taxpayer may exclude up to $250,000 ($500,000 if married filing a 

joint return) of gain realized on the sale or exchange of a principal residence.227 To be eligible 

for the exclusion, the taxpayer must have owned and used the residence as a principal residence 

for at least two of the five years prior to the sale or exchange. A taxpayer who fails to meet these 

requirements by reason of a change of place of employment, health, or, to the extent provided 

under regulations, unforeseen circumstances is able to exclude an amount equal to the fraction of 

the $250,000 ($500,000 if married filing a joint return) that is equal to the fraction of the two 

 

227 Sec. 121.
143

years that the ownership and use requirements are met. There are no special rules relating to the 

sale or exchange of a principal residence that was acquired in a like-kind exchange within the 

prior five years.

Description of Proposal

The proposal provides that the exclusion for gain on the sale or exchange of a principal 

residence does not apply if the principal residence was acquired in a like-kind exchange in which 

any gain was not recognized within the prior five years.

Effective Date

The proposal is effective for sales or exchanges of principal residences after the date of 

enactment.

13. Prevention of mismatching of interest and original issue discount deductions and 

income inclusions in transactions with related foreign persons (sec. 3033 of the bill and

secs. 163 and 267 of the Code)

Present Law

Income earned by a foreign corporation from its foreign operations generally is subject to 

U.S. tax only when such income is distributed to any U.S. person that holds stock in such 

corporation. Accordingly, a U.S. person that conducts foreign operations through a foreign 

corporation generally is subject to U.S. tax on the income from such operations when the income 

is repatriated to the United States through a dividend distribution to the U.S. person. The income 

is reported on the U.S. person's tax return for the year the distribution is received, and the United 

States imposes tax on such income at that time. However, certain anti-deferral regimes may 

cause the U.S. person to be taxed on a current basis in the United States with respect to certain 

categories of passive or highly mobile income earned by the foreign corporations in which the 

U.S. person holds stock. The main anti-deferral regimes are the controlled foreign corporation 

rules of subpart F (sections 951-964), the passive foreign investment company rules (sections 

1291-1298), and the foreign personal holding company rules (sections 551-558). 

As a general rule, there is allowed as a deduction all interest paid or accrued within the 

taxable year with respect to indebtedness, including the aggregate daily portions of original issue 

discount (“OID”) of the issuer for the days during such taxable year.228 However, if a debt 

instrument is held by a related foreign person, any portion of such OID is not allowable as a 

deduction to the payor of such instrument until paid (“related-foreign-person rule”). This 

related-foreign-person rule does not apply to the extent that the OID is effectively connected 

with the conduct by such foreign related person of a trade or business within the United States 

(unless such OID is exempt from taxation or is subject to a reduced rate of taxation under a treaty 

obligation).229 Treasury regulations further modify the related-foreign-person rule by providing 

 

228 Section 163(e)(1).

229 Section 163(e)(3).
144

that in the case of a debt owed to a foreign personal holding company (“FPHC”), controlled 

foreign corporation (“CFC”) or passive foreign investment company (“PFIC”), a deduction is 

allowed for OID as of the day on which the amount is includible in the income of the FPHC, 

CFC or PFIC, respectively.230

In the case of unpaid stated interest and expenses of related persons, where, by reason of 

a payee's method of accounting, an amount is not includible in the payee's gross income until it is 

paid but the unpaid amounts are deductible currently by the payor, the amount generally is 

allowable as a deduction when such amount is includible in the gross income of the payee.231 

With respect to stated interest and other expenses owed to related foreign corporations, Treasury 

regulations provide a general rule that requires a taxpayer to use the cash method of accounting 

with respect to the deduction of amounts owed to such related foreign persons (with an exception 

for income of a related foreign person that is effectively connected with the conduct of a U.S. 

trade or business and that is not exempt from taxation or subject to a reduced rate of taxation 

under a treaty obligation).232 As in the case of OID, the Treasury regulations additionally

provide that in the case of stated interest owed to a FPHC, CFC, or PFIC, a deduction is allowed 

as of the day on which the amount is includible in the income of the FPHC, CFC or PFIC.233

Description of Proposal

The proposal provides that deductions for amounts accrued but unpaid (whether by U.S. 

or foreign persons) to related FPHCs, CFCs, or PFICs are allowable only to the extent that the 

amounts accrued by the payor are, for U.S. tax purposes, currently included in the income of all 

of the direct or indirect U.S. owners of the related foreign person under the relevant inclusion 

rules. Deductions that have accrued but are not allowable under this proposal are allowed when 

the amounts are paid. The proposal grants the Secretary regulatory authority to provide 

exceptions to these rules, including an exception for amounts accrued where payment of the 

amount accrued occurs within a short period after accrual, and the transaction giving rise to the 

payment is entered into by the payor in the ordinary course of a business in which the payor is 

predominantly engaged.

Effective Date

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

 

230 Treas. Reg. sec. 1.163-12(b)(3). In the case of a PFIC, the regulations further require 

that the person owing the amount at issue has in effect a qualified electing fund election pursuant 

to section 1295 with respect to the PFIC.

231 Section 267(a)(2).

232 Treas. Reg. sec. 1.267(a)-3(b)(1), (c).

233 Treas. Reg. sec. 1.267(a)-3(c)(4).
145

14. Exclusion from gross income for interest on overpayments of income tax by individuals 

(sec. 3034 of the bill and new sec. 139A of the Code)

Present Law

Overpayment interest

Interest is included in the list of items that are required to be included in gross income 

(sec. 61(a)(4)). Interest on overpayments of Federal income tax is required to be included in 

taxable income in the same manner as any other interest that is received by the taxpayer. 

Cash basis taxpayers are required to report overpayment interest as income in the period 

the interest is received. Accrual basis taxpayers are required to report overpayment interest as 

income when all events fixing the right to the receipt of the overpayment interest have occurred 

and the amount can be estimated with reasonable accuracy. Generally, this occurs on the date 

the appropriate IRS official signs the pertinent schedule of overassessments. 

Underpayment interest

A corporate taxpayer is allowed to currently take into account interest paid on 

underpayments of Federal income tax as an ordinary and necessary business expense. Typically, 

this results in a current deduction. However, the deduction may be deferred if the interest is 

required to be capitalized or may be disallowed if and to the extent it is determined to be a cost 

of earning tax exempt income under section 265.

Section 163(h) of the Code prohibits the deduction of personal interest by taxpayers other 

than corporations. Noncorporate taxpayers, including individuals, generally are not allowed to 

deduct interest on the underpayment of Federal income taxes.

Temporary regulations provide that personal interest includes interest paid on 

underpayments of individual Federal, State or local income taxes, regardless of the source of the 

income generating the tax liability. This is consistent with the statement in the General 

Explanation of the Tax Reform Act of 1986 that “(p)ersonal interest also includes interest on 

underpayments of individual Federal, State, or local income taxes notwithstanding that all or a 

portion of the income may have arisen in a trade or business, because such taxes are not 

considered derived from conduct of a trade or business.” The validity of the temporary 

regulation has been upheld in those Circuits that have considered the issue, including the Fourth, 

Sixth, Eighth, and Ninth Circuits. 

Personal interest also includes interest that is paid by a trust, S corporation, or other passthrough entity on underpayments of State or local income taxes. Personal interest does not 

include interest that is paid with respect to sales, excise or similar taxes that are incurred in 

connection with a trade or business or an investment activity. 

Description of Proposal

The proposal excludes overpayment interest that is paid to individual taxpayers on 

overpayments of Federal income tax from gross income. Interest excluded under the provision is 
146

not considered disqualified income that could limit the earned income credit. Interest excluded 

under the provision also is not considered in determining what portion of a taxpayer’s social 

security or tier 1 railroad retirement benefits are subject to tax (sec. 86), whether a taxpayer has 

sufficient taxable income to be required to file a return (sec. 6012(d)), or for any other 

computation in which interest exempt from tax is otherwise required to be added to adjusted 

gross income.

The exclusion from income of overpayment interest does not apply if the Secretary 

determines that the taxpayer’s principal purpose for overpaying his or her tax is to take 

advantage of the exclusion.

For example, a taxpayer prepares his return without taking into account significant 

itemized deductions of which he is, or should be, aware. Before the expiration of the statute of 

limitations, the taxpayer files an amended return claiming these itemized deductions and 

requesting a refund with interest. Unless the taxpayer can establish a principal purpose for 

originally overpaying the tax other than collecting excludible interest, the Secretary may 

determine that the principal purpose of waiting to claim the deductions on an amended return 

was to earn interest that would be excluded from income. In that case, the interest on the 

overpayment could not be excluded from income.

It is expected that the Secretary will indicate whether the interest is eligible to be 

excluded from income on the Form 1099 it provides that taxpayer for taxable year in which the 

underpayment interest is paid. 

Effective Date

The proposal is effective for interest received in calendar years beginning after the date of 

enactment.

15. Deposits made to suspend the running of interest on potential underpayments (sec. 3035 

of the bill and new sec. 6603 of the Code)

Present Law

Generally, interest on underpayments and overpayments continues to accrue during the 

period that a taxpayer and the IRS dispute a liability. The accrual of interest on an underpayment 

is suspended if the IRS fails to notify an individual taxpayer in a timely manner, but interest will 

begin to accrue once the taxpayer is properly notified. No similar suspension is available for 

other taxpayers.

A taxpayer that wants to limit its exposure to underpayment interest has a limited number 

of options. The taxpayer can continue to dispute the amount owed and risk paying a significant 

amount of interest. If the taxpayer continues to dispute the amount and ultimately loses, the 

taxpayer will be required to pay interest on the underpayment from the original due date of the 

return until the date of payment.

In order to avoid the accrual of underpayment interest, the taxpayer may choose to pay 

the disputed amount and immediately file a claim for refund. Payment of the disputed amount 
147

will prevent further interest from accruing if the taxpayer loses (since there is no longer any 

underpayment) and the taxpayer will earn interest on the resultant overpayment if the taxpayer 

wins. However, the taxpayer will generally lose access to the Tax Court if it follows this 

alternative. Amounts paid generally cannot be recovered by the taxpayer on demand, but must 

await final determination of the taxpayer’s liability. Even if an overpayment is ultimately 

determined, overpaid amounts may not be refunded if they are eligible to be offset against other 

liabilities of the taxpayer. 

The taxpayer may also make a deposit in the nature of a cash bond. The procedures for 

making a deposit in the nature of a cash bond are provided in Rev. Proc. 84-58. 

A deposit in the nature of a cash bond will stop the running of interest on an amount of 

underpayment equal to the deposit, but the deposit does not itself earn interest. A deposit in the 

nature of a cash bond is not a payment of tax and is not subject to a claim for credit or refund. A 

deposit in the nature of a cash bond may be made for all or part of the disputed liability and 

generally may be recovered by the taxpayer prior to a final determination. However, a deposit 

in the nature of a cash bond need not be refunded to the extent the Secretary determines that the 

assessment or collection of the tax determined would be in jeopardy, or that the deposit should 

be applied against another liability of the taxpayer in the same manner as an overpayment of tax. 

If the taxpayer recovers the deposit prior to final determination and a deficiency is later 

determined, the taxpayer will not receive credit for the period in which the funds were held as a 

deposit. The taxable year to which the deposit in the nature of a cash bond relates must be 

designated, but the taxpayer may request that the deposit be applied to a different year under 

certain circumstances. 

Description of Proposal

In general

The proposal allows a taxpayer to deposit cash with the IRS that the may subsequently be 

used to pay an underpayment of income, gift, estate, generation-skipping, or certain excise taxes. 

Interest will not be charged on the portion of the underpayment that is paid by the deposited 

amount for the period the amount is on deposit. Generally, deposited amounts that have not been 

used to pay a tax may be withdrawn at any time if the taxpayer so requests in writing. The 

withdrawn amounts will earn interest at the applicable Federal rate to the extent they are 

attributable to a disputable tax.

The Secretary may issue rules relating to the making, use, and return of the deposits.

Use of a deposit to offset underpayments of tax

Any amount on deposit may be used to pay an underpayment of tax that is ultimately 

assessed. If an underpayment is paid in this manner, the taxpayer will not be charged 

underpayment interest on the portion of the underpayment that is so paid for the period the funds 

were on deposit.

For example, assume a calendar year individual taxpayer deposits $20,000 on May 15, 

2005, with respect to a disputable item on its 2004 income tax return. On April 15, 2007, an 
148

examination of the taxpayer’s year 2004 income tax return is completed, and the taxpayer and 

the IRS agree that the taxable year 2004 taxes were underpaid by $25,000. The $20,000 on 

deposit is used to pay $20,000 of the underpayment, and the taxpayer also pays the remaining 

$5,000. In this case, the taxpayer will owe underpayment interest from April 15, 2005 (the 

original due date of the return) to the date of payment (April 15, 2007) only with respect to the 

$5,000 of the underpayment that is not paid by the deposit. The taxpayer will owe underpayment 

interest on the remaining $20,000 of the underpayment only from April 15, 2005, to May 15, 

2005, the date the $20,000 was deposited.

Withdrawal of amounts

A taxpayer may request the withdrawal of any amount of deposit at any time. The 

Secretary must comply with the withdrawal request unless the amount has already been used to 

pay tax or the Secretary properly determines that collection of tax is in jeopardy. Interest will be 

paid on deposited amounts that are withdrawn at a rate equal to the short-term applicable Federal 

rate for the period from the date of deposit to a date not more than 30 days preceding the date of 

the check paying the withdrawal. Interest is not payable to the extent the deposit was not 

attributable to a disputable tax.

For example, assume a calendar year individual taxpayer receives a 30-day letter showing 

a deficiency of $20,000 for taxable year 2004 and deposits $20,000 on May 15, 2006. On April 

15, 2007, an administrative appeal is completed, and the taxpayer and the IRS agree that the 

2004 taxes were underpaid by $15,000. $15,000 of the deposit is used to pay the underpayment. 

In this case, the taxpayer will owe underpayment interest from April 15, 2005 (the original due 

date of the return) to May 15, 2006, the date the $20,000 was deposited. Simultaneously with 

the use of the $15,000 to offset the underpayment, the taxpayer requests the return of the 

remaining amount of the deposit (after reduction for the underpayment interest owed by the 

taxpayer from April 15, 2005, to May 15, 2006). This amount must be returned to the taxpayer 

with interest determined at the short-term applicable Federal rate from the May 15, 2006, to a 

date not more than 30 days preceding the date of the check repaying the deposit to the taxpayer.

Limitation on amounts for which interest may be allowed

Interest on a deposit that is returned to a taxpayer shall be allowed for any period only to 

the extent attributable to a disputable item for that period. A disputable item is any item for 

which the taxpayer 1) has a reasonable basis for the treatment used on its return and 2) 

reasonably believes that the Secretary also has a reasonable basis for disallowing the taxpayer’s 

treatment of such item. 

All items included in a 30-day letter to a taxpayer are deemed disputable for this purpose. 

Thus, once a 30-day letter has been issued, the disputable amount cannot be less than the amount 

of the deficiency shown in the 30-day letter. A 30-day letter is the first letter of proposed 

deficiency that allows the taxpayer an opportunity for administrative review in the Internal 

Revenue Service Office of Appeals.
149

Deposits are not payments of tax

A deposit is not a payment of tax prior to the time the deposited amount is used to pay a 

tax. Thus, the interest received on withdrawn deposits will not be eligible for the proposed 

exclusion from income of an individual. Similarly, withdrawal of a deposit will not establish a 

period for which interest was allowable at the short-term applicable Federal rate for the purpose 

of establishing a net zero interest rate on a similar amount of underpayment for the same period.

Effective Date

The proposal applies to deposits made after the date of enactment. Amounts already on 

deposit as of the date of enactment are treated as deposited (for purposes of applying this 

provision) on the date the taxpayer identifies the amount as a deposit made pursuant to this 

provision.

16. Authorize IRS to enter into installment agreements that provide for partial payment 

(sec. 3036 of the bill and sec. 6159 of the Code)

Present Law

The Code authorizes the IRS to enter into written agreements with any taxpayer under 

which the taxpayer is allowed to pay taxes owed, as well as interest and penalties, in installment 

payments if the IRS determines that doing so will facilitate collection of the amounts owed (sec. 

6159). An installment agreement does not reduce the amount of taxes, interest, or penalties 

owed. Generally, during the period installment payments are being made, other IRS enforcement 

actions (such as levies or seizures) with respect to the taxes included in that agreement are held 

in abeyance. 

Prior to 1998, the IRS administratively entered into installment agreements that provided 

for partial payment (rather than full payment) of the total amount owed over the period of the 

agreement. In that year, the IRS Chief Counsel issued a memorandum concluding that partial 

payment installment agreements were not permitted.

Description of Proposal

The proposal clarifies that the IRS is authorized to enter into installment agreements with 

taxpayers which do not provide for full payment of the taxpayer’s liability over the life of the 

agreement. The proposal also requires the IRS to review partial payment installment agreements 

at least every two years. The primary purpose of this review is to determine whether the 

financial condition of the taxpayer has significantly changed so as to warrant an increase in the 

value of the payments being made.

Effective Date

The proposal is effective for installment agreements entered into on or after the date of 

enactment. 
150

17. Extension of IRS user fees (sec. 3037 of the bill and sec. 7528 of the Code)

Present Law

The IRS provides written responses to questions of individuals, corporations, and

organizations relating to their tax status or the effects of particular transactions for tax purposes. 

The IRS generally charges a fee for requests for a letter ruling, determination letter, opinion 

letter, or other similar ruling or determination. 234 Public Law 108-89235 extended the statutory 

authorization for these user fees through December 31, 2004, and moved the statutory 

authorization for these fees into the Code.236

Description of Proposal

The proposal extends the statutory authorization for these user fees through September 

30, 2013. 

Effective Date

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

 

234 These user fees were originally enacted in section 10511 of the Revenue Act of 1987 

(Pub. Law No. 100-203, December 22, 1987). Public Law 104-117 (An Act to provide that 

members of the Armed Forces performing services for the peacekeeping efforts in Bosnia and 

Herzegovina, Croatia, and Macedonia shall be entitled to tax benefits in the same manner as if 

such services were performed in a combat zone, and for other purposes (March 20, 1996)) 

extended the statutory authorization for these user fees through September 30, 2003.

235 117 Stat. 1131; H.R. 3146, signed by the President on October 1, 2003.

236 That Public Law also moved into the Code the user fee provision relating to pension 

plans that was enacted in section 620 of the Economic Growth and Tax Relief Reconciliation Act 

of 2001 (Pub. L. 107-16, June 7, 2001).
151

IV. TRADE ENHANCEMENT AND COMPLIANCE PROVISIONS

A. Repeal of Exclusion for Extraterritorial Income

(sec. 4001 of the bill and secs. 114 and 941-943 of the Code)

Present Law

The United States has long provided export-related benefits under a series of tax regimes, 

including the domestic international sales corporation (“DISC”) regime, the foreign sales 

corporation (“FSC”) regime, and the extraterritorial income (“ETI”) regime. Each of these 

regimes has been found to violate U.S. obligations under international trade agreements. In 

2000, the European Union (“EU”) succeeded in having the FSC regime declared a prohibited 

export subsidy by the WTO. In response to this WTO ruling, the United States repealed the FSC 

rules and enacted a new regime under the FSC Repeal and Extraterritorial Income Exclusion Act 

of 2000. The EU immediately challenged the ETI regime in the WTO, and in January of 2002 a

WTO Appellate Body held that the ETI regime also constituted a prohibited export subsidy 

under the relevant trade agreements.

Under the ETI regime, an exclusion from gross income applies with respect to 

“extraterritorial income,” which is a taxpayer’s gross income attributable to “foreign trading 

gross receipts.” This income is eligible for the exclusion to the extent that it is “qualifying 

foreign trade income.” Qualifying foreign trade income is the amount of gross income that, if 

excluded, would result in a reduction of taxable income by the greatest of: (1) 1.2 percent of the 

foreign trading gross receipts derived by the taxpayer from the transaction; (2) 15 percent of the 

“foreign trade income” derived by the taxpayer from the transaction;237 or (3) 30 percent of the 

“foreign sale and leasing income” derived by the taxpayer from the transaction. 238 

Foreign trading gross receipts are gross receipts derived from certain activities in 

connection with “qualifying foreign trade property” with respect to which certain economic 

processes take place outside of the United States. Specifically, the gross receipts must be: (1) 

from the sale, exchange, or other disposition of qualifying foreign trade property; (2) from the 

lease or rental of qualifying foreign trade property for use by the lessee outside the United States; 

(3) for services which are related and subsidiary to the sale, exchange, disposition, lease, or 

rental of qualifying foreign trade property (as described above); (4) for engineering or 

architectural services for construction projects located outside the United States; or (5) for the 

performance of certain managerial services for unrelated persons. A taxpayer may elect to treat 

 

237 “Foreign trade income” is the taxable income of the taxpayer (determined without 

regard to the exclusion of qualifying foreign trade income) attributable to foreign trading gross 

receipts. 

238 “Foreign sale and leasing income” is the amount of the taxpayer's foreign trade 

income (with respect to a transaction) that is properly allocable to activities that constitute 

foreign economic processes. Foreign sale and leasing income also includes foreign trade income 

derived by the taxpayer in connection with the lease or rental of qualifying foreign trade property 

for use by the lessee outside the United States.
152

gross receipts from a transaction as not foreign trading gross receipts. As a result of such an 

election, a taxpayer may use any related foreign tax credits in lieu of the exclusion.

Qualifying foreign trade property generally is property manufactured, produced, grown, 

or extracted within or outside the United States that is held primarily for sale, lease, or rental in 

the ordinary course of a trade or business for direct use, consumption, or disposition outside the 

United States. No more than 50 percent of the fair market value of such property can be 

attributable to the sum of: (1) the fair market value of articles manufactured outside the United 

States; and (2) the direct costs of labor performed outside the United States. With respect to 

property that is manufactured outside the United States, certain rules are provided to ensure 

consistent U.S. tax treatment with respect to manufacturers.

Description of Proposal

The bill repeals the ETI exclusion. Pursuant to transition rules, taxpayers retain a portion 

of their otherwise-applicable ETI benefits for transactions during a three-year transition period 

(80 percent for 2004 and 2005, and 60 percent for 2006). However, the proposal provides that 

the ETI exclusion provisions remain in effect for transactions in the ordinary course of a trade or 

business if such transactions are pursuant to a binding contract239 between the taxpayer and an 

unrelated person and such contract is in effect on January 14, 2002, and at all times thereafter.

In addition, foreign corporations that elected to be treated for all Federal tax purposes as 

domestic corporations in order to facilitate the claiming of ETI benefits are allowed to revoke 

such elections within one year of the date of enactment of the bill without recognition of gain or 

loss, subject to anti-abuse rules.

Effective Date

The provision is effective for transactions after December 31, 2003.

 

239 This rule also applies to a purchase option, renewal option, or replacement option that 

is included in such contract.
153

B. Extension of Customs User Fees

(sec. 4002 of the bill)

Present Law

Section 13031 of the Consolidated Omnibus Budget Reconciliation Act of 1985 

(COBRA) (P.L. 99-272), authorized the Secretary of the Treasury to collect certain service fees. 

Section 412 (P.L 107-296) of the Homeland Security Act of 2002 authorized the Secretary of the 

Treasury to delegate such authority to the Secretary of Homeland Security. Provided for under 

19 U.S.C. 58c, these fees include: processing fees for air and sea passengers, commercial trucks, 

rail cars, private aircraft and vessels, commercial vessels, dutiable mail packages, barges and 

bulk carriers, merchandise, and Customs broker permits. COBRA was amended on several 

occasions but most recently by P.L. 108-89, which extended authorization for the collection of 

these fees through March 31, 2004.

Description of Proposal

The bill extends the certain merchandise processing fees authorized under the 

Consolidated Omnibus Budget Reconciliation Act of 1985 through September 30, 2013. Certain 

other fees, the so-called “COBRA fees” related to overtime and premium services, also are 

extended through September 30, 2013. For fiscal years after September 30, 2005, the Secretary 

of the Treasury is to charge fees in amount that are reasonably related to the costs of providing 

customs services in connection with the activity or item for which the fee is charged.

The bill also includes a Sense of the Congress that the fees set forth in paragraphs (1) 

through (8) of subsection (a) of section 13031 of the Consolidated Omnibus Budget 

Reconciliation Act of 1985 have been reasonably related to the costs of providing customs 

services in connection with the activities or items for which the fees have been charged under 

such paragraphs. The Sense of Congress also states that the fees collected under such paragraphs 

have not exceeded, in the aggregate, the amounts paid for the costs described in subsection 

(f)(3)(A) incurred in providing customs services in connection with the activities or items for 

which the fees were charged under such paragraphs.

The bill further provides that the Secretary of the Treasury conduct a study of all the fees 

collected by the Department of Homeland Security, and shall submit to the Congress, not later 

than September 30, 2005, a report containing the recommendations of the Secretary on what fees 

should be eliminated, what the rate of fees retains should be, and any other recommendations 

with respect to the fees that the Secretary considers appropriate. 

Effective Date

The proposal is effective upon the date of enactment.