TECHNICAL EXPLANATION OF H.R. 2896,

THE “AMERICAN JOBS CREATION ACT OF 2003”

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

August 13, 2003

JCX-72-03
i

CONTENTS

Page

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

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

A. Reduction in Corporate Income Tax Rates (sec. 1001 of the bill and sec. 11 of the

Code)................................................................................................................................... 2

B. Extension and Modification of the Research Credit (sec. 1011 of the bill and sec. 41

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

C. Temporary Deduction for Certain Dividends Received from Controlled Foreign 

Corporations (sec. 1021 of the bill and new sec. 965 of the Code).................................... 9

D. Increase Section 179 Expensing (sec. 1031 of the bill and section 179 of the Code) ...... 11

E. One-Year Extention of Additional First-Year Depreciation (sec. 1041 of the bill and

sec. 168 of the Code) ........................................................................................................ 13

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

Property (sec. 1042 of the bill and sec. 168 of the Code)................................................. 18

G. Shorter Recovery Periods for Manufacturing Property (sec. 1043 of the bill and

sec. 168 of the Code) ........................................................................................................ 21

H. Five-Year Carryback of Net Operating Losses (sec. 1051 of the bill and secs. 172 and

56 of the Code).................................................................................................................. 23

I. Alternative Minimum Tax Relief (secs. 1061-1063 of the bill and secs. 55-59 of the 

Code)................................................................................................................................. 25

J. Provisions Relating to S Corporation Reform and Simplification (secs. 1071-1080 of

the Code and secs. 1361-1379 and 4975 of the Code)...................................................... 27

1. Shareholders of an S corporation.................................................................................. 27

2. Treatment of S corporation shareholders...................................................................... 29

3. Provisions relating to banks.......................................................................................... 30

4. Qualified subchapter S subsidiaries.............................................................................. 32

K. Protecting Employee Benefits........................................................................................... 33

1. Treatment of nonqualified deferred compensation plans (sec. 1091 of the bill and

 new sec. 409A and sec. 6051 of the Code)................................................................... 33
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2. Exclusion of incentive stock options and employee stock purchase plan stock options

 from wages (sec. 1092 of the bill and secs. 421(b), 423(c), 3121(a), 3231, and

 3306(b) of the Code)..................................................................................................... 38

L. Extension of Provision Permitting Qualified Transfers of Excess Pension Assets to 

Retiree Health Accounts (sec. 1093 of the bill and sec. 420 of the Code) ...................... 40

M. Treatment of Active Income ............................................................................................. 42

1. Repeal controlled foreign corporation rules for foreign base company sales and

 services income (sec. 1101 of the bill and sec. 954 of the Code)................................. 42

2. Extension and modification of exceptions under subpart F for active financing

 income (sec. 1102 of the bill and secs. 953 and 954 of the Code)................................ 43

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

 corporations under foreign personal holding company income rules (sec. 1103 of

 the bill and sec. 954(c) of the Code)............................................................................. 45

4. Look-through treatment for sales of partnership interests (sec. 1104 of the bill and

 sec. 954(c) of the Code)................................................................................................ 46

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

 rules (sec. 1105 of the bill and secs. 542, 551-558, 954, 1246, and 1247 of the

 Code)............................................................................................................................. 47

6. Subpart F treatment of pipeline transportation income (sec. 1106 of the bill and

 sec. 954(g) of the Code)................................................................................................ 47

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

 transactions in commodities (sec. 1107 of the bill and sec. 954 of the Code).............. 48

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

 income (sec. 1108 of the bill and sec. 954 of the Code)............................................... 51

N. Reduction of Double Taxation of Corporate Earnings ..................................................... 53

1. Interest expense allocation rules (sec. 1111 of the bill and sec. 864 of the Code) ....... 53

2. Recharacterization of overall domestic loss (sec. 1112 of the bill and sec. 904 of

 the Code)....................................................................................................................... 57

3. Reduction to two foreign tax credit baskets (sec. 1113 of the bill and sec. 904 of

 the Code)....................................................................................................................... 58

4. Ten-year foreign tax credit carryforward (sec. 1114 of the bill and sec. 904 of

 the Code)....................................................................................................................... 60

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

 corporations (sec. 1115 of the bill and sec. 904 of the Code)....................................... 61

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

 section 902 and 960 credits (sec. 1116 of the bill and secs. 902 and 901) ................... 62

7. Clarification of treatment of certain transfers of intangible property (sec. 1117 of

 the bill and sec. 367(d) of the Code)............................................................................. 64

8. Application of uniform capitalization rules for foreign persons (sec. 1118 of the

 bill and sec. 263A of the Code) .................................................................................... 65

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

 course of trade or business (sec. 1119 of the bill and sec. 956 of the Code)................ 66
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10. Treatment of certain dividends of regulated investment companies (sec. 1120 of

 the bill and secs. 871 and 881 of the Code)................................................................ 68

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

 functional currency (sec. 1121 of the bill and sec. 986 of the Code).......................... 73

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

 (sec. 1122 of the bill and sec. 871 of the Code).......................................................... 74

TITLE II - PROVISIONS TO REDUCE TAX AVOIDANCE THROUGH CORPORATE 

EARNINGS STRIPPING AND EXPATRIATION..................................................................... 76

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) .................... 76

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

Code)................................................................................................................................. 79

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) ............ 83

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

sec. 845(a) of the Code).................................................................................................... 88

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

and secs. 877, 2107, 2501 and 6039G of the Code) ......................................................... 90

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

sec. 6043A of the Code).................................................................................................... 96

G. Studies (sec. 2007 of the bill) ........................................................................................... 98

TITLE III - PROVISIONS RELATING TO TAX SHELTERS................................................ 100

A. Taxpayer Related Provisions .......................................................................................... 100

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

 new sec. 6707A of the Code)...................................................................................... 100

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)...................................................................................... 103

3. Tax shelter exception to confidentiality privileges relating to taxpayer

 communications (sec. 3003 of the bill and sec. 7525 of the Code)............................ 107

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

 sec. 6501 of the Code) ................................................................................................ 107

5. Disclosure of reportable transactions by material advisors (secs. 3005 and 3006 of

 the bill and secs. 6111 and 6707 of the Code)............................................................ 108

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

 (secs. 3005 and 3007 of the bill and secs. 6112 and 6708 of the Code)..................... 111
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7. Penalties on promoters of tax shelters (sec. 3008 of the bill and sec. 6700 of the

 Code)........................................................................................................................... 114

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

 bill and sec. 6662 of the Code) ................................................................................... 114

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

 (sec. 3010 of the bill and sec. 7408 of the Code)........................................................ 115

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)............................................ 115

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)......................... 117

B. Other Provisions.............................................................................................................. 118

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

 bill and secs. 305 and 1286 of the Code).................................................................... 118

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)........................ 121

3. Affirmation of consolidated return regulation authority (sec. 3023 of the bill and

 sec. 1502 of the Code) ................................................................................................ 122

4. Disallowance of certain partnership loss transfers (sec. 3024 of the bill and

 secs. 704, 734, and 743 of the Code).......................................................................... 127

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

 partner (sec. 3025 of the bill and sec. 755 of the Code) ............................................. 130

6. Repeal of special rules for FASITs (sec. 3026 of the bill and secs. 860H through

 860L of the Code)....................................................................................................... 132

7. Limitation on transfer of built-in losses on REMIC residuals (sec. 3027 of the bill

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

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

 earnings in U.S. property (sec. 3028 of the bill and sec. 956 of the Code)................ 136

9. Modify qualification rules for tax-exempt property and casualty insurance

 companies (sec. 3029 of the bill and secs. 501(c)(15) and 831(b) of the Code)......... 137

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

 tax rules (sec. 3030 of the bill and sec. 831 of the Code)........................................ 139

11. Qualified tax collection contracts (sec. 3031 of the bill and new sec. 6306 of the

 Code)......................................................................................................................... 141

TITLE IV - TRADE ENHANCEMENT AND COMPLIANCE PROVISIONS....................... 144

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

and 941-943 of the Code) ............................................................................................... 144

B. Extension of Customs User Fees (sec. 4002 of the bill) ................................................. 146
1

INTRODUCTION

This document,1 prepared by the staff of the Joint Committee on Taxation, provides a 

technical explanation of H.R. 2896, the “American Jobs Creation Act of 2003” as introduced by 

Chairman Thomas of the Ways and Means Committee on July 25, 2003.

 

1

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

Explanation of H.R. 2896, the “American Jobs Creation Act of 2003” (JCX-72-03), August 13, 

2003.
2

TITLE I - CORPORATE REFORM AND GROWTH INCENTIVES

A. Reduction in Corporate Income Tax Rates

(sec. 1001 of the bill and sec. 11 of the Code)

Present Law

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

rate schedule to its taxable income.

Table 1.–Marginal Federal Corporate Income Tax Rates

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. As a result, a corporation 

with taxable income between $335,000 and $10 million effectively is subject to a flat tax rate of 

34 percent. 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.2

Explanation of Provision

The bill reduces marginal tax rates applicable to corporations. For taxable years 

beginning after 2004 and before 2009, the bill creates a new 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 in 2009, the 33-percent marginal tax rate applies to taxable income in excess of 

$75,000 and less than or equal to $2 million. Corporate taxable income in excess of $1 million 

($2 million for 2009) is taxed at a 34-percent marginal tax rate, plus the benefit of the marginal 

tax rates less than 34 percent is phased out by a five-percent surcharge. The phase-out creates a 

39-percent marginal tax rate for incomes over $1 million ($2 million in 2009) but less than 

$1,420,000 ($2,620,000 in 2009). Beyond the phase-out range, a 34-percent marginal tax rate 

applies up to $10 million.

For taxable years beginning in 2010 and 2011, the bill replaces the 33-percent marginal 

corporate tax rate with a 32-percent marginal tax rate applicable to taxable income in excess of 

$75,000 and less than or equal to $5 million. Corporate taxable income in excess of $5 million 

 

2

 The maximum rate of tax on the net capital gains of a corporation is 35 percent.
3

is taxed at a 34-percent marginal tax rate, plus the benefit of the marginal tax rates less than 34 

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

tax rate for incomes over $5 million, but less than $7,205,000. Beyond the phase-out range, a 

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

For taxable years beginning in 2012 and thereafter, the bill extends the 32-percent rate 

bracket to corporations with taxable incomes not exceeding $10 million. As under present law, 

the 35-percent marginal tax rate begins at incomes over $10 million. In addition, beginning at 

incomes over $10 million, the benefit of the 32-percent, 25-percent, and 15-percent marginal tax 

rates relative to the 34-percent marginal tax rate of present law is phased out by a five-percent 

surcharge. The phase-out creates a 40-percent marginal tax rate for incomes over $10 million, 

but less than $14,205,000. Beyond the phase-out range, a 35-percent marginal tax rate applies.3

Table 2, below, summarizes the marginal tax rates applicable under the Federal corporate 

income tax under present law and under the bill.

Table 2.–Marginal Federal Corporate Income Tax Rates

Under Present Law and Under the Bill

Taxable Income

Over But not over

Present 

Law

2005 -

2008 2009 2010 -2011

2012 and 

Thereafter

$0 $50,000 15% 15% 15% 15% 15%

$50,000 $75,000 25% 25% 25% 25% 25%

$75,000 $100,000 34% 33% 33% 32% 32%

$100,000 $335,000 39% 33% 33% 32% 32%

$335,000 $1,000,000 34% 33% 33% 32% 32%

$1,000,000 $1,420,000 34% 39% 33% 32% 32%

$1,420,000 $2,000,000 34% 34% 33% 32% 32%

$2,000,000 $2,620,000 34% 34% 39% 32% 32%

$2,620,000 $5,000,000 34% 34% 34% 32% 32%

$5,000,000 $7,205,000 34% 34% 34% 39% 32%

$7,205,000 $10,000,000 34% 34% 34% 34% 32%

$10,000,000 $14,205,000 35% 35% 35% 35% 40%

$14,205,000 $15,000,000 35% 35% 35% 35% 35%

$15,000,000 $18,333,333 38% 38% 38% 38% 38%

$18,333,333 and over 35% 35% 35% 35% 35%

 

3

 The bill as introduced also reduced the point at which the present-law phase-out of the 

benefit of the 34-percent rate begins from $15 million to $10 million. This lower beginning 

point of the phase out was a clerical error and no change was intended. The provision is 

described as it was intended.
4

Effective Date

The provision is effective for taxable years beginning after December 31, 2004.
5

B. Extension and Modification of the Research Credit

(sec. 1011 of the bill and sec. 41 of the Code)

Present Law

General rule

Section 41 provides for a research tax credit equal to 20 percent of the amount by which a 

taxpayer’s qualified research expenses for a taxable year exceed its base amount for that year. 

The research tax credit is scheduled to expire and generally will not apply to amounts paid or 

incurred after June 30, 2004.

A 20-percent research tax credit also applies to the excess of (1) 100 percent of corporate 

cash expenses (including grants or contributions) paid for basic research conducted by 

universities (and certain nonprofit scientific research organizations) over (2) the sum of (a) the 

greater of two minimum basic research floors plus (b) an amount reflecting any decrease in 

nonresearch giving to universities by the corporation as compared to such giving during a fixedbase period, as adjusted for inflation. This separate credit computation is commonly referred to 

as the university basic research credit (see sec. 41(e)).

Computation of allowable credit

Except for certain university basic research payments made by corporations, the research 

tax credit applies only to the extent that the taxpayer’s qualified research expenses for the current 

taxable year exceed its base amount. The base amount for the current year generally is computed 

by multiplying the taxpayer’s fixed-base percentage by the average amount of the taxpayer’s 

gross receipts for the four preceding years. If a taxpayer both incurred qualified research 

expenses and had gross receipts during each of at least three years from 1984 through 1988, then 

its fixed-base percentage is the ratio that its total qualified research expenses for the 1984-1988 

period bears to its total gross receipts for that period (subject to a maximum fixed-base 

percentage of 16 percent). All other taxpayers (so-called start-up firms) are assigned a fixedbase percentage of three percent. In computing the credit, a taxpayer’s base amount may not be 

less than 50 percent of its current-year qualified research expenses.

Alternative incremental research credit regime

Taxpayers are allowed to elect an alternative incremental research credit regime.4 If a 

taxpayer elects to be subject to this alternative regime, the taxpayer is assigned a three-tiered 

fixed-base percentage (that is lower than the fixed-base percentage otherwise applicable under 

present law) and the credit rate likewise is reduced. Under the alternative credit regime, a credit 

rate of 2.65 percent applies to the extent that a taxpayer’s current-year research expenses exceed 

a base amount computed by using a fixed-base percentage of one percent (i.e., the base amount 

equals one percent of the taxpayer’s average gross receipts for the four preceding years) but do 

not exceed a base amount computed by using a fixed-base percentage of 1.5 percent. A credit 

rate of 3.2 percent applies to the extent that a taxpayer’s current-year research expenses exceed a 

 

4

 Sec. 41(c)(4).
6

base amount computed by using a fixed-base percentage of 1.5 percent but do not exceed a base 

amount computed by using a fixed-base percentage of two percent. A credit rate of 3.75 percent 

applies to the extent that a taxpayer’s current-year research expenses exceed a base amount 

computed by using a fixed-base percentage of two percent. An election to be subject to this 

alternative incremental credit regime may be made for any taxable year beginning after June 30, 

1996, and such an election applies to that taxable year and all subsequent years unless revoked 

with the consent of the Secretary of the Treasury.

Eligible expenses

Qualified research expenses eligible for the research tax credit consist of: (1) in-house 

expenses of the taxpayer for wages and supplies attributable to qualified research; (2) certain 

time-sharing costs for computer use in qualified research; and (3) 65 percent of amounts paid or 

incurred by the taxpayer to certain other persons for qualified research conducted on the 

taxpayer’s behalf (so-called contract research expenses).5 

To be eligible for the credit, the research must not only satisfy the requirements of 

present-law section 174 (described below) but must be undertaken for the purpose of discovering 

information that is technological in nature, the application of which is intended to be useful in 

the development of a new or improved business component of the taxpayer, and substantially all 

of the activities of which must constitute elements of a process of experimentation for functional 

aspects, performance, reliability, or quality of a business component. Research does not qualify 

for the credit if substantially all of the activities relate to style, taste, cosmetic, or seasonal design 

factors (sec. 41(d)(3)). In addition, research does not qualify for the credit: (1) if conducted 

after the beginning of commercial production of the business component; (2) if related to the 

adaptation of an existing business component to a particular customer’s requirements; (3) if 

related to the duplication of an existing business component from a physical examination of the 

component itself or certain other information; or (4) if related to certain efficiency surveys, 

management function or technique, market research, market testing, or market development, 

routine data collection or routine quality control (sec. 41(d)(4)). Research does not qualify for 

the credit if it is conducted outside the United States, Puerto Rico, or any U.S. possession.

Relation to deduction

Under section 174, taxpayers may elect to deduct currently the amount of certain research 

or experimental expenditures paid or incurred in connection with a trade or business, 

notwithstanding the general rule that business expenses to develop or create an asset that has a 

 

5

 Under a special rule enacted as part of the Small Business Job Protection Act of 1996, 

75 percent of amounts paid to a research consortium for qualified research is treated as qualified 

research expenses eligible for the research credit (rather than 65 percent under the general rule 

under section 41(b)(3) governing contract research expenses) if (1) such research consortium is a 

tax-exempt organization that is described in section 501(c)(3) (other than a private foundation) or

section 501(c)(6) and is organized and operated primarily to conduct scientific research, and 

(2) such qualified research is conducted by the consortium on behalf of the taxpayer and one or 

more persons not related to the taxpayer. Sec. 41(b)(3)(C).
7

useful life extending beyond the current year must be capitalized.6 However, deductions allowed 

to a taxpayer under section 174 (or any other section) are reduced by an amount equal to 100 

percent of the taxpayer’s research tax credit determined for the taxable year (Sec. 280C(c)). 

Taxpayers may alternatively elect to claim a reduced research tax credit amount under section 41 

in lieu of reducing deductions otherwise allowed (sec. 280C(c)(3)).

Explanation of Provision

The bill extends the present-law research credit to qualified amounts paid or incurred 

before January 1, 2008. 

In addition, the bill creates an “alternative simplified credit” for qualified research 

expenses. The bill, thereby, provides three alternatives by which taxpayers may claim a credit 

for qualified research expenses (i.e., the general rule, the alternative incremental credit, or the 

alternative simplified credit). Under the alternative simplified credit a taxpayer may elect to 

claim a credit equal to 12 percent of qualified research expenses for the taxable year in excess of 

60 percent of average qualified research expenses determined for a base period. For any taxable 

year the average qualified research expenses for the base period is determined as the average of 

qualified research expenses from three of the five taxable years immediately preceding such 

current taxable year. For this calculation, from the five preceding taxable years, the taxable year 

with the highest qualified research expenses and the taxable year with the lowest qualified 

research expenses are not taken into account.

If a taxpayer has no qualified research expenses in any two of the five taxable years 

immediately preceding the current taxable year, the bill provides that the alternative simplified 

credit is six-percent of qualified research expenses for the current taxable year.

If the taxpayer elects to claim the alternative simplified credit for a taxable year, the 

election remains in effect for all succeeding taxable years unless revoked with the consent of the 

Secretary.7 If a taxpayer had elected to claim the alternative incremental credit and elects to 

claim the alternative simplified credit, the bill provides that if, on the date of enactment of this 

bill, the taxpayer had an election in effect to claim the alternative incremental credit, that election 

is treated as revoked with the consent of the Secretary upon the election to claim the alternative 

simplified credit. If the taxpayer did not have an election to claim the alternative incremental 

credit in effect on the date of enactment of this bill, but subsequently elected to claim the 

alternative incremental credit, the taxpayer would have to seek the permission of the Secretary to 

revoke the election prior to electing the new alternative simplified credit. 

 

6

 Taxpayers may elect 10-year amortization of certain research expenditures allowable as 

a deduction under section 174(a). Secs. 174(f)(2) and 59(e).

7

 The bill provides that an election to claim the alternative simplified credit may be in 

effect only for taxable years beginning after June 30, 2004, and before January 1, 2007.
8

Effective Date 

The provision to extend the present-law research credit is effective for amounts paid or 

incurred after the date of enactment. The provision creating the alternative simplified credit is 

effective for taxable years beginning after June 30, 2004.
9

C. Temporary Deduction for Certain Dividends Received

from Controlled Foreign Corporations

(sec. 1021 of the bill and new sec. 965 of the Code)

Present Law

The United States employs a “worldwide” tax system, under which domestic corporations 

generally are taxed on all income, whether derived in the United States or abroad. Income 

earned by a domestic parent corporation from foreign operations conducted by foreign corporate 

subsidiaries generally is subject to U.S. tax when the income is distributed as a dividend to the 

domestic corporation. Until such repatriation, the U.S. tax on such income generally is deferred. 

However, under anti-deferral rules, the domestic parent corporation may be taxed on a current 

basis in the United States with respect to certain categories of passive or highly mobile income 

earned by its foreign subsidiaries, regardless of whether the income has been distributed as a 

dividend to the domestic parent corporation. The main anti-deferral provisions in this context 

are the controlled foreign corporation rules of subpart F8 and the passive foreign investment 

company rules.9 A foreign tax credit generally is available to offset, in whole or in part, the U.S. 

tax owed on foreign-source income, whether earned directly by the domestic corporation, 

repatriated as a dividend, or included in income under the anti-deferral rules.10

Explanation of Provision

Under the bill, certain dividends received by a U.S. corporation from a controlled foreign 

corporation are eligible for an 80-percent dividends-received deduction. At the taxpayer’s 

election, this deduction is available for dividends received either: (1) during the first six months 

of the taxpayer’s first taxable year beginning on or after the date of enactment of the bill; or (2) 

during any six-month or shorter period after the date of enactment of the bill, during the 

taxpayer’s last taxable year beginning before such date. Dividends received after the election 

period will be taxed in the normal manner under present law.

The deduction applies only to dividends includible in gross income for the taxable year 

that includes the election period. The deduction does not apply to deemed repatriations under 

section 956. The deduction also does not apply to distributions of earnings previously taxed 

under subpart F, except to the extent that the subpart F inclusions result from the payment of a 

dividend by one controlled foreign corporation to another controlled foreign corporation within a 

certain chain of ownership during the election period. This exception enables multinational 

corporate groups to qualify for the deduction in connection with the repatriation of earnings from 

lower-tier controlled foreign corporations.

 

8

 Secs. 951-964.

9

 Secs. 1291-1298.

10 Secs. 901, 902, 960, 1291(g).
10

The deduction is subject to a number of limitations. First, it applies only to repatriations 

in excess of the taxpayer’s average repatriation level over three of the five most recent taxable 

years ending on or before March 31, 2003, determined by disregarding the highest-repatriation 

year and the lowest-repatriation year among such five years (the “base-period average”).11 The 

amount of dividends eligible for the deduction also is limited to the amount of earnings shown as 

permanently reinvested outside the United States on the taxpayer’s most recent audited financial 

statement which is certified on or before March 31, 2003. If such statement fails to show a 

specific amount of earnings permanently reinvested outside the United States, then the taxpayer 

will not be entitled to a deduction under the bill. In addition, dividends qualifying for the 

deduction must be invested in the United States pursuant to a plan approved by the senior 

management and board of directors of the corporation claiming the deduction.

The bill provides that no foreign tax credit (or deduction) is allowed for foreign taxes 

attributable to the deductible portion of qualifying dividends. In addition, the bill provides that 

income attributable to the nondeductible portion of a qualifying dividend may not be offset by 

net operating losses, and the tax attributable to such income generally may not be offset by 

credits (other than foreign tax credits) and may not reduce the alternative minimum tax otherwise 

owed by the taxpayer.

The benefits of the deduction are subject to recapture in the event that, subsequent to the 

election period, the taxpayer’s repatriation level falls below its base-period average. This 

recapture provision applies for the 10 taxable years following the taxable year in which a 

deduction is claimed under the provision. For purposes of determining whether a repatriation 

shortfall has occurred in a taxable year, any excess of repatriations over the required average in 

previous post-election-period years may be carried forward to the year at issue.

Effective Date

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

provision.

 

11 Although deemed repatriations under section 956 do not qualify for the deduction, 

they are included in the base-period average.
11

D. Increase Section 179 Expensing

(sec. 1031 of the bill and section 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 up to $100,000 (for taxable years beginning in 

2003, 2004, and 2005) of the cost of qualifying property placed in service for the taxable year 

(sec. 179).12 The $100,000 annual investment 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 (for taxable years beginning in 2003, 2004, and 2005). The $100,000 and 

$400,000 dollar limitations are indexed annually for inflation for taxable years beginning after 

2003 and before 2006. 

For taxable years beginning in 2006 and thereafter, the amount of the annual investment 

eligible to be deducted under the provision is $25,000. The $25,000 annual investment 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. Qualifying property also includes 

off-the-shelf computer software placed in service in a taxable year beginning in 2003, 2004, or 

2005. 

An election to expense qualifying property generally is made on the taxpayer's original 

return for the taxable year to which the election relates, and generally may be revoked only with 

the consent of the Commissioner.13 With respect to a taxable year beginning after 2002 and 

before 2006, taxpayers may make or revoke expensing elections on amended returns without the 

consent of the Commissioner.14

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

for the 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 

 

12 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).

13 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. 

14 Such revocation, once made, is irrevocable. Sec. 179(c)(2).
12

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

for which a deduction is allowed under section 179.

Explanation of Provision

The bill provides that the present-law temporary increases in the dollar limitations, as 

well as the treatment of off-the-shelf computer software as qualifying property, are extended to 

apply to property placed in service in taxable years beginning in 2006 and 2007. The bill 

provides that the dollar limitations are indexed annually for inflation for two additional years, 

i.e., for taxable years beginning after 2005 and before 2008. With respect to a taxable year 

beginning after 2005 and before 2008, the bill permits taxpayers to make or revoke expensing 

elections on amended returns without the consent of the Commissioner.

Effective Date

The provision is effective upon the date of enactment.
13

E. One-Year Extention of Additional First-Year Depreciation 

(sec. 1041 of the bill and sec. 168 of the Code)

Present Law 

In general 

A taxpayer is allowed to recover, through annual depreciation deductions, the cost of 

certain property used in a trade or business or for the production of income. The amount of the 

depreciation deduction allowed with respect to tangible property for a taxable year is determined 

under the modified accelerated cost recovery system (“MACRS”). Under MACRS, different 

types of property generally are assigned applicable recovery periods and depreciation methods. 

The recovery periods applicable to most tangible personal property range from 3 to 25 years. The 

depreciation methods generally applicable to tangible personal property are the 200-percent and 

150-percent declining balance methods, switching to the straight-line method for the taxable year 

in which the depreciation deduction would be maximized. 

Section 280F limits the annual depreciation deductions with respect to passenger 

automobiles to specified dollar amounts, indexed for inflation.

Section 167(f)(1) provides that capitalized computer software costs, other than computer 

software to which section 197 applies, are recovered ratably over 36 months. 

In lieu of depreciation, a taxpayer with a sufficiently small amount of annual investment 

generally may elect to deduct up to $100,000 of the cost of qualifying property placed-in-service 

for the taxable year (sec. 179). In general, qualifying property is defined as depreciable tangible 

personal property (and computer software) that is purchased for use in the active conduct of a 

trade or business. 

Thirty-percent additional first-year depreciation deduction

The Job Creation and Worker Assistance Act of 200215 (“JCWAA”) allows an additional 

first-year depreciation deduction equal to 30 percent of the adjusted basis of qualified property.16 

The amount of the additional first-year depreciation deduction is not affected by a short taxable 

year. The additional first-year depreciation deduction is allowed for both regular tax and 

alternative minimum tax purposes for the taxable year in which the property is placed in 

service.17 The basis of the property and the depreciation allowances in the year of purchase and 

 

15 Pub. Law No. 107-147, sec. 101 (2002), as amended by Pub. Law No. 108-27, sec. 

201 (2003).

16 The additional first-year depreciation deduction is subject to the general rules 

regarding whether an item is deductible under section 162 or subject to capitalization under 

section 263 or section 263A.

17 However, the additional first-year depreciation deduction is not allowed for purposes 

of computing earnings and profits.
14

later years are appropriately adjusted to reflect the additional first-year depreciation deduction. 

In addition, there are no adjustments to the allowable amount of depreciation for purposes of 

computing a taxpayer’s alternative minimum taxable income with respect to property to which 

the provision applies. A taxpayer is allowed to elect out of the additional first-year depreciation 

for any class of property for any taxable year.18

In order for property to qualify for the additional first-year depreciation deduction, it 

must meet all of the following requirements. First, the property must be property (1) to which 

MACRS applies with an applicable recovery period of 20 years or less, (2) water utility property 

(as defined in section 168(e)(5)), (3) computer software other than computer software covered by 

section 197, or (4) qualified leasehold improvement property (as defined in section 168(k)(3)). 19 

Second, the original use20 of the property must commence with the taxpayer on or after 

September 11, 2001.21 Third, the taxpayer must acquire the property within the applicable time 

period. Finally, the property must be placed in service before January 1, 2005. An extension of 

the placed-in-service date of one year (i.e., January 1, 2006) is provided for certain property with 

a recovery period of ten years or longer and certain transportation property.22 Transportation 

 

18 A taxpayer may elect out of the 50-percent additional first-year depreciation 

(discussed below) for any class of property and still be eligible for the 30-percent additional firstyear depreciation.

19 A special rule precludes the additional first-year depreciation deduction for any 

property that is required to be depreciated under the alternative depreciation system of MACRS. 

20 The term “original use” means the first use to which the property is put, whether or not 

such use corresponds to the use of such property by the taxpayer. 

If, in the normal course of its business, a taxpayer sells fractional interests in property to 

unrelated third parties, then the original use of such property begins with the first user of each 

fractional interest (i.e., each fractional owner is considered the original user of its proportionate 

share of the property). 

21 A special rule applies in the case of certain leased property. In the case of any property 

that is originally placed in service by a person and that is sold to the taxpayer and leased back to 

such person by the taxpayer within three months after the date that the property was placed in 

service, the property would be treated as originally placed in service by the taxpayer not earlier 

than the date that the property is used under the leaseback. 

If property is originally placed in service by a lessor (including by operation of section 

168(k)(2)(D)(i)), such property is sold within three months after the date that the property was 

placed-in-service, and the user of such property does not change, then the property is treated as 

originally placed-in-service by the taxpayer not earlier than the date of such sale. A technical 

correction is needed so the statute reflects this intent. 

22 In order for property to qualify for the extended placed-in-service date, the property is 

required to have a production period exceeding two years or an estimated production period 

exceeding one year and a cost exceeding $1 million.
15

property is defined as tangible personal property used in the trade or business of transporting 

persons or property.

The applicable time period for acquired property is (1) after September 10, 2001, and 

before January 1, 2005, but only if no binding written contract for the acquisition is in effect 

before September 11, 2001, or (2) pursuant to a binding written contract which was entered into 

after September 10, 2001, and before January 1, 2005.23 With respect to property that is 

manufactured, constructed, or produced by the taxpayer for use by the taxpayer, the taxpayer 

must begin the manufacture, construction, or production of the property after September 10, 

2001, and before January 1, 2005. Property that is manufactured, constructed, or produced for 

the taxpayer by another person under a contract that is entered into prior to the manufacture, 

construction, or production of the property is considered to be manufactured, constructed, or 

produced by the taxpayer. For property eligible for the extended placed-in-service date, a special 

rule limits the amount of costs eligible for the additional first-year depreciation. With respect to 

such property, only the portion of the basis that is properly attributable to the costs incurred 

before January 1, 2005 (“progress expenditures”), is eligible for the additional first-year 

depreciation.24 

Property does not qualify for the additional first-year depreciation deduction when the 

user of such property (or a related party) would not have been eligible for the additional firstyear depreciation deduction if the user (or a related party) were treated as the owner.25 For 

example, if a taxpayer sells to a related party property that was under construction prior to 

September 11, 2001, the property does not qualify for the additional first-year depreciation 

deduction. Similarly, if a taxpayer sells to a related party property that was subject to a binding

written contract prior to September 11, 2001, the property does not qualify for the additional 

first-year depreciation deduction. As a further example, if a taxpayer (the lessee) sells property 

in a sale-leaseback arrangement, and the property otherwise would not have qualified for the 

additional first-year depreciation deduction if it were owned by the taxpayer-lessee, then the 

lessor is not entitled to the additional first-year depreciation deduction.

The limitation on the amount of depreciation deductions allowed with respect to certain 

passenger automobiles (sec. 280F) is increased in the first year by $4,600 for automobiles that 

qualify (and do not elect out of the increased first-year deduction). The $4,600 increase is not 

indexed for inflation.

 

23 Property does not fail to qualify for the additional first-year depreciation merely 

because a binding written contract to acquire a component of the property is in effect prior to 

September 11, 2001.

24 For purposes of determining the amount of eligible progress expenditures, it is 

intended that rules similar to sec. 46(d)(3) as in effect prior to the Tax Reform Act of 1986 shall 

apply. 

25 A technical correction is needed so that the statute reflects this intent. 
16

Fifty-percent additional first-year depreciation

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (“JGTRRA”)26 provides an 

additional first-year depreciation deduction equal to 50 percent of the adjusted basis of qualified 

property.27 Qualified property is defined in the same manner as for purposes of the 30-percent 

additional first-year depreciation deduction provided by the JCWAA except that the applicable 

time period for acquisition (or self construction) of the property is modified. Property eligible 

for the 50-percent additional first-year depreciation deduction is not eligible for the 30-percent 

additional first-year depreciation deduction. 

 In order to qualify, the property must be acquired after May 5, 2003, and before January 

1, 2005, and no binding written contract for the acquisition can be in effect before May 6, 

2003.28 With respect to property that is manufactured, constructed, or produced by the taxpayer 

for use by the taxpayer, the taxpayer must begin the manufacture, construction, or production of 

the property after May 5, 2003. For property eligible for the extended placed-in-service date 

(i.e., certain property with a recovery period of ten years or longer and certain transportation 

property), a special rule limits the amount of costs eligible for the additional first-year 

depreciation. With respect to such property, only progress expenditures properly attributable to 

the costs incurred before January 1, 2005, are eligible for the additional first-year depreciation.29

In addition, JGTRRA increases the limitation on the amount of depreciation deductions 

allowed with respect to certain passenger automobiles (sec. 280F of the Code) in the first year to 

$7,650 (in lieu of the $4,600 provided under the JCWAA) for automobiles that qualify (if the 

taxpayer does not elect out of the increased first-year deduction). The $7,650 increase is not 

indexed for inflation.

Explanation of Provision

The bill extends both the 30-percent and the 50-percent additional first-year depreciation 

deduction by one year. Thus, the bill extends the additional first-year depreciation deduction to 

property acquired (or self-constructed) and placed in service prior to January 1, 2006 (from 

 

26 Pub. Law No. 108-27, sec. 201 (2003).

27 JGTRRA clarifies that the adjusted basis of qualified property acquired by a taxpayer 

in a like kind exchange or an involuntary conversion is eligible for the additional first year 

depreciation deduction.

28 Property does not fail to qualify for the additional first-year depreciation merely 

because a binding written contract to acquire a component of the property is in effect prior to 

May 6, 2003. However, no additional first-year depreciation is permitted on any such 

component. No inference is intended as to the proper treatment of components placed in service 

under the 30 percent additional first-year depreciation provided by the JCWAA.

29 For purposes of determining the amount of eligible progress expenditures, it is 

intended that rules similar to sec. 46(d)(3) as in effect prior to the Tax Reform Act of 1986 shall 

apply. 
17

January 1, 2005). The bill extends the placed-in-service date requirement for certain property 

with a recovery period of ten years or longer and certain transportation property to include 

property placed in service prior to January 1, 2007 (instead of January 1, 2006). In addition, 

progress expenditures eligible for the additional first-year depreciation is extended to include 

costs incurred prior to January 1, 2006 (instead of January 1, 2005).

Effective Date

The provision is effective on the date of enactment.
18

F. Recovery Period for Depreciation of Certain 

Leasehold Improvements and Restaurant Property

(sec. 1042 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)).30 This rule applies regardless of whether the lessor or the 

lessee places the leasehold improvements in service.31 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)).32

 

30 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.

31 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.

32 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); 
19

Qualified leasehold improvement property

The Job Creation and Worker Assistance Act of 200233 as amended by the Jobs and 

Growth Tax Relief Reconciliation Act of 200334 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. 

Explanation of Provision

The bill provides a statutory 20-year recovery period for qualified leasehold improvement 

property.35 The bill 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).

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

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

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

first-year depreciation deduction under sec. 168(k).
20

The bill also provides a statutory 20-year recovery period for qualified restaurant 

property.36 For purposes of the bill, qualified restaurant property means any building (or any 

addition or improvement to such building) if 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 bill requires that qualified restaurant property be recovered using the straight-line 

method. 

Effective Date

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

bill. 

 

36 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.
21

G. Shorter Recovery Periods for Manufacturing Property 

(sec. 1043 of the bill and sec. 168 of the Code)

Present Law 

In general 

A taxpayer is allowed to recover, through annual depreciation deductions, the cost of 

certain property used in a trade or business or for the production of income. The amount of the 

depreciation deduction allowed with respect to tangible property for a taxable year is determined 

under the modified accelerated cost recovery system (“MACRS”). Under MACRS, different 

types of property generally are assigned applicable recovery periods and depreciation methods. 

The recovery periods generally applicable to manufacturing property range from three to ten 

years. The depreciation method generally applicable to such property is the 200-percent 

declining balance method, switching to the straight-line method for the taxable year in which the 

depreciation deduction would be maximized. 

Generally, MACRS classifies an asset by the economic activity in which the asset is used. 

For example, all depreciable assets used in the manufacture of leather and leather products are 

recovered over seven years. An exception to the classification by economic activity applies to 

assets in which the use generally has no bearing on its useful life. For example, office furniture 

and fixtures, computers, data handling equipment, and automobiles have the same recovery 

period irrespective of the economic activity in which they are used.

An alternative depreciation system is provided for property that is predominantly foreignuse property, tax-exempt use property, tax-exempt-bond-financed property, or property with 

respect to which a taxpayer elects to apply the alternative depreciation system. In these cases, 

the alternative depreciation system requires the use of a longer recovery period and the straightline depreciation method. For example, depreciable assets used in the manufacturing of leather 

and leather products predominantly outside of the United States are recovered using the straightline method and an 11-year recovery period (rather than 200% declining balance method and a 

seven year recovery period). 

Explanation of Provision

The bill reduces the recovery period for manufacturing property. Specifically, 

manufacturing property that would otherwise qualify for a five-, seven-, or ten-year recovery 

period will be eligible for cost recovery using a three, five, or seven year recovery period, 

respectively. For example, all depreciable assets used in the manufacture of leather products, 

that under present law are recovered using a seven-year recovery period, will be recoverable 

using a five-year recovery period. In addition, such property will continue to be eligible for the 

additional first-year depreciation deduction provided by section 168(k). The bill does not apply 

to any manufacturing property depreciated under the alternative depreciation system of MACRS 

(e.g., predominantly foreign-use property).37 

 

37 The bill does not change the recovery periods used for manufacturing property 

recovered under the alternative depreciation system (e.g., predominantly foreign-use property). 
22

For purposes of the bill, manufacturing property is defined as property used in an activity 

which is manufacturing within the meaning of codes 31-33 of the North American Industry 

Classification System of 2002,38 and property treated as manufacturing property in regulations 

prescribed by the Secretary. 

Effective Date

The provision applies to property placed in service after the date of enactment.

 

38 Information regarding the North American Industry Classification System codes can 

be found at www.census.gov. Visitors to the site should select “Subjects A to Z,” followed by 

“N,” and then should select “North American Industry Classification System.” Taxpayers also 

may find a partial list of NAICS codes, described as “Principal Business Activity Codes,” in the 

instructions to their tax return forms.
23

H. Five-Year Carryback of Net Operating Losses

(sec. 1051 of the bill and secs. 172 and 56 of the Code)

Present Law

A net operating loss (“NOL”) is, generally, the amount by which a taxpayer’s allowable 

deductions exceed the taxpayer’s gross income. A carryback of an NOL generally results in the 

refund of Federal income tax for the carryback year. A carryforward of an NOL reduces Federal 

income tax for the carryforward year.

In general, an NOL may be carried back two years and carried forward 20 years to offset 

taxable income in such years.39 Different rules apply with respect to NOLs arising in certain 

circumstances. For example, a three-year carryback applies with respect to NOLs (1) arising 

from casualty or theft losses of individuals, or (2) attributable to Presidentially declared disasters 

for taxpayers engaged in a farming business or a small business. A five-year carryback period 

applies to NOLs from a farming loss (regardless of whether the loss was incurred in a 

Presidentially declared disaster area). Special rules also apply to real estate investment trusts (no 

carryback), specified liability losses (10-year carryback), and excess interest losses (no carryback 

to any year preceding a corporate equity reduction transaction).

The alternative minimum tax rules provide that a taxpayer’s NOL deduction cannot 

reduce the taxpayer’s alternative minimum taxable income (“AMTI”) by more than 90 percent of 

the AMTI (determined without regard to the NOL deduction).

Section 202 of the Job Creation and Worker Assistance Act of 200240 (“JCWAA”) 

provided a temporary extension of the general NOL carryback period to five years (from two 

years) for NOLs arising in taxable years ending in 2001 and 2002. In addition, the five-year 

carryback period applies to NOLs from these years that qualify under present law for a threeyear carryback period (i.e., NOLs arising from casualty or theft losses of individuals or 

attributable to certain Presidentially declared disaster areas). 

A taxpayer can elect to forgo the five-year carryback period. The election to forgo the 

five-year carryback period is made in the manner prescribed by the Secretary of the Treasury and 

must be made by the due date of the return (including extensions) for the year of the loss. The 

election is irrevocable. If a taxpayer elects to forgo the five-year carryback period, then the 

losses are subject to the rules that otherwise would apply under section 172 absent the 

provision.41

 

39 Sec. 172.

40 Pub. Law No. 107-147.

41 Because JCWAA was enacted after some taxpayers had filed tax returns for years 

affected by the provision, a technical correction is needed to provide for a period of time in 

which prior decisions regarding the NOL carryback may be reviewed. Similarly, a technical 

correction is needed to modify the carryback adjustment procedures of sec. 6411 for NOLs 

arising in 2001 and 2002. These issues were addressed in a letter dated April 15, 2002, sent by 
24

JCWAA also provided that an NOL deduction attributable to NOL carrybacks arising in 

taxable years ending in 2001 and 2002, as well as NOL carryforwards to these taxable years, 

may offset 100 percent of a taxpayer’s AMTI.42

Explanation of Provision

The bill extends the provisions of the five-year carryback of NOLs enacted in JCWAA to 

NOLs arising in taxable years ending in 2003.43 

The bill also allows an NOL deduction attributable to NOL carrybacks arising in taxable 

years ending in 2003, as well as NOL carryforwards to these taxable years, to offset 100 percent 

of a taxpayer’s AMTI.

Effective Date

The five-year carryback provision is effective for NOLs generated in taxable years 

ending in 2003. The provision relating to AMTI is effective for NOL carrybacks arising in, and 

NOL carryforwards to, taxable years ending in 2003. 

 

the Chairmen and Ranking Members of the House Ways and Means Committee and Senate 

Finance Committee, as well as in guidance issued by the IRS pursuant to the Congressional letter 

(Rev. Proc. 2002-40, 2002-1 C.B. 1096). 

42 Section 172(b)(2) should be appropriately applied in computing AMTI to take proper 

account of the order that the NOL carryovers and carrybacks are used as a result of this 

provision. See section 56(d)(1)(B)(ii).

43 Because certain taxpayers may have already filed tax returns (or be in the process of 

filing tax returns) for taxable years ending in 2003, the proposal contains special rules to provide 

until November 1, 2003 in which prior decisions regarding the NOL carryback may be reviewed 

by taxpayers. 
25

I. Alternative Minimum Tax Relief

(secs. 1061-1063 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).44

 

44 Other provisions of the bill extend additional depreciation under section 168(k) for an 

additional year, extend the 100-percent AMT net operating loss provision for an additional year, 

and increase the period to which the foreign tax credit may be carried.
26

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.

Depreciation

One of the adjustments in computing AMTI is the depreciation adjustment. In general, 

ACRS property that is depreciated under the 200-percent declining balance method in computing 

taxable income under the regular tax is depreciated under the 150-percent declining balance 

method in computing AMTI. Depreciation on property for which additional depreciation is 

allowable under section 168(k) is not adjusted for purposes of the AMT.

Explanation of Provision

The bill repeals the 90-percent limitation on the use of the net operating loss deduction in 

computing AMTI.

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

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

receive from $7.5 million to $15 million.

The bill generally reduces the AMT adjustment for depreciation by 50 percent. The bill 

replaces the 150-percent declining balance method with the 175-percent declining balance 

method in computing AMTI.

Effective Date

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

2003.

The depreciation provision applies to property placed in service in taxable years 

beginning after December 31, 2005.
27

J. Provisions Relating to S Corporation Reform and Simplification

(secs. 1071-1080 of the Code 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)45 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 

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

 

45 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.
28

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

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

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

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

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

homebuyer expenses of up to $10,000.

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

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

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

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

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

to the beneficiary.

Explanation of Provision

In general

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

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

the lineal descendants 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 provision, if later). The election is made 

available to only one family per corporation, must be made with the consent of all shareholders 

of the corporation and remains in effect until terminated.

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

Individual retirement accounts

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

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

provision.46 

The bill also provides an exemption from prohibited transaction treatment for the sale by 

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

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

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

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

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

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

120 days after the S corporation election is made.

 

46 Under the bill, 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.
29

Effective Date

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

provision relating to IRAs takes effect on the date of enactment of the bill. 

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.

Explanation of Provision

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

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

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

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

Effective Date

The provision applies to taxable years beginning after December 31, 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.
30

Explanation of Provision

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

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

of the S corporation stock.

Effective Date

The provision applies to 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. 

Explanation of Provision

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

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

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

year.

Effective Date

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

3. Provisions 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 
31

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. 

Explanation of Provision

The bill 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 provision 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. 

Explanation of Provision

Under the bill, 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 provision applies to taxable years beginning after December 31, 2003.
32

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.

Explanation of Provision

The bill allows inadvertent invalid qualified subchapter S subsidiary elections and 

terminations to be waived by the IRS.

Effective Date

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

Explanation of Provision

The bill provides authority to the Secretary of the Treasury to provide guidance regarding 

information returns of qualified subchapter S subsidiaries.

Effective Date

The provision applies to taxable years beginning after December 31, 2003.
33

K. Protecting Employee Benefits

1. Treatment of nonqualified deferred compensation plans (sec. 1091 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,47 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 arrangement 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 83.48 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 

 

47

 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.

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

nonqualified deferred compensation.
34

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 451.49 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.50 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.51 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 

 

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

50 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).

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

393.
35

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.

Explanation of Provision

Under the bill, all amounts deferred under a nonqualified deferred compensation plan52

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

substantial risk of forfeiture53 and not previously included in gross income, unless certain 

requirements are satisfied. If the requirements of the bill 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 bill.

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

allowed only upon separation from service, 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. 

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 employees (as defined in section 416(i)) 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 

of not less than twelve months.

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 

 

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

that includes one person. 

53 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.
36

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 used for purposes of the golden parachute 

provisions of section 280G consistent with the purposes of the bill.

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 or of 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).

The bill requires that initial deferral elections must be required to be made at least prior to 

the beginning of the taxable year in which the compensation is earned, 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. Under the bill, a plan may allow 

changes in the time and form of distributions subject to certain requirements. A nonqualified 

deferred compensation plan may allow subsequent elections to delay the timing or form of 

distributions only if (1) the subsequent election is made not less than 12 months prior to the date 

of the first scheduled payment, and (2) the additional deferral with respect to which such election 

is made is for a period of not less than five years. As previously discussed, 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.

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 bill, assets set aside (directly or indirectly) in an offshore trust (or other similar 

arrangement) for the purpose of paying nonqualified deferred compensation 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 
37

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 bill, 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 

qualified retirement plan, tax-deferred annuity, simplified employee pension, and SIMPLE.54 A 

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

under the bill.

Interest imposed under the bill 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 bill. The bill 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 bill. The bill does not affect the rules regarding the timing 

of an employer’s deduction for nonqualified deferred compensation.

The bill 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 bill, the 

Secretary is authorized, through regulations, to establish a minimum amount of deferrals below 

which the reporting requirements do not apply. 

The bill provides the Secretary of the Treasury authority to prescribe regulations as are 

necessary to carry out the purposes of bill, including regulations: (1) providing for 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 in cases where necessary to carry out the 

purposes of the bill. 

 

54 A qualified employer plan also includes a section 501(c)(18) trust.
38

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 provision is effective for amounts deferred in taxable years beginning after 

December 31, 2003.

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

from wages (sec. 1092 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.55 

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.56 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. 57

 

55 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).

56 Secs. 3101, 3111, and 3301.

57 Notice 2002-47, 2002-28 I.R.B. 97.
39

Explanation of Provision

The bill 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 bill, FICA and 

FUTA taxes do not apply upon the exercise of a statutory stock option.58 The bill also provides 

that such remuneration is not taken into account for purposes of determining Social Security 

benefits.

Additionally, the bill provides that Federal income tax withholding is not required on a 

disqualifying disposition, nor when compensation is recognized in connection with an employee 

stock purchase plan discount. Present-law reporting requirements continue to apply.

Effective Date

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

of enactment.

 

58 The bill also provides a similar exclusion under the Railroad Retirement Tax Act. 
40

L. Extension of Provision Permitting Qualified Transfers of 

Excess Pension Assets to Retiree Health Accounts 

(sec. 1093 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.59 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.

Excess assets generally means the excess, if any, of the value of the plan’s assets60 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),61 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 

 

59 Sec. 420.

60 The value of plan assets for this purpose is the lesser of fair market value or actuarial 

value.

61 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.
41

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.62

No qualified transfers may be made after December 31, 2005.

Explanation of Provision

The bill allows qualified transfers of excess defined benefit plan assets through December 

31, 2013. 

Effective Date

The provision is effective on the date of enactment.

 

62 ERISA sec. 101(e). ERISA also provides that a qualified transfer is not a prohibited 

transaction under ERISA or a prohibited reversion.
42

M. Treatment of Active Income

1. Repeal controlled foreign corporation rules for foreign base company sales and services 

income (sec. 1101 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.

Explanation of Provision

The bill repeals the subpart F rules for foreign base company sales and services income. 

The bill continues to treat as subpart F income (as a category of foreign personal holding 

company income) income of a controlled foreign corporation with respect to sales of property 
43

purchased from (or sold to) a related person that is produced in the United States and sold (or 

purchased) for use in the United States.63

Effective Date

The proposal is effective for taxable years of foreign corporations beginning after 

December 31, 2005, and taxable years of U.S. shareholders with or within which such taxable 

years of foreign corporations end. 

2. Extension and modification of exceptions under subpart F for active financing income

(sec. 1102 of the bill and secs. 953 and 954 of the Code)

Present Law

Under the subpart F rules, U.S. shareholders with a 10-percent or greater interest in a 

controlled foreign corporation (“CFC”) are subject to U.S. tax currently on certain income 

earned by the CFC, whether or not such income is distributed to the shareholders. The income 

subject to current inclusion under the subpart F rules includes, among other things, foreign 

personal holding company income and insurance income. In addition, 10-percent U.S. 

shareholders of a CFC are subject to current inclusion with respect to their shares of the CFC's 

foreign base company services income (i.e., income derived from services performed for a 

related person outside the country in which the CFC is organized).

Foreign personal holding company income generally consists of the following: (1) 

dividends, interest, royalties, rents, and annuities; (2) net gains from the sale or exchange of (a) 

property that gives rise to the preceding types of income, (b) property that does not give rise to 

income, and (c) interests in trusts, partnerships, and REMICs; (3) net gains from commodities 

transactions; (4) net gains from foreign currency transactions; (5) income that is equivalent to 

interest; (6) income from notional principal contracts; and (7) payments in lieu of dividends.

Insurance income subject to current inclusion under the subpart F rules includes any 

income of a CFC attributable to the issuing or reinsuring of any insurance or annuity contract in 

connection with risks located in a country other than the CFC's country of organization. Subpart 

F insurance income also includes income attributable to an insurance contract in connection with 

risks located within the CFC's country of organization, as the result of an arrangement under 

which another corporation receives a substantially equal amount of consideration for insurance 

of other country risks. Investment income of a CFC that is allocable to any insurance or annuity 

contract related to risks located outside the CFC's country of organization is taxable as subpart F 

insurance income (Treas. Reg. sec. 1.953-1(a)).

Temporary exceptions from foreign personal holding company income, foreign base 

company services income, and insurance income apply for subpart F purposes for certain income 

 

63 It is intended that this provision be interpreted in a manner consistent with the 

interpretations that have developed with respect to similar language in the context of the foreign 

base company sales income rules, including interpretations relating to the “manufacturing 

exception” applicable under those rules. See Treas. Reg. sec. 1.954-3(a)(4).
44

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”).64

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.

 

64 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.
45

Explanation of Provision

 The bill extends for one year the present-law temporary exceptions from subpart F 

foreign personal holding company income, foreign base company services income, and insurance 

income 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.

Effective Date

The provision is effective for taxable years of foreign corporations beginning after 

December 31, 2006, and before January 1, 2008, and for taxable years of U.S. shareholders with 

or within which such taxable years of such foreign corporations end.

3. Look-through treatment of payments between related controlled foreign corporations 

under foreign personal holding company income rules (sec. 1103 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. 

Explanation of Provision

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. 
46

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. 

4. Look-through treatment for sales of partnership interests (sec. 1104 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.

Explanation of Provision

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, 2004, and taxable years of U.S. shareholders with or within which such taxable 

years of foreign corporations end. 
47

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

(sec. 1105 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). 

Explanation of Provision

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, 2004, and taxable years of U.S. shareholders with or within which such taxable 

years of foreign corporations end. 

6. Subpart F treatment of pipeline transportation income (sec. 1106 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 
48

“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).

Explanation of Provision

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 provision is effective for taxable years of foreign corporations beginning after 

December 31, 2004, and taxable years of U.S. shareholders with or within which such taxable 

years of foreign corporations end.

7. Determination of foreign personal holding company income with respect to transactions 

in commodities (sec. 1107 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) 
49

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.65 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.66

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 

 

65 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)).

66 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)).
50

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)).

Explanation of Provision

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 provision, the general definition of a hedging transaction under section 

1221(b)(2) is modified to include any transaction with respect to a commodity entered into by a 

controlled foreign corporation in the normal course of the controlled foreign corporation’s trade 

or business primarily: (1) to manage risk of price changes or currency fluctuations with respect 

to ordinary property or property described in section 1231(b) which is held or to be held by the 

controlled foreign corporation; or (2) to manage such other risks as the Secretary may prescribe 

in regulations. Gains or losses from a transaction that satisfies the modified definition of a 

hedging transaction are excluded from the definition of foreign personal holding company 

income only if the transaction is clearly identified as a hedging transaction in accordance with 

the hedge identification requirements that apply generally to hedging transactions under section 

1221(b)(2) (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.67

Effective Date

This provision is effective with respect to transactions entered into after December 31, 

2004.

 

67 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.
51

8. Repeal controlled foreign corporation rules for foreign base company shipping income 

(sec. 1108 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 
52

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.

Explanation of Provision

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. 
53

N. Reduction of Double Taxation of Corporate Earnings

1. Interest expense allocation rules (sec. 1111 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 
54

operated exclusively for charitable or educational purposes), certain life insurance companies, 

corporations electing application of the possession tax credit, regulated investment companies, 

real estate investment trusts, and domestic international sales corporations. A foreign 

corporation generally is not an includible corporation.

Definition of affiliated group -- special interest allocation rules

 Subject to exceptions, the consolidated return and interest allocation definitions of 

affiliation generally are consistent with each other.68 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.

Explanation of Provision

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 

 

68 One such exception is that the affiliated group for interest allocation purposes includes 

section 936 corporations that are excluded from the consolidated group.
55

members to foreign-source income in an amount equal to the excess (if any) of (1) the worldwide 

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.69

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)70 as well as all controlled foreign corporations that 

in the aggregate either directly or indirectly71 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, 2005, 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 

 

69 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.

70 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)).

71 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.
56

taxable year for which the election was made and all subsequent taxable years, unless revoked 

with the consent of the Secretary of the Treasury.

Financial institution group election

The 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,72 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.73 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, 2005, 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, 2005.

 

72 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.

73

 See Treas. Reg. sec. 1.904-4(e)(2).
57

2. Recharacterization of overall domestic loss (sec. 1112 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 
58

the fact that the previous year’s $100 U.S.-source loss reduced the taxpayer’s ability to claim 

foreign tax credits.

Explanation of Provision

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

2004.

3. Reduction to two foreign tax credit baskets (sec. 1113 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 
59

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”),74 (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). 

Explanation of Provision

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 group75 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.76 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 

 

74 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.

75 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.

76 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.
60

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

4. Ten-year foreign tax credit carryforward (sec. 1114 of the bill and sec. 904 of the Code)

Present Law

The foreign tax credit is subject to an overall limitation. That is, the total amount of the 

credit may not exceed the proportion of the taxpayer's U.S. tax that the taxpayer's foreign-source 

taxable income bears to the taxpayer's worldwide taxable income for the taxable year. In 

addition, the foreign tax credit limitation is calculated separately for various categories of 

income, generally referred to as "separate limitation categories." The total amount of the foreign 

tax credit on income in each separate limitation category may not exceed the proportion of the 

taxpayer's U.S. tax which the taxpayer's foreign-source taxable income in that category bears to 

its worldwide taxable income.

The amount of creditable taxes paid or accrued (or deemed paid) in any taxable year 

which exceeds the foreign tax credit limitation is permitted to be carried back to the two 

immediately preceding taxable years (to the earliest year first) and carried forward five taxable 

years (in chronological order) and credited (not deducted) to the extent that the taxpayer 

otherwise has excess foreign tax credit limitation for those years. Excess credits that are carried 

back or forward are usable only to the extent that there is excess foreign tax credit limitation in 

such carryover or carryback year. Consequently, foreign tax credits arising in a taxable year are 

utilized before excess credits from another taxable year may be carried forward or backward. In 

addition, excess credits are carried forward or carried back on a separate limitation basis. Thus, 

if a taxpayer has excess foreign tax credits in one separate limitation category for a taxable year, 

those excess credits may be carried back and forward only as taxes allocable to that category, 

notwithstanding the fact that the taxpayer may have excess foreign tax credit limitation in 

another category for that year. If credits cannot be so utilized, they are permanently disallowed.

Explanation of Provision

The bill extends the excess foreign tax credit carryforward period from five to ten years.

Effective Date

The provision is effective for excess foreign tax credits that may be carried to any taxable 

years beginning after December 31, 2004.
61

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

(sec. 1115 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).77 

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.

Explanation of Provision

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 

accumulated.78 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 

 

77 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. 

78 Section 1113 of the bill eliminates the separate basket for dividends from 10/50 

companies. 
62

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

6. Attribution of stock ownership through partnerships to apply in determining section 902 

and 960 credits (sec. 1116 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.

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.79 In Rev. Rul. 71-141,80 the 

 

79 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 
63

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.”81 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).

Explanation of Provision

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

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 provision applies to taxes of foreign corporations for taxable years of such 

corporations beginning after the date of enactment. 

 

(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.

80 1971-1 C.B. 211.

81 T.D. 8708, 1997-1 C.B. 137.
64

7. Clarification of treatment of certain transfers of intangible property (sec. 1117 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.82

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.83 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).84

Explanation of Provision

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 provision 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).

 

82 Secs. 865(d), 862(a).

83 Sec. 904(d).

84 Sec. 904(d)(3).
65

8. Application of uniform capitalization rules for foreign persons (sec. 1118 of the bill and 

sec. 263A of the Code)

Present Law

Taxpayers generally may not currently deduct the costs incurred in producing property or 

acquiring property for resale. In general, the uniform capitalization rules require that a portion of 

the direct and indirect costs of producing property or acquiring property for resale be capitalized 

or included in the cost of inventory (sec. 263A). Consequently, such costs must be recovered 

through an offset to the sales price if the property is produced for sale, or through depreciation or 

amortization if the property is produced for the taxpayer’s own use in a business or investment 

activity. The purpose of this requirement is to match the costs of producing or acquiring goods 

with the revenues realized from their sale or use in the business or investment activity.

Application to foreign corporations

The uniform capitalization rules apply to foreign corporations, whether or not engaged in 

business in the United States. In the case of a foreign corporation carrying on a U.S. trade or 

business, for example, the uniform capitalization rules apply for purposes of computing the

corporation's U.S. effectively connected taxable income, as well as computing its effectively 

connected earnings and profits for purposes of the branch profits tax.

When a foreign corporation is not engaged in a trade or business in the United States, its

taxable income and earnings and profits may nonetheless be relevant under the Code. For 

example, the subpart F income of a controlled foreign corporation may be currently includible on 

the return of a U.S. shareholder of the controlled foreign corporation. Regardless of whether or 

not a foreign corporation is U.S.-controlled, its accumulated earnings and profits must be 

computed in order to determine the amount of taxable dividends and the indirect foreign tax 

credit carried by distributions from the foreign corporation to any domestic corporation that 

owns at least 10 percent of its voting stock.

The earnings and profits surplus or deficit of any foreign corporation for any taxable year 

generally is determined according to rules substantially similar to those applicable to domestic 

corporations. However, Treas. Prop. Reg. sec. 1.964-1(c)(1)(ii)(B) provides that, for purposes of 

computing a foreign corporation’s earnings and profits, the amount of expenses that must be 

capitalized into inventory under the uniform capitalization rules may not exceed the amount 

capitalized in keeping the taxpayer’s books and records. For this purpose, the taxpayer’s books 

and records must be prepared in accordance with U.S. generally accepted accounting principles 

for purposes of reflecting in the financial statements of a domestic corporation the operations of 

its foreign affiliates. This proposed regulation applies only for purposes of determining a foreign 

corporation’s earnings and profits and does not apply for purposes of determining subpart F 

income or income effectively connected with a U.S. trade or business of a foreign corporation.

Explanation of Provision

The bill provides that in lieu of the uniform capitalization rules, costs incurred in 

producing property or acquiring property for resale are capitalized using U.S. generally accepted 

accounting principles (i.e., the method used to ascertain income, profit, or loss for purposes of 
66

reports or statements to shareholders, partners, other proprietors, or beneficiaries, or for credit 

purposes) for purposes of determining a U.S.-owned foreign corporation’s earnings and profits 

and subpart F income. The uniform capitalization rules continue to apply to foreign corporations 

for purposes of determining income effectively connected with a U.S. trade or business and the 

related earnings and profits therefrom.

Effective Date

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

in the taxpayer’s method of accounting required as a result of this provision is treated as a 

voluntary change initiated by the taxpayer and is deemed made with the consent of the Secretary 

of the Treasury (i.e., no application for change in method of accounting is required to be filed 

with the Secretary). Any resultant section 481(a) adjustment required to be taken into account is 

to be taken into account in the first year. 

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

course of trade or business (sec. 1119 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).
67

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 

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)).

Explanation of Provision

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 provision is effective for taxable years of foreign corporations beginning after 

December 31, 2004, and for taxable years of United States shareholders with or within which 

such taxable year of the foreign corporation ends.
68

10. Treatment of certain dividends of regulated investment companies (sec. 1120 of the bill 

and secs. 871 and 881 of the Code)

Present Law

Regulated investment companies

A regulated investment company ("RIC") is a domestic corporation that, at all times 

during the taxable year, is registered under the Investment Company Act of 1940 as a 

management company or as a unit investment trust, or has elected to be treated as a business 

development company under that Act (sec. 851(a)).

In addition, to qualify as a RIC, a corporation must elect such status and must satisfy 

certain tests (sec. 851(b)). These tests include a requirement that the corporation derive at least 

90 percent of its gross income from dividends, interest, payments with respect to certain 

securities loans, and gains on the sale or other disposition of stock or securities or foreign 

currencies, or other income derived with respect to its business of investment in such stock, 

securities, or currencies.

Generally, a RIC pays no income tax because it is permitted to deduct dividends paid to 

its shareholders in computing its taxable income. The amount of any distribution generally is not 

considered as a dividend for purposes of computing the dividends paid deduction unless the

distribution is pro rata, with no preference to any share of stock as compared with other shares of 

the same class (sec. 562(c)). For distributions by RICs to shareholders who made initial 

investments of at least $10,000,000, however, the distribution is not treated as non-pro rata or 

preferential solely by reason of an increase in the distribution due to reductions in administrative 

expenses of the company.

A RIC generally may pass through to its shareholders the character of its long-term 

capital gains. It does this by designating a dividend it pays as a capital gain dividend to the 

extent that the RIC has net capital gain (i.e., net long-term capital gain over net short-term capital 

loss). These capital gain dividends are treated as long-term capital gain by the shareholders. A 

RIC generally also can pass through to its shareholders the character of tax-exempt interest from 

State and local bonds, but only if, at the close of each quarter of its taxable year, at least 50 

percent of the value of the total assets of the RIC consists of these obligations. In this case, the 

RIC generally may designate a dividend it pays as an exempt-interest dividend to the extent that 

the RIC has tax-exempt interest income. These exempt-interest dividends are treated as interest 

excludable from gross income by the shareholders.

U.S. source investment income of foreign persons

In general 

The United States generally imposes a flat 30-percent tax, collected by withholding, on 

the gross amount of U.S.-source investment income payments, such as interest, dividends, rents, 

royalties or similar types of income, to nonresident alien individuals and foreign corporations 

("foreign persons") (secs. 871(a), 881, 1441, and 1442). Under treaties, the United States may 
69

reduce or eliminate such taxes. Even taking into account U.S. treaties, however, the tax on a 

dividend generally is not entirely eliminated. Instead, U.S.-source portfolio investment 

dividends received by foreign persons generally are subject to U.S. withholding tax at a rate of at 

least 15 percent.

Interest

Although payments of U.S.-source interest that is not effectively connected with a U.S. 

trade or business generally are subject to the 30-percent withholding tax, there are exceptions to 

that rule. For example, interest from certain deposits with banks and other financial institutions 

is exempt from tax (secs. 871(i)(2)(A) and 881(d)). Original issue discount on obligations 

maturing in 183 days or less from the date of original issue (without regard to the period held by 

the taxpayer) is also exempt from tax (sec. 871(g)). An additional exception is provided for 

certain interest paid on portfolio obligations (secs. 871(h) and 881(c)). “Portfolio interest” 

generally is defined as any U.S.-source interest (including original issue discount), not 

effectively connected with the conduct of a U.S. trade or business, (i) on an obligation that 

satisfies certain registration requirements or specified exceptions thereto (i.e., the obligation is 

“foreign targeted”), and (ii) that is not received by a 10-percent shareholder (secs. 871(h)(3) and 

881(c)(3)). With respect to a registered obligation, a statement that the beneficial owner is not a 

U.S. person is required (secs. 871(h)(2), (5) and 881(c)(2)). This exception is not available for 

any interest received either by a bank on a loan extended in the ordinary course of its business 

(except in the case of interest paid on an obligation of the United States), or by a controlled 

foreign corporation from a related person (sec. 881(c)(3)). Moreover, this exception is not 

available for certain contingent interest payments (secs. 871(h)(4) and 881(c)(4)). 

Capital gains

Foreign persons generally are not subject to U.S. tax on gain realized on the disposition 

of stock or securities issued by a U.S. person (other than a "U.S. real property holding 

corporation," as described below), unless the gain is effectively connected with the conduct of a 

trade or business in the United States. This exemption does not apply, however, if the foreign 

person is a nonresident alien individual present in the United States for a period or periods 

aggregating 183 days or more during the taxable year (sec. 871(a)(2)). A RIC may elect not to 

withhold on a distribution to a foreign person representing a capital gain dividend. (Treas. Reg. 

sec. 1.1441-3(c)(2)(D)).

Gain or loss of a foreign person from the disposition of a U.S. real property interest is 

subject to net basis tax as if the taxpayer were engaged in a trade or business within the United 

States and the gain or loss were effectively connected with such trade or business (sec. 897). In 

addition to an interest in real property located in the United States or the Virgin Islands, U.S. real 

property interests include (among other things) any interest in a domestic corporation unless the 

taxpayer establishes that the corporation was not, during a 5-year period ending on the date of 

the disposition of the interest, a U.S. real property holding corporation (which is defined 

generally to mean a corporation the fair market value of whose U.S. real property interests equals 

or exceeds 50 percent of the sum of the fair market values of its real property interests and any 

other of its assets used or held for use in a trade or business).
70

Estate taxation

Decedents who were citizens or residents of the United States are generally subject to 

Federal estate tax on all property, wherever situated.85 Nonresidents who are not U.S. citizens, 

however, are subject to estate tax only on their property which is within the United States. 

Property within the United States generally includes debt obligations of U.S. persons, including 

the Federal government and State and local governments (sec. 2104(c)), but does not include 

either bank deposits or portfolio obligations, the interest on which would be exempt from U.S. 

income tax under section 871 (sec. 2105(b)). Stock owned and held by a nonresident who is not 

a U.S. citizen is treated as property within the United States only if the stock was issued by a 

domestic corporation (sec. 2104(a); Treas. Reg. sec. 20.2104-1(a)(5)).

Treaties may reduce U.S. taxation on transfers by estates of nonresident decedents who 

are not U.S. citizens. Under recent treaties, for example, U.S. tax may generally be eliminated 

except insofar as the property transferred includes U.S. real property or business property of a 

U.S. permanent establishment.

Explanation of Provision

In general

Under the bill, a RIC that earns certain interest income that would not be subject to U.S. 

tax if earned by a foreign person directly may, to the extent of such income, designate a dividend 

it pays as derived from such interest income. A foreign person who is a shareholder in the RIC 

generally would treat such a dividend as exempt from gross-basis U.S. tax, as if the foreign 

person had earned the interest directly. Similarly, a RIC that earns an excess of net short-term 

capital gains over net long-term capital losses, which excess would not be subject to U.S. tax if 

earned by a foreign person, generally may, to the extent of such excess, designate a dividend it 

pays as derived from such excess. A foreign person who is a shareholder in the RIC generally 

would treat such a dividend as exempt from gross-basis U.S. tax, as if the foreign person had 

realized the excess directly. The bill also provides that the estate of a foreign decedent is exempt 

from U.S. estate tax on a transfer of stock in the RIC in the proportion that the assets held by the 

RIC are debt obligations, deposits, or other property that would generally be treated as situated 

outside the United States if held directly by the estate.

Interest-related dividends

Under the bill, a RIC may, under certain circumstances, designate all or a portion of a 

dividend as an "interest-related dividend," by written notice mailed to its shareholders not later 

than 60 days after the close of its taxable year. In addition, an interest-related dividend received 

by a foreign person generally is exempt from U.S. gross-basis tax under sections 871(a), 881, 

1441 and 1442.

 

85 The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) 

repealed the estate tax for estates of decedents dying after December 31, 2009. However, 

EGTRRA included a “sunset” provision, pursuant to which EGTRRA’s provisions (including 

estate tax repeal) do not apply to estates of decedents dying after December 31, 2010.
71

However, this exemption does not apply to a dividend on shares of RIC stock if the 

withholding agent does not receive a statement, similar to that required under the portfolio 

interest rules, that the beneficial owner of the shares is not a U.S. person. The exemption does 

not apply to a dividend paid to any person within a foreign country (or dividends addressed to, or 

for the account of, persons within such foreign country) with respect to which the Treasury 

Secretary has determined, under the portfolio interest rules, that exchange of information is 

inadequate to prevent evasion of U.S. income tax by U.S. persons.

In addition, the exemption generally does not apply to dividends paid to a controlled 

foreign corporation to the extent such dividends are attributable to income received by the RIC 

on a debt obligation of a person with respect to which the recipient of the dividend (i.e., the 

controlled foreign corporation) is a related person. Nor does the exemption generally apply to 

dividends to the extent such dividends are attributable to income (other than short-term original 

issue discount or bank deposit interest) received by the RIC on indebtedness issued by the RICdividend recipient or by any corporation or partnership with respect to which the recipient of the 

RIC dividend is a 10-percent shareholder. However, in these two circumstances the RIC remains 

exempt from its withholding obligation unless the RIC knows that the dividend recipient is such 

a controlled foreign corporation or 10-percent shareholder. To the extent that an interest-related 

dividend received by a controlled foreign corporation is attributable to interest income of the RIC 

that would be portfolio interest if received by a foreign corporation, the dividend is treated as 

portfolio interest for purposes of the de minimis rules, the high-tax exception, and the same 

country exceptions of subpart F (see sec. 881(c)(5)(A)).

The aggregate amount designated as interest-related dividends for the RIC’s taxable year 

(including dividends so designated that are paid after the close of the taxable year but treated as 

paid during that year as described in section 855) generally is limited to the qualified net interest 

income of the RIC for the taxable year. The qualified net interest income of the RIC equals the 

excess of: (1) the amount of qualified interest income of the RIC; over (2) the amount of 

expenses of the RIC properly allocable to such interest income.

Qualified interest income of the RIC is equal to the sum of its U.S.-source income with 

respect to: (1) bank deposit interest; (2) short term original issue discount that is currently 

exempt from the gross-basis tax under section 871; (3) any interest (including amounts 

recognized as ordinary income in respect of original issue discount, market discount, or 

acquisition discount under the provisions of sections 1271-1288, and such other amounts as 

regulations may provide) on an obligation which is in registered form, unless it is earned on an 

obligation issued by a corporation or partnership in which the RIC is a 10-percent shareholder or 

is contingent interest not treated as portfolio interest under section 871(h)(4); and (4) any 

interest-related dividend from another RIC.

If the amount designated as an interest-related dividend is greater than the qualified net 

interest income described above, the portion of the distribution so designated which constitutes 

an interest-related dividend will be only that proportion of the amount so designated as the 

amount of the qualified net interest income bears to the amount so designated.
72

Short-term capital gain dividends

Under the bill, a RIC also may, under certain circumstances, designate all or a portion of 

a dividend as a "short-term capital gain dividend," by written notice mailed to its shareholders 

not later than 60 days after the close of its taxable year. For purposes of the U.S. gross-basis tax, 

a short-term capital gain dividend received by a foreign person generally is exempt from U.S. 

gross-basis tax under sections 871(a), 881, 1441 and 1442. This exemption does not apply to the 

extent that the foreign person is a nonresident alien individual present in the United States for a 

period or periods aggregating 183 days or more during the taxable year. However, in this 

circumstance the RIC remains exempt from its withholding obligation unless the RIC knows that 

the dividend recipient has been present in the United States for such period.

The aggregate amount qualified to be designated as short-term capital gain dividends for 

the RIC’s taxable year (including dividends so designated that are paid after the close of the 

taxable year but treated as paid during that year as described in sec. 855) is equal to the excess of 

the RIC’s net short-term capital gains over net long-term capital losses. The short-term capital 

gain includes short-term capital gain dividends from another RIC. As provided under present 

law for purposes of computing the amount of a capital gain dividend, the amount is determined 

(except in the case where an election under sec. 4982(e)(4) applies) without regard to any net 

capital loss or net short-term capital loss attributable to transactions after October 31 of the year. 

Instead, that loss is treated as arising on the first day of the next taxable year. To the extent 

provided in regulations, this rule also applies for purposes of computing the taxable income of 

the RIC.

In computing the amount of short-term capital gain dividends for the year, no reduction is 

made for the amount of expenses of the RIC allocable to such net gains. In addition, if the 

amount designated as short-term capital gain dividends is greater than the amount of qualified 

short-term capital gain, the portion of the distribution so designated which constitutes a shortterm capital gain dividend is only that proportion of the amount so designated as the amount of 

the excess bears to the amount so designated.

As under present law for distributions from REITs, the bill provides that any distribution 

by a RIC to a foreign person shall, to the extent attributable to gains from sales or exchanges by 

the RIC of an asset that is considered a U.S. real property interest, be treated as gain recognized 

by the foreign person from the sale or exchange of a U.S. real property interest. The bill also 

extends the special rules for domestically-controlled REITs to domestically-controlled RICs.

Estate tax treatment

Under the bill, a portion of the stock in a RIC held by the estate of a nonresident decedent 

who is not a U.S. citizen is treated as property without the United States. The portion so treated 

is based upon the proportion of the assets held by the RIC at the end of the quarter immediately 

preceding the decedent’s death (or such other time as the Secretary may designate in regulations) 

that are “qualifying assets”. Qualifying assets for this purpose are bank deposits of the type that 

are exempt from gross-basis income tax, portfolio debt obligations, certain original issue 

discount obligations, debt obligations of a domestic corporation that are treated as giving rise to 

foreign source income, and other property not within the United States.
73

Effective Date

The provision generally applies to dividends with respect to taxable years of RICs 

beginning after the date of enactment. With respect to the treatment of a RIC for estate tax 

purposes, this provision applies to estates of decedents dying after the date of enactment. With 

respect to the treatment of RICs under section 897 (relating to U.S. real property interests), this 

provision is effective on the date of enactment.

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

currency (sec. 1121 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. 

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)).

Explanation of Provision

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.86 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.

 

86 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.
74

Effective Date

This provision is effective with respect to taxable years beginning after December 31, 

2004.

12. Repeal of withholding tax on dividends from certain foreign corporations (sec. 1122 of 

the bill and sec. 871 of the Code)

Present Law

Nonresident individuals who are not U.S. citizens and foreign corporations (collectively, 

foreign persons) are subject to U.S. tax on income that is effectively connected with the conduct 

of a U.S. trade or business; the U.S. tax on such income is calculated in the same manner and at 

the same graduated rates as the tax on U.S. persons (secs. 871(b) and 882). Foreign persons also 

are subject to a 30-percent gross basis tax, collected by withholding, on certain U.S.-source 

passive income (e.g., interest and dividends) that is not effectively connected with a U.S. trade or 

business. This 30-percent withholding tax may be reduced or eliminated pursuant to an 

applicable tax treaty. Foreign persons generally are not subject to U.S. tax on foreign-source 

income that is not effectively connected with a U.S. trade or business.

In general, dividends paid by a domestic corporation are treated as being from U.S. 

sources and dividends paid by a foreign corporation are treated as being from foreign sources. 

Thus, dividends paid by foreign corporations to foreign persons generally are not subject to 

withholding tax because such income generally is treated as foreign-source income. 

An exception from this general rule applies in the case of dividends paid by certain 

foreign corporations. If a foreign corporation derives 25 percent or more of its gross income as 

income effectively connected with a U.S. trade or business for the three-year period ending with 

the close of the taxable year preceding the declaration of a dividend, then a portion of any 

dividend paid by the foreign corporation to its shareholders will be treated as U.S.-source income 

and, in the case of dividends paid to foreign shareholders, will be subject to the 30-percent 

withholding tax (sec. 861(a)(2)(B)). This rule is sometimes referred to as the “secondary 

withholding tax.” The portion of the dividend treated as U.S.-source income is equal to the ratio 

of the gross income of the foreign corporation that was effectively connected with its U.S. trade 

or business over the total gross income of the foreign corporation during the three-year period 

ending with the close of the preceding taxable year. The U.S.-source portion of the dividend 

paid by the foreign corporation to its foreign shareholders is subject to the 30-percent 

withholding tax.

Under the branch profits tax provisions, the United States taxes foreign corporations 

engaged in a U.S. trade or business on amounts of U.S. earnings and profits that are shifted out 

of the U.S. branch of the foreign corporation. The branch profits tax is comparable to the 

second-level taxes imposed on dividends paid by a domestic corporation to its foreign 

shareholders. The branch profits tax is 30 percent of the foreign corporation’s “dividend 

equivalent amount,” which generally is the earnings and profits of a U.S. branch of a foreign 

corporation attributable to its income effectively connected with a U.S. trade or business (secs. 

884(a) and (b)). 
75

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. 

Explanation of Provision

The bill eliminates the secondary withholding tax with respect to dividends paid by 

certain foreign corporations. 

Effective Date

The provision is effective for payments made after December 31, 2004.
76

TITLE II - PROVISIONS 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”),87 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.

Explanation of Provision

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”).88 Interest on guaranteed 

debt generally is not subject to the lowered threshold under the bill. 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.

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 

 

87 This interest also may include interest paid to unrelated parties in certain cases in 

which a related party guarantees the debt. 

88 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.
77

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.89

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 

 

89 The bill as introduced contained a clerical error on this point. The present discussion 

describes the language that was intended to be included in the bill: “In no event shall the 

disallowance under subparagraph (A) reduce the deduction for interest below the sum of the 

amount of interest includible in the gross income of the taxpayer for such taxable year and an 

amount equal to 25 percent of adjusted taxable income (35 percent in the case of the first taxable 

year beginning after December 31, 2003).” Proposed sec. 163(j)(1)(B) flush language, as 

corrected.
78

party interest expense ($25 - $25 = $0), thus yielding no disallowance. Examples 4 and 5 

illustrate the operation of the interest-income netting rules.

The bill continues the present-law rules in the case of taxable REIT subsidiaries.

Effective Date

The provision 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.
79

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 
80

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 
81

recognize gain or loss, assuming the transaction meets the requirements of a reorganization under 

section 368.

Explanation of Provision

The bill applies special tax rules to corporations that undertake certain defined inversion 

transactions. For this purpose, an inversion is a transaction in which, pursuant to a plan or a 

series of related transactions: (1) a U.S. corporation becomes a subsidiary of a foreignincorporated entity or otherwise transfers substantially all of its properties to such an entity after 

March 4, 2003; and (2) the former shareholders of the U.S. corporation hold (by reason of 

holding stock in the U.S. corporation) 60 percent or more (by vote or value) of the stock of the 

foreign-incorporated entity after the transaction.

In such a case, any applicable corporate-level “toll charges” for establishing the inverted 

structure are not offset by tax attributes such as net operating losses or foreign tax credits. 

Specifically, any applicable corporate-level income or gain required to be recognized under 

sections 304, 311(b), 367, 1001, 1248, or any other provision with respect to the transfer of 

controlled foreign corporation stock or the transfer or license of other assets by a U.S. 

corporation as part of the inversion transaction or after such transaction to a related foreign 

person is taxable, without offset by any tax attributes (e.g., net operating losses or foreign tax 

credits). This rule does not apply to certain transfers of inventory and similar property. These 

measures generally apply for a 10-year period following the inversion transaction.

In determining whether a transaction meets the definition of an inversion under the 

provision, stock held by members of the expanded affiliated group that includes the foreign 

incorporated entity is disregarded. For example, if the former top-tier U.S. corporation receives 

stock of the foreign incorporated entity (e.g., so-called “hook” stock), the stock would not be 

considered in determining whether the transaction meets the definition. Similarly, if a U.S. 

parent corporation converts an existing wholly owned U.S. subsidiary into a new wholly owned 

controlled foreign corporation, the stock of the new foreign corporation would be disregarded. 

Stock sold in a public offering related to the transaction also is disregarded for these purposes.

Transfers of properties or liabilities as part of a plan a principal purpose of which is to 

avoid the purposes of the provision are disregarded. In addition, the Treasury Secretary is 

granted authority to prevent the avoidance of the purposes of the provision, including avoidance 

through the use of related persons, pass-through or other noncorporate entities, or other 

intermediaries, and through transactions designed to qualify or disqualify a person as a related 

person or a member of an expanded affiliated group. Similarly, the Treasury Secretary is granted 

authority to treat certain non-stock instruments as stock, and certain stock as not stock, where 

necessary to carry out the purposes of the provision.

Under the proposal, inversion transactions include certain partnership transactions. 

Specifically, the provision applies to transactions in which a foreign-incorporated entity acquires 

substantially all of the properties constituting a trade or business of a domestic partnership, if 

after the acquisition at least 60 percent of the stock of the entity is held by former partners of the 

partnership (by reason of holding their partnership interests), provided that the other terms of the 

basic definition are met. For purposes of applying this test, all partnerships that are under 
82

common control within the meaning of section 482 are treated as one partnership, except as 

provided otherwise in regulations. In addition, the modified “toll charge” provisions apply at the 

partner level.

A transaction otherwise meeting the definition of an inversion transaction is not treated as 

an inversion transaction if, on or before March 4, 2003, the foreign-incorporated entity had 

acquired directly or indirectly more than half of the properties held directly or indirectly by the 

domestic corporation, or more than half of the properties constituting the partnership trade or 

business, as the case may be.

Effective Date

The provision applies to taxable years ending after March 4, 2003.
83

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 nonstatutory90 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.91 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.92 

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.

Explanation of Provision

Under the bill, specified holders of stock options and other stock-based compensation are 

subject to an excise tax upon certain inversion transactions. The bill 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.

 

90 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. 

91 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.

92 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.
84

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,93 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)),94 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 payment95 (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 

bill 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. 

Specified stock compensation includes a compensation arrangement that gives the 

disqualified individual an economic stake substantially similar to that of a corporate shareholder. 

 

93 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.

94 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.

95 Under the bill, 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. 
85

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 bill because the 

direct connection between the compensation amount and the value of the corporation’s stock 

gives the disqualified individual an economic stake substantially similar to that of a shareholder.

The excise tax applies to any such specified stock compensation previously granted to a 

disqualified individual but cancelled or cashed-out within the six-month period ending with the 

inversion transaction, and to any specified stock compensation awarded in the six-month period 

beginning with the inversion transaction. As a result, for example, if a corporation 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 bill, the excise tax does not 

apply to any stock option that is exercised during the six-month period before the inversion or to 

any stock acquired pursuant to such exercise. The excise tax also does not apply to any specified 

stock compensation that is sold, exchanged, distributed or cashed-out during such period in a 

transaction in which 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 bill, the cancellation of a non-lapse restriction is treated as a grant. 

The value of the specified stock compensation on which the excise tax is imposed is the 

fair value in the case of stock options (including warrants or other similar rights to acquire stock) 

and stock appreciation rights and the fair market value for all other forms of compensation. For 

purposes of the tax, the fair value of an option (or a warrant or other similar right to acquire 

stock) or a stock appreciation right is determined using an appropriate option-pricing model, as 

specified or permitted by the Secretary, that takes into account the stock price at the valuation 

date; the exercise price under the option; the remaining term of the option; the volatility of the 

underlying stock and the expected dividends on it; and the risk-free interest rate over the 

remaining term of the option. Options that have no intrinsic value (or “spread”) because the 
86

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 bill. 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 inversion 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 

inversion 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 bill. As discussed above, this includes direct payments of the tax and 

payments to reimburse the individual for payment of the tax. 

The payment of the excise tax has no effect on the subsequent tax treatment of any 

specified stock compensation. Thus, the payment of the tax has no effect on the individual’s 

basis in any specified stock compensation and no effect on the tax treatment for the individual at 

the time of exercise of an option or payment of any specified stock compensation, or at the time 

of any lapse or forfeiture of such specified stock compensation. The payment of the tax is not 

deductible and has no effect on any deduction that might be allowed at the time of any future 

exercise or payment.

Under the bill, the Secretary is authorized to issue regulations as may be necessary or 

appropriate to carry out the purposes of the section.
87

Effective Date

The provision is effective as of March 4, 2003, except that periods before March 4, 2003, 

are not taken into account in applying the excise tax to specified stock compensation held or 

cancelled during the six-month period before the expatriation date.
88

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.96 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.97 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. 

Explanation of Provision

The bill clarifies the rules of section 845, relating to authority for the Treasury Secretary 

to allocate items among the parties to a reinsurance agreement, recharacterize items, or make any 

other adjustment, in order to reflect the proper source and character of the items for each party. 

The bill authorizes such allocation, recharacterization, or other adjustment, in order to reflect the 

proper source, character or amount of the item. It is intended that this authority98 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 investment income, premium or otherwise) and other items, the 

recharacterization of such items, or any other adjustment necessary to reflect the proper amount, 

source or character of the item.

 

96 Sec. 845(a).

97 See S. Rep. No. 97-494, 99th Cong., 2d Sess., 337 (1982) (describing provisions 

relating to the repeal of modified coinsurance provisions).

98 The authority to allocate, recharacterize or make other adjustments was granted in 

connection with the repeal of provisions relating to modified coinsurance transactions.
89

Effective Date

The provision is effective for any risk reinsured after the date of enactment of the 

provision.
90

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. 

residency99 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 

 

99 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). 
91

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.100 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.101 In addition, the U.S. Department of State and 

other governmental agencies are required to provide this information to the IRS.

 

100 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.

101 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. 
92

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.

Explanation of Provision

In general 

The bill provides: (1) objective standards for determining whether former citizens or 

former long-term residents are subject to the alternative tax regime; (2) tax-based (instead of 

immigration-based) rules for determining when an individual is no longer a U.S. citizen or 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 relinquishment or residency termination. 102

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 

 

102 These provisions reflect recommendations contained in Joint Committee on Taxation, 

Review of the Present Law Tax and Immigration Treatment of Relinquishment of Citizenship and 

Termination of Long-Term Residency, (JCS-2-03), February 2003.
93

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 

purposes103 generally do not apply for this purpose. However, for individuals with certain ties to 

 

103 Sections 7701(b)(3)(D), 7701(b)(5) and 7701(b)(7)(B)-(D).
94

countries other than the United States104 and individuals with minimal prior physical presence in 

the United States,105 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).

 

104 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. 

105 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). 
95

Annual return

The bill requires former citizens and former long-term residents to file an annual return 

for each year following citizenship relinquishment or residency termination in which they are 

subject to the alternative tax regime. The annual return is required even if no U.S. Federal 

income tax is due. The annual return requires certain information, including information on the 

permanent home of the individual, the individual’s country of residence, the number of days the 

individual was present in the United States for the year, and detailed information about the 

individual’s income and assets that are subject to the alternative tax regime. This requirement 

includes information relating to foreign stock potentially subject to the special estate tax rule of 

section 2107(b) and the gift tax rules of this bill. 

If the individual fails to file the statement in a timely manner or fails correctly to include 

all the required information, the individual is required to pay a penalty of $5,000. The $5,000

penalty does not apply if it is shown that the failure is due to reasonable cause and not to willful 

neglect.

Effective Date

The provision applies to individuals who relinquish citizenship or terminate long-term 

residency after February 27, 2003.
96

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)).

Explanation of Provision

Under the bill, if gain or loss is recognized in whole or in part by shareholders of a 

corporation by reason of a second corporation’s acquisition of the stock or assets of the first 

corporation, then the acquiring corporation (or the acquired corporation, if so prescribed by the 

Treasury Secretary) is required to make a return containing: 

(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 nominee106) 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.

 

106 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. 
97

This written statement is required to be furnished to the shareholder on or before January 

31 of the year following the calendar year during which the transaction occurred.

The present-law penalties for failure to comply with information reporting requirements 

is extended to failures to comply with the requirements set forth under this bill.

Effective Date

The provision is effective for acquisitions after the date of enactment.
98

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”),107 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 

 

107 This interest also may include interest paid to unrelated parties in certain cases in 

which a related party guarantees the debt. 
99

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.

Explanation of Provision

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 provision is due no later than December 31, 2003. 

The transfer pricing study required under the provision 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.
100

TITLE III - PROVISIONS RELATING TO TAX SHELTERS

A. Taxpayer Related Provisions

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.108 

There are six categories of reportable transactions. The first category is any transaction 

that is the same as (or substantially similar to)109 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”).110 

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).111 

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 

 

108 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.

109 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).

110 Treas. Reg. sec. 1.6011-4(b)(2).

111 Treas. Reg. sec. 1.6011-4(b)(3).
101

transaction are not sustained or, (2) the fees are contingent on the intended tax consequences 

from the transaction being sustained.112

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.113

The fifth category of reportable transactions refers to any transaction done by certain 

taxpayers114 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.115

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.116

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.117 

 

112 Treas. Reg. sec. 1.6011-4(b)(4).

113 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.

114 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.

115 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. 

116 Treas. Reg. sec. 1.6011-4(b)(7).

117 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.
102

Explanation of Provision

In general

The bill 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 bill does not define the terms “listed transaction”118 or “reportable transaction,” nor 

does the bill explain the type of information that must be disclosed in order to avoid the 

imposition of a penalty. Rather, the bill 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 provision is effective for returns and statements the due date for which is after the 

date of enactment.

 

118 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. 
103

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.119 

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.120 

Special rules apply with respect to tax shelters.121 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.122 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.123

 

119 Sec. 6662.

120 Sec. 6662(d)(2)(B).

121 Sec. 6662(d)(2)(C).

122 Sec. 6664(c).

123 Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 1.6664-4(c).
104

Explanation of Provision

In general

The bill 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”).124 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 bill, 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) 125, 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. 

 

124 The terms “reportable transaction” and “listed transaction” have the same meanings 

as used for purposes of the penalty for failing to disclose reportable transactions.

125 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.
105

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 bill 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 6011,126 (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 advisor127 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 indirectly128 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 

 

126

 See the previous discussion regarding the penalty for failing to disclose a reportable 

transaction.

127 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). 

128 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. 
106

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.129 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 bill is not subject to the 

accuracy-related penalty under section 6662. However, such understatement is included for 

purposes of determining whether any understatement (as defined in sec. 6662(d)(2)) is a 

substantial understatement as defined under section 6662(d)(1).

The penalty imposed under this provision shall not apply to any portion of an 

understatement to which a fraud penalty is applied under section 6663.

Effective Date

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

 

129 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). 
107

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.

Explanation of Provision

The bill modifies the rule relating to corporate tax shelters by making it applicable to all 

tax shelters, whether entered into by corporations, individuals, partnerships, tax-exempt entities, 

or any other entity. Accordingly, communications with respect to tax shelters are not subject to 

the confidentiality provision of the Code that otherwise applies to a communication between a 

taxpayer and a federally authorized tax practitioner.

Effective Date

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

enactment.

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

6501 of the Code)

Present Law

In general, the Code requires that taxes be assessed within three years130 after the date a 

return is filed.131 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.132 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.133

 

130 Sec. 6501(a).

131 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)).

132 Sec. 6501(e).

133 Sec. 6501(c).
108

Explanation of Provision

The bill extends the statute of limitations with respect to listed transactions if a taxpayer 

fails to include on any return or statement for any taxable year any information with respect to a 

listed transaction134 which is required to be included (under section 6011) with such return or 

statement. The statute of limitations with respect to such transactions will not expire before the 

date which is one year after the earlier of (1) that 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 entered into a transaction in 2005 that becomes a listed 

transaction in 2006 and the taxpayer fails to disclose such transaction in the manner required by 

Treasury regulations, the 2005 tax return will be subject to the extended statute of limitations 

with respect to that transaction.

Effective Date

The provision is effective for taxable years with respect to which the period for assessing 

a deficiency did not expire before July 24, 2003. 

5. Disclosure of reportable transactions by material advisors (secs. 3005 and 3006 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.135 A “tax shelter” means any 

investment with respect to which the tax shelter ratio136 for any investor as of the close of any of 

the first five years ending after the investment is offered for sale may be greater than two to one 

and which is: (1) required to be registered under Federal or State securities laws, (2) sold 

pursuant to an exemption from registration requiring the filing of a notice with a Federal or State 

securities agency, or (3) a substantial investment (greater than $250,000 and at least five 

investors).137

 

134 The term “listed transaction” has the same meaning as described in a previous 

provision regarding the penalty for failure to disclose reportable transactions.

135 Sec. 6111(a).

136 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.

137 Sec. 6111(c).
109

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.138 

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,”139 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.140 Certain exceptions are provided with respect to the second category of 

transactions.141

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.142 

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 $500.143 However, if the tax shelter involves an 

arrangement offered to a corporation under conditions of confidentiality, the penalty is the 

greater of $10,000 or 50 percent of the fees payable to any promoter with respect to offerings 

prior to the date of late registration. Intentional disregard of the requirement to register increases 

the penalty to 75 percent of the applicable fees.

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. 

 

138 Sec. 6111(d).

139 Treas. Reg. sec. 301.6111-2(b)(2).

140 Treas. Reg. sec. 301.6111-2(b)(3).

141 Treas. Reg. sec. 301.6111-2(b)(4).

142 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).

143 Sec. 6707.
110

Explanation of Provision

Disclosure of reportable transactions by material advisors

The bill repeals the present law rules with respect to registration of tax shelters. Instead, 

the bill requires each material advisor with respect to any reportable transaction (including any 

listed transaction)144 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.145

A “material advisor” means any person (1) who provides material aid, assistance, or 

advice with respect to organizing, managing, promoting, selling, implementing, or carrying out 

any reportable transaction, and (2) who directly or indirectly derives gross income in excess of 

$250,000 ($50,000 in the case of a reportable transaction substantially all of the tax benefits from 

which are provided to natural persons) or such other amount as may be prescribed by the 

Secretary for such advice or assistance.

The Secretary may prescribe regulations which provide (1) that only one material advisor 

has to file an information return in cases in which two or more material advisors would otherwise 

be required to file information returns with respect to a particular reportable transaction, (2) 

exemptions from the requirements of this section, and (3) other rules as may be necessary or 

appropriate to carry out the purposes of this section (including, for example, rules regarding the 

aggregation of fees in appropriate circumstances).

Penalty for failing to furnish information regarding reportable transactions

The bill repeals the present-law penalty for failure to register tax shelters. Instead, the 

bill 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).146 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 

 

144 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related provisions.

145

 See the previous discussion regarding the disclosure requirements under new section 

6707A.

146 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related provisions.
111

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.147 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 provision requiring disclosure of reportable transactions by material advisors applies 

to transactions with respect to which material aid, assistance or advice is provided after the date 

of enactment.

The provision imposing a penalty for failing to disclose reportable transactions applies to 

returns the due date for which is after the date of enactment.

6. Investor lists and modification of penalty for failure to maintain investor lists (secs. 3005 

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).148 Recently issued regulations under section 6112 contain rules 

 

147 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.

148 Sec. 6112.
112

regarding the list maintenance requirements. 149 In general, the regulations apply to transactions 

that are potentially abusive tax shelters entered into, or acquired after, February 28, 2003.150

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.151 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.152 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).153 

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.154

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). 

Explanation of Provision

Investor lists

Each material advisor155 with respect to a reportable transaction (including a listed 

transaction)156 is required to maintain a list that (1) identifies each person with respect to whom 

 

149 Treas. Reg. sec. 301-6112-1.

150 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.

151 Treas. Reg. sec. 301.6112-1(c)(1).

152 Treas. Reg. sec. 301.6112-1(c)(2) and (3).

153 Treas. Reg. sec. 301.6112-1(b).

154 Sec. 6112(c)(2).
113

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 bill authorizes (but does 

not require) the Secretary to prescribe regulations which provide that, in cases in which 2 or 

more persons are required to maintain the same list, only one person would be required to 

maintain the list.

The bill 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 bill modifies the penalty for failing to maintain the required list by making it a timesensitive 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.157 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.

Effective Date

The provision requiring a material advisor to maintain an investor list applies to 

transactions with respect to which material aid, assistance or advice is provided after the date of 

enactment.

The provision imposing a penalty for failing to maintain investor lists applies to requests 

made after the date of enactment. 

The provision clarifying that the identity of any person is not privileged for purposes of 

section 6112 is effective as if included in the amendments made by section 142 of the Deficit 

Reduction Act of 1984. 

 

155 The term “material advisor” has the same meaning as when used in connection with 

the requirement to file an information return under section 6111.

156 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related provisions.

157 In no event will failure to maintain a list be considered reasonable cause for failing to 

make a list available to the Secretary.
114

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.158 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.

Explanation of Provision

The bill modifies the penalty amount to equal 50 percent of the gross income derived by 

the person from the activity for which the penalty is imposed. The new penalty rate applies to 

any activity that involves a statement regarding the tax benefits of participating in a plan or 

arrangement if the person knows or has reason to know that such statement is false or fraudulent 

as to any material matter. The enhanced penalty does not apply to a gross valuation 

overstatement.

Effective Date

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

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).159 

 

158 Sec. 6700.

159 Sec. 6662(a) and (d)(1)(A).
115

Explanation of Provision

The bill modifies the definition of “substantial” for corporate taxpayers. Under the bill, 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 provision 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.160

Explanation of Provision

The bill expands this rule so that injunctions may also be sought with respect to the 

requirements relating to the reporting of reportable transactions161 and the keeping of lists of 

investors by material advisors.162 Thus, under the bill, 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.

Effective Date

The provision 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.163 In general, individuals must fulfill this 

 

160 Sec. 7408.

161 Sec. 6707, as amended by other provisions of this bill.

162 Sec. 6708, as amended by other provisions of this bill.

163 31 U.S.C. 5314.
116

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 

$25,000.164 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.165

On April 26, 2002, the Secretary of the Treasury submitted to the Congress a report on 

these reporting requirements.

166 This report, which was statutorily required,167 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.

Explanation of Provision

The bill adds an additional civil penalty that may be imposed on any person who violates 

this reporting requirement (without regard to willfulness). This new civil penalty is up to $5,000. 

The penalty may be waived if any income from the account was properly reported on the income 

tax return and there was reasonable cause for the failure to report.

Effective Date

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

of enactment.

 

164 31 U.S.C. 5321(a)(5).

165 31 U.S.C. 5322.

166

 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.

167 Sec. 361(b) of the USA PATRIOT Act of 2001 (Pub. L. 107-56).
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)

Present Law

The Secretary of the Treasury is authorized to regulate the practice of representatives of 

persons before the Department of the Treasury.168 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.

Explanation of Provision

The bill makes two modifications to expand the sanctions that the Secretary may impose 

pursuant to these statutory provisions. First, the bill expressly permits censure as a sanction. 

Second, the bill 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 bill also confirms the present-law authority of the Secretary to impose standards 

applicable to written advice with respect to an entity, plan, or arrangement that is of a type that 

the Secretary determines as having a potential for tax avoidance or evasion.

Effective Date

The modifications to expand the sanctions that the Secretary may impose are effective for 

actions taken after the date of enactment.

 

168 31 U.S.C. 330.
118

B. Other Provisions

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.169

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).170 However, there are no specific statutory rules that address stripping transactions with 

respect to common stock or other equity interests (other than preferred stock).171

Stripped bonds

Special rules are provided with respect to the purchaser and “stripper” of stripped 

bonds.172 A “stripped bond” is defined as a debt instrument in which there has been a separation 

 

169

 Helvering v. Horst, 311 U.S. 112 (1940).

170 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).

171 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.

172 Sec. 1286.
119

in ownership between the underlying debt instrument and any interest coupon that has not yet 

become payable.173 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.174 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.175 Special rules apply to require 

that interest or market discount accrued on the bond prior to such disposition must be included in 

the taxpayer’s gross income (to the extent that it had not been previously included in income) at 

the time the stripping occurs, and the taxpayer increases his basis in the bond by the amount of 

such accrued interest or market discount. The adjusted basis (as increased by any accrued 

interest or market discount) is then allocated between the stripped bond and the stripped interest 

coupons in relation to their respective fair market values. Amounts realized from the sale of 

stripped coupons or bonds constitute income to the taxpayer only to the extent such amounts 

exceed the basis allocated to the stripped coupons or bond. With respect to retained items (either 

the detached coupons or stripped bond), to the extent that the price payable on maturity, or on the 

due date of the coupons, exceeds the portion of the taxpayer’s basis allocable to such retained 

items, the difference is treated as OID that is required to be included under the general OID 

periodic income inclusion rules.176

 

173 Sec. 1286(e).

174 Sec. 1286(a).

175 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.

176 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)).
120

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.177 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.178 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.179

Explanation of Provision

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 taxexempt obligations (as defined in section 1275(a)(3)), such as a tax-exempt bond partnership 

described in Rev. Proc. 2002-68,180 modifying and superceding Rev. Proc. 2002-16.181

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 

 

177 Sec. 305(e)(5).

178 Sec. 305(e)(1).

179 Sec. 305(e)(3).

180 2002-43 I.R.B. 753.

181 2002-9 I.R.B. 572.
121

stock, or any combination thereof. The Treasury regulations, when issued, would be applied 

prospectively, except in cases to prevent abuse.

Effective Date

This provision 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 

holding period is not satisfied, the taxpayer is entitled to a deduction for the foreign taxes for 

which the credit is disallowed.

Explanation of Provision

The bill 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 bill does not apply to foreign tax credits that are subject to the present-law 

disallowance with respect to dividends. The bill also does not apply to certain income or gain 
122

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 bill. In addition, the bill authorizes the Treasury Department to issue regulations 

providing that this provision does not apply in appropriate cases.

Effective Date

This provision is effective for amounts that are paid or accrued more than 30 days after 

the date of enactment.

3. Affirmation of consolidated return regulation authority (sec. 3023 of the bill and sec. 

1502 of the Code)

Present Law

An affiliated group of corporations may elect to file a consolidated return in lieu of 

separate returns. A condition of electing to file a consolidated return is that all corporations that 

are members of the consolidated group must consent to all the consolidated return regulations 

prescribed under section 1502 prior to the last day prescribed by law for filing such return.182 

Section 1502 states:

The Secretary shall prescribe such regulations as he may deem necessary in order that the 

tax liability of any affiliated group of corporations making a consolidated return and of 

each corporation in the group, both during and after the period of affiliation, may be 

returned, determined, computed, assessed, collected, and adjusted, in such manner as 

clearly to reflect the income-tax liability and the various factors necessary for the 

determination of such liability, and in order to prevent the avoidance of such tax 

liability.183

Under this authority, the Treasury Department has issued extensive consolidated return 

regulations.184

 

182 Sec. 1501.

183 Sec. 1502. 

184 Regulations issued under the authority of section 1502 are considered to be 

“legislative” regulations rather than “interpretative” regulations, and as such are usually given 

greater deference by courts in case of a taxpayer challenge to such a regulation. See, S. Rep. No. 

960, 70th Cong., 1st Sess. at 15 (1928), describing the consolidated return regulations as 

“legislative in character”. The Supreme Court has stated that “. . . legislative regulations are 

given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the 

statute.” Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 844 

(1984) (involving an environmental protection regulation). For examples involving consolidated 

return regulations, see, e.g., Wolter Construction Company v. Commissioner, 634 F.2d 1029 (6th

Cir. 1980); Garvey, Inc. v. United States, 1 Ct. Cl. 108 (1983), aff’d 726 F.2d 1569 (Fed. Cir. 
123

In the recent case of Rite Aid Corp. v. United States,185 the Federal Circuit Court of 

Appeals addressed the application of a particular provision of certain consolidated return loss 

disallowance regulations, and concluded that the provision was invalid.186 The particular 

provision, known as the “duplicated loss” provision,187 would have denied a loss on the sale of 

stock of a subsidiary by a parent corporation that had filed a consolidated return with the 

subsidiary, to the extent the subsidiary corporation had assets that had a built-in loss, or had a net 

operating loss, that could be recognized or used later.188 

 

1984), cert. denied, 469 U.S. 823 (1984). Compare, e.g., Audrey J. Walton v. Commissioner, 115 

T.C. 589 (2000), describing different standards of review. The case did not involve a 

consolidated return regulation. 

185 255 F.3d 1357 (Fed. Cir. 2001), reh’g denied, 2001 U.S. App. LEXIS 23207 (Fed. 

Cir. Oct. 3, 2001).

186 Prior to this decision, there had been a few instances involving prior laws in which 

certain consolidated return regulations were held to be invalid. See, e.g., American Standard, Inc. 

v. United States, 602 F.2d 256 (Ct. Cl. 1979), discussed in the text infra. see also Union Carbide 

Corp. v. United States, 612 F.2d 558 (Ct. Cl. 1979), and Allied Corporation v. United States, 685 

F. 2d 396 (Ct. Cl. 1982), all three cases involving the allocation of income and loss within a 

consolidated group for purposes of computation of a deduction allowed under prior law by the 

Code for Western Hemisphere Trading Corporations. See also Joseph Weidenhoff v. 

Commissioner, 32 T.C. 1222, 1242-1244 (1959), involving the application of certain regulations 

to the excess profits tax credit allowed under prior law, and concluding that the Commissioner 

had applied a particular regulation in an arbitrary manner inconsistent with the wording of the 

regulation and inconsistent with even a consolidated group computation. Cf. Kanawha Gas & 

Utilities Co. v. Commissioner, 214 F.2d 685 (1954), concluding that the substance of a 

transaction was an acquisition of assets rather than stock. Thus, a regulation governing basis of 

the assets of consolidated subsidiaries did not apply to the case. See also General Machinery 

Corporation v. Commissioner, 33 B.T.A. 1215 (1936); Lefcourt Realty Corporation, 31 B.T.A. 

978 (1935); Helvering v. Morgans, Inc., 293 U.S. 121 (1934), interpreting the term “taxable 

year.” 

187 Treas. Reg. Sec. 1.1502-20(c)(1)(iii).

188 Treasury Regulation section 1.1502-20, generally imposing certain “loss 

disallowance” rules on the disposition of subsidiary stock, contained other limitations besides the 

“duplicated loss” rule that could limit the loss available to the group on a disposition of a 

subsidiary’s stock. Treasury Regulation section 1.1502-20 as a whole was promulgated in 

connection with regulations issued under section 337(d), principally in connection with the socalled General Utilities repeal of 1986 (referring to the case of General Utilities & Operating 

Company v. Helvering, 296 U.S. 200 (1935)). Such repeal generally required a liquidating 

corporation, or a corporation acquired in a stock acquisition treated as a sale of assets, to pay 

corporate level tax on the excess of the value of its assets over the basis. Treasury regulation 

section 1.1502-20 principally reflected an attempt to prevent corporations filing consolidated 

returns from offsetting income with a loss on the sale of subsidiary stock. Such a loss could 
124

The Federal Circuit Court opinion contained language discussing the fact that the 

regulation produced a result different than the result that would have obtained if the corporations 

had filed separate returns rather than consolidated returns.189 

The Federal Circuit Court opinion cited a 1928 Senate Finance Committee Report to 

legislation that authorized consolidated return regulations, which stated that “many difficult and 

complicated problems, ... have arisen in the administration of the provisions permitting the filing 

of consolidated returns” and that the committee “found it necessary to delegate power to the 

commissioner to prescribe regulations legislative in character covering them.”

190 The Court’s 

opinion also cited a previous decision of the Court of Claims for the proposition, interpreting this 

legislative history, that section 1502 grants the Secretary “the power to conform the applicable 

income tax law of the Code to the special, myriad problems resulting from the filing of 

consolidated income tax returns;” but that section 1502 “does not authorize the Secretary to 

choose a method that imposes a tax on income that would not otherwise be taxed.” 191

 

result from the unique upward adjustment of a subsidiary’s stock basis required under the 

consolidated return regulations for subsidiary income earned in consolidation, an adjustment 

intended to prevent taxation of both the subsidiary and the parent on the same income or gain. 

As one example, absent a denial of certain losses on a sale of subsidiary stock, a consolidated 

group could obtain a loss deduction with respect to subsidiary stock, the basis of which originally 

reflected the subsidiary’s value at the time of the purchase of the stock, and that had then been 

adjusted upward on recognition of any built-in income or gain of the subsidiary reflected in that 

value. The regulations also contained the duplicated loss factor addressed by the court in Rite 

Aid. The preamble to the regulations stated: “it is not administratively feasible to differentiate 

between loss attributable to built-in gain and duplicated loss.” T.D. 8364, 1991-2 C.B. 43, 46 

(Sept. 13, 1991). The government also argued in the Rite Aid case that duplicated loss was a 

separate concern of the regulations. 255 F.3d at 1360. 

189 For example, the court stated: “The duplicated loss factor . . . addresses a situation 

that arises from the sale of stock regardless of whether corporations file separate or consolidated 

returns. With I.R.C. secs. 382 and 383, Congress has addressed this situation by limiting the 

subsidiary’s potential future deduction, not the parent’s loss on the sale of stock under I.R.C. sec. 

165.” 255 F.3d 1357, 1360 (Fed. Cir. 2001).

190 S. Rep. No. 960, 70th Cong., 1st Sess. 15 (1928). Though not quoted by the court in 

Rite Aid, the same Senate report also indicated that one purpose of the consolidated return 

authority was to permit treatment of the separate corporations as if they were a single unit, 

stating “The mere fact that by legal fiction several corporations owned by the same shareholders 

are separate entities should not obscure the fact that they are in reality one and the same business 

owned by the same individuals and operated as a unit.” S. Rep. No. 960, 70th Cong., 1st Sess. 29 

(1928). 

191

 American Standard, Inc. v. United States, 602 F.2d 256, 261 (Ct. Cl. 1979). That 

case did not involve the question of separate returns as compared to a single return approach. It 

involved the computation of a Western Hemisphere Trade Corporation (“WHTC”) deduction 

under prior law (which deduction would have been computed as a percentage of each WHTC’s 
125

The Federal Circuit Court construed these authorities and applied them to invalidate 

Treas. Reg. Sec. 1.1502-20(c)(1)(iii), stating that:

The loss realized on the sale of a former subsidiary’s assets after the consolidated 

group sells the subsidiary’s stock is not a problem resulting from the filing of 

consolidated income tax returns. The scenario also arises where a corporate 

shareholder sells the stock of a non-consolidated subsidiary. The corporate 

shareholder could realize a loss under I.R.C. sec. 1001, and deduct the loss under 

I.R.C. sec. 165. The subsidiary could then deduct any losses from a later sale of 

assets. The duplicated loss factor, therefore, addresses a situation that arises from the 

sale of stock regardless of whether corporations file separate or consolidated returns. 

With I.R.C. secs. 382 and 383, Congress has addressed this situation by limiting the 

subsidiary’s potential future deduction, not the parent’s loss on the sale of stock under 

I.R.C. sec. 165.192

The Treasury Department has announced that it will not continue to litigate the validity of 

the duplicated loss provision of the regulations, and has issued interim regulations that permit 

taxpayers for all years to elect a different treatment, though they may apply the provision for the 

past if they wish.193

 

taxable income if the corporations had filed separate returns), in a case where a consolidated 

group included several WHTCs as well as other corporations. The question was how to 

apportion income and losses of the admittedly consolidated WHTCs and how to combine that 

computation with the rest of the group’s consolidated income or losses. The court noted that the 

new, changed regulations approach varied from the approach taken to a similar problem 

involving public utilities within a group and previously allowed for WHTCs. The court objected 

that the allocation method adopted by the regulation allowed non-WHTC losses to reduce 

WHTC income. However, the court did not disallow a method that would net WHTC income of 

one WHTC with losses of another WHTC, a result that would not have occurred under separate 

returns. Nor did the court expressly disallow a different fractional method that would net both 

income and losses of the WHTCs with those of other corporations in the consolidated group. 

The court also found that the regulation had been adopted without proper notice. 

192

 Rite Aid, 255 F.3d at 1360.

193

 See Temp. Reg. Sec.1.1502-20T(i)(2), Temp Reg. Sec.1.337(d)-2T, and Temp. Reg. 

Sec. 1.1502-35T.. The Treasury Department has also indicated its intention to continue to study 

all the issues that the original loss disallowance regulations addressed (including issues of 

furthering single entity principles) and possibly issue different regulations (not including the 

particular approach of Treas. Reg. Sec. 1.1502-20(c)(1)(iii)) on the issues in the future. See

Notice 2002-11, 2002-7 I.R.B. 526 (Feb. 19, 2002); T.D. 8984, 67 F.R. 11034 (March 12, 2002); 

REG-102740-02, 67 F.R. 11070 (March 12, 2002); see also Notice 2002-18, 2002-12 I.R.B. 644 

(March 25, 2002); REG-131478-02, 67 F.R. 65060 (October 18, 2002); and T.D. 9048, 68 F.R. 

12287 (March 14, 2003). 
126

Explanation of Provision

The bill confirms that, in exercising its authority under section 1502 to issue consolidated 

return regulations, the Treasury Department may provide rules treating corporations filing 

consolidated returns differently from corporations filing separate returns. 

Thus, under the statutory authority of section 1502, the Treasury Department is 

authorized to issue consolidated return regulations utilizing either a single taxpayer or separate 

taxpayer approach or a combination of the two approaches, as Treasury deems necessary in order 

that the tax liability of any affiliated group of corporations making a consolidated return, and of 

each corporation in the group, both during and after the period of affiliation, may be determined 

and adjusted in such manner as clearly to reflect the income-tax liability and the various factors 

necessary for the determination of such liability, and in order to prevent avoidance of such 

liability. 

Rite Aid is thus overruled to the extent it suggests that there is not a problem that can be 

addressed in consolidated return regulations if application of a particular Code provision on a 

separate taxpayer basis would produce a result different from single taxpayer principles that may 

be used for consolidation. 

The bill nevertheless allows the result of the Rite Aid case to stand with respect to the 

type of factual situation presented in the case. That is, the legislation provides for the override of 

the regulatory provision that took the approach of denying a loss on a deconsolidating disposition 

of stock of a consolidated subsidiary194 to the extent the subsidiary had net operating losses or 

built in losses that could be used later outside the group.195

Retaining the result in the Rite Aid case with respect to the particular regulation section 

1.1502-20(c)(1)(iii) as applied to the factual situation of the case does not in any way prevent or 

invalidate the various approaches Treasury has announced it will apply or that it intends to 

consider in lieu of the approach of that regulation, including, for example, the denial of a loss on 

a stock sale if inside losses of a subsidiary may also be used by the consolidated group, and the 

possible requirement that inside attributes be adjusted when a subsidiary leaves a group.196

 

194 Treas. Reg. Sec. 1.1502-20(c)(1)(iii).

195 The provision is not intended to overrule the current Treasury Department 

regulations, which allow taxpayers in certain circumstances for the past to follow Treasury 

Regulations Section 1.1502-20(c)(1)(iii), if they choose to do so. Temp. Reg. Sec. 1.1502-

20T(i)(2). 

196

 See, e.g., Notice 2002-11, 2002-7 I.R.B. 526 (Feb. 19, 2002); Temp. Reg. Sec. 

1.337(d)-2T, (T.D. 8984, 67 F.R. 11034 (March 12, 2002) and T.D. 8998, 67 F.R. 37998 (May 

31, 2002)); REG-102740-02, 67 F.R. 11070 (March 12, 2002); see also Notice 2002-18, 2002-12 

I.R.B. 644 (March 25, 2002); REG-131478-02, 67 F.R. 65060 (October 18, 2002); Temp. Reg. 

Sec. 1.1502-35T (T.D. 9048, 68 F.R. 12287 (March 14, 2003)). In exercising its authority under 

section 1502, the Secretary is also authorized to prescribe rules that protect the purpose of 

General Utilities repeal using presumptions and other simplifying conventions.
127

Effective Date.

The provision is effective for all years, whether beginning before, on, or after the date of 

enactment of the provision. No inference is intended that the results following from this 

provision are not the same as the results under present law.

4. Disallowance of certain partnership loss transfers (sec. 3024 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, no gain or loss 

generally is recognized to the contributing partner or the partnership at the time of 

contribution.197 The partnership takes the property at an adjusted basis equal to the contributing 

partner’s adjusted basis in the property.198 The contributing partner increases its basis in its 

partnership interest by the adjusted basis of the contributed property.199 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.200 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 items to the noncontributing partners based on the value of 

their contributions and by allocating to the contributing partner the remainder of each item.201 

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.202 

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 if the contributing partner no longer remains a partner.

 

197 Sec. 721.

198 Sec. 723.

199 Sec. 722.

200 Sec. 704(c)(1)(A).

201 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).

202 Treas. Reg. 1.704-3(a)(7).
128

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.203 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.204 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 certain partnership 

property without recognition of gain or loss by either the partner or the partnership.205 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).206 In a distribution other than in liquidation of a partner’s 

interest, the distributee partner’s basis in the distributed property is equal to the partnership’s 

adjusted basis in the property immediately before the distribution, but not to exceed the partner’s 

adjusted basis in the partnership interest (reduced by any money distributed in the same 

transaction).207

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.208 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).209 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 

 

203 Sec. 743(a).

204 Sec. 743(b).

205 Sec. 731(a) and (b).

206 Sec. 732(b).

207 Sec. 732(a).

208 Sec. 734(a).

209 Sec. 734(b).
129

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.

Explanation of Provision

Contributions of property

Under the bill, 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 

treated as equal to its fair market value at the time of contribution, and the built-in loss is 

eliminated.210 The bill also applies to allocations with respect to property for which differences 

between book value and adjusted tax basis are created (resulting in a built-in loss) when a 

partnership revalues partnership property211 ("reverse section 704(c) allocations").

Transfers of partnership interests

The bill 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 built-in 

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.

Thus, for example, assume that partner S 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 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 

values.

Distribution of partnership property

The bill 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 

 

210 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.

211 The revaluation takes place pursuant to Treas. Reg. sec. 1.704-1(b)(2)(iv)(f).
130

reduction means a downward adjustment of more that $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 (i.e., $2 million greater than it 

was in the hands of the partnership). Under present law, C would recognize a loss of $4 million 

if the LMN stock were then sold for its current value of $1 million.

Under the bill, 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 provision applies to contributions, transfers, and distributions (as the case may be) 

after the date of enactment.

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

partner (sec. 3025 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.212 Similarly, a partner and the partnership generally do not recognize 

gain or loss on the distribution of partnership property.

213 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).214 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.

 

212 Sec. 721(a).

213

 Sec. 731(a) and (b).

214 Sec. 732(b).
131

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.215 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.216 In addition, the allocation rules require that any 

increase or decrease in basis be allocated to partnership property of a like character to the 

property distributed. For this purpose, the two categories of assets are (1) capital assets and 

depreciable and real property used in the trade or business held for more than one year, and (2) 

any other property.217

Explanation of Provision

The bill provides that in applying the basis allocation rules to a distribution in liquidation 

of a partner’s interest, a partnership is precluded from decreasing the basis of corporate stock of 

a partner or a related person. Any decrease in basis that, absent the provision, would have been 

allocated to the stock is allocated to other partnership assets. If the decrease in basis exceeds the 

basis of the other partnership assets, then gain is recognized by the partnership in the amount of 

the excess. 

 

215 Sec. 754.

216 Sec. 755(a).

217 Sec. 755(b).
132

Effective Date. 

The provision applies to distributions after date of enactment.

6. Repeal of special rules for FASITs (sec. 3026 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.218 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.

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;219 (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 

 

218 Sections 860H through 860L.

219 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.
133

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 

REMIC interests under section 860G(a)(1)(B)(i); (3) have a term to maturity of no more than 30 

years, except as permitted by Treasury regulations; (4) be issued to the public with a premium of 

not more than 25 percent of its stated principal amount; and (5) have a yield to maturity 

determined on the date of issue of less than five percentage points above the applicable Federal 

rate (“AFR”) for the calendar month in which the instrument is issued.

Permitted ownership holder

A permitted holder of the ownership interest in a FASIT generally is a non-exempt (i.e., 

taxable) domestic C corporation, other than a corporation that qualifies as a RIC, REIT, REMIC, 

or cooperative.

Transfers to FASITs

In general, gain (but not loss) is recognized immediately by the owner of the FASIT upon 

the transfer of assets to a FASIT. Where property is acquired by a FASIT from someone other 

than the FASIT’s owner (or a person related to the FASIT’s owner), the property is treated as 

being first acquired by the FASIT’s owner for the FASIT’s cost in acquiring the asset from the 

non-owner and then transferred by the owner to the FASIT.

Valuation rules.–In general, except in the case of debt instruments, the value of FASIT 

assets is their fair market value. Similarly, in the case of debt instruments that are traded on an 

established securities market, the market price is used for purposes of determining the amount of 

gain realized upon contribution of such assets to a FASIT. However, in the case of debt 

instruments that are not traded on an established securities market, special valuation rules apply 

for purposes of computing gain on the transfer of such debt instruments to a FASIT. Under these 

rules, the value of such debt instruments is the sum of the present values of the reasonably 

expected cash flows from such obligations discounted over the weighted average life of such 
134

assets. The discount rate is 120 percent of the AFR, compounded semiannually, or such other 

rate that the Treasury Secretary shall prescribe by regulations.

Taxation of a FASIT

A FASIT generally is not subject to tax. Instead, all of the FASIT’s assets and liabilities 

are treated as assets and liabilities of the FASIT’s owner and any income, gain, deduction or loss 

of the FASIT is allocable directly to its owner. Accordingly, income tax rules applicable to a 

FASIT (e.g., related party rules, sec. 871(h), sec. 165(g)(2)) are to be applied in the same manner 

as they apply to the FASIT’s owner. The taxable income of a FASIT is calculated using an 

accrual method of accounting. The constant yield method and principles that apply for purposes 

of determining original issue discount (“OID”) accrual on debt obligations whose principal is 

subject to acceleration apply to all debt obligations held by a FASIT to calculate the FASIT’s 

interest and discount income and premium deductions or adjustments.

Taxation of holders of FASIT regular interests

In general, a holder of a regular interest is taxed in the same manner as a holder of any 

other debt instrument, except that the regular interest holder is required to account for income 

relating to the interest on an accrual method of accounting, regardless of the method of 

accounting otherwise used by the holder.

Taxation of holders of FASIT ownership interests

Because all of the assets and liabilities of a FASIT are treated as assets and liabilities of 

the holder of a FASIT ownership interest, the ownership interest holder takes into account all of 

the FASIT’s income, gain, deduction, or loss in computing its taxable income or net loss for the 

taxable year. The character of the income to the holder of an ownership interest is the same as its 

character to the FASIT, except tax-exempt interest is included in the income of the holder as 

ordinary income.

Although the recognition of losses on assets contributed to the FASIT is not allowed 

upon contribution of the assets, such losses may be allowed to the FASIT owner upon their 

disposition by the FASIT. Furthermore, the holder of a FASIT ownership interest is not 

permitted to offset taxable income from the FASIT ownership interest (including gain or loss 

from the sale of the ownership interest in the FASIT) with other losses of the holder. In addition, 

any net operating loss carryover of the FASIT owner shall be computed by disregarding any 

income arising by reason of a disallowed loss. Where the holder of a FASIT ownership interest 

is a member of a consolidated group, this rule applies to the consolidated group of corporations 

of which the holder is a member as if the group were a single taxpayer.

Explanation of Provision

The bill repeals the special rules for FASITs. The bill provides a transition period for 

existing FASITs, pursuant to which the repeal of the FASIT rules does not apply to any FASIT 

in existence on the date of enactment to the extent that any regular interest issued by the FASIT 

prior to such date continues to remain outstanding in accordance with its original terms.
135

Effective Date

Except as provided by the transition period for existing FASITs, this provision is 

effective for taxable years beginning after December 31, 2003.

7. Limitation on transfer of built-in losses on REMIC residuals (sec. 3027 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.220 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.221

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.222

Explanation of Provision

The bill 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 this provision) 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., this provision may result in the transferee corporation having a negative adjusted 

basis in the REMIC residual interest).

Effective Date

This provision applies to transactions after the date of enactment.

 

220 Sec. 351.

221 Sec. 358.

222 Secs. 334(b) and 362(a) and (b).
136

8. Clarification of banking business for purposes of determining investment of earnings in 

U.S. property (sec. 3028 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. Commissioner223

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.

Explanation of Provision

The bill 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 

“banks” as defined under section 2(c) of the Bank Holding Company Act of 1956 (12 U.S.C. 

1841(c)).

No inference is intended as to the meaning of the phrase “carrying on the banking 

business” under present law or whether this phrase was correctly interpreted by the Sixth Circuit 

in The Limited.

Effective Date

This provision is effective on the date of enactment.

9. Modify qualification rules for tax-exempt property and casualty insurance companies 

(sec. 3029 of the bill and secs. 501(c)(15) and 831(b) of the Code)

Present Law

A property and casualty insurance company is eligible to be exempt from Federal income 

tax if its net written premiums or direct written premiums (whichever is greater) for the taxable 

year do not exceed $350,000 (sec. 501(c)(15)).

A property and casualty insurance company may elect to be taxed only on taxable 

investment income if its net written premiums or direct written premiums (whichever is greater) 

for the taxable year exceed $350,000, but do not exceed $1.2 million (sec. 831(b)).

 

223 286 F.3d 324 (6th Cir. 2002), rev’g 113 T.C. 169 (1999).
138

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).

Explanation of Provision

The bill 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 bill, 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 bill expands the presentlaw controlled group rule so that it also takes into account gross receipts of foreign and taxexempt corporations. 

A company that does not meet the definition of an insurance company is not eligible to be 

exempt from Federal income tax under the bill. For this purpose, the term "insurance company" 

means any company, more than half of the business of which during the taxable year is the 

issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance 

companies (sec. 816(a)). A company whose investment activities outweigh its insurance 

activities is not considered to be an insurance company for this purpose.224 It is intended that 

IRS enforcement activities address the misuse of present-law section 501(c)(15).

The bill also provides that a property and casualty insurance company may elect to be 

taxed only on taxable investment income if its net written premiums or direct written premiums 

(whichever is greater) do not exceed $1.2 million (without regard to whether such premiums 

exceed $350,000) (sec. 831(b)). As under present law, for purposes of determining the amount 

of a company's net written premiums or direct written premiums under this rule, premiums 

received by all members of a controlled group of corporations (as defined in section 831(b)) of 

which the company is a part are taken into account.

It is intended that regulations or other Treasury guidance provide for anti-abuse rules so 

as to prevent improper use of the provision, including, for example, by attempts to characterize 

as premiums any income that is other than premium income.

Effective Date

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

 

224

 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

10. Definition of insurance company for property and casualty insurance company tax 

rules (sec. 3030 of the bill and sec. 831 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 

regulation225 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."226 

 

225 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). 

226 Court cases involving a determination of whether a company is an insurance company 

for Federal tax purposes have examined all of the business and other activities of the company. 

In considering whether a company is an insurance company for such purposes, courts have 

considered, among other factors, the amount and source of income received by the company 

from its different activities. See Bowers v. Lawyers Mortgage Co., 285 U.S. 182 (1932); United 

States v. Home Title Insurance Co., 285 U.S. 191 (1932). See also Inter-American Life 

Insurance Co. v. Comm'r, 56 T.C. 497, aff'd per curiam, 469 F.2d 697 (9th Cir. 1972), in which 

the court concluded that the company was not an insurance company: "The ... financial data 

clearly indicates that petitioner's primary and predominant source of income was from its 

investments and not from issuing insurance contracts or reinsuring risks underwritten by 

insurance companies. During each of the years in issue, petitioner's investment income far 

exceeded its premiums and the amounts of earned premiums were de minimis during those years. 

It is equally as clear that petitioner's primary and predominant efforts were not expended in 

issuing insurance contracts or in reinsurance. Of the relatively few policies directly written by 

petitioner, nearly all were issued to [family members]. Also, Investment Life, in which [family 
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 bill adopts a stricter and more precise standard for a company to be 

taxed as a life insurance company than does the general regulatory definition of an insurance 

company applicable for both life and nonlife insurance companies . . . Whether more than half 

of the business activity is related to the issuing of insurance or annuity contracts will depend on 

the facts and circumstances and factors to be considered will include the relative distribution of 

the number of employees assigned to, the amount of space allocated to, and the net income 

derived from, the various business activities.”227

Explanation of Provision

The bill provides that, for purposes of determining whether a company is a property and 

casualty insurance company, the term "insurance company" is defined to mean any company, 

more than half of the business of which during the taxable year is the issuing of insurance or 

annuity contracts or the reinsuring of risks underwritten by insurance companies. Thus, the bill 

conforms the definition of an insurance company for purposes of the rules taxing property and 

casualty insurance companies to the rules taxing life insurance companies, so that the definition 

is uniform. The provision adopts a stricter and more precise standard than the "primary and 

predominant business activity" test contained in Treasury Regulations. A company whose 

investment activities outweigh its insurance activities is not considered to be an insurance 

company under the provision.228 It is not intended that a company whose sole activity is the runoff 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.

 

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.

227 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).

228

 See Inter-American Life Insurance Co. v. Comm'r, supra. 
141

11. Qualified tax collection contracts (sec. 3031 of the bill and new sec. 6306 of the Code)

Present Law

In fiscal years 1996 and 1997, the Congress earmarked $13 million for IRS to test the use 

of private debt collection companies. There were several constraints on this pilot project. First, 

because both IRS and OMB considered the collection of taxes to be an inherently governmental 

function, only government employees were permitted to collect the taxes.229 The private debt 

collection companies were utilized to assist the IRS in locating and contacting taxpayers, 

reminding them of their outstanding tax liability, and suggesting payment options. If the 

taxpayer agreed at that point to make a payment, the taxpayer was transferred from the private 

debt collection company to the IRS. Second, the private debt collection companies were paid a 

flat fee for services rendered; the amount that was ultimately collected by the IRS was not taken 

into account in the payment mechanism.

The pilot program was discontinued because of disappointing results. GAO reported230

that IRS collected $3.1 million attributable to the private debt collection company efforts; 

expenses were also $3.1 million. In addition, there were lost opportunity costs of $17 million to 

the IRS because collection personnel were diverted from their usual collection responsibilities to 

work on the pilot.

The IRS has in the last several years expressed renewed interest in the possible use of 

private debt collection companies; for example, IRS recently revised its extensive Request for 

Information concerning its possible use of private debt collection companies.231 

In general, Federal agencies are permitted to enter into contracts with private debt 

collection companies for collection services to recover indebtedness owed to the United 

States.232 That provision does not apply to the collection of debts under the Internal Revenue 

Code.233 

On February 3, 2003, the President submitted to the Congress his fiscal year 2004 budget 

proposal,234 which proposed the use of private debt collection companies to collect Federal tax 

debts. 

 

229 Sec. 7801(a).

230 GAO/GGD-97-129R Issues Affecting IRS’ Collection Pilot (July 18, 1997).

231 TIRNO-03-H-0001 (February 14, 2003), at www.procurement.irs.treas.gov. The 

basic request for information is 104 pages, and there are 16 additional attachments.

232 31 U.S.C. sec. 3718.

233 31 U.S.C. sec. 3718(f).

234

 See Office of Management and Budget, Budget of the United States Government, 

Fiscal Year 2004 (H. Doc. 108-3, Vol. I), p. 274.
142

Explanation of Provision

The bill permits the IRS to use private debt collection companies to locate and contact 

taxpayers owing outstanding tax liabilities235 of any type236 and to arrange payment of those 

taxes by the taxpayers. Several steps are involved. First, the private debt collection company 

contacts the taxpayer by letter.237 If the taxpayer’s last known address is incorrect, the private 

debt collection company searches for the correct address. Second, the private debt collection 

company telephones the taxpayer to request full payment.238 If the taxpayer cannot pay in full

immediately, the private debt collection company offers the taxpayer an installment agreement 

providing for full payment of the taxes over a period of as long as three years. If the taxpayer is 

unable to pay the outstanding tax liability in full over a three-year period, the private debt 

collection company obtains financial information from the taxpayer and will provide this 

information to the IRS for further processing and action by the IRS.

The bill specifies several procedural conditions under which the provision would operate. 

First, provisions of the Fair Debt Collection Practices Act apply to the private debt collection 

company. Second, taxpayer protections that are statutorily applicable to the IRS are also made 

statutorily applicable to the private sector debt collection companies. Third, the private sector 

debt collection companies are required to inform taxpayers of the availability of assistance from 

the Taxpayer Advocate. Fourth, subcontractors are prohibited from having contact with 

taxpayers, providing quality assurance services, and composing debt collection notices; any other 

service provided by a subcontractor must receive prior approval from the IRS. 

The bill creates a revolving fund from the amounts collected by the private debt 

collection companies. The private debt collection companies will be paid out of this fund. The 

 

235 There must be an assessment pursuant to section 6201 in order for there to be an 

outstanding tax liability.

236 The bill generally applies to any type of tax imposed under the Internal Revenue 

Code. It is anticipated that the focus in implementing the provision will be: (a) taxpayers who 

have filed a return showing a balance due but who have failed to pay that balance in full; and (b) 

taxpayers who have been assessed additional tax by the IRS and who have made several 

voluntary payments toward satisfying their obligation but have not paid in full. 

237 Several portions of the provision require that the IRS disclose confidential taxpayer 

information to the private debt collection company. Section 6103(n) permits disclosure for “the 

providing of other services ... for purposes of tax administration.” Accordingly, no amendment 

to 6103 is necessary to implement the provision. It is intended, however, that the IRS vigorously 

protect the privacy of confidential taxpayer information by disclosing the least amount of 

information possible to contractors consistent with the effective operation of the provision.

238 The private debt collection company is not permitted to accept payment directly. 

Payments are required to be processed by IRS employees.
143

bill prohibits the payment of fees for all services in excess of 25 percent of the amount collected 

under a tax collection contract.239

Effective Date

The provision is effective on the date of enactment.

 

239 It is assumed that there will be competitive bidding for these contracts by private 

sector tax collection agencies and that vigorous bidding will drive the overhead costs down.
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TITLE 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;240 or (3) 30 percent of the 

“foreign sale and leasing income” derived by the taxpayer from the transaction.241 

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 

 

240 “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. 

241 “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.
145

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.

Explanation of Provision

The bill repeals the ETI exclusion. Pursuant to transition rules, taxpayers retain a portion 

of their otherwise-applicable ETI benefits for transactions during a two-year transition period (65 

percent and 35 percent for 2004 and 2005, respectively). 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.
146

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. 103-182 which extended authorization for the collection of 

these fees through fiscal year 2003.

 Explanation of Provision

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, are extended 

only through September 30, 2006. For fiscal years after September 30, 2006, 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 provisions are effective upon the date of enactment.