DESCRIPTION OF THE CHAIRMAN’S MARK OF THE

“JUMPSTART OUR BUSINESS STRENGTH (JOBS) ACT”

Scheduled for Markup

By the

SENATE COMMITTEE ON FINANCE

on October 1, 2003

Prepared by

the Staff of the

JOINT COMMITTEE ON TAXATION

September 26, 2003

JCX-83-03
i

CONTENTS

Page

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

I. PROVISIONS RELATING TO REPEAL OF EXCLUSION FOR EXTRATERRITORIAL 

INCOME.............................................................................................................................................2

A. Repeal of Exclusion for Extraterritorial Income (sec. 101 of the bill and secs. 114

and 941-943 of the Code)........................................................................................................2

B. Deduction Relating to Income Attributable to United States Production Activities

(sec. 102 of the bill and new sec. 250 of the Code)................................................................5

II. INTERNATIONAL TAX PROVISIONS......................................................................................8

A. International Tax Reform........................................................................................................8

1. Twenty-year foreign tax credit carryforward (sec. 201 of the bill and sec. 904 of the

 Code)...................................................................................................................................8

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

 corporations (sec. 202 of the bill and sec. 904 of the Code)...............................................9

3. Foreign tax credit under alternative minimum tax (sec. 203 of the bill and

 secs. 53-59 of the Code)....................................................................................................10

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

 of the Code).......................................................................................................................11

5. Interest expense allocation rules (sec. 205 of the bill and sec. 864 of the Code) .............12

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

 transactions in commodities (sec. 206 of the bill and sec. 954 of the Code)....................16

B. International Tax Simplification...........................................................................................20

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

 rules (sec. 211 of the bill and secs. 542, 551-558, 954, 1246, and 1247 of the Code) .....20

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

 of the Code).......................................................................................................................20

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

 902 and 960 credits (sec. 213 of the bill and secs. 901 and 902 of the Code)..................21

4. Application of uniform capitalization rules for foreign persons (sec. 214 of the bill

 and sec. 263A of the Code)...............................................................................................23

5. Repeal of withholding tax on dividends from certain foreign corporations (sec. 215

 of the bill and sec. 871 of the Code).................................................................................24

6. Repeal of special capital gains tax on aliens present in the United States for 183 days

 or more (sec. 216 of the bill and sec. 871 of the Code) ....................................................25

III. ADDITIONAL PROVISIONS ...................................................................................................30

A. Proposals Designed to Curtail Tax Shelters..........................................................................30

1. Clarification of the economic substance doctrine .............................................................30

2. Penalty for failure to disclose reportable transactions ......................................................36
Page

ii

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

 transactions having a significant tax avoidance purpose ..................................................39

4. Penalty for understatements from transactions lacking economic substance ...................43

5. Modifications to the substantial understatement penalty..................................................46

6. Tax shelter exception to confidentiality privileges relating to taxpayer

 communications ................................................................................................................47

7. Disclosure of reportable transactions by material advisors..............................................48

8. Investor lists and modification of penalty for failure to maintain investor lists ...............51

9. Actions to enjoin conduct with respect to tax shelters and reportable transactions..........53

10. Understatement of taxpayer’s liability by income tax return preparer...........................54

11. Penalty for failure to report interests in foreign financial accounts................................54

12. Frivolous tax returns and submissions............................................................................55

13. Regulation of individuals practicing before the Department of the Treasury.................56

14. Penalties on promoters of tax shelters.............................................................................57

15. Extend statute of limitations for certain undisclosed transactions..................................58

16. Deny deduction for interest paid to IRS on underpayments involving certain

 tax-motivated transactions ..............................................................................................59

17. Authorize additional $300 million per year to the IRS to combat abusive tax

 avoidance transactions ....................................................................................................59

B. Other Corporate Governance Proposals................................................................................61

1. Affirmation of consolidated return regulation authority...................................................61

2. Chief executive officer required to sign declaration as part of corporate income tax

 return................................................................................................................................66

3. Denial of deduction for certain fines, penalties, and other amounts.................................67

4. Denial of deduction for punitive damages........................................................................69

5. Criminal tax fraud .............................................................................................................70

C. Enron-Related Tax Shelter Proposals...................................................................................72

1. Limitation on transfer and importation of built-in losses .................................................72

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

 partner ...............................................................................................................................73

3. Repeal of special rules for FASITs...................................................................................75

4. Expanded disallowance of deduction for interest on convertible debt .............................79

5. Expanded authority to disallow tax benefits under section 269........................................80

6. Modification of CFC-PFIC coordination rules.................................................................81

D. Tax Treatment of Inversion Transactions .............................................................................85

E. Proposal to Impose Mark-to-Market Tax on Individuals Who Expatriate ...........................91

F. Other Revenue Proposals....................................................................................................101

1. Effectively connected income to include certain foreign source income .......................101

2. Recapture of overall foreign losses on sale of controlled foreign corporation stock......103

3. Disallowance of certain partnership loss transfers..........................................................105

4. Treatment of stripped bonds to apply to stripped interests in bond and preferred

 stock funds......................................................................................................................108

5. Minimum holding period for foreign tax credit with respect to withholding taxes

 on income other than dividends ......................................................................................111
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iii

6. Modify treatment of transfers to creditors in divisive reorganizations...........................112

7. Extend the present-law intangible amortization provisions to acquisitions of sports

 franchises ........................................................................................................................113

8. Clarification of rules for payment of estimated tax for certain deemed asset sales........114

9. Extension of IRS user fees..............................................................................................115

10. Doubling of certain penalties, fines, and interest on underpayments related to

 certain offshore financial arrangements........................................................................116

11. Add vaccines against hepatitis A to the list of taxable vaccines...................................119

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

 sale or exchange of a principal residence......................................................................119

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

 payment.........................................................................................................................120

14. Lease term to include certain service contracts ............................................................121
1

INTRODUCTION

The Senate Committee on Finance has scheduled a markup on October 1, 2003, of 

S. 1637, the “Jumpstart Our Business Strength (JOBS) Act,” together with additional provisions 

not included in S. 1637 as introduced. This document, 1 prepared by the staff of the Joint 

Committee on Taxation, provides a description of S. 1637 and these additional provisions.

 

1

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

the Chairman’s Mark of the “Jumpstart Our Business Strength (JOBS) Act” (JCX-83-03), 

September 26, 2003.
2

I. PROVISIONS RELATING TO REPEAL OF EXCLUSION

FOR EXTRATERRITORIAL INCOME

A. Repeal of Exclusion for Extraterritorial Income

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

Present Law

Like many other countries, the United States has long provided export-related benefits 

under its tax law. In the United States, for most of the last two decades, these benefits were 

provided under the foreign sales corporation (“FSC”) regime. In 2000, the European Union 

(“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 “ETI” act 

and regime). 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;2 or (3) 30 percent of the 

“foreign sale and leasing income” derived by the taxpayer from the transaction. 3 

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 

 

2

 “Foreign trade income” is the taxable income of the taxpayer (determined without 

regard to the exclusion of qualifying foreign trade income) attributable to foreign trading gross 

receipts. 

3

 “Foreign sale and leasing income” is the amount of the taxpayer's foreign trade income 

(with respect to a transaction) that is properly allocable to activities that constitute foreign 

economic processes. Foreign sale and leasing income also includes foreign trade income derived 

by the taxpayer in connection with the lease or rental of qualifying foreign trade property for use 

by the lessee outside the United States.
3

gross receipts from a transaction as not foreign trading gross receipts. As a result of such an 

election, a taxpayer may use any related foreign tax credits in lieu of the exclusion.

Qualifying foreign trade property generally is property manufactured, produced, grown, 

or extracted within or outside the United States that is held primarily for sale, lease, or rental in 

the ordinary course of a trade or business for direct use, consumption, or disposition outside the 

United States. No more than 50 percent of the fair market value of such property can be 

attributable to the sum of: (1) the fair market value of articles manufactured outside the United 

States; and (2) the direct costs of labor performed outside the United States. With respect to 

property that is manufactured outside the United States, certain rules are provided to ensure 

consistent U.S. tax treatment with respect to manufacturers.

Description of Proposal

The proposal repeals the exclusion for extraterritorial income. However, the proposal 

provides that the extraterritorial income exclusion provisions remain in effect for transactions in 

the ordinary course of a trade or business if such transactions are pursuant to a binding contract 

between the taxpayer and an unrelated person and such contract is in effect on September 17, 

2003, and at all times thereafter.

The proposal permits foreign corporations that have elected to be treated as U.S. 

corporations pursuant to the extraterritorial income exclusion provisions to revoke their 

elections. Such revocations are effective on the date of enactment of this proposal. A 

corporation revoking its election is treated as a U.S. corporation that transfers all of its property 

to a foreign corporation in connection with an exchange described in section 354 of the Code. In 

general, the corporation shall not recognize any gain or loss on such deemed transfer. However, 

a revoking corporation shall recognize any gain on any asset held by the corporation: (1) if the 

basis if such asset is determined (in whole or in part) by reference to the basis of such asset in the 

hands of the person from whom the corporation acquired such asset; (2) the asset was acquired 

by an actual transfer (rather than as a result of the U.S. corporation election by the corporation) 

occurring on or after the first day on which the U.S. corporation election by the corporation was 

effective; and (3) a principal purpose of the acquisition was the reduction or avoidance of tax.

The proposal also provides a deduction for taxable years of certain corporations ending 

after the date of enactment of the proposal and beginning before January 1, 2007.4 The amount 

of the deduction for each such taxable year is equal to a specified percentage of the aggregate 

amount that, for the taxable year of a corporation beginning in 2002, was excludable from the 

gross income of the corporation under the extraterritorial income exclusion provisions or was 

treated by the corporation as exempt foreign trade income of related FSCs from property 

acquired by the FSCs from the corporation. However, this aggregate amount does not include 

any amount attributable to a transaction involving a lease by the corporation unless the 

corporation manufactured or produced (in whole or in part) the leased property.

 

4

 The deduction also is available to cooperatives engaged in the marketing of agricultural 

or horticultural products.
4

The specified percentage to be used in determining the deduction is: 80 percent for 

calendar years 2004 and 2005; 60 percent for calendar year 2006; and 0 percent for calendar year 

2007 and calendar years thereafter. For calendar year 2003, the specified percentage is the 

amount that bears the same ratio to 100 percent as the number of days after the date of enactment 

of this proposal bears to 365. In the case of a corporation with a taxable year that is not the 

calendar year (i.e., a fiscal year corporation), a special rule is provided for determining a 

weighted average specified percentage based upon the calendar years that are included in the 

taxable year.

The deduction for a taxable year generally is reduced by the specified percentage of 

exempted FSC income and excluded extraterritorial income of the corporation for the taxable 

year from transactions pursuant to a binding contract. However, this reduction does not apply to 

income attributable to transactions involving a lease by the corporation of property that the 

corporation has not manufactured or produced (in whole or in part).

Effective Date

The proposal is effective for transactions occurring after the date of enactment.
5

B. Deduction Relating to Income Attributable

to United States Production Activities

(sec. 102 of the bill and new sec. 250 of the Code)

Present Law

Under present law, there is no provision in the Code that permits taxpayers to claim a 

deduction from taxable income attributable to domestic production activities, other than 

allowable deductions of costs incurred to produce such income.

Description of Proposal

In general

The proposal provides a deduction for qualified production activities income of a 

corporation. The amount of the deduction for such income in taxable years beginning in: 2004 

is one percent; 2005 is two percent; 2006 is three percent; 2007 and 2008 is six percent; and 

2009 and thereafter is nine percent.

Qualified production activities income

“Qualified production activities income” is the product of an applicable percentage 

multiplied by the modified taxable income 5 of a corporation that is attributable to domestic 

production activities. In general, income attributable to domestic production activities is equal to 

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

allocable to such receipts;6 (2) other deductions, expenses, or losses that are directly allocable to 

such receipts; and (3) a proper share of other deductions, expenses, and losses that are not 

directly allocable to such receipts or another class of income.7

 

5

 “Modified taxable income” is taxable income of the corporation computed without 

regard to the deduction provided by this proposal. Qualified production activities income is 

limited to the modified taxable income of the corporation.

6

 For purposes of determining such costs, any item or service that is imported into the 

United States without an arm’s length transfer price shall be treated as acquired by purchase, and 

its cost shall be treated as not less that its fair market value when it entered the United States. A 

similar rule shall apply in determining the adjusted basis of leased or rented property where the 

lease or rental gives rise to domestic production gross receipts. With regard to property 

previously exported by the corporation for further manufacture, the increase in cost or adjusted 

basis shall not exceed the difference between the fair market value of the property when exported 

and the fair market value of the property when re-imported into the United States after further 

manufacture.

7

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

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

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

relevant present-law rules (e.g., secs. 263A and 861).
6

For taxable years beginning before 2012, the “applicable percentage” is the value of the 

domestic production of the corporation divided by the value of the worldwide production of the 

corporation (the “domestic/worldwide fraction”).8 For taxable years beginning in 2012, the 

applicable percentage is equal to twice the domestic/worldwide fraction. For taxable years

beginning after 2012, the applicable percentage is 100 percent.

Domestic production gross receipts

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

from any sale, exchange or other disposition, or any lease, rental or license, of qualifying 

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

significant part) by the corporation within the United States.9 “Qualifying production property” 

generally is any tangible personal property, computer software, or property described in section 

168(f)(3) or (4) of the Code. However, qualifying production property does not include: (1) 

consumable property that is sold, leased or licensed as an integral part of the provision of 

services; (2) oil or gas (or any primary product thereof); (3) electricity; (4) water supplied by 

pipeline to the consumer; (5) unprocessed timber (i.e., any log, cant or similar form of timber) 

that is softwood; (6) utility services; and (7) any film, tape, recording, book, magazine, 

newspaper or similar property the market for which is primarily topical or otherwise essentially 

transitory in nature.

Other rules

Distributions of qualified production activities income by cooperatives

With regard to member-owned agricultural and horticultural cooperatives formed under 

Subchapter T of the Code, the proposal provides the same treatment of qualified production 

 

8

 For purposes of the domestic/worldwide fraction, the value of domestic production is 

the excess of domestic production gross receipts (as defined below) over the cost of deductible 

purchased inputs that are allocable to such receipts. Similarly, the value of worldwide 

production is the excess of worldwide production gross receipts over the cost of deductible 

purchased inputs that are allocable to such receipts. For purposes of determining the 

domestic/worldwide fraction, purchased inputs include: purchased services (other than 

employees) used in manufacture, production, growth, or extraction activities; purchased items 

consumed in connection with such activities; and purchased items incorporated as part of the 

property being manufactured, produced, grown, or extracted. In the case of corporations that are 

members of certain affiliated groups, the domestic/worldwide fraction is determined by treating 

all members of such groups as a single corporation.

9

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

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

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

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

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

property (whether or not by the corporation).
7

activities income derived from products marketed through cooperatives as it provides for 

qualified production activities income of other taxpayers (i.e., the cooperative may claim a 

deduction from qualified production activities income). In addition, the proposal provides that 

the amount of any patronage dividends or per-unit retain allocations paid to a member of an 

agricultural or horticultural cooperative (to which Part I of Subchapter T applies), which is 

allocable to the portion of qualified production activities income of the cooperative that is 

deductible under this proposal, is excludible from the gross income of the member. In order to 

qualify, such amount must be designated by the organization as allocable to the deductible 

portion of qualified production activities income in a written notice mailed to its patrons not later 

than the payment period described in section 1382(d). The cooperative cannot reduce its income 

under section 1382 (e.g., cannot claim a dividends-paid deduction) for such amounts.

Qualified production activities income of partnerships and S corporations

For purposes of determining the deduction under the proposal, a corporate partner’s 

distributive share of any partnership item shall be taken into account as if directly realized by the 

corporation. Thus, the qualified production activities income of a corporation includes its 

distributive share of such income earned by a partnership in which the corporation is a partner.

The deduction provided by the proposal is allowed to S corporations, computed in the 

same manner as C corporations. The deduction allowed to an S corporation passes through and 

is allowed to the S corporation shareholders on their individual tax returns. The adjusted basis of 

a shareholder’s stock in the S corporation is increased by the amount of the shareholder’s 

deduction allowed under the proposal.

Alternative minimum tax

The deduction provided by the proposal is allowed for purposes of the alternative 

minimum tax (including adjusted current earnings). The deduction is determined by reference to 

alternative minimum taxable income.

Coordination with ETI repeal

For purposes of determining the deduction provided by this proposal, domestic 

production gross receipts does not include gross receipts from any transaction that produces 

excluded extraterritorial income pursuant to the binding contract exception to the ETI repeal 

provisions of this proposal.

Qualified production activities income is determined without regard to any deduction 

provided by the ETI repeal provisions of this proposal.

Effective Date

The proposal is effective for taxable years ending after the date of enactment.
8

II. INTERNATIONAL TAX PROVISIONS

A. International Tax Reform

1. Twenty-year foreign tax credit carryforward (sec. 201 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 used to offset the U.S. tax on income in each separate limitation category may not 

exceed the proportion of the taxpayer's U.S. tax which the taxpayer's foreign-source taxable 

income in that category bears to its worldwide taxable income.

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.

Description of Proposal

The proposal extends the excess foreign tax credit carryforward period from five to 

twenty years.

Effective Date

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

years beginning after December 31, 2004.
9

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

(sec. 202 of the bill and sec. 904 of the Code)

Present Law

U.S. persons may credit foreign taxes against U.S. tax on foreign-source income. 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).10

 

Dividends paid by a 10/50 company that is a passive foreign investment company out of earnings 

and profits accumulated in taxable years beginning before January 1, 2003, continue to be 

subject to a separate foreign tax credit limitation for each such 10/50 company. Dividends paid 

by a 10/50 company out of earnings and profits accumulated in taxable years after December 31, 

2002 are treated as income in a foreign tax credit limitation category in proportion to the ratio of 

the 10/50 company’s earnings and profits attributable to income in such foreign tax credit 

limitation category to its total earnings and profits (a “look-through” approach). 

For these purposes, distributions are treated as made from the most recently accumulated 

earnings and profits. Regulatory authority is granted to provide rules regarding the treatment of 

distributions out of earnings and profits for periods prior to the taxpayer's acquisition of such 

stock.

Description of Proposal

The proposal applies the look-through approach to all dividends paid by a 10/50 company 

that is not a passive foreign investment company, regardless of the year in which the earnings

and profits out of which the dividend is paid were accumulated. In the event that information is 

not available to apply 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 basketing purposes. 

The proposal also provides transition rules regarding the use of pre-effective date foreign 

tax credits associated with a 10/50 company separate limitation category in post-effective date 

years. Look-through principles similar to those applicable to post-effective date dividends from 

a 10/50 company apply to determine the appropriate foreign tax credit limitation category or 

categories with respect to carrying forward foreign tax credits into future years. The proposal 

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. 

 

10 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. 
10

Effective Date

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

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

the Code)

Present Law

In general

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

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

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

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

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

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

benefits resulting from the regular tax treatment of such items.

Foreign tax credit

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

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

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

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

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

ratio of foreign source regular taxable income to total AMTI.

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

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

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

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

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

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

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

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

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

section 904(c).

Description of Proposal

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

credit.

Effective Date

The proposal is effective for taxable years beginning after December 31, 2004.
11

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

Present Law

The United States provides a credit for foreign income taxes paid or accrued. The 

foreign tax credit generally is limited to the U.S. tax liability on a taxpayer’s foreign-source 

income, in order to ensure that the credit serves the purpose of mitigating double taxation of 

foreign-source income without offsetting the U.S. tax on U.S.-source income. This overall 

limitation is calculated by prorating a taxpayer's pre-credit U.S. tax on its worldwide income 

between its U.S.-source and foreign-source taxable income. The ratio (not exceeding 100 

percent) of the taxpayer's foreign-source taxable income to worldwide taxable income 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 
12

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

foreign tax credits.

Description of Proposal

The proposal applies a re-sourcing rule to U.S.-source income in cases in which a 

taxpayer’s foreign tax credit limitation has been reduced as a result of an overall domestic loss. 

Under the proposal, 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 proposal 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 proposal, 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 proposal 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 

proposal 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 proposal.

Effective Date

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

2006.

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

Present Law

In general

In order to compute the foreign tax credit limitation, a taxpayer must determine the 

amount of its taxable income from foreign sources. Thus, the taxpayer must allocate and 

apportion deductions between items of U.S.-source gross income, on the one hand, and items of 

foreign-source gross income, on the other.
13

In the case of interest expense, the rules generally are based on the approach that money 

is fungible and that interest expense is properly attributable to all business activities and property 

of a taxpayer, regardless of any specific purpose for incurring an obligation on which interest is 

paid. (Exceptions to the fungibility concept are recognized or required, however, in particular 

cases, some of which are described below.) The Code provides that, for interest allocation 

purposes, all members of an affiliated group of corporations generally are to be treated as a 

single corporation (the so-called “one-taxpayer rule”) and that allocation must be made on the 

basis of assets rather than gross income.

Affiliated group

In general

The term “affiliated group” in this context generally is defined by reference to the rules 

for determining whether corporations are eligible to file consolidated returns. However, some 

groups of corporations are eligible to file consolidated returns yet are not treated as affiliated for 

interest allocation purposes, and other groups of corporations are treated as affiliated for interest 

allocation purposes even though they are not eligible to file consolidated returns. Thus, under 

the one-taxpayer rule, the factors affecting the allocation of interest expense of one corporation 

may affect the sourcing of taxable income of another, related corporation even if the two 

corporations do not elect to file, or are ineligible to file, consolidated returns.

Definition of affiliated group -- consolidated return rules

For consolidation purposes, the term “affiliated group” means one or more chains of 

includible corporations connected through stock ownership with a common parent corporation 

which is an includible corporation, but only if: (1) the common parent owns directly stock 

possessing at least 80 percent of the total voting power and at least 80 percent of the total value 

of at least one other includible corporation; and (2) stock meeting the same voting power and 

value standards with respect to each includible corporation (excluding the common parent) is 

directly owned by one or more other includible corporations.

Generally, the term “includible corporation” means any domestic corporation except 

certain corporations exempt from tax under section 501 (for example, corporations organized and 

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

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.11 For example, both definitions generally 

exclude all foreign corporations from the affiliated group. Thus, while debt generally is 

 

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

section 936 corporations that are excluded from the consolidated group.
14

considered fungible among the assets of a group of domestic affiliated corporations, the same 

rules do not apply as between the domestic and foreign members of a group with the same 

degree of common control as the domestic affiliated group.

Banks, savings institutions, and other financial affiliates

The affiliated group for interest allocation purposes generally excludes what are referred 

to in the Treasury regulations as “financial corporations” (Treas. Reg. sec. 1.861-11T(d)(4)). 

These include any corporation, otherwise a member of the affiliated group for consolidation 

purposes, that is a financial institution (described in section 581 or section 591), the business of 

which is predominantly with persons other than related persons or their customers, and which is 

required by State or Federal law to be operated separately from any other entity which is not a 

financial institution (sec. 864(e)(5)(C)). The category of financial corporations also includes, to 

the extent provided in regulations, bank holding companies, subsidiaries of banks and bank 

holding companies, and savings institutions predominantly engaged in the active conduct of a 

banking, financing, or similar business (sec. 864(e)(5)(D)).

A financial corporation is not treated as a member of the regular affiliated group for 

purposes of applying the one-taxpayer rule to other non-financial members of that group. 

Instead, all such financial corporations that would be so affiliated are treated as a separate single 

corporation for interest allocation purposes.

Description of Proposal

In general

The proposal modifies the present-law interest expense allocation rules (which generally 

apply for purposes of computing the foreign tax credit limitation) by providing a one-time 

election under which the taxable income of the domestic members of an affiliated group from 

sources outside the United States generally is determined by allocating and apportioning interest 

expense of the domestic members of a worldwide affiliated group on a worldwide-group basis 

(i.e., as if all members of the worldwide group were a single corporation). If a group makes this 

election, the taxable income of the domestic members of a worldwide affiliated group from 

sources outside the United States is determined by allocating and apportioning the interest 

expense of those domestic members to foreign-source income in an amount equal to the excess 

(if any) of (1) the worldwide affiliated group’s worldwide 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.12

 

12 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.
15

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)13 as well as all controlled foreign corporations that, 

in the aggregate, either directly or indirectly,14 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 treatme nt 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 

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 proposal 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 proposal also provides a one-time “financial institution 

group” election that expands the present-law bank group. Under the proposal, 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) 

 

13 The proposal 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)).

14 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.
16

all corporations that are part of the present-law bank group,15 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.16 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, 2009, 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 proposal 

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 proposal provides regulatory authority with respect to the election to 

provide for the direct allocation of interest expense in circumstances in which such allocation is 

appropriate to carry out the purposes of the provision, prevent assets or interest expense from 

being taken into account more than once, or address changes in members of any group (through 

acquisitions or otherwise) treated as affiliated under this provision. 

Effective Date

The proposal is effective for taxable years beginning after December 31, 2009.

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

in commodities (sec. 206 of the bill and sec. 954 of the Code)

Present Law

Subpart F foreign personal holding company income

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

controlled foreign corporation (“U.S. 10-percent shareholders”) are subject to U.S. tax currently 

on certain income earned by the controlled foreign corporation, whether or not such income is 

distributed to the shareholders. The income subject to current inclusion under the subpart F rules 

includes, among other things, “foreign personal holding company income.”

 

15 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 

proposal, 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.

16

 See Treas. Reg. sec. 1.904-4(e)(2).
17

Foreign personal holding company income generally consists of the following: 

dividends, interest, royalties, rents and annuities; net gains from sales or exchanges of (1) 

property that gives rise to the foregoing types of income, (2) property that does not give rise to 

income, and (3) interests in trusts, partnerships, and real estate mortgage investment conduits 

(“REMICs”); net gains from commodities transactions; net gains from foreign currency 

transactions; income that is equivalent to interest; income from notional principal contracts; and 

payments in lieu of dividends.

With respect to transactions in commodities, foreign personal holding company income 

does not consist of gains or losses which arise out of bona fide hedging transactions that are 

reasonably necessary to the conduct of any business by a producer, processor, merchant, or 

handler of a commodity in the manner in which such business is customarily and usually 

conducted by others.17 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.18

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 

 

17 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)).

18 Treasury regulations provide that substantially all of a controlled foreign corporation’s 

business is as an active producer, processor, merchant or handler of commodities if: (1) the sum 

of its gross receipts from all of its active sales of commodities in such capacity and its gross 

receipts from all of its commodities hedging transactions that qualify for exclusion from the 

definition of foreign personal holding company income, equals or exceeds (2) 85 percent of its 

total receipts for the taxable year (computed as though the controlled foreign corporation was a 

domestic corporation) (Treas. Reg. sec. 1.954-2(f)(2)(iii)(C)).
18

taxpayer in the normal course of the taxpayer’s trade or business primarily: (1) to manage risk of 

price changes or currency fluctuations with respect to ordinary property which is held or to be 

held by the taxpayer; (2) to manage risk of interest rate or price changes or currency fluctuations 

with respect to borrowings made or to be made, or ordinary obligations incurred or to be 

incurred, by the taxpayer; or (3) to manage such other risks as the Secretary may prescribe in 

regulations (sec. 1221(b)(2)(A)).

Description of Proposal

The proposal 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 proposal, 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 proposal 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 proposal, 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. 19

 

19 For purposes of determining whether substantially all of the controlled foreign 

corporation’s commodities are comprised of such property, it is intended that the 85-percent 

requirement provided in the current Treasury regulations (as modified to reflect the changes 

made by the proposal) continue to apply.
19

For purposes of 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, the proposal also provides that certain commodities held by a 

controlled foreign corporation that is a regular dealer in commodities or financial instruments 

referenced to commodities are not taken into account in determining whether substantially all of 

the controlled foreign corporation’s commodities are comprised of the property described above.

Effective Date

The proposal is effective with respect to transactions entered into after December 31, 

2004.
20

B. International Tax Simplification

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

(sec. 211 of the bill and secs. 542, 551-558, 954, 1246, and 1247 of the Code)

Present Law

Income earned by a foreign corporation from its foreign operations generally is subject to 

U.S. tax only when such income is distributed to any U.S. persons that hold stock in such 

corporation. Accordingly, a U.S. person that conducts foreign operations through a foreign 

corporation generally is subject to U.S. tax on the income from those operations when the 

income is repatriated to the United States through a dividend distribution to the U.S. person. The

income is reported on the U.S. person's tax return for the year the distribution is received, and the 

United States imposes tax on such income at that time. The foreign tax credit may reduce the 

U.S. tax imposed on such income.

Several sets of anti-deferral rules impose current U.S. tax on certain income earned by a 

U.S. person through a foreign corporation. Detailed rules for coordination among the antideferral rules are provided to prevent the U.S. person from being subject to U.S. tax on the same 

item of income under multiple rules.

The Code sets forth the following anti-deferral rules: the controlled foreign corporation 

rules of subpart F (secs. 951-964); the passive foreign investment company rules (secs. 1291-

1298); the foreign personal holding company rules (secs. 551-558); the personal holding 

company rules (secs. 541-547); the accumulated earnings tax rules (secs. 531-537); and the 

foreign investment company rules (secs. 1246-1247). 

Description of Proposal

The proposal: (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 ending with or within such taxable 

years of such foreign corporations. 

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

Code)

Present Law

Under the rules of subpart F (secs. 951-964), U.S. 10-percent shareholders of a controlled 

foreign corporation are required to include in income currently for U.S. tax purposes certain 
21

types of income of the controlled foreign corporation, whether or not such income is actually 

distributed currently to the shareholders (referred to as “subpart F income”). Subpart F income 

includes foreign base company income and certain insurance income. Foreign base company 

income includes five categories of income: foreign personal holding company income, foreign 

base company sales income, foreign base company services income, foreign base company 

shipping income, and foreign base company oil-related income (sec. 954(a)). Under a de 

minimis rule, if the gross amount of a controlled foreign corporation’s foreign base company 

income and insurance income for a taxable year is less than the lesser of five percent of the 

controlled foreign corporation's gross income or $1 million, then no part of the controlled foreign 

corporation's gross income is treated as foreign base company income or insurance income (sec. 

954(b)(3)(A)).

Description of Proposal

The proposal expands the subpart F de minimis rule to provide that, if the gross amount 

of a controlled foreign corporation’s foreign base company income and insurance income for a 

taxable year is less than the lesser of five percent of the controlled foreign corporation's gross 

income or $5 million, then no part of the controlled foreign corporation's gross income is treated 

as foreign base company income or insurance income.

Effective Date

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

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

years of such foreign corporations.

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

and 960 credits (sec. 213 of the bill and secs. 901 and 902 of the Code)

Present Law

Under section 902, a domestic corporation that receives a dividend from a foreign 

corporation in which it owns ten percent or more of the voting stock is deemed to have paid a 

portion of the foreign taxes paid by such foreign corporation. Thus, such a domestic corporation 

is eligible to claim a foreign tax credit with respect to such deemed-paid taxes. The domestic 

corporation that receives a dividend is deemed to have paid a portion of the foreign corporation’s 

post-1986 foreign income taxes based on the ratio of the amount of the dividend to the foreign 

corporation’s post-1986 undistributed earnings and profits.

Foreign income taxes paid or accrued by lower-tier foreign corporations also are eligible 

for the deemed-paid credit if the foreign corporation falls within a qualified group (sec. 902(b)). 

A “qualified group” includes certain foreign corporations within the first six tiers of a chain of 

foreign corporations if, among other things, the product of the percentage ownership of voting 

stock at each level of the chain (beginning from the domestic corporation) equals at least five 

percent. In addition, in order to claim indirect credits for foreign taxes paid by certain fourth-, 

fifth-, and sixth-tier corporations, such corporations must be controlled foreign corporations 

(within the meaning of sec. 957) and the shareholder claiming the indirect credit must be a U.S. 

shareholder (as defined in sec. 951(b)) with respect to the controlled foreign corporations. The 
22

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. 20 In Rev. Rul. 71-141,21 the 

IRS held that a foreign corporation’s stock held indirectly by two domestic corporations through 

their interests in a domestic general partnership is attributed to such domestic corporations for 

purposes of determining the domestic corporations’ eligibility to claim a deemed-paid foreign tax 

credit with respect to the foreign taxes paid by such foreign corporation. Accordingly, a general 

partner of a domestic general partnership is permitted to claim deemed-paid foreign tax credits 

with respect to a dividend distributed from the foreign corporation to the partnership.

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.”22 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).

 

20 Under section 901(b)(5), an individual member of a partnership or a beneficiary of an 

estate or trust generally may claim a direct foreign tax credit with respect to the amount of his or 

her proportionate share of the foreign taxes paid or accrued by the partnership, estate, or trust. 

This rule does not specifically apply to corporations that are either members of a partnership or 

beneficiaries of an estate or trust. However, section 702(a)(6) provides that each partner 

(including individuals or corporations) of a partnership must take into account separately its 

distributive share of the partnership’s foreign taxes paid or accrued. In addition, under section 

703(b)(3), the election under section 901 (whether to credit the foreign taxes) is made by each 

partner separately.

21 1971-1 C.B. 211.

22 T.D. 8708, 1997-1 C.B. 137.
23

Description of Proposal

The proposal 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 

proposal also clarifies that both individual and corporate partners may claim direct foreign tax 

credits with respect to their proportionate shares of taxes paid or accrued by a partnership. 

Effective Date

The proposal applies to taxes of foreign corporations for taxable years of such 

corporations beginning after the date of enactment. 

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

sec. 263A of the Code)

Present Law

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

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

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

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

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

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

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

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

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

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

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

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

connected earnings and profits for purposes of the branch profits tax.

When a foreign corporation is not engaged in a trade or business in the United States, its 

taxable income and earnings and profits may nonetheless be relevant under the Code. For 

example, the subpart F income of a controlled foreign corporation may be currently includible on 

the return of a U.S. shareholder of the controlled foreign corporation. Regardless of whether or 

not a foreign corporation is U.S.-controlled, its accumulated earnings and profits must be 

computed in order to determine the amount of taxable dividends and the indirect foreign tax 

credit carried by distributions from the foreign corporation to any domestic corporation that 

owns at least 10 percent of its voting stock.

The earnings and profits surplus or deficit of any foreign corporation for any taxable year 

generally is determined according to rules substantially similar to those applicable to domestic 

corporations. However, Treas. Prop. Reg. sec. 1.964-1(c)(1)(ii)(B) provides that, for purposes of 

computing a foreign corporation’s earnings and profits, the amount of expenses that must be 
24

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.

Description of Proposal

The proposal provides that in lieu of the uniform capitalization rules, costs incurred in 

producing property or acquiring property for resale are capitalized using U.S. generally accepted 

accounting principles (i.e., the method used to ascertain income, profit, or loss for purposes of 

reports or statements to shareholders, partners, other proprietors, or beneficiaries, or for credit 

purposes) for purposes of determining a U.S.-owned foreign corporation’s earnings and profits 

and subpart F income. The uniform capitalization rules continue to apply to foreign corporations 

for purposes of determining income effectively connected with a U.S. trade or business and the 

related earnings and profits therefrom.

Effective Date

The proposal 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. 

5. Repeal of withholding tax on dividends from certain foreign corporations (sec. 215 of the 

bill and sec. 871 of the Code)

Present Law

Nonresident individuals who are not U.S. citizens and foreign corporations (collectively, 

foreign persons) are subject to U.S. tax on income that is effectively connected with the conduct 

of a U.S. trade or business; the U.S. tax on such income is calculated in the same manner and at 

the same graduated rates as the tax on U.S. persons (secs. 871(b) and 882). Foreign persons also 

are subject to a 30-percent gross basis tax, collected by withholding, on certain U.S.-source 

passive income (e.g., interest and dividends) that is not effectively connected with a U.S. trade or 

business. This 30-percent withholding tax may be reduced or eliminated pursuant to an 

applicable tax treaty. Foreign persons generally are not subject to U.S. tax on foreign-source 

income that is not effectively connected with a U.S. trade or business.

In general, dividends paid by a domestic corporation are treated as being from U.S. 

sources and dividends paid by a foreign corporation are treated as being from foreign sources. 

Thus, dividends paid by foreign corporations to foreign persons generally are not subject to 

withholding tax because such income generally is treated as foreign-source income. 
25

An exception from this general rule applies in the case of dividends paid by certain 

foreign corporations. If 25 percent or more of a foreign corporation’s gross income is income 

effectively connected with a U.S. trade or business for the three-year period ending with the 

close of the taxable year preceding the declaration of a dividend, then a portion of any dividend 

paid by the foreign corporation to its shareholders will be treated as U.S.-source income and, in 

the case of dividends paid to foreign shareholders, will be subject to the 30-percent withholding 

tax (sec. 861(a)(2)(B)). This rule is sometimes referred to as the “secondary withholding tax.” 

The portion of the dividend treated as U.S.-source income is equal to the ratio of the gross 

income of the foreign corporation that was effectively connected with its U.S. trade or business 

over the total gross income of the foreign corporation during the three-year period ending with 

the close of the preceding taxable year. The U.S.-source portion of the dividend paid by the 

foreign corporation to its foreign shareholders is subject to the 30-percent withholding tax.

Under the branch profits tax provisions, the United States taxes foreign corporations 

engaged in a U.S. trade or business on amounts of U.S. earnings and profits that are shifted out 

of the U.S. branch of the foreign corporation. The branch profits tax is comparable to the 

second-level taxes imposed on dividends paid by a domestic corporation to its foreign 

shareholders. The branch profits tax is 30 percent of the foreign corporation’s “dividend 

equivalent amount,” which generally is the earnings and profits of a U.S. branch of a foreign 

corporation attributable to its income effectively connected with a U.S. trade or business (secs. 

884(a) and (b)). 

If a foreign corporation is subject to the branch profits tax, then no secondary 

withholding tax is imposed on dividends paid by the foreign corporation to its shareholders (sec. 

884(e)(3)(A)). If a foreign corporation is a qualified resident of a tax treaty country and claims 

an exemption from the branch profits tax pursuant to the treaty, the secondary withholding tax 

could apply with respect to dividends it pays to its shareholders. Several tax treaties (including 

treaties that prevent imposition of the branch profits tax), however, exempt dividends paid by the 

foreign corporation from the secondary withholding tax. 

Description of Proposal

The proposal eliminates the secondary withholding tax with respect to dividends paid by 

certain foreign corporations. 

Effective Date

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

6. Repeal of special capital gains tax on aliens present in the United States for 183 days or 

more (sec. 216 of the bill and sec. 871 of the Code)

Present Law

In general

In general, resident individuals who are not U.S. citizens are taxed in the same manner as 

U.S. citizens. Nonresident individuals who are not U.S. citizens are subject to (1) U.S. tax on 
26

income from U.S. sources that are effectively connected with a U.S. trade or business, and (2) a 

30-percent withholding tax on the gross amount of certain types of passive income derived from 

U.S. sources, such as interest, dividends, rents, and other fixed or determinable annual or 

periodical income (sec. 871(a)(1)). Bilateral income tax treaties may modify these tax rules. 

Taxation of capital gains

Income derived from the sale of personal property other than inventory property 

generally is sourced based on the residence of the seller (sec. 865(a)). Thus, nonresident 

individuals who are not citizens generally are not taxable on capital gains because the gains 

generally are considered to be foreign-source income.23 

Special rules apply in the case of sales of personal property by certain foreign persons. In 

this regard, an individual who is otherwise treated as a nonresident is treated as a U.S. resident 

for purposes of sourcing income from the sale of personal property if the individual has a tax 

home in the United States (sec. 865(g)(1)(A)(i)(II)). An individual’s U.S. tax home generally is 

the place where the individual has his or her principal place of business. For example, if a 

nonresident individual with a tax home in the United States sells stocks or other securities for a 

gain, the individual will be treated as a U.S. resident with respect to the sale such that the gain 

will be treated as U.S.-source income potentially subject to U.S. tax. 

In addition, if a nonresident individual maintains an office or other fixed place of 

business in the United States, income from the sale of personal property (including inventory 

property) attributable to such office or place of business is sourced in the United States (sec. 

865(e)(2)(A)). If treated as U.S.-source income, the income would be subject to U.S. tax if 

treated as effectively connected with a U.S. trade or business. This special rule does not apply, 

however, in the case of inventory property that is sold by the foreign person for use, disposition, 

or consumption outside the United States if an office or other fixed place of business of such 

person outside the United States materially participated in the sale (sec. 865(e)(2)(B)).

Moreover, under section 871(a)(2), a nonresident individual who is physically present in 

the United States for 183 days or more during a taxable year is subject to a 30-percent tax on the 

excess of U.S.-source capital gains over U.S.-source capital losses. This 30-percent tax is not a 

withholding tax. The tax under section 871(a)(2) does not apply to gains and losses subject to 

the gross 30-percent withholding tax under section 871(a)(1) or to gains effectively connected 

with a U.S. trade or business. Capital gains and losses are taken into account only to the extent 

that they would be recognized and taken into account if such gains and losses were effectively 

connected with a U.S. trade or business. Capital loss carryovers are not taken into account.

 

23 Nonresident individuals are subject to the 30-percent gross withholding tax, for 

example, with respect to gains from the sale or exchange of intangible property if the payments 

are contingent on the productivity, use, or disposition of the property. Secs. 871(a)(1)(D) and 

881(a)(4).
27

Residency rules

In general, an individual is considered a resident of the United States if the individual (1) 

has entered the United States as a lawful permanent U.S. resident, or (2) is present in the United 

States for 31 or more days during the current calendar year and has been present in the United 

States for a substantial period of time -- 183 or more days during a three-year period weighted 

toward the present year (the “substantial presence test”) (sec. 7701(b)). An individual meets the 

183-day part of the substantial presence test if the sum of (1) the days present during the current 

calendar year, (2) one-third of the days present during the preceding calendar year, and (3) onesixth of the days present during the second preceding calendar year, equals or exceeds 183 

days.24

An exception from being treated as a U.S. resident under the substantial presence test 

applies if (1) the individual is present in the United States for fewer than 183 days during the 

current calendar year, and (2) the individual establishes that he or she has a closer connection 

with a foreign country than with the United States and has a tax home in that country for the 

year. 

In general, an individual is treated as being present in the United States on any day if the 

individual is physically present in the United States at any time during such day. For purposes 

of the substantial presence test, an individual is not treated as present in the United States on any 

day during which (1) the individual regularly commutes to employment (or self-employment) in 

the United States from Canada or Mexico, (2) the individual is in transit between two points 

outside the United States and is physically present in the United States for less than 24 hours, or 

(3) the individual is temporarily present in the United States as a regular member of the crew of a 

foreign vessel engaged in transportation between the United States and a foreign country or U.S. 

possession. 

In addition, for purposes of the substantial presence test, any days that an individual is 

present in the United States as an "exempt individual" are not counted. Exempt individuals 

include certain foreign government-related individuals, teachers, trainees, students, and

professional athletes temporarily in the United States to compete in charitable sports events. In 

addition, the substantial presence test does not count days of presence in the United States of an 

individual who is physically unable to leave the United States because of a medical condition 

that arose while he or she was present in the United States. 

In some circumstances, an individual who meets the definition of a U.S. resident (as 

described above) could also be defined as a resident of another country under the internal laws of 

that country. In order to avoid the double taxation of such individuals, most income tax treaties 

include a set of “tie-breaker” rules to determine the individual’s country of residence for income 

tax purposes. For example, under these treaties a dual resident individual will be deemed to be a 

resident of the country in which he or she has a permanent home.

 

24 Presence for 122 days (or more) per year over the three-year period would be 

sufficient to trigger the substantial presence test.
28

Applicability of special capital gains tax

The special rule under section 871(a)(2) can apply only in a very limited set of cases. 

The rule imposes a 30-percent tax on the net U.S.-source capital gains of nonresident individuals 

who are not citizens and who are physically present in the United States for 183 days or more. 

Thus, in order for the rule to apply, two conditions must be satisfied: (1) the individual must 

spend at least 183 days in the United States during a taxable year without being treated as a U.S. 

resident, and (2) the individual’s capital gains must be from U.S. sources. If these conditions are 

satisfied, then the 30-percent tax applies to the excess of U.S.-source capital gains over U.S.-

source capital losses. However, section 871(a)(2) generally is not applicable because if the 

individual spends 183 days or more in the United States in most cases he or she would be treated 

as a U.S. resident, or if not treated as a U.S. resident, would generally not have U.S.-source 

capital gains.

An individual who is not a citizen and who spends 183 days or more in the United States 

during a calendar year generally would be treated as a U.S. resident under the substantial 

presence test of section 7701(b). Thus, in most cases, the individual who spends at least 183 

days in the United States would not be subject to section 871(a)(2). 25 However, under the 

substantial presence test under section 7701(b), certain days of physical presence in the United 

States are not counted for purposes of meeting the 183-day rule. This includes days spent in the 

United States in which the individual regularly commutes to employment (or self-employment) 

in the United States from Canada or Mexico; the individual is in transit between two points 

outside the United States and is physically present in the United States for less than 24 hours; the 

individual is temporarily present in the United States as a regular member of the crew of a 

foreign vessel engaged in transportation between the United States and a foreign country or U.S. 

possession; and certain exempt individuals. These exceptions from counting physical presence 

in the United States do not apply, however, for purposes of the special rule under section 

871(a)(2). Thus, it is possible in certain cases for an individual to be present in the United States 

for at least 183 days without being treated as a U.S. resident under the substantial presence test 

of section 7701(b).26 

 

25

 See the American Law Institute, Federal Income Tax Project, International Aspects of 

United States Income Taxation, Proposals of the American Law Institute on United States 

Taxation of Foreign Persons and of the Foreign Income of United States Persons, at 112-113 

(1987) (recommending that sec. 871(a)(2) be eliminated and stating “[u]nder Section 7701(b), 

enacted in 1984, an individual physically present in the U.S. for 183 days in a calendar year is 

considered a resident, taxable at net income rates on all of his income; and accordingly the 

justification for Section 871(a)(2) no longer exists.” [footnotes omitted]).

26 It should be noted that there also is a difference with respect to the year over which the 

183-day rule is measured for purposes of the substantial presence test and the rule under sec. 

871(a)(2). The sec. 871(a)(2) tax applies to 183 days or more of presence in the United States 

during the taxable year, while the substantial presence test under sec. 7701(b) applies to 183 days 

or more of presence in the United States during the calendar year. In most cases, however, a 

nonresident individual’s taxable year is his or her calendar year. Secs. 7701(b)(9) and 871(a)(2).
29

Even if an individual spends at least 183 days in the United States but is not treated as a 

U.S. resident under section 7701(b), the nonresident individual’s capital gains generally will be 

treated as foreign-source income and, thus, not subject to section 871(a)(2). In this regard, 

capital gains generally are from foreign sources if the individual is a nonresident, and from U.S. 

sources if the individual is a U.S. resident. Under a special rule, an individual is treated as a U.S. 

resident for sales of personal property (including sales giving rise to capital gains) if the 

individual has a tax home in the United States. This rule applies even if the individual is treated 

as a nonresident for other U.S. tax purposes. An individual’s capital gains would be treated as 

U.S.-source income and potentially subject to section 871(a)(2) if the individual is treated as a 

U.S. resident under this special rule.27

Even in the limited cases in which the special rule under section 871(a)(2) could 

potentially apply, a tax treaty might prevent its application. 28

Description of Proposal

The proposal repeals the special tax on certain capital gains of nonresident aliens under 

section 871(a)(2).

Effective Date

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

 

27 The individual’s income also could be treated as U.S.-source income under sec. 

865(e)(2) if the individual derives income from the sale of personal property that is attributable 

to an office or other fixed place of business that the individual maintains in the United States. 

However, sec. 871(a)(2) would not apply if the income is effectively connected with a U.S. trade 

or business, or if the sale qualifies for the exception from U.S.-source treatment as a result of a 

material participation in the sale by a foreign office of the taxpayer.

28 Under Article 13(5) of the U.S. model income tax treaty, subject to certain exceptions, 

the capital gains of a nonresident individual are exempt from U.S. taxation.
30

III. ADDITIONAL PROVISIONS

A. Proposals Designed to Curtail Tax Shelters

1. Clarification of the economic substance doctrine 

Present Law

In general

The Code provides specific rules regarding the computation of taxable income, including 

the amount, timing, source, and character of items of income, gain, loss and deduction. These 

rules are designed to provide for the computation of taxable income in a manner that provides for 

a degree of specificity to both taxpayers and the government. Taxpayers generally may plan 

their transactions in reliance on these rules to determine the federal income tax consequences 

arising from the transactions. 

In addition to the statutory provisions, courts have developed several doctrines that can 

be applied to deny the tax benefits of tax motivated transactions, notwithstanding that the 

transaction may satisfy the literal requirements of a specific tax provision. The common-law 

doctrines are not entirely distinguishable, and their application to a given set of facts is often 

blurred by the courts and the IRS. Although these doctrines serve an important role in the 

administration of the tax system, invocation of these doctrines can be seen as at odds with an 

objective, “rule-based” system of taxation. Nonetheless, courts have applied the doctrines to 

deny tax benefits arising from certain transactions.29 

A common-law doctrine applied with increasing frequency is the “economic substance” 

doctrine. In general, this doctrine denies tax benefits arising from transactions that do not result 

in a meaningful change to the taxpayer’s economic position other than a purported reduction in 

federal income tax. 30

Economic substance doctrine

Courts generally deny claimed tax benefits if the transaction that gives rise to those 

benefits lacks economic substance independent of tax considerations -- notwithstanding that the 

purported activity actually occurred. The tax court has described the doctrine as follows:

The tax law . . . requires that the intended transactions have economic substance 

separate and distinct from economic benefit achieved solely by tax reduction. 

 

29

 See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), aff’g 73 

T.C.M. (CCH) 2189 (1997), cert. denied 526 U.S. 1017 (1999).

30 Closely related doctrines also applied by the courts (sometimes interchangeable with 

the economic substance doctrine) include the “sham transaction doctrine” and the “business 

purpose doctrine”. See, e.g., Knetsch v. United States, 364 U.S. 361 (1960) (denying interest 

deductions on a “sham transaction” whose only purpose was to create the deductions).
31

The doctrine of economic substance becomes applicable, and a judicial remedy is 

warranted, where a taxpayer seeks to claim tax benefits, unintended by Congress, 

by means of transactions that serve no economic purpose other than tax savings.31

Business purpose doctrine

Another common law doctrine that overlays and is often considered together with (if not 

part and parcel of) the economic substance doctrine is the business purpose doctrine. The 

business purpose test is a subjective inquiry into the motives of the taxpayer -- that is, whether 

the taxpayer intended the transaction to serve some useful non-tax purpose. In making this 

determination, some courts have bifurcated a transaction in which independent activities with 

non-tax objectives have been combined with an unrelated item having only tax-avoidance 

objectives in order to disallow the tax benefits of the overall transaction. 32

Application by the courts

Elements of the doctrine

There is a lack of uniformity regarding the proper application of the economic substance 

doctrine. Some courts apply a conjunctive test that requires a taxpayer to establish the presence 

of both economic substance (i.e., the objective component) and business purpose (i.e., the 

subjective component) in order for the transaction to sustain court scrutiny. 33 A narrower 

approach used by some courts is to invoke the economic substance doctrine only after a 

determination that the transaction lacks both a business purpose and economic substance (i.e., the 

existence of either a business purpose or economic substance would be sufficient to respect the 

transaction).34 A third approach regards economic substance and business purpose as “simply 

 

31

 ACM Partnership v. Commissioner, 73 T.C.M. at 2215.

32

 ACM Partnership v. Commissioner, 157 F.3d at 256 n.48.

33

 See, e.g., Pasternak v. Commissioner, 990 F.2d 893, 898 (6th Cir. 1993) (“The 

threshold question is whether the transaction has economic substance. If the answer is yes, the 

question becomes whether the taxpayer was motivated by profit to participate in the 

transaction.”)

34

 See, e.g., Rice’s Toyota World v. Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985)

(“To treat a transaction as a sham, the court must find that the taxpayer was motivated by no 

business purposes other than obtaining tax benefits in entering the transaction, and, second, that 

the transaction has no economic substance because no reasonable possibility of a profit exists.”); 

IES Industries v. United States, 253 F.3d 350, 358 (8th Cir. 2001) (“In determining whether a 

transaction is a sham for tax purposes [under the Eighth Circuit test], a transaction will be 

characterized as a sham if it is not motivated by any economic purpose out of tax considerations 

(the business purpose test), and if it is without economic substance because no real potential for 

profit exists” (the economic substance test).”) As noted earlier, the economic substance doctrine 

and the sham transaction doctrine are similar and sometimes are applied interchangeably. For a 

more detailed discussion of the sham transaction doctrine, see, e.g., Joint Committee on 

Taxation, Study of Present-Law Penalty and Interest Provisions as Required by Section 3801 of 
32

more precise factors to consider” in determining whether a transaction has any practical 

economic effects other than the creation of tax benefits.35 

Profit potential

There also is a lack of uniformity regarding the necessity and level of profit potential 

necessary to establish economic substance. Since the time of Gregory, several courts have 

denied tax benefits on the grounds that the subject transactions lacked profit potential.36 In 

addition, some courts have applied the economic substance doctrine to disallow tax benefits in 

transactions in which a taxpayer was exposed to risk and the transaction had a profit potential, 

but the court concluded that the economic risks and profit potential were insignificant when 

compared to the tax benefits.37 Under this analysis, the taxpayer’s profit potential must be more 

than nominal. Conversely, other courts view the application of the economic substance doctrine 

as requiring an objective determination of whether a “reasonable possibility of profit” from the 

transaction existed apart from the tax benefits.38 In these cases, in assessing whether a 

reasonable possibility of profit exists, it is sufficient if there is a nominal amount of pre-tax profit 

as measured against expected net tax benefits.

 

the Internal Revenue Service Restructuring and Reform Act of 1998 (including Provisions 

Relating to Corporate Tax Shelters) (JCS-3-99) at 182.

35

 See, e.g., ACM Partnership v. Commissioner, 157 F.3d at 247; James v. 

Commissioner, 899 F.2d 905, 908 (10th Cir. 1995); Sacks v. Commissioner, 69 F.3d 982, 985 (9th

Cir. 1995) (“Instead, the consideration of business purpose and economic substance are simply 

more precise factors to consider... . We have repeatedly and carefully noted that this 

formulation cannot be used as a ‘rigid two-step analysis’.”).

36

 See, e.g., Knetsch, 364 U.S. at 361; Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 

1966) (holding that an unprofitable, leveraged acquisition of Treasury bills, and accompanying 

prepaid interest deduction, lacked economic substance); Ginsburg v. Commissioner, 35 T.C.M. 

(CCH) 860 (1976) (holding that a leveraged cattle-breeding program lacked economic 

substance).

37

 See, e.g., Goldstein v. Commissioner, 364 F.2d at 739-40 (disallowing deduction even 

though taxpayer had a possibility of small gain or loss by owning Treasury bills); Sheldon v. 

Commissioner, 94 T.C. 738, 768 (1990) (stating, “potential for gain . . . is infinitesimally 

nominal and vastly insignificant when considered in comparison with the claimed deductions”).

38

 See, e.g., Rice’s Toyota World v. Commissioner, 752 F.2d at 94 (the economic 

substance inquiry requires an objective determination of whether a reasonable possibility of 

profit from the transaction existed apart from tax benefits); Compaq Computer Corp. v. 

Commissioner, 277 F.3d at 781 (applied the same test, citing Rice’s Toyota World); IES 

Industries v. United States, 253 F.3d at 354 (the application of the objective economic substance 

test involves determining whether there was a “reasonable possibility of profit . . . apart from tax 

benefits.”). 
33

Description of Proposal

In general

The proposal clarifies and enhances the application of the economic substance doctrine. 

The proposal provides that, in a case in which a court determines that the economic substance 

doctrine is relevant to a transaction (or a series of transactions), such transaction (or series of 

transactions) has economic substance (and thus satisfies the economic substance doctrine) only if 

the taxpayer establishes that (1) the transaction changes in a meaningful way (apart from Federal 

income tax consequences) the taxpayer’s economic position, and (2) the taxpayer has a 

substantial non-tax purpose for entering into such transaction and the transaction is a reasonable 

means of accomplishing such purpose.39 

The proposal does not change current law standards used by courts in determining when 

to utilize an economic substance analysis.40 Also, the proposal does not alter the court's ability 

to aggregate or disaggregate a transaction when applying the doctrine. The proposal provides a

uniform definition of economic substance, but does not alter court flexibility in other respects.

Conjunctive analysis

The proposal clarifies that the economic substance doctrine involves a conjunctive 

analysis -- there must be an objective inquiry regarding the effects of the transaction on the 

taxpayer’s economic position, as well as a subjective inquiry regarding the taxpayer’s motives 

for engaging in the transaction. Under the proposal, a transaction must satisfy both tests -- i.e., it 

must change in a meaningful way (apart from Federal income tax consequences) the taxpayer’s 

economic position, and the taxpayer must have a substantial non-tax purpose for entering into 

such transaction (and the transaction is a reasonable means of accomplishing such purpose) -- in 

order to satisfy the economic substance doctrine. This clarification eliminates the disparity that 

exists among the circuits regarding the application of the doctrine, and modifies its application in 

those circuits in which either a change in economic position or a non-tax business purpose 

(without having both) is sufficient to satisfy the economic substance doctrine. 

Non-tax business purpose

The proposal provides that a taxpayer’s non-tax purpose for entering into a transaction 

(the second prong in the analysis) must be “substantial,” and that the transaction must be “a 

 

39 If the tax benefits are clearly contemplated and expected by the language and purpose 

of the relevant authority, it is not intended that such tax benefits be disallowed if the only reason 

for such disallowance is that the transaction fails the economic substance doctrine as defined in 

this proposal. 

40

 See, e.g., Treas. Reg. 1.269-2, stating that characteristic of circumstances in which a 

deduction otherwise allowed will be disallowed are those in which the effect of the deduction, 

credit, or other allowance would be to distort the liability of the particular taxpayer when the 

essential nature of the transaction or situation is examined in the light of the basic purpose or 

plan which the deduction, credit, or other allowance was designed by the Congress to effectuate.
34

reasonable means” of accomplishing such purpose. Under this formulation, the non-tax purpose 

for the transaction must bear a reasonable relationship to the taxpayer’s normal business 

operations or investment activities.41 

In determining whether a taxpayer has a substantial non-tax business purpose, an 

objective of achieving a favorable accounting treatment for financial reporting purposes will not 

be treated as having a substantial non-tax purpose.42 Furthermore, a transaction that is expected 

to increase financial accounting income as a result of generating tax deductions or losses without 

a corresponding financial accounting charge (i.e., a permanent book-tax difference)43 should not 

 

41

 See, e.g., Treas. reg. sec. 1.269-2(b) (stating that a distortion of tax liability indicating 

the principal purpose of tax evasion or avoidance might be evidenced by the fact that “the 

transaction was not undertaken for reasons germane to the conduct of the business of the 

taxpayer”). Similarly, in ACM Partnership v. Commissioner, 73 T.C.M. (CCH) 2189 (1997), the 

court stated:

Key to [the determination of whether a transaction has economic substance] is 

that the transaction must be rationally related to a useful nontax purpose that is 

plausible in light of the taxpayer’s conduct and useful in light of the taxpayer’s 

economic situation and intentions. Both the utility of the stated purpose and the 

rationality of the means chosen to effectuate it must be evaluated in accordance 

with commercial practices in the relevant industry. A rational relationship

between purpose and means ordinarily will not be found unless there was a

reasonable expectation that the nontax benefits would be at least commensurate 

with the transaction costs. [citations omitted]

See also Martin McMahon Jr., Economic Substance, Purposive Activity, and Corporate 

Tax Shelters, 94 Tax Notes 1017, 1023 (Feb. 25, 2002) (advocates “confining the most rigorous 

application of business purpose, economic substance, and purposive activity tests to transactions 

outside the ordinary course of the taxpayer’s business -- those transactions that do not appear to 

contribute to any business activity or objective that the taxpayer may have had apart from tax 

planning but are merely loss generators.”); Mark P. Gergen, The Common Knowledge of Tax 

Abuse, 54 SMU L. Rev. 131, 140 (Winter 2001) (“The message is that you can pick up tax gold 

if you find it in the street while going about your business, but you cannot go hunting for it.”).

42 However, if the tax benefits are clearly contemplated and expected by the language 

and purpose of the relevant authority, such tax benefits should not be disallowed solely because 

the transaction results in a favorable accounting treatment. An example is the repealed foreign 

sales corporation rules.

43 This includes tax deductions or losses that are anticipated to be recognized in a period 

subsequent to the period the financial accounting benefit is recognized. For example, FAS 109 

in some cases permits the recognition of financial accounting benefits prior to the period in 

which the tax benefits are recognized for income tax purposes.
35

be considered to have a substantial non-tax purpose unless a substantial non-tax purpose exists 

apart from the financial accounting benefits.44 

By requiring that a transaction be a “reasonable means” of accomplishing its non-tax 

purpose, the proposal reiterates the present-law ability of the courts to bifurcate a transaction in 

which independent activities with non-tax objectives are combined with an unrelated item having 

only tax-avoidance objectives in order to disallow the tax benefits of the overall transaction. 45

Profit potential

Under the proposal, a taxpayer may rely on factors other than profit potential to 

demonstrate that a transaction results in a meaningful change in the taxpayer’s economic 

position; the proposal merely sets forth a minimum threshold of profit potential if that test is 

relied on to demonstrate a meaningful change in economic position. If a taxpayer relies on a 

profit potential, however, the present value of the reasonably expected pre-tax profit must be 

substantial in relation to the present value of the expected net tax benefits that would be allowed 

if the transaction were respected.46 Moreover, the profit potential must exceed a risk-free rate of 

return. In addition, in determining pre-tax profit, fees and other transaction expenses and foreign 

taxes are treated as expenses.

In applying the profit potential test to a lessor of tangible property, depreciation, 

applicable tax credits (such as the rehabilitation tax credit and the low income housing tax 

credit), and any other deduction as provided in guidance by the Secretary are not taken into 

account in measuring tax benefits. 

Transactions with tax-indifferent parties

The proposal also provides special rules for transactions with tax-indifferent parties. For 

this purpose, a tax-indifferent party means any person or entity not subject to Federal income tax, 

or any person to whom an item would have no substantial impact on its income tax liability. 

Under these rules, the form of a financing transaction will not be respected if the present value of 

the tax deductions to be claimed is substantially in excess of the present value of the anticipated 

 

44 Claiming that a financial accounting benefit constitutes a substantial non-tax purpose 

fails to consider the origin of the accounting benefit (i.e., reduction of taxes) and significantly 

diminishes the purpose for having a substantial non-tax purpose requirement. See, e.g., 

American Electric Power, Inc. v. U.S., 136 F. Supp. 2d 762, 791-92 (S.D. Ohio, 2001) (“AEP’s 

intended use of the cash flows generated by the [corporate-owned life insurance] plan is 

irrelevant to the subjective prong of the economic substance analysis. If a legitimate business 

purpose for the use of the tax savings ‘were sufficient to breathe substance into a transaction 

whose only purpose was to reduce taxes, [then] every sham tax-shelter device might succeed,’” 

citing Winn-Dixie v. Commissioner, 113 T.C. 254, 287 (1999)). 

45

 See, e.g., ACM Partnership v. Commissioner, 157 F.3d at 256 n.48.

46 Thus, a “reasonable possibility of profit” will not be sufficient to establish that a 

transaction has economic substance.
36

economic returns to the lender. Also, the form of a transaction with a tax-indifferent party will 

not be respected if it results in an allocation of income or gain to the tax-indifferent party in 

excess of the tax-indifferent party’s economic gain or income or if the transaction results in the 

shifting of basis on account of overstating the income or gain of the tax-indifferent party.

Other rules

The Secretary may prescribe regulations which provide (1) exemptions from the 

application of this proposal, and (2) other rules as may be necessary or appropriate to carry out 

the purposes of the proposal. 

No inference is intended as to the proper application of the economic substance doctrine 

under present law. In addition, except with respect to the economic substance doctrine, the 

proposal shall not be construed as altering or supplanting any other common law doctrine 

(including the sham transaction doctrine), and this proposal shall be construed as being additive 

to any such other doctrine.

Effective Date

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

2. Penalty for failure to disclose reportable transactions 

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.47 

There are six categories of reportable transactions. The first category is any transaction 

that is the same as (or substantially similar to)48 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”).49 

 

47 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.

48 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).

49 Treas. Reg. sec. 1.6011-4(b)(2).
37

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).50 

The third category of reportable transactions is any transaction for which (1) the taxpayer 

has the right to a full or partial refund of fees if the intended tax consequences from the 

transaction are not sustained or, (2) the fees are contingent on the intended tax consequences 

from the transaction being sustained.51

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.52

The fifth category of reportable transactions refers to any transaction done by certain 

taxpayers53 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.54

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.55

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 

 

50 Treas. Reg. sec. 1.6011-4(b)(3).

51 Treas. Reg. sec. 1.6011-4(b)(4).

52 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.

53 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.

54 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. 

55 Treas. Reg. sec. 1.6011-4(b)(7).
38

tax understatement attributable to such undisclosed transaction is due to reasonable cause, and 

that the taxpayer acted in good faith. 56

Description of Proposal

In general

The proposal creates a new penalty for any person who fails to include with any return or 

statement any required information with respect to a reportable transaction. The new penalty 

applies without regard to whether the transaction ultimately results in an understatement of tax, 

and applies in addition to any accuracy-related penalty that may be imposed.

Transactions to be disclosed

The proposal does not define the terms “listed transaction” 57 or “reportable transaction,” 

nor does the proposal explain the type of information that must be disclosed in order to avoid the 

imposition of a penalty. Rather, the proposal authorizes the Treasury Department to define a 

“listed transaction” and a “reportable transaction” under section 6011. 

Penalty rate

The penalty for failing to disclose a reportable transaction is $50,000. The amount is 

increased to $100,000 if the failure is with respect to a listed transaction. For large entities and 

high net worth individuals, the penalty amount is doubled (i.e., $100,000 for a reportable 

transaction and $200,000 for a listed transaction). The penalty cannot be waived with respect to 

a listed transaction. As to reportable transactions, the penalty can be rescinded (or abated) only 

if: (1) the taxpayer on whom the penalty is imposed has a history of complying with the Federal 

tax laws, (2) it is shown that the violation is due to an unintentional mistake of fact, (3) imposing 

the penalty would be against equity and good conscience, and (4) rescinding the penalty would 

promote compliance with the tax laws and effective tax administration. The authority to rescind 

the penalty can only be exercised by the IRS Commissioner personally or the head of the Office 

of Tax Shelter Analysis. Thus, the penalty cannot be rescinded by a revenue agent, an Appeals 

officer, or any other IRS personnel. The decision to rescind a penalty must be accompanied by a 

 

56 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.

57 The proposal 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. 
39

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 proposal and the reasons for the rescission.

A “large entity” is defined as any entity with gross receipts in excess of $10 million in the 

year of the transaction or in the preceding year. A “high net worth individual” is defined as any 

individual whose net worth exceeds $2 million, based on the fair market value of the individual’s 

assets and liabilities immediately before entering into the transaction.

A public entity that is required to pay a penalty for failing to disclose a listed transaction 

(or is subject to an understatement penalty attributable to a non-disclosed listed transaction, a 

non-disclosed reportable avoidance transaction, 58 or a transaction that lacks economic substance) 

must disclose the imposition of the penalty in reports to the Securities and Exchange 

Commission for such period as the Secretary shall specify. The proposal applies without regard 

to whether the taxpayer determines the amount of the penalty to be material to the reports in 

which the penalty must appear, and treats any failure to disclose a transaction in such reports as a 

failure to disclose a listed transaction. A taxpayer must disclose a penalty in reports to the 

Securities and Exchange Commission once the taxpayer has exhausted its administrative and 

judicial remedies with respect to the penalty (or if earlier, when paid).

Effective Date

The proposal is effective for returns and statements the due date for which is after the 

date of enactment.

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

transactions having a significant tax avoidance purpose 

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. 59 

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 

 

58 A reportable avoidance transaction is a reportable transaction with a significant tax 

avoidance purpose. 

59 Sec. 6662.
40

treatment of the item were adequately disclosed and there was a reasonable basis for its tax 

treatme nt.60 

Special rules apply with respect to tax shelters.61 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. 62 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.63

Description of Proposal

In general

The proposal modifies the present-law accuracy related penalty by replacing the rules 

applicable to tax shelters with a new accuracy-related penalty that applies to listed transactions 

and reportable transactions with a significant tax avoidance purpose (hereinafter referred to as a 

“reportable avoidance transaction”).64 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 

 

60 Sec. 6662(d)(2)(B).

61 Sec. 6662(d)(2)(C).

62 Sec. 6664(c).

63 Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 1.6664-4(c).

64 The terms “reportable transaction” and “listed transaction” have the same meanings as 

used for purposes of the penalty for failing to disclose reportable transactions.
41

substantial authority for the claimed tax treatment, and the taxpayer reasonably believed that the 

claimed tax treatment was more likely than not the proper treatment.

Undisclosed transactions

If the taxpayer does not adequately disclose the transaction, the strengthened reasonable 

cause exception is not available (i.e., a strict-liability penalty applies), and the taxpayer is subject 

to an increased penalty rate equal to 30 percent of the understatement. 

In addition, a public entity that is required to pay the 30 percent penalty must disclose the 

imposition of the penalty in reports to the SEC for such periods as the Secretary shall specify. 

The disclosure to the SEC applies without regard to whether the taxpayer determines the amount 

of the penalty to be material to the reports in which the penalty must appear, and any failure to 

disclose such penalty in the reports is treated as a failure to disclose a listed transaction. A 

taxpayer must disclose a penalty in reports to the SEC once the taxpayer has exhausted its 

administrative and judicial remedies with respect to the penalty (or if earlier, when paid).

Once the 30 percent penalty has been included in the Revenue Agent Report, the penalty 

cannot be compromised for purposes of a settlement without approval of the Commissioner 

personally or the head of the Office of Tax Shelter Analysis. Furthermore, the IRS is required to 

submit an annual report to Congress summarizing the application of this penalty and providing a 

description of each penalty compromised under this proposal and the reasons for the 

compromise. 

Determination of the understatement amount

The penalty is applied to the amount of any understatement attributable to the listed or 

reportable avoidance transaction without regard to other items on the tax return. For purposes of 

this proposal, the amount of the understatement is determined as the sum of (1) the product of the 

highest corporate or individual tax rate (as appropriate) and the increase in taxable income 

resulting from the difference between the taxpayer’s treatment of the item and the proper 

treatment of the item (without regard to other items on the tax return) 65, 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. 

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.

 

65 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.
42

Strengthened reasonable cause exception

A penalty is not imposed under the proposal with respect to any portion of an 

understatement if it shown that there was reasonable cause for such portion and the taxpayer 

acted in good faith. Such a showing requires (1) adequate disclosure of the facts affecting the 

transaction in accordance with the regulations under section 6011,66 (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 advisor67 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 indirectly68 by a material advisor with respect to the transaction, (3) has 

a fee arrangement with respect to the transaction that is contingent on all or part of the intended 

tax benefits from the transaction being sustained, or (4) as determined under regulations 

prescribed by the Secretary, has a disqualifying financial interest with respect to the transaction. 

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 

 

66

 See the previous discussion regarding the penalty for failing to disclose a reportable 

transaction.

67 The term “material advisor” (defined below in connection with the new information 

filing requirements for material advisors) means any person who provides any material aid, 

assistance, or advice with respect to organizing, promoting, selling, implementing, or carrying 

out any reportable transaction, and who derives gross income in excess of $50,000 in the case of 

a reportable transaction substantially all of the tax benefits from which are provided to natural 

persons ($250,000 in any other case). 

68 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. 
43

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. 69 Participation in the 

“management” of a transaction means involvement in the decision-making process regarding any 

business activity with respect to the transaction. Participation in the “promotion or sale” of a 

transaction means involvement in the marketing or solicitation of the transaction to others. Thus, 

an advisor who provides information about the transaction to a potential participant is involved 

in the promotion or sale of a transaction, as is any advisor who recommends the transaction to a 

potential participant. 

Disqualified opinion

An opinion may not be relied upon if the opinion (1) is based on unreasonable factual or 

legal assumptions (including assumptions as to future events), (2) unreasonably relies upon 

representations, statements, finding or agreements of the taxpayer or any other person, (3) does 

not identify and consider all relevant facts, or (4) fails to meet any other requirement prescribed 

by the Secretary.

Coordination with other penalties

Any understatement upon which a penalty is imposed under this proposal is not subject to 

the accuracy-related penalty under section 6662. However, such understatement is included for 

purposes of determining whether any understatement (as defined in sec. 6662(d)(2)) is a 

substantial understatement as defined under section 6662(d)(1).

The penalty imposed under this proposal shall not apply to any portion of an 

understatement to which a fraud penalty is applied under section 6663.

Effective Date

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

4. Penalty for understatements from transactions lacking economic substance 

Present Law

An accuracy-related penalty applies to the portion of any underpayment that is 

attributable to (1) negligence, (2) any substantial understatement of income tax, (3) any 

 

69 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). 
44

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. 70 

The amount of any understatement is reduced by any portion attributable to an item if (1) the 

treatment of the item is supported by substantial authority, or (2) facts relevant to the tax 

treatment of the item were adequately disclosed and there was a reasonable basis for its tax 

treatment. 

Special rules apply with respect to tax shelters.71 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 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. 72 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.73

Description of Proposal

The proposal imposes a penalty for an understatement attributable to any transaction that 

lacks economic substance (referred to in the statute as a “non-economic substance transaction 

understatement”).74 The penalty rate is 40 percent (reduced to 20 percent if the taxpayer 

adequately discloses the relevant facts in accordance with regulations prescribed under section 

6011). No exceptions (including the reasonable cause or rescission rules) to the penalty would 

be available under the proposal (i.e., the penalty is a strict-liability penalty).

A “non-economic substance transaction” means any transaction if (1) the transaction 

lacks economic substance (as defined in the earlier proposal regarding the economic substance 

 

70 Sec. 6662.

71 Sec. 6662(d)(2)(C).

72 Sec. 6664(c).

73 Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 1.6664-4(c).

74 Thus, unlike the new accuracy-related penalty under section 6662A (which applies 

only to listed and reportable avoidance transactions), the new penalty under this proposal applies 

to any transaction that lacks economic substance.
45

doctrine),75 (2) the transaction was not respected under the rules relating to transactions with taxindifferent parties (as described in the earlier proposal regarding the economic substance 

doctrine),76 or (3) any similar rule of law. For this purpose, a similar rule of law would include, 

for example, an understatement attributable to a transaction that is determined to be a sham 

transaction.

For purposes of this proposal, the calculation of an “understatement” is made in the same 

manner as in the separate proposal relating to accuracy-related penalties for listed and reportable 

avoidance transactions (new sec. 6662A). Thus, the amount of the understatement under this 

proposal would be determined as the sum of (1) the product of the highest corporate or individual 

tax rate (as appropriate) and the increase in taxable income resulting from the difference between 

the taxpayer’s treatment of the item and the proper treatment of the item (without regard to other 

items on the tax return), 77 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 

treatme nt of such item. In essence, the penalty will apply to the amount of any understatement 

attributable solely to a non-economic substance transaction.

 Except as provided in regulations, the taxpayer’s treatment of an item will not take into 

account any ame ndment or supplement to a return if the amendment or supplement is filed after 

the earlier of the date the taxpayer is first contacted regarding an examination of such return or 

such other date as specified by the Secretary. 

A public entity that is required to pay a penalty under this proposal (regardless of whether 

the transaction was disclosed) must disclose the imposition of the penalty in reports to the SEC 

for such periods as the Secretary shall specify. The disclosure to the SEC applies without regard 

to whether the taxpayer determines the amount of the penalty to be material to the reports in 

which the penalty must appear, and any failure to disclose such penalty in the reports is treated as 

a failure to disclose a listed transaction. A taxpayer must disclose a penalty in reports to the SEC 

once the taxpayer has exhausted its administrative and judicial remedies with respect to the 

penalty (or if earlier, when paid). 

Prior to this penalty being asserted in the first letter of proposed deficiency that allows 

the taxpayer an opportunity for administrative review in the IRS Office of Appeals (e.g., a 

 

75 The proposal provides that a transaction has economic substance only if: (1) the 

transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s 

economic position, and (2) the transaction has a substantial non-tax purpose for entering into 

such transaction and is a reasonable means of accomplishing such purpose.

76 The proposal provides that the form of a transaction that involves a tax-indifferent 

party will not be respected in certain circumstances.

77 For this purpose, any reduction in the excess of deductions allowed for the taxable 

year over gross income for such year, and any reduction in the amount of capital losses that 

would (without regard to section 1211) be allowed for such year, would be treated as an increase 

in taxable income.
46

Revenue Agent Report), the IRS Chief Counsel or his delegate at the IRS National Office must 

approve the inclusion in writing. Once a penalty (regardless of whether the transaction was 

disclosed) has been included in the Revenue Agent Report, the penalty cannot be compromised 

for purposes of a settlement without approval of the Commissioner personally or the head of the 

Office of Tax Shelter Analysis. Furthermore, the IRS is required to submit an annual report to 

Congress summarizing the application of this penalty and providing a description of each penalty 

compromised under this proposal and the reasons for the compromise.

Any understatement to which a penalty is imposed under this proposal will not be subject 

to the accuracy-related penalty under section 6662 or under new 6662A (accuracy-related 

penalties for listed and reportable avoidance transactions). However, an understatement under 

this proposal would be taken into account for purposes of determining whether any 

understatement (as defined in sec. 6662(d)(2)) is a substantial understatement as defined under 

section 6662(d)(1). The penalty imposed under this proposal will not apply to any portion of an 

understatement to which a fraud penalty is applied under section 6663.

Effective Date

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

5. Modifications to the substantial understatement penalty 

Present Law

Definition of substantial understatement

An accuracy-related penalty equal to 20 percent applies to any substantial understatement 

of tax. A “substantial understatement” exists if the correct income tax liability for a taxable year 

exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 

($10,000 in the case of most corporations).78 

Reduction of understatement for certain positions

For purposes of determining whether a substantial understatement penalty applies, the 

amount of any understatement generally is reduced by any portion attributable to an item if (1) 

the treatment of the item is supported by substantial authority, or (2) facts relevant to the tax 

treatment of the item were adequately disclosed and there was a reasonable basis for its tax 

treatment. 79

 

78 Sec. 6662(a) and (d)(1)(A).

79 Sec. 6662(d)(2)(B).
47

The Secretary is required to publish annually in the Federal Register a list of positions for 

which the Secretary believes there is not substantial authority and which affect a significant 

number of taxpayers.80

Description of Proposal

Definition of substantial understatement

The proposal modifies the definition of “substantial” for corporate taxpayers. Under the 

proposal, a corporate taxpayer has a substantial understatement if the amount of the 

understatement for the taxable year exceeds the lesser of (1) 10 percent of the tax required to be 

shown on the return for the taxable year (or, if greater, $10,000), or (2) $10 million.

Reduction of understatement for certain positions

The proposal elevates the standard that a taxpayer must satisfy in order to reduce the 

amount of an understatement for undisclosed items. With respect to the treatment of an item 

whose facts are not adequately disclosed, a resulting understatement is reduced only if the 

taxpayer had a reasonable belief that the tax treatment was more likely than not the proper 

treatment. The proposal also authorizes (but does not require) the Secretary to publish a list of 

positions for which it believes there is not substantial authority or there is no reasonable belief 

that the tax treatment is more likely than not the proper treatment (without regard to whether 

such positions affect a significant number of taxpayers). The list shall be published in the 

Federal Register or the Internal Revenue Bulletin.

Effective Date

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

6. Tax shelter exception to confidentiality privileges relating to taxpayer communications 

Present Law

In general, a common law privilege of confidentiality exists for communications between 

an attorney and client with respect to the legal advice the attorney gives the client. The Code 

provides that, with respect to tax advice, the same common law protections of confidentiality that 

apply to a communication between a taxpayer and an attorney also apply to a communication 

between a taxpayer and a federally authorized tax practitioner to the extent the communication 

would be considered a privileged communication if it were between a taxpayer and an attorney. 

This rule is inapplicable to communications regarding corporate tax shelters.

Description of Proposal

The proposal modifies the rule relating to corporate tax shelters by making it applicable 

to all tax shelters, whether entered into by corporations, individuals, partnerships, tax-exempt 

 

80 Sec. 6662(d)(2)(D).
48

entities, or any other entity. Accordingly, communications with respect to tax shelters are not 

subject to the confidentiality proposal of the Code that otherwise applies to a communication 

between a taxpayer and a federally authorized tax practitioner.

Effective Date

The proposal is effective with respect to communications made on or after the date of 

enactment.

7. Disclosure of reportable transactions by material advisors 

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.81 A “tax shelter” means any investment 

with respect to which the tax shelter ratio82 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).83

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.84

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,”85 or (2) 

is structured to produce tax benefits that constitute an important part of the intended results of the 

 

81 Sec. 6111(a).

82 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.

83 Sec. 6111(c).

84 Sec. 6111(d).

85 Treas. Reg. sec. 301.6111-2(b)(2).
49

arrangement and the promoter reasonably expects to present the arrangement to more than one 

taxpayer.86 Certain exceptions are provided with respect to the second category of transactions.87

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.88 

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 $500.89 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.

Description of Proposal

Disclosure of reportable transactions by material advisors

The proposal repeals the present law rules with respect to registration of tax shelters. 

Instead, the proposal requires each material advisor with respect to any reportable transaction 

(including any listed transaction) 90 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. 

 

86 Treas. Reg. sec. 301.6111-2(b)(3).

87 Treas. Reg. sec. 301.6111-2(b)(4).

88 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).

89 Sec. 6707.

90 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related proposals.
50

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. 91

A “material advisor” means any person (1) who provides material aid, assistance, or 

advice with respect to organizing, promoting, selling, implementing, or carrying out any 

reportable transaction, and (2) who directly or indirectly derives gross income in excess of 

$250,000 ($50,000 in the case of a reportable transaction substantially all of the tax benefits from 

which are provided to natural persons) for such advice or assistance.

The Secretary may prescribe regulations which provide (1) that only one material advisor 

has to file an information return in cases in which two or more material advisors would otherwise 

be required to file information returns with respect to a particular reportable transaction, (2) 

exemptions from the requirements of this section, and (3) other rules as may be necessary or 

appropriate to carry out the purposes of this section (including, for example, rules regarding the 

aggregation of fees in appropriate circumstances).

Penalty for failing to furnish information regarding reportable transactions

The proposal repeals the present law penalty for failure to register tax shelters. Instead, 

the proposal imposes a penalty on any material advisor who fails to file an information return, or 

who files a false or incomplete information return, with respect to a reportable transaction 

(including a listed transaction).92 The amount of the penalty is $50,000. If the penalty is with 

respect to a listed transaction, the amount of the penalty is increased to the greater of (1) 

$200,000, or (2) 50 percent of the gross income of such person with respect to aid, assistance, or 

advice which is provided with respect to the transaction before the date the information return 

that includes the transaction is filed. Intentional disregard by a material advisor of the 

requirement to disclose a listed transaction increases the penalty to 75 percent of the gross 

income. 

The penalty cannot be waived with respect to a listed transaction. As to reportable 

transactions, the penalty can be rescinded (or abated) only in exceptional circumstances.93 All or 

part of the penalty may be rescinded only if: (1) the material advisor on whom the penalty is 

imposed has a history of complying with the Federal tax laws, (2) it is shown that the violation is 

due to an unintentional mistake of fact, (3) imposing the penalty would be against equity and 

 

91

 See the previous discussion regarding the disclosure requirements under new section 

6707A.

92 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related proposals.

93 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 proposal.
51

good conscience, and (4) rescinding the penalty would promote compliance with the tax laws 

and effective tax administration. The authority to rescind the penalty can only be exercised by 

the Commissioner personally or the head of the Office of Tax Shelter Analysis; this authority to 

rescind cannot otherwise be delegated by the Commissioner. Thus, a revenue agent, an Appeals 

officer, or other IRS personnel cannot rescind the penalty. The decision to rescind a penalty 

must be accompanied by a record describing the facts and reasons for the action and the amount 

rescinded. There will be no right to appeal a refusal to rescind a penalty. The IRS also is 

required to submit an annual report to Congress summarizing the application of the disclosure 

penalties and providing a description of each penalty rescinded under this proposal and the 

reasons for the rescission.

Effective Date

The proposal requiring disclosure of reportable transactions by material advisors applies 

to transactions with respect to which material aid, assistance or advice is provided after the date 

of enactment.

The proposal imposing a penalty for failing to disclose reportable transactions applies to 

returns the due date for which is after the date of enactment.

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

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).94 Recently issued regulations under section 6112 contain rules 

regarding the list maintenance requirements.

95 In general, the regulations apply to transactions 

that are potentially abusive tax shelters entered into, or acquired after, February 28, 2003.96

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. 97 A material advisor is 

defined any person who is required to register the transaction under section 6111, or expects to 

receive a minimum fee of (1) $250,000 for a transaction that is a potentially abusive tax shelter if 

 

94 Sec. 6112.

95 Treas. Reg. sec. 301-6112-1.

96 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.

97 Treas. Reg. sec. 301.6112-1(c)(1).
52

all participants are corporations, or (2) $50,000 for any other transaction that is a potentially 

abusive tax shelter.98 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).99 

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.100

Penalty for failing to maintain investor lists

Under section 6708, the penalty for failing to maintain the list required under section 

6112 is $50 for each name omitted from the list (with a maximum penalty of $100,000 per year). 

Description of Proposal

Investor lists

Each material advisor101 with respect to a reportable transaction (including a listed 

transaction)102 is required to maintain a list that (1) identifies each person with respect to whom 

the advisor acted as a material advisor with respect to the reportable transaction, and (2) contains 

other information as may be required by the Secretary. In addition, the proposal authorizes (but 

does not require) the Secretary to prescribe regulations which provide that, in cases in which 2 or 

more persons are required to maintain the same list, only one person would be required to 

maintain the list.

The proposal also clarifies that, for purposes of section 6112, the identity of any person is 

not privileged under the common law attorney-client privilege (or, consequently, the section 

7525 federally authorized tax practitioner confidentiality provision).

 

98 Treas. Reg. sec. 301.6112-1(c)(2) and (3).

99 Treas. Reg. sec. 301.6112-1(b).

100 Sec. 6112(c)(2).

101 The term “material advisor” has the same meaning as when used in connection with 

the requirement to file an information return under section 6111.

102 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related proposals.
53

Penalty for failing to maintain investor lists

The proposal modifies the penalty for failing to maintain the required list by making it a 

time-sensitive penalty. Thus, a material advisor who is required to maintain an investor list and 

who fails to make the list available upon written request by the Secretary within 20 business days 

after the request will be subject to a $10,000 per day penalty. The penalty applies to a person 

who fails to maintain a list, maintains an incomplete list, or has in fact maintained a list but does 

not make the list available to the Secretary. The penalty can be waived if the failure to make the 

list available is due to reasonable cause.103

Effective Date

The proposal requiring a material advisor to maintain an investor list applies to 

transactions with respect to which material aid, assistance or advice is provided after the date of 

enactment.

The proposal imposing a penalty for failing to maintain investor lists applies to requests 

made after the date of enactment. 

The proposal clarifying that the identity of any person is not privileged for purposes of 

section 6112 is effective as if included in the amendments made by section 142 of the Deficit 

Reduction Act of 1984.

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

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. 104

Description of Proposal

The proposal expands this rule so that injunctions may also be sought with respect to the 

requirements relating to the reporting of reportable transactions 105 and the keeping of lists of 

investors by material advisors.106 Thus, under the proposal, an injunction may be sought against 

a material advisor to enjoin the advisor from (1) failing to file an information return with respect 

to a reportable transaction, or (2) failing to maintain, or to timely furnish upon written request by 

the Secretary, a list of investors with respect to each reportable transaction.

 

103 In no event will failure to maintain a list be considered reasonable cause for failing to 

make a list available to the Secretary.

104 Sec. 7408.

105 Sec. 6707, as amended by other proposals of this bill.

106 Sec. 6708, as amended by other proposals of this bill.
54

Effective Date

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

10. Understatement of taxpayer’s liability by income tax return preparer 

Present Law

An income tax return preparer who prepares a return with respect to which there is an 

understatement of tax that is due to a position for which there was not a realistic possibility of 

being sustained on its merits and the position was not disclosed (or was frivolous) is liable for a 

penalty of $250, provided that the preparer knew or reasonably should have known of the 

position. An income tax return preparer who prepares a return and engages in specified willful 

or reckless conduct with respect to preparing such a return is liable for a penalty of $1,000.

Description of Proposal

The proposal alters the standards of conduct that must be met to avoid imposition of the 

first penalty. The proposal replaces the realistic possibility standard with a requirement that 

there be a reasonable belief that the tax treatment of the position was more likely than not the 

proper treatment. The proposal also replaces the not frivolous standard with the requirement that 

there be a reasonable basis for the tax treatment of the position. 

In addition, the proposal increases the amount of these penalties. The penalty relating to 

not having a reasonable belief that the tax treatment was more likely than not the proper tax 

treatment is increased from $250 to $1,000. The penalty relating to willful or reckless conduct is 

increased from $1,000 to $5,000.

Effective Date

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

11. Penalty for failure to report interests in foreign financial accounts 

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. 107 In general, individuals must fulfill this 

requirement by answering questions regarding foreign accounts or foreign trusts that are 

contained in Part III of Schedule B of the IRS Form 1040. Taxpayers who answer “yes” in 

response to the question regarding foreign accounts must then file Treasury Department Form 

TD F 90-22.1. This form must be filed with the Department of the Treasury, and not as part of 

the tax return that is filed with the IRS.

 

107 31 U.S.C. 5314.
55

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 

$25,000.108 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.109

On April 26, 2002, the Secretary of the Treasury submitted to the Congress a report on 

these reporting requirements.110 This report, which was statutorily required,111 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.

Description of Proposal

The proposal adds an additional civil penalty that may be imposed on any person who 

violates this reporting requirement (without regard to willfulness). This new civil penalty is up 

to $5,000. The penalty may be waived if any income from the account was properly reported on 

the income tax return and there was reasonable cause for the failure to report.

Effective Date

The proposal is effective with respect to failures to report occurring on or after the date of 

enactment.

12. Frivolous tax returns and submissions 

Present Law

The Code provides that an individual who files a frivolous income tax return is subject to 

a penalty of $500 imposed by the IRS (sec. 6702). The Code also permits the Tax Court112 to 

 

108 31 U.S.C. 5321(a)(5).

109 31 U.S.C. 5322.

110

 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.

111 Sec. 361(b) of the USA PATRIOT Act of 2001 (Pub. L. 107-56).

112 Because in general the Tax Court is the only pre-payment forum available to 

taxpayers, it deals with most of the frivolous, groundless, or dilatory arguments raised in tax 

cases.
56

impose a penalty of up to $25,000 if a taxpayer has instituted or maintained proceedings 

primarily for delay or if the taxpayer’s position in the proceeding is frivolous or groundless (sec. 

6673(a)).

Description of Proposal

The proposal modifies the IRS-imposed penalty by increasing the amount of the penalty 

to up to $5,000 and by applying it to all taxpayers and to all types of Federal taxes.

The proposal also modifies present law with respect to certain submissions that raise 

frivolous arguments or that are intended to delay or impede tax administration. The submissions 

to which this proposal applies are requests for a collection due process hearing, installment 

agreements, offers-in-compromise, and taxpayer assistance orders. First, the proposal permits 

the IRS to dismiss such requests. Second, the proposal permits the IRS to impose a penalty of up 

to $5,000 for such requests, unless the taxpayer withdraws the request after being given an 

opportunity to do so.

The proposal requires the IRS to publish a list of positions, arguments, requests, and 

submissions determined to be frivolous for purposes of these proposals.

Effective Date

The proposal is effective for submissions made and issues raised after the date on which 

the Secretary first prescribes the required list.

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

Present Law

The Secretary of the Treasury is authorized to regulate the practice of representatives of 

persons before the Department of the Treasury. 113 The Secretary is also authorized to suspend or 

disbar from practice before the Department a representative who is incompetent, who is 

disreputable, who violates the rules regulating practice before the Department, or who (with 

intent to defraud) willfully and knowingly misleads or threatens the person being represented (or 

a person who may be represented). The rules promulgated by the Secretary pursuant to this 

provision are contained in Circular 230.

Description of Proposal

The proposal makes two modifications to expand the sanctions that the Secretary may 

impose pursuant to these statutory provisions. First, the proposal expressly permits censure as a 

sanction. Second, the proposal permits the imposition of a monetary penalty as a sanction. If the 

representative is acting on behalf of an employer or other entity, the Secretary may impose a 

monetary penalty on the employer or other entity if it knew, or reasonably should have known, of 

the conduct. This monetary penalty on the employer or other entity may be imposed in addition 

 

113 31 U.S.C. 330.
57

to any monetary penalty imposed directly on the representative. These monetary penalties are 

not to exceed the gross income derived (or to be derived) from the conduct giving rise to the 

penalty. These monetary penalties may be in addition to, or in lieu of, any suspension, 

disbarment, or censure.

The proposal also confirms the present-law authority of the Secretary to impose standards 

applicable to written advice with respect to an entity, plan, or arrangement that is of a type that 

the Secretary determines as having a potential for tax avoidance or evasion.

Effective Date

The modifications to expand the sanctions that the Secretary may impose are effective for 

actions taken after the date of enactment.

14. Penalties on promoters of tax shelters 

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. 114 A qualified false or fraudulent statement is any statement with respect to the 

allowability of any deduction or credit, the excludability of any income, or the securing of any 

other tax benefit by reason of holding an interest in the entity or participating in the plan or 

arrangement which the person knows or has reason to know is false or fraudulent as to any 

material matter. A “gross valuation overstatement” means any statement as to the value of any 

property or services if the stated value exceeds 200 percent of the correct valuation, and the 

value is directly related to the amount of any allowable income tax deduction or credit.

The amount of the penalty is $1,000 (or, if the person establishes that it is less, 100 

percent of the gross income derived or to be derived by the person from such activity). A 

penalty attributable to a gross valuation misstatement can be waived on a showing that there was 

a reasonable basis for the valuation and it was made in good faith.

Description of Proposal

The proposal modifies the penalty amount to equal 50 percent of the gross income 

derived by the person from the activity for which the penalty is imposed. The new penalty rate 

applies to any activity that involves a statement regarding the tax benefits of participating in a 

plan or arrangement if the person knows or has reason to know that such statement is false or 

fraudulent as to any material matter. The enhanced penalty does not apply to a gross valuation 

overstatement.

 

114 Sec. 6700.
58

Effective Date

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

15. Extend statute of limitations for certain undisclosed transactions 

Present Law

In general, the Code requires that taxes be assessed within three years115 after the date a 

return is filed.116 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.117 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.118

Description of Proposal

The proposal extends the statute of limitations with respect to a listed transaction if a 

taxpayer fails to include on any return or statement for any taxable year any information with 

respect to a listed transaction119 which is required to be included (under section 6011) with such 

return or statement. The statute of limitations with respect to such a transaction will not expire 

before the date which is one year after the earlier of (1) the date on which the Secretary is 

furnished the information so required, or (2) the date that a material advisor (as defined in 6111) 

satisfies the list maintenance requirements (as defined by section 6112) with respect to a request 

by the Secretary. For example, if a taxpayer engaged in a transaction in 2005 that becomes a 

listed transaction in 2007 and the taxpayer fails to disclose such transaction in the manner 

required by Treasury regulations, then the transaction is subject to the extended statute of 

limitations.120

 

115 Sec. 6501(a).

116 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)).

117 Sec. 6501(e).

118 Sec. 6501(c).

119 The term “listed transaction” has the same meaning as described in a previous 

provision regarding the penalty for failure to disclose reportable transactions.

120 If the Treasury Department lists a transaction in a year subsequent to the year in 

which a taxpayer entered into such transaction and the taxpayer’s tax return for the year the 

transaction was entered into is closed by the statute of limitations prior to the date the transaction 

became a listed transaction, this proposal does not re-open the statute of limitations with respect 

to such transaction for such year. However, if the purported tax benefits of the transaction are 
59

Effective Date

The proposal is effective for taxable years with respect to which the period for assessing 

a deficiency did not expire before October 1, 2003. 

16. Deny deduction for interest paid to IRS on underpayments involving certain 

tax-motivated transactions

Present Law

In general, corporations may deduct interest paid or accrued within a taxable year on 

indebtedness.121 Interest on indebtedness to the Federal government attributable to an 

underpayment of tax generally may be deducted pursuant to this provision. 

Description of Proposal

The proposal disallows any deduction for interest paid or accrued within a taxable year 

on any portion of an underpayment of tax that is attributable to an understatement arising from 

(1) an undisclosed reportable avoidance transaction, (2) an undisclosed listed transaction, or (3) a 

transaction that lacks economic substance.122

Effective Date

The proposal is effective for underpayments attributable to transactions entered into in 

taxable years beginning after the date of enactment. 

17. Authorize additional $300 million per year to the IRS to combat abusive tax avoidance 

transactions

Present Law

There is no explicit authorization of appropriations to the Internal Revenue Service to be 

used to combat abusive tax avoidance transactions.

 

recognized over multiple tax years, the proposal’s extension of the statute of limitations shall 

apply to such tax benefits in any subsequent tax year in which the statute of limitations had not 

closed prior to the date the transaction became a listed transaction.

121 Sec. 163(a). 

122 The definitions of these transactions are the same as those previously described in 

connection with the proposal to modify the accuracy-related penalty for listed and certain 

reportable transactions and the proposal to impose a penalty on understatements attributable to 

transactions that lack economic substance.
60

Description of Proposal

The proposal includes an authorization of an additional $300 million to the Internal 

Revenue Service to be used to combat abusive tax avoidance transactions.

Effective Date

The proposal is effective on the date of enactment.
61

B. Other Corporate Governance Proposals

1. Affirmation of consolidated return regulation authority 

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. 123 

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.124

Under this authority, the Treasury Department has issued extensive consolidated return 

regulations.125

In the recent case of Rite Aid Corp. v. United States,126 the Federal Circuit Court of 

Appeals addressed the application of a particular provision of certain consolidated return loss 

 

123 Sec. 1501.

124 Sec. 1502. 

125 Regulations issued under the authority of section 1502 are considered to be 

“legislative” regulations rather than “interpretative” regulations, and as such are usually given 

greater deference by courts in case of a taxpayer challenge to such a regulation. See, S. Rep. No. 

960, 70th Cong., 1st Sess. at 15 (1928), describing the consolidated return regulations as 

“legislative in character”. The Supreme Court has stated that “. . . legislative regulations are 

given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the 

statute.” Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 844 

(1984) (involving an environmental protection regulation). For examples involving consolidated 

return regulations, see, e.g., Wolter Construction Company v. Commissioner, 634 F.2d 1029 (6th

Cir. 1980); Garvey, Inc. v. United States, 1 Ct. Cl. 108 (1983), aff’d 726 F.2d 1569 (Fed. Cir. 

1984), cert. denied, 469 U.S. 823 (1984). Compare, e.g., Audrey J. Walton v. Commissioner, 115 

T.C. 589 (2000), describing different standards of review. The case did not involve a 

consolidated return regulation. 

126 255 F.3d 1357 (Fed. Cir. 2001), reh’g denied, 2001 U.S. App. LEXIS 23207 (Fed. 

Cir. Oct. 3, 2001).
62

disallowance regulations, and concluded that the provision was invalid.127 The particular 

provision, known as the “duplicated loss” provision,128 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.129 

 

127 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.” 

128 Treas. Reg. Sec. 1.1502-20(c)(1)(iii).

129 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 

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 
63

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.130 

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.”131 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.” 132

 

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. 

130 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).

131 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). 

132

 American Standard, Inc. v. United States, 602 F.2d 256, 261 (Ct. Cl. 1979). That 

case did not involve the question of separate returns as compared to a single return approach. It 

involved the computation of a Western Hemisphere Trade Corporation (“WHTC”) deduction 

under prior law (which deduction would have been computed as a percentage of each WHTC’s 

taxable income if the corporations had filed separate returns), in a case where a consolidated 

group included several WHTCs as well as other corporations. The question was how to 

apportion income and losses of the admittedly consolidated WHTCs and how to combine that 

computation with the rest of the group’s consolidated income or losses. The court noted that the 

new, changed regulations approach varied from the approach taken to a similar problem 

involving public utilities within a group and previously allowed for WHTCs. The court objected 

that the allocation method adopted by the regulation allowed non-WHTC losses to reduce 

WHTC income. However, the court did not disallow a method that would net WHTC income of 

one WHTC with losses of another WHTC, a result that would not have occurred under separate 
64

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. 165.133

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. 134

Description of Proposal

The proposal 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 

 

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. 

133

 Rite Aid, 255 F.3d at 1360.

134

 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). 
65

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 proposal 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 subsidiary135 to the extent the subsidiary 

had net operating losses or built in losses that could be used later outside the group.136

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.137

Effective Date

The proposal 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 the proposal 

are not the same as the results under present law.

 

135 Treas. Reg. Sec. 1.1502-20(c)(1)(iii).

136 The proposal 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). 

137

 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.
66

2. Chief executive officer required to sign declaration as part of corporate income tax 

return 

Present Law

The Code requires138 that the income tax return of a corporation must be signed by either 

the president, the vice-president, the treasurer, the assistant treasurer, the chief accounting 

officer, or any other officer of the corporation authorized by the corporation to sign the return.

The Code also imposes139 a criminal penalty on any person who willfully signs any tax 

return under penalties of perjury that that person does not believe to be true and correct with 

respect to every material matter at the time of filing. If convicted, the person is guilty of a 

felony; the Code imposes a fine of not more than $100,000140 ($500,000 in the case of a 

corporation) or imprisonment of not more than three years, or both, together with the costs of 

prosecution.

Description of Proposal

The proposal requires that the chief executive officer of a corporation sign a declaration 

under penalties of perjury that the corporation’s income tax return complies with the Internal 

Revenue Code and that the CEO was provided reasonable assurance of the accuracy of all 

material aspects of the return. This declaration is part of the income tax return. The proposal is 

in addition to the requirement of present law as to the signing of the income tax return itself. 

Because a CEO’s duties generally do not require a detailed or technical understanding of the 

corporation’s tax return, it is anticipated that this declaration of the CEO will be more limited in 

scope than the declaration of the officer required to sign the return itself.

The Secretary of the Treasury shall prescribe the matters to which the declaration of the 

CEO applies. It is intended that the declaration help insure that the preparation and completion 

of the corporation’s tax return be given an appropriate level of care. For example, it is 

anticipated that the CEO would declare that processes and procedures have been implemented to 

ensure that the return complies with the Internal Revenue Code and all regulations and rules 

promulgated thereunder. Although appropriate processes and procedures can vary for each 

taxpayer depending on the size and nature of the taxpayer’s business, in every case the CEO 

should be briefed on all material aspects of the corporation’s tax return by the corporation’s chief 

financial officer (or another person authorized to sign the return under present law). 

It is also anticipated that, as part of the declaration, the CEO would certify that, to the 

best of the CEO’s knowledge and belief: (1) the processes and procedures for ensuring that the 

corporation files a tax return that complies with the requirements of the Code are operating 

 

138 Sec. 6062.

139 Sec. 7206.

140 Pursuant to 18 U.S.C. 3571, the maximum fine for an individual convicted of a felony 

is $250,000.
67

effectively; (2) the return is true, accurate, and complete; (3) the officer signing the return did so 

under no compulsion to adopt any tax position with which that person did not agree; (4) the CEO 

was briefed on all listed transactions as well as all reportable transactions otherwise required to 

be disclosed on the tax return; and (5) all required disclosures have been filed with the return. 

The Secretary may by regulations prescribe additional requirements for this declaration.141

If the corporation does not have a chief executive officer, the IRS may designate another 

officer of the corporation; otherwise, no other person is permitted to sign the declaration. It is 

intended that the IRS issue general guidance, such as a revenue procedure, to: (1) address 

situations when a corporation does not have a chief executive officer; and (2) define who the 

chief executive officer is, in situations (for example) when the primary official bears a different 

title or when a corporation has multiple chief executive officers. It is intended that, in every 

instance, the highest ranking corporate officer (regardless of title) sign this declaration.

The proposal does not apply to the income tax returns of mutual funds;142 they are 

required to be signed as under present law.

Effective Date

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

3. Denial of deduction for certain fines, penalties, and other amounts 

Present Law

Under present law, no deduction is allowed as a trade or business expense under section 

162(a) for the payment of a fine or similar penalty to a government for the violation of any law 

(sec. 162(f)). The enactment of section 162(f) in 1969 codified existing case law that denied the 

deductibility of fines as ordinary and necessary business expenses on the grounds that 

“allowance of the deduction would frustrate sharply defined national or State policies proscribing 

the particular types of conduct evidenced by some governmental declaration thereof.”143

Treasury regulation section 1.162-21(b)(1) provides that a fine or similar penalty includes 

an amount: (1) paid pursuant to conviction or a plea of guilty or nolo contendere for a crime 

(felony or misdemeanor) in a criminal proceeding; (2) paid as a civil penalty imposed by Federal, 

State, or local law, including additions to tax and additional amounts and assessable penalties 

imposed by chapter 68 of the Code; (3) paid in settlement of the taxpayer’s actual or potential 

liability for a fine or penalty (civil or criminal); or (4) forfeited as collateral posted in connection 

with a proceeding which could result in imposition of such a fine or penalty. Treasury regulation 

 

141 Sec. 6011(a).

142 The proposal does, however, apply to the income tax returns of mutual fund 

management companies and advisors.

143 S. Rep. 91-552, 91st Cong, 1st Sess., 273-74 (1969), referring to Tank Truck Rentals, 

Inc. v. Commissioner, 356 U.S. 30 (1958).
68

section 1.162-21(b)(2) provides, among other things, that compensatory damages (including 

damages under section 4A of the Clayton Act (15 U.S.C. 15a), as amended) paid to a 

government do not constitute a fine or penalty. 

Description of Proposal

The proposal modifies the rules regarding the determination whether payments are 

nondeductible payments of fines or penalties under section 162(f). In particular, the proposal 

generally provides that amounts paid or incurred (whether by suit, agreement, or otherwise) to, 

or at the direction of, a government in relation to the violation of any law or the investigation or 

inquiry into the potential violation of any law are nondeductible under any provision of the 

income tax provisions.144 The proposal applies to deny a deduction for any such payments, 

including those where there is no admission of guilt or liability and those made for the purpose 

of avoiding further investigation or litigation. An exception applies to payments that the 

taxpayer establishes are restitution. 145

 It is intended that a payment will be treated as restitution only if the payment is required 

to be paid to the specific persons, or in relation to the specific property, actually harmed by the 

conduct of the taxpayer that resulted in the payment. Thus, a payment to or with respect to a 

class broader than the specific persons or property that were actually harmed (e.g., to a class 

including similarly situated persons or property) does not qualify as restitution. 146 Restitution is 

limited to the amount that bears a substantial quantitative relationship to the harm caused by the 

past conduct or actions of the taxpayer that resulted in the payment in question. If the party 

harmed is a government or other entity, then restitution includes payment to such harmed 

government or entity, provided the payment bears a substantial quantitative relationship to the 

harm. However, restitution does not include reimbursement of government investigative or 

litigation costs, or payments to whistleblowers.

Amounts paid or incurred to, or at the direction of, any self-regulatory entity that 

regulates a financial market or other market that is a qualified board or exchange under section 

1256(g)(7), and that is authorized to impose sanctions (e.g., the National Association of 

Securities Dealers) are subject to the proposal. To the extent provided in regulations, amounts 

paid or incurred to, or at the direction of, any other nongovernmental entity that exercises selfregulatory powers as part of performing an essential governmental function are also subject to 

the provision. 

 

144 The proposal provides that such amounts are nondeductible under chapter 1 of the 

Internal Revenue Code. 

145 The proposal does not affect the treatment of antitrust payments made under section 4 

of the Clayton Act, which will continue to be governed by the provisions of section 162(g). 

146 Similarly, a payment to a charitable organization benefiting a broader class than the 

persons or property actually harmed, or to be paid out without a substantial quantitative 

relationship to the harm caused, would not qualify as restitution. Under the proposal, such a 

payment not deductible under section 162 would also not be deductible under section 170. 
69

No inference is intended as to the treatment of payments as nondeductible fines or 

penalties under present law. In particular, the proposal is not intended to limit the scope of 

present-law section 162(f) or the regulations thereunder. 

Effective Date

The proposal is effective for amounts paid or incurred on or after April 28, 2003; 

however the proposal does not apply to amounts paid or incurred under any binding order or 

agreement entered into before such date. Any order or agreement requiring court approval is not 

a binding order or agreement for this purpose unless such approval was obtained on or before 

April 27, 2003.

4. Denial of deduction for punitive damages

Present Law

In general, a deduction is allowed for all ordinary and necessary expenses that are paid or 

incurred by the taxpayer during the taxable year in carrying on any trade or business.147 

However, no deduction is allowed for any payment that is made to an official of any 

governmental agency if the payment constitutes an illegal bribe or kickback or if the payment is 

to an official or employee of a foreign government and is illegal under Federal law.148 In 

addition, no deduction is allowed under present law for any fine or similar payment made to a 

government for violation of any law.149 Furthermore, no deduction is permitted for two-thirds of 

any damage payments made by a taxpayer who is convicted of a violation of the Clayton 

antitrust law or any related antitrust law.150

In general, gross income does not include amounts received on account of personal 

physical injuries and physical sickness.151 However, this exclusion does not apply to punitive 

damages.152

Description of Proposal

The proposal denies any deduction for punitive damages that are paid or incurred by the 

taxpayer as a result of a judgment or in settlement of a claim. If the liability for punitive 

damages is covered by insurance, any such punitive damages paid by the insurer are included in 

 

147 Sec. 162(a).

148 Sec. 162(c).

149 Sec. 162(f).

150 Sec. 162(g).

151 Sec. 104(a).

152 Sec. 104(a)(2).
70

gross income of the insured person and the insurer is required to report such amounts to both the

insured person and the IRS.

Effective Date

The proposal is effective for punitive damages that are paid or incurred on or after the 

date of enactment.

5. Criminal tax fraud 

Present Law

Attempt to evade or defeat tax

In general, section 7201 imposes a criminal penalty on persons who willfully attempt to 

evade or defeat any tax imposed by the Code. Upon conviction, the Code provides that the 

penalty is up to $100,000 or imprisonment of not more than five years (or both). In the case of a 

corporation, the Code increases the monetary penalty to a maximum of $500,000.

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

In general, section 7203 imposes a criminal penalty on persons required to make 

estimated tax payments, pay taxes, keep records, or supply information under the Code who 

willfully fails to do so. Upon conviction, the Code provides that the penalty is up to $25,000 or 

imprisonment of not more than one year (or both). In the case of a corporation, the Code 

increases the monetary penalty to a maximum of $100,000.

Fraud and false statements

In general, section 7206 imposes a criminal penalty on persons who make fraudulent or 

false statements under the Code. Upon conviction, the Code provides that the penalty is up to 

$100,000 or imprisonment of not more than three years (or both). In the case of a corporation, 

the Code increases the monetary penalty to a maximum of $500,000.

Uniform sentencing guidelines

Under the uniform sentencing guidelines established by 18 U.S.C. 3571, a defendant 

found guilty of a criminal offense is subject to a maximum fine that is the greatest of: (a) the 

amount specified in the underlying provision, (b) for a felony153 $250,000 for an individual or 

$500,000 for an organization, or (c) twice the gross gain if a person derives pecuniary gain from 

the offense. This Title 18 provision applies to all criminal provisions in the United States Code, 

including those in the Internal Revenue Code. For example, for an individual, the maximum fine 

 

153 Section 7206 states that making fraudulent or false statements under the Code is a 

felony. In addition, this offense is a felony pursuant to the classification guidelines of 18 U.S.C. 

3559(a)(5). 
71

under present law upon conviction of violating section 7206 is $250,000 or, if greater, twice the 

amount of gross gain from the offense. 

Description of Proposal

Attempt to evade or defeat tax

The proposal increases the criminal penalty under section 7201 of the Code for 

individuals to $250,000 and for corporations to $1,000,000. The proposal increases the 

maximum prison sentence to ten years. 

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

The proposal increases the criminal penalty under section 7203 of the Code from a

misdemeanor to a felony and increases the maximum prison sentence to ten years. 

Fraud and false statements

The proposal increases the criminal penalty under section 7206 of the Code for 

individuals to $250,000 and for corporations to $1,000,000. The proposal increases the 

maximum prison sentence to five years. The proposal also provides that in no event shall the 

amount of the monetary penalty under this provision be less than the amount of the 

underpayment or overpayment attributable to fraud.

Effective Date

The proposal is effective for offenses committed after the date of enactment. 
72

C. Enron-Related Tax Shelter Proposals

1. Limitation on transfer and importation of built-in losses

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. 154 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.155

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.156 

Description of Proposal

Importation of built-in losses

The proposal provides that if a net built-in loss is imported into the U.S in a tax-free 

organization or reorganization from persons not subject to U.S. tax, the basis of each property so 

transferred is its fair market value. A similar rule applies in the case of the tax-free liquidation 

by a domestic corporation of its foreign subsidiary. 

Under the proposal, a net built-in loss is treated as imported into the U.S. if the aggregate 

adjusted bases of property received by a transferee corporation exceeds the fair market value of 

the properties transferred. Thus, for example, if in a tax-free incorporation, some properties are 

received by a corporation from U. S. persons subject to tax, and some properties are received 

from foreign persons not subject to U.S. tax, this provision applies to limit the adjusted basis of 

each property received from the foreign persons to the fair market value of the property. In the 

case of a transfer by a partnership (either domestic or foreign), this provision applies as if the 

properties had been transferred by each of the partners in proportion to their interests in the 

partnership.

 

154 Sec. 351.

155 Sec. 358.

156 Secs. 334(b) and 362(a) and (b).
73

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

The provision provides that if the aggregate adjusted bases of property contributed by a 

transferor (or by a control group of which the transferor is a member) to a corporation exceed the 

aggregate fair market value of the property transferred in a tax-free incorporation, the 

transferee’s aggregate basis of the properties is limited to the aggregate fair market value of the 

transferred property. Under the provision, any required basis reduction is allocated among the 

transferred properties in proportion to their built-in-loss immediately before the transaction. In 

the case of a transfer after which the transferor owns at least 80 percent of the vote and value of 

the stock of the transferee corporation, any basis reduction required by the provision is made to 

the stock received by the transferor and not to the assets transferred.

Effective Date

The proposal applies to transactions after February 13, 2003.

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

partner

Present Law

In general

Generally, a partner and the partnership do not recognize gain or loss on a contribution of 

property to a partnership.157 Similarly, a partner and the partnership generally do not recognize 

gain or loss on the distribution of partnership property. 158 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).159 Thus, the partnership’s tax basis in the distributed property is adjusted (increased 

or decreased) to reflect the partner’s tax basis in the partnership interest.

Election to adjust basis of partnership property 

When a partnership distributes partnership property, generally, the basis of partnership 

property is not adjusted to reflect the effects of the distribution or transfer. The partnership is 

permitted, however, to make an election (referred to as a 754 election) to adjust the basis of 

 

157 Sec. 721(a).

158 Sec. 731(a) and (b).

159 Sec. 732(b).
74

partnership property in the case of a distribution of partnership property. 160 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.161 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. 162

Description of Proposal

The proposal provides that in applying the basis allocation rules to a distribution in 

liquidation of a partner’s interest, a partnership is precluded from decreasing the basis of 

corporate stock of a partner or a related person. Any decrease in basis that, absent the proposal, 

would have been allocated to the stock is allocated to other partnership assets. If the decrease in 

basis exceeds the basis of the other partnership assets, then gain is recognized by the partnership 

in the amount of the excess. 

Effective Date

The proposal applies to distributions after February 13, 2003.

 

160 Sec. 754.

161 Sec. 755(a).

162 Sec. 755(b).
75

3. Repeal of special rules for FASITs

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.163 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;164 (2) have assets substantially all of which 

(including assets that the FASIT is treated as owning because they support regular interests) are 

specified types called “permitted assets;” (3) have non-ownership interests be certain specified 

types of debt instruments called “regular interests”; (4) have a single ownership interest which is 

held by an "eligible holder"; and (5) not qualify as a regulated investment company (“RIC”). 

Any entity, including a corporation, partnership, or trust may be treated as a FASIT. In addition, 

a segregated pool of assets may qualify as a FASIT.

An entity ceases qualifying as a FASIT if the entity's owner ceases being an eligible 

corporation. Loss of FASIT status is treated as if all of the regular interests of the FASIT were 

retired and then reissued without the application of the rule that deems regular interests of a 

FASIT to be debt.

 

163 Sections 860H through 860L.

164 Once an election to be a FASIT is made, the election applies from the date specified 

in the election and all subsequent years until the entity ceases to be a FASIT. If an election to be 

a FASIT is made after the initial year of an entity, all of the assets in the entity at the time of the 

FASIT election are deemed contributed to the FASIT at that time and, accordingly, any gain (but 

not loss) on such assets will be recognized at that time.
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Permitted assets

For an entity or arrangement to qualify as a FASIT, substantially all of its assets must 

consist of the following “permitted assets”: (1) cash and cash equivalents; (2) certain permitted 

debt instruments; (3) certain foreclosure property; (4) certain instruments or contracts that 

represent a hedge or guarantee of debt held or issued by the FASIT; (5) contract rights to acquire 

permitted debt instruments or hedges; and (6) a regular interest in another FASIT. Permitted 

assets may be acquired at any time by a FASIT, including any time after its formation.

“Regular interests” of a FASIT

“Regular interests” of a FASIT are treated as debt for Federal income tax purposes, 

regardless of whether instruments with similar terms issued by non-FASITs might be 

characterized as equity under general tax principles. To be treated as a “regular interest”, an 

instrument must have fixed terms and must: (1) unconditionally entitle the holder to receive a 

specified principal amount; (2) pay interest that is based on (a) fixed rates, or (b) except as 

provided by regulations issued by the Treasury Secretary, variable rates permitted with respect to 

real estate mortgage investme nt conduit interests under section 860G(a)(1)(B)(i); (3) have a term 

to maturity of no more than 30 years, except as permitted by Treasury regulations; (4) be issued 

to the public with a premium of not more than 25 percent of its stated principal amount; and (5) 

have a yield to maturity determined on the date of issue of less than five percentage points above 

the applicable Federal rate (“AFR”) for the calendar month in which the instrument is issued.

Permitted ownership holder

A permitted holder of the ownership interest in a FASIT generally is a non-exempt (i.e., 

taxable) domestic C corporation, other than a corporation that qualifies as a RIC, REIT, REMIC, 

or cooperative.

Transfers to FASITs

In general, gain (but not loss) is recognized immediately by the owner of the FASIT upon 

the transfer of assets to a FASIT. Where property is acquired by a FASIT from someone other 

than the FASIT’s owner (or a person related to the FASIT’s owner), the property is treated as 

being first acquired by the FASIT’s owner for the FASIT’s cost in acquiring the asset from the 

non-owner and then transferred by the owner to the FASIT.

Valuation rules.–In general, except in the case of debt instruments, the value of FASIT 

assets is their fair market value. Similarly, in the case of debt instruments that are traded on an 

established securities market, the market price is used for purposes of determining the amount of 

gain realized upon contribution of such assets to a FASIT. However, in the case of debt 

instruments that are not traded on an established securities market, special valuation rules apply 

for purposes of computing gain on the transfer of such debt instruments to a FASIT. Under these 

rules, the value of such debt instruments is the sum of the present values of the reasonably 

expected cash flows from such obligations discounted over the weighted average life of such 

assets. The discount rate is 120 percent of the AFR, compounded semiannually, or such other 

rate that the Treasury Secretary shall prescribe by regulations.
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Taxation of a FASIT

A FASIT generally is not subject to tax. Instead, all of the FASIT’s assets and liabilities 

are treated as assets and liabilities of the FASIT’s owner and any income, gain, deduction or loss 

of the FASIT is allocable directly to its owner. Accordingly, income tax rules applicable to a 

FASIT (e.g., related party rules, sec. 871(h), sec. 165(g)(2)) are to be applied in the same manner 

as they apply to the FASIT’s owner. The taxable income of a FASIT is calculated using an 

accrual method of accounting. The constant yield method and principles that apply for purposes 

of determining original issue discount (“OID”) accrual on debt obligations whose principal is 

subject to acceleration apply to all debt obligations held by a FASIT to calculate the FASIT’s 

interest and discount income and premium deductions or adjustments.

Taxation of holders of FASIT regular interests

In general, a holder of a regular interest is taxed in the same manner as a holder of any 

other debt instrument, except that the regular interest holder is required to account for income 

relating to the interest on an accrual method of accounting, regardless of the method of 

accounting otherwise used by the holder.

Taxation of holders of FASIT ownership interests

Because all of the assets and liabilities of a FASIT are treated as assets and liabilities of 

the holder of a FASIT ownership interest, the ownership interest holder takes into account all of 

the FASIT’s income, gain, deduction, or loss in computing its taxable income or net loss for the 

taxable year. The character of the income to the holder of an ownership interest is the same as its 

character to the FASIT, except tax-exempt interest is included in the income of the holder as 

ordinary income.

Although the recognition of losses on assets contributed to the FASIT is not allowed 

upon contribution of the assets, such losses may be allowed to the FASIT owner upon their 

disposition by the FASIT. Furthermore, the holder of a FASIT ownership interest is not 

permitted to offset taxable income from the FASIT ownership interest (including gain or loss 

from the sale of the ownership interest in the FASIT) with other losses of the holder. In addition, 

any net operating loss carryover of the FASIT owner shall be computed by disregarding any 

income arising by reason of a disallowed loss. Where the holder of a FASIT ownership interest 

is a member of a consolidated group, this rule applies to the consolidated group of corporations 

of which the holder is a member as if the group were a single taxpayer.

Real estate mortgage investment conduits

In general, a real estate mortgage investment conduit (“REMIC”) is a self-liquidating 

entity that holds a fixed pool of mortgages and issues multiple classes of investor interests. A 

REMIC is not treated as a separate taxable entity. Rather, the income of the REMIC is allocated 

to, and taken into account by, the holders of the interests in the REMIC under detailed rules.165 

In order to qualify as a REMIC, substantially all of the assets of the entity must consist of 

 

165

 See sections 860A through 860G.
78

qualified mortgages and permitted investments as of the close of the third month beginning after 

the startup day of the entity. A “qualified mortgage” generally includes any obligation which is 

principally secured by an interest in real property, and which is either transferred to the REMIC 

on the startup day of the REMIC in exchange for regular or residual interests in the REMIC or 

purchased by the REMIC within three months after the startup day pursuant to a fixed-price 

contract in effect on the startup day. A “permitted investment” generally includes any intangible 

property that is held for investment and is part of a reasonably required reserve to provide for full 

payment of certain expenses of the REMIC or amounts due on regular interests.

All of the interests in the REMIC must consist of one or more classes of regular interests 

and a single class of residual interests. A “regular interest” is an interest in a REMIC that is 

issued with a fixed term, designated as a regular interest, and unconditionally entitles the holder 

to receive a specified principal amount (or other similar amount) with interest payments that are 

either based on a fixed rate (or, to the extent provided in regulations, a variable rate) or consist of 

a specified portion of the interest payments on qualified mortgages that does not vary during the 

period such interest is outstanding. In general, a “residual interest” is any interest in the REMIC 

other than a regular interest, and which is so designated by the REMIC, provided that there is 

only one class of such interest and that all distributions (if any) with respect to such interests are 

pro rata. Holders of residual REMIC interests are subject to tax on the portion of the income of 

the REMIC that is not allocated to the regular interest holders.

Original issue discount accruals with respect to debt instruments and pools of debt 

instruments subject to acceleration of principal payment

The holder of a debt instrument with original issue discount (“OID”) generally accrues 

and includes in gross income, as interest, the OID over the life of the obligation, even though the 

amount of the interest may not be received until the maturity of the instrument. 166 In general, 

issuers of debt instruments with OID accrue and deduct the amount of OID as interest expense in 

the same manner as the holder.

Special rules for determining the amount of OID allocated to a period apply to certain 

instruments and pools of instruments that may be subject to prepayment. First, if a borrower can 

reduce the yield on a debt by exercising a prepayment option, the OID rules assume that the 

borrower will prepay the debt. In addition, in the case of (1) any regular interest in a REMIC or 

qualified mortgage held by a REMIC, (2) any other debt instrument if payments under the 

instrument may be accelerated by reason of prepayments of other obligations securing the 

instrument, or (3) any pool of debt instruments the yield on which may be affected by reason of 

 

166 The amount of OID with respect to a debt instrument is the excess of the stated 

redemption price at maturity over the issue price of the debt instrument. The stated redemption 

price at maturity includes all amounts payable at maturity. The amount of OID in a debt 

instrument is allocated over the life of the instrument through a series of adjustments to the issue 

price for each accrual period. The adjustment to the issue price is determined by multiplying the 

adjusted issue price (i.e., the issue price increased by adjustments prior to the accrual period) by 

the instrument’s yield to maturity, and then subtracting the interest payable during the accrual 

period.
79

prepayments, the daily portions of the OID on such debt instruments and pools of debt 

instruments generally are determined by taking into account an assumption regarding the 

prepayment of principal for such instruments. The prepayment assumption to be used for this 

purpose is that which the parties use in pricing the particular transaction.

Description of Proposal

The proposal repeals the special rules for FASITs. The proposal provides a transition 

period for existing FASITs, pursuant to which the repeal of the FASIT rules would not apply to 

any FASIT in existence on the date of enactment to the extent that regular interests issued by the 

FASIT prior to such date continue to remain outstanding in accordance with their original terms.

For purposes of the REMIC rules, the proposal also modifies the definitions of qualified 

mortgages, permitted investments, and regular interests so that certain types of real estate loans 

and loan pools can be transferred to, or purchased by, a REMIC. In addition, the proposal 

modifies the OID rules with respect to certain instruments and pools of instruments that may be 

subject to principal prepayment so that the prepayment assumption used in determining the daily 

portions of the OID on such debt instruments and pools of debt instruments for an accrual period 

is a current prepayment assumption determined as of the close of such accrual period in the 

manner prescribed by regulations.

Effective Date

Except as provided by the transition period for existing FASITs, the proposal is effective 

after February 13, 2003.

4. Expanded disallowance of deduction for interest on convertible debt

Present Law

Whether an instrument qualifies for tax purposes as debt or equity is determined under all 

the facts and circumstances based on principles developed in case law. If an instrument qualifies

as equity, the issuer generally does not receive a deduction for dividends paid and the holder 

generally includes such dividends in income (although corporate holders generally may obtain a 

dividends-received deduction of at least 70 percent of the amount of the dividend). If an 

instrument qualifies as debt, the issuer may receive a deduction for accrued interest and the 

holder generally includes interest in income, subject to certain limitations.

Original issue discount (“OID”) on a debt instrument is the excess of the stated 

redemption price at maturity over the issue price of the instrument. An issuer of a debt 

instrument with OID generally accrues and deducts the discount as interest over the life of the 

instrument even though interest may not be paid until the instrument matures. The holder of 

such a debt instrument also generally includes the OID in income on an accrual basis.

Under present law, no deduction is allowed for interest or OID on a debt instrument 

issued by a corporation (or issued by a partnership to the extent of its corporate partners) that is 

payable in equity of the issuer or a related party (within the meaning of sections 267(b) and 

707(b)), including a debt instrument a substantial portion of which is mandatorily convertible or 
80

convertible at the issuer's option into equity of the issuer or a related party. 167 In addition, a debt 

instrument is treated as payable in equity if a substantial portion of the principal or interest is 

required to be determined, or may be determined at the option of the issuer or related party, by 

reference to the value of equity of the issuer or related party. 168 A debt instrument also is treated 

as payable in equity if it is part of an arrangement that is designed to result in the payment of the 

debt instrument with or by reference to such equity, such as in the case of certain issuances of a 

forward contract in connection with the issuance of debt, nonrecourse debt that is secured 

principally by such equity, or certain debt instruments that are paid in, converted to, or 

determined with reference to the value of equity if it may be so required at the option of the 

holder or a related party and there is a substantial certainty that option will be exercised.169

Description of Proposal

The proposal expands the present-law disallowance of interest deductions on certain 

corporate debt that is payable in, or by reference to the value of, equity. Under the proposal, the 

disallowance includes interest on corporate debt that is payable in, or by reference to the value 

of, any equity held by the issuer (or any related party) in any other person, without regard to 

whether such equity represents more than a 50-percent ownership interest in such person. The 

basis of such equity is increased by the amount of interest deductions that is disallowed by the 

proposal. The proposal directs the Treasury Department to issue regulations that provide rules 

for determining the manner in which the basis of equity held by the issuer (or related party) is 

increased by the amount of interest deductions that is disallowed under the proposal.

The proposal does not apply to debt that is issued by an active dealer in securities (or a 

related party) if the debt is payable in, or by reference to the value of, equity that is held by the 

securities dealer in its capacity as a dealer in securities.

Effective Date

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

5. Expanded authority to disallow tax benefits under section 269

Present Law

Section 269 provides that if a taxpayer acquires, directly or indirectly, control (defined as 

at least 50 percent of vote or value) of a corporation, and the principal purpose of the acquisition 

is the evasion or avoidance of Federal income tax by securing the benefit of a deduction, credit, 

or other allowance that would not otherwise have been available, the Secretary may disallow the 

 

167 Sec. 163(l), enacted in the Taxpayer Relief Act of 1997, Pub. L. No. 105-34, sec. 

1005(a).

168 Sec. 163(l)(3)(B).

169 Sec. 163(l)(3)(C).
81

such tax benefits.170 Similarly, if a corporation acquires, directly or indirectly, property of 

another corporation (not controlled, directly or indirectly, by the acquiring corporation or its 

stockholders immediately before the acquisition), the basis of such property is determined by 

reference to the basis in the hands of the transferor corporation, and the principal purpose of the 

acquisition is the evasion or avoidance of Federal income tax by securing a tax benefit that 

would not otherwise have been available, the Secretary may disallow such tax benefits.171 

Description of Proposal

The proposal expands section 269 by repealing the requirement that the acquisition of 

property be from a corporation not controlled by the acquirer. Thus, under the proposal, section 

269 disallows the tax benefits of (1) any acquisition of stock sufficient to obtain control of a 

corporation,172 and (2) any acquisition by a corporation of property from a corporation in which 

the basis of such property is determined by reference to the basis in the hands of the transferor 

corporation, if the principal purpose of such acquisition is the evasion or avoidance of Federal 

income tax.

Effective Date

The proposal applies to property acquired after February 13, 2003. 

6. Modification of CFC-PFIC coordination rules

Present Law

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

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

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

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

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

However, certain anti-deferral regimes may cause the domestic parent corporation to be taxed on 

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

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

as a dividend to the domestic parent corporation. The main anti-deferral regimes in this context 

are the controlled foreign corporation rules of subpart F173 and the passive foreign investment 

company rules.174 Deferral of U.S. tax is considered appropriate, on the other hand, with respect 

 

170 Sec. 269(a)(1).

171 Sec. 269(a)(2).

172 In this regard, the proposal applies regardless of whether an acquisition results in an 

increase in the acquiror’s ownership percentage in a corporation or involves the issuance of 

actual stock certificates or shares by a corporation to the acquiror.

173 Secs. 951-964.

174 Secs. 1291-1298.
82

to most types of active business income earned abroad. A foreign tax credit generally is 

available to offset, in whole or in part, the U.S. tax owed on foreign-source income, whether 

earned directly by the domestic corporation, repatriated as an actual dividend, or included under 

one of the anti-deferral regimes.175

Subpart F,176 applicable to controlled foreign corporations and their shareholders, is the 

main anti-deferral regime of relevance to a U.S.-based multinational corporate group. A 

controlled foreign corporation generally is defined as any foreign corporation if U.S. persons 

own (directly, indirectly, or constructively) more than 50 percent of the corporation’s stock 

(measured by vote or value), taking into account only those U.S. persons that own at least 10 

percent of the stock (measured by vote only).177 Under the subpart F rules, the United States 

generally taxes the U.S. 10-percent shareholders of a controlled foreign corporation on their pro 

rata shares of certain income of the controlled foreign corporation (referred to as “subpart F 

income”), without regard to whether the income is distributed to the shareholders.178 

Subpart F income generally includes passive income and other income that is readily 

movable from one taxing jurisdiction to another. Subpart F income consists of foreign base 

company income,179 insurance income,180 and certain income relating to international boycotts 

and other violations of public policy.181 Foreign base company income consists of foreign 

personal holding company income, which includes passive income (e.g., dividends, interest, 

rents, and royalties), as well as a number of categories of non-passive income, including foreign 

base company sales income, foreign base company services income, foreign base company 

shipping income and foreign base company oil-related income.182 

In effect, the United States treats the U.S. 10-percent shareholders of a controlled foreign 

corporation as having received a current distribution out of the corporation's subpart F income. 

In addition, the U.S. 10-percent shareholders of a controlled foreign corporation are required to 

include currently in income for U.S. tax purposes their pro rata shares of the corporation's 

earnings invested in U.S. property. 183

 

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

176 Secs. 951-964.

177 Secs. 951(b), 957, 958.

178 Sec. 951(a).

179 Sec. 954.

180 Sec. 953.

181 Sec. 952(a)(3)-(5).

182 Sec. 954.

183 Secs. 951(a)(1)(B), 956.
83

The Tax Reform Act of 1986 established an additional anti-deferral regime, for passive 

foreign investment companies. A passive foreign investment company generally is defined as 

any foreign corporation if 75 percent or more of its gross income for the taxable year consists of 

passive income, or 50 percent or more of its assets consists of assets that produce, or are held for 

the production of, passive income.184 Alternative sets of income inclusion rules apply to U.S. 

persons that are shareholders in a passive foreign investment company, regardless of their 

percentage ownership in the company. One set of rules applies to passive foreign investment 

companies that are “qualified electing funds,” under which electing U.S. shareholders currently 

include in gross income their respective shares of the company’s earnings, with a separate 

election to defer payment of tax, subject to an interest charge, on income not currently 

received.185 A second set of rules applies to passive foreign investment companies that are not 

qualified electing funds, under which U.S. shareholders pay tax on certain income or gain 

realized through the company, plus an interest charge that is attributable to the value of 

deferral.186 A third set of rules applies to passive foreign investment company stock that is 

marketable, under which electing U.S. shareholders currently take into account as income (or 

loss) the difference between the fair market value of the stock as of the close of the taxable year 

and their adjusted basis in such stock (subject to certain limitations), often referred to as 

“marking to market.”187

Under section 1297(e), which was enacted in 1997 to address the overlap of the passive 

foreign investment company rules and subpart F, a controlled foreign corporation generally is not 

also treated as a passive foreign investment company with respect to a U.S. shareholder of the 

corporation. This exception applies regardless of the likelihood that the U.S. shareholder would 

actually be taxed under subpart F in the event that the controlled foreign corporation earns 

subpart F income. Thus, even in a case in which a controlled foreign corporation’s subpart F 

income would be allocated to a different shareholder under the subpart F allocation rules, a U.S. 

shareholder would still qualify for the exception from the passive foreign investment company 

rules under section 1297(e).

Description of Proposal

The proposal adds an exception to section 1297(e) for U.S. shareholders that face only a 

remote likelihood of incurring a subpart F inclusion in the event that a controlled foreign 

corporation earns subpart F income, thus preserving the potential application of the passive 

foreign investment company rules in such cases.

 

184 Sec. 1297.

185 Sec. 1293-1295.

186 Sec. 1291.

187 Sec. 1296.
84

Effective Date

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

after February 13, 2003, and for taxable years of U.S. shareholders in which or with which such 

taxable years of controlled foreign corporations end.
85

D. Tax Treatment of Inversion Transactions 

Present Law

Determination of corporate residence

The U.S. tax treatment of a multinational corporate group depends significantly on 

whether the top-tier “parent” corporation of the group is domestic or foreign. For purposes of 

U.S. tax law, a corporation is treated as domestic if it is incorporated under the law of the United 

States or of any State. All other corporations (i.e., those incorporated under the laws of foreign 

countries) are treated as foreign. Thus, place of incorporation determines whether a corporation 

is treated as domestic or foreign for purposes of U.S. tax law, irrespective of other factors that 

might be thought to bear on a corporation’s “nationality,” such as the location of the 

corporation’s management activities, employees, business assets, operations, or revenue sources, 

the exchanges on which the corporation’s stock is traded, or the residence of the corporation’s 

managers and shareholders.

U.S. taxation of domestic corporations

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

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

mitigate the double taxation that may arise from taxing the foreign-source income of a domestic 

corporation, a foreign tax credit for income taxes paid to foreign countries is provided to reduce 

or eliminate the U.S. tax owed on such income, subject to certain limitations. 

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

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

dividend to the domestic corporation. Until such repatriation, the U.S. tax on such income is 

generally deferred. However, certain anti-deferral regimes may cause the domestic parent 

corporation to be taxed on a current basis in the United States with respect to certain categories 

of passive or highly mobile income earned by its foreign subsidiaries, regardless of whether the 

income has been distributed as a dividend to the domestic parent corporation. The main antideferral regimes in this context are the controlled foreign corporation rules of subpart F188 and 

the passive foreign investment company rules.189 A foreign tax credit is generally available to 

offset, in whole or in part, the U.S. tax owed on this foreign-source income, whether repatriated 

as an actual dividend or included under one of the anti-deferral regimes.

U.S. taxation of foreign corporations

The United States taxes foreign corporations only on income that has a sufficient nexus to 

the United States. Thus, a foreign corporation is generally subject to U.S. tax only on income 

that is “effectively connected” with the conduct of a trade or business in the United States. Such 

 

188 Secs. 951-964.

189 Secs. 1291-1298.
86

“effectively connected income” generally is taxed in the same manner and at the same rates as 

the income of a U.S. corporation. An applicable tax treaty may limit the imposition of U.S. tax 

on business operations of a foreign corporation to cases in which the business is conducted 

through a “permanent establishment” in the United States.

In addition, foreign corporations generally are subject to a gross-basis U.S. tax at a flat 

30-percent rate on the receipt of interest, dividends, rents, royalties, and certain similar types of 

income derived from U.S. sources, subject to certain exceptions. The tax generally is collected 

by means of withholding by the person making the payment. This tax may be reduced or 

eliminated under an applicable tax treaty. 

U.S. tax treatment of inversion transactions

Under present law, U.S. corporations may reincorporate in foreign jurisdictions and 

thereby replace the U.S. parent corporation of a multinational corporate group with a foreign 

parent corporation. These transactions are commonly referred to as “inversion” transactions. 

Inversion transactions may take many different forms, including stock inversions, asset 

inversions, and various combinations of and variations on the two. Most of the known 

transactions to date have been stock inversions. In one example of a stock inversion, a U.S. 

corporation forms a foreign corporation, which in turn forms a domestic merger subsidiary. The 

domestic merger subsidiary then merges into the U.S. corporation, with the U.S. corporation 

surviving, now as a subsidiary of the new foreign corporation. The U.S. corporation’s 

shareholders receive shares of the foreign corporation and are treated as having exchanged their 

U.S. corporation shares for the foreign corporation shares. An asset inversion reaches a similar 

result, but through a direct merger of the top-tier U.S. corporation into a new foreign corporation, 

among other possible forms. An inversion transaction may be accompanied or followed by 

further restructuring of the corporate group. For example, in the case of a stock inversion, in 

order to remove income from foreign operations from the U.S. taxing jurisdiction, the U.S. 

corporation may transfer some or all of its foreign subsidiaries directly to the new foreign parent 

corporation or other related foreign corporations. 

In addition to removing foreign operations from the U.S. taxing jurisdiction, the 

corporate group may derive further advantage from the inverted structure by reducing U.S. tax 

on U.S.-source income through various “earnings stripping” or other transactions. This may 

include earnings stripping through payment by a U.S. corporation of deductible amounts such as 

interest, royalties, rents, or management service fees to the new foreign parent or other foreign 

affiliates. In this respect, the post-inversion structure enables the group to employ the same taxreduction strategies that are available to other multinational corporate groups with foreign 

parents and U.S. subsidiaries, subject to the same limitations. These limitations under present 

law include section 163(j), which limits the deductibility of certain interest paid to related 

parties, if the payor’s debt-equity ratio exceeds 1.5 to 1 and the payor’s net interest expense 

exceeds 50 percent of its “adjusted taxable income.” More generally, section 482 and the 

regulations thereunder require that all transactions between related parties be conducted on terms 

consistent with an “arm’s length” standard, and permit the Secretary of the Treasury to reallocate 

income and deductions among such parties if that standard is not met.
87

Inversion transactions may give rise to immediate U.S. tax consequences at the 

shareholder and/or the corporate level, depending on the type of inversion. In stock inversions, 

the U.S. shareholders generally recognize gain (but not loss) under section 367(a), based on the 

difference between the fair market value of the foreign corporation shares received and the 

adjusted basis of the domestic corporation stock exchanged. To the extent that a corporation’s 

share value has declined, and/or it has many foreign or tax-exempt shareholders, the impact of 

this section 367(a) “toll charge” is reduced. The transfer of foreign subsidiaries or other assets to 

the foreign parent corporation also may give rise to U.S. tax consequences at the corporate level 

(e.g., gain recognition and earnings and profits inclusions under sections 1001, 311(b), 304, 367, 

1248 or other provisions). The tax on any income recognized as a result of these restructurings 

may be reduced or eliminated through the use of net operating losses, foreign tax credits, and 

other tax attributes. 

In asset inversions, the U.S. corporation generally recognizes gain (but not loss) under 

section 367(a) as though it had sold all of its assets, but the shareholders generally do not 

recognize gain or loss, assuming the transaction meets the requirements of a reorganization under 

section 368.

Description of Proposal

In general

The proposal defines two different types of corporate inversion transactions and 

establishes a different set of consequences for each type. Certain partnership transactions also 

are covered. 

Transactions involving at least 80 percent identity of stock ownership

The first type of inversion is a transaction in which, pursuant to a plan or a series of 

related transactions: (1) a U.S. corporation becomes a subsidiary of a foreign-incorporated entity 

or otherwise transfers substantially all of its properties to such an entity;190 (2) the former 

shareholders of the U.S. corporation hold (by reason of holding stock in the U.S. corporation) 80 

percent or more (by vote or value) of the stock of the foreign-incorporated entity after the 

transaction; and (3) the foreign-incorporated entity, considered together with all companies 

connected to it by a chain of greater than 50 percent ownership (i.e., the “expanded affiliated 

group”), does not have substantial business activities in the entity’s country of incorporation, 

compared to the total worldwide business activities of the expanded affiliated group. The 

proposal denies the intended tax benefits of this type of inversion by deeming the top-tier foreign 

corporation to be a domestic corporation for all purposes of the Code.191 

 

190 It is expected that the Treasury Secretary will issue regulations applying the term 

“substantially all” in this context and will not be bound in this regard by interpretations of the 

term in other contexts under the Code.

191 Since the top-tier foreign corporation is treated for all purposes of the Code as 

domestic, the shareholder-level “toll charge” of sec. 367(a) does not apply to these inversion 

transactions. However, with respect to inversion transactions completed before 2004, regulated 
88

Except as otherwise provided in regulations, the proposal does not apply to a direct or 

indirect acquisition of the properties of a U.S. corporation no class of the stock of which was 

traded on an established securities market at any time within the four-year period preceding the 

acquisition. In determining whether a transaction would meet the definition of an inversion 

under the proposal, stock held by members of the expanded affiliated group that includes the 

foreign incorporated entity is disregarded. For example, if the former top-tier U.S. corporation 

receives stock of the foreign incorporated entity (e.g., so-called “hook” stock), the stock would 

not be considered in determining whether the transaction meets the definition. Stock sold in a 

public offering (whether initial or secondary) or private placement related to the transaction also 

is disregarded for these purposes. Acquisitions with respect to a domestic corporation or 

partnership are deemed to be “pursuant to a plan” if they occur within the four-year period 

beginning on the date which is two years before the ownership threshold under the proposal is 

met with respect to such corporation or partnership.

Transfers of properties or liabilities as part of a plan a principal purpose of which is to 

avoid the purposes of the provision are disregarded. In addition, the Treasury Secretary is 

granted authority to prevent the avoidance of the purposes of the provision, including avoidance 

through the use of related persons, pass-through or other noncorporate entities, or other 

intermediaries, and through transactions designed to qualify or disqualify a person as a related 

person, a member of an expanded affiliated group, or a publicly traded corporation. Similarly, 

the Treasury Secretary is granted authority to treat certain non-stock instruments as stock, and 

certain stock as not stock, where necessary to carry out the purposes of the provision. 

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

ownership

The second type of inversion is a transaction that would meet the definition of an 

inversion transaction described above, except that the 80-percent ownership threshold is not met. 

In such a case, if a greater-than-50-percent ownership threshold is met, then a second set of rules 

applies to the inversion. Under these rules, the inversion transaction is respected (i.e., the foreign 

corporation is treated as foreign), but: (1) any applicable corporate-level “toll charges” for 

establishing the inverted structure may not be offset by tax attributes such as net operating losses 

or foreign tax credits; (2) the IRS is given expanded authority to monitor related-party 

transactions that may be used to reduce U.S. tax on U.S.-source income going forward; and (3) 

section 163(j), relating to “earnings stripping” through related-party debt, is strengthened. These 

measures generally apply for a 10-year period following the inversion transaction. In addition, 

inverting entities are required to provide information to shareholders or partners and the IRS with 

respect to the inversion transaction.

With respect to “toll charges,” any applicable corporate-level income or gain required to 

be recognized under sections 304, 311(b), 367, 1001, 1248, or any other provision with respect to 

the transfer of controlled foreign corporation stock or other assets by a U.S. corporation as part 

of the inversion transaction or after such transaction to a related foreign person is taxable, 

 

investment companies and certain similar entities are allowed to elect to recognize gain as if sec. 

367(a) did apply.
89

without offset by any tax attributes (e.g., net operating losses or foreign tax credits). To the 

extent provided in regulations, this rule will not apply to certain transfers of inventory and 

similar transactions conducted in the ordinary course of the taxpayer’s business.

In order to enhance IRS monitoring of related-party transactions, the proposal establishes 

a new pre-filing procedure. Under this procedure, the taxpayer will be required annually to 

submit an application to the IRS for an agreement that all return positions to be taken by the 

taxpayer with respect to related-party transactions comply with all relevant provisions of the 

Code, including sections 163(j), 267(a)(3), 482, and 845. The Treasury Secretary is given the 

authority to specify the form, content, and supporting information required for this application, 

as well as the timing for its submission.

The IRS will be required to take one of the following three actions within 90 days of 

receiving a complete application from a taxpayer: (1) conclude an agreement with the taxpayer 

that the return positions to be taken with respect to related-party transactions comply with all 

relevant provisions of the Code; (2) advise the taxpayer that the IRS is satisfied that the 

application was made in good faith and substantially complies with the requirements set forth by 

the Treasury Secretary for such an application, but that the IRS reserves substantive judgment as 

to the tax treatment of the relevant transactions pending the normal audit process; or (3) advise 

the taxpayer that the IRS has concluded that the application was not made in good faith or does 

not substantially comply with the requirements set forth by the Treasury Secretary.

In the case of a compliance failure described in (3) above (and in cases in which the 

taxpayer fails to submit an application), the following sanctions will apply for the taxable year 

for which the application was required: (1) no deductions or additions to basis or cost of goods 

sold for payments to foreign related parties will be permitted; (2) any transfers or licenses of 

intangible property to related foreign parties will be disregarded; and (3) any cost-sharing 

arrangements will not be respected. In such a case, the taxpayer may seek direct review by the 

U.S. Tax Court of the IRS’s determination of compliance failure.

If the IRS fails to act on the taxpayer’s application within 90 days of receipt, then the 

taxpayer will be treated as having submitted in good faith an application that substantially 

complies with the above-referenced requirements. Thus, the deduction disallowance and other 

sanctions described above will not apply, but the IRS will be able to examine the transactions at 

issue under the normal audit process. The IRS is authorized to request that the taxpayer extend 

this 90-day deadline in cases in which the IRS believes that such an extension might help the 

parties to reach an agreement. 

The “earnings stripping” rules of section 163(j), which deny or defer deductions for 

certain interest paid to foreign related parties, are strengthened for inverted corporations. With 

respect to such corporations, the proposal eliminates the debt-equity threshold generally 

applicable under section 163(j) and reduces the 50-percent thresholds for “excess interest 

expense” and “excess limitation” to 25 percent.

In cases in which a U.S. corporate group acquires subsidiaries or other assets from an 

unrelated inverted corporate group, the provisions described above generally do not apply to the 

acquiring U.S. corporate group or its related parties (including the newly acquired subsidiaries or 
90

assets) by reason of acquiring the subsidiaries or assets that were connected with the inversion 

transaction. The Treasury Secretary is given authority to issue regulations appropriate to carry 

out the purposes of this provision and to prevent its abuse.

Partnership transactions

Under the proposal, both types of inversion transactions include certain partnership 

transactions. Specifically, both parts of the proposal apply to transactions in which a foreignincorporated entity acquires substantially all of the properties constituting a trade or business of a 

domestic partnership (whether or not publicly traded), if after the acquisition at least 80 percent 

(or more than 50 percent but less than 80 percent, as the case may be) of the stock of the entity is 

held by former partners of the partnership (by reason of holding their partnership interests), and 

the “substantial business activities” test is not met. For purposes of determining whether these 

tests are met, all partnerships that are under common control within the meaning of section 482 

are treated as one partnership, except as provided otherwise in regulations. In addition, the 

modified “toll charge” provisions apply at the partner level.

Effective Date

The regime applicable to transactions involving at least 80 percent identity of ownership 

applies to inversion transactions completed after March 20, 2002. The rules for inversion 

transactions involving greater-than-50-percent identity of ownership apply to inversion 

transactions completed after 1996 that meet the 50-percent test and to inversion transactions 

completed after 1996 that would have met the 80-percent test but for the March 20, 2002 date. 
91

E. Proposal to Impose Mark-to-Market Tax on Individuals Who Expatriate

Present Law

In general

U.S. citizens and residents generally are subject to U.S. income taxation on their 

worldwide income. The U.S. tax may be reduced or offset by a credit allowed for foreign income 

taxes paid with respect to foreign-source income. Nonresidents who are not U.S. citizens are 

taxed at a flat rate of 30 percent (or a lower treaty rate) on certain types of passive income 

derived from U.S. sources, and at regular graduated rates on net profits derived from a U.S. 

business. 

Income tax rules with respect to expatriates

An individual who relinquishes his or her U.S. citizenship or terminates his or her U.S. 

residency with a principal purpose of avoiding U.S. taxes is subject to an alternative method of 

income taxation for the 10 taxable years ending after the expatriation or residency termination 

under section 877. The alternative method of taxation for expatriates modifies the rules 

generally applicable to the taxation of nonresident noncitizens in several ways. First, the 

individual is subject to tax on his or her U.S.-source income at the rates applicable to U.S. 

citizens rather than the rates applicable to other nonresident noncitizens. Unlike U.S. citizens, 

however, individuals subject to section 877 are not taxed on foreign-source income. Second, the 

scope of items treated as U.S.-source income for section 877 purposes is broader than those 

items generally considered to be U.S.-source income under the Code.192 Third, individuals 

subject to section 877 are taxed on exchanges of certain types of property that give rise to U.S.-

source income for property that gives rise to foreign-source income.193 Fourth, an individual 

subject to section 877 who contributes property to a controlled foreign corporation is treated as 

receiving income or gain from such property directly and is taxable on such income or gain. The 

alternative method of taxation for expatriates applies only if it results in a higher U.S. tax 

liability than would otherwise be determined if the individual were taxed as a nonresident 

noncitizen.

 

192 For example, gains on the sale or exchange of personal property located in the United 

States, and gains on the sale or exchange of stocks and securities issued by U.S. persons, 

generally are not considered to be U.S.-source income under the Code. Thus, such gains would 

not be taxable to a nonresident noncitizen. However, if an individual is subject to the alternative 

regime under sec. 877, such gains are treated as U.S.-source income with respect to that 

individual.

193 For example, a former citizen who is subject to the alternative tax regime and who 

removes appreciated artwork that he or she owns from the United States could be subject to 

immediate U.S. tax on the appreciation. In this regard, the removal from the United States of 

appreciated tangible personal property having an aggregate fair market value in excess of 

$250,000 within the 15-year period beginning five years prior to the expatriation will be treated 

as an “exchange” subject to these rules.
92

The expatriation tax provisions apply to long-term residents of the United States whose 

U.S. residency is terminated. For this purpose, a long-term resident is any individual who was a 

lawful permanent resident of the United States for at least 8 out of the 15 taxable years ending 

with the year in which such termination occurs. In applying the 8-year test, an individual is not 

considered to be a lawful permanent resident for any year in which the individual is treated as a 

resident of another country under a treaty tie-breaker rule (and the individual does not elect to 

waive the benefits of such treaty). 

Subject to the exceptions described below, an individual is treated as having expatriated 

or terminated residency with a principal purpose of avoiding U.S. taxes if either: (1) the 

individual’s average annual U.S. Federal income tax liability for the 5 taxable years ending 

before the date of the individual’s loss of U.S. citizenship or termination of U.S. residency is 

greater than $100,000 (the “tax liability test”), or (2) the individual’s net worth as of the date of 

such loss or termination is $500,000 or more (the “net worth test”). The dollar amount 

thresholds contained in the tax liability test and the net worth test are indexed for inflation in the 

case of a loss of citizenship or termination of residency occurring in any calendar year after 

1996. An individual who falls below these thresholds is not automatically treated as having a 

principal purpose of tax avoidance, but nevertheless is subject to the expatriation tax provisions 

if the individual’s loss of citizenship or termination of residency in fact did have as one of its 

principal purposes the avoidance of tax.

Certain exceptions from the treatment that an individual relinquished his or her U.S. 

citizenship or terminated his or her U.S. residency for tax avoidance purposes may also apply. 

For example, a U.S. citizen who loses his or her citizenship and who satisfies either the tax 

liability test or the net worth test (described above) can avoid being deemed to have a principal 

purpose of tax avoidance if the individual falls within certain categories (such as being a dual 

citizen) and the individual, within one year from the date of loss of citizenship, submits a ruling 

request for a determination by the Secretary of the Treasury as to whether such loss had as one of 

its principal purposes the avoidance of taxes. 

Estate tax rules with respect to expatriates

Nonresident noncitizens generally are subject to estate tax on certain transfers of U.S.-

situated property at death. 194 Such property includes real estate and tangible property located 

within the United States. Moreover, for estate tax purposes, stock held by nonresident 

noncitizens is treated as U.S.-situated if issued by a U.S. corporation.

Special rules apply to U.S. citizens who relinquish their citizenship and long-term 

residents who terminate their U.S. residency within the 10 years prior to the date of death, unless 

the loss of status did not have as one its principal purposes the avoidance of tax (sec. 2107). 

Under these rules, the decedent’s estate includes the proportion of the decedent’s stock in a 

 

194 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 the EGTRRA’s provisions (including 

estate tax repeal) do not apply to estates of decedents dying after December 31, 2010.
93

foreign corporation that the fair market value of the U.S.-situs assets owned by the corporation 

bears to the total assets of the corporation. This rule applies only if (1) the decedent owned, 

directly, at death 10 percent or more of the combined voting power of all voting stock of the 

corporation and (2) the decedent owned, directly or indirectly, at death more than 50 percent of 

the total voting stock of the corporation or more than 50 percent of the total value of all stock of 

the corporation. 

Taxpayers are deemed to have a principal purpose of tax avoidance if they meet the fiveyear tax liability test or the net worth test, discussed above. Exceptions from this tax avoidance 

treatment apply in the same circumstances as those described above (relating to certain dual 

citizens and other individuals who submit a timely and complete ruling request with the IRS as to 

whether their expatriation or residency termination had a principal purpose of tax avoidance).

Gift tax rules with respect to expatriates

Nonresident noncitizens generally are subject to gift tax on certain transfers by gift of 

U.S.-situated property. Such property includes real estate and tangible property located within 

the United States. Unlike the estate tax rules for U.S. stock held by nonresidents, however, 

nonresident noncitizens generally are not subject to U.S. gift tax on the transfer of intangibles, 

such as stock or securities, regardless of where such property is situated.

Special rules apply to U.S. citizens who relinquish their U.S. citizenship or long-term 

residents of the United States who terminate their U.S. residency within the 10 years prior to the 

date of transfer, unless such loss did not have as one of its principal purposes the avoidance of 

tax (sec. 2501(a)(3)). Under these rules, nonresident noncitizens are subject to gift tax on 

transfers of intangibles, such as stock or securities. Taxpayers are deemed to have a principal 

purpose of tax avoidance if they meet the five-year tax liability test or the net worth test, 

discussed above. Exceptions from this tax avoidance treatment apply in the same circumstances 

as those described above (relating to certain dual citizens and other individuals who submit a 

timely and complete ruling request with the IRS as to whether their expatriation or residency 

termination had a principal purpose of tax avoidance).

Other tax rules with respect to expatriates

The expatriation tax provisions permit a credit against the U.S. tax imposed under such 

provisions for any foreign income, gift, estate, or similar taxes paid with respect to the items 

subject to such taxation. This credit is available only against the tax imposed solely as a result of 

the expatriation tax provisions, and is not available to be used to offset any other U.S. tax 

liability.

In addition, certain information reporting requirements apply. Under these rules, a U.S. 

citizen who loses his or her citizenship is required to provide a statement to the State Department 

(or other designated government entity) that includes the individual's social security number, 

forwarding foreign address, new country of residence and citizenship, a balance sheet in the case 

of individuals with a net worth of at least $500,000, and such other information as the Secretary 

may prescribe. The information statement must be provided no later than the earliest day on 

which the individual (1) renounces the individual’s U.S. nationality before a diplomatic or 
94

consular officer of the United States, (2) furnishes to the U.S. Department of State a statement of 

voluntary relinquishment of U.S. nationality confirming an act of expatriation, (3) is issued a 

certificate of loss of U.S. nationality by the U.S. Department of State, or (4) loses U.S. 

nationality because the individual’s certificate of naturalization is canceled by a U.S. court. The 

entity to which such statement is to be provided is required to provide to the Secretary of the 

Treasury copies of all statements received and the names of individuals who refuse to provide 

such statements. A long-term resident whose U.S. residency is terminated is required to attach a 

similar statement to his or her U.S. income tax return for the year of such termination. An 

individual's failure to provide the required statement results in the imposition of a penalty for 

each year the failure continues equal to the greater of (1) 5 percent of the individual's 

expatriation tax liability for such year, or (2) $1,000.

The State Department is required to provide the Secretary of the Treasury with a copy of 

each certificate of loss of nationality approved by the State Department. Similarly, the agency 

administering the immigration laws is required to provide the Secretary of the Treasury with the 

name of each individual whose status as a lawful permanent resident has been revoked or has 

been determined to have been abandoned. Further, the Secretary of the Treasury is required to 

publish in the Federal Register the names of all former U.S. citizens with respect to whom it 

receives the required statements or whose names or certificates of loss of nationality it receives 

under the foregoing information-sharing provisions.

Immigration rules with respect to expatriates

Under U.S. immigration laws, any former U.S. citizen who officially renounces his or her 

U.S. citizenship and who is determined by the Attorney General to have renounced for the 

purpose of U.S. tax avoidance is ineligible to receive a U.S. visa and will be denied entry into the 

United States. This provision was included as an amendment (the “Reed amendment”) to 

immigration legislation that was enacted in 1996.

Description of Proposal

In general

The proposal generally subjects certain U.S. citizens who relinquish their U.S. citizenship 

and certain long-term U.S. residents who terminate their U.S. residence to tax on the net 

unrealized gain in their property as if such property were sold for fair market value on the day 

before the expatriation or residency termination. Gain from the deemed sale is taken into 

account at that time without regard to other Code provisions; any loss from the deemed sale 

generally would be taken into account to the extent otherwise provided in the Code. Any net 

gain on the deemed sale is recognized to the extent it exceeds $600,000 ($1.2 million in the case 

of married individuals filing a joint return, both of whom relinquish citizenship or terminate 

residency). The $600,000 amount is increased by a cost of living adjustment factor for calendar 

years after 2003.

Individuals covered

Under the proposal, the mark-to-market tax applies to U.S. citizens who relinquish 

citizenship and long-term residents who terminate U.S. residency. An individual is a long-term 
95

resident if he or she was a lawful permanent resident for at least eight out of the 15 taxable years 

ending with the year in which the termination of residency occurs. An individual is considered 

to terminate long-term residency when either the individual ceases to be a lawful permanent 

resident (i.e., loses his or her green card status), or the individual is treated as a resident of 

another country under a tax treaty and the individual does not waive the benefits of the treaty.

Exceptions from the mark-to-market tax are provided in two situations. The first 

exception applies to an individual who was born with citizenship both in the United States and in 

another country; provided that (1) as of the expatriation date the individual continues to be a 

citizen of, and is taxed as a resident of, such other country, and (2) the individual was not a 

resident of the United States for the five taxable years ending with the year of expatriation. The 

second exception applies to a U.S. citizen who relinquishes U.S. citizenship before reaching age 

18 and a half, provided that the individual was a resident of the United States for no more than 

five taxable years before such relinquishment.

Election to be treated as a U.S. citizen

Under the proposal, an individual is permitted to make an irrevocable election to continue 

to be taxed as a U.S. citizen with respect to all property that otherwise is covered by the 

expatriation tax. This election is an “all or nothing” election; an individual is not permitted to 

elect this treatment for some property but not for other property. The election, if made, would 

apply to all property that would be subject to the expatriation tax and to any property the basis of 

which is determined by reference to such property. Under this election, the individual would 

continue to pay U.S. income taxes at the rates applicable to U.S. citizens following expatriation 

on any income generated by the property and on any gain realized on the disposition of the 

property. In addition, the property would continue to be subject to U.S. gift, estate, and 

generation-skipping transfer taxes. In order to make this election, the taxpayer would be 

required to waive any treaty rights that would preclude the collection of the tax. 

The individual also would be required to provide security to ensure payment of the tax 

under this election in such form, manner, and amount as the Secretary of the Treasury requires. 

The amount of mark-to-market tax that would have been owed but for this election (including 

any interest, penalties, and certain other items) shall be a lien in favor of the United States on all 

U.S.-situs property owned by the individual. This lien shall arise on the expatriation date and 

shall continue until the tax liability is satisfied, the tax liability has become unenforceable by 

reason of lapse of time, or the Secretary is satisfied that no further tax liability may arise by 

reason of this proposal. The rules of section 6324A(d)(1), (3), and (4) (relating to liens arising in 

connection with the deferral of estate tax under section 6166) apply to liens arising under this 

proposal. 

Date of relinquishment of citizenship

Under the proposal, an individual is treated as having relinquished U.S. citizenship on the 

earliest of four possible dates: (1) the date that the individual renounces U.S. nationality before a 

diplomatic or consular officer of the United States (provided that the voluntary relinquishment is 

later confirmed by the issuance of a certificate of loss of nationality); (2) the date that the 

individual furnishes to the State Department a signed statement of voluntary relinquishment of 
96

U.S. nationality confirming the performance of an expatriating act (again, provided that the 

voluntary relinquishment is later confirmed by the issuance of a certificate of loss of nationality); 

(3) the date that the State Department issues a certificate of loss of nationality; or (4) the date that 

a U.S. court cancels a naturalized citizen’s certificate of naturalization.

Deemed sale of property upon expatriation or residency termination

The deemed sale rule of the proposal generally applies to all property interests held by 

the individual on the date of relinquishment of citizenship or termination of residency. Special 

rules apply in the case of trust interests, as described below. U.S. real property interests, which 

remain subject to U.S. tax in the hands of nonresident noncitizens, generally are excepted from 

the proposal. Regulatory authority is granted to the Treasury to except other types of property 

from the proposal.

Under the proposal, an individual who is subject to the mark-to-market tax is required to 

pay a tentative tax equal to the amount of tax that would be due for a hypothetical short tax year 

ending on the date the individual relinquished citizenship or terminated residency. Thus, the 

tentative tax is based on all income, gain, deductions, loss, and credits of the individual for the 

year through such date, including amounts realized from the deemed sale of property. The 

tentative tax is due on the 90th day after the date of relinquishment of citizenship or termination 

of residency.

Retirement plans and similar arrangements

Subject to certain exceptions, the proposal applies to all property interests held by the 

individual at the time of relinquishment of citizenship or termination of residency. Accordingly, 

such property includes an interest in an employer-sponsored retirement plan or deferred 

compensation arrangement as well as an interest in an individual retirement account or annuity 

(i.e., an IRA).195 However, the proposal contains a special rule for an interest in a “qualified 

retirement plan.” For purposes of the proposal, a “qualified retirement plan” includes an 

employer-sponsored qualified plan (sec. 401(a)), a qualified annuity (sec. 403(a)), a tax-sheltered 

annuity (sec. 403(b)), an eligible deferred compensation plan of a governmental employer 

(sec. 457(b)), or an IRA (sec. 408). The special retirement plan rule applies also, to the extent 

provided in regulations, to any foreign plan or similar retirement arrangement or program. An 

interest in a trust that is part of a qualified retirement plan or other arrangement that is subject to 

the special retirement plan rule is not subject to the rules for interests in trusts (discussed below).

Under the special rule, an amount equal to the present value of the individual’s vested, 

accrued benefit under a qualified retirement plan is treated as having been received by the 

individual as a distribution under the plan on the day before the individual’s relinquishment of 

citizenship or termination of residency. It is not intended that the plan would be deemed to have 

made a distribution for purposes of the tax-favored status of the plan, such as whether a plan may 

 

195 Application of the provision is not limited to an interest that meets the definition of 

property under section 83 (relating to property transferred in connection with the performance of 

services).
97

permit distributions before a participant has severed employment. In the case of any later 

distribution to the individual from the plan, the amount otherwise includible in the individual’s 

income as a result of the distribution is reduced to reflect the amount previously included in 

income under the special retirement plan rule. The amount of the reduction applied to a 

distribution is the excess of: (1) the amount included in income under the special retirement plan 

rule over (2) the total reductions applied to any prior distributions. However, under the proposal, 

the retirement plan, and any person acting on the plan’s behalf, will treat any later distribution in 

the same manner as the distribution would be treated without regard to the special retirement 

plan rule.

It is expected that the Treasury Department will provide guidance for determining the 

present value of an individual’s vested, accrued benefit under a qualified retirement plan, such as 

the individual’s account balance in the case of a defined contribution plan or an IRA, or present 

value determined under the qualified joint and survivor annuity rules applicable to a defined 

benefit plan (sec. 417(e)).

Deferral of payment of tax

Under the proposal, an individual is permitted to elect to defer payment of the mark-tomarket tax imposed on the deemed sale of the property. Interest is charged for the period the tax 

is deferred at a rate two percentage points higher than the rate normally applicable to individual 

underpayments. Under this election, the mark-to-market tax attributable to a particular property 

is due when the property is disposed of (or, if the property is disposed of in whole or in part in a 

nonrecognition transaction, at such other time as the Secretary may prescribe). The mark-tomarket tax attributable to a particular property is an amount that bears the same ratio to the total 

mark-to-market tax for the year as the gain taken into account with respect to such property bears 

to the total gain taken into account under these rules for the year. The deferral of the mark-tomarket tax may not be extended beyond the individual’s death.

In order to elect deferral of the mark-to-market tax, the individual is required to provide 

adequate security to the Treasury to ensure that the deferred tax and interest will be paid. Other 

security mechanisms are permitted provided that the individual establishes to the satisfaction of 

the Secretary that the security is adequate. In the event that the security provided with respect to 

a particular property subsequently becomes inadequate and the individual fails to correct the 

situation, the deferred tax and the interest with respect to such property will become due. As a 

further condition to making the election, the individual is required to consent to the waiver of 

any treaty rights that would preclude the collection of the tax.

The deferred amount (including any interest, penalties, and certain other items) shall be a 

lien in favor of the United States on all U.S.-situs property owned by the individual. This lien 

shall arise on the expatriation date and shall continue until the tax liability is satisfied, the tax 

liability has become unenforceable by reason of lapse of time, or the Secretary is satisfied that no 

further tax liability may arise by reason of this proposal. The rules of section 6324A(d)(1), (3), 

and (4) (relating to liens arising in connection with the deferral of estate tax under section 6166) 

apply to liens arising under this proposal. 
98

Interests in trusts

Under the proposal, detailed rules apply to trust interests held by an individual at the time 

of relinquishment of citizenship or termination of residency. The treatment of trust interests 

depends on whether the trust is a qualified trust. A trust is a qualified trust if a court within the 

United States is able to exercise primary supervision over the administration of the trust and one 

or more U.S. persons have the authority to control all substantial decisions of the trust.

Constructive ownership rules apply to a trust beneficiary that is a corporation, 

partnership, trust, or estate. In such cases, the shareholders, partners, or beneficiaries of the 

entity are deemed to be the direct beneficiaries of the trust for purposes of applying these 

proposals. In addition, an individual who holds (or who is treated as holding) a trust instrument 

at the time of relinquishment of citizenship or termination of residency is required to disclose on 

his or her tax return the methodology used to determine his or her interest in the trust, and 

whether such individual knows (or has reason to know) that any other beneficiary of the trust 

uses a different method.

Nonqualified trusts.–If an individual holds an interest in a trust that is not a qualified 

trust, a special rule applies for purposes of determining the amount of the mark-to-market tax due 

with respect to such trust interest. The individual’s interest in the trust is treated as a separate 

trust consisting of the trust assets allocable to such interest. Such separate trust is treated as 

having sold its net assets as of the date of relinquishment of citizenship or termination of 

residency and having distributed the assets to the individual, who then is treated as having 

recontributed the assets to the trust. The individual is subject to the mark-to-market tax with 

respect to any net income or gain arising from the deemed distribution from the trust.

The election to defer payment is available for the mark-to-market tax attributable to a 

nonqualified trust interest. Interest is charged for the period the tax is deferred at a rate two 

percentage points higher than the rate normally applicable to individual underpayments. A 

beneficiary’s interest in a nonqualified trust is determined under all the facts and circumstances, 

including the trust instrument, letters of wishes, and historical patterns of trust distributions.

Qualified trusts.–If an individual has an interest in a qualified trust, the amount of 

unrealized gain allocable to the individual’s trust interest is calculated at the time of expatriation 

or residency termination. In determining this amount, all contingencies and discretionary 

interests are assumed to be resolved in the individual’s favor (i.e., the individual is allocated the 

maximum amount that he or she could receive). The mark-to-market tax imposed on such gains 

is collected when the individual receives distributions from the trust, or if earlier, upon the 

individual’s death. Interest is charged for the period the tax is deferred at a rate two percentage 

points higher than the rate normally applicable to individual underpayments.

If an individual has an interest in a qualified trust, the individual is subject to the mark-tomarket tax upon the receipt of distributions from the trust. These distributions also may be 

subject to other U.S. income taxes. If a distribution from a qualified trust is made after the 

individual relinquishes citizenship or terminates residency, the mark-to-market tax is imposed in 

an amount equal to the amount of the distribution multiplied by the highest tax rate generally 

applicable to trusts and estates, but in no event will the tax imposed exceed the deferred tax 
99

amount with respect to the trust interest. For this purpose, the deferred tax amount is equal to (1) 

the tax calculated with respect to the unrealized gain allocable to the trust interest at the time of 

expatriation or residency termination, (2) increased by interest thereon, and (3) reduced by any 

mark-to-market tax imposed on prior trust distributions to the individual.

If any individual’s interest in a trust is vested as of the expatriation date (e.g., if the 

individual’s interest in the trust is non-contingent and non-discretionary), the gain allocable to 

the individual’s trust interest is determined based on the trust assets allocable to his or her trust 

interest. If the individual’s interest in the trust is not vested as of the expatriation date (e.g., if 

the individual’s trust interest is a contingent or discretionary interest), the gain allocable to his or 

her trust interest is determined based on all of the trust assets that could be allocable to his or her 

trust interest, determined by resolving all contingencies and discretionary powers in the 

individual’s favor. In the case where more than one trust beneficiary is subject to the 

expatriation tax with respect to trust interests that are not vested, the rules are intended to apply 

so that the same unrealized gain with respect to assets in the trust is not taxed to both individuals.

Mark-to-market taxes become due if the trust ceases to be a qualified trust, the individual 

disposes of his or her qualified trust interest, or the individual dies. In such cases, the amount of 

mark-to-market tax equals the lesser of (1) the tax calculated under the rules for nonqualified 

trust interests as of the date of the triggering event, or (2) the deferred tax amo unt with respect to 

the trust interest as of that date.

The tax that is imposed on distributions from a qualified trust generally is deducted and 

withheld by the trustees. If the individual does not agree to waive treaty rights that would 

preclude collection of the tax, the tax with respect to such distributions is imposed on the trust, 

the trustee is personally liable for the tax, and any other beneficiary has a right of contribution 

against such individual with respect to the tax. Similar rules apply when the qualified trust 

interest is disposed of, the trust ceases to be a qualified trust, or the individual dies.

Coordination with present-law alternative tax regime

The proposal provides a coordination rule with the present-law alternative tax regime. 

Under the proposal, the expatriation income tax rules under section 877, and the expatriation 

estate and gift tax rules under sections 2107 and 2501(a)(3) (described above), do not apply to a 

former citizen or former long-term resident whose expatriation or residency termination occurs 

on or after February 5, 2003.

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

Under the proposal, the exclusion from income provided in section 102 (relating to 

exclusions from income for the value of property acquired by gift or inheritance) does not apply 

to the value of any property received by gift or inheritance from a former citizen or former longterm resident (i.e., an individual who relinquished U.S. citizenship or terminated U.S. residency), 

subject to the exceptions described above relating to certain dual citizens and minors. 

Accordingly, a U.S. taxpayer who receives a gift or inheritance from such an individual is 

required to include the value of such gift or inheritance in gross income and is subject to U.S. tax 

on such amount. Having included the value of the property in income, the recipient would then 
100

take a basis in the property equal to that value. The tax does not apply to property that is shown 

on a timely filed gift tax return and that is a taxable gift by the former citizen or former longterm resident, or property that is shown on a timely filed estate tax return and included in the 

gross U.S. estate of the former citizen or former long-term resident (regardless of whether the tax 

liability shown on such a return is reduced by credits, deductions, or exclusions available under 

the estate and gift tax rules). In addition, the tax does not apply to property in cases in which no 

estate or gift tax return is required to be filed, where no such return would have been required to 

be filed if the former citizen or former long-term resident had not relinquished citizenship or 

terminated residency, as the case may be. Applicable gifts or bequests that are made in trust are 

treated as made to the beneficiaries of the trust in proportion to their respective interests in the 

trust.

Information reporting

The proposal provides that certain information reporting requirements under present law 

(sec. 6039G) applicable to former citizens and former long-term residents also apply for 

purposes of the proposal.

Immigration rules

The proposal amends the immigration rules that deny tax-motivated expatriates reentry 

into the United States by removing the requirement that the expatriation be tax-motivated, and 

instead denies former citizens reentry into the United States if the individual is determined not to 

be in compliance with his or her tax obligations under the proposal’s expatriation tax proposals 

(regardless of the subjective motive for expatriating). For this purpose, the proposal permits the 

IRS to disclose certain items of return information of an individual, upon written request of the 

Attorney General or his delegate, as is necessary for making a determination under section 

212(a)(10)(E) of the Immigration and Nationality Act. Specifically, the proposal would permit 

the IRS to disclose to the agency administering section 212(a)(10)(E) whether such taxpayer is in 

compliance with section 877A and identify the items of noncompliance. Recordkeeping 

requirements, safeguards, and civil and criminal penalties for unauthorized disclosure or 

inspection would apply to return information disclosed under this proposal.

Effective Date

The proposal generally is effective for U.S. citizens who relinquish citizenship or longterm residents who terminate their residency on or after February 5, 2003. The proposals 

relating to gifts and inheritances are effective for gifts and inheritances received from former 

citizens and former long-term residents on or after February 5, 2003, whose expatriation or 

residency termination occurs on or after such date. The proposals relating to former citizens 

under U.S. immigration laws are effective on or after the date of enactment.
101

F. Other Revenue Proposals

1. Effectively connected income to include certain foreign source income

Present Law

Nonresident alien individuals and foreign corporations (collectively, foreign persons) are 

subject to U.S. tax on income that is effectively connected with the conduct of a U.S. trade or 

business; the U.S. tax on such income is calculated in the same manner and at the same 

graduated rates as the tax on U.S. persons.196 Foreign persons also are subject to a 30-percent 

gross-basis tax, collected by withholding, on certain U.S.-source income, such as interest, 

dividends and other fixed or determinable annual or periodical (“FDAP”) income, that is not 

effectively connected with a U.S. trade or business. This 30-percent withholding tax may be 

reduced or eliminated pursuant to an applicable tax treaty. Foreign persons generally are not 

subject to U.S. tax on foreign-source income that is not effectively connected with a U.S. trade or 

business.

Detailed rules apply for purposes of determining whether income is treated as effectively 

connected with a U.S. trade or business (so-called “U.S.-effectively connected income”).197 The 

rules differ depending on whether the income at issue is U.S-source or foreign-source income. 

Under these rules, U.S.-source FDAP income, such as U.S.-source interest and dividends, and 

U.S.-source capital gains are treated as U.S.-effectively connected income if such income is 

derived from assets used in or held for use in the active conduct of a U.S. trade or business, or 

from business activities conducted in the United States. All other types of U.S.-source income 

are treated as U.S.-effectively connected income (sometimes referred to as the “force of 

attraction rule”).

In general, foreign-source income is not treated as U.S.-effectively connected income.198 

However, foreign-source income, gain, deduction, or loss generally is considered to be 

effectively connected with a U.S. business only if the person has an office or other fixed place of 

business within the United States to which such income, gain, deduction, or loss is attributable 

and such income falls into one of three categories described below.199 For these purposes, 

income generally is not considered attributable to an office or other fixed place of business 

within the United States unless such office or fixed place of business is a material factor in the 

production of the income, and such office or fixed place of business regularly carries on 

activities of the type that generate such income.200

 

196 Sections 871(b) and 882.

197 Section 864(c).

198 Section 864(c)(4).

199 Section 864(c)(4)(B).

200 Section 864(c)(5). 
102

The first category consists of rents or royalties for the use of patents, copyrights, secret 

processes, or formulas, good will, trademarks, trade brands, franchises, or other like intangible 

properties derived in the active conduct of the U.S. trade or business.201 The second category 

consists of interest or dividends derived in the active conduct of a banking, financing, or similar 

business within the United States, or received by a corporation whose principal business is 

trading in stocks or securities for its own account. 202 Notwithstanding the foregoing, foreignsource income consisting of dividends, interest, or royalties is not treated as effectively 

connected if the items are paid by a foreign corporation in which the recipient owns, directly, 

indirectly, or constructively, more than 50 percent of the total combined voting power of the 

stock. 203 The third category consists of income, gain, deduction, or loss derived from the sale or 

exchange of inventory or property held by the taxpayer primarily for sale to customers in the 

ordinary course of the trade or business where the property is sold or exchanged outside the 

United States through the foreign person’s U.S. office or other fixed place of business.204 Such 

amounts are not treated as effectively connected if the property is sold or exchanged for use, 

consumption, or disposition outside the United States and an office or other fixed place of 

business of the taxpayer in a foreign country materially participated in the sale or exchange.

The Code provides sourcing rules for enumerated types of income, including interest, 

dividends, rents, royalties, and personal services income.205 For example, interest income 

generally is sourced based on the residence of the obligor. Dividend income generally is sourced 

based on the residence of the corporation paying the dividend. Thus, interest paid on obligations 

of foreign persons and dividends paid by foreign corporations generally are treated as 

foreign-source income.

Other types of income are not specifically covered by the Code's sourcing rules. For 

example, fees for accepting or confirming letters of credit have been sourced under principles 

analogous to the interest sourcing rules.206 In addition, under regulations, payments in lieu of 

dividends and interest derived from securities lending transactions are sourced in the same 

manner as interest and dividends, including for purposes of determining whether such income is 

effectively connected with a U.S. trade or business.207 Moreover, income from notional principal 

contracts (such as interest rate swaps) generally is sourced based on the residence of the recipient 

 

201 Section 864(c)(4)(B)(i).

202 Section 864(c)(4)(B)(ii).

203 Section 864(c)(4)(D)(i).

204 Section 864(c)(4)(B)(iii).

205 Sections 861 through 865.

206 See Bank of America v. United States, 680 F.2d 142 (Ct. Cl. 1982).

207 Treas. Reg. sec. 1.864-5(b)(2)(ii).
103

of the income, but is treated as U.S.-source effectively connected income if it arises from the 

conduct of a United States trade or business.208

Description of Proposal

Under the proposal, each category of foreign-source income that is treated as effectively 

connected with a U.S. trade or business is expanded to include economic equivalents of such 

income (i.e., economic equivalents of certain foreign-source (1) rents and royalties, (2) dividends 

and interest, and (3) income on sales or exchanges of goods in the ordinary course of business). 

Thus, such economic equivalents are treated as U.S.-effectively connected income in the same 

circumstances that foreign-source rents, royalties, dividends, interest, or certain inventory sales 

are treated as U.S.-effectively connected income. For example, foreign-source interest and 

dividend equivalents are treated as U.S.-effectively connected income if the income is 

attributable to a U.S. office of the foreign person, and such income is derived by such foreign 

person in the active conduct of a banking, financing, or similar business within the United States, 

or the foreign person is a corporation whose principal business is trading in stocks or securities 

for its own account.

Effective date

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

2. Recapture of overall foreign losses on sale of controlled foreign corporation stock

Present Law

U.S. persons may credit foreign taxes against U.S. tax on foreign-source income. The 

amount of foreign tax credits that may be claimed in a year is subject to a limitation that prevents 

taxpayers from using foreign tax credits to offset U.S. tax on U.S.-source income. The amount 

of foreign tax credits generally is limited to the portion of the taxpayer's U.S. tax which the 

taxpayer's foreign-source taxable income (i.e., foreign-source gross income less allocable 

expenses or deductions) bears to the taxpayer's worldwide taxable income for the year.209

Separate limitations are applied to specific categories of income.

Special recapture rules apply in the case of foreign losses for purposes of applying the 

foreign tax credit limitation. 210 Under these rules, losses for any taxable year in a limitation 

category which exceed the aggregate amount of foreign income earned in other limitation 

categories (a so-called “overall foreign loss”) are recaptured by resourcing foreign-source 

income earned in a subsequent year as U.S.-source income.211 The amount resourced as 

 

208 Treas. Reg. sec. 1.863-7(b)(3).

209 Section 904(a).

210 Section 904(f).

211 Section 904(f)(1).
104

U.S.-source income generally is limited to the lesser of the amount of the overall foreign losses 

not previously recaptured, or 50 percent of the taxpayer's foreign-source income in a given year 

(the “50-percent limit”). Taxpayers may elect to recapture a larger percentage of such losses.

A special recapture rule applies to ensure the recapture of an overall foreign loss where 

property which was used in a trade or business predominantly outside the United States is 

disposed of prior to the time the loss has been recaptured.212 In this regard, dispositions of trade 

or business property used predominantly outside the United States are treated as having been 

recognized as foreign-source income (regardless of whether gain would otherwise be recognized 

upon disposition of the assets), in an amount equal to the lesser of the excess of the fair market 

value of such property over its adjusted basis, or the amount of unrecaptured overall foreign 

losses. Such foreign-source income is resourced as U.S.-source income without regard to the 

50-percent limit. For example, if a U.S. corporation transfers its foreign branch business assets 

to a foreign corporation in a nontaxable section 351 transaction, the taxpayer would be treated 

for purposes of the recapture rules as having recognized foreign-source income in the year of the 

transfer in an amount equal to the excess of the fair market value of the property disposed over 

its adjusted basis (or the amount of unrecaptured foreign losses, if smaller). Such income would 

be recaptured as U.S.-source income to the extent of any prior unrecaptured overall foreign 

losses.213

Detailed rules apply in allocating and apportioning deductions and losses for foreign tax 

credit limitation purposes. In the case of interest expense, such amounts generally are 

apportioned to all gross income under an asset method, under which the taxpayer's assets are 

characterized as producing income in statutory or residual groupings (i.e., foreign-source income 

in the various limitation categories or U.S.-source income).214 Interest expense is apportioned 

among these groupings based on the relative asset values in each. Taxpayers may elect to value 

assets based on either tax book value or fair market value.

Each corporation that is a member of an affiliated group is required to apportion its 

interest expense using apportionment fractions determined by reference to all assets of the 

affiliated group. For this purpose, an affiliated group generally is defined to include only 

domestic corporations. Stock in a foreign subsidiary, however, is treated as a foreign asset that 

may attract the allocation of U.S. interest expense for these purposes. If tax basis is used to 

value assets, the adjusted basis of the stock of certain 10-percent or greater owned foreign 

corporations or other non-affiliated corporations must be increased by the amount of earnings 

and profits of such corporation accumulated during the period the U.S. shareholder held the 

stock, for purposes of the interest apportionment.

 

212 Section 904(f)(3).

213 Coordination rules apply in the case of losses recaptured under the branch loss 

recapture rules. Section 367(a)(3)(C). 

214 Section 864(e) and Temp. Treas. Reg. sec. 1.861-9T.
105

Description of Proposal

Under the proposal, the special recapture rule for overall foreign losses that currently 

applies to dispositions of foreign trade or business assets is to apply to the disposition of 

controlled foreign corporation stock. Thus, dispositions of controlled foreign corporation stock 

are recognized as foreign-source income in an amount equal to the lesser of the fair market value 

of the stock over its adjusted basis, or the amount of prior unrecaptured overall foreign losses. 

Such income is resourced as U.S.-source income for foreign tax credit limitation purposes 

without regard to the 50-percent limit.

Effective date

The proposal is effective as of the date of enactment.

3. Disallowance of certain partnership loss transfers

Present Law

Contributions of property

Under present law, if a partner contributes property to a partnership, generally no gain or 

loss is recognized to the contributing partner at the time of contribution. 215 The partnership takes 

the property at an adjusted basis equal to the contributing partner’s adjusted basis in the 

property. 216 The contributing partner increases its basis in its partnership interest by the adjusted 

basis of the contributed property. 217 Any items of partnership income, gain, loss and deduction 

with respect to the contributed property is allocated among the partners to take into account any 

built-in gain or loss at the time of the contribution. 218 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. 219 

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.220 

 

215 Sec. 721.

216 Sec. 723.

217 Sec. 722.

218 Sec. 704(c)(1)(A).

219 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).

220 Treas. Reg. 1.704-3(a)(7).
106

If the contributing partner’s interest is liquidated, there is no specific guidance preventing the 

allocation of the built-in loss to the remaining partners. Thus, it appears that losses can be 

“transferred” to other partners where the contributing partner no longer remains a partner.

Transfers of partnership interests

Under present law, a partnership does not adjust the basis of partnership property 

following the transfer of a partnership interest unless the partnership has made a one-time 

election under section 754 to make basis adjustments.221 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.222 These adjustments are intended to adjust the basis 

of partnership property to approximate the result of a direct purchase of the property by the 

transferee partner. Under these rules, if a partner purchases an interest in a partnership with an 

existing built-in loss and no election under section 754 in effect, the transferee partner may be 

allocated a share of the loss when the partnership disposes of the property (or depreciates the 

property).

Distributions of partnership property

With certain exceptions, partners may receive distributions of partnership property 

without recognition of gain or loss by either the partner or the partnership.223 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).224 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).225

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.226 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 

 

221 Sec. 743(a).

222 Sec. 743(b).

223 Sec. 731(a) and (b).

224 Sec. 732(b).

225 Sec. 732(a).

226 Sec. 734(a).
107

the distributee partner).227 To the extent the adjusted basis of the distributed properties increases 

(or loss is recognized) the partnership’s adjusted basis in its properties is decreased by a like 

amount; likewise, to the extent the adjusted basis of the distributed properties decrease (or gain is 

recognized), the partnership’s adjusted basis in its properties is increased by a like amount. 

Under these rules, a partnership with no election in effect under section 754 may distribute 

property with an adjusted basis lower than the distributee partner’s proportionate share of the 

adjusted basis of all partnership property and leave the remaining partners with a smaller net 

built-in gain or a larger net built-in loss than before the distribution.

Description of Proposal

Contributions of property

Under the proposal, a built-in loss may be taken into account only by the contributing 

partner and not by other partners. Except as provided in regulations, in determining the amount 

of items allocated to partners other than the contributing partner, the basis of the contributed 

property is treated as the fair market value at the time of contribution. Thus, if the contributing 

partner’s partnership interest is transferred or liquidated, the partnership’s adjusted basis in the 

property is based on its fair market value at the time of contribution, and the built-in loss is 

eliminated.228 

Transfers of partnership interests

The proposal provides that the basis adjustment rules under section 743 are mandatory in 

the case of the transfer of a partnership interest with respect to which there is a substantial builtin loss (rather than being elective as under present law). For this purpose, a substantial built-in 

loss exists if the partnership's adjusted basis in its property exceeds by more than $250,000 the 

fair market value of the partnership property.

Thus, for example, assume that partner A sells his 25-percent partnership interest to B for 

its fair market value of $1 million. Also assume that, immediately after the transfer, the fair 

market value of partnership assets is $4 million and the partnership's adjusted basis in the 

partnership assets is $4.3 million. Under the proposal, section 743(b) applies, so that a $300,000 

decrease is required to the adjusted basis of the partnership assets with respect to B. As a result, 

B would recognize no gain or loss if the partnership immediately sold all its assets for their fair 

market value.

Distribution of partnership property

The proposal provides that the 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 

 

227 Sec. 734(b).

228 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.
108

basis 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. Under present law, C would 

recognize a loss of $4 million if the LMN stock were sold for $1 million.

Under the proposal, however, there is a substantial basis adjustment because the $2 

million increase in the adjusted basis of LMN stock (described in section 734(b)(2)(B)) is greater 

than $250,000. Thus, the partnership is required to decrease the basis of XYZ stock (under 

section 734(b)(2)) by $2 million (the amount by which the basis LMN stock was increased), 

leaving a basis of $5 million. If the XYZ stock were then sold by the partnership for $1 million, 

A and B would each recognize a loss of $2 million.

 Effective Date

The proposal applies to contributions, transfers, and distributions (as the case may be) 

after the date of enactment.

4. Treatment of stripped bonds to apply to stripped interests in bond and preferred stock 

funds

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.229

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 

 

229

 Helvering v. Horst, 311 U.S. 112 (1940).
109

below).230 However, there are no specific statutory rules that address stripping transactions with

respect to common stock or other equity interests (other than preferred stock).231

Stripped bonds

Special rules are provided with respect to the purchaser and “stripper” of stripped 

bonds.232 A “stripped bond” is defined as a debt instrument in which there has been a separation 

in ownership between the underlying debt instrument and any interest coupon that has not yet 

become payable.233 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.234 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.235 Special rules apply to require 

 

230 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).

231 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.

232 Sec. 1286.

233 Sec. 1286(e).

234 Sec. 1286(a).

235 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.
110

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.236

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.237 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.238 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. 239

Description of Proposal

The proposal authorizes the Treasury Department to promulgate regulations that, in 

appropriate cases, apply rules that are similar to the present-law rules for stripped bonds and 

stripped preferred stock to direct or indirect interests in an entity or account substantially all of 

the assets of which consist of bonds (as defined in section 1286(e)(1)), preferred stock (as 

defined in section 305(e)(5)(B)), or any combination thereof. The proposal applies only to cases 

in which the present-law rules for stripped bonds and stripped preferred stock do not already 

apply to such interests.

 

236 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)).

237 Sec. 305(e)(5).

238 Sec. 305(e)(1).

239 Sec. 305(e)(3).
111

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 proposal 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. 2002-68,240 modifying and superceding Rev. Proc. 2002-16.241

No inference is intended as to the treatment under the present-law rules for stripped 

bonds and stripped preferred stock, or under any other provisions or doctrines of present law, of 

interests in an entity or account substantially all of the assets of which consist of bonds, preferred 

stock, or any combination thereof. The Treasury regulations, when issued, would be applied 

prospectively, except in cases to prevent abuse.

Effective Date

The proposal is effective for purchases and dispositions occurring after the date of 

enactment.

5. Minimum holding period for foreign tax credit with respect to withholding taxes on 

income other than dividends

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 

 

240 2002-43 I.R.B. 753.

241 2002-9 I.R.B. 572.
112

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.

Description of Proposal

The proposal expands the present-law disallowance of foreign tax credits to include 

credits for gross-basis foreign withholding taxes with respect to any item of income or gain from 

property if the taxpayer who receives the income or gain has not held the property for more than 

15 days (within a 30-day testing period), exclusive of periods during which the taxpayer is 

protected from risk of loss. The proposal does not apply to foreign tax credits that are subject to 

the present-law disallowance with respect to dividends. The proposal also does not apply to 

certain income or gain that is received with respect to property held by active dealers. Rules 

similar to the present-law disallowance for foreign tax credits with respect to dividends apply to 

foreign tax credits that are subject to the proposal. In addition, the proposal authorizes the 

Treasury Department to issue regulations providing that the proposal does not apply in 

appropriate cases.

Effective Date

The proposal is effective for amounts that are paid or accrued more than 30 days after the 

date of enactment.

6. Modify treatment of transfers to creditors in divisive reorganizations 

Present Law

Section 355 of the Code permits a corporation (“distributing”) to separate its businesses 

by distributing a subsidiary tax-free, if certain conditions are met. In cases where the distributing 

corporation contributes property to the corporation (“controlled’) that is to be distributed, no gain 

or loss is recognized if the property is contributed solely in exchange for stock or securities of 

the controlled corporation (which are subsequently distributed to distributing’s shareholders). 

The contribution of property to a controlled corporation that is followed by a distribution of its 

stock and securities may qualify as a reorganization described in section 368(a)(1)(D). That 

section also applies to certain transactions that do not involve a distribution under section 355 

and that are considered ‘acquisitive” rather than “divisive” reorganizations. 

The contribution in the course of a divisive section 368(a)(1)(D) reorganization is also 

subject to the rules of section 357(c). That section provides that the transferor corporation will 

recognize gain if the amount of liabilities assumed by controlled exceeds the basis of the 

property transferred to it.
113

Because the contribution transaction in connection with a section 355 distribution is a 

reorganization under section 368(a)(1)(D), it is also subject to certain rules applicable to both 

divisive and acquisitive reorganizations. One such rule, in section 361(b), states that a transferor 

corporation will not recognize gain if it receives money or other property and distributes that 

money or other property to its shareholders or creditors. The amount of property that may be 

distributed to creditors without gain recognition is unlimited under this provision.

Description of Proposal

The proposal limits the amount of money or other property that a distributing corporation 

can distribute to its creditors without gain recognition under section 361(b) to the amount of the 

basis of the assets contributed to a controlled corporation in a divisive reorganization. In 

addition, the proposal provides that acquisitive reorganizations under section 368(a)(1)(D) are no 

longer subject to the liabilities assumption rules of section 357(c).

Effective Date

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

7. Extend the present-law intangible amortization provisions to acquisitions of sports 

franchises

Present Law

The purchase price allocated to intangible assets (including franchise rights) acquired in 

connection with the acquisition of a trade or business generally must be capitalized and 

amortized over a 15-year period.242 These rules were enacted in 1993 to minimize disputes 

regarding the proper treatment of acquired intangible assets. The rules do not apply to a 

franchise to engage in professional sports and any intangible asset acquired in connection with 

such a franchise.243 However, other special rules apply to certain of these intangible assets.

Under section 1056, when a franchise to conduct a sports enterprise is sold or exchanged, 

the basis of a player contract acquired as part of the transaction is generally limited to the 

adjusted basis of such contract in the hands of the transferor, increased by the amount of gain, if 

any, recognized by the transferor on the transfer of the contract. Moreover, not more than 50 

percent of the consideration from the transaction may be allocated to player contracts unless the 

transferee establishes to the satisfaction of the Commissioner that a specific allocation in excess 

of 50 percent is proper. However, these basis rules may not apply if a sale or exchange of a 

franchise to conduct a sports enterprise is effected through a partnership.244 Basis allocated to 

the franchise or to other valuable intangible assets acquired with the franchise may not be 

amortizable if these assets lack a determinable useful life.

 

242 Sec. 197.

243 Sec. 197(e)(6).

244

 P.D.B. Sports, Ltd. v. Comm’r, 109 T.C. 423 (1997).
114

Description of Proposal

The proposal extends the 15-year recovery period for intangible assets to franchises to 

engage in professional sports and any intangible asset acquired in connection with such a 

franchise acquisitions of sports franchises (including player contracts). Thus, the same rules for 

amortization of intangibles that apply to other acquisitions under present law will apply to 

acquisitions of sports franchises.

Effective Date

The proposal is effective for acquisitions occurring after the date of enactment.

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

Present Law

In certain circumstances, taxpayers can make an election under section 338(h)(10) to treat 

a qualifying purchase of 80 percent of the stock of a target corporation by a corporation from a 

corporation that is a member of an affiliated group (or a qualifying purchase of 80 percent of the 

stock of an S corporation by a corporation from S corporation shareholders) as a sale of the 

assets of the target corporation, rather than as a stock sale. The election must be made jointly by 

the buyer and seller of the stock and is due by the 15th day of the ninth month beginning after the 

month in which the acquisition date occurs. An agreement for the purchase and sale of stock 

often may contain an agreement of the parties to make a section 338(h)(10) election. 

Section 338(a) also permits a unilateral election by a buyer corporation to treat a qualified 

stock purchase of a corporation as a deemed asset acquisition, whether or not the seller of the 

stock is a corporation (or an S corporation is the target). In such a case, the seller or sellers 

recognize gain or loss on the stock sale (including any estimated taxes with respect to the stock 

sale), and the target corporation recognizes gain or loss on the deemed asset sale. 

Section 338(h)(13) provides that, for purposes of section 6655 (relating to additions to tax 

for failure by a corporation to pay estimated income tax), tax attributable to a deemed asset sale 

under section 338(a)(1) shall not be taken into account. Some taxpayers may be taking the 

position that this exception applies to a section 338(h)(10) election and that when such an 

election is made, neither any stock sale nor any asset sale needs to be taken into account for 

estimated tax purposes. 

Description of Proposal

The proposal would clarify section 338(h)(13) to provide that the exception for estimated 

tax purposes with respect to tax attributable to a deemed asset sale does not apply with respect to 

a qualified stock purchase for which an election is made under section 338(h)(10).

Under the proposal, if a transaction eligible for the election under section 338(h)(10) 

occurs, estimated tax would be determined based on the stock sale unless and until there is an 

agreement of the parties to make a section 338(h)(10) election.
115

If at the time of the sale there is an agreement of the parties to make a section 338(h)(10) 

election, then estimated tax would be computed based on an asset sale. If the agreement to make 

a section 338(h)(10) election is concluded after the stock sale, such that the original computation 

was based on a stock sale, estimated tax would be recomputed based on the asset sale election. 

No inference is intended as to present law.

Effective Date

The proposal would be effective for transactions that occur after the date of enactment of 

the proposal. 

9. Extension of IRS user fees

Present Law

The IRS provides written responses to questions of individuals, corporations, and 

organizations relating to their tax status or the effects of particular transactions for tax purposes. 

The IRS generally charges a fee for requests for a letter ruling, determination letter, opinion 

letter, or other similar ruling or determination. Public Law 104-117245 extended the statutory 

authorization for these user fees246 through September 30, 2003.

Description of Proposal

The proposal extends the statutory authorization for these user fees through September 

30, 2013. The proposal also moves the statutory authorization for these fees into the Code.247

Effective Date

The proposal, including moving the statutory authorization for these fees into the Code 

and repealing the off-Code statutory authorization for these fees, is effective for requests made 

after the date of enactment.

 

245 An Act to provide that members of the Armed Forces performing services for the 

peacekeeping efforts in Bosnia and Herzegovina, Croatia, and Macedonia shall be entitled to tax 

benefits in the same manner as if such services were performed in a combat zone, and for other 

purposes (March 20, 1996).

246 These user fees were originally enacted in section 10511 of the Revenue Act of 1987 

(Pub. Law No. 100-203, December 22, 1987).

247 The proposal also moves into the Code the user fee provision relating to pension 

plans that was enacted in section 620 of the Economic Growth and Tax Relief Reconciliation 

Act of 2001 (Pub. L. 107-16, June 7, 2001).
116

10. Doubling of certain penalties, fines, and interest on underpayments related to certain 

offshore financial arrangements 

Present Law

In general 

The Code contains numerous civil penalties, such as the delinquency, accuracy-related 

and fraud penalties. These civil penalties are in addition to any interest that may be due as a 

result of an underpayment of tax. If all or any part of a tax is not paid when due, the Code 

imposes interest on the underpayment, which is assessed and collected in the same manner as the 

underlying tax and is subject to the same statute of limitations.

Delinquency penalties

Failure to file.–Under present law, a taxpayer who fails to file a tax return on a timely 

basis is generally subject to a penalty equal to 5 percent of the net amount of tax due for each 

month that the return is not filed, up to a maximum of five months or 25 percent. An exception 

from the penalty applies if the failure is due to reasonable cause. The net amount of tax due is 

the excess of the amount of the tax required to be shown on the return over the amount of any tax 

paid on or before the due date prescribed for the payment of tax. 

Failure to pay.–Taxpayers who fail to pay their taxes are subject to a penalty of 0.5 

percent per month on the unpaid amount, up to a maximum of 25 percent. If a penalty for 

failure to file and a penalty for failure to pay tax shown on a return both apply for the same 

month, the amount of the penalty for failure to file for such month is reduced by the amount of 

the penalty for failure to pay tax shown on a return. If a return is filed more than 60 days after its 

due date, then the penalty for failure to file tax shown on a return may not reduce the penalty for 

failure to pay below the lesser of $100 or 100 percent of the amount required to be shown on the 

return. For any month in which an installment payment agreement with the IRS is in effect, the 

rate of the penalty is half the usual rate (0.25 percent instead of 0.5 percent), provided that the 

taxpayer filed the tax return in a timely manner (including extensions). 

Failure to make timely deposits of tax.–The penalty for the failure to make timely 

deposits of tax consists of a four-tiered structure in which the amount of the penalty varies with 

the length of time within which the taxpayer corrects the failure. A depositor is subject to a 

penalty equal to 2 percent of the amount of the underpayment if the failure is corrected on or 

before the date that is five days after the prescribed due date. A depositor is subject to a penalty 

equal to 5 percent of the amount of the underpayment if the failure is corrected after the date that 

is five days after the prescribed due date but on or before the date that is 15 days after the 

prescribed due date. A depositor is subject to a penalty equal to 10 percent of the amount of the 

underpayment if the failure is corrected after the date that is 15 days after the due date but on or 

before the date that is 10 days after the date of the first delinquency notice to the taxpayer (under 

sec. 6303). Finally, a depositor is subject to a penalty equal to 15 percent of the amount of the 

underpayment if the failure is not corrected on or before the date that is 10 days after the date of 

the day on which notice and demand for immediate payment of tax is given in cases of jeopardy. 
117

An exception from the penalty applies if the failure is due to reasonable cause. In 

addition, the Secretary may waive the penalty for an inadvertent failure to deposit any tax by 

specified first-time depositors. 

Accuracy-related penalties

The accuracy-related penalty is imposed at a rate of 20 percent of the portion of any 

underpayment that is attributable, in relevant part, to (1) negligence, (2) any substantial 

understatement of income tax and (3) any substantial valuation misstatement. In addition, the 

penalty is doubled for certain gross valuation misstatements. These consolidated penalties are 

also coordinated with the fraud penalty. This statutory structure operates to eliminate any 

stacking of the penalties. 

No penalty is to be imposed if it is shown that there was reasonable cause for an 

underpayment and the taxpayer acted in good faith. However, Treasury has issued proposed 

regulations that limit the defenses available to the imposition of an accuracy-related penalty in 

connection with a reportable transaction when the transaction is not disclosed. 

Negligence or disregard for the rules or regulations.–If an underpayment of tax is 

attributable to negligence, the negligence penalty applies only to the portion of the underpayment 

that is attributable to negligence. Negligence any failure to make a reasonable attempt to comply 

with the provisions of the Code. Disregard includes any careless, reckless or intentional 

disregard of the rules or regulations. 

Substantial understatement of income tax.–Generally, an understatement is substantial if 

the understatement exceeds the greater of (1) 10 percent of the tax required to be shown on the 

return for the tax year or (2) $5,000. In determining whether a substantial understatement exists, 

the amount of the understatement is reduced by any portion attributable to an item if (1) the 

treatment of the item on the return is or was supported by substantial authority, or (2) facts 

relevant to the tax treatment of the item were adequately disclosed on the return or on a 

statement attached to the return. 

Substantial valuation misstatement.–A penalty applies to the portion of an underpayment 

that is attributable to a substantial valuation misstatement. Generally, a substantial valuation 

misstatement exists if the value or adjusted basis of any property claimed on a return is 200 

percent or more of the correct value or adjusted basis. The amount of the penalty for a 

substantial valuation misstatement is 20 percent of the amount of the underpayment if the value 

or adjusted basis claimed is 200 percent or more but less than 400 percent of the correct value or 

adjusted basis. If the value or adjusted basis claimed is 400 percent or more of the correct value 

or adjusted basis, then the overvaluation is a gross valuation misstatement.

Gross valuation misstatements.–The rate of the accuracy-related penalty is doubled (to 40 

percent) in the case of gross valuation misstatements. 
118

Fraud penalty 

The fraud penalty is imposed at a rate of 75 percent of the portion of any underpayment 

that is attributable to fraud. The accuracy-related penalty does not to apply to any portion of an 

underpayment on which the fraud penalty is imposed.

Interest Provisions

Taxpayers are required to pay interest to the IRS whenever there is an underpayment of 

tax. An underpayment of tax exists whenever the correct amount of tax is not paid by the last 

date prescribed for the payment of the tax. The last date prescribed for the payment of the 

income tax is the original due date of the return. 

Different interest rates are provided for the payment of interest depending upon the type 

of taxpayer, whether the interest relates to an underpayment or overpayment, and the size of the 

underpayment or overpayment. Interest on underpayments is compounded daily. 

Offshore Voluntary Compliance Initiative

In January 2003, Treasury announced the Offshore Voluntary Compliance Initiative 

(“OVCI”) to encourage the voluntary disclosure of previously unreported income placed by 

taxpayers in offshore accounts and accessed through credit card or other financial arrangements. 

A taxpayer had to comply with various requirements in order to participate in OVCI, including 

sending a written request to participate in the program by April 15, 2003. This request had to 

include information about the taxpayer, the taxpayer’s introduction to the credit card or other 

financial arrangements and the names of parties that promoted the transaction. Taxpayers 

eligible under OVCI will not be liable for civil fraud, the fraudulent failure to file penalty or the 

civil information return penalties. The taxpayer will pay back taxes, interest and certain 

accuracy-related and delinquency penalties.

Voluntary Disclosure Initiative

A taxpayer's timely, voluntary disclosure of a substantial unreported tax liability has long 

been an important factor in deciding whether the taxpayer's case should ultimately be referred for 

criminal prosecution. The voluntary disclosure must be truthful, timely, and complete. The 

taxpayer must show a willingness to cooperate (as well as actual cooperation) with the IRS in 

determining the correct tax liability. The taxpayer must make good-faith arrangements with the 

IRS to pay in full the tax, interest, and any penalties determined by the IRS to be applicable. A 

voluntary disclosure does not guarantee immunity from prosecution. It creates no substantive or 

procedural rights for taxpayers

Description of Proposal

The proposal increases the total amount of civil penalties, interest and fines applicable by 

a factor of two for taxpayers who would have been eligible to participate in either the OVCI or 

the Treasury Department’s voluntary disclosure initiative, which applies to the taxpayer by 

reason of the taxpayer’s underpayment of U.S. income tax liability through certain financing 

arrangements, but did not participate in either program. 
119

Effective Date

The proposal generally is effective with respect to a taxpayer’s open tax years on or after 

date of enactment.

11. Add vaccines against hepatitis A to the list of taxable vaccines

Present Law

A manufacturer’s excise tax is imposed at the rate of 75 cents per dose248 on the 

following vaccines routinely recommended for administration to children: diphtheria, pertussis, 

tetanus, measles, mumps, rubella, polio, HIB (haemophilus influenza type B), hepatitis B, 

varicella (chicken pox), rotavirus gastroenteritis, and streptococcus pneumoniae. The tax applied 

to any vaccine that is a combination of vaccine components equals 75 cents times the number of 

components in the combined vaccine.

Amounts equal to net revenues from this excise tax are deposited in the Vaccine Injury 

Compensation Trust Fund to finance compensation awards under the Federal Vaccine Injury 

Compensation Program for individuals who suffer certain injuries following administration of 

the taxable vaccines. This program provides a substitute Federal, “no fault” insurance system for 

the State-law tort and private liability insurance systems otherwise applicable to vaccine 

manufacturers. All persons immunized after September 30, 1988, with covered vaccines must 

pursue compensation under this Federal program before bringing civil tort actions under State 

law.

Description of Proposal

The proposal adds any vaccine against hepatitis A to the list of taxable vaccines. The 

proposal also makes a conforming amendment to the trust fund expenditure purposes. 

Effective Date

The proposal is effective for vaccines sold beginning on the first day of the first month 

beginning more than four weeks after the date of enactment.

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

exchange of a principal residence

Present Law

Under present law, a taxpayer may exclude up to $250,000 ($500,000 if married filing a 

joint return) of gain realized on the sale or exchange of a principal residence.249 To be eligible 

for the exclusion, the taxpayer must have owned and used the residence as a principal residence 

 

248 sec. 4131

249 Sec. 121.
120

for at least two of the five years prior to the sale or exchange. A taxpayer who fails to meet these 

requirements by reason of a change of place of employment, health, or, to the extent provided 

under regulations, unforeseen circumstances is able to exclude an amount equal to the fraction of 

the $250,000 ($500,000 if married filing a joint return) that is equal to the fraction of the two 

years that the ownership and use requirements are met. There are no special rules relating to the 

sale or exchange of a principal residence that was acquired in a like-kind exchange within the 

prior five years.

Description of Proposal

The proposal provides that the exclusion for gain on the sale or exchange of a principal 

residence does not apply if the principal residence was acquired in a like-kind exchange in which 

any gain was not recognized within the prior five years.

Effective date

The proposal is effective for sales or exchanges of principal residences after the date of 

enactment.

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

Present Law

The Code authorizes the IRS to enter into written agreements with any taxpayer under 

which the taxpayer is allowed to pay taxes owed, as well as interest and penalties, in installment 

payments if the IRS determines that doing so will facilitate collection of the amounts owed (sec. 

6159). An installment agreement does not reduce the amount of taxes, interest, or penalties 

owed. Generally, during the period installment payments are being made, other IRS enforcement 

actions (such as levies or seizures) with respect to the taxes included in that agreement are held 

in abeyance. 

Prior to 1998, the IRS administratively entered into installment agreements that provided 

for partial payment (rather than full payment) of the total amount owed over the period of the 

agreement. In that year, the IRS Chief Counsel issued a memorandum concluding that partial 

payment installment agreements were not permitted.

Description of Proposal

The proposal clarifies that the IRS is authorized to enter into installment agreements with 

taxpayers which do not provide for full payment of the taxpayer’s liability over the life of the 

agreement. The proposal also requires the IRS to review partial payment installment agreements 

at least every two years. The primary purpose of this review is to determine whether the 

financial condition of the taxpayer has significantly changed so as to warrant an increase in the 

value of the payments being made.
121

Effective Date

The proposal is effective for installment agreements entered into on or after the date of 

enactment. 

14. Lease term to include certain service contracts 

Present Law

Under present law, "tax-exempt use property" must be depreciated on a straight-line basis 

over a recovery period equal to the longer of the property's class life or 125 percent of the lease 

term. 250 For purposes of this rule, "tax-exempt use property" is property that is leased (other than 

under a short-term lease) to a tax-exempt entity. 251 For this purpose, the term "tax-exempt 

entity" includes Federal, state and local governmental units, charities, and, foreign entities or 

persons.252

In determining the length of the lease term for purposes of the 125 percent calculation, a 

number of special rules apply. In addition to the stated term of the lease, the lease term includes: 

(1) any additional period of time in the realistic contemplation of the parties at the time the 

property is first put in service; (2) any additional period of time for which either the lessor or 

lessee has the option to renew the lease (whether or not it is expected that the option will be 

exercised); (3) any additional period of any successive leases which are part of the same 

transaction (or series of related transactions) with respect to the same or substantially similar 

property; and (4) any additional period of time (even if the lessee may not continue to be the 

lessee during that period), if the lessee (a) has agreed to make a payment in the nature of rent 

with respect to such period or (b) has assumed or retained any risk of loss with respect to such 

property for such period.

Tax-exempt use property does not include property that is used by a taxpayer to provide a 

service to a tax-exempt entity. So long as the relationship between the parties is a bona fide 

service contract, the taxpayer will be allowed to depreciate the property used in satisfying the 

contract under normal MACRS rules, rather than the rules applicable to tax-exempt use property.

Description of Proposal

The proposal requires lessors of tax-exempt use property to include the term of service 

contracts and other similar arrangements in the lease term for purposes of determining the 

recovery period.

 

250 Sec. 168(g)(3)(A).

251 Sec. 168(h)(1).

252 Sec. 168(h)(2).
122

Effective Date

The proposal is effective for leases and other similar arrangements entered into after the 

date of enactment. No inference is intended with respect to the tax treatment of leases and other 

similar arrangements entered into before such date.