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[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]

 
       REVENUE PROVISIONS IN PRESIDENT'S FISCAL YEAR 2000 BUDGET

=======================================================================

                                HEARING

                               before the

                      COMMITTEE ON WAYS AND MEANS
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED SIXTH CONGRESS

                             FIRST SESSION

                               __________

                             MARCH 10, 1999

                               __________

                             Serial 106-21

                               __________

         Printed for the use of the Committee on Ways and Means

                                

                      U.S. GOVERNMENT PRINTING OFFICE
 58-945 CC                   WASHINGTON : 2000
------------------------------------------------------------------------------
                   For sale by the U.S. Government Printing Office
 Superintendent of Documents, Congressional Sales Office, Washington, DC 20402

                      COMMITTEE ON WAYS AND MEANS

                      BILL ARCHER, Texas, Chairman

PHILIP M. CRANE, Illinois            CHARLES B. RANGEL, New York
BILL THOMAS, California              FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida           ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut        WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York               SANDER M. LEVIN, Michigan
WALLY HERGER, California             BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana               JIM McDERMOTT, Washington
DAVE CAMP, Michigan                  GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota               JOHN LEWIS, Georgia
JIM NUSSLE, Iowa                     RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas                   MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington            WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia                 JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio                    XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania      KAREN L. THURMAN, Florida
WES WATKINS, Oklahoma                LLOYD DOGGETT, Texas
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida

                     A.L. Singleton, Chief of Staff
                  Janice Mays, Minority Chief Counsel

Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.

                            C O N T E N T S

                               __________

                                                                   Page

Advisories announcing the hearing................................     2

                               WITNESSES

U.S. Department of the Treasury, Hon. Donald C. Lubick, Assistant 
  Secretary, Tax Policy, accompanied by Hon. Jonathan Talisman, 
  Deputy Assistant Secretary, Tax Policy.........................    13

                                 ______

 Alliance of Tracking Stock Stakeholders, Robert Hernandez.......   149
American Association of Educational Service Agencies, Rene 
  ``Jay'' Bouchard...............................................   193
American Bar Association, Stefan F. Tucker.......................    54
American Institute of Certified Public Accountants, David A. 
  Lifson.........................................................    71
American Society of Association Executives, Michael S. Olson.....    90
Bouchard, Rene ``Jay,'' Steuben-Allegany Counties; Steuben-
  Allegany Board of Cooperative Educational Services; American 
  Association of Educational Service Agencies; and National Rural 
  Education Association..........................................   193
 Business Council for Sustainable Energy, Michael Marvin.........   170
Chicago School Reform Board of Trustees, Gery Chico..............   184
Clark/Bardes, W.T. Wamberg.......................................   143
Employee Stock Ownership Plans Association, Delores L. ``Dee'' 
  Thomas.........................................................   176
 Etheridge, Hon. Bob, a Representative in Congress from the State 
  of North Carolina..............................................     6
Ewing & Thomas, Inc., Delores L. ``Dee'' Thomas..................   176
Hernandez, Robert, Alliance of Tracking Stock Stakeholders, and 
  USX Corporation................................................   149
Hill, J. Eldred, III, Unemployment Insurance Institute...........   181
 Kies, Kenneth J., PricewaterhouseCoopers LLP....................   101
Lifson, David A., American Institute of Certified Public 
  Accountants....................................................    71
Marvin, Michael, Business Council for Sustainable Energy.........   170
 National Rural Education Association, Rene ``Jay'' Bouchard.....   193
Olson, Michael S., American Society of Association Executives....    90
PricewaterhouseCoopers LLP, Kenneth J. Kies......................   101
Sinclaire, William T., U.S. Chamber of Commerce..................    65
Steuben-Allegany Board of Cooperative Educational Services, and 
  Steuben-Allegany Counties, Rene ``Jay'' Bouchard...............   193
Thomas, Delores L. ``Dee,'' Ewing & Thomas, Inc., and Employee 
  Stock Ownership Plans Association..............................   176
Tucker, Stefan F., American Bar Association......................    54
Unemployment Insurance Institute, J. Eldred Hill III.............   181
U.S. Chamber of Commerce, William T. Sinclaire...................    65
USX Corporation, Robert Hernandez................................   149
 Weinberger, Mark A., Washington Counsel, P.C....................   132
Wamberg, W.T., Clark/Bardes......................................   143

                       SUBMISSIONS FOR THE RECORD

America's Community Bankers, statement...........................   205
American Bankers Association, statement..........................   213
American Council of Life Insurance, statement....................   216
American Insurance Association, statement........................   220
American Network of Community Options and Resources, Annandale, 
  VA, statement..................................................   224
American Payroll Association, American Society for Payroll 
  Management, American Trucking Association, National Association 
  of Manufacturers, National Federation of Independent Business, 
  National Retail Federation, Service Bureau Consortium, Society 
  for Human Resource Management, U.S. Chamber of Commerce, UWC, 
  Inc., joint letter.............................................   228
American Petroleum Institute, statement..........................   229
American Public Power Association, statement and attachment......   235
American Society for Payroll Management, joint letter (See 
  listing under American Payroll Association)....................   228
American Trucking Association, joint letter (See listing under 
  American Payroll Association)..................................   228
Associated Builders and Contractors, Inc., Rosslyn, VA, 
  Christopher T. Salp, letter....................................   237
Association for Advanced Life Underwriting, joint statement......   355
Association for Play Therapy, Fresno, CA, William M. Burns, 
  letter.........................................................   238
Association of International Automobile Manufacturers, Inc., 
  Arlington, VA, statement.......................................   238
Beard, Daniel P., National Audubon Society, statement............   375
Bond Market Association, statement...............................   239
Bryan Cave LLP, Richard C. Smith, Phoenix, AZ, statement.........   288
Burns, William M., Association for Play Therapy, Fresno, CA, 
  letter.........................................................   238
Business Insurance Coalition, et al., joint statement............   249
Business Roundtable, Thomas Usher, statement.....................   252
Carter, Judy, R&D Credit Coalition, and Softworks, Alexandria, 
  VA, joint statement............................................   389
Central & South West Corporation, Dallas, TX, statement..........   254
Coalition for the Fair Taxation of Business Transactions, 
  statement......................................................   257
Coalition of Mortgage REITs, et al., joint statement.............   266
Coalition of Service Industries:
    statement and attachment.....................................   270
    et al., joint statement......................................   273
Coalition to Preserve Employee Ownership of S Corporations, 
  statement......................................................   275
Committee of Annuity Insurers, statement and attachment..........   278
Committee to Preserve Private Employee Ownership, statement......   283
Conservation Trust of Puerto Rico, San Juan, Puerto Rico, 
  statement......................................................   287
Economic Concepts, Inc., Phoenix, AZ, Richard C. Smith, joint 
  statement......................................................   288
Edison Electric Institute, statement.............................   290
Employer-Owned Life Insurance Coalition, statement...............   294
Equipment Leasing Association, Arlington, VA, statement..........   299
Financial Executives Institute, statement........................   302
General Motors Corporation, statement............................   311
Governors' Public Power Alliance, Lincoln, NE, statement.........   317
Interstate Conference of Employment Security Agencies, Inc., and 
  Service Bureau Consortium, Inc., joint letter..................   319
Investment Company Institute, statement..........................   320
Large Public Power Council, statement............................   328
M Financial Group, Portland, OR, statement.......................   331
Management Compensation Group, Portland, OR, statement...........   335
Massachusetts Mutual Life Insurance Company, Springfield, MA, 
  statement......................................................   339
McCrery, Hon. Jim, a Representative in Congress from the State of 
  Louisiana, statement and attachment............................   343
McVey, Ross J., Telephone & Data Systems, Inc., Middleton, WI, 
  letter.........................................................   418
Mechanical-Electrical-Sheet Metal Alliance, statement............   345
Merrill Lynch & Co., Inc., statement.............................   347
National Association of Life Underwriters, and Association for 
  Advanced Life Underwriting, joint statement....................   355
National Association of Manufacturers:
    (See listing under American Payroll Association).............   228
    statement....................................................   358
National Association of Real Estate Investment Trusts, Steven A. 
  Wechsler, statement............................................   366
National Audubon Society, Daniel P. Beard, statement.............   375
National Federation of Independent Business, joint letter (See 
  listing under American Payroll Association)....................   228
National Mining Association, statement...........................   376
National Retail Federation, joint letter (See listing under 
  American Payroll Association)..................................   228
Niche Marketing, Inc., Costa Mesa, CA, Richard C. Smith, joint 
  statement......................................................   288
PricewaterhouseCoopers Leasing Coalition, statement..............   378
R&D Credit Coalition, Judy Carter, joint statement...............   389
Salp, Christopher T., Associated Builders and Contractors, Inc., 
  Rosslyn, VA, letter............................................   237
Sanders, Hon. Bernie, a Representative in Congress from the State 
  of Vermont, statement..........................................   394
SC Group Incorporated, El Paso, TX, joint statement..............   403
Securities Industry Association, statement.......................   395
Security Capital Group Incorporated, Santa Fe, NM, and SC Group 
  Incorporated, El Paso, TX, joint statement.....................   403
Service Bureau Consortium, Inc.:
    joint letter (See listing under American Payroll Association)   228
    joint letter.................................................   319
Smith, Richard C., Bryan Cave LLP, Phoenix, AZ, Niche Marketing, 
  Inc., Costa Mesa, CA, Economic Concepts, Inc., Phoenix, AZ, 
  joint statement................................................   288
Society for Human Resource Management, joint letter (See listing 
  under American Payroll Association)............................   228
Softworks, Alexandria, VA, Judy Carter, joint statement..........   389
Stock Company Information Group, statement and attachment........   405
Tax Council, statement...........................................   408
Telephone & Data Systems, Inc., Middleton, WI, Ross J. McVey, 
  letter.........................................................   418
United States Telephone Association, statement...................   421
U.S. Chamber of Commerce, joint letter (See listing under 
  American Payroll Association)..................................   228
Usher, Thomas, Business Roundtable, statement....................   252
UWC, Inc., joint letter (See listing under American Payroll 
  Association)...................................................   228
Washington Counsel, P.C., LaBrenda Garrett-Nelson, and Mark 
  Weinberger, statement..........................................   423
Wechsler, Steven A., National Association of Real Estate 
  Investment Trusts, statement...................................   366

       REVENUE PROVISIONS IN PRESIDENT'S FISCAL YEAR 2000 BUDGET

                              ----------                              

                       WEDNESDAY, MARCH 10, 1999

                          House of Representatives,
                               Committee on Ways and Means,
                                                    Washington, DC.
    The Committee met, pursuant to notice, at 11:30 a.m., in 
room 1100, Longworth House Office Building, Hon. Bill Archer 
(Chairman of the Committee) presiding.
    [The advisories announcing the hearing follow:]

ADVISORY

FROM THE COMMITTEE ON WAYS AND MEANS

FOR IMMEDIATE RELEASE                         CONTACT: (202) 225-1721
February 18, 1999
No. FC-7

                      Archer Announces Hearing on
                   Revenue Provisions in President's
                        Fiscal Year 2000 Budget

     Congressman Bill Archer (R-TX), Chairman of the Committee on Ways 
and Means, today announced that the Committee will hold a hearing on 
revenue provisions in President Clinton's fiscal year 2000 budget 
proposals. The hearing will take place on Wednesday, March 10, 1999, in 
the main Committee hearing room, 1100 Longworth House Office Building, 
beginning at 10:00 a.m.
      
    Oral testimony at this hearing will be from both the U.S. 
Department of the Treasury and public witnesses. Any individual or 
organization not scheduled for an oral appearance may submit a written 
statement for consideration by the Committee or for inclusion in the 
printed record of the hearing.
      

BACKGROUND:

      
    On February 1, President Clinton submitted his fiscal year 2000 
budget to the Congress. This budget submission contains numerous 
revenue provisions; some of these were included in previous budget 
submissions, but many are new. Among the new items in the budget are 
several general and specific provisions intended to address corporate 
tax shelters. The hearing will give the Committee the opportunity to 
consider carefully these revenue initiatives.
      
    In announcing the hearing, Chairman Archer stated: ``I am 
disappointed that the President provides no meaningful tax relief in 
his budget for Americans, caught in the tax trap, who are working more 
and paying even higher taxes. Instead, his budget contains 81 
provisions to increase taxes by more than $82 billion over the next 
five years. At a time when the Federal Government is collecting more 
taxes than it needs, the President should not be asking the Congress to 
adopt proposals that would further increase the tax burden on the 
American people.''
      

FOCUS OF THE HEARING:

      
    The Committee will focus on the revenue proposals contained in 
President Clinton's fiscal year 2000 budget. With respect to the 
Administration's tax shelter proposals, the Committee invites 
additional or alternative suggestions to constrain inappropriate 
corporate tax sheltering activity without impeding legitimate business 
transactions.
      

DETAILS FOR SUBMISSIONS OF REQUESTS TO BE HEARD:

      
    Requests to be heard at the hearing must be made by telephone to 
Traci Altman or Pete Davila at (202) 225-1721 no later than the close 
of business, Friday, February 26, 1999. The telephone request should be 
followed by a formal written request to A.L. Singleton, Chief of Staff, 
Committee on Ways and Means, U.S. House of Representatives, 1102 
Longworth House Office Building, Washington, D.C. 20515. The staff of 
the Committee will notify by telephone those scheduled to appear as 
soon as possible after the filing deadline. Any questions concerning a 
scheduled appearance should be directed to the Committee on staff at 
(202) 225-1721.
      
    In view of the limited time available to hear witnesses, the 
Committee may not be able to accommodate all requests to be heard. 
Those persons and organizations not scheduled for an oral appearance 
are encouraged to submit written statements for the record of the 
hearing. All persons requesting to be heard, whether they are scheduled 
for oral testimony or not, will be notified as soon as possible after 
the filing deadline.
      
    Witnesses scheduled to present oral testimony are required to 
summarize briefly their written statements in no more than five 
minutes. THE FIVE-MINUTE RULE WILL BE STRICTLY ENFORCED. The full 
written statement of each witness will be included in the printed 
record, in accordance with House Rules.
      
    In order to assure the most productive use of the limited amount of 
time available to question witnesses, all witnesses scheduled to appear 
before the Committee are required to submit 300 copies, along with an 
IBM compatible 3.5-inch diskette in WordPerfect 5.1 format, of their 
prepared statement for review by Members prior to the hearing. 
Testimony should arrive at the Committee office, room 1102 Longworth 
House Office Building, no later than March 8, 1999. Failure to do so 
may result in the witness being denied the opportunity to testify in 
person.
      

WRITTEN STATEMENTS IN LIEU OF PERSONAL APPEARANCE:

      
    Any person or organization wishing to submit a written statement 
for the printed record of the hearing should submit six (6) single-
spaced copies of their statement, along with an IBM compatible 3.5-inch 
diskette in WordPerfect 5.1 format, with their name, address, and 
hearing date noted on a label, by the close of business, Wednesday, 
March 24, 1999, to A.L. Singleton, Chief of Staff, Committee on Ways 
and Means, U.S. House of Representatives, 1102 Longworth House Office 
Building, Washington, D.C. 20515. If those filing written statements 
wish to have their statements distributed to the press and interested 
public at the hearing, they may deliver 200 additional copies for this 
purpose to the Committee office, room 1102 Longworth House Office 
Building, by close of business the day before the hearing.
      

FORMATTING REQUIREMENTS:

      
     Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
Committee.
      
    1. All statements and any accompanying exhibits for printing must 
be submitted on an IBM compatible 3.5-inch diskette in WordPerfect 5.1 
format, typed in single space and may not exceed a total of 10 pages 
including attachments. Witnesses are advised that the Committee will 
rely on electronic submissions for printing the official hearing 
record.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. A witness appearing at a public hearing, or submitting a 
statement for the record of a public hearing, or submitting written 
comments in response to a published request for comments by the 
Committee, must include on his statement or submission a list of all 
clients, persons, or organizations on whose behalf the witness appears.
      
    4. A supplemental sheet must accompany each statement listing the 
name, company, address, telephone and fax numbers where the witness or 
the designated representative may be reached. This supplemental sheet 
will not be included in the printed record.
      
    The above restrictions and limitations apply only to material being 
submitted for printing. Statements and exhibits or supplementary 
material submitted solely for distribution to the Members, the press, 
and the public during the course of a public hearing may be submitted 
in other forms.
      

    Note: All Committee advisories and news releases are available on 
the World Wide Web at `HTTP://WWW.HOUSE.GOV/WAYS__MEANS/'.
      

    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.
      

                                

                     *** NOTICE--Change in Time ***

ADVISORY

FROM THE COMMITTEE ON WAYS AND MEANS

FOR IMMEDIATE RELEASE                            CONTACT: (202) 225-1721
March 5, 1999
No. FC-7-Revised

               Time Change for Full Committee Hearing on
                       Wednesday, March 10, 1999,
                  on Revenue Provisions in President's
                        Fiscal Year 2000 Budget

    Congressman Bill Archer (R-TX), Chairman of the Committee on Ways 
and Means, today announced that the full Committee hearing on revenue 
provisions in President Clinton's fiscal year 2000 budget proposals, 
previously scheduled for Wednesday, March 10, 1999, at 10:00 a.m., in 
the main Committee hearing room, 1100 Longworth House Office Building, 
will begin instead at 11:30 a.m.
      
    All other details for the hearing remain the same. (See full 
Committee press release No. FC-7, dated February 18, 1999.)
      

                                

    Chairman Archer. The Committee will come to order.
    This afternoon's hearing has been called to review the 
revenue proposals contained in President Clinton's budget for 
the fiscal year beginning October 1. A hearty welcome to our 
guests and to Secretary Lubick. I thank all of you for joining 
us.
    According to the nonpartisan Joint Committee on Taxation, 
the White House proposes an $89 billion tax increase over the 
next 10 years. The budget contains 47 tax reduction proposals 
totaling $82 billion, but it also includes 75 tax hikes, which 
raise $172 billion. The combination of the two is a net $89 
billion tax hike.
    With a multitrillion dollar surplus projected as far as the 
eye can see, it is hard to understand why anyone would want to 
raise taxes on any entity or individual in this country. As for 
the proposed tax cuts, they most definitely complicate the 
Code. If you are a nonsmoker who drives a fuel-efficient car 
from your rooftop solar-equipped home to your specialized small 
business investment company where you work, you get a tax cut.
    However, given how difficult the tax forms are to fill out, 
I'm not sure that taxpayers will welcome those ideas. On the 
other hand, accountants, tax lawyers, and social engineers will 
be most happy, I'm sure.
    On the tax side, where they are raised, the budget contains 
dozens of tax-hike repeats which have already been met with the 
massive bipartisan opposition of most Ways and Means Members. 
In fact, of the 75 hikes in the budget, 34 provisions worth 
$132 billion are old news.
    Let's not go down that road again.
    There are, however, some ideas that we will explore. The 
area of corporate tax shelters is one field that merits review. 
I have already announced my support for a school construction 
initiative. I intend to pursue other areas on which we can 
build common ground.
    On balance, however, this budget would make April 15th a 
bigger headache for the taxpayers. Higher taxes, bigger 
headaches, more complexity. I intend to pursue a different 
course to lower taxes, to close unintended loopholes and abuses 
and anachronisms on the way to a simpler and a fairer code.
    And I look forward to working with all Members of the 
Committee to get this job done.
    [The opening statement follows:]

Statement of Hon. Bill Archer, a Representative in Congress from the 
State of Texas

    Good morning.
    Today's hearing has been called to review the revenue 
proposals contained in the President Clinton's budget for the 
fiscal year beginning October 1st, a little less than seven 
months away.
    Welcome to our guests and to Secretary Lubick. Thank you 
for joining us.
    According to the non-partisan Joint Committee on Taxation, 
the White House proposes an $89 billion tax increase over the 
next ten years. The budget contains forty-seven tax reduction 
proposals worth $82.1 billion, but it also includes seventy-
five tax hikes which raise $171.8 billion. The combination of 
the two is the $89 billion tax hike.
    With a multi-trillion dollar surplus projected as far as 
the eye can see, it's hard to understand why anybody would want 
to raise taxes on anyone.
    As for the proposed tax cuts, they sure complicate the 
code. If you're a non-smoker, who drives a fuel-efficient car 
from your rooftop solar-equipped home to your specialized small 
business investment company where you work, you get a tax cut. 
However, given how difficult the tax forms are to fill out, I'm 
not sure that taxpayers will welcome these ideas. On the other 
hand, accountants, tax lawyers, and social engineers will find 
much to approve.
    On the tax hike side, the budget contains dozens of tax 
hike repeats which have already met with the massive bipartisan 
opposition of most Ways and Means members. In fact, of the 
seventy-five tax hikes in the budget, 34 provisions worth $132 
billion are old news. Let's not go down that road again.
    There are, however, some ideas we will explore. The area of 
corporate tax shelters is one field which merits review. I have 
already announced my support for a school construction 
initiative. I intend to pursue other areas on which we can 
build common ground.
    On balance however, this budget would make April 15th a 
bigger headache for the taxpayers. Higher taxes, bigger 
headaches, more complexity...I intend to pursue a different 
course to lower taxes, to close legitimate loopholes and 
anachronisms, on the way to a simpler, fairer code.
    I look forward to working with all Members of the Committee 
to get the job done.
      

                                

    Chairman Archer. I yield to the other gentleman from Texas 
on the Committee for any statement he might like to make in 
behalf of the Minority.
    Mr. Doggett. Thank you, Mr. Chairman. I am ready to move 
onto the hearing.
    Chairman Archer. All right. We will commence then with our 
first witness, who is one of our colleagues, our friend and 
Member Bob Etheridge from North Carolina. Congressman 
Etheridge, we are happy to have you before us. We would 
encourage you to limit your verbal presentation to 5 minutes, 
and without objection, your entire printed statement will be 
inserted in the record.
    So you may proceed.

 STATEMENT OF HON. BOB ETHERIDGE, A REPRESENTATIVE IN CONGRESS 
                FROM THE STATE OF NORTH CAROLINA

    Mr. Etheridge. Thank you, Mr. Chairman. And I want to thank 
you and Ranking Member Rangel and the other Members of the 
Committee for allowing me this opportunity this afternoon. I do 
appreciate your courtesies of giving me the opportunity to 
present my views on the revenue provisions of the President's 
proposal fiscal year 2000 budget. And as you have just said, I 
understand you are going to adhere to the 5-minute rule, and I 
am going to try stick to it and move very quickly.
    So I am going to focus my portion of the testimony this 
afternoon on the President's revenue proposals regarding school 
construction and modernization. And it is an issue that at the 
same time is near and dear to my heart and certainly is 
important to my district in North Carolina because, as you 
know, prior to my election to the people's House, I had served 
8 years, which is two terms, as the elected State 
superintendent in my State. Prior to that I had the distinct 
privilege of spending 10 years in the State House, where I 
chaired the appropriations Committee for 4 years. And prior to 
that, I was a county commissioner for 4 years, for 2 years of 
which I had been chair.
    So throughout my political career, I have been involved in 
this issue of building schools and helping improve the quality 
of education for all of our children. And it is important to 
all of us.
    Across America today, there are 53 million children 
attending school. Too many of these children are not being 
educated in the kind of quality, well-equipped facilities where 
discipline and order foster academic achievement.
    For many years, our Nation's school children have gone to 
classes in trailers, in closets, overstuffed and rundown 
classrooms. The nonpartisan General Accounting Office has 
determined that there exists somewhere in the neighborhood of 
$112 billion in school construction needs in America right now. 
That does not measure the impact of enrollment growth.
    We now have more children in our public schools than at any 
time in our Nation's history, including the height of the baby 
boom. As the children of the baby boomers themselves now begin 
to reach school age, the resulting baby-boom echo is putting 
tremendous pressure on our educational facilities in every 
State and in every community.
    That is why the administration's proposal, sponsored in the 
House by my friend Mr. Rangel, is critically needed as a policy 
innovation for the dawn of the new millennium. The Rangel 
School Modernization Act will utilize the resources of the 
Federal Government to leverage investments that localities 
across the country are struggling to make to modernize their 
school infrastructure.
    The Rangel bill, of which I am a strong supporter and an 
original cosponsor, will provide Federal tax credits to bond 
holders to finance approximately $22 billion in school 
construction bonds across America. The bonds under this bill 
will be allocated among the States on an income-formula basis 
and to the largest school districts whose aging infrastructure 
presents a serious need for school modernization.
    In my district, the problem is somewhat different. 
Communities throughout the Second District in North Carolina 
are growing by leaps and bounds, and our schools are bursting 
at the seams. Local community leaders are scrambling to find 
creative solutions to the problem of explosive growth, and they 
need our help, and they need it now.
    For example, just this past week, I visited Wake Forest-
Rolesville High School in Wake County, which is one of the 
larger counties in my district. There teachers and students are 
struggling mightily against the constraints of overcrowding to 
achieve the shared goal of quality education. But in Wake 
County, we are adding anywhere from 3,500 to 4,500 students per 
year to a school system that is really hurting.
    The county has grown by more than 33.8 percent since 1990, 
and counties throughout my district have grown by anywhere from 
20 to 30 percent. These localities simply do not have the means 
to build schools fast enough to have first-class facilities.
    To complement the Rangel bill, I have written and 
introduced H.R. 996, the Etheridge School Construction Act, 
which will provide tax credits to leverage $7.2 billion in 
school construction bonds for localities suffering from the ill 
effects of burdensome growth.
    I am proud that this bill has 67 cosponsors, many of whom, 
Mr. Chairman, are on this Committee. And I invite other Members 
to join me.
    For example, Texas qualifies for $840 million under H.R. 
996, and I ask permission to submit the entire list for the 
record.
    Chairman Archer. Without objection, so ordered.
    Mr. Etheridge. In conclusion, there is no reason why school 
construction should be a partisan issue. Indeed, I would argue 
that our children's future is the last thing that should be 
left to the mercy of partisan politics.
    Earlier this century, the men and women who have been 
called the greatest generation came home from World War II and 
put their shoulders to the wheel, built schools, gave us the 
kind of economy we are now enjoying. We have the opportunity, 
Mr. Chairman, to do the same.
    Now we have a chance, as we move to the 21st century and 
emerge from the cold war to make the new millennium a 
millennium of education for all children.
    [The prepared statement and attachment follow:]

Statement of Hon. Bob Etheridge, a Representative in Congress from the 
State of North Carolina

    Thank you Mr. Chairman, Ranking Democrat, my good friend 
Charlie Rangel, and all the committee Members for allowing me 
to testify here this morning.
    I appreciate your courtesy of giving me the opportunity to 
present my views on the revenue provisions of the President's 
proposed Fiscal Year 2000 budget. I understand the five-minute 
rule will be strictly enforced, and therefore I would like to 
focus my testimony on the President's revenue proposal 
regarding school construction and modernization. It is an issue 
that is at the same time near and dear to my heart and 
absolutely critical to the Congressional District I represent.
    Prior to my election to the People's House in 1996, I 
served eight years as the two-term North Carolina 
Superintendent of public schools, which is a statewide elected 
position in my state. Earlier, I had served in the state 
legislature as the chairman of the Appropriations Committee and 
on the county commission in my home of Harnett County. So I 
have a rather unique perspective as someone who has struggled 
with this issue at each of the different levels of government. 
Throughout my years in public office, building schools and 
improving education for our children has been my life's work.
    Across the country today, there are 53 million children 
attending school in America's classrooms. Far too many of these 
children are not being educated in modern, well-equipped 
facilities where discipline and order foster academic 
achievement. For many of our nation's schoolchildren, class is 
being taught in a trailer or in a closet or in an overstuffed 
or run-down classroom. The nonpartisan Government Accounting 
Office has determined there exists nationwide $112 billion in 
school construction needs just to accommodate today's 
enrollment levels.
    We now have more children in our public schools than at any 
time in our nation's history, including the height of the Baby 
Boom. As the children of the Baby Boomers themselves now begin 
to reach school age, the resulting ``Baby Boom Echo'' is 
putting tremendous pressure on our educational facilities.
    This is why the Administration's proposal, sponsored in the 
House by my good friend Mr. Rangel, is a critically needed 
policy innovation for the dawn of the next century. The Rangel 
School Modernization Act will utilize the resources of the 
federal government to leverage investments that localities 
across the country are struggling to make to modernize their 
school infrastructure. The Rangel bill, of which I am a strong 
supporter and an original cosponsor, will provide federal tax 
credits to bond holders to finance $22 billion in school 
construction bonds throughout the country. The bonds under the 
Rangel bill will be allocated among the states on an income-
based formula and to the largest school districts where aging 
infrastructure presents a serious need for school 
modernization.
    In my district, the problem is somewhat different. 
Communities throughout the Second Congressional District are 
growing by leaps and bounds, and our schools are bursting at 
the seams. Local community leaders a scrambling to find 
creative solutions to the problem of explosive growth, and they 
need our help.
    For example, earlier this week, I visited Wake Forest-
Rolesville High School in Wake County in my district. There the 
teachers and students are struggling mightily against the 
constraints of overcrowding to achieve the shared goal of 
quality education. But in Wake County, we are adding 3500 to 
4500 students per year to the school system. The county has 
grown by more than 29.4 percent since 1990, and counties 
throughout my district have experienced growth of 20 to 30 
percent. These localities simply do not have the means to build 
the schools fast enough to provide this generation of 
schoolchildren a first-class education.
    To complement the Rangel bill, I have written and 
introduced H.R. 996, the Etheridge School Construction Act, 
which will provide tax credits for $7.2 billion in school 
construction bonds for localities suffering the ill effects of 
boundless growth. I am proud to have Mr. Rangel and a number of 
my colleagues from this committee among the bill's 67 
cosponsors, and I invite all the Members of the committee to 
sign on to H.R. 996. I have here a list that may interest you. 
These are the allocation amounts of what the individual states 
would get from my bill. For example, Texas qualifies for $840 
million under H.R. 996. I ask permission to submit the entire 
list for the record.
    In conclusion, there is no reason why school construction 
should be a partisan issue. Indeed, I would argue that our 
children's future is the last thing that should be left to the 
mercy of partisan politics. Earlier this century, the men and 
women who have been called ``The Greatest Generation,'' 
resolved after winning World War II to invest in children and 
in the education of those children. That collective decision 
ushered in an era of economic prosperity, relative 
international peace and human progress that is unrivaled in the 
history of God's creation. We are the direct beneficiaries of 
that foresight, commitment and investment. As we emerge from 
the Cold War and enter a new millenium, I challenge this 
committee and this Congress to exercise the same patriotic 
devotion to our duty to provide for stronger future generations 
by coming together across party lines to pass common sense, 
visionary legislation like the Rangel School Modernization Act 
and the Etheridge School Construction Act.
    Thank you, Mr. Chairman. I would be happy to answer any 
questions.
      

                                

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    Chairman Archer. Thank you, Congressman Etheridge. Are 
there any questions for Congressman Etheridge? Mr. Weller.
    Mr. Weller. Thank you, Mr. Chairman. And Mr. Etheridge, I 
welcome you to the Committee and glad you are here today.
    Mr. Etheridge. Thank you, Mr. Weller.
    Mr. Weller. Also want to point out, of course, you are 
talking today of course about school construction, and that is 
not really a partisan issue, as you point out. Both Chairman 
Archer and a number of Republicans have initiated school 
construction initiatives.
    I know Representative Dunn and I have a tax simplification 
package, and we set aside $3 billion for school construction in 
our package. So I think clearly there is a bipartisan agreement 
that we want to do something. And, of course, the mechanics of 
doing that will be part of the process this year.
    I think I would also like to point, as you note, education 
is important. And this Committee has made education pretty 
important here. We provided this year around April 15th there 
will be hundreds of thousands, if not millions, of Americans 
who will be taking advantage of the student loan interest 
deduction, a thousand-dollar deduction, that they will have 
thanks to this Committee, which enacted in the last couple of 
years.
    And also education savings accounts for those who want to 
save for their children. There is more we need to do but----
    You know, the issue today before this Committee is the over 
$170 billion in tax increases that the administration has 
proposed. And from your point of view, of course, the 
administration has proposed, I think, about $176 billion in tax 
hikes as part of their budget to pay for school construction. 
And there are other initiatives they discuss in the budget.
    And I was wondering, what are your thoughts about the $176 
billion in tax hikes that are in the administration's budget? 
Do you support those?
    Mr. Etheridge. Well, let me say I appreciate what this 
Committee has done. What you did last year, and what we all 
voted on to make education available for children who go to the 
universities because that is important.
    Today, I am talking about those who want to get their start 
and make sure they show up at a school in a quality environment 
to learn because there are communities, even though they have 
certain resources, and they are taxed to the extent and in many 
cases they can't meet those needs. So I think we have a chance, 
at the Federal level now, to form a partnership, not unlike 
what we have done in so many other areas when we have the 
resources to do it.
    The whole issue of tax increases and tax reductions are 
issues that we all have to come together and work and jointly 
decide whether or not they fit our priorities.
    But I happen to believe the issue of opportunities for 
children are opportunities we have a chance to claim and deal 
with.
    Mr. Weller. Reclaiming my time, Representative. I think we 
agree. As I stated earlier, education is a priority, and in the 
administration's budget they propose $176 billion in tax 
increases, new taxes, on products important to your State and 
others. And I was just wondering, do you support--can you pick 
out one or two you think to be appropriate pay-fors to pay for 
the administration's school construction budget, something you 
think is an appropriate offset, something you would recommend.
    Mr. Etheridge. I have listed offsets in the proposal, Mr. 
Weller, that I laid out. There are definite proposals in there. 
There is one tax that I will not support, and I have already 
made public that. And that is another increase in the cigarette 
tax because that has a definite impact directly on my district.
    Mr. Weller. That is about a third of the President's tax 
hike.
    Mr. Etheridge. Not sure what that number is.
    Mr. Weller. The President also proposes as part of his pay-
fors for his budget, about $9 billion in Medicare cuts to our 
local hospitals and $140 million in new taxes on our health-
care providers. Do you feel those are appropriate pay-fors for 
a school construction initiative?
    Mr. Etheridge. Well, I didn't list any of those, I would 
say, in my proposal. Those proposals, they will have to be 
decided before any Committee. But the ones I laid out have 
nothing to do with Medicare and Medicare issues.
    Mr. Weller. So then you oppose the President's cuts in 
Medicare reimbursements to hospitals and oppose the 
administration's tax increase.
    Mr. Etheridge. And I can assure you, my hospitals are not 
happy with it either.
    Mr. Weller. All right. Well thank you, Representative.
    Chairman Archer. If there are no further questions for 
Congressman Etheridge, we thank you for your appearance and for 
your presentation.
    Mr. Etheridge. Thank you, sir.
    Chairman Archer. Our next witness is Assistant Secretary of 
the Treasury, Hon. Don Lubick, who is no stranger to our 
Committee. We are happy to have you with us today, and pleased 
to receive your verbal testimony. Without objection, your 
entire printed statement, will be inserted in the record.
    Welcome, you may proceed.

 STATEMENT OF HON. DONALD C. LUBICK, ASSISTANT SECRETARY, TAX 
 POLICY, U.S. DEPARTMENT OF THE TREASURY; ACCOMPANIED BY HON. 
   JONATHAN TALISMAN, DEPUTY ASSISTANT SECRETARY, TAX POLICY

    Mr. Lubick. Thank you, Mr. Chairman. I appreciate as usual 
the----
    Chairman Archer. Mr. Lubick, if I may, I should have also 
introduced and welcomed Jonathan Talisman, who is the Deputy 
Assistant Secretary for Tax Policy with the Treasury. We are 
happy to have you with us today too.
    Mr. Talisman. Thank you, Mr. Chairman.
    Chairman Archer. All right, Mr. Lubick.
    Mr. Lubick. As you have noted, Mr. Chairman, there is a lot 
of baggage that we are carrying. So it takes two of us. 
[Laughter.]
    I always appreciate the rather kind treatment that I get 
here, even though I know occasionally you may disagree with 
something that I advocate. So appreciate that as well. And it 
goes for all the Members of the Committee.
    I would like to address today the revenue provisions 
included in the President's Fiscal 2000 budget.
    The Nation has moved from an era of large annual budget 
deficits to an era of budget surpluses, which are projected to 
continue for many, many years. This has resulted from the 
fiscal policy of the last 6 years, the economy it helped 
produce, and the ongoing interaction between the two.
    Rather than facing an annual requirement to reduce the 
deficit, we now have before us the opportunity to face the 
serious challenges for generations to come by making wise 
policy choices. These challenges lie primarily in the area of 
the economic and fiscal pressures created by the retirement 
baby-boom generation. Meeting those challenges is exactly what 
the President's budget does.
    The core of the budget is fiscal discipline and thereby 
increased national savings in order to promote continuing 
economic growth and retirement security in the years ahead.
    The President's proposal is to commit 62 percent of the 
unified surplus for the next 15 years to Social Security. This 
is an infusion of $2.76 trillion to the trust fund, in addition 
to the $2.7 trillion of forecast off-budget surplus generated 
by payroll taxes in excess of receipts for the next 15 years, 
which would go to Social Security anyway.
    The infusion, including increased rates of return from 
investing about 20 percent of the 62 percent of the unified 
surplus in equities, will extend the predicted period of 
solvency for the trust fund from 2032 to 2055. The remaining 20 
years to reach 75 years of solvency will require tough 
decisions to be made jointly by the President and Congress.
    An additional 15 percent of the surplus would be allocated 
to Medicare, and the President also proposes to devote 12 
percent of the surplus to a program to encourage saving through 
USA Accounts. The majority of workers would receive an 
automatic contribution, and in addition, those who make 
voluntary contributions could receive a matching contribution 
to their USA Account.
    The matching contribution would be more progressive than 
current tax subsidies for retirement savings, helping most the 
workers who most need to increase retirement savings.
    By creating a retirement savings program for working 
Americans with individual and government contributions, all 
Americans will become savers and enjoy a more financially 
secure retirement.
    The remaining 11 percent would be allocated to other 
priorities, including defense funding.
    Finally, the budget insists that none of the surpluses be 
used at all until we have put Social Security on a sound 
financial footing for the long term.
    I would like to address primarily today the package of 
about $34 billion in targeted tax reductions, which I would 
like to summarize briefly. They include increased funding for 
education, including tax credit bond programs totaling $25 
billion to spur State and local government investment in 
elementary and secondary schools, expansion of the current law 
incentive for employer-provided educational assistance and a 
number of other items.
    There are measures to make child care affordable by 
expanding the current child- and dependent-care credit and by 
providing a new employer credit to promote employee child care.
    There are provisions to provide tax relief for individuals 
with long-term care needs or those who care for others with 
such needs, and to workers with disabilities. There are 
measures to promote health insurance coverage for employees of 
small business. There are incentives to promote the livability 
and revitalization of urban and rural communities, a tax credit 
to attract new capital to businesses located in low-income 
communities--expansion of the current law--low-income housing 
credit, and $3.6 billion in tax incentives to promote energy 
efficiency and reduce greenhouse gases.
    There are several provisions to expand and simplify and 
increase the portability of retirement savings mechanisms. We 
have been in discussions with your Members, Congressmen Portman 
and Cardin, to deal with that problem.
    We have proposed the extension of a recently enacted 
provision that prevents the nonrefundable tax credits, such as 
the education credit and the child credits, from being affected 
by the alternative minimum tax. I know that is a problem you 
concerned yourself with much recently.
    And we proposed extenders of several tax provisions, such 
as the R&D tax credit, the work opportunity and welfare-to-work 
credits and the brownfields expensing program.
    And there are also some provisions that would simplify the 
administration of the tax laws.
    Mr. Chairman, sound fiscal policy demands that these 
proposals be fully funded, so the President's budget includes a 
package of revenue offsets that would fully offset our targeted 
tax incentives. Our revenue offsets would curtail corporate tax 
shelters and close loopholes in the tax law in the areas of 
financial products, corporate taxes, pass-through entities, tax 
accounting, cost recovery, insurance to exempt organizations, 
State and gift taxation, and a number of others.
    Let me focus for a moment on proposals in our package that 
we believe will curtail significantly the development, 
marketing, and purchase of products designed to produce a 
substantial reduction in a corporation's tax liability.
    The administration believes that there has been an increase 
in the use of corporate tax shelters and is concerned about 
this proliferation for several reasons. Corporate tax shelters 
reduce the corporate tax base. Moreover, they erode the 
integrity of the tax system as a whole. The view that large, 
well-advised corporations can and do avoid their legal tax 
liabilities by engaging in transactions unavailable to most 
other taxpayers may lead to a perception of unfairness and if 
unabated, may lead to a decrease in voluntary compliance.
    Finally, the significant resources used to create, 
implement, and defend complex sheltering transactions are 
better used in more productive activities.
    To date, most attacks on corporate tax shelters have been 
targeted at specific transactions and have incurred on an ad 
hoc, after-the-fact basis through legislative proposals, 
administrative guidance, and litigation.
    At the Treasury Department, a number of actions have been 
taken to address corporate tax shelters. We have made 
legislative proposals aimed at corporate-owned life insurance, 
which awaits action by the Congress, section 357(c) abuses, 
which has been advanced in both chambers, and liquidating 
REITs, real estate investment trusts, which were enacted last 
year.
    On the regulatory front, we have issued guidance such as 
the notice on step-down preferred, fast-paced, slow-pay 
transactions, and at litigation, we have won two important 
cases, ACM, and ASA.
    But we often hear that we are only hitting the tip of the 
iceberg.
    Addressing corporate tax shelters on a transaction-by-
transaction ad hoc basis raises certain concerns. First, it is 
not possible to identify and address all current and future 
sheltering transactions. Taxpayers with an appetite for 
corporate tax shelters will simply move from those transactions 
that are specifically prohibited by the new legislation to 
other transactions, the treatment of which is less specified.
    Second, legislating on a piecemeal basis further 
complicates the Code, and seemingly calls into question the 
viability of common-law tax doctrines such as sham transaction, 
business purpose, economic substance, and substance over form.
    Finally, using a transactional legislative approach to 
corporate tax shelters may embolden some promoters and 
participants to rush shelter products to market in the belief 
that any reactive legislation would be applied only on a 
prospective basis.
    Mr. Chairman, we are gratified by recent statements that 
you have made supporting the need to address this problem. I 
won't go further by saying you have committed to anything in 
particular, but we are very pleased that you recognize that 
there is a problem to be addressed. We also want to thank the 
Members of this Committee for addressing specific corporate tax 
shelters that we or others have brought to their attention.
    In addition, we are pleased that numerous tax practitioners 
and representatives even of Fortune 500 companies have spoken 
to us expressing their support for taking action. The 
administration, therefore, proposes several remedies to curb 
the growth of corporate shelters.
    First, we propose more general remedies to deter 
corporations from entering into any sheltering transactions. 
These proposals would disallow any tax benefit created in a 
corporate tax shelter and would address common characteristics 
found in corporate tax shelters.
    In addition, we propose specific remedies for certain 
transactions that we have already identified as being used to 
shelter improperly corporate income from Federal taxation. 
Also, all the parties to a structured transaction under our 
proposals, would have an incentive to assure that the 
transaction comports with established principles.
    The Treasury Department recognizes that this more general 
approach to corporate tax shelters raises certain concerns. 
Applying various substantive and procedural rules to a 
corporate tax shelter for a tax-avoidance transaction requires 
definitions of such terms. As described in greater detail in 
our written testimony, the administration's proposals define 
these terms.
    Critics of the proposals have suggested that these 
definitions are too broad or may create too much uncertainty 
and thus may inhibit otherwise legitimate transactions. The 
Treasury Department does not intend to affect any legitimate 
transaction. Let me state, however, that the definition we have 
proposed is similar to existing articulations of various 
judicial doctrines and may be viewed as largely enforcing the 
judicially created concept of economic substance that obtains 
in under current law.
    The definition of corporate tax shelter, as used in our 
proposals, is narrower and, therefore, less uncertain than 
other definitions and formulations, which are part of our 
present legal treatment used in the Code and judicial 
interpretations of its provisions. We strike no new ground in 
defining the nature of tax shelters.
    Taxpayers and practitioners have lived with the concepts 
our definitions embody, as they have been enunciated by the 
courts since the twenties. A measure of uncertainty is not only 
inevitable but perhaps desirable to prevent over-aggressive 
tax-avoidance scheming.
    We ask practitioners to come forward with examples of 
legitimate tax planning that would be jeopardized by our 
definition.
    Mr. Chairman, Members of the Committee, we will respond and 
work with this Committee to refine our definition in a manner 
that will protect from penalty any legitimate, normal, course-
of-business transactions. I also want to mention that our 
budget contains a number of provisions that would close 
loopholes in the Code. They have great merit. They are 
discussed fully in my prepared remarks, which I appreciate your 
including in the record.
    In conclusion, Mr. Chairman and Members of the Committee, 
the administration looks forward to working with you as you 
examine our proposals. We hope that you reach the conclusion 
that they are all meritorious, and that this Committee will 
approve them.
    Mr. Talisman and I stand at the ready to attempt to answer 
any questions you may have.
    [The prepared statement follows:]

Statement of Hon. Donald C. Lubick, Assistant Secretary, Tax Policy, 
U.S. Department of the Treasury

    Mr. Chairman, Mr. Rangel, and Members of this committee, it 
is a pleasure to speak with you today about the President's FY 
2000 budget.
    The nation has moved from an era of large annual budget 
deficits to an era of budget surpluses for many years to come. 
This has resulted from the fiscal policy of the last six years, 
the economy it helped produce, and the ongoing interaction 
between the two. Rather than facing an annual requirement to 
reduce the deficit, we now have before us the opportunity to 
face the serious challenges for generations to come by making 
wise policy choices. These challenges lie primarily in the area 
of the economic and fiscal pressures created by the retirement 
of the baby boom generation. Meeting those challenges is 
exactly what the President's budget does. The core of this 
budget is fiscal discipline, and thereby increased national 
savings, in order to promote continuing economic growth and 
retirement security in the years ahead.
    In 1992, the deficit reached a record of $290 billion, the 
Federal debt had quadrupled during the preceding twelve years, 
and both the deficit and debt were projected to rise 
substantially. The deficit binge has left us with publicly held 
debt of $3.7 trillion, and an annual debt service requirement 
that amounts to 15 percent of the budget. Now however, for the 
next 15 years, OMB forecasts cumulative unified surpluses of 
over $4.85 trillion.
    It is important to note that transformation from deficits 
to surpluses has come about concurrent with tax burdens on 
typical working families being at record lows for recent 
decades. For a family of four with a median income, the federal 
income and payroll tax burden is at its lowest level in 21 
years, in part because of the child tax credit enacted in the 
1997 balanced budget plan. For a family of four with half the 
median income, the income and payroll tax burden is at its 
lowest level in 31 years, in part because of the 1993 expansion 
of the Earned Income Tax Credit for fifteen million families as 
well as the 1997 enactment of the child tax credit. And for a 
family of four with double the median income, the federal 
income tax burden is at its lowest level since 1973. While 
overall tax revenues have risen as a percentage of GDP, that is 
in part because higher income individuals have had large 
increases in incomes, resulting from, among other things, 
bonuses based on high stock prices and increased realizations 
of capital gains, and in part because of increased corporate 
earnings.
    The President's proposal is to commit 62 percent of the 
unified surplus for the next 15 years to Social Security. This 
is an infusion of $2.8 trillion to the trust fund in addition 
to the $2.7 trillion of forecast off-budget surpluses generated 
by payroll taxes in excess of benefit payments. This infusion, 
including increased rates of return from investing one-fifth of 
the 62 percent of the unified surplus in equities, will push 
back the date of trust fund exhaustion from 2032 to 2055. 
Closing the remaining gap and thus assuring solvency over 75 
years will require tough decisions to be made jointly by the 
President and Congress.
    An additional 15 percent of the surplus would be allocated 
to Medicare. The President also proposes to devote 12 percent 
of the unified surplus to establishing a new system of 
Universal Savings Accounts. These accounts would provide a tax 
credit to millions of American workers to help them save for 
their retirement. A majority of workers could receive an 
automatic contribution. In addition, those who make voluntary 
contributions could receive a matching contribution to their 
USA account. The matching contribution would be more 
progressive than current tax subsidies for retirement savings--
helping most the workers who most need to increase retirement 
savings. By creating a retirement savings program for working 
Americans with individual and government contributions, all 
Americans will become savers and enjoy a more financially 
secure retirement.
    The remaining 11 percent would be allocated to other 
priorities, including increased defense spending. Finally, the 
budget insists that none of the surpluses be used at all until 
we have put Social Security on sound financial footing for the 
long-term.
    When President Clinton was elected, publicly held debt 
equaled 50 percent of GDP. As a result of the President's plan, 
by 2014, publicly held debt will decline to about 7 percent of 
GDP. This reduction in debt will have three effects. First, the 
government will not have to refinance as much federal debt and 
thereby will consume less of national savings, thus making 
capital more readily available to the private sector. That, in 
turn, will reduce interest rates and increase confidence in the 
economy, increasing economic growth, job creation and standards 
of living. Second, debt service costs will decline 
dramatically. When the President came into office debt service 
costs of the federal government in 2014 were projected to 
constitute 27 percent of the federal budget. Under the 
President's proposal, and because of the progress we have made 
to date, we estimate the debt service costs will be 2 percent 
of the federal budget in 2014. Third, the decrease in debt 
means the federal government will have a greatly improved 
capacity to access external capital should the need arise.
    This is not the time, with the economy running so well, for 
major tax cuts that are not offset by other measures. Public 
debt reduction is an opportunity that we should not squander, 
and it will reap broader and more permanent economic prosperity 
than any tax cut could. Public debt reduction has many of the 
economic effects of a tax cut, but maintains the fiscal 
discipline necessary to meet future challenges. It is the only 
responsible course to take.

Targeted incentives

    Thus, the President's Budget also proposes a fully funded 
package of about $34 billion in targeted tax reductions, 
including provisions to rebuild the nation's schools, make 
child and health care more affordable, revitalize communities, 
provide incentives for energy efficiency, promote retirement 
savings, provide for tax simplification, and extend expiring 
provisions.
    More specifically, to enhance productivity and maintain our 
country's competitive position in the years ahead, and to 
provide relief for working families, the Administration 
proposes:
     increased funding for education, including tax 
credit bond programs totaling $25 billion to spur State and 
local government investment in elementary and secondary 
schools, expansion of the current-law tax incentive for 
employer-provided educational assistance, simplification and 
expansion of the deduction allowed for student loan interest 
payments, tax-free treatment for certain education awards, and 
a tax credit for certain workplace literacy and basic education 
programs;
     measures to make child care more affordable, by 
expanding the current-law child and dependent care tax credit 
and by providing a new employer credit to promote employee 
child care;
     providing tax relief (in the form of a $1,000 
credit) to individuals with long-term care needs, or who care 
for others with such needs, and to workers with disabilities;
     measures to promote health insurance coverage for 
employees of small businesses;
     incentives to promote the livability and 
revitalization of urban and rural communities, including a tax 
credit bond program totaling $9.5 billion to help States and 
local governments finance environmental projects, a tax credit 
to attract new capital to businesses located in low-income 
communities, expansion of the current-law low-income housing 
tax credit program, and $3.6 billion in tax incentives to 
promote energy efficiency and reduce greenhouse gases;
     several provisions to expand, simplify, and 
increase the portability of retirement savings mechanisms, and 
to make it easier for individuals to save for retirement on 
their own; and
     extension of a recently enacted provision that 
allows individuals to claim nonrefundable tax credits--such as 
the education credits and the $500 child credit--without being 
affected by the alternative minimum tax; and
     extension of several tax provisions that are 
scheduled to expire, including the R&E tax credit, work 
opportunity and welfare-to-work tax credits, and the so-called 
``brownfields'' expensing provision.
    The President's plan also includes a package of provisions 
that would simplify the administration of the Federal tax laws.
    The following is a more detailed summary of the tax 
incentive provisions included in the President's plan.

                  1. MAKE HEALTH CARE MORE AFFORDABLE

    Long-term care and disabled workers credits.--Deductions 
available under current law for long-term care and work-related 
impairment expenses do not benefit taxpayers who claim the 
standard deduction and, even if a taxpayer itemizes deductions, 
do not cover all formal and informal costs of providing 
assistance to individuals with long-term care needs or to 
disabled individuals who work. In recognition of such formal 
and informal long-term care costs and their effect on a 
taxpayer's ability to pay taxes, the President's plan would 
allow taxpayers to claim a new long-term care credit of $1,000 
if the taxpayer, a spouse, or an individual receiving support 
from (or residing with) the taxpayer has ``long-term care 
needs.'' An individual generally would have ``long-term care 
needs'' if unable for at least six months to perform at least 
three activities of daily living without substantial assistance 
from another individual, or if unable to perform at least one 
activity of daily living or certain age appropriate activities 
due to severe cognitive impairment.
    In addition, the President's plan would help compensate 
taxpayers with disabilities for costs associated with work 
(e.g., personal assistance or special transportation) by 
allowing taxpayers with earned income to claim a $1,000 credit 
if the taxpayer is unable for at least 12 months to perform at 
least one activity of daily living without substantial 
assistance from another individual.
    To claim one (or possibly both) of the credits, taxpayers 
would be required to obtain a physician's certification to 
demonstrate the required level of long-term care needs, but 
would not be required to substantiate any particular out-of-
pocket expenses. The proposed credits would be phased out--in 
combination with the current-law $500 child credit--for certain 
higher-income taxpayers.
    Small business health plans.--The President's plan would 
make health care costs more affordable by assisting small 
businesses in their efforts to provide health insurance to 
employees. Small businesses generally face higher costs than do 
larger employers in providing health plans to their employees, 
which has led to a significantly higher percentage of small 
business employees being uninsured compared to the national 
average. Health benefit purchasing coalitions pool employer 
workforces and provide an opportunity to purchase health 
insurance at a reduced cost, but such coalitions have been 
hindered by limited access to capital. In response, the 
President's plan includes a special, temporary rule that would 
allow tax-exempt private foundations to make grants or loans 
prior to January 1, 2004, to qualified health benefit 
purchasing coalitions to support the coalition's initial 
operating expenses.
    Moreover, the President's plan would allow employers that 
have fewer than 50 employees and that did not have an employee 
health plan during 1997 or 1998 to claim a 10-percent credit 
for certain premium payments made for employee health insurance 
purchased through a qualified coalition. The proposed credit 
would be allowed for health plans established before January 1, 
2004, and would be allowed for contributions made during the 
first 24 months that an employer purchases health insurance 
through a qualified coalition.

                    2. EXPAND EDUCATION INITIATIVES

    School construction and modernization.--Because many school 
systems lack sufficient fiscal capacity to respond to aging 
school buildings and growing enrollments, the President's plan 
includes a new tax credit bond program that would leverage 
Federal support to spur new State and local investment in 
elementary and secondary school modernization. Under this 
program, State and local governments (including U.S. 
possessions) would be authorized to issue up to $22 billion of 
``qualified school modernization bonds'' ($11 billion in each 
of 2000 and 2001). One half of the $22 billion cap would be 
allocated among the 100 school districts with the largest 
number of children living in poverty and up to 25 additional 
school districts with particular needs of assistance. The 
remaining half of the $22 billion cap would be allocated among 
the States and Puerto Rico. In addition, $400 million of bonds 
($200 million in each of 2000 and 2001) would be allocated for 
construction and renovation of Bureau of Indian Affairs funded 
schools.
    A holder of these bonds would receive annual Federal income 
tax credits, set according to market interest rates by the 
Treasury Department, in lieu of interest being paid by the 
State or local government. At least 95 percent of the bond 
proceeds of a qualified school modernization bond must be used 
(generally within 3 years of the date of issuance) to finance 
public school construction or rehabilitation pursuant to a plan 
approved by the Department of Education. Issuers would be 
responsible for repayment of principal after a maximum term of 
15 years.
    The President's plan also provides for expansion of the 
current-law ``qualified zone academy bond'' program, by 
authorizing the issuance of an additional $2.4 billion of such 
bonds and allowing the bond proceeds to be used for new school 
construction.
    Other education incentives.--To expand educational 
opportunities throughout a taxpayer's lifetime, the President's 
budget plan also includes the following provisions that build 
on current-law tax incentives for education: (1) extend section 
127 exclusion for employer-provided educational assistance 
through the end of the year 2001 and expand the exclusion to 
apply to graduate-level courses (currently, the exclusion is 
limited to undergraduate courses beginning before June 1, 
2000); (2) eliminate the current-law rule under section 221 
that limits deductible student loan interest to interest paid 
only during the first 60 months that interest payments are 
required on a loan (this will simplify greatly the student loan 
interest deduction provision); (3) eliminate tax liability when 
Federal student loan balances are canceled after the student 
finishes making income-contingent payments on the loan; (4) 
provide tax-free treatment for certain awards under the 
National Health Service Corps scholarship and loan repayment 
programs, the Armed Forces Health Professions scholarship and 
loan repayment programs, and the Americorps loan repayment 
program; (5) provide for an allocated tax credit to encourage 
corporate sponsorship of qualified zone academies in designated 
empowerment zones and enterprise communities; and (6) allow 
employers to claim a 10-percent credit (up to $525 per eligible 
employee) for certain workplace literacy programs that provide 
basic skills instruction at or below the level of a high school 
degree or English literacy.

                  3. MAKING CHILD CARE MORE AFFORDABLE

    Increase, expand and simplify the child and dependent care 
tax credit.--Many working parents cannot find affordable and 
safe child care. The needs of moderate-income families can best 
be served through an expansion of the current-law child and 
dependent care tax credit, which was last increased in 1982. 
The President's plan would increase the maximum credit rate 
from 30 percent to 50 percent, and would extend eligibility for 
the maximum credit rate to taxpayers with adjusted gross 
incomes of $30,000 (rather than $10,000 as under current law). 
The new 50-percent credit rate would be phased down gradually 
for taxpayers with adjusted gross incomes between $30,000 and 
$59,000. The credit rate would be 20 percent for taxpayers with 
adjusted gross incomes over $59,000.
    In addition, to enable parents to make the best choices for 
caring for their infants, who require special care and 
attention, the President's plan would further expand the 
eligibility for the child and dependent care tax credit. 
Parents with infants under the age of one would be eligible for 
an additional credit amount, even if the parent stays at home 
to care for the infant rather than working outside the home and 
incurring out-of-pocket child care expenses. Under the 
proposal, a taxpayer who resides with his or her infant under 
the age of one would be deemed to have child care expenses of 
$500 ($1,000 for two or more infants under the age of one). 
Taxpayers residing with children under the age of one who also 
incur out-of-pocket child care expenses in order to work would 
simply add such out-of-pocket expenses to the deemed $500 (or 
$1,000) of child care expenses, and would then calculate the 
section 21 credit by multiplying deemed and actual out-of-
pocket child care expenses by the applicable 20- to 50-percent 
credit rate.
    The President's plan would simplify eligibility for the 
credit by eliminating the complicated household maintenance 
test under current law (except that a married taxpayer filing a 
separate return would still have to meet the current-law 
household maintenance test in order to qualify for the credit). 
In addition, to ensure that the credit retains its value over 
time, certain credit parameters would be indexed for inflation.
    Employer-provided child care credit.--As part of the 
Administration's comprehensive initiative to address child care 
needs of working families, the President's plan would allow 
employers to claim a credit equal to 25 percent of expenses 
incurred to build or acquire a child care facility for employee 
use, or to provide child care services to children of employees 
directly or through a third party. Employers also would be 
entitled to a credit equal to 10 percent of expenses incurred 
to provide employees with child care resource and referral 
services. A taxpayer's total credit could not exceed $150,000 
per taxable year.

                4. INCENTIVES TO REVITALIZE COMMUNITIES

    Better America Bonds.--Conventional tax-exempt bonds may 
not provide a deep enough subsidy to induce State and local 
governments to undertake environmental projects with diffuse 
public benefits. Accordingly, the President's plan includes a 
new tax credit bond program, under which States and local 
governments (including U.S. possessions and Native American 
tribal governments) would be authorized to issue an aggregate 
of $9.5 billion of ``Better America Bonds.'' Similar to the 
President's school modernization bond proposal (discussed 
above) and the current-law qualified zone academy bonds, 
holders of such bonds would receive annual Federal income tax 
credits in lieu of interest being paid by the State or local 
government. At least 95 percent of the bond proceeds must be 
used (generally within 3 years of the date of issuance) to 
finance projects to protect open spaces or accomplish certain 
other qualified environmental purposes. The Environmental 
Protection Agency would allocate bond authority to particular 
environmental projects based on a competitive application 
process. Issuers of the bonds would be responsible for 
repayment of principal after a maximum term of 15 years.
    New Markets Tax Credit.--Businesses located in low-income 
urban and rural communities often lack access to sufficient 
equity capital. To attract new capital to these businesses, 
taxpayers would be allowed a credit against Federal income 
taxes for certain investments made to acquire stock (or other 
equity interests) in a community development investment entity 
selected by the Treasury Department to receive a credit 
allocation. The Treasury Department would authorize selected 
community development entities to issue up to a total of $6 
billion of equity interests with respect to which investors 
could claim a credit equal to approximately 25 percent (in 
present-value terms) of the investment.
    Under the proposal, selected community development 
investment entities, in turn, would be required to use the 
investment proceeds to provide loans or equity capital to 
qualified active business located in low-income communities. 
Such businesses generally would be required to satisfy the 
requirements for ``enterprise zone businesses'' under current 
law and must be located in census tracts with either (1) 
poverty rates of at least 20 percent or (2) median family 
income which does not exceed 80 percent of metropolitan area 
family income (or 80 percent of non-metropolitan statewide 
family income in the case of a non-metropolitan census tract). 
There would be no requirement that employees of a qualified 
active business be residents of a low-income community.
    Increase low-income housing tax credit per capita cap.--
Most State agencies receive more qualified proposals for low-
income rental housing than can be undertaken with the current-
law State limitation for the low-income housing tax credit. 
This limitation has not changed since it was established in 
1986. Accordingly, the President's plan would increase the 
current-law $1.25 per capita limitation for the low-income 
housing tax credit to $1.75 per capita. This increase would 
allow additional low-income housing to be provided but still 
would require that State agencies choose projects that meet 
specific housing needs.
    Other provisions.--As additional incentives to revitalize 
communities, the President's plan would (1) enhance the 
current-law provisions that allow certain investment gains to 
be rolled over on a tax-free basis to purchase stock in a 
specialized small business investment company (SSBIC) and that 
provide a partial capital gains exclusion for the sale of such 
stock held for more than five years; and (2) provide that 
businesses located in the two new empowerment zones, with 
respect to which the zone designation takes effect on January 
1, 2000 (i.e., Cleveland and Los Angeles), will be eligible to 
claim the empowerment zone wage credit for the full, ten-year 
period of zone designation, as is the case with the original 
nine empowerment zones designated in 1994.

           5. ENERGY EFFICIENCY AND ENVIRONMENTAL IMPROVEMENT

    In an effort to improve the environment, the President's 
budget proposes $3.6 billion in tax incentives to promote 
energy efficiency and to reduce emissions of greenhouse gases.
    Energy-efficient buildings would be encouraged by a tax 
credit of up to $2,000 for the purchase of highly energy-
efficient new homes, and by a 10 or 20 percent credit (subject 
to a cap) for the purchase of certain energy-efficient building 
equipment (fuel cells, electric heat pump water heaters, 
natural gas heat pumps, electric heat pumps, natural gas water 
heaters, and advanced central air conditioners). The credit for 
energy-efficient homes would apply to purchases in calendar 
years 2000 through 2004 and the credit for energy-efficient 
building equipment would apply to purchases in calendar years 
2000 through 2003.
    Transportation-related incentives would encourage the 
purchase of electric vehicles and highly energy-efficient 
hybrid vehicles. The current-law credit of up to $4,000 for the 
purchase of a qualifying electric vehicle would be extended 
through 2006, and a new credit of up to $4,000 would be allowed 
in calendar years 2003 through 2006 for purchases of fuel-
efficient hybrid vehicles.
    The Administration's budget proposals would also promote 
increased energy efficiency through the use of combined heat 
and power (CHP) technologies by allowing an 8-percent 
investment tax credit for qualifying CHP equipment placed in 
service in calendar years 2000 through 2002.
    Finally, tax incentives would be provided for the increased 
use of renewable energy sources: a credit of up to $2,000 would 
be allowed for solar photovoltaic equipment placed in service 
during calendar years 2000 through 2006 and of up to $1,000 for 
solar hot water heating systems placed in service during 
calendar years 2000 through 2005. In addition, the current-law 
tax credit for electricity produced from wind or biomass would 
be extended for five years. For this purpose, eligible biomass 
sources would be expanded to include certain biomass derived 
from forest-related resources and agricultural sources, and a 
reduced credit would be allowed for co-firing biomass in coal 
plants.

       6. EXPANDED RETIREMENT SAVINGS, SECURITY, AND PORTABILITY

    With changing demographics, it is especially important to 
increase retirement savings. Much of the legislation enacted in 
recent years has been successful in expanding retirement 
savings, providing incentives to individuals and employers. 
Approximately two-thirds of the retirement savings in this 
country (exclusive of annuity contracts) is employer-provided 
retirement savings. Employer-provided pensions currently 
benefit 50 million workers. The President's budget encourages 
savings through employer-provided plans.
    While the employer system is strong, we cannot be content. 
Half of all American workers--more than 50 million people--have 
no pension plan at all. Women have less pension coverage than 
men. Only 30 percent of all women aged 65 or older were 
receiving a pension in 1994 (either worker or survivor 
benefits) compared to 48 percent of men. An increasingly mobile 
workforce makes accumulating and managing retirement benefits 
more difficult. Workers frustrated by keeping track of their 
various retirement accounts are tempted to cash out their 
retirement benefits and spend these all important savings on 
current consumption. Two-thirds of workers receiving a lump sum 
distribution from a pension plan do not roll over the 
distribution into retirement savings.
    We need to continue to promote retirement savings by 
enacting pension legislation to expand the number of people who 
will have employer-provided pensions, by simplifying the 
pension laws for business, by improving pension funding and 
making pensions more secure and portable for workers.
    The President's budget includes several incentives to 
encourage the provision of retirement benefits by small 
business. First, a three-year tax credit is provided to 
encourage small businesses to set up retirement programs. 
Second, to make it easier for workers to make contributions to 
Individual Retirement Accounts (IRAS), employers would be 
encouraged to offer payroll deduction programs. Third, the 
President's plan provides a simplified defined benefit-type 
plan for small business, known as the ``SMART Plan.'' The 
Administration's proposal is similar in many respects to the 
bipartisan ``SAFE plan'' proposal of Representatives Earl 
Pomeroy and Nancy Johnson. The SMART (Secure Money Annuity or 
Retirement Trust) plan combines many of the best features of 
defined benefit and defined contribution plans and provides 
another easy-to-administer pension option for small businesses. 
Most nondiscrimination rules and a number of other pension plan 
requirements would be waived for this new plan. SMART plans 
would be an option for most small businesses with 100 or fewer 
employees that do not offer (and have not offered during the 
last 5 years) a defined benefit or money purchase plan. 
Employers choosing a SMART plan would make contributions for 
all eligible workers (over 21 with at least $5,000 in W-2 
earnings with the employer in that year and in two preceding 
consecutive years). Participants would be guaranteed a minimum 
annual benefit upon retirement, but could receive a larger 
benefit if the return on plan investments exceeds specified 
conservative assumptions (i.e., a 5 percent rate of return). 
The SMART benefit would generally be guaranteed by the Pension 
Benefit Guaranty Corporation, at a reduced premium.
    To make it easier to consolidate retirement savings, the 
President's budget provides rules to permit eligible rollover 
distributions from a qualified retirement plan to be rolled 
over into a Section 403(b) tax-sheltered annuity or visa versa; 
to allow rollovers from non qualified deferred compensation 
plans of state or local government (Section 457 plans) to be 
rolled over into an IRA; to permit rollovers of IRAs into 
workplace retirement plans; to allow rollovers of after-tax 
contributions to new employer's defined contribution plan or an 
IRA if separate tracking of after-tax contribution is provided; 
to allow the Thrift Savings Plan (a retirement savings plan for 
federal government employees) to accept tax-free rollovers from 
private plans; and to allow employees of state and local 
governments to use funds in their retirement plans to purchase 
service credits in new plans without a taxable distribution. 
This allows teachers who often move between state and school 
districts in the course of their careers to more easily earn a 
pension reflecting a full career of employment in the state in 
which they end their career.

                  7. EXTENSION OF EXPIRING PROVISIONS

    The President's plan includes the extension of several 
important tax incentive provisions that are scheduled to expire 
in 1999, including (1) a one-year extension of the R&E tax 
credit to apply to qualified research conducted before July 1, 
2000 (and extension of the credit to qualified research 
conducted in Puerto Rico), and (2) one-year extensions of the 
work opportunity tax credit and welfare-to-work tax credit to 
cover employees who begin work before July 1, 2000.
    The President's plan also proposes extending through the 
year 2001 the recently enacted tax credit for the first-time 
purchase of a principal residence in the District of Columbia 
(which currently is scheduled to expire at the end of the year 
2000).
    In addition, the President's plan would make permanent the 
so-called ``brownfields'' provision, which allows taxpayers to 
treat certain environmental remediation expenditures that would 
otherwise be chargeable to capital account as deductible in the 
year paid or incurred. The ``brownfields'' provision currently 
is scheduled to expire at the end of the year 2000.

AMT Relief

    Of particular importance to individual taxpayers, the 
Administration proposes to extend, for two years, the provision 
enacted in 1998 that allows an individual to offset his or her 
regular tax liability by nonrefundable tax credits--such as the 
education credits and the child credit--regardless of the 
amount of the individual's tentative minimum tax. The 
Administration is concerned that the individual alternative 
minimum tax (AMT) may impose financial and compliance burdens 
upon taxpayers that have few tax preference items and were not 
the originally intended targets of the AMT. In particular, the 
Administration is concerned that the individual AMT may act to 
erode the benefits of nonrefundable tax credits that are 
intended to provide relief for middle-income taxpayers. During 
the proposed extension period, the Administration hopes to work 
with Congress to develop a longer-term solution to the 
individual AMT problem.

                      8. SIMPLIFICATION PROVISIONS

    The President's plan includes several other provisions that 
would simplify the administration of Federal tax laws. These 
provisions would: (1) extend the current-law rule for farmers 
to all self-employed individuals that allows individuals to 
elect to increase their self-employment income for purposes of 
obtaining social security coverage; (2) provide statutory 
hedging and other rules (generally codifying rules previously 
promulgated by the Treasury Department) to ensure that business 
property is treated as ordinary property; (3) clarify rules 
relating to certain disclaimers by donees of gifts or bequests; 
(4) simplify the foreign tax credit limitation for dividends 
from so-called ``10/50 companies''; (5) eliminate the U.S. 
withholding tax on distributions from U.S. mutual funds that 
hold substantially all of their assets in cash or U.S. debt 
securities (or foreign debt securities that are not subject to 
withholding tax under foreign law); (6) expand the declaratory 
judgment relief available under current-law to charities to all 
organizations seeking tax-exempt status under section 501(c); 
and (6) simplify the active trade or business requirement for 
tax-free corporate spin-offs. The Administration hopes to work 
with the Congress to develop and enact additional, appropriate 
simplification measures.

                      9. MISCELLANEOUS PROVISIONS

    Other targeted tax incentives included in the President's 
plan include a proposed extension and modification of the 
current-law Puerto Rico economic-activity credit, to provide a 
more efficient and effective tax incentive for the economic 
development of Puerto Rico.
    In addition, to reduce the burdens faced by displaced 
workers, the President's plan would exclude up to $2,000 of 
certain severance payments from the income of the recipient. 
This exclusion would apply to payments received by an 
individual who was separated from service in connection with a 
reduction in the employer's work force, but only if the 
individual does not attain employment within six months of the 
separation from service at a compensation level that is at 
least 95 percent of the compensation the individual received 
before the separation from service and only if total severance 
payments received by the individual do not exceed $75,000.
    To address the financial troubles of the steel industry, 
the President's plan would extend to 5 years the carryback 
period for the net operating loss (NOL) of a steel company. An 
eligible taxpayer could elect to forgo the 5-year carryback and 
apply the current-law carryback rules. The benefit proposed 
would feed directly into a financially troubled steel company's 
cash flow, providing immediate needed relief.

                     10. ELECTRICITY RESTRUCTURING

    Restructuring the electric industry to encourage retail 
competition promises significant economic benefits to both 
business and household consumers of electricity. In order to 
reap the benefits of restructuring, steps must be taken to 
provide a level playing field for investor-owned and publicly-
owned electric systems as well as to provide relief from the 
rules governing private use of tax-exempt bond-financed 
electric facilities in appropriate circumstances. The 
President's plan provides that no new facilities for electric 
generation or transmission may be financed with tax-exempt 
bonds. Distribution facilities may continue to be financed with 
tax-exempt bonds subject to existing private use rules. 
Distribution facilities are facilities operating at 69 
kilovolts or less (including functionally related and 
subordinate property). In order to develop efficient 
nondiscriminatory transmission services, publicly-owned 
electric utility companies may be required to turn the 
operation of their transmission facilities over to independent 
systems operators or use those facilities in a manner that may 
violate the private use rules. In addition, as traditional 
service areas of both investor-owned and publicly-owned systems 
are opened to retail competition, the latter may find it 
necessary to enter into contracts with private users of 
electricity in order to prevent their generation facilities 
from becoming stranded costs. Without relief from the private 
use rules, publicly-owned electric systems may not choose to 
open their service areas to competition or to allow their 
transmission facilities to be operated by a private party.
    In response, the President's plan provides that bonds 
issued to finance transmission facilities prior to the 
enactment of legislation to implement restructuring would 
continue their tax-exempt status if private use results from 
action pursuant to a Federal order requiring non-discriminatory 
open access to those facilities. In addition, bonds issued to 
finance generation or distribution facilities issued prior to 
enactment of such legislation would continue their tax-exempt 
status if private use results from retail competition, or if 
private use results from the issuer entering into a contract 
for the sale of electricity or use of its distribution property 
that will become effective after implementation of retail 
competition. Sale of facilities financed with tax-exempt bonds 
to private entities would continue to constitute a change in 
use. Bonds issued to refund, but not advance refund, bonds 
issued before enactment of legislation implementing 
restructuring would be permitted.
    Finally, the President's plan would amend the rules 
applicable to nuclear decommissioning funds in order to address 
issues raised by the restructuring of the electric industry.

Revenue offsets

    Our revenue offsets would curtail corporate tax shelters, 
and close loopholes in the tax law in the areas of financial 
products, corporate taxes, pass-through entities, tax 
accounting, cost recovery, insurance, exempt organizations, 
estate and gift taxation, taxation of international 
transactions, pensions, compliance, and others. These offsets 
generally would be effective with respect to a future date 
(e.g., date of first committee action, or date of enactment). 
We look forward to working with the committee to develop 
grandfather rules where appropriate.

                         Corporate Tax Shelters

    The Administration believes there has been an increase in 
the use of corporate tax shelters and is concerned about this 
proliferation for several reasons. First, corporate tax 
shelters reduce the corporate tax base. Congress intended 
corporations to be a source of Federal revenue in enacting the 
various provisions of the corporate income tax. Questionable 
transactions that reduce corporate tax liability frustrate this 
intent. Moreover, corporate tax shelters erode the integrity of 
the tax system as a whole. A view that well-advised 
corporations can and do avoid their legal tax liabilities by 
engaging in transactions unavailable to most other taxpayers 
may lead to a perception of unfairness and, if unabated, may 
lead to a decrease in voluntary compliance. Finally, the 
significant resources used to create, implement and defend 
complex sheltering transactions are better used in productive 
activities. Similarly, the IRS must expend significant 
resources to combat such transactions.
    To date, most attacks on corporate tax shelters have been 
targeted at specific transactions and have occurred on an ad-
hoc, after-the-fact basis--through legislative proposals, 
administrative guidance, and litigation. At the Treasury 
Department, a number of actions have been taken to address 
corporate tax shelters. For example, we've made legislative 
proposals aimed at section 357(c) basis creation abuses, which 
has advanced in both chambers, and liquidating REITs, which was 
enacted last year. On the regulatory front, we have issued 
guidance, such as the notice on stepped-down preferred, fast-
pay, slow-pay transactions, and in litigation, we've won two 
important cases--ACM and ASA. But we often hear that we are 
only hitting the tip of the iceberg.
    Addressing corporate tax shelters on a transaction-by-
transaction, ad hoc basis, however, raises certain concerns. 
First, it is not possible to identify and address all current 
and future sheltering transactions. Taxpayers with an appetite 
for corporate tax shelters will simply move from those 
transactions that are specifically prohibited by the new 
legislation to other transactions the treatment of which is 
less clear. Second, legislating on a piecemeal basis further 
complicates the Code and seemingly calls into question the 
viability of common law tax doctrines such as sham transaction, 
business purpose, economic substance and substance over form. 
Finally, using a transactional legislation approach to 
corporate tax shelters may embolden some promoters and 
participants to rush shelter products to market on the belief 
that any retroactive legislation would be applied only on a 
prospective basis.
    The primary goal of any corporate tax shelter is to 
eliminate, reduce, or defer corporate income tax. To achieve 
this goal, corporate tax shelters are designed to manufacture 
tax benefits that can be used to offset unrelated income of the 
taxpayer or to create tax-favored or tax-exempt economic 
income. Most corporate tax shelters rely on one or more 
discontinuities in the tax law, or exploit a provision in the 
Code or Treasury regulations in a manner not intended by 
Congress or the Treasury Department.
    Corporate tax shelters may take several forms. For this 
reason, they are hard to define. However, corporate tax 
shelters often share certain common characteristics. For 
example, through hedges, circular cash flows, defeasements, or 
other devices, corporate participants in a shelter often are 
insulated from any risk of economic loss or opportunity for 
economic gain with respect to the sheltering transaction. Thus, 
corporate tax shelters are transactions without significant 
economic substance, entered into principally to achieve a 
desired tax result. Similarly, the financial accounting 
treatment of a shelter generally is significantly more 
favorable than the corresponding tax treatment; that is, the 
shelter produces a tax ``loss'' that is not reflected as a book 
loss. However, the corporate tax shelter may produce a book 
earnings benefit by reducing the corporation's effective tax 
rate.
    Corporate tax shelter schemes often are marketed by their 
designers or promoters to multiple corporate taxpayers and 
often involve property or transactions unrelated to the 
corporate participant's core business. These two features may 
distinguish corporate tax shelters from traditional tax 
planning.
    Many corporate tax shelters involve arrangements between 
corporate taxpayers and persons not subject to U.S. tax such 
that these tax indifferent parties absorb the taxable income 
from the transaction, leaving tax losses to be allocated to the 
corporation. The tax indifferent parties in effect ``rent'' 
their tax exempt status in return for a accomodation fee or an 
above-market return on investment. Tax indifferent parties 
include foreign persons, tax-exempt organizations, Native 
American tribal organizations, and taxpayers with loss or 
credit carryforwards.
    Taxpayers entering into corporate tax shelter transactions 
often view such transactions as risky because the expected tax 
benefits may be successfully challenged. To protect against 
such risk, purchasers of corporate tax shelters often require 
the seller or a counterparty to enter into a tax benefit 
protection arrangement. Thus, corporate tax shelters are often 
associated with high transactions costs, contingent or 
refundable fees, unwind clauses, or insured results.
    These themes run through our budget proposals and, we hope, 
help us to focus on finding broader, ex ante solutions to the 
corporate tax shelter problem.
    The Administration therefore proposes several remedies to 
curb the growth of corporate tax shelters. We propose more 
general remedies to deter corporations from entering into any 
sheltering transactions. These proposals would disallow any tax 
benefit created in a corporate tax shelter, as so defined, and 
would address common characteristics found in corporate tax 
shelters as described above. Also, all the parties to a 
structured transaction would have an incentive, under our 
proposals, to assure that the transaction comports with 
established principles.
    The Treasury Department recognizes that this more general 
approach to corporate tax shelters raises certain concerns. 
Applying various substantive and procedural rules to a 
``corporate tax shelter'' or a ``tax avoidance transaction'' 
requires definitions of such terms. As described in greater 
detail below, the Administration's proposals define these 
terms. Critics of the proposals have suggested that these 
definitions are too broad or may create too much uncertainty 
and thus may inhibit otherwise legitimate transactions. The 
Treasury Department does not intend to affect legitimate 
business transactions and looks forward to working with the 
tax-writing committees in refining the corporate tax shelter 
proposals. However, some level of uncertainty is unavoidable 
with respect to complex transactions. In addition, the 
definition of corporate tax shelter as used in our proposals is 
narrower and therefore less uncertain than other definitions 
and formulations used in the Code. Moreover, the definition we 
have proposed is similar to existing articulations of various 
judicial doctrines and may be viewed as largely enforcing the 
judicially-created concept of economic substance of current 
law. Finally, some amount of uncertainty may be useful in 
discouraging taxpayers from venturing to the edge, thereby 
risking going over the edge, of established principles.
    The Administration's proposals that generally would apply 
to corporate tax shelters are:
    Deny certain tax benefits in tax avoidance transactions.--
Under current law, if a person acquires control of a 
corporation or a corporation acquires carryover basis property 
of a corporation not controlled by the acquiring corporation or 
its shareholders, and the principal purpose for such 
acquisition is evasion or avoidance of Federal income tax by 
securing certain tax benefits, the Secretary may disallow such 
benefits to the extent necessary to eliminate such evasion or 
avoidance of tax. However, this current rule has been 
interpreted narrowly. The Administration proposes to expand the 
current rules to authorize the Secretary to disallow a 
deduction, credit, exclusion, or other allowance obtained by a 
corporation in a tax avoidance transaction.
    For this purpose, a tax avoidance transaction would be 
defined as any transaction in which the reasonably expected 
pre-tax profit (determined on a present value basis, after 
taking into account foreign taxes as expenses and transaction 
costs) of the transaction is insignificant relative to the 
reasonably expected tax benefits (i.e., tax benefits in excess 
of the tax liability arising from the transaction, determined 
on a present value basis) of such transaction. In addition, a 
tax avoidance transaction would be defined to cover 
transactions involving the improper elimination or significant 
reduction of tax on economic income. The proposal would not 
apply to tax benefits clearly contemplated by the applicable 
current-law provision (e.g., the low-income housing tax 
credit).
    Modify substantial understatement penalty for corporate tax 
shelters.--The current 20-percent substantial understatement 
penalty imposed on corporate tax shelter items can be avoided 
if the corporate taxpayer had reasonable cause for the tax 
treatment of the item and good faith. The Administration 
proposes to increase the substantial understatement penalty on 
corporate tax shelter items to 40 percent. The penalty will be 
reduced to 20 percent if the corporate taxpayer discloses to 
the National Office of the Internal Revenue Service within 30 
days of the closing of the transaction appropriate documents 
describing the corporate tax shelter and files a statement 
with, and provides adequate disclosure on, its tax return. The 
penalty could not be avoided by a showing of reasonable cause 
and good faith. For this purpose, a corporate tax shelter would 
be defined as any entity, plan, or arrangement (to be 
determined based on all the facts and circumstances) in which a 
direct or indirect corporate participant attempts to obtain a 
tax benefit in a tax avoidance transaction.
    Deny deductions for certain tax advice and impose an excise 
tax on certain fees received.--The proposal would deny a 
deduction for fees paid or accrued in connection with the 
promotion of corporate tax shelters and the rendering of 
certain tax advice related to corporate tax shelters. The 
proposal would also impose a 25-percent excise tax on fees 
received in connection with the promotion of corporate tax 
shelters and the rendering of certain tax advice related to 
corporate tax shelters.
    Impose excise tax on certain rescission provisions and 
provisions guaranteeing tax benefits.--The Administration 
proposes to impose on the purchaser of a corporate tax shelter 
an excise tax of 25 percent on the maximum payment to be made 
under the arrangement. For this purpose, a tax benefit 
protection arrangement would include certain rescission 
clauses, guarantee of tax benefits arrangement or any other 
arrangement that has the same economic effect (e.g., insurance 
purchased with respect to the transaction).
    Preclude taxpayers from taking tax positions inconsistent 
with the form of their transactions.--Under current law, if a 
taxpayer enters into a transaction in which the economic 
substance and the legal form are different, the taxpayer may 
take the position that, notwithstanding the form of the 
transaction, the substance is controlling for Federal income 
tax purposes. Many taxpayers enter into such transactions in 
order to arbitrage tax and regulatory laws. Under the proposal, 
except to the extent the taxpayer discloses the inconsistent 
position on its tax return, a corporate taxpayer, but not the 
Internal Revenue Service, would be precluded from taking any 
position (on a tax return or otherwise) that the Federal income 
tax treatment of a transaction is different from that dictated 
by its form, if a tax indifferent person has a direct or 
indirect interest in such transaction.
    Tax income from corporate tax shelters involving tax-
indifferent parties.--The proposal would provide that any 
income received by a tax-indifferent person with respect to a 
corporate tax shelter would be taxable, either to the tax-
indifferent party or to the corporate participant.
    The Administration also proposes to amend the substantive 
law related to specific transactions that the Treasury 
Department has identified as giving rise to corporate tax 
shelters. No inference is intended as to the treatment of any 
of these transactions under current law.
    Require accrual of income on forward sale of corporate 
stock.--There is little substantive difference between a 
corporate issuer's current sale of its stock for a deferred 
payment and an issuer's forward sale of the same stock. In both 
cases, a portion of the deferred payment compensates the issuer 
for the time-value of money during the term of the contract. 
Under current law, the issuer must recognize the time-value 
element of the deferred payment as interest if the transaction 
is a current sale for deferred payment but not if the 
transaction is a forward contract. Under the proposal, the 
issuer would be required to recognize the time-value element of 
the forward contract as well.
    Modify treatment of built-in losses and other attribute 
trafficking.--Under current law, a taxpayer that becomes 
subject to U.S. taxation may take the position that it 
determines its beginning bases in its assets under U.S. tax 
principles as if the taxpayer had historically been subject to 
U.S. tax. Other tax attributes are computed similarly. A 
taxpayer may thus ``import''' built-in losses or other 
favorable tax attributes incurred outside U.S. taxing 
jurisdiction (e.g., from foreign or tax-exempt parties) to 
offset income or gain that would otherwise be subject to U.S. 
tax. The proposal would prevent the importation of attributes 
by eliminating tax attributes (including built-in items) and 
marking to market bases when an entity or an asset becomes 
relevant for U.S. tax purposes. This proposal would be 
effective for transactions in which assets or entities become 
relevant for U.S. tax purposes on or after the date of 
enactment.
    Modify treatment of ESOP as S corporation shareholder.--
Pursuant to provisions enacted in 1996 and 1997, an employee 
stock ownership plan (ESOP) may be a shareholder of an S 
corporation and the ESOP's share of the income of the S 
corporation is not subject to tax until distributed to the plan 
beneficiaries. The Administration proposes to require an ESOP 
to pay tax on S corporation income (including capital gains on 
the sale of stock) as the income is earned and to allow the 
ESOP a deduction for distributions of such income to plan 
beneficiaries.
    Prevent serial liquidation of U.S. subsidiaries of foreign 
corporations.--Dividends from a U.S. subsidiary to its foreign 
parent corporation are subject to U.S. withholding tax. In 
contrast, if a domestic corporation distributes earnings in a 
tax-free liquidation, the foreign shareholder generally is not 
subject to any withholding tax. Some foreign corporations 
attempt to avoid dividend withholding by serially forming and 
liquidating holding companies for their U.S. subsidiaries. The 
proposal would impose withholding tax on any distribution made 
to a foreign corporation in complete liquidation of a U.S. 
holding company if the holding company was in existence for 
less than five years. The proposal would also achieve a similar 
result with respect to serial terminations of U.S. branches.
    Prevent capital gains avoidance through basis shift 
transactions involving foreign shareholders.--To prevent 
taxpayers from attempting to offset capital gains by generating 
artificial capital losses through basis shift transactions 
involving foreign shareholders, the Administration proposes to 
treat the portion of a dividend that is not subject to current 
U.S. tax as a nontaxed portion and thus subject to the basis 
reduction rules applicable to extraordinary dividends. Similar 
rules would apply in the event that the foreign shareholder is 
not a corporation.
    Limit inappropriate tax benefits for lessors of tax-exempt 
use property.--The Administration is concerned that certain 
structures involving tax-exempt use property are being used to 
generate inappropriate tax benefits for lessors. The proposal 
would deny a lessor the ability to recognize a net loss from a 
leasing transaction involving tax-exempt use property during 
the lease term. A lessor would be able to carry forward a net 
loss from a leasing transaction and use it to offset net gains 
from the transaction in subsequent years. This proposal would 
be effective for leasing transactions entered into on or after 
the date of enactment.
    Prevent mismatching of deductions and income inclusions in 
transactions with related foreign persons.--The Treasury 
Department has learned of certain structured transactions 
designed to allow taxpayers inappropriately to take advantage 
of the certain current-law rules by accruing deductions to 
related foreign personal holding company (FPHC), controlled 
foreign corporation (CFC) or passive foreign investment company 
(PFIC) without the U.S. owners of such related entities taking 
into account for U.S. tax purposes an amount of income 
appropriate to the accrual. This results in an improper 
mismatch of deductions and income. The proposal would provide 
that deductions for amounts accrued but unpaid to related 
foreign CFCs, PFICs or FPHCs would be allowable only to the 
extent the amounts accrued by the payor are, for U.S. tax 
purposes, reflected in the income of the direct or indirect 
U.S. owners of the related foreign person. The proposal would 
contain an exception for certain short term transactions 
entered into in the ordinary course of business.
    Restrict basis creation through section 357(c).--A 
transferor generally is required to recognize gain on a 
transfer of property in certain tax-free exchanges to the 
extent that the sum of the liabilities assumed, plus those to 
which the transferred property is subject, exceeds the basis in 
the property. This gain recognition to the transferor generally 
increases the basis of the transferred property in the hands of 
the transferee. If a recourse liability is secured by multiple 
assets, it is unclear under current law whether a transfer of 
one asset where the transferor remains liable is a transfer of 
property ``subject to the liability.'' Similar issues exist 
with respect to nonrecourse liabilities. Under the 
Administration's proposal, the distinction between the 
assumption of a liability and the acquisition of an asset 
subject to a liability generally would be eliminated. The 
transferor's recognition of gain as a result of assumption of 
liability would not increase the transferee's basis in the 
transferred asset to an amount in excess of its fair market 
value. Moreover, if no person is subject to U.S. tax on gain 
recognized as the result of the assumption of a nonrecourse 
liability, then the transferee's basis in the transferred 
assets would be increased only to the extent such basis would 
be increased if the transferee had assumed only a ratable 
portion of the liability, based on the relative fair market 
values of all assets subject to such nonrecourse liability.
    Modify anti-abuse rule related to assumption of 
liabilities.--The assumption of a liability in an otherwise 
tax-free transaction is treated as boot to the transferor if 
the principal purpose of having the transferee assume the 
liability was the avoidance of tax on the exchange. The current 
language is inadequate to address the avoidance concerns that 
underlie the provision. The Administration proposes to modify 
the anti-abuse rule by deleting the limitation that it only 
applies to tax avoidance on the exchange itself, and changing 
``the principal purpose'' standard to ``a principal purpose.''
    Modify corporate-owned life insurance (COLI) rules.--In 
general, interest on policy loans or other indebtedness with 
respect to life insurance, endowment or annuity contracts is 
not deductible unless the insurance contract insures the life 
of a ``key person'' of a business. In addition, the interest 
deductions of a business generally are reduced under a 
proration rule if the business owns or is a direct or indirect 
beneficiary with respect to certain insurance contracts. The 
COLI proration rules generally do not apply if the contract 
covers an individual who is a 20-percent owner of the business 
or is an officer, director, or employee of such business. These 
exceptions under current law still permit leveraged businesses 
to fund significant amounts of deductible interest and other 
expenses with tax-exempt or tax-deferred inside buildup on 
contracts insuring certain classes of individuals. The 
Administration proposes to repeal the exception under the COLI 
proration rules for contracts insuring employees, officers or 
directors (other than 20-percent owners) of the business. The 
proposal also would conform the key person exception for 
disallowed interest deductions attributable to policy loans and 
other indebtedness with respect to life insurance contracts to 
the 20-percent owner exception in the COLI proration rules.

                        Other Revenue Provisions

    In addition to the general and specific corporate tax 
shelter proposals, the Administration's budget contains other 
revenue raising proposals that are designed to remove 
unwarranted tax benefits, ameliorate discontinuities of current 
law, provide simplification and improve compliance. Some of 
these proposals are described below.

                Proposals Relating to Financial Products

    The proposals relating to financial products narrowly 
target certain transactions and business practices that 
inappropriately exploit existing tax rules. Three of the 
proposals address the timing of income from debt instruments. 
Other proposals address specific financial products 
transactions that are designed to achieve tax results that are 
significantly better than the results that would be obtained by 
entering into economically equivalent transactions. At the same 
time, a number of these proposals contain provisions that are 
designed to simplify existing law and provide relief for 
taxpayers in cases where the literal application of the 
existing rules can produce an uneconomic result.
    Mismeasurement of economic income.--The tax rules that 
apply to debt instruments generally require both the issuer and 
the holder of a debt instrument to recognize interest income 
and expense over the term of the instrument regardless of when 
the interest is paid. If the debt instrument is issued at a 
discount (that is, it is issued for an amount that is less than 
the amount that must be repaid), the discount functions as 
interest--as compensation for the use of money. Recognizing 
this fact, the existing tax rules require both parties to 
account for this discount as interest over the life of the debt 
instrument.
    The Administration's budget contains three proposals that 
are designed to reduce the mismeasurement of economic income on 
debt instruments: (1) a rule that requires cash-method banks to 
accrue interest income on short-term obligations, (2) rules 
that require accrual method taxpayers to accrue market 
discount, and (3) a rule that requires the issuer in a debt-
for-debt exchange to spread the interest expense incurred in 
the exchange over the term of the newly-issued debt instrument.
    Specific transactions designed to exploit current rules.--
There are a number of strategies involving financial products 
that are designed to give a taxpayer the ``economics'' of a 
particular transaction without the tax consequences of the 
transaction itself. For example, so-called ``hedge fund swaps'' 
are designed to give an investor the ``economics'' of owning a 
partnership interest in a hedge fund without the tax 
consequences of being a partner. These swaps purportedly allow 
investors to defer the recognition of income until the end of 
the swap term and to convert ordinary income into long-term 
capital gain.
    Another strategy involves the used of structured financial 
products that allow investors to monetize appreciated financial 
positions without recognizing gain. If a taxpayer holds an 
appreciated financial position in personal property and enters 
into a structured financial product that substantially reduces 
the taxpayer's risk of loss in the appreciated position, the 
taxpayer may be able to borrow against the combined position 
without recognizing gain. Under current law, unless the 
borrowing is ``incurred to purchase or carry'' the structured 
financial product, the taxpayer may deduct its interest expense 
on the borrowing even though the taxpayer has not included the 
gain from the appreciated position.
    The Administration's budget contains proposals that are 
designed to eliminate the inappropriate tax benefit these 
transactions create. The ``constructive ownership'' proposal 
would limit the amount of long-term capital gain a taxpayer 
could recognize from a hedge fund swap to the amount of long-
term capital gain that would have been recognized if the 
investor had invested in the hedge fund directly. Another 
proposal would clarify that a taxpayer cannot currently deduct 
expenses (included interest expenses) from a transaction that 
monetizes an appreciated financial position without triggering 
current gain recognition.

              Proposals Relating to Pass-through Entities

    There are five coordinated proposals relating to basis 
adjustments and gain recognition in the partnership area. The 
proposals have three purposes: simplification, rationalization, 
and prevention of tax avoidance. The proposals accomplish these 
goals through a variety of means. In one proposal, the ability 
of taxpayers to elect whether or not to adjust the basis of 
partnership assets is eliminated in a situation where the 
election is leading to tax abuses. In another proposal, we 
would limit basis adjustments with respect to particular types 
of property, which enables us, in a different proposal, to 
repeal a provision that has been widely criticized as overly 
complex and irrational.
    In addition to the partnership proposals, two REIT 
proposals are included in the budget. One proposal allows REITs 
to conduct expanded business activities in situations where a 
corporate level tax will be collected with respect to such 
activities. The other REIT proposal limits closely held REITs, 
which have been the primary vehicle for carrying out such 
corporate tax shelters as step-down preferred stock and the 
liquidating REIT transactions.
    A final proposal in the pass-through area would impose a 
tax on gain when a large C corporation converts to an S 
corporation.

               Proposals Relating to Corporate Provisions

    The corporate proposals focus on a developing trend in 
structuring dispositions of assets or stock that technically 
qualify as tax-free transactions, but circumvent the repeal of 
General Utilities by allowing corporations to ``sell'' 
appreciated property without recognizing any gain. There has 
been a proliferation of highly publicized transactions in which 
corporations exploit the purposes of the tax-free 
reorganization provisions, (i.e., to allow a corporation to 
change its form when the taxpayer's investment remains in 
corporate solution), to maximize their ability to cash out of 
their investments and minimize the amount of tax paid. In 
addition, the corporate proposals attempt to simplify the law 
and prevent whipsaw of the government in certain tax-free 
transactions.
    Modify tax-free treatment for mere adjustments in form.--In 
order for an acquisition or distribution of appreciated assets 
to qualify as wholly or partly tax-free, the transaction must 
satisfy a series of relatively stringent requirements. If the 
transaction fails to satisfy the requirements, it will be taxed 
in accordance with the general recognition principles of the 
Code. After the repeal of General Utilities, there are few 
opportunities to dispose of appreciated assets without a tax 
liability, and our proposals would help to ensure that those 
remaining exceptions to the repeal of General Utilities are not 
circumvented. The provisions of the Code that allow for tax-
free treatment date back to the early years of the tax system 
and did not contemplate the creative tax planning that has 
taken place in the last several years. As a result, many of the 
corporate tax provisions have been manipulated, resulting in 
avoidance of tax.
    The Administration's budget contains several proposals that 
are designed to eliminate opportunities under current law for 
corporations to achieve tax-free treatment for transactions 
that should be taxable. The proposals include (1) modifying the 
``control'' test for purposes of tax-free incorporations, 
distributions and reorganizations to include a value component 
so that corporations may not ``sell'' a significant amount of 
the value of the corporation while continuing to satisfy the 
current law control test that focuses solely on voting power, 
(2) requiring gain recognition upon the issuance of ``tracking 
stock'' or a recapitalization of stock or securities into 
tracking stock, and (3) requiring gain recognition in 
downstream transactions in which a corporation that holds stock 
in another corporation transfers its assets to that corporation 
in exchange for stock.
    Preventing taxpayers from taking inconsistent positions in 
certain nonrecognition transactions.--No gain or loss is 
recognized upon the transfer of property to a controlled 
corporation in exchange for stock. There is an inconsistency in 
the treatment by the Internal Revenue Service and the Claims 
Court as to the treatment of a transfer of less than all 
substantial rights to use intangible property. Accordingly, 
transferor and transferee corporations have taken the position 
that best achieves their tax goals. The proposal would 
eliminate this whipsaw potential by treating any transfer of an 
interest in intangible property as a tax-free transfer and 
requiring allocation of basis between the retained rights and 
the transferred rights based upon respective fair market 
values.

         Proposals Relating to Tax Accounting and Cost Recovery

    The Administration's budget contains measures that are 
principally designed to improve measurement of income by 
eliminating methods of accounting that result in a 
mismeasurement of economic income or provide disparate 
treatment among similarly situated taxpayers.
    Repeal installment method for accrual basis taxpayers.--The 
proposal would repeal the installment method of accounting for 
accrual method taxpayers (other that those taxpayers that 
benefit from dealer disposition exceptions under current law) 
and eliminate inadequacies in the installment method pledging 
rules in order to better reflect the economic results of a 
taxpayer's business during the taxable year.
    Apply uniform capitalization rules to tollers.--To 
eliminate the disparate treatment between manufacturers and 
tollers and better reflect the income of tollers, the proposal 
would require tollers (other than small businesses) to 
capitalize their direct costs and an allocable portion of their 
indirect costs to property tolled.
    Provide consistent amortization periods for intangibles.--
To encourage the formation of new businesses, the proposal 
would allow a taxpayer to elect to deduct up to $5,000 each of 
start-up and organizational expenditures. Start-up and 
organizational expenditures not currently deductible would be 
amortized over a 15-year period consistent with the 
amortization period for acquired intangibles.
    Clarify recovery period of utility grading costs.--The 
proposal would clarify and rationalize current law by assigning 
electric and gas utility clearing and grading costs incurred to 
locate transmission and distribution lines and pipelines to the 
class life assigned to the benefitted assets, giving these 
costs a recovery period of 20 years and 15 years, respectively. 
The class life assigned to the benefitted assets is a more 
appropriate estimate of the useful life of these costs, and 
thus will improve measurement of the utility's income.
    Deny change in method treatment to tax-free formations.--
The proposal would eliminate abuses with respect to changes in 
accounting methods by expanding the transactions to which the 
carryover of method of accounting rules apply to include tax-
free contributions to corporations and partnerships.
    Deny deduction for punitive damages.--The deductibility of 
punitive damage payments under current law undermines the role 
of such damages in discouraging and penalizing certain 
undesirable actions or activities. The proposal would disallow 
any deduction for punitive damages to conform the tax treatment 
to that of other payments, such as penalties and fines, that 
are also intended to discourage violations of public policy.
    Disallow interest on debt allocable to tax-exempt 
obligations.--Under current law, security dealers and financial 
intermediaries other than banks are able to reduce their tax 
liabilities inappropriately through double Federal tax benefits 
of interest expense deductions and tax-exempt interest income, 
notwithstanding that they operate similarly to banks. The 
proposal would eliminate the disparate treatment between banks 
and financial intermediaries, such as security dealers and 
other financial intermediaries, by providing that a financial 
intermediary investing in tax-exempt obligations would be 
disallowed deductions for a portion of its interest expense 
equal to the portion of its total assets that is comprised of 
tax-exempt investments.
    Eliminate the income recognition exception for accrual 
method service providers.--Under current law, accrual method 
service providers are provided a special exception to the 
general accrual rules that permit them, in effect, to reduce 
current taxable income by an estimate of future bad debt 
losses. This method of estimation results in a mismeasurement 
of a taxpayer's economic income and, because this tax benefit 
only applies to amounts to be received for the performance of 
services, discriminates in favor of service providers. The 
proposal would repeal the special exception for accrual method 
service providers.
    Repeal lower-of-cost-or-market inventory accounting 
method.--The allowance of write-downs under the lower-of-cost 
or market (LCM) method or subnormal goods method is an 
inappropriate exception from the realization principle and is 
essentially a one-way mark-to-market method that understates 
taxable income. The proposal would repeal the LCM and subnormal 
goods methods.

                    Proposals Relating to Insurance

    The Administration's budget contains proposals to more 
accurately measure the economic income of insurance companies 
by updating and modernizing certain provisions of current law. 
The proposals would (1) require recapture of policyholder 
surplus accounts, (2) modify rules for capitalizing policy 
acquisition costs of life insurance companies, and (3) increase 
the proration percentage for property casualty (P&C) insurance 
companies.
    Between 1959 and 1984, stock life insurance companies 
deferred tax on a portion of their profits. These untaxed 
profits were added to a policyholders surplus account (PSA). In 
1984, Congress precluded life insurance companies from 
continuing to defer tax on future profits through PSAs. 
However, companies were permitted to continue to defer tax on 
their existing PSAs. Most pre-1984 policies have terminated so 
there is no remaining justification for allowing these 
companies to continue to defer tax on profits they earned 
between 1959 and 1984.
    Under current law, pursuant to a provision enacted in 1990, 
insurance companies capitalize varying percentages of their net 
premiums for certain types of insurance contracts, and 
generally amortize these amounts over 10 years (five years for 
small companies). These capitalized amounts are intended to 
serve as proxies for each company's actual commissions and 
other policy acquisition expenses. However, data reported by 
insurance companies to State insurance regulators each year 
indicates that the insurance industry is capitalizing less than 
half of its policy acquisition costs, which results in a 
mismatch of income and deductions. The Administration proposes 
that insurance companies be required to capitalize modified 
percentages of their net premiums for certain lines of 
business.
    In computing their underwriting income, P&C insurance 
companies deduct reserves for losses and loss expenses 
incurred. These loss reserves are funded in part with the 
company's investment income. In 1986, Congress reduced the 
reserve deductions of P&C insurance companies by 15 percent of 
the tax-exempt interest or the deductible portion of certain 
dividends received. In 1997, Congress expanded the 15-percent 
proration rule to apply to the inside buildup on certain 
insurance contracts. The existing 15-percent proration rule 
still enables P&C insurance companies to fund a substantial 
portion of their deductible reserves with tax-exempt or tax-
deferred income. Other financial intermediaries, such as life 
insurance companies, banks and brokerage firms, are subject to 
more stringent proration rules that substantially reduce or 
eliminate their ability to use tax-exempt or tax-deferred 
investments to fund currently deductible reserves or deductible 
interest expense.

             Proposals Relating to International Provisions

    The Administration's budget contains proposals designed to 
ensure that economically similar international transactions are 
taxed in a similar manner, prevent manipulation and 
inappropriate use of exemptions from U.S. tax, allocate income 
between U.S. and foreign sources in a more appropriate manner, 
and determine the foreign tax credit in a more accurate manner. 
Specific proposals include:
    Expand section 864(c)(4)(B) to interest and dividend 
equivalents.--Under U.S. domestic law, a foreign person is 
subject to taxation in the United States on a net income basis 
with respect to income that is effectively connected with a 
U.S. trade or business (ECI). The test for determining whether 
income is effectively connected to a U.S. trade or business 
differs depending on whether the income at issue is U.S. source 
or foreign source. Only enumerated types of foreign source 
income--rents, royalties, dividends, interest, gains from the 
sale of inventory property, and insurance income--constitute 
ECI, and only in certain circumstances. The proposal would 
expand the categories of foreign-source income that could 
constitute ECI to include interest equivalents (including 
letter of credit fees) and dividend equivalents in order to 
eliminate arbitrary distinctions between economically 
equivalent transactions.
    Recapture overall foreign losses upon disposition of CFC 
stock.--If deductions against foreign income result in (or 
increase) an overall foreign loss which is then set against 
U.S. income, current law has recapture rules that require 
subsequent foreign income or gain to be recharacterized as 
domestic. Recapture can take place when directly-owned foreign 
assets are disposed of. However, there may be no recapture when 
stock in a controlled foreign corporation (CFC) is disposed of. 
The proposal would correct that asymmetry by providing that 
property subject to the recapture rules upon disposition would 
include stock in a CFC.
    Amend 80/20 company rules.--Interest or dividends paid by a 
so-called ``80/20 company'' generally are partially or fully 
exempt from U.S. withholding tax. A U.S. corporation is treated 
as an 80/20 company if at least 80 percent of the gross income 
of the corporation for the three year period preceding the year 
of a dividend is foreign source income attributable to the 
active conduct of a foreign trade or business (or the foreign 
business of a subsidiary). Certain foreign multinationals 
improperly seek to exploit the rules applicable to 80/20 
companies in order to avoid U.S. withholding tax liability on 
earnings of U.S. subsidiaries that are distributed abroad. The 
proposal would prevent taxpayers from avoiding withholding tax 
through manipulations of these rules.
    Modify foreign office material participation exception.--In 
the case of a sale of inventory property that is attributable 
to a nonresident's office or other fixed place of business 
within the United States, the sales income is generally treated 
as U.S. source. The income is treated as foreign source, 
however, if the inventory is sold for use, disposition, or 
consumption outside the United States and the nonresident's 
foreign office or other fixed place of business materially 
participates in the sale. Income that is treated as foreign 
source under this rule is not treated as effectively connected 
with a U.S. trade or business and is not subject to U.S. tax. 
The proposal would provide that the foreign source exception 
shall apply only if an income tax equal to at least 10 percent 
of the income from the sale is actually paid to a foreign 
country with respect to such income.
    Stop abuses of CFC exception under section 833.--A foreign 
corporation is subject to a four-percent tax on its United 
States source gross transportation income. The tax will not 
apply if the corporation is organized in a country (an 
``exemption country'') that grants an equivalent tax exemption 
to U.S. shipping companies or is a controlled foreign 
corporation (the ``CFC exception''). The premise for the CFC 
exception is that the U.S. shareholders of a CFC will be 
subject to current U.S. income taxation on their share of the 
foreign corporation's shipping income and, thus, the four-
percent tax should not apply if the corporation is organized in 
an exemption country. Residents of non-exemption countries, 
however, can achieve CFC status for their shipping companies 
simply by owning the corporations through U.S. partnerships. 
The proposal would stop this abuse by narrowing the CFC 
exception.
    Replace sales-source rules with activity-based rules.--If 
inventory is manufactured in the United States and sold abroad, 
Treasury regulations provide that 50 percent of the income from 
such sales is treated as earned by production activities and 50 
percent by sales activities. The income from the production 
activities is sourced on the basis of the location of assets 
held or used to produce the income. The income from the sales 
activity (the remaining 50 percent) is sourced based on where 
title to the inventory transfers. If inventory is purchased in 
the United States and sold abroad, 100 percent of the sales 
income generally is deemed to be foreign source. These rules 
generally produce more foreign source income for Unites States 
tax purposes than is subject to foreign tax and thereby allow 
U.S. exporters that operate in high-tax foreign countries to 
credit tax in excess of the U.S. rate against their U.S. tax 
liability. The proposal would require that the allocation 
between production activities and sales activities be based on 
actual economic activity.
    Modify rules relating to foreign oil and gas extraction 
income.--To be eligible for the U.S. foreign tax credit, a 
foreign levy must be the substantial equivalent of an income 
tax in the U.S. sense, regardless of the label the foreign 
government attaches to it. Current law recognizes the 
distinction between creditable taxes and non-creditable 
payments for specific economic benefit but fails to achieve the 
appropriate split between the two in a case where a foreign 
country imposes a levy on, for example, oil and gas income 
only, but has no generally imposed income tax. The proposal 
would treat as taxes payments by a dual-capacity taxpayer to a 
foreign country that would otherwise qualify as income taxes or 
``in lieu of'' taxes, only if there is a ``generally applicable 
income tax'' in that country. Where the foreign country does 
generally impose an income tax, as under present law, credits 
would be allowed up to the level of taxation that would be 
imposed under that general tax, so long as the tax satisfies 
the new statutory definition of a ``generally applicable income 
tax.'' The proposal also would create a new foreign tax credit 
basket for foreign oil and gas income.

                    Miscellaneous revenue proposals

    The President's budget also includes miscellaneous revenue 
proposals, many of which were proposed in prior budgets. Some 
of these proposals are: (1) taxing the investment income of 
trade associations, (2) the repeal of the percentage depletion 
for non-fuel minerals mined on Federal lands, (3) the 
reinstatement of the oil spill excise tax, with an increase in 
the full funding limitation from $1 billion to $5 billion, (4) 
a modification of the FUTA deposit requirement, (5) 
simplification of the foster child definition for purposes of 
the earned income tax credit, (6) an excise tax on the purchase 
of structured settlements, (7) several proposals to improve 
compliance, (8) repeal of the de minimis rental income rule, 
and (9) certain pension and compensation-related provisions. 
The budget proposals also include various other provisions that 
affect receipts. These are the reinstatement of the 
environmental tax imposed on corporate taxable income ($2.7 
billion), reinstatement of the Superfund excise taxes ($3.8 
billion), and receipts from tobacco legislation ($34.5 
billion). The budget also converts a portion of the aviation 
excise taxes into cost-based user fees and replaces the Harbor 
Maintenance Tax with a user fee.
    In conclusion, Mr. Chairman and Mr. Rangel, and members of 
this committee, the Administration looks forward to working 
with you as you examine our proposals. We want to thank you for 
your comments about our corporate tax shelter proposals, and 
your willingness to listen.
      

                                

    Chairman Archer. Mr. Lubick, thank you for condensing the 
recommendations for tax changes. Had you gone into detail on 
all of them, you probably would have consumed the better part 
of the day, and maybe not even then have completed all of them.
    I couldn't help but think as I listened to you that you 
have portrayed exactly why I think we have to abolish the 
income tax. We have an endless stream of efforts that come 
forward every year to close quote ``loopholes,'' to find some 
way to make the tax clearer while adding many additional 
complications. It seems like every additional complication that 
we add creates the need for more complications as the private 
sector's brilliant and creative minds go to work on all the 
complexities.
    So I regret that today is not the day that we are going to 
mark up a bill to abolish the income tax.
    Mr. Lubick. Well, I had hoped I would not lead you to that 
conclusion, Mr. Chairman.
    Chairman Archer. Unfortunately, this is not the day. So we 
do have to discuss the complexities of what you have 
recommended, and the areas where we believe you are on the 
right track. There are a few proposals in your budget 
recommendations, and we certainly want to work with you to see 
that the laws are changed.
    You are right, probably, about 5 percent of the time, we 
are glad to work with you within that framework.
    Mr. Lubick. That's one of the best batting averages I have 
had in my experience here. [Laughter.]
    Chairman Archer. I want the Members to have plenty of time 
to inquire, and I'm going to try to keep mine as brief as 
possible. There are a couple of things I did want to ask you.
    Does the administration have a fundamental objection to 
broad-based tax relief?
    Mr. Lubick. No, Mr. Chairman. Actually, we think if the 
relief is framed, first of all, that it be fiscally 
responsible, second that it be fair and equitable, that it be--
that it not complicate the Code--we are certainly responsive to 
that. There are, however, a number of constraints we have. We 
think it is important at the start to deal with the problem of 
putting Social Security on a sound basis. I know you have 
endorsed that concept as well.
    And when that is done, there are other very, very pressing 
needs to be addressed both in terms of retirement, encouraging 
savings for retirement by that part of our population that is 
not adequately able to do it now. So that is why we have 
proposed that when that Social Security problem is solved that 
part of the surplus be used for that.
    And ultimately, there are a host of very crying needs that 
should be addressed. You have enumerated a number of them. From 
time to time, you have talked about the alternative minimum 
tax, but all in all, I think there certainly is room at the 
proper time, if done in the proper way, to have general relief.
    Chairman Archer. Within the constraints, of course, which 
have been stated before this Committee by the representatives 
of the administration as to the overall budget. Presently, you 
have opted for targeted tax cuts rather than any sort of broad-
based tax relief. And so I just wanted to be sure that you 
didn't have some inherent objection to broad-based tax relief.
    Mr. Lubick. Well, certainly not. But at the present time we 
are operating under budget constraints as you are more aware 
than I. If there are particular pressing needs, basically the 
only way that they can be addressed is through the tax system 
today. The question of spending programs to deal with these 
problems is really practically out of the question. And so 
there has been this great pressure over the last decade to use 
the tax system, which, as you have pointed out, has put a 
strain on it.
    At this time, in the areas I have outlined, where we have 
addressed it, we have come to the conclusion that there are 
indeed special exigencies that would require some sort of 
action. And that is why we proposed to enact them on a fully 
funded basis. I think you would doubtless agree that your 
general abhorrence of tax increases does not extend to a 
situation where deficiencies in the Code have to be rectified, 
things that you never intended should be cleaned up, and that, 
of course, will in effect raise revenue from those persons that 
were taking undue advantage of the Code.
    So you are not proposing an enactment of a static 
situation. So we have tried to identify those situations in 
providing the funding for the targeted tax relief that we think 
is appropriate in a way that would not do violence to your 
general predilection, which we share, against tax increases.
    We haven't, for example, proposed general changes, 
increases in rates. We haven't proposed restrictions, or 
cutbacks on longstanding deductions or credits or exclusions. 
You have pointed out that this involves a significant number of 
proposals, each of which is, in terms of the universe of 
taxation, somewhat not cosmic. But I think if we get to a 
situation where we have dealt with the most pressing problems, 
then it is time to consider broader and more expensive changes 
in the tax system as well as the new rules of the game that are 
going to operate both as to spending and taxation when we are 
over those hurdles.
    Chairman Archer. Mr. Lubick, I am trying to keep my time as 
short as possible to permit the other Members to inquire. I 
asked one question and it has taken quite a long time to pursue 
that question.
    Suffice it to say that within the constraints that you 
mention, you opted in your budget for targeted tax relief. This 
means that the administration has decided where resources 
should be put rather than broad-based tax relief, where the 
taxpayers would make the decision as to what they thought the 
priorities were. That is clear in your budget.
    Let me get back to the next issue to which you lead me. 
Your budget does not provide any net tax relief. That is 
apparent on the face of it.
    Mr. Lubick. Although we have a proposal after the----
    Chairman Archer. No. But in your budget there is no net tax 
relief.
    Mr. Lubick. You are correct.
    Chairman Archer. Rather it raises on a net basis $89 
billion in net revenues, irrespective of how you describe them. 
And yet, it is also a fact that in your budget and under 
current law, the Federal Government is taxing a higher 
percentage of GDP than in peacetime history for this country.
    People are paying those taxes. The burden of those taxes 
must be borne by increased prices of goods and services in this 
country. They have to be recovered. And it is built into every 
single product and service that we buy.
    I am concerned about whether you view this high level of 
taxes with any kind of alarm. I am particularly curious as to 
why your budget proposes an $89 billion net increase in tax 
revenues at a time that we are projecting surpluses. Do you 
believe that the level of taxes as a percentage of GDP is too 
low?
    Do you really think that the highest peacetime level of 
taxes in this country's history is too low and therefore you 
need another $89 billion of new revenues?
    Mr. Lubick. Mr. Chairman, I believe it is fair to say that 
the amount of revenues taken, and I deal with the Federal 
Government only, as we have no control over the States or 
localities, but you are correct that as calculated, the 
percentage of revenue over GDP is about 20.6 percent.
    Chairman Archer. Almost 21 percent at the Federal level.
    Mr. Lubick. However, within a couple of years, it slated to 
decline to 20 percent because of provisions that have already 
been enacted. But there are several aspects to this.
    First of all----
    Chairman Archer. OK, but you want to increase that 
percentage before it shows any decline? You don't think that is 
enough? You think that the revenue percentage is too low so you 
want to increase it by $89 billion?
    Mr. Lubick. Well, one of the things, of course, that I 
think if you are talking about our wish list, you do have to 
take into account the reductions that we are proposing 
following the Social Security, which I think would, in great 
measure, if not entirely, offset that. So I don't think there 
is anything inherent in our proposals that calls for putting a 
greater burden of taxation at the Federal level on the American 
people.
    In point of fact, we do not. So that the long-range 
proposal, taking into account everything that we have proposed, 
would be the other way around.
    But I think it should be noted that for most Americans, the 
level of taxation at the present time is the lowest it has been 
in long-term memory. For a median-income family of four, the 
Federal income plus payroll tax burden, that is including both 
the employer and the employee shares of the payroll tax, is 
lower today than at any time in the past 21 years.
    The Federal income tax burden alone for the median-income 
is lower than at any time in the past 30 years.
    Chairman Archer. Yes, I am aware of that claim, and it has 
been presented to us on several occasions by representatives of 
the administration. Yet it does not take into account that the 
Federal tax burden is hidden in the price of all our goods and 
services.
    And the poor pay the most. They just don't know it.
    Sadly, I hear you saying, as a representative of the 
administration, that the highest peacetime tax take in history, 
as a percent of GDP, which must be borne by all Americans is 
still not high enough. Furthermore, you have to increase it on 
a net basis of $89 billion. I just find that difficult to come 
to grips with.
    But I have used up more than my time. So I recognize Mr. 
Crane for inquiry.
    Mr. Crane. Thank you very much, Mr. Chairman. I'm having a 
hearing in April on Customs, including user fees, but I have a 
couple of questions for you today. In the President's budget, 
he has proposed increasing the passenger processing fee paid by 
travelers arriving by commercial aircraft and vessels from $5 
to $6.40 and removing exemptions from the fee.
    According to the administration, this would partially 
offset Customs costs associated with processing air and sea 
passengers, but many people believe that the $5 fee is already 
too high and is more than Customs' actual costs in processing 
arriving travelers. Can you explain the basis for the increased 
fee?
    Mr. Lubick. Well, it is my understanding, Mr. Crane, that 
this is essentially a user fee, which is designed to recover 
the full costs of the services provided by the U.S. Customs 
Service and to recover it on a more uniform basis. It is my 
understanding that the $5 fee currently does not recover the 
full costs. The $6.40 is the amount that would cover all 
services that should be subject to the fee. And even that does 
not cover the administrative cost. This is based on our 
calculation of reimbursement for the costs of direct services 
for a clearly identifiable set of beneficiaries.
    That is the definition of a user fee as opposed to a tax. 
It is designed to impose upon those who clearly, identifiably 
benefiting from the service and who should bear the cost rather 
than the taxpayers as a whole.
    Mr. Crane. So you are saying it is absolutely a user fee 
only and it is because of the cost that you have defined?
    Mr. Lubick. That is my understanding. I am not prepared to 
give you an accountant's eye view of it, but I believe that the 
Customs Service will be able to substantiate that.
    Mr. Crane. Well, may I ask of you then, could you put 
something in writing for me just to verify the position that 
you have taken on that one.
    Second question. The President has proposed charging an 
access fee for the use of Customs' automated systems to offset 
the cost of modernizing Customs automation. The trade industry 
believes that it has been paying for Customs modernization 
automation in other user fees, the merchandise, rather, 
processing fees and believes that the assessment of an access 
fee is excessive and should not be borne by the industry.
    How will the fee be set, and will this be applied to the 
use of Customs automation for merchandise originating from 
NAFTA countries?
    Mr. Lubick. Mr. Crane, again I think, this was designed to 
cover the investment that the Customs Service has to make to 
install its newly automated system. The current system is over 
15 years old, has suffered many brownouts and breakdowns. The 
estimated cost of the investment is about a billion dollars 
over the next 4 years, and the fees will only recover a part of 
these costs, about a $160 million a year, or about $640 million 
over the next 4 years. The remaining costs we hope to recover 
internally through savings. So it is the same basis.
    Mr. Crane. Thank you. I yield back the balance of my time.
    Chairman Archer. Mr. Doggett.
    Mr. Doggett. Thank you, Mr. Chairman. Mr. Secretary, Forbes 
magazine in December, not normally a major critic of the 
corporate community in America, as I'm sure you are aware, ran 
a cover story on tax-shelter hustlers, pointing out that 
respectable accountants are peddling dicey corporate tax 
loopholes.
    I wanted to inquire of you concerning how serious a problem 
this is.
    Mr. Lubick. Well I have stated how serious we think it is--
very serious. Mr. Talisman, who is accompanying today has been 
spending virtually full time in the preparation of an analysis 
of this subject, which we will release in the very near future, 
when it is completed. And perhaps he wants to address his view 
on the seriousness of it because he has been down there in the 
foxholes. I don't know what has been running over his feet.
    Mr. Doggett. That would be fine.
    Mr. Talisman. Mr. Doggett, we believe it is a very serious 
problem for the reasons articulated in Don's oral testimony and 
written testimony. One, it undermines the integrity of the 
system when products are being promoted to large corporations 
merely to avoid tax with no economic substance.
    Second, it will cause other taxpayers to view the system as 
unfair, which obviously may undermine the voluntary compliance 
system. Also, we think that the resource allocation both from 
the outside practitioners and others who are promoting these is 
not a wise use, a productive use of resources.
    Mr. Doggett. By resources, you mean basically that some of 
the brightest minds in the country devote their every waking 
hour to trying to avoid paying the taxes that ordinary 
taxpayers have to pay.
    Mr. Talisman. Correct. And also because we at the Treasury 
and Internal Revenue Service spend a great deal of resources 
tracking down these shelters and then having to shut them down 
on an ex post basis, and litigating cases for many years 
involving tax shelters.
    Mr. Doggett. So the taxpayer who doesn't get to take 
advantage of these high-flying schemes, pays for it twice by 
having to pay taxes that someone else is not paying and then by 
having to pay for the enforcement resources necessary to try to 
ferret out these schemes?
    Mr. Talisman. That is correct.
    Mr. Doggett. Now the Forbes magazine article suggested that 
the size of the dimensions of this problem may exceed $10 
billion in tax a year. Is that a fair estimate?
    Mr. Talisman. Well, the answer to your question is, is that 
it is very difficult to put a firm estimate on the amount of 
revenue that is being lost to the system.
    However, there have been several shelters in recent memory, 
for example, liquidating REITs or the step-down preferred 
transaction, where the size of those transactions over the 
course of a 10-year period were in the multibillions of 
dollars.
    As a result, you know, a $10 billion estimate seems like it 
would be in the ballpark, but again it is very difficult to put 
an exact number on----
    Mr. Lubick. This whole operation, Mr. Doggett, is 
clandestine. They operate under confidentiality arrangements, 
whether explicit or implicit, so it is----
    Mr. Doggett. If my time permits, I want to explore that 
also, but I think the first and most important point is that 
the dimensions of this problem--it is a very sizable number, 
whether it is $10 billion or $9 billion or $20 billion, we are 
talking about billions of dollars in what even Forbes magazine 
described as tax schemes never intended by this Congress.
    Now I gather by some of the comments that have already been 
made in the Committee that there are some who feel that all tax 
cuts are created equal and that all tax increases are created 
equal. But with $10 billion a year, you could a long way to 
meeting the child-care needs through a child-care tax credit to 
a working mom. Couldn't you?
    In terms of the costs of these proposals?
    Mr. Talisman. That is right.
    Mr. Doggett. So that for the working mother or the person 
that needs long-term care or the person who needs educational 
assistance, we would be giving them a tax cut. Some may 
ridicule that and say that we ought to treat everybody the 
same, but with the money that we would be bringing into the 
treasury by addressing these schemes, we would have the 
capability to meet some of the real needs that are out there 
for tax cuts for working moms or those who have long-term care 
needs, or some of the other measures that you have before the 
Committee?
    Mr. Talisman. The package of raisers on corporate tax 
shelters raises, according to our figures, around $7.2 billion. 
So, yes, that would----
    Mr. Doggett. And that would pay for the child-care tax 
credit, would it not?
    Mr. Talisman. That is correct. Yes.
    Mr. Doggett. And, has the use of contingency fees by some 
of these accounting firms become a prevalent practice in these 
tax schemes where they earn more if they avoid taxes?
    Mr. Talisman. There are a number of devices that are used 
to protect the corporate participant, including contingent 
fees, rescission agreements, unwind clauses, and, even now, the 
sale of insurance.
    Mr. Doggett. I look forward to your report on this very 
serious problem. Thank you, Mr. Chairman.
    Chairman Archer. I would simply suggest to the gentleman 
the $7.5 billion has already been consumed by the 
administration for its other tax reductions, and so he will 
have to look elsewhere for the desirable things that he wants 
to do in the Tax Code.
    Ms. Dunn.
    Ms. Dunn. Thank you, Mr. Chairman. Mr. Lubick, one of the 
Treasury Department revenue proposals would change the control 
test that is applicable for tax-free incorporations for 
distributions and also for reorganizations. The effective date 
of the proposal is recommended by the Treasury Department for 
transactions occurring on or after the date of enactment of the 
proposal.
    So, what I would like to ask you, am I correct in assuming 
that you would ensure that companies that have filed ruling 
requests with the IRS before the effective date of enactment 
would be grandfathered from any proposed changes?
    Mr. Lubick. We generally defer to the Committee's wisdom on 
appropriate transition rules to prevent retroactive unfairness. 
And this would be a situation where we would be glad to work 
with you and give you our ideas. But we think we are concerned 
with establishing the principle first and foremost, which we 
think is correct for the future. And to the extent persons 
happen to be caught in the web in a way that they have no 
opportunity to extricate themselves, I think the Committee has 
traditionally given fairness relief, and we certainly concur 
that is your province.
    Ms. Dunn. You would let----
    Mr. Lubick. We concur that it is your appropriate province 
to do that.
    Ms. Dunn. Good. Thank you.
    Chairman Archer. Mr. Coyne.
    Mr. Coyne. Thank you, Mr. Chairman. Mr. Secretary, the 
administration is proposing making the brownfields expensing 
provisions permanent.
    Mr. Lubick. Yes, sir.
    Mr. Coyne. Regarding the legislation we passed in 1997. I 
wonder if you could tell us how the brownfields expensing 
provision is working so far and how it is being used?
    Mr. Lubick. Well, we think it has worked very well. We 
should have some statistics that show a very large impact in 
cleaning up and making more livable communities inhabited by 
low-income and less fortunate persons.
    So far, I know that least 25 sites have been certified and 
there has been significant benefit there. And I'm not quite 
sure how many are in the process of achieving that status, but 
it is--I would judge it as very significant success.
    Mr. Coyne. Have you any idea of who is using the 
provisions?
    Mr. Lubick. Well, the limitation is to census tracts that 
have a poverty rate of 20-percent or more, or other census 
tracts with a small population under 2,000 where 75 percent of 
it is zoned for industrial or commercial use and is contiguous 
to census tracts with a 20 percent poverty rate or more, or the 
areas designated as Federal empowerment zones or enterprise 
zones or there are 76 EPA brownfields pilots that were 
announced prior to 1997. So those areas are eligible as well. 
They are both urban and rural. So is has widespread application 
to those areas where the need for renewal is most important.
    Mr. Coyne. Is the administration making any other 
recommendations besides making it permanent in the Code during 
this budget process? Are there any other recommendations on 
that list?
    Mr. Lubick. With respect to these areas?
    Mr. Coyne. Right.
    Mr. Lubick. Yes, we do. We have, in particular, our new 
markets credit, which is intended to fund community development 
entities that are providing funds for private enterprise to go 
into this sort of area to carry on active businesses. And that 
in itself should improve the business. We have a proposal for 
our Better American Bonds, which is a tax credit modeled on the 
QZAB, the Qualified Zone Academy Bonds, the bonds that were 
previously adopted by this Committee to provide bonds to 
finance environmental improvement, which does not normally 
generate revenue to pay off the bonds. So this tax credit will 
help communities issue those sort of bonds.
    We have some extension of enterprise and empowerment zones. 
So there are a number of other things in the budget that are 
addressing needs in these areas, including the extension of the 
work-opportunity credit and the welfare-to-work credits to help 
residents of those districts.
    Mr. Coyne. OK. Thank you. The administration's budget 
request includes a proposal to reduce the deduction for 
interest on borrowing unrelated to life insurance, and I wonder 
if you could discuss the rationale for that proposed change?
    Mr. Talisman. In 1996, Congress passed legislation to 
restrict direct borrowing against life insurance policies. And 
then in 1997, Congress further restricted the use of COLI, 
corporate-owned life insurance, products with respect to 
nonemployees, where you are borrowing against life insurance 
contracts, for example, on homeowners, and so forth. This 
proposal extends that principle, which is the tax arbitrage 
that results from use of tax-exempt interest when combined with 
inside buildup of life insurance.
    Where the borrowing against the life insurance is not 
directly traceable to the life insurance contract, but is in 
effect, leveraging the life insurance contract. So that it 
would again prorate your interest deduction and disallow an 
interest deduction consistent with the changes that were made 
in 1996 and 1997.
    Mr. Coyne. So are you generally characterizing that as a 
tax shelter?
    Mr. Talisman. We are characterizing that as a tax shelter. 
Yes, we are, because it provides arbitrage benefits that can be 
used to shelter other income.
    Mr. Coyne. In the past, hasn't it been used for very 
legitimate reasons?
    Mr. Talisman. Well, when you say was it used for legitimate 
reasons, the tax benefits can be dedicated to very legitimate 
reasons. For example, retirement benefits, and so forth.
    However, the arbitrage is not condoned by the Code and in 
fact it would be inconsistent with what Congress has done in 
1996 and 1997.
    Mr. Coyne. Thank you.
    Chairman Archer. Mr. Weller.
    Mr. Weller. Thank you, Mr. Chairman. Mr. Secretary, good to 
see you again.
    Mr. Lubick. You too, Mr. Weller.
    Mr. Weller. And I have enjoyed listening to the statistics 
going back and forth on the tax burden, and I will share one 
too, I guess. It is my understanding that about the average 
family's income today, at least the average family in Illinois, 
goes to government at the State and local level. And of that, 
my understanding is, probably what is the highest tax burden on 
Illinois families in the history of our country. What is it 
almost 21 percent of our gross domestic product today goes to 
the Federal Government alone?
    So that is my statistic I would like to toss out about how 
high taxes are, and the tax burden on Americans.
    Mr. Lubick. May I differ with that statistic?
    Mr. Weller. Well, perhaps when you respond to my question 
here. You know, when I was back home over the last weekend, you 
know, you always run into folks and actually read the fine 
print, and they ask questions of me. They say, you know, in the 
President's budget, why in the President's budget in a time of 
surplus, when we have all this extra money, do we need $176 
billion in tax increases? And why in this time of surplus does 
the President propose spending $250 billion in Social Security 
trust funds for other purposes?
    And I am pretty pleased with the decision by our leadership 
to put a stop that type of practice that the President wants to 
continue.
    I also note in your budget that you continue to advocate 
targeted tax cuts, and some might describe a targeted tax cut 
as targeted so very few benefit and they get very little. And 
the issue of brownfields tax incentives was mentioned just a 
few moments ago, and I am, of course, a strong advocate of 
that, I often wonder, don't middle-class communities--I think 
middle-class communities--the need environmental cleanup as 
well. I can think of towns like New Lenox and Morris and 
LaSalle-Peru that can use that environmental tax incentive 
which is targeted so much that they are denied that opportunity 
to clean up the environment.
    What I want to focus on here, particularly, is in your 
budget, you are asking essentially for some blanket authority 
to address what you call tax avoidance schemes. And I think I 
am one of those who believes that when Congress writes a law, 
your job is to follow the law and, of course, collect those 
taxes. That is our intent.
    But last year, when the Ways and Means Committee and the 
Congress passed what I feel is one of our greatest 
accomplishments, and that is the IRS reform, we were 
addressing, as part of IRS reform, an area where we felt that 
IRS was doing something we did not want the IRS and the 
Department of Treasury to do. And that is the issue of meal 
taxes in the hospitality industry.
    And in the IRS reform bill there was section 5002, which 
gave a protection to the working moms, the cocktail waitresses, 
the coat-check people, the people who provide hospitality at 
various employers, including almost 4,000 employees of the 
south suburbs that I represent.
    It is interesting, these individuals make an average of 
about $16,000 a year in the hospitality industry because of the 
nature of their job and demands of their job, they are called 
upon to be around all the time. They may have to wear certain 
types of uniforms. And so they are provided meals, maybe a hot 
dog or something by their employer to make it convenient for 
them.
    And for some reason, you insist on taxing them on that hot 
dog. Now, the IRS reform legislation made it very clear the 
intent of this Congress was--is that we do not want you to tax 
that working mom, probably raising some kids--she is probably a 
single mother who is a waitress or cocktail waitress or working 
in the checkout, or that busboy, for example.
    But it is my understanding that you are continuing to come 
back and insisting on taxing that employee of the hospitality 
industry. As I point out, 4,000 people in the district I 
represent. I just don't understand why you are ignoring the 
intent of Congress and legislation that the President signed.
    I was wondering if you can respond to that and explain why 
you are so insistent on taxing the hot dog and the meal that is 
provided to these working moms in the hospitality industry?
    Mr. Lubick. We do have an overall problem, Mr. Weller, 
which is that if we have a general standard that meals 
furnished by an employer to an employee are outside of the tax 
base, that compensation will immediately respond, so that every 
worker in the country will be getting a little-bit reduced 
salary and some meals, which will be--so, the general principle 
is difficult. Now there are exceptions where they have been 
longstanding exceptions in the Internal Revenue Code.
    Mr. Weller. Mr. Secretary, just quickly reclaiming my time, 
the intent of Congress--we put a safe harbor in the law in 
section 5002 of the IRS reform legislation, which your 
President and my President signed into law. We made it very 
clear that you should not be taxing the cocktail waitress, the 
working mom who is given a hotdog as part of--to help her be 
able to be at work. Now that was the intent of Congress, and 
yet you continue to come back and insist on taxing this 
cocktail waitress and this busboy and those in the hospitality 
industry.
    And I just don't understand why you ignore the intent of 
Congress, when we made it very clear that we want you to put a 
stop to taxing these individuals.
    Chairman Archer. The gentleman's time has expired.
    Mr. Neal.
    Mr. Neal. Thank you, Mr. Chairman. Thank you, Mr. Lubick 
for your usual sturdy performance here. I appreciate your 
presence. The alternative minimum tax. The administration 
proposes to extend tax relief from the alternative minimum tax 
for tax relief for individuals for nonrefundable credits for 2 
additional years, for this year and for next year. I am going 
to reintroduce in the next few days my bill from the last 
Congress to provide relief on a permanent basis.
    As you know, Mr. Chairman, you were helpful last year on 
this issue. We discussed it. What is the administration's long-
term position on this issue?
    Mr. Lubick. Well, as a long-term matter, Mr. Neal, it is, I 
think, abundantly clear that these credits, like so many other 
things that are under the individual tax, were never intended 
to be the sort of tax preference that the tax should apply to. 
Unfortunately, under the revenue scoring constraints that we 
operate under, those things which, I think virtually everybody 
agrees, ought to be changed have not been capable of being 
addressed on a permanent basis.
    The problem is going to get continually worse, and we would 
hope that a way could be found to deal with this situation on a 
permanent basis. Not only the credits, but State and local 
taxes, personal exemptions, perhaps even the 15 percent can be 
considered a preference under the alternative minimum tax. That 
certainly was not the intent when the alternative minimum tax 
was first conceived. It was excessive use of tax preferences, 
and the problem awaits the will of people to devote the funds 
to that before the problem gets completely out of hand.
    Mr. Neal. Well, given revenue forecasts for the foreseeable 
future, does that provide us with an avenue for relief or 
potential for relief?
    Mr. Lubick. Well, I would hope so. There was a reference to 
the surplus. Of course, at the present time, the unified 
surplus depends upon the Social Security surplus. It depends 
upon using the funds that were dedicated to the Social Security 
Trust Fund for other purposes. If you didn't count Social 
Security, we would not be in surplus either this year or next 
year.
    But, yes, I think Chairman Archer has been talking about 
this for some time, and I think quite correctly. And as such 
time--this is one of the big-ticket items of general relief 
that I think ultimately is appropriate.
    Mr. Neal. Thank you, Mr. Lubick, and I hope that we will 
have a chance with the Chairman and Members of the Committee to 
pursue this issue because I think we all acknowledge that we 
are reaching a critical juncture, and as time moves along, I 
think we cannot continue to repair this on a 1- or 2-year 
basis. We have to speak about a more permanent solution.
    The second question I have is, since Mr. Weller mentioned 
the issue of tax avoidance, Mrs. Kennelly, as you know, last 
year, produced a fairly extensive bill that dealt with this 
whole question of hedge funds. And the administration's 
proposal seems to be a bit more narrow than the one that Mrs. 
Kennelly offered, which I intend to work on again this year, 
and about which I have been seeking information and advice.
    Could you give us an explanation about the effective date 
and how you intend to treat this issue in coming months?
    Mr. Talisman?
    Mr. Talisman. I think, Mr. Neal, when you said it was more 
narrow, I think you may mean that we limited it to partnerships 
as opposed to other pass-through entities. Again, we narrowly 
tailored our proposal to focus on total return swaps on 
partnership interest because that was the way we understood the 
transactions were being done. We realize that it may be 
possible, theoretically possible, to achieve conversion and 
deferral using total return swaps on other pass-through 
structures, such as REITs and PFICs, passive foreign investment 
companies. We are currently looking at that issue.
    We understand that PFICs are actually already addressed by 
the law, but we are also looking at that issue as well. We 
would certainly like to work with you and your staff in 
addressing this issue.
    Mr. Neal. My intention is to proceed with a version of the 
Kennelly bill, and I hope that we will be able to find some 
common ground as this moves along. I do think this general area 
has the potential for serious problems down the road.
    Thanks, Mr. Chairman.
    Chairman Archer. I thank the gentleman for his line of 
inquiry. I have been disturbed for a long time about the 
alternative minimum tax. Clearly now the problem is exacerbated 
by the new child credit and the Hope scholarship credit. Even 
if you eliminate those items from the alternative minimum tax, 
the tax still hits the personal exemption. Currently, many 
people are not entitled to take a personal exemption without 
paying a tax on it. The personal exemption has been an 
inherent, fundamental part of the income tax law.
    Yet this pernicious alternative minimum tax comes back in 
when you have to reformulate all your income. You have done 
your regular tax return, but then you have to compute and add 
back in your personal exemption and pay a tax on it.
    Mr. Lubick, why can't we just abolish the personal 
alternative minimum tax? Why have it in the Code?
    Mr. Lubick. There are a few items, but a very few items, 
that probably may be justified to be under it. Most of the 
other preferences that were there originally, have been taken 
care of.
    Chairman Archer. Should the personal exemption be under it?
    Mr. Lubick. It certainly shouldn't be, nor should the 
standard deduction, nor should the deduction for State and 
local taxes, nor should the deduction for medical expenses.
    Chairman Archer. Well, you have named all of them. Let's 
just get rid of it. What else is left?
    Mr. Lubick. Well, there are a few minor things like stock 
options----
    Chairman Archer. Yes, but they don't amount to a hill of 
beans. I would like for my friend from Massachusetts to join 
with me to abolish the personal alternative minimum tax. We are 
facing a situation where a married couple, earning $59,000, 
taking the standard deduction only, will be under the minimum 
tax in the next century.
    I mean, this is ridiculous. The gentleman set me off on 
this. This is a cause celebre for me. I apologize to the other 
Members of the Committee for taking the time.
    Mr. McInnis.
    Mr. McInnis. Thank you, Mr. Chairman. To the Secretary, you 
know, in regards to the Chairman's comments, wouldn't you agree 
that the alternative minimum tax is outside the boundaries it 
was originally intended to address.
    Mr. Lubick. I think I stated it in my answer to Mr. Neal 
that certainly is our opinion in the Treasury Department and 
the question is that it becomes expensive and then you have to 
find some pay-for under the existing rules, and the problem is 
that because there is an exemption under the alternative 
minimum tax that was adopted originally that was not indexed, 
the exemption took most people out of it.
    Now the value of that exemption compared to a person's 
income has been depreciating on an annual basis, and so each 
year that you delay in doing this, it becomes more expensive to 
do it.
    So it is a problem that I think, on the merits, we can 
achieve virtual unanimity.
    Mr. McInnis. I guess a couple of other points I should ask. 
First of all, for my colleagues, well, the contingency fee 
issue that was discussed with some accountants. I went to law 
school, and I should also point out that trial lawyers collect 
contingency fees handling tax matters as well. So it is not 
exclusive to a set of hardworking accountants.
    Mr. Talisman. The proposal would not impose any 
restrictions on----
    Mr. McInnis. I understand that. I am just clarifying a 
comment, so we know the trial lawyers are in this pool of money 
as well.
    I guess, when we talk about these shelters, the legitimacy 
of those no longer become a concern if we were to reform the 
Tax Code and put in a consumption tax.
    It would seem to me that the ultimate goal is fundamental 
reform of the system and then we can eliminate all of the 
questions of this issue.
    But let me go on and ask, I'm a little unclear, Mr. 
Secretary, tell me again how you draw the determination between 
tax shelters that are outside the original intent and are 
misapplying the intent of the law versus directives to the 
Treasury Department to find revenue raisers? And do you have--
the second question is, do you have incorporated in these tax 
shelters, shelters that still live within the boundaries of 
their original intentions but are a susceptible target for 
revenue-raising?
    Mr. Lubick. The are expressly taken out. Where Congress 
intended a provision to operate like a tax shelter, for 
example, the low-income housing credit, they are expressly 
excluded. We are dealing with the unintended shelters.
    Mr. McInnis. So there are no shelters in there that are 
acting within their boundaries but placed in there to find 
revenue.
    Mr. Lubick. If the result achieved is that which Congress 
was trying to get at, as is true of many special preferences 
which have the effect of sheltering other income, this 
provision explicitly does not deal with those. It imposes no 
restrictions. It couldn't. It couldn't. They are permitted. If 
they are permitted under the law--anything that is permitted 
under the law is not a tax shelter by our definition.
    Mr. McInnis. OK. And to determine that, I assume you look 
at legislative history. What are the combination of factors you 
use to apply to a specific tax shelter where it is somewhat 
gray as to whether the law allows it or not?
    I mean, if the law didn't allow it, you could go back and 
audit and recover the funds. But here there is an area where 
you are saying, well, maybe they are within the letter of the 
law but they are not within the intent of the law.
    Mr. Talisman. The definition of tax shelter has two 
components. One is that the pretax profit is insignificant 
relative to the aftertax benefit. That is an articulation that 
actually is in the judicial doctrines, including the Shelton 
case and the recent ACM case. That clearly contemplated by the 
Code to which Mr. Lubick was referring to is already in the 
definition of corporate tax shelter for purposes of section 
6662. So that articulation is already in the regulations, the 
section 6662 that items that are clearly contemplated by the 
Code do not constitute a tax shelter.
    So that has been a definitional rule that has been in 
existence for many years.
    Mr. McInnis. Thank you, Mr. Chairman.
    Chairman Archer. Mr. Tanner.
    Mr. Tanner. Thank you, Mr. Chairman, and my question was 
really touched on by Mr. McInnis and also to some degree Mr. 
Doggett. You said in response to a question by Mr. Doggett you 
have a report out about the abuse of the system as it relates 
to these--when could we expect that?
    Mr. Lubick. Mr. Talisman is the guy who is in charge of it, 
so I think I will let him answer the question so I don't go 
under the gun.
    Mr. Talisman. We are hopeful to have it out within, I would 
say, a month. We are working very hard on it, but we want to 
make sure that it is as complete as possible.
    Mr. Tanner. And in that report, you will, I suppose, define 
for us further what you consider----
    Mr. Talisman. And we will also, I hope, take into account 
many of the recommendations that we will see based on the 
testimony today so that we can comment on those as well.
    Mr. Lubick. We have been talking with practitioners, with 
companies, and we continue to have our doors open to people to 
help us make sure we don't make any mistakes.
    Mr. Tanner. Well, I am sure you understand there is concern 
that definition and so on as it relates to achieving a solution 
to the problems we are talking about here in that, frankly, a 
minimization of one's tax liability is a completely legitimate 
business purpose.
    Mr. Lubick. That is legitimate. Right.
    Mr. Tanner. And I think what Mr. McInnis was talking about, 
we are all concerned about, the fairness of the Code and so 
forth. And to get at these schemes of course is something that 
we are all interested in. But there are certain, may we say, 
provisions of the Tax Code that are not black and white, and 
those instances, we would hate to see--because we will get the 
complaints--we would hate to see the service take a position 
with regard to, for example, good-faith exception, the 
substantial authority, those words, you have some proposal 
there is----
    Mr. Lubick. We believe in the definition of tax shelter 
that we have underdefined rather than overreached. We have 
tried to make sure we don't go too far. And we believe we are 
exactly within the Code as it is enacted or has been 
interpreted by courts for a long time.
    Mr. Tanner. This will be addressed in your report?
    Mr. Lubick. Right.
    Mr. Tanner. Good. We will look forward to it. Thank you.
    Chairman Archer. Mrs. Johnson.
    Mrs. Johnson of Connecticut. Thank you. And welcome, Mr. 
Lubick. I do find it quite remarkable that you are proposing 
$82 billion in tax increases when we have a surplus because 
taxes do even all come out of workers' pockets. You can call 
them corporate, but in the end they are paid by you and me and 
the next guy, either through product prices, lost wages, and so 
on.
    I took a lot of heat last year, and this Committee took a 
lot of heat, for proposing $80 billion in tax cuts. And here 
you are, with a surplus, coming to us with $82 billion over 5 
years in tax increases. So I just wonder why you thought it was 
necessary--and I would appreciate it if you would keep it 
short, because I do have specific questions as well--but why, 
when there is a surplus and when the surplus going out into 
other years is trillions, why?
    Mr. Lubick. Well, Mrs. Johnson, the package that we have 
talked about of initiatives and revenue-raisers is balanced. So 
we are dealing with some user fees in the aviation industry, 
which again is really not a tax but a question of those 
benefiting from the services----
    Mrs. Johnson of Connecticut. The $82 billion, though, was 
only taxes, not user fees.
    Mr. Lubick. Pardon me?
    Mrs. Johnson of Connecticut. The $82 billion was only 
taxes, not user fees. You are right, it is more money if you 
include both taxes and user fees.
    Mr. Lubick. No. I think what we are trying to do is recover 
from the users of the system the cost----
    Mrs. Johnson of Connecticut. Right. But that is not in my 
$82 billion figure, as I understand it.
    Mr. Lubick. And I think the other item involves the excise 
tax on tobacco, which is in the budget, but I think----
    Mrs. Johnson of Connecticut. Are you really saying though 
when you say balanced, that our budget is balanced, that you 
proposed $82 billion in tax increases plus user-fee increases 
in order to fund the new spending in the budget?
    Yes. The answer is simply yes. I mean, let's not belabor 
this. We all know that to stay within the caps you would have 
had to free spending and cut $17 billion. And to work within 
the balanced budget you had to pay for new spending and so we 
have $82 billion in proposals to increase taxes to fund new 
spending. It is simple.
    I don't want to belabor it, I just want it clear.
    Mr. Lubick. But I think you are not taking into account the 
proposal involving USA Accounts, which is a tax reduction of--
--
    Mrs. Johnson of Connecticut. Sure. And that is one of the 
new programs out there, and they all cost money, whether they 
cost money to the Tax Code or whether they cost money through 
appropriated dollars. But the fact is what you are doing is 
raising the money to pay for new programs. And one of them 
happens a very interesting and in some circumstances, a very 
desirable approach for savings.
    Mr. Lubick. It is a tax reduction. It seems to me it is a 
tax reduction.
    Mrs. Johnson of Connecticut. Sure. It is. But the fact is 
you are raising taxes to fund it. So I just think we ought to 
be honest about this. To stay within the budget caps and within 
the budget deal, all the new spending that the President is 
talking about, whether it is long-term care assistance, whether 
it is education funding, whether it is construction grants, 
whatever it is, it is funded by this pot of $82 billion in tax 
increases and the additional fees. And the reason you have to 
do that is because you know and I know that to stay within the 
balanced budget he would have had to free spending and cut $17 
billion in outlays.
    So I just want that on the record. But I also want to say 
then--ask you, why have you chosen, first of all, when clearly 
if you are serious about your spending purposes, why have you 
chosen to fund them in part with 30 proposals that have been 
rejected by this Committee on a bipartisan basis, I think 2 
years in a row but certainly the last time. And then, 
specifically, now how can you justify focusing and undoing 
something this Committee did, and it happened to be my 
amendment, just the last year, and then you do it in such a way 
that there is a kind of retroactive whiplash?
    And I am referring to the change that you are making in the 
S corporations, the change in the S corporation law that we put 
in there explicitly to allow S corporations to develop ESOPs, 
employee stock ownership plans. And you specifically undo what 
we just did last year.
    Mr. Lubick. I think, Mrs. Johnson, there has been a lot of 
writing since that was adopted. And I think we have adhered to 
the objective that was sought at the time, which was to make 
sure that an ESOP, which is an S corporation shareholder, is 
not subject to double taxation. And the problem is that by 
exempting the ESOP from being taxed on its current share of 
subchapter S income, you are creating one gigantic tax shelter, 
which has been written about by the commentators as a 
tremendous opportunity.
    Instead, what we have proposed to do, is to do what is the 
situation with respect every other S corporation shareholder. 
After the tax is paid currently that there is no tax at the 
corporate level, but there is a tax at one level currently with 
respect to all S-income.
    Mrs. Johnson of Connecticut. I will be happy to work with 
you on this because I don't believe that is what you are doing, 
and I think what you are doing is so extremely complicated that 
no one in their right mind would try to go into this negative 
carry-forward business.
    But as far as I am concerned, I doubt that you as a 
government person have ever been in a company that is doing 
open-book management. But it is way beyond continuous 
improvement. It is such a level of involvement in management 
decisionmaking on a weekly basis and creates the most 
absolutely incredible level of efficiency and effectiveness and 
teamwork that it absolutely blows your socks off.
    And why those employees who are literally part of managing 
day-in and day-out, can't have an ESOP I cannot imagine.
    And why, from Washington, we should get into double 
taxation and all this stuff. But I will be happy to look at the 
literature, but I am not going to sit quietly by while you 
reverse progress we made last year that is really in harmony 
with the most dynamic things happening in our entrepreneurial 
society.
    My red light has been on. So, thank you.
    Chairman Archer. The gentlelady's time has long since 
expired. [Laughter.]
    Mrs. Thurman.
    Mrs. Thurman. However, Mr. Lubick, I want to echo Mrs. 
Johnson's words because that is where my questions were going 
to go to as well.
    Mr. Lubick. We will be glad to discuss with both of you the 
reasons why I think we can demonstrate that this maintains the 
incentive for the ESOP and maintains the incentive for it to be 
part of S, but at the same time produces a very equitable 
result which was intended from the beginning, when the S 
corporations were adopted in about 1958.
    Mrs. Thurman. However, when we talk about the form of a 
loophole, this has only been in the law for 15 months, which is 
what Mrs. Johnson said. I guess one of the questions I would 
like answered is, can you cite some of those abuses and/or 
could you give us some ideas of what maybe IRS has done in the 
enforcement of this so that we would not go into changing what 
was the incentive.
    I think it was specifically put into law as an incentive 
for these corporations to work into employee-owned, which is 
very important to them.
    The second thing that I might remind you is that there was 
a similar situation to this in the Senate last year, very 
similar to this proposal, if not exactly this proposal. And one 
that this whole Congress, Democrat, Republican, Independent, 
has made very clear. And we talked about it when we did the tax 
reform; it is complexity. This becomes very complex for these 
folks. It was actually reviewed by the Senate last year, and 
they threw out any of this change just because of the 
complexity of what could potentially happen on that.
    I think the third issue is the retroactivity. We got enough 
grief in 1993 on retroactivity, and now we are looking at doing 
something again on this ESOP issue.
    So I think we have some very serious questions.
    I will say to you that I was pleased with the decision that 
you have made to listen to the testimony that is going to be 
given in this panel as we go through today. I think you are 
going to find out why some people find this very objectionable, 
why this has worked particularly in this area, some people that 
are actually in and doing these kinds of ESOPs and why this is 
so important.
    So I really hope that you do live up to that and take into 
consideration what they say because I think they can add a lot 
of light to this issue.
    Other than that, there are obviously several things in this 
budget that I really do like. Sometimes, as Mrs. Johnson said, 
we probably rejected many of these, but I think the priorities 
that have been set forth in the budget are the right ones for 
folks, whether it is the long-term care or child care, 
whatever. And I just hope there is a way that we can achieve 
these goals without being totally disruptive in this country.
    Mr. Lubick. Thank you.
    Chairman Archer. Mr. Collins.
    Mr. Collins. No questions.
    Chairman Archer. Mr. Lubick, Mr. Talisman, thank you for 
your endurance. We appreciate your testimony, and you are free 
to stay as long as you want and listen to the other witnesses. 
Thank you.
    Mr. Talisman. Thank you, Mr. Chairman.
    Mr. Lubick. We have a large group here of supporters, as 
you can see. At Treasury rates, we can afford to tie up the 
whole shop for an afternoon, but they are going to observe very 
carefully. Thank you.
    [The prepared statement and attachment of Mr. English 
follows:]

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    Chairman Archer. Our next panel is Stefan Tucker, William 
Sinclaire, David Lifson, and Michael Olson. If you would come 
to the witness table, please.
    [Pause for witnesses to come forward.]
    The Chair encourages guests to leave the room quietly so 
that we may continue. We have a long list of witnesses yet to 
appear this afternoon.
    Gentlemen, as usual, I would admonish you to attempt to 
keep your verbal testimony to within 5 minutes, and, without 
objection, your entire written statements will be printed in 
the record.
    Mr. Tucker, will you lead off and will you identify 
yourself for the record and whom you represent and then 
proceed.

  STATEMENT OF STEFAN F. TUCKER, CHAIR, SECTION OF TAXATION, 
                    AMERICAN BAR ASSOCIATION

    Mr. Tucker. Thank you, Mr. Chair. My name is Stefan F. 
Tucker, I am the chair of the section of taxation of the 
American Bar Association. I am appearing here today on behalf 
of the section of taxation and, with respect to one item, 
appearing here on behalf of the American Bar Association 
itself. We very much appreciate the opportunity to appear 
before you today. The section of taxation has a membership of 
20,000 tax lawyers, and, with a broad-based and diverse group 
of tax lawyers, we are, in fact, the national representative of 
the legal profession with regard to tax matters.
    First, I would like to point out that the tax section has 
been a firm advocate, day-in and day-out, of simplification. 
And we think that this tax bill does not represent 
simplification. We have already sent the letter dated February 
26, Mr. Chairman, of which you were sent a copy, noting to the 
administration that we are very disappointed in the breadth of 
the proposal.
    When I sit here with 70 pages of proposals, that clearly 
does not meet anybody's goal of simplification and lack of 
complexity. We think careful scrutiny has to be given to any of 
these proposals, and we think that, from our perspective, 
complexity really fosters noncompliance, whereas simplification 
enhances understanding and compliance.
    And we are willing to continue to take that position.
    We agree with you on one item, very clearly. And that is 
the alternative minimum tax is just something that ought to be 
eliminated on the personal basis. We think now is the time, 
when we are facing budget surpluses, for Congress to stand up 
and say this really counts, and we recognize there may be a 
cost, but you are going to have 9 million taxpayers who 
unexpectedly are going to go into the AMT over the next decade. 
We are seeing it on personal exemptions; we are seeing it on 
State and local income taxes; we are seeing it on the standard 
deduction; we are seeing it on a number of items that nobody 
ever thought about.
    Now is the time to do it. If we let this continue to go on, 
it's is going to get worse; it is never going to get better. 
And the scoring is going to get continually worse. It will 
never get better.
    And yet it is an item that will lead to the destruction, we 
believe, of the income tax system at some point.
    We also believe strongly----
    Chairman Archer. Mr. Tucker, then perhaps we should leave 
it in place. [Laughter.]
    Mr. Tucker. We may have different views on that as tax 
lawyers.
    We also think that the phase-out concept is an item whose 
time has come and gone. And it is just another way of saying 
that we don't want to raise tax rates, so we are going to 
impact people with the phase-out of itemized deductions, or the 
phase-out of personal exemptions. We think it is about time to 
face reality.
    It is probably strange for tax professionals, tax lawyers, 
to say ``let's stop the undersided approach and just go 
straight up,'' but we think we ought to.
    We are really here, most importantly, to talk about 
corporate tax shelters. And when I use the term ``corporate tax 
shelter,'' please understand it is not just focused on 
corporations. It focuses equally as much on limited liability 
companies, partnerships, business trusts, and trusts. It is a 
very widespread situation.
    And I will tell you that we at the tax section strongly 
share the concerns of the Treasury Department that the tax 
shelter problem is a real problem. From our perspective, we 
would urge that you do not heed those who say that there are no 
problems. Do not heed those that say that corporations pay 
enough taxes.
    It has been noted already, up here, that the less the 
corporation pays, the more the individual pays. If we are going 
to reduce tax rates, let's reduce them at the individual level 
and let the corporations pay their fair share.
    The problems are real. The problems are there. They are not 
self-correcting. It's a secretive and insidious methodology, 
and let's not ignore the Trojan horse--it's already in the 
gate. The promoters are sneaking out at night. Put them out in 
full daylight and let people see what it is. Let's look and see 
whether the emperor really has any clothes in these corporate 
tax shelters.
    And our focus is disclosure, disclosure, disclosure. Put it 
out and let people look at it, and then determine whether or 
not it truly works.
    We think that, on the tax shelters, there are four 
features: there is a discrepancy between book and tax 
treatment; there is little economic risk to the corporation; 
too often there is a ``tax indifferent party'' involved; and 
there is a broad-based marketing by the promoter, by counsel, 
and apparently sometimes by the staff of the taxpayer itself. 
And we think that penalties ought to be imposed on those 
levels.
    And if someone comes up in front of you and says there are 
no problems, we would urge that what you do is say: Are you the 
purchaser of a product? Are you the marketer of a product? Are 
you or your clients the marketers of products? If they are, ask 
them to give you three or four, and then look at those, and 
then see if they fit within these criteria that we have.
    Last, because our time is already short, I would urge you 
to look at the proposed income tax----
    Chairman Archer. Because I interrupted, you may feel free 
to go on for another minute or so.
    Mr. Tucker. Thank you, sir. I really appreciate it.
    What we would like to do, if I can, is point out that there 
are solutions. We really believe, first and foremost, that 
there ought to be additional reporting for tax shelters, and we 
would note that the taxpayer ought to be attaching to the 
return detailed explanations. The taxpayer ought to be giving 
descriptions of due diligence. Why is there such a difference 
between the due diligence done in a public offering and the due 
diligence that is done in a corporate tax shelter?
    Why are there simplistic assumptions being made that nobody 
has to back up? What is needed is security and real 
enforcement. One is SEC enforcement on the public offering, and 
two is the penalties imposed upon the people: damages, 
liability for not doing the job right.
    You don't want to just do this at the corporate level. You 
want to look at the promoter. And you want to look at the 
advisers. If everybody has risk, it is going to make a 
difference.
    We think you should broaden the substantial understatement 
penalty to cover outside advisers, promoters, and tax-
indifferent parties. And if those tax-indifferent parties are 
exempt organizations, and they are being used to inure to the 
benefit of private parties, maybe they are violating the rules 
that apply to exempt organizations.
    We think you ought to focus on a real definition of large 
tax shelters. There is a 1997 tax provision that still hasn't 
had its definition yet. It was noted before, we are still 
awaiting it from Treasury. It's difficult, to come up with a 
definition. It ought to be done.
    And Congress ought to say that there are existing 
enforcement tools at the audit level that can be supported with 
funding to look at this.
    Last, on the taxation of investment income of trade 
associations, on behalf of the ABA itself, we know that a 
majority of the Members of the Ways and Means Committee have 
stated they do not believe that this is something that should 
be done.
    We think that it is a big problem. It ought not to be done; 
there ought not to be a tax on investment income. You impose a 
tax here, you simply put the dollars into another source. It is 
going to be a wash. It is not anything that ought to be done at 
this point.
    Thank you, sir.
    [The prepared statement follows:]

Statement of Stefan F. Tucker, Chair, Section of Taxation, American Bar 
Association

    Mr. Chairman and Members of the Committee:
    My name is Stefan F. Tucker. I appear before you today in 
my capacity as Chair of the American Bar Association Section of 
Taxation. This testimony is presented on behalf of the Section 
of Taxation. Accordingly, except as otherwise indicated, it has 
not been approved by the House of Delegates or the Board of 
Governors of the American Bar Association and, accordingly, 
should not be construed as representing the position of the 
Association.
    As you know, the ABA Tax Section is comprised of 
approximately 20,000 tax lawyers. As the largest and broadest-
based professional organization of tax lawyers in the country, 
we serve as the national representative of the legal profession 
with regard to the tax system. We advise individuals, trusts 
and estates, small businesses, exempt organizations and major 
national and multi-national corporations. We serve as attorneys 
in law firms, as in-house counsel, and as advisors in other, 
multidisciplinary practices. Many of the Section's members have 
served on the staffs of the Congressional tax-writing 
Committees, in the Treasury Department and the Internal Revenue 
Service, and the Tax Division of the Department of Justice. 
Virtually every former Assistant Secretary of the Treasury for 
Tax Policy, Commissioner of Internal Revenue, Chief Counsel of 
the Internal Revenue Service and Chief of Staff of the Joint 
Committee on Taxation is a member of the Section.
    The Section appreciates the opportunity to appear before 
the Committee today to discuss certain proposals contained in 
President Clinton's budget for Fiscal Year 2000. Our testimony 
today will not include comments on each and every proposal in 
the President's budget. We do anticipate, however, that 
additional individual comments on various proposals will be 
submitted in the near future. In addition, individual members 
of the Tax Section would be pleased to provide assistance and 
comments to members of the Ways and Means Committee and to 
staff on any proposals you might identify.
    Our general focus today will be the overall need for 
simplification of the tax code and the corresponding need to 
avoid additional complexity. In addition, we would like to 
comment on the various tax shelter proposals contained in the 
budget, as well as the proposal to tax the investment income of 
trade associations.

                     SIMPLIFICATION AND COMPLEXITY 

    The ABA and its Tax Section have long been forceful 
advocates for simplification of the Internal Revenue Code. In 
resolutions proposed by the Tax Section and passed by the full 
ABA in 1976 and 1985, we are on record urging tax law 
simplicity, a broad tax base and lower tax rates. We have 
reiterated this position in testimony before the House Ways and 
Means and Senate Finance Committees on numerous occasions.
    Over the past two decades, the Code has become more and 
more complex, as Congress and various administrations have 
sought to address complicated issues, target various tax 
incentives and raise revenue without explicit rate increases. 
As the complexity of the Code has increased, so has the 
complexity of the regulations that the IRS and Treasury have 
issued interpreting the Code. Moreover, the sheer volume of tax 
law changes has made learning and understanding these new 
provisions even more difficult for taxpayers, tax practitioners 
and Service personnel alike.
    Although, until recently, many of these changes have not 
affected the average taxpayer, the volume of changes has 
created the impression of instability, in that the Code is 
becoming perhaps too complicated for everyone. This takes a 
tremendous toll on taxpayer confidence, evidence of which can 
be found in the broad public support for the IRS restructuring 
legislation passed last year. This Committee often hears how 
our tax system relies heavily on the willingness of the average 
taxpayer voluntarily to comply with his or her tax obligations. 
Members of the Tax Section can attest to the widespread 
disaffection among taxpayers with the current Code. Their 
willingness, and their ability, to keep up with the pace and 
complexity of changes, is at a point beyond which it should not 
be pushed.
    It now appears that many in Congress are interested in 
enacting tax reductions this year. Press accounts indicate that 
various options are being discussed. The Tax Section does not 
take a position with respect to the wisdom of tax reduction 
generally or any particular proposals. We do urge, however, 
that the members of this Committee keep simplification and 
avoidance of complexity uppermost in their minds as any tax 
reduction packages are fashioned. Tax relief can be delivered 
in ways that avoid new, complicated rules and that steer clear 
of phase-outs that act as hidden marginal rate increases. While 
such broad-based reductions may not have the cache' of new, 
more targeted provisions, they will avoid the layering of new 
complexity over old. To paraphrase Hippocrates, if Congress 
chooses to reduce taxes, we urge you to do no harm.
    To this end, on behalf of the Tax Section, I recently sent 
to Secretary Rubin a letter expressing our disappointment that 
the President's budget proposes to add a multitude of new tax 
credits to the Federal income tax system. Our point in that 
letter was that, although each credit taken in isolation could 
be viewed as meritorious, that kind of micro-balancing 
inevitably leads to the type of tax system that is, in total, 
overly complex and undeserving of public respect. Particularly 
in light of the various, complicated provisions added by the 
1997 tax act, Congress and the Administration must focus on the 
cumulative impact of all new provisions sought to be added. 
Only then can they resist the accretion of income tax benefits 
and penalties that are unrelated to the administrable 
measurement of annual taxable income and ability to pay.
    My letter to Secretary Rubin also urged that particularly 
close scrutiny be given to any proposals that include income 
phaseouts. These phaseouts have gained popularity in the last 
two decades, and are responsible for a significant amount of 
the complexity imposed on individual taxpayers. As noted 
previously, phaseouts create the effect of a marginal rate 
increase as a taxpayer's income moves through the phaseout 
range, and the effects of multiple phaseouts on the same 
taxpayer can create capricious results. Phaseouts also play a 
significant role in the creation of marriage tax ``penalties,'' 
and add to the difficulty in addressing that set of issues. We 
urge you to resist their continued use in the enactment of 
additional tax incentives.
    We do not claim to have all the answers. The Tax Section 
will continue, diligently, to point out opportunities to 
achieve simplification whenever possible, including several 
ideas that we will discuss later in this testimony. However, it 
is also necessary that we point out that simplification 
requires hard choices and a willingness to embrace proposals 
that are often dull and without passionate political 
constituencies. Simplification may not garner political capital 
or headlines, but it is crucial. Complexity fosters non-
compliance; simplification enhances understanding and 
compliance.
    To date, simplification has not achieved the commitment 
that we believe is required. Too often, other objectives have 
tended to crowd simplification out as a priority. We urge the 
Ways and Means Committee to adjust this balance. Without a 
commitment on the part of the members of this Committee to 
eliminate old and avoid new complexity, the trend will not be 
reversed. Members of the Ways and Means Committee must endorse 
simplification as a bedrock principle, and that principle must 
be communicated to all involved in the tax-writing process. 
Time must be taken, and effort must be made, to ensure that 
this goal remains paramount.
    To that end, the Congress adopted as part of the IRS 
restructuring bill a procedure to analyze the complexity of 
proposals with widespread applicability to individuals or small 
business. By means of this complexity analysis, the Joint 
Committee on Taxation will call attention to provisions that 
could result in substantial increases in complexity, and will 
suggest ways in which the goals of those proposals can be 
achieved in simpler ways. We strongly support this increased 
focus on complexity and urge the members of this Committee to 
pay heed to the JCT analyses. Only by raising awareness of 
problems with proposals before they become law will Congress 
make substantial inroads into the problem.
    We would now like to address certain specific areas in 
which the Tax Section considers the need for simplification 
immediate.

                       A. Alternative Minimum Tax

    As this Committee is well aware, there is an inherent 
problem with the individual alternative minimum tax which, if 
not fixed, will result in approximately 9 million additional 
taxpayers becoming AMT taxpayers within the next decade. Many 
have referred to this problem as a ticking time bomb. Arguably, 
most of these taxpayers are not of the type envisioned as being 
subject to the AMT when it was revised in 1986. Moreover, many 
of these individuals will not even be aware they are subject to 
the AMT until completing their returns or, worse, receiving 
deficiency notices from the IRS.
    The problem stems generally from the effects of inflation. 
Married couples with alternative minimum taxable income under 
$45,000 ($22,500 for individuals) are generally exempt from the 
AMT. These thresholds were effective for tax years beginning 
after December 31, 1992, but were not indexed for inflation. As 
time passes, inflation (even minimal inflation, as compounded) 
will erode these thresholds in terms of real dollars. As a 
result, more and more taxpayers will be pulled into the AMT. 
The problem is exacerbated by the fact that the AMT does not 
permit individuals to claim state taxes as a deduction against 
the AMT. As the income levels of these individuals increase 
(with inflation or otherwise), and their state tax liabilities 
rise correspondingly, they face the increased chance that they 
will be pulled into the AMT merely because they claimed state 
taxes as an itemized deduction for regular tax purposes.
    This looming problem was compounded by the enactment of 
various new credits, as incentives, in the 1997 tax act. The 
provisions, such as the child tax credit under IRC Sec.  24 and 
the Hope Scholarship and Lifetime Learning credits under IRC 
Sec.  25A, do not apply for purposes of the AMT. Congress has 
recognized this problem by enacting a one-year moratorium (for 
1998) that allows application of these incentive credits for 
both the regular tax and the AMT.
    We urge this Committee in the strongest possible terms to 
solve the problems with the AMT once and for all. There is 
universal acknowledgement that the effects I have described are 
unintended and unjustified. It is also acknowledged that the 
revenue cost associated with a permanent solution will only 
increase over time and may eventually become prohibitive. It 
would be a travesty if a permanent solution to the AMT became 
caught on the merry-go-round of expiring provisions. A 
permanent solution should not be deferred merely because it 
competes with other, more popular proposals for tax reduction.

      B. Phaseout of Itemized Deductions and Personal Exemptions 

    At the urging of the Tax Section, the American Bar 
Association at its February Mid-Year meeting adopted a 
recommendation that the Congress repeal the phaseout for 
itemized deductions (the so-called Pease provision) and the 
phaseout for personal exemptions (the PEP provision). We 
recommend that the revenue that would be lost by repeal be made 
up with explicit rate increases. This would address any revenue 
neutrality concern as well as any concern with respect to the 
distributional effects of repeal.
    It may be difficult for members of Congress to appreciate 
the level of cynicism engendered by these two phaseouts. 
Countless times, taxpayers who might not otherwise be troubled 
by the amount of tax they are paying have reacted in anger when 
confronted with the fact that they have lost--either wholly or 
partially--their itemized deductions and personal exemptions. 
They are no more comforted when told that these phaseouts 
should really be viewed as substituting for an explicit rate 
increase. Almost without exception, they react by asking why 
Congress refuses to impose the additional rate rather than 
trying to pull the wool over their eyes.
    We have no answer to that question. We take pride in the 
fact that a private sector organization such as the ABA is 
willing to recommend a simplification proposal funded by a 
marginal rate increase on the same taxpayers benefiting from 
the simplification. We urge this Committee to give serious 
consideration to the ABA's recommendation.

          C. Streamlining of Penalty and Interest Provisions 

    The 1998 IRS Restructuring Act instructs both the Joint 
Committee on Taxation and the Treasury Department to conduct 
separate studies of the penalty and interest provisions of the 
Code and to make recommendations for their reform.
    The Tax Section believes that reform of the penalty and 
interest provisions is appropriate at this time and look 
forward to working with the JCT and Treasury. There are many 
cases in which the application of penalty and interest 
provisions take on greater significance to taxpayers than the 
original tax liability itself. The Tax Section is concerned 
that these provisions often catch individuals unaware, and that 
the system lacks adequate flexibility to achieve equitable 
results. In light of the significant changes being made by the 
IRS, the completion of this study and eventual enactment of the 
recommendations will be welcome.
    The Tax Section has submitted preliminary comments to the 
staff of the Joint Committee on Taxation that we hope will be 
useful in developing alternatives. We expect to submit final 
comments and recommendations to both the Joint Committee and 
Treasury in the late spring.

                    D. International Simplification 

    We are also pleased that various members of the Ways and 
Means Committee and of the Senate Finance Committee are 
discussing significant simplifying changes in the international 
tax area. In particular, we commend Messrs. Houghton and Levin 
of this Committee for their leadership on this issue.
    Provisions of the tax code relating to international 
taxation are among the most complex in existence. While we 
recognize that taxation of individuals and corporations earning 
income in multiple countries necessarily involves numerous 
complications, we firmly believe that significant simplifying 
changes can be made to existing provisions without losing sight 
of the various principles guiding those provisions. We urge 
this Committee to devote significant effort to these 
simplification proposals, and we look forward to working with 
you on that effort. 

             PROVISIONS RELATING TO CORPORATE TAX SHELTERS 

    The Administration's budget includes no fewer than 16 
provisions dealing in one way or another with the issue of 
aggressive corporate tax shelters. The purpose of our statement 
today is not to comment on the specifics of the 
Administration's proposals. We understand that the Treasury 
shortly will issue an amplification of its proposals. We are 
fully prepared to provide detailed comments on the proposals 
following issuance of the amplification. In the meantime, we 
wish to offer our own comments on the corporate tax shelter 
problem and suggest a course of action.
    The sheer number of proposals included in the Budget 
obviously reflects the Treasury Department's concern about the 
corporate tax shelter phenomenon. While we believe the 
Committee should carefully consider the number of proposals 
included in the Budget, their possible overlap, and their 
potential impact on normal business transactions, the Tax 
Section strongly shares the Treasury's concerns with very 
aggressive positions being taken by taxpayers and their 
advisors in connection with certain transactions and the fact 
that these transactions frequently are being mass marketed. We 
also share the concern expressed by Chairman Archer regarding 
practices that abuse the tax code by making unintended end runs 
around it, and we compliment the Chairman for articulating his 
concern publicly and, thus, bringing additional attention to 
this problem.

                            A. The Problem 

    We have witnessed with growing alarm the aggressive use by 
large corporate taxpayers* of tax ``products'' that have little 
or no purpose other than reduction of Federal income taxes. We 
are particularly concerned about this phenomenon because it 
appears that the lynchpin of these transactions is the opinion 
of the professional tax advisor. The opinion provides a level 
of assurance to the purchaser of the tax plan that it will have 
a good chance of achieving its intended purpose. Even if the 
taxpayer ultimately loses, the existence of a favorable opinion 
is generally thought to insulate the taxpayer from penalties 
for attempting to understate its tax liability. While some 
might dispute this as a legal conclusion, recent cases tend to 
support the absence of risk for penalties where favorable tax 
opinions have been given.
    Because of our concern that opinions of tax professionals 
are playing such a key role in the increased use of corporate 
tax shelters, the Tax Section has established a task force to 
consider amendments to the American Bar Association's rules for 
standards of practice of our members. We undertook a similar 
project in the early 1980's when so-called ``retail'' tax 
shelters proliferated. That effort resulted in the promulgation 
of ABA Formal Ethics Opinion 346 and in the adoption of a 
similar standard in Treasury's Circular 230, which contains the 
ethical standards that tax professionals must comply with under 
threat of losing the right to practice before Treasury and IRS. 
We expect that our task force will recommend changes in these 
disciplinary rules to address the current tax shelter 
phenomenon.
    Likewise, we are concerned about the blatant, yet 
secretive, marketing of these corporate tax shelters. As 
discussed below, unless penalties that cannot be seen as mere 
minor costs of doing business by the promoters are imposed upon 
the promoters, and strongly and diligently enforced, no end is 
or will be in sight.
    The tax shelter products that concern us generally have the 
following features. First, there is a discrepancy between the 
book treatment of the transaction and its treatment for Federal 
income tax purposes (stated simply, the creation of a 
significant tax loss with no similar loss for financial 
accounting purposes). Second, there is little economic risk to 
the corporation from entering into the transaction other than 
transaction costs. Third, one party to the transaction is 
frequently what the Treasury refers to as ``tax indifferent'' 
(that is, a foreign taxpayer not subject to U.S. tax, a U.S. 
organization exempt from Federal income tax, or a taxable U.S. 
corporation that has large net operating loss carryovers). 
Finally, and most telling, it is generally assumed by the 
promoter, by counsel and apparently by the taxpayer itself 
that, if the ``product'' comes to the attention of Treasury or 
Congressional staffs, it will be blocked, but almost invariably 
prospectively, by administrative action or by legislation.
    The aggressive tax shelters that concern us do not overuse 
tax benefits consciously granted by Congress (such as 
accelerated depreciation or credits) nor are they tax-favored 
methods of accomplishing a business acquisition or financing. 
They are transactions that the parties themselves would 
generally concede have little support in sound tax or economic 
policy, but are, the parties assert, transactions not clearly 
prohibited by existing law. Not surprisingly, explicit or 
implicit confidentiality is also a common requisite of today's 
tax shelter products.
    The modern tax shelter transaction usually feeds off a 
glitch or mistake in the tax law, often one that is accessed by 
finding, or even creating, a purported business purpose for 
entering into the transaction. Tax shelter products that 
capitalize on mistakes in the Code are not as troublesome to us 
as those that depend upon the existence of questionable facts 
to support the success of the product. Mistakes in the Code 
will eventually be discovered and corrected by the IRS, 
Treasury or the tax-writing Committees of Congress. When 
mistakes are discovered and corrected by legislation, it is the 
prerogative of Congress to determine whether the situation 
warrants retroactive application of the correction.
    Far more troublesome is the practice of reducing taxes by 
misusing sound provisions of the Code. Exploitation of rules 
that generally work correctly by applying them in contexts for 
which they were never intended, supported by questionable 
factual conclusions, is the hallmark of the most aggressive tax 
shelters today. Discovery on audit is the tax system's 
principal defense, but, in a self-assessment system, the audit 
tool cannot be expected to uncover every sophisticated tax 
avoidance device. The law should provide clear incentives for 
taxpayers to comply with the rules and, in all events, properly 
to disclose the substance of complex transactions.
    Thus, our concern is centered on the transaction that 
depends upon a dubious factual setting for success. Foremost 
among these is the conclusion or assertion that there is a 
real, non-tax business purpose or motive for entering into the 
transaction. There are others. In some cases, it will be 
essential for the opinion-giver to conclude that the 
transaction in question is not a step in a series of 
transactions, which, if collapsed into a single transaction, 
would not achieve the tax benefits sought. A third type of 
factual underpinning often essential to the delivery of a 
favorable tax opinion is the permanence, or intended long-term 
economic viability, of a business arrangement among the parties 
(for example, a joint venture, partnership or newly formed 
corporation). A venture may be represented to be a long-term 
business undertaking among the parties, when in fact it is a 
complex, single-purpose, tax-motivated arrangement which was 
formed shortly before and will be dissolved shortly after the 
tax benefit is realized.
    In most of these cases, the tax law is quite clear. Without 
the presence of a sufficient business purpose, unless the 
transaction is not a step in a series of related events, or 
unless the new business venture represents a valid business 
arrangement with a sufficient degree of longevity, the tax 
benefit claimed is simply not available under existing law. 
That bears repeating. Most if not all of the tax shelter 
transactions that concern us depend upon avoidance of well-
established principles of law such as the business purpose 
doctrine, the step-transaction rule, the substance-over-form 
doctrine, or the clear reflection of income standard. Thus, the 
role of the opinion giver often disintegrates into the job of 
designing or blessing a factual setting to support 
applicability of the Code provisions that will arguably produce 
the desired benefit. The result is the application of a 
provision of the Internal Revenue Code that otherwise has a 
logical and sound policy purpose to reach a result that is 
nonsensical, in some cases almost ludicrous.
    A sad additional fact is that all parties to these 
transactions know there is substantial likelihood that the 
device employed, including the imaginative assertion of the 
proper factual setting, will not be uncovered by IRS agents 
even if the corporation is audited, as most large taxpayers 
are. The tax law is too complex and the returns of major 
taxpayers are too voluminous. Many tax shelter products involve 
numerous parties, complex financial arrangements and invoke 
very sophisticated provisions of the tax law. It often takes 
time and painstaking analysis by well-informed auditors to 
ascertain that what is reported as a legitimate business 
transaction has little, if any, purpose other than the 
avoidance of Federal income taxes. Accordingly, there is a very 
reasonable prospect that a product will win the ``audit 
lottery.'' This aspect of the problem is compounded by the fact 
that present law gives no reward for full disclosure in the 
case of corporate tax shelter transactions.
    Let me emphasize that the transactions that concern us--and 
the tax opinions that support them--are altogether different 
than attempts to reduce taxes on a business transaction that 
has a true business or economic objective independent of 
reduction of Federal income taxes. But drawing distinctions 
between tax-dominated transactions and true business 
transactions that may involve major tax planning is sometimes 
tricky, particularly in the legislative context. For that 
reason, we recommend that the Congressional response to the tax 
shelter problem be measured and appropriate. It should not 
overreach; it should not risk inhibiting legitimate business 
transactions. As we all know, taxpayers have the right to 
arrange their financial affairs to pay the minimum amount of 
tax required under the law. Our desire is that in doing so they 
not avoid the intent of the law by benignly neglecting judicial 
and administrative principles in which the tax law is quite 
properly grounded.

                         B. Possible Solutions

    We recommend that your emphasis be on compelling the full 
disclosure of the nature and true economic impact of specified 
classes of transactions. No taxpayer, or taxpayer's advisor, 
has the right to ignore or obfuscate the essential facts 
necessary to support the legal position relied upon to produce 
the desired tax benefit. Thus, we recommend that provisions be 
added to the Code that would give the parties a clear incentive 
to focus on the essential facts relied upon to bring the 
transaction within the applicable Code provisions. If that 
factual underpinning, and its legal significance, is properly 
understood by the taxpayer and its advisors, and is properly 
disclosed on the tax return, then the system will work much 
better. The facts to which I refer include objective facts that 
bear on the subjective inquiry the law requires. The inquiry 
would not need to state a conclusion as to the taxpayer's state 
of mind, but the objective facts that indicate the taxpayer's 
actual intent or purpose should be fully understood by the 
parties and clearly disclosed on the tax return. 
    In order to focus the inquiry on the facts relied upon to 
support these tax sensitive transactions, there should be a 
realistic possibility that penalties will be levied where the 
non-tax economic benefits from a transaction are slight when 
compared to the potential tax benefits. We agree with the 
Treasury Department that, in these types of transactions, 
promoters who market the tax shelter and professionals who 
render opinions supporting them should face penalties as well 
as the taxpayer. The Treasury Department has, in addition, 
suggested that tax-indifferent parties should face a potential 
tax if the transaction is ultimately found wanting. Under 
proper circumstances, that seems desirable. All essential 
parties to a tax-driven transaction should have an incentive to 
make certain that the transaction is within the law. 
    You may hear the argument that changes such as those we are 
advocating will cause uncertainty and unreliability in the tax 
law. As noted earlier, the Tax Section strongly supports as 
much simplicity and clarity as possible throughout the Code. 
However, total certainty is impossible where complex 
transactions are involved. This is particularly true when the 
parties seek to avoid judicial principles developed to deny tax 
benefits to overly tax-motivated transactions. Taxpayers and 
their advisors know that relative certainty can easily be 
achieved in legitimate business transactions by steering a 
safer course and staying in the middle of the road. The more 
clearly the transaction stays within established judicial and 
administrative principles, the more certainty is assured. When 
they venture to the outer edge, certainty cannot be assured, 
nor should it be; the parties who consciously risk going over 
the edge should clearly understand there are severe 
consequences for doing so.
    In an important way, the protection of common law and 
general anti-abuse principles contributes to certainty and 
reliability in the tax law. Tax shelter transactions commonly 
depend in large part on very literal interpretations of the 
words of the Code or regulations. They utilize the clarity in 
the way the tax law is written to undermine its purpose. In so 
doing, these transactions discourage the writing of clear and 
certain tax law in favor of more vaguely stated principles that 
cannot be so easily skirted. One of the important results of 
anti-abuse principles developed by the courts is the protection 
of clearly-stated provisions of law on which taxpayers can rely 
with certainty for every day business transactions.
    As you can see, we think the best and most effective route 
for this Committee to follow in dealing with the corporate tax 
shelter problem is increased, meaningful disclosure, with 
proper due diligence of, and accountability for, the factual 
conclusions relied upon by the taxpayer. This will, perforce, 
have to involve an expanded penalty structure as well. If this 
is done properly, there may be no need for some of the more 
complex and broader changes Treasury has proposed. Consistent 
with our comments on simplicity earlier in this statement, we 
would encourage the Committee to be mindful of the significant 
complexity that could be imposed on thousands of taxpayers who 
are not employing tax shelters if the solutions selected to 
address this problem are overly broad.
    Finally, this Committee and the Congress need to be certain 
that the Internal Revenue Service's resources are adequate to 
deal with the tax shelter issues. In part, promoters of tax 
shelters are successful in marketing their products because 
they and large taxpayers have concluded that the IRS is less to 
be feared today. They are aware of the problems within the 
agency, the Congressional criticism it has received, and its 
dwindling resources. Our recommendations are directed primarily 
at increased reporting and disclosure for ``large tax 
shelters.'' We think such changes, together with expanded 
penalties, will increase voluntary compliance. However, the 
Internal Revenue Service must have the resources to analyze the 
information reported and to pursue noncompliance vigorously, or 
the increased reporting will be a paper tiger.

                         C. Specific Proposals

    We would suggest the following changes in the Internal 
Revenue Code to accomplish the goals outlined:

1. Additional reporting for ``tax shelters''

    A question should be added to the corporate income tax 
return requiring the taxpayer to state whether any item on the 
return is attributable to an entity, plan, arrangement or 
transaction that constitutes a ``large tax shelter'' (as 
defined below). If the answer is yes, detailed information 
should be required to be furnished with the return, including:
    (a) A detailed description of the facts, assumptions of 
facts, and factual conclusions relied upon in any opinion or 
advice provided by an outside tax advisor with respect to the 
treatment of the transaction on the return;
    (b) A description of the due diligence performed by outside 
advisors to ascertain the accuracy of such facts, assumptions 
and factual conclusions;
    (c) A statement signed by the corporate officer with 
principal knowledge of the facts that such facts, assumptions 
or factual conclusions are true and correct as of the date the 
return is filed, to the best of such person's knowledge and 
belief. If the actual facts varied materially from the facts, 
assumptions or factual conclusions relied upon in the outside 
advisor's advice or opinion, the statement would need to 
describe such variances;
    (d) Copies of any written material provided in connection 
with the offer of the tax shelter to the taxpayer by a third 
party; 
    (e) A full description of any express or implied agreement 
or arrangement with any advisor, or with any offeror, that the 
fee payable to such person would be contingent or subject to 
possible reimbursement; and
    (f) A full description of any express or implied warranty 
from any person with respect to the anticipated tax results 
from the tax shelter.

2. Broaden the substantial understatement penalty to cover 
outside advisors, promoters and ``tax indifferent parties''

    If the substantial understatement penalty of existing law 
is imposed on the taxpayer, a similar penalty should be imposed 
on any outside advisors and promoters who actively participated 
in the sale, planning or implementation of the tax shelter. The 
same type of penalty should also be imposed on ``tax 
indifferent parties,'' unless any such party can establish that 
it had no reason to believe the transaction was a tax shelter 
with respect to the taxpayer.

3. Definition of ``large tax shelter'' for purposes of the 
substantial understatement penalty

    The definition of ``tax shelter'' presently contained in 
section 6662(d)(2)(C)(iii) should be retained. The term ``large 
tax shelter'' would be defined as any tax shelter involving 
more than $10 million of tax benefits in which the potential 
business or economic benefit is immaterial or insignificant in 
relation to the tax benefit that might result to the taxpayer 
from entering into the transaction. In addition, if any element 
of a tax shelter that could be implemented separately would 
itself be a `` large tax shelter'' if it were implemented as a 
stand-alone event, the entire transaction would constitute a 
``large tax shelter.''
4. Specific new penalties should be provided in the case of tax 
shelters that fail to disclose the required information 
(whether or not the tax shelter is ultimately sustained or 
rejected by the courts)

    In a self-assessment system, accurate reporting and 
disclosure are essential. Where that does not occur, penalties 
are necessary. This is particularly true in the case of large 
and complex tax-motivated transactions. There should be a clear 
disincentive to playing the audit lottery in these types of 
transactions. This could be coupled with a reduction in the 
rate of any otherwise applicable penalties for those 
corporations that comply with the disclosure requirements set 
forth in 1, above. This would provide an incentive (and not 
just a disincentive) to make such disclosures.

5. Articulate a clear Congressional policy that existing 
enforcement tools should be utilized to stop the proliferation 
of large tax shelters

    Congress should make clear its view that examination of 
large tax shelter transactions by the Internal Revenue Service 
should be considered a tax administration priority. This should 
include the application of both civil and criminal penalties 
when appropriate.

          TAXATION OF INVESTMENT INCOME OF TRADE ASSOCIATIONS

    One of the proposals included in the President's budget 
raises serious concerns for the American Bar Association. We 
have been asked by the ABA to convey to this Committee its 
grave concerns about this proposal.
    The proposal would tax all net investment income of trade 
associations, business leagues, chambers of commerce and 
professional sports leagues (under IRC Sec.  501(c)(6)) in 
excess of $10,000 per year. The tax would be imposed at 
generally applicable corporate rates. The tax would not be 
imposed to the extent such net income was set aside to be used 
for any charitable purpose described in IRC Sec.  170(c)(4).
    The principal basis for the Administration's proposal is 
the erroneous assumption that the endowments that have been 
accumulated by some trade associations represent excessive dues 
payments by the members of these organizations. Thus, the 
Administration argues, the investment income earned on these 
excessive dues payments should be subject to tax just as they 
would have been if the dues had been set at the proper level, 
and the ``excess'' invested individually by the members of the 
association.
    The ABA has serious reservations about this analysis. Even 
if it is correct to assume that these endowments represent 
excessive dues payments received in earlier years, the 
investment income earned on the excess (whether earned by the 
trade association or by its members) has the practical effect 
of reducing dues that become payable in future years. 
Therefore, the only significant consequence of permitting these 
excess dues to be invested by a tax exempt entity without 
taxation is to defer the government's receipt of the tax on 
such income from the year of the initial dues payment to the 
year in which the excess dues are applied to carry out the 
trade association's exempt activities.
    We understand the theoretical economic analysis that 
underlies this proposal. We would submit, however, that this 
theoretical analysis ignores the real world, practical 
implications of the proposal. As a large trade association, the 
ABA must point out that this proposal will discourage the 
accumulation of endowments, severely hamper multi-year 
planning, and limit the ability of these organizations to fund 
socially desirable programs.
    For example, these organizations (like any other) fund 
large outlays over time, rather than in the year of the outlay. 
Dues of trade associations and other section 501(c)(6) 
organizations are set at levels necessary to fund such outlays 
by allowing them to accumulate funds for capital expenditures, 
etc. A tax on investment income would make planning for such 
large expenditures very difficult, and highly impractical. The 
organizations would be forced either to collect their dues on a 
level basis and incur the tax (thus necessitating higher, fully 
deductible dues to make up the difference) or to lower their 
dues, not accumulate any savings, and then make special 
assessments in the year of the large expenditure in order to 
fund the project (with such special assessments also being tax 
deductible). There is simply no good reason to put these 
organizations to that choice.
    There is also no valid policy reason for singling out trade 
associations for this treatment, but excluding other mutual-
benefit organizations such as labor unions, agricultural and 
horticultural organizations, and civic associations. All these 
types of organizations, although exempt from income tax under 
different provisions of the tax code, are essentially treated 
the same for tax purposes. Given this identity of treatment, it 
is not appropriate to single out organizations exempt from tax 
under section 501(c)(6) for this new investment tax.

                               CONCLUSION

    Mr. Chairman, thank you for the opportunity to appear 
before the Committee today. I will be pleased to respond to any 
questions.
      

                                

    Chairman Archer. Thank you, Mr. Tucker. I am constrained to 
inquire whether any of those promoters might be lawyers?
    Mr. Tucker. We think that there clearly may be some, but we 
always remember Pogo, ``We have met the enemy, and sometimes 
it's us.''
    Chairman Archer. OK. Mr. Sinclaire. If you will identify 
yourself for the record, you may proceed.

   STATEMENT OF WILLIAM T. SINCLAIRE, SENIOR TAX COUNSEL AND 
        DIRECTOR OF TAX POLICY, U.S. CHAMBER OF COMMERCE

    Mr. Sinclaire. Mr. Chairman, Members of the Committee, I am 
Bill Sinclaire and I am with the U.S. Chamber of Commerce. The 
U.S. Chamber of Commerce appreciates this opportunity to 
express its views on the revenue-raising provisions in the 
administration's fiscal year 2000 budget proposal and to make 
tax relief recommendations. The U.S. Chamber is the world's 
largest business federation, representing more than 3 million 
businesses and organizations of every size, sector and region. 
The breadth of this membership places the Chamber in a unique 
position to speak for the business community.
    On February 1, the administration released its budget 
proposal for fiscal year 2000. The proposed budget would 
increase taxes on businesses by approximately $80 billion over 
5 years, and it would keep tax receipts, as a percentage of 
Gross Domestic Product, at or above 20 percent. The Chamber 
believes the administration's budget proposal is fraught with 
revenue raisers that would impinge on or replace sound tax 
policy with a short-sighted call for additional tax revenue. 
The Federal budget surplus in fiscal year 2000 will be larger 
than at any time since 1951, and a strong economy with 
substantial payments from the business community have played a 
significant role in this budgetary success. It would make 
little sense to endorse $80 billion in tax increases when 
considering the increase is aimed at those who have greatly 
contributed to this foremost accomplishment.
    In addition, many of the revenue raisers in the 
administration's budget proposal lack a sound policy 
foundation. The Chamber recommends that Congress reject 
proposals that would increase taxes on the business community 
and do nothing to create jobs, increase the competitiveness of 
American businesses, or strengthen the U.S. economy. As we 
prepare for the economic challenges of the next century, we 
must orient our current tax policies in a way that minimizes 
their negative impact on taxpayers, overall economic growth, 
and the ability of American businesses to compete globally.
    Instead of asking for the adoption of proposals that would 
add to the Federal tax burden on the business community, the 
administration should be leading the way in reducing the 
encumbrance in a meaningful manner, especially when the Federal 
Government is collecting more taxes than it needs.
    Accordingly, the Chamber recommends that there be tax 
relief of at least the following:
    First, the individual and corporate alternative tax should 
be completely repealed.
    Second, although recently reduced for individuals, the 
capital gains tax should be reduced even further, and relief is 
still needed for corporations.
    Next, Federal estate and gift tax relief should be 
implemented by its immediate repeal or through its phase-out 
over several years.
    Furthermore, businesses should be able to expense the cost 
of their equipment purchases more rapidly. In particular, the 
small-business equipment expensing allowance should be 
increased.
    Moreover, the jobs of many U.S. workers are tied to the 
exports and foreign investments of U.S. businesses, and job 
growth is becoming increasingly dependent on expanded, 
competitive, and strong foreign trade. The Federal Tax Code 
restrains U.S. businesses from competing most effectively 
abroad, which in turn reduces economic growth in the United 
States. In this regard, there should be a permanent extension 
to the act of financing income exception to Subpart F, and a 
repeal of the limitation on the amount of receipts that defense 
product exporters may treat as exempt foreign trade income. In 
addition, the Chamber has supported the International Tax 
Simplification for American Competitiveness Act of 1998, 
including its substantively similar predecessors.
    Also, the research and experimentation tax credit needs to 
be further expanded and extended permanently so business can 
better rely on and utilize the credit.
    In addition, the existing Federal tax laws relating to S 
corporations need to be updated, simplified, and reformed.
    Finally, self-employed individuals can currently deduct 
only 60 percent of their health insurance costs. The deduction 
should be increased to 100 percent for 1999.
    In conclusion, our country's long-term economic health 
depends on sound economic and tax policies. The Federal tax 
burden on American businesses is too high, and needs to be 
reduced. Our Federal Tax Code wrongly favors consumption over 
savings and investment. As we continue to prepare for the 
economic challenges of the next century, we must align our tax 
policies in a way that encourages more savings, investment, 
productivity growth, and economic growth.
    Mr. Chairman, Members of the Committee, this concludes my 
prepared remarks, and thank you for allowing the U.S. Chamber 
to express its views.
    [The prepared statement follows:]

Statement of William T. Sinclaire, Senior Tax Counsel and Director of 
Tax Policy, U.S. Chamber of Commerce

    The U.S. Chamber of Commerce appreciates this opportunity 
to express its views on the revenue-raising provisions in the 
Administration's Fiscal Year 2000 budget proposal, and to make 
tax-relief recommendations. The U.S. Chamber is the world's 
largest business federation, representing more than three 
million businesses and organizations of every size, sector and 
region. This breadth of membership places the Chamber in a 
unique position to speak for the business community.

          Revenue Raisers in Administration's Budget Proposal

    On February 1, 1999, the Administration released its budget 
proposal for Fiscal Year 2000. The proposed budget would 
increase taxes on businesses by approximately $80 billion over 
five years (according to the Joint Committee on Taxation). 
Moreover, by the Administration's own admission, it would keep 
tax receipts, as a percentage of gross domestic product, at or 
above 20 percent for the foreseeable future.
    The Chamber believes the Administration's budget proposal 
is fraught with revenue raisers that would impinge on or 
replace sound tax policy with a shortsighted call for 
additional tax revenue. The federal budget surplus in FY 2000 
will be larger than at any time since 1951, and a strong 
economy with substantial tax payments from the business 
community have played a significant role in this budgetary 
success. It would make little sense to endorse $80 billion in 
tax increases, when considering the increase is aimed directly 
at those who have greatly contributed to this foremost 
accomplishment.
    In addition, many of the revenue raisers in the 
Administration's budget proposal lack a sound policy 
foundation. The Chamber recommends that Congress reject 
proposals that would increase taxes on the business community 
and do nothing to create jobs, increase the competitiveness of 
American businesses, or strengthen the U.S. economy. As we 
prepare for the economic challenges of the next century, we 
must orient our current tax policies in a way that minimizes 
their negative impact on taxpayers, overall growth, and the 
ability of American businesses to compete globally.
    The Administration's budget contains 16 separate proposals 
that are explicitly directed at so-called ``corporate tax 
shelters.'' These are in addition to many others that would 
amend specific federal tax code provisions that the 
Administration believes create unwarranted tax avoidance 
opportunities. The corporate tax shelter proposals are 
undefined in scope, overlap in coverage, violate principles of 
income measurement and would place virtually unlimited power in 
the hands of the Internal Revenue Service. If enacted, they 
would introduce unacceptable uncertainty regarding the tax 
consequences of even the most basic business transactions. This 
is not a situation with which the business community should be 
subjected.
    Included in, and in addition to the 16 corporate tax 
shelter provisions, the Administration's budget proposal 
contains numerous provisions that would raise revenue. By way 
of example, and not limitation, these objectionable provisions 
include the following:
    Replace Export Source-Rule With Activity-Based Rule--Under 
current law, if inventory is purchased or manufactured in the 
U.S. and sold abroad, 50 percent of the income is treated as 
earned by production activities (U.S.-source income) and 50 
percent by sales activities (foreign-source income). This law 
is beneficial to U.S. manufacturing companies that export 
overseas because it increases their ability to utilize foreign 
tax credits and alleviate double taxation. The Administration 
proposes that the allocation between production and sales 
activities be based on actual economic activity. This proposal, 
however, could increase U.S. taxes on export companies and, 
therefore, encourage them to produce their goods overseas, 
rather than in the United States.
    Capitalize Acquisition Costs--Insurance companies would be 
required to capitalize modified percentages of their net 
premiums for certain insurance contracts in order to more 
accurately reflect the ratio of actual policy acquisition 
expenses to net premiums and the typical useful lives of the 
contracts. This provision would increase the tax liabilities of 
insurance companies, which in turn would be passed on to its 
customers.
    Require Monthly Deposits Of Unemployment Taxes--Beginning 
in 2005, employers would be required to deposit their federal 
and state unemployment taxes monthly, instead of quarterly, if 
an employer's federal unemployment tax liability in the prior 
year was $1,100 or more. This provision, which would not bring 
in any additional revenue to the government, would impose an 
undue administrative burden on businesses, especially smaller 
businesses.
    Tax Net Investment Income Of Trade Associations--Trade 
associations, chambers of commerce, non-profit business leagues 
and professional sports leagues that have annual net investment 
income exceeding $10,000 would be subject to the unrelated 
business income tax on their excess net investment income. This 
provision, which does not apply to labor unions and other tax-
exempt entities, would groundlessly tax properly invested funds 
that would later be used to further the tax-exempt purposes of 
non-profit entities.
    Increase The Proration Percentage--Property and casualty 
insurance companies would have to increase the proration 
percentage on their funding of loss reserves by income that 
may, in whole or part, be exempt from tax. With the property 
and casualty industry investing 21 percent of their financial 
assets in, and holding about 14 percent of all tax-exempt debt, 
there could be a reduction in demand for tax-exempt debt and a 
rise in the interest rates of tax exempt obligations.
    Repeal Lower-Of-Cost-Or-Market Inventory Accounting 
Method--Taxpayers would no longer be able to value their 
inventories by applying the lower-of-cost-or-market accounting 
method or by writing down the cost of goods that are unsalable 
at normal prices or unusable in their usual way because of 
damage, imperfection or other similar causes. This provision 
would increase taxes on those businesses that use the ``first-
in-first-out'' method or cause them to switch to the ``last-in-
last-out'' method for both tax and financial statement 
purposes.
    Repeal The Installment Method For Accrual Basis Taxpayers--
The installment method of accounting (which allows a taxpayer 
to defer recognition of income on the sale of certain property 
until payments are received) would no longer be available for 
accrual basis taxpayers. This provision would cause taxpayers 
to either pay tax on gains which have not yet been received or 
convert to the cash basis.
    Modify The Corporate-Owned Life Insurance Rules--The 
Administration would repeal the exception under the corporate-
owned life insurance rules proration rules for contracts 
insuring employees, officers or directors (other than 20 
percent owners) of a business. This provision could have a 
devastating effect on life insurance products that protect 
businesses, especially small businesses, against financial loss 
caused by the death of their key employees.
    Deny Tax Benefits Resulting From Non-Economic 
Transactions--Proposals would increase the substantial 
understatement penalty for corporate taxpayers from 20 percent 
to 40 percent for items attributable to a corporate tax 
shelter, deny certain tax benefits obtained in a corporate tax 
shelter, deny deductions for certain tax advice, impose an 
excise tax on fees received in connection to corporate tax 
shelters, and impose an excise tax on certain tax benefit 
protection arrangements. These proposals unfairly target 
legitimate tax saving devices and related expenses and should 
be dismissed.
    Deny Deductions For Punitive Damages--No deduction would be 
allowed for punitive damages paid or incurred by a taxpayer, 
whether upon judgment or in settlement of a claim. In addition, 
where the punitive damages are paid by an insurance company, 
the taxpayer would be required to include in gross income the 
amount of damages paid on its behalf. This provision would deny 
businesses the ability to deduct legitimate business expenses 
relating to legal claims.
    Repeal Tax-Free Conversions Of Large C-Corporations To S-
Corporations--Under current law, the conversion of a C-
corporation to an S-corporation is generally tax-free. The 
``built-in'' gains of a corporation's assets are not taxed if 
the assets are not sold within 10 years of conversion. The 
Administration proposes to treat the conversion of a ``large'' 
C-corporation (those with a value exceeding $5 million) into an 
S-corporation as a taxable event to both the corporation (with 
respected to its appreciated assets) and its shareholders (with 
respect to their stock). This provision would prevent many C-
corporations that want to avoid double taxation from electing 
to be S-corporations.
    Eliminate Non-Business Valuation Discounts--Valuation 
discounts on the minority interests of family limited 
partnerships or limited liability companies would no longer be 
allowed for estate and gift tax purposes unless such entities 
are active businesses. This provision would make it more 
difficult for business owners to develop estate plans that 
would keep their businesses intact, and their employees 
working, after their deaths.
    Require The Recapture Of Policyholder Surplus Accounts--The 
Administration would require stock life insurance companies 
with policyholder surplus accounts to include in the income the 
amount in the account. This proposal is contrary to the intent 
of Congress in enacting current law.
    Modify Rules For Debt-Financed Portfolio Stock--This 
proposal by the Administration would effectively reduce the 
dividends-received deduction (the ``DRD'') for any corporation 
carrying debt (virtually all corporations) and would 
specifically target financial service companies, which tend to 
be more debt-financed. The purpose of the DRD is to eliminate, 
or at least alleviate, the impact of potential multiple layers 
of corporate taxation. However, this proposal would exacerbate 
the multiple taxation of corporate income, penalize investment, 
and mark a retreat from efforts to develop a more fair, 
rational, and simple tax system.
    Deny The DRD For Certain Preferred Stock--This is another 
proposal that would deny the DRD for certain types of preferred 
stock which the Administration believes are more like debt than 
equity. Although concerned that dividend payment from such 
preferred stock more closely resemble interest payment than 
debt, the proposal does not include a provision to allow 
issuers to take interest expense deductions on such payments. 
Accordingly, the instruments would be denied both equity and 
debt tax benefits.
    Reinstate Superfund Excise Taxes And The Environmental Tax 
On Corporate Income--Excise taxes which were levied on various 
petroleum products, chemicals and imported substances and 
dedicated to the Superfund Trust Fund would be reinstated 
through September 30, 2009. The corporate environmental income 
tax (which was also dedicated to the Superfund Trust Fund) 
would be reinstated through December 31, 2009. These taxes 
expired on December 31, 1995. These Superfund taxes should be 
thoroughly examined, evaluated and made part of a comprehensive 
plan to reform the Superfund program before they are 
reinstated.
    Defer Interest Deduction And Original Issue Discount On 
Certain Convertible Debt--The Administration has proposed to 
defer deductions for interest accrued on convertible debt 
instruments with original issue discount (``OID'') until the 
interest is paid in cash. However, these hybrid instruments and 
convertible OID bond instruments have allowed many U.S. 
companies to raise billions of dollars of investment capital. 
This proposal is contrary to sound tax policy that matches the 
accrual of interest income by holders of OID instruments with 
the ability of issuers to deduct accrued interest. Re-
characterizing these instruments as equity for tax purposes is 
fundamentally incorrect and would put American companies at a 
distinct disadvantage to their foreign competitors, which are 
not bound by such restrictions.
    Increase Taxes On Tobacco Sales--The Administration plans 
to propose tobacco legislation that would raise revenues of 
$34.5 billion over the next five years. Regardless of the 
Administration's altruistic motives to reduce teenage smoking, 
levying such a huge tax increase on a single industry would set 
a dangerous precedent for future tax increases on other 
industries.
    Convert Airport And Airway Excise Taxes To Cost-Based User 
Fees--Excise taxes which are currently levied on domestic and 
international air passenger transportation and domestic air 
freight transportation and deposited in the Airport and Airway 
Trust Fund would be reduced as new cost-based user fees for air 
traffic services are phased in beginning in 2000. The excise 
taxes would be reduced as necessary to ensure that the amount 
collected each year from the user fees and excise taxes is, in 
the aggregate, equal to the total budget resources requested 
for the Federal Aviation Administration in the succeeding year. 
A $5.3 billion tax increase on the business community and the 
public-at-large, especially before the issue of whether 
existing excise taxes should be replaced by cost-based user 
fees is fully debated, is unacceptable and should be thwarted.

                     Business Tax Relief is Needed

    Instead of asking for the adoption of proposals that would 
add to the federal tax burden on the business community, the 
Administration should be leading the way in reducing the 
encumbrance in a meaningful manner especially when the federal 
government is collecting more taxes than it needs. Accordingly, 
the Chamber recommends that there be tax relief in at least the 
following areas:
    Alternative Minimum Tax--Both the individual and corporate 
alternative minimum tax (``AMT'') negatively affect American 
businesses, particularly those that invest heavily in capital 
assets. The Taxpayer Relief Act of 1997 (the ``1997 Act'') 
exempts ``small business corporations'' from the corporate AMT, 
however, unincorporated businesses are still subject to the 
individual AMT, and larger corporations remain subject to the 
corporate AMT.
    While the Chamber supports the full repeal of both the 
individual and corporate AMT, to the extent complete repeal is 
not feasible, significant reforms should be enacted. Such 
reforms include providing a ``small business'' exemption for 
individual taxpayers; eliminating the depreciation adjustment; 
increasing the individual AMT exemption amounts; allowing 
taxpayers to offset their current year AMT liabilities with 
accumulated minimum tax credits; and making the AMT system less 
complicated and easier to comply with.
    Capital Gains Tax--Lower capital gains tax rates for both 
individuals and corporations would help maintain our growing 
economy by promoting capital investment and mobility. Although 
the 1997 Act reduced the maximum capital gains tax rate for 
individuals from 28 percent to 20 percent (10 percent for those 
in the 15-percent income-tax bracket), it should be reduced 
even further. In addition, capital gains tax relief is still 
needed for corporations, whose capital gains continue to be 
taxed at regular corporate income tax rates (to a maximum of 35 
percent).
    Estate and Gift Tax--The federal estate and gift tax is an 
inefficient, distortive tax that discourages saving, investment 
and job growth, unfairly penalizes small businesses, and 
accounts for little more than one percent of total federal 
revenues. It can deplete the estates of those who have saved 
their entire lives and force successful small businesses to 
liquidate or lay off workers. With a maximum rate of 55 
percent, the tax is confiscatory, and its compliance, planning 
and collection costs are extremely high in relationship to the 
tax collected (according to the Joint Economic Committee).
    The Chamber supports legislation introduced by 
Representative Cox (R-CA) and Senator Kyl (R-AZ), the Family 
Heritage Preservation Act (H.R. 86; S. 56), which would 
immediately repeal the estate and gift tax, as well as 
legislation introduced by Representatives Dunn (R-WA) and 
Tanner (D-TN) and Senator Campbell (R-CO), the Estate and Gift 
Tax Rate Reduction Act of 1999 (H.R. 8; S. 38), which would 
phase-out the tax over 11 years by annually reducing each rate 
of tax by five percentage points.
    Equipment Expensing--In order to spur additional investment 
in income-producing assets, businesses should be able to fully 
expense the cost of their equipment purchases in the year of 
purchase. In particular, the small business equipment expensing 
allowance--which is $19,000 for 1999 and scheduled to increase 
to $25,000 by 2003--should be increased or immediately 
accelerated to the $25,000 amount.
    Foreign Tax Rules--The jobs of many U.S. workers are tied 
to the exports and foreign investments of U.S. businesses and 
job growth is becoming increasingly dependent on expanded, 
competitive, and strong foreign trade. The current federal tax 
code restrains U.S. businesses from competing most effectively 
abroad--which in turn reduces economic growth in the U.S. While 
the 1997 Act contained some foreign tax relief and 
simplification measures, our foreign tax rules need to be 
further simplified and reformed so American businesses can 
better compete in today's global economy.
    The Chamber supported the International Tax Simplification 
for American Competitiveness Act of 1998 (H.R. 4173; S 2231), 
introduced by Representatives Houghton and Levin, and Senators 
Hatch and Baucus in the 105th Congress, and its substantively 
similar predecessors in the 105th and prior Congresses. The 
Chamber also supports legislation (H.R. 681), introduced by 
Representatives McCrery (R-LA) and Neal (D-MA), which would 
permanently extend the active financing income exception to 
Subpart F, and the Defense Jobs and Trade Promotion Act of 1999 
(H.R. 796), introduced by Representative S. Johnson (R-TX), 
which would repeal the limitation on the amount of receipts 
that defense product exporters may treat as exempt foreign 
trade income.
    Independent Contractor/Worker Classification--The 
reclassification by the Internal Revenue Service of workers 
from independent contractors to employees can be devastating to 
business owners, as it can subject them to large amounts of 
back federal and state taxes, penalties and interest. Existing 
classification rules must be simplified and clarified so 
disputes with the IRS are minimized. The Chamber has supported 
legislation that would provide more objective ``safe harbors'' 
for determining the status of a worker.
    Research and Experimentation Tax Credit--The research and 
experimentation (``R&E'') tax credit encourages companies to 
invest additional resources into the research, development and 
experimentation of products and services that benefit society 
as a whole. While the 1998 Omnibus Budget Bill extended this 
credit through June 30, 1999, it needs to be extended 
permanently, and further expanded, so businesses can better 
rely on and utilize the credit. The Chamber supports 
legislation (H.R. 835) introduced by Representatives Johnson 
(R-CT) and Matsui (D-CA) which expands and permanently extends 
the R&E tax credit.
    S-Corporation Reform--The existing federal tax laws 
relating to S-corporations need to be updated, simplified and 
reformed so small businesses can access more funds and better 
compete in today's economy. While various relief provisions 
were enacted in 1996, other reforms still need to be 
implemented, including the allowance of ``plain vanilla'' 
stock, elimination of ``excess passive investment income'' as a 
termination event, and modification of how certain fringe 
benefits are taxed to S corporation shareholders. The Chamber 
supports legislation introduced by Representative Shaw (R-FL), 
the Subchapter S Revision Act of 1999 (H.R. 689), which 
contains these and other measures.
    Self-Employed Health Insurance Deduction--Self-employed 
individuals can only deduct a portion of their health insurance 
costs each year (60 percent in 1999, 2000, 2001, 70 percent in 
2002, and 100 percent in 2003 and thereafter). The Chamber 
believes that the self-employed should be able to fully deduct 
their health insurance expenses in the year incurred.

                               Conclusion

    Our country's long-term economic health depends on sound 
economic and tax policies. The federal tax burden on American 
businesses is too high and needs to be reduced. Our federal tax 
code wrongly favors consumption over savings and investment. As 
we continue to prepare for the economic challenges of the next 
century, we must orient our tax policies in a way that 
encourages more savings, investment, productivity growth, and 
economic growth.
    The revenue-raising provisions contained in the 
Administration's Fiscal Year 2000 budget proposal would further 
increase taxes on businesses and reduce savings and investment. 
The U.S. Chamber urges that these provisions be rejected, and 
not included in any legislation.
      

                                

    Chairman Archer. Thank you, Mr. Sinclaire.
    Mr. Lifson, if you will identify yourself for the record, 
you may proceed.

 STATEMENT OF DAVID A. LIFSON, CHAIR, TAX EXECUTIVE COMMITTEE, 
       AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

    Mr. Lifson. My name is David Lifson. Thank you, Mr. 
Chairman. I am the chair of the Tax Executive Committee of the 
American Institute of CPAs. We are pleased to present our 
comments on selected revenue proposals in the President's 
fiscal year 2000 budget.
    Our members work daily with the tax provisions that you 
enact, and we are committed to helping make our tax system as 
simple and as fair as possible. The tax law is exceedingly 
difficult, and we help our clients cope with its complexity.
    Our involvement with taxpayers assists both the government 
and our clients by assuring that taxpayers pay their fair share 
of taxes but no more. Where the tax law is complex, we want to 
work with you to craft legislation that accomplishes your 
policy objectives with the least possible confusion and 
uncertainty for taxpayers.
    We have several major concerns about the administration's 
proposal. In recent years, tax legislation has increasingly 
included complex thresholds, ceiling, phase-ins, phase-outs, 
effective dates, and sunset dates in your efforts to provide 
benefits within the limits of revenue neutrality. The 
administration's budget tax proposals would increase complexity 
through the numerous proposed targeted credits.
    While we have no doubt that these credits are well-
intentioned, cumulatively, they would further weigh down our 
tax system. Many average taxpayers do not understand the 
benefit to which they are entitled, and while it is still 
early, we believe that many taxpayers will miss some of the 
benefits that you intended to deliver to them on their 1998 tax 
return.
    Other taxpayers are disappointed to learn that they do not 
qualify for benefits that they have heard about because complex 
fine-print phase-outs disqualify them. Taxpayers cannot be 
expected to plan, and they have trouble even complying with 
this level of complexity.
    We have provided you with a detailed recommendation for 
standard phase-ins and phase-outs. It would greatly simplify 
the tax law, particularly as it applies to middle-income 
families. This involves simplifying over 65 different 
provisions in the Tax Code in three concise areas.
    Another area that needs no complexity introduction, is the 
alternative minimum tax. We are concerned that while it is a 
good idea to enact the proposed credit, the proposed additional 
adjustment in the budget for the next 2 years, to keep the 
alternative minimum tax from encroaching on people for whom it 
was not intended.
    We ultimately encourage you to repeal the AMT. If you 
cannot find a way to repeal it, you need to greatly simplify 
it. I won't repeat the many wise comments that were made 
earlier that many of the elements that were left over in the 
AMT no longer serve their purpose.
    Another area that we are extremely concerned about is 
section 127, Education Exclusion. We think there needs to be 
certainty in education benefits, and we don't understand why 
that shouldn't be made a permanent change so students could 
plan 4-year careers with reasonable certainty about the tax 
law.
    We also applaud--we have some things we can applaud about 
the administration's proposals, especially the portability of 
retirement savings and pension plans. This is an area where we 
think it is important that citizens be given more 
responsibility for their own retirement savings, and is very 
consistent with the realities on the concerns of today's very 
mobile work force.
    The administration has proposed measures to curtail what 
are described as tax avoidance transactions. We oppose abuses 
of our tax system by improper activities, and believe that 
their restriction makes the tax system fairer for all. However, 
Congress should carefully examine the Treasury's proposals. 
Since we believe that part of abuse curtailment, the 
administration is recommending policies that are not properly 
focused and would not address the issues.
    Further, we know that you have instructed the IRS and 
Treasury and Joint Tax Committee to come up with a 
rationalization of the penalty and interest system. We think 
that is the place for penalty reform to be debated. We think 
that if penalties are not clearly understood by the 
participants, then they will not act as a deterrent for 
behavior that is objectionable to this Congress.
    We also oppose the administration's proposed tax on 
investment income of trade associations. The recommendation is 
not consistent with the general thrust of the tax law, and it 
would bring additional taxes and further layers of complexity 
to many small and medium-size business organizations.
    We thank you for the time to comment on some specific 
proposals. We have a lengthy submission with some solutions as 
well as raising problems.
    Thank you for your time, and we stand at the ready.
    [The prepared statement follows:]

Statement of David A. Lifson, Chair, Tax Executive Committee, American 
Institute of Certified Public Accountants

    Mr. Chairman, and members of this distinguished committee:
    My name is David A. Lifson, and I am the chair of the Tax 
Executive Committee of the American Institute of Certified 
Public Accountants (AICPA). I am pleased to present to you, 
today, our comments on selected revenue proposals in the 
President's fiscal year 2000 budget. The AICPA is the 
professional association of certified public accountants, with 
more than 330,000 members, many of whom provide comprehensive 
tax services to all types of taxpayers, including businesses 
and individuals, in various financial situations. Our members 
work daily with the tax provisions you enact, and we are 
committed to helping make our tax system as simple and fair as 
possible.
    The tax law is exceedingly difficult, and we help our 
clients cope with this complexity. Our involvement with 
taxpayers assists both client and government by assuring that 
taxpayers pay their fair share of taxes and no more. Where the 
tax law is complex, we want to work with you to craft 
legislation that accomplishes your objectives with the least 
possible confusion and uncertainty for taxpayers.
    We have several major concerns about the Administration's 
proposals. In recent years, tax legislation has increasingly 
included complex thresholds, ceilings, phase-ins, phase-outs, 
effective dates, and sunset dates in an effort to provide 
benefits as broadly as possible within the limits of revenue 
neutrality. The Administration's budget tax proposals, as 
drafted, continue this trend through the numerous proposed 
targeted credits. While these credits are well-intentioned, 
cumulatively they would further weigh down our tax system with 
complexity. Many average taxpayers do not understand the 
benefits to which they are entitled, and while it is still 
early, we believe that taxpayers will miss some of the benefits 
that you intended for them to take on their 1998 returns all 
too frequently. Other taxpayers are disappointed to learn that 
they do not qualify for benefits that they have heard about 
because of complex, fine-print phase-outs. Taxpayers cannot 
plan and they have trouble even complying with this complexity. 
Our statement below contains a recommendation for standard 
phase-ins and phase-outs that will greatly simplify the tax 
law, particularly as it applies to middle income families. 
Depending on the income levels of phase-ins and phase-outs, 
this proposal should not be unduly expensive, and would be a 
substantial improvement to our tax system. In the area of tax 
simplification, we also encourage you to consider alternatives 
to targeted tax credits and cuts, including an increased 
standard deduction, increased personal exemption amount, 
reduction of the income level at which current rates apply, and 
relief from the marriage penalty.
    The Administration's proposal extends, for two years, 
refundable credits against the individual alternative minimum 
tax to offset the application of AMT to middle-income taxpayers 
as a result of credits enacted in the Taxpayer Relief Act of 
1997. At that time, we brought these problems to your 
attention, and while we support the temporary relief the 
Administration proposes, we strongly encourage you to repeal 
the AMT or at least greatly simplify it. The AMT is a burden on 
our tax system, and this burden is increasingly being placed on 
middle-income taxpayers. We have included detailed 
recommendations for AMT simplification in our statement in the 
event you reject the cause for outright repeal.
    The Section 127 exclusion for employer-provided educational 
assistance needs to have greater stability in our tax law. 
While the temporary extension proposed in the budget is 
helpful, it does not provide the dependably consistent 
incentive that will encourage students to undertake the 
substantial personal and financial commitment necessary to 
prepare them for the future. Section 127 education benefits 
should be made permanent, not just extended.
    We applaud the Administration's proposals to improve the 
portability of retirement savings and pension plans. This helps 
citizens take greater responsibility for their retirement 
savings and is consistent with today's mobile workforce.
    The Administration has proposed measures to curtail what 
are described as ``tax avoidance transactions.'' We oppose 
abuses of our tax system by improper activities, and believe 
that their restriction makes the tax system fairer for all. 
However, Congress should carefully examine Treasury's 
proposals, since we believe, as part of abuse curtailment, the 
Administration is recommending standards that are not properly 
focussed or defined to address the issues. Many have already 
observed that the proposed standards are overly broad and 
vague. Further, new or enhanced penalties to encourage 
compliance in this area should be considered as part of the 
penalty study presently being undertaken by the Joint Tax 
Committee staff and the Treasury Department, not just as add-
ons to an already patchwork tax penalty structure. We would be 
happy to work with Congress and the Treasury in distinguishing 
between legitimate tax planning and improper tax activities.
    We oppose the Administration's proposal to tax investment 
income of trade associations. This recommendation is not 
consistent with the general thrust of the tax law in making 
these organizations exempt and is not consistent with sound 
business practices of trade associations. The proposal would 
bring additional taxes and complexity to many small and medium-
sized organizations.
    The AICPA has not fully completed its review of the 
Administration's budget tax proposals. We have commented on 
some specific proposals below and hope to provide additional 
comments as soon as our committees complete their work. We 
appreciate this opportunity to provide comments and would be 
happy to answer any questions. Please contact David Lifson, 
Chair of the Tax Executive Committee, or Gerald Padwe, Vice-
President-Taxation of the AICPA, if we can be of assistance. 
Thank you for considering our comments.

              I. INDIVIDUAL INCOME TAX PROPOSALS GENERALLY

    The Administration's revenue proposals contain numerous 
provisions affecting individuals, such as: a new long-term care 
credit, a new disabled workers tax credit, the child and 
dependent care tax credit expansion, the employer-provided 
educational assistance exclusion extension, a new energy 
efficient new homes credit, the electric vehicles credit 
extension, AMT relief extension, a new D.C. homebuyers credit, 
optional self-employment contributions computations, a new 
severance pay exemption, a new rental income inclusion, etc. 
While we are not commenting on the policy need for these 
provisions, we note that Congress must consider the general 
administrability of these provisions.
    We are very concerned about the increasing complexity of 
the tax law as a result of targeted individual tax cuts. The 
1997 Taxpayer Relief Act contained several targeted individual 
tax cuts that were first effective for 1998 individual income 
tax returns. As discussed in the Wall Street Journal of 
February 17, 1999, these provisions, while providing tax relief 
to certain individuals, have greatly increased the complexity 
of the preparation of individual income tax returns. This 
increased compliance burden is born mostly by lower income 
taxpayers who can least afford the cost of hiring a 
professional income tax return preparer.
    IRS National Taxpayer Advocate W. Val Oveson, in his first 
report to Congress, stated that increasing tax law complexity 
is imposing significant compliance and administrative burdens 
on the IRS and taxpayers. The report also cited the increasing 
complexity caused by the targeted individual tax cuts contained 
in the 1997 Taxpayer Relief Act.
    The Administration's tax proposals contain 28 new targeted 
tax cuts. Many of these provisions have limited applicability; 
none are available to high-income taxpayers. Unfortunately, the 
way these provisions are drafted with different income limits 
for each provision, taxpayers need to make many additional tax 
calculations just to determine if they are eligible for the tax 
benefit. The Administration's tax proposals will add several 
additional income limits to the Internal Revenue Code.
    Below are a few examples of provisions in the 
Administration's tax proposals that have different phase-out 
limits:
     The long-term care credit and disabled workers tax 
credit would be phased out ``by $50 for each $1,000 (or 
fraction thereof) by which the taxpayer's modified AGI 
exceeds'' $110,000 (married filing a joint return taxpayers), 
$75,000 (single/head of household), or $55,000 married filing 
separate.
     The first-time D.C. homebuyers credit phases out 
for individuals with AGI between $70,000 and $90,000 ($110,000 
to $130,000 for joint filers).
     The severance pay exemption would not apply if the 
total severance payments received exceed $75,000.
     The expanded child and dependent care credit 
proposal would allow taxpayers the 50 percent credit rate if 
their AGI is $300,000 or less, then the credit rate would be 
reduced by one percentage point for each additional $1,000 of 
AGI in excess of $300,000, and taxpayers with AGI over $59,000 
would be eligible for a 20 percent credit rate.
     The student loan interest deduction (to which the 
President's proposal would eliminate the current 60-month 
limit) phases out ratably for single taxpayers with AGI between 
$40,000 and $55,000 and between $60,000 and $75,000 for married 
filing a joint return taxpayers.
    This type of law, with so many different phase-out limits, 
provides incredible challenges for middle-income taxpayers, in 
determining how much of what benefit they are entitled to. We 
suggest common phase-out limits among all individual tax 
provisions in order to target benefits to one of three uniform 
groups and simplify the law. Our phase-out simplification 
proposal is attached.
    Another problem with these targeted tax cuts is that the 
impact of the alternative minimum tax (AMT) on these cuts is 
not adequately addressed. This is evidenced by the provision in 
the 1998 IRS Restructuring and Return Act and the provision in 
the Administration's tax proposals that provide temporary 
relief from the AMT for individuals qualifying for some of the 
targeted tax credits. We believe that the individual 
alternative minimum tax needs to be simplified; our proposal is 
attached.
    Finally, much of the complexity in the individual income 
tax system is the result of recent efforts to provide 
meaningful tax relief to medium and low-income taxpayers. In 
order to aid simplification, we believe that Congress should 
consider alternatives to targeted tax cuts, including the new 
ones proposed by the Administration, with provisions such as 
the following:
     Increased standard deduction.
     Increased amount for personal exemptions.
     Increasing the taxable income level where the 28 
percent tax and the 31 percent tax rate begins.
     Marriage penalty relief.
    The AICPA would like to further study the complexity caused 
by the proliferation of credits with their complex provisions, 
and hopes to provide further specific comments as this 
legislation progresses.

Phase-Outs Based on Income Level

    Present Law.--Numerous sections in the tax law provide for 
the phase-out of benefits from certain deductions or credits 
over various ranges of income based on various measures of the 
taxpayer's income. There is currently no consistency among 
these phase-outs in either the measure of income, the range of 
income over which the phase-outs apply, or the method of 
applying the phase-outs. Furthermore, the ranges for a 
particular phase-out often differ depending on filing status, 
but even these differences are not consistent. For example, the 
traditional IRA deduction phases out over a different range of 
income for single filers than it does for married-joint filers; 
whereas the $25,000 allowance for passive losses from rental 
activities for active participants phases out over the same 
range of income for both single and married-joint filers. 
Consequently, these phase-outs cause inordinate complexity, 
particularly for taxpayers attempting to prepare their tax 
returns by hand; and the instructions for applying the phase-
outs are of relatively little help. See the attached Exhibit 
for a listing of most current phase-outs, including their 
respective income measurements, phase-out ranges (for 1998) and 
phase-out methods.
    Note that currently many the phase-out ranges for married-
filing-separate (MFS) taxpayers are 50 percent of the range for 
married-filing-joint (MFJ), while many of the phase-out ranges 
for single and head of household (HOH) taxpayers are 75 percent 
of married-joint. That causes a marriage penalty when the 
spouses' incomes are relatively equal.
    Recommended Change.--True simplification could easily be 
accomplished by eliminating phase-outs altogether. However, if 
that is considered either unfair (simplicity is often at odds 
with equity) or bad tax policy, significant simplification can 
be achieved by creating consistency in the measure of income, 
the range of phase-out (including as between filing statuses) 
and the method of phase-out.
    Instead of the approximately 20 different phase-out ranges 
(shown in attached Exhibit A), there should only be three--at 
levels representing low, middle, and high income taxpayers.
    If there are revenue concerns, the ranges and percentages 
could be adjusted, as long as the phase-outs for each income 
level group (i.e., low, middle, high income) stayed consistent 
across all relevant provisions. In addition, marriage penalty 
impact should be considered in adjusting phase-out ranges for 
revenue needs.
    We propose that, in an effort to eliminate the marriage 
penalty and simplify the Code, all phase-out ranges for 
married-filing-separate (MFS) taxpayers should be the same as 
those for single and head of household (HOH) taxpayers, which 
would be 50 percent of the range for married-filing-joint (MFJ) 
range.
    The benefits that are specifically targeted to low-income 
taxpayers, such as the earned income credit, elderly credit, 
and dependent care credit, would phase-out under the low-income 
taxpayer phase-out range. The benefits that are targeted to low 
and middle income taxpayers, such as the traditional IRA 
deduction and education loan interest expense deduction, would 
phase-out under the middle-income taxpayer phase-out range. 
Likewise, those benefits that are targeted not to exceed high 
income levels, such as the new child credit, the new education 
credits and Education IRA, and the new Roth IRA, as well as the 
existing law AMT exemption, itemized deductions, personal 
exemptions, adoption credit and exclusion, series EE bond 
exclusion, and section 469 $25,000 rental exclusion and credit, 
would phase-out under the high-income taxpayer phase-out range. 
See the chart below.

       Proposed Adjusted Gross Income Level Range for Beginning to End of Phase-Out for Each Filing Status
----------------------------------------------------------------------------------------------------------------
                  Category of Taxpayer                       Married Filing Joint         Single & HOH & MFS
----------------------------------------------------------------------------------------------------------------
LOW-INCOME..............................................           $ 15,000-$ 37,500            $ 7,500-$ 18,750
MIDDLE-INCOME...........................................           $ 60,000-$ 75,000           $ 30,000-$ 37,500
HIGH-INCOME.............................................           $225,000-$450,000          $ 112,500-$225,000
----------------------------------------------------------------------------------------------------------------

                                                                            EXHIBIT A--Selected AGI Phase-Out Amounts
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                                                             Proposed--Single &
           IRC Section                   Provision              Ft nt.             Current-Joint      Current--Single & HOH  Current--Married/Sep.      Proposed-Joint           HOH & MFS
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                            PHASE-OUT LEVELS FOR LOW-INCOME TAXPAYERS

------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
21...............................  30 Percent Dependent  (3).................        $10,000-$20,000        $10,000-$20,000  No credit............        $15,000-$37,500         $7,500-$18,750
                                    Care Credit.
22...............................  Elderly Credit......  (4).................        $10,000-$25,000         $7,500-$17,500  $5,000-$12,500.......        $15,000-$37,500         $7,500-$18,750
32...............................  EITC (No Child).....  (2,3,4).............         $5,570-$10,030                $10,030  No credit............        $15,000-$37,500         $7,500-$18,750
32...............................  EITC (1 Child)......  (2,3,4).............        $12,260-$26,473        $12,260-$26,473  No credit............        $15,000-$37,500         $7,500-$18,750
32...............................  EITC (2 or More       (2,3,4).............        $12,260-$30,095        $12,260-$30,095  No credit............        $15,000-$37,500         $7,500-$18,750
                                    Children).
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                          PHASE-OUT LEVELS FOR MIDDLE-INCOME TAXPAYERS

------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
219..............................  IRA Deduction w/      (1,7,9).............        $50,000-$60,000        $30,000-$40,000  No deduction.........        $60,000-$75,000        $30,000-$37,500
                                    retirement plan.
221..............................  Education Loan        (1,2,6).............        $60,000-$75,000        $40,000-$55,000  No deduction.........        $60,000-$75,000        $30,000-$37,500
                                    Interest Exp..
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                           PHASE-OUT LEVELS FOR HIGH-INCOME TAXPAYERS

------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
24...............................  Child Credit........  (1,5,6).............              $110,000-               $75,000-  $55,000-.............      $225,000-$450,000      $112,500-$225,000
25A..............................  Hope Credit &         (1,2,6).............       $80,000-$100,000        $40,000-$50,000  No credit............      $225,000-$450,000      $112,500-$225,000
                                    Lifetm. Lrng. Cr..
23 & 137.........................  Adoption Credit/      (1,7)...............       $75,000-$115,000       $75,000-$115,000  No benefit...........      $225,000-$450,000      $112,500-$225,000
                                    Exclusion.
55(d)............................  AMT Exemption.......  (1,8)...............      $150,000-$330,000      $112,500-$247,500  $75,000-$165,000.....      $225,000-$450,000      $112,500-$225,000
68...............................  Itemized Deduction    (2).................              $124,500-              $124,500-  $62,250-.............      $225,000-$450,000      $112,500-$225,000
                                    level.
135..............................  EE Bond int.          (1,2,7).............       $78,350-$108,350        $52,250-$67,250  No exclusion.........      $225,000-$450,000      $112,500-$225,000
                                    Exclusion.
151..............................  Personal Exemption..  (2).................      $186,800-$309,300      $124,500-$247,000  $93,400-$154,650.....      $225,000-$450,000      $112,500-$225,000
                                                                                                       HOH$155,650-$278,150
219(g)(7)........................  IRAw/spouse w/        (1,6,7).............      $150,000-$160,000         Not applicable  No deduction.........      $225,000-$450,000      $112,500-$225,000
                                    retrmt.plan.
408A.............................  Roth IRA Deduction..  (1,6)...............      $150,000-$160,000       $95,000-$110,000  No deduction.........      $225,000-$450,000      $112,500-$225,000
408A.............................  IRA to Roth IRA       (1,6,7).............               $100,000               $100,000  No rollover..........      $225,000-$450,000      $112,500-$225,000
                                    Rollover.
469(i)...........................  $25,000 Rent Passive  (1,7)...............      $100,000-$150,000      $100,000-$150,000  $50,000-$75,000......      $225,000-$450,000      $112,500-$225,000
                                    Loss.
469(i)...........................  Passive Rehab.        (1,7)...............      $200,000-$250,000      $200,000-$250,000  $100,000-$125,000....      $225,000-$450,000      $112,500-$225,000
                                    Credit.
530..............................  Education IRA         (1,6)...............      $150,000-$160,000       $95,000-$110,000  No deduction.........      $225,000-$450,000      $112,500-$225,000
                                    Deduction.
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Footnotes: (1) Modifications to AGI apply; (2) Inflation indexed; (3) Earned income limitations; (4) Low income only; (5) Phase-out range depends on number of children; (6) Newly enacted in
  1997; (7) Also see section 221(b)(2); (8) Phase-out applies to alternative minimum taxable income rather than AGI; (9) Increases for future years are specifically provided in the statute.

    Additionally, instead of the differing methods of phase-
outs (shown in attached Exhibit B), the phase-out methodology 
for all phase-outs would be the same, such that the benefit 
phases out evenly over the phase-out range. Every phase-out 
should be based on adjusted gross income (AGI).

                 EXHIBIT B--Current Method of Phase-Out
------------------------------------------------------------------------
                                                 Current Methodology for
       Code Section(s)          Tax Provision    Phase-outs Application
------------------------------------------------------------------------
21...........................  Dependent Care   Credit percent reduced
                                Credit.          from 30 percent to 20
                                                 percent in AGI range
                                                 noted by 1 percent
                                                 credit for each $2,000
                                                 in income
22...........................  Elderly Credit.  Credit amount reduced by
                                                 excess over AGI range
23 & 137.....................  Adoption Credit  Benefit reduced by
                                & Exclusion.     excess of modified AGI
                                                 over lowest amount
                                                 noted divided by 40,000
24...........................  Child Credit...  Credit reduced by $50
                                                 for each $1,000 in
                                                 modified AGI over
                                                 lowest amount divided
                                                 by 10,000 (single) and
                                                 20,000 (joint)
25A..........................  Education        Credits reduced by
                                Credits (Hope/   excess of modified AGI
                                Lifetime         over lowest amount
                                Learning).       divided by 10,000
                                                 (single) and 20,000
                                                 (joint)
32...........................  Earned Income    Credit determined by
                                Credit.          earned income and AGI
                                                 levels
55...........................  AMT Exemption..  Exemption reduced by \1/
                                                 4\ of AGI in excess of
                                                 lowest amount noted
68...........................  Itemized         Itemized deductions
                                Deductions.      reduced by 3 percent of
                                                 excess AGI over amount
                                                 noted
135..........................  Series EE Bonds  Excess of modified AGI
                                                 over lowest amount
                                                 divided by 15,000
                                                 (single), 30,000
                                                 (joint) reduces
                                                 excludable amount
151..........................  Personal         AGI in excess of lowest
                                Exemption.       amount, divided by
                                                 2,500, rounded to
                                                 nearest whole number,
                                                 multiplied by 2, equals
                                                 the percentage
                                                 reduction in the
                                                 exemption amounts
219..........................  Traditional IRA  Individual retirement
                                w/ Retirement    account (IRA)
                                Plan.            limitation ($2,000/
                                                 $4,000) reduced by
                                                 excess of AGI over
                                                 lowest amount noted
                                                 divided by $10,000
219(g)(7)....................  IRA w/Spouse w/  Deduction for not active
                                Retiremt. Plan.  spouse reduced by
                                                 excess of modified AGI
                                                 over lowest amount
                                                 noted divided by 10,000
221..........................  Education Loan   Deduction reduced by
                                Interest         excess of modified AGI
                                Expense          over lowest amount
                                Deduction.       noted divided by 15,000
408A.........................  Roth IRA.......  Contribution reduced by
                                                 excess of modified AGI
                                                 over lowest amount
                                                 noted divided by 15,000
                                                 (single) and 10,000
                                                 (joint)
408A.........................  IRA Rollover-    Rollover not permitted
                                Roth IRA.        if AGI exceeds 100,000
                                                 or if MFS
469(i).......................  Passive Loss     Benefit reduced by 50
                                Rental $25,000   percent of AGI over
                                Rule.            lowest amount noted
530..........................  Education IRA    Contribution reduced by
                                Deduction.       excess of modified AGI
                                                 over lowest amount
                                                 noted divided by 15,000
                                                 (single) and 10,000
                                                 (joint)
------------------------------------------------------------------------

    Contribution to Simplification.--The current law phase-outs 
complicate tax returns immensely and impose marriage penalties. 
The instructions related to these phase-outs are difficult to 
understand and the computations often cannot be done by the 
average taxpayer by hand. The differences among the various 
phase-out income levels are tremendous. Either we should 
eliminate phase-outs and accomplish the same goal with a lot 
less complexity by adjusting rates, or at least make the phase-
outs applicable at consistent income levels (only three) and 
apply them to consistent ranges and use a consistent 
methodology. This would ease the compliance burden on many 
individuals. If there were only three ranges to know and only 
one methodology, it would be easier to recognize when and how a 
phase-out applies. Portions of numerous Internal Revenue Code 
sections could be eliminated. By making the MFJ phase-out 
ranges double the ranges applicable to single individuals, and 
by making the MFS ranges the same as single individuals, the 
marriage penalty associated with phase-out ranges would be 
eliminated.

Alternative Minimum Tax Proposal

    Background on AMT.--The budget proposals would extend, for 
two years, the availability of refundable credits against the 
individual alternative minimum tax. Thus, this issue has now 
joined the list of ``extenders'' or ``expiring provisions'' 
which Congress must address every few years, searching for the 
revenues to prevent some tax inequity (as here) or maintain 
some tax incentive.
    We are clearly pleased to support this proposal, but we 
would caution the Congress (as we have in the past) that there 
are many more issues with the individual AMT that need to be 
addressed. Some of these issues are discussed below.
    Complexity of AMT.--The AMT is one of the most complex 
parts of the tax system. Each of the adjustments of Internal 
Revenue Code (IRC) section 56, and preferences of IRC section 
57, requires computation of the income or expense item under 
the separate AMT system. The supplementary schedules used to 
compute many of the necessary adjustments and preferences must 
be maintained for many years to allow the computation of future 
AMT as items turn around.
    Generally, the fact that AMT cannot always be calculated 
directly from information on the tax return makes the 
computation extremely difficult for taxpayers preparing their 
own returns. This complexity also calls into question the 
ability of the Internal Revenue Service (IRS) to audit 
compliance with the AMT. The inclusion of adjustments and 
preferences from pass-through entities also contributes to the 
complexity of the AMT system.
    Effects of the Taxpayer Relief Act of 1997 and AMT on 
Individual Taxpayers.--If the Administration's budget proposal 
on temporary AMT relief expansion is not enacted, several tax 
credits included in the Taxpayer Relief Act of 1997 will have a 
dramatic impact on the number of individuals who will find 
themselves subject to the alternative minimum tax (AMT). For 
many, this will come as a real surprise and, in all likelihood, 
will cause substantial problems for the IRS, which will have to 
redirect significant resources to this area in the future to 
ensure compliance, educate taxpayers, and handle taxpayer 
questions. We believe the Administration's proposal should be 
for permanent AMT relief rather than just temporary two-year 
relief.
    Most sophisticated taxpayers understand that there is an 
alternative tax system, and that they may sometimes wind up in 
its clutches; unsophisticated taxpayers, however, may never 
have even heard of the AMT, certainly do not understand it, and 
do not expect to ever have to worry about it. Unfortunately, 
that is changing--and fairly rapidly--since a number of the 
more popular items, such as the education and child credits 
that were recently enacted, offset only regular tax and not 
AMT. Due to these changes, we believe it is most important that 
Congress obtain information (from Treasury, the Joint Committee 
on Taxation staff, or OMB) not only as to the revenue impact of 
the interaction of all these recent tax changes with the AMT, 
but also of the likely number of families or individuals that 
will be paying AMT as a result of the 1997 tax legislation.
    Indexing the AMT Brackets and Exemption.--While the AICPA 
has not undertaken detailed studies, we have all seen, during 
the past year, anecdotal examples indicating the likelihood 
that taxpayers with adjusted gross incomes in the $60,000-
$70,000 range (or below) will be subject to AMT. Aside from the 
fairness issues involved--this is not the group that the AMT 
has ever been targeted to hit--we see some potentially serious 
compliance and administration problems. Many of these taxpayers 
have no idea that they may be subject to the AMT (if, indeed, 
they are even aware that there is an AMT). Thus, we anticipate 
large numbers of taxpayers not filling out a Form 6251 or 
paying the AMT who may be required to do so, thus requiring 
extra enforcement efforts on the part of the IRS to make these 
individuals (most of whom will be filing in absolute good 
faith) aware of their added tax obligations. Further, IRS 
notices to these taxpayers assessing the proper AMT may well be 
perceived as unfair, subjecting the IRS to unfair criticism 
that should be directed elsewhere.
    Individual AMT Recommendations.--We recognize that there is 
no simple solution to the AMT problem given the likely revenue 
loss to the government. As a start, however, Congress should 
consider:
    1. Increasing and/or indexing the AMT brackets and 
exemption amounts.
    2. Eliminating itemized deductions and personal exemptions 
as adjustments to regular taxable income in arriving at 
alternative minimum taxable income (AMTI) (e.g., all--or 
possibly a percentage of--itemized deductions would be 
deductible for AMTI purposes).
    3. Eliminating many of the AMT preferences by reducing for 
all taxpayers the regular tax benefits of AMT preferences 
(e.g., require longer lives for regular tax depreciation).
    4. Allowing certain regular tax credits against AMT (e.g., 
low-income tax credit, tuition tax credits)--permanently, 
rather than just for the next two years.
    5. Providing an exemption from AMT for low and middle-
income taxpayers with regular tax AGI of less than $100,000.
    6. Considering AMT impact in all future tax legislation.
    Due to the increasing complexity, compliance problems, and 
a perceived lack of fairness towards the intended target, an 
additional alternative Congress might also want to consider is 
eliminating the individual AMT altogether.
    Contribution to Simplification of AMT.--The goal of 
fairness that is the basis for AMT has created hardship and 
complexity for many taxpayers who have not used preferences to 
lower their taxes but have been caught up in the system's 
attempt to bring fairness. Many of these individuals are not 
aware of these rules and complete their return themselves, 
causing confusion and errors. The 1997 law and the impact of 
inflation on indexed tax brackets and the AMT exemption are 
causing more lower income taxpayers to be inadvertently subject 
to AMT. Increasing and/or indexing the AMT brackets and 
exemption (recommendation 1) would solve this problem.
    Under recommendation 2, those individuals who are affected 
only by itemized deductions and personal exemption adjustments 
would no longer have to compute the AMT. Itemized deductions 
are already reduced by the 3 percent AGI adjustment, 2 percent 
AGI miscellaneous itemized deduction disallowance, 7.5 percent 
AGI medical expense disallowance, $100 and 10 percent AGI 
casualty loss disallowance, and the 50 percent disallowance for 
meals and entertainment. Similarly, the phase out of exemptions 
already affects high-income taxpayers. It is also worth noting 
that because state income taxes vary, taxpayers in high income 
tax states may incur AMT solely based on the state in which 
they live, while other taxpayers with the same adjusted gross 
income (AGI), but who live in states with lower or no state 
income taxes, would not pay AMT. This results in Federal tax 
discrimination against residents of high tax states.
    In addition, under recommendation 3, many of the AMT 
preferences could be eliminated by reducing for all taxpayers 
the regular tax benefits of present law AMT preferences (e.g., 
require longer lives for regular tax depreciation). This would 
add substantial simplification to the Code, recordkeeping and 
tax returns.
    Under recommendation 4, those who are allowed regular tax 
credits, such as the low income or tuition tax credits, would 
be allowed to decrease their AMT liability by the credits. This 
would increase simplicity and create fairness. Compliance would 
be improved.
    Under recommendation 5, fewer taxpayers will be subject to 
AMT and the associated problems. By increasing the AMT 
exemption to exclude low and middle income taxpayers, the AMT 
will again be aimed at its original target--the high-income 
taxpayer.
    By eliminating AMT altogether, all the individual AMT 
problems would be solved.
    Conclusion on AMT.--In conclusion, we see the AMT as 
becoming more prevalent and causing considerable disillusion to 
many taxpayers whom do not see themselves as wealthy and who 
will believe they are being punished unfairly. The AMT will 
apply to many taxpayers it was not originally intended to 
affect. We believe our proposals offer a wide range of ways to 
help address this problem.

     I.B.2--Exclusion For Employer-Provided Educational Assistance

    Section 127 allows workers to exclude up to $5,250 a year 
in employer reimbursements or direct payments for tuition, 
fees, and books for certain courses. This exclusion expires on 
June 1, 2000. The President's proposal would extend the Section 
127 exclusion for eighteen months for both undergraduate and 
graduate courses.
    We support extension of the Section 127 exclusion and 
encourage Congress to consider making it a permanent part of 
the tax code. We also support re-inclusion of graduate-level 
courses as expenses qualifying for the exclusion. Expanding and 
making Section 127 a permanent part of the tax code would 
remove the uncertainty and ambiguity that employees and 
employers now regularly face.
    Evidence indicates that Section 127 has met the broad 
policy goals for which it was designed. It has provided 
incentive for upward mobility of employees who might not 
otherwise choose or be able to afford to return to school to 
improve their skills and educational qualifications. It has 
reduced complexity in the tax law because it does not require a 
distinction between job-related and non-job related educational 
assistance. Further, it has also reduced possible inequities 
among taxpayers by allowing lower-skilled employees, on a 
nondiscriminatory basis, eligibility for the exclusion without 
worry about the job-related test.
    Complexity could be further reduced by making Section 127 
permanent thereby eliminating the periodic rolling forward of 
the expiration date and the need for retroactive reinstatement. 
This is particularly troublesome to students who are planning a 
multi-year education program and cannot plan on consistent 
after-tax costs throughout their education. These students are 
often on a tight budget and find it difficult to plan for and 
implement full-degree programs.
    The continued education and increased competence of the 
U.S. worker are critical to surpassing the challenges of an 
international marketplace.

     I.F.13-17--Promote Expanded Retirement Savings, Security, and 
                              Portability

    The President's budget contains five provisions to increase 
pension portability, the ability to roll over retirement 
savings between pension plans. The AICPA supports these 
provisions and commends the Administration for addressing a 
complex area of the tax law that is becoming increasingly 
utilized given our mobile workforce. These provisions would 
simplify planning and reduce the pitfalls and penalties that 
taxpayers run afoul of in attempting to comply with the current 
rules.
    Under the budget proposal:
    An eligible rollover distribution from a qualified 
retirement plan could be rolled over to a qualified retirement 
plan, a Code section 403 (b) annuity, or a traditional IRA. 
Likewise, an eligible rollover distribution from a Section 403 
(b) annuity could be rolled over to another Section 403 (b) 
annuity, a qualified retirement plan, or a traditional IRA. The 
conduit IRA rules would be modified similarly.
    Individuals who have a traditional IRA and whose IRA 
contributions have been tax deductible would be allowed to 
transfer funds from their traditional IRA into their qualified 
defined benefit retirement plan or Section 403(b) annuity, 
provided that the retirement plan trustee meets the same 
standards as an IRA trustee.
    After-tax employee contributions to a qualified retirement 
plan could be included in a rollover contribution to a 
traditional IRA or another qualified retirement plan, provided 
that the plan or IRA provider agrees to track and report the 
after-tax portion of the rollover for the individual. 
Distributions of the after-tax contributions would continue to 
be nontaxable.
    Individuals would be permitted to roll over distributions 
from a governmental Section 457 plan to a traditional IRA.
    State and local employees would be able to use funds from 
their Section 403 (b) annuities or government Section 457 plans 
to purchase service credits through a direct transfer without 
first having to take a taxable distribution of these amounts.
    In addition, there are numerous other pension provisions 
from previous budget proposals which the AICPA supports. These 
provisions would: Make it easier for workers to contribute to 
IRAs through payroll deduction at work; provide a three-year 
small business tax credit to encourage them to start up 
retirement programs; create a new simplified defined benefit 
pension plan (The SMART Plan-Secure Money Annuity or Retirement 
Trust Plan); provide faster vesting of employer matching 
contributions; improve pension disclosure; improve benefits of 
non-highly compensated employees under Section 401 (k) safe 
harbor plans; simplify the definition of highly compensated 
employee; simplify full-funding limitations and Section 415 
benefit limits for multi-employer plans, and eliminate partial 
termination rules for multi-employer plans. All of these 
provisions would assist taxpayers in setting up retirement 
plans and improve the overall rate of savings in the U.S.
    The AICPA supports these recommendations and believes that 
Congress should consider further efforts to encourage 
retirement savings and investment, including making personal 
financial planning more available to employees through employee 
benefits plans.

 I.H.7--Simplify the Active Trade or Business Requirement for Tax-Free 
                               Spin-Offs

    The AICPA supports the Administration's proposal to improve 
the operation of Section 355. This is a longstanding one, well-
known to the corporate tax community. Current law poses trouble 
for taxpayers: for the unwary, a trap; for the well-advised, 
sometimes a costly (and economically unproductive) detour.
    The problem lies in the statute itself, which accommodates 
pure holding companies, but not hybrids. In applying the 
``active conduct'' test to holding companies, Section 
355(b)(2)(A) requires that ``substantially all'' of its assets 
consist of stock (and securities) of controlled subsidiaries 
that are themselves engaged in the ``active conduct,'' etc. The 
``substantially all'' requirement is not defined in either 
statute or regulations. The IRS has defined it, in the context 
of an advance ruling, as 90% of gross assets. This raises a 
very high threshold for holding companies, one that can be met 
only by pure (or virtually so) holding companies.
    The unwary taxpayer will make a distribution to 
shareholders that may wind up as a tax controversy. The well-
advised taxpayer will take a detour. The objective of the 
detour is to convert the hybrid holding company into an 
operating company. This can usually be accomplished, so long as 
the holding company has at least one controlled subsidiary that 
meets the ``active conduct'' test. For example, the holding 
company can cause the controlled subsidiary to be completely 
liquidated, so that the latter's active business is now 
operated directly by the holding company. From an economic 
perspective, this step is meaningless because it shouldn't 
matter whether a business is conducted directly or indirectly. 
But the step is a tax cure-all because, unlike a holding 
company, an operating company is not subject to a quantitative 
test. Rather, the latter is subject to a qualitative test: is 
it operating an active business?
    There is no apparent reason for the statute's asymmetric 
approach to holding companies and operating companies, 
respectively. According to IRS advance ruling guidelines, at 
least 90% of a holding company's gross assets must be invested 
in qualifying assets, i.e., stock in controlled subsidiaries 
that are engage in the active conduct,'' etc. On the other 
hand, according to the IRS advance ruling guidelines, an 
operating company need have as little at 5% of its gross assets 
invested in the active business.
    The Administration's proposal would address this lack of 
symmetry by treating an affiliated group as a single taxpayer. 
No longer would a hybrid holding company be forced to relocate 
an active business within its corporate family in order to meet 
the ``active conduct'' requirement. This amendment is entirely 
consistent with the prevailing, single-entity theory of 
consolidated returns, and it has our full support.

                    II.A.1-6--Corporate Tax Shelters

    The President's budget contains sixteen proposals 
addressing ``corporate tax shelters.'' The first six of these 
address the topic generically by imposing new penalties and 
sanctions and by establishing new tax rules to govern 
transactions generally. This section provides our comments on 
the six generic proposals. We expect to comment on some of the 
specific transaction rules separately in subsequent submissions 
after our technical committees have completed their reviews of 
the proposals.
    We begin by recognizing that tax laws are usually followed, 
but that they can also be abused. Where there are abuses, we 
hold no brief for them--whether they fall under the pejorative 
rubric of ``tax shelters'' or any other part of our tax system. 
Thus, we sympathize with and support efforts to restrict 
improper tax activities through appropriate sanctions. 
Specifically, we favor the Administration's recommendation 
regarding exploitation of the tax system by the use of tax-
indifferent parties.
    However, we also support and defend the right of taxpayers 
to arrange their affairs to minimize the taxes they must fairly 
pay and, with that in mind, we have some serious concerns about 
where the President's proposals draw the distinction between 
legitimate tax planning and improper tax activities. We see 
them as an overbroad grant of power to the Internal Revenue 
Service to impose extremely severe sanctions on corporate 
taxpayers by applying standards that are far from clear and 
that could give examining revenue agents a virtual hunting 
license to go after corporate taxpayers (which, by the way 
include huge numbers of small and medium-sized businesses, not 
just Fortune 100 companies). This would seem to be inconsistent 
with the taxpayer rights thrust of last year's IRS 
restructuring legislation. In our view, the debate concerning 
the sanctions for improper corporate tax behavior must begin 
with a clear understanding of the standards that distinguish 
abusive transactions from legitimate tax planning. What 
standards justify the imposition of extraordinary punishment on 
a corporation (or tax adviser) whose tax treatment of a 
transaction is successfully challenged by the IRS?
    Our primary concern with the Treasury proposals is the 
absence of a clear standard defining what is and what is not an 
abusive transaction, which would apply to most provisions of 
the tax law. The proposals modifying the substantial 
understatement penalty for corporate tax shelters and denying 
certain tax benefits to persons avoiding income tax as a result 
of ``tax avoidance transactions'' set forth a too-vague 
definition of abusive uses of the income tax laws that must be 
clarified. Anti-abuse legislation should be directed at 
transactions that are mere contrivances designed to subvert the 
tax law. The Treasury proposals move beyond the scope we think 
is appropriate to reach transactions that are described vaguely 
as ``the improper elimination or significant reduction of tax 
on economic income.'' This criterion, whatever meaning is 
ascribed to it, is certain to capture transactions that would 
not be considered abusive by most and other transactions that 
have been undertaken for legitimate business purposes. We 
believe that greater clarity is possible, and would like to 
work with the staff to develop a clearer, more objective 
standard for identifying abusive transactions that can be used 
for most provisions of the tax code. A clearer standard would 
provide advantages to tax administrators and taxpayers alike by 
promoting consistency in its application. In addition, we would 
like to reverse the proliferation of highly subjective terms 
such as ``significant,'' ``insignificant,'' ``improper,'' and 
``principal'' which are used in the Treasury proposals and 
current law. While we doubt that it is possible to eliminate 
them all, it would be a laudable goal to minimize their number.
    While the crafting of a clear standard is indeed a 
difficult task, perhaps we can begin to approach the issue by 
trying to agree on what types of transactions should not be 
considered abusive. It should be considered a fundamental 
principle that Congress intended the income tax laws to apply 
to all transactions, without penalty, that either are 
undertaken for legitimate business purposes, or which further 
specific governmental, economic or social goals that were 
contemplated by discrete legislation. Therefore, a transaction 
undertaken for reasons germane to the conduct of the business 
of the taxpayer, or that is expected to provide a pre-tax 
return which is reasonable in relation to the costs incurred, 
or that reasonably accords with the purpose for which a 
specific tax incentive or benefit was enacted should not be 
considered abusive. While our discussion below criticizes the 
Treasury standard for abusive conduct, we do not have our own 
fully developed definition to propose to you at this time. 
However, we have asked a task force of our Tax Executive 
Committee to examine this issue and we are hopeful that we can 
submit our specific recommendations to you and to Treasury in a 
timely fashion. We would be pleased to have the opportunity to 
work with you and them to see if it is possible to develop a 
standard that could be used for most purposes of the Code.
    The budget proposals provide punitive sanctions on ``tax 
avoidance transactions,'' and Treasury's explanation of the 
proposals defines such transactions to include those where 
reasonably expected pre-tax profit is ``insignificant'' 
relative to reasonably expected tax benefits. It is the 
softness and inadequacy of this definition to deal with the 
breadth of the transactions swept into the sanctions, combined 
with the extreme nature of the weapons given the IRS, which 
create our concern that legitimate tax planning will also be 
caught up in this maelstrom. How does this concept apply, for 
example, to a host of business decisions that do not involve 
profit motive, but rather are to defer income or accelerate 
deductions? (We do recognize that there is a proposed exception 
under which a transaction would not be considered ``tax 
avoidance'' if the benefit is ``clearly contemplated'' by the 
applicable provision. However, ``clear contemplation'' is 
generally in the eye of the beholder, and if that contemplation 
is intended to reflect what Congress had in mind when the 
provision was passed, we would respectfully suggest that many 
provisions in our highly complex tax laws have no ``clear'' 
congressional contemplation.)
    A second major concern (alluded to earlier) is that these 
proposals would result in an alarming shift in authority from 
Congress to the IRS. These proposals would result in a grant to 
the IRS of virtually unbridled discretion in the imposition of 
penalties and other sanctions--and this would come only one 
year after Congress had concluded there was a need to rein in 
an agency that had proved itself overzealous in pursuing 
taxpayers. The obscure manner in which the proposals define the 
term ``tax avoidance transaction,'' combined with the wide 
range of penalties and other sanctions that could be invoked 
upon a finding of such a transaction, would provide IRS 
auditors with enormous opportunities and incentives to assert 
the existence of ``tax avoidance transactions'' almost at will. 
Unfortunately, within a few years we would expect aggressive 
agents to use this weapon as a means of forcing corporate 
taxpayers to capitulate on other items under examination.
    Our third concern is that the provisions are so broad they 
could negatively affect legitimate tax planning. Without 
backing away from our earlier point regarding abuses of the tax 
laws, appropriate planning to minimize taxes paid is still a 
fundamental taxpayer right that must be defended. ``The legal 
right of a taxpayer to decrease the amount of what otherwise 
would be his taxes, or altogether avoid them, by means which 
the law permits, cannot be doubted...'' (Gregory v. Helvering, 
293 U.S. 465, 1935). We think the budget proposals provide so 
many powers to the government there is a real likelihood that, 
if enacted, they could prevent advisers and taxpayers from 
undertaking or considering tax-saving measures that are not 
abusive.
    We are also concerned that increased and multiple 
penalties, based on a loosely defined standard and with no 
abatement for reasonable cause, should not apply in a 
subjective area where differences of opinion are the norm, not 
the exception. We believe that penalties should be enacted to 
encourage compliance with the tax laws, not to raise revenue. 
The enactment of new penalties must be carefully developed with 
consideration for the overall penalty structure and any 
overlaps with existing penalties. We also believe that there 
should be incentives for taxpayers to disclose tax transactions 
that could potentially lack appropriate levels of authority and 
that penalties should be abated with proper disclosure and 
substantial authority.
    In this regard, it should be noted that the Joint Committee 
on Taxation and the Treasury Department are undertaking 
independent studies of the entire tax penalty structure, at the 
request of the Congress. The AICPA has recently submitted 
numerous comments about the penalty administration system to 
the Joint Committee and Treasury, and we have commented a 
number of times in the past few years that, the penalty system 
has become more difficult to administer in the past decade. We 
favor a review, de novo, of the penalty system, and we would 
suggest (as part of that review but also for purposes of the 
current hearing) that merely adding new or increased penalties 
to the law whenever Congress or the Administration wishes to 
curtail taxpayer activity is not the proper answer. The result 
is inevitable taxpayer confusion and a higher likelihood that 
the penalty system cannot be administered consistently by the 
IRS (with resulting inequities among taxpayers).
    The Administration has proposed a large variety of 
financial sanctions on transactions that are ultimately 
determined to permit ``tax avoidance.'' These include a 
doubling of the substantial understatement penalty to 40%, an 
extension of that penalty at 20% to fully disclosed positions, 
the ability of the IRS to disallow any tax benefits derived 
from the transaction, disallowance of deductions for fees paid 
to promoters or for tax advice about the transaction, and an 
excise tax of 25% on the amount of such fees received. In 
addition, no ``reasonable cause'' exception will exist to argue 
against the penalty part of any deficiency. Since (as we 
discuss below) there is little incentive for disclosure in 
these proposals, the 40% substantial understatement penalty 
plus the 35% corporate tax rate on disallowance of any tax 
benefit, will produce a 75% tax cost (in addition to the 
economic costs) for entering such a transaction--indeed a 
significant deterrent. For the part of the deficiency 
attributable to fees or tax advice, an additional 25% excise 
tax is imposed, for a 100% tax cost (or ``only'' 80% if there 
is full disclosure under the terms of the proposals)--again, 
with no ``reasonable cause'' exception.
    We would note that these amounts equal or exceed the tax 
penalty for civil fraud (75%). Thus, enactment of the 
President's proposals would single out these transactions as 
equal to or worse than civil tax fraud. We recognize there may 
be those who believe that tax avoidance transactions are the 
equivalent of civil tax fraud and deserve this level of 
sanction. However, we would also note that the due process 
requirements for showing civil fraud are vastly higher than for 
tax avoidance transactions. For example, the government bears 
the burden of proof for showing civil fraud; for assessing 
sanctions on a tax avoidance transaction, the burden of proof 
is on the taxpayer (it may or may not shift to the government 
if the case is litigated, depending on the size of the 
corporation and the development of the administrative 
proceeding). Further, for tax avoidance transactions, these 
proposals would legislate away the ability of a taxpayer to 
argue that the position was taken in good faith and there was 
reasonable cause for the taxpayer to act as it did.
    While respecting the views on the other side, we do not 
believe the case has been made that tax avoidance transactions 
(under the loose proposed standard discussed above) rise to the 
level of civil fraud. We certainly do not understand why the 
due process requirements in place for civil fraud are absent 
here.
    With further respect to the issue of promoters and tax 
advisers, the fee disallowance and excise tax recommendations 
imply that there are presently inadequate deterrents in the law 
for those who advise on ``abusive'' corporate transactions. We 
would like to suggest that consideration be given to whether 
changes in Circular 230 (the Treasury regulations governing the 
right to practice before the IRS) could be a more effective 
answer to some of these problems rather than another tax and 
added penalties (on the disallowance of adviser fees). We 
recognize that Circular 230 would not apply as presently 
written to some promoters, but there have been some proposals 
in recent months regarding potential changes in Circular 230 
that may be appropriate for consideration. In addition, 
preparer and promoter penalties under current law could be 
reviewed for adequacy.
    We do not agree with the proposal that precludes taxpayers 
from taking tax positions inconsistent with the form of their 
transactions--but not because we believe taxpayers should be 
able to casually disavow the form. However, the Joint Committee 
on Taxation analysis of this provision raises several issues 
that we believe should be addressed. At this point, we are not 
convinced that the tax law or system of tax administration 
would be improved by this provision. Given the abundance of 
existing case law on this issue, it is not clear to us why new 
legislation is required at this time.
    One final concern: if the Treasury is concerned that the 
current disclosure rules may not be effective, we are prepared 
to address the question of when and what form of disclosure 
should be required in order to identify the types of 
transactions with which the Administration is concerned. 
However, we question the lack of incentives for disclosure both 
under current law and the President's proposals. The 
Administration's disclosure proposals come on top of 
registration requirements that were enacted only a year ago (on 
which we are still awaiting regulations). For those affected by 
the previous registration requirements, this proposal would be 
overkill (requiring disclosure for registration purposes with 
the IRS as the transaction begins to be marketed, and 
additional disclosure to the IRS within 30 days of closing a 
transaction). We believe that provisions that do not aid the 
tax administrator but add tremendous burdens to preparers and 
taxpayers should be eliminated. We stand ready to work with you 
and the IRS on this issue.
    Today, we can do no more than offer our first impressions 
of these proposals. Our analysis and study has just begun as 
these proposals and the areas of law which they affect are 
necessarily complex. However, we are prepared to devote the 
effort necessary to complete a full, careful and timely review 
in this area, to offer you our best recommendations and to work 
with you and your staffs to develop improvements in the law 
that can and should be made to deal with identified problem 
areas.

 II.B.2--Require Current Accrual of Market Discount by Accrual Method 
                               Taxpayers

    The administration's proposal would require accrual method 
taxpayers to include market discount in income as it accrues. 
The accrual would be limited to the greater of the original 
yield to maturity or the applicable federal rate, plus 5%. 
Under current law, a taxpayer is only required to include 
market discount in income when cash payments are received. 
Alternatively, a taxpayer may elect to currently include market 
discount in income. The AICPA does not support the 
administration's proposal regarding market discount for the 
reasons enumerated below.
    Market discount may, in many circumstances, be economically 
equivalent to original issue discount (``OID''). In many 
situations, however, market discount may arise solely because 
of a decline in the credit-worthiness of the borrower and the 
resulting discount is not related to the time value of money. 
For this reason, the current market discount regime protects 
taxpayers from including in taxable income market discount that 
may very well never be collected. The Administration's proposal 
that market discount be accrued in an amount up to the greater 
of the original yield to maturity or the applicable federal 
rate, plus 5%, would, in many instances, require a taxpayer to 
accrue income that may very well never be collected.
    The IRS and Treasury, to date, have not issued 
comprehensive guidance on how taxpayers should accrue interest, 
market discount and original issue discount on debt obligations 
where there is substantial uncertainty that the income will be 
collected. Accordingly, the mandatory accrual of market 
discount should not be required until guidance on non-accrual 
of discount is released.
    The Administration is proposing to require the current 
accrual of market discount. A similar requirement exists for 
original issue discount. However, while substantial guidance 
has been issued in the form of Treasury Regulations and other 
published guidance with regard to OID, no such guidance has 
been issued under the market discount provisions. As a result, 
taxpayers have been struggling with complex market discount 
provisions contained in the code since 1984 but with no 
guidance on how to apply the provisions. The AICPA believes 
that, substantive guidance should be issued to instruct a 
taxpayer exactly how to apply these provisions. Substantive 
guidance is needed to address the accrual of market discount in 
several areas, including, but not limited to, (1) obligations 
subject to prepayment; (2) obligations that become demand 
obligations after the original issue date; and (3) obligations 
purchased at significant discounts because of a decline in the 
credit rating of the issuer. Until such guidance is issued, the 
AICPA does not believe it is prudent to require the current 
accrual of market discount.
    This proposal, if enacted, would expand complex tax rules 
applicable to sophisticated financial transactions to a broad 
universe of taxpayers. As it is, taxpayers are faced with a 
myriad of questions when determining how market discount is 
deemed to accrue. Thus, it is unrealistic to expand a complex 
regime to a broader universe of taxpayers without first issuing 
guidance with respect to the original provisions. For example, 
it is common for a taxpayer to hold a market discount 
obligation with OID. In this circumstance, most taxpayers will 
have to perform three computations to determine income with 
respect to these obligations, one for financial accounting 
purposes, one for tax purposes with respect to the OID and one 
for tax purposes regarding market discount. Even taxpayers 
``familiar with the complexities of reporting income under an 
accrual method'' would find this burdensome.
    Any perceived abuse by the administration that taxpayers 
are able to achieve a deferral by not recognizing market 
discount currently is unfounded as well. Many taxpayers (such 
as financial institutions) that hold market discount 
obligations use debt to purchase and carry such obligations. 
Generally, such taxpayers cannot deduct interest expense 
incurred to purchase and carry the market discount obligations 
thereby eliminating, much if not all, of the benefit resulting 
from the deferral of market discount.

             II.D.4--Repeal of Tax-Free C-to-S Conversions

    The AICPA continues to strongly oppose the Administration's 
proposal to treat the conversion of a so-called ``large'' 
(greater than $5 million in value) C corporation to an S 
corporation as a taxable liquidation. The Administration's 
proposal also in effect would impose a new ``merger tax'' on 
certain acquisitions of C corporations by S corporations. We 
continue to believe that the proposal is short-sighted, would 
be harmful to small business, and is grossly inconsistent with 
Congressional efforts to reform Subchapter S to make it more 
attractive and more workable. We are pleased that the Congress 
has consistently rejected this included in the Administration's 
previous budget recommendations.
    This proposal would repeal the section 1374 built-in gains 
tax for corporations whose stock is valued at more than $5 
million when they convert to S corporation status. In place of 
the section 1374 built-in gains tax, which would tax built-in 
gains if and when built-in gain property is disposed of during 
the ten-year period after conversion, the proposal would 
require such converting corporations to recognize immediately 
all the built-in gain in their assets at the time of 
conversion. The proposal would be effective for conversions for 
taxable years beginning on or after January 1, 2000.
    The AICPA strongly opposes this proposal. We believe this 
proposal constitutes a major change in corporate tax law, and 
one that would be contrary to sound tax policy. As stated 
above, we believe that any significant change affecting 
Subchapter S should only be undertaken pursuant to a 
comprehensive review and not be the subject of piecemeal 
changes designed primarily to attain revenue goals.
    Current section 1374 is designed to preserve a double-level 
tax on appreciation in assets that accrued in a corporation 
before it elected S corporation status. To accomplish this, 
section 1374 subjects S corporations to a corporate-level tax 
on asset dispositions during the ten years following 
conversion. Section 1374's primary purpose is to prevent a C 
corporation from avoiding the 1986 Tax Reform Act's repeal of 
the General Utilities doctrine, by converting to S corporation 
status prior to a sale of its business. Since its enactment, 
section 1374 has been refined several times in order to 
strengthen its operation, such as the addition of a suspense 
account mechanism to prevent built-in gains from escaping tax 
due to the taxable income limitation. The experiences of our 
members indicate section 1374 is effective in achieving its 
purpose. We see no reason to abandon this mechanism.
    The proposal also is counter to well-established policy 
regarding the tax treatment of the conversion of C corporations 
to S corporation status. For example, in 1988, Section 106(f) 
of S. 2238 and Section 10206 of H.R. 3545, the then-pending 
Technical Corrections Bill, would have modified the computation 
of the built-in gains tax by removing the taxable income 
limitation. This provision was ultimately rejected under 
``wherewithal to pay'' principles. At that time, the AICPA's 
position was articulated in the following passage from a letter 
from then Chairman of the AICPA Tax Division, Herbert J. 
Lerner, to the Honorable Dan Rostenkowski; this statement 
continues to reflect the position of the AICPA:

          Perhaps of even greater long-term concern is that this 
        technical correction seems to be yet another manifestation of a 
        fundamental change in tax philosophy. Several staff members 
        from the tax writing committees have told us that they believe 
        that any conversion from C to S status should be taxed as 
        though the corporation had been liquidated and a new 
        corporation formed. We believe that this is not sound tax 
        policy and that it would be contrary to the underlying purpose 
        of Subchapter S which has been widely used by small businesses 
        for some 25-30 years. ... This liquidation philosophy is a 
        major change in tax policy and should be debated as such, 
        should be subject to public hearings and should not be allowed 
        to creep into the law through incremental changes.

    It is noted that a similar attempt to repeal the taxable 
income limitation for elections made after March 30, 1988 was 
rejected by Congress in 1992 (Section 2 of H.R. 5626). A 
legislative proposal to effectively treat the conversion as a 
liquidation was also rejected by Congress in 1982.
    The AICPA believes that the proposal under consideration 
would effectively repeal the availability of Subchapter S for 
so-called ``large'' corporations (i.e., corporations valued at 
over $5 million). As noted, the proposal would require such 
corporations to be taxed immediately on all unrealized gain in 
their assets, including goodwill, and to pay a tax on this 
gain. For large corporations with significant unrealized value, 
the cost of conversion would be exceedingly expensive and, 
therefore, Subchapter S status would in effect be rendered 
completely inaccessible to them. As a result, the proposal 
would generally leave Subchapter S status available only to 
those large corporations with either little or no built-in gain 
or sufficient net operating loss carryovers to offset the gain. 
We do not believe that restricting the benefits of Subchapter S 
to this latter class of C corporations represents sound tax 
policy.
    A further objection we have to the proposal is the use of 
the $5 million fair market value threshold for determining the 
applicability of the tax. Basing the applicability of the 
provision, which could have devastating tax consequences, on 
such a subjective benchmark is simply untenable. If a 
corporation wished to convert to S corporation status, how 
could it conclusively determine whether or not the immediate 
taxation of built-in gains would apply? Even if the corporation 
incurred the cost of obtaining an appraisal, how would the 
corporation be sure the valuation would not later be challenged 
by the Internal Revenue Service? As a pure business matter, 
many corporations simply would not be willing to accept any 
significant level of uncertainty regarding this potentially 
devastating tax on paper gains. Adding such a burdensome and 
uncertain provision to the tax law clearly would be contrary to 
sound tax policy.
    In summary, the AICPA feels strongly that the proposal to 
repeal section 1374 for large corporations and impose an 
immediate tax on all unrealized gain in their assets runs 
counter to long-standing tax policy which Congress has adhered 
to for many years. Further, although the proposal may serve the 
purpose of raising revenue, it would do so to the detriment of 
certainty and fairness in the tax law. The proposal would 
effectively eliminate new conversions to Subchapter S status 
for most corporations valued at more than $5 million; such a 
major change in the tax law should not be made without careful 
analysis. We, therefore, strongly urge you to remove the 
proposal from consideration.

 II.E.5--Repeal the Lower of Cost or Market Inventory Accounting Method

    This proposal would eliminate the use of the lower of cost 
or market method for federal income tax purposes. This proposal 
has been made on a number of occasions in the past, and the 
AICPA has opposed each such proposal.
    We continue to oppose this proposal. This method has been 
accepted in the tax law since 1918 and is an integral part of 
generally accepted accounting principles (GAAP). LCM conformity 
with GAAP does provide some needed simplicity. Further, there 
is no reason why this method should suddenly become 
impermissible. It is not a one-sided application of mark-to-
market because once a taxpayer lowers the selling price of its 
goods below their cost, the taxpayer is not going to realize a 
profit on the eventual sale of the goods.
    We are disappointed that a widely established and 
universally used tax accounting method, which finds its genesis 
in generally accepted accounting principles, would--after 
having been a part of our tax structure for over 80 years--be 
proposed for repeal. The process is particularly unfortunate 
because, when all is said and done, the LCM repeal proposal 
involves a timing difference only, rather than a truly 
substantive change in tax policy. At the end of the day, the 
issue becomes whether components of inventory transactions are 
recorded on a return this year or next year; there is no issue 
as to whether they will ever be recorded at all.
    Now, suddenly, Congress is asked to change a basic tax rule 
that predates almost all of us. Taxpayers will have to live 
with this change for decades or longer. On that basis, 
particularly for an issue that involves only timing, it is 
particularly distressing to see the change occur under this 
process. One would think that 76 years of totally accepted 
usage is precedential enough to warrant a more deliberate 
process for its removal from the law.
    Without wishing to detract from our main point--LCM should 
not be repealed--let us note that if Congress determines to 
eliminate lower of cost or market, there needs to be a small 
business exception in the interest of simplicity. Many small 
businesses (particularly those meeting the retail de minimis 
exception to the uniform capitalization rules) are currently 
able to use their financial statement inventory numbers on 
their tax returns. Since the LCM method will still be required 
for financial reporting, it will no longer be possible for 
these taxpayers to use financial statement inventory on their 
returns. Market writedowns will have to be segregated for 
proper reporting as a book-tax difference. Thus, especially for 
small business, there will be a disproportionate additional 
cost of compliance on top of the added tax cost for not being 
able to use LCM.
    We believe, therefore, it is imperative that there be a 
meaningful small business exception if LCM is repealed. The 
Administration proposal includes a small business exception 
modeled on present Code section 448 (ability to use the cash 
basis of accounting), which holds that the provisions are not 
applicable to businesses that average less than $5 million 
annual gross receipts (not to be confused with gross income, 
which can be a substantially lower number) over a three-year 
period. Since, however, we are considering an inventory method 
change, and inventories generally turn over several times a 
year, it could be a very small business indeed which meets a $5 
million gross receipts test. Accordingly, we think it essential 
that, if a gross receipts exemption is used, it should be at 
least at the $10 million level, rather than $5 million. In 
fact, the most recent de minimis statutory rule involving 
inventories is the so-called ``retail exception'' in the 
uniform capitalization rules, and it is at a $10 million gross 
receipts level. Alternatively, Congress might consider a $5 
million gross income de minimis rule (which would be gross 
receipts less cost of sales).

     II.H.1--Subject Investment Income of Trade Associations to Tax

    The President's budget proposals would impose a corporate-
rate tax on ``net investment income'' of section 501(c)(6) 
organizations (trade associations and other business leagues). 
Our comments on this proposal are clearly made in our members' 
interests as well as for tax policy reasons: the AICPA is a 
section 501(c)(6) organization and it does have investment 
income which would be subject to this new proposed tax.
    Nonetheless, we question the policy basis on which the 
proposals are being put forth. It is implied that current law 
provides an incentive to fund association operations on a tax-
free basis (through the build up of non-taxed investment 
assets) because members receive a deduction for dues payments 
but would have been taxed on the earnings attributable to those 
payments had the payments not been made to a 501(c)(6) 
organization. Thus, according to the Treasury Department 
General Explanation of the Administration's Revenue Proposals, 
members are ``avoiding tax'' on the earnings from their dues.
    While we understand the theoretical basis for this 
argument, it just does not comport with business reality. No 
business is going to view dues payments to a trade association 
as a prudent means of sheltering income from tax, on the 
grounds that earnings on the payments are tax free if for the 
account of the association but taxable if for the account of 
the member. In order to get the benefit of this ``shelter,'' 
the member has to actually pay over money to the association, 
which puts those funds absolutely outside the members' 
control--a fairly ludicrous business decision if the thinking 
behind the extra or advance payment is the avoidance of income 
tax.
    We would also note that associations accumulate surplus not 
to accelerate deductions or provide tax deferrals, but because 
it is prudent business practice. By providing cushions against 
membership fall-off in times of economic decline, for example, 
an association is able to protect against annual dues 
fluctuations. And, as an organization which relies 
predominantly on member dues to fund its exempt purposes, the 
AICPA is very much aware of member sensitivity to annual 
changes in dues. Associations need to provide a stable dues 
structure to smooth out member fall-off and increases from year 
to year (which, in turn, affects the association's annual 
operating budget for its normal activities). Further, prudence 
dictates that there be some cushion available for unanticipated 
business issues that arise during a year. (We do recognize that 
there is a $10,000 exemption from the proposed tax, but that 
amount applies equally to associations with 250 members and 
250,000 members. Even for taxable entities (corporations), the 
Code permits earnings to be accumulated for the ``reasonable 
needs of the business'' before a penalty tax is imposed.)
    Finally, we note that the Joint Committee on Taxation has 
estimated this provision as a $698 million revenue raiser over 
five years and a $1.6 billion revenue raiser over ten years. We 
do not know the basis of those revenue estimates, but we would 
point out that for any association that becomes subject to this 
additional tax, it will either have to curtail services to 
members or raise member dues to fund the tax. Those dues 
increases will result in additional deductible payments by 
members, with a concomitant reduction in federal revenues.

           II.I.6--Eliminate Non-business Valuation Discounts

    The administration's proposal would eliminate valuation 
discounts except as they apply to active businesses. This 
proposal is built upon the presumption that there is no reason 
other than estate tax avoidance for the formation of a family 
limited partnership (FLP). We disagree. There are any number of 
other reasons why a taxpayer might wish to set up an FLP 
including: management of assets in case of incompetency, 
increased asset protection, the reduction of family disputes 
concerning the management of assets, to prevent the undesired 
transfer of a family member's interests due to a failed 
marriage, and to provide flexibility in business planning not 
available through trusts, corporations or other business 
entities.
    The beneficiaries of FLPs do not receive control over the 
underlying assets and generally have no say as to the 
management of those assets. Individuals receiving non-public, 
non-tradeable interests in a legally binding arrangement are 
not in as good a position as they would have been if they had 
received the underlying assets outright. Substantial economic 
data indicate that the value of these interests is less than 
the value of the underlying assets. Valuation discounts are a 
legitimate method of recognizing the restrictions faced by 
holders of FLP interests.
    The wholesale change to the taxation of these entities is 
unreasonable and too broad. It assumes that FLPS are used only 
to avoid transfer taxes and disregards the non-tax reasons for 
their formation and the fact that these non-tax reasons do 
reduce the value of these interests to owners. In addition, the 
Internal Revenue Service already has tools to combat abuses in 
this area including valuation penalties, disclosure 
requirements on gift tax returns, and the ability to examine 
the business purpose of FLPs.

   II.I.7--Eliminate Gift Tax Exemption for Personal Residence Trusts

    The administration's proposal would repeal the personal 
residence exception of section 2702(a)(3)(A)(ii). If a 
residence is used to fund a GRAT or a GRUT, the trust would be 
required to pay out the required annuity or unitrust amount; 
otherwise the grantor retained interest would be valued at zero 
for gift tax purposes.
    The reasons for change include the inconsistency in the 
valuation of a gift made to a remainderman in a personal 
residence trust and in transactions not exempt from section 
2702 and that the use value of a residence is a poor substitute 
for an annuity or unitrust interest. Because the grantor 
ordinarily remains responsible for the insurance, maintenance 
and property taxes on the residence, the administration 
contends that the actuarial tables overstate the value of the 
grantor's retained interest in the property.
    In reply to the proposal, we would note that the present 
rules pertaining to personal residence trusts were enacted by 
Congress in 1990 as a specific statutory exception to the 
general rules of section 2702 to provide a mechanism for 
taxpayers to transfer a personal residence to family members 
with minimal transfer tax consequences. The proposal ignores 
the longstanding protected and preferred status the personal 
residence has held throughout the tax code. Examples of this 
status include the exemption provided to personal residences at 
the time section 2702 was originally enacted, maintenance of 
the itemized deduction for real estate taxes and mortgage 
interest on personal residences as provided in the Tax Reform 
Act of 1986 and the homestead exemption provided in the 
bankruptcy statutes. The acquisition and ownership of the 
personal residence has long been acknowledged as being central 
to the ``realization of the American dream'' and should 
continue to be protected and encouraged. In fact, it can be 
argued that the personal residence, or at least some portion of 
the value thereof, should be excluded from the transfer tax 
base altogether.
    In addition, we dispute the contention that the use value 
of a residence is significantly less than the value of an 
annuity or unitrust interest. Commonly, real estate investments 
are predicated upon an assumed return (capitalization rate) 
ranging from 12%-15%. Even allowing for the payment of 
insurance, maintenance and property taxes expenses by the 
grantor and considering also that residential real estate 
appreciates on average by approximately 2% per year, it can be 
argued that the use value of the residence should be 7%-10% of 
the value of the property. As such, it can be argued that the 
actuarial tables do, in fact, assign an appropriate value to 
the grantor's retained interest.
    The current law does not permit abusive application of the 
personal residence trust technique. Recently finalized 
regulations (Reg. Sec. 25.2702-5) prohibit the sale of the 
residence back to the grantor thus eliminating use of the 
technique as a means to circumvent the rules regarding GRATs 
and GRUTs. Furthermore, restrictions on the amount of property 
adjoining the residence which may be placed into a personal 
residence trust eliminate the technique as a means to transfer 
investment real estate on a tax-protected basis.

       II.L.2 and 4--Compliance Provisions Relating to Penalties

    We take no position the merits of these proposals, but 
oppose their enactment before completion of the penalty studies 
being conducted independently by the Joint Committee on 
Taxation and the Department of the Treasury. As was noted when 
Congress last overhauled our penalty system in 1989, a 
piecemeal approach to enacting penalties over the years causes 
a complex collection of penalties that are not rationally 
related to a taxpayer's conduct and not understood by 
taxpayers. This does not encourage taxpayers to modify their 
behavior in the intended way, and causes taxpayer frustration 
when applied.
    With penalty studies already underway, we believe these 
provisions should be studied and considered as part of overall 
penalty reform legislation. Deferring enactment now would help 
assure that these penalties were consistent and rational in a 
reformed penalty system and could avoid a possible extra round 
of penalty changes in these areas. The AICPA has commented to 
Treasury on its penalty study and would be happy to work with 
Congress to develop a simple, fair and rational penalty system.

 II.L.3--Repeal Exemption for Withholding on Certain Gambling Winnings

    We disagree with the proposal to require withholding on 
bingo and keno winnings in excess of $5,000. Because gambling 
winnings are taxable only to the extent that they exceed 
gambling losses, this proposal could result in over-withholding 
by not taking into account gambling losses, particularly for 
smaller ``winners.'' The currently required reporting of these 
winnings on Form 1099 should be sufficient to promote and track 
compliance in most cases. For the unusual large winner, say 
$100,000 or more, withholding would more likely be appropriate.
      

                                

    Chairman Archer. Thank you, Mr. Lifson. We will be looking 
carefully at all of your written suggestions and criticisms. 
Mr. Olson, if you will identify yourself for the record, you 
may proceed.

STATEMENT OF MICHAEL S. OLSON, CERTIFIED ASSOCIATION EXECUTIVE, 
  PRESIDENT AND CHIEF EXECUTIVE OFFICER, AMERICAN SOCIETY OF 
                     ASSOCIATION EXECUTIVES

    Mr. Olson. Thank you, Mr. Chairman, distinguished Members 
of the Committee. My name is Michael Olson. I am president and 
chief executive officer of the American Society of Association 
Executives. ASAE is an individual membership organization made 
up of approximately 25,000 association executives and associate 
members who are managing over 11,000 of America's trade 
associations and professional societies.
    And I am here representing that membership today, Mr. 
Chairman, opposing the specifics of the budget proposal 
submitted by the Clinton administration that would tax the net 
investment income of the 501(c)(6) association community to the 
extent their net income exceeds $10,000 a year.
    It does this by subjecting the income to the unrelated 
business income tax, or UBIT. Income that would be subject to 
taxation, however, is not as narrow as one might expect from 
the administration term investment income. It actually includes 
virtually all passive income, including rent, royalties, 
capital gains, interest, and dividend revenues.
    America's trade, professional, and philanthropic 
associations are an integral part of our society in this 
country. They allocate one of every four dollars they spend to 
member education and training, and public information 
activities in their respective communities. These same 
associations fuel America's prosperity by pumping billions of 
dollars into the economy and creating literally hundreds of 
thousands of jobs.
    Importantly, associations perform many quasigovernmental 
functions. These include the areas of product performance and 
safety standards, continuing education, public information, 
professional standards, ethics, research, statistics, political 
education, and community service.
    Without associations, the government and other institutions 
would face added and expensive burdens in order to perform 
these very essential functions.
    The administration has suggested that its proposal would 
only affect a small percentage of associations, that it only 
applies to lobbying organizations, and that it somehow provides 
additional tax benefits to those members who pay dues to these 
associations.
    Every one of these assertions is misleading and incorrect. 
ASAE estimates that this proposal will tax virtually all 
associations with annual operating budgets as low as $200,000 a 
year, hardly organizations of considerable size. In fact, the 
bulk of the organizations affected by this proposal would 
include associations at the State and local level, many of whom 
perform little if any lobbying functions.
    Furthermore, existing law already eliminates any tax 
preference, benefit, or subsidy for the lobbying activities of 
these organizations. The primary argument the administration 
has used to support its proposal is that members of these 
(c)(6) organizations somehow have come up with a scheme to 
prepay their dues in order to enjoy a tax-free return on the 
investment. This argument, quite frankly, is absurd.
    There is every incentive for trade and professional 
associations to keep their membership dues as low as possible, 
and to suggest that members wish to be overcharged in order to 
somehow enjoy a tax-free return on investment is both illogical 
and unrealistic. Furthermore, there is no way that the 
suspected investment strategy could benefit members since 
501(c) organizations are prohibited from paying dividends, not 
to mention the prohibition against any individual inurement.
    In many ways, this proposal attacks the basic tax-exempt 
status of associations and runs counter to the demonstrated 
commitment of Congress to furthering the purposes of tax-exempt 
organizations. The administration has singled out 501(c)(6) 
organizations, although there are 25 categories of 501(c) 
organizations. And they propose to treat them in the same 
manner as social clubs, which are organized for the private 
benefit of individual members.
    If Congress enacts this proposal, it will alter in a 
fundamental way the tax policy that has governed the tax-exempt 
community for nearly a century and will set a dangerous 
precedent for further changes in tax law for all tax-exempt 
organizations.
    In closing, Mr. Chairman, I would like to say to you and 
the Committee Members how tremendously pleased I and ASAE as an 
organization are that 28 Members of this Committee have written 
to the Chairman and Ranking Member expressing their opposition 
to this specific administration proposal, and we hope you would 
make that a part of the record along with our testimony.
    Thank you for your courtesy, sir.
    [The prepared statement follows:]

Statement of Michael S. Olson, Certified Association Executive, 
President and Chief Executive Officer, American Society of Association 
Executives

    Mr. Chairman, my name is Michael S. Olson, CAE. I recently 
became the President and Chief Executive Officer of the 
American Society of Association Executives (ASAE). ASAE is an 
individual membership society made up of 24,700 association 
executives and suppliers. Its members manage more than 11,000 
leading trade associations, individual membership societies, 
and other voluntary membership organizations across the United 
States and in 48 countries around the globe. ASAE also 
represents suppliers of products and services to the 
association community.
    I am here to testify in strong opposition to the budget 
proposal submitted to Congress by the Clinton Administration 
that would tax the net investment income of Section 501(c)(6) 
associations to the extent the income exceeds $10,000 annually. 
Income that would be subject to taxation, however, is not as 
narrow as would be expected from the characterization in the 
proposal of ``investment income'' but includes all ``passive'' 
income such as rent, royalties, interest, dividends, and 
capital gains. This provision, which is estimated by the 
Treasury Department to raise approximately $1.4 billion dollars 
over five years, would radically change the way revenue of 
these tax-exempt organizations is treated under federal tax 
law. In addition, if enacted this proposal would jeopardize the 
very financial stability of many Section 501(c)(6) 
organizations.
    America's trade, professional and philanthropic 
associations are an integral part of our society. They allocate 
one of every four dollars they spend to member education and 
training and public information activities, according to a new 
study commissioned by the Foundation of the American Society of 
Association Executives. ASAE member organizations devote more 
than 173 million volunteer hours each year--time valued at more 
than $2 billion--to charitable and community service projects. 
95 percent of ASAE member organizations offer education 
programs for members, making that service the single most 
common association function. ASAE member associations are the 
primary source of health insurance for more than eight million 
Americans, while close to one million people participate in 
retirement savings programs offered through associations.
    Association members spend more than $1.1 billion annually 
complying with association-set standards, which safeguard 
consumers and provide other valuable benefits. Those same 
associations fuel America's prosperity by pumping billions of 
dollars into the economy and creating hundreds of thousands of 
good jobs. Were it not for associations, other institutions, 
including the government, would face added burdens in the areas 
of product performance and safety standards, continuing 
education, public information, professional standards, ethics, 
research and statistics, political education, and community 
service. The work of associations is woven through the fabric 
of American society, and the public has come to depend on the 
social and economic benefits that associations afford.
    The Administration has suggested that their proposal would 
only affect a small percentage of associations, that it is 
targeted to larger organizations, that the proposal targets 
``lobbying organizations,'' and that it somehow provides 
additional tax benefits to those who pay dues to associations. 
All of these assertions are misleading, ill-informed and 
incorrect.
    Based on information from ASAE's 1997 Operating Ratio 
Report, this proposal will tax most associations with annual 
operating budgets as low as $200,000, hardly organizations of 
considerable size. In fact, the bulk of the organizations 
affected would include associations at the state and local 
level, many of whom perform little if any lobbying functions. 
Furthermore, existing law, as outlined below, already 
eliminates any tax preference, benefit, or subsidy for the 
lobbying activities of these organizations, and can even unduly 
penalize their lobbying.
    The primary argument the Administration has used to support 
its proposal is that members of Section 501(c)(6) organizations 
prepay their dues in order to enjoy a tax-free return on 
investment. This argument, quite frankly, is absurd and is 
discussed below in full. There is every incentive for trade and 
professional associations to keep dues as low as possible for 
obvious reasons, and to suggest that members wish to be 
overcharged in order to somehow enjoy a tax-free return on 
investment is both illogical and unrealistic. Furthermore, 
there is no way that this suspected investment strategy could 
benefit members since Section 501(c)(6) organizations are 
prohibited from paying dividends.
    In many ways, this proposal attacks the basic tax-exempt 
status of associations, and runs counter to the demonstrated 
commitment of Congress to furthering the purposes of tax-exempt 
organizations. These exempt purposes, such as training, 
standard-setting, and providing statistical data and community 
services, are supported in large part by the income that the 
Administration's proposal would tax and thereby diminish. If 
Congress enacts this proposal, it will alter in a fundamental 
way the tax policy that has governed the tax-exempt community 
for nearly a century, and will set a dangerous precedent for 
further changes in tax law for all tax-exempt organizations.
    I would now like to review more completely the existing tax 
law governing this area, and to specifically address some of 
the arguments that have been made in support of the 
Administration's proposal. I believe that a careful 
consideration of the issues involved will make the Committee 
conclude that this proposal is both ill-advised and ill-
conceived, and should be rejected.

   I. Taxation of Section 501(c)(6) Organizations Under Current Law.

    Section 501(c)(6) organizations are referred to in the tax 
law as ``business leagues'' and ``chambers of commerce.'' Today 
they are typically known as trade associations, individual 
membership societies, and other voluntary membership 
organizations. These organizations are international, national, 
state, and local groups that include not only major industry 
trade associations but also small town merchants' associations 
or the local Better Business Bureau. Currently, the tax law 
provides that Section 501(c)(6) organizations are exempt from 
federal taxation on income earned in the performance of their 
exempt purposes. Associations engage primarily in education, 
communications, self-regulation, research, and public and 
governmental information and advocacy. Income received from 
members in the form of dues, fees, and contributions is tax-
exempt, as are most other forms of organizational income such 
as convention registrations and publication sales. However, 
Section 501(c)(6) groups and many other kinds of exempt 
organizations are subject to federal corporate income tax on 
revenues from business activities unrelated to their exempt 
purposes (``;unrelated business income tax'' or ``UBIT''). UBIT 
is applicable to income that is earned as a result of a 
regularly-carried-on trade or business that is not 
substantially related to the organizations' tax-exempt 
purposes. Section 501(c)(6) organizations are also subject to 
specific taxes on any income they spend on lobbying activities.
    The UBIT rules were designed to prevent tax-exempt 
organizations from gaining an unfair advantage over competing, 
for-profit enterprises in business activities unrelated to 
those for which tax-exempt status was granted. Congress 
recognized, however, that Section 501(c)(6) tax-exempt 
organizations were not competing with for-profit entities or 
being unfairly advantaged by the receipt of tax-exempt income 
from certain ``passive'' sources: rents, royalties, interest, 
dividends, and capital gains. Tax-exempt organizations use this 
``passive'' income to further their tax-exempt purposes and to 
help maintain modest reserve funds--to save for necessary 
capital expenditures, to even out economic swings, and the 
like. Indeed, the legislative history regarding UBIT recognizes 
that ``passive'' income is a proper source of revenue for 
charitable, educational, scientific, and religious 
organizations [Section 501(c)(3) organizations], issue advocacy 
organizations [Section 501(c)(4) organizations], and labor 
unions and agricultural organizations [Section 501(c)(5) 
organizations], as well as trade associations, individual 
membership societies, and other voluntary membership 
organizations [Section 501(c)(6) organizations].
    Therefore, Congress drafted the tax code to expressly 
provide that UBIT for most tax-exempt organizations does not 
extend to ``passive'' income. As a result, exempt organizations 
such as associations are not taxed on rents, royalties, 
dividends, interest, or gains and losses from the sale of 
property. The proposal to tax ``net investment income'' of 
Section 501(c)(6) organizations would allow the IRS to impose a 
tax on all such previously untaxed sources of ``passive'' 
income. Contrary to its denomination, the scope of the tax is 
clearly much broader than just ``investment income.''

       II. Taxation of Section 501(c)(6) Organizations Under the 
Administration Budget Proposal: Treating Professional Associations Like 
                             Social Clubs.

    Under the Administration's proposal, Section 501(c)(6) 
organizations would be taxed on all ``passive'' income in 
excess of $10,000. This proposed tax would not be imposed on 
exempt income that is set aside to be used exclusively for 
charitable and educational purposes. Funds set aside in this 
manner by Section 501(c)(6) organizations could be taxed, 
however, if those funds are ultimately used for these purposes. 
In addition, the proposal would tax gains realized from the 
sale of property used in the performance of an exempt function 
unless the funds are reinvested in replacement property.
    Essentially, the budget proposal would bring Section 
501(c)(6) organizations under the same unrelated business 
income rules that apply to Section 501(c)(7) social clubs, 
Section 501(c)(9) voluntary employees' beneficiary 
associations, and Section 501(c)(20) group legal services 
plans. These organizations receive less favorable tax treatment 
due to Congress' belief that they have fundamentally different, 
and less publicly beneficial purposes than other tax-exempt 
organizations. The Clinton Administration proposes to equate 
trade associations, individual membership societies, and other 
such voluntary membership organizations with country clubs, 
yacht clubs, and health clubs.
    Social clubs, for example, are organized under Section 
501(c)(7) for the pleasure and recreation of their individual 
members. As case law and legislative history demonstrate, 
social clubs were granted tax exemption not to provide an 
affirmative tax benefit to the organizations, but to ensure 
that their members are not disadvantaged by their decision to 
join together to pursue recreational opportunities. Receiving 
income from non-members or other outside sources is therefore a 
benefit to the individual members not contemplated by this type 
of exemption.
    With regard to associations exempt under Section 501(c)(6), 
however, Congress intended to provide specific tax benefits to 
these organizations to encourage their tax-exempt activities 
and public purposes. These groups are organized and operated to 
promote common business and professional interests, for example 
by developing training material, providing volunteer services 
to the public, or setting and enforcing safety or ethical 
standards. In fact, the tax code prohibits Section 501(c)(6) 
organizations from directing their activities at improving the 
business conditions of only their individual members. They must 
enhance entire ``lines of commerce;'' to do otherwise 
jeopardizes the organizations' exempt status. Social clubs have 
therefore long been recognized by Congress as completely 
different from professional associations, engaged in different 
activities that merit a different exempt status.
    Social clubs have always been taxed differently from 
associations. This reflects their different functions. Social 
clubs are organized to provide recreational and social 
opportunities to their individual members. Associations are 
organized to further the interests of whole industries, 
professions, and other fields of endeavor. ``Passive'' income 
received by an association is reinvested in tax-exempt 
activities of benefit to the public, rather than in 
recreational/social activities for a limited number of people. 
Applying the tax rules for social clubs to associations imposes 
unreasonable and unwarranted penalties on those organizations. 
For example, under the Administration's proposal, these 
organizations would be taxed on all investment income unless it 
is set aside for charitable purposes. Income that is used to 
further other legitimate organizational activities of value to 
the industry, the profession, and the public would therefore be 
taxed. In addition, the proposal would tax these organizations 
on all gains received from the sale of property unless those 
gains are reinvested in replacement property. This tax on gains 
would apply to real estate, equipment, and other tangible 
property. It would also apply, however, to such vastly diverse 
assets as software, educational material developed to assist an 
industry or profession, certification and professional 
standards manuals, and other forms of intellectual property 
which further exempt purposes.
    It is important to note that the Administration's proposal 
targets only Section 501(c)(6) organizations. No other 
categories of tax-exempt organizations would be taxed in this 
proposal. The Administration's proposal inappropriately seeks 
to impose the tax scheme designed for Section 501(c)(7) social 
and recreational clubs only on Section 501(c)(6) associations. 
Congress has recognized that organizations exempt in these 
different categories serve different purposes and long ago 
fashioned a tax exemption scheme to reflect these differences. 
The Administration's proposal runs counter to common sense and 
would discourage or prevent Section 501(c)(6) organizations 
from providing services, including public services, consistent 
with the purposes for which these associations were granted 
exemption.

           III. Taxation of Association Lobbying Activities.

    The Clinton Administration's proposal has been 
characterized by the Secretary of the Treasury as a tax on 
``lobbying organizations,'' suggesting that associations 
somehow now enjoy a favored tax status for their lobbying 
activities. This is incorrect. Many associations do not conduct 
any lobbying activity. Moreover, the lobbying activities of 
associations have no tax preferences, advantages, or subsidies 
whatsoever; the funds are fully taxed by virtue of the Omnibus 
Budget Reconciliation Act of 1993. That law imposed a tax on 
all lobbying activities of trade and professional associations, 
either in the form of a flat 35% tax on all funds that the 
organization spends on lobbying activities, or as a pass-
through of non-deductibility to individual association members.
    Indeed, not only is there no tax benefit or tax exemption 
for associations' lobbying activities, either for the members 
or for the entities themselves, but the 1993 law provides a tax 
penalty on any funds used to lobby. Lobbying tax penalties can 
arise in essentially three ways:
    1. Proxy Tax. The ``proxy'' tax, an alternative to 
informing association members of dues non-deductibility because 
of association lobbying, is set at a flat 35% level. This is 
the highest level of federal income tax for corporations, paid 
only by corporations with net incomes over $18.33 million. 
Associations are denied the ``progressivity'' of the income tax 
schedule. Therefore, even though no associations ever achieve 
nearly that level of income, they must pay the proxy tax as if 
they did.
    2. Allocation Rule. Under the ``allocation rule,'' all 
lobbying expenses are allocated to dues income to determine the 
percentage of members' dues that are non-deductible. Most 
associations pay for their lobbying expenses using many sources 
of income. Increasingly, associations have far more non-dues 
income than dues income. The allocation rule, however, requires 
association members to pay tax on all association income used 
to conduct lobbying activities, regardless of the percentage of 
lobbying actually paid for from their dues. Indeed, under the 
``allocation rule,'' a business can pay more tax if it joins an 
association that lobbies for a particular government policy 
than if the business had undertaken the lobbying itself.
    3. Estimation Rule. The ``estimation rule'' requires that 
associations estimate in advance how much dues income and 
lobbying expense they anticipate. The estimation forms the 
basis for the notice of dues non-deductibility, which must be 
given at the time of dues billing or collection. If reality 
turns out to be different from the estimates, the association 
or its members are subject to very high penalties. There is no 
way to ensure freedom from the penalty for underestimating 
short of ceasing to spend money on lobbying the moment the 
association reaches its estimate. There is no way to avoid the 
penalty for overestimating at all.
    Associations are therefore already subject to more than tax 
neutrality and absence of exemption or subsidy for lobbying 
activities. The Administration's proposal would not make any 
provision with respect to lobbying activities of these 
associations, although it would certainly generally weaken the 
financial resources of associations and reduce their ability to 
assist industries, professions, and the public. Indeed, the 
Administration's characterization of the proposal as one that 
addresses ``lobbying organizations'' is tantamount to an 
Administration decision to further weaken and suppress the 
ability of tax-exempt organizations to lobby at all.

                      IV. Taxation of Member Dues.

    The Administration's proposal has also been justified by 
its proponents as eliminating a double tax advantage claimed to 
be enjoyed by dues-paying association members. According to the 
Administration, association members already receive an 
immediate deduction for dues or similar payments to Section 
501(c)(6) organizations. At the same time, members avoid paying 
taxes on investment income by having the association invest 
dues surplus for them tax-free.
    This argument is flawed for a variety of reasons:
     The argument implies that members voluntarily pay 
higher dues than necessary as an investment strategy. While in 
some circumstances members of tax-exempt associations can 
deduct their membership dues like any other business expense, 
members receive no other tax break for dues payments. As 
discussed above, they are in fact denied a deduction for any 
amount of dues their association allocates to lobbying 
expenses.
     The argument implies that associations overcharge 
their members for dues, thereby creating a significant surplus 
of dues income. In fact, dues payments usually represent only a 
portion of an association's income; and dues are virtually 
always determined by a board or committee consisting of 
members, who would hardly tolerate excessively high dues. 
Finally, associations tend to maintain only modest surpluses to 
protect against financial crises, expending the rest on 
programs and services. Again, associations are member-governed; 
members would typically make certain that their associations do 
not accumulate a surplus beyond the minimum that is necessary 
and prudent for the management of their associations.
     The argument assumes that Section 501(c)(6) 
organizations somehow pay dividends to their members. Tax-
exempt organizations do not pay dividends or returns in any 
form to their members, let alone for payment of dues. Indeed, 
an organization's exempt status may be revoked if any portion 
of its earnings are directed to individuals.
    In other words, the Administration suggests that 
association members are voluntarily paying higher than 
necessary dues, solely to avoid paying tax on their own 
investment income resulting when not all dues revenues are 
expended immediately. This is the same as suggesting that 
individuals donate to charities in hopes that the charities 
will earn investment income on un-spent donations. It is an 
argument that defies common sense and completely misunderstands 
the structure and operation of tax-exempt organizations.

 V. Expenditures Attributed to Investment and Other ``Passive'' Income 
 Would Generally Qualify As Deductible Expenses If Incurred by Members 
                          of the Association.

    The investment income and other ``passive'' income of 
associations is used to further the exempt purpose of the 
organizations. Most if not all of these expenditures for 
association programs and activities, which are made on behalf 
of the association's members, would be deductible if carried on 
directly by the members. This is because these expenses would 
otherwise be regarded as ordinary and necessary business 
expenses under Section 162(a) of the tax code or as a 
charitable contribution. Therefore, it is inappropriate to 
essentially deny this deduction by imposing the UBIT tax on 
this income. Under the Administration's proposal, this would in 
fact be the indirect result of subjecting the ``passive'' 
income of Section 501(c)(6) organizations to taxation.

    VI. The Administration's Proposed Tax Would Reach All Forms of 
         ``Passive'' Income and Jeopardize Tax-Exempt Programs.

    Trade associations, individual membership societies, and 
other similar voluntary membership organizations typically 
receive only a portion of their income from membership dues, 
fees, and similar charges. In many such organizations, 
particularly professional societies, there are natural limits 
or ``glass ceilings'' on the amounts of dues that can be 
charged to members. As a result, these Section 501(c)(6) tax-
exempt organizations have increasingly sought additional 
sources of income to enable them to continue their often broad 
programs of exempt activities on behalf of businesses, 
professions, and the public. One of those additional sources 
has been ``passive'' income--rents, royalties, dividends, 
interest, and capital gains--that may be earned from a variety 
of sources.
    Section 501(c)(6) organizations rely heavily on ``passive'' 
income to support their exempt activities. The proposal would 
adversely affect virtually all associations, since most 
organizations from time to time receive some amount of rents, 
royalties, interest, dividends, or capital gains. These 
associations use ``passive'' income to further a host of 
beneficial activities which would be threatened by imposition 
of the Clinton Administration's ``investment'' tax. For 
example, Section 501(c)(6) tax-exempt associations are 
responsible for:
     Drafting and disseminating educational materials.
     Establishing skills development seminars and 
programs.
     Creating training and safety manuals for various 
professions.
     Producing books, magazines, newsletters, and other 
publications.
     Increasing public awareness, knowledge, and 
confidence in an industry's or a profession's practices.
     Conducting and sponsoring industry research and 
surveys.
     Compiling statistical data for industries and 
professions which is often requested or relied upon by 
government.
     Providing professionals and businesses with new 
technical and scientific information.
     Developing and enforcing professional safety and 
health standards.
     Developing and enforcing ethical standards for 
industry practice.
     Operating accreditation, certification, and other 
credentialing programs.
     Organizing and implementing volunteer programs.
    The Administration's proposal imposes a broad-based, 
pervasive, and detrimental penalty on virtually all 
associations of any kind or size. A tax on the ``investment 
income'' of Section 501(c)(6) organization does not address any 
issue of income used for lobbying activities; all such 
activities by these organizations is already free of tax 
exemption or subsidy of any kind (indeed, it can be subject to 
offsetting ``penalty'' taxation). There is no double or special 
tax benefit to those who pay dues to associations. Instead the 
Administration's proposal taxes significant sources of funding 
that associations use now for highly desirable services to 
entire industries, professions, and the public. Treating 
Section 501(c)(6) organization in the same manner as social 
clubs ignores the special, quasi-public purposes and functions 
of associations, and threatens the ability of such 
organizations to continue to provide publicly beneficial 
services in the future. In summary, this proposal is a 
legitimate threat, albeit ill-conceived, to the ongoing 
viability of thousands of America's membership organizations, 
and should be rejected by this Committee.
    Thank you for this opportunity to testify before you today. 
I would be happy to supplement this testimony with answers to 
any questions you may have.
      

                                

    Chairman Archer. Without objection, so ordered. The chair 
appreciates the testimony of all four of you. Specifically, I 
would like to ask Mr. Lifson and Mr. Tucker, who I think 
represent some of the finest talent, experience, and expertise 
in dealing with the Tax Code. I understand that you both are 
concerned about the complexity of the tax-relief proposals. 
However, I don't want to get into any of those issues for this 
question. Relative to the President's budget, which, if any, of 
the administration's revenue-raising proposals could you 
support and feel was justified by tax policy?
    Mr. Tucker. We clearly can support the focus on corporate 
tax shelters. We think----
    Chairman Archer. That is mentioned in your testimony, 
correct?
    Mr. Tucker. Right. Sixteen provisions are too many. They 
are too complex. We think there needs to be a straight focus on 
disclosure, but we can support the focus on that as long as it 
does not eliminate legitimate business transactions for which 
there is a business purpose.
    Chairman Archer. Have you been able to examine in detail 
the administration's proposal on tax shelters?
    Mr. Tucker. We have, and we are doing it. We have set up a 
task force to work specifically with the----
    Chairman Archer. But you have not reached a conclusion 
about the details of that proposal?
    Mr. Tucker. No, sir.
    Chairman Archer. All right. Well, we will be happy to have 
your input when you do reach that conclusion.
    Mr. Tucker. We will be glad to.
    Chairman Archer. Which, if any, other revenue-raiser in the 
President's budget would either one of you support?
    Mr. Lifson. The only area that we feel extreme concern 
about is the treatment of tax-indifferent parties, which I 
think is part of the 16 specific areas, or the tax-shelter 
area. We have no position yet on any of the other revenue-
raisers. We are working on a supplemental submission at this 
time.
    Chairman Archer. So you are not in a position to either 
support or oppose all of the other revenue-raisers?
    Mr. Lifson. Correct.
    Chairman Archer. How soon do you think you might conclude 
your analysis?
    Mr. Tucker. We can get back to you within a couple of 
weeks. We have no problem going through that in detail.
    Chairman Archer. Fine. That would be very helpful. Thank 
you.
    Mr. Doggett.
    Mr. Doggett. Thank you, Mr. Chairman. Let's see, Mr. 
Sinclaire, I believe that in your written testimony you 
outlined nine different forms of tax cuts that you favor for 
business. What would be the cost of those to the Treasury.
    Mr. Sinclaire. I do not have a revenue estimate on those 
items.
    Mr. Doggett. You do not have a----
    Mr. Sinclaire. No, I do not.
    Mr. Doggett. Is it something you could supply the 
Committee?
    Mr. Sinclaire. We do not have any basis to develop revenue 
estimates. We would rely on revenue estimates that come from 
the Joint Committee.
    Mr. Doggett. And in addition to those nine specific forms, 
did I understand your oral testimony to be that you favor 
repealing all taxes on corporate profits?
    Mr. Sinclaire. No.
    Mr. Doggett. You do not? Your focus is on these nine 
specific forms?
    Mr. Sinclaire. That is not the complete list. There are 
other items where we support tax reform such as extension of 
section 127, items of that nature, the WOTC, the welfare-to-
work tax credit. Also, there are other items. This is not an 
exclusive list of items.
    Mr. Doggett. One gets the impression from the Forbes 
article that I referenced earlier and from other sources, that 
some corporate officials are actually being harassed into using 
these tax shelters by what are referred to as tax-shelter 
hustlers. Do you find that to be a problem?
    Mr. Sinclaire. The Chamber does not provide tax advice----
    Mr. Doggett. The Chamber took a position on these nine 
forms of tax cuts. Do you think that it is important to address 
this problem of tax hustlers and the whole problem of tax 
shelters and tax avoidance?
    Mr. Sinclaire. When there is an abusive situation, the 
Chamber does not condone that. So in that sense, yes we would 
favor that there be some examination and possible changes.
    Mr. Doggett. Mr. Tucker, with reference to your testimony, 
is this problem of aggressive positions by tax shelter hustlers 
a sizable one in this country?
    Mr. Tucker. Whenever you have significant tax reduction 
that occurs, not because of business purpose or business-
related, but simply because somebody is marketing a product 
that combines different provisions of the Code that were not 
intended to be utilized together, we think that does create 
problems. When you see the corporate taxes are reduced at the 
cost of what could otherwise be benefits for individuals or 
small business, then we think, yes, that is still a problem.
    Mr. Doggett. And I would suppose that it is also a 
professional problem, reflecting on those tax practitioners who 
are trying to counsel their clients to comply completely with 
the tax law if there is somebody down the street suggesting you 
can avoid a significant amount of tax?
    Mr. Tucker. Yes, sir.
    Mr. Doggett. If I understand one of your specific 
recommendations, in which I think you do share with the 
Treasury that is mentioned in your testimony, you believe that 
it is important that there be penalties not only against the 
corporations that might have taken advantage of one of these 
improper rackets, but more particularly to focus it on the 
people that hustled them into it and sold them on one of these 
improper schemes.
    Mr. Tucker. Yes, sir, as well as the tax-indifferent party 
that may be joining into that scheme.
    Mr. Doggett. And you offer that on behalf of your section 
even though, I suppose, there may be some, certainly some tax 
lawyers in the country, and maybe some members of your section, 
that could be subject to these penalties.
    Mr. Tucker. We believe that this is a very important set of 
provisions for the country as a whole. We recognize that any 
time something is done prospectively, you may eliminate certain 
very beneficial items to certain people, but we think this is 
something that is important for the country.
    Mr. Doggett. You mentioned prospectively. Is it important 
that there be a capacity to apply some of these penalties 
retroactively?
    Mr. Tucker. We think that we already have a number of 
provisions in the Code, that, if we had the funding for the 
Revenue Service to go out and do the proper scrutiny analysis 
(when you have substance versus form, when you have the step 
transaction theory), the business purpose theory--there are 
already a number of points that could be utilized.
    What we are really looking at is the ability to have them 
look at items because disclosure has been given, and we think 
that is important, because even those activities that have 
happened in the past could be picked up under these preexisting 
judicial and legislative actions.
    Mr. Doggett. The Forbes article suggested that just one 
firm here in the Washington, DC, area had as many as 40 people 
out promoting these kinds of schemes. Just in terms of the 
dimension of the problem around the country, are there a 
significant number of people involved in promoting questionable 
tax schemes around the country?
    Mr. Tucker. Legend says that there are. I cannot tell you 
whether there are, but we hear that there are numbers of 
people, but I certainly could not say who they are or what 
numbers there are.
    Mr. Doggett. Thank you. Look forward to getting your 
report.
    Mr. Tucker. Thank you, sir.
    Mr. Houghton [presiding]. Mr. Weller.
    Mr. Weller. Thank you, Mr. Chairman. Appreciate the panel's 
testimony here and recognize we have a vote and we are going to 
have to break for a few minutes to go vote. I will try and be 
quick.
    First, Mr. Lifson, your testimony on simplifying the Code, 
I welcome that, and your suggestions and ideas. And not only do 
you note that once again the administration in their targeted 
tax cuts create more marriage-tax penalties with their phase-
outs. Right now, I think, in addition to the joint filers, the 
marriage tax penalty, and then if you add in over 60 additional 
marriage penalties that are created by various phase-outs, we 
really don't need three or four more, which the administration 
proposes adding to complicate the Tax Code even more.
    And I would also like to mention in your testimony on page 
4 that some suggestions that you propose as we look for ways to 
simplify the Tax Code and, of course address some of the 
unfairness, you suggest marriage-tax penalty relief, increasing 
the amount for personal exemptions, increasing the standard 
deduction, and also expanding the 15-percent tax bracket. And I 
just want you to urge you to take a look at a tax 
simplification package that Rep. Dunn and I have offered, which 
we believe simplifies the Code as well as addresses the 
unfairness in the Tax Code.
    And one of the things we do is we expand the 15-percent 
bracket. So a family of four making $55,000 is in the 15-
percent tax bracket, rather than the 28-percent tax bracket as 
they are today. Eliminate the marriage penalty, eliminate the 
death tax, eliminate tax on retirement savings. And so I 
welcome your suggestions and I am anxious to look at this 
further.
    I recognize because of the vote we are going to have to run 
here. But I do want to ask a quick question of Mr. Olson.
    Mr. Olson. Yes, sir.
    Mr. Weller. The administration is part of the $176 billion 
tax increase package that the President proposes in his budget, 
includes a new tax on associations, which you referenced in 
your testimony. A lot of times when people think of 
associations they think of Chamber of Commerce, they think of 
the Farm Bureau, they think of the National Federation of 
Independent Business. Can you give an example of some of the 
smaller groups that--and give an example not only of a smaller 
organization, but also the impact of this new tax increase that 
the administration wants to impose on the money they have in 
the bank account, for example, with the tax on the interest 
they would have in the money they would set aside from dues and 
that. Could you give an example?
    Mr. Olson. I might answer your question in reverse order. 
The issue of accruing investments and creating a fund balance 
for a nonprofit or tax-exempt organization is important to 
understand because it is the result of careful stewardship over 
many, many years, and in many instances, decades, of volunteer 
leadership, where you are in an environment corporately where 
nothing can inure to the benefit of one individual. You have 
group stewardship of these resources. So these are not fast, 
overnight, quick-buck profits that have been accumulated by a 
corporation, these are carefully shepherded investment funds 
that have grown through prudent management of member resources 
over many years.
    Examples of some of the smaller groups that have fund 
balances that could be impacted extend to groups like Rotary 
clubs, Boy Scouts, Young Republicans, the Democratic Women, of 
State organizations, local organizations. Anything with a 
(c)(6) in its classification under the Internal Revenue Service 
code, and there are over 70,000 such organizations, would be 
directly impacted by this.
    And the average of these 70-some thousand in terms of the 
investment revenues as a part of their total budget runs about 
5.5 percent. Regardless of the size budget, the percentage is 
about the same. And that is a big part of their operation.
    Mr. Weller. Mr. Olson, you indicated, you have just made 
the statement that the Young Republicans, the Democratic 
Women's Club--I guess I'm running out of time because of this--
you know, one point I would like to make is that, you know, 
Secretary Lubick said somehow the individual members will 
benefit by the new tax on their organization. And I hope that 
you can submit some testimony for the record----
    Mr. Olson. We have for the record. It's in our lengthy 
preparation. Yes, sir, it is there in detail.
    Mr. Weller. Thank you.
    Mr. Olson. Thank you for asking.
    Mr. Houghton. Gentlemen, I am sorry. We have to vote. We 
will have to leave. And then as soon as we have our vote, maybe 
votes, we will take a look at our next panel, Mr. Kies, 
Weinberger, Wamberg, and Hernandez. Thank you very much for 
coming. Sorry we have to push it.
    [Recess.]
    Chairman Archer [presiding.] The Committee will come to 
order. Our next panel, which is our second-to-last panel, is 
before us now, and welcome. Mr. Kies, if you will identify 
yourself--I know you are relatively unknown [laughter] in this 
room--you may proceed.

  STATEMENT OF KENNETH J. KIES, MANAGING PARTNER, WASHINGTON 
       NATIONAL TAX SERVICES, PRICEWATERHOUSECOOPERS LLP

    Mr. Kies. Thank you, Mr. Chairman. My name is Ken Kies. I 
am a managing partner at PricewaterhouseCoopers, Washington 
National Tax Services office. The firm has more than 6,500 tax 
professionals in the United States and Canada, and works 
closely with thousands of corporate clients worldwide, 
including most of the Fortune 500.
    I'm here to comment on the administration's corporate tax 
shelter proposals, specifically the first six proposals in the 
Treasury's list under that section. My comments summarize the 
key points of a 50-page analysis we have prepared on these 
proposals and which has been made available to the Committee 
today.
    Our analysis reflects the collective experience of many of 
the firm's corporate clients. In our view, these proposals are 
overreaching, unnecessary, and at odds with sound tax-policy 
principles. In my brief time today, I am going to give you 
several reasons why these proposals should be rejected.
    First, despite statements made by the administration and 
inferences left by the recent Forbes article on tax shelters, 
there is no revenue data or other evidence that would suggest 
that corporate tax planning is eroding the corporate income tax 
base. To the contrary, as CBO data show, corporate income tax 
payments as a percentage of GDP over the past 4 years are at 
their highest level since 1980, and are projected to remain 
there for the next 10 years.
    Second, Treasury and IRS already have more than adequate 
tools to address perceived abuses. These include numerous tax 
penalties, common-law doctrines, like the economic substance 
and business purpose doctrine, and more than 70 antiabuse 
provisions in the Code today. Treasury also has the ability to 
move quickly to respond to perceived abuses by issuing 
administrative notices.
    Third, Treasury and IRS have not used the tools they 
already have. Congress in 1997 enacted legislation broadening 
the definition of a tax shelter, subject to stiff penalties. At 
that time, Commerce expressly stated that this change would 
discourage taxpayers from entering into questionable 
transactions.
    As of today, Treasury, still has not issued regulations 
necessary to activate the 1997 changes. Without having used the 
tools that Congress specifically granted in 1997, the 
administration is now asking for a new set of tools it believes 
are more appropriate.
    Fourth, the proposals presented by Treasury are dangerously 
vague. They turn on a subjective and, I believe, 
unadministerable definition of a tax-avoidance transaction. 
This definition could be used by the IRS agents to increase 
taxes on a broad range of legitimate business transactions.
    The IRS would have the authority simply to deny tax 
benefits even for transactions that clearly comply with 
substantive tax law.
    I believe these proposals, if enacted, would represent the 
broadest grant of discretion ever given by a Congress to agents 
of the IRS. Ironically, this would come a year after Congress 
took action to rein in the power of IRS agents.
    Fifth, corporate tax executives have told us that these 
proposals would make their jobs nearly impossible. There could 
be no certainty as to the tax treatment of complex business 
transactions, which are often undertaken across borders and are 
subject to a patchwork of laws imposed by U.S., foreign, State, 
and local taxing jurisdictions. And let's not forget that these 
corporate tax executives are the individuals who are in charge 
of collecting more than one-half of the total tax revenue that 
fund our government, not only through corporate income tax 
payments, but also through individual income tax and payroll 
tax withholding and the collection of the bulk of the existing 
excise taxes.
    Sixth, corporate tax executives are conservative by nature. 
In addition to being bound by professional and company-imposed 
ethical standards, they have a fiduciary duty to avoid monetary 
penalties that could reduce their company's profitability. 
Moreover, most corporations are extremely sensitive about 
preserving and enhancing their corporate image, thus corporate 
tax executives are careful not to recommend a transaction to 
their management that later might be reported unfavorably in 
the national press.
    Because of the extreme complexity of tax rules, corporate 
tax executives need assistance from their professional advisers 
and other to help determine tax-efficient and prudent ways to 
implement business objectives.
    Seventh, I believe these proposals would represent a 
dramatic shift in the balance between the Congress and 
executive branch in terms of tax policymaking. For many years, 
Congress and the executive branch have had differing views on 
the merits of proposed changes to tax law. As an example, the 
current administration in its past three submissions on the 
budget, has advanced more than 40 revenue-raising proposals 
that have been opposed by the Congress, in many cases on a 
bipartisan basis. This is a healthy tension, one that more 
often than not yields correct tax policy decisions. The 
administration's proposals effectively would ask Congress to 
allow the executive branch in the form of the individual IRS 
agent to dictate much of tax policymaking.
    To conclude, Treasury and the IRS already have more than 
ample tools to address situations involving abusive tax 
planning. Some tools that you have provided have gathered dust 
for 2 years. At this time, I believe there is no demonstrated 
need to expand on these tools, particularly in such a way that 
would give IRS agents nearly limitless authority to recast the 
tax treatment of legitimate business transactions.
    I would be happy to answer any questions that you or the 
Members of the Committee have, Mr. Chairman. Thank you.
    [The prepared statement and attachments follow. Appendices 
to the statement are being retained in the Committee files.]

Statement of Kenneth J. Kies, Managing Partner, Washington National Tax 
Services, PricewaterhouseCoopers LLP

                            I. Introduction

    PricewaterhouseCoopers appreciates the opportunity to 
submit this written testimony to the Committee on Ways and 
Means on the revenue-raising proposals included in the 
Administration's FY 2000 budget submission.
    PricewaterhouseCoopers, the world's largest professional 
services organization, provides a full range of business 
advisory services to corporations and other clients, including 
audit, accounting, and tax consulting. The firm, which has more 
than 6,500 tax professionals in the United States and Canada, 
works closely with thousands of corporate clients worldwide, 
including most of the companies comprising the Fortune 500. 
These comments reflect the collective experiences of many of 
our corporate clients.
    Our testimony focuses on broad new measures proposed by the 
Administration relating to ``corporate tax shelters.'' 
Specifically, these include proposals that would (1) modify the 
substantial understatement penalty for corporate tax shelters; 
(2) deny certain tax benefits to persons avoiding income tax as 
a result of ``tax-avoidance transactions''; (3) deny deductions 
for certain tax advice and impose an excise tax on certain fees 
received with respect to ``tax-avoidance transactions'' (4) 
impose an excise tax on certain rescission provisions and 
provisions guaranteeing tax benefits; (5) preclude taxpayers 
from taking tax positions inconsistent with the form of their 
transactions; and (6) tax income from corporate tax shelters 
involving ``tax-indifferent parties.'' \1\
---------------------------------------------------------------------------
    \1\ General Explanation of the Administration's Revenue Proposals, 
Department of the Treasury, February 1999, pp. 95-105.
---------------------------------------------------------------------------
    In our view, these proposals are overreaching, unnecessary, 
and at odds with sound tax policy principles. They introduce a 
broad and amorphous definition of a ``corporate tax shelter'' 
that could be used by Internal Revenue Service (Service) 
revenue agents to challenge many legitimate transactions 
undertaken by companies operating in the ordinary course of 
business in good-faith compliance with the tax laws. If enacted 
by Congress, these proposals would represent one of the 
broadest grants of authority ever given to the Treasury 
Department in the promulgation of regulations and, even more 
troubling, to Service agents in their audits of corporate 
taxpayers.

                        A. Initial observations.

1. Revenue data shows no erosion of the corporate tax base.

    Before turning to our specific concerns with the 
Administration's proposals, it is worthwhile to consider 
several important points. First, these proposals have arisen in 
response to a perception at the Treasury Department that tax-
planning activities are eroding the corporate tax base.\2\ The 
facts suggest otherwise. Corporate income tax payments reached 
$189 billion in 1998 and are projected by the Congressional 
Budget Office (CBO) to grow to $267 billion in the next 10 
years.\3\ Projections by the CBO and the Office of Management 
and Budget (OMB) show that these corporate revenues will remain 
relatively stable as a share of the overall economy in the 
coming years. There is no data in the projections of CBO or OMB 
to suggest that corporate tax activity will cause corporate tax 
revenues to decline in the future.
---------------------------------------------------------------------------
    \2\ Budget of the United States Government: Fiscal Year 2000, 
Analytical Perspectives, p. 71.
    \3\ The Economic and Budget Outlook: Fiscal Years 2000-2009, 
Congressional Budget Office, January 1999, p. 53.
---------------------------------------------------------------------------
    Moreover, corporate income tax receipts as a percentage of 
taxable corporate profits stood at 32.4 percent in 1998 and are 
projected to remain relatively constant over the next 10 years 
(32.5 percent in 2008).\4\ This is approximately the effective 
tax rate that would result by subjecting all corporate taxable 
income to the graduated corporate tax rate schedule, which 
taxes income at rates starting at 15 percent and increasing to 
the top statutory rate of 35 percent.\5\ The CBO measure of the 
corporate tax base is based, with minor modifications, on the 
economic profits measured by the national income and product 
accounts rather than income reported for tax purposes. As a 
result, there is nothing in this forecast to suggest that the 
corporate tax base is under assault from an imagined new 
``market'' in corporate tax shelters.
---------------------------------------------------------------------------
    \4\ Ibid.
    \5\ Approximately 80 percent of corporate income is earned by 
corporations subject to the 35-percent top statutory rate. The largest 
7,500 corporations account for approximately 80 percent of all the 
corporate income tax collected.
---------------------------------------------------------------------------
    In fact, during the past four years corporate income tax 
payments as a percentage of gross domestic product have reached 
their highest levels since 1980.\6\
---------------------------------------------------------------------------
    \6\ The Economic and Budget Outlook: Fiscal Years 2000-2009, supra 
n.4., at 131.

2. The proposals are inconsistent with the Congressional view 
that the scope of Treasury Department authority should be 
---------------------------------------------------------------------------
limited.

    The Administration's proposals run counter to the spirit of 
recent Congressional actions. In last year's landmark Internal 
Revenue Service Restructuring and Reform Act,\7\ Congress 
enacted significant new limitations on the authority of Service 
agents in audit situations. Now, a mere eight months later, the 
Administration is asking Congress to empower agents with broad 
authority to ``deny tax benefits'' where they see fit.
---------------------------------------------------------------------------
    \7\ Internal Revenue Service Restructuring and Reform Act of 1998, 
P.L. 105-208.
---------------------------------------------------------------------------
    In last year's Administration budget (for FY 1999), 
Treasury asked for expansive authority to ``set forth the 
appropriate tax results'' and ``deny tax benefits'' in hybrid 
transactions \8\ and in situations involving foreign losses.\9\ 
Congress dismissed these proposals. The FY 2000 budget 
proposals now ask for authority of the same type but 
significantly broader than the authorization that Congress 
rejected just last year. The Treasury's new proposals thus can 
be seen as an attempted end run around earlier failed 
initiatives--this time accompanied by the shibboleth of 
``stopping tax shelters.''
---------------------------------------------------------------------------
    \8\ General Explanation of the Administration's Revenue Proposals, 
Department of the Treasury, February 1998, p. 144.
    \9\ Id. at 143.

3. Congress in the past has taken actions to stop perceived tax 
---------------------------------------------------------------------------
shelter abuses when necessary.

    Congress has been alert to perceived tax shelter issues and 
has taken a series of actions in the past. In fact, Congress in 
1997 enacted legislation \10\ broadening the definition of a 
``tax shelter'' subject to stiff penalties under the Internal 
Revenue Code and requiring that such arrangements be reported 
in writing to the Service.\11\ The Joint Committee on 
Taxation's ``Blue Book'' explanation discusses the intent 
underlying these changes:\12\
---------------------------------------------------------------------------
    \10\ Taxpayer Relief Act of 1997, P.L. 105-34.
    \11\ Under the 1997 legislation, the statutory definition of a tax 
shelter was modified to eliminate the requirement that the tax shelter 
have as ``the principal purpose'' the avoidance or evasion of Federal 
income tax; the new law requires only that the tax shelter have as ``a 
significant purpose'' the avoidance or evasion of tax. See discussion 
in Part IV below of current penalties and registration requirements 
applicable to tax shelters.
    \12\ Joint Committee on Taxation, General Explanation of Tax 
Legislation Enacted in 1997 (JCS-23-97), December 17, 1997, p. 222.

          The Congress concluded that the provision will improve 
        compliance with the tax laws by giving the Treasury Department 
        earlier notification than it generally receives under present 
        law of transactions that may not comport with the tax laws. In 
        addition, the provision will improve compliance by discouraging 
---------------------------------------------------------------------------
        taxpayers from entering into questionable transactions.

    Nineteen months later, the Treasury Department has yet to 
implement the new tax shelter reporting rules. To provide fair 
notice to taxpayers, Congress made the effective date of these 
provisions contingent upon Treasury's issuing guidance on the 
new requirements. But as of this date, no such guidance has 
been issued. It is totally inappropriate from the standpoint of 
sound tax policy that Treasury at this time would request 
expanded authority to address the issue of tax shelters when it 
has eschewed recent authority explicitly granted by the 
Congress on the identical issue.\13\
---------------------------------------------------------------------------
    \13\ It should be noted that this unfinished regulation project is 
but one of many interpretive projects that the Treasury Department has 
not completed; the collective effect of this unfinished work is 
considerable uncertainty for corporate taxpayers attempting to comply 
with the tax law in good faith. This issue will be discussed further in 
these comments, and an illustrative list of unfinished regulation 
projects relevant to corporate taxpayers is set forth in Appendix F.
---------------------------------------------------------------------------
    Moreover, the Administration's penalty proposals come at 
the same time that Treasury and the Joint Committee on 
Taxation, as required by the 1998 Internal Revenue Service 
Restructuring and Reform Act, are conducting studies reviewing 
whether the existing penalty provisions are ``effective 
deterrents to undesired behavior.'' \14\ These studies, which 
are required to be completed by this summer, are to make any 
legislative and administrative recommendations deemed 
appropriate. The Treasury proposals, if enacted, would preempt 
the careful penalty review process that was designed by the 
Congress last year.
---------------------------------------------------------------------------
    \14\ P.L. 105-208, sec. 3801.
---------------------------------------------------------------------------
    Meanwhile, Congress and Treasury successfully have worked 
together to identify specific situations where the tax laws are 
being applied inappropriately and to enact quickly substantive 
tax-law changes in response. Recent examples include 
legislation enacted or introduced relating to liquidations of 
REITs or RICs \15\ and transfers of assets subject to 
liabilities under section 357(c).\16\ The Administration's FY 
2000 budget proposes a series of specific changes in a number 
of other areas. Whether or not the tax policy rationales given 
by Treasury for these targeted proposals are persuasive, the 
appropriate manner in which to curb avoidance potential is for 
Congress to deliberate upon specific legislative proposals, and 
not to grant broad and unfettered authority to Treasury and 
Service revenue agents.
---------------------------------------------------------------------------
    \15\ P.L 105-277, sec. 3001 (provision aimed at attempts to read 
statutory provisions as permitting income deducted by a liquidating 
REIT or RIC and paid to its parent corporation to be entirely tax free 
during the period of liquidation).
    \16\ A provision addressing the tax treatment of certain transfers 
of assets subject to liabilities described in section 357(c) passed the 
House February 8, 1999, as part of H.R. 435; an identical provision was 
approved by the Senate Finance Committee January 22, 1999, as part of 
S. 262. The provisions would apply to transfers on or after October 19, 
1998, the date on which House Ways and Means Committee Chairman Bill 
Archer introduced legislation on this topic. That legislation was 
developed by Chairman Archer in coordination with the Treasury 
Department in response to concerns that some taxpayers were structuring 
transactions ``to take advantage of the uncertainty'' under the tax 
law.
---------------------------------------------------------------------------
    Finally, it should be mentioned that the broad grant of 
authority in the Treasury Department tax shelter proposals is 
totally unnecessary. On several occasions in recent years, 
Treasury has determined that administrative actions were 
necessary to stop certain perceived avoidance transactions.\17\ 
While we may not agree that Treasury's action was appropriate 
in each instance that such action was taken, it is clear that 
no further grant of authority is necessary or warranted from 
the Congress on these matters.
---------------------------------------------------------------------------
    \17\ Treasury Department activities to stop perceived avoidance 
transactions will be discussed in further detail in these comments. An 
illustrative list of prior Treasury Department administrative actions 
to stop perceived avoidance is set forth in Appendix C.
---------------------------------------------------------------------------

                        B. Outline of comments.

    These comments set forth a number of key considerations 
that should be weighed by Congress in evaluating the 
Administration's corporate tax shelter proposals:
     First, we discuss each of the Administration's 
corporate tax shelter proposals, offering a brief critique and 
analysis on tax policy grounds.
     Second, we explore the potential detrimental 
impact of the Administration's proposals on an illustrative 
series of legitimate business transactions.
     Third, we analyze the existing tools that are 
available to the Treasury Department and the Internal Revenue 
Service--and Congress--to address tax shelters and other 
perceived abuses under the tax system. This discussion includes 
an explanation of current-law penalty and disclosure rules; 
specific anti-abuse rules; common-law doctrines (e.g., 
``economic substance'' and ``substance over form'') that may be 
invoked; and opportunities to address abuses through 
legislative action.
     Fourth, we discuss the vital role played by 
corporations in administering U.S. tax laws--while dealing with 
their complexity--and the important responsibilities of 
corporate tax directors to their shareholders. These roles and 
responsibilities are often overlooked during consideration of 
U.S. corporate income tax policy.
     Finally, we discuss the role played by accounting 
firms in advising corporations on tax issues.
    II. ANALYSIS OF ADMINISTRATION S CORPORATE TAX SHELTER PROPOSALS

    A. Modify substantial understatement penalty for corporate tax 
                               shelters.

1. Treasury proposal.

    The proposal generally would increase the penalty 
applicable to a substantial understatement by a corporate 
taxpayer from 20 percent to 40 percent for any item 
attributable to a ``corporate tax shelter,'' effective for 
transactions occurring on or after the date of first committee 
action. In addition, the present-law reasonable cause exception 
from the penalty would be repealed for any item attributable to 
a corporate tax shelter.
    A ``corporate tax shelter'' would be defined as any entity, 
plan, or arrangement (to be determined based on all facts and 
circumstances) in which a direct or indirect corporate 
participant attempts to obtain a tax benefit in a tax avoidance 
transaction. A ``tax benefit'' would be defined to include a 
reduction, exclusion, avoidance, or deferral of tax, or an 
increase in a refund, but would not include a tax benefit 
``clearly contemplated by the applicable provision (taking into 
account the Congressional purpose for such provision and the 
interaction of such provision with other provisions of the 
Code).''
    A ``tax avoidance transaction'' would be defined as any 
transaction in which the reasonably expected pre-tax profit 
(determined on a present-value basis, after taking into account 
foreign taxes as expenses and transaction costs) of the 
transaction is insignificant relative to the reasonably 
expected net tax benefits (i.e., tax benefits in excess of the 
tax liability arising from the transaction, determined on a 
present-value basis) of such transaction. In addition, a tax 
avoidance transaction would be defined to cover certain 
transactions involving the improper elimination or significant 
reduction of tax on economic income.

2. Analysis.

    This proposal is overbroad, unnecessary, and totally 
inconsistent with the goals of rationalizing penalty 
administration and reducing taxpayer burdens.
    First, the proposal creates the entirely new and vague 
concept of a ``tax avoidance transaction.'' The first prong of 
the definition of a tax avoidance transaction is styled as an 
objective test requiring a determination of whether the present 
value of the reasonably expected pre-tax profit from the 
transaction is insignificant relative to the present value of 
the reasonably expected tax benefits from the transaction. 
However, the inclusion of so many subjective concepts in this 
equation precludes its being an objective test. As an initial 
matter, what constitutes the ``transaction'' for purposes of 
this test? Next, what are the parameters for ``reasonable 
expectation'' in terms of both pre-tax economic profit and tax 
benefits? Further, where is the line drawn regarding the 
significance of the reasonably expected pre-tax economic profit 
relative to the reasonably expected net tax benefits?
    Not only is this prong of the test extremely vague, the 
uncertainty is compounded by the second prong of the definition 
of tax avoidance transaction. Under this alternative 
formulation, certain transactions involving the improper 
elimination or significant reduction of tax on economic income 
would be considered to be tax avoidance transactions even if 
they did not satisfy the profit/tax benefit test described 
above. The inclusion of this second prong renders the 
definition entirely subjective, with virtually no limit on the 
Service's discretion to deem a transaction to be a tax 
avoidance transaction.
    Second, elimination of the reasonable cause exception would 
result in situations where a revenue agent is compelled to 
impose a 40-percent penalty even though the agent determines 
that (1) there is substantial authority supporting the return 
position taken by the taxpayer, and (2) the taxpayer reasonably 
believed (based, for example, on the opinion or advice of a 
qualified tax professional) that its tax treatment of the item 
was more likely than not the proper treatment. If, in that 
situation, a revenue agent concluded it would be appropriate to 
``waive'' the penalty, the agent could do so only by 
determining that the transaction in question was not a 
corporate tax shelter, i.e., that the increased penalty was not 
applicable. Over time, one clearly unintended consequence of 
forcing revenue agents to make such choices might be a skewed 
definition of the term ``tax shelter.''
    The automatic nature of the proposed increased penalty 
would alter substantially the dynamics of the current process 
by which the vast majority of disputes between the Service and 
corporate taxpayers are resolved administratively. Today, even 
where a corporation and the Service agree that there is a 
substantial understatement of tax attributable to a tax shelter 
item, the determination as to whether the substantial 
understatement penalty should be waived for reasonable cause 
continues to focus on the merits of the transaction and the 
reasonableness of the taxpayer's beliefs regarding those 
merits. If, however, the reasonable cause exception no longer 
were available, the parties necessarily would have to focus on 
whether the transaction in question was a ``tax avoidance 
transaction'' and other definitional issues unrelated to the 
underlying merits of the transaction.
    Stripping revenue agents of their discretion to waive 
penalties for reasonable cause would make it more difficult for 
the Service to achieve its objective of resolving cases at the 
lowest possible level. Unnecessary litigation also would 
result. In many cases, the size of the penalty and the absence 
of flexibility regarding its application could compel the 
taxpayer to refuse to concede or compromise its position on the 
merits of the issue, since only by prevailing on the merits 
could the taxpayer avoid the penalty. Moreover, the mere 
availability of such an onerous penalty may cause some revenue 
agents to threaten its assertion as a means of exacting 
unrelated (and perhaps unwarranted) concessions from the 
taxpayer. Clearly, the use of the increased substantial 
understatement penalty as a ``bargaining chip'' is not 
appropriate or warranted for the proper determination of tax 
liability of a corporation and the efficient administration of 
the examination process.
    Increasing the penalty on substantial understatements that 
result from corporate tax shelters to 40 percent also would be 
inconsistent with the Service's published policy regarding 
penalties. Policy Statement P-1-18 states that ``[p]enalties 
support the Service's mission only if penalties enhance 
voluntary compliance.'' Similarly, Internal Revenue Manual 
(20)122 provides that ``[t]he fundamental reason for having 
penalties is to support and encourage voluntary compliance.'' 
Thus, the Service's principal purpose in asserting penalties is 
not to punish, but rather to ensure and enhance voluntary 
compliance. The imposition of a 40-percent substantial 
understatement penalty in situations where under current law 
reasonable cause would be found to exist would punish taxpayers 
that in fact are in compliance with the tax laws.
    Creating new penalties--especially ones whose applicability 
depends on whether a particular transaction meets an inexact 
definition--would put too many revenue agents in a position of 
having to interpret statutes, rules, and regulations unrelated 
to the substance of the issue or transaction in question. Based 
on our experience, it is likely that many agents would find it 
easier and less risky to assert the new penalty rather than 
expose themselves to being second-guessed by others at the 
Service as to whether the penalty was applicable. Accordingly, 
pressures on revenue agents may cause the new penalty to be 
asserted initially in far too many circumstances than are 
warranted.
    Further, the Service historically has had significant 
difficulty administering civil tax penalties fairly and 
consistently among regions, service centers, district offices, 
and functions. Those difficulties resulted in the 
Commissioner's establishing a task force in 1987 to study civil 
tax penalties, the issuance of a report by that task force in 
February 1989, a legislative overhaul of the Code's penalty 
provisions in 1989,\18\ and the creation and issuance of the 
Consolidated Penalty Handbook as part of the Internal Revenue 
Manual.
---------------------------------------------------------------------------
    \18\ The ``Improved Penalty Administration and Compliance Tax Act'' 
was enacted as part of the Omnibus Budget Reconciliation Act of 1989. 
(P.L. 101-239, secs. 7701-7743)
---------------------------------------------------------------------------
    It is evident that Congress believes there is room for 
significant further improvement and clarity in the 
administration of penalties. As discussed above, the Internal 
Revenue Service Restructuring and Reform Act of 1998 requires 
the Joint Committee on Taxation and the Treasury Department to 
conduct separate studies regarding whether the current civil 
tax penalties operate fairly, are effective deterrents to 
undesired behavior, and are designed in a manner that promotes 
efficient and effective administration.\19\ The Joint Committee 
and Treasury will make whatever legislative and administrative 
recommendations they deem appropriate to simplify penalty 
administration and reduce taxpayer burden. With these important 
studies in process at this time, this legislative proposal to 
increase the substantial understatement is ill-conceived and 
unwarranted.
---------------------------------------------------------------------------
    \19\ See n.14, supra.
---------------------------------------------------------------------------

B. Deny certain tax benefits to persons avoiding income tax as a result 
                     of tax-avoidance transactions.

1. Treasury proposal.

    The proposal would expand the current-law rules in section 
269 to authorize Treasury to disallow a deduction, credit, 
exclusion, or other allowance obtained in a ``tax avoidance 
transaction'' (as defined above). The proposal would be 
effective for transactions entered into on or after the date of 
first committee action.

2. Analysis.

    In crafting this proposal, Treasury has disregarded the 
off-quoted observation of Judge Learned Hand that taxpayers are 
entitled to arrange their business affairs so as to minimize 
taxation and are not required to choose the transaction that 
results in the greatest amount of tax.\20\ Under the Treasury 
proposal, even though a taxpayer's transaction has economic 
substance and legitimate business purpose, the Service would be 
empowered to deny the tax savings to the taxpayer if another 
route of achieving the same end result would have resulted in 
the remittance of more tax.
---------------------------------------------------------------------------
    \20\ Judge Hand wrote: ``Over and over again courts have said that 
there is nothing sinister in so arranging one's affairs as to keep 
taxes as low as possible. Everybody does so, rich or poor; and all do 
right, for nobody owes any public duty to pay more than the law 
demands: taxes are enforced extractions, not voluntary contributions'' 
(Comm'r v. Newman, 159 F.2d 848, 850-51 (2d Cir.1947) (dissenting 
opinion)).
---------------------------------------------------------------------------
    Essentially, this proposal would grant unfettered authority 
to the Service to determine independently whether a taxpayer is 
engaging in a transaction defined as a ``tax avoidance 
transaction,'' and, based on that determination, to disallow 
any deduction, credit, exclusion, or other allowance obtained 
by the taxpayer. A tax avoidance transaction would be defined 
to include a transaction involving the ``improper elimination'' 
or ``significant reduction'' of tax on economic income. In 
other words, if the Service believed for any reason that the 
taxpayer had structured a transaction that yields too much in 
tax savings, it would have the power to strike it down. This 
power could be invoked without regard to the legitimacy of the 
taxpayer's business purposes for entering into the transaction 
or the economic substance underlying the transaction. In other 
words, if the transaction is too tax efficient, then it simply 
would not be permitted by the Service.
    The Administration states that this proposed enormous 
expansion of the current section 269 rules must be adopted 
because the current-law restrictions only apply to the 
acquisition of control or the acquisition of carryover basis 
property in a corporate transaction. It is important to place 
the current rules in context. The statutory rule has been in 
the tax law since 1943. Congress at that time was concerned 
that corporations were trafficking in net operating losses and 
excess profits credits.\21\ The statute is focused on 
acquisitions of corporate control and nontaxable corporate 
reorganizations that produce tax advantages following the 
combination that were not independently available to the 
parties prior to the combination.
---------------------------------------------------------------------------
    \21\ See H.Rpt. No. 871, 78th Cong., 1st Sess. 49 (1943).
---------------------------------------------------------------------------
    The original objective for enactment of section 269--to 
police the transfer of tax benefits in corporate combinations--
has been virtually superseded by other statutes and 
regulations. For example, sections 382, 383, and 384 provide 
detailed limitations on the use of NOLs, built-in deductions, 
and tax credits following certain corporate combinations. The 
consolidated return regulations under section 1502 contain 
numerous limitations on the use of net operating losses, built-
in deductions, and tax credits following the addition of a new 
member to a consolidated group. Further, section 1561 places 
limits on surtax exemptions in the case of certain controlled 
corporate groups.
    Nevertheless, even though section 269 has been superseded 
in certain respects by subsequent specific legislation and 
thereby rarely is applied, taxpayers considering prudent 
planning transactions must take into account section 269 in 
many different corporate contexts because of the broad reach of 
its provisions. This statute results in burdensome and time-
consuming administrative issues for taxpayers and revenue 
agents alike, with few changes in positions ultimately required 
and little revenue generated in return. The issue of whether 
the taxpayer has obtained a particular benefit it would not 
otherwise enjoy often is a difficult determination, and 
determining the taxpayer's principal purpose is a subjective 
exercise. This results in a lack of uniformity in the statute's 
application.
    The Administration now proposes to expand significantly an 
outdated and significantly superseded statute. The proposal 
would cover transactions that significantly reduce tax on what 
the Service views as ``economic income.'' Such potentially 
broad application would create uncertainty for corporate 
taxpayers following prudent tax planning to implement business 
objectives in a variety of transactions.
    Another significant expansion of section 269 contemplated 
in the Treasury proposal is to cover any ``exclusion'' obtained 
in conjunction with any broadly defined ``tax avoidance 
transaction.'' Currently, section 269 refers only to a 
``deduction, credit or other allowance'' secured by the 
taxpayer in an inappropriate manner. Under current law, courts 
have refused to apply section 269 in instances where the 
secured benefit is an exclusion from income.\22\ To address the 
allocation of income from one taxpayer to another, Congress has 
legislated other provisions, such as the allocation rules of 
section 482 under which Treasury has promulgated comprehensive 
regulations. No tax policy rationale exists for the expansion 
of current section 269 to cover these situations.
---------------------------------------------------------------------------
    \22\ Modern Home Fire and Casualty Insur. Co. v. Comm'r, 54 TC 839 
(1970).
---------------------------------------------------------------------------

 C. Denial of deductions for certain tax advice; excise tax on certain 
         fees received with respect to corporate tax shelters.

1. Treasury proposal.

    The Treasury proposal would deny a deduction to a 
corporation for fees paid or incurred in connection with the 
purchase and implementation of corporate tax shelters and the 
rendering of tax advice related to corporate tax shelters. The 
proposal also would impose a 25-percent excise tax on fees 
received in connection with the purchase and implementation of 
corporate tax shelters (including fees related to the 
underwriting or other fees) and the rendering of tax advice 
related to corporate tax shelters. These proposals would be 
effective for fees paid or incurred, and fees received, on or 
after the date of first committee action.

2. Analysis.

    The imprecise definition of a corporate tax shelter 
transaction contained in this and related Treasury proposals 
would make it difficult for taxpayers and professional tax 
advisers to determine the circumstances under which this 
provision would be applicable. The substantive burdens of 
interpreting and complying with the statute and the 
administrative problems that taxpayers and the Service would 
face in attempting to apply this provision cannot be 
overstated.
    Further aggravating the complexity and burdens that are 
imbedded in this proposal is the fact that the ultimate 
determination that a particular transaction was a corporate tax 
shelter may not be made until several years after the fees are 
paid. In that situation, issues arise as to when the excise tax 
is due, whether the applicable statute of limitations has 
expired, and whether and upon what date interest would be owed 
on the liability.
    More fundamentally, the creation of the proposed excise tax 
subjects tax advisers to an entirely new and burdensome tax 
regime, a regime that again shifts the focus away from the 
substantive tax aspects of the transaction to unrelated 
definitional and computational issues. It is also unclear who 
would administer or enforce this new tax regime. For instance, 
if the existence of a tax shelter is determined as a result of 
an income tax examination of a corporation, would the revenue 
agents conducting that examination have jurisdiction over a 
resulting excise tax examination of the taxpayer's tax adviser? 
Would the income tax and excise tax examinations be conducted 
concurrently? How would conflicts of interest between the 
taxpayer and the adviser be identified and handled? These are 
only a few of the serious real-world issues that would have to 
be resolved to administer an inherently vague and cumbersome 
proposal.
    Finally, the real possibility exists that the effect of the 
proposal may be to deter certain taxpayers from seeking and 
obtaining necessary advice and guidance from a qualified tax 
professional in many transactions where the broad and vague 
scope of the prohibition calls into question the ultimate 
deductibility of fees. In many such cases, it is likely that 
qualified tax advice would have either convinced the taxpayer 
that it would be unwise or improper to enter into the 
transaction, or resulted in the restructuring of the 
transaction so as to bring it within full compliance with the 
letter and spirit of the internal revenue laws.

 D. Impose excise tax on certain rescission provisions and provisions 
                       guaranteeing tax benefits.

1. Treasury proposal.

    The proposal would impose on the corporate purchaser of a 
corporate tax shelter an excise tax of 25 percent on the 
maximum payment under a ``tax benefit protection arrangement'' 
(including a rescission clause and insurance purchased with 
respect to a transaction) at the time the arrangement is 
entered into. The proposal would apply to arrangements entered 
into on or after the date of first committee action.

2. Analysis.

    This proposal breaches basic normative rules of tax law by 
purporting to tax an expectancy, and by not limiting tax to 
income received or realized by a taxpayer.
    As a practical matter, the provision fails to consider the 
way rescission provisions or guarantees work. Generally, such 
an agreement puts the tax adviser at risk for an agreed-upon 
percentage of the amount of additional tax for which the 
taxpayer ultimately is liable as a result of the transactions 
to which the adviser's advice relates. That amount, of course, 
cannot be determined unless and until the Service proposes 
adjustments to the taxpayer's liability related to the item or 
transaction in question, and the taxpayer's correct liability 
is either agreed upon or determined by a court. Until such 
time, it is unclear how an excise tax determination 
appropriately could be made, and assessing tax based upon the 
highest potential rescission benefits obtainable by a taxpayer 
in the future, whether actually realized or not, contravenes 
basic issues of fairness in our normative income tax system.
    Further, the creation of the proposed excise tax subjects 
corporate taxpayers to an entirely new and burdensome tax 
regime, a regime that again shifts the focus away from the 
substantive tax aspects of the transaction in question to 
unrelated matters regarding the taxpayer's use of a tax adviser 
and the details of its relationship with the adviser. As such, 
the provision constitutes an unwarranted intrusion into the 
manner in which corporate taxpayers conduct their business 
affairs. In addition, the provision not only discourages, but 
actually stigmatizes, the willingness of qualified tax advisers 
to stand behind the quality and accuracy of their professional 
services.

 E. Preclude taxpayers from taking tax positions inconsistent with the 
                      form of their transactions.

1. Treasury proposal.

    The proposal generally would provide that a corporate 
taxpayer could not take any position on its return or refund 
claim that the income tax treatment of a transaction differs 
from that dictated by its form if a ``tax-indifferent party'' 
has an interest in the transaction. The form of a transaction 
would be determined based on all facts and circumstances, 
including the treatment given the transaction for regulatory or 
foreign law purposes. A ``tax indifferent party'' would be 
defined to include foreign persons, Native American tribal 
organizations, tax-exempt organizations, and domestic 
corporations with expiring loss or credit carryforwards. The 
proposal would be effective for transactions entered into on or 
after the date of first committee action.

2. Analysis.

    The prevalent theme of this proposal is an approach of 
``heads I win, tails you lose.''
    The Administration's proposal would turn upside down the 
most sacred of all tax doctrines: the tax treatment of a 
transaction should be based on its substance, and not its form, 
when its form does not properly reflect its substance. While 
some courts have said that there are restrictions on when a 
taxpayer may take a position contrary to the form of its own 
transaction, even those courts have not imposed an absolute 
prohibition. If the form chosen by the taxpayer has economic 
substance, then the taxpayer generally may not assert that the 
transaction should be taxed in accordance with a different 
form. However, if the taxpayer can show that the form chosen 
does not reflect the economic substance of the transaction, 
then a court generally will evaluate the merits of the 
taxpayer's claim.
    In cases where the tax treatment of a transaction is 
derived from a written agreement between a taxpayer and a third 
party, courts have been more hesitant to entertain a substance-
over-form argument made by the taxpayer. In these cases, the 
economic relationship between the taxpayer and other party is 
established primarily by the agreement itself, rather than 
independent evidence. The most typical case involves an 
allocation of the purchase price among various assets after the 
taxable acquisition of a business. Courts essentially have 
incorporated the ``parol evidence'' rule from applicable State 
law into the tax law. In some circuits, this means that the 
taxpayer may assert substance over form only with ``strong 
proof.'' Other circuits, following the so-called ``Danielson 
rule,'' hold that the taxpayer may assert substance over form 
only with proof that would render the agreement unenforceable 
(e.g., proof of mistake or fraud). Courts have limited the 
application of the strong proof rule or the Danielson rule to 
cases involving a written agreement between two parties, where 
the Service is confronted with potentially conflicting tax 
claims and thus a potential whipsaw.
    The Treasury proposal essentially is a drastic expansion of 
the Danielson rule with an unusual twist. First, the proposed 
rule prohibiting taxpayers from asserting substance over form 
would not be limited to cases involving an economic 
relationship set forth in a written agreement with a third 
party; rather, it would apply to any transaction where a 
taxpayer has chosen a particular form. Second, the proposal 
would apply where there are no potentially conflicting tax 
claims, and thus no potential for whipsaw, contrary to the 
approach adopted by the courts.
    The fact that a taxpayer, under the proposal, could 
disclose on its return that it was treating a transaction 
differently than the transaction's form does not answer these 
criticisms. The meaning of ``form'' would be unclear in many 
circumstances. Does ``form'' refer to the label given to the 
transaction or instrument, or does it refer to the rights and 
liabilities set forth in the documentation? For example, if an 
instrument is labeled debt, but has features in the 
documentation typically associated with an equity interest, is 
the form debt or equity?
    Recent attention has been given to Canadian exchangeable 
share transactions, in which a U.S. corporation acquires a 
Canadian corporation and the Canadian shareholders retain 
shares in the Canadian target that are exchangeable for shares 
in the U.S. acquiror. These shares appear in form to be shares 
in the Canadian target but in substance may have legal and 
economic rights equivalent to shares in the U.S. acquiror. One 
commentator recently suggested that taxpayers structuring these 
transactions and treating these instruments as shares in the 
Canadian target are taking positions contrary to the ``form.'' 
However, this seems to be a classic case where the Service 
would be asserting that the form of the transaction (i.e., 
shares in the Canadian target) does not reflect its substance 
(i.e., shares in the U.S. acquiror). The issue should not be 
what the form of the transaction is but rather what the 
substance is.
    This proposal would have the unfortunate effect of forcing 
the taxpayer and the Service to fight over the characterization 
of a transaction's form, when they ought to be debating the 
substance of the transaction. The proposal does not subject the 
Service to the same rule, i.e., the Service would not be 
precluded from asserting substance over form.

  F. Tax income from corporate tax shelters involving tax-indifferent 
                                parties.

1. Treasury proposal.

    The proposal would impose tax on ``tax-indifferent 
parties'' on income allocable to such a party in a corporate 
tax shelter, effective for transactions entered into on or 
after the date of first committee action.

2. Analysis.

    This proposal ignores the fact that many businesses 
operating in the global economy are not U.S. taxpayers, and 
that in the global economy it is increasingly necessary and 
common for U.S. companies to enter into transactions with such 
entities. Moreover, the fact that a tax-exempt person earns 
income that would be taxable if instead it had been earned by a 
taxable entity cannot in and of itself be viewed as 
objectionable by the government--if that were the case, the 
solution simply would be to repeal all tax exemptions. This 
overreaching Treasury proposal cannot be justified on any tax 
policy grounds.
    Invocation of a rule that would impose tax on otherwise 
nontaxable persons should require some greater evidence of tax 
abuse than the mere fact that one of the parties is a foreign 
person or a tax-exempt entity. The only limit on the 
application of this proposed rule would be the basic definition 
of a corporate tax shelter, but as discussed elsewhere in this 
testimony, that overbroad definition and the nearly unfettered 
authority contained in the proposal likely would cover many 
routine business arrangements.
    Moreover, as it applies to foreign persons in particular, 
the provision is overbroad in two significant respects. First, 
treating foreign persons as tax-indifferent ignores the fact 
that in many circumstances they may be subject to significant 
U.S. tax, either because they are subject to the withholding 
tax rules, because they are engaged in a U.S. trade or 
business, or because their income is taxable to their U.S. 
shareholders. To treat all such persons as by definition tax-
indifferent would lead to the application of the tax-
indifferent party tax to persons that are already subject to 
U.S. tax. The coordination of normal U.S. taxes with the 
special tax-indifferent party tax is not addressed by the 
proposals, so it is not clear whether it is intended that a 
second U.S. tax would be collected in such cases. If that is 
not the intent, then coordination rules would be required, 
which could create substantial complexity, particularly when 
the liability for the tax-indifferent party tax is imposed on 
other parties to the transaction.
    Second, limiting the collection of the tax to parties other 
than treaty-protected foreign persons does not hide the fact 
that the tax-indifferent party tax would constitute a 
significant treaty override. Collecting the tax-indifferent 
party liability from other parties would function purely as a 
collection mechanism, much like a withholding tax, but it is 
the income of the foreign person that would be subject to the 
tax.\23\ Imposing such a tax on treaty-protected income remains 
inconsistent with treaty obligations regardless of the 
collection mechanism adopted. Such a treaty override seems 
doubly objectionable in a context in which the tax avoidance 
about which Treasury is concerned is not that of the treaty-
protected foreigner, but rather that of another taxpayer. Thus, 
while Treasury and Congress may conclude that in certain 
circumstances a treaty override is required to advance 
significant U.S. tax policy goals, this misguided and 
unnecessary provision does not justify the serious damage to 
treaty relationships that it would engender.
---------------------------------------------------------------------------
    \23\ Depending on the terms of the relevant contractual 
arrangements, the other participants who paid the tax on the income of 
the foreign person might well seek to recover that tax from the foreign 
person.
---------------------------------------------------------------------------

  III. POTENTIAL IMPACT OF TREASURY PROPOSALS ON LEGITIMATE BUSINESS 
                              TRANSACTIONS

    The overreaching and vague Treasury Department proposals 
would have a severely detrimental impact on tax analysis and 
planning relating to a large number of legitimate business 
transactions. The proposals contemplate that many of the 
provisions would apply whenever a corporate tax shelter (as 
newly defined) is found to exist, even if the taxpayer's 
position is substantively correct under the Code, regulations, 
and case law.\24\ By contrast, the current-law tax shelter 
penalty provisions come into play only if the taxpayer 
initially is found to have understated its tax liability.
---------------------------------------------------------------------------
    \24\ This follows from the facts that the trigger for applying 
several of the proposed sanctions (other than the understatement 
penalty) is the mere existence of a corporate tax shelter, and that the 
definition of a corporate tax shelter does not appear to exclude any 
arrangement based on the substantive correctness of the positions taken 
by the taxpayer. Sanctions that could be invoked on this basis include 
the denial of tax benefits under section 269, the denial of deductions 
for fees paid, the excise tax on fees received, and the excise tax on 
tax benefit guarantees. Indeed, it would appear that by permitting the 
denial of benefits under section 269 without reference to substantive 
correctness, the Treasury proposal then could come full circle and 
impose an understatement penalty on the taxpayer even though its 
position had been shown to be substantively correct in the first 
instance.
---------------------------------------------------------------------------
    Faced with the regime of draconian sanctions proposed by 
Treasury, taxpayers would find it difficult to make business 
decisions with any certainty as to the tax consequences, since 
even a correct application of existing rules could be 
overturned based on a finding that a transaction worked an 
``improper deferral'' or a ``significant reduction of tax.'' 
Our testimony below presents only a few of the examples that 
could be cited of normal business transactions that could be 
caught in the web woven by the new proposals.

                     A. International transactions.

1. Debt capitalization of U.S. subsidiary of foreign parent.

    Something as basic as the capital structure of a company 
can be said to reduce the tax on the company's economic income. 
For example, if the foreign parent of a U.S. subsidiary chooses 
to capitalize the subsidiary with significant debt, the U.S. 
tax liability of the U.S. subsidiary may be reduced 
substantially, with no effect on the group's economic income. 
Existing law includes provisions under which the Service can 
test the legitimacy of the interest deductions claimed by the 
subsidiary in that situation, including the ``earnings 
stripping'' rules under section 163(j), the anti-conduit rules 
under section 7701(l), various treaty-shopping rules, and 
common law debt-equity principles. Even if the taxpayer's 
interest deduction passed all of those hurdles, the Treasury 
proposals could be interpreted to label the corporation's 
capital structure as a tax shelter, given the reduction of tax 
on economic income.
    The taxpayer could avoid the tax shelter designation only 
if it could show that the tax benefit of its interest deduction 
was ``clearly contemplated'' under the Code. Thus, 
notwithstanding all the rules that the tax law has developed to 
test interest deductions, the final determination of the 
taxpayer's liability would come down to application of a rule 
that provides virtually no substantive guidance. When is the 
tax benefit of a deduction for interest ``clearly 
contemplated'' by the Code? Obviously not always, because the 
Code has many specific rules that limit the extent to which a 
taxpayer may receive a tax benefit for interest it has paid. If 
a transaction satisfies those specific provisions of the Code, 
can its tax benefits safely be described as ``clearly 
contemplated'' within the meaning of the proposed tax shelter 
provisions? Presumably not, because Treasury considers its 
proposal to be a significant change to current law, so as to 
permit the Service to prevail in circumstances in which it 
could not prevail under existing law.
    Thus, under the Treasury proposals, taxpayers are left with 
the uneasy sense that some interest deductions that satisfy all 
current substantive tax provisions must be ``clearly 
contemplated,'' and hence are safe from further scrutiny under 
this proposal as corporate tax shelters, while other interest 
deductions would not so qualify. The taxpayer, however, would 
have no idea how to distinguish between them. Moreover, 
taxpayers and the Service often would disagree over when a 
benefit was ``clearly contemplated.'' In the case of a debt-
capitalized U.S. subsidiary, the Service might well argue that 
in its opinion the benefit received (namely, the interest 
deduction) exceeds that which was ``clearly contemplated'' by 
Congress.
    To complicate matters further, the likelihood of a ``not 
clearly contemplated'' attack may be greater in the context of 
a cross-border transaction. While the current Treasury 
explanation of its proposals does not discuss extensively the 
use of hybrid entities or instruments,\25\ previous Treasury 
proposals suggest that the presence of a cross-border hybrid 
likely would affect Treasury's analysis. For example, suppose 
that the debt instrument giving rise to the U.S. subsidiary's 
interest deduction was viewed as stock by the parent's home 
country, so that the payments were viewed as dividends that 
received favorable tax treatment in that jurisdiction.\26\ 
Would the Service argue that the benefit of the subsidiary's 
interest deduction is ``clearly contemplated'' only when the 
payment is viewed as interest in the hands of both the payor 
and the payee? Treasury pronouncements to date provide no clear 
answer, having suggested, for example, that inconsistent cross-
border characterizations leading to the recognition of a 
foreign tax credit in two jurisdictions simultaneously may be 
abusive in Treasury's view, while the simultaneous recognition 
of depreciation deductions in two jurisdictions has been viewed 
by Treasury as appropriate.\27\
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    \25\ There is an oblique reference to hybrid arrangements in 
connection with the proposal that would prohibit taxpayers from taking 
a position that is inconsistent with the form of their transactions.
    \26\ For example, the parent might receive a foreign tax credit for 
the underlying U.S. corporate tax paid by the U.S. subsidiary, or the 
dividends might be eliminated through a ``participation exemption'' or 
similar regime.
    \27\ See Notice 98-5 and the Administration's 1998 budget 
proposals.
---------------------------------------------------------------------------
    Accordingly, a foreign parent faced with the need to 
determine the capital structure for its U.S. operations would 
find it extraordinarily difficult to predict its U.S. tax 
treatment with any certainty. Even if a cross-border 
transaction complies with all existing rules, and regardless of 
whether the transaction tries to achieve any cross-border 
arbitrage, a company always would face the possibility of a 
Service challenge that would deny the benefit of its deductions 
and impose several other sanctions based on interpretations of 
the ``corporate tax shelter'' definition. Adding this type of 
fundamental uncertainty to the already extreme complexity of 
the Code cannot be defended as appropriate tax policy.

2. Foreign tax reduction

    As a threshold matter, it is not clear whether the Treasury 
proposal is limited to avoidance of U.S. as opposed to foreign 
taxes. The proposals are drafted broadly in terms of ``a tax 
benefit in a tax avoidance transaction,'' ``a significant 
reduction of tax,'' etc. Recent Treasury Department activities 
should make it clear that the inquiry is a serious one, since 
IRS Notice 98-11 establishes that Treasury may be as concerned 
about avoidance of foreign taxes as about U.S. taxes. This 
follows from the fact that the Notice would treat otherwise 
identical transactions differently, depending on whether the 
effect of the transaction was to achieve a reduction of foreign 
tax.\28\
---------------------------------------------------------------------------
    \28\ The Notice proposes rules that would trigger subpart F 
inclusions with respect to payments involving hybrid branches only if 
such payments had the effect of reducing foreign taxes. The policy 
debate concerning the substantive treatment set forth in the statute is 
beyond the scope of this testimony--it should suffice for our purposes 
here to note that Treasury does seem to object to foreign tax reduction 
by U.S. taxpayers.
---------------------------------------------------------------------------
    The new tax shelter proposals would seem to give Treasury 
authority to deny tax benefits in connection with any 
arrangements entered into by a U.S.-based multinational in 
connection with the debt-capitalization of its foreign 
operations, or indeed any transaction or structure that had the 
effect of significantly reducing foreign taxes. The uncertainty 
would be further compounded by the issue of hybrid status 
discussed above--would the Service be more likely to challenge 
a foreign tax-reduction structure with hybrid elements? For 
example, would a ``hybrid branch'' within the meaning of Notice 
98-11 be more susceptible to challenge than a conventional 
branch that had the same tax effect (i.e., foreign tax 
reduction with no subpart F inclusion)? The question cannot be 
answered based on the proposals themselves or any other 
Treasury guidance.
    Accordingly, enactment of the Treasury proposals would 
throw the structuring of international operations of U.S. 
companies into complete tax uncertainty--the tax consequences 
of many transactions and investments would not be determinable 
until long after the fact, since their tax results could not be 
determined based on the existing Code, regulations, or case 
law. Instead, the taxpayer would have to wait until Service 
revenue agents reviewed the transactions and determined whether 
they were offended by any particular aspect, regardless of the 
extent to which the transaction complied with existing law. 
This discretion and the unprecedented complexity and 
uncertainty it would cause cannot be justified on any tax 
policy principle.

3. Foreign tax credits in high-tax settings.

    If the Treasury proposals were enacted, a U.S.-based 
multinational could find itself in a remarkable whipsaw. 
Efforts to reduce foreign taxes could trigger a response of the 
Service based on Notice 98-11 type concerns; on the other hand, 
failure to reduce foreign taxes potentially could subject the 
taxpayer to scrutiny based on the fact that the resulting 
foreign tax credits were deemed disproportionate to its 
economic income. This follows from the Treasury proposal 
defining a tax shelter to include any arrangement in which pre-
tax profits are insignificant in relation to net tax benefits. 
By selectively defining the relevant ``transaction,'' the 
Service could determine that any particular activity in a 
foreign jurisdiction produced limited net income, and thus that 
such income was ``insignificant'' in relation to the foreign 
tax credits associated with it. This problem is particularly 
acute in the case of financial institutions that may engage in 
a portfolio of transactions, some of which could be isolated 
and shown to be economic losses. But the problem also could be 
faced by any business with multiple product or service lines of 
varying profitability.
    Further, even in the case of an activity with ``normal'' 
profits, foreign tax base or timing differences could increase 
artificially the apparent foreign tax rate to the point where 
the economic profit would appear to be insignificant by 
comparison. With tax base and timing differences, a normal 
business scenario could produce a foreign tax rate that looks 
high enough that the economic profit could be viewed as not 
substantial relative to the foreign tax credit benefits.
    Moreover, by treating foreign taxes paid as an expense like 
any other, the proposals misconceive and distort the role of 
the foreign tax credit in the U.S. tax system. By treating 
foreign taxes as an expense, Treasury is in effect positing 
that the correct standard for identifying an abuse is to ask 
whether the taxpayer would carry out a transaction if it did 
not receive a foreign tax credit at all--in other words, a 
transaction should be viewed as proper only if it makes 
economic sense without regard to any foreign tax credits.
    This cannot be right in view of the fundamental purpose of 
the foreign tax credit. Most foreign business operations 
conducted by U.S.-based taxpayers in jurisdictions that impose 
significant taxes probably would be untenable in the absence of 
a U.S. credit for those foreign taxes. Does the Treasury 
proposal mean that all U.S.-owned controlled foreign 
corporations in Germany, Japan, Italy, France, and the United 
Kingdom, among other countries, represent corporate tax 
shelters? The basic goal of the foreign tax credit is to enable 
U.S.-based companies to conduct overseas activities without 
suffering double taxation, and that function is served by 
treating a foreign tax as if it were a U.S. tax (up to the U.S. 
rate). Thus, adopting a definition of tax shelter that takes as 
its analytical starting point a world in which no foreign taxes 
are creditable is inconsistent with the fundamental operation 
of U.S. international tax rules as they have operated for 
decades.
    In sum, the Treasury proposals would make the U.S. tax 
results of cross-border transactions largely unknowable. 
Transactions that satisfied the requirements of all existing 
statutory, regulatory, and judicial standards nevertheless 
could be challenged by the Service under standards of utter 
vagueness. They could be attacked for paying too little foreign 
tax, or for paying too much. They could be targeted for 
violating nebulous policy concerns, such as those with respect 
to hybrids, that Treasury has not yet managed to articulate 
fully.
    This fundamental tax uncertainty would deprive U.S. 
businesses of the ability to make rational cross-border 
business decisions, disrupting international trade and 
investment at a time when the growth of a global economy has 
made them an increasingly important component of U.S. economic 
prosperity. Finally, the Treasury proposals would damage U.S. 
international tax policy by abandoning some of its fundamental 
precepts, and do broader damage to U.S. tax policy in general 
by seeking to replace known legal standards with a regime 
governed solely by administrative edict.

                       B. Corporate transactions.

1. In general.

    There is a lengthy list of legitimate merger and 
acquisition transactions that could be caught by Treasury's 
proposed broad definition of ``tax avoidance transaction.'' For 
example, tax-free reorganizations involving small corporations 
acquired by large corporations or spin-off transactions 
involving unequal amounts of debt allocated between the 
separated entities might be treated by the Service as ``tax 
avoidance transactions.'' The nearly unfettered ability of the 
Service to recharacterize the tax effects of legitimate 
corporate transactions would cause considerable uncertainty in 
many cases of prudent and appropriate tax structuring of 
transactions.
    By contrast to the haphazard manner in which the rules for 
taxing corporate transactions would develop under the Treasury 
proposals, current law consists of statutory, regulatory, and 
judicial doctrines that have been refined and developed over 
time and that provide guidance and appropriate tax results in 
corporate transactional planning.

2. Reasons for concern.

    Broad anti-abuse rules like the Treasury proposals can 
adversely affect the ability of corporations to engage in 
legitimate business transactions by bringing the tax 
consequences of ordinary transactions into question. Given the 
Service's limited resources, such disputes may not be resolved 
satisfactorily through ordinary avenues such as the private 
letter ruling process.
    The development of the tax law regarding transfers of 
property outside the United States provides a relevant example. 
Prior to 1984, section 367(a) required transferors of property 
to foreign persons to receive permission from the Service, in 
the form of a private letter ruling, in order for the transfer 
to qualify as a nontaxable transaction. This was to ensure that 
the principal purpose of the outbound transfer was not tax 
avoidance. By requiring that taxpayers get advance approval 
before making an outbound transfer of assets, taxpayers were 
precluded from completing a transaction and determining in 
later litigation, if necessary, the question of whether tax 
avoidance was one of the principal purposes of the transaction. 
Under these rules, Treasury was able to prevent taxpayers from 
undertaking legitimate business transactions simply by 
declining to issue a favorable private letter ruling.
    To remedy this inequity, the Tax Reform Act of 1976 
established a special declaratory judgment procedure (section 
7477) allowing taxpayers to immediately litigate the Service's 
section 367 determinations in the Tax Court. Under the 
procedure, the taxpayer was able to have the dispute reviewed 
by the Tax Court if it was demonstrated that a request had been 
made to the Service for a determination and that the Service 
either failed to act or acted adversely. After a number of 
taxpayer-favorable decisions, Congress replaced this system in 
1984, and today taxpayers are not required to obtain a private 
letter ruling in advance of a section 367 transaction.
    Obviously, requiring taxpayers to obtain prior approval 
from Treasury for legitimate business transactions proved to be 
an unworkable process. In order for a voluntary tax system to 
work in a global economy, taxpayers must be able to implement 
their business strategy while providing a review process that 
ensures appropriate and consistent tax treatment for all. The 
Treasury proposals, by creating general corporate anti-abuse 
rules without guidelines or restrictions, would result in 
uncertainty for taxpayers engaging in ordinary corporate 
transactions and generally would burden taxpayers with the 
responsibility of litigating disputes with the Service over the 
limits of the anti-abuse rules themselves.

                      C. Partnership transactions.

    As the globalization of the world economy continues, many 
companies are turning to partnership joint ventures as a 
preferred business form to conduct new business operations. 
Such joint ventures provide immediate access to technology, 
financing, new markets, and human capital that otherwise might 
take years for a company to develop internally. The reach of 
Treasury's tax shelter proposals seriously jeopardizes this 
legitimate joint-venture activity.
    Many joint ventures are speculative in nature. Pre-tax 
profits are anticipated but may be longer term, and the 
investment's ultimate rate of return is uncertain. It is quite 
common for joint ventures to generate economic losses in 
formative years; these ``tax benefits'' could be significant 
when compared to reasonably expected pre-tax profits at the 
outset of the joint venture.
    The breadth of the Treasury's proposed definition of a tax 
shelter quite likely would impose an in terrorem effect in the 
formation of joint ventures with marginal rates of return 
because of increased uncertainty created by the potentially 
broad reach of the new proposals. The consequence would be a 
lack of competitiveness by U.S. companies in the global market.
    In certain industries, partnerships are used to spread the 
risk of research. These research partnerships, which generate 
little in short-term profits, are economically viable because 
of the potential intellectual capital created in the long term. 
Conceivably, under the Administration's definition of tax 
shelters, the Service would be put in the position of second-
guessing the economics of a particular research partnership, 
causing the parties to justify anticipated pre-tax profits in 
light of failures to generate viable new technology. Fear of 
Service challenges to what are otherwise legitimate business 
decisions could well dampen the kind of research U.S. companies 
undertake.
    Oil and gas exploration depends on huge amounts of capital 
generated through the formation of partnerships. This industry 
can be wildly speculative. If the Treasury tax shelter 
proposals were adopted, the Service effectively would sit side-
by-side with the wildcatters in assessing what wells can be 
drilled in order to avoid these activities later being defined 
as a tax shelter.
    Consider, for example, the case of an independent oil and 
gas operator that frequently engages in searches for oil on 
undeveloped and unexplored land that is not near proven fields. 
The taxpayer engages in a particular speculative wildcat oil-
drilling venture at an anticipated cost of $5 million. Based on 
the experience of taxpayers engaging in this type of business, 
there is a 90-percent chance that the taxpayers will not find a 
commercially profitable oil deposit and that the entire $5 
million investment will be lost. There is a 10-percent 
probability that the venture will produce pre-tax economic 
profits in the average probability-weighted amount of $40 
million. Under the Treasury proposals, the Service might treat 
the venture as a corporate tax shelter on the ground that the 
reasonably expected pre-tax profit is insignificant relative to 
the reasonably expected net tax benefits.
    The real estate industry also relies heavily on partnership 
vehicles. In the case of real estate investment trusts (REITs), 
lower-tier partnerships routinely are used to acquire new 
properties from sellers interested in diversifying their own 
investment portfolios. The proposed definition of a tax shelter 
would cause reassessments of what properties a REIT can invest 
in because, more often than not, a particular real estate deal 
will be speculative in nature.
    Other industries that use the partnership vehicle to 
aggregate capital for investment purposes include venture 
capital funds and investment partnerships. Both generate 
capital to be invested in other businesses for higher and 
sometimes speculative rates of return. An overbroad and vague 
tax shelter definition may well alter the types of investments 
made at the margin by these industries.
    Investment decisions are made all the time by competent 
business executives and investors. Unfortunately, Treasury's 
misguided tax shelter proposals would call into question many 
of their investment decisions. Injecting the Service into what 
are otherwise legitimate business decisions would create an 
unintended and detrimental drag on our robust economy.

                        D. Other illustrations.

    As discussed above, the Treasury proposals would discourage 
taxpayers from undertaking beneficial but unprofitable 
activities that, absent legitimate tax incentives, they would 
not perform. Such activities particularly are vulnerable to 
being tagged as tax shelters because they literally could be 
viewed as arrangements in which a ``corporate participant 
attempts to obtain a tax benefit in a tax avoidance 
transaction.''
    As one example of the potential chilling effects of the 
Treasury proposals, legislation enacted in 1997 allows 
taxpayers to deduct certain costs of cleaning up economically 
depressed sites, known as ``brownfields.'' The legislation 
sought to encourage taxpayers to clean up sites that otherwise 
might prove too costly or uneconomical to clean up. Under the 
tax shelter proposal, a taxpayer's attempt to deduct cleanup 
costs whose treatment is not clear under the brownfields 
statute could be treated as a tax shelter.
    The claimed deductions might constitute a ``tax benefit'' 
under the proposal because certain deductions while potentially 
permissible may not be deemed ``clearly contemplated by the 
applicable provision'' (emphasis added). Moreover, the 
taxpayer's cleanup activities could be considered a ``tax 
avoidance transaction'' because the taxpayer's pre-tax profit 
from cleaning up a site probably would be insignificant 
relative to its reasonably expected tax benefits. Thus, a 
taxpayer that cleans up a brownfields site and claims a 
deduction for its costs could face a serious risk of being 
treated as a tax shelter participant merely because the 
treatment of some of those costs is less than clear under the 
statute. Treasury may well respond that it does not intend to 
impact detrimentally the recently enacted ``brownfields'' 
statute. The fact remains that the overbroad reach of the 
Treasury proposals could call into question the tax effect of 
this provision and many other normal business transactions and 
activities.
    Besides the examples set forth above, numerous ordinary 
business transactions could be affected by the Treasury 
proposals. These could include certain hedging transactions, 
certain sale-leaseback transactions, various corporate 
distributions, and certain transactions between joint venture 
entities.

          IV. ADEQUACY OF EXISTING TOOLS TO ADDRESS ``ABUSE''

  A. Current penalties and registration requirements relating to tax 
                               shelters.

    The chief tax executive of a corporation has several duties 
and responsibilities in the tax analysis, collection, and 
enforcement process.\29\ Some are derived from the tax 
executive's fiduciary duties to shareholders to preserve and 
protect corporate assets, including a duty to protect corporate 
assets from unnecessary additions to tax through the imposition 
of penalties.
---------------------------------------------------------------------------
    \29\ A detailed description of the responsibilities and burdens of 
a chief tax executive is set forth in Part V of these comments.
---------------------------------------------------------------------------
    The existing penalty structure in the Code is a burdensome 
and complex patchwork of rules that present the chief tax 
executive with considerable uncertainty in determining their 
application and scope. The corporate tax executive must 
consider carefully the possible application of those penalties 
prior to implementing any particular course of action.
    Three broad types of penalties potentially apply with 
respect to tax shelters: (1) the accuracy-related penalty under 
section 6662, which is applicable to underpayments of tax 
resulting from certain types of conduct, (2) tax shelter-
specific penalties such as those applicable to promoters of 
abusive tax shelters and to the failure to register or furnish 
information regarding tax shelters, and (3) penalties related 
to the preparation or presentation of tax returns, claims, or 
other documents reporting the benefits or attributes of tax 
shelter items. A list of these penalty provisions is contained 
in Appendix A.

1. Accuracy-related penalty.

    One of the most significant penalties that a chief tax 
executive must consider in analyzing any transaction is the 
accuracy-related penalty under section 6662. That penalty is 
imposed on any portion of an underpayment attributable to one 
or more of the following:
     negligence or disregard of rules and regulations;
     any substantial understatement of income tax;
     any substantial valuation misstatement;
     any substantial overstatement of pension 
liabilities; or
     any substantial estate or gift tax valuation 
understatement.
    The penalty equals 20 percent of the portion of the 
underpayment attributable to the specified conduct. The first 
three components of the accuracy-related penalty (i.e., the 
negligence/intentional disregard, substantial understatement, 
and valuation misstatement components) are the most relevant to 
potential tax shelter transactions.
    Pursuant to section 6664(c), the accuracy-related penalty 
will not be imposed on any portion of an underpayment if the 
taxpayer shows there was a reasonable cause for the 
underpayment and that the taxpayer acted in good faith with 
respect to such portion. The determination of whether a 
taxpayer acted with ``reasonable cause and in good faith'' is 
made on a case-by-case basis, taking into account all pertinent 
facts and circumstances, the most important of which is the 
extent of the taxpayer's efforts to assess its proper tax 
liability. As a general rule, it is more difficult to establish 
the existence of reasonable cause when the underpayment of tax 
is attributable to true tax shelter activities.
    a. Definition of ``tax shelter'' for purposes of the 
accuracy penalty rules.--For purposes of the accuracy-related 
penalty imposed by section 6662, the term ``tax shelter'' means 
a partnership or other entity (e.g., a trust), an investment 
plan or arrangement, or any other plan or arrangement the 
purpose of which is to avoid or evade federal income tax. 
Congress significantly broadened the scope of these rules in 
the Taxpayer Relief Act of 1997, to treat an entity, plan, or 
arrangement as a tax shelter if one of its significant purposes 
is tax avoidance or evasion.\30\ The Service and Treasury have 
not yet issued guidance regarding the definition of the term 
``significant purpose.''
---------------------------------------------------------------------------
    \30\ Section 6662(d)(2)(C)(iii). Prior law defined tax shelter 
activity as an entity, plan or arrangement only if it had as its 
primary purpose the avoidance or evasion of tax.
---------------------------------------------------------------------------
    The broadened definition of the term ``tax shelter'' for 
accuracy-related penalty purposes under the 1997 Act is a 
powerful tool that the Treasury and the Service can utilize to 
respond to perceived avoidance situations. The failure, 
however, to provide necessary guidance under that statute, in 
the form of regulations or otherwise, has made it extremely 
difficult for chief tax executive to analyze and evaluate 
potential transactions so as to protect against the imposition 
of such penalties.
    b. Negligence or disregard of rules or regulations.--A 20-
percent accuracy-related penalty is imposed on the amount of 
any underpayment that is attributable to negligence or the 
disregard of rules or regulations. Negligence includes any 
careless, reckless, or intentional disregard of rules or 
regulations, any failure to make a reasonable attempt to comply 
with the provisions of the law, and any failure to exercise 
ordinary and reasonable care in the preparation of a tax 
return. In other words, negligence is the lack of due care or 
failure to do what a reasonable and ordinarily prudent person 
would do under the circumstances. Disregard of rules or 
regulations means any careless, reckless, or intentional 
disregard of the Code, regulations (final or temporary), or 
revenue rulings or notices published in the Internal Revenue 
Bulletin.\31\
---------------------------------------------------------------------------
    \31\ Treas. Reg. section 1.6662-3(b)(2).
---------------------------------------------------------------------------
    Negligence includes the failure to keep adequate books and 
records or to substantiate items properly.\32\ A position with 
respect to an item is attributable to negligence if it lacks a 
``reasonable basis.''\33\ Negligence is strongly indicated 
where, for example, a taxpayer fails to include on an income 
tax return an income item shown on an information return, or a 
taxpayer fails to make a reasonable attempt to ascertain the 
correctness of a deduction, credit, or exclusion on a return 
that would seem to a reasonable and prudent person to be ``too 
good to be true'' under the circumstances.\34\ This prudence 
standard is imposed on a chief tax executive as he or she 
analyzes the appropriateness of a particular transaction.
---------------------------------------------------------------------------
    \32\ Treas. Reg. section 1.6662-3(b)(1).
    \33\ Pursuant to Treas. Reg. section 1.6662-3(b)(3), the 
``reasonable basis'' standard is a relatively high standard of tax 
reporting and is not satisfied by a return position that is merely 
arguable or merely a colorable claim. A return position generally 
satisfies the standard if it is reasonably based on one or more of the 
authorities set forth in Treas. Reg. section 1.6662-4(d)(3)(iii), 
taking into account the relevance and persuasiveness of the authorities 
and subsequent developments, even though it may not satisfy the 
substantial authority standard as defined in Treas. Reg. section 
1.6662-4(d)(2).
    \34\ Treas. Reg. section 1.6662-3(b).
---------------------------------------------------------------------------
    c. Substantial understatement of income tax.--In 
determining whether it would be prudent to enter into a 
particular transaction, the corporate tax executive also must 
consider the component of the accuracy-related penalty that is 
imposed on the portion of any underpayment that is attributable 
to a substantial understatement of income tax. An 
``understatement of tax'' is the excess of the amount required 
to be shown on the return for the tax year less the amount of 
tax actually shown on the return, reduced by any rebates.
    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) $10,000 (in the 
case of a corporation other than an S corporation or a personal 
holding company).
    d. Substantial valuation misstatement.--A 20-percent 
accuracy-related penalty also is imposed on the portion of any 
underpayment of tax attributable to a substantial valuation 
misstatement with respect to the value or adjusted basis of 
property reported on any return. In the case of a gross 
valuation misstatement, the penalty is increased to 40 percent. 
These penalties apply if the aggregate of all portions of the 
underpayment attributable to the misstatement exceeds $10,000 
for corporations other than S corporations or a personal 
holding company.\35\ This aspect of the accuracy-related 
penalty regime has received renewed emphasis and review by 
corporate tax executives in light of the Tax Court's recent 
decision upholding the Service's imposition of the 40-percent 
penalty.\36\
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    \35\ Section 6662(e)(1) provides that a valuation misstatement is 
substantial if: the value or adjusted basis of any property claimed on 
any income tax return is 200 percent or more of the correct value or 
adjusted basis; or (a) the price for any property or services (or for 
the use of property) in connection with any transaction between trades 
or businesses owned or controlled, directly or indirectly, by the same 
interests (as described in section 482) is 200 percent or more (or 50 
percent or less) of the amount determined to be the correct amount of 
such price, or (b) in tax years beginning after December 31, 1993, the 
net section 482 transfer price adjustment for the tax year exceeds the 
lesser of $5,000,000 or 10 percent of the taxpayer's gross receipts. 
Pursuant to section 6662(h)(2), a gross valuation misstatement occurs 
where: the value or adjusted basis of any property claimed on any 
return is 400 percent or more of the amount determined to be the 
correct value or adjusted basis; or (a) the price for any property, or 
for its use, or for services, claimed on any return in connection with 
a transaction between persons described in section 482 is 400 percent 
or more (or 25 percent or less) of the amount described in section 482 
to be the correct amount of such price, or (b) in tax years beginning 
after December 31, 1993, the net section 482 transfer price adjustment 
for the tax year exceeds the lesser of $20,000,000 or 20 percent of the 
taxpayer's gross receipts.
    \36\ DHL Corp. v. Comm'r, T.C. Memo. 198-461, December 30, 1998.
---------------------------------------------------------------------------
    e. Concluding analysis.--In sum, the accuracy-related 
penalty provides a powerful incentive for corporate tax 
executives to review closely and analyze both the structure and 
the implementation of any proposed business transaction that 
results in tax benefits, and to impose prudence on the 
decision-making process. This penalty, and the overall penalty 
regime, can be made much clearer and more precise so as to 
provide corporate tax executives with certainty in analyzing 
particular transactions. To this end, the ongoing studies aimed 
at reviewing and potentially streamlining the current complex 
and burdensome penalty system hold the potential for meaningful 
improvements.\37\ At this time, there is no demonstrated 
justification for increasing the penalties and adding further 
uncertainty to the process as contemplated by the Treasury 
proposals.
---------------------------------------------------------------------------
    \37\ The penalty studies were required by section 3801 of the 
Internal Revenue Service Restructuring and Reform Act of 1998.

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2. Penalties imposed on tax shelter promoters.

    The Code contains a number of penalties applicable to tax 
shelter promoters. These promoter penalties collectively form a 
``safety net'' to ensure that tax shelter activities are not 
promoted and that misinformation about proper tax rules is not 
disseminated by unscrupulous advisors. It is highly unlikely 
that a prudent tax executive of a large corporation seriously 
would consider entering into the sort of abusive transaction 
for which promoter penalties would be applicable. Accordingly, 
the penalties are briefly described below to illustrate that 
the Code already contains a number of safeguards against 
abusive tax planning activities.
    a. Penalty for promoting abusive tax shelters.--Under 
section 6700(a), a civil penalty--equal to the lesser of $1,000 
or 100 percent of the gross income derived (or to be derived) 
by the particular promoter from the activity--may be imposed 
against persons who promote abusive tax shelters. The term 
``promoting'' encompasses organizing such tax shelters, 
participating directly or indirectly in their sale, and making 
or furnishing (or causing another person to make or furnish) 
certain false or frauduent statements \38\ or gross valuation 
overstatements \39\ in connection with their organization or 
sale. Pursuant to section 7408, the Service also can obtain an 
injunction against such promoters to enjoin them from further 
promotion activity.
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    \38\ A 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. 
Section 6700(a)(2)(A).
    \39\ A gross valuation overstatement is a statement as to the value 
of property or services that is directly related to the amount of any 
income tax deduction or credit, provided that the value exceeds 200 
percent of the correct value. Section 6700(a)(2)(B).
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    b. Aiding and abetting penalty.--The Service may impose a 
penalty under section 6701 of $1,000 ($10,000 with respect to 
corporate tax returns and documents) against any person who (1) 
aids, assists, or gives advice in the preparation or 
presentation (e.g., during a Service examination) of any 
portion of a tax return, affidavit, claim, or other document; 
(2) knows (or has reason to believe) that the portion of the 
return or document will be used in connection with any material 
matter arising under the internal revenue laws; and (3) knows 
that, if the portion of the tax return or other document is 
used, an understatement of another person's tax liability would 
result.
    In addition, disciplinary action may be taken against any 
professional appraiser against whom an aiding and abetting 
penalty under section 6701(a) has been imposed with respect to 
the preparation or presentation of an appraisal resulting in an 
understatement of tax liability.

3. Penalties for failure to furnish information regarding tax 
shelters.

    a. Penalty for failure to register a tax shelter.--An 
organizer of an entity, plan, or arrangement that meets the 
definition of a tax shelter under section 6111 who fails to 
timely register such shelter, or who files false or incomplete 
information with such registration, is subject to a penalty 
under section 6707(a). The penalty equals the greater of (1) 
$500 or (2) one percent of the amount invested in the shelter.
    The penalty for failing to register a ``confidential 
corporate tax shelter,'' as defined in section 6111(d) (as 
amended by the Taxpayer Relief Act of 1997), is the greater of 
(1) $10,000, or (2) 50 percent of the fees paid to all 
promoters with respect to offerings prior to the date of the 
late registration. The penalty applies to promoters and to 
actual participants in any corporate tax shelter who were 
required to register the tax shelter but failed to do so. For 
participants, the 50-percent penalty is based solely on fees 
paid by the participant. The penalty is increased to 75 percent 
of applicable fees where the failure to register the tax 
shelter is due to intentional disregard on the part of either a 
promoter or a participant.\40\
---------------------------------------------------------------------------
    \40\ Section 6707(a)(3).
---------------------------------------------------------------------------
    b. Penalty for failure to furnish tax shelter 
identification numbers.--Pursuant to section 6707(b)(1), a 
person who sells an interest in a tax shelter and fails to 
furnish the shelter's identification number to each investor in 
the shelter is subject to a monetary penalty unless the failure 
is due to reasonable cause. Section 6707(b)(2) provides that an 
investor who fails to furnish the shelter's identification 
number on a return reporting a tax item related to the tax 
shelter also is subject to penalty.
    c. Penalty for failure to maintain lists of investors in 
potentially abusive tax shelters.--Pursuant to section 6708, 
any person who is required to maintain a tax shelter customer 
list, as required by section 6112, and who fails to include any 
particular investor on the list will be assessed a penalty for 
each omission unless it is shown that the failure results from 
reasonable cause and not from willful neglect. The maximum 
penalty for failure to maintain the list is $100,000 per 
calendar year. This penalty is in addition to any other penalty 
provided by law.

4. Tax return preparer penalties.

    Section 6694(a) provides that if any part of an 
understatement of liability with respect to a return or claim 
for refund is due to a position that did not have a realistic 
possibility of being sustained on its merits \41\ and an income 
tax return preparer with respect to that return or claim knew 
(or reasonably should have known) of that position, the 
preparer is subject to a penalty of $250 with respect to the 
return or claim, unless it is shown that there is reasonable 
cause for the understatement and that the preparer acted in 
good faith. The penalty will not apply if the position (1) was 
adequately disclosed and (2) is not frivolous.\42\
---------------------------------------------------------------------------
    \41\ A position is considered to satisfy the realistic possibility 
standard if a reasonable and well-informed analysis by a person 
knowledgeable in tax law would lead that person to conclude that the 
position has approximately a one-in-three, or greater, likelihood of 
being sustained on its merits. Treas. Reg. section 1.6694-2(b)(1). In 
determining whether a position has a realistic possibility of being 
sustained, the relevant authorities are the same as those considered in 
determining whether, for purposes of the accuracy-related penalty, 
there is substantial authority for a tax return position. Treas. Reg. 
section 1.6694-2(b)(2).
    \42\ A frivolous position is one that is patently improper. Treas. 
Reg. section 1.6694-2(c)(2).
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    If the preparer establishes that an understatement 
attributable to an unrealistic position was due to reasonable 
cause and that the preparer acted in good faith, the preparer 
penalty will not be imposed. This determination depends upon 
the facts and circumstances of the particular case, including 
the nature of the error, the frequency and materiality of the 
error, the preparer's normal office practices, and reliance on 
any other preparer's advice.\43\
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    \43\ Treas. Reg. section 1.6694-2(d).

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5. Registration requirements.

    Section 6111 requires tax shelter organizers \44\ to 
register tax shelters with the Service by the day on which the 
first offering for sale of interests in the tax shelter 
occurs.\45\ Pursuant to section 6111(d), which was added by the 
Taxpayer Relief Act of 1997, certain ``confidential 
arrangements'' are also treated as tax shelters for purposes of 
the registration requirements. Those provisions, however, are 
not effective until the Service or Treasury issues guidance 
with respect to the 1997 Act amendments to the registration 
requirements. To date, no such guidance has been issued. The 
Service and Treasury, therefore, have failed to take advantage 
of what would appear to be a potent weapon in the Government's 
arsenal to curb abusive tax shelter activity.
---------------------------------------------------------------------------
    \44\ The term ``tax shelter organizer'' is defined as the person 
who is principally responsible for organizing a tax shelter (``the 
principal organizer''), i.e., any person who discovers, creates, 
investigates, or initiates the investment, devises the business or 
financial plans for the investment, or carries out those plans through 
negotiations or transactions with others. Temp. Treas. Reg. section 
301.6111-1T, A-27.
    \45\ The temporary regulations provide that certain investments 
will not be subject to tax shelter registration even if they 
technically meet the definition of a tax shelter. The following 
investments are not subject to registration: (1) sales of residences 
primarily to persons who are expected to use the residences as their 
principal place of residence, and (2) with certain exceptions, sales or 
leases of tangible personal property by the manufacturer (or a member 
of an affiliated group) of the property primarily to persons who are 
expected to use the property in their principal active trade or 
business. By Notice, the Service may specify other investments that are 
exempt from the registration requirement. Temp. Treas. Reg. section 
301.6111-1T, A-24. In addition, the tax shelter registration 
requirements are suspended with respect to any tax shelter that is a 
``projected income investment.'' Generally, a tax shelter is a 
projected income investment if it is not expected to reduce the 
cumulative tax liability of any investor for any year during any of the 
first five years ending after the date on which the investment is 
offered for sale.
---------------------------------------------------------------------------
    In the context of the tax shelter registration 
requirements, section 6111(d)(1) provides that a ``corporate 
tax shelter'' includes any entity, plan, arrangement, or 
transaction: (1) that has as a significant purpose the 
avoidance \46\ of tax or evasion by a corporate participant; 
(2) that is offered to any potential participant under 
conditions of confidentiality; \47\ and (3) for which the tax 
shelter promoters may receive total fees in excess of $100,000.
---------------------------------------------------------------------------
    \46\ As in the case of the definition of ``tax shelter'' for 
accuracy-related penalty purposes, the terms ``significant purpose'' 
and ``tax avoidance'' are not defined or explained for tax shelter 
registration purposes.
    \47\ A transaction is offered under conditions of confidentiality 
if: (1) a potential participant (or any person acting on its behalf) 
has an understanding or agreement with or for the benefit of any 
promoter to restrict or limit the potential participant's disclosure of 
the tax shelter or any significant tax features of the tax shelter; or 
(2) the promoter (a) claims, knows, or has reason to know, (b) knows or 
has reason to know that any other person (other than the potential 
participant) claims, or (c) causes another person to claim that the 
transaction (or any aspect thereof) is proprietary to the promoter or 
any party other than the potential participant, or is otherwise 
protected from disclosure or use. Section 6111(d)(2).
---------------------------------------------------------------------------
    Under the rules applicable to confidential corporate tax 
shelters, individuals who merely discussed participation in the 
shelter may in some circumstances be required to comply with 
the registration requirements. A promoter of a corporate tax 
shelter is required to register the shelter with the Service 
not later than the day on which the tax shelter is first 
offered for sale to potential users. As previously discussed, 
civil penalties under section 6707 may be imposed for the 
failure to timely register a tax shelter. Criminal penalties 
are applicable to willful noncompliance with the registration 
requirements.\48\
---------------------------------------------------------------------------
    \48\ See, e.g., section 7203.
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    These registration rules, which Treasury and the Service 
have not yet implemented, as well as the collective impact of 
the existing complex and disparate penalty regime, render the 
Treasury proposals unnecessary and inappropriate.

                 B. Existing ``common-law'' doctrines.

    Pursuant to several ``common-law'' tax doctrines, Treasury 
and the Service have the ability to challenge taxpayer 
treatment of a transaction that they believe is inconsistent 
with statutory rules and the underlying Congressional intent. 
For example, these doctrines may be invoked where the Service 
believes that (1) the taxpayer has sought to circumvent 
statutory requirements by casting the transaction in a form 
designed to disguise its substance, (2) the taxpayer 
artificially has divided the transaction into separate steps, 
(3) the taxpayer has engaged in ``trafficking'' in tax 
attributes, or (4) the taxpayer improperly has accelerated 
deductions or deferred income recognition.
    These broadly applicable doctrines--known as the business 
purpose doctrine, the substance over form doctrine, the step 
transaction doctrine, and the sham transaction and economic 
substance doctrine--provide the Service considerable leeway to 
recast transactions based on economic substance, to treat 
apparently separate steps as one transaction, and to disregard 
transactions that lack business purpose or economic substance. 
Recent applications of those doctrines have demonstrated their 
effectiveness and cast doubt on Treasury's asserted need for 
additional tools.
    Since the enactment of the internal revenue laws, the 
Service, often with the blessing of the courts, has probed 
taxpayers' business motives. Such inquiries have led to the 
development of the ``business purpose doctrine,'' which permits 
the Service to disregard for federal income tax purposes a 
variety of transactions entered into without any economic, 
commercial, or legal purpose other than the hoped-for favorable 
tax consequences. Although the business purpose doctrine 
originated in the context of corporate reorganizations,\49\ it 
quickly was extended to other areas.\50\
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    \49\ Gregory v. Helvering [35-1 USTC para. 9043], 293 U.S. 465 
(1935), which generally is regarded as the origin of the business 
purpose doctrine, involved a reorganization motivated by tax avoidance.
    \50\ In Commissioner v. Transport Trading & Terminal Corp. [49-2 
USTC para. 9337], 176 F.2d 570 (2d Cir. 1949), cert. denied, 338 U.S. 
955 (1950), the doctrine was extended to all statutes that describe 
commercial transactions.
---------------------------------------------------------------------------
    The ``substance over form doctrine'' often is associated 
with the business purpose doctrine. Under the substance over 
form doctrine, a court may ignore the form of a transaction and 
apply the tax law to the transaction's substance if the court 
perceives that the substance of a transaction lies within the 
intended reach of a statute, but that the form of the 
transaction takes the event outside that reach.\51\ Therefore, 
while a taxpayer may structure a transaction so that it 
satisfies the formal requirements of the tax law, the Service 
may deny legal effect to the transaction if its sole purpose is 
to evade taxation.\52\
---------------------------------------------------------------------------
    \51\ The Business Purpose Doctrine: The Effect of Motive on Federal 
Income Tax Liability, 49 Fordham L. Rev. 1078, 1080 (1981).
    \52\ Stewart v. Commissioner [83-2 USTC para. 9573], 714 F.2d 977, 
987 (9th Cir. 1983).
---------------------------------------------------------------------------
    The courts have long been willing to elevate substance over 
form in interpreting a sophisticated code of tax laws where 
slight differences in a transaction's design can lead to 
divergent tax results. In the tax law arena, the substance over 
form doctrine has been used expansively to justify the 
Service's recasting of transactions.\53\ For example, the 
doctrine has been used to: (1) void reorganizations,\54\ (2) 
reject the assignment of income,\55\ (3) recharacterize the 
sale or transfer of property between related parties,\56\ (4) 
recharacterize sale and leaseback arrangements,\57\ (5) 
disallow interest deductions,\58\ and (6) disregard the 
separate corporate entity.\59\
---------------------------------------------------------------------------
    \53\ 49 Fordham L. Rev. at 1080-81 (listing examples and collecting 
citations).
    \54\ Gregory v. Helvering, supra n. 49.
    \55\ Helvering v. Horst [40-2 USTC para. 9787], 311 U.S. 112, 114-
120 (1940) (holding that income, rather than income-producing property, 
had been assigned).
    \56\ Commissioner v. Court Holding Co. [45-1 USTC para. 9215], 324 
U.S. 331, 333-334 (1945).
    \57\ Frank Lyon Co. v. U.S. [78-1 USTC para. 9370], 435 U.S. 561 
(1978).
    \58\ Knetsch v. U.S. [60-2 USTC para. 9785], 364 U.S. 361 (1960).
    \59\ Moline Properties, Inc. v. Commissioner [43-1 USTC para. 
9464], 319 U.S. 436, 438-439 (1943).
---------------------------------------------------------------------------
    The ``step transaction'' doctrine permits the Service to 
aggregate formally separate transactions into a single 
transaction. Under the doctrine, tax results are determined by 
looking at the final result of the various steps of the 
transaction. The doctrine particularly ignores the intermediate 
steps in a transaction where those steps primarily were taken 
for tax purposes.
    The ``sham transaction'' doctrine allows the Service to 
deny deductions and losses or otherwise recast transactions 
that lack any economic results beyond a tax deduction. The sham 
transaction doctrine has been expanded to apply even to certain 
bona fide transactions, where sufficient economic motivation is 
lacking.
    The recent decisions in ACM v. Commissioner \60\ and ASA 
Investerings v. Commissioner \61\ illustrate the continuing 
force of these long-standing judicial doctrines. In ACM, the 
Third Circuit, affirming the Tax Court, relied on the sham 
transaction and economic substance doctrines to disallow losses 
generated by a partnership's purchase and resale of notes. The 
Tax Court similarly invoked those doctrines in ASA Investerings 
to disallow losses on the purchase and resale of private 
placement notes. Both cases involved complex, highly 
sophisticated transactions, yet the Service successfully used 
common law principles to prevent the taxpayers from realizing 
tax benefits from the transactions.
---------------------------------------------------------------------------
    \60\ 157 F3d 231 (3d Cir. 1998).
    \61\ [98-2 USTC para. 52,845], T.C.M. 1998-305 (1998).

---------------------------------------------------------------------------
1. The business purpose and substance over form doctrines.

    The business purpose and substance over form doctrines 
continue to serve as powerful tools for the Service to 
recharacterize a taxpayer's transactions to combat tax 
avoidance.\62\ The business purpose doctrine generally provides 
that a transaction will not be respected for tax purposes 
unless it serves some purpose other than tax avoidance. The 
Supreme Court's decision in Gregory v. Helvering,\63\ generally 
is cited as the origin of the business purpose doctrine. In 
Gregory, a reorganization complied with all of the formal 
statutory requirements, but was disregarded for federal income 
tax purposes because no valid economic purpose existed for the 
creation and immediate liquidation of a transferee corporation. 
The transaction simply was an attempt to convert ordinary 
dividend income into capital gains. The Supreme Court's 
decision was not based on any tax-avoidance motive of the 
taxpayer, but rather on the lack of a business purpose for the 
transaction which the statutory scheme contemplated. The court 
stated:
---------------------------------------------------------------------------
    \62\ See, e.g., ASA Investerings, supra; ACM Partnership, supra.
    \63\ Supra n. 49.

          The legal right of the taxpayer to decrease the amount of 
        what otherwise would be his taxes, or altogether avoid them, by 
        means which the law permits, cannot be doubted. But the 
        question for determination is whether what was done, apart from 
        tax motive, was the thing which the statute intended. [293 U.S. 
---------------------------------------------------------------------------
        at 469]

    The Tax Court has noted that the doctrine in Gregory is not 
limited to the field of corporate reorganizations, but has a 
much wider scope.\64\
---------------------------------------------------------------------------
    \64\ Braddock Land Co. v. Commissioner, 75 T.C. 324, 329 (1980).
---------------------------------------------------------------------------
    The substance over form doctrine, which is closely 
associated with the business purpose doctrine, generally allows 
courts to follow the economic substance of a transaction where 
a court believes the taxpayer's empty form shelters a 
transaction from the rules that otherwise should govern. As 
indicated above, the Service has succeeded in using the 
substance over form doctrine to recharacterize a variety of 
transactions. Furthermore, the substance over form doctrine 
offers the Service the added advantage of generally working in 
the government's favor and not in the taxpayer's.\65\
---------------------------------------------------------------------------
    \65\ Higgins v. Smith, 308 U.S. 473 (1940); U.S. v. Morris & E.R. 
Co., 135 F.2d 711, 713 (2d Cir. 1943) (``[T]he Treasury may take a 
taxpayer at his word, so to say; when that serves its purpose, it may 
treat his corporation as a different person from himself; but that is a 
rule which works only in the Treasury's own favor[.]''), cert. denied, 
320 U.S. 754 (1943).

---------------------------------------------------------------------------
2. The step transaction doctrine.

    Another version of the substance over form concept appears 
in the ``step transaction doctrine,'' which also applies 
throughout the tax law. The step transaction doctrine allows 
the Service to collapse and treat as a single transaction a 
series of formally separate steps, if the steps are 
``integrated, interdependent, and focused toward a particular 
result.''\66\ Thus, the step transaction doctrine ignores the 
intermediate steps in a transaction where those steps 
constitute an indirect path toward the transaction's endpoint 
and where those steps primarily were taken to get better tax 
results. Under the doctrine, tax results are determined by 
looking at the ultimate result of a series of transactions.
---------------------------------------------------------------------------
    \66\ Penrod v. Commissioner, 88 T.C. 1415, 1428 (1987). See M. 
Ginsburg & J. Levin, Mergers, Acquisitions and Buyouts, para.608 (Oct. 
1998 ed.).
---------------------------------------------------------------------------
    While the boundaries of the step transaction doctrine are 
subject to debate, courts have articulated three versions of 
the doctrine: (1) an end result test, (2) an interdependence 
test, and (3) a binding commitment test.\67\ The broadest 
version is the end result test, which aggregates a series of 
transactions if the transactions are prearranged parts of a 
single transaction intended from the start to reach an ultimate 
result. Slightly less broad is the interdependence test, which 
groups together a series of transactions if the transactions 
are so interdependent that the legal relations created by one 
transaction would be pointless absent the other steps. The 
narrowest version is the binding commitment test, which joins 
together a series of transactions if, at the time the first 
step is taken, a binding legal commitment requires the later 
steps.\68\ While the courts have disagreed over which 
particular test to apply in particular circumstances, such 
uncertainty has not prevented the courts from applying the 
doctrine liberally.\69\
---------------------------------------------------------------------------
    \67\ Ginsburg & Levin, supra, at para.608.1.
    \68\ Id.
    \69\ See, e.g., Jacobs Engineering Group v. U.S. [97-1 USTC para. 
50,340], No. CV 96-2662, 1997 U.S. Dist. LEXIS 3467 (C.D. Calif. March 
6, 1997); Associated Wholesale Grocers v. U.S. [91-1 USTC para. 
50,165], 927 F.2d 1517 (10th Cir. 1991); Security Industrial Insurance 
Co. v. U.S. [83-1 USTC para. 9320], 702 F.2d 1234 (5th Cir. 1983).

---------------------------------------------------------------------------
3. Sham transaction doctrine and economic motivation test.

    The sham transaction doctrine offers another route by which 
courts and the Service have attacked transactions lacking in 
economic substance or reality. Among the leading cases 
articulating the sham transaction doctrine are Knetsch v. U.S. 
\70\ and Goldstein v. Commissioner.\71\ In Knetsch, the Supreme 
Court held that a transaction--the purchase of ten 30-year 
deferred annuity bonds, financed by a down payment and funds 
borrowed from the issuer against the cash surrender value of 
the bonds--was ``a sham,'' lacking any appreciable economic 
results, because ``there was nothing of substance to be 
realized [by the taxpayer] beyond a tax deduction'' (364 U.S. 
at 366). The court diverted its attention from the taxpayer's 
tax avoidance motive and focused instead on the taxpayer's 
failure to establish the presence of business purpose (the 
taxpayer's subjective state of mind) or a justifying economic 
substance (an objective test) in the transaction.
---------------------------------------------------------------------------
    \70\ 60-2 USTC para. 9785], 364 U.S. 361 (1960).
    \71\ [66-2 USTC para. 9561], 364 F.2D 734 (2d Circ. 1966), cert. 
denied 385 U.S. 1005 (1967)
---------------------------------------------------------------------------
    The court based its conclusions on the fact that the 
taxpayer paid 3\1/2\ percent interest to the issuer of the 
bonds on its financing loan, while the investment grew at only 
2\1/2\ percent per year. The net annual cash loss of one 
percent of the borrowed funds was incurred only to achieve a 
tax deduction for the interest paid, not for an ``economic'' 
profit. Although the taxpayer could have refinanced the loan if 
funds became available from another lender at a lower rate, he 
either failed to present evidence regarding the prospect of a 
decline in interest rates or failed to convince the trial judge 
that refinancing was a realistic option, and the Supreme Court 
implicitly assumed that it was not.\72\
---------------------------------------------------------------------------
    \72\ B. Bittker, Pervasive Judicial Doctrines in the Construction 
of the Internal Revenue Code, 21 How. L. J. 693 (1978).
---------------------------------------------------------------------------
    In Goldstein, the taxpayer borrowed funds at 4 percent 
interest to purchase bonds paying 1\1/2\ percent interest and 
pledged the bonds as security for the loan. While the court 
held that the loans were not sham transactions because the 
indebtedness was valid, it nevertheless denied the interest 
deduction because the taxpayer did not enter into the 
transactions in order to derive any economic gain through 
appreciation in value of the bonds. Rather, the taxpayer 
borrowed the money solely in order to secure a large interest 
deduction which could be deducted from other income.
    The Second Circuit's approach extended the sham transaction 
doctrine by adding an economic motivation requirement. As a 
result, the interest expense arising from even a bona fide 
indebtedness must meet an additional requirement of economic 
motivation to be deductible. Courts have denied interest 
deductions in transactions similar to those in Goldstein but 
without calling the transaction a sham--a term now reserved for 
a mere paper or ``fake'' transaction.\73\ Under the economic 
motivation requirement, an interest deduction may be disallowed 
if no economic gain could be realized beyond a tax 
deduction.\74\
---------------------------------------------------------------------------
    \73\ Rice's Toyota World, Inc. v. Commissioner, 81 T.C. 184, 200 
(1983).
    \74\ See, e.g., Rothschild v. U.S. [69-1 USTC para. 9224], 186 
Ct.Cl. 709, 407 F.2d 404, 406 (1969).
---------------------------------------------------------------------------
    More recently, in ACM, supra, the Third Circuit applied the 
economic substance requirement and sham transaction doctrine to 
disallow losses generated by a partnership's purchase and 
resale of notes. The Tax Court, in disallowing the losses, 
stressed the taxpayer's lack of any nontax business motive. 
However, the Third Circuit, affirming the Tax Court, focused on 
the transaction's lack of economic substance. The court held 
the transaction lacked economic substance because it involved 
``only a fleeting and economically inconsequential investment 
by the taxpayer.'' The Tax Court pursued a similar approach in 
ASA Investerings, supra, to deny a loss on the purchase and 
resale of private placement notes.
    The above judicial doctrines and the numerous of cases they 
have generated have proven difficult to translate into clear, 
bright-line rules. That difficulty stems in part from the 
highly complicated facts in those cases, and in part from the 
uncertainty as to which facts the courts believed credible and 
which facts proved relevant to the outcome.\75\ As a result of 
this uncertainty, the exact scope of those judicial doctrines 
is ill-defined and potentially extremely broad. This breadth, 
in effect, has acted as yet another arrow in the Service's 
quiver by exerting a strong in terrorem effect. While those 
judicial doctrines may not be impermeable, they represent a 
broad range of weapons available to the Service to attack tax 
avoidance. Moreover, those doctrines already impose high costs 
on legitimate business planning and inhibit efficiency.
---------------------------------------------------------------------------
    \75\ Bittker, supra n. 72.
---------------------------------------------------------------------------

                C. Current anti-abuse rules in the Code.

    The Code contains numerous provisions that give the 
Treasury Department and the Service broad authority to prevent 
tax avoidance, to reallocate income and deductions, to deny tax 
benefits, and to ensure taxpayers clearly report income. An 
illustrative list of more than 70 provisions that explicitly 
grant Treasury and the Service such authority appears in 
Appendix B.
    As demonstrated by this list, Treasury and the Service long 
have had powerful ammunition to challenge tax avoidance 
transactions. The Service has broad power to reallocate income, 
deductions, credits, or allowances between controlled taxpayers 
to prevent evasion of taxes or to clearly reflect income under 
section 482. While much attention has been focused in recent 
years on the application of section 482 in the international 
context, section 482 also applies broadly in purely domestic 
situations. The Service also has the authority to disregard a 
taxpayer's method of accounting if it does not clearly reflect 
income under section 446(b).
    In the partnership context, the Service has issued broad 
anti-abuse regulations under subchapter K.\76\ Those rules 
allow the Service to disregard the existence of a partnership, 
to adjust a partnership's methods of accounting, to reallocate 
items of income, gain, loss, deduction, or credit, or to 
otherwise adjust a partnership's or partner's tax treatment in 
situations where a transaction meets the literal requirements 
of a statutory or regulatory provision, but where the Service 
believes the results are inconsistent with the intent of the 
partnership tax rules.
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    \76\ Treas. Reg. 1.701-2.
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    The Service also has issued a series of far-reaching anti-
abuse rules under its legislative grant of regulatory authority 
in the consolidated return area. For example, under Treas. Reg. 
Sec. 1.1502-20, a parent corporation is severely limited in its 
ability to deduct any loss on the sale of a consolidated 
subsidiary's stock. The consolidated return investment basis 
adjustment rules also contain an anti-avoidance rule.\77\ The 
rule provides that the Service may make adjustments ``as 
necessary'' if a person acts with ``a principal purpose'' of 
avoiding the requirements of the consolidated return rules. The 
consolidated return rules feature several other anti-abuse 
rules.\78\
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    \77\ Treas. Reg. Sec. 1.1502-32(e).
    \78\ E.g., Treas. Reg. Sec. 1.1502-13(h) (anti-avoidance rules with 
respect to the intercompany transaction provisions) and Treas. Reg. 
Sec. 1.1502-17(c) (anti-avoidance rules with respect to the 
consolidated return accounting methods).
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                            D. IRS Notices.

    The Service from time to time has issued IRS Notices 
stating its intention to issue subsequent regulations that 
would shut down certain transactions. Thus, a Notice allows the 
government (assuming that the particular action is within 
Treasury's rulemaking authority) to move quickly, without 
having to await development of the regulations themselves--
often a time-consuming process--that will provide more detailed 
rules concerning a particular transaction.
    The Service has not been adverse to issuing such Notices. 
Recent examples include Notice 97-21, in which the Service 
addressed multiple-party financing transactions that used a 
special type of preferred stock; Notice 95-53, in which the 
Service addressed the tax consequences of ``lease strip'' or 
``stripping transactions'' separating income from deductions; 
and Notices 94-46 and 94-93, addressing so-called ``corporate 
inversion'' transactions viewed as avoiding the 1986 Act's 
repeal of the General Utilities doctrine.\79\ Appendix C 
includes an illustrative list of these types of IRS Notices 
issued in the past 10 years.
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    \79\ The General Utilities doctrine generally provided for 
nonrecognition of gain or loss on a corporation's distribution of 
property to its shareholders with respect to their stock. See, General 
Utils. & Operating Co. v. Helvering, 296 US 200 (1935). The General 
Utilities doctrine was repealed in 1986 out of concern that the 
doctrine tended to undermine the application of the corporate-level 
income tax. H.R. Rep. No. 426, 99th Cong., 1st Sess. 282 (1985).
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    Moreover, the Service currently has the ability to prevent 
abusive transactions that occur before a Notice is issued. 
Section 7805(b) expressly gives the Service authority to issue 
regulations that have retroactive effect ``to prevent abuse.'' 
Therefore, although many Notices have set the date of Notice 
issuance as the effective date for forthcoming regulations,\80\ 
the Service can and has used its authority to announce 
regulations that would be effective for periods prior to the 
date the Notice was issued.\81\ Alternatively, the Service in 
Notices has announced that it will rely on existing law to stop 
abusive transactions that have already occurred.\82\
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    \80\ See, e.g., Notice 95-53, 1995-2 CB 334, and Notice 89-37, 
1989-1 CB 679.
    \81\ See, e.g., Notice 97-21, 1997-1 CB 407.
    \82\ Notice 96-39, I.R.B. 1996-32.
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                        E. Legislative changes.

    To the extent that Treasury and the Service may lack 
rulemaking or administrative authority to challenge a 
particular transaction, the avenue remains open to seek 
enactment of legislation. In this regard, over the past 30 
years dozens upon dozens of changes to the tax statute have 
been enacted to address perceived avoidance and abuses. 
Appendix D includes an illustrative list.
    These legislative changes can be broken down into two 
general categories. The first includes legislative changes that 
respond specifically to a transaction deemed to be abusive or 
otherwise outside the intended scope of the tax laws. For 
example, bills (H.R. 435, S. 262) now pending before the 106th 
Congress would address ``basis-shifting'' transactions 
involving transfers of assets subject to liabilities under 
section 357(c). The proposal first was advanced by the 
Administration, in its FY 1999 budget submission, and 
subsequently was introduced as legislation by House Ways and 
Means Committee Chairman Bill Archer. Other recent examples of 
specific legislative actions to address potential or identified 
abuses would include a provision addressing liquidating REIT 
and RIC transactions enacted in the 1998 \83\ and a provision 
imposing a holding period requirement for claiming foreign tax 
credits with respect to dividends under section 901(k), enacted 
as part of the Taxpayer Relief Act of 1997.\84\ The 
Administration's FY 2000 budget submission includes a number of 
proposals addressing specific types of transactions. As stated 
above, whether or not the tax policy rationales given by 
Treasury for these proposals are persuasive, as a procedural 
matter it is proper that these proposals now will undergo 
Congressional scrutiny.
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    \83\ P.L. 105-277, section 3001.
    \84\ P.L. 105-34, section 1053.
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    These targeted legislative changes often have immediate, or 
even retroactive, application. For example, the section 357(c) 
proposal currently before Congress would be effective for 
transfers on or after October 19, 1998--the date that Chairman 
Archer introduced the proposal in the form of legislation. 
Chairman Archer took this action, in part, to stop these 
transactions earlier than would have been the case under 
effective date originally proposed by the Administration (the 
date of enactment). Moreover, in some cases, Congress includes 
language in the legislative history stating that ``no 
inference'' is intended regarding the tax treatment under prior 
law of the transaction addressed in the legislation. This 
language is intended, in part, to preclude any interpretation 
that otherwise might arise that enactment of the provision 
necessarily means that the transaction in question was 
sanctioned by prior law.
    It should be noted that Congress and the Administration do 
not always agree on the appropriateness of specific legislative 
proposals advanced by Treasury that purport to address areas of 
perceived abuse. In fact, more than 40 revenue-raising 
proposals proposed by the Administration in its last three 
budget proposals (for FY 1997, FY 1998, and FY 1999) have been 
rejected by the Congress. Appendix E provides a list of these 
Administration proposals.
    The second category of legislation includes more general 
changes to the ground rules under which corporate tax 
executives and the Service operate. These ``operative rules'' 
include, for example, modifications to the penalty structure 
applicable to tax shelters, tax understatements, and 
negligence, as well as new reporting requirements. Operative 
changes generally are considered by Congress far less 
frequently than the changes targeting specific abuses, and for 
good reason. These changes typically are intended to influence 
taxpayer behavior or increase Service audit tools where 
Congress sees an identifiable need for change. Changes then 
usually are given time to take full effect so that their impact 
can be measured to determine if they have achieved their 
desired result or if additional action might be necessary.
    In 1997, as discussed above, Congress enacted changes 
broadening the definition of ``tax shelter'' transactions 
subject to penalties and requiring that transactions be 
reported to the Service when undertaken under a confidentiality 
arrangement. Congress concluded that this change would 
``improve compliance by discouraging taxpayers from entering 
into questionable transactions.'' \85\ Because these changes 
have not yet taken effect (a result of Treasury's failure to 
issue regulations--to this date--that would activate the 
changes), Congress has not yet had an opportunity to gauge 
their impact.
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    \85\ Joint Committee on Taxation, General Explanation of Tax 
Legislation Enacted in 1997 222 (1997).
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    Before the 1997 Act changes to the tax shelter rules, 
Congress had last enacted operative changes in this area of the 
tax law as part of the Uruguay Round Agreement Act of 1994, 
under which Congress modified the substantial understatement 
penalty for corporations participating in tax shelters.
    The corporate tax shelter proposals advanced in the 
Administration's FY 2000 budget that are within the scope of 
this testimony would represent the most far-reaching operative 
changes ever enacted by Congress. Moreover, not only would they 
take effect before Congress has had a chance to evaluate the 
impact of its last round of operative changes, they would take 
effect even before the last round of changes has entered into 
force. Such a change is unprecedented in the annals of tax 
policymaking in this area.
    In some instances, these newly proposed operative 
provisions would allow Treasury to challenge the very same 
types of transactions that have been targeted by specific 
legislative changes sought by the Administration but rejected 
by Congress. Given the apparent divergence of views between 
Congress and the Administration on the appropriateness of 
specific tax legislative changes, it would be odd for the 
Congress at this time to hand Treasury and the Service 
unprecedented authority to dictate tax policy.

         V. RESPONSIBILITIES AND BURDENS OF CORPORATE TAXPAYERS

            A. Responsibilities of corporate tax executives.

    The chief tax executive of a typical U.S. corporation has 
many responsibilities and burdens in the tax preparation, 
collection, and enforcement process. This individual must 
oversee and implement systems to collect a variety of federal 
income, wage withholding, and excise taxes. He or she must be 
able to analyze and implement an incredibly complex, ever-
changing and, in many instances, arcane and outdated tax system 
made up of an intricate jumble of statutes, case law, 
regulations, rulings, and administrative procedural 
requirements.
    Notwithstanding this veritable maze of complicated and many 
times inconsistent rules that collectively comprises our tax 
law, this individual has a further responsibility to the 
management and shareholders of the corporation. He or she must 
understand management's business decisions and planning 
objectives, assess the tax law consequences of business 
activities, and counsel management about the tax consequences 
of various possible decisions. In the course of assisting 
management in the formation of business decisions, the 
corporate tax executive must assess the state of a very complex 
and uncertain tax law and must be able to provide advice to 
management on appropriate ways to minimize tax liabilities.
    Once those business decisions are made, he or she must 
implement them by supervising the formation of applicable 
entities, creating necessary systems for capturing tax-related 
information as it is generated from the business, and 
implementing necessary procedures for the calculation and 
remittance of taxes, information returns, and other 
documentation and materials necessary for compliance under the 
federal tax laws. Finally, the chief tax executive must be able 
to explain the appropriateness of tax positions taken by the 
company, as well as its tax collection, remittance, and 
reporting systems, to the Service upon examination.\86\
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    \86\ Large corporations are enrolled in the Service's coordinated 
examination program (CEP) and generally are under continuous audit by 
the Service to assure the appropriateness of tax return positions taken 
by those corporations.
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    In short, a chief tax executive must be able to understand 
an incredibly complex set of federal tax rules, advise and 
assist management in the formation of decisions that result in 
proper minimization of taxes, implement tax collection and 
reporting system for those decisions, and explain the 
appropriateness of those decisions and systems in examination 
discussions with the Service.

      B. Tax executive's vital role to the U.S. government as tax 
                             administrator.

    Collectively, the chief tax executives of U.S. corporations 
play a very significant role in the collection and remittance 
of federal taxes. They shoulder the ultimate responsibility 
within their corporations for adequate systems to collect and 
remit corporate income taxes, federal wage withholding taxes, 
and an array of excise taxes. The corporate tax department is 
the private administrator of the U.S. income tax.
    It is estimated that corporate income tax collections in FY 
1998 were $189 billion. Individual income tax payments withheld 
by corporations and remitted to the Treasury were approximately 
$375 billion, or more than 40 percent of gross individual 
income tax collected. Payroll tax withheld for Social Security 
and unemployment insurance by corporations amounted to 
approximately $315 billion, or 61 percent of payroll taxes 
collected. Corporations accounted for the bulk of the $76 
billion in excise and customs duties collected. In sum, of the 
$1.7 trillion in tax revenue collected by the Federal 
government in FY 1998, corporations either remitted directly or 
withheld and remitted more than 50 percent, vastly reducing the 
compliance burden on the Service and individuals.
    In addition to direct tax payments and withholding, 
corporations also provide information returns to the Service on 
payments made to employees, contractors, suppliers, and 
investors. In 1998 more than one billion information returns 
were filed by U.S. businesses with the Service, accounting for 
income and transactions exceeding $18 trillion.\87\ In addition 
to providing this information to the Service, U.S. businesses 
also provide this information (as required) to affected 
taxpayers to assist them in meeting their tax filing 
obligations.\88\ Corporations provided the vast majority of 
these information returns.
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    \87\ Not all dollar amounts reported on information returns are 
included in income. For example, the 1099-B reports the gross proceeds 
from the sale of certain investments. Only the gain from the sale of 
these investments is included in gross income.
    \88\ These information returns include Form W-2 (Wage and Tax 
Statement), Form W-2G (Certain Gambling Winnings), Form 1099-DIV 
(Dividends and Distributions), Form 1099-INT (Interest Income), Form 
1099-MISC (Miscellaneous Income), Form 1099-OID (Original Issue 
Discount), Form 1099-R (Distributions from Pensions, Annuities, etc.), 
Form 1099-B (Proceeds from Broker and Barter exchange Transactions), 
Form 5498 (Individual Retirement Arrangement Contribution Information), 
Form 1099-A, Acquisition or Abandonment of Secured Property, Form 1098 
(Mortgage Interest Statement), Form 1099-S (Proceeds from Real Estate 
Transactions), Form 1099C (relating to forgiven debt), Form 5498-MSA 
(Medical Savings Account Information), Form 1099-MSA (Distributions 
from Medical Savings Accounts), Form 1099-LTC (Long-Term Care and 
Accelerated Death Benefits), and Form 1098-E (Student Loan Interest 
Statement).
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    Without the help of corporate tax departments, collection 
and other administrative costs to the government would be 
significantly higher and rates of compliance significantly 
lower.

       C. Challenges and burdens presented by tax law complexity.

1. In general: burdens and costs.

    The extreme complexity of the U.S. tax law is especially 
burdensome for corporate taxpayers. Confronted by a jumble of 
statutes, case law, and administrative rulings and notices, the 
tax executives of a corporation often must take into account a 
veritable library full of materials in determining the 
appropriate tax treatment of a specific transaction.
    There are 3,052 pages of statutory language in the Internal 
Revenue Code (1994 ed.), and 11,368 pages of Treasury 
regulations contained in Title 26 of the Code of Federal 
Regulations. (Additionally, the Treasury Department has a 
substantial backlog of unfinished guidance projects designed to 
assist in the clarification of these complex rules (see list 
contained in Appendix F)). Further, there are thousands of 
pages of Revenue Rulings, Revenue Procedures, Notices, private 
letter rulings, technical advice memoranda, field service 
memoranda, and other administrative materials potentially 
relevant to the determination of the appropriate tax treatment 
of a particular transaction. More than 9,300 Tax Court cases 
have been decided since 1949, and thousands of additional court 
precedents exist in tax cases decided by the U.S. District 
Courts, the U.S. Courts of Appeals, the Court of Claims, and 
the U.S. Supreme Court. Further, there are about 50 
international tax treaties and various other agreements that 
may be applicable to the U.S. tax treatment of specific 
international transactions.
    Research has found that the compliance costs of the 
corporate income tax resulting from this complexity are 
significant. In 1992, Professor Joel Slemrod of the University 
of Michigan surveyed firms in the Fortune 500 and found an 
average compliance cost of $2.11 million, or more than $1 
billion for the entire Fortune 500.\89\ The cost for a sample 
of 1,329 large firms was more than $2 billion in the aggregate. 
About 70 percent of this cost is estimated to be attributable 
to the federal tax system, with the remaining 30 percent 
attributable to State and local income taxes. These estimates 
exclude the costs of complying with payroll, property, excise, 
withholding, and other taxes.
---------------------------------------------------------------------------
    \89\ Joel B. Slemrod and Marsha Blumenthal, ``The Income Tax 
Compliance Cost of Big Business,'' Public Finance Quarterly, October 
1996, v. 24, no. 4, pp. 411-438.
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    The firms surveyed by Professor Slemrod generally were 
among the largest 5,000 U.S. companies. He found that 
compliance costs are largest for the biggest firms, but 
relative to firm payroll, assets, or sales, they are 
proportionately larger for the smaller firms in this sample.
    The specific sources of the complexity of the U.S. tax law 
are many. In Professor Slemrod's survey, respondents were asked 
to identify the aspects of the tax law that were most 
responsible for the cost of compliance. Three aspects cited 
most often were the depreciation rules, the alternative minimum 
tax, and the uniform capitalization rules.
    The depreciation and uniform capitalization rules are 
examples of the complexity created through differences between 
financial statement income and taxable income. The U.S. tax 
accounting rules deviate significantly from financial 
accounting rules, requiring substantial modifications to 
financial statement income in order to compute taxable income. 
This is in contrast to the tax laws of other countries, such as 
Japan, where there is much greater conformity between book 
income and taxable income. The depreciation and uniform 
capitalization rules also are examples of areas that have 
become more burdensome in recent years, with changes enacted 
with the Tax Reform Act of 1986 serving to increase the 
complexity.
    The other area most frequently cited by the survey 
respondents, the alternative minimum tax, adds yet another 
layer of complexity. After making all the adjustments from 
financial statement income required in computing regular 
taxable income, the taxpayer then must compute alternative 
minimum taxable income. The computation of alternative minimum 
taxable income requires an extensive series of adjustments to 
regular taxable income, including adjustments to reflect 
different depreciation rules (which already is an area of 
particular complexity under the regular income tax). It is not 
just alternative minimum taxpayers that must make these 
computations; all these computations must be made in order for 
the taxpayer to determine whether it is subject to the 
alternative minimum tax. Moreover, like the depreciation and 
uniform capitalization rules, the alternative minimum tax rules 
were made significantly more burdensome by the 1986 Act 
changes.\90\
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    \90\ Respondents in Professor Slemrod's survey, supra n. 89, cited 
alternative minimum tax, uniform capitalization, and depreciation as 
among the 1986 Act provisions that most contributed to increasing the 
complexity of the U.S. tax system.

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2. Complexity in international transactions.

    For a corporate taxpayer with foreign operations or 
foreign-source income, compliance with complicated rules noted 
above is just the beginning. These taxpayers are subject to a 
set of detailed rules with respect to the U.S. tax treatment of 
the taxpayer's foreign income. The United States taxes domestic 
corporations on their worldwide income. The international tax 
rules--both specific provisions and the body of rules in 
general--were another area of complexity cited by many of the 
respondents in Professor Slemrod's study.
    U.S. taxpayers must calculate separately domestic-source 
and foreign-source income. To do so, they must allocate and 
apportion all expenses between domestic and foreign sources. In 
addition, the foreign tax credit rules apply separately to nine 
different categories or ``baskets'' of income.\91\ Accordingly, 
U.S. taxpayers must calculate foreign-and domestic-source 
income--and allocate and apportion expenses to such income--
separately for each basket. All these computations then must be 
done again under the alternative minimum tax rules.
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    \91\ The rules currently create additional income baskets for 
dividends from each foreign corporation in which the taxpayer owns a 
10-percent voting interest but which is not a controlled foreign 
corporation. Although the Taxpayer Relief Act of 1997 included a 
provision eliminating these additional baskets, that provision will not 
be effective until 2003. (A Treasury budget proposal would accelerate 
this elimination.)
---------------------------------------------------------------------------
    U.S. taxpayers with foreign subsidiaries must report 
currently for U.S. tax purposes certain types of the foreign 
subsidiaries' income, even though that income is not 
distributed currently to the U.S. parent. In addition to the 
complicated rules that must be applied to determine the portion 
of the subsidiaries' income that is subject to current 
inclusion, U.S. tax accounting rules must be applied to 
determine the foreign subsidiaries' earnings and profits (which 
may require a translation first from local GAAP to U.S. GAAP 
and then from U.S. GAAP to U.S. tax accounting principles). The 
U.S. parent also must include with its U.S. tax return detailed 
information with respect to each foreign subsidiary.\92\
---------------------------------------------------------------------------
    \92\ Provisions enacted with the 1997 Act require similar reporting 
with respect to foreign partnerships in which the U.S. taxpayer has an 
interest.
---------------------------------------------------------------------------
    Of course, a U.S. taxpayer with foreign operations is 
subject not just to the U.S. tax rules but also to the tax 
rules of the country where the operations are located. For many 
U.S. multinational corporations, this means that the 
corporation will be responsible for compliance with the tax 
laws of numerous jurisdictions around the world. The results of 
each operation must be reported both for local tax purposes and 
for U.S. tax purposes, under rules that may reflect significant 
differences in terms of both characterization and timing. 
Layered on top of the local and U.S. tax rules are the 
provisions of an applicable income tax treaty between the two 
countries. The treaty provisions have the effect of modifying 
the impact of the internal rules of the particular countries. 
Application of the treaty requires understanding of the 
provisions of the treaty itself as well as any understandings 
or protocols associated with the treaty and the Treasury 
Department's detailed technical explanation of the treaty.
    One specific example of the tax law complexities and 
commensurate responsibilities confronting a chief tax executive 
of a large U.S.-based multinational corporation is the planning 
and analysis necessary to implement an internal restructuring 
of a line of business within the company. An internal 
restructuring of a particular business unit within a corporate 
structure may be desired by management to build efficiencies in 
the overall business, to prepare for an acquisition of a 
related line of business, or to prepare for a disposition of a 
line of business. In any event, the chief tax executive must 
research and analyze dozens of discrete tax issues in the 
implementation of this management decision, including the 
choice of appropriate entity (e.g., partnership, corporation, 
or single member LLC), place of organization (involving State 
tax or international tax issues), possible carryover of tax 
attributes (e.g., accounting methods and periods, earnings and 
profits, and capital and net operating losses), consideration 
of new tax elections, and consideration of the application of 
complex consolidated tax return regulations. Moreover, if the 
internal restructuring impacts any foreign operations of the 
company, the chief tax executive also must research and analyze 
all the foreign tax implications of the restructuring. The 
foreign tax treatment of the internal restructuring--and of any 
alternative approaches to accomplishing the business 
objectives--may be very different than the U.S. tax treatment 
of the same transaction or transactions.

   D. Responsibility of the corporate tax executive to shareholders.

    Corporate executives have a fiduciary duty to increase the 
value of a corporation for the benefit of its shareholders. 
Reducing a corporation's overall tax liability can increase the 
value of a corporation's stock. There are, however, several 
reasons that corporate tax executives will avoid undertaking 
aggressive, tax-motivated transactions.
    Corporate tax executives must meet professional and 
company-imposed ethical standards that preclude taking 
unsupported, negligent, or fraudulent tax positions.\93\ Also, 
incurring significant tax penalties has the effect of reducing 
shareholder value. If the reversal of a tax position and the 
cost of the penalties are not properly provided for in a 
company's financial statements, a restatement of those 
financial statements may be required, which could be 
devastating to a corporation's stock value. Financial 
accounting standards require that all material tax positions 
which are contingent as to their outcome must be specifically 
disclosed to shareholders. Also, with most corporations focused 
on preserving and enhancing their brands, corporate tax 
executives are careful not to recommend a transaction to 
management that later might be reported unfavorably in the 
national press as being improper.
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    \93\ Corporate tax executives are governed by professional conduct 
standards promulgated by the American Bar Association (ABA) and the 
American Institute of Certified Public Accountants (AICPA) if the 
corporate tax executive is a member of either of these two professions. 
In addition, a corporate tax executive is governed by ``Circular 230'' 
(31 C.F.R. Part 10), which provides rules of conduct for practicing 
before the Service. Additionally, the existing penalty provisions 
(discussed above) that apply to the corporation act as a significant 
deterrent to a tax exeuctive's recommending a transaction that might 
trigger penalties.
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                  VI. RESPONSIBILITIES OF TAX ADVISERS

    This section of the testimony sets out views of the role 
played by accounting firms in providing assistance to 
corporations on tax issues.

        A. Reasons why corporate tax executives need assistance.

    As discussed previously, the chief tax executive of a 
corporation has many duties and burdens in analyzing federal, 
State, and foreign tax consequences of business decisions, 
implementing collection and remittance systems for a variety of 
federal and State income and excise taxes, and reviewing tax 
return positions with Service and State tax personnel upon 
examination of tax return positions. These duties require 
accurate analysis of very complex federal statutes, 
regulations, rulings, and administrative procedures, which in 
turn requires keeping current on statutory, regulatory, and 
administrative developments as well as a burgeoning body of 
case law. Also, today's chief tax executive must have an 
intimate knowledge of information technology systems designed 
to capture necessary tax data from business operations and 
provide essential compliance and remittance functions.
    Only in the smallest of corporate business contexts can one 
person be charged with all these disparate responsibilities. In 
large corporations, even with the assistance of a significant 
number of knowledgeable staff, the chief tax executive must 
turn to outside advisers for professional assistance for a 
variety of consulting and compliance needs.

   B. Assisting tax executives fulfill duties as tax administrators.

    The accounting profession provides invaluable assistance to 
the chief tax executive in his or her role as a tax 
administrator charged with the collection and remittance of a 
variety of federal taxes. Accounting firms provide assistance 
in designing and implementing information technology systems to 
track data for preparation of the company's tax return, as well 
as systems for collecting, remitting, and providing appropriate 
information returns and schedules for employee withholding and 
other taxes.\94\ In many instances, the chief tax executive of 
a corporation utilizes a mix of systems provided by accounting 
firms and other service providers which are then implemented by 
corporate personnel; in other instances, compliance and 
reporting functions are ``outsourced'' in whole or in part to 
accounting firms by the corporation.
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    \94\ Payroll service firms and other service providers also can 
provide corporations with assistance in tax administrative functions.
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    To the extent accounting firms assist in the tax 
administrator role of the chief tax executive of a corporation, 
the accounting firm is subject to the commensurate duties to 
provide accurate data collection, retrieval, remittance, and 
reporting systems. Given the sophisticated information 
technology systems necessary in large corporations to comply 
with the complex tax laws, it is fair to say that the 
accounting profession's involvement substantially enhances 
corporate tax compliance and augments Service tax 
administration.

         C. Assistance in addressing complex analytical issues.

    The ever-changing tax law, with its lack of precision and 
clarity, requires a chief tax executive to confront analytical 
difficulties in assessing the tax consequences of business 
activities. Many of these business activities are common to 
many corporations and industries. For example, considerable 
uncertainty exists currently as to the appropriate tax 
classification of a variety of expenditures made by 
corporations in upgrading technological business systems.
    The accounting profession can bring invaluable assistance 
to corporate tax executives faced with having to analyze the 
tax consequences of an array of business activities where the 
appropriate tax analysis is not clear from the rules and 
procedures, and where the time invested by the corporation in 
developing an independent analysis of the taxation of a 
business activity cannot be justified given the broad 
experience of professional advisors in analyzing similar 
situations for other corporations.\95\ In such cases, the 
accounting firm providing analytical assistance is subject to 
standards of professional responsibility.\96\
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    \95\ Law firms provide legal advice with respect to tax analytical 
and planning issues. These comments are focused on the role of 
accounting firms.
    \96\ The AICPA's ``Statements on Responsibilities in Tax Practice'' 
(1988 Rev.) consist of advisory opinions that provide conduct 
guidelines to practicing CPAs. The statements (cited as ``SRTPs'') 
cover a number of common situations that the practicing CPA deals with 
on a regular basis. Most importantly, SRTP No. 1 provides guidelines 
for taking tax return positions.
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    Also, decisions made to promote the objectives of a 
corporation--for example, to expand a U.S.-based business 
abroad or to divest a portion of the business deemed no longer 
part of the ``focus'' of the corporation--can result in 
literally hundreds of substantive tax issues that must be 
researched and assessed in order to provide the chief tax 
executive a degree of certainty that certain tax positions are 
appropriate. Only the largest corporations have tax departments 
of sufficient size and personnel specialization to afford the 
company the ability to perform this necessary analysis 
internally. In many cases, the accounting profession provides 
essential assistance to corporations in fulfilling these 
analytical responsibilities.

                 D. Assistance in prudent tax planning.

    Corporate executives have fiduciary duties to shareholders 
to consider the tax results of various potential business 
decisions and appropriately to minimize the tax impact of 
business operations. Accordingly, in working closely with 
management, the chief tax executive of a corporation must offer 
proactive assistance in structuring business decisions to meet 
planning objectives while prudently minimizing tax 
consequences.
    As one simple example, a company may feel that the product 
manufactured by a particular subsidiary no longer promotes the 
business objectives of the corporation. The value of the 
subsidiary exceeds the tax basis in its assets, and if the 
subsidiary were sold a large capital gain would be realized and 
recognized by the corporation. A prudent tax professional would 
recommend to management that, as part of its overall business 
decision making process regarding the subsidiary, a tax-free 
reorganization be considered, possibly a spin-off of the 
subsidiary to the corporation's shareholders for a valid 
business purpose (the fit and focus of the remaining group) 
while preserving the most value of the subsidiary to those 
shareholders. The chief tax executive of a corporation would be 
remiss if he or she did not focus management on the tax 
implications of this potential decision and actively explore 
alternative business structures to fulfill management 
objectives.\97\
---------------------------------------------------------------------------
    \97\ It is pertinent to note that the tax law allows taxpayers to 
select among a variety of structures and forms to accomplish business 
objectives, some of those decisions resulting in lower ultimate tax 
liability than other decisions. This deliberation and choice for 
taxpayers should be considered a normal part of the income tax system, 
and should not be inhibited or penalized. For example, the staff of the 
Joint Committee on Taxation does not consider choosing doing business 
in partnership form (subject to a single level of tax on operations) 
instead of doing business in corporate form (subject to taxation at the 
corporate and shareholder levels) a tax expenditure, or exception to 
normal tax rules. See, Joint Committee on Taxation, Estimates of 
Federal Tax Expenditures For Fiscal Years 1999-2003 (JCS-7-98), 
December 14, 1998, p. 6.
---------------------------------------------------------------------------
    Accounting firms provide professional consulting services 
to the chief tax executive as various planning ideas are 
reviewed and analyzed to determine the most advantageous method 
for implementing business objectives from a tax standpoint. 
Such planning assistance is necessary for most corporations 
that do not have sufficient internal resources to review and 
understand the vast number of issues involved in assessing the 
best structure or optimal course of action necessary to fulfill 
corporate objectives in the most tax-efficient manner.
    In some areas of business planning, many corporations may 
share similar objectives. For example, many corporations across 
various industries recently have been investigating mergers to 
obtain essential business economies of scale. Accordingly, 
accounting firms have developed specialty expertise in many 
complex and sophisticated issues relating to the taxation of 
merger and acquisition activity. These firms thus can advise 
corporate executives in an efficient manner on merger and 
acquisition issues without forcing the executives to ``reinvent 
the wheel'' by devoting a significant amount of time and 
resources to obtaining solutions that accounting firms have 
more readily available because of specialization and 
experience. Also, to the extent that the contemplated 
transaction would result in potential foreign tax law 
consequences, the fact that large accounting firms have 
personnel or affiliated firms in multiple world-wide locations 
means that they can provide efficient services to the chief 
corporate executive of a U.S.-based multinational corporation.

                            VII. CONCLUSION

    We respectfully urge Congress to reject the 
Administration's broad proposals relating to ``corporate tax 
shelters.'' As discussed above, the proposals could affect many 
legitimate business transactions, further hamstringing 
corporate tax executives seeking to navigate the maze of 
federal, State, and international tax laws applicable to 
corporations. Congress already has provided Treasury with ample 
administrative tools--some of which Treasury has not yet self-
activated--to address situations of perceived abuse. There is 
no demonstrated need at this time to expand these tools, 
particularly in such a way that would give the Service's 
revenue agents nearly carte blanche authority to ``deny tax 
benefits.'' Instead, where specific areas of concern are 
identified, Congress and the Treasury should work together--as 
they have done in the past--to enact legislation targeting such 
cases.
      

                                

    Chairman Archer. Thank you, Mr. Kies. Let me reiterate that 
your printed statement will be inserted in the record, without 
objection, in its entirety.
    Mr. Weinberger, if you will identify yourself, you may 
proceed.

STATEMENT OF MARK A. WEINBERGER, PRINCIPAL, WASHINGTON COUNSEL, 
                              P.C.

    Mr. Weinberger. Thank you, Mr. Chairman. My name is Mark 
Weinberger. I am a partner with Washington Counsel, a law firm 
here in Washington.
    I appreciate this opportunity to testify today on the 
administration's revenue proposals, specifically those relating 
to corporate tax shelters. I understand and appreciate the 
concern that motivated the administration to put forward the 
corporate tax shelter proposals. To the extent taxpayers are 
entering into transactions that are not sanctioned under 
applicable law, those taxpayers extract a cost that is borne by 
all taxpayers, both individuals and corporations, and may 
undermine the foundation of our voluntary tax system.
    However, in my opinion, the administration's corporate tax 
shelter proposals are unnecessary, and certainly premature, 
exceedingly vague and far-reaching, and appear to create an 
unprecedented transfer of power to the executive branch, and 
specifically IRS revenue agents.
    I would like to make seven short observations.
    First, the rhetorical and anecdotal press accounts that 
have surfaced surrounding tax shelters suggests the corporate 
tax base is rapidly eroding and is in imminent danger of 
imploding. While the perception of a problem is in itself a 
problem, and therefore requires attention, the evidence simply 
does not suggest the entire corporate tax base is at risk.
    Corporate tax receipts have risen for the last 9 years, and 
are projected to increase in the coming years. Moreover, the 
administration's own estimates of the savings its proposals are 
projected to achieve are modest, less than 0.2 percent of the 
total projected tax receipts over the next 5 years.
    Second, the administration's proposals are sweeping 
separately and collectively. The subjective nature of the 
definitions will create significant uncertainty and lead to 
widely disparate treatment of similarly situated taxpayers. 
They impose new taxes on seemingly legitimate and ordinary 
business transactions, something I am sure this Committee is 
not intent on doing.
    Third, the proposal represents an unprecedented delegation 
of power to the executive branch and IRS revenue agents to 
override laws enacted by Congress, and to institute new laws by 
administrative fiat. The Super section 269 proposal would give 
the executive branch authority to disregard its own regulations 
and the laws duly enacted by this Congress when the Secretary 
does not like the results. The rules would clearly diminish 
congressional prerogative. An interesting question would be, 
how many of the revenue raisers previously rejected by this 
Committee or accepted, but in alternative form, would have been 
unnecessary to even submit to Congress for consideration if 
these rules were in place?
    Fourth, while the expanded authority would technically vest 
with the Secretary, it will be exercised by the IRS agents all 
around the country. Such power can be abused by agents and used 
to threaten taxpayers to settle unrelated tax issues that arise 
in annual audits. This is a one-way street that can only be 
used to the taxpayers' detriment. It is contrary to the steps 
this Committee and Congress took last year in enacting the IRS 
Restructuring and Reform Act.
    Fifth, Congress must act judiciously. Once such power is 
transferred to the executive branch, it would be very hard for 
Congress to reclaim it. Any attempt by Congress to reverse such 
action would be scored as a revenue loser under current scoring 
conventions. Some of the issues raised by the alternative 
minimum tax discussion earlier would also exist here.
    Sixth, the executive branch already has considerable tools 
at its disposal to address tax-abusive transactions. The IRS 
has been aggressive and often successful in attacking 
transactions through exam and litigation, and has stepped up 
the issuances of notices and regulations to address what it 
perceives as abuses. In addition, this Committee addressed 
legislatively situations brought to its attention by Treasury 
when it deemed proper.
    Importantly, as recently as in 1997, this Committee and 
ultimately Congress, passed a law expanding the definition of 
what qualifies as a tax shelter for purposes of reporting 
requirements and the substantial understatement penalty 
provisions. Treasury, in asking for this proposal, explained 
that the provision would help the IRS get information about 
deals in a timely manner so that it could audit and take 
appropriate action. Treasury has not even implemented this 
provision yet, and the administration is asking for more power, 
broader authority, and more punitive weapons.
    Seventh, if the current rules are inadequate, the Committee 
should review them and their effect before adding another layer 
of penalties and rules on top of the existing system. This only 
creates more complexity and potential pitfalls for taxpayers. 
It goes in the exact opposite direction of the IRS 
Restructuring and Reform bill's mandated study to review 
penalty and interest rules with an eye toward simplifying 
penalty and interest administration and reducing taxpayer 
burden.
    In conclusion, Mr. Chairman, as I said at the outset, I 
understand and appreciate the concern that motivated the 
administration to put forward the proposals being discussed. I 
am eager to work with the Committee Members and staff, along 
with Treasury, to address the many imperfections in our tax 
system. With all due respect, I think a more appropriate 
approach to deal with the problems the administration raised 
would be to more thoroughly evaluate the scope of the problem, 
and analyze the effectiveness of the tools the IRS already has 
in its exposure, including those that have been enacted but 
have not yet been utilized. Only when the necessary tools are 
proved wanting should the Committee provide additional tools. 
Even then, such provisions should be narrowly crafted.
    I will be happy to answer any questions the Committee has 
at the appropriate time. Thank you.
    [The prepared statement follows:]

Statement of Mark A. Weinberger, Principal, Washington Counsel, P.C.

    MR. CHAIRMAN and Members of the Committee, I appreciate 
this opportunity to testify today on certain of the 
Administration's revenue raising proposals addressing so-called 
``corporate tax shelters.'' While my written testimony 
discusses the ``tax shelter proposals,'' I will be happy to 
answer questions regarding other provisions in the President's 
FY2000 Budget that I am familier with. I am appearing today on 
behalf of a number of companies who share your objective of a 
tax system that is fair, easy to understand and administer, and 
does not undermine the ability of business to create jobs at 
home and compete in our global economy. However, the testimony 
I am submitting today represents my own views and may not 
reflect the view of each company.
    The unifying theme of the companies I represent is a desire 
to work with Congress, and the Treasury Department, to ensure 
that we have a fair and administrable tax system from both the 
taxpayer's and the government's perspective. To the extent that 
taxpayers are entering into transactions that are not 
sanctioned under the applicable law, those taxpayers extract a 
cost that is born by all other taxpayers--both individuals and 
corporations, and may undermine the foundation of our voluntary 
tax system. We are concerned, however, that several of the 
current corporate tax shelter proposals in the President's 
FY2000 budget are unnecessary and certainly premature, 
exceedingly vague and far reaching, and appear to create an 
unprecedented transfer of power to the Executive Branch and 
specifically IRS revenue agents. As a result, we believe they 
can cause problems in policy and practice. We would like to 
offer our support, however, in working with your staff, and 
with the Administration, in addressing the many imperfections 
that plague our complex and burdensome tax system.
    It is difficult to address in detail the Administration's 
corporate tax shelter proposals because they have not yet been 
drafted, the Administration has not yet released statutory 
language nor its promised ``White Paper,'' and because the 
proposals are a radical departure from historic norms of income 
taxation. Nonetheless, as you review the Administration's 
proposals, we urge you to consider two significant points:
     First, any legislative action should be 
commensurate with the problem, if and when articulated.
     Second, any legislative action should not create 
unintended adverse consequences that outweigh any expected 
benefits.

             I. Overview of the Administration's Proposals

    The Administration has proposed several general provisions 
aimed at curbing corporate tax shelters, as well as a number of 
specific provisions intended to attack the results of 
particular transactions. Following is a brief overview of the 
general provisions.

A. The Administration Has Proposed Broad Definitions of 
Corporate Tax Shelters

    The Administration's Budget suggests that ``corporate tax 
shelters'' may take several forms but often share common 
characteristics, including (i) marketing by promoters to 
multiple corporate taxpayers, (ii) arranging transactions 
between corporate taxpayers and persons not subject to U.S. 
tax, (iii) high transaction costs, (iv) contingent or 
refundable fees, (v) unwind clauses, (vi) financial accounting 
treatment that is significantly more favorable than the 
corresponding tax treatment, and (vii) property or transactions 
unrelated to the corporate taxpayer's core business. These 
factors are incorporated into four broad definitions included 
in the Administration's proposals that potentially could extend 
to a broad sweep of corporate transactions not ordinarily 
considered inappropriate.\1\
---------------------------------------------------------------------------
    \1\ Even the Treasury Department has acknowledged that its proposed 
definitions may unintentionally target ``good transactions.'' Bureau of 
National Affairs, Daily Tax Report G-3 (March 5, 1999).
---------------------------------------------------------------------------
    1. A corporate tax shelter would be defined as any entity, 
plan or arrangement (to be determined based on all facts and 
circumstances) in which a direct or indirect corporate 
participant attempts to obtain a tax benefit in a tax avoidance 
transaction.
    2. A tax benefit would be defined to include a reduction, 
exclusion, avoidance or deferral of tax, or an increase in a 
refund, but would not include a tax benefit clearly 
contemplated by the applicable provision (taking into account 
the congressional purpose for such provision and the 
interaction of such provision with other provisions of the 
Code).
    3. A tax avoidance transaction would be defined as any 
transaction in which the reasonably expected pre-tax profit 
(determined on a present value basis, after taking into account 
foreign taxes as expenses and transaction costs) of the 
transaction is insignificant relative to the reasonably 
expected net tax benefits (i.e., tax benefits in excess of the 
tax liability arising from the transaction, determined on a 
present value basis) of such transaction. In addition, a tax 
avoidance transaction would be defined to cover certain 
transactions involving the improper elimination or significant 
reduction of tax on economic income (emphasis added).
    4. A tax indifferent party would be defined as a foreign 
person, a Native American tribal organization, a tax-exempt 
organization, and domestic corporations with expiring loss or 
credit carryforwards. For purposes of this definition, loss and 
credit carryforwards would generally be treated as expiring if 
the carryforward is more than 3 years old.
B. Summary Description of the Administration's Proposals

    1. Modify Substantial Understatement Penalty for Corporate 
Tax Shelters.--This proposal would increase the substantial 
understatement penalty applicable to corporate taxpayers for 
any item attributable to a ``corporate tax shelter'' from 20 
percent to 40 percent of the tax associated with the 
understatement. In addition, the reasonable cause exception 
would be eliminated for any item attributable to a corporate 
tax shelter. The penalty could be reduced to 20 percent if the 
corporate taxpayer (i) discloses the transaction to the IRS and 
files copies of the transaction documents within 30 days of the 
transaction's closing, (ii) files a statement with its tax 
return verifying that such disclosure has been made and (iii) 
provides adequate disclosure on its tax returns as to the book/
tax differences resulting from the corporate tax shelter item 
for the taxable years in which the tax shelter transaction 
applies.
    2. Deny Certain Tax Benefits to Persons Avoiding Income Tax 
as a Result of Tax Avoidance Transactions.--This ``Super 
Section 269'' proposal would expand the scope of the 
government's existing authority to disallow certain benefits 
when certain acquisitions are undertaken for the principal 
purpose of evading or avoiding federal income tax by securing 
the benefit of a deduction, credit or allowance. As proposed, 
Section 269 would be expanded to allow the government to 
disallow any deduction, credit, exclusion or other allowance 
obtained in a ``tax avoidance transaction.'' \2\
---------------------------------------------------------------------------
    \2\ All Section references are to Sections of the Internal Revenue 
Code of 1986, as amended (the ``Code'').
---------------------------------------------------------------------------
    3. Deny Deductions for Certain Tax Advice and Impose an 
Excise Tax on Certain Fees Received.--This proposal would deny 
a deduction to a corporate taxpayer that participates in a 
``tax avoidance transaction'' for fees paid or incurred in 
connection with the purchase and implementation of ``corporate 
tax shelters'' and the rendering of tax advice related to 
``corporate tax shelters.'' In addition, the proposal would 
impose a 25 percent excise tax on the receipt of such fees.
    4. Impose Excise Tax on Certain Rescission Provisions and 
Provisions Guaranteeing Tax Benefits.--This proposal would 
impose a 25 percent excise tax on the maximum payment under a 
``tax benefit protection arrangement'' entered into in 
connection with the purchase of a ``corporate tax shelter'' by 
a corporate taxpayer. The Administration would define a ``tax 
benefit protection arrangement'' to include a rescission 
clause, guarantee of tax benefits arrangement or any other 
arrangement that has the same economic effect (e.g., insurance 
purchased with respect to the transaction).
    5. Preclude Taxpayers from Taking Tax Positions 
Inconsistent with the Form of Their Transactions.--This 
proposal would prohibit a corporate taxpayer from taking any 
position (on any return or refund claim) that the federal 
income tax treatment of a transaction is different from that 
dictated by its form if a ``tax indifferent party'' has a 
direct or indirect interest in the transaction. This rule would 
not apply if (i) the taxpayer discloses the inconsistent 
position on a timely filed original federal income tax return 
for the taxable year in which the transaction is entered into, 
(ii) if reporting the substance of the transaction more clearly 
reflects the income of the taxpayer (but only to the extent 
allowed by regulations), or (iii) to certain transactions 
identified in regulations, such as publicly available 
securities lending and sale-repurchase transactions.
    6. Tax Income from Corporate Tax Shelters Involving Tax-
Indifferent Parties.--This proposal would provide that any 
income allocable to a ``tax indifferent party'' with respect to 
a ``corporate tax shelter'' is taxable to such party, 
regardless of any statutory, regulatory or treaty exclusion or 
exception. Moreover, all other taxpayers involved in the 
``corporate tax shelter'' would be jointly and severally liable 
for the tax.

II. The First Objective Should Be to Assess Causes and the Severity of 
 ``The Problem'' and Ensure Any Remedies Do Not Risk Causing More Harm 
                               than Good.

    The rhetoric, and anecdotal press accounts, that have 
surfaced surrounding ``tax shelters'' suggest that the 
corporate tax base is rapidly eroding and in imminent danger of 
imploding. In his testimony before this Committee last month, 
Treasury Secretary Rubin stated that the targeted transactions 
``not only erode the corporate tax base, they also breed 
disrespect for the tax system both by people who participate in 
the corporate tax shelter market and by others who perceive 
corporate tax shelter users as paying less than their fair 
share of tax.'' \3\ While the perception of a problem is in 
itself a problem and therefore, requires attention, the data we 
have reviewed simply does not support the claims that the 
entire corporate tax base is at risk.\4\
---------------------------------------------------------------------------
    \3\ Hearing on the President's Fiscal Year 2000 Budget Before the 
House Committee on Ways and Means, 106 Cong. (1999) (statement by the 
Honorable Robert E. Rubin, Secretary U.S. Department of the Treasury).
    \4\ The following table is compiled from data set forth in Office 
of Management and Budget, Historical Tables, Budget of the United 
States Government, Fiscal Year 2000 (February 1999).
---------------------------------------------------------------------------
    These statistics indicate that, despite the 
Administration's belief that certain transactions are 
contributing to the erosion of the corporate tax base, 
corporate taxpayers in the United States have paid more money 
to the federal government for each of the past nine years, and 
that the percentage of corporate income tax receipts as 
compared to both total federal receipts and gross domestic 
product has remained steady over the past decade.\5\ Indeed, 
the Administration's own revenue estimates suggest that the 
scope of the problem is limited.\6\
---------------------------------------------------------------------------
    \5\ Moreover, the Administration's estimates for the next five 
years indicate that this trend will continue, with corporate income 
taxes as a percentage of gross domestic product remaining at 
approximately 2.1 percent for each of those years and annual corporate 
payments continuing to trend up.
    \6\ The Administration estimates that the six proposals outlined 
above would increase revenues by $1.76 billion over five years--less 
than 0.2% of total projected corporate tax receipts over that period. 
Of this amount, $830 million relates to the proposal to tax income 
attributable to tax indifferent parties.
---------------------------------------------------------------------------
    One of the reasons cited by government agencies and 
officials for surpluses higher than expected over the past 
couple years, and in the future, is a stronger than expected 
economy resulting in higher than expected profits and in turn 
taxable revenue. U.S. businesses have become more efficient in 
their business operations and have been able to raise capital 
to effectively compete in the global market place.

                                          Corporate Income Tax Receipts
----------------------------------------------------------------------------------------------------------------
                                                   Corporate Income                      Percent of   Percent of
                      Year                           Tax Receipts      Total Receipts      Total         GDP
----------------------------------------------------------------------------------------------------------------
FY1989..........................................       $103,291,000       $991,190,000        10.4%         1.9%
FY1990..........................................        $93,507,000     $1,031,969,000         9.1%         1.6%
FY1991..........................................        $98,086,000     $1,055,041,000         9.3%         1.7%
FY1992..........................................       $100,270,000     $1,091,279,000         9.2%         1.6%
FY1993..........................................       $117,520,000     $1,154,401,000        10.2%         1.8%
FY1994..........................................       $140,385,000     $1,258,627,000        11.2%         2.1%
FY1995..........................................       $157,004,000     $1,351,830,000        11.6%         2.2%
FY1996..........................................       $171,824,000     $1,453,062,000        11.8%         2.3%
FY1997..........................................       $182,293,000     $1,579,292,000        11.5%         2.3%
FY1998..........................................       $188,677,000     $1,721,798,000        11.0%         2.2%
----------------------------------------------------------------------------------------------------------------

    However, the Congressional Budget Office (CBO) notes that 
``corporate profits are beginning to be squeezed by higher 
labor costs and the inability of firms to raise prices in the 
face of strong opposition from home and abroad.'' \7\ CBO also 
notes that corporate profits will decline primarily because of 
a projected increase in GDP share devoted to depreciation.\8\ 
CBO predicts that some decline in corporate profits from recent 
levels is ``inevitable'' because of the sensitivity of 
corporate profits to business-cycle fluctuations.\9\ In an era 
of projected budget surpluses, the size of which is due in part 
to increased corporate profits and taxes thereon, the Congress 
should think seriously before enacting proposals that would 
restrict the ability of corporate taxpayers to operate 
efficiently and respond to changing market conditions.\10\ This 
is especially true when CBO is predicting increased pressures 
on future corporate profits.
---------------------------------------------------------------------------
    \7\ CBO, Economic and Budget Outlook, Fiscal Year 2000-2009, 
January 1999, p. 24.
    \8\ Ibid, p. 27.
    \9\ Ibid.
    \10\ This comment refers to the potential stifling effect the tax 
shelter proposals may have on legitimate corporate transactions as well 
as several other proposals in the President's FY2000 budget aimed at 
making it more difficult for taxpayers to efficiently restructure and 
raise capital (e.g., tax increase proposals listed in sections entitled 
``Financial Products'' and ``Corporate Provisions'' in the General 
Explanation of the Administration's Revenue Proposals, (February 
1999)).
---------------------------------------------------------------------------
    Accordingly, the Committee should not let anecdotal 
evidence and targeted press accounts attacking various 
transactions lead to enacting hastily contrived legislation 
that remains vague and over reaching. The threshold for 
enacting legislation in the area remains high. In my view, tax 
shelters do not threaten the entire corporate tax base. 
Accordingly, responses to the problem, when appropriately 
articulated, should not be left vague and far reaching in a way 
that threatens the ability of U.S. businesses to operate 
efficiently and, ultimately, corporate profits and the Federal 
revenues they generate.

   III. Treasury Has Several Existing Tools to Combat its Perceived 
      Problem Which Should Be Evaluated Before Piling on New Ones.

    Much of the rhetoric relating to the Administration's 
proposals suggests that the government needs the tools proposed 
therein because it is not aware of transactions and tax 
planning arrangements which it might deem inappropriate. That 
is why the Administration proposed numerous specific provisions 
to attack transactions that it does not like, plus the general 
provisions in case there are others which they have not yet 
found.
    The IRS has several old and some new tools at its disposal 
to deal with the issue. Before enacting new proposals, existing 
proposals should be carefully and thoroughly reviewed. If they 
do not work or are inadequate perhaps they should be repealed 
and replaced with new ones. However, adding another layer of 
penalties and rules to overlay existing ones merely creates 
more complexity and potential pitfalls for taxpayers. It goes 
in the exact opposite direction of the intent of the study 
authorized as part of the Internal Revenue Service 
Restructuring and Reform Act of 1998 (IRS Reform Act) which 
requires a study reviewing the ``administration and 
implementation by the Internal Revenue Service of interest and 
penalty provisions .... and legislative or administrative 
recommendations....to simplify penalty or interest 
administration and to reduce taxpayer burden.'' \11\
---------------------------------------------------------------------------
    \11\ See, Joint Committee on Taxation Press Release, 98-2 (December 
21, 1998).
---------------------------------------------------------------------------
    As recently as 1997, this Committee and ultimately the 
Congress, passed a law that expanded the definition of what 
qualifies as a ``tax shelter'' for purposes of registering such 
transactions with the IRS.\12\ When Treasury proposed the 
registration in February 1997, it explained that the provision 
would help get the IRS useful information about corporate deals 
at an early stage to help identify transactions to audit and 
then take appropriate action--presumably seeking additional 
legislative and regulatory action when necessary.\13\
---------------------------------------------------------------------------
    \12\ See Section 1028 of the Taxpayer Relief Act of 1997(adding 
Section 6111(d) to the Internal Revenue Code).
    \13\ See the U.S. Treasury Department's General Explanations of the 
Administration's Revenue Proposals, at 81 (February 1997). According to 
Treasury: Many corporate tax shelters are not registered with the IRS. 
Requiring registration of corporate tax shelters would result in the 
IRS receiving useful information at an early date regarding various 
forms of tax shelter transactions engaged in by corporate participants. 
This will allow the IRS to make better informed judgments regarding the 
audit of corporate tax returns and to monitor whether legislation or 
administrative action is necessary regarding the type of transactions 
being registered.
---------------------------------------------------------------------------
    The filing requirement becomes effective when Treasury 
Regulations are prescribed. To date, such regulations have not 
been issued. Putting aside the many issues to be resolved once 
Treasury releases its view of the expansive new definition of 
corporate tax shelters, there appears to have been little 
effort to assess the effectiveness of existing programs,\14\ as 
modified in 1997, before compounding it with this myriad of new 
proposals.
---------------------------------------------------------------------------
    \14\ Section 6111 was added to the Code in the Tax Reform Act of 
1984. In 1989, the Commissioner's task force Report on Civil Tax 
Penalties concluded that ``[v]irtually no empirical data exists'' about 
the Section 6111 penalty (VI-22 and n. 29 (1989)). See also, New Tax 
Shelter Penalties Target Most Tax Planning, Mark Ely and Evelyn Elgin, 
Tax Notes (December 8, 1997).
---------------------------------------------------------------------------
    The new expansive definition of tax shelters was also 
carried over to Section 6662, the substantial understatement 
penalty provision. Accordingly, the increased exposure to the 
penalty, as a result of the 1997 changes, is virtually brand 
new and has not been assessed.\15\ In this case, unlike the 
registration requirement discussed above, there is no 
requirement that the arrangement involve a corporation, a 
confidentiality agreement or minimum promoter fees. As a 
result, it is worth noting, that under current law a corporate 
taxpayer can fully disclose a position on a tax return and can 
have substantial authority for such position but still be 
subject to penalty if the transaction is considered a tax 
shelter. The only way to avoid a penalty is to establish 
reasonable cause which, by regulation, Treasury has already 
circumscribed so that for example, a taxpayer's reasonable 
belief that it is more likely than not to prevail may not be 
sufficient.\16\ The Administration would remove even the 
reasonable cause escape hatch, in addition to doubling the 
penalty rate in certain circumstances.
---------------------------------------------------------------------------
    \15\ As suggested by the staff of the Joint Committee on Taxation 
in their description of the Administration's revenue proposals, ``it 
may be premature to propose new measures to deal with corporate tax 
shelters when provisions have already been enacted that are intended to 
that, but where there has been no opportunity to evaluate the 
effectiveness of those already-enacted provisions because they have not 
yet become effective because of the lack of the required guidance.'' 
Staff of the Joint Committee on Taxation, Description of Revenue 
Provisions Contained in the President's Fiscal year 2000 Budget 
Proposal, JCS-1-99 at 165 (Feb. 22, 1999) (hereinafter the ``JCT 
Report'').
    \16\ See Sections 6662(d)(2)(c)(ii) and 6664(c) establishing the 
reasonable cause exception. See Treas. Reg. Section 1.664-(4)(e)(3) 
discussing the limitation.
---------------------------------------------------------------------------
    Many have argued that the success of the 1997 changes to 
the substantial understatement penalty rules will turn on how 
artfully the term tax shelter is defined by the Treasury 
Department and enforced by IRS agents. There is great concern 
in the business community that the expanded definition will 
provide a strong incentive for revenue agents to set up 
penalties as bargaining chips in negotiations. Before 
considering giving these agents more authority and larger 
weapons, I believe it is important to evaluate the effect of 
these most recent changes. It seems premature, if not 
unnecessary, to be exploring the Administration's 16 new 
proposals even before the most recent changes take effect.
    Moreover, as a practical matter, when it does identify what 
it perceives as ``abuses,'' the IRS has been aggressive (and 
often successful) in attacking those transactions through 
examination and litigation. Significant cases that the 
government has won in recent years include: Ford Motor Co. v. 
Commissioner, 102 T.C. 87 (1994), aff'd 71 F.3d 209 (6th Cir. 
1995) (Tax Court limited a current deduction for a settlement 
payment, stating that tax treatment claimed by the taxpayer 
would have enabled it to profit from its tort liability); 
Jacobs Engineering Group, Inc. v. United States, 97-1 USTC 
87,755 (CCH para. 50,340) (C.D. Cal. 1997) (applying Section 
956 to a transaction despite the fact that a literal reading of 
the regulations would not have subjected the taxpayer to that 
provision); ACM Partnership v. Commissioner, 73 T.C.M. (CCH) 
2189 (1997), aff'd 157 F.3d 231 (3d Cir. 1998) (not respecting 
a partnership's purchase and subsequent sale of notes, stating 
that the transaction lacked economic substance); ASA 
Investerings Partnership v. Commissioner, 76 T.C.M. (CCH) 325 
(1998) (applying an intent test to determine that a foreign 
participant in a partnership was a lender, rather than a 
partner, for federal income tax purposes); but see, Wolff v. 
Commissioner, 148 F.3d 186 (2nd Cir. 1998) (reversing the Tax 
Court's denial of an ordinary loss in connection with the 
extinguishment of an unregulated futures contract, stating that 
the fact that the taxpayer selected the cancellation method (as 
opposed to closing the contract by offset) does not justify 
imposition of the legal ``substance over form'' fiction).
    Likewise, the Administration regularly addresses what it 
perceives as ``abuses'' through notices and regulations. In 
recent years, the Treasury Department has promulgated a number 
of regulations and other rules intended to stop certain so 
called ``inappropriate'' tax planning. These include the 
partnership anti-abuse regulations,\17\ the anti-conduit 
financing regulations,\18\ the temporary regulations targeting 
the improper use of tax treaties by hybrid entities \19\ and 
the recently proposed regulations targeting fast-pay stock 
arrangements.\20\ Moreover, on a number of occasions in recent 
years, the Treasury Department has issued notices to target 
specific tax planning techniques, typically announcing its 
intention to issue regulations addressing such techniques, 
effective as of the date of the notice. Examples of this 
approach include notices attacking inversion transactions,\21\ 
fast-pay stock arrangements,\22\ transactions involving the 
acquisition or generation of foreign tax credits \23\ and 
transactions involving foreign hybrid entities.\24\
---------------------------------------------------------------------------
    \17\ Treas. Reg. Sec. 1.701-2.
    \18\ Treas. Reg. Sec. 1.881-3; Prop. Treas. Reg. Sec. 1.7701(l)-2.
    \19\ Temp. Treas. Reg. Sec. 1.894-1T.
    \20\ Prop. Treas. Reg. Sec. 1.7701(l)-3.
    \21\ Notice 94-46, 1994-1 C.B. 356.
    \22\ Notice 97-21, 1997-1 C.B. 407.
    \23\ Notice 98-5, 1998-3 I.R.B. 49.
    \24\ Notice 98-11, 1998-6 I.R.B. 13.
---------------------------------------------------------------------------
    Under the present system, when the Treasury Department 
identifies a perceived ``abusive'' transaction, whether through 
rulemaking or by way of a specific legislative proposal, this 
Committee and its counterpart in the Senate have not hesitated 
to enact legislation to curb transactions that they perceive as 
inappropriate. For example, two years ago, Mr. Chairman, you 
announced a proposal targeting certain Morris Trust 
transactions, and, working with the Senate and the Treasury 
Department, enacted a solution through the tax legislative 
process. Similarly, last May you introduced legislation to 
eliminate certain tax benefits involving the liquidation of a 
regulated investment company or real estate investment trust, 
and, working with the Senate and the Treasury Department, 
enacted a solution effective as of the date of your 
announcement. The solutions that Congress provides to the 
perceived problems identified by the Treasury Department are 
not always the solutions proposed by the Administration, but 
that is merely a reflection of our system of government, which 
separates the executive and legislative functions in 
independent branches. Thus, the Morris Trust legislation 
imposes a tax at the corporate level, whereas the Treasury 
Department's original proposal would have imposed a tax at both 
the corporate and shareholder levels.
    We are not suggesting that there are no transactions which 
generate unanticipated and inappropriate tax consequences. To 
the contrary, these results are the inevitable outcome of a tax 
system that is too complex and burdensome. We also recognize 
the obvious--taxpayers and their advisors move quickly to take 
advantage of perceived tax planning opportunities. However, 
wholesale new laws with vague and punitive components do not 
further a cooperative environment for taxpayers and the 
government. We believe there is a great difference between 
disclosure requirements and punitive tax increases. The 
concepts should be separated.
    On that note, disclosure of appropriate information to the 
IRS is an important element of successful enforcement. This 
Committee approved enhanced disclosure of tax shelters in the 
1997 IRS Restructuring and Reform Act. This is on top of 
existing disclosure requirements. In this regard, we note that 
corporate taxpayers generally are required to reconcile their 
book and taxable income on the face of the corporate income tax 
return.\25\ As indicated above, the Administration has 
suggested that many ``corporate tax shelters'' involve 
differences between the financial accounting treatment and the 
federal income taxation of a transaction. To the extent that 
this is correct, corporate taxpayers already are required to 
show this difference to the IRS. Every book-tax difference is 
subject to a fairly full set of IDRs, which probably exceeds 
the information the IRS will get in disclosure. Because the 
vast majority of large corporate taxpayers participate in the 
large case examination program, in which revenue agents work at 
the taxpayer's headquarters in order to conduct continual 
audits of the taxpayer's returns, and because these agents have 
ready access to the taxpayer's corporate tax department, the 
IRS already has the information it needs to identify potential 
``corporate tax shelters.'' If this information proves 
inadequate, perhaps modification of existing disclosure laws is 
in order.
---------------------------------------------------------------------------
    \25\ Internal Revenue Service Form 1120, Schedule M-1.
---------------------------------------------------------------------------

 IV. The Administration Is Seeking an Unprecedented and Inappropriate 
                          Delegation of Power

    To the extent that this Committee determines that 
legislative action is required in this area, such action should 
be commensurate with the problem. Moreover, the Committee 
should balance carefully the expected benefit of any 
legislative proposal with the likely adverse consequences of 
enacting such a proposal. As discussed below, the 
Administration's proposals are not commensurate with the 
problem, and, in fact, represent an unprecedented delegation of 
legislative authority to the Executive Branch and IRS revenue 
agents.
    The breadth of the operative definitions for the proposals, 
outlined above, indicates that the Treasury Department is 
casting a very wide net with its proposals. The subjective 
nature of the definitions would create significant uncertainty 
as to their applicability in many circumstances, as well as 
lead to the potential for widely disparate treatment of 
similarly situated taxpayers. Of particular concern is the 
proposed definition of a ``tax avoidance transaction,'' which 
requires a comparison of the ``reasonably expected pre-tax 
profit'' and the ``reasonably expected net tax benefits,'' as 
well as a determination of whether a transaction involves the 
``improper elimination or significant reduction of tax on 
economic income.'' \26\ The proposed definition of a ``tax 
benefit'' suffers from similar flaws, in that it requires an 
evaluation of whether a tax benefit is ``clearly contemplated'' 
by a particular Code provision ``taking into account the 
congressional purpose'' for the provision, as well as the 
``interaction of such provision with other provisions of the 
Code.'' The proposed definition of a ``tax indifferent party,'' 
on the other hand, would ignore congressional purpose, allowing 
the IRS to tax Native American tribal organizations or tax-
exempt organizations, despite the fact that Congress has 
provided those categories of taxpayers with exemptions from 
tax. Moreover, the latter definition would add another kind of 
uncertainty for taxpayers, in that parties to a transaction 
could wind up subject to deficiencies and penalties for the 
simple reason that they did not know whether another party to 
the same transaction had expiring loss or credit carryforwards. 
Quite simply, these sweeping definitions are a recipe for 
attacks on legitimate tax planning, Executive Branch 
nullification of laws duly enacted by Congress, and endless 
litigation and confrontation between taxpayers and agents.
---------------------------------------------------------------------------
    \26\ It should be noted that this definition would encompass a 
number of the Administration's other legislative proposals, including 
some that the Congress has rejected out of hand. For example, more than 
three years ago the Treasury Department proposed legislation that would 
impose an average cost basis regime for securities. This proposal, 
which the Congress has rejected repeatedly, would end the current 
practice of allowing taxpayers to determine which particular stock to 
sell, when the only factor in that decision today is the amount of gain 
that will be subject to tax as a result. Undoubtedly, the taxpayer's 
decision in such cases is tax motivated, has no impact on expected pre-
tax profits, and could lead to a ``reduction of tax on economic 
income.''
---------------------------------------------------------------------------
    What is particularly troubling about the unprecedented 
delegation of authority to the Executive Branch and revenue 
agents are the proposals, such as the ``Super Section 269'' 
proposal, which would allow the Executive Branch and revenue 
agents to reverse substantive results otherwise required under 
particular Code provisions based on their determination that a 
transaction involves the improper elimination or reduction of 
tax on economic income or otherwise comes within the proposed 
definition of a ``tax avoidance transaction.'' In the real 
world, corporate taxpayers regularly enter into transactions or 
arrange their affairs in such a manner as to reduce their 
income taxes. The capital markets tend to reward corporations 
that can increase financial income without increasing taxable 
income.
    Notwithstanding these realities the ``Super Section 269'' 
proposal, as described by the Administration, would apply to an 
endless number of routine transactions and tax planning 
activities that no reasonable observer would consider 
``abusive.'' As Judge Learned Hand observed over sixty years 
ago:

          A transaction, otherwise within an exception of the tax law, 
        does not lose its immunity, because it is actuated by a desire 
        to avoid, or, if one choose, to evade, taxation. Any one may so 
        arrange his affairs that his taxes shall be as low as possible; 
        he is not bound to choose that pattern which will best pay the 
        Treasury; there is not even a patriotic duty to increase one's 
        taxes.\27\
---------------------------------------------------------------------------
    \27\ Helvering v. Gregory, 69 F.2d 809, 810 (2nd Cir. 1934), aff'd 
293 U.S. 465 (1935).

    This basic principle would be reversed in one grand gesture 
if the Congress enacts ``Super Section 269.'' Under that 
provision, taxpayers could be penalized for merely arranging 
their transactions in such a manner as to obtain the lowest 
amount of tax required under the Code.
    To date, the breathtaking scope of this particular proposal 
has been defended on two grounds. On occasion, it has been 
claimed that it is narrower than current law. This seems odd--
if true, however, there is no reason to enact it. The other 
defense is the classic ``trust me'' claim--we're from the 
government, we can tell the good from the bad, and we won't 
abuse our power. While perhaps well intentioned, policy 
initiatives of the Treasury and National Office of the IRS are 
sometimes ill-advised, and often implemented by IRS agents in 
ways unanticipated and unintended. Whether it is because the 
laws are so complex or the agents use them as a means to 
extract other concession, such broad authority is dangerous. 
The proposal provides too much authority to the Executive 
Branch and revenue agents and will be difficult to undo once 
such power is transferred.
    In order to fathom the Administration's intended scope of 
the ``Super Section 269'' proposal, we urge you to pose the 
following questions to the Treasury Department:
     How many of the specific proposals presented by 
the Administration would be redundant if the Congress enacts 
the ``Super Section 269'' proposal?
     How many of the dozens of revenue raising 
provisions enacted by the Congress in the past twenty years 
addressing transactions characterized as loopholes, tax 
shelters and the like would be redundant if the Congress enacts 
the ``Super Section 269'' proposal?
     How many of the dozens of revenue raising 
provisions presented by this Administration (as well as those 
presented by the two prior Administrations) but that have been 
rejected by the Congress would effectively become law if the 
Congress enacts the ``Super Section 269'' proposal?
    We respectfully suggest that you reject the 
Administration's proposals dealing with corporate tax shelters 
until they provide you with convincing and satisfactory answers 
to these and similar questions.
    As a substantive matter, the ``Super Section 269'' proposal 
would give the Executive Branch authority to disregard its own 
regulations, and the laws duly enacted by the Congress, when 
``the Secretary'' does not like the results.\28\ The problem 
with this is that it would allow ``the Secretary'' to determine 
both (i) whether there is a problem, and (ii) how to address 
the perceived problem. Once ``the Secretary'' changed the law 
under this authority, any attempt by the Congress to reverse 
such an action as bad policy would be scored as a revenue loser 
under the current scoring conventions in the Federal Budget 
process. Congress would find itself in the odd position of 
having extreme difficulty overturning Treasury's rules. This is 
an extraordinary proposal, and one that we urge you to reject.
---------------------------------------------------------------------------
    \28\ For example, the proposal to tax income allocable to ``tax 
indifferent parties'' specifically states that it would tax such income 
``regardless of any statutory, regulatory or treaty exclusion or 
exception.''
---------------------------------------------------------------------------
    Moreover, no one should be fooled by the delegations to 
``the Secretary.'' The real world implication of the 
Administration's proposals is that, although the proposals 
undoubtedly would authorize ``the Secretary'' to disallow 
deductions, impose excise taxes or otherwise implement the 
proposals, at the end of the day it is the IRS revenue agents 
sitting in the corporate offices of corporate taxpayers who 
will be deciding what is ``clearly contemplated'' by a 
particular Code provision.
    This new power for revenue agents requested by the 
Administration could be abused, such as by being used to 
threaten taxpayers to settle unrelated tax issues that may 
arise during an audit.\29\ For example, it is not difficult to 
imagine a revenue agent setting up assessments based on an 
alleged ``corporate tax shelter,'' including the proposed 40 
percent substantial understatement penalty, in an attempt to 
obtain concessions from the taxpayer on other issues. Although 
the Internal Revenue Service is in the process of remaking 
itself in response to Congress's goal in last year's IRS 
Restructuring and Reform Act, we urge you to think carefully 
before delegating such significant power to revenue agents.
---------------------------------------------------------------------------
    \29\ See JCT Report, supra note 14, at 166.
---------------------------------------------------------------------------
    The penalty suggested by the Administration for corporate 
taxpayers that engage in transactions that the Administration 
does not like is unprecedented. The overlapping proposals would 
have the effect of taxing corporate income not twice, as is the 
norm under our current system, but three or more times. For 
example, a corporate taxpayer could (i) lose expected tax 
benefits under the ``Super Section 269'' proposal, (ii) lose 
deductions for fees paid in a transaction, (iii) pay an excise 
tax on fees in a transaction, (iv) pay an excise tax on a ``tax 
benefit arrangement'' entered into in connection with the 
transaction, (v) pay taxes attributable to a ``tax indifferent 
party'' involved in the transaction, and (vi) pay a forty 
percent (40%) penalty on top of the underlying tax. The 
cumulative effect in some cases could be treble or quadruple 
taxation, or worse. Never before has the Congress sought to tax 
the same transaction so many times. What is even more striking 
is that, as noted above, such onerous penalties could be 
imposed on taxpayers who comply with the specific Code 
provisions enacted by Congress and regulations issued by the 
Treasury Department. That is, the taxpayer loses even if it 
follows the rules.

   V. The Administration's Proposals Violate Fundamental Notions of 
                        Neutrality and Fair Play

    In many ways, what is most striking about the 
Administration's proposals is their blatant disregard for 
fundamental notions of neutrality and fair play. This disregard 
is evident in four respects.
    First, the Administration fails to acknowledge that many of 
the ``uneconomic'' tax consequences of which it complains are 
the direct result of its own ``uneconomic'' rules--rules that 
the Administration crafted for the purpose of over-taxing 
taxpayers. Perhaps the single best way for the Administration 
to curb transactions with results that it finds troublesome 
would be for the Administration to write rules that are even-
handed and neutral in their application. For example, when the 
IRS successfully asserted in litigation and other guidance that 
Section 357(c) applies to a liability even when the 
transferring taxpayer remains liable for it (thereby leading to 
an assessment that substantially exceeds its ``economic 
income,''), other taxpayers reached the reasonable conclusion 
that this rule of law would apply in all circumstances, not 
just when it helped the IRS and hurt taxpayers. Section 357(c) 
applies when the liability is secured by another asset that the 
transferor retains. Mr. Chairman, your bill to address such 
transactions would not be necessary if the IRS had adopted a 
more even-handed approach in the first instance.\30\
---------------------------------------------------------------------------
    \30\ See H.R. 18, 106th Cong., 1st Sess. (1999).
---------------------------------------------------------------------------
    Second, the Administration fails to acknowledge that many 
of the ``problems'' of which it complains are the by-product of 
the way we tax enterprise income and our system of double 
taxation. Unfortunately, it appears that the Administration has 
chosen not to work through these difficult structural issues. 
It is as though they have thrown up their hands in surrender 
and said, ``we give up on principled solutions; just let us do 
what we want based on what we think is fair.''
    Third, the Administration's proposals are a one way street. 
In some respects, the ``Super Section 269'' proposal is a 
request for equitable powers--let the IRS do ``right'' when the 
law as written has consequences ``not clearly contemplated'' by 
Congress. Setting aside the uncertainties created by this 
concept, and setting aside the wisdom of delegating such power 
to the IRS, one question remains. What about all of those 
circumstances where the law as written has unanticipated 
consequences that are adverse to taxpayers? We suggest you ask 
whether the Administration would support an ``equitable 
relief'' provision that runs both ways. Would the 
Administration support a provision that would entitle taxpayers 
to the ``right'' answer when a literal application of the law 
would give rise to unfair results--unless, of course, those 
unfair results were ``clearly contemplated'' by Congress? 
Mechanical rules seem to be binding on taxpayers, why not the 
IRS? Our fear is the proposals put forth by the Administration 
would have the unintended effect of eliminating any incentive 
for the Administration to write fair and even-handed rules.\31\
---------------------------------------------------------------------------
    \31\ For example, if Congress enacted the ``Super Section 269'' 
proposal, it is quite possible that the IRS could use that authority to 
attack transactions without trying to develop fair rules to address 
perceived problems. To illustrate, the Administration's proposal to 
prevent the importation of ``built-in losses'' would apply equally to 
gains and losses. Thus, when a foreign individual with appreciated 
property becomes a resident of the United States, the basis of that 
property would be marked to market, so that the individual would be 
taxable upon a sale of the property only to the extent of any gain 
attributable to the period after immigration. If the ``Super Section 
269'' proposal is enacted, but the ``built-in loss importation'' 
proposal is not, then the IRS would be able to target built-in loss 
importation transactions, but at the same time would continue to tax a 
lifetime of earnings not attributable to an individual's residence in 
the United States.
---------------------------------------------------------------------------
    Fourth, the Administration has offered few proposals to 
remedy the many defects of our system that adversely affect 
corporate taxpayers. There are no comprehensive proposals to 
simplify the tax law. There are no proposals to remedy the mess 
created by INDOPCO, Inc. v. Commissioner.\32\ There are no 
proposals to ameliorate the over-taxation of economic income 
and the repeated taxation of that income. There are no 
proposals to enhance the competitiveness of American companies 
in the global economy.
---------------------------------------------------------------------------
    \32\ 503 U.S. 79 (1992).
---------------------------------------------------------------------------

                             VI. Conclusion

    As I stated at the outset, Mr. Chairman, we understand and 
appreciate the concern that motivated the Administration to put 
forward the proposals that the Committee is discussing today. 
We are eager to work with you and your colleagues, and with the 
Administration, to address the many imperfections in our tax 
system--flaws that disadvantage taxpayers, as well as flaws 
that harm the federal fisc. With all due respect, however, it 
is clear that the path suggested by the Administration is a 
radical and unwarranted departure from long-standing norms--a 
departure that would not do justice to taxpayers and the tax 
system.
    A more appropriate approach to the problems suggested by 
the Administration is to evaluate (i) the true scope of the 
perceived problem, (ii) the ability of the IRS to identify 
imperfections in our tax system through the tools it already 
has, and (iii) the ability of the government to address the 
problems that it does identify, either through the rulemaking 
process or in the courts. Only when the Treasury Department and 
the IRS do not have the necessary tools to address the problems 
that they identify, or when the Treasury Department identifies 
problems that it cannot address through its existing regulatory 
authority, should this Committee provide additional tools and 
delegations of authority to the IRS.
      

                                

    Chairman Archer. Thank you, Mr. Weinberger.
    Mr. Wamberg, you are next. If you will identify yourself 
for the record, you may proceed.

STATEMENT OF W.T. WAMBERG, CHAIRMAN OF THE BOARD, CLARK/BARDES, 
                         DALLAS, TEXAS

    Mr. Wamberg. Good afternoon. My name is Tom Wamberg. I am 
the chairman of the board of Clark/Bardes, a publicly traded 
company, headquartered in Dallas, Texas.
    Our company designs insurance-based programs for financing 
employee benefit plans. Our clients include a broad range of 
businesses. They use these insurance products as assets to 
offset the liabilities of these employee benefit plans and to 
supplement and secure plans for senior executives.
    I am here today to express Clark/Bardes' strong opposition 
to the administration's proposal that would increase taxes on 
companies that purchase insurance covering the lives of their 
employees. This same proposal was included in the 
administration's budget last year, but was wisely not enacted. 
I would like to express our appreciation to the Members of the 
this Committee who last year raised strong objections to the 
administration's proposed tax increase on insurance products. I 
am pleased to know that this opposition remains strong this 
year.
    There are many reasons why Congress again, should not adopt 
the administration's proposal. The first is, employer-owned 
life insurance has long been used by businesses to fund a 
variety of business needs, including the need to finance their 
growing retiree health and benefit obligations. The rules under 
ERISA generally make it impossible for businesses to set aside 
funds to secure these benefits. Investment in life insurance, 
which does not run afoul of the ERISA rules, allows employers 
to meet their future benefit obligations.
    Second, the tax policy concern that caused Congress to 
target leverage COLI in 1996 do not support the 
administration's proposal before us today. The current proposal 
would deny deductions for interest payments for any employer 
that happens to own life insurance, even though there is no 
direct link between the loan interest and the life insurance. 
Unlike the 1997 provision targeting the use of COLI with 
respect to nonemployees, this proposal attacks the very 
traditional uses of employer-owned life insurance.
    Third, the administration's proposal represents yet another 
move by the administration to deny deductions for ordinary and 
necessary business expenses. If the proposals were enacted, 
companies would see expenses that they have deducted for years 
suddenly becoming nondeductible. For example, interest on a 
loan taken out 10 years ago to finance the creation or startup 
of a business. This is not a fair result.
    Fourth, the administration's proposal is a thinly disguised 
attempt to tax the inside buildup on life insurance policies. 
Congress in the past has rejected proposals to change the tax 
treatment of inside buildup, and for good reason. The 
investment element inherent in permanent life insurance is a 
significant form of savings and long-term investment. I think 
you would agree that these are things that we should be 
encouraging and not taxing.
    Finally, I would like to address the Treasury's attempt to 
brand employer-owned life insurance as a corporate tax shelter. 
This is a totally unwarranted characterization intended to 
build unthinking support for a failed proposal. A tax shelter 
is defined under the Code as any entity, plan, or arrangement, 
with respect to which tax avoidance or evasion is a significant 
purpose. It is difficult to see how traditional employer-owned 
life insurance programs could be viewed as meeting this 
definition.
    For example, consider a situation where a company owning 
life insurance policies on the lives of its employees decided 
independently to borrow money totally unrelated to its life 
insurance program. Suppose they did that to construct a new 
manufacturing plant. The administration apparently believes 
that these separate actions can be collapsed down and viewed as 
a tax avoidance transaction. But it would be absurd to suggest 
that the company in this situation should be hit with stiff 
penalties that apply to true tax shelter transactions.
    Under a broader view, a tax shelter might be thought of as 
an arrangement involving an unintended application of tax laws. 
It is impossible to argue that current employer-owned life 
insurance programs involve an unintended application of tax 
laws. In fact, few areas of the tax law have received such 
thorough scrutiny in recent years. Indeed, the use of employer-
owned life insurance was expressly sanctioned in legislation in 
1996 and 1997.
    In closing, I would respectfully urge the Committee to 
reject the administration's misguided proposal to tax employer-
owned life insurance as it did last year. The administration 
once again has failed to articulate a clear or compelling tax 
policy concern in respect to the current rules, and now has 
sought to couch employer-owned life insurance, altogether 
inappropriately, as a tax shelter. If enacted, the 
administration's proposal would represent a significant 
departure from current law and tax policy regarding the 
treatment of life insurance. It would have a significantly 
adverse impact on the ability of businesses to solve a variety 
of their needs, including the ability to finance meaningful 
health benefits to retired workers.
    Thank you for your attention to this important matter.
    [The prepared statement follows:]

Statement of W.T. Wamberg, Chairman of the Board, Clark/Bardes, Dallas, 
Texas

    Clark/Bardes appreciates the opportunity to testify before 
the House Ways and Means Committee on the revenue-raising 
proposals included in the Administration's FY 2000 budget 
submission. Our testimony focuses specifically on a proposal 
that would increase taxes on companies purchasing insurance 
covering the lives of their employees.
    Clark/Bardes is a publicly traded company headquartered in 
Dallas, Texas, and with offices around the country. We design, 
market, and administer insurance-based employee benefit 
financing programs. Our clients, which include a broad range of 
businesses, use insurance products as assets to offset the 
liabilities of employee benefits and to supplement and secure 
benefits for key executives.
    Clark/Bardes strongly opposes the Administration's proposed 
tax increase on ``corporate-owned life insurance'' (``COLI''). 
The same proposal was floated by the Administration in its FY 
1999 budget submission and wisely rejected by Congress. Perhaps 
in recognition of the fact that Congress last year found no 
coherent tax policy justification for such a change, the 
Administration this year has branded COLI as a ``corporate tax 
shelter''--an egregious characterization intended to build 
visceral support for the proposal. Regardless of the 
Administration's rhetoric, the reasons for rejecting the COLI 
tax increase remain the same:
     Employer-owned life insurance remains an effective 
means for businesses to finance their growing retiree health 
and benefit obligations.
     The Administration's proposal shares none of the 
same tax policy concerns that drove Congressional action on 
COLI in 1996 and 1997 legislation.
     The current-law tax treatment of COLI was 
sanctioned explicitly by Congress in the 1996 and 1997 
legislation.
     The Administration's proposal is a thinly 
disguised attempt to tax the ``inside buildup'' on insurance 
policies--i.e., a tax on a long-standing means of savings.
     The Administration's proposal represents yet 
another move by the Administration--along a slippery slope--to 
deny deductions for ordinary and necessary business expenses.

                  Use of Employer-Owned Life Insurance

    Before turning to the Administration's proposal, Clark/
Bardes believes it is important to provide background 
information on employer-owned life insurance--a business 
practice that does not appear to be well understood.
    Many employers, large and small, provide health and other 
benefits to their retired employees. While ERISA rules 
generally make ``dedicated'' funding impossible, employers 
generally seek to establish a method of financing these 
obligations. This allows them not only to secure a source of 
funds for these payments but also to offset the impact of 
financial accounting rules that require employers to include 
the present value of the projected future retiree benefits in 
their annual financial statements.
    Life insurance provides an effective means for businesses 
to finance their retiree benefits. Consultants, like Clark/
Bardes, and life insurance companies work with employers to 
develop programs to enable the employers to predict retiree 
health benefit needs and match them with proceeds payable under 
the life insurance programs. A simplified example may help to 
illustrate:

          ABC Company guarantees its employees a generous health 
        benefits package upon retirement. ABC Company is required to 
        book a liability on its balance sheet for the eventual 
        retirement of its employees, and needs to find ways to fund 
        these obligations.
          ABC Company, working with consultants, takes out a series of 
        life insurance policies on its employees. It pays level 
        insurance premiums to the insurance carrier each year. The cash 
        value on the life insurance policy accumulates on a tax-
        deferred basis. In the event that the contract is surrendered, 
        ABC Company pays tax on any gain in the policy. In the event 
        that employees die, ABC Company receives the death benefit and 
        uses these funds to make benefits payments to its retired 
        employees. Actuaries are able to match closely the amount of 
        insurance necessary to fund ABC Company's liabilities.

    The Administration's COLI proposal effectively would take 
away an employer's ability to finance retiree benefit programs 
using life insurance, and thus could force businesses to 
severely limit or discontinue these programs. It is ironic that 
the President's proposal would hamstring a legitimate means of 
funding post-retirement benefits when a major focus of Congress 
is to encourage private sector solutions to provide for the 
needs of our retirees.

                   The Administration's COLI Proposal

    The Administration's proposal to tax employer-owned life 
insurance should be viewed in light of the basic tax rules 
governing life insurance and interest expenses and recent 
changes made by Congress to the tax treatment of COLI.
    Since 1913, amounts paid due to the death of an insured 
person have been excluded from Federal gross income. The 
present-law provision providing this exclusion is section 101 
of the Internal Revenue Code of 1986, as amended (the 
``Code''). Amounts paid upon the surrender of a life insurance 
policy are excluded from taxable income to the extent of the 
aggregate amount of premiums or other consideration paid for 
the policy, pursuant to section 72(e) of the Code.
    Section 163 of the Code generally allows deductions for 
interest paid on genuine indebtedness. However, sections 
264(a)(2) and (a)(3) of the Code, enacted in 1964, prohibit 
deductions if the interest is paid pursuant to (i) a single 
premium life insurance contract, or (ii) a plan of purchase 
that contemplates the systematic direct or indirect borrowing 
of part or all of the increases in the cash value of such 
contract, unless the requirements of an applicable exception to 
the disallowance rule are satisfied. One of the exceptions to 
this interest disallowance provision, known as the ``four-out-
of-seven'' rule, is satisfied if no part of four of the annual 
premiums due during a seven-year period (beginning with the 
date the first premium on the contract is paid) is paid by 
means of indebtedness.
    The Tax Reform Act of 1986 (the ``1986 Act'') amended 
section 264 of the Code to limit generally deductions for 
interest paid or accrued on debt with respect to COLI policies 
covering the life of any officer, employee, or individual who 
is financially interested in the taxpayer. Specifically, it 
denied deductions for interest to the extent that borrowing 
levels on corporate-owned policies exceeded $50,000 of cash 
surrender value per insured officer, employee, or financially 
interested individual.
    Congress in the Health Insurance Portability and 
Accountability Act of 1996 (the ``1996 Act'') eliminated 
deductions for interest paid on loans taken against the tax-
free earnings under the life insurance contract. Specifically, 
the 1996 Act denied a deduction for interest paid or accrued on 
any indebtedness with respect to any life insurance policies 
covering an officer, employee, or financially interested 
individual of the policy owner. The 1996 Act provided a phase-
out rule for indebtedness on existing COLI contracts, 
permitting continued interest deductions in declining 
percentages through 1998.
    The 1996 Act provided an exception for certain COLI 
contracts. Specifically, the Act continued to allow deductions 
with respect to indebtedness on COLI covering up to 20 ``key 
persons,'' defined generally as an officer or a 20-percent 
owner of the policy owner, subject to the $50,000 indebtedness 
limit, and further subject to a restriction that the rate of 
interest paid on the policies cannot exceed the Moody's 
Corporate Bond Yield Average-Monthly Corporates for each month 
interest is paid or accrued.
    The Taxpayer Relief Act of 1997 (the ``1997 Act'') added 
section 264(f) to the Code. This provision generally disallows 
a deduction for the portion of a taxpayer's total interest 
expense that is allocated pro rata to the excess of the cash 
surrender value of the taxpayer's life insurance policies over 
the amounts of any loans with respect to the policies, 
effective for policies issued after June 8, 1997. However, 
section 264(f)(4) provides a broad exception for policies 
covering 20-percent owners, officers, directors, or employees 
of the owner of the policy. Thus, the interest deduction 
disallowance provision in the 1997 Act generally affected only 
COLI programs covering the lives of non-employees.
    The COLI proposal in the Administration's FY 2000 budget, 
submitted on February 1, 1999, would extend the section 264(f) 
interest deduction disallowance to COLI programs covering the 
lives of employees.\1\ The proposal therefore would apply a 
proportionate interest expense disallowance based on all COLI 
cash surrender values. The exact amount of the interest 
disallowance would depend on the ratio of the average cash 
values of the taxpayer's non-leveraged life insurance policies 
to the average adjusted bases of all other assets.
---------------------------------------------------------------------------
    \1\ By eliminating the section 264(f)(4) exception that currently 
exempts COLI programs covering the lives of employees, officers, and 
directors.
---------------------------------------------------------------------------

                    Lack of Tax Policy Justification

    The Treasury Department, in its ``Green Book'' explanation 
of the revenue proposals in the Administration's FY 2000 
budget, implies that the COLI measures taken by Congress in 
1996 and 1997 were incomplete in accomplishing their intended 
goals. A closer inspection of the tax policy considerations 
that gave rise to the 1996 and 1997 changes would suggest 
otherwise.
    The 1996 Act changes to the tax treatment of COLI focused 
on leveraged COLI transactions (i.e., transactions involving 
borrowings against the value of the life insurance policies), 
which it believed represented an inappropriate and unintended 
application of the tax rules. The ``Blue Book'' explanation of 
the 1996 Act, prepared by the staff of the Joint Committee on 
Taxation, states that leveraged COLI programs ``could be viewed 
as the economic equivalent of a tax-free savings account owned 
by the company into which it pays itself tax-deductible 
interest.'' \2\ The Blue Book further states:
---------------------------------------------------------------------------
    \2\ Joint Committee on Taxation, General Explanation of Tax 
Legislation Enacted in the 104th Congress (JCS-12-96), December 18, 
1996, p. 363.

          ... Congress felt that it is not appropriate to permit a 
        deduction for interest that is funding the increase in value of 
        an asset of which the taxpayer is the ultimate beneficiary as 
        recipient of the proceeds upon the insured person's death. 
        Interest paid by the taxpayer on a loan under a life insurance 
        policy can be viewed as funding the inside buildup of the 
        policy. The taxpayer is indirectly paying the interest to 
        itself, through the increase in value of the policy of which 
        the taxpayer is the beneficiary.\3\
---------------------------------------------------------------------------
    \3\ Id, at 364.

    The 1997 Act COLI provision grew out of concerns over plans 
by a particular taxpayer, Fannie Mae, to acquire corporate-
owned life insurance on the lives of its mortgage holders. The 
1997 Act changes, therefore, specifically targeted COLI 
programs developed with respect to non-employees. Both the 
House Ways and Means Committee Report and the Senate Finance 
Committee Report on the 1997 Act discuss an example involving a 
---------------------------------------------------------------------------
Fannie Mae-type fact pattern:

          If a mortgage lender can ... buy a cash value life insurance 
        policy on the lives of mortgage borrowers, the lender may be 
        able to deduct premiums or interest on debt with respect to 
        such a contract, if no other deduction disallowance rule or 
        principle of tax law applies to limit the deductions. The 
        premiums or interest could be deductible even after the 
        individual's mortgage loan is sold to another lender or to a 
        mortgage pool. If the loan were sold to a second lender, the 
        second lender might also be able to buy a cash value life 
        insurance contract on the life of the borrower, and to deduct 
        premiums or interest with respect to that contract.\4\
---------------------------------------------------------------------------
    \4\ H.R. Rep. No. 105-148, 105th Cong., 1st Sess. p. 501; S. Rep. 
No. 105-33, 105th Cong., 1st Sess., p. 186.

    The COLI proposal in the Administration's FY 2000 budget 
lacks any similarly compelling tax policy justification. Unlike 
the 1996 Act provision targeting leveraged COLI programs, the 
Administration's proposal would apply where there is no link 
between loan interest and the COLI program.\5\ And unlike the 
1997 Act provision targeting the use of COLI with respect to 
non-employees, this proposal does not involve a newly conceived 
use of COLI.
---------------------------------------------------------------------------
    \5\ Current law is quite specific that interest deductions 
resulting from both direct and indirect borrowing, i.e., using the 
policy as collateral, are disallowed. Sec. 264(a)(3).
---------------------------------------------------------------------------
    In explaining the rationale underlying the proposal, the 
Treasury Department argues that the ``inside buildup'' on life 
insurance policies in COLI programs gives rise to ``tax 
arbitrage benefits'' for leveraged businesses.\6\ Treasury 
argues that businesses use inside buildup on COLI policies to 
fund deductible interest payments, thus jumping to the 
conclusion that COLI considerations govern decisions regarding 
when businesses incur debt. This view is clearly erroneous. 
Businesses incur debt for business reasons (e.g. business 
expansion).
---------------------------------------------------------------------------
    \6\ General Explanation of the Administration's Revenue Proposals, 
Department of the Treasury, February 1999, p.118.
---------------------------------------------------------------------------

                     COLI is Not a ``Tax Shelter''

    Clark/Bardes strongly objects to the Administration's 
characterization of COLI as a ``corporate tax shelter.'' The 
penalty provisions of the Internal Revenue Code define a tax 
shelter as any entity, plan, or arrangement with respect to 
which tax avoidance or evasion is a significant purpose.\7\ A 
separate proposal in the Administration's FY 2000 budget 
proposes a new definition of ``corporate tax shelter'' under 
section 6662 that would apply to ``attempts to obtain a tax 
benefit'' in a ``tax avoidance transaction,'' defined as any 
transaction in which the reasonably expected pre-tax profit is 
insignificant relative to the reasonably expected net tax 
benefits.\8\
---------------------------------------------------------------------------
    \7\ Section 6662(d)(2)(C)(iii)
    \8\ As a separate matter, Clark/Bardes believes the 
Administration's proposed new definition of ``corporate tax shelter'' 
is unnecessary, ill-advised, and could be broadly applied by IRS agents 
to attack many legitimate business transactions.
---------------------------------------------------------------------------
    It is difficult to see how traditional COLI programs might 
reasonably be viewed as meeting any of these ``tax shelter'' 
definitions. As discussed above, the Administration's proposal 
would deny interest deductions on borrowings totally unrelated 
to COLI, for example, where a company owning life insurance 
policies on the lives of employees borrows money to construct a 
new manufacturing plant, or conversely, where a company that 
borrowed ten years ago to construct a plant now considers 
purchasing life insurance to help finance retiree benefits. The 
Administration apparently believes that these disparate actions 
can be collapsed and viewed as a tax-avoidance transaction or 
as an attempt to obtain tax benefits. It is difficult to see 
just what tax might be avoided in this situation or what tax 
benefit is being sought. Does Treasury seriously suggest that 
such a company should be hit with the stiff penalties that 
apply to tax shelter transactions? These are serious questions 
that do not appear to have thought through completely under the 
Treasury proposal.
    Under a broader view, a ``tax shelter'' might be thought of 
as an arrangement involving an unintended application of the 
tax laws. It is impossible to argue that current COLI programs 
involve an unintended application of the tax laws. Few other 
areas of the tax law have received as thorough scrutiny in 
recent years. In the 1996 Act, Congress explicitly allowed COLI 
programs to continue in the future so long as they were not 
leveraged. In the 1997 Act, Congress carefully crafted a 
specific exception (designed to preserve longstanding use of 
unleveraged COLI) to the pro rata interest expense disallowance 
provisions for COLI programs covering employees. In other 
words, current COLI programs involve an intended application of 
the tax law.

                 Attack on ``Inside Buildup,'' Savings

    The Administration's COLI proposal, at its core, is not 
about ``tax shelters'' at all. Rather, it is a thinly veiled 
attack on the very heart of traditional permanent life 
insurance--that is, the ``inside buildup'' of credits (or cash 
value) within these policies that permits policyholders to pay 
level premiums over the lives of covered individuals. Although 
couched as a limitation on interest expense deductions, the 
proposal generally would have the same effect as a direct tax 
on inside buildup. Thus, the proposal would reverse the 
fundamental tax treatment of level-premium life insurance that 
has been in place since 1913.
    Congress in the past has rejected proposals to alter the 
tax treatment of inside buildup, and for good reason. The 
investment element inherent in permanent life insurance is a 
significant form of savings. Congress and the Administration in 
recent years have worked together in the opposite direction, 
considering new incentives for savings and long-term investment 
and removing obvious obstacles. It is odd that the 
Administration at this time would propose making it more 
difficult to save and invest through life insurance.

            Inappropriate Limitation on Business Deductions

    In some respects, Treasury's proposed denial of deductions 
for interest expenses for companies owning life insurance is 
not surprising. This proposal comes on the heels of other 
Clinton Administration proposals to chip away at deductions for 
expenses that long have been treated as ordinary and necessary 
costs of doing business. Another recent example is the 
provision in the Administration's FY 2000 budget to deny 
deductions for damages paid by companies to plaintiffs groups.
    But the proposal is troubling nonetheless, as illustrated 
by a simple example. The XYX company in 1997 borrows funds to 
build a new manufacturing facility. The XYZ company in 1997 and 
1998 is able to deduct interest paid on these borrowings. In 
1999, the XYZ company, responding to concerns over mounting 
future retiree health obligations, purchases insurance on the 
lives of its employees. IRS agents tell the XYZ company that it 
has just entered into a ``tax shelter.'' Suddenly, the XYZ 
company finds that a portion of the interest on the 1997 loan 
is no longer viewed by the government as an ordinary and 
necessary business expense. XYZ therefore is taxed, 
retroactively, on its 1997 borrowing.
    The proposal becomes even more troubling when one considers 
the logical extensions of the Administration's rationale with 
respect to COLI. Might the IRS, using the same reasoning, 
someday deny home mortgage interest deductions for individuals 
who also own life insurance? Might the government deny 
deductions for medical expenses for individuals that enjoy tax-
preferred accumulations of earnings in 401(k) accounts or IRAs?

                               Conclusion

    Clark/Bardes respectfully urges the Committee on Ways and 
Means to reject the Administration's misguided COLI proposal, 
as it did in 1998. As discussed above, the Administration once 
again has failed to articulate a clear or compelling tax policy 
concern with respect to the current-law rules, and now has 
sought to couch COLI, altogether inappropriately, as a ``tax 
shelter.'' If enacted, the Administration's proposal would 
represent a significant departure from current law and tax 
policy regarding the treatment of life insurance. It would have 
a significantly adverse impact on the ability of businesses to 
solve a variety of needs including the ability to finance 
meaningful retiree health benefits. It also would provide a 
disincentive for savings and long-term investment and would 
represent yet another attack on deductions for ordinary and 
necessary business expenses.
    Clark/Bardes commends the 31 Members of the House Ways and 
Means Committee who have urged, in a February 4 letter, 
Chairman Bill Archer (R-TX) and Ranking Minority Member Charles 
Rangel (R-TX) to oppose enactment of the Administration's 
``unwarranted'' revenue proposals targeting life insurance. We 
share your views.
      

                                

    Chairman Archer. Thank you, Mr. Wamberg.
    Mr. Hernandez, if you will identify yourself for the 
record, you may proceed.

   STATEMENT OF ROBERT HERNANDEZ, ALLIANCE OF TRACKING STOCK 
 STAKEHOLDERS, AND VICE CHAIRMAN AND CHIEF FINANCIAL OFFICER, 
           USX CORPORATION, PITTSBURGH, PENNSYLVANIA

    Mr. Hernandez. Thank you. I am Bob Hernandez, vice chairman 
and chief financial officer of USX Corp. I would also like to 
thank you, Mr. Chairman, for inviting USX to testify today. I 
would like to thank you on behalf of Vic Beghini, president of 
Marathon Oil, which as you know is headquartered in your 
district and the many Marathon employees that are there.
    My testimony is on a subject that affects many communities, 
many jurisdictions, and many other corporations. My testimony 
will be on a little-known, but very serious proposal in the 
administration's fiscal year 2000 budget to tax the issuance of 
tracking stock. This proposal should be rejected by Congress 
and formally withdrawn by Treasury. It would impair companies' 
ability to invest in new business and technology development. 
It would harm existing stockholders. It would cost jobs. It 
would impose enormous costs, reduce business expansion, and 
although I am not a tax expert, there is no sound basis in tax 
theory or policy for taxing the issuance of parent company 
stock.
    I would like to submit my statement for the record on 
behalf of the Alliance for Tracking Stock Stakeholders. This 
alliance is an informal group of companies that share concern 
for their continued ability to meet business objectives through 
the issuance of tracking stock.
    Tracking stocks are separate classes of common stock issued 
by companies in more than one line of business. The holders of 
tracking stock receive dividends based on the earnings of a 
specified segment of the corporate issuer. My company, USX, for 
example, currently has two tracking stocks. One follows our 
steel business, the other tracks our energy business. The steel 
shareholders receive their dividends based on the performance 
of the steel segment. The energy stockholders get their 
dividends based on the performance of the energy side of the 
house.
    Tracking stock developed in our case because stock markets 
prefer ``pure play'' securities, while debt markets prefer the 
more stable cash flows associated with companies in more than 
one business. This is an opportunity to appeal to both markets. 
The ability to issue these tracking stocks permitted my company 
to raise more than $2.5 billion of equity that was vitally 
needed to revitalize our businesses, (and $3.5 billion of lower 
cost debt) since we adopted it in 1991.
    Fifteen companies have issued 37 separate tracking stocks 
since 1991. Specific reasons the other companies have issued 
tracking stock vary, but include: growth of startup businesses 
as a source of equity capital, stock-based employee incentive 
programs, maintaining consolidated credit as we did to enhance 
borrowing arrangements, enhancing stock market value, and so 
forth.
    I hope you can see that tracking stock is motivated by 
compelling business needs. It has unlocked shareholder value 
and opened up new capital markets to many diversified 
companies.
    The administration's proposed tax legislation would have a 
chilling effect on those markets. It could force companies to 
recapitalize up to $400 billion of equity securities. 
Provisions actually could adversely impact tax revenues. They 
would destroy the operating financial and administrative 
synergies that are found in these combined entities. Therefore, 
the revenue raising estimates are not realistic, and actually 
could be negative.
    As chief financial officer of USX, and a member of our 
board since 1991, I have been involved in every aspect of our 
planning and implementation of our tracking stock structure. 
From the start, we have always viewed our structure as one that 
is based on sound business considerations. I can state for the 
record we never considered tax avoidance as a reason to 
establish our tracking stock structure.
    Without tracking stock though, it is quite likely that U.S. 
Steel, which is our steel unit, would have substantially scaled 
back operations and suffered severe financial distress. 
Instead, it has become the most viable integrated steel company 
in its industry, with good-paying jobs, and operations 
resulting in substantial payments of income and payroll taxes 
to Federal, State, and local governments. Similarly, because of 
the investments we have been able to make by virtue of the 
financial flexibility afforded by our structure, our Marathon 
energy unit is considered to have one of the best growth 
production profiles in the industry.
    But Treasury asserts that tracking stock might be an 
indirect way to accomplish tax-free spinoffs under section 355 
of the Code. To the contrary, tracking stock is used to keep 
businesses together instead of divesting of them. Tracking 
stock is not the economic equivalent of a disposition of a 
business.
    USX, for example, issued what we called Delhi tracking 
stock in 1992, to create a separate group in order to grow the 
gas gathering and transmission business. Five years later, we 
decided to exit that business. Delhi assets were sold to a 
third party and a taxable transaction resulted in $208 million 
of taxes payable. In addition, Delhi tracking stock 
shareholders were subsequently taxed as a result of the taxable 
redemption of their shares. If taxes were our primary 
consideration, the original transaction in 1992 would have been 
rearranged to avoid taxes through a spinoff to shareholders.
    Finally, there appears to be a Treasury concern that 
tracking stock will become a widely used tax avoidance 
mechanism in the future. Corporations don't issue tracking 
stock for tax reasons. USX, for example, looked at a variety of 
alternatives in 1991 when we implemented it. We were under 
pressure at that time to bust up the company into two 
companies--a steel company and an energy company. This could 
have been accomplished as a section 355 tax-free spinoff. We 
rejected the spinoff alternative, purely for sound business 
reasons, the most notable of which was a concern about the 
economic viability of our steel unit at that time as a stand-
alone company.
    So, in summary, let me say a tax on tracking stock would be 
counterproductive for job creation and capital formation. It 
would accomplish no meaningful improvement in U.S. tax policy 
or revenues. Indeed, it would have a contrary effect. Treasury 
can utilize existing tools, such as regulations and 
pronouncements to deal with inappropriate uses of tax tracking 
stock if and when they arise.
    Thank you very much.
    [The prepared statement and attachments follow:]

Statement of Robert Hernandez, Alliance of Tracking Stock Stakeholders, 
and Vice Chairman and Chief Financial Officer, USX Corporation, 
Pittsburgh, Pennsylvania

                           Position Statement

    The Administration's proposal to impose a tax on the 
issuance of tracking stock (Tracking Stock) is unsound tax 
policy which, if enacted, will restrain new business and 
technology investment and development, cost jobs, cause severe 
harm to companies with Tracking Stock presently outstanding, 
and reduce business expansion. Therefore, this proposal should 
be rejected.
     The issuance of Tracking Stock is motivated by 
compelling business needs. It provides a market-efficient 
source of capital, particularly to corporations attempting to 
grow lines of business that would not be valued appropriately 
by the equity markets without Tracking Stock.
     The proposal, if passed, would not only eliminate 
a valuable source of capital to new businesses, but could also 
force companies with approximately $400 billion of equity 
securities outstanding to recapitalize at a considerable cost 
to them and to their shareholders.
     Treasury has authority to deal with Tracking Stock 
under current law. If Treasury becomes aware of inappropriate 
uses of Tracking Stock, it should resolve the issues 
administratively (through Treasury regulations and 
pronouncements) in a way that avoids adverse consequences to 
business-driven Tracking Stock issuers.
     The revenue estimates are unrealistic. The 
proposal would economically eliminate the use of Tracking Stock 
and provide little if any revenue to the Treasury.

                      Definition of Tracking Stock

    Tracking Stock is a type of equity security issued by some 
companies to track the performance or value of one or more 
separate businesses of the issuing corporation. The holder of 
Tracking Stock has the right to share in the earnings or value 
of less than all of the corporate issuer's earnings or assets. 
The Tracking Stock instrument has developed largely in response 
to the dual economies arising from the equity market's 
preference for ``pure-play'' securities (i.e., pure, single 
line of business companies) and the debt market's preference 
for diversified corporate balance sheets.

                        Business Considerations

    Since General Motors first used it as an acquisition 
currency in September 1984, to acquire Electronic Data Systems 
Corporation (EDS), Tracking Stock has found wide receptivity by 
shareholders in North America.
    To date, a total of 15 public companies have issued 37 
separate Tracking Stocks for a variety of business reasons 
including :
     Acquisitions
     Growth of start-up businesses
     Source of equity capital
     Creation of stock-based employee incentive 
programs
     Continuation of economies of scale for 
administrative costs
     Retention of operating synergies
     Maintenance of consolidated credit and existing 
borrowing arrangements
     Valuation enhancement
     Increasing shareholder knowledge, and
     Broadening of the investor base
    Numerous real-life examples demonstrate the beneficial 
impact that capital, raised through the issuance of Tracking 
Stock, has had on the U.S. economy:
     USX Corporation raised sufficient capital, through 
its U.S. Steel Tracking Stock, to modernize its steel 
operations and transform U.S. Steel from a company that 
generated billions of dollars in losses throughout most of the 
80's into a more efficient steel company. It is the largest 
employer in the domestic steel industry, with high paying jobs, 
generating taxable income rather than losses and paying 
substantial income and payroll taxes to federal, state and 
local governments.
     Genzyme Corporation, a biotechnology company 
founded in 1981, develops innovative products and services to 
prevent, diagnose, and treat serious and life-threatening 
diseases. It initiated its use of Tracking Stock in 1994 when 
it founded a new program to develop tissue repair technologies. 
More recently, it adopted a new Tracking Stock to fund 
molecular oncology research, including cancer vaccine clinical 
trials in breast, ovarian and skin cancer.
     Perkin-Elmer, a high technology company, chose 
Tracking Stock for several business reasons including: 
facilitating new business and technology development; 
recruiting and retaining key employees; exposing and 
facilitating appropriate valuation for new technology 
opportunities; and providing flexibility for raising future 
capital and optimizing further development and expansion of 
each of its businesses.
    For more detail, see the attached case histories of these 
companies.
    Barring a replacement source of capital, the economic 
benefits of Tracking Stock, to these and other companies, will 
be substantially eliminated if a tax is imposed on issuance.

Financial Market Impact of the Administration's Budget Proposal to Tax 
                             Tracking Stock

     Should the Tracking Stock proposal be enacted and 
any future issuances of Tracking Stock deemed a taxable sale, 
companies currently capitalized with Tracking Stock, and their 
shareholders, would be severely impacted. The imposition of 
corporate tax upon the issuance of equity effectively would 
shut down a Tracking Stock company's ability to access the 
equity capital market.
     Their ability to raise capital through the debt 
market would be severely reduced. Such a provision would 
undermine Tracking Stock companies' credit worthiness in the 
market place since they would be unable to strengthen their 
balance sheets and build their business in a cost efficient 
manner.
     This proposal precludes companies with Tracking 
Stock from being able to engage in ordinary non-taxable 
corporate reorganizations (e.g., stock for stock exchanges) 
thus limiting their ability to compete with companies with 
traditional stock structures.
     As a result of these consequences, investors would 
see Tracking Stock as an inefficient capital structure and 
equity valuations would suffer.
     Ultimately, as a result of this Tracking Stock 
proposal, approximately $400 billion of equity securities could 
need to be restructured at great cost and under intense market 
pressure causing a loss of shareholder investment and 
competitive vulnerability.
     For the high-technology industry in particular, 
those companies would lose a medium used to attract and retain 
key personnel.

                           Tax Considerations

    Treasury expresses a concern that Tracking Stock has been 
used to circumvent established corporate tax rules in 
Subchapter C, in particular the spin-off requirements of 
section 355, including the recently enacted Morris Trust 
provisions. The case histories included herein and the facts of 
other Tracking Stock issuances establish that Tracking Stock 
transactions have been carried out for compelling business 
reasons. These transactions have not been tax motivated and in 
particular have not circumvented the section 355 rules.
     Tracking Stock is consistent with Subchapter C of 
the Internal Revenue Code because the tracked business remains 
in the same corporation and the Tracking Stock represents 
equity in that same corporation. For the same reasons, Tracking 
Stock does not reduce a corporation's tax liability compared to 
its tax liability prior to the issuance of Tracking Stock. 
Thus, revenues to the U.S. Treasury are the same before and 
after the initial transaction. If the tracked business is 
successful, however, it will generate taxable income, create 
jobs and pay additional taxes to federal, state and local 
governments. Likewise, increased equity valuations generate 
additional capital gains for individuals.
     Unlike Morris Trust transactions, corporations do 
not use Tracking Stock to dispose of businesses tax-free. 
Tracking Stock is a vehicle used for building and maintaining 
business assets within a single corporation.
     Tracking Stock does not result in a sale of the 
tracked business. Subsequent to adopting Tracking Stock, a 
corporation will recognize gain on any future disposition of 
its assets, unless all of the provisions of Section 355 are 
satisfied.
     Corporations do not issue Tracking Stock for tax 
reasons. The fiduciary responsibilities incumbent on the 
directors of a corporation with Tracking Stock (i.e., to 
multiple shareholder interests) far outweigh any conceivable 
tax motivation.
     Legislation is unnecessary. Treasury has authority 
to address transactions it perceives as inappropriate under 
current law, through regulations and pronouncements, in a way 
that avoids adverse consequences to business-motivated Tracking 
Stock issuers.
     A statutory attack is unnecessary and 
inappropriate because:
    --It harms innocent corporations, impairing their equity 
and adversely impacting their ability to raise capital.
    --It harms shareholders, by reducing the market value of 
their shares.
    --It harms employees and customers. Unless a replacement 
source of capital is found, businesses will scale back 
operations, adversely impacting employees, customers, and the 
communities in which the companies operate.
    --It adds more complexity to the Internal Revenue Code.
     Tracking Stock transactions undertaken to-date 
have been driven by business considerations. The complexities 
associated with the issuance of Tracking Stock should prevent 
it from becoming a tax motivated vehicle. Tracking Stock is 
only appropriate for a small number of companies for which the 
business advantages outweigh the complexities. These 
complexities include:
    --The fiduciary responsibilities of the Board of Directors 
to shareholders of all classes of common stock, which may 
create conflicts
    --Each Tracking Stock business has continued exposure to 
the liabilities of the consolidated entity.
     The published revenue estimates for the proposal 
to tax issuance of Tracking Stock are unrealistic. Subjecting 
future issuances to tax would increase costs to a level that 
would preclude future issuances, except in dire circumstances. 
Thus, the legislation would generate little or no revenue.

                               Conclusion

     The issuance of Tracking Stock is motivated by 
compelling business needs. Treasury's Tracking Stock proposal 
will disrupt financial markets and cause severe harm to 
companies with Tracking Stock since it will not only restrict 
access to capital in the future, but also require massive 
financial re-engineering for some companies. Individual 
investors, and possibly entire communities in which Tracking 
Stock companies operate, will be adversely affected as a result 
of the competitive pressures this tax would impose.

Three Tracking Stock Case Studies are also Submitted as 
Attachments to this Statement:
     USX Corporation
     Genzyme Corporation
     The Perkin-Elmer Coporation

Alliance of Tracking Stock Stakeholders.--The Alliance is an 
informal group of companies that currently utilize or are 
considering using Tracking Stock. These companies share a 
common concern for the value of shareholder investment in 
tracking stocks, as well as their continued ability to meet 
various business objectives through the issuance of tracking 
stock. For further information, contact Scott Salmon, Manager, 
Governmental Affairs, USX Corporation, 202-783-6797.
      

                                

USX Corporation Tracking Stock Case Study

                            Company Overview

    USX Corporation is a diversified corporation headquartered 
in Pittsburgh, PA, engaged in the energy business through its 
Marathon Oil Group and in the steel business through its U.S. 
Steel Group. USX, formerly United States Steel Corporation, was 
founded in 1901 and acquired Marathon Oil Company in 1982 
(Marathon was formed in 1887). U.S. Steel is the largest steel 
producer in the U.S. and today employs approximately 19,600, 
down dramatically from about 149,000 in 1980. Marathon is a 
significant worldwide producer of oil and gas and the fourth 
largest refiner in the U.S., employing almost 33,000.
    USX Corporation is currently represented in the equity 
market by two classes of tracking stock--USX Marathon Group 
Common Stock (``MRO'') and USX U.S. Steel Group Common Stock 
(``X''). Total market capitalization at December 31, 1998, was 
$12.6 billion. Consolidated revenues for 1998 were $28.3 
billion; with net assets of $21.1 billion.

               USX Tracking Stock Business Considerations

    In the late 1980's, USX' largest shareholder, Carl Icahn, 
held 13.3% of USX' stock, and advocated a proposal to spin-off 
the steel division as a separate company due to his belief that 
USX presented a confusing mix of businesses to investors and 
that the Marathon energy business was significantly undervalued 
relative to its energy sector peers.
    Although a tax-free spin-off could have been accomplished, 
management objected to the Icahn proposal for a number of 
compelling business reasons:
     USX was facing significant internal challenges 
including heavy capital expenditure requirements for plant 
modernization, reserve development and environmental 
compliance, as well as substantial debt maturities and 
significant retiree pension and medical costs;
     USX was facing a challenging external economic 
environment for both its energy and steel businesses;
     A spin-off was not judged to be in the best 
interests of USX's creditors, stockholders, and employees;
     There were concerns about the economic viability 
of a standalone steel company;
     Incremental costs to operate standalone companies 
would have been in excess of $70-$90 million per year in 
increased administrative costs, state and local taxes, interest 
costs and insurance costs;
     Neither of the standalone entities would have been 
investment grade.
    The Icahn spin-off proposal was defeated at the May 1990 
shareholders meeting. However, as an alternative to the Icahn 
proposal, USX management soon thereafter proposed creating U.S. 
Steel and Marathon Tracking Stocks. The Tracking Stock 
proposal:
     Established separate equity securities to trade 
based upon the performance of the U.S. Steel and Marathon 
businesses
     Retained the benefits of a consolidated 
corporation while providing for separate equity market 
valuations for its steel and energy businesses. The USX 
Tracking Stock capital structure results in incremental cost 
savings of approximately $70 to $90 million annually. These 
cost savings are achieved through savings in insurance costs, 
administrative costs, State and Local taxes, and interest 
savings.
     Created flexibility for shareholders to hold the 
stock of either the steel business, the energy business or both 
businesses, and
     Maintained flexibility for USX to continue to 
pursue other alternatives for its steel business, including a 
joint venture or sale.
    USX did not seek to circumvent the rules under Section 355 
when it opted to issue Tracking Stock. USX did consider a tax-
free spin-off of stock of its steel business to its 
shareholders and was advised by outside counsel that a tax-free 
spin-off would qualify under Section 355. The USX fact pattern 
strongly supported this opinion because USX owned 100% of the 
steel operations; a spin-off would have effected complete 
separation of the steel assets from USX through the 
distribution to the USX shareholders; both the steel and oil 
businesses were 5-year active businesses within the meaning of 
Section 355(b); and, there were good business reasons for a 
complete separation of the businesses.

                USX Market Valuation and Tracking Stock

    Prior to the announcement of the Tracking Stock Proposal, 
it was clear that the valuation of USX was heavily penalized by 
the market. Although USX was valued in line with its steel 
peers, the stock traded at a significant discount to its energy 
peers. This occurred despite the fact 75% of the company's 
total value was attributable to Marathon's activities.
    On January 31, 1991, the day following the announcement of 
its Tracking Stock Proposal, USX's stock closed 8.2% higher--
increasing its market value by more than $600 million. The 
Tracking Stock Proposal received a 96% vote of approval at 
USX's shareholders' meeting on May 6, 1991. As a direct result 
of the Tracking Stock structure, USX also experienced a pick-up 
of 29 additional equity research analysts.
    Currently, Marathon's Tracking Stock trades based on the 
fundamentals of its energy business. U.S. Steel's Tracking 
Stock trades based on the performance of the steel business, 
however, during weak steel business cycles, U.S. Steel trades 
at a premium to its peers due to its stronger consolidated 
balance sheet (a result of the Tracking Stock structure). To 
date, USX has raised over $2.5 billion in eight equity 
offerings using Tracking Stock.

         The USX Delhi Gas Gathering and Transmission Business

    On September 24, 1992, USX created its third Tracking Stock 
through a $144 million initial public offering (IPO) of its 
Delhi natural gas gathering Tracking Stock. The Delhi issuance 
represented the first IPO of a Tracking Stock.
    USX sold the assets comprising the Delhi business to Koch 
Industries in late 1997 in a taxable transaction incurring $208 
million of taxes payable, including $193 million in federal 
taxes. Net proceeds of $195 million were used to redeem all of 
the Delhi Tracking Stock, a taxable transaction to the 
shareholders.

                        Delhi Transaction Results
------------------------------------------------------------------------

------------------------------------------------------------------------
Delhi Sale Price ($MM)..................................            $762
 Less: Debt, Other Liabilities and Adjustments ($MM)....             359
 Less: Corporate Taxes Payable by USX ($MM).............             208
 Net Proceeds to Delhi Shareholders ($MM)...............            $195
 Net Proceeds to Delhi Shareholders Per Share...........          $20.60
 Delhi IPO Share Price in 1992..........................          $16.00
 % Increase to IPO Share Price..........................           28.8%
------------------------------------------------------------------------

    If USX had chosen to spin-off Delhi to shareholders in 1992 
(instead of issuing Tracking Stock), it could have disposed of 
the subsidiary to its shareholders at approximately the IPO 
price and USX would not have incurred taxes on the disposition.
    In addition, if USX had issued conventional common stock in 
the IPO of Delhi (instead of issuing Tracking Stock), USX could 
have completed a spin-off, merger or joint venture transaction 
at a comparable value to the sale price without incurring 
taxes.

     Tracking Stock Facilitates Capital Formation not Tax Avoidance

    Tracking Stock is a financing innovation that allows 
companies with more than one line of business to raise capital 
efficiently by tapping the value securities markets place on 
``pure play'' equity instruments.
    Tracking Stock is consistent with the intent of Subchapter 
C because businesses remain in the same corporation and 
Tracking Stock will not reduce a corporation's tax liability 
compared with its tax liability prior to the issuance of 
Tracking Stock. Corporate tax revenues to the U.S. Treasury are 
essentially the same before and after a Tracking Stock 
transaction.
    Tracking Stock does not result in a ``sale'' of the tracked 
business. A corporation will recognize gain on any future 
disposition of its assets unless all of the provisions of 
Section 355 are satisfied. Tracking Stock involves the 
antithesis of situations giving rise to the anti-Morris Trust 
legislation and, therefore, does not threaten Section 355(e).
    Legislation is unnecessary--Congress and the IRS have 
recognized the existence of Tracking Stock, and abusive 
transactions can be addressed under current law. Section 
355(d)(6)(B)(iii), for example, prevents a third-party from 
buying up Tracking Stock in order to spin-off the tracked 
business. In addition, the IRS has issued several Section 355 
rulings to corporations that have Tracking Stock outstanding 
(e.g. GM).
    Due to the business complexities of Tracking Stock, it 
should remain appropriate only for companies for which the 
business advantages outweigh the complexities. These same 
considerations augur against it ever becoming a tax-motivated 
vehicle.

                              Conclusions

    The Administration's proposal to impose a tax on the 
issuance of Tracking Stock is unsound tax policy which, if 
enacted, will restrain new business and technology investment 
and development, cost jobs, cause severe harm to companies (and 
their investors) with Tracking Stock outstanding, and reduce 
business expansion.
    Treasury's new tax proposal to Tax the Issuance of Tracking 
Stock should be rejected.
      

                                

Genzyme Corporation: Background Use of Tracking Stock

    Genzyme Corporation (Cambridge, MA) is a biotechnology 
company that develops innovative products and services to 
prevent, diagnose, and treat serious and life-threatening 
diseases. The company was founded in 1981 and has developed 
extensive capabilities in research and development, 
manufacturing, marketing, and other disciplines necessary for 
success in the health care marketplace. One of the top five 
biotech companies in the world, Genzyme had 1997 revenues of 
$609 million, R&D expenses of $90 million, pre-tax income of 
$26 million, and income taxes of $12 million.\1\
---------------------------------------------------------------------------
    \1\ Consolidated financial data for all company operations. Audited 
financial data for 1998 not yet available.
---------------------------------------------------------------------------

                      Current corporate structure

    Genzyme has adopted a corporate structure that best 
supports the needs of its developing businesses. This structure 
consists of three divisions, each of which has its own common 
stock intended to reflect its value and track its performance. 
These stocks are known as ``tracking stocks.'' \2\
---------------------------------------------------------------------------
    \2\ Genzyme Transgenics Corporation (Nasdaq:GZTC) is a separate 
corporation in which Genzyme Corporation holds a minority stake (about 
41%) of outstanding stock. These shares have been assigned to Genzyme 
General. Genzyme Transgenics develops and produces recombinant proteins 
and monoclonal antibodies in the milk of genetically engineered animals 
for medical uses.
---------------------------------------------------------------------------
    Genzyme General (Nasdaq:GENZ) develops, manufactures, and 
markets pharmaceuticals for a variety of unmet medical needs, 
but has a special focus on treatments for rare genetic 
disorders that disable or kill children (such as Gaucher 
disease, Fabry disease, Pompe disease, and cystic fibrosis). 
This division also makes a variety of diagnostic test kits, 
provides genetic diagnostic services, and has a significant 
surgical product business.
    Genzyme Tissue Repair (Nasdaq:GZTR) develops, manufactures, 
and markets therapies consisting of human cells which are 
cultured from a tiny sample of a patient's healthy tissue and 
surgically implanted to repair or replace damaged tissue, such 
as skin for severe burn victims and knee cartilage for injured 
athletes. This division is also investigating the use of brain 
cells from pig fetuses to treat Parkinson's and Huntington's 
diseases.
    Genzyme Molecular Oncology (Nasdaq:GZMO) is developing a 
new generation of chemotherapy products, focusing on cancer 
vaccines and angiogenesis (tumor blood vessel) inhibitors. It 
has initiated cancer vaccine trials in melanoma patients and 
expects to initiate trials in breast and ovarian cancer 
shortly.

    Administration's proposal to tax the issuance of tracking stocks

    The Administration proposes to tax the issuance of tracking 
stocks. According to the Treasury Department's ``Green Book,'' 
this proposal is based on Treasury's assumption that companies 
use tracking stock to sell subsidiaries without incurring tax 
liability on their profits. Treasury claims enactment of this 
proposal would raise $600 million in new revenues over the next 
5 years. Treasury also claims its proposal would not be 
retroactive, though it is unclear whether companies who issue 
new shares of existing tracking stocks would be subjected to 
the tax.
    This proposal reflects a fundamental misunderstanding about 
why companies issue tracking stocks. The faulty premise is 
discussed in detail below, but is illustrated by the following:
    Genzyme's use of tracking stocks has not--and will not--
produce any tax benefits for the company. The company pays 
taxes based on the earnings of the entire corporation, which is 
a single entity for tax purposes regardless of the types of 
securities it issues to its investors.
    Genzyme instituted its tracking stock structure as a means 
of financing the acquisition of the companies that comprise the 
principal assets of the new divisions. This use is the opposite 
of Treasury's contention that tracking stocks are used to 
achieve tax-free sales.
    Only 12 companies have issued tracking stocks in the last 
15 years. If tracking stocks truly offered a means for 
achieving permanent tax avoidance on the divestiture of 
subsidiaries, one would expect it to have attracted many more 
adherents than have appeared during a period of vigorous merger 
and acquisition activity in which hundreds of companies have 
divested themselves of subsidiaries.
    Tracking stock issuance does not transfer ownership. When a 
company replaces a single class of shareholder equity with two 
(or more) classes of tracking stock equities, the total value 
of the newly issued equities equals the total value of the 
original equities which must be forfeited in exchange. The 
newly-issued tracking stocks literally replace the original 
shares in the portfolios of the company's investors.\3\ This 
substitution is not a divestiture: no corporate assets are 
transferred, no management control is forfeited, no cash or 
other consideration is paid, and no corporate liabilities are 
relieved.\4\ Furthermore, the subsequent issuance of new 
tracking stock shares will raise capital for the exclusive use 
of the tracked division and does not increase the assets of any 
other division.
---------------------------------------------------------------------------
    \3\ When investors sell these tracking stocks, they will be 
required to pay tax on their capital gains if the sale price exceeds 
their adjusted basis in the tracking stock shares.
    \4\ For example, if an investor were to purchase 100% of Genzyme 
Tissue Repair tracking stock--which would cost $54 million at current 
market prices--he would gain neither ownership nor management control 
of that division. He would, however, possess the right to any and all 
future dividends attributable to that division, as well as voting and 
liquidation rights equal to the small portion of Genzyme Corporation 
represented by these shares.
---------------------------------------------------------------------------
    This proposal would create a substantial new tax burden. In 
effect, the Administration proposes taxing tracking stock 
companies each time they raise capital for R&D and other 
legitimate business activities merely because newly issued 
shares would track a single division, rather than the entire 
company. Tracking stock companies would become the only 
companies in the country to be taxed on paid-in capital.
    This proposal would not raise revenue. Tracking stock 
issuance is currently tax-neutral. If it were it to be taxed, 
no company would ever issue it and it would not raise $600 
million.

             Benefits of tracking stocks over consolidation

    Enhances capital formation by enlarging the pool of 
investors for whom Genzyme could offer a stock consistent with 
their investment goals. Tracking stocks provide investors with 
the ability to select the single business unit that best 
reflects their growth expectations and risk tolerance, rather 
than the traditional all-or-nothing investment choice offered 
by most diversified companies. Genzyme is the most diversified 
company in the biotech industry, with respect to both its 
product/service/technology mix and the investment risk 
associated with its businesses. For example, Genzyme General 
offers proven earnings, consistent growth, moderate volatility, 
and high liquidity, while Genzyme Tissue Repair and Genzyme 
Molecular Oncology are earlier-stage, longer-term investments 
that represent ``pure plays'' in their respective technologies. 
Each Genzyme stock is likely to appeal to some investors who 
would not find a consolidated common stock to meet their 
investment criteria.
    Improves overall shareholder value by providing visibility 
to pipeline products whose value might otherwise be overlooked. 
Once a biotech company launches its first products, stock 
analysts tend to switch their focus from the value of the 
company's pipeline to its ability to sustain revenue and 
earnings growth for currently marketed products. Tracking stock 
is a mechanism which forces an independent valuation of 
unprofitable, R&D-intensive divisions.
    Reduces disincentives to making large investments in long-
term R&D programs. Once a company achieves profitability, 
management is often judged on earnings performance and must 
contend with a shareholder base that is not always tolerant of 
early-stage R&D programs. Such programs rarely increase the 
price-earnings multiple, so managers who make such investments 
are almost always penalized with reduced stock prices. By 
creating an investment vehicle that attracts more risk-tolerant 
investors, management can invest more in science and technology 
programs without eroding the company's market value.
    Provides investors with more information about the various 
business units of the company. Genzyme tracking stockholders 
receive more detailed information than is ordinarily reported 
by individual business units of public companies (such as 
separate financial statements, management's discussion and 
analysis, descriptions of business, and other information).

              Benefits of tracking stocks over divestiture

    Maintains access to a seasoned management team and other 
resources that would not be available to a small independent 
company. Genzyme's expertise in such areas as R&D, clinical and 
regulatory affairs, manufacturing, and administration are 
generally broader and deeper than is typically available to 
start-up companies similar to its smaller divisions.
    Provides access to debt capital based on the financial 
strength of the entire corporation. Biotech companies have huge 
capital requirements, lengthy product development cycles, and 
high risks of failure. Businesses with these attributes find it 
difficult to borrow funds and risk the possibility that poor 
stock market conditions, rather than poor corporate 
performance, could destroy them. Weak equity markets for small 
cap companies outside of the Internet industry have forced many 
start-ups (including both Genzyme Tissue Repair and Genzyme 
Molecular Oncology) to cancel or postpone public offerings. As 
units of Genzyme Corporation, however, these businesses can 
borrow from the company, which can access a $200+ million bank 
line of credit and $250 million in public convertible debt.
    Enhances incentives for the management and staff of each 
division to increase shareholder value. The use of tracking 
stock options enables the company to motivate employees with a 
share of the value they help to create.

                              CONCLUSION:

    Tracking stocks have legitimate business uses and are not 
vehicles for tax avoidance. Proposals to tax their issuance are 
misguided because they would more likely result in re-
consolidation than in new federal revenues. This outcome would 
undermine investor choice, shareholder value, and start-up 
business stability in companies like Genzyme that use tracking 
stocks to grow their businesses.

             Appendix: Genzyme's Capital Formation History

    Genzyme's 17-year history of capital formation--during 
which it raised more than $1 billion to support R&D, technology 
development, manufacturing, and other activities--illustrates 
how tracking stocks can be used to build a strong and 
diversified company.
    During the five years after its founding in 1981, Genzyme 
was a privately-held company whose operations were funded by 
venture capital and private placements totaling $4 million. The 
company went public in 1986, raising $22 million in its initial 
public offering (IPO). Follow-on offerings, which were made in 
1989 and 1991, raised an additional $173 million. Off-balance 
sheet offerings contributed an additional $122 million in 
research and development funding for specified projects.
    In 1991, Genzyme obtained FDA approval for its first 
product, a drug to treat a rare (and sometimes fatal) genetic 
disorder called Gaucher disease. To facilitate continued growth 
and innovation, the company engaged in a number of 
acquisitions, seeking out other biotechnology companies whose 
research programs, while promising, were not financially 
sustainable without additional capital resources that were more 
readily available to Genzyme.
    Ironically, it was to accomplish such an acquisition--and 
not for purposes of divestiture--that Genzyme adopted its use 
of tracking stocks in December 1994. The acquired company was 
another Massachusetts company, BioSurface Technology, which had 
developed exciting techniques for re-growing human tissue for 
transplantation.
    To finance the acquisition, Genzyme common stock was 
replaced by two stocks: one tracking a newly created division--
named Genzyme Tissue Repair (GTR)--into which BioSurface was 
merged, and the other tracking the remainder of the company--
renamed Genzyme General. BioSurface shareholders were granted 
GTR tracking stock in exchange for their BioSurface shares. And 
since additional Genzyme assets were allocated to GTR, GTR 
tracking stock was also issued to all Genzyme Corporation 
shareholders as a non-taxable dividend.
    In 1995, GTR issued additional shares in an initial public 
offering (IPO) in which it raised $42 million. In 1996, a 
second offering raised $29 million; in 1997, a third offering 
raised $13 million. In addition, GTR has access to an $18 
million line of credit from the corporation.
    In 1998, Genzyme General purchased another biotech 
company--Pharmagenics--which had developed a new technology to 
analyze the differences in how genes are expressed in cancerous 
tissue versus healthy tissue. This technology appears to be a 
powerful tool in the development of new approaches to treating 
cancer. Once again, Genzyme combined the acquired company with 
some existing General division assets, and created another 
tracking stock, Genzyme Molecular Oncology (GMO). Due to poor 
market conditions for biotech start-ups, GMO has postponed its 
IPO and has instead obtained a private placement of $19 million 
of convertible debt. It also has access to a line of credit 
from the corporation under terms similar to those provided to 
GTR.
    Last year, Genzyme General also raised $250 million in a 
private placement of convertible debt.
      

                                

The Perkin-Elmer Corporation

           Background and Decision to Utilize Tracking Stock

    Perkin-Elmer is a sixty year-old high technology company, 
headquartered in Wilton, Connecticut.
    The company was founded during World War II when Germany 
was the dominant worldwide supplier of optical equipment such 
as telescopes and sighting instruments.
     Perkin-Elmer's business evolved from optics into 
several other technologies, including scientific equipment, 
guidance and navigation equipment, semiconductor manufacturing 
equipment and biotech systems.
     The company has distinguished itself with its 
long-term consistency and success in developing new 
technologies into successful products and businesses
     Currently, Perkin-Elmer is divided into three 
primary business units: Analytical Instruments, Biosystems, and 
the recently formed Celera Genomics
     These units involved different technologies, 
markets and financial models
    In order to survive constantly over its history as a high 
technology company, Perkin-Elmer has been forced to evolve, 
particularly as technology development accelerates and becomes 
more competitive.
    Currently, several factors have prompted management to 
broadly assess structural alternatives to facilitate further 
evolution and success. The clear structure of choice has been 
determined to be tracking stock. Motivating factors include the 
following:
    --Meeting investor demands, involving business and 
technology comprehension, appreciation, focus and ``pure play''
    --Accommodating various investor risk/reward interests, 
recognizing that each business/technology has a substantially 
different financial profile
    --Recruiting and retaining employees in businesses ranging 
from start-ups to relatively mature businesses, while also 
facilitating employee movement between business units
    --Providing an optimal ``incubator'' for development of new 
technologies--where a fast moving and focused start-up 
environment can be supported by broader and proven resources. 
These resources include management, technology, capital, 
administrative resources and reputation (both for customers and 
investors)
    --Facilitating ongoing visibility and appreciation of 
business, financial, and technological progress for investors, 
customers, and employees through increased disclosure and 
separate financial statements
    --Maximizing total shareholder value, particularly by 
exposing technologies and opportunities that may otherwise be 
``buried'' within a larger business structure
    --Distinguishing related businesses in their respective 
markets while facilitating ongoing technology synergies
    --Optimizing an acquisition currency for further 
development and expansion of each business
    --Providing an optimal tool for raising future capital, 
even though Perkin-Elmer's current tracking stock offering is 
not being used to raise capital
    For Perkin-Elmer's new genomics business, tracking stock 
was identified as best accommodating all of these interests, 
and the company has taken extensive steps to accomplish 
tracking stock, all in reliance on current law.
    These steps include: creating our new Celera Genomics 
business unit, recruiting employees, granting stock options and 
filing with the SEC--all with tracking stock as a foundation:
     Although tracking stock has yet to be officially 
implemented, anticipation of such has been enthusiastically 
received by investors, employees and customers

        Proposed New Tax Legislation and Effects on Perkin-Elmer

    Tracking stock was also chosen as the structure of choice 
based on facilitating Perkin-Elmer's further evolution and 
likely issuances of additional classes of tracking stock.
    Throughout all of the analysis and considerations addressed 
above, taxes were not a factor.
    While not a factor, critical reliance was placed on the 
fact that the tracking stock restructuring would not carry any 
tax penalties versus the status quo.
    The presumption that tracking stock is used to disguise 
spin-offs and save taxes is totally inapplicable to Perkin-
Elmer. Although a separate tracking stock, Perkin-Elmer's 
Celera Genomics will necessarily continue to be an integral 
part of the Perkin-Elmer family.
    A spin-off of Celera Genomics was not feasible for many 
reasons, including the ongoing need for, and synergies with, 
Perkin-Elmer's management, technologies, capital availability 
and reputation
     Highlighting the inappropriateness of assuming 
that tracking stocks are disguised spin-offs is the current 
example of Perkin-Elmer's Analytical Instruments business. Due 
to the lack of comparable synergies toward that business, 
Perkin-Elmer has specifically decided not to make its 
Instruments business another class of tracking stock; it has 
decided to sell that business to a third party. Tax 
considerations were not a motivating factor in either case
    Perkin-Elmer management has not considered current tax law 
as an advantage or ``loophole'' with respect to our proposed 
tracking stock because no alternative involved spinning off or 
selling the genomics business. A spin-off or sale would be 
unhealthy and perhaps fatal to the young business and would be 
detrimental to shareholders, employees and the development of 
science and technology. Management views tracking stock to be a 
neutral tax event as compared to viable alternatives, all of 
which involve retention of the genomics business within the 
Perkin-Elmer family.
    The current tax proposal could represent a fatal blow to 
Perkin-Elmer's proposed restructuring. From Perkin-Elmer's 
perspective, the proposed legislation would not eliminate a tax 
loophole; it would eliminate tracking stock as a viable 
alternative by imposing a significant tax penalty on the 
structure. This, in turn, would represent an obstacle to 
Perkin-Elmer's further success and evolution. As such, it would 
impede the effective development of science, technology, 
medicine and corresponding contributions toward employment and 
success for American companies.
      

                                

    Chairman Archer. Thank you, Mr. Hernandez.
    Mr. Kies and Mr. Weinberger, I think both of you were in 
the room during the testimony of the previous panel. You 
listened to what Mr. Tucker, representing the ABA, said about 
tax shelters. Where do you differ with him?
    Mr. Kies. Well, Mr. Chairman, Mr. Tucker was careful I 
think to say that actually his statements were not on behalf of 
the American Bar Association itself, other than his opposition 
to taxing the investment income of their trade association, of 
which I am a member. So his position is not yet the official 
position of the ABA.
    I think where we basically differ is a different view of 
the tools that are available to the Service today. The IRS has, 
as we said in our testimony, a substantial array of tools at 
its disposal to deal with what are real abuse situations, and 
indeed has been reasonably successful in using them.
    The concern that we have is that the kind of discretion 
that would be given to the Service would go way beyond anything 
that is necessary for them to deal with problem situations that 
they legitimately have to deal with, and that what they should 
really do is use the tools that are at their disposal, 
including what was enacted in 1997 that has not yet been 
implemented through regulations.
    Chairman Archer. Mr. Weinberger, do you have anything to 
add to that?
    Mr. Weinberger. No, other than to say that when you look at 
the written testimony of the ABA, I think there is a lot more 
in common with what we said than was apparent in the verbal 
testimony. One of the suggestions in the ABA's written 
testimony was ``we recommend that congressional response to the 
tax shelter problem be measured and appropriate. It should not 
overreach. It should not risk inhibiting legitimate business 
transactions.''
    That is, I think, on all fours with what we are saying. 
They did not reference anywhere in their verbal or written 
testimony the changes that were made in 1997 expanding the tax 
shelter reporting requirement and substantial understatement 
penalty definition or the reason they were enacted. So I think 
that I would just focus more on the existing tools at hand.
    Chairman Archer. He, I believe, alluded to a need for 
greater disclosure. Would you agree with that?
    Mr. Kies. Well again, what the 1997 act would do is require 
disclosure of tax shelter activities where there is 
confidentiality involved. The Service ought to implement the 
authority that they have got so that they can take advantage of 
that.
    Overdisclosure, though, should be looked at cautiously. If 
you cause taxpayers to have to disclose every transaction they 
enter into, what you will get is a blizzard of paper at the IRS 
that will not be useful as an effective tool in enforcement. 
Right now, the tax returns filed by corporate taxpayers, as you 
have seen in other testimony before this Committee, measure 
many feet in height. There is a tremendous amount of disclosure 
that goes on today. Effective auditing can address most of the 
problems to the extent that they actually exist.
    Mr. Weinberger. Mr. Chairman, I want to concur with that. 
In fact, when the Treasury asked Congress to pass the proposal 
that you passed in 1997, providing expanded tax shelter 
registration rules that have not yet been implemented, they 
specifically said in the Green Book, ``many corporate tax 
shelters are not registered with the IRS . . . [R]equiring 
registration of tax shelters would result in the IRS receiving 
useful information at an earlier date regarding various forms 
of tax shelter transactions engaged in by corporate 
participants. This will allow the IRS to make better informed 
judgments regarding audits, and so on, and so on.''
    We think that is why it is premature for these sweeping new 
proposals to take place before those proposals are even 
implemented.
    Chairman Archer. In the opinion of each of you, are there 
abuses out there?
    Mr. Kies. There certainly are bad actors. There always have 
been. But the government has not decided, for example, to take 
away everybody's driver's license because there are a few 
speeders. To impose sweeping or give sweeping discretion to the 
IRS which could be used against all corporate taxpayers because 
there are a few problem actors, we think would be a misguided 
thing to do.
    The audit process and the other tools available to the 
Service can be effectively used to police bad actors. We think 
most corporate taxpayers are trying to actually get the answer 
right, file returns that correctly report their liability, 
while serving the responsibility they have to their 
shareholders to not overpay their liability. We think that is 
what most corporate tax managers are trying to accomplish. For 
those that are the bad players, the Service ought to go after 
them. I don't think anybody would defend protecting those types 
of taxpayers.
    Chairman Archer.
    Mr. Doggett.
    Mr. Doggett. Thank you very much. Mr. Kies, I read in the 
Sunday New York Times that you have been assigned the lead role 
of drafting the Republican Social Security plan. How are you 
coming?
    Mr. Kies. I am unaware of that assignment.
    Mr. Doggett. It's inaccurate? You are not doing that?
    Mr. Kies. I am happy to talk to anybody about Social 
Security, both Democrats and Republicans, and I have. I 
participated in the White House Conference on Social Security 
at the White House's request. I have been happy to talk about 
the issue.
    Mr. Doggett. But the New York Times story is in error and 
you are not drafting the Republican plan?
    Mr. Kies. I am no longer with the Congress. I provide would 
be happy to provide informal advice to anybody who is 
interested in it.
    Mr. Doggett. So the report is erroneous?
    Mr. Kies. That is correct.
    Mr. Doggett. Thank you. If I understand your written and 
oral testimony correctly, you oppose every single proposal that 
the administration has advanced relating to corporate tax 
shelters?
    Mr. Kies. That is precisely correct.
    Mr. Doggett. You feel that the best thing for this Congress 
to do about tax shelter hustlers for the time being is to do 
nothing?
    Mr. Kies. I think the best thing that Congress could do is 
to give stern and direct directions to Treasury and to the 
Internal Revenue Service to utilize the tools that they have at 
their disposal to address these kind of problems.
    Mr. Doggett. And you recommend that the Congress take no 
further legislative action of any kind concerning corporate tax 
shelter hustlers this year?
    Mr. Kies. I think the Congress ought to wait and see if 
what was given to the Service in 1997 is effectively addressing 
the problems that were identified then.
    Mr. Doggett. Which is another way of saying do nothing, as 
far as legislative proposals. Correct?
    Mr. Kies. That is correct.
    Mr. Doggett. Now I want to be sure I understand how this 
process works, and whether the reports of it are accurate. At 
your firm, is it correct that contingency fees of up to 30 
percent are charged on tax savings for corporate tax shelters 
and tax avoidance schemes?
    Mr. Kies. Actually, I think you are referring to the Forbes 
article. That was a reference to, I believe, the proposal at 
the beginning of the article, which dealt with another firm's 
proposal.
    Mr. Doggett. I am asking the question generically, though 
the Forbes article does refer specifically to your firm and to 
comments made by one of your partners here in the Washington 
office. But my question, without regard to Forbes, is whether 
or not it is true that there are charges of up to 30 percent on 
a contingency fee basis on tax avoidance schemes?
    Mr. Kies. Mr. Doggett, we don't advise people on tax 
avoidance schemes. But if you are asking do we ever have 
contingency fee arrangements, there are situations--they are 
somewhat unusual--in which we provide advice which has 
contingencies associated with it, whereby we tell our clients 
that we are prepared to stand behind our advice, and if it 
turns out to be incorrect, to return fees that have been paid.
    Mr. Doggett. So in short, if the corporate tax shelter, if 
you prefer that term, works, you get 30 percent of the amount 
that they save. If it doesn't work, they don't owe you 
anything. Is that the way it works?
    Mr. Kies. The 30 percent, frankly, I don't know if we have 
any 30-percent arrangements.
    Mr. Doggett. Your partner indicated you did, though I think 
it goes down to as low as 8 percent, he said.
    Mr. Kies. Again, what I am saying is that there are 
contingency fee arrangements. The exact percentage, I am not 
aware of.
    Mr. Doggett. That is the way it works though, whether it is 
30 percent or 8 or 25, if you succeed on the tax shelter, your 
company shares in a good chunk of the savings, and if you don't 
succeed, the corporation owes your company nothing for the 
advice?
    Mr. Kies. There are circumstances like that.
    Mr. Doggett. Your partner also described this as a ``new 
pricing model.'' Does that mean that this use of the 
contingency fee system on corporate tax shelters is relatively 
new?
    Mr. Kies. Actually, there have been contingency fee 
arrangements for many years. Litigators use contingency fee 
arrangements both in tax and nontax.
    Mr. Doggett. He also described what he referred to as black 
box products that are sold by your firm. Is that term familiar 
to you?
    Mr. Kies. Actually I have never heard it used, but the 
context in which it appeared in the article was to describe a 
unique planning transaction. Frankly, every piece of advice 
that we give to a specific taxpayer is unique to that taxpayer. 
So the black box kind of sounds like it's mysterious, but I am 
not sure that it connotes any kind of unusual----
    Mr. Doggett. He suggested that staffers at your office were 
required to come up with one new idea of this type per week. Is 
that correct?
    Mr. Kies. No. That is not correct.
    Mr. Doggett. And is it correct that there are up to 40 
newly hired professional salesmen to pitch these corporate 
shelter ideas just in this office?
    Mr. Kies. No. That's not correct. Firm-wide we have people 
who are actually relationship persons with the clients that we 
serve. Those people, part of their job is to bring to the 
attention of clients the range of services that we provide, 
which include State and local, pension planning, multinational. 
I mean there are people whose job is to help educate our 
clients about the range of services we provide. That is true of 
most of the professional firms today.
    Mr. Doggett. Thank you.
    Mr. Kies. Sure.
    Chairman Archer.
    Mr. Collins.
    Mr. Collins. Thank you, Mr. Chairman.
    Mr. Kies, I believe in your testimony you referred to a 
Judge Learned Hand.
    Mr. Kies. Yes, sir.
    Mr. Collins. A quote that is often referred to by Mr. Hand 
or by Judge Hand. What was that quote, sir?
    Mr. Kies. Well, I don't know the precise quote, but the 
basic message that he had was that people don't have an 
obligation to maximize the tax liability that they pay.
    The exact quote was, ``A transaction, otherwise within an 
exception of the tax law, does not lose its immunity'' that is, 
it's not available, ``because it is actuated by a desire to 
avoid or if one chose, to evade taxation. Anyone may arrange 
his affairs that his taxes shall be as low as possible; he is 
not bound to choose the pattern which will best pay the 
Treasury; there is not even a patriotic duty to increase one's 
taxes.''
    What Judge Hand was basically saying is people are 
perfectly entitled to plan their transactions legally in a way 
that will lower their tax liability.
    Mr. Collins. In other words, a taxpayer can seek advice as 
to how they would result in a minimum of taxation?
    Mr. Kies. Not only can they do that, but as a matter of 
fact, corporate tax managers have the fiduciary obligation to 
their shareholders to plan their transactions that way.
    Mr. Collins. Very good. Thank you, sir.
    Thank you, Mr. Chairman.
    Chairman Archer.
    Mr. Houghton.
    Mr. Houghton. Thank you, Mr. Chairman. You know, I am 
really interested in sort of the macro issues here in terms of 
the revenue provisions. There are a lot of different categories 
of taxes. One is if a tax is different. I think you have a 32.6 
percent corporate tax average. That could be different. It 
could be split up different ways. It could be an unfair tax.
    The thing I am most interested in is the consequence taxes. 
When these tax provisions are put forward, what are the ones 
that have economic and national consequences? What are those 
ones that you think are important? That is what I am interested 
in. To anybody who wants to talk to it.
    Mr. Kies. Mr. Houghton, in terms of--you mean the proposals 
that the administration has?
    Mr. Houghton. Right. Right.
    Mr. Kies. Which ones would have economic consequences?
    Mr. Houghton. Right.
    Mr. Kies. Well, obviously it depends on the amount of 
revenue they are raising. I mean ironically, the tax shelter 
provisions are only predicted by the Joint Committee to raise 
$300 million a year, so the economic consequence wouldn't seem 
to be very substantial. The consequence in terms of the ability 
of people to have any confidence as to what the rules are could 
be quite sweeping.
    There are other proposals in here that have clear economic 
consequence. If you raise the cigarette taxes by $69 billion or 
whatever the number is, the economic consequence is that people 
that smoke, which is mainly low- and middle-income individuals, 
are going to experience an economic penalty. Consumption taxes 
clearly would get borne by the consumer. So an increase in the 
cigarette excise tax, an increase in the airline ticket fees, 
clearly get borne by the consumer.
    Other proposals in here, for example, there is a wide range 
of proposals----
    Mr. Houghton. I guess what I am searching for is if you 
increase the airlines tax, does that mean that one fewer person 
flies? What is the economic consequence of some of these 
things?
    Mr. Kies. The economists certainly predict that increases 
in excise taxes do decrease consumption. Indeed, if you ask the 
Joint Committee, they could tell you from their model what 
would be the decreased consumption as a result of increasing 
those excise taxes. Same thing in the case of taxes, excise 
taxes on airline travel. There would be an impact in terms of 
decreased consumption.
    Mr. Houghton. Would you like to----
    Mr. Weinberger. Well, Mr. Houghton, I guess to your generic 
question, I think any of the proposals that restrict the 
ability of companies to raise capital or to reorganize 
efficiently are going to hurt the overall profit to the 
company, which are a large reason for our continued surplus 
according to CBO. Part of the reasons we have expanding 
surpluses over the original projections was due to corporate 
profits, and there should be a high threshold to enact 
proposals that will have a negative effect on these companies' 
ability to either raise capital or effectively reorganize in an 
efficient manner.
    Mr. Kies. That is an important point, because it gets to, 
for example, the tracking stock proposal.
    Mr. Hernandez. To that point, the Treasury's revenue 
estimates of I think it's $600 million, are unrealistic, 
because people just wouldn't issue tracking stock. But it does 
reduce the ability of companies to raise capital.
    Mr. Houghton. So that is a very significant issue.
    OK. Well, thank you very much.
    Chairman Archer.
    Mr. Portman.
    Mr. Portman. Thank you, Mr. Chairman.
    Following up on that question, my questions go to the 
issues you raised with regard to the life insurance provisions. 
And particularly, Mr. Wamberg, as it relates to the personal 
savings rate, which as you know is at a low ebb right now. 
Probably not since 1933 have we seen such a low personal 
savings rate in this country. In fact, it was even negative a 
couple months late last year. Everyone in the economic field, 
right, left or center, across the ideological spectrum, seems 
to agree that that is a very important indicator of the healthy 
economy into the future, that we can't sustain our economic 
growth without higher savings rates and more capital formation.
    You talked about the administration's proposal to tax 
employer-owned life insurance. I am looking at your testimony. 
You focus more on the health insurance side, saying that that 
could affect fringes on the health side. The examples you use 
are primarily in that area. How would it affect the pension 
side? In particular, defined benefit plans, but also on the 
defined contribution side. In other words, a 401(k) or another 
kind of profit-sharing plan. How would that tend to affect the 
way it would work in the real world? Kind of following on Mr. 
Houghton's statement, what are the real-world impacts of these 
proposals?
    Mr. Wamberg. The question is a good one. It would have a 
severe impact for corporations to be able to keep their 
executive team together and put retention devices in and make 
sure that they stay with that company for the duration.
    We have a labor shortage in this country in a lot of 
different sectors, but clearly in top management. Because of 
ERISA and because of continuing government limitations on what 
can be provided through a qualified pension plan, what can be 
provided through qualified defined contribution and profit 
sharing plans, and how much an employee can contribute to a 
401(k) plan, there is significantly low limits.
    What companies do is they will supersede those programs, 
not take a tax deduction to do it, but they will offer benefits 
to those executives with vesting and other components to make 
sure that they stay, and stay focused with that company. They 
will use life insurance to match that liability. They are 
creating a long-term liability by creating these plans for 
their management team. They are putting life insurance on these 
executives as a long-term asset so that when the benefits come 
due, they have the money to pay it.
    So if you took that benefit away from corporations, you 
would have a very severe take-away from management's ability to 
do what is right for their management teams, for their 
shareholders, and so forth.
    Mr. Portman. Apart from what is right for the management 
team, and what is right in terms of retaining as you say, 
management employees, what would the impact be on savings? I 
assume many of these products you are talking about, whether it 
is enhancing a qualified plan, or whether it is a supplement to 
that, these are plans that involve saving. The life insurance 
is what helps to finance that longer term liability you talked 
about.
    Mr. Wamberg. Exactly. We would be talking in very large 
numbers. I do not have a specific number, but understand what 
we are doing, is we are taking money out of the consumption 
stream and we are putting it away and we are saving it for the 
future.
    Mr. Portman. Other comments on this general issue?
    Mr. Kies. I think, Mr. Portman, clearly the provisions of 
current law that assist employers to either help save for 
retiree health or retiree retirement benefits both are a major 
plus in terms of total national savings. They facilitate the 
ability of employers to deliver those benefits to their 
employees.
    In the case of retiree health benefits, if it weren't for 
the programs like the corporate-owned life insurance programs 
that help fund retiree health benefits, in many cases employers 
wouldn't be able to afford to provide them, and people would be 
looking to the Federal Government for those type of benefits. 
So I think they play a critical role in helping the private 
sector deliver a key part of those benefits.
    Mr. Weinberger. I just have a quick point, which would be, 
as we look at Social Security and the problems we have with 
unfunded benefits there, I think that we wouldn't want to take 
away funding sources for retirement benefits outside the Social 
Security system. We would run into the same problem that we 
have with the Social Security system.
    Mr. Portman. I would hope, given the situation we are in 
with regard to our savings and with regard to our pension 
system, where only half of all workers are now covered by any 
kind of a pension, and beyond that, as you say, the problems we 
have with our public retirement system, Social Security, that 
proposals would come from the Congress and the administration 
to help companies encourage savings and encourage pensions. 
That would be one of my major concerns with the 
administration's proposals on the insurance side.
    Thank you, Mr. Chairman.
    Mr. Kies. Mr. Chairman, could I ask your indulgence for 1 
minute? I would just like to go back to Mr. Doggett's question 
on my role in Social Security, because I want to make sure that 
I was clear.
    Mr. Doggett, I have talked to probably 40 Members of 
Congress in the past year about Social Security issues, both 
Democrat and Republican, and have also been available to 
participate in the White House conference. So I have been 
available to talk to anybody who is interested in the issue. 
Only the Republican Members of the Congress could decide what 
their own plan is going to be. I just wanted to make sure I was 
clear that I actually have participated in a lot of discussions 
with----
    Mr. Doggett. But other than attending the conference, you 
are not drafting the language and forwarding drafts or 
participating in drafting in any way?
    Mr. Kies. I have actually drafted a variety of different 
approaches to Social Security that people have sometimes been 
interested in looking at.
    Mr. Doggett. So to that extent, maybe the New York Times 
article is not erroneous? You are drafting provisions for a 
Republican plan?
    Mr. Kies. No. I am not. I have drafted and shared with a 
variety of people different ideas. In fact, I intend to publish 
something soon, as a number of other people have.
    Mr. Portman. Mr. Chairman.
    Chairman Archer. Who seeks recognition?
    Mr. Portman.
    Mr. Portman. One further question, if I might just briefly. 
I have not had the opportunity to talk to Mr. Kies about Social 
Security, and I would like to go on record saying I would be 
delighted to. When you have time, I would like to sit down and 
talk to you about your ideas on Social Security. I am getting 
them from a broad array of people and your expertise would be 
most welcome.
    Mr. Kies. Certainly, Mr. Portman.
    Chairman Archer. The Chair is not sure what the gentleman 
from Texas is driving at. Let me make it perfectly clear that 
if there is a Republican plan--and I hope there will be because 
we certainly don't have a Democrat plan--it would be very nice 
to have a specific plan that will save Social Security for 75 
years. Further, it will be drafted in-house, in the Congress of 
the United States, and it will be put in statutory language by 
our staff, and the normal drafting staff on Capitol Hill. So 
that should be very clear.
    Let me ask you just a final question on tax shelters. For 
the benefit of the Committee, what is the definition of a tax 
shelter?
    Mr. Kies. Well, Mr. Chairman, there are a variety of 
definitions. But the one that is contained in the 
administration proposal includes any transaction in which the 
reasonably expected pretax profit of the transaction is 
insignificant relative to the reasonably expected net tax 
benefit.
    One of the reasons we are very concerned about that is that 
we believe a number of legitimate business transactions could 
fall within that definition. For example, a wildcat oil driller 
who spends $5 million, who has only a 10 percent expectation of 
hitting oil, under current law would clearly be permitted to 
deduct those expenses against his other income if he doesn't 
strike oil. Clearly he does not have a reasonable expectation 
of a net profit if he only has a 10 percent likelihood of 
striking oil.
    Those are the kind of circumstances that we are extremely 
concerned about the scope of this kind of authority. It is 
particularly concerning because the Treasury is proposing to 
eliminate any reasonable basis exception where the taxpayer had 
reasonably relied on current law. But the definition almost 
becomes in the eye of the beholder if it has that kind of 
breadth to it.
    Chairman Archer. Does anybody want to add anything?
    Mr. Weinberger.
    Mr. Weinberger. Quickly, Mr. Chairman. I share the same 
concern for the definition of tax shelter. When you look at 
pretax profit versus tax benefits, any kind of recapitalization 
of preferred stock equity for debt could be considered to be a 
tax shelter because there is no pretax profit, although there 
is clearly a business purpose for doing it.
    But what I wanted to just point out is that not even all of 
the transactions in the President's budget that we are 
concerned about, including the most troublesome, the section 
269 proposal, is triggered off a tax shelter. It is triggered 
off of tax avoidance transaction, which also is--any 
transaction involving the improper elimination or significant 
reduction of tax on economic income. That is the only 
definition we have right now to understand what that proposal 
means.
    Chairman Archer. Under my Chairmanship of this Committee, 
we are going to attempt to eliminate every abuse that is being 
used to circumvent the clear ends of the Tax Code. But we do 
not want to have a net that drags in everybody, simply because 
we want to get some people who have abused. We have to find a 
way. I hope anybody who has ideas will give them to us. How we 
can get at the abusers without extending the long arm of the 
IRS into everybody's business?
    It just points up to me, once again, as almost every panel 
and witness has pointed up to me, we will never fix the income 
tax. Income is such a gray area, by definition, that we will 
never fix it. We will keep trying and trying and trying. I hope 
I can win more converts to getting rid of it completely and 
totally, and getting to a specific form of taxation rather than 
a gray area form of taxation.
    I thank you for your contribution. I think we will be ready 
now for the next panel.
    Our next panel will include Michael Marvin, Delores ``Dee'' 
Thomas, Eldred Hill, Gery Chico, and Rene Bouchard. The Chair 
would invite all of our guests to cease chatter so we can 
continue with our last panel.
    Our first witness will be Michael Marvin. Once again, we 
hope you can keep your verbal presentation to 5 minutes or 
less. Your entire written statement, without objection, will be 
included in the record, as will all of the statements for all 
of the witnesses on the panel.
    With that, if you will identify yourself for the record, 
you may proceed.

   STATEMENT OF MICHAEL MARVIN, EXECUTIVE DIRECTOR, BUSINESS 
                 COUNCIL FOR SUSTAINABLE ENERGY

    Mr. Marvin. Thank you, Mr. Chairman. I am Michael Marvin, 
the executive directive of the Business Council for Sustainable 
Energy. It is a pleasure to appear before this Committee to 
present the Council's perspective on proposed tax incentives 
for clean energy technologies.
    The Council was created in 1992 by energy executives who 
were concerned about the economic, national security, and 
environmental ramifications of our Nation's energy policies. 
Our membership ranges from large multinational corporations, to 
smaller companies, to national trade groups. The administration 
has introduced tax legislation providing incentives for the 
purchase or development of clean energy technologies. 
Separately, other Members of this Committee, Mr. Matsui, Mr. 
Thomas, and many others have introduced some similar provisions 
to the administration's package.
    The administration's initiative is incorporated within the 
so-called Climate Change Technology Initiative, which is a 5-
year $3.6 billion package that addresses a range of 
technologies across the utility, housing, and transportation 
sectors. This is a modest package of incentives that moves us 
toward becoming a more efficient economy. I would like to 
highlight briefly a few incentives I believe are indicative of 
the goals that the administration is trying to achieve.
    To encourage the purchase of efficient homes, families 
would receive a $1,000 to $2,000 tax credit for the purchase of 
homes substantially above energy code. While the 
administration's provision represents a strong start, we 
believe the legislation introduced last Congress by 
Representative Thomas is even more persuasive. Mr. Thomas' 
legislation would expand that credit to include significantly 
retrofitted existing homes, and make other technical changes 
that will make this work better in the real world marketplace. 
The Thomas legislation has been endorsed by organizations 
ranging from the National Association of Home Builders to the 
Alliance to Save Energy.
    To promote renewable energy development, the package 
includes a 5-year extension of the wind and biomass production 
tax credit. Legislation has been sponsored by a majority of 
Democrats and Republicans on this Committee to continue that 
for 5 years. In particular, Congressmen Thomas, Matsui, and 
McDermott have led that charge. It provides a modest incentive 
for the purchase of solar rooftop power systems, and creates 
short-term incentives for many other energy technologies such 
as natural gas water heaters, heat pumps, advanced central air 
conditioners, and combined heat and power.
    I want to underscore what I think are two important 
characteristics of this package. First, every provision has a 
cap on the maximum amount of credit a consumer could receive, 
usually between $1,000 and $4,000. Second, each credit sunsets 
within 3 to 6 years, giving this Committee greater control over 
energy tax policy.
    We believe these provisions make sense, whether you believe 
the climate is the most compelling threat to our society or 
whether you believe it lacks scientific merit. Regardless of 
climate change, there are concerns about energy independence, 
about local and regional air pollution, about diversification 
of the Nation's fuel supply, about helping U.S. business thrive 
in the increasingly competitive global marketplace. The fact 
that climate change has become so talked about in terms of 
energy and environmental policy does not minimize the 
importance of these other issues.
    The Council believes that the key to greater market 
penetration and more effective, more efficient technologies is 
accelerated capital stock turnover. How do we encourage 
businesses and consumers to replace equipment like clothes 
washers, automobiles, and heat pumps, with more efficient and 
cleaner alternatives, when the up front costs of that equipment 
may be slightly higher than less efficient equipment?
    Let me offer an example that is not covered by this 
package. Maytag recently developed a clothes washer that uses 
about 48 percent less water, and up to 70 percent less energy, 
but that machine costs more than does the average washer. By 
implementing a tax measure that reduces the up front cost to 
the consumer, a number of important objectives can be 
accomplished. Consumers get the value of higher efficiency 
equipment. Consumers save money. The environment benefits from 
reduced energy and water consumption. By increasing the 
efficiency of the products, U.S. companies stand to gain a 
larger share of rapidly expanding export markets.
    According to the U.S. Energy Information Administration, 60 
percent of the greenhouse gases that this country is expected 
to emit in the year 2010 will be emitted from products that 
have not yet been purchased. If we have to set and achieve any 
significant national goals of carbon emissions without command 
and control regulation, it is this 60 percent that this 
Committee can affect. Incentivizing, not requiring companies to 
increase efficiency, is a necessary first step.
    Now it is important that we be honest here and recognize 
that a $700 million per year tax package in the energy world, 
while not insignificant, pales in comparison to the roughly 
$280 billion that we spend in natural gas and electricity each 
year. Key opportunities were missed in this package. For 
natural gas vehicles, other appliances, insulation, and even 
outdoor power equipment, short-term tax credits can help move 
companies in a direction that benefits consumers, the economy, 
and the environment. In other words, the markets for these 
products can be influenced by tax policy without government 
picking winners.
    Thank you again for your time. The Council and its members 
want to continue working with the Committee to ensure the voice 
of business is heard in this debate.
    [The prepared statement follows:]

Statement of Michael Marvin, Executive Director, Business Council for 
Sustainable Energy

    The Business Council for Sustainable Energy is pleased to 
offer testimony to the House Ways and Means Committee on the 
Administration's proposed FY 2000 tax incentives to encourage 
the expanded use of clean energy technologies throughout the 
nation.
    The Council was formed in 1992 and is comprised of 
businesses and industry trade associations which share a 
commitment to pursue an energy path designed to realize our 
nation's economic, environmental and national security goals 
through the rapid deployment of efficient, low-and non-
polluting natural gas, energy efficiency, and renewable energy 
technologies. Our members range from Fortune 500 enterprises to 
small entrepreneurial companies, to national trade 
associations.
    Few activities have a greater impact on our nation's 
economy, environment, and national security than the production 
and use of energy. Our economic well-being depends on energy 
expenditures, which account for approximately 7 to 8 percent of 
the nation's gross domestic product and a similar fraction of 
that value in U.S. and world trade. Energy production and use 
also account for a large share of environmental problems, such 
as regional smog, acid rain, and the accumulation of greenhouse 
gases in the atmosphere. Finally, our national security is 
increasingly linked to energy production and use, given our 
nation's increasing dependence on foreign oil sources, 
including those from the politically unstable Middle East.
    To expand the nation's portfolio of energy resources, the 
Council has worked with this Administration as well as many 
Members of Congress to promote tax incentives for clean energy 
technologies. Strong leadership has come from this Committee in 
the past as well, including Rep. Bob Matsui, who introduced 
legislation similar to the Administration's Clean Energy tax 
package in the 105th Congress, and Rep. Bill Thomas, a long-
time leader for energy efficiency in homes and renewable energy 
development.
    In commenting on the Administration's package, the Council 
has identified a number of key areas that the FY 2000 budget 
addresses (as well as some that are not included). We urge this 
Committee to give the following provisions every consideration.

                         Energy Efficient Homes

Provide a Flat $2,000 Credit

    The BCSE supports the adoption of a flat $2,000 credit 
which will ensure that all homes will be constructed or 
renovated to be energy efficient, not merely the most expensive 
models. With implementation of this credit, builders will have 
an incentive to construct modestly-priced, energy efficient 
homes and low and middle-income homeowners will be encouraged 
to renovate their homes with new energy efficient technologies.

Offer New Home Credit to the Home Builder

    Rather than provide an incentive directly to the new home 
buyer, the Council supports a flat $2,000 tax credit for the 
new home builder, who can pass it along to the buyer at 
closing. A tax credit to the builder will encourage the 
construction of a large number of new energy efficient homes, 
which will expand the percentage of energy efficient homes in 
the marketplace, thereby stimulating additional builder and 
consumer interest in these dwellings. A credit for the home 
builder will also reduce the financial burden of using existing 
technology to increase energy efficiency.

Offer Existing Home Credit to the Home Owner

    The Council supports a tax credit for the owner of existing 
homes that have been upgraded by the home owner to be 30 
percent or more efficient than the IECC. To achieve a 30 
percent increase in energy efficiency will require a major 
effort by the homeowner, and the $2,000 credit will only cover 
a small percentage of the marginal cost of upgrading home 
energy efficiency, relative to the new home credit.

Employ 1998 International Energy Conservation Code

    Instead of relying on the 1993 Model Energy Code as a 
measure of energy efficiency, the Council supports the 1998 
IECC, given this measure's accuracy in accounting for the 
impact of seasonal and climatic variations on energy 
efficiency. This reduces the likelihood that one region of the 
country will have an advantage in the measurement of energy 
efficiency. The BCSE also supports other conservation tools 
which use total energy efficiency analysis.

Utilize Systems of Energy Efficient Technologies

    Rather than provide incentives for specific technologies 
within new and existing energy efficient homes, the BCSE 
recognizes that a wide array of energy efficient natural gas, 
windows, insulation, lighting, geothermal, and photovoltaic 
technologies can be used in concert to enable new and existing 
homes to be 30 percent more efficient than the IECC. Examples 
of energy efficient technologies which could be used to achieve 
the 30 percent standard could include advanced natural gas 
water heaters, heat pumps, furnaces and cooling equipment, 
fiber glass, rock wool, slag wool and polyisocyanurate 
insulation, energy efficient exterior windows, geothermal heat 
pumps, and fluorescent and outdoor solar lighting.

                  Energy Efficient Building Equipment

    The BCSE is pleased with the Administration's proposal 
which provides a 20 percent tax credit for fuel cells, natural 
gas heat pumps, high efficiency central air conditioners, and 
advanced natural gas water heaters (subject to a cap). However, 
the Council recognizes the need for incentives for energy 
efficient building technologies to be broadened for the benefit 
of consumers and the environment. The BCSE recommends 
consideration of a 20 percent tax credit for advanced natural 
gas water heaters with an energy factor (EF) of .65, a 20 
percent tax credit for natural gas cooling equipment with a 
coefficient of performance of .6, and a 20 percent tax credit 
for advanced natural gas furnaces with an annual fuel 
utilization efficiency of 95 percent. Given the significant 
reduction in greenhouse gas emissions which can be achieved 
through the expanded use of small-scale distributed generation 
technologies, the BCSE supports a 20 percent tax credit for all 
fuel cells, regardless of their minimum generating capacity. 
Other technologies which could be included in a broadened tax 
incentive package include variable frequency drives and motors, 
building automation systems, and compressed air systems.

                       Alternative Fuel Vehicles

    While the BCSE recognizes the Administration's efforts to 
provide tax incentives to encourage consumer demand for 
vehicles with two and three times the base fuel economy of 
vehicles on the road today, we are concerned that it has not 
provided an incentive for natural gas vehicle (NGV) technology. 
While NGVs are more expensive than gasoline and diesel 
vehicles, these technologies reduce CO2 emissions by 
30 percent below that of gasoline vehicles currently on the 
road. The BCSE supports a 50 cent per gallon income tax credit 
for each ``gasoline gallon equivalent'' of compressed natural 
gas, liquified natural gas, liquified petroleum gas, and any 
liquid with at least 85 percent methanol content used in a 
newly purchased alternative-fueled vehicle which meets 
applicable federal or state emissions standards. These tax 
incentives will increase demand for clean fuel vehicles, 
especially in fleet markets, accelerate production of NGVs, and 
lower the initial purchase cost of the technology.

                              Wind Energy

    The BCSE supports the Administration's proposal to provide 
a straight 5-year extension (through July 1, 2004) of the 
existing wind energy production tax credit (PTC) provision 
providing a 1.5 cent per kilowatt hour tax credit (adjusted for 
inflation) for electricity generated by wind energy. An 
extension of the current credit prior to its expiration on June 
30, 1999 will stimulate investments and current project 
planning that are now threatened due to the uncertainty 
surrounding the PTC's extension. In addition to the 
Administration's proposal, legislation was introduced during 
the 105th Congress (H.R. 1401/S. 1459) to provide a 5 year 
extension for the wind energy PTC. The Council also supports a 
30 percent tax credit for small wind turbines with generating 
capacities of 50 kilowatts or less. (H.R. 2902) which was 
introduced during the 105th Congress. The goal of the new 
program is to stimulate the U.S. domestic market, increase 
production volumes and reduce production costs. Growing export 
markets for small wind turbines provide effective leverage of 
the federal investment in job creation.

                                Biomass

    The BCSE supports the expansion of the biomass energy PTC 
from its current ``closed loop'' definition to include a 1.5 
cent per kilowatt hour tax credit for electricity produced from 
landfill gas, wood waste, agricultural residue, and municipal 
solid waste. In addition to offsetting greenhouse gas 
emissions, the use of biomass energy can address problems of 
landfill overcapacity, forest fires, and watershed 
contamination.

                    Combined Heat and Power Systems

    The following points should be added to the 
Administration's proposed investment tax credit for combined 
heat and power systems.
    ``The proposed definition of a qualified CHP system in the 
Administration's proposal is equipment used in the simultaneous 
or sequential production of electricity, thermal energy 
(including heating and cooling and/or mechanical power) and 
mechanical power.''
    Language in the current proposal could be construed to 
limit the credit solely to those taxpayers that produce 
mechanical power in conjunction with electric or thermal energy 
production. In addition, specificity is needed as to what 
``equipment'' is included in the CHP definition. A better 
definition of a qualified CHP system is: equipment and related 
facilities used in the sequential production of electricity 
and/or mechanical power and thermal energy (including heating 
and cooling). Eligible equipment shall include all necessary 
and integral to the CHP process including prime movers 
(turbines, engines, boilers), heat recovery boilers, air and 
water filtration, pollution and noise control, and paralleling 
switchgear but may exclude buildings, fuel handling and storage 
and electrical transmission.''
    Items such as thermal insulation, controls, and steam traps 
should be included within tax incentives for CHP systems. Tax 
credits instituted from a systems standpoint will enhance the 
overall efficiency of CHP technologies.
    BCSE supports the addition of language concerning thermal 
distributing networks to the CHP investment tax credit:
    Distribution piping used to transport thermal energy 
including steam, hot water and/or chilled water as well as 
condensate return systems shall be included as part of a 
qualifying CHP system. Thermal distribution systems added to 
existing electricity-only energy facilities which then meet the 
definition of CHP facilities shall be eligible for the tax 
credit.
    Furthermore, the BCSE supports the addition of the 
following language concerning backpressure steam turbines to 
the CHP investment tax credit:
    ``Backpressure steam turbines can be highly efficient 
generators of electricity and thermal energy. When used in 
distributed thermal energy systems to replace pressure reducing 
valves these turbines convert higher pressure thermal energy 
into lower pressure thermal energy along with electricity. 
Backpressure steam turbines with a capacity of between 50 kw 
and 3000 kw that reduce steam pressure and generate electricity 
qualify for the CHP Investment Tax Credit.

                         White Good Appliances

    The BCSE supports a 25 percent tax credit for the purchase 
of Energy-Star-certified white good appliances. Such 
a credit would give consumers an incentive to purchase the 
highest efficiency appliances, expanding the market for the 
technologies, and encouraging the manufacturer participation in 
this voluntary program. At a minimum, the Council would urge 
the Administration to adopt credits for the most energy 
efficient clothes washers and refrigerators which are in the 
market today.

                          Residential Biomass

    Fuel pellets are a residential biomass technology used to 
heat residences throughout the U.S. The BCSE supports a 15 
percent tax credit for fuel pellets used for residential home 
heaters and a 20 percent tax credit for fuel pellets used in 
residential and commercial water heaters, a market which is not 
as mature as the market for residential home heaters.

                      Research and Experimentation

    The BCSE supports a permanent extension of the research and 
experimentation (R&E) tax credit. In response to a request by 
Council member Gas Research Institute, the Policy Economics 
Group of KPMG Peat Marwick examined the most recent economic 
evidence and official IRS statistical information to determine 
whether a permanent extension of the R&E tax credit was 
warranted. Conclusions were that the credit's effectiveness 
warranted a permanent extension, which may improve its 
effectiveness. The current short-term approach to subsidizing 
long-lasting research and development investments imposes 
unnecessary additional risks on R&D-performing companies, and 
does not best serve the country's long-term economic interests.

                     Residential Solar Technologies

    The BCSE supports a tax credit equal to 15 percent of a 
qualified investment for neighborhood solar systems which 
enable energy consumers within multifamily dwellings, rented 
housing, and homes with roofs not suitable for direct 
photovoltaic (PV) installation to heat and cool their homes. 
The inclusion of tax incentives for neighborhood solar systems 
will reduce the cost of these investments while reducing 
overall greenhouse gas emissions. The Council also recommends a 
flat $400 credit for residential solar water heating or space 
heating systems certified by the Solar Rating and Certification 
Corporation or comparable agency. The credit could be added to 
the Administration's hot water efficiency credit. The BCSE also 
supports a $100 tax credit for pool heaters for family 
households with income under $85,000 or single households with 
income under $65,000.

     Clean and Fuel Efficient Outdoor Power and Lighting Equipment

    BCSE supports a tax credit for the purchase of clean and 
fuel efficient outdoor power and lighting equipment used in 
residential, commercial, and industrial applications. The 
credit would equal 10 percent of the purchase price of outdoor 
power and lighting equipment. Outdoor power equipment that 
meets Environmental Protection Agency Tier II emissions 
standards prior to their implementation or effective dates 
would be eligible for this tax credit. The creation of an 
analogous tax credit for manufacturers of these technologies 
could also result in substantial fuel savings and other 
environmental benefits.

                               Conclusion

    The Council recognizes the leadership this Committee has 
shown in the past to promote incentives for clean energy 
technologies as well as the positive impact these provisions 
have had on our nation's economy, environment, and national 
security. We pledge to continue working with the Committee, the 
Congress, and the Administration to pursue comprehensive 
initiatives which will accelerate new developments in the way 
we produce, generate, and consume energy. Many of us in the 
business community are willing to stand behind comprehensive 
clean energy tax incentive proposals and those who support 
them.

Note: Where appropriate, the BCSE identifies legislation that 
was introduced in the 105th Congress which includes similar or 
identical language to that recommended here.
      

                                

    Chairman Archer. Thank you, Mr. Marvin.
    Ms. Thomas, if you will identify yourself for the record, 
you may proceed.
    Mrs. Thurman. Mr. Chairman
    Chairman Archer. Certainly, Mrs. Thurman.
    Mrs. Thurman. Thank you. Mr. Chairman, I actually would 
like to take an opportunity here to thank Ms. Thomas for being 
here. She actually is one of my constituents.
    Chairman Archer. I suspected that when you asked to be 
recognized.
    Mrs. Thurman. Yes. I kind of thought you might. I want you 
to know that she runs a 100-percent, employee-owned business. 
She has been very active. She is going to be the first woman to 
be the national president of the ESOP group. I think you are 
going to find her testimony dynamic, informative, and one that, 
as we heard the administration say this morning, for all of you 
actually that are sitting there, that they are listening and 
paying attention. So I just wanted to have this opportunity.
    I am really glad you are here, particularly when it's sunny 
and warm in Florida.
    Chairman Archer. We are happy to have you here. If you will 
identify yourself for the record, you may proceed.

STATEMENT OF DELORES L. ``DEE'' THOMAS, VICE PRESIDENT, EWING & 
 THOMAS, INC., NEW PORT RICHEY, AND SEBRING, FLORIDA, AND VICE 
       CHAIR, EMPLOYEE STOCK OWNERSHIP PLANS ASSOCIATION

    Ms. Thomas. Thank you, Chairman Archer. Thank you ladies 
and gentlemen, for the opportunity to speak with you today. My 
name is Dee Thomas. I am vice president of an independent 
physical therapy company located in New Port Richey and 
Sebring, Florida. Important for today's hearing is the fact 
that Ewing & Thomas is the only 100-percent, employee-owned 
physical therapy company in America through an ESOP, an 
employee stock ownership plan, and that is a sub S. Of our 45 
employees, 38 are employee-owners, owning 100 percent of our 
company. I testify today on behalf of those employee-owners, 
and on behalf of the ESOP Association. It has over 2,000 
members representing 1 million employee-owners in America.
    My purpose here today is to express my concern and 
opposition to the administration's proposal to repeal the 1997 
law which was designed to encourage the creation of employee-
ownership in S corporations, and in particular, those with high 
percentage ESOPs, such as my own company.
    Ewing & Thomas provides physical therapy services to a 
community in the second poorest district in Florida. Our 
industry is becoming increasingly controlled by large companies 
and megaconglomerates. Many of the small independents are 
either being sold or going out of business as a result of 
changes in the healthcare laws. The conscience of American 
healthcare is becoming an extinct species.
    I am convinced that Ewing & Thomas continues to survive in 
this ever-competitive environment because of our employee-
ownership culture and the current single tax status as a sub S 
ESOP. ESOP transactions have cost our little company great 
amounts of money because the ESOP laws are complex and we 
require a lot of lawyers and administrators to keep us straight 
and make sure that our employee-owners are all well protected.
    But ESOPs are more than laws and regulations. They are a 
way of life at Ewing & Thomas. We have employee-owners on all 
levels at our six-member board of directors. We have 
participation in decisionmaking at all levels with our ESOP 
Committee. We share and discuss all of our financial 
information. Our little company has paid for 10 needy employee-
owners to go to college so that they can be better employee-
owners and they can better our company.
    Each day, incredible unselfish acts are performed by this 
group of uncommon employee-owners. This past year during tough 
times, our higher paid salaries unanimously agreed to take a 
freeze on all of their wages and benefits so that our 
nonmanagement hourly people would not be laid off and would not 
lose their jobs. This is employee-ownership at its best. We are 
in this for the long haul.
    Your esteemed colleague, Congresswoman Karen Thurman, has 
visited our company and met with our employee-owners first 
hand. You can also take a minute and speak with Al Maxime and 
Gary Walz, who have traveled with me today. They each have 
their own special employee-ownership story.
    This Committee has to make a basic choice because this 
issue is not just about sub S ESOPs, but about your belief in 
the value of employee-ownership in America. You can reject the 
administration's proposal or you can modify it, and in so 
doing, stand with employee ownership. Or you can accept the 
proposal and in doing so, repudiate support for employee 
ownership, a message that will be heard by 1 million employee-
owners and 2.2 million sub S companies in this country.
    In simple language, my objections are: the retroactive 
clause applied to companies such as mine because our account 
balances would fall sharply. Number two, it is not rational to 
reverse something that is only 14 months old. Number three, the 
proposal is incredibly complex. What a bunch of gobbley-goop. 
No businessperson in their right mind would go into some kind 
of deal like this. The proposal by permitting a tax deduction 
for distribution for the ESOP against the UBIT is an incentive 
for the corporation to make distributions as rapidly as 
possible. This is not a sound way of saving.
    The proposal puts the S corporation with an ESOP at a 
distinct disadvantage to the C corporation with the ESOP. The S 
corporation will pay a much higher tax and without any ESOP 
incentive. This is a much bigger issue than the tax 
consequences of a sub S ESOP. It is about your stand for 
employee-ownership in America. It is about your belief in 
increasing the distribution of wealth in our country. It is 
about workers having a voice, respect, and dignity in the place 
that they work, and security for their retirement years. The 
100-percent, sub S ESOP companies are the best this country has 
to offer. We have done all the right things for all the right 
reasons, our employee-owners.
    Members of this Committee, we ask for your protection from 
this proposal. We are prepared to work with you and your staff 
to ensure the multitude of sub S companies the promise of 
employee-ownership. I urge you to allow us to work together to 
spread employee-ownership as a commonly accepted way of doing 
business as we enter the next century. I thank you all for 
letting this small company be heard. It's a great system that 
we have.
    [The prepared statement follows. Attachments are being 
retained in the Committee files.]

Statement of Delores L. ``Dee'' Thomas, Vice President, Ewing & Thomas, 
Inc., New Port Richey, and Sebring, Florida, and Vice Chair, Employee 
Stock Ownership Plans Association

    Thank you. My name is Delores L. ``Dee'' Thomas. I am Vice 
President of an independent physical therapy company, Ewing & 
Thomas, Inc. located in New Port Richey and Sebring, Florida.
    Important for today's hearing is the fact that Ewing & 
Thomas is the only physical therapy company in America 
operating as a 100% employee-owned company, through an employee 
stock ownership plan, or ESOP. Ewing & Thomas is also an S 
corporation. There are 38 employee owners at Ewing & Thomas, 
which is nearly all of our current employees.
    Today, I testify not only on behalf of the employee owners 
of Ewing & Thomas, but also for The ESOP Association, a 
national 501(c)(6) association with over 2000 members 
representing nearly1 million employee owners.
    My purpose is to express the ESOP community's opposition to 
the revenue raising proposal in the Administration's proposed 
budget to repeal a 1997 law that has proven to be a needed 
incentive for the creation and operation of companies which are 
100%, or near 100% employee-owned companies. The proposal is 
set forth on page 110 of the Treasury Department's so-called 
``Green Book'' describing the Administration's revenue raising 
proposals in the Fiscal Year 2000 budget.
    I ask your indulgence as I make a few general remarks. I do 
so because in the employee ownership world our focus is on the 
long-term, not the short-term.
    We believe that significant employee ownership does improve 
the performance of a corporation, and just as important does 
maximize human potential and self-dignity of all employees as 
they share in the wealth they help to create.
    Our beliefs are backed-up by solid evidence, such as a 
recent study by Dr. Melhad of Northwestern University's Kellogg 
of Business and Management, which reviewed the performance of 
over 400 companies over 4 years. Attachment 1 to this statement 
is a synopsis of the research conducted over the past 15 years 
that supports our beliefs.
    I am very active in The ESOP Association, nationally, and 
in our Florida Chapter. On May 1, I will become the Chair of 
the Association, our highest elected office.
    But clearly I can testify best about employee ownership 
through the experience as an executive of Ewing & Thomas.
    In 1987, Mrs. Ewing and I, who started our independent firm 
in 1969, faced the potential demise of our company, as Mrs. 
Ewing had reached an age where she did not want to practice 
each day, and I had a serious illness. We needed an exit 
strategy, but were afraid of what would happen to our employees 
and our community involvement if we sold out to a large 
national or regional chain. Fortunately, Congress has provided 
a wonderful alternative--selling to the ESOP for the benefit of 
the employees.
    Did we take advantage of the tax laws favoring exiting 
shareholders of closely-held companies? Yes, we did. Did we 
have to pay high fees to lawyers, valuators, administrators, 
and accountants to make the ESOP happen, so that the complex 
ESOP laws would be honored to protect the employees? Yes, we 
did.
    But let me emphasize, the ESOP is more than laws and 
regulations to our employees. It has become their way of life.
    For example:
     We have employee owners from all levels on our 
six-person Board of Directors.
     We have employee owners participating in decision-
making at all levels.
     We share and discuss all of our financial 
information with all employee owners.
     It was a joint decision that our company has sent 
ten needy employee owners to college to better themselves and 
our company.
     Each day incredible unselfish acts are performed 
by this group of employee owners.
     We all participate in state and local meetings 
where we share our ESOP experience and learn from other 
employee-owned companies.
    Attachments 2 are articles recognizing Ewing & Thomas as a 
special place to work.
    If you do not believe me, or the articles, ask your 
colleague Congresswoman Thurman, who has visited on several 
occasions with our employee owners.
    And if you don't believe me, Congresswoman Thurman, or the 
newspapers, ask Alphonso Maxime or Gary Walz, employee owners 
from Ewing & Thomas now standing. They will be more than 
willing to speak with you or your staff about employee 
ownership, and their experience at Ewing & Thomas.
    Is Ewing & Thomas unique? No.
    When I think of employee ownership I think of Bimba 
Manufacturing in Illinois; Reflexite in Connecticut; Austin 
Industries in Texas; Acadian Ambulance in Louisiana; the Braas 
Company in Minnesota; and the list goes on and on.
    Many members of this Committee know these companies and 
their employee owners up close and personal.
    This Committee has a basic choice.
    The Committee can accept the Administration's proposal, and 
take a stand to retard the expansion of employee ownership; or 
this Committee can reject, or significantly alter the 
Administration's proposal, and take a stand with the employee 
ownership community.
    Clearly, we must respond to the specific proposal from the 
Administration, and explain why its enactment would retard 
employee ownership growth; but keep in mind, if you want 
employee ownership to grow, as practiced in the companies I've 
cited, then you will discard the Administration's proposal.
    To summarize the Administration's proposal: The proposal is 
designed to raise taxes by imposing on an S corporation an 
unrelated business income tax, or UBIT, on the ESOP's share of 
the income of that corporation. The proposal goes on to provide 
that when the ESOP makes a distribution to an employee owner 
when he or she retires or leaves the company, the S corporation 
can take a tax deduction against the UBIT owed for the year in 
which the distribution is made.
    The proposal's effective date is meaningless as it is to 
apply to all S corporation ESOPs after enactment, and is to 
lower the tax deduction for distributions made by those 
companies who did not pay the UBIT between January 1, 1998, and 
the date when the new law is effective.
    Contrast this proposal with current law, which was adopted 
by Congress, and signed by President Clinton approximately 
fourteen months before the Administration proposed the drastic 
change summarized above. Current law provides that the ESOP's 
share of the S corporation's taxable income is deferred from 
current taxation until the ESOP makes distributions to the ESOP 
participants, who are in essence the shareholders of the S 
corporation.
    To understand the Administration's proposal fully requires 
some history.
    Shortly after the enactment of the Tax Reform Act of 1986, 
the ESOP community urged Congress to enact law to permit S 
corporations to sponsor employee ownership through ESOPs.
    Our efforts gained momentum in 1990 when your colleague 
Congressman Cass Ballenger introduced the ESOP Promotion Act of 
1990, which contained a section to permit ESOPs in S 
corporations. Similar legislation was introduced in each 
subsequent Congress, twice attracting over 100 co-sponsors. 
Each time, eight to ten members of the Ways and Means Committee 
were original co-sponsors of these pro-employee ownership 
bills.
    In 1996, our advocacy work began to payoff, as the Congress 
adopted a provision of the Small Business Jobs Protection Act 
of 1996, a law to permit an S corporations to sponsor an ESOP.
    Immediately, however, all realized that the 1996 law was 
fatally flawed. The major policy problem was the 1996 law was 
going to tax S corporation income twice if it had an ESOP, 
because it would have imposed the UBIT on the ESOP's share of 
the S corporation's taxable income, and a tax on the 
individuals receiving ESOP distributions.
    Groups led by representatives of S corporation groups urged 
the members of the tax committees to undo the double tax on the 
ESOP's share of the S corporation's income.
    And, at the same time, the ESOP community urged Congress to 
provide S corporations the same tax benefits for promoting 
employee ownership as available for C corporations, such as the 
deferral of the capital gains tax on the proceeds of sales of 
closely held stock to an ESOP under limited circumstances, 
deductible dividends paid on ESOP stock in certain 
circumstances, and the increase in the corporate tax deduction 
for contributions to an ESOP up to 25% of payroll, plus the 
interest on the loan used to acquire stock for the employees 
through an ESOP.
    So, as the work on the 1997 law known as the Taxpayer's 
Relief Act began, these points were being made to 
Congresspeople supportive of increasing employee ownership in 
America.
    First, in early summer 1997, this Committee adopted by 
voice vote Congresswoman Johnson's amendment to clean up some 
of the technical problems with the 1996 law.
    Then the Senate Finance Committee had to decide--how to 
encourage ESOPs in S corporations? Their decision was not to 
use the C corporation ESOP tax benefits in an S corporation, 
but to have a unique benefit, the deferral of tax on the ESOP's 
share of the corporation's taxable income until distributions 
to the employee owners.
    In making this decision, the Senate staff people did review 
a taxation scheme very similar to the one proposed in the 
Administration's Fiscal Year 2000 budget. It involved paying 
the UBIT on the ESOP's share of the S corporation's income, and 
then later providing a tax credit or tax deduction. But this 
scheme was rejected. The staff agreed that it was too 
confusing. They felt that the system would never be clearly 
understood, or work in the real world.
    How ironic that now the Administration makes a similar 
proposal, which was deemed too complex in 1997!
    In any event, the result in 1997 was a decision not to have 
the C corporation ESOP tax benefits available to an S 
corporation ESOP but to have the ESOP share of the taxable 
income of the S corporation subject to a deferred taxation when 
the beneficial shareholders of the S corporation, the employees 
got their money from the ESOP.
    A key point in all of this decision making is the clear-cut 
intent of the Senate to have an incentive for the creation and 
operation of ESOPs in S corporations. In fact, the proposal was 
scored as a near $400 million revenue drop over the 10 year 
period of the revenue estimates for the 1997 Taxpayer's Tax 
Relief Act.
    When this approach was proposed by ESOP supporters in the 
Senate, the ESOP community told key Congressional leaders that 
this approach was unique, and felt it to be a powerful 
incentive for the creation of 100% ESOP companies or near 100% 
ESOP companies operating S corporations.
    We were correct. Since the law became effective January 1, 
1998, we estimate approximately 75 to 100 of our Association's 
members have become 100% employee-owned S corporations through 
an ESOP. Some of these companies increased their employee 
ownership of their owner's share from less than 100% to 100%.
    Clearly in our minds this was the intent--the incentive of 
the law to increase the distribution of wealth in America.
    Is this a good policy? If you support employee ownership, 
the question becomes is it good employee ownership policy?
    Yes, if Congress wishes to have an incentive for 100% or 
near 100% employee ownership--a level of employee ownership 
that is rare in America, less than 500 companies, but a level 
that can be magical in creating an company culture where voices 
are heard and votes do count--a company like Ewing & Thomas.
    Why do large ESOPs, as measured by the size of the company 
owned by the employees need an incentive that is different from 
the C corporation ESOPs? Because the 100% ESOP company must 
have significant cash values as it reaches maturity--5, 10, 15, 
20, or more years of employee ownership in order to buy back 
the stock from departing employees with large accounts in the 
ESOP. We call this burden on ESOP companies our repurchase 
obligation, or repurchase liability. Obviously, the bigger 
share of the company owned by employees through the ESOP, and 
the older the ESOP becomes, the more money the company has to 
have to buy back stock from departing employee owners.
    All too often we see fine examples of ESOP companies, where 
employees are sharing substantially in the wealth they help 
create, abandon employee ownership due to this repurchase 
obligation issue, and the demands on cash. I cite AVIS and 
reference Attachment 3.
    The one level of tax on a 100% S corporation ESOP solves 
this problem due to the fact that the cash saved may be used to 
fund the repurchase of stock from departing employees.
    Finally, I cite the objections of The ESOP Association to 
the Administration's proposal.
    Objection One: By being retroactive, by applying to 
companies like mine that honestly relied on the law passed by 
Congress, and signed the by the President just fourteen months 
ago, the proposal pulls the rug out from under the employee 
owners of my company and others like us.
    Those in the Administration who came up with this proposal 
might think we were naive to believe that the law was for the 
benefit of companies like ours. Maybe they are laughing behind 
their backs at us. We may be naive, and not sophisticated to 
the cleaver nuances of how tax laws are made; but we do know 
when we are being treated unfairly, and we don't like it.
    Objection Two: It is not rational to reverse the 1997 
decision to encourage more employee ownership only fourteen 
months after the decision was made. As representatives of The 
ESOP Association told key Congressional decisionmakers in 1997, 
providing a deferral of the tax of the ESOP's share of the S 
corporation's taxable income would be a significant incentive 
to be a 100% ESOP company, like Ewing & Thomas believed. The 
law has worked just as predicted. Why get rid of this 
incentive?
    Objection Three: The Administration's proposal is, in 
essence, the same, impossible to administer scheme the 
Congressional staff experts declared incredibly complex in 
1997. My non-legal description of the proposal is as follows: 
The S corporations with an ESOP loans the Federal government 
money equal to the UBIT tax. Then, 5, 10, 15, 20, or even more 
years down the road, the Federal government pays back the loan 
in drips and drabs, in amounts related to distributions of ESOP 
accounts that will not have any relationship whatsoever to the 
amount of the UBIT paid in any one year.
    Objection Four: The proposal, by permitting a tax deduction 
for distributions from the ESOP against the current year UBIT 
owed by the S corporation is an incentive for the corporations 
to make distributions as rapidly as possible, or timed to 
profitable years. Thus the proposal is an incentive that is 
absolutely the opposite of good savings policy, where we want 
to keep in the money in the savings systems for retirement 
income security.
    Objection Five: The Administration's proposal puts the S 
corporation with an ESOP at a distinct disadvantage compared to 
a C corporation ESOP. If the proposal is the law, the S 
corporation ESOP, particularly those with 100% employee 
ownership, pays more taxes than C corporations, and have none 
of the special ESOP tax benefits, such as the ability of 
certain sellers to an ESOP to deferred the capital gains tax, 
deductible dividends paid on ESOP stock, and the higher 
percentage of payroll that can be contributed to a leveraged 
ESOP. These three are all available to the C corporation, but 
not the S corporation.
    This is a much bigger issue than the tax consequences of S 
Corporation ESOPs. It is about your stand for employee 
ownership in America. It is about your belief in increasing the 
distribution of wealth in this country, about workers having a 
voice, respect and dignity in the place that they work and 
security for their retirement years.
    The 100% S Corporation ESOP companies are the best this 
country has to offer--we have done all the right things, for 
all the right reasons--employee owners!
    Members of this committee we ask for your protection from 
this proposal. We are prepared to work with you and your staff 
to assure the multitude of S Corporation companies can meet the 
promise of employee ownership.
    I urge you to allow us to work together to spread employee 
ownership as a commonly accepted way of doing business as we 
enter the next century.
    Thank you for allowing this small company to be heard.
      

                                

    Chairman Archer. Ms. Thomas, that is what we are about, to 
hear from people large and small and across the board. Thank 
you for your testimony.
    Mr. Hill, if you will identify yourself for the record, you 
may proceed.

   STATEMENT OF J. ELDRED HILL III, PRESIDENT, UNEMPLOYMENT 
       INSURANCE INSTITUTE, SHEPHERDSTOWN, WEST VIRGINIA

    Mr. Hill. Yes, thank you, Mr. Chairman. My name is J. 
Eldred Hill III. I am the president of the Unemployment 
Insurance Institute. I thank you for this opportunity to 
testify regarding tax proposals in the President's fiscal year 
2000 budget, affecting the Nation's unemployment insurance 
system.
    The President's budget contains a proposal to accelerate 
the collections of FUTA, Federal Unemployment Tax Act of 1939, 
and State UI, Unemployment Insurance, taxes from quarterly to 
monthly beginning in the year 2005. It would require every 
employer whose FUTA liability in the immediately preceding year 
was $1,100 or more to compute and pay both FUTA and State UI 
taxes 12 times a year. Although this proposal in theory would 
only affect businesses not classified as small under Federal 
law, in practice, this proposal would also affect small 
businesses which rely primarily on part-time workers, small 
employers experiencing employee turnover beyond their control, 
and small employers who provide summer jobs for youth.
    This proposal, quite frankly, is a budget gimmick, which 
would allow the administration to count two extra months of 
FUTA collections as fiscal year 2005 revenue, producing a one-
time artificial budget gain of an estimated $1.2 billion. 
Accelerated collections would not raise a nickel in new 
revenue. Monthly collections would triple the paperwork and 
other employer compliance costs forever. In addition, it would 
triple the collection workload on the State employment security 
agencies, increasing costs, and taking precious staff time away 
from their primary responsibilities, of providing the 
unemployed with benefits and jobs.
    Mr. Chairman, unemployment contributes to a number of 
social ills, including depression, alcohol and drug abuse, 
domestic violence, repossessions, foreclosures, and evictions. 
These real-world costs are not on a budget line. Yet under the 
President's proposal, the Nation's unemployed could expect 
reduced services as limited staff resources are used for more 
frequent collections.
    The President's budget also contains proposals which would 
charge new fees to employers who request certification under 
both the Work Opportunity Tax Credit, and the Welfare-to-Work 
Tax Credit. Both of these Federal programs were designed to 
encourage employers to hire targeted workers, and it would be 
counterproductive to reduce those incentives.
    We have heard a good bit today here about fees that are 
included in the President's budget. Though these fees are 
innocuous on the surface, certification costs are incidental to 
these fees. The new fees are designed to be artificially high 
and the additional revenue generated would be used for the 
administration of the unemployment insurance system and the 
employment service. These fees would be collected and spent at 
the State level. The President's budget projects these fees to 
generate $20 million per year, and upon enactment would cut 
Federal appropriations for the administration of State UI and 
ES programs by a corresponding $20 million.
    These new fees are in effect a new FUTA surcharge. The 
Nation's employers are already paying FUTA taxes which are more 
than adequate to fund the administration of the UI and ES 
systems. In 1997, Congress passed the Taxpayer Relief Act, 
extending the unnecessary and so-called temporary 0.2 FUTA 
surcharge for 9 years.
    According to the President's budget, the Federal 
administrative account, extended benefit account, and loan 
account, will have combined statutory excesses of $5.68 billion 
in fiscal year 2003, and $3.93 billion in fiscal year 2004. 
Still, States on average see only 52 percent of dedicated FUTA 
taxes returned for the administration of these programs. 
Employers in 20 States also pay an additional State 
administrative surcharge, which diverts revenues from the 
benefit funds.
    Mr. Chairman, in an era when we are engaged in public 
debate over the budget surplus, it would be unfair for Congress 
to allow employers to be further burdened with new, unneeded 
FUTA surcharges or monthly collection.
    Mr. Chairman, I appreciate this opportunity to appear 
before the Committee. I would be happy to answer any questions 
you or your colleagues may have. Thank you.
    [The prepared statement follows:]

Statement of J. Eldred Hill III, President, Unemployment Insurance 
Institute, Shepherdstown, West Virginia

    Mr. Chairman and Members of the Committee:
    Thank you for the opportunity to testify regarding the tax 
proposals in the President's FY 2000 budget affecting the 
nation's unemployment insurance system.
    The President's FY 2000 budget contains a proposal to 
accelerate collections of FUTA and state UI taxes from 
quarterly to monthly beginning in 2005. It would require every 
employer who's FUTA liability in the immediately preceding year 
was $1,100 or more to compute and pay both FUTA and state UI 
taxes 12 times a year. Although this proposal in theory would 
only affect businesses not classified as ``small'' under 
federal law; in practice this proposal would also affect small 
businesses which rely primarily on part-time workers, small 
employers experiencing employee turnover beyond their control, 
and small employers who provide summer jobs for youth.
    This proposal is a budget gimmick which would allow the 
Administration to count 2 extra months of FUTA collections as 
FY 2005 revenue, producing a one time artificial budget gain of 
an estimated $1.2 billion. Accelerated collections would not 
raise a nickel in new revenue.
    Monthly collections would triple the paperwork and other 
employer compliance costs forever. In addition it would triple 
the collection workload on the State Employment Security 
Agencies, increasing costs, and taking precious staff time away 
from their primary responsibilities of providing the unemployed 
with benefits and jobs. Unemployment contributes to a number of 
social ills, including depression, alcohol and drug abuse, 
domestic violence, repossessions, foreclosures, and evictions. 
These real world costs are not on a budget line, yet under the 
President's proposal, the nation's unemployed could expect 
reduced services as limited staff resources are used for more 
frequent collections.
    The President's budget also contains proposals which would 
charge new fees to employers who request certification under 
the Work Opportunity Tax Credit and the Welfare-to-Work Tax 
Credit. Both of these federal programs were designed to 
encourage employers to hire targeted workers, and it would be 
counterproductive to reduce those incentives. The proposal also 
includes similar fees for employers of alien workers. Though 
innocuous on the surface, certification costs are incidental to 
these fees. The new fees are designed to be artificially high, 
and the additional revenue generated would be used for 
administration of unemployment insurance (UI) and the 
employment service (ES). These fees would be collected and 
spent at the state level. The President's budget projects these 
fees to generate $20 million per year, and upon enactment would 
cut federal appropriations for the administration of state UI 
and ES programs by a corresponding $20 million.
    These new ``fees'' are in effect a new FUTA surcharge. The 
nation's employers are already paying FUTA taxes which are more 
than adequate to fund the administration of the UI and ES 
systems. In 1997 Congress passed The Taxpayer Relief Act 
extending the unnecessary 0.2% FUTA Surcharge for nine years. 
According to the President's budget, the federal administrative 
account (ESAA), extended benefit account (EUCA), and loan 
account (FUA) will have statutory excesses of $5.68 billion in 
FY 2003 and $3.93 billion in FY 2004. Still, states on average 
see only 52% of dedicated FUTA taxes returned for the 
administration of these programs. Employers in 20 states also 
pay an additional state administrative surcharge which diverts 
revenues from benefit funds. Mr. Chairman, in an era when we 
are engaged in public debate over the budget surplus, it would 
be unfair for Congress to allow employers to be further 
burdened with new unneeded FUTA charges or monthly taxation.
    Mr. Chairman, I appreciate this opportunity to appear 
before this committee. I would be happy to answer any questions 
you or your colleagues might have.
      

                                

    Chairman Archer. Thank you, Mr. Hill.
    I am told that our next witness is to be introduced by one 
of our colleagues, the gentleman from Illinois, Mr. 
Blagojevich.
    Mr. Blagojevich. Thank you very much, Mr. Chairman. I will 
be very brief.
    A little over 10 years ago, Bill Bennett, who was then the 
Secretary of Education under President Reagan, came to Chicago 
and declared our school system the worst school system in the 
country. A little over 10 years later, under the leadership of 
our mayor, Mayor Daley, and under the leadership of our 
president of the Chicago School Reform board of trustees, Gery 
Chico, the Chicago public schools' success at school reform is 
being held as a national model, and most recently was spoken of 
by President Clinton in his State of the Union Address.
    As a product of the public schools, I am proud today to 
introduce the chief executive officer of the Chicago public 
schools, Gery Chico, and let him tell this Committee about some 
of the innovative things that the school board has performed in 
our city and for our schools over the last 3 to 5 years. Gery?
    Thank you, Mr. Chairman.
    Chairman Archer. Thank you, Congressman Blagojevich.
    Mr. Chico, you have already been identified for the record, 
so you may proceed.

STATEMENT OF GERY CHICO, PRESIDENT, CHICAGO SCHOOL REFORM BOARD 
                          OF TRUSTEES

    Mr. Chico. Thank you, Mr. Chairman. I would like to thank 
you for the opportunity to speak about an issue that is near 
and dear to my heart and a lot of people in Chicago, and that 
is the need to rebuild our school facilities. I would like to 
thank Speaker Hastert and Congressman Rangel, who we had the 
pleasure of meeting with this morning as a courtesy call to 
explain our positions, and now to give the Committee our 
position on this issue.
    Since 1995, Chicago has committed nearly $2 billion from 
local funds to improve our school facilities. We are doing our 
part, but we think we need partners at the Federal level to 
help us meet the continuing need, Mr. Chairman, which 
conservatively is put at about another $1.5 billion just for 
Chicago alone. The fact is, improving the learning environment 
improves performance. A litany of studies shows that, although 
I don't think you need studies to know that.
    When kids are in overcrowded classrooms, or taking class in 
hallways and basements, they figure school isn't important. In 
1998, the report card on America's infrastructure, issued by 
the American Society of Civil Engineers, Mr. Chairman, gave 
schools an ``F'', being the only category of infrastructure 
with an ``F'' rating. Roads, bridges, mass transit, aviation, 
and others came in substantially higher. We can't afford to 
send that message to our children.
    In thinking about the proposals before the Committee I want 
to emphasize what I think are four basic characteristics that 
any plan that the Committee would adopt should have, so that we 
can get the help we need. One, simplicity. Two, flexibility. 
Three, the plan ought to be substantial. Four, we need 
immediate help.
    If it is not a simple plan, it creates a lot of paperwork 
which eats up time and money. If it is not flexible, it will 
dictate terms rather than support us, and that is not 
appropriate in our view. If it is not substantial, it is really 
not very relevant. There is an estimated $200 billion in school 
infrastructure needs nationwide. We need a real commitment, not 
token help. If it's not immediate, it is also not very relevant 
to us because every year we delay, it deprives our children of 
the education that we think they need and that we think that 
they need today.
    Before the Committee are two proposals. One plan has an 
arbitrate component, that allows school districts to borrow 
money and invest it for up to 4 years now instead of 2 years, 
and use the extra interest earned toward school construction or 
improvements. Our concerns are that this plan does not provide 
enough money to make an impact, at least in Chicago's view, nor 
does it provide the money right away.
    In Chicago, we have issued four bond issues over the last 4 
years to create that $2 billion. Only one of those four bond 
issues would we have seen a positive arbitrage of one-tenth of 
1 percent. In fact, the last bond issue that we saw just 2 
weeks ago, we pay an interest rate of 5.17 percent and reinvest 
at 4.85 percent, for negative arbitrage. It also doesn't work 
for Chicago because we spend our money as soon as we get it, 
Mr. Chairman. We can not afford the luxury of waiting 1 year, 2 
years, or 3 years because people expect us to act and act 
quickly.
    The other plan advanced by the Clinton administration and 
Vice President Gore and Congressman Rangel creates new school 
modernization bonds, both of which rely on tax credits. It will 
offer up to $25 billion in bonding authority to school 
districts around the country. From our standpoint, this is a 
solid plan for the reason that it provides us substantial 
relief. In the case of Chicago, we figure that we could issue 
$670 million in bonds and save $333 million in interest 
payments. We think that is real help.
    The Federal Government would even be more effective if they 
would extend the payback period beyond the proposed 15 years in 
the proposal before the Committee because the principle-only 
payment for such a short term of 15 years is virtually the same 
or close to the payments of principle and interest over 30 
years.
    The plan also calls for the Department of Education to sign 
off on individual capital plans. We think, however, that the 
Department's role should be limited to receiving descriptions 
of capital plans and annual reports, and nothing more.
    Unlike the school modernization bonds, the use of the 
qualified zone academy bonds requires a substantial business 
contribution. Unless Congress adjusts the proposal, to offer 
business a significant incentive to make this investment, many 
smaller local school districts won't be able to access the 
program. For example, we are using this qualified academy zone 
bond now for the second time. We have had to pull in five 
surrounding districts to Chicago: Elgin, Aurora, DeKalb, 
Mendota, and East St. Louis, to help them access this bond 
issue, because otherwise they can't come up with the local 
private sector match of 10 percent. It is just too much for 
those districts.
    We understand there is also a plan in front of the Senate 
to enable private investors to fund school construction by 
offering investors significant depreciation incentives along 
with favorable tax-exempt financing. This concept works only if 
the buildings remain free from real property taxation at the 
local level. Congress should allow the school districts to 
maintain title and allow the tax benefit to go to the private 
investor if it goes down this road.
    I have offered more detailed explanation of our 
observations here in my written testimony. In the space of 5 
minutes, I don't think we can--I won't revisit the 
philosophical debate over whether the Federal Government has a 
role to help us in education, but I will just repeat what I 
said 6 weeks ago in front of Chairman Goodling's Committee. 
That is, I think we need to make school construction a national 
priority. We simply can't do it by ourselves any more. We have 
been pretty aggressive about it at the local level. We really 
need the Federal Government's help. I would like to thank the 
Committee for hearing my testimony.
    [The prepared statement follows:]

Statement of Gery Chico, President, Chicago School Reform Board of 
Trustees

    Mr. Chairman and Members of the Committee:
    Thank you for the opportunity to address you on the issue 
of how the federal government can play a role in rebuilding 
America's schools.
    I want to begin by thanking Speaker Denny Hastert who 
recently visited our schools. We shared with him our progress 
in improving performance and reforming a system once considered 
one of the worst in the nation. Today, we've been called a 
national model of reform.
    I also want to thank Congressman Charles Rangel--who 
created the Qualified Zone Academy Bonds.
    Chicago was the first school district in the nation to use 
the bonds. We're using the money to build the city's first 
JROTC academy--at the site of the former home of the leading 
African-American military regiment on Chicago's south side.
    Thank you Congressman Rangel and the entire committee.
    I also want to thank Congressman Rod Blagojevich for making 
school construction an important issue. Although he's not on 
the committee, he's been a strong voice for us.
    Finally, I want to thank President Clinton and Vice-
President Gore for giving attention to this vitally important 
issue.
    Two years ago, the president came to Chicago and met Mayor 
Daley and me and several others and we outlined the scope of 
the infrastructure needs in our schools and the local 
commitment we have made.
    Since 1995, Chicago has committed close to $2 billion in 
primarily local funding for 575 separate projects at 371 
schools. That money has built 8 new schools and 48 additions or 
annexes, adding 632 new classrooms to the district, which 
serves 430,000 school children.
    But more needs to be done, and Chicago cannot do it all 
alone. We're doing our part, but we need partners at the 
federal level to meet all the needs.
    We've conservatively identified another $1.5 billion in 
additional improvements needed before we can say that our 
schools are truly the kinds of learning environments that we 
know will make a difference.
    The fact is, improving the learning environment improves 
performance. When kids are in crumbling school buildings with 
outdated equipment, they're getting the message that education 
isn't important.
    When they're in overcrowded classrooms or taking class in 
hallways or basements because the classrooms are full--they 
figure school isn't important.
    We can't afford to send that message to our children. We're 
entering a new century. Every forward-thinking industry knows 
they can pack up and move anywhere on earth and conduct their 
business.
    If we want them to stay here and invest in America, we have 
to give them a workforce that can deliver--in Chicago and in 
schools throughout the nation.
    The fact is, every school district needs help. Last year, 
during the Rebuild America's Schools Campaign, we generated 
83,000 letters of support from districts all across Illinois, 
and they all said they needed federal help to rebuild their 
schools.
    In thinking about the plans under consideration, I want to 
emphasize four basic characteristics of a good school 
modernization funding plan: simple, flexible, substantial and 
immediate.
    If it's not simple it creates a lot of paperwork, which 
eats up time and money and doesn't build or modernize schools.
    If it's not flexible, it won't help everyone do what they 
want to do; it will dictate rather than support--and that's not 
appropriate.
    If it's not substantial, it's irrelevant. There's an 
estimated $200 billion in needs nationwide. We need a real 
commitment--not a token gesture.
    And if it's not immediate, it's also irrelevant. The 
challenge is to do the right thing today--not years from now. 
Every year our children move another grade. Every year we delay 
deprives our children of the education they deserve--and need.
    Before the committee are two proposals and I want to 
briefly offer our observations and recommendations. Obviously, 
we will work with you under any circumstances because the need 
is so great.
    One plan has an arbitrage component that essentially allows 
school districts to borrow money as they currently do, but 
invest that money for up to four years--instead of just two--
and then use the extra interest earned toward school 
improvements.
    Our concerns are that this ultimately does not provide 
enough money to make an impact--nor does it provide any money 
right away. In Chicago, only one of the four bond issues we 
have done since 1996 had positive arbitrage and the earnings 
were negligible--one-tenth of one percent per annum.
    It also doesn't work for Chicago because we spend our money 
as soon as we get it--and most other districts are in the same 
position. So this arbitrage plan is neither substantial nor 
immediate.
    The other plan, advanced by the President, expands on the 
QZAB program and creates new school modernization bonds, both 
of which rely on tax credits. It will offer up to $25 billion 
in bonding authority to school districts around the country.
    From Chicago's standpoint, this is a good plan because it's 
interest-free subsidy really adds up.
    We estimate that the President's school modernization bond 
program will allow Chicago to issue $676 million in bonds and 
save us up to $333 million in interest payments. Now that's an 
incentive and a form of assistance that can really make a 
difference.
    And the federal help would be even more effective if 
Congress extended the payback period beyond the proposed 15 
years to 20, 25, or even 30. Why? Because the principal-only 
payment for 15 years is the same as, or very close to, the 
payments of principal and interest over 30 years. As it is 
currently written, the 15-year payback has almost the same 
financial burden as if a school district borrowed the money 
over 30 years with interest.
    We also believe that the Department of Education's role 
should be limited to receiving descriptions of capital plans 
and annual reports. They should not sign off on individual 
capital plans.
    Unlike the school modernization bonds, the use of QZABs 
will require substantial business contributions to schools. 
Unless Congress adjusts the proposal to provide businesses with 
a substantial incentive to make this investment, many local 
school districts will be unable to access the program. In fact, 
under this year's QZAB program, which requires a 10 percent 
private contribution to the capital cost of projects, we are 
partnering with five other schools districts in Illinois--
Mendota, DeKalb, Aurora, Elgin and East St. Louis--who probably 
could not have structured a QZAB on their own because of 
required private contribution. The circumstances probably will 
be the same under the new business contribution requirement.
    There is also a proposal in the Senate which would enable 
private investors to use private activity bonds to fund school 
construction. This proposal seeks to spur private investment in 
school construction by offering investors significant 
depreciation incentives along with favorable tax exempt 
financing. This concept works only if the buildings remain free 
from real property taxes.
    To keep the buildings free from real property taxes, 
Congress should allow the school district to maintain exclusive 
title to its property but the tax law should impute a tax basis 
to the private investor. This would enable the private investor 
to depreciate the property but avoid a title transfer and real 
property taxation that would undercut the depreciation tax 
benefit and the usefulness of the private activity bond.
    In the space of five minutes, I don't want to revisit the 
philosophical debate over whether the federal government has 
any role at all with respect to education. I will just repeat 
what I said six weeks ago here in Washington when I testified 
before the House Committee on Education and the Workforce.
    America felt it was a national priority to build the 
interstate highway system in the 1950's, but we've never made 
the rebuilding of our schools a national priority. But at the 
dawn of the new millennium, our schools are not merely a 
national priority--they're a matter of national security and we 
need to enhance and strengthen them.
    Thank you Mr. Chairman and members of the Committee for 
your time and consideration.
      

                                

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    Chairman Archer. Thank you, Mr. Chico.
    Our next witness will be introduced by one of our own, Mr. 
Houghton.
    Mr. Houghton. Thank you very much, Mr. Chairman. Mr. 
Bouchard does not come from sunny Florida. He comes from cold, 
upstate New York. But we are delighted to have him here, 
distinguished man, distinguished educator for over 39, almost 
40 years. He has been superintendent and head of many 
organizations, one of them being the National Rural Education 
Association.
    Thanks very much for being with us.
    Chairman Archer. Mr. Bouchard, you have also been 
identified for the record, so you may proceed.

 STATEMENT OF RENE ``JAY'' BOUCHARD, DISTRICT SUPERINTENDENT, 
  STEUBEN-ALLEGANY COUNTIES, BATH, NEW YORK; CHIEF EXECUTIVE 
  OFFICER, STEUBEN-ALLEGANY BOARD OF COOPERATIVE EDUCATIONAL 
SERVICES; MEMBER, EXECUTIVE COMMITTEE, AMERICAN ASSOCIATION OF 
EDUCATIONAL SERVICE AGENCIES; AND MEMBER, EXECUTIVE COMMITTEE, 
              NATIONAL RURAL EDUCATION ASSOCIATION

    Mr. Bouchard. Thank you, Mr. Chairman. I represent the 
National Rural Education Association. I would like to speak 
about the provision in the President's fiscal year 2000 budget 
that would provide States and local districts desperately 
needed help in modernizing America's public schools.
    Unfortunately, rural schools often are nothing more than an 
afterthought in the national debate on public education. 
Nevertheless, I think there is a story to be told. For example, 
one out of every two public schools in America is located in a 
rural area or small town. Thirty-eight percent of America's 
students go to school in rural areas. Forty-one percent of 
public schoolteachers work in rural schools. Yet rural and 
small town schools receive only 22 percent of the total funding 
for K-12 education.
    Last year, this Committee succinctly captured the challenge 
facing the Nation's schools when it stated ``A great need 
exists for construction and renovation of public schools if 
American educational excellence is to be maintained.'' 
Nationwide, the GAO found that it would take $112 billion just 
to make the necessary repairs on our schools, to ensure that 
they are safe and healthy for our children. Another $73 billion 
is needed to build additional schools and enlarging existing 
schools to alleviate overcrowded conditions. The need for 
access to the Internet and other technologies is particularly 
acute in rural areas.
    The $22 billion in zero-interest school modernization bonds 
included in the administration's proposal would put more power 
in the hands of States and local school districts. The 
provision would allow bond buyers to receive Federal tax 
credits in lieu of interest, thereby freeing up money the 
districts would be paying for interest to be used for teaching 
and learning.
    We are pleased that Representative Charles Rangel of New 
York, the Ranking Member of this Committee, who will introduce 
the President's proposal in the House soon, has expressed a 
willingness to consider giving a larger allocation to States, 
potentially resulting in more funds being available to rural 
schools. Representative Nancy Johnson of Connecticut, a Senior 
Member on the Majority side of this Committee, will also soon 
introduce her bill to provide tax credits on school 
modernization bonds. With such bipartisan support, I strongly 
urge this Committee to include such school modernization tax 
credits in any tax bill considered this year.
    Another proposal to assist school facilities is being 
proposed by this Chairman, Chairman Archer, and included in 
H.R. 2, the leadership's education package. This recommendation 
would allow for a longer period of time an additional 2 years 
in which earnings on bond proceeds can be kept by school 
districts instead of being rebated to the Federal Government. I 
would recommend though that because of the arbitrage rebate 
relief proposal, it may benefit larger school districts, as Mr. 
Chico talked about just recently. But it may be appropriate to 
include it as an addition to the school modernization bonds in 
the President's proposal. The Committee should also consider 
raising the smaller-issuer exemption from $10 million to $25 
million, which would provide additional benefits to rural 
schools that issue bonds below this limit.
    One other bill that has just been introduced, H.R. 996, by 
Representative Etheridge, we heard from earlier here today, 
also deserves this Committee's attention. This proposal would 
provide another $7.2 billion in zero-interest bonds targeted to 
States which have the fastest increases in population in school 
enrollment.
    The American people's attitude toward modernization, stated 
in a recent survey, that 82 percent said that they support a 
$22 billion 5-year spending proposal to rebuild America's 
schools. Americans living in rural areas, 81 percent favor that 
proposal. Numerous studies have documented the positive 
correlation between student achievement and better building 
conditions. A poll of the American Association of School 
Administrators in April 1997 found that 94 percent of American 
educators said computer technology had improved teaching and 
learning. The Internet brings a vast library to our fingertips 
in a timely and unencumbered manner.
    Beyond the educational benefits that technology has to 
offer modern schools, we ensure that students will be equipped 
to compete equally and fairly in a job market that is relying 
more heavily on proficiency in obtaining, synthesizing, and 
presenting information.
    Another example that I wanted to mention was Mr. Chico's 
remark about the American Society of Civil Engineers, that gave 
an ``F'' to education in regard to the study of the 
infrastructure in this country. Yet while the Congress just 
last year provided $216 billion for roads, bridges, and mass 
transit through the highway bill, to date virtually no Federal 
funds have been made available to improve school buildings.
    Mr. Chairman, we appreciate your interest in rural 
education, and the willingness of your Committee to address the 
issue of public school construction and renovation. We hope 
this Committee can actually expand on the President's proposal 
as it prepares revenue legislation to assist rural communities 
modernize their schools. Unless we give students equal access 
to the tools necessary to succeed in the current marketplace, 
we not only short change them, but we short change ourselves by 
producing a citizenry unable to maintain our standard of living 
as a community, and to compete in the global arena. Thank you.
    [The prepared statement follows:]

Statement of Rene ``Jay'' Bouchard, District Superintendent, Steuben-
Allegany Counties, Bath, New York; Chief Executive Officer, Steuben-
Allegany Board of Cooperative Educational Services; Member, Executive 
Committee, American Association of Education Services Agencies; and 
Member, Executive Committee, National Rural Education Association

    Mr. Chairman and Members of the Committee:
    On behalf of the National Rural Education Association, I 
want to thank you for the opportunity to address the Committee. 
My name is Rene ``Jay'' Bouchard, and I would like to speak 
about the provision in the President's Fiscal Year 2000 budget 
that would provide states and local districts desperately 
needed help in modernizing America's public schools.
    Mr. Chairman, I come before you as someone who in one 
professional capacity or another has been involved in public 
education for 39 years. I have had the honor of serving as a 
teacher, a vice-principal, and principal at the secondary 
level. I have also served as a superintendent. Since 1982, I 
have jointly held the positions of Chief Executive Officer for 
the Steuben-Allegany Board of Cooperative Educational Services, 
a confederation of 15 rural and small town school districts, 
and Superintendent of the District of Steuben-Allegany 
Counties.
    I had the privilege of serving as president of the National 
Rural Education Association, or NREA, from 1993 to 1994. I 
currently sit on NREA's Executive Committee. I am also a member 
of the Executive Committee of the American Association of 
Educational Service Agencies.
    I think it would be helpful to speak briefly about NREA. 
The National Rural Education Association is the oldest 
established national organization of its kind in the United 
States. The Association traces its origins back to 1907. 
Through the years, it has evolved into a strong and respected 
organization of rural school administrators, teachers, board 
members, regional service agency personnel, researchers, 
business and industry representatives, and others interested in 
maintaining the vitality of rural school systems across the 
country.

                       THE NEEDS OF RURAL SCHOOLS

    While president of NREA, I had the opportunity to travel 
extensively throughout the United States and saw first-hand the 
challenges that schools, administrators, students, and teachers 
in rural areas and small towns face every day. These schools 
are more likely than not to be underfunded, and their teachers, 
when compared to their urban and suburban counterparts, receive 
lower than average salaries and fewer benefits, have fewer 
professional development opportunities, and have less access to 
higher education.
    Unfortunately, rural schools often are nothing more than an 
afterthought in the national debate about public education. 
Nevertheless, there is a story to be told. For example, one out 
of every two public schools in America is located in a rural 
area or small town. Thirty-eight percent of America's students 
go to schools in rural areas. Forty-one percent of public 
school teachers work in rural schools. Yet, rural and small 
town schools receive only 22 percent of the total funding for 
K-12 education.
    Consequently, rural and small town educators must address 
increasing expectations with diminishing resources. The school 
modernization proposal in the President's budget proposal can 
provide desperately needed assistance in the area of greatest 
need--modernization of school buildings.
    Last year, no less a distinguished body than this Committee 
succinctly captured the challenge facing the nation's schools 
when it stated: ``A great need exists for construction and 
renovation of public schools if American educational excellence 
is to be maintained.''
    I could not have said it better myself.
    The common perception among many outside the education 
community is that the need for modern, safe schools that are 
not overcrowded, and offer access to the Internet and other 
education technology exists only in inner-city communities. The 
truth of the matter, according to a landmark 1996 national 
study by the General Accounting Office (GAO), ``School 
Facilities: America's Schools Report Differing Conditions,'' is 
that one out of two rural schools have at least one inadequate 
structural and mechanical feature. These include roofs, 
exterior walls, electrical systems, and heating, ventilation, 
and air conditioning systems.
    In addition, GAO found that 30.3 percent of rural schools, 
serving more than 4.5 million students, had at least one 
overall school building that was deemed inadequate.
    The age and physical condition of our nation's schools also 
hinders or prevents many from being retrofitted to accommodate 
technology. According to the GAO report, the electrical systems 
at nearly half of all schools are inadequate for full-scale 
computer use.
    Nationwide, GAO found that it would take $112 billion just 
to make necessary repairs on our schools to ensure that they 
are safe and healthy places for children to learn. On top of 
these repair needs, because enrollment in our public schools is 
at a record high level, and projected to grow every year for at 
least the next decade, another $73 billion is needed to build 
additional schools and enlarge existing schools to alleviate 
overcrowded conditions.
    The most recent figures from the National Center for 
Education Statistics show that while we as a nation have made 
substantial progress in connecting public classrooms to the 
Internet, vast disparities remain between disadvantaged and 
rural school districts and affluent ones. In addition, 
according to a July 1998 report form the National 
Telecommunications and Information Administration, rural 
students (as well as urban and minority students) lack computer 
access at home and must depend on schools or libraries for 
access to technology.
    The need for access to the Internet and other technologies 
is particularly acute in rural areas. Because of tight budgets 
and a limited ability to offer higher level and specialized 
classes, rural schools are especially reliant on distance 
learning technologies.
    A case in point are the 15 school districts that comprise 
the Steuben-Allegany Board of Cooperative Educational Services 
that I oversee. Combined, these western New York districts, 
which have consolidated many of their administrative and 
curricular functions to achieve economies of scale, enroll 
20,000 students. The districts are spread over 1,600 square 
miles, an area that is slightly larger than the entire state of 
Rhode Island.
    Over 44 percent of the students in our schools are eligible 
for the free and reduced price lunch program. That figure 
climbs as high as 63 percent in some of our schools.
    Given how widely dispersed is the area served by the 
Steuben-Allegany Board of Cooperative Educational Services, the 
ability to share resources electronically is crucial. In my 
region, less than 15 percent of our students are in schools 
with Internet access in their classrooms. Most of our schools 
only have one or two single station connections to the Internet 
in the entire school.

 THE PRESIDENT'S SCHOOL MODERNIZATION PROPOSAL WOULD HELP RURAL SCHOOLS

    The school modernization proposal in the President's budget 
proposal would go a long way in helping us and others like us 
to remedy this problem, repair and upgrade all the mechanical 
systems of our buildings and better respond to environmental 
hazards in our schools.
    The $22 billion in zero interest school modernization bonds 
included in the Administration's proposal would put more power 
in the hands of states and local school districts and will not 
create new federal bureaucracy. Decision making and management 
prerogatives remain at the local level. By allowing local 
communities to finance school construction or renovation with 
the equivalent of interest-free bonds, the proposal presents 
schools districts with a unique opportunity to renovate 
existing buildings and build new schoolhouses.
    The provision would allow bond buyers to receive federal 
tax credits in lieu of interest, thereby freeing up money the 
districts would be paying for interest to be used for teaching 
and learning. Since over the 15-year repayment period of these 
school modernization bonds interest payments typically 
represent as much as 50 percent of the total repayment, the 
savings to schools from this proposal will be substantial. 
Fiscal relief to school districts such as mine will help 
relieve pressure on property taxes, and thus make it easier to 
convince our local voters to pass school bond referenda.
    Combined with the $2.4 billion expansion of the existing 
Qualified Zone Academy Bond (QZAB) Program, these two proposals 
would generate nearly $25 billion in bonds at a cost to the 
U.S. Treasury of $3.1 billion over five years, according to the 
Joint Committee on Taxation. This is a national investment in 
schools and in the work force for tomorrow's economy. I also 
want to add that while the perception of QZABs is that these 
bonds only benefit urban areas, any school district with at 
least 35% of its children eligible for free or reduced-price 
school lunch also qualifies.
    New York State alone would be eligible for more than $2.7 
billion in tax credit bonds.
    The President's proposal calls for a 50-50 split in bonding 
authority, with half of the allocation to the states and half 
to the 100 school districts with the largest number of low-
income students. State agencies would assign the bonding 
authority to districts, schools, or other governmental units 
based on the family income level of the students to be served, 
or other factors as they see fit. Most importantly for rural 
schools is a requirement that the state give special 
consideration to rural areas, as well as to high-growth areas. 
Such a funding formula would greatly benefit rural schools.
    Additionally, we are pleased that Representative Charles 
Rangel of New York, the ranking member of this committee, who 
will introduce the President's proposal in the House soon, has 
expressed a willingness to consider giving a larger allocation 
to states, potentially resulting in more funds being available 
to rural schools. In addition, I am very pleased to note that 
Representative Nancy Johnson of Connecticut, a senior member on 
the majority side of this committee, will also soon introduce 
her own bill to provide tax credits on school modernization 
bonds. With such bipartisan support I strongly urge this 
committee to include such school modernization tax credits in 
any tax bill considered this year.

                  OTHER SCHOOL MODERNIZATION PROPOSALS

    I also want to comment on another proposal to assist school 
facilities proposed by Chairman Archer, and included in HR 2, 
the leadership's education package. The Chairman recognized the 
need for the federal government to assist school communities in 
his proposal to change arbitrage rules. His recommendation will 
allow for a longer period of time, an additional two years, in 
which earnings on bond proceeds can be kept by school 
districts, instead of being rebated to the federal government. 
This is a positive proposal that will provide fiscal benefit to 
some school districts.
    However, for many rural districts this proposal will 
generate little if any additional funds. For most rural 
districts, if they do pass a bond, they will immediately put 
those proceeds into the school construction or renovation. The 
local voters who approve bonds expect projects to be initiated 
and completed as quickly as possible. I should note that 
districts with bonds of less than $10 million annually are 
currently exempt from arbitrage rules, which represents the 
majority of bonds issues by rural schools.
    I would recommend though, that because the arbitrage rebate 
relief proposal may benefit larger school districts, it may be 
appropriate to include it as an addition to the school 
modernization bonds in the President's proposal. The committee 
should also consider raising the small issuer exemption from 
$10 million to $25 million, which would provide some additional 
benefit to rural schools that issue bonds below this limit.
    One other bill that has just been introduced, HR 996 by 
Rep. Etheridge of North Carolina, also deserves this 
committee's attention. This proposal, intended as an addition 
to the school modernization bonds in the President's budget, 
would provide another $7.2 billion in zero interest bonds 
targeted to states which have had the fastest increases in 
population and school enrollment. The high growth states that 
would be the greatest beneficiaries of these bonds include many 
rural areas.
    With the average school building in America greater than 50 
years old, we cannot afford to wait any longer for the kind of 
help the President's proposal would offer. Localities and 
states, including New York, are addressing this pressing issue 
as best they can, but they cannot go it alone. The President's 
proposal provides the framework for the kind of local/state/
federal partnership necessary to address this national 
emergency.

      THE PUBLIC SUPPORTS FEDERAL HELP TO MODERNIZE PUBLIC SCHOOLS

    The American people understand the connection between safe 
and modern schools and student achievement. In fact, according 
to the most comprehensive survey to date on American's 
attitudes toward school modernization, 82 percent said they 
support a $22 billion, five-year spending proposal to rebuild 
America's schools. The survey, conducted on behalf of the 
Rebuild America Coalition, by leading Republican pollster Frank 
Luntz in January, found that Americans whether they live in the 
inner city, the suburbs or rural areas, whether they are 
affluent or low-income, whether they are black or white, men or 
women, Republican or Democrat believe that modernizing 
America's schools is a national priority.
    Of those Americans living in rural areas, 81 percent 
favored such a proposal. Twenty-six percent of rural Americans 
said that public school buildings in their community were in 
need of repair, replacement or modernization. Rural Americans 
said the best reasons to modernize public schools were to 
ensure a safe and healthy place for children to learn (46.1%) 
and to provide more space to allow for smaller class sizes 
(34.2%).
    Numerous studies have documented the positive correlation 
between student achievement and better building conditions. A 
1996 study found an 11-point difference in academic achievement 
between students in classrooms that are substandard and the 
same demographic group of children in a first-class learning 
environment. A poll issued by the American Association of 
School Administrators in April 1997 found that 94 percent of 
American educators said computer technology had improved 
teaching and learning.
    I have seen first-hand the difference technology can make 
in the classroom. The range of resource materials available to 
teachers and students on the Internet is staggering. The 
Internet brings a vast library to our fingertips in a timely 
and unencumbered manner. It provides students and teachers 
alike access to timely, relevant, and interactive information 
about the world around them and our past.
    Children in rural communities as well as children in urban 
and suburban areas should be educated in modern, well-equipped 
schools, with small classes. Beyond the educational benefits 
that technology has to offer, modern schools ensure that 
students will be equipped to compete equally and fairly in a 
job market that is relying more heavily on proficiency in 
obtaining, synthesizing, and presenting information.
    One last example of the desperate need for federal help to 
modernize schools comes from the American Society of Civil 
Engineers. Last year, this distinguished organization released 
an analysis of the state of our nation's infrastructure. They 
analyzed the condition of roads, bridges, wastewater treatment 
systems, dams, hazardous waste sites, and solid waste disposal 
sites. They found that public schools buildings are in worse 
condition than any other part of our nation's infrastructure. 
Yet, while the Congress just last year provided $216 billion 
for roads, bridges and mass transit through the highway bill, 
to date virtually no federal funds have been made available to 
improve school buildings.
    Mr. Chairman we appreciate your interest in rural education 
and the willingness of your Committee to address the issue of 
public school construction and renovation. It is crucial that 
Congress enact the proposals such as the President's school 
modernization plan. We hope this committee can actually expand 
on the President's proposal as it prepares revenue legislation 
to assist rural communities modernize their schools.
    Unless we give students equal access to the tools necessary 
to succeed in the current marketplace, we not only shortchange 
them but we shortchange ourselves by producing a citizenry 
unable to maintain our standard of living as a community and to 
compete in the global arena.
    Thank you.
      

                                

    Chairman Archer. Does any Member wish to inquire?
    Mr. Doggett.
    Mr. Doggett. Thank you very much.
    Mr Chico, we hear so much about what is wrong with public 
education from those who are determined to undermine it. It is 
very good to hear some of the right things that are happening 
in Chicago. I congratulate you on your success.
    Mr. Chico. Thank you.
    Mr. Doggett. If I understand your testimony, the arbitrage 
proposal which has been advanced, will do very little for 
continued improvement in the Chicago public schools?
    Mr. Chico. That is correct.
    Mr. Doggett. And given its cost, which I think is a little 
less than $2 billion, if we had that $2 billion to apply in 
some way to education, you would advise us to apply it 
somewhere else rather than the arbitrage proposal?
    Mr. Chico. I would say that between the Rangel and Clinton-
Gore proposal is about $3.7 billion. I just know for a fact 
that we could actually access that money and put it to use. 
Believe me, I don't come here with any bias. If I felt that we 
could use the arbitrage provision and I ran the calculations 
and saw if it generated any money for us over the last four 
issues, I would say let's do it. But it does not.
    Mr. Doggett. Is it your feeling that that situation is not 
unique to the Chicago public schools, but that there are many 
other districts with demands such that they have to apply their 
bond moneys immediately that there are many other districts 
around the country that likewise would not benefit 
significantly from this proposal?
    Mr. Chico. I believe that to be the case. I don't want to 
speak for New York, but I spoke with the New York 
representative before the meeting, and you have heard from the 
small rural district association here, and you have heard from 
Chicago. That is a pretty good snapshot, I believe.
    Furthermore, I would ask the question, I mean who could 
afford to hold onto their money for 4 years? I mean I have 
never seen that luxury.
    Mr. Doggett. So while this proposal might be presented as 
benefiting all schools, just as every American has the right to 
buy a Rolls Royce if they can afford it, some of our school 
districts will not be able to afford to use this provision that 
would be available to them under this arbitrage bill?
    Mr. Chico. I think so.
    Mr. Doggett. With reference to our rural schools, Mr. 
Bouchard, in my State of Texas, some of our rural school 
districts have got more oil wells than they do children. Then 
some just a little bit down the highway who, because they have 
only have rock and cedar trees, can't afford to buy air 
conditioners for the classrooms. Are there problems that some 
of our rural school districts around the country face because 
they are property poor districts?
    Mr. Bouchard. Absolutely. I come from an area in the Finger 
Lakes region of New York that is the same as what you are 
talking about, very, very, very poor. I have been in the inner 
city of New York City, and I have seen more poverty in my area 
than I have seen in New York City schools.
    Mr. Doggett. Do you think that it is appropriate that as we 
look at this whole school construction issue, that we focus on 
at least if not addressing these inequities between property-
poor and property-rich districts, at least try not to 
exacerbate them and make them worse by simply passing 
legislation that only the richest can take advantage of?
    Mr. Bouchard. Absolutely.
    Mr. Doggett. Thank you very much. Thank you both, and the 
entire panel.
    Mrs. Thurman. Mr. Chairman.
    Chairman Archer. Mrs. Thurman.
    Mrs. Thurman. Dee, let me ask you just a couple of 
questions. In reading your testimony and looking at some of the 
language from the tax stuff that was given to us by the 
administration, there is one area that has me a little 
confused. There is something in there about retroactive tax 
increases. But at the same time, it says that this proposal or 
this initiative would actually take place the day this bill is 
passed. Can you explain the retroactive issue for us?
    Ms. Thomas. Yes. I think so. Again, it is not a simple 
thing to understand. But I think effectively what happens is 
that in this proposal is that there really isn't any effective 
date. It talks about an effective date. What really happens is 
there is not really an effective date.
    The proposal goes on to say that we would be able to take 
deduction for distributions and apply that against the UBIT. 
Then it goes on to say that companies such as ours that have 
already enacted the sub S ESOP, that we would have to--we 
wouldn't be able to use that benefit. We would have to just 
keep applying that until we had paid off what we have already 
used. So for us, and for any like us, there is really no 
effective date because it is going to be the same for all sub S 
ESOPs. So that is the retroactive problem that we have.
    Mrs. Thurman. And then the other issue, and I guess maybe 
to the two colleagues that came with you as well, based on your 
understanding, do you think you could remain as an ESOP and as 
an independent company at this point?
    Ms. Thomas. I think that it would be difficult for us. 
Number one, this Committee needs to understand that Ewing & 
Thomas functions in a world of a lot of federally regulated 
Medicare money. There are a lot of changes that are occurring 
that are really hitting on the independent practitioners, and 
especially the small independent physical therapists. Not just 
this issue, but some supervision issues and so the list goes 
on. So that is not helping us. We are kind of in the squeeze 
between that and now the sub S.
    The sub S ESOP issue, with the proposal, there is so much, 
I call it gobbley-goop, because it's very difficult for a 
regular ordinary businessperson to understand. So that is going 
to cost us administrative costs from a lawyer and evaluation 
and administration firms. That is probably going to be over 
what we already paying. Then we are looking at the possibility 
of like a 40-percent tax, so we'll have that. Plus again, the 
administrative fee. Then we have our repurchase liability that 
we also have to continue to worry about.
    So the proposal is going to be difficult for those of us 
that made the election in good faith.
    Mrs. Thurman. Thank you.
    Mr. Marvin, I just want to say that I appreciate your being 
here. I think the issues that you have raised as we go into the 
next millennium are extremely important to this country. I am a 
cosponsor--also I am one of the people on the efficiency on 
energy. We really appreciate you all bringing these issues to 
us, because they are very important into the future. Also, I 
would say to our school districts, I have some large schools 
districts and I have some rural districts, but I am also a 
former teacher. So I understand. And a seventh and eighth 
grade, not university.
    Mr. Chico. You were on the frontlines.
    Mrs. Thurman. I was right on the frontlines, and I actually 
worked in a portable. So I can appreciate what you are saying 
and certainly can appreciate from a standpoint of children 
learning, and how important it is that they are in an 
environment, if nothing else, to have the technical 
advancements that are available in any kind of modernization 
that we do. So we certainly appreciate the time you have taken. 
Mr. Hill, we thank you for being here too.
    Chairman Archer.
    Mr. Collins.
    Mr. Collins. Thank you, Mr. Chairman.
    Mr. Chico, does Chicago School Reform board of trustees, is 
that the Chicago----
    Mr. Chico. School board.
    Mr. Collins. School board?
    Mr. Chico. What they did, Congressman, is we were in such 
bad shape 4 years ago they virtually created an emergency act. 
The Illinois legislature turned over the power for the control 
of the schools to the Chicago mayor. They created this interim 
board called the Reform Board of trustees, using the word 
trustees to connote urgency.
    Mr. Collins. OK. Well then you are actually the school 
board?
    Mr. Chico. We are the school board. We are the school 
board.
    Mr. Collins. So you are familiar with all the areas of the 
cost of education?
    Mr. Chico. Yes.
    Mr. Collins. Versus just the cost of construction of 
schools.
    Mr. Chico. Yes, sir.
    Mr. Collins. In relation to that, are you familiar or do 
you have other areas of funding that are supposed to come from 
the Federal level but don't come, and the lack of that causes 
you to have to----
    Mr. Chico. Yes.
    Mr. Collins [continuing]. Cough up moneys in other areas 
that prohibit you from using it for construction, such as the 
IDEA?
    Mr. Chico. Yes, sir. Special education. We receive about 8 
percent from the Federal Government, and the Federal Government 
has set a target for itself of providing 40 percent to the cost 
of our special education.
    Mr. Collins. Should the Congress come up with more funding 
in that area, would it free up some funds for you to be able to 
use for your school construction?
    Mr. Chico. Yes, sir.
    Mr. Collins. So if the bond issue, the bond provisions were 
not put in place, there are other places you possibly could get 
funds from then?
    Mr. Chico. Absolutely. The money is money. What we would do 
is if the Congress saw fit to increase the amounts sent to 
school districts for special education, we would take that 
money, take out the general dollars that we now put in from the 
local level into special education, put that back into other 
purposes like school construction.
    Mr. Collins. Are there other areas that are mandates that 
the Federal Government or the Congress puts on you that costs 
you money that you could use for this same purpose if those 
type of regulations were giving some relief to you?
    Mr. Chico. There is probably a smattering of what you would 
call unfunded mandates, Congressman. But none are as poignant 
as the special education shortfall.
    Mr. Collins. Oh I am sure there's not. That is a very 
expensive item.
    Mr. Chico. Yes.
    Mr. Collins. But I am just thinking that the Congress, in 
its attempt to oftentimes fund different areas, will put 
mandates down and cause certain things that you have to do in 
reporting and administrative costs too that cost a billion to 
the operation versus the moneys you actually receive.
    Mr. Chico. There is no doubt about it, Congressman. I will 
give you a short story. When the Illinois legislature in 1995 
created this emergency act to give the mayor responsibility for 
the Chicago public schools, they also gave us flexibility to 
use funds in different ways. So instead of mandating that there 
is a particular formula for how to fund something, they put the 
money in a general bloc, sent it to the Chicago public schools. 
I think we have used it very effectively, because over a 15-
year period, they never had a balanced budget. For the last 4 
years, we have had balanced budgets, and we hope to have them 
until 2003 at least, when our labor agreement expires.
    Mr. Collins. You said the State did this?
    Mr. Chico. The State of Illinois. The Chicago Board of 
Education is a separate municipal corporation established by 
State statute. So the State is our ultimate authority.
    Mr. Collins. Yes. So the State kind of block-granted down 
to you the funds, and says you use it for education.
    Mr. Chico. Yes.
    Mr. Collins. Are you familiar with the fact that in the 
last Congress, we passed something very similar, called Dollars 
for the Classroom Act, that would have given you funds with the 
flexibility to use them as you see need for the classroom?
    Mr. Chico. I am not familiar with how much flexibility we 
received as an individual school district. I understand that 
the legislation was designed pretty much to give flexibility at 
the State level. In turn, that was supposed to benefit us. We 
are all for that in concept. Anything that allows us--we feel 
we can pretty much solve a lot of our own problems, not all of 
them, I mean here I think we have made a very good-faith effort 
at raising $2 billion from local taxpayers, but unfortunately, 
the nature of the need is still greater. That is why we are 
looking to the Congress for help.
    Mr. Collins. Yes. I fully understand because in the third 
district of Georgia that I represent, we have some mayors that 
are very fast growing. They are having growing pains, similar 
to what you are having.
    Thank you very much. I think you will see this Congress try 
to give you some relief in several areas, such as mandates, and 
also the area of the IDEA.
    Mr. Chico. Thank you very much, Congressman.
    Mr. Collins. Thank you. Thank you, Mr. Chairman.
    Chairman Archer. Does any other Member wish to inquire?
    Mr. Weller.
    Mr. Weller. Thank you, Mr. Chairman. I am glad I got back 
here in time.
    I would like to direct my question to local school 
superintendent from Illinois, Gery Chico. I see you met Mr. 
Collins, who was directing some questions here. I particularly 
want to thank you for acknowledging the bipartisan partnership 
that worked, when we had a Republican Majority in the House and 
a Republican Majority in the State senate, and of course a 
Republican Governor, and they worked with Mayor Daley and got 
rid of some dead wood and made some changes. The mayor is 
taking advantage of that. Your team has done a good job of 
bringing about some positive change.
    Mr. Chico. Thank you, Congressman.
    Mr. Weller. Its beneficiaries are the kids. So I salute you 
and want to thank you for that. I also appreciate the 
opportunities I have had as a Representative of Chicago to 
visit your schools and see first-hand the good work that you 
are doing.
    Mr. Chico. You are always welcome.
    Mr. Weller. When you and I have had conversations, you are 
particularly, of course, interested in the school construction 
bond initiatives that come before us. As Rod Blagojevich, my 
former colleague in the assembly remembers, I was the sponsor 
of a similar initiative when I was in the State legislature. So 
I have always been a strong supporter, and I think recognize 
the need to fix leaking roofs and need for new classrooms.
    Just for the record though, in the State of Illinois, I 
know in the State legislature and the Governor in the last 
couple years have approved a school construction funding 
initiative. How much is that, and how long is that in place 
for?
    Mr. Chico. It's $1.3 billion. It goes for about 5 years. 
The unfortunate part of the problem is that the estimated need 
for the State of Illinois is about $12 to $13 billion. One of 
the other shortcomings we believe, Congressman, of the Illinois 
mechanism is that 5 years trickles the money out to Chicago too 
long. We would like to have the ability to borrow against that 
longer stream and do the job today so that we don't have to 
wait 4 years to get to the leaky roof and make it an entirely 
new roof rather than a patch job.
    Mr. Weller. OK. Again, I'm sorry, the dollar amount?
    Mr. Chico. It's 1.3.
    Mr. Weller. It's 1.3 over 5. Then the Chicago public 
schools, your own school district, also has a school 
construction initiative. What is the total on that?
    Mr. Chico. Two billion.
    Mr. Weller. So your share of the State?
    Mr. Chico. Two fifty.
    Mr. Weller. Two hundred and fifty million. So you have 
essentially got almost $1.5 billion that will be essentially 
yours coming from both the State initiative and then from the 
local initiative?
    Mr. Chico. It works out like this: $2 billion was raised 
locally, and about $250 million from that $1.3 billion State 
issue will come to Chicago also. So about $2.25.
    Mr. Weller. That's $2.25 billion.
    Mr. Chico. Total for Chicago.
    Mr. Weller. Total. Then the QAZ, Qualified Academy Zone, 
bonds that qualify, the zone academy bonds that were part of 
the Balanced Budget Act and came as an initiative out of this 
Committee, how are you using them within the Chicago public 
schools?
    Mr. Chico. I think we were the first in the country to 
access the qualified academy zone bonds. Last year, the State 
allocation was about $14.5 million. We were the only district 
that stepped up and asked for the allocation, so we were given 
the entire allocation. We took it and we renovated an old 
United States armory and we created an ROTC high school for the 
city at 38th and Calumet, along with an African-American 
military museum right next to it.
    This year, we are going for--we are working with five other 
districts, plus Chicago, for the $15 million State allocation. 
As I said in my testimony, Chicago will work with East St. 
Louis, DeKalb, Aurora, Elgin, and Mendota, to share that $15 
million pool. But what will happen here, Congressman, is 
Chicago will do the brunt of the work and help raise the 10-
percent, private-sector match because that $1.5 million is a 
lot of money to ask a rural town or a smaller town to go get.
    Mr. Weller. Reclaiming my time. Is it a coincidence four of 
those five school districts are in the district of the Speaker 
of the House? [Laughter.]
    Mr. Chico. No, not really, because I'll tell you what. If 
we had our druthers--no, not necessarily. If we had our 
druthers, we have actually reached out to other people, too, 
around the State. These are the ones that have come forward 
first. We would like to work with 40 or 50 districts.
    Mr. Weller. Sure. I'm of course running out of time here. 
Let me ask this, just on a philosophical standpoint. As we have 
talked, and Mr. Collins brought this issue up, is we have 
worked to give you greater flexibility and shift dollars back 
to the States, and of course trying to get more dollars into 
the classroom. Who would you rather apply to for the funds, the 
Illinois State Board of Education or the Federal Department of 
Education?
    Mr. Chico. It depends who will give them to me quicker.
    Mr. Weller. Well today, under today's circumstance, who has 
less paperwork and who is the most responsive?
    Mr. Chico. Congressman, in my testimony I said that I do 
not believe the United States Department of Education should 
sign off on our money. I said that we will be glad to observe a 
reporting requirement. I think there ought to be some checks 
and balances. But I do not believe we should make undue stops 
for undue labor of review of a plan. I mean I think this is 
fairly basic stuff. You are either fixing the building or 
you're not fixing the building. You are building a new 
classroom or you're not.
    The State of Illinois has been very good. They have used 
the Capital Development Board in Illinois. They have been a 
very quick vehicle to transfer that money to the local 
districts. So if our suggestion is heeded, then I think we will 
be OK at the Federal level, too. But I don't think we should 
create another organization for a very involved process to get 
sign-off from at the Federal level.
    Mr. Weller. Thank you. Thank you, Mr. Chairman. I see I am 
out of time.
    Chairman Archer. I was going to say, ``gentlemen,'' but we 
have a wonderful lady on this panel too. My gratitude to all of 
you for coming and giving us the benefit of your testimony 
today. We have all learned a lot. We thank you, and we wish you 
well.
    There being no further business before the Committee, the 
Committee will stand adjourned.
    [Whereupon, at 5:12 p.m., the hearing was adjourned.]
    [Submissions for the record follow:]

Statement of America's Community Bankers

    Mr. Chairman and Members of the Committee:
    America's Community Bankers appreciates this opportunity to 
submit testimony for the record of the hearing on the revenue 
raising provisions in the Administration's fiscal year 2000 
budget proposal. America's Community Bankers (ACB) is the 
national trade association for 2,000 savings and community 
financial institutions and related business firms. The industry 
has more than $1 trillion in assets, 250,000 employees and 
15,000 offices. ACB members have diverse business strategies 
based on consumer financial services, housing finance, and 
community development.
    ACB wishes to focus on five provisions included in the 
Administration's budget. We urge the Committee to reject the 
Administration's proposals to change the rules for bank-owned 
life insurance, modify section 1374, tax the investment 
earnings of section 501(c)(6) organizations, and eliminate 
``corporate tax shelters.'' On the other hand, we recommend 
that the Committee include in legislation, as soon as possible, 
the Administration's proposal to increase the low-income 
housing tax credit.

                       Bank-Owned Life Insurance

    ACB strongly disagrees with the Administration's proposal 
to disallow deductions for interest paid by corporations that 
purchase permanent life insurance on the lives of their 
officers, directors, and employees. This disallowance is 
retroactive in that it would occur with respect to life 
insurance contracts already in force. The Administration's 
proposal would revamp a statutory scheme enacted just two years 
ago. In 1997 Congress enacted a provision to disallow a 
proportional part of a business's interest-paid deductions on 
unrelated borrowings where the business purchases a life 
insurance policy on anyone and where the business is the direct 
or indirect beneficiary. Integral to this general rule, 
however, is an exception for business-owned life insurance 
covering employees, officers, directors, and 20 percent or more 
owners. The combination of the general rule and its exception 
implemented a sensible policy--that the benefits of permanent 
life insurance, where they are directly related to the needs of 
a business, should continue to be available to businesses
    The Administration is now proposing that the implicit 
agreement made two years ago be broken by eliminating the 
exception for employees, officers, and directors for taxable 
years beginning after the date of enactment. It would continue 
to apply to 20-percent owners. Thus, a portion of the interest-
paid deductions of a business for a year would be disallowed 
according to the ratio of the average unborrowed policy cash 
values of life insurance, annuities, and endowment contracts to 
total assets. Insurance contracts would be included in this 
denominator to the extent of unborrowed cash values. (It also 
appears that a 1996 exception that permits an interest-paid 
deduction for borrowings against policies covering key 
employees would be repealed.)
    The Administration's proposal would result in a 
significantly larger loss of deductions for a bank or thrift 
than a similar-sized commercial firm because financial 
institutions are much more leveraged than commercial firms. 
Financial institutions, because of their statutory capital 
requirements, have been under a special constraint to look to 
life insurance to fund retirement benefits after the issuance 
of FASB Statement 106 in December 1990. FASB 106, which was 
effective for 1992, requires most employers to give effect in 
their financial statements to an estimate of the future cost of 
providing retirees with health benefits. The impact of charging 
such an expense to the earnings of a company could be a 
significant reduction in capital. Many financial institutions 
were faced with the necessity of reneging on the commitments 
they had made to their employees or finding an alternative 
investment. Many of these institutions have chosen to fund 
their pension obligations, as well as retiree health care 
benefits, using permanent life insurance.
    The banking regulators have permitted financial 
institutions to use life insurance to fund their employee 
benefit liabilities, but restricted the insurance policies that 
may be used to those that do not have a significant investment 
component and limited the insurance coverage to the risk of 
loss or the future liability. (See e.g., the OCC's Banking 
Circular 249 (February 4, 1991) and the OTS's Thrift Activities 
Regulatory Handbook, Section 250.2.) On September 20, 1996, the 
OCC issued Bulletin 96-51 which recognized the usefulness of 
permanent life insurance in the conduct of banking and granted 
banks increased flexibility to use it--consistent with safety 
and soundness considerations. The bulletin makes clear that the 
necessity to control a variety of risks created by life 
insurance ownership (liquidity, credit, interest rate, etc.) 
requires a bank to limit its purchases to specific business 
needs rather than for general investment purposes. In addition, 
bank purchases of life insurance will be limited by the need to 
maintain regulatory capital levels. (The other bank regulators 
are in agreement with the OCC position.)
    The Administration's proposed change in the current law 
treatment of business-owned life insurance would require many 
financial institutions, because of the extent of their loss of 
deductions, to terminate their policies. Policy surrender 
would, however, subject the banks to immediate tax on the cash 
value and possible cash-in penalties that would reduce capital.
    In most cases financial institutions have purchased life 
insurance to provide pension and retiree health benefits. If 
Congress were to make it uneconomical for businesses to 
purchase life insurance contracts, the employee benefits they 
fund would inevitably have to be reduced. For the 
Administration to make business-owned life insurance 
uneconomical, given its usefulness in providing employee 
benefits, is inconsistent with the other proposals in the 
Administration's budget proposal that would enhance pension and 
other retiree benefits.
    The Administration's argument that financial intermediaries 
are able to arbitrage their interest-paid deductions on 
unrelated borrowings where they own permanent life insurance is 
unconvincing. The leveraging of their capital by banks and 
thrifts to make loans is a vital component of a strong economy. 
The Administration's proposal would punish financial 
institutions, simply because they are inherently much more 
leveraged, to a much greater extent than similar-sized 
commercial firms for making what would otherwise be sound 
business decisions--to insure themselves against the death of 
key employees or to provide for the retirement health or 
security of their employees by means of life insurance.
    This is the fourth year in a row that legislation has been 
proposed to limit the business use of life insurance. This is 
the second year in a row that the Administration has asked 
Congress to find a relationship between life insurance on 
employees, officers, and directors that a corporation owns or 
is the beneficiary of and general debt issued on the credit of 
the corporation. The continuing attacks on corporate-owned life 
insurance deprive taxpayers of certainty and, from the 
Administration's point of view, are counterproductive. 
Corporate taxpayers may feel compelled to purchase life 
insurance to qualify for the current tax treatment before the 
opportunity is lost. ACB urges the Committee to unequivocally 
affirm that the current law treatment of corporate-owned life 
insurance represents a sound compromise that should not be 
disturbed.

                     Low-Income Housing Tax Credit

    America's Community Bankers strongly supports the 
Administration's proposal to increase the per capita limit on 
the low-income housing tax credit from $1.25 to $1.75. As an 
important part of the thrift industry's commitment to housing, 
ACB's member institutions have been participants, as direct 
lenders and, through operating subsidiaries, as investors, in 
many low-income housing projects that were viable only because 
of the LIHTC. The ceiling on the annual allocation of the LIHTC 
has not been increased since the credit was created by the Tax 
Reform Act of 1986. Many member institutions have communicated 
to ACB that there are shortages of affordable rental housing in 
their communities and that, if the supply of LIHTCs were 
increased, such housing could be more efficiently be produced 
to address this shortage.
    The LIHTC was created in 1986 to replace a variety of 
housing subsidies whose efficiency had been called into 
question. Under Section 42 of the Internal Revenue Code, a 
comprehensive regime of allocation and oversight was created, 
requiring the involvement of both the IRS and state and local 
housing authorities, to assure that the LIHTC is targeted to 
increase the available rental units for low-income citizens. 
This statutory scheme has been revised in several subsequent 
tax acts to eliminate potential abuses.
    Every year since 1987, each state has been allocated a 
total amount of LIHTCs equal to $1.25 per resident. The annual 
per capita limit may be increased by a reallocation of the 
unused credits previously allocated to other states, as well as 
the state's unused LIHTC allocations from prior years. The 
annual allocation must be awarded within two years or returned 
for reallocation to other states. State and local housing 
authorities are authorized by state law or decree to award the 
state's allocation of LIHTCs to developers who apply by 
submitting proposals to develop qualified low-income housing 
projects.
    A ``qualified low-income project'' under Section 42(g) of 
the Code is one that satisfies the following conditions. (1) It 
must reserve at least 20 percent of its available units for 
households earning up to 50 percent of the area's median gross 
income, adjusted for family size, or at least 40 percent of the 
units must be reserved for households earning up to 60 percent 
of the area's median gross income, adjusted for family size. 
(2) The rents (including utility charges) must be restricted 
for tenants in the low-income units to 30 percent of an imputed 
income limitation based on the number of bedrooms in the unit. 
(3) During a compliance period, the project must meet 
habitability standards and operate under the above rent and 
income restrictions. The compliance period is 15 years for all 
projects placed in service before 1990. With substantial 
exceptions, an additional 15-year compliance period is imposed 
on projects placed in service subsequently.
    Putting together a qualifying proposal is only the first 
step, however, for a developer seeking an LIHTC award. The 
state or local housing agency is required to select from among 
all of the qualifying projects by means of a LIHTC allocation 
plan satisfying the requirements of Section 42(m). The 
allocation plan must set forth housing priorities appropriate 
to local conditions and preference must be given to projects 
that will serve the lowest-income tenants and will serve 
qualified tenants for the longest time.
    Section 42 effectively requires state and local housing 
agencies to create a bidding process among developers to ensure 
that the LIHTCs are allocated to meet housing needs 
efficiently. To this end the Code imposes a general limitation 
on the maximum LIHTC award that can be made to any one project. 
Under Section 42(b) the maximum award to any one project is 
limited to nine percent of the ``qualified basis'' (in general, 
development costs, excluding the cost of land, syndication, 
marketing, obtaining permanent financing, and rent reserves) of 
a newly constructed building. Qualified basis may be adjusted 
by up to 30 percent for projects in a qualified census tract or 
``difficult development area.'' For federally subsidized 
projects and substantial rehabilitations of existing buildings, 
the maximum annual credit is reduced to four percent. The nine 
and four percent annual credits are payable over 10 years and 
in 1987, the first year of the LIHTC, the 10-year stream of 
these credits was equivalent to a present value of 70 percent 
and 30 percent, respectively. of qualified basis. Since 1987, 
the Treasury has applied a statutory discount rate to the 
nominal annual credit percentages to maintain the 70 and 30 
percent rates.
    The LIHTC has to be taken over 10 years, but the period 
that the project must be in compliance with the habitability 
and rent and income restrictions is 15 years. This creates an 
additional complication. The portion of the LIHTC that should 
be theoretically be taken in years 11 through 15 is actually 
taken pro rata during the first 10 years. Where there is 
noncompliance with the project's low-income units during years 
11 through 15, the related portion of the LIHTC that was, in 
effect, paid in advance will be recaptured.
    Where federally subsidized loans are used to finance the 
new construction or substantial rehabilitation, the developer 
may elect to qualify for the 70 percent present value of the 
credit by reducing the qualified basis of the property. Where 
federal subsidies are subsequently obtained during the 15-year 
compliance period, the qualified basis must then be adjusted. 
On the other hand, certain federal subsidies do not affect the 
LIHTC amount, such as the Affordable Housing Program of the 
Federal Home Loan Banks, Community Development Block Grants, 
and HOME Investment Partnership Act funds.
    The LIHTCs awarded to developers are, typically, offered to 
syndicators of limited partnerships. Because of the required 
rent restrictions on the project, the syndications attract 
investors who are more interested in the LIHTCs and other 
deductions the project will generate than the unlikely prospect 
of rental profit. The partners, who may be individuals or 
corporations, provide the equity for the project, while the 
developer's financial stake may be limited to providing the 
debt financing.
    The LIHTC is limited, however, in its tax shelter potential 
for the individual investor. Individuals are limited by the 
passive loss rules to offsetting no more than $25,000 of active 
income (wages and business profits) with credits and losses 
from rental real estate activities. For an individual in the 
28% bracket, for example, the benefit from the LIHTC would be 
limited to $7,000. It should also be borne in mind that such 
credits are unavailable against the alternative minimum tax 
liability of individuals and corporations.
    Three years ago the Chairs of the Ways and Means Committee 
and its Subcommittee on Oversight requested the GAO to study 
the LIHTC program and, specifically, to evaluate: whether the 
LIHTC was being used to meet state priority housing needs; 
whether the costs were reasonable; and whether adequate 
oversight was being performed. The resulting GAO report was 
generally favorable. See Tax Credits: Opportunities to Improve 
Oversight of the Low-Income Housing Program (GAO/GGD/RCED-97-
55, March 28, 1997). The GAO found that the LIHTC has 
stimulated low-income housing development and that the 
allocation processes implemented by the states generally 
satisfy the requirements of the Code. In fact, the GAO found 
that the LIHTC was being targeted by the states to their very 
poorest citizens. The incomes of those for whom the credit was 
being used to provide housing were substantially lower than the 
maximum income limits set in the statute. While the GAO could 
find no actual abuses or fraud in the LIHTC program, it did 
determine that the procedures that some states use to review 
and implement project proposals need to be improved. The report 
also recommended a number of changes in the IRS regulations to 
ensure adequate monitoring and reporting so that the IRS can 
conduct its own verification of compliance with the law.
    The only increase in the total amount of LIHTCs since 1987 
has been through population growth, which has been only five 
percent nationwide over the 10-year period (floor statement of 
Senator Alphonse D'Amato, October 3, 1997). Had the $1.25 per 
capita limit been indexed for inflation since the inception of 
the LIHTC, as is commonly done in other Code provisions, it 
would be comparable to the $1.75 limit the Administration is 
proposing. According to the Joint Committee on Taxation, the 
Consumer Price Index measurement of cumulative inflation 
between 1986 and the third quarter of 1998 was approximately 
49.5 percent. Using this index to adjust the per capita limit, 
it would now be approximately $1.87. The GDP price deflator for 
residential fixed investment indicates 39.9 percent price 
inflation, which would have increased the per capita limit to 
approximately $1.75. (See Joint Committee on Taxation, 
Description of Revenue Provisions Contained in the President's 
Fiscal Year 2000 Budget Proposal (JCS-1-99), February 22, 1999)
    More affordable low-income housing is currently needed. 
``Despite the success of the Housing Credit in meeting 
affordable rental housing needs, the apartments it helps 
finance can barely keep pace with the nearly 100,000 low cost 
apartments which were demolished, abandoned, or converted to 
market use each year. Demand for Housing Credits currently 
outstrips supply by more than three to one nationwide. 
Increasing the cap as I propose would allow states to finance 
approximately 27,000 more critically needed low-income 
apartments each year using the Housing Credit, helping to meet 
this growing need.'' (floor statement of Representative Nancy 
Johnson, January 6, 1999). ``In the state of Florida, for 
example, the LIHTC has used more than $187 million in tax 
credits to produce approximately 42,000 affordable rental units 
valued at over $2.2 billion. Tax credit dollars are leveraged 
at an average of $18 to $1. Nevertheless, in 1996, nationwide 
demand for the housing credit greatly outpaced supply by a 
ratio of nearly 3 to 1. In Florida, credits are distributed 
based upon a competitive application process and many 
worthwhile projects are denied due to a lack of tax credit 
authority'' (floor statement of Senator Bob Graham, October 3, 
1997).
    ``In 1996, states received applications requesting more 
than $1.2 billion in housing credits--far surpassing the $365 
million in credit authority available to allocate that year. In 
New York, the New York Division of Housing and Community 
Renewal received applications requesting more than $104 million 
in housing credits in 1996--nearly four times the $29 million 
in credit authority it already had available'' (floor statement 
of Senator Alphonse D'Amato, October 3, 1997). ``The Housing 
Credit is the primary federal-state tool for producing 
affordable rental housing all across the country. Since it was 
established, state agencies have allocated over $3 billion in 
Housing Credits to help finance nearly one million homes for 
low income families, including 70,000 apartments in 1997. In my 
own state of Connecticut, the Credit is responsible for helping 
finance over 7,000 apartments for low income families, 
including 650 apartments in 1997 (floor statement of 
Representative Nancy Johnson, January 6, 1999).
    Based on the foregoing, it is clear that it is time to 
increase the LIHTC.

           Repeal of Section 1374 for ``Large'' Corporations

    Under the Administration's budget proposal, section 1374 
would no longer apply to corporations that have a value of more 
than $5 million. The repeal of section 1374 would apply to 
Subchapter S elections that become effective after December 31, 
1999. Section 1374 was enacted by the Tax Reform Act of 1986 in 
order that taxpayers could not avoid the repeal of the General 
Utilities rule (see General Utilities v. Helvering, 296 US 200 
(1935)) that was one of the primary achievements of the 1986 
Act. Under the General Utilities rule, a corporation could 
avoid corporate level tax on appreciated property by 
distributing such property to its shareholders. Section 1374 
was enacted in lieu of the kind of liquidation tax now being 
proposed by the Administration. Section 1374 provides that the 
``built-in'' gain on appreciated assets held by a corporation 
that makes a Subchapter S election will be triggered where the 
assets are disposed of within 10 years of the election. Ten 
years, though an essentially arbitrary period, is long enough 
to indicate conclusively that the taxpayer did not have a tax 
avoidance motive on these amounts for making the election.
    The current Administration proposal first appeared in the 
President's Seven-Year Balanced Budget Proposal, published in 
December 7, 1995. It provides that a ``large'' regular 
corporation--with a value of more than $5 million--electing to 
become a Subchapter S corporation or merging into one will be 
treated as if it were liquidated, followed by the contribution 
of the assets its shareholders received in exchange for their 
stock to the S corporation. The proposal would impose taxation 
on any appreciated assets held by the corporation and would tax 
the shareholders as if they had sold their stock and reinvested 
the proceeds in the new Subchapter S entity.
    Although as a general matter, enactment of the 
Administration's proposal would probably make the Subchapter S 
election too expensive for many existing corporations, 
including commercial banks, the proposal would impose a 
particular and prohibitive tax liability on the typical savings 
institution or savings bank (thrift). In effect, Congress will 
have made only a hollow gesture towards making Subchapter S 
status available to thrifts.
    Last year Congress advanced the ongoing process of 
financial modernization by making it possible for thrifts to 
change to commercial bank charters or to diversify their 
lending activities to diminish risk created by concentrated 
lending and to better serve their communities. This was 
accomplished by requiring all thrifts to ``recapture'' into 
taxable income their loan loss reserves accumulated after 1987, 
except to the extent necessary to create an opening reserve 
balance for those ``small'' thrifts permitted to remain on the 
experience reserve method. The threat of subjecting the 
remaining, pre-1988 reserve accumulation to recapture upon a 
charter change or a diversification of the institution's loan 
portfolio was dispelled. Recapture of the pre-1988 reserve will 
still occur, however, where the thrift liquidates or otherwise 
distributes the capital accumulated using the special thrift 
subsidy reserve method that had been in existence since 1952 
but that was repealed by Congress last year. Almost any 
established thrift that is forced to recapture the capital 
accumulated between 1952 and 1987 from the special thrift 
reserve method would suffer a huge cut in its capital and a 
likely regulatory capital shortfall, given the importance of 
the previous deductions permitted under the method.
    Although in Notice 97-18, published in the Internal Revenue 
Bulletin 1997-10 on March 10, 1997, the Internal Revenue 
Service distinguished the pre-1988 reserves of a thrift from 
the experience reserves subject to recapture as a section 
481(a) adjustment, there can be little doubt that the pre-1988 
reserves satisfy the definition of a built-in gain in section 
1374(d)(5) of the Internal Revenue Code.
    ACB concurs with other commentators that the 
Administration's proposal to repeal 1374 is not sound tax 
policy. The taxation of excess passive income, as well as the 
10-year holding period requirement to avoid the taxation of 
built-in gains, limits the ability of corporations to avoid tax 
by making a Subchapter S election. The proposed repeal of 
section 1374 for large corporations would eliminate the 
realization concept to such an extent that a corporation may be 
unable to pay the required tax without an actual liquidation of 
the assets of the business. This proposal would contravene one 
of the principal purposes of the amendments to the Subchapter S 
provisions made in 1982 and 1996--to increase the 
attractiveness and availability of the Subchapter S election.
    At a minimum, however, ACB strongly requests that, if the 
Committee were to agree with the Administration on the need to 
impose liquidation treatment on certain Subchapter S 
conversions, an exception be created to avoid the recapture of 
the pre-1988 loan loss reserves of thrifts. The very purpose of 
the amendments to the reserve recapture rules made last year 
was to limit the circumstances in which reserve recapture will 
be imposed. It is inconsistent to create a new situation in 
which recapture will be imposed. The Administration's proposal 
will force many eligible thrifts to make the Subchapter S 
election on a rush basis, rather than be effectively foreclosed 
after the 1999 calendar year. The provision creates a trap for 
the unwary thrift that could have a devastating impact on its 
capital. This proposal will raise little, if any, revenue from 
the thrift industry if their pre-1988 reserves are made subject 
to recapture under it.

             Investment Earnings of 501(c)(6) Organizations

    Section 501(c)(6) of the Code creates an income tax 
exemption tax for nonprofit business leagues, chambers of 
commerce, and professional and trade associations. Such 
organizations are not taxed on the revenues derived from 
membership dues and exempt purpose activities. Income derived 
from business activities unrelated to the tax-exempt purpose 
is, however, taxed under section 511 of the Code at the regular 
corporate rate, but an exclusion is provided for interest, 
dividends, royalties, certain rental income, certain gains from 
the disposition of property, and certain other income.
    The Administration is proposing to tax the ``net investment 
income'' of section 501(c)(6) organizations--i.e., the 
interest, dividends, rents, royalties, and certain gains and 
losses from the disposition of property, minus all directly 
connected expenses. An exception would be provided for the 
first $10,000 earned by an association from these sources, but 
all investment income over the $10,000 floor will be subject to 
the unrelated business income tax (UBIT).
    The Treasury provides the following rationale for the 
proposal:

          The current-law exclusion from the UBIT for certain 
        investment income of a trade association allows the 
        organization's members to obtain an immediate deduction for 
        dues or similar payments to the organization in excess of the 
        amounts needed for current operations, while avoiding tax on a 
        proportionate share of the earnings from investing such surplus 
        amounts. If the trade association member instead had retained 
        its proportionate share of the surplus and itself had invested 
        that amount, the earnings thereon would have been taxed in the 
        year received by the member. Although in some instances 
        investment income earned tax-free by a trade association may be 
        used to reduce member payments in later years, and hence reduce 
        deductions claimed by members in such years, the member still 
        has gained a benefit under current law through tax deferral. 
        Thus, under current-law rules, trade association members may be 
        able to claim current deduction for future expenses. Even 
        assuming that dues and similar payments would be deductible by 
        the member if made in a later year, to the extent that 
        investment income is earned by the trade association in one 
        year and spent in a later year, the current-law exclusion 
        effectively provides the benefit of a deduction before the 
        expenditure actually is made. (U.S. Department of Treasury, 
        General Explanations of the Administration's Revenue Proposals, 
        (February, 1999), at p.60).

    Based on this rationale, it is the Administration's view 
that the UBIT should be used to eliminate the ability of 
members of 501(c)(6) organizations to leverage their dues by 
overpaying them in order to accumulate earnings on a tax-free 
basis--regardless of the purpose for which these earnings are 
accumulated. Assuming for the moment that this leveraging 
actually occurs, it would be an expansion of the UBIT beyond 
the purpose for which it was created and impose it on a 
501(c)(6) organization's earnings used in furtherance of its 
tax-exempt purpose. The UBIT was created to prevent tax-exempt 
entities from competing unfairly with taxable businesses (e.g., 
the sort of competition that, nevertheless, exists between 
credit unions and commercial banks and thrifts). The 
legislative history makes clear that ``the problem at which the 
tax on unrelated business income is directed here is primarily 
that of unfair competition. The tax-free status of [section 
501(c)] organizations enables them to use their profits tax-
free to expand operation, while their competitors expand only 
with the profits remaining after taxes.'' (H.R. Rep. No. 81-
2319, 81st Cong., 2d Sess. 36-37 (1950) and S. Rep. No.81-2375, 
81st Cong., 2d Sess. 28-29 (1950)). The same legislative 
history also makes clear that investment earnings used to 
advance the tax-exempt purpose are not to be subject to the 
UBIT ``because they are `passive' in character and are not 
likely to result in serious competition for taxable businesses 
having similar income'' (H.R. Rep. No. 81-2139 at 36-38; S. 
Rep. No. 81-2375 at 30-31).
    The investment earnings of 501(c)(6) organizations are used 
to fund research, educational, and charitable activities--in 
short, all of the activities that serve the 501(c)(6) 
organization's tax exempt purpose. The reasons for granting an 
exemption for investment income from UBIT are as valid today as 
they were fifty years ago. The Administration is able to point 
to nothing that has changed since the creation of the UBIT such 
that Congress should reverse the policy decision it made at 
that time.
    While the investment earnings of 501(c)(6) organizations 
are in the end used directly to further their tax-exempt 
functions, the maintenance of a capital reserve is a budgetary 
necessity to provide for unanticipated costs and avoid a 
financial crisis. Taxing these reserves will reduce the ability 
of a 501(c)(6) organization to plan for the future performance 
of its tax-exempt purpose. Dues income may fluctuate from one 
year to the next and 501(c)(6) organizations do not have the 
same access to the credit markets as regular corporations.
    The implication of the Administration's rationale is that 
501(c)(6) members are prepaying their dues because it is more 
advantageous for the 501(c)(6) organization to accrue the 
earnings on the excess dues payment. In effect, the tax-exempt 
status of the 501(c)(6) organization can be used to create an 
economic benefit for the members. This would certainly be news 
to the members. In most cases the members of a 501(c)(6) 
organization prefer to review annually the value of their 
membership and would not be interested in prepaying dues. In 
addition, the same need to assure future liquidity in their own 
businesses would constrain an overpayment of dues.
    In any case, the Administration's economic benefit theory 
is fallacious. The reserves of a 501(c)(6) organization are 
almost always invested in the most conservative instruments. 
Very few members are likely to believe that they could not get 
a better return on these funds in their own businesses and it 
is likely that a failure to do so in their own businesses could 
mean liquidation or unemployment. Moreover, a conscious attempt 
to implement this economic theory would require a complex dues 
formula to prevent some members from overpaying dues based on 
their loss of investment opportunity relative to other members.
    The Treasury concedes that a tax on the investment income 
of a 501(c)(6) organization would require it to raise its 
membership dues, with the result that the increased UBIT 
revenue would be significantly offset by a deductible business 
expense. It appears, however, that, in the view of Treasury, 
matching the year of the UBIT and the dues deduction, in 
addition to generating revenue by eliminating the ``float,'' is 
theoretically preferable.
    The failure of the Administration to include the investment 
earnings of labor unions, which are tax-exempt under section 
501(c)(5), in its proposal raises the issue of whether the 
proposal is politically motivated. Labor unions generally 
support Democrats; chambers of commerce, included in section 
501(c)(6), generally favor Republicans. Both 501(c)(5) and 
501(c)(6) organizations advance comparable goals and Congress 
has, thus far, determined that both should receive similar tax 
treatment. A Treasury official reportedly attempted to make a 
distinction on the basis that union members generally claim the 
standard deduction on their returns, while most members of 
501(c)(6) organizations claim a business expense deduction. The 
fact that someone chooses to take the standard deduction 
because it produces a greater tax benefit than claiming an 
employee business expense does not eliminate the comparability 
of dues paid to 501(c)(5) and 501(c)(6) organizations. 
Moreover, not all union members, such as those belonging to the 
Screen Actors and Writers Guilds and the Airline Pilots 
Association in many cases, take the standard deduction. Not all 
members of 501(c)(6) organizations are able to deduct their 
dues because of the limitation on the deductibility of employee 
business expenses nor can they have their employers reimburse 
them.
    For all of the foregoing reasons ACB strongly urges the 
Committee to reject the Administration's proposal to tax the 
investment earnings of 501(c)(6) organizations.

                         Corporate Tax Shelters

    The Administration has proposed a multifaceted and broad-
based attack to eliminate what it deems to be abusive ``tax 
shelters.'' Unfortunately, the definitions used are so vague 
and encompassing and the penalties prescribed are so draconian 
that the enactment of these proposals would have a chilling 
effect on many legitimate transactions. The individual 
components of the Administration's tax shelter attack will be 
discussed in the order presented in the budget proposal.

1. Modify substantial understatement rule for corporate tax 
shelters.

    The Administration is proposing to double the substantial 
understatement penalty for corporate taxpayers from 20percent 
to 40 percent for any item attributable to a ``corporate tax 
shelter.'' A corporate tax shelter under the proposal would be 
``any entity, plan, or arrangement (to be determined based on 
all facts and circumstances)) in which a direct or indirect 
corporate participant attempts to obtain a tax benefit in a tax 
avoidance transaction.'' A ``tax benefit,'' according to the 
proposal, would ``include a reduction, exclusion, avoidance, or 
deferral of tax, or an increase in a refund, but would not 
include a tax benefit clearly contemplated by the applicable 
provision (taking into account the Congressional purpose for 
such provision and the interaction of such provision with other 
provisions of the Code).'' A ``tax avoidance transaction'' is 
defined ``as any transaction in which the reasonably expected 
pre-tax profit (determined on a present value basis, after 
taking into account foreign taxes as expenses and transaction 
costs) of the transaction is insignificant relative to the 
reasonably expected net tax benefits ... In addition, a tax 
avoidance transaction would be defined to cover certain 
transactions involving the improper elimination or significant 
reduction of tax on economic income.''
    Simply presenting its definitions makes apparent how 
troubling the proposal is. As is apparent from the definitions, 
IRS agents would be empowered to recommend draconian penalties 
on the basis of very subjective determinations. It is 
disconcerting to think that the Treasury will be defining by 
regulation such potentially broad terms as ``transaction,'' 
``reasonable expectation,'' and what is an ``improper 
elimination or significant reduction of tax on economic 
income'' in the context of ``tax avoidance transaction.''
    Most troubling is the alternative definition of a tax 
avoidance transaction. It could possibly include virtually any 
transaction that an IRS agent chooses. In addition, it appears 
that existing precedents and defenses otherwise available to 
taxpayers to defend the legitimacy of a transaction may not be 
available under this definition. To combine a definition of 
such breadth and subjectivity as the alternative with a 
doubling of the substantial underpayment penalty is to create 
an enormous potential for IRS abuse. The threat of raising the 
tax avoidance issue would give IRS agents enormous leverage to 
force concessions on other items in dispute, apart from the 
direct impact of the provision.

2. Deny certain tax benefits to persons avoiding income tax as 
a result of tax-avoidance transactions.

    The Administration is proposing to expand the scope of 
section 269 of the Code by adding a provision authorizing the 
disallowance of any deduction, credit, exclusion, or tax 
benefit obtained in a tax avoidance transaction. Under current 
law, section 269 provides that where a person gains control of 
a corporation or a corporation acquires carryover basis 
property and the principal purpose of the acquisition is the 
evasion or avoidance of federal income tax by creating a 
deduction, credit, or other tax benefit, the benefit may be 
disallowed to the extent necessary to eliminate the evasion or 
avoidance.
    Once again, the Administration proposes the creation of 
punitive provision whose breadth and scope is breathtaking. 
Essentially, any corporate acquisition resulting in ``an 
improper elimination or significant reduction of tax on 
economic income'' could have any of the resulting tax benefits 
denied by the IRS. According to the Administration, the IRS 
should be given the statutory right to restructure any 
corporate acquisition where, in the IRS view, the taxpayer has 
obtained too much tax benefit.

3. Deny deductions for certain tax advice and impose an excise 
tax on certain fees received.

    Under current law, fees paid by corporations for tax advice 
are deductible as an ordinary and necessary business expense. 
The Administration is seeking to eliminate the deductibility of 
fees paid by corporations for advice with respect to the 
purchase and implementation of ``tax shelters'' or related to 
``tax shelters.'' The proposal would also impose a 25 percent 
excise tax on fees received with respect to corporate tax 
shelter advice and related to implementing corporate tax 
shelters (including underwriting fees). If a taxpayer claims a 
deduction for a fee, whose deductibility is eliminated by this 
proposal, that deduction would be subject to the substantial 
underpayment penalty.
    This is a singularly insidious proposal because it is 
doubly punitive and because the chilling effects of the 
ambiguities within the term ``tax shelter'' would impact both 
the corporate client and its professional advisers. Many 
legitimate transactions may not be done or may be done only 
after very expensive intellectual agonizing and the imposition 
of additional risk-based fees. This provision is another 
indication of the Administration's overreaction to the current 
marketing of aggressive tax advice by some tax advisers. The 
Administration has chosen to terrorize corporate America with a 
carpet bombing campaign to eliminate the threat of tax 
shelters, instead of using the perfectly adequate weapons of 
current law to surgically attack the problem.

4. Impose excise tax on certain rescission provisions and 
provisions guaranteeing tax benefits.

    The Administration would impose on corporations an excise 
tax of 25 percent on the maximum payment under a recession or 
insurance agreement entered into in connection with a corporate 
tax shelter. The maximum payment would be the aggregate amount 
the taxpayer would receive if the tax benefits of the corporate 
tax shelter were denied. The Treasury report states that if, 
for example, the taxpayer pays $100 for a guarantee of the tax 
treatment of a transaction and the tax benefits are valued at 
$10,000 under the guarantee, the taxpayer would owe an excise 
tax of $2,500 automatically even if the IRS subsequently denies 
only $5,000 of the tax benefits.
    This is another purely punitive provision and it will also 
have the effect of disrupting legitimate business transactions 
and relationships. Ironically, it differs from the previous 
proposals in that a punitive tax would be imposed in the 
situation where a tax adviser is sufficiently confident that he 
has provided sound tax advice that he is willing to stand 
behind it with a guarantee.
    It is the strongly held view of ACB that the foregoing 
provisions could add significant cost and compliance burdens to 
an already overly complex tax burden faced by our members. The 
definitions are ambiguous and overly broad and ACB is concerned 
that this approach may be intentional. ACB is concerned that 
the Administration may intend these provisions to have a 
chilling effect on aggressive tax planning at its inception. 
Such an intention, if it were to exist, would amount to virtual 
tax terrorism. The Administration already has an array of 
effective Code provisions and court precedents to combat tax 
shelters and we urge the Committee to reject these ill-
considered proposals.
    Once again, Mr. Chairman, ACB is grateful to you and the 
other members of the Committee for the opportunity you have 
provided to make our views known on the Administration's tax 
proposals. If you have any questions or require additional 
information, please contact Jim O'Connor, Tax Counsel at ACB, 
at 202-857-3125.
      

                                

Statement of American Bankers Association

    The American Bankers Association (ABA) is pleased to have 
an opportunity to submit this statement for the record on 
certain of the revenue provisions of the Administration's 
fiscal year 2000 budget.
    The American Bankers Association brings together all 
categories of banking institutions to best represent the 
interests of the rapidly changing industry. Its membership--
which includes community, regional, and money center banks and 
holding companies, as well as savings associations, trust 
companies and savings banks--makes ABA the largest banking 
trade association in the country.
    The Administration's Fiscal Year 2000 budget proposal 
contains a number of provisions of interest to banking 
institutions. Although we would welcome certain of those 
provisions, we are once again deeply concerned with a number of 
the Administration's revenue raising measures. Many of the 
subject revenue provisions are, in fact, thinly disguised tax 
increases rather than ``loophole closers.'' As a package, they 
could inhibit job creation and inequitably penalize business. 
The package may also lead to the reduction of employee and 
retiree benefits provided by employers.
    Our views on the most troubling provisions are set out 
below.

                       REVENUE INCREASE MEASURES

            Modify the Corporate-Owned Life Insurance Rules

    The ABA strongly opposes the Administration's proposal to 
modify the corporate-owned life insurance rules. We urge you 
not to enact any further restrictions on the availability of 
corporate owned life insurance arrangements. We believe that 
the Administration's proposal will have unintended consequences 
that are inconsistent with other congressional policies, which 
encourage businesses to act in a prudent manner in meeting 
their liabilities to employees. Corporate owned life insurance 
as a funding source has a long history in tax law as a 
respected tool, and its continued use was effectively ratified 
by the Tax Reform Act of 1997. In this connection, taxpayers 
have, in good faith, made long term business decisions based on 
existing tax law. They should be protected from the retroactive 
effects of legislation that would result in substantial tax and 
non-tax penalties.
    Moreover, federal banking regulators recognize that 
corporate-owned life insurance serves a necessary and useful 
business purpose. Bank regulatory guidelines confirm that 
purchasing life insurance for the purpose of recovering or 
offsetting the costs of employee benefit plans is an 
appropriate purpose that is incidental to banking.
    The subject provision would effectively eliminate the use 
of corporate owned life insurance to offset escalating employee 
and retiree benefit liabilities (such as health insurance, 
survivor benefits, etc.). It would also penalize companies by 
imposing a retroactive tax on those that have purchased such 
insurance. Cutbacks in such programs may lead to the reduction 
of benefits provided by employers. We urge you to, once again, 
reject this revenue proposal.

       S Corporations--Repeal Section 1374 for Large Corporations

    The ABA opposes the proposal to repeal Internal Revenue 
Code section 1374 for large S corporations. The proposal would 
accelerate net unrealized built-in gains (BIG) and create a 
corporate level tax on BIG assets while also creating a 
shareholder level tax with respect to their stock. The BIG tax 
would apply to gains attributable to assets held on the first 
day, negative adjustments due to accounting method change, 
intangibles such as core deposits and excess servicing rights 
and recapture of the bad debt reserve.
    Financial institutions have only recently been allowed by 
Congress to elect subchapter S status. Effectively, this 
proposal would close the window of opportunity for them to 
elect sub S by making the cost of conversion prohibitively 
expensive for the majority of eligible banks, which we believe 
is contrary to congressional intent. We urge you to reject the 
Administration's proposal and to enact legislation that would 
assist community banks in qualifying under the current rules.

               Increased Information Reporting Penalties

    The ABA strongly opposes the Administration's proposal to 
increase penalties for failure to file information returns. The 
Administration reasons that the current penalty provisions may 
not be sufficient to encourage timely and accurate reporting. 
We disagree. The banking industry prepares and files a 
significant number of information returns annually in good 
faith for the sole benefit of the Internal Revenue Service 
(IRS). The suggestion that the Administration's proposal closes 
``corporate loopholes'' presumes that corporations are 
noncompliant, a conclusion for which there is no substantiating 
evidence. Further, there is no evidence available to support 
the assertion that the current penalty structure is inadequate. 
Certainly, the proposed increase in penalty is unnecessary and 
would not be sound tax policy. We urge you to once again reject 
this revenue proposal.

                  Substantial Understatement Penalties

    The ABA opposes the Administration's proposals to modify 
the substantial understatement penalty. The proposed increases 
would be overly broad and would penalize innocent mistakes and 
inadvertent errors. The establishment of an inflexible standard 
would effectively discourage legitimate ``plain vanilla'' 
business tax planning. We urge you to reject this revenue 
proposal.

  Eliminate Dividends-Received Deduction for Certain Preferred Stock/
           Modify the Rules for Debt-Financed Portfolio Stock

    The ABA strongly opposes the Administration's proposals to 
deny the dividends-received deduction for non-qualified 
preferred stock and to modify the standard for determining 
whether portfolio stock is debt financed. The Administration 
states that taxpayers have taken advantage of the dividends 
received deduction for payments on instruments that 
economically appear to be more akin to debt. We disagree. The 
ABA, along with other members of the financial services 
community, has steadfastly opposed all attempts to further 
limit the dividends received deduction.
    The dividends-received deduction currently reduced the 
impact of the multiple level taxation of earnings from one 
corporation paid to another and should not be considered a 
``corporate loophole.'' Eliminating the deduction for certain 
preferred stock would create a multiple level corporate tax 
with respect to such stock. We urge you to oppose the 
Administration's proposal.
    The proposal to modify the rules for debt-financed 
portfolio stock should also be rejected. In an attempt to 
tighten the ``directly attributable'' standard, the 
Administration proposes a pro rata formula that would be overly 
inclusive and would effectively eliminate the dividends 
received deduction for financial institutions.
    Additionally, the subject proposals would also effectively 
increase state tax liabilities for institutions that file 
separate state tax returns with respect to subsidiaries 
operating in certain states as the federal taxable income 
amount is used in calculating state tax liabilities. We 
strongly urge that these proposals be rejected.

        Expand Reporting of Cancellation of Indebtedness Income

    The Administration's budget proposes to require that 
information reporting on discharges of indebtedness be done by 
any entity involved in the business of lending money. The ABA 
opposes this proposal, as it would increase the administrative 
burdens and costs borne by credit card companies and other 
financial institutions. We urge you to reject the 
Administration's proposal.

                          Environmental Taxes

    The ABA opposes the proposal to reinstate environmental 
taxes. We believe the burden of payment of the taxes will fall 
on current owners of certain properties (who may in many 
instances be financial institutions) rather than the owners at 
the time the damage occurred. It would, thus, impose a 
retroactive tax on innocent third parties. In any event, such 
taxes would be better considered as part of overall program 
reform legislation. We urge you to reject the Administration's 
proposal.

               Require Current Accrual of Market Discount

    The ABA opposes the Administration's proposal to require 
current accrual of market discount by accrual method taxpayers. 
This proposal would not only increase administrative complexity 
but would raise taxes on business unnecessarily. We urge you to 
reject the Administration's proposal.

        Modify Treatment of Start-up and Organizational Expenses

    The Administration's proposal would lengthen the 
amortization period for start-up and organizational expenses in 
excess of $55,000 from 5 to 15 years. Such change could have a 
negative impact on the formation of small financial 
institutions as well as financial services entities, which 
typically involve start-up costs well in excess of the 
threshold amount. We urge you to reject the Administration's 
proposal.

       Limit Tax Benefits for Lessors of Tax-Exempt Use Property

    The ABA opposes the Administration's actions with respect 
to tax-exempt use property. Recent IRS action in this area 
would retroactively impact agreements that were entered into in 
accordance with the requirements of the Internal Revenue Code. 
Since this proposal is subject to congressional action, we 
believe that any change to the current treatment of such 
transactions should be prospective. We believe action by the 
Service is not appropriate at this time.

         Subject Investment Income of Trade Associations to Tax

    The ABA strongly opposes the Administration's proposal to 
tax the net investment income of trade associations. The 
proposal would impose a tax on all passive income such as 
interest, dividends, capital gains, rents, and royalties. It 
would not only impact national organizations but smaller state 
and local associations as well. In many instances, dues 
payments represent a relatively small portion of an 
association's income. Associations maintain surpluses to 
protect against financial crises and to provide quality service 
to members at an affordable cost. Indeed, it is used to further 
the exempt purposes of the organization.
    The Administration's proposal would impose an overly broad, 
and ill conceived tax on well managed trade associations that 
would directly affect their ability to continue to provide 
services vital to their exempt purpose. We urge you to reject 
the Administration's proposal.

                              Other Issues

    The Administration's proposal contains a number of other 
provisions, which will negatively impact many different types 
of appropriate business activities. Some are overly broad, 
which may have unintended consequences in the long and short 
term. We strongly urge you to reject the following provisions.
     Extend section 265 pro rata disallowance of tax-
exempt interest expense to all corporations
     Modify treatment of ESOP as S corporation 
shareholder
     Impose excise tax on purchase of structured 
settlements
     Penalty increases with respect to corporate tax 
shelters
     Limit inappropriate tax benefits for lessors of 
tax exempt use property
     Require banks to accrue interest on short-term 
obligations
     Modify and clarify straddle rules
     Tax issuance of tracking stock
     Modify the structure of businesses indirectly 
conducted by REITs
     Modify the treatment of closely held REITs
     Deny deduction for punitive damages
     Treat certain foreign-source interest and 
dividends equivalents as U.S.-effectively connected income
     Recapture overall foreign losses when controlled 
foreign corporation stock is disposed
     Increase section 4973 excise tax on excess IRA 
contributions
    The impact of the above provisions will affect businesses 
in various ways, depending upon their structures. Some of the 
consequences are foreseeable; others are unforeseeable. One 
result may be a restriction or change in products and services 
provided to consumers. Another may be a restriction on the 
ability of financial institutions to compete globally.

                        TAX INCENTIVE PROPOSALS

                         Educational Assistance

    The ABA supports the permanent extension of tax incentives 
for employer provided education. The banking and financial 
service industries are experiencing dramatic technological 
changes. This provision will assist in the retraining of 
employees to better face global competition. Employer provided 
educational assistance is a central component of the modern 
compensation package and is used to recruit and retain vital 
employees.

                Research and Experimentation Tax Credit

    The ABA supports the permanent extension of the tax credit 
for research and experimentation. The banking industry is 
actively involved in the research and development of new 
intellectual products and services in order to compete in an 
increasingly sophisticated and global marketplace. The proposal 
would extend sorely needed tax relief in this area.

                     Individual Retirement Accounts

    The ABA fully supports efforts to expand the availability 
of retirement savings. We are particularly pleased that the 
concept of tax-advantaged retirement savings has garnered long-
standing bi-partisan support and that the Administration's plan 
contains many significant proposals to encourage savings.

                     Low-income Housing Tax Credit

    The ABA supports the proposal to raise the $1.25 per capita 
cap to $1.75 per capita. This dollar value has not been 
increased since it was first set in the 1986 Act. Raising the 
cap would assist in the development of much needed affordable 
rental housing in all areas of the country.

                      Qualified Zone Academy Bonds

    The ABA supports the proposal to authorize the issuance of 
additional qualified zone academy bonds and school 
modernization bonds and to modify the tax credit bond program. 
The proposed changes would facilitate the usage of such bonds 
by financial institutions in impacted areas.

                               CONCLUSION

    The ABA appreciates having this opportunity to present our 
views on the revenue raising provisions contained in the 
President's fiscal year 2000 budget proposal. We look forward 
to working with you in the future on these most important 
matters.
      

                                

Statement of American Council of Life Insurance

    The American Council of Life Insurance (ACLI) is strongly 
opposed to the totally unwarranted $7 billion tax increase on 
life insurance companies and products in the Administration's 
Fiscal Year 2000 Budget Proposal. As 31 members of this 
Committee have already recognized, these proposals would 
seriously threaten the hopes of millions of Americans for a 
financially secure retirement and jeopardize the financial 
protection of families, businesses and family farms.
    The Council is pleased to provide this statement 
representing, for the first time in twenty years, a life 
insurance industry fully united on all tax issues affecting our 
industry. For many years we have been told by members of this 
Committee that the industry's voice on tax issues is weakened 
by the disagreements among the stock and mutual segments. Last 
month, however, there was an historic change--the end of the 
long-standing stock and mutual differences. With one voice now, 
the Council declares that there is no justification for 
provisions of the Code that separately tax stock and mutual 
life companies. With one voice now, the Council opposes any 
increase in taxes on any industry segment. With one voice now, 
the Council demonstrates that our industry already pays more 
than its fair share of taxes, and the Administration's 
proposals are both totally unjustified and bad tax policy. We 
are also pleased that the National Association of Life 
Underwriters supports the Council in this statement.
    The nearly 500 company members of the ACLI offer life 
insurance, annuities, pensions, long term care insurance, 
disability income insurance and other retirement and financial 
protection products. Our members are deeply committed to 
helping all Americans provide for a secure life and retirement.
    Two of the proposals in the Fiscal Year 2000 Budget 
Proposal would make annuities and life insurance more expensive 
for individuals and families struggling to save for retirement 
and protect against premature deaths. Annuities are the only 
financial product that provides guarantees against outliving 
one's income. Life insurance is the only product that gives 
security to families should a breadwinner die prematurely. 
Another proposal could wipe out a financial product that 
protects businesses and allows them to provide employee 
benefits, including retiree health benefits.
    The proposals do not make sense, and represent a retreat by 
the Administration from its stated goal of encouraging all 
Americans to take more personal responsibility for their income 
needs in retirement and at times of unexpected loss. They also 
seem to reflect a failure to understand the important role life 
insurance products play in the retirement and protection plans 
of middle-income Americans. ACLI member companies strongly 
support fixing Social Security first, but they are convinced 
that it will be impossible to reach this goal in the absence of 
a strong and vital private retirement and financial security 
system. Tax proposals that weaken that system are misguided and 
contradictory.
    Contrary to the Administration's perception, life insurance 
companies already pay federal taxes at a rate which is 
significantly higher than the rate for all U.S. corporations. 
Additional federal taxes would unfairly increase that already 
high tax burden. A recently completed study by Coopers & 
Lybrand shows that life insurers paid $54.4 billion in Federal 
corporate income taxes from 1986-1995. The average effective 
tax rate for U.S. life insurers over that ten year period was 
31.9%, significantly higher than the 25.3% average effective 
rate for all U.S. corporations. Moreover, the effective rate 
rose sharply during the ten-year study period, from 23.9% 
between 1986 and 1990, to 37.1% between 1991 and 1995, with the 
imposition of the DAC tax in 1990 (described below).
    The Administration Budget Proposal for Fiscal 2000 contains 
many unwarranted tax increases on life insurance products, 
policyholders and companies. The major increases include:

      PROPOSAL TO INCREASE DAC TAX ON ANNUITIES AND LIFE INSURANCE

    In addition to paying regular corporate income taxes, life 
insurers must pay a tax based on gross premiums from the sales 
of their products, including life insurance and annuities. This 
tax is known as the DAC tax. This new tax was imposed in 1990 
to serve as a proxy for the amount of expenses life companies 
incur to put life and annuity policies on their books. Under 
the DAC tax, these expenses are no longer tax deductible in the 
year paid; rather the deduction is spread over a ten year 
period. (The acronym DAC stands for deferred acquisition 
costs.) The DAC tax is an arbitrary addition to corporate 
income tax calculated as a percentage of the net premiums 
attributable to each type of policy. It was not logically 
defensible in 1990, and is not now. The Administration proposes 
to triple the DAC tax on annuities, nearly double the tax on 
individual whole life insurance, raise the tax on group whole 
life six-fold and also increase other DAC taxes.

ACLI RESPONSE:

     An Increase in the DAC Tax on Annuities and Life 
Insurance Would Make Important Protection and Retirement 
Savings Products More Expensive. Today Americans are living 
longer than ever before and our aging population is putting 
more pressure on already-strained government entitlement 
programs. Consequently, individuals must take more 
responsibility for their own retirement income and protection 
needs. Adding taxes based on the premiums companies receive for 
retirement and protection products will lead directly to higher 
prices and undermine Americans' private retirement and 
protection efforts.
     The Administration Proposal Represents a Thinly 
Disguised Tax Increase on Policyholders and an Attack on Inside 
Build-up. The proposed DAC tax increase falls principally on 
annuities and whole life insurance, both individual and group. 
These are the products that allow policyholders to accumulate 
earnings to fund the costs of insurance in the later, more 
expensive years of the policy. The inside build-up is taxed if 
cash is withdrawn from the policy. This tax treatment 
represents sound social and tax policy designed to encourage 
individuals to purchase these important retirement and 
protection products. The increase in the DAC tax on annuities 
and whole life insurance is an attempt to tax indirectly the 
policyholders' inside build-up on these products, contrary to 
sound tax policy. The tax will certainly have that effect on 
policyholders through increased costs and lower returns.
     The Tax System Prior to Enactment of the 1990 DAC 
Tax Already Deferred Life Insurers' Deductions for Acquisition 
Costs through Reduced Reserve Deductions. It is Inappropriate 
to Further Extend this Unfair ``Double Deferral'' Scheme. In 
1984, Congress reduced companies' reserve deductions by a 
formula that effectively defers deductions for policy 
acquisition costs. Thus, the DAC tax was unnecessary in 1990 
and should not be increased in the 21st century. No insurance 
accounting system (GAAP or state regulatory) requires both the 
use of low reserves and deferral of deductions for policy 
acquisition expenses. Treasury specifically cites the GAAP 
system as a model for requiring deferred deductions for 
acquisition costs, but ignores the fact that GAAP does not also 
require reduced reserve deductions.

             PROPOSAL TO TAX POLICYHOLDERS SURPLUS ACCOUNTS

    Prior to the Tax Reform Act of 1984, shareholder-owned life 
insurance companies established policyholders surplus accounts 
(PSAs), reflecting a portion of their operating gains that were 
not subject to tax. PSA amounts would be taxed only if such 
amounts were deemed distributed to shareholders or the company 
ceased being a life insurance company. In 1984, Congress 
completely rewrote the structure of taxation of life insurance 
companies to tax them on a comprehensive income basis. As part 
of that thorough rewrite, Congress decided to eliminate further 
additions to PSAs. Congress also concluded that the shareholder 
distribution trigger for taxing PSAs would be maintained. The 
Administration now proposes to force life companies to include 
these tax accounts in income and pay tax on the PSA over a ten 
year period.

ACLI RESPONSE:

     The Administration Proposal Is a Retroactive Tax 
and a Violation of Fair Tax Treatment. To reach back for tax 
revenues on long-past operating results, some from nearly 40 
years ago, is wrong. Congress addressed the tax treatment of 
policyholders surplus accounts 15 years ago. In fact, the 
Committee Reports to the 1984 Tax Reform Act specifically 
provide that life insurance companies ``will not be taxed on 
previously deferred amounts unless they are treated as 
distributed to shareholders or subtracted from the 
policyholders surplus account under rules comparable to those 
provided under the 1959 Act.'' Such arbitrary efforts to 
retroactively change the tax rules applicable to old operations 
reveals a desperate revenue grab by Treasury.
     The Administration Proposal Inappropriately 
Resurrects Tax Code Deadwood. The policyholders surplus account 
(Section 815 of the tax code) is merely a tax accounting 
mechanism or record in the practical operations of life 
insurance companies. There are no special untaxed assets set 
aside in a vault available to pay this unanticipated tax. In 
fact, the accountants have concluded that under state statutory 
and GAAP accounting rules that govern shareholder-owned life 
insurance companies, Section 815 accounts would very rarely, if 
ever, be triggered, and, if so, would be triggered only by 
activities under the control of the taxpayer. Thus, statutory 
and GAAP accounting conclude that the potential tax liability 
under Section 815 should be disregarded for accounting 
purposes. No one could conceive that Treasury would resurrect 
this deadwood. Only now, when Treasury needs to fill out its 
budget, is the deadwood brought to life.
     The Administration Proposal Creates Immediate Full 
Loss of Shareholder Value, in Addition to Tax Hit. Should this 
proposal become law, shareholder-owned life insurance companies 
would be hit first when forced to pay tax over a ten-year 
period out of the earnings and assets that would otherwise be 
used to do business and protect policyholders. The companies 
would also be forced to record immediately the new, full tax 
liability on their public accounting reports to shareholders. 
This creates an immediate loss to shareholders of the entire 
amount of the new tax, not just the first year payment.
     The Administration Reasoning Relating the PSAs to 
Specific Policies is Specious. There is not now, and never has 
been, any relationship between liabilities under specific 
policies and additions to PSAs that took place prior to 1984. 
Thus, Treasury is disingenuous when it suggests that taxing 
PSAs now would cause no harm to policyholders from a past era. 
What the new tax will do is affect the return to current 
policyholders since this is a tax that must be paid from 
current operations.

                PROPOSAL TO TAX BUSINESS LIFE INSURANCE

    In 1996, Congress eliminated the deductibility of interest 
paid on loans borrowed directly against business life insurance 
(policy loans), except in very limited circumstances involving 
grandfathered policies and policies covering key individuals. 
In 1997, Congress further limited deductions for interest on 
unrelated business borrowing if the business owns life 
insurance. This most recent tax penalty does not apply to 
contracts covering employees, officers, directors and 20-
percent owners. The Administration now proposes to place an 
additional tax on companies that borrow for any purpose if 
those companies also own life insurance, including key employee 
insurance. The proposal would also increase taxes on companies 
that borrow directly against life insurance policies covering 
key employees. This proposal would destroy the carefully 
crafted limitations created in the 1996 and 1997 legislation by 
eliminating most key persons as defined in the 1996 Act and 
eliminating employees, officers and directors from the 1997 Act 
provisions.

ACLI RESPONSE:

    Further changes in the tax treatment of business life 
insurance are unnecessary and would unfairly disrupt the 
fundamental protection and benefit plans of many businesses. 
Far from a ``tax shelter'' as Treasury contends, business life 
insurance is a product that protects businesses, especially 
small businesses, and allows all businesses to provide employee 
benefits, including retiree health benefits. The proposal would 
eliminate the use of business life insurance in providing those 
protections and benefits.
     The Proposal Is Anti-Business Expansion. Under the 
proposal, the mere ownership of a whole life insurance policy 
on the president of a company could result in additional tax to 
that company. This additional tax would be imposed against 
loans that bear no relation to any borrowing from the life 
insurance policy, but rather would result from normal business 
borrowing for expansion and similar fundamental purposes. There 
is no good reason why the mere ownership of a policy on the 
employees, directors or officers of the firm should result in a 
tax penalty on unrelated borrowing. The businesses affected by 
this proposal will have to choose between protecting themselves 
against the premature death of a valued employee, officer or 
director, and borrowing to increase their business. This forced 
choice between valid, unrelated business needs is bad tax and 
economic policy.
     Key Person Direct Borrowing Exception Is 
Important. In 1996, Congress reviewed the taxation of policy 
loans borrowed directly from life insurance policies. As a 
result of this review, substantial restrictions were placed on 
this borrowing, limiting it to coverage on a small number of 
key employees. The present proposal ignores this review and 
crafts new and more draconian limitations. There is no 
rationale for changing from the 1996 legislation to the current 
proposal. The key person exception is especially important to 
allow small businesses access to their limited assets.
     Mere Ownership Of A Policy On An Employee, Officer 
Or Director Should Not Result In A Tax Penalty. In 1997, 
Congress reviewed the taxation of borrowing unrelated to life 
insurance policies where the business also happened to own life 
insurance. As a result of this review, a tax penalty was 
imposed on companies that have loans unrelated to the life 
insurance policy if the policy covers customers, debtors and 
other similar insureds. Coverage of employees, officers, 
directors and 20-percent owners was specifically exempt from 
this penalty. There is no rationale for changing from the 1997 
legislation to the current proposal under which policies on 
employees, officers and directors can result in a tax penalty. 
Protection of valuable workplace human capital assets is 
crucial to business and should not be penalized.
     Protecting Against Loss Of Valuable Employees Is 
Fundamental To Business Operations. Just as businesses rely on 
insurance to protect against the loss of property, they need 
life insurance to minimize the economic costs of losing other 
valuable assets, such as employees. This is especially 
important with respect to small businesses, the survival and 
success of which often rest with their key employees. Without 
access to permanent life insurance at a reasonable cost, 
companies may not have the capital necessary to keep operations 
afloat after the loss of such assets. The proposal can well 
make that cost in excess of what a business can afford.
     Businesses Need Employee Coverage To Fund Retiree 
Benefits. Corporations frequently use life insurance as a 
source of funds for various employee benefits, such as retiree 
health care. Permanent life insurance helps make these benefits 
affordable. Loss of interest deductions on unrelated borrowing 
is an inappropriate tax penalty that will force these companies 
to reduce employee and retiree benefits funded through business 
life insurance.
     The Administration ``Arbitrage'' Reasoning is 
Specious and Masks an Unwarranted Attempt to Tax Inside Build-
Up. Any further tax changes to business life insurance target 
the current treatment of inside build-up on permanent life 
insurance. The effect of denying general interest deductions by 
reference to the cash value of life insurance is to tax the 
cash value build-up in the permanent policy. Allowing general 
business interest deductions to accompany mere ownership of 
life insurance cash values does not represent tax arbitrage and 
is fully consistent with general tax and social policy. For 
example, a business that uses commercial real estate as 
collateral for a loan does not lose the deduction of loan 
interest even though the property's value consists of 
appreciation and even though the tax on that appreciation is 
deferred until the property is sold. Additionally, the rate of 
tax on any gain is the lower capital gains rate. Similarly, 
other business tax benefits, such as the research and 
development tax credit, do not result in a loss of interest 
deductions when a firm borrows for normal business purposes. 
The Administration's arbitrage reasoning is plainly 
inappropriate because if applied to an individual it would 
cause the loss of home mortgage interest deductions when a 
taxpayer also owns permanent life insurance.
      

                                

Statement of American Insurance Association

                              INTRODUCTION

    The American Insurance Association (AIA) is a national 
trade association representing more than 300 major insurance 
companies that provide all lines of property and casualty (P&C) 
insurance nationwide and globally.
    AIA appreciates having this opportunity to comment on the 
revenue proposals in the Administration's' fiscal year 2000 
budget. AIA's concerns with these proposals can be grouped into 
three categories, as follows:
     P&C insurer-targeted proposal (i.e., increasing 
the ``proration'' of tax exempt interest and certain dividends 
received by P&C insurers from 15% to 25%);
     Broader proposals opposed by AIA (i.e., 
reinstating Superfund excise taxes and corporate environmental 
income tax (EIT); requiring the current accrual of market 
discount; denying a deduction for punitive damages; increasing 
information reporting penalties; taxing the investment income 
of section 501(c)(6) trade associations); and
     Tax changes supported by AIA (i.e., extending the 
active financing income exception; imposing the excise tax on 
structured settlements).
    These comments principally address the adverse impacts of 
the ``proration'' proposal, which is targeted at P&C insurers 
(and, indirectly, the exempt bond market in which they 
participate). However, AIA feels no less strongly about its 
positions, described below, on extending the active financing 
income exception, which otherwise will sunset this year, and 
reinstating Superfund taxes.
    In addition, AIA feels strongly, from an association 
perspective, that it is time to put to rest for good the 
proposal to tax the investment income of trade associations, 
which was rejected by Congress in 1987.

                     P&C INSURER-TARGETED PROPOSAL

Proration of Tax Exempt Interest and Dividends Received

    As part of its fundamental overhaul of the tax rules 
governing P&C insurers, Congress in 1986 adopted the 
``proration'' rule, effectively taxing a portion of P&C 
insurers' exempt interest and dividend income.\1\ Congress 
fixed this portion at the 15% level to generate additional 
taxable income from P&C insurers, while maintaining such 
insurers as viable investors in the market for municipal 
bonds.\2\ This purpose was reaffirmed, in effect, when Congress 
excluded insurers from a proposal in 1997 to disallow an 
interest expense deduction with respect to a pro rata portion 
of municipal bond earnings.\3\
---------------------------------------------------------------------------
    \1\ P&C insurers are major holders of tax-exempt municipal bonds. 
In 1997, P&C insurers held some $180 billion (almost 14%) of the total 
$1.3 trillion of outstanding exempt bonds.
    \2\ These bonds--a vital source of capital for state and local 
governments--are used to finance new public school construction, build 
bridges, roads, and water and sewer systems, airports, and for a 
variety of other traditional public uses.
    \3\ The exemption is included in the pro rata interest disallowance 
rule included in the Administration's fiscal year 2000 budget.
---------------------------------------------------------------------------
    Last year, the Administration unsuccessfully sought to 
double the tax on exempt interest received by P&C insurers. 
Treasury's stated rationale was that P&C insurers should be 
treated more like other financial intermediaries, whose ability 
to purchase municipal bonds already had been, as Treasury 
stated, ``severely curtailed or eliminated.'' The 
Administration, presumably persuaded last year that 30% 
proration would have unacceptable impacts on the municipal bond 
market, now proposes instead to hike P&C insurer proration to 
25%. This proposal would be effective with respect to 
investments acquired on or after the date of first committee 
action.
    Last year, AIA surveyed its membership to assess the 
impacts of adopting the Administration's proration proposal. 
Respondents to the survey, comprising almost 20% of total P&C 
insurance industry premium volume and collectively holding 
almost $39 billion of municipal bonds, confirmed that they 
would buy fewer municipal bonds if the proposal was adopted, 
unless municipal bond yields increased sufficiently.\4\ This 
would, in turn, increase the costs of borrowing for state and 
local issuers and the tax burden on state and local taxpayers, 
with no discernible tax policy or public policy benefits. 
Indeed, it was estimated last year that 75% of the total 
additional taxes raised by the proration proposal would have 
been borne by state and local governments, and ultimately 
taxpayers, in the form of increased municipal bond yields.\5\
---------------------------------------------------------------------------
    \4\ A P&C insurer must match its investments with its liabilities, 
so that the increased yield that such an insurer would need to invest 
in municipal bonds under 25% proration, typically would not be realized 
by changing the duration of the insurer's investment portfolio.
    \5\ Municipal Market Comment, Friedlander & Mosley (Salomon Smith 
Barney, February 6, 1998).
---------------------------------------------------------------------------
    It is obvious that a P&C insurer will not invest in a 
municipal bond unless the investment yields a greater after-tax 
return than a taxable bond. As a matter of arithmetic, this 
``breakeven'' ratio, now 68.6%, would rise to 71.2% (relative 
to U.S. Treasury securities) if the 25% proration proposal were 
adopted. This already is perilously close to the typical market 
yield spreads between exempt and taxable bonds, particularly in 
the typical ``P&C maturity range'' (i.e., 10 to 20 years 
maturity). As a practical matter, however, a P&C insurer will 
invest in a municipal bond only when this yield ratio is 
sufficiently in excess of this breakeven ratio to take account 
of the significant risk premium that the municipal bond 
carries. This risk premium arises from a number of liquidity, 
tax and business risks, including the following:
     Alternative investments. Even now, the municipal 
bond market is illiquid relative to the markets for higher-
yielding, taxable P&C investments.
     Capital gains rates. Reduced individual capital 
gains rates have increased the attractiveness of equities for 
these investors, further narrowing liquidity in the exempt bond 
market.
     ``Grandfathered'' bonds. P&C insurers would be 
reluctant to sell current exempt bond holdings, 
``grandfathered'' under the proration proposal, significantly 
narrowing liquidity in the exempt market.
     Alternative buyers. Current tax rules make it 
uneconomic, in general, for a P&C to invest in municipal bonds 
at the shorter end of the maturity curve. If a P&C insurer's 
costs increase in the P&C maturity range, where support from 
retail investors and mutual funds is only occasional, it is 
unclear that there would be any alternative market in this 
range.
     Regular tax rates. Corporate tax rates have 
fluctuated widely over the past 10 to 15 years. The possibility 
of reduced marginal tax rates is a significant risk factor for 
a P&C insurer investing in a municipal bond in the P&C maturity 
range.
     Shifting proration rules. A P&C investor cannot 
ignore the risk that the market will perceive the 25% proration 
proposal as the latest in a series of continuing attempts to 
erode the value of exempt interest, demanding an additional 
risk premium across all sectors of the exempt market.
     Tax restructuring. A P&C insurer purchasing a 
municipal bond in the P&C maturity range, even today, cannot 
ignore the risk that fundamental tax restructuring (e.g., a 
flat tax, or national sales tax replacing the federal income 
tax) might eliminate any tax incentive to hold such bonds.
     Alternative minimum tax (AMT). For a P&C insurer, 
adverse loss experience, including a single major catastrophic 
event (e.g., Hurricane Andrew, the Northridge Earthquake), can 
readily and dramatically change assumptions about underwriting 
results. Where adverse underwriting results give rise to 
liability for the AMT, a P&C insurer faces a significant 
penalty on tax-exempt interest.\6\
---------------------------------------------------------------------------
    \6\ Exempt interest is now taxed to a P&C insurer at an effective 
rate of 15.75%, well above the 5.25% effective tax rate under the 
regular tax. While AMT credits may mitigate this penalty, they do not 
eliminate it.
---------------------------------------------------------------------------
     State tax. Most states do not subject P&C insurers 
to state income tax. Such insurers are subject instead to a 
premium tax, which is a gross receipts tax on total direct 
premiums received by the insurer. P&C insurers investing in 
municipal bonds, in general, will realize reduced yields with 
no tax benefit at the state level.
    These risk factors increase significantly above the 
``arithmetic breakeven ratio'' the market yield ratio that a 
P&C investor must demand to purchase a municipal bond. As a 
result, if proration increases, a P&C insurer would invest in a 
municipal bond in the P&C maturity range only if yields 
increased significantly (e.g., by an estimated 10 to 15 basis 
points, under 30% proration \7\).
---------------------------------------------------------------------------
    \7\ Municipal Market Comment, Friedlander & Mosley (Salomon Smith 
Barney, February 13, 1998).
---------------------------------------------------------------------------
    Even a small increase in the interest cost to municipal 
finance would substantially increase the aggregate financial 
costs to state and local governments of critical debt-financed 
public works projects. Last year, the Bond Market Association 
estimated that, if 30% proration had been in effect in 1997, 
when some $207 billion in tax exempt securities were issued, it 
would have cost issuers $2 to $3 billion over the life of their 
issues (assuming an average 15-year maturity).
    The proration proposal also would increase the taxation of 
certain dividends received by a P&C insurer. This would reduce 
financing options for U.S. companies, increase the costs of 
capital, and reduce liquidity in domestic capital markets. For 
these reasons, Congress has wisely rejected other proposals in 
recent years to increase the taxation of dividends received.
    The remaining tax burden of increased proration would be 
borne by the P&C insurance industry and its policyholders. 
There is no justification for singling-out this industry, 
already bearing its fair share of the federal income tax 
burden, for another tax hike. The 1986 and 1990 tax acts 
imposed on P&C insurers a number of fundamental, targeted tax 
law changes that significantly increased this industry's 
federal tax burden. Studies of the 1986 changes, including 
Treasury's own study, consistently reflect that the P&C 
industry has substantially exceeded Congress' revenue 
expectations. Other changes, including the taxation of 
municipal bond interest under the AMT, which became more severe 
in 1990, and the limitation in 1997 of the net operating loss 
carryback period, further disproportionately burden P&C 
insurers.

                         BROADER TAX PROPOSALS

Superfund Taxes

    The Administration proposes to reinstate the Superfund 
taxes that expired on December 31, 1995. However, the 
authorization for the Superfund hazardous waste cleanup 
program, which the taxes were intended to finance, expired at 
the end of 1994, and the Administration has continued to block 
all Congressional attempts to reauthorize and reform the 
program. AIA would support the reinstatement of the taxes only 
as part of comprehensive Superfund reform legislation, and only 
if revenues from these taxes are used for hazardous waste 
cleanup, and not to fund unrelated programs.

Market Discount

    The Administration proposes to require the current accrual 
of market discount on debt instruments. The proposal would be 
effective for debt instruments acquired on or after the date of 
enactment. P&C insurers must invest in debt securities and 
equities to back loss reserves needed to meet obligations to 
policyholders. AIA opposes this proposal because it would 
impose additional costs and complexity \8\ on P&C insurers and 
their policyholders. Significantly, the proposal would be 
retroactive, in effect, because it would apply to bonds 
``acquired'' (rather than ``issued'') after enactment, thereby 
diminishing the value of a market discount bond in the existing 
portfolio of an affected P&C insurer.
---------------------------------------------------------------------------
    \8\ The complexity of the provision also is a concern reflected in 
the Description of Revenue Provisions Contained in the President's 
Fiscal Year 2000 Budget A Proposal, prepared by the staff of the Joint 
Committee on Taxation, at 207 (February 22, 1999).

---------------------------------------------------------------------------
Punitive Damages

    The Administration proposes to deny a deduction in all 
cases where punitive damages are paid or incurred by the 
taxpayer. In cases where the liability is covered by insurance, 
the Administration proposes that the damages must be included 
in the income of the insured and the insurer must report such 
amounts to the insured and the IRS.
    The Administration's proposal appears to assume that 
punitive damages are generally covered by insurance. As a 
general rule, however, punitive damages are not (and, in many 
states, cannot be) covered by insurance.
    In the typical civil litigation case, where insurance may 
cover a settlement payment but not a punitive damages award, 
this proposal would provide an incentive for a commercial 
insured to settle, even at a higher amount, in order to avoid 
the possibility of a punitive damage award. By driving up the 
cost of settlements, the proposal would increase the costs of 
insurance.
    In the (unusual) case, where punitive damages are covered 
by insurance, the proposal would impose a new information 
reporting burden on P&C insurers, who are still struggling 
(with no regulatory guidance) with the burdens and 
uncertainties arising under the requirement, adopted in 1997, 
to report ``gross proceeds'' payments to attorneys.

Information Reporting Penalties

    The Administration proposes to increase the penalties for 
failures to correctly file certain information returns from $50 
per return to the greater of $50 or 5% of the amount required 
to be reported (subject to certain exceptions). As applied to 
the millions of Forms 1099-MISC that individual P&C insurers 
must file for payments to third-party service providers (e.g., 
auto body repair shops), with whom they typically have no 
account relationship and no prior dealings, this proposal would 
impose additional costs with minimal compliance benefits. 
Moreover, as applied to ``gross proceeds'' attorney reporting 
required under the 1997 tax act, imposing this penalty as a 
percentage of the amount required to be reported (much of 
which, typically, will be a nontaxable claims payment) would 
disproportionately burden P&C insurers.\9\
---------------------------------------------------------------------------
    \9\ Id. at 323.

---------------------------------------------------------------------------
Investment Income Tax on Trade Associations

    The Administration proposes to subject the investment 
income of trade associations to the unrelated business income 
tax (UBIT). For several reasons, AIA feels that this proposal, 
wisely rejected by the Congress in 1987, should be firmly 
repudiated this year.
     If this proposal is adopted, affected trade 
associations would need to increase member dues to pay the new 
tax \10\ or reduce member services. The proposal would subject 
to this Hobson's Choice--inexplicably and inequitably--exempt 
trade associations that lobby, like AIA, but not other exempt 
organizations that lobby.
---------------------------------------------------------------------------
    \10\ This would increase the tax deduction taken by members for 
dues payments, and reduce any revenue raised by the proposal. In this 
regard, Treasury estimates that this proposal would raise $1.44 billion 
over five years, while the Joint Committee on Taxation estimates that 
it would raise $700 million over the same period.
---------------------------------------------------------------------------
     The purpose of UBIT is to avoid unfair competition 
with respect to for-profit businesses. The taxation of a trade 
association's passive investment income in no way addresses any 
issue of competitiveness, however, nor has Treasury even 
suggested that it does.
     A tax exempt trade association's investment income 
does not, and cannot, result in private inurement to any 
private shareholder or individual. Rather, this income is 
allocated to the association's operating budget, furthering its 
exempt purposes (i.e., improving the business conditions of a 
particular line of business).
     For a trade association, which cannot access the 
capital or credit markets, investment income can serve as a 
vital buffer against instability during economic downturns. The 
proposed tax, which would erode this buffer, would perversely 
penalize associations for taking this prudent step.

                      TAX CHANGES SUPPORTED BY AIA

Active Financing Income Exception

    The Administration's budget proposals provide for the extension of 
six expiring provisions, but omit the active financing income exception 
to subpart F of the Internal Revenue Code, which expires at the end of 
1999. This provision, which helps to level the playing field with 
respect to foreign multinational and local country competitors in 
global markets, is essential to the competitiveness of U.S. insurers 
seeking to enter or expand in those markets. It also is essential to 
the equitable tax treatment of U.S. financial services industries 
relative to other U.S. industries.
    AIA endorses H.R. 681, which would achieve a permanent, stable tax 
regime in this area. AIA agrees with comments on this issue filed with 
the Committee (and joined in by AIA) by The Coalition of Services 
Industries. At a minimum, this provision should be extended along with 
other extensions of expiring provisions in the budget bill.

Structured Settlements

    The Administration proposes to impose a 40% excise tax on persons 
acquiring a payment stream (i.e., factoring) a structured settlement. 
This proposal is similar to bills sponsored this year and last by Rep. 
Shaw. The staff of the Joint Committee on Taxation has aptly described 
the value of this proposal, as follows:

          The proposal responds to the social concern that injured 
        persons may not be adequately protected financially in 
        transactions in which a long-term payment stream is exchanged 
        for a lump sum. Transfer of the payment stream under a 
        structured settlement arrangement arguably subverts the purpose 
        of the structured settlement provisions of the Code to promote 
        periodic payments for injured persons.\11\
---------------------------------------------------------------------------
    \11\ Id. at 329.

    AIA agrees that this proposal will help to maintain the 
integrity of the structured settlement process.

                              CONCLUSIONS

    AIA respectfully urges the Committee to reject the 
Administration's budget proposals to:
     increase the taxation of otherwise tax-exempt 
income and certain dividends received,
     reinstate Superfund excise taxes and the corporate 
EIT,
     require the current accrual of market discount on 
bonds,
     disallow a deduction for punitive damages,
     increase information reporting penalties, and
     tax the investment income of trade associations.
    AIA also urges the Committee to extend the active financing 
income exception under subpart F of the Code, and to adopt the 
budget proposal to impose an excise tax on the ``factoring'' of 
structured settlements.
    AIA remains ready to assist the Committee in any way 
possible to achieve these goals.
      

                                

Statement of American Network of Community Options and Resources 
(ANCOR), Annandale, Virginia

    This testimony outlines the comments and suggestions of the 
American Network of Community Options and Resources (``ANCOR'') 
on the Administration's proposal to simplify the foster child 
definition under the earned income tax credit (``EITC'').
    Formed in 1970 to improve the quality of life of persons 
with disabilities and their families by coordinating the 
efforts of concerned providers of private support services, 
ANCOR is comprised of more than 650 organizations from across 
the United States together providing community supports to more 
than 150,000 individuals with disabilities.
    ANCOR supports the underlying goals of the Administration's 
EITC proposal to clarify the scope of current tax law as it 
applies to foster families. However, ANCOR also strongly 
recommends that the proposal be drafted to reflect a proposed 
amendment to Section 131 of the Internal Revenue Code of 1986, 
as amended (the ``Code''). This amendment would eliminate 
inequities and uncertainties of current law and uniformly allow 
foster care providers to exclude from income the foster care 
payments they receive from a governmental source. ANCOR 
believes that amending Section 131 in this manner would (i) 
support State and local government efforts to reduce 
bureaucracy and costs, (ii) simplify the tax treatment of 
foster care payments, and (iii) encourage much-needed foster 
care providers to participate in foster care programs.

        Description of Current Law and Administration's Proposal

I. Current law.

    Section 32 of the Code allows a taxpayer to claim the EITC 
if he or she lives with a child or grandchild for more than 
half the year. In addition, a taxpayer may claim the EITC if he 
or she lives with a ``foster child.'' ``Foster child'' is 
defined as an individual who lives with the taxpayer for the 
entire year and for whom the taxpayer cares as such taxpayer's 
own child. To qualify for the EITC, the individual must be (i) 
younger than 19 years of age if not a full time student, (ii) 
younger than 24 years of age if a full time student, or (iii) 
any age if permanently and totally disabled. Section 32 does 
not require that a foster child for whom a family takes the 
EITC be placed in the household by any particular type of 
foster care agency.

II. Administration's proposal.

    For purposes of qualifying for the EITC under Section 32, 
the Administration proposes defining ``foster child'' to 
include, inter alia, children (or disabled individuals) placed 
in the taxpayer's home by an agency of a State, one of its 
political subdivisions, or tax-exempt child placement agency 
licensed by a State. This language tracks the language in 
Section 131, another Code provision relating to taxation of 
foster families.

               Analysis of the Administration's Proposal

I. The Administration's proposal would help clarify who 
qualifies for the EITC under Code Section 32.

    We believe that clarifying who qualifies as a foster child 
or individual as suggested by the Administration will help 
prevent the unintentional mistakes of countless taxpayers who 
now question whether their situations meet the qualifications 
of Section 32. Additionally, such clarifying changes would 
provide qualifying foster care providers with an adequate 
guarantee of their eligibility to take the EITC. Clarity would 
also help reduce the expense qualifying foster care providers 
often incur when they are forced to prove that they have 
claimed the EITC lawfully. Any such clarifying amendments, 
however, should parallel those proposed for Section 131, as 
explained below.

II. Congress should further clarify the tax treatment of foster 
care payments by amending Code Section 131.

    Defining the term ``foster child'' as it applies to the 
EITC is only a first step in simplifying the complicated tax 
rubric associated with the provision of foster care services. 
Additional changes should be made to Section 131 of the Code, 
which creates a dichotomy in the tax treatment of foster care 
providers for individuals under 19 years of age and those who 
provide treatment to individuals over 19 years of age. These 
Section 131 changes should also be applied to the treatment of 
a ``foster child'' under Section 32.
    For children under 19 years old, Section 131 of the Code 
currently permits foster care providers to exclude foster care 
payments from taxable income when a government entity or 
charitable tax-exempt organization directly places the 
individual and makes the foster care payments. For individuals 
19 years of age or older, Section 131 excludes foster care 
payments from taxable income only when a government entity 
makes the placement and the payment. Thus, the excludability of 
foster care payments, even though such payments are derived 
from government funds, is linked to the type of agency that 
places the individual with a foster care provider.
    This inflexible and dated treatment of taxpayers who 
provide services to children and special needs individuals has 
become more evident as foster care placement has developed as a 
preferred means of service provision to many individuals. In 
addition to the benefits this form of service produces for 
special needs individuals, foster homes have proven their 
efficacy for these individuals when compared to institutional 
services and are a growing choice of State and local 
governments. Governmental entities have found that foster care 
provides better service to certain special needs individuals 
and is less expensive and onerous for them to maintain. This 
type of residential alternative also adds to the available 
stock of community housing and expands the availability of 
qualified individuals to provide support to both adults and 
children with disabilities.
    A realization that foster care placement is the best 
solution in certain circumstances, added with a desire to 
reduce government involvement in the day-to-day placement and 
service decisions, has resulted in governmental agencies 
becoming more reliant on private agencies to arrange foster 
care services for both children and adults. The private sector 
continues to play an important and growing role on behalf of 
government by arranging for and supervising these homes through 
licensing or certification by State or local governments.
    Congress should amend Section 131 to allow all foster care 
providers the ability to exclude from income foster care 
payments received from a governmental source regardless of 
whether a governmental entity placed the foster child, as long 
as a governmental entity has either certified or licensed the 
placement agency. Amending Section 131 in such a way would not 
only support the efforts of State and local governments to 
address the needs of their communities more effectively, but 
would also simplify the treatment of foster care payments and 
reduce the administrative burden of the Internal Revenue 
Service (``IRS'').
    A. Current law fails to support the decisions of State and 
local governments.--Governmental entities are becoming 
increasingly reliant on private agencies to place both children 
and special needs adults in foster care. In particular, 
governmental entities have found that foster care for special 
needs adults reduces the expense that is usually incurred when 
maintaining group homes and institutional settings. 
Additionally, State and local governments often use outside 
entities to make case-specific decisions (such as 
identification of those individuals who would benefit from 
foster care and those foster care families with whom such 
individuals should be placed) as a means of reducing 
bureaucracy in an already trying situation. Current law, 
however, fails to provide the same tax treatment to those 
foster care families identified by private entities acting 
under a license or certification with States, counties and 
municipalities as is provided to foster care families that are 
identified directly by the State. Disparate treatment exists 
despite the fact that from the governmental entities' 
perspectives, the activities are the same. As a result of the 
difference in treatment, State and local governments are 
discouraged from contracting with private agencies to make 
placement decisions. The tax code should support State and 
local governments that decide to cut costs, reduce bureaucracy 
and support the special needs individuals in their communities 
through expanding their foster care programs.
    B. Current law is confusing to taxpayers and to the IRS.--
As illustrated by Table 1, incongruent treatment of foster care 
providers has created a complex system of determining when 
providers can exclude their foster care payments from income.

                  Table 1--Excludability of Foster Care Payments from Income Under Section 131
----------------------------------------------------------------------------------------------------------------
                                                                   Age of Foster Care
          Placement Agency                      Payor                  Individual          Payment Excludable?
----------------------------------------------------------------------------------------------------------------
State or political subdivision......  State or political        19 years....  Yes
                                       subdivision.
State or political subdivision......  501(c)(3)...............  19 years....  No
State or political subdivision......  Not 501(c)(3)...........  19 years....  No
Licensed 501(c)(3)..................  State or political        19 years....  No
                                       subdivision.
Licensed 501(c)(3)..................  501(c)(3)...............  19 years....  No
Licensed 501(c)(3)..................  Not 501(c)(3)...........  19 years....  No
Not 501(c)(3).......................  State or political        19 years....  No
                                       subdivision.
Not 501(c)(3).......................  501(c)(3)...............  19 years....  No
Not 501(c)(3).......................  Not 501(c)(3)...........  19 years....  No
----------------------------------------------------------------------------------------------------------------

    The confusion presented by current law was exemplified by 
the recent decision in Micorescu v. Commissioner, T.C. Memo 
1998-398. In Micorescu, the Tax Court held that an Oregon 
family providing foster care services to adults in the family's 
home could not exclude from income payments received from the 
private agency that placed the foster individuals with the 
family. The court reasoned that because the adult foster 
individuals were placed with the family by a private agency 
rather than by the State or an agency of the State, the foster 
individuals were not ``qualified foster individuals'' within 
the meaning of Section 131. The court reached this conclusion 
even though the organization that placed the adults in the 
family's home both contracted with and received funds from the 
State of Oregon. Equal treatment of all foster care families 
(i) who receive payments from an agency that operates under a 
license or certification by a government entity or (ii) who 
receive payments directly from a government entity would reduce 
the confusion that currently exists. Foster families, like the 
family involved in the Micorescu case, would know with 
certainty whether they could exclude their income.
    Taxpayers are not alone in their confusion. Section 131 has 
proven so confusing, in fact, that IRS officials and 
experienced certified public accountants and tax attorneys also 
have difficulty ascertaining when a payment is excludable. Our 
members can site various examples of situations in which foster 
care providers have been told informally by an IRS official 
and/or an experienced tax advisor that their foster care 
payments were to be excluded from taxable income, when in fact 
those payments were not excludable. Amending Section 131 would, 
therefore, prevent not only the confusion taxpayers and their 
tax advisors have over whether foster care payments are 
excludable, but also the confusion experienced by the IRS 
officials that are charged with administering the law.
    C. Current treatment of foster care payments discourages 
much-needed foster care families from participating in foster 
care programs.--Current law discourages families from becoming 
foster care providers, even though these rules allow families 
to offset taxable foster care payments (paid by non-qualified 
agencies) by treating expenditures made on behalf of a foster 
individual as a business expense deductions. Such deductions 
are permitted only if the families maintain detailed expense 
records. Accordingly, otherwise willing foster care families 
are discouraged from accepting individuals placed by non-
qualified agencies because such providers are forced to endure 
the time and inconvenience associated with keeping extensive 
records. In addition, the confusion created by Section 131's 
complex rules discourages many potential foster care families 
from participating in these programs. The result is a smaller 
pool of available, qualified and willing foster care providers 
and a growing pool of special needs individuals for whom group 
housing or institutional living is inappropriate. Amending 
Section 131 as suggested would help address the increasing 
demand for foster care providers.
    D. Legislation introduced this year would remedy these 
problems.--Bills were introduced in the Senate (S.670) and in 
the House (H.R. 1194) that propose to eliminate the illogical 
differences in the tax treatment of payments received by foster 
care providers. These bills would simplify the current rules 
under Section 131 for foster care payments. Under the 
legislation, foster care providers would avoid onerous record 
keeping by excluding from income any foster care payment 
received regardless of the age of the foster care individual 
and the type of entity that placed the individual, as long as 
foster care payments are funded by governmental monies and the 
placement agency licensed or certified by a State or local 
government to make payments.

                               Conclusion

    The Administration's proposal clarifies when a taxpayer, 
who is caring for a foster individual, may take the EITC and 
thus reduces taxpayer confusion and unintentional mistakes. The 
Administration's proposal is but one needed step, however, 
toward removing confusion created by the complicated rubric 
associated with the taxation of foster care payments. 
Therefore, we additionally recommend amending Section 131 of 
the Internal Revenue Code so that all governmental payments 
received by foster care providers be treated the same. This 
change should also be reflected in any change affecting the 
definition of ``foster child'' in Section 32. If enacted, 
current law's confusing and unfair tax rules would no longer 
discourage much-needed foster care families from participating 
in foster care programs. Amending Section 131 and Section 32 in 
this fashion also will support State and local governments in 
their efforts to reduce bureaucracy and cut costs, provide more 
alternatives to institutionalization and simplify tax 
administration.
      

                                

                                                  February 23, 1999

The Honorable Bill Archer
Chairman, Committee on Ways and Means
1102 Longworth House Office Building
Washington, D.C. 20515-6348

The Honorable Charles Rangel
Ranking Member, Committee on Ways and Means
1106 Longworth House Office Building
Washington, D.C. 20515-6348

    Dear Chairman Archer and Ranking Member Rangel:

    We are writing to express our opposition to a provision in the 
Administration's FY 2000 budget proposal that would accelerate, from 
quarterly to monthly, the collection of most federal and state 
unemployment insurance (UI) taxes beginning in 2005. A similar proposal 
was put forth in the Administration's FY 1999 Budget and was rejected 
by Congress.
    Imposing monthly collection of federal and state UI taxes is a 
burdensome device that accelerates the collection of these taxes to 
generate a one time artificial revenue increase for budget-scoring 
purposes and real, every year increases in both compliance costs for 
employers and collection costs for state unemployment insurance 
administrators. The Administration's proposal is fundamentally 
inconsistent with every reform proposal that seeks to streamline the 
operation of the UI system and with its own initiatives to reduce 
paperwork and regulatory burdens.
    This proposal is even more objectionable than some other tax speed-
up gimmicks considered in the past. For example, a proposal to move an 
excise tax deposit date forward by one month into an earlier fiscal 
year may make little policy sense, but it would not necessarily create 
major additional administrative burdens. The UI speed-up proposal, 
however, would result directly in significant and continuing costs to 
taxpayers and to state governments--tripling the number of required UI 
tax collection filings from 8 to 24 per affected employer each year.
    The Administration implicitly recognizes that the added federal and 
state deposit requirements would be burdensome, at least for small 
business, since the proposal includes an exemption for certain 
employers with limited FUTA liability. Even many smaller businesses 
that add or replace employees or hire seasonal workers would not 
qualify for the exemption, however, since new FUTA liability accrues 
with each new hire, including replacement employees. This deposit 
acceleration rule makes no sense for businesses large or small, and an 
exemption for certain small businesses does nothing to improve this 
fundamentally flawed concept.
    We are all strongly supportive of UI reform that simplifies the 
system and reduces the burden on employers and the costs of 
administration to the federal and state governments. Adopting the 
Administration's UI collection speed-up proposal, however, would take 
the system in exactly the opposite direction, creating even greater 
burdens than those which exist under the current system.
    We urge you to reject the Administration's UI collection speed-up 
proposal and focus instead on proposals that would make meaningful 
system-wide reforms. Thank you for your consideration of our views on 
this important issue. Please do not hesitate to let us know if we can 
provide additional assistance.

            Sincerely,
                                   American Payroll Association
                                   American Society for Payroll 
                                       Management
                                   American Trucking Association
                                   National Association of 
                                       Manufacturers
                                   National Federation of Independent 
                                       Business
                                   National Retail Federation
                                   Service Bureau Consortium, Inc.
                                   Society for Human Resource 
                                       Management
                                   U.S. Chamber of Commerce
                                   UWC, Inc.

cc: Members of the Committee on Ways and Means
      

                                

Statement of American Petroleum Institute

Introduction

    This testimony is submitted by the American Petroleum 
Institute (API) for the March 10, 1999 Ways and Means hearing 
on the tax provisions in the Administration's fy 2000 budget 
proposal. API represents approximately 400 companies involved 
in all aspects of the oil and gas industry, including 
exploration, production, transportation, refining, and 
marketing.
    The U.S. oil and gas industry is suffering through its 
worst times in recent memory. The collapse of world oil prices 
that began in late 1997 continued and worsened through 1998. 
While there has been some modest recovery in prices in recent 
weeks, many analysts view this recovery as transitory, and see 
little firm basis for sustained recovery in market conditions 
for several years. It is especially troubling that at this time 
when the industry is already reeling, the Administration has 
come forward with proposals that would increase taxes on oil 
and gas companies by as much as $6 billion over the next five 
years. Congress can help to ensure that no additional harm is 
done to this industry by rejecting the Administration's 
proposal to increase taxes on the foreign source income of oil 
and gas companies, and the proposals to reinstate the Superfund 
taxes and the Oil Spill tax.

Background

    By the end of 1998, as a result of reduced worldwide demand 
and excess production, U.S. wellhead crude oil prices had 
fallen to their lowest inflation-adjusted levels since the 
Great Depression. At year's end the average U.S. wellhead price 
was less than $8 per barrel, barely half the $15.06 average for 
the same month one year earlier. For the year, the annual 
average wellhead price was an estimated $10.85 per barrel, down 
by more than a third from $17.24 in 1997.
    Domestic oil exploration and development activity suffered 
dramatically from the lower oil prices. The total number of 
operating rigs in the U.S. fell 44% from February 98 to 
February 99. The decline for oil rigs was 69% and for gas rigs 
28%. Oil and gas companies' current upstream spending plans for 
1999 for the U.S. have been cut by 20 percent, according to a 
recent survey conducted by Salomon Smith Barney. U.S. companies 
have been forced to delay or outright cancel projects in other 
regions of the world, as well.
    Industry employment has suffered. Bureau of Labor 
Statistics data show that from October 1998 to February 1999 
the oil and gas extraction industry, including field service 
companies, lost 26,000 jobs. That 4 month loss was 6,000 more 
jobs than were lost during the entire year from October 1997 to 
October 1998. The most recent decline reduced the number of 
upstream jobs in the U.S. to about 291,000--60 percent less 
than the peak in early 1982 of 754,000 jobs.
    For petroleum refiners lower crude oil prices generally 
have not yielded higher refinery profit rates. Gasoline prices 
for 1998, adjusted for inflation, were the lowest observed 
since 1920. Regular gasoline prices dropped to 96 cents per 
gallon by year-end. They averaged about $1.06 per gallon for 
the year. The low product prices have come on the heels of 
major operating cost increases resulting from compliance with 
numerous government regulations, especially regulations aimed 
at environmental improvement. In 1997 (the latest year 
available), the refining sector spent slightly over $4 billion 
on U.S. environmental expenditures.

Administration Proposals

    Our testimony will address the following proposals:
     modify rules relating to foreign oil and gas 
extraction income;
     reinstate excise taxes and the corporate 
environmental tax deposited in the Hazardous Substance 
Superfund Trust Fund;
     reinstate the oil spill excise tax;
     corporate tax shelters;
     Harbor Maintenance Tax Converted to User Fee; and
     tax investment income of trade associations

        RULES RELATING TO FOREIGN OIL AND GAS EXTRACTION INCOME

    President Clinton's budget proposal includes the following 
provisions:
     In situations where taxpayers are subject to a 
foreign income tax and also receive an economic benefit from 
the foreign country, taxpayers would be able to claim a credit 
for such taxes under Code Section 901 only if the country has a 
``generally applicable income tax'' that has ``substantial 
application'' to all types of taxpayers, and then only up to 
the level of taxation that would be imposed under the generally 
applicable income tax.
     Effective for taxable years beginning after 
enactment, new rules would be provided for all foreign oil and 
gas income (FOGI). FOGI would be trapped in a new separate FOGI 
basket under Code Section 904(d). FOGI would be defined to 
include both foreign oil and gas extraction income (FOGEI) and 
foreign oil related income (FORI).
     Despite these changes, U.S. treaty obligations 
that allow a credit for taxes paid or accrued on FOGI would 
continue to take precedence over this legislation (e.g., the 
so-called ``per country'' limitation situations.)
    This proposal, aimed directly at the foreign operations of 
U.S. petroleum companies, seriously threatens the ability of 
those companies to remain competitive on a global scale, and 
API strongly opposes the proposal.
    If U.S. oil and gas concerns are to stay in business, they 
must look overseas to replace their diminishing reserves, since 
the opportunity for domestic reserve replacement has been 
restricted by both federal and state government policy. The 
opening of Russia to foreign capital, the competition for 
investment by the countries bordering the Caspian Sea, the 
privatization of energy in portions of Latin America, Asia, and 
Africa--all offer the potential for unprecedented opportunity 
in meeting the challenges of supplying fuel to a rapidly 
growing world economy. In each of these frontiers U.S. 
companies are poised to participate actively. However, if U.S. 
companies can not economically compete, foreign resources will 
instead be produced by foreign competitors, with little or no 
benefit to the U.S. economy, U.S. companies, or American 
workers.
    With non-OPEC development being cut back, and OPEC market 
share once again rising, a key concern of federal policy should 
be that of maintaining the global supply diversity that has 
been the keystone of improved energy security for the past two 
decades. The principal tool for promotion of that diversity is 
active participation by U.S. firms in the development of these 
new frontiers. At a time when those operations are especially 
vulnerable, federal policy should be geared to enhancing the 
competitiveness of U.S. firms operating abroad, not reducing it 
with new tax burdens.
    The foreign tax credit (FTC) principle of avoiding double 
taxation represents the foundation of U.S. taxation of foreign 
source income. The Administration's budget proposal would 
destroy this foundation on a selective basis for foreign oil 
and gas income only, in direct conflict with long established 
tax policy and with U.S. trade policy of global integration, 
embraced by both Democratic and Republican Administrations.

The FTC Is Intended To Prevent Double Taxation

    Since the beginning of Federal income taxation, the U.S. 
has taxed the worldwide income of U.S. citizens and residents, 
including U.S. corporations. To avoid double taxation, the FTC 
was introduced in 1918. Although the U.S. cedes primary taxing 
jurisdiction for foreign income to the source country, the FTC 
is intended to prevent the same income from being taxed twice, 
once by the U.S. and once by the source country. The FTC is 
designed to allow a dollar for dollar offset against U.S. 
income taxes for taxes paid to foreign taxing jurisdictions. 
Under this regime, foreign income of foreign subsidiaries is 
not immediately subject to U.S. taxation. Instead, the 
underlying earnings become subject to U.S. tax only when the 
U.S. shareholder receives a dividend (except for certain 
``passive'' or ``Subpart F'' income.) Any foreign taxes paid by 
the subsidiary on such earnings is deemed to have been paid by 
any U.S. shareholders owning at least 10% of the subsidiary, 
and can be claimed as FTCs against the U.S. tax on the foreign 
dividend income (the so-called ``indirect foreign tax 
credit'').

Basic Rules of the FTC

    The FTC is intended to offset only U.S. tax on foreign 
source income. Thus, an overall limitation on currently usable 
FTCs is computed by multiplying the tentative U.S. tax on 
worldwide income by the ratio of foreign source income to 
worldwide taxable income. The excess of FTCs can be carried 
back 2 years and carried forward 5 years, to be claimed as 
credits in those years within the same respective overall 
limitations.
    The overall limitation is computed separately for not less 
than 9 ``separate limitation categories.'' Under present law, 
foreign oil and gas income falls into the general limitation 
category. Thus, for purposes of computing the overall 
limitation, FOGI is treated like any other foreign active 
business income. Separate special limitations still apply, 
however, for income: (1) whose foreign source can be easily 
changed; (2) which typically bears little or no foreign tax; or 
(3) which often bears a rate of foreign tax that is abnormally 
high or in excess of rates of other types of income. In these 
cases, a separate limitation is designed to prevent the use of 
foreign taxes imposed on one category to reduce U.S. tax on 
other categories of income.

FTC Limitations For Oil And Gas Income

    Congress and the Treasury have already imposed significant 
limitations on the use of foreign tax credits attributable to 
foreign oil and gas operations. In response to the development 
of high tax rate regimes by OPEC, taxes on foreign oil and gas 
income have become the subject of special limitations. For 
example, each year the amount of taxes on FOGEI may not exceed 
35% (the U.S. corporate tax rate) of such income. Any excess 
may be carried over like excess FTCs under the overall 
limitation. FOGEI is income derived from the extraction of oil 
and gas, or from the sale or exchange of assets used in 
extraction activities.
    In addition, the IRS has regulatory authority to determine 
that a foreign tax on FORI is not ``creditable'' to the extent 
that the foreign law imposing the tax is structured, or in fact 
operates, so that the tax that is generally imposed is 
materially greater than the amount of tax on income that is 
neither FORI nor FOGEI. FORI is foreign source income from (1) 
processing oil and gas into primary products, (2) transporting 
oil and gas or their primary products, (3) distributing or 
selling such, or (4) disposing of assets used in the foregoing 
activities. Otherwise, the overall limitation (with its special 
categories discussed above) applies to FOGEI and FORI. Thus, as 
active business income, FOGEI and FORI would fall into the 
general limitation category.

The Dual Capacity Taxpayer ``Safe Harbor'' Rule

    As distinguished from the rule in the U.S. and some 
Canadian provinces, mineral rights in other countries vest in 
the foreign sovereign, which then grants exploitation rights in 
various forms. This can be done either directly or through a 
state owned enterprise (e.g., a license or a production sharing 
contract). Because the taxing sovereign is also the grantor of 
mineral rights, the high tax rates imposed on oil and gas 
profits have often been questioned as representing, in part, 
payment for the grant of ``a specific economic benefit'' from 
mineral exploitation rights. Thus, the dual nature of these 
payments to the sovereign have resulted in such taxpayers being 
referred to as ``dual capacity taxpayers.''
    To help resolve controversies surrounding the nature of tax 
payments by dual capacity taxpayers, the Treasury Department in 
1983 finalized the ``dual capacity taxpayer rules'' of the FTC 
regulations. Under the facts and circumstances method of these 
regulations, the taxpayer must establish the amount of the 
intended tax payment that otherwise qualifies as an income tax 
payment and is not paid in return for a specific economic 
benefit. Any remainder is a deductible rather than creditable 
payment (and in the case of oil and gas producers, is 
considered a royalty). The regulations also include a safe 
harbor election (see Treas. Reg. 1.901-2A(e)(1)), whereby a 
formula is used to determine the tax portion of the payment to 
the foreign sovereign, which is basically the amount that the 
dual capacity taxpayer would pay under the foreign country's 
general income tax. Where there is no generally applicable 
income tax, the safe harbor rule of the regulation allows the 
use of the U.S. tax rate in a ``splitting'' computation (i.e., 
the U.S. tax rate is considered the country's generally 
applicable income tax rate).

The Proposal Disallows FTCs Of Dual Capacity Taxpayers where 
the Host Country Has No Generally Applicable Income Tax

    If a host country had an income tax on FOGI (i.e., FOGEI or 
FORI), but no generally applicable income tax, the proposal 
would disallow any FTCs on FOGI. This would result in 
inequitable and destructive double taxation of dual capacity 
taxpayers, contrary to the global trade policy advocated by the 
U.S.
    The additional U.S. tax on foreign investment in the 
petroleum industry would not only eliminate many new projects; 
it could also change the economics of past investments. In some 
cases, this would not only reduce the rate of return, but also 
preclude a return of the investment itself, leaving the U.S. 
business with an unexpected ``legislated'' loss. In addition, 
because of the uncertainties of the provision, it would also 
introduce more complexity and potential for litigation into the 
already muddled world of the FTC.
    The unfairness of the provision becomes even more obvious 
if one considers the situation where a U.S. based oil company 
and a U.S. based company other than an oil company are subject 
to an income tax in a country without a generally applicable 
income tax. Under the proposal, only the U.S. oil company would 
receive no foreign tax credit, while the other taxpayer would 
be entitled to the full tax credit for the very same tax.
    The proposal's concerns with the tax versus royalty 
distinction were resolved by Congress and the Treasury long ago 
with the special tax credit limitation on FOGEI enacted in 1975 
and the Splitting Regulations of 1983. These were then later 
reinforced in the 1986 Act by the fragmentation of foreign 
source income into a host of categories or baskets. The earlier 
resolution of the tax versus royalty dilemma recognized that 
(1) if payments to a foreign sovereign meet the criteria of an 
income tax, they should not be denied complete creditability 
against U.S. income tax on the underlying income; and (2) 
creditability of the perceived excessive tax payment is better 
controlled by reference to the U.S. tax burden, rather than 
being dependent on the foreign sovereign's fiscal choices.

The Proposal Limits FTCs To The Amount Which Would Be Paid 
Under the Generally Applicable Income Tax

    By elevating the regulatory safe harbor to the exclusive 
statutory rule, the proposal eliminates a dual capacity 
taxpayer's right to show, based on facts and circumstances, 
which portion of its income tax payment to the foreign 
government was not made in exchange for the conferral of 
specific economic benefits and, therefore, qualifies as a 
creditable tax. Moreover, by eliminating the ``fall back'' to 
the U.S. tax rate in the safe harbor computation where the host 
country has no generally applicable income tax, the proposal 
denies the creditability of true income taxes paid by dual 
capacity taxpayers under a ``schedular'' type of business 
income tax regime (i.e., regimes which tax only certain 
categories of income, according to particular ``schedules''), 
merely because the foreign sovereign's fiscal policy does not 
include all types of business income.
    For emerging economies of lesser developed countries which 
may not be ready for an income tax, as for post-industrial 
nations which may turn to a transaction tax, it is not 
realistic to always demand the existence of a generally 
applicable income tax. Even if the political willingness exists 
to have a generally applicable income tax, such may not be 
possible because the ability to design and administer a 
generally applicable income tax depends on the structure of the 
host country's economy. The available tax regimes are defined 
by the country's economic maturity, business structure and 
accounting sophistication. The most difficult problems arise in 
the field of business taxation. Oftentimes, the absence of 
reliable accounting books will only allow a primitive 
presumptive measure of profits. Under such circumstances the 
effective administration of a general income tax is impossible. 
All this is exacerbated by phenomena which are typical for less 
developed economies: a high degree of self-employment, the 
small size of establishments, and low taxpayer compliance and 
enforcement. In such situations, the income tax will have to be 
limited to mature businesses, along with the oil and gas 
extraction business.

The Proposal Increases The Risk Of Double Taxation

    Adoption of the Administration's proposals would further 
tilt the playing field against overseas oil and gas operations 
by U.S. business, and increase the risk of double taxation of 
FOGI. This will severely hinder U.S. oil companies in their 
competition with foreign oil and gas concerns in the global oil 
and gas exploration, production, refining, and marketing arena, 
where the home countries of their foreign competition do not 
tax FOGI. This occurs where these countries either exempt 
foreign source income or have a foreign tax credit regime which 
truly prevents double taxation.
    To illustrate, assume foreign country X offers licenses for 
oil and gas exploitation and also has an 85% tax on oil and gas 
extraction income. In competitive bidding, the license will be 
granted to the bidder which assumes exploration and development 
obligations most favorable to country X. Country X has no 
generally applicable income tax. Unless a U.S. company is 
assured that it will not be taxed again on its after-tax profit 
from country X, it very likely will not be able to compete with 
another foreign oil company for such a license because of the 
different after tax returns.
    Because of the 35% additional U.S. tax, the U.S. company's 
after tax return will be more than one-third less than its 
foreign competitor's. Stated differently, if the foreign 
competitor is able to match the U.S. company's proficiency and 
effectiveness, the foreigner's return will be more than 50% 
greater than the U.S. company's return. This would surely harm 
the U.S. company in any competitive bidding. Only the 
continuing existence of the FTC, despite its many existing 
limitations, assures that there will be no further tilting of 
the playing field against U.S. companies' efforts in the global 
petroleum business.
Separate Limitation Category For FOGI

    To install a separate FTC limitation category for FOGI 
would single out the active business income of oil companies 
and separate it from the general limitation category or basket. 
There is no legitimate reason to carve out FOGI from the 
general limitation category or basket. The source of FOGEI and 
FORI is difficult to manipulate. The source of FOGI was 
determined by nature millions of years ago. FORI is generally 
derived from the country where the processing or marketing of 
oil occurs which presupposes substantial investment in 
nonmovable assets. Moreover, Treasury has issued detailed 
regulations addressing this sourcing issue. Also, unless any 
FORI is earned in the extraction or consumption country, it is 
very likely taxed currently, before distribution, as subpart F 
income even though it is definitely not passive income.

The FTC Proposals Are Bad Tax Policy

    Reduction of U.S. participation in foreign oil and gas 
development because of misguided tax provisions will adversely 
affect U.S. employment, and any additional tax burden may 
hinder U.S. companies in competition with foreign concerns. 
Although the host country resource will be developed, it will 
be done by foreign competition, with the adverse ripple effect 
of U.S. jobs losses and the loss of continuing evolution of 
U.S. technology. By contrast, foreign oil and gas development 
by U.S. companies increases utilization of U.S. supplies of 
hardware and technology. The loss of any major foreign project 
by a U.S. company will mean less employment in the U.S. by 
suppliers, and by the U.S. parent, in addition to fewer U.S. 
expatriates at foreign locations. Many of the jobs that support 
overseas operations of U.S. companies are located here in the 
United States--an estimated 350,000 according to a 1998 
analysis by Charles River Associates, a Cambridge, 
Massachusetts-based consulting firm. That figure consists of: 
60,000 in jobs directly dependent on international operations 
of U.S. oil and gas companies; over 140,000 employed by U.S. 
suppliers to the oil and gas industry's foreign operations; 
and, an additional 150,000 employed in the U.S. supporting the 
200,000 who work directly for the oil companies and their 
suppliers.
    Thus, the questions to be answered are: Does the United 
States--for energy security and international trade reasons, 
among others--want a U.S. based petroleum industry to be 
competitive in the global quest for oil and gas reserves? If 
the answer is ``yes,'' then why would the U.S. government adopt 
a tax policy that is punitive in nature and lessens the 
competitiveness of the U.S. petroleum industry? The U.S. tax 
system already makes it extremely difficult for U.S. 
multinationals to compete against foreign-based entities. This 
is in direct contrast to the tax systems of our foreign-based 
competitors, which actually encourage those companies to be 
more competitive in winning foreign projects. What we need from 
Congress are improvements in our system that allow U.S. 
companies to compete more effectively, not further impediments 
that make it even more difficult and in some cases impossible 
to succeed in today's global oil and gas business environment. 
These improvements should include, among others, the repeal of 
the plethora of separate FTC baskets, the extension of the 
carryback/carryover period for foreign tax credits, and the 
repeal of section 907.
    The Administration's fy 1999 budget included these same 
proposals which would have reduced the efficacy of the FTC for 
U.S. oil companies. Congress considered these proposals last 
year and rightfully rejected them. They should be rejected this 
year as well.

                REINSTATMENT OF EXPIRED SUPERFUND TAXES

    The Administration's proposal would reinstate the Superfund 
excise taxes on petroleum and certain chemicals as well as the 
Corporate Environmental Tax through October 1, 2009. API 
strongly opposes this proposal.
    It is generally agreed that the CERCLA program, otherwise 
known as Superfund, has matured to the point that most of the 
sites on the National Priorities List (NPL) are in some phase 
of cleanup. Problems, however, remain in the structure of the 
current program. The program should undergo comprehensive 
legislative reform and should sunset at the completion of 
cleanups of the CERCLA sites currently on the NPL. Issues that 
the reform legislation should address include: liability, 
remedy selection, and natural resource damage assessments. A 
restructured and improved Superfund program can and should be 
funded through general revenues.
    Superfund sites are a broad societal problem. Revenues 
raised to remediate these sites should be broadly based rather 
than unfairly burdening a few specific industries. EPA has 
found wastes from all types of businesses and government 
agencies at hazardous waste sites. The entire economy benefited 
in the pre-1980 era from the lower cost of handling waste 
attributable to standards that were acceptable at the time. To 
place responsibility for the additional costs resulting from 
retroactive Superfund cleanup standards on the shoulders of a 
very few industries when previous economic benefits were widely 
shared is patently unfair.
    The petroleum industry is estimated to be responsible for 
less than 10 percent of the contamination at Superfund sites 
but has historically paid over 50 percent of the Superfund 
taxes. This inequity should be rectified. Congress should 
substantially reform the program and fund the program through 
general revenues or other broad-based funding sources.

                  REINSTATMENT OF OIL SPILL EXCISE TAX

    The Administration proposes reinstating the five cents per 
barrel excise tax on domestic and imported crude oil dedicated 
to the Oil Spill Liability Trust Fund through October 1, 2009, 
and increasing the trust fund limitation (the ``cap'') from $1 
billion to $5 billion. API strongly opposes the proposal.
    Collection of the Oil Spill Excise Tax was suspended for 
several months during 1994 because the Fund had exceeded its 
cap of $1 billion. It was subsequently allowed to expire 
December 31, 1994, because Congress perceived there was no need 
for additional taxes. Since that time, the balance in the Fund 
has remained above $1 billion, despite the fact that no 
additional tax has been collected. Clearly, the legislated 
purposes for the Fund are being accomplished without any need 
for additional revenues. Congress should reject this proposal.

                         CORPORATE TAX SHELTERS

    In a sweeping attack on corporate tax planning, the 
Administration has proposed sixteen provisions purported to 
deal with corporate tax shelters. These proposals are overly 
broad and would bring within their scope many corporate 
transactions that are clearly permitted under existing law. 
Moreover, their ambiguity would leave taxpayers uncertain as to 
the tax consequences of their activities and would lead to 
increased controversy and litigation. Business taxpayers must 
be able to rely on the tax code and existing income tax 
regulations in order to carry on their business activities. 
Treasury's proposed rules could cost the economy more in lost 
business activity than they produce in taxing previously 
``sheltered'' income.

     HARBOR MAINTENANCE EXCISE TAX CONVERTED TO COST-BASED USER FEE

    The Administration's budget contains a placeholder for 
revenue from a new Harbor Services User Fee and Harbor Services 
Fund. This fee would raise nearly $1 billion in new taxes, 
almost twice what is needed for maintenance dredging. The 
Administration delayed sending the proposal to the 105th 
Congress because of the intense and uniform opposition from 
ports, shippers, carriers and labor. Despite this opposition, 
the Administration has provided few details about how the new 
user fee would be structured and has not sought stakeholder 
input since last September.
    API strongly supports the use of such funds for channel 
maintenance and dredge disposal. We object to the 
Administration's proposal to use these funds for port 
construction and other services. The Administration should 
earmark these funds to address the growing demand for harbor 
maintenance and dredging. Moreover, we urge Congress to pass 
H.R. 111 and create an off-budget trust fund for the Harbor 
Services Fund. Finally, API urges Congress to take the lead in 
seeking stakeholder input and developing a fair and equitable 
means of generating the needed revenue.

         SUBJECT INVESTMENT INCOME OF TRADE ASSOCIATIONS TO TAX

    The Administration's proposal would subject to tax the net 
investment income in excess of $10,000 of trade associations 
and other organizations described in section 501(c)(6). API 
opposes this provision that is estimated to increase taxes on 
trade associations and other similar not-for-profit 
organizations by $1.4 billion. We agree with the Tax Council 
and other groups that subjecting trade association investment 
income to the unrelated business income tax (UBIT) conflicts 
with the current-law purpose of imposing UBIT on associations 
and other tax-exempt organizations to prevent such 
organizations from competing unfairly against for-profit 
businesses. The Administration's proposal mischaracterizes the 
benefit that trade association members receive from such 
earnings. Without such earnings, members of these associations 
would have to pay larger tax-deductible dues. There is no tax 
abuse. Congress should reject this proposal.
      

                                

Statement of the American Public Power Association

    The American Public Power Association (APPA) is pleased to 
present this statement on the electric restructuring tax 
proposal included in the president's FY 2000 budget. APPA is 
the national service organization representing the interests of 
more than 2,000 municipal and other state and locally owned 
utilities throughout the United States. Collectively, public 
power utilities deliver electric energy to one of every seven 
U.S. electric consumers (about 40 million people), serving some 
of the nation's largest cities. However, the majority of APPA's 
member systems are located in small and medium-sized 
communities in every state except Hawaii.
    APPA appreciates the opportunity to comment on the 
Administration's proposal on tax-exempt bonds for electric 
facilities of public power entities. The proposal deals with an 
issue of extreme importance to the more than 2,000 community-
owned electric providers, the bondholders of the over $75 
billion in outstanding tax-exempt bonds and the communities 
that rely on low cost, reliable electric power. This is an 
issue that has developed as a result of wholesale and retail 
electricity competition, and needs legislative attention as 
soon as possible.

                        Changing Circumstances:

    Many states have begun to establish retail electricity 
markets, abolishing the traditional regulated monopoly regime 
and replacing it with one in which all consumers have a choice 
of electricity suppliers. Nearly twenty states have adopted 
such legislation or regulation to open up to competition. These 
state laws can not be effective unless Congress removes certain 
tax barriers to retail competition. One such barrier is the 
existing ``private use'' test on the over $75 billion in 
outstanding tax-exempt bonds used to build and maintain 
electric generation, transmission and distribution facilities. 
In addition, consumers need desperately for Congress to clarify 
existing tax law to encourage an efficient and fair electric 
marketplace.
    This state trend to promote retail electric competition 
follows action by Congress in 1992 to increase competition at 
the wholesale level, by empowering the Federal Energy 
Regulatory Commission (FERC) to compel all transmission owners, 
including public power systems, to allow third parties 
equaitable access to their transmission lines. If municipal 
electric utilities open their transmission systems to wholesale 
competition, they face violating the private use restrictions 
on their existing tax-exempt bonds, thus creating an enormous 
disincentive for public power systems to embrace both retail 
and wholesale electricity competition.
    Municipal electric utilities that have issued tax-exempt 
bonds to finance their facilities under the old regulated 
monopoly framework face tough and potentially costly options 
for operating in the new restructured legal environment. If 
municipal utilities enter the competitive arena and violate the 
private use restrictions, tax-exempt bond financing on their 
affected facilities utilized by private parties becomes 
retroactively taxable, leading to immediate bondholder 
lawsuits. Or, in the alternative, municipal utilities may 
decide to compete and refinance their facilities with taxable 
bonds, causing an increase in financing costs. In either case, 
existing customers will have to pay higher electricity prices 
due to the accommodation to regulatory changes that no one 
foresaw at the time of the original financings. On the other 
hand, if public power systems choose not to compete, they will 
inevitably lose customers, resulting in the remaining customers 
paying higher costs for the underutilized infrastructure.

        Administration's Proposal--A Step in the Right Direction

    We commend the Administration's legislative proposal to 
eliminate federal tax code barriers to electricity competition 
facing public power. Most importantly, the Administration's tax 
proposal lifts the existing private use test on outstanding 
tax-exempt bonds and eliminates a disincentive for public power 
systems to participate in wholesale and retail electricity 
competition. In addition, this provision also protects existing 
bondholders from the possible retroactive taxability of their 
bonds. Lastly, the Administration's bill preserves public power 
systems' ability to issue tax-free bonds for local distribution 
facilities, which is defined as 69kv or lower.
    Unfortunately, the proposal is in effect, a federal mandate 
that prohibits all community owned utilities from building or 
maintaining transmission and generation facilities, on a tax-
exempt basis. Most small municipalities do not have outstanding 
tax-exempt bonds and would therefore endure a significant 
penalty to resolve a problem that does not currently apply to 
them. Moreover, this prohibition applies even if the 
transmission or generation facilities are dedicated to 
municipal functions providing public benefits to its community. 
APPA believes this aspect of the Administration's proposal is 
extremely severe, hindering many smaller community owned 
electric systems from utilizing tax-exempt debt for important 
infrastructure needs, and exercising their rights of local 
control. With regard to transmission, energy policy is moving 
us to a system in which all consumers will benefit if building 
certain portions of the transmission gird is done on a tax-
exempt basis, thus lowering costs for all consumers.
    In summary, the Administration's tax proposal moves us in 
the right direction, in that it protects the existing tax-
exempt debt of public power communities, but on a prospective 
going forward basis it is unnecessarily severe for many 
communities that have no outstanding bonds and would prefer to 
preserve their existing authority over financing of electric 
generation and transmission facilities.
    APPA is pleased that the Administration is sensitive to 
these concerns and would like to work together with members of 
Congress and public power communities to address this concern. 
In fact, on February 4th, Energy Secretary Bill Richardson 
wrote to APPA and acknowledged some differences in their 
approach and said he believed ``these differences can be 
resolved. It is absolutely essential that Congress address this 
issue quickly so as not to further impede the progress of 
competitive programs,'' Secretary Richardson said. (See 
attached DOE letter dated February 4, 1999.)

   A Fair, Bipartisan Compromise is Advanced--The Bond Fairness and 
                Protection Act of 1999, H.R. 721/S. 386

    A proposal that embraces local control and local choices 
has been advanced in Congress. The Bond Fairness and Protection 
Act of 1999 is much better suited to deal with the diversity in 
the marketplace, while protecting the fundamental rights of 
state and local government, and providing transition relief to 
the outstanding tax-exempt bonds.
    More specifically, the Bond Fairness and Protection Act, a 
bill introduced in the Senate as S. 386 by Senators Slade 
Gorton (R-WA) and Robert Kerrey (D-NE) and in the House as H.R. 
721 by Representatives J.D. Hayworth (R-AZ) and Robert Matsui 
(D-CA), is a compromise solution to the private use problem. If 
enacted, the Gorton-Kerrey/Hayworth-Matsui bill will accomplish 
two objectives: 1) clarify existing tax laws and regulations 
regarding the private use rules so that they will work in a new 
competitive marketplace; and 2) provide encouragement for 
public power utilities to open their transmission or 
distribution systems, thereby providing more choice to all 
consumers.
    Under the bill, publicly owned utilities would have two 
options: 1) They could continue to operate under a clarified 
version of the existing tax laws and private use regulations; 
or 2) If relief from private use restrictions were needed, 
municipal utilities could opt for a full grandfathering of 
their outstanding tax-exempt debt, but they would have to 
exercise an ``irrevocable termination election,'' permanently 
eliminating their ability to issue tax-exempt debt to build any 
new generating facilities. Such an election would not affect 
transmission and distribution facilities which unlike 
generation will continue to operate as regulated monopolies. 
This removes the disincentive for municipal electric systems to 
participate in competitive markets without providing a 
competitive advantage to either public power or private 
utilities.
    Because the bill provides publicly owned utilities the 
flexibility to participate in competitive markets without 
jeopardizing the tax-exempt status of their bonds while 
requiring a significant trade-off to some private utilities' 
concerns, it has attracted the support of a number of 
organizations. The list includes: The National League of 
Cities, The National Association of Counties, The Governors 
Public Power Alliance, The International City/County Managers 
Association, The Government Finance Officers Association, The 
California Independent Energy Producers, Enron, the National 
Consumers' League, Public Citizen, and The Natural Resources 
Defense Council and some individual investor-owned utilities. A 
number of investor owned utilities either support or are 
neutral on the bill, and many are seeking small clarifications 
to help promote competition in general.

                              Conclusion:

    A fully competitive retail electricity market will include 
a variety of electrical suppliers, many of which are for-
profit, taxable entities and others like public power systems, 
that are not-for profit state and local agencies. Each type of 
market participant faces barriers to participate in future 
competitive markets. Municipal financing concerns are one 
barrier that must be addressed as part of a balanced approach 
to a fair and open marketplace. The Administration's tax 
provision is a step in the right direction, but, Congress 
should embrace efforts to preserve local communities' choices 
and instead enact H.R 721/S. 386, a bipartisan compromise that 
makes political and economic sense.
    We appreciate the opportunity to present our statement, and 
look forward to working with the Ways and Means members and 
staff as the budget debate progresses.

    [Attachment is being retained in the Committee files.]
      

                                

              Associated Builders and Contractors, Inc.    
                                    Rosslyn, Virginia 22209
                                                     March 24, 1999

The Honorable Bill Archer
Chairman, Ways and Means Committee
U.S. House of Representatives
Washington, DC 20515

    Dear Mr. Chairman:

    On behalf of Associated Builders and Contractors (ABC) and its more 
than 20,000 member firms, I would like to respectfully submit the 
following comments for the record of the hearing of March 10, 1999 
entitled ``Revenue Provisions in President's Fiscal Year 2000 Budget.''
    President Clinton's FY 2000 budget proposes a significant tax 
increase on Associations that are tax exempt under section 501 (c) (6) 
of the Internal Revenue Code. Under the administration's proposal, 
trade associations that have net ``investment'' income in excess of 
$10,000 for any taxable year would be subject to the unrelated business 
income tax (UBIT), for the portion over $10,000. This would adversely 
affect ABC's tax liability, as well as the tax liability of our 
chapters that may have ``investment'' income over $10,000. ABC strongly 
opposes this proposal, which would significantly impact ABC's financial 
status.
    ABC's ``investment'' income is not generated by any activity in 
competition with tax-paying businesses. Congress recognized in the 
``unrelated business tax'' (UBIT) rules, that Section 501 (c)(6) tax-
exempt groups were not competing with for-profit entities or being 
unfairly advantaged by the receipt of tax-exempt income from certain 
``passive'' sources such as interest, dividends, capital gains and 
royalties. ABC and other associations' income from these sources are 
used to further its exempt purposes, including education, improving 
industry safety, and training, and for community involvement. For 
example, ABC might be forced to curtail its ongoing non-profit efforts 
to attract and train young people for a lucrative career in the 
construction industry.
    Additionally, it is important to recognize that keeping this 
``investment'' and ``passive'' income free from taxation enables ABC 
and other 501 (c)(6) associations to maintain modest surplus funds from 
year to year in order maintain stability during economic downturns.
    The Administration's proposal appears to assume that 501 (c)(6) 
associations like ABC are effectively over-charging their members for 
dues, and their members expect to realize investment gains from those 
overpayments. This is absurd logic, which shows a patent 
misunderstanding of the structure and operation of tax-exempt 
organizations. In fact, dues payments do not make up the larger portion 
of an average association's annual revenue.
    For the aforementioned reasons, ABC would like to express its 
strong opposition to the Administration's proposal to tax 501 (c)(6) 
investment income. Thank you for considering ABC's comments.

            Sincerely,
                                        Christopher T. Salp
                                          Washington Representative
      

                                

                           Association for Play Therapy    
                                           Fresno, CA 93703
                                                      March 9, 1999

Hon. Bill Archer, Chair
Committee on Ways and Means
United States House of Representatives
1102 Longworth Office Building
Washington, DC 20515

Re: Opposition to Taxing Association Savings

    Dear Chair Archer:

    During its February 27 meeting in Baltimore, MD, the Board of 
Directors of the International Association for Play Therapy, Inc. 
unanimously elected to oppose the Administration budget proposal to 
raise $1.4 billion over the next five years by taxing interest and 
dividends in excess of $10,000 earned annually by non-profit 
organizations.
    Our private 501c(6) association and its 3,300 volunteer member 
mental health professionals have since 1982 researched and promoted the 
therapeutic benefits of play and play therapy on behalf of children and 
others. We have diligently and responsibly built an emergency reserve 
fund, the earnings from which may eventually finance research and other 
programs that further satisfy our mission statement. Because 
competition for grants, sponsorships, and other forms of non-dues 
revenues is fierce, it is critical that we and other associations 
continue to enjoy this fundraising option and that interest earned from 
our savings not be taxed.
    Please advise me if you will oppose this proposal. Your leadership 
and assistance are critical and sincerely appreciated. Thank you very 
much.

            Cordially,
                                           William M. Burns
                                                 Executive Director

cc: Chair Rise VanFleet, Ph.D.
      

                                

Statement of Association of International Automobile Manufacturers, 
Inc., Arlington, Virginia

    The Association of International Automobile Manufacturers, 
Inc. (``AIAM'') respectfully submits this statement for the 
Committee on Ways & Means March 10, 1999 hearing record 
regarding the Revenue Provisions in the President's Budget for 
Fiscal Year 2000. AIAM is a trade association that represents 
companies which sell passenger cars and light trucks in the 
United States that are manufactured both here and abroad.\1\
---------------------------------------------------------------------------
    \1\ AIAM is the trade association representing the U.S. 
subsidiaries of international automobile companies doing business in 
the United States. Member companies distribute passenger cars, light 
trucks, and multipurpose passenger vehicles in the U.S. Nearly two-
thirds of these vehicles are manufactured in the New American Plants 
established by AIAM companies in the past decade.
    International automakers support American jobs in manufacturing, 
supplier industries, ports, distribution centers, headquarters, R & D 
centers and automobile dealerships. AIAM also represents manufacturers 
of tires and other original equipment with production facilities in the 
U.S. and abroad.
---------------------------------------------------------------------------
    AIAM members import and produce in U.S. manufacturing 
facilities light vehicles for sale in the U.S. Automobile 
manufacturers have invested millions of dollars into the 
research and development of environmentally superior vehicles, 
yet the demand for these autos remain at remarkably low levels. 
Nearly every automaker in the world has begun development of 
advanced propulsion technology vehicles. For example, motor 
vehicles like Honda's EV Plus, Nissan's Altra, and Toyota's 
Prius are currently offered (or will be shortly) for sale in 
the U.S. market by these innovative automobile manufacturers.
    While AIAM reserves judgement on the details of the 
Administration's Fiscal Year 2000 Budget proposal to provide a 
tax credit for advanced technology vehicles, AIAM endorses the 
underlying market-based principles of the proposal. Should the 
Committee desire any assistance in the development of this tax 
incentive, AIAM stands ready to be involved in the process.
    While automakers continue to make strides in environmental 
technology, there is a lack of consumer demand for new premium 
priced advanced technology vehicles. Creating market-driven 
incentives to entice consumers towards the purchase of 
environmentally superior vehicles is necessary if we are going 
to achieve the environmental gains we all desire. AIAM believes 
credits will encourage the purchase of new environmentally 
superior vehicles.
    There currently are two design principles that AIAM member 
companies agree should be included in a tax incentive program. 
Incentives should capitalize on the power and efficiency of the 
retail market; and should be easy for consumers to use.

Incentives should capitalize on the power and efficiency of the retail 
                                 market

    The retail vehicle market is a ready institution for 
bringing incentives directly to bear on the people who may want 
to buy fuel efficient vehicles at the moment they are making 
that choice. The market, being a constant factor in purchasing 
decisions, will deliver economic incentives and results with 
virtually no delay or administrative cost.
    An unsatisfactory alternative to a market-driven design 
would be a new command-and-control regime of regulations 
between manufacturers and government. By all experience, the 
erection and operation of another regulatory apparatus would be 
slow, expensive, nonadaptive, and adversarial. It could not be 
structured in any way to deal with potential buyers as they 
decide whether to choose fuel-efficient vehicles.
    It is AIAM's opinion that a market-based approach to energy 
conservation is superior in effectiveness to regulation. Market 
incentives encourage energy conservation and the costs on 
society is far less than those imposed by command-and-control 
regulations.

             Incentives should be easy for consumers to use

    For this type of policy to succeed through tax incentives, 
the incentives should be easy for consumers to use.
    To be most effective in selling fuel-efficient vehicles, 
the availability and value of the credit should be certain and 
palpable at the buyer's moment of decision.
    To achieve the program's objectives, the credit should be 
available whether the potential buyer is an individual or 
business; rich, poor, or middle-income; is a minimum tax payer 
or not; is considering a foreign-or domestic-manufactured 
vehicle, and other distinguishing characteristics.
    AIAM believes that a manufacturers' rebate-style incentive 
at point of purchase is the most effective type of credit. This 
type of approach would provide an immediate and enticing 
incentive for the purchase of an advanced technology vehicle. 
This could be accomplished by designing the credit so that it 
goes directly to the manufacturer. The manufacturer, in turn, 
would pass the incentive along to the customer at the time of 
purchase, thereby creating an immediate incentive to purchase 
the qualifying vehicle.

                              Conclusion 

    The Administration has taken a constructive step by 
promulgating the concepts of tax incentive programs for the 
purchase of qualifying fuel efficient vehicles. Building a 
basis for market-driven consumer incentive policy is important 
in creating a demand for advanced technology vehicles in the 
United States that have the potential to deliver environmental 
and energy-saving benefits. AIAM would be pleased to provide 
the Committee whatever further information on this issue the 
Committee would find useful.
      

                                

Statement of Bond Market Association

    The Bond Market Association is pleased to present this 
statement on tax proposals in the president's FY 2000 budget. 
The Bond Market Association represents approximately 200 
securities firms and banks that underwrite, trade and sell debt 
securities, both domestically and internationally. We take an 
active interest in tax policy that affects the ability of 
corporations, state and local governments and the federal 
government to access the capital markets to finance investment. 
Indeed, capital investment is the engine that powers long-term 
economic growth, and the federal tax code can have a profound 
effect on the cost of capital investment. It is in our interest 
and, we believe, the nation's interest to foster a tax system 
that encourages capital investment and makes capital available 
as efficiently as possible.
    Perhaps the most important thing Congress has done in 
recent years to facilitate capital investment has been to 
pursue policies which helped to eliminate the federal budget 
deficit. For decades, the deficit served as a drain on the pool 
of funds available to finance new investment. Every dollar of 
overspending was a dollar not available to build roads, 
schools, factories, housing and other capital assets that 
contribute to economic growth and improve living standards. 
This committee, under Chairman Archer's leadership, played a 
vital role in crafting policies that have eliminated the 
deficit and freed up economic resources for productive use. At 
the same time, this committee has managed to resist ill-
conceived tax increases on capital formation and has even 
supported proposals designed to expand access to the capital 
markets, such as last year's increase in tax-exempt private-
activity bond volume caps. For that, we commend you.
    The president's budget contains a number of proposals that 
would affect the capital markets. Unfortunately, many of these 
proposals are recycled versions of the same tax increases that 
Congress has rejected for years. As we have in the past, we 
strongly oppose these tax increases on savings and investment. 
Other proposals, although well-intentioned, would likely not 
provide the level of assistance they are intended to.

                         Tax Increase Proposals

Increase proration percentage for property and casualty 
companies

    The Association commented extensively on a variation of 
this proposal in our statement to the committee in February 
1998.\1\ Although the administration has tempered the proposal 
slightly in its current budget, it would still represent a 
significant tax increase on ``tax-exempt'' interest earned by 
property and casualty (P&C) insurance companies.
---------------------------------------------------------------------------
    \1\ Statement of The Bond Market Association, Submitted to the 
House Committee on Ways and Means, on Certain Revenue Provisions in the 
Administration's FY 1999 Budget, February 25, 1998.
---------------------------------------------------------------------------
    P&Cs are an extremely important source of demand for 
municipal securities. In a market dominated by individual 
investors--approximately 64 percent of outstanding municipal 
bonds are held by individuals or their proxies, money-market 
and mutual funds--P&Cs play a vital role in maintaining market 
stability by providing a steady source of demand. If not for 
the active participation of P&Cs in the municipal bond market, 
state and local borrowing rates would be much higher than they 
are.
    So-called ``tax-exempt'' interest earned by P&Cs on 
municipal bond transactions is not truly tax-exempt. P&Cs are 
permitted a deduction for contributions to loss reserves. 
However, this deduction is reduced by an amount equal to 15 
percent of their ``proration income,'' which includes tax-
exempt bond interest. P&Cs lose 15 cents of an otherwise 
allowable deduction for every dollar of tax-exempt interest 
they earn. This loss of deduction is tantamount to a direct tax 
of 5.25 percent on their municipal bond interest income.
    The administration has proposed raising the loss reserve 
deduction disallowance from 15 percent of proration income to 
25 percent. This would increase the implicit tax rate on 
municipal bond interest earned by P&Cs from 5.25 percent to 
8.75 percent, an increase of 67 percent. (In its FY 1999 
budget, the administration proposed a full doubling of the 
proration tax.) Describing the administration's proposal as a 
tax increase on P&Cs, however, disguises its true effect. In 
reality, the burden of this proposed tax increase would fall 
almost entirely on state and local government bond issuers, not 
on P&Cs. Under current market conditions, interest rates on 
tax-exempt securities would not be sufficient to continue to 
attract P&Cs to the municipal market. Unfortunately, in the 
market sectors where P&Cs are most active, there are few other 
ready buyers at current interest rates. It is likely that if 
the administration's proposal were enacted, once municipal bond 
yields rose to fully reflect the proposal's effects, P&Cs would 
remain active as municipal market investors. However, interest 
rates paid by state and local governments on their borrowing 
would be higher than if the proposal had not been enacted. P&Cs 
will simply be compensated for their additional tax liability 
through higher returns on their municipal bond portfolios. The 
effect for state and local governments would be higher 
borrowing costs. Implicitly, approximately 40-60 percent--
perhaps up to 75 percent--of the tax would be borne not by P&Cs 
but by state and local governments in the form of higher 
borrowing costs. Of course, higher borrowing costs simply 
discourage new investment in schools, roads, airports, sewer 
systems, parks and the many other infrastructure projects that 
are financed with tax-exempt bonds. The staff of the Joint 
Committee on taxation was absolutely correct in its analysis:

          [P&C] insurers are large holders of tax-exempt bonds. A 
        reduction in demand for these securities by the [P&C] insurers 
        may lead to an increase in borrowing costs for state and local 
        governments. Even a small increase in the interest cost to tax-
        exempt finance could create a substantial increase in the 
        aggregate financial cost of debt-financed public works projects 
        to state and local governments.\2\
---------------------------------------------------------------------------
    \2\ Staff of the Joint Committee on Taxation, ``Description of 
Revenue Provisions in the President's FY 2000 Budget Proposal'' (JCS-1-
99), February 22, 1999, pgs. 275-276.

    Moreover, the administration has offered little justification for 
this proposed tax increase. The Treasury Department states only that a 
5.25 percent P&C tax on municipal bond interest is too low because it 
``still allows [P&Cs] to fund a substantial portion of their deductible 
reserves with tax-exempt or tax-deferred income.'' \3\ This argument 
fails to draw any parallel between interest earned on municipal bonds 
and deductions for contributions to loss reserves. The relationship 
between municipal bond interest and loss reserve deductions is no 
closer than that between municipal bond interest and any deductible 
expense, such as that for wages and salaries. The administration also 
fails to justify the apparent arbitrary proration percentage level 
contained in its proposal. Why is a 25-percent proration level more 
appropriate than a 15-percent level? Why in its FY 1999 budget did the 
administration propose a 30-percent level, but this year's proposal is 
for a 25-percent level? Both questions are unanswered, and both suggest 
that the administration's proposal is less an adjustment of tax policy 
to address changing circumstances and more a pure tax increase proposed 
solely as a revenue-raiser with little tax policy justification.
---------------------------------------------------------------------------
    \3\ Department of the Treasury, ``General Explanations of the 
Administration's Revenue Proposals, February 1999, page 159.

---------------------------------------------------------------------------
Disallow Interest on Debt Allocable to Tax-exempt Obligations

    A second proposed tax increase in the administration's budget is 
also ostensibly targeted at corporations. However, like the 
``proration'' issue discussed above, this tax increase would be borne 
by state and local government bond issuers who would pay higher 
interest rates on their borrowing. This proposal would apply the 
current-law ``pro rata'' interest expense disallowance that applies to 
financial institutions to all financial intermediaries.
    Currently, all taxpayers, including all corporations, are 
prohibited from deducting interest expenses associated with purchasing 
or carrying tax-exempt bonds. Most corporations, including some 
financial intermediaries, are required to demonstrate that any tax-
exempt bond holdings were not financed with the proceeds of borrowing--
the so-called ``tracing rule.'' Most corporations are relieved of this 
burden if their tax-exempt bond holdings do not exceed two percent of 
their total assets--the so-called ``two-percent de minimis rule.'' 
Securities firms and banks, however, are subject to stricter treatment; 
they automatically lose a pro rata portion of their interest expense 
deduction if they earn any tax-exempt interest. In applying the 
disallowance, securities firms are permitted to disregard interest 
expense that is clearly traceable to activities unrelated to municipal 
bonds. The administration's proposal would apply the pro rata 
disallowance provision currently applicable to banks to all ``financial 
intermediaries,'' including securities firms, finance and leasing 
companies, and certain government-sponsored corporations. The proposal 
would affect various segments of the municipal bond market differently.
    For securities firms, the proposal would apply the current-law pro 
rata disallowance to a larger portion of a firm's total interest 
expense deduction, even to interest which is clearly and demonstrably 
unrelated to holding municipal bonds. A large portion of a securities 
firm's borrowing is for specific purposes. Securities firms use 
repurchase agreements--a form of secured borrowing--to finance 
overnight holdings of Treasury securities bought in the normal course 
of market-making activity. Or, in another example, firms incur margin 
loans for stock purchases. In both these examples, the interest expense 
associated with the borrowing is clearly related to activity unrelated 
to buying or holding municipal bonds, and so is disregarded in applying 
the pro rata disallowance of interest expense. In both these examples 
as well as others, under the administration's proposal, this interest 
expense would be subject to the disallowance. Securities firms' after-
tax costs of carrying municipal bonds would increase.
    Securities firms buy and sell municipal bonds in the normal course 
of doing business. As underwriters, they buy newly issued securities 
and resell them to investors. When investors seek to sell bonds before 
their maturity, securities firms quote prices and buy municipal bonds 
on the secondary market. As a result of the administration's proposal, 
the after-tax cost of holding municipal bonds in the normal course of 
business would increase because every time a securities firm bought a 
bond, it would face a higher after-tax ``cost of carry.'' Firms would 
be less willing, at least on the margin, to take positions in municipal 
securities being bought and sold by investors and would consequently 
bid prices less aggressively. In the end, virtually all the additional 
tax liability faced by securities firms would ultimately be borne by 
bond issuers and investors in the forms of higher issuance and 
transaction costs.
    The administration's proposal would affect other market sectors, as 
well. The proposal would remove government-sponsored corporations from 
the markets for tax-exempt housing and student loan bonds by repealing 
the two-percent de minimis rule for these investors. Organizations such 
as Fannie Mae and Freddie Mac are major buyers of bonds issued for low-
and middle-income owner-occupied and multi-family rental housing. 
Sallie Mae buys tax-exempt student loan bonds. These investors keep 
financing costs low for worthwhile state and local housing and student 
loan programs, and their loss from the market would make it more 
difficult and more expensive for states and localities to provide these 
services. Finally, the proposal would dramatically raise costs for 
firms that finance equipment leases for states and localities. These 
costs would be passed onto state and local governments in the form of 
higher leasing costs. Hardest hit would be smaller governments, since 
they have a more difficult time accessing the conventional capital 
markets and tend to depend more on leasing as a form of long-term 
financing.
    The administration argues that current law permits securities 
dealers and other financial intermediaries ``to reduce their tax 
liability inappropriately through double federal tax benefits of 
interest expense deduction and tax-exempt interest, notwithstanding 
that they operate similarly to banks.'' This statement is simply not 
true. Current law could not be more direct. It is not legal for any 
corporation to deduct the interest expense associated with holding tax-
exempt bonds. It is true that not all corporations are bound to the pro 
rata disallowance of interest expense deductions as banks are. 
Equalizing treatment between banks and non-banks, however, could just 
as easily entail the application of the tracing and two-percent de 
minimis rules to banks as the application of the pro rata disallowance 
to non-banks. The administration also argues that ``the treatment of 
banks should be applicable to other taxpayers engaged in the business 
of financial intermediation, such as securities dealers.'' And further, 
``it is difficult to trace funds within the institution and nearly 
impossible to assess the taxpayer's purpose in accepting deposits or 
making other borrowings.'' Both these statements are very misleading. 
In fact, banks and securities firms are both subject to nearly 
identical rules under current law. Both are already subject to the pro 
rata disallowance of interest expense deductions. Securities firms are 
simply able, in applying the disallowance, to disregard certain 
interest expense that clearly is traceable. Moreover, of The Bond 
Market Association's numerous commercial bank members, we are aware of 
none that have complained about unfair treatment under current law or 
who have called for anything similar to the administration's proposal.

Require Current Accrual of Market Discount by Accrual Method Taxpayers

    Under current law, market discount occurs when taxpayers buy bonds 
at a discount to face value (par). Market discount, the difference 
between a bond's purchase price and its face value, is generally 
treated as ordinary interest income. The only exception is that tax 
liability is incurred not annually, but when the bond is sold or 
redeemed. The administration has proposed that accrual taxpayers would 
be required to recognize the accrual of market discount--and pay taxes 
on that accrual--annually.
    Much of the problem with the administration's proposed treatment of 
market discount stems from its mistreatment under current law. On the 
basis of good tax policy and for purposes of tax symmetry, market 
discount really should be treated as a capital gain rather than as 
ordinary income. After all, market discount occurs when, as a result of 
a decline in market prices, a bond is sold in the secondary market at a 
price lower than its original issue price (or, in the case of a bond 
with original issue discount, its adjusted issue price). In such a 
case, the seller of the bond would incur a capital loss. The buyer of 
the bond, however, would recognize ordinary income. Such treatment is, 
at the very least, unfair. This asymmetry is mitigated, however, by the 
fact that like a capital gain, taxpayers are not required to recognize 
market discount income until a bond is sold or redeemed. The capital-
gain nature of market discount is highlighted in the case of distressed 
debt. In this case, when an investor buys a bond at a deeply discounted 
price due to credit deterioration of the issuer and then realizes a 
gain due to improvements in the issuer's credit condition, the gain is 
much more in the character of a capital gain than of interest income. 
The administration recognizes this point in its explanation of its 
proposal.\4\
---------------------------------------------------------------------------
    \4\ Ibid., Page 121.
---------------------------------------------------------------------------
    The administration has proposed that accrual taxpayers be required 
to recognize the accrual of market discount as it occurs and to incur 
tax liability on market discount annually. As a result, the proposal 
would exacerbate problems and inconsistencies associated with current-
law treatment of market discount.
    First, the proposal would introduce significant complexity to the 
treatment of market discount. As the JCT staff recognizes, when the 
existing market discount provisions were adopted in 1984, Congress 
purposefully established the current scheme of treatment--incurring tax 
liability only when a bond is sold or redeemed--in recognition that 
annual accrual treatment would be too complex.\5\ The problem of 
complexity is compounded, as the JCT staff also recognizes, when a bond 
carries both original-issue discount and market discount. The 
complexity of the market discount rules were highlighted in 1993, when 
the treatment of market discount on municipal bonds was changed from 
capital gain to ordinary income. This provision caused significant 
confusion among municipal bond investors.
---------------------------------------------------------------------------
    \5\ Staff of the Joint Committee on Taxation, Page 207.
---------------------------------------------------------------------------
    Second, the administration's proposal would reduce the 
attractiveness of bonds trading at a discount to investors who are 
accrual taxpayers. Unfortunately, the tax treatment of market discount 
becomes an increasing concern to investors at times of market 
uncertainty, when bond prices are declining as a result of rising 
interest rates and when, as a result, market liquidity is hampered. 
Imposing additional, negative tax consequences on buyers of discounted 
debt instruments would simply fuel the illiquidity fire. This problem 
is compounded in times of persistent and severe declines in bond 
prices. It would be possible in these conditions for certain investors 
to pay tax annually on the accrual of market discount when, because the 
value of the bond fails to increase as fast as the discount accrues, 
little no real cash income is ever actually earned. In such severe 
cases, an investor would be forced to recognize the accrual of market 
discount as ordinary income, even though that income was actually 
absorbed in a capital loss. Although this mistreatment exists under 
current law, it would be exacerbated if accrual taxpayers are forced to 
recognize market discount annually.

Defer interest deduction and original issue discount on certain 
convertible debt

    The administration has proposed to change the tax treatment of 
original issue discount (OID) on convertible debt securities. OID 
occurs when the stated coupon of a debt instrument is below the yield 
demanded by investors. The most common case is a zero-coupon bond, 
where all the interest income earned by investors is in the form of 
accrued OID. Under current law, corporations that issue debt with OID 
may deduct the interest accrual while bonds are outstanding. In 
addition, taxable OID investors must recognize the accrual of OID as 
interest income. Under the administration's proposal, for OID 
instruments which are convertible to stock, issuers would be required 
to defer their deduction for accrued OID until payment was made to 
investors in cash. For convertible OID debt where the conversion option 
is exercised and the debt is paid in stock, issuers would lose the 
accrued OID deduction altogether. Investors would still be required to 
recognize the accrual of OID on convertible debt as interest income, 
regardless of whether issuers took deductions.
    The administration's proposal is objectionable on several grounds. 
First, convertible zero-coupon debt has efficiently provided 
corporations with billions of dollars in capital financing. The change 
the administration proposes would significantly raise the cost of 
issuing convertible zero-coupon bonds, and in doing so would discourage 
corporate capital investment. Second, the administration's presumptions 
for the proposal are flawed. The administration has argued that ``the 
issuance of convertible debt instrument[s] is viewed by market 
participants as a de facto issuance of equity.'' \6\ However, 
performance does not bear this claim. In fact, of the convertible zero-
coupon debt retired since 1985, approximately 70 percent has been 
retired in cash, and only 30 percent has been converted to stock. 
Indeed, the market treats convertible zero-coupon bonds more as debt 
than as equity.
---------------------------------------------------------------------------
    \6\ Department of the Treasury, page 127.
---------------------------------------------------------------------------
    Third, and perhaps most important, the administration's proposal 
violates the basic tenet of tax symmetry, the notion that the 
recognition of income by one party should be associated with a 
deduction by a counterparty. This fundamental principle exists to help 
ensure that income is taxed only once. Under the proposal, investors 
would be taxed fully on the accrual of OID on convertible zero-coupon 
debt, but issuers' deductions would be deferred or denied. The proposal 
would compound problems associated with the multiple taxation of 
investment income, thereby raising the cost of corporate capital.
    Because the proposal would exacerbate problems of multiple taxation 
of corporate income and because it would raise the cost of corporate 
capital investment, we urge the rejection of the administration's 
proposal.

Deny DRD for preferred stock with certain non-stock characteristics

    Under current law, corporate taxpayers that earn dividends on 
investments in other corporations are permitted a tax deduction equal 
to at least 70 percent of those earnings. The deduction is designed to 
mitigate the negative economic effects associated with multiple 
taxation of corporate earnings. The administration has proposed 
eliminating the dividends-received deduction (DRD) for preferred stock 
with certain characteristics. This proposal would increase the taxation 
of corporate earnings and discourage capital investment.
    The DRD is important because it reduces the effects of multiple 
taxation of corporate earnings. When dividends are paid to a taxable 
person or entity, those funds are taxed twice, once at the corporate 
level and once at the level of the taxpayer to whom the dividends are 
paid. These multiple levels of taxation raise financing costs for 
corporations, create global competitiveness problems, and generally 
reduce incentives for capital formation. The DRD was specifically 
designed to reduce the burden of one layer of taxation by making 
dividends largely non-taxable to the corporate owner.
    The administration has argued that certain types of preferred 
stock, such as variable-rate and auction-set preferred, ``economically 
perform as debt instruments and have debt-like characteristics.'' \7\ 
However, the administration has not proposed that such instruments be 
formally characterized as debt eligible for interest payment and 
accrual deductions. The administration has sought to characterize 
certain preferred stock in such a way as to maximize tax revenue; it 
would be ineligible for both the DRD and the interest expense 
deduction.
---------------------------------------------------------------------------
    \7\ Ibid., page 132.
---------------------------------------------------------------------------
    Eliminating the DRD for these instruments would exacerbate the 
effects of multiple taxation. The change would be tantamount to a tax 
increase on corporate earnings since the minimum deduction available to 
certain investors would fall. This tax increase would flow directly to 
issuers of preferred stock affected by the proposal who would face 
higher financing costs as investors demanded higher pre-tax yields. 
Amplifying the competitive disadvantages of multiple taxation of 
American corporate earnings would be the fact that many of our largest 
economic competitors have already adopted tax systems under which 
inter-corporate dividends are largely or completely untaxed. 
Eliminating the DRD for preferred stock with certain characteristics 
would cut U.S. corporations off from an efficient source of financing, 
thereby discouraging capital investment.

                         New Budget Initiatives

Provide Tax Credits for Holders of Qualified School 
Modernization Bonds and Qualified Zone Academy Bonds and 
Provide Tax Credits for Holders of Better America Bonds

    The administration has proposed policy initiatives 
significantly expanding the use of ``tax credit bonds.'' Under 
this new financing structure, states and localities would be 
able to issue qualified debt securities for targeted projects, 
including the construction and rehabilitation of public primary 
and secondary school facilities and for certain environmental 
uses. Investors in the bonds earn federal income tax credits, 
presumably in lieu of interest payments by the issuers.
    Qualified Zone Academy Bonds.--In 1997, Congress passed and 
the President signed H.R. 2014 (P.L. 105-34), a budget 
reconciliation bill which included the Taxpayer Relief Act of 
1997. Section 226 of the bill provides tax credits for holders 
of ``Qualified Zone Academy Bonds'' (QZABs). QZABs are bonds 
which may be issued by state and local governments to finance 
rehabilitation projects for public primary and secondary 
schools located in empowerment zones or enterprise communities 
or where at least 35 percent of students qualify for subsidized 
lunches under the National School Lunch Act. QZABs represent 
the first use of ``tax credit bonds'' to provide assistance for 
a designated public policy goal.
    Although the goals of the QZAB program are laudable, the 
structure of the QZAB provision has seriously hindered its 
usefulness to school districts. Although some problems with the 
program are inherent in the tax credit bond structure, there 
are several notable problems with QZABs in particular.
    The program is very small.--The Taxpayer Relief Act 
authorized only $400 million of QZAB issuance per year for two 
years. This $400 million amount is allocated among all the 
states, so any one state receives a relatively small 
allocation. In 1999, for example, the District of Columbia is 
permitted to issue a total of only $1.2 million of QZABs. The 
small size and short term of the program causes several 
problems. First, it is difficult for bond issuers, attorneys, 
underwriters, investors and others associated with capital 
market transactions to commit resources to developing expertise 
on a new and unknown financing vehicle when very little 
issuance will be permitted to take place. Second, the small 
issuance volume ensures that there will be no significant 
secondary market for QZABs. A lack of market liquidity 
discourages investors and raises costs for issuers.
    The program requires ``private business contributions.''--
In order to qualify for QZAB financing, a school district must 
secure a ``private business contribution'' to the project being 
financed. The contribution must comprise at least 10 percent of 
the proceeds of the QZAB issue. The contribution can take the 
form of property or services. In practice, it has been 
prohibitively difficult for school districts to secure private 
business contributions needed to qualify for QZAB financing.
    The credit rate is reset monthly.--The tax credit rate--the 
rate that determines the amount of tax credit earned by holders 
of QZABs--is set by the Treasury department monthly. This reset 
period is too infrequent to allow for efficient pricing and 
issuance of QZABs. Market interest rates change daily, even 
hourly, so a monthly reset period virtually ensures that the 
current credit will bear little relation to current market 
yields. Moreover, the credit rate is set at 110 percent of the 
``applicable federal rate'' (AFR). This rate, however, does not 
necessarily reflect the actual rate of return that investors 
would demand in order to buy QZABs at a price that would leave 
the issuer with a no-cost source of capital.
    Investors are limited.--Only three classes of investors are 
permitted to earn federal income tax credits by holding QZABs, 
banks, insurance companies and ``corporations actively engaged 
in the business of lending money.'' Individual investors, a 
potentially strong source of demand for tax-preferred 
investments, are excluded as QZAB investors.
    New construction is not eligible.--The QZAB program 
provides assistance only for the rehabilitation of existing 
school facilities. Construction of new schools is not eligible 
for QZAB financing. School districts whose capital investment 
plans include primarily the construction of new schools are not 
helped significantly by the program.
    These problems, along with other issues related to tax 
credit bonds generally (see below), have crippled the QZAB 
program. To date, only three QZAB transactions have taken 
place. Moreover, the two publicly offered issues sold at a 
discounted price. In other words, in neither case did the 
school district receive a zero-percent interest rate, as the 
QZAB program is intended to provide. In both cases, issuers had 
to offer significant original issue discount, in addition to 
the federal tax credits, in order to attract investors.

New Initiatives

    In its FY200 budget, the administration has proposed a 
significant expansion of tax credit bonds for school 
construction and rehabilitation and environmental purposes. 
First, in recognition of the severe limitation that the 
``private business contribution'' imposes on the QZAB program, 
the administration has proposed a tax credit for corporations 
that provide contributions to qualified zone academies located 
in empowerment zones and enterprise communities equal to 50 
percent of the value of the contribution. Each empowerment zone 
would be able to allocate $4 million in credits and each 
enterprise community would be allowed to designate $2 million 
of credits. This proposal may make it easier to attract private 
business contributions for QZAB-financed projects.
    Second, the administration has proposed expanding the QZAB 
program. Under the administration's proposal, eligible school 
districts could issue $1 billion of QZABs in 2000 and $1.4 
billion in 2001. The program would be expanded to include 
school construction as well as rehabilitation. Eligibility 
requirements for QZAB projects, including the private business 
contribution, would remain the same. The QZAB structure would 
be changed to bring it into line with other proposed tax credit 
bond programs. (See below.)
    Third, the administration has proposed new tax credit bond 
programs for school construction and renovation, Qualified 
School Modernization Bonds (QSMBs), and for greenspace 
preservation and other environmental uses, Better America Bonds 
(BABs). Although the QSMB and BAB proposals attempt to remedy 
some of the problems with QZABs, they would also impose new 
requirements on states and localities that do not apply under 
the QZAB program. The administration's proposal stipulates that 
the Education Department would be required to approve the 
school modernization plan of any state or school district that 
used QSMBs. The Environmental Protection Agency (EPA) would be 
required to approve all projects funded with BABs.
    The QZAB program provides a simple allocation formula based 
on state populations of individuals living below the poverty 
line. The proposed QSMB program, although much larger than the 
QZAB program, imposes more stringent allocations. The 
administration proposes $11 billion of QSMB issuance per year 
in 2000 and 2001. Half of this volume would be allocated to the 
100 school districts with the largest number of children living 
below poverty. The Education Department would also be able to 
designate an additional 25 school districts which ``are in 
particular need of assistance.'' The other half would be 
allocated among the states based on funding currently received 
under the Education Department's Title I grant program. Other 
allocations would be reserved for U.S. possessions and for 
schools funded by the Bureau of Indian Affairs. BABs would 
presumably be allocated by the EPA competitively on a project-
by-project basis.

The Proposed New Structure for Tax Credit Bonds

    In its FY 2000 budget, the administration proposes a new 
structure for all tax credit bonds. This new structure would 
apply to QZABs issued after December 31, 1999, QSMBs and BABs. 
In general, the structure is designed so that investors would 
buy tax credit bonds at face value--with no original issue 
discount--and with no pledge of interest payments by the 
issuer. If it works as designed, all of an investor's return 
would be earned in the form of the tax credit. The issuer is 
supposed to receive a zero-percent cost of capital.
    Under the proposal, any taxpayer could claim a credit 
associated with holding a tax credit bond. Bondholders would 
become eligible to claim the credit annually on the anniversary 
date of a bond's issuance. Tax credits would be treated as 
taxable interest and would be included in a taxpayer's gross 
income calculation. The maximum term of a tax credit bond would 
be 15 years. Credits would be non-refundable, but could be 
carried forward for up to five years. The credit rate would be 
set daily rather than monthly, as under the current QZAB 
program. The credit rate would be based on prevailing market 
yields in the corporate bond market. An issuer selling tax 
credit bonds would use the tax credit rate published by the 
Treasury Department on the day prior to the day the bonds are 
sold.

Tax Credit Bonds and the Capital Markets

    Although the administration's proposed new structure for 
tax credit bonds is an improvement over the structure used in 
the current QZAB program, from a market perspective, there are 
flaws inherent in any tax credit bond which would result in 
significant inefficiencies. Perhaps the most significant 
involves the timing of tax credits and the nature of the 
investment return sought by bond investors.
    With a traditional bond that pays cash interest, the yield 
calculation used by investors to price the value of a bond 
assumes that investors will receive interest payments according 
to a specified schedule and that investors will have the 
opportunity to reinvest those payments immediately. In the 
standard yield or price calculation, there is no time when any 
portion of an investor's return is not generating income. In 
contrast, the value of a tax credit under any of the proposed 
tax credit bond proposals is largely dependent on timing and on 
the tax situation of a particular investor. Under the 
administration's proposal, an investor earns the ability to 
take an annual credit on the anniversary date of a bond's 
issuance. However, the credit becomes economically valuable to 
the investor only when it has the effect of reducing a tax 
payment, and that occurs only on a day when an investor is 
required to make a federal tax payment. For some investors, tax 
payment dates occur only once per year. In the likely 
occurrence that the anniversary date does not coincide with a 
tax payment date, the investor incurs a period of time when the 
credit has no significant economic value. Because no money has 
changed hands, it is not possible for the investor to 
``reinvest'' the credit as he or she could with a cash interest 
payment. The investor loses the reinvestment income that 
normally begins accruing on an interest payment date.
    The situation worsens in years when a tax credit bond 
investor has no tax liability whatsoever. Under the 
administration's proposal, tax credits may be carried forward 
for up to five years. However, if an investor has no tax 
liability in a given year and is forced to carry the credit 
forward, the period of time during which the credit provides no 
economic value is extended even further. Again, until an 
investor is able to earn true economic value from the credit 
through a reduction in a tax payment, the reinvestment 
potential normally associated with interest payments is lost. 
This substantially erodes the value of the investment. These 
timing problems make it exceedingly difficult to efficiently 
price the value of a tax credit bond and introduces 
inefficiencies to the structure. Indeed, the value of the bond 
differs from investor to investor, depending on their tax 
circumstances.
    A second problem associated with the tax credit bond 
proposal involves the overall size of the program. The overall 
volume of tax credit bond issuance would increase substantially 
under the administration's various proposals. Taken together, 
the QZAB, QSMB and BAB proposals would authorize the issuance 
of nearly $29 billion of tax credit bonds over five years. In 
the context of the capital markets overall, however, this is a 
relatively small volume of issuance, especially given the 
novelty of the financing structure. In contrast, in 1998 alone, 
states and localities issued $286 billion of traditional 
municipal bonds. The relatively small size of the tax credit 
bond market would ensure that little secondary market trading 
took place. Tax credit bonds would be illiquid instruments. As 
a result, investors would demand a liquidity premium--a higher 
rate of return--from bond issuers.
    A third problem with tax credit bonds relates to the timing 
and value of the credit rate. The administration has proposed 
to set the credit rate on a daily basis using prevailing market 
yields in the corporate bond market. Tax credit bond issuers 
would use the previous day's credit rate when pricing and 
selling their bonds. However, market interest rates change from 
day to day and even from minute to minute. It is unlikely that 
the interest rates used on Monday to set the credit rate would 
still prevail on Tuesday, when an issuer came to market with a 
bond issue. If rates have risen, issuers would have to make up 
the difference by offering a discounted price on their bonds.
    Market professionals have also expressed concerns about the 
credit rate itself and the attractiveness to investors of tax 
credit bonds with credit rates based on corporate bond yields. 
Because they would be priced and sold to investors based on 
corporate bond rates of return, they would compete for capital 
with corporate bonds themselves and similar taxable 
investments. However, because they are tax-preferred 
investments, tax credit bonds would be of little value to tax-
exempt or tax-deferred investors such as pension funds, 
retirement accounts and foreigners, groups of investors which 
are very active in the U.S. taxable bond markets. The only 
investor groups to whom tax-credit bonds would be attractive 
are domestic individuals and corporations, largely banks and 
insurance companies, since they are most active in the capital 
markets as investors.
    For individual investors, tax-credit bonds would compete 
with tax-exempt municipal bonds and taxable corporate bonds. 
For many individual investors, municipal bonds provide a more 
attractive after-tax rate of return than corporate and similar 
taxable bonds. This stands whether the taxable investment pays 
cash interest or offers a tax credit at a rate based on 
prevailing corporate bond rates of return. It is unlikely that 
investors for whom tax-exempt municipal bonds provide a 
superior after-tax rate of return to corporate bonds would be 
attracted to tax credit bonds with yields based on the 
corporate market. Banks and insurance companies, who are active 
in the corporate bond market, would potentially find the credit 
rate appealing. However, the timing issues outlined above would 
make tax credit bonds with interest rates based on corporate 
bond yields less attractive than corporate bonds themselves. In 
short, it is likely that the pool of potential investors in tax 
credit bonds would be severely limited, given that tax-credit 
bonds would compete against corporate bonds themselves and 
similar taxable investments.
    A fourth and final problem associated with the 
administration's proposals involves the degree to which federal 
agencies are required to approve projects before they qualify 
for tax credit bond financing. This approach runs counter to 
the flexibility and freedom enjoyed by states and localities in 
planning, financing and executing their construction projects. 
It is virtually unheard of for a local school district to seek 
federal approval before proceeding with a construction project. 
Injecting a high degree of federal control in the financing 
process would discourage school districts from taking advantage 
of the tax credit bond programs.
    In sum, given the problems associated with tax credit bonds 
outlined above, it is highly unlikely that any state or local 
government would obtain a zero-percent cost of capital through 
a tax credit bond. Given the inefficiencies built into the tax 
credit bond structure, states and localities would invariably 
be forced to sell bonds at a discount to attract investor 
interest. The difference between the sale price of tax credit 
bonds and their face value would represent interest cost to the 
issuer in the form of original issue discount.

An Alternative--Tax-exempt Financing

    Tax-exempt bonds are the single most important source of 
financing for state and local investment in public school 
infrastructure. Over the past decade or so, tax-exempt bonds 
have financed approximately 90 percent of the nation's 
investment in public schools. Tax-exempt bonds are efficient, 
well-understood, popular among investors, and have an 
established market infrastructure with a several-hundred-year 
history beginning in colonial times. Moreover, tax-exempt bonds 
provide an important source of federal assistance from the 
federal government to states and localities. Because the 
federal government foregoes the tax revenue on interest earned 
by investors on qualified municipal bonds, investors demand a 
much lower rate of interest than they otherwise would. States 
and localities benefit through a lower cost of capital.
    Tax-exempt bonds are not plagued by any of the problems 
that would affect the success of tax credit bonds. Because they 
pay cash interest, municipal bonds are not affected by the 
timing issues that would erode the value of tax credit bonds. 
Because it is a large and established market with a broad base 
of investors, secondary market trading is relatively active and 
liquid. Interest rates are set efficiently according to market-
based rates of return, and issuers do not need any form of 
federal approval to tap the capital markets.
    As beneficial as tax-exempt bonds are in helping school 
districts finance construction and rehabilitation, the federal 
tax code contains a number of restrictions on the issuance and 
use of tax-exempt bonds that prevent school districts from 
using municipal bonds to their full potential. Congress has 
considered and is considering several targeted changes to 
improve the ability of school districts to use tax-exempt bonds 
to finance school construction. These proposals would address 
restrictions related to private use, arbitrage, refinancings 
and restrictions on investing in school bonds. They would 
provide meaningful assistance to school districts by lowering 
the cost of financing for school construction projects. The 
proposals would result in more schools being built and repaired 
and would, in some cases, accelerate construction projects that 
are on school districts' capital investment plans.
    On February 4, Chairman Archer announced his support for an 
initiative to extend from two years to four the construction 
spend-down exemption from arbitrage rebate rules for school 
bonds. In announcing this initiative, Chairman Archer correctly 
recognized that addressing existing impediments to the broader 
use of tax-exempt bonds for school construction would go a long 
way towards encouraging and assisting local school districts to 
build more schools faster. We fully support Chairman Archer's 
proposal and we urge Congress to enact it quickly. We also urge 
Congress to consider, as an alternative or supplement to tax-
credit bonds, other targeted changes to municipal bond rules 
for school bonds to spur public school construction and 
rehabilitation.

                                Summary

    Government fiscal policy, especially tax policy, can have a 
profound effect on the ability of governments and corporations 
to undertake capital investment. Tax increase proposals as 
seemingly arcane, technical and focused as ``increasing the 
proration percentage for property and casualty companies'' or 
``disallowing interest on debt allocable to tax-exempt 
obligations'' would have effects far beyond what is apparent. 
By affecting the choices and preferences of investors, these 
proposals would also have a significant negative effect on the 
ability of borrowers to finance capital investments at the 
lowest possible cost. We share the belief of many members of 
this committee that our tax system ought to encourage and 
facilitate capital investment. The administration's tax 
increase proposals outlined above would have the opposite 
effect. We urge you to oppose these provisions.
    We agree with the administration's goals in other areas. We 
agree, for example, that tax incentives designed to assist and 
encourage school districts to build and rehabilitate public 
schools are appropriate. Unfortunately, it appears that the 
administration's tax credit bond initiatives would fail to 
achieve the goal of providing state and local governments with 
a zero-interest source of capital. We urge Congress to explore 
alternative ways to expand traditional municipal bond financing 
for school construction and rehabilitation.
    We appreciate the opportunity to present our statement, and 
we look forward to working with Ways and Means members and 
staff as the budget debate progresses.
      

                                

Statement of Business Insurance Coalition

AIG Life Companies (U.S.)
American Council of Life Insurance
American General Corporation
America's Community Bankers
Association for Advanced Life Underwriting
Business Use Insurance Committee
Clarke/Bardes, Inc.
Harris, Crouch, Long, Scott & Miller, Inc.
Massachusetts Mutual Life Insurance Company
MetLife
National Association of Life Underwriters
New York Life Insurance Company
Pacific Life
Security Life of Denver Insurance
Southland Insurance Company

    The Business Insurance Coalition, which is comprised of the 
above-listed purchasers, issuers, and sellers of business-use 
life insurance, submits this statement opposing the 
Administration's FY 2000 budget proposal to impose new taxes on 
businesses that own or benefit from permanent life insurance.
    American businesses, large and small, have for many decades 
used life insurance to assure business continuation, provide 
employee benefits and attract and retain key employees. There 
is no justification for discouraging or eliminating these 
traditional business uses of life insurance. The Administration 
has again proposed--as it did last year--a heavy tax on life 
insurance held by businesses that would strongly discourage the 
vast majority of employers from utilizing this important 
product. We urge Members of the Ways and Means Committee to 
reject it once again.

  Life Insurance Allows Business Continuation, Protects Employees and 
                 Funds Vital Employee Benefit Programs

    Permanent life insurance protects businesses against the 
economic losses which could occur after the death of an owner 
or employee. Life insurance death benefits provide liquid cash 
to pay estate taxes upon the death of a business owner, to buy 
out heirs of a deceased owner or to meet payroll and other 
ongoing expenses when an income-producing worker dies.
    Permanent life insurance purchased with after-tax dollars 
smoothes the transition during difficult times, allowing the 
business--and its employees--to continue working by preventing 
or mitigating losses associated with these disruptions. 
Anecdotal evidence of this abounds; every Representative and 
Senator will hear from constituents whose jobs still exist 
because their employers were protected from financial loss by 
life insurance.
    Many businesses, both large and small, also use permanent 
life insurance to finance employee benefit programs, thus 
enabling them to attract and retain their most important asset: 
skilled, experienced employees. Insurance-financed benefit 
programs are as diverse as the companies that use them, ranging 
from those which provide broad-based health coverage for 
retirees to non-qualified pensions and savings benefits.

The Proposal Reverses Recent Congressional Action by Imposing New Taxes 
                     on Business-Use Life Insurance

    The Administration's FY 2000 budget proposal would severely 
impact all of the aforementioned business uses of life 
insurance. Under the proposal, any business with general 
business debt unrelated to insurance would lose part of its 
deduction for interest paid on that debt simply because the 
business owns, or is the beneficiary of, permanent life 
insurance. The business' interest deduction would be reduced by 
an amount related to the net unborrowed cash values in such 
policies (except for those covering the lives of 20 percent 
owners). This would impose an indirect tax on accumulating cash 
values of the insurance--as unborrowed cash values increase, 
the business' interest deduction disallowance would 
correspondingly increase.
    The Administration proposal would repeal specific 
exceptions to a 1997 rule enacted by Congress which generally 
disallows a portion of a business' deduction for interest paid 
on unrelated borrowing where the business directly or 
indirectly benefits from insurance covering the lives of anyone 
but an employee, officer, director or 20 percent or greater 
owner. The pending proposal would remove all exceptions except 
that applicable to 20 percent owners.
    Last year, the Administration made the same proposal, which 
seeks to overturn current law developed after three years of 
Congressional examination into appropriate business uses of 
life insurance. It again asks Congress to reconsider its 1996 
and 1997 determinations that there is no inappropriate 
interrelationship between owning (or benefiting from) life 
insurance on employees, officers and directors and general, 
unrelated borrowing decisions. More broadly, the proposal seeks 
to repeal long-standing tax policy which confers on 
corporations the right to enjoy the same important insurance 
tax benefits that are available to individuals.

The Administration Proposal Would Severely Impact Businesses That Rely 
                           on Life Insurance

    Enactment of the Administration proposal would make it 
significantly--in most cases, prohibitively--more expensive for 
businesses to own permanent life insurance. This would increase 
the number of inadequately protected businesses, which would, 
in turn, cause more businesses to fail when their owners and/or 
key workers die (a result directly at odds with the effort to 
save family-owned businesses as ongoing entities in the estate 
tax debate).
    The Administration proposal also would stifle business 
expansion and job creation by placing an arbitrary tax on 
normal corporate indebtedness of companies that own life 
insurance. The net effect would be to increase the cost of 
business expansion and discourage business growth, which is 
both bad economic and tax policy.
    If enacted, the Administration proposal also would make it 
more difficult, perhaps impossible, for many businesses to use 
life insurance in connection with employee and retiree 
benefits. It would hurt employees by unduly restricting the 
benefits companies can provide to key workers. It would hurt 
businesses by making it more difficult to attract and retain 
quality employees.
    Finally, the Administration proposal would impose a double 
tax penalty on certain business policyholders forced to 
surrender or sell their life insurance policies. The first tax 
penalty would be paid through reduced interest deductions on 
the business' unrelated borrowing. The second tax penalty would 
occur upon surrender of the policy, which the retroactive 
application of the Administration's new tax on existing 
policies would be certain to trigger. The business would again 
be required to pay tax on the gain generated inside the policy. 
Plainly, there is no justification for imposing two taxes (a 
proration tax and a tax on policy surrender) with respect to 
the same item of income (life insurance inside build-up).

   The Administration's ``Arbitrage'' Justification Is Without Merit

    The Administration asserts that tax legislation is needed 
to prohibit ``arbitrage'' with respect to cash value life 
insurance. This is not the case. Current law (IRC section 264) 
disallows the deduction of interest on ``policy indebtedness'' 
and has always applied to direct borrowing (policy loans) and 
indirect borrowing (third party debt) where the debt is used to 
``purchase or carry'' life insurance.
    What remains outside of section 264, then, is solely debt 
that is unrelated to a business' decision to ``purchase or 
carry'' life insurance, such as a manufacturer's mortgage to 
purchase a new plant or a travel agency's loan to buy a new 
copy machine. Under the Administration's proposal, these 
businesses would be penalized for protecting themselves against 
the premature death of key persons or funding retiree health 
benefits through life insurance, even if they have neither 
borrowed funds to purchase the policies nor taken out loans 
against the policies. If the Administration's logic were 
applied to individual taxpayers, homeowners would lose their 
ability to deduct interest on their home mortgage loans because 
they also own permanent life insurance.
    Current tax law is designed to capture situations involving 
arbitrage with respect to cash value life insurance. The 
Administration's attempt to characterize any form of debt as 
leverage which renders a business' purchase of life insurance 
tax ``arbitrage'' is nothing but smoke and mirrors designed to 
hide its true purpose: the imposition of new taxes on business-
use life insurance.

 The Administration's Characterization of Business Insurance as a Tax 
                          Shelter is Nonsense

    The tax attributes of life insurance are clearly defined by 
the Internal Revenue Code, of which they have been a part for 
many years. Those attributes have been the object of study by 
Congress from time to time and refinement of some of the 
ancillary rules. The fundamental tax attributes have remained 
unchanged, however, and they are well understood.
    As noted above, life insurance has long been used by 
businesses to assure business continuation, provide employee 
benefits, and attract and retain key employees. These business 
uses of life insurance are also well known. Indeed, they have 
been examined exhaustively by the Congress in each of the last 
three years.
    In 1996, Congress examined business life insurance and made 
adjustments with respect to policy loans. It did so again in 
1997, when it imposed limitations on life insurance covering 
the lives of non-employees. Both times, Congress left alone 
traditional uses of life insurance by businesses. In 1998, 
Congress again examined business life insurance, this time 
rejecting the very proposal the Administration again makes this 
year to impose a new tax on all forms of cash value life 
insurance held by business by denying a deduction for interest 
on unrelated debt.
    It is therefore surprising that the Administration now 
seeks to characterize business insurance as a tax shelter. At 
the heart of the Administration's tax shelter proposals is the 
concept of a ``tax avoidance transaction.'' Mere ownership of 
life insurance, the tax attributes of which are longstanding 
and well known, plainly cannot be such a transaction.
    More specifically, the Administration makes it clear in its 
tax shelter proposals that a tax shelter does not include any 
``tax benefit clearly contemplated by the applicable 
provision.'' Department of the Treasury, General Explanation of 
the Administration's Revenue Proposals at 96 (February 1999). 
The tax attributes of life insurance are not only clearly 
contemplated and well understood--they were precisely the 
attributes examined at length by Congress in 1996, 1997 and 
1998.
    The Administration's proposal is to impose a new tax on 
traditional business uses of life insurance, and nothing more. 
It should be considered--and rejected--on its merits, and not 
based on the Administration's incongruous and entirely 
inappropriate characterization of life insurance as a ``tax 
shelter.''

  Tax Policy Should Encourage Appropriate Business-Use Life Insurance 
                                Programs

    At the heart of the debate over the Administration's 
proposal is the issue of whether business uses of life 
insurance should be encouraged or discouraged. The Business 
Insurance Coalition fundamentally disagrees with the 
Administration's position, which threatens all present and 
future uses of life insurance by businesses, and its members 
firmly believe that business-use life insurance falls clearly 
within the policy purposes supporting the tax benefits 
presently accorded to life insurance products.
    Tax policy applicable to business-use life insurance should 
encourage appropriate use of business life insurance by 
embodying the following principles:
     Businesses, in their use of life insurance, should 
have the benefit of consistent tax laws in order to facilitate 
reliable and effective long-range planning.
     All businesses, regardless of size or structure, 
should be able to use life insurance to provide benefits for 
their workers. Life insurance is an appropriate method of 
facilitating provision of retirement income, medical and 
survivorship benefits.
     Businesses must be able to use life insurance as 
an important part of their financial protection plans, and the 
insurance industry should respond to new business needs.
     Businesses, like individuals, should be able to 
use all products which qualify as life insurance under 
applicable federal and state law.
     Businesses should be able to use life insurance 
products in ways consistent with the public interest and the 
intent of the tax laws.
     Businesses should be able to use life insurance to 
protect against the financial loss of the insured's death, or 
to meet other financial needs or objectives, including but not 
limited to:
    --successful continuation of business operations following 
the death of an insured key employee;
    --purchase of a business interest, thereby enabling the 
insured's family to obtain a fair value for its business 
interest and permitting the orderly continuation of the 
business by new owners;
    --redemption of stock to satisfy estate taxes and transfer 
costs of an insured stockholder's estate;
    --creation of funds to facilitate benefits programs for 
long-term current and retired employees, such as programs 
addressing needs for retirement income, post-retirement medical 
benefits, disability income, long-term care, or similar needs; 
and
    --payment of life insurance or survivor benefits to 
families or other beneficiaries of insured employees.
   Businesses Need Reliable and Predictable Tax Rules to Guide Their 
                          Financial Decisions

    Life insurance is a long-term commitment. It spreads its 
protection--and premium obligations--over life spans, often 40 
or 50 years. Its value base is predicated on the lifetime 
income-producing potential of the person insured. Thus, the 
process of selecting, using and paying for permanent insurance 
is one that contemplates decades of financial planning 
implications.
    Accordingly, the rules governing the choices inherent in 
constructing a business-use life insurance program must be 
clear and reliable. Certainty of rules that drive the 
configuration of decades-long financial commitments is crucial. 
There must be a stable environment that acknowledges long-
established practices.
    This need is even more acute today because of the 
Congressional actions of 1996 and 1997, which created a virtual 
``road map'' for businesses to follow in designing and 
implementing their business-use life insurance programs. The 
two years of debate addressed business-use life insurance 
practices in substantial detail, settling all of the issues 
raised by the pending Administration proposal. Thus, businesses 
reasonably thought they could proceed with some certainty under 
the rules enacted in 1996 and then further refined in 1997. To 
reopen these issues--which were addressed and settled less than 
two years ago--and then to change them again would be 
unconscionably unfair.

 Conclusion: The Administration's Business-Use Life Insurance Proposal 
 Unfairly and Adversely Affects Every Business with Current or Future 
                                  Debt

    The Business Insurance Coalition strongly opposes the 
Administration's FY 2000 budget proposal on business-use life 
insurance, which unfairly and adversely affects every business 
that has current or future debt unrelated to its ownership of 
life insurance. The Business Insurance Coalition has 
demonstrated the appropriateness of the current rules governing 
business-use life insurance, which underpins business 
continuation and employee protection.
    Life insurance that protects businesses against the loss of 
key personnel and/or facilitates the provision of employee 
benefits should not be subject to further changes in applicable 
tax law. The question before Congress should be: Do current 
uses of business life insurance serve legitimate policy 
purposes justifying the tax benefits accorded life insurance 
generally? We believe that this question should be answered 
with an emphatic ``YES,'' and urge the Committee to again 
reject the Administration's proposal to impose new taxes on 
business-use.
      

                                

Statement of Business Roundtable

    I am Thomas Usher, chief executive officer of USX 
Corporation and chairman of the Taxation Task Force of The 
Business Roundtable. I am testifying in writing to the views of 
The Business Roundtable on tax legislation for 1999. The 
members of The Business Roundtable are chief executive officers 
of leading corporations with a combined workforce of more than 
10 million employees in the United States.
    In the United States, corporations employ more people, pay 
more wages, fund more research, invest in more plant and 
equipment, and support more employee benefits than any other 
type of business. We also pay more federal income tax. 
Therefore, one of our main public policy interests is how taxes 
are affecting corporations in their central economic role as 
engines pulling the national economy.
    From that perspective, we urge Congress to reduce the 
corporate income tax. Corporate funds that are not diverted to 
taxes can go into building the economy and underwriting 
prosperity in future years. The old saying is true: the time to 
invest is when you have it. The condition of the federal 
budget, itself a beneficiary of economic growth, makes a 
corporate tax reduction feasible.
    Lowering the corporate income tax rate would be the most 
effective form of corporate tax reduction. It would affect all 
types of corporations. It would put funds into play to compete 
for economic projects that have the best prospects for creating 
value and stimulating growth. The alternative is for the 
government to pick business winners based on politics and thus 
dilute the beneficial impact of a business tax reduction.
    The top corporate income tax rate is 35 percent. It is in 
the 30's today rather than the 20's as the result of tax reform 
politics in 1986 and not for any reason of tax or economic 
policy. The original tax reform ideal was to broaden the tax 
base and lower tax rates so that the net change was revenue 
neutral. If Congress had applied this principle to the 
corporate income tax in the Tax Reform Act of 1986, the top 
corporate tax rate would have been 26 or 27 percent. But to 
obtain support for tax reform in 1986, the government enacted 
more than a 20 percent corporate tax increase so that it could 
cut individuals' taxes in the same amount.
    Other broad improvements to the federal corporate income 
tax would allow businesses to create additional value. These 
improvements include simplification of tax rules governing 
international business; a permanent tax credit to encourage 
research and experimentation so that the credit functions more 
effectively, as all commentators on the subject have observed; 
and alternative minimum tax relief so that heavy-investing 
companies are not penalized and capital can flow into job-
producing uses rather than prepayment of income tax.
    Constructive measures like cutting corporate tax rates and 
simplifying international tax rules stand in stark contrast to 
the Administration's proposals to increase taxes on business. 
Corporations are singled out in certain proposals that have 
soundbite appeal but only magnify the worst tendencies of the 
tax system to complicate, confuse, and retard economic growth. 
Each of these revenue-raising proposals regarding global 
operations, exports, corporate tax planning, tracking stock, 
and punitive damages is objectionable on its own and should be 
rejected. Together these proposals represent an additional tax 
burden on American business that is anticompetitive in the 
global marketplace.
    We would have thought it axiomatic that U.S. tax policy 
should not handicap U.S. enterprises in the international 
contest for business. But the Administration's proposals would 
have a particularly harsh impact on international operations. 
They could be employed by IRS agents to deny foreign tax 
credits and interest deductions where corporate structures are 
debt-financed. They would add significantly to the tax burden 
of U.S. multinationals and make it impossible for them to 
operate with certainty regarding the tax treatment of their 
global operations. The proposal to repeal the ``export sales 
source rule'' would increase taxes sharply on U.S. companies 
that export goods overseas.
    The Administration's proposal to tax the issuance of 
tracking stock is unprecedented. Such a tax would constitute 
the only direct tax on the issuance of common stock. Companies 
use tracking stock for compelling business reasons: to raise 
capital efficiently to grow or acquire businesses, to attract 
and retain employees, and to satisfy investor demands. The 
imposition of a tax on the issuance of tracking stock would 
constrict new business technology investment, disrupt financial 
markets, cost jobs, and require massive financial re-
engineering for some companies.
    In the name of attacking ``corporate tax shelters'' the 
Administration would give IRS auditors unprecedented authority 
to impose taxes and penalties on almost any business 
transaction where tax-planning considerations may have played a 
role. These proposals could affect a wide range of legitimate 
business transactions undertaken in the ordinary course of 
business. The proposals would compromise the rights of 
taxpayers to pay no more than the minimum amount they owe under 
the tax laws and overlook the ample tools the government 
already possesses to address abuses of the tax system. The 
proposals are even more surprising coming so soon after the 
Administration itself found it necessary to rein in undesirable 
practices of IRS agents and reform the IRS.
    It is accepted in tax theory and in the actual practice of 
our global competitors to allow business deductions against 
income. Yet the Administration proposes to deny deductions for 
punitive damages paid by corporations upon judgment by a court 
or upon settlement of a claim. It is particularly unfair given 
our litigious society and given that the federal government has 
failed to enact any meaningful tort reform.
    Finally, we would not have expected the Administration to 
propose a $20 billion corporate income tax increase over the 
same 5-year period that federal budget surpluses will amass to 
$953 billion.
    Who will look to the bigger picture? We respectfully urge 
this Committee, this House of Representatives, and this 
Congress to close the book on fragmentary and narrow-gauged tax 
measures, like many of those in the Administration's budget, 
and to consider more visionary policies that promote the 
general economic welfare of this nation as it engages in the 
global contest for income and prosperity.
    Thank you for considering our views.
      

                                

Statement of Central & South West Corporation, Dallas, Texas

    Mr. Chairman and Members of the Committee, we thank you for 
the opportunity to submit this statement on behalf of Central & 
South West Corporation of Dallas, Texas on the importance of 
extending the wind energy production tax credit (PTC) until the 
year 2004.
    Central and South West Corporation (CSW) is an investor-
owned electric utility holding company based in Dallas, Texas. 
CSW owns and operates four electric utilities in the United 
States: Central Power and Light Company, Public Service Company 
of Oklahoma, Southwestern Electric Power Company, and West 
Texas Utilities Company. These companies serve 1.7 million 
customers in an area covering 152,000 square miles of Texas, 
Oklahoma, Louisiana, and Arkansas.
    CSW also owns a regional electricity company in the United 
Kingdom, SEEBOARD plc, which serves 2 million customers in 
Southeast England. CSW engages in international energy, 
telecommunications and energy services businesses through 
nonutility subsidiaries including CSW Energy, CSW 
International, C3 Communications, EnerShop, and CSW Energy 
Services. CSW is currently in the process of seeking regulatory 
approval for a merger with American Electric Power Company, 
based in Columbus, Ohio, and expects the merger to be completed 
sometime in the 4th quarter of 1999.
    CSW has been active in the research and development of wind 
energy for six years, and was named as the American Wind Energy 
Association's Utility of the Year in 1996. CSW owns and 
operates the first wind farm built as part of the U. S. 
Department of Energy's Turbine Verification Program in which 
state-of-the-art, U.S.-manufactured wind turbine technology is 
being tested. In addition, a 75 MW wind farm is currently being 
built near the west Texas community of McCamey in order to 
serve the customers of three CSW subsidiaries--West Texas 
Utilities Company, Central Power and Light Company, and 
Southwestern Electric Power Company.
    We want to commend Representative Bill Thomas, and all of 
the cosponsors of H.R. 750, and Senators Grassley, Jeffords and 
Conrad and all of the cosponsors of S. 414, for their 
leadership in supporting legislation to extend the wind energy 
PTC until the year 2004. H.R. 750 and S. 414 both have broad, 
bipartisan support. H.R. 750 was introduced with sixty (60) 
original cosponsors, including nineteen (19) members of this 
committee. H.R. 750 is now supported by 86 cosponsors including 
23 of the members, a majority, of this committee.
    We also want to commend President Clinton for including, 
and funding, a five-year extension of the wind energy PTC in 
the Administration's FY 2000 Budget.
    We hope the Congress will take swift action to extend the 
wind energy PTC by enacting the provisions of H.R. 750--S. 414 
before the expiration of the current PTC on June 30, 1999.

                  I. BACKGROUND OF THE WIND ENERGY PTC

    The wind energy PTC, enacted as part of the Energy Policy 
Act of 1992, provides an inflation-adjusted 1.5 cents/kilowatt-
hour credit for electricity produced with wind equipment for 
the first ten years of a project's life. The credit is 
available only if the wind energy equipment is located in the 
United States and electricity is generated and sold. The credit 
applies to electricity produced by a qualified wind energy 
facility placed in service after December 3, 1993, and before 
June 30, 1999. The current credit will expire on June 30, 1999.

                 II. WHY DO WE NEED A WIND ENERGY PTC?

  A. The Wind Energy PTC is Helping to Drive Costs Down, Making Wind 
        Energy a Viable and Efficient Source of Renewable Power

    The efficiency of wind generated electric energy has 
increased dramatically since the early to mid-1980's. The 
machine technology of the 1980's was in its early stages and 
costs of wind energy during this time period exceeded 25 cents 
per kilowatt-hour. Since that time, however, the wind industry 
has succeeded in reducing wind energy production costs by a 
remarkable 80% to the current cost of about 4.5 cents/kilowatt-
hour. The 1.5 cent/kilowatt-hour credit enables the industry to 
compete with other generating sources currently being sold at 
3.0 cents/kilowatt-hour.
    The industry expects that its costs will continue to 
decline as wind turbine technology and manufacturing economies 
of scale increase in efficiency. Through further machine 
development and manufacturing efficiencies, the wind energy 
industry anticipates the cost of wind energy will be further 
reduced to 3 cents/kilowatt-hour or lower by the year 2004, 
which will enable it to fully compete on its own in the 
marketplace.
    The most significant factor contributing to the dramatic 
reduction in U.S. wind energy production costs over the years--
since the 1980's--has been the dramatic improvement in machine 
efficiency. Since the 1980's, the industry has developed three 
generations of new and improved machines, with each generation 
of design improving upon its predecessor. As a result, reduced 
costs of production of new wind turbines, blade designs, 
computer controls, and extended machine component life have 
been achieved. Proven machine technology has evolved from the 
50-kilowatt machines of the 1980's to the 750-kilowatt machines 
of today that have the capacity to satisfy the energy demands 
of as many as 150 to 200 homes annually. Moreover, a new 1500-
kilowatt machine is currently undergoing the last phases of 
development and testing that will further improve the 
technology's efficiency and further reduce wind power costs to 
about 4 cents per kilowatt-hour.
    The wind industry anticipates that wind energy production 
costs will continue to decline in the future, and is confident 
that the next two generations of wind turbine design--estimated 
to be available by the year 2004--will sufficiently lower the 
technology costs to allow the industry to fully compete in the 
United States on its own merits with fossil-fueled generation. 
The five-year extension of the wind energy production tax 
credit will bridge the gap for the domestic industry until it 
is fully able to stand on its own by the year 2004.

 B. Wind Power will Play an Important Role in a Deregulated Electrical 
                                 Market

    The electrical generation market is going through 
significant changes as a result of efforts to restructure the 
industry at both the Federal and State levels. If the wind 
energy PTC is extended, renewable energies such as wind power 
are certain to play an important role in a deregulated 
electrical generation market. Wind power alone has the 
potential to generate power to as many as 10 million homes by 
the end of the next decade. Extending the credit will help the 
wind energy industry secure its position in the deregulated 
marketplace as a fully competitive, renewable source of 
electricity.

   C. Wind Power Contributes to the Reduction of Greenhouse Emissions

    Wind-generated electricity is an environmentally-friendly 
form of renewable energy that produces no greenhouse gas 
emissions. ``Clean'' energy sources such as wind power are 
particularly helpful in reducing greenhouse gas emissions. The 
reduction of greenhouse gas emissions in the United States will 
necessitate the promotion of clean, environmentally-friendly 
sources of renewable energy such as wind energy. The extension 
of the wind energy PTC will assure the continued availability 
of wind power as a clean, renewable energy source.

        D. Wind Power has Significant Economic Growth Potential

1. Domestic

    Wind energy has the potential to play a meaningful role in 
meeting the growing electricity demand in the United States. As 
stated above, with the appropriate commitment of resources to 
wind energy projects, wind power could generate power to as 
many as 10 million homes by the end of the next decade. There 
currently are a number of wind power projects operating across 
the country. These projects are currently generating 1,761 
megawatts of wind power in the following states: Texas, New 
York, Minnesota, Iowa, California, Hawaii and Vermont.
    There also are a number of new wind projects currently 
under development in the United States. These new projects will 
generate 670 megawatts of wind power in the following states: 
Texas, Colorado, Minnesota, Iowa, Wyoming and California.
    The domestic wind energy market has significant potential 
for future growth because, as the sophistication of wind energy 
technology continues to improve, new geographic regions in the 
United States become suitable for wind energy production. The 
top twenty states for future wind energy potential, as measured 
by annual energy potential in the billions of kWhs in 
environment and land use exclusions for wind class sites of 3 
and higher, include:

 1.                         North Dakota...................       1,210
 2.                         Texas..........................       1,190
 3.                         Kansas.........................       1,070
 4.                         South Dakota...................       1,030
 5.                         Montana........................       1,020
 6.                         Nebraska.......................         868
 7.                         Wyoming........................         747
 8.                         Oklahoma.......................         725
 9.                         Minnesota......................         657
10.                         Iowa...........................         551
11.                         Colorado.......................         481
12.                         New Mexico.....................         435
13.                         Idaho..........................          73
14.                         Michigan.......................          65
15.                         New York.......................          62
16.                         Illinois.......................          61
17.                         California.....................          59
18.                         Wisconsin......................          58
19.                         Maine..........................          56
20.                         Missouri \1\...................          52

Source: An Assessment of the Available Windy Land Area and Wind Energy
  Potential in the Contiguous United States, Pacific Northwest
  Laboratory, 1991.

    Sixteen states, including our home state of Texas, have 
greater wind energy potential than California where, to date, 
the vast majority of wind development has taken place.

a. Wind Power Projects can Serve as a Supplemental Source of 
Income for Farmers

    As discussed above, the increasing sophistication of wind 
energy technology has opened up new regions of the country to 
wind energy production. One area of the country that has been 
opened up to wind power production over the last few years is 
the Farm Belt. Since wind power projects and farming are fully 
compatible--a wind power plant can operate on land that is 
being farmed with little or no displacement of crops or 
livestock--wind power projects are now be sited on land in the 
Farm Belt that is also being used for crop and/or livestock 
production. The land rent paid by wind project developers is a 
valuable source of additional income for farmers. For example, 
a new wind plant soon to go on line in Clear Lake, Iowa will 
pay rent to fourteen different landowners who will be 
supplementing their income by leasing their land for the 
operation of the plant without disrupting their ongoing farming 
operations. This is a win-win situation for both farmers and 
consumers in Iowa.

2. International

    The global wind energy market has been growing at a 
remarkable rate over the last several years and is the world's 
fastest growing energy technology. The growth of the market 
offers significant export opportunities for United States wind 
turbine and component manufacturers. The World Energy Council 
has estimated that new wind capacity worldwide will amount to 
$150 to $400 billion worth of new business over the next twenty 
years. Experts estimate that as many as 157,000 new jobs could 
be created if United States wind energy equipment manufacturers 
are able to capture just 25% of the global wind equipment 
market over the next ten years. Only by supporting its domestic 
wind energy production through the extension of the wind energy 
PTC can the United States hope to develop the technology and 
capability to effectively compete in this rapidly growing 
international market.

     E. The Immediate Extension of the Wind Energy PTC is Critical

    Since the wind energy PTC is a production credit available 
only for energy actually produced from new facilities, the 
credit is inextricably tied to the financing and development of 
new facilities. The financing and permitting requirements for a 
new wind facility often require up to two to three or more 
years of lead time. With the credit due to expire in less than 
four months, June 30, 1999, wind energy developers and 
investors are unable to plan any new wind power projects. The 
immediate extension of the wind energy PTC is therefore 
critical to the continued development and evolution of the wind 
energy market.

                            III. CONCLUSION

    Extending the wind energy PTC for an additional five years 
is critical for a number of reasons. The credit enables wind-
generated energy to compete with fossil fuel-generated power, 
thus promoting the development of an industry that has the 
potential to efficiently meet the electricity demands of 
millions of homes across the United States. If the wind energy 
PTC is extended, wind energy is certain to be an important form 
of renewable energy in a deregulated electrical market, and is 
an environmentally-friendly energy source that can aid in the 
reduction of greenhouse gas emissions. The economic 
opportunities of the wind energy market are significant, both 
domestically and internationally. As such, we urge Congress to 
act quickly to extend the wind energy PTC until the year 2004 
so that the industry can continue to develop this important 
renewable energy resource.
    Thank you for providing us with this opportunity to present 
our views on the extension of the wind energy PTC.
      

                                

Statement of Coalition for the Fair Taxation of Business Transactions 
\1\

    The Coalition for the Fair Taxation of Business 
Transactions (the ``Coalition'') is composed of U.S. companies 
representing a broad cross-section of industries. The Coalition 
is opposed to the broad-based ``corporate tax shelter'' 
provisions in the Administration's budget because of their 
detrimental impact on legitimate business transactions. The 
Coalition is particularly concerned with the broad delegation 
of authority provided to IRS agents under these proposals, 
which we believe reverses some of the reforms of the IRS 
Restructuring and Reform Act, passed just last year.
---------------------------------------------------------------------------
    \1\ This testimony was prepared by Arthur Andersen on behalf of the 
Coalition for the Fair Taxation of Business Transactions.
---------------------------------------------------------------------------

                              Introduction

    The Administration's Fiscal Year 2000 Budget contains 
several proposals addressing so-called ``corporate tax 
shelters.'' The proposals fall into two general categories. The 
first is a set of broad-based proposals that could result in 
multiple penalties for any corporation that engages in a 
transaction that results in any reduction of taxes. The second 
is a set of specific proposals targeted at specific 
transactions that Treasury and the IRS view as abusive or 
inappropriate. These proposals, especially the set of broad-
based proposals, appear to be driven by a perception on the 
part of Treasury and the IRS of a substantial increase in 
``corporate tax shelter'' activity in recent years and that 
such activity has caused a serious erosion in the corporate tax 
base.
    As a general matter, the Coalition does not believe that 
there has been a substantial erosion of the corporate tax base. 
Statistics recently released by the Congressional Budget Office 
(CBO) \2\ demonstrate that, rather than falling, corporate 
income tax receipts have been steadily rising in recent years. 
Further, CBO and the Office of Management and Budget (``OMB'') 
both project that revenues from corporate income taxes will 
continue to rise over the next 10 years. In fact, the average 
tax rate paid by corporations is approximately 32.5 percent and 
is projected by CBO to rise to 33.6 percent in 2000. In 
addition, according to CBO, corporate income tax receipts grew 
3.5 percent for fiscal year 1998, while taxable corporate 
profits grew at a slower rate of only 2.3 percent. In light of 
the average corporate tax rate remaining relatively constant, 
there does not appear to be any compelling reason for a radical 
set of new proposals addressing ``corporate tax shelters.''
---------------------------------------------------------------------------
    \2\ The Economic and Budget Outlook: Fiscal Years 2000-2009, 
Congressional Budget Office, January 1999
---------------------------------------------------------------------------
    The Coalition also believes that, in addition to being 
unnecessary, the broad-based proposals could seriously 
undermine a corporation's ability to undertake legitimate 
business transactions. The vague, generalized language of the 
various proposals does not provide sufficient guidance to 
corporate taxpayers as to what transactions will constitute a 
``corporate tax shelter.'' As a result, virtually every 
transaction, regardless of its purpose, undertaken by a 
corporate taxpayer that minimizes the corporation's taxes in 
any way will be potentially subject to the very harsh penalties 
contained in the tax shelter proposals.
    In addition, the Coalition also believes that the broad-
based corporate tax shelter proposals would unjustifiably 
delegate too much authority to the IRS and allow the IRS to 
impose harsh penalties on activities that represent legitimate 
business transactions. The tenor and potential effect of these 
broad-based proposals fly in the face of the Congressional 
policy underlying enactment of the IRS Restructuring and Reform 
Act of 1998. In particular, Congress expressed serious concerns 
about the excessive amount of power in the hands of IRS agents 
and, in response, modified the structure and operations of the 
IRS and expanded the rights of taxpayers against the 
intrusiveness of the IRS. The broad grant of authority to IRS 
agents in the Administration's tax shelter proposals is 
contrary to the theme of the IRS Restructuring and Reform Act 
of 1998 to curtail the power that IRS agents have over 
taxpayers.
    Finally, the Coalition believes the level of penalties 
proposed by the Administration is particularly harsh in light 
of the overwhelming complexity of the current tax laws. The 
combination of the proposals would create a cascading of 
penalties that, both individually and in the aggregate, would 
be unfair and excessive. Congress has already stated that 
cascading penalties are unfair and expressed its disapproval of 
them in the IRS Restructuring and Reform Act.
    In sum, Congress should reject these overly broad and 
unworkable proposals. The proposals transfer excessive and 
unnecessary authority to the IRS and unfairly impact legitimate 
business transactions that are not tax-motivated. Moreover, the 
Administration's new definition of corporate tax shelter 
creates additional uncertainty in a tax code that is already 
overwhelmed with complexity.

                II. Definition of Corporate Tax Shelter

    One need look no further than the proposed new definition 
of corporate tax shelter \3\ to find the genesis of the 
problems with the Administration's budget proposals. Rather 
than providing an objective definition of a ``corporate tax 
shelter,'' the proposal simply defines a corporate tax shelter 
as any entity, plan, or arrangement in which a corporation 
obtained a ``tax benefit'' in a ``tax avoidance transaction.'' 
Under the proposal, it would no longer be necessary to find 
that a transaction had a ``significant purpose,'' or indeed any 
purpose, to avoid taxes for the transaction to be characterized 
as a corporate tax shelter. As discussed below, these concepts 
and definitions are overly broad and vague, and are so 
subjective that they give virtually unlimited discretion to the 
IRS to determine if a transaction is a corporate tax shelter.
---------------------------------------------------------------------------
    \3\ For transactions entered into before August 6, 1997, a ``tax 
shelter'' is defined as a partnership or other entity, an investment 
plan or arrangement, or any other plan or arrangement if the principal 
purpose of the partnership, entity, plan, or arrangement is the 
avoidance or evasion of Federal income tax. The Taxpayer Relief Act of 
1997 amended section 6662(d)(2)(C)(ii) to provide a new definition of 
tax shelter for purposes of the substantial understatement penalty. 
Under this new definition of tax shelter, the tax avoidance purpose of 
an entity or arrangement need not be its principal purpose. Now a tax 
shelter is any entity, investment, plan, or arrangement with a 
significant purpose of avoiding or evading Federal income taxes. The 
new definition of tax shelter is effective for transactions entered 
into after August 5, 1997.
---------------------------------------------------------------------------
    The proposal defines a ``tax benefit'' as a reduction, 
exclusion, avoidance or deferral of tax (or an increase in a 
refund) unless the benefit was ``clearly contemplated'' by the 
applicable Code provision. The proposal provides no guidance on 
how to determine when a tax benefit is clearly contemplated. It 
appears that a benefit can be an impermissible ``tax benefit'' 
even if the benefit was permitted under the actual language of 
the applicable Code provision. In the absence of any clear 
guidance, the proposal would apparently provide IRS revenue 
agents with the power to determine whether a taxpayer's tax 
benefit was a ``clearly contemplated'' permissible benefit. 
This part of the proposal simply grants too much authority to 
individual revenue agents, which will inevitably result in 
increased confrontations between taxpayers and revenue agents 
and a backlog of litigation in the Tax Court.
    The proposal defines a ``tax avoidance transaction'' as any 
transaction in which the reasonably expected pre-tax profit 
(determined on a present value basis, after taking into account 
foreign taxes as expenses and transaction costs) of the 
transaction is insignificant relative to the reasonably 
expected net tax benefits (i.e., tax benefits in excess of the 
tax liability arising from the transaction, determined on a 
present value basis) of such transaction. In addition, a tax 
avoidance transaction is defined to cover certain transactions 
involving the improper elimination or significant reduction of 
tax on economic income.
    As in the case of the definition of ``tax benefit,'' the 
Administration's proposal fails to provide any guidance on what 
transactions would constitute ``tax avoidance transactions.'' 
For example, the proposal does not provide any guidance as to 
the amount of expected pre-tax profit that would be 
insignificant relative to the reasonably expected net tax 
benefits. The proposal also fails to provide guidance as to how 
a corporate taxpayer is to accomplish the impossible task of 
present valuing expected net tax benefits. This inflexible, 
mathematical analysis does not allow for the possibility of 
legitimate business transactions that do not produce an easily 
identifiable pre-tax profit. For example, a corporation may 
need to structure its affairs to conform to regulatory 
requirements or a company may reorganize its structure to gain 
access to certain foreign markets. A company may also need to 
restructure or reorganize to gain economies of scale. In 
addition, a company may enter into a transaction to obtain 
funds for working capital at a lower cost. \4\ These 
transactions are motivated by business concerns, even though 
they do not directly produce a pre-tax economic return by 
themselves. If these legitimate transactions are done in a tax 
efficient manner, they apparently will be characterized 
automatically as a tax shelter because they do not produce a 
direct economic return. Further, under the proposal, IRS agents 
could attempt to classify any loss transaction as a tax shelter 
when the transaction does not provide the expected return.
---------------------------------------------------------------------------
    \4\ The IRS recently issued a Technical Advice Memorandum, TAM 
199910046 (November 16, 1998), in which it upheld the taxpayer's 
interest deduction, ruling that merely because the taxpayer did not 
earn a profit on the transaction did not imply that the transaction 
lacked economic substance.
---------------------------------------------------------------------------
    Under the second part of the proposed definition of tax 
avoidance transaction, any transaction that results in a 
significant reduction of tax on economic income could be 
classified as a corporate tax shelter. The proposal is silent 
as to what types of transactions would involve the ``improper 
elimination'' or ``significant reduction'' of tax on economic 
income. The Administration's proposal contains no restraints on 
the use of this provision by the IRS; therefore, the IRS can 
classify any legitimate business transaction as a corporate tax 
shelter if, in the opinion of the IRS, the transaction resulted 
in a significant reduction of tax on economic income. For 
example, the IRS could possibly classify such routine business 
transactions as tax-free reorganizations, tax-free spinoffs, or 
even check-the-box classification elections as corporate tax 
shelters. In other words, this proposal would allow the IRS to 
penalize corporate taxpayers for arranging their transactions 
in a tax efficient manner. This proposals ignores Judge Learned 
Hand's observation that:

          Anyone may so arrange his affairs that his taxes shall be as 
        low as possible, he is not bound to chose that pattern which 
        will best pay the Treasury, there is not even a patriotic duty 
        to increase one's taxes.\5\
---------------------------------------------------------------------------
    \5\ Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff'd 
293 U.S. 465 (1935).

    Despite Treasury's claims to the contrary, these proposed 
broad definitions are not simply a codification of existing 
judicial doctrines. Current case law views a significant pre-
tax profit as a sufficient, but not a necessary, condition for 
finding that a transaction does not represent a corporate tax 
shelter. In addition, case law has always considered valid 
business reasons as part of the evaluation of corporate 
transactions. For example, the Supreme Court has upheld a 
transaction ``which is compelled or encouraged by business or 
regulatory realities, is imbued with tax-independent 
considerations, and is not shaped solely by tax-avoidance 
features that have meaningless labels attached.'' Frank Lyon 
Co. v. United States, 435 U.S. 561, 583-84 (1978). Similarly, 
cases have held that ``when a transaction has no substance 
other than to create deductions, the transaction is disregarded 
for tax purposes.'' Knetsch v. United States, 364 U.S. 361, 366 
(1960). The most recent case applying this analysis examined 
both the objective economics of a transaction, as well as the 
subjective business motivations claimed by the parties. ACM 
Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998). 
Therefore, adopting a purely mechanical test that compares pre-
tax profits to tax benefits, without looking to business 
reasons for the transaction, goes far beyond the holdings in 
current case law.

              Analysis of Corporate Tax Shelter Proposals

A. Modified Substantial Understatement Penalty

    The Administration's budget proposal would increase the 
substantial understatement penalty from 20 percent to 40 
percent with respect to any item attributable to a corporate 
tax shelter.\6\ A corporation can reduce the 40 percent penalty 
to 20 percent by fulfilling specific disclosure requirements. 
This proposal would also eliminate the reasonable cause 
exception to the imposition of the penalty for any item 
attributable to a corporate tax shelter.
---------------------------------------------------------------------------
    \6\ Generally, Section 6662(a) of the Internal Revenue Code imposes 
a 20 percent penalty on the portion of an underpayment of tax 
attributable to a substantial understatement of income tax.
---------------------------------------------------------------------------
    There is no rationale for increasing the substantial 
understatement penalty from 20 to 40 percent. The current 20 
percent penalty is a powerful incentive for corporate taxpayers 
to closely analyze any proposed business transaction that 
results in tax benefits. Moreover, Treasury has failed to 
provide objective evidence to establish that doubling the 
substantial understatement will have any incremental behavioral 
effect. In addition, the proposed definition of ``corporate tax 
shelter'' is too vague, and creates too much uncertainty, to 
justify a 40 percent penalty. Such an increase in penalties is 
also inconsistent with the intent of the IRS Restructuring and 
Reform Act to simplify penalty administration and reduce 
burdens on taxpayers.
    Even less justified is the elimination of the reasonable 
cause exception to the penalty. The reasonable cause exception 
is an essential function of the penalty regime and is found in 
virtually every penalty provision of the Code. The rationale 
for such an exception is simple: in light of the complexity of 
the Code and the significant uncertainty in its interpretation, 
it is unfair to automatically impose a penalty upon a taxpayer 
who has made a good faith effort to comply with the tax law. 
Without such an exception, taxpayers will be faced with a 
draconian 40 percent penalty for a misinterpretation of the 
law, even if there is an honest disagreement on the 
interpretation of fact and law that is reasonable in light of 
all the facts and circumstances. In effect, taxpayers will be 
held to a strict liability standard in interpreting overly 
complex tax laws.
    The elimination of the reasonable cause exception will also 
have a serious impact on the administration of the tax law. For 
example, preventing the IRS from waiving penalties for 
reasonable cause will result in a decline in the number of 
cases settled administratively. The size of the penalty and the 
inability on the part of the IRS to waive the penalty will 
require taxpayers to litigate the underlying issue of whether 
the transaction was a corporate tax shelter. In addition, the 
combination of the elimination of the reasonable cause 
exception and the creation of a subjective definition of 
corporate tax shelter will give agents an unwarranted 
opportunity to hold corporate taxpayers hostage during the 
examination process. Revenue agents can threaten to propose 
adjustments based on alleged corporate tax shelter transactions 
to extract unreasonable concessions by the corporate taxpayer 
on other issues. The use of the increased substantial 
understatement penalty to obtain concessions from corporate 
taxpayers is inconsistent with the goals expressed in the IRS 
Restructuring and Reform Act of 1998.

B. Deny Certain Tax Benefits to Persons Avoiding Income Tax as 
a Result of Tax Avoidance Transactions

    Currently, under section 269 of the Code, the Secretary of 
the Treasury has the authority to disallow a tax benefit in 
certain acquisition transactions where the principle purpose 
for entering into the transaction is the evasion or avoidance 
of Federal income tax by obtaining the benefit of a deduction, 
credit, or other allowance. This provision applies to 
transactions involving the acquisition of control of a 
corporation (directly or indirectly), or to transactions where 
a corporation acquires (directly or indirectly) carryover basis 
property of another corporation that was not controlled by the 
acquiring corporation immediately before the transaction. The 
tax benefits that may be disallowed under section 269 include 
net operating losses, foreign tax credit carryovers, investment 
credit carryovers, depreciation deductions, and a wide range of 
other tax attributes.
    The Administration's proposal would dramatically expand 
section 269 and give the IRS authority to disallow a deduction, 
credit, exclusion, or other allowance obtained in a ``tax 
avoidance transaction.'' \7\ Thus, the proposal goes well 
beyond the context of the current section 269 and would 
represent an inappropriate delegation of authority to Treasury 
and IRS personnel. Under this proposal, revenue agents could 
disallow any deduction, credit, exclusion, or other allowance 
obtained by a corporate taxpayer based on their subjective 
determination that a transaction falls within the vague 
definition of a ``tax avoidance transaction.'' This authority 
could be used to deny a corporate taxpayer a tax benefit 
provided by the Code merely because the IRS believes that the 
transaction yielded too much tax savings, regardless of a 
corporate taxpayer's legitimate business purpose for entering 
into the transaction. Again, this is giving an IRS agent too 
much discretion and is inconsistent with the IRS Restructuring 
and Reform Act.
---------------------------------------------------------------------------
    \7\ The definition of ``tax avoidance transaction'' for purpose of 
this transaction is the same as is used to define a corporate tax 
shelter, discussed above.

C. Deny Deductions For Certain Tax Advice and Imposition of an 
---------------------------------------------------------------------------
Excise Tax on Certain Fees Received.

    The Administration's proposal would deny a deduction for 
fees paid or incurred in connection with the purchase and 
implementation, as well as the rendering of tax advice related 
to, corporate tax shelters and impose a 25-percent excise tax 
on fees received in connection therewith. This proposal relies 
on the same vague and faulty definition of ``tax avoidance 
transaction'' as the previously discussed proposals. Thus, if 
in the IRS's view a transaction significantly reduces tax on 
economic income, or if the transaction does not meet the 
economic profit test, a tax deduction can be denied for tax 
advice that represents an ordinary and necessary business 
expense associated with a legitimate business transaction. An 
even more absurd result is that a deduction would be disallowed 
for fees related to tax advice where the advice is to not 
invest in a particular transaction because it may be considered 
a tax shelter.
    This provision also illustrates the overlapping nature of 
the corporate tax shelter proposals and the potentially 
cascading penalties they can impose on a corporate taxpayer. 
For example, assume that a taxpayer entered into a legitimate 
business transaction on the advice of its tax adviser that the 
transaction was not a tax avoidance transaction. If the IRS 
subsequently determines that the transaction did not have 
sufficient pre-tax benefits, the transaction could be 
classified as a tax avoidance transaction. The corporate 
taxpayer would be subject to at least three penalties: (1) 
denial of the deduction for fees paid to the tax adviser for 
what has previously always been considered an ordinary and 
necessary business expense, (2) the 40 percent modified 
substantial understatement penalty on the disallowed deduction 
for the fees paid, and (3) the 40 percent modified substantial 
understatement penalty on the tax attributed to the tax 
benefits denied as a result of the IRS characterizing the 
transaction as a tax avoidance transaction.
    Finally, this particular proposal to impose an excise tax 
on fees received in connection with a tax shelter raises 
numerous administrative issues. The determination that a 
transaction falls within the new definition of corporate tax 
shelters may not be made until years after the payment or the 
receipt of fees, which raises questions concerning the statute 
of limitations and the IRS's assessment authority against the 
``shelter provider.'' Fairness demands that the fee recipient 
also be provided an opportunity to challenge the tax shelter 
determination, which may result in the issue being litigated 
twice. These are only a few of the practical problems that need 
resolution in order to implement this vague proposal.

D. Impose Excise Tax on Certain Rescission Provisions and 
Provisions Guaranteeing Tax Benefits

    The Administration's budget proposal would impose an excise 
tax on a ``tax benefit protection arrangement'' provided to the 
purchaser of a corporate tax shelter. A tax benefit protection 
arrangement would include a rescission clause requiring a 
seller or counterparty to unwind the transaction, a guarantee 
of tax benefits arrangement, or any other arrangement that has 
the same economic effect (e.g., insurance purchased with 
respect to the transaction). The Administration's plan would 
impose on the purchaser of a corporate tax shelter an excise 
tax of 25% on the maximum payment to be made under a tax 
benefit arrangement if the tax benefits are denied.
    As a practical matter, this proposal fails to consider how 
rescission clauses or guarantees work. Generally, these 
agreements put a tax adviser at risk for an agreed-upon 
percentage of any additional tax that the taxpayer ultimately 
owes as a result of the transaction. This amount cannot be 
determined unless and until the Service proposes adjustments to 
the taxpayer's liability with respect to the transaction and 
the taxpayer's correct tax liability is either agreed upon by 
the parties or determined by a court. Until such time, a 
corporate taxpayer cannot determine the maximum payment 
possible under the arrangement. Moreover, assessing an excise 
tax based upon the highest potential benefits that could 
possibly be obtained in the future under such an agreement is 
fundamentally unfair and is too onerous a penalty.
E. Preclude Taxpayers From Taking Tax Positions Inconsistent 
With the Form of Their Transaction

    The Administration's budget proposal would generally 
provide that a corporate taxpayer is precluded from taking any 
position that is inconsistent with its form if a ``tax 
indifferent party'' is involved in the transaction. This rule 
would not apply (1) if the taxpayer discloses the inconsistent 
position on a timely filed original return; (2) to the extent 
provided in regulations, if reporting the substance of the 
transaction more clearly reflects income; or (3) to certain 
transactions (such as publicly-available securities, lending 
and sale-repurchase transactions) identified in regulations.
    This proposal would essentially require a U.S. taxpayer to 
be bound by the form of a transaction unless it disclosed the 
inconsistent position to the IRS. Presumably, an IRS agent 
could then scrutinize the transaction to determine whether it 
would be considered a tax shelter. This would place undue 
authority in the hands of IRS agents to change the tax 
treatment of a transaction and would result in arbitrary and 
inconsistent application of the tax law.
    For example, a foreign jurisdiction may respect a note as 
debt even though it would be characterized as equity for U.S. 
tax purposes. (A 100-year note is generally treated as equity 
for U.S. tax purposes; however, another country's tax laws may 
respect the note as debt.) As a result, payments on the note by 
a foreign subsidiary to its U.S. parent would be treated as 
deductible interest under the foreign country's tax laws. The 
U.S. would treat the payment as a dividend that would provide 
the U.S. parent with a deemed paid foreign tax credit. Because 
the instrument was formally labeled a note, however, the 
taxpayer's treatment of the note as equity for U.S. purposes 
would be inconsistent with the form. Assuming the parent had 
expiring foreign tax credits, the U.S. parent would be a tax-
indifferent party under the proposal. Therefore, an agent on 
audit might deny the foreign tax credit generated by the 
dividend payment on the grounds that the taxpayer treated the 
note as debt for foreign tax purposes and the foreign tax 
benefit created a tax shelter.
    This result is especially harsh for three reasons. First, 
the appropriate goal of U.S. tax policy should be to determine 
the proper character of a transaction for federal income tax 
purposes and then to tax the transaction in accordance with 
that character. A rule that allows recharacterization based 
upon inconsistent treatment under foreign law is at odds with 
this policy because two transactions that are economically 
indistinguishable will be treated differently. Furthermore, it 
violates the general principle that U.S. tax principles and not 
foreign principles should control. Second, the foreign country 
may have made a conscious policy decision to respect the note 
as debt. It is inappropriate to give an agent on audit the 
ability to penalize a taxpayer for using a benefit provided by 
the foreign tax law; the agent would essentially be 
substituting the agent's judgment for the judgment of the 
foreign country's lawmakers. Third, this provision interferes 
with the consistent application of U.S. tax law because an 
agent on audit would have tremendous discretion to choose not 
to follow normal tax principles. The determination of the tax 
treatment of a transaction would be made by individual agents, 
not by Congress or by Treasury in its regulatory capacity.

F. Tax Income From Corporate Tax Shelters Including Tax-
Indifferent Parties.

    The Administration's budget plan would impose a tax on 
corporate tax shelter transactions involving ``tax-
indifferent'' parties. A ``tax-indifferent'' party is defined 
as a foreign person, a Native American tribal organization, a 
tax-exempt organization, or a domestic corporation with 
expiring loss or credit carryforwards (generally more than 3 
years old). The transactions targeted by this proposal 
generally result in the tax-indifferent parties having income 
or gain from the transaction, while taxable corporate 
participants may have deductions or loss from the transaction. 
The proposal would impose tax on the tax-indifferent party by 
recharacterizing the item of gain or income as taxable. For 
example, a foreign person would be treated as earning taxable 
effectively connected income; a tax-exempt organization would 
be treated as earning unrelated business taxable income. All 
other participants in the corporate tax shelter would be 
jointly and severally liable for the tax.
    As with the other corporate tax shelter provisions, the 
broad definition of corporate tax shelter does not provide 
sufficient specificity for taxpayers or tax-indifferent parties 
to determine what transactions might run afoul of these rules. 
The vague and subjective definition creates an environment of 
uncertainty for such parties when making business and 
investment decisions, and it is likely that many routine 
business arrangements would fall within this broad definition.
    The proposal also raises treaty issues because it would 
provide that tax on income or gain allocable to a foreign 
person would be determined without regard to applicable 
treaties. Even though the other parties to a transaction might 
bear the ultimate liability for the tax under this proposal, 
the proposal would in essence impose a U.S. tax burden on a 
transaction that should be exempt from U.S. tax under the 
treaty, thus changing the economics of the transaction. The 
imposition of tax on a transaction that should be exempt under 
a treaty could raise concerns from treaty partners.

   IV. Current Legislative And Regulatory ``Tax Shelter'' Provisions

    As discussed above, the Administration's broad-based 
proposals would grant the IRS unfettered authority to determine 
what is a corporate tax shelter and to subject these 
transactions to harsh and cascading penalties. We are concerned 
with Treasury's request for this broad authority when they have 
not even tried to use some of the tools that Congress has 
granted within the last few years. A better approach to any 
perceived problem would be for Treasury to use the tools 
currently within its arsenal, along with specific legislative 
or regulatory actions targeted at closing perceived loopholes. 
The broad scope of such current alternatives is illustrated 
below.

A. Substantial Understatement Penalty

    Current law imposes a 20 percent penalty on the portion of 
an underpayment of tax attributable to a substantial 
understatement of income tax. For corporations, a substantial 
understatement of income tax exists if it exceeds the greater 
of 10 percent of the tax required to be shown on the tax return 
or $10,000.\8\ If a corporation has a substantial 
understatement of income tax attributable to a tax shelter 
item, a corporation is liable for the substantial 
understatement penalty unless it can demonstrate reasonable 
cause.
---------------------------------------------------------------------------
    \8\ The Administration has also proposed to treat a corporation's 
understatement of more than 10 million dollars of income tax as 
substantial for purposes of the substantial understatement penalty, 
whether or not it exceeds 10 percent of the taxpayer's total tax 
liability.
---------------------------------------------------------------------------
    As discussed above, Congress expanded the definition of tax 
shelter for purposes of the substantial understatement penalty 
in the Taxpayer Relief Act of 1997. Under this expanded 
definition, a transaction may be a tax shelter if a significant 
purpose of the transaction was to avoid taxes. (Under the prior 
provision, a transaction was a tax shelter only if the 
principal purpose of the transaction was to avoid taxes). This 
significant expansion of the definition of tax shelter has been 
in the law for less than two years, and there has not been 
sufficient time to determine whether this new definition is 
effective. Before enacting a plethora of new penalties and 
granting revenue agents larger and more potent weapons, the 
expanded definition in current law should be given a chance to 
work.

B. Tax Shelter Registration

    The 1997 Act added section 6111(d), which treats certain 
confidential arrangements as tax shelters that must be 
registered with the IRS. For purposes of this provision, a 
``tax shelter'' includes any entity, plan, arrangement, or 
transaction: (1) a significant purpose of the structure of 
which is tax avoidance or evasion by a corporate participant; 
(2) that is offered to any potential participant under 
conditions of confidentiality; and (3) for which promoters may 
receive fees in excess of $100,000 in the aggregate. An offer 
is considered to be made under conditions of confidentiality 
if: (1) the potential participant has an understanding or 
agreement with or for the benefit of any promoter that 
restricts or limits the disclosure of the transaction or any 
significant tax benefits; or (2) any promoter of the tax 
shelter claims, knows, or has reason to know that the 
transaction is proprietary to the promoter or any other person 
other than the potential participant, or is otherwise protected 
from disclosure or use by others.\9\ The penalty for failing to 
timely register a corporate tax shelter can be severe: the 
greater of $10,000 or 50 percent of the fees paid to all 
promoters from offerings prior to the date of registration. If 
the failure to file is intentional, the penalty is increased to 
75 percent of the fees.\10\
---------------------------------------------------------------------------
    \9\ Section 6111(d)(2).
    \10\ Section 6707
---------------------------------------------------------------------------
    This registration requirement was intended to provide 
Treasury and the IRS with useful information about corporate 
transactions as early as possible, enabling them to more easily 
identify these transactions. In addition, this information 
enables Treasury to make determinations with respect to when 
administrative or legislative action may be necessary. The 
committee report explained the need for this corporate tax 
shelter registration requirement:

          The provision will improve compliance with the tax laws by 
        giving the Treasury Department earlier notification than it 
        generally receives under present law of transactions that may 
        not comport with the tax laws. In addition, the provision will 
        improve compliance by discouraging taxpayers from entering into 
        questionable transactions.\11\
---------------------------------------------------------------------------
    \11\ H.R. Rep. No. 105-148, 105th Cong., 1st Sess. 429.

    These tax shelter registration provisions apply to any tax 
shelter offered to potential participants after the date that 
the Treasury Department issues guidance on registration. As of 
this date, no guidance has been issued and, therefore, this 
registration provision is not yet effective. It is premature to 
propose a new and complex set of measures to deal with a 
perceived increase in corporate tax shelter activity when 
powerful provisions have already been enacted, but Treasury has 
not, almost two years after enactment, implemented them. Rather 
than enact a number of vague and subjective provisions as 
proposed, the more prudent course would be to issue the 
required guidance so that the registration requirements become 
effective, then evaluate the registration provisions to 
---------------------------------------------------------------------------
determine whether they produce the desired result.

C. Anti-Abuse Rules

    Treasury and the IRS have a wide range of general anti-
abuse provisions already available to combat the perceived 
proliferation of corporate tax shelters. For example, if a 
taxpayer's method of accounting does not clearly reflect 
income, section 446(b) of the Code authorizes the IRS to 
disregard the taxpayer's method of accounting and to compute 
the taxpayer's income under a method of accounting it believes 
more clearly reflects income. Under section 482 of the Code, 
the IRS can allocate, distribute, or apportion income, 
deductions, credits and allowances between controlled taxpayers 
to prevent evasion of taxes or to accurately reflect their 
taxable income.
    Treasury has promulgated Treas. Reg. ' 1.701-2 as a broad 
anti-abuse rule that permits the IRS to stop perceived abuses 
with respect to partnerships. Under this anti-abuse regulation, 
the IRS already has the ability to disregard the existence of a 
partnership, adjust a partnership's method of accounting, 
reallocate items of income, gain, loss, deduction or credit, or 
adjust a partnership's or partner's tax treatment in situations 
where a transaction meets the literal requirements of a 
statutory or regulatory provision, but where the IRS believes 
the results are inconsistent with the intent of the partnership 
tax rules.
    The IRS also has broad authority to stop abuses in the 
corporate context. For example, the IRS can recharacterize 
certain stock sales by shareholders as dividends when the 
purchaser is the issuing corporation or a related corporation 
under section 302(d) or section 304. Section 338(e)(3) 
authorizes the IRS to treat certain stock acquisitions as 
qualified stock purchases in order to prevent avoidance of the 
requirements of section 338. Section 355(d)(9) gives the IRS 
the regulatory authority to prevent the avoidance of certain 
gain recognition requirements under section 355 through the use 
of related persons, intermediaries, pass-through entities or 
other arrangements.

D. Case Law

    There is a well-established body of case law addressing tax 
shelters. The principles developed in these cases include the 
``sham transaction'' doctrine, the ``business purpose'' 
doctrine, and the ``economic substance'' doctrine. In applying 
these principles, the IRS may assert that a transaction should 
not be respected for tax purposes because it did not have a 
substantive purpose beyond securing tax benefits. See, e.g., 
Gregory v. Helvering, 293 U.S. 465 (1935); Knetsch v. United 
States, 364 U.S. 361 (1960); Rice's Toyota World, Inc. v. 
Commissioner, 752 F.2d 89 (4th Cir. 1985); Goldstein v. 
Commissioner, 364 F.2d 734 (2d Cir. 1966); Sheldon v. 
Commissioner, 94 T.C. 738 (1990). These principles have been in 
existence for many years, and they have not lost their utility. 
They represent a set of standards that can be applied no matter 
how sophisticated a transaction might be. Most recently, the 
IRS successfully litigated two cases in this area, ACM 
Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), 
aff'g, rev'g in part and remanding, 73 TCM 2189 (1997), cert. 
denied, S. Ct. Dkt. No. 98-1106 and ASA Investerings v. 
Commissioner, 76 TCM 325 (1998).

E. IRS Announcements

    The IRS has the authority to issue administrative 
pronouncements to address perceived abusive transactions. These 
pronouncements may take the form of notices, rulings, or other 
announcements. In the past few years, the IRS has not hesitated 
to take advantage of this authority. For example, Notice 97-21 
effectively shut down ``step-down preferred'' transactions. 
More recently, in fact within the past few days, the IRS has 
attacked certain types of ``lease-in lease-out'' transactions 
that it perceived to be abusive through the issuance of Rev. 
Rul. 99-14. The number of announcements the IRS has issued in 
the past few years addressing perceived tax shelter activity 
has been substantial: Notice 98-11 (attacking ``hybrid branch 
arrangements''); Notice 98-5 (attacking transactions that 
generate foreign tax credits); Notice 96-39 (setting forth the 
IRS' position on determining whether income from a partnership 
represented Subpart F income); Notice 95-53 (attacking lease 
stripping transactions); Notice 94-48 (scrutinizing tax-
deductible passthrough debt to buy back stock, or ``reverse 
MIPs''); Notice 94-47 (scrutinizing tax-deductible preferred 
instruments, or ``MIPS''); Notice 94-93 (attacking ``corporate 
inversion'' transactions); Notice 94-46 (attacking outbound 
``corporate inversion transactions'').
    Note that as part of the IRS Restructuring and Reform Act, 
Congress expressed its concern and disagreement with the policy 
direction of Notice 98-11, as well as their interest in 
reviewing these issues and taking legislative action they 
deemed to be appropriate. This controversy demonstrates the 
need for determinations of what constitutes an abusive 
transaction to be made in a public manner, through issuance of 
legislation or an administrative pronouncement, rather than 
being made by individual IRS agents.

F. Legislation Targeted to Specific Transactions

    Another important alternative to the broad-based 
Administration proposals is specific, targeted statutory 
changes. Each year Treasury transmits to Congress its 
suggestions for changes to the tax laws, including targeted 
proposals to stop abuses and, as a matter of course, Congress 
has asserted its legislative powers to clarify and amend 
statutes that are unclear or allow for abuse. On a number of 
occasions, the Congressional tax writing committees have 
enacted targeted statutory changes to end specific tax shelter 
or abusive activity, often with the assistance and consultation 
of the Treasury Department. For example, in 1998 and 1997 
alone, Congress pursued and enacted a number of targeted 
proposals, including:
     Modification of certain deductible liquidating 
distributions of regulated investment companies (RIC) and real 
estate investment trusts (REIT);
     Restrictions on 10-year net operating loss 
carryback rules for specified liability losses;
     Requirement of gain recognition on certain 
appreciated financial positions in personal property;
     Election of mark-to-market for securities traders 
and for traders and dealers in commodities;
     Limitation on the exception for investment 
companies under section 351;
     Determination of original issue discount where 
pooled debt obligations are subject to acceleration;
     Denial of interest deduction for on certain 
convertible preferred stock;
     Requirement of gain recognition for certain 
extraordinary dividends;
     Anti-Morris Trust provisions;
     Reform of the tax treatment of certain corporate 
stock transfers;
     Treatment of certain preferred stock as boot;
     Modification of holding period for the dividends-
received deduction;
     Inclusion of income from notional principal 
contracts and stock lending transactions under Subpart F;
     Restriction on like-kind exchanges involving 
foreign personal property;
     Imposition of holding period requirement for 
claiming foreign tax credits with respect to dividends;
     Allocation of basis of properties distributed to a 
partner by a partnership;
     Elimination of the substantial appreciation 
requirement for inventory on sale of partnership interest; and
     Modification of treatment of company-owned life 
insurance.
    These proposals, which raise nearly $20 billion in tax 
revenue over 10 years, were targeted at clarifying the statute 
and/or stopping abuses of the tax law and have been effective 
in ending certain tax shelter activity. While we believe that 
many of these items are not abuses, this incomplete list 
demonstrates that if a statutory provision allows for broader 
application than Congress may have intended, Congress and the 
Treasury can statutorily shut them down. Treasury is now 
essentially asking Congress to short-circuit this well-
established legislative approach and provide the IRS with broad 
authority to characterize a wide range of transaction as ``tax 
shelters'' without the need for Congressional oversight or 
approval.

                               Conclusion

    The Administration's ``corporate tax shelter'' proposals go 
far beyond simply closing unwarranted loopholes: the proposals 
would have a detrimental impact on legitimate business 
transactions and could result in the imposition of draconian 
penalties on taxpayers. The unfettered power transferred to IRS 
agents would shift the formulation of tax policy from Congress 
to the tax collector by giving IRS agents unprecedented 
latitude to reclassify transactions as corporate tax shelters. 
Congress, not the tax administrator, should make these tax 
policy decisions.
      

                                

Statement of Coalition of Mortgage REITs

    The following comments are offered by a group of mortgage 
real estate investment trusts (hereinafter referred to as the 
``Coalition'') to the Committee on Ways and Means in 
conjunction with its March 10 hearing on the revenue-raising 
provisions of the Clinton Administration's FY 2000 budget plan. 
Coalition members include IndyMac Mortgage Holdings, Inc., 
Dynex Capital, Inc., IMPAC Mortgage Holdings, Inc., IMPAC 
Commercial Holdings, Inc., Redwood Trust, Inc., and Capstead 
Mortgage Holdings. These comments focus on the Administration's 
proposal to modify the structure of businesses indirectly 
conducted by real estate investment trusts (``REITs'').
    IndyMac Mortgage Holdings, Inc., based in Pasadena, 
California, is the largest publicly traded mortgage REIT \1\ in 
terms of stock market capitalization, and its structure and 
business activities make it a useful reference point in 
discussing the impact of the Administration's proposal. IndyMac 
is a diversified lending company with a focus on residential 
mortgage products, and is active in residential and commercial 
construction lending, manufactured housing lending, and home 
improvement lending. IndyMac is a NYSE-traded company with $6 
billion in assets and nearly 1,000 employees. IndyMac Mortgage 
Holdings participates in the mortgage conduit and 
securitization business through an affiliated taxable operating 
company, IndyMac, Inc.
---------------------------------------------------------------------------
    \1\ A mortgage REIT invests primarily in debt secured by mortgages 
on real estate assets. An equity REIT, by contrast, invests primarily 
in equity or ownership interests directly in real estate assets.
---------------------------------------------------------------------------
    The Coalition has specific concerns over the 
Administration's proposal to modify the structure of businesses 
indirectly conducted by REITs. As a result of these concerns, 
the Coalition's support for this proposal would be contingent 
on critical modifications being made. Without these 
modifications, IndyMac and other REITs would be unable to 
continue to participate in the mortgage conduit or 
securitization business. The changes requested by the Coalition 
would be consistent with the Administration's goal not to 
impede the competitiveness of REITs, while at the same time 
addressing--more than adequately, we believe--the concerns of 
the Treasury Department over any potential for tax avoidance by 
mortgage REITs.

                     The Mortgage Conduit Business

    As one of its most important business activities, IndyMac 
operates as one of only a small number of private mortgage 
conduits in this country. While small in number, mortgage 
conduits play a vital financing role in America's residential 
housing market, essentially acting as the intermediary between 
the originator of a mortgage loan and the ultimate investor in 
mortgage-backed securities (MBSs).
    The conduit first purchases mortgage loans made by 
financial institutions, mortgage bankers, mortgage brokers, and 
other mortgage originators to homebuyers and others. When a 
conduit has acquired sufficient individual loans to serve as 
collateral for a loan pool, it creates an MBS or a series of 
MBSs, which then are sold to investors through underwriters and 
investment bankers. After securitization, the conduit acts as a 
servicer of the loans held as collateral for the MBSs, meaning 
that the conduit collects the principal and interest payments 
on the underlying mortgage loans and remits them to the trustee 
for the MBS holders.
    Perhaps the best-known mortgage conduits are the 
government-owned Government National Mortgage Association 
(Ginnie Mae) and the government-sponsored Fannie Mae and 
Freddie Mac. These government sponsored enterprises (GSEs) act 
as conduits for loans meeting specified guidelines that pertain 
to loan amount, product type, and underwriting standards, known 
as ``conforming'' mortgage loans.
    Private conduits such as IndyMac play a similar role for 
``nonconforming'' mortgage loans that do not meet GSE selection 
criteria. Mortgage loans purchased by IndyMac include ``Alt-
A,'' nonconforming and jumbo residential loans, sub-prime 
loans, consumer construction loans, manufacturing housing 
loans, home improvement loans, and other mortgage-related 
assets. Many of IndyMac's borrowers are low-income and minority 
consumers who are not eligible for programs currently offered 
by the GSEs or Ginnie Mae. In sum, IndyMac, through its conduit 
activities, has helped to fill a significant void in the 
residential mortgage and mortgage investment industry that the 
GSEs have been unable to fill.

                      IndyMac's Business Structure

    IndyMac's mortgage conduit business is conducted primarily 
through two entities: IndyMac Mortgage Holdings, Inc., which as 
discussed above is a REIT (hereafter referred to as ``IndyMac 
REIT''), and its taxable affiliate, IndyMac, Inc. (hereafter 
referred to as ``IndyMac Operating''). IndyMac REIT owns all of 
the preferred stock and 99 percent of the economic interest in 
IndyMac Operating, which is a taxable C corporation.
    IndyMac REIT is the arm of the conduit business that 
purchases and holds mortgage loans. IndyMac Operating is the 
arm of IndyMac REIT that acquires loans for IndyMac REIT, 
pursuant to a contractual sales commitment, and securitizes and 
services the loans. In order to control the interest rate risks 
associated with managing a pipeline of loans held for sale, 
IndyMac Operating also conducts necessary hedging activities. 
In addition, IndyMac Operating performs servicing for all loans 
and MBSs owned or issued by it. IndyMac Operating is liable for 
corporate income taxes on its net income, which is derived 
primarily from gains on the sale of mortgage loans and MBSs as 
well as servicing fee income.
    Use of this ``preferred stock'' structure for conducting 
business is, in part, an outgrowth of the tax laws governing 
REITs. IndyMac REIT, by itself, effectively is unable to 
securitize its loans through the most efficient capital markets 
structure, called a real estate mortgage investment conduit 
(``REMIC''). This is because the issuance of REMICs by a REIT 
in effect would be treated as a sale for tax purposes; such 
treatment in turn would expose the REIT to a 100-percent 
prohibited tax on ``dealer activity.'' Similarly, it is well 
understood that the ability to service a loan is critical to 
owning a loan, and IndyMac REIT would be subject to strict and 
unworkable limits on engaging in mortgage servicing activities 
for third parties. Such activities would generate nonqualifying 
fee income under the 95-percent REIT gross income test,\2\ 
potentially disqualifying IndyMac REIT from its status as a 
REIT. It is critical to keep in mind that all net income 
derived by IndyMac Operating from its business activities is 
subject to two tiers of taxation at state and federal levels.
---------------------------------------------------------------------------
    \2\ The 95-percent test generally limits REITS to receiving income 
that qualifies as rents from real property and portfolio income.
---------------------------------------------------------------------------
    In business terms, IndyMac's use of the preferred stock 
structure aligns its ``core competencies,'' which has allowed 
it to compete in the mortgage banking and conduit business. 
This alignment makes available the benefits of centralized 
management, lower costs, and operating efficiencies, and has 
allowed IndyMac to respond to market changes, such as trends 
toward securitization, all to the benefit of homeowners who do 
not fit within traditional GSE lending criteria.

                        Administration Proposal

    The proposal in the Administration's FY 2000 budget would 
prohibit use of the REIT preferred stock subsidiary structure. 
Specifically, the proposal would amend section 856(c)(5)(B) of 
the Internal Revenue Code to prohibit REITs from holding stock 
possessing more than 10 percent of the
    vote or value of all classes of stock of a corporation. 
This proposal has arisen out of a concern on the part of 
Treasury that income earned by preferred stock subsidiaries 
escapes corporate tax as a result of ``transmuting of operating 
income into interest paid to the REIT and other non-arm's 
length pricing arrangements.'' \3\
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    \3\ General Explanations of the Administration's Revenue Proposals, 
Department of the Treasury, February 1999, p. 140. IndyMac believes 
Treasury's income-shifting argument is significantly overstated. The 
REIT rules strictly regulate the types and amount of income that may be 
earned by a REIT. IndyMac REIT and others in the REIT industry are 
strongly discouraged from taking aggressive tax positions, given the 
severity of potential tax penalties, including loss of REIT status and 
the 100-percent prohibited transactions tax.
---------------------------------------------------------------------------
    At the same time, Treasury recognizes that many activities 
conducted by REIT preferred stock subsidiaries represent 
legitimate business activities that should continue to be 
available to REIT investors: \4\
---------------------------------------------------------------------------
    \4\ Id, at 140.

          Many of the businesses performed by the REIT subsidiaries are 
        natural outgrowths of a REIT's traditional operations, such as 
        third-party management and development businesses. While it is 
        inappropriate for the earnings from these non-REIT businesses 
        to be sheltered through a REIT, it also is counter-intuitive to 
        prevent these entities from taking advantage of their evolving 
        experiences and expanding into areas where their expertise may 
---------------------------------------------------------------------------
        be of significant value.

    In light of these concerns, the Administration proposal 
would allow a REIT to establish a ``taxable REIT subsidiary'' 
(``TRS'') to perform certain activities that cannot be 
conducted directly by a REIT. These TRSs would be subject to a 
number of restrictions, including a provision that a TRS could 
not deduct any interest incurred on debt funded directly or 
indirectly by the REIT. Other restrictions would place limits 
on the value of TRSs that could be owned by REITs; impose an 
excise tax on any excess payments made by the TRS to the REIT; 
and limit intercompany rentals between the REIT and the TRS. 
\5\
---------------------------------------------------------------------------
    \5\ The proposal would allow REITs to convert preferred stock 
subsidiaries into TRSs on a tax-free basis within a window period, as 
yet unspecified.
---------------------------------------------------------------------------
    It is not clear that the Treasury proposal ever 
contemplates mortgage REIT preferred stock subsidiaries like 
IndyMac Operating.\6\ If not, the inability of mortgage REITs 
to utilize the ``taxable REIT subsidiary'' structure would have 
a severe negative impact on IndyMac and the housing industry. 
If mortgage REITs are intended to be permitted to establish 
TRSs, it is still the case that the Administration's current 
proposal contains unworkable restrictions that effectively 
would end the synergies between mortgage REITs and taxable 
entities that have so benefited homeowners and the housing 
industry.
---------------------------------------------------------------------------
    \6\ For example, the Treasury explanation of the proposal discusses 
activities of a TRS by reference to ``tenant'' and ``non-tenant'' 
activities.
---------------------------------------------------------------------------
    In allowing REITs to conduct otherwise disqualifying 
business activities through taxable subsidiaries, the 
Administration's FY 2000 budget proposal represents a 
significant improvement over a similar proposal included in 
last year's Administration budget submission. Like the current 
proposal, last year's proposal would have prohibited use of the 
REIT preferred stock subsidiary structure. However, last year's 
proposal, rather than allowing REITs to convert preferred stock 
subsidiaries into a taxable subsidiary, would have 
``grandfathered'' existing preferred stock structures, but 
under an overly restrictive set of rules that was viewed as 
unworkable by industry.

                        Impact on Mortgage REITs

    If the Administration's FY 2000 budget proposal were 
enacted, IndyMac REIT would be forced to end its preferred 
stock affiliation with IndyMac Operating. In order to continue 
in the mortgage conduit business, IndyMac REIT and other 
mortgage REITs would have to consider converting their 
affiliates into a TRS under the terms outlined by the 
Administration in its proposal, assuming that the 
Administration's proposal contemplates this provision applying 
to mortgage REIT subsidiaries.
    At least in concept, IndyMac would be willing to entertain 
a conversion of IndyMac Operating from a preferred stock 
affiliate into a taxable subsidiary. As discussed above, 
IndyMac Operating does not engage in the type of income 
shifting activities that have prompted Treasury's concerns.
    However, certain restrictions proposed by the Treasury 
Department with respect to the operation of the TRS would be 
completely unworkable for IndyMac and other mortgage REITs. 
Most significant, by far, is the Administration's proposed 
disallowance of interest deductions on debt funded directly or 
indirectly by the REIT.
    This proposed restriction overlooks the fundamental element 
of debt in the day-to-day business operations of finance 
companies, like mortgage conduits. IndyMac Operating borrows 
extensively to finance its operations, such as the purchase of 
mortgages. These loans can come from outside third parties, 
such as banks or investment banks, with the sponsoring REIT as 
effective guarantor, or from loans directly from the sponsoring 
REIT.
    Direct loans from the sponsoring REIT clearly would be 
impacted by the Administration's proposal, and it is possible 
that guaranteed loans would also be covered as ``indirect'' 
loans. To the extent that any or all of these types of loans 
are considered direct or indirect loans subject to the interest 
expense disallowance, the inability to deduct a finance 
company's core and largest business expense would make it 
impossible for IndyMac Operating to compete with all other 
finance companies which are entitled to deduct such expenses. 
This exposure would be sufficient to force an end to IndyMac 
Operating's ability to conduct its business activities in 
conjunction with IndyMac REIT, thus divorcing the two critical 
elements of IndyMac's mortgage conduit business. If IndyMac and 
the other mortgage REITs were unable to conduct their business, 
it would have a severe impact on the housing market, because 
IndyMac and other mortgage REITs provide a vital link between 
investors and borrowers in the non-conforming and jumbo markets 
who are not served by the GSEs.
    The taxable preferred stock subsidiaries of IndyMac and 
other mortgage REITs operate in the same manner as a finance 
company that makes loans and securitizes or sells them to 
investors. All finance companies that are not depository 
institutions require external debt to fund loan originations. 
All operate at relatively high leverage because loan assets 
typically are saleable and thus relatively liquid.
    Through their affiliation with a REIT, these taxable 
preferred stock subsidiaries are able to access capital to fund 
operations at lower rates than would be the case if they tried 
to access public debt markets directly. Compared to the taxable 
entity, the REIT is generally better capitalized and larger, in 
terms of assets and borrowings, and thus can borrow at lower 
rates than the preferred stock subsidiary. Lenders generally 
lend to the REIT and the taxable entity on a combined basis, 
and require credit support from the larger entity.
    Without credit support, the taxable subsidiaries would have 
higher borrowing costs, which ultimately would be passed on to 
borrowers served through the mortgage conduit businesses 
operated by IndyMac and others as higher interest rates and 
costs.\7\ The proposal would operate, therefore, like a tax on 
these homeowner/borrowers. There is no reason to impose this 
tax--there are specific rules already in the Code that could be 
adopted to prevent the potential for tax abuse that has given 
rise to the Administration's proposal. These rules are 
described in the following section.
---------------------------------------------------------------------------
    \7\ These higher borrowing costs would translate into increased 
deductible interest expenses for the taxable subsidiaries, which would 
reduce the amount of revenues that would be collected as a result of 
the proposal.
---------------------------------------------------------------------------

                        Necessary Modifications

    The Administration's proposed interest deduction 
disallowance is intended to prevent excessive interest charges 
by a sponsoring REIT to its taxable subsidiary, or TRS. As 
opposed to the TRS interest expense disallowance proposed by 
the Treasury Department, the Coalition strongly believes that 
the ``earnings stripping'' limitations imposed under section 
163(j) of the Internal Revenue Code for interest paid to or 
accrued by tax-exempt entities and foreign persons would 
adequately, and more fairly, prevent any perceived abuses 
resulting from direct or indirect lending between a REIT and a 
TRS. At the same time, adoption of this rule would preserve the 
TRS's ability to conduct its business and serve its customers.
    Enacted in 1989, section 163(j) was crafted specifically to 
prevent the siphoning of earnings from a corporation by a 
related person that is exempt from U.S. tax, e.g., a foreign 
company. Those rules extend both to direct lending activities 
as well as to guarantees by a related person of loans obtained 
by the corporation from unrelated persons. Under these rules, a 
corporation's interest deductions for a taxable year may be 
denied if the corporation has excess interest expense for a 
year and its ratio of debt to equity exceeds 1.5 to 1.
    Substitution of this earnings stripping rule for the 
complete interest deduction disallowance under the 
Administration's proposal would guard against true abuse while 
accommodating legitimate mortgage conduit business activities. 
The purpose of section 163(j) was to limit interest deductions 
for leveraged companies that generate a negative spread in view 
of the likelihood that the negative spread was attributable to 
earnings stripping. In contrast, the companies affiliated with 
IndyMac and other mortgage REITs in the mortgage conduit 
business generally generate excess interest income--i.e., they 
generate a positive spread on interest income. IndyMac 
Operating has never incurred negative spread in its six years 
of operation. In fact, IndyMac's taxable affiliate has incurred 
tax liability for positive spread it has earned in each year 
since its founding in 1993.
    It is a fundamental fact in the finance industry that 
companies operating in the mortgage banking and conduit 
business, like IndyMac Operating, operate at relatively high 
leverage ratios. The same is true for GSEs like Ginnie Mae and 
Fannie Mae, as it is for Merrill Lynch, Bank of America, and 
other well-known industry names. The presence of this debt is 
inherent in the business of a finance company and is not, in 
and of itself, any indication of a situation where earnings are 
being stripped. In enacting the rules under section 163(j), 
Congress made clear that an earnings stripping situation 
involves the combination of high leverage and a negative 
interest spread. The Coalition agrees.
    In sum, the Coalition believes that adoption of the section 
163(j) rules would allow IndyMac and other mortgage REITs to 
continue to participate in the mortgage conduit business and 
provide financing to segments of the housing industry not 
currently served by the GSEs. At the same time, we believe the 
section 163(j) rules would guard effectively against true 
earnings stripping situations. It would be unreasonable to 
subject REITs and their affiliates to the Administration's 
complete disallowance of interest deductions, a rule that would 
be more stringent than those currently applied with respect to 
transactions between U.S. and related foreign companies.

                               Conclusion

    Congress enacted the REIT rules in 1960 to give small 
investors the same access to dynamic real estate markets that 
are available to larger investors. Working with the National 
Association of Real Estate Investment Trusts (``NAREIT''), 
Congress has amended the REIT statute many times since to 
respond to dramatic changes in the real estate industry. The 
Administration's proposal to modify the structure of businesses 
that may be conducted indirectly by REITs may be viewed, and 
commended, as a further effort to modernize the REIT rules.
    However, as discussed above, the Administration proposal 
must be modified to address the concerns of an important sector 
of the REIT industry, namely mortgage REITs. Specifically, the 
proposed restrictions on the operation of the taxable REIT 
subsidiaries under the Administration's proposal would 
fundamentally impede the business practices of REITs like 
IndyMac involved in the mortgage conduit business. The proposed 
outright elimination of deductions for interest on intercompany 
debt or REIT-guaranteed debt would lead IndyMac and other 
mortgage REITs to sever themselves from the core competencies 
of servicing and securitizing mortgage loans. Thus, IndyMac's 
individual investors no longer would be able to participate 
effectively in the mortgage conduit business, contrary to 
Congressional intent to give these REIT investors access to the 
real estate mortgage markets.
    If the Administration's proposal is to receive serious 
consideration, it will be paramount to replace the proposed 
wholesale interest deduction disallowance with the earnings 
stripping rules under section 163(j). The Coalition also 
believes that the intended applicability of the TRS provisions 
to mortgage REITs should be made explicit. In addition, we 
believe it will be necessary to apply these rules over an 
appropriate transitional period. The Coalition is prepared to 
work with Congress, the Treasury, and NAREIT to develop 
solutions in this regard.
      

                                

Statement of Coalition of Service Industries \1\

    The Coalition of Service Industries, which represents a 
broad range of financial institutions, including both large and 
small institutions, strongly opposes the Administration's 
proposal to increase penalties for failure to file correct 
information returns.
---------------------------------------------------------------------------
    \1\ The Coalition of Service Industries (CSI) was established in 
1982 to create greater awareness of the major role services industries 
play in our national economy; promote the expansion of business 
opportunities abroad for US service companies; and encourage US 
leadership in attaining a fair and competitive global marketplace. CSI 
represents a broad array of US service industries including the 
financial, telecommunications, professional, travel, transportation, 
information and information technology sectors.
---------------------------------------------------------------------------
    The proposed penalties are unwarranted and place an undue 
burden on already compliant taxpayers. It seems clear that 
most, if not all, of the revenue estimated to be raised from 
this proposal would stem from the imposition of higher 
penalties due to inadvertent errors rather than from enhanced 
compliance. The financial services community devotes an 
extraordinary amount of resources to comply with current 
information reporting and withholding rules and is not 
compensated by the U.S. government for these resources. The 
proposed penalties are particularly inappropriate in that (i) 
there is no evidence of significant current non-compliance and 
(ii) the proposed penalties would be imposed upon financial 
institutions while such institutions were acting as integral 
parts of the U.S. government's system of withholding taxes and 
obtaining taxpayer information.

                              The Proposal

    As included in the President's fiscal year 2000 budget, the 
proposal generally would increase the penalty for failure to 
file correct information returns on or before August 1 
following the prescribed filing date from $50 for each return 
to the greater of $50 or 5 percent of the amount required to be 
reported.\2\ The increased penalties would not apply if the 
aggregate amount that is timely and correctly reported for a 
calendar year is at least 97 percent of the aggregate amount 
required to be reported for the calendar year. If the safe 
harbor applies, the present-law penalty of $50 for each return 
would continue to apply.
---------------------------------------------------------------------------
    \2\ A similar proposal was included in President Clinton's fiscal 
year 1997, 1998 and 1999 budgets.
---------------------------------------------------------------------------

                    Current Penalties are Sufficient

    We believe the current penalty regime already provides 
ample incentives for filers to comply with information 
reporting requirements. In addition to penalties for 
inadvertent errors or omissions,\3\ severe sanctions are 
imposed for intentional reporting failures. In general, the 
current penalty structure is as follows:
---------------------------------------------------------------------------
    \3\ It is important to note that many of these errors occur as a 
result of incorrect information provided by the return recipients such 
as incorrect taxpayer identification numbers (TINs).
---------------------------------------------------------------------------
     The combined standard penalty for failing to file 
correct information returns and payee statements is $100 per 
failure, with a penalty cap of $350,000 per year.
     Significantly higher penalties--generally 20 
percent of the amount required to be reported (for information 
returns and payee statements), with no penalty caps--may be 
assessed in cases of intentional disregard.\4\
---------------------------------------------------------------------------
    \4\ The standard penalty for failing to file correct information 
returns is $50 per failure, subject to a $250,000 cap. Where a failure 
is due to intentional disregard, the penalty is the greater of $100 or 
10 percent of the amount required to be reported, with no cap on the 
amount of the penalty.
---------------------------------------------------------------------------
     Payors also may face liabilities for failure to 
apply 31 percent backup withholding when, for example, a payee 
has not provided its taxpayer identification number (TIN).
    There is no evidence that the financial services community 
has failed to comply with the current information reporting 
rules and, as noted above, there are ample incentives for 
compliance already in place.\5\ It seems, therefore, that most 
of the revenue raised by the proposal would result from higher 
penalty assessments for inadvertent errors, rather than from 
increased compliance with information reporting requirements. 
Thus, as a matter of tax compliance, there appears to be no 
justifiable policy reason to substantially increase these 
penalties.
---------------------------------------------------------------------------
    \5\ Also note that, in addition to the domestic and foreign 
information reporting and penalty regimes that are currently in place, 
for payments to foreign persons, an expanded reporting regime with the 
concomitant penalties is effective for payments made after December 31, 
1999. See TD 8734, published in the Federal Register on October 14, 
1997. The payor community is being required to dedicate extensive 
manpower and monetary resources to put these new requirements into 
practice. Accordingly, these already compliant and overburdened 
taxpayers should not have to contend with new punitive and unnecessary 
penalties.
---------------------------------------------------------------------------

            Penalties Should Not Be Imposed to Raise Revenue

    Any reliance on a penalty provision to raise revenue would 
represent a significant change in Congress' current policy on 
penalties. A 1989 IRS Task Force on Civil Penalties concluded 
that penalties ``should exist for the purpose of encouraging 
voluntary compliance and not for other purposes, such as 
raising of revenue.'' \6\ Congress endorsed the IRS Task 
Force's conclusions by specifically enumerating them in the 
Conference Report to the Omnibus Budget Reconciliation Act of 
1989.\7\ There is no justification for Congress to abandon its 
present policy on penalties, which is based on fairness, 
particularly in light of the high compliance rate among 
information return filers.
---------------------------------------------------------------------------
    \6\ Statement of former IRS Commissioner Gibbs before the House 
Subcommittee on Oversight (February 21, 1989, page 5).
    \7\ OBRA 1989 Conference Report at page 661.
---------------------------------------------------------------------------

                       Safe Harbor Not Sufficient

    Under the proposal, utilization of a 97 percent substantial 
compliance ``safe harbor'' is not sufficient to ensure that the 
higher proposed penalties apply only to relatively few filers. 
Although some information reporting rules are straightforward 
(e.g., interest paid on deposits), the requirements for certain 
new financial products, as well as new information reporting 
requirements,\8\ are often unclear, and inadvertent reporting 
errors for complex transactions may occur. Any reporting 
``errors'' resulting from such ambiguities could easily lead to 
a filer not satisfying the 97 percent safe harbor.
---------------------------------------------------------------------------
    \8\ For example, Form 1099-C, discharge of indebtedness reporting, 
or Form 1042-S, reporting for bank deposit interest paid to certain 
Canadian residents.
---------------------------------------------------------------------------

      Application of Penalty Cap to Each Payor Entity Inequitable

    We view the proposal as unduly harsh and unnecessary. The 
current-law $250,000 penalty cap for information returns is 
intended to protect the filing community from excessive 
penalties. However, while the $250,000 cap would continue to 
apply under the proposal, a filer would reach the penalty cap 
much faster than under current law. For institutions that file 
information returns for many different payor entities, the 
protection offered by the proposed penalty cap is substantially 
limited, as the $250,000 cap applies separately to each payor.
    In situations involving affiliated companies, multiple 
nominees and families of mutual funds, the protection afforded 
by the penalty cap is largely illusory because it applies 
separately to each legal entity. At the very least, any further 
consideration of the proposal should apply the penalty cap 
provisions on an aggregate basis. The following examples 
illustrate why aggregation in the application of the penalty 
cap provisions is critical.

EXAMPLE I--Paying Agents

     A bank may act as paying agent for numerous issuers of 
stocks and bonds. In this capacity, a bank may file information 
returns as the issuers' agent but the issuers, and not the 
bank, generally are identified as the payors. Banks may use a 
limited number of information reporting systems (frequently 
just one overall system) to generate information returns on 
behalf of various issuers. If an error in programming the 
information reporting system causes erroneous amounts to be 
reported, potentially all of the information returns 
subsequently generated by that system could be affected. Thus, 
a single error could, under the proposal, subject each issuer 
for whom the bank filed information returns, to information 
reporting penalties because the penalties would be assessed on 
a taxpayer-by-taxpayer basis. In this instance, the penalty 
would be imposed on each issuer. However, the bank as paying 
agent may be required to indemnify the issuers for resulting 
penalties.
     Recommendation: For the purposes of applying the penalty 
cap, the paying agent (not the issuer) should be treated as the 
payor.

EXAMPLE II--Retirement Plans

     ABC Corporation, which services retirement plans, 
approaches the February 28th deadline for filing with the 
Internal Revenue Service the appropriate information returns 
(i.e., Forms 1099-R). ABC Corporation services 500 retirement 
plans and each plan must file over 1,000 Forms 1099-R. A 
systems operator, unaware of the penalties for filing late 
Forms 1099, attempts to contact the internal Corporate Tax 
Department to inform them that an extension of time to file is 
necessary to complete the preparation and filing of the 
magnetic media for the retirement plans. The systems operator 
is unable to reach the Corporate Tax Department by the February 
28th filing deadline and files the information returns the 
following week. This failure, under the proposal, could lead to 
substantial late filing penalties for each retirement plan that 
ABC Corporation services (in this example, up to $75,000 for 
each plan).\9\
---------------------------------------------------------------------------
    \9\ If the corrected returns were filed after August 1, the 
penalties would be capped at $250,000 per plan.
---------------------------------------------------------------------------
    Recommendation: Retirement plan servicers (not each 
retirement plan) should be treated as the payor for purposes of 
applying the penalty cap.

EXAMPLE III--Related Companies

    A bank or broker dealer generally is a member of an 
affiliated group of companies, which offer different products 
and services. Each company that is a member of the group is 
treated as a separate payor for information reporting and 
penalty purposes. Information returns for all or most of the 
members of the group may be generated from a single information 
reporting system. One error (e.g., a systems programming error) 
could cause information returns generated from the system to 
contain errors on all subsequent information returns generated 
by the system. Under the proposal, the penalty cap would apply 
to each affiliated company for which the system(s) produces 
information returns.
    Recommendation: Each affiliated group \10\ should be 
treated as a single payor for purposes of applying the penalty 
cap.
---------------------------------------------------------------------------
    \10\ A definition of ``affiliated group'' which may be used for 
this purpose may be found in Section 267(f) or, alternatively, Section 
1563(a).
---------------------------------------------------------------------------
    While these examples highlight the need to apply the type 
of penalty proposed by the Treasury on an aggregated basis, 
they also illustrate the indiscriminate and unnecessary nature 
of the proposal.

                               CONCLUSION

    The Coalition of Service Industries represents the 
preparers of a significant portion of the information returns 
that would be impacted by the proposal to increase penalties 
for failure to file correct information returns. In light of 
the current reporting burdens imposed on our industries and the 
significant level of industry compliance, we believe it is 
highly inappropriate to raise penalties. In addition to this 
testimony, we sent a letter to Secretary of the Treasury Robert 
Rubin, signed by some of our member associations, voicing our 
opposition to the proposal. A copy of the letter is attached.
    Congress has considered and rejected this proposal on three 
previous occasions, and we hope it will continue to reject this 
unwarranted penalty increase. Thank you for your consideration 
of our views.

    [An attachment is being retained in the Committee files.]
      

                                

Statement of Coalition of Service Industries \1\

                              Introduction

    The Administration's Budget Proposal for fiscal year 2000 
(the ``FY2000 Budget'') provides for the extension of six 
expiring provisions, but fails to extend the active financing 
exception to subpart F.\2\ The active financing exception to 
subpart F should be extended at the same time as other 
provisions that will expire during calendar year 1999. 
Moreover, at a time when the Administration and the 
Congressional Budget Office are predicting ``on budget'' 
surpluses in the near term, CSI, on behalf of the undersigned 
industry groups, believes that the active financing exception 
to subpart F should be made a permanent provision in the law.
---------------------------------------------------------------------------
    \1\ The Coalition of Service Industries (CSI) was established in 
1982 to create greater awareness of the major role services industries 
play in our national economy; promote the expansion of business 
opportunities abroad for US service companies; and encourage US 
leadership in attaining a fair and competitive global marketplace. CSI 
represents a broad array of US service industries including the 
financial, telecommunications, professional, travel, transportation, 
information and information technology sectors.
    \2\ ``Subpart F'' refers to the regime prescribed by Sections 951-
964 of the Internal Revenue Code of 1986, as amended (the ``Code''); 
except as noted, all references to ``sections'' hereinafter are to the 
Code.
---------------------------------------------------------------------------

                               Background

     When subpart F was first enacted in 1962, the original 
intent was to require current U.S. taxation of foreign income 
of US multinational corporations that was passive in nature. 
The 1962 law was careful not to subject active financial 
services business income to current taxation through a series 
of detailed carve-outs. In particular, dividends, interest and 
certain gains derived in the active conduct of a banking, 
financing, or similar business, or derived by an insurance 
company on investments of unearned premiums or certain reserves 
were specifically excluded from current taxation if such income 
was earned from activities with unrelated parties. In 1986, the 
provisions that were put in place to ensure that a controlled 
foreign corporation's (CFC) active financial services business 
income would not be subject to current tax were repealed in 
response to concerns about the potential for taxpayers to route 
passive or mobile income through tax havens. In 1997,\3\ the 
1986 rules were revisited, and an exception to the subpart F 
rules was added for the active income of US based financial 
services companies, along with rules to address concerns that 
the provision would be available to passive operations. The 
active financing income provision was revisited in 1998, in the 
context of extending the provision for the 1999 tax year, and 
considerable changes were made to focus the provision on active 
financial services businesses that perform significant 
operations in their home country.
---------------------------------------------------------------------------
    \3\ Taxpayer Relief Act of 1997, Conference Report to H.R. 2014, H. 
Rept. 105-220, pages 639-645.
---------------------------------------------------------------------------
     A comparison of current U.S. law with the laws of foreign 
countries shows that the United States imposes significantly 
stricter standards on CFCs of U.S.-based financial services 
companies in order for them to qualify as active financing 
income. For example, German law merely requires that income be 
earned by a bank with a commercially viable office established 
in the CFC's jurisdiction. Germany does not require that the 
CFC conduct the activities generating the income or that the 
income come from transactions with customers solely in the 
CFC's country of incorporation. The United Kingdom has an even 
less restrictive regime than Germany. These countries do not 
impose current taxation on CFC income as long as the CFC is 
engaged primarily in legitimate business activities primarily 
with unrelated parties. In sum, current U.S. treatment of CFC 
active financing income is more restrictive than the treatment 
afforded such income by many of the United States' competitors.
    Active financial services income is universally recognized 
as active trade or business income. Thus, if the current law 
provision were permitted to expire at the end of this year, 
U.S. financial services companies would find themselves at a 
significant competitive disadvantage vis-a-vis all their major 
foreign competitors when operating outside the United States. 
In addition, because the U.S. active financing exception is 
currently temporary, it denies U.S. companies the certainty 
their foreign competitors have. The need for certainty in this 
area cannot be overstated. U.S. companies need to know the tax 
consequences of their business operations. Over the last two 
years US companies have implemented numerous system changes in 
order to comply with two very different versions of the active 
financing law, and are unable to take appropriate strategic 
action if the tax law is not stable.

The Active Financing Exception to Subpart F Is Essential to the 
Competitive Position of American Financial Services Industries 
in the Global Marketplace

    The financial services sector is the fastest growing 
component of the U.S. trade in services surplus (which is 
expected to exceed $80 billion this year). It is therefore very 
important that the Congress act to maintain a tax structure 
that does not hinder the competitive efforts of the U.S. 
financial services industry, rather than allowing the active 
financing exception to subpart F to expire (and thereby revert 
to a regime that penalizes U.S.-owned financial services 
companies).
    The growing interdependence of world financial markets has 
highlighted the urgent need to rationalize U.S. tax rules that 
undermine the ability of American financial services industries 
to compete in the international arena. From a tax policy 
perspective, financial services businesses should be eligible 
for the same U.S. tax treatment of worldwide income as that of 
manufacturing and other non-financial businesses. The 
inequitable treatment of financial services industries under 
prior law jeopardized the international expansion and 
competitiveness of U.S.-based financial services companies, 
including finance and credit entities, commercial banks, 
securities firms, and insurance companies.
    This active financing provision is particularly important 
today as the U.S. financial services industry is the global 
leader and plays a pivotal role in maintaining confidence in 
the international marketplace. Also, recently concluded trade 
negotiations have opened new foreign markets for this industry, 
and it is essential that our tax laws complement this trade 
effort. The Congress must not allow the tax code to revert to 
penalizing U.S.-based companies upon expiration of the 
temporary provision this year.

The Active Financing Exception Should Be Made Permanent.

    According to Ways and Means Committee member Amo Houghton's 
floor statement during the debate on the Conference Report on 
the 1997 legislation that first enacted an active financing 
exception to subpart F, the fact that the provision would 
sunset after one year was ``a function of revenue concerns, not 
doubts as to its substantive merit.'' \4\ Indeed, even in the 
course of subjecting the original active financing exception to 
a (now defunct) line-item veto, the Administration 
acknowledged, and continues to acknowledge that the ``primary 
purpose of the provision was proper.'' \5\
---------------------------------------------------------------------------
    \4\ Congressional Record, July 31, 1997.
    \5\ White House Statement, August 11, 1997.
---------------------------------------------------------------------------
     The international growth of American finance and credit 
companies, banks, securities firms, and insurance companies 
will be impaired by an ``on-again, off-again'' system of annual 
extensions that does not allow for certainty. Making this 
provision a permanent part of the law would enhance the 
position of the U.S. financial services industry.

                               Conclusion

     On behalf of the entire American financial services 
industry, the Coalition of Service Industries urges the Ways 
and Means Committee to adopt H.R. 681, the bipartisan bill 
(recently introduced by Reps. McCrery, Neal, and other members 
of the committee) to make the active financing exception to 
subpart F permanent. H.R. 681 would provide a consistent, 
equitable, and stable international tax regime for the U.S. 
financial services industry.

                              Signatories:

American Bankers Association
American Council of Life Insurance
American Financial Services Association
American Insurance Association
The Bankers Roundtable
Coalition of Finance and Credit Companies
Coalition of Service Industries
Council of Insurance Agents and Brokers
National Association of Manufacturers
Securities Industry Association
The New York Clearing House Association L.L.C.
The Tax Council
US Council for International Business
      

                                

Statement of Coalition to Preserve Employee Ownership of S Corporations

    This statement is respectfully submitted on behalf of the 
Coalition to Preserve Employee Ownership of S Corporations 
(``Coalition'') in connection with the Committee's hearings on 
revenue provisions included in the President's fiscal year 2000 
budget. The Coalition appreciates the Committee's interest in 
public comments on the Administration's budget proposals and 
welcomes the opportunity to express its strong opposition to 
one of these proposals in particular--the proposal to repeal 
the recently-enacted provision of The Taxpayer Relief Act of 
1997 (``1997 Act'') that exempts S corporation income that 
flows through to an ESOP shareholder from the unrelated 
business income tax (``UBIT''). As explained below, we believe 
that the 1997 Act provision is furthering the goal Congress 
intended of facilitating employee ownership of closely-held 
businesses and should not be repealed; that it is inappropriate 
as a matter of tax policy to keep changing tax laws upon which 
businesses rely; that the Administration's tax proposal is 
inconsistent with the general intent of Congress underlying 
Subchapter S, is overly complex, and would impose a new tax 
burden on employees; and that the proposal cannot be justified 
on ``anti-tax shelter'' grounds. Therefore, we respectfully 
request this Committee to reject the Administration's proposal 
and to keep in place the law it enacted not two years ago.

                               BACKGROUND

    ESOPs provide an opportunity for millions of Americans to 
own a piece of the businesses for which they work. They not 
only provide greater incentives for employees to help the 
companies grow, but also play a critical role in the employees' 
retirement planning strategies. As explained below, Congress 
recently has taken important steps to remove some of the 
barriers to employee ownership that existed for closely-held 
businesses. The Coalition commends the Congress for its 
recognition of the value of employee ownership and hopes that 
this Committee will continue to support employee ownership in 
the future.
    In the Small Business Job Protection Act of 1996 (the 
``1996 Act''), Congress allowed ESOPs to be shareholders of S 
corporations, in recognition of the fact that the previous-law 
``prohibition of certain tax-exempt organizations being S 
corporation shareholders may have inhibited employee-ownership 
of closely-held businesses.'' Joint Committee on Taxation's 
General Explanation of Tax Legislation Enacted in the 104th 
Congress (JCS-12-96). The 1996 Act, however, included a number 
of restrictive tax rules with respect to ESOPs of S 
corporations that generally made employee ownership of an S 
corporation unattractive. For example, the 1996 Act provided 
that:
    The income of the S corporation that flowed through to the 
ESOP shareholder, as well as any gain on the sale of S 
corporation stock, would be treated as unrelated business 
taxable income (``UBTI'') and would be subject to tax at the 
ESOP level. Thus, the S corporation income would be subject to 
tax twice--once to the ESOP and once to the participants upon 
distribution.
    The increased deduction limitation under Section 404(a)(9) 
of the Internal Revenue Code of 1986, as amended (``Code''), 
would not apply to S corporations. As a result, even though a C 
corporation generally can deduct contributions to an ESOP that 
are made to allow the ESOP to pay interest and principal on the 
loan it incurred to acquire the corporation's stock, up to an 
amount equal to 25 percent of the compensation paid or accrued 
to employees under the plan, an S corporation generally is 
limited to a deduction for contributions equal to 15 percent of 
the compensation paid or accrued to such employees.
    The deduction for dividends paid on certain employer 
securities under Code Section 404(k)(1) would not be available 
to S corporations. As a result, even though a C corporation may 
deduct the amount of certain cash dividends that ultimately are 
passed through to the participants of the ESOP, an S 
corporation is not entitled to such a deduction.
    The special ``rollover'' rules of Code Section 1042 that 
are designed to encourage the contribution of employer stock to 
ESOPs would not apply to S corporation stock. As a result, even 
though shareholders may be able to defer gain on the sale of C 
corporation stock to an ESOP if they reinvest the proceeds in 
certain qualifying securities, such deferral is not available 
on the sale of S corporation stock.
    In the 1997 Act, Congress decided to repeal the first of 
these restrictions, such that S corporation income or loss that 
passes through to an ESOP shareholder, and any gain or loss on 
the sale by the ESOP of S corporation stock, would not be 
subject to UBIT. The legislative history indicates that this 
change was made because the Congress believed ``that treating S 
corporation income as UBTI is not appropriate because such 
amounts would be subject to tax at the ESOP level, and also 
again when benefits are distributed to ESOP participants.'' S. 
Rept. 105-33 (105th Cong., 1st Sess.), at p. 80. This change 
became effective for taxable years beginning after December 31, 
1997. In reliance on this law change, many employee-owned 
businesses have elected S corporation status, in some cases 
increasing the amount of stock owned for the benefit of their 
employees. Further, some existing S corporations have 
established ESOPs. Finally, some corporations are in the 
process either of establishing ESOPs or restructuring so that 
they will be eligible to elect S corporation status. These 
companies are furthering the goal of increasing employee 
ownership that Congress was trying to advance in enacting the 
1997 Act provision.
    Now, barely a year after the 1997 Act provision became 
effective, the Administration is asking the Congress to reject 
the decision it made in the 1997 Act. In particular, the 
Administration has included in the ``corporate tax shelter'' 
section of its budget a proposal to repeal the 1997 Act 
provision and, instead, to allow an S corporation ESOP a 
deduction for distributions to participants and beneficiaries 
to the extent of the S corporation income on which it has paid 
UBIT. The proposal also would modify net operating loss rules 
in effect to allow for the carryback of ``excess'' distribution 
deductions for 2 years, and the carryforward of such deductions 
for 20 years. The proposal would be effective for tax years 
beginning after the date of first committee action. Thus, it 
would apply to income and gain of corporations that already 
have ESOPs and/or that already have converted to S corporation 
status, as well as to corporations that are in the process of 
establishing ESOPs or converting to S corporation status.

              PROBLEMS WITH THE ADMINISTRATION'S PROPOSAL

    The Coalition believes that the Administration's proposal 
is fundamentally flawed for the reasons set forth below.

The 1997 Act Provision Is Furthering the Laudable Goal of 
Increasing Employee Ownership and Should Not Be Repealed

    As indicated above, Congress enacted the 1996 and 1997 Act 
provisions regarding S corporation ESOPs in order to remove 
obstacles that had deterred employee ownership of closely-held 
corporations. Thus far, these provisions have been successful 
in achieving this objective of facilitating employee ownership. 
As a direct result of the law changes, employees have increased 
their ownership of closely-held businesses, shareholders have 
decided to transfer more stock to ESOPs, and S corporations 
that previously could not have had ESOPs have been able to give 
their employees an ownership interest in the business. It is 
virtually certain that Congress's decisions in 1996 and 1997 
will encourage even greater employee ownership in the future. 
It makes no sense to repeal a provision which is doing exactly 
what Congress intended it to do and which is furthering a 
valuable policy goal.

It Is Inappropriate as a Matter of Tax Policy to Change a Tax 
Law on Which Businesses Have Relied in Making Costly Business 
Decisions

    The Coalition also believes it would be grossly 
inappropriate as a matter of tax policy to encourage ESOP 
ownership of S corporations in 1997 and, not two years later, 
to fundamentally alter the tax consequences of such ownership. 
As explained further below, converting to S corporation status, 
selling more stock to an ESOP, and establishing an ESOP are all 
important decisions that have real economic consequences. 
Businesses that are considering these actions should be able to 
make their decisions based on a relatively stable set of tax 
rules, rather than to have to suffer from tax laws that become 
effective in one tax year and are repealed in the next.
    Corporations that converted to S corporation status in 
reliance on the 1997 Act provision (or that are in the process 
of converting) have had to weigh the costs and benefits of 
their decision in order to determine whether it was (or is) 
prudent. As indicated above, for a company with an ESOP, 
converting to S corporation status involves losing certain 
benefits (such as Code Sections 404(a)(9) and 404(k)(1)) that 
are available to C corporations, but not to S corporations. 
Further, converting to S corporation status in many cases 
involves eliminating the economic interests of ``ineligible'' 
shareholders; restructuring debt, options and other 
arrangements that could be recharacterized as a ``second class 
of stock''; implementing new shareholders' agreements; paying a 
``LIFO recapture tax,'' etc. Companies that also elected to 
treat subsidiaries as ``Qualified Subchapter S Subsidiaries'' 
will have lost forever their basis in the stock of such 
subsidiaries, which could have significant negative 
consequences in the event of a future sale of those businesses. 
If the 1997 Act provision had not been enacted, these companies 
likely would not have incurred the costs, or accepted the 
consequences, associated with becoming S corporations. It would 
be improper from a tax policy perspective to encourage 
conversions in 1997 and to fundamentally change the 
consequences thereof not more than two years later.
    Similarly, companies that have increased the extent to 
which they are employee owned, or that are in the process of 
establishing ESOPs, have relied on the 1997 Act provision in 
determining whether the costs of establishing ESOPs are 
outweighed by the benefits. In this regard, it is critical to 
understand that establishing an ESOP is a very costly process. 
It typically involves, among other things, conducting a 
feasibility study; obtaining valuations; making comprehensive 
changes to the overall compensation arrangements; and making 
difficult decisions about the extent to which employees should 
have access to information about, and be involved in, the 
business. ESOPs also are subject to numerous regulatory and 
disclosure requirements by the Department of Labor. In 
addition, in the case of a leveraged ESOP, significant 
financing costs may be incurred. Companies that undertake 
actions with such significant consequences and costs should be 
able to rely on a relatively stable set of tax laws.

 The Administration's Proposal Not Only Is Complex, But Also 
Could Result in S Corporation Income Being Subject to Two 
Levels of Tax and in Employees Bearing a New Tax Burden

    As a general matter, Congress has recognized throughout 
Subchapter S that, subject to limited exceptions, S corporation 
income should only be subject to one level of tax. However, as 
explained below, the Administration's proposal in some 
situations improperly would result in S corporation income 
being subject to two levels of tax--one at the ESOP level and 
one at the participant level. Such a result not only would be 
inconsistent with the general Congressional intent underlying 
Subchapter S, but also would create an untenable new tax burden 
on the employee-owners of ESOP-owned companies.
    The Administration's proposal apparently attempts to ensure 
that S corporation income is subject to only one level of tax 
by introducing a new deduction mechanism. However, this 
deduction mechanism not only introduces needless complexity 
into an already overly complex tax law, but also is 
fundamentally flawed. For example, assume an ESOP had S 
corporation income in excess of distributions for a number of 
years prior to the termination or revocation of the 
corporation's S election. Under the Administration's proposal, 
the S corporation earnings would be subject to immediate tax at 
the ESOP level. However, if the ESOP distributed those earnings 
to participants more than two years after the corporation 
terminated or revoked its S corporation election, neither the 
carryback nor carryforward provisions of the proposal likely 
would be useful because the ESOP would be unlikely to have 
earnings subject to UBTI at that time (i.e., after the 
corporation has become a C corporation). Thus, the S 
corporation earnings in effect would be subject to tax at both 
the ESOP level (when earned) and the participant level (when 
distributed), with the employees bearing the burden of the 
double-level tax.
    By contrast, the Congressional decision in the 1997 Act to 
exempt S corporation income from UBIT at the ESOP level is 
simple and ensures that S corporation income properly is 
subject to tax only once--when the income is distributed to 
participants. The Coalition strongly endorses this decision and 
encourages this Committee not to entertain the introduction of 
a complex deduction mechanism that is technically flawed, can 
engender tax results inconsistent with the general intent 
underlying Subchapter S, and would produce a new tax burden on 
employees.

 Repealing the 1997 Act Provision Cannot Be Justified on 
``Anti-Tax Shelter'' Grounds

    As indicated above, the Administration included its 
proposal to repeal the 1997 Act provision as part of the 
``corporate tax shelter'' section of its budget. As should be 
apparent from the above, the 1997 Act provision is playing a 
valuable role in fostering employee ownership of closely-held 
businesses and enabling people to enhance their retirement 
savings. Members of this Coalition that have converted to S 
corporation status, established ESOPs, or given ESOPs greater 
stakes in the business are doing exactly what the Congress 
intended when it enacted the 1997 Act provision--they are not 
engaging in a tax shelter, taking advantage of a loophole, or 
otherwise engaging in an abusive transaction.
    The Coalition understands that this Committee may be 
concerned about particular transactions in which taxpayers may 
be using ESOPs in a manner not intended by the Congress in 
1997. For example, the Joint Committee on Taxation, in its 
Description of Revenue Provisions Contained in the President's 
Fiscal Year 2000 Budget Proposal, suggested that there may be 
concerns regarding S corporation ESOPs in cases where there are 
only one or two employees. In addition, it referenced a 
technique described by Prof. Martin Ginsburg in which the 1997 
Act provision can be used to create a ``tax holiday'' for other 
shareholders of an S corporation. \1\ If Congress is concerned 
about particular transactions, the appropriate response is to 
craft narrow solutions targeting those transactions, rather 
than to reject wholesale the decision made in the 1997 Act to 
further employee ownership of closely-held companies.
---------------------------------------------------------------------------
    \1\ Ginsburg, ``The Taxpayer Relief Act of 1997: Worse Than You 
Think,'' 76 Tax Notes 1790 (September 29, 1997).
---------------------------------------------------------------------------

                            RECOMMENDATIONS

    For the reasons set forth above, the Coalition strongly 
urges the Committee not to approve the Administration's 
proposal. If the Committee is concerned about perceived abuses, 
the Coalition would be happy to work with the Committee and its 
staff in devising an appropriate solution that is tailored to 
the particular transactions with which the Committee is 
concerned.
    The Coalition appreciates the Committee's interest in its 
views on this significant issue.

This testimony was prepared on behalf of the Coalition by 
Arthur Andersen LLP.
      

                                

Statement of Committee of Annuity Insurers

    The Committee of Annuity Insurers is composed of forty-two 
life insurance companies that issue annuity contracts, 
representing approximately two-thirds of the annuity business 
in the United States. The Committee of Annuity Insurers was 
formed in 1981 to address Federal legislative and regulatory 
issues affecting the annuity industry and to participate in the 
development of Federal tax policy regarding annuities. A list 
of the member companies is attached at the end of this 
statement. We thank you for the opportunity to submit this 
statement for the record.
    All of the Administration's proposals relating to the 
taxation of life insurance companies and their products are 
fundamentally flawed. However, the focus of this statement is 
the Administration's proposal to increase the so-called ``DAC 
tax'' imposed under IRC section 848 and, in particular, the 
increase proposed with respect to annuity contracts used for 
retirement savings outside of pension plans (``non-qualified 
annuities''). The Administration's proposal reflects unsound 
tax policy and, if enacted, would have a substantial, adverse 
effect on private retirement savings in America. As was the 
case last year, the Administration has demonstrated that it 
does not understand the important role that annuities and life 
insurance play in assuring Americans that they will have 
adequate resources during retirement and adequate protection 
for their families.
    Annuities are widely owned by Americans. At the end of 
1997, there were approximately 38 million individual annuity 
contracts outstanding, nearly three times the approximately 13 
million contracts outstanding just 11 years before. The 
premiums paid into individual annuities--amounts saved by 
individual Americans for their retirement--grew from 
approximately $34 billion in 1987 to $90 billion in 1997, an 
average annual increase of greater than 10 percent.
    Owners of non-qualified annuities are predominantly middle-
income Americans saving for retirement. The reasons for this 
are obvious. Annuities have unique characteristics that make 
them particularly well-suited to accumulate retirement savings 
and provide retirement income. Annuities allow individuals to 
protect themselves against the risk of outliving their savings 
by guaranteeing income payments that will continue as long as 
the owner lives. Deferred annuities also guarantee a death 
benefit if the owner dies before annuity payments begin.
    The tax rules established for annuities have been 
successful in increasing retirement savings. Eighty-four 
percent of owners of non-qualified annuities surveyed by The 
Gallup Organization in 1998 reported that they have saved more 
money than they would have if the tax advantages of an annuity 
contract had not been available. Almost nine in ten (88%) 
reported that they try not to withdraw any money from their 
annuity before they retire because they would have to pay tax 
on the money withdrawn.
    As discussed below, the proposal contained in the 
Administration's FY 2000 budget to increase the DAC tax is in 
substance a tax on owners of non-qualified annuity contracts 
and cash value life insurance. It would make these products 
more expensive and less attractive to retirement savers. It 
would also lower the benefits payable to savers and families. 
Furthermore, as also discussed below, the DAC tax is 
fundamentally flawed and increasing its rate would simply be an 
expansion of bad tax policy.

   1. The Administration's DAC proposal is in substance a tax on the 
                owners of annuities and life insurance.

    Last year, the Administration's budget proposals included 
several direct tax increases on annuity and life insurance 
contract owners, including imposition of tax when a variable 
contract owner changed his or her investment strategy and a 
reduction in cost basis for amounts paid for insurance 
protection. The proposals were rightly met with massive 
bipartisan opposition and were rejected. This year's budget 
proposal on DAC is simply an attempt to increase indirectly the 
taxes of annuity and life insurance contract owners. We urge 
this Committee to reject the Administration's back door tax 
increase on annuity and life insurance contract owners in the 
same decisive manner in which the Committee rejected last 
year's proposed direct tax increases.
    IRC section 848 denies life insurance companies a current 
deduction for a portion of their ordinary and necessary 
business expenses equal to a percentage of the net premiums 
paid each year by the owners of certain types of contracts. 
These amounts instead must be capitalized and then amortized 
over 120 months. The amounts that currently must be capitalized 
are 1.75 percent of non-qualified annuity premiums, 2.05 
percent of group life insurance premiums, and 7.70 percent of 
other life insurance premiums (including noncancellable or 
guaranteed renewable accident and health insurance). Under the 
Administration's proposal, these categories of contracts would 
be modified and the percentages would be dramatically 
increased. Specifically, the rate for annuity contracts would 
almost triple to 5.15 percent while the rate for individual 
cash value life insurance would almost double to 12.85 percent.
    The tax resulting from the requirements of section 848 is 
directly related to the amount of premiums paid by the owners 
of the contracts. Thus, as individuals increase their annuity 
savings (by paying more premiums), a company's taxes increase--
the higher the savings, the higher the tax. It is clear that 
since the enactment of DAC in 1990, the DAC tax has been passed 
through to the individual owners of annuities and life 
insurance. Some contracts impose an express charge for the cost 
of the DAC tax, for example, while other contracts necessarily 
pay lower dividends or less interest to the policyholder. Still 
other contracts impose higher general expense charges to cover 
the DAC tax. (See The Wall Street Journal, December 10, 1990, 
``Life Insurers to Pass Along Tax Increase.'')
    According to the Joint Committee on Taxation, the increased 
capitalization percentages proposed in the Administration's FY 
2000 budget will result in increased taxes of $3.73 billion for 
the period 1999-2004 and $9.48 billion for the period 1999-
2009. This tax increase will largely come from middle-income 
Americans who are purchasing annuities to save for retirement 
and cash value life insurance to protect their families. 
According to a Gallup survey conducted in April 1998, most 
owners of non-qualified annuities have moderate annual 
household incomes. Three-quarters (75%) have total annual 
household incomes under $75,000. Eight in ten owners of non-
qualified annuities state that they plan to use their annuity 
savings for retirement income (83%) or to avoid being a 
financial burden on their children (82%).
    The Administration's proposal will discourage private 
retirement savings and the purchase of life insurance. Congress 
in recent years has become ever more focused on the declining 
savings rate in America and on ways to encourage savings and 
retirement savings in particular. As described above, Americans 
have been saving more and more in annuities, which are the only 
non-pension retirement investments that can provide the owner 
with a guarantee of an income that will last as long as the 
owner lives. Life insurance contracts can uniquely protect 
families against the risk of loss of income. Increasing the 
cost of annuities and cash value life insurance and reducing 
the benefits will inevitably reduce private savings and the 
purchase of life insurance protection.

2. Contrary to the Administration's claims, an increase in the DAC tax 
  is not necessary to reflect the income of life insurance companies 
                              accurately.

    The Administration claims that the increases it proposes in 
the DAC capitalization percentages are necessary to accurately 
reflect the economic income of life insurance companies. In 
particular, the Administration asserts that ``life insurance 
companies generally capitalize only a fraction of their policy 
acquisition expenses.'' In fact, as explained below, life 
insurance companies already more than adequately capitalize the 
expenses they incur in connection with issuing annuity and life 
insurance contracts. The Administration's proposal would 
further distort life insurance company income simply to raise 
revenue.
    As a preliminary matter, the Administration cites certain 
data that life insurance companies report to state insurance 
regulators as a basis for its claim that only a fraction of 
policy selling expenses are being capitalized. In particular, 
the Administration points to the ratio of commissions to net 
premiums during the period 1993 -1997, and notes that the ratio 
is higher than the current DAC capitalization percentage. The 
Administration's ratios present an inaccurate and misleading 
picture of the portion of commissions being capitalized under 
current law.
    The Administration's ratios apparently treat expense 
allowances paid on reinsured contracts as commissions and in 
doing so effectively count those amounts twice. As a result, 
the numerators in the Administration's ratios are significantly 
overstated. If expense allowances paid in connection with 
reinsurance are accounted for properly, the ratio of 
commissions to net premiums is significantly lower than 
described by the Administration.
    More importantly, the current tax rules applicable to life 
insurance companies capitalize policy selling expenses not only 
through the section 848 DAC tax, but also by requiring (in IRC 
section 807) reserves for life insurance and annuity contracts 
to be based on a ``preliminary term'' or equivalent method. It 
is a matter of historical record that preliminary term reserve 
methods were developed because of the inter-relationship of 
policy selling expenses and reserves. Since the early 1900's, 
when preliminary term reserve methods began to be accepted by 
state insurance regulators, the relationship between policy 
reserves and a life insurance company's policy selling expenses 
has been widely recognized. See, e.g., K. Black, Jr. and H. 
Skipper, Jr, Life Insurance 565-69 (12th ed. 1994); McGill's 
Life Insurance 401-408 (edited by E. Graves and L. Hayes, 
1994).
    Under a preliminary term reserve method, the reserve 
established in the year the policy is issued is reduced (from a 
higher, ``net level'' basis) to provide funds to pay the 
expenses (such as commissions) the life insurer incurs in 
issuing the contract. The amount of this reduction is known as 
the ``expense allowance,'' i.e., the amount of the premium that 
may be used to pay expenses instead of being allocated to the 
reserve. Of course, the life insurance company's liability for 
the benefits promised to the policyholder remains the same even 
if a lower, preliminary term reserve is established. As a 
result, the amount added to the reserve in subsequent years is 
increased to take account of the reduction in the first year.
    In measuring a life insurance company's income, reducing 
the first year reserve deduction by the expense allowance is 
economically equivalent to computing a higher, net level 
reserve and capitalizing, rather than currently deducting, that 
portion of policy selling expenses. Likewise, increasing the 
reserve in subsequent years is equivalent to amortizing those 
policy selling expenses over the subsequent years. Thus, under 
the current income tax rules applicable to life insurance 
companies, policy selling expenses are capitalized both under 
the section 848 DAC tax and through the required use of 
preliminary term reserves. The Administration's FY 2000 budget 
proposal completely ignores this combined effect.
    This relationship between policy selling expenses and 
preliminary term reserves has been recognized by Congress. In 
accordance with the treatment mandated by the state regulators 
for purposes of the NAIC annual statement, life insurance 
companies have always deducted their policy selling expenses in 
the year incurred in computing their Federal income taxes. 
Until 1984, life insurance companies also computed their tax 
reserves based on the reserve computed and held on the annual 
statement. However, under the Life Insurance Company Income Tax 
Act of 1959 (the ``1959 Act''), if a company computed its 
annual statement reserves on a preliminary term method, the 
reserves could be recomputed on the higher, net level method 
for tax purposes. Because companies were allowed to compute 
reserves on the net level method and to deduct policy selling 
expenses as incurred, life insurance companies under the 1959 
Act typically incurred a substantial tax loss in the year a 
policy was issued.
    When Congress was considering revisions to the tax 
treatment of life insurance companies in 1983, concern was 
expressed about the losses incurred in the first policy year as 
a result of the interplay of the net level reserve method and 
the current deduction of first year expenses. In particular, 
there was concern that a mismatching of income and deductions 
was occurring. As a consequence, as those who participated in 
the development of the Deficit Reduction Act of 1984 (the 
``1984 Act'') know, Congress at that time considered requiring 
life insurance companies to capitalize and amortize policy 
selling expenses.
    Congress chose not to change directly the tax treatment of 
policy selling expenses, however. Rather, recognizing that the 
effect of the use of preliminary term reserve methods is 
economically identical to capitalizing (and amortizing over the 
premium paying period) the expense allowance by which the first 
year reserve is reduced, Congress decided to alter the 
treatment of selling expenses indirectly by requiring companies 
to use preliminary term methods, rather than the net level 
method, in computing life insurance reserves.
    Although the published legislative history of the 1984 Act 
does not explicitly comment on this congressional decision to 
address the treatment of selling expenses through reduction of 
the allowable reserve deduction, the legislative history of the 
Tax Reform Act of 1986 does. In 1986, Congress became concerned 
that there was a mismatching of income and deductions in the 
case of property and casualty insurers. In particular, some 
thought that allowing a property and casualty company a 
deduction for both unearned premium reserves and policy selling 
expenses resulted in such a mismatching.
    Again, recognizing the relationship between the treatment 
of reserves and selling expenses, Congress chose to reduce the 
unearned premium reserve deduction of property and casualty 
insurers by 20 percent, while allowing selling expenses to 
remain currently deductible. See I.R.C. section 832(b)(4). The 
legislative history of this rule noted that ``this approach is 
equivalent to denying current deductibility for a portion of 
the premium acquisition costs.'' Jt. Comm. on Taxation, General 
Explanation of the Tax Reform Act of 1986, at p. 595 (``1986 
Act Bluebook''). Moreover, Congress specifically excluded life 
insurance reserves that were included in unearned premium 
reserves from the 20 percent reduction. See I.R.C. section 
832(b)(7). It did so, according to the legislative history, 
because under the 1984 Act life insurance reserves ``are 
calculated . . . in a manner intended to reduce the 
mismeasurement of income resulting from the mismatching of 
income and expenses.'' See 1986 Act Bluebook at p. 595 
(emphasis added).
    In summary, life insurance companies are already over 
capitalizing policy selling expenses for income tax purposes 
because of the combination of the current DAC tax and the 
mandated use of preliminary term reserves. In these 
circumstances, increasing the DAC capitalization percentages 
will not result in a clearer reflection of the income of life 
insurance companies. To the contrary, increasing the 
percentages as the Administration proposes would further 
distort life insurance company income simply to raise revenue.

3. Contrary to the Administration's suggestion, an increase in the DAC 
               tax is inconsistent with GAAP accounting.

    The Administration's explanation of the DAC proposal 
implies that increases in the DAC percentages are consistent 
with generally accepted accounting principles (GAAP). The 
Administration states that ``[l]ife insurance companies 
generally capitalize only a portion of their actual policy 
acquisition costs. In contrast, when preparing their financial 
statements using [GAAP], life companies generally capitalize 
their actual acquisition costs.'' What the Administration's 
explanation fails to note is that, while it is correct that 
under GAAP accounting actual acquisition costs are capitalized, 
GAAP accounting does not mandate the use of preliminary term 
reserves. In fact, no system of insurance accounting ``doubles 
up'' on capitalization by requiring a combination of 
capitalization of actual policy acquisition costs combined with 
the use of preliminary term reserves.
    It is clear from the legislative history of the Omnibus 
Budget Reconciliation Act of 1990 (the ``1990 Act'') that 
Congress expressly considered and rejected GAAP as a basis for 
accounting for life insurance company policy selling expenses. 
The Chairman of the Senate Budget Committee inserted in the 
Congressional Record the language submitted by the Senate 
Finance Committee describing the section 848 DAC tax. 136 
Congressional Record at S15691 (Oct. 18, 1990). In this 
explanation, the Finance Committee recognized that, while there 
were some potential benefits to the GAAP approach, there were a 
number of drawbacks to it. As a result, the Finance Committee 
chose a proxy approach of amortizing a percentage of premiums 
over an arbitrary 10 year period, rather than capitalizing 
actual selling expenses and amortizing them over the actual 
life of the contracts. In doing so, the Finance Committee 
observed that

          The Committee recognizes that this approach to the 
        amortization of policy acquisition expenses does not measure 
        actual policy acquisition expenses. However, the Committee 
        believes that the advantage of retaining a theoretically 
        correct approach is outweighed by the administrative simplicity 
        of this proxy approach. Further, the Committee believes that 
        the level of amortizable amounts obtained under this proxy 
        approach should, in most cases, understate actual acquisition 
        expenses. . . . Id.

    The House legislative history contains similar explanatory 
material. See Legislative History of Ways and Means Democratic 
Alternative (WMCP 101-37), October 15, 1990, at 27-28.
    In short, when Congress enacted the DAC tax in 1990, it 
knew that the proxy percentages did not capitalize the full 
amount of acquisition expenses as does GAAP accounting. 
However, as discussed above, the combination of the current DAC 
percentages with the mandated use of preliminary term reserves 
already results in two different capitalization mechanisms. If 
GAAP accounting is the appropriate model for taxing life 
insurance companies, as the Administration suggests, then the 
DAC tax should be repealed, not increased.
    In conclusion, the Committee of Annuity Insurers urges the 
Committee to reject the Administration's proposal to increase 
the section 848 DAC tax. The proposal is simply a disguised tax 
on the owners of annuities and life insurance contracts. 
Furthermore, the proposal lacks any sound policy basis and 
further distorts the income of life insurance companies.

                   The Committee of Annuity Insurers

Aetna Inc., Hartford, CT
Allmerica Financial Company, Worcester, MA
Allstate Life Insurance Company, Northbrook, IL
American General Corporation, Houston, TX
American International Group, Inc., Wilmington, DE
American Investors Life Insurance Company, Inc., Topeka, KS
American Skandia Life Assurance Corporation, Shelton, Conseco, Inc., 
Carmel, IN
COVA Financial Services Life Insurance Co., Oakbrook Terrace, IL
Equitable Life Assurance Society of the United States, New York, NY
Equitable of Iowa Companies, DesMoines, IA
F & G Life Insurance, Baltimore, MD
Fidelity Investments Life Insurance Company, Boston, MA
GE Life and Annuity Assurance Company, Richmond, VA
Great American Life Insurance Co., Cincinnati, OH
Hartford Life Insurance Company, Hartford, CT
IDS Life Insurance Company, Minneapolis, MN
Integrity Life Insurance Company, Louisville, KY
Jackson National Life Insurance Company, Lansing, MI
Keyport Life Insurance Company, Boston, MA
Life Insurance Company of the Southwest, Dallas, TX
Lincoln National Corporation, Fort Wayne, IN
ManuLife Financial, Boston, MA
Merrill Lynch Life Insurance Company, Princeton, NJ
Metropolitan Life Insurance Company, New York, NY
Minnesota Life Insurance Company, St. Paul, MN
Mutual of Omaha Companies, Omaha, NE
Nationwide Life Insurance Companies, Columbus, OH
New England Life Insurance Company, Boston, MA
New York Life Insurance Company, New York, NY
Ohio National Financial Services, Cincinnati, OH
Pacific Life Insurance Company, Newport Beach, CA
Phoenix Home Mutual Life Insurance Company, Hartford, CT
Protective Life Insurance Company, Birmingham, AL
ReliaStar Financial Corporation, Seattle, WA
Security First Group, Los Angeles, CA
SunAmerica, Inc., Los Angeles, CA
Sun Life of Canada, Wellesley Hills, MA
Teachers Insurance & Annuity Association of America--College Retirement
Equities Fund (TIAA-CREF), New York, NY
The Principal Financial Group, Des Moines, IA
Travelers Insurance Companies, Hartford, CT
Zurich Kemper Life Insurance Companies, Chicago, IL
      

                                

Statement of Committee to Preserve Private Employee Ownership

                              Introduction

    This statement is submitted on behalf of the Committee to 
Preserve Private Employee Ownership (``CPPEO''), which is a 
separately funded and chartered committee of the S Corporation 
Association. As of March 1, 1999, 19 employers have joined 
CPPEO and over 20,000 employees in virtually every state in the 
country are represented by companies that belong to CPPEO.
    CPPEO welcomes the opportunity to submit this statement for 
the written record to the Committee on Ways and Means regarding 
two of the proposals in the President's Fiscal Year 2000 
Budget. CPPEO strongly opposes the proposal to effectively 
repeal the provision in the Taxpayer Relief Act of 1997 (the 
``1997 Act'') \1\ that allowed S corporations to create ESOPs 
in order to promote employee stock ownership and employee 
retirement savings for S corporation employees. CPPEO urges the 
Ways and Means Committee to reject the Administration's S 
corporation ESOP proposal and continue to allow S corporations 
to have ESOP shareholders as contemplated in the 1997 Act. 
CPPEO also strongly opposes the Administration's proposal to 
tax ``large'' C corporations and their shareholders upon a 
conversion to S corporation status. CPPEO urges the Ways and 
Means Committee to reject this proposal, which has been 
included in the President's budget for the past three years and 
has been rejected each year, on the grounds it would inhibit 
the ability of S corporations to acquire C corporations, would 
impose burdensome complexity, and may represent a first step in 
an attempt to eliminate S corporations as a form of doing 
business.
---------------------------------------------------------------------------
    \1\ 1 P.L. 105-34.
---------------------------------------------------------------------------

               Legislative History of S Corporation ESOPs

    In the early 1990's, efforts began to enact legislation 
that would allow S corporation employees to enjoy the benefits 
of employee stock ownership that were conferred on C 
corporation employees under the ESOP provisions. Finally, in 
1996 Congress included a provision in the Small Business Jobs 
Protection Act of 1996 (the ``1996 Act'') \2\ that allowed S 
corporations to have ESOP shareholders, effective for taxable 
years beginning after December 31, 1997, so that S corporation 
employees could partake in the benefits of employee ownership 
that were already afforded to employees of C corporations. This 
provision, which was added just prior to enactment, did not 
result in a viable method to allow S corporation ESOPs, though 
it clearly expressed Congress' intent that S corporations 
should be allowed to have employee plan owners.
---------------------------------------------------------------------------
    \2\ 2 P.L. 104-188.
---------------------------------------------------------------------------
    The 1996 Act did not provide S corporation ESOPs with all 
of the incentives that are provided to encourage C corporation 
ESOPs. For example, under Internal Revenue Code section 1042, 
\3\ shareholders that sell employer stock to a C corporation 
ESOP are allowed to defer the recognition of gain from such 
sale. In addition, under section 404(a)(9), C corporations are 
allowed to make additional deductible contributions that are 
used by an ESOP to repay the principal and interest on loans 
incurred by the ESOP to purchase employer stock. C corporations 
are also allowed deductions under section 404(k) for dividends 
paid to an ESOP that are used either to make distributions to 
participants or to repay loans incurred by the ESOP to purchase 
employer stock. In addition, as a practical matter S 
corporation ESOP participants would be unable to use a 
substantial tax break--the ``net unrealized appreciation'' 
exclusion in section 402(e)(4)--because this benefit applies 
only to distributions of employer stock, which S corporations 
typically cannot do, as described below.
---------------------------------------------------------------------------
    \3\ 3 All ``section'' references are to the Internal Revenue Code 
of 1986, as amended.
---------------------------------------------------------------------------
    These incentives provided to C corporation ESOPs were not 
provided to S corporation ESOPs and a major disincentive was 
imposed on S corporation ESOPs by the 1996 Act. A 39.6 percent 
tax (the unrelated business income tax of section 511, or 
``UBIT'') was imposed on employees' retirement accounts with 
respect to the ESOP's share of the income of the sponsoring S 
corporation and any gain realized by the ESOP when it sold the 
stock of the sponsoring S corporation. The imposition of UBIT 
on S corporation ESOPs meant that the same income was being 
taxed twice, once to employees' ESOP accounts and a second time 
to the employees' distributions from the ESOP. Accordingly, 
owning S corporation stock through an ESOP would subject 
employees to double tax on their benefits, while individuals 
holding S corporation stock directly would be subject to only a 
single level of tax.
    The 1996 Act had another defect that made ESOPs an 
impractical choice for providing employee retirement benefits 
to S corporation employees--the right of ESOP participants to 
demand their distributions in the form of employer securities. 
S corporations cannot have more than 75 shareholders and cannot 
have IRAs or certain other qualified retirement plans as 
shareholders. Therefore, S corporations generally could not 
adopt ESOPs without taking the risk that the future actions of 
an ESOP participant could nullify the corporation's election of 
S corporation status--such as rolling over his or her stock 
into an IRA.
    In the 1997 Act, Congress reaffirmed its policy goal of 
making ESOPs available to the employees of S corporations and 
addressed the problems with the ESOP provisions in the 1996 
Act. Congress did not provide S corporation ESOPs with all the 
advantages and incentives provided to C corporation ESOPs, 
including the favorable tax treatment for shareholders selling 
stock to the ESOP and increased deductions and contribution 
limits for the sponsoring employer discussed above, but it did 
fix the critical problems. The double tax on S corporation 
stock held by an ESOP was eliminated by exempting income 
attributable to S corporation stock held by the ESOP from UBIT. 
Thus, only one level of tax was to be imposed, which would be 
imposed on the ESOP participant when he or she received a 
distribution from the ESOP. S corporation ESOPs also were given 
the right to distribute cash to participants in lieu of S 
corporation stock in order to address the problems of 
ineligible S corporation shareholders and the numerical limit 
on S corporation shareholders.
    In 1997 it was clear that a key feature of the legislation 
was that S corporation ESOPs would not have the same incentives 
afforded to C corporation ESOPs. The incentives provided to C 
corporation ESOPs that were not allowed to S corporation ESOPs 
under the 1996 Act, as described above, would continue to be 
allowed only to C corporation ESOPs. However, S corporation 
ESOPs would enjoy two benefits not available to C corporation 
ESOPs.
    First, the income of S corporation ESOPs under the 1997 Act 
is subject to only a single level of tax. This is an inherent 
attribute of the way S corporations and their shareholders are 
taxed, and in fact is the fundamental characteristic of the S 
corporation tax regime. No one, including the Administration, 
disputes that only one level of tax should be imposed on S 
corporations and their shareholders. The second benefit 
provided to S corporation ESOPs is that the one level of tax is 
deferred until benefits are distributed to ESOP participants. 
Considerable thought was given in 1997 to whether this deferral 
of tax should be allowed. Various ways of taxing S corporation 
ESOPs and their participants were considered in 1997, including 
ways essentially the same as the Administration's proposal, and 
were rejected as too complex, burdensome, and unworkable. In 
order to achieve a workable S corporation ESOP tax regime with 
incentives that were commensurate with those available to C 
corporation ESOPs, Congress determined that the deferral of the 
one level of tax, in lieu of the special incentives afforded to 
C corporation ESOPs, was appropriate. The Administration is 
rejecting this determination just 18 months after Congress has 
acted.

            The Administration's S Corporation ESOP Proposal

    The Administration proposes to reimpose UBIT on S 
corporation ESOPs, both new and old. The specific provisions 
relating to UBIT adopted in the 1997 Act would be repealed. As 
explained by Assistant Secretary Donald Lubick in his testimony 
before this Committee, the benefit of tax deferral would be 
eliminated by reimposing UBIT on S corporation ESOPs. 
Acknowledging that double taxation of S corporations and their 
shareholders is not appropriate, the Administration would 
provide S corporation ESOPs with a special deduction to be used 
against their liability for UBIT when distributions are made to 
ESOP participants.

   The Administration's S Corporation ESOP Proposal Would Frustrate 
                          Congressional Policy

    The Administration's S corporation ESOP proposal would 
frustrate the Congressional policy of allowing S corporations 
to establish ESOPs for their employees principally because the 
Administration proposal will not only end deferral, but also 
will reinstate double taxation. The Administration's proposal 
to allow a deduction to the ESOP for distributions to 
participants will not prevent double taxation.
    S corporation ESOPs will be required to pay UBIT for all 
the years that they hold S corporation stock, but will not be 
allowed any way to recover those taxes until distributions are 
made to participants. The rules limiting the timing of 
distributions by an ESOP to its employee participants, like the 
rules for all qualified retirement plans, encourage long-term 
retirement savings and are intended to produce the result that 
distributions to an employee will occur many years, even 
decades, after the employee first becomes a participant in the 
ESOP. A 2-year carryback and a 20-year carryforward of excess 
deductions will not ensure that the taxes paid by the ESOP over 
many years, even decades, will be recovered. Thus, there is no 
assurance that the deduction will prevent double taxation of 
employee benefits. In fact, the estimated revenue to be raised 
by the Administration's proposal is the same as the revenue 
cost of the 1997 Act, demonstrating that the Administration's 
proposal is simply an attempt to repeal the provisions of the 
1997 Act and is not aimed at preventing unintended uses of 
current law.
    The Administration's proposed scheme for eliminating tax 
deferral and attempting to prevent double taxation has another 
substantial defect. That is, any tax refunds to the ESOP for 
the tax deductions allowed to the ESOP cannot be fairly 
allocated and paid to the employee participants. Assume, for 
the sake of illustration, that employees A and B are the 
participants in an S corporation ESOP, each owning an equal 
number of shares of S corporation stock through the ESOP. A and 
B work for the next 20 years and the ESOP pays tax on the 
income of the S corporation attributable to their shares of 
stock. Then A decides to retire and the ESOP sells the shares 
of stock in A's account to the S corporation and pays A the 
proceeds. The ESOP would receive a deduction for the 
distribution to A and would be able to reduce its UBIT 
liability for the year it makes a distribution to A. In this 
example, there would be no way the ESOP could use the full 
amount of the deduction for the year it makes a distribution to 
A, nor would it be able to fully use the excess amount when it 
carries the excess deduction back two years. Thus, the ESOP 
would not be able to realize the full benefit of the deduction, 
which was supposed to allow the ESOP to recoup the taxes it 
paid over the past 20 years with respect to the stock in A's 
account and, presumably, give A that benefit to offset the 
second level of taxes A will pay. By the time the ESOP realizes 
all the benefits of the deduction, A will have long ceased to 
be a participant in the ESOP and those benefits will be 
allocated to the remaining participant, namely B.
    In addition, it is not clear how the ESOP could properly 
allocate the benefits that it can immediately realize. The 
deduction is allowed for distributions to participants. After 
the proceeds from the sale of the stock in A's account are 
distributed to A, A ceases to be a participant. The ESOP cannot 
make any additional allocations or distributions to A. As the 
sole remaining participant, B will receive the benefit of those 
deductions.
    The Administration's proposal also resurrects a problem 
under ERISA that the 1997 Act eliminated. The imposition of 
UBIT on S corporation ESOPs raises concerns about fiduciary 
obligations under ERISA for potential ESOP plan sponsors and 
trustees. The potential for double taxation and the inequitable 
allocation of benefits among plan participants will make the 
establishment of S corporation ESOPs unpalatable to anyone who 
would be subject to ERISA. In addition, qualified plan trustees 
typically avoid investments that give rise to UBIT because it 
obligates the trustee to file a federal income tax return for 
the plan's UBIT liability. Under the Administration's proposal, 
the establishment of an S corporation ESOP would necessarily 
involve making investments that give rise to UBIT liability 
because ESOPs are required to invest primarily in employer 
securities.
    The Administration's proposal attempts to characterize the 
treatment of S corporation ESOPs as a corporate tax shelter. 
The beneficiaries of S corporation ESOPs are employees, not the 
S corporation. Moreover, the IRS already has an arsenal of 
anti-abuse tools to deal with any unintended benefits from 
creating an S corporation ESOP. Current law was enacted to do 
just what it is doing--encouraging employee ownership of S 
corporations. Indeed, advocating the repeal of a successful 
retirement program directly contradicts the Administration's 
stated objective of increasing retirement savings, as reflected 
in the 17 retirement savings proposals included in its fiscal 
year 2000 budget.

     Conversions From C Corporation Status to S Corporation Status

    Under current law, the conversion of a C corporation into 
an S corporation (whether by electing S corporation status or 
by merging the C corporation into an existing S corporation) 
generally does not result in the recognition of gain or loss by 
either the C corporation or its shareholders. Current law 
limits the potential for using the tax-free conversion to S 
corporation status to shift appreciated assets from a C 
corporation to an S corporation in order to avoid the corporate 
level tax on the sale of the assets. Under current law, a 
corporate level tax is imposed on an S corporation if it sells 
appreciated assets within ten years of acquiring the assets in 
a conversion from C corporation status. S corporation 
shareholders are also taxed on the gain, reduced by the amount 
of tax paid by the S corporation.

   The Administration's Proposal to Tax Conversions to S Corporation 
                        Status Is Bad Tax Policy

    Under the Administration's proposal, a C corporation and 
its shareholders would be taxed on a conversion of the C 
corporation to S corporation status (whether by electing S 
corporation status or by merger into an existing S 
corporation), if the value of the corporation on the date of 
conversion is more than $5 million. By imposing a tax on the 
merger of C corporations into existing S corporations (and 
mergers preceded by the election of S corporation status by an 
existing C corporation), the Administration's proposal would 
unfairly inhibit the ability of S corporations to expand their 
businesses through corporate acquisitions. C corporations are 
allowed to make tax-free corporate acquisitions, but S 
corporations would be denied that privilege.
    This unfair result would, moreover, come at the price of 
burdensome complexity. The $5 million threshold value for 
imposing tax on S corporation conversions would create a 
``cliff'' effect that would result in disputes over valuation 
that would be difficult to resolve for corporations that are 
not publicly traded. In addition, more rules would be needed to 
address the murky issues of whether conversions below the $5 
million threshold were ``abusive'' transactions structured to 
avoid the conversion tax.
    The Administration's proposal may represent a first step 
towards the repeal of the S corporation tax regime. The 
restrictions on S corporations (primarily the ``one class of 
stock'' rule and limitations on the number and type of 
shareholders) do not compare favorably with the flexibility 
afforded limited liability companies, which have expanded the 
availability of corporate limited liability combined with a 
single level of tax. Therefore, the desirability of S 
corporation status for newly-formed businesses has been 
decreased. The Administration's proposal would decrease the 
desirability of C corporations converting to S corporation 
status. Enactment of the Administration's proposal would 
confine S corporation status principally to existing S 
corporations, at which point the opponents of the S corporation 
tax regime would challenge the need to preserve a separate tax 
regime for the benefit of only existing S corporations and 
their shareholders. The S corporation tax regime has served 
small businesses well for the past 40 years and there is no 
good reason to dismantle that regime now.

                               Conclusion

    Current law encourages employee ownership of S corporations 
and promotes employee retirement savings. Current law is 
working exactly as it was intended to work when Congress 
amended the ESOP rules for S corporations in the 1997 Act. 
Accordingly, CPPEO urges this Committee to reject the 
Administration's S corporation ESOP proposal. The tax and 
retirement policies reflected in the 1997 Act, resolved just a 
few months ago, should not now be undone.
    In addition, current law fairly treats corporate 
acquisitions by S corporations the same as corporate 
acquisitions by C corporations. Accordingly, CPPEO urges this 
Committee to reject the Administration's proposal to tax 
conversions to S corporation status. The Administration's 
proposal is not needed, would unfairly discriminate against S 
corporations, would add burdensome complexity to the tax law, 
and would threaten the continued existence of the S corporation 
tax regime.
      

                                

[By permission of the Chairman]

Statement of the Conservation Trust of Puerto Rico

                       Introduction and Overview

    This testimony outlines the comments of the Conservation 
Trust of Puerto Rico (``Conservation Trust'' or ``Trust'') on 
the Administration's fiscal year 2000 budget proposal to 
increase, for a five year period, the amount of the rum excise 
tax that is covered over to Puerto Rico and the U.S. Virgin 
Islands. The proposal would dedicate to the Conservation Trust 
a portion of the amount covered over to Puerto Rico. 
Congressman Phil Crane (R-IL) originally developed this 
proposal in the 105th Congress, after the Trust lost its 
funding source in 1996 upon repeal of the Qualified Possession 
Source Investment Income (``QPSII'') provisions of Section 936 
of the Internal Revenue Code (``Code'').
    The Trust strongly supports the short-term funding proposal 
included in the fiscal year 2000 budget request. Passage of 
this proposal would allow the Trust to become more independent 
by building a sufficient endowment to guarantee the Trust's 
long-term viability. This short-term plan has bipartisan Ways 
and Means Committee support, led by Congressmen Crane and 
Rangel (D-NY), and will help the Trust continue to meet its 
sole mission of preserving and protecting the most ecologically 
valuable natural lands and historic sites of Puerto Rico.

               Conservation Trust's Purpose and Financing

    The Conservation Trust is a non-profit institution 
specifically created to carry out a joint plan of the U.S. and 
Puerto Rico for the protection and enhancement of the natural 
resources and beauty of Puerto Rico. The Trust was established 
in 1968 by an agreement between the U.S. Department of the 
Interior and the Government of Puerto Rico. The Trust is 
classified by the Internal Revenue Service as exempt under 
501(c)(3) and 509(a)(3) of the Code as an institution organized 
and operated to perform the functions of the U.S. and Puerto 
Rico in the area of conservation. The Commonwealth Department 
of the Treasury also classifies the Trust as a non-profit 
institution.
    Since its inception, the Trust has acquired more than 6,000 
acres of endangered land and through various programs protects 
an additional 7,000 acres. The Trust's acquisition represents 
80% of all land acquired for permanent conservation in Puerto 
Rico by public or private entities over the last 20 years. The 
Trust also engages in educational programs which include, among 
other things, the design of environmental and conservation 
curricula, the adoption of schools, summer camps, and 
environmental interpretation of properties, and a reforestation 
program. Despite the Trust's active role, however, only 5% of 
the Island is under some protection by either the Federal or 
Commonwealth conservation agencies or the Conservation Trust.
    For the first 10 years of its existence, the Trust was 
funded through a fee imposed by the Department of the Interior 
on petroleum and petrochemical companies operating in Puerto 
Rico under the Oil Import Allocation Program. Upon expiration 
of the Oil Import Allocation Program, the Trust sustained its 
activities through the use of income generated by companies 
doing business in the Island and eligible to take the 
``possessions tax credit'' under Section 936 of the Code. The 
Trust was authorized by local law to participate in financial 
transactions that utilized QPSII. Through mid-1996, this 
funding mechanism generated almost 80% of the Trust's revenues.

  Section 936 Changes Eliminated Funding Source for Conservation Trust

    The Omnibus Budget Reconciliation Act of 1993 (``OBRA 
'93'') phased-down the possessions credit significantly during 
tax years 1994 to 1998. Additionally, OBRA '93 increased the 
rum tax cover over from $10.50 to $11.30 for the same five 
taxable years, ending on September 31, 1998. Viewing the 
Section 936 legislation as a signal that reliance on the QPSII 
program was infeasible and the program was at risk of being 
eliminated altogether after 1998, the Trust made significant 
adjustments to its land acquisition plans and capital 
improvement programs after passage of OBRA '93. In addition to 
these adjustments, a major portion of the Trust's yearly income 
was reallocated to build an endowment fund designed to reach 
$90 million by 1998.
    In 1996, however, Congress passed the Small Business Job 
Protection Act. This legislation repealed the QPSII provisions 
of Section 936, thereby cutting off an essential outside 
funding source much earlier than any such loss was expected.
    The elimination of the Section 936 and the QPSII provisions 
has had a substantial negative impact on the Trust's 
operations. Specifically, the repeal has eliminated the Trust's 
primary income source used to meet endowment goals. Since 
passage of the Small Business Job Protection Act in 1996, the 
volume of funds invested in Trust notes has decreased from an 
average of $1.3 billion to $1.4 billion to approximately $550 
million, of which $120 million is from pre-1997 long-term 
investments. Additionally, the net income made per transaction 
has diminished because of the increase in the rates the Trust 
must now pay to obtain new financing.
    The loss of Section 936 income has also impeded the Trust's 
ability to complete pre-1996 conservation efforts as well as 
start new projects. Prior to the repeal of Section 936, the 
Trust acquired and began restoring Esperanza, an historic sugar 
mill site on the Island. The Trust had also planned to purchase 
a salt landing necessary to preserving the fish and migratory 
bird population on the Island. The loss of QPSII funds, 
however, severely limited the Trust's ability to continue 
restoration efforts at Esperanza or to make additional 
acquisitions, such as the salt landing. The Trust's financial 
constraints are also inhibiting its ability to properly address 
the damage resulting from Hurricane Georges.
    The Trust has proven extremely effective at advancing its 
mission, however, there is still much more work that needs to 
be done. These goals will be impossible to reach without short-
term financing to build an endowment sufficient to guarantee 
the Trust's viability. Congressman Crane's proposal, which the 
Administration included in its Fiscal Year 2000 budget request, 
will provide such short-term support.

     Description of Current Law and Proposed Solution for the Trust

I. Current law.

    Section 5001 of the Internal Revenue Code (``the Code'') 
imposes an excise tax of $13.50 per proof gallon on distilled 
spirits made or imported into the U.S. Section 7652 of the Code 
further provides for a payment (a ``cover over'') of $10.50 per 
proof gallon of the excise tax levied on rum that is imported 
into the U.S., Puerto Rico, or the Virgin Islands.
    OBRA '93 provided that, for a five-year period, $11.30 of 
the excise tax be covered over to the treasury of Puerto Rico. 
After September 30, 1998, the amount covered over to Puerto 
Rico returned to the pre-OBRA '93 amount of $10.50.

II. Proposed Solution.

    The Administration's fiscal year 2000 budget proposal would 
increase the rum excise cover over from $10.50 to $13.50 per 
proof gallon for Puerto Rico and the Virgin Islands for five 
years, beginning October 1, 1999. Of such amount that is 
covered over to Puerto Rico, $.50 per proof gallon would be 
dedicated to the Trust. The proposal would be effective for rum 
imported or brought into the U.S. after September 30, 1999 and 
before October 1, 2004. This proposal is also reflected in 
legislation (S. 213) that Senator Daniel P. Moynihan (D-NY) 
introduced this year.

                               Conclusion

    Enactment of the cover-over proposal would allow the Trust 
to become more independent by building a sufficient endowment 
to guarantee the Trust's long-term viability. This short-term 
infusion would ensure that the Trust's managers, including the 
Department of the Interior, continue the Trust's mission of 
preserving the environmental and historic beauty of the Island 
of Puerto Rico.
      

                                

Statement of Richard C. Smith, Partner, Bryan Cave LLP, Niche 
Marketing, Inc., Costa Mesa, California, and Economics Concepts, Inc., 
Phoenix, Arizona

    Mr. Chairman and Members of the Committee:
    My name is Richard C. Smith, and I am a partner in the 
Phoenix, Arizona office of Bryan Cave LLP, a leading 
international law firm, where a significant portion of my 
practice involves counseling clients with respect to employee 
benefits and planning employee benefit plans and programs. I am 
submitting this statement for the record today on behalf of two 
clients that sponsor welfare benefit plans, Niche Marketing, 
Inc. of Costa Mesa, California, and Economic Concepts, Inc. of 
Phoenix, Arizona.
    We believe that the Administration's proposal to further 
limit the deductibility of contributions to multiple employer 
welfare benefit plans under sections 419 and 419A of the 
Internal Revenue Code is ill-advised and will undermine the 
ability of smaller employers to fund bona fide benefits to 
their employees at precisely the times in the business cycle 
when those benefits would be most needed. In our opinion, the 
Administration's proposal has gone further than is necessary to 
eliminate the abuses described by the Treasury Department in 
its explanation of the proposal.
    By way of background, sections 419 and 419A were enacted to 
limit certain abusive practices associated with the pre-funding 
of welfare benefits and generally limit such pre-funding, 
including severance and death benefits. Congress, however, 
permitted a limited exception to the general limitations for 
certain multiple employer welfare benefit funds with 10 or more 
participating employers where the relationship of participating 
employers would be closer to the relationship of insureds to an 
insurer than to the relationship of an employer to a fund.
    This exception for ten or more employer plans under section 
419A(f)(6) has the specific purpose of allowing small employers 
the ability to compete with larger employers in providing 
severance and death benefits to their employees. Major 
employers are able to fund such benefits on a pay-as-you-go 
basis because of their financial resources. Small employers do 
not have the cash resources to pay such benefits when they 
become due. In fact, because layoffs and terminations most 
often occur when there is a business slowdown--meaning cash 
flow or profits are not available--severance benefits are most 
important just at the time such employers are least likely to 
be able to pay for them. Thus, smaller employers were given the 
ability to fund such benefits in advance, when cash is 
available, in recognition that the cash to pay such benefits 
would likely be available to employers in the lean years.
    Rather than curtailing the ability of smaller employers to 
continue to provide bona fide severance and death benefits to 
their employees by eliminating whole classifications of 
benefits, as the Administration's proposal would do, 
legislation if enacted should focus on the perceived abuses. In 
that regard, the major perceived abuse cited in the Treasury 
Department General Explanation of Revenue Proposals in the 
Clinton Administration FY2000 Budget is the requirement that to 
qualify as a ten or more employer plan under Section 419A of 
the Code, the plan must not be experience rated with respect to 
individual participating employers.
    A plan may be deemed to be experience rated with respect to 
an individual employer because the employer (a) reaps the 
favorable economic consequences if its benefit costs are less 
than those assumed when the employer's premium was set, and (b) 
bears the economic risk that the benefit cost will exceed those 
assumed when the premium was set. Experience rating may reflect 
the employer's experience not only with regard to benefit 
payments, but also with regard to administrative costs or 
investment return. Thus, a plan provides an experience rating 
arrangement with respect to an employer if the employer's 
contributions are increased or decreased to reflect the benefit 
payments or administrative costs with respect to the employer's 
employees or the investment return with respect to the 
employer's contributions.
    In Robert D. Booth and Janice Booth v. Commissioner, 108 
T.C. No. 25 (1997), which was cited in the Treasury Department 
General Explanation, the Tax Court took the position that an 
experience rating arrangement may also include one where 
benefits rather than employer costs vary with fund experience. 
However, even under this definition of experience rating, gains 
or losses would still have to be segregated employer by 
employer for the plan to be experience rated with respect to 
individual participating employers.
    It is true that some plans have attempted to disguise 
experience rating by creating reserve or other similar funds to 
which experience gains and losses are allocated. The final 
disposition of such experience gains and losses in such case is 
often unclear and a portion thereof may be allocated solely to 
the group of employees of a particular employer with respect to 
which the experience gain or loss relates. However, alleviating 
this problem can be accomplished without eliminating severance 
or death benefits funded with other than group term insurance.
    This can be accomplished by first making sure that funding 
requirements in such plans are based solely on compensation, 
years of service, dates of employment, dates of birth, 
insurance risk classification and reasonable actuarial 
assumptions. Secondly, this can be accomplished by requiring 
that all experience as to benefit payments, forfeitures, 
investment returns, and administrative costs are allocated 
throughout the plan and the experience with respect to the 
employees of a particular employer are not segregated or 
allocated to that employer or its employee group. In addition, 
it could be required that all such experience gains or losses 
are allocated on an annual basis and not used to establish a 
reserve account. I would be happy to discuss these possible 
provisions with you further or suggest specific statutory 
changes if you wish.
    In summary, the operation of welfare benefit plans under 
section 419A(f)(6) of the Code enables small employers to 
provide severance and death benefits to their employees by 
allowing them to fund such benefits in advance when profits are 
sufficient to do so. In no case are any funds paid into such a 
plan ever permitted to revert to the employer that contributed 
them. The Administration's proposed changes would eliminate the 
use of cash value insurance that provides sufficient funding to 
pay future mortality costs and severance benefits. Rather than 
eliminating such benefits, the Committee should attempt to find 
ways to expand the ability for employees to receive insured 
death and severance benefits while merely eliminating abuses 
that have occurred in certain cases. This can be done by more 
carefully drafting the rules with respect to experience rating 
as described above. As we have seen in the pension and other 
areas in the past, if benefits are taken away from business 
owners, the rank and file employees are more likely than not to 
receive no benefits at all.
    We appreciate the Committee's attention and would be 
pleased to assist the Committee in resolving this important 
issue for the many thousands of small employers who rely in 
good faith on these plans to provide an important benefit to 
their employees.
      

                                

Statement of Edison Electric Institute

    The Edison Electric Institute (EEI) appreciates the 
opportunity to submit written comments to the Committee on Ways 
and Means regarding the Administration's FY 2000 revenue 
proposals.
    EEI is the association of United States shareholder-owned 
electric companies, international affiliates and industry 
associates worldwide. Our U.S. members serve over 90 percent of 
all customers served by the shareholder-owned segment of the 
industry. They generate approximately three-quarters of all the 
electricity generated by electric companies in the country and 
service about 70 percent of all ultimate customers in the 
nation.
    The 135 revenue proposals included in the Administration's 
fiscal year 2000 budget cover a broad range of topics, many of 
which are of interest to EEI. However, rather than comment on 
numerous provisions contained in the Administration's budget 
and potentially obscure the issues of critical importance to 
the electric industry, EEI will comment on three areas that are 
unique to the electric industry: fair competition between 
electric utilities, adequate funding of nuclear plant 
decommissioning, and the extension and modification of the 
production tax credit for wind and biomass facilities. EEI will 
also comment on the provisions dealing with tax shelters 
because this provision has the potential to adversely impact 
numerous taxpayers including shareholder owned utilities. EEI 
would be pleased to work with the Committee on any proposals 
that will be considered by the Committee for legislative 
action.

    TREATMENT OF BONDS ISSUED TO FINANCE ELECTRIC OUTPUT FACILITIES

    The electricity industry is shifting from regulation to the 
use of competitive markets to sell power and related services 
and products. For competition to work, the Federal government 
needs to address the artificial competitive advantages of tax-
exemptions and tax-exempt financing used by government-owned 
utilities when competing against other sellers of electricity, 
so that all competitors can participate in open markets under 
the same set of rules.
    Shareholder-owned and government-owned utilities grew up 
contemporaneously, but represented distinctly different 
approaches to providing electrical power. Shareholder-owned 
utilities started out as entrepreneurial businesses mainly 
serving towns and cities and they were taxed like any other 
business. By contrast, government-owned utilities came into 
their own during the 1930s, when only about 15 percent of 
small-town America had access to electricity. Tax-exemptions 
and other kinds of government subsidies were used to finance 
electrification in an attempt to break the grip of the Great 
Depression. Today, 99 percent of America is electrified.
    Up to now, the two systems have lived side-by-side serving 
customers in their geographically defined service areas. The 
different tax treatment of the two types of utilities creates 
profound problems when they compete in open markets. In order 
for competition to work well, the marketplace, and not tax law, 
must determine the outcome. In a competitive marketplace, 
providing some competitors with federal tax subsidies in the 
form of exemption from income tax and the ability to finance 
facilities using tax-exempt debt, merely because they are 
instruments of State or local governments, can alter the 
competitive outcome and result in a misallocation of societal 
resources. The Council of Economic Advisers stated in the 
``Economic Report of the President'' (Transmitted to Congress 
February 1996) on pages 188-189 that:

          ``For competition to work well, it must take place on a level 
        playing field: competition will be distorted if producers are 
        given selective privileges ... to further even legitimate 
        social goals. ... As competition grows, increasing distortions 
        may result from some entities having access to special 
        privileges such as federally tax-exempt bonds ...''

    When these tax-exemptions and tax-free bonds are used in 
competitive markets, they act as subsidies that undermine 
competition. As competitive markets are beginning to form, now 
is the time to address the problem.

The Administration's Proposal

    EEI supports the Administration's approach to addressing 
this problem in that it acknowledges the need to change current 
tax law to reflect the move to a competitive industry. It does 
so by stipulating that no new facilities for electric 
transmission or generation may be financed with tax-exempt 
bonds. This represents a good start from which to resolve these 
important issues.

Congressional Proposals

    EEI strongly believes that there is no essential 
governmental purpose served when a governmental utility goes 
outside its service territory and sells output into areas in 
which it has no legitimate governmental interest. Rather, such 
a governmental utility is acting as a commercial entity and 
should be treated as such. It should no longer be able to issue 
new tax-exempt debt to finance power plants or transmission 
facilities, and it should be subject to Federal income tax on 
the income from the sales it makes to persons outside its 
historical service area. Legislation accomplishing this 
objective will be introduced this month by Representative Phil 
English. EEI strongly supports this legislation and encourages 
the Committee on Ways and Means to consider it during its 
deliberations on a tax bill this year.
    Legislation (H.R.721) also has been introduced that would 
broaden the ability of government-owned utilities to leverage 
their tax preferences to compete against taxpaying utilities. 
It would allow government-owned utilities to sell power from 
federally subsidized facilities to customers outside their 
existing service territory without paying income tax on profits 
from those sales. It would considerably broaden the ability of 
government-owned utilities to build new transmission facilities 
with tax-exempt bonds, facilitating government control of 
transmission as the industry deregulates. EEI, therefore, 
opposes this bill as it runs contrary to both the English and 
Administration proposals.

      TREATMENT OF CONTRIBUTIONS TO NUCLEAR DECOMMISSIONING TRUSTS

    Code Section 468A allows a special rule for the future 
costs of decommissioning nuclear power plants. A current 
deduction is allowed for contributions to a qualified external 
trust fund (``Fund''), the net assets of which are to be used 
exclusively to provide for the safe and timely decommissioning 
of a taxpayer's nuclear plant.
    As Code Section 468A was being considered in 1984, Congress 
was concerned about time value of money advantages then 
described as ``premature accruals.'' Nuclear plant 
decommissioning involves a significant fixed liability that, in 
a regulated environment, is ideally suited for funding during 
the operating life of the plant. Funding in this manner assures 
that the electric customers that receive the electricity from 
the plant also pay their ratable share of the decommissioning 
costs. Safe and environmentally acceptable decommissioning was 
considered of sufficient national importance to warrant a 
special tax deduction. Congress did not intend that this 
deduction would lower the taxes paid by the owner of a nuclear 
plant in present value terms. The time value of money concern 
was redressed by requiring that the income earned by the Fund 
be taxed as it is earned and also taxed a second time when the 
trust's funds are withdrawn by the plant owner to pay 
decommissioning costs.\1\
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    \1\ The fund is, in fact, a grantor trust for all purposes save 
federal tax purposes. Section 468A(e)(2) taxes the fund as if it were a 
corporation. However, in the case of a normal grantor trust, previously 
taxed income would not be treated as income again as funds are 
withdrawn.
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    The original intent of Congress was to spread the deduction 
of decommissioning costs over the operating life of the plant 
and also to facilitate the creation of a dedicated external 
trust fund.\2\ This was accomplished with Section 468(A) which 
facilitates contributions to an independent trust to provide 
reasonable assurance that the amounts will be available to pay 
for the costs of decommissioning. We believe the current 
circumstances have changed considerably and current provisions 
of 468(A) are no longer pertinent nor appropriate.
---------------------------------------------------------------------------
    \2\ 1984 Tax Reform Act, Legislative Background of Senate Finance 
Committee Deficit Reduction Provisions, pages 277-9.
---------------------------------------------------------------------------
    In addition to imposing a double tax on earnings, Congress 
imposed limits: (1) to prevent the accumulation of more monies 
in a Fund than are required to fund the portion of future 
decommissioning costs allocable to the remaining plant life, 
and (2) to ensure that contributions to the reserve are not 
accelerated.
    In an era in which the remaining lives of many nuclear 
plants are being revised downward, restrictions that are based 
upon concerns over accumulating more funds than are required or 
accelerated funding are no longer well-founded. The important 
national concern is that funds will be available when needed to 
pay the costs of decommissioning. In fact, the limitations that 
restrict the annual amount of qualified contributions could 
serve as a deterrent to the transferability of the ownership 
interest in the nuclear plants or in the deregulation of the 
electric generation. Proper tax and public policy should be to 
allow a tax deduction for nuclear decommissioning when the net 
present value of the decommissioning liability is contributed 
to the independent trust fund. For this reason, EEI strongly 
believes that the purposes of these limits are no longer 
appropriate due to changes in the electric industry.
    In addition, Congress required that the contribution to the 
Fund be paid only from monies, collected under regulatory 
authority, from customers for that specific purpose. As 
generating plants are deregulated this limitation may have the 
unintended effect of prohibiting deductions for funding 
decommissioning. Put another way, no regulatory authority, no 
deduction. The Administration is to be commended for proposing 
the repeal of this limitation.

                ENERGY AND ENVIRONMENTAL TAX PROVISIONS

    As producers of electricity and processors of the earth's 
finite fuels, electric utilities continue to support the use of 
tax credits to sponsor both the efficient uses of electricity 
and the generation of electricity from wind or biomass.

Wind

    The production tax credit (PTC) for wind (and closed-loop 
biomass) facilities will expire on July 1, 1999. To promote the 
continued development of wind energy production in the United 
States, the Administration's budget includes a five-year 
extension of the PTC. The credit provides an inflation-adjusted 
1.5 cents/kilowatt-hour credit for electricity produced from a 
new U.S. wind facility for the first ten years of its 
existence. The credit is only available if the wind energy 
equipment is located in the U.S. and electricity is generated 
and sold in the marketplace.
    The PTC assists wind-generated energy in competing with 
fossil fuel-generated power. In the 1980's electricity 
generated with wind could cost as much as 25 cents/kilowatt-
hour. Since then wind energy production has increased its 
efficiency by a remarkable 80% to the current cost of under 5 
cents/kilowatt hour. The current 1.7 cents/kilowatt-hour credit 
enables the industry to compete with other generating sources 
being sold within the range of 3 cents/kilowatt-hour. The 
extension of the credit will enable the industry to continue to 
develop and improve its technology so it will be able to fully 
stand on its own in only a few years. Indeed, experts predict 
the cost of wind equipment alone can be reduced by another 40% 
from current levels with an appropriate commitment of resources 
to research and development. This is exactly what Congress 
envisioned when it enacted the PTC, the development and 
improvement of wind energy technology.
    The immediate extension of the PTC is critical. Since the 
PTC is a production credit available only for energy actually 
produced from new facilities, the credit is inextricably tied 
to the financing and development of new facilities. The 
financing and permitting requirements for a new wind facility 
often require up to three or more years of lead-time. With the 
credit due to expire on June 30, 1999, wind energy developers 
and investors can not plan any new projects without the 
assurance of the continued availability of the PTC. The 
immediate extension of the PTC is therefore critical to 
continued development of the wind energy market.
    The Administration is to be commended for its commitment to 
promote the continued development and improvement of wind 
energy technology. At this stage of development, wind power is 
unable to compete head to head with traditional electric 
generation. The potential for further improvement exists and it 
is therefore prudent to encourage development of this industry 
with the extension of the PTC.

Biomass

    The purpose of the closed-loop biomass credit is to provide 
an incentive for locking carbon into plant cellulose material 
temporarily, which reduces carbon dioxide's effect on global 
warming.
    The present biomass credit, which requires that the crop 
must be raised for the exclusive use of producing electricity, 
has not been effective. To our knowledge there is not one 
facility in the nation that has been able to take advantage of 
this credit.
    However, electricity from crop by-products can accomplish 
essentially the same purpose. Natural decomposition of forest 
and agricultural by-products produce greenhouse gasses such as 
methane in addition to carbon dioxide. Using forest or 
agricultural by-products to produce electricity would serve the 
dual role of reducing the use of irreplaceable fossil fuel, 
allowing fossil fuel carbon to remain trapped, and the 
conversion of otherwise wasted biomass products to valuable 
fuel. The proposed definition allowing forest and agriculture 
by-products to qualify as creditable biomass would provide the 
needed economic stimulus that was originally intended for the 
closed-loop biomass credit. EEI, therefore, believes that the 
broadened definition of biomass fuel and the extension of the 
tax credit are required steps to increase electric generation 
from this fuel source.

         UNDERSTATEMENT PENALTY FOR ``CORPORATE TAX SHELTERS''

    EEI believes that proposed modifications to the 
understatement penalty which proposes an automatic 40% penalty 
based upon an overly broad and vague definition of ``corporate 
tax shelter'' will cause major problems and interfere with 
legitimate transactions. The 40% penalty question turns on 
whether the arrangements of corporate affairs so that taxes 
would be as low as possible were ``clearly contemplated by the 
applicable provision (taking into account the Congressional 
purpose for such provision and the interaction of such 
provision with other provisions of the Code.)''
    The clearly contemplated Congressional purpose of the 
provisions of the Internal Revenue Code is currently the topic 
of discussion at innumerable IRS Appellate hearings and court 
cases. If the actual results of the IRS administrative appeals 
process as reported by the General Accounting Office and court 
case results of our members are valid indications of what 
Congress clearly intended, the statistics demonstrate that the 
disputed adjustments of the IRS agents are incorrect 80% of the 
time.\3\ The record of the IRS Agents demonstrates that when it 
comes to determining what is the clearly contemplated 
Congressional purpose for such provision, the clear intention 
appears to be more apparent to the corporate tax professionals 
than IRS tax professionals.
---------------------------------------------------------------------------
    \3\ GAO/GGD-98-128 IRS Audit Results and Cost Measures Coordinated 
Examination Program results, Table 2, page 10.
---------------------------------------------------------------------------
    Complex tax law will result in legitimate differences of 
opinion. Different minds do understand the facts and the law 
differently. Corporate tax professionals and IRS tax 
professionals can deal within this technical realm, and the 
substantial tax dollars and interest dollars in the balance. 
The injection of a penalty into this situation is an altogether 
different matter. A penalty, especially a penalty of this 
magnitude, calls into question the honesty of the corporate tax 
professionals and the corporate officers. The Administration is 
proposing to inject a punishing 40% penalty for misinterpreting 
the Congressional purpose without any consideration of a 
determination, made contemporaneously with the decision to 
enter into the transaction, that the position taken was more 
likely than not to prevail and without consideration of any 
reasonable cause.
    The proper forum for dispute resolution is one that focuses 
on the merits of the issue and the plain meaning of the law 
which the penalty provision makes infinitely more complex. The 
40% nondeductible provision will lead to deep seeded taxpayer 
resentment of the tax system. The national system of taxation 
will not be improved by the addition of a 40% penalty, based 
upon the subjective opinion of the taxing authority, as to 
whether or not a transaction was entered into for the purpose 
of keeping taxes as low as possible within the clearly 
contemplated Congressional purpose.\4\
---------------------------------------------------------------------------
    \4\ We also agree with Judge Learned Hand who stated, ``There is 
nothing sinister in so arranging one's affairs to keep taxes as low as 
possible.''
---------------------------------------------------------------------------

                               CONCLUSION

    EEI believes that a level playing field is essential for 
efficient competition in the electric industry. Although the 
Administration has proposed to reduce the prospective subsidies 
received by governmental utilities through tax-exempt 
financing, the Administration has not addressed their exemption 
from income tax. EEI recommends that the Committee should 
disallow the use of tax-exempt financing for government owned 
utilities which choose to sell more than a de minimus amount of 
electricity outside their municipal boundaries.
    EEI supports the Administration's proposal to repeal the 
cost of service requirement for contributions to a qualified 
nuclear decommissioning fund. In addition, EEI believes that 
the qualifying percentage and the limitation based on ruling 
amounts should also be repealed.
    EEI supports the Administration's proposal for the five-
year extension of the production tax credit for wind and 
biomass facilities.
    EEI also is concerned about the broad definition of an 
improper corporate tax shelter and the unfavorable effect it 
will have on our tax system.
      

                                

Statement of Employer-Owned Life Insurance Coalition

    This statement presents the views of the Employer-Owned 
Life Insurance Coalition, a broad coalition of employers 
concerned by the provision in the Administration's fiscal year 
2000 budget that would increase the taxes of leveraged owners 
of life insurance policies.

  Congress Should Reject the Administration's Life Insurance Proposals

    The Administration's fiscal year 2000 budget proposal would 
increase taxes of highly-leveraged taxpayers that purchase life 
insurance. Businesses purchasing insurance on the lives of 
their employees would be denied a portion of the deduction to 
which they are otherwise entitled for ordinary and necessary 
interest expenses unrelated to the purchase of life insurance. 
The Administration's characterization of this proposal as 
eliminating a ``tax shelter'' obscures the real goal of this 
proposal, which is to tax the accumulated cash value, commonly 
known as ``inside buildup,'' within these policies.
    Congress has consistently refused to tax inside buildup 
and, for the reasons set forth below, we urge Congress to 
reject this ill-conceived proposal as well.

 Disguised Attack on Historical Treatment of Traditional Life Insurance

    The Administration's proposal drives at the heart of 
permanent life insurance. Although the Treasury Department has 
characterized the proposal as preventing ``tax arbitrage,'' the 
proposal in reality targets the very essence of traditional 
permanent life insurance: the inside buildup. The 
Administration's proposal would impose a new tax on businesses 
based on the cash value of their life insurance policies.
    The Administration's proposal would deny a portion of a 
business's otherwise allowable interest expense deductions 
based on the cash value of insurance purchased by the business 
on the lives of its employees. Though thinly disguised as a 
limitation on interest expenses deductions, the proposal 
generally would have the same effect as a tax on inside 
buildup. Similar to a tax on inside buildup, the interest 
disallowance would be measured by reference to the cash values 
of the business's insurance policies--as the cash values 
increase the disallowance would increase, resulting in 
additional tax. So while not a direct tax on inside buildup, 
the effect would be similar--accumulate cash value in a life 
insurance policy, pay an additional tax.

     Historical Tax Treatment of Permanent Life Insurance is Sound

    The Administration's proposal would change the fundamental 
tax treatment of traditional life insurance that has been in 
place since the federal tax code was first enacted in 1913. 
Congress has on a number of occasions considered, and each time 
rejected, proposals to alter this treatment. In fact, just last 
year, Congress rejected a number of proposals, including the 
proposal now under consideration, to tax inside build up. 
Nothing has changed that would alter the considered judgment of 
prior Congresses that the historical tax treatment of 
traditional life insurance is grounded in sound policy and 
should not be modified.
    Among the reasons we believe that these latest attacks on 
life insurance are particularly unjustified, unnecessary and 
unwise are--

Cash Value is Incidental to Permanent Life Insurance Protection

    The cash value of life insurance is merely an incident of 
the basic plan called ``permanent life insurance'' whereby 
premiums to provide protection against the risk of premature 
death are paid on a level basis for the insured's lifetime or 
some other extended period of years. In the early years of a 
policy, premiums necessarily exceed the cost of comparable term 
insurance. These excess premiums are reflected in the ``cash 
value'' of the policy. As fairness would dictate, the insurance 
company credits interest to the accumulated cash value, which 
helps finance the cost of coverage in later years, reducing 
aggregate premium costs.
    Thus, while a permanent life insurance policy in a sense 
has an investment component, this feature is incidental to the 
underlying purpose of the policy. The essential nature of the 
arrangement is always protection against the risk of premature 
death. For businesses, life insurance protects against the 
economic devastation that can occur with the death of an 
invaluable employee or the business owner. Life insurance is a 
cost-effective way to obtain this protection because the costs 
for life insurance do not increase as the covered individual 
ages.
    While some might conclude that only small businesses need 
the stability provided by permanent life insurance, this is not 
in fact true. All corporations are susceptible to catastrophic 
economic losses resulting from the death of an invaluable 
employee. Large corporations use permanent life insurance to 
protect against, and level out the costs associated with, the 
economic uncertainty the possibility of such future losses 
creates. The United States Court of Appeals for the Seventh 
Circuit,\1\ discussing why corporations purchase liability 
insurance, noted that:
---------------------------------------------------------------------------
    \1\ Sears, Roebuck and Co. v. Commissioner, 972 F.2d 858, 862 (7th 
Cir., 1992)

          Corporations . . . do not insure to protect their wealth and 
        future income, as natural persons do, or to provide income 
        replacement or a substitute for bequests to their heirs (which 
        is why natural persons buy life insurance). Investors can 
        ``insure'' against large risks in one line of business more 
        cheaply than do corporations, without the moral hazard and 
        adverse selection and loading costs: they diversify their 
        portfolios of stock. Instead corporations insure to spread the 
        costs of casualties over time. Bad experience concentrated in a 
        single year, which might cause bankruptcy (and its associated 
---------------------------------------------------------------------------
        transaction costs), can be paid for over several years.

    A regular, level, predictable life insurance premium 
replaces the uncertainty of large, unpredictable losses caused 
by the death of such an employee. This predictability frees all 
corporations to make long term plans for business development 
and growth.

The Tax Code Already Strictly Limits Cash Value Accumulations

    The Administration's proposal ignores the major overhauls 
of life insurance taxation made by Congress over the past 20 
years. These reforms have resulted in a set of stringent 
standards that ensure that life insurance policies cannot be 
used to cloak inappropriate investments.
    The most significant reforms occurred in the 1980's, when 
Congress and the Treasury undertook a thorough study of life 
insurance. It was recognized that while all life insurance 
policies provided protection in the event of death, some 
policies were so heavily investment oriented that their 
investment aspects outweighed the protection element. After 
much study, Congress established stringent statutory 
guidelines, approved by the Administration, that limit life 
insurance tax benefits at both the company and policyholder 
levels to those policies whose predominant purpose is the 
provision of life insurance protection.
     In 1982, Congress first applied temporary 
``guideline premium'' limitations to certain flexible premium 
insurance contracts;
     In 1984, Congress revised and tightened these 
limitations and extended them to all life insurance products;
     In 1986, the Congress again reviewed these 
definitional guidelines, making additional technical and 
clarifying changes;
     Finally, in 1988, the Congress again addressed 
these issues, developing still more restrictive rules for 
certain modified endowment contracts and modifying the rules 
applicable to life insurance contracts to require that premiums 
applicable to mortality charges be reasonable, as defined by 
Treasury regulation.
    Today, these guidelines (set forth in sections 7702 and 
7702A of the Internal Revenue Code) significantly limit the 
investment element of any policy by requiring specific 
relationships between death benefits and policy accumulations 
under complicated technical rules (the so-called cash value 
test or the guideline premium/cash value corridor tests). 
Policies that cannot meet these limitations were deemed 
``investment oriented'' in the judgment of Congress and are not 
eligible for tax treatment as life insurance.
    On the other hand, Congress and the Administration clearly 
intended that inside buildup within policies satisfying the new 
criteria would not be subject to taxation. In fact, 
policymakers concluded that with the tightening of the 
definition of life insurance and the placing of narrower limits 
on the investment orientation of policies, there was all the 
more reason for continuing an exemption for inside buildup. 
Buck Chapoton, then Assistant Secretary of the Treasury for Tax 
Policy testified on this point before a Ways & Means 
subcommittee in 1983, explaining that:

          the treatment of [inside buildup bears] an important 
        relationship to the definition of life insurance; that is, to 
        the extent the definition of life insurance is tightened, 
        thereby placing narrower limits on the investment orientation 
        of a life insurance policy, there is more reason for allowing 
        favorable tax treatment to the [inside buildup] under policies 
        that fall under a tighter definition. [Tax Treatment of Life 
        Insurance; Hearings Before the Subcommittee on Select Revenue 
        Measures of the House Committee on Ways and Means, May 10, 
        1983, 98th Cong., 1st Sess. 16 (1983).]

    Congress proceeded on this basis and, as noted above, in 
1984 established a tighter and narrower definition of life 
insurance.
    In addition to blessing the continuation of tax benefits 
for inside buildup within life insurance contracts when it 
considered these issues in the 1982, 1984, 1986 and 1988 
legislation described above, Congress did so on numerous other 
occasions by failing to enact Treasury proposals to tax inside 
buildup. For example, notwithstanding Treasury proposals to tax 
inside buildup contained in the 1978 Blueprints for Tax Reform, 
the November, 1984 Treasury Tax Reform proposals, the 1985 Tax 
Reform Proposals and various budget proposals in the 90's, 
Congress consistently refused to tax inside buildup within life 
insurance policies.

The Tax Code Already Prevents Abusive Leveraging of Life 
Insurance

    Businesses purchasing life insurance policies that satisfy 
the rigorous life insurance qualification tests are still 
further restricted in the funding and use of those policies. 
Since 1964, the Internal Revenue Code has denied interest 
deductions on Loans traceable to the acquisition or holding of 
a life insurance policy. However, Congress has always 
distinguished between the perceived abuses of life insurance 
and the legitimate use of life insurance.
    Congress has implicitly endorsed continuation of inside 
buildup in each of the past three years while addressing 
specific perceived abuses. In 1996 it considered and addressed 
certain perceived problems with policy loans by repealing the 
deduction for interest on policy loans. However, no attempt was 
made to tax inside build-up generally.
    In 1997, Congress became concerned that Fannie Mae intended 
to use its quasi-federal status and preferred borrowing 
position to purchase coverage for its customers (denying a 
portion of Fannie Mae's otherwise applicable interest 
deductions). When drafting the interest disallowance, Congress 
distinguished its concerns regarding what was considered to be 
Fannie Mae's inappropriate efforts to exploit its preferred 
borrowing position from the typical situation involving 
employer-owned policies. As a result, Congress provided a clear 
exemption for policies purchased by a business on employees, 
officers, directors and 20-percent owners.
    Finally, just last year Congress rejected the same indirect 
attack on inside buildup the Administration proposes again this 
year. In the same year, however, Congress again demonstrated 
its commitment to preserving tax-favored status for employer 
policies by enacting additional technical corrections to 
clarify the scope of the exemption enacted in 1997 (e.g. to 
cover former employees, group contracts, etc.).
    In 1998, the Administration's fiscal year 1999 budget also 
contained direct assaults on the tax preferred status of inside 
build up in proposals designed to tax inside build up in 
certain policy changes and transactions involving insurance 
company separate accounts as well as through adjustments to 
annuity basis rules. These proposals were widely criticized, 
and Congress rejected all of them. This year, the 
Administration has abandoned this direct attack in favor of an 
indirect taxation of inside buildup.
    In each of the past three years, Congress was asked to 
address concerns over perceived exploitation of certain tax 
benefits related to life insurance. It had the opportunity to 
impose sweeping, across the board changes to the traditional 
taxation of life insurance policies. Congress rejected this 
course, choosing instead to pursue a reasoned middle course. 
Legislation was crafted to narrowly address specific concerns 
without trimming any of the core tax benefits afforded with 
respect to inside buildup.
    Given this detailed review of life insurance policies, 
employers reasonably relied on the continued availability of 
inside buildup with respect to the policies they previously 
held, as well as in subsequent policy purchases. Similarly, 
carriers reasonably relied on the continued availability of 
inside buildup in developing and marketing insurance policies. 
Treasury's attempt, once again, to reverse Congress's well 
reasoned decision is unconscionable. For yet another year, 
policyholders and carriers made business decisions in reliance 
on congressional decisions and are again thrown into turmoil as 
a result of the Administration's thinly disguised attack on 
inside buildup. Consistent with every prior, Congressional 
decision on this issue, this proposal must AGAIN be summarily 
rejected.

Purchase of Life Insurance Has Recognized, Legitimate Business 
Purposes

    In re-proposing this disallowance, the Administration has 
attempted to shift Congressional attention away from the 
proposal's unstated goal of taxing the inside buildup by 
labeling the proposal, not as a proposed insurance tax 
modification as it did last year, but as a corporate tax 
shelter. Nothing has changed in the proposal from last year to 
this year except the packaging. The proposal is still just an 
attack on inside build up--it is not an attempt to eliminate a 
tax shelter because no tax shelter exists.
    The Administration would have you believe that every 
business purchasing life insurance is engaging in tax arbitrage 
if that business is or becomes leveraged. It is irrelevant 
under the Administration's proposal that the debt was acquired 
at a different time, or that the business had distinctly 
separate, but equally valid, non-tax business reasons for 
acquiring a life insurance policy and incurring debt. The 
purchase of a life insurance policy will ``taint'' previously, 
legitimately acquired debt, and the existence of a life 
insurance policy will ``taint'' any debt acquired after the 
life insurance policy is purchased.
    Legitimate business purposes exist for purchasing life 
insurance. Similarly, businesses incur debt for equally valid 
business reasons. But there is no room in the Administration's 
proposal to recognize the potentially valid reasons for 
engaging in two unrelated transactions. This approach 
completely disregards Congress's long-standing respect for and 
support of, debt-financed transactions and the purchase of life 
insurance by businesses.

             Appreciation in Cash Value Should Not Be Taxed

Long-Term Investment Should be Encouraged, Not Penalized

    Permanent life insurance provides significant amounts of 
long-term funds for investment in the U.S. economy. These funds 
are attributable to permitted levels of policy investment. 
Businesses acquire life insurance policies to provide 
protection against the death of a valued employee or owner as 
well as a funding vehicle for many employee benefits, often 
including retiree benefits. These reasons for purchasing and 
maintaining life insurance policies benefit the U.S. economy. 
By ensuring that fewer businesses fail due to the death of an 
invaluable individual other employees are still employed. By 
funding employee benefits, more active employees and retirees 
are provided for, which reduces the strain on public benefits.
    The incidental investment element inherent in permanent 
life insurance should, if anything, be encouraged, not 
penalized. Congress and the Administration have repeatedly 
emphasized the need to increase U.S. savings, especially long 
term and retirement savings. Recent efforts have used the tax 
code to encourage savings, not penalize them. Consider, for 
example, the recent expansion of IRAs, the introduction of Roth 
IRAs and education IRAs, as well as small employer savings 
vehicles like the SIMPLE. Given these savings goals, the 
Administration proposal to significantly reduce or eliminate 
business's efforts to fund long-term employee benefits and 
retirement savings programs for their employees appears 
especially misguided.

Unrealized Appreciation Should Not be Taxed

    There is another, more fundamental, reason why the 
incidental investment inherent in permanent life insurance 
should not be taxed currently: accumulating cash values 
represent unrealized appreciation. Taxing a business currently 
on the increase in the cash value of a life insurance policy 
would be like taxing a homeowner each year on the appreciation 
in value of the home even though the home has not been sold. 
This would be inconsistent with historical and fundamental 
concepts of the federal income tax and contrary to the 
traditional principle that the government should not tax 
unrealized amounts which taxpayers cannot receive without 
giving up important rights and benefits. Taxing life insurance 
policyholders on accumulating cash values would single out life 
insurance by withdrawing the protection generally provided 
against taxation of an amount the receipt of which is subject 
to substantial restrictions. Given that much of this 
``investment'' actually reflects a prepayment of premiums 
designed to spread costs levelly over the insured's life, this 
would be especially inappropriate.

     Ordinary and Necessary Interest Expenses Should be Deductible

    The Administration's proposal to disallow otherwise 
deductible interest expenses is inconsistent with fundamental 
income tax principles.

Interest Payments are an Ordinary and Necessary Business 
Expense

    It is difficult to comprehend how an otherwise ordinary and 
necessary business expense loses its status as such solely 
because a business purchases life insurance on its employees. 
For example, few would argue that if Acme Computer borrows 
funds to help finance the cost of a new supercomputer assembly 
plant, the interest Acme pays on the debt is a legitimate 
business expense that is properly deductible. How can it be 
that if Acme decides it is prudent to purchase life insurance 
on the leader of the team that developed the supercomputer--to 
help offset the inevitable transition costs that would follow 
the team leader's unexpected death--that a portion of the 
interest payments is suddenly no longer considered a legitimate 
business expense? This is precisely the effect of the 
Administration's proposal.
    To fully appreciate this provision, apply the underlying 
rationale to an individual taxpayer: Should any homeowner who 
purchases or holds life insurance be denied a portion of the 
otherwise applicable deduction for mortgage interest? Or, 
carrying the analogy a bit further, should any homebuyer who 
contributes to an IRA or a section 401(k) plan (thereby 
receiving the tax benefits of tax deferral or, in the case of a 
Roth IRA, tax exemption) be denied a portion of the otherwise 
applicable deduction for mortgage interest?
    The Treasury Department asserts that the deduction denial 
would prevent tax arbitrage in connection with cash value 
policies. However, the proposal does not apply to debt directly 
or even indirectly secured by cash values; interest on such 
amounts is nondeductible under current law. Section 264 of the 
Internal Revenue Code disallows a deduction for interest on 
policy loans from the insurer as well as on loans from third 
parties to the extent the debt is traceable to the decision to 
purchase or maintain a policy. Thus, the only interest 
deductions that would be affected by the proposal would be 
those attributable to unrelated business debt--loans secured by 
anything but life insurance. The arbitrage concern is a red 
herring; the real target is inside buildup.
    If the Administration has concerns about the insurance 
policy purchased on the life of the team leader, then it should 
say so--and it should address the issue directly. It is 
inappropriate to deny instead a legitimate business expense 
deduction as an indirect means of taxing inside buildup. 
Congress, for sound policy reasons, has steadfastly refused to 
enact proposals that more directly attack inside buildup; it 
should similarly refuse to enact this proposal.

Disproportionate Impact on Similar Businesses

    The Administration's proposal to impose a tax penalty on 
businesses that purchase life insurance on their employees 
would have a disproportionate impact on highly-leveraged 
businesses. For financial institutions that are generally 
highly-leveraged because assets of their customers are 
generally viewed as debt of the institution, the effects of the 
proposal would be disproportionately harsh. This is 
inconsistent with a fundamental tenet of the tax laws that, to 
the extent possible, taxation should be neutral with respect to 
core business decisions such as the appropriate degree of debt. 
It is also patently unfair and without policy justification.
    To illustrate the disproportionate burden on highly-
leveraged businesses, take the following example: Assume two 
competing companies, each with $50 million in assets. Company A 
has $2 million in outstanding debt, with an annual interest 
expense of $150,000. Company B has $20 million in outstanding 
debt, with an annual interest expense of $1.8 million.

          If Company A purchases an insurance policy on the life of its 
        resident genius, Company A would be required to forego a 
        portion of the interest expense on its outstanding debt. For 
        example, if the cash value of the policy were $5 million, one-
        tenth of the annual interest expense, or $15,000, would not be 
        deductible.
          If Company B buys the same policy for its resident genius, it 
        too would be required to forego one-tenth of its interest 
        expense deduction. However, for Company B, this amounts to a 
        foregone deduction of $180,000--12 times the amount foregone by 
        Company A.

    The deduction disallowances illustrated above would occur 
each year, compounding the disproportionate impact on Company 
B. Over a span of 30 years, Company B could lose interest 
deductions in excess of $5.4 million--while Company A might 
lose closer to $450,000.
    Whatever one's beliefs about the proper tax treatment of 
life insurance policies, what possible justification exists for 
imposing a tax penalty associated with the purchase of such a 
policy that varies with the level of a company's outstanding 
debt?

                               Conclusion

    For the reasons explained above, we believe the Congress, 
consistent with its long-standing interest in preserving tax 
benefits for inside buildup within life insurance contracts, 
should reject the Administration's insurance proposal, which 
would effectively subject inside buildup to current taxation.
      

                                

Statement of Equipment Leasing Association, Arlington, Virginia

                              INTRODUCTION

    The Equipment Leasing Association is submitting this 
statement for the record to express our concerns regarding the 
proposed ``corporate tax shelter proposals'' included in the 
Clinton Administration's proposed FY 2000 Budget. ELA has over 
800 member companies throughout the United States who provide 
financing for all types of businesses in all types of markets. 
Large ticket leasing includes the financing of transportation 
equipment such as aircraft, rail cars and vessels. Middle 
market lessors finance high-tech equipment including main frame 
computers and PC networks, as well as medical equipment such as 
MRIs (magnetic resonance imaging) and CT (computed tomography) 
systems. Lessors in the small ticket arena provide financing 
for equipment essential to virtually all businesses such as 
phone systems, pagers, copiers, scanners and fax machines.

                      WHAT TYPE OF COMPANY LEASES?

    More companies, particularly small businesses, acquire new, 
state of the art equipment through leasing than through any 
other type of financing. Eighty percent of all U.S. companies 
lease some or all of their equipment. Companies that lease tend 
to be smaller, growth-oriented and focused on productivity--
these are companies long on ideas, but often, short on capital.

                          WHY COMPANIES LEASE

    Companies choose lease financing for several reasons:
     Leasing permits 100% financing;
     Leasing permits a close matching of rental 
payments to the revenue produced by the use of the equipment;
     Leasing allows companies to keep their debt lines 
open for working capital rather than tying it up in capital 
expenditures;
     Companies that lease know that they make money by 
using the equipment, not owning it;
     Leasing allows a company to focus on its core 
business--they don't have to worry about maintenance, upgrading 
or asset disposition;
     Leasing minimizes concerns about the technological 
obsolescence of the company's equipment;
     Leasing shifts asset management risk to the 
lessor, away from the user.
    Leasing by commercial enterprises increases productivity 
and stimulates economic growth. While the federal and state tax 
codes provide various incentives to invest in new equipment, 
many companies find they are not in a financial position to 
utilize the incentives. However, through leasing, the intended 
incentives to invest can be passed through to the company using 
the equipment in the form of lower rental payments because the 
leasing company utilizes the intended investment incentives. 
The use of leasing in this manner has long been intended by 
Congress.

                          LEASING CREATES JOBS

    It is estimated that each increase of $1 billion in 
equipment investment creates approximately 30,000 jobs (Brimmer 
Report). According to the U.S. Department of Commerce, in 1998 
alone, the equipment leasing industry financed over $183 
billion in equipment acquisition and it is anticipated that 
equipment lessors will finance over $200 billion in new 
equipment acquisition in 1999.

                 STATE AND LOCAL GOVERNMENTS LEASE, TOO

    It is not only commercial enterprises that lease equipment. 
Tax-exempt entities such as states, cities, counties and other 
subdivisions around the U.S. often lease various types of 
equipment in an effort to keep taxpayer costs down. Equipment 
leased by local governments includes 911 emergency phone 
systems, computers, school buses and police vehicles. Tax-
exempt hospitals often lease their emergency vehicles and high-
cost, sophisticated diagnostic medical equipment, in an effort 
to keep health care costs down.
    Lessors also lease equipment to other tax-exempt entities 
such as foreign corporate enterprises or individuals. Examples 
include automobile fleet leasing, leases of tractors and 
trailers, and leases of aircraft (both commercial and 
corporate). Further, many domestic lessees have the right to 
sublease assets into foreign markets in times when the 
equipment may be surplus. Very often, these subleases are to 
entities in foreign markets which have the need for the asset

 THE ADMINISTRATION'S ``CORPORATE TAX SHELTER'' PROPOSALS REPRESENT A 
                 SIGNIFICANT CHANGE IN U.S. TAX POLICY

    An analysis of the Administration's sweeping and vague 
corporate tax shelter proposals raises the concern that leasing 
transactions which conform to long standing tax policy and 
Congressional intent could be negatively impacted by the 
Administration's proposals. If this were the case, these 
proposals would represent a significant change in longstanding 
U.S. tax policy. Treasury officials have advised us that it is 
generally not their intent to negatively impact lease finance 
structures, and that this would be clarified in their 
anticipated ``white paper.'' Without this clear exclusion of 
leasing transactions that meet the standards of current law 
from the sweeping new corporate tax shelter proposals, ELA must 
oppose these proposals and urges Congress to reject them.
    ELA has long supported two fundamental principles of 
federal tax policy. First, the form of financing chosen to 
facilitate the acquisition of assets, whether loans or leases, 
should be respected as long as economically valid. Second, the 
principle that the tax treatment of an owner of an asset should 
not differ whether the asset is used directly by the owner or 
leased to another end-user. Again, in their current form, the 
Administration's proposals appear to violate these two 
principles and have already had a chilling effect on equipment 
acquisition in certain markets. Therefore, ELA opposes them and 
urges Congress to reject them.

   FURTHER LIMITING LESSORS' TAX BENEFITS IN TAX-EXEMPT USE PROPERTY 
                        TRANSACTIONS IS WRONG !

    ELA has grave concerns regarding the scope of the 
Administration's proposal to ``Limit Inappropriate Tax Benefits 
For Lessors of Tax-Exempt Use Property.'' While Treasury has 
expressed concerns regarding one specific type of cross-border 
financing structure--the ``lease-in/lease-out'' (``LILO'') 
structure--the Administration's legislative proposal would 
impact virtually every cross-border transaction with a tax-
exempt entity. The proposal may also impact domestic lease 
transactions wherein the lessee may be able to sublease the 
equipment to a foreign user at some point during its life. (A 
tax-exempt entity includes the United States, State or local 
governments, tax-exempt organizations, and any foreign person 
or entity (Section 168(h)(2)).
    Under current law, lessors of ``tax-exempt use property'' 
are already penalized, as they are limited in their ability to 
claim certain tax benefits. Lessors of tax-exempt use property 
are prohibited from using either an accelerated method of 
depreciation or economic depreciation if the lease term is 
equal to or greater than an asset's class life. Instead, they 
are required to use a straight-line method over a recovery 
period that is not less than 125% of the lease term.
    The Administration's proposal would further inhibit lease 
financing, as it would generally prohibit a lessor of property 
leased to a foreign lessee (as well as other tax-exempt 
persons) from currently utilizing net losses from a leasing 
transaction. Instead, to the extent a lessor of tax-exempt use 
property realizes in any year a net loss, the net loss would be 
suspended and carried forward to offset the future income from 
the transaction. This proposal would eliminate all of the tax 
deferral benefits that underpin the economics of cross-border 
leasing.
    Every lease transaction generates deductions in the early 
years of the transaction, which are offset by the taxable 
income in the later years. It is the U.S. lessor's ability to 
use these deductions against its other business income that 
allows it to provide the lessee with a lease rate that is lower 
than a straight borrowing. If enacted, this proposal will have 
a devastating impact on U.S. companies currently involved in 
selling assets to foreign entities where lease financing has 
been a significant feature of the marketplace, for example, 
manufacturers of aircraft and aircraft engines. As such, the 
proposal is contrary to long-established policies of promoting 
U.S. exports. (The proposal could also negatively impact U.S. 
domestic leasing by inhibiting flexibility of use and 
subleasing of the asset).
    Clearly, the Administration's proposal goes far beyond what 
is necessary to prevent perceived abusive transactions as it 
encroaches upon non-abusive transactions that are permitted 
under current law. In fact, in light of the 1986 depreciation 
rules providing for straight-line depreciation over the class-
life of foreign use property (which were intended to replicate 
economic depreciation), we believe that the Pickle depreciation 
rules, insofar as they relate to foreign lessees, are no longer 
necessary or appropriate and do not reflect sound tax policy. 
Consequently, we urge Congress to reject this proposal and 
encourage the Treasury Department to support a depreciation 
rule which does not discriminate between property owned by a 
U.S. taxpayer that is used outside the U.S. and property owned 
by a U.S. taxpayer that is leased to a foreign person. In both 
cases the income is fully taxable.

    TREASURY HAS SUFFICIENT AUTHORITY UNDER CURRENT LAW TO ADDRESS 
                      FINANCING STRUCTURE CONCERNS

    It is clear that Treasury has authority under current law 
to shut down the ``lease-in/lease-out'' (``LILO'') transactions 
that it opposes (see Revenue Ruling 99-14). Instead of 
advancing an overly broad legislative proposal which will 
disrupt efficient, economic-based transactions, we once again 
call upon Treasury to exercise its existing authority under 
current law to address its specific concerns and issue final 
467 regulations, which have been pending in proposed form for 
over two years.
    The Administration's proposal is also overly broad in that 
it could inappropriately affect legitimate business deductions 
that may be tangentially related to a leasing transaction but 
are not generated to shelter income. This legislation is not 
needed. A much narrower solution for addressing Treasury's 
concerns regarding ``LILOs'' is available--the issuance of 
final Section 467 regulations.
    We also believe that the Administration's proposal is in 
direct conflict with the Congressional objective of developing 
a U.S. trade policy which will provide U.S. companies with the 
ability to compete on a level playing field with their foreign 
competitors. If enacted, this legislation will severely inhibit 
the ability of U.S. exporters and financial institutions to 
compete effectively on a global scale. If U.S. companies are 
not able to compete on cross-border leases, tax revenues 
currently going to the U.S. Treasury will be lost to foreign 
Treasuries, as all leases, including cross-border leases, 
generate more taxable income than deductions over the life of 
the lease agreement.

    PROPOSAL TO ``DISALLOW INTEREST ON DEBT ALLOCABLE TO TAX-EXEMPT 
OBLIGATIONS'' WILL INCREASE STATES' AND MUNICIPALITIES' COST OF CAPITAL

    ELA opposes the Administration's proposal to ``disallow 
interest on debt allocable to tax-exempt obligations,'' as the 
elimination of the 2% de minimis rule will impair the ability 
of state and local governments to raise capital. While non-
financial corporations may not account for a large percentage 
of total municipal securities outstanding, these corporate 
buyers do play a vital role in three important market segments: 
1) short term municipal investments, 2) state and local 
government housing and student loan bonds, and 3) municipal 
leasing transactions.

                               CONCLUSION

    The uncertainty caused by the Administration's proposals 
has already had a chilling effect on equipment acquisitions in 
various markets. For over three decades, ELA members have 
provided lessees with various lease financing options which 
conform to long standing tax policy and Congressional intent. 
Taxpayers ask, ``at what point did Congressionally-intended 
incentives for investment and economic growth become `abusive 
corporate tax shelters'?''
    Congress, the Treasury Department and the courts have long 
recognized that companies financing the acquisition of 
equipment through a loan are the recipients of various tax 
incentives. These same bodies also have long recognized that 
equipment acquired through leasing involves the transfer of tax 
benefits from the user of the equipment to the owner-lessor. As 
a direct result of these sound tax policies, American citizens 
are the beneficiaries of the most modern and productive economy 
in the world. While equipment lessors would undoubtedly be 
negatively impacted by the proposed changes discussed above, 
the ultimate impact will be to drive up the cost of capital 
equipment acquisitions for U.S. businesses, particularly small 
businesses.
      

                                

Statement of Financial Executives Institute (``FEI'')

                              INTRODUCTION

    MR. CHAIRMAN AND MEMBERS OF THE COMMITTEE:
    FEI's Committee on Taxation is pleased to present its views 
on the Administration's Budget proposals and their impact on 
the international competitiveness of U.S. businesses and 
workers. FEI is a professional association comprising 14,000 
senior financial executives from over 8,000 major companies 
throughout the United States. The Tax Committee, which 
formulates tax policy for the Institute, is comprised of the 
senior tax officers from over 30 of the nation's largest 
corporations.
    FEI thanks the House Ways & Means Committee for scheduling 
these hearings on the Administration's budget proposals. We 
support a few of the proposals, for example, the extension of 
the tax credit for research. This provision should help improve 
the competitive position of U.S. companies. However, in many of 
the other tax proposals, the Administration replaced sound tax 
policy with some unwise revenue raisers. These latter proposals 
do nothing to achieve the objective of retaining U.S. jobs and 
making the U.S. economy stronger. For example, provisions are 
found in the Budget to extend Superfund taxes with no 
concomitant improvement of the cleanup programs, arbitrarily 
change the sourcing of income rules on export sales by U.S. 
based manufacturers, and restrict the ability of ``dual 
capacity taxpayers'' to take credit for certain taxes paid to 
foreign countries.
    Targeting publicly held U.S. multinationals doing business 
overseas for budget revenue raisers is unwise and FEI urges 
that such proposals not be adopted by Congress. Businesses 
establish foreign operations to serve local overseas markets so 
they are able to compete more efficiently with foreign based 
competition. In addition to assisting with the growth of 
exports and consequently job creation in the U.S., investments 
abroad help the U.S. balance of payments. The long-standing 
creditability of foreign income taxes is intended to alleviate 
the double taxation of foreign income. Replacing such credits 
with less valuable deductions will result in double taxation 
and greatly increase the costs of doing business overseas, 
which will place U.S. multinationals at a competitive 
disadvantage versus foreign based companies.
    U.S. jobs and the economy overall would be best served by 
Congress working with the Administration to do all it can to 
make the U.S. tax code more friendly; a position already 
afforded our international competitors by their home country 
governments. The budget should be written with the goal of 
reintegrating sound tax policy into decisions about the revenue 
needs of the government. Provisions that merely increase 
business taxes by eliminating legitimate business deductions 
should be avoided. Ordinary and necessary business expenses are 
integral to our current income based system, and needless 
elimination of them will only distort that system. Higher 
business taxes impact all Americans, directly or indirectly. It 
should be kept in mind that millions of ordinary Americans are 
shareholders, through their retirement plans, of corporate 
America and that proposals that decrease the competitiveness of 
U.S. business harm those persons both as shareholders and 
employees.

                            EFFECTIVE DATES

    FEI would like to voice its view that it is bad tax policy 
to add significant tax burdens on business in a retroactive 
manner. Businesses should be able to rely on the tax rules in 
place when making economic decisions, and expect that those 
rules will not change while their investments are still 
ongoing. It seems plainly unfair to encourage businesses to 
make economic decisions based on a certain set of rules, but 
then change those rules midstream after the taxpayer has made 
significant investments in reliance thereon. Thus, whenever 
possible, we call on Congress to assure that significant tax 
changes do not have retroactive application. To do otherwise 
can have a chilling effect on business investments that could 
be adversely impacted by rumored tax changes.

                 PROVISIONS THAT SHOULD NOT BE ADOPTED

    Sound and justifiable tax policy should be paramount when 
deciding on taxation of business--not mere revenue needs. In 
this light, FEI offers the following comments on certain 
specific tax increase proposals set forth in the 
Administration's budget:

                     REPEAL OF CODE SECTION 863(b)

    When products manufactured in the U.S. are sold abroad, 
Code Sec. 863(b) enables the U.S. manufacturer to treat half of 
the income derived from those sales as foreign source income, 
as long as title passes outside the U.S. Since title on export 
sales to unrelated parties often passes at the point of origin, 
this provision is more often applied to export sales to foreign 
affiliates.
    The Administration proposes to repeal Sec. 863(b) because 
it allegedly gives multinational corporations a competitive 
advantage over U.S. exporters that conduct all of their 
business activities in the U.S. It also believes that replacing 
Sec. 863(b) with an allocation based on actual economic 
activity will raise $6.6 billion over five years. This proposal 
is nonsensical.
    First, to compete effectively in overseas markets, most 
U.S. manufacturers find that they must have operations in those 
foreign markets to sell and service their products. Many find 
it necessary to manufacture products specially designed for a 
foreign market in the country of sale, importing vital 
components of that product from the U.S. wherever feasible. 
Thus, the supposed competitive advantage over a U.S. exporter 
with no foreign assets or employees is a myth. There are many 
situations in which a U.S. manufacturer with no foreign 
activities simply cannot compete effectively in foreign 
markets.
    Second, except in the very short term, this proposal could 
reduce the Treasury's revenues rather than increase them. This 
is because the multinational corporations, against which this 
proposal is directed, may have a choice. Instead of exporting 
their products from the U.S., they may be able to manufacture 
them abroad to the extent of excess capacity in foreign plants. 
If even a small percentage of U.S. exporters are in a position 
to make such a switch, the proposal will fail to achieve the 
desired result and taxes on manufacturing profits and 
manufacturing wages will go to foreign treasuries, instead of 
to the U.S. Amazingly, the Administration seems to encourage 
this result by calling for an allocation based on ``actual 
economic activity,'' which would cause a behavioral response to 
increase economic activity in foreign jurisdictions that could 
result in more foreign jobs, investment, and profits.
    At present, the U.S. has too few tax incentives for 
exporters, especially compared to foreign countries with VAT 
regimes. The U.S. should be stimulating the expansion of 
exports. Given our continuing trade deficit, it would be unwise 
to remove a tax incentive for multinational corporations to 
continue making GATT legal export sales from the United States. 
Ironically, this proposal could result in multinationals using 
existing foreign manufacturing operations instead of U.S. based 
operations to produce export products. We encourage Congress 
not to adopt it.

                        FOREIGN BUILT-IN LOSSES

    Another proposal would require the Treasury to issue 
regulations to prevent taxpayers from ``importing built-in 
losses incurred outside U.S. taxing jurisdictions to offset 
income or gain that would otherwise be subject to U.S. tax.'' 
The Administration argues that, although there are rules in the 
Code that limit a U.S. taxpayer's ability to avoid paying U.S. 
tax on built-in gain (e.g., Code Secs. 367(a), 864(c)(7), and 
877), similar rules do not exist that prevent built-in losses 
from being used to shelter income otherwise subject to U.S. tax 
and, as a result, taxpayers are avoiding Subpart F income 
inclusions or capital gains tax. We believe that this 
directive, which is written extremely broadly, is unnecessary 
due to the existence of rules already available in the Code, 
e.g., the anti-abuse provisions of Code Secs. 269, 382, 446(b), 
and 482. Both this proposal, and the one immediately above 
regarding the use of hybrid entities, would severely impact the 
ability of U.S. multinationals to compete on an equal footing 
against foreign-based companies.

                       FOREIGN OIL AND GAS INCOME

    The President's budget proposal dealing with foreign oil 
and gas income moves in the direction of limiting use of the 
foreign tax credit on foreign oil and gas income. This 
selective attack on a single industry's utilization of the 
foreign tax credit is not justified. U.S. based oil companies 
are already at a competitive disadvantage under current law 
since most of their foreign based competition pay little or no 
home country tax on foreign oil and gas income. Perversely, 
this proposal cedes an advantage to overseas competitors by 
subjecting foreign oil and gas income to U.S. double taxation, 
which will severely hinder U.S. oil companies in the global oil 
and gas exploration, production, refining and marketing arena.

                            SUPERFUND TAXES

    The three taxes that fund Superfund (corporate 
environmental tax, petroleum excise tax, and chemical feed 
stock tax) and the Oil Spill Fund Tax all expired on December 
31, 1995. The President's budget would reinstate the two excise 
taxes at their previous levels for the period, as well as 
reinstate the Oil Spill Tax, effective after the date of 
enactment through September 30, 2009. The corporate 
environmental tax would be reinstated at its previous level for 
taxable years beginning after December 31, 1998 and before 
January 1, 2010. In addition, the funding cap for the Oil Spill 
Tax would be increased from the current $1 Billion amount, to a 
much higher level of $5 Billion.
    These taxes, which were previously dedicated to Superfund 
and the Oil Spill Fund, would instead be used to generate 
revenue to balance the budget. This use of taxes historically 
dedicated to funding specific programs for deficit reduction 
purposes should be rejected. The decision whether to re-impose 
these taxes dedicated to financing Superfund should instead be 
made as part of a comprehensive examination of reforming the 
entire Superfund program.

           ELIMINATING THE DEDUCTIBILITY OF PUNITIVE DAMAGES

    Another provision that clearly lacks any policy foundation 
(and appears to be included purely for revenue-raising 
purposes) is the proposal to deny all future payments 
associated with ``punitive'' damages incurred in civil law 
suits, effective for damages paid or incurred after the date of 
enactment. Civil punitive damages are a risk that virtually all 
companies are susceptible to in our present litigious society. 
They are often based on arbitrary and capricious jury awards 
and should be distinguished from the primarily criminal-type 
punitive damages currently denied deductibility under the Code. 
Punitive damages generally are subject to tax in the hands of 
the recipient under the changes made to those rules in 1996. In 
effect, Treasury seeks a windfall from punitive damage payments 
by denying their deduction while taxing their receipt. We 
adamantly oppose what would be a material change in the tax 
law.

                   INCREASING EXCISE TAXES ON TOBACCO

    The Administration proposes new tobacco legislation that 
would provide for net revenues of approximately $34.5 billion 
over the five-year period from October 1, 1999, to September 
30, 2004. We oppose any excise tax increases on tobacco because 
these higher taxes would clearly fall on those least able to 
pay (predominantly lower-income individuals). With a $700 
billion surplus projected for the next 5 years, Congress should 
not even consider taxing individuals. This provision is merely 
another blatant revenue raiser.

                   TAXING ISSUANCE OF TRACKING STOCK

    ``Tracking stock'' is an economic interest that is intended 
to relate to, and track the economic performance of, one or 
more separate assets of the issuer. It gives its holder a right 
to share in the earnings or value of less than all of the 
corporate issuer's earnings or assets. Under the proposal, upon 
issuance of tracking stock, gain would be recognized in an 
amount equal to the excess of the fair market value of the 
tracked asset over its adjusted basis. Treasury views the 
issuance of tracking stock as tantamount to a spin-off and 
accordingly wants to impose tax. In fact, issuance of tracking 
stock is not a spin-off. The stockholder's value is still 
subject to the claims of the creditors of the parent 
corporation, and has liquidation or redemption rights only in 
the parent company, not the tracked assets. FEI opposes this 
attempt by Treasury to trigger a double tax on corporate 
income.

             MODIFYING TAX TREATMENT OF DOWNSTREAM MERGERS

    Under this provision, where a target corporation does not 
satisfy the stock ownership requirements of section 1504(a)(2) 
(generally, 80 percent or more of vote and value) with respect 
to the acquiring corporation, and the target corporation 
combines with the acquiring corporation in a reorganization in 
which the acquiring corporation is the survivor, the target 
corporation must recognize gain, but not loss, as if it 
distributed the acquiring corporation stock that it held 
immediately prior to the reorganization to its shareholders. 
FEI opposes elimination of this longstanding and well-
recognized ability to reorganize in a tax-free manner.

                 PREVENT TRAFFICKING IN BUILT-IN LOSSES

    Under current law, a person that becomes subject to U.S. 
tax for the first time determines the basis of property and 
other tax attributes as though the person had always been 
subject to U.S. tax. This has been the rule since the beginning 
of the income tax. As a result, a taxpayer coming under the 
U.S. system may take advantage of built-in losses and would be 
taxed on built-in gains. Treasury wants to replace the current 
rule with a ``fresh start'' that eliminates all tax attributes 
(including built-in losses and other items) and marks the 
taxpayer's assets to market when they become subject to U.S. 
tax. The proposal could benefit some taxpayers who would be 
entitled to a tax-free step-up in basis in their appreciated 
property at the time they become subject to U.S. tax. This far-
reaching proposal would add much complexity to the tax laws.
    The Administration argues that although current rules limit 
a U.S. taxpayer's ability to avoid paying U.S. tax on built-in 
gain, similar rules do not exist that prevent built-in losses 
from being used to shelter income otherwise subject to U.S. 
tax. Treasury's proposal, which is extremely broad, is 
unnecessary. Existing anti-abuse provisions such as sections 
269, 382, 446(b), and 482 address this issue. Congress should 
resist the temptation that Treasury has placed before it to 
make an ad hoc, yet very fundamental, change to our 
international tax rules.

                      PAYMENTS TO 80/20 COMPANIES

    Currently, a portion of interest or dividends paid by a 
domestic corporation to a foreign entity may be exempt from 
U.S. withholding tax provided the payor corporation is a so-
called ``80/20 Company,'' i.e., at least eighty percent of its 
gross income for the preceding three years is foreign source 
income attributable to the active conduct of a foreign trade or 
business. The Administration believes that the testing period 
is subject to manipulation and allows certain companies to 
improperly avoid U.S. withholding tax on certain distributions 
attributable to a U.S. subsidiary's U.S. source earnings. As a 
result, it proposes to arbitrarily change the 80/20 rules by 
applying the test on a group-wide (as opposed to individual 
company) basis. However, there is little evidence that these 
rules have been manipulated on a broad scale in the past and we 
do not believe such a drastic change is needed at this time.

            MODIFYING THE SUBSTANTIAL UNDERSTATEMENT PENALTY

    The Administration proposed to make any tax deficiency 
greater than $10 million ``substantial'' for purpose of the 
penalty, rather than applying the existing test that such tax 
deficiency must exceed 10% of the taxpayer's liability for the 
year. While to the individual taxpayer or even a privately-held 
company, $10 million may be a substantial amount of money--to a 
publicly-held multinational company, in fact, it may not be 
``substantial.'' Furthermore, a 90% accurate return, given the 
agreed-upon complexities and ambiguities contained in our 
existing Internal Revenue Code, should be deemed substantial 
compliance, with only additional taxes and interest due and 
owing. There is no policy justification to apply a penalty to 
publicly-held multinational companies which are required to 
deal with much greater complexities than are all other 
taxpayers.
    The difficulty in this area is illustrated by the fact that 
the Secretary of the Treasury has yet to comply with Code Sec. 
6662(d)(2)(D), which requires the Secretary to publish a list 
of positions being taken for which the Secretary believes there 
is not substantial authority and which would affect a 
significant number of taxpayers. The list is to be revised not 
less frequently than annually. Taxpayers still await the 
Secretary's first list.

            INCREASED PENALTIES FOR FAILURE TO FILE RETURNS

    The Administration also proposed to increase penalties for 
failure to file information returns, including all standard 
1099 forms. IRS statistics bear out the fact that compliance 
levels for such returns are already extremely high. Any 
failures to file on a timely basis generally are due to the 
late reporting of year-end information or to other unavoidable 
problems. Under these circumstances, an increase in the penalty 
for failure to timely file returns would be unfair and would 
fail to recognize the substantial compliance efforts already 
made by American business.

           REPEALING LOWER OF COST OR MARKET INVENTORY METHOD

    Certain taxpayers can currently determine their inventory 
values by applying the lower of cost or market method, or by 
writing down the cost of goods that are not salable at normal 
prices, or not usable because of damage or other causes. The 
Administration is proposing to repeal these options and force 
taxpayers to recognize income from changing their method of 
accounting, on the specious grounds that writing down unusable 
or non-salable goods somehow ``understates taxable income.'' We 
strongly disagree with this unwarranted proposal. In addition, 
we believe that in the least, the lower of cost or market 
method should continue to be permissible when used for 
financial accounting purposes, to avoid the complexity of 
maintaining separate inventory accounting systems.

                  DEFERRAL OF OID ON CONVERTIBLE DEBT

    The Administration has included a number of past proposals 
aimed at financial instruments and the capital markets, which 
were fully rejected during the last session of Congress. These 
reintroduced proposals should again be rejected out of hand. 
One proposal would defer deductions by corporate issuers for 
interest accrued on convertible debt instruments with original 
issue discount (``OID'') until interest is paid in cash. The 
proposal would completely deny the corporation an interest 
deduction unless the investors are paid in cash (e.g., no 
deduction would be allowed if the investors convert their bonds 
into stock). Investors in such instruments would still be 
required to pay income tax currently on the accrued interest. 
In effect, the proposal defers or denies an interest deduction 
to the issuer, while requiring the holder to pay tax on the 
interest currently.
    FEI opposes this proposal because it is contrary to sound 
tax policy and symmetry that matches accrual of interest income 
by holders of OID instruments with the ability of issuers to 
deduct accrued interest. There is no justifiable reason for 
treating the securities as debt for one side of the transaction 
and as equity for the other side. There is also no reason, 
economic or otherwise, to distinguish a settlement in cash from 
a settlement in stock.
    Moreover, the instruments in question are truly debt rather 
than equity. Recent statistics show that over 70 percent of all 
zero-coupon convertible debt instruments were retired with 
cash, while only 30 percent of these instruments were 
convertible to common stock. Re-characterizing these 
instruments as equity for some purposes is fundamentally 
incorrect and will put American companies at a distinct 
disadvantage to their foreign competitors, who are not bound by 
such restrictions. These hybrid instruments and convertible OID 
bond instruments have allowed many U.S. companies to raise tens 
of billions of dollars of investment capital used to stimulate 
the economy. Introducing this imbalance and complexity into the 
tax code will discourage the use of such instruments, limit 
capital raising options, and increase borrowing costs for 
corporations.

              ATTACKING LEGITIMATE CORPORATE TAX PLANNING

    The Treasury Department's sweeping attack on corporate tax 
planning is alarming and unwarranted. The Administration's 
decision to seek a harsh new penalty regime and to impose 
Treasury and Internal Revenue Service judgements on taxpayers 
is disturbing. Merely labeling everything that it does not like 
as ``corporate tax shelters'' does not justify Treasury's 
attempt to tilt the tax playing field steeply and permanently 
in its favor. Well over 90 percent of President Clinton's tax 
increase proposals come from items previously rejected by 
Congress or from items that are substantive changes to long-
standing and non-controversial provisions of the tax code.
    The Administration's proposals to address what it labels as 
``tax avoidance transactions'' are overly broad and would bring 
within their net many corporate transactions that are clearly 
permitted under existing law. Legitimate tax planning to 
conform to domestic and foreign non-tax legal or regulatory 
requirements may well be subject now to confiscatory penalties 
for failure to satisfy these overly broad standards.
    The Administration wants to impose strict liability for a 
confiscatory 40-percent penalty on taxpayers who enter into 
transactions that IRS agents determine are uneconomic. The fact 
that the taxpayer acted reasonably and in good faith or had a 
substantial business purpose for the transaction would not 
matter. This is simply not the right standard. Our business 
transactions and the tax laws that apply to them are too 
complex. Taxpayers and the government inevitably will disagree. 
Taxpayers should be allowed to assert their views as freely as 
IRS agents assert theirs.
    Since 1982, Congress has littered the Internal Revenue Code 
with penalties, disclosures, confiscatory rates of interest, 
and endless amounts of reporting. More than 75 sections of tax 
laws enacted since 1982 directly address corporate compliance 
from a penalty or procedural perspective. Today, if a corporate 
taxpayer enters into a transaction it believes is less-likely-
than-not to result in the claimed tax benefits, that taxpayer 
faces substantial exposure on examination. The resulting 
deficiency could carry a 20 percent understatement penalty. 
Both the deficiency and the penalty would accrue interest at 
penalty rates. An advisor selling the transaction would be 
subject to registration, possible promoter and aiding and 
abetting penalties, and discovery by other clients.

                       TAX AVOIDANCE TRANSACTIONS

    Treasury proposes five new rules built from a new concept: 
the ``tax avoidance transaction.'' A tax avoidance transaction 
is defined as one in which the reasonably expected pre-tax 
profit of the transaction (on a present value basis) is 
insignificant relative to the reasonably expected net tax 
benefits of the transaction (on a present value basis). A 
transaction also is deemed to be a tax avoidance transaction if 
it involves ``improper elimination or reduction of tax on 
economic income.'' In turn, a ``corporate tax shelter'' is 
defined as any entity, plan, or arrangement in which a direct 
or indirect corporate participant attempts to obtain a tax 
benefit in a tax avoidance transaction.
    This seemingly bright-line definition of a tax avoidance 
transaction is simply an invitation to an entirely new realm of 
ambiguity. Disputes would emerge over the general rules for 
measurement of profits; the treatment of non-deductible 
expenses and tax-free income; the reasonableness of 
expectations, discount rates, forecasting parameters; the 
allocation of general and administrative costs; the choice of 
applicable tax rates; assumptions about the state of the tax 
law; and dozens of other issues. As every member of the tax-
writing committees knows from dealing with revenue estimates, 
it is much easier to know that an idea makes sense than to 
estimate its economic consequences with precision.
    One bad answer to all of these questions is the probable 
Treasury response: ``We will tell you in regulations.'' No 
regulation adequately could resolve the issues raised by these 
new concepts. Taxpayers would be left with the choice of doing 
things the IRS way or risking a no-fault penalty.
    To function efficiently and productively, business 
taxpayers must be able to depend on the rule of law. That means 
relying on the tax code and existing income tax regulations. If 
the Administration's vague ``tax shelter'' proposals become 
law, few businesses would feel comfortable relying on those 
statutes or regulations. Treasury's proposed rules could cost 
the economy more in lost business activity than they produce in 
taxing previously ``sheltered'' income.

                   RESTRICTING CORPORATE TAX PLANNING

    The provision imposing a 20-percent strict liability 
penalty on any underpayment associated with a tax avoidance 
transaction is wrong. Taxpayers should have the freedom to take 
reasoned, reasonable, and supportable positions on their tax 
returns. Increasing the penalty to 40 percent if the taxpayer 
failed to report its participation in the transaction within 30 
days of entering into it is simply setting a trap for ordinary 
businesses. Tax lawyers and accountants are not at every 
business meeting ready to file reports to the IRS.
    Treasury's request for blanket regulatory authority to 
extend section 269 to disallow any deduction, credit, 
exclusion, or other allowance obtained in a tax avoidance 
transaction is nothing more or less than a request that the 
Congress turn over a substantial portion of its tax-writing 
responsibilities to un-elected executive branch officials.
    Treasury also wants Congress to deny corporate taxpayers 
any deduction for fees paid in connection with the purchase or 
implementation of a tax avoidance transaction or for related 
tax advice. Advisors also would be subject to a 25 percent 
excise tax on such fees. Corporate tax directors and their 
outside advisors are not criminals. By denying a deduction and 
imposing an excise tax, this proposal would provide harsher 
treatment under the tax code for legitimate tax-planning 
activity than that applicable to illegal bribes, kickbacks, 
penalties for violations of the law, and expenditures in 
connection with the illegal sale of drugs.
    Purchasers of a corporate tax shelter who also acquire a 
full or partial guarantee of the projected benefits would be 
subject to an excise tax equal to 25 percent of the benefits 
that were guaranteed. Congress ought to stay out of the private 
marketplace. In truth, insurance of a tax result is merely the 
expression of someone's opinion that the transaction will work. 
The Administration would say that if a taxpayer purchases 
insurance against a tax adjustment in a specific transaction 
for $10,000 and the limit on the policy is $1,000,000, the 
proposal would subject the corporate client to a $250,000 tax. 
The insurer obviously has a lot of faith in the transaction to 
be willing to take a risk premium equal to 1 percent of the 
exposure.
    The proposals would also tax otherwise tax-exempt entities 
when they are parties to a corporate taxpayer's tax avoidance 
transaction. The law is already filled with rules to prevent 
arbitrage with exempt entities. Taxing hospitals, universities, 
and pension funds because some IRS agent found a tax shelter on 
the other side of one of their transactions is not a solution 
to any problems that may still exist. The proposal targets 
exempt organizations, Native American tribal organizations, 
foreign persons, and domestic corporations with expiring net 
operating losses. The corporate parties would be jointly and 
severally liable for this tax if unpaid by the exempt taxpayer. 
In addition, in the case of a foreign person properly claiming 
the benefit of a treaty, or a Native American tribal 
organization, the tax on the income allocable to such persons 
in all cases would be collected from the corporate parties.
    An additional provision would preclude taxpayers from 
taking tax positions inconsistent with the form of their 
transactions if a tax-indifferent party was involved in the 
transaction. A taxpayer could take an inconsistent position by 
disclosing the inconsistency. In effect, the rule is a 
reporting requirement (chiefly with respect to hybrid 
transactions) masquerading as a deduction limitation.
    In summary, the Clinton Administration's attempt to tilt 
the playing field in favor of the IRS would make it very 
difficult for taxpayers to engage in legitimate transactions to 
(1) reduce U.S. tax with foreign losses, (2) reposition 
companies for better loss utilization, (3) undertake tax 
reducing stock sales across internal corporate ownership 
chains, (4) use hybrid financing techniques, (5) sell assets at 
reduced tax rates, and/or (6) create mergers that streamline 
corporate structures. These actions would hurt the ability of 
U.S. corporations to operate economically and to compete 
effectively against their foreign-based competitors. Congress 
must reject this power grab by the IRS and Treasury.

            PROVIDING CONSISTENT AMORTIZATION OF INTANGIBLES

    Under current law, start-up and organizational expenditures 
are amortized at the election of the taxpayer over a period of 
not less than 60 months. Certain acquired intangible assets 
(goodwill, trademarks, franchises, patents, etc.) held in 
connection with the conduct of a trade or business or an 
activity for the production of income must be amortized over 15 
years. Under the budget proposals, start-up and organizational 
expenditures would be amortized over a 15-year period. Small 
businesses would be allowed a $5,000 expensing of such costs. 
FEI believes that the proper treatment of many start-up and 
organizational expenses in a neutral tax system would be 
expensing. Moving in the opposite direction, toward a longer 
artificial recovery period for such expenses, is simply 
increasing taxes on companies that are growing and expanding.

           MODIFYING RULES FOR DEBT-FINANCED PORTFOLIO STOCK

    This proposal would effectively reduce the dividends-
received deduction (``DRD'') for any corporation carrying 
debt--virtually all corporations--and would specifically target 
financial service companies, which tend to be more debt-
financed. FEI vigorously opposes this proposal, as it has 
opposed more straightforward proposals to reduce the DRD in the 
past.
    The purpose of the DRD is to eliminate, or at least 
alleviate, the impact of potential multiple layers of corporate 
taxation. Under current law, the DRD is not permitted to the 
extent that relevant ``portfolio stock'' is debt financed. 
Portfolio stock is defined as stock in which the corporate 
taxpaying owner holds less than 50 percent of the vote or 
value. Portfolio stock has generally been treated as debt 
financed when acquired with the proceeds of indebtedness, or 
when it secures the repayment of indebtedness. The 
Administration's proposal would expand the DRD disallowance 
rule of current law for debt financed stock by assuming that 
all corporation debt is allocated to the company's assets on a 
pro-rata basis. The proposal would, thus, partially disallow 
the DRD for all corporations based on a pro-rata allocation of 
its corporate debt.
    We believe the proposal would exacerbate the multiple 
taxation of corporate income, penalize investment, and mark a 
retreat from efforts to develop a more fair, rational, and 
simple tax system. Just as troubling is the notion that the DRD 
should be dramatically reduced for companies, including 
financial service companies, that are highly leveraged. The 
proposal is particularly problematic for the securities 
industry, which maintains large quantities of equity 
investments in the ordinary course of its business operations. 
FEI believes that multiple taxation of corporate earnings 
should be reduced, rather than expanded. The Administration's 
proposal clearly moves in the wrong direction.

          ELIMINATING THE ``DRD'' FOR CERTAIN PREFERRED STOCK

    Another proposal would deny the dividend received deduction 
(``DRD'') for certain types of preferred stock, which the 
Administration believes are more like debt than equity. 
Although concerned that dividend payments from such preferred 
stock more closely resembles interest payments than dividends, 
the proposal does not simultaneously propose to allow issuers 
of such securities to take interest expense deductions on such 
payments. Again, the Administration violates sound tax policy 
and, in this proposal, would deny these instruments the tax 
benefits of both equity and debt.
    FEI opposes this proposal as not being in the best 
interests of either tax or public policy. Currently, the U.S. 
is the only major western industrialized nation that subjects 
corporate income to multiple levels of taxation. Over the 
years, the DRD has been decreased from 100% for dividends 
received by corporations that own over 80 percent of other 
corporations, to the current 70% for less than 20 percent owned 
corporations. As a result, corporate earnings have become 
subject to multiple levels of taxation, thus driving up the 
cost of doing business in the U.S. To further decrease the DRD 
would be another move in the wrong direction.

          DEFERRED ACQUISITION COST CAPITALIZATION PERCENTAGES

    This proposal would increase the percentage of life 
insurance and annuity premiums subject to DAC capitalization. 
House Ways and Means Committee Chairman Bill Archer, R-Texas, 
already has publicly announced that the DAC proposal will not 
be included in any package put forth by his committee. We are 
in full agreement with him. The current DAC rates are more than 
appropriate in light of the other rules that apply to life 
insurance companies that tend to overstate their income for tax 
purposes.

             MODIFYING CORPORATE-OWNED LIFE INSURANCE RULES

    Treasury continues its four-year assault on COLI programs 
by proposing to repeal an exception to the present law 
proportionate interest disallowance rules for contracts on 
employees, officers or directors, other than 20 percent owners 
of the business that are the owners or beneficiaries of an 
annuity, endowment, or life insurance contract. This exception 
was designed to allow employers to create key-person life 
insurance programs, fund non-qualified deferred compensation 
with the advantages of life insurance, and meet other real 
business needs. The effect of this proposal would be to tax the 
inside build up in cash value life insurance whenever it is 
owned by a business that also has debt. Given the very long-
term nature of life insurance investments, this rule would make 
insurance unattractive even to companies with no debt today, 
because they might need to borrow at some future date.

            RECAPTURING POLICYHOLDER SURPLUS ACCOUNTS (PSA)

    Life insurance companies that were taxed under the old 
``phase II positive'' regime of the 1959 Act would have their 
tax bills for 1959 through 1983 rewritten by Treasury's 
proposal to tax policyholder surplus accounts. Companies would 
be required to include in their gross income over 10 years 
(one-tenth per year) the balances of the policyholder surplus 
accounts accumulated from 1959 through 1983. These accounts 
were part of a complex, Rube Goldberg set of provisions 
designed to balance the tax burdens of various segments of the 
insurance industry. Different companies benefited from 
different provisions, retroactively denying one set of 
companies their treatment is fundamentally unfair. Companies 
with policyholder surplus accounts never expected to pay tax on 
them. Congress should not change the rules at this late date.

              CONVERTING THE AIRPORT AND AIRWAY TRUST FUND

    The Administration wants to restructure the Airport and 
Airway Trust Fund. FEI has no opinion on those proposals. The 
Administration also wants to lower air ticket taxes and in 
their place impose FAA user fees. This all ends up with an 
extra $5.3 billion going to Washington. FEI opposes increasing 
government revenues from the air transportation sector. The 
Airport and Airway Trust Fund is not spending what it has. Why 
is more needed? The assets in the trust fund are projected to 
grow from $12.3 billion in 1999 to $20.9 billion in 2004. It is 
hard to understand why we need a $5 billion cost increase to 
the public, much of which would be paid by the business 
community.

              ELIMINATING NON-BUSINESS VALUATION DISCOUNTS

    The proposal would deny any valuation discounts for 
interests in entities holding ``non-business assets.'' This 
provision would eliminate most of the value of using family 
limited partnerships to reduce the transfer tax value of gifted 
or inherited property. Although FEI takes no position on estate 
and gift tax issues, we do note that this proposal is an 
unmistakable tax increase.

             TAXING INVESTMENT INCOME OF TRADE ASSOCIATIONS

    Under the proposal, trade associations (including FEI) of 
commerce, business leagues, and other similar not-for-profit 
organizations organized under Internal Revenue Code section 
501(c)(6) generally would be subject to tax on their net 
investment income in excess of $10,000. FEI opposes this $1.4 
billion tax increase on trade associations. The current-law 
purpose of imposing unrelated business income tax on 
associations and other tax-exempt organizations is to prevent 
such organizations from competing unfairly against for-profit 
businesses. Subjecting trade association investment income to 
UBIT is counter to this legislative purpose. The Treasury 
proposal mischaracterizes the benefit that trade association 
members receive from such earnings. If these earnings on a 
trade association's assets did not exist, members of these 
associations would have to pay larger tax-deductible dues. 
There simply is not a tax abuse here. Congress should leave the 
present law rules as they are.

                         POSITIVE TAX PROPOSALS

    As stated above, certain of the Administration's tax 
proposals will have a positive impact on the economy. For 
example:

                    EXTENSION OF RESEARCH TAX CREDIT

    The proposal to extend the research tax credit is to be 
applauded. The credit, which applies to amounts of qualified 
research in excess of a company's base amount, has served to 
promote research that otherwise may never have occurred. The 
buildup of ``knowledge capital'' is absolutely essential to 
enhance the competitive position of the U.S. in international 
markets--especially in what some refer to as the Information 
Age. Encouraging private sector research work through a tax 
credit has the decided advantage of keeping the government out 
of the business of picking specific winners or losers in 
providing direct research incentives. FEI recommends that 
Congress work together with the Administration to extend the 
research tax credit on a permanent basis.

          ACCELERATING EFFECTIVE DATE OF 10/50 COMPANY CHANGE

    Another proposal would accelerate the effective date of a 
tax change made in the 1997 Tax Relief Act affecting foreign 
joint ventures owned between ten and fifty percent by U.S. 
parents (so-called ``10/50 Companies''). This change will allow 
10/50 Companies to be treated just like controlled foreign 
corporations by allowing ``look-through'' treatment for foreign 
tax credit purposes for dividends from such joint ventures. The 
1997 Act, however, did not make the change effective for such 
dividends unless they were received after the year 2003 and, 
even then, required two sets of rules to apply for dividends 
from earnings and profits (``E&P'') generated before the year 
2003, and dividends from E&P accumulated after the year 2002. 
The Administration's proposal will, instead, apply the look-
through rules to all dividends received in tax years after 
1998, no matter when the E&P constituting the makeup of the 
dividend was accumulated.
    This change will result in a tremendous reduction in 
complexity and compliance burdens for U.S. multinationals doing 
business overseas through foreign joint ventures. It will also 
reduce the competitive bias against U.S. participation in such 
ventures by placing U.S. companies on a much more level playing 
field from a corporate tax standpoint. This proposal epitomizes 
the favored policy goal of simplicity in the tax laws, and will 
go a long way toward helping the U.S. economy by strengthening 
the competitive position of U.S. based multinationals.

          MAKING PERMANENT THE EXPENSING OF REMEDIATION COSTS

    The Administration's proposal to make permanent the current 
deductibility of costs for so-called ``brownfields'' 
remediation under Code section 198 is a welcome extension of a 
change contained in the 1997 Taxpayer Act, which allowed 
certain remediation costs incurred with qualified contaminated 
sites (so-called ``brownfields'') to be currently deductible as 
long as they are incurred by December 31, 2000. Extension of 
this treatment on a permanent basis removes any doubts among 
taxpayers as to the future deductibility of these expenditures 
and promotes the goal of encouraging environmental remediation.

           EXTENDING NOL CARRYBACK PERIOD FOR STEEL COMPANIES

    The Administration's proposal to extend the carryback 
period for net operating losses (``NOLs'') of steel companies 
from two to five years is both fair and equitable due to the 
financial troubles that many steel companies are experiencing. 
The benefit provided by this longer carryback period would feed 
directly into a financially troubled steel company's cash flow, 
providing immediate and necessary relief. Our only suggestion 
is that this longer carryback period be extended to other 
troubled industries, such as the petroleum, chemical, and 
aerospace industries, to name a few.

                               CONCLUSION

    FEI urges Congress not to adopt the revenue raising 
provisions identified above when formulating its own budget 
proposals. They are based on unsound tax policy. Congress, in 
considering the Administration's budget, should elevate sound 
and justifiable tax policy over mere revenue needs. Revenue can 
be generated consistent with sound tax policy, and that is the 
approach that should be followed as the budget process moves 
forward.
    The Administration's proposals would add complexity in 
direct contrast to the Administration's stated need to simplify 
the tax law in order to assist the Internal Revenue Service in 
more effectively filling its role as the nation's tax 
collector. We thank the Committee for this opportunity to share 
our views on this important subject.
      

                                

Statement of General Motors Corporation

    The Clinton Administration proposes to tax the issuance of 
tracking stock, a type of stock that tracks the economic 
performance of less than all the assets of the issuing 
corporation. General Motors Corporation (``GM'') has a unique 
perspective on this proposed legislation. GM was the first 
publicly-traded company to issue tracking stock (GM's Class E 
Common Stock), in connection with its acquisition of Electronic 
Data Systems Corporation (``EDS'') in 1984. In total, GM has 
issued more than $10 billion in tracking stocks and has nearly 
$5 billion in such stock outstanding currently.
    GM believes that it would be beneficial for the Committee 
to understand (1) the business circumstances that caused GM to 
create tracking stock in the first instance and (2) GM's 
experience with this stock since it was first issued. GM's 
experience demonstrates that tracking stock is an exceedingly 
valuable business mechanism that cannot reasonably be used for 
tax avoidance. GM strongly urges this Committee to reject the 
Administration's proposal to tax the issuance of tracking 
stock.

                  GM's Experience With Tracking Stock

    GM is the world's largest manufacturer and distributor of 
motor vehicles. In 1998, GM had worldwide sales of more than 
$160 billion and provided employment to more than 600,000 
workers.

A. Acquisitions of EDS and Hughes Aircraft Company

    In the mid-1980's, GM was concerned that the company needed 
to be better prepared for the cyclical downturns in the U.S. 
automotive market. The company was primarily a manufacturer of 
automobiles and automotive components, which made GM vulnerable 
to the periodic recessions that occur in the automotive 
industry. At the same time, GM was attempting to implement 
cost-effective data processing systems across its worldwide 
operations. GM also believed that it had to increase its high 
technology expertise as a means to accelerate the application 
of electronics in its automotive products.
    GM thought the best way to diversify its earnings base to 
withstand economic downturns, reduce its cost structure, and 
address the need for increased electronic content in its 
automotive products was to make significant acquisitions in the 
computer servicing, data processing, and high-technology 
electronics industries. Toward that end, GM began to 
investigate the acquisition of two companies, EDS and Hughes 
Aircraft Company (``Hughes''). EDS was then a rapidly growing 
data processing and computer company located in Dallas, Texas. 
GM believed that the integration of GM's automotive business 
with EDS's computer expertise would provide GM an ``electronic 
backbone,'' increase GM's marketing efficiencies and reduce its 
cost structure. Hughes was one of the leading defense 
electronics companies in the world, with expertise in 
engineering, electronics and science. GM believed a combination 
of its automotive manufacturing business with Hughes' 
engineering and electronics expertise would dramatically 
improve GM's products. Moreover, the ownership of EDS and 
Hughes would make GM a more diversified company and thus reduce 
the cyclicality of GM's earnings.
    GM negotiated the acquisition of EDS with EDS's top 
executives, principally Ross Perot and Morton Meyerson. EDS's 
executives were intrigued by the growth potential that could 
result from a merger with GM, but they had many concerns about 
receiving ordinary GM common stock as the merger consideration. 
EDS perceived itself as a nimble, high-growth, high-technology 
company, and the company's executives worried about the 
consequences of merging into GM and staking their economic 
fortunes with those of a slower-growth, mature automotive 
company. In particular, EDS's executives were concerned that 
GM's enormous size would render EDS's successes immaterial to 
GM and would suppress EDS's entrepreneurial spirit. EDS was 
also concerned that its employees would not be motivated by 
holding stock and stock options in a company whose stock price 
they could not meaningfully influence by their efforts.
    GM tracking stock was the key to persuading EDS to merge 
with GM. GM's Class E Common Stock had liquidation and 
bankruptcy rights on an equal footing with GM's existing common 
stock and represented a full integration of GM's assets with 
EDS's assets. Class E Common Stock voted in the election of 
GM's Board of Directors, and had no voting rights in the 
election of EDS directors. However, the dividends on the Class 
E Common Stock would be payable by GM based on the earnings of 
EDS. GM anticipated that the Class E Common Stock's value would 
reflect primarily the performance of EDS. The idea for this 
stock was not driven or motivated by tax considerations (the 
acquisition was fully taxable to EDS's shareholders), but 
instead was created by business people seeking to solve a 
business problem.
    The creation of this stock in fact solved the problems 
identified by EDS's executives and permitted the merger to go 
forward. The creation of Class E Common Stock created a 
separately-traded equity that could be separately valued, and 
in turn this equity could be made available to EDS employees to 
provide direct incentives for them to improve and grow their 
distinct business. As a service business, it was critical to 
EDS's stability and growth that it retain its key employees. At 
the same time, GM was able to acquire all of EDS and integrate 
EDS's expertise into GM's automotive business.
    Shortly after GM completed its acquisition of EDS, GM began 
negotiations with the Howard Hughes Medical Institute 
(``HHMI'') for the acquisition of Hughes. Hughes was a premier 
high-technology company. Whereas EDS's expertise was in 
computer software and data processing, Hughes' line of business 
was high-technology electronics and engineering. But the HHMI 
expressed concerns similar to those heard from EDS executives 
about receiving GM automotive stock as the merger 
consideration. HHMI perceived GM's automotive stock as a 
relatively unattractive investment. By offering HHMI a GM 
tracking stock whose dividends were based on the earnings of 
Hughes' business, the merger proposal became more attractive to 
HHMI. GM was thus able to complete this acquisition in 1985.
    The acquisitions of Hughes and EDS undeniably played an 
important role in the resurgence of GM. EDS and Hughes brought 
new engineering and scientific expertise, managerial focus, 
high technology, capital and growth to GM. At the same time, 
being owned by GM benefitted both EDS and Hughes. The values of 
Class E Common Stock and Class H Common Stock both experienced 
significant growth. And with the increased capital that GM was 
able to provide Hughes, Hughes (i) made technological advances 
that have markedly improved the technological content of GM 
vehicles (such as ``head-up'' displays), and (ii) created new 
nonautomotive products that have benefitted the U.S. economy, 
including well-known consumer goods such as DirecTV and pay-at-
the-pump fuel stations.

B. Funding GM's Defined Benefit Pension Plan

    While the acquisitions of Hughes and EDS helped reenergize 
GM, the economic downturn in the early 1990's adversely 
affected GM's financial position. At that time, GM's defined 
benefit pension plan for its U.S. automotive workers became 
severely underfunded, and the company did not have the cash to 
eliminate that underfunding. The underfunding of the GM plan 
was estimated to represent approximately 50% of the entire 
contingent underfunding liability of the Pension Benefit 
Guaranty Corporation (``PBGC''), which generated substantial 
controversy and concern at that government agency and in the 
media.
    In order to fund its pension plans, GM began working with 
the PBGC and the Departments of Labor and Treasury to make a 
substantial contribution of Class E Common Stock to the GM 
pension plans. In general, the PBGC does not favor a 
corporation's pension plan being funded with traditional 
employer company stock, since any downturns in that company's 
business will reduce the company's ability to make future 
contributions and at the same time cause the company's 
underfunding to increase as its stock price declines. In this 
case, however, the PBGC reacted positively to GM's suggestion 
of a contribution of Class E Common Stock since the fortunes of 
this stock were less tied to GM's automotive business. Working 
with the PBGC and the Departments of Labor and Treasury, GM 
successfully completed in March 1995 a contribution of 
approximately $7 billion of Class E Common Stock to the GM 
plans. This contribution dramatically reduced the level of GM's 
underfunding (and in turn the PBGC's contingent liability), in 
a way that would not have been possible without the use of 
tracking stock.
    GM's use of tracking stock to fund its pension plan did not 
constitute any form of tax avoidance and was not motivated by 
tax reasons. Indeed, GM made this contribution only after 
extensive collaboration with the Treasury Department, the Labor 
Department, and the PBGC. Each government agency supported GM's 
issuing Class E Common Stock to fund GM's pension plan.

C. Recent Experiences with Tracking Stock

    GM ultimately spun off EDS to GM's shareholders in 1996, 
nearly 12 years after GM had acquired EDS. The spin-off was 
accomplished tax-free under Code Sec. 355, with GM receiving a 
ruling from the IRS that the spin-off met all relevant 
requirements of the Internal Revenue Code. GM spun off EDS 
because GM concluded that it could continue to enjoy the 
benefits of EDS's expertise through a long-term supply 
agreement. At the same time, EDS's business had progressed to 
the point where EDS concluded that being owned by GM was 
detrimental to its ability to attract new business from 
customers or enter into strategic alliances with third parties. 
A spin-off with a long-term supply agreement thus benefitted 
both parties.
    As GM was considering the strategic alternatives available 
to it regarding EDS, one alternative that was briefly 
considered was to sell a substantial block of Class E Common 
Stock to a company interested in purchasing a controlling 
interest in EDS. While GM believes that it had strong business 
reasons for such a transaction, such a sale arguably might have 
been the type of transaction that the Clinton Administration 
finds objectionable about tracking stock, i.e., a sale of 
tracking stock in lieu of a sale of subsidiary stock. But when 
GM negotiated with potential strategic purchasers, none of them 
was willing to invest in EDS without acquiring a direct 
ownership in EDS's assets or having a significant voice in EDS 
management.
    Each potential strategic purchaser noted that if GM were to 
go bankrupt or have trouble paying creditors, the assets of EDS 
would be available to satisfy the claims of GM creditors. 
Consequently, every potential strategic purchaser of a 
substantial portion of EDS rejected any suggestion that it 
simply acquire Class E Common Stock. This reluctance 
demonstrates why the Clinton Administration's concerns about 
tracking stock are hypothetical, not real. There is no 
practical way to dispose of a subsidiary through the sale of 
tracking stock. Potential strategic purchasers are unwilling, 
for substantial business reasons, to purchase tracking stock 
instead of the underlying subsidiary's stock or assets.
    In 1997, GM also disposed of the defense electronics 
business of Hughes. This transaction was accomplished by 
spinning off the Hughes Defense business to all classes of GM 
shareholders, with Hughes Defense then merging with Raytheon 
Corporation. GM's Class H Common Stock remained outstanding, 
with such stock continuing to track the earnings of Hughes' 
remaining businesses (principally telecommunications and 
satellites). This transaction was tax-free under Code Sec. 355, 
with GM receiving a favorable ruling from the IRS. The 
existence of Class H Common Stock in no way facilitated this 
transaction. Indeed, the existence of GM tracking stock was, if 
anything, a complicating factor, since it required GM, among 
other things, to weigh the relative interests of its different 
classes of common stock, determine that the spin off and 
related transactions were fair to all classes of GM 
stockholders, and condition the transactions on approvals by 
each class of GM common stock.

                 Lessons Learned from the GM Experience

    GM's experience with tracking stock demonstrates 
conclusively why tracking stock is a valuable business tool and 
not a tool for tax avoidance. The lessons from the GM 
experience include the following:

A. Compelling Business Purposes

    The stated concern of the Clinton Administration is that 
corporations will issue tracking stock in order to dispose of a 
business without paying the tax that would normally be owed 
after a taxable sale. We are aware of no case where this has 
ever occurred. Corporations generally issue tracking stock when 
they acquire (not sell) a new business or when they need to 
raise additional capital to expand or preserve a business. For 
example:
     GM issued tracking stock when it acquired EDS and 
Hughes
     Genzyme issued tracking stock in order to obtain 
funding for its research and development activities
     Sprint issued tracking stock when it acquired all 
of the stock of Sprint PCS
     USX issued tracking stock when it needed 
additional capital to restore its steel business
     GM issued tracking stock in order to alleviate the 
underfunding in its pension plan
    GM could not have acquired EDS or Hughes without the 
ability to issue tracking stock, since the prior owners of EDS 
and Hughes did not view GM's automotive stock as an attractive 
investment. Nor could it have funded its underfunded pension 
plan without tracking stock, since a large block of GM 
automotive stock was not an appropriate mechanism to fund the 
GM pension plans.

B. Investor Choice

    Tracking stock permits greater investor choice. Investors 
can choose the business operations of a corporation in which 
they wish to invest, as opposed to investing in a corporate 
conglomerate. In today's specialized financial markets, many 
mutual funds and other investors invest only in certain types 
of companies, such as sector funds that only invest in computer 
or technology companies. Most sector funds do not invest in the 
stock of corporate conglomerates. By issuing tracking stock, GM 
created separately traded stocks that were purchased by 
investors who otherwise would not have been willing to invest 
in the GM group as a whole.
    This element of investor choice continues to reflect itself 
in GM's shareholder base even today. GM's automotive stock is 
an attractive investment for so-called value investors, i.e., 
investors who prefer equities with a lower price-to-earnings 
ratio that pay a reasonable dividend. GM's Class H Common 
Stock, on the other hand, is a growth stock with a high price-
to-earnings ratio that does not currently pay dividends. If GM 
had only one class of equity outstanding, the GM story would be 
confusing to the marketplace, and, for example, investors in 
growth stocks would not be attracted to invest in the GM group.

C. Raising Capital

    Tracking stock provides an efficient mechanism to raise 
capital. Many of the corporations that have issued tracking 
stock are mature businesses whose stocks trade at relatively 
low price-to-earnings ratios, such as GM (autos), USX (steel), 
Pittston (coal), and Georgia Pacific (forestry), but who own 
subsidiaries that are in different businesses. If these 
corporations were to issue their own stock in a tax-free public 
offering, the proceeds received in exchange for the equity 
surrendered would reflect the low price-to-earnings ratio of 
the core business. By issuing tracking stock that tracks the 
business of a higher-growth subsidiary, the issuing corporation 
is able to raise more capital with less dilution to existing 
shareholders. And by doing so, the issuing company's ability to 
invest and grow its own business is enhanced.
    This value disparity can clearly be seen in GM's experience 
with tracking stock. GM's automotive stock has typically traded 
at a price-to-earnings multiple of approximately 8-10. GM's 
Class E Common Stock typically traded, however, at a multiple 
of from 20-30; GM's Class H Common Stock also trades at very 
high multiples, currently above 60. When GM needed to fund its 
pension plan in the early 1990's, GM was able to provide 
approximately $7 billion to the plan by issuing high-multiple 
Class E Common Stock. If GM had been required to issue its 
automotive stock to the plan, a much greater amount of 
shareholder dilution would have been required in order to 
provide $7 billion of funding.

D. Executive Accountability and Employee Incentives

    Corporate officers invariably are more focused on 
shareholder value when they know that their actions will 
directly affect equity valuations. In the absence of tracking 
stock, executives at Hughes and EDS would have known that their 
actions would have had only minimal influence on GM's stock 
price, since the equity markets invariably have valued GM's 
business principally on the performance of GM's automotive 
business.
    By creating separate tracking stocks, employees at EDS and 
Hughes knew that their actions had a more direct impact on 
stock values. From a shareholder perspective, a tracking stock 
much more closely aligned the financial incentives of EDS and 
Hughes' employees with those of GM's shareholders. The 
existence of tracking stock also permitted employees to receive 
stock in their 401(k) plans and stock options whose value was 
tied to the business at which they worked. It was these types 
of issues that principally caused GM to propose tracking stock 
when it acquired EDS in 1984.

E. Shareholder Value

    Tracking stock is a powerful generator of shareholder 
value. Equity markets tend to discount conglomerates, valuing 
an entire business at less than its component parts are worth. 
Tracking stock permits each distinct business to be separately 
valued on its own fundamentals and earnings, while at the same 
time allowing corporate groups to obtain operating synergies 
and economies of scale.
    The value enhancement possible through tracking stock was 
clearly seen on March 10, 1999, when DuPont Corporation 
announced that it would issue a class of DuPont tracking stock 
to track DuPont's life sciences business. DuPont's stock rose 
nearly 8% in value upon this announcement. Moreover, DuPont's 
stated reasons for issuing this stock were the textbook case 
for tracking stock. DuPont's mature chemical business traded at 
a relatively low price-to-earnings ratio, masking the value of 
DuPont's high-value pharmaceuticals and life sciences business. 
By issuing tracking stock, DuPont intends to unlock the value 
of its life sciences business, while also creating an 
acquisition currency that it can use to make acquisitions in 
the life sciences business.

F. Tracking Stock Not Used for Tax Avoidance Purposes

    The Clinton Administration proposes to tax tracking stock 
based on the assumption that such stock can be used for tax 
avoidance. However, tracking stock carries none of the indicia 
of tax avoidance. The hallmark of corporate tax avoidance 
transactions is that such transactions are effected without 
public disclosure, without any business purpose or economic 
substance, in order to generate artificial tax losses. In 
contrast, tracking stock issuances have all been fully 
disclosed to shareholders and have been completed only when the 
use of tracking stock made compelling business sense.
    The Administration also is apparently concerned that a 
corporation will simply sell tracking stock in order to dispose 
of a subsidiary, in lieu of selling the subsidiary's stock in a 
taxable sale. This concern ignores what has actually happened 
in the marketplace with tracking stock. GM issued both Class E 
Common Stock and Class H Common Stock for business reasons to 
consummate important acquisitions for the company. GM believes 
that the other public corporations that have issued tracking 
stock have also done so for strong business reasons. Tracking 
stock is an effective business tool for making acquisitions and 
raising capital, but it cannot realistically be used for 
dispositions.
    As discussed above, GM considered selling a substantial 
block of Class E Common Stock to potential strategic purchasers 
of EDS in the early 1990's. GM quickly learned that it was just 
not possible to effect such a transaction. No potential 
strategic purchaser was willing to purchase any significant 
amount of tracking stock, because tracking stock does not carry 
with it any rights to manage and control the underlying assets. 
Moreover, the strategic purchaser's economic investment would 
have remained linked to the economic fortunes of GM, a scenario 
that was unacceptable to any potential purchaser. Based on its 
experience with tracking stock, GM believes that tracking stock 
cannot realistically be used in the way that the Clinton 
Administration apparently fears, i.e., tracking stock offers no 
reasonable avenue for tax avoidance and cannot be used to 
effect an otherwise taxable sale.
    Another impediment to using tracking stock for tax purposes 
is that such stock is complex and cannot be issued or sold 
without substantial public disclosure and explanation to 
shareholders. When corporations have sought to issue tracking 
stock without a compelling business reason, shareholders have 
rejected it (as, for example, K-Mart's shareholders did in 
1994). In the fifteen years since tracking stock was first 
issued, we are aware of only fifteen public companies that have 
issued such stock.

G. Congress Has Already Enacted, and Treasury Can Adopt, 
Provisions to Ensure that Tracking Stock Cannot Be Used for Tax 
Avoidance

    The concerns of the Clinton Administration appear to be 
based on a fear that a taxpayer might use tracking stock to 
sell off its interest in a subsidiary to a third party without 
paying tax on any gain realized from appreciation in that 
subsidiary. Fifteen years of history with tracking stock shows, 
however, that such stock has not been used for tax avoidance. 
The fears of the Administration thus are premised on 
hypothetical tax avoidance, as opposed to a response to any 
actual abuses involving tracking stock.
    The Administration proposal also ignores two important 
facts: Congress has already enacted legislation to ensure that 
tracking stock is not used as a substitute for selling the 
subsidiary itself, and Treasury has the authority under Code 
Sec. 337(d) to enact regulations if any taxpayer in fact 
creates some as-yet-unidentified way to use tracking stock for 
tax avoidance purposes.
    In 1990, Congress enacted Code Sec. 355(d)(6)(B)(iii). This 
statute prevents a parent corporation from selling a large 
block of tracking stock to a third party and then later 
distributing the stock of the tracked subsidiary to that third 
party in a tax-free split-off under Code Sec. 355. This statute 
thus addresses the exact situation that the Clinton 
Administration is apparently concerned about--the sale of 
tracking stock to a third party as a substitute for a taxable 
divestiture. Code Sec. 355(d) is premised on the assumption 
that no third party would ever agree to purchase a business via 
the use of tracking stock unless that third party knew that 
ultimately the tracking stock would be unwound and the third 
party would receive the underlying business via a tax-free 
spin-off. Code Sec. 355(d)(6)(B)(iii) prevents this technique.
    In addition, Code Sec. 337(d) provides Treasury with the 
authority to issue regulations to carry out the purposes of so-
called ``General Utilities repeal,'' i.e., to ensure that 
corporations cannot sell the stock of a subsidiary at a gain 
without incurring a tax liability. If Treasury had any specific 
concerns that tracking stock was being used to avoid General 
Utilities repeal, this statute gives Treasury full authority to 
issue regulations to prevent that avoidance. Since Code 
Sec. 337(d) was enacted in 1986, Treasury has not adopted any 
regulations to address any perceived tracking stock abuses, 
because, we believe, there have been no abuses. In the event 
Treasury becomes concerned that tracking stock is being used in 
some specified tax-avoidance manner, Treasury should use the 
authority already given it to implement a targeted response, 
instead of simply asking Congress to effectively eliminate the 
use of tracking stock altogether (as the Clinton Administration 
proposal would surely do).

                               Conclusion

    GM recognizes that both the Clinton Administration and the 
Congress have a real and substantial interest in curtailing the 
use of tax avoidance mechanisms and tax shelters by 
corporations. GM believes that corporate use of inappropriate 
shelters merits this Committee's attention and remediation. 
However, we are aware of no circumstance where any corporation 
has used tracking stock as a tax avoidance mechanism.
    Corporations that have issued tracking stock have done so 
for compelling business reasons. The proposed new rules for 
taxing tracking stock would have the effect of virtually 
eliminating a legitimate and valuable business mechanism, 
hurting shareholder value, restraining capital formation and 
job creation, and giving rise to marketplace and employee 
confusion, while doing nothing to eliminate tax avoidance.
    GM strongly urges this Committee to reject the 
Administration's proposal to tax the issuance of tracking 
stock. Thank you.
      

                                

Statement of Governors' Public Power Alliance, Lincoln, Nebraska

    The Governors' Public Power Alliance is pleased to submit 
this statement to the Committee on Ways and Means, U.S. House 
of Representatives, on the revenue provisions in the Clinton 
administration's fiscal year 2000 budget. The Alliance is 
specifically concerned about the electricity restructuring 
provisions found in the FY 2000 budget: Deny tax-exempt status 
for new electric utility bonds except for distribution related 
expenses.
    The Governors' Public Power Alliance, a bipartisan Alliance 
of governors, was formed so that federal initiatives do not 
disadvantage the millions of Americans who are served by 
locally and consumer-owned electric utilities.
    Tennessee Governor Donald Sundquist and Nebraska Governor 
Mike Johanns chair the Alliance. Alaska Governor Tony Knowles 
is vice chairman. Other Alliance members are Florida Governor 
Jeb Bush, South Dakota Governor Bill Janklow, Puerto Rico 
Governor Pedro Rossello and Washington Governor Gary Locke.

            The Alliance and Electric Utility Restructuring

    One of every four American consumers receives electric 
power from consumer-owned electric systems or member-owned 
rural electric cooperatives. These are locally owned assets 
that for more than 115 years have made enormous contributions 
to the nation's economic prosperity and that of our states, 
cities and rural areas. Their local ownership and not-for-
profit mission makes them very different from private 
companies, requiring different solutions to the challenges of 
the new marketplace envisioned by restructuring advocates.
    The federal government can't create one restructuring model 
and expect all 50 states to follow it. Every one of our states 
has unique characteristics that will make a `` one-size fits 
all'' federal model unworkable, unfair and costly to consumers.
    The governors are concerned that consumers served by local 
and regional electric systems may be overlooked in federal 
legislative and regulatory proposals. The more than 2,000 
publicly owned electric systems and 900 plus rural electric 
cooperative utilities may be seen as small when compared with 
the nation's 240 investor-owned electric companies, they 
provide essential services to a large portion of America's 
electric customers.
    The Alliance subscribes to these principles dealing with 
electric utility restructuring:
     Several issues are solely within federal 
jurisdiction and must be addressed to open the door to retail 
competition and foster the development of competitive markets.
     The cornerstone of federal policy should be a 
commitment to respect state and local decision-making.
     It is inappropriate for the federal government to 
preempt state and local restructuring efforts. Instead, the 
federal government should respect the traditional prerogative 
of state and local authorities to regulate retail utility 
transactions and support their efforts.
     Any federal legislation should facilitate state 
and local decisions regarding retail competition.
     Federal barriers to competition should be 
eliminated.
     Federal legislation is needed to establish 
additional protections against the establishment and abuse of 
market power.
    Public power's first and only purpose is to provide 
excellent, efficient service to their local citizens/customers 
at the lowest possible cost. Like hospitals, community schools, 
water, sewer, parks, police and fire departments, these 
``public power'' systems are locally created institutions that 
address a basic community need: they operate to provide an 
essential public service at a reasonable, not-for-profit price. 
Public power systems are governed democratically through their 
state and local government structures. They operate in the 
sunshine, subject to open meeting laws, public records laws and 
conflict of interest rules. Most, especially the smaller ones, 
are governed by a city council, while oftentimes an elected or 
appointed board independently governs others.
    Local power customers are direct stakeholders in the 
utilities' operations and future. In turn, public power 
utilities are community institutions with community-wide goals. 
As state and local government organizations and entities, they 
boost economic development, return taxes and make in-lieu-of-
tax payments to states and communities, and lower citizen costs 
through coordination of services with other government 
entities. Local electric systems give citizens--as direct 
stakeholders--opportunities to participate in service, 
financial and operating decisions. For purposes of competition, 
they serve as an important yardstick against which to measure 
the price, service, reliability and performance of private 
power companies.
    While restructuring of the electric industry and 
introducing competition will likely give consumers new choices 
in terms of their purchase of electric power, through their 
state and local governments, consumers have always had a choice 
between creating their own public power systems or awarding 
franchises to private power companies. We wish to preserve this 
choice for all citizens.

          Electric Utility Restructuring and Tax Exempt Bonds

    Substantial portions of generation, transmission and 
distribution facilities owned by public power systems were 
financed through the issuance of tax-exempt bonds. These bonds, 
like bonds for all types of governmental purposes, carry with 
them restrictions on the amount of private use allowed for 
those facilities. While sound tax policies may warrant certain 
restrictions on private use of public facilities, public power 
facilities have been singled out for unduly restrictive 
treatment.
    These private use restrictions, which previously had a 
negative but survivable impact on the financing of community 
owned and operated electric output facilities, in their new 
form--and in the new competitive environment--will restrict the 
financing of governmental facilities far beyond the intention 
of Congress expressed in the Tax Reform Act of 1986. The 
restrictions are also contrary to the goals of the Energy 
Policy Act of 1992, and will impermissibly infringe upon the 
historical and fundamental right of the citizens of their 
locale to act as a community and utilize their own best 
judgment in the provision of essential governmental services.
    The Clinton administration should be commended for tackling 
this difficult issue. We are encouraged to see the 
administration proposal seek to ``modify'' and revise tax-
exempt bond rules as part of electric utility restructuring 
``so that consumers benefit from competition.'' As we 
understand it, the proposal, to encourage public power systems 
to implement retail competition, states that outstanding bonds 
previously issued to finance generation and distribution 
facilities would continue their tax-exempt status ``even if the 
issuer implements retail competition.'' Similarly, bonds issued 
to finance transmission facilities would also continue their 
tax-exempt status ``even if private use resulted from allowing 
nondiscriminatory open access'' to those facilities, including, 
for example, participation in an independent system operator 
(ISO).
    However, the same proposal seems to prohibit public power 
systems from building both generation and transmission 
facilities in the future with tax-exempt bonds (``...interest 
on bonds...would not be exempt''). While we fully appreciate 
the political debate surrounding this issue, we are 
particularly concerned about the essence of this provision: 
community owned electric systems, especially the majority of 
the small systems around this country, could no longer exercise 
their right at local control and regulation, and may be 
unnecessarily burdened by an overly restrictive proposal.
    We have expressed similar concerns directly to the 
administration. In a February 3 letter to Secretary of Energy 
Bill Richardson, the Alliance asked the administration to 
review its policy in this area. The transmission provision may 
be particularly troubling. While the generation side of the 
electric industry is currently undergoing a major 
transformation, the transmission side is not. For all the 
discussion about ISOs, regional transmission organizations, and 
transcos, several questions remain about transmission. For this 
reason, retaining the ability to issue tax-exempt debt for 
transmission facilities is critical to the future of community 
owned electric systems.

                  The Bond Fairness and Protection Act

    A similar legislative proposal has been offered in both the 
House and Senate. The Bond Fairness and Protection Act--
introduced in the 106th Congress by Senators Slade Gorton and 
Bob Kerrey in the Senate (S. 386), and by Representatives. J. 
D. Hayworth and Bob Matsui in the House (H.R. 721)--is a fair 
and reasonable solution to the problems posed by the private 
use restrictions on public power bonds.
    The bills, companion measures in both houses, provide state 
and locally owned utilities with two options for obtaining the 
necessary level of relief they need to enter competitive 
electricity markets without jeopardizing the tax-exempt status 
of outstanding bonds or raising rates. The bill also requires 
those taking this relief to make significant concessions on the 
future use of tax-exempt bonds by giving up the right to issue 
such debt for generation facilities, but retaining the same 
right to issue debt in the future for transmission and 
distribution facilities.
    We urge the Committee to incorporate H.R. 721 into the 
committee bill. Of great import to the Alliance, the measure 
also respects state and local authority by allowing those 
decisions to be made at the state and local level.
    The Governors' Public Power Alliance appreciates the 
opportunity to submit this statement for the record. We look 
forward to working with the Committee on these and other 
matters.
      

                                

Interstate Conference of Employment Security Agencies, Inc.  
                                                           
                            Service Bureau Consortium, Inc.
                                                  February 26, 1999

The Honorable Bill Archer
Chairman, Committee on Ways and Means
1102 Longworth House Office Building
Washington, D.C. 20515-6348

The Honorable Charles Rangel
Ranking Member, Committee on Ways and Means
1106 Longworth House Office Building
Washington, D.C. 20515-6348

    Dear Chairman Archer and Ranking Member Rangel:

    The Administration's FY 2000 budget proposal contains a provision 
that would accelerate, from quarterly to monthly, the collection of 
most federal and state unemployment insurance (UI) taxes beginning in 
2005. The Interstate Conference of Employment Security Agencies (ICESA) 
and the Service Bureau Consortium (SBC) strongly oppose this provision. 
A similar proposal was put forth in the Administration's FY 1999 Budget 
and was rejected by Congress.
    ICESA is the national organization of state administrators of 
unemployment insurance, employment and training services, and labor 
market information programs. SBC is a non-profit trade association 
whose member companies are organizations that provide payroll 
processing and employment tax services to more than 800,000 employers, 
representing more than one-third of the private sector workforce. 
Together, these organizations represent both those who collect UI taxes 
and those who process the tax payments.
    Imposing monthly collection of federal and state UI taxes is a 
burdensome device that accelerates the collection of these taxes to 
generate a one time artificial revenue increase for budget-scoring 
purposes and real, every year increases in both compliance costs for 
employers and collection costs for state unemployment insurance 
administrators. The Administration's proposal is fundamentally 
inconsistent with every reform proposal that seeks to streamline the 
operation of the UI system and with its own initiatives to reduce 
paperwork and regulatory burdens.
    This proposal is even more objectionable than some other tax speed-
up gimmicks considered in the past. For example, a proposal to move an 
excise tax deposit date forward by one month into an earlier fiscal 
year may make little policy sense, but it would not necessarily create 
major additional administrative burdens. The UI speed-up proposal, 
however, would result directly in significant and continuing costs to 
taxpayers and to state governments--tripling the number of required UI 
tax collection filings from 8 to 24 per affected employer each year.
    The Administration implicitly recognizes that the added federal and 
state deposit requirements would be burdensome, at least for small 
business, since the proposal includes an exemption for certain 
employers with limited FUTA liability. Even many smaller businesses 
that add or replace employees or hire seasonal workers would not 
qualify for the exemption, however, since new FUTA liability accrues 
with each new hire, including replacement employees. This deposit 
acceleration rule makes no sense for businesses large or small, and an 
exemption for certain small businesses does nothing to improve this 
fundamentally flawed concept.
    We both strongly support UI reform that simplifies the system and 
reduces the burden on employers and the costs of administration to the 
federal and state governments. Adopting the Administration's UI 
collection speed-up proposal, however, would take the system in exactly 
the opposite direction, creating even greater burdens than those which 
exist under the current system.
    We urge you to reject the Administration's UI collection speed-up 
proposal and focus instead on proposals that would make meaningful 
system-wide reforms. Thank you for your consideration of our views on 
this important issue. Please do not hesitate to let us know if we can 
provide additional assistance.

            Sincerely,
        Interstate Conference of Employment Security Agencies, Inc.
                                    Service Bureau Consortium, Inc.

cc: Members of the Committee on Ways and Means
      

                                

Statement of Investment Company Institute

    The Investment Company Institute (the ``Institute'') \1\ 
submits for the Committee's consideration the following 
comments regarding proposals to (1) enhance retirement 
security, (2) exempt from withholding tax all distributions 
made to foreign investors in certain qualified bond funds, (3) 
require mandatory accrual of market discount, (4) increase the 
penalties under section 6721 of the Internal Revenue Code \2\ 
for failure to file correct information returns, (5) tax 
partial liquidations of partnership interests, and (6) modify 
section 1374 to require current gain recognition on the 
conversion of a large C corporation to an S corporation.
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    \1\ The Investment Company Institute is the national association of 
the American investment company industry. Its membership includes 7,446 
open-end investment companies (``mutual funds''), 456 closed-end 
investment companies and 8 sponsors of unit investment trusts. Its 
mutual fund members have assets of about $5.662 trillion, accounting 
for approximately 95% of total industry assets, and have over 73 
million individual shareholders.
    \2\ All references to ``sections'' are to sections of the Internal 
Revenue Code of 1986, as amended (the ``Code'').
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                   I. Retirement Security Initiatives

    The U.S. mutual fund industry serves the needs of American 
households saving for their retirement and other long-term 
financial goals. By permitting millions of individuals to pool 
their savings in a diversified fund that is professionally 
managed, mutual funds provide an important financial management 
role for middle-income Americans. Mutual funds also serve as an 
important investment medium for employer-sponsored retirement 
programs, including small employer savings vehicles like the 
new Savings Incentive Match Plan for Employees (``SIMPLE'') and 
section 401(k) plans, and for individual savings programs such 
as traditional and Roth IRAs. As of December 31, 1997, mutual 
funds held over $1.59 trillion in retirement assets, including 
$774 billion held in qualified retirement plans.\3\
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    \3\ ``Mutual Funds and the Retirement Market,'' Fundamentals, Vol. 
7, No. 2 (Investment Company Institute, July 1998).
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    The Institute has long supported legislative efforts to 
enhance retirement savings opportunities for Americans; 
including legislation that would expand retirement savings 
opportunities, simplify retirement plan administration and 
enable individuals to more easily manage their retirement 
accounts. Therefore, with respect to the items in the 
Administration's FY 2000 budget proposal, we support those 
provisions that would make retirement savings more portable, 
thus enabling Americans to more easily manage their retirement 
savings, and those that would increase small employer 
retirement plan coverage. Nevertheless, we believe that the 
Administration's proposals should be modified and broadened in 
several respects. In particular, as discussed further below, we 
recommend that (1) the portability proposal be broadened to 
include 457 plans, (2) the portability proposal be revised to 
eliminate unnecessary burdens on IRA custodians and trustees, 
(3) the SIMPLE plan deferral limit be raised, (4) Congress 
repeal or modify costly regulations that discourage plan 
formation, such as the ``top-heavy'' rule, (5) Congress ensure 
that any new programs do not undermine successful programs 
already in existence, such as SIMPLE plans, and (6) Congress 
raise contribution limits for IRAs and employer-sponsored plans 
and allow older Americans to make ``catch-up'' contributions.

A. Retirement Account Portability

    Background.--Because average job tenure at any one job is 
under 5 years,\4\ individuals are likely to have at least 
several employers over the course of their careers. As a 
result, the portability of retirement plan assets is an 
important policy goal.
---------------------------------------------------------------------------
    \4\ Debunking the Retirement Myth: Lifetime Jobs Never Existed for 
Most Workers, Employee Benefit Research Institute, Issue Brief No. 197 
(May 1998).
---------------------------------------------------------------------------
    Under current law, an individual moving from one private 
employer to another, where both employers provide section 
401(k) plan coverage, generally may roll over his or her vested 
account balance to the new employer. Where an individual moves 
from a private employer to a university or hospital or to the 
government sector, however, such account portability is not 
permitted. The problem arises because each type of employer has 
its own separate type of tax-qualified individual account 
program. Neither the university's section 403(b) program nor 
the governmental employer's ``457 plan'' program may accept 
401(k) plan money, and vice versa. Moreover, with the exception 
of ``conduit IRAs,'' moving IRA assets into an employer-
sponsored plan is prohibited.
    Recommendation.--The Institute supports the 
Administration's legislative proposal to permit portability 
among different types of retirement plans. Such legislation 
would enable individuals to bring retirement savings with them 
when they change jobs, consolidate accounts and more readily 
manage retirement assets. However, the Administration's 
portability proposal should be expanded to permit rollovers of 
457 plan amounts to 401(k) plans and 403(b) arrangements and 
vice versa.
    In addition, the Institute believes that portability 
legislation should be administratively feasible. Therefore, the 
Institute does not support the Administration's proposal to 
require IRA trustees and custodians to track and report the 
basis related to after-tax rollovers. Currently, IRA trustees 
and custodians do not verify or track the tax nature of an IRA 
contribution; this proposal would impose new and burdensome 
administrative requirements on IRA trustees and custodians with 
respect to IRA contributions. A specific methodology and tax 
form already is being used to track basis in IRA accounts, and 
could be easily adopted for this purpose. Thus, there is no 
need to create a wholly new reporting and accounting regime.
    With respect to its proposal regarding rollovers of IRAs to 
qualified plans and 403(b) arrangements, the Administration 
would limit eligibility to those individuals who have a 
traditional IRA and whose IRA contributions have all been 
deductible. The Institute recommends expansion of this 
eligibility provision to permit taxpayers who have made non-
deductible IRA contributions to roll over IRA amounts to 
qualified plans or 403(b) arrangements. Specifically, Congress 
should permit the rollover of all pre-tax IRA amounts, 
including deductible contributions and earnings, to plans 
regardless of whether a taxpayer has ever made a non-deductible 
contribution to an IRA. The Institute supports similar IRA 
rollover proposals contained in H.R. 739, the ``Retirement 
Account Portability Act of 1999,'' which was introduced by 
Representative Pomeroy (D-ND), and H.R. 1102, the 
``Comprehensive Retirement Security and Pension Reform Act of 
1999,'' which was introduced by Representative Portman (R-OH) 
and Representative Cardin (D-MD).

B. Small Employer Retirement Plan Coverage

    Background.--Retirement plan coverage is a matter of 
serious public concern. Coverage rates remain especially low 
among small employers. Less than one-half of employers with 25 
to 100 employees sponsored retirement plans. The percentage is 
even lower in the case of employers with fewer than 25 
employees. The enactment \5\ of legislation creating SIMPLE 
plans was a major first step toward improving coverage, but 
more remains to be done.
---------------------------------------------------------------------------
    \5\ In 1993, the most recent year for which data is available, only 
19 percent of employers with fewer than 25 employees sponsored a 
retirement plan. EBRI Databook on Employee Benefits. Employee Benefit 
Research Institute, 1997.
---------------------------------------------------------------------------
    Recommendations.--Congress should (1) improve the SIMPLE 
plan program for small employers by raising the salary deferral 
limitation, (2) lower the cost of the plan establishment and 
administration, especially for small employers, by eliminating 
or modifying regulations, such as the ``top-heavy'' rule and 
providing a tax credit for small employers establishing plans 
for the first time, and (3) assure that new small employer plan 
initiatives provide effective incentives for plan establishment 
and do not undermine currently successful programs.
    1. Raise the SIMPLE Plan Deferral Limitation.--In 1996, 
Congress created the successful SIMPLE program. The SIMPLE is a 
simplified defined contribution plan available to employers 
with fewer than 100 employees. An informal Institute survey of 
its largest members found that as of March 31, 1998, 
approximately 63,000 SIMPLE IRA plans had been established by 
these firms, representing an increase of 47% during the first 
three months of 1998. Further, the Institute found that 
approximately 343,000 SIMPLE IRA accounts had been established 
as of March 31, 1998, representing an increase of approximately 
61% from year-end 1997 figures. Most significantly, the 
informal survey demonstrated that virtually all (98%) of SIMPLE 
plan formation is among the smallest of employers--those with 
fewer than 25 employees. Indeed, employers with 10 or fewer 
employees represented about 90% of these plans. Thus, for the 
first time, significant numbers of small employers are able to 
offer and maintain retirement plans for their employees. We 
believe the SIMPLE plan works because it is, as its name 
states, simple. It is easy to implement and easy to understand 
and places little administrative burden on small employers.
    Currently, however, an employee working for an employer 
offering the SIMPLE may save only up to $6,000 annually in his 
or her SIMPLE account while an employee in a 401(k) plan, 
typically sponsored by a mid-size or larger employer, is 
permitted to contribute up to $10,000. Congress can readily 
address this inequity by amending the SIMPLE program to permit 
participating employees to defer up to $10,000 of their salary 
into the plan, that is, up to the limit set forth at section 
402(g) of the Internal Revenue Code. This change would enhance 
the ability of many individuals to save for retirement and, 
yet, would impose no additional costs on small employers 
sponsoring SIMPLEs.\6\
---------------------------------------------------------------------------
    \6\ As noted below, we also believe that the limits under section 
402(g) should be raised.
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    We also believe that the SIMPLE program would be more 
effective for employers of 25-100 employees if there were a 
salary-reduction-only formula option. Such an option has been 
proposed in H.R. 1102 and should be considered as part of any 
retirement program reform bill seeking to address small 
employer coverage rates.
    2. Repeal or Modify Unnecessary, Costly Regulations, Such 
as The Top-Heavy Rule, That Inhibit Small Employer Plan 
Formation.--Congress could raise the level of small employer 
retirement plan formation if it reduced the cost of plan 
formation and maintenance. One way to reduce these costs is for 
the federal government to subsidize them. The Administration 
has proposed a ``start-up tax credit'' for small employers that 
establish a retirement plan in 2000. Such a tax incentive may 
induce certain small employers to establish retirement plans.
    Another approach would be to seek the actual reduction of 
on-going plan costs attributed to regulation. For instance, a 
1996 U. S. Chamber of Commerce survey showed that the ``top-
heavy'' rule \7\ is the most significant regulatory impediment 
to small businesses establishing a retirement plan.\8\ Repeal 
or modification of the ``top-heavy'' rule would likely lead to 
additional small employer plan formation.
---------------------------------------------------------------------------
    \7\ Section 416 of the Internal Revenue Code. The ``top-heavy'' 
rule requires employers, in situations where over 60 percent of total 
plan assets represent benefits for ``key'' employees, to (1) increase 
the benefits paid to non-key employees, and (2) accelerate the plan's 
vesting schedule. Small businesses are more likely to have individuals 
with ownership interests working at the company and in supervisory or 
officer positions, each of which are considered ``key'' employees, 
thereby exacerbating the impact of the rule.
    \8\ Federal Regulation and Its Effect on Business--A Survey of 
Business by the U.S. Chamber of Commerce About Federal Labor Employee 
Benefits, Environmental and Natural Resource Regulations, U.S. Chamber 
of Commerce, June 25, 1996.
---------------------------------------------------------------------------
    Finally, Congress certainly should avoid discouraging plan 
formation by adding to the cost of retirement plans. Thus, the 
Institute strongly urges that Congress not enact the 
Administration's recommendation that a new mandatory employer 
contribution be required of employers using design-based safe 
harbor formulas in their 401(k) plans.
    3.  New Programs For Small Employers Should Provide 
Effective Incentives For Plan Establishment and Not Undermine 
Currently Successful Programs.--The Administration has also 
proposed enhancing the ``payroll deduction IRA'' program and 
creating a new simplified defined benefit plan program for 
small employers. In considering these proposals, it is 
important to assure that incentives are appropriately designed 
to induce program participation and that the programs do not 
undermine current retirement plan options.
    For instance, the Administration would create an additional 
incentive to use the payroll deduction IRA program by excluding 
payroll deduction contributions from an employee's income. 
Accordingly, they would not be reported on the employee's Form 
W-2. As the success of the 401(k) and SIMPLE programs 
demonstrate, payroll deduction provides an effective, 
disciplined way for individuals to save, and its encouragement 
is a laudable policy goal. However, simplifying tax reporting 
alone may not provide a sufficient incentive for employers to 
establish a payroll deduction IRA program. More importantly, 
the interaction of an expanded payroll deduction IRA program 
with the new and successful SIMPLE program should be carefully 
considered. As noted above, the SIMPLE plan program has been 
extremely attractive to the smallest employers, exactly those 
for whom a payroll deduction IRA program is designed. Any new 
program expansion should not undermine this already existing, 
successful small employer program. Because the maximum IRA 
contribution amount is $2,000 (an amount not increased since 
1981), it may not be appropriate to induce small employers to 
use that program rather than the popular SIMPLE program, which 
would permit employees a larger plan contribution. Similar 
considerations should be made with regard to any simplified 
defined benefit program.

C. Permit Individuals to Save Adequate Amounts for Retirement 
by Raising Contribution Limits, Including The IRA Limit

    Many individuals cannot save as much as they need to under 
current retirement plan caps. An item notably absent from the 
FY 2000 budget proposal is a proposal to raise the contribution 
limits applicable to qualified plans and IRAs. Most 
significantly, the IRA limit remains at $2,000--a limit set in 
1981. If adjusted for inflation, this limit would be at about 
$5,000. IRAs are especially important for individuals with no 
available employer-sponsored plan, who are significantly 
disadvantaged.
    Similarly, we believe other retirement plan limits, such as 
the section 402(g) limit on salary deferrals and the section 
415 limit on defined contribution plan contributions should be 
raised. These limits should also be adjusted to reflect the 
typical work and saving patterns of most Americans. Many 
Americans find it difficult to save for retirement when they 
have more pressing financial obligations, including purchasing 
a home, raising a family and providing college education for 
their children. All of these circumstances reflect the need to 
create a ``catch-up'' rule for employer-sponsored plans and 
IRAs whereby individuals age 50 and older can increase their 
annual contributions. All of these proposals, which are 
strongly supported by the Institute, are contained in H.R. 
1102.

   II. Withholding Tax Exemption for Certain Bond Fund Distributions

Background

    Individuals around the world increasingly are turning to 
mutual funds to meet their diverse investment needs. Worldwide 
mutual fund assets have increased from $2.4 trillion at the end 
of 1990 to $7.6 trillion as of September 30, 1998. This growth 
in mutual fund assets is expected to continue as the middle 
class continues to expand around the world and baby boomers 
enter their peak savings years.
    U.S. mutual funds offer numerous advantages. Foreign 
investors may buy U.S. funds for professional portfolio 
management, diversification and liquidity. Investor confidence 
in our funds is strong because of the significant shareholder 
safeguards provided by the U.S. securities laws. Investors also 
value the convenient shareholder services provided by U.S. 
funds.
    Nevertheless, while the U.S. fund industry is the global 
leader, foreign investment in U.S. funds is low. Today, less 
than one percent of all U.S. fund assets are held by non-U.S. 
investors.
    One significant disincentive to foreign investment in U.S. 
funds is the manner in which the Code's withholding tax rules 
apply to distributions to non-U.S. shareholders from U.S. funds 
(treated for federal tax purposes as ``regulated investment 
companies'' or ``RICs''). Under U.S. law, foreign investors in 
U.S. funds receive less favorable U.S. withholding tax 
treatment than they would receive if they made comparable 
investments directly or through foreign funds. This withholding 
tax disparity arises because a U.S. fund's income, without 
regard to its source, generally is distributed as a 
``dividend'' subject to withholding tax.\9\ Consequently, 
foreign investors in U.S. funds are subject to U.S. withholding 
tax on distributions attributable to two types of income--
interest income (on ``portfolio interest'' obligations and 
certain other debt instruments) and short-term capital gains--
that would be exempt from U.S. withholding tax if received 
directly or through a foreign fund.
---------------------------------------------------------------------------
    \9\ The U.S. statutory withholding tax rate imposed on non-exempt 
income paid to foreign investors is 30 percent. U.S. income tax 
treaties typically reduce the withholding tax rate to 15 percent.
---------------------------------------------------------------------------
    A U.S. fund may ``flow through'' the character of the 
income it receives only pursuant to special ``designation'' 
rules in the Code. One such character preservation rule permits 
a U.S. fund to designate distributions of long-term gains to 
its shareholders (both U.S. and foreign) as ``capital gain 
dividends.'' As capital gains are exempt from U.S. withholding 
tax, foreign investors in a U.S. fund are not placed at a U.S. 
tax disadvantage with respect to distributions of the fund's 
long-term gains.
    Legislation introduced in both the House and the Senate in 
every Congress since 1991, and most recently in 1997,\10\ would 
permit all U.S. funds also to preserve, for withholding tax 
purposes, the character of interest income and short-term gains 
that would be exempt from U.S. withholding tax if received by 
foreign investors directly or through a foreign fund. The 
Institute strongly supports these ``investment 
competitiveness'' bills.
---------------------------------------------------------------------------
    \10\ The ``Investment Competitiveness Act of 1997'' was introduced 
by Representatives Crane, Dunn and McDermott (as H.R. 707) and by 
Senators Baucus, Gorton and Murray (as S. 815).
---------------------------------------------------------------------------
Proposal

    The President's Fiscal Year 2000 budget proposal, like the 
1999 budget proposal, includes a provision that generally would 
exempt from U.S. withholding tax all distributions to foreign 
investors by a U.S. fund that invests substantially all of its 
assets in U.S. debt securities or cash.\11\ A fund's 
distributions would remain eligible for this withholding tax 
exemption if the fund invests some of its assets in foreign 
debt instruments that are free from foreign tax pursuant to the 
domestic laws of the relevant foreign countries. Importantly, 
the taxation of U.S. investors in U.S. funds would not be 
affected by the proposal.
---------------------------------------------------------------------------
    \11\ The proposal would be effective for taxable years beginning 
after the date of enactment.

---------------------------------------------------------------------------
Recommendation

    The Institute urges the Committee to support enactment of 
legislation broader than that proposed by the Administration. 
Specifically, such legislation would exempt from U.S. 
withholding tax all distributions by U.S. funds--including 
equity, balanced and bond funds--of interest and short-term 
capital gains to foreign investors that would be exempt if 
received by a foreign investor either directly or through a 
foreign fund.\12\ Such legislation would eliminate U.S. tax 
incentives for foreign investors to prefer foreign funds over 
U.S. funds. Providing comparable withholding tax treatment for 
all U.S. funds would enhance the competitive position of U.S. 
fund managers and their U.S.-based work force.
---------------------------------------------------------------------------
    \12\ This legislation should contain appropriate safeguards to 
ensure that the exemption (1) applies only to interest that would be 
exempt from U.S. withholding tax if received by a foreign investor 
directly or through a foreign fund and (2) does not permit foreign 
investors in U.S. funds to avoid otherwise-applicable foreign tax by 
investing in U.S. funds that qualify for treaty benefits under the U.S. 
treaty network.
---------------------------------------------------------------------------
    Should the Committee determine to support the 
Administration's narrower proposal, which is limited to U.S. 
bond funds, the Institute recommends that such legislation 
distinguish between ``tax-exempt'' and ``taxable'' foreign 
securities. Specifically, no limit should be placed on the 
ability of a U.S. fund to hold a foreign bond, such as a 
Eurobond,\13\ that is exempt from foreign tax in the hands of a 
U.S. investor pursuant to the domestic law of the relevant 
foreign country (a ``tax-exempt'' foreign bond). In contrast, 
strict limits should be placed on the ability of a U.S. fund to 
hold a foreign bond that would be subject to foreign tax in the 
hands of a U.S. investor but for an income tax treaty with the 
United States (a ``taxable'' foreign bond). Such an approach 
was followed in legislation introduced last year that was 
drafted to reflect the Administration's Fiscal Year 1999 budget 
proposal.\14\
---------------------------------------------------------------------------
    \13\ ``Eurobonds'' are corporate or government bonds denominated in 
a currency other than the national currency of the issuer, including 
U.S. dollars. Eurobonds are an important capital source for 
multinational companies.
    \14\ The ``International Tax Simplification for American 
Competitiveness Act of 1998'' was introduced in the House by 
Representatives Houghton, Levin and Crane (as H.R. 4173) and in the 
Senate by Senators Hatch and Baucus (as S. 2331).
---------------------------------------------------------------------------

               III. Mandatory Accrual of Market Discount

Background

    Market discount generally is defined as the excess of the 
principal amount of a debt instrument (or the adjusted issue 
price in the case of a debt instrument issued with original 
issue discount\15\ over a holder's basis in the debt instrument 
immediately after acquisition. A bond typically will trade in 
the secondary market at a price below its principal amount (and 
hence with market discount) because an increase in interest 
rates after the date the bond was issued has reduced its 
value.\16\ Assuming no further changes in interest rates or in 
the creditworthiness of the issuer, the market value of a bond 
purchased with market discount would increase on a consistent 
yield basis until its maturity date.
---------------------------------------------------------------------------
    \15\ Original issue discount (``OID'') is defined generally as the 
excess of a debt instrument's stated redemption price at maturity over 
its issue price. The total amount of OID on a debt instrument generally 
does not change over the period the debt instrument is outstanding.
    \16\ A decline in the creditworthiness of an issuer also may cause 
a bond to trade in the secondary market at a discount.
---------------------------------------------------------------------------
    Current law generally does not require any taxpayer--
whether the taxpayer determines income on a cash or an accrual 
basis--to take market discount accruals into taxable income 
until the date the bond matures or is sold.\17\ Upon 
disposition, the amount of gain on a market discount bond, up 
to the amount of the accrued market discount, is taxed as 
ordinary income; any excess amount is treated as capital gain. 
Among the reasons for not taking market discount accruals into 
income on a current basis are that market discount (1) arises 
from market changes that affect the yield of a bond rather than 
from the terms of the bond itself, (2) may not be realized in 
part or in whole by any holder disposing of a bond prior to 
maturity,\18\ and (3) can be difficult to compute.
---------------------------------------------------------------------------
    \17\ Partial principal payments on a market discount bond are 
included as ordinary income to the extent of accrued market discount. 
Holders also may elect to take market discount accruals into income 
currently.
    \18\ The amount that ultimately will be received upon the sale of a 
bond depends, among other things, upon future changes in interest 
rates. If interest rates increase, bonds purchased with market discount 
may be sold at a loss; in this case, none of the accrued market 
discount ever is realized.

---------------------------------------------------------------------------
Proposal

    Under the President's Fiscal Year 2000 budget proposal, 
accrual basis taxpayers would be required to include market 
discount in income currently, i.e., as it accrues.\19\ The 
holder's yield for market discount purposes would be limited to 
the greater of (1) the original yield-to-maturity of the debt 
instrument plus five percentage points or (2) the applicable 
Federal rate (at the time the holder acquired the debt 
instrument) plus five percentage points. Importantly, the 
proposal would not apply to cash basis taxpayers, such as 
individuals.
---------------------------------------------------------------------------
    \19\ The proposal would apply to debt instruments acquired on or 
after the date of enactment.

---------------------------------------------------------------------------
Recommendation

    The Institute urges the Committee to reject the proposed 
requirement that accrual basis taxpayers, such as RICs, 
currently include in taxable income their market discount 
accruals. First, the proposal would accelerate the inclusion of 
market discount in the RIC's taxable income without the receipt 
of any cash that could be used by the RIC to meet its 
distribution obligations to its shareholders.\20\ Second, the 
proposal would result in over-inclusions of taxable ordinary 
income to the extent that a bond purchased with market discount 
is sold for an amount that is less than the purchase price plus 
accrued market discount. These results are particularly 
inappropriate for a RIC's individual shareholders, who would 
experience neither income acceleration nor over-inclusion of 
market discount if they were to make comparable investments 
directly.
---------------------------------------------------------------------------
    \20\ Under section 852(a), a RIC must distribute at least 90 
percent of its ordinary income with respect to its fiscal year to 
qualify for treatment under Subchapter M of the Code. In addition, 
under section 4982, a RIC will incur an excise tax unless it 
distributes by December 31 essentially all of its calendar year 
ordinary income (and capital gain through October 31).

---------------------------------------------------------------------------
Example

    To illustrate these effects, assume a bond with a principal 
amount of $10,000 and a five percent coupon payment that has 
five years to maturity. Further assume that a RIC acquires this 
bond for $9,000 and holds it for three years. Finally, assume 
that interest rate fluctuations between the date the bond was 
acquired by the RIC and the date the bond was sold were such 
that the value of the bond, at disposition, was only $9,500.
    Under current law, the RIC accrues $200 of market discount 
each year, but need not include the accruals in income until 
the year of sale.\21\ Upon disposition, the RIC would treat the 
$500 gain ($9,500 proceeds less $9,000 basis) as ordinary 
income.
---------------------------------------------------------------------------
    \21\ Alternatively, a RIC could elect to accrue the market discount 
on a ``constant yield'' basis under section 1276(b)(2).
---------------------------------------------------------------------------
    As the proposal would not apply to cash basis taxpayers, an 
individual that held the market discount bond directly would 
continue to receive the same tax treatment that the RIC 
receives under current law; prior to disposition, no amounts 
would be includible in taxable income.
    In contrast, the proposal would require the RIC to treat 
the $200 accrual in each of the three years as ordinary income, 
which must be distributed currently by the RIC to its 
shareholders. Upon disposition, at which time the RIC's cost 
basis has been increased to $9,600 (to reflect the $600 of 
market discount included in income), the RIC would have a $100 
capital loss. This loss could be used by the RIC to offset 
capital gain at the RIC level, but could not be ``flowed 
through'' to the RIC's shareholders.\22\
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    \22\ RICs may not flow through capital losses to their investors, 
pursuant to Subchapter M of the Code. Capital losses may be carried 
forward for eight years, pursuant to section 1212(a)(1)(C)(i). In 
recent years, some RICs investing in bonds have been unable to generate 
sufficient capital gains to offset losses carried forward before they 
expired.
---------------------------------------------------------------------------
    The proposal also should be rejected because of the 
potential negative impact on the liquidity of bonds (tax-exempt 
bonds, in particular) in any interest rate environment in which 
existing bonds would trade at a significant discount to 
principal amount. Because of the potential negative tax 
consequences of purchasing market discount bonds (e.g., 
accelerated inclusion of ordinary income and capital losses in 
the event of subsequent interest rate increases), RICs and 
other accrual basis taxpayers might have strong incentives to 
buy only newly-issued bonds.

IV. Increased Penalties for Failure to File Correct Information Returns

Background

    Current law imposes penalties on payers, including RICs, 
that fail to file with the Internal Revenue Service (``IRS'') 
correct information returns showing, among other things, 
payments of dividends and gross proceeds to shareholders. 
Specifically, section 6721 imposes on each payer a penalty of 
$50 for each return with respect to which a failure occurs, 
with a maximum penalty of $250,000.\23\ The $50 penalty is 
reduced to $15 per return for any failure that is corrected 
within 30 days of the required filing date and to $30 per 
return for any failure corrected by August 1 of the calendar 
year in which the required filing date occurs.
---------------------------------------------------------------------------
    \23\ Failures attributable to intentional disregard of the filing 
requirement generally are subject to a $100 per failure penalty that is 
not eligible for the $250,000 maximum.

---------------------------------------------------------------------------
Proposal

    The President's Fiscal Year 2000 budget contains a proposal 
that would increase the $50-per-return penalty for failure to 
file correct information returns to the greater of $50 per 
return or five percent of the aggregate amount required to be 
reported correctly but not so reported.\24\ The increased 
penalty would not apply if the total amount reported for the 
calendar year was at least 97 percent of the amount required to 
be reported.
---------------------------------------------------------------------------
    \24\ The proposal would be effective for returns the due date for 
which (without regard to extensions) is more than 90 days after the 
date of enactment.

---------------------------------------------------------------------------
Recommendation

    The Institute urges the Committee to reject the proposal to 
increase the penalty for failure to file correct information 
returns. Information reporting compliance is a matter of 
serious concern to RICs. Significant effort is devoted to 
providing the IRS and RIC shareholders with timely, accurate 
information returns and statements. As a result, a high level 
of information reporting compliance is maintained within the 
industry.
    The Code's information reporting penalty structure was 
comprehensively revised by Congress in 1989 to encourage 
voluntary compliance. Information reporting penalties are not 
designed to raise revenues.\25\ The current penalty structure 
provides adequate, indeed very powerful, incentives for RICs to 
promptly correct any errors made.
---------------------------------------------------------------------------
    \25\ In the Conference Report to the 1989 changes, Congress 
recommended to IRS that they ``develop a policy statement emphasizing 
that civil tax penalties exist for the purpose of encouraging voluntary 
compliance.'' H.R. Conf. Rep. No. 386, 101st Cong., 1st Sess. 661 
(1989).
---------------------------------------------------------------------------

            V. Partial Liquidations of Partnership Interests

Background

    Under current law, a partial liquidation of a partnership 
interest is taxable only to the extent that any cash 
distributed exceeds the partner's adjusted basis in its 
partnership interest immediately before the distribution. Thus, 
in the case of a ``master/feeder fund structure,'' \26\ a RIC 
feeder fund partner typically may liquidate a portion of its 
interest in the master fund partnership in the ordinary course 
of its business without incurring capital gain on its 
underlying investment in the partnership. A RIC feeder fund 
will partially liquidate its interest in the master fund 
partnership on any day in which it needs to generate cash to 
meet shareholder redemptions.\27\
---------------------------------------------------------------------------
    \26\ The master/feeder structure has developed as a vehicle 
pursuant to which RICs (known as ``feeder funds'') generally invest 
substantially all of their assets in one partnership (known as the 
``master fund''). On occasion, institutional investors or other 
entities also may be feeder funds.
    \27\ RIC feeder funds typically are structured as open-end 
investment companies, the shares of which are redeemable upon 
shareholder demand pursuant to the Investment Company Act of 1940. On 
occassion, RIC feeder funds also may be structured as ``interval 
funds,'' which issue shares that are redeemable on a periodic, rather 
than daily, basis.
---------------------------------------------------------------------------
Proposal

    Under the President's Fiscal Year 2000 budget proposal, a 
partial liquidation of a partner's interest in a partnership 
would be taxed as a complete liquidation of that portion of the 
partner's interest.\28\ Gain or loss on the partial liquidation 
would be determined by allocating the distributee partner's 
basis ratably over the portions of the partnership interest 
that are liquidated and retained. The rationale for the 
proposed change, according to the Treasury Department's 
``General Explanations of the Administration's Revenue 
Proposals,'' is that the current law rules ``provide for an 
inappropriate deferral of gain.''
---------------------------------------------------------------------------
    \28\ The proposal would apply to certain partial liquidations made 
after date of enactment. From a discussion with a Treasury Department 
official, we understand that the proposal is not intended to be applied 
on a daily basis.

---------------------------------------------------------------------------
Recommendation

    Should the Committee decide to expand the circumstances in 
which partial liquidations of partnership interests are taxed, 
the Institute urges the Committee not to apply the change to 
RIC feeder fund investments in master funds. This exception 
should be made because the rationale for the proposal--to 
prevent deferral--simply does not apply.
    Under current law, the shareholder in a RIC feeder fund 
whose redemption request triggers the RIC's need for cash, and 
hence the partial liquidation of the RIC's interest in the 
master fund partnership, already is required to take into 
account currently any gain--attributable to appreciation in the 
value of the shareholder's investment, through the RIC, in the 
master fund partnership--on the shares redeemed. The existing 
basis calculation rules of section 1012 and share redemption 
rules of section 302 apply to prevent deferral.
    The only impact of applying this proposal to master/feeder 
funds would be to require a taxable distribution by a RIC 
feeder fund of gains to its non-redeeming shareholders, who did 
not trigger the partial liquidation.\29\ This result would be 
unfair and presumably is unintended. Consequently, should the 
Committee determine to pursue the Administration's proposal, an 
exception for the master/feeder fund structure should be 
adopted.
---------------------------------------------------------------------------
    \29\ The distribution requirements applicable to RICs require that 
dividends be declared ratably to all RIC shares outstanding on the date 
the dividend distribution is declared. Unlike the rules applicable to 
partnerships, no ability exists to specially allocate the gain to the 
redeeming RIC shareholder.
---------------------------------------------------------------------------

       VI. Conversions of Large C Corporations to S Corporations

Background

    Section 1374 generally provides that when a C corporation 
converts to an S corporation, the S corporation will be subject 
to corporate level taxation on the net built-in gain on any 
asset that is held at the time of the conversion and sold 
within 10 years. In Notice 88-19, 1988-1 C.B. 486, the IRS 
announced that regulations implementing repeal of the so-called 
General Utilities doctrine would be promulgated under section 
337(d) to provide that section 1374 principles, including 
section 1374's ``10-year rule'' for the recognition of built-in 
gains, would be applied to C corporations that convert to 
regulated investment company (``RIC'') or real estate 
investment trust (``REIT'') status.
    Notice 88-19 was supplemented by Notice 88-96, 1988-2 C.B. 
420, which states that the regulations to be promulgated under 
section 337(d) will provide a safe harbor from the recognition 
of built-in gain in situations in which a RIC fails to qualify 
under Subchapter M for one taxable year and subsequently 
requalifies as a RIC. Specifically, Notice 88-96 provides a 
safe harbor for a corporation that (1) immediately prior to 
qualifying as a RIC was taxed as a C corporation for not more 
than one taxable year, and (2) immediately prior to being taxed 
as a C corporation was taxed as a RIC for at least one taxable 
year. The safe harbor does not apply to assets acquired by a 
corporation during the C corporation year in a transaction that 
results in its basis in the assets being determined by 
reference to a corporate transferor's basis.

Proposal 

    The President's Fiscal Year 2000 budget proposes to repeal 
section 1374 for large corporations.\30\ For this purpose, a 
corporation is a large corporation if its stock is valued at 
more than five million dollars at the time of the conversion to 
an S corporation. Thus, a conversion of a large C corporation 
to an S corporation would result in gain recognition both to 
the converting corporation and its shareholders. The proposal 
further provides that Notice 88-19 would be revised to provide 
that the conversion of a large C corporation to a RIC or REIT 
would result in the immediate recognition of the corporation's 
net built-in gain. Thus, the Notice, if revised as proposed, no 
longer would permit a large corporation that converts to a RIC 
or REIT to elect to apply rules similar to the 10-year built-in 
gain recognition rules of section 1374.
---------------------------------------------------------------------------
    \30\ The proposal to repeal section 1374 for large corporations 
would apply to Subchapter S elections first effective for a taxable 
year beginning after January 1, 2000 and to acquisitions (e.g., 
mergers) after December 31, 1999.

---------------------------------------------------------------------------
Recommendation

    Because the safe harbor set forth in Notice 88-96 is not 
based upon the 10-year built-in gain rules of section 1374, the 
repeal of section 1374 for a large C corporation should have no 
effect on Notice 88-96. The safe harbor is based on the 
recognition that the imposition of a significant tax burden on 
a RIC that requalifies under Subchapter M after failing to 
qualify for a single year would be inappropriate. Moreover, the 
imposition of tax in such a case would fall directly on the 
RIC's shareholders, who typically are middle-income investors.
    The Institute understands from discussions with the 
Treasury Department that the proposed revision to section 1374 
and the related change to Notice 88-19 are not intended to 
impact the safe harbor provided by Notice 88-96.
    Should this proposal be adopted, the Institute recommends 
that the legislative history include a statement, such as the 
following, making it clear that the proposed revision to 
section 1374 and the related change to Notice 88-19 would not 
impact the safe harbor set forth in Notice 88-96 for RICs that 
fail to qualify for one taxable year:

          This provision is not intended to affect Notice 88-96, 1988-2 
        C.B. 420, which provides that regulations to be promulgated 
        under section 337(d) will provide a safe harbor from the built-
        in gain recognition rules announced in Notice 88-19, 1988-1 
        C.B. 486, for situations in which a RIC temporarily fails to 
        qualify under Subchapter M. Thus, it is intended that the 
        regulations to be promulgated under section 337(d) will contain 
        the safe harbor described in Notice 88-96.
      

                                

Statement of Large Public Power Council

                            I. INTRODUCTION

    We appreciate the opportunity to submit this written 
statement for the record of the Committee on Ways and Means 
hearing on the revenue provisions in the President's FY 2000 
Budget. We are the Large Public Power Council (the ``LPPC''), 
an organization composed of 21 of the nation's largest locally-
owned and controlled power systems. A list of our members is 
attached as an appendix to this statement. LPPC members 
directly and indirectly provide reliable, high-quality, low-
cost electricity to more than 40 million people. This includes 
tens of thousands of large and small businesses located in some 
of the faster-growing urban and rural residential and 
commercial markets in America. Like their approximately 2000 
smaller public power counterparts located in every state but 
Hawaii, LPPC's members are not-for-profit entities committed 
only to the people and communities they serve.
    We are pleased to see that the President's FY 2000 Budget 
includes the proposals that the Administration originally made 
last year relating to the tax aspects of electricity 
deregulation. As we stated last year both when the temporary 
regulations on private use were issued and when the 
comprehensive electricity restructuring proposal was unveiled, 
the LPPC supports the Administration's efforts to address, in a 
rational and equitable way, the tax issues raised by 
electricity deregulation.
    We believe, however, that improvements can be made to the 
President's approach to resolving these tax issues. In this 
statement, we will outline the tax issues created for publicly-
owned utilities in a deregulated environment, discuss the 
President's solution to these problems, and propose an 
alternative bipartisan compromise that may better address those 
problems.

               II. TAX ISSUES IN ELECTRICITY DEREGULATION

    Publicly-owned utilities have operated up to now under a 
strict regime of Federal tax rules governing their ability to 
issue tax-exempt bonds. Under current Federal tax law, interest 
on state and local government bonds generally is excluded from 
income if the bonds are issued to finance governmental 
activities. Facilities for electric generation, transmission, 
and distribution are eligible for financing with tax-exempt 
bonds when the financed facilities are used by or paid for by a 
state or local governmental entity. Generally, bond-financed 
facilities are used for a governmental purpose even when the 
electricity they generate or transmit is sold to private 
persons provided those persons are treated as members of the 
general public. The so-called ``private use'' rules limit the 
amount of power that publicly-owned utilities may sell to 
private entities through facilities financed with tax-exempt 
bonds.
    For years, the private use rules were cumbersome but 
manageable. These rules, however, were enacted in an era that 
did not contemplate electricity deregulation. As states 
deregulate, the private use rules are threatening many 
communities that are served by public power with significant 
financial penalties as they adjust to the changing marketplace. 
While Federal deregulation legislation has yet to be enacted, 
eighteen states have already gone forward and begun to 
deregulate electricity at the state and local level. The era of 
competition has already begun in those states.
    With competition, publicly-owned utilities face some 
difficult choices. In order to develop efficient 
nondiscriminatory transmission services, publicly-owned 
utilities will be required to turn operation of their 
transmission facilities over to independent systems operators 
or otherwise use those facilities in a manner that may violate 
the private use rules. As traditional service areas of both 
investor-owned and publicly-owned facilities are opened to 
retail competition, publicly-owned utilities may find it 
necessary to enter into contracts with private users of 
electricity in order to prevent their generation facilities 
from becoming stranded costs and to be able to pay debt service 
on their bonds. For instance, when electricity is sold under 
long-term contracts to private persons, the private use 
restrictions of the Internal Revenue Code may render the 
interest on outstanding bonds taxable.
    In effect, publicly-owned utilities face the prospect of 
violating the private use rules, or walling off their customers 
from competition: in either case consumers would experience 
higher rates--the precise opposite of what deregulation is 
supposed to achieve. The consumer can only lose when this 
happens.

III. THE PRESIDENT'S PROPOSALS ON THE TAX ISSUES RELATED TO ELECTRICITY 
                             RESTRUCTURING

                        A. Treasury regulations

    In January 1998, the Treasury and the Internal Revenue 
Service (``IRS'') issued temporary and proposed regulations 
relating to the rules for generation, transmission, and 
distribution of electricity with facilities financed with tax-
exempt bonds. These rules provide limited relief, within the 
context of present law, from the application of the private use 
rules in a deregulated environment. Because these regulations 
are temporary, they expire three years after publication unless 
the IRS finalizes or reissues them.
    We applaud the Administration's efforts to afford publicly-
owned utilities some opportunity to participate in a 
deregulated market. However, the regulations fail to address 
some serious problems, including the ability of publicly-owned 
utilities to meet the needs of existing customers. Further, as 
noted above, they are temporary, and unless finalized, will 
expire in less than two years (January 22, 2001). Thus, we 
concur with the Administration that legislative action is 
needed to address the private use problem facing publicly-owned 
utilities.

            B. The Administration's FY 2000 budget proposals

    On March 24, 1998, the Department of Energy announced the 
Administration's Comprehensive Electricity Competition Plan. 
Included in the plan were revisions to the tax rules governing 
private use of tax-exempt bond-financed electric facilities. 
The President has included these tax proposals in his FY 2000 
Budget submission.
    These proposals are several. First, the Administration 
proposal would bar the use of tax-exempt bonds for new 
facilities for electric generation and transmission.
    Distribution facilities could continue to be financed with 
tax-exempt bonds subject to the existing private use rules. 
Second, the Administration proposal would grandfather existing 
tax-exempt bonds from the private use rules if the bonds were 
used to finance: (1) transmission facilities the private use of 
which results from a FERC order requiring non-discriminatory 
open access to those facilities; or (2) generation or 
distribution facilities the private use of which results from 
retail competition or a contract effective after implementation 
of retail competition. The proposal would permit current, but 
not advance, refunding, of bonds issued before date of 
enactment of The Administration's Comprehensive Electricity 
Competition Plan.
    In addition, the Administration includes a proposal to 
accommodate the need in a deregulated environment of investor-
owned utilities with nuclear facilities for modification of the 
treatment of contributions to nuclear decommissioning funds.
    LPPC applauds these proposals as rational and equitable 
attempts to address the problems faced by utilities in a 
deregulated environment. In the case of publicly-owned 
utilities, the Administration would provide relief from the 
application of the private use rules; in the case of certain 
investor-owned utilities, it would make workable the provision 
governing the treatment of contributions to nuclear 
decommissioning funds. We believe, however, that there is an 
alternative approach that better addresses the different 
situations in which the various publicly-owned utilities may 
find themselves.

  IV. THE BOND FAIRNESS AND PROTECTION ACT: AN ALTERNATIVE BIPARTISAN 
                          COMPROMISE APPROACH

    The LPPC urges the Committee to consider an alternative 
approach to the private use issue, one that is supported by a 
bipartisan group of Members and Senators, the Bond Fairness and 
Protection Act of 1999 (H.R. 721 in the House and S. 386 in the 
Senate). This legislative proposal would provide publicly-owned 
utilities with an option: they can continue to issue tax-exempt 
bonds for generation transmission and distribution facilities 
under a set of private use rules clarified to provide a modest 
set of changes to deal with deregulation, or they can elect to 
forego the ability to issue tax-exempt bonds for new generation 
facilities, but with a grandfather of their existing tax-exempt 
bonds from the adverse application of the private use rules.
    The clarifications to the private use rules proposed in the 
legislation are intended to accommodate the reality of 
operating in a deregulated market, nearly all of which were 
recognized by Treasury in the relief provided in its temporary 
regulations. Private use would not include certain ``permitted 
open access transactions.'' The bill lists the following 
activities as permitted open access transactions: (1) providing 
open access transmission service consistent with FERC Order No. 
888 or with state open transmission access rules; (2) joining 
an FERC-approved ISO, regional transmission group (RTG), power 
exchange, or in accordance with an ISO, RTG, or power exchange 
tariff; (3) providing open access distribution services to 
competing retail sellers of electricity; or (4) if open 
transmission or distribution services are offered, contracting 
for sales of power at non-tariff rates with on-system 
purchasers or existing off-system purchasers.
    Only the last of these clarifications is new and would 
merely permit publicly-owned utilities to enter into long-term 
contracts with their existing customers, a change that is 
essential if these utilities are to compete with other electric 
providers for these customers. In fact, this change would 
merely give publicly-owned utilities the same ability to 
contract with their customers as the investor-owned ``two 
county'' utility that benefit from tax-exempt bonds have. 
Moreover, given the changing nature of how electricity is being 
sold, a publicly-owned utility should not have to give up the 
ability to issue tax-exempt bonds merely in order to contract 
or to provide service to its historic customers.
    The advantage of this approach is that it provides needed 
flexibility to public utilities; if a public utility wants to 
participate in the competitive market generally it will need to 
give up its ability to issue tax-exempt bonds in the future, 
thereby mitigating any perception of a competitive advantage. 
If a public utility is not interested in competing in the open 
market or has little outstanding debt, it need not make the 
election. Moreover, this approach links the availability of 
relief from the retroactive application of the private use 
rules to outstanding tax-exempt bonds with a willingness to 
forego the ability to issue tax-exempt debt in the future for 
generation facilities.
    The Bond Fairness and Protection Act of 1999 has attracted 
the support of a diverse group of organizations including, for 
example, from the private sector, the Independent Energy 
Producers, and from the public sector, the National League of 
Cities. Similarly, the Government Finance Officers Association 
has endorsed the need for private use relief of the type 
contained in this bill.

                             V. CONCLUSION

    Again, Mr. Chairman, we appreciate this opportunity to 
present our views on the electricity restructuring provisions 
in the President's FY 2000 Budget. We urge the Committee to act 
this year to provide much needed relief from the unintended 
application of the private use restrictions of the Internal 
Revenue Code to publicly-owned utilities struggling to adapt to 
the changing marketplace while continuing to serve their 
customers by providing cheap and reliable electricity. The 
marketplace is not waiting for Federal legislation to force 
deregulation; it is happening now in numerous states and 
localities around the country. But only Congress can change the 
Federal tax rules that are hampering the ability of publicly-
owned and controlled utilities to provide the services on which 
consumers depend.
    We would be happy to assist the Committee in any way 
possible as you consider the tax issues related to electric 
deregulation.
      

                                

Statement of M Financial Group, Portland, Oregon

                              Introduction

    The President's FY 2000 budget proposal calls for increases 
in taxes and treatment of life insurance policyholders and life 
insurance companies that would discourage long-term savings and 
private responsibility for financial security for American 
families.

Undermines Individual's Ability to Save

    At a time when Americans need to save and plan more for 
their retirement, several provisions of the budget would 
prevent life insurance products from continuing to provide 
effective solutions to long-term benefit, savings, and 
retirement security needs. This unfortunate proposal 
drastically undermines the government's decades-long policy of 
encouraging individuals and businesses to provide for their own 
and their employees' financial security. At a time when the 
long-term national savings rate is at an all time low and with 
the prospect of increased pressure on social security, the 
President's budget takes away several key methods of providing 
for that financial security. In many cases, the proposals 
result in a retroactive tax increase on middle-class working 
Americans.

Ten Percent Tax Increase

    The proposals affecting the life insurance industry, taken 
together, represent an almost 10 percent increase in the taxes 
paid annually by the life insurance industry. In the FY 2000 
Budget, Treasury continues to pursue an unfair and unwarranted 
attack on the life insurance industry and the products it 
provides which benefit the financial security of millions of 
Americans.

Proposals of Particular Concern

    COLI Proposal--Increases taxation on companies that own 
life insurance policies on their employees and officers. This 
tax increase could significantly reduce the level of funding 
for employee-related benefits, undermining employee security 
associated with these benefits and the financial protection of 
families and businesses. The proposal particularly hurts small 
businesses which rely on life insurance policies to provide 
benefits and incentives to their employees. The proposal's 
characterization of COLI as a corporate tax avoidance scheme 
that represents a loophole in the Internal Revenue Code is 
particularly objectionable.
    Proposal to Modify Rules for Capitalization of Policy 
Acquisition Costs of Life Insurance Companies--Increases the 
cost of life insurance and annuity products by increasing the 
tax burden on these products. The administration proposes a 
two-thirds increase in the federal tax cost associated with 
life insurance products and a threefold increase for annuity 
products. If enacted, the new taxes will end up being an added 
cost passed through to policyholders. This hurts all Americans 
who rely on insurance products to provide financial security 
for their family by raising the cost of providing that 
protection.

Continued Unfair Targeting of the Life Insurance Industry

    We believe that these proposals, together with the other 
proposals that target the insurance industry, such as the 
required recapture of policyholder surplus, need to be reviewed 
in light of the fact that the insurance industry is already one 
of the most highly taxed industries in America. A recent 
Coopers & Lybrand study reveals that insurers pay an average 
effective tax rate of 37 percent, as opposed to the 24 percent 
paid by all other U.S. corporations studied over the same time 
period. Yet, Treasury continues to single out the insurance 
industry for attack. If these attacks go unchecked, they will 
ultimately threaten the financial strength and solvency of the 
industry and the financial protection that it provides to 
millions of families.
Threat to the Solvency of the Insurance Industry

    By increasing costs associated with insurance products, 
these proposals ultimately could pose a threat to the capital 
base and solvency of the industry, an industry which employs 
and supports millions of Americans. Particularly hard hit would 
be U.S. small businesses and insurance company employees.

Revenue Effects Uncertain

    Perversely, these proposals might even reduce current 
levels of tax revenue generated as a result of the reduced 
purchase of insurance products and a commensurately adverse 
offset of insurance company income.
    In summary, these provisions are unsound and illogical. 
They threaten to discourage long term savings, further eroding 
individual responsibility for providing financial protection 
and security for the future. They threaten to destabilize the 
financial condition of life insurance companies by 
disproportionately taxing the industry, which would affect 
millions of existing policyholders and insurance company 
employees.

                           M Financial Group

    M Financial Group is a marketing and reinsurance 
organization comprised of over 100 independently owned firms, 
located across the country, that focus on providing financial 
security and solutions to the estate and benefit planning needs 
of individuals and businesses.
    Collectively, these firms manage life insurance policies in 
force for their clients representing over $2 billion of annual 
life insurance premiums, over $12 billion of policyholder 
account values, and over $45 billion of total death benefit 
protection.

Multitude of Benefits

    These insurance arrangements enhance individual Americans' 
financial security by
     Allowing businesses an effective vehicle to fund 
benefit liabilities for employee retirement income payments, 
salary continuance for employees' spouses, and other post-
retirement benefits.
     Providing for financial liquidity to families at 
time of death to pay estate taxes. Many families' assets are in 
illiquid forms such as family-owned real estate or small 
businesses. Life insurance helps families meet their estate tax 
and business continuity needs without having to sell the 
underlying asset. Life insurance provides a liquid source of 
funds to meet the liability without disrupting families, 
allowing small businesses to continue into the next generation 
and provide jobs to their employees.
     Providing business with a financial means to 
continue operation upon death of a key executive, during the 
period when it is seeking to replace the key individual.
     Giving individuals the ability to provide 
survivors with death benefit protection while supplementing 
retirement savings.

Life Insurance Provides Many Advantages

    Life insurance is a particularly effective and efficient 
vehicle to defray the costs of these benefits while encouraging 
savings. It helps provide individuals and employers with a 
source of future income to offset various unpredictable future 
needs, such as untimely death or long-term medical needs. Given 
the economic realities the nation faces in having to fix Social 
Security to support the retirement of the baby boom generation, 
insurance offers an excellent product that helps match the need 
for savings and the need for financial protection. The impact 
of the proposal on the ability to use life insurance on all of 
these areas is devastating.

Retroactive Tax Provisions Make Bad Policy

    In addition, the proposed retroactive application of the 
provisions to policies already purchased and owned by millions 
of Americans thwarts effective tax-planning. A precedent of 
retroactive application of tax increases to existing contracts 
is inherently unfair and reduces the potential for the tax law 
to provide effective long-term incentives for establishing 
private savings programs.
    We applaud the strong opposition to these proposals voiced 
by many Members of Congress. We are certain that upon closer 
examination of the facts and issues surrounding these 
proposals, the Members will reject this tax increase on the 
American public.
    The balance of this document provides specific background 
on the impact of these proposals on certain uses of life 
insurance that help provide financial security to millions of 
Americans.

    PROPOSAL: Repeal of the exception for employees, officers, and 
  directors under the Corporate Owned Life Insurance (COLI) proration 
                                 rules.

Background:

    COLI policies have long been used by businesses to enhance 
employee savings and provide retirement benefits. COLI helps 
promote the long-term financial security of employees and their 
families such as in the case of untimely death.

COLI Helps Companies Offer Employee Benefits

    The need to use COLI to provide employee and retirement 
benefits arises from prior legislative initiatives such as 
ERISA, TEFRA, and DEFRA, which have limited a company's use of 
tax-qualified pension arrangements. Over time, these 
limitations have made the use of traditional pension 
arrangements more complex and less effective. Hit most hard by 
these limitations are middle-level executives, as defined by 
the Department of Labor. The compression on qualified plans and 
the corporate desire to restore such benefits has led to an 
increased reliance on nonqualified plans.

COLI Encourages Personal Savings

    The use of nonqualified plans is an extremely effective 
vehicle for increasing the personal savings rate at a time when 
Americans are living longer and there is more uncertainty of 
the ability of other social programs to provide needed employee 
and retirement benefits. Nonqualified plans offer long-term 
benefits that give employees the means to provide themselves 
and their families with financial security. These plans have 
long-term emerging liabilities and actuarial risk, which are 
well-suited to funding with life insurance. This use of COLI 
serves an important social and economic purpose in helping to 
finance these plans.

Examples of Beneficial Programs Funded By COLI--

     Supplements retirement income and survivor 
benefits beyond those available under qualified plan limits. 
These benefits promote the financial security of millions of 
Americans.
     Enables employees to contribute after-tax dollars 
to enhance their retirement and survivor benefits.
     Allows businesses to provide benefits needed to 
attract and retain key employees.
     Supports the ability, particularly for small 
businesses, to withstand the significant financial loss 
resulting from the premature death of a key employee.
     Provides business continuity in circumstances that 
could otherwise result in failure and significant economic 
hardship for all employees.

COLI Useful to both Large and Small Corporations

    Almost all public and an increasing number of small private 
U.S. companies use life insurance to provide some form of 
financial security and stability to the organization, the 
employees and their families. For many corporations, COLI is 
the tool of choice to manage effectively the liabilities 
related to employee death and retirement benefits. Defraying 
the costs of these liabilities with after-tax dollars in COLI 
policies is consistent with Federal retirement savings 
incentives and is good public policy.\1\
---------------------------------------------------------------------------
    \1\ The written statement addresses the negative impact of the 
Administration's Proposal on traditional COLI plans, and does not 
address Bank-Owned Life Insurance (BOLI). The use of COLI by financial 
institutions that borrow funds at low cost might raise issues apart 
from those discussed here. Because M Financial's business does not 
include the sale of BOLI products, we express no opinion on the 
propriety of such arrangements.

---------------------------------------------------------------------------
Effect of Proposal:

    The changes to COLI increase current taxes for all 
businesses that own or are beneficiaries of a life insurance 
policy. This proposal would seriously curtail the availability 
of the benefits these policies provide and reduce personal 
savings. This proposal will limit the protection available to 
families and increase the risks to businesses due to premature 
death of an employee.
    The proposed changes to IRC Sec. 264 increase taxes by 
disallowing a portion of the company's interest deduction for 
unrelated debt. This proposal would affect all business uses of 
life insurance. To preserve the motivation and opportunity for 
private saving, it is important to preserve the ability for 
businesses to purchase life insurance to provide an array of 
benefits to their employees. At a time when Congress is 
increasing incentives for employee-based savings through the 
expansion of Roth IRAs and other provisions, it is 
contradictory to tax the use of life insurance to fund the same 
benefits.
    Current law already limits potential abuses in COLI 
applications used to defray the costs of the types of 
liabilities previously mentioned: Qualified plan limits 
restrict the amount of insurance that can be purchased by an 
employer on a currently deductible basis. IRC Sec. 7702 and IRC 
Sec. 7702A require corporate-owned policies to provide true 
death benefit protection. IRC Sec. 264 prevents leverage 
arbitrage by prohibiting tax deductible borrowing against a 
corporate-owned life insurance policy. All these provisions 
combine to assure that COLI will be used to defray the costs of 
real benefit liabilities in a manner consistent with tax 
policy.
    Unfortunately, the effect of the COLI proposal in the 
Administration's Budget would be to limit wholly appropriate 
business uses of life insurance--such as assuring that 
employees receive the retirement benefits they have been 
promised and are counting on getting--by making the cost of 
insurance products economically unfeasible. The proposal would 
unnecessarily deny the benefits of COLI to millions of 
Americans.
    Moreover, the Administration's rationale for the COLI 
proposal is fundamentally flawed and unjustified. The 
Administration believes that allowing a taxpayer a deduction 
for interest incurred on indebtedness in the operation of a 
business is wrong if the business owns life insurance on its 
employees, even if the business indebtedness is entirely 
unrelated to the insurance. This belief flies in the face of 
fundamental principals of tax law, which allow for ordinary and 
necessary business expenses.
    Under recent changes in current law, interest on 
indebtedness directly related or ``traced'' to corporate owned 
life insurance is already subject to disallowance. The new COLI 
proposal would go well beyond current law and deny deductions 
for interest that is completely unrelated to the insurance. 
This is not only unjustified, but is also overly broad and 
creates inequities between businesses that rely on debt 
financing and those that are equity financed.
    In cases where a business provides insurance-financed 
benefit programs such as broad-based health coverage for 
retirees, nonqualified pensions, or other supplemental or 
survivor benefits, a ``tax'' would now be imposed if the 
business had any indebtedness on its books. This resulting 
``tax'' would most likely cause the business to scale back its 
benefit programs, causing harm to the long-term health and 
security of its employees. Across the country, this would have 
a devastating impact on many small and mid-sized businesses who 
rely on insurance to fund such programs.
    By indirectly ``taxing'' retirement and benefit programs, 
the COLI proposal is directly contrary to efforts by the 
Administration and Congress to provide incentives to increase 
U.S. savings (e.g., expansion of IRAs, Roth IRAs, SIMPLE IRAs).
    Finally, the COLI proposal would create a retroactive tax 
increase on millions of businesses and middle-class working 
Americans by denying an interest deduction on policies that 
have been in place for years. Businesses that relied on 
existing tax laws would be penalized and employees who relied 
on benefits funded by existing insurance policies would be 
unconscionably harmed.
    Far from the Administration's characterization of COLI as 
an abusive tax shelter, COLI is an appropriate means to fulfill 
the American goal of uninterrupted business operation while 
providing retirement security to employees.

  PROPOSAL: Modify Rules For Capitalizing Policy Acquisition Costs of 
                        Life Insurance Companies

Background:

    In 1990, Congress enacted Section 848, which requires that 
insurance companies capitalize a portion of policy acquisition 
costs. This co-called ``DAC tax'' sought to match the timing of 
some of the expenses incurred in the sale of insurance products 
with the income received over the product life.

Effect of Proposal:

    This proposal increases the ``DAC tax'' and thereby 
increases the cost for life insurance and annuity products to 
the American public. This added cost reduces the attractiveness 
and effectiveness of life insurance and annuity policies as 
long-term financial security vehicles.
    The proposal represents an indirect tax on people who seek 
to provide financial protection for their retirement or their 
family to meet future unexpected circumstances.
    The proposed increase in tax on insurance products will be 
largely passed on to and borne by the purchasers of those 
products. The ``DAC tax'' burden on annuity products would be 
tripled and the tax on life insurance products would be 
increased by two-thirds.
    Last year, Treasury tried to impose new direct taxes on 
insurance product policyholders. Congress rebuffed that 
attempt. Now Treasury returns and seeks to do indirectly what 
Congress refused to permit it to do directly.
    As the Administration recognizes in its social security 
proposals, individuals need to ensure that adequate resources 
are available in retirement. This proposal perversely 
discourages individuals from providing for their retirement by 
imposing new taxes on their doing so.
    Life insurance and annuity products are designed to help 
provide long-term financial security needs of Americans. It is 
desirable that these products be available to the public in a 
predictable and cost efficient manner. Cash value life products 
efficiently and effectively bundle protection and saving 
elements into a package that provides early protection against 
loss and generates long-term earnings that can be used as a 
source of retirement funds or to offset the higher cost of 
providing loss protection benefits at older ages. To encourage 
the long-term nature of these products, current law already 
taxes gains and imposes penalty taxes where contracts are 
surrendered without providing the intended death and retirement 
benefits. This proposal effectively acts as a preemptive tax 
penalizing all contracts in advance.
    The Treasury proposal says that the current ``DAC tax'' 
does not provide for capitalization of actual acquisition 
expenses. But capitalization of acquisition expenses are also 
currently taken into consideration in the Internal Revenue Code 
through the computation of tax reserves. This computation 
requires that first year expenses be spread over future years, 
which reduces deductible tax reserves in the first policy year 
and spreads the recognition of these expenses over future 
policy years.
    In any event, the current ``DAC tax'' was the result of 
considered Congressional deliberations in 1990 to strike a 
balance between capitalization policy and the need to avoid 
imposing unreasonably heavy taxes on the insurance industry. It 
is inappropriate for Congress now to revisit that decision 
(particularly in absence of significant change in the 
underlying facts).
      

                                

Statement of Management Compensation Group, Portland, Oregon

                            I. INTRODUCTION

     We appreciate the opportunity to submit this written 
statement for the record of the House Ways and Means Committee 
hearing on the ``Revenue Provisions in the President's Fiscal 
Year 2000 Budget.'' We are the Management Compensation Group 
(``MCG''), a group of independently owned firms located across 
the country, dedicated to assisting businesses to provide 
retirement, health and other benefits to their employees. We 
help small, medium and larger businesses finance benefit plans 
through the purchase of corporate-owned life insurance 
(``COLI''). The use of COLI serves a valid social and economic 
purpose in financing these benefit plans.
     The President's FY 2000 Budget reproposes a modification 
to the COLI rules which was soundly rejected by Congress last 
year. The President's proposal, which was also contained in his 
FY 1999 Budget, would apply the proration rule adopted in the 
Taxpayer Relief Act of 1997 (P.L. 105-34) to virtually all 
COLI, by eliminating exceptions to the rule for employees, 
officers and directors (the ``COLI proposal''). Without 
discussion, the COLI proposal is listed in the FY 2000 Budget 
under the heading of ``Corporate Tax Shelters.''
     As in the testimony we submitted last year, we again 
strenuously OBJECT to the President's COLI proposal.
     In this statement, we will provide a description of the 
President's COLI proposal; background on the legitimate 
business uses of COLI and the history of tax changes; support 
for why COLI is not a tax shelter; and a discussion of why the 
President's COLI proposal should again be rejected outright by 
Congress.

                   II. THE PRESIDENT'S COLI PROPOSAL

     Under current law, businesses are generally allowed a tax 
deduction for interest on indebtedness incurred in their trade 
or business. Businesses often own life insurance policies on 
the lives of their employees, officers and directors. These 
policies meet a number of business needs, including: (1) 
providing financial liquidity; (2) allowing businesses to fund 
employee and retirement benefits; (3) providing continuation of 
business operations upon the death of a key executive; and (4) 
providing survivors with death benefit protections.
     The tax laws deny an interest deduction on any 
indebtedness WITH RESPECT TO life insurance policies. 
Therefore, any interest which is directly related or 
``traceable'' to a life insurance policy is already denied 
under current law. If there is no relationship between the 
indebtedness and a corporate-owned life insurance policy on an 
employee, officer or director, then there is no denial of 
interest.
     The President's FY 2000 Budget plan reproposes a 
modification of the COLI rules which was proposed in his FY 
1999 Budget and soundly rejected by Congress last year. The 
proposal would change the current COLI rules and deny interest 
deductions on indebtedness incurred by a business completely 
UNRELATED to the ownership of insurance on an employee, officer 
or director. This proposal would have a devastating impact on 
businesses and employees throughout the country.

  III. BACKGROUND OF BUSINESS USES OF COLI AND HISTORY OF TAX CHANGES

1) Permanent Life Insurance For Business

     The use of permanent life insurance in a business setting first 
arose as a means to protect against the premature death of key 
employees. The savings element in permanent life insurance also allowed 
for the accumulation of value for use in the buyback of stock or to 
protect against business interruption.
     As businesses saw a need to fund for pension and other benefit 
liabilities that fell outside of their qualified plans, COLI in its 
current use evolved. The combination of predictable premiums, long-term 
asset accumulation and protection against death benefit liabilities 
makes COLI an ideal funding vehicle for these programs.
     In these arrangements, businesses purchase COLI in an amount 
necessary to match the emerging liabilities for benefits outside of 
qualified plans. The COLI asset is typically placed in a trust, and 
specific arrangements are made to eliminate excess assets from building 
up within the trust. While such assets remain available to creditors 
should bankruptcy occur, they are otherwise pledged and held in trust 
for the sole purpose of extinguishing corporate liability associated 
with the benefit plans.
     Funds used to purchase COLI are paid with after-tax dollars. The 
growth of these funds only serves to help the plans keep pace with the 
emerging liability. If cash value is withdrawn from the policies, it is 
subject to taxation at ordinary income rates. The company foregoes a 
current deduction, unlike qualified pension plans, and provides a 
dedicated buffer for future pension payments. Funding under these plans 
is typically limited to those eligible for participation in these 
programs.

 2) History Of Tax Changes Related To COLI

     In the past, Congress has been concerned about the use of COLI as 
a pure investment vehicle without appropriate insurance elements. As a 
consequence, it has acted to restrict COLI and certain investment-
oriented insurance products, while protecting the tax-deferred nature 
of permanent life insurance.
     The 1954 Code contained a provision limiting interest deductions 
on loans taken out directly or otherwise to purchase insurance (Code 
section 264). Since then, Congress has strengthened this provision 
several times. Most recently, in the Taxpayer Relief Act of 1997 (the 
``1997 Act''), Congress eliminated a broad range of exceptions and 
generally disallowed any interest on indebtedness ``with respect to'' 
the ownership of a life insurance contract. This disallowed any direct 
and ``traceable'' interest. A limited exception for ``key person'' 
policies under $50,000 remained in place.
     The 1997 Act also added a new ``proration'' rule which denied 
interest deductions on indebtedness ``unrelated'' to the ownership of 
insurance policies. An exception to the proration rule was provided for 
insurance purchased on lives of employees, officers, directors, and 20 
percent owners (Code section 264(f)). This exception is the subject of 
the President's COLI proposal.\1\
---------------------------------------------------------------------------
    \1\ Other changes affecting insurance products occurred over the 
years. Certain investment-oriented insurance products called ``modified 
endowments'' were restricted by Congress in 1988. This class of 
policies loses many or some of the favorable treatment available to 
other contracts under Code section 72. Congress in 1990 imposed another 
limitation on insurance policies with the enactment of the deferred 
acquisition cost provision (Code section 848)(the ``DAC tax''). This 
provision limits the ability of insurance companies to deduct 
immediately the costs incurred in issuing a policy. The economic effect 
of the DAC provision has been to impose a federal premium tax.
---------------------------------------------------------------------------

                   IV. COLI IS NOT A ``TAX SHELTER''

    Without discussion, the COLI proposal is listed in the FY 
2000 Budget under the heading of ``Corporate Tax Shelters.'' 
COLI is not a ``corporate tax shelter.''
    In a February 12, 1998 House Ways and Means hearing last 
year on ``Reducing the Tax Burden,'' Chairman Archer entered 
into an exchange with Congressman Kucinich on the President's 
FY 1999 tax proposals which included the same COLI proposal 
contained in this year's budget plan. The exchange is as 
follows:

          CHAIR ARCHER: ``If the gentleman is referring to the list 
        that the President has se[n]t up [the President's FY 1999 
        budget revenue raisers, which includes the exact same COLI 
        proposal]
          MR.KUCINICH: I am.
          CHAIR ARCHER: Then, I would simply tell him, even the 
        Washington Post had an article in the last week with headlines 
        that it ``Slams the middle class. It hits widows with 
        annuities, taxes savings which are inside build-ups of life 
        insurance policies, which hits the holders of those policies,'' 
        and those are the major areas of revenue raising.
          If you call those loopholes, I think you're going to find 
        there are an awful lot of people in this country, including 
        widows with annuities, are going to come out and say, ``Wait a 
        minute. That's not a loophole.'' (emphasis added) See, 
        ``Unofficial Transcript of Ways & Means Hearing on Reducing Tax 
        Burden,'' reprinted in Tax Notes Today (February 18, 1998)

    COLI is not a loophole and is not a corporate tax shelter. 
As discussed above, the use of COLI is well-documented as a 
legitimate means of funding employee retirement, health and 
other benefits. While some would argue that Congress has 
already provided special tax-favored treatment specifically to 
encourage businesses to provide health and pension benefits and 
that it was not intended that COLI be used to circumvent 
statutory limits, these arguments are specious and do not 
support a determination that COLI is a ``tax shelter.''
    Congress has long been aware of the legitimate use of COLI 
to fund retiree health benefits and supplemental pension 
benefits. The tax results achieved through the use of COLI are 
not ``unintended,'' are not ``unwarranted,'' and do not involve 
``aggressive interpretations'' of the law. The legitimate use 
of COLI does not involve tax evasion, is not offered under 
conditions of confidentiality and clearly does not fall within 
the existing definition of ``corporate tax shelter,'' under 
section 6111(d) of the Code. By any reasonable standard the use 
of COLI does not rise to the level of being described as a 
``corporate tax shelter.''

                       V. DISCUSSION OF PROPOSAL

    The President's COLI proposal is seriously flawed, 
inequitable, overly broad, and unjustified. It must again be 
REJECTED by Congress.

1) ``Tax Arbitrage'' Is A Smoke-Screen and Ignores Existing 
Statutory Limitations

    While the Administration has in the past suggested that 
traditional COLI provides unwarranted tax arbitrage, the 
argument is not persuasive and is nothing but a smoke screen to 
mask its attempt to tax inside build up of life insurance--a 
proposal that likewise has been resoundingly rejected in the 
past.
    There are legitimate tax policy reasons for allowing 
ordinary and necessary tax deductions for businesses that incur 
indebtedness and pay interest expenses. Similarly, there is a 
valid tax policy reason for allowing businesses to own 
permanent life insurance and for allowing the growth of these 
policies to be tax-deferred.
    To arbitrarily tie these two fundamental tax concepts 
together as a means of raising revenue is disingenuous. If 
denying a deduction for an expense completely unrelated to an 
item of income were acceptable, we would have complete chaos in 
the tax code.
    An example of how ill-conceived this policy would be is the 
case of a taxpayer who earns tax-deferred income in a ROTH IRA 
and also makes tax deductible mortgage interest payments. If 
the taxpayer's mortgage interest deduction were denied on the 
theory that he/she has ``tax arbitrage'' from unrelated tax-
deferred earnings in the ROTH IRA, the entire tax code would 
have to be reviewed and the deductibility of deductions would 
always be in question. The purpose of the tax deferral, in this 
case to increase the ability of Americans to save for 
retirement and the interest deduction, to promote home 
ownership, are completely unrelated. There is no connection 
between the ROTH IRA and the mortgage indebtedness just as 
there is no connection here between the business indebtedness 
and the COLI policy. In the business setting, the analogy would 
be to deny an interest deduction on the purchase of office 
equipment solely because a business purchased key man life 
insurance.
    Importantly, current law contains safeguards for interest 
that is ``related'' or ``traceable'' to the ownership of life 
insurance, denying interest deductions in such cases. These 
safeguards came about through major reforms by Congress over 
the past 20 years to the taxation of life insurance. Starting 
in the early 1960s and continuing through the mid-1990s, these 
changes to the Internal Revenue Code address perceived problems 
and prevent abusive leveraging of life insurance. As described 
above, the most recent changes occurred in the 1997 Act.
    The President's COLI proposal ignores this history and 
statutory safeguards, and goes well beyond the established 
criteria approved by Congress and the Administration. Rather 
than looking at whether there are specific relationships 
between the policy and the indebtedness or the policy and other 
criteria deemed to be ``investment oriented,'' the President's 
COLI proposal attempts to disallow deductions for completely 
unrelated interest. The Administration apparently believes that 
allowing a taxpayer a deduction for interest incurred on 
indebtedness in the operation of a business is wrong if the 
business owns life insurance on its employees, officers, or 
directors, even if the business indebtedness is completely 
unrelated to the insurance. This belief is contrary to 
fundamental principals of tax policy as well as the social 
objectives such deductions are meant to achieve.

2) The COLI Proposal is Inequitable

    By denying interest deductions on businesses that own life 
insurance, the President's COLI proposal creates unjustified 
inequities between businesses that rely on debt financing and 
those that are equity-financed. Under the proposal, two 
taxpayers in the same industry would be treated differently for 
tax purposes depending on whether they incurred debt in the 
operation of their business or whether they relied on equity 
investments.
    In addition, businesses in different industries would be 
treated differently as a result of the proposal. Many capital 
intensive industries rely heavily on debt and would be 
disproportionately disadvantaged because the proposal would 
deny their interest deductions. This would occur even though 
the debt-financed businesses would own the same amount of life 
insurance and provide the same amount of employee and 
retirement benefits as their equity-financed competitors.

3) Back Door Tax Increase on Cash Value and Unrealized 
Appreciation in Business Assets

    Like the proposal which was rejected last year, the 
President's FY 2000 budget proposal would apply the 1997 
proration rules to all COLI and BOLI. Effectively, this would 
result in a backdoor taxation of cash values on all business 
life insurance.
    As stated above, permanent life insurance has traditionally 
been a tax-favored investment for good social and tax policy 
reasons. The essential element of the insurance--to protect 
against the premature death of a key employee--and the use of 
the ``cash value'' savings element--to protect against business 
interruption or to fund pension and retirement benefits--have 
long been recognized as worthy goals.
    By denying an interest deduction to businesses that own 
such policies and tying the denial to the ``pro-rated'' amount 
of ``unborrowed cash value,'' the Administration is indirectly 
``taxing'' the cash value on permanent insurance owned by a 
taxpayer. Traditional concepts of fairness should prevent the 
Administration to do indirectly what they choose not to do 
directly.
    Moreover, this indirect tax increase on the cash value of a 
life insurance policy results in a tax on the ``unrealized 
appreciation'' in a taxpayer's asset. This result would be 
similar to taxing a homeowner each year on the appreciation of 
his/her home.
    Fundamental concepts of tax policy dictate that taxes 
generally should be incurred on the ``recognition'' of a 
taxable event, such as a sale or exchange of property. To now 
impose a tax on ``unrealized appreciation'' would not only 
violate traditional concepts of tax policy, but could result in 
huge administrative burdens on taxpayers and the government if 
followed in other areas of the law.
    Finally, it should be recognized that the cash value of 
life insurance is incidental to the underlying purpose of a 
``permanent life insurance'' policy. The fundamental nature of 
the policy is the protection of risk of death. Cash value is 
merely an incident of this purpose. Legally, cash value is 
reserved to pay death benefits and is provided to policyholders 
through Non-Forfeiture provisions mandated under State law.

4) Unjustified Elimination of Funding for Employee and 
Retirement Benefits

    The President's COLI proposal would increase current taxes 
on all businesses that own or are the beneficiaries of a 
permanent life insurance policy. It would seriously curtail the 
availability of the benefits these policies fund and increase 
the risk of business failure from loss of a key employee. While 
there is a clear relationship between the providing of 
insurance and the funding of benefits, there is no relationship 
between interest on business indebtedness and unrelated 
insurance used to fund benefits.
    Current rules already limit potential abuses in traditional 
COLI applications. Code section 264 prevents leveraged 
arbitrage from tax-deductible borrowing ``related to'' a 
corporate-owned life insurance policy. Code section 7702 and 
7702A require corporate-owned policies to provide a reasonable 
amount of death benefit protection. And qualified plan limits 
restrict the amount of insurance that can be purchased by an 
employer on a currently deductible basis. It is not clear what 
public purpose extending these rules to cover unrelated 
interest deductions would serve.
    The effect of the President's COLI proposal would be to 
limit wholly appropriate business uses of life insurance by 
making the cost of insurance products economically infeasible. 
Eliminating business owned life insurance could result in the 
elimination or reduction in the amount of employer-provided 
employee and retirement benefits. Such a change would put 
unnecessary and undue pressure on Social Security and public 
financing of benefits. At a time when the country faces 
significant funding problems with Social Security, there is no 
sound policy reason to put additional burdens on financing of 
employee benefits and retirement savings.
    In attempting to correct perceived abuses of COLI, the 
proposal unnecessarily deprives businesses of the legitimate 
benefits of COLI to protect against business interruption, loss 
of a key employee, or to fund employee benefits. The COLI 
proposal is overly broad and imposes restrictions far beyond 
those needed to address any perceived abuse. If there are 
abuses to be corrected, they should be addressed in a more 
narrow manner.

5) COLI Proposal is Inconsistent with Well-founded Savings and 
Retirement Policies

    At the very same time that the President and Congress are 
calling for more tax incentives for personal savings and 
directing attention to the impending retirement security 
crisis, the President is proposing a provision that would 
ultimately reduce personal savings.
    The President and Congress have repeatedly called for new 
long-term savings provisions (e.g., Universal Savings Accounts 
(USAs), ROTH 401(k)s) and expansions of existing savings 
provisions (e.g., increases in traditional IRA limits, Roth 
IRAs limits, and 401(k) limits). By indirectly ``taxing'' life 
insurance which funds retirement and benefit programs, the COLI 
proposal moves in the complete opposite direction of such 
efforts. By undermining these initiatives, the COLI proposal 
stands out as a stark example of inconsistent and contradictory 
tax and retirement policy.
    Moreover, the President's COLI proposal will harm 
retirement savings initiatives and have an overall negative 
impact on the National savings rate in the United States.

                             VI. CONCLUSION

    Like last year, we urge the Committee to again reject in 
its entirety the President's COLI proposal. The proposal is 
seriously flawed, inequitable, overly broad, and unjustified. 
It negatively impacts life insurance policyholders and the 
entire insurance industry, including insurance companies and 
agents across the United States. Moreover, it goes well beyond 
any perceived abuses raised by the Administration. It was 
rejected by Congress last year and should be rejected again.
    We would be happy to provide the Committee with additional 
information about the legitimate business uses of life 
insurance at any time.
      

                                

Statement of the Massachusetts Mutual Life Insurance Company

    Massachusetts Mutual Life Insurance Company is the eleventh 
largest life insurance company in the United States, doing 
business throughout the nation. The Company offers life and 
disability insurance, deferred and immediate annuities, and 
pension employee benefits. Through its affiliates, 
Massachusetts Mutual offers mutual funds and investment 
services. The Company serves more than two million 
policyholders nationwide and, with its affiliates, has more 
than $175 billion in assets under management. Massachusetts 
Mutual is deeply concerned about the Administration's renewed 
attack on cash value life insurance and annuities. The 
Administration would seriously impair the ability of families 
and businesses to make reasonable provisions for retirement and 
survivor needs. We appreciate the opportunity to offer 
testimony concerning the Administration's proposals.

                     Business Owned Life Insurance

    The Administration has renewed its proposal to penalize 
businesses that hold cash value life insurance, a proposal that 
Congress rejected last year after extensive review. This year, 
the Administration has tried to categorize business life 
insurance as a tax shelter that provides unwarranted benefits 
to business entities. However, in the Administration's own 
terms, the definition of a tax shelter does not include any 
``tax benefit clearly contemplated by the applicable 
provision'' of current tax law. Over the past few years, 
Congress has repeatedly examined the tax treatment of business 
life insurance. The current rules are a direct product of that 
analysis. Congress clearly considered the tax benefits for 
business life insurance when it passed the recent amendments to 
the applicable provisions of the Internal Revenue Code. In 
reality, the Administration proposal is an attack on the inside 
build-up of policy values.
    Congress has already eliminated the use of life insurance 
for tax arbitrage. Congress has created appropriate and 
effective limitations on the ability of a business entity to 
deduct interest on debt when it holds cash value life 
insurance. Following amendments enacted in 1996, federal law 
allows a business to take an interest deduction for loans 
against only those insurance policies covering the life of 
either a 20% owner of the business or another key person. No 
more than 20 individuals may qualify as key persons and the 
business can deduct interest on no more than $50,000 of policy 
debt per insured life. A special rule grandfathers policies 
issued before June 21, 1986. The 1997 tax act then limited the 
interest a business can deduct on its general debt if the 
business also has cash value life insurance on a person other 
than its employee, officer, director or 20% owner (or a 20% 
owner and spouse). To determine its allowable interest 
deductions, a business must reduce its general debt 
proportionately to take into consideration the unborrowed cash 
values in policies it holds on insureds not covered by these 
exceptions. This ``pro rata'' disallowance rule applies to 
policies issued or materially changed after June 8, 1997.
    The President's budget proposals would destroy the 
carefully crafted limitations set by the 1996 and 1997 
amendments to the Internal Revenue Code. The Administration 
would extend the pro rata disallowance rule to all business 
owned life insurance policies except those covering 20% owners. 
Although the Treasury Report and the Joint Committee 
explanation are ambiguous on the subject, the report issued by 
the OMB indicates that the Administration would also eliminate 
the interest deduction for loans against any policies other 
than those insuring 20% owners of the business. In addition, 
the Administration would not grandfather policies that were 
purchased under prior laws.
    The proposals would make cash value life insurance 
prohibitively expensive for all businesses. By excepting only 
policies that insure 20% owners, the Administration ignores the 
fact that business life insurance serves many legitimate, non-
tax purposes. Certainly, life insurance provides a means for 
businesses to survive the death of an owner, offering immediate 
liquidity for day-to-day maintenance of the business or the 
funds to purchase the decedent's interest from heirs who are 
unwilling or incapable of continuing the business. The 
Administration has declared that an exception for policies 
insuring 20% owners would adequately protect the legitimate 
business use of cash value life insurance. Nevertheless, 
despite the Administration's unsupported assertions, the 
purchase of life insurance to fund business buy-outs is not the 
sole legitimate use of business insurance. Businesses employ 
life insurance for many other equally meritorious purposes.
    A business must protect itself from the economic drain and 
instability caused by the loss of any major asset. More than 
any machinery, realty or tangible goods, the talents of its key 
personnel sustain a business as a viable force in the economy. 
Life insurance provides businesses with the means to protect 
the workplace by replacing revenues lost on the death of a key 
person and by offsetting the costs of finding and training a 
suitable successor. Businesses use life insurance to provide 
survivor and post-retirement benefits to their employees, 
officers and directors. As part of a supplemental compensation 
package, these benefits help attract and retain talented and 
loyal personnel, the very individuals who are crucial to the 
ongoing success of any business. The Administration proposal 
would significantly increase the cost for a business to protect 
itself or to provide benefits. In fact, the Administration 
would penalize businesses for providing even a split-dollar 
life insurance plan to assist employees in providing for the 
security of their families.
    In 1996, Congress revised the rules for deducting interest 
on policy loans to impose limits on the number of insureds and 
the amount of policy debt. Businesses need to retain the 
ability to borrow against policies on their key persons without 
incurring a tax penalty. Buying key person insurance makes 
sound business sense, but it requires a long-term commitment of 
capital. The business policyholder must have the flexibility to 
borrow against such policies in times of need without adverse 
tax consequences. The current key person exception is 
especially important to smaller businesses that have less 
access to alternative sources of borrowing. The rules enacted 
in 1996 have successfully curtailed the abusive sale of life 
insurance for tax leverage.
    Two years ago, Congress examined the tax treatment of 
general debt where a business also happened to hold cash value 
life insurance. Based on this review, it created a tax penalty 
for businesses that hold life insurance on their debtors, 
customers or any insureds other than their employees, officers, 
directors or 20% owners. Last year, as part of its fiscal year 
1999 budget, the Administration proposed extending the penalty 
to all business life insurance policies other than those 
covering 20% owners. Congress re-examined the treatment of 
unrelated business debt and rejected the Administration's 
proposal last year. Now, the Administration has submitted the 
same proposal, with no better tax policy justification than it 
has offered in the past.
    The legitimate needs for workplace protection insurance 
have not altered in the past three years. Nor will the business 
need for life insurance simply disappear if the pro rata 
disallowance rule is extended to policies covering employees, 
officers and directors. However, the resulting cost for 
businesses will increase if they cannot deduct interest on 
their general debt because they also hold cash value life 
insurance. The pro rata rule disallows that part of a business' 
interest deduction which is in the same proportion to its total 
interest deduction as the unborrowed cash values of policies it 
holds are to its total assets. As a result, the Administration 
proposal would most seriously hurt smaller businesses with 
higher debt to asset ratios and service companies that hold 
fewer assets but depend on their personnel for their economic 
well being. In effect, these businesses which rely more heavily 
on the contributions and talents of their workforce will incur 
a heavier financial burden if they try to insure against the 
risk of losing key personnel or if they try to provide employee 
benefits. Term insurance does not provide businesses with a 
reasonable alternative to cash value insurance. While often 
appropriate for temporary arrangements, term insurance is both 
costly and unsuitable for long-range needs. The loss of 
interest deductions on unrelated borrowing is an exceedingly 
harsh punishment to impose on a business for taking prudent 
financial measures to protect its valuable human assets or to 
provide benefits for its employees and retirees.
    Congress has repeatedly examined the tax treatment of 
business owned life insurance. Amendments it has passed in the 
last several years have effectively curtailed the use of life 
insurance for tax arbitrage. There is no reason to change the 
rules yet again. There is no justification for the 
Administration's proposal to penalize businesses that purchase 
cash value life insurance to safeguard their own well being or 
to provide benefits for their workforce. Businesses use life 
insurance for legitimate purposes. Like any other taxpayer, a 
business also needs some stability in the tax law in order to 
make long-term plans for its own financial welfare and that of 
its employees. The Administration would have Congress revisit 
the tax treatment of business life insurance, for the fourth 
time in four years, with the express purpose of removing the 
carefully crafted rules set in the 1996 and 1997 tax acts.

                Multiple-Employer Welfare Benefit Plans

    Internal Revenue Code Section 419A prescribes the 
requirements under which an employer can deduct contributions 
to a multiple-employer plan that provides certain welfare 
benefits for participating employees. For any employer to 
secure the deduction, the plan must involve ten or more 
employers and must meet certain other restrictions. Among other 
permissible benefits, multiple-employer plans can provide death 
benefits for covered employees. The Administration proposes to 
ban the use of cash value life insurance to provide death 
benefits under multiple-employer welfare plans.
    Essentially, this proposal is nothing more than another 
attack on the business use of cash value life insurance. The 
Administration has declared that term insurance would provide 
adequately for the promised employee benefits. Notwithstanding 
the Administration's assertions, it is a basic fact that term 
insurance becomes expensive for long-range needs and for older 
employees. A business that participates in a multiple-employer 
plan might prefer term insurance for younger or more mobile 
employees and permanent insurance for the more mature employees 
who are expected to remain with the employer. The use of 
permanent insurance allows the plan to lock in more favorable 
insurance rates for the latter category of employees. The 
flexibility to use either term or cash value insurance allows 
businesses to make appropriate provisions for their various 
employees. Permanent policies also create a pool of values the 
plan trustee can access for premium payments when current year 
contributions to the plan are inadequate to sustain existing 
levels of coverage.
    All assets in a multiple-employer plan must be applied for 
the benefit of the participating employees. The employers have 
no right or access to the plan assets. In fact, the existing 
law imposes a 100% excise tax on any asset or funds reverting 
to an employer. Therefore, the already specious arguments 
against a business holding cash value life insurance have no 
merit when applied to policies in a multiple-employer welfare 
benefit plan. The business gets no tax shelter for the growth 
in policy values and cannot leverage the policies' inside 
build-up either directly or indirectly. Since the insurance 
must benefit the participating employees, it clearly does not 
fit within the Administration's characterization of a corporate 
tax shelter.
    Welfare benefit plans covered under Section 419A cannot 
provide any form of deferred compensation, experience rating or 
segregation of plan assets by individual employers. The 
Internal Revenue Service currently has the authority to 
regulate welfare benefit plans in order to deny employers any 
tax deduction for contributions to abusive arrangements. That 
abuses exist with welfare benefit plans is a fact, as 
illustrated in several recent court cases. That the Service has 
not exercised its regulatory authority is, however, another 
fact. The solution to any abuses is not for Congress to 
legislate against the use of a particular form of life 
insurance but for the Service to establish clear guidelines for 
multiple employer plans.

                                DAC Tax

    In 1990, Congress passed Internal revenue Code Section 848, 
requiring insurers to capitalize and amortize the acquisition 
costs arising from the sale of certain non-pension life 
insurance, annuity and other insurance products. Rather than 
identify actual acquisition costs, Section 848 employs a proxy 
method to determine the portion of otherwise deductible life 
company expenses an insurer must capitalize. Known as the 
``DAC'' tax (for deferred acquisition costs), the proxy method 
uses as its base set percentages of the premium collected for 
different types of contracts. The rate for annuities is 1.75% 
of premium and, for individual life insurance, the rate is 
7.70%. To compute the amount of general deductions that it must 
capitalize rather than deduct currently, an insurance company 
would then total the relevant percentages of the premiums it 
received. Capitalized amounts are generally amortized over 10 
years, using a half year convention: i.e., of the amount 
capitalized, the insurer would deduct 5% in the year of 
capitalization, 10% in each of the next 9 years, and 5% in the 
following year. Small insurers get a corresponding 5-year 
amortization.
    The Clinton Administration proposes significant increases 
to the DAC rates for annuities and cash value life insurance. 
The annuity rate would rise to 4.25% for the first five years, 
and to 5.15% thereafter. For permanent life insurance, the rate 
would jump to 10.50% for the first five years and to 12.85% 
thereafter. These proposed increases are draconian and would 
significantly impede the ability of insurers to compete in the 
financial market. Moreover, the owners of annuities and cash 
value life insurance policies would ultimately bear the burden 
of the higher DAC rates. The steep rise in the DAC rates would 
inevitably increase the cost for policyholders who use life 
insurance as a safety net or annuities as a safeguard against 
outliving their assets. The Administration proposal, which 
would increase the cost for policyholders to provide for their 
retirement and survivor needs, is inconsistent with its stated 
goal of encouraging taxpayers to take responsibility for their 
financial well being.
    When enacted, the DAC tax imposed a major tax increase on 
the life insurance industry, raising by approximately 50% the 
aggregate tax paid by the industry at the time. The 5-year 
revenue estimate was $8 billion, while the industry tax bill at 
the time ranged from $3 to $3.5 billion per year. The 
Administration's current proposal would turn an already 
significant tax into a punitive economic burden.
    The DAC provision represents a very arbitrary and costly 
addition to the tax burden on the life insurance industry and 
its customers. Despite its name and stated intent, the DAC tax 
focuses not on company acquisition expenses but rather on gross 
premium receipts. The fact that an insurer's successful efforts 
to control or reduce expenses have no effect on its DAC 
capitalization highlights the arbitrary nature of the tax. The 
proxy bears no relation to the company's actual acquisition 
costs, particularly in the current financial environment when 
costs are dropping significantly throughout the industry. 
Purportedly targeting acquisition costs, section 848, in 
reality, taxes gross revenue. With a base of total premium 
rather than first year premium, the DAC tax is not related to 
acquisition costs.
    Moreover, the DAC provision ignores the fact that the 
federal tax system already imposes a proxy capitalization 
requirement. Insurers must also reduce their reserve deductions 
by a formula that effectively amortized policy acquisition 
costs. In effect, insurers suffer a double hit. They must use a 
lower reserve deduction to take into account acquisition costs 
and they must also defer deductions for deemed ``acquisition'' 
costs.
    Increased taxes on the premiums insurers receive will raise 
the price of insurance products and make it more difficult for 
consumers to protect their survivors and provide for retirement 
needs. In pricing life insurance, a common industry practice is 
to charge for DAC as if it were another premium tax, but in the 
1-1= % range, a method that reflects the DAC cost to the 
insurer. This one component of the federal income tax 
ultimately costs policyholders more than half of the total 
state tax imposed on life insurance. The Administration 
proposal would increase this cost to more than the total state 
tax cost. When Congress is looking for ways to encourage 
personal savings, it makes no sense to increase taxes on 
annuities and life insurance, products designed specifically 
for long-term financial planning.
    The Administration would justify the significant increase 
in the DAC rates as a means to guarantee that life insurers pay 
their fair share of federal income taxes. Contrary to 
widespread misperception, the life insurance industry is 
already a substantial federal taxpayer. As measured by a 
Coopers & Lybrand study done for the American Council of Life 
Insurance, the average effective tax rate for U.S. life 
insurers was 31.9% over the 10-year period of 1986-1995. The 
effective tax rate for all U.S. corporations for that same 
period was only 25.3%. In fact, the Coopers & Lybrand study 
reveals that life insurers' effective tax rate rose from 23.9% 
in the 1986-1990 period to 37.1% for the period 1991 through 
1995. The hefty increase in the effective tax rate resulted 
primarily from the enactment of the DAC provision. The current 
DAC tax on premiums hurts the life insurance industry in 
competing with other financial intermediaries for savings 
dollars. Surely, no increase in this tax is warranted.

                               Conclusion

    The revenue provisions contained in the President Clinton's 
budget for fiscal year 2000 would drastically increase the tax 
burden on life insurers and their policyholders. The 
Administration would penalize businesses for using cash value 
life insurance to provide for their own financial protection 
and to extend benefits for their workforce. Congress has 
recognized the legitimate business use of permanent life 
insurance and, in the past few years, crafted a careful set of 
rules to eliminate the potential use of insurance as a tax 
arbitrage. The Administration would now overturn all those 
rules it so recently signed into law, not because of any 
discernible abuse but because it deems the purchase of cash 
value life insurance to be an inappropriate use of business 
funds. The proposed ban on cash value life insurance in 
multiple employer plans would deprive a business of the 
discretion to determine the most reasonable funding for its 
long-term employee benefits. Finally, the proposed changes in 
DAC rates would increase the tax burden on an industry that is 
already heavily taxed, diminish that industry's competitiveness 
in the financial market, and raise the consumer cost of 
products best suited to encourage savings and responsible 
planning for inevitable future needs. With projected budget 
surpluses, it is inconceivable that the Administration would 
seek to raise substantial taxes from an industry uniquely 
qualified to help families and businesses provide for their 
financial security.
      

                                

Statement of Hon. Jim McCrery, a Representative in Congress from the 
State of Louisiana

    Mr. Chairman, as you know, thirty-one members of this 
Committee signed a letter to you and Mr. Rangel opposing the 
insurance proposals in the FY 2000 budget. Some of these tax 
increases, such as the COLI proposal, were rejected by Congress 
when they were part of the President's budget last year. The 
new provisions, such as the DAC tax proposal, similarly 
represent tax increases on products that help enhance 
American's retirement security and their ability to protect 
their families and businesses. Mr. Chairman, I would like to 
reiterate my strong opposition to these tax increases.
      

                                

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Statement of Mechanical-Electrical-Sheet Metal Alliance

    The Mechanical--Electrical--Sheet Metal Alliance (the 
Alliance) vigorously urges members of the House Ways and Means 
Committee to reject a provision in the Administration budget 
proposal that would levy an income tax on association 
investment income. This proposed tax would compromise the 
beneficial public and economic interest programs carried out by 
tax-exempt business associations.
    The Mechanical--Electrical--Sheet Metal Alliance represents 
more than 12,000 specialty construction contractor members of 
the Mechanical Contractors Association of America (MCAA), the 
National Electrical Contractors Association (NECA) and the 
Sheet Metal and Air Conditioning Contractors National 
Association (SMACNA). Alliance contractors employ over half a 
million highly skilled construction trades workers.
    The proposal would tax association investment income over 
$10,000. This taxable income would include dividends, interest, 
royalties, rents, and certain gains and losses from 
dispositions of property described in IRC section 512(b)(5) 
(i.e., capital gains). Associations keep reserves that earn 
income to protect against shortfalls in dues from year to year. 
While reserves typically are limited, income on those amounts 
should remain dedicated to the association's tax-exempt 
purposes.
    An income tax of this nature would have a negative impact 
on the privately funded career training and safety services 
provided to Alliance member companies. Not only would this tax 
affect the three Alliance national associations, but in 
addition would affect each of their combined 292 affiliated 
state and local chapters independently.

                       Safety and Health Programs

    The Alliance prides itself on the safety and health 
programs that it makes available to its members. MCAA received 
the Construction Industry Safety Excellence Association 
Development Award Grant in 1997. Additionally, NECA and SMACNA 
received the prestigious Business Roundtable (BRT) Construction 
Industry Safety Excellence (CISE) Association Excellence Award 
in 1998 and 1997, respectively. According to the BRT CISE 
Awards Committee, this award marks outstanding ``leadership in 
improving construction site safety, demonstrated through strong 
programs and effective measurement systems that collect and 
distribute safety performance data for members' guidance.'' BRT 
is an organization of more than 200 chief executive officers 
from leading U.S. corporations.
    Each year, the Alliance hosts a conference for industry 
safety professionals. The Construction Alliance Conference on 
Risk Management and Safety, offers workshops on establishing 
effective safety management programs, complying with workers' 
compensation statutes and provides updates on current 
Occupational Safety and Health Administration initiatives. 
Construction industry injury rates are declining nationwide 
because of these efforts.

               Career Advancement and Management Training

    Alliance member organizations offer a vast array of career 
enhancing services for all industry employees--from production 
craft through supervisory, professional and administrative 
employees. The three Alliance associations host national 
conventions with industry-related education as the primary 
focus. Each individual association also provides professional 
programs designed for chapter association managers.
    MCAA conducts its Institute for Project Management (IPM), a 
two-week curriculum that presents systematic strategies for 
improving job site management. This continuing education 
certified program has been held twice a year for the past 
twelve years. MCAA also conducts its Mid-Year Education 
Conference, where project managers from member companies learn 
about construction claims, managing multiple projects, 
estimating, coping with substance abuse, people management, and 
leadership skills.
    In 1998 SMACNA produced 32 Technical Manuals, provided 
material and personnel for 35 Technical seminars, and has a 
growing Technical University Program all designed for 
contractors, engineers and design professionals. In addition, 
SMACNA sponsors wide-ranging educational programs for the 
future contractor leaders in the sheet metal and air 
conditioning industry including a Business Management 
University Program, a Graduate Business Management Program, a 
Supervisory TrainingProgram, and hosts of other educational 
seminars--57 in 1998.
    In 1998, NECA introduced its Management Education Institute 
(MEI). MEI conducts seminars in 12-14 cities per year, covering 
topics such as company management, field supervision, project 
management, estimating, marketing, safety and insurance and 
more. MEI also includes a virtual campus, which is open to 
everyone, on topics such as financial accounting and effective 
leadership to name a few.

                          Codes and Standards

    To a much greater extent than other countries, U.S. 
commerce and industry depends on a so-called voluntary 
standards system for regulation of health, safety, performance, 
and ratings of products and systems. These voluntary standards 
are written by private sector organizations including trade 
associations and professional societies, and ratified by an 
open consensus process administered by the American National 
Standards Institute (ANSI).
    The U.S. government has recognized the importance of this 
voluntary standards system for meeting federal procurement and 
safety goals through Office of Management and Budget Circular 
A-119 and the 1996 Technology Transfer Act. Both of these 
encourage government agencies to depend on private standards 
setting to the extent feasible and give guidance for agency 
participation in the voluntary standards system. Federal 
participation is coordinated by the National Institute of 
Standards Technology (NIST), working in close coordination with 
ANSI. Alliance associtions' active involvement in creating and 
implementing model codes would be limited if new association 
taxes were levied.
    The National Certified Pipe Welding Bureau (NCPWB), a 
department of the MCAA, helps create uniform welding procedures 
that adhere to nation-wide welding codes. These uniform 
procedures help MCAA members to furnish safe and dependable 
pipe installation, and uniformly trained and qualified welders, 
that ensures public safety.
    SMACNA develops technical standards, manuals, and 
guidelines for the construction industry addressing all facets 
of sheet metal and HVAC fabrication, manufacturing, and 
installation. SMACNA produces almost twice as many technical 
standards and manuals as it did ten years ago.
    NECA is an active participant in the development of the 
National Electrical Code (U.S. national wiring rules) and 23 
other voluntary electrical and safety standards written by 
private-sector organizations. NECA is also the developer and 
publisher of a series of construction quality documents called 
the National Electrical Safety Standards.

                      State and Local Associations

    Each of the Alliance members' affiliated associations 
(chapters) also conduct many more parallel programs in their 
areas to advance the industry and high-skilled workforce 
standards and careers in those communities. Alliance affiliates 
sponsor journeyman upgrade training, career advancement 
training, safety and skills certification. In addition, many 
chapters engage in community service as well, working with 
Habitat for Humanity and senior citizen HEATS-ON programs in 
many areas. All these programs are funded from association 
revenues--and in lean years in a very cyclical industry--from 
association reserve funds and income earned on them. These 
contingency-funding sources must be preserved.
    The Alliance would like to thank the Committee on Ways and 
Means for the opportunity to submit comments on this issue. 
Again, Alliance member programs as outlined in this statement, 
and countless others including charitable work done by both the 
national associations and local chapters, would be put at great 
risk if the Administration proposal were to become law.
      

                                

Statement of Merrill Lynch & Co., Inc.

    Merrill Lynch is pleased to provide this written statement 
for the record of the March 10, 1999 hearing of the Committee 
on Ways & Means on ``Revenue Provisions in the President's 
Fiscal Year 2000 Budget.'' \1\
---------------------------------------------------------------------------
    \1\ Merrill Lynch also endorses the comments submitted to the 
Committee on these provisions by the Securities Industry Association 
and The Bond Market Association.
---------------------------------------------------------------------------

                            I. INTRODUCTION

    Merrill Lynch believes that a strong, healthy economy will 
provide for increases in the standard of living that will 
benefit all Americans as we enter the challenges of the 21st 
Century. Investments in our nations future through capital 
formation will increase productivity enabling the economy to 
grow at a healthy rate. Merrill Lynch is, therefore, extremely 
supportive of fiscal policies that raise the United States 
savings and investment rates. For this reason, Merrill Lynch 
has been a strong and vocal advocate of policies aimed to 
balance the federal budget. Merrill Lynch applauds the efforts 
of this Congress to finally reach the commendable goal of 
balancing the budget.
    While Merrill Lynch applauds the efforts of many to balance 
the federal budget, it is unfortunate that some of the tax 
changes proposed by the Administration in its FY 2000 Budget 
would raise the costs of capital and discourage capital 
investment--policies contradictory to the objective of a 
balanced budget. The Administration's FY 2000 Budget contains a 
number of revenue-raising proposals that would raise the cost 
of financing new investments in plant, equipment, research, and 
other job-creating assets. This will have an adverse effect on 
the economy.
    Moreover, many of these proposals have previously been 
fully considered and rejected out-of-hand by Congress. On many 
prior occasions, Merrill Lynch has spoken out against the 
negative impact such proposals would have on our Nation.
    Merrill Lynch agrees with comments by Chairman Bill Archer 
in announcing these hearings, where he stated:

          ``At a time when the Federal Government is collecting more 
        taxes than it needs, the President should not be asking the 
        Congress to adopt proposals that would further increase the tax 
        burden on the American people.''

    These remarks are consistent with Chairman Archer's prior 
statement to President Clinton when many of these same 
proposals were being considered for inclusion in prior budgets. 
On a broad basis, Chairman Archer stated that he is ``deeply 
troubled and believe(s) that the impact of your plan is 
fundamentally anti-business, anti-growth and . . . further 
concerned that the manner in which you have arrived at these 
proposals appears to be based on how much revenue you can raise 
from tax increases rather than how to improve the current tax 
code based on sound policy changes.'' See, Letter from Chairman 
Bill Archer to President Clinton (dated December 11, 1995). 
Chairman Archer also stated that:

          ``you have proposed numerous new tax increases on business 
        which reflect anti-business bias that I fear will diminish 
        capital formation, economic growth, and job creation. For 
        example, I don't understand why you would want to exacerbate 
        the current problem of multiple taxation of corporate income by 
        reducing the intercorporate dividends received deduction and 
        denying legitimate business interest deductions. . . . it will 
        not only be America's businesses that pay the tab; hard-
        working, middle income Americans whose nest-eggs are invested 
        in the stock market will pay for these tax hikes.''

    Based on these and other serious concerns by Congress, many 
of the capital market proposals which the Administration is now 
reproposing were rejected outright in prior years. We see no 
legitimate reason to now reconsider these unsound policies.
    The U.S. enjoys the world's broadest and most dynamic 
capital markets. These markets allow businesses to access the 
capital needed for growth, while providing investment vehicles 
individuals can rely on to secure their own futures. Our 
preeminent capital markets have long created a competitive 
advantage for the United States, helping our nation play its 
leading role in the global economy. Consistent with Chairman 
Archer's statements, in a period of record budget surplus, the 
last thing Congress should be considering are more taxes on the 
capital markets.
    Merrill Lynch remains seriously concerned about the damage 
the Administration's proposals could cause to the capital-
raising activities of American business and the investments 
these companies are making for future growth. Merrill Lynch 
believes these proposals are anti-investment and anti-capital 
formation. If enacted, they would increase the cost of capital 
for American companies, thereby harming investment activities 
and job growth.
    Unfortunately, the Administration's proposals would serve 
to limit the financing alternatives available to businesses, 
harming both industry and the individuals who invest in these 
products. Merrill Lynch believes this move by the 
Administration to curtail the creation of new financial options 
runs directly counter to the long-run interests of our economy 
and our country.
    Moreover, there is no policy consistency to many of the 
Administration's proposals. In many cases, they are a ``one-
way'' street which results in a ``heads I win, tails you lose'' 
type standard. By creating anti-taxpayer results on one-side of 
a transaction, without applying the same rules to the other 
side of the transaction, the Administration creates further 
inequities in the Code and erodes voluntary compliance with the 
tax system.
    While Merrill Lynch is opposed to all such proposals in the 
Administration's FY 2000 Budget,\2\ our comments in this 
written statement will be limited to the proposals that:
---------------------------------------------------------------------------
    \2\ Other anti-business, anti-growth proposals include the generic 
``corporate tax shelter'' proposals, the proposal to modify the rules 
for debt-financed portfolio stock, the proposal to require accrual of 
the time value element on forward sale of corporate stock and the 
proposal to increase the proration percentage for property & casualty 
(P&C) insurance companies. There is no inference of support for 
proposals not mentioned in this written statement.
---------------------------------------------------------------------------
     Defer original issue discount deduction on 
convertible debt. This proposal would place additional 
restrictions on the use of hybrid preferred instruments and 
convertible original issue discount (``OID'') bonds and would 
defer the deduction for OID and interest on convertible debt 
until payment in cash (conversion into the stock of the issuer 
or a related party would not be treated as a ``payment'' of 
accrued OID). This proposal is nearly identical to ones 
proposed by the Administration in its FY '97, FY '98, and FY 
'99 budget plans, which were repeatedly rejected by Congress.
     Eliminate the dividends-received deduction 
(``DRD'') for certain preferred stock. This proposal would deny 
the 70- and 80-percent DRD for certain types of preferred 
stock. The proposal would deny the DRD for such ``nonqualified 
preferred stock'' where: (1) the instrument is putable; (2) the 
issuer is required to redeem the securities; (3) it is likely 
that the issuer will exercise a right to redeem the securities; 
or (4) the dividend on the securities is tied to an index, 
interest rate, commodity price or similar benchmark. This 
proposal is also nearly identical to ones proposed in previous 
budgets, which were also repeatedly rejected by Congress.
    Hereinafter these proposals will be referred to as the 
``Administration's proposals.''
    To be clear, these proposals are not ``loopholes'' or 
``corporate tax shelters.'' They are fundamental changes in the 
tax law that will increase taxes on savings and investment. 
They do little more than penalize middle-class Americans who 
try to save through their retirement plans and mutual funds. 
Rather than being a hit to Wall Street, as some claim, these 
proposals are a tax on Main Street--a tax on those who use 
capital to create jobs all across America and on millions of 
middle-class individual savers and investors.
    It is unfortunate that the Treasury has chosen to 
characterize these proposals as ``unwarranted corporate tax 
subsidies'' and ``tax loopholes.'' The fact is, the existing 
tax debt/equity rules in issue here have been carefully 
reviewed--some for decades--by Treasury and Internal Revenue 
Service (``IRS'') officials, and have been deemed to be sound 
tax policy by the courts. Far from being ``unwarranted'' or 
``tax loopholes,'' the transactions in issue are based on well 
established rules and are undertaken by a wide range of the 
most innovative, respected, and tax compliant manufacturing and 
service companies in the U.S. economy, who collectively employ 
millions of American workers.
    Merrill Lynch urges Congress to get past misleading 
``labels'' and weigh the proposals against long standing tax 
policy. Under such analysis, these proposals will be exposed 
for what they really are--nothing more than tax increases on 
Americans.
    Merrill Lynch believes that these proposals are ill-
advised, for four primary reasons:
     They Will Increase The Cost of Capital, 
Undermining Savings, Investments, and Economic Growth. While 
Treasury officials have stated their tax proposals will 
primarily affect the financial sector, this is simply not so. 
In reality, the burden will fall on issuers of, and investors 
in, these securities--that is, American businesses and 
individuals. Without any persuasive policy justification, the 
Administration's proposals would force companies to abandon 
efficient and cost-effective means of financing now available 
and turn to higher-cost alternatives, and thus, limit 
productive investment. Efficient markets and productive 
investment are cornerstones to economic growth.
     They Violate Established Tax Policy Rules. These 
proposals are nothing more than ad hoc tax increases that 
violate established rules of tax policy. In some cases, the 
proposals discard tax symmetry and deny interest deductions on 
issuers of debt instruments, while forcing holders of such 
instruments to include the same interest in income. 
Disregarding well-established tax rules for the treatment of 
debt and equity only when there is a need to raise revenue is a 
dangerous and slippery slope that can lead to harmful tax 
policy consequences.
     They Will Disrupt Capital Markets. Arbitrary and 
capricious tax law changes have a chilling effect on business 
investment and capital formation. Indeed, the Administration's 
proposals have already caused significant disruption in 
capital-raising activities, as companies reevaluate their 
options.
     They Will Fail to Generate Promised Revenue. The 
Administration's proposals are unlikely to raise the promised 
revenue, and could even lose revenue. Treasury's revenue 
estimates appear to assume that the elimination of the tax 
advantage of certain forms of debt would cause companies to 
issue equity instead. To the contrary, most companies would 
likely move to other forms of debt issuance--ones that carry 
higher coupons and therefore involve higher interest deductions 
for the issuer.
    At a time when the budget is balanced and the private 
sector and the federal government should join to pursue ways to 
strength the U.S. economy, the Administration has proposed tax 
law changes that would weaken the economy by disrupting 
capital-raising activities across the country. Merrill Lynch 
strongly urges the Administration and Congress to set aside 
these proposals. Looking forward, Merrill Lynch would be 
delighted to participate in full and open discussions on the 
Administration's proposals, so that their ramifications can be 
explored in depth.
    The following are detailed responses and reaction to three 
of the Administration's proposals that would directly affect 
capital-raising and investment activities in the U.S.

        II. PROPOSAL TO DEFER OID DEDUCTION ON CONVERTIBLE DEBT

    The Administration's FY 2000 Budget contains proposals that 
would defer the deduction for original issue discount (``OID'') 
until payment and deny an interest deduction if the instrument 
is converted to the stock of the issuer or a related party. 
These proposed changes to fundamental tax policy rules relating 
to debt and equity come under two separate (but related) 
proposals. Similar proposals were proposed and rejected by 
Congress a number of times in the past three years.
    One proposal, among other things, defers OID on convertible 
debt. The only stated ``Reasons for Change'' relating 
specifically to this proposal is contained in the Treasury 
Department's ``General Explanations of the Administration's 
Revenue Proposals'' (February 1999) (the ``Green Book''):

          ``In many cases, the issuance of convertible debt with OID is 
        viewed by market participants as a de facto purchase of equity. 
        Allowing issuers to deduct accrued interest and OID is 
        inconsistent with this market view.''
    This is the same justification used in Treasury's 1997 and 
1998 Green Book and rejected by Congress.
    Merrill Lynch strongly opposes the Administration's 
proposal to defer deductions for OID on Original Issue Discount 
Convertible Debentures (``OIDCDs'') for a number of reasons 
more fully described below. To summarize:
     The Treasury's conclusion that the marketplace 
treats OIDCD as de facto equity is erroneous and inconsistent 
with clearly observable facts;
     In an attempt to draw a distinction between OIDCDs 
and traditional convertible debt, Treasury has in prior years 
misstated current law with regard to the deduction of accrued 
but unpaid interest on traditional convertible debentures, and 
apparently continues to rely on such misstatements;
     The proposal ignores established authority that 
treats OIDCDs as debt, including guidance from the IRS in the 
form of a private letter ruling;
     The proposed elimination of deductions for OID 
paid in stock is at odds with the tax law's general treatment 
of expenses paid in stock;
     The proposal would destroy the symmetry between 
issuers and holders of debt with OID. This symmetry has been 
the pillar of tax policy regarding OID. The Administration 
offers no rationale for repealing this principle;
     The proposal disregards regulations adopted after 
nearly a decade of careful study by the Treasury and the 
Internal Revenue Service. Consequently, the Administration's 
proposal would hastily reverse the results of years of careful 
study; and
     While billed as a revenue raiser, it is clear that 
adoption of the Administration's proposal would in fact reduce 
tax revenue.
     Finally, this proposal has been fully considered 
by this same Congress and rejected in prior years.

A. Treasury's Conclusion That The Market Treats OIDCD As De 
Facto Equity Is Erroneous And Inconsistent With Clearly 
Observable Facts.

    The proposal is based on demonstrably false assumptions 
about market behavior, which assumptions are also inconsistent 
with clearly observable facts. There is no uncertainty in the 
marketplace regarding the status of OIDCDs as debt. These 
securities are booked on the issuers' balance sheets as debt, 
are viewed as debt by the credit rating agencies, and are 
treated as debt for many other legal purposes, including 
priority in bankruptcies. In addition, zero coupon convertible 
debentures are typically sold to risk averse investors who seek 
the downside protection afforded by the debentures. Thus, both 
issuers and investors treat convertible bonds with OID as debt, 
not equity. Accordingly, it is clear that the market's ``view'' 
supports the treatment of OIDCD as true debt for tax purposes.
    Treasury makes clear that its proposal would not affect 
``typical'' convertible debt on the grounds that the 
``typical'' convertible debentures are not certain to convert. 
Because OIDCDs have been available in the market place in 
substantial volume for over ten years, it is possible to 
compare the conversion experience of so-called ``typical'' 
convertible debentures with the conversion experience of 
OIDCDs, nearly all of which have been zero coupon convertible 
debt. The data shows that ``typical'' convertible debentures 
are much more likely to convert to equity, that is, to be paid 
off in stock, than zero coupon convertible debentures.
    The instruments in question are truly debt rather than 
equity. An analysis of 97 liquid yield option notes (``LYONs'') 
sold in the public market between 1985 and 1998, shows that 57 
of those issued had already been retired (as of December 1997). 
Of those 57, only 15 were finally paid in stock. The other 42 
were paid in cash. The remaining 40 of the 97 issues were still 
outstanding as of December 31, 1997. If those 40 securities 
were called, only 19 of them would have converted to stock and 
the other 21 would have been paid in cash. In other words, the 
conversion features of only 19 of the 40 issues remaining 
outstanding are ``in the money.'' Overall, only 35% of the 
public issuances of LYONs had been (or would be if called) paid 
in stock. Thus, in only 35% of these OIDCD issuances had the 
conversion feature ultimately controlled.
    On the other hand, an analysis of 669 domestic issues of 
``typical'' convertible debt retired since 1985 shows just the 
opposite result (as of December 1997). Seventy-three percent 
(73%) of these offerings converted to the issuer's common 
stock. Accordingly, based on historical data, typical 
convertible debt is significantly more likely to be retired 
with equity than cash, as compared to LYONs.
    The Treasury's proposal is clearly without demonstrable 
logic. It makes no sense to say that an instrument that has 
approximately a 30% probability of converting into common stock 
is ``viewed by market participants as a de facto purchase of 
equity,'' and therefore, the deduction for OID on that 
instrument should be deferred (or denied), while an instrument 
that has over a 70% probability of conversion should be treated 
for tax purposes as debt.\3\ We would be happy to provide this 
data, and any other relevant information, to the Administration 
and Congress.
---------------------------------------------------------------------------
    \3\ Given this data, even if one accepted the Treasury's assertion 
that probability of conversion in some way governed appropriate tax 
treatment, the proposal obviously addresses the wrong convertible 
security.

B. Prior Misstatements of Current Law Continue to Be Relied 
---------------------------------------------------------------------------
Upon

    In prior year's Budget proposals, Treasury's has made 
statements of ``Current Law,'' which apparently continue to be 
relied upon in its FY 2000 Budget. These statements misstate 
the law regarding interest that is accrued but unpaid at the 
time of the conversion. The Treasury has in the past suggested 
that the law regarding ``typical'' convertible debt is 
different from the law for convertible debt with OID. This is 
clearly not the case. Both the Treasury's own regulations and 
case law require that stated interest on a convertible bond be 
treated the same as OID without regard to whether the 
bondholder converts.
    When the Treasury finalized the general OID regulations in 
January, 1994 (T.D. 8517), the Treasury also finalized Treasury 
Regulations section 1.446-2 dealing with the method of 
accounting for the interest. The regulations state:

          ``Qualified stated interest (as defined in section 1.1273-
        1(c)) accrues ratably over the accrual period (or periods) to 
        which it is attributable and accrues at the stated rate for the 
        period (or periods).'' See, Treas. Reg. Section 1.446-2(b).
    All interest on a debt obligation that is not OID is 
``qualified stated interest.'' Treasury regulations define 
``qualified stated interest'' under Treas. Reg. Section 1.1273-
1(c) as follows:

          (i) In general, qualified stated interest is stated interest 
        that is unconditionally payable in cash or in property . . . or 
        that will be constructively received under section 451, at 
        least annually at a single fixed rate . . .
          (ii) Unconditionally payable . . . For purposes of 
        determining whether interest is unconditionally payable, the 
        possibility of a nonpayment due to default, insolvency or 
        similar circumstances, or due to the exercise of a conversion 
        option described in section 1272-1(e) is ignored. This applies 
        to debt instruments issued on or after August 13, 1996 
        (emphasis added).

    Thus, according to the Treasury's own regulations, fixed 
interest on a convertible bond is deductible as it accrues 
without regard to the exercise of a conversion option. The 
Treasury's suggestion to the contrary in the description of the 
Administration's proposal contradicts the Treasury's own 
recently published regulations.
    In addition, case law from the pre-daily accrual era 
established that whether interest or OID that is accrued but 
unpaid at the time an instrument converts is an allowable 
deduction depends on the wording of the indenture. In Bethlehem 
Steel Corporation v. United States, 434 F.2nd 1357 (Ct. Cl. 
1971), the Court of Claims interpreted the indenture setting 
forth the terms of convertible bonds and ruled that the 
borrower did not owe interest if the bond converted between 
interest payment dates. The Court merely interpreted the 
indenture language and concluded that no deduction for accrued 
but unpaid interest was allowed because no interest was owing 
pursuant to the indenture. The Court stated that if the 
indenture had provided that interest was accrued and owing, and 
that part of the stock issued on conversion paid that accrued 
interest, a deduction would have been allowed. The indentures 
controlling all of the public issues of zero coupon convertible 
debt were written to comply with the Bethlehem Steel court's 
opinion and thus, the indentures for all of these offerings 
provide that if the debentures convert, part of the stock 
issued on conversion is issued in consideration for accrued but 
unpaid OID.
    Thus, there is no tax law principle that requires a 
difference between ``typical'' convertible bonds and zero 
coupon convertible deductions. The only difference is a matter 
of indenture provisions and that difference has been overridden 
by the Treasury's own regulations.

C. Proposal Ignores Established Authority That Treats OIDCDs As 
Debt, Including Guidance From The IRS In The Form Of A Private 
Letter Ruling.

    Under current law, well-established authority treats OIDCDs 
as debt for tax purposes, including guidance from the IRS in 
the form of a private letter ruling. The IRS has formally 
reviewed all the issues concerning OIDCDs and issued a private 
letter ruling confirming that the issuer of such securities may 
deduct OID as it accrues. See, PLR 9211047 (December 18, 1991). 
Obviously rather than having not exploited [a] lack of guidance 
from the IRS, issuers of OIDCDs have relied on official IRS 
guidance in the form of a private letter ruling. That the IRS 
issued a ruling on this topic confirms that OIDCDs do not 
exploit any ambiguity between debt and equity. If any such 
ambiguity existed the IRS would not have issued its ruling.

D. Proposal Is Inconsistent With The Fundamental Principle That 
Payment In Stock Is Equivalent To Payment In Cash.

    We would now like to focus not on the timing of the 
deduction but on the portion of the Administration's proposal 
that would deny the issuer a deduction for accrued OID if 
ultimately paid in stock. The proposal is inconsistent with the 
general policy of the tax law that treats a payment in stock 
the same as a payment in cash. A corporation that issues stock 
to purchase an asset gets a basis in that asset equal to the 
fair market value of the stock issued. There is no difference 
between stock and cash. A corporation that issues stock to pay 
rent, interest or any other deductible item may take a 
deduction for the item paid just as if it had paid in cash.
    More precisely on point, the 1982 Tax Act added section 
108(e)(8) \4\ to repeal case law that allowed a corporate 
issuer to escape cancellation of indebtedness income if the 
issuer retired corporate debt with stock worth less than the 
principal amount of the corporate debt being retired. The 
policy of that change was to make a payment with stock 
equivalent to a payment with cash. Section 108(e)(8) clearly 
defines the tax result of retiring debt for stock. As long as 
the market value on the stock issued exceeds the amortized 
value of the debt retired, there is no cancellation of 
indebtedness income. The Administration's proposal to treat 
payment of accrued OID on convertible debt differently if the 
payment is made with stock rather than cash is inconsistent 
with the fundamental rule that payment with stock is the same 
as payment with cash. The Administration's proposal would 
create an inconsistency without any reasoned basis.
---------------------------------------------------------------------------
    \4\ All section references are to the Internal Revenue Code of 
1986, as amended.

E. Treasury's Proposal Removes The Long Established Principle 
---------------------------------------------------------------------------
Of Tax Symmetry Between Issuers And Holders Of Debt With OID.

    As discussed above, the current law is clear that an issuer 
of a convertible debenture with OID is allowed to deduct that 
OID as it accrues. The Service's private letter ruling, cited 
above, confirms this result. It is important to note that the 
OID rules were originally enacted to ensure proper timing and 
symmetry between income recognition and tax deductions for tax 
purposes. Proposals that disrupt this symmetry violate this 
fundamental goal of tax law.
    The Administration's proposal reverses the policy of 
symmetry between issuers and holders of OID obligations. Since 
1969, when the tax law first addressed the treatment of OID, 
the fundamental policy of the tax law has been that holders 
should report OID income at the same time that the issuer takes 
a deduction. The Administration's proposal removes this 
symmetry for convertible debt with OID. Not only would the 
holders report taxable income before the issuer takes a 
deduction, but if the debt is converted, the holders would have 
already reported OID income and the issuer would never have an 
offsetting deduction. The Administration does not offer any 
justification for this unfairness.

F. Treasury's Proposal Is An Arbitrary Attempt To Reverse Tax 
Policies That Were Adopted After Nearly A Decade Of Careful 
Study.

    The manner in which this legislative proposal was offered 
is a significant reason to doubt the wisdom of enacting a rule 
to defer or deny deductions for OID on convertible debentures. 
When the Treasury issued proposed regulations interpreting 1982 
and 1984 changes in the Internal Revenue Code regarding OID, 
the Treasury asked for comments from the public regarding 
whether special treatment was necessary for convertible 
debentures. See, 51 Federal Register 12022 (April 18, 1986).
    This issue was studied by the Internal Revenue Service and 
the Treasury through the Reagan, Bush and Clinton 
Administrations. Comments from the public were studied and 
hearings were held by the current administration on February 
16, 1993. When the current Treasury Department adopted final 
OID regulations in January of 1994, the final regulations did 
not exclude convertible debentures from the general OID rules. 
After nearly nine years of study under three Administrations 
and after opportunity for public comment, the Treasury decided 
that it was not appropriate to provide special treatment for 
OID relating to convertible debentures. Merrill Lynch suggests 
that it is not wise policy to reverse a tax policy that 
Treasury had adopted after nearly a decade of study and replace 
it with a policy previously rejected by Congress on a number of 
occasions.

G. Proposal Regarding OID Convertible Debentures Would Reduce 
Tax Revenue.

    While billed as a ``revenue raiser,'' adoption of the 
Administration's proposal with respect to OIDCDs would in fact 
reduce tax revenue for the following reasons:
     Issuers of OIDCDs view them as a debt security 
with an increasing strike price option imbedded to achieve a 
lower interest rate. This a priori view is supported by the 
historical analysis of OIDCDs indicating that over 70% have 
been, or if called would be, paid off in cash.
     If OIDCDs were no longer economically viable, 
issuers would issue straight debt.
     Straight debt rates are typically 200 to 300 basis 
points higher than comparable rates. Therefore, issuers' 
interest deductions would be significantly greater.
     According to the Federal Reserve Board data, at 
June 30, 1995 over 60% of straight corporate debt is held by 
tax deferred accounts versus less that 30% of OIDCDs held by 
such accounts.
    Consequently, the empirical data suggests that if OIDCDs 
are not viable, issuers will issue straight debt with higher 
interest rates being deducted by issuers and paid to a 
significantly less taxed holder base. The Administration's 
proposal would therefore reduce tax revenue while at the same 
time interfering with the efficient operation of the capital 
markets.
    Giving full consideration to the above data, Merrill Lynch 
believes rejection of the proposal with respect to OIDCDs is 
warranted and the reasons for doing so compelling.

     III. PROPOSAL TO ELIMINATE THE DRD ON CERTAIN PREFERRED STOCK.

    The Administration has proposed to deny the 70-and 80-
percent DRD for certain types of preferred stock. The proposal 
would deny the DRD for such ``nonqualified preferred stock'' 
where: (1) the instrument is putable; (2) the issuer is 
required to redeem the securities; (3) it is likely that the 
issuer will exercise a right to redeem the securities; or (4) 
the dividend on the securities is tied to an index, interest 
rate, commodity price or similar benchmark. A similar proposal 
was proposed and rejected by Congress a number of times in the 
past three years.
    It has long been recognized that the ``double taxation'' of 
dividends under the U.S. tax system tends to limit savings, 
investment, and growth in our economy. The DRD was designed to 
mitigate this multiple taxation, by excluding some dividends 
from taxation at the corporate level.
    Unfortunately, the Administration's proposal to eliminate 
the DRD on certain stock would significantly undermine this 
policy. In the process, it would further increase the cost of 
equity capital and negatively affect capital formation.
    From an economic standpoint, Merrill Lynch believes that in 
addition to exacerbating multiple taxation of corporate income, 
the Administration's proposal is troubling for a number of 
reasons and would have a number of distinct negative impacts:
     Dampen Economic Growth. If the DRD elimination 
were enacted, issuers would react to the potentially higher 
cost of capital by: lowering capital expenditures, reducing 
working capital, moving capital raising and employment 
offshore, and otherwise slowing investments in future growth. 
In particular, American banks, which are dependent on the 
preferred stock market to raise regulatory core capital, would 
see a significant increase in their cost of capital and, hence, 
may slow their business-loan generation efforts.
     Limit Competitiveness of U.S. Business. The 
elimination of the DRD would also further disadvantage U.S. 
corporations in raising equity vis-a-vis our foreign 
competitors, especially in the UK, France, and Germany. In 
these countries, governments have adopted a single level of 
corporate taxation as a goal, and inter-corporate dividends are 
largely or completely tax free. As long as American firms 
compete in the global economy under the weight of a double-or 
triple-taxation regime, they will remain at a distinct 
competitive disadvantage.
     Discriminate Against Particular Business Sectors 
and Structures. The Administration's proposal may have a 
disproportionate impact on taxpayers in certain industries, 
such as the financial and public utility industries, that must 
meet certain capital requirements. Certain types of business 
structures also stand to be particularly affected. Personal 
holding companies, for example, are required to distribute 
their income on an annual basis (or pay a substantial penalty 
tax) and thus do not have the option to retain income to lessen 
the impact of multiple levels of taxation.
     Companies Should Not Be Penalized for Minimizing 
Risk of Loss. As a result of the Administration's proposal, the 
prudent operation of corporate liability and risk management 
programs could result in disallowance of the DRD. Faced with 
loss of the DRD, companies may well choose to curtail these 
risk management programs.
     No Tax Abuse. In describing the DRD proposal, the 
Administration suggests that some taxpayers ``have taken 
advantage of the benefit of the dividends received deduction 
for payments on instruments that, while treated as stock for 
tax purposes, economically perform as debt instruments.'' To 
the extent Treasury can demonstrate that the deduction may be 
subject to misuse, targeted anti-avoidance rules can be 
provided. The indiscriminate approach of eliminating the DRD 
goes beyond addressing inappropriate transactions and 
unnecessarily penalizes legitimate corporate investment 
activity.
    While the overall revenue impact of the DRD proposal may be 
positive, Merrill Lynch believes the revenue gains will not be 
nearly as large as projected, due to anticipated changes in the 
behavior of preferred-stock issuers and investors.
     Issuers of Preferred Stock. Eliminating the DRD 
will increase the cost of preferred-stock financing and cause 
U.S. corporations to issue debt instead of preferred stock 
because of interest deductibility. This overall increase in 
deductible interest would result in a net revenue loss to 
Treasury.
     Secondary Market for Preferred Stock. Currently, 
the market for outstanding preferred stock is divided into two 
segments:
    --A multi-billion dollar variable-rate preferred stock 
market where dividends are set via Dutch auctions. The dividend 
rate on these securities will necessarily increase to adjust 
for the elimination of the DRD, and may cause some of these 
issuers to call these preferred securities at par and replace 
them with debt. This will result in a revenue loss to Treasury.
    --A multi-billion dollar fixed-rate preferred stock market 
where the issuing corporations cannot immediately call the 
securities. Retail investors, who comprise 80% of this market 
cannot utilize the DRD and therefore pay full taxes on 
dividends. Hence, there will be no meaningful revenue gains to 
Treasury from this market segment.
    This proposal may also create losses for individual 
investors. Institutions, which own approximately 20% of all 
fixed-rate preferred stock, may sell their holdings given the 
increased taxation. Individual investors will bear the brunt of 
any price decline, because they currently account for about 80% 
of the fixed-rate preferred market. These capital losses, when 
taken, will offset any capital gains and result in a revenue 
loss to Treasury.
    At a time when U.S. tax policy should be moving toward 
fewer instances of ``double taxation,'' Merrill Lynch believes 
it would be a mistake to eliminate the DRD on certain limited-
term preferred stock. Any such action will make ``triple 
taxation'' even more pronounced in, and burdensome on, our 
economy.

                             V. CONCLUSION

    Based on the discussion set forth above, Congress should 
reject the Administration's proposals out of hand. These 
proposals which include the deferral of legitimate interest 
deductions and the elimination of the DRD are nothing more than 
tax increases which raise the cost of financing new 
investments, plant, equipment, research, and other job-creating 
assets. These tax increases hurt the ability of American 
companies to compete against foreign counterparts and are born 
by the millions of middle-class Americans who try to work and 
save through their retirement plans and mutual fund 
investments. These impediments to investment and savings would 
hurt America's economic growth and continued leadership in the 
global economy. At a time of budget surpluses, the last thing 
Congress should be considering are increased taxes on capital 
markets.
    Moreover, from a tax policy perspective, the 
Administration's proposals are ill-advised, arbitrary and 
capricious tax law changes that have a chilling effect on 
business investment and capital formation. Indeed, the 
Administration's proposals are nothing more than ad hoc tax 
increases that violate established rules of tax policy. In some 
cases, the proposals discard tax symmetry and deny interest 
deductions on issuers of certain debt instruments, while 
forcing holders of such instruments to include the same 
interest in income. Disregarding well-established tax rules for 
the treatment of debt and equity only when there is a need to 
raise revenue is a dangerous and slippery slope that can lead 
to harmful tax policy consequences.
    The Administration's proposals also are unlikely to raise 
the promised revenue, and could even lose revenue. Treasury's 
revenue estimates appear to assume that the elimination of the 
tax advantage of certain forms of debt would cause companies to 
issue equity instead. To the contrary, most companies would 
likely move to other forms of debt issuance--ones that carry 
higher coupons and therefore involve higher interest deductions 
for the issuer.
    Far from being ``unwarranted'' or ``tax loopholes,'' the 
transactions in issue are based on well established rules and 
are undertaken by a wide range of the most innovative, 
respected, and tax compliant manufacturing and service 
companies in the U.S. economy, who collectively employ millions 
of American workers.
    Merrill Lynch urges Congress to get past misleading 
``labels'' and weigh the proposals against long standing tax 
policy. Under such analysis, these proposals will be exposed 
for what they really are--nothing more than tax increases on 
Americans.
    For all the reasons stated above, the Administration's 
proposals should AGAIN be rejected in toto.
      

                                

Statement of National Association of Life Underwriters (NALU), and 
Association for Advanced Life Underwriting (AALU)

    The National Association of Life Underwriters (NALU) and 
the Association for Advanced Life Underwriting (AALU) submit 
this statement strongly opposing the Administration's Fiscal 
Year 2000 budget proposal that imposes new taxes on the 
business uses of life insurance. NALU represents more than 
104,000 life insurance agents, most of them rank-and-file 
professionals, around the country. AALU, a conference of NALU, 
represents those whose businesses focus on specialized life 
insurance applications in business, employee benefits, and 
estate planning situations. Together, NALU and AALU represent 
the interests not only of our more than 100,000 life and health 
insurance professionals, but also the millions of individuals 
and businesses that own life insurance.
     Currently, thousands of businesses--small and large--own 
life insurance that protects them and millions of people they 
employ from major financial hardship resulting from the death 
of key persons. Business life insurance also enables businesses 
to attract, retain and provide benefits to current and retired 
employees. Such critically important and long-standing business 
uses of life insurance should not be disturbed. We therefore 
urge Members of the Ways and Means Committee to reject the 
Administration's proposal, which would effectively eliminate 
these essential business, job and benefit protections by 
imposing a major tax disincentive for purchasing life insurance 
or continuing to keep current policies in force.

Administration's Proposal is a Broad Attack on the Vast Majority of the 
 Business Uses of Life Insurance and Unfairly Categorizes Traditional 
                  Uses as ``Corporate Tax Shelters.''

    The Administration's proposal would be devastating in its 
economic effects. Specifically, it would impose a tax penalty--
directly based on accumulating cash value--on businesses that 
own life insurance and have any debt whatsoever. The only 
exception would be for policies covering 20 percent or greater 
owners.
    For example, consider a small partnership of 10 equal 
owners. The partnership carries key person insurance on its 
principal rainmaker. It also has a bank loan, secured by its 
accounts receivable, taken out to pay for new, updated office 
equipment. Under the Clinton proposal, this partnership would 
have to reduce its deduction for interest paid on the office 
equipment loan just because it carries life insurance on one of 
its owners. The bank loan for office equipment is in no way 
connected to the life insurance, yet the deductible interest on 
that loan is affected by the Clinton proposal. This is 
inherently unfair. It puts the partnership in a position of 
having to pay a tax penalty for its decision to carry permanent 
life insurance for a long-standing, traditional life insurance 
purpose.
    Businesses have the need, at various times, both to own 
permanent life insurance and to borrow. Given the fact that 
life insurance represents a long-term investment of perhaps 
forty years, any automatic tax penalty imposed on businesses 
that own permanent life insurance and which engage in unrelated 
borrowing will seriously undermine business uses of life 
insurance and the benefits that they provide.
    Almost as disturbing as the business life insurance 
proposal itself, is the fact that the proposal is included 
within the ``corporate tax shelter'' portion of the 
Administration's budget. Such common business uses of life 
insurance as key-person protection, buy-sell agreements, split 
dollar, deferred compensation and employee benefits serve very 
important functions and should certainly not be characterized 
as tax shelters.
    The Administration's characterization of the business uses 
of permanent life insurance as tax shelters may well betray an 
inappropriate, negative bias against the product. The 
Administration proposes broadening the definition of what 
constitutes a tax shelter, but even under this looser standard, 
the Administration states that a tax shelter does not include 
``a tax benefit clearly contemplated by the applicable 
provision.'' Department of Treasury, General Explanation of the 
Administration's Revenue Proposals at 96 (February 1999).
    It would be hard to argue that the tax attributes of the 
business uses of life insurance are not clearly contemplated, 
given the fact that Congress has examined such uses and such 
tax attributes in each of the past four years, and enacted 
legislation covering such uses in 1996 and 1997. In fact, in 
1997 Congress made a clear decision not to apply the tax 
penalty now proposed, where the life insurance policies cover 
the lives of officers, directors, employees or twenty or 
greater percent owners.

   Current Law Sets Appropriate Standards for Business Life Insurance

    In 1996, Congress largely eliminated the ability of 
businesses to deduct interest on loans associated with life 
insurance. This general rule applies whether the business 
borrows directly from a life insurance policy or borrows 
indirectly by pledging the life insurance policy as collateral 
for a loan. It also applies if there is a demonstrable 
connection between the decision to purchase life insurance and 
the decision to borrow and deduct interest.
    The only exceptions from this business life insurance loan 
disallowance are for (1) contracts purchased on or before June 
20, 1986 or (2) contracts covering key persons, provided the 
indebtedness is not greater than $50,000 per insured life and 
the total number of such persons cannot exceed the greater of 
(a) 5 or (b) the lesser of (i) 5 percent of total officers and 
employees or (ii) 20.
    In 1997, after a well-publicized intent by Fannie Mae to 
initiate a multibillion dollar program of purchasing permanent 
life insurance on the lives of mortgage borrowers, Congress 
enacted legislation, which for the first time and under very 
narrow circumstances, disallowed otherwise deductible interest 
without first requiring a link between the decisions of a 
business to purchase life insurance and to borrow money.
    NALU and AALU did not oppose this legislation because we 
understood a Congressional disapproval of the expansion of the 
use of permanent life insurance by businesses beyond a long-
established utilization to cover the lives of owners, officers, 
directors and employees. We appreciated that Congress was 
surgical in structuring the legislation to prevent a widespread 
new use of permanent life insurance to cover borrowers, while 
causing little disturbance to the long-standing ability of 
businesses to use permanent life insurance to protect 
themselves, their 20 percent or greater owners, officers, 
directors and employees and to provide benefits for them. We 
reluctantly yielded on the point that it's unfair to penalize 
life insurance ownership because of a business's decision to 
borrow for reasons and using assets unrelated to life 
insurance. Despite our deeply-rooted conviction that tying 
insurance ownership to unrelated loan interest is inherently 
unfair and wrong, we understood Congress' goal was to prevent 
the expansion of the use of life insurance outside of the 
employment context.
    In 1999, for the second year in a row, the Clinton 
Administration budget proposal includes a provision which would 
broadly impose the tax penalty which is now narrowly targeted 
on business uses of life insurance covering individuals like 
mortgage borrowers, who are not 20 percent or greater owners, 
officers, directors or employees. Nothing is said in the 
proposal that would justify this devastating and ill-advised 
departure. Businesses which utilize permanent life insurance to 
insure their key persons should not be penalized because they 
engage in unrelated borrowing.

   Current Business Uses of Life Insurance which would be Hit by the 
                        Administration Proposal

     The Administration's proposal would impose a tax penalty 
on all current and future policyholders, except those covering 
twenty percent or more owners, and would penalize life 
insurance used for the following traditional purposes. The 
following examples illustrate why it is essential that the 
Administration's proposal be rejected:
     Successful continuation of business operations 
following the death of an insured key employee.
    Virtually every business has one or more employees whose 
production is critical to the business' financial health. It 
could be key management personnel, or perhaps it is the 
salesperson who brings in the work for the business to perform. 
Other examples include those whose jobs demand the creativity 
of product development, a marketing initiative or a merger or 
acquisition, the success of which depends heavily on the 
continued personal involvement of these individuals. Or it may 
be the extra-skilled technician who knows how to work the 
crucial computer or manufacturing system that is the heart of 
the business' performance.
    There are very many situations in which such individuals 
are not twenty or greater percent owners.
    When one or more of these individuals die, the business 
faces the enormous cost of replacing these workers' individual 
skills. During the time when a replacement is sought and during 
the ``learning curve'' period when the new worker(s) get up to 
speed, the firm is likely to lose both new business and 
productivity with respect to existing business. In this so-
called ``key person'' scenario, it is this measurable loss that 
life insurance death benefits replace.
     Purchase of a business interest, thereby enabling 
the insured's family to obtain a fair value for its business 
interest and permitting the orderly continuation of the 
business by its new owners or the redemption of stock to 
satisfy estate taxes and transfer costs of an insured 
stockholder's estate.
    Life insurance protects businesses against the financial 
devastation that occurs when one of several business owners 
dies. The buy-sell or stock redemption involves the use of life 
insurance to pay the decedent owner's heirs the decedent's 
ownership interest. This avoids the use of business assets--
which may not be in liquid form--to meet this obligation. 
Without the use of business life insurance for these purposes, 
either the decedent's heirs will become potentially active 
participants in the business as they exercise their new 
ownership rights, or--in the worst case--the business itself 
might have to be sold in order to satisfy the financial 
obligation to the decedent owner's heirs.
    In each of these scenarios, the existence of death benefits 
could very well spell the difference between the continued 
operation of the business and its failure. The continued 
operation of the business, of course, means the continuation of 
the jobs that the business provides to its employees, and the 
continuation of the business's impact on other businesses in 
the community. It also means that the business will continue to 
pay its income taxes to the Federal and state governments and 
to contribute to our overall economic growth.
    As with the case of key person insurance, there are many 
needs for a business to utilize life insurance for buy-sell or 
stock redemption purposes, which involve owners who have less 
than a twenty percent interest in the entity.
     Creation of funds to facilitate benefit programs 
for long-term current and retired employees, such as programs 
addressing needs for retirement income, post-retirement medical 
benefits, disability income, long-term care or similar needs. 
Payment of life insurance or survivor benefits to families or 
other beneficiaries of insured employees. Facilitation of 
employee ownership of and benefits from permanent life 
insurance death and retirement income protection through split 
dollar arrangements.
    The success of any business is contingent on attracting and 
retaining the employees that it needs, through appropriate 
compensation and benefit packages. This can be particularly 
difficult in situations addressed by the Administration's 
proposal--individuals who have no ownership interest or an 
interest of less than twenty percent. Life insurance, through 
the above means, provides effective ways for businesses to hire 
and retain a high quality workforce. Providing employee 
benefits is especially difficult for small businesses, and life 
insurance offers the flexibility and cost feasibility that 
makes it possible.

                               Conclusion

    In conclusion, NALU and AALU urge Congress to reject the 
Administration's misconceived proposal on business life 
insurance. The business use of life insurance is not a tax 
shelter; it protects businesses against the loss of key 
persons, provides for the orderly continuation of businesses 
and facilitates the ability of businesses to attract and retain 
quality employees.
    Thank you.
      

                                

Statement of National Association of Manufacturers

                              INTRODUCTION

    The National Association of Manufacturers (NAM) appreciates 
the opportunity offered by Committee Chairman Archer to comment 
on the revenue provisions in the Administration's FY 2000 
budget proposal. The NAM is the nation's largest national 
broad-based industry trade group. Its 14,000 member companies 
and subsidiaries, including approximately 10,000 small 
manufacturers, are in every state and produce about 85 percent 
of U.S. manufactured goods. The NAM's member companies and 
affiliated associations represent every industrial sector and 
employ more than 18 million people.
    The NAM believes that federal taxes are too high and too 
complex, making the current federal tax code the single biggest 
obstacle to economic growth. Congress should pursue a 
comprehensive overhaul of the federal tax code that would not 
only make it simpler, but would also stimulate--rather than 
penalize--the generation of income from work, saving, 
investment and entrepreneurial activity. Until such reform goes 
into effect, the NAM will seek a major reduction in taxes to 
stimulate job creation and economic growth--preferably an 
across-the-board cut in all federal income tax rates of at 
least 10 percent. The NAM also supports targeted relief such as 
a permanent and strengthened R&D tax credit, ``death-tax'' 
repeal, repeal of the corporate Alternative Minimum Tax, S-
corporation tax rate relief, capital gains tax relief, 
international tax simplification, and other pro-growth changes.
    We commend the Administration's support for several pro-
growth tax incentives, including an extension of the R&D tax 
credit. On balance, however, the Administration's budget 
proposal enlarges the size and scope of the government but 
fails to advance broad, pro-growth tax reductions. Moreover, 
the majority of the revenue raisers in this budget would 
restrict growth and constitute bad tax policy. Overall, the 
proposals run counter to the NAM's goal of maintaining 
sustained economic growth to enhance living standards for all 
Americans. Although this is not an exhaustive list, following 
are the NAM's comments on some of the specific provisions.

                          PRO-GROWTH PROPOSALS

      Tax Credit for Research and Experimentation (R&D Tax Credit)

    The NAM is pleased that the Administration included an 
extension of the R&D tax credit in its fiscal year 2000 budget 
proposal, but is disappointed that the extension is only for 12 
months. By expiring mid-year, a 12-month extension results in 
unnecessary tax complexity. We urge Congress and the 
Administration to act on a permanent, seamless extension of 
this important tax incentive.
    The importance of R&D cannot be overstated. Increased 
productivity, new product development and process improvements 
are direct results of technological advances that occur from 
R&D activities. Notably, nearly two-thirds of the growth in 
manufacturing and up to one-third of the growth in the overall 
economy can be attributed to technological advances.
    An NAM economic analysis shows that a permanent R&D tax 
credit would actually increase the rate of GDP growth over the 
long term, as opposed to a one-time shift in the level of GDP. 
This is an important distinction from most policy initiatives, 
which have no effect on the rate of long-term economic growth. 
Many of our nation's foreign-trade competitors offer permanent 
tax and financial incentives for R&D; the credit helps mitigate 
this competitive disadvantage of U.S. companies.
    We urge Congress and the President to work together to end 
more than 15 years of temporary lapses with extensions that may 
or may not be retroactive to the expiration date. The NAM 
strongly supports ending the uncertainty of credit extensions 
by making the R&D tax credit permanent. In addition, the 
alternative incremental research credit (AIRC) should be 
further expanded so businesses can better rely on and utilize 
the credit. The NAM supports legislation (H.R. 835) introduced 
by Representatives Johnson (R-CT-6) and Matsui (D-CA-5) and (S. 
680) introduced by Senators Hatch (R-UT) and Baucus (D-MT) that 
permanently extends the R&D tax credit and increases the AIRC.

           Exclusion for Employer-Provided Tuition Assistance

    The NAM applauds the Administration's proposal to extend 
the current Section 127 exclusion for employer-provided tuition 
assistance through the end of 2002, and expand the tax benefit 
to cover graduate education beginning in July 1999. It is our 
hope that Congress will make Section 127 permanent, in order to 
help companies and their employees better prepare for the 
growing challenges of the modern workplace.
    We strongly believe that education and lifelong learning 
are the key to continued economic growth and worker prosperity. 
Our economy will continue to grow only if our workers are armed 
with the skills they need to thrive in tomorrow's workplace. 
Expansion and extension of the exclusion for employer-provided 
education assistance is a welcomed proposal.

               Look-Through Treatment for 10/50 Companies

    The NAM supports the Administration's proposal to 
accelerate the effective date of a provision in the 1997 Tax 
Relief Act affecting foreign joint ventures where U.S. persons 
own at least 10 percent, but not more than 50 percent, of the 
stock (so-called ``10/50 companies''). This change would treat 
10/50 companies like controlled foreign corporations by 
allowing ``look-through'' treatment, for foreign tax-credit 
purposes, of dividends from such joint ventures. Under the 1997 
Act, the change is effective only for dividends received in tax 
years beginning after 2002. In addition, two sets of rules 
apply: one for dividends from pre-2003 earnings and profits 
(E&P); another for dividends from post-2002 E&P. The 
Administration's proposal would instead apply the look-through 
rules to all dividends received in tax years beginning after 
1998, regardless of when the E&P accumulated.
    The proposal would reduce the tremendous complexity and 
compliance burdens faced by U.S. multinationals doing business 
overseas through foreign joint ventures. It would also reduce 
the competitive bias against U.S. participation in foreign 
joint ventures by placing U.S. companies on a much more level 
playing field from a corporate-tax standpoint. In sum, it would 
provide sorely needed simplification of the tax laws and would 
go a long way toward helping the U.S. economy by strengthening 
the competitiveness of U.S.-based multinationals. The NAM 
withholds its support for the proposed grant of regulatory 
authority regarding pre-acquisition earnings and profits 
subject to greater clarification of what rules are 
contemplated.

Tax Incentives To Promote Energy Efficiency and Improve the Environment

    In general, the NAM supports a voluntary approach for 
private sector research to improve energy efficiency and the 
environment, rather than federal mandates. While the NAM 
generally approves of the thrust of the Administration's tax-
incentive proposals pertaining to energy efficiency, the 
manufacturing community would prefer a permanent extension of 
the current R&D tax credit to better allow the market to 
allocate limited resources in this area.

                         ANTI-GROWTH PROPOSALS

                               Corporate

General Corporate Tax Planning

    The NAM is concerned about the Administration's attack on 
legitimate corporate tax planning. The Administration's 
proposals to address what it labels as ``tax avoidance 
transactions'' are overly broad and would bring within their 
net many corporate transactions that are clearly permitted 
under existing law. Legitimate tax planning to conform to 
domestic and foreign non-tax legal or regulatory requirements 
could well be subject to confiscatory penalties for failing to 
satisfy these overly broad standards. In particular, the 
Administration would impose strict liability for a confiscatory 
40-percent penalty on taxpayers entering into transactions that 
IRS agents determine are uneconomic. The fact that the taxpayer 
acts reasonably and in good faith, or has a substantial 
business purpose for the transaction would not matter. This is 
simply not the right standard. Our business transactions and 
the tax laws that apply to them are too complex. Taxpayers and 
the government inevitably will disagree. Taxpayers should be 
allowed to assert their views as freely as IRS agents assert 
theirs.
    To function efficiently and productively, business 
taxpayers must be able to rely on the tax code and existing 
income-tax regulations. If the Administration's vague ``tax-
shelter'' proposals become law, few businesses would feel 
comfortable relying on those statutes or regulations. 
Treasury's proposed rules could cost the economy more in lost 
business activity than they produce in taxing previously 
``sheltered'' income.
    In sum, the Administration's attempt to tilt the playing 
field in favor of the IRS would make it very difficult for 
taxpayers to engage in a number of legitimate transactions. 
These actions would hurt the ability of U.S. corporations to 
operate economically and to compete effectively against their 
foreign-based competitors. At the same time, though, there are 
some abusive transactions that need to be addressed. The NAM 
would welcome the opportunity to work with Congress and the 
Administration to resolve these issues.

Tracking Stock

    Under the Administration's budget, the issuance of 
``tracking stock'' would be taxable to the issuer based on the 
gain in the tracked assets. ``Tracking stock'' is a class of 
stock on which dividends are payable and other shareholder 
rights are determined with respect to a distinct business unit 
that represents less than all the assets of the issuing 
corporation. The NAM opposes this attempt by Treasury to 
trigger a double tax on corporate income.
    Tracking stock has been used in a number of circumstances 
for compelling business reasons and not for tax-avoidance 
purposes. It is an efficient means of raising capital. 
Moreover, with tracking stock, investors can choose the 
specific operations of a corporation in which to invest, rather 
than investing in a corporate conglomerate. Tracking stock also 
is effective in promoting employee incentives and 
accountability for employees working in the ``tracked'' 
operation, and facilitates the acquisition of a new business or 
the expansion of an existing business. If enacted, this 
proposal would adversely impact existing tracking-stock values 
and preclude future use of this valuable type of security.

Tax Treatment of Downstream Mergers

    The NAM also opposes the Administration's proposal to 
change the tax treatment of certain downstream mergers. 
Downstream mergers generally involve a parent corporation 
(target) that holds stock in a subsidiary company (acquiring). 
The Administration's proposal would apply in cases where the 
target company does not satisfy the stock-ownership 
requirements of Section 1504(a)(2) (generally, 80 percent or 
more of vote and value) with respect to the acquiring 
corporation, and the target corporation combines with the 
acquiring corporation in a reorganization in which the 
acquiring corporation is the survivor. In these cases, the 
target corporation must recognize gain, but not loss, on the 
acquiring corporation stock it distributes to shareholders 
immediately before the reorganization. The proposed change 
would eliminate a longstanding and well-recognized ability of 
companies to reorganize in a tax-free manner.

Debt-Financed Portfolio Stock

    The NAM opposes the Administration's proposal to modify the 
standard for determining whether portfolio stock is debt-
financed. This provision would effectively reduce the 
dividends-received deduction (DRD) for any corporation carrying 
debt (virtually all corporations) and would specifically target 
financial-service companies, which tend to be more debt-
financed.
    The purpose of the DRD is to eliminate, or at least 
alleviate, the impact of potential multiple layers of corporate 
taxation. Under current law, the DRD is not permitted to the 
extent that relevant ``portfolio stock'' is debt-financed. 
Portfolio stock is defined as stock in which the corporate 
taxpayer owner holds less than 50 percent of the vote or value. 
Portfolio stock has generally been treated as debt-financed 
when it is acquired with the proceeds of indebtedness or 
secures the repayment of indebtedness. The Administration's 
proposal would expand the DRD disallowance rule for debt-
financed stock by assuming that all corporate debt is allocated 
to the company's assets on a pro-rata basis. Thus, the proposal 
would partially disallow the DRD for all corporations based on 
a pro-rata allocation of its corporate debt.
    We believe the proposal would exacerbate the multiple 
taxation of corporate income, penalize investment and mark a 
retreat from efforts to develop a fairer, more rational and 
simpler tax system. The NAM believes that multiple taxation of 
corporate earnings should be reduced, rather than expanded. The 
Administration's proposal clearly moves in the wrong direction.

Dividends-Received Deduction for Certain Preferred Stock

    Another proposal would deny the dividends-received 
deduction (DRD) on stock that the Administration believes is 
more like debt than equity. This has been both proposed by the 
Administration and rejected by Congress in the past. The NAM 
objects to this provision since it is not in the best interests 
of tax or public policy.
    As noted above, the DRD was designed to alleviate the 
impact of multiple layers of corporate taxation. Without the 
DRD, income would be taxed three times: when it is earned by a 
corporation; when the income is paid as a dividend to a 
corporate shareholder; and when the income of the receiving 
corporation is paid as a dividend to an individual shareholder. 
The DRD was enacted to provide for full deductibility of 
intercorporate dividends.
    Although the Administration is concerned that dividend 
payments from certain preferred stock more closely resemble 
interest payments than dividends, the proposal would not allow 
issuers of this preferred stock to take interest expense 
deductions on the dividend payments. This proposal, which would 
deny these instruments the tax benefits of both debt and 
equity, would violate sound tax policy.

Corporate-Owned Life Insurance (COLI) Rules

    The NAM opposes the Administration's proposal to repeal an 
exception to the current proportionate interest disallowance 
rules for contracts on employees, officers or directors, other 
than 20-percent owners of the business. This proposal has been 
included in earlier Administration budgets and rejected by 
Congress in the past. This exception was designed to allow 
employers to create key-person life-insurance programs, fund 
non-qualified deferred compensation with the advantages of life 
insurance and meet other real business needs. The proposal 
would tax the inside buildup in cash-value life insurance owned 
by a business that also has debt. Given the long-term nature of 
life-insurance investments, this rule would make insurance 
unattractive even to companies that currently have no debt 
because they might need to borrow at some future date.

Deferral of Original Issue Discount (OID) on Convertible Debt

    The Administration's budget includes a number of past 
proposals aimed at financial instruments and capital markets, 
which were fully rejected by previous Congresses. These 
recycled proposals should be rejected again. One proposal would 
defer deductions by corporate issuers for interest accrued on 
convertible-debt instruments with original issue discount (OID) 
until interest is paid in cash. The proposal would completely 
deny the corporation an interest deduction unless the investors 
are paid in cash (e.g., no deduction would be allowed if the 
investors convert their bonds into stock). Investors in these 
instruments still would be required to pay income tax currently 
on the accrued interest. In effect, the proposal would defer or 
deny an interest deduction to the issuer while requiring the 
holder to pay tax on the interest currently.
    The NAM opposes this proposal because, by failing to match 
the accrual of interest income by holders of OID instruments 
with the ability of issuers to deduct accrued interest, it is 
contrary to sound tax policy. Moreover, there is no justifiable 
reason for treating the securities as debt for one side of the 
transaction and as equity for the other side. There is also no 
reason, economic or otherwise, to distinguish a settlement in 
cash from a settlement in stock.

                            General Business

Deductibility of Punitive Damages

    The Administration proposes to make punitive-damage 
payments in civil suits non-deductible, whether made in 
satisfaction of a judgment or in settlement of a claim. In 
addition, punitive damages paid by an insurance company on a 
taxpayer's behalf would be includable in the gross income of 
the taxpayer. The NAM strongly urges Congress to reject this 
provision.
    Currently, punitive-damage payments are deductible by a 
business and are generally includable in the gross income of 
the recipient. In many states, the present punitive-damage 
system has been characterized in recent years by dramatic 
increases in the number and size of punitive-damage awards and 
is badly in need of reform. There is a need for better and more 
uniform standards and guidelines on when punitive damages can 
be awarded and the size of the awards. There are wide 
differences in standards among the states. Thus, the proposal 
would treat essentially similar conduct differently, depending 
on where it occurs.
    The Administration's proposal would exacerbate all the 
problems of the current punitive-damage system, effectively 
increasing the size (cost) of awards and settlements and having 
a chilling effect on productive commercial activity. The 
proposal also would provide plaintiffs' attorneys with greater 
leverage to extract settlements of deductible compensatory 
damages in lieu of threatened non-deductible punitive damages. 
In short, the proposal would change the nature of settlement 
negotiations to minimize the ``tax take'' of the government, 
which would be an undesirable feature for any civil justice 
system. The proposal also would deny businesses the ability to 
deduct ordinary and necessary business expenses relating to 
legal claims.
    Finally, the proposal to eliminate the deductibility of 
civil punitive-damage awards raises strong concerns, especially 
given Congress's continued failure to reform the civil-justice 
system, and the inappropriate comparison that proponents have 
made with the non-deductibility of criminal fines and 
penalties. It would be unfair to eliminate the deduction for 
civil punitive-damage awards in the absence of any meaningful 
reform of the civil-justice system.

Superfund Taxes

    The Superfund program has been funded historically by the 
corporate environmental income tax and excise taxes on 
petroleum, chemical feedstock and imported chemical substances, 
all of which expired on Dec. 31, 1995. The Administration's 
budget proposal would reinstate the excise taxes for the period 
after the date of enactment and before Oct. 1, 2009. The 
corporate environmental income tax would be reinstated for tax 
years beginning after Dec. 31, 1998, and before Jan. 1, 2010. 
The Administration has tried to reinstate these taxes in the 
past, although earlier attempts were rejected by Congress. The 
NAM opposes these proposals.
    Under the ``pay-go'' rules of the federal budget laws, any 
Superfund reauthorization bill that includes new spending must 
also include offsets, i.e., the reinstated Superfund taxes or 
equivalent revenues ``within the four corners of the bill.'' 
Thus, as a practical matter, an extension of the Superfund 
taxes separate from a Superfund reauthorization bill may 
preclude the possibility of a major legislative reform of the 
Superfund program during the period when the taxes are 
reinstated. The NAM urges Congress only to consider reinstating 
these taxes as part of meaningful reform of the Superfund 
program. The extension of Superfund taxes without changing the 
existing Superfund regime only exacerbates a serious problem.

Deposit Requirements for Unemployment Insurance Taxes

    The NAM opposes a provision in the Administration's budget 
that would accelerate, from quarterly to monthly, the 
collection of most federal and state unemployment-insurance 
(UI) taxes. Imposing a monthly collection of federal and state 
UI taxes would accelerate the collection of taxes to generate a 
one-time, artificial revenue increase for budget-scoring 
purposes. At the same time, though, the change would 
permanently increase both compliance costs for employers and 
collection costs for state unemployment insurance 
administrators. The Administration's proposal is fundamentally 
inconsistent with every reform proposal that seeks to 
streamline the operation of the UI system, as well as the 
government's own initiatives to reduce paperwork and regulatory 
burdens. This deposit acceleration rules makes no sense for 
small or large businesses, and an exemption for certain small 
businesses would not improve this fundamentally flawed concept.

Tax Treatment of Start-Up and Organizational Expenses

    Under current law, start-up and organizational expenditures 
are amortized at the election of the taxpayer over a period of 
not less than 60 months. In contrast, a 15-year amortization 
period applies to certain acquired intangible assets (goodwill, 
trademarks, franchises, patents, etc.) held in connection with 
the conduct of a trade or business, or an activity for the 
production of income. The NAM opposes the Administration's 
proposal to extend the amortization period from 5 to 15 years 
for start-up and organizational expenditures incurred by 
certain businesses. Although a de minimis rule would allow 
businesses to deduct up to $5,000 a year of these costs, this 
benefit would be phased out as total expenditures exceed 
$50,000. The NAM believes that the proper treatment of many 
start-up and organizational expenses in a neutral tax system 
would be expensing. Moving in the opposite direction, toward a 
longer artificial recovery period for such expenses, would 
simply increase taxes on companies that are growing and 
expanding.

Inventory Accounting Methods

    The NAM opposes the Administration's proposal to repeal two 
inventory-accounting methods. This proposal was included in 
earlier Administration budget plans and rejected by Congress. A 
taxpayer that sells goods in the active conduct of its trade or 
business generally must maintain inventory records in order to 
determine the cost of goods sold during the taxable period. 
Cost of goods sold generally is determined by adding the 
taxpayer's inventory at the beginning of the period to 
purchases made during the period and subtracting the taxpayer's 
inventory at the end of the period. Because of the difficulty 
of applying the specific identification method of accounting, 
taxpayers often use methods such as ``first-in, first-out'' 
(FIFO) and ``last-in, first-out'' (LIFO).
    Certain taxpayers can currently determine their inventory 
values by applying the lower of cost or market (LCM) method, or 
by writing down the cost of goods that are unsalable at normal 
prices or unusable in the normal way because of damage, 
imperfection or other causes (the ``subnormal-goods'' method). 
The Administration would repeal these options and force 
taxpayers to recognize income from changing their method of 
accounting on the grounds that writing down unusable or 
unsalable goods somehow ``understates taxable income.'' We urge 
Congress to reject this proposal. In addition, the NAM believes 
that the LCM method should continue to be permissible for 
financial-accounting purposes to avoid the complexity of 
maintaining separate inventory-accounting systems.

Substantial Understatement Penalty

    Under the Administration's proposal, any tax deficiency 
greater than $10 million would be considered ``substantial'' 
for purposes of the penalty. In contrast, under the existing 
test, the tax deficiency must exceed 10 percent of the 
taxpayer's liability for the year. The Administration's 
proposal has been rejected by Congress in the past. The NAM 
also opposes the Administration's proposal to tighten the 
substantial understatement penalty.
    For many individual taxpayers and even privately-held 
companies, $10 million may be a substantial amount of money. 
However, for a large, publicly held multinational company, $10 
million may not be ``substantial.'' Further, in view of the 
complexities and ambiguities contained in the existing tax 
code, a 90-percent accurate return should be deemed substantial 
compliance with only additional taxes and interest due and 
owing. There is no policy justification to apply a penalty to 
publicly held multinational companies that are required to deal 
with much greater complexities than other taxpayers.

Penalties for Filing Incorrect Information Returns

    Similarly, the NAM opposes the Administration's proposal to 
increase penalties for failing to file information returns, 
including all standard 1099 forms. IRS statistics bear out the 
fact that compliance levels for filing information returns are 
already extremely high. Any failures to file on a timely basis 
generally are due to the late reporting of year-end information 
or to other unavoidable problems. Under these circumstances, an 
increase in the penalty for failure to file timely returns 
would be unfair and would fail to recognize the substantial 
compliance efforts already made by American business.

                              International

Export-Source Rule

    The NAM strongly opposes the Administration's proposal to 
replace the current export-source rule with an activity-based 
sourcing rule. The proposal, which has been part of earlier 
budget plans, has been consistently rejected by Congress. The 
export-source rule, which has been included in tax regulations 
since 1922, applies in cases where goods manufactured in the 
United States are sold abroad. Under this rule, half of the 
income derived from these sales is treated as foreign-source 
income as long as title to the goods passes outside the United 
States. The export-source rule increases the ability of U.S. 
exporters to use foreign tax credits and avoid double taxation 
of foreign earnings.
    The Administration contends that the export-source rule is 
not needed to alleviate double taxation because of our tax-
treaty network. We strongly disagree. The United States has tax 
treaties with fewer than a third of all jurisdictions. More 
significantly, double taxation is generally caused by the many 
restrictions in U.S. tax laws on crediting foreign taxes paid 
on the international operations that U.S. companies must have 
to compete in the global marketplace. Among these restrictions 
are the allocation rules for interest and R&D expenses, the 
many foreign tax-credit ``baskets'' and the treatment of 
domestic losses.
    The Administration also alleges that the export-source rule 
gives multinational corporations a competitive advantage over 
U.S. exporters that conduct all of their business activities in 
the United States. However, to compete overseas effectively, 
most U.S. manufacturers find that they must have operations in 
these foreign markets to sell and service their products. The 
supposed competitive advantage over a U.S. exporter with no 
foreign assets or employees is a myth. There are many 
situations in which a U.S. manufacturer with no foreign 
activities simply cannot compete effectively in foreign 
markets.
    Moreover, this proposal could reduce Treasury revenues by 
encouraging U.S. exporters to move their operations offshore. 
Instead of exporting products from the United States, they may 
be able to manufacture them abroad to the extent of excess 
capacity in foreign plants. If even a small percentage of U.S. 
exporters made a switch, the proposal would fail to achieve the 
desired result, and taxes on manufacturing profits and 
manufacturing wages would go to foreign governments.
    At present, the United States has too few tax incentives 
for exporters, especially compared to foreign countries with 
VAT regimes. The United States should be stimulating the 
expansion of exports. Given our continuing trade deficit, it 
would be unwise to remove a WTO consistent tax incentive for 
multinational corporations to continue making export sales from 
the United States. Ironically, this proposal could result in 
multinationals using existing foreign manufacturing operations 
instead of U.S.-based operations to produce export products. 
The NAM strongly urges Congress to retain the current export-
source rule.

Foreign Built-In Losses

    The NAM opposes a proposal in the Administration's budget 
that would require the Treasury Department to issue regulations 
to prevent taxpayers from ``importing built-in losses incurred 
outside U.S. taxing jurisdictions to offset income or gain that 
would otherwise be subject to U.S. tax.'' This provision also 
has been proposed by the Administration in the past and 
rejected by Congress. The Administration argues that, although 
there are rules limiting a U.S. taxpayer's ability to avoid 
paying U.S. tax on built-in gain, there are no similar rules to 
prevent taxpayers from using built-in losses to shelter income 
otherwise subject to U.S. tax. As a result, taxpayers are 
avoiding Subpart F income inclusions or capital-gains tax. We 
believe that this directive, which is written extremely 
broadly, is unnecessary because of existing rules in the Code. 
This proposal would severely impact the ability of U.S. 
multinationals to compete on an equal footing against foreign-
based companies.

Foreign Oil and Gas Income Tax Credits

    The NAM also opposes a provision in the Administration's 
budget that would limit the availability of foreign tax credits 
for certain foreign taxes paid on foreign oil and gas 
extraction income. Congress also has rejected the proposal in 
the past. This selective attack on a single industry's use of 
the foreign tax credit is not justified. U.S.-based oil 
companies are already at a competitive disadvantage under 
current law because most of their foreign-based competitors pay 
little or no home-country tax on foreign oil and gas income. 
The proposal would increase the risk that foreign oil and gas 
income would be subject to double taxation, severely hindering 
U.S. oil companies in the global oil and gas exploration, 
production, refining and marketing arena. The NAM is 
particularly opposed to this provision because it undermines 
the entire foreign tax-credit system and sets a very bad tax-
policy precedent by making the recoupment of double-taxation 
costs contingent on the industry in which a company is engaged.

Payments from 80/20 Companies

    Currently, a portion of interest or dividends paid by a 
domestic corporation to a foreign entity may be exempt from 
U.S. withholding tax, provided the payor corporation is a so-
called ``80/20 company,'' i.e., at least 80 percent of its 
gross income for the preceding three years is foreign-source 
income attributable to the active conduct of a foreign trade or 
business.
    The NAM opposes the Administration's proposed changes to 
the 80/20 rules. This Administration proposal has been rejected 
by Congress in the past. The Administration alleges that the 
testing period is subject to manipulation and allows certain 
companies to improperly avoid U.S. withholding tax on certain 
distributions attributable to a U.S. subsidiary's U.S. source 
earnings. As a result, the Administration would apply the test 
on a group-wide (as opposed to individual company) basis. 
However, there is little evidence that these rules have been 
manipulated on a broad scale in the past, and we do not believe 
such a drastic change is justified. Such a change also 
negatively impacts U.S. taxpayers operating as branches in 
foreign jurisdictions for legitimate business reasons.

                       Small and Medium Businesses

Conversions of C-Corporations to S-Corporations

    The NAM opposes a provision to tax the conversion of a C-
corporation to an S-corporation, which has been proposed by the 
Administration and rejected by Congress in the past. Under 
current law, the conversion of a C-corp to an S-corp generally 
is a tax-free event although the new S-corp must recognize 
built-in gain on former C-corp assets that are sold within 10 
years of the conversion. Under a provision in the 
Administration's budget, however, the conversion of a C-corp to 
an S-corp would trigger taxes immediately.
    The proposed tax law change represents a stark departure 
from the federal government's strong support for S-corps. S-
corps were created more than 40 years ago to give owners of 
small and medium companies more flexibility in setting up and 
operating their businesses. This hybrid mix of a partnership 
and a corporation was specifically designed to encourage the 
growth and stability of small and medium businesses by allowing 
owners to maintain control of their companies while benefiting 
from the liability protections afforded corporate shareholders.
    Small and medium companies, many of which are S-corps, are 
central to the growth of our economy. In fact, about one-fourth 
of our national income is generated by small and medium 
businesses. This proposal would effectively bar many businesses 
from becoming S-corps, and would have a particularly severe 
impact on small and medium companies. In contrast, the NAM 
urges Congress to act on S-corp rate-relief legislation, which 
would help mitigate some of the remaining deterrents for 
companies to convert to S-corporation status.

Treatment of ESOPs as S-Corp Shareholders

    The NAM also opposes the Administration's proposal that 
would require an employee stock-ownership plan (ESOP) to pay 
tax on S-corp income (including capital gains on the sale of 
the stock) as the income is earned. The provision would reverse 
important reforms in the S-corp rules enacted in recent years 
and eliminate any incentive for S-corps to establish ESOPs.
    Tax law changes enacted in 1996 and 1997 permit ESOPs to be 
S-corp shareholders. In addition, the ESOP's share of the S-
corp's income is not subject to tax until it is distributed to 
plan beneficiaries. Under the proposal, however, an ESOP's S-
corp income would be subject to the unrelated business income 
tax (UBIT) when the income is earned. The recent tax law 
changes enabled S-corp owners, for the first time, to set up 
ESOPs for their employees. The proposed changes would remove an 
important incentive for establishing and maintaining these 
plans.

Estate and Gift Tax Provisions

    In the area of estate and gift taxes, the NAM opposes 
Administration proposals to scrap some techniques that allow a 
business owner to move illiquid assets out of the estate first. 
These proposals also have been rejected by Congress in the 
past. Forcing business owners to delay transfer of business 
ownership until death would result in an even higher failure 
rate for family-owned businesses.
    The Qualified Terminable Interest Property Trust (QTIP) was 
designed by Congress to allow both spouses to use their full 
individual-unified credits. QTIPs were set up expressly to 
prevent the estate tax from impoverishing a surviving spouse. 
The proposed restrictions on the use of QTIPs would force an 
estate to choose between losing the unified credit, breaking up 
the business, or divesting the surviving spouse of cash, 
leaving the ``second to die'' holding the illiquid assets.
    Personal Residence Trusts are significant tools for estate 
planners only because the family home is another illiquid 
asset. Allowing parents to give the family home to their 
children at a future date, while retaining the parents' right 
to live in the house for as long as they desire, permits a 
planner to give the estate the maximum liquidity to deal with 
the death tax bill.
    Finally, the rules on minority valuation again produce 
little revenue gain, but they allow the IRS to decide whether 
the cash or cash equivalents of an active business exceed the 
``reasonable working capital needs of the business.'' This test 
is already defined under the accumulated-earnings tax, and it 
has been the subject of much litigation already.
    Less than one-third of family businesses survive to the 
second generation. The Administration's proposals to further 
restrict estate-planning opportunities may raise minimal 
revenue, but would drive down the survival rate even further. 
The Treasury Department derides these estate-planning tools as 
legal fictions. However, estate and gift taxes themselves are 
bad. Family-owned businesses should not need to resort to legal 
fictions to stay in business. Federal estate and gift taxes 
should be abolished, not raised.

                          Exempt Organizations

Tax on Trade Association's Investment Income

    The NAM strongly opposes the Administration's proposal to 
tax so-called ``investment'' income of trade associations, 
i.e., income associations receive from interest, dividends, 
rents, capital gains and royalties. Under the plan, all 
investment income greater than $10,000 earned by a trade 
association would be subject to the unrelated business income 
tax (UBIT).
    It is difficult to underestimate the impact this proposed 
tax would have on associations. Associations rely on this 
income to carry out a wide range of exempt-status activities 
including education, training, research and community outreach. 
In addition, keeping investment income tax-free encourages 
organizations to maintain modest surplus funds from year to 
year, in order to remain stable during economic downturns. 
Unlike for-profit companies, associations cannot issue stock or 
seek money in public offerings to provide the necessary 
protection from fiscal crises. Moreover, the purpose of UBIT is 
to prevent associations and other tax-exempt organizations from 
competing unfairly against for-profit businesses. However, this 
investment income is not generated by activities that compete 
with tax-paying businesses. Rather, taxing trade association's 
investment income would impose an unjust and unnecessary 
penalty on legitimate association activities.

               CONCLUSION: NEED FOR PRO-GROWTH TAX RELIEF

    The NAM recognizes the importance and benefits of the 
existing surpluses in the federal budget. Clearly, the 
country's robust economic growth over the past seven years has 
been a key factor in moving the federal budget into a surplus 
position. Consequently, it is imperative that federal policies 
support continued economic growth. Unfortunately, most of the 
revenue raisers discussed above would discourage economic 
growth by providing disincentives to savings and investment and 
raising the cost of capital for manufacturers.
    While the Administration's budget plan offers a few 
beneficial incentives, on balance it does not include any 
broad, pro-growth tax reductions. The NAM believes that there 
is room in the federal budget surplus for a broad-based tax 
cut. With the total federal tax take at record levels, tax 
rates should be lowered for all. If the surplus is not returned 
to taxpayers through tax cuts, it will likely go towards more 
government spending. In fact, without the ``growth insurance'' 
of a broad-based rate cut, the surplus itself could be in 
jeopardy because more growth yields more revenues to the 
federal treasury.
    The NAM also believes there are a number of other pro-
growth tax provisions that would benefit the American economy. 
These include a permanent and strengthened R&D tax credit, 
repeal of the ``death'' tax and the corporate Alternative 
Minimum Tax, reduction in S-corp tax rates on reinvested 
profits, international tax simplification and capital-gains tax 
relief for individuals and corporations.
      

                                

Statement of Steven A. Wechsler, President and Chief Executive Officer, 
National Association of Real Estate Investment Trusts

    As requested in Press Release No. FC-7 (February 18, 1999), 
the National Association of Real Estate Investment 
Trusts (``NAREIT'') respectfully submits these 
comments in connection with the Ways and Means Committee's 
review of certain revenue provisions presented to the Committee 
as part of the Administration's Fiscal Year 2000 Budget.
    NAREIT's comments address the Administration proposals to 
(1) modify the real estate investment trust (``REIT'') asset 
tests to permit REITs to own taxable REIT subsidiaries; (2) 
modify the treatment of closely held REITs; and (3) amend 
section 1374 \1\ to treat an ``S'' election by a large C 
corporation as a taxable liquidation of that C corporation. We 
appreciate the opportunity to present these comments.
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    \1\ For purposes of this Statement, ``section'' refers to the 
Internal Revenue Code of 1986, as amended.
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    NAREIT is the national trade association for real estate 
companies. Members are REITs and other publicly-traded 
businesses that own, operate and finance income-producing real 
estate, as well as those firms and individuals who advise, 
study and service these businesses. REITs are companies whose 
income and assets are mainly connected to income-producing real 
estate. By law, REITs regularly distribute most of their 
taxable income to shareholders as dividends. NAREIT represents 
over 200 REITs or other publicly-traded real estate companies, 
as well as over 2,000 investment bankers, analysts, 
accountants, lawyers and other professionals who provide 
services to REITs.

                           Executive Summary

    Taxable REIT Subsidiaries. NAREIT welcomes the 
Administration's taxable REIT subsidiary proposal as a very 
significant step in the right direction to modernize the REIT 
rules. Current law requires REITs to use awkward methods in 
order to provide services to third parties, and also prevents 
REITs from remaining competitive in providing needed and 
emerging services to their tenants. The taxable REIT subsidiary 
structure would codify, yet simplify, the current law 
structure, while simultaneously allowing a REIT to provide new 
services to its tenants so long as these services are subject 
to a corporate level tax.
    As an alternative to the Administration's REIT subsidiary 
proposal, NAREIT recommends that Congress enact the Real Estate 
Investment Trust Modernization Act of 1999 being drafted by 
Representatives Thomas and Cardin (the ``Thomas/Cardin Bill''). 
The Thomas/Cardin Bill would incorporate the principles of the 
Administration proposal, with four significant exceptions. 
First, The Thomas/Cardin Bill would require taxable REIT 
subsidiaries to fit within the current, unified 25 percent 
asset test, rather than the complex and cumbersome 5 and 15 
percent assets tests under the Administration proposal. Second, 
the Thomas/Cardin Bill would limit interest deductions on debt 
between a REIT and its taxable subsidiary in accordance with 
the current earnings stripping rules of section 163(j), whereas 
the Administration would eliminate even a reasonable amount of 
intra-party interest deductions. Third, the Thomas/Cardin Bill 
would prohibit a taxable REIT subsidiary from operating or 
managing hotels, while allowing a subsidiary to lease a hotel 
from its affiliated REIT so long as (a) the rents are set at 
market levels, and (b) the rents are not tied to net profits, 
and (c) the hotel is operated by an independent contractor. 
Fourth, the Thomas/Cardin Bill would not apply the new rules on 
taxable REIT subsidiaries to current arrangements so long as a 
new trade or business is not engaged in and substantial new 
property is not acquired, unless the REIT affirmatively elects 
taxable REIT subsidiary status. Conversely, the Administration 
proposal would apply to current arrangements after an undefined 
period of time.
    Closely Held REITs. NAREIT supports the Administration's 
intention to craft a new ownership test intended to correspond 
to a REIT's primary mission: to make investment in income-
producing real estate accessible to ordinary investors. 
However, we believe that the Administration's proposal is too 
broad, and therefore should be narrowed to prevent non-REIT C 
corporations from owning 50 percent or more of a REIT's stock 
(by vote or value). In addition, the new rules should not apply 
to so-called ``incubator REITs'' that have proven to be a 
viable method by which ordinary investors can access publicly 
traded real estate investments.
    Built-in Gain Tax. Congress has rejected the 
Administration's call for a change in the section 1374 rules 
for three straight budgets. NAREIT recommends that Congress 
again reject this proposal. We also ask Congress to conduct 
oversight of the IRS to ensure that it does not do 
administratively what it has not been able to achieve by 
legislation.

                          Background on REITs

    A REIT is essentially a corporation or business trust 
combining the capital of many investors to own and, in most 
cases, operate income-producing real estate, such as 
apartments, shopping centers, offices and warehouses. Some 
REITs also are engaged in financing real estate. REITs must 
comply with a number of requirements, some of which are 
discussed in detail in this statement, but the most fundamental 
of these are as follows: (1) REITs must pay at least 95 percent 
of their taxable income to shareholders; \2\ REITs must derive 
most of their income from real estate held for the long term; 
and (3) REITs must be widely held.
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    \2\From 1960 until 1980, both REITs and regulated investment 
companies (mutual funds) shared a requirement to distribute at least 90 
percent of their taxable income to their shareholders. Although mutual 
funds continue this 90 percent distribution test, since 1980 REITs have 
had to distribute 95 percent of their taxable income. To conform to the 
mutual fund rules once again and to provide more after-tax funds to pay 
for capital expenditures and debt amortization, NAREIT supports 
returning the REIT's distribution test to the 90 percent threshold.
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    In exchange for satisfying these requirements, REITs (like 
mutual funds) benefit from a dividends paid deduction so that 
most, if not all, of a REIT's earnings are taxed only at the 
shareholder level. On the other hand, REITs pay the price of 
not having retained earnings available to expand their 
business. Instead, capital for growth, capital expenditures and 
payment of loan principal largely comes from new money raised 
in the investment marketplace from investors who have 
confidence in the REIT's future prospects and business plan.
    Congress created the REIT structure in 1960 to make 
investments in large-scale, significant income-producing real 
estate accessible to the smaller investor. Based in part on the 
rationale for mutual funds, Congress decided that the only way 
for the average investor to access investments in larger-scale 
commercial properties was through pooling arrangements. In much 
the same ways as shareholders benefit by owning a portfolio of 
securities in a mutual fund, the shareholders of REITs can 
unite their capital into a single economic pursuit geared to 
the production of income through commercial real estate 
ownership. REITs offer distinct advantages for smaller 
investors: greater diversification through investing in a 
portfolio of properties rather than a single building and 
expert management by experienced real estate professionals.
    Despite the advantages of the REIT structure, the industry 
experienced very little growth for over 30 years mainly for two 
reasons. First, at the beginning REITs were handcuffed. REITs 
were basically passive portfolios of real estate. REITs were 
permitted only to own real estate, not to operate or manage it. 
This meant that REITs needed to use third party independent 
contractors, whose economic interests might diverge from those 
of the REIT's owners, to operate and manage the properties. 
This was an arrangement the investment marketplace did not 
accept warmly.
    Second, during these years the real estate investment 
landscape was colored by tax shelter-oriented characteristics. 
Through the use of high debt levels and aggressive depreciation 
schedules, interest and depreciation deductions significantly 
reduced taxable income--in many cases leading to so-called 
``paper losses'' used to shelter a taxpayer's other income. 
Since a REIT is geared specifically to create ``taxable'' 
income on a regular basis and a REIT is not permitted to pass 
``losses'' through to shareholders like a partnership, the REIT 
industry could not compete effectively for capital against tax 
shelters.
    In the Tax Reform Act of 1986 (the ``1986 Act''), Congress 
changed the real estate investment landscape. On the one hand, 
by limiting the deductibility of interest, lengthening 
depreciation periods and restricting the use of ``passive 
losses,'' the 1986 Act drastically reduced the potential for 
real estate investment to generate tax shelter opportunities. 
This meant, going forward, that real estate investment needed 
to be on a more economic and income-oriented footing.
    On the other hand, as part of the 1986 Act, Congress took 
the handcuffs off REITs. The Act permitted REITs not merely to 
own, but also to operate and manage most types of income 
producing commercial properties by providing ``customary'' 
services associated with real estate ownership. Finally, for 
most types of real estate (other than hotels, health care 
facilities and some other activities that consist of a higher 
degree of personal services), the economic interests of the 
REIT's shareholders could be merged with those of the REIT's 
operators and managers.
    Despite Congress' actions in 1986, significant REIT growth 
did not begin until 1992. One reason was the real estate 
recession in the early 1990s. During the late 1980s banks and 
insurance companies kept up real estate lending at a 
significant pace. Foreign investment, particularly from Japan, 
also helped buoy the marketplace. But by 1990 the combined 
impact of the Savings and Loan crisis, the 1986 Act, 
overbuilding during the 1980s by non-REITs and regulatory 
pressures on bank and insurance lenders, led to a nationwide 
depression in the real estate economy. During the early 1990s 
commercial property values dropped between 30 and 50 percent. 
Credit and capital for commercial real estate became largely 
unavailable. As a result of this capital crunch, many building 
owners defaulted on loans, resulting in huge losses by 
financial institutions. The Resolution Trust Corporation took 
over the real estate assets of insolvent financial 
institutions.
    Against this backdrop, starting in 1992, many private real 
estate companies realized that the best and most efficient way 
to access capital was from the public marketplace through 
REITs. At the same time, many investors decided that it was a 
good time to invest in commercial real estate--assuming 
recovering real estate markets were just over the horizon. They 
were right.
    Since 1992, the REIT industry has attained impressive 
growth as new publicly traded REITs infused much needed equity 
capital into the over-leveraged real estate industry. Today 
there are over 200 publicly traded REITs with an equity market 
capitalization exceeding $140 billion. These REITs are owned 
primarily by individuals, with 49 percent of REIT shares owned 
directly by individual investors and 37 percent owned by mutual 
funds, which are owned mostly by individuals. Today's REITs 
offer smaller real estate investors three important qualities 
never accessible and available before: liquidity, security and 
performance.
     Liquidity. REITs have helped turn real estate liquid. 
Through the public REIT marketplace of over 200 real estate 
companies, investors can buy and sell interests in portfolios 
of properties and mortgages--as well as the management 
associated with them--on an instantaneous basis. Illiquidity, 
the bane of real estate investors, is gone.
     Security. Because real estate is a physical asset with a 
long life during which it has the potential to produce income, 
investors always have viewed real estate as an investment 
option with security. But now, through REITs, small investors 
have an added level of security never available before in real 
estate investment. Today's security comes from information. 
Through the advent of the public REIT industry (which is 
governed by SEC and securities exchange-mandated information 
disclosure and reporting), the flow of available information 
about the company and its properties, the management and its 
business plan, and the property markets and their prospects are 
available to the public at levels never before imagined. As a 
result, REIT investors are provided a level of security never 
available before in the real estate investment marketplace.
     Performance. Since their inception, REITs have provided 
competitive investment performance. Over the past 20 years, 
REIT market performance has been comparable to that of the 
Russell 2000 and has exceeded the returns from fixed income and 
direct real estate investments. Because REITs annually pay out 
almost all of their taxable income, a significant component of 
total return on investment reliably comes from dividends. In 
1998, REITs paid out almost $11 billion in dividends to their 
shareholders. Just as Congress intended, today small investors 
have access through REITs to large-scale, income producing real 
estate on a basis competitive with large institutions and 
wealthy individuals.
    But REITs certainly do not just benefit investors. The 
lower debt levels associated with REITs compared to real estate 
investment overall have a positive effect on the overall 
economy. Average debt levels for REITs are 35-40 percent of 
market capitalization, compared to leverage of 80 percent and 
higher used by privately owned real estate (which has the 
effect of minimizing income tax liabilities). The higher equity 
capital cushions REITs from the severe effects of fluctuations 
in the real estate market that have traditionally occurred. The 
ability of REITs to better withstand market downturns has a 
stabilizing effect on the real estate industry and lenders, 
resulting in fewer bankruptcies and work-outs. The general 
economy benefits from lower real estate losses by federally 
insured financial institutions.
    NAREIT believes the future of the REIT industry will see a 
continuous and significant shift from private to public 
ownership of U.S. real estate. At the same time, future growth 
may be limited by the competitive pressures for REITs to be 
able to provide more services to their tenants than they are 
currently allowed to perform. Although the 1986 Act took off 
the handcuffs and the Taxpayer Relief Act of 1997 included 
additional helpful REIT reforms, REITs still must operate under 
certain significant, unnecessary restrictions. NAREIT looks 
forward to working with Congress and the Administration further 
to modernize and improve the REIT rules so that REITs can 
continue to offer smaller investors opportunities for rewarding 
investments in income-producing real estate.

                      I. TAXABLE REIT SUBSIDIARIES

    As part of the asset diversification tests applied to 
REITs, a REIT may not own more than 10 percent of the 
outstanding voting securities of a non-REIT corporation 
pursuant to section 856 (c)(5)(B).\3\ The Administration's 
Fiscal Year 1999 Budget proposed to amend section 856(c)(5)(B) 
to prohibit REITs from holding stock possessing more than 10 
percent of the vote or value of all classes of stock of a non-
REIT corporation.\4\ Significantly, the Administration's Fiscal 
Year 2000 Budget proposes an exception to this vote or value 
rule for taxable REIT subsidiaries.
---------------------------------------------------------------------------
    \3\The shares of a wholly-owned ``qualified REIT subsidiary'' 
(``QRS'') of the REIT are ignored for this test.
    \4\Since it is a disregarded entity for tax purposes, a qualified 
REIT subsidiary would be excepted from the requirement that a REIT not 
own more than 10 percent of the vote or value of another corporation.
---------------------------------------------------------------------------

                     A. Background and Current Law

    The activities of REITs are strictly limited by a number of 
requirements that are designed to ensure that REITs serve as a 
vehicle for public investment in real estate. First, a REIT 
must comply with several income tests. At least 75 percent of 
the REIT's gross income must be derived from real estate, such 
as rents from real property, mortgage interest and gains from 
sales of real property (not including dealer sales).\5\ In 
addition, at least 95 percent of a REIT's gross income must 
come from the above real estate sources, dividends, interest 
and sales of securities.\6\
---------------------------------------------------------------------------
    \5\I.R.C. Sec. 856(c)(3).
    \6\I.R.C. Sec. 856(c)(2).
---------------------------------------------------------------------------
    Second, a REIT must satisfy several asset tests. On the 
last day of each quarter, at least 75 percent of a REIT's 
assets must be real estate assets, cash and government 
securities. Real estate assets include interests in real 
property and mortgages on real property. As mentioned above, 
the asset diversification rules require that a REIT not own 
more than 10 percent of the outstanding voting securities of an 
issuer (other than a qualified REIT subsidiary under section 
163(j)). In addition, no more than 5 percent of a REIT's assets 
can be represented by securities of a single issuer (other than 
a qualified REIT subsidiary).
    REITs have been so successful in operating their properties 
and providing permissible services to their tenants that they 
have been asked to provide these services to non-tenants, 
building off of expertise and capabilities associated with the 
REIT's real estate activities. In addition, mortgage REITs are 
presented with substantial opportunities to service the 
mortgages that they securitize. The asset and income tests, 
however, restrict how REITs can engage in these activities. A 
REIT can earn only up to 5 percent of its income from sources 
other than rents, mortgage interest, capital gains, dividends 
and interest. However, many REITs have had the opportunity to 
maximize shareholder value by earning more than 5 percent from 
third party services.
    Starting in 1988, the Internal Revenue Service (``IRS'') 
issued private letter rulings to REITs approving a structure to 
facilitate a REIT providing a limited amount of services to 
third parties.\7\ These rulings sanctioned a structure under 
which a REIT owns no more than 10 percent of the voting stock 
and up to 99 percent of the value of a non-REIT corporation 
through nonvoting stock. Usually, managers or shareholders of 
the REIT own the voting stock of the ``Third Party Subsidiary'' 
(``TPS,'' also known as a ``Preferred Stock Subsidiary''). The 
TPS typically either provides to unrelated parties services 
already being delivered to a REIT's tenants, such as 
landscaping and managing a shopping mall in which the REIT owns 
a joint venture interest, or engages in other real estate 
activities, such as development, which the REIT cannot 
undertake to the same extent. A TPS of a mortgage REIT 
typically services a pool of securitized mortgages and sells 
mortgages as part of the securitization process that has the 
effect of lowering homeowners' interest rates.
---------------------------------------------------------------------------
    \7\PLRs 9440026, 9436025, 9431005, 9428033, 9340056, 8825112.

    See also PLRs 9507007, 9510030, 9640007, 9733011, 9734011, 
9801012, 9808011, 9835013.
    The REIT receives dividends from the TPS that are treated 
as qualifying income under the 95 percent income test, but not 
the 75 percent income test.\8\ Accordingly, a REIT continues to 
be principally devoted to real estate operations. While the IRS 
has approved using the TPS for services to third parties and 
``customary'' services to tenants the REIT could otherwise 
provide, the IRS has not permitted the use of these 
subsidiaries to provide impermissible, non-customary real 
estate services to REIT tenants.\9\
---------------------------------------------------------------------------
    \8\The REIT does not qualify for a dividends received deduction 
with respect to TPS dividends. I.R.C. Sec. 857(b)(2)(A).
    \9\But see PLR 9804022. In addition, the IRS has been flexible in 
allowing a TPS to engage in an ``independent line of business'' in 
which it provides a service to the public and a minority of the users 
are REIT tenants. See, e.g., PLRs 9627017, 9734011, 9835013.
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                       B. Administration Proposal

    In 1998, the Administration proposed changing the asset 
diversification tests to prevent a REIT from owning securities 
in a C corporation that represent 10 percent of either the 
corporation's vote or its value. The proposal would have 
applied with respect to stock acquired on or after the date of 
first committee action. In addition, to the extent that a 
REIT's ownership of TPS stock would have been grandfathered by 
virtue of the effective date, the grandfather status would have 
terminated if the TPS engaged in a new trade or business or 
acquired substantial new assets on or after the date of first 
committee action.
    In its Fiscal Year 2000 Budget, the Administration again 
proposes to base the 10 percent asset test on either vote or 
value. However, it also proposes an exception for two types of 
taxable REIT subsidiaries (``TRS''). A qualified business 
subsidiary (``QBS'') would be the successor to the current TPS 
and could engage in the same activities as can a TPS today. A 
REIT could not own more than 15 percent of its assets in QBSs. 
The second type of TRS would be a qualified independent 
contractor subsidiary (``QIKS''), which could provide non-
customary services to the affiliated REIT's tenants. A REIT 
could not own more than 5 percent of its assets in QIKSs as 
part of its 15 percent TRS allocation.
    A TRS could not deduct any interest payments to its 
affiliated REIT, and 100% excise tax penalties would be imposed 
to the extent that any pricing between a TRS and either its 
affiliated REIT or that REIT's tenants was not set on an arms' 
length basis. The new TRS rules would apply to all existing 
TPSs after a time period to be determined by Congress.

          C. Statement in Support of Taxable REIT Subsidiaries

    The REIT industry has grown significantly during the 1990s, 
from an equity market capitalization under $10 billion to a 
level approaching $135 billion. The TPS structure is used 
extensively by today's REITs and has been a small, but 
important, part of recent industry growth. These subsidiaries 
help ensure that the small investors who own REITs are able to 
maximize the return on their capital by taking full economic 
advantage of core business competencies developed by REITs in 
owning and operating the REIT's real estate or mortgages. 
NAREIT appreciates the Administration's recognition that it 
makes sense to allow a REIT to utilize these core competencies 
through taxable subsidiaries so long as the REIT remains 
focused on real estate and the subsidiary's operations are 
appropriately subject to a corporate level tax.
    In addition, the Administration's proposal recognizes that 
the REIT rules need to be modernized to permit REITs to remain 
competitive. By virtue of the ``customary'' standard in 
defining permissible REIT rental activities, REITs must wait 
until their competitors have established new levels of service 
before providing that service to their customers. This ``lag 
effect'' assures that REITs are never leaders in their markets, 
but only followers, to the detriment of their shareholders. 
Under the Administration proposal, the REIT could render such 
services to its tenants through a subsidiary that is subject to 
corporate tax.
    The Administration's TRS' proposal is a significant step in 
the right direction, but NAREIT requests Congress instead to 
enact the Thomas/Cardin Bill. The Thomas/Cardin closely follows 
the Administration's subsidiary proposal, but improves and 
clarifies this concept in four major ways.
    First, the Thomas/Cardin Bill would require taxable REIT 
subsidiaries to fit within the current, unified 25 percent 
asset test, rather than the unnecessarily complex and 
cumbersome 5 and 15 percent assets tests under the 
Administration proposal described above. Requiring two types of 
TRSs would cause severe complexity and administrative burdens, 
such as allocating costs between a QBS and a QIKS without 
incurring a 100% excise tax. Further, the Code should 
encourage, rather than prohibit, the same TRS providing the 
same service to its affiliated REIT's tenants and to third 
parties to make it easier to ensure that the pricing of those 
services is set at market rates. Moreover, the 5 and 15 percent 
limits are unnecessarily restrictive given the fact that the 
subsidiary is subject to a corporate level tax on all of its 
activities. The Thomas/Cardin Bill adopts the better approach 
of treating TRS stock as an asset that must fit within the 
current 25 percent basket of non-real estate assets a REIT can 
own, along with other non-real estate assets such as personal 
property.
    Second, the Thomas/Cardin Bill would limit interest 
deductions on debt between a REIT and its taxable REIT 
subsidiary in accordance with the current earnings stripping 
rules of section 163(j), whereas the Administration would 
eliminate even a reasonable amount of intra-party interest 
deductions. Congress confronted very similar earnings stripping 
concerns in the 1980s with respect to foreign organizations and 
their U.S. subsidiaries and resolved these concerns by enacting 
section 163(j). This section permits interest deductions on 
objective, modest amounts of related party debt. Section 163(j) 
is easily implemented and guidance has been provided by final 
regulations. The Thomas/Cardin Bill would adopt even more 
strict rules for REITs and their subsidiaries by limiting the 
interest deductions to market rates. Clearly, REITs should not 
be forced to comply with an absolute denial of legitimate 
interest deductions when foreign organizations in similar 
circumstances are not so limited.
    Third, the Administration's proposal does not address 
whether REITs could use a TRS to own or operate hotels. Given 
Congress' decision in 1998 to curtail the activities of so-
called hotel paired share REITs, NAREIT believes it appropriate 
to ensure that taxable REIT subsidiaries cannot replicate the 
activities of these entities. The Thomas/Cardin Bill would 
prohibit a taxable REIT subsidiary from operating or managing 
hotels, while allowing a subsidiary to lease a hotel from its 
affiliated REIT so long as (a) the rents are set at a market 
levels, (b) the rents are not tied to net profits, and (c) the 
hotel is operated by an independent contractor.
    Fourth, the Thomas/Cardin Bill would not apply the new 
rules on subsidiaries to current arrangements so long as a new 
trade or business is not engaged in and substantial new 
property is not acquired, unless the REIT affirmatively elects, 
on a timely basis, taxable REIT subsidiary status for such TPS. 
Conversely, the Administration proposal would become effective 
after an undefined period of time. REITs have planned their 
operations based on IRS rulings starting in 1988 that have 
sanctioned TPSs and should not be penalized for following 
established law. The Thomas/Cardin Bill wisely would adopt the 
concepts in last year's Administration's effective date that 
acknowledged the IRS' acquiescence to the TPS structure.

                         II. CLOSELY HELD REITS

    The Administration's Fiscal Year 1999 Budget proposes to 
add a new rule, creating a limit of 50 percent on the vote or 
value of stock any entity could own in any REIT.

                     A. Background and Current Law

    As discussed above, Congress created REITs to make real 
estate investments easily and economically accessible to the 
small investor. To carry out this purpose, Congress mandated 
two rules to ensure that REITs are widely held. First, five or 
fewer individuals cannot own more than 50% of a REIT's 
stock.\10\ In applying this test, most entities owning REIT 
stock are ``looked through'' to determine the ultimate 
ownership of the stock by individuals. Second, at least 100 
persons (including corporations and partnerships) must be REIT 
shareholders.\11\ Both tests do not apply during a REIT's first 
taxable year, and the ``five or fewer'' test only applies in 
the last half of all taxable years.\12\
---------------------------------------------------------------------------
    \10\I.RC. Sec. 856(h)(1). There is no apparent reason why the 
proposed ownership test similarly should not be aimed at limiting more 
than 50 percent stock ownership, rather than 50 percent or more as now 
proposed.
    \11\I.R.C. Sec. 856(a)(5).
    \12\I.R.C. Sec. Sec. 542(a)(2) and 856(h)(2).
---------------------------------------------------------------------------
    The Administration appears to be concerned about non-REITs 
establishing ``captive REITs'' and REITs doing ``step-down 
preferred'' transactions used for various tax planning purposes 
the Administration finds abusive such as the ``liquidating 
REIT'' structure curtailed by the 1998 budget legislation.\13\ 
The Administration proposes changing the ``five or fewer'' test 
by imposing an additional requirement. The proposed new rule 
would prevent any ``person'' (i.e., a corporation, partnership 
or trust, including a pension or profit sharing trust) from 
owning stock of a REIT possessing more than 50 percent of the 
total combined voting power of all classes of voting stock or 
more than 50 percent of the total value of shares of all 
classes of stock. Certain existing REIT attribution rules would 
apply in determining such ownership, and the proposal would be 
effective for entities electing REIT status for taxable years 
beginning on or after the date of first committee action.
---------------------------------------------------------------------------
    \13\AREIT supported the Administration's and Congress' move to 
limit the tax benefits of liquidating REITs.
---------------------------------------------------------------------------

 B. Statement Providing Limited Support for Administration Proposal on 
                           Closely Held REITs

    NAREIT shares the Administration's concern that the REIT 
structure not be used for abusive tax avoidance purposes, and 
therefore NAREIT concurs as to the intent of the proposal. We 
are concerned, however, that the Administration proposal casts 
too broad a net, prohibiting legitimate and necessary use of 
``closely held'' REITs. A limited number of exceptions are 
necessary to allow certain entities to own a majority of a 
REIT's stock. NAREIT certainly agrees with the Administration's 
decision to exclude a REIT's ownership of another REIT's stock 
from the proposed new ownership limit.\14\ NAREIT would like to 
work with Congress and the Administration to ensure that any 
action to curb abuses does not disallow legitimate and 
necessary transactions.
---------------------------------------------------------------------------
    \14\If the proposed test remains applicable to all persons owning 
more than 50 percent of a REIT's stock, then Congress should apply the 
exception for a REIT owning another REIT's stock by examining both 
direct and indirect ownership so as not to preclude an UPREIT owning 
more than 50 percent of another REIT's stock.
---------------------------------------------------------------------------
    First, an exception should be allowed to enable a REIT's 
organizers to have a single large investor for a temporary 
period, such as in preparation for a public offering of the 
REIT's shares. Such an ``incubator REIT'' sometimes is majority 
owned by its sponsor to allow the REIT to accumulate a track 
record that will facilitate its going public. The 
Administration proposal would prohibit this important approach 
which, in turn, could curb the emergence of new public REITs in 
which small investors may invest.
    Second, there is no reason why a partnership, mutual fund, 
pension or profit-sharing trust or other pass-through entity 
should be counted as one entity in determining whether any 
``person'' owns 50 percent of the vote or value of a REIT. A 
partnership, mutual fund or other pass-through entity is 
usually ignored for tax purposes. The partners in a partnership 
and the shareholders of a mutual fund or other pass-through 
entity should be considered the ``persons'' owning a REIT for 
purposes of any limits on investor ownership. Similarly, the 
Code already has rules preventing a ``pension held'' REIT from 
being used to avoid the unrelated business income tax 
rules,\15\ and therefore the new ownership test should not 
apply to pension or profit-sharing plans. Instead, NAREIT 
suggests that the new ownership test apply only to non-REIT C 
corporations that own more than 50 percent of a REIT's 
stock.\16\
---------------------------------------------------------------------------
    \15\I.R.C. Sec. 856(h)(3).
    \16\As under the current ``five or fewer'' test, any new ownership 
test should not apply to a REIT's first taxable year or the first half 
of subsequent taxable years. See I.R.C. Sec. Sec. 542(a)(2) and 
856(h)(2).
---------------------------------------------------------------------------

                               C. Summary

    NAREIT supports a change in the REIT rules to prevent the 
abusive use of closely held REITs, but is concerned that the 
Administration proposal is overly broad. NAREIT looks forward 
to working with Congress and the Administration to craft a 
solution that will prevent such abuses without impeding 
legitimate and necessary transactions, such as those mentioned 
above.

                           III. SECTION 1374

    The Administration's Fiscal Year 2000 Budget proposes to 
amend section 1374 to treat an ``S'' election by a C 
corporation valued at $5 million or more as a taxable 
liquidation of that C corporation followed by a distribution to 
its shareholders. This proposal also was included in the 
Administration's Fiscal Year 1997, 1998 and 1999 proposed 
budgets.

                     A. Background and Current Law

    Prior to its repeal as part of the Tax Reform Act of 1986, 
the holding in a court case named General Utilities permitted a 
C corporation to elect S corporation, REIT or mutual fund 
status (or transfer assets to an S corporation, REIT or mutual 
fund in a carryover basis transaction) without incurring a 
corporate-level tax. With the repeal of the General Utilities 
doctrine in 1986, such transactions arguably would have been 
immediately subject to tax but for Congress' enactment of 
section 1374. Under section 1374, a C corporation making an S 
corporation election pays any tax that otherwise would have 
been due on the ``built-in gain'' of the C corporation's assets 
only if and when those assets are sold or otherwise disposed of 
during a 10-year ``recognition period.'' The application of the 
tax upon the disposition of the assets, as opposed to the 
election of S status, works to distinguish legitimate 
conversions to S status from those made for purposes of tax 
avoidance.
    In Notice 88-19, 1988-1 C.B. 486 (the ``Notice''), the IRS 
announced that it intended to issue regulations under section 
337(d)(1) that in part would address the avoidance of the 
repeal of General Utilities through the use of REITs and 
regulated investment companies (``RICs,'' i.e. mutual funds). 
In addition, the IRS noted that those regulations would enable 
the REIT or RIC to be subject to rules similar to the 
principles of section 1374. Thus, a C corporation can elect 
REIT status and incur a corporate-level tax only if the REIT 
sells assets in a recognition event during the 10-year 
``recognition period.''
    In a release issued February 18, 1998, the Treasury 
Department announced that it intends to revise Notice 88-19 to 
conform to the Administration's proposed amendment to limit 
section 1374 to corporations worth less than $5 million, with 
an effective date similar to the statutory proposal. This 
proposal would result in a double layer of tax: once to the 
shareholders of the C corporation in a deemed liquidation and 
again to the C corporation itself upon such deemed liquidation.
    Because of the Treasury Department's intent to extend the 
proposed amendment of section 1374 to REITs, these comments 
address the proposed amendment as if it applied to both S 
corporations and REITs.

 B. Statement in Support of the Current Application of Section 1374 to 
                                 REITs

    As stated above, the Administration proposal would limit 
the use of the 10-year election to REITs valued at $5 million 
or less. NAREIT believes that this proposal would contravene 
Congress' original intent regarding the formation of REITs, 
would be both inappropriate and unnecessary in light of the 
statutory requirements governing REITs, would impede the 
recapitalization of commercial real estate, likely would result 
in lower tax revenues, and ignores the basic distinction 
between REITs and partnerships.
    A fundamental reason for a continuation of the current 
rules regarding a C corporation's decision to elect REIT status 
is that the primary rationale for the creation of REITs was to 
permit small investors to make investments in real estate 
without incurring an entity level tax, and thereby placing 
those persons in a comparable position to larger investors. 
H.R. Rep. No. 2020, 86th Cong., 2d. Sess. 3-4 (1960).
    By placing a toll charge on a C corporation's REIT 
election, the proposed amendment would directly contravene this 
Congressional intent, as C corporations with low tax bases in 
assets (and therefore a potential for a large built-in gains 
tax) would be practically precluded from making a REIT 
election. As previously noted, the purpose of the 10-year 
election is to allow C corporations to make S corporation and 
REIT elections when those elections are supported by non-tax 
business reasons (e.g., access to the public capital markets), 
while protecting the Treasury from the use of such entities for 
tax avoidance.
    Additionally, REITs, unlike S corporations, have several 
characteristics that support a continuation of the current 
section 1374 principles. First, there are statutory 
requirements that make REITs long-term holders of real estate. 
The 100 percent REIT prohibited transactions tax \17\ 
complements the 10-year election mechanism.
---------------------------------------------------------------------------
    \17\I.R.C. Sec. 857(b)(6).
---------------------------------------------------------------------------
    Second, while S corporations may have no more than 75 
shareholders, a REIT faces no statutory limit on the number of 
shareholders it may have and is required to have at least 100 
shareholders. In fact, some REITs have hundreds of thousands of 
beneficial shareholders. NAREIT believes that the large number 
of shareholders in a REIT and management's responsibility to 
each of those shareholders preclude the use of a REIT as a 
vehicle primarily to circumvent the repeal of General 
Utilities. Any attempt to benefit a small number of investors 
in a C corporation through the conversion of that corporation 
to a REIT is impeded by the REIT widely-held ownership 
requirements.
    The consequence of the Administration proposal would be to 
preclude C corporations in the business of managing and 
operating income-producing real estate from accessing the 
substantial capital markets' infrastructure comprised of 
investment banking specialists, analysts, and investors that 
has been established for REITs. In addition, other C 
corporations that are not primarily in the business of 
operating commercial real estate would be precluded from 
recognizing the value of those assets by placing them in a 
professionally managed REIT. In both such scenarios, the 
hundreds of thousands of shareholders owning REIT stock would 
be denied the opportunity to become owners of quality 
commercial real estate assets.
    Furthermore, the $5 million dollar threshold that would 
limit the use of the current principles of section 1374 is 
unreasonable for REITs. While many S corporations are small or 
engaged in businesses that require minimal capitalization, 
REITs as owners of commercial real estate have significant 
capital requirements. As previously mentioned, it was Congress' 
recognition of the significant capital required to acquire and 
operate commercial real estate that led to the creation of the 
REIT as a vehicle for small investors to become owners of such 
properties. The capital intensive nature of REITs makes the $5 
million threshold essentially meaningless for REITs.
    It should be noted that this proposed amendment is unlikely 
to raise any substantial revenue with respect to REITs, and may 
in fact result in a loss of revenues. Due to the high cost that 
would be associated with making a REIT election if this 
amendment were to be enacted, it is unlikely that any C 
corporations would make the election and incur the associated 
double level of tax without the benefit of any cash to pay the 
taxes. In addition, by remaining C corporations, those entities 
would not be subject to the REIT requirement that they make 
taxable distributions of 95% of their income each tax year. 
While the REIT is a single-level of tax vehicle, it does result 
in a level of tax on nearly all of the REIT's income each year.
    Moreover, the Administration justifies its de facto repeal 
of section 1374 by stating that ``[t]he tax treatment of the 
conversion of a C corporation to an S corporation generally 
should be consistent with the treatment of its [sic] conversion 
of a C corporation to a partnership.'' Regardless of whether 
this stated reason for change is justifiable for S 
corporations, in any event it should not apply to REITs because 
of the differences between REITs and partnerships.
    Unlike partnerships, REITs cannot (and have never been able 
to) pass through losses to their investors. Further, REITs can 
and do pay corporate level income and excise taxes. Simply put, 
REITs are C corporations. Thus, REITs are not susceptible to 
the tax avoidance concerns raised by the 1986 repeal of the 
General Utilities doctrine.
    We note that on March 9, 1999, the Treasury Department and 
the IRS released their 1999 Business Plan, in which it listed a 
project for ``[r]egulations regarding conversion of C 
corporation to [sic] RIC or REIT status.'' On February 22, 
1996, the Treasury Department issued a release stating that 
``the IRS intends to revise Notice 88-19 to conform to the 
proposed amendment to section 1374, with an effective date 
similar to the statutory proposal.'' We urge the Congress to 
use its oversight authority to be certain that the Treasury 
Department does not enact the ``built-in gain'' tax on REITs 
and RICs administratively. Any such action would directly 
contravene Congress' repeated rejection of any statutory change 
in this area.

                               C. Summary

    The 10-year recognition period of section 1374 currently 
requires a REIT to pay a corporate-level tax on assets acquired 
from a C corporation with a built-in gain, if those assets are 
disposed of within a 10-year period. Combined with the 
statutory requirements that a REIT be a long-term holder of 
assets and be widely-held, current law assures that the REIT is 
not a vehicle for tax avoidance. The proposal's two level tax 
would frustrate Congress' intent to allow the REIT to permit 
small investors to benefit from the capital-intensive real 
estate industry in a tax efficient manner.
    Accordingly, NAREIT believes that tax policy considerations 
are better served if the Administration's section 1374 proposal 
is not enacted. Further, the Administration should not 
contravene the Congress' clear intent in this area by 
attempting to impose this double level tax on REITs and RICs by 
administrative means.
      

                                

Statement of Daniel P. Beard, Senior Vice President, Public Policy, 
National Audubon Society

    Mr. Chairman and Members of the Committee:
    I appreciate the opportunity to testify before you today on 
the revenue provisions contained in President Clinton's Fiscal 
Year 2000 Budget. I know it is unusual for the Audubon Society 
to be providing testimony before the Ways and Means Committee. 
However, the President's Budget contains a major, new, and 
exciting environmental initiative, the Better America Bonds 
that is part of the revenue provisions of the budget.
    The Better America Bonds proposal would leverage $700 
million dollars in federal tax credits to provide $9.5 billion 
dollars to finance the purchase of open space, protect water 
quality, and revitalize brownfields. The Better America Bonds 
harness the extraordinary power of the tax code for 
environmental protection including saving vanishing bird and 
wildlife habitat.
    Conservationists applaud the Better America Bonds as an 
innovative approach to financing environmental protection. The 
bonds provide the financial incentives to do the right thing, 
taking a step beyond pure regulatory approaches to 
environmental problems. The bonds use a relatively small amount 
of federal tax dollars to leverage billions of dollars of 
private capital to address urgent environment needs across the 
nation. Yet, decision-making remains at the local level.
    The Better America Bonds proposal comes at a time when the 
pressures from development and sprawl have never been higher. 
In virtually every community development is threatening a 
special place or open space. Every year America loses 2.5 
million acres of open space, 100,000 acres of wetlands, and 3 
million acres of farmland. Nearly 40% of the nation's waterways 
are still unsafe for fishing and swimming.
    The populations of many bird species continue to decline 
significantly because of loss of habitat. There are 90 domestic 
bird species on the endangered species list. The U.S. Fish and 
Wildlife Service lists another 124 species of migratory nongame 
birds on their list of migratory nongame birds of management 
concern.
    Mr. Chairman, the Better America Bonds provide communities 
with a critical tool: the financial ability to compete on a 
level playing field with developers and other interests. 
Importantly, these bonds are a flexible tool, they can be 
tailored to meet the needs of individual communities--your 
town, any town--from Texas to New York to California.
    On behalf of the one million members and supporters of the 
National Audubon Society, I strongly urge the Committee to 
support the Better America Bonds. National Audubon Society has 
included the Better America Bonds in Audubon's Action Agenda 
for this Congress. With the Better America Bonds, cities and 
towns are empowered to preserve open space and bird and 
wildlife habitat for our children to enjoy.
      

                                

Statement of National Mining Association

    The National Mining Association (NMA) appreciates the 
opportunity to submit this statement for the Committee's record 
on the President's Fiscal Year 2000 tax proposals. The NMA is 
an industry association representing most of the Nation's 
producers of coal, metals, industrial and agricultural 
minerals. Our membership also includes equipment manufacturing 
firms and other providers of products and services to the 
mining industry. The NMA has not received a federal grant, 
contract or subcontract in Fiscal Years 1999, 1998, 1997, 1996 
or 1995.
    Mining directly employs over 300,000 workers. Nearly 5 
million Americans have jobs as a result of the mining 
industry's contribution to personal, business and government 
income throughout the nation. The headquarters of NMA member 
company operations are located in nearly every state of the 
Union and some form of mining represented by the NMA occurs in 
all 50 states.

                        THE PRESIDENT'S PROPOSAL

    Of primary concern to our industry is the Administration's 
budget proposal to repeal the percentage depletion allowance 
for minerals mined on federal and former federal lands where 
mining rights were originally acquired under the Mining Law. 
The mining industry is adamantly opposed to this proposal. The 
President included this provision in his 1997,1998 and 1999 
budget proposals. It was a bad idea then, it is a worse idea 
now.
    Repeal of the allowance is a major tax increase on 
companies whose mines are located primarily in the western 
United States. As it is not uncommon for ownership of mineral 
deposits to change hands, the proposal would especially 
penalize mining companies who purchased their properties from 
original claimants or other intermediary mining concerns.
    The U.S. Department of Labor reports that the mining 
industry provides some of the highest paying nonsupervisory 
jobs in the United States. The average mining wage in 1996 was 
$49,995 (not including benefits, overtime and bonuses)--far 
above the national average wage of $30,053. We believe that tax 
policy should foster the creation of more of these high-paying 
jobs. Unfortunately, the Administration's proposal places many 
of these jobs, principally in economically vulnerable rural 
areas in the West, at risk.

                       MINING AND THE MINING LAW

    From our perspective, the President's depletion proposal 
has more to do with mining on public lands in the western 
states than it does with tax policy. The NMA and its member 
companies continue to advocate responsible amendments to the 
Mining Law, including a reasonable royalty provision. This 
reform effort has been stymied at every turn by anti-mining 
groups. Those opposing responsible amendments to the Mining Law 
seek changes that would make mining on public lands nearly 
impossible. The President's proposal to increase the tax burden 
on certain hardrock mines would appear to be part of a 
sustained and coordinated effort to accomplish that goal.
    It is a serious misconception to think that minerals mined 
on federal lands are free for the taking--that mining companies 
receive something for nothing and are therefore recipients of 
so-called ``corporate welfare.'' The NMA wishes to set the 
record straight.
    Minerals have no worth if left in the ground undiscovered 
in the hundreds of millions of acres of unused land controlled 
by the federal government. They only attain value after they 
are discovered and produced. And they won't be produced unless 
there is significant investment and a financial risk shouldered 
by the mining industry.
    The pamphlet prepared by the Joint Committee on Taxation 
describing the President's fiscal 2000 tax proposals (Joint 
Committee on Taxation, Description of Revenue Provisions 
Contained in the President's Fiscal Year 2000 Budget Proposal 
(JCS-1-99), February 22, 1999) states, in part, that:

      Once a claimed mineral deposit is determined
      to be economically recoverable, and at least
      $500 of development work has been performed,
      the claim holder may apply for a ``patent'' to
      obtain full title to the land for $2.50 or
      $5.00 per acre.

    The Committee should note that considerable funds must be 
expended in order to demonstrate to the satisfaction of the 
federal government that the claim contains an ``economically 
recoverable'' mineral deposit. It is not uncommon for a mining 
company to expend several hundred thousands to over a million 
dollars in conducting exploration activity, performing 
environmental analyses and gaining the necessary permits prior 
to being able to demonstrate that the deposit is ``economically 
recoverable'' in order to receive a patent under the Mining 
Law.
    The $2.50 or $5.00 per acre fee note in the pamphlet is 
merely a patent application fee. The costs a mining company 
must incur to get to the patenting phase usually run in excess 
of $2,000 per acre, or $40,000 per 20-acre claim. It is 
impossible to obtain a patent simply by writing a check to the 
government for $2.50 or $5.00 per acre--a fact conveniently 
overlooked by mining's critics. Obtaining a patent is an 
expensive, time-consuming, laborious and by no means guaranteed 
process.
    With or without a patent, a significant amount of capital 
must then be invested to develop the mine and build the 
necessary infrastructure to process raw ore into an acceptable 
product. It is not uncommon to spend in excess of $400 million 
to bring a domestic world-scale mine into production. The cost 
of processing facilities is high: A state-of-the-art smelter 
can have capital costs approaching $1 billion. To argue that 
minerals are ``free for the taking'' and mining companies are 
recipients of so-called corporate welfare is fallacious at 
best.

             THE IMPORTANCE OF THE DOMESTIC MINING INDUSTRY

    The President's proposal coupled with other legislative and 
regulatory initiatives is effectively placing much federally 
controlled land off-limits to mineral exploration and is making 
the United States an increasingly hostile business environment 
for mining investment. As mining companies must continuously 
search for new reserves or literally mine themselves out of 
business, this negative environment is increasingly forcing 
them to look overseas for new exploration projects.
    The NMA believes it is in the vital interest of the United 
States to have a viable domestic mining industry. A study 
prepared by the Western Economic Analysis Center reports that 
the domestic mining industry, directly and indirectly, accounts 
for significant economic activity--$524 billion in 1995 alone. 
It is beyond a doubt that continued economic growth and 
improvements in the standard of living for all Americans will 
depend upon a reliable supply of energy and raw materials. The 
U.S. mining industry has the potential to provide much of our 
resource needs--if it is allowed to do so.

                            IMPACT OF REPEAL

    Increasing the tax burden on the mining industry is 
effectively an increase in production costs. Because minerals 
are commodities traded in the international marketplace at 
prices determined by worldwide supply and demand factors, 
mining companies cannot recover higher costs by raising prices.
    This tax increase is likely to have the following short-and 
long-term disruptive effects on the industry:
     Reduce the operating lives of many mines by 
increasing the ore cut-off grade. Minerals that would otherwise 
have been economic to extract will remain in the ground and not 
be recovered, resulting in poor stewardship of our natural 
resources. Existing jobs, federal, state and local tax revenues 
will be lost.
     Higher taxes will reduce a company's ability to 
make the necessary investment in existing operations to improve 
production efficiencies and respond to constantly changing 
environmental, reclamation, and health and safety standards.
     Investment in new projects will decline. This 
change to long-standing tax policy will adversely affect the 
economics of new projects. Many new projects will become 
uneconomic, resulting in lost opportunities for new jobs and 
tax revenues.
    Clearly, the long-term consequences of this tax increase 
are serious. Without continuous investment in new domestic 
projects to replace old mines, mineral production in the United 
States will decline. We consumed 46,000 pounds of mined 
materials per person in 1997. The increasing short-fall between 
the nation's demand for mineral products and domestic supply 
will then be satisfied by imports of minerals mined by overseas 
by foreign workers. U. S. exports will become jobs and many 
areas of the country will experience economic decline and an 
erosion of state and local tax bases.
    Despite the continued overall growth of the economy, the 
copper and gold metals mining industry (the primary target of 
the Administration's proposal) has entered into a serious 
cyclical decline. The price of gold is at its lowest point in 
19 years (having declined over 25 percent in the last year) and 
the price of copper has declined over 40 percent in the past 
two years. Many mining companies are struggling to remain 
profitable and keep mines open and miners working to weather 
this downturn. Indeed, several companies have already 
implemented mine closures and significant layoffs over the past 
year.

                        THE DEPLETION ALLOWANCE

    The mining industry is characterized by relative rarity of 
commercially viable mineral deposits, high economic risks, 
geologic unknowns, high capital requirements and long lead 
times for development of new mines. The depletion allowance 
recognizes the unique nature of mineral extraction by providing 
a rational and realistic method of measuring the decreasing 
value of a deposit as minerals are extracted. As the 
replacement cost of a new mine is always higher in real terms 
than the mine it replaces, the allowance helps generate the 
capital needed to bring new mines into production.

                      THE NEED FOR TAX REDUCTIONS

    The mining industry (and other capital-intensive 
industries) already pay high average tax rates through the 
application of the corporate alternative minimum tax (AMT). The 
General Accounting Office in a 1995 study reported that the 
average effective tax rate for mining companies under the AMT 
is 32 percent. The AMT gives the United States the worst 
capital cost recovery system in the industrialized world. 
Rather than increasing the Tax burden on mining should not be 
increased, as proposed by the Administration, it should be 
reduced by reform of the corporate AMT.

                               CONCLUSION

    We urge the Committee and the Congress to reject this job-
killing and self-defeating tax increase targeted at the mining 
industry. Instead, Congress should pass tax legislation 
designed to foster investment and economic growth in mining and 
other capital intensive industries and should include reform of 
the corporate AMT.
      

                                

Statement of PricewaterhouseCoopers Leasing Coalition

                            I. Introduction

    On behalf of a group of companies in the leasing industry 
(hereinafter the ``Leasing Coalition''), PricewaterhouseCoopers 
appreciates the opportunity to present this written statement 
to the House Ways and Means Committee in conjunction with its 
March 10, 1999, hearing on the revenue proposals in the 
Administration's FY 2000 budget.
    Our comments center on tax increases proposed by the 
Administration that would overturn the carefully constructed 
body of law, built over decades, governing the tax treatment of 
leasing transactions. These proposals include a leasing-
industry specific measure targeting what Treasury refers to as 
``inappropriate benefits'' \1\ for lessors of tax-exempt use 
property. The Leasing Coalition also has strong concerns over 
the impact on leasing transactions of several general 
Administration proposals relating to ``corporate tax 
shelters,'' including a proposal empowering IRS agents to 
``deny tax benefits'' in ``tax-avoidance transactions.'' \2\
---------------------------------------------------------------------------
    \1\ General Explanations of the Administration's Revenue Proposals, 
Department of the Treasury, February 1999, at 113.
    \2\ Id, at 97.
---------------------------------------------------------------------------
    In these comments, the Leasing Coalition discusses the 
rationale underlying the present-law tax treatment of leasing 
transactions and examines the impact of the Administration's 
proposals on commonplace leasing arrangements. We also discuss 
the potentially adverse impact of these proposals on the 
competitiveness of American businesses, on exports, and on the 
cost of capital.
    We conclude by urging Members of the House Ways and Means 
Committee to reject the Administration's tax proposals that 
would adversely affect the leasing industry. These proposals 
inappropriately would overturn the longstanding body of tax law 
governing common leasing transactions, branding these 
legitimate business transactions as ``corporate tax shelters.'' 
Instead of considering proposals at this time that would impair 
the competitiveness of the leasing industry, we respectfully 
would suggest that the Administration and Congress consider 
ways to help U.S. companies that use leasing as a form of 
financing expand in the global marketplace.

                        II. The Leasing Industry

    Leasing is an increasingly common means of financing 
investment in equipment and other property. In 1998, the U.S. 
Department of Commerce estimated that approximately 31 percent 
of all domestic equipment investment was financed through 
leasing rather than outright acquisition.\3\ Approximately 80 
percent of U.S. companies lease some or all of their 
equipment.\4\ The leasing industry in 1998 financed more than 
$180 billion in equipment acquisitions, an amount expected to 
exceed $200 billion in 1999.
---------------------------------------------------------------------------
    \3\ U.S. Department of Commerce, Economics and Statistics 
Administration, Bureau of Economic Analysis.
    \4\ Equipment Leasing Association.
---------------------------------------------------------------------------
    Lessees, or the users of the property, find leasing an 
attractive financing mechanism for a number of reasons. Because 
a lease allows 100-percent financing, the lessee is able to 
preserve cash that would be necessary to buy or make a 
downpayment on a piece of equipment. Moreover, lessees 
generally are able to secure financing under a lease at a lower 
cost than under a loan. A lessee also may wish to use the asset 
only for a short period of time, and may not want to risk 
having the value of the equipment decline more quickly than 
expected--or become obsolete--during this period of use. For 
financial statement purposes, leasing can be preferable in that 
it allows the lessee to avoid booking the asset (and the 
accompanying liability) on its balance sheet. Finally, the 
lessee may find rental deductions for lease payments more 
beneficial, from a timing perspective, than depreciation 
deductions taken over a certain schedule (e.g., double-
declining balance).
    Leasing also provides a number of business advantages to 
lessors. Manufacturing companies (e.g., automobile, computer, 
aircraft, and rolling stock manufacturers) may act as lessors 
through subsidiary companies as a means of providing their 
wares to customers. Financial institutions like banks, thrifts, 
and insurance companies engage in leasing as a core part of 
their financial intermediation business. As the owner of the 
equipment, the lessor is able to take full deductions for 
depreciation. In 1998, between 2,000 and 3,000 companies acted 
as equipment lessors.
    Leasing also promotes exports of U.S. equipment, and thus 
helps U.S. companies compete in the global economy. Many lease 
transactions undertaken by U.S. lessors are cross-border 
leases, i.e., leases of equipment to foreign users. These 
involve all types of equipment, including tankers, railroad 
cars, machine tools, computers, copy machines, printing 
presses, aircraft, mining and oil drilling equipment, and 
turbines and generators. Many of these leases are supported in 
one form or another by the Export-Import Bank of the United 
States, which insures the credit of foreign lessees.

                      III. Tax Treatment of Leases

                             A. Present Law

    A substantial body of law has developed over the last forty 
years regarding the treatment of leasing transactions for 
federal income tax purposes. At issue is whether a transaction 
structured as a lease is respected as a lease for tax purposes 
or is recharacterized as a conditional sale of the property. If 
the transaction is respected as a lease for tax purposes, the 
lessor is treated as the owner of the property and therefore is 
entitled to depreciation deductions with respect to the 
property. The lessor also is entitled to interest deductions 
with respect to any financing of the property, and recognizes 
income in the form of the rental payments it receives. The 
lessee is entitled to a business deduction for the rental 
payments it makes with respect to the property. On the other 
hand, if the transaction is recharacterized as a conditional 
sale, the purported lessee is treated as having purchased the 
property in exchange for a debt instrument. The purported 
lessee is treated as the owner of the property and is entitled 
to depreciation deductions with respect to the property. In 
addition, the purported lessee is entitled to interest 
deductions for a portion of the amount it pays under the 
purported lease. The purported lessor recognizes gain or loss 
on the conditional sale and recognizes interest income with 
respect to a portion of the amount received under the purported 
lease. The purported lessor is entitled to interest deductions 
with respect to any financing of the property.
    Guidance regarding the determination whether a transaction 
is respected as a lease for tax purposes is provided pursuant 
to an extensive body of case law. There also have been 
significant IRS pronouncements addressing this determination. 
Finally, statutory provisions provide specific rules regarding 
the tax consequences of certain leasing transactions.

1. Case law

    The determination whether a transaction is respected as a 
lease for tax purposes generally is made based on the substance 
of the transaction and not its form.\5\ This substantive 
determination focuses on which party is the owner of the 
property that is subject to the lease (i.e., which party has 
the benefits and burdens of ownership with respect to the 
property).\6\ In addition, the transaction must have economic 
substance or a business purpose in order to be classified as a 
lease for tax purposes.\7\
---------------------------------------------------------------------------
    \5\ Helvering v. F. & R. Lazarus & Co., 308 U.S. 252 (1939).
    \6\ Estate of Thomas v. Commissioner, 84 T.C. 412 (1985).
    \7\ See Rice's Toyota World, Inc. v. Commissioner, 81 T.C. 184 
(1983), aff'd in part, rev'd in part, 752 F.2d 89 (4th Cir. 1985); 
Frank Lyon Co. v. United States, 435 U.S. 561 (1978).
---------------------------------------------------------------------------
    The most important attributes of ownership are the upside 
potential for economic gain and the downside risk of economic 
loss based on the residual value of the leased property.\8\ The 
presence of a fair market value purchase option in a lease 
agreement should not impact the determination of tax 
ownership.\9\ Moreover, the fact that such an option is fixed 
at the estimated fair market value should not by itself cause 
the lease to be treated as a conditional sale.\10\ However, 
where a lessee is economically or legally compelled to exercise 
the purchase option because, for example, the option price is 
nominal in relation to the value of the property, the lease 
likely would be treated as a conditional sale.\11\
---------------------------------------------------------------------------
    \8\ Swift Dodge v. Commissioner, 692 F.2d 651 (9th Cir. 1982), 
rev'g, 76 T.C. 547 (1981).
    \9\ Lockhart Leasing Co. v. Commissioner, 54 T.C. 301, 314-15 
(1970), aff'd 446 F.2d 269 (10th Cir. 1971).
    \10\ See Frank Lyon Co. v. United States, supra.
    \11\ Oesterreich v. Commissioner, 226 F.2d 798 (9th Cir. 1955), 
rev'g, 12 T.C.M. 277 (1953).
---------------------------------------------------------------------------
    Another important indicia of ownership for tax purposes is 
the holding of legal title; this factor, however, is not 
determinative.\12\ The right to possess the property throughout 
its economic useful life also is an attribute of ownership for 
tax purposes. For example, the entitlement of the lessee to 
possession of the property for its entire useful life would be 
a strong indication that the lessee rather than the lessor 
should be considered the owner of the property for tax 
purposes.\13\
---------------------------------------------------------------------------
    \12\ Coleman v. Commissioner, 87 T.C. 178, 201 (1986), aff'd 883 
F.2d 303 (3d Cir. 1987).
    \13\ Pacific Gamble Robinson v. Commissioner, 54 T.C.M. 915 (1987).
---------------------------------------------------------------------------
    The economic substance test finds its genesis in the 
Supreme Court opinion in Frank Lyon Co., supra. There, the 
United States Supreme Court determined that a sale and 
leaseback should not be disregarded for federal income tax 
purposes if the transaction:

          is a genuine multi-party transaction with economic substance 
        which is compelled or encouraged by business or regulatory 
        realities, is imbued with tax-independent considerations, and 
        is not shaped solely by tax-avoidance features that have 
        meaningless labels attached . . . . Expressed another way, so 
        long as the lessor retains significant and genuine attributes 
        of the traditional lessor status, the form of the transaction 
        adopted by the parties governs for tax purposes.\14\
---------------------------------------------------------------------------
    \14\ Id. at 583.

    The IRS challenged the sale-leaseback transaction in Frank 
Lyon on the grounds that it was a sham. However, the Court 
concluded that, in the absence of specific facts evidencing a 
sham transaction motivated solely by tax-avoidance purposes, a 
lessor need only possess ``significant and genuine attributes 
of traditional lessor status,'' evidenced by the economic 
realities of the transaction, in order for a lease to be 
respected for federal income tax purposes. The Court recognized 
that there can be many business or economic reasons for 
entering into a lease. Legal, regulatory, and accounting 
requirements, for example, can serve as motivations to lease an 
asset. Instead of trying to identify one controlling factor, 
the Court used the same test as the other leasing cases--that 
all facts and circumstances must be considered in determining 
economic substance. Further, the Court noted that ``the fact 
that favorable tax consequences were taken into account by Lyon 
on entering into the transaction is no reason for disallowing 
those consequences.'' \15\
---------------------------------------------------------------------------
    \15\ Id. at 561.
---------------------------------------------------------------------------
    In the wake of Frank Lyon, the Tax Court has refined the 
analysis of whether a lease should be respected for tax 
purposes. Under Rice's Toyota World, Inc. v. Commissioner, 
supra, and its progeny, the Tax Court will disregard a lease 
transaction for lack of economic substance only if (i) the 
taxpayer had no business purpose for entering into the 
transaction other than to reduce taxes, and (ii) the 
transaction, viewed objectively, offered no realistic profit 
potential. Further elaborating on this standard, the Tax Court 
in Mukerji v. Commissioner \16\ set forth the test that in 
subsequent cases has been used to determine whether a lease 
should be disregarded for tax purposes:
---------------------------------------------------------------------------
    \16\ 87 T.C. 926 (1986).

          [u]nder such test, the Court must find ``that the taxpayer 
        was motivated by no business purpose other than obtaining tax 
        benefits in entering into the transaction, and that the 
        transaction had no economic substance because no reasonable 
        possibility of a profit exists.'' \17\
---------------------------------------------------------------------------
    \17\ Id. at 959 (quoting Rice's Toyota World, supra, at 91).

    Once business purpose is established, a lease transaction 
should not be classified as a ``sham.'' A finding of no 
business purpose, however, is not conclusive evidence of a sham 
transaction. The transaction will still be valid if it 
possesses some economic substance. The Tax Court has developed 
an objective test for economic substance. A lease will meet the 
threshold of economic substance and will be respected when the 
net ``reasonably expected'' residual value and the net rentals 
(both net of debt service) will be sufficient to allow 
taxpayers to recoup their initial equity investment.\18\ 
Applying this analysis, the Tax Court in several cases has 
concluded that a purported lease transaction was devoid of 
business purpose and lacked economic substance because the 
taxpayers could not reasonably expect to recoup their capital 
from the projected non-tax cash flows in the lease.\19\
---------------------------------------------------------------------------
    \18\ See Mukerji, supra.
    \19\ See Goldwasser v. Commissioner, 56 T.C.M. 606 (1988); Casebeer 
v. Commissioner, 54 T.C.M. 1432 (1987); and James v. Commissioner, 87 
T.C. 905 (1986).
---------------------------------------------------------------------------
    Most recently, outside the context of leasing transactions, 
the Tax Court in ACM Partnership v. Commissioner \20\ had the 
opportunity to apply a form of economic substance test. There, 
the Tax Court stated that ``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 a transaction that serves no economic purpose other 
than tax savings.'' \21\ The court further found that the 
taxpayer could not have hoped to recover its initial investment 
and its costs under any reasonable economic forecast. This 
proposition that the economic substance test cannot be 
satisfied if a taxpayer cannot demonstrate a reasonable 
expectation of pre-tax profit is consistent with the long-
standing body of case law regarding lease transactions.
---------------------------------------------------------------------------
    \20\ 157 F.3d 231 (3rd Cir. 1998).
    \21\  Id. at 130.

---------------------------------------------------------------------------
2. Administrative pronouncements

    Through revenue rulings and other administrative 
pronouncements, the IRS has identified certain principles and 
factors it considers relevant in determining whether a 
transaction should be treated for tax purposes as a lease or as 
a conditional sale.
    In Rev. Rul. 55-540,\22\ the IRS indicated that conditional 
sale treatment is evidenced where the lessee effectively has 
the benefits and burdens of ownership for the economic life of 
the property, as demonstrated by, for example, the application 
of rentals against the purchase price or otherwise to create an 
equity interest, the identification of a portion of rentals as 
interest, the approximate equality of total rentals and the 
cost of the property plus interest, or the existence of nominal 
renewal or purchase options. The passage of legal title itself 
is not determinative.
---------------------------------------------------------------------------
    \22\ 1955-2 C.B. 39. See also Rev. Rul. 55-541, 1955-2 C.B. 19.
---------------------------------------------------------------------------
    In addition, the IRS has issued a series of revenue 
procedures setting forth guidelines that must be satisfied to 
obtain an advance ruling that a ``leveraged lease'' (a 
transaction involving three parties--a lessor, a lessee, and a 
lender to the lessor) will be respected as a lease for tax 
purposes.\23\ According to Rev. Proc. 75-21, the guidelines set 
forth therein were published
---------------------------------------------------------------------------
    \23\ See Rev. Proc. 75-21, 1975-1 C.B. 715 (setting forth several 
requirements that must be satisfied for the Service to rule that a 
transaction is a lease for tax purposes); Rev. Proc. 75-28, 1975-1 C.B. 
752 (specifying information that must be submitted pursuant to Rev. 
Proc. 75-21); Rev. Proc. 76-30, 1976-2 C.B. 647 (providing that the 
Service will not issue an advance ruling if the property subject to the 
``lease'' is limited use property); Rev. Proc. 79-48, 1979-2 C.B. 529 
(modifying Rev. Proc. 75-21 to allow the lessee to pay for certain 
improvements).

          to clarify the circumstances in which an advance ruling 
        recognizing the existence of a lease ordinarily will be issued 
        and thus to provide assistance to taxpayers in preparing ruling 
        requests and to assist the Service in issuing advance ruling 
        letters as promptly as practicable. These guidelines do not 
        define, as a matter of law, whether a transaction is or is not 
        a lease for federal income tax purposes and are not intended to 
        be used for audit purposes. If these guidelines are not 
        satisfied, the Service nevertheless will consider ruling in 
        appropriate cases on the basis of all the facts and 
---------------------------------------------------------------------------
        circumstances. (Emphasis added.)

    Thus, the IRS guidelines are intended only to provide a 
list of criteria that if satisfied ordinarily will entitle a 
taxpayer to a favorable ruling that a leveraged lease of 
equipment will be respected as a lease for tax purposes.
    With respect to economic substance, the IRS guidelines set 
forth a profit test that will be met if:

          the aggregate amount required to be paid by the lessee to or 
        for the lessor over the lease term plus the value of the 
        residual investment [determined without regard to the effect of 
        inflation] exceed an amount equal to the sum of the aggregate 
        disbursements required to be paid by or for the lessor in 
        connection with the ownership of the property and the lessor's 
        equity investment in the property, including any direct costs 
        to finance the equity investment, and the aggregate amount 
        required to be paid to or for the lessor over the lease term 
        exceeds by a reasonable amount the aggregate disbursements 
        required to be paid by or for the lessor in connection with the 
        ownership of the property.\24\
---------------------------------------------------------------------------
    \24\ Rev. Proc. 75-21, supra.

    The IRS guidelines do not specify any particular amount of 
profit that a lease must generate.\25\
---------------------------------------------------------------------------
    \25\ The IRS guidelines understate the actual profit earned over 
the lease term by failing to adjust the residual value of the 
investment for inflation.
---------------------------------------------------------------------------
    The IRS itself has not relied exclusively on the criteria 
set forth in the IRS guidelines when analyzing the true lease 
status of a lease transaction. Moreover, the courts have not 
treated the IRS guidelines as determinative when analyzing 
whether a transaction should be respected as a lease for tax 
purposes.\26\ Rather, the IRS guidelines are viewed as 
constituting a ``safe harbor'' of sorts. Accordingly, 
satisfaction of the conservative rule set forth by the 
applicable IRS guideline with respect to a particular criterion 
usually is viewed as an indication that the transaction should 
not be challenged on such a criterion.
---------------------------------------------------------------------------
    \26\ In a footnote in Frank Lyon, supra at n. 14, the Supreme Court 
specifically recognized that the IRS guidelines ``are not intended to 
be definitive.'' Moreover, in Estate of Thomas v. Commissioner, 84 T.C. 
412, 440 n. 15 (1985), the Tax Court viewed the failure to satisfy all 
the IRS guidelines as not determinative because the facts and 
circumstances demonstrated that the transaction satisfied the 
``spirit'' of the guidelines.

---------------------------------------------------------------------------
3. Statutory provisions

    The party that is treated as the owner of the leased asset 
is entitled to depreciation deductions in respect of such 
asset. The Deficit Reduction Act of 1984 enacted the ``Pickle'' 
rules (named after one of the sponsors of the provision, 
Representative J.J. Pickle), which restrict the benefits of 
accelerated depreciation in the case of property leased to a 
tax-exempt entity.
    The Pickle rules generally provide that, in the case of any 
``tax-exempt use property'' subject to a lease, the lessor 
shall be entitled to depreciate such property using the 
straight-line method and a recovery period equal to no less 
than 125 percent of the lease term.\27\ Tax-exempt use 
property, for this purpose, generally is tangible property 
leased to a tax-exempt entity, which is defined to include any 
foreign person or entity.\28\ In applying the Pickle rules, 
Treasury regulations adopted in 1996 provide that the lease 
term will be deemed to include certain periods beyond the 
original duration of the lease. Under these regulations, which 
extend beyond the reach of the statutory provision, the lease 
term includes both the actual lease term and any period of time 
during which the lessee (or a related person) (i) agreed that 
it would or could be obligated to make a payment of rent or a 
payment in the nature of rent or (ii) assumed or retained any 
risk of loss with respect to the property (including, for 
example, holding a note secured by the property).\29\
---------------------------------------------------------------------------
    \27\ I.R.C. section 168(g).
    \28\ I.R.C. section 168(h).
    \29\ Treas. Reg. Section 1.168(i)-2(b)(1).
---------------------------------------------------------------------------

                  B. Administration's Budget Proposals

    The Administration's FY 2000 budget includes several proposals that 
could have the effect of completely rewriting longstanding tax law on 
leasing transactions. These proposals, if enacted, would replace the 
substantial and specific body of law regarding leasing transactions 
that has developed over the last forty years with broad and largely 
undefined standards that could be used by IRS revenue agents to 
challenge traditional leasing transactions undertaken by companies 
operating in the ordinary course of business in good-faith compliance 
with the tax laws. Moreover, the proposal to modify the tax rules 
applicable to cross-border leasing would penalize U.S. lessors and 
would further hamper the ability of U.S.-based multinationals to 
compete in the export market.

1. Proposal to deny certain tax benefits to persons avoiding income tax 
as a result of tax avoidance transactions

    The proposal would expand the current-law rules of I.R.C. section 
269 to authorize Treasury to disallow any deduction, credit, exclusion, 
or other allowance obtained in a tax-avoidance transaction.\30\ For 
this purpose, a tax-avoidance transaction would be any transaction in 
which the present value of the reasonably expected pre-tax profit from 
the transaction is insignificant relative to the present value of the 
reasonably expected net tax benefits from the transaction. In addition, 
the term ``tax-avoidance transaction'' would be defined to cover 
certain transactions involving the improper elimination or significant 
reduction of tax on economic income.
---------------------------------------------------------------------------
    \30\ The ``tax-avoidance transaction'' concept also is implicated 
in several other Administration proposals relating to the consequences 
of corporate tax shelters. Under these proposals, a corporate tax 
shelter is defined as an arrangement in which a corporate participant 
obtains a tax benefit in a tax-avoidance transaction. If a corporate 
tax shelter is found to exist, the Administration proposals would (1) 
impose a significantly increased substantial understatement penalty, 
(2) deny deductions for fees for tax advice and impose a 25-percent 
excise tax on such fees, and (3) impose a 25-percent excise tax on 
certain rescission provisions or provisions guaranteeing tax benefits. 
If a transaction is determined to be a tax-avoidance transaction, each 
of these proposals also potentially would be applicable.
---------------------------------------------------------------------------
    This proposal creates the entirely new and vague concept of a 
``tax-avoidance transaction.'' The first prong of the definition of a 
tax-avoidance transaction is styled as an objective test requiring a 
determination of whether the present value of the reasonably expected 
pre-tax profit from a transaction is insignificant relative to the 
present value of the reasonably expected net tax benefits from the 
transaction. However, the inclusion of so many subjective concepts in 
this equation precludes it from operating as an objective test. As an 
initial matter, what constitutes the ``transaction'' for purposes of 
this test? \31\ Next, what are the mechanics for computing pre-tax 
economic profits and net tax benefits and for determining present 
values (e.g., what discount rate should be used)? Further, where is the 
line drawn regarding the significance of the reasonably expected pre-
tax economic profit relative to the reasonably expected net tax 
benefits? Moreover, is the determination of ``insignificance'' 
transaction-specific; stated otherwise, does the form of the 
transaction affect the determination of what will be considered 
``insignificant'' for these purposes?
---------------------------------------------------------------------------
    \31\ By itself, the determination of the scope of the transaction 
is both extremely complex and vitally important to the application of 
this test. Some of the questions to be resolved include: Do the 
qualified nonrecourse indebtedness rules control the determination of 
whether debt is considered part of a transaction? If recourse debt is 
taken into account in defining the transaction, how is the 
appropriately allocable amount of such debt to be determined? In 
addition, in defining the transaction, will an implicit charge for the 
use of capital be taken into account? Will allocations of internal 
expenses and corporate overhead to the transactions be required? 
Moreover, will a lease of multiple assets or multiple classes of assets 
be treated as a single transaction or multiple transactions? All of 
these questions and more must be answered in order to determine the 
scope of the transaction, which would be only the starting point in 
applying this test.
---------------------------------------------------------------------------
    Not only is this prong of the test extremely vague, the uncertainty 
is compounded by the second prong of the definition of tax-avoidance 
transaction. Under this alternative formulation, certain transactions 
involving the improper elimination or significant reduction of tax on 
economic income would be considered to be tax-avoidance transactions 
even if they did not otherwise constitute tax-avoidance transactions 
under the profit/tax benefit test described above. The inclusion of 
this second prong renders the definition entirely subjective, with 
virtually no limit on the IRS's discretion to deem a transaction to be 
a tax-avoidance transaction.
    Under this proposal, once the IRS had used its unfettered authority 
to determine independently that a taxpayer had engaged in a tax-
avoidance transaction, the IRS would be entitled to disallow any 
deduction, credit, exclusion, or other allowance obtained by the 
taxpayer in such transaction. Thus, even though a taxpayer's 
transaction has economic substance and legitimate business purpose, the 
IRS would be empowered to deny the tax savings to the taxpayer if 
another route to achieving the same end result would have resulted in 
the remittance of more tax. In other words, if an IRS revenue agent 
believed for any reason that a taxpayer's transaction was too tax 
efficient, he or she would have the power to strike it down, even if 
the actual pre-tax return on the transaction satisfied any objective 
benchmark for appropriate returns. That power could be invoked without 
regard to the legitimacy of the taxpayer's business purpose for 
entering into the transaction or the economic substance underlying the 
transaction.
    In the context of leasing transactions, this proposal effectively 
could wipe out the entire body of law that has developed over the last 
forty years. A leasing transaction that is scrutinized and passes 
muster under the benefits and burdens of ownership, business purpose, 
and economic substance tests could run afoul of this vague new 
standard. This proposal would completely disregard the presence of a 
business purpose, ignoring the business reality that lease transactions 
often are motivated by criteria that would not be taken into account 
under this new standard. It would replace the traditional economic 
analysis of lease transactions with this new and largely undefined 
standard. The long-standing law regarding the treatment of leasing 
transactions allows taxpayers to employ prudent tax planning to 
implement business objectives while giving the IRS the tools it needs 
to address potentially abusive transactions. The extraordinary power 
that would be vested both in Treasury and in individual IRS revenue 
agents is unnecessary and would create substantial uncertainty that 
would frustrate commerce done through traditional leasing transactions.

2. Proposal to preclude taxpayers from taking tax positions 
inconsistent with the form of their transactions

    The proposal generally would provide that a corporate taxpayer 
could not take any position on a tax return or refund claim that the 
income tax treatment of a transaction differs from the treatment 
dictated by the form of the transaction if a ``tax-indifferent party'' 
has an interest in the transaction, unless the taxpayer discloses the 
inconsistent treatment on its original return for the year the 
transaction is entered into. The form of the transaction would be 
determined based on all the facts and circumstances, including the 
treatment given the transaction for regulatory or foreign law purposes. 
A ``tax-indifferent party'' would be defined to include foreign 
persons, native American tribal organizations, tax-exempt 
organizations, and domestic corporations with expiring loss or credit 
carryforwards.\32\
---------------------------------------------------------------------------
    \32\ The ``tax-indifferent party'' concept also is implicated in a 
separate Administration proposal that would impose U.S. tax on any 
income allocable to a tax-indifferent party with respect to a corporate 
tax shelter.
---------------------------------------------------------------------------
    This proposal would have a chilling effect on a variety of leasing 
transactions. For example, the proposal could affect ``inbound'' lease 
transactions (i.e., transactions involving a foreign lessor and U.S. 
lessee), where the transaction takes the form of a lease under foreign 
law but constitutes a financing for U.S. tax purposes under the body of 
law described above. The proposal also might be implicated by 
``outbound'' lease transactions (i.e., transactions involving a U.S. 
lessor and foreign lessee), where the transaction takes the form of a 
lease for U.S. tax purposes under the body of law described in the 
preceding section but is treated as a financing under foreign law. If 
the ``form'' of the transaction is to be determined for purposes of the 
proposal by taking into account the foreign law treatment of the 
transaction, what is the ``form'' of this transaction? In many cases, 
the U.S. lessor or lessee does not know and is not able to ascertain 
the treatment of the transaction under foreign law. In such instances, 
the U.S. party would have to file some sort of protective disclosure, 
which would result in a deluge of filings with respect to leasing 
transactions. Query then whether such disclosure would be of any use to 
the IRS. This proposal also would have a chilling effect on municipal 
leases where the city (or other governmental unit) and the lessor treat 
the lease as a conditional sale for tax purposes. Moreover, the 
proposal represents a serious departure from the treatment of leasing 
transactions under present law.
    Under well-established law, a taxpayer may disavow the form of a 
transaction if the taxpayer's actions show an honest and consistent 
respect for the substance of the transaction. If such consistency 
exists, the taxpayer can successfully disavow the form of the 
transaction by introducing ``strong proof'' that the parties intended 
the transaction to be something different from its form.\33\
---------------------------------------------------------------------------
    \33\ Coleman v. Commissioner, 87 T.C. 178, 201 (1986), aff'd 883 
F.2d 303 (3d Cir. 1987); Illinois Power Co. v. Commissioner, 87 T.C. 
1417 (1986). In Commissioner v. Danielson, 378 F.2d 771 (3rd Cir. 
1967), cert. denied, 389 U.S. 858 (1967), a case involving a stock 
purchase agreement, the court stated that a taxpayer can challenge the 
tax consequences of his agreement only through the production of proof 
which ``would be admissible to alter that construction or to show its 
unenforceability because of mistake, undue influence, fraud, duress, 
etc.'' Id. at 775. The court in Danielson itself distinguished leasing 
transactions as a context in which the standard set forth in Danielson 
was not to apply. See Helvering v. Lazarus, supra; Tech. Adv. Mem. 
9307002 (October 5, 1992).
---------------------------------------------------------------------------
    The IRS recently applied the ``strong proof'' standard to an 
inbound Japanese leveraged lease transaction of an aircraft.\34\ In 
determining that the U.S. lessee had met this burden of proof, and thus 
remained the owner of the aircraft for U.S. tax purposes (despite the 
fact that the Japanese lessor was considered the owner of such aircraft 
for Japanese tax purposes), the IRS stated:
---------------------------------------------------------------------------
    \34\ Tech. Adv. Mem. 9802002 (September 18, 1997).

          dual tax ownership will not be a concern in the United States 
        when it is solely the result of differing U.S. and foreign 
        legal standards of tax ownership being applied to the same 
        facts because tax ownership is determined under U.S. legal 
        standards without regard to the tax ownership treatment 
        obtained under foreign law. Thus, the United States need not be 
        concerned where the taxpayer in a cross-border transaction is 
        able to show that the same facts that led the foreign taxing 
        authorities to conclude that ownership lies in the foreign 
        party, also support the conclusion that the taxpayer is the 
---------------------------------------------------------------------------
        owner under U.S. standards.

    In the context of leasing transactions, the 
Administration's proposal is unnecessary and is a clear 
departure from longstanding rules applicable to leasing 
transactions as expressly sanctioned by the IRS.

3. Proposal to limit ``inappropriate'' tax benefits for lessors 
of tax-exempt use property

    The proposal would deny recognition of a net loss from a 
leasing transaction involving tax-exempt use property during 
the lease term. For this purpose, the leasing transaction would 
be defined to include the lease itself and all related 
agreements (i.e., sale, loan, and option agreements) entered 
into by the lessor with respect to the lease of the tax-exempt 
use property. Property leased to foreign persons, governments, 
and tax-exempt organizations would be considered tax-exempt use 
property.
    This proposal would adversely impact a variety of common 
leasing transactions, including leasing to municipalities and 
tax-exempt organizations and export leasing. Domestic 
manufacturers, distributors, and retailers alike avail 
themselves of export leasing, not only as a pure financing 
vehicle for major equipment sales, but also as a powerful sales 
tool to promote equipment sales abroad. Lease financing is 
attractive to customers for a variety of reasons, including the 
preservation of cash, possible balance sheet accounting 
benefits, and a hedge against obsolescence risk. Consider, as 
an example, a U.S. manufacturer seeking to expand its export 
sales. That manufacturer's foreign competition is offering 
lease financing to its customer base. The U.S. manufacturer can 
compete in the global market only by offering lease financing 
on comparable terms. This proposal, which would increase the 
cost of export leasing, hampers the ability of U.S.-based 
multinationals to compete in the export markets.
    This proposal, which affects all deductions and losses with 
respect to leasing transactions, is much broader than the 
current Pickle depreciation rules that severely limit 
depreciation deductions for U.S. lessors that lease to foreign 
lessees. For example, assume that a U.S. lessor enters into a 
cross-border lease with a Mexican lessee with the rent stated 
in pesos. A currency loss due to a devaluation of the peso, 
realized upon receipt of the peso-denominated rent, might have 
to be deferred under this proposal. Other types of actual 
losses could be deferred similarly. In these situations, the 
proposal would have the effect of denying the current 
recognition for tax purposes of actual current economic losses.
    The only rationale that has been offered for the proposal 
is Treasury Department concern regarding a narrow class of 
relatively recent cross-border leasing transactions commonly 
referred to as ``LILO'' transactions. As the leasing industry 
has repeatedly told Treasury, those transactions would be 
eliminated if the IRS were simply to finalize regulations that 
it has proposed under section 467. The relevant statutory 
provision, I.R.C. section 467, was enacted in 1984--15 years 
ago; the relevant regulations were issued in proposed form in 
1996--3 years ago. Yet Treasury and the IRS have chosen not to 
take the simple step of finalizing the section 467 regulations 
in order to address these transactions. Indeed, after the 
release of the FY 2000 budget proposals, which included this 
proposal, Treasury and the IRS addressed the treatment of LILO 
transactions through the issuance of Rev. Rul. 99-14, choosing 
to use the weaker tool available to them--the issuance of a 
revenue ruling setting forth a litigating position--rather than 
the stronger weapon in their arsenal--the finalization of 
regulations that have remained in proposed form for 3 years. 
The additional tool that this legislative proposal would 
provide is unnecessary and would be harmful to a significant 
sector of the economy.
    Not only should the Congress reject this proposal, it 
should consider taking action to help U.S. companies engaged in 
leasing expand in the global marketplace. In this regard, the 
leasing industry has repeatedly objected to the Treasury 
regulations that treat the lease term, for purposes of the 
Pickle rules, as including periods beyond the actual lease 
term. The Congress should act to reverse these overreaching 
regulations. Moreover, the Congress should consider repeal of 
the Pickle rules themselves.

            IV. Impact of Administration's Budget Proposals

                    A. Impact on Common Transactions

1. Leveraged lease

    Consider a standard domestic leveraged lease under which an 
airline carrier enters into a ``sale-leaseback'' transaction in 
order to finance a newly manufactured aircraft. Under this 
transaction, the airline carrier purchases the aircraft from 
the aircraft manufacturer and immediately sells it to an 
institutional investor. The investor finances the acquisition 
through an equity investment equal to 25 percent of the $100 
million purchase price and a fixed-rate nonrecourse debt 
instrument from a third-party lender equal to the remaining 75 
percent. Immediately after the sale, the investor leases the 
aircraft to the airline carrier pursuant to a net lease for a 
term of 24 years. Upon the expiration of the lease term, the 
aircraft will be returned to the investor (the lessor). During 
year 18 of the lease, the airline carrier (the lessee) will 
have an option to purchase the aircraft from the investor for a 
fixed amount, which will be set at an amount greater than or 
equal to a current estimate of the then-fair market value of 
the aircraft. As the tax owner of the aircraft, the lessor is 
entitled to depreciation deductions in respect of the aircraft 
and deductions in respect of the interest that accrues on the 
loan.
    The lease in this example complies with applicable case law 
and with the cash flow and profit tests set forth in Rev. Proc. 
75-21. In fact, the sum of the rentals and the expected 
residual value exceeds the aggregate disbursements of the 
lessor and the lessor's equity investment, together with 
applicable costs, by approximately $18 million (or 18 percent 
of the asset purchase price).
    Even though this transaction complies with the established 
body of leasing law, it appears that it potentially could be 
characterized as a ``tax-avoidance transaction'' under the 
Administration's proposal, discussed above. As noted above, the 
manner in which the proposal would test whether a transaction 
is or is not a ``tax-avoidance transaction'' is capable of 
numerous different interpretations and appears to be highly 
subjective. Under a range of potential applications of the 
proposal to this transaction, it might be determined that the 
lessor would reasonably expect an annual pre-tax return 
anywhere in the range of 2.5 percent to 5.5 percent. On an 
after-tax basis, the lessor might be determined to reasonably 
expect an annual return anywhere in the range of 6.5 percent to 
8.5 percent. Depending on the particular manner in which the 
proposed test might be applied, the differential between the 
pre-tax and the after-tax returns could be large enough to 
suggest that an IRS agent might take the position that the 
discounted value of the reasonably expected pre-tax profit is 
not sufficient under the proposed test when compared to the 
discounted value of the reasonably expected net tax benefits.
    Regardless of how the test is applied, however, the tax 
advantages received by the lessor in this example are identical 
to the tax benefits that would be received by any owner of the 
property financing the property in a similar manner and in the 
same tax bracket. If the tax benefits are disallowed only for 
lessors, leasing will be put at a disadvantage relative to 
direct ownership. There is no sensible policy that would 
declare a leasing transaction to lack economic substance when 
the identical cash flows and tax benefits would occur for any 
similarly situated direct owner of such an asset.

2. Export leases

    Export leases are another example of a type of commonplace 
leasing transaction that could be impacted adversely by the 
Administration's budget proposals. Leaving aside the general 
question whether these types of leases might be deemed to 
constitute ``tax-avoidance transactions,'' they would be hit by 
the separate Administration proposal specifically targeting 
leasing arrangements involving tax-exempt parties. The 
proposal, as discussed above, generally would preclude a lessor 
of tax-exempt use property from recognizing a net loss 
generated during the lease term by a leasing transaction 
involving tax-exempt use property.
    Consider a commonplace ``operating lease'' transaction 
under which a foreign airline carrier seeks to lease a new 
aircraft from a U.S. manufacturer. The lessor finances the 
acquisition of such aircraft through an equity investment equal 
to 20 percent of the purchase price and a loan from a third-
party lender equal to the remaining 80 percent. The lessor 
leases the aircraft to the foreign airline carrier pursuant to 
an operating lease for a term of 5 years. The rents due 
thereunder, as well as the expected residual value of the 
aircraft, are dictated by the market. Upon expiration of the 
lease term, the aircraft will be returned to the lessor, 
whereupon the lessor will in all likelihood re-lease the 
aircraft for additional 5-year periods to other airline 
carriers. The lessor, as the tax owner of the aircraft, will be 
entitled to depreciation deductions in respect of the aircraft, 
using the straight-line method over a term equal to 12 years 
(i.e., the class life, which is greater than 125 percent of the 
5-year lease term), and deductions in respect of the interest 
that accrues on the loan. For purposes of this example, it is 
assumed that the lessor will sell the aircraft for its 
estimated residual value at the end of the second re-lease 
period in year 15.
    The effect of the Administration's proposal would be to 
decrease the return to the lessor. The decrease could be large 
enough that the U.S. lessor could not offer attractive aircraft 
financing, surrendering this business opportunity to a foreign 
lessor and manufacturer. Under current law, the lessor would be 
able to achieve an after-tax yield of approximately 6.7 
percent. That return is based, in part, on the rents due under 
the lease (and the re-lease) and the residual value of the 
aircraft upon the expiration of the re-lease (in each case, net 
of any debt service), and, in part, on the net tax benefits 
available to such lessor. If, as would be required under the 
Administration's proposal, the net tax losses available to the 
lessor in the early years had to be carried forward to offset 
the taxable income generated by such lease in the later years, 
the after-tax yield of the lessor (holding all other variables 
constant) would drop to approximately 6.1 percent.
    Or, consider a transaction under which a foreign airline 
carrier seeks to finance a new aircraft produced by a U.S. 
manufacturer on a long-term basis. The foreign airline carrier 
purchases the aircraft from the U.S. manufacturer and 
immediately sells it to a U.S. institutional investor. The 
investor finances the acquisition through an equity investment 
equal to 13 percent of the purchase price and a fixed-rate 
nonrecourse debt instrument from a third-party lender equal to 
the remaining 87 percent. Immediately after the sale, the 
investor leases the aircraft to the foreign airline carrier 
pursuant to a net lease for a term of 24 years. Upon expiration 
of the lease term, the aircraft will be returned to the 
investor (the lessor). At the end of year 18.5 of the lease, 
the foreign airline carrier (the lessee) will have the option 
to purchase the aircraft for a fixed amount, which will be set 
at an amount equal to or greater than a current estimate of the 
then-fair market value of the aircraft. The investor, as the 
tax owner of the aircraft, will be entitled to depreciation 
deductions in respect of the aircraft, using the straight-line 
method over a term that is at least equal to 125 percent of the 
lease term, and deductions in respect of the interest that 
accrues on the loan. In the early years of the lease term, the 
depreciation deductions and interest expense deductions exceed 
the amounts paid by the lessee to the lessor. The lease in this 
example complies with applicable case law and with the cash 
flow and profits tests set forth in Rev. Proc. 75-21.
    The effect of the Administration's tax-exempt use property 
proposal would be to increase the cost of financing this 
transaction. Under current law, the investor in this example is 
able to offer the lessee financing at a rate that would equate 
to the airline borrowing at about a 7.1-percent interest rate--
a lower rate than the lessee could hope to achieve if it 
financed the acquisition through a loan. This lower cost of 
capital is due to the tax deferral created when the lessor 
takes depreciation and interest deductions in the early years 
of the lease, amounting to net losses, and recognizes income in 
the later years. Carrying forward these net losses to offset 
taxable income generated by the lease, as the Administration 
proposal would require, would increase the 7.1.-percent 
effective interest rate in this example by 40 basis points, to 
7.5 percent. Taking into account the dollar size of these 
transactions (with typical deals in the hundreds of millions of 
dollars), a 40 basis point shift would render this U.S. 
manufacturer/lessor's financing uncompetitive in the global 
markets.

                      B. Impact on Competitiveness

    The ability of U.S. equipment manufacturers to compete in 
global markets may depend in part on their ability to arrange 
financing terms for their potential customers that are 
competitive with those that can be arranged by foreign 
producers. The Administration's budget proposals would make it 
much more difficult and potentially impossible to arrange 
financing on competitive terms.
    For example, consider the case of a U.S. aircraft 
manufacturer seeking to expand into the European market.\35\ A 
European airline may find price to be a final determining 
factor in comparing an aircraft manufactured by a U.S. company 
with one produced by a European manufacturer. Financing 
provisions, such as lease terms, directly influence the cost. 
The U.S. manufacturer's ability to sell its aircraft to the 
European airline may be contingent on its ability to assist the 
airline with arranging a suitable lease that is competitive 
with the lease terms that can be offered with respect to the 
European aircraft.
---------------------------------------------------------------------------
    \35\ About half of the aircraft flown in Europe are leased rather 
than owned by airlines.
---------------------------------------------------------------------------
    As shown in the examples above (see section IV. A), a U.S. 
aircraft manufacturer might be able to offer a European airline 
a short-term operating lease or a long-term financial lease, 
taking into account current U.S. tax law, at a rate that would 
be attractive to the foreign airline. In the financial lease, 
the airline effectively would borrow at a 7.1-percent interest 
rate. The European aircraft manufacturer, if it worked through 
a German investor, might be able to offer financing to the 
airline at a much lower rate, potentially as low as 5.5 
percent.\36\ A chief reason for this disparity is the favorable 
tax treatment of leased property under German law, including 
significantly accelerated depreciation for the lessor even when 
the lessee is a tax-exempt entity under German tax law. Under 
the present Pickle rules, a U.S. export lease on U.S. equipment 
cannot compete with a German lease on similar German equipment. 
The availability of favorable lease rules in foreign 
jurisdictions, such as the German rules, already hinders the 
ability of U.S. companies to compete in the global market. 
Changes to the rules further impairing the tax treatment of 
export leasing will further disadvantage U.S. leasing companies 
and U.S. manufacturers vis-a-vis their foreign counterparts.
---------------------------------------------------------------------------
    \36\ Using similar assumptions and terms as under the example in 
section IV.A.
---------------------------------------------------------------------------
    If enacted, the Administration's budget proposals would 
tilt the balance in these competitive financing situations even 
further against the U.S. manufacturer. For leasing-intensive 
industries, the proposals could make it prohibitive to expand 
in existing markets or to enter into emerging markets on a 
competitive basis.
    The Administration's proposals also would impede the 
ability of U.S.-based financial institutions to compete in the 
worldwide leasing market. If enacted, the Administration's 
proposals would give foreign-based financial institutions a leg 
up in providing financing. The impact of these proposals on the 
U.S. financial sector, an important part the U.S. economy, 
should not be overlooked.

                          C. Impact on Exports

    Because the Administration's proposals effectively would 
make U.S.-manufactured goods in leasing-intensive industries 
more expensive in foreign markets, these measures could be 
expected to have an adverse effect on American exports.
    A significant percentage of American exports is 
attributable to leasing. While no exact data regarding this 
percentage is available, consider that data discussed in 
section II, above, indicated that nearly one third of all 
equipment investment, at least on a domestic basis, is financed 
through leasing. Further, consider that exports of equipment in 
1997 represented 43 percent of all goods exported by the United 
States.\37\ Moreover, the share of exported goods accounted for 
by equipment has been rising steadily since 1980. Despite the 
strong showing of U.S. exported equipment, we live in a highly 
competitive world and face worldwide competition in our export 
markets and at home for these products.
---------------------------------------------------------------------------
    \37\ Department of Commerce, Bureau of Economic Analysis.
---------------------------------------------------------------------------
    In certain sectors most likely to be leasing-intensive, 
exports are accountable for a substantial share of domestic 
production. For example, exports account for 50 percent of U.S. 
production of aircraft, aircraft engines, and other aircraft 
parts; 28 percent of U.S. production of construction equipment; 
31 percent of U.S. production of farm machinery; 40 percent of 
U.S. production of machine tools; and 56 percent of U.S. 
production of mining machinery. In the absence of these 
exports, domestic employment in these equipment-producing 
industries would be substantially reduced.

         D. Impact on Start-Ups, Companies in Economic Downturn

    Some companies that directly own their assets may find that 
they have a higher cost of capital than their competitors due 
to special tax circumstances. For example, companies in a loss 
position (as is the case for many businesses in the start-up 
phase) and companies paying AMT (which often hits companies 
experiencing economic downturns) often have a higher cost of 
capital because they cannot immediately claim all of the 
depreciation allowances provided under the tax law. These 
companies may be at a competitive disadvantage relative to 
other firms. Some regard it as unfair that a company in the 
start-up phase or recovering from an economic downturn faces 
higher costs for new investment than its competitors.
    Through leasing, a company in these circumstances often can 
achieve a cost of capital comparable to that of its 
competitors. Leasing helps to ``level the playing field'' 
between companies in an adverse tax situation and their 
competitors by equalizing the cost of capital. For certain 
assets, leasing can lower the cost of capital for a firm in 
this tax situation by as much as one percentage point. This can 
mean the difference between successfully competing and 
bankruptcy. Rehabilitation or liquidation in bankruptcy can be 
more detrimental to U.S. revenues than the granting of ordinary 
depreciation and interest deductions.
    By denying the benefits of leasing, the Administration's 
proposals would further increase the cost of capital for 
companies in such circumstances. As a result, the economy 
suffers real losses. Investment may be allocated not on the 
basis of who is the most efficient or productive producer, but 
who is in the most favorable tax situation. In the absence of 
leasing, a company in a loss position--facing a higher cost of 
capital than its competitors--might not be able to undertake 
new investment even if, in the absence of taxes, it would be 
the most efficient firm.

                             V. Conclusion

    The Leasing Coalition urges Members of the House Ways and 
Means Committee to reject the Administration's tax proposals 
that would adversely affect the leasing industry. As discussed 
above, we believe these proposals inappropriately would 
overturn the longstanding and carefully crafted body of tax law 
governing common leasing transactions and would have a 
deleterious impact on the U.S. economy. Moreover, we find it 
highly objectionable that these common and legitimate business 
transactions effectively are being cast by the Administration 
as ``corporate tax shelters.'' Instead of considering proposals 
at this time that would impair the competitiveness of the 
leasing industry and industries that manufacture goods commonly 
acquired through lease arrangements, we respectfully would 
suggest that the Administration and Congress consider ways to 
help U.S. companies that use leasing as a form of financing 
expand in the global marketplace.
      

                                

Statement of Judy Carter, Chief Executive Officer and President, 
Softworks, Alexandria, Virginia; and R&D Credit Coalition

    Mr. Chairman and members of the committee, my name is Judy 
Carter, and I am the Chief Executive Officer and President of 
Softworks of Alexandria, Virginia. I thank you for the 
opportunity to submit this statement on behalf of the R&D 
Credit Coalition on the importance of making permanent the 
research and experimentation tax credit (commonly referred to 
as the ``R&D'' credit). The R&D Credit Coalition is a broad-
based coalition of 53 trade associations and approximately 
1,000 small, medium and large companies, all united in seeking 
the permanent extension of the R&D credit. The members of the 
R&D Credit Coalition represent many of the most dynamic and 
fastest growing companies in the nation and include the entire 
spectrum of technology, manufacturing, pharmaceuticals and 
software.
    Softworks has been in the information technology business 
for 21 years--during this time we have both contributed to and 
benefited from the evolution of information and computing 
technology. We are a global company with software solutions 
that are sold in every major market around the world. We have 
offices in the UK, France, Italy, Spain, Germany, Japan, 
Australia and Brazil, as well as thirteen offices throughout 
the U.S. and Canada. We have over 2000 customers worldwide 
including 82 of the Fortune 100 companies and about 42% of the 
Fortune 500. Importantly, we currently employ over two hundred 
workers in the United States.
    I want to commend Representatives Nancy Johnson and Bob 
Matsui, and the original cosponsors of H.R. 835, and Senators 
Hatch and Baucus, and the original cosponsors of S. 680, for 
introducing legislation to permanently extend the R&D credit 
and to provide a modest 1% increase in the Alternative 
Incremental Research Credit (``AIRC'') rates. I also want to 
commend President Clinton for including, and funding, an 
extension of the R&D tax credit in the Administration's FY 2000 
Budget.
    As the Committee members consider tax legislative options 
in the 106th Congress, the Coalition encourages them to 
implement fiscal policies and initiatives that will fuel the 
U.S. economy, keeping American companies and their workers 
prosperous and competitive in the changing global marketplace 
as we enter the 21st century. Without a growing economy, 
Americans' standard of living, and our ability to support the 
needs of our aging population, will be in jeopardy. Faced with 
a static or decreasing workforce as U.S. demographics shift, 
U.S. lawmakers must focus on encouraging technology development 
to increase productivity, enabling a smaller workforce to 
support a growing population of retirees. Increased technology 
development will help to ensure sustained economic growth and 
the prosperous environment needed to continue to improve our 
standard of living for current and future generations of 
Americans, will permit additional individual tax reductions, 
and will ensure a growing economy with resources necessary to 
adequately support the health and retirement needs of an aging 
U.S. population. The R&D tax credit, according to many 
government and private sector experts, is a proven, effective 
means of generating increased research and development 
activity, which in turn will provide effective means of 
generating increased research and development activity, which 
in turn will provide the technology improvements to benefit the 
economy.
    Last year the accounting firm of Coopers & Lybrand (now 
PricewaterhouseCoopers) completed a new study, Economic 
Benefits of the R&D Tax Credit, (January, 1998) that 
dramatically illustrates the significant economic benefits 
provided by the credit, and further reinforces the need to make 
the credit permanent. According to the study, making the R&D 
credit permanent would stimulate substantial amounts of 
additional R&D, increase national productivity and economic 
growth almost immediately, and provide U.S. workers with higher 
wages and after-tax income. I hope the Congress will take swift 
action to permanently extend the R&D credit by enacting the 
provisions of H.R. 835--S. 680 before the credit expires once 
again on June 30, 1999.

                   I. R&D CREDIT LEGISLATIVE HISTORY

    The R&D credit was enacted in 1981 to provide an incentive 
for companies to increase their U.S. R&D activities. As 
originally passed, the R&D credit was to expire at the end of 
1985. Recognizing the importance and effectiveness of the 
provisions, Congress decided to extend it. In fact, since 1981 
the credit has been extended nine times. In addition, the 
credit's focus has been sharpened by limiting both qualifying 
activities and eligible expenditures. With each extension, the 
Congress indicated its strong bipartisan support for the R&D 
credit.
    In 1986, the credit lapsed, but was retroactively extended 
and the rate cut from 25 percent to 20 percent. In 1988, the 
credit was extended for one year. However, the credit's 
effectiveness was further reduced by decreasing the deduction 
for R&D expenditures by 50% of the credit. In 1989, Congress 
extended the credit for another year and made changes that were 
intended to increase the incentive effect for established as 
well as start-up companies. In the 1990 Budget Reconciliation 
Act, the credit was extended again for 15 months through the 
end of 1991. The credit was again extended through June 30, 
1992, by the Tax Extension Act of 1991. In OBRA 1993, the 
credit was retroactively extended through June 30, 1995.
    In 1996, as part of the Small Business Job Protection Act 
of 1996, the credit was extended for eleven months, through May 
31, 1997, but was not extended to provide continuity over the 
period July 1, 1995 to June 30, 1996. This one-year period, 
July 1, 1995 to June 30, 1996, was the first gap in the 
credit's availability since its enactment in 1981.
    In 1996, the elective Alternative Incremental Research 
Credit (``AIRC'') was added to the credit, increasing its 
flexibility and making the credit available to R&D intensive 
industries which could not qualify for the credit under the 
regular criteria. The AIRC adds flexibility to the credit to 
address changes in business models and R&D spending patterns 
which are a normal part of a company's life cycle. The sponsors 
of H.R. 835 and S. 680 recognize the importance of the AIRC. 
Their legislation, in addition to making the credit permanent, 
provides for a modest increase in the AIRC rates that will 
bring the AIRC's incentive effect more into line with the 
incentive provided by the regular credit to other research-
intensive companies.
    The Congress next approved a thirteen month extension of 
the R&D credit that was enacted into law as part of the 
Taxpayer Relief Act of 1997. The credit was made available for 
expenditures incurred from June 1, 1997 through June 30, 1998, 
with no gap between this and the previous extension. Most 
recently, the Congress approved a one year extension of the 
credit, until June 30, 1999.
    According to the Tax Reform Act of 1986, the R&D credit was 
originally limited to a five-year term in order ``to enable the 
Congress to evaluate the operation of the credit.'' While it is 
understandable that the Congress in 1981 would want to adopt 
this new credit on a trial basis, the credit has long since 
proven over the sixteen years of its existence to be an 
excellent highly leveraged investment of government resources 
to provide an effective incentive for companies to increase 
their U.S.-based R&D.
    The historical pattern of temporarily extending the credit, 
combined with the first gap in the credit's availability, 
reduces the incentive effect of the credit. The U.S. research 
community needs a stable, consistent R&D credit in order to 
maximize its incentive value and its contribution to the 
nation's economic growth and sustain the basis for ongoing 
technology competitiveness in the global arena.

                    II. WHY DO WE NEED A R&D CREDIT?

     A. The credit offsets the tendency for under investment in R&D

    The single biggest factor driving productivity growth is 
innovation. As stated by the Office of Technology Assessment in 
1995: ``Much of the growth in national productivity ultimately 
derives from research and development conducted in private 
industry.'' Sixty-six to eighty percent of productivity growth 
since the Great Depression is attributable to innovation. In an 
industrialized society R&D is the primary means by which 
technological innovation is generated.
    Companies cannot capture fully the rewards of their 
innovations because they cannot control the indirect benefits 
of their technology on the economy. As a result, the rate of 
return to society from innovation is twice that which accrues 
to the individual company. This situation is aggravated by the 
high risk associated with R&D expenditures. As many as eighty 
percent of such projects are believed to be economic failures.
    Therefore, economists and technicians who have studied the 
issue are nearly unanimous that the government should intervene 
to increase R&D investment. The most recent study, conducted by 
the Tax Policy Economics Group of Coopers & Lybrand, concluded 
that ``...absent the R&D credit, the marketplace, which 
normally dictates the correct allocation of resources among 
different economic activities, would fail to capture the 
extensive spillover benefits of R&D spending that raise 
productivity, lower prices, and improve international trade for 
all sectors of the economy.'' Stimulating private sector R&D is 
particularly critical in light of the decline in government 
funded R&D over the years. Direct government R&D funding has 
declined from 57% to 36% of total R&D spending in the U.S. from 
1970 to 1994. Over this same period, the private sector has 
become the dominant source of R&D funding, increasing from 40% 
to 60%.

    B. The credit helps U.S. business remain competitive in a world 
                              marketplace

    The R&D credit has played a significant role in placing 
American businesses ahead of their international competition in 
developing and marketing new products. It has assisted in the 
development of new and innovative products; providing 
technological advancement, more and better U.S. jobs, and 
increased domestic productivity and economic growth. This is 
increasingly true in our knowledge and information-driven world 
marketplace.
    Research and development must meet the pace of competition. 
In many instances, the life cycle of new products is 
continually shrinking. As a result, the pressure of getting new 
products to market is intense. Without robust R&D incentives 
encouraging these efforts, the ability to compete in world 
markets is diminished.
    Continued private sector R&D is critical to the 
technological innovation and productivity advances that will 
maintain U.S. leadership in the world marketplace. Since 1981, 
when the credit was first adopted, there have been dramatic 
gains in R&D spending. Unfortunately, our nation's private 
sector investment in R&D (as a percentage of GDP) lags far 
below many of our major foreign competitors. For example, U.S. 
firms spend (as a percentage of GDP) only one-third as much as 
their German counterparts on R&D, and only about two-thirds as 
much as Japanese firms. This trend must not be allowed to 
continue if our nation is to remain competitive in the world 
marketplace.
    Moreover, we can no longer assume that American companies 
will automatically choose to site their R&D functions in the 
United States. Foreign governments are competing aggressively 
for U.S. research investments by offering substantial tax and 
other financial incentives. Even without these tax incentives, 
the cost of performing R&D in many foreign jurisdictions is 
lower than the cost to perform equivalent R&D in the U.S.
    An OECD survey of sixteen member countries found that 
thirteen offer R&D tax incentives. Of the sixteen OECD nations 
surveyed, twelve provide a R&D tax credit or allow a deduction 
for more than 100% of R&D expenses. Six OECD nations provide 
accelerated depreciation for R&D capital. According to the OECD 
survey, the U.S. R&D tax credit as a percentage of industry-
funded R&D was third lowest among nine countries analyzed.
    Making the U.S. R&D tax credit permanent, however, would 
markedly improve U.S. competitiveness in world markets. The 
1998 Coopers & Lybrand study found that, with a permanent 
credit, annual exports of goods manufactured here would 
increase by more than $6 billion, and imports of good 
manufactured elsewhere would decrease by nearly $3 billion. 
Congress and the Administration must make a strong and 
permanent commitment to attracting and retaining R&D investment 
in the United States. The best way to do that is to permanently 
extend the R&D credit.

    C. The credit provides a targeted incentive for additional R&D 
 investment, increasing the amount of capital available for innovative 
                           and risky ventures

    The R&D credit reduces the cost of capital for businesses 
that increase their R&D spending, thus increasing capital 
available for risky research ventures.
    Products resulting from R&D must be evaluated for their 
financial viability. Market factors are providing increasing 
incentives for controlling the costs of business, including 
R&D. Based on the cost of R&D, the threshold for acceptable 
risk either rises or falls. When the cost of R&D is reduced, 
the private sector is likely to perform more of it. In most 
situations, the greater the scope of R&D activities, or risk, 
the greater the potential for return to investors, employees 
and society at large.
    The R&D credit is a vital tool to keep U.S. industry 
competitive because it frees-up capital to invest in leading 
edge technology and innovation. It makes available additional 
financial resources to companies seeking to accelerate research 
efforts. It lowers the economic risk to companies seeking to 
initiate new research, which will potentially lead to enhanced 
productivity and overall economic growth.

   D. Private industrial R&D spending is very responsive to the R&D 
 credit, making the credit a cost effective tool to encourage economic 
                                 growth

    Economic studies of the credit, including the Coopers & 
Lybrand 1998 study, the KPMG Peat Marwick 1994 study, and the 
article by B. Hall entitled: ``R&D Tax Policy in the 1980s: 
Success or Failure?'' Tax Policy and the Economy (1993), have 
found that a one-dollar reduction in the after-tax price of R&D 
stimulates approximately one dollar of additional private R&D 
spending in the short-run, and about two dollars of additional 
R&D in the long run. The Coopers & Lybrand study predicts that 
a permanent R&D credit would lead U.S. companies to spend $41 
billion more (1998 dollars) on R&D for the period 1998-2010 
than they would in the absence of the credit. This increase in 
private U.S. R&D spending, the 1998 study found, would produce 
substantial and tangible benefits to the U.S. economy.
    Coopers & Lybrand estimated that this permanent extension 
would create nearly $58 billion of economic growth over the 
same 1998-2010 period, including $33 billion of additional 
domestic consumption and $12 billion of additional business 
investment. These benefits, the 1998 study found, stemmed from 
substantial productivity increases that could add more than $13 
billion per year of increased productive capacity to the U.S. 
economy. Enacting a permanent R&D credit would lead U.S. 
companies to perform significantly more R&D, substantially 
increase U.S. workers' productivity, and dramatically grow the 
domestic economy.

          E. Research and Development is About Jobs and People

    Investment in R&D is ultimately an investment in people, 
their education, their jobs, their economic security, and their 
standard of living. Dollars spent on R&D are primarily spent on 
salaries for engineers, researchers and technicians.
    When taken to market as new products, incentives that 
support R&D translate to salaries of employees in 
manufacturing, administration and sales. Of exceptional 
importance to Softworks and the other members of the R&D Credit 
Coalition, R&D success also means salaries to the people in our 
distribution channels who bring our products to our customers 
as well as service providers and developers of complementary 
products. And, our customers ultimately drive the entire 
process by the value they put on the benefit to them of 
advances in technology (benefits that often translate into 
improving their ability to compete). By making other industries 
more competitive, research within one industry contributes to 
preserving and creating jobs across the entire economy.
    My experience has been that more than 75 percent of 
expenses qualifying for the R&D credit go to salaries for 
researchers and technicians, providing high-skilled, high-wage 
jobs to U.S. workers. Investment in R&D, in people working to 
develop new ideas, is one of the most effective strategies for 
U.S. economic growth and competitive vitality. Indeed, the 1998 
Coopers & Lybrand study shows improved worker productivity 
throughout the economy and the resulting wage gains going to 
hi-tech and low-tech workers alike. U.S. workers' personal 
income over the 1998-2010 period, the 1998 study predicts, 
would increase by more than $61 billion if the credit were 
permanently extended.

             F. The R&D credit is a market driven incentive

    The R&D credit is a meaningful, market-driven tool to 
encourage private sector investment in research and development 
expenditures. Any taxpayer that increases their R&D spending 
and meets the technical requirements provided in the law can 
qualify for the credit. Instead of relying on government-
directed and controlled R&D spending, businesses of all sizes, 
and in all industries, can best determine what types of 
products and technology to invest in so that they can ensure 
their competitiveness in the world marketplace.

III. THE R&D CREDIT SHOULD BE MADE PERMANENT TO HAVE MAXIMUM INCENTIVE 
                                 EFFECT

    As the Joint Committee on Taxation points out in the 
Description of Revenue Provisions in the President's Fiscal 
Year 2000 Budget Proposal (JCS-1-99), ``If a taxpayer considers 
an incremental research project, the lack of certainty 
regarding the availability of future credits increases the 
financial risk of the expenditure.'' Research projects cannot 
be turned off and on like a light switch; if corporate managers 
are going to take the benefits of the R&D credit into account 
in planning future research projects, they need to know that 
the credit will be available to their companies for the years 
in which the research is to be performed. Research projects 
have long horizons and extended gestation periods. Furthermore, 
firms generally face longer lags in adjusting their R&D 
investments compared, for example, to adjusting their 
investments in physical capital.
    In order to increase their R&D efforts, businesses must 
search for, hire, and train scientists, engineers and support 
staff. They must often invest in new physical plants and 
equipment. There is little doubt that a portion of the 
incentive effect of the credit has been lost over the past 
seventeen years as a result of the constant uncertainty over 
the continued availability of the credit.
    If the credit is to provide its maximum potential for 
increased R&D activity, the practice of periodically extending 
the credit for short periods, and then allowing it to lapse, 
must be eliminated, and the credit must be made permanent. Only 
then will the full potential of its incentive effect be felt 
across all the sectors of our economy.

                             IV. CONCLUSION

    Making the existing R&D credit permanent best serves the 
country's long term economic interests as it will eliminate the 
uncertainty over the credit's future and allow R&D performing 
businesses to make important long-term business decisions 
regarding research spending and investment. Private sector R&D 
stimulates investment in innovative products and processes that 
greatly contribute to overall economic growth, increased 
productivity, new and better U.S. jobs, and higher standards of 
living in the United States. Moreover, by creating an 
environment favorable to private sector R&D investment, jobs 
will remain in the United States. Investment in R&D is an 
investment in people. A permanent R&D credit is essential for 
the United States economy in order for its industries to 
compete globally, as international competitors have chosen to 
offer direct financial subsidies and reduced capital cost 
incentives to ``key'' industries. The R&D Credit Coalition 
strongly supports the permanent extension of the R&D credit, 
and increasing the AIRC rates by 1%, and urges Congress to 
enact the provisions of H.R. 835--S. 680 before the credit 
expires on June 30, 1999.
      

                                

Statement of Hon. Bernie Sanders, a Representative in Congress from the 
State of Vermont

    Mr. Chairman, thank you for holding this hearing and 
providing me with the opportunity to express my concerns 
regarding the Clinton Administration's FY2000 revenue proposal. 
Among the many suggestions is a change in the way Employee 
Stock Ownership Plans are taxed. This is a vitally important 
issue that impacts many communities throughout the country, 
especially in my home state of Vermont.
    Employee Stock Ownership Plans (ESOPs) play a vital role in 
our changing economy. Presently, over 11,100 ESOPs operate 
within the United States whose net worth exceeds 400 billion 
dollars. Unlike most corporations, employees own a piece of 
these companies, and their success. Today, there are more than 
7.7 million employee-owners in America, encouraging employment 
stability, job creation, and subsequent long-term economic 
growth.
    ESOPs provide an incentive for employees to work hard and 
work together to make their business more effective. They 
encourage job creation and facilities investment, which are at 
the bedrock of healthy long-term economic growth. Employee-
ownership fosters a culture of cooperation and a real and 
lasting connection to a company. The company benefits because 
the employees work harder. The employee benefits by building 
long-term wealth and retirement security. Employee ownership is 
good for employees and good for the country. Congress should 
act to promote employee ownership rather than implement 
measures that would make it more difficult.
    ESOPs promote economic prosperity as well as basic 
democratic values in America. We live and work in an economy 
that is characterized by concentration, a trend that tends to 
place enormous distance between the people who make decisions 
and the people who work for companies. The choices that make 
the best sense to those in control--downsizing, maximization of 
short-term profits, and sending jobs overseas--are not always 
the decisions that are in the best interests of American 
workers.
    Everyone stands to gain from employee-owned ventures. 
Working people gain a stake in the company and control over 
their workplace. In turn, the company stands to profit because 
workers have greater incentive to streamline operations and 
increase output. By affording employees a real stake in the 
success of the business, companies prosper. Yet perhaps more 
importantly, employee-ownership builds a better, more equitable 
America where people have control over the economic fate of 
their households and their communities.
    Employee-ownership fosters a different set of priorities 
which focuses on the promotion of the worker, the company and 
the community in which the ESOP is located. Instead of 
maximizing short term profit, employee owners concentrate on 
the long-term health of their company and their community. In 
addition to the development of new techniques to improve 
production, employee-ownership affords workers the chance to 
enjoy a long term career with one company. In an era of down-
sizing and part-time work, the advantages of long-term 
employment with one company, such as health care and decent 
retirement, are quickly things of the past. As the income gap 
continues to widen, employee-ownership builds long term 
prosperity for middle-class and working Americans by 
encouraging job creation and stability as well as practices 
that sustain local economies and their communities.
    I want to tell you a little about a company from my 
district--King Arthur Flour in Norwich, Vermont. King Arthur, 
the oldest flour company in the United States, turned into an 
ESOP in 1996. Right now they earn $21 million dollars a year in 
sales, employing 110 people.
    And what does King Arthur's prosperity have to do with 
worker ownership? A lot, if you ask the people from King 
Arthur. The spirit of employer-ownership has taken root there, 
making the company more efficient and profitable. And King 
Arthur is able to provide many of its' employee-owners 
something that is becoming rare it our economy--good-paying 
jobs that have decent benefits and provide for a comfortable 
retirement. But don't take my word--let me give you some 
examples of how employee-ownership has made this difference.
    When the people working in the warehouse realized that 
there was a connection between the number of boxes they packed 
and the size of their stock allocation at the end of the year, 
they decided to act. They worked out ways to do their jobs more 
efficiently and between 1994 and 1997 the King Arthur warehouse 
team increased its boxes per work-hour from 13 to 25 with no 
new technology, no loss of safety, and no increase in product 
damage. That is an amazing increase in just three years.
    Another example of can be found in the catalogue operations 
at King Arthur. Employees sat down and figured out how much 
each returned product cost the company. Working together with 
several departments, King Arthur has lowered the return rate to 
just 2 percent, an incredible accomplishment.
    I come before the committee today to express serious 
concerns regarding the Administrations FY2000 Revenue proposal. 
Amid the many suggestions is one to change the way in which 
Employee Stock Ownership Plans are taxed. The Clinton 
Administration has proposed eliminating the special exemption 
from ``UBIT'' (unrelated business income tax) for ESOPs in S 
corporations.
    The Administration views this exemption as a violation of 
the general principle that business income should be taxed when 
it is earned. They are concerned that not doing so allows 
significant deferral, and avoidance, of tax on S corporation 
income that is owned by an ESOP. The Administration would like 
to tax these ESOP owned corporation like any other, then offer 
a deduction for profit paid out to employee-owners.
    This proposal bothers me for two reasons. This rule was 
developed to provide a tax incentive to encourage the 
establishment and success of ESOPs. The Administration fails to 
explain why the principle of taxing income when it is earned is 
more important than the encouragement of ESOPs. The proposal 
would offer some tax advantage to ESOPs, but a lesser, and 
importantly, more complicated one.
    I am aware that some tax consultants have been attempting 
to take advantage of this tax opportunity in a way that 
Congress did not intend. I would urge the members of the 
Committee to close this opportunity to those for whom it was 
not intended, but I strongly feel that it should be preserved 
for legitimate ESOPs. Abuse by some tax consultants is no 
justification for the elimination of this important provision 
for ESOPs.
      

                                

Statement of Securities Industry Association

                            I. Introduction

     The Securities Industry Association (``SIA'') appreciates 
the opportunity to submit written testimony to the Committee on 
Ways and Means regarding the revenue-raising proposals in the 
Administration's FY 2000 budget which deal with financial 
instruments and transactions. SIA brings together the shared 
interests of more than 740 securities firms. SIA member-firms 
(including investment banks, broker-dealers, and mutual fund 
companies) are active in all U.S. and foreign markets and in 
all phases of corporate and public finance. The U.S. securities 
industry manages the accounts of more than 50 million investors 
directly and tens of millions of investors indirectly through 
corporate, thrift, and pension plans. The industry generates 
more than $300 billion of revenues yearly in the U.S. economy 
and employs more than 600,000 individuals.
     We are concerned about the effects that the revenue 
proposals in the Administration's fiscal year 2000 budget that 
are discussed below would have on the functioning of capital 
markets if they were enacted. Our comments are both technical 
and practical, and we draw upon our substantial experience in 
helping businesses raise capital and reorganize ownership 
structures to meet business needs, as well as in standing ready 
to both buy and sell stocks, securities, and derivative 
products in order to accommodate the free flow of capital to 
its most productive uses.
     In broad summary of what is set out below, we think these 
proposals have the following flaws: First, they are founded on 
notions of economic equivalence that are factually inaccurate 
and in any case inconsistent with current tax policy and 
practice. Second, their adoption would needlessly impede the 
free flow of capital and the functioning of capital markets. 
Third, their adoption would effectively increase the tax on 
investment capital--particularly the corporate-level tax--
thereby discouraging savings and investment. We note that the 
U.S. already imposes one of the world's highest effective rates 
of tax on investment capital and that it is one of the few 
first-world countries which has not yet ``integrated'' its 
corporate-level tax. Finally, their adoption would disadvantage 
U.S. financial institutions in their efforts to compete with 
foreign financial institutions.

II. Require Accrual of Time Value Element on Forward Sale of Corporate 
                                 Stock

     The Administration's FY 2000 budget includes a proposal to 
effectively treat a corporation which agrees to issue shares of 
its stock in the future (a so-called ``forward sale'' of its 
own stock) as if it had (a) issued its stock on the date of the 
agreement in exchange for a smaller amount of cash, and (b) 
lent this smaller amount of cash back to the deemed purchaser 
of the stock for the period between the date of the agreement 
and the date of actual issuance of the stock. The excess of the 
amount which the company actually received in the future over 
the amount which the company was deemed to receive today would 
be taxable interest income, rather than a nontaxable receipt of 
property in exchange for the issuance of stock.
     The basis for this proposal, according to the 
Administration, is that a corporation's agreement to sell its 
own stock in the future is economically equivalent to selling 
its stock today and lending the proceeds of the sale back to 
the purchaser of the stock. SIA believes, however, that there 
are several problems with the Administration's logic.
     First, our system imposes tax by reference to the 
transactions which taxpayers actually enter into, not by 
reference to alternative transactions which taxpayers might 
have entered into, but didn't, to reach economically similar 
results. There are an infinite number of transactions which 
give rise to different tax results notwithstanding that they 
give rise to economic results that are arguably equivalent. The 
continued ownership of appreciated property is economically 
equivalent, for example, to selling it and buying it back 
again, and holding debt is economically equivalent, for 
example, to holding stock, selling an at-the-money call on that 
stock and buying an at-the-money put on that stock. We 
therefore do not think it desirable to seek to tax financial 
transactions on the basis of their economic similarity to other 
financial transactions.
     Second, an agreement to issue stock in the future is not 
economically similar to an issuance of stock today. A taxpayer 
who merely agrees to purchase stock in the future lacks (a) the 
right to dividends on the stock, (b) the right to vote the 
stock and (c) the ability to dispose of, or pledge, the stock. 
In short, the taxpayer lacks all of the current benefits and 
indicia of ownership.\1\ Such a taxpayer is not ever exposed to 
the risk of the issuer's bankruptcy, because a forward contract 
to acquire issuer stock is generally void in the event of the 
issuer's bankruptcy.
---------------------------------------------------------------------------
    \1\ See Staff of Joint Comm. on Taxation, 106th Cong., Description 
of Revenue Provisions Contained in the President's Fiscal Year 2000 
Budget Proposal 179 (Comm. Print JCS-1-99) (hereafter, the ``Joint 
Committee Description'').
---------------------------------------------------------------------------
    Third, there is no economic similarity, as posited by the 
Administration, in the case of a stock which pays dividends. If 
the relevant stock pays dividends equal to the market rate of 
interest, for example, the ``forward price'' of the stock 
generally equals the current price of the stock, and treating 
as interest a portion of the amount received in the future for 
the stock would be theoretically incorrect. Put differently, 
under the more typical circumstance in which the relevant stock 
pays dividends, the Administration's proposal would in effect 
treat a forward issuer as making deemed nondeductible dividend 
payments on deemed currently issued stock and immediately 
receiving those payments back again as includable interest 
income.
    Fourth, far from increasing tax equivalence and 
consistency, adoption of this proposal would create 
inconsistency by deeming certain events to occur for purposes 
of determining the tax treatment of a forward issuer of stock 
but not for purposes of determining the tax treatment of the 
forward purchaser of stock. Thus, the proposal would require an 
issuing corporation to recognize income from a deemed receipt 
of interest from the purchaser, but it would not permit the 
purchaser to deduct deemed payments of interest to the issuing 
corporation. We think that such inconsistent and one-sided 
treatment violates the basic fairness principles underlying 
sound tax administration.
    Finally, the harsh treatment accorded future sales of a 
corporation's stock would effectively prevent corporations from 
agreeing to issue their stock in the future. Yet there are 
legitimate business reasons for agreeing to issue stock in the 
future. For example, an issuer may believe that its stock is 
temporarily overpriced but not yet have any use for the cash 
proceeds of a current stock issuance. We see no reason to 
interfere with capital markets in this manner.

          III. Modify Rules for Debt-Financed Portfolio Stock

     Section 246A of current law \2\ disallows the dividends-
received deduction to the extent that relevant portfolio stock 
is debt financed. Portfolio stock has generally been treated as 
debt-financed where (a) it is acquired with the proceeds of 
indebtedness, or (b) it secures the repayment of indebtedness. 
The Administration's FY 2000 budget includes a proposal to 
attribute general corporate indebtedness pro-rata to a 
corporation's assets for purposes of treating the corporation's 
portfolio stock as debt-financed, regardless of how or why the 
indebtedness is incurred. This means that the dividends-
received deduction would be partially disallowed for most 
corporations. Enactment of this proposal would therefore be 
equivalent to substantially reducing the dividends-received 
deduction. The effective reduction would depend on the leverage 
of the relevant corporation, however, and the deductions of 
highly leveraged corporations, such as most financial 
institutions, would be greatly reduced.
---------------------------------------------------------------------------
    \2\ All section references are to the Internal Revenue Code.
---------------------------------------------------------------------------
    SIA objects to this proposal. The dividends-received 
deduction is designed to prevent multiple levels of corporate 
taxation from being imposed on the same dollar of earnings when 
corporations invest equity capital in other corporations. SIA 
believes that this deduction plays an essential role in the 
economy and should be increased, rather than reduced. The 
deduction permits the free flow of equity capital from 
``mature'' corporations with limited economic opportunities to 
``growth'' corporations which can employ the capital to expand 
the economy. Absent the deduction, the government would be 
imposing multiple-level corporate taxation on capital seeking 
its most productive use.
    Congress recognized the essential role of the dividends-
received deduction when it first enacted Section 246A of the 
Code in 1984. The provision was enacted to deal with a 
relatively narrow concern. The relevant ``blue book'' contains 
the following language, for example: ``Specifically, under 
prior law, corporate taxpayers were borrowing money and using 
the proceeds to acquire dividend-paying portfolio stock . . .. 
If the indebtedness was non-recourse, the transaction may have 
involved little risk and, if properly structured, may not even 
have had to be fully reflected on the investing corporation's 
balance sheet.'' \3\ Congress made it quite clear, however, 
that it did not intend a broad disallowance. The relevant House 
Report contains the following language:
---------------------------------------------------------------------------
    \3\ 1984 Blue Book at 128.

          ``The bill contemplates that the directly attributable 
        requirement will be satisfied if there is a direct relationship 
        between the debt and an investment in stock. The bill does not 
        contemplate the use of any allocation or apportionment formula 
        or fungibility concept. Thus, for example, the bill does not 
        apply merely as a result of (i) the existence of outstanding 
        commercial paper that is issued by a corporation as part of an 
        ongoing cash management program or (ii) deposits received by a 
        depositary institution as a part of the ordinary course of its 
        business. However, if indebtedness is clearly incurred for the 
        purpose of acquiring dividend-paying stock or otherwise is 
        directly traceable to such an acquisition, the indebtedness 
        would constitute portfolio indebtedness. Thus, if stock is held 
        in a margin account with a securities broker, the margin 
        borrowing constitutes portfolio indebtedness. The same result 
        would follow with respect to any nonrecourse loan secured, in 
        whole or in part, by dividend-paying stock.\4\
---------------------------------------------------------------------------
    \4\ H.R. Rep. No. 98-432, pt. 2, at 1184 (1984). The relevant 
Senate report contains almost identical language. See S. Rep. No. 98-
169, at 165-66 (1984).

    The Administration has not pointed out any change in 
circumstance which might lead Congress to change its mind.
    We are also troubled by the inequity of the 
Administration's proposal. We do not see why the dividends-
received deduction should be effectively disallowed for 
securities dealers or disallowed in proportion to corporate 
leverage. Securities dealers, which are almost always highly 
leveraged, maintain equity portfolios in the ordinary course of 
business for reasons that are wholly unrelated to tax.
    In any case, we think this proposal would have several 
undesirable collateral consequences. First, it would encourage 
corporations to lend capital to other corporations, rather than 
make equity investments. The resulting increase in corporate 
leverage would weaken the stability of the corporate sector and 
result in needless and costly bankruptcies in the event of an 
economic downturn. Second, it would reduce the international 
competitiveness of U.S. corporations by effectively increasing 
the rate of U.S. corporate-level taxation, a rate which is 
already much higher than the rate imposed on foreign 
competitors by many of our trading partners, most of which have 
already integrated their corporate-level taxes. Third, it would 
disrupt capital markets by leading to sudden and unanticipated 
drops in the secondary market values of preferred and other 
yield-oriented equities that were issued assuming no 
``haircut'' for corporate leverage. Finally, for the reasons 
set out above, it would impede securities dealers from holding 
significant inventories in such equities in order to stand 
ready to buy or sell them (i.e., to ``make a market'' in those 
equities), thereby diminishing the liquidity of such equities 
and further exacerbating the problems set out above.

 IV. Deny the Dividends-Received Deduction for Certain Preferred Stock

    The Administration's FY 2000 budget also includes a 
proposal to disallow the dividends-received deduction all 
together for dividends received on term preferred stock (i.e., 
stock that will likely be redeemed within 20 years) and 
floating-rate preferred stock (i.e., stock with dividend rates 
which vary with interest rates, commodity rates or similar 
indices). For reasons similar to those set out in III. above, 
SIA objects to this proposal. Indeed, Congress considered and 
rejected this proposal last year.
    According to the Administration, the rationale for this 
proposal is that such stock has debt-like characteristics. This 
is not an argument, however, for disallowing the dividends-
received deduction. Under current law an issuer of preferred 
stock does not get any interest deduction, and the issuance of 
preferred stock rather than debt therefore generally increases, 
rather than decreases, aggregate corporate-level tax by 
introducing an additional 10.5% tax on dividends (i.e., a 35% 
tax on the 30% of the dividend that is taxable).
    The Administration also maintains that the proposal is 
justified because current law denies the dividends-received 
deduction where holders are protected from risk of loss. 
Congress has already concluded, however, that the dividends-
received deduction should not be disallowed merely because the 
terms of the preferred stock are designed to insulate a holder 
from market risks such as changes in interest rates.\5\ Such 
terms do not protect the holder from the key risk which 
distinguishes equity from debt for tax purposes: the risk that 
the issuer will not pay dividends if its business performs 
poorly. Neither is a holder of preferred stock protected from 
this risk merely because the stock is scheduled for ultimate 
redemption. The stock is never redeemed if the issuer becomes 
insolvent prior to redemption, in which case the holder has no 
creditor's claim. The holder may receive neither dividends nor 
the redemption price if the issuer lacks sufficient earnings, 
and in such a case the holder cannot sue the issuer to enforce 
payment.
---------------------------------------------------------------------------
    \5\ See e.g., H.R. Conf. Rep. No. 98-861, at 818-19 (1984), dealing 
with the enactment of Section 246(c) of the Code: ``The substantially 
similar standard is not satisfied merely because the taxpayer (1) holds 
a single instrument that is designed to insulate the holder from market 
risks (e.g., adjustable rate preferred stock that is indexed to the 
Treasury Bill rate). . . .''
---------------------------------------------------------------------------
    In any case, we see no basis for selectively eliminating 
the dividends-received deduction for particular classes of 
preferred stocks. The Administration's proposal is unfair and 
one-sided, because it would deny a dividends-received deduction 
on the theory that the security is ``debt,'' but it would not 
grant an interest deduction instead. The result would make it 
impossible to issue the relevant securities, because the 
securities would fall into a noneconomic ``no man's land'' for 
tax purposes. There are important and legitimate business 
reasons, however, why some corporations investing equity 
capital in other corporations receive term preferred stock 
rather than perpetual preferred stock, or floating preferred 
stock rather than fixed preferred stock. We do not see any 
reason to force capital markets to limit the means by which 
domestic corporations can provide each other with equity 
capital.

    V. Defer Interest and OID Deductions on Certain Convertible Debt

    The Administration's FY 2000 budget contains a proposal to 
defer deductions for interest accruing on zero-coupon debt that 
is convertible into the stock of the issuing corporation until 
the interest is actually paid. If the holder exchanged the 
right to receive such accrued but unpaid interest for stock 
before the instrument matured, the interest deduction would 
effectively be disallowed all together. This proposal has been 
repeatedly considered and rejected by Congress since 1995.
    We oppose this provision as lacking a coherent policy 
rationale. The only possible rationale for the proposed 
disallowance is that an issuance of convertible discount debt 
is economically similar to an issuance of equity, and an issuer 
should therefore not be entitled to deduct interest accruing on 
discount debt that is ultimately converted into equity. We 
assume that the Administration would not propose, however, to 
disallow deductions for interest paid on conventional current-
pay convertible debt. As an empirical matter, current-pay 
convertible debt is far more likely to be converted into equity 
than is zero-coupon convertible debt. A converting holder of 
zero-coupon debt must give up the right to receive accrued but 
unpaid interest; a converting holder of current-pay debt does 
not give up this right, because the interest has already been 
received. This is borne out by the fact that most current-pay 
convertible debt instruments are ultimately converted into 
stock prior to maturity, whereas most zero-coupon convertible 
debt instruments are ultimately not converted. In other words, 
it is generally the zero-coupon instruments, not the current-
pay instruments, which in fact pay principal at maturity.
    Moreover, this provision would result in inconsistent 
treatment of issuers and holders. Issuers would be denied any 
deductions for accrued but unpaid original issue discount, yet 
holders would still be required to include such discount in 
income. We think this would be unfair as a matter of policy.

                   VI. Tax Issuance of Tracking Stock

    ``Tracking stock'' is an economic interest (e.g., stock) 
which ``tracks'' the economic performance of one or more 
divisions or subsidiaries of the issuing corporation. The 
Administration's FY 2000 budget includes a proposal which would 
require a corporation to recognize gain upon the issuance of 
tracking stock in an amount equal to the excess of the fair 
market value of the tracked assets over their adjusted basis. 
According to the Administration, the rationale for this 
proposal is that issuing corporations are avoiding the gain 
which they would otherwise recognize if they sold stock in the 
tracked subsidiary or division.
    We disagree with the assumptions underlying this proposal. 
In many cases, the proceeds of an issuance of tracking stock 
are contributed to the relevant tracked subsidiary or division. 
Thus, the overall transaction is economically equivalent (and 
could be replicated by) a primary issuance of stock to new 
investors by the relevant subsidiary or division. Such a 
primary issuance would ``dilute'' the parent's interest in the 
subsidiary but would not cause the parent to recognize gain. We 
therefore do not agree that the issuance of tracking stock is 
primarily designed to avoid recognition of gain.
    Admittedly an issuance of tracking stock is sometimes 
chosen over the alternative of a primary issuance partly to 
prevent the relevant subsidiary from being ``deconsolidated'' 
from the parent. There are many legitimate business reasons, 
however, for choosing an issuance of tracking stock over a 
primary issuance, including (a) the issuer's desire to retain 
full economic control over (but not full economic participation 
in) the relevant subsidiary, (b) the desire to permit both 
parent and subsidiary to achieve the lower financing costs 
associated with a higher credit rating based on a stronger, 
unified credit, (c) the desire to obtain or avoid desirable or 
onerous accounting or regulatory objectives or consequences, 
and (d) the desire to maximize synergies and cooperation. 
Further, enactment of this proposal would leave corporations 
which have already issued tracking stock in an untenable 
position. Such corporations must issue new equity on an ongoing 
basis to grow, make acquisitions and meet other business 
requirements. If this new equity cannot be issued in proportion 
to existing equity (i.e., cannot include issuances of new 
tracking stock on a pro-rata basis), the balance in the 
corporation's capital structure will be undermined.
    As discussed above in connection with the Administration's 
proposal to treat a forward issuance of stock like an 
``economically equivalent'' current issuance, SIA does not 
believe that taxpayers should be taxed by reference to 
economically similar transactions which they might have 
undertaken to reach their economic objectives but didn't. 
Moreover, an issuance of tracking stock is clearly not 
economically equivalent to a sale of stock in the tracked 
subsidiary. Among other things, such an issuance (a) leaves 
investors fully exposed to loss from the bankruptcy of the 
issuing corporation, (b) generally gives investors voting 
control over the issuing, rather than the tracked, corporation 
and (c) subjects investors to substantial limitations on the 
receipt of dividends or profits which relate to the performance 
of the issuing, rather than the tracked, corporation.\6\
---------------------------------------------------------------------------
    \6\ See the Joint Committee Description at 224-225:
---------------------------------------------------------------------------
    ``While it generally is anticipated that the issuing corporation 
will pay dividends linked to the tracked assets, in many instances 
holders of tracking stock may not actually be entitled to the 
dividends, even though the tracked assets are profitable, if the parent 
corporation does not declare dividends. The tracked assets may be 
subject to liabilities of the parent corporation that may diminish the 
tracking stock shareholders' interests in the values of such assets. 
Under such circumstances, it might be questioned whether the issuance 
of such stock is economically equivalent to a direct ownership of the 
underlying assets. If tracking stock has a value that differs from the 
value of the underlying assets, it could be questioned whether the 
issuing corporation is properly treated as having distributed the 
entire value of the attributable portion of the tracked asset.''

            VII. Apply Section 265(b) to Securities Dealers

    Section 265(a)(2) generally disallows deductions for 
interest on indebtedness incurred or continued to purchase or 
carry tax-exempt debt. Under relevant case law and IRS 
regulatory authority, securities dealers are generally required 
to allocate their indebtedness pro-rata among their assets for 
this purpose, with certain exceptions where indebtedness 
proceeds are clearly traceable to purposes other than the 
acquisition of tax-exempt debt. Section 265(b) applies a 
blanket pro-rata allocation rule to banks and other financial 
institutions.
    The Administration's FY 2000 budget includes a proposal to 
apply Section 265(b) to securities dealers. The stated purpose 
of this proposal is to deny securities dealers the right to 
trace the proceeds of certain borrowings to specified taxable 
investments. This proposal, if adopted, would effectively 
overturn 30 years of guidance concerning what portion of a 
securities dealer's indebtedness is deemed effectively incurred 
to carry inventories of tax-exempt securities.
    More specifically, when Congress first enacted Section 
265(a)(2) of the Code in 1917, it clearly did not desire a pro-
rata disallowance of interest expense for general business 
purposes.\7\ In fact, Congress considered whether to amend the 
predecessor to section 265(a)(2) to enact a pro-rata 
disallowance rule in 1918, 1924, 1926 and 1934, and each time 
explicitly refused to do so.\8\ Thereafter, the Second Circuit, 
in Leslie v. Commissioner,\9\ concluded that securities dealers 
must allocate general subordinated indebtedness pro-rata among 
their business assets for purposes of applying Section 
265(a)(2) but conceded that Section 265(a)(2) is not properly 
applied to disallow interest deductions where ``business 
reasons not related to purchase of tax-exempt securities 
dominate the incurring of indebtedness.'' It allowed the 
Commissioner to allocate the taxpayer's indebtedness pro-rata 
among its business assets only because the proceeds of the 
indebtedness could not be traced to the acquisition of taxable 
assets. Likewise, under Rev. Proc. 72-18,\10\ the Internal 
Revenue Service generally requires securities dealers to 
allocate their indebtedness pro-rata among their business 
assets but recognizes that such allocation is inappropriate 
where indebtedness is incurred for certain specified 
purposes.\11\ Similarly, in Rev. Rul. 74-294,\12\ the Service 
concluded that indebtedness incurred to make margin loans to 
customers was not allocable to tax-exempt debt because the 
indebtedness proceeds had to be segregated in a separate 
account.
---------------------------------------------------------------------------
    \7\ Revenue Act of 1917, ch. 63, Sec. Sec.  1201(1) & 1207(2), 40 
Stat. 300, 330, 335 (1917).
    \8\ See J.S. Seidman, Seidman's Legislative History of Federal 
Income Tax Laws 1938-1961 301, 597, 727-28, 910 (1938).
    \9\ 413 F.2d 636, 639 (2d Cir., 1969), cert. den. 396 U.S. 1007 
(1970).
    \10\ 1971-1 C.B. 740.
    \11\ Id. at Section 5.04: Indebtedness incurred to acquire or 
improve physical facilities is not allocated partly to tax-exempt debt.
    \12\ 1974-1 C.B. 71.
---------------------------------------------------------------------------
    The objective of all of these authorities has been to carry 
out the will of Congress as regards the application of Section 
265 to securities dealers. In pursuance of this goal, these 
authorities have generally required pro-rata allocation, but 
they have also recognized the fact that some indebtedness is 
clearly not incurred to carry tax-exempt debt. The only 
rationale advanced by the Administration for reversing all of 
this guidance is that specific identification is not available 
to banks. Yet banks do not, like securities dealers, generally 
hold inventories of tax-exempt debt securities for sale to 
customers in the ordinary course of business. To the extent 
that they do, they also should be entitled to specific 
identification. Uniformity of treatment should not be sought by 
extension of a flawed rule.
    In fact, the rule proposed by the Administration would be 
exceedingly harsh on securities dealers. Consider, for example, 
a securities dealer maintaining a ``matched book'' of repo 
transactions whereby the dealer effectively borrows and onlends 
large amounts of cash (which borrowings and onloans are fully 
collateralized by Treasury securities) and earns a thin 
``spread'' for its corresponding role as a ``middleman'' in the 
efficient flow of capital. Under the Administration's proposal, 
such a dealer would be required to allocate the ``borrowings'' 
pro-rata among its assets, including its inventory of tax-
exempt securities, and a portion of its deductions for interest 
paid on the borrowings (but not its income from the onloans) 
would be disallowed accordingly. In effect, the net taxable 
income from the transactions would substantially exceed the 
economic income. Similarly, where a securities dealer borrowed 
money and onlent the proceeds to a customer in connection with 
a customer margin account, the resulting taxable income would 
substantially exceed the net economic income. Such treatment 
would hamper the ability of U.S. securities dealers to compete 
effectively with foreign securities dealers. If and to the 
extent that current rules have a similar effect on banks (i.e., 
to the extent that banks make markets in tax-exempt debt), we 
think the rules for banks should be changed.
    The Administration maintains that ``it is difficult to 
trace funds within an institution and nearly impossible to 
assess the taxpayer's purpose in accepting deposits or making 
other borrowings.'' To the contrary, however, the IRS has 
successfully audited securities dealers under an allocation 
methodology which includes both pro-rata allocation and 
specific tracing since the introduction of its 1972 revenue 
procedure on the subject.

  VIII. Require Current Accrual of Market Discount by Accrual Method 
                               Taxpayers

    The Administration's FY 2000 budget includes a proposal 
which would require accrual-basis taxpayers to include the 
difference between the purchase price of a debt obligation and 
the issue price of the obligation--i.e., the ``market 
discount'' on the obligation--in income as it accrues. The 
accrual rate would be limited to 5 percentage points above (a) 
the original yield of the debt or (b) the applicable federal 
rate of interest at the time the debt was acquired. The basis 
for this proposal, according to the Administration, is that the 
failure of current law to require current accrual of market 
discount ``creates asymmetries between similarly situated 
holders.''
    Congress has provided for the deferral of market discount 
in light of its simplicity and its consistency with the 
treatment of the issuer. Like the issuer, all holders continue 
to accrue interest at a rate equal to the initial yield of the 
debt instrument, regardless of subsequent changes in the value 
of the debt arising from changes in circumstance (e.g., changes 
in the market rate of interest or credit worthiness). Congress 
has also provided for the deferral of market discount partly in 
consideration of the administrative difficulties associated 
with requiring cash-basis holders to measure and accrue such 
discount currently.\13\
---------------------------------------------------------------------------
    \13\ See the Joint Committee Description at 207, and Staff of Joint 
Comm. on Taxation, 98th Cong., General Explanation of the Revenue 
Provisions of the Deficit Reduction Act of 1984 93 (Comm. Print 1984) 
(hereafter, ``1984 Blue Book'').
---------------------------------------------------------------------------
    In light of the above, we believe that it is this proposal, 
rather than current law, which would create asymmetries. The 
proposed treatment of accrual-basis holders would not be 
consistent with the treatment of cash-basis holders, who would 
still (for the reasons set out above) be permitted to defer the 
inclusion in income of market discount to maturity. We do not 
think it fair or advisable to impose a substantially less 
desirable tax treatment on a category of investors based solely 
on their accounting method.
    We are also concerned about the policy implications of this 
proposal. Current market discount rules generally encourage 
investors to acquire distressed debt in the secondary markets. 
The resulting increase in the liquidity of such debt helps to 
stabilize the financial positions of troubled corporations. 
Similarly, current market discount rules help increase the 
liquidity of Treasury and other government securities in rising 
interest-rate environments. We believe the Administration 
should set out in greater detail the likely economic impact of 
this proposal.

                 IX. Modify and Clarify Straddle Rules

    The Administration's FY 2000 budget includes a proposal 
designed to ``clarify'' that taxpayers cannot currently deduct 
certain expenses and losses that are attributable to structured 
financial transactions that are part of a straddle. We think 
this proposal is too broad. The proposal would disallow current 
deductions for all expenses incurred in connection with a 
straddle, even though the expenses are not incurred to purchase 
or carry the straddle and even though the expenses are not 
related to increases or decreases in the value of the 
underlying property.\14\ In the case of a typical 5-year 
exchangeable debt instrument, for example, the proposal would 
disallow deductions for fixed conventional market-rate interest 
payments (e.g., 7% per annum), even though the proceeds of the 
borrowing were used for wholly unrelated purposes and the 
relevant growth stock did not serve as collateral for the 
borrowing.
---------------------------------------------------------------------------
    \14\ See the Joint Committee Description at 217.
---------------------------------------------------------------------------
    If the straddle rules are modified, moreover, we think the 
modifications should also deal with rules which currently work 
against taxpayers in an unfair manner. For example, under 
current straddle rules, a small loss can be deferred even 
though larger amounts of gain have been recognized on the 
offsetting position, because there is still some unrecognized 
gain left in the offsetting position (e.g., unrealized gain 
which antedated the straddle). Likewise, losses can be deferred 
to the extent of unrealized offsetting gains, but gains are 
never deferred to the extent of unrealized offsetting losses. 
Partly in recognition of these facts, the Administration last 
year proposed to permit taxpayers to elect to treat straddles 
as hedging transactions and account for the timing of gains and 
losses on a unified basis. The Administration did not include 
this proposal among its proposals for hedging transactions this 
year, however. We think this proposal should be included as 
part of any current plan to change the straddle rules.

        X. The Administration's Corporate Tax Shelter Proposals

    The Administration's FY 2000 budget includes a group of 
proposals which respond to a perceived increase in corporate 
tax shelter transactions. These proposals would introduce a 
variety of penalties for attempting to obtain a ``tax benefit'' 
by entering into a ``tax avoidance transaction.'' A ``tax 
avoidance transaction'' is generally defined to include (a) any 
transaction where the expected pre-tax profit is insignificant 
relative to the expected tax benefit, and (b) certain 
transactions involving ``the improper elimination or 
significant reduction of tax on economic income.'' A tax 
benefit would include any reduction, exclusion, avoidance or 
deferral of tax that was not ``clearly contemplated by the 
applicable provision.''
    The penalties would generally include all of the following: 
(a) automatic disallowance of the relevant tax benefits, 
regardless of what would otherwise be the outcome under current 
law, (b) automatic imposition of a substantial understatement 
penalty, (c) increase in the amount of the understatement 
penalty from 20% to 40%, (d) disallowance of all deductions for 
fees, including underwriting fees, paid to enter into the 
transaction, (e) imposition of a 25% excise tax on such fees, 
(f) imposition of an immediate 25% excise tax on the maximum 
amount which the taxpayer could conceivably collect from 
insurance, gross-up provisions, make-whole provisions or other 
mechanisms designed to compensate the taxpayer for loss of tax 
benefits and associated penalties, and (g) imposition of tax on 
otherwise tax-exempt or foreign persons who invest in, or 
otherwise participate in, the relevant transactions.
    One of the principal tasks of the securities industry is to 
help corporations structure and implement financial 
transactions. SIA recognizes that the Administration is 
concerned about strictly tax-motivated transactions. Such 
transactions must be distinguished, however, from the much 
broader group of financial transactions that are not motivated 
primarily by tax considerations but are legitimately structured 
to minimize their tax consequences. The latter are often novel 
and complex, and the application of existing tax rules to them 
is often a matter of first impression. There are, moreover, 
numerous ``gray areas'' where the application of existing legal 
concepts is not entirely clear. The objective rules that are 
set out in statutes, regulations, case law and other official 
guidance are mostly ``good'' rules that have been carefully 
thought out and work well in most cases. SIA agrees that 
taxpayers should not be allowed to abuse these rules to avoid 
paying tax. The system as we know it will not work, however, if 
taxpayers cannot rely on these rules to determine the tax 
consequences of new financial transactions without fearing that 
their good faith efforts will be second guessed with drastic 
consequences. Moreover, a taxpayer's efforts to structure 
legitimate business transactions in the most tax-advantageous 
manner in light of these rules should not make them or their 
advisors the targets of legislation that is intended to deal 
with corporate tax shelter activity.
    It is not easy (indeed it may be impossible) to define 
``tax avoidance transaction'' in a way which effectively 
catches strictly tax-motivated transactions without catching 
the tax-motivated aspects of legitimate business transactions. 
The Administration's penalty proposals would place enormous 
pressure on this definition, however, by automatically imposing 
severe and redundant penalties on taxpayers purporting to 
derive tax benefits from tax avoidance transactions.
    We note, moreover, that efforts to define ``tax avoidance 
transaction'' using such concepts as whether a transaction 
``improperly eliminates tax on economic income'' or ``creates a 
tax benefit which is not clearly contemplated by the applicable 
provision'' introduces a ``normative'' concept which cannot be 
found in objective rules. The objective rules set out in our 
statutes and regulations are not necessarily economic. For 
example, some rules do not impose tax on economic gains, and 
other rules impose tax on noneconomic gains (e.g., impose tax 
on dividends). There is no ``natural law'' of federal income 
taxation. Thus, no statute or regulation can serve to determine 
whether a taxpayer has used objective rules to ``improperly 
eliminate tax on economic income'' or ``create a tax benefit 
which has not been contemplated by the applicable provision.'' 
That is something which must be decided by individuals.
    It follows that the efficacy of proposals based on such 
definitions must depend on the judgement and discretion of IRS 
agents. The additional steps required to structure a merger, 
acquisition, spinoff or other business transaction to be tax-
free or tax-deferred, rather than fully taxable, can often be 
described as transactions entered into solely to avoid taxes. 
The same can be said of steps undertaken to structure 
financings in the most tax-advantageous manner while still 
addressing various accounting, regulatory, rating agency, 
foreign and domestic law concerns. If IRS agents were to treat 
such additional steps as tax-avoidance transactions, taxpayers 
might be forced to concede disputed technical issues to avoid 
the risk of onerous penalties. In any case, the IRS would have 
to substantially increase its resources to permit it to work 
through a large volume of complex financial transactions, 
analyze the underlying intent of the relevant objective rules 
and do so on a basis that was timely enough to permit business 
to proceed without serious interruption.
      

                                

Statement of Security Capital Group Incorporated, Santa Fe, New Mexico, 
and SC Group Incorporated, El Paso, Texas

    This statement is submitted on behalf of Security Capital 
Group Incorporated of Santa Fe, New Mexico and its subsidiary, 
SC Group Incorporated of El Paso, Texas (collectively 
``Security Capital'') for inclusion in the record of the 
hearings held by the Committee on Ways and Means on March 10, 
1999 concerning the Administration's tax legislative proposals 
for fiscal year 2000. In those proposals, the Administration 
recommended legislation, supported in principle by Security 
Capital, dealing with taxable REIT subsidiaries. The 
Administration also renewed its prior request for legislation 
to prohibit the use of closely-held REITs. This statement is 
directed to the closely-held REIT proposal.
    As described in Treasury's General Explanation of the 
Administration's Revenue Proposals a new requirement would be 
established for REIT status such ``. . . that no person can own 
stock of a REIT possessing more than 50 percent of the total 
combined voting power of all classes of voting stock or more 
than 50 percent of the total value of shares of all classes of 
stock.'' In support of this change, the General Explanation 
states that the Administration ``has become aware of a number 
of tax avoidance transactions involving the use of closely held 
REITs.'' (General explanation at p. 142).
    Security Capital does not disagree with the view that 
Congress should address situations involving the inappropriate 
use of provisions of the Internal Revenue Code for unintended 
purposes. At the same time, however, Security Capital remains 
unconvinced that a broad prohibition on all closely-held REITS 
is necessary to prevent improper tax avoidance. In confronting 
past uses of the REIT structure in ways believed by policy-
makers to be inappropriate, both the Administration (in the 
case of step-down preferred transactions) and Congress 
(liquidating REIT transaction) have taken a targeted approach. 
In Security Capital's view this is the most appropriate way to 
proceed and it seems desirable to take this approach with 
respect to closely-held REITs.
    If, however, Congress does adopt the Administration's 
proposed blanket prohibition on closely-held REITs, it should 
structure the legislation so that it will meet the 
Administration's objective of not ``frustrating the intended 
viability of REITs.'' (General Explanation at p. 142). As 
discussed more fully below, this requires that there be a 
specific exception for so-called ``incubator'' REITs. 
Otherwise, the proposed restriction on closely-held REITs would 
effectively prohibit the use of the REIT structure as the 
vehicle to enter a new market or new line of real estate and 
build the business from the ground up, culminating in a ``going 
public'' transaction. Such effects would, in Security Capital's 
view, frustrate ``the intended viability of REITs.''

                     Importance of Incubator REITs

    There are numerous examples of publicly-held REITs that 
were, when first formed, closely-held REITs. Among the REITs 
which started as so-called ``incubator'' REITs are Security 
Capital's industrial distribution REIT (the nation's largest), 
and a portion of its multi-family housing REIT (the nation's 
second largest). ``Incubator'' REITs which have developed into 
widely-held REITs have created jobs and opportunities for 
thousands of Americans, and through the taxes paid on the 
dividends they issue to shareholders, have resulted in 
additional revenues to the Treasury. For example, the 
development of ``incubator'' REITs has been a major factor in 
the growth at our client's El Paso facility from 12 to 536 
employees.
    ``Incubator'' REITs are formed with the specific 
expectation that they will become public after an appropriate 
``incubation'' period. In most cases, the specific intent to 
``go public'' has been evident from the outset in, for example, 
the REIT's financing documents. This period normally takes at 
least three years (perhaps a year or two longer in some cases 
depending on market conditions). During this incubation period, 
the REIT assembles a staff, raises initial interim capital to 
finance the acquisition of a portfolio of properties, operates 
the acquired properties and otherwise develops the type of 
``track record'' necessary for a successful ``going public'' 
transaction.
    Security Capital believes that ``incubator'' REITs have 
been an important component in the industry's ability to 
fulfill the goals set forth by Congress when it created the 
REIT structure. They are the building blocks upon which 
successful, widely-held REITs have been built, enabling small 
investors to participate in large scale, income producing real 
estate and allowing the capital of many to be united into a 
single economic enterprise.

           Why ``Incubation'' Requires Use of a REIT Vehicle

    Use of a closely-held REIT (as opposed to a ``C'' 
corporation or partnership) during the incubation period is 
necessary if the ``incubator'' is to develop into a widely-held 
public REIT. Some have questioned whether this necessity is 
limited to the intangible benefit of increasing the likelihood 
of favorable reviews from one or more investment analysts at 
the time of the ``going public'' transaction. Security Capital 
questions whether any such market perceptions about the 
desirability of use of the REIT structure from outset can be 
prudently ignored by those who seek access to the public 
capital markets. Nevertheless, even if such perceptions did not 
exist, there would remain other important and substantive 
considerations that, in Security Capital's view, make use of a 
closely-held REIT during the incubation period highly important 
from a non-tax standpoint.
    Use of a ``C'' corporation during the incubation period 
would place the entity at a competitive disadvantage. A key 
activity during the incubation period is the solicitation of 
initial capital from third parties in order to finance the 
acquisition of the portfolio of properties that will form the 
basis for the ``going public'' transaction. The third party 
providers of such initial capital demand returns that are 
commensurate with those obtainable from other similar 
investments in real estate (i.e., significant current dividends 
such as those paid by REITs). In those limited instances where 
``C'' corporations are used with respect to real estate, 
investors typically receive far more modest dividends and the 
emphasis is on long term appreciation in value. The incremental 
cost of providing REIT-level current returns through dividends 
in a ``C'' corporation structure obviously would be quite 
significant and this added cost would in turn limit the ability 
of the entity to compete for property during the incubation 
period. We estimate that this disadvantage is equal to 
approximately 160 basis points on property yields.
    Use of a partnership during the incubation period would 
likewise be detrimental from a business point of view. First 
and foremost, there are some investors who will not invest in 
partnerships due to illiquidity concerns and historical abuses. 
By foreclosing the REIT vehicle, these incubator companies will 
further be at a competitive disadvantage. Additionally, a 
partnership creates significant administrative burdens and 
builds in detrimental conflicts of interest. Following the 
``going public'' transaction, the REIT would be required to use 
a carryover basis for any properties carried on the 
partnership's books at historic cost. Where, as is often the 
case, historic cost differs from current value, there could 
undoubtedly be conflicts of interest between the initial 
providers of capital and the new public investors on matters 
such as the selection of properties to hold or to sell. In 
addition, in some cases, public shareholders could experience 
an immediate dilution attributable to the combination of 
carryover basis and the fixed minority ownership percentage of 
the original partners. Finally, as in the case of a ``C'' 
corporation, multiple sets of records would be required to 
account for the entity as a ``C'' corporation or partnership 
for tax purposes and to establish a track record of REIT 
qualification and performance.
    As discussed below, Security Capital believes that an 
appropriate incubator REIT exception can be structured with 
sufficient safeguards to prevent use of qualifying incubator 
REITs for the type of tax avoidance transactions that prompted 
the Treasury to propose the closely-held REIT prohibition in 
the first instance.

               Key Components of Incubator REIT Exception

    In Security Capital's view, a bona fide incubator REIT 
possesses a series of characteristics that should form the 
basis of an exception from any general prohibition on closely-
held REITs. First, an incubator REIT typically receives at 
least some of its initial capital from unrelated investors. In 
contrast, closely-held REITs of the type with which Treasury 
apparently is concerned are typically held almost exclusively 
by one party or a group of related parties. Second, an 
incubator REIT typically increases its real estate holdings 
through acquisition and/or development by some amount 
progressively over the incubation period. In contrast, a 
closely-held REIT frequently has a static portfolio of assets. 
Third, an incubator REIT typically operates its real estate 
assets directly, whereas closely-held REITs formed by non-real 
estate businesses generally do not engage in such operational 
activities. Fourth, incubator REITs from the outset typically 
take actions (e.g., securing audited financial statements) that 
will be required following the ``going public'' transaction. 
Finally, an incubator REIT typically documents a specific 
intent to engage in a ``going public'' transaction and such 
expressions of specific intent appear in private placement 
memoranda, loan memoranda and similar documents.
    If Congress views these five distinguishing characteristics 
of bona fide incubator REITs as insufficient in and of 
themselves to permit structuring an exemption with adequate 
assurance against tax avoidance transactions, one or more 
additional requirements could be imposed to limit any perceived 
potential for abuse. For example, the time period for which 
incubator REIT status would be available could be limited to a 
stated number of years. If a ``going public'' transaction had 
not been completed by the end of the stated period, REIT status 
would thereafter be lost. To accommodate market conditions, 
however, the initial incubation period could be extended for an 
additional period, such as 24 months, but all tax benefits 
attributable to such extended period would be subject to 
recapture (with interest) unless a ``going public'' transaction 
was in fact consummated during that additional period. There is 
precedent for such a recapture regime (e.g., sections 1291-1297 
of the Internal Revenue Code relating to passive foreign 
investment companies) and it could be buttressed with an 
appropriate transferee liability rule.
    In addition, during the incubation period, the REIT could 
have only a single class of stock. Security Capital understands 
that many of the tax avoidance transactions with which Treasury 
is concerned either require or would be facilitated by more 
complex capital structures. These complex structures are not 
integral to the incubator REIT process and Security Capital 
sees no objection to prohibiting them as part of a properly 
crafted exemption.
    Security Capital looks forward to continuing to work 
constructively with the Administration and Congress in 
connection with the development of legislation to enable REITs 
to continue effectively to serve their important economic 
functions.
      

                                

Statement of Stock Company Information Group

    This testimony is submitted on behalf of the members of the 
Stock Company Information Group who are listed on the last page 
hereof. The Stock Information Group was formed in 1981 to 
address Federal legislative and regulatory issues affecting the 
stock life insurance companies and to participate in the 
development of a revised income tax structure for life 
insurance companies. We thank the Committee for the opportunity 
to comment on the Administration's proposal relating to 
policyholders surplus accounts.
    While the Stock Information Group believes that each of the 
Administration's proposals relating to the taxation of life 
insurance companies and their products should be rejected as 
lacking in merit, this statement is limited to the proposal to 
take into income over ten years amounts represented by pre-1984 
``policyholders surplus accounts'' as described in Internal 
Revenue Code section 815.

                               Background

    The history of taxing life insurance companies reflects a 
struggle to reach what, at any given point in time, is viewed 
as the proper measure of a life insurance company's taxable 
income and the proper rate at which to tax that income. Prior 
to 1959, life insurance companies were taxed only on their 
investment income. Their underwriting (i.e., premium) income 
was not taxed, and underwriting expenses were not deductible.
    In 1959, Congress changed the tax framework for life 
insurance companies in an effort to tax life insurance company 
income more accurately. The new tax structure sought to tax the 
life insurance industry on a broader, more comprehensive 
measure of income, considering not only investment income, but 
also underwriting income. Under this structure, all life 
insurance companies paid tax on investment income that was not 
set aside for policyholders. In addition, life insurance 
companies paid tax on one-half of their underwriting income.
    Under the provisions of section 815 of the Internal Revenue 
Code, the other half of underwriting income for stock life 
insurance companies was not generally to be taxed unless 
distributed to shareholders of the life insurance company. 
Income that was not to be taxed unless distributed to 
shareholders was treated as part of a ``policyholders surplus 
account'' or ``PSA.'' Mutual life insurance companies were not 
required to establish policyholders surplus accounts because 
they generally distributed the underwriting component of their 
income back to policyholders in the form of deductible 
dividends. In this manner, the 1959 tax structure sought to tax 
the proper amount of a life insurance company's income, 
irrespective of whether the company was a stock or a mutual.
    In 1984, Congress again revised the income tax rules for 
life insurance companies. Once again, Congress focused its 
effort in seeking a clearer reflection of income. Dividend 
deductions for mutual life insurers were limited. Additions to 
the policyholders surplus accounts of stock companies were 
discontinued, but existing accounts were not subjected to tax.
    Congress recognized that this broader tax base would result 
in too great a tax burden on life insurance companies if they 
were taxed at the generally applicable corporate tax rate. 
Thus, Congress decided to include a provision which would have 
the effect of reducing the corporate tax rate from 46 percent 
to 36.8 percent for life insurance companies. When the general 
corporate rate was reduced to 34 percent in 1986, the special 
provision for life insurance companies was considered no longer 
necessary and was repealed.

                                 Issue

    What is at issue today is whether life insurance companies 
with historical policyholders surplus accounts should be 
subjected to an additional retroactive tax burden in 1999. In 
1984, when Congress chose to deny further additions to 
policyholders surplus accounts, it explicitly decided not to 
subject these accounts to tax unless one of the specific events 
described in the statute (principally dissolution of the 
company) occurred. Due to the structure of prior law, if these 
accounts had been subjected to tax, the new law would have 
increased the taxes of one portion of the life insurance 
industry, a result that Congress believed was unfair.
    What is just as important, however, in the context of 
today's issue, is that Congress did not believe that taxing 
these accounts was necessary in order to properly measure 
taxable income. In 1984, Congress knew that very little tax was 
paid, or would be paid, with respect to these ``old'' 
policyholders surplus accounts. Congress' action in 1984 
reflected a recognition that these historical accounts served, 
in their time, as an appropriate mechanism for computing the 
taxable income of one segment of the life insurance industry. 
Under that 1959 tax structure, taxable income was computed, and 
the tax was paid. Congress saw no need or reason in 1984 to 
increase ``artificially'' the taxable income of companies with 
policyholders surplus accounts.

   Why the Administration's Proposal to Trigger Tax on Policyholders 
                  Surplus Accounts Should Be Rejected

    What was true in 1984 is just as true today: Companies with 
policyholders surplus accounts have already paid their fair 
share of taxes under the tax provisions that applied to them at 
the time. To tax these accounts today would unfairly impose a 
retroactive tax on business conducted well over fifteen years 
ago.
    The proposal does not close a loophole. It does not repeal 
an unintended tax benefit. Congress explicitly provided that, 
with certain minor exceptions, there would be no tax on 
policyholders surplus accounts absent distribution to 
shareholders. The Administration's proposal is simply a 
retroactive tax increase totaling more than $1 billion over 
five years (and twice that amount over ten years) on the 
approximately 600 life insurance companies which have 
policyholders surplus accounts.
    The life insurance industry already pays Federal income 
taxes at a significantly higher rate than corporations in other 
industries. According to a recent Coopers & Lybrand study, the 
average effective tax rate for life insurance companies in the 
period from 1986 to 1995 was 31.9 percent. This compares to a 
rate of 25.3 percent for all U.S. corporations. From 1991 to 
1995, the average effective rate for life insurance companies 
was 37.1 percent. It would be unfair to add to this already 
extraordinarily high rate by imposing a surtax in the form of a 
tax on policyholders surplus accounts.
    In addition to the economic consequences of such a large 
tax increase, there would also be significant financial 
statement consequences. If the Administration's proposal were 
enacted, the 600 affected companies would be required under 
Generally Accepted Accounting Principles (``GAAP'') to reduce 
their earnings reported to shareholders for the full amount of 
the tax liability in the year of enactment. This negative 
impact on earnings would result even if, as the Administration 
proposes, the tax is paid over ten years.
    The Treasury Department description wrongly suggests that 
the policyholders surplus accounts concern old life insurance 
contracts which are no longer in existence and, as a result, 
the policyholder surplus accounts are somehow unnecessary 
today. This argument disregards the intention of Congress as 
expressed in section 815. Congress very explicitly stated the 
circumstances under which tax might be triggered. Determination 
of tax liability in no way is dependent upon the existence or 
termination of any particular contracts.
    The Administration's proposal to tax policyholders surplus 
accounts implies that there exists an actual account or reserve 
fund from which the tax would be paid. This is not the case. 
The proposal is simply a surtax on certain life insurance 
companies, but payable out of current earnings and calculated 
by reference to premium income received over the years 1959 
through 1983.
    It is important to understand that the PSA is merely a tax 
memo account and has no meaning for any other purpose. Life 
insurance companies do not carry the PSA on any books and 
records other than those required for the federal income tax 
return, and there is no fund or segregated group of assets 
supporting the PSA.
    In fact, the only financial reporting of the PSA under GAAP 
would be a note to the consolidated financial statements that 
the insurance companies have not accrued for any taxes 
associated with the PSA. In other words, the only evidence of 
the PSA in either GAAP or insurance regulatory financials is a 
note in the GAAP financials that the PSA exists for tax 
purposes but that the tax liability is never expected to become 
due.
    This GAAP treatment originated in 1972, when, the 
predecessor of the Financial Accounting Standards Board issued 
an opinion, APB 23, on the appropriate accounting treatment of 
amounts deferred under section 815 which stated, in part, as 
follows:

          The Board concludes that a difference between taxable income 
        and pretax accounting income attributable to amounts designated 
        as policyholders' surplus of a stock life insurance company may 
        not reverse until indefinite future periods or may never 
        reverse. The insurance company controls the events that create 
        the tax consequences and the company is generally required to 
        take specific action before the initial difference reverses. 
        Therefore, a stock life insurance company should not accrue 
        income taxes on the difference between taxable income and pre-
        tax accounting income attributable to amounts designated as 
        policyholders' surplus.

    The conclusion of APB 23, as it concerns policyholders 
surplus accounts, was carried over in FAS 60, and, most 
importantly, the treatment was preserved in FAS 109 which 
currently governs financial accounting presentation of income 
taxes. Adopted in 1992, FAS 109 repudiated the APB 23 premise 
that taxes did not have to be accrued if they would be paid 
only in the indefinite future, but retained nonaccrual for only 
four items covered under APB 23, one of which was the PSA, and 
stated that a tax accrual would be required only if it became 
apparent that the tax would become payable in the foreseeable 
future. Thus, the accounting community recognized that neither 
the companies nor the government expected that the tax on the 
PSA would become due or payable.
    Similarly, for state regulatory purposes, there has never 
been a requirement for the establishment of a liability, or an 
apportionment of surplus, for potential tax liability in 
connection with PSA's. In fact, there is no requirement that 
any potential liability be disclosed. State insurance 
departments would not regulate an insurance company any 
differently if it had no potential PSA tax liability or a 
billion dollar potential tax liability. This is simply because 
there is no expectation that this tax will ever be due.
    Thus, there is no ``fund,'' ``reserve,'' ``provision'' or 
any other type of liability or allocation of assets on a life 
insurance company's statutory or GAAP financial statements to 
pay this proposed tax. Any additional tax imposed would reduce 
a company's current earnings in the year in which the 
legislation is enacted and ultimately would reduce the 
company's capital and surplus.

                               Conclusion

    The Administration's proposal is simply a very large 
retroactive tax increase relating to business transactions 
which occurred over fifteen years ago. The proposal should be 
rejected.

                    STOCK COMPANY INFORMATION GROUP

                     Phase III Tax Member Companies

AEGON, USA
AETNA INC
ALLSTATE LIFE INSURANCE COMPANY
AMERICAN GENERAL CORPORATION
CIGNA CORPORATION
CONSECO
GE LIFE AND ANNUITY ASSURANCE COMPANY
HARTFORD LIFE INSURANCE COMPANIES
IDS LIFE INSURANCE COMPANY
ING NORTH AMERICA INSURANCE CORPORATION
JEFFERSON-PILOT CORPORATION
LINCOLN NATIONAL CORPORATION
MIDLAND NATIONAL
RELIASTAR LIFE INSURANCE COMPANY
TRANSAMERICA OCCIDENTAL LIFE INSURANCE COMPANY
TRAVELERS INSURANCE COMPANIES
ZURICH KEMPER LIFE INSURANCE COMPANIES
      

                                

Statement of Tax Council

    MR. CHAIRMAN AND MEMBERS OF THE COMMITTEE:
    The Tax Council is pleased to present its views on the 
administration's budget proposals and their impact on the 
national economy and international competitiveness of U.S. 
businesses and workers. The Tax Council is an association of 
senior level tax professionals representing over one hundred of 
the largest corporations and business in the United States, 
including companies involved in manufacturing, mining, energy, 
electronics, transportation, public utilities, consumer 
products and services, retailing, accounting, banking, and 
insurance. We are a nonprofit organization that has been active 
since 1967. We are one of the few professional organizations 
that focus exclusively on federal tax policy issues for 
businesses, including sound federal tax policies that encourage 
both capital formation and capital preservation in order to 
increase the real productivity of the nation.
    The Tax Council applauds the House Ways & Means Committee 
for scheduling these hearings on the administration's budget 
proposals involving taxes. We do not disagree with all of these 
proposals. For example, we support (1) extending the tax credit 
for research, (2) accelerating the effective date of the rules 
regarding look-through treatment for dividends received from 
``10/50 Companies,'' and (3) making permanent the ability to 
currently deduct certain environmental expenditures. These 
provisions will go a long way toward improving the overall 
economy and the competitive position of U.S. multinational 
companies. However, in devising many of its other tax 
proposals, the administration has replaced sound tax policy 
with a shortsighted call for more revenue.
    Many of the revenue raisers found in the latest Budget 
proposals introduced by the administration lack a sound policy 
foundation. Although they may be successful in raising revenue, 
they do nothing to achieve the objective of retaining U.S. jobs 
and making the U.S. economy stronger. For example, provisions 
are found in the Budget to (1) extend Superfund taxes without 
attempting to improve the cleanup programs, (2) repeal the use 
of ``lower of cost or market'' inventory accounting, (3) 
arbitrarily change the sourcing of income rules on export sales 
by U.S. based manufacturers, (4) impose overly broad rules and 
draconian penalties on so-called ``corporate tax shelters'' 
giving unprecedented power to the IRS to disallow legitimate 
tax planning, (5) inequitably limit the ability of so-called 
``dual capacity taxpayers'' (i.e., multinationals engaged in 
vital petroleum exploration and production overseas) to take 
credit for certain taxes paid to foreign countries, and (6) 
restrict taxpayers from having the ability to mark-to-market 
certain customer trade receivables.
    In its efforts to balance the budget, the administration is 
unwise to target publicly held U.S. multinationals doing 
business overseas, and the Tax Council urges that such 
proposals be seriously reconsidered. The predominant reason 
that businesses establish foreign operations is to serve local 
overseas markets so they are able to compete more efficiently. 
Investments abroad provide a platform for the growth of exports 
and indirectly create jobs in the U.S., along with improving 
the U.S. balance of payments. The creditability of foreign 
income taxes has existed in the Internal Revenue Code for over 
70 years as a way to help alleviate the double taxation of 
foreign income. Replacing such credits with less valuable 
deductions will greatly increase the costs of doing business 
overseas, resulting in a competitive disadvantage to U.S. 
multinationals versus foreign-based companies.
    In order that U.S. companies can better compete with 
foreign-based multinationals, the administration should instead 
do all it can to make the U.S. tax code more friendly and 
consistent with the administration's more enlightened trade 
policy. Rather than proposing provisions that reward some 
industries and penalizes others, the administration's budget 
should be written with the goal of reintegrating sounder tax 
policy into decisions about the revenue needs of the 
government. Provisions that merely increase business taxes by 
eliminating legitimate business deductions should be avoided. 
Ordinary and necessary business expenses are integral to our 
current income based system, and arbitrarily denying a 
deduction for such expenses will only distort that system. 
Higher business taxes impact all Americans, directly or 
indirectly. For example, they result in higher prices for goods 
and services, stagnant or lower wages paid to employees in 
those businesses, and smaller returns to shareholders. Those 
shareholders may be the company's employees, or the pension 
plans of other middle class workers.
    Corporate tax incentives like the research tax credit have 
allowed companies to remain strong economic engines for our 
country, and have enabled them to fill even larger roles in the 
health and well being of their employees. For these reasons, 
sound and justifiable tax policy should be paramount when 
deciding on taxation of business--not mere revenue needs.

                         POSITIVE TAX PROPOSALS

    The administration's budget includes several tax provisions 
that would have a positive impact on the economy. We believe 
Congress should adopt these proposals, and in some cases (such 
as the research and experimentation tax credit), should go 
further than the administration has proposed.
    Extend the Research and Experimentation Tax Credit.--The 
administration's proposal to extend the research tax credit for 
another year is laudable. The credit, which applies to amounts 
of qualified research in excess of a company's base amount, has 
served to promote research that otherwise may never have 
occurred. The buildup of ``knowledge capital'' is absolutely 
essential to enhance the competitive position of the U.S. in 
international markets--especially in what some refer to as the 
``Information Age.'' Encouraging private sector research work 
through a tax credit has the decided advantage of keeping the 
government out of the business of picking specific winners or 
losers in providing direct research incentives. The Tax Council 
recommends the administration and Congress work together to 
make the research tax credit a permanent fixture of the tax 
code so that companies can rely on it when planning future 
additions to their research budgets.
    Make Permanent the Expensing of Brownfields Remediation 
Costs.--The administration's proposal to make permanent the 
current deductibility of costs for so-called ``brownfields'' 
remediation under Code section 198 is a welcome extension of a 
change contained in the 1997 Taxpayer Act, which allowed 
certain remediation costs incurred with qualified contaminated 
sites (so-called ``brownfields'') to be currently deductible as 
long as they are incurred by December 31, 2000. Extension of 
this treatment on a permanent basis removes any doubts among 
taxpayers as to the future deductibility of these expenditures 
and promotes the goal of encouraging environmental remediation.
    Simplify the Foreign Tax Credit Limitation for Dividends 
from 10/50 Companies.--The administration is commended for its 
proposal to accelerate the effective date of a tax change made 
in the 1997 Tax Relief Act affecting foreign joint ventures 
owned between 10 percent and 50 percent by U.S. parents (so-
called ``10/50 companies''). This change will allow 10/50 
companies to be treated just like controlled foreign 
corporations by allowing ``look-through'' treatment for foreign 
tax credit purposes for dividends from such joint ventures. The 
1997 Act did not make the change effective for such dividends 
unless they were received after the year 2003 and, even then, 
required two sets of rules to apply for dividends from earnings 
and profits (``E&P'') generated before the year 2003, and 
dividends from E&P accumulated after the year 2002. The 
administration's proposal instead would apply the look-through 
rules to all dividends received in tax years after 1998, no 
matter when the E&P constituting the makeup of the dividend 
were accumulated.
    This change would result in a tremendous reduction in 
complexity and compliance burdens for U.S. multinationals doing 
business overseas through foreign joint ventures. It also would 
reduce the competitive bias against U.S. participation in such 
ventures by placing U.S. companies on a much more level playing 
field from a corporate tax standpoint. This proposal epitomizes 
the favored policy goal of simplicity in the tax laws, and 
would go a long way toward helping the U.S. economy by 
strengthening the competitive position of U.S.-based 
multinationals.
    Extend Carryback Period for NOLs of Steel Companies.--The 
administration's proposal to extend the carryback period for 
net operating losses (``NOLs'') of steel companies from two to 
five years is both fair and equitable due to the financial 
troubles that many steel companies are experiencing. The 
benefit provided by this longer carryback period would feed 
directly into a financially troubled steel company's cash flow, 
providing immediate and necessary relief. Our only suggestion 
is that this longer carryback period be extended to other 
troubled industries, such as the petroleum, chemical, and 
aerospace industries, to name a few.
    Simplify the Active Trade or Business Requirement for Tax-
Free Spin-Offs.--Affiliated groups that utilize a holding 
company structure often must undertake a series of internal 
restructurings in order to satisfy the active trade or business 
best of section 355(b)(2) before a corporate subsidiary may be 
spun off to shareholders. These preliminary restructurings can 
be extremely costly and serve no purpose other than to satisfy 
the literal language of the current active business test. The 
administration has proposed to simplify the application of the 
active business test by applying it on an affiliated group 
basis. This proposal would eliminate the pointless and costly 
restructurings now required and represents real tax 
simplification.
    Subpart F Active Financing Income.--We also urge the 
Congress to support a reinstatement and extension of the 
deferral of U.S. tax on the active financing income of foreign 
subsidiaries. Such an extension is vital to providing stability 
in the tax rules and allowing U.S. owned financial service 
businesses to compete effectively against their foreign 
competitors.

                 PROVISIONS THAT SHOULD BE RECONSIDERED

    The Tax Council offers the following comments on certain 
specific tax increase proposals set forth in the 
administration's budget:

``Corporate Tax Shelters'' v. Legitimate Corporate Tax Planning

    The administration's sweeping attack on corporate tax 
planning is alarming and unwarranted. The administration's 
decision to seek a harsh new penalty regime and to impose 
Treasury and Internal Revenue Service judgements on taxpayers 
is disturbing. Use of a politically unpopular label such as 
``corporate tax shelters'' does not justify the 
administration's attempt to intimidate taxpayers engaged in 
legitimate tax planning which might run afoul of the new tax 
shelter definition to be promulgated by Treasury.
    The administration's proposals to address what it labels as 
tax avoidance transactions are overly broad and would bring 
within their net many corporate transactions that are clearly 
permitted under existing law. Legitimate tax planning to 
conform to domestic and foreign non-tax legal or regulatory 
requirements could well be subject now to confiscatory 
penalties for failure to satisfy these overly broad standards.
    Is Strict Liability the Right Rule?.--The administration 
wants to impose strict liability in the form of a confiscatory 
40-percent penalty on taxpayers who enter into transactions 
that IRS agents find uneconomic. That the taxpayer acted 
reasonably and in good faith or had a substantial business 
purpose for the transaction would not matter. This is simply 
the wrong standard. Business transactions and the tax laws that 
apply to them are complex. Taxpayers and the government 
inevitably will disagree. IRS agents should be encouraged to 
seek the correct amount of any tax payment. Taxpayers should be 
allowed to assert their views as freely as IRS agents.
    Do We Need More Rules?.--Since 1982, the Internal Revenue 
Code has been littered with penalties, disclosures, 
confiscatory rates of interest, and endless amounts of 
reporting. More than 75 sections of tax laws enacted since 1982 
directly address corporate compliance from a penalty or 
procedural perspective. Today, if a corporate taxpayer enters 
into a transaction it believes is less-likely-than-not to 
result in the claimed tax benefits, that taxpayer faces 
substantial exposure on examination. The resulting deficiency 
could carry a 20 percent understatement penalty. Both the 
deficiency and the penalty would accrue interest at penalty 
rates. An advisor selling the transaction could be subject to 
registration, promoter and aiding and abetting penalties, and 
discovery by other clients. Isn't this enough?
    The administration's tax policy in this area is, at best, 
unclear. The administration complains tax shelters are 
ubiquitous in the corporate community, yet while large segments 
of American business have been abandoning the corporate form 
and moving to partnerships, limited liability companies, and S 
corporations, corporate tax revenues continue to grow.
    These Proposals Would Cause Uncertainty.--The 
administration proposes five new rules built from a new 
concept: the tax avoidance transaction. A tax avoidance 
transaction is defined as one in which the reasonably expected 
pre-tax profit of the transaction (on a present value basis) is 
insignificant relative to the reasonably expected net tax 
benefits of the transaction (on a present value basis). A 
transaction also is deemed to be a tax avoidance transaction if 
it involves improper elimination or reduction of tax on 
economic income. In turn, a corporate tax shelter is defined as 
any entity, plan, or arrangement in which a direct or indirect 
corporate participant attempts to obtain a tax benefit in a tax 
avoidance transaction.
    This seemingly bright-line definition of a tax avoidance 
transaction is simply an invitation to an entirely new realm of 
ambiguity. Disputes would emerge over the general rules for 
measurement of profits; the treatment of non-deductible 
expenses and tax-free income; the reasonableness of 
expectations, discount rates, forecasting parameters; the 
allocation of general and administrative costs; the choice of 
applicable tax rates; assumptions about the state of the tax 
law; and dozens of other issues. As every member of the two 
congressional tax-writing committees knows from dealing with 
revenue estimates, it is much easier to know that an idea makes 
sense than to estimate its economic consequences with 
precision.
    One bad answer to all of these questions is the probable 
Treasury response: We will tell you in regulations. No 
regulation adequately could resolve the issues raised by these 
new concepts. Taxpayers would be left with the choice of doing 
things the IRS way or risking a no-fault penalty.
    To function efficiently and productively, business 
taxpayers must be able to depend on the rule of law. That means 
relying on the tax code and existing income tax regulations. If 
the administration's vague ``tax shelter'' proposals become 
law, few businesses would feel comfortable relying on those 
statutes or regulations. The administration's proposed rules 
could cost the economy more in lost business activity than they 
produce in taxing previously ``sheltered'' income.

The Tax Council Opposes Proposed Restrictions on Corporate Tax 
Planning

    First, the provision imposing a 20-percent strict liability 
penalty on any underpayment associated with a tax avoidance 
transaction is wrong. Taxpayers should have the freedom to take 
reasoned, reasonable, and supportable positions on their tax 
returns. Increasing the penalty to 40 percent if the taxpayer 
failed to report its participation in the transaction within 30 
days of entering into it is simply setting a trap for ordinary 
businesses. Tax lawyers and accountants are not at every 
business meeting ready to file reports to the IRS.
    Second, Treasury's request for blanket regulatory authority 
to extend section 269 to disallow any deduction, credit, 
exclusion, or other allowance obtained in a tax avoidance 
transaction is nothing more or less than a request that the 
Congress turn over a substantial portion of its tax-writing 
responsibilities to un-elected executive branch officials.
    Third, the administration wants Congress to deny corporate 
taxpayers any deduction for fees paid in connection with the 
purchase or implementation of a tax avoidance transaction or 
for related tax advice. Advisors also would be subject to a 25 
percent excise tax on such fees, a provision that raises a host 
of procedural issues stemming from the fact that advisors are 
not party to audits or litigation that result in the 25-percent 
tax (e.g., would a separate proceeding be required before 
imposition of the tax, or would an advisor be required or 
permitted to intervene in an audit or litigation?). Corporate 
tax directors and their outside advisors are not criminals. By 
denying a deduction and imposing an excise tax, this proposal 
would provide harsher treatment under the tax code for 
legitimate tax-planning activity than that applicable to 
illegal bribes, kickbacks, penalties for violations of the law, 
and expenditures in connection with the illegal sale of drugs.
    Fourth, purchasers of a corporate tax shelter who also 
acquire a full or partial guarantee of the projected benefits 
would be subject to an excise tax equal to 25 percent of the 
benefits that were guaranteed. Congress ought to stay out of 
the private marketplace. In truth, insurance of a tax result is 
merely the expression of an advisor's opinion that the 
transaction and its tax consequences are based on a correct 
interpretation of the law.
    Fifth, the proposals would tax otherwise tax-exempt 
entities when they are parties to a corporate taxpayer's tax 
avoidance transaction. The law is already filled with rules to 
prevent arbitrage with exempt entities. Taxing hospitals, 
universities, and pension funds because some IRS agent found a 
tax shelter on the other side of one of their transactions is 
not a solution to any problems that may exist. The proposal 
targets exempt organizations, Native American tribal 
organizations, foreign persons, and domestic corporations with 
expiring net operating losses. The corporate parties would be 
jointly and severally liable for this tax if unpaid by the 
exempt taxpayer. In the case of a foreign person properly 
claiming the benefit of a treaty, or a Native American tribal 
organization, the tax on the income allocable to such persons 
in all cases would be collected from the corporate parties.
    An additional provision would preclude taxpayers from 
taking tax positions inconsistent with the form of their 
transactions if a tax-indifferent party was involved in the 
transaction. A taxpayer could take an inconsistent position by 
disclosing the inconsistency. In effect, the rule is a 
reporting requirement masquerading as a deduction limitation.
    The administration also proposes to make any tax deficiency 
greater than $10 million ``substantial'' for purpose of the tax 
code's substantial understatement penalty, rather than applying 
the existing test that such tax deficiency must exceed 10 
percent of the taxpayer's liability for the year. There is 
absolutely no basis for the administration's assertion that 
large corporate taxpayers are ``playing the audit lottery'' 
because of the purportedly high threshold amount at which the 
substantial understatement penalty applies. A $10 million tax 
saving is the result of a $28 million deduction. Large 
corporations are subject to annual and continuous IRS audits by 
teams of IRS agents. Such a transaction is not entered into in 
the belief that the coordinated examination team will miss it.

Financial Products

    Modify Rules for Debt-Financed Portfolio Stock.--The 
administration's proposal modifying the rules for debt-financed 
portfolio stock effectively would reduce the dividends-received 
deduction (DRD) for any corporation carrying debt--virtually 
all corporations--but would specifically target financial 
services companies, which tend to be more debt-financed. The 
Tax Council vigorously opposes this proposal as it has in the 
past opposed more straightforward proposed reductions in the 
DRD.
    The purpose of the DRD is to eliminate or at least 
alleviate the impact of potential multiple layers of corporate 
tax. Under current law, the DRD is not permitted to the extent 
that relevant portfolio stock is debt financed. The 
administration's proposal would expand the DRD disallowance 
rule of current law for debt financed stock by assuming that 
all the debt of the corporation is allocated to the company's 
assets on a pro-rata basis. The proposal would therefore 
partially disallow the DRD for all corporations based on a pro-
rata allocation of corporate debt.
    The proposal would exacerbate the multiple taxation of 
corporate income, penalize investment, and mark a retreat from 
efforts to develop a more fair, rational, and simple tax 
system. Just as troubling is the notion that the DRD should be 
dramatically reduced for companies that are highly-leveraged. 
The proposal is particularly problematic for the securities 
industry, which maintains large quantities of equity 
investments in the ordinary course of its business operations. 
The Tax Council believes that, if anything, the multiple 
taxation of corporate earnings should be reduced rather than 
expanded, and that the administration's proposal clearly moves 
in the wrong direction.
    Defer Interest Deduction and Original Issue Discount (OID) 
on Certain Convertible Debt.--The administration also proposes 
to defer deductions for interest accrued on convertible debt 
instruments with original issue discount (``OID'') until 
interest is paid in cash. These hybrid instruments and 
convertible OID bond instruments have allowed many U.S. 
companies to raise tens of billions of dollars of investment 
capital. The Tax Council opposes this proposal because it is 
contrary to the sound tax policy that matches accrual of 
interest income by holders of OID instruments with the ability 
of issuers to deduct accrued interest.
    Moreover, the instruments in question are truly debt rather 
than equity. Recent statistics show that more than 70 percent 
of all zero-coupon convertible debt instruments were retired 
with cash, while only 30 percent of these instruments were 
convertible to common stock. Re-characterizing these 
instruments as equity for tax purposes is fundamentally 
incorrect and would put American companies at a distinct 
disadvantage to their foreign competitors, which are not bound 
by such restrictions. Any abuse that the administration intends 
to abate should be targeted more narrowly.

Corporate Provisions

    Require Accrual of Time Value Element on Forward Sale of 
Corporate Stock.--The proposal would require a corporation that 
enters into a forward contract for the sale of its own stock to 
treat a portion of the payment received as taxable interest 
income. This proposal would create a discontinuity in the tax 
treatment between a forward sale of stock and an issuance in 
the future of stock for the same price on the same date as the 
settlement date. There is no apparent policy rationale for the 
proposal (e.g., there is not conversion of ordinary income to 
capital gain by virtue of a corporation entering into a forward 
contract to sell its own stock). Similarly, there is no 
economic gain to a corporation or its existing shareholders 
where the fair market value on the settlement date equals the 
contract price under the forward contract. For these reasons, 
Congress should reject this proposal.
    Conform Control Test for Tax-Free Incorporations, 
Distributions, and Reorganizations.--The administration has 
proposed yet another corporate tax increase in the form of a 
proposal to alter the definition of ``control,'' for purposes 
of determining the tax-free status of certain corporate 
reorganizations or restructurings. The proposal would 
substitute an ``80-percent-by-vote-and-value'' test for the 
current law test that looks to whether a corporate parent holds 
80 percent of the voting stock and 80 percent of non-voting 
stock in a subsidiary.
    The test of ``control'' is itself arbitrary, and there is 
little in the way of tax policy that argues for drawing the 
line by reference to vote and/or value. There is a concern, 
however, that the proposed amendment to the definition of 
``control'' will unfairly penalize taxpayers, particularly 
where the amended definition would have a retroactive and 
(perhaps unintended) collateral impact on the ability of 
taxpayers to comply with other conditions to obtaining tax-free 
organization status. This might occur, for example, where a 
taxpayer would be prevented from coming into compliance with 
the new test due to the treatment in section 355(b)(2)(D) 
(which would prevent a spin-off from qualifying for tax-free 
treatment for five years from the date on which stock necessary 
to meet the new control test was purchased).
    At a minimum, the administration's proposal should be 
targeted to deal with alleged ``abuses,'' while allowing the 
other taxpayers adequate time to come into compliance with such 
a sweeping change in tax policy.
    Tax Issuance of Tracking Stock.--Tracking stock is an 
economic interest that is intended to relate to, and track the 
economic performance of, one or more separate assets of the 
issuer. It gives its holder a right to share in the earnings or 
value of less than all of the corporate issuer's earnings or 
assets. Under the proposal, upon issuance of tracking stock, 
gain would be recognized in an amount equal to the excess of 
the fair market value of the tracked asset over its adjusted 
basis. The stockholder's value still is subject to the claims 
of the creditors of the parent corporation, and has liquidation 
or redemption rights only in the parent company, not the 
tracked assets. The Tax Council opposes this attempt by the 
administration to impose a new tax on corporate transactions.
    Modify Tax Treatment of Downstream Mergers.--Under this 
provision, where a target corporation does not satisfy the 
stock ownership requirements of section 1504(a)(2) (generally, 
80 percent or more of vote and value) with respect to the 
acquiring corporation, and the target corporation combines with 
the acquiring corporation in a reorganization in which the 
acquiring corporation is the survivor, the target corporation 
must recognize gain, but not loss, as if it distributed the 
acquiring corporation stock that it held immediately prior to 
the reorganization to its shareholders. The Tax Council opposes 
elimination of this longstanding and well-recognized ability to 
reorganize in a tax-free manner.
    Deny Dividends-Received Deduction for Certain Preferred 
Stock.--Another proposal would deny the DRD for certain types 
of preferred stock, which the administration believes are more 
like debt than equity. Although concerned that dividend 
payments from such preferred stock more closely resemble 
interest payments than dividends, the proposal does not 
simultaneously propose to allow issuers of such securities to 
take interest expense deductions on such payments. Again, the 
administration violates sound tax policy and, in this proposal, 
would deny these instruments the tax benefits of both equity 
and debt.
    The Tax Council opposes this. The United States is the only 
major western industrialized nation that subjects corporate 
income to multiple levels of taxation. Over the years, the DRD 
has been decreased to the current 70 percent for less than 20 
percent-owned corporations. As a result, corporate earnings 
have become subject to multiple levels of taxation, thus 
driving up the cost of doing business in the United States. To 
further decrease the DRD would be another move in the wrong 
direction.

Provisions Affecting Partners

    Modify Basis Adjustment Rules for Partnership 
Distributions.--The administration proposes certain changes 
relating to the basis adjustment rules for partnership 
distributions. Under these rules, depreciable or amortizable 
property could never receive a step up on distribution to a 
partner in a liquidation; only capital assets could receive an 
increase. If the partner's basis in its partnership interest 
exceeds the basis of the property distributed to it (and no 
capital assets were distributed), the partner would recognize a 
long-term capital loss. The Tax Council is concerned that these 
proposals would require the shifting of basis from depreciable 
property to non-depreciable property. This is the wrong result.

Tax Accounting

    Repeal Installment Method for Accrual-Basis Taxpayers.--The 
administration is asking Congress simply to eliminate the 
installment method for accrual-basis taxpayers. Installment 
sales treatment was studied and revised completely in 1980. At 
that time, the legitimate time value of money concerns of the 
administration were addressed. Under current law, if a 
corporation defers income recognition on an installment sale, 
it must make the Treasury whole by paying an interest charge on 
the deferred tax.
    All that this proposal would do is accelerate actual tax 
cash flows to Treasury so it can spend the money sooner. 
Conceptually, the net present value of tax payments is not 
directly affected. For corporate taxpayers and the IRS, 
however, this provision actually would open an entirely new and 
difficult area of controversy. Corporate taxpayers typically 
elect installment sale treatment when the price of a 
transaction is contingent rather than dispute with the IRS over 
the value of the contingent price. For example, a business unit 
may be sold for cash plus a percentage of the revenues for a 
stated number of years.
    Deny Deduction for Punitive Damages.--Another provision 
that clearly lacks any policy foundation (and appears to be 
included purely for revenue-raising purposes) is the proposal 
to deny the deductibility of all future payments associated 
with ``punitive'' damages incurred in civil law suits. Civil 
punitive damages are a risk that virtually all companies are 
susceptible to in our present litigious society. They are often 
based on arbitrary and capricious jury awards rather than 
genuine violations of public policy and should be distinguished 
from the primarily criminal-type payments currently denied 
deductibility under the Code. Settlements would create a morass 
of new questions. Punitive damages generally are subject to tax 
in the hands of the recipient under the changes made to those 
rules in 1996. In effect, the administration seeks a windfall 
from punitive damage payments by denying their deduction while 
taxing their receipt. We adamantly oppose what would be an 
overreaching change in the tax law.
    Repeal Lower-of-Cost-or-Market Inventory Accounting 
Method.--Certain taxpayers currently may determine their 
inventory values by applying the lower-of-cost-or-market 
method, or by writing down the cost of goods that are not 
salable at normal prices, or not usable because of damage or 
other causes. The administration is proposing to repeal these 
options and force taxpayers to recognize income from changing 
their method of accounting, on the specious grounds that 
writing inventory to market or writing down unusable or non-
salable goods somehow ``understates taxable income.'' Generally 
Accepted Accounting Principles (GAAP) require such write-downs 
in order to correctly state income. We strongly disagree with 
this unwarranted proposal. In addition, we believe that at the 
least, the lower of cost or market method should continue to be 
permissible when used for financial accounting purposes, to 
avoid the complexity of maintaining dual inventory accounting 
systems.

Changes Affecting Tax-Exempt Income

    Disallow Interest on Debt Allocable to Tax-Exempt 
Obligations.--The administration seeks to effectively eliminate 
the ``two-percent de minimis rule'' of present law and disallow 
a portion of interest expense deductions for certain entities 
that earn tax-exempt interest. Although last year's proposal 
was designed to apply to corporations generally, this year's 
proposal would apply only to ``financial intermediaries.'' 
Under the proposal, financial intermediaries that earn tax-
exempt interest would lose a portion of their interest expense 
deduction based on the ratio of average daily holdings of 
municipals to average daily total assets.
    In a related proposal, the administration seeks to increase 
from 15 percent to 25 percent the portion of a property 
casualty insurance company's tax-exempt income that is 
effectively subjected to tax through special proration rules. 
This would effectively eliminate any advantage of investment in 
tax-exempt bonds by property-casualty insurance companies.
    The Tax Council strongly opposes the administration's 
proposals to increase the tax cost of state and municipal bond 
investments. Financial intermediaries and property casualty 
insurance companies play an important role in the markets for 
municipal leases, housing bonds, and student loan bonds. By 
eliminating this significant source of demand for municipal 
securities, the administration's proposal would force state and 
local governments to pay higher interest rates on the bonds 
they issue, significantly increasing their costs of capital. 
The cost of public facilities, such as school construction and 
housing projects, would be increased. This proposal is entirely 
inconsistent with tax incentive programs for some of the same 
state and local projects. At a time when the state and local 
governments are asked to do more, Congress should not make it 
more costly for them to achieve their goals.

Cost Recovery

    Provides Consistent Amortization Periods for Intangibles.--
Under current law, start-up and organizational expenditures are 
amortized at the election of the taxpayer over a period of not 
less than 60 months. Certain acquired intangible assets 
(goodwill, trademarks, franchises, patents, etc.) held in 
connection with the conduct of a trade or business or an 
activity for the production of income must be amortized over 15 
years. Under the budget proposals, start-up and organizational 
expenditures would be amortized over a 15-year period. Small 
businesses would be allowed a $5,000 expensing of such costs. 
The Tax Council believes that the proper treatment of many 
start-up and organizational expenses in a neutral tax system 
would be expensing. Moving in the opposite direction, toward a 
longer artificial recovery period for such expenses, is simply 
increasing taxes on companies that are growing and expanding.

Insurance Provisions

    Require Recapture of Policyholder Surplus Accounts (PSA).--
Life insurance companies that were taxed under the old phase II 
positive regime of the Life Insurance Company Income Tax Act of 
1959 would have their tax bills for 1959 through 1983 rewritten 
by the administration's proposal to tax policyholder surplus 
accounts. Companies would be required to include in their gross 
income over 10 years (one-tenth per year) the balances of the 
policyholder surplus accounts accumulated from 1959 through 
1983. These accounts were part of a complex, Rube Goldberg set 
of provisions designed to balance the tax burdens of various 
segments of the insurance industry. Different companies 
benefited from different provisions, retroactively denying one 
set of companies their treatment is fundamentally unfair. 
Companies with policyholder surplus accounts never expected to 
pay tax on them. Congress should not change the rules at this 
late date.
    Modify Rules for Capitalizing Policy Acquisition Costs of 
Life Insurance Companies.--This proposal would increase the 
percentage of life insurance and annuity premiums subject to 
DAC capitalization. House Ways and Means Committee Chairman 
Bill Archer, R-Texas, already has announced the DAC proposal 
will not be included in any package put forth by his committee. 
We agree with him. The current DAC rates are more than 
appropriate in light of the other rules that apply to life 
insurance companies that tend to overstate their income for tax 
purposes.
    Modify Corporate-Owned Life Insurance (COLI) Rules.--The 
administration continues its four-year assault on COLI programs 
by proposing to repeal an exception to the present law 
proportionate interest disallowance rules for contracts on 
employees, officers or directors, other than 20 percent owners 
of the business that are the owners or beneficiaries of an 
annuity, endowment, or life insurance contract. This exception 
was designed to allow employers to create key-person life 
insurance programs, fund non-qualified deferred compensation 
and retiree health benefits, and meet other real business 
needs. The effect of this proposal would be to tax the inside 
build up in cash value life insurance whenever it is owned by a 
business that also has debt. Given the very long-term nature of 
life insurance investments, this rule would make insurance 
unattractive even to companies with no debt today, because they 
might need to borrow at some future date.

Exempt Organizations

    Subject Investment Income of Trade Associations to Tax.--
Under the proposal, trade associations including chambers of 
commerce, business leagues, and other similar not-for-profit 
organizations organized under Internal Revenue Code section 
501(c)(6) generally would be subject to tax on their net 
investment income in excess of $10,000. The Tax Council opposes 
this $1.4 billion tax increase on trade associations. The 
current-law purpose of imposing unrelated business income tax 
on associations and other tax-exempt organizations is to 
prevent such organizations from competing unfairly against for-
profit businesses. Subjecting trade association investment 
income to UBIT is counter to this legislative purpose. The 
administration proposal mischaracterizes the benefit that trade 
association members receive from such earnings. If these 
earnings on a trade association's assets did not exist, members 
of these associations would have to pay larger tax-deductible 
dues. There simply is not a tax abuse here. Congress should 
leave the present law rules as they are.

International

    In its efforts to offset the cost of new government 
spending, the administration is unwise to target publicly held 
U.S. multinationals doing business overseas, and the Tax 
Council urges that its international tax increase proposals be 
rejected. The predominant reason businesses establish foreign 
operations is to serve local overseas markets so they can 
compete more efficiently. Investments abroad provide a platform 
for the growth of exports and indirectly create jobs in the 
United States, along with improving the U.S. balance of 
payments. The creditability of foreign income taxes, which has 
existed in the Internal Revenue Code for over 70 years, is 
necessary to alleviate the double taxation of foreign income. 
Replacing these credits with less valuable deductions for any 
industry would greatly increase the costs of doing business 
overseas, resulting in a competitive disadvantage to U.S. 
multinationals.
    So that U.S. companies can better compete with foreign-
based multinationals, the administration should instead do all 
it can to make the U.S. tax code more friendly and consistent 
with the administration's more enlightened trade policy. 
Provisions that merely increase business taxes by eliminating 
legitimate business deductions should be avoided. Ordinary and 
necessary business expenses are integral to our current income-
based system, and arbitrarily denying a deduction for such 
expenses would only distort that system. Higher business taxes 
affect all Americans, directly or indirectly. For example, they 
result in higher prices for goods and services, stagnant or 
lower wages paid to employees in those businesses, and smaller 
returns to shareholders. Those shareholders may be the 
company's employees, or the pension plans of other middle-class 
workers.
    The Tax Council believes that a fundamental reconsideration 
of the ways in which the United States taxes its corporate 
citizens when they operate abroad is long overdue. The result 
of that review should be to make U.S. companies more, not less, 
competitive. The administration has proposed a series of 
changes that move in the wrong direction.
    Modify Treatment of Built-In Losses and Other Attribute 
Trafficking.--Under current law, a person who becomes subject 
to U.S. tax for the first time determines the basis of property 
and other tax attributes as though the person had always been 
subject to U.S. tax. This has been the rule since the beginning 
of the income tax. As a result, a taxpayer coming under the 
U.S. system may take advantage of built-in losses and would be 
taxed on built-in gains. The administration wants to replace 
the current rule with a ``fresh start'' that eliminates all tax 
attributes (including built-in losses and other items) and 
marks the taxpayer's assets to market when they become subject 
to U.S. tax. The proposal could benefit some taxpayers who 
would be entitled to a tax-free step-up in basis in their 
appreciated property at the time they become subject to U.S. 
tax. This far-reaching proposal would add much complexity to 
the tax laws.
    The administration argues that although current rules limit 
a U.S. taxpayer's ability to avoid paying U.S. tax on built-in 
gain, similar rules do not exist that prevent built-in losses 
from being used to shelter income otherwise subject to U.S. 
tax. The administration's extremely broad proposal is 
unnecessary. Existing anti-abuse provisions such as sections 
269, 382, 446(b), and 482 address this issue. Congress should 
reject this ad hoc, yet very fundamental, change to our 
international tax rules.
    Replace Sales-Source Rules with Activity-Based Rules.--The 
administration again proposes to replace the 50/50 source rule 
that determines the source of income from the manufacture of 
property in the United States and its sale outside the United 
States. An actual economic activity test rather than a fixed 
percentage would apply. This proposal is nothing short of a 
major tax on exports.
    Exports are fundamental to our economic growth and our 
future standard of living. Over the past three years, exports 
have accounted for about one-third of total U.S. economic 
growth. The export source rule operates to encourage companies 
to produce their goods in their U.S. plants rather than in 
their foreign facilities. Repeal or cutbacks in the rule would 
reduce exports and jeopardize the addition of these high-paying 
jobs.
    Since 1922, the 50/50 export source rule has been 
beneficial to companies that manufacture in the United States 
and export abroad because it increases the likelihood that 
double taxation of foreign income will be minimized by timely 
use of the foreign tax credit. Because the U.S. tax law 
restricts the ability of companies to get credit for the 
foreign taxes that they pay (e.g., through the interest and 
research and experimentation allocations), many multinational 
companies face double taxation on their overseas operations, 
i.e., taxation by both the U.S. and the foreign jurisdiction. 
The export source rule helps alleviate this double taxation 
burden and thereby encourages U.S.-based manufacturing by 
multinational exporters.
    The administration attempts to justify eliminating the 50/
50 rule by arguing that it provides U.S. multinational 
exporters operating in high tax foreign countries a competitive 
advantage over U.S. exporters that conduct their business 
activities in the U.S. The administration also notes that the 
U.S. tax treaty network protects export sales from foreign 
taxation in countries where we have treaties, thereby reducing 
the need for the export source rule. Both of these arguments 
are seriously flawed.
    First, exporters with only domestic operations never incur 
foreign taxes and, thus, are not even subjected to the onerous 
penalty of double taxation. Also, domestic-only exporters are 
able to claim the full benefit of deductions for U.S. tax 
purposes for all their U.S. expenses, e.g., interest on debt 
and R&D costs, because they do not have to allocate any of 
those expenses against foreign source income. Rather than 
creating a competitive advantage, the source rule simply levels 
the playing field for U.S.-based multinational exporters. 
Second, tax treaties cannot substitute for the export source 
rule. It is not income from export sales, but rather foreign 
earnings, that are the main cause of the double taxation 
described above. To the extent the treaty system lowers foreign 
taxation, it can help to alleviate the double tax problem, but 
only by treaty partners. These tend to be the most highly 
industrialized nations of the world. We have few treaties with 
most developing nations, which are the primary targets for our 
export growth in the future.
    Foreign Oil and Gas Income Tax Credits.--The Tax Council's 
policy position on foreign source income is clear--``A full, 
effective foreign tax credit should be restored and the 
complexities of current law, particularly the multiplicity of 
separate `baskets,' should be eliminated.''
    The president's proposal dealing with foreign oil and gas 
income moves in the opposite direction by limiting use of the 
foreign tax credit on foreign oil and gas income. This 
selective attack on a single industry's utilization of the 
foreign tax credit is not justified. U.S.-based oil companies 
are already at a competitive disadvantage under current law 
since most of their foreign-based competitors pay little or no 
home country tax on foreign oil and gas income. The proposal 
increases the risk of foreign oil and gas income being subject 
to double taxation, which would severely hinder U.S. oil 
companies in the global oil and gas exploration, production, 
refining, and marketing arena.

Compliance

    Increase Penalties for Failure to File Correct Information 
Returns.--The administration proposes to increase penalties for 
failure to file information returns, including all standard 
1099 forms. IRS statistics bear out the fact that compliance 
levels for such returns are already extremely high. Any 
failures to file on a timely basis generally are due to the 
late reporting of year-end information or to other unavoidable 
problems. Under these circumstances, an increase in the penalty 
for failure to timely file returns would be unfair and would 
fail to recognize the substantial compliance efforts already 
made by American business.

Other Provisions That Affect Receipts

    Three Superfund Taxes.--The three taxes that fund the 
Superfund used to clean up abandoned hazardous waste sites 
(corporate environmental tax, petroleum excise tax, and 
chemical feed stock tax) and the Oil Spill Liability Trust Fund 
all expired December 31, 1995. The president's budget would 
reinstate the two excise taxes, as well as the 5 cents-per-
barrel Oil Spill Tax, at their previous levels for the period 
after the date of enactment through September 30, 2009. The 
corporate environmental tax would be reinstated at its previous 
level for taxable years beginning after December 31, 1998, and 
before January 1, 2010. Moreover, the funding cap for the Oil 
Spill Tax would be increased from the current $1 billion amount 
to the unreasonably high level of $5 billion.
    These taxes, which were previously dedicated to Superfund 
and the Oil Spill Fund, would instead be used to generate 
revenue to swell the surplus or increase federal government 
spending. This use of taxes, when historically dedicated to 
funding specific programs, should be rejected. The decision 
whether to re-impose these taxes dedicated to financing 
Superfund should instead be made as part of a comprehensive 
examination of reforming the entire Superfund program.
    Convert a Portion of the Excise Taxes Deposited in the 
Airport and Airway Trust Fund to Cost-Based User Fees.--The 
administration wants to restructure the Airport and Airway 
Trust Fund. The Tax Council has no opinion on those proposals. 
The administration also wants to lower air ticket taxes and in 
their place impose Federal Aviation Administration user fees. 
The ultimate result of these proposals is an additional $5.3 
billion going to Washington. The Tax Council opposes increasing 
government revenues from the air transportation sector. The 
Airport and Airway Trust Fund is not spending what it has. Why 
is more needed? The assets in the trust fund are projected to 
grow from $12.3 billion in 1999 to $20.9 billion in 2004. It is 
hard to understand why we need a $5 billion cost increase to 
the traveling public.

                               CONCLUSION

    The Tax Council strongly urges the administration to 
reconsider the tax policy behind many of the revenue-raising 
proposals in its FY 2000 budget. Congress, in considering the 
administration's proposals, should elevate sound and 
justifiable tax policy over mere revenue needs.
      

                                

                         Telephone & Data Systems, Inc.    
                                        Middleton, WI 53562
                                                     March 23, 1999

A.L. Singleton
Chief of Staff
Committee on Ways and Means
U.S. House of Representatives
1102 Longworth House Office Building
Washington, D.C. 20515

    Mr. Singleton, Ways and Means Members:

    I am writing on behalf of Telephone & Data Systems, Inc. (TDS) to 
voice both our concern over the proposed ``Tax Shelter'' legislation 
now before your committee and our support for the permanent 
implementation of Internal Revenue Code (IRC) Section 127--the income 
exclusion for both graduate and undergraduate employer provided 
educational assistance payments. TDS is a telecommunications company 
with over 9,900 employees providing service to over 3,000,000 customers 
in 35 states.

                         Tax Shelter Proposals

    These proposals seem to stem from the December 14, 1998 
issue of Forbes in which the cover story labeled certain tax 
reducing transactions with movie ratings (i.e. PG-13, R and X) 
based upon their view of the relative degree of egregiousness. 
TDS also realizes the importance of effective and enforceable 
tax laws on the equitable administration of this country's 
revenue collection systems. It is certainly an honorable 
legislative objective to strive for such administration, and we 
appreciate your desire to correct ``loopholes'' in the 
application of the IRC. We maintain, however, that the already 
thin line between tax planning and ``tax avoidance'' will 
become even more subjective under these proposals. Further, 
these proposals indicate a preference toward interpretations of 
the intent of the law over the law itself. Where the letter of 
the law has been followed, it should be respected as a 
Constitutional right to apply the law, even if taxpayer 
favorable. In a 2nd Circuit Court Decision (1947), Judge 
Learned Hand clearly understood the concept when he stated;

          ``Over and over again courts have said that there is nothing 
        sinister in so arranging one's affairs as to keep taxes as low 
        as possible. Nobody owes any public duty to pay more than the 
        law demands. Taxes are enforced extractions and not voluntary 
        contributions. To demand more in the name of morals is mere 
        cant.''

    We know that it is easier to take a simple, blanket 
approach to a legislative objective than to craft more complex, 
specific provisions that attempt to take into account all 
current and possible fact patterns. Our concern is that the 
President's proposal would provide the IRS with a new weapon 
which, as currently crafted, would raise the risk of serious 
wounds being inflicted on innocent bystanders. The following 
transactions could now be considered ``tax avoidance 
transactions'' subject to disallowance:
     Investing in Municipal bonds rather than fully-
taxable securities
     Charitable contributions--they have no pre-tax 
economics
     Donating appreciated property rather than cash to 
charity--the primary purpose is viewed as tax planning by those 
who benefit from it, but tax avoidance by those who do not.
     Choosing to sell a business' assets rather than 
its stock--generally the primary motivation is to minimize tax.
    The IRS has already demonstrated that it will shamelessly 
exaggerate the application of an IRS favorable decision on 
specific facts.\1\ In our opinion, the IRS has taken the 
INDOPCO decision and is moving down a continuum toward 
capitalization of virtually all salaries and marketing expenses 
because they provide some future benefit beyond the current 
year. The only deductible costs will be for unsuccessful 
efforts and employees who provide no benefits to the company--
why employ them?
---------------------------------------------------------------------------
    \1\ INDOPCO, 503 U.S. 79 (1992)
---------------------------------------------------------------------------
    We recognize that it is difficult to be patient. Difficult 
to wait for the wheels of common law jurisprudence to turn out 
a sufficiently accurate and enveloping body of case law, such 
that ``justice is done'' to all parties. All of these things 
prompt you, as a body, to strike quickly and soundly. We urge 
you to take the more difficult path. To take the path of 
patience. To take the path of methodical judgment.
    In addition, we have two technical concerns with the 
President's proposed Tax Shelter legislation that we hope you 
will consider. First, it unnecessarily duplicates existing law, 
and it will inappropriately subrogate the enacted language of 
the Internal Revenue Code beneath ``legislative history.'' 
Second, we are bothered by the perpetual shift of authority, 
away from the courts and Congress and towards the IRS.
    The President's proposals unnecessarily duplicate existing 
law in several key areas, two of which are ``form vs. 
substance'' and tax fraud.

Form vs. Substance:

          In the Description of Revenue Provisions Contained in the 
        President's Fiscal Year 2000 Budget Proposal (hereinafter, 
        ``the Description''), Substance over Form Section, the drafters 
        characterize the ``Danielson rule'' \2\ and the ``strong 
        proof'' rule as set forth in Ullman \3\ as providing 
        ``relatively high standards of proof'' which a taxpayer must 
        meet before being allowed to elevate the substance of a 
        transaction over the form that the taxpayer selected for that 
        transaction. This is a gross understatement of the impact these 
        cases have on a taxpayer attempting to ``overturn'' the form of 
        a transaction which he or she devised. In Danielson, the court 
        provided that a taxpayer must show ``proof which in an action 
        between the parties...would be admissible to alter that 
        construction or to show its unenforceability because of 
        mistake, undue influence, fraud, duress, etc.'' Therefore, to 
        prevail under the ``Danielson rule'' a taxpayer must not only 
        be able to show that the form of the transaction was not the 
        intended form but also that the parol evidence rules would 
        allow the taxpayer to challenge the form of the transaction 
        against the other party in a court of law. In short, this 
        provides that the only time a taxpayer can advocate substance 
        as controlling over form is when the binding form of the 
        transaction is itself in substantial doubt.
---------------------------------------------------------------------------
    \2\ See, Danielson v. Commissioner, 378 F.2d 771 (3d Cir. 1967) 
cert. denied, 389 U.S. 858 (1967)
    \3\ See, Ullman v. Commissioner, 264 F.2d 305 (2d Cir. 1959)
---------------------------------------------------------------------------
          The Danielson court went on to find that ``the ``strong 
        proof'' rule [See Ullman above] would require that the taxpayer 
        be held to his agreement absent proof of the type which would 
        negate it in an action between the parties to the agreement.'' 
        Therefore, even under the ``strong proof'' rule, the taxpayer 
        will be held to the form of his or her transaction absent 
        substantial doubt as to the form. This section of the 
        Description also states that it is important to ``impose 
        restrictions on the taxpayer's ability to argue against the 
        form it has chosen.'' It is our belief that court cases such as 
        Danielson and its successors have already imposed such 
        restrictions. Enacting any legislation that attempts to further 
        confine taxpayers to the ``bed that they have made'' would 
        serve no useful purpose.

Tax Fraud:

          In the Description, Section on the Understatement Penalty, 
        the drafters discuss the President's proposed increase (from 
        20% to 40%) in the substantial understatement penalty. They 
        also point out the ``safe harbors'' available to the taxpayer 
        in order to avoid imposition of the ``extra'' 20%:
              1) Disclosure of the ``transaction'' to the National 
            Office within 30 days of filing the return
              2) Attaching a statement of disclosure to the return, or
              3) Providing adequate disclosure of the book to tax 
            differences (M-1's) on the return.
          Ignoring the ambiguity of multiple court definitions of 
        ``adequate disclosure,'' it seems to us that any taxpayer not 
        engaged in attempting to defraud the IRS will be exempt from 
        the 20% ``excess'' penalty. After all, the only time its 
        appears such a penalty could be imposed is when a taxpayer 
        misrepresents book-to-tax adjustments that are material with an 
        intent to deceive the IRS. There are already multitudes of 
        penalties and punishments (some criminal) for this kind of 
        behavior. It does not seem necessary to us to ``arm'' the IRS 
        with another ``weapon'' sure to be threatened against all 
        taxpayers but which could only be used on those already 
        penalized by myriad other regulations.

    The President's proposals inappropriately subrogate the 
enacted language of the IRC beneath ``legislative history.'' In 
doing so, these proposals will not only make it more difficult 
and time-consuming for trial judges but it will also 
effectively turn over years of Common Law precedent.
    In the Description, Section on Tax Avoidance Transactions, 
the drafters state that under the President's proposed 
expansion of IRC Sec. 269, the Secretary will be able to 
``disallow a deduction, credit, exclusion, or other allowance 
obtained in a tax avoidance transaction.'' The Description 
continues by providing, by reference to the Section on 
Understatement Penalties, the definition of a ``tax avoidance 
transaction'';

          Any transaction in which the reasonably expected pre-tax 
        profit...of the transaction is insignificant relative to the 
        reasonably expected net tax benefits...of such transaction. In 
        addition, a tax avoidance transaction would be defined to cover 
        certain transactions involving the improper elimination or 
        significant reduction of tax on economic income.

    Our concern with this proposal lies in the definition of 
``improper.'' If enacted, this proposal would give the 
Secretary the authority to disallow the ``tax benefits'' of a 
transaction if the Secretary deemed the transaction merely 
``improper.'' This is not only a drastic change from the 
current law's standard but it puts the courts in a new 
predicament if the taxpayer challenges the Secretary's 
determination.
    Current case law supports the Secretary's disallowance of 
tax benefits generated from transactions, the principle purpose 
of which is the avoidance of tax. Interpretation of this 
standard, as well as similar legislative breakwaters,\4\ 
certainly requires a complex measurement of the pre-tax 
economics and tax benefits of the transaction, but is a 
measurement that is possible to make within the letter of the 
law. If the standard is changed from ``principal purpose'' to 
merely ``improper,'' the courts, obviously, must look to what 
is proper and what is improper. Whenever the courts must look 
to proper and improper they must look to legislative intent. 
There becomes no path open to a court that does not lead down 
this treacherous and ambiguous slope of original legislative 
mindset. When Treasury and the IRS challenge a taxpayer's tax 
benefit as improper, a court will have no choice but to delve 
into the history of the section rather than interpreting it on 
its face. The language of a statute will cease to be decisive, 
even if unambiguous, as the propriety or impropriety judged by 
the historic intent and focus of Congress becomes the only 
relevant question.
---------------------------------------------------------------------------
    \4\ Such as ``primary'' or ``significant'' purpose
---------------------------------------------------------------------------
    Obviously, this would turn a large amount of case law on 
it's collective head. The current Common Law requirement is not 
to look to legislative history unless the statute is patently 
ambiguous. As the court stated in Pope v. Rollins Protective 
Services Co., 703 F.2d 197, 206 (5th Cir. 1983) \5\; ``[i]t is 
axiomatic that where a statute is clear and unambiguous on its 
face, a court will not look to legislative history to alter the 
application of the statute except in rare and exceptional 
circumstances.'' Forcing a court to consistently weigh all 
``improper'' benefit cases by this standard not only overrides 
centuries of stare decisis but also puts the intent of the 
lawmakers, as presumed by the judiciary, in higher regard than 
the plain face of the law itself. It is the legislature's 
responsibility to draft statutes that do not require this sort 
of ``revisionism'' by the judicial benches of this country. 
Accordingly, if there are specific provisions you wish to 
change, then change them, leaving not a legacy that needs IRS 
and judicial interpretation to decide propriety, but rather one 
that speaks loudly and independently.
---------------------------------------------------------------------------
    \5\ See also, e.g. Dickerson v. New Banner Institute, Inc., 103 
S.Ct. 986, 990, (1983); North Dakota v. United States, 103 S.Ct. 1095, 
1103 (1983); Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 
11, 19, 100 S.Ct. 242, 246, 62 L.Ed.2d 146 (1979). ``Absent a clearly 
expressed legislative intention to the contrary, that language must 
ordinarily be regarded as conclusive.'' Consumer Product Safety Comm'r 
v. GTE Sylvania, Inc., 447 U.S. 102, 108, 100 S.Ct. 2051, 2056, 64 
L.Ed.2d 766 (1980). Rubin v. United States, 449 U.S. 424, 430, 101 
S.Ct. 698, 701, 66 L.Ed.2d 633 (1981);
---------------------------------------------------------------------------
    As we have already alluded to, many of the President's 
proposals seem to give broad and unregulated authority to the 
IRS. This is particularly true in the areas of substantial 
underpayment penalty and denial of benefits associated with 
``tax avoidance transactions.'' It is generally unclear to us 
what would justify this broadened authority. It was not that 
long ago that your body had hearings to disclose and discuss 
abusive IRS practices; certainly increasing their already broad 
power without a corresponding increase in Congressional 
oversight will not prove worthwhile. As we have previously 
mentioned it also seems unlikely for this expansion of IRS 
power to result in less litigation, as an IRS sword sharpened 
legislatively can only be dulled by repeated judicial 
admonition.
    We acknowledged in our introduction the importance of this 
legislation. It is certainly good public policy to have a fair 
and rationale tax code. As in all things, fairness in the tax 
code is a balancing act and one must strive for equilibrium. 
Making the IRS, an enforcement agency and one party in an 
adversarial system, an omnipotent arbiter of your present 
intent does not seem likely to strike an appropriate balance 
between taxpayer and IRS. Take the difficult path now, craft 
your proposals wisely so that the judiciary can interpret the 
letter of the law, and the IRS can enforce it. Do not take the 
``low road'' and plague the court system and ``good faith'' 
taxpayers with an over-armed, trigger happy, out of control 
IRS.

                    Educational Assistance Proposal

    We are sure that you are aware of the positive impact that 
educational assistance, in any form, has on individuals, 
businesses and society at large. We at TDS also realize the 
importance of education in improving our employees' work 
performance and in expanding their horizons. TDS has a long-
standing commitment to employee betterment and education on 
many levels, including a company-wide employee education policy 
that provides time off and full reimbursement for successfully 
completed courses regardless of the subject of study.
    Presently, IRC Section 127's exclusion allows employee-
students at the undergraduate level to reap the benefits of 
employer provided educational assistance without bearing the 
burden of increased Federal income taxes. In addition to 
legislatively solidifying this employee opportunity, it is 
TDS's position that you should extended this benefit to 
employees pursuing a graduate course of study. In order to 
maintain and enhance our position in an increasingly 
competitive marketplace we need our employees to continuously 
maintain and enhance their own professional competence. Often, 
this further education manifests itself in the form of a 
graduate academic environment because an undergraduate degree 
is already a prerequisite for many positions. We feel strongly 
that there should not be a distinction between IRC Section 127 
``covered'' and ``non-covered'' courses based on whether a 
course is undergraduate or graduate. This type of arbitrary 
line drawing only serves to apply Section 127 unfairly, 
excluding important and needed coursework simply because an 
individual has surpassed some minimum educational requirement.
    It seems that everywhere one looks these days new 
educational opportunities and possibilities are being bantered 
about. Soon, you will have the ability to go beyond rhetoric 
and towards implementation, the ability to solidify and expand 
an educational program that will help current and future 
generations. We urge you to take this opportunity to provide 
America's employees with the educational opportunities they 
need to face the next millennia. Specifically, we request that 
you make the employer provided educational assistance income 
exclusion permanent and apply it to all workers who strive to 
improve themselves.
            Sincerely,
                                              Ross J. McVey
                             Assistant Controller and Director--Tax
      

                                

Statement of United States Telephone Association

    The United States Telephone Association (``USTA'') is 
pleased to have this opportunity to file a statement for the 
record in connection with the March 10, 1999 hearing held by 
the Committee on Ways & Means on the Administration's tax 
proposals. USTA is the primary trade association of local 
telephone companies serving more than 98 percent of the access 
lines in the United States and represents over 1100 members 
from the smallest of independents to the large regional 
companies.
    We have carefully reviewed all of the tax proposals 
submitted as part of the Administration's budget package for 
their impact on our industry. However, the proposals we comment 
on in this submission are only those which would have the most 
significant impact on USTA members and the economic environment 
in which our industry operates.

      1. Extension of the Research and Experimentation Tax Credit

    We vigorously support the extension of this vital credit 
for another twelve months from July 1, 1999 to June 30, 2000, 
as called for in the Administration's budget. Although USTA 
would prefer a longer term extension, or, better yet, that the 
credit be made permanent, we believe that the credit provides 
an important incentive for U.S. companies to increase and 
expand the level of commitment to tomorrow's world of 
communication, and deserves to be extended.
    As the information age continues to advance in both 
technology and reach, the credit becomes increasingly 
important. It provides a real incentive for U.S. companies in 
our rapidly changing industry to increase and expand the level 
of commitment to the next generation of communications. The 
extension of the research and experimentation credit is one of 
the intelligent choices Congress can make to insure that the 
U.S. remains the world's leader in communications. Indeed, 
Congress should seriously consider making this credit a 
permanent feature of the tax code and remove any doubt about 
its future so that technology-intensive businesses, such as 
USTA's members, can plan with confidence the shape of 
tomorrow's communications revolution.

  2. Extend the Exclusion for Employer-Provided Educational Assistance

    As part of its education initiatives, the Administration 
has proposed an eighteen month extension of the current law 
exclusion from an employee's income for amounts paid (up to 
$5,250 per year) by employers for undergraduate courses 
beginning before January 1, 2002. In addition, the exclusion 
would be reinstated for expenses paid for graduate education, 
effective for courses beginning after June 30, 1999 and before 
January 1, 2002. USTA strongly supports these initiatives.
    The exclusion is one of the most useful and practical means 
of encouraging educational opportunity and to react to the 
changing needs of the workplace. While USTA would prefer a 
permanent extension of the exclusion, the eighteen month 
extension, as well as the application to graduate courses, is 
well-received in the telecommunications industry where many 
employers offer educational assistance. We urge Congress to 
avoid any disruption in the tax treatment of these expenses (as 
has occurred in the past) by swiftly enacting these proposals.

                  3. Corporate Tax Shelter Provisions

    USTA urges Congress to carefully review the tax shelter 
proposals which the Administration has authored. Abuse of the 
tax system should not be tolerated since it results in higher 
taxes for those who dutifully comply, and encourages disrespect 
among taxpayers generally. However, there is a careful line 
which should be drawn between legitimate tax planning in the 
course of business transactions that are often quite 
complicated, and outright manipulation of the system solely for 
tax avoidance purposes.
    The Administration has proposed both specific and broad 
measures to combat corporate tax shelters. With regard to 
specific provisions that deal with clearly described 
transactions or accounting practices, Congress should evaluate 
these as it traditionally has. However, with regard to broader 
proposals, such as the Administration's proposed definitional 
changes in what constitutes a ``tax shelter,'' ``tax avoidance 
transaction,'' ``tax benefit,'' etc. and its proposal to impose 
substantially increased penalties, its disallowance of 
deductions for tax advice in certain situations, etc., USTA 
urges real caution. A great deal of effort should be devoted to 
evaluating these proposals to determine if they are too broadly 
crafted, imprecise and/or provide the IRS with too broad a 
grant of power to determine violations.

           4. Reimpose Superfund Corporate Environmental Tax

    The Administration's proposal would reinstate, for taxable 
years beginning after December 31, 1998 and before January 1, 
2010, a corporate environmental tax imposed at a rate of 0.12 
percent on the amount by which the modified alternative minimum 
taxable income of a corporation exceeded $2 million. USTA, 
while clearly in favor of environmental programs benefiting 
society, opposes the reinstatement of the Superfund tax in this 
manner at this time. Superfund currently faces no budgetary 
crisis, and, as the Chairman of the Committee on Ways and Means 
has noted, programmatic reform must take place prior to 
reinstating Superfund taxes that have expired. USTA supports 
this concept. In addition, if it is deemed necessary to 
reimpose this tax on corporations, USTA would strongly support 
a simplified calculation of alternative minimum taxable income 
for purposes of computing the Superfund Corporate Environmental 
tax.

                5. Monthly Deposit Requirement for FUTA

    USTA opposes the Administration's proposal to increase the 
frequency of FUTA and state unemployment insurance deposits 
from quarterly to monthly if the employer's tax liability in 
the prior year was $1,100 or more. This proposal would triple 
the number of required submissions and attendant paperwork, 
greatly increasing the already substantial FUTA administrative 
costs of employers. The one-time revenue gain to the federal 
treasury will more than be offset in the future by the real 
additional long-term administrative costs to the IRS from more-
frequent FUTA tax collection. The federal government should not 
penalize those businesses that are not delinquent in making the 
required payments by imposing more frequent collections. 
Rather, means should be identified to enforce the obligations 
of those who have not made the required payments.

       6. Subject Investment Income of Trade Associations to Tax

    USTA joins with its sister trade and industry associations 
in opposing the Administration's proposal to tax net investment 
income in excess of $10,000.
    The Administration's rationale for its proposal seemingly 
ignores the purpose of 501(c) (6) organizations that use 
investment income for the betterment of their memberships. The 
Administration appears to premise its proposal on the potential 
for dues reductions for members through the use of tax-exempt 
income. Although it has never been questioned that proceeds 
from Association investments might be appropriately used for 
such a purpose, even if investment income is used to reduce 
member dues payments there will be a resulting reduction in 
deductions taken for dues not paid. To suggest, as the 
Administration does, that the production of investment income 
in trade associations is merely a tool by which taxable member 
organizations receive the timing benefits of a tax deduction 
before making deductible dues payments seriously misunderstands 
the operation of most such associations. USTA, like many other 
industry organizations, uses its investment income for a 
variety of beneficial purposes--all related to the operation of 
the Association and its exempt purposes.
    The Administration's proposal is an unnecessary and 
misinformed effort to produce revenue, and should not be 
adopted.

                      7. Estate and Gift Taxation

    USTA supports efforts aimed at reducing estate taxes, 
particularly for small, family owned and operated businesses. 
Estate and gift taxes make it more difficult to maintain family 
ownership and control, encourage burdensome spending on 
strategies to deal with such taxes, and can cause unwanted and 
unwise transfers of ownership after years of dedicated 
stewardship.
    Unfortunately, not one of the Administration's 1999 
proposals in this area is designed to reduce such taxes. USTA 
urges Congress to work towards the reduction of estate taxes, 
not their enhancement.
      

                                

Statement of LaBrenda Garrett-Nelson and Mark Weinberger, on behalf of 
Washington Counsel, P.C., Attorneys-at-Law

    Washington Counsel, P.C. is a law firm based in the 
District of Columbia that represents a variety of clients on 
tax legislative and policy issues.

                              Introduction

    At a time when the Administration and the Congressional 
Budget Office are predicting an ``on budget'' surplus, Treasury 
has proposed yet another corporate tax increase in the form of 
a proposal to tax the issuance of ``tracking stock.'' In 
effect, this proposal would increase the cost of capital to 
corporations by inhibiting the use of ``tracking stock'' as a 
financing option. Apart from proposing a new tax and granting 
broad regulatory authority to Treasury, the Administration's 
proposal fails to offer any tax policy reason for the change. 
Moreover, it is not at all clear that the issuance of tracking 
stock is an appropriate time to impose a tax, because there is 
no bail out of corporate earnings. For these and other reasons 
set forth below, the ``tracking stock'' proposal should be 
rejected.

      Summary Of The Administration's ``Tracking Stock'' Proposal

    The Administration's proposal would impose a new tax ``upon 
issuance of tracking stock or a recapitalization of stock or 
securities into tracking stock.'' The tax would be based on a 
hypothetical ``gain,'' determined by reference to ``an amount 
equal to the excess of the fair market value of the tracked 
asset over its adjusted basis.'' For purposes of this rule, 
``tracking stock'' would be defined as stock that relates to, 
and tracks the economic performance of, less than all of the 
assets of the issuing corporation,'' if either (1) dividends 
are ``directly or indirectly determined by reference to the 
value or performance of the tracked entity or assets,'' or (2) 
liquidation rights are ``directly or indirectly determined by 
reference to the tracked entity or assets.'' ``General 
principles of law would continue to apply to determine whether 
tracking stock is stock of the issuer or not stock of the 
issuer.'' Treasury would be authorized to prescribe regulations 
treating ``tracking stock as nonstock (e.g., debt, a notional 
principal contract, etc.) or as stock of another entity as 
appropriate to prevent tax avoidance, and to provide for 
increased basis in the tracked assets as a result of gain 
recognized.'' The ``issuance of tracking stock [would] not 
result in another class of the stock of the corporation 
becoming tracking stock if the dividend and liquidation rights 
of such other class are determined by reference to the 
corporation's general assets, even though limited by the rights 
attributable to the tracking stock.'' The provision would be 
effective for ``tracking stock'' issued on or after the date of 
enactment.

 I. The Administration's Proposal Would Inhibit The Use Of A Valuable 
                        Corporate Financing Tool

    Over the last 15 years, corporations have utilized 
``tracking stock'' as a vehicle for raising capital and to meet 
a variety of non-tax, business needs. By limiting the financing 
options of U.S. corporations, the Administration's ``tracking 
stock'' proposal would impinge on the ability of corporations 
to raise low-cost capital in an efficient manner, and thereby 
have an adverse impact on economic growth, job creation, and 
the international competitiveness of U.S. businesses. The 
``tracking stock'' proposal would also inhibit the ability of 
businesses to use ``tracking stock'' in several other 
beneficial situations, such as issuing the stock in employee 
incentive programs to attract and retain key employees and to 
better align management and shareholders interests.

A. Corporations Have Issued Tracking Stock For a Variety of 
Business Reasons

    ``Tracking stock'' is issued by corporations that have 
multiple lines of business that the marketplace would value at 
different prices if each line of business were held by a 
separate corporation.. By issuing ``tracking stock,'' a 
corporation can raise capital in a manner that improves the 
attractiveness of the issuer's stock to the public. The 
valuation of the entire enterprise increases, because 
``tracking stock'' provides a mechanism for ``tracking'' the 
performance of individual businesses. There is, however, no 
actual separation of a tracked subsidiary or other asset. The 
corporate issuer continues to benefit from operating 
efficiencies that would be lost if different lines of business 
became independent. These efficiencies include economies of 
scale, sharing of administrative costs, and reduced borrowing 
rates based on the issuing corporation's overall credit rating. 
Thus, it is clear that corporations issue ``tracking stock'' 
for the business purpose of obtaining the highest value for the 
separate tracked business, while maintaining legal ownership 
and other operating synergies.
    Tracking stock has also been used as ``acquisition 
currency,'' issued to the former shareholders of an acquired 
subsidiary. A commonly cited example of the use of tracking 
stock as acquisition currency is GM's 1984 acquisition of EDS, 
in which GM Class E tracking stock was issued. In this context, 
tracking stock can serve a variety of business purposes, 
including (for example) providing an incentive for managers of 
a newly acquired business to remain with the company; or 
allowing former shareholders of the acquired business to 
continue participation in the business's growth.
    As another example, tracking stock has been issued in 
wholly internal transactions. These internal issuances are 
undertaken to maintain separate business reporting for rating 
agency and SEC regulatory accounting purposes, while achieving 
local tax consolidation in various foreign countries.

B. The Essential Elements of ``Tracking Stock'' Are Consistent 
With the Form of the Transaction as Stock of The Issuer

    Typically, ``tracking stock'' is issued as a class of 
common stock, the return on which is determined by reference to 
less than all of the issuer's assets. The ``tracked'' asset can 
take a variety of forms (e.g., a line of business, a separate 
subsidiary, or a specified percentage of a separable business). 
Significantly, there is no legal separation of corporate 
assets, and thus an investor's return is subject to the 
economic risks of the issuer's entire operation:
    (1) Voting rights of a holder of tracking stock are in the 
issuer (not, for example, a ``tracked'' subsidiary);
    (2) Dividend Rights, although based on the earnings of a 
tracked subsidiary or other asset, are subject to whether the 
parent/issuer's board of directors declares a dividend, as well 
as state law limitations on the parent/issuer's ability to pay 
(without regard to a ``tracked'' subsidiary's ability to pay).
    (3) Liquidation Rights might be determined by reference to 
the value of tracked assets, but investors in tracking stock 
have no special right to those assets; rather they are entitled 
to share in all of the issuer's assets on a pro rata basis.

 II. The Administration's Tracking Stock Proposal Presents Serious Tax 
      Policy Concerns, in Addition to Unresolved Technical Issues

A. Unjustified and Radical Departure From the Normal Treatment 
of a Stock Issuance

    Section 1032 \1\ provides tax-free treatment to the 
corporation in every case where a corporation issues its own 
stock, without regard to whether the issuance constitutes a 
tax-free exchange or a transaction in which gain or loss is 
recognized to the recipient of the stock. The Administration's 
proposal represents a radical departure from this established 
tax principle, and inappropriately relies on the typical 
features of tracking stock to justify the result.
---------------------------------------------------------------------------
    \1\ Except as provided, references to ``sections'' are to the 
Internal Revenue Code of 1986, as amended (referred to herein as the 
``Code'').
---------------------------------------------------------------------------
    The typical dividend, voting, and liquidation rights of 
tracking stock supports the conclusion that such stock is stock 
of the issuing corporation, particularly where the holder's 
right to dividends are left to the discretion of the issuer's 
board of directors, voting rights are in the issuer, and the 
holder stands behind creditors with no right to specific assets 
on liquidation.
    Lastly, it should be said that it is simply unsound tax 
policy to write ad hoc rules, without regard to whether those 
rules have any basis in established tax law principles. One 
sure result of this approach is the creation of discontinuities 
in the law. For example, if ``tracking stock'' is singled out 
for a tax increase, taxpayers issuing tracking stock would be 
inequitably disadvantaged as compared to other taxpayers using 
substantially similar economic arrangements. What then would 
the Administration have accomplished apart from interfering 
with the capital markets by increasing the costs associated 
with issuances of tracking stock?

B. Imposition of a Preemptive Tax Without Any Showing of Abuse 
or Other Tax Policy Concern

    As observed by the staff of the Joint Committee on 
Taxation, ``tracking stock may be structured in any number of 
ways that could result in holders having very different types 
of rights with respect to tracked assets.'' \2\ Indeed, the 
Administration itself characterized the present law 
classification as a determination that ``is dependent upon the 
correlation to the underlying tracked assets.'' Nevertheless, 
the Administration proposes to impose a tax upon every issuance 
of tracking stock, even if there are no tax policy concerns.
---------------------------------------------------------------------------
    \2\ Description Of Revenue Provision Contained In The President's 
Fiscal Year 2000 Budget Proposal, prepared by the staff of the Joint 
committee on Taxation (February 22, 1999) (referred to as ``JCS-1-99'') 
at page 224.
---------------------------------------------------------------------------
    For example, the Administration has failed to explain why a 
tax should be imposed where tracking stock is issued 
``internally''--wholly among members of an affiliated group of 
corporations--for the purpose of facilitating separate 
financial reporting or other non-U.S. tax, business goals. 
There is no apparent tax policy concern where tracking stock is 
issued in a non-divisive transaction, particularly in the case 
of an internal issuance. As another example, it is not clear 
why a tax should be imposed where tracking stock is issued to 
provide an incentive under an employee compensation plan, as a 
tool for linking compensation to the performance of a business 
under the recipient's management.

C. Technical Issues

    Circular Definition Of Tracking Stock.--The Administration 
recognizes that the proposed definition of ``tracking stock'' 
could include stock that has no tracking-stock features. For 
example, consider a corporation with one class of common stock 
outstanding, which then issues a new class of tracking stock, 
dividends on which are based on the operating results of one of 
the corporation's two subsidiaries. In such a case, by 
definition, the pre-existing common will constitute ``stock 
that relates to . . . less than all of the assets of the 
issuing corporation;'' similarly, dividends on the common will 
essentially track the results of the other subsidiary.
    The proposal seeks to address the circularity in the 
definition of tracking stock by including the statement that 
the ``issuance of tracking stock will not result in another 
class of the stock of the corporation becoming tracking stock 
if the dividend and liquidation rights of such other class are 
determined by reference to the corporation's general assets, 
even though limited by the rights attributable to the tracking 
stock.'' The proposal fails, however, to describe the mechanics 
of this ``savings'' clause.
    Absence of Guidance Regarding Collateral Consequences 
Resulting From Potential Application of the Definition of 
``Tracking Stock'' to Instruments That Resemble Tracking Stock. 
Reportedly, Treasury is examining the use of ``exchangeable 
shares'' (which can be thought of as ``reverse tracking 
stock,'' in that the shareholder's return is based on the 
results of the corporate parent of the issuing corporation). 
Exchangeable shares'' have been used in acquisitions in which 
U.S. companies have acquired Canadian subsidiaries.\3\ Very 
generally, these acquisitions take the form of 
recapitalizations in which shareholders of the acquired company 
exchange their stock for exchangeable shares, with the U.S. 
acquirer holding the balance of the company's outstanding 
stock. Among the many issues presented if the Administration's 
tracking stock proposal is intended to sweep in securities such 
as exchangeable shares, is whether dividend payments to 
Canadian shareholders in these cases is subject to U.S. 
withholding (on the grounds that the exchangeable shares are 
stock of the ``tracked'' U.S. acquirer).
---------------------------------------------------------------------------
    \3\ See IRS Officials Consider Cross-border Exchangeable Stock 
Deals,'' Tax Notes Today (January 29, 1999)
---------------------------------------------------------------------------
    Failure To Provide Any Substantive Guidance. Apart from the 
imposition of a new tax, the Administration's proposal fails to 
provide any substantive guidance on the treatment of tracking 
stock under the Code. Although the treatment of tracking stock 
as stock of the issuer/parent is characterized as problematic, 
the proposal includes the statement that ``[g]eneral principles 
of law would continue to apply to determine whether tracking 
stock is stock of the issuer or not stock of the issuer.'' 
Similarly, rather than providing operating rules to deal with 
identified issues, the Administration proposes to grant new and 
exceedingly broad regulatory authority for Treasury to 
prescribe rules treating tracking stock as nonstock, etc. 
Presumably, regulatory guidance would be applied prospectively; 
however, it is not at all clear whether Treasury contemplates a 
grant of authority to recast a transaction on a retroactive 
basis.
    Unprecedented Basis Adjustment For Tracked Assets. The 
absence of careful analysis is highlighted by the 
Administration's suggestion that regulations could provide for 
increases of ``inside'' basis as the result of gain 
recognition. As the staff of the Joint Committee on Taxation 
has pointed out, however, ``present law generally does not 
increase the basis of assets as a result of gain recognition on 
the distribution or sale of stock, unless an election is made 
under section 338'' (relating to stock sales treated as deemed 
asset sales). Thus, there is uncertainty regarding the 
circumstances (if any) in which Treasury would exercise 
regulatory authority to increase basis.\4\
---------------------------------------------------------------------------
    \4\ The Tax Reform Act of 1986 provided similar authority in 
section 336(e), relating to certain stock sales and distributions 
treated as asset transfers, but Treasury has never issued regulations.
---------------------------------------------------------------------------
    Uncertainty Regarding The Identity Of The Taxpayer. The 
Administration's proposal does not expressly state that the tax 
would be imposed on the issuing corporation (as opposed to a 
recipient of tracking stock). The imposition of tax on a 
recipient would make for incongruous results; particularly, for 
example, where the recipient receives the stock in exchange for 
cash and realizes no economic gain.
    Tax Consequences of After-acquired Shares. The proposal 
would tax an issuance of tracking stock only to the extent that 
there is a gain measured by reference to the difference between 
the tracked asset's value and basis. Consider, however, a 
hypothetical case where there is no gain on the original 
issuance of a tracking stock (e.g., because the tracked asset 
is either a recently purchased business or stock with respect 
to which a section 338 election was made to step up the basis). 
Presumably, no tax would be imposed when the tracking stock is 
first issued. What if additional appreciated property is 
contributed three years later, in exchange for shares out of 
the same issue of tracking stock. Would all of the tracked 
assets be marked to market because the additional shares are 
tied to the entire (fungible) pool of tracked assets?
    Characterization of the Deemed Taxable Event For Purposes 
of Other Code Sections. Little thought seems to have been given 
to the effect of the gain recognition event. Would it 
constitute a deemed sale of the tracked assets? If so, would 
the sale be viewed as a transaction with a related person or an 
unrelated person? Where a controlled foreign corporation is 
involved, the answers to these questions could affect whether 
the deemed gain is currently taxable under subpart F of the 
Code.

III. The Administration Has Failed To Establish A Reason To Single Out 
                Tracking Stock for Congressional Action

    The Administration has failed to set forth a basis for 
either legislative action or the delegation of additional 
regulatory authority to Treasury. Tracking stock is not a new 
concept in the tax law. Even under the Administration's 
proposal, general principles would continue to apply to require 
that the terms of tracking stock be consistent with treatment 
of such stock as stock of the issuer.\5\ Moreover, the 
enactment of the proposal would effectively put an end to the 
market for tracking stock, and thus little if any revenue would 
be raised.
---------------------------------------------------------------------------
    \5\ To date, however, the Administration has all but abdicated its 
authority to address tracking stock under current law. See Rev. Proc. 
99-3, 1999-1 I.R.B. 109, sec. 3.01(44) (stating that the Internal 
Revenue (``IRS'') will not issue rulings regarding the classification 
of tracking stock). But see Treas. reg. sec. 1.367(b)-4 (1998 
regulations in which the IRS did address the treatment of stock that 
entitles the holder to participate disproportionately in the earnings 
generated by particular assets, in the context of prescribing 
circumstances in which gain will be triggered on the exchange of stock 
in foreign corporations).

A. Over Fifty Years of Tax Law Contradicts the Administration's 
Statement that ``Tracking Stock is . . . Outside the 
Contemplation of Subchapter C and Other Sections of the . . . 
---------------------------------------------------------------------------
Code.''

    The stated rationale for the Administration's proposal 
begins with the bald conclusion that the ``use of tracking 
stock is clearly outside the contemplation of subchapter C and 
others sections of the . . . Code.'' On the other hand, the 
Administration proposes to rely on ``general principles of tax 
law'' to resolve the rather fundamental issue regarding whether 
tracking stock is stock in the issuing corporation. It is quite 
clear, that present law is adequate to the task, particularly 
in view of the existence of case law that pre-dates the 
Internal Revenue Code of 1954.
    Judicial Authority Relating to Tracking Stock Dates Back 
Fifty Years. As early as 1947, the U.S. Tax Court had occasion 
to consider the federal income tax consequences of the issuance 
of tracking stock in the case of Union Trusteed Funds, Inc. v. 
Commissioner.\6\ That case involved a regulated investment 
company (``RIC'') organized as a single corporation with 
several series of stock, each of which series represented an 
interest in the income and assets of a particular fund. Union 
Trusteed Funds held that the RIC would be treated as a single 
corporation.
---------------------------------------------------------------------------
    \6\ 8 T.C. 1133 (1947), acq. 1947-2 C.B. 4.
---------------------------------------------------------------------------
    Again, in 1965, the Ninth Circuit Court of Appeals reviewed 
a case where a corporation issued a new class of nonvoting 
preferred stock to new shareholders, in exchange for funds that 
the corporation used to establish a new line of business.\7\ 
After a six-year period, if the new line of business was 
terminated or the preferred shareholders sold their stock, the 
corporation was obligated to redeem the preferred stock by the 
distribution of 90 percent of the assets in the new line of 
business. Here, again, notwithstanding the liquidation 
preference of the preferred stock, the court upheld the 
treatment of the corporation as a single company.
---------------------------------------------------------------------------
    \7\ Maxwell Hardware Co. v. Commissioner, 343 F.2d 713 (9th Cir. 
1965).

Similarly, the Congress has Dealt With Tracking Stock, When 
Deemed Appropriate in View of the Particular Purpose of 
Specific Tax Provisions. The Congress has taken account of the 
existence of tracking stock, as appropriate for purposes of 
particular tax provisions. For example, in 1986 the Congress 
reversed the result in the Union Trusteed Funds case (described 
above), by adding section 861(h) and thereby providing 
specifically for the separate application of the RIC 
qualification tests to each series in a series fund, based on 
the rationale that each such series functions as a separate 
RIC.\8\ Significantly, the drafters of the 1986 RIC change did 
not appear to view the law as unsettled with respect to a 
series fund organized as a corporation. Rather, the amendment 
was enacted to resolve discontinuities that resulted where a 
series funds was organized as a single business trust (the 
treatment of which was uncertain).\9\
---------------------------------------------------------------------------
    \8\ General Explanation of the Tax Reform Act of 1986, prepared by 
the staff of the Joint Committee on Taxation (May 4, 1987) at page 377.
    \9\ Id. At 376 (describing the need to clarify the treatment of a 
series fund organized as a business trust).
---------------------------------------------------------------------------
    As another example, in the original enactment of the 
Passive Foreign Investment Company (``PFIC'') regime, the 
Congress anticipated the possibility that tracking stock might 
be used to circumvent those rules, and thus included regulatory 
authority to treat ``separate classes of stock . . . in a 
corporation . . . as interests in separate corporations.'' \10\ 
Interestingly, the Congress did not suggest that all tracking 
stock should be so treated, thus allowing for circumstances in 
which the form of an issuance of tracking stock should be 
respected.
---------------------------------------------------------------------------
    \10\ General Explanation of the Tax Reform Act of 1986 at page 1032 
(positing that, without this regulatory authority, a foreign 
corporation engaged in an active business, which would not be a PFIC, 
could issue a separate class of stock and use the proceeds to invest in 
a PFIC or to invest directly in passive assets).
---------------------------------------------------------------------------
    More recently, in 1990, the Congress specifically addressed 
a tracking stock issue in the legislative history of Section 
355(d), a provision added to deny tax-free treatment to a 
``disguised sale'' of a subsidiary. Very generally, section 
355(d) triggers a tax on the distributing corporation in a 
divisive reorganization where 50 percent or more of the 
corporation's stock was acquired by purchase during the 
preceding five years. In measuring the five-year window, 
section 355(d)(6) reduces the holding period for stock for any 
period during which the holder's risk of loss is substantially 
diminished by any device or transaction. In this regard, the 
Conference Report on the 1990 legislation specifically cites 
the use of ``so-called `tracking stock' that grants particular 
rights to the holder or the issuer with respect to the 
earnings, assets, or other attributes of less than all the 
activities of a corporation or any of its subsidiaries.'' \11\
---------------------------------------------------------------------------
    \11\ H.R. Conf. Rep. No. 5835 p. 87.

B. Treasury Has Sufficient Authority Under Present Law To 
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Address Tracking Stock

    As detailed below, the Administration's request for 
expanded regulatory authority should be rejected because 
current law already provides sufficient tools for Treasury to 
deal with the tracking-stock issues identified as ``reasons for 
change.''
    The General Utilities Issue. The Administration avers that 
the treatment of tracking stock as stock of the issuer allows a 
corporation to ``sell an economic interest in a subsidiary 
without recognizing any gain.'' This, the Administration 
suggests, is inconsistent with the 1986 legislation that 
reversed the General Utilities rule, so called after the case 
that provided an exception for liquidating distributions to the 
rule imposing two levels of tax on corporate earnings.
    In the first instance, the Code does not impose a tax in 
every case where a corporation sells an economic interest in a 
subsidiary-the tax consequences depend on the nature of the 
``economic interest'' (e.g., the sale of an option to buy stock 
in a subsidiary generally is treated as an open transaction 
until the option is exercised or expires, although the 
existence of such an option could have consequences under 
provisions such as constructive ownership rules). Moreover, the 
Administration's proposal does not even purport to resolve the 
General Utilities issue. In any event, some would argue that 
Section 337(d) already provides the Administration with ample 
authority to prevent the circumvention of General Utilities 
repeal.\12\
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    \12\ Indeed, a senior Treasury official was reported to have 
announced that Treasury would exercise its section 337(d) authority to 
prevent the use of tracking stock (presumably, to address abusive 
situations where general principles of law would be violated) ``to sell 
a business without triggering...a tax.'' Tax Notes Today (March 20, 
1989).
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    Inclusion of Tracked Subsidiary in a Consolidated Group. 
The Administration cites the fact that a subsidiary may remain 
a member of the parent's consolidated group after the issuance 
of tracking stock, as if this result is bad per se. It is not 
immediately clear why the issuance of subsidiary tracking stock 
should result in de-consolidation, as long as the parent 
corporation retains the 80-percent-of-vote-and value level of 
control prescribed by section 1504. In any case, similar to 
Treasury's existing authority to deal with General Utilities, 
Section 1504 already grants regulatory authority for Treasury 
to prescribe rules necessary or appropriate to carry out the 
purposes of the statutory definition of an affiliated group.
    Tax-free Distribution of Tracking Stock. The 
Administration's ``reasons for change'' also notes the concern 
that ``a distribution of the shares is tax-free to the 
shareholders and to the issuer, and the issuer can achieve 
separation from the tracked assets or subsidiary without 
satisfying the strict requirements for tax-free distribution.'' 
This statement assumes without analysis, that tracking stock 
effects a true separation in all cases. To the contrary, even 
where the terms of the tracking stock contemplates the payment 
of dividends based on the tracked assets,\13\ the holder still 
participates in the economic benefits and burdens of the issuer 
as a whole. Thus, the insolvency of the issuer/parent would 
preclude the payment of dividends and render subsidiary 
tracking stock worthless, without regard to the stand-alone 
value of the tracked subsidiary.
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    \13\ As the staff of the Joint Committee on Taxation observed, 
``holders of tracking stock may not actually be entitled to the 
dividends, even though the tracked assets are profitable, if the parent 
corporation does not declare dividends.'' JCS-1-99 at page 224.
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    Consistent with the theory that underlies the tax-free 
treatment of stock dividends and reorganizations, the issuance 
of tracking stock is not an appropriate time to impose a tax, 
to the extent that a taxpayer's investment remains in corporate 
solution, and the stock represents merely a new form of 
participation in a continuing enterprise.\14\ Nevertheless, the 
Administration's proposal would trigger a tax on the issuance 
of tracking stock, even in a case where a distribution of the 
tracked subsidiary would satisfy ``the strict requirements for 
tax-free distribution.''
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    \14\ See generally Bittker and Eustice, Federal Income Taxation of 
Corporations and Shareholders, par. 12.01[3] regarding the theory 
underlying tax-free treatment
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    Additionally, even where the correlation between the 
tracking stock and a tracked subsidiary is such that there is a 
separation in ``substance,'' Treasury's existing authority 
under section 337(d) (the General Utilities anti-abuse rule) 
would be available. In any event, it should also be noted that 
the issuer of tracking stock remains liable for any tax 
attributable to appreciation in the tracked assets, thus 
preserving two levels of tax.

C. It is Questionable Whether the Administration's Proposal 
Would Increase Tax Revenues

    It is arguable that the use of tracking stock increases tax 
revenues. This view is based on the availability of financing 
options such as the issuance of debt, an alternative that would 
generate interest deductions and thereby eliminate tax on 
corporate earnings. By comparison, the issuance of tracking 
stock does not reduce a corporation's tax liability because 
dividends are paid out of after-tax income. In any case, one 
likely consequence of the Administration's proposal is that few 
(if any) corporations will issue tracking stock.

                               Conclusion

    In curtailing the availability of financing options, the 
Administration's tracking stock proposal would force companies 
to abandon an efficient means of raising low-cost capital, and 
to turn instead to higher-cost alternatives. This runs counter 
to the long-term interests of the American economy. Moreover, 
there are numerous unanswered questions regarding the 
applicability and administrability of the tracking stock 
proposal. For these reasons, the Congress should reject the 
Administration's tracking stock proposal.

                                  
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