foreign mortality and morbidity. Second, the special rule for start-up companies that was
included in the canceled provision would be eliminated, as would the look-through rule. Third,
the proposal would provide that the present-law statutory definition of a life insurance contract
(under secs. 7702 or 101(f)), as well as the distribution on death requirement of section 72(s) and
the diversification requirement of section 817(h), would not apply for purposes of determining
reserves for a life insurance or annuity contract under sections 953 and 954 of the Code,
provided that neither the policyholders, the insureds or annuitants, nor the beneficiaries with
respect to the contract are U.S. persons.

With respect to income derived in the active conduct of a banking, financing, or similar
business, the proposal differs from the canceled provision in the following significant respects.
First, the exception from foreign personal holding company income generally would apply only
to income derived from transactions with customers located in the same country in which the
CFC is created or organized (or in which a qualified business unit of the CFC maintains its
principal office and conducts substantial business activity). Second, the determination of where
a customer is treated as located would be made under rules prescribed by the Secretary of the
Treasury. Third, the look-through rule that was included in the canceled provision for purposes
of determining the income eligible for the exception would be eliminated.

This proposal in the Chairman's amendment in the nature of a substitute differs from the
proposal in the original Chairman's mark’ only with respect to the rules for coordinating the new
exceptions to foreign personal holding company income and foreign base company services
income for certain active financing income with the dividend holding period requirements of
section 901(k) (described below).

Income from the active conduct of an insurance business

The proposal would provide an exception from foreign personal holding company
income for certain investment income of a qualifying insurance company with respect to risks
located within the CFC’'s country of creation or organization. The rules of this proposal would
differ from the rules of present-law section 953 of the Code, which determines the subpart F
inclusions of a U.S. shareholder relating to insurance income of a CFC. Such insurance income
under section 953 generally is computed in accordance with the rules of subchapter L of the
Code. Review of the proposal’s insurance rules would be appropriate when final guidance under
section 953 is published by the Treasury Department. Among other issues, this review should
consider whether it its more appropriate to determine the reserves for property and casualty
contracts of CFCs using the applicable foreign interest rate and, if sufficient data is available, a
foreign loss payment pattern, when using the applicable U.S. interest rate and U.S. loss payment
pattern results in a materially different reserve amount.

? The proposal in the original Chairman's mark is described in Joint Committee on
Taxation, Description of Legislation to Restore and Modify Provisions in the Taxpayer Relief
Act of 1997 Canceled Under the Line Item Veto Act (\CX-47-97), September 19, 1997.

5.



the qualified business unit maintains its principal office and conducts substantial business
activity. The determination of where a customer is located would be made under rules
prescribed by the Secretary of the Treasury.

An additional exception from the definition of foreign personal holding company income
would be provided for certain income derived by a securities dealer within the meaning of
section 475. This exception would apply to interest or dividends (or equivalent amounts
described in sec. 954(c)(1)(E) or (G)) from any transaction (including a hedging transaction or a
transaction consisting of a deposit of collateral or margin described in section 956(c)(2)(J))
entered into in the ordinary course of the dealer’s trade or business as such a securities dealer,
but only if there is material participation in such transaction by employees located in the country
under the laws of which the dealer is created or organized (or, in the case of a qualified business
unit of the dealer that both maintains its principal office and conducts substantial business in a
country, employees located in that country).

Anti-abuse rule

The proposal provides an anti-abuse rule which would be applicable for purposes of these
exceptions from foreign personal holding company income. For purposes of applying these
exceptions, items with respect to a transaction or series of transactions would be disregarded if
one of the principal purposes of the transaction or transactions is to qualify income or gain for
these exceptions. The reach of this anti-abuse rule explicitly includes any change in the method
of computing reserves or any other transaction or transactions one of the principal purposes of
which is the acceleration or deferral of any item in order to claim the benefits of these exceptions
and the organization of entities in order to satisfy any same country requirement for these
exceptions.

Foreign company services income

The proposal also would provide a corresponding exception from foreign base company
services income. This exception would apply to income derived in connection with the
performance of services that are directly related to a transaction the income from which is not
foreign personal holding company income by reason of section 954(h). This exception also
would apply to income derived in connection with the performance of services that are directly
related to a transaction to which the additional exception for certain income of dealers applies.

Coordination with section 901(k)

The proposal in the Chairman’s amendment in the nature of a substitute differs from the
proposal in the original Chairman’s mark with respect to the rules for coordinating the new
exceptions to foreign personal holding company income and foreign base company services
income for certain active financing income with the dividend holding period requirements of
section 901(k), Under the proposal in the original Chairman’s mark, the new exceptions to
foreign personal holding company income and foreign base company services income would not

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10 percent of reserves (determined for purposes of the proposal) for contracts regulated in the
country in which sold as life insurance or annuity contracts.

To prevent the shifting of relatively high-yielding assets to generate investment income
that qualifies under this temporary exception, the proposal provides that, except as provided by
the Treasury Secretary, income would be allocated to contracts as follows. In the case of a
separate-account-type contract (including a variable contract not meeting the requirements of
section 817), the income credited under the contract would be allocable only to that contract.
Income not so allocated would be allocated ratably among all contracts that are not separate
account-type contracts.

Under the proposal, a qualifying insurance company would mean any entity which: (1) is
regulated as an insurance company under the laws of the country in which it is created or
organized; (2) derives at least 50 percent of its net written premiums from the insurance or
reinsurance of risks located within the country in which it is created or organized; and (3) is
engaged in the active conduct of an insurance business and would be subject to tax under
subchapter L if it were a domestic corporation.

The proposal would clarify that the rules added by the proposal do not apply to
investment income (includable in the income of a U.S. shareholder of a CFC pursuant to section
953) allocable to contracts that insure related party risks or risks located in a country other than
the country in which the qualifying insurance company is created or organized.

Income from the active conduct of a banking, financing. or similar business

The proposal would provide an exception from foreign personal holding company
income for income that is derived in the active conduct by a CFC of a banking, financing, or
similar business from transactions with customers located within the same country under the
laws of which the CFC is created or organized. For this purpose, it is intended that income
derived from the following types of activities would be considered to be income derived in the
active conduct of a banking, financing, or similar business:

(a) regularly making personal, mortgage, industrial, or other loans in the ordinary course of
the corporation’s trade or business,

(b) factoring evidences of indebtedness for customers,

(c) purchasing, selling, discounting, or negotiating for customers notes, drafts, checks, bills
of exchange, acceptances, or other evidences of indebtedness,

(d) issuing letters of credit and negotiating drafts drawn thereunder for customers,

-7-



The proposal would provide an exception for income (received from a person other than
a related person) from investments made by a qualifying insurance company of its reserves or 80
percent of its unearned premiums (as defined for purposes of the proposal). For this purpose, in
the case of contracts regulated in the country in which sold as property, casualty, or health
insurance contracts, unearned premiums and reserves would mean unearned premiums and
reserves for losses incurred determined using the methods and interest rates that would be used if
the qualifying insurance company were subject to tax under subchapter L of the Code. Thus, for
this purpose, unearned premiums would be determined in accordance with section 832(b)(4), and
reserves for losses incurred would be determined in accordance with section 832(b)(5) and 846
of the Code (as well as any other rules applicable to a U.S. property and casualty insurance
company with respect to such amounts).

In the case of a contract regulated in the country in which sold as a life insurance or
annuity contract, reserves for such contracts would be determined as follows. The reserves
would equal the greater of: (1) the net surrender value of the contract (as defined in section
807(e)(1)(A)), including in the case of pension plan contracts, or (2) the amount determined by
applying the tax reserve method that would apply if the qualifying insurance company were
subject to tax under subchapter L of the Code, with the following modifications. First, there
would be substituted for the applicable Federal interest rate an interest rate determined for the
foreign country in which the qualifying insurance company was created or organized, calculated
(except as provided by the Treasury Secretary in order to address insufficient data and similar
problems) in the same manner as the mid-term applicable Federal interest rate ("AFR") (within
the meaning of section 1274(d)). Second, there would be substituted for the prevailing State
assumed rate the highest assumed interest rate permitted to be used for purposes of determining
statement reserves in the foreign country for the contract. Third, in lieu of U.S. mortality and
morbidity tables, there would be applied mortality and morbidity tables that reasonably reflect
the current mortality and morbidity risks in the foreign country.

In no event would the reserve for any contract at any time exceed the foreign statement
reserve for the contract, reduced by any catastrophe or deficiency reserve or any similar reserve.
This rule would apply whether the contract is regulated as a property, casualty, health, life
insurance, annuity, or any other type of contract.

The proposal would provide that the present-law statutory definition of a life insurance
contract (under secs. 7702 or 101(f)), as well as the distribution on death requirement of section
72(s) and the diversification requirement of section 817(h), would not apply for purposes of
determining reserves for a life insurance or annuity contract under section 953 or 954 of the
Code, provided that neither the policyholders, the insureds or annuitants, nor the beneficiaries
with respect to the contract are U.S. persons. However, if any such persons are U.S. persons,
this exception from the application of those rules would not apply.

The proposal also would provide an exception for income from investment of assets

equal to (1) one-third of premiums earned during the taxable year on insurance contracts
regulated in the country in which sold as property, casualty, or health insurance contacts, and (2)

-6-



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purchasing or selling stock, debt instruments, interest rate or currency futures or other
securities or derivative financial products (including notional principal contracts) from or
to customers and holding stock, debt instruments and other securities as inventory for
sale to customers, unless the relevant securities or derivative financial products are not
held in a dealer capacity,

effecting transactions in securities for customers as a securities broker,

investing premiums accepted by insurance brokers or agents for transmittal to insurance
companies on behalf of policyholders and other income from insurance brokerage or
agency services, except to the extent that the income is derived from transactions that
would give rise to foreign base company services income under section 954(e)(1), and

any other activity that the Secretary of the Treasury determines to be a financing activity
conducted by active corporations in the ordinary course of their business.

This exception for income derived in the active conduct of a banking, financing, or

similar business from transactions with same-country customers would apply only if the CFC is
predominantly engaged in the active conduct of a banking, financing, or similar business. For
this purpose, a CFC is considered to be predominantly engaged in the active conduct of a
banking, financing or similar business if more than 70 percent of its gross income is derived

from such business from transactions with customers located within the same country under the
laws of which the corporation is created or organized. Alternatively, a CFC is considered to be
predominantly engaged in the active conduct of a banking, financing, or similar business if (i) it
is engaged in the active conduct of a banking business and it is an institution licensed to do
business as a bank in the United States (or is any other corporation not so licensed which is
specified by regulations) or (ii) it is engaged in the active conduct of a securities business and it
is registered as a securities broker or dealer or Government securities broker or dealer under the
Securities Exchange Act of 1934 (or is any other corporation not so registered which is specified
in regulations). In this regard, it is intended that these requirements for the active conduct of a
banking or securities business would be interpreted in the manner provided in the regulations
proposed under section 1296(b) (as in effect prior to the enactment of the Taxpayer Relief Act of
1997); it further is intended that these requirements would be considered to be satisfied by an
entity that is a qualified bank affiliate or qualified securities affiliate as defined under such
proposed regulations. See Prop. Treas. Reg. secs. 1.1296-4 and 1.1296-6.

For purposes of this exception, a customer of a CFC is any person that has a customer

relationship with the CFC. However, a related person (within the meaning of sec. 954(d)(3)),
officer, director, or employee of any CFC would not be treated as a customer with respect to any
transaction a principal purpose of which is to satisfy any requirement for this exception. In
applying this exception, certain income derived by a qualified business unit of a CFC would be
treated as derived from transactions with customers located in the same country in which the
CFC is created or organized. This treatment would apply to income derived by a qualified
business unit of a CFC from transactions with customers that are located in the country in which

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September 23, 1997
ICX-48-97°

Chairman's Amendment in the Nature of a Substitute
Relating to Provisions in the Taxpayer Relief Act of 1997
Canceled Pursuant to the Line Item Veto Act

This document, prepared by the staff of the Joint Committee on Taxation, describes the
Chairman's amendment in the nature of a substitute relating to the provisions in the Taxpayer
Relief Act of 1997 that provided for the treatment of sales of processing facilities to farmer
cooperatives and for exceptions from subpart F for certain active financing income and that were
canceled by the President pursuant to the Line Item Veto Act. Following is a description of the
farmer cooperative proposal and the active financing income proposal as included in the
Chairman's amendment in the nature of a substitute.

1. Tax-Free Rollover of Sale of Processing Facilities to Cooperatives
Present Law

There are no provisions under present law which permit the tax-free rollover of gain on
the sale of stock in a processing or refining company to a farmers' cooperation.

However, if certain requirements are satisfied, a taxpayer may defer recognition of gain
on the sale of qualified securities to an employee stock ownership plan (“ESOP”) or an eligible
worker-owned cooperative to the extent that the taxpayer reinvests the proceeds in qualified
replacement property (sec. 1042). Gain is recognized when the taxpayer disposes of the
qualified replacement property. One of the requirements that must be satisfied for deferral to
apply is that, immediately after the sale, the ESOP must own at least 30 percent of the stock of
the corporation issuing the qualified securities. In general, qualified securities are securities
issued by a domestic C corporation that has no stock outstanding that is readily tradeable on an
established securities market. Deferral treatment does not apply to gain on the sale of qualified
securities by a C corporation.

Description of Proposal

The proposal would permit the tax-free rollover of up to $75 million per year of gainon -
the sale of all (i.e., 100 percent) of the stock of a corporation that owns a processing facility to
any particular cooperative which is engaged in marketing agricultural or horticultural products.
The seller would have to reinvest the proceeds from the sale of the stock of the corporation
owning the processing facilities within one year of such sale in stock of an active C corporation
other than stock in the selling of target corporations or any related person. In order to qualify, at
least 50 percent of the product that the facility processes for any 3 of 5 taxable years after the
sale must be purchased from the cooperative or from members of the cooperative. In addition, in
the case of a cooperative that (1) had gross receipts in excess of $1 billion in any prior taxable



apply for any taxable year of a foreign corporation unless such corporation (and all members of
an affiliated group of which it is a member) elect not to have the securities dealer exception to
the dividend holding period requirement provided in section 901(k)(4) apply to taxes paid or
accrued during such year by such foreign corporation or any member. The amendment would
modify this rule. Under the amendment, the foreign tax credits that are allowable by reason of
the securities dealer exception to the dividend holding period requirement would be reduced by
an amount equal to the ratio of (1) the income from the active conduct of a securities business to
which these active financing income exceptions apply, to (2) the total income from the active
conduct of a securities business not currently includible in income under subpart F (including
income to which these exceptions apply). Alternatively, if the corporation (and all members of
an affiliated group of which it is a member) so elect, these exceptions for active financing
income would not apply and the securities dealer exception to the dividend holding period
requirement would apply without modification. These rules would apply on an affiliated group
basis.

Effective Date
The proposal would apply only to the first full taxable year of a foreign corporation

beginning in 1998, and to the taxable years of United States shareholders with or within which
such taxable year of such foreign corporations ends.

-I1-


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performing trust services, including as a fiduciary, agent, or custodian, for customers,
provided such trust activities are not performed in connection with services provided by a
dealer in stock, securities or similar financial instruments,

arranging foreign exchange transactions (including any section 988 transaction within the
meaning of section 988(c)(1)) for, or engaging in foreign exchange transactions with,

customers,

arranging interest rate or currency futures, forwards, options or notional principal
contracts for, or entering into such transactions with, customers,

underwriting issues of stock, debt instruments or other securities under best efforts or
firm commitment agreements for customers,

engaging in leasing (including entering into leases and purchasing, servicing and
disposing of leases and leased assets),

providing charge and credit card services or factoring receivables obtained in the course
of providing such services,

providing traveler’s check and money order services for customers,

providing correspondent bank services for customers,

providing paying agency and collection agency services for customers,

maintaining restricted reserves (including money or securities) in a segregated account in
order to satisfy a capital or reserve requirement imposed by a local banking or securities
regulatory authority, .

engaging in hedging activities directly related to another activity described herein,

repackaging mortgages and other financial assets into securities and servicing activities
with respect to such assets (including the accrual of interest incidental to such activity),

engaging in financing activities typically provided by an investment bank, such as project
financing provided in connection with construction projects, structured finance (including
the extension of a loan and the sale of participations or interests in the loan to other
financial institutions or investors), and leasing activities to the extent incidental to such
financing activities, .

providing financial or investment advisory services, investment management services,
fiduciary services, or custodial services,

-8-



Insurance income subject to current inclusion under the subpart F rules includes any
income of a CFC attributable to the issuing or reinsuring of any insurance or annuity contract in
connection with risks located in a country other than the CFC's country of organization and
related person insurance income. Subpart F insurance income also includes income attributable
to an insurance contract in connection with risks located within the CFC's country of
organization, as the result of an arrangement under which another corporation receives a
substantially equal amount of consideration for insurance of other-country risks. Investment
income of a CFC that is allocable to any insurance or annuity contract related to risks located
outside the CFC's country of organization is taxable as subpart F insurance income (Prop. Treas.
reg. sec. 1.953-1(a)). Investment income allocable to risks located within the CFC's country of
organization generally is taxable as foreign personal holding company income.

Present law provides rules determining whether contracts are treated as life insurance or
annuity contracts for Federal income tax purposes. A statutory definition of life insurance
contract, designed to limit the investment orientation of the contract, is provided in section 7702
(and section 101(f) provides similar rules for certain contracts issued before January 1, 1985).
Certain variable contracts (other than pension plan contracts) are not treated as annuity,
endowment, or life insurance contracts for any period (and any subsequent period) for which the
investments made by the underlying segregated asset account are not adequately diversified (sec.
817(h)). In addition, a contract is not treated as an annuity contract unless rules are satisfied
with respect to required distributions where the holder dies before the entire interest in the
contract has been distributed (sec. 72(s)). Other rules determining whether contracts are treated
as life insurance or annuity contracts also apply under present law. .

Description of Proposal

In general

The proposal would provide temporary exceptions from foreign personal holding
company income and foreign base company services income for subpart F purposes for certain
income that is derived in the active conduct of an insurance, banking, financing or similar
business. These exceptions would be applicable only for taxable years beginning in 1998.

The proposal is similar to a provision that was contained in the Taxpayer Relief Act of
1997 and that was canceled by the President in accordance with the Line Item Veto Act. The
proposal reflects significant modifications to the canceled provision to address concerns about
the breadth of that provision.

With respect to income derived in the active conduct of an insurance business, the
proposal differs from the canceled provision in the following significant respects. First, rather
than providing several alternative methods for determining reserves for life insurance and
annuity contracts, such reserves would be the greater of: (1) the net surrender value of the
contracts; or (2) the reserve determined using the U.S. method (.e., the method that would apply
if the company were subject to tax under subchapter L), but using foreign interest rates and

4.



This proposal in the Chairman's amendment in the nature of a substitute differs from the
proposal in the original Chairman's mark' in that the amendment:

(1) Imposes a requirement that at least 50 percent of the product that the facility
processes for any 3 of 5 taxable years after the sale must be purchased from the cooperative or
from members of the cooperative.

(2) Provides that the requirement that at least 50 percent of the product that the facility
processed for any 3 of 5 taxable years before the sale must have been purchased from the
cooperative or from members of the cooperative only would apply in the case of a cooperative
that (a) had gross receipts in excess of $1 billion in any prior taxable year, or (b) produced a
“specialty product” (generally any farm product other than wheat, feed grain, oilseeds, cotton,
Tice, dairy products, cattle, sheep or hogs).

(3) Substitutes a recapture tax for the 10-percent excise tax in the case of certain post-
acquisition prohibited transactions.

Effective Date
The proposal would apply to sales after December 31, 1997.

2. Exceptions under Subpart F for Certain Active Financing Income

Present Law

Under the subpart F rules, certain U.S. shareholders of a controlled foreign corporation
("CFC") are subject to U.S. tax currently on certain income earned by the CFC, whether or not
such income is distributed to the shareholders. The income subject to current inclusion under the
subpart F rules includes, among other things, "foreign personal holding company income" and
insurance income. The U.S. 10-percent shareholders of a CFC also are subject to current
inclusion with respect to their shares of the CFC's foreign base company services income (i.e.,
income derived from services performed for a related person outside the country in which the
CFC is organized).

Foreign personal holding company income generally consists of the following: dividends,
interest, royalties, rents and annuities; net gains from sales or exchanges of (1) property that
gives rise to the preceding types of income, (2) property that does not give rise to income, and
(3) interests in trusts, partnerships, and REMICs; net gains from commodities transactions; net
gains from foreign currency transactions; income that is equivalent to interest; income from
notional principal contracts; and payments in lieu of dividends.

' The proposal in the original Chairman's mark is described in Joint Committee on
Taxation, Description of Legislation to Restore and Modify Provisions in the Taxpayer Relief
Act of 1997 Canceled Under the Line Item Veto Act (JCX-47-97), September 19, 1997:

3-



year, or (2) produced a “specialty product” (generally any farm product other than wheat, feed
grain, oilseeds, cotton, rice, dairy products, cattle, sheep or hogs) at least 50 percent of the
product that the facility processed for any 3 of 5 taxable years before the sale must have been
purchased from the cooperative or from members of the cooperative.

The liquidation of the corporation owning the processing facilities into, the cooperative
would be a taxable liquidation and the basis of the assets in the hands of the acquired corporation
would not be stepped-up to their acquisition price. The cooperative would be subject to a
recapture tax if it were to sell the stock of the processing corporation with 3 years after it was
acquired or if it failed to meet the post-acquisition 3-out-of-5 year use test. The amount of the
tax based on the amount of gain deferred by the seller.

The proposal is similar to a provision in the recently-passed “Taxpayers Relief Act of
1997” that was vetoed by the President under his line-item veto authority in that both provisions
would allow a tax-free rollover of gain on sale of a processing corporation to a cooperative. This
proposal differs from the vetoed provision in the following respects:

(1) The proposal would have a cap under which the maximum amount of gain than could
be deferred for sales to any particular cooperative would be $75 million per year.

(2) The proposal would prevent the conversion of a deferral provision into an exemption
by preventing the reinvestment to be in stock of the selling corporation or a related person.

(3) The proposal would lengthen the period of time that the processing corporation must
obtain more than 50 percent of its product from certain cooperatives or their members from one
year to any 3 of the 5 years preceding the sale to the cooperatives. In addition, the proposal
would require that the processing corporation must obtain more than 50 percent of its product
from any cooperative or its members for any 3 of the 5 years following the sale to the
cooperative. The effect of these differences should be to increase the portion of the tax benefit of
the tax-free rollover that is passed through to the cooperative since only a sale to a limited
number of cooperatives will be eligible for the tax-free rollover.

(4) The proposal would insure that assets stay in corporation solution unless gain is
recognized by providing that the liquidation of the corporation owning the processing facilities
would not be tax-free.

(5) The proposal would adopt an anti-churning rule that would impose a recapture tax on
the cooperative if it were to sell the stock of the processing corporation within 3 years after its
acquisition by the cooperative or if the processing facility does not continue to use the products
of the cooperative.

(6) The proposal would prevent a basis step-up without gain recognition by disallowing
the application section 338(h)(10) to the acquiring cooperative.

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