DESCRIPTION OF H.R. 4520,

THE “AMERICAN JOBS CREATION ACT OF 2004”

Scheduled for Markup

by the

HOUSE COMMITTEE ON WAYS AND MEANS

on June 14, 2004

Prepared by

the Staff of the

JOINT COMMITTEE ON TAXATION

June 10, 2004

JCX-41-04
i

CONTENTS

Page

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

I. END SANCTIONS AND REDUCE CORPORATE TAX RATES FOR DOMESTIC 

MANUFACTURING AND SMALL CORPORATIONS.............................................................. 2

A. Repeal of Exclusion for Extraterritorial Income ................................................................. 2

B. Reduced Corporate Income Tax Rate for Domestic Production Activities Income ........... 4

C. Reduced Corporate Income Tax Rate for Small Corporations ........................................... 7

II. JOB CREATION INCENTIVES FOR MANUFACTURES, SMALL BUSINESSES, AND 

FARMERS .................................................................................................................................... 10

A. Extension of Increased Section 179 Expensing for Small Businesses.............................. 10

B. Depreciation...................................................................................................................... 12

1. Recovery period for depreciation of certain leasehold improvements and restaurant 

property ....................................................................................................................... 12

2. Modification of depreciation allowance for aircraft ................................................... 14

3. Modification of placed in service rule for bonus depreciation property..................... 17

C. Proposals Relating to S Corporation Reform and Simplification..................................... 19

1. Shareholders of an S corporation................................................................................ 19

2. Treatment of S corporation shareholders.................................................................... 21

3. Proposals relating to banks ......................................................................................... 22

4. Qualified subchapter S subsidiaries............................................................................ 24

5. Repayment of loan for qualifying employer securities held by an ESOP .................. 24

D. Alternative Minimum Tax Relief...................................................................................... 27

1. Foreign tax credit under the alternative minimum tax; expansion of exemption 

from alternative minimum tax for small corporations; coordinate farmers’ 

income averaging and the alternative minimum tax ................................................... 27

E. Restructuring of Incentives for Alcohol Fuels.................................................................. 29

F. Exclusion of Incentive Stock Options and Employee Stock Purchase Plan Stock Options 

from Wages....................................................................................................................... 36

G. Incentives to Reinvest Foreign Earnings in the United States.......................................... 38

H. Other Incentive Provisions................................................................................................ 40

1. Special rules for livestock sold on account of weather-related conditions ................. 40

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

dividends..................................................................................................................... 41

3. Capital gains treatment to apply to outright sales of timber by landowner ................ 42

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

regulated investment company.................................................................................... 42

5. Improvements related to real estate investment trusts ................................................ 44

6. Treatment of certain dividends of regulated investment companies........................... 52

7. Taxation of certain settlement funds........................................................................... 58

8. Expand human clinical trials expenses qualifying for the orphan drug tax credit...... 59
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9. Simplification of excise tax imposed on bows and arrows......................................... 59

10. Repeal excise tax on fishing tackle boxes.................................................................. 60

11. Repeal of excise tax on sonar devices suitable for finding fish................................. 61

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

inventories.................................................................................................................. 61

13. Suspension of occupational taxes relating to distilled spirits, wine, and beer........... 62

III. TAX REFORM AND SIMPLIFICATION FOR BUSINESSES BASED IN THE UNITED 

STATES........................................................................................................................................ 65

A. Interest Expense Allocation Rules.................................................................................... 65

B. Recharacterization of Overall Domestic Loss .................................................................. 70

C. Reduction to Two Foreign Tax Credit Baskets................................................................. 73

D. Look-Through Rules to Apply to Dividends from Noncontrolled Section 902 

Corporations...................................................................................................................... 77

E. Attribution of Stock Ownership Through Partnerships to Apply in Determining Section 

902 and 960 Credits .......................................................................................................... 79

F. Foreign Tax Credit Treatment of Deemed Payments Under Section 367(d).................... 81

G. United States Property Not to Include Certain Assets of Controlled Foreign 

Corporation 82

H. Election Not to Use Average Exchange Rate for Foreign Tax Paid Other Than in 

Functional Currency.......................................................................................................... 85

I. Repeal of Withholding Tax on Dividends From Certain Foreign Corporations............... 86

J. Provide Equal Treatment for Interest Paid by Foreign Partnerships and Foreign 

Corporations...................................................................................................................... 88

K. Look-Through Treatment of Payments Between Related Controlled Foreign Corporations 

Under Foreign Personal Holding Company Income Rules............................................... 89

L. Look-Through Treatment Under Subpart F for Sales of Partnership Interests................. 90

M. Repeal of Foreign Personal Holding Company Rules and Foreign Investment Company 

Rules ................................................................................................................................. 91

N. Determination of Foreign Personal Holding Company Income With Respect to 

Transactions in Commodities.................................................................................................. 92

O. Modifications to Treatment of Aircraft Leasing and Shipping Income ............................ 95

P. Modification of Exceptions Under Subpart F for Active Financing Income.................... 98

IV. EXTENSION OF CERTAIN EXPIRING PROVISIONS ................................................... 100

A. Extend Alternative Minimum Tax Relief for Individuals............................................... 100

B. Extension of the Research Credit.................................................................................... 102

C. Extension and Modification of the Section 45 Electricity Production Credit................. 105

D. Indian Employment Tax Credit....................................................................................... 106

E. Extend the Work Opportunity Tax Credit....................................................................... 107

F. Extend the Welfare-To-Work Tax Credit....................................................................... 108

G. Extension of the Above-the-line Deduction for Certain Expenses of Elementary and 

Secondary School Teachers............................................................................................ 109

H. Extension of Accelerated Depreciation Benefit for Property on Indian Reservations ... 110

I. Extend Enhanced Charitable Deduction for Computer Technology and Equipment ..... 111
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J. Extension of Expensing of Certain Environmental Remediation Costs ......................... 112

K. Extension of Archer Medical Savings Accounts (“MSAs”)........................................... 113

L. Taxable Income Limit on Percentage Depletion for Oil and Natural Gas Produced from 

Marginal Properties......................................................................................................... 115

M. Qualified Zone Academy Bonds..................................................................................... 117

N. Extension of Tax Incentives for Investment in the District of Columbia ....................... 119

O. Extend the Authority to Issue Liberty Zone Bonds........................................................ 121

P. Disclosure to Law Enforcement Agencies Regarding Terrorist Activities..................... 124

Q. Disclosure of Return Information Relating to Student Loans......................................... 125

R. Extension of Cover Over of Excise Tax on Distilled Spirits to Puerto Rico and Virgin 

Islands ............................................................................................................................. 126

S. Extension of Joint Review .............................................................................................. 128

T. Parity in the Application of Certain Limits to Mental Health Benefits .......................... 129

U. Disclosure of Tax Information to Facilitate Combined Employment Tax Reporting .... 130

V. Extension of Tax Credit for Electric Vehicles and Tax Deduction for CleanFuel Vehicles .................................................................................................................. 131

V. DEDUCTION OF STATE AND LOCAL GENERAL SALES TAXES.............................. 132

A. Deduction of State and Local General Sales Taxes........................................................ 132

VI. REVENUE PROVISIONS ................................................................................................... 133

A. Provisions to Reduce Tax Avoidance Through Individual and Corporate Expatriation 133

1. Tax treatment of expatriated entities and their foreign parents ................................ 133

2. Excise tax on stock compensation of insiders in expatriated corporations............... 136

3. Reinsurance of U.S. risks in foreign jurisdictions .................................................... 140

4. Revision of tax rules on expatriation of individuals................................................. 141

5. Reporting of taxable mergers and acquisitions ......................................................... 146

6. Studies....................................................................................................................... 147

B. Taxpayer-Related Proposals........................................................................................... 149

1. Penalty for failing to disclose reportable transactions .............................................. 149

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

transactions having a significant tax avoidance purpose .......................................... 151

3. Tax shelter exception to confidentiality privileges relating to taxpayer 

communications ........................................................................................................ 155

4. Statute of limitations for unreported listed transactions ........................................... 156

5. Disclosure of reportable transactions by material advisors...................................... 157

6. Investor lists and modification of penalty for failure to maintain investor lists ....... 160

7. Penalties on promoters of tax shelters....................................................................... 162

8. Modifications to the definition of the substantial understatement............................ 163

9. Actions to enjoin conduct with respect to tax shelters and reportable transactions.. 164

10. Penalty for failure to report interests in foreign financial accounts.......................... 164

11. Regulation of individuals practicing before the Department of the Treasury.......... 165

12. Treatment of stripped interests in bond and preferred stock funds.......................... 166

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

than dividends ........................................................................................................... 169
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14. Disallowance of certain partnership loss transfers................................................... 170

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

partner ...................................................................................................................... 175

16. Repeal of special rules for FASITs, etc. .................................................................. 176

17. Limitation on transfer of built-in losses on REMIC residuals................................. 181

18. Clarification of banking business for purposes of determining investment of earnings 

in U.S. property........................................................................................................ 182

19. Alternative tax for certain small insurance companies............................................ 184

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

reportable transactions .............................................................................................. 184

21. Clarification of rules for payment of estimated tax for certain deemed asset sales. 185

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

or exchange of a principal residence......................................................................... 186

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

income inclusions in transactions with related foreign persons............................... 187

24. Exclusion from gross income for interest on overpayments of income tax by 

individuals................................................................................................................. 189

25. Deposits made to suspend the running of interest on potential underpayments ....... 190

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

payment..................................................................................................................... 193

27. Affirmation of consolidated return regulation authority........................................... 194

28. Reform of tax treatment of certain leasing arrangements and limitation on deductions 

allocable to property used by governments or other tax-exempt entities ................. 199

C. Reduction of Fuel Tax Evasion....................................................................................... 207

1. Exemption from certain excise taxes for mobile machinery vehicles ...................... 207

2. Taxation of aviation-grade kerosene ......................................................................... 208

3. Mechanical dye injection and related penalties ........................................................ 214

4. Authority to inspect on-site records.......................................................................... 216

5. Registration of pipeline or vessel operators required for exemption of bulk 

transfers to registered terminals or refineries............................................................ 217

6. Display of registration and penalties for failure to display registration and to 

register....................................................................................................................... 218

7. Penalties for failure to report .................................................................................... 219

8. Collection from Customs bond where importer not registered................................. 219

9. Modification of the use tax on heavy highway vehicles........................................... 221

10. Modification of ultimate vendor refund claims with respect to farming .................. 222

11. Dedication of revenue from certain penalties to the Highway Trust Fund ............... 222

12. Taxable fuel refunds for certain ultimate vendors .................................................... 222

13. Two-party exchanges................................................................................................ 224

14. Simplification of tax on tires..................................................................................... 225

D. Nonqualified Deferred Compensation Plans................................................................... 226

1. Treatment of nonqualified deferred compensation plans.......................................... 226

E. Other Revenue Provisions............................................................................................... 233

1. Qualified tax collection contracts ............................................................................. 233

2. Modify charitable contribution rules for donations of patents and other 

intellectual property .................................................................................................. 235
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3. Require increased reporting for noncash charitable contributions............................ 239

4. Require qualified appraisals for charitable contributions of vehicles....................... 240

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

franchises .................................................................................................................. 242

6. Increase continuous levy for certain Federal payments ............................................ 243

7. Modification of straddle rules................................................................................... 244

8. Add vaccines against Hepatitis A to the list of taxable vaccines.............................. 248

9. Add vaccines against influenza to the list of taxable vaccines................................. 248

10. Extension of IRS user fees........................................................................................ 249

11. Extension of customs user fees................................................................................. 250

12. Safe harbor for churches ........................................................................................... 251

VII. MARKET REFORM FOR TOBACCO GROWERS ......................................................... 254
1

INTRODUCTION

The House Committee on Ways and Means has scheduled a markup on June 14, 2004, on 

H.R. 4520, the “American Jobs Creation Act of 2004.” This document, 1 prepared by the staff of 

the Joint Committee on Taxation, provides a description of the “American Jobs Creation Tax Act 

of 2004.”

 

1

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

H.R. 4520, the “American Jobs Creation Act of 2004” (JCX-41-04), June 10, 2004.
2

I. END SANCTIONS AND REDUCE CORPORATE TAX RATES FOR DOMESTIC 

MANUFACTURING AND SMALL CORPORATIONS

A. Repeal of Exclusion for Extraterritorial Income

Present Law

The United States has long provided export-related benefits under a series of tax regimes, 

including the domestic international sales corporation (“DISC”) regime, the foreign sales 

corporation (“FSC”) regime, and the extraterritorial income (“ETI”) regime. Each of these 

regimes has been found to violate U.S. obligations under international trade agreements. In 

2000, the European Union (“EU”) succeeded in having the FSC regime declared a prohibited 

export subsidy by the WTO. In response to this WTO ruling, the United States repealed the FSC 

rules and enacted a new regime under the FSC Repeal and Extraterritorial Income Exclusion Act 

of 2000. The EU immediately challenged the ETI regime in the WTO, and in January of 2002 a 

WTO Appellate Body held that the ETI regime also constituted a prohibited export subsidy 

under the relevant trade agreements.

Under the ETI regime, an exclusion from gross income applies with respect to 

“extraterritorial income,” which is a taxpayer’s gross income attributable to “foreign trading 

gross receipts.” This income is eligible for the exclusion to the extent that it is “qualifying 

foreign trade income.” Qualifying foreign trade income is the amount of gross income that, if 

excluded, would result in a reduction of taxable income by the greatest of: (1) 1.2 percent of the 

foreign trading gross receipts derived by the taxpayer from the transaction; (2) 15 percent of the 

“foreign trade income” derived by the taxpayer from the transaction;2 or (3) 30 percent of the 

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

Foreign trading gross receipts are gross receipts derived from certain activities in 

connection with “qualifying foreign trade property” with respect to which certain economic 

processes take place outside of the United States. Specifically, the gross receipts must be: (1) 

from the sale, exchange, or other disposition of qualifying foreign trade property; (2) from the 

lease or rental of qualifying foreign trade property for use by the lessee outside the United States; 

(3) for services which are related and subsidiary to the sale, exchange, disposition, lease, or 

rental of qualifying foreign trade property (as described above); (4) for engineering or 

architectural services for construction projects located outside the United States; or (5) for the 

performance of certain managerial services for unrelated persons. A taxpayer may elect to treat 

 

2

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

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

receipts. 

3

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

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

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

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

by the lessee outside the United States.
3

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

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

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

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

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

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

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

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

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

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

Description of Proposal

The proposal repeals the ETI exclusion. For transactions prior to 2005, taxpayers retain 

100 percent of their ETI benefits. For transactions after 2004, the proposal provides taxpayers 

with 80 percent of their otherwise-applicable ETI benefits for transactions during 2005 and 60 

percent of their otherwise-applicable ETI benefits for transactions during 2006. However, the 

proposal provides that the ETI exclusion provisions remain in effect for transactions in the 

ordinary course of a trade or business if such transactions are pursuant to a binding contract4

between the taxpayer and an unrelated person and such contract is in effect on January 14, 2002, 

and at all times thereafter.

In addition, foreign corporations that elected to be treated for all Federal tax purposes as 

domestic corporations in order to facilitate the claiming of ETI benefits are allowed to revoke 

such elections within one year of the date of enactment of the proposal without recognition of 

gain or loss, subject to anti-abuse rules.

Effective Date

The proposal is effective for transactions after December 31, 2004.

 

4

 This rule also applies to a purchase option, renewal option, or replacement option that 

is included in such contract.
4

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

Present Law

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

rate schedule to its taxable income.

Table 1.–Marginal Federal Corporate Income Tax Rates for 2004

Taxable income: Income tax rate:

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

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

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

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

The benefit of the first two graduated rates described above is phased out by a fivepercent surcharge for corporations with taxable income between $100,000 and $335,000. Also, 

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

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

$18,333,333 or more effectively is subject to a flat rate of 35 percent.

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

income attributable to domestic production activities.

Description of Proposal

In general

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

activities income may not exceed 32 percent (34 percent for taxable years beginning before 

2007) of the qualified production activities income.

Qualified production activities income

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

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

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

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

such receipts or another class of income.5

 

5

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

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

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

relevant present-law rules (e.g., secs. 263A and 861).
5

Domestic production gross receipts

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

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

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

or in significant part) by the corporation within the United States;6 (2) any sale, exchange or 

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

(3) construction, engineering or architectural services performed in the United States for 

construction projects located in the United States. However, domestic production gross receipts 

do not include any gross receipts of the taxpayer derived from property that is leased, licensed or 

rented by the taxpayer for use by any related person. 7

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

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

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

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

film (other than compensation in the form of residuals and participations) constitutes 

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

directors, and producers.

Under the bill, an election under section 631(a) made by a corporate taxpayer for a 

taxable year ending on or before the date of enactment to treat the cutting of timber as a sale or 

exchange, may be revoked by the taxpayer without the consent of the IRS for any taxable year 

ending after that date. The prior election (and revocation) is disregarded for purposes of making 

a subsequent election.

 

6

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

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

taxpayer performs storage, handling or other processing activities (other than transportation 

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

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

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

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

respect to which the taxpayer performs processing activities (in whole or in significant part) 

within the United States.

7

 It is intended that principles similar to those under the present-law extraterritorial 

income regime apply for this purpose. See Temp. Treas. Reg. sec. 1.927(a)-1T(f)(2)(i). For 

example, this exclusion generally does not apply to property leased by the taxpayer to a related 

person if the property is held for sublease, or is subleased, by the related person to an unrelated 

person for the ultimate use of such unrelated person. Similarly, the license of computer software 

to a related person for reproduction and sale, exchange, lease, rental or sublicense to an unrelated 

person for the ultimate use of such unrelated person is not treated as excluded property by reason 

of the license to the related person.
6

Effective Date

The proposal is effective for taxable years beginning after December 31, 2004.
7

C. Reduced Corporate Income Tax Rate for Small Corporations

Present Law

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

rate schedule to its taxable income.

Table 1.–Marginal Federal Corporate Income Tax Rates for 2004

Taxable income: Income tax rate:

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

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

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

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

The benefit of the first two graduated rates described above is phased out by a fivepercent surcharge for corporations with taxable income between $100,000 and $335,000. Also, 

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

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

$18,333,333 or more effectively is subject to a flat rate of 35 percent.

Description of Proposal

Under the bill, a corporation's regular income tax liability is determined by applying the 

following tax rate schedules to its taxable income.

Table 2.–Marginal Federal Corporate Income Tax Rates for 2013 and thereafter

Taxable income: Income tax rate:

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

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

$75,001 - $20,000,000 ......................... 32 percent of taxable income

Over $20,000,000................................. 35 percent of taxable income

The benefit of the graduated rates described above is phased out by a three-percent 

surcharge for corporations with taxable income between $20 million and $40,341,667; a 

corporation with taxable income of $40,341,667 or more effectively is subject to a flat rate of 35 

percent.
8

Table 3.–Marginal Federal Corporate Income Tax Rates for 2011-2012

Taxable income: Income tax rate:

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

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

$75,001 - $5,000,000 ........................... 32 percent of taxable income

$5,000,001 - $10,000,000 ................... 34 percent of taxable income

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

The benefit of the first three graduated rates described above is phased out by a fivepercent surcharge for corporations with taxable income between $5,000,000 and $7,205,000. 

Also, the benefit of the 34-percent rate is phased out by a three-percent surcharge for 

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

taxable income of $18,333,333 or more effectively is subject to a flat rate of 35 percent.

Table 4.–Marginal Federal Corporate Income Tax Rates for 2008-2010

Taxable income: Income tax rate:

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

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

$75,001 - $1,000,000 ........................... 32 percent of taxable income

$1,000,001 - $10,000,000 ................... 34 percent of taxable income

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

The benefit of the first three graduated rates described above is phased out by a fivepercent surcharge for corporations with taxable income between $1,000,000 and $1,605,000. 

Also, the benefit of the 34-percent rate is phased out by a three-percent surcharge for 

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

taxable income of $18,333,333 or more effectively is subject to a flat rate of 35 percent.

Table 5.–Marginal Federal Corporate Income Tax Rates for 2005-2007

Taxable income: Income tax rate:

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

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

$75,001 - $1,000,000 ........................... 33 percent of taxable income

$1,000,001 - $10,000,000 ................... 34 percent of taxable income

Over $10,000,000 35 percent of taxable income
9

The benefit of the first three graduated rates described above is phased out by a fivepercent surcharge for corporations with taxable income between $1,000,000 and $1,420,000. 

Also, the benefit of the 34-percent rate is phased out by a three-percent surcharge for 

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

taxable income of $18,333,333 or more effectively is subject to a flat rate of 35 percent.

Effective Date

The proposal is effective for taxable years beginning after December 31, 2004.
10

II. JOB CREATION INCENTIVES FOR MANUFACTURES,

SMALL BUSINESSES, AND FARMERS

A. Extension of Increased Section 179 Expensing

for Small Businesses

Present Law

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

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

Reconciliation Act (JGTRRA) of 20038 increased the amount a taxpayer may deduct, for taxable 

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

service for the taxable year.9 In general, qualifying property is defined as depreciable tangible 

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

of a trade or business. The $100,000 amo unt is reduced (but not below zero) by the amount by 

which the cost of qualifying property placed in service during the taxable year exceeds $400,000. 

The $100,000 and $400,000 amounts are indexed for inflation. 

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

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

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

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

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

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

active conduct of a trade or business. 

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

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

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

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

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

for which a deduction is allowed under section 179.

Under present law, an expensing election is made under rules prescribed by the 

Secretary.10 Applicable Treasury Regulations provide that an expensing election generally is 

made on the taxpayer's original return for the taxable year to which the election relates.11

 

8

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

9

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

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

1397A), or a renewal community (sec. 1400J).

10 Sec. 179(c)(1).
11

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

thereafter), an expensing election may be revoked only with consent of the Commissioner.12 

JGTRRA permits taxpayers to revoke expensing elections on amended returns without the 

consent of the Commissioner with respect to a taxable year beginning after 2002 and before 

2006.13

Description of Proposal

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

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

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

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

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

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

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

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

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

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

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

beginning before 2008. The Committee expects that the Secretary will prescribe regulations to 

permit a taxpayer to make an expensing election on an amended return without the consent of the 

Commissioner.

Effective Date

The proposal is effective on the date of enactment.

 

11 Treas. Reg. sec. 1.179-5. Under these regulations, a taxpayer may make the election 

on the original return (whether or not the return is timely), or on an amended return filed by the 

due date (including extensions) for filing the return for the tax year the property was placed in 

service. If the taxpayer timely filed an original return without making the election, the taxpayer 

may still make the election by filing an amended return within six months of the due date of the 

return (excluding extensions). 

12 Sec. 179(c)(2). 

13

 Id.
12

B. Depreciation

1. Recovery period for depreciation of certain leasehold improvements and restaurant 

property

Present Law

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

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

property generally is depreciated under the modified accelerated cost recovery system 

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

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

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

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

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

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

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

Depreciation of leasehold improvements

Depreciation allowances for improvements made on leased property are determined 

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

term of the lease (sec. 168(i)(8)).14 This rule applies regardless of whether the lessor or the 

lessee places the leasehold improvements in service.15 If a leasehold improvement constitutes 

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

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

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

(d)(2), and (i)(6)).16

 

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

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

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

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

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

depreciation under MACRS.

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

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

The Tax Reform Act of 1986 repealed these provisions.

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

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

conventions applicable to such property. The determination of whether improvements are 

characterized as tangible personal property or as nonresidential real property often depends on 

whether or not the improvements constitute a “structural component” of a building (as defined by 

Treas. Reg. sec. 1.48-1(e)(1)). See, e.g., Metro National Corp v. Commissioner, 52 TCM (CCH) 
13

Qualified leasehold improvement property

The Job Creation and Worker Assistance Act of 2002, as amended by the Jobs and 

Growth Tax Relief Reconciliation Act of 2003, generally provides an additional first-year 

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

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

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

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

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

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

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

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

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

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

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

Treatment of dispositions of leasehold improvements 

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

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

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

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

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

lease. 

Description of Proposal

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

improvement property placed in service before January 1, 2006.17 The proposal requires that 

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

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

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

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

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

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

transfers of property that qualify for non-recognition treatment.

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

property placed in service before January 1, 2006.18 For purposes of the proposal, qualified 

 

1440 (1987); King Radio Corp Inc. v. U.S., 486 F.2d 1091 (10th Cir. 1973); Mallinckrodt, Inc. v. 

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

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

first-year depreciation deduction under sec. 168(k).
14

restaurant property means any improvement to a building if such improvement is placed in 

service more than three years after the date such building was first placed in service and more 

than 50 percent of the building’s square footage is devoted to the preparation of, and seating for, 

on-premises consumption of prepared meals. The proposal requires that qualified restaurant 

property be recovered using the straight-line method. 

Effective Date

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

2. Modification of depreciation allowance for aircraft 

Present Law

In general 

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

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

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

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

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

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

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

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

in which the depreciation deduction would be maximized. 

Thirty-percent additional first year depreciation deduction

The Job Creation and Worker Assistance Act of 200219 (“JCWAA”) allows an additional 

first-year depreciation deduction equal to 30 percent of the adjusted basis of qualified property. 20 

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

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

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

service.21 The basis of the property and the depreciation allowances in the year of purchase and 

 

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

depreciation deduction under sec. 168(k) by virtue of the assigned 15-year recovery period.

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

201 (2003).

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

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

section 263 or section 263A.

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

of computing earnings and profits.
15

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

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

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

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

depreciation for any class of property for any taxable year.22

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

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

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

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

section 197, or (4) qualified leasehold improvement property (as defined in section 168(k)(3)). 23 

Second, the original use24 of the property must commence with the taxpayer on or after 

September 11, 2001. Third, the taxpayer must acquire the property within the applicable time 

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

An extension of the placed-in-service date of one year (i.e., January 1, 2006) is provided 

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

property. 25 Transportation property is defined as tangible personal property used in the trade or 

business of transporting persons or property.

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

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

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

after September 10, 2001, and before January 1, 2005.26 For property eligible for the extended 

 

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

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

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

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

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

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

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

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

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

share of the property).

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

must be subject to section 263A by reason of having a production period exceeding two years or 

an estimated production period exceeding one year and a cost exceeding $1 million.

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

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

September 11, 2001.
16

placed-in-service date, a special rule limits the amount of costs eligible for the additional first 

year depreciation. With respect to such property, only the portion of the basis that is properly 

attributable to the costs incurred before January 1, 2005 (“progress expenditures”) is eligible for 

the additional first-year depreciation.27 

Fifty-percent additional first year depreciation

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA”)28 provides an 

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

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

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

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

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

additional first-year depreciation deduction. 

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

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

2003.29 With respect to property that is manufactured, constructed, or produced by the taxpayer 

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

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

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

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

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

the costs incurred before January 1, 2005 are eligible for the additional first-year depreciation.30

Description of Proposal

The proposal provides criteria under which certain non-commercial aircraft can qualify 

for the extended placed in service date. Qualifying aircraft would be eligible for the additional 

first-year depreciation deduction if placed in service before January 1, 2006. In order to qualify, 

the aircraft must:

 

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

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

apply. 

28 Pub. L. No. 108-27, sec. 201 (2003).

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

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

May 6, 2003. However, no 50 percent additional first-year depreciation is permitted on any such 

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

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

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

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

apply. 
17

(a) meet the appropriate placed-in-service date requirements;

(b) not be tangible personal property used in the trade or business of transporting persons 

or property (except for agricultural or firefighting purposes); 

(c) be purchased by a purchaser who, at the time of the contract for purchase, has made a 

nonrefundable deposit of at least ten percent of the cost or $100,000; and 

(d) have an estimated production period exceeding four months and a cost exceeding 

$200,000. 

Effective Date

The proposal is effective as if included in the amendments made by section 101 of the 

Job Creation and Worker Assistance Act of 2002, which applies to property placed in service 

after September 10, 2001. However, because the property described by the provision qualifies 

for the additional first-year depreciation deduction under present law if placed in service prior to 

January 1, 2005, the provision will only modify the treatment of property placed in service 

during calendar year 2005. 

3. Modification of placed in service rule for bonus depreciation property

Present Law

Section 101 of the Job Creation and Worker Assistance Act of 2002 (“JCWAA”) 

provides generally for 30-percent additional first-year depreciation, and provides a binding 

contract rule in determining property that qualifies for it. The requirements that must be satisfied 

in order for property to qualify include that (1) the original use of the property must commence 

with the taxpayer on or after September 11, 2001, (2) the taxpayer must acquire the property 

after September 10, 2001 and before September 11, 2004, and (3) no binding written contract for 

the acquisition of the property is in effect before September 11, 2001 (or, in the case of selfconstructed property, manufacture, construction, or production of the property does not begin 

before September 11, 2001). In addition, the Act provides a special rule in the case of certain 

leased property. In the case of any property that is originally placed in service by a person and 

that is sold to the taxpayer and leased back to such person by the taxpayer within three months 

after the date that the property was placed in service, the property is treated as originally placed 

in service by the taxpayer not earlier than the date that the property is used under the leaseback. 

The Act did not specifically address the syndication of a lease by the lessor. 

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

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

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

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

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

respect to which the 50-percent additional first-year depreciation deduction is claimed is not also 

eligible for the 30-percent additional first-year depreciation deduction. In order to qualify, the 

property must be acquired after May 5, 2003 and before January 1, 2005, and no binding written 

contract for the acquisition can be in effect before May 6, 2003. With respect to property that is 
18

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

must begin the manufacture, construction, or production of the property after May 5, 2003. 

Description of Proposal

The proposal provides that if property is originally placed in service by a lessor 

(including by operation of section 168(k)(2)(D)(i)), such property is sold within three months 

after the date that the property was placed in service, and the user of such property does not 

change, then the property is treated as originally placed in service by the taxpayer not earlier than 

the date of such sale. The provision also provides a special rule in the case of multiple units of 

property subject to the same lease. In such cases, property will qualify as placed in service on 

the date of sale if it is sold within three months after the final unit is placed in service, so long as 

the period between the time the first and last units are placed in service does not exceed 12 

months. 

Effective Date

The proposal is generally effective as if included in the amendments made by section 101 

of the Job Creation and Worker Assistance Act of 2002. However, the special rule in the case of 

multiple units of property subject to the same lease applies to property sold after June 4, 2004.
19

C. Proposals Relating to S Corporation Reform and Simplification

Overview

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

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

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

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

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

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

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

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

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

shareholder.

1. Shareholders of an S corporation 

Present Law

In general

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

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

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

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

whom are individuals (and certain trusts, estates, charities, and qualified retirement plans)31 who 

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

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

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

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

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

DISC.

Individual retirement accounts

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

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

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

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

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

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

 

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

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

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

S corporation stock, are taken into account in computing unrelated business taxable income.
20

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

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

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

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

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

homebuyer expenses of up to $10,000.

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

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

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

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

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

to the beneficiary.

Description of Proposal

In general

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

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

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

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

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

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

in effect until terminated. 

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

Individual retirement accounts

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

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

proposal.32 

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

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

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

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

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

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

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

120 days after the S corporation election is made.

 

32 Under the bill, the present-law rules treating S corporation stock held by a qualified 

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

holding stock of a bank that is an S corporation.
21

Effective Date

The proposals generally apply to taxable years beginning after December 31, 2004. The 

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

2. Treatment of S corporation shareholders

(a) Electing small business trusts

Present Law

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

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

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

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

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

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

receive a distribution from the trust.

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

becomes a potential current beneficiary to avoid disqualification.

Description of Proposal

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

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

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

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

Effective Date

The proposal applies to taxable years beginning after December 31, 2004.

(b) Qualified subchapter S trusts

Present Law

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

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

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

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

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

beneficiary for the life of the beneficiary.
22

Description of Proposal

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

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

of the S corporation stock.

Effective Date

The proposal applies to taxable years beginning after December 31, 2004.

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

Present Law

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

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

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

subsequent taxable year. 

Description of Proposal

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

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

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

year.

Effective Date

The proposal applies to taxable years beginning after December 31, 2004.

3. Proposals relating to banks

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

corporations

Present Law

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

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

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

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

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

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

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

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

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

year. Net passive income is defined as passive investment income reduced by the allowable 
23

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

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

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

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

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

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

property) of an options or commodities dealer. 

Description of Proposal

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

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

as passive investment income for purposes of applying the excess net passive income rules.

Effective Date

The proposal applies to taxable years beginning after December 31, 2004.

(b) Treatment of qualifying director shares

Present Law

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

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

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

Description of Proposal

Under the bill, restricted bank director stock is not taken into account as outstanding 

stock in applying the provisions of subchapter S. Thus, the stock will not be treated as a second 

class of stock; the holder of the stock will not be treated as a shareholder by reason of the 

ownership of the stock; and the stock will be disregarded in allocating items of income, loss, etc. 

among the shareholders.

Restricted bank director stock means shares in a bank (as defined in section 581), a bank 

holding company (within the meaning of section 2(a) of the Bank Holding Company Act of 

1956), or a financial holding company (as defined in section 2(p) of that Act) held by an 

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

to an agreement with the bank or holding company (or corporation in control of the bank or 

company) pursuant to which the holder agrees to sell the stock back upon ceasing to be a director 

at the same price the individual acquired the stock. 

Distributions (not in exchange for the stock) with respect to the restricted shares are 

includible in the gross income of the director and deductible by the S corporation.
24

Effective Date

The proposal applies to taxable years beginning after December 31, 2004.

4. Qualified subchapter S subsidiaries

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

terminations

Present Law

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

waived.

Description of Proposal

The bill allows inadvertent invalid qualified subchapter S subsidiary elections and 

terminations to be waived by the IRS.

Effective Date

The proposal applies to taxable years beginning after December 31, 2004.

(b) Information returns for qualified subchapter S subsidiaries

Present Law

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

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

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

of the parent S corporation.

Description of Proposal

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

information returns of qualified subchapter S subsidiaries.

Effective Date

The proposal applies to taxable years beginning after December 31, 2004.

5. Repayment of loan for qualifying employer securities held by an ESOP

Present Law

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

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

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

traded common stock of the employer or a member of the same controlled group; (2) if there is 
25

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

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

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

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

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

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

including a special exemption from the prohibited transaction rules.

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

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

imposition of an excise tax. 33 Prohibited transactions include, among other transactions, (1) the 

sale, exchange or leasing of property between a plan and a disqualified person, (2) the lending of 

money or other extension of credit between a plan and a disqualified person, and (3) the transfer 

to, or use by or for the benefit of, a disqualified person of the income or assets of the plan. 

However, certain transactions are exempt from prohibited transaction treatment, including 

certain loans to enable an ESOP to purchase qualifying employer securities.34 In such a case, the 

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

loan. Contributions to the ESOP and dividends paid on employer securities held by the ESOP 

are used to repay the loan. The employer securities are held in a suspense account and released 

for allocation to participants’ accounts as the loan is repaid.

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

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

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

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

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

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

contributions described in (2).35 In addition, the payments made on the loan by the ESOP during 

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

prior years, less loan payments made in prior years.

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

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

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

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

used to acquire the employer securities (whether or not allocated to participants).36 In the case of 

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

 

33 Sec. 4975.

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

to as a “leveraged” ESOP.

35 Treas. Reg. sec. 54.4975-7(b)(5).

36 Sec. 404(k)(5)(B).
26

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

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

dividend would have been allocated to the participant. 37

Description of Proposal

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

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

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

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

to acquire the securities (whether or not allocated to participants). This relief does not apply in 

the case of a distribution with respect to S corporation stock that is allocated to a participant 

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

distribution is allocated to the participant for the year which the distribution would have been 

allocated to the participant. 

Effective Date

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

December 31, 2004. 

 

37 Sec. 404(k)(2)(B).
27

D. Alternative Minimum Tax Relief

1. Foreign tax credit under the alternative minimum tax; expansion of exemption from 

alternative minimum tax for small corporations; coordinate farmers’ income averaging 

and the alternative minimum tax 

Present Law

In general

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

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

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

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

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

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

benefits resulting from the regular tax treatment of such items.

Foreign tax credit

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

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

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

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

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

ratio of foreign source regular taxable income to total AMTI.

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

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

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

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

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

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

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

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

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

section 904(c).

Small corporation exemption

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

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

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

Farmer income averaging 

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

may elect to compute his or her current year tax liability by averaging, over the prior three-year 
28

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

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

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

Description of Proposal

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

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

receive from $7.5 million to $20 million.

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

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

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

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

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

Effective Date

The proposal relating to the foreign tax credit applies to taxable years beginning after 

December 31, 2004. 

The proposal relating to the small corporation exemption applies to taxable years 

beginning after December 31, 2005.

The proposal relating to farmers’ income averaging applies to taxable years beginning 

after December 31, 2003.
29

E. Restructuring of Incentives for Alcohol Fuels

Present Law

Alcohol fuels income tax credit

The alcohol fuels credit is the sum of three credits: the alcohol mixture credit, the alcohol 

credit, and the small ethanol producer credit. Generally, the alcohol fuels credit expires after 

December 31, 2007.38

A taxpayer (generally a petroleum refiner, distributor, or marketer) who mixes ethanol 

with gasoline (or a special fuel

39) is an “ethanol blender.” Ethanol blenders are eligible for an 

income tax credit of 52 cents per gallon of ethanol used in the production of a qualified mixture 

(the “alcohol mixture credit”). A qualified mixture means a mixture of alcohol and gasoline, (or 

of alcohol and a special fuel) sold by the blender as fuel, or used as fuel by the blender in 

producing the mixture. The term alcohol includes methanol and ethanol but does not include 

(1) alcohol produced from petroleum, natural gas, or coal (including peat), or (2) alcohol with a 

proof of less than 150. Businesses also may reduce their income taxes by 52 cents for each 

gallon of ethanol (not mixed with gasoline or other special fuel) that they sell at the retail level as 

vehicle fuel or use themselves as a fuel in their trade or business (“the alcohol credit”). The 52-

cents-per-gallon income tax credit rate is scheduled to decline to 51 cents per gallon during the 

period 2005 through 2007. For blenders using an alcohol other than ethanol, the rate is 60 cents 

per gallon.40 

A separate income tax credit is available for small ethanol producers (the “small ethanol 

producer credit”). A small ethanol producer is defined as a person whose ethanol production 

capacity does not exceed 30 million gallons per year. The small ethanol producer credit is 10 

cents per gallon of ethanol produced during the taxable year for up to a maximum of 15 million 

gallons. 

The credits that comprise the alcohol fuels tax credit are includible in income. The credit 

may not be used to offset alternative minimum tax liability. The credit is treated as a general 

business credit, subject to the ordering rules and carryforward/carryback rules that apply to 

business credits generally.

 

38 The alcohol fuels credit is unavailable when, for any period before January 1, 2008, 

the tax rates for gasoline and diesel fuels drop to 4.3 cents per gallon.

39 A special fuel includes any liquid (other than gasoline) that is suitable for use in an 

internal combustion engine.

40 In the case of any alcohol (other than ethanol) with a proof that is at least 150 but less 

than 190, the credit is 45 cents per gallon (the “low-proof blender amount”). For ethanol with a 

proof that is at least 150 but less than 190, the low-proof blender amount is 38.52 cents for sales 

or uses during calendar year 2004, and 37.78 cents for calendar years 2005, 2006, and 2007. 
30

Excise tax reductions for alcohol mixture fuels

Generally, motor fuels tax rates are as follows:41

Gasoline 18.3 cents per gallon

Diesel fuel and kerosene 24.3 cents per gallon

Special motor fuels 18.3 cents per gallon generally

Alcohol-blended fuels are subject to a reduced rate of tax. The benefits provided by the 

alcohol fuels income tax credit and the excise tax reduction are integrated such that the alcohol 

fuels credit is reduced to take into account the benefit of any excise tax reduction.

Gasohol

Registered ethanol blenders may forgo the full income tax credit and instead pay reduced 

rates of excise tax on gasoline that they purchase for blending with ethanol. Most of the benefit 

of the alcohol fuels credit is claimed through the excise tax system.

The reduced excise tax rates apply to gasohol upon its removal or entry. Gasohol is 

defined as a gasoline/ethanol blend that contains 5.7 percent ethanol, 7.7 percent ethanol, or 10 

percent ethanol. For the calendar year 2004, the following reduced rates apply to gasohol:42

5.7 percent ethanol 15.436 cents per gallon

7.7 percent ethanol 14.396 cents per gallon

10.0 percent ethanol 13.200 cents per gallon

Reduced excise tax rates also apply when gasoline is being purchased for the production 

of “gasohol.” When gasoline is purchased for blending into gasohol, the rates above are 

multiplied by a fraction (e.g., 10/9 for 10-percent gasohol) so that the increased volume of motor 

fuel will be subject to tax. The reduced tax rates apply if the person liable for the tax is 

registered with the IRS and (1) produces gasohol with gasoline within 24 hours of removing or 

 

41 These fuels are also subject to an additional 0.1 cent-per-gallon excise tax to fund the 

Leaking Underground Storage Tank Trust Fund. See secs. 4041(d) and 4081(a)(2)(B). In 

addition, the basic fuel tax rate will drop to 4.3 cents per gallon beginning on October 1, 2005.

42 These rates include the additional 0.1 cent-per-gallon excise tax to fund the Leaking 

Underground Storage Tank Trust Fund. These special rates will terminate after September 30, 

2007 (sec. 4081(c)(8)). 
31

entering the gasoline or (2) gasoline is sold upon its removal or entry and such person has an 

unexpired certificate from the buyer and has no reason to believe the certificate is false.43

Qualified methanol and ethanol fuels

Qualified methanol or ethanol fuel is any liquid that contains at least 85 percent methanol 

or ethanol or other alcohol produced from a substance other than petroleum or natural gas. 

These fuels are taxed at reduced rates.44 The rate of tax on qualified methanol is 12.35 cents per 

gallon. The rate on qualified ethanol in 2004 is 13.15 cents. From January 1, 2005 through 

September 30, 2007, the rate of tax on qualified ethanol is 13.25 cents.

Alcohol produced from natural gas

A mixture of methanol, ethanol, or other alcohol produced from natural gas that consists 

of at least 85 percent alcohol is also taxed at reduced rates.45 For mixtures not containing 

ethanol, the applicable rate of tax is 9.25 cents per gallon before October 1, 2005. In all other 

cases, the rate is 11.4 cents per gallon. After September 30, 2005, the rate is reduced to 2.15 

cents per gallon when the mixture does not contain ethanol and 4.3 cents per gallon in all other 

cases.

Blends of alcohol and diesel fuel or special motor fuels

A reduced rate of tax applies to diesel fuel or kerosene that is combined with alcohol as 

long as at least 10 percent of the finished mixture is alcohol. If none of the alcohol in the 

mixture is ethanol, the rate of tax is 18.4 cents per gallon. For alcohol mixtures containing 

ethanol, the rate of tax in 2004 is 19.2 cents per gallon and 19.3 cents per gallon for 2005 

through September 30, 2007. Fuel removed or entered for use in producing a 10 percent dieselalcohol fuel mixture (without ethanol), is subject to a tax of 20.44 cents per gallon. The rate of 

tax for fuel removed or entered for use to produce a 10 percent diesel-ethanol fuel mixture is 

21.333 cents per gallon for 2004 and 21.444 cents per gallon for the period January 1, 2005 

through September 30, 2007.46

 

43 Treas. Reg. sec. 48.4081-6(c). A certificate from the buyer assures that the gasoline 

will be used to produce gasohol within 24 hours after purchase. A copy of the registrant’s letter 

of registration cannot be used as a gasohol blender’s certificate.

44 These reduced rates terminate after September 30, 2007. Included in these rates is the 

0.05-cent-per-gallon Leaking Underground Storage Tank Trust Fund tax imposed on such fuel. 

(sec. 4041(b)(2)).

45 These rates include the additional 0.1 cent-per-gallon excise tax to fund the Leaking 

Underground Storage Tank Trust Fund (sec. 4041(d)(1)).

46 These rates include the additional 0.1 cent-per-gallon excise tax to fund the Leaking 

Underground Storage Tank Trust Fund.
32

Special motor fuel (nongasoline) mixtures with alcohol also are taxed at reduced rates. 

Aviation fuel

Noncommercial aviation fuel is subject to a tax of 21.9 cents per gallon. 47 Fuel mixtures 

containing at least 10 percent alcohol are taxed at lower rates.48 In the case of 10 percent ethanol 

mixtures, for any sale or use during 2004, the 21.9 cents is reduced by 13.2 cents (for a tax of 8.7 

cents per gallon), for 2005, 2006, and 2007 the reduction is 13.1 cents (for a tax of 8.8 cents per 

gallon) and is reduced by 13.4 cents in the case of any sale during 2008 or thereafter. For 

mixtures not containing ethanol, the 21.9 cents is reduced by 14 cents for a tax of 7.9 cents. 

These reduced rates expire after September 30, 2007. 49

When aviation fuel is purchased for blending with alcohol, the rates above are multiplied 

by a fraction (10/9) so that the increased volume of aviation fuel will be subject to tax.

Refunds and payments

If fully taxed gasoline (or other taxable fuel) is used to produce a qualified alcohol 

mixture, the Code permits the blender to file a claim for a quick excise tax refund. The refund is 

equal to the difference between the gasoline (or other taxable fuel) excise tax that was paid and 

the tax that would have been paid by a registered blender on the alcohol fuel mixture being 

produced. Generally, the IRS pays these quick refunds within 20 days. Interest accrues if the 

refund is paid more than 20 days after filing. A claim may be filed by any person with respect to 

gasoline, diesel fuel, or kerosene used to produce a qualified alcohol fuel mixture for any period 

for which $200 or more is payable and which is not less than one week.

Ethyl tertiary butyl ether (ETBE)

Ethyl tertiary butyl ether (“ETBE”) is an ether that is manufactured using ethanol. 

Unlike ethanol, ETBE can be blended with gasoline before the gasoline enters a pipeline because 

ETBE does not result in contamination of fuel with water while in transport. Treasury 

regulations provide that gasohol blenders may claim the income tax credit and excise tax rate 

reductions for ethanol used in the production of ETBE. The regulations also provide a special 

election allowing refiners to claim the benefit of the excise tax rate reduction even though the 

fuel being removed from terminals does not contain the requisite percentages of ethanol for 

claiming the excise tax rate reduction.

 

47 This rate includes the additional 0.1 cent-per-gallon tax for the Leaking Underground 

Storage Tank Trust fund.

48 Secs. 4041(k)(1) and 4091(c).

49 Sec. 4091(c)(1). 
33

Highway Trust Fund

With certain exceptions, the taxes imposed by section 4041 (relating to retail taxes on 

diesel fuels and special motor fuels) and section 4081 (relating to tax on gasoline, diesel fuel and 

kerosene) are credited to the Highway Trust Fund. In the case of alcohol fuels, 2.5 cents per 

gallon of the tax imposed is retained in the General Fund.50 In the case of a taxable fuel taxed at 

a reduced rate upon removal or entry prior to mixing with alcohol, 2.8 cents of the reduced rate is 

retained in the General Fund.51

Taxes from gasoline and special motor fuels used in motorboats and gasoline used in the 

nonbusiness use of small-engine outdoor power equipment

The Aquatic Resources Trust Fund is funded by a portion of the receipts from the excise 

tax imposed on motorboat gasoline and special motor fuels, as well as small-engine fuel taxes, 

that are first deposited into the Highway Trust Fund. As a result, transfers to the Aquatic 

Resources Trust Fund are governed in part by Highway Trust Fund provisions.52

A total tax rate of 18.4 cents per gallon is imposed on gasoline and special motor fuels 

used in motorboats. Of this rate, 0.1 cent per gallon is dedicated to the Leaking Underground 

Storage Tank Trust Fund. Of the remaining 18.3 cents per gallon, the Code currently transfers 

13.5 cents per gallon from the Highway Trust Fund to the Aquatics Resources Trust Fund and 

Land and Water Conservation Fund. The remainder, 4.8 cents per gallon, is retained in the 

General Fund. In addition, the Sport Fish Restoration Account of the Aquatics Resources Trust 

Fund receives 13.5 cents per gallon of the revenues from the tax imposed on gasoline used as a 

fuel in the nonbusiness use of small-engine outdoor power equipment. The balance of 4.8 cents 

per gallon is retained in the General Fund.53

Description of Proposal

Overview

The proposal eliminates reduced rates of excise tax for alcohol-blended fuels and imposes 

the full rate of excise tax on alcohol-blended fuels (18.4 cents per gallon on gasoline blends and 

24.4 cents per gallon of diesel blended fuel). In place of reduced rates, the proposal permits the 

section 40 alcohol mixture credit, with certain modifications, to be applied against excise tax 

liability. The credit may be taken against the tax imposed on taxable fuels (by section 4081). 

To the extent a person does not have section 4081 liability, the proposal allows taxpayers to file a 

claim for payment equal to the amount of the credit for the alcohol used to produce an eligible 

 

50 Sec. 9503(b)(4)(E).

51 Sec. 9503(b)(4)(F).

52 Sec. 9503(c)(4) and 9503(c)(5).

53 The Sport Fish Restoration Account also is funded with receipts from an ad valorem 

manufacturer's excise tax on sport fishing equipment.
34

mixture. Under certain circumstances, a tax is imposed if an alcohol fuel mixture credit is 

claimed with respect to alcohol used in the production of any alcohol mixture, which is 

subsequently used for a purpose for which the credit is not allowed or changed into a substance 

that does not qualify for the credit. The proposal eliminates the General Fund retention of 

certain taxes on alcohol fuels, and credits these taxes to the Highway Trust Fund. 

Alcohol fuel mixture excise tax credit and payment provisions

Alcohol fuel mixture excise tax credit

The proposal eliminates the reduced rates of excise tax for alcohol-blended fuels and 

taxable fuels used to produce an alcohol fuel mixture. Under the proposal, the full rate of tax for 

taxable fuels is imposed on both alcohol fuel mixtures and the taxable fuel used to produce an 

alcohol fuel mixture. 

In lieu of the reduced excise tax rates, the proposal provides that the alcohol mixture 

credit provided under section 40 may be applied against section 4081 excise tax liability 

(hereinafter referred to as “the alcohol fuel mixture credit”). The credit is treated as a payment 

of the taxpayer’s tax liability received at the time of the taxable event. The alcohol fuel mixture 

credit is 52 cents for each gallon of alcohol used by a person in producing an alcohol fuel 

mixture for sale or use in a trade or business of the taxpayer. The credit declines to 51 cents per 

gallon after calendar year 2004. For mixtures not containing ethanol (renewable source 

methanol), the credit is 60 cents per gallon. As discussed further below, the excise tax credit is 

refundable in order to provide a benefit equivalent to the reduced tax rates, which are being 

repealed under the proposal.

For purposes of the alcohol fuel mixture credit, an “alcohol fuel mixture” is a mixture of 

alcohol and gasoline or alcohol and a special fuel which is sold for use or used as a fuel by the 

taxpayer producing the mixture. Alcohol for this purpose includes methanol, ethanol, and 

alcohol gallon equivalents of ETBE or other ethers produced from such alcohol. It does not 

include alcohol produced from petroleum, natural gas, or coal (including peat), or alcohol with a 

proof of less than 190 (determined without regard to any added denaturants). Special fuel is any 

liquid fuel (other than gasoline) which is suitable for use in an internal combustion engine. The 

benefit obtained from the excise tax credit is coordinated with the alcohol fuels income tax 

credit. For refiners making an alcohol fuel mixture with ETBE, the mixture is treated as sold to 

another person for use as a fuel only upon removal from the refinery. The excise tax credit is 

available through December 31, 2010.

Payments with respect to qualified alcohol fuel mixtures 

To the extent the alcohol fuel mixture credit exceeds any section 4081 liability of a 

person, the Secretary is to pay such person an amount equal to the alcohol fuel mixture credit 

with respect to such mixture. These payments are intended to provide an equivalent benefit to 

replace the partial exemption for fuels to be blended with alcohol and alcohol fuels being 

repealed by the proposal. If claims for payment are not paid within 45 days, the claim is to be 

paid with interest. The proposal also provides that in the case of an electronic claim, if such 
35

claim is not paid within 20 days, the claim is to be paid with interest. If claims are filed 

electronically, the claimant may make a claim for less than $200.

The proposal does not apply with respect to alcohol fuel mixtures sold after December 

31, 2010. 

Alcohol fuel subsidies borne by General Fund

The proposal eliminates the requirement that 2.5 and 2.8 cents per gallon of excise taxes 

be retained in the General Fund with the result that the full amount of tax on alcohol fuels is 

credited to the Highway Trust Fund. The proposal also authorizes the full amount of fuel taxes 

to be appropriated to the Highway Trust Fund without reduction for amounts equivalent to the 

excise tax credits allowed for alcohol fuel mixtures, and the Trust Fund is not required to 

reimburse any payments with respect to qualified alcohol fuel mixtures.

Motorboat and small engine fuel taxes

The proposal eliminates the General Fund retention of the 4.8 cents per gallon of the 

taxes imposed on gasoline and special motor fuels used in motorboats and gasoline used as a fuel 

in the nonbusiness use of small-engine outdoor power equipment.

Effective Dates

The proposals generally are effective for fuel sold or used after September 30, 2004. The 

repeal of the General Fund retention of the 2.5/2.8 cents per gallon of tax regarding alcohol fuels 

and the repeal of the 4.8 cents per gallon General Fund retention of the taxes imposed on fuels 

used in motorboats and small engine equipment is effective for taxes imposed after 

September 30, 2003. The proposal regarding the crediting of the full amount of tax to the 

Highway Trust Fund without regard to credits and payments is effective for taxes received after 

September 30, 2004, and payments made after September 30, 2004.
36

F. Exclusion of Incentive Stock Options and Employee Stock

Purchase Plan Stock Options from Wages

Present Law

Generally, when an employee exercises a compensatory option on employer stock, the 

difference between the option price and the fair market value of the stock (i.e., the “spread”) is 

includible in income as compensation. In the case of an incentive stock option or an option to 

purchase stock under an employee stock purchase plan (collectively referred to as “statutory 

stock options”), the spread is not included in income at the time of exercise.54 

If the statutory holding period requirements are satisfied with respect to stock acquired 

through the exercise of a statutory stock option, the spread, and any additional appreciation, will 

be taxed as capital gain upon disposition of such stock. Compensation income is recognized, 

however, if there is a disqualifying disposition (i.e., if the statutory holding period is not 

satisfied) of stock acquired pursuant to the exercise of a statutory stock option. 

Federal Insurance Contribution Act (“FICA”) and Federal Unemployment Tax Act 

(“FUTA”) taxes (collectively referred to as “employment taxes”) are generally imposed in an 

amount equal to a percentage of wages paid by the employer with respect to employment. 55 The 

applicable Code provisions56 do not provide an exception from FICA and FUTA taxes for wages 

paid to an employee arising from the exercise of a statutory stock option. 

There has been uncertainty in the past as to employer withholding obligations upon the 

exercise of statutory stock options. On June 25, 2002, the IRS announced that until further 

guidance is issued, it would not assess FICA or FUTA taxes, or impose Federal income tax 

withholding obligations, upon either the exercise of a statutory stock option or the disposition of 

stock acquired pursuant to the exercise of a statutory stock option. 57

Description of Proposal

The proposal provides specific exclusions from FICA and FUTA wages for remuneration 

on account of the transfer of stock pursuant to the exercise of an incentive stock option or under 

an employee stock purchase plan, or any disposition of such stock. Thus, under the proposal, 

 

54 Sec. 421. For purposes of the individual alternative minimum tax, the transfer of stock 

pursuant to an incentive stock option is generally treated as the transfer of stock pursuant to a 

nonstatutory option. Sec. 56(b)(3).

55 Secs. 3101, 3111 and 3301.

56 Secs. 3121 and 3306.

57 Notice 2002-47, 2002-28 I.R.B. 97.
37

FICA and FUTA taxes do not apply upon the exercise of a statutory stock option. 58 The proposal 

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

Security benefits.

Additionally, the proposal provides that Federal income tax withholding is not required 

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

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

Effective Date

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

enactment. 

 

58 The provision also provides a similar exclusion under the Railroad Retirement Tax 

Act. 
38

G. Incentives to Reinvest Foreign Earnings in the United States

Present Law

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

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

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

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

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

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

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

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

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

are the controlled foreign corporation rules of subpart F59 and the passive foreign investment 

company rules.60 A foreign tax credit generally is available to offset, in whole or in part, the 

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

repatriated as a dividend, or included in income under the anti-deferral rules.61

Description of Proposal

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

foreign corporation are eligible for an 85-percent dividends-received deduction. At the 

taxpayer’s election, this deduction is available for dividends received either: (1) during the first 

six months of the taxpayer’s first taxable year beginning on or after the date of enactment of the 

bill; or (2) during any six-month or shorter period after the date of enactment of the bill, during 

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

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

The deduction applies only to dividends and other amounts included in gross income as 

dividends (e.g., amounts described in section 1248(a)). The deduction does not apply to items 

that are not included in gross income as dividends, such as subpart F inclusions or deemed 

repatriations under section 956. Similarly, the deduction does not apply to distributions of 

earnings previously taxed under subpart F, except to the extent that the subpart F inclusions 

result from the payment of a dividend by one controlled foreign corporation to another controlled 

foreign corporation within a certain chain of ownership during the election period. This 

exception enables multinational corporate groups to qualify for the deduction in connection with 

the repatriation of earnings from lower-tier controlled foreign corporations.

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

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

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

 

59 Secs. 951-964.

60 Secs. 1291-1298.

61 Secs. 901, 902, 960, 1291(g).
39

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

addition to actual dividends, deemed repatriations under section 956 and distributions of earnings 

previously taxed under subpart F are included in the base-period average.

Second, the amount of dividends eligible for the deduction is limited to the greatest of: 

(1) $500 million; (2) the amount of earnings shown as permanently invested outside the United 

States on the taxpayer’s most recent audited financial statement which is certified on or before 

March 31, 2003; or (3) in the case of an applicable financial statement that fails to show a 

specific amount of such earnings, but that does show a specific amount of tax liability 

attributable to such earnings, the amount of such earnings determined in such manner as the 

Treasury Secretary may prescribe.

Third, dividends qualifying for the deduction must be invested in the United States 

pursuant to a plan approved by the senior management and board of directors of the corporation 

claiming the deduction.

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

attributable to the deductible portion of any dividend received during the taxable year for which 

an election under the proposal is in effect. For this purpose, the taxpayer may specifically 

identify which dividends are treated as carrying the deduction and which are not; in the absence 

of such identification, a pro rata amount of foreign tax credits will be disallowed with respect to 

every dividend received during the taxable year. 

The bill also provides that the income attributable to the nondeductible portion of a 

qualifying dividend may not be offset by net operating losses, and the tax attributable to such 

income generally may not be offset by credits (other than foreign tax credits and AMT credits) 

and may not reduce the alternative minimum tax otherwise owed by the taxpayer. No deduction

under sections 243 or 245 is allowed for any dividend for which a deduction is allowed under the 

proposal.

Effective Date

The proposal is effective for a taxpayer’s first taxable year beginning on or after the date 

of enactment of the bill, or the taxpayer’s last taxable year beginning before such date, at the 

taxpayer’s election.
40

H. Other Incentive Provisions

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

Present Law

Generally, a taxpayer realizes gain to the extent the sales price (and any other 

consideration received) exceeds the taxpayer’s basis in the property. The realized gain is subject 

to current income tax unless the gain is deferred or not recognized under a special tax provision. 

Under section 1033, gain realized by a taxpayer from an involuntary conversion of 

property is deferred to the extent the taxpayer purchases property similar or related in service or 

use to the converted property within the applicable period. The taxpayer’s basis in the 

replacement property generally is the same as the taxpayer’s basis in the converted property, 

decreased by the amount of any money or loss recognized on the conversion, and increased by 

the amount of any gain recognized on the conversion.

The applicable period for the taxpayer to replace the converted property begins with the 

date of the disposition of the converted property (or if earlier, the earliest date of the threat or 

imminence of requisition or condemnation of the converted property) and ends two years after 

the close of the first taxable year in which any part of the gain upon conversion is realized (the 

“replacement period”). Special rules extend the replacement period for certain real property and 

principal residences damaged by a Presidentially-declared disaster to three years and four years, 

respectively, after the close of the first taxable year in which gain is realized. 

Section 1033(e) provides that the sale of livestock (other than poultry) that is held for 

draft, breeding, or dairy purposes in excess of the number of livestock that would have been sold 

but for drought, flood, or other weather-related conditions is treated as an involuntary 

conversion. Consequently, gain from the sale of such livestock could be deferred by reinvesting 

the proceeds of the sale in similar property within a two-year period.

In general, cash-method taxpayers report income in the year it is actually or 

constructively received. However, section 451(e) provides that a cash-method taxpayer whose 

principal trade or business is farming who is forced to sell livestock due to drought, flood, or 

other weather-related conditions may elect to include income from the sale of the livestock in the 

taxable year following the taxable year of the sale. This elective deferral of income is available 

only if the taxpayer establishes that, under the taxpayer’s usual business practices, the sale would 

not have occurred but for drought, flood, or weather-related conditions that resulted in the area 

being designated as eligible for Federal assistance. This exception is generally intended to put 

taxpayers who receive an unusually high amount of income in one year in the position they 

would have been in absent the weather-related condition.

Description of Proposal

The proposal extends the applicable period for a taxpayer to replace livestock sold on 

account of drought, flood, or other weather-related conditions from two years to four years after 

the close of the first taxable year in which any part of the gain on conversion is realized. The 
41

extension is only available if the taxpayer establishes that, under the taxpayer’s usual business 

practices, the sale would not have occurred but for drought, flood, or weather-related conditions 

that resulted in the area being designated as eligible for Federal assistance. In addition, the 

Secretary of the Treasury is granted authority to further extend the replacement period on a 

regional basis should the weather-related conditions continue longer than three years. Also, for 

property eligible for the proposal’s extended replacement period, the proposal provides that the 

taxpayer can make an election under section 451(e) until the period for reinvestment of such 

property under section 1033 expires. 

Effective Date

The proposal is effective for any taxable year with respect to which the due date (without 

regard to extensions) for the return is after December 31, 2002. 

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

Present Law

Under present law, cooperatives generally are treated similarly to pass-through entities in 

that a cooperative is not subject to corporate income tax to the extent the cooperative timely pays 

patronage dividends. In general, patronage dividends are comprised of amounts that are paid to 

patrons (1) on the basis of the quantity or value of business done with or for patrons, (2) under a 

valid enforceable written obligation to the patron that was in existence before the cooperative 

received such amounts, and (3) which are determined by reference to the net earnings of the 

cooperative from business done with or for patrons.

Treasury Regulations provide that net earnings are reduced by dividends paid on capital 

stock or other proprietary capital interests (referred to as the “dividend allocation rule”).62 The 

effect of this rule is to reduce the amount of earnings that a cooperative can treat as patronage 

income and, thus, the amount that the cooperative can deduct as patronage dividends.

Description of Proposal

The proposal provides a special rule for dividends on capital stock of a cooperative. To 

the extent provided in organizational documents of the cooperative, dividends on capital stock do 

not reduce patronage income.

Effective Date

The proposal is effective for distributions made in taxable years beginning after the date

of enactment.

 

62 Treas. Reg. sec. 1.1388-1(a)(1).
42

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

Present Law

Under present law, a taxpayer disposing of timber held for more than one year is eligible for 

capital gains treatment in three situations. First, if the taxpayer sells or exchanges timber that is 

a capital asset (sec. 1221) or property used in the trade or business (sec. 1231), the gain generally 

is long-term capital gain; however, if the timber is held for sale to customers in the taxpayer’s 

business, the gain will be ordinary income. Second, if the taxpayer disposes of the timber with a 

retained economic interest, the gain is eligible for capital gain treatment (sec. 631(b)). Third, if 

the taxpayer cuts standing timber, the taxpayer may elect to treat the cutting as a sale or 

exchange eligible for capital gains treatment (sec. 631(a)). 

Descripion of Proposal

Under the bill, in the case of a sale of timber by the owner of the land from which the timber 

is cut, the requirement that a taxpayer retain an economic interest in the timber in order to treat 

gains as capital gain under section 631(b) does not apply. Outright sales of timber by the 

landowner will qualify for capital gains treatment in the same manner as sales with a retained 

economic interest qualify under present law, except that the usual tax rules relating to the timing 

of the income from the sale of the timber will apply (rather than the special rule of section 631(b) 

treating the disposal as occurring on the date the timber is cut).

Effective Date

The proposal is effective for sales of timber after December 31, 2004.

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

regulated investment company 

Present Law

Treatment of RICs

A regulated investment company (“RIC”) generally is treated as a conduit for Federal 

income tax purposes. In computing its taxable income, a RIC deducts dividends paid to its 

shareholders to achieve conduit treatment (sec. 852(b)). In order to qualify for conduit 

treatment, a RIC must be a domestic corporation that, at all times during the taxable year, is 

registered under the Investment Company Act of 1940 as a management company or as a unit 

investment trust, or has elected to be treated as a business development company under that Act 

(sec. 851(a)). In addition, the corporation must elect RIC status, and must satisfy certain other 

requirements (sec. 851(b)).

One of the RIC qualification requirements is that at least 90 percent of the RIC's gross 

income is derived from dividends, interest, payments with respect to securities loans, and gains 

from the sale or other disposition of stock or securities or foreign currencies, or other income 

(including but not limited to gains from options, futures, or forward contracts) derived with 

respect to its business of investing in such stock, securities, or currencies (sec. 851(b)(2)). 
43

Income derived from a partnership is treated as meeting this requirement only to the extent such 

income is attributable to items of income of the partnership that would meet the requirement if 

realized by the RIC in the same manner as realized by the partnership (the “look-through” rule 

for partnership income) (sec. 851(b)). Under present law, no distinction is made under this rule 

between a publicly traded partnership and any other partnership.

The RIC qualification rules include limitations on the ownership of assets and on the 

composition of the RIC's assets (sec. 851(b)(3)). Under the ownership limitation, at least 50 

percent of the value of the RIC's total assets must be represented by cash, government securities 

and securities of other RICs, and other securities; however, in the case of such other securities, 

the RIC may invest no more than five percent of the value of the total assets of the RIC in the 

securities of any one issuer, and may hold no more than 10 percent of the outstanding voting 

securities of any one issuer. Under the limitation on the composition of the RIC's assets, no 

more than 25 percent of the value of the RIC's total assets may be invested in the securities of 

any one issuer (other than Government securities), or in securities of two or more controlled 

issuers in the same or similar trades or businesses. These limitations generally are applied at the 

end of each quarter (sec. 851(d)).

Treatment of publicly traded partnerships

Present law provides that a publicly traded partnership means a partnership, interests in 

which are traded on an established securities market, or are readily tradable on a secondary 

market (or the substantial equivalent thereof). In general, a publicly traded partnership is treated 

as a corporation (sec. 7704(a)), but an exception to corporate treatment is provided if 90 percent 

or more of its gross income is interest, dividends, real property rents, or certain other types of 

qualifying income (sec. 7704(c) and (d)).

A special rule for publicly traded partnerships applies under the passive loss rules. The 

passive loss rules limit deductions and credits from passive trade or business activities (sec. 469). 

Deductions attributable to passive activities, to the extent they exceed income from passive 

activities, generally may not be deducted against other income. Deductions and credits that are 

suspended under these rules are carried forward and treated as deductions and credits from 

passive activities in the next year. The suspended losses from a passive activity are allowed in 

full when a taxpayer disposes of his entire interest in the passive activity to an unrelated person. 

The special rule for publicly traded partnerships provides that the passive loss rules are applied 

separately with respect to items attributable to each publicly traded partnership (sec. 469(k)). 

Thus, income or loss from the publicly traded partnership is treated as separate from income or 

loss from other passive activities.

Description of Proposal

The proposal modifies the 90 percent test with respect to income of a RIC to include 

income derived from an interest in a publicly traded partnership. The proposal also modifies the 

lookthrough rule for partnership income of a RIC so that it applies only to income from a 

partnership other than a publicly traded partnership.
44

The proposal provides that the limitation on ownership and the limitation on composition 

of assets that apply to other investments of a RIC also apply to RIC investments in publicly 

traded partnership interests.

The proposal provides that the special rule for publicly traded partnerships under the 

passive loss rules (requiring separate treatment) applies to a RIC holding an interest in a publicly 

traded partnership, with respect to items attributable to the interest in the publicly traded 

partnership.

Effective Date

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

5. Improvements related to real estate investment trusts 

Present Law

In general

Real estate investment trusts (“REITs”) are treated, in substance, as pass-through entities 

under present law. Pass-through status is achieved by allowing the REIT a deduction for 

dividends paid to its shareholders. REITs are generally restricted to investing in passive 

investments primarily in real estate and securities.

A REIT must satisfy four tests on a year-by-year basis: organizational structure, source of 

income, nature of assets, and distribution of income. Whether the REIT meets the asset tests is 

generally measured each quarter. 

Organizational structure requirements

To qualify as a REIT, an entity must be for its entire taxable year a corporation or an 

unincorporated trust or association that would be taxable as a domestic corporation but for the 

REIT provisions, and must be managed by one or more trustees. The beneficial ownership of the 

entity must be evidenced by transferable shares or certificates of ownership. Except for the first 

taxable year for which an entity elects to be a REIT, the beneficial ownership of the entity must 

be held by 100 or more persons, and the entity may not be so closely held by individuals that it 

would be treated as a personal holding company if all its adjusted gross income constituted 

personal holding company income. A REIT is disqualified for any year in which it does not 

comply with regulations to ascertain the actual ownership of the REIT's outstanding shares.

Income requirements

In order for an entity to qualify as a REIT, at least 95 percent of its gross income 

generally must be derived from certain passive sources (the "95-percent income test"). In 

addition, at least 75 percent of its income generally must be from certain real estate sources (the 

"75-percent income test"), including rents from real property (as defined) and gain from the sale 

or other disposition of real property.
45

Qualified rental income

Amounts received as impermissible “tenant services income” are not treated as rents from 

real property. 63 In general, such amounts are for services rendered to tenants that are not 

“customarily furnished” in connection with the rental of real property. 64 Special rules also 

permit amounts to be received from certain “foreclosure property” treated as such for three years 

after the property is acquired by the REIT in foreclosure after a default (or imminent default) on 

a lease of such property or an indebtedness which such property secured. 

Rents from real property, for purposes of the 95-percent and 75-percent income tests, 

generally do not include any amount received or accrued from any person in which the REIT 

owns, directly or indirectly, 10 percent or more of the vote or value.65 An exception applies to 

rents received from a taxable REIT subsidiary (“TRS”) (described further below) if at least 90 

percent of the leased space of the property is rented to persons other than a TRS or certain related 

persons, and if the rents from the TRS are substantially comparable to unrelated party rents.66

Certain hedging instruments

Except as provided in regulations, a payment to a REIT under an interest rate swap or cap 

agreement, option, futures contract, forward rate agreement, or any similar financial instrument, 

entered into by the trust in a transaction to reduce the interest rate risks with respect to any 

indebtedness incurred or to be incurred by the REIT to acquire or carry real estate assets, and any 

gain from the sale or disposition of any such investment, is treated as income qualifying for the 

95-percent income test.

Tax if qualified income tests not met 

If a REIT fails to meet the 95-percent or 75-percent income tests but has set out the 

income it did receive in a schedule and any error in the schedule is due to reasonable cause and 

not willful neglect, then the REIT does not lose its REIT status but instead pays a tax measured 

 

63 A REIT is not treated as providing services that produce impermissible tenant services 

income if such services are provided by an independent contractor from whom the REIT does 

not derive or receive any income. An independent contractor is defined as a person who does not 

own, directly or indirectly, more than 35 percent of the shares of the REIT. Also, no more than 

35 percent of the total shares of stock of an independent contractor (or of the interests in net 

assets or net profits, if not a corporation) can be owned directly or indirectly by persons owning

35 percent or more of the interests in the REIT.

64 Rents for certain personal property leased in connection with the rental of real 

property are treated as rents from real property if the fair market value of the personal property 

does not exceed 15 percent of the aggregate fair market values of the real and personal property

65 Sec. 856(d)(2)(B).

66 Sec. 856(d)(8).
46

by the greater of the amount by which 90 percent 67 of the REIT’s gross income exceeds the 

amount of items subject to the 95-percent test, or the amount by which 75 percent of the REIT’s 

gross income exceeds the amount of items subject to the 75-percent test. 68 

Asset requirements

75-percent asset test

To satisfy the asset requirements to qualify for treatment as a REIT, at the close of each 

quarter of its taxable year, an entity must have at least 75 percent of the value of its assets 

invested in real estate assets, cash and cash items, and government securities (the “75-percent 

asset test”). The term real estate asset is defined to mean real property (including interests in real 

property and mortgages on real property) and interests in REITs.

Limitation on investment in other entities

A REIT is limited in the amount that it can own in other corporations. Specifically, a 

REIT cannot own securities (other than Government securities and certain real estate assets) in 

an amount greater than 25 percent of the value of REIT assets. In addition, it cannot own such 

securities of any one issuer representing more than 5 percent of the total value of REIT assets or 

more than 10 percent of the voting securities or 10 percent of the value of the outstanding 

securities of any one issuer. Securities for purposes of these rules are defined by reference to 

the Investment Company Act of 1940.

“Straight debt” exception

Securities of an issuer that are within a safe-harbor definition of “straight debt” (as 

defined for purposes of subchapter S)69 are not taken into account in applying the limitation that 

a REIT may not hold more than 10 percent of the value of outstanding securities of a single 

issuer, if : 1) the issuer is an individual, 2) the only securities of such issuer held by the REIT or 

a taxable REIT subsidiary of the REIT are straight debt, or 3) the issuer is a partnership and the 

trust holds at least a 20 percent profits interest in the partnership.

Straight debt for purposes of the REIT provision 70 is defined as a written or 

unconditional promise to pay on demand or on a specified date a sum certain in money if (i) the 

 

67 Prior to 1999, the rule had applied to the amount by which 95 percent of the income 

exceeded the items subject to the 95 percent test. 

68 The ratio of the REIT’s net to gross income is applied to the excess amount, to 

determine the amount of tax (disregarding certain items otherwise subject to a 100-percent tax). 

In effect, the formula seeks to require that all of the REIT net income attributable to the failure of 

the income tests will be paid as tax. Sec. 857(b)(5).

69 Sec. 1361(c)(5), without regard to paragraph (B)(iii) thereof. 

70 Sec. 856(c)(7).
47

interest rate (and interest payment dates) are not contingent on profits, the borrower’s discretion,

or similar factors, and (ii) there is no convertibility (directly or indirectly) into stock.

Certain subsidiary ownership permitted with income treated as income of the REIT

Under one exception to the rule limiting a REIT’s securities holdings to no more than 10 

percent of the vote or value of a single issuer, a REIT can own 100 percent of the stock of a 

corporation, but in that case the income and assets of such corporation are treated as income and 

assets of the REIT. 

Special rules for Taxable REIT subsidiaries

Under another exception to the general rule limiting REIT securities ownership of other 

entities, a REIT can own stock of a taxable REIT subsidiary (“TRS”), generally, a corporation 

other than a real estate investment trust71 with which the REIT makes a joint election to be 

subject to special rules. A TRS can engage in active business operations that would produce 

income that would not be qualified income for purposes of the 95-percent or 75-percent income 

tests for a REIT, and that income is not attributed to the REIT. For example a TRS could 

provide noncustomary services to REIT tenants, or it could engage directly in the active 

operation and management of real estate (without use of an independent contractor); and the 

income the TRS derived from these nonqualified activities would not be treated as disqualified 

REIT income. Transactions between a TRS and a REIT are subject to a number of specified 

rules that are intended to prevent the TRS (taxable as a separate corporate entity) from shifting 

taxable income from its activities to the pass-through entity REIT or from absorbing more than 

its share of expenses. Under one rule, a 100-percent excise tax is imposed on rents, deductions, 

or interest paid by the TRS to the REIT to the extent such items would exceed an arm’s length 

amount as determined under section 482.72

Rents subject to the 100 percent excise tax do not include rents for services of a TRS that 

are for services customarily furnished or rendered in connection with the rental of real property. 

They also do not include rents from a TRS that are for real property or from incidental 

personal property provided with such real property.

Income distribution requirements

A REIT is generally required to distribute 90 percent of its income before the end of its 

taxable year, as deductible dividends paid to shareholders. This rule is similar to a rule for 

regulated investment companies (“RICs”) that requires distribution of 90 percent of income. If a 

 

71 Certain corporations are not eligible to be a TRS, such as a corporation which directly

or indirectly operates or manages a lodging facility or a health care facility, or directly or 

indirectly provides to any other person rights to a brand name under which any lodging facility 

or health care facility is operated. Sec. 856(l)(3).

72 If the excise tax applies, then the item is not reallocated back to the TRS under section 

482. 
48

REIT declares certain dividends after the end of its taxable year but before the time prescribed 

for filing its return for that year and distributes those amounts to shareholders within the 12 

months following the close of that taxable year, such distributions are treated as made during 

such taxable year for this purpose. As described further below, a REIT can also make certain 

“deficiency dividends” after the close of the taxable year after a determination that it has not 

distributed the correct amount for qualification as a REIT. 

Consequences of failure to meet requirements

A REIT loses its status as a REIT, and becomes subject to tax as a C corporation, if it 

fails to meet specified tests regarding the sources of its income, the nature and amount of its 

assets, its structure, and the amount of its income distributed to shareholders.

In the case of a failure to meet the source of income requirements, if the failure is due to 

reasonable cause and not to willful neglect, the REIT may continue its REIT status if it pays the 

disallowed income as a tax to the Treasury. 73

There is no similar provision that allows a REIT to pay a penalty and avoid 

disqualification in the case of other qualification failures. 

A REIT may make a deficiency dividend after a determination is made that it has not 

distributed the correct amount of its income, and avoid disqualification. The Code provides only 

for determinations involving a controversy with the IRS and does not provide for a REIT to 

make such a distribution on its own initiative. Deficiency dividends may be declared on or after 

the date of “determination”. A determination is defined to include only (i) a final decision by the 

Tax Court or other court of competent jurisdiction, (ii) a closing agreement under section 7121, 

or (iii) under Treasury regulations, an agreement signed by the Secretary and the REIT. 

Description of Proposal 

The proposal makes a number of modifications to the REIT rules. 

Straight debt modification

The proposal modifies the definition of “straight debt” for purposes of the limitation that 

a REIT may not hold more than 10 percent of the value of the outstanding securities of a single 

issuer, to provide more flexibility than the present law rule. In addition, except as provided in 

regulations, neither such straight debt nor certain other types of securities are considered 

“securities” for purposes of this rule. 

Straight debt securities

As under present law, “straight-debt” is still defined by reference to section 1361(c)(5), 

without regard to subparagraph (B)(iii) thereof (limiting the nature of the creditor).

 

73 Secs. 856(c)(6) and 857(b)(5).
49

Special rules are provided permitting certain contingencies for purposes of the REIT 

provision. Any interest or principal shall not be treated as failing to satisfy section 

1361(c)(5)(B)(i) solely by reason of the fact that the time of payment of such interest or principal 

is subject to a contingency, but only if one of several factors applies. The first type of 

contingency that is permitted is one that does not have the effect of changing the effective yield 

to maturity, as determined under section 1272, other than a change in the annual yield to 

maturity, but only if (i) any such contingency does not exceed the greater of 1⁄4 of one percent or 

five percent of the annual yield to maturity, or (ii) neither the aggregate issue price nor the 

aggregate face amount of the debt instruments held by the REIT exceeds $1,000,000 and not 

more than 12 months of unaccrued interest can be required to be prepaid thereunder. 

Also, the time or amount of any payment is permitted to be subject to a contingency upon 

a default or the exercise of a prepayment right by the issuer of the debt, provided that such 

contingency is consistent with customary commercial practice.74

The proposal eliminates the present law rule requiring a REIT to own a 20 percent equity 

interest in a partnership in order for debt to qualify as “straight debt”. The bill instead provides 

new “look-through” rules determining a REIT partner’s share of partnership securities, generally 

treating debt to the REIT as part of the REIT’s partnership interest for this purpose, except in the 

case of otherwise qualifying debt of the partnership. 

Certain corporate or partnership issues that otherwise would be permitted to be held 

without limitation under the special straight debt rules described above will not be so permitted if 

the REIT holding such securities, and any of its taxable REIT subsidiaries, holds any securities 

of the issuer which are not permitted securities (prior to the application of this rule) and have an 

aggregate value greater than one percent of the issuer’s outstanding securities. 

Other securities

Except as provided in regulations, the following also are not considered “securities” for 

purposes of the rule that a REIT cannot own more than 10 percent of the value of the outstanding 

securities of a single issuer: (i) any loan to an individual or an estate, (ii) any section 467 rental 

agreement, (as defined in section 467(d)), other than with a person described in section 

856(d)(2)(B), (iii) any obligation to pay rents from real property, (iv) any security issued by a 

State or any political subdivision thereof, the District of Columbia, a foreign government, or any 

political subdivision thereof, or the Commonwealth of Puerto Rico, but only if the determination 

of any payment received or accrued under such security does not depend in whole or in part on 

the profits of any entity not described in this category, or payments on any obligation issued by 

such an entity, (v) any security issued by a real estate investment trust; and (vi) any other 

arrangement that, as determined by the Secretary, is excepted from the definition of a security.

 

74 The present-law rules that limit qualified interest income to amounts the determination 

of which do not depend, in whole or in part, on the income or profits of any person, continue to 

apply to such contingent interest. See, e.g., secs. 856(c)(2)(G), 856(c)(3)(G) and 856(f). 
50

Safe harbor testing date for certain rents

 The proposal provides specific safe-harbor rules regarding the dates for testing whether 

90 percent of a REIT property is rented to unrelated persons and whether the rents paid by 

related persons are substantially comparable to unrelated party rents. These testing rules are 

provided solely for purposes of the special provision permitting rents received from a TRS to be 

treated as qualified rental income for purposes of the income tests.75

Customary services exception 

The proposal prospectively eliminates the safe harbor allowing rents received by a REIT 

to be exempt from the 100 percent excise tax if the rents are for customary services performed by 

the TRS76 or are from a TRS and are for the provision of certain incidental personal property. 

Instead, such payments would be free of the excise tax if they satisfy the present law safe-harbor 

that applies if the REIT pays the TRS at least 150 percent of the cost to the TRS of providing any 

services.

Hedging rules

The rules governing the tax treatment of arrangements engaged in by a REIT to reduce 

interest rate risks are prospectively conformed to the rules included in section 1221.

95-percent gross income requirement 

The proposal prospectively amends the tax liability owed by the REIT when it fails to 

meet the 95-percent of gross income test by applying a taxable fraction based on 95 percent, 

rather than 90 percent, of the REIT’s gross income. 

Consequences of failure to meet requirements

Under the proposal, a REIT may avoid disqualification in the event of certain failures of 

the requirements for REIT status, provided that 1) the failure was due to reasonable cause and 

not willful neglect, 2) the failure is corrected, and 3) except for certain failures not exceeding a 

specified de minims amount, a penalty amount is paid. 

Certain de minimis asset failures of 5-percent or 10-percent tests

One requirement of present law is that, with certain exceptions, (i) not more than 5 

percent of the value of total REIT assets may be represented by securities of one issuer, and (ii) a 

 

75 The proposal does not modify any of the standards of section 482 as they apply to 

REITs and to TRSs. 

76 Although a REIT could itself provide such service and receive the income without 

receiving any disqualified income, in that case the REIT itself would be bearing the cost of 

providing the service. Under the present law exception for a TRS providing such service, there 

is no explicit requirement that the TRS be reimbursed for the full cost of the service.
51

REIT may not hold securities possessing more than 10 percent of the total voting power or 10 

percent of the total value of the outstanding securities of any one issuer.77 The requirements 

must be satisfied each quarter.

The proposal provides that a REIT will not lose its REIT status for failing to satisfy these 

requirements in a quarter if the failure is due to the ownership of assets the total value of which 

does not exceed the lesser of (i) one percent of the total value of the REIT’s assets at the end of 

the quarter for which such measurement is done or (ii) 10 million dollars; provided in either case 

that the REIT either disposes of the assets within six months after the last day of the quarter in 

which the REIT identifies the failure (or such other time period prescribed by the Treasury), or 

otherwise meets the requirements of those rules by the end of such time period.78

Larger asset test failures (whether of 5-percent or 10-percent tests, or of 75-percent or 

other asset tests)

Under the proposal, if a REIT fails to meet any of the asset test requirements for a 

particular quarter and the failure exceeds the de minimis threshold described above, then the 

REIT still will be deemed to have satisfied the requirements if: (i) following the REIT’s 

identification of the failure, the REIT files a schedule with a description of each asset that caused 

the failure, in accordance with regulations prescribed by the Treasury; (ii) the failure was due to 

reasonable cause and not to willful neglect, (iii) the REIT disposes of the assets within 6 months 

after the last day of the quarter in which the identification occurred or such other time period as 

is prescribed by the Treasury (or the requirements of the rules are otherwise met within such 

period), and (iv) the REIT pays a tax on the failure. 

The tax that the REIT must pay on the failure is the greater of (i) $50,000, or (ii) an 

amount determined (pursuant to regulations) by multiplying the highest rate of tax for 

corporations under section 11, times the net income generated by the assets for the period 

beginning on the first date of the failure and ending on the date the REIT has disposed of the 

assets (or otherwise satisfies the requirements). 

Such taxes are treated as excise taxes, for which the deficiency provisions of the excise 

tax subtitle of the Code (subtitle F) apply. 

Conforming reasonable cause and reporting standard for failures of income tests

The proposal conforms the reporting and reasonable cause standards for failure to meet 

the income tests to the new asset test standards. However, the proposal does not change the rule 

 

77 Sec. 856(c)(4)(B)(iii). These rules do not apply to securities of a TRS, or to securities 

that qualify for the 75 percent asset test of section 856(c)(4)(A), such as real estate assets, cash 

items (including receivables), or Government securities. 

78 A REIT might satisfy the requirements without a disposition, for example, by 

increasing its other assets in the case of the 5 percent rule; or by the issuer modifying the amount 

or value of its total securities outstanding in the case of the 10 percent rule.
52

under section 857(b)(5) that for income test failures, all of the net income attributed to the 

disqualified gross income is paid as tax. 

Other failures

The proposal adds a provision under which, if a REIT fails to satisfy one or more 

requirements for REIT qualification, other than the 95-percent and 75-percent gross income tests 

and other than the new rules provided for failures of the asset tests, the REIT may retain its REIT 

qualification if the failures are due to reasonable cause and not willful neglect, and if the REIT 

pays a penalty of $50,000 for each such failure.

Taxes and penalties paid deducted from amount required to be distributed

Any taxes or penalties paid under the provision are deducted from the net income of the 

REIT in determining the amount the REIT must distribute under the 90-percent distribution 

requirement. 

Expansion of deficiency dividend procedure

The proposal expands the circumstances in which a REIT may declare a deficiency 

dividend, by allowing such a declaration to occur after the REIT unilaterally has identified a 

failure to pay the relevant amount. Thus, the declaration need not await a decision of the Tax 

Court, a closing agreement, or an agreement signed by the Secretary of the Treasury. 

Effective Date

The proposal generally is effective for taxable years beginning after December 31, 2000. 

However, some of the proposals are effective for taxable years beginning after the date of 

enactment. These are: the new “look through” rules determining a REIT partner’s share of 

partnership securities for purposes of the “straight debt” rules; the proposal changing the 90-

percent of gross income reference to 95 percent, for purposes of the tax liability if a REIT fails to 

meet the 95-percent of gross income test; the new hedging definition; the rule modifying the

treatment of rents with respect to customary services, and the new rules for correction of certain 

failures to satisfy the REIT requirements.

6. Treatment of certain dividends of regulated investment companies

Present Law

Regulated investment companies

A regulated investment company ("RIC") is a domestic corporation that, at all times 

during the taxable year, is registered under the Investment Company Act of 1940 as a 

management company or as a unit investment trust, or has elected to be treated as a business

development company under that Act (sec. 851(a)).
53

In addition, to qualify as a RIC, a corporation must elect such status and must satisfy 

certain tests (sec. 851(b)). These tests include a requirement that the corporation derive at least 

90 percent of its gross income from dividends, interest, payments with respect to certain 

securities loans, and gains on the sale or other disposition of stock or securities or foreign 

currencies, or other income derived with respect to its business of investment in such stock, 

securities, or currencies.

Generally, a RIC pays no income tax because it is permitted to deduct dividends paid to 

its shareholders in computing its taxable income. The amount of any distribution generally is not 

considered as a dividend for purposes of computing the dividends paid deduction unless the 

distribution is pro rata, with no preference to any share of stock as compared with other shares of 

the same class (sec. 562(c)). For distributions by RICs to shareholders who made initial 

investments of at least $10,000,000, however, the distribution is not treated as non-pro rata or 

preferential solely by reason of an increase in the distribution due to reductions in administrative 

expenses of the company.

A RIC generally may pass through to its shareholders the character of its long-term 

capital gains. It does this by designating a dividend it pays as a capital gain dividend to the 

extent that the RIC has net capital gain (i.e., net long-term capital gain over net short-term capital 

loss). These capital gain dividends are treated as long-term capital gain by the shareholders. A 

RIC generally also can pass through to its shareholders the character of tax-exempt interest from 

State and local bonds, but only if, at the close of each quarter of its taxable year, at least 50 

percent of the value of the total assets of the RIC consists of these obligations. In this case, the 

RIC generally may designate a dividend it pays as an exempt-interest dividend to the extent that 

the RIC has tax-exempt interest income. These exempt-interest dividends are treated as interest 

excludable from gross income by the shareholders.

U.S. source investment income of foreign persons

In general 

The United States generally imposes a flat 30-percent tax, collected by withholding, on 

the gross amount of U.S.-source investment income payments, such as interest, dividends, rents, 

royalties or similar types of income, to nonresident alien individuals and foreign corporations 

("foreign persons") (secs. 871(a), 881, 1441, and 1442). Under treaties, the United States may 

reduce or eliminate such taxes. Even taking into account U.S. treaties, however, the tax on a 

dividend generally is not entirely eliminated. Instead, U.S.-source portfolio investment 

dividends received by foreign persons generally are subject to U.S. withholding tax at a rate of at 

least 15 percent.

Interest

Although payments of U.S.-source interest that is not effectively connected with a U.S. 

trade or business generally are subject to the 30-percent withholding tax, there are exceptions to 

that rule. For example, interest from certain deposits with banks and other financial institutions 

is exempt from tax (secs. 871(i)(2)(A) and 881(d)). Original issue discount on obligations 

maturing in 183 days or less from the date of original issue (without regard to the period held by 
54

the taxpayer) is also exempt from tax (sec. 871(g)). An additional exception is provided for 

certain interest paid on portfolio obligations (secs. 871(h) and 881(c)). “Portfolio interest” 

generally is defined as any U.S.-source interest (including original issue discount), not 

effectively connected with the conduct of a U.S. trade or business, (i) on an obligation that 

satisfies certain registration requirements or specified exceptions thereto (i.e., the obligation is 

“foreign targeted”), and (ii) that is not received by a 10-percent shareholder (secs. 871(h)(3) and 

881(c)(3)). With respect to a registered obligation, a statement that the beneficial owner is not a 

U.S. person is required (secs. 871(h)(2), (5) and 881(c)(2)). This exception is not available for 

any interest received either by a bank on a loan extended in the ordinary course of its business 

(except in the case of interest paid on an obligation of the United States), or by a controlled 

foreign corporation from a related person (sec. 881(c)(3)). Moreover, this exception is not 

available for certain contingent interest payments (secs. 871(h)(4) and 881(c)(4)). 

Capital gains

Foreign persons generally are not subject to U.S. tax on gain realized on the disposition 

of stock or securities issued by a U.S. person (other than a "U.S. real property holding 

corporation," as described below), unless the gain is effectively connected with the conduct of a 

trade or business in the United States. This exemption does not apply, however, if the foreign 

person is a nonresident alien individual present in the United States for a period or periods 

aggregating 183 days or more during the taxable year (sec. 871(a)(2)). A RIC may elect not to 

withhold on a distribution to a foreign person representing a capital gain dividend. (Treas. Reg. 

sec. 1.1441-3(c)(2)(D)).

Gain or loss of a foreign person from the disposition of a U.S. real property interest is 

subject to net basis tax as if the taxpayer were engaged in a trade or business within the United 

States and the gain or loss were effectively connected with such trade or business (sec. 897). In 

addition to an interest in real property located in the United States or the Virgin Islands, U.S. real 

property interests include (among other things) any interest in a domestic corporation unless the 

taxpayer establishes that the corporation was not, during a 5-year period ending on the date of 

the disposition of the interest, a U.S. real property holding corporation (which is defined 

generally to mean a corporation the fair market value of whose U.S. real property interests equals 

or exceeds 50 percent of the sum of the fair market values of its real property interests and any 

other of its assets used or held for use in a trade or business).

Estate taxation

Decedents who were citizens or residents of the United States are generally subject to 

Federal estate tax on all property, wherever situated.79 Nonresidents who are not U.S. citizens, 

however, are subject to estate tax only on their property which is within the United States. 

Property within the United States generally includes debt obligations of U.S. persons, including 

 

79 The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) 

repealed the estate tax for estates of decedents dying after December 31, 2009. However, 

EGTRRA included a “sunset” provision, pursuant to which EGTRRA’s provisions (including 

estate tax repeal) do not apply to estates of decedents dying after December 31, 2010.
55

the Federal government and State and local governments (sec. 2104(c)), but does not include 

either bank deposits or portfolio obligations, the interest on which would be exempt from U.S. 

income tax under section 871 (sec. 2105(b)). Stock owned and held by a nonresident who is not 

a U.S. citizen is treated as property within the United States only if the stock was issued by a 

domestic corporation (sec. 2104(a); Treas. Reg. sec. 20.2104-1(a)(5)).

Treaties may reduce U.S. taxation on transfers by estates of nonresident decedents who 

are not U.S. citizens. Under recent treaties, for example, U.S. tax may generally be eliminated 

except insofar as the property transferred includes U.S. real property or business property of a 

U.S. permanent establishment.

Description of Proposal

In general

Under the proposal, a RIC that earns certain interest income that would not be subject to 

U.S. tax if earned by a foreign person directly may, to the extent of such income, designate a 

dividend it pays as derived from such interest income. A foreign person who is a shareholder in 

the RIC generally would treat such a dividend as exempt from gross-basis U.S. tax, as if the 

foreign person had earned the interest directly. Similarly, a RIC that earns an excess of net 

short-term capital gains over net long-term capital losses, which excess would not be subject to 

U.S. tax if earned by a foreign person, generally may, to the extent of such excess, designate a 

dividend it pays as derived from such excess. A foreign person who is a shareholder in the RIC 

generally would treat such a dividend as exempt from gross-basis U.S. tax, as if the foreign 

person had realized the excess directly. The proposal also provides that the estate of a foreign 

decedent is exempt from U.S. estate tax on a transfer of stock in the RIC in the proportion that 

the assets held by the RIC are debt obligations, deposits, or other property that would generally 

be treated as situated outside the United States if held directly by the estate.

Interest-related dividends

Under the proposal, a RIC may, under certain circumstances, designate all or a portion of

a dividend as an "interest-related dividend," by written notice mailed to its shareholders not later 

than 60 days after the close of its taxable year. In addition, an interest-related dividend received 

by a foreign person generally is exempt from U.S. gross-basis tax under sections 871(a), 881, 

1441 and 1442.

However, this exemption does not apply to a dividend on shares of RIC stock if the 

withholding agent does not receive a statement, similar to that required under the portfolio 

interest rules, that the beneficial owner of the shares is not a U.S. person. The exemption does 

not apply to a dividend paid to any person within a foreign country (or dividends addressed to, or 

for the account of, persons within such foreign country) with respect to which the Treasury 

Secretary has determined, under the portfolio interest rules, that exchange of information is 

inadequate to prevent evasion of U.S. income tax by U.S. persons.

In addition, the exemption generally does not apply to dividends paid to a controlled 

foreign corporation to the extent such dividends are attributable to income received by the RIC 

on a debt obligation of a person with respect to which the recipient of the dividend (i.e., the 
56

controlled foreign corporation) is a related person. Nor does the exemption generally apply to 

dividends to the extent such dividends are attributable to income (other than short-term original 

issue discount or bank deposit interest) received by the RIC on indebtedness issued by the RICdividend recipient or by any corporation or partnership with respect to which the recipient of the 

RIC dividend is a 10-percent shareholder. However, in these two circumstances the RIC remains 

exempt from its withholding obligation unless the RIC knows that the dividend recipient is such 

a controlled foreign corporation or 10-percent shareholder. To the extent that an interest-related 

dividend received by a controlled foreign corporation is attributable to interest income of the RIC 

that would be portfolio interest if received by a foreign corporation, the dividend is treated as 

portfolio interest for purposes of the de minimis rules, the high-tax exception, and the same 

country exceptions of subpart F (see sec. 881(c)(5)(A)).

The aggregate amount designated as interest-related dividends for the RIC’s taxable year 

(including dividends so designated that are paid after the close of the taxable year but treated as 

paid during that year as described in section 855) generally is limited to the qualified net interest 

income of the RIC for the taxable year. The qualified net interest income of the RIC equals the 

excess of: (1) the amount of qualified interest income of the RIC; over (2) the amount of 

expenses of the RIC properly allocable to such interest income.

Qualified interest income of the RIC is equal to the sum of its U.S.-source income with 

respect to: (1) bank deposit interest; (2) short term original issue discount that is currently 

exempt from the gross-basis tax under section 871; (3) any interest (including amounts 

recognized as ordinary income in respect of original issue discount, market discount, or 

acquisition discount under the provisions of sections 1271-1288, and such other amounts as 

regulations may provide) on an obligation which is in registered form, unless it is earned on an 

obligation issued by a corporation or partnership in which the RIC is a 10-percent shareholder or 

is contingent interest not treated as portfolio interest under section 871(h)(4); and (4) any 

interest-related dividend from another RIC.

If the amount designated as an interest-related dividend is greater than the qualified net 

interest income described above, the portion of the distribution so designated which constitutes 

an interest-related dividend will be only that proportion of the amount so designated as the 

amount of the qualified net interest income bears to the amount so designated.

Short-term capital gain dividends

Under the proposal, a RIC also may, under certain circumstances, designate all or a 

portion of a dividend as a "short-term capital gain dividend," by written notice mailed to its 

shareholders not later than 60 days after the close of its taxable year. For purposes of the U.S. 

gross-basis tax, a short-term capital gain dividend received by a foreign person generally is 

exempt from U.S. gross-basis tax under sections 871(a), 881, 1441 and 1442. This exemption 

does not apply to the extent that the foreign person is a nonresident alien individual present in the 

United States for a period or periods aggregating 183 days or more during the taxable year. 

However, in this circumstance the RIC remains exempt from its withholding obligation unless 

the RIC knows that the dividend recipient has been present in the United States for such period.
57

The aggregate amount qualified to be designated as short-term capital gain dividends for 

the RIC’s taxable year (including dividends so designated that are paid after the close of the 

taxable year but treated as paid during that year as described in sec. 855) is equal to the excess of 

the RIC’s net short-term capital gains over net long-term capital losses. The short-term capital 

gain includes short-term capital gain dividends from another RIC. As provided under present 

law for purposes of computing the amount of a capital gain dividend, the amount is determined 

(except in the case where an election under sec. 4982(e)(4) applies) without regard to any net 

capital loss or net short-term capital loss attributable to transactions after October 31 of the year. 

Instead, that loss is treated as arising on the first day of the next taxable year. To the extent 

provided in regulations, this rule also applies for purposes of computing the taxable income of 

the RIC.

In computing the amount of short-term capital gain dividends for the year, no reduction is 

made for the amount of expenses of the RIC allocable to such net gains. In addition, if the 

amount designated as short-term capital gain dividends is greater than the amount of qualified 

short-term capital gain, the portion of the distribution so designated which constitutes a shortterm capital gain dividend is only that proportion of the amount so designated as the amount of 

the excess bears to the amount so designated.

As under present law for distributions from REITs, the proposal provides that any 

distribution by a RIC to a foreign person shall, to the extent attributable to gains from sales or 

exchanges by the RIC of an asset that is considered a U.S. real property interest, be treated as 

gain recognized by the foreign person from the sale or exchange of a U.S. real property interest. 

The proposal also extends the special rules for domestically-controlled REITs to domesticallycontrolled RICs.

Estate tax treatment

Under the proposal, a portion of the stock in a RIC held by the estate of a nonresident 

decedent who is not a U.S. citizen is treated as property without the United States. The portion 

so treated is based upon the proportion of the assets held by the RIC at the end of the quarter 

immediately preceding the decedent’s death (or such other time as the Secretary may designate 

in regulations) that are “qualifying assets”. Qualifying assets for this purpose are bank deposits 

of the type that are exempt from gross-basis income tax, portfolio debt obligations, certain 

original issue discount obligations, debt obligations of a domestic corporation that are treated as 

giving rise to foreign source income, and other property not within the United States.

Effective Date

The proposal generally applies to dividends with respect to taxable years of RICs 

beginning after December 31, 2004. With respect to the treatment of a RIC for estate tax 

purposes, the proposal applies to estates of decedents dying after December 31, 2004. With 

respect to the treatment of RICs under section 897 (relating to U.S. real property interests), the 

proposal is effective after December 31, 2004.
58

7. Taxation of certain settlement funds

Present Law

In general, section 468B provides that a payment to a designated settlement fund that 

extinguishes a tort liability of the taxpayer will result in a deduction to the taxpayer. A 

designated settlement fund means a fund which is established pursuant to a court order, 

extinguishes the taxpayer's tort liability, is managed and controlled by persons unrelated to the 

taxpayer, and in which the taxpayer does not have a beneficial interest in the trust.

Generally, a designated or qualified settlement fund is taxed as a separate entity at the 

maximum trust rate on its modified income. Modified income is generally gross income less 

deductions for administrative costs and other incidental expenses incurred in connection with the 

operation of the settlement fund.

The cleanup of hazardous waste sites is sometimes funded by environmental “settlement 

funds” or escrow accounts. These escrow accounts are established in consent decrees between 

the Environmental Protection Agency (“EPA”) and the settling parties under the jurisdiction of a 

Federal district court. The EPA uses these accounts to resolve claims against private parties 

under Comprehensive Environmental Response, Compensation and Liability Act of 1980 

(“CERCLA”).

Present law provides that nothing in any provision of law is to be construed as providing 

that an escrow account, settlement fund, or similar fund is not subject to current income tax.

Description of Proposal

The proposal clarifies that certain settlement funds established in consent decrees for the 

sole purpose of resolving claims under CERCLA are to be treated as beneficially owned by the 

United States government and therefore, not subject to Federal income tax. 

To qualify the settlement fund must be: (1) established pursuant to a consent decree 

entered by a judge of a United States District Court; (2) created for the receipt of settlement 

payments for the sole purpose of resolving claims under CERCLA; (3) controlled (in terms of 

expenditures of contributions and earnings thereon) by the government or an agency or 

instrumentality thereof; and (4) upon termination, any remaining funds will be disbursed upon 

instructions by such government entity in accordance with applicable law. With regard to the 

last requirement, it is intended that, upon termination, any remaining funds will be disbursed to 

the government entity (e.g., the EPA) and used in accordance with applicable law.

Effective Date

The proposal is effective for taxable years beginning after December 31, 2004.
59

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

Present Law

Taxpayers may claim a 50-percent credit for expenses related to human clinical testing of 

drugs for the treatment of certain rare diseases and conditions, generally those that afflict less 

than 200,000 persons in the United States. Qualifying expenses are those paid or incurred by the 

taxpayer after the date on which the drug is designated as a potential treatment for a rare disease 

or disorder by the Food and Drug Administration (“FDA”) in accordance with section 526 of the 

Federal Food, Drug, and Cosmetic Act.

Description of Proposal

The proposal expands qualifying expenses to include those expenses related to human 

clinical testing paid or incurred after the date on which the taxpayer files an application with the 

FDA for designation of the drug under section 526 of the Federal Food, Drug, and Cosmetic Act 

as a potential treatment for a rare disease or disorder, if certain conditions are met. Under the 

proposal, qualifying expenses include those expenses paid or incurred after the date on which the 

taxpayer files an application with the FDA for designation as a potential treatment for a rare 

disease or disorder if the drug receives FDA designation before the due date (including 

extensions) for filing the tax return for the taxable year in which the application was filed with 

the FDA. As under present law, the credit may only be claimed for such expenses related to 

drugs designated as a potential treatment for a rare disease or disorder by the FDA in accordance 

with section 526 of such Act.

Effective Date

The proposal is effective for expenditures paid or incurred after the date of enactment.

9. Simplification of excise tax imposed on bows and arrows 

Present Law

The Code imposes an excise tax of 11 percent on the sale by a manufacturer, producer or 

importer of any bow with a draw weight of 10 pounds or more.80 An excise tax of 12.4 percent 

is imposed on the sale by a manufacturer or importer of any shaft, point, nock, or vane designed 

for use as part of an arrow which after its assembly (1) is over 18 inches long, or (2) is designed 

for use with a taxable bow (if shorter than 18 inches).81 No tax is imposed on finished arrows. 

An 11-percent excise tax also is imposed on any part of an accessory for taxable bows and on 

quivers for use with arrows (1) over 18 inches long or (2) designed for use with a taxable bow (if 

shorter than 18 inches).82 

 

80 Sec. 4161(b)(1)(A).

81 Sec. 4161(b)(2).

82 Sec. 4161(b)(1)(B).
60

Description of Proposal

The proposal increases the draw weight for a taxable bow from 10 pounds or more to a 

peak draw weight of 30 pounds or more.83 The proposal also imposes an excise tax of 12 percent 

on arrows generally. An arrow for this purpose is defined as a taxable arrow shaft to which 

additional components are attached. The present law 12.4-percent excise tax on certain arrow 

components is unchanged by the bill. In the case of any arrow comprised of a shaft or any other 

component upon which tax has been imposed, the amount of the arrow tax is equal to the excess 

of (1) the arrow tax that would have been imposed but for this exception, over (2) the amount of 

tax paid with respect to such components.84 Finally, the proposal subjects certain broadheads (a 

type of arrow point) to an excise tax equal to 11 percent of the sales price instead of 12.4 percent.

Effective Date

The proposal is effective for articles sold by the manufacturer, producer, or importer after 

December 31, 2004.

10. Repeal excise tax on fishing tackle boxes

Present Law

Under present law, a 10-percent manufacturer’s excise tax is imposed on specified sport 

fishing equipment. Examples of taxable equipment include fishing rods and poles, fishing reels, 

artificial bait, fishing lures, line and hooks, and fishing tackle boxes. Revenues from the excise 

tax on sport fishing equipment are deposited in the Sport Fishing Account of the Aquatic 

Resources Trust Fund. Monies in the fund are spent, subject to an existing permanent 

appropriation, to support Federal-State sport fish enhancement and safety programs.

Description of Proposal

The proposal repeals the excise tax on fishing tackle boxes.

Effective Date

The proposal is effective for articles sold by the manufacturer, producer, or importer after 

December 31, 2004.

 

83 Draw weight is the maximum force required to bring the bowstring to a full-draw 

position not less than 26 1/4-inches, measured from the pressure point of the hand grip to the 

nocking position on the bowstring.

84 A credit or refund may be obtained when an item was taxed and it is used in the 

manufacture or production of another taxable item. Sec. 6416(b)(3). As arrow components and 

finished arrows are both taxable, in lieu of a refund of the tax paid on components, the proposal 

suspends the application of sec. 6416(b)(3) and permits the taxpayer to reduce the tax due on the 

finished arrow by the amount of the previous tax paid on the components used in the 

manufacture of such arrow. 
61

11. Repeal of excise tax on sonar devices suitable for finding fish

Present Law

In general, the Code imposes a 10 percent tax on the sale by the manufacturer, producer, 

or importer of specified sport fishing equipment. 85 A three percent rate, however, applies to the 

sale of electric outboard motors and sonar devices suitable for finding fish. 86 Further, the tax 

imposed on the sale of sonar devices suitable for finding fish is limited to $30. A sonar device 

suitable for finding fish does not include any device that is a graph recorder, a digital type, a 

meter readout, a combination graph recorder or combination meter readout. 87

Revenues from the excise tax on sport fishing equipment are deposited in the Sport 

Fishing Account of the Aquatic Resources Trust Fund. Monies in the fund are spent, subject to 

an existing permanent appropriation, to support Federal-State sport fish enhancement and safety 

programs.

Description of Proposal

The proposal repeals the excise tax on all sonar devices suitable for finding fish.

Effective Date

The proposal is effective articles sold by the manufacturer, producer, or importer after 

December 31, 2004.

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

Present Law

As is true of most major Federal excise taxes, the excise tax on distilled spirits is imposed 

at a point in the chain of distribution before the product reaches the retail (consumer) level. Tax 

on domestically produced and/or bottled distilled spirits arises upon production (receipt) in a 

bonded distillery and is collected based on removals from the distillery during each semimonthly period. Distilled spirits that are bottled before importation into the United States are 

taxed on removal from the first U.S. warehouse where they are landed (including a warehouse 

located in a foreign trade zone).

No tax credits are allowed under present law for business costs associated with having 

tax-paid products in inventory. Rather, excise tax that is included in the purchase price of a 

product is treated the same as the other components of the product cost, i.e., deductible as a cost 

of goods sold. 

 

85 Sec. 4161(a)(1).

86 Sec. 4161(a)(2).

87 Sec. 4162(b).
62

Description of Proposal

The proposal creates a new income tax credit for eligible wholesale distributors of 

distilled spirits. An eligible wholesaler is any person who holds a permit under the Federal 

Alcohol Administration Act as a wholesaler of distilled spirits. 

The credit is calculated by multiplying the number of cases of bottled distilled spirits by 

the average tax-financing cost per case for the most recent calendar year ending before the 

beginning of such taxable year. A case is 12 80-proof 750-milliliter bottles. The average taxfinancing cost per case is the amount of interest that would accrue at corporate overpayment 

rates during an assumed 60-day holding period on an assumed tax rate of $22.83 per case of 12 

750-milliliter bottles. 

 The credit only applies to domestically bottled distilled spirits88 purchased directly from 

the bottler of such spirits. The credit is in addition to present-law rules allowing tax included in 

inventory costs to be deducted as a cost of goods sold.

The credit cannot be carried back to a taxable year beginning before January 1, 2005.

Effective Date

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

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

Present Law

Under present law, special occupational taxes are imposed on producers and others 

engaged in the marketing of distilled spirits, wine, and beer. These excise taxes are imposed as 

part of a broader Federal tax and regulatory engine governing the production and marketing of 

alcoholic beverages. The special occupational taxes are payable annually, on July 1 of each year. 

The present tax rates are as follows:

Producers89: 

Distilled spirits and wines (sec. 5081) $1,000 per year, per premise

Brewers (sec. 5091) $1,000 per year, per premise

Wholesale dealers (sec. 5111):

Liquors, wines, or beer $500 per year

 

88 Distilled spirits that are imported in bulk and then bottled domestically qualify as 

domestically bottled distilled spirits.

89 A reduced rate of tax in the amount of $500 is imposed on small proprietors. Secs. 

5081(b), 5091(b).
63

Retail dealers (sec. 5121):

Liquors, wines, or beer $250 per year

Nonbeverage use of distilled spirits (sec. 5131): $500 per year

Industrial use of distilled spirits (sec. 5276): $250 per year

The Code requires every wholesale or retail dealer in liquors, wine or beer to keep

records of their transactions.90 A delegate of the Secretary of the Treasury is authorized to 

inspect the records of any dealer during business hours.91 There are penalties for failing to 

comply with the recordkeeping requirements.92

The Code limits the persons from whom dealers may purchase their liquor stock intended 

for resale. Under the Code, a dealer may only purchase from: 

(1) a wholesale dealer in liquors who has paid the special occupational tax as such 

dealer to cover the place where such purchase is made; or

(2) a wholesale dealer in liquors who is exempt, at the place where such purchase is 

made, from payment of such tax under any provision chapter 51 of the Code; or

(3) a person who is not required to pay special occupational tax as a wholesale dealer 

in liquors.93

Violation of this restriction is punishable by $1,000 fine, imprisonment of one year, or 

both. 94 A violation also makes the alcohol subject to seizure and forfeiture.95

Description of Proposal 

Under the proposal, the special occupational taxes on producers and marketers of 

alcoholic beverages are suspended for a three-year period, July 1, 2004 through June 30, 2007. 

Present law recordkeeping and registration requirements will continue to apply, notwithstanding 

 

90 Secs. 5114, 5124.

91 Sec. 5146.

92

 Sec. 5603.

93 Sec. 5117. For example, purchases from a proprietor of a distilled spirits plant at his 

principal business office would be covered under item (2) since such a proprietor is not subject to 

the special occupational tax on account of sales at his principal business office. Sec. 5113(a). 

Purchases from a State-operated liquor store would be covered under item (3). Sec. 5113(b).

94 Sec. 5687.

95 Sec. 7302.
64

the suspension of the special occupation taxes. In addition, during the suspension period, it shall 

be unlawful for any dealer to purchase distilled spirits for resale from any person other than a 

wholesale dealer in liquors who is subject to the recordkeeping requirements.

Effective Date

The proposal is effective on the date of enactment.
65

III. TAX REFORM AND SIMPLIFICATION FOR BUSINESSES

BASED IN THE UNITED STATES

A. Interest Expense Allocation Rules

Present Law

In general

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

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

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

foreign-source gross income, on the other.

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

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

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

paid.96 For interest allocation purposes, the Code provides that all members of an affiliated 

group of corporations generally are treated as a single corporation (the so-called “one-taxpayer 

rule”) and allocation must be made on the basis of assets rather than gross income.

Affiliated group

In general

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

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

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

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

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

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

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

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

Definition of affiliated group -- consolidated return rules

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

includible corporations connected through stock ownership with a common parent corporation 

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

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

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

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

directly owned by one or more other includible corporations.

 

96 However, exceptions to the fungibility principle are provided in particular cases, some 

of which are described below.
66

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

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

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

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

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

corporation generally is not an includible corporation.

Definition of affiliated group -- special interest allocation rules

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

affiliation generally are consistent with each other.97 For example, both definitions generally 

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

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

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

degree of common control as the domestic affiliated group.

Banks, savings institutions, and other financial affiliates

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

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

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

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

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

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

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

the extent provided in regulations, bank holding companies (including financial holding 

companies), subsidiaries of banks and bank holding companies (including financial holding 

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

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

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

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

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

corporation for interest allocation purposes.

Description of Proposal

In general

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

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

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

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

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

 

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

section 936 corporations that are excluded from the consolidated group.
67

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

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

sources outside the United States is determined by allocating and apportioning the third-party 

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

excess (if any) of (1) the worldwide affiliated group’s worldwide third-party interest expense 

multiplied by the ratio which the foreign assets of the worldwide affiliated group bears to the 

total assets of the worldwide affiliated group,98 over (2) the third-party interest expense incurred 

by foreign members of the group to the extent such interest would be allocated to foreign sources 

if the provision’s principles were applied separately to the foreign members of the group.99

For purposes of the new elective rules based on worldwide fungibility, the worldwide 

affiliated group means all corporations in an affiliated group (as that term is defined under 

present law for interest allocation purposes)100 as well as all controlled foreign corporations that, 

in the aggregate, either directly or indirectly,101 would be members of such an affiliated group if 

section 1504(b)(3) did not apply (i.e., in which at least 80 percent of the vote and value of the 

stock of such corporations is owned by one or more other corporations included in the affiliated 

group). Thus, if an affiliated group makes this election, the taxable income from sources outside 

the United States of domestic group members generally is determined by allocating and 

apportioning interest expense of the domestic members of the worldwide affiliated group as if all 

of the interest expense and assets of 80-percent or greater owned domestic corporations (i.e., 

corporations that are part of the affiliated group under present-law section 864(e)(5)(A) as 

modified to include insurance companies) and certain controlled foreign corporations were 

attributable to a single corporation. 

 

98 For purposes of determining the assets of the worldwide affiliated group, neither stock 

in corporations within the group nor indebtedness (including receivables) between members of 

the group is taken into account. It is anticipated that the Treasury Secretary will adopt 

regulations addressing the allocation and apportionment of interest expense on such indebtedness 

that follow principles analogous to those of existing regulations. Income from holding stock or 

indebtedness of another group member is taken into account for all purposes under the presentlaw rules of the Code, including the foreign tax credit provisions.

99 Although the interest expense of a foreign subsidiary is taken into account for 

purposes of allocating the interest expense of the domestic members of the electing worldwide 

affiliated group for foreign tax credit limitation purposes, the interest expense incurred by a 

foreign subsidiary is not deductible on a U.S. return.

100 The provision expands the definition of an affiliated group for interest expense 

allocation purposes to include certain insurance companies that are generally excluded from an 

affiliated group under section 1504(b)(2) (without regard to whether such companies are covered 

by an election under section 1504(c)(2)).

101 Indirect ownership is determined under the rules of section 958(a)(2) or through 

applying rules similar to those of section 958(a)(2) to stock owned directly or indirectly by 

domestic partnerships, trusts, or estates.
68

In addition, if an affiliated group elects to apply the new elective rules based on 

worldwide fungibility, the present-law rules regarding the treatme nt of tax-exempt assets and the 

basis of stock in nonaffiliated ten-percent owned corporations apply on a worldwide affiliated 

group basis.

The common parent of the domestic affiliated group must make the worldwide affiliated 

group election. It must be made for the first taxable year beginning after December 31, 2008, in 

which a worldwide affiliated group exists that includes at least one foreign corporation that 

meets the requirements for inclusion in a worldwide affiliated group. Once made, the election

applies to the common parent and all other members of the worldwide affiliated group for the 

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

with the consent of the Secretary of the Treasury.

Financial institution group election

The proposal allows taxpayers to apply the present-law bank group rules to exclude 

certain financial institutions from the affiliated group for interest allocation purposes under the 

worldwide fungibility approach. The provision also provides a one-time “financial institution 

group” election that expands the present-law bank group. Under the provision, at the election of 

the common parent of the pre-election worldwide affiliated group, the interest expense allocation 

rules are applied separately to a subgroup of the worldwide affiliated group that consists of (1) 

all corporations that are part of the present-law bank group, and (2) all “financial corporations.” 

For this purpose, a corporation is a financial corporation if at least 80 percent of its gross income 

is financial services income (as described in section 904(d)(2)(C)(i) and the regulations 

thereunder) that is derived from transactions with unrelated persons.102 For these purposes, items 

of income or gain from a transaction or series of transactions are disregarded if a principal 

purpose for the transaction or transactions is to qualify any corporation as a financial 

corporation. 

The common parent of the pre-election worldwide affiliated group must make the 

election for the first taxable year beginning after December 31, 2008, in which a worldwide 

affiliated group includes a financial corporation. Once made, the election applies to the financial 

institution group for the taxable year and all subsequent taxable years. In addition, the provision 

provides anti-abuse rules under which certain transfers from one member of a financial 

institution group to a member of the worldwide affiliated group outside of the financial 

institution group are treated as reducing the amount of indebtedness of the separate financial 

institution group. The provision provides regulatory authority with respect to the election to 

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

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

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

acquisitions or otherwise) treated as affiliated under this provision. 

 

102

 See Treas. Reg. sec. 1.904-4(e)(2).
69

Effective Date

The proposal is effective for taxable years beginning after December 31, 2008.
70

B. Recharacterization of Overall Domestic Loss

Present Law

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

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

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

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

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

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

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

multiplied by its pre-credit U.S. tax to establish the amount of U.S. tax allocable to the taxpayer's 

foreign-source income and, thus, the upper limit on the foreign tax credit for the year.

In addition, this limitation is calculated separately for various categories of income, 

generally referred to as “separate limitation categories.” The total amount of the foreign tax 

credit used to offset the U.S. tax on income in each separate limitation category may not exceed 

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

that category bears to its worldwide taxable income.

If a taxpayer's losses from foreign sources exceed its foreign-source income, the excess 

(“overall foreign loss,” or “OFL”) may offset U.S.-source income. Such an offset reduces the 

effective rate of U.S. tax on U.S.-source income. 

In order to eliminate a double benefit (that is, the reduction of U.S. tax previously noted 

and, later, full allowance of a foreign tax credit with respect to foreign-source income), present 

law includes an OFL recapture rule. Under this rule, a portion of foreign-source taxable income 

earned after an OFL year is recharacterized as U.S.-source taxable income for foreign tax credit 

purposes (and for purposes of the possessions tax credit). Unless a taxpayer elects a higher 

percentage, however, generally no more than 50 percent of the foreign-source taxable income 

earned in any particular taxable year is recharacterized as U.S.-source taxable income. The 

effect of the recapture is to reduce the foreign tax credit limitation in one or more years 

following an OFL year and, therefore, the amount of U.S. tax that can be offset by foreign tax 

credits in the later year or years.

Losses for any taxable year in separate foreign limitation categories (to the extent that 

they do not exceed foreign income for the year) are apportioned on a proportionate basis among 

(and operate to reduce) the foreign income categories in which the entity earns income in the loss 

year. A separate limitation loss recharacterization rule applies to foreign losses apportioned to 

foreign income pursuant to the above rule. If a separate limitation loss was apportioned to 

income subject to another separate limitation category and the loss category has income for a 

subsequent taxable year, then that income (to the extent that it does not exceed the aggregate 

separate limitation losses in the loss category not previously recharacterized) must be 

recharacterized as income in the separate limitation category that was previously offset by the 

loss. Such recharacterization must be made in proportion to the prior loss apportionment not 

previously taken into account.
71

A U.S.-source loss reduces pre-credit U.S. tax on worldwide income to an amount less 

than the hypothetical tax that would apply to the taxpayer's foreign-source income if viewed in 

isolation. The existence of foreign-source taxable income in the year of the U.S.-source loss 

reduces or eliminates any net operating loss carryover that the U.S.-source loss would otherwise 

have generated absent the foreign income. In addition, as the pre-credit U.S. tax on worldwide 

income is reduced, so is the foreign tax credit limitation. Moreover, any U.S.-source loss for any 

taxable year is apportioned among (and operates to reduce) foreign income in the separate 

limitation categories on a proportionate basis. As a result, some foreign tax credits in the year of 

the U.S.-source loss must be credited, if at all, in a carryover year. Tax on U.S.-source taxable 

income in a subsequent year may be offset by a net operating loss carryforward, but not by a 

foreign tax credit carryforward. There is currently no mechanism for recharacterizing such 

subsequent U.S.-source income as foreign-source income.

For example, suppose a taxpayer generates a $100 U.S.-source loss and earns $100 of 

foreign-source income in Year 1, and pays $30 of foreign tax on the $100 of foreign-source 

income. Because the taxpayer has no net taxable income in Year 1, no foreign tax credit can be 

claimed in Year 1 with respect to the $30 of foreign taxes. If the taxpayer then earns $100 of 

U.S.-source income and $100 of foreign-source income in Year 2, present law does not 

recharacterize any portion of the $100 of U.S.-source income as foreign-source income to reflect 

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

foreign tax credits.

Description of Proposal

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

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

Under the provision, a portion of the taxpayer's U.S.-source income for each succeeding taxable 

year is recharacterized as foreign-source income in an amount equal to the lesser of: (1) the 

amount of the unrecharacterized overall domestic losses for years prior to such succeeding 

taxable year, and (2) 50 percent of the taxpayer's U.S.-source income for such succeeding taxable 

year.

The proposal defines an overall domestic loss for this purpose as any domestic loss to the 

extent it offsets foreign-source taxable income for the current taxable year or for any preceding 

taxable year by reason of a loss carryback. For this purpose, a domestic loss means the amount 

by which the U.S.-source gross income for the taxable year is exceeded by the sum of the 

deductions properly apportioned or allocated thereto, determined without regard to any loss 

carried back from a subsequent taxable year. Under the provision, an overall domestic loss does 

not include any loss for any taxable year unless the taxpayer elected the use of the foreign tax 

credit for such taxable year.

Any U.S.-source income recharacterized under the provision is allocated among and 

increases the various foreign tax credit separate limitation categories in the same proportion that 

those categories were reduced by the prior overall domestic losses, in a manner similar to the 

recharacterization rules for separate limitation losses.
72

It is anticipated that situations may arise in which a taxpayer generates an overall 

domestic loss in a year following a year in which it had an overall foreign loss, or vice versa. In 

such a case, it would be necessary for ordering and other coordination rules to be developed for 

purposes of computing the foreign tax credit limitation in subsequent taxable years. The 

proposal grants the Secretary of the Treasury authority to prescribe such regulations as may be 

necessary to coordinate the operation of the OFL recapture rules with the operation of the overall 

domestic loss recapture rules added by the provision.

Effective Date

The proposal is effective for losses incurred in taxable years beginning after 

December 31, 2006.
73

C. Reduction to Two Foreign Tax Credit Baskets

Present Law

In general

The United States taxes its citizens and residents on their worldwide income. Because 

the countries in which income is earned also may assert their jurisdiction to tax the same income 

on the basis of source, foreign-source income earned by U.S. persons may be subject to double 

taxation. In order to mitigate this possibility, the United States provides a credit against U.S. tax 

liability for foreign income taxes paid, subject to a number of limitations. The foreign tax credit 

generally is limited to the U.S. tax liability on a taxpayer’s foreign-source income, in order to 

ensure that the credit serves its purpose of mitigating double taxation of cross-border income 

without offsetting the U.S. tax on U.S.-source income. 

The foreign tax credit limitation is applied separately to the following categories of 

income: (1) passive income, (2) high withholding tax interest, (3) financial services income, (4) 

shipping income, (5) certain dividends received from noncontrolled section 902 foreign 

corporations (“10/50 companies”),

103 (6) certain dividends from a domestic international sales 

corporation or former domestic international sales corporation, (7) taxable income attributable to 

certain foreign trade income, (8) certain distributions from a foreign sales corporation or former 

foreign sales corporation, and (9) any other income not described in items (1) through (8) (socalled “general basket” income). In addition, a number of other provisions of the Code and U.S. 

tax treaties effectively create additional separate limitations in certain circumstances.104

Financial services income

In general, the term “financial services income” includes income received or accrued by a 

person predominantly engaged in the active conduct of a banking, insurance, financing, or 

similar business, if the income is derived in the active conduct of a banking, financing or similar 

 

103 Subject to certain exceptions, dividends paid by a 10/50 company in taxable years 

beginning after December 31, 2002 are subject to either a look-through approach in which the 

dividend is attributed to a particular limitation category based on the underlying earnings which 

gave rise to the dividend (for post-2002 earnings and profits), or a single-basket limitation 

approach for dividends from all 10/50 companies that are not passive foreign investment 

companies (for pre-2003 earnings and profits). Under section 304 of the bill, these dividends are 

subject to a look-through approach, irrespective of when the underlying earnings and profits 

arose.

104

 See, e.g., sec. 56(g)(4)(C)(iii)(IV) (relating to certain dividends from corporations 

eligible for the sec. 936 credit); sec. 245(a)(10) (relating to certain dividends treated as foreign 

source under treaties); sec. 865(h)(1)(B) (relating to certain gains from stock and intangibles 

treated as foreign source under treaties); sec. 901(j)(1)(B) (relating to income from certain 

specified countries); and sec. 904(g)(10)(A) (relating to interest, dividends, and certain other 

amounts derived from U.S.-owned foreign corporations and treated as foreign source under 

treaties).
74

business, or is derived from the investment by an insurance company of its unearned premiums 

or reserves ordinary and necessary for the proper conduct of its insurance business (sec. 

904(d)(2)(C)). The Code also provides that financial services income includes income, received 

or accrued by a person predominantly engaged in the active conduct of a banking, insurance, 

financing, or similar business, of a kind which would generally be insurance income (as defined 

in section 953(a)), among other items.

Treasury regulations provide that a person is predominantly engaged in the active 

conduct of a banking, insurance, financing, or similar business for any year if for that year at 

least 80 percent of its gross income is “active financing income.”105 The regulations further 

provide that a corporation that is not predominantly engaged in the active conduct of a banking, 

insurance, financing, or similar business under the preceding definition can derive financial 

services income if the corporation is a member of an affiliated group (as defined in section 

1504(a), but expanded to include foreign corporations) that, as a whole, meets the regulatory test 

of being “predominantly engaged.”106 In determining whether an affiliated group is 

“predominantly engaged,” only the income of members of the group that are U.S. corporations, 

or controlled foreign corporations in which such U.S. corporations own (directly or indirectly) at 

least 80 percent of the total voting power and value of the stock, are counted.

“Base difference” items

Under Treasury regulations, foreign taxes are allocated and apportioned to the same 

limitation categories as the income to which they relate.107 In cases in which foreign law

imposes tax on an item of income that does not constitute income under U.S. tax principles (a 

“base difference” item), the tax is treated as imposed on income in the general limitation 

category. 108

Description of Proposal

In general

The proposal generally reduces the number of foreign tax credit limitation categories to 

two: passive category income and general category income. Other income is included in one of 

the two categories, as appropriate. For example, shipping income generally falls into the general 

limitation category, whereas high withholding tax interest generally could fall into the passive 

income or the general limitation category, depending on the circumstances. Dividends from a 

domestic international sales corporation or former domestic international sales corporation, 

income attributable to certain foreign trade income, and certain distributions from a foreign sales 

corporation or former foreign sales corporation all are assigned to the passive income limitation 

 

105 Treas. Reg. sec. 1.904-4(e)(3)(i) and (2)(i).

106 Treas. Reg. sec. 1.904-4(e)(3)(ii). 

107 Treas. Reg. sec. 1.904-6.

108 Treas. Reg. sec. 1.904-6(a)(1)(iv).
75

category. The proposal does not affect the separate computation of foreign tax credit limitations 

under special provisions of the Code relating to, for example, treaty-based sourcing rules or 

specified countries under section 901(j).

Financial services income

In the case of a member of a financial services group or any other person predominantly 

engaged in the active conduct of a banking, insurance, financing or similar business, the proposal 

treats income meeting the definition of financial services income as general category income. 

Under the proposal, a financial services group is an affiliated group that is predominantly 

engaged in the active conduct of a banking, insurance, financing or similar business. For this 

purpose, the definition of an affiliated group under section 1504(a) is applied, but expanded to 

include certain insurance companies (without regard to whether such companies are covered by 

an election under section 1504(c)(2)) and foreign corporations. In determining whether such a 

group is predominantly engaged in the active conduct of a banking, insurance, financing, or 

similar business, only the income of members of the group that are U.S. corporations or 

controlled foreign corporations in which such U.S. corporations own (directly or indirectly) at 

least 80 percent of total voting power and value of the stock are taken into account.

The proposal does not alter the present law interpretation of what it means to be a “person 

predominantly engaged in the active conduct of a banking, insurance, financing, or similar 

business.”109 Thus, other provisions of the Code that rely on this same concept of a “person 

predominantly engaged in the active conduct of a banking, insurance, financing, or similar 

business” are not affected by the proposal. For example, under the “accumulated deficit rule” of 

section 952(c)(1)(B), subpart F income inclusions of a U.S. shareholder attributable to a 

“qualified activity” of a controlled foreign corporation may be reduced by the amount of the U.S. 

shareholder’s pro rata share of certain prior year deficits attributable to the same qualified 

activity. In the case of a qualified financial institution, qualified activity consists of any activity 

giving rise to foreign personal holding company income, but only if the controlled foreign 

corporation was predominantly engaged in the active conduct of a banking, financing, or similar 

business in both the year in which the corporation earned the income and the year in which the 

corporation incurred the deficit. Similarly, in the case of a qualified insurance company, 

qualified activity consists of activity giving rise to insurance income or foreign personal holding 

company income, but only if the controlled foreign corporation was predominantly engaged in 

the active conduct of an insurance business in both the year in which the corporation earned the 

income and the year in which the corporation incurred the deficit. For this purpose, 

“predominantly engaged in the active conduct of a banking, insurance, financing, or similar 

business” is defined under present law by reference to the use of the term for purposes of the 

separate foreign tax credit limitations.110 The present-law meaning of “predominantly engaged” 

for purposes of section 952(c)(1)(B) remains unchanged under the proposal.

 

109

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

110

 See H.R. Rep. No. 99-841, 99th Cong., 2d Sess. II-621 (1986); Staff of the Joint 

Committee on Taxation, 100th Cong., 1st Sess., General Explanation of the Tax Reform Act of 

1986, at 984 (1987). 
76

The proposal requires the Treasury Secretary to specify the treatment of financial services 

income received or accrued by pass-through entities that are not members of a financial services 

group. It is anticipated that these regulations will be generally consistent with regulations 

currently in effect.

“Base difference” items

Creditable foreign taxes that are imposed on amounts that do not constitute income under 

U.S. tax principles are treated as imposed on general limitation income.

Effective Date

The proposal is effective for taxable years beginning after December 31, 2006.

Taxes paid or accrued in a taxable year beginning before January 1, 2007, and carried to 

any subsequent taxable year are treated as if this proposal were in effect on the date such taxes 

were paid or accrued. Thus, such taxes are assigned to one of the two foreign tax credit 

limitation categories, as appropriate. 

The Treasury Secretary is given authority to provide by regulations for the allocation of 

income with respect to taxes carried back to pre-effective-date years (in which more than two 

limitation categories are in effect).
77

D. Look-Through Rules to Apply to Dividends from

Noncontrolled Section 902 Corporations

Present Law

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

general, the amount of foreign tax credits that may be claimed in a year is subject to a limitation 

that prevents taxpayers from using foreign tax credits to offset U.S. tax on U.S.-source income. 

Separate limitations are also applied to specific categories of income.

Special foreign tax credit limitations apply in the case of dividends received from a 

foreign corporation in which the taxpayer owns at least 10 percent of the stock by vote and 

which is not a controlled foreign corporation (a so-called “10/50 company”). Dividends paid by 

a 10/50 company that is not a passive foreign investment company out of earnings and profits 

accumulated in taxable years beginning before January 1, 2003 are subject to a single foreign tax 

credit limitation for all 10/50 companies (other than passive foreign investment companies).111

 

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

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

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

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

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

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

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

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

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

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

stock.

Description of Proposal

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

company regardless of the year in which the earnings and profits out of which the dividend is 

paid were accumulated.112 If the Treasury Secretary determines that a taxpayer has inadequately 

substantiated that it assigned a dividend from a 10/50 company to the proper foreign tax credit 

limitation category, the dividend is treated as passive category income for foreign tax credit 

basketing purposes.113 

 

111 Dividends paid by a 10/50 company in taxable years beginning before January 1, 

2003 are subject to a separate foreign tax credit limitation for each 10/50 company. 

112 This look-through treatment also applies to dividends that a controlled foreign 

corporation receives from a 10/50 company and then distributes to a U.S. shareholder. 

113 It is anticipated that the Treasury Secretary will reconsider the operation of the 

foreign tax credit regulations to ensure that the high-tax income rules apply appropriately to 

dividends treated as passive category income because of inadequate substantiation. 
78

Effective Date

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

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

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

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

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

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

allows the Treasury Secretary to issue regulations addressing the carryback of foreign tax credits 

associated with a dividend from a 10/50 company to pre-effective-date years.
79

E. Attribution of Stock Ownership Through Partnerships to Apply

in Determining Section 902 and 960 Credits

Present Law

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

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

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

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

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

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

corporation’s post-1986 undistributed earnings and profits.

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

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

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

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

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

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

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

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

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

application of the indirect foreign tax credit below the third tier is limited to taxes paid in taxable 

years during which the payor is a controlled foreign corporation. Foreign taxes paid below the 

sixth tier of foreign corporations are ineligible for the indirect foreign tax credit.

Section 960 similarly permits a domestic corporation with subpart F inclusions from a 

controlled foreign corporation to claim deemed-paid foreign tax credits with respect to foreign 

taxes paid or accrued by the controlled foreign corporation on its subpart F income.

The foreign tax credit provisions in the Code do not specifically address whether a 

domestic corporation owning ten percent or more of the voting stock of a foreign corporation 

through a partnership is entitled to a deemed-paid foreign tax credit. 114 In Rev. Rul. 71-141,115

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

 

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

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

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

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

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

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

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

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

partner separately.

115 1971-1 C.B. 211.
80

through their interests in a domestic general partnership is attributed to such domestic 

corporations for purposes of determining the domestic corporations’ eligibility to claim a 

deemed-paid foreign tax credit with respect to the foreign taxes paid by such foreign corporation. 

Accordingly, a general partner of a domestic general partnership is permitted to claim deemedpaid foreign tax credits with respect to a dividend distribution from the foreign corporation to the 

partnership.

However, in 1997, the Treasury Department issued final regulations under section 902, 

and the preamble to the regulations states that “[t]he final regulations do not resolve under what 

circumstances a domestic corporate partner may compute an amount of foreign taxes deemed 

paid with respect to dividends received from a foreign corporation by a partnership or other passthrough entity.”116 In recognition of the holding in Rev. Rul. 71-141, the preamble to the final 

regulations under section 902 states that a “domestic shareholder” for purposes of section 902 is 

a domestic corporation that “owns” the requisite voting stock in a foreign corporation rather than 

one that “owns directly” the voting stock. At the same time, the preamble states that the IRS is 

still considering under what other circumstances Rev. Rul. 71-141 should apply. Consequently, 

uncertainty remains regarding whether a domestic corporation owning ten percent or more of the 

voting stock of a foreign corporation through a partnership is entitled to a deemed-paid foreign 

tax credit (other than through a domestic general partnership).

Description of Proposal

The proposal clarifies that a domestic corporation is entitled to claim deemed-paid 

foreign tax credits with respect to a foreign corporation that is held indirectly through a foreign 

or domestic partnership, provided that the domestic corporation owns (indirectly through the 

partnership) ten percent or more of the foreign corporation’s voting stock. No inference is 

intended as to the treatment of such deemed-paid foreign tax credits under present law. The 

proposal also clarifies that both individual and corporate partners (or estate or trust beneficiaries) 

may claim direct foreign tax credits with respect to their proportionate shares of taxes paid or 

accrued by a partnership (or estate or trust). 

Effective Date

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

corporations beginning after the date of enactment. 

 

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

F. Foreign Tax Credit Treatment of Deemed Payments Under Section 367(d)

Present Law

In the case of transfers of intangible property to foreign corporations by means of 

contributions and certain other nonrecognition transactions, special rules apply that are designed 

to mitigate the tax avoidance that may arise from shifting the income attributable to intangible 

property offshore. Under section 367(d), the outbound transfer of intangible property is treated 

as a sale of the intangible for a stream of contingent payments. The amounts of these deemed 

payments must be commensurate with the income attributable to the intangible. The deemed 

payments are included in gross income of the U.S. transferor as ordinary income, and the 

earnings and profits of the foreign corporation to which the intangible was transferred are 

reduced by such amounts. 

The Taxpayer Relief Act of 1997 (the “1997 Act”) repealed a rule that treated all such 

deemed payments as giving rise to U.S.-source income. Because the foreign tax credit is 

generally limited to the U.S. tax imposed on foreign-source income, the prior-law rule reduced 

the taxpayer’s ability to claim foreign tax credits. As a result of the repeal of the rule, the source 

of payments deemed received under section 367(d) is determined under general sourcing rules. 

These rules treat income from sales of intangible property for contingent payments the same as 

royalties, with the result that the deemed payments may give rise to foreign-source income.117

The 1997 Act did not address the characterization of the deemed payments for purposes 

of applying the foreign tax credit separate limitation categories.118 If the deemed payments are 

treated like proceeds of a sale, then they could fall into the passive category; if the deemed 

payments are treated like royalties, then in many cases they could fall into the general category 

(under look-through rules applicable to payments of dividends, interest, rents, and royalties 

received from controlled foreign corporations).119

Description of Proposal

The proposal specifies that deemed payments under section 367(d) are treated as royalties 

for purposes of applying the separate limitation categories of the foreign tax credit.

Effective Date

The proposal is effective for amounts treated as received on or after August 5, 1997 (the 

effective date of the relevant provision of the 1997 Act).

 

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

118 Sec. 904(d).

119 Sec. 904(d)(3).
82

G. United States Property Not to Include Certain Assets

of Controlled Foreign Corporation

Present Law

In general, the subpart F rules120 require U.S. shareholders with a 10-percent or greater 

interest in a controlled foreign corporation (“U.S. 10-percent shareholders”) to include in taxable 

income their pro rata shares of certain income of the controlled foreign corporation (referred to 

as “subpart F income”) when such income is earned, whether or not the earnings are distributed 

currently to the shareholders. In addition, the U.S. 10-percent shareholders of a controlled 

foreign corporation are subject to U.S. tax on their pro rata shares of the controlled foreign 

corporation's earnings to the extent invested by the controlled foreign corporation in certain U.S. 

property in a taxable year.121

A shareholder’s income inclusion with respect to a controlled foreign corporation's 

investment in U.S. property for a taxable year is based on the controlled foreign corporation’s 

average investment in U.S. property for such year. For this purpose, the U.S. property held 

(directly or indirectly) by the controlled foreign corporation must be measured as of the close of 

each quarter in the taxable year.122 The amount taken into account with respect to any property 

is the property’s adjusted basis as determined for purposes of reporting the controlled foreign 

corporation’s earnings and profits, reduced by any liability to which the property is subject. The 

amount determined for inclusion in each taxable year is the shareholder’s pro rata share of an 

amount equal to the lesser of: (1) the controlled foreign corporation’s average investment in 

U.S. property as of the end of each quarter of such taxable year, to the extent that such 

investment exceeds the foreign corporation’s earnings and profits that were previously taxed on 

that basis; or (2) the controlled foreign corporation’s current or accumulated earnings and profits 

(but not including a deficit), reduced by distributions during the year and by earnings that have 

been taxed previously as earnings invested in U.S. property.123 An income inclusion is required 

only to the extent that the amount so calculated exceeds the amount of the controlled foreign 

corporation’s earnings that have been previously taxed as subpart F income.124

For purposes of section 956, U.S. property generally is defined to include tangible 

property located in the United States, stock of a U.S. corporation, an obligation of a U.S. person, 

and certain intangible assets including a patent or copyright, an invention, model or design, a 

 

120 Secs. 951-964.

121 Sec. 951(a)(1)(B).

122 Sec. 956(a).

123 Secs. 956 and 959.

124 Secs. 951(a)(1)(B) and 959.
83

secret formula or process or similar property right which is acquired or developed by the 

controlled foreign corporation for use in the United States.125

Specified exceptions from the definition of U.S. property are provided for: (1) 

obligations of the United States, money, or deposits with persons carrying on the banking 

business; (2) certain export property; (3) certain trade or business obligations; (4) aircraft, 

railroad rolling stock, vessels, motor vehicles or containers used in transportation in foreign 

commerce and used predominantly outside of the United States; (5) certain insurance company 

reserves and unearned premiums related to insurance of foreign risks; (6) stock or debt of certain 

unrelated U.S. corporations; (7) moveable property (other than a vessel or aircraft) used for the 

purpose of exploring, developing, or certain other activities in connection with the ocean waters 

of the U.S. Continental Shelf; (8) an amount of assets equal to the controlled foreign 

corporation’s accumulated earnings and profits attributable to income effectively connected with 

a U.S. trade or business; (9) property (to the extent provided in regulations) held by a foreign 

sales corporation and related to its export activities; (10) certain deposits or receipts of collateral 

or margin by a securities or commodities dealer, if such deposit is made or received on 

commercial terms in the ordinary course of the dealer’s business as a securities or commodities 

dealer; and (11) certain repurchase and reverse repurchase agreement transactions entered into by 

or with a dealer in securities or commodities in the ordinary course of its business as a securities 

or commodities dealer.126

Description of Proposal

The proposal adds two new exceptions from the definition of U.S. property for 

determining current income inclusion by a U.S. 10-percent shareholder with respect to an 

investment in U.S. property by a controlled foreign corporation.

The first exception generally applies to securities acquired and held by a controlled 

foreign corporation in the ordinary course of its trade or business as a dealer in securities. The 

exception applies only if the controlled foreign corporation dealer: (1) accounts for the securities 

as securities held primarily for sale to customers in the ordinary course of business; and (2) 

disposes of such securities (or such securities mature while being held by the dealer) within a 

period consistent with the holding of securities for sale to customers in the ordinary course of 

business.

The second exception generally applies to the acquisition by a controlled foreign 

corporation of obligations issued by a U.S. person that is not a domestic corporation and that is 

not (1) a U.S. 10-percent shareholder of the controlled foreign corporation, or (2) a partnership, 

estate or trust in which the controlled foreign corporation or any related person is a partner, 

beneficiary or trustee immediately after the acquisition by the controlled foreign corporation of 

such obligation.

 

125 Sec. 956(c)(1).

126 Sec. 956(c)(2).
84

Effective Date

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

December 31, 2004, and for taxable years of United States shareholders with or within which 

such taxable years of such foreign corporations end.
85

H. Election Not to Use Average Exchange Rate for Foreign Tax Paid

Other Than in Functional Currency

Present Law

For taxpayers that take foreign income taxes into account when accrued, present law 

provides that the amount of the foreign tax credit generally is determined by translating the 

amount of foreign taxes paid in foreign currencies into a U.S. dollar amount at the average 

exchange rate for the taxable year to which such taxes relate (sec. 986(a)(1)). This rule applies 

to foreign taxes paid directly by U.S. taxpayers, which taxes are creditable in the year paid or 

accrued, and to foreign taxes paid by foreign corporations that are deemed paid by a U.S. 

corporation that is a shareholder of the foreign corporation, and hence creditable in the year that 

the U.S. corporation receives a dividend or has an income inclusion from the foreign corporation. 

This rule does not apply to any foreign income tax: (1) that is paid after the date that is two 

years after the close of the taxable year to which such taxes relate; (2) of an accrual-basis 

taxpayer that is actually paid in a taxable year prior to the year to which the tax relates; or (3) 

that is denominated in an inflationary currency (as defined by regulations).

Foreign taxes that are not eligible for translation at the average exchange rate generally 

are translated into U.S. dollar amounts using the exchange rates as of the time such taxes are 

paid. However, the Secretary is authorized to issue regulations that would allow foreign tax 

payments to be translated into U.S. dollar amounts using an average exchange rate for a specified 

period (sec. 986(a)(2)).

Description of Proposal

For taxpayers that are required under present law to translate foreign income tax 

payments at the average exchange rate, the proposal provides an election to translate such taxes 

into U.S. dollar amounts using the exchange rates as of the time such taxes are paid, provided the 

foreign income taxes are denominated in a currency other than the taxpayer’s functional 

currency. 127 Any election under the proposal applies to the taxable year for which the election is 

made and to all subsequent taxable years unless revoked with the consent of the Secretary. The 

proposal authorizes the Secretary to issue regulations that apply the election to foreign income 

taxes attributable to a qualified business unit.

Effective Date

The proposal is effective with respect to taxable years beginning after December 31, 

2004.

 

127 Electing taxpayers translate foreign income tax payments pursuant to the same 

present-law rules that apply to taxpayers that are required to translate foreign income taxes using 

the exchange rates as of the time such taxes are paid.
86

I. Repeal of Withholding Tax on Dividends From Certain Foreign Corporations

Present Law

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

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

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

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

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

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

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

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

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

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

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

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

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

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

foreign corporations. If a foreign corporation derives 25 percent or more of its gross income as 

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

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

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

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

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

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

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

or business over the total gross income of the foreign corporation during the three-year period 

ending with the close of the preceding taxable year. The U.S.-source portion of the dividend 

paid by the foreign corporation to its foreign shareholders is subject to the 30-percent 

withholding tax.

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

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

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

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

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

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

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

884(a) and (b)). 

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

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

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

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

could apply with respect to dividends it pays to its shareholders. Several tax treaties (including 
87

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

foreign corporation from the secondary withholding tax. 

Description of Proposal

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

certain foreign corporations. 

Effective Date

The proposal is effective for payments made after December 31, 2004.
88

J. Provide Equal Treatment for Interest Paid by Foreign Partnerships

and Foreign Corporations

Present Law

In general, interest income from bonds, notes or other interest-bearing obligations of 

noncorporate U.S. residents or domestic corporations is treated as U.S.-source income.128 Other 

interest (e.g., interest on obligations of foreign corporations and foreign partnerships) generally 

is treated as foreign-source income. However, Treasury regulations provide that a foreign 

partnership is a U.S. resident for purposes of this rule if at any time during its taxable year it is 

engaged in a trade or business in the United States.129 Therefore, any interest received from such 

a foreign partnership is U.S.-source income.

Notwithstanding the general rule described above, in the case of a foreign corporation 

engaged in a U.S. trade or business (or having gross income that is treated as effectively 

connected with the conduct of a U.S. trade or business), interest paid by such U.S. trade or 

business is treated as if it were paid by a domestic corporation (i.e., such interest is treated as 

U.S.-source income).130

Description of Proposal

The proposal treats interest paid by foreign partnerships in a manner similar to the 

treatment of interest paid by foreign corporations. Thus, interest paid by a foreign partnership is 

treated as U.S.-source income only if the interest is paid by a U.S. trade or business conducted by 

the partnership or is allocable to income that is treated as effectively connected with the conduct 

of a U.S. trade or business. The proposal applies only to foreign partnerships that are 

predominantly engaged in the active conduct of a trade or business outside the United States.

Effective Date

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

 

128 Sec. 861(a)(1).

129 Treas. Reg. sec. 1.861-2(a)(2).

130 Sec. 884(f)(1).
89

K. Look-Through Treatment of Payments Between Related Controlled Foreign 

Corporations Under Foreign Personal Holding Company Income Rules

Present Law

In general, the rules of subpart F (secs. 951-964) require U.S. shareholders with a 10-

percent or greater interest in a controlled foreign corporation to include certain income of the 

controlled foreign corporation (referred to as “subpart F income”) on a current basis for U.S. tax 

purposes, regardless of whether the income is distributed to the shareholders.

Subpart F income includes foreign base company income. One category of foreign base 

company income is foreign personal holding company income. For subpart F purposes, foreign 

personal holding company income generally includes dividends, interest, rents and royalties, 

among other types of income. However, foreign personal holding company income does not 

include dividends and interest received by a controlled foreign corporation from a related 

corporation organized and operating in the same foreign country in which the controlled foreign 

corporation is organized, or rents and royalties received by a controlled foreign corporation from 

a related corporation for the use of property within the country in which the controlled foreign 

corporation is organized. Interest, rent, and royalty payments do not qualify for this exclusion to 

the extent that such payments reduce the subpart F income of the payor. 

Description of Proposal

Under the proposal, dividends, interest, rents, and royalties received by one controlled 

foreign corporation from a related controlled foreign corporation are not treated as foreign 

personal holding company income to the extent attributable or properly allocable to non-subpartF income of the payor. For these purposes, a related controlled foreign corporation is a 

controlled foreign corporation that controls or is controlled by the other controlled foreign 

corporation, or a controlled foreign corporation that is controlled by the same person or persons 

that control the other controlled foreign corporation. Ownership of more than 50 percent of the 

controlled foreign corporation's stock (by vote or value) constitutes control for these purposes. 

Effective Date

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

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

years of such foreign corporations end. 
90

L. Look-Through Treatment Under Subpart F for Sales of Partnership Interests

Present Law 

In general, the subpart F rules (secs. 951-964) require U.S. shareholders with a 10-

percent or greater interest in a controlled foreign corporation to include in income currently for 

U.S. tax purposes certain types of income of the controlled foreign corporation, whether or not 

such income is actually distributed currently to the shareholders (referred to as “subpart F 

income”). Subpart F income includes foreign personal holding company income. Foreign 

personal holding company income generally consists of the following: (1) dividends, interest, 

royalties, rents, and annuities; (2) net gains from the sale or exchange of (a) property that gives 

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

interests in trusts, partnerships, and REMICs; (3) net gains from commodities transactions; (4) 

net gains from foreign currency transactions; (5) income that is equivalent to interest; (6) income 

from notional principal contracts; and (7) payments in lieu of dividends. Thus, if a controlled 

foreign corporation sells a partnership interest at a gain, the gain generally constitutes foreign 

personal holding company income and is included in the income of 10-percent U.S. shareholders 

of the controlled foreign corporation as subpart F income.

Description of Proposal

The proposal treats the sale by a controlled foreign corporation of a partnership interest as 

a sale of the proportionate share of partnership assets attributable to such interest for purposes of 

determining subpart F foreign personal holding company income. This rule applies only to 

partners owning directly, indirectly, or constructively at least 25 percent of a capital or profits 

interest in the partnership. Thus, the sale of a partnership interest by a controlled foreign 

corporation that meets this ownership threshold constitutes subpart F income under the proposal 

only to the extent that a proportionate sale of the underlying partnership assets attributable to the 

partnership interest would constitute subpart F income. The Treasury Secretary is directed to 

prescribe such regulations as may be appropriate to prevent the abuse of this provision.

Effective Date

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

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

years of such foreign corporations end. 
91

M. Repeal of Foreign Personal Holding Company Rules

and Foreign Investment Company Rules

Present Law

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

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

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

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

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

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

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

U.S. tax imposed on such income.

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

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

item of income under multiple rules.

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

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

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

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

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

Description of Proposal

The bill: (1) eliminates the rules applicable to foreign personal holding companies and 

foreign investment companies; (2) excludes foreign corporations from the application of the 

personal holding company rules; and (3) includes as subpart F foreign personal holding company 

income personal services contract income that is subject to the present-law foreign personal 

holding company rules. 

Effective Date

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

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

years of foreign corporations end. 
92

N. Determination of Foreign Personal Holding Company Income

With Respect to Transactions in Commodities

Present Law

Subpart F foreign personal holding company income

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

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

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

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

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

Foreign personal holding company income generally consists of the following: 

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

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

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

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

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

payments in lieu of dividends.

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

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

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

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

conducted by others.131 In addition, foreign personal holding company income does not consist 

of gains or losses which are comprised of active business gains or losses from the sale of 

 

131 For hedging transactions entered into on or after January 31, 2003, Treasury 

regulations provide that gains or losses from a commodities hedging transaction generally are 

excluded from the definition of foreign personal holding company income if the transaction is 

with respect to the controlled foreign corporation’s business as a producer, processor, merchant 

or handler of commodities, regardless of whether the transaction is a hedge with respect to a sale 

of commodities in the active conduct of a commodities business by the controlled foreign 

corporation. The regulations also provide that, for purposes of satisfying the requirements for 

exclusion from the definition of foreign personal holding company income, a producer, 

processor, merchant or handler of commodities includes a controlled foreign corporation that 

regularly uses commodities in a manufacturing, construction, utilities, or transportation business 

(Treas. Reg. sec. 1.954-2(f)(2)(v)). However, the regulations provide that a controlled foreign 

corporation is not a producer, processor, merchant or handler of commodities (and therefore 

would not satisfy the requirements for exclusion) if its business is primarily financial (Treas. 

Reg. sec. 1.954-2(f)(2)(v)).
93

commodities, but only if substantially all of the controlled foreign corporation’s business is as an 

active producer, processor, merchant, or handler of commodities.132

Hedging transactions

Under present law, the term “capital asset” does not include any hedging transaction 

which is clearly identified as such before the close of the day on which it was acquired, 

originated, or entered into (or such other time as the Secretary may by regulations prescribe).133 

The term “hedging transaction” means any transaction entered into by the taxpayer in the normal 

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

currency fluctuations with respect to ordinary property which is held or to be held by the 

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

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

the taxpayer; or (3) to manage such other risks as the Secretary may prescribe in regulations.134

Description of Proposal

The proposal modifies the requirements that must be satisfied for gains or losses from a 

commodities hedging transaction to qualify for exclusion from the definition of subpart F foreign 

personal holding company income. Under the proposal, gains or losses from a transaction with 

respect to a commodity are not treated as foreign personal holding company income if the 

transaction satisfies the general definition of a hedging transaction under section 1221(b)(2). For 

purposes of this proposal, the general definition of a hedging transaction under section 

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

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

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

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

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

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

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

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

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

1221(b)(2).135

 

132 Treasury regulations provide that substantially all of a controlled foreign 

corporation’s business is as an active producer, processor, merchant or handler of commodities 

if: (1) the sum of its gross receipts from all of its active sales of commodities in such capacity 

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

from the definition of foreign personal holding company income, equals or exceeds (2) 85 

percent of its total receipts for the taxable year (computed as though the controlled foreign 

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

133 Sec. 1221(a)(7).

134 Sec. 1221(b)(2)(A).

135 Sec. 1221(a)(7) and (b)(2)(B).
94

The proposal also changes the requirements that must be satisfied for active business 

gains or losses from the sale of commodities to qualify for exclusion from the definition of 

foreign personal holding company income. Under the proposal, such gains or losses are not 

treated as foreign personal holding company income if substantially all of the controlled foreign 

corporation’s commodities are comprised of: (1) stock in trade of the controlled foreign 

corporation or other property of a kind which would properly be included in the inventory of the 

controlled foreign corporation if on hand at the close of the taxable year, or property held by the 

controlled foreign corporation primarily for sale to customers in the ordinary course of the 

controlled foreign corporation’s trade or business; (2) property that is used in the trade or 

business of the controlled foreign corporation and is of a character which is subject to the 

allowance for depreciation under section 167; or (3) supplies of a type regularly used or 

consumed by the controlled foreign corporation in the ordinary course of a trade or business of 

the controlled foreign corporation. 136

For purposes of applying the requirements for active business gains or losses from 

commodities sales to qualify for exclusion from the definition of foreign personal holding 

company income, the proposal also provides that commodities with respect to which gains or 

losses are not taken into account as foreign personal holding company income by a regular dealer 

in commodities (or financial instruments referenced to commodities) are not taken into account 

in determining whether substantially all of the dealer’s commodities are comprised of the 

property described above.

Effective Date

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

2004.

 

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

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

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

made by the proposal) continue to apply.
95

O. Modifications to Treatment of Aircraft Leasing and Shipping Income

Present Law

In general, the subpart F rules (secs. 951-964) require U.S. shareholders with a 10-

percent or greater interest in a controlled foreign corporation (“CFC”) to include currently in 

income for U.S. tax purposes certain income of the CFC (referred to as "subpart F income"), 

without regard to whether the income is distributed to the shareholders (sec. 951(a)(1)(A)). In 

effect, the Code treats the U.S. 10-percent shareholders of a CFC as having received a current 

distribution of their pro rata shares of the CFC's subpart F income. The amounts included in 

income by the CFC's U.S. 10-percent shareholders under these rules are subject to U.S. tax 

currently. The U.S. tax on such amounts may be reduced through foreign tax credits.

Subpart F income includes foreign base company shipping income (sec. 954(f)). Foreign 

base company shipping income generally includes income derived from the use of an aircraft or 

vessel in foreign commerce, the performance of services directly related to the use of any such 

aircraft or vessel, the sale or other disposition of any such aircraft or vessel, and certain space or 

ocean activities (e.g., leasing of satellites for use in space). Foreign commerce generally 

involves the transportation of property or passengers between a port (or airport) in the U.S. and a 

port (or airport) in a foreign country, two ports (or airports) within the same foreign country, or 

two ports (or airports) in different foreign countries. In addition, foreign base company shipping 

income includes dividends and interest that a CFC receives from certain foreign corporations and 

any gains from the disposition of stock in certain foreign corporations, to the extent the 

dividends, interest, or gains are attributable to foreign base company shipping income. Foreign 

base company shipping income also includes incidental income derived in the course of active 

foreign base company shipping operations (e.g., income from temporary investments in or sales 

of related shipping assets), foreign exchange gain or loss attributable to foreign base company 

shipping operations, and a CFC’s distributive share of gross income of any partnership and gross 

income received from certain trusts to the extent that the income would have been foreign base 

company shipping income had it been realized directly by the corporation. 

Subpart F income also includes foreign personal holding company income (sec. 954(c)). 

For subpart F purposes, foreign personal holding company income generally consists of the 

following: (1) dividends, interest, royalties, rents and annuities; (2) net gains from the sale or 

exchange of (a) property that gives rise to the preceding types of income, (b) property that does 

not give rise to income, and (c) interests in trusts, partnerships, and REMICS; (3) net gains from 

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

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

dividends.

Subpart F foreign personal holding company income does not include rents and royalties 

received by the CFC in the active conduct of a trade or business from unrelated persons (sec. 

954(c)(2)(A)). The determination of whether rents or royalties are derived in the active conduct 

of a trade or business is based on all the facts and circumstances. However, the Treasury 

regulations provide certain types of rents are treated as derived in the active conduct of a trade or 

business. These include rents derived from property that is leased as a result of the performance 

of marketing functions by the lessor if the lessor, through its own officers or employees located 
96

in a foreign country, maintains and operates an organization in such country that regularly 

engages in the business of marketing, or marketing and servicing, the leased property and that is 

substantial in relation to the amount of rents derived from the leasing of such property. An 

organization in a foreign country is substantial in relation to rents if the active leasing 

expenses137 equal at least 25 percent of the adjusted leasing profit. 138

Also generally excluded from subpart F foreign personal holding company income are 

rents and royalties received by the CFC from a related corporation for the use of property within 

the country in which the CFC was organized (sec. 954(c)(3)). However, rent and royalty 

payments do not qualify for this exclusion to the extent that such payments reduce subpart F 

income of the payor.

Description of Proposal

The proposal repeals the subpart F rules relating to foreign base company shipping 

income. The bill also amends the exception from foreign personal holding company income 

applicable to rents or royalties derived from unrelated persons in an active trade or business, by 

providing a safe harbor for rents derived from leasing an aircraft or vessel in foreign commerce. 

Such rents are excluded from foreign personal holding company income if the active leasing 

expenses comprise at least 10 percent of the profit on the lease. This proposal is to be applied in 

accordance with existing regulations under sec. 954(c)(2)(A) by comparing the lessor’s “active 

leasing expenses” for its pool of leased assets to its “adjusted leasing profit.”

The safe harbor will not prevent a lessor from otherwise showing that it actively carries 

on a trade or business. In this regard, the requirements of section 954(c)(2)(A) will be met if a 

lessor regularly and directly performs active and substantial marketing, remarketing, 

management and operational functions with respect to the leasing of an aircraft or vessel (or 

component engines). This will be the case regardless of whether the lessor engages in marketing 

of the lease as a form of financing (versus marketing the property as such) or whether the lease is 

classified as a finance lease or operating lease for financial accounting purposes. If a lessor 

acquires, from an unrelated or related party, a ship or aircraft subject to an existing FSC or ETI 

lease, the requirements of section 954(c)(2)(A) will be satisfied if, following the acquisition, the 

lessor performs active and substantial management, operational, and remarketing functions with 

respect to the leased property. If such a lease is transferred to a CFC lessor, it will no longer be 

eligible for FSC or ETI benefits. 

 

137 “Active-leasing expenses” are section 162 expenses properly allocable to rental 

income other than (1) deductions for compensation for personal services rendered by the lessor's 

shareholders or a related person, (2) deductions for rents, (3) section 167 and 168 expenses, and 

(4) deductions for payments to independent contractors with respect to leased property. Treas. 

Reg. sec. 1.954-2(c)(2)(iii).

138 Generally, “adjusted leasing profit” is rental income less the sum of (1) rents paid or 

incurred by the CFC with respect to such rental income; (2) section 167 and 168 expenses with 

respect to such rental income; and (3) payments to independent contractors with respect to such 

rental income. Treas. Reg. sec. 1.954-2(c)(2)(iv).
97

An aircraft or vessel will be considered to be leased in foreign commerce if it is used for 

the transportation of property or passengers between a port (or airport) in the United States and 

one in a foreign country or between foreign ports (or airports), provided the aircraft or vessel is 

used predominantly outside the United States. An aircraft or vessel will be considered used 

predominantly outside the United States if more than 50 percent of the miles during the taxable 

year are traversed outside the United States or the aircraft or vessel is located outside the United 

States more than 50 percent of the time during such taxable year. 

It is anticipated that the Secretary of the Treasury will issue timely guidance to make 

conforming changes to existing regulations, including guidance that aircraft or vessel leasing 

activity that satisfies the requirements of section 954(c)(2)(A) shall also satisfy the requirements 

for avoiding income inclusion under section 956 and section 367(a).

Effective Date

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

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

years of foreign corporations end. 
98

P. Modification of Exceptions Under Subpart F for Active Financing Income

Present Law

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

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

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

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

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

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

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

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

Foreign personal holding company income generally consists of the following: 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Temporary exceptions from foreign personal holding company income, foreign base 

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

that is derived in the active conduct of a banking, financing, or similar business, or in the conduct 

of an insurance business (so-called “active financing income”).139

With respect to income derived in the active conduct of a banking, financing, or similar 

business, a CFC is required to be predominantly engaged in such business and to conduct 

 

139 Temporary exceptions from the subpart F provisions for certain active financing 

income applied only for taxable years beginning in 1998. Those exceptions were modified and 

extended for one year, applicable only for taxable years beginning in 1999. The Tax Relief 

Extension Act of 1999 (P.L. No. 106-170) clarified and extended the temporary exceptions for 

two years, applicable only for taxable years beginning after 1999 and before 2002. The Job 

Creation and Worker Assistance Act of 2002 (P.L. No. 107-147) extended the temporary 

exceptions for five years, applicable only for taxable years beginning after 2001 and before 2007, 

with a modification relating to insurance reserves.
99

substantial activity with respect to such business in order to qualify for the exceptions. In 

addition, certain nexus requirements apply, which provide that income derived by a CFC or a 

qualified business unit (“QBU”) of a CFC from transactions with customers is eligible for the 

exceptions if, among other things, substantially all of the activities in connection with such 

transactions are conducted directly by the CFC or QBU in its home country, and such income is 

treated as earned by the CFC or QBU in its home country for purposes of such country's tax 

laws. Moreover, the exceptions apply to income derived from certain cross border transactions, 

provided that certain requirements are met. Additional exceptions from foreign personal holding 

company income apply for certain income derived by a securities dealer within the meaning of 

section 475 and for gain from the sale of active financing assets.

In the case of insurance, in addition to temporary exceptions from insurance income and 

from foreign personal holding company income for certain income of a qualifying insurance 

company with respect to risks located within the CFC's country of creation or organization, 

temporary exceptions from insurance income and from foreign personal holding company 

income apply for certain income of a qualifying branch of a qualifying insurance company with 

respect to risks located within the home country of the branch, provided certain requirements are 

met under each of the exceptions. Further, additional temporary exceptions from insurance 

income and from foreign personal holding company income apply for certain income of certain 

CFCs or branches with respect to risks located in a country other than the United States, 

provided that the requirements for these exceptions are met.

Description of Proposal

The proposal modifies the present-law temporary exceptions from subpart F foreign 

personal holding company income and foreign base company services income for income 

derived in the active conduct of a banking, financing, or similar business. For purposes of 

determining whether a CFC or QBU has conducted directly in its home country substantially all 

of the activities in connection with transactions with customers, the proposal provides that an 

activity is treated as conducted directly by the CFC or QBU in its home country if the activity is 

performed by employees of a related person and: (1) the related person is itself an eligible CFC 

the home country of which is the same as that of the CFC or QBU; (2) the activity is performed 

in the home country of the related person; and (3) the related person is compensated on an arm’s 

length basis for the performance of the activity by its employees and such compensation is 

treated as earned by such person in its home country for purposes of the tax laws of such 

country.

Effective Date

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

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

years of foreign corporations end. 
100

IV. EXTENSION OF CERTAIN EXPIRING PROVISIONS

A. Extend Alternative Minimum Tax Relief for Individuals

Present Law

Present law provides for certain nonrefundable personal tax credits (i.e., the dependent 

care credit, the credit for the elderly and disabled, the adoption credit, the child tax credit, 140 the 

credit for interest on certain home mortgages, the HOPE Scholarship and Lifetime Learning 

credits, the IRA credit, and the D.C. homebuyer’s credit). 

For taxable years beginning in 2003, all the nonrefundable personal credits are allowed to 

the extent of the full amount of the individual’s regular tax and alternative minimum tax.

For taxable years beginning after 2003, the credits (other than the adoption credit, child 

credit and IRA credit) are allowed only to the extent that the individual’s regular income tax 

liability exceeds the individual’s tentative minimum tax, determined without regard to the 

minimum tax foreign tax credit. The adoption credit, child credit, and IRA credit are allowed to 

the full extent of the individual’s regular tax and alternative minimum tax.

The alternative minimum tax is the amount by which the tentative minimum tax exceeds 

the regular income tax. An individual’s tentative minimum tax is an amount equal to (1) 26 

percent of the first $175,000 ($87,500 in the case of a married individual filing a separate return) 

of alternative minimum taxable income (“AMTI”) in excess of an exemption amount that phases 

out and (2) 28 percent of the remaining AMTI. The maximum tax rates on net capital gain used 

in computing the tentative minimum tax are the same as under the regular tax. AMTI is the 

individual’s taxable income adjusted to take account of specified preferences and adjustments. 

The exemption amounts are: (1) $45,000 ($58,000 in taxable years beginning before 2005) in the 

case of married individuals filing a joint return and surviving spouses; (2) $33,750 ($40,250 in 

taxable years beginning before 2005) in the case of other unmarried individuals; (3) $22,500 

($29,000 in taxable years beginning before 2005) in the case of married individuals filing a 

separate return; and (4) $22,500 in the case of an estate or trust. The exemption amounts are 

phased out by an amount equal to 25 percent of the amount by which the individual's AMTI 

exceeds (1) $150,000 in the case of married individuals filing a joint return and surviving 

spouses, (2) $112,500 in the case of other unmarried individuals, and (3) $75,000 in the case of 

married individuals filing separate returns or an estate or a trust. These amounts are not indexed 

for inflation.

Description of Proposal

The bill extends the provision allowing an individual to offset the entire regular tax 

liability and alternative minimum tax liability by the personal nonrefundable credits for taxable 

years beginning in 2004 and 2005.

 

140 A portion of the child credit may be refundable.
101

Effective Date 

The proposal applies to taxable years beginning after December 31, 2003.
102

B. Extension of the Research Credit

Present Law

General rule

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

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

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

incurred after June 30, 2004.

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

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

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

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

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

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

Computation of allowable credit

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

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

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

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

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

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

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

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

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

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

Alternative incremental research credit regime

Taxpayers are allowed to elect an alternative incremental research credit regime.141 If a 

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

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

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

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

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

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

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

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

 

141 Sec. 41(c)(4).
103

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

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

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

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

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

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

with the consent of the Secretary of the Treasury.

Eligible expenses

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

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

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

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

taxpayer’s behalf (so-called contract research expenses).142 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Relation to deduction

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

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

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

 

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

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

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

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

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

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

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

more persons not related to the taxpayer. Sec. 41(b)(3)(C).
104

useful life extending beyond the current year must be capitalized.143 However, deductions 

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

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

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

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

Description of Proposal

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

incurred before January 1, 2006. 

Effective Date 

The proposal is effective for amounts paid or incurred after the date of enactment. 

 

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

as a deduction under section 174(a). Secs. 174(f)(2) and 59(e).
105

C. Extension and Modification of the Section 45 Electricity Production Credit

Present Law

An income tax credit is allowed for the production of electricity from either qualified 

wind energy, qualified “closed-loop” biomass, or qualified poultry waste facilities (sec. 45). The 

amount of the credit is 1.5 cents per kilowatt hour (indexed for inflation) of electricity produced. 

The amount of the credit is 1.8 cents per kilowatt hour for 2004. The credit is reduced for grants, 

tax-exempt bonds, subsidized energy financing, and other credits.

The credit applies to electricity produced by a wind energy facility placed in service after 

December 31, 1993, and before January 1, 2004, to electricity produced by a closed-loop 

biomass facility placed in service after December 31, 1992, and before January 1, 2004, and to a 

poultry waste facility placed in service after December 31, 1999, and before January 1, 2004. 

The credit is allowable for production during the 10-year period after a facility is originally 

placed in service. In order to claim the credit, a taxpayer must own the facility and sell the 

electricity produced by the facility to an unrelated party. In the case of a poultry waste facility, 

the taxpayer may claim the credit as a lessee/operator of a facility owned by a governmental unit.

Closed-loop biomass is plant matter, where the plants are grown for the sole purpose of 

being used to generate electricity. It does not include waste materials (including, but not limited 

to, scrap wood, manure, and municipal or agricultural waste). The credit also is not available to 

taxpayers who use standing timber to produce electricity. Poultry waste means poultry manure 

and litter, including wood shavings, straw, rice hulls, and other bedding material for the 

disposition of manure.

The credit for electricity produced from wind, closed-loop biomass, or poultry waste is a 

component of the general business credit (sec. 38(b)(8)). The credit, when combined with all 

other components of the general business credit, generally may not exceed for any taxable year 

the excess of the taxpayer's net income tax over the greater of (1) 25 percent of net regular tax

liability above $25,000, or (2) the tentative minimum tax. For credits arising in taxable years 

beginning after December 31, 1997, an unused general business credit generally may be carried 

back one year and carried forward 20 years (sec. 39). To coordinate the carryback with the 

period of application for this credit, the credit for electricity produced from closed-loop biomass 

facilities may not be carried back to a tax year ending before 1993 and the credit for electricity 

produced from wind energy may not be carried back to a tax year ending before 1994 (sec. 39).

Description of Proposal

The proposal extends the placed in service date for wind facilities and closed-loop 

biomass facilities to facilities placed in service after December 31, 1993 (December 31, 1992 in 

the case of closed-loop biomass facilities) and before January 1, 2006. The proposal does not 

extend the placed in service date for poultry waste facilities. 

Effective Date

The proposal is effective for electricity produced and sold from qualifying facilities after 

December 31, 2003.
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D. Indian Employment Tax Credit

Present Law

In general, a credit against income tax liability is allowed to employers for the first 

$20,000 of qualified wages and qualified employee health insurance costs paid or incurred by the 

employer with respect to certain employees (sec. 45A). The credit is equal to 20 percent of the 

excess of eligible employee qualified wages and health insurance costs during the current year 

over the amount of such wages and costs incurred by the employer during 1993. The credit is an 

incremental credit, such that an employer’s current-year qualified wages and qualified employee 

health insurance costs (up to $20,000 per employee) are eligible for the credit only to the extent 

that the sum of such costs exceeds the sum of comparable costs paid during 1993. No deduction 

is allowed for the portion of the wages equal to the amount of the credit.

Qualified wages means wages paid or incurred by an employer for services performed by 

a qualified employee. A qualified employee means any employee who is an enrolled member of 

an Indian tribe or the spouse of an enrolled member of an Indian tribe, who performs 

substantially all of the services within an Indian reservation, and whose principal place of abode 

while performing such services is on or near the reservation in which the services are performed. 

An employee will not be treated as a qualified employee for any taxable year of the employer if 

the total amount of wages paid or incurred by the employer with respect to such employee during 

the taxable year exceeds an amount determined at an annual rate of $30,000 (adjusted for 

inflation after 1993). 

The wage credit is available for wages paid or incurred on or after January 1, 1994, in 

taxable years that begin before January 1, 2005.

Description of Proposal

The proposal extends the Indian employment credit incentive for one year (to taxable 

years beginning before January 1, 2006).

Effective Date

The proposal is effective on the date of enactment.
107

E. Extend the Work Opportunity Tax Credit

Present Law

In general

The work opportunity tax credit ("WOTC") is available on an elective basis for 

employers hiring individuals from one or more of eight targeted groups. The credit equals 40 

percent (25 percent for employment of 400 hours or less) of qualified wages. Generally, 

qualified wages are wages attributable to service rendered by a member of a targeted group 

during the one-year period beginning with the day the individual began work for the employer.

The maximum credit per employee is $2,400 (40 percent of the first $6,000 of qualified 

first-year wages). With respect to qualified summer youth employees, the maximum credit is 

$1,200 (40 percent of the first $3,000 of qualified first-year wages).

For purposes of the credit, wages are generally defined as under the Federal 

Unemployment Tax Act, without regard to the dollar cap.

Targeted groups eligible for the credit

The eight targeted groups are: (1) families eligible to receive benefits under the 

Temporary Assistance for Needy Families ("TANF") Program; (2) high-risk youth; (3) qualified 

ex-felons; (4) vocational rehabilitation referrals; (5) qualified summer youth employees; (6) 

qualified veterans; (7) families receiving food stamps; and (8) persons receiving certain 

Supplemental Security Income ("SSI") benefits.

The employer's deduction for wages is reduced by the amount of the credit.

Expiration date

The credit is effective for wages paid or incurred to a qualified individual who begins 

work for an employer before January 1, 2004.

Description of Proposal

The bill extends the work opportunity tax credit for two years (through December 31, 

2005).

Effective Date

The proposal is effective for wages paid or incurred to a qualified individual who begins 

work for an employer on or after January 1, 2004, and before January 1, 2006.
108

F. Extend the Welfare-To-Work Tax Credit

Present Law

In general

The welfare-to-work tax credit is available on an elective basis for employers for the first 

$20,000 of eligible wages paid to qualified long-term family assistance recipients during the first 

two years of employment. The credit is 35 percent of the first $10,000 of eligible wages in the 

first year of employment and 50 percent of the first $10,000 of eligible wages in the second year 

of employment. The maximum credit is $8,500 per qualified employee.

Qualified long-term family assistance recipients are: (1) members of a family that has 

received family assistance for at least 18 consecutive months ending on the hiring date; (2) 

members of a family that has received family assistance for a total of at least 18 months (whether 

or not consecutive) after the date of enactment of this credit if they are hired within 2 years after 

the date that the 18-month total is reached; and (3) members of a family who are no longer 

eligible for family assistance because of either Federal or State time limits, if they are hired 

within two years after the Federal or State time limits made the family ineligible for family 

assistance. Family assistance means benefits under the Temporary Assistance to Needy Families 

("TANF") program.

For purposes of the credit, wages are generally defined under the Federal Unemployment 

Tax Act, without regard to the dollar amount. In addition, wages include the following: (1) 

educational assistance excludable under a section 127 program; (2) the value of excludable 

health plan coverage but not more than the applicable premium defined under section 

4980B(f)(4); and (3) dependent care assistance excludable under section 129.

The employer's deduction for wages is reduced by the amount of the credit.

Expiration date

The welfare to work credit is effective for wages paid or incurred to a qualified individual 

who begins work for an employer before January 1, 2004.

Description of Proposal

The bill extends the welfare to work credit for two years (through December 31, 2005).

Effective Date

The proposal is effective for wages paid or incurred to a qualified individual who begins 

work for an employer on or after January 1, 2004, and before January 1, 2006. 
109

G. Extension of the Above-the-line Deduction for Certain Expenses

of Elementary and Secondary School Teachers

Present Law

In general, ordinary and necessary business expenses are deductible (sec. 162). However, 

in general, unreimbursed employee business expenses are deductible only as an itemized 

deduction and only to the extent that the individual’s total miscellaneous deductions (including 

employee business expenses) exceed two percent of adjusted gross income. An individual’s 

otherwise allowable itemized deductions may be further limited by the overall limitation on 

itemized deductions, which reduces itemized deductions for taxpayers with adjusted gross 

income in excess of $142,700 (for 2004). In addition, miscellaneous itemized deductions are not 

allowable under the alternative minimum tax.

Certain expenses of eligible educators are allowed as an above-the-line deduction. 

Specifically, for taxable years beginning in 2002 and 2003, an above-the-line deduction is 

allowed for up to $250 annually of expenses paid or incurred by an eligible educator for books, 

supplies (other than nonathletic supplies for courses of instruction in health or physical 

education), computer equipment (including related software and services) and other equipment, 

and supplementary materials used by the eligible educator in the classroom. To be eligible for 

this deduction, the expenses must be otherwise deductible under section 162 as a trade or 

business expense. A deduction is allowed only to the extent the amount of expenses exceeds the 

amount excludable from income under section 135 (relating to education savings bonds), 

529(c)(1) (relating to qualified tuition programs), and section 530(d)(2) (relating to Coverdell 

education savings accounts).

An eligible educator is a kindergarten through grade 12 teacher, instructor, counselor, 

principal, or aide in a school for at least 900 hours during a school year. A school means any 

school that provides elementary education or secondary education, as determined under State 

law.

The above-the-line deduction for eligible educators is not allowed for taxable years 

beginning after December 31, 2003.

Description of Proposal

The proposal extends the availability of the above-the-line deduction for two years, i.e., 

for taxable years beginning during 2004 and 2005.

Effective Date

The proposal is effective for taxable years beginning after December 31, 2003.
110

H. Extension of Accelerated Depreciation Benefit for Property on Indian Reservations

Present Law

With respect to certain property used in connection with the conduct of a trade or 

business within an Indian reservation, depreciation deductions under section 168(j) will be 

determined using the following recovery periods:

3-year property................................... 2 years

5-year property................................... 3 years

7-year property................................... 4 years

10-year property................................. 6 years

15-year property................................. 9 years

20-year property................................. 12 years

Nonresidential real property............... 22 years

“Qualified Indian reservation property” eligible for accelerated depreciation includes 

property which is (1) used by the taxpayer predominantly in the active conduct of a trade or 

business within an Indian reservation, (2) not used or located outside the reservation on a regular 

basis, (3) not acquired (directly or indirectly) by the taxpayer from a person who is related to the 

taxpayer (within the meaning of section 465(b)(3)(C)), and (4) described in the recovery-period 

table above. In addition, property is not “qualified Indian reservation property” if it is placed in 

service for purposes of conducting gaming activities. Certain “qualified infrastructure property” 

may be eligible for the accelerated depreciation even if located outside an Indian reservation, 

provided that the purpose of such property is to connect with qualified infrastructure property 

located within the reservation (e.g., roads, power lines, water systems, railroad spurs, and 

communications facilities). 

The depreciation deduction allowed for regular tax purposes is also allowed for purposes 

of the alternative minimum tax. The accelerated depreciation for Indian reservations is available 

with respect to property placed in service on or after January 1, 1994, and before January 1, 

2005. 

Description of Proposal 

The proposal extends the accelerated depreciation incentive for one year (to property 

placed in service before January 1, 2006).

Effective Date

The proposal is effective on the date of enactment.
111

I. Extend Enhanced Charitable Deduction for Computer Technology and Equipment 

Present Law

Under present law, a taxpayer’s deduction for charitable contributions of computer 

technology and equipment generally is limited to the taxpayer’s basis (typically, cost) in the 

property. However, certain corporations may claim a deduction in excess of basis for a qualified 

computer contribution. 144 This enhanced deduction is equal to the lesser of (1) basis plus onehalf of the item’s appreciated value (i.e., basis plus one half of fair market value minus basis) or 

(2) two times basis. The enhanced deduction for qualified computer contributions expires for 

any contribution made during any taxable year beginning after December 31, 2003.

A qualified computer contribution means a charitable contribution of any computer 

technology or equipment that meets standards of functionality and suitability as established by 

the Secretary of the Treasury. The contribution must be to certain educational organizations or 

public libraries and made not later than three years after the taxpayer acquired the property or, if 

the taxpayer constructed the property, not later than the date construction of the property is 

substantially completed.145 The original use of the property must be by the donor or the 

donee,146 and in the case of the donee, must be used substantially for educational purposes 

related to the function or purpose of the donee. The property must fit productively into the 

donee’s education plan. The donee may not transfer the property in exchange for money, other 

property, or services, except for shipping, installation, and transfer costs. Property is considered 

constructed by the taxpayer only if the cost of the parts used in the construction of the property 

(other than parts manufactured by the taxpayer or a related person) does not exceed 50 percent of 

the taxpayer’s basis in the property. Contributions may be made to private foundations under 

certain conditions.

Description of Proposal

The proposal extends the enhanced deduction for qualified computer contributions to 

contributions made during any taxable year beginning before January 1, 2005.

Effective Date

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

 

144 Sec. 170(e)(6).

145 If the taxpayer constructed the property and reacquired such property, the 

contribution must be within three years of the date the original construction was substantially 

completed. Sec. 170(e)(6)(D)(i).

146 This requirement does not apply if the property was reacquired by the manufacturer 

and contributed. Sec. 170(e)(6)(D)(ii).
112

J. Extension of Expensing of Certain Environmental Remediation Costs

Present Law

Taxpayers can elect to treat certain environmental remediation expenditures that would 

otherwise be chargeable to capital account as deductible in the year paid or incurred (sec. 198). 

The deduction applies for both regular and alternative minimum tax purposes. The expenditure 

must be incurred in connection with the abatement or control of hazardous substances at a 

qualified contaminated site.

A “qualified contaminated site” generally is any property that (1) is held for use in a trade 

or business, for the production of income, or as inventory and (2) is at a site on which there has 

been a release (or threat of release) or disposal of certain hazardous substances as certified by the 

appropriate State environmental agency (so called “brownfields”). However, sites that are 

identified on the national priorities list under the Comprehensive Environmental Response, 

Compensation, and Liability Act of 1980 cannot qualify as targeted areas.

Eligible expenditures are those paid or incurred before January 1, 2004.

Explanation of Provision

The bill extends the present-law expensing provision for two years (through December 

31, 2005).

Effective Date

The proposal is effective for expenses paid or incurred after December 31, 2003, and 

before January 1, 2006.
113

K. Extension of Archer Medical Savings Accounts (“MSAs”)

Present Law

In general

Within limits, contributions to an Archer MSA are deductible in determining adjusted 

gross income if made by an eligible individual and are excludable from gross income and wages 

for employment tax purposes if made by the employer of an eligible individual. Earnings on 

amounts in an Archer MSA are not currently taxable. Distributions from an Archer MSA for 

medical expenses are not includible in gross income. Distributions not used for medical 

expenses are includible in gross income. In addition, distributions not used for medical expenses 

are subject to an additional 15-percent tax unless the distribution is made after age 65, death, or 

disability.

Eligible individuals

Archer MSAs are available to employees covered under an employer-sponsored high 

deductible plan of a small employer and self-employed individuals covered under a high 

deductible health plan. 147 An employer is a small employer if it employed, on average, no more 

than 50 employees on business days during either the preceding or the second preceding year. 

An individual is not eligible for an Archer MSA if he or she is covered under any other health 

plan in addition to the high deductible plan.

Tax treatment of and limits on contributions

Individual contributions to an Archer MSA are deductible (within limits) in determining 

adjusted gross income (i.e., “above-the-line”). In addition, employer contributions are 

excludable from gross income and wages for employment tax purposes (within the same limits), 

except that this exclusion does not apply to contributions made through a cafeteria plan. In the 

case of an employee, contributions can be made to an Archer MSA either by the individual or by 

the individual’s employer. 

The maximum annual contribution that can be made to an Archer MSA for a year is 65 

percent of the deductible under the high deductible plan in the case of individual coverage and 75 

percent of the deductible in the case of family coverage.

Definition of high deductible plan

A high deductible plan is a health plan with an annual deductible of at least $1,700 and 

no more than $2,600 in the case of individual coverage and at least $3,450 and no more than 

$5,150 in the case of family coverage. In addition, the maximum out-of-pocket expenses with 

 

147 Self-employed individuals include more than two-percent shareholders of S 

corporations who are treated as partners for purposes of fringe benefit rules pursuant to section 

1372.
114

respect to allowed costs (including the deductible) must be no more than $3,450 in the case of 

individual coverage and no more than $6,300 in the case of family coverage.148 A plan does not 

fail to qualify as a high deductible plan merely because it does not have a deductible for 

preventive care as required by State law. A plan does not qualify as a high deductible health 

plan if substantially all of the coverage under the plan is for permitted coverage (as described 

above). In the case of a self-insured plan, the plan must in fact be insurance (e.g., there must be 

appropriate risk shifting) and not merely a reimbursement arrangement.

Cap on taxpayers utilizing Archer MSAs and expiration of pilot program

The number of taxpayers benefiting annually from an Archer MSA contribution is limited 

to a threshold level (generally 750,000 taxpayers). The number of Archer MSAs established has 

not exceeded the threshold level.

After 2003, no new contributions may be made to Archer MSAs except by or on behalf 

of individuals who previously had Archer MSA contributions and employees who are employed 

by a participating employer.

Trustees of Archer MSAs are generally required to make reports to the Treasury by 

August 1 regarding Archer MSAs established by July 1 of that year. If any year is a cut-off year, 

the Secretary is to make and publish such determination by October 1 of such year.

Description of Proposal

The proposal extends Archer MSAs through December 31, 2004. The proposal also 

provides that the reports required for 2004 are treated as timely if made within 90 days after the 

date of enactment. 

Effective Date

The proposal is generally effective on January 1, 2004. The proposal relating to reports 

is effective on the date of enactment.

 

148 These dollar amounts are for 2004. These amounts are indexed for inflation, rounded 

to the nearest $50.
115

L. Taxable Income Limit on Percentage Depletion for Oil and Natural Gas

Produced from Marginal Properties

Present Law

Overview of depletion

Depletion, like depreciation, is a form of capital cost recovery. In both cases, the 

taxpayer is allowed a deduction in recognition of the fact that an asset--in the case of depletion 

for oil or gas interests, the mineral reserve itself--is being expended in order to produce income. 

Certain costs incurred prior to drilling an oil or gas property are recovered through the depletion 

deduction. These include costs of acquiring the lease or other interest in the property and 

geological and geophysical costs (in advance of actual drilling).

Depletion is available to any person having an economic interest in a producing property. 

An economic interest is possessed in every case in which the taxpayer has acquired by 

investme nt any interest in minerals in place, and secures, by any form of legal relationship, 

income derived from the extraction of the mineral, to which it must look for a return of its 

capital.149 Thus, for example, both working interests and royalty interests in an oil- or gasproducing property constitute economic interests, thereby qualifying the interest holders for 

depletion deductions with respect to the property. A taxpayer who has no capital investment in 

the mineral deposit does not possess an economic interest merely because it possesses an 

economic or pecuniary advantage derived from production through a contractual relation.

Cost depletion

Two methods of depletion are currently allowable under the Code: (1) the cost depletion 

method, and (2) the percentage depletion method.150 Under the cost depletion method, the 

taxpayer deducts that portion of the adjusted basis of the depletable property which is equal to 

the ratio of units sold from that property during the taxable year to the number of units remaining 

as of the end of taxable year plus the number of units sold during the taxable year. Thus, the 

amount recovered under cost depletion may never exceed the taxpayer's basis in the property.

Percentage depletion and related income limitations

The Code generally limits the percentage depletion method for oil and gas properties to 

independent producers and royalty owners.151 Generally, under the percentage depletion method, 

15 percent of the taxpayer's gross income from an oil- or gas-producing property is allowed as a 

deduction in each taxable year.152 The amount deducted generally may not exceed 100 percent 

 

149 Treas. Reg. sec. 1.611-1(b)(1).

150 Secs. 611-613.

151 Sec. 613A.

152 Sec. 613A(c).
116

of the net income from that property in any year (the "net-income limitation").153 The 100-

percent net-income limitation for marginal wells has been suspended for taxable years beginning 

after December 31, 1997, and before January 1, 2004. 

Description of Proposal

The suspension of the 100-percent net-income limitation for marginal wells is extended 

an additional two years, through taxable years beginning before January 1, 2006.

Effective Date

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

 

153 Sec. 613(a).
117

M. Qualified Zone Academy Bonds

Present Law

Tax-exempt bonds

Interest on State and local governmental bonds generally is excluded from gross income 

for Federal income tax purposes if the proceeds of the bonds are used to finance direct activities 

of these governmental units or if the bonds are repaid with revenues of the governmental units. 

Activities that can be financed with these tax-exempt bonds include the financing of public 

schools (sec. 103).

Qualified zone academy bonds

As an alternative to traditional tax-exempt bonds, States and local governments are given 

the authority to issue “qualified zone academy bonds” (“QZABs”) (sec. 1397E). A total of $400 

million of qualified zone academy bonds may be issued annually in calendar years 1998 through 

2003. The $400 million aggregate bond cap is allocated each year to the States according to their 

respective populations of individuals below the poverty line. Each State, in turn, allocates the 

credit authority to qualified zone academies within such State. 

Financial institutions that hold qualified zone academy bonds are entitled to a 

nonrefundable tax credit in an amount equal to a credit rate multiplied by the face amount of the 

bond. A taxpayer holding a qualified zone academy bond on the credit allowance date is entitled 

to a credit. The credit is includable in gross income (as if it were a taxable interest payment on 

the bond), and may be claimed against regular income tax and AMT liability.

The Treasury Department sets the credit rate at a rate estimated to allow issuance of 

qualified zone academy bonds without discount and without interest cost to the issuer. The 

maximum term of the bond is determined by the Treasury Department, so that the present value 

of the obligation to repay the bond is 50 percent of the face value of the bond.

“Qualified zone academy bonds” are defined as any bond issued by a State or local 

government, provided that: (1) at least 95 percent of the proceeds are used for the purpose of 

renovating, providing equipment to, developing course materials for use at, or training teachers 

and other school personnel in a “qualified zone academy”, and (2) private entities have promised 

to contribute to the qualified zone academy certain equipment, technical assistance or training, 

employee services, or other property or services with a value equal to at least 10 percent of the 

bond proceeds.

A school is a “qualified zone academy” if: (1) the school is a public school that provides 

education and training below the college level, (2) the school operates a special academic 

program in cooperation with businesses to enhance the academic curriculum and increase 

graduation and employment rates, and (3) either (a) the school is located in an empowerment 

zone or enterprise community designated under the Code, or (b) it is reasonably expected that at 

least 35 percent of the students at the school will be eligible for free or reduced-cost lunches 

under the school lunch program established under the National School Lunch Act.
118

Description of Proposal

The bill authorizes issuance of up to $400 million of qualified zone academy bonds 

annually for calendar years 2004 and 2005. 

Effective Date

The proposal is effective for obligations issued after the date of enactment.
119

N. Extension of Tax Incentives for Investment in the

District of Columbia

Present Law

DC Zone incentives

The Taxpayer Relief Act of 1997 designated certain economically depressed census tracts 

within the District of Columbia as the District of Columbia Enterprise Zone (the “D.C. Zone”), 

within which businesses and individual residents are eligible for special tax incentives. The D.C. 

Zone designation is in effect for the period from January 1, 1998, through December 31, 2003. 

In addition to the tax incentives generally available with respect to empowerment zones, the D.C. 

Zone also has a zero-percent capital gains rate that applies to gain from the sale of certain 

qualified D.C. Zone assets acquired after December 31, 1997, and held for more than five years.

With respect to the tax-exempt financing incentives, the D.C. Zone generally is treated 

like a Round I empowerment zone; therefore, the issuance of such tax-exempt bonds is subject to 

the District of Columbia’s annual private activity bond volume limitation. However, the 

aggregate face amount of all outstanding qualified D.C. zone facility bonds per qualified D.C. 

Zone business may not exceed $15 million (rather than $3 million, as is the case for Round I 

empowerment zones). 

Homebuyers tax credit

First-time homebuyers of a principal residence in the District of Columbia are eligible for 

a nonrefundable tax credit of up to $5,000 of the amount of the purchase price. The $5,000 

maximum credit applies both to individuals and married couples. Married individuals filing 

separately can claim a maximum credit of $2,500 each. The credit phases out for individual 

taxpayers with adjusted gross income between $70,000 and $90,000 ($110,000-$130,000 for 

joint filers). For purposes of eligibility, "first-time homebuyer" means any individual if such 

individual did not have a present ownership interest in a principal residence in the District of 

Columbia in the one-year period ending on the date of the purchase of the residence to which the 

credit applies. The credit is scheduled to expire for property purchased after December 31, 2003.

Description of Proposal

DC Zone incentives

The bill extends the D.C. Zone designation and tax-exempt financing incentives for two 

years (through December 31, 2005). The bill extends the date before which a DC Zone asset 

must be acquired for purposes of utilizing the zero-percent capital gains rate for two years (to 

January 1, 2006), and extends the period within which gain is treated as qualified capital gain for 

two years (through December 31, 2010).
120

Homebuyers tax credit

The bill extends the first-time homebuyer credit for two years (through December 31, 

2005).

Effective Date

The proposals are effective on the date of enactment, except that the provision relating to 

tax-exempt financing incentives applies to obligations issued after December 31, 2003. 
121

O. Extend the Authority to Issue Liberty Zone Bonds

Present Law

In general

Interest on debt incurred by States or local governments is excluded from income if the 

proceeds of the borrowing are used to carry out governmental functions of those entities or the 

debt is repaid with governmental funds (sec. 103). Interest on bonds that nominally are issued by 

States or local governments, but the proceeds of which are used (directly or indirectly) by a 

private person and payment of which is derived from funds of such a private person is taxable 

unless the purpose of the borrowing is approved specifically in the Code or in a non-Code 

provision of a revenue Act. These bonds are called “private activity bonds.” The term “private 

person” includes the Federal Government and all other individuals and entities other than States 

or local governments.

In most cases, the aggregate volume of tax-exempt private activity bonds that may be 

issued in a State is restricted by annual volume limits. For calendar year 2004, these annual 

volume limits are equal to the greater of $80 per resident of the State or $234 million.

Tax-exempt private activity bonds

Interest on private activity bonds is tax-exempt only for qualified bonds. Qualified bonds 

include: (1) exempt facility bonds; (2) qualified mortgage bonds; (3) qualified veteran mortgage 

bonds; (4) qualified small-issue bonds; (5) qualified student loan bonds; (6) qualified 

redevelopment bonds; and (7) qualified 501(c)(3) bonds. A further provision allows tax-exempt 

financing for “environmental enhancements of hydro-electric generating facilities.” Tax-exempt 

financing also is authorized for capital expenditures for small manufacturing facilities and land 

and equipment for first-time farmers (“qualified small-issue bonds”), local redevelopment 

activities (“qualified redevelopment bonds”), and eligible empowerment zone and enterprise 

community businesses. 

Tax-exempt financing is also allowed for qualified New York Liberty Bonds issued 

during calendar years 2002, 2003, and 2004. An aggregate limit of $8 billion of tax-exempt 

private activity bonds to finance the construction and rehabilitation of nonresidential real 

property154 and residential rental real property155 in a newly designated “Liberty Zone” (the 

 

154 No more than $800 million of the authorized bond amount may be used to finance 

property used for retail sales of tangible property (e.g., department stores, restaurants, etc.) and 

functionally related and subordinate property. The term nonresidential real property includes 

structural components of such property if the taxpayer treats such components as part of the real 

property structure for all Federal income tax purposes (e.g., cost recovery). The $800 million 

limit is divided equally between the Mayor and the Governor.

155 No more than $1.6 billion of the authorized bond amount may be used to finance 

residential rental property. The $1.6 billion limit is divided equally between the Mayor and the 

Governor.
122

“Zone”) of New York City is allowed.156 Property eligible for financing with these bonds 

includes buildings and their structural components, fixed tenant improvements,157 and public 

utility property (e.g., gas, water, electric and telecommunication lines). All business addresses 

located on or south of Canal Street, East Broadway (east of its intersection with Canal Street), or 

Grand Street (east of its intersection with East Broadway) in the Borough of Manhattan are 

considered to be located within the Zone. Issuance of these bonds is limited to projects approved 

by the Mayor of New York City or the Governor of New York State, each of whom may 

designate up to $4 billion of the bonds authorized under the bill.

If the Mayor or the Governor determines that it is not feasible to use all of the authorized 

bonds that he is authorized to designate for property located in the Zone, up to $1 billion of 

bonds may designated by each to be used for the acquisition, construction, and rehabilitation of 

nonresidential real property (including fixed tenant improvements) located outside the Zone and 

within New York City. 158 Bond-financed property located outside the Zone must meet the 

additional requirement that the project have at least 100,000 square feet of usable office or other 

commercial space in a single building or multiple adjacent buildings.

Subject to the following exceptions and modifications, issuance of these tax-exempt 

bonds is subject to the general rules applicable to issuance of exempt-facility private activity 

bonds:

(1) Issuance of the bonds is not subject to the aggregate annual State private activity 

bond volume limits (sec. 146);

(2) The restriction on acquisition of existing property is applied using a minimum 

requirement of 50 percent of the cost of acquiring the building being devoted to 

rehabilitation (sec. 147(d));

(3) The special arbitrage expenditure rules for certain construction bond proceeds

apply to available construction proceeds of the bonds (sec. 148(f)(4)(C));

(4) The tenant targeting rules applicable to exempt-facility bonds for residential rental 

property (and the corresponding change in use penalties for violations of those 

 

156 Current refundings of outstanding New York Liberty Bonds bonds do not count 

against the $8 billion volume limit to the extent that the amount of the refunding bonds does not 

exceed the outstanding amount of the bonds being refunded. In addition, qualified New York 

Liberty Bonds may be issued after December 31, 2004 to refund (other than advance refund) 

qualified New York Liberty Bonds originally issued before January 1, 2005, to the extent the 

amount of the refunding bonds does not exceed the outstanding amount of the refunded bonds. 

The bonds may not be advance refunded.

157 Fixtures and equipment that could be removed from the designated zone for use 

elsewhere are not eligible for financing with these bonds.

158 Public utility property and residential property located outside the Zone cannot be 

financed with the bonds.
123

rules) do not apply to such property financed with the bonds (secs. 142(d) and 

150(b)(2));

(5) Repayments of bond-financed loans may not be used to make additional loans, 

but rather must be used to retire outstanding bonds (with the first such retirement 

occurring 10 years after issuance of the bonds);159 and

(6) Interest on the bonds is not a preference item for purposes of the alternative 

minimum tax preference for private activity bond interest (sec. 57(a)(5)).

Description of Proposal

The proposal extends authority to issue New York Liberty Bonds through December 31, 

2008.

Effective Date

The proposal is effective for bonds issued after the date of enactment and before January 

1, 2009.

 

159 It is intended that redemptions will occur at least semi-annually beginning at the end 

of 10 years after the bonds are issued; however, amounts less than $250,000 are not required to 

be used to redeem bonds at such intervals.
124

P. Disclosure to Law Enforcement Agencies Regarding Terrorist Activities

Present Law

Return information includes a taxpayer’s identity. 160 The IRS may disclose return 

information, other than taxpayer return information, to officers and employees of Federal law 

enforcement upon a written request. The request must be made by the head of the Federal law 

enforcement agency (or his delegate) involved in the response to or investigation of terrorist 

incidents, threats, or activities, and set forth the specific reason or reasons why such disclosure 

may be relevant to a terrorist incident, threat, or activity. The information is to be disclosed to 

officers and employees of the Federal law enforcement agency who would be personally and 

directly involved in the response to or investigation of terrorist incidents, threats, or activities. 

The information is to be used by such officers and employees solely for such response or 

investigation. 161 

The Federal law enforcement agency may redisclose the information to officers and 

employees of State and local law enforcement personally and directly engaged in the response to 

or investigation of the terrorist incident, threat, or activity. The State or local law enforcement 

agency must be part of an investigative or response team with the Federal law enforcement 

agency for these disclosures to be made.162 No disclosures may be made under this provision 

after December 31, 2003.

If a taxpayer’s identity is taken from a return or other information filed with or furnished 

to the IRS by or on behalf of the taxpayer, it is taxpayer return information. Since taxpayer 

return information is not covered by this disclosure authorization, taxpayer identity so obtained 

cannot be disclosed and thus associated with the other information being provided.

Description of Proposal

The proposal extends the disclosure authority relating to terrorist activities. Under the 

proposal, no disclosures can be made after December 31, 2005.

The proposal makes a technical change to clarify that a taxpayer’s identity is not treated 

as taxpayer return information for purposes of disclosures to law enforceme nt agencies regarding 

terrorist activities.

Effective Date

The proposal extending authority is effective for disclosures made on or after the date of 

enactment. The technical change is effective as if included in section 201 of the Victims of 

Terrorism Tax Relief Act of 2001.

 

160 Sec. 6103(b)(2)(A).

161 Sec. 6103(i)(7)(A). 

162 Sec. 6103(i)(7)(A)(ii). 
125

Q. Disclosure of Return Information Relating to Student Loans

Present Law

Present law prohibits the disclosure of returns and return information, except to the extent 

specifically authorized by the Code.163 An exception is provided for disclosure to the 

Department of Education (but not to contractors thereof) of a taxpayer’s filing status, adjusted 

gross income and identity information (i.e., name, mailing address, taxpayer identifying number) 

to establish an appropriate repayment amount for an applicable student loan. 164 The Department 

of Education disclosure authority is scheduled to expire after December 31, 2004.165

An exception to the general rule prohibiting disclosure is also provided for the disclosure 

of returns and return information to a designee of the taxpayer.166 Because the Department of 

Education utilizes contractors for the income-contingent loan verification program, the 

Department of Education obtains taxpayer information by consent under section 6103(c), rather 

than under the specific exception. 167 The Department of Treasury has reported that the Internal 

Revenue Service processes approximately 100,000 consents per year for this purpose.168 

Description of Proposal

The bill extends the disclosure authority relating to the disclosure of return information to 

carry out income contingent repayment of student loans. Under the bill, no disclosures can be 

made after December 31, 2005.

Effective Date

The proposal is effective with respect to disclosures made after the date of enactment.

 

163 Sec. 6103.

164 Sec. 6103(l)(13).

165 Pub. L. No. 108-89, sec. 201 (2003).

166 Sec. 6103(c).

167 Department of Treasury, Report to the Congress on Scope and Use of Taxpayer 

Confidentiality and Disclosure Provisions, Volume I: Study of General Provisions (October 

2000) at 91.

168 Department of Treasury, General Explanations of the Administration’s Fiscal Year 

2004 Revenue Proposals (February 2003) at 133.
126

R. Extension of Cover Over of Excise Tax on Distilled Spirits

to Puerto Rico and Virgin Islands

Present Law

A $13.50 per proof gallon169 excise tax is imposed on distilled spirits produced in or 

imported (or brought) into the United States.170 The excise tax does not apply to distilled spirits 

that are exported from the United States, including exports to U.S. possessions (e.g., Puerto Rico 

and the Virgin Islands).171

The Code provides for cover over (payment) to Puerto Rico and the Virgin Islands of the 

excise tax imposed on rum imported (or brought) into the United States, without regard to the 

country of origin. 172 The amount of the cover over is limited under section 7652(f) to $10.50 per 

proof gallon ($13.25 per proof gallon during the period July 1, 1999 through December 31, 

2003).

Thus, tax amounts attributable to shipments to the United States of rum produced in 

Puerto Rico are covered over to Puerto Rico. Tax amounts attributable to shipments to the 

United States of rum produced in the Virgin Islands are covered over to the Virgin Islands. Tax 

amounts attributable to shipments to the United States of rum produced in neither Puerto Rico 

nor the Virgin Islands are divided and covered over to the two possessions under a formula.173 

Amounts covered over to Puerto Rico and the Virgin Islands are deposited into the treasuries of 

the two possessions for use as those possessions determine.174 All of the amounts covered over 

are subject to the limitation.

Description of Proposal

The proposal temporarily suspends the $10.50 per proof gallon limitation on the amount 

of excise taxes on rum covered over to Puerto Rico and the Virgin Islands. Under the proposal, 

the cover over amount of $13.25 per proof gallon is extended for rum brought into the United 

 

169 A proof gallon is a liquid gallon consisting of 50 percent alcohol. See sec. 

5002(a)(10), (11).

170 Sec. 5001(a)(1). 

171 Secs. 5062(b), 7653(b) and (c). 

172 Sec. 7652(a)(3), (b)(3), and (e)(1). One percent of the amount of excise tax collected 

from imports into the United States of articles produced in the Virgin Islands is retained by the 

United States under section 7652(b)(3).

173 Sec. 7652(e)(2).

174 Sec. 7652(a)(3), (b)(3), and (e)(1).
127

States after December 31, 2003 and before January 1, 2006. After December 31, 2005, the cover 

over amount reverts to $10.50 per proof gallon. 

Effective Date

The proposal is effective for articles brought into the United States after December 31, 

2003.
128

S. Extension of Joint Review

Present Law

The Code required the Joint Committee on Taxation to conduct a joint review175 of the 

strategic plans and budget of the IRS from 1999 through 2003.176 The Code also required the 

Joint Committee to provide an annual report177 from 1999 through 2003 with respect to:

• Strategic and business plans for the IRS;

• Progress of the IRS in meeting its objectives;

• The budget for the IRS and whether it supports its objectives;

• Progress of the IRS in improving taxpayer service and compliance;

• Progress of the IRS on technology modernization; and

• The annual filing season.

Description of Proposal

The proposal requires that the Joint Committee conduct a joint review before June 1, 

2005. The proposal requires the Joint Committee to provide an annual report before June 1, 

2005, but specifies that the content of the annual report is the matters addressed in the joint 

review.178

Effective Date

The proposal is effective on the date of enactment.

 

175 The joint review was required to include two members of the majority and one 

member of the minority of the Senate Committees on Finance, Appropriations, and 

Governmental Affairs, and of the House Committees on Ways and Means, Appropriations, and 

Government Reform and Oversight.

176 Sec. 8021(f).

177 Sec. 8022(3)(C).

178 Accordingly, the proposal deletes the specific list of matters required to be covered in 

the annual report.
129

T. Parity in the Application of Certain Limits to Mental Health Benefits 

Present Law

The Mental Health Parity Act of 1996 amended the Employee Retirement Income 

Security Act of 1974 (“ERISA”) and the Public Health Service Act (“PHSA”) to provide that 

group health plans that provide both medical and surgical benefits and mental health benefits 

cannot impose aggregate lifetime or annual dollar limits on mental health benefits that are not 

imposed on substantially all medical and surgical benefits. The provisions of the Mental Health 

Parity Act were initially effective with respect to plan years beginning on or after January 1, 

1998, for a temporary period. Since enactment, the mental health parity requirements in ERISA 

and the PHSA have been extended on more than one occasion and currently are scheduled to 

expire with respect to benefits for services furnished on or after December 31, 2004.

The Taxpayer Relief Act of 1997 added to the Internal Revenue Code (“Code”) the 

requirements imposed under the Mental Health Parity Act, and imposed an excise tax on group 

health plans that fail to meet the requirements. The excise tax is equal to $100 per day during the 

period of noncompliance and is generally imposed on the employer sponsoring the plan if the 

plan fails to meet the requirements. The maximum tax that can be imposed during a taxable year 

cannot exceed the lesser of 10 percent of the employer’s group health plan expenses for the prior 

year or $500,000. No tax is imposed if the Secretary determines that the employer did not know, 

and exercising reasonable diligence would not have known, that the failure existed.

The Code provisions were initially effective with respect to plan years beginning on or 

after January 1, 1998, for a temporary period.179 The Code provisions have been extended on a 

number of occasions, and expired with respect to benefits for services furnished after December 

31, 2003.

Description of Proposal 

The proposal extends the Code provisions relating to mental health parity to benefits for 

services furnished after the date of enactment and before January 1, 2006. Thus, the excise tax 

on failures to meet the requirements imposed by the Code provisions does not apply after 

December 31, 2003, and before the date of enactment.

Effective Date

The proposal is effective for benefits for services furnished after the date of enactment.

 

179 The excise tax does not apply to benefits for services furnished on or after September 

30, 2001, and before January 10, 2002.
130

U. Disclosure of Tax Information to Facilitate Combined Employment Tax Reporting 

Present Law

Traditionally, Federal tax forms are filed with the Federal government and State tax 

forms are filed with individual States. This necessitates duplication of items common to both 

returns. 

The Taxpayer Relief Act of 1997180 permitted implementation of a demonstration project 

to assess the feasibility and desirability of expanding combined Federal and State reporting. 

There were several limitations on the demonstration project. First, it was limited to the sharing of 

information between the State of Montana and the IRS. Second, it was limited to employment 

tax reporting. Third, it was limited to disclosure of the name, address, TIN, and signature of the 

taxpayer, which is information common to both the Montana and Federal portions of the 

combined form. Fourth, it was limited to a period of five years.

The authority for the demonstration project expired on the date five years after the date of 

enactment (August 5, 2002).

Description of Proposal

The proposal renews authority for the demonstration project through December 31, 2005.

Effective Date

The proposal is effective on the date of enactment.

 

180 Sec. 976; P.L. 105-34; August 5, 1997.
131

V. Extension of Tax Credit for Electric Vehicles and Tax

Deduction for Clean-Fuel Vehicles

Present Law

Electric vehicles

A 10-percent tax credit is provided for the cost of a qualified electric vehicle, up to a 

maximum credit of $4,000 (sec. 30). A qualified electric vehicle is a motor vehicle that is 

powered primarily by an electric motor drawing current from rechargeable batteries, fuel cells, or 

other portable sources of electrical current, the original use of which commences with the 

taxpayer, and that is acquired for the use by the taxpayer and not for resale. The full amount of 

the credit is available for purchases prior to 2002. The credit phases down in the years 2004 

through 2006, and is unavailable for purchases after December 31, 2006.

Clean-fuel vehicles

Certain costs of qualified clean-fuel vehicle property may be expensed and deducted 

when such property is placed in service (sec. 179A). Qualified clean-fuel vehicle property 

includes motor vehicles that use certain clean-burning fuels (natural gas, liquefied natural gas, 

liquefied petroleum gas, hydrogen, electricity and any other fuel at least 85 percent of which is 

methanol, ethanol, any other alcohol or ether). The maximum amount of the deduction is 

$50,000 for a truck or van with a gross vehicle weight over 26,000 pounds or a bus with seating 

capacity of at least 20 adults; $5,000 in the case of a truck or van with a gross vehicle weight 

between 10,000 and 26,000 pounds; and $2,000 in the case of any other motor vehicle. Qualified 

electric vehicles do not qualify for the clean-fuel vehicle deduction. The deduction phases down 

in the years 2004 through 2006, and is unavailable for purchases after December 31, 2006.

Description of Proposal

The proposal suspends the phase down of allowable tax credit for electric vehicles and 

the deduction for clean-fuel vehicles in 2004 and 2005. Thus, a taxpayer who purchases a 

qualifying vehicle may claim 100 percent of the otherwise allowable credit or deduction for 

vehicles purchased in 2004 and 2005. For vehicles purchased in 2006 the credit or deduction 

remains at 25 percent of the otherwise allowable amount as under present law. 

Effective Date

The proposal is effective for vehicles placed in service after December 31, 2003.
132

V. DEDUCTION OF STATE AND LOCAL GENERAL SALES TAXES

A. Deduction of State and Local General Sales Taxes

Present Law

An itemized deduction is permitted for certain taxes paid, including individual income 

taxes, real property taxes, and personal property taxes. No itemized deduction is permitted for 

State or local general sales taxes.

Description of Proposal

The proposal provides that, at the election of the taxpayer, an itemized deduction may be 

taken for State and local general sales taxes in lieu of the itemized deduction provided under 

present law for State and local income taxes. The amount of the deduction would be required to 

be determined under tables prescribed by the Secretary. Such tables would be based on the 

average consumption by taxpayers, on a State by State basis, taking into account filing status, 

number of dependents, adjusted gross income, and rates of State and local general sales taxation.

The term ‘general sales tax’ means a tax imposed at one rate with respect to the sale at 

retail of a broad range of classes of items. However, in the case of items of food, clothing, 

medical supplies, and motor vehicles, the fact that the tax does not apply with respect to some or 

all of such items would not be taken into account in determining whether the tax applies with 

respect to a broad range of classes of items, and the fact that the rate of tax applicable with 

respect to some or all of such items is lower than the general rate of tax shall not be taken into 

account in determining whether the tax is imposed at one rate. Except in the case of a lower rate 

of tax applicable with respect to food, clothing, medical supplies, or motor vehicles, no 

deduction shall be allowed for any general sales tax imposed with respect to an item at a rate 

other than the general rate of tax. However, in the case of motor vehicles, if the rate of tax 

exceeds the general rate, such excess shall be disregarded and the general rate shall be treated as 

the rate of tax.

A compensating use tax with respect to an item shall be treated as a general sales tax, 

provided such tax is complimentary to a general sales tax and a deduction for sales taxes is 

allowable with respect to items sold at retail in the taxing jurisdiction that are similar to such 

item. 

Effective Date

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

to January 1, 2006.
133

VI. REVENUE PROVISIONS

A. Provisions to Reduce Tax Avoidance Through Individual

and Corporate Expatriation

1. Tax treatment of expatriated entities and their foreign parents

Present Law

Determination of corporate residence

The U.S. tax treatment of a multinational corporate group depends significantly on 

whether the parent corporation of the group is domestic or foreign. For purposes of U.S. tax law, 

a corporation is treated as domestic if it is incorporated under the law of the United States or of 

any State. All other corporations (i.e., those incorporated under the laws of foreign countries) 

are treated as foreign.

U.S. taxation of domestic corporations

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

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

mitigate the double taxation that may arise from taxing the foreign-source income of a domestic 

corporation, a foreign tax credit for income taxes paid to foreign countries is provided to reduce 

or eliminate the U.S. tax owed on such income, subject to certain limitations. 

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

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

dividend to the domestic corporation. Until such repatriation, the U.S. tax on such income is 

generally deferred. However, certain anti-deferral regimes may cause the domestic parent 

corporation to be taxed on a current basis in the United States with respect to certain categories 

of passive or highly mobile income earned by its foreign subsidiaries, regardless of whether the 

income has been distributed as a dividend to the domestic parent corporation. The main antideferral regimes in this context are the controlled foreign corporation rules of subpart F (secs. 

951-964) and the passive foreign investment company rules (secs. 1291-1298). A foreign tax 

credit is generally available to offset, in whole or in part, the U.S. tax owed on this foreignsource income, whether repatriated as an actual dividend or included under one of the antideferral regimes.

U.S. taxation of foreign corporations

The United States taxes foreign corporations only on income that has a sufficient nexus to 

the United States. Thus, a foreign corporation is generally subject to U.S. tax only on income 

that is “effectively connected” with the conduct of a trade or business in the United States. Such 

“effectively connected income” generally is taxed in the same manner and at the same rates as 

the income of a U.S. corporation. An applicable tax treaty may limit the imposition of U.S. tax 

on business operations of a foreign corporation to cases in which the business is conducted 

through a “permanent establishment” in the United States.
134

In addition, foreign corporations generally are subject to a gross-basis U.S. tax at a flat 

30-percent rate on the receipt of interest, dividends, rents, royalties, and certain similar types of 

income derived from U.S. sources, subject to certain exceptions. The tax generally is collected 

by means of withholding by the person making the payment. This tax may be reduced or 

eliminated under an applicable tax treaty. 

U.S. tax treatment of inversion transactions

Under present law, a U.S. corporation may reincorporate in a foreign jurisdiction and 

thereby replace the U.S. parent corporation of a multinational corporate group with a foreign 

parent corporation. These transactions are commonly referred to as inversion transactions. 

Inversion transactions may take many different forms, including stock inversions, asset 

inversions, and various combinations of and variations on the two. Most of the known 

transactions to date have been stock inversions. In one example of a stock inversion, a U.S. 

corporation forms a foreign corporation, which in turn forms a domestic merger subsidiary. The 

domestic merger subsidiary then merges into the U.S. corporation, with the U.S. corporation 

surviving, now as a subsidiary of the new foreign corporation. The U.S. corporation’s 

shareholders receive shares of the foreign corporation and are treated as having exchanged their 

U.S. corporation shares for the foreign corporation shares. An asset inversion reaches a similar 

result, but through a direct merger of the top-tier U.S. corporation into a new foreign corporation, 

among other possible forms. An inversion transaction may be accompanied or followed by 

further restructuring of the corporate group. For example, in the case of a stock inversion, in 

order to remove income from foreign operations from the U.S. taxing jurisdiction, the U.S. 

corporation may transfer some or all of its foreign subsidiaries directly to the new foreign parent 

corporation or other related foreign corporations. 

In addition to removing foreign operations from the U.S. taxing jurisdiction, the 

corporate group may derive further advantage from the inverted structure by reducing U.S. tax 

on U.S.-source income through various earnings stripping or other transactions. This may 

include earnings stripping through payment by a U.S. corporation of deductible amounts such as 

interest, royalties, rents, or management service fees to the new foreign parent or other foreign 

affiliates. In this respect, the post-inversion structure enables the group to employ the same taxreduction strategies that are available to other multinational corporate groups with foreign 

parents and U.S. subsidiaries, subject to the same limitations (e.g., secs. 163(j) and 482). 

Inversion transactions may give rise to immediate U.S. tax consequences at the 

shareholder and/or the corporate level, depending on the type of inversion. In stock inversions, 

the U.S. shareholders generally recognize gain (but not loss) under section 367(a), based on the 

difference between the fair market value of the foreign corporation shares received and the 

adjusted basis of the domestic corporation stock exchanged. To the extent that a corporation’s 

share value has declined, and/or it has many foreign or tax-exempt shareholders, the impact of 

this section 367(a) “toll charge” is reduced. The transfer of foreign subsidiaries or other assets to 

the foreign parent corporation also may give rise to U.S. tax consequences at the corporate level 

(e.g., gain recognition and earnings and profits inclusions under secs. 1001, 311(b), 304, 367, 

1248 or other provisions). The tax on any income recognized as a result of these restructurings 

may be reduced or eliminated through the use of net operating losses, foreign tax credits, and 

other tax attributes. 
135

In asset inversions, the U.S. corporation generally recognizes gain (but not loss) under 

section 367(a) as though it had sold all of its assets, but the shareholders generally do not 

recognize gain or loss, assuming the transaction meets the requirements of a reorganization under 

section 368.

Description of Proposal

The bill applies special tax rules to corporations that undertake certain defined inversion 

transactions. For this purpose, an inversion is a transaction in which, pursuant to a plan or a 

series of related transactions: (1) a U.S. corporation becomes a subsidiary of a foreignincorporated entity or otherwise transfers substantially all of its properties to such an entity after 

March 4, 2003; (2) the former shareholders of the U.S. corporation hold (by reason of holding 

stock in the U.S. corporation) 60 percent or more (by vote or value) of the stock of the foreignincorporated entity after the transaction; and (3) the foreign-incorporated entity, considered 

together with all companies connected to it by a chain of greater than 50-percent ownership (i.e., 

the “expanded affiliated group”) does not conduct substantial business activities in the entity’s 

country of incorporation compared to the total worldwide business activities of the expanded 

affiliated group.

In such a case, any applicable corporate-level “toll charges” for establishing the inverted 

structure are not offset by tax attributes such as net operating losses or foreign tax credits. 

Specifically, any applicable corporate-level income or gain required to be recognized under 

sections 304, 311(b), 367, 1001, 1248, or any other provision with respect to the transfer of 

controlled foreign corporation stock or the transfer or license of other assets by a U.S. 

corporation as part of the inversion transaction or after such transaction to a related foreign 

person is taxable, without offset by any tax attributes (e.g., net operating losses or foreign tax 

credits). This rule does not apply to certain transfers of inventory and similar property. These 

measures generally apply for a 10-year period following the inversion transaction.

In determining whether a transaction meets the definition of an inversion under the 

proposal, stock held by members of the expanded affiliated group that includes the foreign 

incorporated entity is disregarded. For example, if the former top-tier U.S. corporation receives 

stock of the foreign incorporated entity (e.g., so-called “hook” stock), the stock would not be 

considered in determining whether the transaction meets the definition. Similarly, if a U.S. 

parent corporation converts an existing wholly owned U.S. subsidiary into a new wholly owned 

controlled foreign corporation, the stock of the new foreign corporation would be disregarded. 

Stock sold in a public offering related to the transaction also is disregarded for these purposes.

Transfers of properties or liabilities as part of a plan a principal purpose of which is to 

avoid the purposes of the proposal are disregarded. In addition, the Treasury Secretary is granted 

authority to prevent the avoidance of the purposes of the proposal, including avoidance through 

the use of related persons, pass-through or other noncorporate entities, or other intermediaries, 

and through transactions designed to qualify or disqualify a person as a related person or a 

member of an expanded affiliated group. Similarly, the Treasury Secretary is granted authority 

to treat certain non-stock instruments as stock, and certain stock as not stock, where necessary to 

carry out the purposes of the proposal.
136

Under the proposal, inversion transactions include certain partnership transactions. 

Specifically, the proposal applies to transactions in which a foreign-incorporated entity acquires 

substantially all of the properties constituting a trade or business of a domestic partnership, if 

after the acquisition at least 60 percent of the stock of the entity is held by former partners of the 

partnership (by reason of holding their partnership interests), provided that the other terms of the 

basic definition are met. For purposes of applying this test, all partnerships that are under 

common control within the meaning of section 482 are treated as one partnership, except as 

provided otherwise in regulations. In addition, the modified “toll charge” provisions apply at the 

partner level.

A transaction otherwise meeting the definition of an inversion transaction is not treated as 

an inversion transaction if, on or before March 4, 2003, the foreign-incorporated entity had 

acquired directly or indirectly more than half of the properties held directly or indirectly by the 

domestic corporation, or more than half of the properties constituting the partnership trade or 

business, as the case may be.

Effective Date

The proposal applies to taxable years ending after March 4, 2003.

2. Excise tax on stock compensation of insiders in expatriated corporations 

Present Law

The income taxation of a nonstatutory181 compensatory stock option is determined under 

the rules that apply to property transferred in connection with the performance of services (sec. 

83). If a nonstatutory stock option does not have a readily ascertainable fair market value at the 

time of grant, which is generally the case unless the option is actively traded on an established 

market, no amount is included in the gross income of the recipient with respect to the option until 

the recipient exercises the option. 182 Upon exercise of such an option, the excess of the fair 

market value of the stock purchased over the option price is generally included in the recipient’s 

gross income as ordinary income in such taxable year.183 

The tax treatment of other forms of stock-based compensation (e.g., restricted stock and 

stock appreciation rights) is also determined under section 83. The excess of the fair market

 

181 Nonstatutory stock options refer to stock options other than incentive stock options 

and employee stock purchase plans, the taxation of which is determined under sections 421-424. 

182 If an individual receives a grant of a nonstatutory option that has a readily 

ascertainable fair market value at the time the option is granted, the excess of the fair market 

value of the option over the amount paid for the option is included in the recipient’s gross 

income as ordinary income in the first taxable year in which the option is either transferable or 

not subject to a substantial risk of forfeiture.

183 Under section 83, such amount is includable in gross income in the first taxable year 

in which the rights to the stock are transferable or are not subject to substantial risk of forfeiture.
137

value over the amount paid (if any) for such property is generally includable in gross income in 

the first taxable year in which the rights to the property are transferable or are not subject to 

substantial risk of forfeiture. 

Shareholders are generally required to recognize gain upon stock inversion transactions. 

An inversion transaction is generally not a taxable event for holders of stock options and other 

stock-based compensation.

Description of Proposal

Under the proposal, specified holders of stock options and other stock-based 

compensation are subject to an excise tax upon certain inversion transactions. The proposal 

imposes a 15-percent excise tax on the value of specified stock compensation held (directly or 

indirectly) by or for the benefit of a disqualified individual, or a member of such individual’s 

family, at any time during the 12-month period beginning six months before the corporation’s 

expatriation date. Specified stock compensation is treated as held for the benefit of a disqualified 

individual if such compensation is held by an entity, e.g., a partnership or trust, in which the 

individual, or a member of the individual’s family, has an ownership interest.

A disqualified individual is any individual who, with respect to a corporation, is, at any 

time during the 12-month period beginning on the date which is six months before the 

expatriation date, subject to the requirements of section 16(a) of the Securities and Exchange Act 

of 1934 with respect to the corporation, or any member of the corporation’s expanded affiliated 

group,184 or would be subject to such requirements if the corporation (or member) were an issuer 

of equity securities referred to in section 16(a). Disqualified individuals generally include 

officers (as defined by section 16(a)),185 directors, and 10-percent-or-greater owners of private 

and publicly-held corporations.

The excise tax is imposed on a disqualified individual of an expatriated corporation (as 

previously defined in the bill) only if gain (if any) is recognized in whole or part by any 

shareholder by reason of a corporate inversion transaction previously defined in the bill.

Specified stock compensation subject to the excise tax includes any payment186 (or right 

to payment) granted by the expatriated corporation (or any member of the corporation’s 

 

184 An expanded affiliated group is an affiliated group (under section 1504) except that 

such group is determined without regard to the exceptions for certain corporations and is 

determined applying a greater than 50 percent threshold, in lieu of the 80 percent test.

185 An officer is defined as the president, principal financial officer, principal accounting 

officer (or, if there is no such accounting officer, the controller), any vice-president in charge of 

a principal business unit, division or function (such as sales, administration or finance), any other 

officer who performs a policy-making function, or any other person who performs similar 

policy-making functions.

186 Under the proposal, any transfer of property is treated as a payment and any right to a 

transfer of property is treated as a right to a payment. 
138

expanded affiliated group) to any person in connection with the performance of services by a 

disqualified individual for such corporation (or member of the corporation’s expanded affiliated 

group) if the value of the payment or right is based on, or determined by reference to, the value 

or change in value of stock of such corporation (or any member of the corporation’s expanded 

affiliated group). In determining whether such compensation exists and valuing such 

compensation, all restrictions, other than a non-lapse restriction, are ignored. Thus, the excise 

tax applies, and the value subject to the tax is determined, without regard to whether such 

specified stock compensation is subject to a substantial risk of forfeiture or is exercisable at the 

time of the inversion transaction. Specified stock compensation includes compensatory stock 

and restricted stock grants, compensatory stock options, and other forms of stock-based 

compensation, including stock appreciation rights, phantom stock, and phantom stock options. 

Specified stock compensation also includes nonqualified deferred compensation that is treated as 

though it were invested in stock or stock options of the expatriating corporation (or member). 

For example, the proposal applies to a disqualified individual’s deferred compensation if 

company stock is one of the actual or deemed investment options under the nonqualified deferred 

compensation plan. 

Specified stock compensation includes a compensation arrangement that gives the 

disqualified individual an economic stake substantially similar to that of a corporate shareholder. 

Thus, the excise tax does not apply if a payment is simply triggered by a target value of the 

corporation’s stock or where a payment depends on a performance measure other than the value 

of the corporation’s stock. Similarly, the tax does not apply if the amount of the payment is not 

directly measured by the value of the stock or an increase in the value of the stock. For example, 

an arrangement under which a disqualified individual would be paid a cash bonus of $500,000 if 

the corporation’s stock increased in value by 25 percent over two years or $1,000,000 if the stock 

increased by 33 percent over two years is not specified stock compensation, even though the 

amount of the bonus generally is keyed to an increase in the value of the stock. By contrast, an 

arrangement under which a disqualified individual would be paid a cash bonus equal to $10,000 

for every $1 increase in the share price of the corporation’s stock is subject to the proposal 

because the direct connection between the compensation amount and the value of the 

corporation’s stock gives the disqualified individual an economic stake substantially similar to 

that of a shareholder.

The excise tax applies to any such specified stock compensation previously granted to a 

disqualified individual but cancelled or cashed-out within the six-month period ending with the 

expatriation date, and to any specified stock compensation awarded in the six-month period 

beginning with the expatriation date. As a result, for example, if a corporation cancels 

outstanding options three months before the transaction and then reissues comparable options 

three months after the transaction, the tax applies both to the cancelled options and the newly 

granted options. It is intended that the Secretary issue guidance to avoid double counting with 

respect to specified stock compensation that is cancelled and then regranted during the applicable 

twelve-month period.

Specified stock compensation subject to the tax does not include a statutory stock option 

or any payment or right from a qualified retirement plan or annuity, tax-sheltered annuity, 

simplified employee pension, or SIMPLE. In addition, under the proposal, the excise tax does 

not apply to any stock option that is exercised during the six-month period before the 
139

expatriation date or to any stock acquired pursuant to such exercise, if income is recognized 

under section 83 on or before the expatriation date with respect to the stock acquired pursuant to 

such exercise. The excise tax also does not apply to any specified stock compensation that is 

exercised, sold, exchanged, distributed, cashed-out, or otherwise paid during such period in a 

transaction in which income, gain, or loss is recognized in full.

For specified stock compensation held on the expatriation date, the amount of the tax is 

determined based on the value of the compensation on such date. The tax imposed on specified 

stock compensation cancelled during the six-month period before the expatriation date is 

determined based on the value of the compensation on the day before such cancellation, while 

specified stock compensation granted after the expatriation date is valued on the date granted. 

Under the proposal, the cancellation of a non-lapse restriction is treated as a grant. 

The value of the specified stock compensation on which the excise tax is imposed is the 

fair value in the case of stock options (including warrants or other similar rights to acquire stock) 

and stock appreciation rights and the fair market value for all other forms of compensation. For 

purposes of the tax, the fair value of an option (or a warrant or other similar right to acquire 

stock) or a stock appreciation right is determined using an appropriate option-pricing model, as 

specified or permitted by the Secretary, that takes into account the stock price at the valuation 

date; the exercise price under the option; the remaining term of the option; the volatility of the 

underlying stock and the expected dividends on it; and the risk-free interest rate over the 

remaining term of the option. Options that have no intrinsic value (or “spread”) because the 

exercise price under the option equals or exceeds the fair market value of the stock at valuation 

nevertheless have a fair value and are subject to tax under the proposal. The value of other forms 

of compensation, such as phantom stock or restricted stock, is the fair market value of the stock 

as of the date of the expatriation transaction. The value of any deferred compensation that can be 

valued by reference to stock is the amount that the disqualified individual would receive if the 

plan were to distribute all such deferred compensation in a single sum on the date of the 

expatriation transaction (or the date of cancellation or grant, if applicable). It is expected that the 

Secretary issue guidance on valuation of specified stock compensation, including guidance 

similar to the revenue procedures issued under section 280G, except that the guidance would not 

permit the use of a term other than the full remaining term and would be modified as necessary 

or appropriate to carry out the purposes of the provision. Pending the issuance of guidance, it is 

intended that taxpayers can rely on the revenue procedure issued under section 280G (except that 

the full remaining term must be used and recalculation is not permitted). 

The excise tax also applies to any payment by the expatriated corporation or any member 

of the expanded affiliated group made to an individual, directly or indirectly, in respect of the 

tax. Whether a payment is made in respect of the tax is determined under all of the facts and 

circumstances. Any payment made to keep the individual in the same after-tax position that the 

individual would have been in had the tax not applied is a payment made in respect of the tax. 

This includes direct payments of the tax and payments to reimburse the individual for payment 

of the tax. It is expected that the Secretary issue guidance on determining when a payment is 

made in respect of the tax and that such guidance include certain factors that give rise to a 

rebuttable presumption that a payment is made in respect of the tax, including a rebuttable 

presumption that if the payment is contingent on the inversion transaction, it is made in respect 
140

to the tax. Any payment made in respect of the tax is includible in the income of the individual, 

but is not deductible by the corporation.

To the extent that a disqualified individual is also a covered employee under section 

162(m), the $1,000,000 limit on the deduction allowed for employee remuneration for such 

employee is reduced by the amount of any payment (including reimbursements) made in respect 

of the tax under the proposal. As discussed above, this includes direct payments of the tax and 

payments to reimburse the individual for payment of the tax. 

The payment of the excise tax has no effect on the subsequent tax treatment of any 

specified stock compensation. Thus, the payment of the tax has no effect on the individual’s 

basis in any specified stock compensation and no effect on the tax treatment for the individual at 

the time of exercise of an option or payment of any specified stock compensation, or at the time 

of any lapse or forfeiture of such specified stock compensation. The payment of the tax is not 

deductible and has no effect on any deduction that might be allowed at the time of any future 

exercise or payment.

Under the proposal, the Secretary is authorized to issue regulations as may be necessary 

or appropriate to carry out the purposes of the proposal.

Effective Date

The proposal is effective as of March 4, 2003, except that periods before March 4, 2003, 

are not taken into account in applying the excise tax to specified stock compensation held or 

cancelled during the six-month period before the expatriation date.

3. Reinsurance of U.S. risks in foreign jurisdictions

Present Law

In the case of a reinsurance agreement between two or more related persons, present law 

provides the Treasury Secretary with authority to allocate among the parties or recharacterize 

income (whether investment income, premium or otherwise), deductions, assets, reserves, credits 

and any other items related to the reinsurance agreement, or make any other adjustment, in order 

to reflect the proper source and character of the items for each party. 187 For this purpose, related 

persons are defined as in section 482. Thus, persons are related if they are organizations, trades 

or businesses (whether or not incorporated, whether or not organized in the United States, and 

whether or not affiliated) that are owned or controlled directly or indirectly by the same interests. 

The provision may apply to a contract even if one of the related parties is not a domestic 

company. 188 In addition, the provision also permits such allocation, recharacterization, or other 

adjustments in a case in which one of the parties to a reinsurance agreement is, with respect to 

 

187 Sec. 845(a).

188 See S. Rep. No. 97-494, 97th Cong., 2d Sess., 337 (1982) (describing provisions 

relating to the repeal of modified coinsurance provisions).
141

any contract covered by the agreement, in effect an agent of another party to the agreement, or a 

conduit between related persons.

Description of Proposal

The bill clarifies the rules of section 845, relating to authority for the Treasury Secretary 

to allocate items among the parties to a reinsurance agreement, recharacterize items, or make any 

other adjustment, in order to reflect the proper source and character of the items for each party. 

The bill authorizes such allocation, recharacterization, or other adjustment, in order to reflect the 

proper source, character or amount of the item. It is intended that this authority189 be exercised 

in a manner similar to the authority under section 482 for the Treasury Secretary to make 

adjustments between related parties. It is intended that this authority be applied in situations in 

which the related persons (or agents or conduits) are engaged in cross-border transactions that 

require allocation, recharacterization, or other adjustments in order to reflect the proper source, 

character or amount of the item or items. No inference is intended that present law does not 

provide this authority with respect to reinsurance agreements.

No regulations have been issued under section 845(a). It is expected that the Treasury 

Secretary will issue regulations under section 845(a) to address effectively the allocation of 

income (whether investment income, premium or otherwise) and other items, the 

recharacterization of such items, or any other adjustment necessary to reflect the proper amount, 

source or character of the item.

Effective Date

The proposal is effective for any risk reinsured after the date of enactment of the 

proposal.

4. Revision of tax rules on expatriation of individuals

Present Law

In general

U.S. citizens and residents generally are subject to U.S income taxation on their 

worldwide income. The U.S. tax may be reduced or offset by a credit allowed for foreign 

income taxes paid with respect to foreign source income. Nonresident aliens are taxed at a flat 

rate of 30 percent (or a lower treaty rate) on certain types of passive income derived from U.S. 

sources, and at regular graduated rates on net profits derived from a U.S. trade or business. The 

estates of nonresident aliens generally are subject to estate tax on U.S.-situated property (e.g., 

real estate and tangible property located within the United States and stock in a U.S. 

corporation). Nonresident aliens generally are subject to gift tax on transfers by gift of U.S.-

situated property (e.g., real estate and tangible property located within the United States, but 

excluding intangibles, such as stock, regardless of where they are located). 

 

189 The authority to allocate, recharacterize or make other adjustments was granted in 

connection with the repeal of provisions relating to modified coinsurance transactions.
142

Income tax rules with respect to expatriates

For the 10 taxable years after an individual relinquishes his or her U.S. citizenship or 

terminates his or her U.S. residency190 with a principal purpose of avoiding U.S. taxes, the 

individuals is subject to an alternative method of income taxation than that generally applicable 

to nonresident aliens (the “alternative tax regime”). Generally, the individual is subject to 

income tax only on U.S.-source income 191 at the rates applicable to U.S. citizens for the 10-year 

period. 

An individual who relinquishes citizenship or terminates residency is treated as having 

done so with a principal purpose of tax avoidance and is generally subject to the alternative tax 

regime if: (1) the individual’s average annual U.S. Federal income tax liability for the five 

taxable years preceding citizenship relinquishment or residency termination exceeds $100,000; 

or (2) the individual’s net worth on the date of citizenship relinquishment or residency 

termination equals or exceeds $500,000. These amounts are adjusted annually for inflation.192 

Certain categories of individuals (e.g., dual residents) may avoid being deemed to have a tax 

avoidance purpose for relinquishing citizenship or terminating residency by submitting a ruling 

request to the IRS regarding whether the individual relinquished citizenship or terminated 

residency principally for tax reasons. 

Anti-abuse rules are provided to prevent the circumvention of the alternative tax regime.

Estate tax rules with respect to expatriates

Special estate tax rules apply to individual’s who relinquish their citizenship or long-term 

residency within the 10 years prior to the date of death, unless he or she did not have a tax 

avoidance purpose (as determined under the test above). Under these special rules, certain 

closely-held foreign stock owned by the former citizen or former long-term resident is includible 

in his or her gross estate to the extent that the foreign corporation owns U.S.-situated assets.

Gift tax rules with respect to expatriates

Special gift tax rules apply to individual’s who relinquish their citizenship or long-term 

residency within the 10 years prior to the date of death, unless he or she did not have a tax 

avoidance purpose (as determined under the rules above). The individual is subject to gift tax on 

 

190 Under present law, an individual’s U.S. residency is considered terminated for U.S. 

Federal tax purposes when the individual ceases to be a lawful permanent resident under the 

immigration law (or is treated as a resident of another country under a tax treaty and does not 

waive the benefits of such treaty). 

191 For this purpose, however, U.S.-source income has a broader scope than it does

typically in the Code. 

192 The income tax liability and net worth thresholds under section 877(a)(2) for 2004 are 

$124,000 and $622,000, respectively. See Rev. Proc. 2003-85, 2003-49 I.R.B. 1184. 
143

gifts of U.S.-situated intangibles made during the 10 years following citizenship relinquishment 

or residency termination. 

Information reporting

Under present law, U.S. citizens who relinquish citizenship and long-term residents who 

terminate residency generally are required to provide information about their assets held at the 

time of expatriation. However, this information is only required once. 

Description of Proposal

In general 

The bill provides: (1) objective standards for determining whether former citizens or 

former long-term residents are subject to the alternative tax regime; (2) tax-based (instead of 

immigration-based) rules for determining when an individual is no longer a U.S. citizen or longterm resident for U.S. Federal tax purposes; (3) the imposition of full U.S. taxation for 

individuals who are subject to the alternative tax regime and who return to the United States for 

extended periods; (4) imposition of U.S. gift tax on gifts of stock of certain closely-held foreign 

corporations that hold U.S.-situated property; and (5) an annual return-filing requirement for 

individuals who are subject to the alternative tax regime, for each of the 10 years following 

citizenship relinquishment or residency termination. 193

Objective rules for the alternative tax regime

The bill replaces the subjective determination of tax avoidance as a principal purpose for 

citizenship relinquishment or residency termination under present law with objective rules. 

Under the bill, a former citizen or former long-term resident would be subject to the alternative 

tax regime for a 10-year period following citizenship relinquishment or residency termination, 

unless the former citizen or former long-term resident: (1) establishes that his or her average 

annual net income tax liability for the five preceding years does not exceed $124,000 (adjusted 

for inflation after 2004) and his or her net worth does not exceed $2 million, or alternatively 

satisfies limited, objective exceptions for dual citizens and minors who have had no substantial 

contact with the United States; and (2) certifies under penalties of perjury that he or she has 

complied with all U.S. Federal tax obligations for the preceding five years and provides such 

evidence of compliance as the Secretary of the Treasury may require.

The monetary thresholds under the bill replace the present-law inquiry into the taxpayer’s 

intent. In addition, the bill eliminates the present-law process of IRS ruling requests.

If a former citizen exceeds the monetary thresholds, that person is excluded from the 

alternative tax regime if he or she falls within the exceptions for certain dual citizens and minors 

(provided that the requirement of certification and proof of compliance with Federal tax 

 

193 These proposals reflect recommendations contained in Joint Committee on Taxation, 

Review of the Present Law Tax and Immigration Treatment of Relinquishment of Citizenship and 

Termination of Long-Term Residency, (JCS-2-03), February 2003.
144

obligations is met). These exceptions provide relief to individuals who have never had 

substantial connections with the United States, as measured by certain objective criteria, and 

eliminate IRS inquiries as to the subjective intent of such taxpayers. 

In order to be excepted from the application of the alternative tax regime under the bill, 

whether by reason of falling below the net worth and income tax liability thresholds or 

qualifying for the dual-citizen or minor exceptions, the former citizen or former long-term 

resident also is required to certify, under penalties of perjury, that he or she has complied with all 

U.S. Federal tax obligations for the five years preceding the relinquishment of citizenship or 

termination of residency and to provide such documentation as the Secretary of the Treasury may 

require evidencing such compliance (e.g., tax returns, proof of tax payments). Until such time, 

the individual remains subject to the alternative tax regime. It is intended that the IRS will 

continue to verify that the information submitted was accurate, and it is intended that the IRS 

will randomly audit such persons to assess compliance.

Termination of U.S. citizenship or long-term resident status for U.S. Federal income tax 

purposes

Under the bill, an individual continues to be treated as a U.S. citizen or long-term resident 

for U.S. Federal tax purposes, including for purposes of section 7701(b)(10), until the individual: 

(1) gives notice of an expatriating act or termination of residency (with the requisite intent to 

relinquish citizenship or terminate residency) to the Secretary of State or the Secretary of 

Homeland Security, respectively; and (2) provides a statement in accordance with section 

6039G.

Sanction for individuals subject to the individual tax regime who return to the United 

States for extended periods

The alternative tax regime does not apply to any individual for any taxable year during 

the 10-year period following citizenship relinquishment or residency termination if such 

individual is present in the United States for more than 30 days in the calendar year ending in 

such taxable year. Such individual is treated as a U.S. citizen or resident for such taxable year 

and therefore is taxed on his or her worldwide income. 

Similarly, if an individual subject to the alternative tax regime is present in the United 

States for more than 30 days in any calendar year ending during the 10-year period following 

citizenship relinquishment or residency termination, and the individual dies during that year, he 

or she is treated as a U.S. resident, and the individual’s worldwide estate is subject to U.S. estate 

tax. Likewise, if an individual subject to the alternative tax regime is present in the United States 

for more than 30 days in any year during the 10-year period following citizenship relinquishment 

or residency termination, the individual is subject to U.S. gift tax on any transfer of his or her 

worldwide assets by gift during that taxable year.

For purposes of these rules, an individual is treated as present in the United States on any 

day if such individual is physically present in the United States at any time during that day. The 

present-law exceptions from being treated as present in the United States for residency 
145

purposes194 generally do not apply for this purpose. However, for individuals with certain ties to 

countries other than the United States195 and individuals with minimal prior physical presence in 

the United States,196 a day of physical presence in the United States is disregarded if the 

individual is performing services in the United States on such day for an unrelated employer 

(within the meaning of sections 267 and 707(b)), who meets the requirements the Secretary of 

the Treasury may prescribe in regulations. No more than 30 days may be disregarded during any 

calendar year under this rule. 

Imposition of gift tax with respect to stock of certain closely held foreign corporations

Gifts of stock of certain closely-held foreign corporations by a former citizen or former 

long-term resident who is subject to the alternative tax regime are subject to gift tax under this 

bill, if the gift is made within the 10-year period after citizenship relinquishment or residency 

termination. The gift tax rule applies if: (1) the former citizen or former long-term resident, 

before making the gift, directly or indirectly owns 10 percent or more of the total combined 

voting power of all classes of stock entitled to vote of the foreign corporation; and (2) directly or 

indirectly, is considered to own more than 50 percent of (a) the total combined voting power of 

all classes of stock entitled to vote in the foreign corporation, or (b) the total value of the stock of 

such corporation. If this stock ownership test is met, then taxable gifts of the former citizen or 

former long-term resident include that proportion of the fair market value of the foreign stock 

transferred by the individual, at the time of the gift, which the fair market value of any assets 

owned by such foreign corporation and situated in the United States (at the time of the gift) bears 

to the total fair market value of all assets owned by such foreign corporation (at the time of the 

gift). 

This gift tax rule applies to a former citizen or former long-term resident who is subject to 

the alternative tax regime and who owns stock in a foreign corporation at the time of the gift, 

regardless of how such stock was acquired (e.g., whether issued originally to the donor, 

purchased, or received as a gift or bequest).

 

194 Secs. 7701(b)(3)(D), 7701(b)(5) and 7701(b)(7)(B)-(D).

195 An individual has such a relationship to a foreign country if the individual becomes a 

citizen or resident of the country in which (1) the individual becomes fully liable for income tax 

or (2) the individual was born, such individual’s spouse was born, or either of the individual’s 

parents was born. 

196 An individual has a minimal prior physical presence in the United States if the 

individual was physically present for no more than 30 days during each year in the ten-year 

period ending on the date of loss of United States citizenship or termination of residency. 

However, an individual is not treated as being present in the United States on a day if (1) the 

individual is a teacher or trainee, a student, a professional athlete in certain circumstances, or a 

foreign government-related individual or (2) the individual remained in the United States 

because of a medical condition that arose while the individual was in the United States. Sec. 

7701(b)(3)(D)(ii). 
146

Annual return

The bill requires former citizens and former long-term residents to file an annual return 

for each year following citizenship relinquishment or residency termination in which they are 

subject to the alternative tax regime. The annual return is required even if no U.S. Federal 

income tax is due. The annual return requires certain information, including information on the 

permanent home of the individual, the individual’s country of residence, the number of days the 

individual was present in the United States for the year, and detailed information about the 

individual’s income and assets that are subject to the alternative tax regime. This requirement 

includes information relating to foreign stock potentially subject to the special estate tax rule of 

section 2107(b) and the gift tax rules of this bill. 

If the individual fails to file the statement in a timely manner or fails correctly to include 

all the required information, the individual is required to pay a penalty of $5,000. The $5,000

penalty does not apply if it is shown that the failure is due to reasonable cause and not to willful 

neglect.

Effective Date

The proposal applies to individuals who relinquish citizenship or terminate long-term 

residency after June 3, 2004.

5. Reporting of taxable mergers and acquisitions

Present Law

Under section 6045 and the regulations thereunder, brokers (defined to include stock 

transfer agents) are required to make information returns and to provide corresponding payee 

statements as to sales made on behalf of their customers, subject to the penalty provisions of 

sections 6721-6724. Under the regulations issued under section 6045, this requirement generally 

does not apply with respect to taxable transactions other than exchanges for cash (e.g., stock 

inversion transactions taxable to shareholders by reason of section 367(a)).

Description of Proposal

Under the bill, if gain or loss is recognized in whole or in part by shareholders of a 

corporation by reason of a second corporation’s acquisition of the stock or assets of the first 

corporation, then the acquiring corporation (or the acquired corporation, if so prescribed by the 

Treasury Secretary) is required to make a return containing: 

(1) A description of the transaction;

(2) The name and address of each shareholder of the acquired corporation that 

recognizes gain as a result of the transaction (or would recognize gain, if there 

was a built-in gain on the shareholder’s shares);

(3) The amount of money and the value of stock or other consideration paid to each 

shareholder described above; and
147

(4) Such other information as the Treasury Secretary may prescribe.

Alternatively, a stock transfer agent who records transfers of stock in such transaction 

may make the return described above in lieu of the second corporation.

In addition, every person required to make a return described above is required to furnish 

to each shareholder (or the shareholder’s nominee197) whose name is required to be set forth in 

such return a written statement showing:

(1) The name, address, and phone number of the information contact of the person 

required to make such return;

(2) The information required to be shown on that return; and

(3) Such other information as the Treasury Secretary may prescribe.

This written statement is required to be furnished to the shareholder on or before January 

31 of the year following the calendar year during which the transaction occurred.

The present-law penalties for failure to comply with information reporting requirements 

are extended to failures to comply with the requirements set forth under this bill.

Effective Date

The proposal is effective for acquisitions after the date of enactment.

6. Studies

Present Law

Due to the variation in tax rates and tax systems among countries, a multinational 

enterprise, whether U.S.-based or foreign-based, may have an incentive to shift income, 

deductions, or tax credits in order to arrive at a reduced overall tax burden. Such a shifting of 

items could be accomplished by establishing artificial, non-arm’s-length prices for transactions 

between group members.

Under section 482, the Secretary of the Treasury is authorized to reallocate income, 

deductions, or credits between or among two or more organizations, trades, or businesses under 

common control if he determines that such a reallocation is necessary to prevent tax evasion or to 

clearly reflect income. Treasury regulations adopt the arm's-length standard as the standard for 

determining whether such reallocations are appropriate. Thus, the regulations provide rules to 

identify the respective amounts of taxable income of the related parties that would have resulted 

if the parties had been uncontrolled parties dealing at arm's length. Transactions involving 

intangible property and certain services may present particular challenges to the administration 

 

197 In the case of a nominee, the nominee must furnish the information to the shareholder 

in the manner prescribed by the Secretary of the Treasury. 
148

of the arm’s-length standard, because the nature of these transactions may make it difficult or 

impossible to compare them with third-party transactions.

In addition to the statutory rules governing the taxation of foreign income of U.S. persons 

and U.S. income of foreign persons, bilateral income tax treaties limit the amount of income tax 

that may be imposed by one treaty partner on residents of the other treaty partner. For example, 

treaties often reduce or eliminate withholding taxes imposed by a treaty country on certain types 

of income (e.g., dividends, interest and royalties) paid to residents of the other treaty country. 

Treaties also contain provisions governing the creditability of taxes imposed by the treaty 

country in which income was earned in computing the amount of tax owed to the other country 

by its residents with respect to such income. Treaties further provide procedures under which 

inconsistent positions taken by the treaty countries with respect to a single item of income or 

deduction may be mutually resolved by the two countries.

Description of Proposal

The bill requires the Secretary of the Treasury to conduct and submit to the Congress 

three studies. The first study will examine the effectiveness of the transfer pricing rules of 

section 482, with an emphasis on transactions involving intangible property. The second study 

will examine income tax treaties to which the United States is a party, with a view toward 

identifying any inappropriate reductions in withholding tax or opportunities for abuse that may 

exist. The third study will examine the impact of the provision of this bill on inversion 

transactions.

Effective Date

The tax treaty study required under the proposal is due no later than June 30, 2005. The 

transfer pricing study required under the proposal is due no later than June 30, 2005. The 

inversions study required under the proposal is due no later than December 31, 2005.
149

B. Taxpayer-Related Proposals

1. Penalty for failing to disclose reportable transactions

Present Law

Regulations under section 6011 require a taxpayer to disclose with its tax return certain 

information with respect to each “reportable transaction” in which the taxpayer participates.198 

There are six categories of reportable transactions. The first category is any transaction 

that is the same as (or substantially similar to)199 a transaction that is specified by the Treasury 

Department as a tax avoidance transaction whose tax benefits are subject to disallowance under 

present law (referred to as a “listed transaction”).200 

The second category is any transaction that is offered under conditions of confidentiality. 

In general, a transaction is considered to be offered to a taxpayer under conditions of 

confidentiality if the advisor who is paid a minimum fee places a limitation on disclosure by the 

taxpayer of the tax treatment or tax structure of the transaction and the limitation on disclosure 

protects the confidentiality of that advisor's tax strategies (irrespective if such terms are legally 

binding).201 

The third category of reportable transactions is any transaction for which (1) the taxpayer 

has the right to a full or partial refund of fees if the intended tax consequences from the 

transaction are not sustained or, (2) the fees are contingent on the intended tax consequences 

from the transaction being sustained.202

The fourth category of reportable transactions relates to any transaction resulting in a 

taxpayer claiming a loss (under section 165) of at least (1) $10 million in any single year or $20 

 

198 On February 27, 2003, the Treasury Department and the IRS released final 

regulations regarding the disclosure of reportable transactions. In general, the regulations are 

effective for transactions entered into on or after February 28, 2003. 

The discussion of present law refers to the new regulations. The rules that apply with 

respect to transactions entered into on or before February 28, 2003, are contained in Treas. Reg. 

sec. 1.6011-4T in effect on the date the transaction was entered into.

199 The regulations clarify that the term “substantially similar” includes any transaction 

that is expected to obtain the same or similar types of tax consequences and that is either 

factually similar or based on the same or similar tax strategy. Further, the term must be broadly 

construed in favor of disclosure. Treas. Reg. sec. 1-6011-4(c)(4).

200 Treas. Reg. sec. 1.6011-4(b)(2).

201 Treas. Reg. sec. 1.6011-4(b)(3).

202 Treas. Reg. sec. 1.6011-4(b)(4).
150

million in any combination of years by a corporate taxpayer or a partnership with only corporate 

partners; (2) $2 million in any single year or $4 million in any combination of years by all other 

partnerships, S corporations, trusts, and individuals; or (3) $50,000 in any single year for 

individuals or trusts if the loss arises with respect to foreign currency translation losses.203

The fifth category of reportable transactions refers to any transaction done by certain 

taxpayers204 in which the tax treatment of the transaction differs (or is expected to differ) by 

more than $10 million from its treatment for book purposes (using generally accepted accounting 

principles) in any year.205

The final category of reportable transactions is any transaction that results in a tax credit 

exceeding $250,000 (including a foreign tax credit) if the taxpayer holds the underlying asset for 

less than 45 days.206

Under present law, there is no specific penalty for failing to disclose a reportable 

transaction; however, such a failure can jeopardize a taxpayer’s ability to claim that any income 

tax understatement attributable to such undisclosed transaction is due to reasonable cause, and 

that the taxpayer acted in good faith. 207 

Description of Proposal

In general

The proposal creates a new penalty for any person who fails to include with any return or 

statement any required information with respect to a reportable transaction. The new penalty 

applies without regard to whether the transaction ultimately results in an understatement of tax, 

and applies in addition to any accuracy-related penalty that may be imposed.

 

203 Treas. Reg. sec. 1.6011-4(b)(5). Rev. Proc. 2003-24, 2003-11 I.R.B. 599, exempts 

certain types of losses from this reportable transaction category.

204 The significant book-tax category applies only to taxpayers that are reporting 

companies under the Securities Exchange Act of 1934 or business entities that have $250 million 

or more in gross assets.

205 Treas. Reg. sec. 1.6011-4(b)(6). Rev. Proc. 2003-25, 2003-11 I.R.B. 601, exempts 

certain types of transactions from this reportable transaction category. 

206 Treas. Reg. sec. 1.6011-4(b)(7).

207 Section 6664(c) provides that a taxpayer can avoid the imposition of a section 6662 

accuracy-related penalty in cases where the taxpayer can demonstrate that there was reasonable 

cause for the underpayment and that the taxpayer acted in good faith. Regulations under sections 

6662 and 6664 provide that a taxpayer’s failure to disclose a reportable transaction is a strong 

indication that the taxpayer failed to act in good faith, which would bar relief under section 

6664(c).
151

Transactions to be disclosed

The proposal does not define the terms “listed transaction” 208 or “reportable transaction,” 

nor does the proposal explain the type of information that must be disclosed in order to avoid the 

imposition of a penalty. Rather, the proposal authorizes the Treasury Department to define a 

“listed transaction” and a “reportable transaction” under section 6011. 

Penalty rate

The penalty for failing to disclose a reportable transaction is $10,000 in the case of a 

natural person and $50,000 in any other case. The amount is increased to $100,000 and 

$200,000, respectively, if the failure is with respect to a listed transaction. The penalty cannot be 

waived with respect to a listed transaction. As to reportable transactions, the penalty can be 

rescinded (or abated) only if rescinding the penalty would promote compliance with the tax laws 

and effective tax administration. The authority to rescind the penalty can only be exercised by 

the IRS Commissioner personally. Thus, a revenue agent, an Appeals officer, or any other IRS 

personnel cannot rescind the penalty. The decision to rescind a penalty must be accompanied by 

a record describing the facts and reasons for the action and the amount rescinded. There will be 

no taxpayer right to appeal a refusal to rescind a penalty. The IRS also is required to submit an 

annual report to Congress summarizing the application of the disclosure penalties and providing 

a description of each penalty rescinded under this provision and the reasons for the rescission.

Effective Date

The proposal is effective for returns and statements the due date for which is after the 

date of enactment.

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

transactions having a significant tax avoidance purpose

Present Law

The accuracy-related penalty applies to the portion of any underpayment that is 

attributable to (1) negligence, (2) any substantial understatement of income tax, (3) any 

substantial valuation misstatement, (4) any substantial overstatement of pension liabilities, or (5) 

any substantial estate or gift tax valuation understatement. If the correct income tax liability 

exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 

($10,000 in the case of corporations), then a substantial understatement exists and a penalty may 

 

208 The provision states that, except as provided in regulations, a listed transaction means 

a reportable transaction, which is the same as, or substantially similar to, a transaction 

specifically identified by the Secretary as a tax avoidance transaction for purposes of section 

6011. For this purpose, it is expected that the definition of “substantially similar” will be the 

definition used in Treas. Reg. sec. 1.6011-4(c)(4). However, the Secretary may modify this 

definition (as well as the definitions of “listed transaction” and “reportable transactions”) as 

appropriate. 
152

be imposed equal to 20 percent of the underpayment of tax attributable to the understatement. 209 

The amount of any understatement generally is reduced by any portion attributable to an item if 

(1) the treatment of the item is supported by substantial authority, or (2) facts relevant to the tax 

treatment of the item were adequately disclosed and there was a reasonable basis for its tax 

treatment. 210 

Special rules apply with respect to tax shelters.211 For understatements by non-corporate 

taxpayers attributable to tax shelters, the penalty may be avoided only if the taxpayer establishes 

that, in addition to having substantial authority for the position, the taxpayer reasonably believed 

that the treatment claimed was more likely than not the proper treatment of the item. This 

reduction in the penalty is unavailable to corporate tax shelters. 

The understatement penalty generally is abated (even with respect to tax shelters) in cases 

in which the taxpayer can demonstrate that there was “reasonable cause” for the underpayment 

and that the taxpayer acted in good faith. 212 The relevant regulations provide that reasonable 

cause exists where the taxpayer “reasonably relies in good faith on an opinion based on a 

professional tax advisor’s analysis of the pertinent facts and authorities [that] . . . unambiguously 

concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will 

be upheld if challenged” by the IRS.213

Description of Proposal

In general

The proposal modifies the present-law accuracy related penalty by replacing the rules 

applicable to tax shelters with a new accuracy-related penalty that applies to listed transactions 

and reportable transactions with a significant tax avoidance purpose (hereinafter referred to as a 

“reportable avoidance transaction”).214 The penalty rate and defenses available to avoid the 

penalty vary depending on whether the transaction was adequately disclosed.

Disclosed transactions

In general, a 20-percent accuracy-related penalty is imposed on any understatement 

attributable to an adequately disclosed listed transaction or reportable avoidance transaction. 

 

209 Sec. 6662.

210 Sec. 6662(d)(2)(B).

211 Sec. 6662(d)(2)(C).

212 Sec. 6664(c).

213 Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 1.6664-4(c).

214 The terms “reportable transaction” and “listed transaction” have the same meanings 

as used for purposes of the penalty for failing to disclose reportable transactions.
153

The only exception to the penalty is if the taxpayer satisfies a more stringent reasonable cause 

and good faith exception (hereinafter referred to as the “strengthened reasonable cause 

exception”), which is described below. The strengthened reasonable cause exception is available 

only if the relevant facts affecting the tax treatment are adequately disclosed, there is or was 

substantial authority for the claimed tax treatment, and the taxpayer reasonably believed that the 

claimed tax treatment was more likely than not the proper treatment.

Undisclosed transactions

If the taxpayer does not adequately disclose the transaction, the strengthened reasonable 

cause exception is not available (i.e., a strict-liability penalty applies), and the taxpayer is subject 

to an increased penalty rate equal to 30 percent of the understatement. 

Determination of the understatement amount

The penalty is applied to the amount of any understatement attributable to the listed or 

reportable avoidance transaction without regard to other items on the tax return. For purposes of 

the proposal, the amount of the understatement is determined as the sum of (1) the product of the 

highest corporate or individual tax rate (as appropriate) and the increase in taxable income

resulting from the difference between the taxpayer’s treatment of the item and the proper 

treatment of the item (without regard to other items on the tax return) 215, and (2) the amount of 

any decrease in the aggregate amount of credits which results from a difference between the 

taxpayer’s treatment of an item and the proper tax treatment of such item. 

Except as provided in regulations, a taxpayer’s treatment of an item shall not take into 

account any amendment or supplement to a return if the amendment or supplement is filed after 

the earlier of when the taxpayer is first contacted regarding an examination of the return or such 

other date as specified by the Secretary.

Strengthened reasonable cause exception

A penalty is not imposed under the proposal with respect to any portion of an 

understatement if it shown that there was reasonable cause for such portion and the taxpayer 

acted in good faith. Such a showing requires (1) adequate disclosure of the facts affecting the 

transaction in accordance with the regulations under section 6011,216 (2) that there is or was 

substantial authority for such treatment, and (3) that the taxpayer reasonably believed that such 

treatment was more likely than not the proper treatment. For this purpose, a taxpayer will be 

treated as having a reasonable belief with respect to the tax treatment of an item only if such 

belief (1) is based on the facts and law that exist at the time the tax return (that includes the item) 

 

215 For this purpose, any reduction in the excess of deductions allowed for the taxable 

year over gross income for such year, and any reduction in the amount of capital losses which 

would (without regard to sec. 1211) be allowed for such year, shall be treated as an increase in 

taxable income.

216

 See the previous discussion regarding the penalty for failing to disclose a reportable 

transaction.
154

is filed, and (2) relates solely to the taxpayer’s chances of success on the merits and does not take 

into account the possibility that (a) a return will not be audited, (b) the treatment will not be 

raised on audit, or (c) the treatment will be resolved through settlement if raised. 

A taxpayer may (but is not required to) rely on an opinion of a tax advisor in establishing 

its reasonable belief with respect to the tax treatment of the item. However, a taxpayer may not 

rely on an opinion of a tax advisor for this purpose if the opinion (1) is provided by a 

“disqualified tax advisor,” or (2) is a “disqualified opinion.”

Disqualified tax advisor

A disqualified tax advisor is any advisor who (1) is a material advisor217 and who 

participates in the organization, management, promotion or sale of the transaction or is related 

(within the meaning of section 267(b) or 707(b)(1)) to any person who so participates, (2) is 

compensated directly or indirectly218 by a material advisor with respect to the transaction, (3) has 

a fee arrangement with respect to the transaction that is contingent on all or part of the intended 

tax benefits from the transaction being sustained, or (4) as determined under regulations 

prescribed by the Secretary, has a disqualifying financial interest with respect to the transaction. 

Organization, management, promotion or sale of a transaction–A material advisor is 

considered as participating in the “organization” of a transaction if the advisor performs acts 

relating to the development of the transaction. This may include, for example, preparing 

documents (1) establishing a structure used in connection with the transaction (such as a 

partnership agreement), (2) describing the transaction (such as an offering memorandum or other 

statement describing the transaction), or (3) relating to the registration of the transaction with any 

federal, state or local government body. 219 Participation in the “management” of a transaction 

 

217 The term “material advisor” (defined below in connection with the new information 

filing requirements for material advisors) means any person who provides any material aid, 

assistance, or advice with respect to organizing, managing, promoting, selling, implementing, or 

carrying out any reportable transaction, and who derives gross income in excess of $50,000 in 

the case of a reportable transaction substantially all of the tax benefits from which are provided 

to natural persons ($250,000 in any other case). 

218 This situation could arise, for example, when an advisor has an arrangement or 

understanding (oral or written) with an organizer, manager, or promoter of a reportable 

transaction that such party will recommend or refer potential participants to the advisor for an 

opinion regarding the tax treatment of the transaction. 

219 An advisor should not be treated as participating in the organization of a transaction if 

the advisor’s only involvement with respect to the organization of the transaction is the rendering 

of an opinion regarding the tax consequences of such transaction. However, such an advisor 

may be a “disqualified tax advisor” with respect to the transaction if the advisor participates in 

the management, promotion or sale of the transaction (or if the advisor is compensated by a 

material advisor, has a fee arrangement that is contingent on the tax benefits of the transaction, or 

as determined by the Secretary, has a continuing financial interest with respect to the 

transaction). 
155

means involvement in the decision-making process regarding any business activity with respect 

to the transaction. Participation in the “promotion or sale” of a transaction means involvement in 

the marketing or solicitation of the transaction to others. Thus, an advisor who provides 

information about the transaction to a potential participant is involved in the promotion or sale of 

a transaction, as is any advisor who recommends the transaction to a potential participant. 

Disqualified opinion

An opinion may not be relied upon if the opinion (1) is based on unreasonable factual or 

legal assumptions (including assumptions as to future events), (2) unreasonably relies upon 

representations, statements, finding or agreements of the taxpayer or any other person, (3) does 

not identify and consider all relevant facts, or (4) fails to meet any other requirement prescribed 

by the Secretary.

Coordination with other penalties

Any understatement upon which a penalty is imposed under this proposal is not subject to 

the accuracy-related penalty under section 6662. However, such understatement is included for 

purposes of determining whether any understatement (as defined in sec. 6662(d)(2)) is a 

substantial understatement as defined under section 6662(d)(1).

The penalty imposed under this provision shall not apply to any portion of an 

understatement to which a fraud penalty is applied under section 6663.

Effective Date

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

3. Tax shelter exception to confidentiality privileges relating to taxpayer communications 

Present Law

In general, a common law privilege of confidentiality exists for communications between 

an attorney and client with respect to the legal advice the attorney gives the client. The Code 

provides that, with respect to tax advice, the same common law protections of confidentiality that 

apply to a communication between a taxpayer and an attorney also apply to a communication 

between a taxpayer and a federally authorized tax practitioner to the extent the communication 

would be considered a privileged communication if it were between a taxpayer and an attorney. 

This rule is inapplicable to communications regarding corporate tax shelters.

Description of Proposal

The proposal modifies the rule relating to corporate tax shelters by making it applicable 

to all tax shelters, whether entered into by corporations, individuals, partnerships, tax-exempt 

entities, or any other entity. Accordingly, communications with respect to tax shelters are not 

subject to the confidentiality provision of the Code that otherwise applies to a communication 

between a taxpayer and a federally authorized tax practitioner.
156

Effective Date

The proposal is effective with respect to communications made on or after the date of 

enactment.

4. Statute of limitations for unreported listed transactions

Present Law

In general, the Code requires that taxes be assessed within three years220 after the date a 

return is filed.221 If there has been a substantial omission of items of gross income that total 

more than 25 percent of the amount of gross income shown on the return, the period during 

which an assessment must be made is extended to six years.222 If an assessment is not made 

within the required time periods, the tax generally cannot be assessed or collected at any future 

time. Tax may be assessed at any time if the taxpayer files a false or fraudulent return with the 

intent to evade tax or if the taxpayer does not file a tax return at all.223

Description of Proposal

The proposal extends the statute of limitations with respect to a listed transaction if a 

taxpayer fails to include on any return or statement for any taxable year any information with 

respect to a listed transaction224 which is required to be included (under section 6011) with such 

return or statement. The statute of limitations with respect to such a transaction will not expire 

before the date which is one year after the earlier of (1) the date on which the Secretary is 

furnished the information so required, or (2) the date that a material advisor (as defined in 6111) 

satisfies the list maintenance requirements (as defined by section 6112) with respect to a request 

by the Secretary. For example, if a taxpayer engaged in a transaction in 2005 that becomes a 

listed transaction in 2007 and the taxpayer fails to disclose such transaction in the manner 

required by Treasury regulations, then the transaction is subject extended statute of limitations.225

 

220 Sec. 6501(a).

221 For this purpose, a return that is filed before the date on which it is due is considered 

to be filed on the required due date (sec. 6501(b)(1)).

222 Sec. 6501(e).

223 Sec. 6501(c).

224 The term “listed transaction” has the same meaning as described in a previous 

provision regarding the penalty for failure to disclose reportable transactions.

225 If the Treasury Department lists a transaction in a year subsequent to the year in 

which a taxpayer entered into such transaction and the taxpayer’s tax return for the year the 

transaction was entered into is closed by the statute of limitations prior to the date the transaction 

became a listed transaction, this proposal does not re-open the statute of limitations with respect 

to such transaction for such year. However, if the purported tax benefits of the transaction are 
157

Effective Date

The proposal is effective for taxable years with respect to which the period for assessing 

a deficiency did not expire before date of enactment. 

5. Disclosure of reportable transactions by material advisors

Present Law

Registration of tax shelter arrangements

An organizer of a tax shelter is required to register the shelter with the Secretary not later 

than the day on which the shelter is first offered for sale.226 A “tax shelter” means any 

investment with respect to which the tax shelter ratio227 for any investor as of the close of any of 

the first five years ending after the investment is offered for sale may be greater than two to one 

and which is: (1) required to be registered under Federal or State securities laws, (2) sold 

pursuant to an exemption from registration requiring the filing of a notice with a Federal or State 

securities agency, or (3) a substantial investment (greater than $250,000 and involving at least 

five investors).228

Other promoted arrangeme nts are treated as tax shelters for purposes of the registration 

requirement if: (1) a significant purpose of the arrangement is the avoidance or evasion of 

Federal income tax by a corporate participant; (2) the arrangement is offered under conditions of 

confidentiality; and (3) the promoter may receive fees in excess of $100,000 in the aggregate.229

In general, a transaction has a “significant purpose of avoiding or evading Federal income 

tax” if the transaction: (1) is the same as or substantially similar to a “listed transaction,”230 or 

(2) is structured to produce tax benefits that constitute an important part of the intended results of 

the arrangement and the promoter reasonably expects to present the arrangement to more than 

 

recognized over multiple tax years, the proposal’s extension of the statute of limitations shall 

apply to such tax benefits in any subsequent tax year in which the statute of limitations had not 

closed prior to the date the transaction became a listed transaction.

226 Sec. 6111(a).

227 The tax shelter ratio is, with respect to any year, the ratio that the aggregate amount of 

the deductions and 350 percent of the credits, which are represented to be potentially allowable 

to any investor, bears to the investment base (money plus basis of assets contributed) as of the 

close of the tax year.

228 Sec. 6111(c).

229 Sec. 6111(d).

230 Treas. Reg. sec. 301.6111-2(b)(2).
158

one taxpayer.231 Certain exceptions are provided with respect to the second category of 

transactions.232

An arrangement is offered under conditions of confidentiality if: (1) an offeree has an 

understanding or agreement to limit the disclosure of the transaction or any significant tax 

features of the transaction; or (2) the promoter knows, or has reason to know, that the offeree’s 

use or disclosure of information relating to the transaction is limited in any other manner.233 

Failure to register tax shelter

The penalty for failing to timely register a tax shelter (or for filing false or incomplete 

information with respect to the tax shelter registration) generally is the greater of one percent of 

the aggregate amount invested in the shelter or $500.234 However, if the tax shelter involves an 

arrangement offered to a corporation under conditions of confidentiality, the penalty is the 

greater of $10,000 or 50 percent of the fees payable to any promoter with respect to offerings 

prior to the date of late registration. Intentional disregard of the requirement to register increases 

the penalty to 75 percent of the applicable fees.

Section 6707 also imposes (1) a $100 penalty on the promoter for each failure to furnish 

the investor with the required tax shelter identification number, and (2) a $250 penalty on the 

investor for each failure to include the tax shelter identification number on a return.

Description of Proposal

Disclosure of reportable transactions by material advisors

The proposal repeals the present law rules with respect to registration of tax shelters. 

Instead, the proposal requires each material advisor with respect to any reportable transaction 

(including any listed transaction) 235 to timely file an information return with the Secretary (in 

such form and manner as the Secretary ma y prescribe). The return must be filed on such date as 

specified by the Secretary. 

 

231 Treas. Reg. sec. 301.6111-2(b)(3).

232 Treas. Reg. sec. 301.6111-2(b)(4).

233 The regulations provide that the determination of whether an arrangement is offered 

under conditions of confidentiality is based on all the facts and circumstances surrounding the 

offer. If an offeree’s disclosure of the structure or tax aspects of the transaction are limited in 

any way by an express or implied understanding or agreement with or for the benefit of a tax 

shelter promoter, an offer is considered made under conditions of confidentiality, whether or not 

such understanding or agreement is legally binding. Treas. Reg. sec. 301.6111-2(c)(1).

234 Sec. 6707.

235 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related provisions.
159

The information return will include (1) information identifying and describing the 

transaction, (2) information describing any potential tax benefits expected to result from the 

transaction, and (3) such other information as the Secretary may prescribe. It is expected that the 

Secretary may seek from the material advisor the same type of information that the Secretary 

may request from a taxpayer in connection with a reportable transaction. 236

A “material advisor” means any person (1) who provides material aid, assistance, or 

advice with respect to organizing, managing, promoting, selling, implementing, or carrying out 

any reportable transaction, and (2) who directly or indirectly derives gross income in excess of 

$250,000 ($50,000 in the case of a reportable transaction substantially all of the tax benefits from 

which are provided to natural persons) or such other amount as may be prescribed by the 

Secretary for such advice or assistance.

The Secretary may prescribe regulations which provide (1) that only one material advisor 

has to file an information return in cases in which two or more material advisors would otherwise 

be required to file information returns with respect to a particular reportable transaction, (2) 

exemptions from the requirements of this section, and (3) other rules as may be necessary or 

appropriate to carry out the purposes of this section (including, for example, rules regarding the 

aggregation of fees in appropriate circumstances).

Penalty for failing to furnish information regarding reportable transactions

The proposal repeals the present-law penalty for failure to register tax shelters. Instead, 

the proposal imposes a penalty on any material advisor who fails to file an information return, or 

who files a false or incomplete information return, with respect to a reportable transaction 

(including a listed transaction).237 The amount of the penalty is $50,000. If the penalty is with 

respect to a listed transaction, the amount of the penalty is increased to the greater of (1) 

$200,000, or (2) 50 percent of the gross income of such person with respect to aid, assistance, or 

advice which is provided with respect to the transaction before the date the information return 

that includes the transaction is filed. Intentional disregard by a material advisor of the 

requirement to disclose a listed transaction increases the penalty to 75 percent of the gross 

income. 

The penalty cannot be waived with respect to a listed transaction. As to reportable 

transactions, the penalty can be rescinded (or abated) only in exceptional circumstances.238 All 

or part of the penalty may be rescinded only if rescinding the penalty would promote compliance 

with the tax laws and effective tax administration. The authority to rescind the penalty can only 

 

236

 See the previous discussion regarding the disclosure requirements under new section 

6707A.

237 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related provisions.

238 The Secretary’s present-law authority to postpone certain tax-related deadlines 

because of Presidentially-declared disasters (sec. 7508A) will also encompass the authority to 

postpone the reporting deadlines established by the provision.
160

be exercised by the Commissioner personally. Thus, a revenue agent, an Appeals officer, or 

other IRS personnel cannot rescind the penalty. The decision to rescind a penalty must be 

accompanied by a record describing the facts and reasons for the action and the amount 

rescinded. There will be no right to appeal a refusal to rescind a penalty. The IRS also is 

required to submit an annual report to Congress summarizing the application of the disclosure 

penalties and providing a description of each penalty rescinded under this provision and the 

reasons for the rescission.

Effective Date

The proposal requiring disclosure of reportable transactions by material advisors applies 

to transactions with respect to which material aid, assistance or advice is provided after the date 

of enactment.

The proposal imposing a penalty for failing to disclose reportable transactions applies to 

returns the due date for which is after the date of enactment.

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

Present Law

Investor lists

Any organizer or seller of a potentially abusive tax shelter must maintain a list identifying 

each person who was sold an interest in any such tax shelter with respect to which registration 

was required under section 6111 (even though the particular party may not have been subject to 

confidentiality restrictions).239 Recently issued regulations under section 6112 contain rules 

regarding the list maintenance requirements. 240 In general, the regulations apply to transactions 

that are potentially abusive tax shelters entered into, or acquired after, February 28, 2003.241

The regulations provide that a person is an organizer or seller of a potentially abusive tax 

shelter if the person is a material advisor with respect to that transaction. 242 A material advisor is 

defined any person who is required to register the transaction under section 6111, or expects to 

receive a minimum fee of (1) $250,000 for a transaction that is a potentially abusive tax shelter if 

all participants are corporations, or (2) $50,000 for any other transaction that is a potentially 

 

239 Sec. 6112.

240 Treas. Reg. sec. 301.6112-1.

241 A special rule applies the list maintenance requirements to transactions entered into 

after February 28, 2000 if the transaction becomes a listed transaction (as defined in Treas. Reg. 

1.6011-4) after February 28, 2003.

242 Treas. Reg. sec. 301.6112-1(c)(1).
161

abusive tax shelter.243 For listed transactions (as defined in the regulations under section 6011), 

the minimum fees are reduced to $25,000 and $10,000, respectively.

A potentially abusive tax shelter is any transaction that (1) is required to be registered 

under section 6111, (2) is a listed transaction (as defined under the regulations under section 

6011), or (3) any transaction that a potential material advisor, at the time the transaction is 

entered into, knows is or reasonably expects will become a reportable transaction (as defined 

under the new regulations under section 6011).244 

The Secretary is required to prescribe regulations which provide that, in cases in which 

two or more persons are required to maintain the same list, only one person would be required to 

maintain the list.245

Penalty for failing to maintain investor lists

Under section 6708, the penalty for failing to maintain the list required under section 

6112 is $50 for each name omitted from the list (with a maximum penalty of $100,000 per year).

Description of Proposal

Investor lists

Each material advisor246 with respect to a reportable transaction (including a listed 

transaction)247 is required to maintain a list that (1) identifies each person with respect to whom 

the advisor acted as a material advisor with respect to the reportable transaction, and (2) contains 

other information as may be required by the Secretary. In addition, the proposal authorizes (but 

does not require) the Secretary to prescribe regulations which provide that, in cases in which two 

or more persons are required to maintain the same list, only one person would be required to 

maintain the list.

The proposal also clarifies that, for purposes of section 6112, the identity of any person is 

not privileged for any purpose, such as either under the common law attorney-client privilege or 

under the section 7525 federally authorized tax practitioner rules. 

 

243 Treas. Reg. sec. 301.6112-1(c)(2) and (3).

244 Treas. Reg. sec. 301.6112-1(b).

245 Sec. 6112(c)(2).

246 The term “material advisor” has the same meaning as when used in connection with 

the requirement to file an information return under section 6111.

247 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related provisions.
162

Penalty for failing to maintain investor lists

The proposal modifies the penalty for failing to maintain the required list by making it a 

time-sensitive penalty. Thus, a material advisor who is required to maintain an investor list and

who fails to make the list available upon written request by the Secretary within 20 business days 

after the request will be subject to a $10,000 per day penalty. The penalty applies to a person 

who fails to maintain a list, maintains an incomplete list, or has in fact maintained a list but does 

not make the list available to the Secretary. The penalty can be waived if the failure to make the 

list available is due to reasonable cause.248 

Effective Date

The proposal requiring a material advisor to maintain an investor list applies to 

transactions with respect to which material aid, assistance or advice is provided after the date of 

enactment.

The proposal imposing a penalty for failing to maintain investor lists applies to requests 

made after the date of enactment. 

The proposal clarifying that the identity of any person is not privileged for purposes of 

section 6112 is effective as if included in the amendments made by section 142 of the Deficit 

Reduction Act of 1984. 

7. Penalties on promoters of tax shelters

Present Law

A penalty is imposed on any person who organizes, assists in the organization of, or 

participates in the sale of any interest in, a partnership or other entity, any investment plan or 

arrangement, or any other plan or arrangement, if in connection with such activity the person 

makes or furnishes a qualifying false or fraudulent statement or a gross valuation 

overstatement. 249 A qualified false or fraudulent statement is any statement with respect to the 

allowability of any deduction or credit, the excludability of any income, or the securing of any 

other tax benefit by reason of holding an interest in the entity or participating in the plan or 

arrangement which the person knows or has reason to know is false or fraudulent as to any 

material matter. A “gross valuation overstatement” means any statement as to the value of any 

property or services if the stated value exceeds 200 percent of the correct valuation, and the 

value is directly related to the amount of any allowable income tax deduction or credit.

The amount of the penalty is $1,000 (or, if the person establishes that it is less, 100 

percent of the gross income derived or to be derived by the person from such activity). A 

 

248 In no event will failure to maintain a list be considered reasonable cause for failing to 

make a list available to the Secretary.

249 Sec. 6700.
163

penalty attributable to a gross valuation misstatement can be waived on a showing that there was 

a reasonable basis for the valuation and it was made in good faith.

Description of Proposal

The proposal modifies the penalty amount to equal 50 percent of the gross income 

derived by the person from the activity for which the penalty is imposed. The new penalty rate 

applies to any activity that involves a statement regarding the tax benefits of participating in a 

plan or arrangement if the person knows or has reason to know that such statement is false or 

fraudulent as to any material matter. The enhanced penalty does not apply to a gross valuation 

overstatement.

Effective Date

The proposal is effective for activities after the date of enactment.

8. Modifications to the definition of the substantial understatement

Present Law

An accuracy-related penalty equal to 20 percent applies to any substantial understatement 

of tax. A “substantial understatement” exists if the correct income tax liability for a taxable year 

exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 

($10,000 in the case of most corporations).250 

Description of Proposal

The proposal modifies the definition of “substantial” for corporate taxpayers. Under the 

proposal, a corporate taxpayer has a substantial understatement if the amount of the 

understatement for the taxable year exceeds the lesser of (1) 10 percent of the tax required to be 

shown on the return for the taxable year (or, if greater, $10,000), or (2) $10 million.

Effective Date

The proposal is effective for taxable years beginning after date of enactment.

 

250 Sec. 6662(a) and (d)(1)(A).
164

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

Present Law

The Code authorizes civil action to enjoin any person from promoting abusive tax 

shelters or aiding or abetting the understatement of tax liability. 251

Description of Proposal

The proposal expands this rule so that injunctions may also be sought with respect to the 

requirements relating to the reporting of reportable transactions 252 and the keeping of lists of 

investors by material advisors.253 Thus, under the proposal, an injunction may be sought against 

a material advisor to enjoin the advisor from (1) failing to file an information return with respect 

to a reportable transaction, or (2) failing to maintain, or to timely furnish upon written request by 

the Secretary, a list of investors with respect to each reportable transaction.

Effective Date

The proposal is effective on the day after the date of enactment.

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

Present Law

The Secretary of the Treasury must require citizens, residents, or persons doing business 

in the United States to keep records and file reports when that person makes a transaction or 

maintains an account with a foreign financial entity. 254 In general, individuals must fulfill this 

requirement by answering questions regarding foreign accounts or foreign trusts that are 

contained in Part III of Schedule B of the IRS Form 1040. Taxpayers who answer “yes” in 

response to the question regarding foreign accounts must then file Treasury Department Form 

TD F 90-22.1. This form must be filed with the Department of the Treasury, and not as part of 

the tax return that is filed with the IRS.

The Secretary of the Treasury may impose a civil penalty on any person who willfully 

violates this reporting requirement. The civil penalty is the amount of the transaction or the 

value of the account, up to a maximum of $100,000; the minimum amount of the penalty is 

$25,000.255 In addition, any person who willfully violates this reporting requirement is subject to 

 

251 Sec. 7408.

252 Sec. 6707, as amended by other provisions of this bill.

253 Sec. 6708, as amended by other provisions of this bill.

254 31 U.S.C. 5314.

255 31 U.S.C. 5321(a)(5).
165

a criminal penalty. The criminal penalty is a fine of not more than $250,000 or imprisonment for 

not more than five years (or both); if the violation is part of a pattern of illegal activity, the 

maximum amount of the fine is increased to $500,000 and the maximum length of imprisonment 

is increased to 10 years.256

On April 26, 2002, the Secretary of the Treasury submitted to the Congress a report on 

these reporting requirements.257 This report, which was statutorily required,258 studies methods 

for improving compliance with these reporting requirements. It makes several administrative 

recommendations, but no legislative recommendations. A further report was required to be 

submitted by the Secretary of the Treasury to the Congress by October 26, 2002.

Description of Proposal

The proposal adds an additional civil penalty that may be imposed on any person who 

violates this reporting requirement (without regard to willfulness). This new civil penalty is up 

to $5,000. The penalty may be waived if any income from the account was properly reported on 

the income tax return and there was reasonable cause for the failure to report.

Effective Date

The proposal is effective with respect to failures to report occurring on or after the date of 

enactment.

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

Present Law

The Secretary of the Treasury is authorized to regulate the practice of representatives of 

persons before the Department of the Treasury. 259 The Secretary is also authorized to suspend or 

disbar from practice before the Department a representative who is incompetent, who is 

disreputable, who violates the rules regulating practice before the Department, or who (with 

intent to defraud) willfully and knowingly misleads or threatens the person being represented (or 

a person who may be represented). The rules promulgated by the Secretary pursuant to this 

provision are contained in Circular 230.

 

256 31 U.S.C. 5322.

257

 A Report to Congress in Accordance with Sec. 361(b) of the Uniting and 

Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct 

Terrorism Act of 2001, April 26, 2002.

258 Sec. 361(b) of the USA PATRIOT Act of 2001 (Pub. L. No. 107-56).

259 31 U.S.C. 330.
166

Description of Proposal

The proposal makes two modifications to expand the sanctions that the Secretary may 

impose pursuant to these statutory provisions. First, the proposal expressly permits censure as a 

sanction. Second, the proposal permits the imposition of a monetary penalty as a sanction. If the 

representative is acting on behalf of an employer or other entity, the Secretary may impose a 

monetary penalty on the employer or other entity if it knew, or reasonably should have known, of 

the conduct. This monetary penalty on the employer or other entity may be imposed in addition 

to any monetary penalty imposed directly on the representative. These monetary penalties are 

not to exceed the gross income derived (or to be derived) from the conduct giving rise to the 

penalty. These monetary penalties may be in addition to, or in lieu of, any suspension, 

disbarment, or censure of such individual.

The proposal also confirms the present-law authority of the Secretary to impose standards 

applicable to written advice with respect to an entity, plan, or arrangeme nt that is of a type that 

the Secretary determines as having a potential for tax avoidance or evasion.

Effective Date

The modifications to expand the sanctions that the Secretary may impose are effective for 

actions taken after the date of enactment.

12. Treatment of stripped interests in bond and preferred stock funds

Present Law

Assignment of income in general

In general, an “income stripping” transaction involves a transaction in which the right to 

receive future income from income-producing property is separated from the property itself. In 

such transactions, it may be possible to generate artificial losses from the disposition of certain 

property or to defer the recognition of taxable income associated with such property. 

Common law has developed a rule (referred to as the “assignment of income” doctrine) 

that income may not be transferred without also transferring the underlying property. A leading 

judicial decision relating to the assignment of income doctrine involved a case in which a 

taxpayer made a gift of detachable interest coupons before their due date while retaining the 

bearer bond. The U.S. Supreme Court ruled that the donor was taxable on the entire amount of 

interest when paid to the donee on the grounds that the transferor had “assigned” to the donee the 

right to receive the income.260

In addition to general common law assignment of income principles, specific statutory 

rules have been enacted to address certain specific types of stripping transactions, such as 

transactions involving stripped bonds and stripped preferred stock (which are discussed 

 

260

 Helvering v. Horst, 311 U.S. 112 (1940).
167

below).261 However, there are no specific statutory rules that address stripping transactions with 

respect to common stock or other equity interests (other than preferred stock).262

Stripped bonds

Special rules are provided with respect to the purchaser and “stripper” of stripped 

bonds.263 A “stripped bond” is defined as a debt instrument in which there has been a separation 

in ownership between the underlying debt instrument and any interest coupon that has not yet 

become payable.264 In general, upon the disposition of either the stripped bond or the detached 

interest coupons, the retained portion and the portion that is disposed of each is treated as a new 

bond that is purchased at a discount and is payable at a fixed amount on a future date. 

Accordingly, section 1286 treats both the stripped bond and the detached interest coupons as 

individual bonds that are newly issued with original issue discount (“OID”) on the date of 

disposition. Consequently, section 1286 effectively subjects the stripped bond and the detached 

interest coupons to the general OID periodic income inclusion rules.

A taxpayer who purchases a stripped bond or one or more stripped coupons is treated as 

holding a new bond that is issued on the purchase date with OID in an amount that is equal to the 

excess of the stated redemption price at maturity (or in the case of a coupon, the amount payable 

on the due date) over the ratable share of the purchase price of the stripped bond or coupon, 

determined on the basis of the respective fair market values of the stripped bond and coupons on 

the purchase date.265 The OID on the stripped bond or coupon is includible in gross income 

under the general OID periodic income inclusion rules.

A taxpayer who strips a bond and disposes of either the stripped bond or one or more 

stripped coupons must allocate his basis, immediately before the disposition, in the bond (with 

 

261 Depending on the facts, the IRS also could determine that a variety of other Codebased and common law-based authorities could apply to income stripping transactions, 

including: (1) sections 269, 382, 446(b), 482, 701, or 704 and the regulations thereunder; (2) 

authorities that recharacterize certain assignments or accelerations of future payments as 

financings; (3) business purpose, economic substance, and sham transaction doctrines; (4) the 

step transaction doctrine; and (5) the substance-over-form doctrine. See Notice 2003-55, 2003-

34 I.R.B. 395, modifying and superseding Notice 95-53, 1995-2 C.B. 334 (accounting for lease 

strips and other stripping transactions).

262 However, in Estate of Stranahan v. Commissioner, 472 F.2d 867 (6th Cir. 1973), the 

court held that where a taxpayer sold a carved-out interest of stock dividends, with no personal 

obligation to produce the income, the transaction was treated as a sale of an income interest.

263 Sec. 1286.

264 Sec. 1286(e).

265 Sec. 1286(a).
168

the coupons attached) between the retained and disposed items.266 Special rules apply to require 

that interest or market discount accrued on the bond prior to such disposition must be included in 

the taxpayer’s gross income (to the extent that it had not been previously included in income) at 

the time the stripping occurs, and the taxpayer increases his basis in the bond by the amount of 

such accrued interest or market discount. The adjusted basis (as increased by any accrued 

interest or market discount) is then allocated between the stripped bond and the stripped interest 

coupons in relation to their respective fair market values. Amounts realized from the sale of 

stripped coupons or bonds constitute income to the taxpayer only to the extent such amounts 

exceed the basis allocated to the stripped coupons or bond. With respect to retained items (either 

the detached coupons or stripped bond), to the extent that the price payable on maturity, or on the 

due date of the coupons, exceeds the portion of the taxpayer’s basis allocable to such retained 

items, the difference is treated as OID that is required to be included under the general OID 

periodic income inclusion rules.267

Stripped preferred stock

“Stripped preferred stock” is defined as preferred stock in which there has been a 

separation in ownership between such stock and any dividend on such stock that has not become 

payable.268 A taxpayer who purchases stripped preferred stock is required to include in gross 

income, as ordinary income, the amounts that would have been includible if the stripped 

preferred stock was a bond issued on the purchase date with OID equal to the excess of the 

redemption price of the stock over the purchase price.269 This treatment is extended to any 

taxpayer whose basis in the stock is determined by reference to the basis in the hands of the 

purchaser. A taxpayer who strips and disposes the future dividends is treated as having 

purchased the stripped preferred stock on the date of such disposition for a purchase price equal 

to the taxpayer’s adjusted basis in the stripped preferred stock. 270

Description of Proposal

The bill authorizes the Treasury Department to promulgate regulations that, in 

appropriate cases, apply rules that are similar to the present-law rules for stripped bonds and 

stripped preferred stock to direct or indirect interests in an entity or account substantially all of 

the assets of which consist of bonds (as defined in section 1286(e)(1)), preferred stock (as 

 

266 Sec. 1286(b). Similar rules apply in the case of any person whose basis in any bond 

or coupon is determined by reference to the basis in the hands of a person who strips the bond.

267 Special rules are provided with respect to stripping transactions involving tax-exempt 

obligations that treat OID (computed under the stripping rules) in excess of OID computed on 

the basis of the bond’s coupon rate (or higher rate if originally issued at a discount) as income 

from a non-tax-exempt debt instrument (sec. 1286(d)).

268 Sec. 305(e)(5).

269 Sec. 305(e)(1).

270 Sec. 305(e)(3).
169

defined in section 305(e)(5)(B)), or any combination thereof. This provision applies only to 

cases in which the present-law rules for stripped bonds and stripped preferred stock do not 

already apply to such interests.

For example, such Treasury regulations could apply to a transaction in which a person 

effectively strips future dividends from shares in a money market mutual fund (and disposes 

either the stripped shares or stripped future dividends) by contributing the shares (with the future 

dividends) to a custodial account through which another person purchases rights to either the 

stripped shares or the stripped future dividends. However, it is intended that Treasury 

regulations issued under this provision would not apply to certain transactions involving direct or 

indirect interests in an entity or account substantially all the assets of which consist of taxexempt obligations (as defined in section 1275(a)(3)), such as a tax-exempt bond partnership 

described in Rev. Proc. 2002-68,271 modifying and superseding Rev. Proc. 2002-16.272

No inference is intended as to the treatment under the present-law rules for stripped 

bonds and stripped preferred stock, or under any other provisions or doctrines of present law, of 

interests in an entity or account substantially all of the assets of which consist of bonds, preferred 

stock, or any combination thereof. The Treasury regulations, when issued, would be applied 

prospectively, except in cases to prevent abuse.

Effective Date

The proposal is effective for purchases and dispositions occurring after the date of 

enactment.

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

than dividends

Present Law

In general, U.S. persons may credit foreign taxes against U.S. tax on foreign-source 

income. The amount of foreign tax credits that may be claimed in a year is subject to a limitation 

that prevents taxpayers from using foreign tax credits to offset U.S. tax on U.S.-source income. 

Separate limitations are applied to specific categories of income.

As a consequence of the foreign tax credit limitations of the Code, certain taxpayers are 

unable to utilize their creditable foreign taxes to reduce their U.S. tax liability. U.S. taxpayers 

that are tax-exempt receive no U.S. tax benefit for foreign taxes paid on income that they 

receive.

Present law denies a U.S. shareholder the foreign tax credits normally available with 

respect to a dividend from a corporation or a regulated investment company (“RIC”) if the 

shareholder has not held the stock for more than 15 days (within a 30-day testing period) in the 

 

271 2002-43 I.R.B. 753.

272 2002-9 I.R.B. 572.
170

case of common stock or more than 45 days (within a 90-day testing period) in the case of 

preferred stock (sec. 901(k)). The disallowance applies both to foreign tax credits for foreign 

withholding taxes that are paid on the dividend where the dividend-paying stock is held for less 

than these holding periods, and to indirect foreign tax credits for taxes paid by a lower-tier 

foreign corporation or a RIC where any of the required stock in the chain of ownership is held 

for less than these holding periods. Periods during which a taxpayer is protected from risk of 

loss (e.g., by purchasing a put option or entering into a short sale with respect to the stock) 

generally are not counted toward the holding period requirement. In the case of a bona fide 

contract to sell stock, a special rule applies for purposes of indirect foreign tax credits. The 

disallowance does not apply to foreign tax credits with respect to certain dividends received by 

active dealers in securities. If a taxpayer is denied foreign tax credits because the applicable 

holding period is not satisfied, the taxpayer is entitled to a deduction for the foreign taxes for 

which the credit is disallowed.

Description of Proposal

The proposal expands the present-law disallowance of foreign tax credits to include 

credits for gross-basis foreign withholding taxes with respect to any item of income or gain from 

property if the taxpayer who receives the income or gain has not held the property for more than 

15 days (within a 30-day testing period), exclusive of periods during which the taxpayer is 

protected from risk of loss. The proposal does not apply to foreign tax credits that are subject to 

the present-law disallowance with respect to dividends. The proposal also does not apply to 

certain income or gain that is received with respect to property held by active dealers. Rules 

similar to the present-law disallowance for foreign tax credits with respect to dividends apply to 

foreign tax credits that are subject to the proposal. In addition, the proposal authorizes the 

Treasury Department to issue regulations providing that the proposal does not apply in 

appropriate cases.

Effective Date

The proposal is effective for amounts that are paid or accrued more than 30 days after the 

date of enactment.

14. Disallowance of certain partnership loss transfers

Present Law

Contributions of property

Under present law, if a partner contributes property to a partnership, generally no gain or 

loss is recognized to the contributing partner at the time of contribution. 273 The partnership takes 

the property at an adjusted basis equal to the contributing partner’s adjusted basis in the 

property. 274 The contributing partner increases its basis in its partnership interest by the adjusted 

 

273 Sec. 721.

274 Sec. 723.
171

basis of the contributed property. 275 Any items of partnership income, gain, loss and deduction 

with respect to the contributed property are allocated among the partners to take into account any 

built-in gain or loss at the time of the contribution. 276 This rule is intended to prevent the transfer 

of built-in gain or loss from the contributing partner to the other partners by generally allocating 

items to the noncontributing partners based on the value of their contributions and by allocating 

to the contributing partner the remainder of each item. 277 

If the contributing partner transfers its partnership interest, the built-in gain or loss will be 

allocated to the transferee partner as it would have been allocated to the contributing partner.278 

If the contributing partner’s interest is liquidated, there is no specific guidance preventing the 

allocation of the built-in loss to the remaining partners. Thus, it appears that losses can be 

“transferred” to other partners where the contributing partner no longer remains a partner.

Transfers of partnership interests

Under present law, a partnership does not adjust the basis of partnership property 

following the transfer of a partnership interest unless the partnership has made a one-time 

election under section 754 to make basis adjustments.279 If an election is in effect, adjustments 

are made with respect to the transferee partner to account for the difference between the 

transferee partner’s proportionate share of the adjusted basis of the partnership property and the 

transferee’s basis in its partnership interest.280 These adjustments are intended to adjust the basis 

of partnership property to approximate the result of a direct purchase of the property by the 

transferee partner. Under these rules, if a partner purchases an interest in a partnership with an 

existing built-in loss and no election under section 754 is in effect, the transferee partner may be 

allocated a share of the loss when the partnership disposes of the property (or depreciates the 

property).

Distributions of partnership property

With certain exceptions, partners may receive distributions of partnership property 

without recognition of gain or loss by either the partner or the partnership.281 In the case of a 

 

275 Sec. 722.

276 Sec. 704(c)(1)(A).

277 If there is an insufficient amount of an item to allocate to the noncontributing 

partners, Treasury regulations allow for curative or remedial allocations to remedy this 

insufficiency. Treas. Reg. sec. 1.704-3(c) and (d).

278 Treas. Reg. sec. 1.704-3(a)(7).

279 Sec. 743(a).

280 Sec. 743(b).

281 Sec. 731(a) and (b).
172

distribution in liquidation of a partner’s interest, the basis of the property distributed in the 

liquidation is equal to the partner’s adjusted basis in its partnership interest (reduced by any 

money distributed in the transaction).282 In a distribution other than in liquidation of a partner’s 

interest, the distributee partner’s basis in the distributed property is equal to the partnership’s 

adjusted basis in the property immediately before the distribution, but not to exceed the partner’s 

adjusted basis in the partnership interest (reduced by any money distributed in the same 

transaction).283

The determination of the basis of individual properties distributed by a partnership is 

dependent on the adjusted basis of the properties in the hands of the partnership.284 If a 

partnership interest is transferred to a partner and the partnership has not elected to adjust the 

basis of partnership property, a special basis rule provides for the determination of the transferee 

partner's basis of properties that are later distributed by the partnership.285 Under this rule, in 

determining the basis of property distributed by a partnership within two years following the 

transfer of the partnership interest, the transferee may elect to determine its basis as if the 

partnership had adjusted the basis of the distributed property under section 743(b) on the 

transfer. The special basis rule also applies to distributed property if, at the time of the transfer, 

the fair market value of partnership property other than money exceeds 110 percent of the 

partnership's basis in such property and a liquidation of the partnership interest immediately after 

the transfer would have resulted in a shift of basis to property subject to an allowance of 

depreciation, depletion or amortization. 286

Adjustments to the basis of the partnership’s undistributed properties are not required 

unless the partnership has made the election under section 754 to make basis adjustments.287 If 

an election is in effect under section 754, adjustments are made by a partnership to increase or 

decrease the remaining partnership assets to reflect any increase or decrease in the adjusted basis 

of the distributed properties in the hands of the distributee partner (or gain or loss recognized by 

the distributee partner).288 To the extent the adjusted basis of the distributed properties increases 

(or loss is recognized) the partnership’s adjusted basis in its properties is decreased by a like 

amount; likewise, to the extent the adjusted basis of the distributed properties decrease (or gain is 

recognized), the partnership’s adjusted basis in its properties is increased by a like amount. 

Under these rules, a partnership with no election in effect under section 754 may distribute 

property with an adjusted basis lower than the distributee partner’s proportionate share of the 

 

282 Sec. 732(b).

283 Sec. 732(a).

284 Sec. 732 (a)(1) and (c).

285 Sec. 732(d).

286 Treas. Reg. sec. 1.732-1(d)(4).

287 Sec. 734(a).

288 Sec. 734(b).
173

adjusted basis of all partnership property and leave the remaining partners with a smaller net 

built-in gain or a larger net built-in loss than before the distribution.

Description of Proposal

Contributions of property

Under the proposal, a built-in loss may be taken into account only by the contributing 

partner and not by other partners. Except as provided in regulations, in determining the amount 

of items allocated to partners other than the contributing partner, the basis of the contributed 

property is treated as the fair market value at the time of contribution. Thus, if the contributing 

partner’s partnership interest is transferred or liquidated, the partnership’s adjusted basis in the 

property is based on its fair market value at the time of contribution, and the built-in loss is 

eliminated.289 

Transfers of partnership interests

The proposal provides generally that the basis adjustment rules under section 743 are 

mandatory in the case of the transfer of a partnership interest with respect to which there is a 

substantial built-in loss (rather than being elective as under present law). For this purpose, a 

substantial built-in loss exists if the partnership's adjusted basis in its property exceeds by more 

than $250,000 the fair market value of the partnership property.

Thus, for example, assume that partner A sells his 25-percent partnership interest to B for 

its fair market value of $1 million. Also assume that, immediately after the transfer, the fair 

market value of partnership assets is $4 million and the partnership's adjusted basis in the 

partnership assets is $4.3 million. Under the bill, section 743(b) applies, so that a decrease is 

required to the adjusted basis of the partnership assets with respect to B. As a result, B would 

recognize no gain or loss if the partnership immediately sold all its assets for their fair market 

value.

The bill provides that an electing investment partnership is not treated as having a 

substantial built-in loss, and thus is not required to make basis adjustments to partnership 

property, in the case of a transfer of a partnership interest. In lieu of the partnership basis 

adjustments, a partner-level loss limitation rule applies. Under this rule, the transferee partner's 

distributive share of losses (determined without regard to gains) from the sale or exchange of 

partnership property is not allowed, except to the extent it is established that the partner's share 

of such losses exceeds the loss recognized by the transferor partner. In the event of successive 

transfers, the transferee partner's distributive share of such losses is not allowed, except to the 

extent that it is established that such losses exceed the loss recognized by the transferor (or any 

prior transferor to the extent not fully offset by a prior disallowance under this rule). Losses 

disallowed under this rule do not decrease the transferee partner's basis in its partnership interest. 

Thus, on subsequent sale or exchange of its partnership interest, such a partner's gain is reduced 

(or loss increased) because the basis of the partnership interest has not been reduced by such 

 

289 It is intended that a corporation succeeding to attributes of the contributing corporate 

partner under section 381 shall be treated in the same manner as the contributing partner.
174

losses. The proposal is applied without regard to any termination of a partnership under section 

708(b)(1)(B). In the case of a basis reduction to property distributed to the transferee partner in a 

nonliquidating distribution, the amount of the transferor's loss taken into account under this rule 

is reduced by the amount of the basis reduction.

For this purpose, an electing investment partnership means a partnership that satisfies the 

following requirements: (1) it makes an election under the provision that is irrevocable except 

with the consent of the Secretary; (2) it would be an investment company under section 

3(a)(1)(A) of the Investment Company Act of 1940290 but for an exemption under paragraph (1) 

or (7) of section 3(c) of that Act; (3) it has never been engaged in a trade or business; (4) 

substantially all of its assets are held for investment; (5) at least 95 percent of the assets 

contributed to it consist of money; (6) no assets contributed to it had an adjusted basis in excess 

of fair market value at the time of contribution; (7) all partnership interests are issued by the 

partnership pursuant to a private offering and during the 24-month period beginning on the date 

of the first capital contribution to the partnership; (8) the partnership agreement has substantive 

restrictions on each partner's ability to cause a redemption of the partner's interest, and (9) the 

partnership agreement provides for a term that is not in excess of 15 years.

The proposal requires an electing investment partnership to furnish to any transferee 

partner the information necessary to enable the partner to compute the amount of losses 

disallowed under this rule.

Distributions of partnership property

The proposal provides that a basis adjustment under section 734(b) is required in the case 

of a distribution with respect to which there is a substantial basis reduction. A substantial basis 

reduction means a downward adjustment of more than $250,000 that would be made to the basis 

of partnership assets if a section 754 election were in effect.

Thus, for example, assume that A and B each contributed $2.5 million to a newly formed 

partnership and C contributed $5 million, and that the partnership purchased LMN stock for $3 

million and XYZ stock for $7 million. Assume that the value of each stock declined to $1 

million. Assume LMN stock is distributed to C in liquidation of its partnership interest. Under 

present law, the basis of LMN stock in C’s hands is $5 million. Under present law, C would 

recognize a loss of $4 million if the LMN stock were sold for $1 million.

Under the proposal, however, there is a substantial basis adjustment because the $2 

million increase in the adjusted basis of LMN stock (described in section 734(b)(2)(B)) is greater 

than $250,000. Thus, the partnership is required to decrease the basis of XYZ stock (under 

section 734(b)(2)) by $2 million (the amount by which the basis of LMN stock was increased), 

leaving a basis of $5 million. If the XYZ stock were then sold by the partnership for $1 million, 

A and B would each recognize a loss of $2 million.

 

290 Section 3(a)(1)(A) provides, “when used in this title, 'investment company' means any 

issuer which is or hold itself out as being engaged primarily, or proposes to engage primarily, in 

the business of investing, reinvesting, or trading in securities.”
175

Effective Date

The proposal applies to contributions and distributions (as the case may be) after the date 

of enactment. The proposal generally applies to transfers after the date of enactment, except in 

the case of an electing investment partnership in existence on June 4, 2004, the requirement that 

the partnership agreement have substantive restrictions on redemptions does not apply, and the 

requirement that the partnership agreement provide for a term not exceeding 15 years is modified 

to permit a term not exceeding 20 years.

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

partner

Present Law

In general

Generally, a partner and the partnership do not recognize gain or loss on a contribution of 

property to the partnership.291 Similarly, a partner and the partnership generally do not recognize 

gain or loss on the distribution of partnership property. 292 This includes current distributions and 

distributions in liquidation of a partner’s interest. 

Basis of property distributed in liquidation

The basis of property distributed in liquidation of a partner’s interest is equal to the 

partner’s tax basis in its partnership interest (reduced by any money distributed in the same 

transaction).293 Thus, the partnership’s tax basis in the distributed property is adjusted (increased 

or decreased) to reflect the partner’s tax basis in the partnership interest.

Election to adjust basis of partnership property 

When a partnership distributes partnership property, the basis of partnership property 

generally is not adjusted to reflect the effects of the distribution or transfer. However, the 

partnership is permitted to make an election (referred to as a 754 election) to adjust the basis of 

partnership property in the case of a distribution of partnership property. 294 The effect of the 754 

election is that the partnership adjusts the basis of its remaining property to reflect any change in 

basis of the distributed property in the hands of the distributee partner resulting from the 

distribution transaction. Such a change could be a basis increase due to gain recognition, or a 

basis decrease due to the partner’s adjusted basis in its partnership interest exceeding the 

 

291 Sec. 721(a).

292 Sec. 731(a) and (b).

293 Sec. 732(b).

294 Sec. 754.
176

adjusted basis of the property received. If the 754 election is made, it applies to the taxable year 

with respect to which such election was filed and all subsequent taxable years. 

In the case of a distribution of partnership property to a partner with respect to which the 

754 election is in effect, the partnership increases the basis of partnership property by (1) any 

gain recognized by the distributee partner and (2) the excess of the adjusted basis of the 

distributed property to the partnership immediately before its distribution over the basis of the 

property to the distributee partner, and decreases the basis of partnership property by (1) any loss 

recognized by the distributee partner and (2) the excess of the basis of the property to the 

distributee partner over the adjusted basis of the distributed property to the partnership 

immediately before the distribution.

The allocation of the increase or decrease in basis of partnership property is made in a 

manner that has the effect of reducing the difference between the fair market value and the 

adjusted basis of partnership properties.295 In addition, the allocation rules require that any 

increase or decrease in basis be allocated to partnership property of a like character to the 

property distributed. For this purpose, the two categories of assets are (1) capital assets and 

depreciable and real property used in the trade or business held for more than one year, and (2) 

any other property. 296

Description of Proposal

The proposal provides that in applying the basis allocation rules to a distribution in 

liquidation of a partner’s interest, a partnership is precluded from decreasing the basis of 

corporate stock of a partner or a related person. Any decrease in basis that, absent the proposal, 

would have been allocated to the stock is allocated to other partnership assets. If the decrease in 

basis exceeds the basis of the other partnership assets, then gain is recognized by the partnership 

in the amount of the excess.

Effective Date

The proposal applies to distributions after the date of enactment.

16. Repeal of special rules for FASITs, etc.

Present Law

Financial asset securitization investment trusts

In 1996, Congress created a new type of statutory entity called a “financial asset 

securitization trust” (“FASIT”) that facilitates the securitization of debt obligations such as credit 

 

295 Sec. 755(a).

296 Sec. 755(b).
177

card receivables, home equity loans, and auto loans.297 A FASIT generally is not taxable; the 

FASIT’s taxable income or net loss flows through to the owner of the FASIT.

The ownership interest of a FASIT generally is required to be entirely held by a single 

domestic C corporation. In addition, a FASIT generally may hold only qualified debt 

obligations, and certain other specified assets, and is subject to certain restrictions on its 

activities. An entity that qualifies as a FASIT can issue one or more classes of instruments that 

meet certain specified requirements and treat those instruments as debt for Federal income tax 

purposes. Instruments issued by a FASIT bearing yields to maturity over five percentage points 

above the yield to maturity on specified United States government obligations (i.e., “high-yield 

interests”) must be held, directly or indirectly, only by domestic C corporations that are not 

exempt from income tax.

Qualification as a FASIT

To qualify as a FASIT, an entity must: (1) make an election to be treated as a FASIT for 

the year of the election and all subsequent years;298 (2) have assets substantially all of which 

(including assets that the FASIT is treated as owning because they support regular interests) are 

specified types called “permitted assets;” (3) have non-ownership interests be certain specified 

types of debt instruments called “regular interests”; (4) have a single ownership interest which is 

held by an "eligible holder"; and (5) not qualify as a regulated investment company (“RIC”). 

Any entity, including a corporation, partnership, or trust may be treated as a FASIT. In addition, 

a segregated pool of assets may qualify as a FASIT.

An entity ceases qualifying as a FASIT if the entity's owner ceases being an eligible 

corporation. Loss of FASIT status is treated as if all of the regular interests of the FASIT were 

retired and then reissued without the application of the rule that deems regular interests of a 

FASIT to be debt.

Permitted assets

For an entity or arrangement to qualify as a FASIT, substantially all of its assets must 

consist of the following “permitted assets”: (1) cash and cash equivalents; (2) certain permitted 

debt instruments; (3) certain foreclosure property; (4) certain instruments or contracts that 

represent a hedge or guarantee of debt held or issued by the FASIT; (5) contract rights to acquire 

permitted debt instruments or hedges; and (6) a regular interest in another FASIT. Permitted 

assets may be acquired at any time by a FASIT, including any time after its formation.

 

297 Secs. 860H through 860L.

298 Once an election to be a FASIT is made, the election applies from the date specified 

in the election and all subsequent years until the entity ceases to be a FASIT. If an election to be 

a FASIT is made after the initial year of an entity, all of the assets in the entity at the time of the 

FASIT election are deemed contributed to the FASIT at that time and, accordingly, any gain (but 

not loss) on such assets will be recognized at that time.
178

“Regular interests” of a FASIT

“Regular interests” of a FASIT are treated as debt for Federal income tax purposes, 

regardless of whether instruments with similar terms issued by non-FASITs might be 

characterized as equity under general tax principles. To be treated as a “regular interest”, an 

instrument must have fixed terms and must: (1) unconditionally entitle the holder to receive a 

specified principal amount; (2) pay interest that is based on (a) fixed rates, or (b) except as 

provided by regulations issued by the Treasury Secretary, variable rates permitted with respect to 

real estate mortgage investment conduit interests under section 860G(a)(1)(B)(i); (3) have a term 

to maturity of no more than 30 years, except as permitted by Treasury regulations; (4) be issued 

to the public with a premium of not more than 25 percent of its stated principal amount; and (5) 

have a yield to maturity determined on the date of issue of less than five percentage points above 

the applicable Federal rate (“AFR”) for the calendar month in which the instrument is issued.

Permitted ownership holder

A permitted holder of the ownership interest in a FASIT generally is a non-exempt (i.e., 

taxable) domestic C corporation, other than a corporation that qualifies as a RIC, REIT, REMIC, 

or cooperative.

Transfers to FASITs

In general, gain (but not loss) is recognized immediately by the owner of the FASIT upon 

the transfer of assets to a FASIT. Where property is acquired by a FASIT from someone other 

than the FASIT’s owner (or a person related to the FASIT’s owner), the property is treated as 

being first acquired by the FASIT’s owner for the FASIT’s cost in acquiring the asset from the 

non-owner and then transferred by the owner to the FASIT.

Valuation rules.–In general, except in the case of debt instruments, the value of FASIT 

assets is their fair market value. Similarly, in the case of debt instruments that are traded on an 

established securities market, the market price is used for purposes of determining the amount of 

gain realized upon contribution of such assets to a FASIT. However, in the case of debt 

instruments that are not traded on an established securities market, special valuation rules apply 

for purposes of computing gain on the transfer of such debt instruments to a FASIT. Under these 

rules, the value of such debt instruments is the sum of the present values of the reasonably 

expected cash flows from such obligations discounted over the weighted average life of such 

assets. The discount rate is 120 percent of the AFR, compounded semiannually, or such other 

rate that the Treasury Secretary shall prescribe by regulations.

Taxation of a FASIT

A FASIT generally is not subject to tax. Instead, all of the FASIT’s assets and liabilities 

are treated as assets and liabilities of the FASIT’s owner and any income, gain, deduction or loss 

of the FASIT is allocable directly to its owner. Accordingly, income tax rules applicable to a 

FASIT (e.g., related party rules, sec. 871(h), sec. 165(g)(2)) are to be applied in the same manner 

as they apply to the FASIT’s owner. The taxable income of a FASIT is calculated using an 

accrual method of accounting. The constant yield method and principles that apply for purposes 

of determining original issue discount (“OID”) accrual on debt obligations whose principal is 
179

subject to acceleration apply to all debt obligations held by a FASIT to calculate the FASIT’s 

interest and discount income and premium deductions or adjustments.

Taxation of holders of FASIT regular interests

In general, a holder of a regular interest is taxed in the same manner as a holder of any 

other debt instrument, except that the regular interest holder is required to account for income 

relating to the interest on an accrual method of accounting, regardless of the method of 

accounting otherwise used by the holder.

Taxation of holders of FASIT ownership interests

Because all of the assets and liabilities of a FASIT are treated as assets and liabilities of 

the holder of a FASIT ownership interest, the ownership interest holder takes into account all of 

the FASIT’s income, gain, deduction, or loss in computing its taxable income or net loss for the 

taxable year. The character of the income to the holder of an ownership interest is the same as its 

character to the FASIT, except tax-exempt interest is included in the income of the holder as 

ordinary income.

Although the recognition of losses on assets contributed to the FASIT is not allowed 

upon contribution of the assets, such losses may be allowed to the FASIT owner upon their 

disposition by the FASIT. Furthermore, the holder of a FASIT ownership interest is not 

permitted to offset taxable income from the FASIT ownership interest (including gain or loss 

from the sale of the ownership interest in the FASIT) with other losses of the holder. In addition, 

any net operating loss carryover of the FASIT owner shall be computed by disregarding any 

income arising by reason of a disallowed loss. Where the holder of a FASIT ownership interest 

is a member of a consolidated group, this rule applies to the consolidated group of corporations 

of which the holder is a member as if the group were a single taxpayer.

Real estate mortgage investment conduits

In general, a real estate mortgage investment conduit (“REMIC”) is a self-liquidating 

entity that holds a fixed pool of mortgages and issues multiple classes of investor interests. A 

REMIC is not treated as a separate taxable entity. Rather, the income of the REMIC is allocated 

to, and taken into account by, the holders of the interests in the REMIC under detailed rules.299

 

In order to qualify as a REMIC, substantially all of the assets of the entity must consist of 

qualified mortgages and permitted investments as of the close of the third month beginning after 

the startup day of the entity. A “qualified mortgage” generally includes any obligation which is 

principally secured by an interest in real property, and which is either transferred to the REMIC 

on the startup day of the REMIC in exchange for regular or residual interests in the REMIC or 

purchased by the REMIC within three months after the startup day pursuant to a fixed-price 

contract in effect on the startup day. A “permitted investment” generally includes any intangible 

property that is held for investment and is part of a reasonably required reserve to provide for full 

payment of certain expenses of the REMIC or amounts due on regular interests.

 

299

 See secs. 860A through 860G.
180

All of the interests in the REMIC must consist of one or more classes of regular interests 

and a single class of residual interests. A “regular interest” is an interest in a REMIC that is 

issued with a fixed term, designated as a regular interest, and unconditionally entitles the holder 

to receive a specified principal amount (or other similar amount) with interest payments that are 

either based on a fixed rate (or, to the extent provided in regulations, a variable rate) or consist of 

a specified portion of the interest payments on qualified mortgages that does not vary during the 

period such interest is outstanding. In general, a “residual interest” is any interest in the REMIC 

other than a regular interest, and which is so designated by the REMIC, provided that there is 

only one class of such interest and that all distributions (if any) with respect to such interests are 

pro rata. Holders of residual REMIC interests are subject to tax on the portion of the income of 

the REMIC that is not allocated to the regular interest holders.

Description of Proposal

The proposal repeals the special rules for FASITs. The proposal provides a transition 

period for existing FASITs, pursuant to which the repeal of the FASIT rules would not apply to 

any FASIT in existence on the date of enactment to the extent that regular interests issued by the 

FASIT prior to such date continue to remain outstanding in accordance with their original terms.

For purposes of the REMIC rules, the proposal also modifies the definitions of REMIC 

regular interests, qualified mortgages, and permitted investments so that certain types of real 

estate loans and loan pools can be transferred to, or purchased by, a REMIC. Specifically, the 

proposal modifies the present-law definition of a REMIC “regular interest” to provide that an 

interest in a REMIC does not fail to qualify as a regular interest solely because the specified 

principal amount of such interest or the amount of interest accrued on such interest could be 

reduced as a result of the nonoccurrence of one or more contingent payments with respect to one 

or more reverse mortgages loans, as defined below, that are held by the REMIC, provided that on 

the startup day for the REMIC, the REMIC sponsor reasonably believes that all principal and 

interest due under the interest will be paid at or prior to the liquidation of the REMIC. For this 

purpose, a reasonable belief concerning ultimate payment of all amounts due under an interest is 

presumed to exist if, as of the startup day, the interest receives an investment grade rating from at 

least one nationally recognized statistical rating agency.

In addition, the proposal makes three modifications to the present-law definition of a 

“qualified mortgage.” First, the proposal modifies the definition to include an obligation 

principally secured by real property which represents an increase in the principal amount under 

the original terms of an obligation, provided such increase: (1) is attributable to an advance 

made to the obligor pursuant to the original terms of the obligation; (2) occurs after the REMIC 

startup day; and (3) is purchased by the REMIC pursuant to a fixed price contract in effect on the 

startup day. Second, the proposal modifies the definition to generally include reverse mortgage 

loans and the periodic advances made to obligors on such loans. For this purpose, a “reverse 

mortgage loan” is defined as a loan that: (1) is secured by an interest in real property; (2) 

provides for one or more advances of principal to the obligor (each such advance giving rise to a 

“balance increase”), provided such advances are principally secured by an interest in the same 

real property as that which secures the loan; (3) may provide for a contingent payment at 

maturity based upon the value or appreciation in value of the real property securing the loan; (4) 

provides for an amount due at maturity that cannot exceed the value, or a specified fraction of the 
181

value, of the real property securing the loan; (5) provides that all payments under the loan are 

due only upon the maturity of the loan; and (6) matures after a fixed term or at the time the 

obligor ceases to use as a personal residence the real property securing the loan. Third, the 

proposal modifies the definition to provide that, if more than 50 percent of the obligations 

transferred to, or purchased by, the REMIC are (1) originated by the United States or any State 

(or any political subdivision, agency, or instrumentality of the United States or any State) and (2) 

principally secured by an interest in real property, then each obligation transferred to, or 

purchased by, the REMIC shall be treated as secured by an interest in real property.

In addition, the proposal modifies the present-law definition of a “permitted investment” 

to include intangible investment property held as part of a reasonably required reserve to provide 

a source of funds for the purchase of obligations described above as part of the modified 

definition of a “qualified mortgage.”

Effective Date

Except as provided by the transition period for existing FASITs, this proposal is effective 

on January 1, 2005.

17. Limitation on transfer of built-in losses on REMIC residuals

Present Law

Generally, no gain or loss is recognized when one or more persons transfer property to a 

corporation in exchange for stock and immediately after the exchange such person or persons 

control the corporation. 300 The transferor's basis in the stock of the controlled corporation is the 

same as the basis of the property contributed to the controlled corporation, increased by the 

amount of any gain (or dividend) recognized by the transferor on the exchange, and reduced by 

the amount of any money or property received, and by the amount of any loss recognized by the 

transferor.301 The basis of property received by a controlled corporation in a tax-free transfer to 

the corporation is the same as the adjusted basis in the hands of the transferor, adjusted for gain 

or loss recognized by the transferor.302

Description of Proposal

The proposal provides that if a residual interest (as defined in section 860G(a)(2)) in a 

real estate mortgage investment conduit (“REMIC”) is contributed to a corporation and the 

transferee corporation’s adjusted basis in the REMIC residual interest would (but for the 

proposal) exceed the fair market value of the REMIC residual interest immediately after the 

contribution, the transferee corporation’s adjusted basis in the REMIC residual interest is limited 

to the fair market value of the REMIC residual interest immediately after the contribution, 

 

300 Sec. 351.

301 Sec. 358.

302 Sec. 362(a).
182

regardless of whether the fair market value of the REMIC residual interest is less than, equal to, 

or greater than zero (i.e., the proposal may result in the transferee corporation having a negative 

adjusted basis in the REMIC residual interest).

Effective Date

The proposal applies to transactions after the date of enactment.

18. Clarification of banking business for purposes of determining investment of earnings in 

U.S. property

Present Law

In general, the subpart F rules (secs. 951-964) require the U.S. 10-percent shareholders of 

a controlled foreign corporation to include in income currently their pro rata shares of certain 

income of the controlled foreign corporation (referred to as “subpart F income”), whether or not 

such earnings are distributed currently to the shareholders. In addition, the U.S. 10-percent 

shareholders of a controlled foreign corporation are subject to U.S. tax currently on their pro rata 

shares of the controlled foreign corporation's earnings to the extent invested by the controlled 

foreign corporation in certain U.S. property (sec. 951(a)(1)(B)).

A shareholder’s current income inclusion with respect to a controlled foreign 

corporation's investment in U.S. property for a taxable year is based on the controlled foreign 

corporation’s average investment in U.S. property for such year. For this purpose, the U.S. 

property held (directly or indirectly) by the controlled foreign corporation must be measured as 

of the close of each quarter in the taxable year (sec. 956(a)). The amount taken into account with 

respect to any property is the property’s adjusted basis as determined for purposes of reporting 

the controlled foreign corporation’s earnings and profits, reduced by any liability to which the 

property is subject. The amount determined for current inclusion is the shareholder’s pro rata 

share of an amount equal to the lesser of: (1) the controlled foreign corporation’s average 

investment in U.S. property as of the end of each quarter of such taxable year, to the extent that 

such investment exceeds the foreign corporation’s earnings and profits that were previously 

taxed on that basis; or (2) the controlled foreign corporation’s current or accumulated earnings 

and profits (but not including a deficit), reduced by distributions during the year and by earnings 

that have been taxed previously as earnings invested in U.S. property (secs. 956 and 959). An 

income inclusion is required only to the extent that the amount so calculated exceeds the amount 

of the controlled foreign corporation’s earnings that have been previously taxed as subpart F 

income (secs. 951(a)(1)(B) and 959).

For purposes of section 956, U.S. property generally is defined to include tangible 

property located in the United States, stock of a U.S. corporation, an obligation of a U.S. person, 

and certain intangible assets including a patent or copyright, an invention, model or design, a 

secret formula or process or similar property right which is acquired or developed by the 

controlled foreign corporation for use in the United States (sec. 956(c)(1)).

Specified exceptions from the definition of U.S. property are provided for: (1) 

obligations of the United States, money, or deposits with persons carrying on the banking 

business; (2) certain export property; (3) certain trade or business obligations; (4) aircraft, 
183

railroad rolling stock, vessels, motor vehicles or containers used in transportation in foreign 

commerce and used predominantly outside of the United States; (5) certain insurance company 

reserves and unearned premiums related to insurance of foreign risks; (6) stock or debt of certain 

unrelated U.S. corporations; (7) moveable property (other than a vessel or aircraft) used for the 

purpose of exploring, developing, or certain other activities in connection with the ocean waters 

of the U.S. Continental Shelf; (8) an amount of assets equal to the controlled foreign 

corporation’s accumulated earnings and profits attributable to income effectively connected with 

a U.S. trade or business; (9) property (to the extent provided in regulations) held by a foreign 

sales corporation and related to its export activities; (10) certain deposits or receipts of collateral 

or margin by a securities or commodities dealer, if such deposit is made or received on 

commercial terms in the ordinary course of the dealer’s business as a securities or commodities 

dealer; and (11) certain repurchase and reverse repurchase agreement transactions entered into by 

or with a dealer in securities or commodities in the ordinary course of its business as a securities 

or commodities dealer (sec. 956(c)(2)).

With regard to the exception for deposits with persons carrying on the banking business, 

the U.S. Court of Appeals for the Sixth Circuit in The Limited, Inc. v. Commissioner303

concluded that a U.S. subsidiary of a U.S. shareholder was “carrying on the banking business” 

even though its operations were limited to the administration of the private label credit card 

program of the U.S. shareholder. Therefore, the court held that a controlled foreign corporation 

of the U.S. shareholder could make deposits with the subsidiary (e.g., through the purchase of 

certificates of deposit) under this exception, and avoid taxation of the deposits under section 956 

as an investment in U.S. property.

Description of Proposal

The proposal provides that the exception from the definition of U.S. property under 

section 956 for deposits with persons carrying on the banking business is limited to deposits with 

persons at least 80 percent of the income of which is derived in the active conduct of a banking 

business from unrelated persons. For purposes of applying this proposal, the deposit recipient 

and all persons related to the deposit recipient are treated as one person in applying the 80-

percent test.

No inference is intended as to the meaning of the phrase “carrying on the banking 

business” under present law or whether this phrase was correctly interpreted by the Sixth Circuit 

in The Limited.

Effective Date

This proposal is effective on the date of enactment.

 

303 286 F.3d 324 (6th Cir. 2002), rev’g 113 T.C. 169 (1999).
184

19. Alternative tax for certain small insurance companies

Present Law

A property and casualty insurance company generally is subject to tax on its taxable 

income (sec. 831(a)). The taxable income of a property and casualty insurance company is 

determined as the sum of its underwriting income and investment income (as well as gains and 

other income items), reduced by allowable deductions (sec. 832).

A property and casualty insurance company may elect to be taxed only on taxable

investment income if its net written premiums or direct written premiums (whichever is greater) 

do not exceed $1.2 million (sec. 831(b)). For purposes of determining the amount of a 

company’s net written premiums or direct written premiums under this rule, premiums received 

by all members of a controlled group of corporations (as defined in section 831(b)) of which the 

company is a part are taken into account (including gross receipts of foreign and tax-exempt 

corporations).

Description of Proposal

Under the proposal, the $1.2 million ceiling on net written premiums or direct written 

premiums for purposes of the election to be taxed only on taxable investment income is 

increased to $1.89 million, and is indexed for taxable years beginning in a calendar year after 

2004.

Effective Date

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

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

reportable transactions

Present Law

In general, corporations may deduct interest paid or accrued within a taxable year on 

indebtedness.304 Interest on indebtedness to the Federal government attributable to an 

underpayment of tax generally may be deducted pursuant to this provision. 

Description of Proposal

The proposal disallows any deduction for interest paid or accrued within a taxable year 

on any portion of an underpayment of tax that is attributable to an understatement arising from 

an undisclosed listed transaction or from an undisclosed reportable transaction (other than a 

 

304 Sec. 163(a). 
185

listed transaction) if a significant purpose of such transaction is the avoidance or evasion of 

Federal income tax. 305

Effective Date

The proposal is effective for underpayments attributable to transactions entered into in 

taxable years beginning after the date of enactment.

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

Present Law

In certain circumstances, taxpayers can make an election under section 338(h)(10) to treat 

a qualifying purchase of 80 percent of the stock of a target corporation by a corporation from a 

corporation that is a member of an affiliated group (or a qualifying purchase of 80 percent of the 

stock of an S corporation by a corporation from S corporation shareholders) as a sale of the 

assets of the target corporation, rather than as a stock sale. The election must be made jointly by 

the buyer and seller of the stock and is due by the 15th day of the ninth month beginning after the 

month in which the acquisition date occurs. An agreement for the purchase and sale of stock 

often may contain an agreement of the parties to make a section 338(h)(10) election. 

Section 338(a) also permits a unilateral election by a buyer corporation to treat a qualified 

stock purchase of a corporation as a deemed asset acquisition, whether or not the seller of the 

stock is a corporation (or an S corporation is the target). In such a case, the seller or sellers 

recognize gain or loss on the stock sale (including any estimated taxes with respect to the stock 

sale), and the target corporation recognizes gain or loss on the deemed asset sale. 

Section 338(h)(13) provides that, for purposes of section 6655 (relating to additions to tax 

for failure by a corporation to pay estimated income tax), tax attributable to a deemed asset sale 

under section 338(a)(1) shall not be taken into account. 

Description of Proposal

The proposal clarifies section 338(h)(13) to provide that the exception for estimated tax 

purposes with respect to tax attributable to a deemed asset sale does not apply with respect to a 

qualified stock purchase for which an election is made under section 338(h)(10).

Under the proposal, if a qualified stock purchase transaction eligible for the election 

under section 338(h)(10) occurs, estimated tax would be determined based on the stock sale 

unless and until there is an agreement of the parties to make a section 338(h)(10) election.

 

305 The definitions of these transactions are the same as those previously described in 

connection with the proposal elsewhere in this bill to modify the accuracy-related penalty for 

listed and certain reportable transactions.
186

If at the time of the sale there is an agreement of the parties to make a section 338(h)(10) 

election, then estimated tax is computed based on an asset sale, computed from the date of the 

sale. 

If the agreement to make a section 338(h)(10) election is concluded after the stock sale, 

such that the original computation was based on the stock sale, estimated tax is recomputed 

based on the asset sale election. 

No inference is intended as to present law.

Effective Date

The proposal is effective for qualified stock purchase transactions that occur after the 

date of enactment.

22. Exclusion of like-kind exchange property from nonrecognition treatment on the sale or 

exchange of a principal residence

Present Law

Under present law, a taxpayer may exclude up to $250,000 ($500,000 if married filing a 

joint return) of gain realized on the sale or exchange of a principal residence.306 To be eligible 

for the exclusion, the taxpayer must have owned and used the residence as a principal residence 

for at least two of the five years prior to the sale or exchange. A taxpayer who fails to meet these 

requirements by reason of a change of place of employment, health, or, to the extent provided 

under regulations, unforeseen circumstances is able to exclude an amount equal to the fraction of 

the $250,000 ($500,000 if married filing a joint return) that is equal to the fraction of the two 

years that the ownership and use requirements are met. There are no special rules relating to the 

sale or exchange of a principal residence that was acquired in a like-kind exchange within the 

prior five years.

Description of Proposal

The bill provides that the exclusion for gain on the sale or exchange of a principal 

residence does not apply if the principal residence was acquired in a like-kind exchange in which 

any gain was not recognized within the prior five years.

Effective Date

The proposal is effective for sales or exchanges of principal residences after the date of 

enactment.

 

306 Sec. 121.
187

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

income inclusions in transactions with related foreign persons

Present Law

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

U.S. tax only when such income is distributed to any U.S. person that holds stock in such 

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

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

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

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

States imposes tax on such income at that time. However, certain anti-deferral regimes may 

cause the U.S. person to be taxed on a current basis in the United States with respect to certain 

categories of passive or highly mobile income earned by the foreign corporations in which the 

U.S. person holds stock. The main anti-deferral regimes are the controlled foreign corporation 

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

1291-1298), and the foreign personal holding company rules (secs. 551-558). 

As a general rule, there is allowed as a deduction all interest paid or accrued within the 

taxable year with respect to indebtedness, including the aggregate daily portions of original issue 

discount (“OID”) of the issuer for the days during such taxable year.307 However, if a debt 

instrument is held by a related foreign person, any portion of such OID is not allowable as a 

deduction to the payor of such instrument until paid (“related-foreign-person rule”). This 

related-foreign-person rule does not apply to the extent that the OID is effectively connected 

with the conduct by such foreign related person of a trade or business within the United States 

(unless such OID is exempt from taxation or is subject to a reduced rate of taxation under a treaty 

obligation).308 Treasury regulations further modify the related-foreign-person rule by providing 

that in the case of a debt owed to a foreign personal holding company (“FPHC”), controlled 

foreign corporation (“CFC”) or passive foreign investment company (“PFIC”), a deduction is 

allowed for OID as of the day on which the amount is includible in the income of the FPHC, 

CFC or PFIC, respectively.309

In the case of unpaid stated interest and expenses of related persons, where, by reason of 

a payee's method of accounting, an amount is not includible in the payee's gross income until it is 

paid but the unpaid amounts are deductible currently by the payor, the amount generally is 

allowable as a deduction when such amount is includible in the gross income of the payee.310 

With respect to stated interest and other expenses owed to related foreign corporations, Treasury 

 

307 Sec. 163(e)(1).

308 Sec. 163(e)(3).

309 Treas. Reg. sec. 1.163-12(b)(3). In the case of a PFIC, the regulations further require 

that the person owing the amount at issue have in effect a qualified electing fund election 

pursuant to section 1295 with respect to the PFIC.

310 Sec. 267(a)(2).
188

regulations provide a general rule that requires a taxpayer to use the cash method of accounting 

with respect to the deduction of amounts owed to such related foreign persons (with an exception 

for income of a related foreign person that is effectively connected with the conduct of a U.S. 

trade or business and that is not exempt from taxation or subject to a reduced rate of taxation 

under a treaty obligation).311 As in the case of OID, the Treasury regulations additionally

provide that in the case of stated interest owed to a FPHC, CFC, or PFIC, a deduction is allowed 

as of the day on which the amount is includible in the income of the FPHC, CFC or PFIC.312

Description of Proposal

The proposal provides that deductions for amounts accrued but unpaid (whether by U.S. 

or foreign persons) to related FPHCs, CFCs, or PFICs are allowable only to the extent that the 

amounts accrued by the payor are, for U.S. tax purposes, currently includible in the income of 

the direct or indirect U.S. owners of the related foreign corporation under the relevant inclusion 

rules. Deductions that have accrued but are not allowable under this proposal are allowed when 

the amounts are paid.

For purposes of determining how much of the amount accrued, if any, is currently 

includible in the income of a U.S. person under the relevant inclusion rules, properly allowable 

deductions of the related foreign corporation and qualified deficits under section 952(c)(1)(B) are 

taken into account. For this purpose, properly allowable deductions of the related foreign 

corporation are those expenses, losses, or other deductible amounts of the foreign corporation 

that are properly allocable, under the principles of section 954(b)(5), to the relevant income of 

the foreign corporation.

For example, assume the following facts. A U.S. parent corporation accrues an expense 

item of 100 to its 60-percent owned CFC. The item constitutes foreign base company income in 

the hands of the CFC. An unrelated foreign corporation owns the remaining 40 percent interest 

in the CFC. The item is the only potential subpart F income of the CFC and has not been paid by 

the end of the taxable year of the parent. Expenses of 60 are properly allocated or apportioned to 

the 100 of foreign base company income under the principles of section 954(b)(5). In addition, 

other income and expense items of the CFC result in a loss of 30, which when taken together 

with the 40 (100 - 60) of net foreign base company income, results in current net income for the 

CFC of 10. Assuming further that the CFC has no current earnings and profits adjustments, the 

CFC’s subpart F income in this case is limited to 10, six of which is includible in the gross 

income of the U.S. parent as its pro rata share of subpart F income. Under these facts, the U.S. 

parent is allowed a current deduction of 42 ((10 + 60) x 60%). If the other income and expense 

items of the CFC result in a loss of 50 instead of 30, the U.S. parent would instead be allowed a 

current deduction of 30 ((40 - 50 + 60) x 60%).

The proposal grants the Secretary regulatory authority to provide exceptions to these 

rules, including an exception for amounts accrued where payment of the amount accrued occurs 

 

311 Treas. Reg. sec. 1.267(a)-3(b)(1), -3(c).

312 Treas. Reg. sec. 1.267(a)-3(c)(4).
189

within a short period after accrual, and the transaction giving rise to the payment is entered into 

by the payor in the ordinary course of a business in which the payor is predominantly engaged.

Effective Date

The proposal is effective for payments accrued on or after date of enactment.

24. Exclusion from gross income for interest on overpayments of income tax by individuals

Present Law

Overpayment interest

Interest is included in the list of items that are required to be included in gross income 

(sec. 61(a)(4)). Interest on overpayments of Federal income tax is required to be included in 

taxable income in the same manner as any other interest that is received by the taxpayer. 

Cash basis taxpayers are required to report overpayment interest as income in the period 

the interest is received. Accrual basis taxpayers are required to report overpayment interest as 

income when all events fixing the right to the receipt of the overpayment interest have occurred 

and the amount can be estimated with reasonable accuracy. Generally, this occurs on the date 

the appropriate IRS official signs the pertinent schedule of overassessments. 

Underpayment interest

A corporate taxpayer is allowed to currently take into account interest paid on 

underpayments of Federal income tax as an ordinary and necessary business expense. Typically, 

this results in a current deduction. However, the deduction may be deferred if the interest is 

required to be capitalized or may be disallowed if and to the extent it is determined to be a cost 

of earning tax exempt income under section 265.

Section 163(h) of the Code prohibits the deduction of personal interest by taxpayers other 

than corporations. Noncorporate taxpayers, including individuals, generally are not allowed to 

deduct interest on the underpayment of Federal income taxes.

Temporary regulations provide that personal interest includes interest paid on 

underpayments of individual Federal, State or local income taxes, regardless of the source of the 

income generating the tax liability. This is consistent with the statement in the General 

Explanation of the Tax Reform Act of 1986 that “(p)ersonal interest also includes interest on 

underpayments of individual Federal, State, or local income taxes notwithstanding that all or a 

portion of the income may have arisen in a trade or business, because such taxes are not 

considered derived from conduct of a trade or business.” The validity of the temporary

regulation has been upheld in those Circuits that have considered the issue, including the Fourth, 

Fifth, Sixth, Seventh, Eighth, and Ninth Circuits. 

Personal interest also includes interest that is paid by a trust, S corporation, or other passthrough entity on underpayments of State or local income taxes. Personal interest does not 
190

include interest that is paid with respect to sales, excise or similar taxes that are incurred in 

connection with a trade or business or an investment activity. 

Description of Proposal

The proposal excludes overpayment interest that is paid to individual taxpayers on 

overpayments of Federal income tax from gross income. Interest excluded under the provision is 

not considered disqualified income that could limit the earned income credit. Interest excluded 

under the provision also is not considered in determining what portion of a taxpayer’s social 

security or tier 1 railroad retirement benefits are subject to tax (sec. 86), whether a taxpayer has 

sufficient taxable income to be required to file a return (sec. 6012(d)), or for any other 

computation in which interest exempt from tax is otherwise required to be added to adjusted 

gross income.

The exclusion from income of overpayment interest does not apply if the Secretary 

determines that the taxpayer’s principal purpose for overpaying his or her tax is to take 

advantage of the exclusion.

For example, a taxpayer prepares his return without taking into account significant 

itemized deductions of which he is, or should be, aware. Before the expiration of the statute of 

limitations, the taxpayer files an amended return claiming these itemized deductions and 

requesting a refund with interest. Unless the taxpayer can establish a principal purpose for 

originally overpaying the tax other than collecting excludible interest, the Secretary may 

determine that the principal purpose of waiting to claim the deductions on an amended return 

was to earn interest that would be excluded from income. In that case, the interest on the 

overpayment could not be excluded from income.

It is expected that the Secretary will indicate whether the interest is eligible to be 

excluded from income on the Form 1099 it provides that taxpayer for the taxable year in which 

the underpayment interest is paid. 

Effective Date

The proposal is effective for interest received in calendar years beginning after the date of 

enactment.

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

Present Law

Generally, interest on underpayments and overpayments continues to accrue during the 

period that a taxpayer and the IRS dispute a liability. The accrual of interest on an underpayment 

is suspended if the IRS fails to notify an individual taxpayer in a timely manner, but interest will 

begin to accrue once the taxpayer is properly notified. No similar suspension is available for 

other taxpayers.

A taxpayer that wants to limit its exposure to underpayment interest has a limited number 

of options. The taxpayer can continue to dispute the amount owed and risk paying a significant 
191

amount of interest. If the taxpayer continues to dispute the amount and ultimately loses, the 

taxpayer will be required to pay interest on the underpayment from the original due date of the 

return until the date of payment.

In order to avoid the accrual of underpayment interest, the taxpayer may choose to pay 

the disputed amount and immediately file a claim for refund. Payment of the disputed amount 

will prevent further interest from accruing if the taxpayer loses (since there is no longer any 

underpayment) and the taxpayer will earn interest on the resultant overpayment if the taxpayer 

wins. However, the taxpayer will generally lose access to the Tax Court if it follows this 

alternative. Amounts paid generally cannot be recovered by the taxpayer on demand, but must 

await final determination of the taxpayer’s liability. Even if an overpayment is ultimately 

determined, overpaid amounts may not be refunded if they are eligible to be offset against other 

liabilities of the taxpayer. 

The taxpayer may also make a deposit in the nature of a cash bond. The procedures for 

making a deposit in the nature of a cash bond are provided in Rev. Proc. 84-58. 

A deposit in the nature of a cash bond will stop the running of interest on an amount of 

underpayment equal to the deposit, but the deposit does not itself earn interest. A deposit in the 

nature of a cash bond is not a payment of tax and is not subject to a claim for credit or refund. A 

deposit in the nature of a cash bond may be made for all or part of the disputed liability and 

generally may be recovered by the taxpayer prior to a final determination. However, a deposit 

in the nature of a cash bond need not be refunded to the extent the Secretary determines that the 

assessment or collection of the tax determined would be in jeopardy, or that the deposit should 

be applied against another liability of the taxpayer in the same manner as an overpayment of tax. 

If the taxpayer recovers the deposit prior to final determination and a deficiency is later 

determined, the taxpayer will not receive credit for the period in which the funds were held as a 

deposit. The taxable year to which the deposit in the nature of a cash bond relates must be 

designated, but the taxpayer may request that the deposit be applied to a different year under 

certain circumstances. 

Description of Proposal

In general

The proposal allows a taxpayer to deposit cash with the IRS that may subsequently be 

used to pay an underpayment of income, gift, estate, generation-skipping, or certain excise taxes. 

Interest will not be charged on the portion of the underpayment that is deposited for the period 

that the amount is on deposit. Generally, deposited amounts that have not been used to pay a tax 

may be withdrawn at any time if the taxpayer so requests in writing. The withdrawn amounts 

will earn interest at the applicable Federal rate to the extent they are attributable to a disputable 

tax.

The Secretary may issue rules relating to the making, use, and return of the deposits.
192

Use of a deposit to offset underpayments of tax

Any amount on deposit may be used to pay an underpayment of tax that is ultimately 

assessed. If an underpayment is paid in this manner, the taxpayer will not be charged 

underpayment interest on the portion of the underpayment that is so paid for the period the funds 

were on deposit.

For example, assume a calendar year individual taxpayer deposits $20,000 on May 15, 

2005, with respect to a disputable item on its 2004 income tax return. On April 15, 2007, an 

examination of the taxpayer’s year 2004 income tax return is completed, and the taxpayer and 

the IRS agree that the taxable year 2004 taxes were underpaid by $25,000. The $20,000 on 

deposit is used to pay $20,000 of the underpayment, and the taxpayer also pays the remaining 

$5,000. In this case, the taxpayer will owe underpayment interest from April 15, 2005 (the 

original due date of the return) to the date of payment (April 15, 2007) only with respect to the 

$5,000 of the underpayment that is not paid by the deposit. The taxpayer will owe underpayment 

interest on the remaining $20,000 of the underpayment only from April 15, 2005, to May 15, 

2005, the date the $20,000 was deposited.

Withdrawal of amounts

A taxpayer may request the withdrawal of any amount of deposit at any time. The 

Secretary must comply with the withdrawal request unless the amount has already been used to 

pay tax or the Secretary properly determines that collection of tax is in jeopardy. Interest will be 

paid on deposited amounts that are withdrawn at a rate equal to the short-term applicable Federal 

rate for the period from the date of deposit to a date not more than 30 days preceding the date of 

the check paying the withdrawal. Interest is not payable to the extent the deposit was not 

attributable to a disputable tax.

For example, assume a calendar year individual taxpayer receives a 30-day letter showing 

a deficiency of $20,000 for taxable year 2004 and deposits $20,000 on May 15, 2006. On April 

15, 2007, an administrative appeal is completed, and the taxpayer and the IRS agree that the 

2004 taxes were underpaid by $15,000. $15,000 of the deposit is used to pay the underpayment. 

In this case, the taxpayer will owe underpayment interest from April 15, 2005 (the original due 

date of the return) to May 15, 2006, the date the $20,000 was deposited. Simultaneously with 

the use of the $15,000 to offset the underpayment, the taxpayer requests the return of the 

remaining amount of the deposit (after reduction for the underpayment interest owed by the 

taxpayer from April 15, 2005, to May 15, 2006). This amount must be returned to the taxpayer 

with interest determined at the short-term applicable Federal rate from the May 15, 2006, to a 

date not more than 30 days preceding the date of the check repaying the deposit to the taxpayer.

Limitation on amounts for which interest may be allowed

Interest on a deposit that is returned to a taxpayer shall be allowed for any period only to 

the extent attributable to a disputable item for that period. A disputable item is any item for 

which the taxpayer 1) has a reasonable basis for the treatment used on its return and 2) 

reasonably believes that the Secretary also has a reasonable basis for disallowing the taxpayer’s 

treatment of such item. 
193

All items included in a 30-day letter to a taxpayer are deemed disputable for this purpose. 

Thus, once a 30-day letter has been issued, the disputable amount cannot be less than the amount 

of the deficiency shown in the 30-day letter. A 30-day letter is the first letter of proposed 

deficiency that allows the taxpayer an opportunity for administrative review in the Internal 

Revenue Service Office of Appeals.

Deposits are not payments of tax

A deposit is not a payment of tax prior to the time the deposited amount is used to pay a 

tax. Similarly, withdrawal of a deposit will not establish a period for which interest was 

allowable at the short-term applicable Federal rate for the purpose of establishing a net zero 

interest rate on a similar amount of underpayment for the same period.

Effective Date

The proposal applies to deposits made after the date of enactment. Amounts already on 

deposit as of the date of enactment are treated as deposited (for purposes of applying this 

provision) on the date the taxpayer identifies the amount as a deposit made pursuant to this 

provision.

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

Present Law

The Code authorizes the IRS to enter into written agreements with any taxpayer under 

which the taxpayer is allowed to pay taxes owed, as well as interest and penalties, in installment 

payments if the IRS determines that doing so will facilitate collection of the amounts owed (sec. 

6159). An installment agreement does not reduce the amount of taxes, interest, or penalties 

owed. Generally, during the period installment payments are being made, other IRS enforcement 

actions (such as levies or seizures) with respect to the taxes included in that agreement are held 

in abeyance. 

Prior to 1998, the IRS administratively entered into installment agreements that provided 

for partial payment (rather than full payment) of the total amount owed over the period of the 

agreement. In that year, the IRS Chief Counsel issued a memorandum concluding that partial 

payment installment agreements were not permitted.

Description of Proposal

The proposal clarifies that the IRS is authorized to enter into installment agreements with 

taxpayers which do not provide for full payment of the taxpayer’s liability over the life of the 

agreement. The proposal also requires the IRS to review partial payment installment agreements 

at least every two years. The primary purpose of this review is to determine whether the 

financial condition of the taxpayer has significantly changed so as to warrant an increase in the 

value of the payments being made.
194

Effective Date

The proposal is effective for installment agreements entered into on or after the date of 

enactment. 

27. Affirmation of consolidated return regulation authority 

Present Law

An affiliated group of corporations may elect to file a consolidated return in lieu of 

separate returns. A condition of electing to file a consolidated return is that all corporations that 

are members of the consolidated group must consent to all the consolidated return regulations 

prescribed under section 1502 prior to the last day prescribed by law for filing such return. 313 

Section 1502 states:

The Secretary shall prescribe such regulations as he may deem necessary in order that the 

tax liability of any affiliated group of corporations making a consolidated return and of 

each corporation in the group, both during and after the period of affiliation, may be 

returned, determined, computed, assessed, collected, and adjusted, in such manner as 

clearly to reflect the income-tax liability and the various factors necessary for the 

determination of such liability, and in order to prevent the avoidance of such tax 

liability.314

Under this authority, the Treasury Department has issued extensive consolidated return 

regulations.315

In the recent case of Rite Aid Corp. v. United States,316 the Federal Circuit Court of 

Appeals addressed the application of a particular provision of certain consolidated return loss 

 

313 Sec. 1501.

314 Sec. 1502. 

315 Regulations issued under the authority of section 1502 are considered to be 

“legislative” regulations rather than “interpretative” regulations, and as such are usually given 

greater deference by courts in case of a taxpayer challenge to such a regulation. See, S. Rep. No. 

960, 70th Cong., 1st Sess. at 15 (1928), describing the consolidated return regulations as 

“legislative in character”. The Supreme Court has stated that “. . . legislative regulations are 

given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the 

statute.” Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 844 

(1984) (involving an environmental protection regulation). For examples involving consolidated 

return regulations, see, e.g., Wolter Construction Company v. Commissioner, 634 F.2d 1029 (6th

Cir. 1980); Garvey, Inc. v. United States, 1 Ct. Cl. 108 (1983), aff’d,726 F.2d 1569 (Fed. Cir. 

1984), cert. denied, 469 U.S. 823 (1984). Compare, e.g., Audrey J. Walton v. Commissioner, 115 

T.C. 589 (2000), describing different standards of review. The case did not involve a 

consolidated return regulation. 
195

disallowance regulations, and concluded that the provision was invalid.317 The particular 

provision, known as the “duplicated loss” provision,318 would have denied a loss on the sale of 

stock of a subsidiary by a parent corporation that had filed a consolidated return with the 

subsidiary, to the extent the subsidiary corporation had assets that had a built-in loss, or had a net 

operating loss, that could be recognized or used later.319 

 

316 255 F.3d 1357 (Fed. Cir. 2001), reh’g denied, 2001 U.S. App. LEXIS 23207 (Fed. 

Cir. Oct. 3, 2001).

317 Prior to this decision, there had been a few instances involving prior laws in which 

certain consolidated return regulations were held to be invalid. See, e.g., American Standard, Inc. 

v. United States, 602 F.2d 256 (Ct. Cl. 1979), discussed in the text infra. see also Union Carbide 

Corp. v. United States, 612 F.2d 558 (Ct. Cl. 1979), and Allied Corporation v. United States, 685 

F. 2d 396 (Ct. Cl. 1982), all three cases involving the allocation of income and loss within a 

consolidated group for purposes of computation of a deduction allowed under prior law by the 

Code for Western Hemisphere Trading Corporations. See also Joseph Weidenhoff v. 

Commissioner, 32 T.C. 1222, 1242-1244 (1959), involving the application of certain regulations 

to the excess profits tax credit allowed under prior law, and concluding that the Commissioner 

had applied a particular regulation in an arbitrary manner inconsistent with the wording of the 

regulation and inconsistent with even a consolidated group computation. Cf. Kanawha Gas & 

Utilities Co. v. Commissioner, 214 F.2d 685 (1954), concluding that the substance of a 

transaction was an acquisition of assets rather than stock. Thus, a regulation governing basis of 

the assets of consolidated subsidiaries did not apply to the case. See also General Machinery 

Corporation v. Commissioner, 33 B.T.A. 1215 (1936); Lefcourt Realty Corporation, 31 B.T.A. 

978 (1935); Helvering v. Morgans, Inc., 293 U.S. 121 (1934), interpreting the term “taxable 

year.” 

318 Treas. Reg. sec. 1.1502-20(c)(1)(iii).

319 Treasury Regulation section 1.1502-20, generally imposing certain “loss 

disallowance” rules on the disposition of subsidiary stock, contained other limitations besides the 

“duplicated loss” rule that could limit the loss available to the group on a disposition of a 

subsidiary’s stock. Treasury Regulation section 1.1502-20 as a whole was promulgated in 

connection with regulations issued under section 337(d), principally in connection with the socalled General Utilities repeal of 1986 (referring to the case of General Utilities & Operating 

Company v. Helvering, 296 U.S. 200 (1935)). Such repeal generally required a liquidating 

corporation, or a corporation acquired in a stock acquisition treated as a sale of assets, to pay 

corporate level tax on the excess of the value of its assets over the basis. Treasury regulation 

section 1.1502-20 principally reflected an attempt to prevent corporations filing consolidated 

returns from offsetting income with a loss on the sale of subsidiary stock. Such a loss could 

result from the unique upward adjustment of a subsidiary’s stock basis required under the 

consolidated return regulations for subsidiary income earned in consolidation, an adjustment 

intended to prevent taxation of both the subsidiary and the parent on the same income or gain. 

As one example, absent a denial of certain losses on a sale of subsidiary stock, a consolidated 

group could obtain a loss deduction with respect to subsidiary stock, the basis of which originally 

reflected the subsidiary’s value at the time of the purchase of the stock, and that had then been 
196

The Federal Circuit Court opinion contained language discussing the fact that the 

regulation produced a result different than the result that would have obtained if the corporations 

had filed separate returns rather than consolidated returns.320 

The Federal Circuit Court opinion cited a 1928 Senate Finance Committee Report to 

legislation that authorized consolidated return regulations, which stated that “many difficult and 

complicated problems, ... have arisen in the administration of the provisions permitting the filing 

of consolidated returns” and that the committee “found it necessary to delegate power to the 

commissioner to prescribe regulations legislative in character covering them.”321 The Court’s 

opinion also cited a previous decision of the Court of Claims for the proposition, interpreting this 

legislative history, that section 1502 grants the Secretary “the power to conform the applicable 

income tax law of the Code to the special, myriad problems resulting from the filing of 

consolidated income tax returns;” but that section 1502 “does not authorize the Secretary to 

choose a method that imposes a tax on income that would not otherwise be taxed.” 322

 

adjusted upward on recognition of any built-in income or gain of the subsidiary reflected in that 

value. The regulations also contained the duplicated loss factor addressed by the court in Rite 

Aid. The preamble to the regulations stated: “it is not administratively feasible to differentiate 

between loss attributable to built-in gain and duplicated loss.” T.D. 8364, 1991-2 C.B. 43, 46 

(Sept. 13, 1991). The government also argued in the Rite Aid case that duplicated loss was a 

separate concern of the regulations. 255 F.3d at 1360. 

320 For example, the court stated: “The duplicated loss factor . . . addresses a situation 

that arises from the sale of stock regardless of whether corporations file separate or consolidated 

returns. With I.R.C. secs. 382 and 383, Congress has addressed this situation by limiting the 

subsidiary’s potential future deduction, not the parent’s loss on the sale of stock under I.R.C. sec. 

165.” 255 F.3d 1357, 1360 (Fed. Cir. 2001).

321 S. Rep. No. 960, 70th Cong., 1st Sess. 15 (1928). Though not quoted by the court in 

Rite Aid, the same Senate report also indicated that one purpose of the consolidated return 

authority was to permit treatment of the separate corporations as if they were a single unit, 

stating “The mere fact that by legal fiction several corporations owned by the same shareholders 

are separate entities should not obscure the fact that they are in reality one and the same business 

owned by the same individuals and operated as a unit.” S. Rep. No. 960, 70th Cong., 1st Sess. 29 

(1928). 

322

 American Standard, Inc. v. United States, 602 F.2d 256, 261 (Ct. Cl. 1979). That 

case did not involve the question of separate returns as compared to a single return approach. It 

involved the computation of a Western Hemisphere Trade Corporation (“WHTC”) deduction 

under prior law (which deduction would have been computed as a percentage of each WHTC’s 

taxable income if the corporations had filed separate returns), in a case where a consolidated 

group included several WHTCs as well as other corporations. The question was how to 

apportion income and losses of the admittedly consolidated WHTCs and how to combine that 

computation with the rest of the group’s consolidated income or losses. The court noted that the 

new, changed regulations approach varied from the approach taken to a similar problem 

involving public utilities within a group and previously allowed for WHTCs. The court objected 
197

The Federal Circuit Court construed these authorities and applied them to invalidate 

Treas. Reg. Sec. 1.1502-20(c)(1)(iii), stating that:

The loss realized on the sale of a former subsidiary’s assets after the consolidated 

group sells the subsidiary’s stock is not a problem resulting from the filing of 

consolidated income tax returns. The scenario also arises where a corporate 

shareholder sells the stock of a non-consolidated subsidiary. The corporate 

shareholder could realize a loss under I.R.C. sec. 1001, and deduct the loss under 

I.R.C. sec. 165. The subsidiary could then deduct any losses from a later sale of 

assets. The duplicated loss factor, therefore, addresses a situation that arises from the 

sale of stock regardless of whether corporations file separate or consolidated returns. 

With I.R.C. secs. 382 and 383, Congress has addressed this situation by limiting the 

subsidiary’s potential future deduction, not the parent’s loss on the sale of stock under 

I.R.C. sec. 165.323

The Treasury Department has announced that it will not continue to litigate the validity of 

the duplicated loss provision of the regulations, and has issued interim regulations that permit 

taxpayers for all years to elect a different treatment, though they may apply the provision for the 

past if they wish. 324

Description of Proposal

The proposal confirms that, in exercising its authority under section 1502 to issue 

consolidated return regulations, the Treasury Department may provide rules treating corporations 

filing consolidated returns differently from corporations filing separate returns. 

Thus, under the statutory authority of section 1502, the Treasury Department is 

authorized to issue consolidated return regulations utilizing either a single taxpayer or separate 

 

that the allocation method adopted by the regulation allowed non-WHTC losses to reduce 

WHTC income. However, the court did not disallow a method that would net WHTC income of 

one WHTC with losses of another WHTC, a result that would not have occurred under separate 

returns. Nor did the court expressly disallow a different fractional method that would net both 

income and losses of the WHTCs with those of other corporations in the consolidated group. 

The court also found that the regulation had been adopted without proper notice. 

323

 Rite Aid, 255 F.3d at 1360.

324

 See Temp. Reg. sec. 1.1502-20T(i)(2), Temp. Reg. sec. 1.337(d)-2T, and Temp. Reg. 

sec. 1.1502-35T. The Treasury Department has also indicated its intention to continue to study 

all the issues that the original loss disallowance regulations addressed (including issues of 

furthering single entity principles) and possibly issue different regulations (not including the 

particular approach of Treas. Reg. Sec. 1.1502-20(c)(1)(iii)) on the issues in the future. See

Notice 2002-11, 2002-7 I.R.B. 526 (Feb. 19, 2002); T.D. 8984, 67 F.R. 11034 (March 12, 2002); 

REG-102740-02, 67 F.R. 11070 (March 12, 2002); see also Notice 2002-18, 2002-12 I.R.B. 644 

(March 25, 2002); REG-131478-02, 67 F.R. 65060 (October 18, 2002)T.D. 9048, 68 F.R. 12287 

(March 14, 2003); and T.D. 9118, REG-153172-03 (March 17, 2004). 
198

taxpayer approach or a combination of the two approaches, as Treasury deems necessary in order 

that the tax liability of any affiliated group of corporations making a consolidated return, and of 

each corporation in the group, both during and after the period of affiliation, may be determined 

and adjusted in such manner as clearly to reflect the income-tax liability and the various factors 

necessary for the determination of such liability, and in order to prevent avoidance of such 

liability. 

Rite Aid is thus overruled to the extent it suggests that the Secretary is required to identify 

a problem created from the filing of consolidated returns in order to issue regulations that change 

the application of a Code provision. The Secretary may promulgate consolidated return

regulations to change the application of a tax code provision to members of a consolidated group, 

provided that such regulations are necessary to clearly reflect the income tax liability of the 

group and each corporation in the group, both during and after the period of affiliation. 

The proposal nevertheless allows the result of the Rite Aid case to stand with respect to 

the type of factual situation presented in the case. That is, the legislation provides for the 

override of the regulatory provision that took the approach of denying a loss on a 

deconsolidating disposition of stock of a consolidated subsidiary325 to the extent the subsidiary 

had net operating losses or built in losses that could be used later outside the group.326

Retaining the result in the Rite Aid case with respect to the particular regulation section 

1.1502-20(c)(1)(iii) as applied to the factual situation of the case does not in any way prevent or 

invalidate the various approaches Treasury has announced it will apply or that it intends to 

consider in lieu of the approach of that regulation, including, for example, the denial of a loss on 

a stock sale if inside losses of a subsidiary may also be used by the consolidated group, and the 

possible requirement that inside attributes be adjusted when a subsidiary leaves a group.327

 

325 Treas. Reg. sec. 1.1502-20(c)(1)(iii).

326 The provision is not intended to overrule the current Treasury Department 

regulations, which allow taxpayers in certain circumstances for the past to follow Treasury 

Regulations section 1.1502-20(c)(1)(iii), if they choose to do so. Temp. Reg. sec. 1.1502-

20T(i)(2). 

327

 See, e.g., Notice 2002-11, 2002-7 I.R.B. 526 (Feb. 19, 2002); Temp. Reg. Sec. 

1.337(d)-2T, (T.D. 8984, 67 F.R. 11034 (March 12, 2002) and T.D. 8998, 67 F.R. 37998 (May 

31, 2002)); REG-102740-02, 67 F.R. 11070 (March 12, 2002); see also Notice 2002-18, 2002-12 

I.R.B. 644 (March 25, 2002); REG-131478-02, 67 F.R. 65060 (October 18, 2002); Temp. Reg. 

Sec. 1.1502-35T (T.D. 9048, 68 F.R. 12287 (March 14, 2003)); and T.D. 9118, REG-153172-03 

(March 17, 2004). In exercising its authority under section 1502, the Secretary is also authorized 

to prescribe rules that protect the purpose of General Utilities repeal using presumptions and 

other simplifying conventions.
199

Effective Date

The proposal is effective for all years, whether beginning before, on, or after the date of 

enactment of the provision. No inference is intended that the results following from this 

proposal are not the same as the results under present law.

28. Reform of tax treatment of certain leasing arrangements and limitation on deductions 

allocable to property used by governments or other tax-exempt entities

Present Law

Overview of depreciation

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

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

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

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

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

based on such property’s class life. The recovery periods applicable to most tangible personal 

property (generally tangible property other than residential rental property and nonresidential 

real property) range from 3 to 25 years and are significantly shorter than the property’s class life, 

which is intended to approximate the economic useful life of the property. In addition, the 

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

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

in which the depreciation deduction would be maximized.

Characterization of leases for tax purposes

In general, a taxpayer is treated as the tax owner and is entitled to depreciate property 

leased to another party if the taxpayer acquires and retains significant and genuine attributes of a 

traditional owner of the property, including the benefits and burdens of ownership. No single 

factor is determinative of whether a lessor will be treated as the owner of the property. Rather, 

the determination is based on all the facts and circumstances surrounding the leasing transaction.

A sale-leaseback transaction is respected for Federal tax purposes if “there is a genuine 

multiple-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.”328

Recovery period for tax-exempt use property

Under present law, “tax-exempt use property” must be depreciated on a straight-line basis 

over a recovery period equal to the longer of the property’s class life or 125 percent of the lease 

 

328

 Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978).
200

term. 329 For purposes of this rule, “tax-exempt use property” is tangible property that is leased 

(other than under a short-term lease) to a tax-exempt entity. 330 For this purpose, the term “taxexempt entity” includes Federal, State and local governmental units, charities, and, foreign 

entities or persons.331

In determining the length of the lease term for purposes of the 125-percent calculation, 

several special rules apply. In addition to the stated term of the lease, the lease term includes 

options to renew the lease or other periods of time during which the lessee could be obligated to 

make rent payments or assume a risk of loss related to the leased property.

Tax-exempt use property does not include property that is used by a taxpayer to provide a 

service to a tax-exempt entity. So long as the relationship between the parties is a bona fide 

service contract, the taxpayer will be allowed to depreciate the property used in satisfying the 

contract under normal MACRS rules, rather than the rules applicable to tax-exempt use 

property. 332 In addition, property is not treated as tax-exempt use property merely by reason of a 

short-term lease. In general, a short-term lease means any lease the term of which is less than 

three years and less than the greater of one year or 30 percent of the property’s class life.333

Also, tax-exempt use property generally does not include qualified technological 

equipment that meets the exception for leases of high technology equipment to tax-exempt 

entities with lease terms of five years or less.334 The recovery period for qualified technological 

equipment that is treated as tax-exempt use property, but is not subject to the high technology 

equipment exception, is five years.335

 

329 Sec. 168(g)(3)(A). Under present law, section 168(g)(3)(C) states that the recovery 

period of “qualified technological equipment” is five years.

330 Sec. 168(h)(1).

331 Sec. 168(h)(2).

332 Sec. 7701(e) provides that a service contract will not be respected, and instead will be 

treated as a lease of property, if such contract is properly treated as a lease taking into account all 

relevant factors. The relevant factors include, among others, the service recipient controls the 

property, the service recipient is in physical possession of the property, the service provider does 

not bear significant risk of diminished receipts or increased costs if there is nonperformance, the 

property is not used to concurrently provide services to other entities, and the contract price does 

not substantially exceed the rental value of the property. 

333 Sec. 168(h)(1)(C).

334 Sec. 168(h)(3). However, the exception does not apply if part or all of the qualified 

technological equipment is financed by a tax-exempt obligation, is sold by the tax-exempt entity 

(or related party) and leased back to the tax-exempt entity (or related party), or the tax-exempt 

entity is the United States or any agency or instrumentality of the United States. 

335 Sec. 168(g)(3)(C).
201

The term “qualified technological equipment” is defined as computers and related 

peripheral equipment, high technology telephone station equipment installed on a customer’s 

premises, and high technology medical equipment. 336 In addition, tax-exempt use property does 

not include computer software because it is intangible property.

Description of Proposal

Overview

The proposal modifies the recovery period of certain property leased to a tax-exempt 

entity, alters the definition of lease term for all property leased to a tax-exempt entity, and 

establishes rules to limit deductions associated with leases to tax-exempt entities if the leases do 

not satisfy specified criteria.

Modify the recovery period of certain property leased to a tax-exempt entity

The proposal modifies the recovery period for qualified technological equipment and 

computer software leased to a tax-exempt entity337 to be the longer of the property’s assigned 

class life or 125 percent of the lease term. The proposal does not apply to short-term leases, as 

defined under present law with a modification described below for short-term leases of qualified 

technological equipment.

Modify definition of lease term

In determining the length of the lease term for purposes of the 125-percent calculation, 

the proposal provides that the lease term includes all service contracts (whether or not treated as 

a lease under section 7701(e)) and other similar arrangements that follow a lease of property to a 

tax-exempt entity and that are part of the same transaction (or series of transactions) as the lease. 

Under the proposal, service contracts and other similar arrangements include arrangements by 

which services are provided using the property in exchange for fees that provide a source of 

repayment of the capital investment in the property. 338 This requirement applies to all leases of 

property to a tax-exempt entity.

 

336 Sec. 168(i)(2).

337 The proposal defines a tax-exempt entity as under present law. Thus, it includes 

Federal, State, local, and foreign governmental units, charities, foreign entities or persons.

338 For purposes of the proposal, a service contract does not include an arrangement for 

the provision of services if the leased property or substantially similar property is not utilized to 

provide such services. For example, if at the conclusion of a lease term, a tax-exempt lessee 

purchases property from the taxpayer and enters into an agreement pursuant to which the 

taxpayer maintains the property, the maintenance agreement will not be included in the lease 

term for purposes of the 125-percent computation.
202

Expand short-term lease exception for qualified technological equipment

For purposes of determining whether a lease of qualified technological equipment to a 

tax-exempt entity satisfies the present-law 5-year short-term lease exception for leases of 

qualified technological equipment, the proposal provides that the term of the lease does not 

include an option or options of the lessee to renew or extend the lease, provided the rents under 

the renewal or extension are based upon fair market value determined at the time of the renewal 

or extension. The aggregate period of such renewals or extensions not included in the lease term 

under this provision may not exceed 24 months. In addition, this provision does not apply to any 

period following the failure of a tax-exempt lessee to exercise a purchase option if the result of 

such failure is that the lease renews automatically at fair market value rents.

Limit deductions for leases of property to tax-exempt parties

The proposal also provides that if a taxpayer leases property to a tax-exempt entity, the 

taxpayer may not claim deductions from the lease transaction in excess of the taxpayer’s gross 

income from the lease for that taxable year. This provision does not apply to certain transactions 

involving property with respect to which the low-income housing credit or the rehabilitation 

credit is allowable.

This provision applies to deductions or losses related to a lease to a tax-exempt entity and 

the leased property.339 Any disallowed deductions are carried forward and treated as deductions 

related to the lease in the following taxable year subject to the same limitations. Under rules 

similar to those applicable to passive activity losses (including the treatment of dispositions of 

property in which less than all disposition gain or loss is recognized),340 a taxpayer generally is 

permitted to deduct previously disallowed deductions and losses when the taxpayer completely 

disposes of its interest in the property.

A lease of property to a tax-exempt party is not subject to the deduction limitations of this 

provision if the lease satisfies all of the following requirements:341

(1) Tax-exempt lessee does not monetize its lease obligation

 

339 Deductions related to a lease of tax-exempt use property include any depreciation or 

amortization expense, maintenance expense, taxes or the cost of acquiring an interest in, or lease 

of, property. In addition, this provision applies to interest that is properly allocable to taxexempt use property, including interest on any borrowing by a related person, the proceeds of 

which were used to acquire an interest in the property, whether or not the borrowing is secured 

by the leased property or any other property.

340

 See Sec. 469(g).

341 Even if a transaction satisfies each of the following requirements, the taxpayer will be 

treated as the owner of the leased property only if the taxpayer acquires and retains significant 

and genuine attributes of an owner of the property under the present-law tax rules, including the 

benefits and burdens of ownership.
203

In general, the tax-exempt lessee may not monetize its lease obligations (including any 

purchase option) in an amount that exceeds 20 percent of the taxpayer’s adjusted basis342 in the 

leased property at the time the lease is entered into.343 Specifically, a lease does not satisfy this 

requirement if the tax-exempt lessee monetizes such excess amount pursuant to an arrangement, 

set-aside, or expected set-aside, that is to or for the benefit of the taxpayer or any lender, or is to 

or for the benefit of the tax-exempt lessee, in order to satisfy the lessee’s obligations or options 

under the lease. This determination shall be made at all times during the lease term and shall 

include the amount of any interest or other income or gain earned on any amount set aside or 

subject to an arrangement described in this provision. For purposes of determining whether 

amounts have been set aside or are expected to be set aside, amounts are treated as set aside or 

expected to be set aside only if a reasonable person would conclude that the facts and 

circumstances indicate that such amounts are set aside or expected to be set aside.344

The Secretary may provide by regulations that this requireme nt is satisfied, even if a taxexempt lessee monetizes its lease obligations or options in an amount that exceeds 20 percent of 

the taxpayer’s adjusted basis in the leased property, in cases in which the creditworthiness of the 

tax-exempt lessee would not otherwise satisfy the taxpayer’s customary underwriting standards. 

Such credit support would not be permitted to exceed 50 percent of the taxpayer’s adjusted basis 

in the property. In addition, if the lease provides the tax-exempt lessee an option to purchase the 

property for a fixed purchase price (or for other than the fair market value of the property 

determined at the time of exercise of the option), such credit support at the time that such option 

may be exercised would not be permitted to exceed 50 percent of the purchase option price.

Certain circular lease transactions fail this requirement without regard to the amount by 

which the tax-exempt lessee monetizes its lease obligations or options. Thus, a lease does not 

satisfy this requirement if the tax-exempt lessee enters into an arrangement to monetize in any 

amount its lease obligations or options if such arrangement involves (1) a loan (other than an 

amount treated as a loan under section 467 with respect to a section 467 rental agreement) from 

 

342 For purposes of this requirement, the adjusted basis of property acquired by the 

taxpayer in a like-kind exchange or involuntary conversion to which section 1031 or section 

1033 applies is equal to the lesser of (1) the fair market value of the property as of the beginning 

of the lease term, or (2) the amount that would be the taxpayer’s adjusted basis if section 1031 or 

section 1033 did not apply to such acquisition.

343 Arrangements to monetize lease obligations include defeasance arrangements, loans 

by the tax-exempt entity (or an affiliate) to the taxpayer (or an affiliate) or any lender, deposit 

agreements, letters of credit collateralized with cash or cash equivalents, payment undertaking 

agreements, prepaid rent (within the meaning of the regulations under section 467), sinking fund 

arrangements, guaranteed investment contracts, financial guaranty insurance, or any similar 

arrangements.

344 It is anticipated that the customary and budgeted funding by tax-exempt entities of 

unrestricted accounts or funds for general working capital needs or for the purpose of exercising 

a purchase option under a lease will not be considered arrangements, set-asides, or expected setasides under this requirement.
204

the tax-exempt lessee to the taxpayer or a lender, (2) a deposit that is received, a letter of credit 

that is issued, or a payment undertaking agreement that is entered into by a lender otherwise 

involved in the transaction, or (3) in the case of a transaction that involves a lender, any credit 

support made available to the taxpayer in which any such lender does not have a claim that is 

senior to the taxpayer.

(2) Taxpayer maintains a substantial equity investment in property

The taxpayer must make and maintain a substantial equity investment in the leased 

property. For this purpose, a taxpayer generally does not make or maintain a substantial equity 

investment unless (1) at the time the lease is entered into, the taxpayer initially makes an 

unconditional at-risk equity investment in the property of at least 20 percent of the taxpayer’s 

adjusted basis345 in the leased property at that time,346 (2) the taxpayer maintains such equity 

investment throughout the lease term (unless the lease term is 5 years or less), and (3) at all times 

during the lease term, the fair market value of the property at the end of the lease term is 

reasonably expected to be equal to at least 20 percent of such basis (unless the lease term is 5 

years or less).347 For this purpose, the fair market value of the property at the end of the lease 

term is reduced to the extent that a person other than the taxpayer bears a risk of loss in the value 

of the property.

(3) Tax-exempt lessee does not bear more than minimal risk of loss

The tax-exempt lessee generally may not assume or retain more than a minimal risk of 

loss, other than the obligation to pay rent and insurance premiums, to maintain the property, or 

other similar conventional obligations of a net lease.348 For this purpose, a tax-exempt lessee 

 

345 For purposes of this requirement, the adjusted basis of property acquired by the 

taxpayer in a like-kind exchange or involuntary conversion to which section 1031 or section 

1033 applies is equal to the lesser of (1) the fair market value of the property as of the beginning 

of the lease term, or (2) the amount that would be the taxpayer’s adjusted basis if section 1031 or 

section 1033 did not apply to such acquisition.

346 The taxpayer’s at-risk equity investment shall include only consideration paid, and 

personal liability incurred, by the taxpayer to acquire the property. Cf. Rev. Proc. 2001-28, 

2001-2 C.B. 1156.

347

 Cf. Rev. Proc. 2001-28, sec. 4.01(2), 2001-1 C.B. 1156. The fair market value of the 

property must be determined without regard to inflation or deflation during the lease term and 

after subtracting the cost of removing the property.

348 Examples of arrangements by which a tax-exempt lessee might assume or retain a 

risk of loss include put options, residual value guarantees, residual value insurance, and service 

contracts. However, leases do not fail to satisfy this requirement solely by reason of lease 

provisions that require the tax-exempt lessee to pay a contractually stipulated loss value to the 

taxpayer in the event of an early termination due to a casualty loss, a material default by the taxexempt lessee (excluding the failure by the tax-exempt lessee to enter into an arrangement 
205

assumes or retains more than a minimal risk of loss if, as a result of obligations assumed or 

retained by, on behalf of, or pursuant to an agreement with the tax-exempt lessee, the taxpayer is 

protected from either (1) any portion of the loss that would occur if the fair market value of the 

leased property were 25 percent less than the leased property’s reasonably expected fair market 

value at the time the lease is terminated, or (2) an aggregate loss that is greater than 50 percent of 

the loss that would occur if the fair market value of the leased property were zero at lease 

termination. 349 In addition, the Secretary may provide by regulations that this requirement is not 

satisfied where the tax-exempt lessee otherwise retains or assumes more than a minimal risk of 

loss. Such regulations shall be prospective only.

This requirement does not apply to leases with lease terms of 5 years or less.

Coordination with like-kind exchange and involuntary conversion rules

Under this provision, neither the like-kind exchange rules (sec. 1031) nor the involuntary 

conversion rules (sec. 1033) apply if either (1) the exchanged or converted property is taxexempt use property subject to a lease that was entered into prior to the effective date of this 

provision and the lease would not have satisfied the requirements of this provision had such 

requirements been in effect when the lease was entered into, or (2) the replacement property is 

tax-exempt use property subject to a lease that does not meet the requirements of this provision.

Other rules

This provision continues to apply throughout the lease term to property that initially was 

tax-exempt use property, even if the property ceases to be tax-exempt use property during the 

lease term. 350 In addition, this provision is applied before the application of the passive activity 

loss rules under section 469.

This provision does not alter the treatment of any Qualified Motor Vehicle Operating 

Agreement within the meaning of section 7701(h). In the case of any such agreement, the 

second and third requirements provided by this provision (relating to taxpayer equity investment 

and tax-exempt lessee risk of loss, respectively) shall be applied without regard to any terminal 

rental adjustment clause.

 

described above), or other similar extraordinary events that are not reasonably expected to occur 

at lease inception.

349 For purposes of this requirement, residual value protection provided to the taxpayer 

by a manufacturer or dealer of the leased property is not treated as borne by the tax-exempt 

lessee if the manufacturer or dealer provides such residual value protection to customers in the 

ordinary course of its business.

350 Conversely, however, a lease of property that is not tax-exempt use property does not 

become subject to this provision solely by reason of requisition or seizure by the Federal 

government in national emergency circumstances.
206

Effective Date

The proposal generally is effective for leases entered into after March 12, 2004.351 

However, the proposal does not apply to property located in the United States that is subject to a 

lease with respect to which a formal application (1) was submitted for approval to the Federal 

Transit Administration (an agency of the Department of Transportation) after June 30, 2003, and 

before March 13, 2004, (2) is approved by the Federal Transit Administration before January 1, 

2005, and (3) includes a description and the fair market value of such property.

The provisions relating to coordination with the like-kind exchange and involuntary 

conversion rules are effective with respect to property that is exchanged or converted after the 

date of enactment.

No inference is intended regarding the appropriate present-law tax treatment of 

transactions entered into prior to the effective date of this proposal. In addition, it is intended 

that this proposal shall not be construed as altering or supplanting the present-law tax rules 

providing that a taxpayer is treated as the owner of leased property only if the taxpayer acquires 

and retains significant and genuine attributes of an owner of the property, including the benefits 

and burdens of ownership. This proposal also is not intended to affect the scope of any other 

present-law tax rules or doctrines applicable to purported leasing transactions.

 

351 If a lease entered into on or before March 12, 2004, is transferred in a transaction that 

does not materially alter the terms of such lease, this proposal shall not apply to the lease as a 

result of such transfer.
207

C. Reduction of Fuel Tax Evasion

1. Exemption from certain excise taxes for mobile machinery vehicles

Present Law

Under present law, the definition of a “highway vehicle” affects the application of the 

retail tax on heavy vehicles, the heavy vehicle use tax, the tax on tires, and fuel taxes.352 Section 

4051 of the Code provides for a 12-percent retail sales tax on tractors, heavy trucks with a gross 

vehicle weight (“GVW”) over 33,000 pounds, and trailers with a GVW over 26,000 pounds. 

Section 4071 provides for a tax on highway vehicle tires that weigh more than 40 pounds, with 

higher rates of tax for heavier tires. Section 4481 provides for an annual use tax on heavy 

vehicles with a GVW of 55,000 pounds or more, with higher rates of tax on heavier vehicles. 

All of these excise taxes are paid into the Highway Trust Fund.

Federal excise taxes are also levied on the motor fuels used in highway vehicles. 

Gasoline is subject to a tax of 18.4 cents per gallon, of which 18.3 cents per gallon is paid into 

the Highway Trust Fund and 0.1 cent per gallon is paid into the Leaking Underground Storage 

Tank (“LUST”) Trust Fund. Highway diesel fuel is subject to a tax of 24.4 cents per gallon, of 

which 24.3 cents per gallon is paid into the Highway Trust Fund and 0.1 cent per gallon is paid 

into the LUST Trust Fund.

The Code does not define a “highway vehicle.” For purposes of these taxes, Treasury 

regulations define a highway vehicle as any self-propelled vehicle or trailer or semitrailer 

designed to perform a function of transporting a load over the public highway, whether or not 

also designed to perform other functions. Excluded from the definition of highway vehicle are 

(1) certain specially designed mobile machinery vehicles for non-transportation functions (the 

“mobile machinery exception”); (2) certain vehicles specially designed for off-highway 

transportation for which the special design substantially limits or impairs the use of such vehicle 

to transport loads over the highway (the “off-highway transportation vehicle” exception); and (3) 

certain trailers and semi-trailers specially designed to function only as an enclosed stationary 

shelter for the performance of non-transportation functions off the public highways.353

The mobile machinery exception applies if three tests are met: (1) the vehicle consists of 

a chassis to which jobsite machinery (unrelated to transportation) has been permanently 

mounted; (2) the chassis has been specially designed to serve only as a mobile carriage and 

mount for the particular machinery; and (3) by reason of such special design, the chassis could 

not, without substantial structural modification, be used to transport a load other than the 

particular machinery. An example of a mobile machinery vehicle is a crane mounted on a truck 

chassis that meets the forgoing factors.

 

352 Secs. 4051, 4071, 4481, 4041 and 4081.

353 See Treas. Reg. sec. 48.4061-1(d). 
208

On June 6, 2002, the Treasury Department put forth proposed regulations that would 

eliminate the mobile machinery exception. 354 The other exceptions from the definition of 

highway vehicle would continue to apply with some modifications. Under the proposed 

regulations, the chassis of a mobile machinery vehicle would be subject to the retail sales tax on 

heavy vehicles unless the vehicle qualified under the off-highway transportation vehicle 

exception. Also, under the proposed regulations, mobile machinery vehicles may be subject to 

the heavy vehicle use tax. In addition, the tax credits, refunds, and exemptions from tax may not 

be available for the fuel used in these vehicles.

Description of Proposal

The proposal codifies the present-law mobile machinery exemption for purposes of three 

taxes: the retail tax on heavy vehicles, the heavy vehicle use tax, and the tax on tires. Thus, if a 

vehicle can satisfy the three-part test, it will not be treated as a highway vehicle and will be 

exempt from these taxes. 

For purposes of the fuel excise tax, the three-part design test is codified and a use test is 

added by the proposal. Specifically, in addition to the three-part design test, the vehicle must 

not have traveled more than 7,500 miles over public highways during the owner’s taxable year. 

Refunds of fuel taxes are permitted on an annual basis only. For purposes of this rule, a person’s 

taxable year is his taxable year for income tax purposes.

Effective Date

The proposal generally is effective after the date of enactment. As to the fuel taxes, the 

proposal is effective for taxable years beginning after the date of enactment.

2. Taxation of aviation-grade kerosene

Present Law

In general

Aviation fuel is kerosene and any liquid (other than any product taxable under section 

4081) that is suitable for use as a fuel in an aircraft. 355 Unlike other fuels that generally are taxed 

upon removal from a terminal rack, 356 aviation fuel is taxed upon sale of the fuel by a producer 

or importer.357 Sales by a registered producer to another registered producer are exempt from 

tax, with the result that, as a practical matter, aviation fuel is not taxed until the fuel is used at the 

 

354 Prop. Treas. Reg. sec. 48.4051-1(a), 67 Fed. Reg. 38913, 38914-38915 (2002).

355 Sec. 4093(a).

356 A rack is a mechanism capable of delivering taxable fuel into a means of transport 

other than a pipeline or vessel. Treas. Reg. sec. 48.4081-1(b).

357 Sec. 4091(a)(1). 
209

airport. Use of untaxed aviation fuel by a producer is treated as a taxable sale.358 The producer 

or importer is liable for the tax. The rate of tax on aviation fuel is 21.9 cents per gallon. 359 

The tax on aviation fuel is reported by filing Form 720 - Quarterly Federal Excise Tax 

Return. Generally, semi-monthly deposits are required using Form 8109B - Federal Tax Deposit 

Coupon or by depositing the tax by electronic funds transfer.

Partial exemptions

In general, aviation fuel sold for use or used in commercial aviation is taxed at a reduced 

rate of 4.4 cents per gallon. 360 Commercial aviation means any use of an aircraft in a business of 

transporting persons or property for compensation or hire by air (unless the use is allocable to 

any transportation exempt from certain excise taxes).361 

In order to qualify for the 4.4 cents per gallon rate, the person engaged in commercial 

aviation must be registered with the Secretary362 and provide the seller with a written exemption 

certificate stating the airline’s name, address, taxpayer identification number, registration 

number, and intended use of the fuel. A person that is registered as a buyer of aviation fuel for 

use in commercial aviation generally is assigned a registration number with a “Y” suffix (a “Y” 

registrant), which entitles the registrant to purchase aviation fuel at the 4.4 cents per gallon rate. 

Large commercial airlines that also are producers of aviation fuel qualify for registration 

numbers with an “H” suffix. As producers of aviation fuel, “H” registrants may buy aviation 

fuel tax free pursuant to a full exemption that applies to sales of aviation fuel by a registered 

producer to a registered producer. If the “H” registrant ultimately uses such untaxed fuel in 

domestic commercial aviation, the H registrant is liable for the aviation fuel tax at the 4.4 cents 

per gallon rate. 

 

358 Sec. 4091(a)(2).

359 Sec. 4091(b). This rate includes a 0.1 cent per gallon Leaking Underground Storage 

Tank (“LUST”) Trust Fund tax. The LUST Trust Fund tax is set to expire after March 31, 2005, 

with the result that on April 1, 2005, the tax rate is scheduled to be 21.8 cents per gallon. Secs. 

4091(b)(3)(B) & 4081(d)(3). Beginning on October 1, 2007, the rate of tax is reduced to 4.3 

cents per gallon. Sec. 4091(b)(3)(A).

360 Sec. 4092(b). The 4.4 cent rate includes 0.1 cent per gallon that is attributable to the 

LUST Trust Fund financing rate. A full exemption, discussed below, applies to aviation fuel that 

is sold for use in commercial aviation as fuel supplies for vessels or aircraft, which includes use 

by certain foreign air carriers and for the international flights of domestic carriers. Secs. 4092(a), 

4092(b), & 4221(d)(3).

361 Secs. 4092(b) & 4041(c)(2).

362 Form 637 - Application for Registration (For Certain Excise Tax Activities). A bond 

may be required as a condition of registration. 
210

Exemptions

Aviation fuel sold by a producer or importer for use by the buyer in a nontaxable use is 

exempt from the excise tax on sales of aviation fuel.363 To qualify for the exemption, the buyer 

must provide the seller with a written exemption certificate stating the buyer’s name, address, 

taxpayer identification number, registration number (if applicable), and intended use of the fuel.

Nontaxable uses include: (1) use other than as fuel in an aircraft (such as use in heating 

oil); (2) use on a farm for farming purposes; (3) use in a military aircraft owned by the United 

States or a foreign country; (4) use in a domestic air carrier engaged in foreign trade or trade 

between the United States and any of its possessions;364 (5) use in a foreign air carrier engaged in 

foreign trade or trade between the United States and any of its possessions (but only if the 

foreign carrier’s country of registration provides similar privileges to United States carriers); (6) 

exclusive use of a State or local government; (7) sales for export, or shipment to a United States 

possession; (8) exclusive use by a nonprofit educational organization; (9) use by an aircraft 

museum exclusively for the procurement, care, or exhibition of aircraft of the type used for 

combat or transport in World War II, and (10) use as a fuel in a helicopter or a fixed-wing 

aircraft for purposes of providing transportation with respect to which certain requirements are 

met.365

A producer that is registered with the Secretary may sell aviation fuel tax-free to another 

registered producer.366 Producers include refiners, blenders, wholesale distributors of aviation 

fuel, dealers selling aviation fuel exclusively to producers of aviation fuel, the actual producer of 

the aviation fuel, and with respect to fuel purchased at a reduced rate, the purchaser of such fuel.

Refunds and credits

A claim for refund of taxed aviation fuel held by a registered aviation fuel producer is 

allowed367 (without interest) if: (1) the aviation fuel tax was paid by an importer or producer (the 

“first producer”) and the tax has not otherwise been credited or refunded; (2) the aviation fuel 

was acquired by a registered aviation fuel producer (the “second producer”) after the tax was 

paid; (3) the second producer files a timely refund claim with the proper information; and (4) the 

first producer and any other person that owns the fuel after its sale by the first producer and 

before its purchase by the second producer have met certain reporting requirements.368 Refund 

 

363 Sec. 4092(a).

364 “Trade” includes the transportation of persons or property for hire. Treas. Reg. sec. 

48.4221-4(b)(8).

365 Secs. 4041(f)(2), 4041(g), 4041(h), 4041(l), and 4092.

366 Sec. 4092(c).

367 Sec. 4091(d).

368 Treas. Reg. sec. 48.4091-3(b).
211

claims should contain the volume and type of aviation fuel, the date on which the second 

producer acquired the fuel, the amount of tax that the first producer paid, a statement by the 

claimant that the amount of tax was not collected nor included in the sales price of the fuel by the 

claimant when the fuel was sold to a subsequent purchaser, the name, address, and employer 

identification number of the first producer, and a copy of any required statement of a subsequent 

seller (subsequent to the first producer but prior to the second producer) that the second producer 

received. A claim for refund is filed on Form 8849, Claim for Refund of Excise Taxes, and may 

not be combined with any other refunds.369 

A payment is allowable to the ultimate purchaser of taxed aviation fuel if the aviation 

fuel is used in a nontaxable use.370 A claim for payment may be made on Form 8849 or on Form 

720, Schedule C. A claim made on Form 720, Schedule C, may be netted against the claimant’s 

excise tax liability. 371 Claims for payment not so taken may be allowable as income tax 

credits372 on Form 4136, Credit for Federal Tax Paid on Fuels.

Description of Proposal

The proposal changes the incidence of taxation of aviation fuel from the sale of aviation 

fuel to the removal of aviation fuel from a refinery or terminal, or the entry into the United States 

of aviation fuel. Sales of not previously taxed aviation fuel to an unregistered person also are 

subject to tax. 

Under the proposal, the full rate of tax -- 21.9 cents per gallon -- is imposed upon 

removal of aviation fuel from a refinery or terminal (or entry into the United States). Aviation 

fuel may be removed at a reduced rate -- either 4.4 or zero cents per gallon -- only if the aviation 

fuel is: (1) removed directly into the wing of an aircraft (i) that is registered with the Secretary as 

a buyer of aviation fuel for use in commercial aviation (e.g., a “Y” registrant under current law), 

(ii) that is a foreign airline entitled to the present law exemption for aviation fuel used in foreign 

trade, or (iii) for a tax-exempt use; or (2) removed or entered as part of an exempt bulk 

transfer.373 An exempt bulk transfer is a removal or entry of aviation fuel transferred in bulk by 

pipeline or vessel to a terminal or refinery if the person removing or entering the aviation fuel, 

the operator of such pipeline or vessel, and the operator of such terminal or refinery are 

registered with the Secretary. 

Under a special rule, the proposal treats certain refueler trucks, tankers, and tank wagons 

as a terminal if certain requirements are met. For the special rule to apply, a qualifying truck, 

tanker, or tank wagon must be loaded with aviation fuel from a terminal: (1) that is located 

 

369 Treas. Reg. sec. 48.4091-3(d)(1).

370 Sec. 6427(l)(1).

371 Treas. Reg. sec. 40.6302(c)-1(a)(3).

372 Sec. 34.

373 See sec. 4081(a)(1)(B).
212

within an airport, and (2) from which no vehicle licensed for highway use is loaded with aviation 

fuel, except in exigent circumstances identified by the Secretary in regulations. It is intended 

that a terminal is located within an airport if the terminal is located in a secure facility on airport 

grounds. For example, if an access road runs between a terminal and an airport’s runways, and 

the terminal, like the runways, is physically located on airport grounds and is part of a secure 

facility, it is intended that under the proposal the terminal is located within the airport. It is 

intended that an exigent circumstance under which loading a vehicle registered for highway use 

with fuel would not disqualify a terminal under the special rule, includes, for example, the 

unloading of fuel from bulk storage tanks into highway vehicles in order to repair the storage 

tanks. 

In order to qualify for the special rule, a refueler truck, tanker, or tank wagon must: (1) 

deliver the aviation fuel directly into the wing of the aircraft at the airport where the terminal is 

located; (2) have storage tanks, hose, and coupling equipment designed and used for the purposes 

of fueling aircraft; (3) not be licensed for highway use; and (4) be operated by the terminal

operator (who operates the terminal rack from which the fuel is unloaded) or by a person that 

makes a daily accounting to such terminal operator of each delivery of fuel from such truck, 

tanker, or tank wagon. 374

The proposal does not change the applicable rates of tax under present law, 21.9 cents per 

gallon for use in noncommercial aviation, 4.4 cents per gallon for use in commercial aviation, 

and zero cents per gallon for use by domestic airlines in an international flight, by foreign 

airlines, or other nontaxable use. The proposal imposes liability for the tax on aviation fuel 

removed from a refinery or terminal directly into the wing of an aircraft for use in commercial 

aviation on the person receiving the fuel, in which case, such person self-assesses the tax on a 

return. The proposal does not change present-law nontaxable uses of aviation fuel, or change the 

persons or the qualifications of persons who are entitled to purchase fuel at a reduced rate, except 

that a producer is not permitted to purchase aviation fuel at a reduced rate by reason of such 

persons’ status as a producer. 

Under the proposal, a refund is allowable to the ultimate vendor of aviation fuel if such 

ultimate vendor purchases fuel tax paid and subsequently sells the fuel to a person qualified to 

purchase at a reduced rate and who waives the right to a refund. In such a case, the proposal 

permits an ultimate vendor to net refund claims against any excise tax liability of the ultimate 

vendor, in a manner similar to the present law treatment of ultimate purchaser payment claims. 

As under present law, if previously taxed aviation fuel is used for a nontaxable use, the 

ultimate purchaser may claim a refund for the tax previously paid. If previously taxed aviation 

fuel is used for a taxable non aircraft use, the fuel is subject to the tax imposed on kerosene (24.4 

cents per gallon) and a refund of the previously paid aviation fuel tax is allowed. Claims by the 

ultimate vendor or the purchaser that are not taken as refund claims may be allowable as income 

tax credits. 

 

374 The proposal requires that if such delivery of information is provided to a terminal 

operator (or if a terminal operator collects such information), that the terminal operator provide 

such information to the Secretary.
213

For example, for an airport that is not served by a pipeline, aviation fuel generally is 

removed from a terminal and transported to an airport storage facility for eventual use at the 

airport. In such a case, the aviation fuel will be taxed at 21.9 cents per gallon upon removal from 

the terminal. At the airport, if the fuel is purchased from a vendor by a person registered with 

the Secretary to use fuel in commercial aviation, the purchaser may buy the fuel at a reduced rate 

(generally, 4.4 cents per gallon for domestic flights and zero cents per gallon for international 

flights) and waive the right to a refund. The ultimate vendor generally may claim a refund for 

the difference between 21.9 cents per gallon of tax paid upon removal and the rate of tax paid to 

the vendor by the purchaser. To obtain a zero rate upon purchase, a registered domestic airline 

must certify to the vendor at the time of purchase that the fuel is for use in an international flight; 

otherwise, the airline must pay the 4.4 cents per gallon rate and file a claim for refund to the 

Secretary if the fuel is used for international aviation. If a zero rate is paid and the fuel 

subsequently is used in domestic and not international travel, the domestic airline is liable for tax 

at 4.4 cents per gallon. A foreign airline eligible under present law to purchase aviation fuel taxfree would continue to purchase such fuel tax-free. 

As another example, for an airport that is served by a pipeline, aviation fuel generally is 

delivered to the wing of an aircraft either by a refueling truck or by a “hydrant” that runs directly 

from the pipeline to the airplane wing. If a refueling truck that is not licensed for highway use 

loads fuel from a terminal located within the airport (and the other requirements of the proposal 

for such truck and terminal are met), and delivers the fuel directly to the wing of an aircraft for 

use in commercial aviation, the aviation fuel is taxed at 4.4 cents per gallon upon delivery to the

wing and the person receiving the fuel is liable for the tax, which such person would be able to 

self-assess on a return. 375 If fuel is loaded into a refueling truck that does not meet the 

requirements of the proposal, then the fuel is treated as removed from the terminal into the 

refueling truck and tax of 21.9 cents per gallon is paid on such removal. The ultimate vendor is 

entitled to a refund of the difference between 21.9 cents per gallon paid on removal and the rate 

paid by a commercial airline purchaser (assuming the purchaser waived the refund right). If fuel 

is removed from a terminal directly to the wing of an aircraft registered to use fuel in commercial 

aviation by a hydrant or similar device, the person removing the aviation fuel is liable for a tax of 

4.4 cents per gallon (or zero in the case of an international flight or qualified foreign airline) and 

may self-assess such tax on a return.

Under the proposal, a floor stocks tax applies to aviation fuel held by a person (if title for 

such fuel has passed to such person) on October 1, 2004. The tax is equal to the amount of tax 

that would have been imposed before October 1, 2004, if the proposal was in effect at all times 

before such date, reduced by the tax imposed by section 4091, as in effect on the day before the 

date of enactment. The Secretary shall determine the time and manner for payment of the tax, 

including the nonapplication of the tax on de minimis amounts of aviation fuel. Under the 

proposal, 0.1 cents per gallon of such tax is transferred to the LUST Trust Fund. The remainder 

is transferred to the Airport and Airway Trust Fund. 

 

375 Alternatively, if the aviation fuel in the example is for use in noncommercial aviation, 

the fuel is taxed at 21.9 cents per gallon upon delivery into the wing. Self-assessment of the tax 

would not apply in such case.
214

Effective Date

The proposal is effective for aviation fuel removed, entered, or sold after September 30, 

2004.

3. Mechanical dye injection and related penalties

Present Law

Statutory rules

Gasoline, diesel fuel and kerosene are generally subject to excise tax upon removal from 

a refinery or terminal, upon importation into the United States, and upon sale to unregistered 

persons unless there was a prior taxable removal or importation of such fuels.376 However, a tax 

is not imposed upon diesel fuel or kerosene if all of the following are met: (1) the Secretary 

determines that the fuel is destined for a nontaxable use, (2) the fuel is indelibly dyed in 

accordance with regulations prescribed by the Secretary, 377 and (3) the fuel meets marking 

requirements prescribed by the Secretary. 378 A nontaxable use is defined as (1) any use that is 

exempt from the tax imposed by section 4041(a)(1) other than by reason of a prior imposition of 

tax, (2) any use in a train, or (3) certain uses in buses for public and school transportation, as 

described in section 6427(b)(1) (after application of section 6427(b)(3)).379

The Secretary is required to prescribe necessary regulations relating to dyeing, including 

specifically the labeling of retail diesel fuel and kerosene pumps.380

A person who sells dyed fuel (or holds dyed fuel for sale) for any use that such person 

knows (or has reason to know) is a taxable use, or who willfully alters or attempts to alter the dye 

 

376 Sec. 4081(a)(1)(A). If such fuel is used for a nontaxable purpose, the purchaser is 

entitled to a refund of tax paid, or in some cases, an income tax credit. See sec. 6427.

377 Dyeing is not a requirement, however, for certain fuels under certain conditions, i.e., 

diesel fuel or kerosene exempted from dyeing in certain States by the EPA under the Clean Air 

Act, aviation-grade kerosene as determined under regulations prescribed by the Secretary, 

kerosene received by pipeline or vessel and used by a registered recipient to produce substances 

(other than gasoline, diesel fuel or special fuels), kerosene removed or entered by a registrant to 

produce such substances or for resale, and (under regulations) kerosene sold by a registered 

distributor who sells kerosene exclusively to ultimate vendors that resell it (1) from a pump that 

is not suitable for fueling any diesel-powered highway vehicle or train, or (2) for blending with 

heating oil to be used during periods of extreme or unseasonable cold. Sec. 4082(c), (d).

378 Sec. 4082(a).

379 Sec. 4082(b). 

380 Sec. 4082(e).
215

in any dyed fuel, is subject to a penalty. 381 The penalty also applies to any person who uses dyed 

fuel for a taxable use (or holds dyed fuel for such a use) and who knows (or has reason to know) 

that the fuel is dyed.382 The penalty is the greater of $1,000 per act or $10 per gallon of dyed 

fuel involved. In determining the amount of the penalty, the $1,000 is increased by the product 

of $1,000 and the number of prior penalties imposed upon such person (or a related person or 

predecessor of such person or related person).383 The penalty may be imposed jointly and 

severally on any business entity, each officer, employee, or agent of such entity who willfully 

participated in any act giving rise to such penalty. 384 For purposes of the penalty, the term “dyed 

fuel” means any dyed diesel fuel or kerosene, whether or not the fuel was dyed pursuant to 

section 4082.385

Regulations

The Secretary has prescribed certain regulations under this provision, including 

regulations that specify the allowable types and concentration of dye, that the person claiming 

the exemption must be a taxable fuel registrant, that the terminal must be an approved terminal 

(in the case of a removal from a terminal rack), and the contents of the notice to be posted on 

diesel fuel and kerosene pumps.386 However, the regulations do not prescribe the time or method 

of adding the dye to taxable fuel.387 Diesel fuel is usually dyed at a terminal rack by either 

manual dyeing or mechanical injection.

Description of Proposal

With respect to terminals that offer dyed fuel, the proposal eliminates manual dyeing of 

fuel and requires dyeing by a mechanical system. Not later than 180 days after enactment of this 

proposal, the Secretary of the Treasury is to prescribe regulations establishing standards for 

tamper resistant mechanical injector dyeing. Such standards shall be reasonable, cost-effective, 

and establish levels of security commensurate with the applicable facility. 

 

381 Sec. 6715(a). 

382 Sec. 6715(a).

383 Sec. 6715(b).

384 Sec. 6715(d).

385 Sec. 6715(c)(1).

386 Treas. Reg. secs. 48.4082-1, -2. 

387 In March 2000, the IRS withdrew its Notice of Proposed Rulemaking PS-6-95 (61 

F.R. 10490 (1996)) relating to dye injection systems. Announcement 2000-42, 2000-1 C.B. 949. 

The proposed regulation established standards for mechanical dye injection equipment and 

required terminal operators to report nonconforming dyeing to the IRS. See also Treas. Reg. 

sec. 48.4082-1(c), (d).
216

The proposal adds an additional set of penalties for violation of the new rules. A penalty, 

equal to the greater of $25,000 or $10 for each gallon of fuel involved, applies to each act of 

tampering with a mechanical dye injection system. The person committing the act is also 

responsible for any unpaid tax on removed undyed fuel. A penalty of $1,000 is imposed for each 

failure to maintain security for mechanical dye injection systems. An additional penalty of 

$1,000 is imposed for each day any such violation remains uncorrected after the first day such 

violation has been or reasonably should have been discovered. For purposes of the daily penalty, 

a violation may be corrected by shutting down the portion of the system causing the violation. If 

any of these penalties are imposed on any business entity, each officer, employee, or agent of 

such entity or other contracting party who willfully participated in any act giving rise to such 

penalty shall be jointly and severally liable with such entity for such penalty. If such business 

entity is part of an affiliated group, the parent corporation of such entity shall be jointly and 

severally liable with such entity for the penalty.

Effective Date

The proposal requiring the use of mechanical dye injection systems and imposing 

penalties is effective 180 days after the date that the Secretary issues the required regulations. 

The Secretary must issue such regulations no later than 180 days after enactment.

4. Authority to inspect on-site records

Present Law

The Internal Revenue Service is authorized to inspect any place where taxable fuel is 

produced or stored (or may be stored). The inspection is authorized to: (1) examine the 

equipment used to determine the amount or composition of the taxable fuel and the equipment 

used to store the fuel; and (2) take and remove samples of taxable fuel. Places of inspection 

include, but are not limited to, terminals, fuel storage facilities, retail fuel facilities or any 

designated inspection site.388 

In conducting the inspection, the Internal Revenue Service may detain any receptacle that 

contains or may contain any taxable fuel, or detain any vehicle or train to inspect its fuel tanks 

and storage tanks. The scope of the inspection includes the book and records kept at the place of 

inspection to determine the excise tax liability under section 4081.389

 

Description of Proposal

The proposal expands the scope of the inspection to include any books, records or 

shipping papers pertaining to taxable fuel at the place of inspection.

 

388 Sec. 4083(c)(1)(A).

389 Treas. Reg. sec. 48.4083-1(c)(1).
217

Effective Date

The proposal is effective on the date on enactment.

5. Registration of pipeline or vessel operators required for exemption of bulk transfers to 

registered terminals or refineries

Present Law

In general, gasoline, diesel fuel, and kerosene (“taxable fuel”) are taxed upon removal 

from a refinery or a terminal.390 Tax also is imposed on the entry into the United States of any 

taxable fuel for consumption, use, or warehousing. The tax does not apply to any removal or 

entry of a taxable fuel transferred in bulk (a “bulk transfer”) to a terminal or refinery if both the 

person removing or entering the taxable fuel and the operator of such terminal or refinery are 

registered with the Secretary. 391 

Present law does not require that the vessel or pipeline operator that transfers fuel as part 

of a bulk transfer be registered in order for the transfer to be exempt. For example, a registered 

refiner may transfer fuel to an unregistered vessel or pipeline operator who in turn transfers fuel 

to a registered terminal operator. The transfer is exempt despite the intermediate transfer to an 

unregistered person. 

In general, the owner of the fuel is liable for payment of tax with respect to bulk transfers 

not received at an approved terminal or refinery. 392 The refiner is liable for payment of tax with 

respect to certain taxable removals from the refinery. 393

Description of Proposal

The proposal requires that for a bulk transfer of a taxable fuel to be exempt from tax, any 

pipeline or vessel operator that is a party to the bulk transfer be registered with the Secretary. 

Transfer to an unregistered party will subject the transfer to tax.

The Secretary is required to publish periodically a list of all registered persons who are 

required to register. 

 

390 Sec. 4081(a)(1)(A).

391 Sec. 4081(a)(1)(B). The sale of a taxable fuel to an unregistered person prior to a 

taxable removal or entry of the fuel is subject to tax. Sec. 4081(a)(1)(A).

392 Treas. Reg. sec. 48.4081-3(e)(2). 

393 Treas. Reg. sec. 48.4081-3(b).
218

Effective Date

The proposal is effective on October 1, 2004, except that the Secretary is required to 

publish the list of registered persons beginning on July 1, 2004.

6. Display of registration and penalties for failure to display registration and to register

Present Law

Blenders, enterers, pipeline operators, position holders, refiners, terminal operators, and 

vessel operators are required to register with the Secretary with respect to fuels taxes imposed by 

sections 4041(a)(1) and 4081.394 A non assessable penalty for failure to register is $50.395 A 

criminal penalty of $5,000, or imprisonme nt of not more than 5 years, or both, together with the 

costs of prosecution also applies to a failure to register and to certain false statements made in 

connection with a registration application. 396

Description of Proposal

The proposal requires that every operator of a vessel who is required to register with the 

Secretary display on each vessel used by the operator to transport fuel, proof of registration 

through an electronic identification device prescribed by the Secretary. A failure to display such 

proof of registration results in a penalty of $500 per month per vessel. The amount of the 

penalty is increased for multiple prior violations. No penalty is imposed upon a showing by the 

taxpayer of reasonable cause. The proposal authorizes amounts equivalent to the penalties 

received to be appropriated to the Highway Trust Fund.

The proposal imposes a new assessable penalty for failure to register of $10,000 for each 

initial failure, plus $1,000 per day that the failure continues. No penalty is imposed upon a 

showing by the taxpayer of reasonable cause. In addition, the proposal increases the present law 

non assessable penalty for failure to register from $50 to $10,000 and the present law criminal 

penalty for failure to register from $5,000 to $10,000. The proposal authorizes amounts 

equivalent to any of such penalties received to be appropriated to the Highway Trust Fund.

Effective Date

The proposal requiring display of registration is effective on October 1, 2004. The 

proposal relating to penalties is effective for penalties imposed after September 30, 2004.

 

394 Sec. 4101; Treas. Reg. sec. 48.4101-1(a) & (c)(1). 

395 Sec. 7272(a).

396 Sec. 7232.
219

7. Penalties for failure to report

Present Law

A fuel information reporting program, the Excise Summary Terminal Activity Reporting 

System (“ExSTARS”), requires terminal operators and bulk transport carriers to report monthly 

on the movement of any liquid product into or out of an approved terminal.397 Terminal 

operators file Form 720-TO - Terminal Operator Report, which shows the monthly receipts and 

disbursements of all liquid products to and from an approved terminal.398 Bulk transport carriers 

(barges, vessels, and pipelines) that receive liquid product from an approved terminal or deliver 

liquid product to an approved terminal file Form 720-CS - Carrier Summary Report, which 

details such receipts and disbursements. In general, the penalty for failure to file a report or a 

failure to furnish all of the required information in a report is $50 per report.399

Description of Proposal

The proposal imposes a new assessable penalty for failure to file a report or to furnish 

information required in a report required by the ExSTARS system. The penalty is $10,000 per 

failure with respect to each vessel or facility (e.g., a terminal or other facility) for which 

information is required to be furnished. No penalty is imposed upon a showing by the taxpayer 

of reasonable cause. The proposal authorizes amounts equivalent to the penalties received to be 

appropriated to the Highway Trust Fund.

Effective Date

The proposal is effective for penalties imposed after September 30, 2004.

8. Collection from Customs bond where importer not registered

Present Law

Typically, gasoline, diesel fuel, and kerosene are transferred by pipeline or barge in large 

quantities (“bulk”) to terminal storage facilities that geographically are located closer to 

destination retail markets. A fuel is taxed when it “breaks bulk,” i.e., when it is removed from the 

refinery or terminal, typically by truck or rail car, for delivery to a smaller wholesale facility or a 

retail outlet. The party liable for payment of the taxes is the “position holder,” i.e., the person 

shown on the records of the terminal facility as owning the fuel. 

 

397 Sec. 4010(d); Treas. Reg. sec. 48.4101-2. The reports are required to be filed by the 

end of the month following the month to which the report relates.

398 An approved terminal is a terminal that is operated by a taxable fuel registrant that is 

a terminal operator. Treas. Reg. sec. 48.4081-1(b).

399 Sec. 6721(a).
220

Tax is also imposed on the entry into the United States of any taxable fuel for 

consumption, use, or warehousing. 400 This tax does not apply to any entry of a taxable fuel 

transferred in bulk to a terminal or refinery if the person entering the taxable fuel and the 

operator of such terminal or refinery are registered. The “enterer” is liable for the tax. An 

enterer generally means the importer of record (under customs law) with respect to the taxable 

fuel. However, if the importer of record is acting as an agent (a broker for example), the person 

for whom the agent is acting is the enterer. If there is no importer of record for taxable fuel 

entered into the United States, the owner of the taxable fuel at the time it is brought into the 

United States is the enterer. An importer’s liability for Customs duties includes a liability for 

any internal revenue taxes that attach upon the importation of merchandise unless otherwise 

provided by law or regulation. 401

As a part of the entry documentation, the importer, consignee, or an authorized agent 

usually is required to file a bond with Customs. The bond, among other things, guarantees that 

proper entry summary, with payment of estimated duties and taxes when due, will be made for 

imported merchandise and that any additional duties and taxes subsequently found to be due will 

be paid. 

As a condition of permitting anyone to be registered with the IRS, under section 4101 of 

the Code, the Secretary may require that such person give a bond in such sum as the Secretary 

determines appropriate.

Description of Proposal

Under the proposal, the importer of record is jointly and severally liable for the tax 

imposed upon entry of fuel into the United States if, under regulations, any other person that is 

not registered with the Secretary as a taxable fuel registrant is liable for such tax. If the importer 

of record is liable for the tax and such tax is not paid on or before the last date prescribed for 

payment, the Secretary may collect such tax from the Customs bond posted with respect to the 

importation of the taxable fuel to which the tax relates.

For purposes of determining the jurisdiction of any court of the United States or any 

agency of the United States, any action by the Secretary to collect the tax from the Customs bond 

is treated as an action to collect tax from a bond authorized by section 4101 of the Code, not as 

an action to collect from a bond relating to the importation of merchandise.

Effective Date

The proposal is effective for fuel entered after September 30, 2004. 

 

400 Sec. 4081(a)(1)(A)(iii).

401 19 CFR 141.3.
221

9. Modification of the use tax on heavy highway vehicles

Present Law

An annual use tax is imposed on heavy highway vehicles, at the rates below.402

Under 55,000 pounds ....................... No tax

55,000-75,000 pounds...................... $100 plus $22 per 1,000 pounds over 55,000

Over 75,000 pounds ......................... $550

The annual use tax is imposed for a taxable period of July 1 through June 30. Generally, 

the tax is paid by the person in whose name the vehicle is registered. In certain cases, taxpayers 

are allowed to pay the tax in installments.403 State governments are required to receive proof of 

payment of the use tax as a condition of vehicle registration. 

Exemptions and reduced rates are provided for certain “transit-type buses,” trucks used 

for fewer than 5,000 miles on public highways (7,500 miles for agricultural vehicles), and 

logging trucks.404 Any highway motor vehicle that is issued a base plate by Canada or Mexico 

and is operated on U.S. highways is subject to the highway use tax whether or not the vehicles 

are required to be registered in the United States. The tax rate for Canadian and Mexican 

vehicles is 75 percent of the rate that would otherwise be imposed.405

Description of Proposal

The proposal eliminates the ability to pay the tax in installments. It also eliminates the 

reduced rates for Canadian and Mexican vehicles. The proposal requires taxpayers with 25 or 

more vehicles for any taxable period to file their returns electronically. Finally, the proposal 

permits proration of tax for vehicles sold during the taxable period.

Effective Date

The proposal is effective for taxable periods beginning after the date of enactment. 

 

402 Sec. 4481.

403 Sec. 6156.

404 See generally, sec. 4483.

405 Sec. 4483(f): Treas. Reg. sec. 41.4483-7(a).
222

10. Modification of ultimate vendor refund claims with respect to farming

Present Law

In general, the Code provides that, if diesel fuel, kerosene, or aviation fuel on which tax 

has been imposed is used by any person in a nontaxable use, the Secretary is to refund (without 

interest) the amount of tax imposed. The refund is made to the ultimate purchaser of the taxed 

fuel. However, in the case of diesel fuel or kerosene used on a farm for farming purposes or by a 

State or local government, refund payments are paid to the ultimate, registered vendors 

(“ultimate vendors”) of such fuels.

Description of Proposal

In the case of diesel fuel or kerosene used on a farm for farming purposes, the proposal 

limits ultimate vendor claims for refund to sales of such fuel in amounts less than 250 gallons per 

farmer per claim. 

Effective Date

The proposal is effective for fuels sold for nontaxable use after the date of enactment.

11. Dedication of revenue from certain penalties to the Highway Trust Fund

Present Law

Present law does not dedicate to the Highway Trust Fund any penalties assessed and 

collected by the Secretary. 

Description of Proposal

The proposal dedicates to the Highway Trust Fund amounts equivalent to the penalties 

paid under sections 6715 (relating to dyed fuel sold for use or used in taxable use), 6715A 

(penalty for tampering or failing to maintain security requirements for mechanical dye injection 

systems), 6717 (penalty for failing to display tax registration on vessels), 6718 (penalty for 

failing to register under section 4101), 6725 (penalty for failing to report information required by 

the Secretary), 7232 (penalty for failing to register and false representations of registration 

status), and 7272 (but only with regard to penalties related to failure to register under section 

4101).

Effective Date

The proposal is effective October 1, 2004.

12. Taxable fuel refunds for certain ultimate vendors

Present Law

The Code provides that, in the case of gasoline on which tax has been paid and sold to a 

State or local government, to a nonprofit educational organization, for supplies for vessels or 
223

aircraft, for export, or for the production of special fuels, a wholesale distributor that sells the 

gasoline for such exempt purposes is treated as the person who paid the tax and thereby is the 

proper claimant for a credit or refund of the tax paid. In the case of undyed diesel fuel or 

kerosene used on a farm for farming purposes or by a State or local government, a credit or 

payment is allowable only to the ultimate, registered vendors (“ultimate vendors”) of such fuels. 

In general, refunds are paid without interest. However, in the case of overpayments of 

tax on gasoline, diesel fuel, or kerosene that is used to produce a qualified alcohol mixture and 

for refunds due ultimate vendors of diesel fuel or kerosene used on a farm for farming purposes 

or by a State or local government, the Secretary is required to pay interest on certain refunds. 

The Secretary must pay interest on refunds of $200 or more ($100 or more in the case of 

kerosene) due to the taxpayer arising from sales over any period of a week or more, if the 

Secretary does not make payment of the refund within 20 days.

Description of Proposal

For sales of gasoline to a State or local government for the exclusive use of a State or 

local government or to a nonprofit educational organization for its exclusive use on which tax 

has been imposed, the proposal conforms the payment of refunds to that procedure established 

under present law in the case of diesel fuel or kerosene. That is, the ultimate vendor claims for 

refund.

The proposal modifies the payment of interest on refunds. Under the proposal, in the 

case of overpayments of tax on gasoline, diesel fuel, or kerosene that is used to produce a 

qualified alcohol mixture and for refunds due ultimate vendors of diesel fuel or kerosene used on 

a farm for farming purposes or by a State or local government, all refunds unpaid after 45 days 

must be paid with interest. If the taxpayer has filed for his or her refund by electronic means, 

refunds unpaid after 20 days must be paid with interest.

Lastly, for claims for refund of tax paid on diesel fuel or kerosene sold to State and local 

governments or for sales of gasoline to a State or local government for the exclusive use of a 

State or local government or to a nonprofit educational organization for its exclusive use on 

which tax has been imposed and for which the ultimate purchaser utilized a credit card, the 

proposal deems the person extending the credit to the ultimate purchaser to be the ultimate 

vendor. That is, the person extending credit via a credit card administers claims for refund, and 

is responsible for supplying all the appropriate documentation currently required from ultimate 

vendors. 

Effective Date

The proposal is effective on October 1, 2004.
224

13. Two-party exchanges

Present Law

Most fuel is taxed when it is removed from a registered terminal.406 The party liable for 

payment of this tax is the “position holder.” The position holder is the person reflected on the 

records of the terminal operator as holding the inventory position in the fuel.407

 It is common industry practice for oil companies to serve customers of other oil 

companies under exchange agreements, e.g., where Company A's terminal is more conveniently 

located for wholesale or retail customers of Company B. In such cases, the exchange agreement 

party (Company B in the example) owns the fuel when the motor fuel is removed from the 

terminal and sold to B’s customer. 

Description of Proposal

The proposal permits two registered parties to switch position holder status in fuel within 

a registered terminal (thereby relieving the person originally owning the fuel408 of tax liability as 

the position holder) if all of the following occur:

(1) The transaction includes a transfer from the original owner, i.e., the person who 

holds the original inventory position for taxable fuel in the terminal as reflected in 

the records of the terminal operator prior to the transaction.

(2) The exchange transaction occurs at the same time as completion of removal 

across the rack from the terminal by the receiving person or its customer. 

(3) The terminal operator in its books and records treats the receiving person as the 

person that removes the product across a terminal rack for purposes of reporting 

the transaction to the Internal Revenue Service.

(4) The transaction is the subject of a written contract.

Effective Date

The proposal is effective on the date of enactment.

 

406 A “terminal” is a storage and distribution facility that is supplied by pipeline or 

vessel, and from which fuel may be removed at a rack. A “rack” is a mechanism capable of 

delivering taxable fuel into a means of transport other than a pipeline or vessel.

407 Such person has a contractual agreement with the terminal operator to store and 

provide services with respect to the fuel. A “terminal operator” is any person who owns, 

operates, or otherwise controls a terminal. A terminal operator can also be a position holder if 

that person owns fuel in its terminal.

408 In the proposal, this person is referred to as the “delivering person.”
225

14. Simplification of tax on tires

Present Law

A graduated excise tax is imposed on the sale by a manufacturer (or importer) of tires 

designed for use on highway vehicles (sec. 4071). The tire tax rates are as follows:

Tire Weight Tax Rate

Not more than 40 lbs. ................................................... No tax

More than 40 lbs., but not more than 70 lbs................. 15 cents/lb. in excess of 40 lbs.

More than 70 lbs., but not more than 90 lbs................. $4.50 plus 30 cents/lb. in excess of 70 lbs.

More than 90 lbs........................................................... $11.50 plus 50 cents/lb. in excess of 90 lbs.

No tax is imposed on the recapping of a tire that previously has been subject to tax. Tires 

of extruded tiring with internal wire fastening also are exempt.

The tax expires after September 30, 2005.

Description of Proposal

The proposal modifies the excise tax applicable to tires. The proposal replaces the 

present-law tax rates based on the weight of the tire with a tax rate based on the load capacity of 

the tire. In general, the tax is 9.4 cents for each 10 pounds of tire load capacity in excess of 

3,500 pounds. In the case of a biasply tire, the tax rate is 4.7 cents for each 10 pounds of tire 

load capacity in excess of 3,500 pounds. 

The proposal modifies the definition of tires for use on highway vehicles to include any 

tire marked for highway use pursuant to certain regulations promulgated by the Secretary of 

Transportation. The proposal also exempts from tax any tire sold for the exclusive use of the 

United States Department of Defense or the United States Coast Guard.

Tire load capacity is the maximum load rating labeled on the tire pursuant to regulations 

promulgated by the Secretary of Transportation. A biasply tire is any tire manufactured 

primarily for use on piggyback trailers.

Effective Date

The proposal is effective for sales in calendar years beginning more than 30 days after the 

date of enactment.
226

D. Nonqualified Deferred Compensation Plans

1. Treatment of nonqualified deferred compensation plans 

Present Law

In general

The determination of when amounts deferred under a nonqualified deferred compensation 

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

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

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

receipt, the economic benefit doctrine,409 the provisions of section 83 relating generally to 

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

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

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

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

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

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

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

Nonqualified deferred compensation is generally subject to social security and Medicare 

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

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

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

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

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

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

(and subject to income tax withholding).

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

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

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

purposes of section 83.410 Property includes real and personal property other than money or an 

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

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

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

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

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

 

409

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

541 (6th Cir. 1952); Rev. Rul. 60-31, 1960-1 C.B. 174.

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

nonqualified deferred compensation.
227

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

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

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

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

to pay money or property in the future.

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

includible in income when it is actually or constructively received under section 451.411 Income 

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

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

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

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

substantial limitation or restriction.

Rabbi trusts 

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

nonqualified deferred compensation, while still allowing deferral of income inclusion. A “rabbi 

trust” is a trust or other fund established by the employer to hold assets from which nonqualified 

deferred compensation payments will be made. The trust or fund is generally irrevocable and 

does not permit the employer to use the assets for purposes other than to provide nonqualified 

deferred compensation, except that the terms of the trust or fund provide that the assets are 

subject to the claims of the employer’s creditors in the case of insolvency or bankruptcy.

As discussed above, for purposes of section 83, property includes a beneficial interest in 

assets set aside from the claims of creditors, such as in a trust or fund, but does not include an 

unfunded and unsecured promise to pay money in the future. In the case of a rabbi trust, terms 

providing that the assets are subject to the claims of creditors of the employer in the case of 

insolvency or bankruptcy have been the basis for the conclusion that the creation of a rabbi trust 

does not cause the related nonqualified deferred compensation arrangement to be funded for 

income tax purposes.412 As a result, no amount is included in income by reason of the rabbi 

trust; generally income inclusion occurs as payments are made from the trust.

The IRS has issued guidance setting forth model rabbi trust provisions.413 Revenue 

Procedure 92-64 provides a safe harbor for taxpayers who adopt and maintain grantor trusts in 

connection with unfunded deferred compensation arrangements. The model trust language 

requires that the trust provide that all assets of the trust are subject to the claims of the general 

creditors of the company in the event of the company’s insolvency or bankruptcy. 

 

411 Treas. Reg. secs. 1.451-1 and 1.451-2.

412 This conclusion was first provided in a 1980 private ruling issued by the IRS with 

respect to an arrangement covering a rabbi; hence the popular name “rabbi trust.” Priv. Ltr. Rul. 

8113107 (Dec. 31, 1980).

413 Rev. Proc. 92-64, 1992-2 C.B. 422, modified in part by Notice 2000-56, 2000-2 C.B. 

393.
228

Since the concept of rabbi trusts was developed, arrangements have developed which 

attempt to protect the assets from creditors despite the terms of the trust. Arrangements also 

have developed which attempt to allow deferred amounts to be available to individuals, while 

still purporting to meet the safe harbor requirements set forth by the IRS.

Description of Proposal

Under the proposal, all amounts deferred under a nonqualified deferred compensation 

plan414 for all taxable years are currently includible in gross income to the extent not subject to a 

substantial risk of forfeiture415 and not previously included in gross income, unless certain 

requirements are satisfied. If the requirements of the proposal are not satisfied, in addition to 

current income inclusion, interest at the underpayment rate plus one percentage point is imposed 

on the underpayments that would have occurred had the compensation been includible in income 

when first deferred, or if later, when not subject to a substantial risk of forfeiture. Actual or 

notional earnings on amounts deferred are also subject to the proposal.

Under the proposal, distributions from a nonqualified deferred compensation plan may be 

allowed only upon separation from service (as determined by the Secretary), death, a specified 

time (or pursuant to a fixed schedule), change in control in a corporation (to the extent provided 

by the Secretary), occurrence of an unforeseeable emergency, or if the participant becomes 

disabled. A nonqualified deferred compensation plan may not allow distributions other than 

upon the permissible distribution events and may not permit acceleration of a distribution, except 

as provided in regulations by the Secretary. 

In the case of a specified employee, distributions upon separation from service may not 

be made earlier than six months after the date of the separation from service. Specified 

employees are key employees416 of publicly-traded corporations.

Amounts payable at a specified time or pursuant to a fixed schedule must be specified 

under the plan at the time of deferral. Amounts payable upon the occurrence of an event are not 

treated as amounts payable at a specified time. For example, amounts payable when an 

individual attains age 65 are payable at a specified time, while amounts payable when an 

individual’s child begins college are payable upon the occurrence of an event.

 

414 A plan includes an agreement or arrangement, including an agreement or arrangement 

that includes one person. 

415 As under section 83, the rights of a person to compensation are subject to a 

substantial risk of forfeiture if the person’s rights to such compensation are conditioned upon the 

performance of substantial services by any individual.

416 Key employees are defined in section 416(i) and generally include officers having 

annual compensation greater than $130,000 (adjusted for inflation and limited to 50 employees), 

five percent owners, and one percent owners having annual compensation from the employer 

greater than $150,000. 
229

Distributions upon a change in the ownership or effective control of a corporation, or in 

the ownership of a substantial portion of the assets of a corporation, may only be made to the

extent provided by the Secretary. It is intended that the Secretary use a similar, but more 

restrictive, definition of change in control as is used for purposes of the golden parachute 

provisions of section 280G consistent with the purposes of the proposal. The proposal requires 

the Secretary to issue guidance defining change of control within 90 days after the date of 

enactment.

An unforeseeable emergency is defined as a severe financial hardship to the participant 

resulting from a sudden and unexpected illness or accident of the participant, the participant’s 

spouse, or a dependent (as defined in 152(a)) of the participant; loss of the participant’s property 

due to casualty; or other similar extraordinary and unforeseeable circumstances arising as a result 

of events beyond the control of the participant. The amount of the distribution must be limited to 

the amount needed to satisfy the emergency plus taxes reasonably anticipated as a result of the 

distribution. Distributions may not be allowed to the extent that the hardship may be relieved 

through reimbursement or compensation by insurance or otherwise, or by liquidation of the 

participant’s assets (to the extent such liquidation would not itself cause a severe financial 

hardship).

A participant is considered disabled if he or she (i) is unable to engage in any substantial 

gainful activity by reason of any medically determinable physical or mental impairment which 

can be expected to result in death or can be expected to last for a continuous period of not less 

than 12 months; or (ii) is, by reason on any medically determinable physical or mental 

impairment which can be expected to result in death or can be expected to last for a continuous 

period of not less than 12 months, receiving income replacement benefits for a period of not less 

than three months under an accident and health plan covering employees of the participant’s 

employer.

As previously discussed, except as provided in regulations by the Secretary, no 

accelerations of distributions may be allowed. For example, changes in the form of a distribution 

from an annuity to a lump sum are not permitted. The proposal provides the Secretary authority 

to provide, through regulations, limited exceptions to the general rule that no accelerations can 

be permitted. It is intended that exceptions be provided only in limited cases where the 

accelerated distribution is required for reasons beyond the control of the participant. For 

example, it is anticipated that an exception could be provided in order to comply with Federal 

conflict of interest requirements or court-approved settlements.

The proposal requires that the plan must provide that compensation for services 

performed during a taxable year may be deferred at the participant’s election only if the election 

to defer is made no later than the close of the preceding taxable year, or at such other time as 

provided in Treasury regulations. In the first year that an employee becomes eligible for 

participation in a nonqualified deferred compensation plan, the election may be made within 30 

days after the date that the employee is initially eligible. 

The time and form of distributions must be specified at the time of initial deferral. A plan 

could specify the time and form of payments that are to be made as a result of a distribution 

event (e.g., a plan could specify that payments upon separation of service will be paid in lump 
230

sum within 30 days of separation from service) or could allow participants to elect the time and 

form of payment at the time of the initial deferral election. If a plan allows participants to elect 

the time and form of payment, such election is subject to the rules regarding initial deferral 

elections under the proposal.

Under the proposal, a plan may allow changes in the time and form of distributions 

subject to certain requirements. A nonqualified deferred compensation plan may allow a 

subsequent election to delay the timing or form of distributions only if: (1) the plan requires that 

such election cannot be effective for at least 12 months after the date on which the election is 

made; (2) except in the case of elections relating to distributions on account of death, disability 

or unforeseeable emergency, the plan requires that the additional deferral with respect to which 

such election is made is for a period of not less than five years from the date such payment 

would otherwise have been made; and (3) the plan requires that an election related to a 

distribution to be made upon a specified time may not be made less than 12 months prior to the 

date of the first scheduled payment. It is expected that in limited cases, the Secretary shall issue 

guidance, consistent with the purposes of the proposal, regarding to what extent elections to 

change a stream of payments are permissible.

If impermissible distributions or elections are made, or if the nonqualified deferred 

compensation plan allows impermissible distributions or elections, all amounts deferred under 

the plan (including amounts deferred in prior years) are currently includible in income to the 

extent not subject to a substantial risk of forfeiture and not previously included in income. In 

addition, interest at the underpayment rate plus one percentage point is imposed on the 

underpayments that would have occurred had the compensation been includible in income when 

first deferred, or if later, when not subject to a substantial risk of forfeiture.

Under the proposal, in the case of assets set aside (directly or indirectly) in a trust (or 

other arrangement determined by the Secretary) for purposes of paying nonqualified deferred 

compensation, such assets are treated as property transferred in connection with the performance 

of services under section 83 (whether or not such assets are available to satisfy the claims of 

general creditors) at the time set aside if such assets are located outside of the United States or at 

the time transferred if such assets are subsequently transferred outside of the United States. Any 

subsequent increases in the value of, or any earnings with respect to, such assets are treated as 

additional transfers of property. Interest at the underpayment rate plus one percentage point is 

imposed on the underpayments that would have occurred had the amounts been includible in 

income for the taxable year in which first deferred or, if later, the first taxable year not subject to 

a substantial risk of forfeiture. The Secretary has authority to exempt arrangements from the 

proposal if the arrangements do not result in an improper deferral of U.S. tax and will not result

in assets being effectively beyond the reach of creditors.

Under the proposal, a transfer of property in connection with the performance of services 

under section 83 also occurs with respect to compensation deferred under a nonqualified deferred 

compensation plan if the plan provides that upon a change in the employer’s financial health, 

assets will be restricted to the payment of nonqualified deferred compensation. The transfer of 

property occurs as of the earlier of when the assets are so restricted or when the plan provides 

that assets will be restricted. It is intended that the transfer of property occurs to the extent that 

assets are restricted or will be restricted with respect to such compensation. For example, in the 
231

case of a plan that provides that upon a change in the employer’s financial health, a trust will 

become funded to the extent of all deferrals, all amounts deferred under the plan are treated as 

property transferred under section 83. If a plan provides that deferrals of certain individuals will 

be funded upon a change in financial health, the transfer of property would occur with respect to 

compensation deferred by such individuals. Any subsequent increases in the value of, or any 

earnings with respect to, such assets are treated as additional transfers of property. Interest at the 

underpayment rate plus one percentage point is imposed on the underpayments that would have 

occurred had the amounts been includible in income for the taxable year in which first deferred 

or, if later, the first taxable year not subject to a substantial risk of forfeiture.

A nonqualified deferred compensation plan is any plan that provides for the deferral of 

compensation other than a qualified employer plan or any bona fide vacation leave, sick leave, 

compensatory time, disability pay, or death benefit plan. A qualified employer plan means a 

qualified retirement plan, tax-deferred annuity, simplified employee pension, and SIMPLE.417 A 

governmental eligible deferred compensation plan (sec. 457) is also a qualified employer plan 

under the proposal.418 Plans subject to section 457, other than governmental eligible deferred 

compensation plans, are subject to both the requirements of section 457 and the proposal. For 

example, in addition to the requirements of the proposal, an eligible deferred compensation plan 

of a tax-exempt employer would still be required to meet the applicable dollar limits under 

section 457. 

Interest imposed under the proposal is treated as interest on an underpayment of tax. 

Income (whether actual or notional) attributable to nonqualified deferred compensation is treated 

as additional deferred compensation and is subject to the proposal. The proposal is not intended 

to prevent the inclusion of amounts in gross income under any provision or rule of law earlier 

than the time provided in the proposal. Any amount included in gross income under the proposal 

shall not be required to be included in gross income under any provision of law later than the 

time provided in the proposal. The proposal does not affect the rules regarding the timing of an 

employer’s deduction for nonqualified deferred compensation.

The proposal requires annual reporting to the Internal Revenue Service of amounts 

deferred. Such amounts are required to be reported on an individual’s Form W-2 for the year 

deferred even if the amount is not currently includible in income for that taxable year. Under the 

proposal, the Secretary is authorized, through regulations, to establish a minimum amount of 

deferrals below which the reporting requirement does not apply. The Secretary may also provide 

that the reporting requirement does not apply with respect to amounts of deferrals that are not 

reasonably ascertainable. It is intended that the exception for amounts not reasonable 

 

417 A qualified employer plan also includes a section 501(c)(18) trust.

418 A governmental deferred compensation plan that is not an eligible deferred 

compensation plan is not a qualified employer plan.
232

ascertainable only apply to nonaccount balance plans and that amounts be required to be reported 

when they first become reasonably ascertainable.419

The proposal provides the Secretary authority to prescribe regulations as are necessary to 

carry out the purposes of proposal, including regulations: (1) providing for the determination of 

amounts of deferral in the case of defined benefit plans; (2) relating to changes in the ownership 

and control of a corporation or assets of a corporation; (3) exempting from the proposals 

providing for transfers of property arrangements that will not result in an improper deferral of 

U.S. tax and will not result in assets being effectively beyond the reach of creditors; (4) defining 

financial health; and (5) disregarding a substantial risk of forfeiture. 

It is intended that substantial risk of forfeitures may not be used to manipulate the timing 

of income inclusion. It is intended that substantial risks of forfeiture should be disregarded in 

cases in which they are illusory or are used inconsistent with the purposes of the proposal. For 

example, if an executive is effectively able to control the acceleration of the lapse of a substantial 

risk of forfeiture, such risk of forfeiture should be disregarded and income inclusion should not 

be postponed on account of such restriction. 

Effective Date

The proposal is effective for amounts deferred after June 3, 2004. The proposal does not 

apply to amounts deferred after June 3, 2004, and before January 1, 2005, pursuant to an 

irrevocable election or binding arrangement made before June 4, 2004. Earnings on amounts 

deferred before the effective date are subject to the proposal to the extent that such amounts 

deferred are subject to the proposal.

It is intended that amounts further deferred under a subsequent election with respect to 

amounts originally deferred before June 4, 2004, are subject to the requirements of the proposal. 

No later than 90 days after the date of enactment, the Secretary shall issue guidance 

providing a limited period of time during which an individual participating in a nonqualified 

deferred compensation plan adopted before June 4, 2004, may, without violating the 

requirements of the proposal, terminate participation or cancel an outstanding deferral election 

with regard to amounts earned after June 3, 2004, if such amounts are includible in income as 

earned.

 

419 It is intended that the exception be similar to that under Treas. Reg. sec. 

31.3121(v)(2)-1(e)(4).
233

E. Other Revenue Provisions

1. Qualified tax collection contracts

Present Law

In fiscal years 1996 and 1997, the Congress earmarked $13 million for IRS to test the use 

of private debt collection companies. There were several constraints on this pilot project. First, 

because both IRS and OMB considered the collection of taxes to be an inherently governmental 

function, only Federal government employees were permitted to collect the taxes.420 The private 

debt collection companies were utilized to assist the IRS in locating and contacting taxpayers, 

reminding them of their outstanding tax liability, and suggesting payment options. If the 

taxpayer agreed at that point to make a payment, the taxpayer was transferred from the private 

debt collection company to the IRS. Second, the private debt collection companies were paid a 

flat fee for services rendered; the amount that was ultimately collected by the IRS was not taken 

into account in the payment mechanism.

The pilot program was discontinued because of disappointing results. GAO reported421

that IRS collected $3.1 million attributable to the private debt collection company efforts; 

expenses were also $3.1 million. In addition, there were lost opportunity costs of $17 million to 

the IRS because collection personnel were diverted from their usual collection responsibilities to 

work on the pilot. The pilot program results were disappointing because "IRS' efforts to design 

and implement the private debt collection pilot program were hindered by limitations that 

affected the program's results." The limitations included the scope of work permitted to the 

private debt collection companies, the number and type of cases referred to the private debt 

collection companies, and the ability of IRS' computer systems to identify, select, and transmit 

collection cases to the private debt collectors.

The IRS has in the last several years expressed renewed interest in the possible use of 

private debt collection companies; for example, IRS recently revised its extensive Request for 

Information concerning its possible use of private debt collection companies.422 

In general, Federal agencies are permitted to enter into contracts with private debt

collection companies for collection services to recover indebtedness owed to the United 

States.423 That provision does not apply to the collection of debts under the Internal Revenue 

Code.424 

 

420 Sec. 7801(a).

421 GAO/GGD-97-129R Issues Affecting IRS’ Collection Pilot (July 18, 1997).

422 TIRNO-03-H-0001 (February 14, 2003), at www.procurement.irs.treas.gov. The 

basic request for information is 104 pages, and there are 16 additional attachments.

423 31 U.S.C. sec. 3718.

424 31 U.S.C. sec. 3718(f).
234

The President’s fiscal year 2004 and 2005 budget proposals proposed the use of private 

debt collection companies to collect Federal tax debts. 

Description of Proposal

The proposal permits the IRS to use private debt collection companies to locate and 

contact taxpayers owing outstanding tax liabilities of any type425 and to arrange payment of those 

taxes by the taxpayers. There must be an assessment pursuant to section 6201 in order for there 

to be an outstanding tax liability. An assessment is the formal recording of the taxpayer’s tax 

liability that fixes the amount payable. An assessment must be made before the IRS is permitted 

to commence enforcement actions to collect the amount payable. In general, an assessment is 

made at the conclusion of all examination and appeals processes within the IRS.426

Several steps are involved in the deployment of private debt collection companies. First, 

the private debt collection company contacts the taxpayer by letter.427 If the taxpayer’s last 

known address is incorrect, the private debt collection company searches for the correct address. 

Second, the private debt collection company telephones the taxpayer to request full payment. 428 

If the taxpayer cannot pay in full immediately, the private debt collection company offers the 

taxpayer an installment agreement providing for full payment of the taxes over a period of as 

long as five years. If the taxpayer is unable to pay the outstanding tax liability in full over a fiveyear period, the private debt collection company obtains financial information from the taxpayer 

and will provide this information to the IRS for further processing and action by the IRS.

The proposal specifies several procedural safeguards and conditions under which the 

provision would operate. First, provisions of the Fair Debt Collection Practices Act apply to the

 

425 The proposal generally applies to any type of tax imposed under the Internal Revenue 

Code. It is anticipated that the focus in implementing the provision will be: (a) taxpayers who 

have filed a return showing a balance due but who have failed to pay that balance in full; and (b) 

taxpayers who have been assessed additional tax by the IRS and who have made several 

voluntary payments toward satisfying their obligation but have not paid in full. 

426 An amount of tax reported as due on the taxpayer’s tax return is considered to be selfassessed. If the IRS determines that the assessment or collection of tax will be jeopardized by 

delay, it has the authority to assess the amount immediately (sec. 6861), subject to several 

procedural safeguards.

427 Several portions of the provision require that the IRS disclose confidential taxpayer 

information to the private debt collection company. Section 6103(n) permits disclosure for “the 

providing of other services ... for purposes of tax administration.” Accordingly, no amendment 

to section 6103 is necessary to implement the provision. It is intended, however, that the IRS 

vigorously protect the privacy of confidential taxpayer information by disclosing the least 

amount of information possible to contractors consistent with the effective operation of the 

provision.

428 The private debt collection company is not permitted to accept payment directly. 

Payments are required to be processed by IRS employees.
235

private debt collection company. Second, taxpayer protections that are statutorily applicable to 

the IRS are also made statutorily applicable to the private sector debt collection companies. In 

addition, taxpayer protections that are statutorily applicable to IRS employees are also made 

statutorily applicable to employees of private sector debt collection companies. Third, the 

private sector debt collection companies are required to inform taxpayers of the availability of 

assistance from the Taxpayer Advocate. Fourth, subcontractors are prohibited from having 

contact with taxpayers, providing quality assurance services, and composing debt collection 

notices; any other service provided by a subcontractor must receive prior approval from the IRS. 

The proposal creates a revolving fund from the amounts collected by the private debt 

collection companies. The private debt collection companies will be paid out of this fund. The 

proposal prohibits the payment of fees for all services in excess of 25 percent of the amount 

collected under a tax collection contract. 429

Effective Date

The proposal is effective on the date of enactment.

2. Modify charitable contribution rules for donations of patents and other intellectual 

property

Present Law

In general, a deduction is permitted for charitable contributions, subject to certain 

limitations that depend on the type of taxpayer, the property contributed, and the donee 

organization. 430 In the case of non-cash contributions, the amount of the deduction generally 

equals the fair market value of the contributed property on the date of the contribution. 

For certain contributions of property, the taxpayer is required to reduce the deduction 

amount by any gain, generally resulting in a deduction equal to the taxpayer’s basis. This rule 

applies to contributions of: (1) property that, at the time of contribution, would not have resulted 

in long-term capital gain if the property was sold by the taxpayer on the contribution date; (2) 

tangible personal property that is used by the donee in a manner unrelated to the donee’s exempt 

(or governmental) purpose; and (3) property to or for the use of a private foundation (other than a 

foundation defined in section 170(b)(1)(E)).

Charitable contributions of capital gain property generally are deductible at fair market 

value. Capital gain property means any capital asset or property used in the taxpayer’s trade or 

business the sale of which at its fair market value, at the time of contribution, would have 

resulted in gain that would have been long-term capital gain. Contributions of capital gain 

property are subject to different percentage limitations than other contributions of property. 

 

429 It is assumed that there will be competitive bidding for these contracts by private 

sector tax collection agencies and that vigorous bidding will drive the overhead costs down.

430 Charitable deductions are provided for income, estate, and gift tax purposes. Secs. 

170, 2055, and 2522, respectively. 
236

Under present law, certain copyrights are not considered capital assets, in which case the 

charitable deduction for such copyrights generally is limited to the taxpayer’s basis.431

In general, a charitable contribution deduction is allowed only for contributions of the 

donor’s entire interest in the contributed property, and not for contributions of a partial 

interest. 432 If a taxpayer sells property to a charitable organization for less than the property’s 

fair market value, the amount of any charitable contribution deduction is determined in 

accordance with the bargain sale rules.433 In general, if a donor receives a benefit or quid pro 

quo in return for a contribution, any charitable contribution deduction is reduced by the amount 

of the benefit received. For contributions of $250 or more, no charitable contribution deduction 

is allowed unless the donee organization provides a contemporaneous written acknowledgement 

of the contribution that describes and provides a good faith estimate of the value of any goods or 

services provided by the donee organization in exchange for the contribution. 434 

Taxpayers are required to obtain a qualified appraisal for donated property with a value 

of $5,000 or more, and to attach the appraisal to the tax return in certain cases.435 Under 

Treasury regulations, a qualified appraisal means an appraisal document that, among other 

things, (1) relates to an appraisal that is made not earlier than 60 days prior to the date of 

contribution of the appraised property and not later than the due date (including extensions) of 

the return on which a deduction is first claimed under section 170;436 (2) is prepared, signed, and 

dated by a qualified appraiser; (3) includes (a) a description of the property appraised; (b) the fair 

market value of such property on the date of contribution and the specific basis for the valuation; 

(c) a statement that such appraisal was prepared for income tax purposes; (d) the qualifications of 

 

431

 See sec. 1221(a)(3), 1231(b)(1)(C).

432 Sec. 170(f)(3).

433 Sec. 1011(b) and Treas. Reg. sec. 1.1011-2.

434 Sec. 170(f)(8).

435 Pub. L. No. 98-369, sec. 155(a)(1) through (6) (1984) (providing that not later than 

December 31, 1984, the Secretary shall prescribe regulations requiring an individual, a closely 

held corporation, or a personal service corporation claiming a charitable deduction for property 

(other than publicly traded securities) to obtain a qualified appraisal of the property contributed 

and attach an appraisal summary to the taxpayer’s return if the claimed value of such property 

(plus the claimed value of all similar items of property donated to one or more donees) exceeds 

$5,000). Under Pub L. No. 98-369, a qualified appraisal means an appraisal prepared by a 

qualified appraiser that includes, among other things, (1) a description of the property appraised; 

(2) the fair market value of such property on the date of contribution and the specific basis for 

the valuation; (3) a statement that such appraisal was prepared for income tax purposes; (4) the 

qualifications of the qualified appraiser; (5) the signature and TIN of such appraiser; and (6) such 

additional information as the Secretary prescribes in such regulations.

436 In the case of a deduction first claimed or reported on an amended return, the deadline 

is the date on which the amended return is filed.
237

the qualified appraiser; and (e) the signature and taxpayer identification number (“TIN”) of such 

appraiser; and (4) does not involve an appraisal fee that violates certain prescribed rules.437

Description of Proposal

The proposal provides that if a taxpayer contributes a patent or other intellectual property 

(other than certain copyrights or inventory) to a charitable organization, the taxpayer’s initial 

charitable deduction is limited to the lesser of the taxpayer’s basis in the contributed property or 

the fair market value of the property. In addition, the taxpayer is permitted to deduct, as a 

charitable deduction, certain additional amounts in the year of contribution or in subsequent 

taxable years based on a specified percentage of the qualified donee income received or accrued 

by the charitable donee with respect to the contributed property. For this purpose, “qualified 

donee income” includes net income received or accrued by the donee that properly is allocable to 

the intellectual property itself (as opposed to the activity in which the intellectual property is 

used). 

The amount of any additional charitable deduction is calculated as a sliding-scale 

percentage of qualified donee income received or accrued by the charitable donee that properly is 

allocable to the contributed property to the applicable taxable year of the donor, determined as 

follows:

Taxable Year of Donor Deduction Permitted for Such Taxable Year

1

st year ending on or after contribution 100 percent of qualified donee income

2

nd year ending on or after contribution 100 percent of qualified donee income

3

rd year ending on or after contribution 90 percent of qualified donee income

4

th year ending on or after contribution 80 percent of qualified donee income

5

th year ending on or after contribution 70 percent of qualified donee income

6

th year ending on or after contribution 60 percent of qualified donee income

7

th year ending on or after contribution 50 percent of qualified donee income

8

th year ending on or after contribution 40 percent of qualified donee income

9

th year ending on or after contribution 30 percent of qualified donee income

10th year ending on or after contribution 20 percent of qualified donee income 

11th year ending on or after contribution 10 percent of qualified donee income

12th year ending on or after contribution 10 percent of qualified donee income

Taxable years thereafter No deduction permitted

 

437 Treas. Reg. sec. 1.170A-13(c)(3).
238

An additional charitable deduction is allowed only to the extent that the aggregate of the amounts 

that are calculated pursuant to the sliding-scale exceed the amount of the deduction claimed upon 

the contribution of the patent or intellectual property. 

No charitable deduction is permitted with respect to any revenues or income received or 

accrued by the charitable donee after the expiration of the legal life of the patent or intellectual 

property, or after the tenth anniversary of the date the contribution was made by the donor.

The taxpayer is required to inform the donee at the time of the contribution that the 

taxpayer intends to treat the contribution as a contribution subject to the additional charitable 

deduction provisions of the proposal. In addition, the taxpayer must obtain written substantiation 

from the donee of the amount of any qualified donee income properly allocable to the 

contributed property during the charity’s taxable year.438 The donee is required to file an annual 

information return that reports the qualified donee income and other specified information 

relating to the contribution. In instances where the donor’s taxable year differs from the donee’s 

taxable year, the donor bases its additional charitable deduction on the qualified donee income of 

the charitable donee properly allocable to the donee’s taxable year that ends within the donor’s 

taxable year.

Under the proposal, additional charitable deductions are not available for patents or other 

intellectual property contributed to a private foundation (other than a private operating 

foundation or certain other private foundations described in section 170(b)(1)(E)).

Under the proposal, the Secretary may prescribe regulations or other guidance to carry 

out the purposes of the proposal, including providing for the determination of amounts to be 

treated as qualified donee income in certain cases where the donee uses the donated property to 

further its exempt activities or functions, or as may be necessary or appropriate to prevent the 

avoidance of the purposes of the proposal. 

Effective Date

The proposal is effective for contributions made after June 3, 2004.

 

438 The net income taken into account by the taxpayer may not exceed the amount of 

qualified donee income reported by the donee to the taxpayer and the IRS under the proposal’s 

substantiation and reporting requirements.
239

3. Require increased reporting for noncash charitable contributions

Present Law

In general, a deduction is permitted for charitable contributions, subject to certain 

limitations that depend on the type of taxpayer, the property contributed, and the donee 

organization. 439 In the case of non-cash contributions, the amount of the deduction generally 

equals the fair market value of the contributed property on the date of the contribution. 

In general, if the total charitable deduction claimed for non-cash property exceeds $500, 

the taxpayer must file IRS Form 8283 (Noncash Charitable Contributions) with the IRS. C 

corporations (other than personal service corporations and closely-held corporations) are 

required to file Form 8283 only if the deduction claimed exceeds $5,000.

Taxpayers are required to obtain a qualified appraisal for donated property (other than 

money and publicly traded securities) with a value of more than $5,000.440 Corporations (other 

than a closely-held corporation, a personal service corporation, or an S corporation) are not 

required to obtain a qualified appraisal. Taxpayers are not required to attach a qualified appraisal 

to the taxpayer’s return, except in the case of contributed art-work valued at more than $20,000. 

Under Treasury regulations, a qualified appraisal means an appraisal document that, among other 

things, (1) relates to an appraisal that is made not earlier than 60 days prior to the date of 

contribution of the appraised property and not later than the due date (including extensions) of 

the return on which a deduction is first claimed under section 170;441 (2) is prepared, signed, and 

dated by a qualified appraiser; (3) includes (a) a description of the property appraised; (b) the fair 

market value of such property on the date of contribution and the specific basis for the valuation; 

(c) a statement that such appraisal was prepared for income tax purposes; (d) the qualifications of 

 

439 Charitable deductions are provided for income, estate, and gift tax purposes. Secs. 

170, 2055, and 2522, respectively. 

440 Pub. L. No. 98-369, sec. 155(a)(1) through (6) (1984) (providing that not later than 

December 31, 1984, the Secretary shall prescribe regulations requiring an individual, a closely 

held corporation, or a personal service corporation claiming a charitable deduction for property 

(other than publicly traded securities) to obtain a qualified appraisal of the property contributed 

and attach an appraisal summary to the taxpayer’s return if the claimed value of such property 

(plus the claimed value of all similar items of property donated to one or more donees) exceeds 

$5,000). Under P.L. 98-369, a qualified appraisal means an appraisal prepared by a qualified 

appraiser that includes, among other things, (1) a description of the property appraised; (2) the 

fair market value of such property on the date of contribution and the specific basis for the 

valuation; (3) a statement that such appraisal was prepared for income tax purposes; (4) the 

qualifications of the qualified appraiser; (5) the signature and taxpayer identification number of 

such appraiser; and (6) such additional information as the Secretary prescribes in such 

regulations.

441 In the case of a deduction first claimed or reported on an amended return, the deadline 

is the date on which the amended return is filed.
240

the qualified appraiser; and (e) the signature and taxpayer identification number of such 

appraiser; and (4) does not involve an appraisal fee that violates certain prescribed rules.442

Description of Proposal

The proposal requires increased donor reporting for certain charitable contributions of 

property other than cash, inventory, or publicly traded securities. The proposal extends to all C 

corporations the present law requirement, applicable to an individual, closely-held corporation, 

personal service corporation, partnership, or S corporation, that the donor must obtain a qualified 

appraisal of the property if the amount of the deduction claimed exceeds $5,000. The proposal 

also provides that if the amount of the contribution of property other than cash, inventory, or 

publicly traded securities exceeds $500,000, then the donor (whether an individual, partnership, 

or corporation) must attach the qualified appraisal to the donor’s tax return. For purposes of the 

dollar thresholds under the proposal, property and all similar items of property donated to one or 

more donees are treated as one property.

The proposal provides that a donor that fails to substantiate a charitable contribution of 

property, as required by the Secretary, is denied a charitable contribution deduction. If the donor 

is a partnership or S corporation, the deduction is denied at the partner or shareholder level. The 

denial of the deduction does not apply if it is shown that such failure is due to reasonable cause 

and not to willful neglect. 

The proposal provides that the Secretary may prescribe such regulations as may be 

necessary or appropriate to carry out the purposes of the proposal, including regulations that may 

provide that some or all of the requirements of the proposal do not apply in appropriate cases.

Effective Date

The proposal is effective for contributions made after June 3, 2004.

4. Require qualified appraisals for charitable contributions of vehicles

Present Law

In general, a deduction is permitted for charitable contributions, subject to certain 

limitations that depend on the type of taxpayer, the property contributed, and the donee 

organization. 443 In the case of non-cash contributions, the amount of the deduction generally 

equals the fair market value of the contributed property on the date of the contribution. 

For certain contributions of property, the taxpayer is required to determine the deductible 

amount by subtracting any gain from fair market value, generally resulting in a deduction equal 

to the taxpayer’s basis. This rule applies to contributions of: (1) property that, at the time of 

 

442 Treas. Reg. sec. 1.170A-13(c)(3).

443 Charitable deductions are provided for income, estate, and gift tax purposes. Secs. 

170, 2055, and 2522, respectively. 
241

contribution, would not have resulted in long-term capital gain if the property was sold by the 

taxpayer on the contribution date; (2) tangible personal property that is used by the donee in a 

manner unrelated to the donee’s exempt (or governmental) purpose; and (3) property to or for the 

use of a private foundation (other than a foundation defined in section 170(b)(1)(E)).

Charitable contributions of capital gain property generally are deductible at fair market 

value. Capital gain property means any capital asset or property used in the taxpayer’s trade or 

business the sale of which at its fair market value, at the time of contribution, would have 

resulted in gain that would have been long-term capital gain. Contributions of capital gain 

property are subject to different percentage limitations than other contributions of property. 

A taxpayer who donates a used automobile to a charitable donee generally deducts the 

fair market value (rather than the taxpayer’s basis) of the automobile. A taxpayer who donates a 

used automobile generally is permitted to use an established used car pricing guide to determine 

the fair market value of the automobile, but only if the guide lists a sales price for an automobile 

of the same make, model and year, sold in the same area, and in the same condition as the 

donated automobile. Similar rules apply to contributions of other types of vehicles and property, 

such as boats. 

Charities are required to provide donors with written substantiation of donations of $250 

or more. Taxpayers are required to report non-cash contributions totaling $500 or more and the 

method used for determining fair market value. 

Taxpayers are required to obtain a qualified appraisal for donated property with a value 

of $5,000 or more, and to attach the appraisal to the tax return in certain cases.444 Under 

Treasury regulations, a qualified appraisal means an appraisal document that, among other 

things, (1) relates to an appraisal that is made not earlier than 60 days prior to the date of 

contribution of the appraised property and not later than the due date (including extensions) of 

the return on which a deduction is first claimed under section 170;445 (2) is prepared, signed, and 

dated by a qualified appraiser; (3) includes (a) a description of the property appraised; (b) the fair 

 

444 Pub. L. 98-369, sec. 155(a)(1) through (6) (1984) (providing that not later than 

December 31, 1984, the Secretary shall prescribe regulations requiring an individual, a closely 

held corporation, or a personal service corporation claiming a charitable deduction for property 

(other than publicly traded securities) to obtain a qualified appraisal of the property contributed 

and attach an appraisal summary to the taxpayer’s return if the claimed value of such property 

(plus the claimed value of all similar items of property donated to one or more donees) exceeds 

$5,000). Under Pub. L. 98-369, a qualified appraisal means an appraisal prepared by a qualified 

appraiser that includes, among other things, (1) a description of the property appraised; (2) the 

fair market value of such property on the date of contribution and the specific basis for the 

valuation; (3) a statement that such appraisal was prepared for income tax purposes; (4) the 

qualifications of the qualified appraiser; (5) the signature and TIN of such appraiser; and (6) such 

additional information as the Secretary prescribes in such regulations.

445 In the case of a deduction first claimed or reported on an amended return, the deadline 

is the date on which the amended return is filed.
242

market value of such property on the date of contribution and the specific basis for the valuation; 

(c) a statement that such appraisal was prepared for income tax purposes; (d) the qualifications of 

the qualified appraiser; and (e) the signature and taxpayer identification number (“TIN”) of such 

appraiser; and (4) does not involve an appraisal fee that violates certain prescribed rules.446

Appraisal fees paid by an individual to determine the fair market value of donated 

property are deductible as miscellaneous expenses subject to the 2 percent of adjusted gross 

income limit. 447

Description of Proposal

The proposal allows a charitable deduction for contributions of vehicles for which the 

taxpayer claims a deduction of more than $250 only if the taxpayer obtains a qualified appraisal 

of the vehicle. The proposal applies to automobiles and other types of motor vehicles 

manufactured primarily for use on public streets, roads, and highways; boats; and aircraft. The 

proposal does not affect contributions of inventory property. The definition of qualified 

appraisal generally follows the definition contained in present law, subject to additional 

regulations or guidance provided by the Secretary. The qualified appraisal of a donated vehicle 

must be obtained by the taxpayer by the time the contribution is made. Under the proposal, the 

Secretary shall prescribe such regulations or other guidance as may be necessary to carry out the 

purposes of the proposal. 

Effective Date

The proposal is effective for contributions made after June 3, 2004.

5. Extend the present-law intangible amortization provisions to acquisitions of sports 

franchises 

Present Law

The purchase price allocated to intangible assets (including franchise rights) acquired in 

connection with the acquisition of a trade or business generally must be capitalized and 

amortized over a 15-year period.448 These rules were enacted in 1993 to minimize disputes 

regarding the proper treatment of acquired intangible assets. The rules do not apply to a 

franchise to engage in professional sports and any intangible asset acquired in connection with 

such a franchise.449 However, other special rules apply to certain of these intangible assets.

 

446 Treas. Reg. sec. 1.170A-13(c)(3).

447

 Rev. Rul. 67-461, 1967-2 C.B. 125. 

448 Sec. 197.

449 Sec. 197(e)(6).
243

Under section 1056, when a franchise to conduct a sports enterprise is sold or exchanged, 

the basis of a player contract acquired as part of the transaction is generally limited to the 

adjusted basis of such contract in the hands of the transferor, increased by the amount of gain, if 

any, recognized by the transferor on the transfer of the contract. Moreover, not more than 50 

percent of the consideration from the transaction may be allocated to player contracts unless the 

transferee establishes to the satisfaction of the Commissioner that a specific allocation in excess 

of 50 percent is proper. However, these basis rules may not apply if a sale or exchange of a 

franchise to conduct a sports enterprise is effected through a partnership.450 Basis allocated to

the franchise or to other valuable intangible assets acquired with the franchise may not be 

amortizable if these assets lack a determinable useful life.

In general, section 1245 provides that gain from the sale of certain property is treated as 

ordinary income to the extent depreciation or amortization was allowed on such property. 

Section 1245(a)(4) provides special rules for recapture of depreciation and deductions for losses 

taken with respect to player contracts. The special recapture rules apply in the case of the sale, 

exchange, or other disposition of a sports franchise. Under the special recapture rules, the 

amount recaptured as ordinary income is the amount of gain not to exceed the greater of (1) the 

sum of the depreciation taken plus any deductions taken for losses (i.e., abandonment losses) 

with respect to those player contracts which are initially acquired as a part of the original 

acquisition of the franchise or (2) the amount of depreciation taken with respect to those player 

contracts which are owned by the seller at the time of the sale of the sports franchise.

Description of Proposal

The proposal extends the 15-year recovery period for intangible assets to franchises to 

engage in professional sports and any intangible asset acquired in connection with the acquisition 

of such a franchise (including player contracts). Thus, the same rules for amortization of 

intangibles that apply to other acquisitions under present law will apply to acquisitions of sports 

franchises. The proposal also repeals the special rules under section 1245(a)(4) and makes other 

conforming changes.

Effective Date

The proposal is effective for property acquired after the date of enactment. The 

amendment to section 1245(a)(4) applies to franchises acquired after the date of enactment.

6. Increase continuous levy for certain Federal payments

Present Law 

If any person is liable for any internal revenue tax and does not pay it within 10 days after 

notice and demand451 by the IRS, the IRS may then collect the tax by levy upon all property and 

 

450

 P.D.B. Sports, Ltd. v. Comm., 109 T.C. 423 (1997).

451 Notice and demand is the notice given to a person liable for tax stating that the tax 

has been assessed and demanding that payment be made. The notice and demand must be 
244

rights to property belonging to the person, 452 unless there is an explicit statutory restriction on 

doing so. A levy is the seizure of the person’s property or rights to property. Property that is not 

cash is sold pursuant to statutory requirements.453

A continuous levy is applicable to specified Federal payments.454 This includes any 

Federal payment for which eligibility is not based on the income and/or assets of a payee. Thus, 

a Federal payment to a vendor of goods or services to the Federal government is subject to 

continuous levy. This continuous levy attaches up to 15 percent of any specified payment due 

the taxpayer.

Description of Proposal

The proposal permits a levy of up to 100 percent of a Federal payment to a vendor of 

goods or services to the Federal government.

Effective Date

The proposal is effective on the date of enactment.

7. Modification of straddle rules

Present Law

In general

A “straddle” generally refers to offsetting positions (sometimes referred to as “legs” of 

the straddle) with respect to actively traded personal property. Positions are offsetting if there is 

a substantial diminution in the risk of loss from holding one position by reason of holding one or 

more other positions in personal property. A “position” is an interest (including a futures or 

forward contract or option) in personal property. When a taxpayer realizes a loss with respect to 

a position in a straddle, the taxpayer may recognize that loss for any taxable year only to the 

extent that the loss exceeds the unrecognized gain (if any) with respect to offsetting positions in 

the straddle.455 Deferred losses are carried forward to the succeeding taxable year and are 

subject to the same limitation with respect to unrecognized gain in offsetting positions.

 

mailed to the person’s last known address or left at the person’s dwelling or usual place of 

business (sec. 6303).

452 Sec. 6331.

453 Secs. 6335-6343.

454 Sec. 6331(h).

455 Sec. 1092.
245

Positions in stock

The straddle rules also generally do not apply to positions in stock. However, the 

straddle rules apply where one of the positions is stock and at least one of the offsetting positions 

is: (1) an option with respect to the stock, 456 (2) a securities futures contract (as defined in 

section 1234B) with respect to the stock, or (3) a position with respect to substantially similar or 

related property (other than stock) as defined in Treasury regulations. In addition, the straddle 

rules apply to stock of a corporation formed or availed of to take positions in personal property 

that offset positions taken by any shareholder.

The stock exception from the straddle rules has been curtailed severely by legislative 

amendment and regulatory interpretation. Under proposed Treasury regulations, the application 

of the stock exception essentially would be limited to offsetting positions involving direct 

ownership of stock and short sales of stock. 457

Unbalanced straddles

When one position with respect to personal property offsets only a portion of one or more 

other positions (“unbalanced straddles”), the Treasury Secretary is directed to prescribe by 

regulations the method for determining the portion of such other positions that is to be taken into 

account for purposes of the straddle rules.458 To date, no such regulations have been 

promulgated.

Unbalanced straddles can be illustrated with the following example: Assume the 

taxpayer holds two shares of stock (i.e., is long) in XYZ stock corporation--share A with a $30 

basis and share B with a $40 basis. When the value of the XYZ stock is $45, the taxpayer pays a 

$5 premium to purchase a put option on one share of the XYZ stock with an exercise price of 

$40. The issue arises as to whether the purchase of the put option creates a straddle with respect 

to share A, share B, or both. Assume that, when the value of the XYZ stock is $100, the put 

option expires unexercised. Taxpayer incurs a loss of $5 on the expiration of the put option, and 

sells share B for a $60 gain. On a literal reading of the straddle rules, the $5 loss would be 

deferred because the loss ($5) does not exceed the unrecognized gain ($70) in share A, which is 

also an offsetting position to the put option--notwithstanding that the taxpayer recognized more 

gain than the loss through the sale of share B. This problem is exacerbated when the taxpayer 

has a large portfolio of actively traded personal property that may be offsetting the loss leg of the 

straddle.

 

456 Although the straddles rules apply to offsetting positions that consist of stock and an 

option with respect to stock, the straddle rules do not apply if the option is a “qualified covered 

call option” written by the taxpayer. In general, a qualified covered call option is defined as an 

exchange-listed option that is not deep-in-the-money and is written by a non-dealer more than 30 

days before expiration of the option.

457 Prop. Treas. Reg. sec. 1.1092(d)-2(c).

458 Sec. 1092(c)(2)(B).
246

Although Treasury has not issued regulations to address unbalanced straddles, the IRS 

issued a private letter ruling in 1999 that addressed an unbalanced straddle situation. 459 Under 

the facts of the ruling, a taxpayer entered into a costless collar with respect to a portion of the 

shares of a particular stock held by the taxpayer.460 Other shares were held in an account as 

collateral for a loan and still other shares were held in excess of the shares used as collateral and 

the number of shares specified in the collar. The ruling concluded that the collar offset only a 

portion of the stock--i.e., the number of shares specified in the costless collar--because that 

number of shares determined the payoff under each option comprising the collar. The ruling 

further concluded that:

In the absence of regulations under section 1092(c)(2)(B), we conclude that it is 

permissible for Taxpayer to identify which shares of Corporation stock are part of 

the straddles and which shares are used as collateral for the loans using 

appropriately modified versions of the methods of section 1.1012-1(c)(2) and (3) 

[providing rules for adequate identification of shares of stock sold or transferred 

by a taxpayer] or section 1.1092(b)-3T(d)(4) [providing requirements and 

methods for identification of positions that are part of a section 1092(b)(2) 

identified mixed straddle].

Description of Proposal

The proposal modifies the straddle rules in three respects: (1) permits taxpayers to 

identify offsetting positions of a straddle; (2) provides a special rule to clarify the present-law 

treatment of certain physically settled positions of a straddle; and (3) repeals the stock exception 

from the straddle rules.

Under the proposal, taxpayers generally are permitted to identify the offsetting positions 

that are components of a straddle at the time the taxpayer enters into a transaction that creates a 

straddle, including an unbalanced straddle.461 If there is a loss with respect to any identified 

position that is part of an identified straddle, the general straddle loss deferral rules do not apply 

to such loss. Instead, the basis of each of the identified positions that offset the loss position in 

the identified straddle is increased by an amount that bears the same ratio to the loss as the 

unrecognized gain (if any) with respect to such offsetting position bears to the aggregate 

unrecognized gain with respect to all positions that offset the loss position in the identified 

 

459

 Priv. Ltr. Rul. 199925044 (Feb. 3, 1999).

460 A costless collar generally is comprised of the purchase of a put option and the sale of 

a call option with the same trade dates and maturity dates and set such that the premium paid 

substantially equals the premium received. The collar can be considered as economically similar 

to a short position in the stock.

461 However, to the extent provided by Treasury regulations, taxpayers are not permitted 

to identify offsetting positions of a straddle if the fair market value of the straddle position 

already held by the taxpayer at the creation of the straddle is less than its adjusted basis in the 

hands of the taxpayer.
247

straddle.462 Any loss with respect to an identified position that is part of an identified straddle 

cannot otherwise be taken into account by the taxpayer or any other person to the extent that the 

loss increases the basis of any identified positions that offset the loss position in the identified 

straddle.

In addition, the proposal provides authority to issue Treasury regulations that would 

specify: (1) the proper methods for clearly identifying a straddle as an identified straddle (and 

identifying positions as positions in an identified straddle); (2) the application of the identified 

straddle rules for a taxpayer that fails to properly identify the positions of an identified 

straddle;463 and (3) provide an ordering rule for dispositions of less than an entire position that is 

part of an identified straddle.

The proposal also clarifies the present-law straddle rules with respect to taxpayers that 

settle a position that is part of a straddle by delivering property to which the position relates. 

Specifically, the proposal clarifies that the present-law straddle loss deferral rules treat as a twostep transaction the physical settlement of a straddle position that, if terminated, would result in 

the realization of a loss. With respect to the physical settlement of such a position, the taxpayer 

is treated as having terminated the position for its fair market value immediately before the 

settlement. The taxpayer then is treated as having sold at fair market value the property used to 

physically settle the position.

The proposal also eliminates the exception from the straddle rules for stock (except 

qualified covered call options). Thus, offsetting positions comprised of actively traded stock and 

a position with respect to substantially similar or related property generally constitute a straddle 

if holding one of the positions results in a substantial diminution of the taxpayer’s risk of loss 

with respect to holding the other position.

Effective Date

The proposal is effective for positions established on or after the date of enactment.

 

462 For this purpose, “unrecognized gain” is the excess of the fair market value of an 

identified position that is part of an identified straddle at the time the taxpayer incurs a loss with 

respect to another identified position in the identified straddle, over the fair market value of such 

position when the taxpayer identified the position as a position in the identified straddle.

463 For example, although the proposal does not require taxpayers to identify any 

positions of a straddle as an identified straddle, it may be necessary to provide rules requiring all 

balanced offsetting positions to be included in an identified straddle if a taxpayer elects to 

identify any of the offsetting positions as an identified straddle.
248

8. Add vaccines against Hepatitis A to the list of taxable vaccines

Present Law

A manufacturer’s excise tax is imposed at the rate of 75 cents per dose464 on the 

following vaccines routinely recommended for administration to children: diphtheria, pertussis, 

tetanus, measles, mumps, rubella, polio, HIB (haemophilus influenza type B), hepatitis B, 

varicella (chicken pox), rotavirus gastroenteritis, and streptococcus pneumoniae. The tax applied 

to any vaccine that is a combination of vaccine components equals 75 cents times the number of 

components in the combined vaccine.

Amounts equal to net revenues from this excise tax are deposited in the Vaccine Injury 

Compensation Trust Fund to finance compensation awards under the Federal Vaccine Injury 

Compensation Program for individuals who suffer certain injuries following administration of 

the taxable vaccines. This program provides a substitute Federal, “no fault” insurance system for 

the State-law tort and private liability insurance systems otherwise applicable to vaccine 

manufacturers. All persons immunized after September 30, 1988, with covered vaccines must 

pursue compensation under this Federal program before bringing civil tort actions under State 

law.

Description of Proposal

The bill adds any vaccine against hepatitis A to the list of taxable vaccines. 

Effective Date

The proposal is effective for vaccines sold beginning on the first day of the first month 

beginning more than four weeks after the date of enactment.

9. Add vaccines against influenza to the list of taxable vaccines

Present Law

A manufacturer’s excise tax is imposed at the rate of 75 cents per dose

465 on the 

following vaccines routinely recommended for administration to children: diphtheria, pertussis, 

tetanus, measles, mumps, rubella, polio, HIB (haemophilus influenza type B), hepatitis B, 

varicella (chicken pox), rotavirus gastroenteritis, and streptococcus pneumoniae. The tax applied 

to any vaccine that is a combination of vaccine components equals 75 cents times the number of 

components in the combined vaccine.

Amounts equal to net revenues from this excise tax are deposited in the Vaccine Injury 

Compensation Trust Fund to finance compensation awards under the Federal Vaccine Injury 

Compensation Program for individuals who suffer certain injuries following administration of 

 

464 Sec. 4131

465 Sec. 4131
249

the taxable vaccines. This program provides a substitute Federal, “no fault” insurance system for 

the State-law tort and private liability insurance systems otherwise applicable to vaccine 

manufacturers. All persons immunized after September 30, 1988, with covered vaccines must 

pursue compensation under this Federal program before bringing civil tort actions under State 

law.

Description of Proposal

The bill adds any trivalent vaccine against influenza to the list of taxable vaccines. 

Effective Date

The proposal is effective for vaccines sold or used beginning on the later of the first day 

of the first month beginning more than four weeks after the date of enactment or the date on 

which the Secretary of Health and Human Services lists any such vaccine for purpose of 

compensation for any vaccine-related injury or death through the Vaccine Injury Compensation 

Trust Fund.

10. Extension of IRS user fees

Present Law

The IRS provides written responses to questions of individuals, corporations, and 

organizations relating to their tax status or the effects of particular transactions for tax purposes. 

The IRS generally charges a fee for requests for a letter ruling, determination letter, opinion 

letter, or other similar ruling or determination. 466 Public Law 108-89467 extended the statutory 

authorization for these user fees through December 31, 2004, and moved the statutory 

authorization for these fees into the Code.468

Description of Proposal

The proposal extends the statutory authorization for these user fees through September 

30, 2014. 

 

466 These user fees were originally enacted in section 10511 of the Revenue Act of 1987 

(Pub. L. No. 100-203, December 22, 1987). Pub. L. No. 104-117 (An Act to provide that 

members of the Armed Forces performing services for the peacekeeping efforts in Bosnia and 

Herzegovina, Croatia, and Macedonia shall be entitled to tax benefits in the same manner as if 

such services were performed in a combat zone, and for other purposes (March 20, 1996)) 

extended the statutory authorization for these user fees through September 30, 2003.

467 117 Stat. 1131; H.R. 3146, signed by the President on October 1, 2003.

468 That Public Law also moved into the Code the user fee provision relating to pension 

plans that was enacted in section 620 of the Economic Growth and Tax Relief Reconciliation Act 

of 2001 (Pub. L. No. 107-16, June 7, 2001).
250

Effective Date

The proposal is effective for requests made after the date of enactment.

11. Extension of customs user fees

Present Law

Section 13031 of the Consolidated Omnibus Budget Reconciliation Act of 1985 

(COBRA) (Pub. L. No. 99-272), authorized the Secretary of the Treasury to collect certain 

service fees. Section 412 (Pub. L. No. 107-296) of the Homeland Security Act of 2002 

authorized the Secretary of the Treasury to delegate such authority to the Secretary of Homeland 

Security. Provided for under 19 U.S.C. 58c, these fees include: processing fees for air and sea 

passengers, commercial trucks, rail cars, private aircraft and vessels, commercial vessels, 

dutiable mail packages, barges and bulk carriers, merchandise, and Customs broker permits. 

COBRA was amended on several occasions but most recently by P.L. 108-121 which extended 

authorization for the collection of these fees through March 1, 2005.469

Description of Proposal

The proposal extends the passenger and conveyance processing fees and the merchandise 

processing fees authorized under the Consolidated Omnibus Budget Reconciliation Act of 1985 

through September 30, 2014. For fiscal years after September 30, 2005, the Secretary is to 

charge fees in amount that are reasonably related to the costs of providing customs services in 

connection with the activity or item for which the fee is charged.

The proposal also includes a Sense of the Congress that the fees set forth in paragraphs 

(1) through (8) of subsection (a) of section 13031 of the Consolidated Omnibus Budget 

Reconciliation Act of 1985 have been reasonably related to the costs of providing customs 

services in connection with the activities or items for which the fees have been charged under 

such paragraphs. The Sense of Congress also states that the fees collected under such paragraphs 

have not exceeded, in the aggregate, the amounts paid for the costs described in subsection 

(f)(3)(A) incurred in providing customs services in connection with the activities or items for 

which the fees were charged under such paragraphs.

The proposal further provides that the Secretary conduct a study of all the fees collected 

by the Department of Homeland Security, and shall submit to the Congress, not later than 

September 30, 2005, a report containing the recommendations of the Secretary on what fees 

should be eliminated, what the rate of fees retains should be, and any other recommendations 

with respect to the fees that the Secretary considers appropriate.

Effective Date

The proposal is effective upon the date of enactment.

 

469 Sec. 201; 117 Stat. 1335.
251

12. Safe harbor for churches

Present Law

Organizations described in section 501(c)(3) and exempt from tax under section 501(a), 

including churches, their integrated auxiliaries, and conventions or associations of churches, may 

not participate in, or intervene in (including the publishing or distributing of statements), any 

political campaign on behalf of (or in opposition to) any candidate for public office.470 The 

prohibition on such political activity is absolute. The sanction for a violation of the prohibition 

is loss of the organization’s tax exempt status and the ability to receive tax deductible 

contributions.

There are three elements to the prohibition: there must be a “candidate,” for “public 

office,” and “participation” or “intervention” in a political campaign. Treasury regulations 

define a candidate as “an individual who offers himself, or is proposed by others, as a contestant 

for an elective public office, whether such office be national, State, or local.”471 The definition 

includes persons who have declared an intention to run for office and generally would include 

incumbents until such time as an incumbent declared an intention not to run for reelection. 

Treasury regulations do not define “public office”; however, the definition of candidate refers to 

an “elective public office, whether . . . national, State, or local.” The IRS has interpreted “public 

office” to include elective positions in political parties. 

Section 501(c)(3) states that participation in a political campaign includes “the publishing 

or distribution of statements.” Treasury regulations also provide that “publication or distribution 

of written or printed statements or the making of oral statements on behalf of or in opposition to . 

. . a candidate” is intervention in a political campaign, and that intervention is not limited to such 

activities.472

In general, political activities that are educational are permitted. Educational activities 

are those that present “a sufficiently full and fair exposition of the pertinent facts,” are not 

biased, and “permit an individual or the public to form an independent opinion or conclusion.”473 

Publicly supported charities also generally may provide a forum for debates by candidates, so 

long as the forum is fair and neutral and all qualified candidates are given equal time for 

debate.474 Voter registration by public charities generally is permitted so long as the activity is 

conducted in a nonpartisan and fair manner. Other forms of voter education, such as publication 

of voter guides, also may be permissible if certain guidelines are followed.475 The prohibition on 

 

470 Sec. 501(c)(3).

471 Treas. Reg. sec. 1.501(c)(3)-1(c)(3)(iii).

472

 Id.

473 Treas. Reg. sec. 1.501(c)(3)-1(d)(3).

474

 See Rev. Rul. 86-95, 1986-2 C.B. 73.

475 Rev. Rul. 78-248, 1978-1 C.B. 154.
252

political activity is not intended to restrict free expression on political matters by persons 

speaking for themselves as individuals and not as representatives of a charitable organization. 

Individuals who speak on their own behalf under facts and circumstances that clearly show that 

the speech is not attributable to the individual’s organization do not implicate the tax-exempt 

status of such organization.

For organizations that engage in prohibited political activity, three penalties may be 

applied either as alternatives to revocation of tax exemption or in addition to loss of tax-exempt 

status: an excise tax, 476 termination assessment of all taxes due,477 and an injunction against 

further political expenditures.478

Description of Proposal

The proposal provides for special rules with respect to the political activities of churches, 

their integrated auxiliaries, and conventions or associations of churches (collectively referred to 

as “church” or “churches”). Under the proposal, a stateme nt by a religious leader of a church 

that is clearly identified as a statement made as a private citizen and not made on behalf of or in 

representation of such church does not jeopardize the church’s tax exempt status, affect the 

church’s status as an organization to which contributions are deductible, or provide a basis for 

the application of excise taxes to the church or church management for prohibited political 

expenditures. A statement is not treated as clearly identified as made as a private citizen if a 

statement is made in an official publication of such church, at an official function of such church, 

or if a statement is paid for in whole or part by such church.

In addition, as an alternative to revocation of a church’s tax exemption and loss of status 

as an organization to which deductible contributions may be made, the proposal provides for 

intermediate sanctions for unintentional violations by a church (including unintentional 

violations by religious leaders of a church not acting in their private capacity) of the prohibition 

on political activity. Such intermediate sanctions apply for up to three unintentional violations 

by a church during any calendar year. The present law penalty of revocation of exemption 

continues to apply to any violation that constitutes an intentional disregard by such church of the 

political activity prohibition and to more than three unintentional violations in a calendar year. It 

is intended that a violation is not considered unintentional merely because the person committing 

the violation did not know that political activity by a church is prohibited or that the activity 

conducted constituted a violation. 

Under the intermediate sanctions regime of the proposal, for a single unintentional 

violation during a calendar year, tax is imposed at the highest corporate tax rate on 1/52 of the 

church’s gross income for such year; for two unintentional violations during a calendar year, tax 

is imposed at the highest corporate tax rate on one half of the church’s gross income for such 

year; and for three unintentional violations during a calendar year, tax is imposed at the highest 

 

476 Sec. 4955.

477 Sec. 6852(a)(1).

478 Sec. 7409.
253

corporate tax rate on all of the church’s gross income for such year. The amount of tax imposed 

with respect to an act is reduced by the amount of any tax imposed with respect to such act as a 

political expenditure pursuant to section 4955. Churches subject to intermediate sanctions under 

the proposal are required to file a return in a time and manner to be provided by the Secretary. 

Such return is subject to the generally applicable accuracy and fraud-related penalties imposed 

by the Code.

Effective Date

The proposal is effective for acts occurring after the date of enactment.
254

VII. MARKET REFORM FOR TOBACCO GROWERS

Present Law

The current tobacco program has two main components: a supply management 

component and a price support component. In addition, in 1982, Congress passed the “No-NetCost Tobacco Program Act” 479 that assured the tobacco program would run at no-net cost to the 

Federal government.

Supply management

The supply management component limits and stabilizes the quantity of tobacco 

marketed by farmers. This is achieved through marketing quotas. The Secretary of Agriculture 

raises or lowers the national marketing quota on an annual basis. The Secretary establishes the 

national marketing quota for each type of tobacco based upon domestic and export demand, but 

at a price above the government support price. The purpose of matching supply with demand is 

to keep the price of tobacco high. There is a secondary market in tobacco quota. Tobacco 

growers who do not have sufficient quota may purchase or rent one.

Support price

Given the numerous variables that affect tobacco supply and demand, marketing quotas 

alone have not always been able to guarantee tobacco prices. Therefore, in addition to marketing 

quotas, Federal support prices are established and guaranteed through the mechanism of 

nonrecourse loans available on each farmer’s marketed crop. The loan price for each type of 

tobacco is announced each year by the Department of Agriculture using the formula specified in 

the law to calculate loan levels. This system guarantees minimum prices for the different types 

of tobacco.

The national loan price on 2004 crop flue-cured tobacco is $1.69 per pound; the burley 

loan price is $1.873 per pound. 

No-net-cost assessment

In 1982, Congress passed the “No-Net-Cost Tobacco Program Act.” The purpose of this 

program is to ensure that the nonrecourse loan program is run at no-net-cost to the Federal 

government.

When tobacco is not contracted, it is sold at an auction sale barn. At the auction sale 

barn, each lot of tobacco goes to the highest bidder, unless that bid does not exceed the 

government’s loan price. When the bid does not exceed this price, the farmer may choose to be 

paid the loan price by a cooperative, with money borrowed from the Commodity Credit 

Corporation (“CCC”). In such cases, the tobacco is consigned to the cooperative (known as a 

price stabilization cooperative), which redries, packs, and stores the tobacco as collateral for the 

 

479 Pub. L. No. 97-218 (1982).
255

CCC. The cooperative, acting as an agent for the CCC, later sells the tobacco, with the proceeds 

going to repay the loan plus interest. If the cooperative does not recover the cost of the loan plus 

interest, the Secretary of Agriculture assesses growers, purchasers and importers of tobacco in 

order to repay the difference. All growers, purchasers and importers of tobacco participate in 

paying these assessments, regardless of whether or not they participate in the loan program. 

The no-net-cost assessment on 2004 crop flue-cured is 10 cents per pound; the burley 

assessment is 2 cents per pound. The no-net-cost assessment funds are deposited in an escrow 

account that is held to reimburse the government for any financial losses resulting from tobacco 

loan operations.

Currently, over 80 percent of growers market their tobacco through contracts with 

tobacco companies, and thus these growers do not participate in the loan program. However, 

they must still pay the no-net-cost assessment when the Secretary levies it. The remaining 20 

percent of growers market their tobacco through the auction system, and are eligible for 

participation in the loan program. Of this group, over 60 percent have consistently participated 

in the loan program during the past several years.

Description of Proposal

The proposal repeals the Federal tobacco support program, including marketing quotas 

and nonrecourse marketing loans.480

The proposal also provides quota holders $7.00 per pound on their 2002 quota allotment 

paid in equal installments over five years.481

Additionally, the proposal provides producers transition payments of $3.00 per pound 

based on their 2002 quota levels paid in equal installments over five years.482

The proposal caps payments to quota holders and growers at $9.6 billion over fiscal years 

2005 through 2009.483

Effective Date

The proposal is effective on the date of enactment.

 

480 Secs. 711-712.

481 Sec. 722.

482 Sec. 723.

483 Sec. 725.