IV ~****************************** 

Tax Treatment of Business 
IV ~ 

CORPORATE T~X RATE REDUCTION 

Present Law 

Und e r pres£nt law, tha corpor a te income tax r ates a r e 2 0 

percent of the first $25,00U of corpor a t e bl e income, 22 

Percent of the ne xt $25,000 of ta xabl e income an0 48 oe rcen t ~f all t axable income in excess of $50,00 0 . These r a t es wi ll 

be in effect through tax able yea rs ending in 1978. For 

subseque nt years, the corpor a t e r a t es a re sched ul ed to be come 

22 pe rcent of the first $25,000 of t a xa bl e income ~nd 48 

pe rcent of taxa ble income ove r $25,000. 

Rea sons for Change 

Two ma j or obj ec tives of t he Administration' s tax 

propos a ls a re to promote long-term capital for~ation and to 

strengthe n and maint a in the c urrent economic r ecove ry. To 

achieve these obj ective s, it is ne c e ssary to reduce the 

e ffective r ates of tax on income from c apital t o provide 

busin e ss with additional incentive s to inve5t . 

A r ed uc t ion in the corporate t a x r ates wi ll ac hi e ve the 

objective of stimula ting capital forma tion in two ways. 

First, the reduction in corporate t a x li abilities will have 

an immed iate, favorabl e effect on coroor a t e cash flow. This 

will f a cilitate the financing of high~r levels of capita l 

spending. Second, the reduction in tax rat es will increase 

expected after-tax profits for any given investment proj ec t. 

This highe r e xpected profitability on investment will 

constitute a significant incentive to corpor at ions to 

incr e ase pl~nned c apital appropriations. In addit ion, since 

these higher after-tax e~ rnings may be e xpec t ed to lead to 

either an incr ease in dividends or a mor~ r ap i d anticipated 

growth in sha re 9rices, the stock marke~ shoul d be f a vor a bly 

a ffe cted, and corporations will find it somew ~t easier to 

obtain external equity financing. 

The proposed e xtension of the investment tax credit to 

industrial structures, a s discussed below, will also help to 

stimulate investment. How ver, the r e are spec ific re a sons 

why it is desirable to include corporate tax r a t e reductions 

in the package a s one of the principal tools for stimulating capital formation: 

1) A change in the corporate tax r a te structure is the 

most str aightforward me thod of reducing the tax buroe n 

on the return from corpor a t e investment. 

2) Not all corporations will rece ive significant 

benefits from the proposed e xte nsion of the inve stment 

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tax credit to structures. Reduction of the corporate 

tax rate will enable all corporations to re lize some 

benefits from the business tax cuts. 

3) In the context of the entire proposal, the corporate 

tax rate reductions are required to prevent ~ shift of 

capital away from corporate investments. Given the 

reduction in the personal income t?x r?tes included in 

the package, maintenance of a rough bal ~nce et e~ n 

taxes on corporate equity income and taxes on other 

forms of capital income (including debt) reouir es an 

accompanying cut in the corporate t?x rates. 

For these reasons, it is desirable to r ed uc e the rat~s 

of tax on corporate income for both small and l arge 

corporations. 

Gener al Explanation 

Effectiv~ October l, 1976, the corporate income tax 

rates will be reduced to 18 perce nt of the first $25,000 of 

corporate taxable income, 20 percent of the next $25,000 of 

taxable income and 45 percent of all taxable income in excess 

of $50,000. Effective January 1, 1960, the tax rate on 

taxable income in excess of $50,000 will be 44 percent. The 

reductions will be ~ermanent. 

Revenue Estimate 

1976 1979 

-1,349 -5,965 

Change in tax liability 

{$ millions) 

Calendar Years 

1980 1981 1982 

- 8,516 -9, 228 -10,010 

1903 

- 10,/64 

Note: These estim3 tcs are bcse d on permane nt extension of 

the present r a tes. 

Techniccl Explanation 

Effective October 1, 1978 the norma] t?x imposed by 

section ll(b) of the Code, which currently is 20 9ercent of 

the first $25 , 000 of taxpble income ~!us 22 9ercent of 

taxable income in e xcess of $25,0UO, will become JS percent of the first $25 , 000 of taxable income ?lus 20 ?ercent of 

taxable income in e xcess of $25 , 0u0 . 

- 252 -
The surtax imposed by section ll(c) of the Code, which 

currently is 26 percent, will be reduced to 25 percent effective October 1, 1978. A further reduction to 24 percent 

will become effective January 1, 1980. The surtax exemption, 

which currently is $50,000, will remain at $50,000. 

Thus, effective October 1, 1978, the corporate rate will 

be 18 percent of the first $25,000 of taxable income, 20 

percent of the next $25,000 and 45 percent of taxable income 

in excess of $50,000. Effective January 1, 1980, the top 

rate will decline to 44 percent. 

In the case of a corporate taxpayer whose fiscal year 

does not begin with the effective date of a rate reduction 

(in this case, October 1, 1978 and January 1, 1980), existing 

law provides for the taxpayer to determine its tax liability 

for the taxable year of transition by computing tentative 

taxes based on the application to its full year's taxable 

income of the rates in effect before and after the date of 

the change, and paying a tax that consists of a portion of 

each tentative tax determined by reference to the number of 

days during the taxable year to which the old and new rates 

applied. In other words, the tax rate for the entire year is 

a weighted average of the t?x rates applicable to the periods 

before and after the rate change with the weights being the 

number of days in the year before and after the change. 

For example, suppose a calendar year corporation has 

taxable income of $100,000 in 1978. Under present law, its 

tax liability for the full year would be 20 percent of the 

first $25,000 of income ($5,000), 22 percent on the next 

$25,000 of income ($5,500) and 48 percent on all taxable 

income over $50,000 ($24,000) for a total tax of $34,500. 

Under the proposal, the full year's tax liability for the 

corporation will be 10 percent of the first $25,000 of 

taxable income ($4,500), 20 percent of the next $25,000 of 

taxable income ($5,000) and 45 percent of taxable income over 

$50,000 ($22,500) for a total t~x liability of $32,000. 

There are 273 days in the transition year before the 

effective date of October 1, 1978, and 92 days on or after 

that date. Therefore the tax on the corporation for the 

transition year will be equal to 273/365 of ~34,500 (or ~25,804) plus 92/365 of $32,000 (or SU,U6b). Thus, the 

calendar year corporation's tax liability on $100,000 of 

t?xable income in 1978 is $33,870. 

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IVB 

INVESTMENT CREDIT 

Present Law 

Taxpayers 2re presently entitled to a credit cg3inst 

their tax liability equal, in general, to 10 pe rcent of 

their investment in certain qualified productive assets. The 

rate of this investment credit was temporarily increased to 

10 percent from 7 percent as of J~nuary 25, 1975, and is 

scheduled to revert to 7 percent on January l, 1981. (In 

the case of investments in certain public utility property, 

the credit is scheduled to revert, in effect, to 4 percent on 

January 1, 1981.) 

In general, property eligible for the investment credit 

consists of depreciable property having an estimated useful 

life of three or more years which is either tangible personal 

property or other tangible prope rty (such as fixtures and 

heavy machinery) that is used as an integral part of the 

productive process. Buildings and their structural 

components, however, do not qu al ify for the credit. 

To reduce the cost of pollution control equipmen t 

required to be installed in plants in use be fore nuary 1, 

1976, a taxpayer may elect to amortize the cost of such 

equipment over a 5-year period in lieu of depreciating the 

equipment over its useful life. However, if pollution 

control equipment is amortized under this special rule, the 

investment credit is limited to 5 percent of the cost of such 

equipment . 

The amount of investment credits for an y ye a r may be 

used, dollar-for-dollar, to offse t completely tax liability 

of up to $25,000 . Credits in excess of $25,000 m?y, in 

gene r a l, be used to offset up to 50 percent of tax liability 

in excess of $25,000. Spec ial provisions, scheduled to be 

phased out ove r time, permit public utilities, railroads end 

airlines to offset mor e than 50 percent of their tax 

liability in e xcess of $2 5 ,000 with investment credits. In 

any year in which the amount of a taxpayer ' s investment 

credits exceeds the applicable limits, the excess may be 

carried back to the three t?x~ble ye2rs before, end forw~rd 

to the seven taxable years after, the yea r in which the a sset 

wa s placed in service. 

Reasons for Change 

The investment credit, originally proposed in 1Y61 to 

stimulate the la9ging modernization of the country's productive facil1ties, has proven to be ?n e ff ec tive 

- 254 -
incentive to capital investment. However, the unavailability 

of the credit for investments in industrial buildings has 

impaired somewhat its utility in promoting investment in 

long-lived manufacturing facilities. 

As first proposed by the Treasury in 1961, the 

investment credit would have been available for investments 

in industrial buildings. However, while the Congress was 

examining the Treasury's 1961 proposal, it became apparent 

that investment in equipment, by historical standards, was 

lagging behind investment in non-residential structures. By the end of 1961, equipment investment had still not regained 

the peak level (in real terms) achieved in the third quarter 

of 1957, while investment in non-residential buildings had 

surpassed its earlier peak during 1960. Thus, the Committee 

on Ways and Means concluded that buildings and their 

structural components should not be eligible for the credit: 

"The credit is available for investments in most 

tangible personal property. It is also available for 

limited types of real property, other than buildings. 

The greater emphasis is placed on equipment and 

machinery because it is believed the need for such 

investment is the major requirement of the economy."l/ 

The decision in 1961, while appropriate at that time, 

has had a distorting effect on the composition of business 

fixed investment in the United States. While annual 

expenditures (in current dollars) for total fixed investment 

have increased by some 295 percent since 1961, expenditures 

for industrial structures have increased by only 145 percent. 

Moreover, during the r e cent cyclical recovery phase, annual 

expenditures for industrial structures have actually 

declined, while other investment expenditures have mildly 

increased. These developments are reflected in Table IVB-1. 

- 255 -
Table IVB-1 

Comparison, in Current Dollars, of Outlays for Total 

Business Fixed Investment and for Industrial Structures 

1960 

1961 

1962 

19o3 

1964 

1965 

1966 

1967 

1968 

1969 

1970 

1971 

1972 

1973 

1974 

1975 

1976 

1977 

Business 

Fixed 

Investment 

1960 - 61 = 

100.6 

99.4 

108.1 

113.1 

125.9 

150.3 

111. a 

173.2 

188.3 

208.8 

211.9 

219.5 

246.5 

286.9 

317.8 

314.6 

341.7 

395.6* 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

* Based on first three quarters only. 

Source: Survey of Current Business. 

- 256 -

Expenditures 

for Industrial 

Structures 

100 

101.3 

98.7 

100.9 

103.2 

126.6 

201.3 

259.2 

235.4 

213.9 

240.9 

232.2 

192.6 

166.1 

221.7 

280.7 

284.8 

255.1 

245.6* 

January 19, 1978 

... 
The decision in 1962 to ·deny the investment credit to 

buildings was also based, in part, on the favorable 

depreciation for Federal income tax purposes afforded 

buildings at that time. In contrast with the situation in 

1962, there has been a substantial tightening in the tax 

treatment ot depreciation of structures. Depreciation 

recapture rules have been extended to real property and it is 

proposed elsewhere in the President's tax progrcm that the 

rules governing depreciation of buildings be changed to 

conform more closely to economic reality. See RE~L ESTATE 

DEPRECIATION. Thus, industrial buildings wiTT no longer 

enjoy the exceedingly favorable depreciation treatment 

available in 1962. 

Accordingly, it is now appropriate to ~xtend the 

stimulus provided by the investment credit to investments in 

industrial structures. This change will eliminate the bias 

of current tax law against balanced programs of industrial 

expansion, and will promote increased investment in 

long-lived productive facilities. Expansion of private 

investment in manufacturing facilities is essential to 

avoiding capacity shortages, with resulting inflationary 

pressures, as the economy continues to move ahead. 

Modernization of the stock of productive capital is likewise 

essential to further gains in labor productivity. Finally, this change will eliminate the many disputes occasioned under 

present law by the need to distinguish between equipment, for 

which the credit is available, and buildings and their 

structural components, for which it is not. 

The investment incentive provided by the credit can be 

strengthened further by modifying the provisions of present 

law that limit current availability of investment credits to 

50 percent of a taxpayer's tax liability in excess of ~25,000. This limitation both dampens th~ investment 

incentive provided by the credit by delaying actual use of 

credits, and adds to the complexity of the tax laws by 

compelling some taxpayers either to resort to the use of 

carryovers, or to engage in complex and costly leasing 

transactions, to obtain the benefits of the investment 

credit. Furthermore, in years in which an excess credit can 

be fully utilized by carrybacks, the procedure for effecting 

a refund entails cumbersome recomputations of prior years' 

tax accounts with no compensating gain to either the taxpayer 

or the Treasury. Relaxing this limitation would t~us 

simplify the tax laws, stimulate capital investment by accelerating the actual ~vailability of investment credits, 

and promote economic efficiency by reducing the disparity, 

caused solely by variations in current tax liabilities, in 

the use of credits by enterprises that have made similar 

amounts of eligible investment. 

- 257 -
It would, however, be incompatible with the goals of the 

President's tax program to permit investment credits to 

eliminate completely a person's tax liability. See T~X 

SHELTERS -- INTRODUCTION. Under present law a taxpayer whose 

tax liebility is $25,000 or less may use investment credits 

to eliminate that liability in its entirety. Permitting 

investment credits to offset up to 90 percent of a taxpayer's 

t a x liability for any year would strike an ap~ropriate 

balance between strengthening the investment 1ncentive 

provided by the credit, on the one hand, and not permitting 

the credit to eliminate 100 percent of tax liability for any 

year, on the other. 

The temporary increase in the credit to 10 percent, scheduled to expire in 1981, has had some beneficial effect 

on the rate of capital investment. However, the temporary 

nature of the 10 percent rate is an additional variable that 

must be taken into account by businesses in making long-range 

investment decisions. This uncertainty diminishes the 

incentive effect of the credit and is undesirable, 

particularly when the rate of capital investment is 

inadequate. For that reason, and because capital formation 

remains a long-term economic policy objective, the present 10 

percent rate of the investment credit should be made 

permanent. 

To reduce further the rising cost of compliance with 

environmental standards, pollution control equipment added to 

pre-1976 plants should, in addition to its eligibility for 

5-year amortization, be eligible for the full 10 percent 

investment credit. It is proposed elsewhere in the tax 

program to eliminate the availability of tax-exempt financing 

to provide pollution control facilities. However, it is ~xpected that, for eligible taxpayers, the benefit of the 

additional 5 percent investment credit for pollution control 

investment in pre-1976 plant generally will offset the loss I 

of tax-exempt financing. See INDUSTRIAL DEVELOPMENT BONDS. 

General Explanation 

As an incentive to business to expand and modernize its 

investment in long-lived industrial facilities, thereby 

reducing the likelihood of future capacity shortages, the 

investment credit will be extended to industrial structures. 

This change will extend to otherwise eligible investments 

made in new industrial buildings as well as investments made 

to rehabilitate existing buildings. 

~n industri~l structur e will include a building and its 

structural components, but only if the building is used as an 

integral part of manufacturing, produc tion or extraction, or 

of furnishing transportation, communi cations, electrical ~n~rgy , gas , water or sewage dispose! services, or if the 

- 258 -
building constitutes a research facility used in connection 

with any of these activities. Thus, for example, buildings used for residential purposes (~., apartment buildings, 

hotels and motels), commercial buildings (~., office 

buildings and retail stores), and buildings used for storage 

or distributional purposes (~., warehouses) will not be 

industrial structures eligible for the credit. Bulk storage 

facilities (~, grain storage bins and oil storage tanks) 

will continue to be eligible for the credit. This change in 

general will be accomplished by deleting the provision of 

present law that specifically excludes a building and its 

structural components from the definition of property 

eligible for the investment credit. 

Because property eligible for the credit is generally 

subject to the depreciation recapture rules applicable to 

equipment rather than the les.s stringent rules applicable to 

real property, buildings for which an investment credit will 

now be allowed will also be subject to the depreciation 

recapture rules (section 1245) for equipment. 

The provision of present law t~at limits the current 

availability of investment credits for any year to $25,000 

plus 50 percent of tax liability in excess of $25,000 will be 

changed to provide that investment credits may offset up to 

90 percent of tax li~bility in any year. Until this change becomes effective (See Effective Dates), airlines, railroads 

and public utilities-will remain subject to the special 

limitations ot current law. Permitting the credit to offset 

90 percent of tax liability will both strengthen the 

inc~ntive provided by the credit and simplify its 

administration. In addition, a uniform percentage limitation 

on the use of the credit will eliminate the inequity of 

present law that allows a complete offset of tax liability 

through the use of investment credits: the invest~ent credit 

will no longer be permitted to offset completely the first 

$25,000 of tax. 1/ 

To assist business enterprises in making long-range 

capital investment decisions and to encourage long-term 

capital formation, the 10 percent rate of the inve~tmene 

credit will be made permanent. Investments in public utility 

property will remain eligible for the perman~nt, 10 percent credit. 

Investments in pollution control equipment will be 

eligible for the full 10 percent investment credit, even if 

an election is made to amortize the cost of such equipment 

over the special 5-year period. 

Effective Dates 

Industrial structures placed in service after 

De cember 31, 1977 will qualify for the investment credit, but 

only to the extent of the portion of the adjusted basis of 

- 259 -
such structures properly attributable to construction after 

that date . Otherwise eligible expenditures to rehcbilitate 

existing industrial structures will also qualify for the 

credit, but only to the extent of the adj usted basis of such 

structures properly attributable to rehabilita tion after 

December 31, 1977. 

For taxable years beginning after December 31, 1978, the 

investment credit (and investment credit carryovers to such 

years) will be usable to offset up to 90 percent of a 

taxpayer's liability for tax. For taxable years beginning after December 31, 1978, investment credits will no longer be 

available to offset completely the first $25,000 of tax. 

These changes will apply to all taxpayers, including public 

utilities, railroads and airlines. 

The 10 percent rate of the investment credit will not 

revert to 7 percent on January 1, 1981, but will be made 

permanent. 

Certified pollution control facilities eligible for the 

special 5-year amortization period will be eligible for the 

full 10 percent investment credit, provided that as of 

December 31, 1977 no election has been made to amortize such 

equipment over the 5-year period. 

- 260 -
Revenue Estimate 

Change In Tax Li ability 

( S Mill ions) 

Calendar Yea rs 

19 78 1979 1980 1981 1982 1983 

Extend 10 

percent 

investment 

credit to 

structures -1147 -1443 -1714 -1942 -2153 -2354 

Full 

Investment 

credit for 

pollution· 

abatement 

facilities - 142 93 - 107 - 127 - 115 - 144 

Change 

investment 

cr ed it 

limit to 

90 percent 

for corporat ions - 682 - 576 - 114 - 194 - 205 

Cha nge 

investment 

credit 

limit to 

90 percent for individuals 52 58 64 71 79 

Note : These est1mates a r e based on permanent e xtens1.on of the Io percent 

investment credit. 

- 261 -
Footnotes 

!/ House Report No. 1447, 87th Cong. 2d Sess. (1962), at 9. 

~/ The same rule -- that credits may offset 90 percent of 

tax liability -- will apply to the work incentive credit 

(section 40 of the Code) which, under present law, may be 

used to offset the first $50,000 of tax liability plus SU 

percent of tax liability in excess of $50,000. 

- 262 -
IVC-1 

SMALL BUSINESS 

INTRODUCTION 

The corporate tax cuts described elsew~ere in the 

Administration's tax proposals will particularly benefit 

small corporations with incomes of $50,000 or less; for these 

corporations the tax reduction will be nearly 10 percent . The Administration is also making three proposals 

specifically to assist small businesses. The first proposal 

will simplify and liberalize the rules (Subchapter S) th~t 

treat certain small corporations like p~rtnerships . The 

second proposal will simplify methods of oepreciation for 

small businesses. And, if an investor loses money on stock 

in a small business, the third proposal will make it easier 

for him to deduct his loss~s. The revenue effect of thes£ 

changes is estimated to be $400 million in 1979 , virtually all of which is accounted for by the reduction in corporate 

rates. 

- 263 -
IVC-2 

LIBERALIZATION OF SUBCHAPTER S 

Present Law 

In general, present law treats a corporation ?s an 

entity separate and apart from its shareholders. Income 

earned by a corporation is taxed to the corporation and 

distributions are t~xed to the shareholders. Losses affect 

the tax liability of the corporation but not that of the 

shareholders. Under Subchapter S, however, a qualifying 

domestic coporation may elect not to pay the regular 

corporate income tax. Instead, the income of the corporation is taxed to the shareholders whether it is distributed as a 

dividend or retained by the corporation. In addition, the 

shareholders are allowed to deduct losses sustained by the 

corporation. This results, in a general way, in a pattern of 

taxation similar to that of partnerships. Subchapter s is 

available only to small corporations with simple structures 

that are essentially similar to partnerships. 

Reasons for Change 

Subchapter S reflects concern regarding the tax-induced 

distortions of business behavior that result from double 

taxation of corporate income. Such distortions include 

favoring debt over equity financing, unnecessary retention of 

earnings in corporate solution, and widespread resort to 

partnerships for certain types of business activities. 

Therefore, it is appropriate to revise Subchapter S to 

eliminate unnecessary barriers to its use. Such barriers 

arise from the fact that the Subchapter S rules, although 

revised since enactment, remain complex and are frequently 

misunderstood in ways that lead to unintended hardships. Complexity in this area is particularly undesirable because 

Subchapter s generally is limited to, and is best suited for, 

small businesses. Accordingly, the proposal simplifies and 

liberalizes Subchapter s. 

Gener~l Explanation 

The proposal will liberalize three sets of rules 

governing treatment of a small business corporation under 

Subchapter S. First, it will increase the permitted number 

of shareholders and relax certain other restrictions on the 

shareholders of a Subchapter S corporation. Second, it will 

liberalize the rules governing election and termination of 

election und~r Subchapter s. And third, it will liberalize 

treatment of losses sustained by a Subchapter S corporation. Under present law, a sharehol~er's deduction for losses 

cannot exceed his investment in the corporation. The 

propose! will permit the 3hareholder to carry excess losses 

over to subsequent taxable years. 

- 264 -
Effective Date 

In g~neral, the propose d change s will apply to t a xable 

ye ars of corporations ginning afte r December 31, 1978. The 

change permitting carryovers will apply to losse s sustained 

in taxable years beginning after December 31, 1978. 

Revenue Estimate 

This proposal will have no significant revenue effect. 

Technical Explanation 

(a) Eligibility for Subchapter S Election 

The proposal will make it easier for a corporation to 

qualify under Subchapter S. 

Number of Shareholders. Under present law, a 

corporation (with certain exceptions) must have ten or fewer 

shareholders to qualify as a sm~ll business corporation 

(section 1371 of the Code). Under the proposal, a 

corporation can qualify if it has fifteen or fewer 

shareholders. 

Certain Trusts Permitted as Shareholders. In general, 

present law requires the shareholders of a qualifying small 

business corporation to be individuals. Exc~ptions are 

provided for grantor trusts and voting trusts, and for 

transitory ownership (for a period of not more than sixty 

days) by trusts established under the will of a deceased 

shareholder (section 137l(f) of the Code). The inability to 

transfer stock to a testamentary trust except on a transitory 

basis may cause sha reholders difficulty in planning their 

estates. To allevi~te this problem, the proposal will permit 

the transfer of shares to a testamentary trust established 

under the will of a deceased shareholder for the term of the 

trust. Similarly, an inter vivos grantor trust that now 

qua lifies as a shareholder will continue to qualify after the 

grantor's death. ~qualifying trust will be required to 

distribute all income currently to its beneficiaries in 

shares fixed by the gove rning instrument of the trust. For 

purposes of determining the number of ~h reholders in the 

electing sm~ll business corpor a tion, each beneficiary having 

a present interest in the trust income will be treated as a 

shar e holde r. Beca use of t~e general incr e ase to 15 

shureholders, spe cial rules tha t permit the corporation to 

have more than 10 shareholders in c e rtain limited 

circumst?nces (section 137l(e) of the Code) will be repealed. 

Husband and Wi fe s One Sha r eholde r. The rules trea ting 

a husba nd and wife s one s~ hold r will be simPlifie d and lib liz e~ . 1n pa rticu l a r, the p roposa l wi l l elim i na t e the 

- 265 -
requirement that the stock be community property or be held 

as joint tenants, tenants by the entirety, or tenants in 

common. 

(b) Election to be Taxed Under Subchapter s 

The rules governing elections to be taxed under 

Subchapter S and terminations of such elections (including 

inadvertent terminations) are unduly complicated and 

restrictive. These rules will be simplified and liberalized. 

Time for Election. Under present law, an election under 

Subchapter S may be made for a taxable year at any time 

during the first month of the year or at any time during the 

preceding month (section 1372(c) of the Code). For a new 

corporation, the first month of the taxable year does not 

begin until the corporation has shareholders, acquires 

assets, or begins doing business, whichever occurs first. 

Unless an election is terminated, it continues in effect and 

does not have to be renewed annually. 

The requirement that an election may not be made more 

than 30 days before the beginning of a year is an unnecessary 

trap. For example, a corporation that hes decided to make en 

election six months before the first day of the year may 

inadvertently fail to make the election in a timely fashion . 

This possibility will be eliminated by permitting the 

corporation to make the election at any time before the 

beginning of the taxable year. Thus, if a corporation 

decides in June of 1979 to elect Subchapter S for calendar 

year 1980, it will be able to do so immediately. In 

addition, an election will be permitted for 60 (instead of 

30) days after the beginning of a taxable year. 

Termination of an Election. Under present law, 

termination of an election is generally r e troactive to the 

first day of the t~xable year, even if it is ca used by a n 

event occurring at the end of the ye ar (section 1372(e) of 

the Code). This had led to hardshi~ in some cases and 

opportunity for mani~ul tion in others. Therefore, under the 

proposal, a terminat1on will generally tak~ effect on the day 

of the triggering event . However, this rul e could e nabl e 

taxpayers to cut short an electing yee r -- particularly an 

initial electing year -- prior to the r ea liza tion of income 

while permitting losses to be pessed through to shareholders. 

Therefore, a termination during the first yea r of an e lection 

will take effect retroac tively. 

Election following Termination. If n election is 

terminated, present law precludes th0 cor~oration (or its 

successor) from making a new elPction until the fifth t~x ble 

year after the termin?tion (unless the Treasury cons nts to a 

new election). This rule has c?uscd difficulty in c ases of 

- 266 -
inaovert~nt termination. In many such cases, the termin?tion 

is not discovered until it is too late for e new e lection. 

Moreove r, the corporation has acted in reli nce on the old 

election. The refor e , under the proposal, if an e lection is 

terminated beca use a corporation c eases to be a small 

business corporation (~, it h?s 16 sha r eholde rs or it owns 

luO percent of the stock of another corporation) ~nd if the 

corporation qualifies for a later year, filing a timely 

return as a Subcha pter S corpor~tion for the lcter yea r will 

be trected as a binding request for consent to e new 

election. In determining whether to grant such a consent, 

the fact th a t termination ~as inadvertent will be taken into 

account. 

(c) Net operating loss carryover 

Under present l aw, a shareholder ma y deduct Josses 

sustained by a Subchapter S corporation to the e xt ent of his 

adjusted basis in stock and debt of the corporation. The 

shareholder is not permitted to carry excess losses over ~o 

subsequent taxable years. Therefore, if a shareholder's pro 

rata share of the corporation's losses e xceeds his adjusted 

basis in stock and debt, the e xcess is not ded uctible . Under 

the proposal, these excess losses will become deductible by 

the shareholder in subsequent years to the extent of 

subsequent increases in the shareholder's ba sis in stock ~nd 

debt. This ch?nge is consistent with the present tr ea tment 

of partnerships. The excess loss will not be tr nsfer eble 

and will be ed uct bl~ only by the same shareholder in a 

subsequent year. 

While the Subchapter S election remains in effpct, the 

c a rryover will be a llowed as a deduction at the end of each 

subsequent taxable year of the corporation. However, the 

amount allowed as a deduction will be limited to the 

shareholder's basis in stock and debt of the corporation at 

the end of the year (giving effect to all adjustments made 

during the year). Any unused portion of the ca rryover will 

be allowed as a ded uction twelve calendar months afte r the 

Subchapter Selection is terminated. Howeve r, the amount 

allowed as a deduction will be limited to the shr.reholder's 

basis in stock and debt at the end of the twelfth month. 

Whenever the carryover is a llowed as a deduction, there will 

be a corresponding reduction in basis. 

- 267 -
IVC - 3 

Depreciation for Small Business 

Present Law 

Under present law, a taxpayer generally may claim 

depreciation either on the basis of the particular "facts and 

circumstances" bearing on his anticipated use of the property 

or under the asset depreciation range and class life system ( "ADR") • 

~ taxpayer claiming depreciation on the basis of facts 

and circumstances must estimate the useful life and salvage 

value for each item of depreciable property used in his trade 

or business. This can be a cumbersome and inexact process for the taxpayer. Moreo~er, the taxpayer's estimates are 

frequently reexamined by auditing agents of the Internal 

Revenue Service, and any discrepancies between their 

estimates and the taxpayer's will result in further time and 

attention being devoted to these factual matters. 

As discussed more fully in connection with the 

President's proposal for simplifying ~DR depreciation, the 

use of ADR depreciation permits a taxpayer to depreciate 

assets on the basis of prescribed useful lives that cannot be 

challenged by the Internal Revenue Service and offers 

substantial other benefits. See SIMPLIFICATION OF ~DR 

DEPRECI~TJON. On the other han1, the ADR system imposes a 

number of form3l accounting and reporting requirements which 

may differ from~ taxpayer's past depreciation pr~ctices. 

Reasons for Change 

The ADR system provides many advant ages for those who 

adopt it. However, while nearly 92% of corporate taxpayers 

with depreci2ble assets of $1 billion or more elected ADR in 

1974, only 0.36% of corporate taxpayers with $500,000 or less 

in depreciable assets elected ~DR in that yer.r. The proposal 

for simplifying the ADR system should encourage more s~allcr 

businesses to adopt ~DR. However, it is also appropriate to 

allow the smallest taxpayers to obtain the mcjor benefits 

which the ADR system allows without requiring them to learn f' 

system which, while simpler in its ultimate operation th3n 

depreciation based on facts and circumstances, may s eem 

strange and complex to small businessmen and their 

bookl<eepers. 

General Explanation 

Under the proposal, the Secreta ry of the Tr ea sury will 

be authorized to issue special regul a tions governing depreciation by small businesse s. Under the se r egulations, 

- 268 -
qualifying small businesses will be permitted to depreciate 

their assets on the basis of prescribed useful lives that 

cannot be challenged by the Internal Revenue Service. The 

electing small business will be able to adopt a useful life 

within the same 20 percent range above and below the 

prescribed life as is permitted under the ADR system. For 

example, if the prescribed useful life for furniture is 10 

years, a taxpayer will be permitted to compute depreciation 

on the basis of any period between 8 and 12 years. 

A simple table will be published to help taxpayers 

determine the range of useful lives over which they can 

depreciate their assets. 

Small businesses electing to depreciate assets on the 

basis of the prescribed useful lives will be able to ignore 

salvage value in claiming their depreciation deductions (as 

will taxpayers who elect the new simplified ~DR system). 

Small businesses will be permitted -- but not required 

to adopt a convention (the "half-year convention") that 

will enable them to begin computing depreciation for all 

assets placed in service during a taxable year from the first 

day of the second half of the taxable year (July 1 for 

calendar year taxpayers). If a small business does not elect 

the half-year convention, it may cl~im depreciation for each 

asset from the date that a sset was placed in service during 

the taxable year. 

Unlike taxpayers who elect the ADR system, qualifying 

businesses generally will not be required to participate in 

any special information gathering surveys. When they are 

r equired to furnish information, it is expected that the 

surveys will be conducted in a manner consistent with the 

limited professional resources normally available to small 

businesses. 

In all othe r respects, taxpayers will be able to 

continue to deprecicte their assets as they have done in the 

past. 

A qualifying busin ess will be any busin~ss whose 

depreci abl e ass~ts have an aggregate initial cost of $500,000 

or l e ss. For this purpose, only assets for which prescribed 

lives are in effect will be taken into account. The $500,000 

test will be applied at the level of the business (for 

e xample, at the part nership l evel rather than at the leve l of 

e ach partne r). Special rules (similar to those now 

applicoble for purposes of the Jobs Cr edit) will be applied 

to prevent the d ivision of a large entit y into a number of 

smaller ones in order to t ake advantage of this provision. 

The opportunity to t ake advantage of this special 

deprecia tion system will be available to more than 90% of all 

corpor a tions, p artne rships and sole proprietorships. 

- 269 -
Effective Date 

The special depreci a tion s ys t em for small busin e sse s 

provided by the proposal will be applicable with respect to 

property placed in service by the taxpayer in taxable yea rs 

beginning after December 31, 1978. It is expected that 

regulations will be 9romulga t ed unde r this section be for e 

March 1, 1980, so that taxpa ye rs filing returns for taxa ble 

years ending on December 31, 1979, will have sufficient time 

to de termine whether to e l ect the new special depr e cia tion 

system for small businesses on the ir returns. 

Revenue Estimate 

The propos a l will ha ve no s ignificant revenue e ff ect. 

- 270 -
IVC-4 

SMALL BUSINESS STOCK 

Present Law 

Generally, the full amount of an ordinary loss is 

allowed as a deduction under present law. On the other hand, 

an individual may deduct capital losses only to the extent of 

capital gains plus $3,000 of ordinary income. Moreover, 

$2,000 of net long-term capital loss is required to offset 

$1,000 of ordinary income. Thus, at most $6,000 long-term 

capital loss can be used to offset $3,000 of ordinary income 

in any taxable year. Unused capital losses can be carried 

over indefinitely to future taxable years. 

Under ~resent law, unless an individual is a dealer, a 

loss on stock is generally treated as a capital loss. 

However, an exception is ~rovided for "section 1244 stock." 

A loss sustained by an individual on section 1244 stock is 

treated as an ordinary loss, up to a maximum of $25,000 in 

any one year ($50,000 in the c~se of a husband and wife 

filing a joint return). This exce~tion is designed to 

encourage investment in small business by decreasing the risk 

of such investment. 

The exception applies only if the stockholder is an 

individual (and not a corporation, estate, or trust). The 

stockholder may purchase section 1244 stock in his individual 

capacity or in partnership with others. However, the 

exception applies only to losses sustained by the original purchaser of section 1244 stock, and not to losses sustained 

by any subsequent purchaser. 

Section 1244 stock must be common stock in a domestic 

corporation. Furthermore, section 1244 stock must be issued 

pursuant to a plan adopted by the issuing corporation, and 

must be issued for money or other property (not including 

stock or securities). 

Two additional requirements a re imposed in order to 

limit the benefits of section 1244 to small business. First, 

a corporation may not issue more than ~500,000 worth of 

section 1244 stock. Second, the tota l stock offering plus 

the equity capital of the cor~oration may not exceed 

$1,000,000. Thus, a corporation whose equity c apital exceeds 

$1,000,000 cannot issue section 1244 stock. 

A further requirement limits the benefits of s e ction 

1244 to operating com~ani s. Under this requir ement, in the 

five years before the taxpayer sustcins a loss on his stock, 

the corporation must derive more than 50 percent of its gross income from sources othe r than roy a lties, r ents, d ividends, 

- 271 -
interest, annuities, and sales or exchanges of stock or 

securities. 

Reasons for Change 

Small businesses need capital to modernize and to 

maintain a rate of expansion that will permit them to 

contribute fully to the well-being of the economy. To assist 

small business in raising the capital it needs, additional 

steps should be taken to decrease the risk of investment in 

small business stock. 

General Explanation 

The proposal will liberalize the rules relating to 

section 1244 stock. A small business corporation will be 

permitted to issue up to $1,000,000 of section 1244 stock, 

which is double the amount permitted by present law. The 

maximum amount allowed as an ordinary loss in any one year 

will be increased to $50,000 ($100,000 in the case of ~ 

husband and wife filing a joint return), which is also double 

the amo~nt allowea under present law. The proposal will also 

eliminate the requirement of a plan and other technical 

requirements that needlessly restrict the ability of small 

business corporations to issue section 1244 stock. 

Effective Date 

The proposed changes will apply to stock issued by corporations in taxable years of the corporation beginning 

after December 31, 1978. 

Revenue Estimate 

The proposal will have no · significant revenue effect. 

Technical Explanation 

Generally, the rules relating to section 1244 stock will 

be liberalized. The size limits on the issuing corporation 

will be relaxed. A corporation will be permitted to issue up 

to $1,000,000 of section 1244 stock, instead of the $500,000 

permitted by present law. Moreover, the existing $1,000,000 

limit on the corporation's equity capital will be completely ~liminated. 

In addition, the requirement of a plan will be 

eliminated. All stock issued during a taxable year of the 

corporation will be section 1244 stock if the aggregate worth 

of all stock ever issued by the corporation is $1,000,000 or 

less. (For this purpose, the worth of stock will be the 

value of the consideration paid for the stock at ~he time it 

was issued.) It the aggregate worth of all stock exceeds 

$1,000,000 at the end of the taxable year, but was l e ss than 

$l,OOO,UOO at the beginning of the year, then an allocable 

portion of the stock issued during the year will be treated 

as section 1244 stock. For example, assume that the 

aggregate worth of all stock issued by a corporation is - 272 -
$400,000 on the first day of its taxable year, January 1 , 

1979. If the corporation issues $900,000 of common stock ct 

$9 ?er share during 1979, then two out of every six shares 

issued during 1979 will be section 1244 stock. The 

corporation will be able to desi gnate certain shares 

specially as section 1244 stock at the time they are issued. 

In the absence of such a special designation , each 

shareholder who purchases stock during 1979 will treat two 

out of every three of his shares as section 1244 stock. 

(Fractional shares will not, however, be treated as section 

1244 stock. Thus, if a shareholder purchases ten sh?.res of 

stock during 1~79, only six shares will be treated as section 

1244 stock.) 

Further, a loss sustained by an individual on section 

1244 stock will be treated as a n ordinary loss up to a 

maximum of $50,000 in any one yea r ($100,000 in the case of a 

husband and wife filing a joint r eturn). These are twice the 

maximum amounts allowed under present law. 

- 273 -
IVD - 1 

CORPORATE PREFERENCES 

REPEAL OF DISC 

Present Law 

A Domestic International Sales Corporation (DISC) is a 

special corporation established to shelter export income from 

taxation. Often it is only a paper corporation with no 

employees or real business activity. The profits of a DISC 

are not taxed to the DISC, but are taxed to the DISC 

shareholders when such profits are distributed or deemed to 

be distributed. 

The shareholders of a DISC (typically a parent 

corporation which is an operating company) are deemed to 

receive an annual dividend equal to a portion of the DISC's 

profits. This deemed dividend is fully taxable to the 

shareholders. Federal income taxation is deferred on the 

remainder of the DISC's profits. Because the tax is deferred 

indefinitely and because the parent can use the DISC's 

retained profits to finance its own export activity, the 

deferral of taxation is in effect equivalent to exemption. 

Prior to 1976 the deemed dividend was fixed at one-half 

of a DISC's total profits. However, the Tax Reform Act of 

1976 reduced DISC benefits. The incremental provision 

adopted in that legislation limits DISC deferral to one-half 

of export profits in excess of 67 percent of average export 

profits over a four-year base period. For taxable years 

beginning in 1976 through 1979, the base period years are 

1972 through 1975. In 1980 and thereafter, the base period 

will move forward on a year-by-year basis. 

A DISC usually acquires goods from its parent 

corporation or an affiliated corporation (a •related 

supplier•) and sells them abroad. Alternatively, a DISC may 

act simply as a commission agent on export sales. Even if 

the DISC does nothing, paper profits are allocated to it. 

The method used for allocating profi s between a DISC 

and its related suppliers is an important part of the DISC 

statute. The allocation is achieved through special 

intercompany pricing rules permitting the DISC to realize 

profits which do not exceed the greater of: 

(a) 4 percent of the qualified export receipts 

attributable to the sale of export property plus 10 percent 

of related •export promotion expenses,• defined as ordinary 

- 274 -
and necessary expenses incurred to obtain export profits; 

(b) 50 percent of the combined profits of the DISC and 

its related suppliers attributable to exports, plus 10 

percent of related export promotion expenses, 

(c) profits based on an arm's-length price. 

Neither the 4 percent method nor the 50 percent method 

may be applied in such a way as to produce a loss to the 

related supplier while the DISC is earning a profit. These 

special rules serve, however, to allow u. s. exporters to 

allocate more income to a DISC, and thus to defer a larger 

portion of their total tax burden, than they could under the 

normal arm's-length rule. 

Reasons for Change 

The principal objectives of the Revenue Act of 1971 were 

•to increase our exports and improve our balance of 

payments." 1/ To help accomplish these objectives, the Act 

added the DISC provisions to the Internal Revenue Code. 

The contribution of the DISC legislation to the promotion of exports has, however, been minimal. A 1977 Treasury 

Department report to Congress estimates the net effect of the 

DISC program on 1975 u.s. exports to have been between $1 

billion and $2.5 billion, less than 3 percent of total u.s. 

exports of $98 billion for 1975. This estimated increase in 

exports attributable to the DISC program was achieved at a 

cost of $1.2 billion in tax revenue. Although U.S. exports 

have increased dramatically since the enactment of the DISC 

legislation, this expansion is largely attributable to other 

factors, including major dollar devaluations, inflation of 

export prices, and a sharp increase in the real volume of 

world trade associated with a rapid rate of real economic 

growth, especially in the Mideast. 

The balance of payments arguments originally advanced in 

support of the DISC legislation are substantially weakened 

under a system of flexible exchange rates. To the extent 

that DISC promotes exports, it lessens the depreciation of 

the dollar in foreign currency markets. Although sudden and 

abrupt depreciation may be undesirable, a slower and more 

orderly depreciation encourages u.s. companies to export more 

and import less. The balance of payments adjustment process 

may take time, but it does take place. Between 1971 and 

1977, the u.s. merchandise trade balance has swung from 

deficit to surplus to deficit to surplus and now back to 

deficit again. DISC is thus an anachronism in a world of 

flexible exchange rates, and a costly and wasteful 

anachronism at that. 

- 275 -
If the United States wishes to assist the balance of 

payments adjustment process, other programs, such as the 

contemplated $2.2 billion increase in direct loans and $1.8 

billion increase in loan guarantees by the Ex-Im Bank, are 

clearly preferable to DISC. Not only can Ex-Im Bank loans be 

more effectively aimed at producing genuine increments in 

U.S. exports, but the program can be scaled down in periods 

of balance of payments surplus. DISC is not an appropriate 

or a particularly effective policy for coping with 

transitional problems of balance of payments adjustment. 

Congress has consistently been more skeptical of the 

DISC program than previous Administrations. In 1971, 

Congress cut in half the Nixon Administration's request for a 

complete deferral of taxation of DISC income. And Congress 

required the Treasury to report annually on the operation of 

the DISC legislation in practice. As the revenue cost of the 

DISC program soared far above initial projections, Congress 

overrode the opposition of the Ford Administration and 

further pared the cost of the DISC program. Nevertheless, 

the revenue cost of the DISC program once again e~ceeds a 

billion dollars per year, with little evidence that this 

money is being wisely spent. 

Like all tax reductions, DISC tends to make it~ 

beneficiaries more competitive. But the beneficiaries of the 

DISC legislation tend to be the largest and most profitable 

of U. s. companies1 DISC helps little, and may actually harm, 

footwear, textile, and steel producers facing competition 

from imports. Moreover, the substantial domestic costs of 

the DISC program are out of all proportion to the dubious 

value of DISC as a •bargaining chip• in international trade 

negotiations. Thus, continuing skepticism of the value of 

DISC is well-founded. The DISC program should be repealed. 

General Explanation 

Tax benefits granted to DISCs and their shareholders are 

to be phased out over a three-year period beginning in 1979 

and ending in 1981. 

The phase-out of DISC benefits will be accomplished by 

increasing the deemed distribution from the present 50 

percent of DISC profits attributable to •incremental• 

exports. For taxable years ending in 1979, DISCs will be 

deemed to distribute 66-2/3 percent of such profits, and for 

taxable years ending in 1980 the deemed distribution will 

rise to 83-1/3 percent. DISC is repealed for the first 

taxable year ending after 1980. Accumulated past earnings of 

a DISC will continue to be tax deferred as long as they 

remain invested in export-related assets. 

- 276 -
Analysis of Impact 

(1) Impact on Exports, the Balance of Trade, and u.s. 

Employment 

Companies benefiting from the DISC program can cite 

impressive statistics on the growth of their exports since 

the DISC legislation w~s enacted in 1971, on the number of 

jobs in their company that are dependent on export sales, on 

the number of jobs in supplier industries indirectly 

dependent on export sales, etc. Naturally, workers will be 

alarmed if told that their jobs depend on the continuation of 

the DISC program. A close examination of company statements 

reveals, however, little information on the specific 

contribution of DISC either to export sales or to employment. 

Disinterested econo•ic analyses of the rapid growth of U. S. 

exports since 1971 indicate that such growth is largely due 

to factors other than DISC. The primary contributors to this 

growth have been: 

Prom 1971 to 1974 the dollar fell in value 

relative to foreign currencies by 13 percent.2/ 

This decline meant that foreign currency prices 

of u.s. exports fell relative to prices of goods 

from other countries, thus making U.S. goods more 

attractive to foreign purchasers. 

About half of the increase in the value of u.s. 

exports from 1971 to 1974 was attributable to 

general increases in all prices, reflecting 

worldwide inflation. The price rise was especially rapid for certain agricultural products and 

industrial supplies. 

A sharp increase in the real (price deflated) 

volu.e of world trade was associated with a rapid 

rate of real growth. According to United Nations 

estiaates, the real volume of world trade was 30 

percent higher in 1974 than in 1971. During this 

period u.s. exports grew more or less in proportion 

to world tradeJ as a consequence, the u.s. share in 

the exports of industrialized countries rose by only 0.6 of a percentage point, from 18.9 percent 

in 1971 to 19.5 percent in 1974. 

The Treasury Departaent's most recent report to Congress 

on the DISC program concluded that, had exchange rates been 

fixed, DISCs would have contributed only $1 billion to $2.5 

billion to net u.s. exports. Much of the growth in exports 

benefiting from the DISC legislation may have come at the 

expense of non-DISC exports. The Treasury report pointed 

out, moreover, that under the system of flexible exchange 

- 277 -
rates adopted in 1973, an increase in u.s. exports will 

increase the demand for dollars in foreign countries. This 

will, in turn, stimulate U.S. imports by reducing import 

prices in terms of dollars. The increase in u.s. exports due 

to DISC is thus offset by an increase in u.s. imports, and 

the net impact of DISC on the balance of trade is much less 

than the impact on exports. 

DISC supporters often argue that flexible exchange rates 

have not been successful in restoring the u.s. balance of 

payments, and that DISC is necessary to reduce the current 

balance of trade deficit. To support their argument, 

proponents of the DISC program note that many foreign 

governments intervene in foreign exchange markets to keep the 

dollar from depreciating, that foreign import quotas and 

other trade barriers prevent u.s. exports from expanding as 

the dollar depreciates, and that foreign demand for many of 

the goods which the U.S. exports (~, agricultural 

products) does not expand much as their price falls. Even if 

these assertions were factually correct, however, they would 

not support the retention of the DISC program. 

If depreciation of the dollar does not promote U.S. 

exports, neither does DISC. Both must work through the same 

mechanism: making exporting more profitable. As the dollar 

depreciates, the foreign currency price for u.s. exports 

translates into a higher dollar value, which raises export 

profits before and after taxes. With a DISC the tax burden 

on export income is decreased, so that after-tax profits 

increase even if before-tax profits are unchanged. If U.S. 

manufacturers cannot expand their exports when depreciation 

of the dollar makes foreign sales more profitable, they should not be able to expand those exports because DISC makes 

those sales more profitable. Thus, the argument that 

flexible exchange rates do not work is also an argument that 

DISC does not work. 

To assess the further argument of some persons that DISC 

promotes U.S. employment, it is necessary to translate the 

impact of DISC on the balance of trade into an impact on 

employment. This requires estimates of the labor intensity 

of exports versus imports. If imports indirectly induced by 

DISC are highly labor intensive, it is possible that the DISC 

program actually produces a decline in U.S. employment. 

DISC represents only one of many ways of reducing taxes, 

and a tax reduction is only one of the available 

macroeconomic tools -- expenditure programs, monetary 

expansion, and debt policy are alternatives -- for 

stimulating the economy. Therefore, a complete evaluation of 

the employment impact of DISC would require an analysis of 

the costs and benefits of alternative programs. Concern 

about u.s. employment should be -- and is-- reflected in the 

President's overall budget proposals, rather than in any one 

part alone. 

- 278 -
(2) Impact on the Competitive Position of U.S. Corporations 

U.S. exporters often argue that repealing DISC will make 

them less competitive in world markets. It is true that any 

tax increase leaves a corporation with fewer funds available 

for new investment, research and development, and so forth. 

But it is also true that competitiveness is a fact of 

business life for all firms, not just the corporations 

benefiting from DISC. Because of the legal and accounting 

costs of complying with the complex DISC legislation, larger 

corporations necessarily make more use of the DISC 

legislation than smaller corporations do. According to the 

1977 Treasury report on DISC, over 60 percent of total DISC 

tax benefits went to parent companies with more than $250 

million in assets. 

Moreover, the profit margin on DISC export sales was 

14.7 percent, which was more than twice as large as the 

comparable 6.5 percent margin on sales to the domestic, U. S. 

market. Those U. S. industries standing most in need of 

assistance, and which benefit not at all from DISC, are those 

facing stiff import competition (~, footwear, textiles, 

steel); they often incur losses that they cannot sustain for 

any extended period of time. Thus, while the DISC program 

perversely tends to help those industries that need help 

least, it also helps least those industries that need help 

most. Clearly, if the ultimate goal is making U.S. 

corporations more competitive, other measures such as the 

Administration's proposed corporate tax rate reduction and 

changes in the investment tax credit are more equitable and 

effective than the DISC program. 

(3) Revenue Cost of DISC 

The revenue cost of DISC in calendar year 1975 was 

$1,390 million. The cost in 1976 was reduced to $870 million 

because of the •incremental• provisions of the Tax Reform 

Act. The costs in 1977 and 1978 are projected to be $1.0 

billion and $1.2 billion, respectively. A rough estimate of 

the cost of each additional dollar of net exports due to DISC 

can be derived by dividing the estimated additional exports 

of between $1 billion and $2.5 billion by the revenue cost 

for fiscal year 1975 of $1.2 billion. Each dollar of 

additional exports thus cost between $1.20 and $.48 in tax 

revenue -- a very expensive cost-benefit ratio. 

Because of its growing concern over the high cost and 

limited benefits of the DISC program, Congress sought in 1976 

to limit DISC benefits to •incremental• exports. Although 

concern with the DISC program is easy to understand, the 1976 

changes appear to have reduced the incentive to export at the 

same time that they reduced the revenue cost. This is 

because an increment to exports in 1976 and thereafter will 

- 279 -
be reflected in a higher base against which •incremental• 

exports will be measured in future years. As a consequence, 

the greater the taxes that are deferred now, the less will be 

the taxes deferred in the future. The Treasury's most recent 

report on DISC concluded that the 1976 changes reduced by 40 

percent the tax incentive to expand exports. Because the 

redu.ction in the revenue cost of the DISC program was also 

roughly 40 percent, there is no reason to believe that the 

DISC program is any more cost-effective now than it was prior 

to 1976. The incremental approach may have produced less 

waste in absolute terms but it is not a solution to the waste 

inherent in the DISC program. 

(4) Impact on U.S. Trade Relations 

The European Community lodged a formal complaint with 

the Contracting Parties of the General Agreement on Tariffs 

and Trade (GATT) in July 1972, asserting that DISC was 

incompatible with Article XVI:4 of the GATT because it 

constituted a tax subsidy on exports. The United States 

entered a counter-complaint against the export tax practices 

of France, Belgium, and the Netherlands. 

Four panels of experts were appointed by GATT, one to 

consider the complaints of the European Community against 

DISC and three to consider the complaints brought by the 

United States against the tax practices of France, Belgium, 

and the Netherlands. Each panel, however, consisted of the 

same persons. 

The panels reported their findings to the GATT Council 

on November 2, 1976. Each of the panels concluded that the 

tax practices subject to complaint •tn some cases had effects 

which were not in accordance with [that country's] 

obligations under 1 ticle XVI:4.• Therefore, each of the 

panels found that •there was a prima facie case of 

nullification or impairment of benefits which other 

contracting parties were entitled to expect under the General 

Agreement (GATT).• 

The GATT Council discussed the panel reports at meetings 

held in November 1976, March 1977, and, most recently, 

November 1977, but it could not reach agreement on their 

adoption. Upon adopt~on, the GATT Council would be in a 

position to make recommendations to the parties regarding 

appropriate settlement of the disputes. At the November 1977 

GATT Council meeting, U. S. representatives proposed that the 

Council adopt the reports of all four panels. The U. S. 

representatives also stressed that the United States was not 

concerned about European tax systems ~ ~, but only with 

the possible tax-haven abuse of those systems. The United 

States expressed the hope that the Europeans shared this 

concern and that this would form a basis for adoption of the 

four reports. 

- 280 -
Prance, Belgium, and the Netherlands continued, however, 

to express reservations about the panel findings on their 

respective tax practices, particularly the definition of 

export activity, and refused to agree to the adoption of the 

panel reports by the GATT Council. Since these countries 

refused to agree on the simultaneous adoption of all the 

panels' reports, the United States refused to accept 

unilaterally the panel report on DISC. 

Supporters of DISC assert that DISC has certain value as 

a •bargaining chip• in international trade negotiations. But 

this factor must be weighed against DISC's substantial and 

growing domestic cost. When DISC is repealed, the United 

States will still have every right to expect other countries 

to bring their tax practices into conformity with GATT. If 

other countries do not make conforming adjustments, the 

Treasury, using the very same reasoning as it did before 

GATT, could find that these foreign tax practices violate 

u.s. domestic law and, accordingly, are subject to 

countervailing duties. In repealing DISC unilaterally, the 

United States will thus not be defenseless in protecting 

itself against the tax practices of foreign countries. 

Effective Date 

The phased repeal of DISC will begin for the first 

taxable year of a DISC ending on or after January 1, 1979 and 

will be complete in taxable years of DISCs ending after 

December 31, 1980. 

Revenue Estimates 

1978 1979 

193 664 

Change in Tax Liability ($ millions) 

Calendar Years 

1980 1981 

1,228 1,513 

Footnotes 

1982 

1,613 

. . 1983 

1,751 

ll B.R. Rep. No. 92-533, 92nd Cong., 1st Sess. 1 (1971): 

s. Rep. No. 92-437, 92nd Cong., 1st Sess. 1 (1971). 

11 The 13 percent figure represents the decline in the 

effective trade-weighted value of the dollar against ten 

major currencies. Source: Board of Governors of the Federal 

Reserve System. - 281 -
IVD - 2 

TERMINATING DEFERRAL 

Present Law 

Under present law u. s. citizens, residents, and corporations 

are subject to u. s. taxation on their worldwide income. Foreign 

corporations, including foreign corporations controlled by u. s. 

taxpayers, are generally subject to U. S. taxation only on income 

earned in the United States. 

Although the income of a foreign corporation controlled by a 

U. s. shareholder is usually consolidated with the income of the 

U. s. shareholder for purposes of financial reporting, this is not 

the case for tax purposes. The shareholder's income subject to 

U. S. tax generally includes only dividends received from the 

foreign corporation and not the earnings that the foreign 

corporation retains. The U. s. tax on dividends from the foreign 

corporation may be offset by a credit allowed for the foreign 

taxes paid by the foreign corporation. 

•oeferral• refers to the practice of not taxing the income of 

a u. s.-controlled foreign corporation until that income is 

distributed to the controlling u. s. shareholders. The term 

•deferral• is employed because the net U. S. tax liability -- equal to the difference between the U. s. tax and the credit for 

foreign taxes -- is •deferred• until such income is distributed as 

a dividend. 

Deferral does not apply when the nature of the controlled 

foreign corporation and its income exhibit •tax haven• characteristics. Tax haven income (so-called •subpart F income•) is 

taxed currently to u. s. shareholders regardless of whether they actually receive the income in the form of a dividend. Likewise, 

u. s. shareholders are taxed on their pro rata share of the 

retained earnings of a foreign personal holding company, and on 

the earnings of any controlled foreign corporation which are in 

effect repatriated to the United States through the purchase of 

certain u. s. property. 

Since the practice of deferral permits the income of 

controlled foreign corporations to escape current u. S. taxation 

until that income is repatriated as a dividend, it is important 

that transfer prices for transactions between U. s. shareholders 

and their controlled foreign corporations be properly determined. 

It is also necessary to ensure that reorganizations involving 

controlled foreign corporations are not undertaken for the purpose 

of tax avoidance. The tax law presently contains complex provisions designed to carry out these purposes. 

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Reasons for Change 

The fundamental defect in the concept of deferral is that it 

makes very substantial tax benefits turn upon an artificial 

factor: whether a foreign corporate charter has been interposed 

between foreign income and the u. s. taxpayer. In addition to 

curing this defect, the termination of deferral will eliminate the 

tax incentive that u. s. taxpayers now have to locate new investment overseas rather than in the United States. 

Terminating deferral will permit the rationalization and 

simplification of U. s. rules for the taxation of foreign income. 

Termination will help stimulate competition between large 

multinational corporations and their smaller competitors, by 

remov1ng tax benefits which accrue principally to the large 

multinationals. Finally, terminating deferral will reduce the 

incentive inherent in present law for U. s. taxpayers to avoid 

u. s. tax by undercharging foreign affiliates for goods, services, 

research, and home office overhead. 

(1) Terminating Deferral will Preclude Substantial Tax Benefits 

From Turning on the Choice of Corporate Structure 

When losses or large foreign tax credits are desired for 

u. S. tax purposes, a u. s. taxpayer may obtain these benefits 

currently by operating overseas through a branch. When foreign 

income does not generate sufficient foreign tax credits to offset 

U. s. tax, a current u. s. tax may be avoided by interposing a 

foreign corporate entity. A u. S. taxpayer is thus permitted to 

choose, through the form of its overseas operations, between two 

very different sets of substantive U. S. tax rules. 

There is no good reason for this state of affairs. A choice 

of tax rules should not be accorded simply because business 

operations are situated abroad rather than in the United States. 

Such operations, in the case of a controlled foreign corporation, 

are an integral part of the overall activity of the u. s.-based 

firm, and the profits from such operations should, for this reason 

alone, be subject to current taxation in the United States. 

In 1969 Congress dealt with a similar situation involving the 

availability of the $25,000 surtax exemption for each entity in a 

group of related domestic corporations. Congress took the view 

that a commonly owned business enterprise should be entitled to 

only one such exemption, whether it was operated under a single 

corporate charter or multiple charters and regardless of any 

genuine business reason for having multiple charters. The issue 

in the case of deferral is essentially the same: even if fully 

justified by business considerations, the interposition of foreign 

corporate charters should not affect the substance of u. S. 

taxation. 

This point is, in fact, already recognized by some provisions 

of the Internal Revenue Code dealing with foreign income. U. S. 

- 283 -
corporations are allowed a foreign tax credit (the so-called 

•deemed paid• credit) for taxes paid by their foreign subsidiaries. This allowance, which in 1975 amounted to more than $3 

billion, reflects a recognition that the existence of a foreign 

corporate charter should not determine tax substance. 

(2) Terminating Deferral Will End a Present Tax Incentive To 

Invest Overseas 

Deferral gives U. s. taxpayers a substantial incentive to 

invest overseas for purely tax reasons. This incentive arises 

from a combination of the absence of current u. s. tax on the 

retained earnings of controlled foreign corporations, and the 

presence of tax inducements in many foreign countries. These 

foreign inducements take the form of low tax rates, rapid 

depreciation, tax holidays, and other special tax advantages not 

available in the United States. 

0. s. investors need not look very far for tax holidays, for 

such benefits are heavily marketed in the United States. One 

foreign country, for example, publishes a brochure urging American 

business to •Get in on the ••. bonanza!• The bonanza includes 

•tax holidays, unlimited remittance of profits, repatriation of 

capital, protection against risks and the assistance offered by a 

friendly government from application to the start of production.• 

Another recent advertisement in a business publication has a 

banner headline: •Exceptional Return on Investment Continues •••• • 

As the advertisement explains, •export profits •••• are 

completely free of tax until 1990. So a U. s. subsidiary .••• 

grows faster, and at less cost to the u. s. parent. In spite of 

the fact that profits can be freely repatriated, u. s. companies 

ploughed back 65 percent of them and notched up an expansion of 

u. s. investment of 30 percent.• With an exemption from foreign 

tax and a deferral of U. S. tax, it is easy to understand why 

profit margins in this country are abnormally high. 

Tax incentives to invest abroad stand in conflict with the 

general policy of the United States to encourage investment of 

U. s. capital where it will be most productive, whether in the 

United States or overseas. The elimination of deferral will 

advance this policy, since it will tend to ensure that foreign 

investment will be motivated by genuine economic factors. 

(3) Ending Deferral Will Permit Simplification of the Rules 

Relating to Taxation of Foreign Income 

The termination of deferral will permit the simplification of 

u. s. rules relating to the taxation of foreign income. Subpart 

F, the rules relating to foreign personal holding companies, the 

rules governing the foreign tax credit, and the rules regarding 

reorganizations of foreign corporations will all be affected. 

The subpart F anti-tax haven provisions originated in a 

proposal submitted to Congress in 1961 by President Kennedy. The 

- 284 -
purpose of that proposal, and of the provisions of subpart F, was 

to prevent u. s. businesses from exploiting the multiplicity of 

foreign tax systems and tax treaties so as to reduce or eliminate 

both U. S. and foreign tax liabilities. 

Subpart F as drafted was not, however, structured to 

eliminate international tax avoidance by U. s. firms. It is 

focused exclusively upon a narrow class of so-called "tax haven" 

income. And its provisions are so complex that only a relative 

handful of persons are capable of understanding all of their 

implications. Although subpart F has doubtless discouraged many 

companies from undertaking blatant tax haven operations, highly 

sophisticated means of circumventing both the specific subpart F 

rules and their general objectives are available. Moreover, the 

Internal Revenue Service does not have the resources to mount an 

effective administrative effort to combat such schemes. 

Terminating deferral for all controlled foreign corporations, 

as this proposal recommends, will permit the replacement of 

subpart F with a simpler, more comprehensible set of rules for 

u. S. taxation of foreign income. T~rminating deferral will also 

permit repeal of the Internal Revenue Code provisions relating to 

taxation of foreign personal holding companies -- another series 

of provisions aimed at tax haven abuses. 

Furthermore, t e rminating deferral will reduce the importance 

of the complicated rules relating to both the "deemed paid" 

foreign tax credit and multinational corporate reorganizations. 

The rules relating to the credit are not limited to controlled 

foreign corporations, and will have to remain in effect to cover 

foreign corporations owned in part, but not controlled, by u. S. 

persons. They will not, however, generally be required with 

respect to controlled foreign corporations if deferral is 

terminated, because a foreign tax credit will be available without 

regard to the "deemed paid" credit. The rules regarding corporate 

reorganizations will become less important because the potential 

for tax avoidance on the transfer of assets abroad will be 

diminished. 

Eliminating deferral will thus have the highly desirable 

effect of making the U. s. system of taxing foreign income more 

comprehensible. The present system, complex and internally 

inconsistent, understood in all its detail by only a very few 

highly trained individuals, is simply not appropriate in the U. S. 

tax system. The rationalization of U. s. rules in this area will 

permit the Administration and Congress to see more clearly where 

real problems exist and to structure appropriate solutions having 

no unintended and unforeseen consequences for either taxpayers or 

the government. 

(4) Terminating Deferral Will Help Equity and Competition 

The present system of U. s. taxation of foreign income, with 

deferral as its centerpiece, has produced increasingly 

- 285 · -
sophisticated methods of tax planning by those involved in 

multinational transactions. As the Internal Revenue Service has 

issued new Regulations limiting opportunities for tax avoidance, 

and as Congress has tightened various rules in the system, 

taxpayers have become more and more ingenious in avoiding their 

impact. Offshore financial subsidiaries, holding companies, and 

captive insurance affiliates have proliferated. Computer programs 

to guide tax planning efforts have been developed. The major 

accounting and law firms have devised ever more refined planning 

tec'tr iques. 

For example, the •rhythm method• of distributing dividends 

from foreign companies has become increasingly popular. Under 

this method foreign corporations only pay dividends to their u. s. 

parent companies in those years in which their effective foreign 

tax rate is high, rather than paying smaller dividends on an 

annual basis. Because of deferral and the •deemed paid• credit 

for foreign taxes paid by the foreign corporation, U. S. companies 

are able through this method to minimize u. s. tax on repatriated 

earnings. The technique illustrates how the existence of 

contradictory principles for taxing foreign income -- the •deemed 

paid• foreign tax credit which effectively treats parent and 

subsidiary as one enterprise, while deferral treats them as 

separate -- inevitably gives rise to opportunities for tax 

avoidance. 

(5) Terminating Deferral Will Help Stop Practices Used To Avoid 

U. S. Tax 

U. s. taxpayers have many opportunities today to avoid u. s. 

tax by engaging in various pricing and other practices in 

transactions with their controlled foreign corporations. A 

multinational enterprise routinely engages in many transactions 

with its foreign affiliates. It often sells machinery, parts, 

components, and finished goods to these foreign corporations, or 

imports the same from them. It lends them money, leases them 

equipment, and provides a wide range of managerial services. 

Basic research and development programs for the mutual benefit of 

the domestic taxpayer and its foreign affiliates are often 

centralized in the United States. 

In computing foreign and domestic tax liabilities, a company 

must assign transfer prices to such inter-affiliate transactions. 

To determine whether the assigned transfer prices are appropriate 

for tax purposes, the United States and many other countries apply 

an arm's-length standard-- i.e., they require terms that would 

have been fixed in comparable transactions between an independent 

buyer and seller. The arm's-length standard is a necessary and 

valuable tax measure, but it is sometimes difficult to administer: 

multinational firms often invest abroad because no wellestablished market exists for the goods and services which are 

transferred in inter-affiliate transactions. In this situation 

u. s. taxpayers sometimes seek to reduce U. S. taxes by channeling 

- 286 -
income to low-tax subsidiaries and deductions to the controlling 

u. s. company. Although many multinational companies follow 

perfectly acceptable transfer pricing practices, the experience of 

the Internal Revenue Service has been that some do not, and the 

resultant loss of U. S. tax revenues can be substantial. 

Of course, extensive Regulations setting forth procedures for 

determining arm's-length transfer prices were published in 1968, 

and have limited the range of discretion previously available to 

taxpayers. But no one familiar with international tax planning 

believes that these Regulations have taken the tax incentive out 

of transfer-pricing. The 1968 Regulations reduced, but by no 

means eliminated, the flexibility which companies have in setting 

inter-affiliate prices. 

Since the elimination of deferral will subject U. S. 

shareholders to current tax on the income of controlled foreign 

corporations, it may be expected to reduce if not eliminate the 

incentive to use techniques which serve to transfer excessive 

income to foreign corporations. 

General Explanation 

This proposal will phase out deferral over a three-year 

period. Beginning in 1981 the income of a controlled foreign 

corporation will be taxable as if it had been earned directly by 

the U. S. shareholder. This is the rule that has always obtained 

under the U. S. tax system where foreign operations are conducted 

by a U. s. taxpayer through a branch, rather than through a 

foreign corporation. Thus, U. s. tax liability under the proposal 

will closely approximate the amount that a u. s. shareholder would 

incur if it operated through a foreign branch. For 1979 and 1980 

the above rule will apply to one-third and two-thirds, respec- tively, of the controlled foreign corporation's income. 

The approach taken in this proposal will result in an 

accurate assessment of the U. s. shareholder's u. s. tax 

liability. Losses incurred by a controlled foreign corporation 

will be allowed to offset the u. s. source income of the 

shareholder. Similarly, foreign taxes imposed on the controlled 

foreign corporation will be treated as if they had been imposed on 

the U. s. shareholder and thus will be taken into account 

currently for purposes of the foreign tax credit rather than when 

the underlying income is actually repatriated. 

The proposal allows the Treasury to consider the negotiation 

of tax treaties providing, in appropriate situations, that u. S. 

shareholders will not be taxed currently on certain income of 

their controlled foreign corporations operating in a treaty 

country. 

- 287 -
Analysis of Impact 

(1) Effect on Investment 

Investment which is responding to real market forces will not 

be affected by the termination of deferral. Such investment 

represents a significant part -- but not all -- of u. s. overseas 

investment. 

Most developed countries impose, in addition to corporate 

income taxes, withholding taxes on dividends, interest, and 

royalties paid to u. S. investors. Although the total tax burden 

in such countries is comparable to or higher than that in the 

United States, u. s. investment still flows to these countries 

because their markets are large and growing, consumer incomes are 

high, the demand for U. s. products is substantial, and a u. s. 

company can maintain its market position only by investing 

locally. Likewise, petroleum and other natural resource 

investments flow to countries with abundant natural resource 

deposits despite substantial tax and other payments to the 

governments in those countries. Finally, many less-developed 

countries attract labor-intensive production with low wage rates 

rather than tax incentives. These investments are far more 

typical of U. s. investment abroad than those motivated solely by 

tax considerations, and they will continue without the added 

benefits of deferral. Terminating deferral will thus operate to 

restrict only tax-induced investments. 

The United States does not have any general interest in 

encouraging tax-induced investments. Foreign countries that offer 

tax incentives are not usually interested only in the type of 

investment that attracts exports from the United States and thus 

promotes domestic employment. To the contrary, foreign tax 

incentives are frequently aimed at the type of investment that 

promotes exports to the United States and thus displaces u. s. 

jobs. The United-states has no reason to favor the latter 

category of investments. 

There is good reason to believe that eliminating deferral 

will provide a moderate stimulus to total u. s. investment and 

employment. For some companies production in the United States is 

a direct and viable alternative to producing abroad. Some U. S. 

companies may have been induced by the combination of deferral and 

foreign tax incentives to stop exporting and start producing 

overseas. Alternatively, some companies may have stopped 

supplying the domestic u. s. market with goods made in the United 

States, electing instead to rely on imports from their own foreign 

affiliates. Moreover, even when domestic investment is not a 

direct substitute for foreign investment, domestic production can 

still benefit indirectly from the repeal of deferral. The capital 

that would have been used to finance a tax-induced foreign 

investment can be retained in the United States and used to 

finance an unrelated, but job-producing, domestic investment. The 

gains may be substantial in specific industries where foreign tax 

practices have hastened the export of jobs and capital. 

- 288 -
(2) Competitiveness of u. s. Corporations Overseas 

Some U. s. companies maintain that they cannot remain 

competitive in world markets without deferral. Any change which 

alters corporate tax burdens tends to alter the funds available 

for new investment, new research and development, and other 

programs aimed at expansion. But if this is true of deferral, it 

is equally true of other tax measures such as changes in the 

corporate tax rate or the investment tax credit. 

These other methods of promoting competitiveness are better 

and fairer than deferral. In order to benefit from deferral, a 

corporation must invest abroad, not in the United States. As 

noted above, deferral may encourage companies to invest abroad for 

export back to the United States, thereby undermining the 

competitiveness of U. s. companies that choose to stay at home. 

Zenith Corporation, for example, was forced to go overseas not 

only by its Japanese competitors (Sony, Panasonic, etc.) but also 

by its American rivals (RCA, Motorola, etc.) that went abroad to 

carry out assembly operations. Finally, deferral promotes 

continued investment overseas; repatriation of profits, which 

would help domestic investment, is actually discouraged by 

deferral. None of these perverse side effects of deferral 

characterizes reduction of the corporate tax rate and expansion of 

the investment tax credit, measures which the Administration has 

proposed. 

It should be noted, finally, that the competitiveness of a 

corporation depends on its overall tax burden, not on any single 

tax provision. Terminating deferral represents only a small 

offset to the benefits envisioned for companies in the 

Administration's tax package. 

(3) Reactions of Foreign Governments 

It is often argued that if the United States terminates 

deferral, foreign countries will retaliate by discriminating 

against o. s. investors so that u. s. companies will pay higher 

taxes to foreign governments rather than the United States. 

Foreign countries, it is said, may revoke the eligibility of u. s. 

subsidiaries for tax holidays or accelerated depreciation, or they 

may deem all earnings distributed and thereby subject to high 

withholding taxes. 

Such developments are, however, unlikely in the case of 

developed countries. The tax rates in most of these countries 

match those of the United States. Furthermore, most developed 

countries have tax treaties with the United States that require 

nondiscriminatory treatment of u. s. investors. Since residents 

of developed countries often have substantial investments in the 

United States, it is doubtful that these countries would risk 

abrogation of their treaties with the United States. 

- 289 -
The United States has tax treaties with only a few lessdeveloped countries, and the tax burden in some of these countries 

is lower than that in the United States. However, in many cases 

there will be no reason for these countries to retaliate against 

U. s. investment, because the termination of deferral will not 

produce higher U. S. taxes for many of the multinational companies operating within their borders. 

Numerous u. s. companies already have an overall excess of 

foreign tax credits, and more will fall into this category if the 

u. s. corporate tax rate is reduced to 44 percent, as the 

Administration proposes. Under the •overall• foreign tax credit 

limitation -- the only limitation now in effect -- operations in 

low and high tax countries are combined. In the case of taxpayers 

with excess foreign tax credits, the United States will not, upon 

the elimination of deferral, impose any tax on profits from 

low-tax countries which are •sheltered• by excess credits from 

high-tax countries. Thus, many u. s. companies operating in 

foreign countries with a low rate of tax will not bear any more 

U. s. tax upon the elimination of deferral, and therefore those 

foreign countries will not have an incentive to raise taxes in 

retaliation to this proposal. 

Furthermore, it is by no means clear that even a low-tax 

country believing that the end of deferral will subject u. s. 

investors to a higher u. s. tax burden will choose to retaliate. 

In the first place, it will be made clear that discriminatory 

taxes aimed at •soaking up• the difference between a foreign 

country's rate and that of the United States are not creditable 

under u. S. law. Low-tax countries desirous of promoting U. s. 

investments may not wish to take actions that could have the 

effect of actually penalizing such investments. More likely, such 

countries may wish to •validate• some of the tax incentives that 

they of£er by seeking treaty provisions under which U. S. 

investors within their borders would continue to be entitled to 

deferral. 

In some cases the United States may wish to validate the tax 

incentives that a developing country offers to U. S. investors. 

For example, investments that promote genuine economic 

development, have a minimal impact on U. s. employment, or 

increase U. s. access to critical raw materials may serve the 

national interest. But rather than giving a blanket incentive to 

foreign investment of all types and in all countries, the United 

States should focus the benefits of deferral through its tax 

treaty program. If deferral is terminated subject to exceptions 

by tax treaties, less-developed countries will be far more eager 

to conclude treaties with the United States than they have been in 

the past and developed countries that have treaties with the 

United States or are engaged in treaty discussions may be 

persuaded to offer favorable concessions. 

- 290 -
(4) Administrative Impact Upon Taxpayers 

It is sometimes argued that terminating deferral will involve 

serious administrative problems for U. s. companies. U. s. 

taxpayers, it is said, will not be able to maintain or obtain 

adequate records reflecting the income and deductions of 

controlled foreign corporations, particularly when there is no 

majority U. s. shareholder. It is also argued that the difficulty 

of translating books and records kept in foreign currency and 

under foreign standards into U. S. currency and standards 

justifies the retention of deferral. 

The Administration is aware that there may be some 

administrative difficulties in some situations. However, U. s. 

companies with overseas branches, which have always been required 

to report foreign operations currently, have been able to solve 

these problems. u. s. parent corporations have long reported the 

earnings of controlled foreign corporations for SEC and general 

accounting purposes. And since 1962, controlled foreign 

corporations of U. S. shareholders have translated their books and 

records into U. S. standards for the purposes of subpart F. 

Finally, the provisions allowing for a "deemed paid" foreign tax 

credit, which have been in the law since 1918, require every u. S. 

corporation owning 10 percent of any foreign corporation (whether 

or not controlled by u. s. interests) to transl Jte foreign books 

and records into U. s. standards in order to obtain the benefit of 

the indirect foreign tax credit. Administrative problems that 

have been surmountable in these cases will likewise be surmountable when deferral is terminated. 

Effective Date 

The phase-out of deferral will apply to the first taxable 

year of each controlled foreign corporation ending in 1979 and to 

taxable years of U. S. shareholders with which or within which 

such taxable years of such foreign corporations end . 

- 291 -
Revenue Estimates 

1978 

0 

. . 1979 

88 

Change In Tax Liability ($ millions) 

Calendar Years 

1980 1981 1982 

280 768 830 

1983 

897 

These estimates do not take into account the effect of the 

proposed reductions in the corporate tax rate. The revenue gain 

from terminating deferral depends on the spread between the u.s. 

and average foreign tax rates. Therefore even a relatively small 

decrease in the u.s. tax rate can substantially reduce the revenue 

gain from terminating deferral. 

Behavioral adjustments could also affect these estimates. 

Some investors may, for example, increase their actual dividends 

and thereby incur foreign dividend withholding taxes; this would 

reduce net taxes paid to the United States. 

Other behavioral adjustments could, however, increase U. s. 

tax revenues beyond the above estimates. U. s. investors may 

invest more at home and less abroad than they would if deferral 

were maintained. The reduction of tax incentives to manipulate intrafirm transfer prices in order to shift taxable income away 

from the United States could produce substantial revenues not 

taken into account in the estimates. Although the potential 

revenue gains from these location-of-investment and transferpricing adjustments are impossible to estimate, they could easily 

outweigh any adverse revenue consequences of other behavioral 

adjustments attributable to the elimination of deferral. 

Technical Explanation 

(1) Current Inclusion of Income Earned by Controlled Foreign 

Corporations 

The proposal will currently include in the income of U. S. 

shareholders their pro-rata share of the gross income and 

deductions of controlled foreign corporations. Income and 

deductions of each controlled foreign corporation will be treated 

as having been earned and incurred by the U. s. shareholder. The 

character of the income or deduction will be the same in the hands 

of the u. s. shareholder as it would have been if the activity had 

- 292 -
been carried out abroad directly rather than through a foreign 

corporation. Controlled foreign corporations will, however, 

continue to be treated as corporations for the purposes of rules 

affecting transfer prices, corporate reorganizations, and other 

provisions of current law. 

(2) Controlled Foreign Corporation 

A controlled foreign corporation will be any foreign 

corporation of which either: (a) more than 50 percent of the 

total combined voting power of all classes of stock is owned, or 

is considered owned, by U. s. shareholders: or (b) more than 50 

percent in the value of the outstanding stock is owned, or is 

considered owned, by U. S. shareholders. The use of a voting 

power test is consistent with present subpart F provisions. The 

use of a value test is consistent with the foreign personal 

holding company provisions. 

(3) u. s. Shareholder 

A u. s. shareholder is a u. s. person who owns, or is 

considered as owning, either: (a) 10 percent or more of the total 

combined voting power of all classes of stock entitled to vote of 

a foreign corporation; or (b) 10 percent or more in the value of 

the outstanding stock of a foreign corporation. For purposes of 

determining whether a company is a controlled foreign corporation 

and whether a person is au. s. shareholder, the meaning of "U. s. 

person" as well as the constructive stock ownership rules will be 

substantially the same as those now contained in subpart F. 

(4) Percentage Inclusion 

The amount of a controlled foreign corporation's gross income 

and deductions attributable to a U. S. shareholder will be 

determined in proportion to that shareholder's rights to the net 

earnings of the corporation. This approach is substantially the 

same as that set forth in the current Regulations under section 

1248. 

(5) Treatment of Noncorporate Shareholders 

Noncorporate shareholders required to include income and 

deductions currently will be treated as though such amounts were 

initially received by a domestic corporation. This rule, the 

mechanics of which have been developed under subpart F, will 

ensure equality of treatment between noncorporate and corporate 

shareholders. 

(6) Losses 

The excess of deductions over the gross income of a 

controlled foreign corporation will be treated as if realized 

directly by au. s. shareholder, regardless of whether a corporate 

shareholder meets the stock ownership requirements for filing a 

consolidated return domestically. 

- 293 -
If a u. S. shareholder has an overall foreign source loss 

attributable in whole or in part to the shareholder's pro-rata 

share of the losses of one or more controlled foreign corporations, the loss may offset his u. s. source income but will be 

subject to the recapture rules currently in section 904. 

(7) U. S. Branch Rule 

Gross income, deductions, and U. S. 

of a controlled foreign corporation will 

U. S. shareholders of that corporation. 

accordingly, be twice subjected to U. s. 

(8) Blocked Income 

taxes of a 0. s. branch 

be attributed to the 

This income will not, 

tax. 

For the purpose of exchange control, certain foreign 

countries do not allow the expatriation of earnings derived within 

their borders. The proposal recognizes that it is inappropriate 

to tax currently all the earnings of a controlled foreign 

corporation in cases where distributions to U. s. shareholders 

have been "blocked" by currency or other restrictions imposed by a 

foreign country. 

The Administration recognizes that the current rules with 

respect to blocked income may not be appropriate when deferral is 

terminated. It is anticipated that Regulations will be promulgated to describe those situations that prevailed prior to 1978 

that will be treated as creating blocked income. However, any 

currency or other restrictions that are imposed solely against 

u. s. shareholders or imposed solely on a shareholder-byshareholder basis will not be recognized as blocking income. 

(9) Repatriation of Previously Taxed Income 

Previously taxed income will be excluded from gross income of 

a u. s. shareholder when such income is distributed to the 

shareholder or any other U. s. person who acquires any portion of 

the U. S. shareholder's interest in the controlled foreign 

corporation. 

(10) Basis Adjustments 

As gross income and deductions of a controlled foreign 

corporation are recognized by the U. s. shareholder, an adjustment 

will be made to the basis of the shareholder's stock in the 

controlled foreign corporation. Actual distributions from the 

corporation that are excluded from gross income because they are 

attributable to previously taxed income will decrease such basis. 

(11) Foreign Tax Credit 

Since income and deductions will be treated as if realized 

directly by u. S. shareholders, foreign taxes paid by controlled 

- 294 -
foreign corporations, regardless of tier, will be treated as if 

paid directly by u. s. shareholders. This rule simplifies the 

foreign tax credit by making unnecessary the •deemed paid• foreign 

tax credit calculation in the case of u. s. shareholders of 

controlled foreign corporations. Further, the rule removes an 

inequity in current law, under which a foreign tax credit is 

denied for any year in which a foreign corporation has a deficit 

calculated under u. s. principles, even though taxes were paid to 

a foreign country. 

Eliminating deferral reduces both a corporation's ability to 

control the effective rate of foreign tax by controlling the 

source and rate of dividend distributions and the corporation's 

ability to minimize timing differences in deductions between the 

United States and foreign countries. To allow for such timing 

differences, it is p roposed that the foreign tax credit carryback be lengthened from 2 to 3 years and that the f oreign tax credit 

carryforward be lengthened from 5 to 7 years. It will be made 

clear that a foreign tax credit will not be allowed for 

withholding taxes applied only to u. s. investors, or on a 

shareholder-by-shareholder basis, or to deemed distributions. 

(12) Exchange Gains and Losses 

The proposal provides that unrealized exchange gains and 

losses will be taken into account by a U. s. shareholder. This is 

the rule for financial accounting purposes and it is similar to a 

tax rule available t o U. s. branches overseas and to the rule used 

to determine earnings and profits under subpart F. The proposal 

provides, however, that au. s. shareholder may elect, with 

respect to all of its foreign operations, not to take into account 

unrealized exchange gains and losses. This election is revocable, 

on a prospective basis, ten years after it has been made. 

(13) Accounting, Record Keeping, and Reporting Requirements 

Rules will be provided for making elections with respect to 

controlled foreign corporations, translating amounts from foreign 

currency, the computation of taxable income and earnings and 

profits, the keeping of records and accounts, and the reporting requirements of u. s. shareholders. 

In general, taxable income and earnings and profits will be 

computed under U. s. standards. The Administration recognizes, 

however, that there are differences between U. s. and foreign 

standards, and will prescribe Regulations describing the extent to 

which deviations from U. S. standards will be allowed. 

(14) Tax Treaties 

The proposal allows the Treasury to consider the negotiation 

of income tax treaties allowing deferral to continue , in approprlate situations, in treaty countries. 

- 295 -
(15) Corporations Organized in Puerto Rico and u. s. Possessions 

A current provision of subpart F allows a controlled foreign 

corporation organized in Puerto Rico or a possession of the United 

States to be excluded from subpart F if it meets certain tests 

with regard to the source and nature of its income and business. 

This provision parallels slightly broader statutory protection 

from U. S. tax granted by way of a special •possessions• tax 

credit available to electing domestic corporations doing business 

in Puerto Rico and the possessions (except the Virgin Islands). 

This proposal allows U. S. shareholders to continue deferral 

with respect to income of corporations organized under the laws of 

the Commonwealth of Puerto Rico or a possession of the United 

States (including the Virgin Islands). Income that would have 

been eligible for the possessions tax credit currently provided by 

the Internal Revenue Code if the controlled foreign corporation 

had been a domestic corporation will not be taxed currently to 

U. S. shareholders. Instead, such income will be treated in the 

same manner as •blocked income.• 

(16) Transition Provisions 

In 1979 and 1980, U. s. shareholders will be required to take 

into income 1/3 and 2/3, respectively, of the gross income and 

deductions of controlled foreign corporations. The provisions of 

subpart F will also apply during these two years, although most of 

subpart F will be repealed for years after 1980. The l/3 and 2/3 

inclusion in 1979 and 1980 will apply to the income and deductions 

of a controlled foreign corporation after adjustment for amounts 

included in income by a u. S. shareholder under the subpart F 

provisions. Thus, if in 1979 a o. s. shareholder's controlled 

foreign corporation has $150 of taxable income of which $30 is 

foreign base company income under subpart F, the inclusion under 

this proposal for the U. s. shareholder will be $40 (1/3 x ($150 - $30) • $40) and the U. s. shareholder's total taxable income 

attributable to the controlled foreign corporation will be $70. 

The rules of subpart F will apply for purposes of calculating 

the foreign tax credit attributable to income included under 

subpart F, and the rules under this proposal will apply for 

purposes of calculating the foreign tax credit attributable to the 

additional amounts included in the U. S. shareholder's income 

under the proposal. 

(17) Other Provisions 

Various provisions of the Internal Revenue Code are modified 

or repealed under this proposal. The foreign personal holding 

company provisions are repealed after 1980. Subpart F is repealed 

for future operations, although it will be necessary to maintain 

certain historical aspects. For example, the rules relating to 

taxation of investments in o. s. property will continue to apply 

to previously accumulated earnings. Also, it will be necessary to 

- 296 -
determine whether actual distributions had been previously taxed 

under subpart F, and to determine the tax on certain amounts 

previously excluded from a u. s. shareholder's gross income under 

subpart P because they were reinvested in qualified shipping 

assets or in less-developed countries; any amounts thus excluded 

will be taxable when they are withdrawn from such investment. 

Section 1248 is also kept in force to handle accumulated earnings. 

- 297 -
IV D-3 

FINANCIAL INSTITUTIONS 

Present Law 

Depository financial institutions are not taxed in a 

manner comparable to other corporate taxpayers. Credit 

l 1ions are completely exempt from tax; commercial banks, 

savings and loan associations, mutual savings banks and 

cooperative banks are allowed to take artificially large 

deductions for additions to bad debt reserves in computing 

taxable income. These deductions are allowed under liberal 

statutory formulas which apply only to these institutions, 

while other taxpayers must generally compute these deductions 

on the basis of experience. 

Commercial banks are permitted until 1988 to accumulate 

bad debt reserves equal to a specified portion of their 

outstanding eligible loans, without regard to actual loss 

experience. The present statutory provision for commercial 

banks is a phase-out, enacted in the Tax Reform Act of 1969, 

of even more generous treatment under prior administrative 

practice. Until 1982, commercial banks are permitted to 

build up their reserves for tax purposes to 1.2 percent of 

eligible loans (in general, loans made in the course of 

normal customer loan activities). Beginning in 1982 and 

before 1988, the build-up is permitted to 0.6 percent of 

eligible loans. Once the tax reserve is built up to these 

maximum levels, or the higher levels permitted prior to 1969, 

a bank can in effect continue to deduct actual losses rather 

than charge losses against its reserve, so long as there is 

no decrease in outstanding eligible loans. To date, this 

rule has permitted banks to shelter from tax approximately $4 

billion of income. Beginning in 1988, however, commercial 

banks will have to base further additions to their reserves 

on actual loss experience. 

Mutual savings banks, savings and loan associations, and 

cooperative banks (commonly referred to as "thrift 

institutions") are allowed to deduct annual additions to 

their bad debt reserves equal to a specified percentage of 

net income. In contrast to the treatment of commercial 

banks, the preferential treatment accorded thrift 

institutions will continue indefinitely; the allowable 

addition is, however, being phased down from 60 percent of 

net income (allowed prior to the Tax Reform Act of 1969) to a 

permanent level of 40 percent in 1979. Eligibility for this 

special percentage method depends on compliance with a 

comprehensive set of investment standards, adopted by 

Congress to limit these tax benefits to institutions engaged 

primarily in home mortgage financing. 

- 298 -
The full percentage deduction is allowed only if a 

specified portion (82% for savings and loan associations and 

72% for mutual savings banks) of an institution's investments 

consist of qualifying asse~s, primarily home mortgages. The 

deduction is reduced if the institution has a smaller portion 

of qualifying assets. The basic standards, however, are 

eas1ly met by most savings and loan associations because of 

other regulatory requirements. 

Thrift institut ions are allowed only half of the 

investment tax credit available to other taxpayers. The 

dividends-received deduction otherwise allowable to a thrift 

institution is also reduced by a percentage equal to the 

percentage of net income exempted from tax by virtue of the 

special bad debt deduction. 

In addition, in the case of both commercial banks and 

thrift institutions, the excess of the bad debt reserve 

deduction, computed under the statutory percentage method, 

over the deducti on which would have been allowed based on 

experience is an item of tax preference, subject to the 

minimum tax. 

Reasons for Change 

Commercial Banks. The allowable bad debt deduction for 

commercial banks grea tly exceeds actual losses. In the 

period 1955-66, comme rcial bank bad debt deductions of $5.7 

billion exceeded actual losses of $2.1 billion by more than 

167 percent. From 1969 t hrough 1975, und e r the present 

statutory provisions, deductions exceeded losses by over $400 

million. (See Tables IVD-1 & IVD-2). If not corrected the 

revenue loss from exc essive bad debt deductions by commercial 

banks for the pe riod 1979 through 1982 is expe cted to exceed 

$710 million. 

The prefer ential bad de bt treatment for commercial banks 

was develope d by administrative action. In 1947, the 

Treasury Department permitted a bank to accumulate a reserve 

to reflect a loss r ate not exceeding three times its averag e 

losses during the previous 20 ye ars; in 1955, banks were 

permitted to select as a base period any 20 consecutive ye a rs 

after 1927, thus permitting inclusion of the de pression 

years. In 1965, in order to eliminate the disparity in 

allowable deductions among individual competing banks, the 

Treasury Department broadened the availability of this 

special tax treatment to all commercial banks by permitting 

bad debt reserves equal to 2.4 percent of outstanding loans 

not insured by the Federal government. This figure is 

roughly three times the average annual bad debt loss of 

commercial banks during the period 1928-47. 

- 29 9 -
Table IV-D-1 

Bad Debt Loaaes and the Bad Debt Deduction: 1969- 1975 

Insured Commercial Banks 

U mi!liongl 

I I . . I I I I I 

1969 : 1970 : 1971 : 1972 I 1973 : 1974 : 1975 : 1976 

Bad debt loaaea 489 982 1087 887 1159 1957 3243 3503 

1\S a :9ercent of uninsured loans 0.18 0.36 0.37 0.26 0.28 0.42 0.68 0.72 

sa .. i ~9bt deductions 521 703 867 973 1265 2286 3612 3691 

as a :?ercent of uninsured loans 0.20 0.26 0.29 0.29 0.31 0.49 0.76 0.75 

Office of the Secretary of the Treasury January- 27, 1978 

Office of Tax Analysis 

Source: Annual Report of the Federal Deposit Insurance Corporation 
Table IV-D-2 

Inc011e, Inco.e Sbarea, Iac:ome Taxea and the Bad Debt 

Deduction: Inaured to..ercial lanka, 1969-1975 

1969 . 1970 . 1971 . 1972 : 1973 : 1974 : 1975 . 

. 1976 

: : : . 

Grose Income: (mi~lions) $30,299 $34,456 $36,710 $40,439 $52,994 $68,018 $66,640 $81,004 

Pe~centage distribution: 

Ad•inistrative and operating expensea 40.4% 42.6% 42.1% 41.4% 35.8% 32.3% 36.41 43.6% 

Interest paid depoaitora & creditors 37.7 35.8 36.6 38.1 45.7 51.2 44.9 39.3 

Net loases on loans 1.3 2.9 3.0 2.2 2.2 2.9 4.9 4.3 

Income attributable to equity 20.5 18.7 18.2 18.4 16.3 13.7 13.8 12.7 

Federal income tax 4.3 4.7 3.7 3.2 2.5 2.0 1.8 1.7 

Net income after tax 1.6.3 14.0 14.5 15.2 13.8 11.7 12.0 11.0 

Federal income tax aa a percent of 

income attributable to equity 20.7 25.1 20.4 17.3 15.5 14.6 13.3 13.3 

Proviaiona for loan lossea aa a 

percent of gross income 1.7 2.0 2.4 2.4 2.4 3.4 5.4 4.6 

Exceaa of provisiona for loan losses 

over net losses 120 -279 -220 86 106 329 369' 188 

Aa a percent of aroas iDCome 0.4 -0.8 -0.6 0.2 0.2 0.5 0.6 0.2 

Additional tax liability that would 

result from the taxation of loan 

loss provisions in excess of net 

losses at 48 percent· 58 -134 -106 41 51 158 177 90 

AIJ a percent of g-ross inc011e 0.2 -0.4 -0.3 0.1 0.1 0.2 0.3 0.1 

Bad Debt Reservea as a percent of 

loans other than Federal Funds, 

Insured Loans, and Loans to other 

banka 2.2 2.2 2.1 2.0 1.8 1.8 1.8 1.3 

Office of the Secretary of the Treasury January 27, 1978 Office of Tax ADalyaia 

Source: Annual Report of the Federal Deposit Inaurance Corporation, 
This very generous treatment was justified as a measure 

to protect commercial banks from possible catastrophic losses. It was argued that a commercial bank should be 

allowed to allocate a large portion of its income to reserves 

to protect its solvency during periods of extreme economic 

distress. However, since banks are not required to set aside 

the resultant tax saving in the form of cash or other liquid 

assets, the tax provision does not assure commercial bank 

solvency. Indeed bank solvency in periods of cyclical 

financial crises can only be assured by actions of the 

Federal Reserve system, which is authorized by law to make 

loans to member banks secured by their business loans and to 

make purchases of government bonds in the open market. 

Similarly, security for depositors is provided through 

deposit insurance. These institutional safeguards, along with continual surveillance of the lending policies of 

individual banks by Federal and state bank regulatory 

agencies, protect the banking system and its depositors. 

In the Tax Reform Act of 1969 Congress recognized that 

continuation of the preferential tax treatment of commercial 

banks was not justified and required the adoption by 1988 of 

the experience method used by other taxpayers. Further, 

since 1976 commercial banks and other financial institutions 

have enjoyed special protection from extraordinary losses in 

the form of a ten year carryback and five year carryforward 

of net operating losses. (In contrast, other taxpayers are 

generally allowed a three year carryback and seven year 

carryforward of net operating losses.) It is, therefore, 

appropriate to place commercial banks on the same footing as 

other taxpayers in determining their bad debt deductions. 

Thrift Institutions. Thrift institutions were 

originally exempt from tax on the same theory that now 

justifies the exemption for social clubs: there is no income 

if one deals with oneself. This exemption for mutual savings 

banks and savings and loan associations was ostensibly ended 

in 1951. Congress recognized at that time that savings and 

loan institutions "are no longer self-contained cooperative 

institutions as they were when originally organized ••. " (S. 

Rep. No. 781, 82d Cong., 1st Sess. 28 (1951) .) In the long 

run, "membership" in these institutions was not restricted so 

that a member's investments and debts were approximately 

equal, nor was it certain that any given member would receive 

a proportionate share of the accumulated earnings of the 

organization. More generally, both mutual savings banks and 

savings and loan associations offered a full range of 

depository and lending services to a broad group of persons 

on terms differing in no significant way from the terms on 

which the same services were offered by taxable financial 

institutions. The size and character of thrift institutions 

required parity between them and their competitors. 

Nevertheless, the movement from tax-exempt to taxable 

- 302 -
status has proceeded slowly. Notwithstanding the 1951 

legislation, thrift institutions were virtually tax exempt 

until 1962 because of their special deduction for bad debt 

reserves. Even after a revision of the bad debt reserve 

deduction in 1962, and until the Tax Reform Act of 1969, 

mutual savings banks were able to avoid substantially all 

Federal income taxes, and savings and loan associations were 

subject to effective tax rates of approximately 15 to 18 

percent, only 30 to 35 percent of the then prevailing 

corporate rate. The 1969 Act increased the effective tax 

rate for thrift institutions to approximately 50 to 60 

percent of the regular corporate rate. 

The preferred tax treatment accorded thrift institutions 

is frequently justified because of the role played by these 

institutions in the horne mortgage market. The thrift 

institution statutory bad debt deduction, however, is an 

insignificant factor in encouraging the supply of horne 

mortgages. The ability of thrift institutions to hold 

mortgages depends critically on the willingness of depositors 

to hold savings accounts in those institutions; this 

willingness to hold deposits depends on the pass-book 

interest rates which the thrift institutions can pay. In 

turn, the interest rate thrift institutions can pay their 

depositors depends primarily on mortgage interest yields and 

the deposit interest rate ceilings imposed by Federal 

authorities. Finally, mortgage interest yields are governed 

by the activity of such federally sponsored institutions as 

the Government National Mortgage Association (GNMA), Federal 

National Mortgage Association (FNMA), and a long list of 

public and private mortgage insurance agencies. 

Allowance of the artificially high statutory bad debt 

deduction for thrift institutions undermines the basic policy 

decision that these entities should be taxable. The bad debt 

deductions of thrift institutions are typically three to six 

times their actual losses. (See Tables IVD-3 through IVD-5). 

Allowance of these deductions at the present statutory levels 

will result in a revenue loss of $4 billion over the six-year 

period 1977-1982. Artificial bad debt deductions do not 

afford thrift institutions protection from insolvency; as in 

the case of commercial banks, there is no requirement that 

the institution's untaxed income be set aside to provide for 

losses. Federal and state regulation and examination, along 

with the maintenance of secondary mortgage markets by 

federally sponsored agencies, protect the solvency of thrift 

institutions Th e special provision allowing ten year 

carryback and five year carryforward of net operating losses 

adequately protects thrift institutions from the tax effects 

of extraordinary, unprecedented losses. 

- 303 -
'l'able IV-D-3 

Bad Debt Deductions and Actual Bad Debts 

Savings and Loan Associations and Mutual Savings Banks 

($ million) 

I J.972 I 1973 I 1974 I 1975 I 1976 

savinqs and Loan Associations 

Actual bad debts 34 

Bad debt deduction 923 

Ratio of bad debt 27.15 

deductions to actual 

bad debts 

Mutual Savings Banks 

Actual bad debts 36 

Bad debt deduction 173 

Ratio of bad debt 4.81 

deductions to actual 

bad debts 

Total 

Actual bad debts 70 

Bad debt deductions 1096 

Ratio of bad debt 15.66 

deductions to actual 

bad debts 

Losses on bad debts as a 

percent of uninsured loans 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

o. 03 

58 

1042 

17.97 

34 

204 

6.00 

92 

1246 

13.54 

0.04 

86 

865 

10.06 

61 

193 

3.16 

147 

1058 

7.20 

0.06 

149 

806 

5.41 

52 

205 

3.94 

201 

lOll 

5.03 

o.o7 

140 

1109 

7.29 

58 

218 

3.76 

198 

1327 

6.70 

January 27, 1978 
Table IV-D-4 

Inc:a.e, Inc:011e Sbarea and the Bad Debt Deduction: 

Iuured ·MutUal .Savina• Banu, 1969-1975 

Gross Inco .. : (ai1liona) 

Percentage diatribution 

Administrative and operatins expenses 

Interest paid depoaitora and creditors 

Net losses on loans 

Income attributable to equity 

Federal income tax 

Net income after tax 

Federal inco.. tax aa a percent of 

inca.. attributable to equity 

Bad debts aa a percent of inc:o .. attributable to equity ' 

Additional tax liability that would 

result from the taxation of all 

inco.e attributable to equity at 48 percent 

M a percent of aroaa illcoee 

Office of the Secretary of the Treaaury 

Office of Tax Analyaia 

1969 . 1970 . 1971 

$3,523 $3,754 $4.471 

13.6% 14.7% 14.2% 

80.0 80.1 76.6 

0.05 0.05 0.1 

6.4 5.1 9.1 

0.4 0.7 1.4 

6.0 4.5 7.7 

6.3 13.0 15.7 

0.4 0.5 0.7 

94 68 131 

2.7 1.8 2.9 

Source1 Annual Report of the Federal Deposit Insurance Corporation 

. 1972 

$5,280 

14.0% 

74.8 

0.1 

11.1 

2.1 

9.1 

18.6 

0.7 

173 

3.3 

• 1973 

$5,973 

14.4% 

75.5 

0.2 

9.9 

1.9 

8.0 

19.2 

1.5 

171 

2.9 

• 1974 t 1975 I 1976 - $6,335 $7,116 $8,333 

14.9% 15.6% 15.7% 

78.7 78.0 76.0 

0.2 0.3 0.9 

6.3 6.1 7.4 

1.3 0.9 1.3 

5.0 S.l 6.1 

20.4 15.5 17.6 

2.5 5.1 12.8 

110 140 187 

1.7 2.0 2.2 

January 27, 1978 
Table IV-O-S 

rncome, Income Shares, and Income Taxesa 

Insured Savinga and ·Loan Associationa, 1972-1975 

Gross Income 1 (millions) 

Percentage distribution 

Administrative and operating expenses 

Interest paid depositors and creditors 

Net losses on loans 

Income attributable to equity Federal income tax 

Net income after tax 

Federal income tax as a percent of 

income attributable to equity 

Bad debts as a percent of income 

attributable to equity 

Additional tax liability that would result 

from the taxation of all income attributable to equity at 48 percent 

As a percent of gross income 

Office of the Secretary of the Treasury Office of Tax Analysis 

I 1972 

$15,323 

17.2t 

68.2 

0.2 

14.4 

3.4 

11.0 

23.5 

1.5 

541 

3.5 

I 1'973 

$18,392 

17.St 

68.5 

0.3 

13.7 

3.4 

10.3 

24.7 

2.3 

588 

3.2 

I 1'974 

$21,102 

17.St 

72.6 

0.4 

9.5 

2.5 

7.0 

26.4 

4.3 

435 

2.1 

I i975 

$23,905 

17.5' 

73.7 

0.6 

8.1 

2.1 

6.1 

25.7 

7.6 

435 

1.8 

January 27, 1978 

Source: Combined Financial Statements, Federal Savings and Loan Insurance corporation 
Credit Unions. Credit unions were excluded from the 

decision to make other thrift institutions taxable in 1951. 

Equity now demands, however, that these entities be placed on 

a parity with thrift institutions, their competitors. 

Many credit unions are no longer truly mutual 

institutions with limited •common bonds• required for 

membership. The legal concept of common bond has been 

expanded so that mere residence in a state may be sufficient 

for membership in a credit union, and even those persons who 

leave an area may continue to be members. A Federal appeals 

court even held recently that an institution may qualif¥ as a 

credit union despite the absence of membership restrict1ons 

if most depositors in fact have similar characteristics, a 

•de facto• common bond. La Caisse Populaire Ste. Marie v. 

United States, 563 F.2d 505 (1st Cir. 1977). 

Many credit unions also are expanding beyond the factory and farm worker constituency that they represented when they 

were first regulated nationally in 1934 by the Farm Credit 

Administration. The residential common bond, although presently the least frequently used, is the fastest growing 

one among Federal credit unions. Furthermore, the size of 

individual accounts is growing. In Federal credit unions, 

accounts larger than $5,000 aggregated $2.1 billion at the 

end of 1970 and $11.1 billion at the end of 1976. This 

increase and the increase in the median income of depositors 

indicate that credit unions are appealing to other than 

low-income workers who have been excluded from access to 

banking services elsewhere. 

The powers and services of credit unions have also 

expanded enormously, especially over the past seven years, so 

that they are becoming indistinguishable from other financial 

institutions. In 1970, Congress enacted Federal share 

insurance legislation, which insures the accounts of Federal 

credit unions and about half of the savings in state credit 

unions. In the Depository Institutions Amendments Act of 

1977, Federal credit unions were granted the power to offer 

credit cards, to loan funds without specific dollar limits 

for up to 12 years, and to make real estate loans for up to 

30 years. Many state-regulated credit unions have similar 

powers, including the authority to offer interest-bearing 

checking accounts. There is no correlation between an 

individual's credit union loans and deposits: persons who 

become members with a $5 share may borrow up to the 

institution's lending limit. The state regulated La Caisse 

Populaire Ste. Marie (St. Mary's Bank), a •credit union,• 

invested more than 80 percent of its loan funds in real 

estate and had substantial demand deposits. 

The sheer growth of these financial intermediaries in 

the decades since 1951 demonstrates that they should be 

treated equally with their competitors. In consumer 

- 307 -
installment credit, credit unions hold 17 percent of the 

market and have been the largest factor in the increase in 

installment credit in the past few years. The assets of some 

of the largest credit unions exceed or rival large savings 

and loan associations in some states, and a few credit union 

groups have even purchased banks. Since the end of 1970, the 

total assets of Federal credit unions have nearly tripled and 

those of state credit unions have more than doubled to a 

total of $45.1 billion for their 33.6 million members. (See 

Tables IVD-6 and IVD-7.) The numbers are even more striking 

when compared to the 1951 figures when thrift institutions 

were made taxable. At that time credit unions had $1 billion 

in assets and 5.2 million members. 

The blurring of the distinction between credit unions 

and other thrift institutions argues for the same tax 

treatment for these entities. In the absence of such 

treatment the tax system elevates form over substance by encouraging banks and other thrift institutions to be 

organized in the form of credit unions. 

General Explanation 

The Administration's proposal will require commercial 

banks to use only the experience method for computing 

additions to their bad debt reserves. They will thus be 

allowed to deduct additions to loss reserves based on the 

larger of their average loan loss experience over the current 

and five preceding years or actual losses. The present 

transition rules, which until 1988 allow a build-up in 

reserves to a percentage of outstanding loans, will be 

repealed. 

The percentage of taxable income method of determining bad debt deductions for thrift institutions will be phased 

down from its current 41 percent level to 30 percent by 1983. 

Credit unions will be made subject to tax on the same basis 

as thrift institutions, and will be permitted to claim the 

thrift institution bad debt deduction: they will not, 

however, be subject to the investment restrictions which 

apply to thrift institutions. The bad debt deduction 

available to credit unions will be phased down ratably from, 

in effect, 100 percent of net income under present law to 30 

percent over a period of five years. 

As a result of these changes, the investment tax credit 

available to thrift institutions (and credit unions) will be 

increased to 70 percent of the credit available to other 

taxpayers. In addition, thrift institutions and credit 

unions will be made eligible for the full (generally, 85 

percent) dividends-received deduction. Dividends received 

will be excluded, however, from income for purposes of 

determining the maximum bad debt deduction. 

- 308 -
Table IV-D-6 

Federal Credit Unions 

: 1972 : 1973 : 1974 l 1975 : 1976 

Gross Income: (millions) 

Percentage distribution 

Administrative and operating expenses 

Interest refunds 

Other interest payments 

Net losses on loans 

Dividends to shares 

Income attributable to equity 

Growth Rate 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

$1,046 $1,251 

32.2\ 31.3\ 

3.5 3.1 

1.4 1.8 

3.2 3.1 

49.4 50.8 

10.4 9.9 

18.0\ 19.7\ 

$1,504 $1,749 $2,124 

29.5\ 30.4t 31.9t 

2.5 2.2 2.0 

2.6 2.9 3.0 

4.4 4.2 2.4 

50.7 52.9 53.2 

10.4 7.4 7.5 

20.2\ 16. 3·\ 21.5\ 

January 27, 1978 

Source: Annual Report of the National Credit Union Administration 
T~ble IV-D-7 

Federally-Insured State-chartered Credit Unions 

1971 . 1972 . . . . 1973 . 1974 . . 1975 : 1976 

Gross Income (millions) $163 $278 $382 $554 $757 $958 

Percentage distribution: 

Administrative and operatinq expenses 35.1% 35.4% 34.6% 34.4% 32.7% 31.8' 

Interest Refunds 3.2 3.1 2.6 2.7 2.2 2.2 

Other interest payments 1.4 1.5 1.9 2.4 2.1 2.4 

Dividends on shares 48.5 46.8 48.7 47.8 48.2 46.4 

Income attributable to equity 11.9 13.2 12.3 12.7 14.7 17.2 

Growth Rate - 70.9% 37 . 4% 45.1% 36.7% 26.6' 

Office of the Secretary of the Treasury January 27, 1978 Office of Tax Analysis 

Source: Annual Report of the National Credit Union Admini strati on 
Analysis of Impact 

Depository institutions may be organized as stock 

corporations (generally, commercial banks and some savings 

and loan associations) or as mutual associations (generally, 

mutual savings banks, credit unions, and non-stock savings 

and loan associations). Institutions organized as stock 

corporations derive most of the funds used to acquire income 

producing assets from depositors and a relatively small 

portion from equity investors. A correspondingly large 

portion of the stock institution's income must be allocated 

to the cost of deposits and a relatively minor portion to 

equity. Since the interest cost of deposits and capital debt 

is deductible in computing taxable income, the burden of 

federal income tax falls initially on that portion of the 

institution's income attributable to equity. 

Stock financial institutions adjust to changes in the 

rate of tax on income attributable to corporate equity in the 

same manner as other corporations. Possible responses by 

stock institutions to the increased tax burden resulting from 

these proposals include one or both of the following: 

(a) Adjustment of portfolios to increase gross income 

sufficiently to cover the higher corporate income tax. This 

could be accomplished by increasing lending rates to 

customers or switching investment to higher yielding assets. 

(b) Reduction of either the nominal interest paid 

depositors or the battery of "free" services provided them. 

Since the gross income and interest expense of these 

institutions is quite large in comparison to the increase in 

tax resulting from these proposals, it is anticipated that 

the proposals ultimately will result in approximately a .03 

to .04 percent increase in lending rates by all affected 

institutions, or in a .02 to .04 percent reduction in rates 

paid depositors. However, in the case of credit unions, if 

the full adjustment were borne by shareholders, the reduction 

would be slightly more than one-half of one percent. 

The equity interest in mutual institutions is held, in 

effect, by depositors. Since "share dividends" (i.e., 

interest on deposits) are deductible by the institution, the 

burden of the Federal income tax falls solely on the income 

of the corporation which is not paid to deposi tors. A mutual 

institution will respond to the proposed changes in a manner 

substantially the same as a stock institution if it desires 

to maintain the same level of retained earnings as under 

present law, i.e., it will seek to increase the spread 

between gross income and its cost of funds to compensate for 

the additional Federal tax. A mutual institution may, on the 

other hand, avoid the imposition of additional tax by 

decreasing that spread. It may reduce its lending rates or, 

- 311 -
more probably, increase its "dividend" to depositors. 

Effective Date 

Repeal of the comm~rcial bank percentage method of 

computing bad debt deductions will be effective for taxable 

years beginning after 1978. The phase-down of the percentage 

method for computing bad debt deductions for thrift 

institutions and the phase-in of the taxation of credit 

unions will commence in the first taxable year beginning 

after 1978. Thrift institutions and credit unions will be 

allowed the increased investment tax credit and the full 

dividends-received deduction for taxable years beginning 

after 1978. 

Revenue Estimate 

1978 1979 

286 

Change In Tax Liability ($ millions) 

Calendar Years 

1980 1981 

367 460 

Technical Explanation 

1982 1983 

367 487 

The percentage of outstanding loans method of computing 

deductible additions to bad debt loss reserves for commercial 

banks under present law will be repealed. 

In the case of thrift institutions, the change in the 

percentage of net income method (from 41 percent in 1978 to 30 

percent in 1983) will be made gradually, with a phase down 

similar to that in current law. The taxation of credit unions 

will be introduced gradually by allowing a deduction for bad 

debts phased down ratably from, in effect, 100 percent of net 

income for 1978 to 30 percent in 1983. Thrift institutions and 

credit unions will be permitted a 30 percent bad debt deduction 

beginning in 1983. 

Bad Debt Deduction for Savings and Loan 

Associations and Mutual Savings Banks 

Under the Percentage of Income Method 

- 312 -
For a taxable year 

beginning in --

1979 

1980 

1981 

1982 

1983 or thereafter 

The applicable 

percentage will be -

38\ 

36\ 

34\ 

32\ 

30\ 

Bad Debt Deduction for Credit Unions Under the 

Percentage of Taxable Income Method 

For a taxable year The applicable 

beginning in -- percentage will be -

1979 86\ 

1980 72\ 

1981 58\ 

1982 44\ 

1983 or thereafter 30\ 

Under present law the bad debt deduction for thrift 

institutions is computed as a percentage of taxable income, 

with certain modifications. Since the dividends-received 

deduction is reduced for thrift institutions using the 

percentage bad debt deduction, these institutions are 

permitted to include the taxable portion of their dividends 

received in taxable income for purposes of computing their 

bad debt deduction. Since thrift institutions and credit 

unions will be allowed a full dividends-received deduction 

under the proposal, dividends received will be excluded from 

taxable income for purposes of computing the bad debt 

deduction. 

- 313 -
IVD - 4 

ACCRUAL ACCOUNTING FOR AGRICULTURAL CORPORATIONS 

Present Law 

The Internal Revenue Code requires that the accounting 

method used in preparing a taxpayer's return •clearly reflect 

income.• This restricts the taxpayer's flexibility in 

choosing among the cash receipts and disbursements method, 

the accrual method and other permissible accounting methods 

in computing taxable income. !/ Most taxpayers who are in 

the business of selling products are required to use the 

accrual method of accounting under which the cost of the 

product must be accumulated in inventory and offset against 

sales receipts. Expenses are thus properly matched with the 

income they produce, and taxable income is •clearly 

reflected• within the meaning of the tax law. 

By virture of administrative rulings issued more than 

50 years ago, however, farmers have generally been exempted 

from the accrual accounting requirement. The reason for this 

exemption was the impression that farmers lack the financial 

resources and the expertise necessary to match farming 

expenditures with the particular farming income. As a 

result, the simpler cash receipts and disbursements method 

was permitted, even though it tended to misstate farmers' 

taxable income. 

Limited exceptions from the cash method privilege for 

farming operations were introduced by the Tax Reform Act of 

1976. That Act established the general rule that 

corporations (and partnerships with a corporate partner) 

engaged in farming must use the accrual method of accounting 

and capitalize preproductive period expenses. However, 

exemptions were provided for (1) nurseries and farms engaged 

in raising or harvesting of trees (other than fruit and nut trees)~ (2) corporations with annual gross receipts of $1 

million or less~ (3) Subchapter s corporations: and (4) 

corporations where 50 percent or more of voting stock and 50 

percent or more of all classes of stock are owned by members 

of the same family. £/ 

Accrual accounting requires that firms match the 

deductions for farming expenditures with the income related 

to those expenditures. For example, an accrual farmer cannot 

deduct currently the cost of feed for his beef cattle: 

rather, the feed cost is reflected in the opening and closing 

inventory values of the cattle. Similarly, a farmer on the 

accrual basis cannot deduct the cost of such items as seed 

and fertilizer until the resulting crops are sold. In the 

- 314 -
case of multi-yiel d assets such as dairy cattle or apple 

orchards, the costs of developing the assets to maturity must 

be capitalized and deducted after maturity through 

depreciation or, in the case of livestock, through inclusion 

in inventory values. However, an exception is provided from 

the capitalization requ i rement for taxes and interest and any 

expenses incurred on account of casualties. 

In addition to the accounting requirements for corporate 

farms, the 1976 Reform Act contains related, but less 

stringent, accounting rules for "farming syndicates." A 

farming syndicate cannot deduct amounts paid for feed, seed, 

fertilizer, or other farm supplies until those supplies are 

actually used or consumed. Moreover, the cost of poultry 

purchased for use in a syndicate's trade or business must be 

capitalized and deducted ratably over the lesser of 12 months 

or their useful life; the cost of poultry purchased by a 

syndicate for resale can be deducted only upon disposition. 

And the expenditures incurred to raise a grove, orchard or 

vineyard to maturity must also be charged to a capital 

account. For these purposes, a "farming syndicate" is a 

partnership, subchapter S corporation or other enterprise, 

such as an agency relationship, which has its participation 

interests registered or required to be registered with a 

State or Federal securities agency, or in which more than 35 

percent of the entity's losses are attributable to limited 

partners or other persons not actively participating in the 

management of the f arming enterprise (referred to in the Code 

as "limited entrepreneurs"). 

Accordingly, the accounting rules for farm corporations 

and farm syndicates are similar with respect to limited 

categories of farm assets. Specifically, both corporations 

and syndicates are required to capitalize the cost of 

poultry, whether used for egg-laying or sold for meat. Both 

are required to capitalize the preproductive period costs of 

groves, orchards or vineyards, even though there are 

variations in the respective rules relating to the time over 

which capitalized amounts can be recovered. With respect to 

all other farm products, however, the accounting requirements 

relating to corporations are substantially more restrictive 

than the syndicate rules. Current law does not require that 

the feed, seed or fertilizer expenses of syndicates be 

matched with the income produced from such assets as field 

crops and cattle. As long as a syndicate actually uses the 

farm supplies during the taxable year, a current deduction is 

permitted. Corporations, on the other hand, are subject to 

the general requirement that all preproductive period 

expenses be matched with related income through use of the 

accrual accounting method and the capitalization of expenses 

incurred before the realization of income. 

- 315 -
Reasons for Change 

In enacting the Tax Reform Act of 1976, Congress recognized instances where the rationale for farmers• cash 

accounting privilege is no longer applicable. Large farming 

corporations cannot fairly claim that they lack access to the 

sophisticated accounting and recordkeeping procedures 

involved in the accrual method of accounting. In fact, most 

large companies are already required to keep financial 

records on the accrual basis in order to obtain certification 

of financial statements by an accountant. As a result, the 

cash method of accounting serves not to relieve large corporations from recordkeeping burdens, but rather to 

misstate substantially the taxable income of those 

enterprises. 

The 1976 Act did not go far enough in its application of 

the accrual requirement. During consideration of the Tax 

Reduction and Simplification Act of 1977, Congress was 

presented with claims that the "one-family corporation" 

exception to the accrual accounting requirement arbitrarily 

granted a substantial competitive advantage to several 

multimillion dollar farming operations at the expense of 

other large farm corporations that failed to fall within the 

definition of a family corporation. The approach taken by 

Congress in the 1977 Act was to extend for one year the 

family corporation exemption to cover at least two additional 

corporations that allegedly had been placed at a competitive 

disadvantage in spite of the fact that these corporations 

each had annual gross sales in excess of $50 million. The 

1977 Act did not address the fundamental cause of the 

inequity; the fact that a distinction between family and 

non-family corporations bears no relationship to the 

rationale of preserving simple bookkeeping methods for small 

farmers who truly lack access to the necessary accounting and 

recordke.eping procedures involved in the accrual method of 

accounting. 

By eliminating the family corporation exemption, the 

Administration's proposal will result in the application of 

the accrual method requirement to all large farming 

corporations (aside from subchapter S corporations, which are 

treated for tax purposes essentially like partnerships). 

Farming corporations with annual gross receipts of $1 million 

or less will still be exempted in order to preserve the 

availability of the cash method of accounting for those 

corporate farms that may lack access to accounting and 

recordkeeping expertise. Moreover, the Administration's 

proposal will extend the accrual accounting requirement to 

all farming syndicates, regardless of size. In those 

instances where interests in farming operations are required 

to be registered with Federal or State securities officials 

or where a substantial portion of the enterprise is owned by 

- 316 -
passive investors, the rationale for cash accounting is also 

inapplicable. Persons who are involved in farming as outside 

investors, whether for tax shelter opportunities or for 

positive economic return, should not share in a cash 

accounting privilege designed for farmers unaccustomed to 

sophisticated financial transactions. 

One additional change is desirable in order to remove an 

exception to the accrual accounting requirements that no 

longer seems warranted. The Administration has proposed that 

state and local taxes, aside from income taxes and real 

property taxes, not be deductible as taxes. Sales taxes, 

personal property taxes and other miscellaneous taxes will 

instead be expensed or capitalized by a taxpayer in 

accordance with the rules relating to other business 

expenditures. Following this general treatment of state and 

local taxes, the taxes of a farmer (aside from income taxes 

and real property taxes) will be treated like any other 

expenditures incurred in raising farm products. 

General Explanation 

The Administration proposal will delete the exception 

for family corporations from the requirement that 

corporations engaged in farming compute taxable income on an 

accrual method of accounting and with the capitalization of 

preproductive period expenses. The proposal will also extend 

those accounting requirements to "farming syndicates" as 

defined in the Tax Reform Act of 1976. 

Therefore, under the Administration's proposal, the 

following farming operations will be required to use an 

accrual method of accounting and to capitalize preproductive 

period expenses: 

(1) All farming syndicates (as defined under current 

law): 

(2) All corporations (and partnerships with a corporate 

partner) engaged in farming, with the exception of 

(a) nurseries or other farming operations that raise 

or harvest trees (other than fruit and nut trees), 

(b) subchapt er S corporations, and (c) corporations 

which do not have annual gross receipts exceeding $1 

million.3/ 

As under present law, the "preproductive period 

expenses" required to be capitalized will not include 

interest or expenditures incurred on account of casualties. 

However, taxes, aside from income taxes and real property 

taxes, will no longer be excluded from the definition of 

"preproductive period expenses.• 

- 317 -
Analysis of Impact 

Approximately 94 percent of all corporate farms have 

annual gross receipts under $1 million and will thereby 

remain eligible to use the cash receipts and disbursements 

method of accounting. In most instances, farming syndicates 

and the large corporations with receipts above $1 million 

already use accrual accounting for financial purposes. Therefore, it is unlikely that the Administration proposal 

will create any substantial recordkeeping problems for the 

large, family corporations and syndicates formerly exempted 

from the accrual method requirement. 

Since the exemption for ordinary corporations will be 

based solely on the amount of gross receipts, equity among 

comparably situated taxpayers will be increased. The 

Administration proposal will eliminate the competitive 

disadvantage incurred by large farm corporations, using the 

accrual method, which must compete with other large 

corporations entitled to use the cash method because the 

latter happen to fall within the definition of •family 

corporation.• 

Effective Date 

The proposed change will be effective for taxable years 

beginning after December 31, 1978. 

Revenue Estimate 

1978 1979 

40 

Change In Tax Liability 

($ millions) 

Calendar Years 

1980 1981 

25 10 

Technical Explanation 

1982 1983 

5 7 

For the purpose of the accrual rules, a "farming 

syndicate" will be defined as it is in the Tax Reform Act of 

1976. Accordingly, a "farming syndicate• will include any 

enterprise (other than a non-subchapter S corporation) 

engaged in the trade or business of farming if any offering 

of interests in the enterprise were required to be registered 

with any federal or state securities agency, or an enterprise 

(other than a non-subchapter S corporation) engaged in the 

trade or business of farming if more than 35 percent of the 

losses during any period are allocable to limited partners or 

- 318 -
other limited entrepreneurs not actively participating in 

the management of the enterprise. The statutory definition 

of "farming syndicate" will also preserve the provisions that 

treat interests meeting the following requirements as 

interests not held by a limited partner or limited 

entrepreneur: (a) where an individual has an interest 

attributable to his active participation in the management of 

any trade or business of farming for a period of not less 

than 5 years; (b) where an interest is held in an enterprise 

engaged in operating a farm which serves as the principal 

residence of the individual who owns that interest; (c) where 

an individual has a participating interest in the further 

processing of livestock raised in a farming operation covered 

by the above provisions or in whose management that 

individual actively participates; (d) where the interest is 

owned by an individual whose principal business activity 

involves active participation in the management of a trade or 

business of farming; and (e) where an individual is a member 

of the family of a grandparent of an individual who would be 

excepted under any of the four situations listed above, and 

his interest is attributable to the active participation of 

such individual. 

With respect to both farming corporations and 

syndicates, •preproductive period expenses" will refer to 

expenditures attributable to crops, animals or other property 

having a crop or yield during the period of time (a) prior to 

the disposition of the first marketable crop or yield of 

property having a useful life of more than one year, or (b) 

before disposition of any property having a useful life of 

one year or less. 4/ Exceptions from the definition will be 

retained for interest and expenses incurred on account of 

casualties, disease or drought; but taxes, aside from income 

taxes and real property taxes, will not be excepted. Also, 

in applying the defi nition, the use of self-produced supplies 

of the farm will be considered a disposition of those 

supplies. 

Finally, any taxpayer required by this provision to 

change its method of accounting will treat such a change as 

having been made with the consent of the Secretary of the 

Treasury, will consider the change as not having been 

initiated by the taxpayer, and will generally be given a ten 

year period to take into account the net amount of 

adjustments required in the computation of taxable income. 

The Secretary will prescribe regulations indicating those 

situations in which less than a ten year period is 

appropriate (~, the taxpayer was in existence for less 

than ten years) • 

- 319 -
Footnotes 

1/ Under the cash receipts and disbursements method, gross 

Income items are to be included for the taxable year in which 

actually or constructively received; and expenses are to be 

deducted for the taxable year in which actually paid. Under 

the accrual method, income is to be included for the taxable 

year in which all the events have occurred which fix the 

right to receive such income and the amount thereof can be 

determined with reasonable accuracy; deductions are permitted 

for the taxable year in which all the events have occurred 

which establish the fact of liability and the amount thereof 

can be determined with reasonable accuracy. 

2/ Under the Tax Reduction and Simplification Act of 1977, 

another exemption until taxable years beginning after 

December 31, 1977 was granted wh ·re two families own at least 

65 percent of the stock or where three families own at least 

50 percent of the stock and substantially all of the 

remaining stock is owned by corporate employees, their 

families or exempt retirement trusts established for the 

benefit of the employees. 

3/ These exceptions will not apply if the entity is a wfarm 

syndicate.w 

!/ Under present law, a farming syndicate must capitalize 

those expenditures incurred in developing a grove, orchard or 

vineyard prior to the first taxable year in which the grove, 

orchard, or vineyard bears a crop or yield in commercial 

quantities. This special rule will be eliminated, and 

farming syndicates raising fruit or nuts will be subject to 

the general provision described above. However, all 

taxpayers will continue to be covered by a special Code 

provision for citrus and almond groves (section 278). That 

provision requires capitalization of the developmental 

expenditures of a citrus or almond grove incurred before the 

close of the fourth taxable year beginning with the taxable 

year in which the trees were planted. Accordingly, a farming 

corporation or syndicate will be required to capitalize 

expenditures during the first four years after planting a 

citrus or almond grove even though the dispostion of the 

first marketable crop or yield might have occurred prior to 

the expiration of that four-year period. 

- 320 -
IVE 

SIMPLIFICATION OF ADR DEPRECIATION 

Present Law 

Under present law, a taxpayer generally may claim 

depreciation either on the basis of the particular "facts and 

circumstances• bearing on his anticipated use of the property 

or under the asset depreciation range and class life system 

( "ADR"). 

A taxpayer claiming depreciation on the basis of facts 

and circumstances must estimate the useful life and salvage 

value for each item of depreciable property used in his trade 

or business. This can be a cumbersome and inexact process 

for the taxpayer. Moreover, the taxpayer's estimates are 

frequently reexamined by auditing agents of the Internal 

Revenue Service, and any discrepancies between their 

estimates and the taxpayer's will result in further time and 

attention being devoted to these factual matters. 

In 1971 Congress authorized the Secretary of the 

Treasury to promulgate regulations establishing the ADR 

system. Under the ADR system, the Treasury Department 

establishes useful lives for classes of assets based upon the 

activity in which the assets are used (~, mining or 

agriculture) or the type of asset (~, automobiles or 

office furniture). A taxpayer is perm1tted to compute 

depreciation on the basis of these lives without any showing 

of facts and circumstances. 

Since the class lives are set so that 70 percent of all 

assets in a class have actual useful lives which are as long 

or longer than the prescribed class life, the use of class 

lives in itself is a benefit to the average taxpayer. 

Moreover, taxpayers are permitted to set useful lives within 

a range extending from 20 percent below to 20 percent above 

the established class lives. 

Taxpayers who adopt the ADR system obtain other 

advantages in the treatment of salvage value and retirements 

of assets. On the other hand, the regulations require 

taxpayers who adopt the ADR system to comply with a number of 

formal accounting and reporting requirements. 

Reasons for Change 

The presence of many attractive features in the ADR 

system has led to its adoption by taxpayers holding more than 

half of all corporate assets. In 1974, 64 percent of all 

depreciable corporate assets were held by taxpayers who 

- 321 -
elected ADR. !/ The largest corporations appreciate the 

advantages of the ADR system. In 1974, nearly 92 percent of 

corporate taxpayers with depreciable assets of $1 billion or 

more elected ADR. In contrast, little more than half of the 

corporate taxpayers with more than $100 million in 

depreciable assets elected ADR: only 0.36 percent of 

corporate taxpayers with $500,000 or less in depreciable 

assets elected ADR in that year. Thus, many corporations 

have not been sharing in the benefits of ADR to the same 

extent as the largest corporations. While it is not clear 

why these businesses have not elected ADR, it would appear 

that the mechanics of asset classification and the 

application of prescribed accounting procedures intimidate 

many businessmen and their accountants. 

The Treasury Department has been studying ways to 

simplify the ADR system. It is expected that a simplified 

ADR system would lead to the use of ADR by additional 

taxpayers. However, because the Congress enacted the 

legislation which authorizes the existing ADR system with a 

particular set of regulations in mind, it is not clear that 

present law would authorize the Secretary of the Treasury to 

promulgate regulations substantially different from those 

contemplated when the statute was enacted. 

A simplified ADR system could reflect a number of 

changes which experience with the existing ADR system 

suggests would be beneficial. For example, the current 

regulations set forth rules for the treatment of salvage 

value (section 1.167 (a)-ll(d) (1)). If a taxpayer does not 

follow •the practice of understating his estimates of gross 

salvage value,• no change will be made to the taxpayer's 

estimate of salvage value unless the change would exceed 10 

percent of unadjusted basis. In the case of most personal 

property, the taxpayer is allowed to decrease salvage value 

by an additional 10 percent (section l67(f) of the code). 

Thus, while the importance of salvage value has been 

significantly diluted, the Internal Revenue Service still 

must reexamine a taxpayer's choice of salvage values to 

determine whether it complies with the tests described above. 

A rule which eliminated this factual determination would be 

more consistent with the goals of ADR. 

The existing regulations permit taxpayers to choose one 

of two conventions to determine the date from which they can 

begin claiming depreciation for property placed in service 

during the year (section 1.167 (a) -11 (c) (2)). Under the 

half-year convention, all assets placed in service during th~ 

year are deemed to have been placed in service on the first 

day of the second half of the taxable year (July 1 for 

calendar year taxpayers). Under the modified half-year 

convention, assets placed in service in the first half of the 

year are deemed to have been placed in service on the first 

day of the year (January 1 for calenda r year taxpayers): 

- 322 -
those placed in service in the second half of the year are 

deemed placed in service on the first day of the succeeding 

year (January 1 of the next year for calendar year 

taxpayers). These alternative conventions add complexity to 

both the operation of the ADR system and its description in 

the regulations. Moreover, one of the conventions--the 

half-year convention--offers a number of practical and 

theoretical advantages in the operation of the ADR system. 

The half-year convention does not require a taxpayer to 

determine exactly when the second half of his taxable year 

begins, a task which may not be simple if the taxpayer's 

taxable year has fewer than twelve months or if the taxpayer 

is on a 52-53 week year. The half-year convention also 

requires the taxpayer to create only one set of vintage 

accounts each year, rather than the two sets required under 

the modified half-year convention. 

The ADR system simplifies depreciation by establishing a 

limited number of rules which, on the average, provide a 

reasonably accurate measurement of income, and which can be 

readily applied both by the taxpayer and by the Internal 

Revenue Service. It is inconsistent with that goal to allow 

complicated options and variations, such as the use of the 

double declining balance method followed by the sum of the 

years-digits method for the same asset. Moreover, with the 

sanction of Congress, the ADR system provides a favorable 

pattern of tax depreciation for the average taxpayer by 

setting the useful lives of assets below average lives and 

then permitting these lives to be reduced by up to 20 

percent. Thus, it is unnecessary to allow taxpayers to 

overlay this guideline system with optional combinations of 

depreciation methods that further accelerate depreciation 

deductions. 

At present, taxpayers electing ADR are subject to 

detailed reporting requirements (section 1.167(a)-ll(f} of 

the regulations). The purpose of these reporting 

requirements is to enable the Treasury Department to 

determine and refine appropriate lives for different classes 

of assets. In practice, the reporting requirements are both 

ineffective and costly to taxpayers and the government. 

Their purpose can be more efficiently accomplished through 

survey techniques involving controlled sampling procedures. 

General Explanation 

Under the proposal, the Secretary of the Treasury will 

be authorized to issue new regulations governing the ADR 

system. It is intended that the new regulations will be 

shorter and simpler than the present regulations. These 

regulations--which should encourage more taxpayers to adopt 

- 323 -
the ADR system--will differ from the present regulations in 

several respects, including the following: 

1. Salvage value will be disregarded for purposes of 

computing depreciation. 

2. All assets will be governed by the •half-year 

convention,• under which they will be deemed to be placed in 

service in the middle of the taxable year. 

3. Taxpayers will be restricted to the straight-line 

and declining balance methods of depreciation. 

4. The annual reporting requirements will be 

eliminated. Taxpayers will be required to respond to survey 

requests to be used in calculating ADR standards. It is 

expected that no industry will be subject to the survey 

procedures more often than once every five years, and thus 

most taxpayers electing ADR will rarely be required to 

respond to such surveys. 

The result of these changes will be a .simpler system for 

taxpayers who elect to depreciate assets under ADR. 

Effective Date 

The simplified ADR system provided by the proposal will 

be applicable with respect to property placed in service by 

the taxpayer in taxable years beginning after December 31, 

1978. It is expected that regulations will be promulgated 

under this section before March 1, 1980, so that taxpayers 

filing returns for taxable years ending on or after December 

31, 1979 will have sufficient time to determine whether to 

elect the new simplified ADR system. 

Revenue Estimate 

The proposal will have a negligible effect on tax 

liability. 

Footnote 

!/ Because assets placed in service before January 1, 1971 

cannot be depreciated under ADR, only 25 percent of the 

assets of these corporations were depreciated under the ADR 

system. This percentage should increase over time. 

- 324 -