PAGENO="0001" MISCELLANEOUS REVENUE ISSUES ~i, ~- ii / * HEARINGS BEFORE THE STJBCOM1~'IITTEE ON SELECT REVENuE MEASTIRES OF THE COMMITTEE ON WAYS AND MEANS HOUSE OF REPRESENTATIVES ONE HUNDRED FIRST CONGRESS SECOND SESSION FEBRUARY 21, AND 22, 1990 VOLUME II Serial 1O1-87 Printed for the use of the Committee on Ways and Means * ii~'~c U.S. GOVERNMENT PRINTING OFFICE 30-860 WASHINGTON 1990 For sale by the Superintendent of Documents, Congressional Sales Offlce U.S. Government Printing Office, Washington, DC 20402 PAGENO="0002" COMMITTEE ON WAYS AND MEANS SAM M. GIBBONS, Florida J.J. PICKLE, Texas CHARLES B. RANGEL, New York FORTNEY PETE STARK, California ANDY JACOBS, Jit., Indiana HAROLD FORD, Tennessee ED JENKINS, Georgia THOMAS J. DOWNEY, New York FRANK J. GUARINI, New Jersey MARTY RUSSO, Illinois DON J. PEASE, Ohio ROBERT T. MATSUI, California BERYL ANTHONY, JR., Arkansas RONNIE G. FLIPPO, Alabama BYRON L. DORGAN, North Dakota BARBARA B. KENNELLY, Connecticut BRIAN J. DONNELLY, Massachusetts WILLIAM J. COYNE, Pennsylvania MICHAEL A. ANDREWS, Texas SANDER M. LEVIN, Michigan JIM MOODY, Wisconsin BENJAMIN L. CARDIN, Maryland SUBCOMMITTEE ON SELECT REVENUE MEASURES CHARLES B. RANGEL, New York, Chairman RONNIE G. FLIPPO, Alabama GUY VANDER JAGT, Michigan BYRON L. DORGAN, North Dakota RAYMOND J. McGRATH, New York BARBARA B. KENNELLY, Connecticut HANK BROWN, Colorado MICHAEL A. ANDREWS, Texas DON SUNDQUIST, Tennessee FORTNEY PETE STARK, California BRIAN J. DONNELLY, Massachusetts DAN ROSTENKOWSKI, Illinois, Chairman BILL ARCHER, Texas GUY VANDER JAGT, Michigan PHILIP M. CRANE, Illinois BILL FRENZEL, Minnesota DICK SCHULZE, Pennsylvania BILL GRADISON, Ohio WILLIAM M. THOMAS, California RAYMOND J. McGRATH, New York HANK BROWN, Colorado ROD CHANDLER, Washington E. CLAY SHAW, JR., Florida DON SUNDQUIST, Tennessee NANCY L. JOHNSON, Connecticut ROBERT J. LEONARD, t2hief Counsel and Staff Director PmLUP D. M05ELEY, Minority Chief of Staff (II) PAGENO="0003" CONTENTS Page Press releases of Tuesday, January 23, and Thursday, February 1, 1990, announcing the hearings 2 WITNESSES U.S. Department of the Treasury, Hon. Kenneth W. Gideon, Assistant Secre- tary for Tax Policy 16 U.S. Department of Defense, Lt. Gen. Donald W. Jones, Deputy Assistant Secretary for Military Manpower and Personnel Policy 64 :~*I~xander, Donald C., United Brands Co., Cincinnati, Ohio 356 Alliance of American Insurers, Clyde Turbeville 180 American Agricultural Insurance Co., Park Ridge, Ill., Clyde Turbeville 180 American Arts Alliance, Robert T. Buck 230 American Association of Museums, Robert T. Buck 230 American Dental Association, Michael J. Crete, D.D.S 492 American Electronics Association, Larry K. Thurston 88 American Insurance Association, Clyde Turbeville 180 American Medical Association, Mark -S. Litwin, M.D., Stacey Garry, M.D, David L. Heidorn, and Terrell Mitchell 497 American Society of Association Executives, Neil Milner 388 Archer, Hon. Bill, a Repi~sentative in Congress from the State of Texas 385 Asihene, Regina, Student Loan Interest Deduction Restoration Coalition 503 Associated Builders and Contractors, Inc., Robert A. Turner 371 Associated General Contractors of America, Glenn Graff 361 Association for Commuter Transportation, Inc., Colleen T. McCarthy 481 Association of American Universities, Robert M. Rosenzweig 245 Association of Art Museum Directors, Robert T. Buck 230 ATR Defense Group, Michael' L. Strang 296 Badger, William'~A., Maryland Public Service Commission National Associa- tion of Regulatory Utility Commissioners, and Capital Contributions in Aid of Construction (CIAC) Coalition 312 Baker, Willie L., Jr., United Food and Commercial Workers International Union, AFL-CIO.. - 402 Beaty, Robert~G.,:~Mitchell's Formal Wear, Inc., Atlanta, Ga., and Internation- al Formalwear Association 452 Bellatti, Roberl MA-illinois State Bar Association 276 Blaz, Hon. Ben, ~aifleI~gate to Congress from the Territory of Guam 60 Brandenburg, Dan 5~: Printing Industries of America, Inc 414 Britt, Raymond L:, Jr., Manufacturers Life Insurance Co., Toronto, Ontario, Canada, and Canadian Life and Health Insurance Association, U.S. Tax- ation Subcommittee 159 Brooklyn Museum, Robert T. Buck 230 Brown, Michael, Microsoft Corp., Redmond, Wash 112 Buck, Robert T., Brooklyn Museum, American Arts Alliance, American Asso- ciation of Museums, and Association of Art Museum Directors 230 Burton, David R., U.S. Chamber of Commerce 70 Canadian Life and Health Insurance Association, U.S. Taxation Subcommit- tee, Raymond L. Britt, Jr 159 Capital Contributions in Aid of Construction (CIAC) Coalition, William A. Badger 312 Carolina Power & Light Co., Raleigh, N.C., Murray Gould 303 Chambers, Caroline, National Association of Regulatory Commissioners 312 (III) PAGENO="0004" IV Page Chapoton, John E., Goldman, Sachs & Co 172 Charles A. Sammons Estate, Vester T. Hughes, Jr 433 Clinton, Conn., town of, Virginia D. Zawoy and Laura Jensen 333 Coalition on the PFIC Provisions, Robert W. Hirt 119 Computer and Business Equipment Manufacturers Association, Dan Kosten- bauder Cone, Jack, National Independent Automobile Dealers Association 342 Crane, Hon. Philip M., a Representative in Congress from the State of Illinois. 13 Crete, Michael J., D.D.S., American Dental Association 492 Cushman & Wakefield, Inc., New York, N.Y., John A. Sedlock 381 Dees, Richard L., McDermott, Will & Emery, Chicago, Ill 280 Deretchin, Joel, Woodlands (Texas) Community Association 474 Duncan, Harley T., Federation of Tax Administrators 257 Ebasco Services, Inc., New York, N.Y., Allen Epstein 83 Edison Electric Institute, Andrew C. Kadak and Murray Gould, Carolina Power & Light Co., Raleigh, N.C 303 Elmdale Farmers Mutual Insurance Co., Inc., Upsala, Minn., Albert J. Nelson, Jr 211 Emerson, Hon. Bill, a Representative in Congress from the State of Missouri... 57 Endick, Jeff, United Food and Commercial Workers International Union, AFL-CIO 402 Epstein, Allen, National Constructors Association and Ebasco Services, Inc., New York, N.Y 83 Federation of American Controlled Shipping, Philip J. Loree 103 Federation of Tax Administrators, Harley T. Duncan 257 Foley, Michael, National Association of Regulatory Utility Commissioners 312 Frenzel, Hon. Bill, a Representative in Congress from the State of Minnesota.. 208 Frankona Reinsurance Co-U.S. Branch, William M. Stroud 128 Garry, Stacey, M.D., American Medical Association 497 Goldman, Sachs & Co., John E. Chapoton 172 - Gould, Murray, Carolina Power & Light Co., Raleigh, NC 303 Graff, Glenn, Linbeck Construction, Houston, Tex., and Associated General Contractors of America 361 Green, Ray, National Automobile Dealers Association 337 Greene, Howard W., Risk and insurance Management Society, Inc 189 Heidorn, David L. American Medical Association 497 Helwig, Henry, National Independent Automobile Dealers Association 342 Hewlett-Packard Co.: Dan Kostenbauder Colleen McCarthy 481 Hirt, Robert W., Measurex Corp., Cupertino, Calif., and Coalition on the PFIC Provisions 119 Hocker, Jean W., Land Trust Alliance and Trust for Public Land 221 Hughes, Vester T., Jr., Charles A. Sammons Estate 433 Huxhold, Gene R., Kemper Financial Companies 396 Illinois State Bar Association, Robert M. Bellatti 276 International Formalwear Association, Robert G. Beaty 452 Jensen, Laura, town of Clinton, Conn 333 Jones, Henry, National Independent Automobile Dealers Association 342 Kadak, Andrew C., Yankee Atomic Electric Co., Boston, Mass., and Edison Electric Institute 303 Kemper Financial Companies, Gene R. Huxhold 396 Kostenbauder, Dan, Hewlett-Packard Co. and Computer and Business Equip- ment Manufacturers Association 96 Kretschmar, Craig and Janet, Cresbard, S. Dak 280 Land Trust Alliance, Jean W. Hocker 221 Lemov, Michael, National Independent Automobile Dealers Association 342 Lewis, Alaina, United States Student Association and:the Student Loan Inter- est Deduction Restoration Coalition 504 Linbeck Construction, Houston, Tex., Glenn Graff 361 Litwin, Mark S., M.D., American Medical Association 497 *Loree, Philip J., Federation of American Controlled Shipping 103 Maisonpierre, Andre, Reinsurance Association of America 196 Management Compensation Group, San Francisco, Calif., William V. Regan III 456 Manufacturers Life Insurance Co., Toronto, Ontario, Canada, Raymond L. Britt, Jr 159 PAGENO="0005" V ~age Maryland Public Service Commission, William A. Badger 312 McCarthy, Colleen T., Hewlett-Packard Co., Palo Alto, Calif., and Association for Commuter Transportation, Inc 481 McDavid, J. Gary, National Council of Farmer Cooperatives 465 McGraw, J.L., Campbell, Mo 218 McKinney, C.A. "Mack," Non Commissioned Officers Association of the United States of America 427 Measurex Corp., Robert W. Hirt 119 Michael, Bernhard, Munich Reinsurance Co-U.S. Branch, New York, N.Y 151 Microsoft Corp., Redmond, Wash., Michael Brown ~. 112 Milner, Neil, American Society of Association Executives ~.. 388 Mitchell, Terrell, American Medical Association 497 Mitchell's Formal Wear, Inc., Atlanta, Ga., Robert G. Beaty 452 Munich Reinsurance Co.,-U.5. Branch, New York, N.Y., Bernhard Michael.... 151 National Association of Home Builders, Martin Perlman 327 National Association of Independent Insurers, Clyde Turbeville 180 National Association of Life Underwriters, William V. Regan III 456 National Association of Mutual Insurance Companies: Clyde Turbeville 180 Albert J. Nelson, Jr 211 National Association of Regulatory Utility Commissioners, William A. Badger, Michael Foley, and Caroline Chambers 312 National Automobile Dealers Association, Ray. Green 337 National Constructors Association, Allen Epstein 83 National Council of Farmer Cooperatives, J. Gary McDavid 465 National Independent Automobile Dealers Association, Jack Cone, Henry Helwig, Henry Jones, and Michael Lemov 342 National Small Business United, David Torchinsky 274 Nelson, Albert J., Jr., Elmdale Farmers Mutual Insurance Co., Inc., Upsala, Minn., and National Association of Mutual Insurance Companies 211 Non Commissioned Officers Association of the United States of America, C.A. "Mack" McKinney 427 Ostrander, Steven R., Rockville, Md 407 Paisan Construction Co., Houston, Tex., Robert A. Turner 371 Pelosi, Hon. Nancy, a Representative in Congress from the State of California 63 Perlman, Martin, Pen Homes, Houston, Tex., and National Association of Home Builders 327 Printing Industries of America, Inc., Dan S. Brandenburg 414 Regan, William V., III, Management Compensation Group, San Francisco, Calif., and National Association of Life Underwriters 456 Reid, Hon. Harry, a U.S. Senator from the State of Nevada 10 Reinsurance Association of America, Andre Maisonpierre 196 Risk and Insurance Management Society, Inc., Howard W. Greene 189 Rosenzweig, Robert M., Association of American Universities 245 Sedlock, John A., Cushman & Wakefield, Inc., New York, N.Y 381 Slattery, Hon. Jim, a Representative in Congress from the State of Kansas 109 Storage Technology Corp., Louisville, Cob., Larry K. Thurston 88 Strang, Michael L., ATR Defense Group 296 Stroud, William M., Zurich American Insurance Co.-U.S. Branch Swiss American Reinsurance Co.-U.5. Branch, and Frankona Reinsurance Co.- U.S. Branch 128 Student Loan Interest Deduction Restoration Coalition, Regina Asihene and Alaina Lewis 503 Swiss American Reinsurance Co.-U.S. Branch, William M. Stroud 128 Thurston, Larry K., Storage Technology Corp., Louisville, Cob., and Ameri- can Electronics Association 88 Torchinsky, David, National Small Business United 274 Trust for Public Land, Jean W. Hocker 221 Turbevifle, Clyde, American Agricultural Insurance Co., National Association of Independent Insurers, Alliance of American Insurers, American Insur- ance Association, and National Association of Mutual Insurance Companies 180 Turner, Robert A., Paisan Construction Co., Houston, Tex~, and Associated Builders and Contractors, Inc 371 United Brands Co., Cincinnati, Ohio, Donald C. Alexander 356 United Food and Commercial Workers International Union, AFL-CIO, Willie L. Baker, Jr., and Jeff Endick 402 PAGENO="0006" VI Page United States Student Association, Alaina Lewis 504 U.S. Chamber of Commerce, David R. Burton 70 Woodlands (Texas) Community Association, Joel Deretchin 474 Yankee Atomic Electric Co., Boston, Mass., Andrew C. Kadak 303 Yates, Hon. Sidney R., a Representative in Congress from the State of Illinois. 12 Zawoy, Virginia D., Town of Clinton, Conn 333 Zurich American Insurance Co.-U.S. Branch, Schaumburg, Ill., William M. Stroud 128 SUBMISSIONS FOR THE RECORD FOREIGN PRovIsIoNs Extension of Carryforward of Foreign Tax Credits: American Petroleum Institute, statement 515 Halliburton Co., Dallas, Texas, Jack R. Skinner, letter 519 Salomon Brothers Inc., New York, N.Y., statement 524 Tax Executives Institute, Inc., William M. Burk, letter 531 Tektronix, Inc., Arlington, Va., Gary L. Conkiing, statement 538 Unisys Corp., Blue Bell, Pa., Jack R. Silverberg, statement 543 Whirlpool Corp., Benton Harbor, Mich., James R. Samartini, letter 545 Carryforward of Pre-1987 Foreign Base Company Shipping Losses: AFL-CIO Maritime Committee, statement 547 American Petroleum Institute, statement 515 Chevron Corp., San Francisco, Calif., statement 550 Modification of Code Section 956 Related to the Characterization of Successive Leans: American Petroleum Institute, statement 515 Carney, Robert T., Dow, Lohnes & Albertson, Washington, D.C., state- ment 552 Deloitte & Touche, Washington, D.C., Steven P. Hannes, letter 556 Ernst & Young, Washington, D.C., letter 559 Fuibright & Jaworski, Washington, D.C., Robert H. Wellen, letter 562 Halliburton Co., Dallas, Texas, Jack R. Skinner, letter 519 Salomon Brothers Inc., New York, N.Y., statement 524 Tax Executives Institute, Inc., William M. Burk, letter 531 Tektronix, Inc., Arlington, Va., Gary L. Conkling, statement 538 Exceptions to the Passive Foreign Investment Company (PFIC) Rules: ADAPSO, Arlington, Va., Luanne James, statement 570 American Investment Services, Inc., Great Barrington, Mass., Lawrence S. Pratt, statement 571 American Petroleum Institute, statement 515 EG&G, Inc., Wellesley, Mass., Louis J. Williams, statement 574 Halliburton Co., Dallas, Texas, Jack R. Skinner, letter 519 Hercules Inc., Wilmington, Del., James D. Knox, statement 578 Salomon Brothers Inc., New York, N.Y., statement 524 Tax Executives Institute, Inc., William M. Burk, letter 531 Tektronix, Inc., Arlington, Va., Gary L. Conkling, statement 538 United States Council for International Business, Richard M. Hammer, letter Treatment of Certain Interest Earned by Brokers of Dealers for Purposes of the Foreign Holding Company Rules: Salomon Brothers Inc., New York, N.Y., statement 524 Convention Treatment of Certain Cruise Ships: Schulze, Hon. Dick, a Representative in Congress from the State of Penn- sylvania, statement 580 Application of the Mirror Tax System to Guam: Guam, Territory of, Department ofRevenue & Taxation, Joaquin G. Blaz, letter (forwarded by the Hon. Ben Blaz, a Delegate to Congress from the Territory of Guam) 584 Modification of the Reinsurance Excise Tax: Association of. British Insurers, London, England, Keith E. Loney, state- ment 586 Association of Italian insurance Companies, Rome, Italy, Renzo Capotosti, statement Gesamtverband der Deutschen Versicherungswirtschaft e.V~, Koln, Ger- many, letter PAGENO="0007" VII Page Modification of the Reinsurance Excise Tax-Continued Guy Carpenter & Co., Inc., New York, N.Y., statement 598 Mortgage Guaranty Insurance Co., statement 600 National Association of Insurance Brokers, Barbara S. Haugen, letter 194 Swiss Insurance Association, Zurich, Switzerland, Christopher. Blanc, statement 604 ACCOUNTING PROVISIONS Annual Accrual Method of Accounting for Certain Farming Corporations: Castle & Cooke, Inc/Dole, Cliff Massa III, statement 608 Maui, Hawaii, Pineapple Co., Andrew W. Singer, statement and attach- ment 612 Look-Back Method for Long-Term Contracts: Halliburton Co., Dallas, Tex., Jack R. Skinner, letter 519 Accrual Method of Accounting: Cushman Realty Corp., Los Angeles, Calif., John C. Cushman III, letter 620 ALTERNATIVE MINIMUM TAX Small Electing Property and Casualty Insurance Companies and the Alterna- tive Minimum Tax: Jacobs, Hon. Andy, Jr., a Representative in Congress from the State of Indiana, statement 621 TransWorld Insurance Co., Inc., Birmingham, Ala., Susan Lazarus, letter. 622 Gifts of Appreciated Property: Independent Sector, Brian O'Connell, letter 626 Nantucket, Mass., Conservation Foundation, Inc., James F. Lentowski, letter and attachments 628 Nantucket, Mass., Land Council, Inc., Lynn Zimmerman, letter 638 National Association of Independent Schools, John W. Sanders, statement 639 New York State Bar Association (Entertainment, Arts and Sports Law Section), Fine Arts Committee, Susan Duke Biederman, letter 641 Trust for New Hampshire Lands, Sarah Thorne, letter 643 PENSIONS AND EMPLOYEE BENEFITS Extension of Section 401(k) Plans to Tax-Exempt Employers: ADAPSO, Arlington, Va., Luanne James, letter 645 American Bankers Association, statement 646 Credit Union National Association, Inc. and Affiliates, Charles 0. Zuver, letter 647 Cultural Institutions Retirement System, statement and attachments 649 Greater Washington Society of Association Executives, Stephen W. Carey, statement 654 International Union, United Automobile, Aerospace & Agricultural Im- plement Workers of America-UAW, Dick Warden, letter 655 Loyal Order of Moose, Mooseheart, Ill., Paul J. O'Hollaren, statement 656 National Education Association and Michigan Education Association, Beverly Wolkow, joint statement 657 Principal Financial Group, Des Moines, Iowa, William F. Gould and Jack Stewart, joint statement 659 Producers Livestock Association, W. Dennis Bolling, statement 660 Welch, John S. and C. Cabell Chinnis, Jr., Lathan & Watkins, Washing- ton, D.C., joint letter 662 Modifications of Voluntary Employees' Beneficiary Associations (VEBA's) Re- strictions: American Association of Advertising Agencies Insurance Trust, Donald S. Lewis, letter 663 National Rural Electric Cooperative Association, statement 664 National Tire Dealers and Retreaders Association, Inc., Philip P. Fried- lander, Jr., letter 669 Society of Professional Benefit Administrators, Frederick D. Hunt, Jr., statement 672 Water Quality Association Employees' Benefit Corp., Lisle, Ill., Peter M. Davis and Jerry J. Hurley, joint letter 674 PAGENO="0008" VIII Page Separate Testing for Pilots: Federal Express Corp., Flight Advisory Board, Bruce B. Cheever, state- ment 678 Modification of Minimum Participation Rules for Plans of Public Safety Em- ployees: International Association of Fire Fighters, Harold A. Schaitberger, state- ment 681 Application of Limitations on Benefits for Clergy Members: Panetta, Hon. Leon E., a Representative in Congress from the State of California, statement 683 ESTATE AND Givr TAXES Special Use Valuation Election Under Section 2032A of the Code: American Institute of Certified Public Accountants, Federal Taxation Division, statement 684 Daschle, Hon. Tom, a U.S. Senator from the State of South Dakota, statement 688 Disclaimer of Gifts: American Institute of Certified Public Accountants, Federal Taxation Division, statement 684 Halbach, Helen W., Estate of K. Martin Worthy, statement 689 Estate Tax Modifications: Alabama Department of Revenue, James M. Sizemore, Jr., statement 699 American Council of Life Insurance, statement 700 American Institute of Certified Public Accountants, Federal Taxation Division, statement 684 Association for Advanced Life Underwriting, statement 704 Lombard, John J., Philadelphia, Pa.; John A. Wallace, Atlanta, Ga.; Stephen E. Martin, Idaho Falls, Idaho; Lloyd Leva Plaine, Washington, D.C.; and Lynn P. Hart, San Francisco, Calif., joint statement and attachment 712 New York Department of Taxation and Finance, James W. Wetzler, statement 267 Wyoming Department of Revenue and Taxation, Thomas D. Roberts, statement 717 OTHER MISCELLANEOUS ISSUES Clarification of Code Section 1071: Pan American Satellite, Greenwich, Conn., Rene Anselmo, statement 718 Contributions in Aid of Construction: Avatar Utilities Inc., Coral Gables, Fla., Robert B. Gordon, statement 724 Edison Electric Institute and Utility CIAC Group, joint statement 732 Nuclear Decommissioning: Entergy Services, Inc., SM. Henry Brown, Jr., statement 737 Investment Company Institute, statement 739 Schulze, Hon. Dick, a Representative in Congress from the State of Penn- sylvania, statement 580 Utility Decommissioning Tax Group, statement and attachments 740 Corporate-Owned Life Insurance: American Council of Life Insurance, statement 700 Massachusetts Mutual Life Insurance Co., statement 748 Modification of Rules on Certain Cooperatives: Farmers Petroleum Cooperative, Inc., Lansing Mich., John M. Feland, letter 752 Farmland Industries, Inc., Kansas City, Mo., James L. Rainey, letter 754 Growmark, Inc., Bloomington, Ill., Norman T. Jones, letter 756 Land O'Lakes, Inc., Minneapolis, Minn., John E. Gherty, letter 757 MFA Inc., Columbia, Mo., B.L. Frew, letter 758 MFC Services (AAL), Madison, Miss., J.L. Harpole, letter 759 Southern States Cooperative, Inc., Richmond, Va., Jerry H. Gass, letter..... 760 Texas Agri~ultura1 Cooperative Council, Billy L. Conner, letter 7131 Union Equity Co-Operative Exchange, Enid, Okla., Edwin Wallace, letter. 762 PAGENO="0009" Ix Page Taxation of Unearned Income of Minors: Archer, Hon. Bill, a Representative in Congress from the State of Texas, statement 763 Tax Treatment of Public Transit and Van Pool Benefits: Action Committee for Transit, Silver Spring, Md., Nicholas M. Brand, statement 764 CARAVAN for Commuters, Inc., Boston, Mass., Carolyn DiMambro, statement 766 Commuter Transportation Services, Inc., Los Angeles, Calif., Jim Sims, statement 767 El Segundo, Calif., Employers Association, Donald H. Camph, letter 769 Greater Washington Board of Trade, Richard Berendzen and W. Don Ladd, joint letter 770 Keep Montgomery County, Md., Moving Committee and Montgomery County, Md., Department of Transportation, John H. Carman and Robert S. McGarry, joint statement 771 MetroPool, Inc., Stamford, Conn., Carol Dee Angell, statement 772 Northern Virginia Transportation Commission, Hon. James P. Moran, Jr., Mayor, City of Alexandria, Va., statement 773 Reston, Va., Board of Commerce, David A. Ross, statement 774 Richmond, Va., Area Metropolitan Transportation Planning Organiza- tion, Daniel N. Lysy, letter and attachment 775 RIDES for Bay Area Commuters, Inc., San Francisco, Calif., Eunice E. Valentine, statement 777 Tn-County Metropolitan Transportation District of Oregon, James E. Cowen, letter 778 Washington State Department of Transportation, Duane Berentson, state- ment 779 Washington State Ridesharing Organization, David Rodrick, statement 780 Deductibility of Student Loan Interest: Schulze, Hon. Dick, a Representative in Congress from the State of Penn- sylvania, statement 580 Earned Income Tax Credit (EITC) for Military Personnel Stationed Overseas: Association of the United States Army, Col. Erik G. Johnson, Jr., USA Ret., statement 782 National Military Family Association, Inc., statement 783 Retired Officers Association, Col. Christopher J. Giaimo, USAF-Retired, statement 784 PAGENO="0010" PAGENO="0011" MISCELLANEOUS REVENUE ISSUES WEDNESDAY, FEBRUARY 21, 1990 HOUSE OF REPRESENTATIVES, COMMITTEE ON WAYS AND MEANS, SUBCOMMITTEE ON SELECT REVENUE MEASURES, Washington, DC. The subcommittee met, pursuant to notice, at 10:10 a.m., in~room 1100, Longworth House Office Building, Hon. Charles B. Rangel (chairman of the subcommittee) presiding. [The press release announcing the hearing follows:] (1) PAGENO="0012" 2 FOR IMMEDIATE RELEASE PRESS RELEASE #8 TUESDAY, JANUARY 23, 1990 SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS U.S. ROUSE OP REPRESENTATIVES 1102 LONOWORTE BUILDING WASEINGTON, D.C. 20515 TELEPHONE: (202) 225-1721 THE HONORABLE CHARLES B. RASGEL (D., N.Y.), CHAIRMAN, SUBCOMMITTEE ON SELECT REVENUE MEASURES, COMMITTEE ON WAYS AND MEANS, U.S. ROUSE OP REPRESENTATIVES, ANNOUNCES CONTINUATION OF PUBLIC HEARINGS ON MISCELLANEOUS REVENUE ISSUES The Honorable Charles B. Rangel (D., N.Y.), Chairman, Subcommittee on Select Revenue Measures, Committee on Ways and Means, U.S. House of Representatives, announced today that the Subcommittee will continue public hearings on miscellaneous revenue issues, on Wednesday, February 21, 1990, and Thursday, February 22, l~9O, beginning at 10:00 a.m. each day in the Committee's main hearing room, 1100 Longworth House Office Building. In announcing the hearings, Chairman Rangel reiterated his remarks made with respect to two earlier hearings on miscellaneous revenue issues: "Chairman Rostenkowski recently has referred to the Subcommittee numerous miscellaneous revenue issues which Members of the full Committee raised but were beyond the scope of the Committee's action in its budget reconciliation markup. These two days of hearings generally will complete the Subcommittee's public hearings on these miscellaneous issues. "In addition, I wish to stress that the nature of these hearings is to focus attention. on the specific issues raised by Members. The hearings will be limited to those issues specifically designated. Consequently, witnesses will be asked to so limit their testimony. Because of the large number of issues covered in these hearings, I must ask witnesses sharing similar views to consolidate their testimony, and I encourage potential witnesses to submit testimony in writing rather than testifying in person." ISSUES ON WHICH TESTIMONY IS INVITED: A. Foreign Provisions 1. Extension of carryforward of foreign tax credits: The proposal. would extend the carryforward of foreign tax credits from five years to 15 years for credits generated in taxable years beginning after December 31, 1988. 2. Carryforward of pre-1987 foreign base comyany shipping losses: The proposal would permit a foreign base company shipping deficit accumuleztec~ ~y ~ controlled ioreign corporation (CFC) to reduce post-effective date foreign base company shipping income of the CFC by allowing the carryforward of CFC shipping and other losses accumulated as of the effective date of the Tax Reform Act of 1986 (1986 Act). 3. Modification of Code section 956 related to the characterization of successive loans: The proposal would retroactively revoke Revenue Ruling 89-73 by providing that for purposes of Code section 956, Revenue Ruling 89-73 shall not apply to the first taxable year ending after May 22, 1989, and all prior taxable years in determining whether two successive obligations or roans shall be treated as one obligation or loan. PAGENO="0013" 3 4. Treatment of related party royalties under ~~eF of a U.S. software company with a two-tier foreign subsidiary Structure (i.e., foreign production affiliate licensing products to foreign sales affiliates for relicensing to customers), related party royalties paid between the foreign sales and production affiliates would be subject to characterization for Subpart F purposes under the foreign base company sales rules applicable to manufacturers generally, rather than under the foreign personal holding company income provisions of Subpart F. 5. ~g~ption~ to the passive foreign investment com~py 1~IC) rules: a. One proposal would provide that certain corporations that engage in substantial manufacturing operations in a foreign country which has a deficit in its trade balance with the United States would not be treated as passive foreign investment companies. b. Another proposal would exempt certain pre-1986 Act shareholders of stock in certain publicly traded companies fromthe PFIC rules. In addition, the proposal would state that certain anti-avoidance provisions would not apply to the appreciation in PFIC stock that is allocable to a taxpayer's holding period prior to the effective date of the PFIC rules. 6. Foreign companies carrying on insurance business: a. One proposal would require Treasury Department regulations relating to the determination of the minimum effectively connected net investment income of property and casualty companies under section 842(b) of the Code to provide that such determination would be made separately for categories of such companies based on long-tail and short-tail business. b. Other proposed modifications include: (i) the effectively connected net investment income of a foreign insurance company for any year would be determined on the basis of the greater of the cumulative actual net investment income or the cumulative minimum net investment income; * (ii) the modification would not apply until two years after the year in which the actual effectively connected net investment income was received or accrued; and (iii) if the amount of minimum effectively connected net investment * income in excess of the actual effectively connected net investment income reduces the amount of a net operating loss, a reduction in the tax on certain. income that is not effectively connected with a United States trade or business would be allowed. 7. Treatment of certain interest earned by brokers or dealers for purposes of the foreign holdL~~jj~ rules: The proposal would restrict the definition of foreign personal holding company income under Code section 553 so as to exclude certain interest income of foreign securities brokers and dealers. PAGENO="0014" 4 8. Convention treatment of certain cruise s~pp~: The proposal would allow taxpayers who attend business `conventions on certain U.S.-f lag and foreign-flag vessels that serve the Caribbean to be eligible to deduct certain convention costs. Eligible vessels would have to employ at least 20-percent Caribbean nationals, would have to limit the convention size to no more than 500 persons, and would have to visit at least one port of a beneficiary country under the Caribbean Basin Initiative. 9. Application of the mirror tax system to Guam: The proposal would provide that the mirror system of taxation will continue to apply to Guam until the effective date of a comprehensive tax code enacted by Guam, as certified by the Governor of Guam. 10. Modification of the reinsurance excise tax: The proposal would increase the excise tix imposed on property and casualty reinsurance ceded abroad in section 4371 ~of the Code from 1 percent to 4 percent. The proposal would provide that such an increase overrides any treaty waiver of the tax. B. Accountimg Provisions 1. Installment sales for automobile dealers: The proposal, as contained in H.R. 2041, relates to allowing installment sale treatment for dealer sales of used cars, with an interest charge on the resulting tax deferral. 2. Annual accrual method of accounting for certain farming corporations: The proposal would make other taxpayers eligible for the same treatment as sugar cane growers under Code section 447(g), where the taxpayer otherwise satisfies the threshold require- ments for the application of section 447(g) and would not have been subject to the restrictions of repealed Code section 278. 3. Look-back method for long-term contracts: The proposal would modify the look-back rule for long-term contracts to eliminate its application to amounts received after the contract completion date as a result of disputes, litigation, or settlements relating to the contract. 4. Accrual method of accountieg: The proposal would amend section 448(d) of the Code to `permit a corporation to use the cash method of accounting if (a) more than 50 `percent of the firm's income over the taxable year and two immediately preceding taxable years is commission income; (b) the firm pays at least 25 percent of the commission to brokers; and (c) the commission income will be received in installments due in more than one taxable year. 3dt#rnativ. Mi~ti~um ¶&` 1. Small electing property and casualty insurance companies and the alternative minimum tax: Under current law, small property and casualty insurance companies may elect to calculate regular tax liabilities based solely upon investment income. The proposal would extend this election to the calculation of alternative minimum tax liability. 2. Capital gains preference for insolvent farmers: The proposal, as contained in H.R. 1849, relates to extending the period during which retroactive relief from the alternative minimum tax is available to certain insolvent farmers with capital gains preferences. PAGENO="0015" 5. -4- 3. Gifts of a reciated ro ert : The proposal would remove as a preference tern from the alternative minimum tax, charitable contributions of appreciated property. D. P.nsions and ~mploy*. Bernet its 1. Extension of section 401(kj plans to tax-exempt ~p1oyers: The proposal would modify present law to permit tax-exempt employers to maintain qualified cash or deferred arrangements, or Code section 401(k) plans. 2. Modifications of voluntary em~loyees' beneficiary associations (VEBA5) restrictions: The proposal would make certain modifications to present-law limits applicable to VEBAs: (a) to eliminate the geographic restrictions on VEBA coverage; (b) to permit Code section 501(c) (9) multiple employer trusts to maintain reserves adequate to meet the safe-harbor limit under current law, plus additional reserves necessary to meet contingent liabilities; and (c) to raise the 10-percent contribution limit for a multiple employer trust to 25 percent if the plan has more than 15 employers. 3. Separate testing for pilots: The proposal would provide that airline pilots could be tested separately for the purpose of pension nondiscrimina- tion rules, even if the pilots were not covered under a collective bargaining agreement. 4. Individual Retirement Account (IRA) limitation modification: Under present law, an individual whose income exceeds certain limitations may not make deductible contributions to an IRA if that individual (or his or her spouse) is covered by an employer- provided pension plan at any time during the year for which the contributions are made.. The proposal would provide that the individual's permissible IRA deduction is reduced by one-twelfth for every month the individual is covered by an employer-provided plan. 5. Modification of minimum participation rules for plans of public safety employees: The proposal would provide that the minimum participation rules do not apply to a plan for qualified public safety employees if no new participants are added to the plan, and the plan satisfied the minimum participation standards on July 17, 1989. 6. Application of limitations on benefits for clergy members: The proposal would provide that up to $15,000 of a tax-exempt parsonage allowance would be treated as compensation during a year for purposes of calculating the maximum limits on contributions and benefits under a qualified pension plan. B. Ei~ploye. Stock Ovnership Plans (EBO)'s): The proposal would provide that certain gratuitous transfers of employer securities to an ESOP be treated under rules similar to those governing charitable remainder trusts. F. Estate and Gift Taxes 1. Special use valuation election under section 2032A of the Code: The two proposals referred to the Subcommittee would: PAGENO="0016" 6 a. Retroactively validate an untimely election under section 2032k of the Code, either categorically or alternatively, by reference to negligence or malpractice of the attorney for the estate in making the election. b. Extend the definition of "qualified use" under section 2032k of the Code to include situations where the qualified heir rents the property to a family member on a net cash basis, retroactive to rentals occurring after December 31, 1976. 2. Disclaimers of gifts: The proposal would make the gift tax effect of a disclaimer depend upon regulations in effect at the time of a disclaimer, but provide (contrary to the Jewett case) that with respect to four Specific property interests created before 1942, the disclaimer of certain contingent future interests results in no taxable gift if executed on a specific date immediately after the disclaimant's interest would have become vested. 3. Estate tax modifications: Three proposals ref erred to the Subcommittee would: a. Require that, to qualify as a present interest for purposes of the annual gift tax exclusion, a contribution to a trust must give the donee a power to withdraw the contribution that lasts until the donee's death and must allow the donee to retain a general power of appointment over the trust assets. b. Cap the State death .tax credit for Federal estate and gift tax purposes at 8.8 percent, the credit percentage under the current Code section 2011 schedule which applies to those adjusted taxable estates at the threshold of the top Federal estate and gift tax bracketsi c. Limit the annual $10,000 per-donee gift tax exclusion to a flat annual per-donor exclusion of $30,000. G. Othsr Misc.llansoui Iseuse 1. Clarification of Code section 1071: The proposal would allow the owner of a specific company to reduce basis in that company by gain realized on sale of interest in television stations which had to be sold after a Federal Communications Commission (FCC) administrative law judge ruled that long-unenforced FCC rules were violated by foreign ownership. 2. Contributions in aid of construction: The proposal would provide that capital contributions in aid of construction received by any regulated water utility to enable the utility to extend water service to the payor would be excluded from the gross income of the water utility. 3. Nuclear decommissioning: The proposal would reduce the tax rate on nuclear decommissioning funds and eliminate restrictions on investments. 4. Two-year class life for tuxedos: The proposal would adopt Treasury's recommended reduction in accelerated cost recovery system (ACRS) class life of tuxedos from nine to two years. PAGENO="0017" 7 5. ~ life insurance: The proposal would require that corporate_o~ed life insurance Contracts irrevocably designate the insured persons and that the death benefit under the contract be payable to the insured's family, in addition to current law limitations governing the deductibility of interest paid or accrued on indebtedness on certain life insurance corporations. These rules would also be extended to interest on indebtedness with respect to life insurance corporations that cover directors, retired employees, and other similar individuals. 6. Modification of rules on áertain cooperatives: The proposal, as contained in H.R. 2353, would allow non-exempt farm cooperatives to elect patronage- sourced treatment for gain or loss from the sale of an asset, provided that the asset was used to facilitate member business. 7. Stadium transition rule: The proposal would increase the transition relieU~rovided in the 1986 Act for a particular stadium by $75 million (for a total of. $125 million), except such $125 million from the State volume cap, and extend the bond issuance deadline by one and one-half years (until June 30, 1992). 8. Taxation of unearned income of minors: The proposal would tax, at the child's rate, iii~~e attributable to lump-sum damages arising from illness or injuries and awarded to the child before the effective date of the 1986 Act. 9. Deductibility of certain fees: The proposal would allow fees paid by residents of "New Communities Act" associations to be deductible in the same manner as property taxes. 10. Tax treatment of public transit and van pool benef its: Present law provides that employer- provided public transit benefits are considered deminimis and thus not included in gross income if they à~é~15 or less per month. The proposal would provide that the first $15 per month of employer- provided public transit benefits would be excludable from the employee's income, even if the total benefit each month exceeds this amount. In addition, the proposal would reinstate the exclusion for employer- provided van pool benefits that expired after December 31, 1985. 11. Deductibility of student loan interest: The proposal would reinstate the full deductibjIit~ of interest on student loans, beginning in taxable year 1990. 12. Deductibility of flight training ex~~~~s: The proposal would provide that for taxable years before 1980, the Federal income tax deductibility of. flight training expenses would be determined wit~iout regard to whether such expenses were reimbursed through certain veterans educational assistance allowances. 13. Earned income tax credit (EIUC) for military ersonnel stationed overseas: Under present law, individuals liv ng outs de the United States are not eligible for the EITc.. The proposal would extend EITC eligibility to U.S. armed service employees Stationed overseas. PAGENO="0018" 8 DETAILS FOR SUBJEISSIONOP REQUESTS TO BE HEARD: Individuals and organizations interested in presenting oral testimony before the Subcommittee must submit their requests to be heard by telephone to Harriett Lawler or Diane Kirkland ((202) 225'-1721] no later than close of business, Friday, February 9, 1990, to be followed b~j.a formal written request to Robert ~. Leonard, Chief Counsel, Committee on Ways and Means, U.S. House of Representatives, 1102 Longworth House Office Building, Washington, D.C. 20515. The Subcommittee staff will notify by telephone those scheduled to appear as soon as possible after the filing deadline. Any questions concerning a scheduled appearance should be directed to the Subcommittee ((202) 225-9710). Persons and organizations having a common position are urged to make every effort to designate one spokesperson to represent them in order for the subcommittee to hear as many points of view as possible. Time for oral presentations will be strictly limited with the under- standing that a more detailed statement may be included in the printed record of the hearings (see formatting requirements below). This process will afford more time for members to question witnesses. In addition, witnesses may be grouped as panelists with strict time limitations for each panelist. In order to assure the most productive use of the limited amount of time available to question hearing witnesses, all witnesses* scheduled to appear before the Subcommittee are required to submit 100 copies of their prepared statements to the Subcommittee office, room 1135 Longworth House Office Building, at least 24 hours in advance of their scheduled appearance. Failure to comply.with this requirement may result in the witness being denied the opportunity to testify in person. WRITTEN STATEMENTS IN LIEU OF PERSONAL APPEARANCE: Persons submitting written statements for the printed record of the hearings should submit at least six (6) copies by the close of business, Friday, March 9, 1990, to Robert 3. Leonard, Chief Counsel, Committee on Ways and Means, U.S. House of Representatives, 1102 Longworth House Office Building, Washington, D.C. 20515. If those filing written statements for the record of the printed hearings wish to have their statements distributed to the press and the interested public, they may provide 100 additional copies for this purpose to the Subcommittee office, room 1135 Longworth House Office Building, before the hearings begin. SEE~ FORNATTING REQUIREMENTS BELOW: Each statement presented for printing to the Committee by a witness, any written statement or exhibit submitted for the printed record or any written comments In response to a request for written comments mustconform to the guidelines listed below. Any statement or exhibit not in compliance with these guidelines will not be printed, but will be maintained In the Committee files for review and use by the Committee. 1. All statements and any accompanying exhibits for printing must be typed In single space on legal-size paper and may not exceed a total of 10 pages. 2. Copies of whole documents submitted as exhibit material will not be accepted for printing. Instead, exhibit material should be referenced and quoted or paraphrased. All exhibit material not meeting these specifications will be maintained in the Committee fIl~sfor review and use bvthe Committee. 3. Statements rOust contain the name alld capacity in which the witness will appear Or, for written conrnents. the name and capacity of the person submitting the statement, as well as any clients or persons, or any organization for whom the witness appears or for whom the statement is submitted. 4. A supplemental sheet must accompany each statement listing the name, fall address, a telephone number where the witness or the designated representative may be reached and a topical outline or summary of the comments and recommendations in the full statement. This supplemental sheet will not be included in the printed record. The above restrictions and limitations apply only to material being submitted for printing. Statements and exhibits or supplementary material submitted solely for distribution to the Members. the press and public during the course of a public hearing. may be submitted in other forma. PAGENO="0019" FOR IMMEDIATE RELEASE PRESS RELEASE Ia-REVISED THURSDAY, FEBRUARY 1, 1990 SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS U. S HOUSE OF REPRESENTATIVES 1102 LONGWORTH BUILDING WASHINGTON, D.C. 20515 TELEPHONE: (202) 225-1721 THE HONORABLE CHARLES B RANGEL (D , N Y) CHAIRMAN, SUBCOMMITTEE ON SELECT REVENUE MEASURES, COMMITTEE ON WAYS AND MEANS, U.S. HOUSE OF REPRESENTATIVES, ANNOUNCES ADDITIONAL ISSUE FOR PUBLIC HEARINGS ON MISCELLANEOUS REVENUE ISSUES The Honorable Charles B. Rangel (D., N.Y.), ChaIrman, Subcommittee on Select Revenue Measures, Committee on Ways and Means, U.S. House of Representatives, announced today that the Subcommittee will include the issue described below in the public hearings on miscellaneous revenue issues, which were previously announced for Wednesday and Thursday, February 21 and 22, 1990, beginning at 10:00 a.m. each day in the Committee's main hearing room, 1100 Longworth House Office Building. All other details for the hearings remain the same. (See Press Release #8, dated Tuesday, January 23, 1990.) In announcing the inclusion of this issue in the previously scheduled hearings, Chairman Rangel reiterated the remarks he made when the hearings were originally announced: "I wish to stress that the nature of these hearings is- to focus attention on specific issues raised by Members. The hearings will be limited to those issues specifically designated. Consequently, witnesses will be asked to so limit their testimony. Because of the large number of issues covered in these hearings, I must ask witnesses sharing similar views to consolidate their testimony, and I encourage potential witnesses to submit testimony in writing rather than - testifying in person." - - - - ADDITIONAL ISSUE ON WHICH TESTIMONY IS INVITED The proposal referred to the Subcommittee would, subject to certain conditions, allocate a certain dollar amount of - - low-income housing credit for 1990 to a particular project which was unable to meet the requirements for a credit carryover in 1989 due to failure by the Department of Housing and Urban Development to approve by December 31, 1989, its application for transfer of ownership of the project. -- - PAGENO="0020" 10 Chairman RANGEL. Good morning. The Subcommittee on Select Revenue Measures will meet today to review miscellaneous reve- nue issues. The issues under consideration today are a part of a group of issues which members of the full Committee on Ways'~and Means raised last year in budget reconciliation. This subcommittee has already held 2 days' hearings. Today's hearing and tomorrow's will conclude the hearings planned on these miscellaneous issues. The purpose of these hearings is to focus attention onihe:specific issues raised by Members of the House and referred toithis subcom- mittee. Through this review; the-subcommittee will be in a position to make an informed decision as to what.~recommendations, if any, should be made to the full Ways and Means Committee with re- spect to these issues before us. Because of the large number of issues to be covered in this hear- ing, the subcommittee will request that public witnesses strictly limit their oral testimony to 5 minutes Although it will not be pos sible to address all the particulars during the short period of time, I would like to assure you that the committee will give careful con- sideration to the written testimony as well as the staff of the sub- committee. I also would like to point out for the benefit of the witnesses that we will be breaking for the joint session at 11 o'clock and resuming immediately following. Do we have any idea, staff, as to how long the joint session is going to take so that we can give a time certain? I assume it would be an hour, though. We might tentatively say that we'll break from 11 to 12, assuming that the session is over at that time. We are honored to have several of our colleagues here to testify on issues of particular interest to them. Congressman Schulze was scheduled to testify, but as most of you know, the death of his wife last week, after a prolonged illness, prevents him from being with us. The House and the committee and subcommittee and staff all extend our deepest regrets and condolences to Dick Schuize and his family. Senator Harry Reid, a former Member of the House, and Con- gressman Sid Yates, a distinguished Member of this body, will be testifying this morning. Because of their schedules we have taken them out of order, and we will hear their testimony now. I regret any inconveniences that have been caused by other witnesses. Senator, it is good to have you back with us, andwe are very anxious to hear from you on the issues that concern you and your constituents in Nevada. STATEMENT OF HON. HARRY REID, A U.S. SENATOR FROM THE STATE OF NEVADA Senator REID. Thank you very much, Mr. Chairman. I deeply appreciate this opportunity to testify on the need to re- store pre-1986 tax treatment of contributions in aid of construction for the provision of water services. Nearly a year ago, I introduced legislation in the Senate, S. 435, to restore pre-1986 treatment of CIAC for all utility services. This is companion legislation to that introduced by Bob Matsui in H.R. 118, now enjoying the support of PAGENO="0021" 11 131 Members of the House. My bill in the Senate is cosponsored by 31 Members of the Senate. Mr. Chairman, it is my understanding you wish to receive testi- mony on proposals that members of the Ways and Means Commit- tee asked be included in last year's reconciliation bill. While Con- gressman Matsui's proposal concerned water, it is important for the subcommittee to understand that CIAC applies to all utilities. While eliminating the CIAC tax for water is important in itself, until pre-1986 treatment of CIAC is restored for all utilities, the problems I describe below will not be completely resolved. The ability of Americans to provide a roof over their heads and their families is progressively weakening. The affordability crisis among prospective first-time home buyers across the Nation is the worst it has been since the end of World War II. How can this situ- ation be rectified? How can we restore a basic standard of living to Americans? 5. 435 proposes a change to a little-known provision of the Tax Reform Act of 1986. This change will not call for the Fed- eral Government to acquire, construct, or rehabilitate affordable housing, even though that probably is something we should be more heavily involved in than we are. But it will help developers build the houses. It will help prospective homeowners afford what to some is little more than a dream. S. 435 will reinstate the tax exemption for contributions in aid of construction. In many cases, when housing is being constructed, builders extend gas and water mains and electric lines into their developments. They then turn this property over to the utilities without charge, or they pay the utilities to install the lines them- selves. Utilities receive this financial or property compensation from the developers for establishing service to the new homes and buildings. Prior to 1986, these contributions were not taxable as income, but the Tax Reform Act of 1986 changed this principle. The impact of this seemingly innocuous technical change is significant. It in- creases the cost of housing by as much as $2,600 in the State of Nevada alone. For each house, an additional $2,600~ By accepting this, we are undermining our basic but paramount aim to help pro- mote affordable housing. This new tax means increased revenue for the Federal Treasury, but at what cost? The intention of the tax was to place part of the new corporate tax burden on utilities. This may have made sense in theory,~ but it has failed miserably in practice. Why? Because utilities pass the tax on to consumers in the form of higher rates. If the tax burden is shifted to builders, they merely incorporate that extra cost into the purchase price of the homes. The buck stops once again at the prospective or current homeowner~ A tax intended for a corpora- tion has instead fallen on the homeowner. I was first alerted to such problems by people in the Reno, NV, area. They told me the water utilities Obtain rights to deliver water from the State. These water rights are considered taxable income even though they have no fair market value and are not deprecia- ble. The additional costs borne by the utility are passed on to Reno homebuilders, schools, and homeowners. Texas, Mr. Chairman, also provides an interesting example. There are over 800 small investor-owned utilities in Texas. They PAGENO="0022" 12 cannot afford the extra tax, so they pass the cost back to develop- ers. Some developers have chosen to circumvent this cost by creat- ing their own utilities and drilling their own wells. The result is a massive, decentralized network of small utilities. This is not good because it leads to uneconomical, inefficient utility service that proves costly and frustrating to the homeowner. Environmental hazards also increase as septic tanks replace central sewer services. Wherever there is growth, you'll find CIAC taking its toll. Utili- ties are spending millions in legal fees to develop ways around the 1986 change. They cannot completely avoid it, and so utilities end up shifting the risk Of new development on to existing homeown- ers-a patently unfair policy as the existing customers otherwise have no stake in the success of new' developments. Added taxation is not the solution to the affordability problem. S. 435 is flOt:~ panacea, but it is ~certainly a step toward a solution. FederaLexpenditures to stimulate production of affordable housing ~have dropped since 1981, Mr. Chairman, 70 percent. Restoring pre- 1986 CIAC treatment will increase the likelihood `that all' Ameri- cans who so desire can purchase a home in which to live. Thank you.. very~much, Mr. Chairman. I appreciate the work the committee has done in this effort, and it is too bad the wishes of thatommittee were not carried forward last year in the Senate. Chairman RANGEL. `Well, Senator,~we wiibfocus attention on this issue that `you brought before us, and hope~that your office will get to us as soon as possible written copies of the~testimony which you ~have submitted to~us this morning. Senator REID. Thank you very much. Chairman RANGEL. Mr~ Sundquist, do you have any questions? Mr.' SUNDQUIST. No questions, Mr. Chairman. Thank you. Chairman RANGEL. OK. Thank you so much, Senator. We'll now hear from Sidney Yates, and I "think this is the issue, ~Congressm~an,~ that is~alreády before us on the tax ~credit allocation for this project in Chicago. STA1~F~MENT OF HON~ SIDNEY R.YATES, `A' REPRESENTATIVE IN CONGRESS FROM THE STATE OF ILLINOIS ~Mr.TYATES. This seeks to revive a tax credit ~for the year 1989, Mr. Chairman, that expired at the' end of the year `before HUD could give its review to aplan of financing that was pending before it. Chairman RANGEL. Well, the chairman already has brought this to my attention, and he, `as well as the committee, recognizes the inequities and the inconvenience that this has caused the people in your district. But you should feel free to proceed in the manner that you feel comfortable. Mr. YATES. I thank you, Mr. Chairman. My statement has been filed, and I ask unanimous consent that it may be received for the record. Chairman RANGEL. Without objection, Mr. Chairman. Mr. YATES. Thank you for allowing me to appear before your committee this morning, Mr. Chairman, in support of my bill, H.R. 3875. It is a very important bill for a very densely populated com- munity in my district. It seeks to revive a low-income housing tax PAGENO="0023" 13 credit granted by the city of Chicago to a developer in 1989 to refi- nance and rehabilitate a HUD-mortgagecj building at 850 Eastwood Avenue in Chicago, IL. Two hundred and thirty families live there now. As I said, the tax credit expired at the end of 1989 before HUD could approve the plan. HUD has acknowledged in writing it didn't have enough time to complete its review, and this tax credit represents the hope of the 230 families to continue to live in afford- able housing~ HUD's review is continuing now, Mr. Chairman. Secretary of HUD, Jack Kemp, stated in Chicago a few days ago that he liked the project and would do everything he could to bring about its ap- proval within HUD's regulations, of course. But essential to the completion of the plan are the low-income housing credits which have expired. The developer hopes to receive tax credits from the city of Chicago for 1990, but that is not certain. The amount that may be made allowed for this project may be inadequate, and that is why this legislation is critical. The developer, and the 230 fami- lies who now live there need the relief that is sought in this bill. For all these reasons, Mr. Chairman, and for the reasons out- lined at greater length in my statement, I ask for the approval by this committee of the bill I filed. Chairman RANGEL. Well, thank you, Mr. Chairman, for personal- ly bringing it to our attention. As I pointed out, the members are familiar with this problem. Are there any questions from the members of the subcommittee? Mr. SUNDQUIST. Mr. Chairman, I just want to thank our col- league for testifying. I have no questions. Mr. YATES. I thank Mr. Sundquist. Chairman RANGEL. I think you want to thank him, too, right, Mr. McGrath. Mr. MCGRATH. Obviously I do. Chairman RANGEL. We always want to thank the members of the distinguished Appropriations Committee for testifying. - Mr. YATES. Well, as one member of that committee, Mr. Chair- man, I am delighted to have the opportunity to appear before our sister committee and to testify." Chairman RANGEL Well, if you ever need any more money to spend, you can count on us [Laughter] Mr YATES Only if you make it available, Mr Chairman Chairman RANGEL Mr Secretary, if you don't mind, we'll hear from Phil Crane, who has another committee appointment, and then we'll get right to you. The member of the full committee has a unique problem, and we thank him for taking time out to share it with us Your full statement, without objection, will be entered into the record. STATEMENT OF HON. PHILIP M~ CRANE, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF ILLINOIS Mr. CRANE. Thank you very much; Mr. Chairman. I deeply ap- preciate your permission to appear and testify before the commit- tee this morning. - PAGENO="0024" 14 I would like to testify in support of two proposals that are before you~ I realize you have a number of witnesses and panels, including witnesses testifying in regard to the issues that I'll be raising here, so I'll be brief. The first matter I would like to address concerns the taxation of U.S. branches of foreign property and casualty insurance compa- nies under section 842 of the Internal. Revenue Code. Section 842 was apparently added to the code in order to ensure that U.S. branches of foreign insurers do not remove U.S.-generated income offshore to avoid taxes. While this seems a reasonable goal, the ap- plication of these rules to U.S. branches of foreign PC companies has created an unfair and onerous burden on a very small number of companies And I might add that I do not believe the drafters of this proposal fully appreciated the impact this language would have on insurance companies such as those testifying today. Although there may be few companies involved and the issue is complicated;' ±he issues these ~companies raise deserve our atten- tion. Although I will leave thexdetailed explanation to representa- tives of Zurich America, located in my district in Illinois, and Mutual Reinsurance Co., located just a few short blocks from the chairman's district in New York, I would like to bring out two points at this time. Under section 842(d)(4), the Department of the Treasury was given the discretion to develop regulations that would take into consideration the differences between PC companies based on the types of risks they insure. Unfortunately, Treasury has not yet seen fit to use this discretion, and, therefore, in order to resolve the problem, I am today urging the subcommittee to consider outright repeal of section 842 as it applies to U.S. branches of foreign PC insurers. The other pQint I would like to raise concerns the revenue impli- cation of such a proposal. Although I have made a request to the Joint Committee on Taxation for a revenue estimate, I would simply comment here that I believe the revenue loss on my pro- posed repeal would be little or nothing. I come to this conclusion * for a number of reasons, not the least of them being that this por- tion of the code was scored as revenue neutral when it was added in 1987. Another serious concern-and one I particularly have as vice chairman of the Trade Subcommittee-relates to U.S. bilateral tax treaties with various countries. The application of section 842. to U.S. branches of foreign PC companies may very well violate U.S. tax agreements with the countries where these insurance com- panies are based. It has, been brought to my attention that both the Swiss `and German companies involved are prepared to refuse to pay any tax derived from section 842 using the United States-Swiss and United States-German tax treaties respectively as authority. Moreover, it is my understanding that both Governments involved are prepared to back this interpretation of the treaties. Mr. Chairman, I urge the Treasury and the Joint Committee on Taxation to. reassess' their positions on this issue, and I urge the subcommittee to dispose of this ill-advised addition to our Tax Code. ` The final issue I want to touch on concerns legislation introduced by our colleague, Bill Emerson, H.R. 1849. Last year, Bill asked PAGENO="0025" 15 that I help in his effort to remedy an inequity that he discovered in the individual alternative minimum tax. Although we were unable to offer the amendment last year, I want to thank the chairman for allowing Bill and his constituent to explain the situation which gave rise to his legislation. Although I will leave the details to Bill, I would like to quickly capsulize the issue. Recognizing that the individual AMT places significant and undue hardships on certain insolvent, farmers, Congress in COBRA in 1985 exempted certain farm insolvency transactions from the in- dividual AMT calculation. Specffically, COBRA provides that in certain cases the capital gain exclusion resulting from the transfer of farm land to a creditor in cancellation of indebtedness, or to a third party under the threat of foreclosure, will not be a preference item for purposes of the minimum tax. However, the exemption dated back only to transactions made after December 31, 1981. This left open a 3-year window, 1978 to 1981, through which a very few unfortunate individuals fell. H.R. 1849 simply extends to individ- uals within the 1978 to 1981 period the same rights Congress saw fit to bestow on all farmers after 1981. Mr. Chairman, again, thank you for the opportunity to bring these issues to the attention of the subcommittee, and I urge my colleagues on the subcommittee to listen closely to the witnesses who will follow on these issues. I believe both of the proposals I mentioned today are reasonable responses to inequities in the code, and I look forward to working with you further on these issues. Chairman RANGEL. We thank you, Mr.. Crane, for bringing these matters before the subcommittee's attention. As you know, we will focus on these issues and make our recommendations with your help to the full committee. Mr. CRANE. Thank you. Chairman RANGEL. Are there any questions by the subcommittee members? [No response.] Chairman RANGEL. We thank you. Mr. CRANE. Thank you, Mr. Chairman. Chairman RANGEL. We'll be back to you. At this time, without objection, I'd like to enter the statement of Richard Schuize into the record and ask staff to make certain that we take care of this matter in the absence of our colleague. [The statement of Mr. Schulze is in "Submissions for the record."] Chairman RANGEL. Then we ask the Secretary, Kenneth Gideon, to come forward. We have your full testimony before us, and with- out objection, it will be entered into the record. There won't be any need to read the entire statement. You could highlight your obser- vations on the proposals that are before this subcommittee, and I would ask the members that are in attendance to pay particular attention so that they will he able to ask you questions in the areas that they would like amplification. If you have no objections to that, you can proceed however you feel comfortable, Mr. Secretary, and we thank you for the support and attention you give to these tax matters in helping us bring them to resolution. PAGENO="0026" 16 STATEMENT OF HON. KENNETH W. GIDEON, ASSISTANT SECRE- TARYFOR'rAX POLICY, U.S. DEPARTMENT OFTIIE TREASURY Mr. GIDEON. Thank you, Mr. Chairman, and members of the com- mittee. I am pleased to be here today to present the views of the administration on 43 miscellaneous measures referred to this sub- committee. In accordance with the chairman's suggestion, .1 am not going to~cover all of them, I am just going. to~eover selected ones in my oral presentation, but I will be happy to respond to questions from members on any of the issues raised at the hearing. Chairman RANGEL. Since some of our new members have ar- rived, it is theiintention of the Chair to break at 11 o'clock for the joint session, and then resume the hearings at noontime, if there are no objections. Mr. GIDEON. Let me just state at the outset that, while we may be sympathetic to some of the problems these measures are intend- ed to resolve, we remain concerned, as we stated earlier before this committee, that the continual enactment of numerous small and complicated changes to the code is not consistent with our objective of a simplified Internal Revenue Code. In addition, we generally do not support efforts to make retroactive changes to prior legislation, particularly when those changes are intended to reopen closed years for tax purposes. Let me first move to just a few of these proposals. Item A.3 at page 3 of my testimony concerns a proposal for revocation of Reve- nue Ruling 89-73. That ruling was issued by the Internal Revenue Service in May of last year. It states the Service's position that under certain circumstances successive loans may be aggregated so that an amount will be considered as outstanding at the end of a controlled foreign corporation's taxable year, and thus potentially subject to tax under subpart F of the code. We oppose this proposal. We believe that Revenue Ruling 89-73 is a correct interpretation of the law, anclis necessary to prevent taxpayer abuse of section 956 that measures a CFC's investment in U.S. property as a snapshot on the last day of the CFC's taxable year. Further, we question whether congressional action simply re- voking a ruling without a change in the underlying substantive statute on which that ruling was based would achieve the result that the proponents apparently desire. Moving on to item A.9 at page 13 of my statement, this proposal is made on behalf of the representatives of the Government of Guam with regard to the application of the mirror tax system to Guam. It would defer the effective date of the 1986 act provisions that affect the Guam system of taxation, including authorizing Guam to enact its own tax system until Guam does, in fact, adopt a comprehensive Guam tax code to replace the current mirror system~ We support the Guam proposal as a matter of tax administra- tion. We think it makes sense to permit Guam to stay on the cur- rent mirror system until Guam develops its ôomprehensive tax law and plans an orderly transition to a new system. If Congress were to enact the Guam proposal, it should consider whether this pro- posal should also be extended to apply as well to the Northern Marianas Islands. PAGENO="0027" 17 Let me move now to item A.10 at page 14 of my statement. This proposal would increase the excise tax imposed on property and casualty reinsurance ceded abroad from 1 to 4 percent of the gross premium. The proposal would provide that such an increase over- rides any treaty waiver of the tax. We oppose the proposal for reasons that will be set forth at length in a forthcoming report to be submitted to the Congress. We do not believe that the economic evidence supports the need for a 4-percent excise tax to maintain the competitiveness of U.S. rein- surers. Moreover, we strongly object to the treaty override aspect of the proposal. As a matter of principle, overriding treaties in this manner is counterproductive to U.S. international tax policy. I would urge you to refer to the forthcoming Treasury report for a more complete discussion of this issue. Moving now to item C.3 on page 19 of my statement. This propos- al would change the alternative minimum tax definition of income by excluding the unrealized gain element of a charitable contribu- tion of appreciated property. Thus, a taxpayer would be entitled to a charitable contribution for the full fair market value of donated property, including any unrealized appreciation, for minimum tax purposes, as the currently the case under the regular tax. We oppose this proposal. First, the alternative minimum tax is intended to ensure that all taxpayers pay significant amounts of tax on their economic income. Second, we are not persuaded that this feature of the AMT has had an adverse effect on charitable giving. As we testified before the full committee 2 weeks ago, survey data indicates that some donors have changed the form of their gifts from those of appreciated property to cash contributions following the 1986 act; however, the overall level of charitable giving has not decreased. Indeed, there is evidence that supports the view that charitable donations have increased since 1986. Moving on now to item G.5 on page 34 of my statement. This pro- posal would further limit the availability of the deduction of inter- est on loans secured by corporate-owned life insurance to policies that irrevocably designate the insured persons and obligate the payment of the death benefit to the insured's family. We do not support this proposal at this time. We believe that there may be a simpler and more direct means of addressing the tax policy concerns raised by corporate-owned life insurance. We are examining these and other tax policy issues in our forthcoming report on life insurance company products, and will be pleased to discuss various policy options with the~ subcommittee when that study is completed. Finally, item G.13 at page 40 of my statement. The Department of Defense has proposed that the earned income tax credit be modi- fied to treat members of the Armed Forces in a more equitable manner and has provided a method of increasing compliance to offset its costs. The administration supports this proposal, which should, in the aggregate, modestly increase Federal revenues. With that, Mr. Chairman, I will be happy to answer the ques- tions of members. [The statement of Mr. Gideon follows:] PAGENO="0028" 18 For Release Upon Delivery Expected at: 10:00 a.rn. Date: February 21, 1990 * -* STATEMENT OF KENNETH W. GIDEON ASSISTANT SECRETARY (TAX POLICY) DEPARTMENT OF THE TREASURY BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS UNITED STATES HOUSE OF REPRESENTATIVES Mr. Chairman and Members of the Subcommittee: I am pleased to be here today to present the views of the Administration on a number of miscellaneous revenue measures referred to -the Select Revenue Measures Subcommittee. While we may be sympathetic to some of the problems these measures are intended to resolve, we are concerned that the continual enactment of numerous small and complicating changes to the Internal Revenue Code will add unnecessary complexity to the Code. In addition, we do not generally support efforts tomake retroactive changes to prior legislation, particularly when such changes are intended to reopen closed years. A. PROPOSALS RELATED TO FOREIGN PROVISIONS - 1. - Extension of Carryforward of Foreign Tax Credits Current Law - Taxpayers may credit income taxes paid to a foreign country or to a possession of the United States against the U.S. tax that would be imposed on the same income. Excess foreign taxes may he carried back two years and carried forward five years. The Internal Revenue Code permits some other credits or deductions to be carried forward for more than five years; for instance, net operating losses may be carried forward for 15 years. Proposal The proposal would extend the carryforward of foreign tax credits from five -years to 15 years for credits oenerated in taxable years beginning after December 31, 1988. Administration Position - We oppose an extension of the carryforward period for foreign tax credits. - -- There is no bright line that supports the use of a five-year period rather than a period somewhat shorter or somewhat longer. On balance, however, we oppose the proøosal because of the significant revenue losses that would occur in later years. During 1989, the Joint Committee estimated that the revenue losses would be as high as $300 million a year after five years. We do not believe that an analogy to the 15-year carryforward period for net operating losses is convincing. The net operating loss carryhack and carryover rules are intended to allow taxpayers to average income and loss over a number of years. For that reason, a lengthy carryover period is PAGENO="0029" 19 appropriate. In contrast, Congress enacted the foreign tax credit carryhack and carryover provision for a more limited purpose, namely, to prevent double taxation caused by different methods of reporting income in the United States and other countries. The legislative history makes clear that Congress was concerned that distortions could result from income being reported in different years in the United States and a foreign country because of different accounting rules. Thus, the limited foreign tax credit carryhack and carryover should he viewed primarily as a means for preserving the matching concept which is the basis of our foreign tax credit system. By extending the carryover, it is likely that, in most cases, we would no longer he adjusting for mere timing or base computation differences resulting from differing foreign tax treatment, hut instead would he permitting the foreign tax paid on one year's income to offset U.S. tax on another year's foreign source income. 2. Carryforward of Pre-1987 Foreign Base Company Shipping Losses Current Law Under Subpart F, U.S. shareholders of a controlled foreign corporation ("CFC") are taxable currently on their pro rata shares of certain types of income earned by the CFC. One type of income required to be included currently is foreign base company shipping income, which is income derived in connection with the use of any aircraft or vessel in foreign commerce, the performance of services in connection with such use, or the sale of such aircraft or vessel. The 1986 Act (as amended by technical corrections passed in 1988) restricted the use of deficits in earnings and profits accrued in pre-1987 years to offset post-1986 Subpart F income. There are limited exceptions for certain categories of Subpart F income, so long as the deficit was in the same category of Subpart F income. Section 952 does not, however, permit the use of pre-1987 shipping deficits to he carried forward to reduce foreign base company shipping income in a post-1986 year. Proposal The proposal would permit a pre-1987 foreign base company shipping deficit accumulated by a CFC to reduce post-1986 foreign base company shipping income of the CFC by allowing the carryforward of losses accumulated as of the effective date of the Tax Reform Act of 1986. We understand that the proposal would limit the carrvforward to deficits accumulated in years after 1975, the date on which shipping income became taxable under Subpart F. In addition, any deficit carried forward would he reduced by any amount of Subpart F shipping income which was not taxable in a pre-1987 year because it was reinvested and not subsequently disinvested. Administration Position We do not. oppose this proposal, provided that the provision is drafted to ensure that there is no double benefit from prior use of the loss to reduce Subpart F income in other categories, and also provided that there is an acceptable revenue offset. In general, the Administration supported provisions of the 1988 technical corrections legislation that allowed pre-1987 deficits to reduce post-1986 Suhoart F income in the same Subpart F category. This amendment would place U~S. shareholders of CFCs that earn shipping income in a position equivalent to U.S. PAGENO="0030" 20 shareholders of CFCs that earn other types of Subpart F income. We note, however, that the chanoe could cause taxpayers to file in 1991 amended returns for 1987, 1988 and 1989. The administrative burden of such a procedure is sionificant for both taxpayers and the IRS. These administrative costs may weigh in favor of grantino relief in a form that allows such losses to he carried forward to future years, rather than in the retroactive form proposed. 3. Modification of Code Section 956 Current Law Under section 956:of the Code, U.S. shareholders of a CFC are taxable on their pro rata shares of the CFC's annual increase in its "investment in U.S. property." The definition of "U.S. property" includes debt obligations of U.S. persons. The determination whether a CFC has increased its investment in U.S. property is made by measuring the amount of such investment on the last day during the taxable year on which the foreign corporation is a CFC. On May 22, 1989, the Interal Revenue Service issued Revenue Ruling 89-73, 1989-1 C.B. 258. The ruling addresses the situation in which a CFC purchases short-term debt obligations of a U.S. shareholder. The debt' obligations are repaid prior to the last day of the taxable year, but', during the next taxable year, the CFC~again purchases short-term debt obligations of the same U.S. shareholder. The ruling sets forth two fact patterns; in one case, ~`the ruling states ~that the~two successive loans will be aggregated so that an~amount will be considered as outstanding at the end of the CFC's taxab'le year (and thus potentially taxable under Subpart F); in the.other fact pattern, the ruling states that the loans will not be aggregated. Proposal The proposal would retroactively revoke Revenue Ruling 89-73 by providing that for purposes of section 956, the ruling shall not apply to the first taxable year ending after May 22, 198.9, and all prior taxable years in determining whether two suOcessive obligations or loans shall he treated as one obligation or loan. Administration Position We oppose this proposal. First, a revenue ruling is simply a statement of the Internal Revenue Service's view of the way in which a provision in the law should be interpreted. Absent a clearer Congressional directive, it is not clear that mere revocation of a ruling would have the substantive effect apparently desired by the proponents. In this case, we believe that the ruling is a correct interpretation of the law based on the same principles.a responsible practitioner would have considered in opining on these facts. We also believe that the ruling is essential to prevent significant taxpayer abuses. Unless successive loans are aggregated for purposes of section 956 in appropriate circumstances,, there are situations in which loans that would be treated as separate loans for certain purposes of the Code (such as section 1001) `could be used to achieve the repatriation of foreign earnings and profits that section 956 was intended to subject to tax. We believe that, in appropriate circumstances, successive loans should be aggregated for purposes of section 956. Indeed, the Service recently identified for, litigation at least one transaction on the issue of how successive loans should be taxed under section 956. PAGENO="0031" 21 Enforcement of section 956 has been a matter of dispute between taxpayers and the Service for many years. The rule in section 956 that measures the CFC's investment in U.S. property as a "snapshot" on the last day of the CFC's taxable year is regrettable. We would urge Conqress to consider modifyino the rule to consider, for instance, a CFC's average investment in U.S. oroperty ~urinq the year. Nonetheless, under the rule that exists today, we believe it is essential that the Service be permitted to consider the substance of a transaction within the meaning of section 956 and not he limited to its form. 4. Treatment of Related Party Róyalties~ under Subpart F Current Law Royalty income earned by a CFC is qenerally treated as passive income and thus taxable to the U.S. shareholders of the CFC under Subpart F as foreion personal holdinq company income. Royalties are not taxable under Subpart F jf they are received from an unrelated person and are derived in the active conduct of a trade or business. Proposal The proposal provides that, in the case of a U.S. software comoany with a two-tier foreian subsidiary structure I, a foreiqn production affiliate that licenses products to foreign sales affiliates for relicensinq to customers), related party royalties paid between the foreign sales and production affiliates would he subject to characterization for Subpart F purposes under the foreiqn base company sales rules applicable to manufacturers generally, rather than under the foreign personal holding company income rules of Subpart F. Administration Position We oppose this proposal. The effect of the proposal would he to provide deferral on royalties in the event the CFC that licenses the software adds sufficient "value" to the product that income from the sale, rather than the license, of the product would not he treated as Subpart F income. The proposal implicitly assumes that CFCs are conducting substantial active, ongoing production and development operations consisting of all of the steps of the production process for the product. What often happens, in fact, is that the CFC transfers the contents of a computer oropram that was not developed by the CFC to a blank disk that was not manufactured by the CFC. We do not believe that the rules and regulatory safe harbors applicable to sales and services income are necessarily appropriate for this type of activity. 5. Exceptions to the Passive Foreign Investment Company Rules Current Law The passive foreign investment company ("PFIC") provisions require a U.S. shareholder of a foreign corporation that qualifies as a PFIC topaytaxunder special rules in the year of a distribution from a PFIC or a disposition of PFIC stock unless the shareholder elects to he taxed currently on his proportionate share of the PFIC's earnings. If a PFIC shareholder does not elect current taxation, the amount of a distribution or the amount of gain on disposition of PFIC stock is considered to relate equally to all years within the taxpayer's holding period for the stock. Amounts allocated to earlier years are subject to tax at the maximum rates in effect for those years and to an PAGENO="0032" 22 interest charge. The PFIC rules apply to active as well as passive earnings of a PFIC. Under the the PFIC rules, a company qualifies as a PFIC if it has .a certain level of passive income or a certain level of passive assets. - Proposals One proposal would provide that CFCs that engage in substantial manufacturing operations in a foreign country that has a deficit in its trade halance with the United States would not he treated as PFICs. Another proposal would exempt certain shareholders in certain publicly traded companies from the PFIC rules. In addition, the proposal would state that certain anti-avoidance provisions would not apply to the appreciation in PFIC stock that is allocable to a taxpayer's holding period prior to the effective date of the PFIC rules. Administration Position We oppose these two proposals, although we continue to he concerned about the scope and operation of the PFIC regime. Since the PFIC regime was enacted, the Treasury Department has had doubts about the broad scope of the PFIC rules. In 1987, in connection with Senate consideration of technical corrections to the 1986 Act, we testified as to our concern that the passive asset test operates to classify too broad a category of companies as PFICs. We concluded that the asset test warrants further study to determine whether it should he amended, or, given the addition o~ other safeguards, discarded, to prevent the PFIC provisions from applying too broadly. We believe that the PFIC provisions should he targeted to cases where a U.S. person's investment inthe stock of a foreign corporation has the predominant effect of allowing the accumulation offshore of passive investment income. The level of a foreign corporation's passive assets is relevant only to the extent that the assets generate current passive income to the corporation or reflect the accumulation of current passive income within a lower tier corporation. The asset test may sublect U.S. nersons to current taxation on the active income of foreign corporations in which they hold shares, even though the foreign corporation may not be predominantly engaged directly or indirectly in the accumulation of passive income. The first proposal would except from the PFIC regime CFCs that have at least 25 percent active income, such as manufacturing income, and that engage in manufacturing or production in countries with which we en-joy a trade surplus. This proposal would not achieve a proper policy balance. The exception that would he created would be limited to corporations that carry on (to a limited extent) only certain types of active operations in a few countries. Furthermore, we do not believe that tax policy should he determined by balance of trade results in this manner. The second proposal has three components. First, it would except certain holders of stock in a class that is regularly traded through American Depository ReOeipts ("ADRs") that are included in the National Association of Securities Dealers Automated Quotation ("NASDAQ") system andnot also traded on a regulated exchange in the United States. The company could not PAGENO="0033" 23 have either substantial (30 percent or more) U.S. ownership or a distribution policy that has the Principal purpose of tax avoidance by its U.S. shareholders. As we understand the proposal, the holders that would he excepted would he limited to those who acquired the stock before October 22, 1986 and who never held more than 1 Percent of the class of stock. Second, the proposal would relieve PFIC shareholders from the antiavoidance rules that deny step-up in basis at death and require recoqnition of qain as ordinary income on a charitable contribution of PFIC stock with respect to appreciation allocable to the shareholder's holdinq period prior to the effective date of the PFIC rules. Purchase of shares in a foreiqn fund prior to the effective date of the PFIC rules should hot provide shareholders with permanent insulation from chanqes in the tax consequences of holdinq PFIC stock. Shareholders in foreiqn funds of the tvoe tarqeted by this proposal, have no better case for a permanent qrandfathe~ with respect to this stock than shareholders in other foreiqn funds. The third component of this proposal would allow shareholders in certain companies that would otherwise be PFICs to elect to he suh-)ect to the rules for foreiqn investment companies under section 1247. Thi.s election would Generally apply to companies enqaqed Primarily in the business of investinc, reinvest'inq, or trading in securities, commodities or interests in property (such as futures, forwards and options) where 50 percent or more of the votinq power of the stock is held by U.S. persons. These companies would he required to distribute 90 percent or more of their income and fulfill other reguirements. We oppose this chanqe for three reasons. First, it would introduce additional complexity by addinq a third taxinq regime to the existinq scheme under which a shareholder of a PFIC may elect current taxation under section 1293 or taxation (subject to an interest charge) under section 1291. Second, shareholders in the electinq company could avoid current taxation of current earninos of lower-tier PFICs. Third, the change itself would necessitate extensive revision of section 1247 to maintain the qreatest possible consistency with the rules for domestic funds. In short, the Proposal would create both complexity and opportunities to avoid current taxation of the type of income that was the Proper taroet of the PFIC rules. 6. Forejon Cornp~nies Carryinq on Insurance Business Current Law A Forejqn corporation that conducts a trade or business in the United States is taxable on a net basis in the United States on the income effectively connected with that trade or business. A special rule is provided for foreian insurance companies. Under section 842, such a company is taxahl.e on its net underwriting income and on the qreater of (i) its net investment income that is effectively connected with its U.S. trade.or business, or (ii) a minimum .amount of net investment income determined usinq a formula that takes into account the foreiqn corporation's U.S. insurance liabilities, the averaqe asset/liability ratio of U.S. insurance companies of the same type (life insurance companies or property and casualty companies) and the averaqe yield earned by U.S. companies of the same type. The computation under the formula is based on U.S. domestic company data from two years earlier. 30-860 0 - 90 - 2 PAGENO="0034" 24 The Treasury Department has broad regulatory authority to determine separate asset/liability ratios and yield ratios for different categories of property and casualty companies, and to provide a carryforward rule that would permit "proper adjustments in succeeding taxable years where the company's actual net investment income for any taxable year which is effectively connected with the conduct of an insurance business in the United States exceeds" the minimum required amount. Proposal I One proposal would require the Treasury Department to determine separate asset/liability and yield ratios for separate cateciories of property and casualty companies, based on whether the companies are predominately engaged in "long-tail" or "short-tail" business. ("Long-tail" business consists of insurance risks, such as medical malpractice, that typically require many years to settle from the date the claim arises until the date that payment is made. "Short-tail" business consists of risks, such as auto liability coverage, that typically are settled in a matter of a few years.) Administration Position We oppose this proposal., because it would require the Treasury Department to issue different sets of ratios whether or not they are warranted. We have carefully considered whether we should exercise our regulatory authority in this manner. To date, we have concluded that we should not, on the ground that dividing property and casualty companies into two or more groups could create inequities greater than the inequities the regulatory authority was intended to eliminate. The Treasury Department intends to reexamine this issue periodically and to consider whether, based on the data available to us at that time, segregation of property and casualty companies is appropriate. We believe, however, that this is an area in which the Treasury Department should have regulatory authority but not he compelled to use it. Proposal II Other proposed modifications include: (i) the effectively connected net investment income of a foreign insurance company for any year would be determined on the basis of the greater of the cumulative actual net investment income or the cumulative minimum net investment income; (ii) the minimum amount of income required to he subject to tax would not be determined until two years after the year in which the actual effectively connected net investment income was received or accrued; and (iii) if the amount of minimum effectively connected net investment income in excess of the actual effectively connected net investment income reduces the amount of a net operating loss, a reduction in the U.S. tax on certain income that is not effectively connected with a United States trade or business would be allowed. Administration Position We oppose the proposed modifications. In general, it is appropriate to permit a taxpayer to use an excess of actual over minimum income from past years to offset an excess of minimum over actual income in a current year, because the record from the past years indicates that the taxpayer has not engaged in a practice of minimizing its U.S. taxes. It is expected that forthcoming regulations under section 842 will PAGENO="0035" 25 adopt such a rule, consistent with the language of section 842(d)(2). It is not appropriate, however, to permit a taxpayer to use its history of Paving tax according to the minimum formula as a basis for reducing the tax due in a current year on its actual U.S. effectively connected income for that year. Since this proposal would allow taxpayeys-~to take advantage of a past excess of actual income over minimum income, which we already Plan to allow in regulations, and would allow a reduction in actual income for past minimum payments, which we do not think is appropriate, we oppose the proposal. We understand the second proposed modification to require taxpayers to make a tentative tax payment each year based on their actual effectively connected income for that year, and then to make a supplementary payment two years later if domestic data for that earlier year demonstrates that the actual net investment income was too low in that earlier year. Prior, law has included such a "true-up" for certain domestic insurance company taxes. We are .symnathetic to taxpayers' compia-ints that-the two-year lao in data collection creates problems. ~In~-oarticular,~average U.S. investment yields for lB86~were signif-cai~rtiy-I-rjgj~~r-tha~ the average yields for 1988. Thus, many foreign companies did not earn sufficient investment income in 1988 to avoid being sub-ject to the minimum payment requirements based on 1986 data. It is not possible for the Treasury Department to provide the necessary data without the two-year Jag. However, we do not believe that a permanent "true-up" mechanism is the-appropriate solution. At most, we believe there shoul.d he relief for the problems created by using 1986 and 1987 data for a provision that did not take effec,t until 1988. Section 842 allows a taxpayer subject to the minimum income rules to reduce U.S. withholding taxes on income not effectively connected with its U.S. trade or business by the amount that the tax on the minimum income exceeds the tax on the taxpayer's effectively connected net investment income. This rule is clearly appropriate. The proposal would allow this offset to occur even if there is no tax consequence of paving tax on minimum actually effectively connected income (rather than actual effectively connected income) because, in either event, an NOL eliminates the current tax. We believe this proposal would unnecessarily complicate tax administration. 7. Treatment of Certain Interest Earned by Brokers or Dealers Current Law U.S. shareholders of a foreign personal holding company ("FPHCs") are taxed on their portion of undistrihuted FPHC income. The status of a corporation as a FPHC is determined on the basis of the corporation's "FPHC income." Such income includes the corporation's interest income, including interest received by a broker/dealer from its business activities. In this respect, FPHC income is similar to Subpart F income, hut is different from personal holding company income (which, since 1986, explicitly excludes broker/dealer interest from the test for determining whether a domestic corporation is a personal holding company). Proposal The oroposal would exclude certain interest income of foreign securities brokers and dealers from the definition of FP~C income, in a manner similar to the broker/dealer exclusion for PAGENO="0036" 26 personal holding company income. We understand that the exclusion would apply only if the broker/dealer is licensed in the foreign country where it engages in business and only if the taxable income of the broker/dealer is subject to foreign income tax at a rate which is greater than 90 oercent of the maximum U.S. corporate rate. Administration Position We do not support this proposal. We believe that the analogy between FPHCs and personal holding companies is not convincing. A personal holding company that engages in securities activities is a domestic company subject to direct regulation by the Securities and Exchanqe Commission. We therefore have some confidence that the interest income in question is really business income -- or at least that the Service will he able to audit the company in a manner that will ensure that passive income does not improperly benefit from the exclusion. We do not have the same confidencein the case of a foreign corporation licensed to do business in a foreign country. Moreover, all of the income of the personal holding company is subject to tax currently as the income of a domestic corporation. Even if the personal holding company rules are analogous to the FPHC rules, they are not the only analogy. The rules in Subpart F are also analogous, and those rules do not exclude broker/dealer interest. In short, we do not believe that the argument by analogy supports the proposal. The reouirement that the excluded income be subject to a foreign tax areater than 90 percent of the maximum U.S. corporate tax substantially reduces the abuse potential. There is, however, no such exception from the foreign personal holding áompany rules for other types of income. We do not believe that a special rule for broker/dealer interest can be justified on the ground that the income meets a "high-tax" test. 8. Convention Treatment of Certain Cruise Ships Current Law U.S. taxpayers may deduct expenses for conventions on cruise ships -- up to $2,000 per person per year -- only if, among other things, the cruise ship is registered in the United States and all of the ship's ports of call are located in the U.S. or possessions of the U.S. Proposal The proposal would expand the cruise ship convention rule to benefit countries covered by the Caribbean Basin Initiative ("CBI"). It would allow taxpayers who attend business conventions on U.S.-flag and certain foreign-flagvesséis that serve the Caribbean to he eligible to deduct certain convention costs. To be eligible, a foreign-flag vessel would have to make at least one port call in a nondiscriminatory beneficiary country (defined as a country whose tax laws do notdiscriminate against conventions held in the United States). Foreign-flag vessels also would qualify only if they employ at least 20 percent nationals in nondiscriminatory Caribbean countries and if the convention size is limited to no more than 500 persons. PAGENO="0037" 27 Administration Position We oppose the proposal. The existing CBI tax henef its were designed to encourage investment in gualifying CR1 countries that would support stahie, long-run economic growth. Conventions in such countries will contribute to a local tourism industry. Hotels and infrastructure must he huiit, and transportation must he provided. All of these items have a significant effect in the local economy. Ry contrast, conventions on cruise ships will contribute little to local CBI economies, since the cruise ships are unlikely to he owned by CBI nationals or to be built in CR1 countries. Moreover, virtually all wages paid to non-CBI crew memhers will end up outside the CBI area. The convention tax benefit probably has some negative impact on the U.S. tourist industry; this has been deemed an acceptable cost because of the direct and substantial benefits to the CR1 beneficiaries. The costs associated with this proposal would be spread among many persons not entitled to preferential treatment, and would often accrue to CBI countries that are not henéficiary countries (because they have not signed a tax information exchange agreement with the United States), reducing the incentive for those countries to negotiate such an agreement. 9. Application of the Mirror. Tax System to Guam Current Law Taxation in Guam is currently imposed by means of a "mirror Code," under which the term "Guam" .j~ substituted for "United States" in the Internal Revenue Code. The 1986 Act authorized Guam to adopt its own separate tax system, conditioned upon an executive agreement between the United States and Guam to coordinate the administration of the two tax systems (an "implementing agreement"). Once this implementing agreement is effective, Guam's tax system would no longer be linked to the U.S. Internal Revenue Code through the "mirror system." This change would have certain collateral conseguences; in particular, it would eliminate the current rule in section 935 which permits residents of Guam to satisfy their tax liability to both Guam and the U.S. by filing a single return with Guam. In April of 1989 the United States and Guam signed an implementing agreement. However, due to Guam's concerns that it was not prepared to adopt an independent tax system, the agreement's effective date was delayed until 1991, unless the two governments agree to an earlier date. Proposal Representatives for the Government of Guam have proposed a deferral of the effective date for the provisions of the 1986 Act which affect the Guam system of taxation (including authorizing Guam to adopt its own tax system). This proposal would further condition the application of the 1986 Act amendments affecting Guam's tax system on the adoption of a comprehensive Guam tax Code to replace the current mirror system. The Governor of Guam would identify the new legislation through a certification to Treasury. Administration Position . The Administration supports Guam's proposal. As a matter of tax administration, it makes sense to permit Guam to stay on the current mirror system (including the single-filing rule of section 935) until Guamdevelops its own comprehensive tax law PAGENO="0038" 28 and plans an orderly transition to a new tax system. The proposal would discourane piece-meal revision of Guam's tax laws. It also would make it feasible for Guam to agree to an effective date for the implementing agreement before its new tax system is in place. The proposal would be revenue neutral, since it merely continues the application of current law. One further issue should be noted. The Commonwealth of the Northern Marianas Islands ("CNMI") is subiect to the same effective date rules for the 1986 Act as Guam. The CNMI has not yet sinned an implementing agreement and CNMI representatives have expressed concerns similar to those of Guam. If Congress chooses to enact the proposal, it should consider extending the proposal to apply as well to the CNMI. - 10. Modification of the Reinsurance Excise Tax Current Law An excise tax of one percent is imposed on premiums for property and casualty reinsuraflce paid to foreign companies that reinsure U.S. situs risks hut are not engaged in the conduct of a U.S. trade or business (and thus are not suhiect to net basis taxation in the United States.) The excise tax is waived in certain United States income tax treaties. Proposal The proposal would increase the excise tax imposed on property and casualty reinsurance ceded abroad from one percent to four percent o~ the gross premium. The proposal would provide that such an increase overrides any treaty waiver of the tax. Administration Position We oppose the proposal, for reasons which are set forth at length in a forthcoming report to he submitted to this Committee. As that report will state, we do not believe that the economic evidence supports the need for a four percent excise tax to maintain the competitiveness of U.S. reinsurers, at least in the case of foreign countries that are not tax havens with resnect to insurance companies. In addition, we object to the treaty override aspect of this proposal for two reasons. As a matter of principle, we believe that overridino treaties in this manner is very counterproductive for U~S. tax policy. Furthermore, we believe that the existing treaty waivers are generally appropriate because of the taxation imposed by the other countries on their domestic insurance companies and because of the reciprocal benefits to U.S. taxpayers achieved by the treaties. For further discussion, I would refer you to the forthcoming Treasury report. B. PROPOSALS RELATED TO ACCOUNTING PROVISIONS 1. Installment Sales for Automobile Dealers Current Law Generally, dealers may not use the installment method to report sales income. Limited exceptions are provided for certain sales of farm property, timeshares and residential lots, but the taxpayer generally must pay interest on the deferred tax liability. PAGENO="0039" 29 Proposal This proposal would allow installment reporting for certain dealer sales of used automobiles, with a corresponding interest charge on the amount of deferred tax. Tn order to qualify under this propos~1 (i) the automobile mustbe more than 3 years old at the time of the disposition, (ii) the sales price of such automobile cannot exceed $6,000, (iii) the term of the installment obligation, cannot exceed 36 months, and (iv) total outstanding qualified installment obligations, which arose during the year, cannot exceed $4 million. Administration Position We oppose this proposal. Tn 1987 Congress appropriately eliminated installment treatment for dealers, based on the ability of such taxpayers to finance, their receivables. While it may he true that used automobile. dealers.experfence high default rates, dealer sales of used automobiles do not differ significantly from dealer sales within other industries which experience high default rates and so should not be accorded special treatment. 2. Annual Accrual Method of Accounting for Certain Farming Corporations Current Law In general, uniform cost capitalization rules govern ~.the inclusion in inventory (or capital accounts) of all costs-which are incurred in manufacturing, construction, and other types of activities involving production of real or tangible personal property. These rules are intended to ensure that costs which are in. reality costs' of producing property are capitalized rather than deducted currently. Certain corporations and qualified partnerships that are permitted to use the "annual accrual method" of accounting with respect to the trade or business of farming sugar cane are exempt from the uniform cost capitalization rules. Proposal Any corporation or'qualjfjed partnership, regardless of whether or not such entity engages in the trade or business of farming sugar cane, that for'its last taxabi.e year ending January 1, 1987 properly used the "annual accrual method" of accounting with respect to any crop would be allowed to continue using such method with respect to that crop and thus would be exempt from the application of the uniform cost capitalization rules. Administration Position We oppose this proposal. As a general matter, we believe that the uniform cost capitalization Provisions result in a more accurate measurement of income or loss from production activities. We support the application of these rules to all trade or business activities. Exempting particular groups of taxpayers from these capitalization requirements increases the inequities which the uniform cost capitalization rules were designed to eliminate. PAGENO="0040" 30 3. Look-Back Method for Long-Term Contracts Current Law Income from long-term contracts generally must be reported under the percentage of completion method of accounting ("PCM"). Under PCM, expected contract profit is recognized ratably, as costs are incurred, over the termof the contract. PCM includes look-back rules intended to compensate for deferral or acceleration of contract income resulting from use of expected (rather than actual) contract profit. Under the look-hack rules, if actual contract profit is greater or less than expected profit, the taxpayer must pay, or is entitled to receive, interest. Look-back interest is computed when a contract is completed, but must he recomputed if contract profit changes because additional contract revenues or costs (e.g., amounts related to a dispute settlement) are taken into account after completion. Taxpayers are allowed (but not required) to discount such adjustments hack to their value as of contract completion. Proposal The proposal would exempt amounts received after contract completion, as a result of disputes, litigation, or settlements from the look-back method. Administration Position We oppose this proposal. If additional revenues received after contract completion are large relative to total profit, this proposal would tend to put the taxpayer in the same position as permitted by the prior law completed contract method, which permitted unwarranted deferral of income. Moreover, the proposal would complicate enforcement by creating disputes over when a contract is considered to he completed. Whether a contract is completed is a highly factual guestion that created endless disputes under prior law. The current law reguirement to recompute look-back interest if additional revenues are received after the completion date substantially reduces the importance of determining the completion date and thus reduces the incentive for taxpayers and the Service to argue about when it occurred. The Administration would not oppose a de minimis rule that would exempt contract revenues taken into account after completion from the look_back method if *such amounts are relatively small compared to total contract profit, and provided that any revenue loss is appropriately offset. We believe that such a rule could he crafted to respond to concerns about the complexity and administrative burden imposed by required recomputation of interest under the look-back method without undermining its purpose, and without significant loss of revenue. 4. Required Use of the Accrual Method of Accountina Current Law In general, corporations, partnerships with corporate partners, and tax shelters must Use the accrual method of accounting (rather than the cash method of accounting). Exceptions apply to certain farming businesses, qualified personal service corporations, and small corporations. Businesses engaged in sales, brokerage services, or similar services are not treated as qualified personal service corporations and therefore must use the accrual method of accounting. Accrual method taxpayers may deduct certain types of cOmpensation only during the year in which such amounts are includibie by the recipient. PAGENO="0041" 31 Proposal The proposal would permit the use of the cash method of accounting hy corporations* that (i) earn more than 50% of their income, over the taxable veer and two immediately preceding taxable years, from commissions, (ii) receive the commission income in more than one tax year, and (iii) pay at least 25% of the commission income to brokers. Administration Position We oppose this proposal. We believe that the accrual method of accounting should apply egually to brokerage, retail, manufacturing and other businesses. We recognize that the proper measurement of income or loss in the types of transactions at issue, i.e., ones that involve both sale and lending features, is oarticularly difficult. Although separating the sales and lending components p5 such transactions might produce a result conceptually preferable to that under current law, such an approach would he complex and would not grant significant relief in the situations-addressed by this proposal. We also believe that it is appropriate to defer the deduction for certain compensation payments until the cash basis recipient reports such compensation in income. This treatment enhances the efficiency of the tax system and discourages taxpayers from structuring deferral transactions with cash basis employees. C. PROPOSALS RELATED TO THE ALTERNATIVE MINIMUM TAX 1. Small Electing Property and Casualty Insurance Comnanies Current Law Certain small property and casualty insu-rance companies may elect to he taxed on their investment income, and not.,th~ir underwriting income, for reoular tax purposes. This-election is available only if the insurer's net written premiums (or, if oreater, direct written premiums) for the taxable year exceed $350,000 but do not exceed $1,200,000. (Property and casualty insurers with net and direct written premiums that do not exceed $350,000 may he exempt from tax under section 501(c)(15).) Proposal The proposal would make the investment income election for small property and casualty companies applicable to the calculation of alternative minimum tax ("AMT") liability for such companies Admi n i.str.a±-ion'--Pos it ion We oppose this proposal. Applying the small, company election in calculating AMT liability would subvert the goal of the AMT to measure the economic income of companies and impose some tax on that income notwithstanding tax preferences applicable under the regular tax. 2. Capital Gains Preference for Insolvent Farmers Current Law From 1979 through 1986, the individual ANT included as a preference item the portion of netcapital gains excluded for regular tax purposes (capital gain preference). PAGENO="0042" ~32 The Consolidated Omnibus Budget Reconciliation Act of 1985 provided that capital gain preferences recognized on certain transfers of farm land by insolvent farmers were exempted from the prior law alternative minimum tax to the extent that the farmer was insolvent. This exemption was effective for dispositions made after December 31, 1981. Proposal The proposal would extend the exemption to dispositions occurring from 1979 through 1981. Administration Position We oppose this proposal. This proposal would require a substantial extension of the statute of limitations in *order to provide relief for all affected taxpayers. We oppose such retroactive relief. 3. Charitable Gifts of Appreciated Property Current Law Generally, a taxpayer who makes a charitable contribution of property may deduct an amount equal to the fair market value of that property. In certain cases, the amount of the deduction may be reduced by the amount of unrealized income or gain inherent in the gift. To the extent the amount of the charitable deduction is not reduced by the amount of unrealized income or gain inherent in the gift, the taxpayer receives a double benefit in the form of a deduction for an amount never taken into income. For AMT purposes, the deduction for charitable contributions is generally not allowed to the extent the fair market value of the gift exceeds the adjusted basis of the property. In effect, any unrealized appreciation is included in income for purposes of the AMT. Proposal The proposal would exclude the unrealized gain element of a charitable contribution of appreciated property from the AMT base. Thus, a taxpayer would beentitled to a charitable contribution deduction for the full fair market value of donated property, including any unrealized appreciation, F or both regular tax and AMT purposes. Administration Position We oppose this proposal. The AMT is intended to ensure that all taxpayers pay significant amounts of tax on their economic income. As a matter of tax policy, the double benefit inherent in the regular tax treatment of certain gifts of appreciated property should not apply for AMT purposes. Moreover, we are not persuaded that this feature of current law has an adverse effect on charitable giving. While survey data indicates that some donors have changed the form of their gifts from appreciated property to cash contributions following the 1986 Act, preliminary data suggest that the overall level of charitable giving has not decreased. Indeed, there is evidence that supports the view that charitable contributions have increased since 1986. Data from Giving USA indicate that contributions by individuals increased f~~i~$76.2 billion in 1986 to $80.8 billion in 1987 and to $86.7 billion in 1988. These figures include the contributions of non-filers and nonitemizers as well as itemizers. PAGENO="0043" 33 D. PROPOSALS RELATED TO PENSIONS AND EMPLOYEE BENEFITS I. Availability of Section 401(k) Plans Current Law Tax-exempt organizations that did not have a cash or deferred arrangement (i.e., a 401(k) plan) in place before the 1986 Act was enacted are prohibited from maintaining such plans. Proposal The proposal would permit all tax-e~xempt~organjzations to maintain qualified cash or deferred-arrangements. Administration Position We do not oppose this proposal, assuming that any revenue loss is appropriately offset. Congress may have concerns that 401(k) plans may permit employers to shift the burden of re- tirement savings to employees (because such plans are funded in part though employee contributions). However, imposing a limitation remedy only on tax-exempts is unfair. Furthermore, due to-generous grandfather rules, only certain tax-exempt employers were affected by the 1986 Act change. Finally, we believe that the strict dollar limits on the amount of salary that may he deferred under a 401(k) plan will prevent abuse of the rules by tax-exempts. 2. Modifications of VEBA Restrictions Current Law Under Treasury regulations, a VEBA is not tax-exempt if it benefits nonunion employees of unrelated employers unless the :~employers are engaged in the same line of business in the same `--~geographic locale. The IRS has interpreted this requirement as prohibiting coverage under a VEBA from extending to nonunion employees of unrelated.employers~engaged in the same line of business if the employees located in more ~ti-ia.n one state or metropolitan area. The same geographic 1ac~a-J'e requirement was held invalid by the 7th Circuit in Water Quality Ass'n Employees' Benefit Corp. v. United States, 795~~2'd 1303 (1986). Deductible contributions to a trust (such as a VEBA) to fund welfare benefits provided under a plan are subject to certain limits under section 419A. These limits are intended to discourage excessive ore-funding, and vary according to the bene- f±t being funded. There are relatively higher limits for post- retirement medical benefits than for other types of benefits. The limits do not apply to trusts that' are part of a plan maintained by 10 or more employers, where no one employer normally makes more than 10 percent of the total annual contributions, on the theory that such risk-pooling resembles an arm's length insurance arrangement under which excessive pre-funding is difficult. Income of a VEBA that is set aside to provide benefits is generally exempt from the unrelated business income tax ("UBIT") to the extent the income does not cause the total amount set aside to exceed the section 4l9A funding limits. Multiple-employer trusts are subject to this rule, even though they are exempt from section 419A itself. FOr purposes of this rule, the section 4l9A limits do not include the special limits for post-retirement medical benefits. Thus, income on amounts set aside to pre-fund post-retirement medical benefits is generally subject to the UBIT. PAGENO="0044" - 34 Proposal The proposal would (1) eliminate the geographic restrictions on VEBA coverage, (2) permit multiple-employer VEBA trusts to maintain reserves adequate to meet the safe-harbor limits under current law, plus additional reserves necessary to meet continoent liabilities; and (3) raise the 10-percent contribution limit for a multiple-employer trust to 25 percent, if the plan has more than 15 employers. Administration Position The Administration opposes each of the proposals. The first would permit a VEBA to perform many of the functions of a nationwide insurance company, on a tax-exempt basis. Although the 7th Circuit has held that the regulation imposing the geographic restriction is invalid, the IRS believes it can defend the restriction in other circuits. A better alternative would be to limit VEBA5 to a three-contiguous-state area, or possibly a larger area if the Secretary determined that the employer group in the three-state area was too small to make self-insurance economical. The second proposal would allow multiple-employer trusts to set aside larger reserves than under current law for post- retirement medical and other unidentified "contingent" benefits, without subjecting income on the reserves to the UBIT. This would increase the tax subsidy for such entities and exacerbate the problem noted above. Also, combined with the fact that contributions to multiple-employer trusts are not subject to the funding limits of section 419A, this proposal could create an unwarranted inducement to over-fund such trusts. The third proposal would exacerbate both problems noted above by treating a trust funded largely by one employer as a multiple- employer trust. Multiple-employer trusts are currently exempt from the fundinci limits in section 419A on the theory that, in cases in which many employers are involved, there is no more opportunity to over-fund than in a typical arm's length insurance arrangement. The proposed change would make a multiple-employer trust look more like a captive insurance company, however, and would undermine the rationale for the exemption. 3. Separate Testing for Pilots under Pension Plan Rules Current Law An employer-maintained retirement plan is tax-qualified only if, among other requirements, it does not discriminate in favor of highly compensated employees. Generally, whether a plan's coverage discriminates in favor of highly compensated employees is determined with respect to the total group of the employer's employees. Special rules applicable to union and non-union employees generally permit each group to be disregarded when testing the coverage of a plan covering employees in the other group. Thus, for example, when testing the coverage of plan that covers non-union employees, all union employees are disregarded. In addition, section 4l0(b)(3)(B) provides that all other employees are disregarded for purposes of testing a plan that is established pursuant to a collective bargaining agreement between air pilots and an employer. Thus, a plan that covers only collectively bargained air pilots will not fail the minimum coverage requirements even though the pilots might all be considered highly compensated. PAGENO="0045" 35 Proposal The proposal would extend the rule that currently applies to pilots that are collectively bargained to all pilots. Thus, a plan that covers only air pilots would be tested ~without regard to all other employees. Accordingly, such a plan~wou1dbe considered to have nondiscriminatory coverage even though all or substantially all the employees it.covers are hixrhl~y compensated. Administration Position We oppose the proposal. The proposal would have the effect of excepting a group of employees who are typically highly compensated employees from the nondiscrimination rules that apply to tax-gualjfjed retirement plans. 4. Modification of Individual Retirement Account Limitation Current Law Under current law, the deduction for contributions to an Individual Retirement Account (IRA) isnot available to individuals who participate in an employer-sponsored retirement plan and whose income exceeds certain levels. An individual is treated as participating in a retirement plan for these purposes if the individual Participates in a plan at any time during the year. - Proposal The proposal would modify the retirement plan participát ion rule to provide that the available IRA deduction is reduced by one-twelfth for each month in which the individual is covered under an employer-provi~ed plan Thus, an individual (whose income exceeds the applicable thresholds) who is a participant in an employer-provided plan for only six months of the year would be entitled to one-half of the IRA deduction. Administration Position We oppose this proposal. The proposal- would increase the complexity and administrative-burden associated with an already complicated set of rules. First, the proposal would subject an individual `a IRA deduction to multiple phase-outs. Under existing law the deduction is phased-out over an income range; the proposal would add a second phase-out based on the number of months of plan participation. Thus, for example, an individual whose income was within the applicable phase-out range and who participates in a retirement plan for only a portion of the year presumably would determine his reduced IRA deduction limit by first calculating the reduction in the $2,000 limit in accordance with the income phase-out rules, and then Prorating this reduction to reflect the partial year of plan participation. Second, the proposal would impose another reporting burden on employers, who would presumably be reguirecl to report the number of months of plan participation for each individual. 5. Public Safety -Employees Current Law Section 4Ol(a)(26) generally reguires a qualified retirement plan to benefit the lesser of 50 employees or 40 percent of-the employees of the employer sponsoring the plan. Proposed rec- ulations extend this reguirement to any separate benefit structure under a plan in accordance with section 4O1(a)(26)(I). PAGENO="0046" 36 Section 401(a)(26)(H) gives state and local government employers an election to apply section 401(a)(26) separately with respect to any classification of guaiified public safety employees for whom a separate plan is maintained. Under section 6065 of the Technical and Miscellaneous Revenue Act of 1988, section 401(a)(26) does not apply to plans sponsored by state and local government employers for plan years beginning before January 1, 1993, with respect to employees who were participants in such plans on July 14, 1988. Proposal Under the proposal, section 401(a)(26) would not apply to a plan for qualified public safety employees if (1) no new par- ticipants are added to the plan after July 17, 1989, and (2) the plan satisfied'the reguirements of section 401(a)(26) on that date. The proposal would become effective upon enactment. Administration Position This proposal does not represent a significant departure from present law and we do not oppose it, assuming any revenue loss is appropriately offset. Nonetheless, we would call the Subcommittee's attention to the dis-jointed and inconsistent pattern of exceptions under section 40l(a)(26) with respect to plans For state and local government employees, and sugoest that such issues might be more appropriately addressed in the context of a aeneral simplification of the rules in this area. 6. Cleroy Members Current Law Annual accruals under a qualified tetirement plan are generally limited by reference to the amount of a participant's compensation. For this purpose, compensation refers only to items that are currently includible in the participant's gross income, plus amounts excluded under section 911. Under section 107, gross income of a "minister of the gospel" does not include the receipt of a parsonage allowance as part of his compensation, regardless of the amount of the allowance or whether it is received in cash or in kind. The Internal' Revenue Service has taken the position that an excludable parsonage allowance may not he taken into account as compensation for purposes of determining the limits applicable to annual accruals under a qualified retirement plan. Proposal The proposal would permit up to $15,000 of excludable par- sonage allowance to be taken into account as compensation for purposes of determining limits on annual accruals under a qualified retirement plan. Administration Position We oppose this proposal. The policy embodied in current law is a sound one that essentially prevents double tax benefits. Taking amounts that are excluded from income into account as compensation f.or purposes of determining the limits on annual accruals under a qualified re~tirement plan would permit an unjustified doubling-up of tax benefits. Moreover, the two tax benefits involved here (one For parsonaae allowances and ~he other for qualified-retirement plans), even when considered separatel,~, are amono the most' generous provided in the Internal PAGENO="0047" 37 Revenue Code. Finally, the oroposal would he a source of ongoing controversy as to the valuation of Parsonage allowances provided in kind. E. PROPOSAL FOR EMPLOYEE STOCK OWNERSHIP PLANS 1. Estate Tax Charitable Deduction for Certain Transfers to anESOP Current Law An estate tax deduction is allowable in the caseof transfers by a decedent for certain public, charitable andreligious uses. No estate tax charitable deduction for a transfer of a remainder interest in Property (other than in a farm or `a Personal residence) is allowable unless the remainder interest is in a charitable remainder trust described in section 664 of the Code or a Pooled income fund described in section 642 of the Code. An ESOP cannot he aremainderman of a charitable remainder trustor a pooled income fund. Proposal A trust of which an ESOP is the remainderman and which otherwise.qualifi~~ as a charitable remainder trust. under section 664 would he treated as a charitable remainder trust for purposes of the estate tax charitable deduction. Thus, in certain circumstances, an estate tax charitable deduction would he allowable for the value of the remainder interest in trust which `is transferred to an ESOP. The-deduction is only available with respect to gualified employer securities that pass from the decedent to the trust and later from the trust to the ESOP. The employer must not be entitled to any deduction with respect to such transfer. In addition, the ESOP must be sub-ject to certain restrictions regarding the allocation of the gualified employer securities to plan participants, including a prohibition on any benefit from such securities accruing to any person related to the decedent or to a more than 5% shareholder. For these purposes, qualified employer securities are employer securities of a domestic corporation none of the stock of which is readily tradeable on an established securities market. Administration Position We oppose this proposal. The estate tax charitable deduction is premised on public, charitable or religious benefit. It is not available with resnect to transfers for private purposes. In the case of a transfer of empJoyer securities to an ESOP, the employees for whom the plan is maintained and the employer who is able to compensate its employees on a tax-favored basis are the beneficiaries of the transfer. Although the tax benefits now enjoyed by ESOPs clearly reflect their favored status, we believe that the current level of benefits is sufficient to encourage the adoption and growth of ESOPs. We also note that although persons related to the decedent cannot receive any direct benefit from the securities transferred to the ESOP under the proposal, such persons `may realize indirect henef it from increased value in their stock resulting from the transfer to the ESOP. F. PROPOSALS RELATED TO ESTATE AND GIFT TAX 1. Special Valuation under Section 2032A Current Law Under certain circumstances, an election is available for estate tax purposes to value real property used for farming or in PAGENO="0048" 38 a trade or business (a `qualified use") which passes to a member of the decedent's family (a "qualified heir") on the basis of its actual use rather than its hiqhest and best use. The estate tax benefit of the special valuation is recaptured if the qualified heir disposes of the property (other than to a family member) or ceases to use the property in the qualified use within 10 years after the decedent's death. Generally, a net cash lease of the property by a qualified heir is not a qualified use. However, a net cash lease of the property by a surviving spouse to a member of his or her family will not he treated as a failure to use the property in a qualified use. The election to value the property under section 2032A is made on the federal estate tax return. For decedents dyinq after 1981, the election may be made on a late return if itis the first return filed. Proposal I A qualified heir would not be treated as failing to use specially valued property in a qualified use solely because the property is leased to a lineal descendant of such qualified heir on a net cash basis. The proposal would he retroactive to leases entered into after December 31, 1976. Proposal II With respect to decedents dying after 1976, the section 2032A election could be made on a late-filed return if it is the first return filed. Alternatively, with respect to such decedents, an untimely election would be valid where the failure to make a timely election was due to the negligence of the estate's attorney. Administration Position We oppose Proposal I on the qrounds that it would apply retroactively. However, we would not oppose such a change on a prospective basis, assuming any revenue loss were appropriately offset. Although cash leasing permits needed flexibility in certain limited situations, it conflicts with the general policy of requiring a qualified heir to have an equity interest in the property to meet the qualified use standard and we would therefore oppose extension of this exception beyond the right to cash lease to lineal descendants. We oppose Proposal II on the grounds that it would apply retroactively. We also oppose the secondpart on the grounds that it seeks to shift the cost of an attorney's negligence to the government. 2. Disclaimer of Certain Remainder Interests Current Law Generally, a disclaimer is a refusal to accept ownership of an interest in property. Under certain circumstances, a person can disclaim an interest in property without such disclaimer being treated as a transfer of the disclaimed property interest by the disclaimant to the person who receives the interest as a result of the disclaimer. A disclaimer effective for Federal transfer tax purposes must be made within a certain time after the transfer creating the interest in the disclaimant. Disclaimers of interests created prior to 1977 are governed by Treasury regulations which generally require that the interest be disclaimed within a reasonable time after knowledge of the existence of the transfer that created such interest. In the case of a remainder interest in property, the time within which PAGENO="0049" 39 an effective disclaimer maybe made is measured from knowledge of the creation, rather than the vesting, of the interest. Jewett v. Commissioner, 455 U.s. 305 (1982). Disclaimers of interests created after 1976 are governed by aection 2518 of the Code. Among other requirements, a qualified disclaimer of a remainder interest under section 2518 must be made within 9 months of the transfer that created the remainder interest. Proposal Permit disclaimers of four specific remainder interests created prior to 1942 made immediately after such interests vested to be treated as effective disclaimers for Federal aift tax purposes. Claims for refunds of gift tax could be made within one year of enactment. Administration Position We oppose this proposal. First, it is intended to apply retroactively. Second, current law applies consistently to remainder interests created before 1977 and after 1976 in viewing the creation, rather than the vesting, of such interests as the relevant event with respect to the time limit for making an effective disclaimer. There is no policy justification for singling out specific interests for special treatment regardless of when they were created. To do so undermines the rule generally applicable to disclaimers of remainder interests which we believe is correct. 3. Gift Tax Annual Exclusion Current Law A donor may exclude from taxable gifts each year the first $10,000 of gifts of present interests in property to each donee. There is no limit on the aggregate amount a donor may exclude each year from taxable gifts through the annual exclusion. Under certain circumstances, a beneficiary's lapsing right to withdraw property transferred in trust (a so called "Crummey power") is treated as a present interest in the transferred property. See, e.g., Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968). Proposal I The gift tax annual exclusion would be limited to $30,000 per donor. The limitation of $10,000 per donee under current law would continue to apply. Proposal II A transfer of property to a trust subject to a beneficiary's withdrawal power would be treated as a present interest for purposes of the gift tax annual exclusion only if the withdrawal power is- nonlapsing during the beneficiary's lifetime. Administration Position We believe the concept of a perdonor limitation deserves further study in the context of a general effort to simplify the estate and gift tax. Were Congress to adopt Proposal I, it may also wish to consider a de minimis per donee exclusion for gifts to donees who are not within the aggregate per donor limit. Proposal II also deserves further study. PAGENO="0050" 40 4. State Death Tax Credit / Current Law A credit is allowed against the Federal estate tax for any estate, inheritance, legacy or succession tax paid to a State which is attributable to property included in the decedent's gross estate. The credit is computed by applying a tiraduated rate table with 20 separate~brackets that range from 0~8~percent to 16 percent o~ the taxable estate. Proposal The state death tax credit would be capped ~at 8.8 percent of - the taxable estate, the eredit bracket applicable to an estate at ~the threshold of the maximum Federal. estate tax rate. Administration Position We do not support this proposal. The original purpose of the credit was to prevent States from competing with each other for high-income residents by having low or no death taxes. Decause almost all States nowhave estate or inheritance taxes, the credit now functions principally as a revenue sharing device. Congress may wish to consider simplification through a flat rate maximum credit that would not significantly alter the current level of revenue sharing. G. OTHER MISCELLANEOUS PROPOSALS 1. Rollover for Investment in Satellite Communications System Current Law If the Federal Communications Commission ("F.C.C.") certifies that a sale or exchange of property is necessary to effectuate policy with respect to ownership or control of radio or television broadcastina stations, the taxpayer may elect to treat the transaction as an involuntary conversion, entitling him to a "rollover" of the gain on the sale. if he invests the proceeds in qualifying replacement property. Stock of a corporation operating a radio or tele~dsion broadcasting station is qualifying replacement property, regardless of the nature of the property sold or exchanged. In addition, the taxpayer may elect to defer the gain by reducing the basis of depreciable property. Proposal The proposal generally would allow a taxpayer who sold a radio or television station and reinvested the proceeds in a satellite communications system to treat the new investment as qualifying replacement property, thereby permitting the taxpayer to "rollover" the gain. We understand that the taxpayer would require a waiver of F.C.C. certification in addition to an amendment to section 1071 in order to gualify for rollover treatment under section 1071. Alternatively, the taxpayer seeks a special rule to have section 1033 apply to the transaction, or to he permitted to reduce the basis of depreciable property by the amount of deferred gain on the sale. Administration Position We oppose this retroactive proposal. It is apparently intended to henefit a particular taxpayer with respect to a transaction which has already occurred. PAGENO="0051" 41 2. Water Company Contributions in Aid of Construction Current Law Utilities are required to pay tax on the value of~ contributions in aid of construction ("CIACs") received from customers. In general, CIACs are payments that a utility requires from a new customer to compensate the utility for the cost of equipment that the utility must buy to serve the customer. Under prior law, utilities could exclude CIACs from income, but could not depreciate the equipment. Congress changed the law in 1986 because it viewed CIACs as prepayments for services. Proposal The proposal would exclude CIACs from income of regulated water companies, provided that they are not included in the utilities rate base. Administration Position We do not support this proposal because it draws an unjustifiable distinction between water companies and other utilities. While it may be arcued that a utility should not he treated as realizing income merely because it has been reimbursed by a customer for the cost of equipment that must be used to serve that customer, such arguments apply to electric and gas companies as well as to water companies. If, after considering these arguments, Congress were to decide to change current law, it should do so for all utilities, and provide an appropriate revenue offset. 3. Nuclear Decommissioninci Funds Current Law A taxpayer that has an interest in a nuclear power plant may deduct amounts paid to a qualified nuclear decommiasionina reserve fund, subject to certain limitations. The assets of a qualified nuclear decommissioning reserve fund not currently needed for qualified expenditures may he invested only in assets of a type permissible for Black Lung Disability~ Trust Funds, which are limited to U.S. public debt securities, obligations of State or local governments that are not in default, and time or demand deposits in a bank or insured credit union located in the United States. A nuclear decommissioning reserve fund is generally taxed as a corporation, at the top corporate rate. Proposal The proposal would reduce the tax rate on qualified nuclear decommissioning reserve funds from 34 percent to 15 percent, and - eliminate the investment restrictions on such funds. Administration Position We do not support the proposal to reduce the rate of taxation of nuclear decommissioning reserve funds. We are concerned both that such a proposal may have a significant revenue effect and that such a rate reduction would disproportionately benefit one industry segment. Nevertheless, -Congress may choose to reduce the rate on such funds in order to tax the income at a rate that approximates the average marginal rate of utility ratepayers, on the theory that the fund is comprised o~ amounts paid by current customers so that the costs of decommissioning will not be borne PAGENO="0052" 42 solely by future~customers. If Congress were to do so, we believe the appropriate rate would be approximately 20 percent, not 15 percent. While restrictions on investments of assets in nuclear decommissioning reserve funds may be warranted from a public policy standpoint, such restrictions need not be imposed by the tax Code. To the extent adequate regulatory restrictions and fiduciary obligations exist outside the tax law, the enforcement of investment restrictions through the tax law is unnecessary and inefficient. Accordingly, assuming the Nuclear Regulatory Commission and appropriate utility regulators also do not object to the elimination of such requirements, wd do not oppose elimination of the "Black Lung" investment restrictions on such funds. 4. Cost Recovery Period for Tuxedos Current Law For purposes of depreciation, tuxedos are property of a type assigned. to a nine year class life with a five year cost recovery period. Proposal The proposal would create a special class of depreciable property for tuxedos that would be assigned a two year class life, and a two year recovery period. Administration Position Congress has directed Treasury's Depreciation Analysis division to conduct a study of the economic useful lives of depreciable assets. In a recently issued report conducted in connection with the ongoing study of economic lives, we found that tuxedos have an economic life of two years. We believe it is appropriate for recovery periods to reflect actual economio life, and therefore are not opposed to the principle of allowing the cost of a tuxedo to be recovered over two years. Nevertheless, as westated in that report, we have reservations about the creation of a special class of property that governs only the recovery period for tuxedos. If similar statutory provisions were enactedwith respect to similarly narrow asset classes, the resulting asset classification system would be excessively cOmplex. This would be contrary to the basic thrust of ACRS, which is to use a few broad-class lives to facilitate a simplified cost recovery system. 5. Corporate Owned Life Insurance Current Law Life insurance contracts owned by businesses are treated the same for tax purposes as life insurance contracts owned by individuals. Thus, the investment earnings ("inside build-up") are not taxed currently, and if a contract is held until death, all of the benefits are excluded from income, including the investment income attributable to inside build-up. In addition, distributions from life insurance contracts are included in the policyholder's income only to the extent the distributions exceed the premiums paid by the policyholder. For these purposes, the premiums paid are not reduced by the mortality charges under the contract. In effect, the cost of insurance protection is deducted against the investment income. This is more generous PAGENO="0053" 43 treatment than the separate purchase of term insurance protection since the cost of term insurance is generally not deductible by businesses and is a nondeductible persona] expense for individuals. Furthermore, loans against life insurance contracts are generally respected as such and are not treated as potentially taxable distributions. Interest on such loans also may be deductible by the corporation to the extent the agoregate amount of loans with respect to any one individual does not exceed $50,000. There is no limit on the number of insured individuals with respect to whom separate $50,000 loans are permitted. The favorable rules described above do not apply if a contract does not meet the definition of a life insurance contract contained in section 7702. In 1988, Congress further tightened the favorable tax treatment of loans and distributions from certain qualified life insurance contracts that are highly investment-oriented For such contracts, distributions (including loans) are treated first as income and then as a recovery of the policyholder's investment. A 10 percent penalty tax is also imposed on certain distributions. Proposal The proposal would further limit the availability of the deduction for interest on loans secured by corporate-owned life insurance to policies that irrevocably designate the insured persons and that obligate payment of the death benefit to the insured's family. Administration Position The Administration does not support this proposal at this time; we believe that there may he simpler and more direct means of addressing the tax policy concerns raised by corporate-owned life insurance. Life insurance contracts owned by businesses raise two serious tax policy concerns. First, to the extent policy loan interest is deductible while the corresponding inside build-up is not taxed currently, the business can shelter other income from tax. Prior to the 1986 Act, it was common for businesses to purchase large amounts of "key-man" life insurance Principally to obtain this tax shelter. The current law $50,000 loan limitation has merely altered the form of this tax shelter since new types of contracts have evolved which substitute a large number of small policies for a small number of large policies. A second concern is the use of life insurance by businesses to fund deferred compensation, and other future liabilities unrelated to death benefits. The ability to use tax free inside build-up to fund deferred compensation, for example, may act as a disincentive to provide benefits through qualified plans, which are subject to nondiscrimination rules and other restrictions. We are examining the tax policy issues raised by corporate-owned life insurance in connection with our forthcoming report on life insurance company products, and would be pleased to discuss various policy options with the Subcommittee when that study is completed. PAGENO="0054" 44 6. Treatmen~p~ Certain Gains Reakiz~ byCoop9ratiVes Current Law Cooperatives may deduct patronage dividends, i.e., amounts paid to a patron on the basis of the business done with or for the patron, pursuant to a pre-existing obligation to pay the amount and determined by reference to the cooperative's income from business done with or for its patrons. There is~no. de:finition of patronage source income. Under the regai~ations, however, incidental income derived from sources not ;~ir~ectly related to the marketing, purchasing, or servicing -~activi-ties~of~a cooperative is treated as non-patronage income. The regulations further provide by example that income from the sale or exchange of capital assets constitutes income derived from sources other than patronage. Proposal The proposal would allow nonexempt cooperatives to elect to treat gain or loss from the sale or other disposition of any asset (including stock) as ordinary income or loss and to treat the gain or loss as patronage source to the extent the asset was used by the cooperative to facilitate the conduct of business with or~for~~it5 patrons. In addition, the proposal would permit cooperatives (1) to elect to have the election apply to prior taxable years, and (2) to revoke the election at any time for ~taxable years beginning after the revocation. A cooperative wouldh~ave to wait three years after a revocation before making another election. ~AdministratiOn Position We oppose this proposal. We specifically object to the provisions of the proposal that would permit elective treatment of gain or loss on the disposition of any asset as ordinary and that would apply the proposal retroacti\Tely. 7. Stadium Transition Rule - Current Law The 1986 Act repealed prior law rules which permitted tax-exempt bonds to he issued to finance sports and convention facilities. The 1986 Act also provided transition relief for certain enumerated projects. One such prolect, described in section 13l7(3)(R) and (7)(E) of the 1986 Act, was a baseball stadium, an adjacent parking facility and a convention center for the city of San Francisco. Proposal The proposal would permit the transfer of $75 million of bond authority from use in financing the convention center to use in financing the baseball stadium and adiacent parkina facilities, for the city of San Francisco. The proposal would also extend the bond issuance deadline by one and one-half years, to July 1, 1992 and provide that the bonds issued for this project are not subject to the State annual private activity bond limitation. Administration Position The Administration opposes revision or extension of this transition rule. In general, we endorse the principle of providing fair and eguitable transition from one tax regime to PAGENO="0055" 45 the next. However, we do not support efforts to retroactively provide additional transition relief from prior legislation. 8. Unearned Income Of Minor Child Current Law Generally, the unearned income of a child under 14 is taxed at the child's parents' marcrinai rate under the so-called "kiddie tax." Proposal Interest income of a child under 14 earned from damacie settlements Or awards arising from illness or iniuries and awarded prior to the effective date of the 1986 Act would he - taxed at the child's rate if such income accrues in a custodial account and cannot be used to satisfy the parents' ohligation of support. Administration Position We do not support this proposal. First, it would apply retroactively. Second the incOme from such pre-1986 awards, although taxed at the parents' rate, is taxed at the reduced rates enacted in 1986. In addition, bracket compression under the current rate structure reduces the potential adverse impact of the kiddie tax. Although this proposal is limited to a situation that does not involve income shifting within the family, the application of the kiddie tax is not dependent on the source of the child's unearned income. Creatino exceptions for such situations would add unnecessary complexity to the Code and could eventually lead to a significant erosion of the kiddie tax. 9. Fees Paid by Residents of "New Communities Act" Associations Current Law Residents of New Communities Act Associations may not deduct annual assessments paid to community associations. Property taxes paid by residents of a community that has taxing power are- deductible. - - Proposal The nrooosal would allow residents of New Communities Act Associations to deduct fees they pay to the association to pay for municipal-type services. Administration Position We oppose this proposal because it would permit a deduction for fees that are essentially in the nature of fees to an association or condominium for enhanced services. The Code does not currently permit taxpayers to deduct such amounts. 10. Treatment of Public Transit and Vanpool Benefits Current Law - - Section 132 excludes certain employer-provided fringe bene- fits from gross income. Among the fringe bOnef its excluded from gross income are so-called "de minimis fringes," whichoenerally include any employer-provided property or service whose value is so small as to make accounting for it unreasonable-or administra- tively impractical. The final regulations implementing this PAGENO="0056" 46 provision follow the legislative history in permitting an employee to treat as a de minimis fringe up to $15 per month of employer-provided tokens, vouchers, or reimbursements used by the employee to cover the costs of commuting hy public transit. This special rule applies as long as the value of the t~kens and vouchers, plus the amount of the reimbursements, does not exceed $15 per month to the employee. Proposal The proposal would permit the first $15 per mont.h of employer-provided public transit benefits to he treated as a de minimis fringe, even if the total amount of such benefits exceeded $15 per month. In addition, the proposal would revive the exclusion from gross income for employer-provided van pool benefits, which expired in 1985. Administration Position We do not support this proposal at this time. We believe that the desirability of additional incentives for employer-provided commuting benefits deserves further study, particularly as to the efficiency and fairness of providing such incentives through the tax system and solely in connection with employer-sponsored programs. 11. Deductibility of Student Loan Interest Current Law The 1986 Act phased out the deduction for nonbusiness (consumer) interest expense, including interest paid on student loans, over a four year period. For 1990, only 10 percent of. consumer interest is deductible. For taxable years after 1990, no~ieduction will be allowed for such interest expense. Proposal The proposal would allow a deduction for interest paid on student loans. This proposal would he paid for by accelerating the phaseout of the consumer interest~deduction, making only 5 percent of consumer interest deductible for 1990. Administration Position The Administration opposes this proposal because it favors one group of borrowers at the expense of others. Acceleration of a phaseout that was enacted as part of the 1986 Act would he independently objectionable, even if it were accomplished in a manner that did not treat some groups of borrowers differently. We are also concerned that this proposal would lose substantial amounts of revenue after the offset period. 12. Deductibility of VA Reimbursed Flight Training Expenses Current Law Revenue Ruling 80-173, 1980-2 C.B. 60, states the position of the Internal Revenue Service that veterans may not deduct the cost of flight training courses reimbursed by the Veterans Administration (the "VA") pursuant to section 1677(b) of title 38, United States Code (repealed in 198lby Public Law 97-95). Prior to the issuance of Revenue Ruling 80-173, the Service had stated in Revenue Ruling 62-213, 1962-2 C.B~ 59, that a deduction for educational expenses need not-be reduced by the amount of any PAGENO="0057" 47 benefits paid by the Veterans Administration. The 1980 ruling distinguished payments for flight training on the ground that they were reimbursed payments. / The U.S. Courts of Appeals for the First, Fourth and Ninth Circuits upheld the Service's retroactive application of Revenue Ruling 80-173, holding that the Service made a rational distinction between flight training expense reimbursements and amounts that were received only as living stipends by other veterans who obtained VA educational assistance for purposes other than flight training. See, Olszewskj v. Commissioner, 45 TCM 659, aff'd by unpublished order (1st Cir. 1983); Ri~i~iv. Commissioner, 46 TCM 1387, aff'd by unpublished opinion (4th Cir. 1984; and Manocchjo v. Commissioner, 78 T.C. 989, aff'd 710 F. 2d 1400 (9th Cir. 1983). In 1985, however, the Eleventh Circuit became the only circuit to strike down Revenue Ruling 80-173 as arbitrary, on the ground that it unfairly discriminates between veterans who take flight training courses and veterans who enroll in any other educational programs. Proposal It is proposed that-- (a) for all taxable years beginning prior to January 1, 1980, the determination as to whether a deduction for flight training expenses is allowable will be made without regard to whether the taxpayer received VA reimbursement pursuant to 38 U.S.C. sec. 1677(b) for such expenses; and (h) all bars (e.g., statute of limitations and res ludicata) against the refund or credit of any overpayment of tax resulting from the application of (a) will be lifted, provided that a claim for refund is filed within one year from the date of enactment of the proposal. Administration Position We oppose this proposal. First, we believe that the interpretation of the law embodied in Revenue Ruling 80-173 reflects sound tax policy. Second, we would oblect to any proposal that opens up for refund years that have been long closed by the statute of limitations. Third, this proposal would reverse the disallowance of deductions upheld by the courts or conceded by taxpayers for all taxable years beginning before January 1, 1980. For example, the taxpayers who litigated and lost in the First, Fourth and Ninth Circuits in the cases cited above would be entitled to refunds. 13. Department of Defense Proposal on the Earned Income Tax Credit Current Law Low-income workers with minor dependents may be eligible for a refundable income tax credit ("EITC") of up to 14 percent of the first $6,810 in earned income. The maximum amount of the EITC is $953. The EITC is reduced by an amount egual to 10 percent of the excess of adlusted gross income ("AGI") or earned income (whichever is greater) over $10,730. The EITC is not available to taxpayers with AGI over $20,264. Both themaxjmum amount of earnings on which the EITC may he taken and the income level at which the phaseout region begins are adjusted for inflation. The dollar figures cited are for 1990. PAGENO="0058" 48 In order to be eligible for the EITC, the minor dependent must have the same principal place of abode as the taxpayer for more than one-half of the taxable year and such abode must he in the United States. Thus, military families stationed overseas are not eligible of the EITC. Earned income eligible of the credit includes wages, salaries, tips, and other employee compensation, plus the amount of the taxpayer's net earnings for self-employment. Thus, for members of the armed forces, earned income includes subsistence and housing allowances as well as combat zone compensation, even though such amounts are not included in AGI. However, because such amounts are not reported to the taxpayer or the Internal Revenue Service, it is difficult for members of the armed forces and the Service to calculate the proper amount of EITC. Eligible individuals may receive the benefit of the EITC in their paychecks throughout the year by electing advance payments. However, because such advance payments must be based on wages rather than earned income, the current rules reguire the armed forces to make substantial overpayments of the EITC to its members which elect to receive advance payments. Proposal The Department of Defense has proposed that the EITC be modified to treat members of the armed forces in a more eguitahie manner. The proposal would (a) extend eligibility for the EITC to members of the armed forces who are serving on extended active duty outside the United States but who are considered a resident of a State pursuant to the Soldiers' and Sailors' Civil Relief Act of 1940; (b) clarify that, solely for purposes of calculating the amount of EITC to which members of the armed forces are entitled, subsistence and housing allowances and combat zone compensation should be included in earned income. In order to aid such members andthe Service in calculating the EITC, a simplified method of calculating the value of the subsistence and housing allowances would be provided and information reporting of the these amounts would be required; and (c) require the armed forces to calculate advance payments to their members on the basis of earned income (rather than wages). None of these provisions would affect taxpayers other than members of the armed forces or employers other than the Department of Defense. Administration Position The Administration supports the Department of Defense's proposed changes to the EITC because they would improve the ecuity and the administration of this credit. 14. Low-Income Housing Credit Current Law - The low-income housing tax credit is allowed for certain capital expenditures with respect to certain newly constructed, substantially rehabilitated or newly acquired low-income residential rental housinc. The credit generally is limited to the amount of credit authority allocated to the building by a designated State or local agency. State and local agencies may authorize credits eachyear subject to an annual credit volume limitation. The annual *credit authority was $1.25 per resident from 1987 through 1989, and $0.9375 per resident in 1990. PAGENO="0059" 49 Proposal The proposal would (i) increase the otherwise available low-income housing credit authority for 1990, and (ii) specially allocate this additional authority to an existing building whose transfer is sublect to the approval of the Department of Housing and Urban Development and application for approval of which was submitted but not aranted as of December 31, 1989. To qualify for this allocation, the taxpayer must have manifested an intention to work with the tenant association of the building to develop a plan of tenant participation and meet other requirements. Administration Position We oppose this proposal. The President's budaet for fiscal year 1991 already provides for a general increase in low-income housing credit authority for 1990, from $0.9375 per resident to $1.25 per resident. The additional authority sought by the proposal is not contemplated by the budget and appears to be targeted to a particular project. PAGENO="0060" 50 Chairman RANGEL. Mr. McGrath. Mr. MCGRATH. Thank you, Mr. Chairman. Let me, Mr. Gideon, first refer to the foreign ~personal holding company rules that are applicable to brokers or dealers. I am couceined whenever our tax laws create a competitive imbalance between two similarly situated enterprises. I would like to see a proposal that would correct the situation where one broker-dealer subsidiary operating in a high tax foreign jurisdiction pays current.. taxes-U.S. tax-while an- other doing exactly the same thingdoes not. I recogniie the rules in this: area are~highly:~complex,~ but ~don't you~gree that we should seek to correct the competitive inequities as they are presently in the law? Mr. GIDEON. We certainly are concerned about issues of competi- tiveness. As that applies to this particular proposal, our concern would be that we address issues of this sort in ~the context of a more general simplification of the~foreigniruleS,~WhiCh 1 hope would be a project that we will all undertake. Mr. MCGRATH. Now, we have ~~~~substantivethearingsand you have testified-in the last few weeks regarding the competitive nature of our industries as EC 1992 comes along. One of the recom- mendations of those who testified at that time was that we simplify our foreign tax provisions. I would like to be working with you on that, if I might. In the area of passive foreign investment companies, PFIC, I un- derstand that the Treasury has some objections to the PFIC propos- al relating to companies operating in countries with trade deficits to the United States. What is your basic objection? Is it merely ad- ministrative, or are there other problems, as well? Mr. GIDEON. Well, again, Mr. McGrath, we think that PFIC sim- plification should take a high order of priority in any simplification effort, but we really don't think that relative trade balance is an appropriate criterion to use as the particular proposal you refer to suggests. We do think, however, that this is an area that bears fur- ther study, and we are working on it. Mr. MCGRATH. Would you support a liberalization of the current PFIC rules? Let me give you an example. Would you support re- pealing the passive asset test entirely, and paying for it by reduc- ing the passive income threshold from 75 to 60 percent, or are there other alternatives that you might want to explore? Mr. GIDEON. We would be very interested in exploring simplifica- tion of PFIC, and the asset test is certainly one of the candidates in any sort of simplification. I would* rather not commit to specific pay-for alternatives at this time, and reserve on what the options might be, but certainly the asset test is something that we would consider seriously. Mr. MCGRATH. One final question, Mr. Chairman. Mr. Gideon, I have been deluged by universities in my area, and all over New York State, regarding the value of donations of gifts of appreciated property in the computation of income for the alternative mini- mum tax. I wonder if you could give me some insight as to Treas- ury's opposition to the repeal of this particular provision? Mr. GIDEON. Well, I think that the concern we have, frankly, is one of support for the minimum tax proposals that were put in place in 1986. If we take these out, essentially all the other people PAGENO="0061" 51 who are adversely affected by a minimum tax, I think, will be back at your door saying, "us too." I think, in this particular area, the evidence that we have seen, and we admit that it is preliminary at this point, so I don't want to say that we have reached a final judg- ment, but the preliminary data available to us suggests that chari- table giving has not declined, and in fact, that it has gone up. Now, the form may have changed, as you might expect, because gifts of appreciated property do not enjoy the same advantage that they enjoyed under old law, so people may prefer simply to make their contributions in cash. It seems to me that the fact that there is a decline in this kind of gift should not be the issue. The issue should be, has there been a net decline in giving. Mr. MCGRATH. I thank the Secretary. Chairman RANGEL. Is anyone else seeking-Mr. Sundquist. Mr. SUNDQUIST. Mr. Chairman, is the floor open for discussion on any part of this? Is that Mr. Gideon's testimony? Chairman RANGEL. Any part that would include the Secretary's observations on the package. Mr. SUNDQUIST. Thank you, Mr. Chairman, Mr. Gideon, I, as always, appreciate your expertise and the way you handle yourself, and the way you are working with this committee. I do have a couple of areas that I would like to address, Mr. Gideon. One is the separate testing for pilots under pension plan rules on page 23, No. 3. The testimony indicates your opposition to amend- ment of section 410(b)(3)(B) because it would provide an exception for highly compensated employees. What I would like to point out is that the existing law section 410(b)(3)(B) already specifically pro- vides an exception for airline pilots who are members of a union, and this proposal would merely eliminate the union requirement for airline pilots. My assumptions are-and you can agree or dis- agree-but that as a result of the thinking here, and your testimo- ny, that nonunion pilots are more highly compensated than union pilots. I don't think that is necessarily true. It would suggest that union pilots should be able to receive better tax qualified benefits than nonunion pilots, and I don't think that would be fair. Further, if we take your conclusions a step further, it would-are you suggesting that section 410(b)(3)(B) be repealed? Mr. GIDEON. Let me say, Mr. Sundquist, we are not sure what that section does that would not already occur as a result of the rules governing union plans. Basically, the policy judgment that we think the Congress has made under ERISA with regard to union plans is to say that you test those plans unit by unit, and that you do not compare in between units, because you trust the collective- bargaining process to protect the lower paid employees from any adverse discriminatory effects. Therefore, we think that union pilots would be tested separately under general principles, even without that section of the law. Now if we are mistaken about that, and it does provide some special benefit to union pilots, as I have indicated to you, we would be very interested in exploring what that special benefit might be, because we do not intend to favor one group over another. When we move to the nonunion context, however,, the problem is that there is no collective-bargaining agreement that Congress has seen fit to use as a proxy for the antidiscrimination rules that PAGENO="0062" 52 apply generally to all other plans. What this proposal, as we under- stand it, would do is create a significant exception for pilots who tend to be, relatively speaking, a highly compensated group, from the discrimination rules applicable to pensions. Now if we have misunderstood this in any way, we are certainly happy to be edu- cated on that point, but at least based on our current understand- ing of the proposal, that's what appears to be the situation, and that's the reason for our announced position. Mr. SUNDQUIST. Thank you, Mr. Gideon. I would appreciate an opportunity to go back and review that with you at a later date, at your convenience, and look at part (b), and see what the signifi- cance is, whether--- Mr. GIDEON. If there is, if we have misunderstood it, we certainly don't mean to create a situation in which one group is favored over the other group. Mr. SUNDQUIST. But on a whole separate tack here, even if pilots are regarded as highly compensated, don't you think that their spe- cial health and physical requirements do make them different from many other employees in terms ofdesigning pension plans? Mr. GIDEON. I think they are different, particularly in terms of their retirement dates. On .the other hand, whether that means there should be a total exception from the discrimination rules, I think, is another~question. Mr. SUNDQUIST.~I appreciate the opportunity to revisit that with you, Mr. Gideon. On page 39, section 12-the deductibility of VA- reimbursed flight training expenses, the problem was created, in my. opinion, by the IRS. Some veterans abided by the IRS ruling and court~decisions, and they have no recourse to recover substan- tial sums because of the retroactivity of the enforcement. The issue is that the Tax Code has been applied in conflicting ways based upoii the geographical and chronological circumstances of various court cases, so it would seem to me that in order to correct this, a problem that IRS~created;~there~ ~would be a disagreement with what you said. The instructions on the. 19~8:~return were c1ear,~and taxpayers thought they were~ complying. The retroactive~applicatiOn was held to be arbitrary by the eleventh circuit court;~and consequently, those taxpayers in the eleventh circuit received favorable treat- ment, but others did not. It seems to me that it is not a very expen- sive correction. In the interest of fairness to veterans who thought they were doing the right thing,ait would seem to me that this ought to be corrected. Mr. GIDEON. I would simply note that three other circuit courts disagreed with that. There is only one favorable decision for the taxpayer, as opposed to three. other circuits that went the other way, and our general problem with this is that it would open~long- closed years. We think that we would, of course, have preferred it if the Service had won all the cases. It did win all of them but one, and I think that it would be desirable if there were more uniformi- ty, but we think that if Congress reopens long-closed years in this manner that that is going to be really more of a burden, and I think this will be far from the only issue that this committee would be asked to reexamine on that basis. PAGENO="0063" 53 Mr. SUNDQUIST. Well, Mr. Gideon, respectfully, I understand what you are saying, but the reason it is long-closed years is be- cause they have been fighting it all these years. The IRS created the problem to begin with, and it seems, in fairness, that it ought to be changed. I do appreciate your understanding. Thank you, Mr. Chairman. Chairman RANGEL. Mr. Secretary, some members have some questions. I will ask staff to submit those to you so that you will be able to respond for the record. Mr. GIDEON. Thank you. [The responses from Mr. Gideon follow:] PAGENO="0064" `54 0 DEPARTMENT OF THE TREASURY ASSISTANT SECRETARY March 14, 1990 The Honorable Michael A. Andrews Committee on Ways and Means U.S. House of Representatives Washington, D.C. 20515 Dear Mr. Andrews: After the February 21 hearing before the Ways & Means Committee on miscellaneous revenue measures, you submitted a question concerning Treasury Department policy on the PFIC asset `-test for the purpose of including the question and answer in the hearing record. Your question and our response are as follows: Question: Concerning passive foreign investment companies, I understand that there is a serious problem relating to the impact of- the PFIC rules on high technology companies. There are a number of active companies within the information services industry that fail the passive assets test because they lease rather than buy the computers and telecommunications equipment that they use to perform their work. Would you look favorably on an amendment to the PFIC rules that would allow companies to capitalize leases of tangible personal property? Answer: As a technical matter,~we do not oppose the concept of amending the asset test to include properly capitalized leases of tangible personal property. The revenue effect of -the proposal, however, is not yet determined. We must condition any receptivity, therefore, on the need to be strictly revenue neutral. - Sincerely, Kenneth W. Gideon Assistant Secretary (Tax Policy) PAGENO="0065" 55 DEPARTMENT OF THE TR EASURY a WASHINGTON ASSISTANTSECRETARY March 14, 1990 The Honorable William 3. Coyne Committee on Ways and Means U.S. House of Representatives Washington, D.C. 20515 Dear Mr. Coyne: After the February 21 hearing before the Ways & Means Committee on miscellaneous revenue measures, you submitted two questions concerning Treasury Department policy on the PFIC asset test- for the purpose of including the questions and answers in the hearing record. Your questions and our responses are as follows: Question: One of our witnesses will testify that the PFIC provison places an "extreme compliance burden" on U.S. controlled foreign subsidiaries and has an "adverse impact" on our international competitiveness". He is referring to the 50 percent asset test. Assistant Secretary Chapoton testified before a subcommittee of the Senate Finance Committee in July of 1987 that "We believe that the PFIC provisons should be targeted to cases where a U.S. person's investment in the stock of a foreign corporation has the predominant effect of allowing the accumulation offshore of passive investment income. In this regard, we believe that the level of a foreign corporation's passive assets generally is not relevant, except to the extent cthat the assets either generate current passive income to the corporation or reflect the accumulation of current passive income - within a lower tter~corporation." 1. Do you corrcut~-with that assessment? Is that still Treasury's position? Answer: I concur with Mr. Chapoton's assessment. it is still Treasury's position. Question: In a letter to you dated February 1, 1990, six members of this Committee asked you to comment on a modification of H.R. 515, that is to drop the 50 percent asset test on a prospective basis, and reduce the 75 percent income test. 30-860 0 - 90 - 3 PAGENO="0066" 56 -2-S 2. Would you comment on that? Answer: The proposal to eliminate the asset test for determining a foreign corporation's status as a PFIC and lower the threshold of passive income that would trigger PFIC status is deserving of serious consideration. However, further work is needed to develop a mechanism to preserve the effect of the PFIC provisions on shareholders of corporations whose activities are substantially passive if those corporations hold stock in other corporations with current passive income. Further, the revenue effect of the proposal is as yet undetermined. Any tentative receptivity towards a proposal that adequately addresses all technical problems must be conditioned by the need to be strictly revenue neutral. Sincerely, 7~Y5iL~ Kenneth W. Gideon Assistant Secretary (Tax Policy) PAGENO="0067" 57 Chairman RANGEL. Thank you very much. Congressman ~Emerson is here with us, from Missouri. Your full statement, Mr. Congressman, will appear in the record, and you should feel free in testifying in any manner that you feel comforta- ble with. STATEMENT OF HON. BILL EMERSON, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF MISSOURI Mr. EMERSON. Thank you, Mr. Chairman, and members of the subcommittee. First of all, I really appreciate your accommodating me here this morning, and giving me this opportunity to testify on the issue of capital gains preference for insolvent farmers. I will be brief. Thank you for making my statement a part of the record. The situation that I wish to address has to do with the fact that in 1978, Congress enacted the alternative minimum tax for individ- uals, which was effective January 1, 1979, and capital gains were included as a preference item. Then, in the period between 1979 and 1985, unfavorable economic conditions, both domestic and international, contributed to a very serious crisis in our agricultur- al sector, and really, it was the most serious farm crisis since the period of the Great Depression. In 1985, Congress realized the great hardship that faced a lot of farmers that had gone belly up, and who, solely because of the ap- plication of the alternative minimum tax, incurred a large tax li- ability on "income," and I stress that "income." They never really earned it, so it wasn't really income, but it was money from the forced sale of their farmland that went directly to their creditors. In 1985, COBRA created an exception to the application of the individual alternative minimum tax for farm insolvency transac- tions, and this relief applied retroactively only to insolvency trans- actions occurring after December 31, 1981, so this left a 3-year window, between 1979 and 1981, during which farmers wh.o lost their farms were still liable for the alternative minimum tax, and that, despite thetfact that Congress had previously recognized the serious inequityiof this circumstance. Now I iutraduj~ed a bill in the last session to change the effective date of the~rniief of insolvent farmers with a capital gains tax pref- erence, and last year I think we probably came forward with it too late. I have certainly been doing everything I can to generate fur- ther interest and consideration of the subject this year. I under- ~stand, on notification from the Joint Committee on Taxation that enactment of this proposal would cost probably-they say less than $5 million-we think it would be significantly less than $5 million. There are two groups of people who would be affected by my bill, those~who have enforcement pending against them-the statute of limitations on tax collection, as we know, is generally 6 years, but the statute begins to run from the first IRS notice, not from the tax year, and there still are some farmers who went belly-up be- tween 1979 and 1981 who are still subject to this tax liability-the other group who would be affected are folks who managed to some- how satisfy their tax liability, but for whom this inequity nonethe- less applied, and who should not have incurred the liability in the first place, and this bill would allow a 1-year extension of the stat- PAGENO="0068" 58 ute of limitations for claims so that these folks may claim a refund, and I thank you for this opportunity to share these thoughts with you, and urge your, and the subcommittee's, and the full commit- tee's favorable consideration of this inequitable situation. [The statement of Mr. Emerson follows:] PAGENO="0069" 59 BILL EMERSON HOUSE COMMITTEE ON Qtongre~ of the ~niteb ~tate~' PUBLIC ~%~~~OTTATION 3~ous~t~ot 1~epre~entatib~ SELECT COMMITTEE ON HUNGER ~a~Ijington, ~QC 205~5 TESTIMONY OF THE -HONORABLE BILL EMERSON BEFORE THE COMMITtEE ON WAYS AND MEANS .::~SE~C1'~EVENJJE SUBCOMMITtEE FEBRUARY 21,1990 Mr. Chairman: I would first like to thank you and the rest of the Subcommittee for allowing me to come here today and testify on the issue of the capital gains preference for insolvent farmers. ..~`:~Irnvhere~'todaylisr~ussa .llttle~noticed provision in the, tax code which has ~"cansed-a'Jreatrdeal of undue hardship-to certain farmers who were already down on ~`their lucktIue~to the farm crisis of~th&'late 1970's and early 1980's. I propose merely that-the effective date of section 13208(b) of the Consolidated Omnibus Budget Reconciliation Act of 1985 be changed from 1981 to 1978. Varying domestic and international economic conditions in the early 1980's contributed to the worst farm crisis this country has seen since the Great Depression. Many farmers, through no fault of their own, were forced into insolvency. I'm sure you will recall that during this time, there was speculation that the family farm would soon become extinct, and that the face of American agriculture would be forever changed. Farmers who became insolvent were often forced to sell their farms under foreclosure. All of the proceeds of the sale went to their creditors; sometimes, despite the sale of the farm, they remained in debt. Yet the sale of the' farm, treated as a preference item, triggered the Alternative Minimum Tax (AMT). As you are aware, Congress enacted the individual AMT in 1978, effective January 1, 1979. The AMT applied to all capital gains, regardless of whether the sale was voluntary or involuntary. What this meant for insolvent farmers was that these folks were suddenly hit with a large tax bill -- a bill which they could not pay -- on what may be termed as "phantom income." Congress recognized the gross inequity of the application of the AMT law to these insolvent farmers, and in the COBRAlaw of 1985, the provision was amended. Farmers who sold or exchanged their farms to their creditors in order to cancel their debt were allowed to reduce the amount of their tax preference. But for some reason, the law afforded relief only to land transfers made after December 31, 1981. This left open a three-year window, from 1979 through 1981, during which the AMT was in full force. The farmer who suffered the misfortune of bankruptcy in December of 1981 was m a very different position from the farmer who held on for just one additional month. The latter individual is covered by COBRA's relief the former suffers the burden of an unfair tax. According to an estimate from the Joint Committee on, Taxation, enactment of this date change would cost less than $5 million. In the interest of fairness, I would ask that you give this proposal favorable consideration. Thank you. - PAGENO="0070" 60 Chairman RANGEL. Well, I am grateful that you brought this in- equity to this committee, and I want to assure you that we will give it a top priority. Mr. EMERSON. Thank you very much. Chairman ~ Any questions? Mr. McGRATh. I, too, want to thank my colleague from Missouri, and this $5 million figure, is that from the Joint Tax-- Mr. EMERSON. It is from the Joint Tax Committee, yes, sir. Mr. MCGRATH. Thank you. Chairman RANGEL. Thank you so much for bringing this to our attention. Mr. SUNDQUIST. Mr. Chairman. Chairman RANGEL. Yes, Mr. Sundquist. Mr. SUNDQUIST. Thank you, Mr. Chairman. I just want to compli- ment my colleague from Missouri for his testimony and for what he is trying to accomplish. He has long been involved in this inter- est of fairness with farmers, and I compliment him for his tenacity. Thank you. Mr. EMERSON. I thank my colleague. Mr. Chairman, there is one further thing I might add here. We have researched the legislative history of the law as it stands, and cannot discern why the date was originally set at 1981, instead of 1978. I think that is very im- portant. We have examined the legislative history, and there is no record in the legislative history of why the date of 1981 was chosen, as opposed to 1978. We think, quite frankly, that it was mere over- sight in the drafting of the law, and it is, nevertheless, unfair to farmers who were foreclosed upon within that 3-year period. Thank you again for your consideration. Chairman RANGEL. Thank you. Mr EMERSON Thank you Chairman RANGEL. The distinguished Member from Guam will be testifying before us, and I would like to advise Ms. Pelosi that we are going to adjourn at 11, for the joint session, until 12, but I might advise you to stay around, because I don't think we are going to spend a lot of time on this matter. Mr. Blaz. STATEMENT OF HON. BEN BLAZ, A DELEGATE TO CONGRESS FROM THE TERRITORY OF GUAM Mr. Br~z. Thank you very much, Mr. Chairman. The proposal I have is a proposal that is supported by the Bush administration, by the speaker of our legislature, the Governor of Guam, myself, your staff, and 1s revenue neutral. Basically what we are asking is a very simple thing, sir. The Tax Reform Act of 1986 permits us to delink the Guam Tax Code-delink from the Federal Government, and we talked about an implementation date of January 1, 1991. That was a very ambitious date for us. It doesn't appear that we are going to meet that deadline, and it is going to cause us some problems, so I come before you to ask, on behalf of our Government and our people, to permit us to have this date not set in stone, or in concrete, and let us implement it, according to the agreement, when we finish the Tax Code which is being rewritten right now, and that is the basis of my appearance. I urge you to give it your PAGENO="0071" 61 approval, sir. Everyone else that is coming before you has approved it. I understand the Treasury does, too. [The statement of Hon. Blaz follows:] PAGENO="0072" 62 STATEMENT OF CONGRESSMAN BEN BLAZ Mr. Chairman and distinguished Members of Congress: I am appearing before your Committee today to support the proposal regarding the "Application of the Mirror Tax System to Guam." Under the Tax Reform Act of 1986, Guam was given the opportunity to write and adopt a comprehensive Guam Tax Code that reflects the economics of the far-flung islands in the Western Pacific. This Guam Tax Code will replace the so- called "mirror system" currently in place. Under the mirror system, the Internal Revenue Code is applied to Guam in tot~ and without regard to the dissimilar economic structures of Guam and the entire country. The Government of Guam has embraced this opportunity to move towards economic independence and stability. A Guam Tax Commission has been formed by the Government of Guam and is now drafting the Guam Tax Code. Officials of the Government of Guam met with officials of the U.S. Treasury early last year and signed an implementation agreement with a January 1, 1991, effective date. I have been advised by the Government of Guam that the January 1, 1991, date may have been too ambitious. The Guam Tax Code will be a complex document and may not be completed before the effective date in the implementation agreement. If the Guam Tax Code is not ready by January 1, 1991, the provisions of the Tax Reform Act will take effect anyway and create at least two problems. First, Section 935 will be prematurely repealed. The repeal would require those taxpayers on Guam who receive non-Guam sourced income to file a return with the Internal Revenue Service as well as with the Government of Guam, the current practice. While this procedure is appropriate where Guam's Tax Code differs substantially from the Internal Revenue Code, it is unnecessary where the two Tax Codes are the same Code. The proposal would maintain the status quo by preventing repeal of Section 935 until Guam implements the Guam Tax Code as contemplated under the Tax Reform Act of 1986. The second problem which could result if Guam is forced to adopt the Internal Revenue Code as its Guam Tax Code on January 1, 1991, is the possibility of piece-meal revision while the Guam Tax Commission drafts the new Guam Tax Code. The Tax Reform Act envisioned a Guam Tax Code which reflected a comprehensive approach to unique economic conditions on the island, not a patchwork of amendments to existing law which could result if the Internal Revenue Code is suddenly designated the Guam Tax Code. Preventing local changes to tax law until adoption of the Guam Tax Code as drafted by the Guam Tax Commission would ensure that the Congressional purpose under the Tax Reform Act of 1986 is properly served. The solution to both these problems is to amend the Tax Reform Act of 1986 to delay the effective date of certain provisions and to keep the "mirror system" until Guam develops its comprehensive tax code. The proposal would not have any revenue impact on the U.S. Treasury. It would only ensure a smooth transition between the "mirror system" and the Guam Tax Code. I urgs your approval of the proposal as submitted. PAGENO="0073" 63 Chairman RANGEL. It makes a lot of sense, and that is the recom- mendation that we will be making to the full committee. Mr. Br~z. Thank you sir. Chairman RANGEL. Are there any questions? The Chair will now recognize Ms. Pelosi of California, who has a matter before this committee. Your full statement will be entered into the record as Mr. Blaz' statement, without objection, was en- tered into the record, and you may proceed in the manner in which you feel comfortable STATEMENT OF HON. NANCY PELOSI, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF CALIFORNIA Ms. PELOSI. Thank you very much, Mr. Chairman. I thank you for placing my full statement in the record. In the interest of time, I will be brief. Thank you and Mr. McGrath for the opportunity to appear here this morning. Mr. Chairman, I ask unanimous consent for you to consider the Tax Reform Act of 1986 affording the city and county of San Fran- cisco-they---we afforded certain transition rules to the city and county of San Francisco of $50 million for a baseball stadium~ and $75 million for convention center meeting rooms. The city of San Francisco needs an increase in its stadium alloca- tion. Because the city was able to structure the financing of its con- vention meeting rooms without using the transition rule, I am here to request that the $75 million meeting room rule be shifted to the $50 million stadium rule. This modification would provide $125 mil- lion for the stadium with no additional cost to the Federal Govern- ment The $50 million is not subject to the volume cap restriction, therefore, it would* be necessary to exempt only the additional $75 million from that restriction, which is1 included in my request. My request includes a deadline extension for the issuance of bonds from December 31, 1990 to December 31, 1993, in order to give the city of San Francisco adequate time to ensure compliance with an environmental and electoral requirements. We have had some minor inconveniences lately in San Francisco. I need not remind the chairman that Congress has been most generous after the earthquake, but we need some additional time. The proposed modification is revenue neutral. It does not involve any increase in governmental cost, as it would merge existing tran- sition rules provided in the Tax RefOrm Act of 1986. I hope that you and members of the subcommittee will give my request favor- able, consideration and, of course, I would be pleased to answer any questions you might have about the request. [Congresswoman Pelosi's proposed modification follows:] (Proposed language is italicized) SEC. 1317(3)(R) A facility is ~described in this subparagraph if such facility is a baseball stadium and adjacent parking facilities with respect to which the city made a carryforward election~of $52,514,000 on February 25, 1985. The aggregate face amount of bonds to which this subparagraph applies shall not exceed $125,000,000 and shall be issued on or before December 31, 1393. Such bonds shall also be treated as meeting the requirements of section 146 of the Code. Section 131 7(7)(E) is hereby repealed. PAGENO="0074" 64 Chairman RANGEL. Well, the committee is certainl~ aware of this problem that San Francisco has, and the gentlelady's interest in this last year was before the committee, and we certainly will bring this to the attention of the full committee. Mr. McGrath. Mr. MCGRATH. Yes, thank you, Mr. Chairman. I thank my col- league from San Francisco for her testimony. Seemingly, it is a rev- enue neutral proposal with an extension of a deadline date due to circumstances beyond the control of the city. I see no reason why we should not grant some relief. Ms. PEL05I. I thank the gentleman for his comment. Thank you, Mr. Chairman. Chairman RANGEL. Thank you. At this time, I think we will adjourn and, let's see now, we have a panel. Is General Jones here? General JONES~ Yes, sir. Chairman RANGEL. General, why don't we take your testimony now before we adjourn. Your full statement is going to be entered into the record. I have been advised that there is no objection from Treasury to your proposal, so you may testify in any manner you see fit. STATEMENT OF LT. GEN. DONALD W~ JONES, DEPUTY ASSISTANT SECRETARY FOR MILITARY MANPOWER AND PERSONNEL POLICY, U.S. DEPARTMENT OF DEFENSE General JONES. All right, sir. Sir, I'll be brief, and I will submit, with your permission, the entire statement in the record, but I am appreciative of the opportunity to testify before this committee, and it is an honor for me to be able to appear before this commit tee on behalf of the administration regarding a tax matter directly affecting uniformed personnel. Now, although the military compensation level is generally con- sidered adequate, the Tax Reform Act of 1986 made substantial changes to the earned income tax credit. Most importantly, the 1986 act increased the levels of income eligible for that credit. By way of example, in 1985, the military earned income, as calculated under that proposal, exceeded the minimum level of earned income to qualify for the credit. When it was set at $11,000, we didn't have any service members who were eligible to qualify for the earned income tax credit. Then, in 1990, when the maximum amount was increased to $20,264, then we have about 120,000 service members who are enti- tled to it. Now, there are a couple of problems that we want to have corrected, and one of them-one of the troublesome parts-is that military families whose earned income is low enough. to qual- ify for the earned income tax credit are denied this refundable tax credit if they are assigned to duty Overseas. Current law requires a household in the United States. Members assigned temporary duty overseas, where they leave their family back in the States, can still qualify for the credit, but those service members who elect to take their family members overseas with them would not qualify under current rules. We think we have 25,000 service members in that low income category who are now serving their nation overseas. PAGENO="0075" 65 Now, the second, and equally important problem area concerns several administrative aspects of the current law that are ambigu- ous, unclear, and unnecessarily complex. Military taxpayers have a hard time understanding and calculating the earned income tax credit, and the Internal Revenue Service has an equally difficult time administering the credit for military taxpayers. These admin- istrative matters concern the definition of earned income for pur- poses of the earned income tax credit, the reporting of earned income, and the advance payment of the earned income tax credit. A proposal correcting these problems was submitted to the chair- man of the Ways and Means Committee in October of 1989 by Sec- retary of Defense Cheney. It is identical to H.R. 3949, as recently introduced by Congressman Slattery. This proposal extends the eli- gibility for earned income tax credit to military families stationed overseas. It also provides a precise, equitable, and easiLy adminis- tered definition of housing and substance allowance for members of the Armed Forces, and finally, we~wiIi~have the four military fi- nance centers help a service member-~rompute his earned income. We will be reporting nontaxable earned income on the W-2 form so that the service member, when he applies for the credit, will have the right amounts to compute. This proposal clarifies the inclusion of housing and subsistence provided to members of the Armed Forces. Housing and subsist- ence is defined to mean the basic allowance for quarters, and the basic allowance for subsistence, provided by title 37, United States Code. We are definitely in favor ofthis. We support Mr. Slattery's bill. We think it will correct an injustice existing for a~inumber of years. We don't think our service members ought to be denied the credit when they serve the country overseas. Mr. Chairman, we would like to express our thanks again. We think Mr. Slattery's bill is cost-effective, because it will cost about $5 million to pay for extenñing the credit overseas~, but we think that we will see significan± savings in the adjustments that we are making in the definition and processing of earned income. We ap- preciate your support, and we would ask that this committee would support us on that effort, sir. [The statement of General Jones follows:] PAGENO="0076" 66 STATEMENT OF LIEUTENANT GENERAL DONALD W. JONES, USA DEPUTY ASSISTANT SECRETARY OF DEFENSE MILITARY MANPOWER AND PERSONNEL POLICY~ Good morning, Mr. Chairman. I am Lieutenant General Donald W. Jones, Deputy Assistant Secretary of Defense for Military Manpower and Personnel Policy. It is a pleasure to testify before the Subcom- mittee on Select Revenue Measures of the House Committee on Ways and Means on behalf of the Department of Defense and the Administration concerning a proposal to modify current law regarding the Earned Income Tax Credit (EITC). Although uniformed members of the Armed Forces frequently appear before congressional armed services commit- tees, it is an unusual and distinct honor and privilege for me to appear before this committee on behalf of the Administration regard- ing a tax matter directly affecting members of the Armed Forces. Section 32 of the Internal Revenue Code of 1986 provides a refundable income tax credit of up to $953.40 in 1990 for qualifying low income families. This credit is reduced at ten percent rate for earned income above $10,730. No credit is available if earned income (or Adjusted Gross Income) is above $20,264. Although military compensation levels are generally considered adequate, the Tax Reform Act of 1986 made substantial changes to the EITC. Most importantly, the 1986 Act increased the levels of income eligible for the credit. By way of example, in 1985 military earned income (as calculated under the proposal) exceeded the maximum level of earned income to qualify for the EITC --- $11,000. No military families would qualify. In 1990, the EITC is available to families with annual earned income less than $20,264. Disregarding spouse and member civilian employment, over 120, 000 military families have earned income low enough to be eligible for some amount of Earned Income Tax Credit in 1990. Two aspects of the current credit are troublesome for low income military families. First, military families whose earned income is low enough to qualify for an Earned Income Tax Credit are denied this refundable tax credit if assigned to duty overseas. Current law requires a household in the United States. Members assigned temporarily over- seas whose households remain in the United States continue to be eligible for this credit. However, if the family accompanies the member overseas eligibility for the EITC is lost. It is simply unfair to deny this increasingly important tax benef it to approxi- mately 25,000 low income military families who are serving the nation overseas. The second and equally important problem area concerns several administrative aspects of current law that are ambiguous, unclear, or unnecessarily complex. Military taxpayers have a hard time under- standing and calculating the EITC. The Internal Revenue Service has an equally difficult time administering the EITC for military taxpay- ers. These administrative matters concern: (a) the definition of earned income for purposes of the EITC; (b) the reporting of earned income; and (c) the advance payment of the EITC. Beginning in 1979, earned income for purposes of the Earned Income Tax Credit includes nontaxable as well as taxable earned income. Treasury regulations include within earned income such nontaxable compensation as disability income, the rental value of a parsonage, and the value of meals and lodging furnished for the convenience of the employer. Guidance from the Internal Revenue Service included within earned income allowances for quarters and subsistence provided to members of the Armed Forces. However, this PAGENO="0077" 67 description was never further defined nor applied to military fami- lies overseas. As you may know, military compensation is quite complex. It can include many different items of taxable pay, several nontaxable allowances, and a multitude of in-kind military benefits. Not surprisingly, a number of military allowances could be considered housing and subsistence allowances. In addition, many members are provided housing or subsistence in-kind rather than an allowance. For clarity, simplicity, consistency, and equity, a clearer defini- tion of military housing and subsistence allowances included in earned income is needed for military taxpayers. Another administrative difficulty concerns reporting earned income to taxpayers and the Internal Revenue Service. If taxpayers like members of the armed forces receive a substantial amount of nontaxable earned income, current reporting requirements concerning earned income are inadequate. Nontaxable earned income is not reported to taxpayers or the Internal Revenue Service. As a result, individual low income taxpayers --- often the least experienced and sophisticated when it comes to taxes --- are required to use an IRS-prepared work sheet (retained by the taxpayer) to calculate earned income and determine the amount of the Earned Income Tax Credit. This credit amount is placed on the annual return and is the only information provided to the IRS to determine the EITC. As you might imagine, problems with accuracy and compliance are substantial. Employers should report nontaxable earned income to the taxpayers and the Internal Revenue Service. This will dramatically improve under- standing, accuracy, compliance, and overall administration of the EITC for military taxpayers. Finally, current law provides an advance payment mechanism for the Earned Income Tax Credit for eligible taxpayers who file a certificate of eligibility. Although less than 100 members have filed advance pay certificates, this advance payment mechanism is substantially flawed where taxpayers like the military receive a substantial amount of nontaxable earned income. Under current law, employers are required to calculate the amount of the advance payment based upon taxable wages. Since earned income includes items not considered wages, advance payments of the EITC based on wages can result in a substantial over or under advance payment of the EITC and an excessive adjustment of the credit and taxes due with the year-end annual return. To eliminate this problem, the advance payment should be based on earned income rather than wages. A proposal addressing these problems was submitted to the Chair- man of the Ways and Means Committee in November, 1989, by Secretary of Defense Cheny. It continues to have the support of the Treasury Department and the Internal Revenue Service. It is identical to H.R. 3949, as recently introduced by Congressman Slattery. This proposal under consideration by the Committee will correct each of these problems for military taxpayers. It extends eligibil- ity for the Earned Income Tax Credit to military families stationed overseas. It provides a precise, equitable, and easily administered definition of housing and subsistence allowances for members of the * Armed Forces. Finally, military employers --- in effect, four military finance centers --- are required to report nontaxable earned income to members and the Internal Revenue Service, on W2 forms and determine advance payments of the EITC on earned income rather than wages. PAGENO="0078" 68 Under current Federal law known as the Soldiers' and Sailors' Civil Relief Act, members of the Armed Forces are considered to retain residence in their State of domicile for purposes of State taxation even though assigned elsewhere pursuant to military orders. As a result, members stationed in Virginia may be taxed by their State of domicile, lets say New Jersey, on their military income earned while stationed in Virginia. This continuing residence in New Jer~ey for State income tax purposes would apply equally well over- seas. The language of the proposal would permit members with resi- dence in a State to be considered maintaining a household within the United States for purposes of qualifying for the Earned Income Tax Credit. Unlike other United States taxpayers overseas, military families are the only substantialgroup with earned income sufficiently low enough to qualify for the EITC. Certainly, other low income taxpay- ers overseas have not complained about the nonavailability of the EITC. The proposal clarifies the inclusion within earned income of housing and subsistence provided to members of theArmed Forces. Housing and subsistence is defined to mean the Basic Allowance for Quarters and the Basic Allowance for Subsistence provided by title 37, United States Code. Locally variable housing allowance supple- ments paid in high-cost areas in the United States and overseas are excluded. Subsistence allowances (other than the Basic Allowance) and overseas cost-of-living allowances are also excluded. In addi- tion, in-kind housing and subsistence are valued at the rates of the basic allowances that would be received if in-kind housing and subsistence were not provided. This definition is consistent with military compensation princi- ples, understandable by military taxpayers,. and administrable by the military finance centers and the Internal Revenue Service. It improves the overall equity of the EITC among members of the Armed Forces whether stationed in the United States or overseas and whether provided with quarters or subsistence in-kind or paid an allowance. The Internal Revenue Service recently adopted this definition of military earned income in taxpayer information guides for filing 1989 tax returns. However, a regulation or ruling has not been issued. Enactment of this definition of housing and subsistence will confirm the validity of this administrative position of the Internal Revenue Service. The proposal would amend current law to require military employ- ers to report to the individual member and the Internal Revenue Service all nontaxable earned income on W2 forms. These employers are also required to determine any advance payment of the Earned Income Tax Credit by reference to earned income rather than taxable wages. We estimate that approximately 25,000 low income military fami- lies stationed overseas wOuld qualify for the EITC at current levels. Based on annual earned income estimates for 1990, the amount of EITC would reach a maximum of approximately $400. The average Earned Income Tax Credit for these families would be about $200. Annual revenue loss to extend the EITC to military families overseas is expected to be about $5 million. However, this revenue loss is more than offset by approximately $23 million in annual PAGENO="0079" 69 savings resulting from improvements in administration and compliance from other aspects of the proposal. With regard to effective dates, provisions confirming the Inter- nal Revenue Service's recent clarification of the definition of earned income should be effective for taxable years beginning after December 31, 1988. Extension of the EITC to low income military * fami1i~s oversea hould be effective for taxable years beginning after December 31, 1989. Changes proposed regarding reporting requirements and advance payments should be effective for taxable ~ after December 31, 1990, to provide a reasonable V implementation period for military finance centers. V The Department of Defense is very aware of continual efforts to eliminate complexity from our tax laws. This proposal is consistent with this overall policy in that it eliminates ambiguity, improve.s understanding, enhances administration and compliance. The EITC is also made more equitable. This proposal has been carefully reviewed by V the Department of Defense, the ~Treasury Department, and the Internal Revenue Service. It represents the~collective judgement of the Administration to equitably resolve a tax problem of substantial proportion affecting members of the Armed Forces, On behalf of the Administration, i urge your committee' s ~favorable support. Thank you for the opportunity to discuss this proposal. I would be pleased to answer any questions. PAGENO="0080" 70 Chairman RANGEL. Thank you, General, for bringing this inequi- ty to our attention. Any questions, Mr. McGrath. Mr. MCGRATH. Thank you, also, General. The Treasury has testi- fied in favor of this adjustment--- General JONES. Yes, sir. Mr. MCGRATH [continuing]. And the earned income tax credit, and further, they say that there would be a modest revenue in- crease of-- General JONES. Yes, sir. We have estimated a $14 to $18 million annual increase, by the way we compute it. In the past, we had not included basic allowance for quarters and the basic allowance for subsistence in the earned income tax amount when people received the benefit in-kind. Some people who probably are qualifying for it now would not be qualifying in the future, but by changing the rules, it allows those who need it most to be able to qualify for the credit. So, it is an equity issue. Mr. MCGRATH. All right. I think it has a lot of merit. Thank you, General. General JONES. Thank you. Chairman RANGEL. Thank you, General. The subcommittee will stand adjourned until the conclusion of the joint session. We will resume hearings at 12 p.m. [Whereupon, at 11:05 a.m., the subcommittee was recessed, to re- convene at 12 p.m.] Chairman RANGEL. The committee will resume hearings. Our first panel will be composed of the U.S. Chamber, Dave Burton, manager, Tax Policy Center; the National Constructors As- sociation, Allen Epstein, chairman; American Electronic Associa- tion, Larry Thurston, director; the Computer and Business Equip- ment Manufacturers Association, Dan Kostenbauder; and the Fed- eration of American Controlled Shipping, Philip Loree. We will start off with Mr. Burton, to be followed by Mr. Epstein, Mr. Thurston, Mr. Kostenbauder, and Mr. Loree. Without objection, all of your statements will be entered into the record and during the 5 minutes allocated you could just highlight your testimony. Mr. Burton. STATEMENT OF DAVID R. BURTON, MANAGER, TAX POLICY CENTER, U.S. CHAMBER OF COMMERCE Mr. BURTON. Thank you. My name is David Burton, manager of the Tax Policy Center of the U.S. Chamber of Commerce. We appreciate the opportunity today to present our views on the various proposals that are the subject matter of this hearing. The chamber is very supportive of the proposal to extend the car- ryforward of foreign tax credits from 5 years to 15 years. The pro- posal is very important to U.S. companies and furthers the sound purpose of the foreign tax credit of preventing the double taxation of U.S. firms on their sale of goods and services abroad. The impor- tance of this issue is enhanced by the increasing number of firms that presently have unused foreign tax credits. Moreover, by ex- PAGENO="0081" 71 tending the carryforward period to 15 years, Congress wOuld con- form the foreign tax credit carryforward rules with the Federal tax rules for carryforwards of the general business tax credit .and net operating losses. There is no legitimate tax policy rationale for treating foreign tax credit carryforwards differently from the tax treatment of the general business credit or NOL's. One of the more complex provisions affecting u.s. companies doing business overseas and the passive foreign investment compa- ny provisions-or PFIC provisions-enacted as part of the 1986 act. The PFJC rules were originally intended to address perceived abuses with respect to minority investments by U S taxpayers in overseas mutual funds. These rules were drafted to eliminate the benefit of tax deferral by imposing an interest charge on the defer- ral of U.S. taxes resulting from PFIC income earned on invest- ments made outside the United States. The chamber is concerned about the complexity and overlapping nature of the PFIC rules in relation to the CFC rules and subpart F rules Given the similarities in the policy objectives of the two rules, it is unfortunate that CFC's have not been excluded from the scope of the PFIC provisions. The chamber believes that CFC's should not be subject to the PFIC rules, especially since the passive income of CFC's is already subject to subpart F. Based on the comprehensive nature of subpart F, the PFIC rules should be amended to exclude CFC's from the scope of the tax law on PFIC's. To the extent that a business is clearly reflecting income and keeping appropriate books and records, the chamber believes that the cash method of accounting should be made available to small business taxpayers on as wide a basis as possible. Therefore, the chamber has been concerned about the provisions in the 1986 act which impose significant limits on the use of the cash method of accounting. Many small businesses find the accrual method of accounting very complex and a tremendous administrative burden. According- ly, the chamber supports extending the availability of the cash method of accounting to a larger segment of the business communi- ty and would support extending the $5 million exception to all firms. The Tax Reform Act of 1986 eliminated eligibility for 401(k) plans for those organizations that are presently exempt under sec- tion 501(c). An exception was made only for those organizations who had plans in place prior to July 1, 1986. At the time the 1986 act was drafted, it apparently was thought that all 501(c) organiza- tions would be eligible for another type of tax-favored plan, a 403(b) plan. Elimination of 401(k) eligibility was seen as an elimination of a redundancy. Unfortunately, this view was not entirely accurate; 501(c)(6) orga- nizations, which include trade and professional associations such as State and local chambers, are in fact not eligible. Thus, they are left with no tax-favored saving vehicle at all for their employees and their employees are, in effect, discriminated against. We would encourage the Congress to reinstate 401(k) plans for tax-exempt or- ganizations. PAGENO="0082" 72 The chamber supports the family savings~account initiative pro- posed by the administration, the Roth back-lóaded~T' A, and Sena- tor Bentsen's proposal to expand IRA's. Restoration of the full tax benefits of IRA's and the creation of family savings accounts will increase savings and investment, pro- mote economic growth and create jobs. ~zResearch shows that over 50 percent ~of naw ~IRA contributions come from reduced consumption and only 20 percent from shifted savings. The subcommittee press release lists several proposed transfer tax modifications. The chamber is particularly. concerned with the proposal to limit the annual $10,000 per-donee gift tax exclusion to a flat annual per-donor exclusion of $30,000. This proposal would have a very negative effect on family businesses. Family businesses are now struggling to survive the increased estate tax burden that results from section 2036(c). Congress would unfairly limit one of the few remaining estate tax opportunities available to family businesses if this was changed. The chamber supports.. returning to pre-1986 law with respect to contributions in aid of constrffction and, finally, we support rein- stating the deductibility of interest on student loans. Thank you very much, Mr. Chairman. I look forward to answer- ing any questions. [The prepared statement of~Mr. Burton follows:] PAGENO="0083" 73 STATEMENT on MISCELLANEOUS REVENUE ISSUES before the SUBCOMMflTEE ON SELECT REVENUE MEASURES of the HOUSE COMMTrrEE ON WAYS AND MEANS for the U.S CHAMBER OF COMMERCE by David R. Burton Februaiy 21, 1990 My name is David R. Burton, Manager, Tax Policy Center, U. S. Chamber of Commerce. We appreciate the opportunity to present our views on the various proposals that are the subject of this hearing. Extension of Carryback and Canyforward Rules for Foreign Thx Credit (A.1) The Chamber is very supportive of the proposal to extend the canyforward of foreign tax credits from five years to 15 years. This proposal is very important to US. companies and furthers the sound purpose of the foreign tax credit of preventing the double taxation of U.S. firms on their sale of goods and services abroad. The importance of this issue is enhanced by the increasing number of firms that presently have unused foreign tax credits. Moreover, by extending the carryforward period to 15 years, Congress would conform the foreign tax credit carryforward rules with the federal tax rules for cariyforwards of the general busineas tax credit and net operating losses (NOLs). There is no legitimate tax policy rationale for treating foreign tax credit carryforwards differently from tax treatment of the general business credit or NOLs. The Chamber supports conforming the cariyback rules for the foreign tax credit with the tax code's treatment of carrybacks for the general business credit and NOLs. The Chamber therefore recommends that the period for carryback of the foreign tax credit be extended from 2 years to 3 years. It also recommends that the ordering of foreign tax PAGENO="0084" 74 credits be conformed with the ordering rules for the general business credit. This latter recommendation would permit the use of a foreign tax credit carryover against U.S. tax before being required to utilize the current year's credit. The current tax treatment of foreign tax credit carrybacks and carryforwards hurts the competitiveness of U.S. companies doing business overseas. Exceptions to the Passive Foreign Investment Company (PFIC) Rules (A.5) One of the more complex provisions affecting U.S. companies doing business overseas is the passive foreign investment companies (PFIC) provision, enacted as part of the Tax Reform Act of 1986. The PFIC rules were originally intended to address perceived abuses with respect to minority investments by U.S. taxpayers in overseas mutual funds. These rules were drafted to eliminate the benefit of tax deferral by imposing an interest charge on the deferral of U.S. taxes resulting from PFIC income earned on investments made outside the U.S. The Chamber is concerned about the complexity and overlapping nature of the PFIC rules in relation to subpart F. Subpart F was added to the Code in 1962 and has been steadily broadened since. It has significant applications with respect to a foreign subsidiary of a U.S. corporation, called a controlled foreign corporation (CFC) for subpart F purposes. The subpart F rules were set up to eliminate the deferral of certain types of income earned by the CFC of a U.S. corporation. Given the similarities in the policy objectives of the two rules, it is unfortunate that CFCs have not been excluded from the scope of the PFIC provisions. The Chamber believes that CFC5 should not be subject to the PFIC rules, especially since the passive income of CFCs is already subject to subpart F. Based on the comprehensive nature of PAGENO="0085" 75 subpart F, the PFIC rules should be amended to exclude CFCs from the scope of the tax law on PFICs. The proposal being addressed by this subcommittee affects certain corporatIons engaged in substantial manufacturing operations in a foreign countzy that has a trade deficit with the U.S. Under this proposal, these particular corporations would not be treated as a passive foreign investment company. The Chamber has reservations about applying such a rule only with respect to countries that have a trade deficit with the U.S. The mechanics of how its application would be determined would be complex, the annual redetermination would lead to great uncertainty and the implications of drafting tax law based on the bilateral trade balance of the U.S. with specific countries, and nothing more, is troubling. We believe instead that the present anticompetitive PFIC rules should be narrowed by eliminating the overlap of subpart F and the PFIC rules. By broadening the proposal under discussion to exclude all CFCs from the scope of the PFIC rules, Congress would be simplifying the law and promoting the competitiveness of U.S. firms. -~ Accrual Method of Accounting (B.4) Prior to the 1986 Tax Act, taxpayers were generally permitted to use any method of accounting that clearly reflected income and was regularly used in keeping its books and records. Under the cash method, a taxpayer generally recognizes income when actually or constructively received and reflects expenses for tax purposes when actually paid. To the extent that a business is clearly reflecting income and keeping appropriate books and records, the Chamber believes that the cash method of accounting should be made available to small business taxpayers on as wide a basis as possible. Therefore, the Chamber has been concerned about the provisions in the Thx Reform Act of 1986 which placed significant limits on the use of the cash method of accounting. As a result of the 1986 Act, C corporations and certain partnerships are required to use the accrual method PAGENO="0086" 76 of accounting. The 1986 Act exempted qualified personal service corporations and businesses with average annual gross receipts of $5 million or less from the requirement to use the accrual method. The accrual method can cause cash flow problems for a business, especially if the firm is forced to pay taxes on income or revenues that have not been actually received from a customer or client, or is forced to pay higher taxes resulting from a~delay in the deductibility, of certain~expenses for tax purposes. This is especially a problem for businesses:that must:keep an inventory and are required to use the accrual method, as such businessesare~not permitted to use the cash method even though they may have less than $5 million in gross receipts. Many small businesses find the accrual method of accounting very complex and a tremendous administrative burden. Accordingly, the Chamber supports extending the availability of the cash method of accounting to a larger segment of the business community. In particular, it would support~extended the $5 million exception to all firms. 401(k)s for lbx-Exempt Organizations (D.1) 401(k) plans allow employees to save for their retirement via a tax-deferred plan, which may or may not feature employer contributions as well. Salary-reduction plans, such as 401(k)s, are extremely popular with employees, and indeed are the fastest-growing segment of the nation's private retirement system. The Tax Reform Act of 1986 eliminated from eligibility for 401(k) plans those organizations that are tax exempt under Section 501(c) of the Internal Revenue Code. An exception was made only for those who had plans in place prior to July 1, 1986. At the time that the 1986 Act was drafted, it apparently was thought th.at all 501(c) PAGENO="0087" 77 organizations were eligible for another type of tax-favored plan, a 403(b) plan. Elimination of 401(k) eligibility was seen as elimination of a redundancy. Unfortunately, this view was not entirely accurate. 501(c)(6) organizations, which include trade and professional associations such as state and local chambers of commerce, are not in fact eligible for 403(b) plans. Thus, they are left with no tax-favored saving vehicle at all. Employees are discriminated against, by law, solely because of their employer's tax-code classification. Because this discrimination is a factor in employment decisions, these employers are at a disadvantage in attracting and retaining qualified employees. Moreover, because the cost of doing so is higher, employees of these organizations are likely to save less. The Chamber urges Congress to rectify its mistake, restore retirement equity to employees of 501(c)(6) organizations, and support the sound publiô policy of encouraging personal saving. Individual Retirement Account limitation modification (D.4) Business growth depends largely on the availability and cost of capital. By curtailing Individual Retirement Accounts (IRAs), lowering 401(k) plan contribution limits, denying 401(k) plans to organizations that are tax exempt under Section 501(c) of the Internal Revenue Code, and placing unwarranted and complex restrictions on private pension plans, the Tax Reform Act reduced incentives for saving and capital formation. Since 1974, over $200 billion has been deposited in IRAs. In 1986, 15 million tax returns reported $38 billion in IRA contributions, almost a third of all personal saving that year. But in 1987 only 7 million returns reported IRA contributions and these totaled only $14 billion. PAGENO="0088" 78 IRA deposits consist largely of newsaving. Based on data they have collected and reviewed, Steven F. Venti and David Wise estimate that 80 percent of IRA contributions are new savingJ11 A 1989 study by Daniel Feenberg and Jonathan Skinner and an earlier study by Martin Feldstein and Daniel Feenberg support the assertion that IRAs consist largely of new savingJ2l As the Feenberg and Skinner study states: " . . . [W}e find little or no evidence which favors the view that IRAs are funded by cashing out existing taxable assets.'131 The Venti and Wise study estimates that over half of each marginal IRA dollar came from reduced consumption; another 20 to 30 percent from reduced taxes; and at most 20 percent from other saving. IRAs were not largely financed by borrowing. IRAs are necessary because the current tax system is biased against saving and favors consumption. Income that is saved is taxed twice . first when it is earned, and again when it earns a return. The tax system should be neutral in its impact on the choice between saving and consumption. This can be done in one of two ways. First, the tax on income that is saved can be removed, usually by allowing a deduction. In the alternative, income that is saved can be taxed, while earnings from that saving is tax exempt. IRA5 available to all taxpayers prior to the Tax Reform Act were based on the first approach. They provided a deduction when deposits were made. Senator Bentsen has [11 Venti, Steven F. and David Wise, `IRAs and Saving,' in M. Feldstein (ed), `Taxes and Capital Formatioi~on, University of Chicago Press, (1986). `Have IRAs Increased U.S. Saving?: Evidence from Consumer Expenditure Surveys,' National Bureau of Economic Research, Working Paper No. 2217, (April 1987). `The Evidence on IRAs,' ~li2iS8~ (Januaty 25, 1988). [21 Feldstein, Martin and Daniel R. Feenberg, `Alternate `Ihx Rules and Personal Saving Incentives: MicroeconOmic Data and Behavioral Simulations,' in M. Feldstein (cd.), Behavioral Simulation Mc4hcicil injkE0licV Azialysis, Chicago: University of Chicago Press, (1983). [~l Feenberg, Daniel and Jonathan Skinner, `Sources of IRA Saving,' National Bureau of Economic Research, Working Paper No. 2845, (February 1989). PAGENO="0089" 79 proposed that taxpayers not currently eligible for deductible IRAs be eligible for 50 percent deductible IRA~. The back-loaded IRA proposed by Senator Roth (S. 1256) and the Family Savings Account proposed by the Bush Administration are based on the second approach. No deduction is allowed when the deposits are made, but if funds remain deposited for the required period of time, all earnings are tax-free and no tax is paid when money is withdrawn from the accounts. - Under the Bush proposal, families could make annual nondeductible contributions of up to $5,000 ($2,500 for each spouse), or single individuals could contribute up to $2,500. Participation in Family Savings Accounts is open to taxpayers filing joint returns with yearly adjusted gross incomes up to $120,000 (single- taxpayers up to $60,000). Contributions to Family Savings Accounts can be made in addition to IRA contributions, and investments can be made in a wide range of financial instruments~ If the funds are held in the Family Savings Account for seven years, all earnings are tax-free. Funds can be left in the account beyond seven years with all interest accumulating tax-free. Earnings on funds withdrawn between three and seven years are subject to income tax, and any earnings on funds withdrawn prior to three years are subject to income tax and an additional 10 percent penalty on those earnings. By reducing the tax bias against savings and increasing the return to savings, this proposal is bound to result in greater savings. Moreover, the fact that the savings can be used for purposes other than retirement will increase peoples' willingness to take advantage of the Family Savings Account as a savings mechanism. The Chamber supports the Family Savings Account initiative proposed by the Administration, the Roth back-loaded IRA, and Senator Bentsen's proposal to expand IRAs. PAGENO="0090" 80 Restoration of the full tax benefits of IRAs and creation of Family Savings Accounts, will increase savings and investment and thereby repair much of the damage done by the Tax Reform Act of 1986. Estate Thx Modifications (R3) The Subcommittee press release lists several proposed transfer tax modifications. The Chamber is particularly concerned with the proposal to limit the annual $10,000 per- donee gift tax exclusion to a flat annual per-donor exclusion of $30,000. This proposal would have a negative effect on family businesses. Family businesses are now struggling to survive the increased estate tax burden that results from Section 2036(c). Many family businesses will not survive, and those that do will be less competitive because of the increased taxes. Obviously, any estate planning opportunity not completely eliminated by Section 2036(c) is an important tool for family businesses. The tax code has created an environment where family business survival is largely dependent upon the extent to which business owners regularly consult with tax attorneys and accountants and engage in long-term estate planning. Those who begin planning at a relatively young age quickly discover the importance of gradually transferring ownership of business assets to their heirs. They are advised to use as thoroughly as possible the advantage of the annual $10,000 per-donee exclusion. Obviously, larger families may be able to make more effective use of this exclusion than small families. But it makes absolutely no sense to punish larger families merely because they wish to spread ownership of the business broadly among the heirs. By enacting this proposal, Congress would unfairly limit one of the few remaining estate tax reducing opportunities available to family businesses. PAGENO="0091" 81 Contributions in Aid of Construction (G.2) Land developers and homebuilders are generally required to build the infrastructure required by their projects and, upon completion of the development, deed the infrastructure to the appropriate authorities or utility companies. `Thaditionally, when a private utility company was involved, this was considered a capital contribution and not ordinary income to the utility. As a result of changes in the Thx Reform Act of 1986, this infrastructure contribution has been reclassified as income to the companies. This has resulted in an increased cost to the utility which in turn is passed to the builder or developer and ultimately the consumer honlebuyer. This new rule reduces the resources available for infrastructure development and places an unfair tax on infrastructure capital. The Chamber supports returning to the previous rule of treating the contribution as a capital contribution. Deductibility of Student Loan Interest (G.11) The Tax Reform Act of 1986 called for the deduction of interest on consumer loans, including student loans, to be phased out over five years. Education loan recipients preparing their 1989 tax returns may deduct only 20 percent of the interest paid on their loans. Only 10 percent of student loan interest will be deductible in 1990, with elimination of the deduction on 1991 tax returns. Congress justified the repeal of this deduction on the grounds that it is a disincentive to savings. But in the face of rapidly escalating higher education costs, many American families are finding it difficult, if not impossible, to save enough to educate their children. PAGENO="0092" 82 The cost of an undergraduate degree rose from $4,912 in 1979-80 to $10,390 in 1987-88, an increase of 112 percent. An increasing number of students rely on educational :thlGans to meet higher education expenses. More than 3.9 million students received ~r~iicationaL loans through federal government programs in 1986-87; countless others secured loans in the private sector. Reinstatement of the deduction for interest on education loans would make the Tax Code fairer for Americans who must borrow to meet higher education expenses. Further, it would help to make education more affordable and, thus, open more opportunities for individuals as we approach the 21st century. The Chamber calls on Congress to reinstate this important tax deduction. PAGENO="0093" 83 Chairman RANGEL. Mr. Epstein. STATEMENT OF ALLEN EPSTEIN, CHAIRMAN, TAX COMMITTEE, NATIONAL CONSTRUCTORS ASSOCIATION, AND DIRECTOR, CORPORATE TAX, EBASCO SERVICES, INC., NEW YORK, NY Mr. EPSTEIN. Thank you. I am Allen Epstein, director, Corporate Tax, Ebasco Services. I am here today in my capacity as the tax committee chairman of the National Constructors Association. The NCA is comprised of many of the Nation's largest firms engaged in the design and con- struction of commercial, industrial and process facifities worldwide. NCA member firms grossed in excess of $50 billion in 1988. The NCA appreciates the opportunity to address the Subcommit- tee on Select Revenue Measures regarding several areas of impor- tance to. its membership: The look-back rule for long-term con- tracts, the carryforward period for foreign tax credits, code section 956, voluntary employees' beneficiary associations, and PFIC's, pas- sive foreign investment companies. We favor the proposals under consideration by this subcommittee in all these five areas. Look-back rule for long-term contracts: Our reason for support- ing the subcommittee's proposal to modify the long-term contract rule is based on our belief that the look-back rule benefits neither the Government nor those who must comply with its burdensome terms and should, therefore, be repealed. First, the administrative cost and burden to contractors of com- pliance with the look-back are inordinately high, involving hun- dreds of manhours of effort for every contractor. The look-back rule frequently requires contractors to perform thousands of calcu- lations each year upon completion of their contracts and to redo the calculations every year thereafter, whenever additional reve- nues are received or costs are incurred, no matter how small the amounts involved. This means that contracts must be kept open for tax purposes years after they are completed. For every contract, contractors must go back to prior year tax returns and recalculate their percentage of completion by substituting actual revenues and costs for the estimated revenues used in their tax returns. Then they have to recalculate what their regular tax and alternative minimum tax liability would have been and compare it to the greater tax previous paid. Finally, they have to compute interest, either payable or refundable from the IRS, on a difference in liabil- ity. On the basis of empirical results known to us, we think that. the interest refundable to contractors under the look-back rule exceeds the interest payable to the IRS, thereby resulting in a net reduc- tion in Federal revenues. Moreover, the estimate for the look-back rule during congressional consideration of the Tax Reform Act of 1986 was revenue neutral. Thus, we believe that the repeal of the look-back rule would cost the Government nothing, while saving the Government considerable compliance costs. The costs associated with compliance with the look-back rule are deductible for tax purposes, thereby further reducing Federal reve- nues. PAGENO="0094" 84 Further, the look-back rule is discriminatory, since it only ap- plies to taxpayers who use the percentage of completion method of accounting for tax purposes. Taxpayers who use various accrual methods of accounting for tax are not subject to the look-back rule. Finally, the repeal of the look rule would conform to Chairman Rostenkowski's recent call for simplification of the Internal Reve- nue Code. Chairman Rostenkowski stated: After enactment of the Tax Reform Act of 1986 . . . I indicated my interest in simplifying the existing tax system. If the policies reflected in the Internal Revenue Code can be achieved with simpler rules, I would urge the Congress to pursue such simplification. We believe that repeal is in that vein. As to the carryforward period for foreign tax credits, I will short- en what I was going to say for the record. It has been well covered by the prior speaker, but basically I think it~again puts us in a noncompetitive position, as most of us do business internationally. These are costs that we have to carry. We do, as in our testimony, state that you hit high and low peri- ods in business~cyeles, especially in large construction contracts. You can have~liinitations because~ of changes in. our ~tax rates and different timing~between foreign governments taxing you and our government taxing you.~ It does'~not~allow you to properly apply these things and, as was said before, we do agree that this should be brought in line with the carryforward loss provisions which were changed to 15 years, and we think that would be in order. Code section 956, we just basically support the priposal that we would retroactively revoke Revenue Ruling 89-73. We think, in fairness to taxpayers faced with potential significant retroactive in- creases in tax-and I did note this morning that I think Mr. Gideon said that he does not believe in retroactive increases or ret- roactive changes, so that would be in keeping with what he ~said about tax policy. Modifications of voluntary employee benefit associations, we just feel that some of these are improperly limited currently. On PFIC's, we again feel, as has been stated, that CFC's should not fall under the PFIC rules. They are already well covered under subpart F. Mr. Burton made it easierfor me to summarize a few of the topics, so I am finished. Thank you. [The prepared statement of Mr. Epstein follows:] PAGENO="0095" 85 Allen Epstein Director, Corporate Tax Ebasco Services, In On. Behalf of the National Constructors Association Statement for the Record Subcommittee on Select Revenue Measures Committee on Ways and Means United States House of Representatives February 21, 1990 Mr. Chairman and Members of the Subcommittee: I am Allen Epstein, Director, Corporate Tax, Ebasco Services, Inc., New York, New York. I am here today in my capacity as the Tax Committee Chairman for the National Constructors Association (NCA). The NCA is connprised of many of the nation's largest firms engaged in the design and construction of major commercial, industrial and process facilities worldwide. NCA member firms grossed in excess of $50 billion in 1988. The NCA appreciates the opportunity to address the Subcommittee on Select Revenue Measures regarding several areas of importance to its membership: the Look-Back Rule for long-term contracts, the carryforward period for foreign tax credits, Code Section 956, Voluntary Employees' Beneficiary Associations, and Passive Foreign Investment Companies. We favor the proposals under consideration by this Subcommittee in all these five areas. LOOK-BACK RULE FOR LONG-TERM CONTRACTS Our reason for supporting the Subcommittee's proposal to modify the Look-Back Rule for long-term contracts is based upon our belief that the Look-Back Rule benefits neither the Government nor those who must comply with its burdensome -terms and should therefore be repealed. First, the administrative cost and burden to contractors of compliance with the Look-Back Rule-are inordinately high, involving hundreds of manhours of effort-for every- contractor. The Look-Back Rule frequently requires - contractors to perform thousands of calculations each year upon completion of their contracts and to redo the calculations every year thereafter, whenever additional revenues are received or costs are incurred, no matter hOw small the amounts- involved. This means that cOntracts must be kept open for tax purposes years after they are completed. For every contract contractors must go back to prior year tax returns and recalculate their percentage of completion by sustituting actual revenues and costs for the estimated revenues and costs used in their tax returns. Then they have to recalculate what their regular tax-and alternative minimum tax liability would have-been and compare the greater of these taxes to the tax previously paid. Finally, they have to compute interest either payable to or refundable from the IRS on the difference in tax liability. - Second, on the basis of empirical results known to us, PAGENO="0096" 86 we think that the interest refundable to contractors.under the Look-Back Rule exceeds the interest payable to the IRS, thereby resulting in a net reduction in federal revenues. Moreover, the estimate for the Look-Back Rule during congressional consideration of the Tax Reform Act of 1986 was revenue neutral. Thus, we~ believe that repeal of the Look-Back Rule would cost the Government nothing while saving the considerable compliance costs. Third, the costs associated with compliance with the Look-Back Rule are deductible for tax purposes, thereby further reducing federal revenues. Fourth, the Look-Back Rule is discriminatory, since it only applies to taxpayers who use_~the percentage of completion method of accounting for tax purposes. Taxpayers who use various accrual methods of accounting for tax purposes are not subject to the Look-Back Rule. Finally, repeal of the Look-Back Rule would~conform to~ chairman Dan Rostenkowski'S recent call for simplification of the InternalRevenue code. chairman RostenkoWski stated: `After enactment of the Tax Reform Act of l986,...I indicated my interest in simplifying the existing tax system. If the policies reflected in the Internal Revenue code can be achieved~with simpler rules, I would urge the congress to pursue such simplification." EXTENSION OF cARRyF0RwARDpLERIOD FOR FOREIGN TAX CREDITS The ~NQ'k strongly supports the proposed extension of the ~arryfariwa±d'peri0d for foreign tax credits from five to fifteen years for the following reasons. First, the severe limitations that have been imposed by recent U.S. tax law changes on the utilization of foreign tax credits, coupled with the reduction in the U.S. tax rate from 46% to 34%, have resulted in the generation of significant foreign tax credit carryforwards by many taxpayers. In fact, the NCA believes that many taxpayers are already experiencing or facing the possible loss of significant foreign tax credit carryforwards under the present five year expiration period. Second, frequently there are substantial timing `differences between when the foreign taxes are imposed relative to when the U.S. ,tax liability on the foreign income is imposed. Specifically, the situation may arise in which the U.S. does not impose taxes on income received from a foreign country but a foreign country does impose a tax. For example, a foreign country may impose a tax on up front payments but the U.S. may not because the taxpayer is using the percentage of completion method of accounting. In such a case, the taxpayer may need a longer foreign tax credit rollover period *to insure that the credits are not lost. Third, an extended carryforward period is also necessary because of the cyclical nature of the construction industry. Frequently, construction companies may have substantial foreign source income in one year subject to significant foreign taxes. Thereafter, the construction industry may enter into a world-wide trough for several years wherein it is incurring domestic and foreign operating losses. These construction companies require a longer carryover period for PAGENO="0097" 87 a period of time sufficient to permit them to bridge the downside of the construction cycle. Fourth, foreign countries often impose taxes on what the U.S. would consider as U.S. source income. For example, some countries provide that amounts paid to engineering companies for services rendered in the U.S. are subject to tax in that foreign country. Therefore, an extended carryover period is necessary to permit the U.S. contractor to accumulate sufficient foreign source income limitation to utilize the credits. Fifth, in view of the significant competitiveness challenges facing the U.S. as the European Community integrates its economy and the managed trade economies of Asia gain momentum, taxpayers need an extension of the foreign tax credit carryforward period in order to remain competitive in the international marketplace. Finally, the carryforward period for net operating losses was increased a number of years ago from five to fifteen years. The same extension for foreign tax credit~ carryforwards is long overdue. There is no justification for having different carryforward periods for these items. MODIFICATION OF CODE SECTION 956 The NCA supports the proposal that would retroactively revoke Revenue Ruling 89-73. In fairness to taxpayers who would otherwise be faced with a potentially significant retroactive increase in taxes, Rev. Rul. 89-73 should only have prospective effect for purposas of CodeSection 956. MODIFICATIONS OF VOLUNTARY EMPLOYEES' BENEFICIARY ASSOCIATIONS RESTRICTIONS The NCA supports the proposal that would make certain modifications to present-law limits applicable to Voluntary Employees' Beneficiary Associations (VEBAs). Significant restrictions have been imposed on VEBAs as a result of recent changes in the tax law. The use of VEBAs to provide benefits to employees should be encouraged, and these modifications of current restrictions will provide a much needed incentive in this regard. ~EXCEPTION5 TO THE PASSIVE FOREIGN INVESTMENT COMPANY (PFIC) RULES The NCA believes that all Controlled Foreign Corporations (CFCs) should be exempted from the Passive Foreign Investment Company (PFIC) rules. Congress never intended that the PFIC rules apply to CFCs. CFCs are already subject to U.S. taxation on their passive investment income under the Subpart Frules. Therefore, there is no reason to subject CFCs to the PFIC rules. I thereby conclude my testimony. I welcome any questions. 30-860 0 - 90 - 4 PAGENO="0098" 88 Chairman RANGEL. Thank you, Mr. Epstein. We will now hear from Mr. Thurston. STATEMENT OF LARRY K. THURSTON, DIRECTOR, CORPORATE TAX, STORAGE TECHNOLOGY CORP., LOUISVILLE, CO, ON BEHALF OF THE AMERICAN ELECTRONICS ASSOCIATION Mr. THURSTON. Thank you, Mr. Chairman. I wish to thank the committee for allowing me to testify today. My name is Larry Thurston and I am testifying on behalf of the American Electronics Association. The AEA is a nationwide organi- zation of more .than 3,500 large and small high-technology compa- nies. I am the director of corporate tax at Storage Technology Corp. Storage Technology is a leading manufacturer and marketer of computer information and storage retrieval systems. We employ over 9,200 persons and have annual worldwide revenues of nearly $1 billion. Nearly all of our research and manufacturing is per- formed here in the United States. In 1984, we experienced a series of setbacks and a severe cash-flow crisis which resulted in large tax losses which are currently being carried forward. I wish to state that, as a matter of public policy, AEA supports the proposal to extend the foreign tax credit carryover period to 15 years and believe Congress should change the ordering rules so that the foreign tax credit carryovers are used first, before current- year foreign tax credits are used. These changes would be consist- ent with the rules for other business credits. We recognize, however, that with current budgetary constraints, Congress may be unable to enact these provisions this year. As a result, Mr. Chairman, what I would like to discuss with the committee today is the immediate need for extending the foreign tax credit to 15 years for companies which are in net operating loss position. This need is great, inasmuch as the foreign tax credit does not currently function as intended for these companies. The intent of the NOL provisions is to permit the averaging of income losses over a period of years. This reduces the disparity be- tween the taxation of businesses that have stable income and the taxation of businesses that experience fluctuations in their income. The intent of the foreign tax credit, on the other hand, is to avoid double taxation of income by both the United States and for- eign governments. As illustrated in my written submission, when these two tax provisions interact, the intent of the foreign tax credit provisions are not currently being met. Instead, the foreign tax credits expire and the companies are effectively double-taxed. The AEA is particularly sensitive to this problem for loss compa- nies. The technology inherent in the electronics industry changes constantly. Products often have short life cycles and are character- ized by rapid obsolescence. Accordingly, earnings of companies in our industry are subject to fluctuations from year to year. A loss company, probably more so than anyone else, likely needs to rein- vest its foreign profits that it might have in additional research and manufacturing facilities. Under the current rules, a loss, company is penalized for repatri- ating these profits for investment here in the United States. While many companies might prefer repatriating their foreign earnings PAGENO="0099" 89 for reinvestment here, current tax law motivates them to invest their profits offshore. This is particularly troublesome for a compa- ny such as Storage Technology, which is committed to maintaining as large a manufacturing base as possible her in the United States. Accordingly, AEA is requesting that the carryover period for the foreign tax credit be extended on a prospective basis to 15 years for companies having net operating losses. Our proposal would only extend the carryover period for tax credits created in NOL years and created in years to which NOL's are carried forward. It is structured so this longer carryover period only gives loss companies the same protection against double tax that companies without NOL's generally receive currently. We believe our proposal will have no revenue impact to the Fed- eral budget in the near term and minimal impact in the long term. Due to the increased incentive for loss companies to reinvest their foreign earnings here in the United States, it is possible that the proposal could, in fact, enhance revenues over the long term. Loss companies wishing to reinvest their earnings here in the United States should not be penalized by law for doing so. They do need protection from double taxation. If the foreign tax credit cannot be extended for 15 years for all taxpayers, AEA believes, at a minimum, an extension of the carry- over period should be adopted for companies which have NOL's. On behalf of the membership of AEA, I thank you for the oppor- tunity to express our views and I would be happy to answer ques- tions. [The prepared statement of Mr. Thurston follows:] PAGENO="0100" 90 STATEMENT OF LARRY K. THURSTON, AMERICAN ELECTRONICS ASSOCIATION My name is Larry Thurston. I am employed as Director, Corporate Tax of Storage Technology Corporation. I am testifying on behalf of the American Electronics Association. The A.E.A. is a nationwide organization of more than 3,500 high technology electronic companies. While the association includes some of the largest electronics companies in the world, the vast majority of its members are smaller firms with 200 employees or less. My company, Storage Technology, is a leading supplier of computer information and storage retrieval devices. Storage Technology was founded in 1969 and today has over 9,200 employees and annual sales of nearly $1 billion. In 1984, Storage Technology experienced a series of setbacks, including stalled strategic initiatives to develop computer and optical disk storage products. Consequently, it experienced a severe cash flow crisis, resulting a filing under Chapter 11 of the Bankruptcy Act on October 31, 1984. The company successfully emerged from bankruptcy on July 28, 1987. Due principally to these setbacks, the company incurred substantial losses on its financial statements and tax returns. These tax net operating losses (NOLs) are currently being carried forward. This testimony willprincipallY discuss the need to extend the foreign tax credit (FTC) carryforward period to fifteen years for companies which have NOLs. It is important to note, however, that as a matter of public policy, A.E.A. believes Congress should extend the FTC carryover period to fifteen years for all taxpayers and should change the ordering rules so that the FTC carryovers are used first before current year FTC5 are used. These changes would be consistent with the provisions for other business tax credits. Such provisions are far more important for the FTC than for other credits since, for U.S. companies to compete successfully in the international - marketplace, it is imperative that the FTC function as intended to avoid double taxation. This differs from the other business credits which principally serve as an incentive to taxpayers to make certain expenditures. While A.E.A. believes that, from a policy point, reordering of the FTC use and extension of the carryforward period is good policy, A.E.A~ recognizes the fiscal constraints under which the government is currently operating. Due to long-term revenue concerns, A.E.A. recognizes that, again this year, Congress may be unable to enact these provisions. In such an event, A.E.A. believes Congress should give special consideration to enacting a narrower extension of the FTC carryover rules for companies that are in a loss position. As discussed throughout the remainder of this testimony, the failure of the FTC to function as intended and the consequent double taxation of income is particularly severe for loss companies. The A.E.A. strongly encourages Congress to correct this problem. PAGENO="0101" 91 Foreicm Tax Credit System Under the U.S. system of taxing income on a worldwide basis, an equitable FTC system is both an essential element in preventing double taxation of foreign source income and important for ensuring tax neutrality r~between domestic and foreign tax systems. This two-fold goal :is~echoed by the existence of negotiated~tax treaties ~wbich the United States and foreign governments have negotiated~to avoid double taxation and to provide'~.~ tax neutrality for investment decisions. A U.S. company can potentially be subject to double taxation when its income is either directly or indirectly subjected to tax in both a foreign country and the U.S. The foreign tax credit serves to minimize the exposure to double taxation by permitting a U.S. taxpayer to offset its U.S. taxes on foreign income by foreign taxes paid. This is the principal purpose behind the foreign tax credit. Through a complex series of calculations, the amount of FTC permitted in any single year is limited to the amount of current year U.S. taxes assessed on income from foreign sources. To the extent the foreign taxes paid exceed the credit allowed, this "excess" FTC is permitted to be carried back and then forward to be used to offset U.S. taxes on foreign income in other years. This carryover of excess credits is needed, in part, to account for the fact that the timing of taxes imposed by foreign governments does not coincide with tax payments to the U.S. due to differences in the timing of taxable events between various governments. Thus, to compensate for these differences, the FTC permits foreign taxes from one year to offset U.S. taxes in another year. Hopefully, through this carryover procedure, a company can, over time, ultimately avoid paying double tax on its income. The carryback and carryforward provisions for the FTC are contained in Internal Revenue Code (IRC) Section 904 (c). IRC Section 904(c) provides that taxpayers may carry unused FTCs back two years and forward five years. By comparison, net operating losses and business credits (such as the research credit) are subject to three year carryback and fifteen year carryforward periods. From a pure tax policy perspective, the FTC carryforward period should be unlimited. An unlimited period is appropriate since the foreign tax credit relieves double taxation rather than provides an incentive. Moreover, even though a credit limitation may restrict current use of a foreign tax credit, the credit should not be lost forever due to expiration of the current statutory carryforward period. Therefore, although an unlimited period is justified, limited carryback and carryforward periods are sensible for administrative simplicity. With the short five year FTC carryforward period under current law, U.S. companies can be subject to double taxation on income earned abroad, with tax being imposed first by the foreign government and then again by the U.S. Ordinarily, a FTC reflecting the foreign tax would be available as an offset against the U.S. tax. However, -~ because of the brief FTC carryforward period, these FTCs can expire before being used against U.S. tax, triggering double tax. This is especially true for U.S. companies with NOLs. PAGENO="0102" 92 A U.S. company with NOL5 often receives no relief from double taxation through the FTC rules. This arises because the company's NOLS must be used to offset its foreign source income and, accordingly, it is not permitted to use a FTC. Assuming its NOLS are large enough to offset its income for several years, its FTC carryovers will expire unused after five years. This frequently happens since the NOLs have their own carryover period of fifteen years and may extend well beyond the current five year carryforward period available for FTCs. The NOL provisions, however, are not intended nor do they function to prevent double taxation. The NOL provisions of current law serve a very separate and distinct purpose from that of the foreign tax credit. As stated in the General Explanation of the Tax Reform Act of 1986 (page 288): The rationale for allowing the deduction of NOL carryforwards (and carrybacks) was that a taxpayer should be able to average income and losses over a period of years to reduce the disparity between the taxation of businesses that have stable income and * businesses that experience fluctuations in income. This concept of averaging over time is different than the intent of the FTC, which is to avoid double taxation of the same income. When income which has been taxed by a foreign government is subsequently offset by U.S. NOLs and, as a result, its FTCs expire unused, the intent of FTC provisions has not been met. On the surface one may question whether an NOL company really has been double taxed in the above situation. since it has paid no U.S. tax on the foreign income (because its NOLs offset its foreign income). Upon a closer look, however, one sees that a double tax has arisen. When a U.S. company uses its NOLs to offset its foreign source income it exhausts its NOL' s more rapidly and, accordingly, begins paying tax on its U.S. income earlier and to a much greater extent than it otherwise would have. Thus, the double tax really arises from the taxes paid after the NOLs have expired. This phenomenon is illustrated in the example shown in Exhibit I to this testimony. This example shows two companies having equal U.S. source and foreign source earnings over a ten year period. One company has stable earnings throughout the ten year period; the other has fluctuating earnings which produce losses in the early years. The company with the fluctuating earnings is precluded from using all of its foreign tax credits before they expire and, as a result, pays a total worldwide tax greater than the company with stable earnings. The A.E.A. is particularly sensitive to this problem for loss companies. The technology inherent in the electronics industry changes constantly. Products often have short life cycles characterized by rapid obsolescence. Accordingly, earnings of companies in the industry are subject to fluctuations from year to year. Companies who perform their research and manufacturing activities in the U.S. are more likely to have fluctuations in their U.S. source earnings. As a result, those companies with the largest portion of their operations in the U.S. are the ones most likely to be harmed the most by the current FTC carryover rules. PAGENO="0103" 93 The current FTC rules have the undesirable result of rewarding companies who reinvest their foreign profits in research and manufacturing outside of the U.S. A loss company likely needs to reinvest any foreign profits it might have in additional research and manufacturing facilities. Under the current rules, a U.S. company is penalized for repatriating these profits to the U.S. Currently, NOL taxpayers who don't have to repatriate u.s. profits have two tax reasons for reinvesting their foreign income outside the U.S. this repatriation penalty and a more current tax deduction for their investment in a foreign country. While many companies might prefer repatriating their foreign earnings for reinvestment in the U.S., current tax law motivates them to do otherwise. Proposed Law Cha~g~. A.E.A. suggeststhat the FTC carryforward rule under IRC Section 904(c) be amended to provide a fifteen year carryforward period for a portion of the excess FTCs generated in either (a) a year in which a NOL is created, or (b) a year to which a NOL is carried forward. The portion of these FTCs eligible for this extended carryforward period would be limited to the U.S. tax rate multiplied by the taxpayer's foreign source taxable income. This limitation would be calculated separately for each FTC basket. To the extent that the FTC for any basket exceeds this limit, the balance would be subject to the current five year carryforward period. The proposed amendment would be prospective and, thus, would apply to FTCs arising after 1989. This proposal would only extend the FTC carryforward period for FTCs created in NOL years and years to which NOLs are carried forward. It would not extend the carryforward period for FTCs arising from carrybacks of NOLS and FTCs (including FTC carryforwards) generated during years companies do not have NOLs. While an extension of the carryforward period for these other FTCs can be easily justified, this proposal is limited in an effort to minimize the revenue impact. Discussion of the Pronosed Law Change. The above proposal has several advantages. First, it will likely have no revenue impact to the federal budget in the near tern and minimal impact in the long term. In fact, due to the elimination of the penalty on loss companies which repatriate foreign earnings for reinvestment, it is possible that the future earnings from reinvesting these profits in the U.S. could, in fact, enhance revenues over the long term. Such revenue enhancement would arise from individual taxes on jobs created by these profits and from future U.S. sourced earnings arising from the successful reinvestment of repatriated profits in the U.S. Second, although the proposal applies to all companies with NOLS, it principally benefits those taxpayers who are really struggling either with a very large loss or a number of years of losses. It is these taxpayers who are the most likely to need to repatriate any foreign profits they might have. From a public policy view, it seems wise to avoid penalizing companies who wish to reinvest foreign profits in the U.S. PAGENO="0104" 94 Third, by limiting the extended carryforward period for each FTC basket to* the U.S * tax rate multiplied by the taxpayer' s foreign source taxable income, the proposed law does not give any "extra" benefits to NOL taxpayers which are not already available to other taxpayers. By limiting the carryforward extension as suggested, the law simply gives NOL companies fifteen years to receive the same benefit that companies without NOLs generally receive~ currently. Finally, a law based on the above proposal is relatively simple, is easy to incorporate into existing law and is easy to administer. Over the past several years the tax laws have become increasingly complex. It is important, wherever possible, to incorporate simplicity into new tax rules. ~onclusioii, In summary, A.E.A. appreciates the opportunity to testify on the need for extending the FTC carryforward period to fifteen years. As stated before, A.E.A. believes an across the board extension of the FTC carryforward period as well as a change in the FTC ordering rules is warranted. At the same time, we are aware of the fiscal constraints which Congress is facing. If the FTC carryforward period cannot be extended for all taxpayers, A.E.A. believes, at a minimum, an extension of the carryforward period to fifteen years should be adopted for companies which have NOLs. We would be pleased to work with any of your staff or the staff of the Joint Committee on Taxation to answer any questions which might arise regarding. our proposal. On behalf of the membership of A.E.A. I thank you for the opportunity to express our views. PAGENO="0105" 95 EXHIBIT I CONPARISION OF A ~ONPANY WITH STABLE EARNINGS TO ONE WITH FLUCTUATING EARNINGS BOTH CONPANIES EARN 2,000 OVER A' 10 YEAR PERIOD Tax Burden for Couçany A lRw Has Stable Earnings Taxable Year 1 2 3 4 5 6 7 8 9 10 Total US Source Income 100 100 100 100 100 100 100 100 100 100 1000 Foreign Source Inc 100 100 100 100 100 100 100 100 100 100 1000 subtotal 200 200 200 200 200 200 200 200 200 200 2000 NOL 0 0 0 0 0 0 0 0 0 0 0 Taxable income 200 200 200 200 200 200 200 200 200 200 2000 U.S. tax rate x34X x34X x34% x345 x34% x365 x34% x34% x34X x34% TentativeU.S.tax 68 68 68 68 68 68 68 68 68 68 680 Foreign Tax credit -25 -25 -25 -25 -25 -25 -25 -25 -25 -25 -250 Net U.S. taxes 43 43 43 43 43 43 43 43 43 43 430 Foreigntaxes 25 25 25 25 25 25 25 25 25 25250 TotalTaxburden 68 68 68 68 68 68 68 68 68 68 680 Tax Burden for Co~eny B l~o Has Fluctuating Earnings Taxable Year 1 2 3 4 5 6 7 8 9 10 Total US Source Income -400 -200 -100 100 100 200 300 300 300 400 1000 Foreign Source Inc 100 100 100 100 100 100 100 100 100 100 1000 subtotal~ -300 -100 0 200 200 300 400 400 400 500 2000 NOL 0 0 0-200-200 0 0 0 0 Q==~~ Taxable income -300 -100 0 0 0 300 400 400 400 500 2000 U.S. tax rate x34X x34Z x34% x34X x36X x34% x342 x345 x34% x345 TentativeU.S.tax. 0 0 0 0 0 102 136 136 136 170 680 ForetgnTaxcredit 0 0 0 0 0 -36 -36 -34 -34 34 170 Net U.S. taxes 0 0 0 0 0 68 102 102 102 136 510 Foreigntaxes 25 25 25 25 25 25 25 25 25 25 250 TotatTaxhurden 25 25 25 25 25 93 127 127127 161 760 ExcessFTC 25 50 75 100 125~100 75 50 25 0 FTC expired 0 0 0 0 0 16 16 16 16 16 80 PAGENO="0106" 96 Chairman RANGEL. Thank you, Mr. Thurston. We will now hear from Mr. Kostenbauder. STATEMENT OF DAN KOSTENBAUDER, CHAIRMAN, TAX COMMIT- TEE, COMPUTER AND BUSINESS EQUIPMENT MANUFACTURERS ASSOCIATION, AND TAX COUNSEL, HEWLETT-PACKARD CO. Mr~ KOSTENBAUDER. Thank you, Mr. Chairman and Mr. McGrath. I am tax counsel for Hewlett-Packard Co., of Palo Alto, CA. I am here to testify on behalf of the Computer & Business Equipment Manufacturers Association or OBEMA. CBEMA is a group of 28 major business equipment and computer companies that are major exporters from the United States. My company, Hewlett-Packard, is a good example of the empha- sis CBEMA companies have traditionally placed on exporting. Last year, Hewlett-Packard, while ranked 39th on the Fortune 500 list of industrials, was ranked 13th on the Fortune list of America's biggest exporters. I am here to testify on three foreign tax provisions which detri- mentally affect United States companies doing business abroad. In particular, CBEMA supports proposals to extend the carryforward period for foreign tax credits, to modify section 956 of the Internal Revenue Code relating to the characterization of successive loans, and to create certain exceptions to the passive foreign investment company or the PFIC rules~ Because my time is limited, I will just focus on the last two pro- posals. Section 956 requires a U.S. shareholder to include in current income his pro rata share of a controlled foreign corporation's in- creased investment in U.S. property. Under section 956, the time to measure the CFC's investment in U.S. property is at the end of the CFC's taxable year, which is a very simple bright-line test. A loan made by a CFC to a U.S. parent company is considered to be an investment in U.S. property. Revenue Ruling 89-73 requires that certain successive loans, al- though not outstanding at the end of the taxable year, be treated as one continuous loan and included in U.S. property investment and, thus, be subject to tax. The revenue ruling not only is con- trary to the clear and simple language of the statute, but adds an additional element of uncertainty. Frankly, U.S; companies should be able to borrow on a short- term basis from their foreign subsidiaries without U.S. tax conse- quences. If U.S. companies are discouraged by this revenue ruling from borrowing from their foreign affiliates, they will need to pay borrowing fees, pay higher interest rates and present public finan- cial statements that would show more debt than would otherwise be necessary. Furthermore, if the U.S. parent company is having financial dif- ficulties, it might not even be able to borrow from unrelated sourc~~s. In the meantime, assets that could have been used back in the United States will be invested abroad. As a result, Revenue Ruling 89-73 will inevitably weaken the competitiveness of U.S. companies. PAGENO="0107" 97 The IRS has been unwilling to rethink its position on this matter. We have discussed it with them and they are pretty clearly opposed to any change. It is, therefore, up to Congress to revoke Revenue Ruling 89-73, on both a retroactive and prospective basis. Turning now to PFIC's, the PFIC provisions were enacted to end the tax deferral on foreign passive !investments that were not al- ready subject to the antideferral rules of subpart F. Unfortunately, this statute was not drafted in accordance with the committee report language, which specifically stated that the PFIC provisions were not to apply to CFC's. Because the consequences of applying the PFIC rules to CFC's can be Draconian, and because the PFIC rules were never intended to apply to CFC's in the first place, CBEMA strongly supports any provision that would completely exclude CFC's from PFIC treat- ment. If that recommendation is not adopted,- we suggest the change to the portion of the PFICT.provisions that~define a PFIC as any foreign corporation where 50 -pereent~or~more of the average value of its assets produce or are held for the production of income. Under this asset test, certain CFC's engaged in substantial man- ufacturing will be considered to be PFIC's, simply because they have cash on hand to finance their projected growth. Clearly, man- ufacturing in a foreign country is not a passive investment. CBEMA, therefore, supports any proposal that would waive the 50 percent asset test for a CFC that is engaged in substantial manu- facturing abroad. As a final comment, CBEMA objects, for three reasons, to any proposal that would waive the 50 percent asset test only where a CFC is located in a foreign country that has a deficit in its trade balance with the United States. First, balance of trade problems cannot be properly addressed by the Tax Code, in part, because business decisions would be influenced toward less competitive re- sults. Second, the rule unfairly penalizes many companies with es- tablished active manufacturing businesses. Finally, because trade balances do change, the rules would create additional uncertainty. Thank you for giving us the opportunity to speak to you about these important issues. [The prepared statement of Mr. Kostenbauder follows:] PAGENO="0108" 98 STATEMENT OF DAN KOSTENBAUDER, TAX COUNSEL FOR HEWLETT-PACKARD COMPANY ON BEHALF OF THE COMPUTER AND BUSINESS EQU I PMENT MANUFACTURERS ASSOCIATION, SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS & MEANS U.S. HOUSE OF REPRESENTATIVES February 21, 1990 Mr. Chairman and Members of the Subcommittee: My name is Dan Kostenbauder. I am Tax Counsel for the Hewlett-Packard Company and am here to testify on behalf of the Computer and Business Equipment Manufactur- ers Association (CBEMA). CBEMA is a group of 28 major computer and business equipment companies that export a substantial amount of products each year. As a result, our companies have a significant presence throughout Europe and the Pacific Rim. My company, Hewlett-Packard, is a good example of the emphasis CBEMA members have traditionally placed on exporting. Last year, Hewlett-Packard, ranked 13th on "America's 50 Biggest Exporters" list with over $2 bil- lion of exports, while ranked 39th on the Fortune 500 list of U.S. industrials. It is our view that the tax laws can help make American companies become even more competitive. I am here to testify today on three foreign tax provisions which detrimentally affect U.S. companies doing business abroad. To correct these inadequacies, CBEMA supports proposals to: 1. Extend the carryforward period for foreign tax credits; 2. Modify section 956 relating to the charac- terization of successive loans; and 3. Create certain exceptions to the passive foreign investment company (PFIC) rules. I. CBEMA Supports Extending The Foreign Tax Credit Carryforward From Five Years to Fifteen Years. Under current law, foreign tax credits not used against U.S. tax in the current year may be carried back two years and forward five years. In contrast, the rules for the general business tax credit and net operating losses permit a three-year carryback and a fifteen year carryforward. The ordering rules for the two credits are also different. The ordering rules for the foreign tax credit require that current year's credits be utilized before any carryovers are taken into account. By contrast, general business tax credit carryovers are permitted to be used before the current year's credits are used. The PAGENO="0109" 99 shorter carryover rule and the "last-in-first-out" order- ing rule make it less likely that previously unused for- eign tax credits will ever be used. As a result, these inequitable rules increase the likelihood of double tax- ation, reduce the competitiveness of U.S. companies oper- ating abroad and needlessly increasethecomplexity of our tax system. When foreign tax credits are permitted to ex- pire, double taxation is likely to result! The United States taxes foreign source income of U.S. companies even though that income is also taxed abroad. To avoid double taxation, the U.S. permits the foreign taxes paid abroad to be credited against U.S. tax. However, when foreign tax credits cannot be used in the current year, current law provides only a narrow time-frame (the carryback and carryforward period) within which such credits must ei- ther be used or expire. The ordering rule, which forces taxpayers to utilize current credits notwithstanding that prior credits are likely to expire, narrows that time- frame even further. Because the 1986 Act lowered the tax rates and increased th~ number of separate foreign tax credit limi- tation baskets in the foreign tax credit calculation, the problem of double taxation due to unused foreign tax credits has increased since the Act was passed. Thus, many companies are increasingly faced with a pool of "excess credits" that are virtually certain to expire; This increased likelihood that the same income will be subject to double taxation makes American compa- nies less competitive in the world market. Unlike our foreign competitors, who know what their tax burden is likely to be before they enter a venture, U.S. companies are less able to predict with certainty their world-wide tax liability because of this double tax potential. When double taxation results, the outcome for U.S. companies is even more onerous since it increases the cost of doing business abroad. The shorter carryover rule and the "last-in- first-out" ordering rule for the foreign tax credit not only harm U.S. companies operating abroad, they also add an additional level of complexity to a tax system that is already far too difficult for most people to understand. Although the foreign tax credit carryforward provision is only one small part of our tax code, simplifying this provision to conform to the rules of the general business credit and net operating losses is at least a step in the right direction. As a result of these very real concerns, CBEMA endorses the proposal to extend the foreign tax credit carryforward period from five years to 15 years. In addition, CBEMA believes that the ordering rule requiring current credits to be used before carryovers can be used should be reversed to conform with the general business credit ordering rules. II. CBEMA Supports the Proposal to Modify Section 956 Relating to the Characterization of Loans. Section 956 requires a U.S. shareholder to include in current income his pro rata share of a con- PAGENO="0110" 100 trolled foreign corporation's (CFC's) increased invest- ment in U.S. property. A loan made by a CFC to a related U.S. entity is considered an investment in U.S. property. The statute states that the time to measure the CFC's investment in U.S. property is at the end of the CFC's taxable year. As such, it provides taxpayers with a very simple bright-line rule which is easily implemented. Revenue Ruling 89-73 would require that certain successive loans, not outstanding at the end of the year, be treated as one continuous loan and included in U.S. property investments under section 956. The Revenue Ruling is not only contrary to the simple and clear lan- guage of the statute, but would add an additional element of uncertainty to an area in which Congress specifically intended a bright-line rule to apply. Taxpayers would be unable to determine at year end which loans would later be treated as "continuous." Thus, intercompany loans of any length of time would be discouraged. Intercompany loans are very healthy and useful for U.S. companies. Multinational companies frequently make intercompany loans to provide for short-term cash flow needs. These loans are paid back before the end of year as cash becomes available. Third party loans are less desirable than these intercompany loans because third parties charge borrowing fees and such loans must be reported on public financial statements. The U.S. tax system should permit U.S. companies to utilize excess cash generated overseas to lower U.S. borrowing costs. Because the Revenue Ruling fosters a less efficient use of assets, it will inevitably hinder the competitiveness of U.S. companies abroad. One of our members provides an excellent exam- ple of how the 956 rule can really make a difference. In the last several years, this company has seen a substan- tial downturn in its U.S.computer sales business, which has resulted in substantial net operating losses in the U.S. Its foreign operations, in contrast, have been generating a profit. As a result of these losses and a major financial restructuring, this company was unable to borrow money in the U.S. to fund its R&D efforts. The company has only two means to borrow the funds necessary to fund its R&D efforts. Neither of these means leads to a satisfactory, low-cost result. If the company has its foreign subsidiary pay a dividend, withholding taxes will be deducted (generating unusable foreign tax credits). Alternatively, if the subsidiary loans the cash to the parent and the Revenue Ruling ap- plies, the foreign tax credits will also be triggered and will probably be left to expire. Neither option affords a low-cost solution to the cash flow problem. This real case example highlights that Revenue Ruling 89-73 works to kick a company when its down. The Service has been unwilling to rethink its position on this issue. It is, therefore, up to Congress to insure that U.S. companies get a fair shake in the global market. Because Revenue Ruling 89-73 is both contrary to the language of section 956 and bad policy, CBEMA sup- ports the proposal to retroactively revoke the ruling. PAGENO="0111" 101 III. CBEMA Supports The Creation of Certain Exceptions to the Passive Foreign Investment Company Rules. The PFIC provisions were enacted to end the tax deferral on foreign passive investments that were not subject to the anti-deferral rules under Subpart F. Un- fortunately, the statute was not drafted in accordance with the Committee Report language which specifically stated that the PFIC provisions were not to apply to CFCs because the Subpart F rules already ended tax deferral for CFCs. Rather, the PFIC rules,~ as currently drafted, apply to CFCs. The application of the PFIC rules to CFCs is draconian at best. If the CFC makes the qualified elect- ing fund (QEF) election, a U.S. shareholder will be forced to currently include in income his proportionate share of all of the CFC's operating income. If the QEF election is not made, the U.S. shareholder will be sub- ject to the interest charge rules, the excess distribu- tion rules (which can result in double taxation), and the loss of the foreign tax credit on dividends even if the dividends are not excess distributions. This is an oner- ous and unintended result which must be ended. CBEMA, therefore, strongly supports any provision that would completely exclude CFCs from PFIC treatment. A second problem with the PFIC rules relates to the definition of a PFIC. The PFIC provisions define a passive foreign investment company as any foreign corpo- ration that meets one of two criteria. An entity will be a PFIC where either 75 percent or more of its income for the taxable year consists of passive income, or where 50 percent or more of the average value of its assetscon- sists of assets that produce, or are held for the produc- tion of, passive income. The passive asset test is too broad. It makes certain controlled foreign entities which are engaging in substantial manufacturing or production operations abroad passive entities simply because they have cash-on-hand to finance their projected growth. Clearly, these entities are anything but passive. The decision to locate a manu- facturing operation in a foreign country is a business decision, not a passive investment decision. CBEMA, therefore, supports any proposal that would waive the 50 percent asset test where an entity is engaged in substan- tial manufacturing operations abroad. One legislative proposal circulated would waive the 50 percent asset test only where the entity is locat- ed in a foreign county which has a deficit in its trade balance with the United States. CBEMA believes that this additional limitation is objectionable for several rea- sons. First, the balance of trade problem that the U.S. has with certain foreign countries is a concern that when addressed by Congress should be done in areas other than the tax code. Such a requirement in the PFIC rules would be a dangerous precedent for other foreign tax rules. Second, the rule would be an unfair penalty for those entities that have already established their active manu- facturing businesses in countries whose trade balance with the U.S. is positive since it is extremely difficult to move such an active operation. Third, the rule would influence business decisions in ways that may make the operation less competitive than it otherwise could have PAGENO="0112" 102 been. Finally, because a country's trade balance with the U.S. will change from year to year, the rules would create an extra layer of uncertainty that is simply un- necessary in the tax area. Thus, although CBEMA strongly supports a waiver of the 50 percent asset test for CFCs that are engaged in substantial manufacturing abroad, where that waiver is limited solely to operations in countries with negative trade balances with the United States, CEEMA must object. Thank you for giving us the opportunity to speak to you about these very important issues. I am happy to answer any questions you have. PAGENO="0113" 103 Chairman RANGEL. Thank you, Mr. Kostenbauder. We will now hear from Mr. Loree. STATEMENT OF PHILIP J. LOREE, CHAIRMAN, FEDERATION OF AMERICAN ~ONTROLLED SHIPPING Mr. LOREE. Thank you, Mr. Chairman. My name is Philip J. Loree. I am chairman of the Federation of American Controlled Shipping. American Controlled Shipping, Mr. Chairman, has been in direct competition with foreign shipowning interests for more than half a century and during this period of time we have held a predominant position in international ship- ping. We have nothing to do with domestic shipping. Unfortunately, since 1986, that position has changed drastically. We are now losing tonnage at a rate four times that of the world fleet. We have, I am afraid, under the 1986 Tax Act, been facing a disincentive to invest and we are losing ships at a rate greater than one a month. We are declining in terms of our share of world carrying capacity. We have, since 1986, declined by some 30 per- cent. This industry has been grievously wounded by the 1986 act and I am here today to speak to one of the two provisions which have most seriously affected the industry and that is the inability of American companies to carry forward pre-1987 losses, to apply them against post-1986 earnings and profits. I believe that this is a question of basic equity, tax equity. Ship- ping is a very high-risk, very cyclical business. No one today can go out and buy a vessel and expect to make money right away. Quite frankly, shipbuilding prices are so high today that, if you went out and purchased a new vessel, you could not expect to be realizing `earnings and profits even today with the market higher than it was during the 10 years, starting at about the mid-1970's, when many of our companies were subjected to intensive competitive pressures, many suffered losses and many left the business. Our own federation lost a third of its members. We have today those companies which had the courage and the foresight to stay in this business and they are faced now with the fact that they cannot take the losses they had incurred prior to 1987 and apply them against post-1986 earnings and profits. We think that is very unfair, Mr. Chairman, and, as a matter of simple tax equity, needs to be changed. We find, when you apply this rule, to keep a vessel operating and maintained and insured and manned over a period of years, even to keep it in layup, is extremely expensive. To retain it over this period and then find that, since we are still in the business, we are to be treated as if we had not done that, puts us at a tremendous disadvantage. We are competing against foreign shipowning interests, only they have the right to apply untaxed or tax-deferred earnings in our business. We have nothing but current taxation under the 1986 act, so the inability even to bring forward our pre-1987 losses is ~`ea1iy unfair. One example of this unfairness deals with simple straight-line depreciation, and I hasten to add that these losses we're not the PAGENO="0114" 104 result of investment credit or ACRS. These were actual losses re- sulting from keeping these vessels in operation. If say, you and I went into partnership 10 years ago and bought a vessel for $100-it would be quite ~a small vessel-and then straight-line depreciated it $5 a year over the next 10 years and sold it today for $80, but during the period from 1981 through 1986 we suffered losses, as many companies did, we would effectively be subject to a tax on a gain of $30, we would be effectively taxed on our own capital, be- cause we would not have been able to write off that depreciation from 1981 through 1986 because of the losses we had incurred. That, we feel, is wrong and really deserves reconsideration by this committee. We are going to submit a written statement to the main commit- tee on reinvestment deferral. We believe that international ship- ping participation by American companies, by providing the United States, under its U.S. national sealift policy, with a reserve fleet of some of the most modern vessels in the world, is very important, and unless something is done, Mr. Chairman, I am afraid we are going to see the continual decline of this fleet so that no one bene- fits but foreign shipowners, and that is wrong. Thank you very much. [The prepared statement of Mr. Loree follows:] PAGENO="0115" 105 STATEMENT OF PHILIP J. LOREE FEDERATION OF AMERICAN CONTROLLED SHIPPING My name is Philip Loree, and I am Chairman of the Federation of American Controlled Shipping, or "FACS." I want to thank the Committee for extending me the opportunity to present our views on one of the critical issues to be considered here today, which involves the U.S. tax treatment of American controlled shipping. FACS members are American companies controlling merchant vessels registered under the laws of Liberia, Panama, the Bahamas and Honduras. These vessels operate on a global basis in international trade and thus are in direct competition with foreign owned vessels. They are also under Effective U.S. Control (EUSC) for requisition, use or charter by the United States in times of national emergency. Over the past fifteen years, substantial changes have been made in the way that the United States taxes international shipping, changes which have increased the potential u.s. tax exposure of American companies engaged in the international shipping business. Several of these changes have directly and adversely affected the international competitiveness of companies owning EUSC ships through controlled foreign corporations ("CFCs"). The result has been that in the past few years the carrying capacity of the American controlled EUSC fleet has been declining at an alarming rate compared to foreign controlled shipping -- a development I will return to later in my testimony. These changes in our tax laws have come at a time when the industry's foreign competitors have continued to receive generous tax and other support from their governments. In 1975 Congress taxed unrepatriateci CFC shipping income, except to the extent of reinvestment in certain shipping assets. I am unaware of any home country major foreign shipowners which restricts deferral in this way. The 1986 Act went a step further and eliminated any possibility of deferring tax on unrepatriated shipping income earned after 1986, thereby placing American controlled shipping at a distinct disadvantage in the world market. Given these pressures from foreign competition and the vital role American controlled shipping plays in our national security strategic planning, I believe that it is also critical to reexamine u.s. tax policy in this area. That is why I am here today. As this Committee is aware, the Tax Reform Act of 1986 imposed significant tax burdens on shipping CFC5. Beyond question, the two most important adverse changes in the 1986 Act are (1) the repeal of the rule allowing tax on CFC shipping income to be deferred if the taxpayer reinvests in qualified shipping assets, and (2) the complete denial of pre- 1987 shipping deficits which otherwise could be carried forward against post-1986 shipping income of the CFC. Although the reinvestment is~ue is not a subject of your hearing today, the pre-1987 reinvestment rule must be restored if our national policy is to maintain an internationally competitive fleet under Effective U.S. Control. Mr. Chairman, within the PAGENO="0116" 106 next few weeks, FACS will be submitting written testimony on the reinvestment issue for the record of the full Committee's hearings on the impact, effectiveness and fairness of the 1986Act. Your Subcommittee's review of the second issue, the denial of loss carryforward, is most welcome. In our opinion, this issue presents a clearcut case of tax inequity which should be rectified. International shipping markets are keyed to~.supplyof and demand for vessels and thus highrisk and cyclical in nature, with recurring :peaks and valleys with.. respect to profits and losses. The effect of disallowing the carryforward of pre-1987 CFC shipping losses is that the U.S. shareholders of shipping CFC5 will now be taxed on post-1986 income without the benefit of an offset for actual economic losses incurred during the years which set the stage for present profitability. The pre-1987 losses for the most part were attributable to a deep andprolonged recession primarily in the bulk sector of the ~shipping industry and were not the result of tax incentives such as ACRS and the investment credit which generally were not available to investments in EUSC ships. The imbalance and inequity generated by this rule are further demonstrated by the consequences resulting from the sale of assets held during loss years. Ships are often held for the purpose of producing future profits from operations or sales and therefore they may have to be held through extended loss periods in order to realize eventually the long-term values of the assets. By imposing current taxation, the 1986 Act effectively is taxing the profit which a shipowning company obtained only because it had the foresight --and the courage -- to hold the asset while it generated current losses. Because the 1986 Act does not permit an offset for a shipping deficit incurred prior to 1987, it has in effect, denied a deduction for all or a portion of the costs of carrying the ship during the loss years. This approach, when applied over the years that a given vessel is operated, could more closely approximate the imposition of tax on gross income rather than net income. These results seem particularly draconian when one considers how even straight line depreciation can be rendered meaningless for American controlled companies seeking to compete in one of the world's most capital intensive enterprises. Consider a situation where gain is realized on the sale of a ship held in loss years prior to 1987. A portion of the gain is necessarily attributable to depreciation allowed during those years. Not only is the deduction for this depreciation lost under the rule denying the carryforward of the pre-1987 losses, but also the gain on the sale of a ship after 1986 includes an amount equal to that depreciation -- a result tantamount to double taxation. In some cases, a tax could conceivably be imposed where there actually is ~p income at all. The disallowance of pre-1987 shipping losses suggests that the repeal of the reinvestment rule in the 1986 Act was treated as the practical equivalent of the elimination of deferral of CFC shipping income. In the past, when deferral of a particular type of CFC PAGENO="0117" 107 income was eliminated, Congress disallowed prior losses. While it is not clear why this approach was taken in those cases, it is clear that CFC shipping income has been subject to the CFC inclusion rules of Subpart F since 1975. CFCs which took advantage of the reinvestment provision merely postponed current recognition of such income, and are not assured permanent deferral. Since 1975, taxpayers which made qualified reinvestments of shipping income have been required to maintain separate accounts of the amounts reinvested. Any amount withdrawn from these accounts, including amounts withdrawn after 1986, are required to be included in income under Subpart F. Therefore, allowing pre-1987 CFC shipping losses to be carried forward against post-1986 CFC shipping income can and should be distinguished and treated differently from other situations where the carryforward of losses was disallowed. For these reasons FACS urges that Congress remove the restrictions on carrying pre-1987 shipping deficits forward against post-1986 shipping income of the CFC. This change is a matter of fundamental tax equity. It would represent an important step toward ameliorating the unduly harsh tax treatment in the 1986 Act. It would help to restore the competitive position of U.S. controlled shipping. Moreover, it would be consistent with the U.S. National Security Sealift Policy which relies on the Effective U.S. Control fleet in times of national emergency. In proposing this change, we emphasize that from our vantage point it is all too clear that the 1986 Act is having a debilitating impact on the internationally competitive status of the Effective U.S. Control fleet. Since 1986, American companies have been divesting equity and voting control over EUSC vessels, particularly newer vessels, to foreign interests at a rate greater than one vessel per month. The carrying capacity of the EUSC fleet has been plummeting at a rate of roughly four times the world rate, and its share of world carrying capacity which was 5% at the start of 1986, has dropped to 3.5% -- a 30% decline. The bottom line is simply that American controlled shipping is losing out to foreign controlled shipping, and predictably will continue to decline unless Congress acts to rectify this situation by restoring reinvestment deferral and the carryforward of pre-1987 -losses. In closing, I again thank the Committee for considering this and other important subjects here today, and I would be glad to answer any questions you may have. PAGENO="0118" 108 Chairman RANGEL. Thank you, Mr. Loree. Mr. McGrath. Mr. MCGRATH. Mr. Loree, obviously the change you seek would affect industries other than the shipping. I am wondering whether or not somebody has asked for and received a revenue estimate of your proposal? Mr. LOREE. We have not been asked. I do not know of anyone who has asked, Mr. McGrath. I think that it obviously has to be done. I believe that careful consideration is going to have to be given to what is happening to this fleet: It is being run down, and that means that the 1986 act is not going to provide great revenues to the United States. We are not talking in terms of great revenues coming in, because companies are disinvesting. They are giving away majority control to foreign ship-owning interests, because they cannot compete, under the circumstances. Just last month, Majestic Shipping Co., which had 2.2 million deadweight tons, had a transfer of 51 percent equity interest in the shipowning corporation to foreign interests, so that tonnage is lost to U.S. control and the company is out of subpart F. That is what the 1986 act is encouraging. So, what we have here is really an incentive to get out of the business, and that is a gift to foreign shipowning interests, which I think is a terrible mistake. So that has to be put into the equation. Mr. MCGRATH. ;i~wonder whether the others on the panel could comment as- to whether or not they have received any revenue esti- mates for the provisions that they all see as the same, they have recommended today. And if you do not, could you submit them for the record? Mr. EPSTEIN. I think, if I may just say, one thing that was stated is a very basic principle of equity here that I think goes beyond - just the revenue estimates. If there were true writeoffs, nothing fancy, no special tax incentives granted, which is maybe something that could beiooked at in changing the rule, the key is that if we look at the U.S. Government as our partners and funding it through acnntract known:as the Revenue Code, as sort of the con- tract between the -two 1parties as to how~we'~share revenue. If we kill the other partner by saying I am notgoing to bite certain ex- penses that were legitimate, you are not going to have a partner to help pay those expenses, so I think we all have a vested interest in this contract we use called the Code for the two partners to act eq- uitably with one another. Mr. MCGRATH. Thank you. I thank the Chairman. Chairman RANGEL. I thank the panel and you can rest assured that the staff and the committee members will be reviewing the in- equities that you presented to this committee for the purpose of bringing them in line with the Code, as the Code should be. Thank you very much. We have a colleague with us, Jim Slattery of Kansas, that would like to present a matter to the subcommittee. PAGENO="0119" 109 STATEMENT OF HON. JIM SLATTERY, A REPRESENTA'rIyE IN CONGRESS FROM THE STATE OF KANSAS Mr. SLATTERY. Mr. chairman, thank you very much. I appreciate the opportunity to appear before your subcommittee. Today I would like to visit with you very briefly about H.R. 3949, which I have introduced, relating to the earned income tax credit and making it available to military personnel who are stationed over- seas. Mr. Chairman, I have a written statement that I would like to provide the committee for the record, and I will just very briefly describe to you what the current situation is and why I think it should be corrected. Chairman RANGEL. Without objection, your full statement will be placed in the record. Mr. SLATTERY. Thank you, Mr. Chairman. Under existing law, military personnel who are stationed over- seas are not entitled to receive the earned income tax credit. To make a long story short, I think that is unfair, and there is no reason why a private first class living in Leavenworth, KS, should be entitled to an earned income tax credit while one stationed over- seas would be denied eligibility for the earned income tax credit. Chairman RANGEL. We received favorable testimony in support of this from DOD, and Treasury has agreed to this. Mr. SLATTERY. That is correct. Treasury is supportive of this. The Department of Defense is supportive of it. Chairman RANGEL. They testified this morning. Mr. SLATTERY. It is basically revenue neutral. There is a good reason for that, because one of the other provisions in that legisla- tion will clarify some administrative problems they have had with the treatment of the earned income tax credit for troops that are in this country. Under existing law, again, if you are living off post and get a cash payment to help deal with your quarters allowance or housing allowance, that counts toward the income eligibility for the earned income tax credit. However, if you are on post and get housing provided, it doesn't count toward it. So by equalizing that and making that all the same and providing that a portion of your housing allowance, the base allowance, will count toward income eligibility for the computation of the earned income tax credit. That picks up some money~ But it also establishes in my judgment a much more equitable treatment of all our military personnel. Then the little bit of revenue that is picked up there will offset the cost of extending the earned income tax credit to those troops that are stationed overseas who are currently not eligible for it. In my opinion, this is a measure that will establish some badly needed equity in terms of how the earned income tax credit is available to our military personnel, and we are talking about those people, as you know, making less than $19,340 a year. As you know, that earned income tax credit phases out once the income goes above $10,500, and it is totally eliminated at the $19,300 level. So we are talking about, for the most part, lower middle income military personnel, and I think this is something that is long over- due. I think it's basically just been an oversight that I hope the committee would give favorable consideration to changing. PAGENO="0120" 110 As you know, Treasury supports it, DOD supports it, and various organizations representing military personnel also support it. I would be happy to try to answer any of your questions. [The statement of Mr. Slattery follows:] PAGENO="0121" 111 1440 Lo~owon,ii lOUSE OTTICE SUING 111 CAPIToL lowe ~ DC 20515 400 SW. Rni STREET (202) 225-6601 TOPEKA, KS 60603 - (913)295-2811 (ZCUitj~t'ts~ of tL,c 1LIiütc~j ~`tatc~ 31)otwe of 1~cptt~tnt~tj&it~ JIM SLATTERY Sscorw DiSTRICT. KANSAS * STATEMENT OF THE HONORABLE JIM SLATTERY * BEFORE THE SELECT REVENUE MEASURES SUBCOMMITTEE OF THE HOUSE COMMITTEE ON WAYS AND MEANS WEDNESDAY, FEBRUARY 21, 1990 I would like to thank you for the opportunity to testify before the Ways and Means Select Revenue Measures Subcommittee on the behalf of legislation I have introduced, H.R. 3949, to extend eligibility for the Earned Incose Tax Credit (EITC) to military personnel and their families stationed overseas. I as pleased to learn that your subcommittee has an interest in correcting this long-standing injustice against thousands of American servicesesbers and I would like to briefly mulninarize for the coSenittee the provisions of H.R. 3949. Under current law, a family that earns less than $20,264 is eligible for an -EITC. This credit, which is phased-out as wages pass $10,730, can be used by low-income families to meet their daily living expenses - from groceries, to child care, to medical expenses. For eligible low-income families, the EITC provides an important supplement to their meager salaries. However, an unfortunate oversight has prevented eligible military families, who have orders to serve outside the United States, from roceiving this credit. Instead, an estimated 25,000 low-income families, who are serving their country abroad, have been forced to forgo eligibility for an EITC. 11.10. 3949 would end this inequity. This bill would ensure that all eligible military families, regardless of where they are stationed, will continue to receive an EITC. 11.10. 3949 also addresses certain administrative concerns expressed by the Internal. Revenue Service and the Department of Defense. This bill would clarify the definition of earned income when calculating the EITC and would codify the definition of military earned income recently adopted by the IRS. Finally, H.R. 3949 would improve the current procedure for advance payment of the EITC to prevent future overpayments. 11.10. 3949 has been endorsed by the U.S. Department of Defense, the Treasury Department, and .the Internal Revenue Service. In addition, this legislation has the support of several military organizations including the National Military Families Association and the Non-Commissioned Officers Association. Later today and again tomorrow, the subcommittee will be hearing tostisony from government agencies and concerned groups who support 11.10. 3949. I as pleased that this legislation has received widespread nJorseseist end I am hopeful that your committee will consider 11.10. 3949 as C free-standing proposal that warrants tImely consideration by the Ways and Means Committee. Ir c!csing, I appreciate this opportunity to discuss 11.10, 3949 end ~iaCSld bs~ pleased to respond to any questIons you say have regarding this :~gir»=.CtjoT. PAGENO="0122" 112 Chairman RANGEL. Makes a lot of sense. We are glad that you brought it to our attention. Mr. McGrath. Mr. MCGRATH. Rangel and McGrath both. Mr. SLATTERY. Thank you very much. Chairman RANGEL. Thank you, Jim. Our next panel: Microsoft Corp., MichaeL Brown, treasurer; Coa- lition on the PFIC Provisions, Robert Hirt, director of tax, Mea- surex Corp.; Zurich American Insurance Co. and Munich American Reinsurance Co. William M. Stroud and Bernhard Michael; and the Canadian Life and Health Insurance Association, Raymond Britt. [Pause.] Mr. MCGRATH. Mr. Brown, why don't you start off? STATEMENT OF MICHAEL BROWN, TREASURER, MICROSOFT CORP., REDMOND, WA Mr. BROWN. Thank you. My name is Mike Brown, and I am treasurer of Microsoft Corp. Microsoft is the world's largest microcomputer software company. We develop, produce, and sell a wide variety of software products. I appreciate very much the opportunity to appear before the sub- committee today. I am here to urge adoption of a proposal to clari- fy current law regarding the application of the subpart F foreign tax rules to computer software companies. I would like to commend Representative Chandler's efforts in seeking such a clarification. In today's hotly contested and highly competitive computer mar- kets, we believe software is the last arena where U.S. companies continue to hold the edge. The concern I raise today is the tax treatment of the foreign manufacturing operations of these U.S. companies. To achieve our present level of worldwide sales, Microsoft had to focus significant effort on the fast-growing markets of Western Europe. Initially, we filled orders for Europe from our plant in Redmond, WA. However, shipping delays in sending our products halfway around the world and our inability to respond quickly to the market from this distance soon resulted in orders lost to the competition. We soon learned, as other U.S. companies before us have learned, that to make a significant entry into a foreign market we had to have a localized production facility nearby. And so we estab- lished a European manufacturing subsidiary which produces and sells our products to foreign sales subs in nearby countries for eventual sale to local customers. My concern today arises from the way the software industry sells its product. This is the so-called box-top license issue. A box-top li- cense is a license often written on the outside of the product con- tainer itself to which the customer presumably agrees simply by the mere act of opening the product package. The industry sells its products in this manner because of the ease with which unauthor- ized copies of our products can be made and because of the varia- tion in and haphazard enforcement of copyright laws around the world. PAGENO="0123" 113 Thus, the purpose of the license is to limit the customer to one copy, not to give him additional rights, which is the concept nor- mally associated with a license. We strongly believe that sales made by the foreign production subsidiary of a U.S. software com- pany to a sales subsidiary for resale to customers are properly re- garded as sales for subpart F purposes in spite of the box-top li- cense. The purchaser is acquiring perpetual use of the product in exchange for a one-time fixed purchase price, and this is, in es- sence, the same way that traditional products are sold by other U.S. industries operating abroad. While we believe under present law that the true sales nature of these transactions dictates that their subpart F treatment be on the basis of the foreign-based company sales rules applicable to other U.S. industries producing abroad, we also believe that an ex- press clarification of this aspect of current law is desirable. The proposed clarification would put potential subpart F ambiguity to rest in light of differing positions the IRS has taken in other con- texts on the question of whether income from software sales is sales income or royalties. The proposal before you would simply clarify current law by ex- pressly providing that when a U.S. software company's foreign pro- duction subsidiary manufactures and sells products to a foreign sales subsidiary for resales to customers along with a box-top li- cense, that production subsidiary's subpart F income is to be deter- mined under the foreign-base company sales rules applied to other U.S. industries producing overseas. Mr. Chairman, if our industry is to retain its edge in today's highly competitive market, we must not be placed at a disadvan- tage in the tax treatment of our overseas production operation rel- ative to other U.S. industries that are producing and selling abroad in essentially the same manner that we do. Thank you very much. [The statement of Mr. Brown follows:] PAGENO="0124" 114 STATEMENT OF MICHAEL BROWN MICROSOFT CORPORATION My name is Michael Brown. I am Treasurer of Microsoft Corporation. Microsoft, headquartered in Redmond, Washington, is the largest microcomputer software company in the world and is engaged in developing and producing a wide variety of software products. Since our founding in 1981, sales have grown from $25,000,000 to an expected sales total of over $1 billion for our year ending June 30, 1990, of which well over 50 percent will be foreign sales. Microsoft presently employs 3,700 people in the United States and 4,800 people worldwide. I very much appreciate the opportunity to appear today before the Subcommittee on Select Revenue Measures to urge the adoption of a proposal to clarify current law regarding the application of the Subpart F foreign tax rules to computer software companies. we wish to commend the efforts of Rep. Chandler in seeking such clarification. i. Software: The Remaining Competitive Edge for 1bS~, Companies in Computer Technology Computer software today constitutes the cutting edge of the information processing industry, with software now largely fueling the dramatic advances that continue to be made in computer technology. Equally important, computer software is the primary area of computer. technology in which U.S. companies continue to hold an edge in the hotly competitive world computer markets. II. Establishing Operations Overseas to P~n8trate Foreign Markets In an effort to expand our worldwide sales, Microsoft has focused significant efforts on the fast-growing market of Western Europe. Microsoft initially tried to fill orders for this overseas market directly from the United States. However, shipping delays from having to send the products halfway around the world and the inability to respond quickly to market changes and customer problems regarding these technologically sophisticated products resulted in significant lost foreign orders. Therefore, we learned early on -- as countless other u.s. industries had learned in the past -- that if we were going to make any significant entry into this large foreign market, it would be necessary to have a regionalized production presence near that market. iii. Necessity for Selling Software Products to Customers ~comoanied by a License Software companies develop, produce, and market products to customers in the same manner as other U.S. companies. Under the customary structure for U.S. software companies that have established production operations abroad, the U.S. company utilizes one or more foreign subsidiaries to produce the units of software products that are then sold to foreign sales subsidiaries in the various countries for local sale to customers. Because of the much greater ease with which a software product may be copied by a customer or others, it is the practice of the software industry in the United States and abroad to transfer its products by means of licenses. The so-called "box-top" license is one to which the customer agrees simply by opening the product's package. PAGENO="0125" 115 This industry practice of transferring the products by license arose because of the vagaries of copyright protection. It is absolutely essential that a'U.S. software company attempting to market its products to customers around the world protect its intellectual property. There is a drastic country-by-country variance in the degree to which the U.S. software company's copyright is accorded local legal recognition. For example, in some countries the U.S. software company's copyright has been virtually ignored by the local business community and j.udiciary, with the local law permitting a domestic "pirate" company to blatantly copy and sell the U.S. company's software product, so long as the local pirate's sales of the product occurred within the borders of that country. As with the other U.S. industries producing overseas, the typical arrangement in the software industry is as follows. The software company's foreign production subsidiary produces units of the product that are held in inventory awaiting orders from the various sales affiliates, Upon receipt of these orders, product units are shipped to the sales affiliate, which is then billed at a one-time flat per unit price for each product unit ordered. The sales subsidiary in turn sells the product to the customer, such as independent distributors or end-users, for a one-time flat price charge that entitles the customer to perpetual use of the product unit. This arrangement has the same incidents of a sale as in the case of the other U.S. manufacturers producing overseas. Iv. Proper Characterization of Software Product Sales Proceeds for Suboart F Purooses A. Characterization as Sales of Finished Product Units For purposes of the Subpart F provisions governing the operations of foreign subsidiaries of U.S. companies, if these software product transactions are characterized as sales, the substantiality of the foreign production subsidiary's operations will be determined under the manufacturing or production test of the section 954 regulations that is applicable to the other U.S. industries producing products abroad. ~ Treas. Reg. § l.954-3(a)(4). If instead these sales proceeds are viewed as passive royalty income merely because the sale is subject to a license to prevent unauthorized copying by the customer, such royalty income could be subject to treatment under the foreign personal holding company income provisions of Subpart F which could automatically deny the benefits of deferral that are available to other U.S. industries producing abroad. We strongly believe that when the U.S. software company's foreign production subsidiary produces and sells units of the product to the foreign sales subsidiary which then resells to customers, these transactions are properly regarded as sales for Subpart F purposes. The purchaser is acquiring perpetual use of the product unit in exchange for a one-time flat purchase price, While we believe that the true sales nature of these software product transactions dictates under current law treatment for Subpart F purposes under the foreign base company sales rules, we also believe that an express clarification of current law in this respect is desirable. Such a clarification would put to rest the potential ambiguity that could arise in the Subpart F context in light of the differing positions taken by the I.R.S. regarding software in a series of private rulings in other contexts, PAGENO="0126" 116 In a private letter ruling in the personal holding company context (LTR 8450025 (September 7, 1984)), the I.R.S. had earlier expressed the view that income earned by the software company from its sales of product to customers was royalty income because the actual transfer of the product unit was accompanied by a license. The Service reasoned that the payment by the customer was in exchange for a license by the software company of the underlying protected proprietary rights in the software and so fell within the literal definition of royalties under Code section 543 as being amounts received for the privilege of using secret processes, formulas, and other similar property. This I.R.S. position treating software income as passive personal holding company income was reversed legtslatively on a retroactive basis by the Tax Reform Act of 1986 (Code sections 543(d) and 553(a)(l)). In subsequent technical advice memoranda in the Domestic International Sales Corporation (DISC) context, the Service adopted a different conceptual view of customer transactions in the software industry that essentially treated the transactions as sales of finished products. ~ National Technical Office Memoranda (LTR5) 8549003 (August 16, 1985) and 8652001 (Undated). ~ ulaa GCM 39449 (related to LTR 8549003). In each case, the issue was whether software products `qualified as "export property" within the meaning of Code section 993 for purposes of receiving DISC benefits. The basic question was whether the transfer of the software tape to the customer constituted a sale or license of the copyright ~itself to which the software was subject (and hence would be excluded~frOm "export property") or instead was a sale of a copyrighted finished product or inventory item (which would qualify as export property). In both of these technical advice memoranda, the Service held that the software product qualified as export property, reasoning that what was being sold to the customer was a copyrighted finished product item, as opposed to a transfer of rights in the underlying copyright itself. In so holding in LTR 8549003, the Service `noted that the customers generally acquired the software tapes under license and maintenance agreements giving the customer the right to use the tapes in perpetuity. The Service concluded: "These arrangements generated for (the software company] income from sales." The Service noted that the software company was not selling its proprietary rights in the source code of the software and that the customer was barred from reproducing the product. In addition, in both rulings the Service cited as additional support for its holding the definition of manufacturing or production of property under Treas. Reg. § l.993-3(C)(2), a test that parallels the manufacturing or production test under the foreign base company sales rules of Subpart F (Treas. Reg. § l.954-3(a)(4)) which we maintain should govern the determination of Subpart F income in the case of a software foreign production subsidiary producing and selling products to foreign sales affiliates for resale to customers. Finally, this treatment of software products as export property was reaffirmed by regulation for Foreign Sales Corporation (FSC) purposes. ~ Treas. Reg. ~S l.927(a)-1T(f)(3). Finally, in a private ruling released on February 2, 1990, the I.R.S. observed that a passive royalty income characterization should not be applied to a software company's income from marketing products to customers so as to disqualify the software company from S corporation status. ~ Private Letter Ruling 9005028 (November 6, 1989). In the ruling, the Service was applying the 1986 Act change to the personal holding company provisions for active software businesses (Code PAGENO="0127" 117 section 543(d)) to a software company that had elected S corporation status. While noting that passive investment income as determined for 5 corporation purposes technically includes "royalties", the Service concluded that software product income qualifying under the 1986 Act change should not be characterized as passive royalty income for S corporation purposes. The Service reasoned that it made no sense to apply the passive income limitation to disqualify from S corporation status a software company that qualified as an active business under Code section 543(d). Thus, while the `I.R.S. has approached software product income somewhat differently in each context, the approach of the more recent rulings seems to have been to try to resolve the characterization issue in such a way that reflects the active operating business nature of such income. A similarly practical approach clearly is warranted in the Subpart F context. The software purchaser is acquiring perpetual use of the product unit in exchange for a one-time, lump sum purchase price payment. The purchaser is not acquiring some interest in the underlying copyright and other proprietary rights of the software company in its software. Indeed, that is the specific purpose of the license to prevent any suggestion that the customer has acquired any such rights and thus to prevent unauthorized copying of the product by the customer or others. Hence, the fact that the software companies sell their products to customers acc6mpanied by a license does not transform the substance of this sale transaction. Therefore, we strongly believe that when the U.S. software company's foreign production subsidiary produces and Eells units of the product to the foreign sales subsidiary for resale to customers, these transactions are properly regarded as sales for Subpart F purposes. B. Characterization as Passive Income Would be Imp~gp~ That these software product transactions should be characterized as sales is further confirmed by the consequences that could flow from treating these sales proceed's instead as royalties merely because the sale is acôompanied by a license to prevent unauthorized copying by the customer. Since royalties traditionally have been considered passive income, such a characterization could subject these active software businesses to a series of mechanical tax provisions that were adopted to deal with abuses associated with passive income. * Such a passive income characterization would have made most software companies personal holding companies subject to an onerous penalty tax. As noted above, the Tax Reform Act of 1986 overturned that result on a retroactive basis, a legislative effort which Microsoft helped lead. * Such' a passive income characterization could disqualify software companies from S Corporation status. The Ways and Means Committee version of the Omnibus Budget Reconciliation Act of 1987 (sec. 10347) included a provision to overturn that result, and in LTR 9005028 the Revenue Service has rejected such passive, characterization to avoid disqualifying S corporation status. * Such a passive income characterization also could cause the income earned by the U.S. software company's foreign production operations to be treated as Subpart F foreign personal holding company income. PAGENO="0128" Thus, if characterized as passive royalties, the income earned by these foreign production subsidiaries of U.S. software companies could constitute "tainted~ Subpart F income under Code section 954(c) subject to immediate U.S. tax at the U.S. parent company level. As a result under such a characterization, the U.S. software company could be deprived of the same benefits of deferral of U.S. tax long enjoyed by other U.S. industries producing abroad to serve foreign markets. As the legislative history of the 1986 Act affirms, Subpart F is essentially directed at "readily movable" passive income that can be shifted among jurisdictions having no substantial relationship to the transaction merely in order to minimize U.S. tax liability. ~ ~ H.R. Rep. No. 99-841, 99th Cong., 2d Sess. (1986), Vol. II, 11-614 through 11-626; Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 198k (May 4, 1987), 964-971. By contrast, the foreign subsidiaries of U.S. software companies at issue here are conducting substantial active, ongoing production and development operations, with the foreign affiliate typically undertaking all of the steps of the production process for the product. The business operations of these foreign subsidiaries require a considerable long-term investment in permanent plant facilities and equipment that cannot simply be shifted from jurisdiction to jurisdiction for tax reasons. It also should be noted that the transactions between the U.S. software company foreign production subsidiary and the foreign sales subsidiaries, as well as the transactions between the production affiliate and the U.S. parent, must withstand the scrutiny of the Code section 482 transfer pricing standards, including the stringent requirements added by the 1986 Act. The highly competitive foreign software market requires a regionalized production presence in order to effectively penetrate that market. Thus, for U.S. software companies it is not a question of using a foreign subsidiary as a repository for passive income that would have been earned in any event wherever the repository was located. CONCLUSION When the U.S. software cornpany~s foreign production subsidiary produces and sells units of the product to the foreign sales subsidiary for resale to customers, these transactions are properly regarded as sales for Subpart F purposes. The purchaser is acquiring perpetual use of the product unit in exchange for a one-time flat purchase price in the same manner as the products produced by other U.S. industries operating abroad. While we believe that the true sales nature of these software product transactions ~dictates under current law treatment for Subpart F purposes under the foreign base company sales rules applicable to other U.S. industries producing products abroad, we also believe that an express clarification of current law in this respect is desirable to permit the U.S. software industry to continue to compete effectively abroad in hotly contested world markets. ~GISLATIVE PROPOSAL TO CLARIFY CURRENT LAW The proposal simply would cl3rify~ current law by expressly providing that in the case of a U.S. software company~S foreign production subsidiary producing and selling products to foreign sales subsidiaries for resale to customers accompanied by a license, the production subsidiary~s income is to be determined for Subpart F purposes under the foreign base company sales rules applicable to other U.S. industries producing products abroad. 118 PAGENO="0129" 119 Chairman RANGEL. Thank you, Mr. Brown. We'll hear now from Mr. Hirt. STATEMENT OF ROBERT W. HIRT, ASSISTANT CONTROLLER AND DIRECTOR OF TAXES, MEASUREX CORP., CUPERTINO, CA, ON BEhALF OF COALITION ON THE PFIC PROVISIONS Mr. HIRT. Thank you, Mr. Chairman and Mr. McGrath. My name is Robert Hirt. I'm the assistant controller and director of taxes of Measurex Corp., and I am here today to testify on behalf of the Coalition on the PFIC Provisions. I am testifying also with the support of the American Electronic Association and the Tax Executives Institute. The PFIC provisions, we believe, have an anticompetitive impact on our company and the companies in our coalition, and create an extreme compliance burden. By way of example, I would like to take my company, Measurex Corp., which is a high-technology company located in Silicon Valley that produces a large computer- based electronic control system primarily used by the pulp and paper industry, but also by the pharmaceutical, rubber, plastic, glass, chemicals, metals, and other industries. Measurex has 63 percent of its business overseas and is, there- fore, a very large exporter of high-technology equipment. We have manufacturing facilities in Cupertino, CA, and Waterford, Ireland. The facility in Waterford supplies manufactured equipment for our European sales and service subsidiaries. It is the sales and service subsidiaries that provide PFIC problems for our corporation. The sales and service subsidiaries typically sell to the customer and re- quire a fairly large upfront deposit from the customer. This cash deposit will remain on the balance sheet of the sales and service subsidiary until the product is shipped out of our Irish plant. The cash from these deposits on the balance sheet, even though these are operating sales and service subsidiaries, will convert these small sales and service subsidiaries into PFIC's under the asset test. This is because only the passive assets are looked at, which in our case would be the cash on the balance sheet, not the offsetting liabilities. The PFIC rules do not permit exceptions for why the cash is on the balance sheet or for how long it is on the balance sheet. I addressed this problem with our European finance managers at a meeting 2 weeks ago. In an all-day meeting, we addressed the compliance burdens of doing an asset test on a quarterly basis. Prior to the end of each quarter, I need to call the finance manag- ers to find out what the receivable collection probability is, and find out what the quarter-end cash balances might be. The operat- ing assets of these small companies are fairly minor, because most of our technicians are out~ in the field and the plants-in our German plants and our Finnish plants-we don't have a need for much brick and mortar to operate our subsidiaries. So the cash bal- ances from these customer deposits produce PFIC status through- out our European operations and throughout the world, for that matter. In 1989, we had eight PFIC's as a result of this. Back in Cupertino, the tax department is called upon to analyze all this additional balance sheet information and come up with a 30-860 0 - 90 - 5 PAGENO="0130" 120 rational plan. Some of the rational plans we have seen include fi- nance managers volunteering to spend additional money for capital expenditures just so we can satisfy the PFIC asset test. Now, that is absurd. We don't want our finance managers planning in an ir- rational, uneconomic manner. We want our business to grow and to go forward on a consistent, logical and economic process, rather than being motivated by any kind of tax reasons. The PFIC provi- sions-in particular, the asset test-are what produce this problem for us. Other companies in the coalition have noted problems such as subsidiaries that were set up to protect patents and trademarks. Now, these subsidiaries are very small operations, but the cash that they need to capitalize the company causes them to be PFIC's. We are talking hundreds of hours of compliance, computer pro- grams, and new IRS forms for every multinational company that operates abroad in a noncapital jntensive manner. I also think the revenue estimates for the PFIC provisions are in- accurate because in most cases the sales and service subsidiaries, in particular, in which we operate are located in high-tax countries. Thus, the foreign tax credit mechanism offsets most of the addi- tional revenue from the PFIC provisions. But the PFIC compliance burden is unbelievable. I would like to recommend that the original House and Senate bills' provisions for the exclusion of controlled foreign corporations from the PFIC provisions be reinstituted. Another example of a measure that could solve much of the compliance problem would be the elimination of the asset test. Our coalition believes that the simplest, most direct method of dealing with this matter would be to exclude CFC's from the PFIC regime. This approach is consist- ent, too, with what Mr. Gideon and Treasury said this morning. Simplicity is something that we are all striving for. When simplici- ty coincides with sound tax policy, we think that's a good combina- tion. Thank you, Mr. Chairman. [The statement and attachment of Mr. Hirt follow:] PAGENO="0131" 121 TESTIMONY OF ROBERT W. HIRT ASSISTANT CONTROLLER AND DIRECTOR OF TAXES OF MEASUREX CORPORATION ON BEHALF OF THE COALITION ON THE PFIC PROVISIONS presented at THE HEARINGS ON MISCELLANEOUS REVENUE MEASURES BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS in connection with Modification of the Passive Foreign Investment Company (PFIC) Provisions, Item A.5. February 21, 1990 I. Introduction. My name is Robert W. Hirt, and I am Assistant Controller and Director of Taxes of Measurex Corporation. I am appearing on behalf of the Coalition on the PFIC Provisions, a group of thirteen companies listed at the end of my testimony. The American Electronics Association ("AEA"), in which Measurex and many of the companies in the Coalition are members, also has in the past urged that the Passive Foreign Investment Company ("PFIC") provisions exceeded their intended scope and needed modification. Accordingly, the AEA supports my testimony. I am testifying here today because of the adverse impact of the PFIC provisions on our international competitiveness, as well the extreme compliance burden we have all experienced in coping with these provisions. These problems stem from the unnecessary overbreadth of the PFIC provisions, which can reach foreign subsidiaries of United States companies conducting active manufacturing - and selling activities. The overly broad scope of the PFIC provisions is most egregious in their application to United States-controlled foreign subsidiaries. The anti-abuse provisions of Subpart F of the Code have applied to such controlled foreign corporations ("CFCs") since 1962. The Subpart F provisions carefully delineate the difference between tax-abusive use of foreign subsidiaries by United States companies, and the necessary use of foreign subsidiaries to compete in the international marketplace. These provisions represent Congress's considered judgment on the use of foreign subsidiaries, and should not have been disturbed. The PFIC provisions as originally drafted by the House in 1985 and the Senate in 1986 left this considered judgment in place by explicitly excluding the application of the PFIC provisions to United States-controlled foreign subsidiaries. Rather, they were directly and narrowly targeted at the perceived abuse--United States taxpayers with minority interests in offshore mutual funds controlled by foreigners who were reaping substantial tax benefits from the failure of Subpart F and other anti-abuse provisions to cover them. Nevertheless, the statutory language of the PFIC provisions as enacted dropped the exclusion of United States-controlled foreign subsidiaries. Now, every United States company that does business using foreign subsidiaries needs to monitor the PFIC provisions to ensure that they do not apply, or, if they do, that they have no harmful effect. In addition, these provisions must be fully analyzed every time foreign operations are changed or modified in response to changes in the business environment. PAGENO="0132" 122 U. Negative Impact on Measurex. I believe Measurex's experience has been typical. By way of background, Measurex was founded in the true entrepreneurial spirit in 1968 by David A. Bossen, who is still our President and Chief Executive Officer. Measurex is the leading United States independent supplier of sensor-based computer systems that measure and control continuous, batch and discrete manufacturing processes. Measurex's Computer-Integrated Manufacturing Excellence (CIMx®) product line ensures efficient economic results for customers by increasing productivity, reducing raw material usage and energy consumption, hnd improving product quality and uniformity. The principal industries served by Measurex are pulp and paper, plastics, metals, rubber, chemicals, glass and pharmaceuticals. Headquartered in the heart of Silicon Valley in Cupertino, California, Measurex employs 2,770 people located in offices and plants in 23 countries. Almost half of these employees are in the sales and service organization, serving customers located in 45 countries. In 1989, 63 percent of Measurex's $285.3 million in revenues were from non-United States customers. Export sales of United States-manufactured products amounted to $61 million in 1989. To ensure that our products can be sold competitively in Europe, we operate a manufacturing subsidiary in Waterford, Ireland. Even so, its operations require components manufactured by Measurex in the United States. For example, in 1989 our Irish manufacturing subsidiary imported $16 million in components from the United States. Our foreign-based sales and service subsidiaries are critical to our success in the international marketplace, as foreign purchasers of our products must be assured of manufacturer support after the purchase. For example to ensure uninterrupted operating results for our customers, our engineers are located on- site in many countries. Virtually all of the income earned by our subsidiaries is operating income, not Subpart F income, because our foreign subsidiaries are operating in the manner approved by Congress. Traditionally we have reinvested the income earned by those foreign subsidiaries in additional overseas expansion, thus increasing our export sales. Nevertheless, we must now carefully monitor these subsidiaries to ensure that the PFIC provisions do not apply; if they did, expansion of our overseas markets would be slowed by the additional administrative and tax costs of financing that expansion. Our problem stems from the "asset test" for PFIC status. Under that test, ~y foreign corporation that has, on a quarterly average basis, more than 50 percent of its assets held in "passive" investments, such as cash and short-term deposits (including working capital), is considered a PFIC. Our foreign finance managers are now required to monitor and report anticipated cash balances prior to each quarter-end in order to check the PFIC asset test. Since we manufacture high-cost specialized computer control equipment, our foreign subsidiaries collect deposits from customers at the time of the order. Typically, the cash deposit is held by the foreign subsidiary until the product is shipped. The deposit and most of the remainder of the sales price is then remitted to the manufacturer in the United States or Ireland. The business reason for the deposit requirement is twofold: (i) ease of refund if required, and/or (ii) local country exchange control or customs rules. But these deposits expose our foreign sales subsidiaries to PPIC status. Therefore, in a perfectly normal business operation, our foreign sales subsidiaries are going to fail the asset test, and become PFIC5. This happened in 1989 in eight countries. Due to the foreign tax credit mechanism, no additional PAGENO="0133" 123 United States income tax was due as a result of the PFIC provisions. Nevertheless, we spent hundreds of documented non-productive hours moving the numbers around on worksheets, on new computer programs and, of course, on new IRS forms. Only last week I returned from Europe where I spent several days with our foreign finance managers dealing with United States tax compliance issues, much of it devoted to compliance with the PFIC provisions. We have spent substantial time working on ways to prevent PFIC status. For example, "active" assets can be increased by not collecting receivables on a timely basis; the cash received would be "passive." Thus, careful handling of the receivables/cash situation as each quarter end approaches may prevent the application of the PFIC provisions. Of course, this type of exercise is absurd. Moreover, events beyond our control can trigger PFIC status. For example, if a sales subsidiary is prevented by. foreign exchange controls from repatriating cash from sales, the subsidiary may become a PFIc. As a result of my attempts last week to clarify the PFIC rules to our European finance managers, we have just received a request for capital expenditures from one of them that uses PFIC as the "key financial justification" for the purchase. Our competitive flexibility is damaged by the PFIC provisions since they attempt to tax operating income of foreign subsidiaries with "too much cash," in effect penalizing success. Our manufacturing operations in Europe are currently supplying most of our products to the European market. We conduct that manufacturing in Irc~and, which temporarily allows us a low tax rate. But we would have to manufacture in one or another EC country in any event to compete effectively in the EC countries; given that business reality, we chose the optimal country for manufacturing operations from a foreign tax point of view. Products manufactured in EC countries enjoy favorable customs rules and other benefits, and as European integration goes forward towards 1992, these benefits, relative to manufacturing in the United States, will increase. Freight costs are substantially reduced, of course. Because of these factors, our manufacturing operation competes very effectively within the EC market with some very large competitors in West Germany, Japan, and Finland. The profits from that success are earmarked for future expansion. That expansion will again increase our United States export sales to meet the new demand created by the expansion. Although our manufacturing subsidiary is not a PFIC, and will not be in the near future, it would be helpful if those profits could be used for expansion or operational needs at the time when it is economically sensible to do so, rather than when it is necessary to do so to avoid PFIC status. Our foreign competition does not face such impediments to rational economic growth. ifi. Negative Impact on Other Coalition Members' Foreign Operations. Other members of our group have had similar experiences. In one case, the PFIC provisions have both hampered competition in a high- tax jurisdiction, and led to a decrease in United States tax. This case involves a member of our group which conducts active operations in the United Kingdom. It discovered to its surprise that its United Kingdom corporate structure, established to secure the benefit of lower United Kingdom tax costs, contained 23. PFICs. It has since restructured to avoid this problem, but at the cost of higher United Kingdom taxes. Now, because of the increased costs, it is having trouble competing with United Kingdom companies in its line of business. Those - companies, of course, are free to take advantage of the special benefits accorded under United Kingdom tax law to structures *that, under the PFIC provisions, would be primarily composed of PFICs. Importantly, because of the restructuring (i) there is no additional United States tax arising from the PFIC provisions, and (ii) the United States tax paid has actually been reduced by the increased United Kingdom taxes, all of which are creditable. PAGENO="0134" 124. Moreover, the PFIC provisions can affect important business decisions. For example, one of our members recently had an opportunity to sell a less profitable portion of one of its foreign businesses, under favorable terms. However, the elimination of this less profitable activity in its foreign subsidiary would have resulted in reduction of the "active" assets of that subsidiary, thus exposing the subsidiary to PFIC status. As a result of this exposure, the company has deferred the sale. Another member was unable to establish a finance entity in Europe because of the PFIC provisions, and, as a result, has lost some business in Europe it would otherwise have had. One Coalition member is required to maintain a substantial number of foreign subsidiaries holding small amounts of cash solely to preserve patent and trademark rights to its products in foreign jurisdictions, which cannot be protected otherwise. These foreign subsidiaries, of course, are largely PFICs. This company, which has over 100 foreign subsidiaries, has found the compliance burden to be substantial. As with Measurex (but on a far larger scale), they must review on a quarterly basis the financial statements of each of these companies, and prepare the various returns and statements now required by the PFIC provisions. Because of the changes in the foreign tax credit rules, this company repatriates virtually all its foreign earnings annually in any case, and bears no additional tax as a result of the PFIC provisions. Overall, the members of our Coalition have found that they must devote substantial time and effort to dealing with the PFIC provisions. The PFIC provisions must be factored into most business decisions involving expansion or restructuring of foreign operations, and add substantial compliance problems on an ongoing basis. Because of these efforts, however, we have generally been able to keep from paying any additional United States taxes solely as a result of the PFIC ~provisions. But our administrative costs for foreign operations have been substantially increased. IV. The Asset Test-Core of the Problem. The asset test, with its arbitrary assumption that the character of assets is directly related to the character of a foreign subsidiary's activities, is the core of the problem. As Measurex's case illustrates, it is all too easy for an active sales and service foreign subsidiary to become a PFIC on the basis of that test. In addition, it may force us to deploy our profits in ways and at times when, as a business matter, we would not choose to do so. Moreover, the compliance burden flows directly from that test. As I have indicated, we are currently expending substantial time and effort on monitoring our foreign subsidiary's gross asset values on a quarterly basis. I can foresee the asset test becoming a "full employment" bill for economists and appraisers. Fair market value of a collection of business assets is notoriously difficult to determine, and is a matter of significant disputes between taxpayers and the IRS in other areas. Now, this dispute will be introduced into our foreign operations. Economists and appraisers will prepare voluminous and expensive reports, but none will be absolutely determinative of the question. Costly and time-consuming litigation will be the only result, focusing around the "battle of the experts." The complexity and uncertainty of the asset test flies in the face of the need to simplify the internal revenue laws. In the case of United States- controlled foreign subsidiaries, already covered by the Subpart F anti-abuse provisions, it is a needless and expensive exercise. PAGENO="0135" 125 V. Resolving the Problem. The members of our Coalition seek a solution under which, at minimum, they can conduct active business operations abroad without having to analyze the potential impact of the PFIC provisions on every business decision, and bear the additional compliance costs associated with these provisions on an ongoing basis. It seems to us this objective could be achieved in either of two ways: 1. Eliminate the Asset Test. The asset test creates the problem for our foreign operations. The income test is essentially. not relevant in our case, because if a controlled foreign subsidiary has the requisite 75 percent "passive" income, all of its income would be currently includible under the Subpart F provisions' "70 percent full inclusion rule" of Code section 954(b)(3)(13). Moreover, we already monitor our foreign operations for the presence of Subpart F foreign personal holding company income, the "passive" income of the PFIC provisions, and so no significant additional compliance costs would result. Of course, there will remain the meaningless filing of the requisite forms and statements required by the election to be treated as a "qualified electing fund" under section 1293. We are aware that this solution introduces technical problems in the case of foreign corporations not covered by the Subpart F provisions, and, if this is the solution Congress would prefer, we stand ready to assist in designing appropriate anti-abuse measures, and of course will support them fully. 2. Restore the Exclusion for Controlk~1 Foreign Corporations. This solution would merely restore the provision that was contained in the Senate version of the 1986 Tax Reform Act under which the PFIC provisions did not apply to United States shareholders of controlled foreign corporations. The Subpart F anti-abuse provisions would, of course, continue to apply in such cases. This solution is the simplest and most straightforward, and apparently the one Congress originally intended. Both of these possible alternatives deal fully with our concerns. Other, more narrowly targeted solutions, although well intended, in our view are unsatisfactory because they do not eliminate the compliance burden and raise issues not germane to the fundamental purpose of the PFIC provisions--to eliminate abusive use of offshore investment funds by taxpayers not otherwise covered by such anti-abuse provisions as Subpart F or the foreign personal holding company provisions. VI. Conclusion. I have used the abbreviation "PFIC" throughout these comments. But that abbreviation stands for "passive foreign investment company." Our operations abroad are not passive in any commen-sense meaning of the term, nor do any of our foreign subsidiaries operate as "investment" companies in the traditional sense. These provisions, necessary as they are in some contexts, are simply inappropriate as applied to controlled foreign subsidiaries of United States corporations. The overly broad scope of the PFIC provisions in this respect is aptly illustrated by the TAMRA amendments to the PFIC provisions. There were over thirty different amending clauses in TAMRA, and the great majority of them dealt with the overlap between the PFIC provisions and the Subpart F provisions. This complexity is simply unnecessary. It achieves no significant additional tax revenue for the United States, it burdens our foreign operations with PAGENO="0136" 126 substantial compliance costs, and it hampers our flexible response to the highly competitive conditions of the international marketplace. We trust that you will agree. Thank you on behalf of myself and the Coalition for this opportunity to present our concerns to this subcommittee. Respectfully submitted, Robert W. Hirt * Assistant Controller and Director of Taxes Measurex Corporation One Results Way Cupertino, California 95014-5991 * (408) 255-1500 On behalf of the Coalition on the PFIC Provisions Counsel to the Coalition: Thomas A. O'Donnell John M. Peterson Baker & McKenzie 815 Connecticut Ave. N.W. Washington, D.C. 20006 (202) 452-7000 PAGENO="0137" 127 ATTACHMENT COALITION ON THE PFIC PROVISIONS Amdahl Corporation Sunnyvale, Calif. Apple Computer, Inc. Cupertino, Calif. Becton Dickinson Company Franklin Lakes, N.J. Brown-Forman Corporation Louisville, Ky. 40201-1080 Measurex Corporation Cupertino, Calif. Mentor Graphics Corporation Beaverton, Oregon Microsoft Corporation Redmond, Wash. NeXT, Inc. Palo Alto, Calif. PHH Corporation Hunt Valley, Md. Prime~Cnmputer Inc. Natick, Mass. Sundstrand Corporation Rockford, 111. Wang Laboratories, Inc. Lowell, Mass. Warner-Lambert Company Morris Plains, N.J. PAGENO="0138" 128 Chairman RANGEL. Thank you. Mr. Stroud. STATEMENT OF WILLIAM M. STROUD, VICE PRESIDENT, TAX DI- RECTOR, ZURICH AMERICAN INSURANCE CO.-U.S. BRANCH, INSURANCE CO.-U.S. BRANCH, AND FRANKONA REINSURANCE CO.-U.S. BRANCH Mr. STROUD. Thank you, and good afternoon, Mr. Chairman. I am William Stroud, vice president and tax director of the Zurich Insurance Co. of Zurich, Switzerland. I am testifying on behalf of my company, as well as Swiss Reinsurance Co. and Fran-* kona Reinsurance Co. Mr. Jerry Lenrow of Coopers & Lybrand is directly behind me. I am testifying to urge you to repeal section 842 as it applies to U.S. branches of foreign property casualty insurance companies doing business in the United States. I urge the repeal ab initio of section 842 because the section is not needed. It is clear that the purpose of the provisions of section 842 and its predecessor was never meant to apply to property casualty insurers. It is not neces- sary for this section to apply as U.S. branches must maintain assets and surplus at least as great as its U.S. domestic competi- tors. U.S. branches operate as domestics subject to all the rules of the New York Insurance Department and, in that regard, must main- tain a trust account into which a considerable dollar amount of assets must reside. U.S. branches are rated by A.M. Best Co., as are all domestic and PC companies. Best reviews a company's profit- ability, placing great emphasis on the investment portfolio. All commercial insurers, both domestic and foreign, need to maintain an A plus or A rating to remain commercially viable in the U.S. insurance market. There are also the NAIC early warning tests which are monitored by the State insurance commissioners. The law is unnecessary, and I urge its repeal. I also urge the repeal because of the unfair mechanical formula contained in section 842. It creates a mathematical standard against which only U.S. branches of foreign property and casualty companies are compared. And since it only applies to U.S. branches, it is unfair. It creates an uneven playing field by subject- ing U.S. branches to special tax burdens. The formula does not take into account the kind of business the U.S. branch may be en- gaged in. If section 842 were applicable to the top domestic commercial property casualty insurers, they would also be subject to the cre- ation of phantom taxable income. I urge the repeal of section 842 as it applies to U.S. branches of foreign property casualty insur- ance companies because it is not needed to regulate the behavior of the PC companies, and the mechanical formula is flawed in its con- struction and application and creates an uneven playing field. Mr. Bernhard Michael will continue. [The statement and attachments of Mr. Stroud follow:] PAGENO="0139" 129 TESTIMONY OF WILLIAM M. STROUD DISCUSSION OF THE APPLICABILITY OF SECTION 842 TO TEE U.S. BRANCHES OF FOREIGN PROPERTY/CASUALTY INSURANCE COMPANIES Introduction The Revenue Act of 1987 amended Section 842 and extended the~ application of a minimum investment income base to U.S. branches of foreign property/casualty (PC) insurance companies. Previously, this provision had applied solely to U.S. branches of foreign life insurance companies. This provision creates an onerous burden on U.S. branches of foreign PC insurance companies. It is a provision enacted in error since rather than insure a level playing field, it leads to an unlevel one. As a consequence, we respectfully request that the portion of Section 842 that applies to PC insurers be repealed ab initio (as detailed in Appendix A). In pursuance of~ this point, we will analyze the impact of this inequitable change on the taxation of U.S. branches of foreign PC companies. Overview of Origin and Operation of U.S. Branches of Property and Casualty Companies `I'here is a very basic difference between the PC and the life insurance business. This difference applies to all insurers operating in the U.S. either as domestics or U.S. branches of foreign insurers. Life insurers calculate the present value of each insurance obligation and add expenses and a profit margin to arrive at the premium. The underlying assumption is that the insured event will occur. PC business on the other hind is written under the basic assumption that only a small portion of the insured events will ever occur. If a PC insurer writing auto coverage were to pay every insured they would be unable to remain in business. For example, assume an annual premium of $2,000 and a maximum ~coverage for liability under a personal auto policy of $100,000/$300,000. Unfortunately, there is no way of knowing how many property/casualty insureds will suffer a covered loss. Thus, there is a distinct need for a continued existence of surplus for ~a~PC insurer, in order to permit future business growth. As will be seen in the discussion of the NAIC "Early Warning Test" (iRIS), a PC insurer is required to maintain a definite surplus to writings ratio. There is no similar requirement for life insurers. Further, PC insurers because of the nature of insurance accounting, suffer a reduction in surplus as writings increase. This is another reason why surplus is necessary. For example, assume a six-month policy is written on October 1 at a premium of $lOOX with a $30X~acquisition cost, that has a loss reported to the insurer prior to December 31 of the first year~ of $28X. The accounting on the intervening December 31 for annuci statement purposes would be as follows: Premium stoox Less:~Unearned Premium Reserve 50X Earned Premiums 50X Less: Acquisition Costs 30X Less: Loss Reserve 28X December 31 of intervening year NAIC"Early Warning Test" The NAIC is concerned about the solvency of PC insurers with a view to the protection of policyholders. To this end, they have devised an F~rly Warning System (IRIS test). It is comprised of 11 individual ratios as follows: 1. Premium to Surplus 2. Change in Writings S~Ius Aid to Sur~ius PAGENO="0140" 130 4. Two Year Overall Operating Ratio 5. Investment Yield 6. Change in Surplus 7. Liabilities to Liquid Assets 8. Agents' Balances to Surplus 9. One Year Reserve Development to Surplus 10. Two Year Reserve Development to Surplus 11. Estimated Current Reserve Deficiency to Surplus For purposes of analyzing the ability of a U.S. branch of a foreign PC insurer to intentionally reduce its U.S. surplus and the resultant investment income, it is important to focus on three of the 11 tests. Test one (1) deals directly with the company's capacity to write insurance. The early warning test is failed where a company's premium writings exceed three times its surplus. This is referred to as the 3 to 1 test. It is interesting that the analysis of this item indicates that for certain long-tail lines something less than a 3 to 1 benchmark is more suitable. If a PC company wants to grow, it is necessary for it to have a concommitant growth in surplus in order to have an acceptable writings to surplus ratio. It would be counterproductive tO intentionally reduce its surplus-investible assets and/or investment yield. It is also significant to focus on the investment yield requirement of the early warning test (test five (5)). The test indicates an investment yield of under six percent would be considered a failing grade. Again, it is not possible for a company to intentionally reduce its investment yield without causing concern on the part of the regulators. For competitive purposes, investment income is considered in the determination of pricing. A dramatic change in surplus (test six (6)) is also considered an early indication of a troubled company. An increase of over 50 percent or a reduction of over 10 percent is considered a failing grade. A.M. Best Rating Guide A.M. Best is internationally recognized as the prime rater of the ability of insurance companies to meet their obligations to their policyholders. In accomplishing this, Best's reviews several indicators, the most of important of which would be grouped under profitability, leverage (relating to adequate capital and surplus), and liquidity. It places great emphasis on the investment portfolio, focusing on its composition and yield, as well as adequacy of capital. For comparison purposes, Best's assigns rates to individual companies ranging from A+ (superior) to C- (fair). Banks, financial institutions, brokers and commercial consumers will generally insist on doing business with an A or better rated company. Therefore, a U.S. branch would be severely penalized if it did not prudently invest or was not adequately capitalized. New York Port-of-Entry Requirements Most foreign insurance companies who are international PC insurance companies were organized long ago under the laws of their respective countries. They commenced their PC business in the United States of America through the establishment of a U.S. Branch with the port-of-entry in the State of New York. As such, they are treated similarly to a N.Y. domiciled PC stock insurer, and thus, are subject to N.Y. rules and regulations. In fact, New York State provides more stringent rules for foreign PC branches than a N.Y. domiciled PC insurer by its restrictions on the handling of assets that must be maintained within the United States. These restrictions provide protection for policyholders and creditors within the U.S. Moreover, no other state has more stringent rules and regulations. Under Section 1315, Article 13 of the New York Insurance Law, a licensed alien insurer, is required to deposit assets with a trustee(s) for the security of its policyholders and creditors of the United States. These assets are known as "trusteed assets." All trusteed assets must be maintained within the U.S. The deed of trust and any amendments are subject to initial approval by the New York Superintendent of Insurance and requires continued approval over time. In contrast, while a domestic entity must maintain deposits and/or bonds, these are not required to be maintained in trust. Thus, the policyholders of U.S. branches of foreign PC companies are assured that the funds are available to pay losses. Further, under Section 1312, Article 13 of the New York Insurance Law, the branches must file with the superintendent an annual "trusteed surplus statement". This statement provides a mechanism to monitor the adequacy of trusteed assets. At a minimum, PAGENO="0141" 131: trusteed assets must equal net liabilities (i.e. loss reserves, unearned premiums and other liabilities net of certain adjustment). A U.S. branch in no instance would or could maintain an insufficient amount of surplus - investment assets - yielding something other than an appropriate amount of taxable investment income. Nature of P.C. Business The application of Section 842 to U.S. branches of foreign PCinsurers is unnecessary and unworkable. Its very nature penalizes certain PC branches who deal in certain lines of business such as workers' compensation, general liability, and:auto liability. The formula may be applicable to life insurers, but does not work for PC companies. Description of Commercial Liability Insurers In the U.S. PC market, commercial liability business is referred to as "long-tail", i.e., significant losses remain unpaid long beyond three years subsequent to the year in which such losses were incurred. In contrast, personal lines business (such as personal automobile and homeowners) and other property coverages are called "short-tail", i.e., generally losses are paid within 1 to 3 years of the year in which such losses were incurred. Companies that write significant commercial liability have larger reserves ~n comparison to statutory surplus. Because commercial "long-tail" claims take longer to settle, predominantly commercial PC insurers have larger unpaid loss reserves in these lines as compared to policyholder surplus. Further, a comparison of the assets to reserves (Unpaid Loss, LAE, and Unearned Premium) ratio for U.S. commercial liability writers would be substantially lower than companies with either greater diversification or a concentration in personal lines. An initial conclusion might be that commercial liability insurers have insufficient assets tc sustain their reserves. However, state insurance regulations through the IRIS test establish criteria for solvency purposes that reflect abnomalies which may occur depending on a company's lines of business. The top 20 comparable domestic PC commercial liabililty insurance groups would not satisfy the requirements of Section 842 with respect to the asset/liability ratio calculation. This in and of itself illustrates the inappropriateness as well as the unworkable nature of Section 842 as it applies to PC companies. Calculation of Taxable Income U.S. branches of foreign PC insurers are required to report and pay U.S. taxes identically to domestic PC insurers. The starting point for calculation of U.S. taxable income, as it is for all domestic PC insurers, is the statutory statement filed with the (N.Y.) insurance department. Nature of Prior Law Under prior law, Section 813 applied strictly to the determination of U.S. gross income of foreign life insurance companies. Specifically, the gross investment income of a foreign corporation carrying on a life insurance business in the U.S. was treated as if it were effectively connected with the conduct of a trade or business in the U.S. Further, prior law also provided that foreign source income of foreign PC companies could not be treated as effectively connected with a U.S. trade or business, i.e. income from foreign obligations was excluded. It is instructive to refer to the committee report accompanying Section 819 of the Life Insurance Company Income Tax Act of 1959 (predecessor to Section 813). Due to the new formula contained in this bill, foreign [life insurance] companies (if it were not for this provision) could obtain far more advantage from reducing their U.s. surplus than they could have obtained under prior law. This is designea to prevent foreign [life] insurance companies doing business in the United States from avoiding tax they would otherwise have to pay to the United States, merely by holding surplus with respect to U.S. business in countries outside of the United States. Nature of 1987 IRC Changes The new law requires that the amount of the company's net investment income which is treated as effectively connected with its U.S. trade or business be adjusted so that it is PAGENO="0142" 132 not lower than the product of the company's "required U.S. assets" and the company's "domestic yield" for the year. The "required U.S. assets" for a tax year are the company's average total insurance liabilities (for a PC insurer: Unpaid Loss, LAE and Unearned Premium) on U.S. business multiplied by a "domestic asset/liability percentage" for the year. The Treasury determines this domestic asset/liability percentage separately for foreign life and foreign PC companies. The determination of PC's is the ratio of: 1) the mean total assets of U.S. domestic PC companies to (2) the mean total insurance liabilities of these companies. The Treasury computes this ratio based upon a representative sample of domestic companies operating in the second preceding taxable year, e.g. for tax year 1988, the 1986 domestic data would be used. Because the Treasury computes their ratios using all types of companies, there is a bias against certain lines of business (i.e., long- tail). In 1988, Congress amended Section 842 by adding Section 842(d)(4) which provides that the Secretary may provide that PC companies be grouped separately by different categories. The Treasury has issued two notices for 1988 and 1989, but has not created separate categories. Rather, the notices have been prepared based on overall industry averages regardless of the type of business that is written. Also, an earnings ratio that is two years old is a very poor indication as to what earnings should be in a volatile stock and interest market. This is another indication that the expansion of Section 842 to include PC insurers is unworkable and unnecessary. Conclusion In conclusion, U.S. branches of foreign PC insurers operate within the U.S. in the same manner as domestic PC insurers. They are subject to the same restrictions and restraints as domestic PC insurers. They must maintain adequate surplus and assets to sustain the desired volume of business and in point of fact, U.S. branches of foreign PC insurance companies entering through New York must maintain their assets in a trusteed account, a requirement domestic PC companies do not meet. There can be no fear that U;S. branches of foreign PC insurance companies could reduce investment income by holding surplus with respect to U.S. business in countries outside of the United States. The application of a life insurance concept establishing a minimum investment income base add thereby creating "phantom income" is neither necessary nor workable. The Section as it relates to PC companies should be repealed. PAGENO="0143" 133 Attachment A Appendix A Elimination of Application of Section 842 to Insurance Companies Taxable Under Part II of Subchapter L. (1) Subsection (a) of section 842 is amended by striking "or II". (2) Paragraph(1) of section 842(b) is amended by striking "or II". (3) Subparagraph (B) of section 842(b)(2) is amended to read as follows: "(B) Total Insurance Liabilities. For purposes of this paragraph, the term "total insurance liabilities" means the sum of the total reserves (as defined in section 816(c)) plus (to the extent not included in total reserves) the items referred to in paragraphs (3), (4), (5), and (6) of section 807(c)." (4) Paragraph (1) of section 842(c) is amended by striking "In the case of a foreign company taxable under Part I, subsection" and inserting "Subsection" before "(b)". (5) Subparagraph (B) of section 842(c)(2) is amended by striking "or II (as the case may be)". (6) Paragraph (2) of section 842(d) is amended by adding at the end thereof "and". (7) Paragraph (3) of section 842(d) is amended to read as follows: "(3) providing for the proper treatment of investments in domestic subsidiaries." (8) Subsection (d) of section 842 is amended by striking paragraph (4). PAGENO="0144" 134 Date of Incorportation: Commenced Business in the United States: State of Domicile of U.S. Branch Operations:~ U.S. Branch Head Office Location: Total U.S. Assets at December 31, 1988: Total U.S. Policyholder surplus at December 31, 1988 U.S. Earned Premium for 1988: Premium to Surplus Ratio for 1988: Total Investment Income & Capital Gains as shown on the 1988 U.S. Branch Annual Statement: Major Offices in the United States in 1988 with number of employees: New York 1400 American Lane Schaumburg, Illinois $2,182,513,124 $384,783,696 $807,502,061 2.09 to 1.0 $139,440,888 Schaumburg, IL Atlanta Dallas Manhattan San Francisco Los Angeles Philadelphia Pittsburgh Attachment B FACT SHEET FOR U.S. BRANCH OF THE ZURICH INSURANCE CO. OF ZURICH SWITZERLAND 1872 1912 1,312 86 101 120 99 85 62 74 7 PAGENO="0145" 135 Attachment C FACT SHEET FOR SWISS REINSURANCE COMPANY OF ZURICH, SWITZERLAND U.S. BRANCH OPERATIONS Date of Incorporation: Commenced Business in the United States: State of Domicile of U.S. Branch Operations: U.S. Branch Head OffIce Location: Total U.S. Assets at December 31, 1988: Total U.S. Policyholder Surplus at December 31, 1988: U.S. Earned Premium for 1988: Premium to Surplus Ratio for 1988: Total Investment Income & Capital Gains as shown on the 1988 U.S. Branch Annual Statement: Major Offices in the Unites States totaling approximately 500 employees: December 19, 1863 October 20, 1910 New York 237 Park Avenue New York, New York $1,037,494,267 $353,588,241 $372,756,741 1.05 to 1.0 $69,821,156 New York City Atlanta, Ga. Boston, Mass. Chicago, Ill. Westport, Ct. Dallas, Tex. Universal City, Calif. Memphis, Tenn. Philadelphia, Penn. San Francisco, Calif. PAGENO="0146" 136 Attachment D FACT SHEET FOR FRANKONA REINSURANCE COMPANY OF MUNICH, GERMANY U.S. BRANCH OPERATIONS Date of Incorporation: June 1, 1886 Commenced Business in the United States: January 1, 1982 State of Domicile of U.S. Branch Operations: Missouri * U.S. Branch Head Office Location: 2405 Grand Avenue Suite 900 Kansas City, MO 64108 Total U.S. Assets at December 31, 1988: $102,111,171 Total U.S. Policyholder Surplus at December 31, 1988: $25,973,738 U.S. Branch Earned Premium for 1988: $33,179,533 Premium to Surplus Ratio: 1.28 to 1.0 U.S. Branch Total Investment Income and Capital Gains: $6,633,070 * The U.S. Branch is licensed in New York and maintains assets in trust in New York. PAGENO="0147" 137 BEST'S KEY RATING GUIDE PREFACE ATTACHNENT E Bests Key Racing Guide is designed to be a quick reference source of Best's Ratings and Financial Size Categories along with selected financial data show- ing the financial condition and opera- ting results of about 1,750 prominent property/casualty insurance companies. These insurers are licensed in the vail- ous states of the United States, domestic and foreign, including those which write reinsurance exclusively. The information contained in this volume has been extracted from the 1987 edition of Best's Insurance Reports, Property/CasuaftyE4j~n, which presents comprehensive financial and statistical reports on property/casualty insurers. Additional data and tests are shown in Btst's Adtunce &uing Report Service (BARRSJ and Best's Trend Repon.These pubhcations all report in considerable depth on the companies reported upon in Best's Kev Rating Guide. lnformarion on life/health insur- ance companies operating in the United States is available in Best's insurance Repo~rs, Life/H~j, Edition. Information on insurance companies operating. in other countries is available in Best's in- surance Reports, International Edition. The A.M. Best Company current- ly reports on approximately 1,750 prop- erty/casualty insurers, representing vir- tually all domestic non-captive proper. ty/casualty insurance companies (as well as licensed United States branches of foreign insurance companies) which ac- tively operate in the United States with admitted assets and annual gross writ- ten premiums of at least $3.5 million. These reports and ratings are prepared without cost to the insurance companies. In the rear section of this volume we present a Directory of other Property! Casualty Insurers, which givesthe user a general description of companies not reported on in the front section. Other sections contain information on the principal underwriting and ad. visory organizations; tables showing the states in which various companies are licensed to do business; listings of the various members of company groups and/or fleets; and listings of compinies and associations which have retired in recent years. Introduction Scope and Content VII PAGENO="0148" 138 * SECTIONI * EXPLANATION OF BEST'S RATING SYSTEM Evaluating the financial condition of an institution cannot be considered an exact science. This is particularly true of property/casualty insurance compa- nies, whose assets largely are invested in interest-sensitive investments such as bonds, and whose liabilities such as loss reserves, primarily are based on actuarial projections of future payments to be made on current policy contracts. The growth, liberalization and un- predictability of our tort litigation sys- tem have seriously challenged the abili- ty of insurers topredict with reasonable confidence the reserves they must es- tablish today to meet future payments. The objective of Best's rating system is to evaluate the factors affecting the overall performance of an insurance company to provide our opinion of the company's relative financial strength and ability to meet its contractual obli- gations. The procedure includes both quantitative and qualitative reviews of the company. Quantitative Evaluation The quantitative evaluation is based on an analysis of the company's finan- cial condition and operating performance uttltztng ~nancial tests. These tests measure a company's performance in the three critical areas of (1) Prof- itability, (2) Leverage and (3) Liquidity in comparison to norms established by the A.M. Best Company. These norms (1) Profitability: Profit is essential for an enduring and strong insurer. It is a measure of the competence and abil- ity of management to provide services and prices attractive to policyholders in competitive markets, and to compare fa- vorably with their peers in cost control and efficiency. We compare net income to net pre- miums earned and to policyholders' surplus over the past five years to eval- uate the degree and trend of overall profitability. The expense ratio is used to compare costs of operations with in- surers in similar lines of business. The combined ratio is an indicator of under- writing success relative to insurers in similar lines of business. The yield on investments is an indicator of the con- tribution of investment income to net income. The qualityof reported net income is reviewed and evaluated. Reported net income can be affected materially by changes in the adequacy of loss reserves, changes in the amount and kind of rein- surance, changes in the difference be- tween statement and market value of assets, and by changes in the amount and kind of direct business. The stability and trend of net in- come also are evaluated. A stable net in- come is important to the stability of an enterprise. An insurer losing half its policyholders' surplus in one year, for example, hardly can be regarded as ade- quate security for long-term obligations. - (2) Leverage: Leverage increases re- turn on capital but also increases the risk of instability. Accordingly, we compare the leverage of each insurer with indus- try norms to evaluate the relative degree of risk to the policyholder. A conserva- tive level of leverage enables an insurer to better weather occasional storms. Leverage exists in many forms. We review the leverage of annual premiums and current liabilities to policyholders' BEST'S KEY RATING GUIDE For your convenience, the Preface are based on an evaluation of the actual is divided into two sections. Section I performance of the property/casualty in~ provides an explanation of Best's Rating dustry. System. Section II provides explana- tions of the financial exhibits and terms used in our reports for those not familiar with insurance accounting terminology. VIII PAGENO="0149" 139 PROPERTY-CASUALTY surplus, both gross and net to reinsur. ance. We also review leverage in relation to net policyholders' surplus-after de. ducting investments in affiliates-to evaluate the effect of pyramiding, which is another form of leverage. Reported leverage also is evaluated for the potential effects of loss reserve adequacy, equities in unearned premi- urns, and differences between statement and market values of assets. (3) Liquidity: An insurer should be prepared at all times, both in the short and long run, to meet its obliga- tions. It does so by holding cash and in- vestments which are sound, diversified and liquid. A high degree of liquidity gives an insurer the flexibility to expand into profitable lines of business and withdraw from unprofitable lines. It en- ables an insurer to meet unexpected needs for cash without the untimely sale of investments. We review a company's Quick Li- quidity-the amount of cash and quick- ly convertible investments-to measure a company's ability to reduce liabilities without recourse to selling long-term in- vestments or borrowing. We review Current Liquidity to measure the pro- portion of net liabilities covered by cash and unaffiliated investments. If this ratio is less than one, the company's solven- cy is dependent on the collectibility or marketability of premium balances and investments in affiliates. We evaluate net cash flow which has an important bearing on an insurer's need for liquidity. We also evaluate the soundness, market value and diversifica- tion of assets. Putting too many eggs in one basket introduces additional risks to the stability of an enterprise. `~Ve also review the effect of Invest- ment Leverage by comparing with poli- cyholders' surplus the loss that would be incurred by a 20% decline in coin- mon stock prices and the reductions in market value of bonds, preferred stocks and mortgage loans caused by an in- crease of interest rates of two percentage Points. Qualitative Evaiuation Our review also includes a quali- tative evaluation of the company's per- formance in areas such as: (4) distrib- ution and volatility of the book of busi- ness, (5) the amount and soundness of its reinsurance, (6) quality and esti- mated market value of assets, (7) the adequacy of its reserves, and (8) the ex- perience of its management. In addition, various other factors of importance are considered such as the composition of the company's book of business and the quality and diversifica- tion of its assets. (4) Distribution and volatility of the book of business: It is essential that a company's book of business be analyzed on both a geographic and a by-line of business basis. Geographic location can have a great impact on the degree of its exposure to various hazards such as hur- ricane, tornado, windstorm, hail or earth- quake. In addition, the mix of a com- pany's business must be studied relative to the distribution of its assets. Some lines of business are quite stable and pre- dictable while others are volatile and can seriously impact the financial stability of an insurer. (5) Amount and soundness of re- insurance: Reinsurance is essential and plays an important role in risk spreading and the financial security of insurers- especially smaller insurers. We review each insurer's reinsurance program to see whether coverage is adequate for the potential risks involved, if the amount of reinsurance is large we also review diversification, quality and purpose of the reinsurance. When reinsurance recoverables are relatively small or moderate (less than half policyholders' surplus) it often is advantageous and economic to deal with one reinsurer. But when reinsur- ance recoverable from one reinsurer ex- ceeds 100% of policyholders' surplus,it can represent a diversification problem. An asset of that size makes the insurer's solvency dependent on a single entity. Ix PAGENO="0150" 140 BEST'S KEY RATING GUIDE When reinsurance recoverables are large; whether diversified or not, there may be quality problems if significant amounts are due from reinsurers that are low-rated or from reinsurers on which we have little information. A Best's Rating may be adversely affected by significant amounrs~of reinsurance or ~reinsurance recoverable, especially if the financial~stability of the reinsurer is unknown. Finally, when reinsurance is unus- ually large in amount, whether or not there are diversification or quality prob- lems, there is the question of purpose. is the amount and location of reinsur- ance normal and appropriate for the type and location of risks written by the primary carrier? if not, there is the potential that the amount or location ~-of the reinsurance is motivated by finan- cial, tax or regulatory concerns, instead of risk spreading. Significant amounts of such reinsurance may distort reported results or remove underlying assets and liabilities from normal disclosure and regulatory review. Significant amounts of reinsurance motivated by financial concerns genetaUy have an adverse ef- fect on a Best's Rating. in general, a Best's Rating is im- proved by reinsurance that is norr~al, appropriate and sound. A Rating is af- fected adversely by reinsurance that is inadequate, excessive~ inappropriate or unsound. (6) Quality and estimated market value of assets: These are reviewed to determine the potential impact on poli- cyholders' surplus if the sale of assets had to take place unexpectedly. The higher the liquidity and/or quality of the assets the less uncertainty there is in the value to be realized upon sale. In addition, the market value of equity assets ss affected by the yield and maturity, which is par- ticutatly true of !oonds. Therefore, we estimate the impact on pot~cyhotdtrs' surplus due to changes in the interest rates on interest scr~stive assets. (7) Adequacy of reserves: An evaluation of the adequacy of aninsur- er's reserves is essential to an evaluation of profitability, leverage and liquidity. This is because reported net income is what remains after the change in re- ported reserves has been deducted, and because reported policyholders' surplus is what is left over after reported reserves have been deducted. For many insurers, a 25% change in current loss reserves would exceed five years of net income. For some insurers, the equity or deficien- cy in reported loss reserves can exceed reported policyholders' surplus. We evaluate the equity in the un- earned premium reserve by estimating the ratio of underwriting expenses to written premiums. This ratio is applied to the unearned premium reserve. We evaluate the adequacy of re- serves for unpaid losses and loss adjust- ment expenses on an ultimate pay-out basis, and estimate the potential effect of discounting them to present value in recognition of future investment income on the amounts held in reserve for fu- ture payments. We also evaluate the degree of un- certainty in the reserves, recognizing that reserves are only estimates of uncer- ta~n future events, lithe degree of uncer- tainty exceeds any equity in the reserves, and is large in relation to net income and policyholders' surplus, the quality of profitability and leverage measures is reduced. (8) Management: The competence, experience and integrity of management, although elusive qualities to measure, are important determinants for success in the insurance business, where finan- cial responsibility and security are more vital than inmost other forms of busi- ness activity. During the past 80 years we have developed close working relationships with the managements of the insurance. companies we report on. We are in ftc quertt `qeat-round contact with many managements. Insurance ex2cutive~ re~ x PAGENO="0151" 141 PROPERTY-CASUALTY resenting over one thousand companies visit with our senior staff each year to discuss financial and opesasing aspects of their performance. These consulta- tions are performed without charge. Ob- viously, this knowledgeof the character and operating philosophy of a compa- ny's top management team plays an im- portant role in our continual evaluation of the performance of an insurance com- pany. Mjustments for Rating Analysis For companies assigned a Best's Rating (A + to C-), their Leverage and Liquidity Tests for the current year also are shown as adjusted by us for Rating analysis. This is not to suggest that the reported data or statutory accounting is incorrect. First, these "Adjusted Tests for Rating Analysis" reflect our adjustments to selected balance sheet items to pro- ~ide a more current and comparable basis for the evaluation of~the perfor- mance of an insurance company. Items evaluatedfor adjustment include: equi- ty in unearned premiums, adequacy of loss reserves on a present value basis, ad- justment to market value of bonds, pre- ferred stocks and mortgages, and a re- view of conditional reserves. Second, and equally important for rating analysis are adjustments that reflect an insurer's relationship with other affiliates and companies; when a company owns subsidiaries, the adjusted tests for the parent company are based on the cOnsolidation of the group. When a company is 1(X)% reinsured, the adjusted tests shown are those of the reinsurer. When a company participates in a qualified pooling arrangement, the adjusted tests shown are based on the consolidation of the pooling companies. \\ hen an insurer invests in a subsidiary that is not a property/casualty compa- ny, the invested asset is excluded to remove the effect of pyramiding. Rating Assignment Procedure Assignment of Best's Rating and Financial Size Category is made in the spring of each year shortly after the com- pany has submitted its annual financial statement (due March 1). Official noti- fication by letter is sent to the chief ex- ecutive officer of each company together with a preliminary proof of the compa- ny's report and financial exhibits as they will appear in our various publications. The company is permitted up to 15 days to comment on and discuss its report and Rating before release of the Rating via our weekly publication, Best's In- surance Management Reports. The as- signed Rating subsequently is reviewed based on the company's six and nine months' quarterly financial reports. The company is notified of any proposed change in the Rating, which again would be communicated to our sub- scribers via our weekly and monthly publications. Best's Rating Classifications Of the 1,750 companies reported on in Best's Insurance Reports, approximately 1,320(75%) are assigned a Best's Rating rangingfromA+ (SuperiOr) toC- (Fair). The remaining 430 (25%) are classified as Rating "Not Assigned." As discussed further in the Preface, the "Not As- signed" category has ten classifications which identify why a company was not eligible for a Best's Rating. Explanations of the nine Best's Rating classifications follow: A+ (Superior) Assigned to those companies which in our opinion have achieved iuperior overall performance when compared to the norms of the property/casualty in- surance industry. On a relative basis A+ (Superior) rated insurers generally have demonstrated the strongest abili- ty to meet their respective policyholder and other contractual obligations. XI PAGENO="0152" 142 B+ (Very Good) Assigned to those companies which in our opinion have achieved very good overall performance when compared to the norms of the property/casualty in. *surance industry. On a relative basis B+ (Very Good) rated insurers generally have demonstrated a very good ability to meet their policyholder and other contractual obligations. BandB- (Good) Assigned to those companies which in our opinion have achieved good over- all performance when compared to the norms of the property/casualty insur- ance industry. On a relative basis B or B- (Good) rated insurers generally have demonstrated a good ability to meet their policyholder and other contractual obligations. C+ (Fairly Good) Assigned to those companies which in our opinion have achieved fairly good overall performance when compared to the norms of the property/casualty in- surance industry. On a relative basis C+ (Fairly Good) rated insurers general. ly have demonstrated a fairly good abili. ty to meet their respective policyholder and other contractual obligations. C and C- (Fair) Assigned to those companies which in our opin~s have achieved fair over- all performance when compared to the norms of the property/casualty insur- ance industry. On a relative basis C and The following Rating Modifiers may be assigned to a Best's Rating classifica- tion of A+ through C-. These modi- fiers are used to qualify the status of an assigned Rating. The modifier will ap- pear as a lower-case suffix to the Rating (i.e. Ac or B w orC x). * "c"-Contingent Rating. Temporari- ly assigned to a company when there has been a decline in performance in its prof- itability, leverage and/or liquidity but the decline has not been significant enough to warrant an actual reduction in the company's previously assigned Rating. Our evaluation may be based on the availability of more current inforrna- tion and/or contingent on the successful execution by management of a program of corrective action. * "w"-Watch List. Indicates the com- pany was placed on our Rating "Watch List" during the year because it experi- enced a downward trend in profitability, leverage and/or liquidity performance, but the decline was not significant enough to warrant an actual reduction in the assigned Rating. Our evaluation may be based on the availability of more current information and/or contingent on the successful execution by manage- ment of a program of corrective action. * "x"-Revised Rating. Indicates the company's assigned Rating was revised during the year to the Rating shown. BEST'S KEY RATING GUIDE A and A-- (Excellent) C- (Fair) rated insurers generally have Assigned to those companies which demonstrated a fair ability to meet their in our opinion have achieved excellent policyholder and other contractual obli- overall performance when compared to gations. the norms of the property/casualty in- surance industry. On a relative basis A or A - (Excellent) rated insurers general- ly have demonstrated a strong ability to Best's Rating Modifiers meet their respective policyholder and other contractual obligations. XII PAGENO="0153" 143 PROPERTY-CASUALTY `The following Rating McvJ.ifiers are used to identify a company whose assigned Rating is based on an affiliaticrn wLth one or more other property/casualty insurers. * "s"-Consolidated Rating. Indicates the Rating is assigned to a parent com- pany and is based on the consolidated performance of the company and its domestic propesty/casuaky subsidiaries in which ownership exceeds 50%. The Rating applies only to the parent com- pany as subsidiaries are normally rated on the basis of their own financial con- dition and performance. * "e"-Parent Rating. Indicates the Rating assigned is that of the parent of a domestic property/casuakv subsidiary in which ownership exceeds 50% and is based on the consolidated performance of the parent and subsidiary. To qualify, the subsidiary must be eligible for a Rating based on its own performance after attaining five consecutive years of representative experience; have common management with the parent; underwrite similar classes of business; and have in- terim leverage and liquidity performance comparable to that of its parent. * "r"-Reinsured Rating. Indicates that the Rating and Financial Size Category assigned to the company are those of an affiliated carrier which rein- sures 100% of the company's written net busrness. For information regarding company's reinsurer see Bes.t~s Insurance Reports. * "p"~.-.Poo1ed Rating. Assigned to companies undercommon management or ownership which pool 100% of their net business. All premiums, expenses and losses are prorated in accordance with specified percentages that rea- sonably relateto the disu*~sst~jc,riof the policyho'ders' surplus of each member dthe group. All members participating 4n the pooling arrangement are assigned the same Rating and Financial Size Category, based on the consolidated performance of the group. For informa- tion regarding the members ofche pool see Best's Insurance Reports. * "g"-Group Rating. To qualify for a Group Rating, the companies in the group must: be affiliated via common management and/or ownesship; pool a substantial portion of their net business; and have only minor differences in their underwriting and operating perfor- mance. All members are assigned the same Rating and Financial Size Cate- gory, based on the consolidated perfor- mance of the group. Ratings "Not Assigned" Classification Approximately 430 or 25% of the companies reported on in Best's Insurance Reports are not eligible for a Best's Rating (A+ to C-). These companies are as- signed to a Rating "Not Assigned" clas- sification (abbreviated NA) which is di- t'ided into ten classifications to identify the reason why the company was not eligible for a Best's Rating. The primary reason is identified by the appropriate numeric suffix. If additional reasons ap- ply, they will be referred to in the report on the company as set forth in Best's In- surance Reports, Properrs/Casuoity Edition. * NA-2 Less than Minimum Size- Assigned to a company whose admitted assets or annual gross premiums written do not meet our minimum size require- ment of $3.5 million. It is also assigned to a company which is virtually dormant or has no net insurance business in force. Exceptions are: the company is 100% reirisured by a Rated company; or is a member of a group participating in a business pooling arrangement; or was formerly assigned a Ratitig. * NA-3 Insufficient Experience-As- signed to a company which has not ac- cumulated at least five consecutive years of representative operating experience. Additional years of experience may be required if the company is principally engaged in "long tail" casualty lines (such as professional malpractice liabili- ty) whereby the development and pay- ment pattern of the loss reserves may XIII PAGENO="0154" 144 BEST'S KEY RATING GUIDE not be sufficiently mature at the end of five years to permit a satisfactory evalua- tion of their adequacy. For most com- panies, the year that we anticipate assigning a Rating is referred to in the report on the company as set forth in Best's Insurance Reports, Property/Co~suaIty Edition. * NA.4 Rating Procedure Inapplica- ble-Assigned to a company when the nature of its operations and/or mix of business are such that our normal rating procedure for property/casualty insur- ers do not properly apply. Examples are companies writing lines of business not common to the property/casualty field; companies writing financial guaranty in- surance; companies retaining only a small portion of their gross premiums written; and companies that have dis- continued writing new and renewal busi- ness and have a defined plan to run-off existing contractual obligations. * NA-5 Significant Change-Assigned to a previously rated company which ex- periences a significant change in owner- ship, management or book of business whereby its operating experience may be interrupted or. subject to change. Depen- ding on the nature of the change, our procedure may require a period of one to five years to elapse before the com- pany is eligible for a Rating. * NA-6 Reinsured by Unrated Rein- surer-Assigned to a company which (a) has a substantial portion of its book of business reinsured by a reinsurer (or * reinsurers) not assigned a Best's Rating or (b) has reinsurance recoverables which exceed its policyholders' surplus due from reinsurers nor as~grttd a Rating. * NA-7 Below Minimum Stan- dards-Assigned to a company that meets our minimum size and experience requirements, but does not meet the minimum standards for a Best's Rating of"C~." * NA.8 Incomplete Financial Infor- ination-Assigned to a company which fails to submit, prior to our Rating deadline, complete financial information for the current five-year period under review. This requirement alsO includes all domestic property/casualty subsidi- aries in which the compan~s ownership exceeds 50%. * NA-9 Company Request-Assigned when a company is eligible for a Rating but disputes our Rating assignment or procedure. If a company subsequently requests a Rating assignment, our policy normally requires a minimum period of three years to elapse before the company is eligible for a Rating. * NA-b Under State Supervi- sion-Assigned when a company is under conservatorship, rehabilitation, receivership or any other form of super- vision, control or restraint by state regulatory authorities. Best's Financial Size Category The Financial Size Category is based on the company's reported poli- cyholders' surplus plus conditional reserve funds such as provision for unauthorized reinsurance, excess of statutory reserves over statement re- serves and miscellaneous voluntary re- serves reported as liabilities. Prior to 1986, it also included equities or ad- justments to selected balance sheet items including: equity in unearned premi- ums; adequacy of loss reserves on a pres- ent value basis; adjustment to market value of bonds, preferred stock and mortgages. To avoid confusion of Best's Ratings with the Financial Size Category, the latter is represented by Roman numerals ranging from Class I (the smallest) to aa~s XV (the )~rgest) as follows: XIV PAGENO="0155" 145 PROPERTY-CASUALTY The Financial Size Category is an indicator of the relative size of an insurer based on its reported policyholders' sur- plus and conditional reserve funds. The size of risks, which an insurer may pru- dently underwrite, assume or retain, is closely tied to its reported policyhold- ers' surplus, sometimes referred to as its capacity. To provide stability and safe. ty, an insurer should limit its maximum loss exposure on a single risk (or group of related risks) to a relatively small percentage of its policyholders' surplus, normally 1% or 2%, and only in very rare cases as much as 10%. * SECTIONU * EXPLANATION OF FINANCIAL EXHIBITS Although most of the financial and statistical exhibits used in our publica- tions are self"explanatory, we have pro- video below explanations of the various exhib~r~ and terms used in Best's Key Rating Guide to assist our subscribers who are nt familiar with insurance ac- Counting terminology. Source of Information The information pr,esented in this volume is based upon each insurance company's sworn annual financial state- ments as prescribed by the National As- sociation of Insurance Commissioners and as filed with the Insurance Commis- sioners of the various states in which the companies are licensed to do business. These statements are presented in accor- dance with the statutory accounting re- quirements and are the official financial statement of the property/casualty in- surance companies. In addition, our reports reflect sup- plemental information obtained by us such as data supplied in response to our questionnaires, state insurance depart- ment examination reports, audit reports prepared by certified public accountants, loss reserve reports prepared by loss re- serve specialists, annual reports to stock- holders and reports filed with the Securi- ties and Exchange Commission. While the information obtained from these sources is believed to be reliable, its accuracy is not guaranteed. We do submit the data toa rigorous, com- puterized cross-checking routine to ver- ify its arithmetic accuracy. We do not, however, audit the companies' financial records or statements and therekwe can- not attest as to the accuracy of the in- formation provided to us. Consequent- ly, no representations or warranties are made or given as to the accuracy or completeness of the information pre- sented herein. Best's Ratings reflect our opinion as to the relative financial strength and performanceof each insurer in compar- ison with others, based on our analysis of the information provided to us. These Ratings are not a warranty of an in- surer's current or future ability to meet its contractual obligations. Comparative Financial and Operating Exhibit The Key Raring Guide exhibit pro- vides five years of financial information Financial Size Category Adjusted PoJicytboiders' Surplus Class Class H Class III Class IV Class V Class Vi Class VII Class VIII Class IX Class X Class Xl Class XII Class XIII Class XIV Class XV (thousands of dollars) Up to 1.000 1.000 to 2.000 2.000 to 5.000 5.000 to 10.000 10,000 to 25.000 25.000 to 50,000 50,000 to 100.000 100,000 to 250.000 250.000 to 500,000 500.000 to 750.000 750,000 to 1.000,000 1,000,000 to 1,250,000 1250.000 to 1.500.000 1,500000 to 2,000,000 2,000,000 or more xv PAGENO="0156" 146 BESTS KEY RATING GUIDE and Best's Rating for each of the 1,750 companies reported on. Included are five key. financial statistics and eight of the 32 tests used by Best's for rating analysis. These tests measure a company's perfor- mance in the three critical areas of Prof- itability, Leverage and Liquidity in~com- parison to the norms established by the A.M. Best Company. These norms are based on an evaluation of the actual per- formance of the property/casualty in- dustry. The current norm established for each test is shown in the center box of each exhibit. A minimum or maximum test limit is also shown providing an ac- * ceptable. range of deviation from the norm. * Direct Premiums Written. This item represents the aggregate amount of premiums directly written by the com- pany, other than reinsurance, issued during the year whether collected or not at the close of the year (plus retrospec- tive audit premium collections), after deducting all return premiums. * Net Premiums Written. This item represents retained premium income, di- rect or through reinsurance, less payS rnents made for reinsurance ceded. * Net Operating Income. This item represents premiums earned less losses and underwriting expenses incurred, plus miscellaneous income, less divi- dends to policyholders, plus miscellane- ous adjustment to surplus due to oper- ating income and expenses for prior years, plus net investment income ex- cluding capital gains, less income taxes. * Total Admitted Assets. This item is total admitted assets. These assets are valued in accord with state laws and reg~ ulations, as reported by the company in its financial statements filed with state insurance regulatory authorities. This item is reported net as to encumbrances on real estate and net as to amounts re- ~overaWe from reinsurers. All secunnes owned by insurance companies are valued in accordance with the standards established by the National Association of Insurance Corn- missioners. Stocks and non.~amortizable bonds are valued at December 31 mar- ket quotations with all other bonds at amortized values. * Policyholders' Surplus. This item is the sum of paid irrcapital,~:contributcd surplus, and net-earned surplus, includ- ing voluntary contingency reserves. It is the difference between total admitted as- sets and total liabilities. Profitability Tests * Combined Ratio. The~sum of the loss ratio, expense ratio `and the divi- dend ratio. Loss Ratio: The ratio of in- curred losses and loss adjustment expenses to net premiums earned, expressed as a percent. Expense Ratio: The ratio of underwriting expenses, miscellaneous in- come and expenses to net premiums written, expressed as a percent. Dividend Ratio: The ratio of dividends to policyholders to net premiums earned, expressed as a percent. * NOl toNPE. Net operating income to net premiums earned, expressed as a percent. If in any given year net premiums earned are less than be- ginning policyholders' surplus, the lat. ter is used as the denominator for that year's calculation. This ratio does not reflect capital gains. * Return on Policyholders' Surplus. The ratio, expressed as a percent, of all operating income, after taxes and other investment gains, to the prior-year end policyholders' surplus. in other words, it is the total return from underwriting and investments after tax, to statutory net worth at the beginning of the year. Leverage Tests. * NPW to PHS. Net premiums writ- ten to Policyholders' Surplus expressed as a ratio. This reflects the leverage, after reinsurance assumed and ceded, of the company's current volume of net busi- ness in relation to its policyholders' surplus. It measures the company's ex- posure to pricing errors in its current book of business. xYI PAGENO="0157" 147 PROPERTY.CASUALTY * Net Liabilities to PHS. Netliabilities equal total liabilities less conditional reserves plus encumbrances on real es- tate less the lower of r~civable from or payable to affiliates. This reflects the leverage of the company's unpaid obliga- tions in relation to its policyholders' surplus. It also measures the company's exposure to errors of estimation in its liabilities. * Net Leverage. The sum of NPW to PHS and Net Liabilities to PHS. This measures simultaneously the company's exposure both to pricing errors and to errors of estimation in its liabilities in relation to policyholders' surplus. * Ceded Reinsurance Leverage. The ratio of the reinsurance premiums ceded rlus the net ceded reinsurance balances for unpaid losses and unearned prerni- urns recoverable plus the ceded reinsur- ance balances payable, associated with non-affiliates and foreign affiliates to policyholders' surplus, expressed as a ratio. Reinsurance premiums ceded to non-aff:Iiates and foreign affiliates are e~tirnated by multiplying total reinsur- ance ceded premiums by the ratio of un- earned premiums on reinsurance ceded to non-affiliates and foreign affiliates to the total unearned premiums on ren- surance ceded. Net ceded reinsurance balances for unpaid losses and unearned ;`rerriiurns recoverabk equal ceded rein- -urnce balances on unpaid losses and unearned premiums recoverable from non-affiliates and foreign affiliates, plus an e~tirnate of IBNR losses on réinsur- ince from non-affiliates and kreign aE. tiliates. less funds held b') the company unjer reinsurance treaties. This ratio represents the portion of the com~anv~ eross premiums and gross *:,iE-~i:tiec ceded to non-aff~Lj~~ rein- - :re~ and forejcn affiJjares~ net of any :nJ~ w:thhejJ. Jr measures the compa- flv~ potential exposure to contingent adjustments on such reinsurance and ~hc corn~an~s dependence on the secur- ~v ;`tv;~jeJ by its reinsurance. * Gross Leverage. The sum o( Net Leverage and Ceded Reinsurance Lever- age. This measures the company's ex- posure to pricing errors and to errors of estimation in its liabilities on its book of business as well as its exposure to con- tingent adjustments and the soundness of its reinsurance. Liquidity Tests * Current Liquidity. The ratio of cash and securities (unaffiliated) plus encum- brances on other properties to net liabilities plus ceded reinsurance balances payable, expressed as a percent. This ratio measures the proportion of liabilities covered by cash and unaf- filiated investments. When this ratio is less than 100, the company's solvency is dependent on the collectibility or marketability of premium balances, in- vestments in affiliates or other unin- vested assets. This ratio assumes the col- lectibility of all amounts recoverable from reinsurers on unpaid losses and un- earned premiums. * Investment Leverage. The ratio to policyholders' surplus of 20% of unaf- filiated common stock plus the reduc- tion in market value of bonds, prefer- red stocks, and mortgage loans that would occur if yields at market values rose 2 percentage points (200 basis points), expressed as a percent. This measures the effect on surplus of a 20% decline in common stock prices and a 2% rise in interest rates. Statutory surplus is not affected by a change in bond values, but, if it were, this ratio measures what the effect would be. * Best's Rating. Please refer to Section I - Explanation of Best's Rating System for details and description of Best's Rating Classification. A.M. BEST COMPANY Oldwick, New Jersey July 20, 1987 XVII PAGENO="0158" I I ~:::::::::: ~~:J :E~ ~ ~ ~ ~ c C) z PAGENO="0159" ~` ~f1f!r[I~~u( If ~ ~ r! ~ Ji ? ~ ~ I - c~,~Ig~e i4~~fj ~ r~1 ti r1i~~v~dr ~1fifIIi[ if f I iIiIpfq[F'~ i~r!~fl!fL ~ ~ 1 ~ ~ 111ff ffllf 11! C{!W'~1 - J I a~a~ ~~d!~g Jill 9ft Vii ~ fr»= 1111 ffllfl t V F ~ ~E~2EE~ fi J ~ t i!~E~i~t~ç ~ ~!~~!~nT g ~ a ii igr~ p PAGENO="0160" ~11t ~ ~1ii'Et~iiW C,' 0 PAGENO="0161" 151 STATEMENT OF BERNHARD MICHAEL, EXECUTIVE MANAGER, MUNICH REINSURANCE CO.-U.S. BRANCH, NEW YORK, NY Mr. MICHAEL. My name is Bernhard Michael. I am in charge of international tax matters for Munich Reinsurance Co. of Germany, and I am appearing on behalf of our U.S. branch located in New York City. I came over from Germany especially to participate in these hearings today to support the repeal of section 842(b) as it ap- plies to property casualty insurance companies. Although the docu- ments inviting testimony do not contemplate section 842(b)'s repeal, the law as it presently stands produces such harsh and unfair tax results that we are compelled to ask for its repeal from its original effective date. Section 842(b) violates the United States-German tax treaty since it imposes more burdens in taxes on German companies than it does on United States companies, and it taxes fictitious profits based on hypothetical assumptions, not actual profits. The United States-German tax treaty prohibits either country from imposing other or more burdens on taxes on a foreign corporation than it does on its own domestic corporations. As Mr. Stroud mentioned, if section 842(b) were applicable to U.S. property casualty companies, a substantial number of these U.S. companies would not have sufficient actual net investment income to meet the test of this section, and thus would be taxed on phantom income. These U.S. companies, in a similar situation as many U.S. branches of foreign reinsurers, are not taxed under sec- tion 842(b); therefore it is discriminatory and violative of the treaty. The U.S. mechanism for adopting a treaty is different from that for creating a Federal statute. Entry into a treaty creates obliga- tions under intermitional law which* may persist regardless of changes in national law. The nature of a treaty is a bargain with another government, and may be said to create expectations on the part of the other government concerning implementation and dura- tion of the treaty bargain. As such, treaty obligations should not be lightly set aside. For all these reasons and those expressed by Mr. Stroud, I re- spectfully request that the Congress consider repeal Of section 842(b) insofar as it applies to U.S. branches of foreign property cas- ualty insurance companies. Thank you very much for listening. [The statement of Mr. Michael follows:] 30-860 0 - 90 - 6 PAGENO="0162" 152 STATEMENT OP MUNICH REINSURANCE COMPANY UNITED STATES BRANCH BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS U. B * HOUSE OF REPRESENTATIVES FEBRUARY 21, 1990 Munich Reinsurance Company is submitting this statement to support the repeal of Internal Revenue Code Section 842(b) as it applies to U.S. branches of property/casualty insurance companies. We believe this tax imputes income that does not exist and places an unfair burden on foreign insurers doing business in the U.S. A branch of Munich Reinsurance Company was first established in the U.S. in the 1890's and was most recently reestablished in New York in 1955. In its New York City offices, the Munich Reinsurance Group (which includes the branch and its affiliate, Munich American Reinsurance Company ("MARC")) occupies 111,650 sq. ft. of space and employs 326 persons, 151 of whom reside in New York city. In addition to the New York offices, the Munic Group has offices in eight other locations throughout the U.S. The U.S. branch writes all forms of property/casualty reinsurance for risks throughout the United States. In 1988, it wrote $403 million of premiums and held over $900 million of assets in trusteed accounts in the United States. Inthe same year, MARC wrote $564 million of premiums and had statutory assets of $845 million. Both the branch and MARC are rated A+, the highest rating given for financial capability, by the A.M. Best Company, the leading insurance rating agency. The branch files a Federal income tax return identical to that filed by U.S. property/casualty companies. The return is based on its NAIC annual statement which again is identical in form to those filed by all U.S. property/casualty insurers. I. A general explanation of Section 842 as it applies to U.S. branches of foreign property/casualty insurers. Section 842(a) of the Internal Revenue Code imposes a tax on U.S. branches of foreign insurance companies doing business in the U.S. in the same manner as they would be taxed if they were a domestic company on their income that is effectively connected with their U.S. trade or business. For this purpose, branch taxable income, whether the income is from U.S. sources or foreign sources, is determined on the basis of Part II of Subchapter L as if the company were a domestic property/casualty insurance company. Section 842(b) enacted in 1987 goes beyond the normal rules for determining effectively connected investment income. By use of an arbitrary formula, it requires that the amount of a company's net investment income that is treated as effectively connected with the U.S. trade or business be increased so that it is no lower than the product of (1) the company's required U.S. assets and (2) the company's domestic investment yield for the year. Therefore, if a foreign insurance company's net investment income that is actually effectively connected with its U.S. business is less than the company's minimum effectively connected net investment income as determined under Section 842 (b) , the U. S. branch must increase its actual effectively connected income by the difference. A U.S. branch's required U.S. assets for a tax year are the mean of its total insurance liabilities on its U.S. business multiplied by its domestic asset/liability percentage for the yearS The domestic asset/liability percentage, determined by the ~Atlanta, Boston, Chicago, Columbus, Dallas, Hartford Philadelphia and San Francisco. PAGENO="0163" 153 Internal Revenue Service, is the ratio of (1) the mean assets of domestic property/casualty insurance companies to (2) the mean totalinsurance liabilities of these domestic companies. The ratio is based on data collected from domestic companies, taxable under the same part of Subchapter L as the foreign company, in the second preceding tax year before the tax year for which the domestic asset/liability percentage is being computed. Pursuant to IRS Notice 89-96, the domestic asset/liability percentage for tax year 1988 was 152.3. For 1989, IRS Notice 90-13 provides a 151.6 domestic asset/liability percentage. Domestic investment yield, also determined by the Internal Revenue Service, is the ratio of (1) the net investment income of domestic property/casualty companies to (2) the mean assets held by these companies. This ratio is also based on the operations of domestic companies, taxable under the same part of Subchapter L as the foreign company, in the second preceding tax year before the tax year for which the percentage is being computed. Notice 89-96 provides a 1988 investment yield of 8.1 percent and Notice 90-13 provides a 1989 investment ~(ield of 6.7 percent. If the company so elects, its own worldwide current investment yield (its worldwide net investment income divided by the mean of its assets) may be substituted for domestic investment yield. To illustrate how Section 842(b) works, assume .a branch has $66 million in insurance liabilities. In 1989, using the asset/liability ratio promulgated by the IRS, it would have minimum required U.S. assets of $100 million ($66 million x 151.6%) and a minimum domestic yield of $6.7 million ($100 million x $6.7). II. Expansion of Section 842(b) to property/casualty companies "solves" a problem that never existed. As part of the Com~rehensive Budget Reconciliation Act of 1987, the concept of minimum investment income was extended to property/casualty companies with the enactment of Section 842 (b). The concept of imputing additional investment income to U.S. branches of foreign insurers had until then applied only to life companies. When the life insurance company income tax law was extensively rewritten in 1959, a predecessor to Section 842(b), Section 819, was enacted. Section 819 imputed a minimum amount of investment income to U.S. branches of foreign life insurance companies. Apparently Congress was influenced by information brought to its attention that unless a minimum amount of investment income was imputed to their U.S. branches, foreign life insurers could enjoy a tax advantage by maintaining surplus outside of the U.S. This imputation concept became known as "minimum effectively connected investment income" ("MII"). Although numerous branches of foreign property/casualty insurance companiesc~ad been operating in the U.S. for many years prior to 1959, the~MII concept was not applied to property/casualty compan±es~ at that time. Presumably no one saw a need to do so. In~1~6~, the entire area of tax law with respect to income attribution to U.S. branches was studied and rewritten as part of the 1966 Foreign Investors Tax Act. Congress specifically scrutinized foreign insurance companies doing business in the U.S. and extensively revised Section 842. This confirmed that foreign property/casualty insurers doing business in the U.S. would be taxed on that business which was effectively connected with that trade or.~business. In House and Senate Committee Reports accompanying Section 4(g)of the 1966 Act, Congress said specifically: "Your committee believes that foreign insurance companies-- life companies and other insurance Companies, ~including both mutual and stock companies -- should, in.~eneral, be taxed on their investment income in the same manner as other foreign corporations. For this reason, the bill provides that a foreign corporation carrying on an insurance business within the United States is to be taxable in the same manner as domestic companies carrying on a similar business with PAGENO="0164" 154 * respect to its income which is effectively connected with the conduct of a trade or business within the United States~" [emphasis added] At the time, Congress saw no need to extend the principles of Section 819 to property/casualty companies. This fact is clearly demonstrated by another paragraph in the same Section 4(g) of the House and Senate Committee Reports which discuss an amendment to Section 819 excluding from its application investment income subject to withholding tax under Section 881. "It has been pointed out to your committee that the !pecial~rule in present law referred to above with respect to foreign life insurance companies -- where these companies hold a lower ratio of surplus for their U.S. business than that held by the average domestic companies -- may lead to what in effect is a double ~ [emphasis added] It is interesting that at that time, Congress was concerned with not double taxing branches of foreign insurance companies. In 1984, Congress again examined Section 819. Congress made technical changes to Section 819 (one of which was renumbering it as Section 813); however, no one asked Congress to extend the provisions of Section 813 to branches of foreign property! casualty companies. This is so despite the fact that this was a time when Congress was focusing on the tax formula of the property/casualty insurance industry. For example, in June 1983, the Senate Finance Committee held hearings on the property/ casualty tax formula, and during this time, the General Accounting Office was also studying this topic and eventually issued a report in 1985. Also witness the 1984 enactment of Section 845 in response to perceived abuse of reinsurance as a tax planning tool by both life and property/casualty insurers. Barely two years later, with the Tax Reform Act of 1986, Congress extensively rewrote the tax law as it applied to property/casualty insurance companies, domestics and U.S. branches. In addition, Congress revised the foreign provisions relating to property/casualty insurance companies in the "controlled foreign corporations" area. Further, Congress enacted a branch profits tax, Section 884, applicable to all foreign companies, insurance and otherwise. Committee Reports accompanying the 1986 Act indicate that the specific purpose of the branch profits tax was to eliminate a perceived advantage branches of foreign corporations enjoyed because income of domestic corporations was usually subject to two levels of taxation, at the corporate level and then the shareholder level, while income of branches of foreign corporations was usually only taxed at the corporate level. Its enactment should be viewed as preempting other special branch taxes such as Section 842(b). If a perceived abuse were to exist, an appropriate penalty had been provided. At this point, Section 884 completely did away with the need for continuation of the NIl concept because virtually no way remained for a foreign branch of an insurance company to lower its tax burden by moving surplus out of the U.S. If ever there was the appropriate time for considering repeal of this concept, it was then. It should be noted that in some instances income tax treaties can prevented immediate imposition of the branch profits tax. For example, the U.S.-German Income Tax Treaty of 1966 is such a treaty; however, upon ratification of the new U.S.-German income tax treaty to become effective in 1990, branch profits will have to be paid at a rate corresponding to the withholding tax rate for dividends from interrelated companies. This rate is 10 percent for 1991 and 5 percent for 1992. In 1987, in the rush to adjournment before Christmas when many sections of the 1987 Omnibus Budget Reconciliation Act were passed leaving little time for input from affected taxpayers, the NIl concept was inexplicably extended to apply to U.S. branches of foreign property/casualty insurance companies. This is PAGENO="0165" 15E. especially surprising when one remembers that Treasury's soie concern was technical amendments to the Nil formula applicable to life companies. For 28 years the Nil formula had applied only to foreign life insurance companies. The legislative history of Section 842(b) is~davoid of any reason for expanding the Mu ru]aes toproperty/casualty~companies, except for a cursory statement that the same rules should a~ply to property/casualty companies as to life companies. This is no justification for a * major change in the taxation of U.S. branches of foreign property/casualty companies, particularly when no abuse had ever * *~~:~beert demonstrated~to exist and where a previously enacted tax law (Section~8~4)had~provjded a "toll charge" applicable to any abiise~that~"ztight develop. The extension of the Nil concept to property~casualty~companies is nothing more than overkill. If there was one advantage that could arguably have remained for U.S. branches of foreign property/casualty insurers, the 1987 Tax Act eliminated it by extending the provision in Section 864 to require U.S. branches of forei~n* property/casualty companies to include in taxable income foreign source effectively connected investment.jncome. The modification of Section 864 and the 1986 ~ 884 branch profits tax imposing the ~fto~harge~'for±r~sferring surplus out of the U.S. were more than~aiiffictent to correct an~' possible perceived abuse in the ~surp~~ maintenance 1~7a foreign property/casualty insurance company. Section 813 should not have been extended to apply to foreign property/casualty insurance companies; it should have been repealed. Its retention as Section 842(b) is an unnecessary second branch profits tax on U.S. branches of foreign property/casualty insurance companies. III. Section 842(b) imputes income to U.S. branches that is not imputed to U.S. insurers under the same circumstances. Section 842(b) is highly discriminatory in its application to U.S. branches of foreign property/casualty companies. It imposes a surplus ratio standard that many U.S. insurers do not maintain. We believe that if the largest U.S. reinsurers* that reinsure primarily long-tail business are examined, one will find that if Section 842(b) was applied to them, most would be forced to recognize investment "income" that does not in fact exist. The primary reason for this is that most of these companies have a lower asset/liability ratio than the industry average. It would be unfair to impute "phantom income" to these U.S. companies, and the law properly does not. However, the U.S. branch of Munich Reinsurance is in the same situation. Its asset/reserve ratio is less than that prescribed by the Internal Revenue Service for 1988. This requires the U.S. branch to report more investment income on its U.S. assets than it earns. As a consequence, the U.S. branch of Munich Reinsurance is treated unfairly when compared to similar U.S. companies. IV. The refusal of the Treasury Department to compute separate domestic asset/liability percentages and separate domestic investment yields for different lines of property/casualty insurance business produces harsh and anomalous results. Section 842(b) was initially enacted without giving recognition to the fact that all property/casualty companies -- both domestic and foreign -- generally have different asset/liability ratios depending upon the type of business being written, for example long-tail business versus short-tail. Congress recognized the inequality in subjecting all lines of business to one overall - average. To make certain that the requisite calculations are based on a comparison of similar domestic to foreign company U.S. operations, the Congress added Section 842(d) (4) in 1988. The Committee Reports state the following: "In addition, the bill authorizes the Treasury Secretary to issue regulations that provide for separate domestic asset/liability percentages and separate domestic investment yields for different types of property and PAGENO="0166" 156 casualty insurance companies. For this purpose, the committee intends that both domestic and foreign property and casualty insurance companies will be categorizedbased on the principal type of business that the company writes for any taxable year. For example, the regulations may provide for a domestic asset/liability percentage and a domestic investment yield that apply to property and casualty insurance companies whose principal business is long-tail lines of business and a separate domestic asset/liability percentage and domestic investment yield that ap~ly to all other property and casualty insurance companies... "The committee believes that the bill's grant of regulatory authority to make the required determinations by categorizing the property and casualty industry among broad classes serves to better effectuate the purpose of the minimum net investment income requirement than the use of a single domestic asset/liability percentage and a single domestic investment yield for the entire property and casualty industry. In addition, such authority should reduce some of the inequities that may result from the use of averages." Despite these clear instructions to Treasury, Treasury declined to do so because its analysis suggested that separate company calculations would be iñappro~riate. Specifically, in Notice 89-96 Treasury stated its position as follows: "Section 842(d) (4) permits the Secretary to prescribe separate domestic asset/liability percentages and domestic investment yields for separate categories of property and liability insurance companies. No guidance will be issued at this time because individual company analysis suggests that separate calculations would not be appropriate." Apparently, the congressional provision enacted in the 1988 Act was in vain. The congress was convinced that distinguishing between categories is necessary, and the property/casualty insurance industry is equipped to supply the data necessary to implement separate computation of percentages and yields. However, Treasury has seen fit to frustrate the clear congressional intent to more fairly tax foreign property/casualty insurance companies. Interestingly, the Treasury has no problem producing the discount factors for short- and long-tail lines that are necessary for the calculation of tax reserves. As congress itself has acknowledged, the use of averages computed from a representative sample of domestic insurance companies creates inequities and anomalous results because it presumes a certain truth in averages that may have no relevance to the unique operations of a company. For example, if a branch is overcapitalized, it still may not be able to generate or maintain the earnings ratio required by Section 842(b). This is attributable in part to use of two-year old data and the fact that investment performance tends to fluctuate. Another example of an anomaly created by the use of an average would be the case of a recently formed branch with adequate capital but less capital than that required by the domestic insurance average. That branch would be taxed on earnings it never even had a chance to earn. Any law which is so inherently flawed and which the Treasury refuses even to attempt to modify in order to mitigate its harsh and unfair results, should be repealed. V. The interplay between Section 884, the branch profits tax and Section 842(b) results in the double taxation of branches of foreign insurance companies. If the surplus of a U.S. branch of a foreign insurance company actually equaled the minimum amount required under Section 842(b) and if the effectively connected investment income actually earned by the branch met the amount imputed by the Internal Revenue Service and if that branch moved surplus out to its PAGENO="0167" 157 foreign home office, it would incur a branch profits tax under Section 884. However, all other things being equal, this same branch would still have to recognize phantom investment income. A law which stifles business growth by so blatently double taxing tends to be confiscatory and should be repealed. VI. Application of Section 842(b) to property/casualty kranches violates the principles of free trade. In a global economy, with U.S. insurance companies seeking to do business worldwide, it is questionable public policy to impose artificial restrictions on foreign companies doing business in the United States. Unfortunately such provisions tend to spread around the world as other countries feel they are being discriminated against or recognize another opportunity to protect their own domestic industries from competition. For example, it is our understanding that the United Kingdom is imposing a similar rule. Lest we forget, when the U.S. adopted discounting for loss reserves in 1986, Canada and the U.K. soon followed suit. Ultimately, the proliferation of branch tax laws similar to Section 842 can only result- in the taxation of over 100 percent of a company's worldwide income. As Europe heads toward the unified European Community of 1992, as the Soviet Union and Eastern Europe are becoming new players in world trade, as the United States presses Japan to lower its internal trade barriers, and as the United States pushes for application of the GATT to services, it is inconsistent for the United States to apply unfair and artificial trade barriers through tax legislation against U.S. branches of foreign property/casualty companies. Only repeal of Section 842(b) can rectify enactment of this poorly conceived protectionist step. VII. This provision violates the U.S. -German Income Tax Treaty. Profits of~a German insurance company carrying on activities through a permanent establishment in the U.S. are excluded front tax in the U.S. unless they are attributable to the U.S. under Article III of the U.S. -German tax treaty of 1966. This is also true under Article 7 of the new U.S. -German treaty which was signed on August 29, 1989 but has not yet been ratified. (Upon ratification, it will become effective as of January 1, 1990.) As investment income is part of the total profits earned by the foreign company in an accounting period, neither future nor hypothetical profits should be taxed by the U.S. Because an individual company situation forms the basis of attribution of the profits concerned, investment income should not be increased fictitiously on the grounds of average U.S. domestic income figures differing from the actual figures of a company. Since the intention of Section 842(b) is to substitute the investment income of a German insurance company taxable in the U.S. under Article III of the treaty (or Article 7 of the pending treaty), by an average investment income, irrespective of whether this income has actually been earned or is attributable to the U.S. under Article III (or Article 7), Section 842(b) subjects German profits to U.S. taxation in contravention of the existing tax treaty. Moreover, Article XVIII, Paragraph 3, of the 1966 U.S.-German tax treaty prohibits either country from imposing other or more burdensome taxes on the foreign corporation than it does on its own domestic corporations. A similar provision, Article 24, Paragraph 2, in the pending treaty provides that the taxation on a permanent establishment in the U.S. shall not be less favorably levied than the tax levied on U.S. enterprises carrying on the same activities. As we maintained earlier, if Section 842(b) were applicable to U.S. property/casualty companies, a substantial number of these U.S. companies would not have sufficient actual net investment income to meet the test of Section 842(b) and thus would be taxed on "phantom income." That these U.S. companies in a similar situation as Munich Reinsurance are not taxed under Section 842(b) is discriminatory and violative of Article XVIII of the 1966 treaty and Article 24 of the pending tax treaty. PAGENO="0168" 158 The U.S. mechanism for adopting a treaty is different from that for creating a U.S. Federal statute. Treaties must be negotiated between the Executive branch of the U.S. government and a foreign government, consented to by two-thirds vote of the Senate and approved by the President. Moreover, entry into a treaty creates obligations under international law which may persist regardless of changes in internal law. The nature of a treaty as a bargain with another government may be said to create expectations on the part of the other government concerning the implementation and duration of the treaty bargain. As such, treaty obligations should not be lightly set aside. VIII. Conclusion. For all the reasons stated above, we respectfully submit that the Congress should repeal Section 842(b) insofar as it applies to U.S. branches of foreign property/casualty companies. PAGENO="0169" 159 Chairman RANGEL. Thank you, Mr. Michael. Mr. Britt. STATEMENT OF RAYMOND L. BRITT, JR., ESQ., INVESTMENT VICE PRESIDENT, UNITED STATES PRIVATE PLACEMENTS AND HIGH YIELD SECURITIES, MANUFACTURERS LIFE INSURANCE CO., TORONTO, CANADA, ON BEHALF OF CANADIAN LIFE AND HEALTH INSURANCE ASSOCIATION'S UNITED STATES TAX- ATION SUBCOMMITTEE Mr. BRITT. I thank the chairman and the other members of the subcommittee for allowing me to appear today to express support for the proposed modifications to section 842(b) of the Internal Rev- enue Code. I am appearing on behalf of the Canadian Life and Health Insurance Association's U.S. Tax Subcommittee. The CLHIA represents 95 percent of all life insurance and health insur- ance companies operating in Canada, both United States and Cana- dian companies. Briefly, section 842(b) subjects a foreign insurance company to tax on the greater of its actual net investment income and a mini- mum amount of net investment income which is calculated using the investment yield and the surplus level of U.S. companies for 2 years previous. Before discussing the proposed modifications, an example of the inequities in 842 may be helpful. If 842(b) had applied to the Pru- dential Life Insurance Co. of America in 1988, the subcommittee es- timates that, using the domestic asset liability percentage and the domestic investment yield released by Treasury for use in 1988, that Prudential's minimum net investment income would have ex- ceeded its reported financial statement NAIC income by $1.5 bil- lion. And assuming, as Treasury does, that taxable net investment income equates NAIC net investment income, the Prudential would be subject to an additional tax of an additional $1.5 billion of net investment income in 1988. This is enormous, considering that the reported pre-tax net income of Prudential was $1.4 billion. Similarly, for the 14 largest U.S. insurance companies, the aggre- gate minimum net investment income would exceed the aggregate reported NAIC net investment income by $8 billion, compared to an aggregate reported pre-tax net income of $5.8 billion.' These ex- amples point out the inequities that are presently in the operation of section 842(b), and we believe the proposed modifications will remedy some of those inequities. The first flaw that we see in 842(b) is the use of 2-year-old data to calculate the domestic asset liability percentage and the domestic investment yield. Section 842(b) directs Treasury to calculate the 2 percentages using 2-year-old representative data from U.S. insur- ance companies. The concern is that the fluctuation of interest rates from year to year will cause the whipsaw effect to foreign companies, which~are subject to tax in each year on the greater of its actual net `investment income and a minimum amount calculat- ed from 2 years previous. A quick example may be helpful. Assume that a domestic insurance company and a foreign insur- ance company have the same investment yields. In 1986, it would be 10 percent; in 1988, 8 percent; and in 1990, 10 percent. In 1988, PAGENO="0170" 160 the foreign insurance company, even though it makes the same in- vestment yield, would be subject to tax on the greater of its own investment yield, 8 percent, or the 10 percent from the 1986 year- that is, 10 percent. In 1990, when both the domestic company and the foreign company earn 10 percent, it would be subject to the greater of its own investment yield, 10 percent, or the minimum from 2 years previous, 8 percent. In those 2 years, even though the domestic company and the for- eign company earn the same amount of income, 18-percent cumula- tive yield, they will be subject to tax on a 20-percent cumulative investment yield. The subcommittee estimates, using data of the 14 largest insur- ance companies, that the 1986 domestic investment yield was 9.84 percent. Whereas, the 1988 domestic investment yield was 8.89 per- cent, a drop of 100 basis points. So even if a foreign insurance com- pany earned 8.89 percent in 1988, it would be subject to tax on 9.84 percent under section 842(b). We propose that in any one year a foreign insurance company will be subject to tax on its actual net investment income, and 2 years subsequent, when Treasury has the data from the 2 years previous, it will then calculate a minimum net investment income figure. If in that year IRS determines that the minimum does exceed actual, IRS would add the difference into income in that year with an interest element to solve the "time value of money" problem. The second flaw that we have identified in 842(b) is the annual "greater-of" problem and the need for a carryover account. In each year, 842 subjects a foreign insurance company to tax on the great- er of its actual and the minimum, calculated using 2-year-old data. But there are other timing problems that cause a concern: year-to- year investment performance, trading practices, and the timing of capital gains and losses between a foreign company and a domestic company can result in significant year-to-year differences in rela- tive net investment income. An example of that timely difference can be found in exhibit B. To compensate for this, we have proposed a carryover account which will tax, on a cumulative basis, a foreign life insurance com- pany on the greater of its cumulative actual net investment income and its cumulative minimum net investment income, fulfilling the purpose of 842(b) but getting away from the annual greater-of ap- proach of the section. Last, the third flaw is the data source which is used by Treasury. Section 842(b) provides that Treasury will calculate the two per- centages using representative data. Treasury uses NAIC financial statement data and not tax data. Congress already has noted that there is a difference between financial statement data and tax data, or you wouldn't have section 56(f)(1) of the code. The problem is foreign companies don't want to be taxed on a minimum net investment income based on the financial statement income of domestic companies when we don't know whether those same domestic companies will be subject to tax on their financial statement income. We recommend the use of tax data and not annual statement data for calculating the percentages. PAGENO="0171" 161 In summary, the subcommittee is not attacking the basic design and intent of 842(b), even though I agree with my colleagues to my left that I would like to see that. We are here today to say that in operation 842(b) is flawed and provides unfavorable and inequitable treatment, and we ask the subcommittee to enact the proposals to take away some of the more discriminating aspects of 842(b). Thank you, Mr. Chairman. [The statement and attachment of Mr. Britt follow:] PAGENO="0172" 162 * RAYMOND L. BRITT, JR., ESO. MARY V. HARCAR. ESO. Testimony of Raymond L. Britt, Jr., Esq. The Manufacturers Life Insurance Company on behalf of CLHIA Subcommittee on U.S. Taxation in Support of ProposedModifications to Section 842(b) MINIMUM NET INVESTMENT INCOME OF FOREIGN INSURANCE COMPANIES CARRYING ON AN INSURANCE BUSINESS WITHIN THE UNITED STATES FEBRUARY 21, 1990 I. Introduction I want to thank the members of the House Ways and Means Select Revenue Measures Subcommittee for this opportunity to appear to express support for three (3) proposed modifications to section 842(b) of the Internal Revenue Code of 1986, as amended (the "Code"). These three modifications are listed in the Subcommittee's list of issues for this hearing as Item (A)(6)(b) under -- A. Foreign Provisions 6. Foreign companies carrying on Insurance Business: b. Other proposed modifications My appearance today is on behalf of the Canadian Life and Health Insurance Association's1 U.S. Taxation Subcommittee (the "Subcommittee"). The Subcommittee supports the proposed modifications to section 842(b) since these amendments would correct some of the inequities currently inherent in section 842(b). This paper, which is submitted on behalf of the Subcommittee,2 will outline the current operation of section 842(b), address the specific design flaws which would be corrected by the proposed modifications, discuss the Subcommittee's general opposition to section 842(b), and discuss the application of Notice 89-96 and Notice 90-13 to the operations of the Canadian life insurance companies. The Canadian Life and Health Insurance Association ("CLHIA") represents over 95% of all life and health insurance companies operating in Canada. 2 This paper has been issued by Raymond L. Britt, Jr., Seq. and Mary V. Harcar, Esq. Each issuer has registered as an agent of The Manufacturers Life Insurance Company, 200 Bloor Street, East, Toronto, Ontario, Canada M4W lE5, under the Foreign Agent's Registration Act. The Manufacturers Life Insurance Company is a member of the Subcommittee. Registration materials are available for inspection at the Department of Justice, Washington, D.C. Such registration does not indicate approval by the U.S. Government of the contents of this paper. PAGENO="0173" 163 II. Operation of Section 84~f~ Effective for taxable years beginning after December 31, 1987, section 842(b) of the Code subjects all foreign insurance companies to tax based upon the greater of (1) a foreign company's actual U.S. effectively connected net investment income ("AECNII") and (2) a minimum amount of effectively connected net investment income ("MECNII") calculated using the investment yield and the surplus level of an "average" U.S. insurance company for two years previous, Pursuant to section 842(b), if a foreign insurance company's AECNII for the year is less than MECNII, the excess of MECNII over AECNII will be added to the foreign company's income for purposes of determining its Life Insurance Company Taxable Income for the year. In addition, if the foreign company is a mutual life insurance company, and its "U.S. Required Assets" exceed its actual U.S. assets, as reported in the annual statement form approved by the National Association of Insurance Commissioners (the "NAIC Annual Statement"), the excess will be added to the company's equitybase for purposes of calculating its section 809 Equity Adjustment for the year. In any year, MECNII is calculated as the product of "U.S. Required Assets" and the "Domestic Investment Yield", where: a)~ U.S. Required Assets is the product of the foreign company's total mean~ insurance liabilities and the Domestic Asset/Liability Percentage; b) Domestic Asset/Liability Percentage is calculated as the domestic companies' total mean assets divided by the domestic companies' totalmean insurance liabilities; and c) Domestic Investment Yield is calculated as the domestic companies' total net investment income divided by the domestic companies' total mean assets, Both the Domestic Asset/Liability Percentage and the Domestic Investment Yield are calculated by the Treasury Department ("Treasury") using "representative data" for domestic insurance companies from two years previous. In Notice 89-96, Treasury released the Domestic Asset/Liability Percentage (120.5%) and the Domestic Investment Yield (10%) to be used by a foreign life insurance company for the first taxable year beginning after December 31, 1987. In Notice 90-13, Treasury announced the DomesticAsset/Liability Percentage (117.2%) and the Domestic Investment Yield (8.7%) to be used by a foreign life insurance company for the taxable year beginning after December 31, 1988. III. Legislative Intent of Section 842 Prior to the Omnibus Budget Reconciliation Act of 1987 (the "1987 Tax Act"), it was felt that foreign companies with insurance activities in the U.S. had a competitive advantage because they were able to artificially reduce investment income subject to U.S. tax. The 1987 Tax Act amended section 842, adding subsection 842(b), which revised the required surplus rules that applied to taxation years prior to 1988 and included a rule under which the net investment income of a foreign insurance company could not be less than MECNII. The Conference Rport to the 1987 Tax Act specified that if section 842(b) were found to be in conflict with any existing U.S. Income tax treaty, section 842(b) is not intended to override the treaty. HR. Rep. No, 100-495, 100th Cong., 1st Sess., 983 (1987). PAGENO="0174" 164 IV. Modifications Needed to Correct Operational Flaws of Section 842(hl Since the enactment of section 842(b) in the 1987 Tax Act, the Subcommittee has discussed with representatives of Treasury and the Joint Committee of Taxation the need for a statutory modification to correct the following design flaws in section 842(b): a) FLAW: Use of Two Year Old Data to Calculate the Domestic Asset/Liability Percentage and the Domestic Investment Yield. The Subcommittee supports the modification listed in the Noticeof these Hearings as Item (A)(6)(b)(ii). This modification would mean that for any taxable year MECNII would be calculated using domestic company data from the ~aise taxable y~i. Thus, AECNII for 1989 would be compared with the average domestic company investment performance for 1989 rather than 1987 (as is the case under current section 842(b)). Section 842(b) provides thatthe Domestic Asset/Liability Percentage and the Domestic Investment Yield are to be calculated using two year old data from domestic insurance companies. This has created a serious problem given the timing of the introduction of section 842(b). Investment yields for 1986 (data from 1986 were used to calculate MECNII for the 1988 taxation year) were much higher than the actual investment yields earned byboth domestic and foreign companies in 1988. Using data from the NAIC Annual Statement for the 14 largest U.S. life insurance companies, the Subcommittee has calculated the 1986 Domestic Investment Yield to be 9.84% (note that this percentage is less than the published Domestic Investment Yield for 1988, 10%), whereas the 1988 Domestic Investment Yield for those same companies is 8.89%, a drop of almost 100 basis points. This problem can reoccur year to year as yields fluctuate. It should be noted that if section 842(b) had applied to Prudential Insurance Company of America ("Prudential") in 1988, the Subcommittee estimates, using the Domestic~ASset/Liabi1ity Percentage and Domestic Investment Yield prescribed by Treasury for use in the taxable year 1988, that Prudential's 1988 MECNII would exceed its 1988 NAIC Annual Statement net investment income by $1.5 billion. If we assume that NAIC Annual Statement net investment income is equal to AECNII, then prudential's 1988 taxable income would have been increased by $1.5 billion, an enormous amount given that its pre-tax net income as reported in its NAIC Annual Statement was only $1.4 billion! Similarly, for the fourteen (14) largest U.S. life insurance companies, their aggregate MECNII would exceed their NAIC Annual Statement net investment income by over $8 billion, compared to their reported pre-tax net income of $5.8 billion. This clearly indicates the inappropriateness of using two year old data in the calculations under section 842(b). It is the Subcommittee's opinion that MECNII should be calculated using the same-year data, not data from two years previous. It is proposed that in any given taxation year, a foreign insurance company should be subject to tax on its AECNII. Two years subsequent, when Treasury has the domestic insurance company data for two years previous, Treasury can calculate a MECNII for the taxation year two years previous, and if the NECNII exceeds the AECNII for that year, the foreign insurance company will include the difference in its tax return for the year in which the MECNII was calculated, plus interest on such excess to eliminate the "time value of money" issue. PAGENO="0175" 165 b) FLAW: "Greater-of Problem and the Need for a Carryover Account. The Subcommittee supports the modification listed in the Notice of these Hearings as Item (A)(6)(b)(i) which would set up a carryover account to minimize the whipsaw effect of section 842(b). ~A~foreign insurance company in any one taxation year is subject to tax on the greater of (1) its AECNII and (2) its MECNII, withMECNII being calculated using domestic company data from two years previous. This greater-of approach will -result in a foreign insurance company being subject to tax on net investment income greater than it or a "representative" domestic insurance company earns over any measured period of time. An example of this problem is inclUded as Appendix A. While adoption of the Subcommittees proposal discussed in the preceding paragraph IV (a) above may eliminate a portion of the greater-of problem created by the use of two year old data, differences in trading practices, year-to-year investment performance, portfolio mix and the timing of capital gains and losses between a foreign insurance company and the `representative" domestic insurance company can result in significant year-to-year differences in relative net investment income levels. An example of the problem caused by the timing -of capital gains and. losses is included as Appendix B. The Subcommittee proposes that a Carryover Account be established by foreign insurance companies subject to section 842(b). The use of a Carryover Account is necessary to ensure that the previously referred to trading differences and timing issues do not result in a foreign insurance company being subject to income tax, over any measured period of time, on a cumulative amount of net investment income that exceeds both what the foreign insurance company and the "representative" domestic insurance company actually earn over that measured period of time. Such a .Carryover Account would keep track, on a~cumulative basis, of the amounts by which MECNII exceed AECNII in particular taxation years and the amounts by which AECNII exceed MECNII in other taxation years. The intent of the Carryover Account is to ensure that a foreign insurance -company wilL±e subject to tax on the greater of its cumulative AECNII over-some measured period of time and the cumulative MECNII over that same measured period of time. The greater-of concept becomes measured on a cumulative basis, not an annual basis. Paragraph 842(d)(2) provides that Treasury shall issue regulations that provide for adjustments in future years where AECNII in a year exceeds MECNII for that year. Therefore, Treasury has the authority, but has yet to exercise that authority, to establish a Carryover Account in the circumstances where AECNII in a year exceeds MECNII for the year. Treasury has expressed the view that it does not have the authority to issue regulations to expand such Carryover Account to take into consideration required adjustments for years where MECNII in a year exceeds AECNII for that yedr. - It is the Subcommittee's opinion that both adjustments are required. The Subcommittee supports the proposed modifications in the Hearing Notice. c) FLAW: Data Source Problem - Financial Statement Data is used to Determine the Domestic Asset/Liability Percentage and the Domestic Investment Yield. Thus, MECNII is not determined using tax return data. The Subcommittee supports the modification of section 842(b) to require that the data used to determine the Domestic Asset/Liability Percentage and the Domestic Investment Yield be derived from the tax returns of U.S. insurance companies rather than from their financial statements. PAGENO="0176" 166 In Notice 89-96, Treasury stated that it utilized NAIC Annual Statement data to determine both the Domestic Asset/Liability Percentage and the Domestic Investment Yield. It is the Subcommittees opinion that tax return data, as opposed to NAIC Annual Statement data, should be used to calculate both the Domestic Asset/Liability Percentage and, more importantly, the Domestic Investment Yield. Tax return net investment income can vary significantly from NAIC Annual Statement income. Congress recognized this point in section 56(f)(l) which provides that, in taxation years 1987, 1988 and 1989, a corporation must increase its alternative minimum taxable income by 50% of the difference between financial statement income, as adjusted, and alternative minimum taxable income computed without regard to section 56(f)(l)! Using NAIC Annual Statement data has the effect of taxing foreign lif~ insurance companies based upon the financial statement income of domestic life insurance companies even though there is no assurance that domestic life insurance companies will be actually subject to tax on that amount of net investment income. Perhaps the most significant difference between NAIC Annual Statement data and tax~ return data is in the calculation of net capital gains and losses. For NAIC Annual Statement purposes, gains and losses are calculated using NAIC asset values, not actual tax costs. NAIC asset values are subject to write-downs and write-ups, with conservative guidelines mandated for use in the preparation of the NAIC Annual Statement dictating more write-downs than write-ups. This results in a book value which is generally less than the tax cost and therefore NAIC Annual Statement gains greater than capital gains on a tax basis. Such overstatements of capital gains inflate the Domestic Investment Yield. This inflation of Domestic Investment Yield is inappropriate since the U.S. insurance companies are not being taxed on the gains calculated in this manner. (d) FLAW: Need for clarification that in a year when the section 842 imputed income is offset by net operating losses section 842 allows for either a reduction in sectiOn 881 taxes or a carryforward of the section 881 tax paid as a credit in future years when taxpayer is paying tax. The Subcommittee supports the modification listed in the Notice of these Hearings as Item (A)(6)(b)(iii). The Subcommittee views this modification as already in section 842 but believes that this reduction in section 881 taxes should be clarified. v. General Opposition to Op~r~atiOfl oSctiL~42.th1 it continues to be the opinion of the Subcommitteethat section 842(b) violates Article XXV (Non_Discrimination) of the 1980 Canada-United States Income Tax Treaty (the "Treaty"). paragraph 6 of Article XXV states that the taxation on a permanent establishment which a resident of a Contracting State has in the other Contracting State shall not be less favourably levied in the other State than the taxation levied on residents of the other State carrying on the sane activities. pursuant to Article XXV(6), the U.S. taxation of the U.S. permanent establishment branch operation of a Canadian company carrying on a life insurance business in the U.S. shall not be less favourable than the U.S. taxation of a U.S. life insurance company. However, due to the design flaws in section 842(b), it is clear that Canadian life insurance companies are subject to a tax burden that is less favourable than the tax burden imposed on a U.S. life insurance company. PAGENO="0177" 167 The Conference Report to the 1987 Tax Act states that Treasury believes that section 842(b) does not violate any treaty. An argument has been made that section 842(b) is merely a means of defining the amount of effectively connected income (`ECI") and therefore does not discriminate against foreign corporations. An argument has also been made that the U.S. can prescribe a method of taxation for foreign companies different from that imposed on domestic companies. Such arguments fail to recognize the purpose of a non-discrimination treaty provision. Such provisions examine the overall effect of a taxing method or provision to determine whether the overall effect of the tax is that a permanent establishment of a nonresident enterprise is taxed less favourably than a resident enterprise which carries on the same activities. See K. van Reed, Nondiscrimination in International Tax Law 166-67 (1986). As discussed in this paper, section 842(b) certainly- taxes foreign life insurance companies less favourably than domestic life insurance companies. A U.S. life insurance company is subject to tax upon the actual net investment income generated by j~ assets. If *the company has a poorinvestment return for a year, or engages in trading practices to accelerate capital losses, or to defer capital gains, and as a result of such trading practices, the companys net investment yield for the year is less than the average net investment yield for all U.S. life insurance companies, the company is still subject to tax on its ~ net investment income for the year. In fact, 50% of all U.S. life insurance companies will have an investment performance which is less than the average investment performance of all U.S. life insurance companies. At least 50% of domestic insurance companies would have additional income imputed to them by section 842(b) if such companies were foreign. Since section 842(b) does not apply to domestic insurance companies, it is plain that foreign life insurance companies will be less favourably taxed than domestic life insurance companies. In order to do business in the U.S., a Canadian life insurance company must hold assets in a U.S. trust to cover 100% of its U.S. liabilities plus an amount of surplus assets as specified by state law. These are the same surplus requirements imposed on a domestic life insurance company. These assets are held in trust. for the protection of U.S. policyholders and are specifically identified (through the Canadian company's U.S. NAIC Annual Statement), as is the investment income generated by such assets. If a U.S. life insurance company held identical assets to those held by a Canadian life insurance company, the U.S. company would be subject to U.S. tax based upon the investment income generated by the specific assets in its portfolio regardless of how the yield on those assets compared to the average investment yield of all U.S. life insurance companies. However, a Canadian life insurance company is not only subject to tax on the investment income ~ctua]..l generated by the assets deposited in the U.S. trust, but is also subject to tax on an additional amount of investment income jf; the average investment income of all U.S. life insurance companies from 2 years prior to the current tax year (measured using financial statement data) is greater than the investment income actually earned by the Canadian life insurance company. Thus, pursuant to section 842(b), a Canadian life insurance company in any year is subject to a less favourable tax than that imposed on a similarly situated U.S. life insurance company. In the Subcommittee's view, this unfavourable tax treatment is a breach of Article XXV of the Treaty. PAGENO="0178" 168 VI. Notice 89-96 and Notice 90-13 Notice 89-96, 1989-35 I.R.B. 1 (October 2, 1989) was promulgated by Treasury on August 8, 1989 to provide interim guidance for applying section 842(b) prior to the release of final regulations. Detailed comments of the Subcommittee regarding Notice 89-96 were delivered to Treasury and the Internal Revenue Service on October 27, 1989. We would be pleased to provide the Subcommitteerwith~a copy of these comments. Notice 89-96 provided that for the purpose of applying section 842(b) for a foreign life insurance companys 1988 taxation year, the Domestic Asset/Liability Percentage would be 120.5% and the Domestic Investment Yield would ~be 10.0%. In the comments of the Subcommittee on Notice 89-96, we noted that part of the methodology used by Treasury to calculate Total Insurance Liabilities for U.S. life insurance companies was inaccurate. The Subcommittee has access to the same data base used by Treasury to calculate the required percentage under section 842(b) and has calculated the appropriate Domestic Asset/Liability Percentage for the first taxable year beginning after December 31, 1987 to be 117.5% using what it considers to be accurate methodology. In fact, the methodology used by the Subcommittee is like that used by Treasury with the exception of the treatment of data included on one line (Line 25) of the NAIC Annual Statement. The Subcommittee has had many conversations with Treasury requesting that Treasury correct its methodology and amend the published Domestic Asset/Liability Percentage for use in taxable year 1988. On January 17, 1990, Notice 90-13, 1990-6 I.R.B. 25 (February 5, 1990) was promulgated. Notice 90-13 released the Domestic Asset/Liability (117.2%) and Domestic Investment Yield (8.7%) to be used by foreign life insurance companies for section 842(b) purposes for the first taxable year beginning after December 31, 1988. These numbers, it should be recalled, are determined using finanàial statement data (from NAIC Annual Statements) from 1986 and 1987. Paragraph IV of Notice 90-13 includes.the following statement: In its initial calculation of the percentages required under section 842 (in Notice 89-96], Treasury relied on industry analysis submitted by representatives of the foreign life insurance industry to determine the fraction of a figure reported on the NAIC statement to be included in "total insurance liabilities" of the foreign life insurance companies. The industry representatives have subsequently determined that their analysis was in error and have submitted evidence indicating the correct fraction to be included. Treasury has reviewed this evidence, gg~g~rs with the corrected value, and has used this fraction to obtain the 1989 percentages published here. ~ change is beino made to the 1988 percentaclee. Thoee numbers were determined using the best information available to Treasury at the time. (Emphasis added). Notice 89-96 provided that the Domestic Asset/Liability Percentage to be used for the first taxable year beginning after December 31, 1987 was 120.5%. Even by Treasury's own admission, that percentage is incorrect. The accurate Domestic Asset/Liability Percentage is 117.5%. Notice 90-13 states that the reason for the incorrect Domestic Asset/Liability Percentage for 1988 was because of an error in the analysis submitted by representatives of the foreign life insurance industry ("Industry Analysis"). In fact, the Industry Analysis was correct as it applied to the data base used in the Industry Analysis supplied to Treasury. However, these data were inappropriate for use in the data base utilized by Treasury. This was due to the fact that the source of the data used in the Industry Analysis was different from the source of the data used by Treasury to calculate the Domestic Asset/Liability Percentage. Since different data PAGENO="0179" 169 sources were used, it was inappropriate to use the Industry Analysis to determine a fraction of a figure reported on the NAIC Statement in the Treasury data to be included in Total Insurance Liabilities. This inappropriate use of the Industry Analysis resulted in Treasury understating Total Mean Domestic Insurance Liabilities and therefore overstating the Domestic Asset/Liability Percentage for 1988. The size of the error was also increased by the fact that Treasury applied the fraction determined for 1986 to bgtji its 1985 and 1986 NAIC Statement data rather than calculating a separate fraction for 1985. It was only after the Domestic Asset/Liability Percentage for 1988 was published by Treasury that the representatives of the foreign life insurance industry realized that there must be an error in the way it was calculated and had discussions with Treasury to determine the cause of the error. As noted above, Treasury agrees that an error was made but has refused to correct the error. The Subcommittee estimates that its member Canadian life insurance companies that use the incorrect 120.5% Domestic Asset/Liability Percentage will be subject to tax in the aggregate on an additional net investment income in 1988 of approximately $60 million. The use of the incorrect Domestic Asset/Liability Percentage exacerbates the problem of using 1986 financial statement data to calculate both the Domestic Asset/Liability Percentage and the Domestic Investment Yield. VII. ~enc1usion Section 842(b) is seriously flawed both in basic design and operation. Through its basic design, foreign insurance companies are subject to tax based on the earnings of their U.S. insurance company competitors, not their own earnings. In a letter to House Ways and Means Committee Chairman Dan Rostenkowski on July 17, 1989, Kenneth Gideon, Assistant Treasury Secretary For Tax Policy, stated that one of the flaws of section 809 of the Code was basing the taxes of mutual life insurance companies on the earnings of competitors. Section 842 is flawed in precisely the same manner. The use of two year old NAIC Annual Statement data is clearly inappropriate. Its use, if applied to Prudential, would result in imputed income under section 842(b) that is greater than 100% of its 1988 net income. A similar result would occur if section 842(b) were applied in 1988 to the 14 largest U.S. life insurance companies. The operation of section 842(b) is plainlydiscriminatory against Canadian life insurance companies particularly in view of the fact that Canadian companies operating in the U.S are subject to the same rules regarding the maintenance of an adequate surplus in a U.S. trust. The use of two-year old, NAIC Annual Statement data, as opposed to same year, tax return data, in addition to the lack of a Carryover Account described in this paper, subjects Canadian life insurance companies to much less favourable taxation than is imposed on U.S. life insurance companies. At present, a U.S. life insurance company that carries on an insurance business in Canada is subject to tax on investment income that is calculated using the company's ~ surplus and its o~ investment yield. Treasury and Congress should consider the possibility that retaliatory efforts could be made by other countries to equalize the impact of section 842(b) by means of provisions aimed at U.S. insurers. ~February 21, 1990 PAGENO="0180" 170 APPENDIX A EXAMPLE OF GREATER-OF Taxable Year 86 87 88 89 90 91 92 Total (88-92) Domestic Yield 8 7 7 6 7 8 8 36 Foreign Yield 7 6 7 8 8 36 §842 Yield 8 7 7 8 8 38 In the Years 1988 through 1992, the foreign company yields and the representative domestic company yields are identical, totaling 36% as a cumulative yield for the period. However, because of the "greater-of' approach of section 842(b), exacerbated by the two-year lag and data collection problems, the foreign company will be subject to tax on a greater cumulative yield over-the period, 38%, than either it or the representative domestic companies earned in that period. A small difference in investment yield can create large distortions in MECNII. The impact on MECNII can create a U.S. tax liability for a foreign life Insurance company that exceeds its U.S. net income. APPENDIX B ~E OF CAPITAL GAINS PROBLEM Assume that a foreign insurance company ("Company A") and the average u.s. insurance company ("Company B") hold the same investment portfolio. Further assume that Company A is subject to tax on the greater of (i) its own net investment income for the year and (ii) net investment income of Company B, the average U.S. life- insurance company, for the year (ignoring the two-year lag issue). Excluding capital gains, each earn the following amount of net investment income in years 1988 and 1989 (in millions): 19M 12~1 Company A 100 120 Company B 100 120 Thus, in both years, Company A would have no imputed income pursuant to subsection 842(b), since its own net investment income and that of Company B, the average U.S. life insurance company, is the same. However, further assume that Company A sold its stock holdings in ABC Corporation on December 15, 1988, for a $10 million gain, while Company B sold its stock holdings in ABC Corporation on January 1, 1989, for an identical gain, $10 million. Including capital gains, the two companies now earn the following amounts of net investment income in years 1988 and 1989 (in millions): 1~1 Company A 110 120 Company B 100 130 Even though both Company A and Company B earn $230 million of net investment income over the two year period, Company A would be subject to tax on $240 million of net investment income during that period pursuant to the "greater-of" structure of subsection 842(b), $110 million in 1988 and $130 million in 1989. PAGENO="0181" 171 Chairman RANGEL. Thank you, Mr. Britt. Mr. McGrath. Mr. McGi~ni. Thank you, Mr. Chairman. I would just comment on a few things and then perhaps ask a question. We had a hearing in the last couple of weeks on the ef- fects of Europe 1992 and the effects of subpart F in terms of the competitive nature of our companies compared to their companies in similar instances. I suspect that we're probably going to be doing something in that area shortly. In terms of PFIC, I have an inter- est in that, also, and we heard from the Treasury today that they seemingly are not for us but not against us. So we're going to have to take a look at that. Mr. Stroud, I was going to ask you a question about what the effect would be if 842 were to be applied to U.S. domestic PC com- panies. What effect would that have on the domestic companies? I think Mr. Britt answered that question. Would you have anything to say about that? Mr. STROUD. Well, the only comment I would like to make, Con- gressman, is that that is the insidious nature of 842. The domestic companies, assuming you applied the formula, they would have to pay the tax. But since they are not subject to the tax, we are the only ones that have to pay the tax. So for the same amount of do!- lars of surplus as our commercial competitors, we end up paying the tax and they do not. Mr. MCGRATH. Mr. Michael, you referred in your testimony to the imposition of section 842 as being somewhat in violation of the United States-German tax agreement. I am wondering whether or not you have taken your case to the State Department in this regard. Mr. MICHAEL. Mr. McGrath, in my opinion, section 842, because it is based on fictitious and hypothetical figures, is not in accord- ance with article VII of the German-United States tax treaty, which says that only profits actually earned by a company can be taxed here in the United States, but not hypothetical profits. Mr. MCGRATH. You are alleging that you are being taxed on income which is phantom in nature. Mr. MICHAEL. That is right. Mr. MCGRATH. Have you sought redress from the State Depart- ment on this? Mr. MICHAEL. Pardon? I didn't understand the question. Mr. MCGRATH. Has your company or the German Government gone to the State Department to complain about the imposition of this? Mr. MICHAEL. We contacted our finance ministry in Germany, and I hope they will contact your Treasury. Mr. MCGRATH. To my knowledge, I don't think we have heard from State on this yet. Mr. MICHAEL. Maybe they haven't already-- Mr. MCGRATH. That is my point. Thank you. Chairman RANGEL. Let me thank the panel and assure them that the full committee will be made apprised of the inequities that you have raised to this committee. The next panel, John Chapoton, counsel, Goldman Sachs; Clyde Turbeville, National Association of Independent Insurers; Howard PAGENO="0182" `172 Greene, Risk & Insurance Management Society; and Andre Maison- pierre, Reinsurance Association of America. We will start off with our old friend, John Chapoton. STATEMENT OF JOHN E. CHAPOTON, ESQ., VINSON & ELKINS, P.C., WASHINGTON, DC, COUNSEL TO GOLDMAN, SACHS & CO., NEW YORK, NY Mr. CHAPOTON. My name is John Chapoton. I am with the Wash- ington office of Vinson & Elkins. I appear today as counsel to Gold- man, Sachs, in support of a proposed amendment tothe foreign personal holding company rules affecting broker-dealers operating abroad. The foreign personal holding company rules, like most foreign rules, are ~quite complex. They were adopted originally to prevent the~use of~a~foreign incorporated pocketbook, that is, where a U.S. person would take assets that produce passive income, put them in ~an~off-~zhore corporation, and thus avoid current U.S. taxation of - `~the income. The classic case would be some bonds, for example, put in a corporation abroad, and that would defer U.S. taxation of the interest income. The foreign personal holding company rules operate to bring that income home, as a deemed dividend, ~which is currently taxed in the United States. The foreign personal holding. company rules were never, it seems to me, designed to apply to the income of an active business and, indeed, the current law exempts all sorts of income and active businesses that earn income that may be of a passive nature if that income is earned in the carrying on of an active business abroad. The proposed amendment would correct an oversight in existing law by exempting interest income earned on securities held as in- ventory by broker-dealers. Current law already recognizes the active nature of the, carrying on of a broker-dealer business abroad by exempting the trading gains of securities dealers, but current law, for some reason, does not exempt interest income the same businesses might earn on their inventories. The active nature of the interest earned by a foreign broker- dealer on its inventories, or by a broker-dealer on its inventories, was explicitly recognized in 1988, when this committee adopted, and Congress passed, an amendment which exempted such income from the domestic personal holding company rules. The proposed amendment would simply make that rule that now applies to do- mestic personal holding companies apply to foreign personal hold- ing companies as well. The amendment is badly needed, because the impact of the for- eign personal holding company rules is uneven. They apply to closely held foreign operations, but not those that are owned by U.S. companies that are widely held, so we have a competitive im- balance. Certain U.S. businesses are at a distinct competitive disad- vantage. They have to pay current U.S. tax on their fore~g.a earn- ings, while their U.S. competitors do not, and of course, i.t places them at a disadvantage vis-a-vis their foreign competitors as well, so we are talking about current taxation of active business i.~:icome earned abroad. PAGENO="0183" 173 The antideferral rules applying to foreign businesses controlled by U.S. corporations are, of course, quite complex. The foreign per- sonal holding company rules, for example, were adopted in 1937; subsequently, there have been adopted the subpart F rules, and more recently the PFIC rules-passive foreign investment company rules. Both of these rules are in place, applicable to U.S. controlled for- eign operations. Neither of them affects the type of broker-dealer operation abroad that we are referring to, for a number of reasons. The chief reason the more modern rules don't apply is because there is a high tax exception if the income is earned in a country that has a tax rate equal to at least 90 percent of the U.S. tax rate. The purpose of that exception is rather obvious, nobody would put income abroad for tax reasons if it is going to be taxed at basically the same rate it would be if earned here. The high tax exemption is not ~present in the foreign personal holding company rules. No one has a good explanation for that and, indeed, it would seem to make a lot of sense to put a high tax exemption in the foreign personal holding company rules as well, even though the amendment before the committee that we are sup- porting-is not that broad. We are aware, Mr. Chairman, that the committee is studying ways to simplify the foreign tax rules, and we certainly would ap- plaud that effort, but we do not think that that effort should be used as a reason to prevent the Congress from rectifying an inequi- ty in this case, or in any other case, when the inequity is identified. That is particularly important in a case such as this, where there is an adverse competitive consequence resulting from the inequity. The correction seems obvious for all similarly situated U.S. con- trolled broker-dealers operating abroad. I must say the method of correction seems as obvious as the need for it. We strongly urge the committee to consider the proposed amendment favorably. Thank you, Mr. Chairman. [The statement and attachment of Mr. Chapoton follow:] PAGENO="0184" 174 STATEMENT BY JOHN E. CHAPOTON BEFORE THE SUBCOMMTITEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS FEBRUARY 21, 1990 MR. CHAIRMAN AND MEMBERS OF THE Co~trvrEE: My name is John E. Chapoton. I am the managing partner of the Washington Office of Vinson & Elkins. I am appearing today as counsel for Goldman, Sachs & Co. I welcome this opportunity to discuss with you a proposal to amend the foreign personal holding company provisions of the Internal Revenue Code. The purpose of the proposed amendment is to correct an apparent oversight in the Code that is placing certain u.s. companies doing business in foreign countries as brokers and dealers of securities at an unfair competitive disadvantage. BACKGROUND The proposed amendment would parallel an amendment made in section 6279 of the Technical and Miscellaneous Revenue Act of 1988 (the 1988 Act) to exclude certain interest income of brokers and dealers from the domestic personal holding company rules. Congress made the 1988 change in recognition of the active nature of the activities carried on.by brokers and dealers. The foreign personal holding company rules (Code § 551 ~ ~q.) and their domestic counterpart (Code § 541 g~ ~q.) serve essentially the same purposes. Both the foreign and domestic rules were designed to prevent tax avoidance by use of an incorporated pocketbook, that is, the use of a corporation to avoid current taxation of various types of passive income to the shareholders. For example, an individual who directly holds interest-bearing bonds for investment could avoid individual income tax on the interest by transferring the bonds to a corporation. The interest income would thus be accrued by and taxed to the corporation, and no tax would be paid by the individual until the earnings of the corporation were distributed in the form of a dividend. The domestic personal holding company rules address this potential tax deferral in effect by requiring payment of the individual income tax on corporate earnings of a personal holding company, whether or not distributed to shareholders. similarly, a U.S. person could avoid current U.S. tax on interest by transferring bonds to a foreign corporation. The foreign personal holding company rules prevent this deferral by requiring current recognition of income by the U.S. person. PAGENO="0185" 175 The purpose of the personal holding company rules is thus to prevent the accumulation of passive income in a corporation in order to avoid current individual income tax. Tax deferral is not a concern, however, in the case of active businesses carried on by corporations. Therefore, both the domestic and foreign personal holding company rules exempt various types of active financial businesses. The domestic personal holding company rules exempt banks,. life insurance companies, and small business investment companies. Code § 542(c). Similarly, the foreign personal holding company rules exempt corporations organized and doing business under the banking and credit laws of a foreign country, provided it is established that the corporation is not formed or availed of for the purpose of evading or avoiding United States income tax on its shareholders. Code § 552(b). The foreign personal holding company rules also exempt specific types of active income. In particular, the foreign personal holding company rules exclude gains on the sale or exchange of stock or securities by a regular dealer. Code § 553 (a) (2). These rules thus already explicitly recognize the active nature of the business of brokers and dealers. AcrIvmEs OF BROKERS AND DEALERS Dealers make markets in securities; that is, dealers. are in the business of buying and selling certain securities at quoted prices. Dealers earn, income from the spread: the difference between the price they pay for securities (bid) and the price at which they sell them (offer). As a part of the business of dealing in securities, dealers maintain substantial inventories of the securities in which they are making a market. When held in inventory, interest-bearing securities continue to accrue interest, and current law treats interest as foreign personal holding company income. In the case of a dealer, however, this income simply arises as part of the active business of dealing in securities. Interest income is also earned by a broker with respect to margin accounts of securities customers and by other lending to customers collateralized by. securities in customers' accounts. This type of lending activity is not different from ordinary bank lending activity. It is thus merely another form of active lending business. Ti~ 1988 Acr A1?,qi~r The 1988 Act amended the domestic' personal holding company rules to recognize the active nature of interest earned by securities brokers and dealers. The 1988 Act exempted the interest income of a broker or dealer in connection with inventories of securities, margin accounts, and customer financing secured by securities. No corollary change was adopted to the foreign personal holding company rules. ` These forms of interest income of a `broker or dealer in securities were exempted from the domestic personal holding company rules because they arise from the conduct of an active business. PAGENO="0186" 176 A similar change is clearly required in the foreign personal holding company rules. COMPETITIVE IMPACT The existing shortcoming in the foreign personal holding company rules does not affect all U.S. brokers and dealers with foreign subsidiaries, and it is thus placing the small group that is affected at a distinct competitive disadvantage. The stockholders of widely-held U.S. corporations are not subject to the foreign personal holding company rules because they do not meet the control requirements of those rules. Consequently, the foreign broker-dealer subsidiary of a widely-held U.S. corporation could not be a foreign personal holding company, even if all of its income consisted of interest or other personal holding company income. This is because the interests of its individual shareholders are not aggregated under the foreign personal holding company attribution rules. Code § 554 (a) (1). Subsidiaries of closely-held U.S. corporations, however, are subject to the foreign personal holding company rules. So, too, are foreign subsidiaries owned by U.S. partnerships, by application of the attribution rules. Code § 554 (a) (2). Thus, the undistributed income of the foreign broker-dealer subsidiaries of these U.S. owners may be subject to current U.S. tax, while the widely-held U.S. corporations with which they compete are not taxed currently on their earnings from the same activities carried on in a foreign broker-dealer subsidiary. Companies such as Goldman, Sachs therefore suffer a' competitive disadvantage vis-a-vis other U.S. securities dealers in foreign markets, most of whom'operate as foreign subsidiaries of widely-held, U.S. corporations. Ti~ FOREIGN PERSONAL HOLDING CoMP~Y Ruu~s IMPROPERLY TAx BROKERS OF SECURITIES The foreign personal holding company rules, we believe, were never intended to cover active financial businesses and thus should not apply to a corporation carrying on business as a broker or dealer in ,securities. A foreign corporation is classified as a foreign personal holding company only if at least 60 percent of its gross income is foreign personal holding company income. Code § 552 (a) (1). The rules treat .q~oss interest income as foreign personal holding company income, without regard to whether this income produces any net income to the corporation. Code § 553 (a) (1). Thus, a securities broker would be required to treat as tainted income the entire amount of interest accrued on securities held in inventory. As a practical matter, however, inventories must be financed, and little or no net interest income may be earned. As a result, the foreign personal holding company rules might attribute a very large amount of tainted interest income to a securities broker, causing it to be classified as a foreign personal holding company, when in fact the broker was incurring a loss on maintenance of its securities inventories. PAGENO="0187" 177 Worse, by operation of the foreign personal holding company rules, the taint of the gross interest income may cause otherwise untainted income from trading activities of a foreign Subsidiary to be subject to current U.S. tax. This is because the entire taxable income of a foreign corporation is taxed currently to its U.S. parent once it is classified as a foreign personal holding company. ~ 556(a). As a result, a dealer that earned no net income with respect to securities inventories might nevertheless find that gross interest income produced by its inventories causes current U.S. taxation of the earnings from its otherwise untainted securities trading. The foreign personal holding company rules are thus unlike the anti-deferral rules of subpart F, which require current recognition only of ~ tainted income (other than in high- tax jurisdictions, that is). Code § 954(b) (5). An example illustrates the problem with the operation of the foreign personal holding company rules. Assume a foreign corporation, a dealer in securities, had gross income of $300 in 1989. Of that amount, $100 was trading income and $200 was gross interest income. Assume further, however, that the foreign corporation had $200 of interest expense as a direct result of financing its securities inventory (which would not be unusual because securities in inventory are not held for investment). Net interest income would therefore be zero [200 minus 200]. But under current law, the corporation satisfies the income criterion to be classified as a foreign personal holding company because 67% of its gross income is tainted interest income [200/300]. Therefore, its entire untainted trading income ($100 less expenses] will be subject to current U.S. tax under the foreign personal holding company rules. This phenomenon is a result of the application of the foreign personal holding company rules to a financial business -- something we submit was never contemplated by the drafters. Banks, for example, have always been exempted from the foreign personal holding company rules. Code § 552(b). At the same time, with respect to income other than interest, only net income is generally included in foreign personal holding company income. For example, with respect to sales of securities or commodities, only net gains (to the extent exceeding losses) are included in foreign personal holding company income, not gross sales revenue. It is thus anomalous not only that the foreign personal holding company rules apply to an active financial business carried on in a foreign country, but also that the gross interest income earned in the active conduct of a securities business abroad should be included in foreign personal holding company income. This type of income should be excluded, just as it now is from domestic personal holding company income as a result of the 1988 legislation. PROPOSAL For these reasons, the foreign personal holding company rules should be amended to correct the competitive inequity described above. Our specific proposal, which would exempt the interest income earned by brokers and dealers of securities with respect to inventories, is set out in the Appendix to this statement. The proposed amendment tracks the 1988 amendment to the domestic personal holding company rules. A parenthetical has been added to make it clear that foreign brokers and dealers need not PAGENO="0188" 178 be registered under U.S. securities~ laws in order to qualify for the exception. The proposal has also been drafted to limit application of the exception to foreign corporations located in high-tax jurisdictions. The purpose of this additional requirement is *to eliminate any possibility, however remote, that the exception could ::~be abused by locating a securities dealer in a tax haven jurisdiction. The anti-deferral rules of~ subpart F and the passive foreign investment company provisions generally exempt businesses located in high-tax jurisdictions, determined in the same manner as the proposed rule. Specifically, subpart F [Code §954 (b) (4)] and the PFIC rules [Code § 1294 (g) (1)] except from current taxation income subj ect to an effective rate of foreign tax that is at least 90 percent of the maximum U.S. rate. The implicit assumption is that businesses are not located in high-tax jurisdictions for purposes of deferring tax because it is a matter of economic indifference whether taxes paid are foreign or domestic, so long as the amount is roughly equal. Therefore, no antideferral rule is necessary. It is not clear why the foreign personal holding company rules do not contain a similar exception, unless it is simply that those rules date from 1934 and are relatively unsophisticated. PAGENO="0189" 179 APPENDIX PROPOSED AMENDMENT Certain Interest Earned by Brokers or -Dealers Not Taken Into Account as Foreign Personal Holding Company Income. (a) In General. -~ Paragraph (1) of section 553(a) of the 1986 Code is amended by inserting a dash after the work "to" in the second sentence; by designating the remainder of the second sentence as subparagraph A; and by adding at the end thereof a comma, followed by the word "and" and the following new subparagraph: "(B) interest received by a broker or dealer (within the meaning of section 3(a) (4) or (5) of the Securities and Exchange Act of 1934 (whether or not registered under such Act)) in connection with -- "(i) any securities or money market instruments held as property described in section 1221(1), "(ii) margin accounts, or "(iii) any financing for a customer secured by securities or money market instruments." For purposes of this subparagraph (B), the tern "dealer" shall include only a regular dealer licensed or otherwise authorized to engage in the business of dealing in stock of securities under the laws of the country in which it is doing business~ This subparagraph shall apply only if the taxable income of the foreign broker or dealer was subject to an effective rate of income tax imposed -by a foreign country greater than 90 percent of the maximum rate of tax specified in section 11." (b) Effective Date. -~ The amendments made by this section shall apply to interest received in taxable years ending after the date of the enactment of this Act. PAGENO="0190" 180 Chairman RANGEL. Thank you, Mr. Chapoton. We will now hear from Mr. Turbeville. STATEMENT OF CLYDE TURBEVILLE, EXECUTIVE VICE PRESI- DENT AND GENERAL MANAGER, AMERICAN AGRICULTURAL IN- SURANCE CO., PARK RIDGE, IL, ALSO ON BEHALF OF THE NA- TIONAL ASSOCIATION OF INDEPENDENT INSURERS, THE ALLI- ANCE OF AMERICAN INSURERS, THE AMERICAN INSURANCE ASSOCIATION, AND THE NATIONAL ASSOCIATION OF MUTUAL INSURANCE COS. 2 Mr. TURBEVILLE. Thank you, Mr. Chairman. I am Clyde Turbe- yule, executive vice president of:American Agricultural Insurance Co. My company serves the reinsurance needs of the many farm bureau-affiliated insurance companies across the country. My com- ments today will relate to the proposed~modification of the reinsur- ance excise tax. I speak today also on behalf of the `National Association of Inde- pendent Insurers, to which my company, and all of our farm bureau insurance customers, belong~ In addition, I speak for the Al- liance~of~AmBrican Insurers, the American Insurance Association, and the~National Association of Mutual Insurance Cos. Together, these four associations represent-a membership of approximately 2,000 property and casualty companies, which write more than 80 percent of the premium volume on property and casualty insurance risk in the United States. These associations' members include both stock and mutual companies~ They range in size from small, one State writers to large, multistate rcompanies. They do. business in every State, and in virtually every community, in the United States. The proposal before us appears rather simple and. straightfor- ward. Premiums paid to foreign reinsurers ~should be~taxed at higher rates to reduce a~competitive~advautage~they'may have over domestic reinsurance as a result of the special burden placed on do- mestic reinsurers by the Tax Reforni Actrof 1986. My company is one of the domestic reinsurers that this proposal is supposed to * benefit, but I see no advantage in this proposal for either my com- pany or for the Farm Bureau `insurance companies that we rein- sure, and it is certainly harmful to~ the thousands of P&C insurers for whom I speak today, and for the millions of people they insure. I wish to comment briefly on a few points we feel are pertinent to the issue. I have also submitted a more detailed written state- ment that we request be included in the record of the hearing. The increased cost of this proposal will not be borne by the for- eign reinsurers. That cost would inevitably be passed on to the ulti- mate consumers who purchase insurance for autos, homes and businesses, but it is also important to note that the proposal would not accomplish what its proponents suggest. Passage of this meas- ure would not result in our dependence on foreign reinsurance. A real-life example will show why. My company, AAIC, handles the property catastrophe reinsur- ance needs of the farm bureau insurance companies. In that capac- ity, we reinsured the losses those companies incurred in North and South Carolina as a result of Hurricane Hugo. PAGENO="0191" 181 Our companies directly reinsure these farm bureau insurance companies. We then seek to buy reinsurance ourselves for expo- sures that are too much for us to handle. We would prefer to place all of this business with domestic reinsurers. In saying this, I intend no criticism of our foreign support. There are sound business reasons for this preference. We, and the insurance departments that regulate us, can generally get a clear picture of the financial soundness of domestic reinsurers. Other factors, such as ease of obtaining payment, and terms of cov- erage, also cause us to favor domestic reinsurers, but our problem has been that sufficient capacity simply is not available from do- mestic reinsurers, so we have no alternative but to place much of this business with foreign. companies. They are essential to us, and without them, we could not write this business. And we are not alone. The domestic reinsurance industry simply does not have enough capacity to meet the P&C insurance needs of the U.S. market. My company's loss payments to the farm bureau companies in North and South Carolina as a result of Hugo approach $70 mil- lion; $40 million of that amount was recovered by us from our for- eign reinsurers, and again, that $40 million of coverage was placed overseas because we did not find adequate reinsurance coverage in our country. Losses ultimately equate to premiums, and must be borne by the companies we reinsure, and therefore, by the individuals who insure with them. If this measure we are discussing today should be adopted, the cost of the reinsurance to cover the $70 million loss in the Carolinas would ultimately increase by $1.2 million. This is the amount that would be generated by quadrupling the excise tax on the foreign portion of our program. Yet it does nothing to in- crease domestic reinsurance capacity, so we still have to use for- eign reinsurers, and our customers will be required to pay a great- er cost for doing so. We object to the proposal, and we think our customers would, also. Therefore, we, and all of the P&C trade associations, oppose this proposal to increase taxes. Thank you for this opportunity to present our thoughts. [The statement of Mr Turbeville follows] PAGENO="0192" 182 TESTIMONY OF CLYDE TURBEVILLE NATIONAL ASSOCIATION OF INDEPENDENT INSURERS; AND ALLIANCE OF AMERICAN INSURERS Description of the Associations The Alliance of American Insurers, the American Insurance Association, the National Association of Independent Insurers and the National Association of Mutual Insurance Companies (`the Associations') are voluntary, non-profit, national trade associations which together represent approximately 2,000 property and casualty ("P & C') insurance companies that write more than 80% of the premium volume with respect to property and casualty insurance risks written in the United States. The Associations' members include P & C companies of all types, including stocks, mutuals, reciprocals and Lloyds--ranging in size from small one-state writers to large multi-state companies. They do business in~every state and virtually every community in the nation. These large and diverse memberships provide a strong voice representing the broadest range of views on major issues. Proposed Modification of the Reinsurance Excise Tax This statement_is. submitted in response to Chairman Rangel's invitation for testimony with respect to a proposal to increase from 1 percent to~4'percent the excise tax which is imposed pursuant to section 4371 of the Internal Revenue Code on premiums on prop~rty and casualty reinsurance ceded abroad. The proposal also would provide that such an increase override any±r~eaty waiver of the tax. Reasons Associations Oppose Excise Tax Increase The Associations and their member insurers oppose the proposal to quadruple the excise tax on reinsurance ceded to~ foreign reinsurers and to override treaty exemptions for the following reasons: 1. As found by the General Accounting Office, available data do not establish that the Tax Reform Act of 1986 has caused a competitive imbalance between domestic and foreign reinsurers that would justify the burdens which would be imposed on U.S. primary writers and the American insurance-buying public by this tax increase. 2. Even if some competitive imbalance has occurred, there has been no showing that the proposed drastic 300% tax hike would correct that imbalance, rather than replace it with different distortions in the competitive arena. 3. The proposed tax hike would unjustifiably increase the cost of reinsurance and insurance to the U.S. consumer. 4. The proposed tax increase would punish U.S. insurers and purchasers of insurance by making it even more difficult to insure hard-to-place risks. 5. The proposed abrogation of treaty provisions might cause retaliation from treaty partners, with resulting unforeseen consequences. PAGENO="0193" 183 1. The Proponents of this Proposed Tax Increase Have Not Shown a Competitive Disadvantage to Domestic Reinsurers Resulting from the P & C Provisions of the 1986 Tax Act. The proposal to increase the tax on property and casualty reinsurance ceded to foreign reinsurers was initially put forward by the Reinsurance Association of America (RAA) in response to alleged tax advantages which RAA argues have been given to foreign companies competing with domestic reinsurers for reinsurance business generated within the U.S. reinsurance marketplace. RAA argues that changes made in the Revenue Act of 1986 affect only domestic P & C reinsurers and do not impact their foreign competitors. They argue that as a result, domestic P & C reinsurers have been put at a competitive disadvantage vis-a-vis their foreign competitors. They seek to `level the playing field' by guadrupling the excise tax imposed on premium on P & C reinsurance ceded abroad. Yet the proponents of this proposed tax hike have not shown that the changes in the taxation .of domestic reinsurers have resulted in placing them at a competitive disadvantage vis-a-vis their foreign counterparts. While it is true that the 1986 amendments which relate specifically to the P & C insurance industry (i.e., discounting of loss reserves, tax on 20% of the increase in unearned premium reserves and proration of a portion of tax-exempt income) have increased the tax burden of the P & C insurance industry as a whole, including, presumably, domestic P & C reinsurers, there has been no showing that these changes have placed domestic reinsurers at a competitive disadvantage vis-a-vis foreign reinsurers. Indeed, the General Accounting Office recently issued a report in which it concluded: Available data are limited and insufficient for supporting a conclusion regarding whether the competitiveness of U.S. reinsurers in the domestic market has been affected positively or negatively by the provisions of the Tax Reform Act of 1986. Although the foreign share of the U.S. reinsurance market has grown since tax reform--from 26.1 percent in 1986 to 32.6 percent in 1987 to a projected 38.6 percent in 1988--the foreign industry's share was also relatively high during the 1960s. During that period, foreign reinsurers garnered, on average, about 37.4 percent of U.S. reinsurance premiums. (Briefing Report to the Honorable Fortney (Pete) Stark, House of Representatives, on the Insurance Excise Tax and Competition for U.S. Reinsurance Premiums, GAO/GGD-89-115BR, p. 2, September, 1989.) ("GAO Report") The GAO also observed that although the Tax Reform Act of 1986 might have increased the tax burden on domestic reinsurers, foreign reinsurers might have similar tax burdens in their ~wn jurisdictions.. In addition, American reinsurers pay U.S. income tax only if they have an operating gain. If an American company operates at a loss, it pays no tax, but may instead carry that loss back or forward to generate refunds or offset future tax liabilities. On the other hand, the excise tax on reinsurancepremiums paid to foreign reinsurers is a 30-860 0 - 90 - 7 PAGENO="0194" 184 gross receipts tax, which is imposed without regard to the profitability or unprofitability of the foreign reinsurer. Hence, it cannot automatically be concluded that the domestic reinsurance industry has been placed at a competitive disadvantage vis-a-vis their foreign counterparts solely by virtue of changes in the Revenue Act of 1986. 2. Even Assuming Competitive Dislocations Were Caused by the Revenue Act of 1986, There Has Been No Showing That the Proposed Tax Increase Would `Level the Playing Field. The ground urged by proponents of the proposed increase in the excise tax on foreign P St C reinsurance premiums is to restore the parity in the U.S. reinsurance market between domestic and foreign reinsurers that was allegedly upset by the Revenue Act of 1986. Yet even assuming for sake of argument that disparities between domestic and foreign reinsurers have arisen as a result of the P St C provisions of the 1986 Act, there has been no showing that the proposed 300 percent increase in the excise tax will restore parity. No basis is shown for adopting the 4 percent rate advocated by the proponents. Apparently that rate represents nothing more than a parroting of the excise tax currently imposed on premiums paid on policies of casualty insurance issued by foreign primary insurers. But it is not at all apparent that the considerations which may have justified a 4% tax on P St C primary coverages are egually applicable to P St C reinsurance coverages. Nor has it been shown that such a significant increase in the tax on premiums on reinsurance ceded to foreign reinsurers would level the playing field at all. It is not unlikely that such a tax increase would merely result in tilting the field in another direction. Moreover, the proposed tax~ increase on foreign reinsurance premiums would apparently be applied across the board without regard to the tax treatment of the foreign reinsurer in its country of domicile. The GAO Report indicates that, as a result of differences in the way various countries define taxable income, it was unable to compare tax burdens of reinsurers from different countries. However, based on information compiled by the Assistant Secretary for Tax Policy, Department of Treasury, on the tax treatment of~ reinsurers in their own countries, the GAO Report concluded that: [F)or the nine countries studied, reinsurers were subject to a variety of. tax laws,. which may or may not affect their tax standing in relation to their U.S. counterparts. These variations, in. combination with the excise tax, could affect a company's tax burden and the extent to which it is advantaged or disadvantaged on its U.S. business. (GAO~ Report, Appendix I, p. 27.) In view of the disparate treatment of foreign reinsurers by the various countries in which they are located, it is entirely conceivable, indeed it is likely, that the proposed across-the-board increase in the excise tax would operate not only to seriously and unfairly prejudice domestic primary P St C insurers, but it would also prejudice many foreign reinsurers PAGENO="0195" 185 in their attempts to compete with domestic U.S. reinsurers and other foreign- reinsurers for U.S. risks, and this prejudice is likely to result in greater cost to the consumer. Such a result can only be characterized as protectionist and is fundamentally at odds with announced foreign trade policies of this country. 3. The Proposal Will Increase the Costof Reinsurance to U.S. Direct Writers and, Therefore, the Cost of Insurance to the Consumer. The inevitable result of raising the excise tax rate will be to increase reinsurance costs. It must be emphasized that the proposal would not increase prices just for the companies that use the foreign markets; it would increase costs for all companies that buy reinsurance. The 1986 Tax Reform Act has already placed a~new tax burden on the profitability of all domestic P & C insurance companies, both primary writers~and~reinsurers, This increase in tax costs caused by the 1986:Act;will, in turn, create pressure for increases in the price-of insurance to the ultimate consumer. While the precise impact of the tax law changes on the industry are not yet known, it is clear that the costs will be substantial. All estimates to date indicate that the tax burden will far exceed the $7.5 Billion for fiscal years 1987-1991 estimated by Congress at the time the 1986 Act was enacted.* And the burden will fall both on domestic insurers and reinsurers. The costs which would result from the proposed increase in the excise tax would only magnify the problem. Not only would the proposal increase the cost of purchasing coverage from foreign reinsurers, but it would also provide domestic reinsurers a cushion for increasing ±heir charges. The proponents of the excise tax increase on premiums paid to foreign reinsurers have provided no justification for imposing these additional costs on the insurance-buying public, particularly since that public is already facing substantial cost increases as a result of the 1986 Tax Reform Act. *For example, Price Waterhouse conducted a survey of P & C companies to measure the impact on the P & C industry of the three provisions of the Revenue Act of 1986 specifically applicable to the P & C industry. The results-of that survey, extrapolated to industry levels, -show that for 1987 the P & C industry's taxable income, before reduction by-NOLs, increased by $9.5 Billion in 1987 as a result of the three~P~& C-specific provisions of the 1986 Act. Even after application~--of NOLs, the P & C industry's 1987 tax liability increased--by $1.7 billion as a result of the three P & C industry-specific provisions. (Survey of 1987 Federal Income Tax Liability of Property and Casualty Insurance Industry, pp. i-u, Price Waterhouse, April 20, 1989). Similarly, an analysis by the Insurance Services Office finds that "For 1987-90, the first four years that TRA 86 is in effect, the industry's tax bill will be $12.2 billion--$7.8 billion more than the industry would have paid under prior law." (ISO Insurance Series, Tax Law Changes and Property/Casualty Insurers: A Comprehensive AnalyEis, p. 1, September 1989). - PAGENO="0196" 186 4. The Proposed Tax Increase Would Punish Insurers and Purchasers of Insurance Who Must Utilize Foreign Reinsurers. Many primary insurers currently reinsure only with U.S. reinsurance companies. Others would prefer to place their reinsurance coverages with domestic reinsurers but are unable to do so. Among the reasons these companies tend not to develop relationships with foreign reinsurers are the following: a. It is often difficult to evaluate the financial security of foreign reinsurers and their ability to pay reinsurance losses. This difficulty is especially problematic with respect to reinsurers domiciled in foreign jurisdictions which have regulatory systems that are different from or less stringent than those employed in this V country. This consideration is particularly pertinent in view of the large number of property and casualty insurance company insolvencies in recent years, and the resulting heightened concern on the part of primary writers, insurance V - regulators and the public as to the financial stability of insurers and reinsurers. V - b. Ease of obtaining payment of claims and terms of coverage also cause domestic insurers to favor using domestic reinsurers. V V V c. Medium and small-sized U.S. primary companies V often do not possess the in-house expertise needed to deal with foreign reinsurers. Yet despite this distinct preference for placing reinsurance coverages with domestic reinsurers, primary insurers and smaller domestic reinsurers seeking to retrocede a portion of their risks often find that domestic reinsurers V V either lack the capacity to provide necessary coverages or are otherwise unwilling to write them. And the inability to place coverages with domestic reinsurers often occurs with respect to large individual and catastrophic risks or novel and diffic~.ilt-to-plaCe risks. Sophisticated foreign reirisurers V have long provided such types of coverage that U.S. carriers are unwilling or unable to reinsure. Consequently, primary insurers frequently Vhave no alternative but to place the business with foreign reinsurers. V V To quadruple the tax rate in these situations would be V to impose unwarranted burdens on domestic insurers and policyholders who have no realistic alternative to seeking coverage overseas. And the increased tax would do nothing to - increase the capacity of domestic reinsurers to provide this coverage or to reduce the V dependence of domestic primary writers on foreign reinsurers. V Indeed, the proposed tax increase would likely have the perverse effect of making it even more difficult to obtain reinsurance coverage for such hard-to-place risks. If premiums paid to foreign reinsurers are subjected to increased excise tax, those reinsurers return on equity may be reduced, and V they will tend not to commit resources to U.S. markets, or to shift their resources elsewhere. To the extent Vth~5 happens, reinsurance capacity available to cover U.S. risks will be further reduced, which will also tend to fur.ther reduce the capacity of U.S. direct writers. PAGENO="0197" 187 5. The Proposed Abrogation of Treaty Provisions Might Cause Retaliation. The proponents of increasing the excise tax on premiums for foreign reinsurance also propose overriding exemptions from the excise tax in existing treaties. Several concerns exist in this area: a. It goes without saying that tax treaties are agreements which grant benefits to both treaty partners and to the citizens of both partners. Individual provisions of treaties generally are arrived at only after extended negotiations and compromises by both parties. A provision favorable to one party is often the price paid for another provision that is of profound importance to the other. The exemption from the excise tax that is provided in some treaties is an advantage both to foreign companies and to the foreign jurisdictions in which they are domiciled. But that advantage, to the extent it exists, does not exist in a vacuum. It is the product of negotiation. Something else was given up by the other party to the treaty in exchange for that exemption. It is therefore dangerous to urge that these treaty provisions be unilaterally nullified with the resultant negative impact on the foreign insurers and treaty partners without knowing in each case what forms of retaliation the U.S. may face in terms of loss of treaty advantages or other adverse impacts. b. U.S. companies with foreign operations need the certainty that tax treaties often provide in order to be able to determine their tax obligations. Those provisions can and do influence whether, and to what extent, a company will choose to operate in a foreign jurisdiction. A unilateral change in the treaty system such as that proposed here could "upset the apple cart" and produce consequences that no one now contemplates. And it is not at all clear that those consequences would be limited to the P & C insurance and reinsurance industries. The Congress should therefore not lightly abrogate provisions of treaties on which parties from both nations have relied in conducting business. c. It is entirely probable that the proposed increase in the excise tax and the accompanying override of existing treaty provisions would be seen by this nation's trading partners as exactly what they are--protectionist legislation. Viewed as such, they would invite retaliation by foreign jurisdictions. Such retaliation could greatly hinder the ability of American carriers to expand sales in Europe and the Pacific Rim. The proposal is also contrary to U.S. efforts to liberalize trade-in-services in the current round of GATT negotiations. d. That such a proposed tax increase should surface at this time is particularly problematic, since the European Economic Community is scheduled to be fully implemented in 1992. One of the most difficult issues now facing the EEC community is a unifying tax structure. Precisely how this difficult problem will be resolved is currently unknown. This uncertainty should alone be sufficent reason tO resist repudiating provisions of tax treaties with EEC countries. PAGENO="0198" 188 CONCLUSION The Associations empathize with the portion of the domestic P & C reinsurance industry represented by RAA in their concerns regarding the serious economic burdens imposed on all domestic P & C insurance companies--both primary writers and reinsurers--by Tax Reform Act of 1986. Those burdens have greatly increased the cost of insurance and are likely to reduce the availability of insurance to the public. However, for the reasons outlined above, the Associations and their members oppose the additional tax increase proposed by the RAA, since such additional tax will further increase the cost of insurance, and further reduce the availability of insurance to the public. Moreover, the proposed tax increase would do little, if anything, to alleviate the competitive imbalance that the RAA asserts, but has not convincingly established, exists. It runs a very real chance of merely shifting to a different imbalance. *The Association and their member insurers recommend that the present excise tax be retained without change and that the proposal to increase that tax and to override treaty exemptions to that tax not be adopted. PAGENO="0199" 189 Chairman RANGEL. Thank you, Mr. Turbeville. Mr. Greene, of New York. STATEMENT OF* HOWARD W. GREENE, ACTING DIRECTOR OF GOVERNMENTAL AFFAIRS, RISK AND INSURANCE MANAGE- MENT SOCIETY, INC., NEW YORK, NY ~,Mr. GREENE. Thank you, Mr. Chairman. I have submitted a more detailed written statement, and I request that that be entered into the record. Chairman RANGEL. Without objection, your full statement will be entered into the record. You may highlight your testimony. Mr. GREENE. Thank you. I am testifying today on behalf of the Risk and Insurance Man- agement Society, which is commonly known as RIMS. RIMS is a nonprofit association of more than 4,300 corporate, governmental, charitable, and institutional consumers of commercial insurance lo- cated throughout the United States and Canada. Our membership ~includes 90~ percent of the Fortune 1000 companies, and ranges from the Girl Scouts of America to Columbia University, to IBM. RIMS members remit an enormous premium volume for risks to insurers, and a significant portion of that risk is reinsured with foreign companies. The proposal to raise the excise tax on reinsur- ance ceded abroad from 1 to 4 percent is therefore of great concern to RIMS members, since it is they who will ultimately foot the cost of any additional tax. RIMS believes that increasing the excise tax on reinsurance ceded abroad is anticonsumer, protectionist, and unnecessary. We strongly urge. this subcommittee to reject the proposal for a number of reasons. First, any increase in the Federal excise tax would be a double-edged sword held to the throat of American in- surance consumers, one side being. affordability, and the other availability. Congress has been deeply concerned with keeping in- surance available and affordable for American consumers. No public policy has been stronger, more consistent, or gained wider support. Raising the Federal excise tax would seriously undermine this clear congressional policy. The burden of an excise tax increase would be largely passed through to insurance consumers as higher premiums, hurting affordability. As for availability, foreign rein- surers play an important role in the volatile domestic insurance market by assuming risks considered undesirable by U.S. reinsur- ers. By reinsuring these risks, foreign reinsurers increase the ca- pacity of domestic primary insurance carriers to provide more and broader types of insurance coverage. An increase in the excise tax can only discourage access to this important reinsurance capacity. Second, a hike in the reinsurance excise tax would be a blatantly protectionist measure. In a recent General Accounting Office report, the GAO concluded that a change regarding the insurance excise tax could be incompatible with U.S. efforts to liberalize trade in the service industries. This might prompt other nations to retaliate by erecting barriers against U.S. companies. Perhaps most alarming, the excise tax proposal would override waivers of the Federal excise tax provided for in various existing PAGENO="0200" 190 treaties. The unilateral abrogation of an excise tax waiver would go far beyond the bounds of domestic tax revenue and insurance policy. It would materially change our country's conduct of its for- eign affairs. Third, proponents of an increased excise tax would have Con- gress believe that unfair foreign competition is the root cause of de- clining domestic reinsurance premium volume. This simply is not the case. The real problem, as acknowledged by both the chairman and chief executive of General Reinsurance, and a senior vice president of American Reinsurance, is not foreign competition, but rather increased retentions by American insurers. By increasing the cost of reinsurance, this proposal might lead to even greater retention by primary insurers, the encouragement of which would be unsound public policy, given that insurance is based on the spreading of risk. RIMS' position in opposing any increase in the excise tax is sup- ported by the National Association of Insurance Brokers. A letter to that effect is attached to RIMS' statement for the record. To summarize, RIMS does not agree with the domestic reinsur- ance industry's contention that an excise tax increase is needed for it to remain globally competitive. The proposal is blatantly anticon- sumer, protectionist, and out of step with the foreign policy inter- ests and priorities of the United States, yet RIMS does not s~e any substantial offsetting gain to the United States which would out- weigh the severe negative impact of the proposal. RIMS therefore urges this subcommittee to summarily reject the proposal to raise the excise tax on insurance ceded abroad. Thank you. [The statement and attachment of Mr. Greene and a letter for the record from Barbara S. Haugen follow:] PAGENO="0201" 191 TESTIMONy OF HOWARD W. GREENE RISK AND INSURANCE MANAGEMENT SOCIETY, INC. GOOD MORNING. M~ NAME IS HOWARD GREENE AND I AM TESTIFYING TODAY ON BE HALF OF THE Risx AND INSURANCE MANAGEMENT SOCIETY, INC., COMMONLY KNOWN AS RIMS. RIMS IS A NONPROFIT ASSOCIATION OF MORE THAN 14,300 CORPORATE, GOVERNMENTAL, CHARITABLE, AND INSTITUTIONAL CONSUMERS OF COMMERCIAL INSURANCE AND INSURANCE SERVICES, LOCATED IN 80 CHAPTERS THROUGHOUT THE UNITED STATES AND CANADA. OUR MEMBERSHIP, WHICH INCLUDES 90 PERCENT OF THE FORTUNE 1,000 COMPANIES, RUNS THE GAMUT FROM THE GIRL SCOUTS OF AMERICA TO COLUMBIA UNIVERSITY TO THE PORT OF OAKLAND io IBM. RIMS MEM- BERS REMIT AN ENORMOUS PREMIUM VOLUME TO INSURERS, A SIGNIFICANT PORTION OF WHICH IS REINSURED WITH FOREIGN COMPANIES. THE PROPOSAL TO RAISE THE EXCISE TAX ON REINSURANCE CEDED ABROAD FROM ONE TO FOUR PERCENT IS THEREFORE OF GREAT CONCERN TO RIMS MEMBERS, SINCE IT IS THEY WHO WILL ULTIMATELY FOOT THE COST OF ANY ADDITIONAL TAX. THE NATIONAL ASSOCIATION OF INSURANCE BROKERS (NAIB), THE TRADE ASSOCIATION OF COMMERCIAL IN- SURANCE BROKERS, HAS WRITTEN A LETTER TO CHAIRMAN RANGEL SUPPORTING RIMS' COMMENTS. THAT LETTER HAS BEEN ATTACHED TO OUR STATEMENT AND I ASK THAT IT BE MADE PART OF THE RECORD OF THIS HEARING. RIMS BELIEVES THAT INCREASING THE EXCISE TAX ON REINSURANCE CEDED ABROAD IS ANTI-CONSUMER, PROTECTIONIST, AND UNNECESSARY. WE STRONGLY URGE THIS SUBCOMMITTEE TO REJECT THE PROPOSAL FOR A NUMBER OF REASONS. FIRST, ANY INCREASE IN THE FEDERAL EXCISE TAX WOULD BE A DOUBLE-EDGED SWORD HELD TO THE THROAT OF AMERICAN INSURANCE CONSUMERS -- ONE SIDE BEING AFFORDABILITY, THE OTHER AVAILABILITY. CONGRESS HAS BEEN DEEPLY CONCERNED WITH KEEPING INSURANCE AVAILABLE AND AFFORDABLE FOR AMERICAN CONSUMERS. No PUBLIC POLICY HAS BEEN STRONGER, MORE CONSISTENT, OR GAIN- ED WIDER SUPPORT. RAISING THE FEDERAL EXCISE TAX WOULD SERIOUSLY UNDER- MINE THIS CLEAR CONGRESSIONAL POLICY. RIMS KNOWS FULL WELL THAT THE BURDEN OF AN EXCISE TAX INCREASE WOULD BE LARGELY PASSED THROUGH TO INSURANCE CONSUMERS AS HIGHER PREMIUMS. IN LIGHT OF THE PRICE ESCALATION SUFFERED BY POLICYHOLDERS IN THE MID1980'S, WE MUST BE WARY OF ACTIONS WHICH WILL INFLATE THE COST OF INSURANCE. SINCE, AS WILL BE DISCUSSED LATER, RIMS QUESTION5THE VALIDITY OF THE "LEVEL PLAYING FIELD" ARGUMENT EXPOUNDED BY PROPONENTS OF THE PROPOSAL, RIMS FEARS THIS ADDITIONAL TRANSACTION COST ON FOREIGN REINSURANCE MIGHT PROVIDE DOMESTIC REINSURERS WITH COVER FOR HIKING THEIR PREMIUMS, FREE OF COMPETITIVE CONCERNS. FOREIGN REINSURERS PL~AY-AN IMPORTANT ROLE IN THE VOLATILE DOMESTIC IN- SURANCE MARKET BY ASSUMING RISKS CONSIDERED UNDESIRABLE BY U.S. REIN SURERS. FOREIGN REINSURERS TEND TO COMPLEMENT DOMESTIC REINSURANCE CAPACITY BY REINSURING CERTAIN LINES, SUCH AS PRODUCT LIABILITY AND ENVIRONMENTAL HAZARD, WHICH THE U.S. MARKET MAY NOT BE PREPARED TO ABSORB. BY REINSURING THESE RISKS, FOREIGN REINSURERS INCREASE THE CAPACITY OF DOMESTIC PRIMARY INSURANCE CARRIERS TO PROVIDE MORE AND BROADER TYPES OF INSURANCE COVERAGE. AN INCREASE IN THE EXCISE TAX CAN ONLY DISCOURAGE ACCESS TO THIS IMPORTANT REINSURANCE CAPACITY. IN EFFECT, THE DOMESTIC REINSIiRANCE INDUSTRY IS ASKING THAT AN IMPEDIMENT TO FOREIGN REINSURANCE BE ENACTED FOR MANY COVERAGES WHICH IT CHOOSES NOT TO OFFER, OR WILL ONLY OFFER AT A HIGHER COST. SECOND, A HIKE IN THE REINSURANCE EXCISE TAX WOULD BE A BLATANTLY PROTECTIONIST MEASURE. CERTAINLY, THIS WOULD BE THE PERCEPTION OF FOREIGN NATIONS. INDEED, THE UNITED STATES GENERAL ACCOUNTING OFFICE'S SEPTEMBER 1989 REPORT, ENTITLED "THE INSURANCE EXCISE TAX AND COMPETITION FOR U.S. REINSURANCE PREMIUMS," QUOTES THE DEPARTMENT o~ COMMERCE AS SAYING THE UNITED STATES HAS PROMOTED TALKS ON THE LIBERALIZATION OF TRADE IN THE SERVICE INDUSTRIES AS A PART OF THE GENERAL AGREEMENT ON TRADE AND TARRIFF (GATT) NEGOTIATIONS. THE GAO CONCLUDES THAT "A CHANGE REGARDING THE INSURANCE EXCISE TAX COULD BE INCOMPATIBLE WITH THE U.S. EFFORT IF THE TAX IS PERCEIVED BY U.S. TRADING PARTNERS AS A BARRIER TO ENTRY INTO THE U.S. MARKET." THIS MIGHT PROMPT OTHER NATIONS TO RECIPROCATE BY ERECTING BARRIERS AGAINST U.S. COMPANIES. FOR EXAMPLE, THE GAO RAISES THE SPECTER OF THE EUROPEAN ECONOMIC COMMUNITY RETALIATING AS AN EFFEC- TIVE BLOCK AGAINST U.S. COMPANIES. PERHAPS MOST ALARMING, THE EXCISE TAX PROPOSAL WOULD OVERRIDE WAIVERS OF THE FEDERAL EXCISE TAX PROVIDED FOR IN VARIOUS EXISTING TREATIES. THE PAGENO="0202" 192 U.S. TREASURY DEPARTMENT HAS STATED IN OPEN HEARINGS THAT TAX TREATIES ARE AGREEMENTS WHICH BENEFIT BOTH TREATY PARTNERS' THE BENEFITS OF THESE TREATIES TO AMERICAN INSURANCE CONSUMERS SHOULD NOT BE TAKEN LIGHTLY' MANY U.S. COMPANIES WITH FOREIGN OPERATIONS HAVE TAKEN THESE TREATIES INTO ACCOUNT WHEN DECIDING HOW TO OPERATE IN A FOREIGN COUNTRY' THE UNILATERAL CHANGE IN THE TREATY SYSTEM COULD UPSET THE "APPLE CART" AND PRODUCE CONSEQUENCES THAT NO ONE CONTEMPLATES. IN AN EVEN BROADER SENSE, LET US NOT FORGET THAT TAX TREATIES ARE PART OF THE UNITED STATES' COMPREHENSIVE APPROACH TO GLOBAL RELATIONS' THE UNILATERAL ABROGATION OF AN EXCISE TAX WAIVER WOULD GO FAR BEYOND THE BOUNDS OF DOMESTIC TAX, REVENUE, AND INSURANCE POLICY IT WOULD MATE~ RIALLY CHANGE OUR COUNTRY'S CONDUCT OF ITS FOREIGN AFFAIRS' YET THE AMERICAN REINSURANCE INDUSTRY ASKS CONGRESS TO DO JUST THAT IN EXCHANGE FOR AN ANTICONSUMER, PROTECTIONIST MEASURE FOR WHICH THE GAO IS UNABLE TO DETERMINE AN EVEN ARGUABLE NEED. THIRD, PROPONENTS OF AN INCREASED EXCISE TAX WOULD HAVE CONGRESS BELIEVE THAT UNFAIR FOREIGN COMPETITION IS THE ROOT CAUSE OF DECLINING DOMESTIC PREMIUM VOLUME. THIS SIMPLY IS NOT THE CASE. AS PUBLISHED IN THE FEBRUARY 8, 1989 ISSUE OF THE JOURNAL OF COMMERCE, RONALD E. FERGUSON, CHAIRMAN AND CHIEF EXECUTIVE OF GENERAL REINSURANCE CORP., WAS QUOTED AS SAYING THAT "THE MAJOR REASON FOR THE DECLINE IN DOMESTIC PROPERTY/CASUALTY PREMIUM VOLUME FOR THE QUARTER AND THE YEAR CONTINUED TO BE THE INCREASED NET RETENTIONS OF OUR CUSTOMERS - PRIMARY INSURANCE COMPANIES'" SIMILARLY, PAUL INDERBITZEN, SENIOR VICE PRESIDENT OF THE AMERICAN REINSURANCE COMPANY, WAS QUOTED IN THE DECEMBER 5, 1988 ISSUE OF B$IHESS INSURANCE AS SAYING "THE BIGGEST IMPACT AS FAR AS REINSURER VOLUME IS CONCERNED IS INCREASED RETENTIONS AND UNDERLYING PRICING BY PRIMARY INSURANCE COMPANIES'" BOTH OF THESE STATEMENTS IN CREDIBLY CAME AT THE SAME TIME THAT THE DOMESTIC REINSURANCE INDUSTRY BEGAN ADVOCATINGTHE EXCISE TAX HIKE PROPOSAL' IN LIGHT OF THESE STATE MENTS BY REPRESENTATIVES OF THE TWO LARGEST REINSURANCE COMPANIES IN THE UNITED STATES, ONE MUST QUESTION WHETHER ALLEGED "UNFAIR" FOREIGN COM PETITION IS BEING USED AS A SCAPEGOAT TO ADVANCE THE PROPOSAL' THE REAL PROBLEM, AS ACKNOWLEDGED BY BOTH GENERAL REINSURANCE AND AMERICAN REINSURANCE, IS NOT FOREIGN COMPETITION, BUT RATHER INCREASED RETENTIONS BY AMERICAN INSURERS' ONE DOES NOT ADDRESS THE MARKETING PROBLEM OF DECREASED DEMAND FOR A PRODUCT OR SERVICE BY RAISING PRICES' INDEED, SUCH A RESPONSE IS LIKELY TO EXACERBATE THE PROBLEM BY FURTHER DAMPENING DEMAND' YET THE IMPACT OF RAISING THE EXCISE TAX WOULD BE PRECISELY THAT - - INCREASING THE COST OF REINSURANCE BOTH DOMESTICALLY AND ABROAD WHEN PRIMARY CARRIERS ARE RETAINING A GREATER SHARE OF THEIR RISK' THIS PROPOSAL MIGHT THEREFORE LEAD TO EVEN GREATER RETENTION BY PRIMARY INSURERS, THE ENCOURAGEMENT OF WHICH WOULD BE UNSOUND PUBLIC POLICY GIVEN THAT INSURANCE IS BASED ON THE SPREADING OF RISK' BY FOCUSING ONLY ON THE PROVISIONS OF THE 1986 TAX REFORM ACT, WHICH REQUIRES THE DISCOUNTING OF LOSS RESERVES, THE DOMESTIC REINSURANCE INDUSTRY ARGUES THAT IT IS AT A NEARLY HOPELESS DISADVANTAGE IN RELATION TO FOREIGN COMPETITORS AND IS SIMPLY ASKING CONGRESS TO "LEVEL THE PLAYING FIELD'" SUCH A SINGULAR FOCUS ON LOSS RESERVE DISCOUNTING CON VENIENTLY IGNORES THE FACT THAT INTERNATIONAL COMPETITORS IN ALL IN DUSTRIES ARE SUBJECT TO DOMICILIARY TAX CODES WHICH AFFORD THEM BOTH AD- VANTAGES ANDDISADVANTAGES VISAVIS THEIR FOREIGN COMPETITION' FOR IN STANCE, (1.5. REINSURERS HAVE THE ABILITY TO REDUCE THEIR TAX LIABILITIES BY INVESTING IN TAX EXEMPT SECURITIES, A BENEFIT WHICH, TO OUR KNOWL- EDGE, HAS NEVER BEEN AVAILABLE TO BRITISH NOR MOST OTHER FOREIGN RE INSURERS' SIMILARLY, THE 1986 TAX REFORM ACT SIGNIFICANTLY LOWERED THE TAX RATES FOR CORPORATE AMERICA, INCLUDING U'S' REINSURERS' WOULD FOREIGN GOVERNMENTS BC JUSTIFIED IN ADOPTING TRADE BARRIERS OF THEIR OWN TO "LEVEL THE PLAYING FIELD" BECAUSE OF THESE AND OTHER EXAMPLES OF DISPARATE TAX TREATMENT? AFTER CONSTRUCTING A DUBIOUS TALE OF WOE AS TO THEIR DISADVANTAGED COM PETITIVE POSITION AS A RESULT OF THE 1986 TAX REFORM ACT, THE DOMESTIC REINSURANCE INDUSTRY PAINTS A PICTURE OF SIGNIFICANT LOSS OF BUSINESS TO FOREIGN COMPETITION' THIS SPECULATIVE SCENARIO IS BACKED NEITHER BY FACT NOR COMMON SENSE' MANY PRIMARY INSURANCE COMPANIES DO NOT DEVELOP RE LATIONSHIPS WITH FOREIGN REINSURERS FOR A NUMBER OF REASONS' FOR ONE, IT IS NOT AN EASY TASK TO EVALUATE THE FINANCIAL SECURITY OF A FOREIGN PAGENO="0203" 193 REINSURER. ALSO, MANY MEDIUM AND SMALL-SIZED U.S. PRIMARY INSURANCE COMPANIES DO NOT POSSESS THE INHOUSE EXPERTISE NEEDED TO DEAL WITH FOREIGN REIN5URERS. IN ADDITION, WHILE FOREIGN REINSURANCE MARKETS MAY WELL OFFER VALUABLE CAPACITY FOR RISKS WHICH DOMESTIC REINSURERS PREFER NOT TO TOUCH, FOREIGN REINSURERS HAVE BECOME MORE SELECTIVE AS TO WHAT U.S. BUSINESS THEY WILL REINSURE. FOREIGN REINSURERS MAY NOT WISH TO TAKE ON RISKS WHICH THEIR DOMESTIC COUNTERPARTS MIGHT BE WILLING TO ACCEPT. IN SHORT, EVEN IF ONE AGREES WITH THE UNFOUNDED CLAIM THAT DOMESTIC REINSURERS FACE A TAX DISADVANTAGE, REINSURANCE CURRENTLY PLACED WITH U.S. REINSURERS IS UNLIKELY TO MAKE A WHOLESALE MAD DASH ABROAD. FINALLY, PROPONENTS OF AN EXCISE TAX INCREASE WHO ANTICIPATE SUBSTANTIAL REVENUE GAIN FOR THE U.S TREASURY ARE LIKELY TO BE DISAPPOINTED. INSUR- ANCE PREMIUMS, WHICH ARE A DEDUCTIBLE BUSINESS EXPENSE, WOULD INEVITABLY INCREASE AS A RESULT OF THIS PROPOSAL. THE INCREASED DEDUCTION TAKEN BY THE POLICYHOLDER/TAXPAYER WOULD LESSEN ANY POTENTIAL REVENUE GAIN WHICH TREASURY MIGHT HOPE TO REALIZE. To SUMMARIZE, RIMS REJECTS THE DOMESTIC REINSURANCE INDUSTRY'S CONTEN- TION THAT AN EXCISE TAX INCREASE IS NEEDED FOR IT TO REMAIN GLOBALY COMPETITIVE. THE PROPOSAL IS BLATANTLY ANTI-CONSUMER, PROTECTIONIST, AND OUT OF STEP WITH THE FOREIGN POLICY INTERESTS OF THE UNITED STATES GIVEN TODAY'S GLOBAL ECONOMY. YET RIMS DOES NOT SEE ANY SUBSTANTIAL OFFSETTING GAIN TO THE UNITED STATES WHICH WOULD OUTWEIGH THE SEVERE NEGATIVE IM- PACT OF THIS PROPOSAL. RIMS THEREFORE URGES THIS SUBCOMMITTEE TO SUMMARILY REJECT THE PROPOSAL TO RAISE THE EXCISE TAX ON REINSURANCE CEDED ABROAD FROM ONE TO FOUR PERCENT. THANK YOU. PAGENO="0204" 194 ~ NA11ONPL ASSODA11ON OF IJS~ANCE BROKERS 1401 New York Avenue, NW. * Suite 720 * Washington. D.C. 20005 * Tetephone (202) 628-6700 February 15, 1990 The Hon. Charles B. Rangel Chairman Subcommittee Ofl Select Revenue Measures Committee on Ways and Means `Washington, DC 20515 Dear Mr. Chairman: The National Association of Insurance Brokers opposes proposals which seek to raise the federal excise, tax on reinsurance ceded abroad or to override waivers of the FET in existing tax treaties. We believe an FET change will raise the cost of insurance for U.S. consumers, and we join with the Risk and Insurance Management Society in opposing this change which can only be described as protectionist. The NAIB is the trade association of commercial insurance brokers. Our members are insurance marketplace experts ,who represent the interests of insurance consumers in the insurance marketplace. NAIB member firms, who range in size from large international companies to regional firms, administer the majority of all commercial insurance placed in the United States and provide insurance and risk management services to clients in the United States and around the world. In 1988, the Reinsurance Association of America (RAA), which represents U.S. reinsurers, called for an increase in the FET on reinsurance to four percent from the current one percent. RAA also proposed elimination of tax treaty waivers of the FET. NAIB opposed the RAA proposal then, and we continue to oppose it. Higher costs of doing business generally are passed on to insurance policyholders. It is inevitable that an increase in the FET would ultimately be borne by insurance buyers. A price increase that can only be explained as protection for U.S. reinsurers against overseas competition cannot be justified. Insurance markets are global in nature, and U.S. insurers rely heavily on overseas reinsurers to assume a portion of their risks. Higher costs for reinsurance overseas will be passed on to buyers as higher premium rates. The proposal contradicts U.S. efforts to open up world markets and eliminate barriers to trade in services, and it could invite retaliation by foreign. governmentsat a.time when U.S. PAGENO="0205" 195 underwriters are seeking to expand their sales in Eu~pe &nd around the globe. U.S. primary underwriters need the additional capacity provided thy foreign reinsurers to meet the needs of American businesses ~rd organizations..: Foreign reinsurers now supply epproximately one third of American--reinsurance needs, but foreign reinsurers often provide coverage not available in the U.S. reinsurance marketplace because of the. size or nature of the risk. U.S. insurers cannot rely sole1y~on domestic reinsurers. Thus, a change in the FET will lead~to higher taxes and higher costs for the tnzurance policyholder. ~ tax increase. Si erely, Barbara S. Haugen - Director of Federal f fairs PAGENO="0206" 196 Chairman RANGEL. Thank you, Mr. Greene. Mr. Maisonpierre. STATEMENT OF ANDRE MAISONPIERRE, PRESIDENT, REINSURANCE ASSOCIATION OF AMERICA Mr. MAISONPIERRE. Thank you, Mr. Chairman. The testimony which we have just heard just obscures the issue which, simply put, is whether all earnings generated from U.S. property and casualty reinsurance premiums shall be subjected to a tax liability, or whether such liability shall be imposed selectively, primarily on premiums paid to U.S. reinsurers. Bear in mind that the excise tax is the only U.S. tax which nonresident reinsurers are subjected to, even though many of these transact millions of dollars in U.S. rein- surance premiums. As I said, the issue is simple. The 1-percent excise tax on reinsur- ance premiums ceded to nonresident insurers today is failing in its objective, which is to maintain an equilibrium in the tax on insur- ance premiums, whether purchased through a resident or a non- resident insurer. The objective is not being achieved for two basic reasons: one, TRA 1986 substantially increased the tax liability of resident reinsurers, largely as a result of loss reserve discounting, and two, the U.S. tax treaty policy. Public policy to equalize the U.S. tax effects on domestic compa- nies and foreigners dates back to the mid-1800's. Specifically, the insurance excise tax was imposed on insurance policies issued by nonresident insurers in 1918. In 1984 and 1985, the Senate and the House, respectively, voted to equalize the tax on insurance and re- insurance premiums to 4 percent. This is exactly what we are urging today. The 1-percent tax on reinsurance premiums is no longer effective as an equalizer, because TRA 1986 increased tax li- ability on domestic reinsurers by an amount in excess of 7.5 per- cent of premium. Since the discounting of loss reserves accounts for most of the increase, and* except for Canada, no other world rein- surance center requires loss reserve discounting for tax purposes, it goes without saying that in view of the extreme fungibility of rein- surance, the U.S. companies have been disadvantaged in their own home market. Further, even the 1-percent tax has been rendered meaningless as the result of the automatic inclusion of its waiver in the model United States tax treaty, and the further ability to front, through the United Kingdom, due to the failure to have included a noncon- duit rule in the United Kingdom tax treaty, a clear violation of treaty policy. Reinsurance is unique. Billions of dollars in U.S. reinsurance premiums are transacted each year, without leaving any finger- prints in the United States by reinsuring with nonresident compa- nies. These are often subject to little or no domestic taxes of their own. In 1988, 38 percent of the U.S. reinsurance premium was ex- ported, a substantial increase over preceding years, and this trend will continue to the detriment of the domestic reinsurance industry unless Congress acts now to reaffirm the long-standing policy of tax equalization amongst competitors. PAGENO="0207" 197 To restore a level playing field, the following steps are needed. First, an increase in the property and casualty reinsurance excise tax to 4 percent, an amount equal to the tax on direct premiums purchased for nonresident insurers; second, to require the immedi- ate imposition of a non-conduit rule in the U.K. tax treaty; third, Congress should go on record as opposing treaty waivers unless Treasury can demonstrate the exported premium is subject to a reasonable amount of home country taxes. As to existing treaties, Congress should allow Treasury 3 years to renegotiate treaties with countries which levy little or no taxes on the domestic reinsurers before the increase in the reinsurance excise tax is made effective. This will give ample time for treaty restructuring and should avoid foreign retaliation. With respect to prospective treaties, the reinsurance excise tax should only be waived when Treasury finds the exporter premium is subject to reasonable home country taxes. Mr. Chairman, the insurance excise tax was adopted almost 70 years ago, in recognition of the peculiar nature of international in- surance and reinsurance markets allowing substantial financial transactions in the United States without a need for a U.S. estab- lishment. This congressional policy should be reaffirmed by increasing the reinsurance excise tax to 4 percent, by requiring the inclusion of a non-conduit provision in the U.K. tax treaty, and by establishing a standard limiting the waiver to countries which impose a reasona- ble level of taxes on their domestic reinsurers. Thank you very much. [The statement of Mr. Maisonpierre follows:] PAGENO="0208" 198 STATEMENT OF ANDRE MAISONPIENR-E President, Reinsurance Association of America I am Andre Maisonpierre, president of the Reinsurance Association of America ("RAA"). I appreciate the opportunity to appear before the Subcommittee on Select Revenue Measures to address an issue of fundamental concern to the domestic reinsurance industry. The RAA is a voluntary association of professional property and casualty reinsurance companies, all of which are incorporated in the United States and licensed in one or more states. Although some members of the Association are owned by foreign insurance interests, the principal sphere of activity of RAA members is the U.S. market. They derive the overwhelming majority of their premium income from the business of reinsurance. The United States currently imposes an excise tax equivalent to four percent of gross premium on direct property and casualty insurance business written by non-admitted (referred to herein as "non-resident") foreign insurance companies and one percent on reinsurance premiums assumed by those companies. However, the United States has agreed through tax treaties to waive the collection of insurance excise taxes for insurers in a number of countries, including Cyprus, France, Hungary, Italy, Malta, Romania, the United Kingdom and the Soviet Union. In addition, the Administration recently signed three new treaties, with West Germany, India and Finland, which waive the excise tax on premiums ceded to non-resident foreign reinsurance companies. In 1988, substantial Congressional opposition arose with respect to provisions in existing treaties with Barbados and Bermuda which waived the excise tax. Consequently, Congress required that the excise tax waivers in these treaties sunset as of December 31, 1989. To counteract the substantially increased federal income tax burden imposed on domestic insurers as a result of the Tax Reform Act of 1986 (the "1986 Act'), the Reinsurance Association of America supports an increasein the federal excise tax on property/casualty reinsurance premiums ceded abroad from the current one percent level to four percent. Given the Senates adoption in 1984 and the House's adoption in 1985 of identical proposed increases in the excise tax, the RAA believes that a consensus can be reached that will address the concerns of domestic reinsurers with respect to their competitive situation. In addition to increasing the excise, tax, the RAA urges that Congress carefully scrutinize the effect of the Administration's tax treaty policy on the competitiveness of domestic reinsurers. The BAA applauds the Congressional requirement that the treaty waivers of the excise tax included in the Barbados and Bermuda treaties sunset at the end of 1989, clearly needed due to the absence of any tax imposed by those countries, but submits that waivers included in other treaties also pose substantial competitiveness issues. For example, the failure to include an "anti-conduit" rule in the U.K. treaty permits the excise tax-free fronting of premium through that country for ultimate destination in non-treaty countries. And even in treaties having excise tax waivers coupled with anti- conduit rules, low effective tax rates in some of those countries can result in insubstantial taxes being imposed on foreign reinsurers of U.S. risks. PAGENO="0209" 199 We understand that the Joint Committee on Taxation has estimated that the RAA proposal could raise in excess of $100 million per year in federal revenues. Conversely, -without the increase in the excise tax, foreign reinsurance transactions in the U.S. market will -cost the federal treasury millions of dollars per year in lost revenues. Those losses will accelerate as foreign penetration of the U.S. reinsurance market continues to increase. History of the Excise Tax The excise tax on insurance premiums has roots going back to the mid-l9th century, but its modern form generally dates back to the Revenue Act of 1918. Its purpose was to remove inequities between domestic and resident foreign insurance companies which were subject to payment of U.S. taxes and their competing non- resident foreign counterparts which were not. Under the 1918 Act, a three percent stamp tax was imposed on insurance policies issued by non-resident foreign insurers and a one percent stamp tax was levied against policies issued by domestic insurers and resident foreign insurers. In 1921, the one percent stamp tax was repealed, leaving in place only the stamp tax applicable to non-resident foreign - insurers. The legislative- history of the 1921 Act indicates that the purpose of the original stamp tax was to-fill in where the income tax -did not apply. Subsequent judicial decisions - concluded that the Congressional intent in enacting these provisions of the Revenue Act of 1921 was to rectify the competitive imbalance resulting because premiums paid to foreign insurance companies not engaged in a trade or business in the U.S. were not subject to any U.S. income tax. From that time on, until the 1986 Act, neither the one percent excise tax rate on foreign reinsurance transactions nor - the tax treaties between the -United States and certain international insurance centers which waived the excise tax were of serious concern to U.S. reinsurers. This was principally because the then-effective U.S. tax burden on domestic reinsurers was negligible. As more fully explained below,- the 1986 Act substantially increased the U.S. --income tax liabilities of domestic and resident foreign -reinsurers, principally due to the requirement that loss reserves be discounted for deduction purposes. This development has serious competitive consequences and, as a result, has increased the importance of the excise tax in the competitive equation. - The heightened importance of the excise tax was underscored by the Congressional requirement in the 1986 Act that Treasury - address the competitive position of domestic reinsurers. -The 1986 Act required Treasury to study--the competitive position of domestic reinsurers and report -to -Congress, by January 1, 1988. As you know, that report has not yet been released although we understand it shall be released shortly. - - Tha tax-writing committees are not the only Congressional committees to express concern over the delicatecompetitive position of domestic reinsurers. When considering ratification of the U.S.-Bermuda tax treaty, the Senate Foreign Relations Committee report (which recommended that the excise tax waiver contained in the treaty sunset -as of Decec~ber 31, 1909) included the followiflg strong statement: PAGENO="0210" 200 The Committee believes that as matter of public policy, tax treaties should not place any U.S. industry~at a competitive disadvantage with foreign competitors, particularly in U.S. markets. The Committee does not believe that those provisions of the U.S. tax laws imposing an excise tax on insurance and reinsurance premiums paid to foreign insurance companies should be waived without prior consultations with the Committees of Congress by Treasury in future tax treaty negotiations. The concerns of the Senate Foreign Relations Committee echo concerns raised by House Ways and Means Committee Chairman Rostenkowski, in a letter dated September 22, 1986, to Senator Lugar urging rejection of the then-proposed Bermuda treaty. Noting that a number of treaties waive the excise tax, Chairman Rostenkowski stated: - In the long run, I do not know why any reinsurance activity will take place in the United States, given the mobility of that activity and thus its extreme sensitivity to tax factors. Despite these strong expressions of view on treaty excise tax waivers and their likely effect on the U.S. industry, the Treasury has continued to routinely include such waivers in subsequent treaty negotiations. Market Share: U.S. Admitted vs. Non-Resident Foreign Reinsurers The foreign share of the U.S. reinsurance market is indeed significant. The U.S. Department of Commerce, Bureau of Economic Analysis estimates that $7.8 billion, net of commissions, of U.S. reinsurance premium was exported to non-resident foreign reinsurers in 1988, the last year for which final data is available. This represents approximately one-third of the entire U.S. property/casualty reinsurance market. Since these foreign reinsurers operate in the U.S. market without a permanent establishment, they generally are not subject to U.S. income taxes. In a briefing report entitled The Insurance Excise Tax and Competition for U.S. Reinsurance Premiums recently issued to Representative Fortney (Pete) Stark, the U.S. General Accounting Office ("GAO") reported on the increasing share of net reinsurance premiums paid to foreign reinsurers with respect to the coverage of U.S. risks. According to that report, the domestic market share of non-resi.dent foreign reinsurers increased from 30.8 percent in 1980 to 38.6 percent (estimated) inl988. The report states that ".. .ascribing a cause-and-effect relationship between tax reform in 1986 and the change in reinsurance market share may be premature", and it is true that a variety of factors may contribute to the shift. However, as recognized by Ways and Means Committee Chairman Rostenkowski, reinsuranceis a fungible commodity and there are few, if any, obstacles that prevent U.S. insurance companies from purchasing reinsurance from companies domiciled anywhere in the world. Reinsurance is perhaps unique in the financial world in that substantial transactions may be carried out even though the reinsurer may not have a business situs in the United States. Thus, although it nay be difficult to directly attribute the PAGENO="0211" 201 recent increases in the domestic reinsurance market share of non- resident foreign reinsurers to tax reform, it is clear that no barriers to entry exist to prevent continued growth in the domestic market share of non-resident foreign reinsurers. Increased foreign penetration is a virtual certainty if non- resident foreign reinsurers enjoy a competitive advantage. This serious concern, also recognized by Ways and Means Committee Chairman Rostenkowski, has led the RAA to advocate an increase in the excise tax on reinsurance ceded abroad to counteract the increased federal income tax liability of domestic reinsurers. Without such an offsetting measure, the~ competitive equilibrium for domestic reinsurers will continue to erode over time. The RAA recognizes that foreigm reinsurers that have established u.s. subsidiaries provide considerable support to the U.S. reinsurance market. The substantial capital committed to the U.S. market by these resident foreign reimsurers, which are regulated and taxed in the same way as domestic reimsurers, is important and must be recognized. As a result of the 1986 Act, these companies also generally have sizeable income tax obligations to the U.S. It has been asserted, though, that the non-resident foreign reimsurance industry complements U.S. reimsurers by providing coverage not available in the U.S. market. In fact, only a small portion of the foreign market is complementary to U.S. reinsurers and, in part, that complementary foreign market is composed of foreign captives owned by U.S. interests. The RAA nevertheless recognizes that there are limited instances in which certain coverages are available only from non-resident foreign reimsurers. Notwithstanding, we do not believe that the provision of complementary types of coverage by such foreign insurers is relevant to the fundamental issue of equitable treatment of competitors through the excise tax system. An increase in the excise tax certainly would not grant the domestic industry any advantage in limes of coverage in which the domestic industry does not compete, nor would it reduce foreign capacity in the domestic market as the tax primarily would be absorbed by the direct insurers and/or the insureds (as is the case currently). 1986 Tax Act Effect on U.S. Reimsurers By requiring loss reserves to be discounted (the principal but by no means the only 1986 tax change affecting domestic insurance companies), the 1986 Act effectively eliminated any unintentional subsidy of insurance costs by substantially changing the basis on which U.S. insurers and reinsurers are taxed. However, that subsidy continues for reinsuranöe ceded to non-resident foreign insurers because they are not subject to U.S. income tax and therefore are not subject to reserve discounting. A nom-resi~nt foreign reinsurer's tax liability for U.S.-based risk premium imcome comtinues to be limited to the excise tax and any taxes imposed in its home country. The size of the foreign market share is a clear indication that a sophisticated distribution mechanism is in place to exploit whatever competitive advantage may be secured by conducting U.S~ reinsurance business without a permanent U.S. establishment. As explained below, domestic reimsurers face a dilemma. To remain competitive in the marketplace, domestic reimsurers need to increase premium rates. Yet competition from foreign companies immune from the 1986 Act constrains the ability of U.S. companies to increase their premiums. PAGENO="0212" 202 To evaluate the impact of the 1986 Act on domestic reinsurers, the RAA developed a theoretical model to measure the additional premium companies must charge to offset the impact of the 1986 Act and to generate after-tax income comparable to the pre-1986 level. The additional premiums required to offset the .additional tax liabilities of domestic reinsurers range from 7.33 percent,_~assumiflg a 100 percent combined ratio, to 8.75 percent, ~assurning~a 105 percent combined ratio. The model also measures the~decrease in profit margin if premiums are not increased. This -reduction ranges from 16.6 percent, assuming a 100 percent combined ratio, to 23.3 percent, assuming a 105 percent combined ratio. The results of the RAA model are buttressed by the findings of a survey conducted by the internationally respected independent accounting firm, Price Waterhouse. The Price Waterhouse survey concluded that the property/casualty provisions of the 1986 Act caused taxes paid by the domestic property and casualty industry to increase by $1.7 billion, of which $904 million was attributable to discounting of loss reserves. The survey also suggests that reserve discounting had its most adverse effect on the reinsurance industry. The message from the RAA model is clear. As a result of the 1986 Act, domestic reinsurers must increase rates substantially to maintain an after-tax rate of return sufficient to permit companies to remain competitive in the capital marketplace and to maintain investment support. Failure to compensate through rate increases for the impact of the 1986 Act will reduce after-tax return, rendering U.S. reinsurance companies weaker competitors and thus jeopardizing their employment levels, their financial stability, and their ability to attract new capital. Increasing the excise tax and its universal collection would substantially diminish the unintended financial advantage now afforded non-resident foreign reinsurers. Indeed, it bears emphasis that the modest three percent increase in the excise tax proposed by the RAA is substantially less than the seven percent (at the minimum) effect of the 1986 Act on domestic reinsurers. Although the RAA acknowledges that an increase in the excise tax would raise the cost of foreign reinsurance, this is not an evil inherent in the proposal but a simple manifestation of the Congressional policy of the 1986 Act and other recent legislation to end federal insurance subsidies and to tax insurance companies on their real economic income. Congress understood that imposing taxes would increase the cost of insurance and reinsurance. The RAA can discern no policy which would justify the continued exemption of foreign reinsurance from this consequence. In any event, the RAA believes that any increase in the price of foreign reinsurance generally will be constrained by market competition. The RAA's Response to GAO Although the GAO report indicated that insufficient data exists for it to support the RAA's findings that U.S. reinsurers were adversely affected by the 1986 Act, the RAA respectfully - disagrees. We are convinced that the RAA tax model demonstrates the need for the excise tax increase. In its report, the GAO identified several issues it says should be considered in deliberating changes in the current excise tax policy. The RAA does not disagree that many factors influence a reinsurer's relative tax position in the U.S. market, PAGENO="0213" 203 aside from the excise tax. One of the most important of these factors is the level of taxation in the home jurisdiction. Historically, most world reinsurance centers use regulation and accounting procedures to emphasize insurance company solvency, not for revenue collection. Prior to the adoption of the 1986 Act, this was true in the U.S. as well. For example, discounting loss reserves, except for the recent change in the U.S~, is universally rejected by world insurance centers. Moreover, many countries allow property/casualty insurers to establish special reserves for catastrophic events, such as earthquakes, which are likely but have not yet occurred. Others even permit insurers to reserve for totally unanticipated losses. These types of reserves are not permissible for U.S. tax purposes. In addition to countries which impose low actual taxes on reinsurance due to their comparatively permissive reserve allowances, low home jurisdiction income taxes also can result from low tax rates. The most notorious in this regard are the so-called tax haven countries, such as Bermuda, the Cayman Islands, Barbados, the Turks and Caicos Islands, the Isle of Man and the Bahamas. These countries do not tax insurance and reinsurance entities. Other insurance centers, such as Malta, Guernsey, Hong Kong, Jersey, Cyprus, Gibraltar, the British Virgin Islands, Ireland, Luxembourg and Singapore, simply have low tax rates. The RAA certainly does not advocate double taxation. As noted above, in many cases the excise tax would not raise a substantial problem of double taxation. On the other hand, as a matter of U.S. tax policy, the RAA submits that U.S. tax jurisdiction should not be meekly surrendered simply because ofT the internal tax laws of foreign countries. Foreign countries could relieve any truly onerous double taxation by providing an appropriate tax credit mechanism. The RAA also would support a properly structured excise tax credit for U.S.-controlled foreign reinsurers subject to U.S. income tax under the "Subpart F" rules. Nevertheless, assuming ~guendo that it is appropriate to surrender U.S. tax jurisdiction ba~id on other countries' claims against income attributable solely to U.S.-based risks, the absence of loss reserve discounting rules, among other factors, strongly indicates that many foreign jurisdictions likely impose a relatively insubstantial tax burden on their reinsurers. Foreign reinsurers located in these jurisdictions and in jurisdictions which allow more permissive income tax reserves than are permitted under U.S. law may well have obtained a competitive windfall as a result of the 1986 Act's effect on domestic reinsurers. The excise tax should be modernized to serve its intended function; namely, to neutralize the tax advantage enjoyed by non-resident foreign reinsurers. The GAO report also questions whether an increased excise tax would be perceived as a barrier to entry into the U.S. reinsurance market and whether it would be compatible with recent efforts to liberalize trade. The RAA does not believe that trade barriers hampering access to reinsurance should be established anywhere in the world. In fact, because of limited U.S. capacity, U.S. risk exposures must rely to some extent on the international market. Barriers to trade may result from protectionist policies and the classic definition of protectionism is the imposition of a tax on foreign goods or services at a level sufficiently high as to force their prices to be higher than the price-of similar but domestically produced goods and services. In contrast, the PAGENO="0214" 204 current U.S. tax laws can be viewed as the reverse of trade protectionism. The 1986 Act, by substantially increasing taxes on domestic reinsurers, effectively created a tax preference for non-resident foreign companies selling reinsurance to the U.S. market. Accordingly, an appropriate increase in the excise tax would not disadvantage foreign competitors nor interfere with the international flow of reinsurance transactions. On the contrary, it would return a more competitive U.S. reinsurance market by ~equalizing tax burdens on competing entities.. Prior to the 1986 Act, no foreign reinsurers claimed they were overtaxed vis-a-vis their domestic competitors. It is astonishing that foreign reinsurers claim that they are not now at a competitive advantage vis-a-vis their domestic counterparts, given the increase in the U.S. tax burden of the domestic industry. Moreover, the alleged concern that an increase in the excise tax would be unduly harsh because the excise tax is a tax on gross premiums is simply a red herring. The premium tax is used as a proxy fora net income tax, similar to other withholding. taxes imposed on foreign persons~Mher.e asserted U.S. tax jurisdiction does not adequately reach~their Operations. To the extent that the proxy tax may result in "overtaxation" in loss years, it also may result in "undertaxation" in profitable years. And, over:~the long haul, most insurance operations are profitable. Ther~efore, an appropriate increase in the excise tax is consistent:~w±ththe corresponding income tax increase engineered bythe~l986 Act for domestic reinsurers. It should benoted~ that a four percent excise tax currently is imposed on direct insurance premiums ceded abroad. No one has suggested that direct insurance premiums are overtaxed. To the extent that a four percent excise tax has not been levied on direct insurance premium, no principled argument can be advanced to support disparate treatment for :reinsurance. In this connection, the RAA would. support elimination of the "cascading' effect of excise taxes imposed on both direct insurance and reinsurance, if it were clear that a full four percent tax were imposed when U.S. risk premium moves offshore. ~Finally, the RAA believes that treaties should be permitted to waive the excise tax only in certain circumstances. The imposition of the excise tax is critical toa competitive reinsurarice market in two ways. Obviously, the excise tax assures that mon-resident foreign reinsurers. pay some U.S. tax on their income from reinsuring U.S. risks,~:thusserVing to equalize competitive factors between resident and non~resident reinsurers. Yet it also has a competitive.~!±mpact on non-resident foreign reinsurers in their competition among themselves. To the extent non-treaty countries represent well-regulated, conscientious reinsurance centers which impose a reasonable level of tax on income from reinsuring U.S. risks, the RAA believes these countries are unfairly treated with respect to other countries whose reinsurers are exempt from the U.S. excise tax. For these measons, Congress should reject the waiver of the excise tax as a component of the U.S. Model Treaty, but condition such a waiver upon the demonstration that it would not provide a competitive advantage to non-resident foreign reinsurers. With respect to prospective treaties, the Treasury should be required to justify the granting of an excisetax waiver only upon the finding that a reasonable level of foreign tax is actually paid with respect to reinsurance of U.S. risks by companies operating in those countries. The RAA recognizes that existing treaties pose a much more difficult problem. Principles of international coinity should not PAGENO="0215" 205 be cast aside without considerable thought given to the best way to resolve dilemmas created by the confluence of existing treaties and changes in policy or economic circumstances. In this regard, the RAA believes that thetax systems of countries for which existing treaties presently waive the excise tax should be thoroughly examined to determine whether in fact they impose a reasonable level of tax on the reinsurance of U.S. risks. If the treaty waiver is found unjustified under this standard, the waiver should be statutorily overridden only if the Administration is unable to renegotiate a termination of the treaty waiver within a reasonable period, such as three years. `Such a reasonable time period for overriding treaty waivers of the excise' tax should dispel any fears of retaliation by our trading partners since they would have ample time to develop appropriate changes in the internal taxation of their own reinsurers so as to avoid double taxation. The RAA urges, however, that immediate steps be taken to correct the lack of an anti-conduit rule in the U.K. treaty. As with the sunsets of the Bermuda and Barbados excise tax waivers, the continuing omission of an anti-conduit rule clearly is at odds with current U.S. treaty policy. The suggestion made by some that U.K. regulation renders fronting for non-treaty reinsurers difficult should not dissuade Congress from acting promptly to close this loophole, if Treasury is unwilling or unable. If the suggestion that U.K. regulation precludes fronting is in fact true, there really should be no opposition to~ the insertion of an anti-conduit provision in the U.K. treaty. Suary The need to achieve tax equity among competitors in the insurance industry has been the subject of considerable discussion by Congress and various segments of the insurance industry. Likewise, the need to remove taxation as an element of competition in the pricing of insurance is fully recognized by European insurers as they prepare for the economic harmonization within the European Community. As foreign governments seek to assist their nationals in increasing penetration of the U.S. reinsurance market, they are exerting great pressure on the U.S. to waive the current excise tax. Domestic reinsurers do not believe that U.S. policy should treat their competitive position in their own country as a mere bargaining chip to be traded away by the Adiflistration in treaty negotiations. Domestic reinsurers also will be unable to compete in international markets if they remain weakened in their primary market. For the following reasons, the R.AA strongly urges Congress to increase the federal excise tax on property/casualty reinsurance and address treaty waivers of the excise tax: (1) The increase in the excise tax is pro- competition. It would better equalize the tax treatment of companies competing for U.S.-risk reinsurance premium. (2) The problem of treaty waivers of the excise tax causing an erosion of the domestic industry's market share affirmatively must be addressed. Specifically, the omission of an anti-conduit rule in the U.K. treaty must be corrected and waivers should be available only where it is de.omstrated that the domestic industry would not be adversely affected. PAGENO="0216" 206 (3) If no action is taken, federal revenues from the property/casualty insurance industry will be adversely affected as more insurance premiums are shifted overseas to escape U.S. taxation. Additionally, the capital and surplus necessary to support this premium will be shifted overseas as well. Consequently, increasing the excise tax not only would benefit the domestic reinsurance industry but would provide a positive revenue source. Again, I appreciate the opportunity to appear before this Subcommittee on behalf of the ReinsuranceAssOCiationOf America to discuss this natter, one which is of grave importance to the domestic reinsurance industry. PAGENO="0217" 207 Chairman RANGEL. Thank you, Mr. Maisonpierre. Mr. McGrath. Mr. MCGRATH. Thank you, Mr. Chairman. Mr. Chapoton, nice to see you back behind that. Mr. CHAPQTON. Mr. McGrath, nice to see you. Mr. MCGRATH. The basic thrust of your amendthent is to recog- nize that American securities brokers and dealers operating over- seas are conducting active businesses. Mr. CHAPOTON. That is correct. Mr. MCGRATI~. We seem to have a little bit of a problem with Treasury. They seem not to want to support this, although recog- nizing that the amendment is an attempt to address an inequity in the code, and they seem to say that they are working on some sort of streamlining of the entire code as it applies in simplifying the foreign tax portion of it. I'm wondering whether or not you could address whether or not that effort could come in time to redress the inequity that you are-- Mr. CHAPOTON. Well, Mr. McGrath, I think, No. 1, I noticed the Treasury said it could not support this proposal. They did not oppose it, as they did many of the items in their testimony this morning. 1 think their concern, institutionally, is-and we have dis- cussed this with Treasury, and with the joint committee staff-the concern is, when you get into an area as complex as the antidefer- ral rules, how do you correct problems that appear in them, and more importantly, maybe more frustrating from my standpoint in this case, is that the foreign personal holding company rules which caused the problem here were adopted, as I mentioned, in 1937, and I dare say that no one really knows what they are after today. They have been supplanted, pretty much, by the PFIC rules and by subpart F, both of which are inapplicable in our case. It is a long way to answer your question. I think it will take a. long time to streamline these rules, a very long time, and this in- equity will continue until a rather simple fix is made in the rules. Mr. MCGRATH. Do you have a revenue estimate on this simple fix? Mr. CHAPOTON. No, we do not have a revenue estimate. It should be minimal, if there is any adverse revenue factor. Mr. MCGRATH. And Mr. Maisonpierre, how do you react to Mr. Greene and Mr. Turbeville's contention that imposing an increase would reduce the amount of reinsurance available to domestic corn- panies to provide that reinsurance? Mr. MAISONPIERRE. I don't understand their thought process. It seems to me that if, as they claim, the alien market has as they say a monopoly over certain types of reinsurance, all it will do is just pass through the cost of the excise tax to the domestic indüs- try. I don't see how what we are proposing: would in any way affect the capacity of the market. It will affect price, there is no question about it, but this is an issue which Congress dealt with back in 1986. At that time, in 1986, you indicated to the industry that you felt that the lack of discounting of loss reserves allowed the indus- try to pay a negligible amount of income tax, the result being that the commercial insurance premium was being subsidized out of the Federal tax base, and you took care of that. PAGENO="0218" 208 I mean, today the commercial insurance premium is no longer subsidized by the Federal tax base, and~the Lommercial reinsur- ance premium is no longer subsidized except for the 38 percent which is exported overseas, which continues to be subsidized. Yes, it will increase costs, but this is a consideration which you recognized back in 1986 `when you imposed discounting of loss re- serves on the industry. Mr. MCGRATH [presiding]. Mr. Greene. Mr. GREENE. The effect that we believe it will have on capacity, -~per se, is that we fear that primary insurers will simply retain more risk if it gets more expensive. We believe that that's a prob- lem that has been pinpointed by domestic. reinsurers themselves. It is not our fear that `the capacity will dribble up so much as it will-more risk will be retained. Mr. MCGRATH. All right. We thank the panel for their testimony, and the committee will stand adjourned until 2 o'clock. [Recess.] Chairman RANGEL. Mr. Frenzel, at this time and place, we are ready to take your testimony. Mr.FRENZEL. I am overwhelmed, Mr. Chairman. Mr. Chairman, I have prepared testimony which is available to the committee and, with your permission, I would ask fqr insertion in the record and will make a short statement. Chairman RANGEL. Is there any objection? None heard, you may proceed. STATEMENT OF HON. BILL FRENZEL, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF MINNESOTA Mr. FRENZEL. Thank you, Mr. Chairman. The members of the committee and the chairman will recall that in the 1986 Tax Reforni Act, we changed our Tax Code to provide that the appreciated portion of gifts made for certain charitable purposes would be included in the computation for'the alternative minimum tax. At the time, I am not certain whether members of the committee understood the consequences of that particular feature. However, once it was enshrined in the version of tax reform as it passed through the Congress, there was certainly after the bill left the committee plenty of discussion on it. So members knew of the diffi- culty that the colleges and universities and museums and other charities expected they would encounter under the law. Already, before we got to the Tax Reform Act, we had some pro- tections against what you might call abuse or even overuse of the contributions of depreciated property. The deductions for appreciat- ed property at that time-and still-could not exceed 30 percent of AGI. In addition we had changed the code in 1984 to provide for proper appraisal and penalties for overvaluation on the part of both the person giving the appraisal and the donor. In any case, we went forward with tax reform and I think the more dire predictions of those people who were recipients of this kind of property were borne out. You will have some testimony later from the American Association of Museums, which indicates a disastrous reduction in gifts made to its members. You will also PAGENO="0219" 209 hear from colleges and universities which have also suffered heavi- ly under this particular part of the tax law. I have introduced a bill, as I did last year with some help-last year, I had the assistance of Mr. Matsui and others-which would remove the inclusion under alternative minimum tax for these gifts of appreciated property. I am sure you know how it works. If somebody has an old retired stock certificate in his or her drawer and wants to give it to a college or a museum or a hospital or a symphony orchestra or the Little Sisters of the Poor or whoever, they are pretty much dissuaded from doing so, because they do not want to get nailed under the alternative minimum tax, whose clutches are hard to escape once you get into them. The kind of people who will typically give an appreciated farm or business, stock certificate, building or whatever, are the kind of people whose affairs are going to be complicated enough, so that they are likely to be easily grasped by the alternative minimum tax. Mr. Chairman, I would urge that the committee allow these gifts of appreciated property, without inclusion under the alternative minimum tax, so that we can undo some of the unnecessary damage created by the Tax Reform Act of 1986. We are denying to these institutions values that they would have achieved under the old law, and I do not think taxpayers are being disadvantaged greatly. Mr. Chairman, I do have a revenue estimate from the Joint Tax Committee and it indicates that, in the first frill year, which would be fiscal year 1991, my bill would cost $72 million to the Treasury for contributions of individuals and about $5 million for corporate contributions. For the full 5-year period-actually it is a little more than 4 because fiscal year 1990 has a little piece in it-the estimate is about $322 million for individuals and $22 million for corporate gifts, for a total of $344 million. That's an average of abbut-well, let us throw out the first year, it's too small-$80 million a year or a little more for having these gifts made to the charities I have de- scribed~ Mr. Chairman, the subcommittee is aware of this issue and I think that I have said enough. I appreciate you taking the time to hear me. [The prepared statement of Mr. Frenzel follows:] STATEMENT OF CONGRESSMAN Biu FRENZEL Thank you, Mr. Chairman. At a time when the full committee is reviewing the effects of the 1986 Tax Reform Act, it is appropriate that we, as a committee, ad- dress the unnecessary, adverse consequences of the 1986 Act. Donations of appreciated property to charitable groups-such as hospitals, higher education, museums, conservation groups, and religious organizations-declined sharply after the 1986 Act treated the appreciated portion of these contributions as a tax preference item in the alternative minimum tax {AMTJ. In an effort to prevent high-income taxpayers from avoiding tax altogether, Tax Reform produced a 1-pound solution to a potential half-pound problem. Both the evidence and the safeguards put into place prior to 1986 lead me~ to be- lieve that provisions restricting donations of appreciated property were unnecessary. A 1985 Treasury study concluded that deductions such as charitable donations did not represent a significant cause of tax avoidance. Then, as now, taxpayers cannot use property giving to avoid taxes altogether be- cause deductions for charitable gifts of appreciated property cannot exceed 30 per- cent of adjusted gross income [AGIJ. Moreover, changes in 1984 assure that property PAGENO="0220" 210 donations are fairly appraised by estblishing detailed guidelines for appraisal and penalties for overvaluation on both the appraiser and the donor. The enactment of Tax Reform in 1986 delivered a severe blow to all charitable organizations which rely on gifts of property either for operating expenses, or as an addition to the collections for which they exist. The value of gifts of property has taken a nose-dive. Following the 1986 act restrictions on deduction of appreciated property, the Association of Art Museum Directors reported a 63 percent decline in the value of donations from 1986-88. The American Association of Museums reports that, as a whole, museums have experienced a decline of 30.3 percent in donations of property, representing 162,000 objects in 1988, and a 44.4 percent decline in FY 1987. Gifts of securities to muse- ums have decreased by 44.3 percent, from FY 1986 to FY 1987, and an additional 11.1 percent decline the following year. Colleges and universities have also suffered. The Council for Aid to Education re- ported that in the 1987-88, academic year, public institutions suffered an 18.6 per- cent real decline in real property gifts, while private colleges and universities suf- fered a 13 percent real decline. Although appreciated property gifts account for less than 1 percent of the number of gifts for higher education, they represent a dispro- portionately high percentage of the value of gifts, accounting for as much as 35.9 percent, according to the National Institutes for Independent Colleges and Universi- ties. There are those who claim that the 1986 act merely shifted the form of support from property to money. Even if this were true, the sale of art works is contrary to the intent of my bill. If a piece of art or an object of historical value is sold, it more than likely will disappear from the public eye. Unlike many European nations which restrict the export of their cultural treasures, the United States has increas- ingly seen art disappear into private hands and removed from the country. Tax policy cannot be fairly assessed without considering their impact on our na- tional objectives of advancing education, health care, environmental protection, and making our cultural heritage accessible to all people. The President's Committee on the Arts and the Humanities concluded in its 1988 report that "the decline in value as well as the number of donations of appreciated property, particularly from potential donors of large leadership gifts, appears to result from the increased cost of making such donations by the inclusion of the ap- preciation in the donor's alternative minimum tax." Property donations, in all categories of donors-individuals, bequests, foundation grants, and corporate gifts-are either slowing or have declined since 1986. As the support for groups which educate our Nation, protect the environment, and preserve our cultural heritage dwindle, the Congress can quickly and easily reverse one of the most damaging aspects of the 1986 Tax Reform Act by restoring appreciated property as an item of preference under the AMT. Chairman RANGEL. Well, we thank you for once again bringing this to our attention. We have some opposition, as you might expect, from Treasury, but we certainly will be supporting-- Mr. FRENZEL. It only proves that the collective soul of those gnomes who labor down at Treasury are at least somewhat lacking in the field of charity, perhaps comparable to that of an oyster. [Laughter.] Chairman RANGEL. Mr. McGrath. Mr. MCGRATH. Thank you, Mr. Chairman. Thank you, Bill, for your statement. I brought this question up this morning to Secretary Gideon, and obviously, as the chairman has indicated, he is not totally enamored with it. I will tell you that, coming from the New York metropolitan area, and serving at least five universities and plenty of museums in my own district, this is a provision that is highly sought. My only. problem, of course, is the revenue aspect of it. As a Re- publican who has taken some abuse because of positions on other so-called gifts to the rich, the question of the distributional effect of tax provisions for that end of the `income spectrum is one, of course, that I am sure that the other side of the aisle will have to wrestle with more than will this side of the aisle. PAGENO="0221" 211 I thank the gentleman for his testimony. Mr. FRENZEL. Well, I thank you. If I can just consider that for a moment. Inasmuch as you have a 30 percent of AGI limit already, I suppose if you are terribly rich you can still give away a lot. I do not consider giving away money to art museums and symphonies and charities and universities to be some kind of abusive practice, nor do I consider that to be a wonderful advantage for wealthy people. It does happen that wealthy people are the kind of people that have these assets to give away, but the museum people will tell you that, in addition to not getting the money, the works of art, are likely to be sold. And while it is not always true that they are sold overseas and lost to the American museum-going public, it is true that frequently that is the case. Large buyers who used to hang out in Europe mostly are now found also on the other side of the Pacif- ic. So in some cases were are suffering a double loss. Not only do we not get the work of art, we do not get the contribution to char- ity. We may lose the work of art for a generation or a century or more, perhaps forever. Mr. MCGRATH. In addition, I would point out that it is strictly at the will of those who would either seek to give it or sell it. If they do not sell it, there would be no realization of a gain to the Treas- ury, in any event. Mr. FRENZEL. To be sure. But I acknowledge that it is hard. The subcommittee does not have a lot of money lying around to make up for revenue losses like this and I simply appreciate the subcom- mittee's interest and attention to this problem. I thank you again. Chairman RANGEL. Thank you, Mr. Frenzel. Mr. FRENZEL. Thank you, Mr. Chairman. Mr. STARK [presiding]. Our next witnesses will comprise a panel: Mr. McGraw, Ms. Hocker, Mr. Buck, and Dr. Rosenzweig. Mr. Nelson, I did not call your name at the beginning. Since you are at the head of the list, we will let you start, followed by Mr. McGraw, Ms. Hocker, Mr. Buck, and Dr. Rosenzweig. Would you like to proceed and summarize or expand on your tes- timony in any manner that you are comfortable with. Without ob- jection, your prepared testimony that has been submitted will appear in the record in its entirety. Mr. Nelson. * STATEMENT OF ALBERT J. NELSON, JR., EXECUTIVE VICE PRESI- DENT AND GENERAL MANAGER ELMDALE FARMERS MUTUAL INSURANCE CO, INC UPSALA MN ALSO ON BEHALF OF THE NATIONAL ASSOCIATION OF MUTUAL INSURANCE COMPANIES Mr. NELSON. Good afternoon, Mr. Chairman, and thank you for the opportunity to address the subcommittee. I am Albert J. Nelson, executive vice president and general man- ager of Elmdale Farmers Mutual Insurance Co., of Upsala, MN. I am also representing the National Association of Mutual Insurance Cos., a national trade association that represents approximately 1,300 property casualty insurance companies across the United States. PAGENO="0222" 212 NAMIC's members include the very largest and the very small- est insurance companies in the United States, from huge interna- tional writers to companies that do business in one county. Mr. Chairman, we have many more of the latter than we do of the former, and it is on behalf of those companies that I speak today. NAMIC supports an amendment to the corporate alternative minimum tax, clarifying Congress' intent that the AMT calculation for small property casualty companies electing to be taxed on tax- able investment income under Internal Revenue Code section 831(b) should not include underwriting income or loss. These companies, which include mine, are very small; They write between $350,000 and $1.2 million in premiums per year. They almost always write only one State, often in only one or two coun- ties. We write~mostly farm property insurance for family farms. Many~of our~companies have been in business for over 100 years, writing protection for the rural economy. We~areiirot particularly sophisticated companies. We do not need ~oriise~actuaries, but we have provided a valuable service for a long time. Our companies can elect to be taxed only on taxable invest- ment income. This insures that we will always be taxpayers, be- cause we cannot evoke the election unless IRS agrees. So, if we have, large underwriting losses, we still pay taxes. If we have big gains, maybe we pay a little less than we ~would have ~otherwise, but we always pay. Congress has said several times that the election is there to pro- vide simplicity for small ~companies who cannot easily cope with the tremendous complexity Df property casualty tax law, especially after discounting of loss reserves, revenue offset and proration came in under the 1986 Tax Reform Act. In exchange for simplicity, we pay taxes all the time and the system seems to work pretty well. The IRS, however, wants to tax us under the corporate AMT. We agree, as much we wish it did not, that the AMT applies to us. The problem is that the IRS wants to tax all our underwriting income in the AMT, despite the fact it is not included in the regular tax. Even worse, they want to go back to 1987 to begin doing this. Their position defeats the purpose of the election. First, it destroys the simplicity of the system. To decide whether we should make the election, we now must calculate our regular taxable income, including discounting, including revenue offset, in- cluding proration. Before the Service took this position, all we needed to do was make a rough comparison of what we expected our underwriting results to be and what we thought our invest- ment income would be. Now the Service wants to impose all the complexity that Congress told us we could avoid. In 1990, it gets worse, because the adjusted current earnings cal- culation would make us include discounting, revenue offset and proration adjustments as ACE income. Second, the Service distorts our income by comparing apples and oranges, underwriting and total investment on the AMT side and taxable investment income on the regular side. The IRS itself says that comparing unlike items is not fair to foreign taxpayers. We think it is equally wrong for small insurance companies. PAGENO="0223" 213 This puts us in a totally unfair position. In bad underwriting years, an electing company still must pay tax, because it cannot revoke the election. In good underwriting years, it will pay a heavy AMT tax. Where is the benefit of the election? Where is the sim- plicity? It is gone. And for the companies that have already made the election, to whom the IRS wants to apply the full AMT, it is worse, because these companies cannot revoke the election. They are forced to continue under it, even though they will not get the benefits that were part of the bargain when they made it. In a sense, the Congress created this problem by not clearly saying in 1986 that electing small companies were not subject to AMT. Congress can remedy this now by limiting the AMT to in- vestment income. The NAMIC proposal would still include tax- exempt investment income in the AMT. Electing small companies would still always pay tax, but they would have the simple, fair system the Congress intended for them and they could concentrate again on serving the farm communities they have helped for over 100 years. Mr. Chairman, my own company is a perfect example of the un- fairness. In 1987, we had an underwriting profit of about $100,000. We paid tax on our investment income and put the rest in re- serves. Along came IRS and said, oh, no, you pay AMT on your in- vestment income and underwriting profit. In 1989, we lost two turkey barns, a chicken barn, and a hog barn, along with Other losses, and we paid out $200,000 more than we took in. We still paid income tax on our investment income-no carryback or carry- forward from 1987. That tax under AMT was just gone. Mr. Chairman, I would be happy to answer any questions, and I thank you. [The prepared statement of Mr. Nels?n follows:] PAGENO="0224" 214 Statement of Albert J. Nelson Elmdale Farmers Mutual Insurance Company, Inc. representing the National Association of Mutual Insurance Companies before the Subcommittee on Select Revenue Measures Committee on Ways and Means U.S. House of Representatives February 21, 1990 Good morning, Mr. Chairman, and thank you for the opportunity to appear before this subcommittee. My name is Albert J. Nelson, and I am executive vice president and general manager of Elmdale Farmers Mutual Insurance Company, Inc. of Upsala, Minnesota. I am representing the National Association of Mutual Insurance Companies, a trade association that represents 1,285 mutual property/casualty insurance companies across the United States. I am here to support NAMIC's proposal to amend section 56 of the Internal Revenue Code to exclude underwriting income and expense from alternative minimum taxable income for small insurance companies that elect to be taxed on taxable investment income under section 831(b), effective for taxable years beginning after December 31, 1986. This proposal is necessary to alleviate the Code's complexity for small companies, the goal the Congress intended to promote when it enacted this provision. It also avoids distortion by ensuring that like items are compared in the regular and minimum tax computations. I. Description of small companies Section 831(b) allows non-life insurance companies with net written premiums (or direct. written premiums, whichever is greater) exceeding $350,000/year but not exceeding $1.2 million/year to elect to be taxed only on taxable investment income. This election may not be revoked without premission of the Internal Revenue Service. The companies that qualify for this election are very small property/casualty companies, that generally operate only in one state, usually only in one or two counties. They typically have very few employees (sometimes as few as 1-4), and primarily write coverages for farms and farmers and rural, low-valued homes. Many of the companies have operated in this manner for the last 100 years or more. The annual statements they file with their state insurance departments may require only a simplified calculation of underwriting income (generally premiums earned minus losses and expenses paid). Some of these companies do not even establish loss reserves or unearned premium reserves, claiming deductions only on a cash basis. None of them have actuaries, or even reasonable. access to actuarial assistance. These are small companies, that do business very simply, yet provide a great deal of the insurance coverage necessary for America's family farmers and rural homeowners. Many of these companies incur underwrlting losses in various years. This is especially true because they have all policies in a small geographical area, and thus are subject to the volatility of local weather (windstorms, hail, etc.) and local economic conditions. Yet some have elected to be taxed on taxable Investment income, even though this means they will pay tax even in years when they are unprofitable because of underwriting losses. They make the election because It makes their tax liability simple and predictable - necessities for companies doing business In this fashion. The election is irrevocable, so companies cannot switch methods to avoid tax. The only way an electing company could avoid tax would be to invest all of its assets in tax-exempt bonds. Many of these companies do not buy state and municipal bonds at all - their most prevalent investments are bank CDs and government securities. Some state laws will not even allow them to buy tax-exempt instruments or stocks. These companies do not have the sophistication, expertise ca interest to do business in a way that minimizes their tax liability. They are interested in the ability to make their tax liability predictable, even at the expense of extra taxes paid in some years. They need this predictability in order to continue serving their customers at a reasonable premium cost as they have for well over a century. The Congress intended that, in return for avoiding the complexities and difficulties of computing a tax on their entire income, these companies would always pay some tax, even in years in which they lose money on a bottom-line basis. This has been a fair arrangement, which has worked well for both the companies and the Treasury. PAGENO="0225" 215 11. Congress created the investment income election to allow this choice Small mutual companies were first granted a choice to be taxed solely on taxable investment income for 1963 where a company had gross premiums and investment income of over $150,000/year, not exceeding $500,000/year. The Senate Finance Committee said then that: This treatment is justified because these small companies often are the assessment type and are not required to compute and report their underwriting income on approved forms for State insurance commission purposes. The bill makes it unnecessary for them to compute their underwriting income in the future. Revenue Act of 1962, 1962-3 C.R. 763. Congress made sure that small mutual companies would not be required to compute income for tax purposes in a more onerous manner than their annual statement income calculation. In the 1986 Tax Reform Act, Congress made the taxation of large property/casualty insurers far more complex and onerous. Major changes included: (1) discounting of loss reserves, under which the Code allows a deduction only for the present value of losses to be paid in the future; (2) the "revenue offset" provision, or a 20% reduction in the deduction insurers can take for unearned premiums; and (3) "proration", or an inclusion in income (through a reduction in loss reserves) of 15% of tax-exempt income and dividends from certain bonds and stocks. These complicated provisions for insurers that did not qualify for the small càmpany provisions should be contrasted, however, with the Tax Reform Act's expansion of the investment income election. The election was expanded in two ways: (1) the premium amounts were changed to net written premiums (or direct written premiums, whichever is greater) and increased to $350,000 and $1,200,000/year (companies with $350,000/year or less in net written - premiums or direct written premiums, whichever is greater - premiums are exempt from tax), and (2) the election was made available to small stock companies as well. The Senate Finance Committee stated that "one provision should afford benefits comparable to present law to small mutual companies." Thus the Congress remained concerned that small insurers should have an option which requires them to pay some income tax while relieving them from administrative and compliance burdens that are too onerous for small companies. Unfortunately, the Congress did not make it clear that electing companies were to be spared from the complexities of the corporate alternative minimum tax ("AMT"), which was greatly expanded in 1986. By failing to clarify this question, Congress opened the way for the Internal Revenue Service to argue, as it does today, that despite the Congressional purpose of simplification, the AMT should apply to all electing company income, including underwriting income or loss. As we will show, the Service's position defeats the Congress' intent, which requires clarification by enactment of the NAMIC proposal. 111. ApplyIng the AMT to ~aderwriting income defeats Congress' purpose, and compares unlike items We believe that the corporate AMP should not apply to electing companies. If it is to apply, the comparison should be taxable investment income to book investment income. Economic income for electing companies is investment income. While the AMT is designed to assure that all companies pay some tax on their economic Income, companies making the investment income election agree to pay tax even in years when they have no economic income. Applying any concept that requires an electing company to calculate underwriting income is violative of the Congressional purpose of simplifying tax compliancefor these companies, and it distorts income by requiring comparisons of unlike items (taxable in~eestrnent income~ in the ~egu1ar tax with total income in the AMP). Unfortunately, no specific AMP exemption was enacted in 1986. However, Congressional intent has at all times been clear -- "simplicity." The bill clarifies that the election to be taxed only on investment income, once made and so long as the requirements for the election are met, may be revoked only with the consent of the Secretary. This clarification may reflect Congress' intent that the election not be used as a means of eliminating tax liability (e.g., by making the election only for years when the taxpayer does not have net operating losses), but rather as a simplification for small companies. 30-860 0 - 90 - 8 PAGENO="0226" 216 Joint Committee on Taxation Staff Description (JCS-l0-88) of Proposed Technical Correction of 1988, page 121, Election to be taxed only on Investment Income (sec. 110(f) of the bill, sec. 1024 of the Reform Act, and sec. 831(b) of the Code) The Service's position clearly defeats the Congressional intent, but a recent technical advice memorandum (LTR 9006001) makes it clear that the Service is not inclined to listen until Congress restates its position. Applying the AMT to an electing small company's underwriting income does several things that are contrary to the reasons the investment income election exists. 1. It forces companies to compute their total taxable income, including the discounting, revenue offset and proration calculations. - The decision whether a small company should make the election was fairly simple before 1987. A company could consider what its taxable investment income was and what it was likely to be in the future, and make a rough calculation of what it expected its underwriting income to be, according to its own annual statement. If a company had a general idea of what its underwriting results would be , it had enough general information to makes its decision, so discounting and the other adjustments were not required. A company desiring simplicity and predictability above all, as many of these companies do, could make the decision even knowing in some years it would pay more tax on investment income alone than it would on total regular taxable income, including underwriting income or loss. Starting in 1987, if the AMT applies to overall income of electing small p/c companies they must compute their regular taxable income, using the loss reserve discounting, revenue offset and proration provisions of the 1986 Tax Reform Act for an indefinite number of years into the future to determine whether an election is warranted. The problem only becomes worse in 1990, because the ACE (adjusted current earnings) preference requires companies to add back to taxable income the discounting, revenue offset and proration additions to arrive at ACE. There will be no other option for 1990 and subsequent years unless the comparison is between investment income and investment income. For small companies, which do not have actuarial services available to them, this would be an intolerable burden. The Service's approach, of course, places companies that have already made the election in an impossible situation. Those companies had a right to believe that, when they made the election, the AMT would not apply or at worse it would only compare taxable investment income with taxable investment income. Now, if the Service's construction prevails, they find themselves in 1990 having to compute underwriting income in determining their tax liability, and may be badly harmed by an election they cannot revoke for reasons they could not have considered when they made the election. Simple fairness would require giving them an opportunity to revoke their election ab initio if the comparison is not taxable investment income with taxable investment income. And, of course, it would mean Congress allowing for an election will have,, in effect, engaged in a vain act. This can not be the proper interpretation. 2. It compares unlike items. - The Service's position requires the comparison of unlike items - taxable investment income in the regular tax with net investment income and underwriting income in the AMT. This is an unsound position, and one that the Service itselt has rejected in at least one other area. Temporary regulations issued concerning the book income AMT preference permit foreign taxpayers to exclude from the book Income calculation items that are not effectively connected with the conduct of a U.S. trade or business, as they are excluded from the regular tax calculation. This proper approach avoids comparison of dissimilar items, yet the IRS does not use It in its consideration of small insurance companies. The Service argues that Congress indicated that it wanted only effectively connected income to be subject to the AMT. Similarly, we are asking Congress to indicate here that it wants only investment income to be considered in the AMT for electing companies. The use of unlike items in the AMT calculation, moreover, subjects an electing company with profitable underwriting to the possibility of always being taxed in the AMT. Thus an electing company would, under the Service's construction, receive none of the benefits for which the Congress enacted the investment income election. It would have to make the regular taxable income calculation, using underwriting income and the complications of discounting, revenue offset and proration, and be taxed on taxable investment income in poor underwriting years and the AMT on total income in good underwriting years. This would make the investment income election worthless, and it is clearly not the result Congress intended in 1986 when it expanded the applicability of the election. PAGENO="0227" 217 IV. Solution - exclude underwriting income from the AMT The solution to this problem, if the Congress is unwilling to exempt electing companies from the AMT, is to exclude underwriting income from the AMT as applied to electing companies, applying to taxable years beginning after December 31, 1986. Tax-exempt income and includible dividends would still be included in the AMT base under our proposal. This would again allow small insurers to plan for the future by projecting their taxable and tax-exempt investment income in deciding whether to make the election. This would rid them of the complexities Congress meant to allow them to avoid. It compares like items with like items for regular tax and AMT purposes -- taxable investment income with net investment income. And it avoids the unfairness of submitting companies that have made an irrevocable election to a retroactive change in law that makes their elections a disadvantage. The point is an electing company can pay more tax when the company has a loss and also when it has income because it will be subject to the AMT. Thus no company should make the election, i.e. applying AMT to cover underwriting makes the election a nullity. V. Conclusion Consequently, and for all of the reasons mentioned above~ we urge the Congress to exclude underwriting income and loss from the corporate AMT calculation for small insurers electing to be taxed~onAaxable investment income, effective for taxable years beginning after December 31, 1986. PAGENO="0228" 218 Mr. STARK. Thank you, Mr. Nelson. Mr. McGraw. STATEMENT OF J.L. McGRAW, A FARMER FROM CAMPBELL, MO Mr. MCGRAW. Thank you, Mr. Chairman and members of the committee. It is a pleasure for me to be here and it is an honor. Mr. Chairman, in 1978, under our minimum tax law, this law se- verely created problems for insolvent farmers who were forced to transfer the title of their farms in payment of debt. According to Mr. Ralph Shilling, the district director of the St. Louis office, this problem is caused because the Congress failed to distinguish between the voluntary sale or assets and a forced trans- fer of title. Well, this forced transfer of title, when you apply the alternate minimum tax to that, it creates an unjust situation to the individual, because he had no money with which to pay the tax, he received no money. It creates an impossible situation for the IRS, because the IRS cannot collect money, because the individual has no money and, ac- cording to Mr. Shilling, the IRS has no choice other than to pursue collection action on this transaction. Now, we are not talking about the fairness of this law. We are talking about humane treatment of an individual, because you have a tax assessed when no actual income was received by the in- dividual and this is something the individual has no control over, because in most instances his insolvency came about because of in- clement weather and things which he had no control over. Most of these loans that were paid off by the foreclosure on these farmers were Farmers Home Administration loans; The man quali- fied for these loans by proving losses which justified and qualified him for the loan. When he could not pay the loan, then the lender forced liquidation of his assets, including the forced transfer of title - to his farm and he had no choice in the matter and he received no money. I believe that the Congress never intended that this law should be applied to the situations of a forced transfer of title to a person's farm in payment of his debts. I believe that it was an oversight on the part of the Congress and the IRS, according to Director Shil- ling, has no recourse other than to pursue collection action. I believe that Congress will want to remedy this situation. They did, in essence, acknowledge that this was an oversight and was an injustice when, in 1985, they made a law, in the COBRA, in which they exempted those farmers who became insolvent after 1981. However, that left a small group of farmers who became insolvent between January 1, 1979 and December 31, 1981, who were still pe- nalized by the injustice of this law. Mr. Chairman, I do not see any good purpose in this injustice being allowed to continue against these people and I believe that the Congress will want to remedy that situation, and H.R. 1849 will * remedy that situation and I do urge the committee, and I pray that you will take action to remedy this situation, to exempt those insol- vent farmers from the inception date of the 1978 tax law. I can speak to you today with first-hand knowledge, because I am a victim of that law. PAGENO="0229" 219 I would appreciate any questions and would answer any ques- tions you have. Thank you. [The prepared statement of Mr. McGraw follows:] PAGENO="0230" 220 TEgI'JMONY OF J.L. MCGRAW Thank you, Mr. Chairnian axai Members of the Committee, for allowing me to come here today and testify before this Subcommittee. I consider it quite an honor. The Revenue Act of 1978, creating the Alternative Minimum Tax (AMT) on capital gains, did a great injustice to farmers who became insolvent. According to the statement of Mr. Ralph Shilling Director of the St. Louis office of the IRS, the law does not distinguish between the voluntary sale of assets and the forced transfer of title. Because of this, the AMT was applied to the difference in the purchase price and the price calculated as the selling price of farm land - even when, because of insolvency and forced liquidation, a farmer was forced to transfer title of his farm. This tax, when assessed against these insojvent farmers, created an impossible situation for them. The proceeds derived from these forced transfers of title to these farms went to the lenders, because of operating loans secured by mortgages on the farm. The farmer received none of the money, and in fact had no money. Therefore, he could not pay the taxes assessed. The taxes assessed also created an impossible situation for the IRS, because, according to Director Shilling, the IRS was compelled by statute to proceed with collection etiforcement action. Since the insolvent farmer had no money, this collection action was an exercise in futility. However, this action by the IRS caused great stress, frustration, and a sense of helplessness to the farmer. This tax, when applied to an insolvent farmer who was forced to transfer title of his farm to others with even seeing the proceeds, is preposterous. This action by the IRS is, in essence, a monetary penalty applied to the farmer because he "went broke.' And this, by his own government! We are not addressing the fairness of this law; we are talking about humane treatment of the individual, which is a basic human right. The IRS applied this law to insolvent farmers in a way which the Congress did not intend. I believe in our legislative system, and I believe that you will correct this injustice. The majority of the cases of farmer insolvency were borrowers who dealt with the Farmers Home Administration. A major portion of these borrowers obtained disaster loans made because of inclement weather conditions. The monetary losses which justify these loans to the farmer had to be proven. The loans had to be secured by collateral - hence, the mortgage of the farmland. When these loans could not be repaid, the lender forced liquidation of the assets -- including the farmland -- and forced the transfer of title, together with the proceeds from the sale of these assets, to the lender. The action of the IRS in assessing the AMT on capital gains to these insolvent farmers caused such cries of anguish, stress, and frustration in the farming community that the Congress, in the COBRA law of 1985, took action to specifically exempt insolvent farmers from this application of the AMT. But this action of the Congress - -which was very welcome, no question - corrected the problem Qniy for those farmers who became insolvent ~ftg~ December 31, 1981. This only partially solved the problem faced by the insolvent farmers. I am certain that from the very beginning, Congress did not intend to put this burden on insolvent farmers. Congress itself, in fact, admitted that it had erred when it corrected the problem for post-1981 transactions. I believe it is the responsibility of Congress to correct this inequity for all of the insolvent farmers. Very little revenue will be lost by correcting the injustice of this law. Those people who are said to owe taxes have no money with which to pay them. HR 1849 would correct the injustice faced by insolvent farmers by exempting the relatively small number of people who have been caught in the three-year window created by COBRA. Mr. Chairman and Members of the Committee, I urge you, and I pray, that you will enact the provisions of HR 1849. I know, first hand, the injustice of the law, because I am a victim of the law. To lose one's livelihood in the later years of one's productive life is a sad situation. But to add the imposition of a heavy tax on `income' that you never really made because you `went broke' -- that is to rub salt in the wound. Please correct the problem and enact HR 1849. Thank you. PAGENO="0231" 221 Mr. STARK. Thank you, Mr. McGraw. Ms. Hocker. STATEMENT OF JEAN W. HOCKER, PRESIDENT, LAND TRUST AL- LIANCE, ALEXANDRIA, VA, ALSO ON BEHALF OF THE TRUST FOR PUBLIC LAND Ms: lOCKER. Thank you, Mr. Chairman. I appreciate the oppor- tunity to testify before you today. I am Jean Hocker, president of the Land Trust Alliance, a na- tional membership organization serving the Nation's local and re- gional land trusts. I want to describe the detrimental impact on land conservation that is resulting from the 1986 tax law provision that makes gifts of appreciated property a preference item for purposes of the alter- native minimum tax, and also want to endorse and urge your sup- port of H.R. 173, which would correct this problem. I speak today. also* on beha1f~ of the Trust for Public Land, a na- tional land conservation organization that has protected about `500,000 acres of land across the country through direct land trans- actions, and I have also been in touch with my colleagues at the Nature ~Conservancy and they share our concerns and they will be submitting testimony for the record as well. Land trusts are nonprofit, tax-exempt land conservation organi- zations that operate at the local or regional level. They protect nat- ural areas, habitat, wetlands, greenways, urban gardens, recre- ational property, a host of kinds of conservation lands. They are or- ganized by local people' who identify the most critical and threat- ened land resources in their community, State or region, and they seek to encourage the owners of those properties to protect their ~land through some kind of charitable transaction. Despite~the diversity of land trusts-and there are `nearly 800 of them across the country-they have protected about 2 million acres of land collectively, they are very diverse. Some are very small, some are very large, but despite this diversity, the programs of most land trusts, like those of the national land conservancies, depend substantially on three kinds of transactions: donations of land, donations of perpetual use restrictions on land, called conser- vation easements, and below-market-rate bargain purchases of land and easements. In. order to fulfill the public purposes for which they are granted tax-exempt status, that is, to conserve land, most, land trusts must be able to attract these donations and bargain purchases, by en- couraging owners of critical properties to enter into charitable land transactions, and most of that encouragement centers on the tax benefits associated with charitable giving. Landowners have long been responsive to those and their donations have conserved mil- lions of acres that would otherwise either have gone unprotected or would have required purchase with public dollars. With the advent of the new rules for the alternative minimum tax in 1986, gifts of land for conservation purposes have been much less attractive for many landowners and important land conserva- tion projects have been lost. PAGENO="0232" 222 Because the income tax deduction is now effectively limited to basis for those taxpayers subject to the alternative minimum tax, it has vastly decreased. the incentives to donate property, rather than to sell it to a developer. IfI have owned my property, say, for 30 years and have a basis in it of maybe $100,000, or maybe much less if it is 30 years old, and developers offer me the current fair market value of $1 million for my property, the tax savings on my basis may not look like a very big incentive, as I weigh whether to sell for development or donate for conservation. Maybe equally problematic is the complexity and uncertainty of the alternative minimum tax. Before 1987, it was fairly easy for a land trust and the landowner to understand the .basic tax princi- ples governing a charitable gift of land. A land trust practitioner or the landowner's professional advisor could determine with relative ease and accuracy the tax implications of a contemplated donation. Now, though, it is extremely difficult to explain the relevant tax laws to a landowner. It is, moreover, nearly impossible to ascertain with any certainty what the tax implications of a conservation gift will be, without a very sophisticated tax analysis, which often cannot be made until the end of the tax year, and that uncertainty and complexity have scared off a lot of potential donors of conservation land, many of whom are neither wealthy nor particularly sophisticated. For many of them it is their first experience with the alternative minimum tax. In fact, a substantial gift of appreciated property for conserva- tion can throw a landowner or taxpayer into the alternative mini- mum tax situation and he may never have even heard of it before. As the director of the Big Sur Land Trust in California told me, "the alternative minimum tax becomes the end of conversations." I have attached to my testimony a number of examples of gifts that have been lost to land conservation and of comments from land trusts throughout the country about this problem. There are many. I cannot stress too strongly that when a gift of open space is not made, it is likely to be lost forever. The woodland or the elk migration route that is not protected today may be consumed in to- morrow's subdivision and its conservation values lost forever to the public. That is a problem unique to land conservation donations and is a major reason why land conservation organizations are so dismayed by the 1986 changes in the tax law. Although there is no legislative history on the 1986 change, we do not believe Congress intended to discourage land donations to nonprofit conservation groups, specifically, nor charitable giving generally, and yet that is what has happened, and in the case of land conservation, it is resulting in the loss of open space that would otherwise be protected for perpetuity. The conservation values of land are not determined by the tax status of the landowner. If protection of a property is in the public interest, then protection should be encouraged equally, by applying the same rules to all potential donors. Thank you very much for the opportunity to state these views. [The prepared statement and attachments of Ms. Hocker follow:] PAGENO="0233" 223 THE LANDTIkUST ALLIANCE Fe,;,crly tie Lead Trast Eachaage 1017 Duke Street* Atexandria, Virginia 22314 703-683-7778 STATEMENT OF JEAN W. MOCKER, PRESIDENT THE LAND TRUST ALLIANCE BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS UNITED STATES HOUSE OF REPRESENTATIVES February 21, 1990 Mr. Chairman and members of the Subcommittee, thank you for the opportunity to testify before you today. I am Jean Hocker, President of The Land Trust Alliance, a national membership organization serving the nation's local and regional land trusts. I wish to describe the detrimental impact on land conservation resulting from the 1986 tax law provision that made gifts of appreciated property a preference item for purposes of the Alternative Minimum Tax. I also want to endorse and urge your support of H.R. 173, which would delete the appreciation on charitable property gifts from the Alternative Minimum Tax. I speak today also on behalf of The Trust for Public Land, a national land conservation organization that has protected about 500,000 acres of land across the country through direct land transactions, often working in partnership with land trusts. Land trusts are nonprofit, tax-exempt land conservation organizations, operating at the local or regional level, that protect natural areas, habitat, wetlands, greenways, urban gardens, scenic and recreational properties, and a host of other kinds of conservation land. Land trusts are organized by local people who identify the most critical and threatened land resources~in~their community, state or region, and then seek to encourage the owners of those properties to protect their land through some kind charitable transaction. In addition to the national conservancy organizations, there are more than 800 local and regional land trusts in the United States, operating in nearly every state, with an aggregate membership of some 700,000 people. Together these local and regional groups have protected about two million acres of land. Many land trusts are small, operated entirely by volunteers; others are quite large and professionally-staffed. Although the earliest land trusts are nearly 100 years old, nearly a third of all land trusts have been formed in the last five years. Despite their diversity, the programs of most land trusts, like those of the national land conservancies, depend substan- tially on three kinds of transactions: donations of land, donations of perpetual use restrictions called conservation *easements, and below-market-rate, bargain purchases of land and easements. In order to fulfill the public purposes for which they are granted tax-exempt status, most land trusts must be able to attract these donations and bargain purchases, by encouraging owners of critical properties to enter into charitable land transactions. And much of that encouragement centers on the tax benefits associated with charitable giving, to which landowners have long been responsive. Their donations have saved millions PAGENO="0234" 224 of acres of open land that would otherwise either have gone unprotected or would have required purchase with public dollars. With the advent in 1986 of the new rules for charitable donations of appreciated property under the Alternative Minimum Tax, gifts of land for conservation purposes have been much less attractive for many landowners, and important land conserva- tion projects have been lost. Because the income tax deduction is now effectively limited to basis for taxpayers who are subject to the Alternative Minimum Tax, the economic incentive to donate property rather than develop it is vastly decreased. If I have owned my property for 30 years, and thus have a basis in the land of, say, $100,000, yet a developer is offering me the current fair market value of $1,000,000 for my property, the tax savings on $100,000 may not look like a big incentive as I weigh whether to sell for develop- ment or donate for conservation. Perhaps equally problematic is the complexity and uncer- tainty of the Alternative Minimum Tax. Before 1987, it was fairly simple for a land trust and a landowner to understand the basic tax principles governing a charitable gift of land. A land trust practitioner or the landowner's professional advisor could determine with relative ease and accuracy the tax implications of a contemplated donation. Now, however, it is extremely difficult to explain the relevant tax laws to a landowner; it is, moreover, nearly impossible to ascertain with any certainty what the tax implications of a conservation donation will be without a very sophisticated tax analysis, which often cannot be made until the close of the tax year. That uncertainty and complexity have scared off many a potential donor of conservation land, many of whom are neither wealthy nor particularly sophisticated. It has also resulted .in landowners' receiving information from their professional advisors that is just, plain wrong. As the director of the Big Sur Land Trust told me: "The Alternative Minimum Tax becomes the end of conversations." Tom Hahn, director of CorLands (The Corporation for Open Lands) in Chicago told me last week of losing an opportunity to make a bargain purchase of 70 acres of land that the State had designated as eligible for Nature Preserve status. He wrote: "After several negotiating sessions, the owners of the property were ready to proceed with a partial donation. However, when tax counsel was brought in by the owners, it was found that they would be subject to the ANT. This brought on two reactions from the owners - first, they did not understand the ANT and expressed con- fusion, and second, there was concern about the possibility of an audit (because of the ANT). After conferring with their tax consultant, they decided against the partial donation."~ Likewise, a Denver lawyer who represents the Boulder County Land Trust, a new land trust in Colorado, wrote me: "The applicability of the alternative minimum tax to gifts of appreciated land is having a devastating impact on the ability of this land trust to implement its projects....Iamassisting the land trust on four projects involving the critical elk migratory lands which are part of the Rocky Mountain National Park ecosystem.... The landowners with whom we are working are all farm families.. . .When we advise these families of the applicability of the alternative minimum tax... their eyes begin to glaze over. To say that the ANT is a serious and substantial impediment to the preserva- tion of vitally important lands is an understatement. PAGENO="0235" 225 The law is so complicated that even some members of the land trust staff have difficulty understanding it themselves, let alone interpreting it conceptually for those farm families." The Trustees of Reservations, the nation's oldest land trust and one of the largest, describes another lost conservation donation: "In 1988, The Trustees of Reservations was approached by the conservation-minded owner of a 70-acre tract of land in rural Massachusetts. The acreage includes an historic house, scenic views across rolling upland fields, extensive woodlands, and more than 1,000 feet of river frontage. The structure of the gift, as eventually agreed upon, was that the owner would give a conservation [easement] to The Trustees on the entire parcel.... Everything was in order for a year-end gift when the donor's accountant advised that, because of the ANT, there would be little or no tax benefit for a 1988 gift. The donor decided to delay the gift, and unfortunately died in January of 1989. As a result, the property may have to be sold for development to pay the estate tax bill." Other examples of the ANT's negative effect on land conser- vation gifts are attached. I cannot stress too strongly that when the gift of open space is not made, it is likely to be lost forever. The woodland or the elk migration route that is not protected today may be subsumed in tomorrow's subdivision, its conservation values forever lost to the public. That is a problem unique to land conservation donations, and is a major reason why land conserva- tion organizations are so dismayed by the 1986 changes in the ANT rules. Although there is no legislative history on the 1986 change, we do not believe Congress intended to discourage land donations to nonprofit conservation groups specifically, nor charitable giving generally. Yet that is what has happened, and -- in the case of land conservation -- it is resulting in the loss of open space that could otherwise have been protected for perpetuity. The conservation values of land are not determined by the tax status of the landowner. If protection of a property is in the public interest, then protection should be encouraged equally by applying the same rules to all potential donors. ~We urge you to support H.R. 173, which restores the pre-1986 rules for dethlctions of appreciated property. Thank you again for the opportunity to share these views imz±th you. Exhibits: A. Impacts of the ANT on Land Conservation: Case Studies B. Effects of the 1986 ANT provision on Charitable Gifts for Land Conservation: Comments from Land Trusts PAGENO="0236" 226 THE A LAND TR~UST ALLIANCE Formerlythe Land Trust Exchange 1017 DukeStreet~ Alexandria, Virginia 22314 703-683-7778 IMPACTS OF THE ALTERNATIVE MINIMUM TAX ON LAND CONSERVATION: CASE STUDIES From The Society for the Protection of New Hampshire Forests: 1) A widow wanted to donate a conservation easement to limit future development on 100 acres of forest land with some prime agricultural soils. The property's value is about $300,000. The planned conservation easement, limiting subdivision to two parcels and allowing only one additional house, would have reduced the property's value to about $200,000, making the easement gift worth $100,000. However, her basis in the property, purchased 25 years ago, was about $6,000. Because of her age, owner needed to sell the land and house to create a retirement fund and to pay for the health ,care cost ofa very elderly father. Upon advice accountant, she decided not to donate the easement because if she both sold the land at the restricted value and paid the required ANT, she would not have enough left to create the necessary retirement fund. The owner decided to sell the property without any restrictions on its future development. 2) In late 1987, a landowner donated a conservation easement to protect a small parcel on an undeveloped pond in central New Hampshire. The easement granted permanent public access to the pond for fishing and boating. Resulting problems with ANT so significantly diminished the tax benefits of this conservation easement gift that the owner has decided to delay indefinitely any further donations of conservation easement to protection the adjoining 150 acres of land overlooking the poind. The owner further commented that the cost of figuring and re-figuring the ANT was another significant reasons his benefits were affected. 3) In 1988, two elderly landowners bargain-sold 1200 acres of land to the Society at one-fifth of its fair market value of $1.5 million. They expected to bargain sell their remaining 1200 acres in 1989. However, because of the ANT, donors were able to use only about a third of the 1988 deduction, even when carried out over six years. The donors' accountant thus advised them not to proceed with any further bargain sales to the Society, and the sale of the remaining 1200 has been delayed indefinitely. From the Essex County Greenbelt Association, Massachusetts: "Our Trust lost a 75-acre gift in the 11th hour because of bad legal advice concerning the ANT". Owner was ready to donate a $1 million riverfront property consisting of woodland, field and wetland, including a rare plant habitat. The tax deduction was not a primary motivation for the landowner, but the landowner's attorney erroneously advised him that he would have to pay a tax in excess of $250,000 on the gift (21% of the appreciated portion of the property's value). Although the attorney was corrected on this point, his advice placed enough doubt in the landowner's mind to cancel the gift. PAGENO="0237" 227 From the Trustees of Reservations, Massachusetts: The conservation-minded owner of 70 acres in rural Massachusetts planned to donate a conservation easement restricting future developmentnf~her land, which includes an historic house, scenic views across--rolzling~upland fields, extensive woodlands, and over 1,000 feet of river frontage.- Everything was in order for a year-end gift in 1988, when the donor's accountant advised that, because of the AMT, there would be little or no tax benefit for the gift in that tax.~year. The donor decided to delay the gift, ~zb~t died in January of 1989. As a result, the property say have to~be~d~tor development to pay the estate tax. From CorLands (Corporation for Open Lands), Chicago: After several negotiating sessions, the owners of a 70 acre parcel, designated by the State as Nature Preserve quality, were ready to proceed with the bargain sale of their property to CorLands. However, when tax counsel was brought in by the owners, it was determined that they would be subject to the ANT. Firat~the.. potential donors were confused, because they did not - ~ Second, counsel advised then that they were ~more likely to the ~audited if they were subject to the ANT. These ;~ZtWo factors leththe~ landowners to decide against the bargain sale to CorLands. From Berkshire County Land Trust, Massachusetts: Elderly couple in Becket, Massachusetts, wanted to protect their 200 acre farm, valued at $850,000, by donating a conservation easement. The land trust obtained a tax analysis, showing that the couple would be subject to the ANT. When the.landowners' accountant reviewed the numbers, he advised against making the gift. Now the property is a likely target for development. From the Boulder County Land Trust, Colorado The land trust is working on four projects involving critical elk migration lands that are part of the Rocky Mountain Park ecosystem. All projects involve either conservation easements or bargain sales. The landowners are all farm families and, in most cases, the land has been in their families for several generations. The land has appreciated and has a very low tax basis. When the land trust lawyer explained the Alternative Minimum Tax to the landowners, they found it very difficult to comprehend and, although no final decisions has yet been made as to these projects, the lawyer believes that if the charitable deduction is limited to basis, the landowners may well decide not to go through with the charitable gifts. PAGENO="0238" 228 THE B LAND TR~UST ALLIANCE Formerly the Land Trust Exchange 1017 Duke Street Alexandria, Virginia 22314 703-683-7778 EFFECTS OF THE 1986 ALTERNATIVE MINIMUM TAX PROVISION ON ON CHARITABLE GIFTS FOR LAND CONSERVATION In 1988, The Land Trust Alliance asked the following question as part of a survey of the nation's local and regional land trusts: Do you feel the 1986 changes in the tax law have affected donations of land or conservation easements to your organization? If so, how? A sampling of responses follows: SAN JUAN PRESERVATION TRUST (WA): "We have one maj or ranch on San Juan Island where we have had problems all alone because of the ... complexity of the ANT situation." BRANDYWINE CONSERVANCY (PA): "ANT is a major problem for planning." COLORADO OPEN LANDS (CO): "Reduced incentive has reduced number of gifts. ANT is now a major consideration." OPEN LAND FUND (MA): "ANT tax on unrealized appreciation [has affected us adversely.)" NASHUA RIVER WATERSHED ASSOCIATION (NH): "Uncertainty of ANT for appreciated value." BOLINAS COMMUNITY LAND TRUST (CA): "Created confusion, which created delays. Had a chilling effect since it substan- tially reduced tax benefits on donation, triggers ANT for most donors." LANCASTER COUNTY CONSERVANCY (PA): "Treatment of appreciated property charitable deduction as a preference discourages land/easement donations." SCHIFF NATURAL LANDS TRUST (NJ): "Imposition of Alternative Minimum Tax has substantially reduced interest of potential donors in gifts of fee title and easements." VINEYARD OPEN LAND FOUNDATION (MA): "The fact that appreciation in value of property is now subject to the Alternative Minimum Tax has largely eliminated a great incentive for donations. We are also less able to negotiate bargain sales for acquisition..." SCENIC HUDSON (NY): "ANT has blocked several transactions." TRUSTEES OF RESERVATIONS (MA): "ANT has been a serious disincen- tive for donors of appreciated property or [conservation easements] involving appreciated property." * **** ****** **** *** *** ** ** * * And we've received other comments from land trusts about the ANT: DUTCHESS LAND CONSERVANCY (NY): [We have] assisted landowners in protection of over 3,500 acres of unique, highly appreciated farmland, scenic, and environmentally significant land. Since 1986, however, the effect of the ANT on gifts of land and easements has significantly reduced the income tax incentive for such gifts." PAGENO="0239" 229 BERKSHIRE COUNTY LAND TRUST & CONSERVATION FUND (MA): "Only the deeply committed give land today. It is the double whaminy situation. Selling [for development] attoday's prices brings alot of money, even though they have to pay big taxes on it. If they give land to our Trust, the fair market value deduction can be virtually wiped out by the Alterna- tive Minimum Tax." MAINE COAST HERITAGE TRUST: "Landowners are taking a hard look at the ANT provisions before moving forward [with a dona- tion]. ... [Some] donors with whom we have spoken have commented that the ANT provisions may make it difficult or undesirable to donate land and easements. ... One landowner with approximately 1200 acres has been forced to conserve his .property in small blocks so as to avoid ANT." PECONIC LAND TRUST (NY): "The Trust has experienced a dramatic reduction in the number of gifts of land and conservation easements since the [enactment] of the 1986 ANT provision on charitable gifts. . . .The ANT works against farmers and other landowners who have inherited their land or purchased it before 1970 [because] such landowners have a low basis in the land. The charitable benefits of donating land and easements.. .in today's world . . .are minimal." NANTUCKET CONSERVATION FOUNDATION (MA): "I am not sure that 1 fully appreciate the whole picture on the ANT provisions, but what I do know is that they have substantially affected our ability to acquire conservation land by gift. When you run the numbers on any appreciated property, the results are consistently gloomy. There is virtually no incentive for a taxpayer to consider a gift unless they really want to convey without regard to its impact on their returns." MONTEREY PRESERVATION LAND TRUST (MA): "We come up against the ANT again and again. ... It absolutely stops us dead!" PAGENO="0240" 230 Mr. STARK. Thank you. Mr. Buck. STATEMENT OF ROBERT T. BUCK, DIRECTOR, THE BROOKLYN MUSEUM, ALSO ON BEHALF OF AMERICAN ARTS ALLIANCE; AMERICAN ASSOCIATION OF MUSEUMS; AND ASSOCIATION OF ART MUSEUM DIRECTORS Mr. BUCK. Thank you, Representative Stark. I am here to talk to you about something you have already heard quite a bit about and I represent directly the Brooklyn Museum, of which I am the director, and the American Arts Alliance and the American Association of Museums and the Association of Art Museum Directors. All of us have benefited over the years by a re- markable American invention and that is the ability for a tax ad- vantage in the direct contribution of a work of art at its full value. When the museum ~ommunity testified before the Ways and Means Committee in 1985 on the appreciated property issue, we emphasized the importance to museums of contributions of appreci- ated property. The unique aspect of the American experience is the extent to which. the public, rather than private collections, have grown largely due to the full deductibility of gifts of appreciated property for tax purposes. An informal study conducted by the American Arts Alliance, the American Association of Museums, and the Association of Art Museum Directors revealed that 80 percent of museums' collections throughout the United States were acquired through these dona- tions. The 1984 Deficit Reduction Act included a series of provisions that introduced new substantiation requirements for gifts of prop- erty and penalties for overstatements of values. The 1989 Budget Reconciliation Act modified the penalty provi- sions on valuations. The museum community supported the 1984 and 1989 changes and believes that the problem of overvaluations of gifts has stabilized. I would like to point out that in the situation of the Brooklyn Museum, we have a dramatic case where over a thousand works of art were given in 1985, which has been reduced to 40 percent today, or 667 works of art. Our case is not an unusual one, if the figures are looked at on a nationwide basis. The American Association of Museums estimates that gifts of ob- jects by individuals to all types of museums declined, from 1986 to 1988, by aggregate value of $63 million or 61 percent; from 1985 to 1988, gifts of objects dropped by $39 million or 49 percent. The AAM further estimates the gifts of appreciated property other than objects declined in aggregate value by $8.8 million or 50 percent from 1986 to 1988, and by $4.1 million or 32 percent from 1985 to 1988. The AAMD reports that from 1987 to 1988, the dollar value of donations fell 29 percent, while the purchase prices of works rose 20 percent. All of this really simply reflects that museums are being squeezed from each end and the collections are suffering. Art and historical artifacts have appreciated dramatically in past years-you all know, you read the record every day in the newspa- PAGENO="0241" 231 pers-and can be expected to increase in value more rapidly than inflation. An increasing number of artistic masterpieces destined for museum collections have been sold at auctions, thus removing them from public access. Many have been sold to private owners and have left the country for good. Removal of gifts from the alternative minimum tax does not * compromise the principles of tax reform. A charitable contribution of appreciated property is unlike other kinds of activity that come within the AMT. It is a permanent, nonrecoverable disposition that irrevocably reduces the donor's net worth. In conclusion, the charitable contribution to a museum is an act of private investment in a public purpose, in which the return is not to the donors but to the public at-large. For that very reason, donors and donees are not merely two halves of yet another special interest working to' protect their particular tax break. The muse- ums, the zoos, and the aquariums serve public purposes, not pri- vate ones. No other element of tax policy produces so large a ratio of public benefit to private advantage. What distinguishes the charitable deduction from other deduc- tions and credits in `,the tax law is its redistributive function. The charitable deduction creates an incentive to give. It does not elimi- nate the financial loss which donors experience when they make their gifts. I appreciate the opportunity to present these views. We hope sin- cerely that other members of the panel speaking on behalf of this will also be listened to very carefully. Thank you, gentlemen. [The prepared statements and attachments of Mr. Buck follow:] PAGENO="0242" 232 Statement of the American Arts Alliance * as submitted to the Subcommittee on Select Revenue Measures * ofthe Committee on Ways and Means of the U.S. House of Representatives Introduction The American Arts Alliance ("Alliance"), a consortium of nonprofit arts institutions, appreciates the opportunity to submit this statement to the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means. The Alliance thanks the Subcommittee for its consideration of the proposal that would remove the appreciated portion of property gifts from the ANT. Summary - The Alliance urges the Subcommittee to endorse the proposal to delete from among the list of tax preference items, for purposes of the alternative minimum tax ("ANT"), gifts of appreciated property to arts institutions and other charitable organizations. Specifically, the Alliance requests the repeal of section 57(a)(6). This expansion of the reach of the ANT was enacted as part of the Tax Reform Act of 1986. The purpose of an enhanced ANT was to raise additional tax revenue in the case of transactions that did not attract the regular income tax. The unintended result of the expanded ANT has been to discourage contributions of works of art and other appreciated property. Thus, charitable gifts of this nature have declined significantly since 1986. Gifts of appreciated property are central to the economic viability of the nonprofit performing, exhibiting and presenting arts institutions represented by the Alliance. The Importance of the Arts to American Socjaty The arts are among the greatest of our national treasures. Artistic performances and exhibitions enable us to experience and value the extraordinary diversity - ethnic, racial, religious- that distinguishes the American experience. It is through the arts that children learn to give form and meaning to their own emerging sense of identity. The arts are a vital part of our education system, and our arts institutions take this responsibility seriously. It is our nation's arts institutions that play the leading role in safeguarding and articulating our national heritage, and in inspiring creativity within new generations of Americans. Finally, as America takes part in the modern global community, our standing as an international leader is strengthened when the creative forces of our artists touch the lives of people throughout the world. The Historical Significance of Tax-Exempt Status and the Charitable DeductiGn The financial well-being of the arts in America is dependent upon enlightened federal tax policies. Since the earliest days of our republic, a concept central to American law has benefitted the arts economy: Government should encourage private philanthropy to address social needs by exempting from taxation private PAGENO="0243" 233 property and monies devoted to providing public services that it would otherwise have to underwrite from revenues. Accordingly, section 501(c) (3) of the Internal Revenue Code ("Code") provides tax-exempt status to nonprofit arts organizations in recognition of their many and varied charitable and educational contributions to American society. The federal tax law defines the term "education" as "the instruction of the individual for purposes of improving or developing his capabilities, or the instruction of the public on subjects useful to the individual and beneficial to the community" (InOone Tax Reg. § l.SOl(c)(3)-l(d)(3)(i)). The Internal Revenue Service has long recognized the concept of "promotion of the arts" as one of the definitions of the term "charitable" Private philanthropy has been the principal source of support for the arts throughout our history, with government doing its part to help the arts flourish by advancing tax policies *that encourage the existence of tax-exempt organizations and private giving to them. Under Code section 170, individual and corporate contributions to tax-exempt, charitable organizations are generally tax- deductible. Thus, the government provides incentives for private contributions, which are vital to the economic stability of nonprofit institutions. Appreciated Property and the Tac Reform Act of l2M The Tax Reform Act of 1986 brought about a wide range of sweeping changes to the tax code. While many of these modifications have had favorable results, the change in the tax treatnent of appreciated property gifts has placed an enormous strain on American arts institutions, particularly the museum community. Our national heritage is displayed and preserved within our art museums. The museums fulfill their public service mission by exhibiting objects of art. Museums have long been aided in this mission by the philanthropic gifts of private owners. For example, the donation of a Thomas Eakins or Jackson Pollack painting is invaluable to an art museum since it becomes an integral part of a collection and can be viewed regularly by the public. Thus by passing from private hands to the public domain the painting has an inestimable value to the American citizenry. The Tax Reform Act of 1986, which included the appreciated portion of property gifts as a tax preference item in the alternative minimum tax, significantly diminished the incentive to donate gifts of appreciated property to charitable institutions. The federal tax law, since 1984, contains rules mandating the independent appraisal and valuation of property contributed to charitable organizations. This body of law, of course, is applicable to gifts of works of art for charitable purposes. These rules, which basically apply to all donated property with a value in excess of $5,000, must be complied with for the donor to be entitled to a charitable contribution deduction for the gift of the property. This law is designed to ensure that gift property is not overvalued for deduction purposes. The Role of Appreciated Property gifts in the Arts Community Gifts of appreciated property are critical to nonprofit arts institutions. This is particularly true in the case of America's art museums. In fact, an informal - study conducted by the Alliance, the American Association of Museums and the Association PAGENO="0244" 234 of Art Museum Directors revealed that 80% of a museum's collection is the result of gifts of appreciated property. It is interesting to note that this statistic holds true for musaums across the country both large and small. By encouraging charitable contributions of appreciated property, the government helps to foster the private/public partnership essential to the financial well-being of arts institutions. Gifts of property often anchor capital fund drives. These major gifts provide credibility and momentum to the fund raising efforts by serving as an imprimatur attracting funds from a variety of other sources. ~This financial support engenders the building of institutions' endowments, and enables inst±tutions to carry on their programs and projects. For a symphony this support can mean a summer concert series, for an opera or dance company the staging of a new performance, or in the case of a dance company a tour to a rural community. In this way gifts of appreciated property help to leverage private support in the same manner as the National Endowment for the Arts does through its matching grant programs. The Effect of 1986 Tax Reform on the Museum CommunIty The arts community, particularly museums, was hard-hit by the change in the law governing the tax treatment of appreciated property. The Association of Art Museum Directors reports, on the basis of a survey of its members, that from 1987 to 1988 the dollar value of donations fell 28.8% while the purchase price of art works rose 20.4%. The drop in the the dollar value of donations over the two year period from 1986 to 1988 is even more dramatic, totaling 63%. In fiscal year 1986, donated works of art had an aggregate value of about $143 million; in contrast, in fiscal year 1988, the comparable figure was $67 millic'n. clearly, major works of art are being prevented from entering the public domain as can be seen in the following charts. NUMBER OF GIFTS OF APPRECIATED PROPERTY i Source: Association of Art Museum Directors Survey PAGENO="0245" 235 VALUE OF GIFTS OF APPRECIATED PROPERTY 40 - U 1986 *1987 1988 Source: Association of Art Museum t~irectors Survey Popular media at both the national and local levels has addressed this problem in recent months. For example, The. St. Louis Business Journal, in its December 18-24, 1989 issue, reports a significant drop in the dollar value of donations to the St. *Louis Art Museum since 1985. At the museum, "the value of donations has plummeted from an average $6.2 million a year between 1980 and 1985 to $349,000 in 1988," according to museum director James Burke. "In past years there were about 40 regular donors each year . Now there are two or three individuals." Meanwhile at the national level, publications have also focused on this issue. ArtNews Magazj~, in its March 1989 issue, devoted a major article to the difficulties faced by the museums. The magazine reported that at the Boston Museum of Fine Arts "end-of-year gifts in 1987 were one-half of the previous year's, both in numbers and value,' according to director (Alan] Shestack, `We got only three or four paintings in 1987, all contemporary, with one exception. " Among other institutions suffering from declines in giving, ArtNews noted that "art donations to the Museum of Contemporary Art in Chicago dropped by 80% from 1985 to 1988, `correlating to the last round of tax changes," according to the museum's acting director and chief curator Bruce Guenther. More recently, Time Magazine observed on September 25, 1989 that "changes in the tax code have made [charitable] giving less attractive." The 1986 alteration of the ANT presumably was among the "changes" referenced. Earlier, in its September 18, 1989 issue, ~ interviewed philanthropist Paul Mellon. On the subject of giving to the arts, the magazine quoted him as saying that "the tax laws don't help you [museums and galleries] very much. It's a combination of the high prices and the business and capital gains things that have to be worked into it, and the minimum tax and so forth. I can't understand it all, and I'm not sure my lawyers understand it." Time MaGazine soon returned to this theme, when its cover story PAGENO="0246" 236 for the November 27, 1989 issue was on the state of the arts in America. The article stated: "American museums have been hit with a double whammy: art inflation and a punitive rewriting, in 1986, of the U.S. tax laws, which destroyed most incentives for the rich to give art away. Tax exemptions through donations was the basis on which American museums grew, and now it is all but gone, with predictably catastrophic results for the future." Time continued: "Thus. . .the Government began to starve its museums just at the moment when the art market began to paralyze then. It.. . leaves in the lurch one of the real successes of American public life, its public art collections." For museums a tax code which encourages individuals to pass works of art on to their heirs, or makes the, sale of art and donation of proceeds more advantageous than an . outright gift of art, undermines the fulfillment `of their public purpose. The public .good is not served when priceless -art.is sold at public auction to private collectors, particularly foreign investors. Too often in the past two years important artworks have been sold to foreign, buyers, thereby denying~the American public the opportunity to appreciate and learitfrom~ these works of arts. * Conc1usi~n' In~eonc1usion, the nonprofit arts community.~bears the enormous -~andostly responsibility ~of fostering creativity and preserving 5 . ouri~natiOn'5 cultural legacy. If America's. arts institutions are to meet this responsibility,~±he contributions, of property must continue `-`to flow to then. Charitable contributions represent the distribution of personal wealth for public benefit. Tax policies encouraging these contributions help to strike the balance of public and private support that is necessary if America `is ±o~zimaintain its arts institutions for the benefit of its citizens. The Alliance is confident that the `intent of tax reform in 1986 was not .to cripple the nonprofit community. We know that members of Congress' share our~ conviction that one measure of a great civilization is its arts. It is in this spirit~that~the Alliance submits this testimony and requests that ~the Snbcommitte.e `endorse the proposal to~eliminate -~the .~appreciat±ofl element, in contributions of property to charity~~a'S a tax .preference item for purposes of ~NT. PAGENO="0247" 237 AMERICAN ARTS ALLIANCE Aci~o COMMnT AcsTk*EoIbxnsw~t. Axi.nARrM~mEux ALa~y SYMpHc~ORcI~N~Yomc ABRGn~KNoxARrGAiiz~ A~A~Mu~ux Auz~ ~ UJ~CETHt~RtCOMMNT AM~io OP~ATn~tR A~R!c~N BAw~ AMON C*~~n~ Mus~u~ orW~m~nApr ~ Mnts~ T~ A~o~* Ov~ C~ AR~* T~E~m Co~y A~xNssM~rsCEN~tR ~ ARrINsrrnyr~ orCmcAoo ArMus~w,PRu~crj~n UNw~&rT Am~N~ Smv,iopy OIlcH~rRA AUOUS~NA COLLZOE * B~OREOP~RACOMP~NT B~xu~o~z SmpHo~y ORCnrz~t~ B~rot4 ~bVGE Sn~rHo,~Y B~u~ L~irncy D~cz COMMNY B~~izy Rz,E~m~ ThfATRE ~ Bo~s~ Thmi~*iuiomc B~ B*ui~ ~ B~u~Riv~MuszuM RurrM.o B~u.Hm~c*iCwit~ C*OR~L~1NOFThC~WOWG~ ~ S!)~~)$~ C~RNEo1tHAu. C~rERSmot CERTHrAT~z G~v,~?!ARxT~pER ~ Music CnxcAoo CKM~1AOPtR~CoMMHY Cmc~oo8~ o~CoM~ ~ C~cu~n~nOpzRAA~oaA11ow Cnrn~Tt Pi~mov~mm~P~x C~c~Smp,IoNy O~m C1Nc~*~4twOt1z&psCrryB~uzr CnrCD~ra5I9~rThL~_R Fou~~iow, INC. CIXCNIUn Mt~uMo?AJN C~.E%tu,~n Ov~* Cl.ECmNDORcx~r*~ CCw~MuNcF~srw~ CCWNCUS MUSEUM o~Asr C0WMBUS SYMPSSCNY OScn~A COCUSEUCLUSE AkIN MUSEUM, HovsIoH Colco~G*ukI~UrAkT Cos~ MusvjsiopGMss CuU*CUon~ DUNcE Fotmc.~s,on DIMUSEUM0NANC Dcucs OPcE.c DoioSy.opryA~occo,oo Dcu.sTnooou Cv.rs* Dccc~CitsorCow..~ccCouzc; h~iNON DccicGoscoUMUpCokpcoy. Dc~oCANrbUSImnN Doc'rocO?EEU Dco'~s P .co..o.ac Oscnsamc Dccccc CEOTEE? STEEP RYORMIEOARTI DCUoo.rIoomInNc?AkIs EocEUcoMww..o?Asr EoocGo,viw ~HonEN~TnEOTIN EUCU ULE Prnu~oo,.ow.c OEcoSEt~cc FUUUUUO SYEI'IIOETOMUESETE,U Fc~c ftooz~ FUcTIosTEUnoo,AkTs FthEOUmnEOEUopMnNcLnoz FrWcmcPcuwo.oc,c FONT WOREISYSEIIOEYOROIISTT,U No~CONcImA9.or~Ucct.~y UMMOIETOIEOTSE ONROOm. GEU*occMus~crAs~ NoEnmcePEEEzInN, Upovsssn'r OOUDCOOZTOPNEA G000MANT--NE MoSSES. G~o..oScEoOtO?AI.r GUEDRESTMIIIONT ODOSONFRONINSCO G~cn~II.*z$n.,,,owy OSEHESTEA OIEORS*IEUEET,MOESEOE GRZNEEM1OJC~AAEEOOEE1ON G~T Hooc..w UoIvi~yvAk~MOm~ * Orri* Co~cuoo HERNEE?FJO.ES.OII MIoSuMorANT HOOIMUNZUMO?ANT H Tos~ Y OP~MONA H M ART OESOOS.SEAOmT.&EEFEETICUU HOTEEIICEIIN,DUREMOIZTIICOU.EOE TEPIIOSUT TEE ~o(oo~UuzT0,5E~ !~NMSRRTSETOSETOLITEE H SnEE.owyOsa.rai~ IINEEMELI,OIIIOVEE H SmwrD Coü,UEy OTOEcIIEITTU H G Tos~s EWLTNWSDAocE Cosoocy H TEE COWEJIT ORIEAOOTHEUSER IovwcU AR~M PEOStE'~OEEIOY bcposaMoszuso~Aj~~ P~1EEEONOE THENNE IoTm.oo Tnr~cu Cowo,.y P,SE~cDEoSScGInw ~PAULGIN1yMUSEUM ThMUSEUMO?ART A JOESZNARTMO.EUM * PNCE~EATEENRE X~v~ ~ ~rMo~ KW.NEETcE.IER,I*PWOEEINOMIE ~ uMDsoo. DA$USERAIIDMIEEOAI.S * I~SEEOPU& LEIUMAUSIDTJEEMIaO'TIIEAINEG*Ofl. PrI~IUs.acThrkIxs ~C~u ZONe WEON?THEUSU * POm$TXEkI~USOUThS.U$ IosizsCoMc~w.orANr PLq~ERyo~ Coweoy LoSAso~zaM~cacsALi * TRWEEIZOENOEIS IONAOELE*MUaCEEEIEEOP!EA *~ * ~ ~ NOEEERThSEIIARNOSEC OREEAMSOQEEOIçOENCO0 ZOCWNuZB~ZT * SEI~MCOE Osa~M~ LOEEAZTMIEREI,UNIVTRS.TVOVMZ*JE ~lSEmOFa.Esos. IYEICONER*OTQOCAOO IZENONEMO,K*R&I$OETT REniowo Hoi~ MonNoS OPERA MUCONITETHEANNE * * Osa.12.so M~ioSB*~OEEMIEZoSO,A,r ROSASTMESEES MERDELEEZESS OSc~iopPtrr~uio~ * MEITEPOUSESMO~OSOPAST SASDEEOTHEAINEILLOUE MSIEEP0UD,x Op~o SANFEONEEEW OPERA MUEN,DEERSE~EOSETSEANEE MII*IOIUEESTMPEOIITOENI~TEA' &u.v~BkDEoaAM.~orART MEEIDAPOIJIIOSIIIIONO,AETE MEROSOIN OSINSEETEA Sk3PELFMOP~A MosuzO~uc IEEE" MocasARTMI~nIe~cPFoIyWo,5S MOITTOONEITMIIEEIJMOPFDSZMIM Mossv..orAz~RISa.oo~o,Du,o,, ~ MUEZRMOVFZSEAZ?~BEEIRS MU~E0?1EAEEHEEIEIRE ~IEEDOSMEElOS1ALAkTGoUrn MIEDODI0PMEEESEART ~SEEYSEOSTOPEEA U.wc1~sssW~,NsWYo~ &nasirCcsac Opu~ NANIOE*LSYES.EOEYOIINEDTEA ~mIECouxazMZEDuEorANc NM*Joe.xs~Mc~e.orAir So~aIoS RGuoozwncx MUSEUS SREENOISDASEECCSEENT NSNHOMPUEEESIENSIOEYOEINIEEREA SONER~ID8IEEEDETOEONPNTM NDEJ~y9rsSE,owy &UIECOSITREDEDTDDO NENMcIEs.elorCo,.r~o,,oANC SEEn~.IuJIsosUkw~srcyfAs,~ NONYOSS USER' NECYOEDc.TIBDUET &TMZIOFEOESELUS.A. NERYc*ECPTTOPEE.U &EIEESEEEDSYW'ERWYOEQWJIIEU,IUJROO NON Y0SE PENNEwIcOE~,sEErsc * 9IONSOMI~JE 54 ROStER NENYOMDSEAXEDTA*EFOOTIVAL STEARIEDRENE Nsw.sx M'~m ~nM.u~ NoSnICA*ImoM~ED.jsovAxT ~ P,oyus Tocy BcoUoo Coopcoy TDIZ*OIA000E000PARII000SCUUUCEO TD003A&M UowEOsrry ThEATREWORJCWCOUOR000 TOEANTERV,O,O/USA, NEw YORE ToIZJI0 MUSEUM orA,,r TEUCSEER O~cs* C~cy Tu~ ThouoRMoONO~ U0DDEIZITAJRTMUSEUM,EYU, Iowa BEAUX URWERRRTTEOERTI, UC Boo D,oco UOREONITOTCUIJFOROUU,RUE000E Uo,cs~r,yo,Iowo McowoorAoy UIUUCERRRTR O?KAII100 Uc,cses'rvop KEOTUCUT AOTMUSECO URIc ONY OTNEROLIKU cc LU000UI UOIUIOOX'ROTVEROIUUT URICEOROTROT WOCUCOU,SCEUECU `coy UTEOM000UOOTFO,RM,RI UUSOOPEUUCOOMCR VEREO0TSUEO'OO,UT ORUREITRI VIRU!R,UOI'EOA Wow AcrCcoy.c. WCUXEOS ANT GOODlY Woo,oo PEOFOSMOSOAJRI Coc,oc WUOR,UOTOR OPERA Wc~,o.oyoo PDRTOSLONGATYS SOCUEYR Wcsn.ooyos UNIOERSRTY/E0000 T0E000 W0wOPEJ1ACOEPUET WRDIELANTMUOEIJM WOULUMNIVEN ToEorSz FTSTIUUL Wssw,Sccz,, SYMPRORY WotrT~op FOUNROSOR WOOSTER G~,up YOUZRNTERIVRTTHT,NTE Y,ozU,nvwnyANrGou~,,, 1989 ASSOCIME MEMBERS COUXAEAEUAEEOOLEYOR POVTSMW WMIYTES TDOOEIESSAOD WRITEES COUAROROTIUE * UOXTDBETSIOSTTRYYRPOOTOIUONE * TECOROONOR 1989 CONTRIBUTORS ACOSTIEMPORASRTHE.IITE XD~EUFERR~ BAINTMODEMUSEUS~ OPANT Baoo.oow Musi,ce CUS~OEOIE MUSEUM OP AR? DSSIOZREPESTRSN ~owwoy Z~IEVEIJoo PLoT Houss K~NccIoSARr Mows OUMMREGAUmOPAXT cORNERS GUSLE.NO?AM? DUSIEPRSSTMOST,uMO,AJIT DSUATLEDSREPISORYAESOcLAIIOR DEEM0SEEESYMPR0SYOEc,Xo,RA EMPIT DEUCE THEUSER ROOm SYMPHORY ORUNERTUU FIREARIIMUSEU4EO?SAOFR,UOcIXUO FMESNOPORJSARMODICOSUIIESYRU 0005EPEEDOPEDA Ho.ms H~SowowOowouw~ HOEOUOWAEAORMTOPAIRS KeowAxr MUSEUM MEEIULAUASTG*Um MURMURED ART MUSEUM * NEWHSSYMPSODYOScRDS1N,U Po,m.coDARpMcSEuol,OoEoo~~ RSENcW00EEUST D000XCOMPUOT QEIMNEROROORNYSU &UIFSORERCOMUREUMOTMOUDROART TESEERETEE&WwEAER KESTREL Uloow o~ MooOSc.sc ART MOSEUM iNca S,s~sooy OScERT?SU Veo,o,*Mo.suw OPFIOEARTS Wcmm.oyos Bouzr WREEUUOSTMPRORYORQIEUYEO WISwyMwoROpM,u,CUNAJ,T WRITEmNUS Muss.,., * * ~ *~ ~:. :1989 MEMBERS * ~ PAGENO="0248" 238 STATEMENT OF THE AMERICAN ASSOCIATION OF MUSEUMS Mr. Chairman, members of the Ways and Means Subcommittee on Select Revenue Measures, the American Association of Museum (AAM) appreciates the opportunity to submit this statement on H.R. 173, a bill introduced by Congressman Bill Frenzel of the Ways and Means Committee. The AAM is an organization of over 10,000 members consisting of 7,700 museum professionals and trustees and over 2,300 museums, zOos, aquariums, botanical gardens, and other institutions that preserve, collect and care for artistic, historical and cultural objects as well as animal and plant life. The AAM believes strongly that Mr. Frenzel's bill represents a substantial improvement in the treatment of gifts of appreciated property from the provisions adopted as part of the 1986 Tax Reform Act. Prior to the 1986 Act, the deduction of gifts of appreciated property at fair market value was not cut back under the alternative minimum tax (AMT). Mr. Chairman, as you and members of the Ways and Means Committee know, the 1986 Tax Reform Act included as an AMT preference item the amount by which the fair market value of a gift of appreciated property exceeds the donor's cost basis. The AAM had the privilege of testifying before the Ways and Means Committee on the treatment of appreciated property gifts in 1985. In our testimony we emphasized the importance to museums of contributions of appreciated property -- whether in the form of securities, real property or gifts to our collections. In the case of some of our nation's most important museums, just over a third of the funds received from major donors have come in the form of securities. We pointed our that since there is no reason to give securities instead of cashunless they have appreciated in value, we believe that all these gifts would be affected by treating gifts of appreciated property as AMT preference items. Back in l985,~we~were most troubled by the impact of the tax law change on gifts of works of art and of historical and cultural objects. One of the ,-~wonders of the modern world is the way we in the United States have, in less - -~than one hundred years, built a chain of public collections all over our nation. The growth of public collections has been especially rapid during more recent years. What has been radically different about the American experience is the extent to which public rather than private collections have grown. Moreover, it is generally recognized, both here and abroad, that this difference is due to the full deductibility of gifts of appreciated property for tax purposes. In a typical case involving a large metropolitan art museum prior to 1986, seventy to seventy-five percent of acquisitions came in the form of gifts of art, ten percent in gifts of funds earmarked for the purchas `f specific works of art, ten percent in bequests, and the remaining fivc ~ ten percent from purchases funded by the income from an endowment restrict~ to the purchase of works of art. In many art museums, however, the permntage of acquisitions received in the form of gifts of art exceeded ninety percent, because only a few museums had or have endowed purchase funds of any significance. In 1985, it was difficult to confirm our fears about the impact of treating appreciated property gifts as an AMT preference item. We relied primarily upon a study conducted by Lawrence Lindsey (then at Harvard University, now Associate Director for Domestic Economic Policy in the White House) which determined that approximately sixty-five percent of the total value of all gifts of appreciated property by taxpayers with adjusted gross income in excess of $100,000 are made by taxpayers who will be subject to the prnpos~d alternative minimum tax. Moreover. Lindsey predicted that the cost of giving by these people will be increased to the point that two-thirds of their gifts as measured by value which would otherwise be received by museums and other cultural institutions would be jeopardized. In 1990, unfortunately, we are able to confirm the accuracy of our fears. In February 1988, the AAM undertook a five year survey sampling of its membership in order to determine the impact of the 1986 Tax Reform Act changes. To date, the data has been collected from years 1985, 1986, 1987 and 1988. PAGENO="0249" 239 The survey Is entitled the "PAM Survey on Contributions of Objects and Dollars." We believe that the data revealed in the survey is accurate within plus or minus five percent. For purposes of this testimony, we will concentrate only on gifts by individuals; not because the data regarding corporate and foundation gifts is different, but because such data is less reliable. The survey sample consisted of 274 institutional AAM members cross-referenced by type, size, and region. The data was amplified to represent national estimates in selected categories for all MM institutional members consisting of 2,271 museums at the time'of the sampling. The data covers gifts by individuals of (1) cash, (ii) objects for museum collections and (iii) appreciated property other. than objects for the' collection. `In" addition, the data was broken out between "regular" gifts and "capital/special campaign" gifts so that data from special campaigns would not obscure data on the normal private donation patterns. The combined data for' both regular and special campaign gifts of appreciated property shows an increase in the value of such gifts from 1985 to 1986 of $29.8 million or 103.11., a decline in the value from 1986 to 1987 of $32.4 million or 55.2 1., and further decline of $278 thousand or 1.11. from 1987 to 1988. It has been argued by some that 1986 gift giving was artificially high because donors accelerated gifts to avoid the changes contained in the 1986 Tax Reform Act which were to take effect in 1987. However, gift giving in 1987 was actually $2.6 million, or 8.91. lower than gift giving in 1985 and gift giving in 1988 was $2.9 million, or 9.9% lower than gift giving in 1985. This strongly suggests that including gifts of appreciated property as `an AMT preference item beginning in calendar year 1987 discouraged gift giving. Other data from the survey provides even more startling evidence of a decline in giving. If gifts given in connection with special/capital campaigns are discounted on the assumption that these campaigns distort normal giving practices because they are infrequent or highly targeted, the decline in giving from 1986 to 1988 and, perhaps more importantly, 1985 to 1988 is even more dramatic. Gifts of appreciated property other than objects declined in aggregate value by $8.8 million or 50.5% from 1986 to 1988, and by $4.l93 million or 32.7% from 1985 to 1988. By any yardstick, this is an extraordinary decline. It means that gifts of stocks, bonds, and other property with a readily ascertainable value - critical to the financial lifeblood of any tax-exempt organization, including museums - declined by almost one-third between 1985 and 1988. Perhaps the most significant affect on the museum community, however, whose central mission is to collect and exhibit our cultural patrimon~ is the decline in value of gifts of objects to museum collections since enacts. `it of the 1986 Tax Reform Act. Gifts of objects to museums by individuals deLined in aggregate value by $31.5 million or 30% from 1986 to 1987, with a furt1~r drop by $32.ll2 million or 44.4% from 1987 to 1988. Gifts of objects declined from 1986 to 1988 by an aggregate value of $63.6 million ~r 61.2% and from 1985 to 1988 the value of gifts of objects dropped by $38.9 million or 49.1%. The degree to which the decline in giving is due to the change in the treatment of appreciated property gifts is demonstrated by comparing the changes in giving described in the two preceding paragraphs with the data developed in the survey covering cash gifts which are not affected by the new rules regarding gifts of appreciated property. The survey indicates that cash contributions declined by only $5.5 million or 6.0% from 1986 to 1987 and increased by $3l.689 million or 36.6% from 1987 to 1988. The major tax code changes covering tax-deductible contributions between 1985 and 1988, in addition to treating appreciated property gifts as AMT preference items, were the reduction in the rates of tax and the elimination of non-itemizer deductions. The latter two changes affected cash gifts and appreciated property gifts equally. Therefore, the fact that cash gifts increased and appreciated property gifts decreased must be due, at least In major part, to the one change that affected only gifts of appreciated property; namely, its treatment as an AWl preference item. Had this empirical evidence been available in 1985 when the MM testified, we believe the Congress might not have included appreciated property gifts in the AMT; PAGENO="0250" 240 We believe the results of the survey confirm the fears we expressed to the coninittee four years ago. The fact is that great ~art and historical artifacts have appreciated dramatically in past years, and because of its relative scarcity can be expected to continue growing in value more rapidly than inflation. Furthermore, we are concerned with the increasing number of artistic masterpieces, destined for museum collection, that have been sold at auction, thus removing them from public access, since enactment of the Tax Reform Act of 1986. Many of these matterpie~eshave been sold to private foreign owners and have left the country for good. The tax treatment of appreciated property is a significant limitation on the incentive to make charitable contributions and does a disservice to America's museums in fulfilling their mission to collect and exhibit art, historical and cultural artifacts. Removal of gifts of appreciated property as a tax preference in the alternative minimum tax would serve the public by~ providing the incentive to make our cultural patrimony accessible for public viewing and appreciation. We also believe, however, that deleting appreciated property gifts from the list of AMT preference items does not compromise the principles of tax reform. A gift of appreciated property Is fundamentally different from the kinds of activities that otherwise come within the alternative minimum tax. A charitable contribution of appreciated property is not an exploitation of a timing difference such as accelerating deductions in business transactions, nor is it a current tax benefit that hopefully will lead to a future economic benefit. A charitable contribution of appreciated property is a permanent, non-recoverable disposition that irrevocably reduces the donor's net worth. A charitable contribution to a museum is an act of private investment in a public purpose in which the return is not to the donors but to the public. ~Eor~cthat very reason, donors and donees are not merely two halves of yet another special interest working to protect their particular tax break. Museums, zoos, and aquariums serve public purposes, not private ones. No other element of tax policy produces so large a ratio of public benefit to private advantage. What distinguishes the charitable deduction from other deductions and credits in the tax laws is its redistributive function. The charitable deduction creates an incentive to give. It does not eliminate the financial loss which donors experience when they make their gifts. The desire to give to worthy causes is inherent in the American character, but the tax laws do affect how much is given. The nonprofit institutions developed and sustained by the private sector are one of the great glories of this country, and they are being put at risk. It must be remembered that tax policy is a piece of larger public policy goals an& that the encouragement of private philanthropy is basic to those larger goals. Practices and customs that are rooted in the nation's histOry and long sustained by law in time rise above their mere statutory base and take on the character of principle. Clearly, the incentives to charitable giving have reached that status. PAGENO="0251" 241 GIFFS BY INDIVIDUALS VALUE OP OBJECTS DONATED `10 AAM MEMBER MUSEUMS 1985-1988 1987 Year of Conthb~tjo~ 1988 PAGENO="0252" $ Amount in Millions 0 5 10 15 20 I - I 1; ______________ _______________ Pd PAGENO="0253" $ Amount in Millions 60 `0 n 0 0~ a 0 a PAGENO="0254" 244 GIFTS BY INDIVIDUALS SPECIAL OR CAPITAL CAMPAIGNS VALUE OF APPRECIATED PROPERTY GIFTS TO AAM MEMBER MUSEUMS 1985-1988 a 1* = a 2 0 rl 1995 1988 1987 1988 Year of Contribution PAGENO="0255" 245 Mr. STARK. Thank you, Mr. Buck. Dr. Rosenzweig. STATEMENT OF ROBERT M. ROSENZWEIG, PH.D., PRESIDENT, ASSOCIATION OF AMERICAN UNIVERSITIES Mr. ROSENZWEIG. Thank you, Mr. Stark. My name is Robert Rosenzweig and I am president of the Asso- ciation of American Universities. I am appearing here today on behalf of the higher education community, to speak to the merits of H.R. 173, a bill that would restore to its pre-1986 position the treatment of gifts of appreciated property in relation to the alter- native minimum tax. I have submitted a statement for the record. Perhaps the most useful thing I can do in the few minutes here this afternoon is ex- plain why those who are responsible for the conduct of colleges and universities think this issue is so important to the well-being of their institutions. At the risk of slight oversimplffication, that reason derives from the basic underpinnings of the economics of colleges and universi- ties. On the cost side, their operating budgets are driven by the fact that the need to do something new-for example, buy books, com- puters, other equipment or to add new fields of knowledge-grows and is rarely matched by an opportunity to stop doing something old. Knowledge is additive and so, therefore, in the long run are educational budgets. On the revenue side, which is what most concerns me here, the sources are small in number, fixed and known. They include appro- priations from government for State-supported institutions, student charges, grants and contracts from government or industry, income from endowment and gifts. For large capital projects built for con- struction or renovation and major equipment purposes, there are essentially. only two sources, gifts and borrowing, and the latter is done under public and private authority. For all practical purposes, that is it. Now, as in any large organizations, sudden temporary downward shifts in revenue can be accommodated in the short run, but since the only controllable source of revenue for colleges and universities is student tuition, in the longer run they can be met only by rais- ing prices, thereby limiting student access, by lowering educational quality or by some combination of the two. At the same time, pressures to restrain tuition increases are mounting and cost containment efforts are under way at many in- stitutions already. For example, over the past year, it has been re- ported to us that some of our most prominent universities have been taking steps both to reduce administrative costs and to make significant adjustments in priorities and programs, steps that will have substantial cost impacts in the long run. Clearly, though, in a period of this kind, meeting capital costs is doubly difficult. The testimony we have from those of our institu- tions who are responsible for private fund raising strongly suggest that the 1986 change in the treatment of gifts of appreciated prop- erty damaged the ability of institutions to attract those major gifts that are the cornerstone of any development campaign and that PAGENO="0256" 246 are particularly crucial, if colleges and universities are to meet the capital needs they face. It is in the nature of such gifts that they cannot be replaced by other sources of income. I want to emphasize the importance of these gifts for meeting capital costs. While the capital needs of all of higher education are large, they have become especially acute for research-intensive uni- versities, the group I know best. A recent report by the National Science Foundation showed that colleges and universities are deferring $2.50 of needed construction for every $1 of planned capital expenditure, and they are deferring $3.60 of needed repair and renovation for every $1 they spend for those purposes. Now, until 20 years ago, the Federal Government helped to meet those needs, but around 1970 it ceased funding the construction or renovation at university research laboratories. In that period, the demand for research has grown, as the facilities in which it is done have deteriorated. It is a fact of life that the financing of capital facilities requires large appropriations, large borrowing or large gifts. The first of those is not available from the Government and so institutions have had to rely on the latter two. Both were con- strained by different provisions of the 1986 act. H.R. 173 is aimed, in part, at enabling institutions of higher learning to attract gifts for the state-of-the-art facilities that modern research and training require. Mr. Chairman, for the last decade, we have been engaged in what amounts to a national debate on the subject of tax policy. The debate has centered on such issues as fairness, simplicity and the proper role of tax policy in providing incentives for preferred types of economic activity. What has tended to be lost in the course of that debate is the historic role of tax policy as an instrument for turning private wealth to public purposes. H.R. 173 is an opportunity to help bring that long-standing aim of American tax law back into proper focus. I hope that the com- mittee and the Congress will seize that opportunity. Thank you, Mr. Chairman. [The prepared statement of Mr. Rosenzweig follows:] PAGENO="0257" 247 STATEMENT OF ROBERT M. ROSENZWEIG, PRESIDENT, ASSOCIATION OF AMERICAN UNIVERSITIES I am Robert M. Rosenzweig, President of the Assodation of American Universities. On behalf of the higher education community, I am pleased to have the opportunity to present testimony in support of HR. 173, a bill to eliminate the provisions of the Internal Revenue Cede that now subject charitable gifts of appreciated property to the alternative minimum tax (the "AMT"). Enactment of these provisions in the Tax Reform Act of 1986 added a major element of confusion, uncertainty and cost to voluntary support of higher education. There is no question that the potential application of the AMT has been a significant disincentive to charitable giving to colleges and universities. There is also no question that the financial pressures upon colleges and universities are severe; that federal support for higher education is decreasing; that the financial ability of students and their families to finance the costs of higher education is limited; and that the demands placed upon higher education for teaching and new knowledge are increasing. In the face of these continuing tretids, colleges and universities rely upon voluntary contributions by individuals to meet the critical gap between resources and needs. In this respect, gifts of appreciated property are particularly significant. Our experience has been that in major fundraising efforts approximately 90 percent of the funds raised will come from 10 percent of the donors, and some institutions indicate that dose to 50 percent of their individual support comes from 1 percent of their donors. Many of these important gifts are gifts of appreciated property, and we have reason to know that these donors - the individuals who determine the success or failure of significant capital campaigns - are very responsive to federal tax incentives or disincentives to giving. Impact on Charitable Giving Although statistical analyses may differ in particular respects, no one in the higher education community doubts that the AMT provisions of the 1986 Act have had a significant adverse impact on major gifts of appreciated property. A report of the Council for Financial Aid to Education of June, 1989 in regard to voluntary support of education for 1987-1988 showed a 16 percent inflation-adjusted decline in gifts of appreciated property, excluding securities, as compared to an over-all decline in private giving to US. colleges and universities of 7.4 percent. This is little reason to believe that donors of stock would behave differently than donors of other kinds of property. Over the same time period, gifts for capital purposes declined by 13.4 percent. According to a recent Chronicle of Philanthropy article dated February 6, 1990, a new "charity indicator" shows that gifts of stock were at their highest level in 1986 following enactment of the Tax Reform Act and have not yet regained their pre-'86 level. This indicator reflects information from monthly reports filed with the SEC on stock dispositions by gift. Charles Clotfelter, Director of the Center for the Study of Philanthropy and Volunteerism at Duke University believes that the indicator could serve as one of the first signs that the 1986 tax law change willaffect giving over the long run. In a survey of over 1,000 institutions now being conducted by the National Institute of Independent Colleges and Universities, preliminary data indicate an inflation-adjusted decline in gifts of appreciated assets by individuals to colleges and universities of 13.5 percent between 1985 and 1988. The limited data available for 1989 indicates, happily, that charitable giving in generalseems to have increased from the level of 1987-1988, and there is some indication that gifts of stock and other appreciated assets were more common than they were a year earlier. Although encouraging, these early figures for 1989 have to be seen in some perspective. Patterns of charitable giving are determined by a variety of factors - the state of the 30-860 0 - 90 - 9 PAGENO="0258" 248 economy, for example, or fluctuations in the stock market, or consumer confidence. The cost of charitable giving as determined by applicable federal income tax rules is clearly another one of these factors. In a particular year, various of these factors willcombine to produce increases or decreases.in the level of charitable contributions, just as the stock market crash contributed to the notable decline in giving in 1987, and apparent economic optimismseems to have contributed to a relative increase in 1989. However, if a particular tax provision demonstrably and substantially increases the after-tax cost of a charitable contribution, it is only reasonable to assume that such a provision alw~y~s acts as a disincentive to giving, and that the level of giving in any year, after all the other factors have come into play, is lower than it would otherwise have been because of that tax disincentive. Obviously we are cheered by recent evidence of some up-turn in charitable giving. However, we must view this apparent development against a much longer-term pattern of declines in the rate of increase in charitable giving to higher education, and very significant declines in the rate of increase in gifts for capital purposes. We also have to recognize - as logic dictates and our own personal experiences confirm - that whatever the trends and statistics may be, we are losing major gifts that we could be getting if the application of the AMT to charitable contributions did not so substantially increase the cost of gifts of property to higher education. Financial Problems of Higher Education Despite the efforts of college and university administrators, the costs of operating our system of higher education are continually escalating. In the academic year 1987-88, colleges and universities spent in the aggregate over $124 billion. The Departmentof Education estimates that 1989-90 expenditures will rise to over $141 billion. Since 1982-83, the Higher Education Price Index has risen 27.6 percent, while the Consumer PriceIndex has risen only 18 percent. The rate of cost increases for higher education reflects the fact that colleges and universities face increasing pressure to compete against industry for faculty members; escalating demands to enhance student aid programs; added needs to improve existing academic programs and to develop new programs capable of meeting the special remedial needs of students who lack adequate preparation forhigher education; and an expanded mandate to purchase costly state-of-the-art teaching and research instrumentation~ While colleges and universities are struggling to keep up with operating costs, we are facing serious capital cost demands, with major bills for overdue construction and maintenance coming due. A recent report by the National Science Foundation indicates that colleges and universities are deferring $2.50 of needed construction for every $1.00 of planned capital expenditure, and that the same institutions are deferring $3.60 of needed repair and renovation work for every $1.00spent on such work. In a recent paper, the Government-University-Industry Research Roundtable noted that "the deterioration and obsolescence of scientific research facilities in the nation's universities are widely recognized." The Roundtable concluded that "consensus now exists in government and in industry, as well as academe, that the situation has reached a point where it threatens the strength of the nation's research enterprise and the quality of education of new scientists and engineers." No one in the Congress would disagree, I think, that a deterioration of our educational and technological capacity at a time when we face such intense competitive and economic pressures is a grave problem of national dimension. We cannot realistically expect to meeL our operating needs and capital demands through tuition increases. In the period from 1980 through 1989, the cost of attending public and private colleges rose by 65 percent, while the amount of student aid, from all sources, increased by only 10.5 percent in constant dollars. Unless we are prepared to shut out minority and disadvantaged students, we have to recognize that our student population is more likely to represent an occasion for increased expenditure than to serve as a source of increased income. PAGENO="0259" 249 Policy Concerns We are sensitive to the fact that the Congress is now facing difficult budgetary choices, and that it must reconcile competing social needs and claims. We believe that a return to the traditional fair market value deduction for charitable gifts of appreciated prOperty would be fully consistent with the Congressionally articulated objectives of fairness, simplicity and stability in the tax system, and of deficit reduction. (i) Fairness The AMT is a shadow tax system that was designed to minimize the chances that an individual could avoid tax liability entirely or substantially by participation in tax-motivated arrangements with little or no economic substance. In those circumstances, application of the AMT promotes important goals of fairness in the tax system. In the case of charitable gifts, however, treatment of the appreciation element of charitable gifts as a "tax preference" is unnecessary in view of the rules already in place that limit the potential for abuse. For example, donors must comply with detailed rules for appraisal and disclosure, designed to ensure proper valuation. Provisions of current law limit deductibility in cases where property will not actually be used in connection with a charitable or educational purpose, or where the character of the property donated makes full deductibility inappropriate. In addition, the current 30 percent limitation on the deductibility of charitable contributions of appreciated property prevents a donor's use of appreciated property gifts to escape tax liability. We continue to support this limitation which would remain in place if the treatment of appreciated property gifts is restored to pre-86 law. We do not believe, therefore, that concerns as to tax fairness should be any impediment to favorable action on this bill. (li) Simplicity and Stability The effect of treating the appreciation element of charitable gifts as a tax-preference item is to bring into the AMT system numbers of individuals who - because they are not participants in the tax shelters or other tax- favored investments - would not otherwise be subject to these exceedingly complex technical rules. The uncertainty this creates for individuals contemplating a charitable gift is significantly inconsistent with the goal of tax simplification. With several major tax bills enacted since the Tax Reform Act of 1986, there is also considerable pressure now for a period of stability in the tax system. Although elimination of the AMT charitable deduction provisions would be another change in the law, the simplification element of the change would be so great, and the return to pre-1986 rules would be so easy, that the. change should have no adverse effect on public perception of the stability of the tax law. Conclusion Prevailing tax policy encourages the transfer of valuable and important private assets to public use. Our tax code has historically recognized that charities meet important societal needs more efficiently than can be done through direct government funding. Giving valuable assets , whether .paintings, stocks or property, results in the permanent loss of the item to the donor and its conversion to public use. When gifts of appreciated property are made, the donor's net worth is always reduced. The obvious alternative to charitable giving, for individuals capable of making major gifts, is to continue to hold and enjoy the property. Such a disincentive effectively blocks the transfer of these private properties to public use. The application of the AMT frequently makes the cost of charitable gifts so great that a decision is made not to give, or at least not to give currently. This outcome fails to benefit either the Treasury or colleges and universities. PAGENO="0260" 250 Mr. STARK. Mr. McGrath. Mr. MCGRATH. I thank the Chairman, and I thank the panel for their testimony. I went through this drill this morning with the As- sistant Secretary of the Treasury, regarding this, and I can assure you they are not in support of this effort at this point. But I want you to know, Mr. Rosenzweig, that John Brademas, Frank Rhodes, Jim Sheward, other presidents of universities in New York, have been speaking to me about this particular subject. Mr. R05ENzwEIG. I am glad to hear that, Mr. McGrath. Mr. MCGRATH. Mr. Buck, your close henchman behind you has been in to see me on a number of occasions, so I am well aware of the situation. I guess, the bottom-line problem here is the magni- tude of the revenue implication here, and that is something I guess we are just going to have to address. I appreciate your testimony, and thank you for coming today. Mr. BUCK. Thank you very much. Mr. STARK. Thank you. I want to thank the panel. Mr. Nelson, I am familiar with the size of the mutual insurance company that you represent, and am sympathetic to it. Unfortunately, the simpli- fication that you are suggesting would cost us something, and we wonder if you are willing to support some measures that would pay for that. One thing that I have always thought might be simpler, and might be easier for companies of your type, and you might be interested for small companies, and that is just going to a premium tax. Mr. NELSON. Say it again? Mr. STARK. Go to a premium tax-Federal premium tax-for companies of your size, and say, why fuss with it? You don't have the resources to go through all those tax calculations, and just say, you are paying a State premium tax now, depending on where you operate, and say, why don't we just replace it with a modest Feder- al premium tax, and exempt you. Now, is that something you -would consider? Mr. NELSON. Oh, I couldn't comment on that. The other one is quite simple too, the calculation of the income tax on investment income is a really simple operation, and it is productive, sir. Mr. STARK. I don't know if it is much different. I just thought it might be a little fairer, but you pay it now. It would be even a sim- pler calculation, but it is a concern as to how we pay for it. Mr. McGraw, I see no reason, except, in fact, if you promise not to come back and insist that I try to correct the Social Security notch, which also deals with some people who were left out of a window, and I can't figure out where to get the $10 or $11 billion a year to help them, I think people in your situation probably should get some help, and maybe you can help me. Under the farmers who were exempt after 1981, I believe-- Mr. MCGRAW. Yes, sir. Mr. STARK. Did they have to go bankrupt? How did they prove their insolvency, to not have to have the IRS-did they have to ac- tually go bankrupt, or just state that they were insolvent to the IRS, do you know? * Mr. MCGRAW. Well, sir, what happens is, when you file your tax returns, it automatically showed that your assets were liquidated, because you had to turn in the-see, where previously, I had been PAGENO="0261" 251 having a depreciation schedule, and all these things with my income tax return-- Mr. STARK. Yes, but you could have-- Mr. MCGRAW. Then in that year, everything was liquidated, and 1 showed that it was liquidated. Mr. STARK. Yes, I understand that, but you could have had, if you weren't the nice guy that you are, you could have had $1 mil- lion worth of tax-exempt bonds locked away in the lock box in the ~FirsbNational Bank of Campbell, and you wouldn't have to show that on your tax return. Now, if you went bankrupt, you would have to tell us, and I just wondered whether you just stated you were insolvent and that was sufficient. Mr. MCGRAW. No, sir. We never had to show anything, because the IRS-it was very evident. The IRS auditors came out and looked at your situation, they can certainly see, they can see- ~when~you are living in abject poverty, they have no trouble deter- ~mining that, when they come to your home. Mr. STARK. That's what the Marcos's tried to show us when they came over here from the Philippines, but-- Mr. MCGRAW. The IRS has no trouble understanding that, and they don't question that, they don't question-the IRS .auditor has already checked that. Mr. STARK. OK, the answer is, no, you didn't have to go bank- rupt, you just had to show the IRS that you were insolvent. Mr. MCGRAW. Yes, but they are pretty thorough, I can assure you of that. Mr. STARK. I understand that. [Laughter.] Well, I think that your testimony will reach sympathetic eyes and ears before this committee, and I want to thank you for being here. Ms. locker and Mr. Buck, I think, have a little bigger prob- lem. I am inclined to recall that both the Treasury Department and the study done at Yale not so long ago tend to cast some ques- tion as to whether or not the Tax Code does affect total charitable giving quite as much as you might have the committee believe, and I rather suspect that it shouldn't, even if you think it does. 1 think that if people don't give you any money because it is a good thing to do, then you ought not to get the money, and if we are going to do it with the Tax Code, in the case of the Trust for Historic Lands, we ought to buy more national parks, then everybody will pay for it according to their ability to pay. That is my personal opinion, but in thinking about your testimony about the poor guy with the million dollar piece of property, and maybe you can help me through this, to make sure I am properly understanding it. If I had this million dollar piece of property that cost me $100,O00,~ and I sold it to a developer, I put, I think, $730,000 in my pocket, right? I mean, I get the $100,000 cash that I had in, and then I would get $900,000-I'd pay 30 percent on that, so that is $270,000. From the million, I would have $630,000 of cash, okay? Ms. HOCKER. More or less, yes. Mr. STARK. OK; now if I gave~ you the property, I would have a tax writeoff, if you had your way, of $900,000, which would, assum~ ing I am still in the 30-percent bracket, at some point would save me $270,000, if I had 1 million dollars' worth of income. If I'm one of these poor people you are talking about, I would have to live a PAGENO="0262" 252 long time to save any money, even if I was in the 30-percent brack- et. Why wouldn't-I would just be as well off being the greedy fellow that I am-to put the $630,000 in my pocket, give you $300,000, if I really wanted to help you, and I would still have my $300,000. I don't see that this charitable donation thing, particular- ly now that we have the tax rates-if we were back in the days of 70-percent marginal rates, you all might have a better argument, but at a max rate of around 30, in seeing as that right-thinking people aren't going to reinstate the capital gains tax again, I don't know as you all aren't on your own, and just have to find rich people who are well-intentioned. Why shouldn't-- Ms. HOCKER. Well, sir, the problem is not, from our standpoint, with the taxpayer, the problem is with the land in question. Mr. STARK. Yes. Ms. HOCKER. It may be that the taxpayer would be better off, personally, to sell the land and donate the money to the Land Con servation Organization; however, it may be that his or her property is the one that has the endangered species on it, it may have the one that has the critical wetlands on it, that may be-- Mr. STARK. That is all taken care of, if we had a decent environ- mental protection agency, and a decent administration, you wouldn't have to worry about that. The Federal Government is supposed to take care of that. Ms. HOCKER. Well-- Mr. STARK. Why do we need you, if we only had honest people in the EPA? Ms. HOCKER. Well, the Land Trust, I won't comment on whether there are honest people in the EPA, but-- Mr. STARK. There haven't been in the past, I would submit to you, but seriously, why do we need you? We have got environmen- tal laws to protect these historic landmarks, and these endangered species, and these wetlands, why should that be a concern of the private sector? Ms. HOCKER. Oh, I think it is very much a concern of the private sector. The kinds of property that the local and regional land con- servation groups are dealing with are property that is of concern to the local communities, and to the states and counties. Mr. STARK. OK, but then, if it is of concern to the local communi- ty, and you are in Wapakoneta, OH, why should I, as a resident of California, have to be paying more income tax so you guys can decide that you want to save the bridge across* the Monongahela River, or something, when I really don't care? Ms. HOCKER. Because, sir, I believe that we decided, as a nation, that communities do want to be livable, that it is important to have green spaces, open. space, greenways, recreational lands, and endangered species. Mr. STARK. Right, you've got it, and that we tax everybody, and we have Federal agencies to do that. I'm just saying, I don't know as you can make a case that we ought to let people selectively have additional Federal subsidy, which is what a tax break is, just be- cause-I'd much rather have you spending your money getting rid of this administration, and getting good people in the White House that would do what you ought to do. From my standpoint, that PAGENO="0263" 253 would be a much more worthy thing for you to do, rather than to say, well, Federal Government isn't doing what it ought to do, so we are going to have a vigilante committee, and we are going to go out and buy the land that we think ought to be protected, for one reason or another, but we want the Federal Government to subsi- dize us. It doesn't wash. Ms. HOCKER~ But you could say that about any charitable gift. Mr. STARK. Well, I'm about to say the same thing to Mr. Buck, and Mr. Rosenzweig, don't feel I'm picking on you. [Laughter.] Ms. HOCKER. The Tax Code has-I mean, you can argue whether the Tax Code ought to be used as incentive for any social good, but, in fact, it is. Mr. STARK. You just hit the nail on the head. It has been, and we tried in 1986 to eliminate those, the realtors kind of subverted that to the largest extent, but for the most part, we have gotten most of the loopholes out of the code, and here you all nice people are back here trying to put some back in again, and you don't know how long it took us to get-do you have any idea-I'm trying to think, what is one of the oldest national parks in the country? Ms. HOCKER. Yellowstone. Mr. STARK. What? Ms. HOCKER. Yellowstone is the oldest national park. Mr. STARK. Who donated Yellowstone? Ms. HOCKER. Nobody owned it. It was public land. Mr. STARK. Nobody donated it? Public land. What is the oldest donated national park? No? Ms. HOCKER. I'm not sure I can answer that. Mr. STARK. Do you think any parks were created before 1913 with donated land? Ms. HOCKER. I would hesitate to say, because I really don't know the answer. Mr. STARK. OK. Thank you. Everybody gets their day in court. I guess I would just say, Mr. Buck, the same thing-I guess I feel the same way about elegant pieces of art that are worth hundreds of thousands, or millions of dollars, that-actually, and I suspect there has been, in the past, some abuse, and I'm not suggesting for a minute that the group you represent would be party to that-but I rather suspect that there have been debatable masterpieces priced at questionable prices to inflate the amount of the tax advantage, and I guess I would just rather see us collect a little more revenue in general, and encourage increased appropriations to the Endowment for the Arts and Humanities, and see that you got your share, and leave it to the wonderfully competent curators across the country to spend that money wisely, but leave it to us to raise it, perhaps, more fairly, and then you can go out and buy-you can be up there at the auctions in New York-- Mr. BUCK. Finished. The auctions are allfinished. Mr. STARK. They are all done, are they? OK. Mr. BUCK. I would like to avail you of one thing that you men- tioned, which was that perhaps the IRS has not shown as much sympathy to the figures that we have gleaned from our own experi- ence. I, personally, over the top of my desk at the Brooklyn Museum, have seen that 40-percent decrease. I have been there 7 PAGENO="0264" 254 years; in the past 54 years, I have seen 40 percent less come in, and not-- Mr. STARK. Now, when you said 40 percent less, that caught my ear a moment ago. You said 40 percent fewer-- Mr. BUCK. Fewer objects. Mr. STARK. Objects? Mr. BUCK. Yes. Mr. STARK. What about gross dollars? Mr. BUCK. Well, the gross dollars go from $2.9 million down to $700,000, so that is even worse. Mr. STARK. So you got $2.9 million 1 year, and you are down to $700,000 the next year? Mr. BUCK. That's right, that's right. Mr. STARK. Boy, you have got a lot of parsimoneous people up there in Brooklyn. Mr. BUCK. I want to remind you, without getting on a soapbox-I don't want to do that, because it is not my place to do so-but there is a tradition in the American experience about the growth of museums on a private basis across the country, in groups of spir- ited citizens getting together and doing this, and to leave the whole job for the American Government is certainly not the way. Mr. STARK. I have gone beyond what any man should do. I have donated my mother-in-law to the cause, and she is very active in these museum trustee organizations. You guys-you do not know what I have done for you. Mr. MCGRATH. If the gentleman will yield, that was not truly only altruistic, I am sure. [Laughter.] Mr. STARK. And Dr. Rosenzweig, I cannot resist this. I just got a letter from the poor, struggling University of. California. And as they are cutting back on scholarships to minorities and continuing to build star wars at the Lawrence Lab in my district, and raising their tuition to low-income students, they now tell me they are going to come back to Washington and build a square-block build- ing over here, probably three blocks away, so they can have a pres- ence in Washington, DC. Now, they already have 50 or 60 full-time employees back here, contributing what to education, I do not know. But they spend more on their public relations office in the District of Columbia than most small universities spend on a decent liberal arts pro- gram. Now they want `to come back and build some* monument to Lord knows what, and how that helps us in California educate the youngsters that we should educate escapes me. So I tend to think that some of these universities, before they come back and ask for tax assistance, might look carefully at whether they are really serving their constituency at home with the money they already have. And I think that some of your mem- bers, if they wanted to be more effective, might direct more of their efforts to fewer monuments and greater concern to `helping low- income students. And I only say that for my alma mater and the university which is headquartered in my district. Now, you may have better universities than California, better educational citizens than they are. But when you have to carry those kind of bad apples in your organization, you do not get much sympathy from me. S PAGENO="0265" 255 Mr. ROSENZWEIG. I think the striking thing, Mr. Stark, about American colleges and universities is actually the extent to which they have made room for low-income students. Mr. STARK. Yes, not the University of California. Mr. ROSENZWEIG. Including the University of California, com- pared to any other nation-the educational system of any other nation in the world. Mr. STARK. We are not comparing us to any other nation. Do not give me that. We are just right here at home, where~ I have got a lot of poor kids that cannot get into the university because they got a lot of guys back here drawing fancy salaries as vice presidents of public relations-- Mr. ROSENZWEIG. With respect, Mr. Stark-- Mr. STARK [continuing]. When they are a tax-supported institu- tion. Mr. ROSENZWEIG. Yes. Mr. MCGRATH. Will the gentleman yield? Mr. STARK. It is absolute nonsense. Yes, I would be glad to yield. Mr. MCGRATH. Thank you. I will bet you are glad you did not start with him. [Laughter.] Let me ask you this; the revenue estimate for Mr. Frenzel's bill over a 5-year period is 370-something millions of dollars. And of course, each individual gift is limited to 30 percent of that person's adjusted gross income. I am wondering whether or not, given the fact that that is an awfully big number for us to deal with, if we added up what every- body here came to visit us today about, plus the other hearings which we have already had, plus the similar one that we are going to have, I guess, tomorrow, it is going to be somewhere in the neighborhood of $6 billion. Now, when we have to raise $6 billion, that is a lot of money. I am wondering whether or not there would still be an incentive if that limitation of 30 percent were reduced to some other number. Could this particular deduction be applied at a lower rate, say 20 or 15 percent, or something like that? Would the 1incentive still be there, or would there be a reduction in thenamount of gifts com- * mensurate with the reduction in the cap~on what the gift might be worth? Mr. ROSENZWEIG. I cannot answer that myself, Mr. McGrath, but I would be glad to look into that and give you-- Mr. MCGRATH. Well, I am just looking at it in terms of reducing that $372 million to some figure that might be aàceptable to the Mr. Starks of the world. Mr~ ROSENZWEIG. Yes. If I can make an observation-- Mr. STARK. Please. *Mr. ROSENZWEIG [continuing]. In response to one of your com- ments, Mr. Stark. The charitable deduction was not an idea that was invented a few years ago and the public was saved from it even~a fewer years ago in 1986. It is as old as the Tax Code. It has been a historic purpose of American tax policy to encourage pri- vate philanthropy. It has been eroded in the last few years, and we PAGENO="0266" 256 are trying to repair that erosion and bring it back to its historic condition. Mr. STARK. Doctor, I could not disagree with you more. There is nothing inherent in the Tax Code except to raise revenue to sup- port the functions of the Federal Government. And to the extent the code is riddled with special preferences, loopholes, subsidies and the rest is just a tribute to the aggressive lobbying of various special interests who saw a way to get some financing without going through the steps of authorization and appropriation, the way most people do which, I might add, gives this committee its august power. But the fact is that a more efficient way to do it is for you to plead your case before the Congress; and if you have a good case for the members of your association, we should authorize that they be given some money, and we should go to our colleagues in the appropriation process and get the money and give it to you. That is the fairer way to do it, and it may not be as quick and it may not be quite as efficient, but it is perhaps more democratic. And there was nothing ever in the Liberty Bond Act, as I recall looking through the original testimony and the growth of it, that ever suggested that the purpose for income tax was to encourage anything. It was just there to give enough money to support the government. Mr. ROSENZWEIG. It has long been a purpose of the internal reve- nue system. Mr. STARK. No, it has not. It has been a purpose of those who saw it as a way to raise some money, but it has never been, and I would defy you to fmd any place in the Tax Code where it says it is the purpose of the Tax Code to encourage anything. Mr. ROSENZWEIG. Well, one infers purpose from behavior. And the behavior of the Congress in writing tax laws has consistently, until 1986, been such as to encourage charitable giving. Mr. STARK. Doctor, that may be your feeling, but even in that area, that has been debated, as I think the Yale studies would show, that there is no clear evidence that that has done that. Again, that is not our issue. There are people who say that the in- vestment tax credit would have encouraged more jobs. I heard Wilbur Mills tell me this and I do not believe it. I just do not be- lieve it. It encouraged a lot of corporate jets. Probably the Universi- ty of California has their own corporate jet. And it has done noth- ing, diddly, for encouraging economic growth or jobs, in my opin- ion. Now you will find some people in the American Enterprise Insti- tute that will say it has; but it has never been a purpose of the code to do anything except raise the revenue that we need. And there will be a lot of people who would like to find ways to finance worthy causes. But one person's worthy cause is another person's waste of money. Thank you, and I will call our next panel. Mr. STARK. I am going to call Mr. Torchinsky, Bellatti and Dees, and Mr. Duncan. I am sorry.- The other witnesses, I understand, are not going to be here to testify. If any of the other witnesses listed are here, please come forward. But I have been informed PAGENO="0267" 257 that these four gentlemen are the only ones here for this testimo- ny. I would ask each of you in order, Mr. Duncan, Torchinsky, Bel- latti, and Dees, if you would like to present your testimony in that order. And please feel free to summarize or expand upon your testi- mony in any manner. And Mr. Dorgan. Mr. DORGAN. Mr. Chairman, I would like to submit for the record a statement from Senator Tom Daschle from South Dakota in which he discusses the problem that has occasioned the testimo- ny today of Janet and Craig Kretschmar. from Cresbard, SD. Senator Daschle has included a rather lengthy statement for the record, which I will not read, but I would like to ask that it be made a part of the permanent record of this committee. And in it, he does describe the special problem of special use valuation and describes what has led to the problems confronted by Janet and Craig Kretschmar, which I assume we will hear more about on this panel. Mr. STARK. -Without objection, the material submitted by the dis- tinguished Senator from South Dakota will be made part of the record in its entirety. And I would like to note that the Senator wanted to make special notice of the Kretschmars' appearance here before~the committee. [The statement of Senator Daschle is in "Submissions for the Record."] Mr. DORGAN. Mr. Chairman. Mr. STARK. Mr. Dorgan. Mr. DORGAN. Might I also point out that I, too, am very interest- ed in this testimony. This deals with a measure that I have been working on in the Ways and Means Committee for some long while. We are very concerned about the application of special use valuation by the~ Internal Revenue Service, and especially con- ceiined about what is happening on family farms~ We want to try to encourage folks in the family to stay On their farms and farm them. And we are concerned that an interpretation by the Internal Revenue Service is jeopardizing that. I think that we'll hear more about that from this paneL~But this is an issue I have worked on for a number of years, and I hope that we can resolve it soon. Mr. STARK. We thank Senator Daschle for his comments, and we look forward to working with him on this problem, and look for- ward to the testimony that~will be presented later. Mr. Duncan, would you like to lead off? STATEMENT OF HARLEY T. DUNCAN, EXECUTIVE DIRECTOR, FEDERATION OF TAX ADMINISTRATORS Mr. DUNCAN. Thank you, Mr. Chairman. Thank you for the op- portunity to appear before you today on the proposal to cap the maximum State death tax credit allowed against Federal estate taxes at 8.8 percent. My name is Harley Duncan, and I am execu- tive director of the Federation of~Tax Administrators. The federa- tion is a nonprofit corporation comprised of the principal tax and revenue-collecting agencies in the 50 States, the District of Colum- bia, New York City, and the Province of Ontario. PAGENO="0268" 258 The federation is opposed to the proposed cap on the state death tax credit for several reasons. The proposal would automatically reduce revenues by a significant amount in a number of States in a time when fiscal difficulties are widespread and growing among the States. We estimate the annual revenue impact to State govern- ments of this measure to be $200 million. The proposal makes no substantive improvement in Federal tax policy, and the proposal has negative consequences for State tax policy by disrupting a 65 year-old system of tax coordination, and setting off a round of unsettling interstate tax competition. The death tax credit has been a permanent feature of the Feder- al estate tax since 1926, when it was enacted as a means of reduc- ing Federal estate taxes, and reducing interstate tax competition by putting a floor on the level of combined State/Federal death taxes. The death tax credit has remained substantively unchanged since 1926, and the rates are exactly as they were specified at that time. As a result of this permanency, all States have structured their inheritance and estate taxes to be coordinated with the State death tax credit. In 25 States and the District of Columbia, the only State death tax is a pickup tax under which the State death tax is an amount equal to the credit allowed for Federal purposes. In 1991, three more States will convert to a pickup tax. The remaining States employ a separate estate tax or inherit- ance tax, but in each case, the State tax also provides that where the amount allowed under the Federal death tax credit is greater than the liability computed under the separate State inheritance or estate tax, the liability shall be the amount of the death tax credit. For States with only a pickup tax, the effect of the proposed cap would be to decrease revenues automatically and significantly in 25 of the 26 jurisdictions, since the effect is really to reduce the tax rates in these jurisdictions. States in this position would either have to forego the revenue, or enact a separate death tax, and es- tablish an administrative structure to accomplish its enforcement. In the remaining States, the effect will vary, depending on the size of the estate, and State death tax rates. The proposal will reduce State revenues, in cases where the adjusted taxable estate exceeds $3 million, and the current law credit is greater than the separately computed State death tax. If, as a result of the cap, the separately computed State tax becomes the greater amount, the State will lose revenue compared to current law. Importantly, however, the taxpayer will not benefit from the entire reduction in the Federal credit. Instead, because the estate is now responsible for a State death tax in addition to a Federal credit, the combined Federal and State death tax liability is great- er than computed under current law. In cases where the Federal credit does not directly affect State death tax liability because the separately computed State death tax exceeds the credit under both current law and the proposed cap, it is the taxpayer, and not the State treasury, who will feel the ef- fects of any change. State administrators are opposed to the cap on the credit for three reasons. First is the fiscal impact. We estimate that enact- ment of the 8.8-percent cap will reduce State death tax revenue by PAGENO="0269" 259 approximately $200 million annually. Death tax revenues in juris- dictions with only a pickup tax will be reduced by about 15 per- cent,. or $150 million, while those in other jurisdictions will be re- duced by about 2 percent, on average. While not a large figure in comparison to Federal budget totals, we think it is particularly in- appropriate at this point in time. The slowdown in economic growth is beginning to take a toll on State finances. The States are having difficulty in maintaining balanced budgets. At last count, 18 States had enacted midyear cutbacks and enacted budgets, and at least half the States face serious fiscal problems in 1990. The President's budget continues a 10-year trend of declining Federal assistance, and increasing State mandates on State govern- ment. The second reason for our opposition is, we fail to see any sub- stantive improvement in Federal tax policy from the proposed cap. Rather, it seems designed primarily to increase Federal revenues, largely at the expense of State governments. Third, we believe that while there are no substantive Federal im- provements, there are negative impacts at the State level. The State death tax credit was enacted as a means of reducing inter- state competition, and it has done that effectively. To reduce the cap as proposed would set off an unsettling round of interstate tax competition. States with a pickup tax would be hard-pressed to in- crease their death taxes. States without a pickup tax would come under serious pressure to reduce those taxes, and the end result would be a significant reduction in the role of death taxes at the State level. Finally, you should remain mindful that States will bear only a part of the increase caused by the proposal. The remainder will be borne by taxpayers when the combined State and Federal death tax liability increases. In conclusion, State administrators ask that you reject the pro- posed cap. It will cause a serious disruption of State death tax sys- tems, which we believe is undesirable and unnecessary, given the lack of substantive Federal tax policy being- pursued, and the cur- rent demands on State government. Thank you very much. [The statement and attachments of Mr. Duncan and a statement for the record of James W. Wetzler follow:] PAGENO="0270" 260 Statement of Harley T. Duncan, Executive Director Federation of Tax Administrators tothe Subcommittee on Select Revenue Measures House Committee on Ways and Means February 21,1990 Mr. Chainnan and Members of the Committee: Thank youfortheopportunitytoappearbeforeyou todayon theproposal tocap the maximum state death tax credit allowed againstfederal estate taxes at 8.8 percentof the adjusted taxable estate. My name is Harley T. Duncan, and I am Executive Director of the Federation of Tax Administrators. Joanne Limbach, Commissionerof the Ohio Department of Taxation and President of the Federation, and James W. Wetzler, Commissioner of the New York State Department of Taxation and Finance had intended to be heretoday, butwerepreventedfromdoingsoby schedulingconflicts. Mr. Weirder's statementhas been submitted to the Committee. TheFederation of Tax Administrators (FTA)isanonprofltcorporationcomprised of the principal tax andrevenuecollectingagencies ineachoftheflftystates, theDistrictof Columbia, New York City and the Province of Ontario, Canada. Our purpose is to improve the techniques and standards of tax administration through a program of research, information exchange, training, and representing the interests of state tax administrators before the Congress and federal executive branch. The Federation is governed by a 15 member Board of Trustees elected by the 53 member agencies. TheFederation anditsmcmbertaxadministrators areopposed tothe proposal tocap the state death tax credit allowed for federal estate tax purposes. Our opposition is based on several grounds: (a) The proposal would automaticallyreducerevenuesbyasigniflcantamountin anumberofstates at a time when fiscal difficulties are widespread and growing among the states; (b)The proposal does little to improve federal or state tax policy, and in fact, contains several undesirable policy ramifications; and (c) The proposal will disrupt a 65-year old system of tax coordination and set off a round of unsettling interstate tax competition. Thetestimonywilldiscusseachofthesepointsinturn. First, however,itpresents somebackground information on the proposal and its effect on states and taxpayers as well as discussing the history of the state death tax credit and state and federal death tax structures and revenues. Background on the Death Tax Credit and State Death Taxes The Internal Revenue Code of 1986 (section 2011) allows a credit against federal estate taxes (on a dollar-for-dollar basis) for state death taxes paid. The state death tax credit is limited based on the size of the estate and a set of graduated rates specified in federal law. The maximum allowable credit ranges from 0.8 percent of the adjusted taxable estate (gross taxable estate minus $60,000) for estates with an adjustedtaxablevalueof$40,000-$90,000to l6percentforestateswith anadjustedtaxablevalue inexcess of $10,040,000. The proposal, as we understand it, would cap the credit rate at 8.8 percent on all estates in excessof$2,540,000. Theeffectistoreducethecreditavailableto(andincreasefederalrevenues from) all estates in excess of $3,040,000 (the top end of the current 8.8 percent bracket.) All stateshavestructuredtheirinheritance/estatetaxestobecoordinatedwiththefederal statedeath tax credit. In twenty-five states and the District of Columbia the only state death tax is a "pick-up" or "sponge" tax.' Under a pick-up tax, the state estate or death tax is an amount equal to the state death tax credit allowed forfederalpurposes. Apick-up tax works asifthe statehad enacted an estate tax with rates equal to the credit schedule specifledin federal law. Underapick-up tax, there isnoadditional netburden to the taxpayer from the state tax; in its absence, additional tax in the same amount would be paid to the federal treasury. The remaining states employ a separate estate tax or a separate inheritance tax,2 although in most cases the definition of the tax base conforms closely to the federal estate tax. In each of these states, the state death tax also provides that in cases where the amount allowed under the federal death tax credit is greater than the liability computed under the separate state inheritance/estate tax, the liability of the taxpayer shall be the amountof the death tax credit. In these states, there is a net additional burden on the taxpayeronly if the separate state taxcxcecds thecredit. (Withoutthe"pick-up"provisions oftheselaws, the taxpayer's total burden would remain unchanged a larger amount, however, would be paid to the federal treasury.) PAGENO="0271" The types of state death taxes in 1990 are displayed below. Types of State Death Taxes o ~ and Pick-up ¼ 12 Estate and Pick-up 0 Pick-up tax only R Pick-uponly-1991 The effectof the proposed cap on the death tax creditwill be to decrease revenues automatically in twenty-five of the twenty-six jurisdictions using only the pick-up tax.3 The actual effect of the reduction in the federal creditis toreduce the taxrates in these states. The federal treasury, not taxpayers, will benefit from the cap-on the state credit. (See Example 1 and 4, Attachment A.)4 States in this position have two choices with respect totheirdeath taxes: (a)forego therevenue; or(b) enact a separate estateorinheritance tax and establish the administrative structure necessary to collect and enforce the tax. In the remaining states (i.e., those with a separate death tax plus a pick-up tax), the effect of the proposal willvarydependingon the sizeof the estate andthe state inheritance/estate taxrates. Theproposal wilireduce staterevenues in cases where the adjustedtaxableestate exceeds $3,040,000 (thepointatwhich the current law credit goeshigher than 8.8 percent) and the current law credit is greater than the separately computed state death tax. If, as a result of the cap, the separately computed state tax becomes the greater amount, the state will lose revenuecompared to currentlaw. Importantly in this situation, the taxpayerwill not actually benefit from the ~ reduction in the federal credit. Instead, because the estate will be responsible for a state death tax in addition to the amount allowed under the federal credit, the combined state-federal death tax liability will be greater than under current law. (See Example 2.)~ Itshouldbeexpectedthatthissituation willnotbeentirelyuncommon giventhatstate death taxrates are lowerin some instances than the rates of the federal credit. The maximum tax rate in some states with a separate g~~g~g tax (notably Ohio and South Carolina) is below the maximum creditrate of 16 percent. A direct comparison for inheritance tax states is not possible because of the varying rates depending on the type of heir, but in most cases the rate applied to the distributive shares of lineal descendants is well below the 16 percent leveL In cases where the reduced federal credit does not directly affect state death tax liability (because the separately computed statedeath taxexceeds the credit underboth currentlaw and the proposal), itis the taxpayer, not the statetreasury, who will feel theeffectof any change. In these cases, thecombined federal- state death tax liability credit will increase as a result of the reduced state death tax credit. (See Example 3 and 6.)Thiswill likelycreatepressureon states toreduce theirdeathtaxratestocompensate forthe federal change as discussed more completely below. History of the State Death Tax Credit The state death tax credit has been apermanent feature of the federal estate tax since 1926. At that time, thefederalgovernmentwasconsideringreducingestatetaxrates (increasedtemporarilyduring World War I) or repealing the tax and leaving it to the states which had traditionally made relatively greater use of the taxthan thefederal government. Atthe sametime, stateleaderswere seekingmechanisms to improve the coordination of federal and state death taxes and to reduce what was becoming an intense competition forwealthyresidents. In the yearspreceding 1926, some states had repealedtheirdeath taxes, and two had 261 Effect on the States PAGENO="0272" 262 adopted constitutional amendments prohibiting such levies in an effort to attract wealthy retirees as residents. Enactment of the credit in 1926 served both purposes. It reduced the federal tax and reduced interstate competition by putting a floor on the level of combined state-federal death tax~s.6 The current creditrates of 0.8-16 percentand the current brackets have remained unchanged since 1926. In the original act, the state tax credit was set at 80 percent of the federal rate applied to any given bracket. As federalrateschanged, the statecreditwas specifiedin nominalterms at thelevelitwas in 1926, e.g., a maximum of l6percent(80percentofthe maximum l926marginalrate of2opercent.) The federal rates have changed on several occasions,-once reaching a maximum of 77 percent for estates in excess of $10 million. The current rates range from 18 percent to 55 percent on estates in excess of $3,000,000. Through the operation of a unified tax credit, estates with a taxable value of less than $600,000 are effectively exempted from federal estate taxes (and state death taxes where there is only a pick-up tax.) State and Federal Death Tax Revenues In FY 1988, total state revenues fromall types of death taxes amounted to about $3.2 billion, or 1.2 percent of all state tax collections as shown in Attachment B. Death taxes ranged from about 4.0 percent total state tax receipts in Connecticut to less than one-tenth of one percent of all taxes in Alaska. The 26 jurisdictionsemployingonlyapick-up taxaccounted for3Opercentof statedeáthtax collections, and death taxes comprised 0.8 percent of total state taxes in thesejurisdictions. Estate tax collections accounted for 1.6 percent of all state taxes in the seven states with a separate estate tax along with the pick-up tax. The greatest share of statedeath taxesisinthe 18 states with aseparateinheritance tax accompanied by thepick- up tax. In thesestates, deathtaxcollectionscomprised2.6percentofalltaxes; theyaccountedfor43percent of total state death tax receipts.7 In the aggregate, state death taxes have been declining in relative importance among state taxes. In 1967, death taxes accounted for2.S1ercentof total state tax collections. This has declined steadily to the current level of about 1.25 percent. Federal estate tax collections in FY 1988 amounted to about $7.6 billion, or slightly more than 0.8 percent of all federal receipts. Estate tax revenues have also declined in relative importance at the federal level over the last 20 years, but the pattern has been a good bit more erratic than with state revenues. In 1967, estate tax revenues comprised 2.0 percent of all federal receipts, a figure which climbed to a peak of 2.6 percent in 1972. The proportion of receipts accounted for by estate taxes declined moderately (to about 2.0 percent again) before the rate reduction contained in the Tax Reform Act of 1976 (reducing the maximum marginal rate from 77 percent.) The rate of decline again accelerated after 1982, as rate reductions and a relatively large exemption (in the form a tax credit) enacted as part of the Economic Recovery Tax Act of 1981 were phased-in. From 1965-1977, state death taxes generally accounted for2O-22 percentof total state and federal death taxrevenues. Since thattime, theyhaverisenmoderatelyrelative tofederalreceipts; statedeath taxes amounted to about 30percent of total federal and statedeath taxes in 1988. Thepauern of state and federal death tax revenues is shown in the chart below. Statedeath taxcreditsclaimedonfederalestatetaxreturnsfiledin 1987 totalledan estimated $1.526 billion, ofwhichjustover$985 millionwasclaimedonestatesofover$2.5 million. Thetotaldeath tax credit arnountedto about 19.5 percentofthefedesalestatetaxliability beforeapplicationofthecredit,i.e., the state credit offset 19.5 percentof the totalfederal liability.9 Theratioofstatedeath creditto total federal liability has increased to the 19 percent level only as the estate tax~reductions contained in the Economic Recovery Tax Act of 1981 have been phased-in. From the mid-1940s until about 1983, the death tax creditoffset an average of only 10 percent of federal estate tax liability.10 Federal and State Death Tax Revenue 1965-1988 12 B 10 02 n S 1965 1975 PAGENO="0273" 263 Opposition to a Cap on the Death Tax Credit State tax administrators are opposed to a cap on the state death tax credit as being considered by this Committee forsevereasons. Gen JJy,theyrevolveamund thefiscal impactof the measure on the states and the undesirable policy consequences of such a measure. Fiscal Impact. Itis est maledthatena entofthepropo~i 8.8percentcap on the state death tax credit will reduce state taxrevenues byapproximately$2(yJ million on an annual basis. This estimate was developed based on data from the states." This amounts to about 7 percent of 1988 death tax collections, buttheimpactdiffers substantiallydependingonth ypeofdeathtaxcu~reni~yinplace Deathtaxrevenues injurisdictions with only apick-up tax wouldbereduc~JbyaJ,out 15 percent or$150 million, while those in states with a separate inheritance or estate tax would be reduced by 2 percent. While this fiscal ~ federal budgetortotal state government operations, there are several factors which, we believe, argue against imposing a loss such as this on state government. * The slowdown ineconomic growthisbeginning totake atoll on state finances. Revenue growth hasbegun toslow,andsi~ficantstepshave~fl~eninanberofstatestomnbalanced budgets as required by state laws and constitutions. At latest count, 18 states (including eight states in thc Northeast) have made mid-yearcuthacks in enacted budgets.'2 Further, a review of fiscal conditions andissuesinthesta~indi~s that atleastone-halfofthestates expect serious budget problems in 1990.'~ * ThePresident'sFy 1991 Budgetcontinuesa lO-yeartrendofdecliningfedemiassis~c~~0 state and local governments. In total, grants-in-aid are the same, in real or inflation-adjusted terms, as they were in 1981. If, however, one subtracts Medicaid assistance from those totals, all other grants have declined bynearly lSpercentinzeai terms since 1981. Atthe same time, the budget encourages new initiatives on the part of state and local governments in the fields of human services, drug enforcement and treatment, environmental protection and other areas. It also proposes imposing additional payroll taxes on certain states to the tune of roughly $3.0 billion annually.'4 * ~ moststates. This proposal or any other tax bill enacted by the Congress is not likely to be passed until late in calendar 1990. By that time, the vast majority of state legislatures will have adjourned having passed a FY 1991 budget thatdoes not anticipate this change. This proposal, if it were enacted, would automaticaJ1y~juce therevenues available to fmance those budgets, and the legislatures would have littlerecourse (otherthan a special session) to adjust fork. This is particularly acute in thosejurisdictionswithoniyapick because therevenuelossinthosestatunis mostsevere and is automatic. They would have no recourse to recoup the revenues but to enact a separate death tax (and establish the necessary administrative structure) or to increase other taxes. Federal Tax Policy. As seen by state tax administrators, the proposed cap on the state death tax credit constitutes no substantive improvement in federal tax policy. Rather, it seems designed primarily ~ Whileitmight be suggested that the purpose of the credit would be to prevent a decline in the effective fr.dergj tax rate on estates in excess of $3.0 million, we believe such analysisisrnisplaceij. In afederal-state system where a coordinative mechanism such as the death tax credit has been in place for 65 years, one must examine the combined state and feder~j effective rate in evaluating the estate tax. As the credit now stands, the combined effective rate does notdecline forlargerestates because of the graduated rates of the'credit. If concern about a declining federal effectiverate isoverriding, the objectiveofpreventing that situation can be achieved without a disruptionofthe statetax systembyreconfig `gfederal taxrates and tax brackets. DIStTI'bUtIOIJ of Federal F.stattT*x Revanue and the State Death Tax Credit Dollar Amounts in $000'ø -1987 Estimates Death Tax Credit NetFederal Liabilfty Total Nwnberof Number of Gross Estate Liability Returns Amount Returns Amount $500,000-$599,999 39,781 2~713 24.441 1,511 15,340 $600,000-$999,999 779.066 11,714 198,649 10,113 580.417 $1,000,000-$2,499,999 2015.003 7.573 339.485 6,888 1,675,518 $2,500,000-$4,999,999 1,715,364 1,998 269,216 1,816 1,446,148 $5,000,000-$9,999,999 1,371,611 724 245,439 663 1,126,172 Over $10,000,000 1,989,609 369 473.149 350 1,516,460 TOTAL $7,910,434 25,091 $1,550,379 21,341 $6,360,055 SOURCE: Based on unpublished IRS Stalisticsof Income Data. PAGENO="0274" 264 Tax Coordination and~terstateiTax Competition. While state administrators see no improve- ments in federal tax policy from the proposed cap, we believe strongly it would have negative policy impacts at the state leveL The state death tax credit was enacted in 1926 as a means of coordinating state ~ state death taxes. It has remained relatively unchanged in the intervening 65 years. State administrators believe thatthe sudden and substantialreduction in the death tax credit under consideration here would in all likelihood set off a dramaticround of interstate tax competition to reduce or eliminate state death taxes. The.,reduction in thecredit will increase the effective rate of the slate death tax. For example, in astate with a 20 percent tax rate on estates over $10 million, the marginal effective state tax rate today is only 4 percent because of the 16 percent federal credit offset. Under the proposal, the effectiverate wouldjump to 11.2 percent, ornearly three times its current leveL This marked increase in statetaxburden willcreatesignificantpressureforstateswithseparateiflheritah1ceore5tate~~~5t0~b0Pt a pick-up tax orotherwise reduce theirdeath taxes. States with only a pick-up tax would be hardpressed to enact any otherformof death taxi The netresult will be an even greaterreduction in state revenues than outlined above (or a shifting to~ other tax sources). There~ will also be a period of several years of considerable uncertainty and instability for states and taxpayers as states adjust to the new world of the reduced credit. It is not unreasonable to expect that competition will occur given past patterns of change in state death taxes. While the death tax credit may have moderatedinterstate tax competition, it has by no means eliminated it. An increasing number of states have begun employing only the pick-up tax in recent years as shown below: Number o(States with Various Types ofDeathiaxes Pick-up, Pick-up Pick-up Pick-up Inheritance Gift Only & Estate & Inheritance & Estate Tax 1970~ 4 8* 36* 2 12 1975 6 10* 32* 2 16 980 12 7 30 1 13 1985 20 9 21 0 8 1990 26 7 17 0 7 1991** 29 5 16 0 7 Before 1978,4statesdidnotapplyapick-UPtax (MiSSiSSippi,NOfthD SouthDkotafldWeStVlrghl11a.) Psiorto 1972, wo other states (Utah and Oregon) did not employ a pick-upprovision. * Based on current law. ;OURCE: ETA compilation based on ACIR, Significant Features ~jFLeca1 Federalism,( various years) and state legislation nacted in each year. Conclusion Inconclusion, state tax administratorsaskyoutorejecttheproposaltocap the statedeathtaxcredit. The proposal will significantly reduce state revenues and will cause serious disruption of state death tax systems. We believe this is undesirable and unnecessary given the lack of substantive federal tax policy being pursued and the current demands on state government. The state death tax credit was putin place to serve the particularpurpose of reducing interstate tax competition. It has remained substantively unchangedfor65 years. As aresult, states have designed their death taxes around the credit. To abruptly change this situation solely in the interests of federal revenue is ill-advised, we believe, given the undesirable policy impacts at the state leveL If there is a particular policy problem inthe state-federal death tax system which needs to be addressed, we believe they should be addressed with both state and federal policy interests in mind. The Federation of Tax Administrators would be glad to participate in any such investigation. PAGENO="0275" 265 Footnotes Rhode Island, South Carejinasud Wi~in willconycstte agis*-uptax onlyin 1991. estaseanti ~ Mesm~xis1eVjedupontheentu~va1ueOfthedeceden5's estate, regardless of its disposition. Rams amgenerallygiadn~a~fl~j~ the size o(theestatc. An inheritance tax is levied ontherec~iernOfabequR~d~~ Highersasesgeneraily apply to non-lineal heirs othedecedent. 3While Virginia employs only apick-up tax, sisselawjsuvides ~ sune tax may not be less than it would be under therates of the statedenth tascred tas ecifi imfcderallawji 1978. Virginiaindicates,however, thatachange in the death tax credit would ~ Isoblons ntstimw encowitered, Example 1 and 4 show the effect in a stase withonly apick-up tax, Exanple2aid S show theeffectina state with apick-up tax and a separaseessatetax withrelafivelylownxra~. Eze3ad6iasnsewthapjcasep~~with somewhathigherrates. In theb ~ Examples 1-3 assumeagross taxable estate (for federal purposes)of $5 million. Examp1es4-6assn~ag,,~ taxableestaseof $10 million. All examples assume conformity between federal and state death taxes in thedthnition o(grora taxable estate. The state will also lose revenueconn,~j tec~entkwif thereviaedor r~m~ the greatezamounsand is the actual state death tax liability. Here thecombined fcdmal-stmc taxburden will notincrease. See example 5. 6 ~ Washington, D.C., January 1961. Office, January 1990. $ Based on data from U.S. Bureau of the Census, State Gover,umsu Fisances in [various years,J, Washington, DC, U.S. GovernmentPrinting Office. Based on unpublished data Born the Statisticsoflncome Division,U.S, Internal Revenue Service. `° Based on data presented in ACIR, Cocrdinazion qrState and Fe ZInheriam~, Estate as4G~l Taxes, (1961) and IRS information from the Statistics of Income in various years. ~` The impact ispmjecsedbasedon actuale.whnasespqwedbyinthvidn~ga~~, Inprparingthenationale~nase,~lj~~ was placed on therelativedecline in the individnal somsrepreaentatjveo~th~ varioussypesofdeath taxes. Acompleselisting of estimated revenue losses on a state-by-stase basis will beferwarded totheCcrnmiuee when available. 12 ~ Florida, Maryland, Michigan, Minnesota, Missouri, North Carolina, North Dakota, Tennessee, Virginia and West Virginis. National Governors' Association andNedonslC n~ma ceofStaiej ~ The Presides? s 1991 Budge:: Impact on the States, Washington, DC, Februasy l99O,p. 11. 13 Rona1dK.St1ell,"TheS~F~O.,g,.~ l9%ashheConnngDaCade,NationslConferenceofStateLegislatures Denver CO, February l990(mimeo). 14 National Governors' Association andNationsIC~eren~ PAGENO="0276" Federal Tax $ Change Percent Change State Tax $ Change Percent Change Combined Tax _____ FrcposedLaw $2,390,800 192,800 315,760 $1,882,240 $78,080 4.3% $393,840 $315,760 ($78,080) (19.8%) $2,198,000 $2,198,000 Tentative Federal Tax Less: Unified Credit Less: StateDeath Tax Credit Federal Tax $ Change Percent Change State Tax Combined Tax $ Change Percent Change 266 AT1~ACIIMENT A Example 1 Assumptions: Gross taxable estate of $5,000,000 for federalpurposes. Conformity between state and federal in definition of gross taxable estate. State pick-up tax only. Current Law ___ Tentative Federal Tax $2,390,800 Less: Unified Credit 192,800 Less: State Death Tax Credit 393,840 $1,804,160 Example 2 Assumptions: Same as Example 1 except that pick-up tax is augmented by a separate estate tax with an exemption level of $170,000 and marginal rates ranging from 6 percent to 8 percent. The marginal rate on this estate is 8 percent. Tentative Federal Tax Less: Unified Credit Less: State Death Tax Credit Federal Tax $ Change Percent Change cwrent Law $2,390,800 192,800 393,840 $1,804,160 $2,390,800 192,800 315,760 $1,882,240 $78,080 4.3% $385,000 (8,840) (2.2%) $2,267,240 $69,240 3.2% State Tax $393,840* $Change Percent Change Combined Tax $2,198,000 $ Change Percent Change *Death tax credit exceeds separate estate tax of $385,000. Example 3 Assumptions: Same as Example 1 except that pick-up tax is augmented by estate tax with rates ranging from 2 percent to 21 percent. The marginal rate on this estate isiS percent. Currentlaw ~ppç~çd Law $2,390,800 $2,390,800 192,800 192,800 393,840 315,760 $1,804,160 $1,882,240 $78,080 4.3% $541,500 $2,423,740 $78,080 3.3% $541,500 $2,345,660 PAGENO="0277" Example 6 Assumptions: Same as Example 4 except thatpick-up tax is augmented by an estate tax with rates ranging from2percent to 21 percent The marginairateon thisestateis 15 percent Cumint Law Proposed Law $5,140,800 $5,140,800 192,800 192,800 1,067,600 798,000. $3,880,400 $4,150,000 $269,600 6.9% Tentative FederalTax Less: Unified Credit Less: StateDeathTax Credit Federal Tax $ Change Percent Change State Tax Combined Tax $ Change Percent Change 267 Example 4 Assumptions: Gross taxable estate of $10,000,000 feefederalpusposes. Conformity between state and federal in definition of gross taxable estate. State pick-up tax only. TentativeFesjeraj Tax Less: Unified Credit Less: StateDeathTaxQedit Crra1~J,~ $5,140,800 192,800 1,067,600 . Proposed Law $5,140,800 192,800 798,000 Federal Tax $ Change Percent Change $3,880,400 ` $4,150,000 $269,600 6.9% State Tax $ Change Percent Change $1,067,600 $798,000 ($269,600) (25.3%) Combined Tax $4,948,000 Example S Assumptions: Same as Example4exccptthatpickup taxis augmented by a separate estate tax with an exemption level of $170,000 and marginal rasesranging from 6 percent to 8 percent. The marginal rate on this estate is 8 percent Tentative Federal Tax Less: Unified Credit Less: StateDeath Tax Credit Cun~nt Law $5,140,800 192,800 1,067,600 $3,880,400 Federal Tax $ Change Percent Change. State Tax $1,067,600* $Change Percent Change Combined Tax $4,948,000 *f)~th tax credit exceeds separate estate tax of $785,000. Proposed Law $5,140,800 192,800 798,000 $4,150,000 $269,600 .6.9% $798,000* ($269,600) (25.3%) $4,948,000 $1,436,500 $5,316,900 $1,436,500 $5,586,500 $269,600 5.1% PAGENO="0278" PHIUlU ~ 00 ~ ~~~-`-4~ ~ ~ ~WEi ~ ~ t~3 ~b3~O)%O C~~O -- ~O\O00~ 3t~b.~ ~M ~ ~~~-J~-3 -`~Mb0 ot~boob~-~ ~OJOO~-~)t3 ~ 00 c~MO~ o~btot~Ot~t3t3 ~-~W ~OtJ~i~0 O~t~) ~J~OO -~ OOOOOOOt~) 0000 O'OOCO~-~ O~-'t~)-'OOOO -.~OOOOOO ~b~o ~ Q~b%~4i~)~OOO ~a~'o ~ ~-~u~--ti1 rn- rri~-t'i~- ~ tI1~-~tT1 ~ ~ tTP-~ 00 ~!J 00 ~ ~ ~li PAGENO="0279" 269 ~A~EMENT OF JAMES W. WETZLER NEW YORK STATE COMNISSIONE~OF TAXATION AND FINANCE TO THE SUBCOMMITTEE ON SELECT REVENUE MEASURES OF THE HOUSE COMMITTEE ON WAYS AND MEANS February 21 1990 New York State opposes the proposal to cap the federal credit for state death taxes at 8.8 percent. Such a change would weaken states' abilities to raise revenue when the federaL government is asking states to assume greater responsibilities for drug treatment, education, environmental protection and many other unmet social needs. Moreover, it would do so in an unnecessarily disruptive way. -- Under present law, the federal government provides a credit against the federal estate tax for state estate or inheritance taxes. There is a cap on the allowable federal credit computed at graduated rates based on the size of the taxable estate. These rates range from 0.8 percent on small estates all the way to 16 percent on that part of the taxable estate exceeding $10,040,000. The cap on the allowable credit equals 80 percent of what the federal estate tax rates were back in 1926, when this provision was last substantively amended. The federal tax law also provides a modest credit against the federal generation- skipping tax ~for state generation-skipping taxes limited to .5 percent of federal tax liability. Interestingly, no federal credit is provided against the federal gift tax for state gift taxes even though Congress unified the~estàte and gift taxes in PAGENO="0280" 270 2 other respects in 1976. Congress enacted the federal credit to preserve estate taxes as a revenue source for the states. Indeed, until 1916, estate taxes were the exclusive preserve of the states. Many states (26 states in the case of the estate tax and 18 states in the case of the generation-skipping tax). levy state taxes that are precisely equal to the allowable federal credit. This is called a "pick- up" tax. Other states, like New York, do not precisely track the federal tax law, but the availability, of the federal credit reduces the burden of the state tax -- the portion of the state tax not offset by the federal credit. Whenever states impose taxes, they must address the ever- present problem of interstate tax differentials. In the case of the estate tax, there is concern that wealthy people will choose to retire in jurisdictions with more lenient estate taxes if interstate tax differentials are excessively large. In New York, * the legal community has expressed a great deal of concern over. the inpact of New York's estate tax in encouraging people to move out of the state, and we have paid a good deal of attention to this issue. At present levels, we do not believe New York's estate tax provides a major incentive to relocate, but a significant increase in the burden of that tax would force us to reexamine that conclusion. . PAGENO="0281" 271 - 29- 3 Were Congress to cap the federal credit at 8.8 percent, the impact on states would differ depending on whether states currently use a pick-up tax. For the 26 states which do this, the impact of the lower cap would be automatically to reduce the state estate tax for large estates, so that their top tax rate would only be 8.8 percent, instead of the 16 percent it is today. These 26 states would experience an immediate revenue loss from this tax reduction, and their legislatures would have to act affirmatively to restore some or all of this lost revenue. In states like New. York whichare decoupled from the federal estate tax, there would be no automatic state tax reduction, but the effect of lowering the federal credit would be to increase the effective burden of the state tax (the tax not offset by the federal credit). For example, in New York State the top estate tax rate is 21 percent, so that when the 16-percent federal credit is netted out, the effective burden of the state estate tax is only 5 percent. (I should note that Governor Cuomo has proposed increasing the top estate tax rate to 22 percent, which would increase the maximum net rate to 6 percent, and adopting a pick-up generation-skipping tax.) Reducing the maximum federal credit to 8.8 percent would increase the effective tax burden in New York from 5 percent to 12.2 percent: it would more than double. An initial consequence of capping the federal credit would PAGENO="0282" 272 4 be mass confusion on the part of the state legislatures and budget-makers. Because of competitive pressure, no state would know for sure where to set its estate tax rates because it would not know what decisions other states were going to make. For example, if many of the states which currently use the pick-up tax were to continue that policy, there would be concern that New Yorkts estate tax rates would create undesirable incentives for wealthy retirees to move out. If states which currently have pick-up taxes were to decouple from the federal credit and maintain their current tax rates, New York could afford to leave ~its estate tax rates in place without fear of worsening its competitive position. It would take years to get all of this sorted out, and in the meantime wealthy individuals would be forced to make their retirement plans at a time of great uncertainty about tax rates. This confusion would be reduced, although be no means eliminated, if the effective date of any reduction in the federal credit were delayed for several years in order to give legislatures a time to act. However, the reality of the legislative process is that many legislatures would probably not act until the last minute, so that there would still be much confusion. Let me also note that the proposed limitation on the federal credit would, in certain cases, make the credit less generous PAGENO="0283" 273 5 than a deduction for state taxes would be. For example, valued at its top tax rate of 21 percent, a deduction for New York State's estate tax against the 55-percent top federal estate tax rate would be equivalent to a tax credit of 11.55 percent, substantially greater than the proposed maximum credit of 8.8 percent. This issue could be addressed by permitting a deduction for state estate taxes in excess of the allowable credit. The critics of the federal credit for state death taxes argue that it is simply a form of revenue sharing which the federal government can no longer afford, or, alternatively, which should be provided through direct cash grants to states. I would argue that this criticism has two flaws. First, a time when the federal government is encouraging the states to act on a wide variety of problems, but is admittedly providing inadequate funds for these initiatives is no time to reduce even indirect forms of revenue sharing. The share of state and local outlays financed by federal grants-in-aid has declined from 26 percent in fiscal year 1980 to only 18 percent in fiscal year 1988. Second, the consequences of limiting this federal credit are, as I have indicated, more troublesome for states than would the removal of an equivalent amount of cash grant. Not only would the states lose the money, but they would also have to work through the period of confusion about relative tax rates that I have outlined above. PAGENO="0284" 274 Mr. STARK. Thank you, Mr. Duncan. Mr. Torchinsky. STATEMENT OF DAVID TORCHINSKY, CPA, ON BEHALF OF NATIONAL SMALL BUSINESS UNITED Mr. TORCHINSKY. Thank you; Mr. Chairman. My name is David Torchinsky, and I am a certified public accountant in the account- ing firm oLKaufman, Davis, Ruebelmann, Posner & Kurtz, in Be- thesda, MD. 1 am here today representing Nathmal Small Business United, also known as NSBU. I am.Lvery pleased and honored to have been asked here today, and I am very proud to be represent- ing small business concerns through NSBU. We are glad to be ad- dressing a State tax concern, perennially one of our highest agenda items. As you may well know, NSBU is the oldest association exclusive- ly representing this country's small business community for over 50 years. NSBU is a volunteer-driven association of small business- es from across the country, founded from a merger of the National Small Business Association, and Small Business United. NSBU serves some 50,000 individual companies, with members in each of the 50 States, as well as local, State and regional associa- tions. NSBU believes that there are already some very fundamen- tal problems with the high rate of estate tax in this country with- out the possible elimination of the corporation, as beneficiary, of key-man life insurance, and elimination of credit for estate taxes already paid to the State. There is no proper economic or policy reason that the death of a principal owner should be a taxable event in the life of a business. While our Tax Code allows for the taxation of the individual for estate purposes, it is a closely held business which must be liquidated or mortgaged to finance the pay- ment of estate taxes. A distinction should be established between the transfer of mere liquid wealth and unproductive resources and the transfer of a pro- ductive and functioning business. The former can be liquidated in order to pay taxes without costing jobs or otherwise disrupting the life of a functioning business. A tax on the recipient of such a busi- ness can thoroughly disrupt the ability of that business to survive, whereas the same company would have gone unchanged if it had been. widely held. The public policy reasons for a tax on some estate items like money, furs, and yachts may be to discourage the inappropriate concentration of wealth in the hands of those who have not earned it themselves, but are there any public policy advantages to threat- ening the life of a productive, viable business employing individ- uals, simply because a principal owner has died? We see none. In order to avoid these consequences, many business owners who wish for their children to continue in the business after them have set up structures for this transfer to occur, and for the tax prob- lems to be handled without devastating the business. To this end, businesses have utilized several procedures, from the estate freeze to taking out life insurance in order to pay the taxes. Now, these tools are under attack, as well. PAGENO="0285" 275 Many small, family owned businesses purchase key-man life in- surance in order to have a liquid asset against which to pay the estate taxes. The corporation pays the premiums, and is the benefi- ciary of these policies. Small businesses, in effect, save for the future without suffering enormous tax penalties. A corporation could use the money invested in a premium to literally save the money for the day it would be needed to pay taxes, but this plan would fail if the owner died before the necessary funds had been saved. Hence, there is a need for an insurance policy to guard against such adverse consequences. Such a policy ensures, essentially, that the Federal Government will receive its money. We believe that this is something that the Federal Government would want to en- courage. Probably more importantly, key-man life insurance allows a cor- porate entity to buy out the heirs of a deceased major shareholder without the heir being forced to sell the shares on~ the outside. If corporations were prohibited from being beneficiaries of key-man life insurance policies, the entire corporation would risk being sold, throwing many out of work, and ending a functioning and produc- tive entity. No legislation should be passed that would result in such adverse consequences. NSBU considers an end to the Federal credit for estate taxes paid at the State level to be nothing more than a tax increase, a duck, if you will. There is no policy objective to be achieved by this tactic, aside from forcing us to pay higher taxes. An end to the credit for State death taxes paid should be viewed no differently than a rate increase. Indeed, it is an effective rate in- crease. The small, family owned businesses of this country are already finding it next to impossible to successfully continue a business after the death of its primary owner, even if that owner was no longer essential to the operations of the business. Unless the family is otherwise wealthy in liquid assets, it simply cannot afford to keep the business and pay the taxes on it, as well. The result of all these unreasonable taxes is that many families are forced to use estate planning to ensure that the proper taxes will be paid, but now Congress is actively engaged in the search to close loopholes which had allowed these taxes to be paid. First estate freezes were squelched, and now corporate beneficiaries of key-man life insurance policies may be terminated. Now, on top of those injuries, some are suggesting that the insult of a tax increase should be heaved. We strongly oppose any legislation that has such a debilitating effect on small businesses. The only way to end the credit for State death taxes paid could be considered if there is a corresponding cut in the overall estate tax rate. The credit is not a loophole. The estate tax rates were established with full knowledge that the credit existed, and therefore, Congress anticipated a lower effective estate tax rate. Raising the real rate now is a clear attempt to raise taxes. Such a proposal would not be in the spirit of tax reform The Tax Reform Act of 1986 was pas~ed to exchange credits and deductions for simpler, lower and more equitable rates. Any legisla- PAGENO="0286" 276 tion to reform the estate tax model should conform with the intent of the 1986 act. The importance of a harmonious relationship among sharehold- ers of a closely held business cannot be overestimated, particularly where management and ownership are one in the same. Preserving the corporate beneficiary of key-man life~ insurance policies, and permitting the credit for State death taxes paid, would ensure that the death of a shareholder is not followed by the death of a small business. We appreciate the opportunity to have testified before you today. Issues involving the continuation of business following the death of a principal in that business is one of the primary concerns of the small business community, and of NSBU. We trust that any change to tax policies' affecting that arena will be made with utmost care, and consideration to the long-term implications of such a policy. Agai~we" thank you for hearing from us today, and we ~at NSBU stantL ready to assist you in any way we can, as we continue to examine the many tax policy questions facing the coun- try today. Thankyou, Mr. Chairman. Mr. STARK. Thank you, Mr. Torehinsky. Mr. Bellatti. STATEMENT OF ROBERT M. BELLATTI, MEMBER ~AND PAST CHAIRMAN, FEDERAL TAX SECTION, ILLINOIS~STATE ~BAR AS- SOCIATION ,Mr. BELLATTL Yes. Thank you, Mr. Chairman. My name is Robert Bellatti, and"' I am here from Springfield, IL, representing the Illinois State Bar Association. I am a past chair- man of the Federal tax section of that bar association. I am the current chairman of~ the AgrieultureCommittee `of the American Bar Tax Section, ~but~Lam~not speaking on behalf of the American Bar or the tax section due to insufficient time to obtain the neces- sary clearances. I can assure you, though, that myviews here ex- pressed reflect the individual views .of the members of our agricul- ture committee. I would"likè to~applaud the efforts of the Representative and Sen- ator from South Dakota in initiating this legislation to cure what is a very serious problem in the farm estate tax special use valuation provisions. I will not give you a long explanation of what that is, but I think you need some explanation to understand the impor- tance of this bill. The special valuation provisions permit farms to be valued on an `income value basis in determining the estate tax, and if all the re- quirements are met'and thIs valuation is obtained, ~hen,the heirs who receive the farm must follow stringent requirements for a 10- to 15-year period after the decedent's death. And ~the bill that we have in front of us today is one that addresses a problem that occurs in maintaining the qualification by the heirs after the dece- dent's death. If, at the time of the decedent's death, the farm has been cash- rented to the decedent's son, then the farm, if other requirements are met, will qualify for the farm estate tax special use valuation. PAGENO="0287" 277 But following the death, if the farm then passes to the decedent's son and daughter, and the daughter cash-rents her half interest in the farm to her brother, so that the same arrangement that her father had is continued with her brother, then after 2 years have passed following the decedent's death, suddenly the daughter is hit with a big tax bill recapturing her share of the estate tax savings because of this cash-rent to the brother. I think that the problem that exists in the current statute has occurred because when Congress passed this law in 1976 and re- viewed it again in 1981, in looking at the term qualified use, the Congress naturally thought that farming would be the qualified use. They would not read into the term qualified use all of the IRS regulations and requirements which say that the qualified use must be a use where the heir has an equity interest, meaning that the heir must be at risk as to the farm's success or failure. And this may make sense as to a lease to a nonfamily member, but where a family member is continuing the farm operation so that the family is obviously at risk, it does not seem to make any sense to impose additional requirements and intrude on family re- lations as to what type of a lease-in my example-the daughter would make to her brother. The cash-rent arrangements are often preferred to maintain good family relations so that the daughter does not have to be looking into all of the farming decisions that her brother makes, which is necessary under a crop share lease ar- rangement. I should also point out that the material participation require- ment that the heirs have to meet can be satisfied by a family member of the qualified heirs. And what we are suggesting in our written statement, which has been submitted, is to amend the stat- ute so that the qualified use requirement can be satisfied by either the qualified heir or a family member of the qualified heir, just like the material participation requirement, Our language is a little different than the bill that Congressman Dorgan has introduced, but it .would cover all of the situations con- templated by Congressman Dorgan's bill, plus it would cover other types of lease arrangements between family members, such as, for example, a fixed bushel rent, which is neither a cash-rent nor a qualified use arrangement under the IRS interpretation. I would also like to mention that unlike many of the provisions you have heard about today and will hear about tomorrow, this provision does not cost the Government much money. Only an un- informed or poorly advised taxpayer would have this problem. The cash-rent arrangement is one that can be avoided if the require- ment is known. about. It is a terribly unfair trap for the unwary. I do not know if you have received any projections of the revenue loss or not. I would frankly be surprised if the annual revenue loss was much in excess of $1 million, if that. But when a particular heir does fall, subject to the. trap, it is a very, severe financial blow to that particular family farm. I do not want to take more of your time today. I would like you to hear now about a~ specific example where this problem has oc- curred. [The statement of Mr. Bellattj follows:} PAGENO="0288" 278 WRITTEN STATEMENT FOR PRINTED RECORD AND IN SUPPORT OF TESTIMONY OF ROBERT M. BELLATTI ON BEHALF OF ILLINOIS STATE BAR ASSOCIATION FEBRUARY 21, 1990 PUBLIC HEARINGS ON MISCELLANEOUS REVENUE ISSUES SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS U. S. HOUSE OF REPRESENTATIVES This written statement has been prepared on behalf of the Illinois State Bar Association ("ISBA") by Robert M. Bellatti, a Springfield, Illinois attorney, who is also testifying for the~ ISBA at the public hearing on February 21, 1990. Mr. Bellatti was Chairman of the Federal Tax Section of the ISBA in l980~8l,:aT1d is one of the~leading experts in the nation on Code §2032A. He testified several times for the ISBA in 1980 and 1981 at Congressional hearings on Code §2032A. Mr. Bellatti is also currently Chairman of the American Bar Association Section of Taxation Committee on Agriculture, but is not formally representing that organization in this written statement. The legislative proposal which the ISBA supports would eliminate a very serious tax trap for farm families and their attorney advisors who have elected Code §2032A farm estate tax special use vaiuation since §2032A was added to the Internal Revenue Code in 1976. This legislative proposal was listed as item F(l)(b) in the January 23, 1990 Press Release which announced this public hearing, and would amend Code §2032A to permit qualified V heirs to rent specially valued property to their own family members on a net cash basis. Code §2032A was enacted to prevent the forced sale of family farms to pay estate taxes. As long as a family member is actively farming~the specially valued property, it should not matter what the economic terms of lease arrangements are among the family members. The problem addressed by thispropOsed amendment to Code §2032A can be described fairly simply. If all of the other §2032A requirements are met, a farm will qualify for V §2032A estate tax special use valuation if at and prior to the owner's death, the owner. has been cash renting the farm to his son or some other "~2O32A family member". §2032A valuation generally reduces the estate tax value by approximately 50%, since it permits the farm tobe valued for Vestatetax purposes based on its income value, not its sale value. In order to limit this estate tax benefit to family farms, the heirs must meet a number Of requirements for 10 years after the owner's death to avoid having to pay to the IRS the estate tax saved by the §2032A election. V This proposed amendment to Code §2032A would permit the heirs who inherit the farm from the owner to continue to cash rent the farm to one of the heirs or a §2032A family member of the heirs without having to forfeit the §2032A estate tax savings. Typically, one or more o~f the heirs is not involved in farming and prefers to receive a fixed cash rent for the heir's interest in the farm. If the tenantis a §2032A family member of the heir, then this cash rent arrangement is still consistent with a family farm operation, and in fact V PAGENO="0289" 279 helps maintain good relations between the farming and nonfarming heirs. Nevertheless, in its present form §2032A imposes a recapture of the estate tax savings on an heir who permits the cash rent arrangement to extend more than 2 years after the owner's death. The pEoposed amendment would eliminate this illogical tax trap and would permit heirs to cash rent their interests in §2032A valued farms to their family members without suffering a loss of the §2032A estate tax savings. The best way to implement this legislative proposal would be to amend §2032A(c)(6)(A) to read as followsf~ "(A)Lsuch property is not used by the qualified heir or a member of the qualified heir's family for the qualified use set forth in subparagraph (A) or (B) of subsection (b)(2) under which the property qualified under subsection (b), or" While this amendment does not specifically refer to renting on a net cash basis, the net cash renting is clearly covered. Various other types of leases between family members might not be covered by the "net cash basis" description. For example, a fixed bushel rental would not be considered a net cash rental and would not be considered a qualified use by the IRS. No type of lease arrangement between family members should cause problems under Code §2032A. The ISBA would be pleased to provide whatever additional technical assistance or testimony that the Committee or Subcommittee or their staffs would like to receive on this matter. Please contact Robert M. -Bellatti at (217) 522-7200 for any further input from the ISBA on this matter. 30-860 0 - 90 - 10 PAGENO="0290" 280 Mr. STARK. Thank you very much, Mr. Bellatti. I now have Mr. Dees, who is accompanied by Mr. and Mrs. Kretschmar. And I do not know whether each of you wants to present your testimony, or whether Mr. Dees is going to. But why don't you proceed in any manner that you like. STATEMENT OF RICHARD L. DEES, PARTNER, McDERMO11~, WILL & EMERY, CHICAGO, IL, ACCOMPANIED BY CRAIG AND JANET KRETSCHMAR, FARMERS, CRESBARD, SD Mr. DEES. Thank you. My name is Richard Dees. I am a partner at McDermott, Will & Emery in Chicago. I am going to make an unusual statement for a lawyer and say that Janet and Craig are best able to tell their story, and I am going to let them do that. The only reason my name appears first is that I was not sure I would be able to convince them to make the long trip to Washington when we had to reply and reserve this time for testimony. So I will turn it over to them. Mr. STARK. Go right ahead. Mr. KRETSCHMAR. My wife, Janet, and I are farmers from Cres- bard, SD, and we appreciate the opportunity to tell our story so you will pass Representative Dorgan's bill to amend section 2032A. This bill will help us and other farm families who risk losing their family farms due to an IRS technicality. I have farmed since I was 21. Janet and I started farming the Holt farms back in 1969, when her father died. The Holt farms were then owned by Janet's mother, Dorothy. While Dorothy was alive, we ran a livestock oper- ation in addition to growing corn, wheat, barley and shared the profits under a share lease. Mrs. Holt died in 1980. At that time, the estate taxes were high and farmland values were even higher. Janet, who along with her two sisters, inherited the Bolt farms worried that the estate taxes might force a sale. Although we farmed other land, we did not own any other land. If we lost the Holt farms, we might have to go out of farming. Section 2032A seemed like a godsend; the smartest thing that Congress ever did. It would let Janet and her sisters value their land for estate purposes at its income value rather than specula- tion value. Instead of $350 an acre, the land is valued for estate purposes at $102 an acre. This saved $54,000 in estate taxes and the Holt family farm. History sure proved this right, when farm values plummeted below $200 an acre. Even today, the farms are only worth $225 an acre. Our lawyer did not want us to use section 2032A. He said it was too new, too complicated and too new. The IRS had not issued a lot of rules, even though it had been around for 4 years. But we went ahead and the estate tax return sailed through. Janet's sister, Peggy, however, presented a concern. Peggy needed a steady income. She could not use the land for collateral because of the IRS lien. The income from the farms, of course, went way up and down. Also, Peggy could not come up with the share of money needed for fertilizer, seed and so forth. PAGENO="0291" 281 So we~ got rid of the livestock operation and switched from a crop-share lease to a cash-rent. This made things a 1ot~ simpler. It was even more important with her husband having died in 1982. Janet and I kept on farming the farm from 1969 to 1987, think- ing we were complying with the law. In January of 1987, we got a questionnaire from the IRS asking questions about the farm. We did not think anything about it, and just answered the questions. About 7 months later, and 7 years after Mrs. Holt died, we got a letter from IRS saying that Janet and her sisters owed a recapture tax equal to the entire $54,000 in estate tax savings, interest since 1981 and penalties for failure to file. The interest alone was incred- ible. We could not figure out how we stopped being a family farm. When we made the section 2032A election, we knew we could not sell to an outsider or quit farming for 15 years, and we had not. The IRS said the cash-lease did not meet the ~qualified use test. We were told that the code just said qualified use meant the use of farm for farming purpose, and it seemed to us that we were doing that. Later our lawyer told us that the IRS had interpreted as meaning we could not cash-rent even in the family. We had not known that we had to get a lawyer involved in the decision to cash-rent. However, we were told that it would not have helped anyway, since the IRS interpretation really was not known until after we started cash-renting. That is why we believe the IRS was so wrong in going after old section 2032A elections for this project. The least IRS could have done was give us a chance to change to a crop-share lease. We did not know what the qualified use test was. But we did know we needed to cash-rent the farms. Although we could have bought Peggy out without recaptured tax under sec- tion 2032A, we did not have the money to do that. We would have lost the farm to an outsider and probably would not have quit farming. We still cannot understand why the IRS thinks buying the farm and farming it is better than farming under a cash-lease. This seems to favor the wealthy farm families. And section 2032A was not intended to do that. Now it looks like the recapture tax may force us to sell anyway. Worse, we will not get the $350 an acre we might have gotten if we had sold in 1981. In fact, Janet and her sisters mortgaged the farm to pay the tax and interest and still needed to put up collateral of $11,000 to get enough to pay the IRS. But we are not quitters. Although I guess the IRS disagrees, Janet and I feel we are fighting for our family farms. Our lawyers tell us that the IRS fights these cases to the Su- preme Court, and that the lawyer's fees can run $50,000. Just coming here to testify is expensive. For what our hotel costs us a night, you can rent a house in Cresbard for a month. This has to be expensive for IRS and a lot more than the tax money involved. There must be something better to spend it on. I would like to have my wife comment on this at this time. Mrs. KRETSCHMAR. The IRS says that because I get a share of the cash-rent with my sisters through our partnership, I am not at risk in the farm. It is like that money goes into a bank somewhere that keeps it from being touched if Craig and I have a bad year on these farms. PAGENO="0292" 282 For the farm program, Craig and I are treated as one, and IRS ignores this as it does the fact that everything is joint, the notes, our debts, our machinery and everything. I feel even more strongly about these cash rents. Craig and I worked hard on the farm. If we have a good year, we ought to benefit. If we do not, then my sister should not get hurt. It is only fair that that does not harm our family relations. It only makes them better. Mr. KRETSCHMAR. We just cannot believe that Congress, which created section 2032A to help us save Janet's farm, intended IRS to use section 2032A to take it away again on a technicality Thank you for giving us a chance to tell our story. [The statements of Mr. and Mrs. Kretschmar and Mr. Dees follow:] PAGENO="0293" 283 Prepared Statement of Janet and Craig Kretsclnnar Cresbard, South Dakota and Richard L Dees McDermott, Will & Emeiy Chicago, Illinois Testimony Presented February 21, 1990 Public Hearings of The Subcommittee on Select Revenue Measures Continuation of Hearings On Miscellaneous Revenue Measures Statement in Support of H.R. 2268 A Bill toAmend the Qualified Use Requirements for Internal Revenue Code Section 2032A Subcommittee Press Release #8, January 23, 1990 Item F. 1. b. Janet and Craig Kretschmar: We are farmers from Cresbard, South Dakota. We are appearing today on our own behalf along with our attorney Richard L. Dees of McDermott, Will & Emery of Chicago, Illinois. We are testifying in support of Representative Dorgan's bill, H.R. 2268, which would clarify the requirements for continuation of qualified use underSection 2032A of the Internal Revenue Code of 1986. Literally, this bifi will help us and other farm families who risk the loss of their family farms due to an IRS technicality. THE KRETSCHMAR STORY Craig has farmed since he was 21. Janet grew up on the Holt family farms with her two sisters Peggy and Cindy. We started farming the Holt Family Farms when Janet's dad died in 1969. Mrs. Holt, Dorothy, inherited the farms when at Mr. Holt's death. Of course, she could not farm the farms herself. While Dorothy was alive we ran a livestock operation in addition to growing corn, wheat and barley. Because of the livestock operation we shared profits with Dorothy under a share lease. Combined crop and livestock operations are never cash rented. Dorothy died about 11 years later in 1980. We operated the farm continuously during that period. At the time estate taxes were sky high as were farmland values. Although we farmed other land, all of that land was rented. The Holt farms were the center of our operations. If we had to sell these farms to pay estate taxes, we would have to go out of farming. Janet inherited the farms with her two sisters who had a similar interest in preserving the family farms. However, the estate tax rates began PAGENO="0294" 284 at 32% and only $175,625 of property escaped estate tax. When we obtained an appraisal of the farm, the land was valued at $350 per acre. Even today that land is worth only $225 per acre. Then we learned about Section 2032A. It allowed us to value the Holt Family Farms at values which were based on the income from the farms, rather than the speculative value an investor might pay. The Section 2032A value was considerably less, $102 per acre. This seemed to us about the smartest thing Congress ever did. Instead, of taxing Dorothy's estate at the value a speculator might pay and forcing its sale, Section 2032A allowed us to keep on farming the Holt Family Farms while paying off the estate tax based on the value of the farm for farming purposes. Section 2032A saved $54,000 in estate taxes and the Holt Family Farms. Without Section 2032A we would have been out of farming. History further proved the wisdom of Congress when the value of the Holt Family Farms plummeted below $200 per acre shortly after Dorothy's death. Even today the Holt Family Farms are worth only $225 per acre. We really did not regret the land price fall. We knew it was all paper anyway. By using Section 2032A we were able to ignore the "paper price" for estate taxes and pay the real price based on the land's valued if farmed. At the time our local attorney did not want us to make the Section 2032A election. Although Congress had passed the provision in 1976, he said that it was too complicated and too new. At that time a lot of the rules and regulations had not been passed even though the section had been around for 4 years. We understand that even today major parts of the regulations are missing. Even where the courts have thrown out substantial po~tion of the regulations, the old, illegal regulations continue in effect. We have been told that Section 2032A is one of the leading sources of attorney malpractice in rural towns and from our own experience there is a lack of understanding about the provision. Nonetheless, we filed the estate tax return claiming the special use value forthe Holt Family Farms and the return sailed through. One of our concerns was Janet's sister Peggy who lived in Minnesota. She needed a steadier income than the Holt Family Farms provided. Also she was not in a financial position to come up with her share of the expenses under a crop share lease. Her financial situation worsened when her husband died in 1982. She could not use the farmland as collateral because of the IRS lien. Of course, the farm income varied substantially from one year to the next. We quit the livestock operation and changed from a crop share lease to a cash rent leaseto give Peggy a steadier source of income. This meant that instead of paying Peggy and Cindy a share of the income from the~ farm, we gave them as specific dollar amount every year. The cash rents just made eveiything simpler. The farm programs had gotten so complicated that ifiling out the forms was a lot simpler by cash renting. We also avoided the need to have a lot of papers signed by everyone. Our accountant, however, said that we needed a partnership between Janet and her sisters to do the accounting properly. We then paid the cash rent to the partnership. We just could not keep things simple. We were told that we had to keep on farming the Holt Family Farms for 15 years or that the estate tax savings of $54,000 would be recaptured through the recapture tax under Code Section 2032A(c). We knew though that it was airight for us to do the farming to the exclusion of Janet's sisters, since we were "family members" of Janet's sisters under Code Section 2032A. All that Section 2032A required was that one family member continue to "materially participate" (the tax word for active farming) in the farm operations. We also were told that we could buy out Peggy if need be without a recapture tax. However, at that time we certainly did not have the money to do so. Interest rates were approaching 20% and we had to pay off the estate tax at the lower estate tax PAGENO="0295" 285 values. The only person who could have paid $350 per acre for that land would have been an outsider. Yet by cash renting we were able to help Peggy without losing the Holt Family Farms. It seemed like the perfect solution. We kept on farming the Holt Family Farms until 1987 when we received a questionnaire from the IRS asking questions about how the farm had been operated. We did not think anything about the questionnaire. We knew that we had an obligation to farm the land for 15 years. We did not call a lawyer, we just answered the questions truthfully. About 7 months later and 7 years after Dorothy died, the IRS sent us a letter saying that Janet and her sisters owed a recapture tax equal to the entire $54,000 in estate tax savings, interest on the tax since 1981 and penalties for failure to ifie a recapture tax return. The interest and penalties were at least twice what the tax was. We could not figure out how the IRS had determined we had stopped being a family farm. We had not sold any part of the land and had continued to farm since 1980. In fact, we had farmed the Holt Family Farms for nearly 20 years when we received the notice from the IRS. The IRS notice indicated that Janet and her sisters had failed to continue the qualified use of the farm The Internal Revenue Code defined qualified use as as a farm for farming purposes, Code Section 2032A(b)(2)(A). Code Section 2032A(c)(6) provided for the imposition of the recapture tax if qualified use -- (A) such property ceases to be used for the qualified use set forth in subparagraph (A) or (B) of subsection (b)(2) under which the property qualified under subsection (b), Again the Holt Family Farms had qualified as a farm and the use of the land for farming purposes had continued. So we were still puzzled. We were told that the qualified use by Janet and her sisters had to be personal. That is no one could qualify on their behalf. This did not make any sense as we had been told that the material participation for 15 years could be by a family member. Sure enough Code Section 2032A(c)(6)(B)(ii) authorized post-death material participation by a family member of Janet and her sisters. (Under the Code they are referred to as qualified heirs ) Although we thought this was about the only time we were able to read and understand the Internal Revenue Code we were told that the IRS read the Code differently. First, it read the words "qualified use" as precluding cash rental arrangements. In the IRS view the qualified heirs had to be "at risk" in the farm operations. Second, although material participation by a family member was permitted, the qualified use by a qualified heir had to be personal. Accordingly, the cash rent terminated the qualified use and resulted in a recapture tax due in 1981. We had not known that we needed a lawyer when we decided to cash rent to help Peggy. However, we were told that most likely the lawyer would not have known about the IRS interpretation. It really did not become knoivn until after we started cash renting. We thought maybe the IRS would let us switch the crop share rentals now that we knew of the requirement, but they would not. They insisted on a recapture event occurring in 1981. We believe this IRS project to go after old 2032A elections made before this IRS position was known is unfair. We understand that this project is underway in Minnesota, South and North Dakota. The questionaire is written in such a way that it even encourges you to answer that you are cash renting. PAGENO="0296" 286 Moreover, we cannot understand the reason for the IRS position. We think of ourselves as being exactly the kind of farm family Congress was trying to help. Without a steady income, Peggy may have had to sell out her 1/3 interest in the farm. At Mrs. Holt's death we certainly did not have the money to buy that interest. Instead, we would have lost the Holt Family Farms to an outsider and probably would have quit farming. We have no idea even today why the IRS thinks that us buying the farm and farming it would have been any better than farming the farm under a cash lease. This rule seems to favor the wealthier farmers and Section 2032A was not intended to do that. Although the IRS position would seem to apply to Peggy and Cindy who are not at risk in the farm operations each year, it would not seem to apply to Janet. However, the IRS says that because Janet gets a share of the cash rents each year through the partnership, she is not at risk in the farm operations. The IRS view apparently is that the cash rent money goes into a bank account somewhere and it is never used in our farming operations. The farm programs, however, treat the two of us as one.. Everything we own and owe is joint. We do not know what kind of marriages the IRS sees, but in a farm marriage you need all the family money to keep the operation going. Our banker would just laugh if we said he cannot have any of the money from Janet's cash rents. We feel even stronger about cash rents helping our family relationships. If we have a good year, we benefit. If we don't, then Janet's sisters are not harmed. Its only laid Its enough that her sisters want to cooperate to keep the family farms. They agreed to this recapture liability and not to sell to speculators when they could have. They should not have to wonder whether we are doing a good job or not. Or, whether we will work as hard as we should since we have to farm for 15 years to avoid the recapture tax. Now the recapture tax may force us to sell any way. There are a lot of ironies. We will get taxed under the recapture tax as if we were paid $350 per acre when in fact there is no way we can get even $250 per acre. To pay the tax and interest we not only mortgaged the farm, but had to put up $11,000 in additional collateral. If Dorothy had died in 1987 when the IRS first raised a question, there would have been no estate taxes owed because of increased exemptions. Perhaps the greatest irony is that legislation which Congress intended to liberalize the qualified use test is now being used to prove that Congress never intended us to meet the qualified use test. But we are not quitters. Although the IRS disagrees, we feel that we are fighting for our family farm. Our lawyers tell us that the IRS fights these cases to the Supreme Court and that legal fees can run $50,000. Just coming to Washington to testify is expensive. For what our hotel room costs a night you can rent a house in Cresbard for a month. This has to be expensive for the IRS too. We cannot believe that this is money well spent. We hear that the IRS needs more money to go after tax shelters and other tax dodges. In our case it hardly seems that the costs of litigation offset the revenue loss. We just cannot believe that Congress which created Section 2032A to help save family farms like ours intended to let the IRS take it away again on a technicality. Thank you for letting us have an opportunity to tell our story. We hope that you will support Representative Dorgan's bill so that no more farm families will have to suffer the torment that we have since that initial IRS letter two years ago. Our attorney, Richard L Dees, of McDermott, Will & Emery, will tell you how he tried to answer some of our questions. Perhaps you will be able to understand better why we feel that Congress needs to address this issue. TECHNICAL MATIERS PAGENO="0297" 287 Congressional Intent on the Use of Technicalities Richard L Dees: Despite Craig's incredulity, there are individuals who are active on Section 2032A issues who believe that Section 2032A is a "gauntlet" which must be run before an estate can obtain the benefits of Section 2032A. Although this characterization was made in a speech by someone active in 2032A issues at both the IRS and Joint Committee and endorsed by others, I find no support for this position in the legislative history. Indeed there is clear evidence to the contrary. These requirements were enacted to ensure that family farmers not speculators obtain the benefits of Section 2032A. The statement of Senator Dixon on the Senate floor is typical of the view of Congress regarding the use of Section 2032A technicalities to deny the benefits to farm families (Congressional Record Senate 4318-19 (April 11,1984)): Mr. President, this is a very simple and straightforward amendment. It attempts to deal with a policy of at least certain agents of the IRS that has the effect of undermining the actions Congress has taken to try to preserve family farms and other small family businesses. The law and the report [to the Tax Reform Act of 1976] both state and public policy issue directly and forcefully. Congress wants to continue the family farm and small, family-owned enterprises,. Congress does not want the death of the owner of a family farm or small, family- operated business to force the sale of that farm or business if the family wants to stay in farming or the small business. The idea was to not permit the federal estate tax to destroy family farms or small businesses. There seem to be people at the IRS, however, who are not interested in preserving family farms and small businesses, and who want to use the slightest technicality to prevent an estate from being valued under the provisions of Section 2032A. Let me give you to examples of steps the IRS seems willing to take in its effort to break up family farms and small businesses. Mr. President, as I read subsection (D) [sic] of Section 2032A, the IRS already has sufficient discretion to permit parties to correct any good faith technical mistakes they make when filing applications for this special valuation treatment. However, the service seems to take the opposite view, clarification of Congressional intent by amending the section is therefore necessary. This may all sound very obscure and unimportant. But it is very important to family farmers and family-operated, small businesses. These families want a chance to be able to continue their family traditions through the generations. Congress has clearly decided to give them that opportunity and not to let the death of the head of a family force the sale of the family farm or business because of the need to pay federal estate taxes. This view has been echoed by the courts as they have overturned hyper-technical IRS regulations which would frustrate Congressional intent. For example, the Fourth Circuit stated in Thtunpson v. Commissioner, 864 F.2d 1128, 1136 (1989): PAGENO="0298" 288 In sum, IRS's position in this case strikes this Court as unreasonably restrictive in view of the language of LR.C. §2032A and the strong congressional intent behind the provision. We wholeheartedly agree with IRS that where statutes grant relief from taxation they must be narrowly construed. However, tax relief is a means whereby Congress sacrifices federal tax revenues to encourage a given type of behavior. In this instance, LR.C. §2032A represents a legislatively struck balance between generating tax revenue and fostering family farms and businesses. To protect the treasury, Congress established stringent criteria to ensure that only worthy family enterprises received the benefits of this provision. It is not for this Court, or IRS, to tinker with this balance. Through its overly restrictive interpretations, IRS has attempted to tip this balance in favor of enhancing revenue, to the detriment of this estate. Consequently, we must even the scales, consonant with the language of LR.C. §2032A and the intent of Congress. And as the federal district court for the Central District of Illinois echoed in ~MjI[~r Estate v. United States 680 Fed. Supp. 1269, 1274 (1988): Congress has expressed concern that the IRS is interpreting §2032A in a more restrictive manner than contemplated by Congress. United States Senator Alan J. Dixon of Illinois noted the tension between Congress' purpose in enacting §2032A and the IRS administrative policy under that section in a Senate floor amendment in which he proposed the perfection provision contained in Code §2032A(d)(3): Further, the Senate Report accompanying the Economic Recovery. Act of 1981, Pub.L No. 97-34, 95 Stat. 306 (1981), stated that although extensive relief had been provided to numerous family farms and businesses, a number of technical requirements of the current use valuation provision have resulted in incomplete relief being received by the owners of many family farms and other businesses for which the committee wished to provide. For these reasons, the committee has provided for a number of changes to the current use valuation provision to assist further in the preservation of family owned and operated farms and other businesses. Clearly, Congress wished to have broad application of §2032A. The disputed regulation, by narrowing the scope of §2032A's applicability, is simply inconsistent with this congressional intent. We have been presented with no legislative history contrary to that just expressed As these court decisions ifiustrate, Congressional intent to interpret Section 2032A broadly is being followed. However, Congress must act to clarify its intent with respect to the qualified use test. In prior years Congress acted to liberalize the test PAGENO="0299" 289 in response to specific fact situations brought to its attention. The courts are now considering these actions as indicative of an intent to generally prohibit cash leases. There is no evidence that Congress intended to approve the IRS qualified use test. In fact, there is a substantial body of evidence that Congress has consistently disagreed with the IRS position and that indeed the IRS has waffled on its own qualified use test. Given this history, it is imperative that Congress adopt Representative Dorgan's bifi to allow family members to cash rent to each other. Arguably, the legislative history permits non-family member cash rents if a family member is active in the business, but we are not urging Congress to intervene in that case. We can see that as a matter of policy that if Section 2032A can be interpreted as permitting farmland cash rented to non-family member to be specially valued that the provision ought to be narrowed prospectively. However, we know of no hearings or legislation addressing this issue. I first became interested in the IRS qualified use test in 1984 when the illinois State Bar Association ified an amicus brief in the Sherrod Estate case. The Kretschmafs did not retain my firm until after the 1988 tax legislation was passed. The remaining provisions of this statement detail the development of the IRS qualified use test in the form of the questions I have heard in the last 6 years. The answers never make sense. What did Congress Originally Intend in 1976 When It Enacted Section 2032A? One would think that the original intent of Congress might have been unclear when Section 2032A was enacted. However, House Report 94-1380, at page 23, flatly contradicts the IRS qualified use position: As indicated above, real property which is used in a trade or business other than the trade or business of farming may also qualify for special use valuation so long as the property was used in a trade or business in which the decedent or a member of his family materially participated prior to the decedent's death. This is true even though the party carrying on the business was not the decedent or a member of his family so long as the decedent or a member of his family materially participated in the business. [Emphasis added] Tie IRS cites other legislative history forbidding `passive" rentals from qualifying for ~~Section 2032A; however, at the time Section 2032A was enacted it was understood that the term `passive' referred to a non-material participation lease. Material participation was a requirement in Section 2032A so of course a non-material participation lease between strangers would not qualify. There is not a single reference to the term `qualified use" being a separate test~ to be met by family members to ensure that each remained at risk in the farm operations. This is another example where inexperience in agricultural taxation matters led the IRS to misinterpret Congressional intent. Accordingly, the 1976 enactment does not support the IRS qualified use test. Is The IRS Qualified Use Test Clear in the Regulations? The IRS position on its own qualified use test has been ambivalent at best. In two 1981 private letter rulings, #8107142 and #8114033, the IRS first advanced the notion that the qualified use test required the personal use of farmland in a trade or business before it could be specifically valued. These rulings specifically applied this IRS qualified use test to deny special use valuation to a decedent who cash rented his farm to his son immediately prior to his death. In hearings on the 1981 tax act the Treasury Department in News Release R-147 specifically repudiated these IRS rulings. PAGENO="0300" 290 Treasury Decision 7786 implemented this change in the regulations on July 7, 1981. It illustrated Treasury's uncertainty as to its own test: The regulations at section 20.2032A-3(b)(1) require (1) that a qualified heir receive or acquire a "present interest" in property before it may be considered qualified real property, and (2) that the decedent have an equity interest in the operation of the farm or other business. It has also been determined, that the equity interest requirement may be satisfied by either the decedent or a memberof the decedent's family. Thus, a passive rental of a farm by a decedent to a member of the decedent's family should not disqualify the property from special use valuation. The purpose of this regulation is to implement these decisions. Because this regulation is liberalizing in nature, it is found unnecessaiy to issue this Treasury decision with notice and public procedure. At a future date the regulations will be reviewed to provide guidance where the parties involved include persons other than qualified heirs and members of the decedent's family. The IRS contemplated that even non-family member cash rents could qualify. The clarification promised therein has never been issued. Moreover, the IRS regulations which were amended did not have a specific qualified use test. Instead, the implicit derivation of the qualified use test from those regulations came from references to a corporation or partnership owned by the decedent which was to be specially valued. The IRS had support for an additional at risk test in this setting because Code Section 2032A(g) incorporated the requirements of Section 6166 in determining whether the business was closely-held and that section had an at risk test as part of the determination of whether there was a trade or business. Thus the IRS has been ambivalent about its own qualified use test. What Support is There for the IRS Position? After Treasury repudiated its position at the Congressional hearings on the 1981 tax act, Congress enacted specific legislation overturning the private letter rulings. The Treasury argued against the need for such legislation given its change in position. In this case no legislation would have been preferable. Despite the narrowness of the legislation, the legislative history seemed to confirm the IRS qualified use test which both Treasury and Congress had rejected. Senate Report 97-144, at page 133, said that non-family member cash leases would fail the qualified use test. However, the Joint Committee of Taxation Staff Explanation (the "Bluebook") issued months later at pages 249-50 without saying so specifically implied that family member cash rents after death might be a problem. That conclusion is inconsistent with Congress' original intent and the specific intent of Congress in overruling the IRS qualified use test. It could not have changed its original intent in 1976 retroactively so Congress could not have intended to narrow the original legislation. Thus the 1981 legislative history reflected a misconception of the statute and its requirements. This is understandable given the complexity of the statute and the critical.timing of the drafting of the legislative history. Although there was considerable testimony on the IRS qualified use test, there was little input to staff on the legislative history and statutory language by the experts. PAGENO="0301" 291 A similar problem arose in 1984 when liberalizing legislation under Section 2032A resulted in comparable inaccurate committee language that appeared to support an IRS position that no non-family member could have an interest (no matter how remote) in a Irust to which specially valued farmland passed. Because of protests from practitioners, the Bluebook later softened the offending language. The tax court and two Federal Courts of Appeals later invalidated the IRS regulations which contained this hyper-technical interpretation. Had practitioners acted similarly in 1981, qualified uselegislation might not be needed today. Is There Any Policy Justification for the IRS Qualified Use Test? I have heard it argued that the IRS qualified use test prevents dynasties where one family line continues to farm the family farm, but multiple family lines inherit the farm. Then it is argued that each generation can specially value the farm based on that one line's material participation. THIS IS ENTIRELy INCORRECT.! At the death of either Peggy or Cindy, the farms will not qualify for continuing special use valuation if the farms are left to their respective descendants. This is true because Janet and Craig are not family members of those descendants. Thus at - the death of either sister, Craig and Janet will have to buy the Holt Family Farms or the property will have to be subject to tax at full fair market value. This cannot be avoided through a crop share lease as the material participation test (not the IRS qualified use test) is not satisfied. Thus beyond siblings the farm cannot continue to be specially valued. The IRS qualified use test furthermore creates anomalous and unintended results. For example, applying the IRS qualified use test requires that farmland be crop- shared in five-out-of-eight years preceding the decedent's death and on the date of the decedent's death, while material participation is tested in the eight year period prior to decedent's retirement or disability under Code §2032A(b)(4). This retirement exception was added to the Code in 1981 at the same time as the 1981 amendment. Had Congress understood that the IRS qualified use test was valid, it would have coordinated the time periods under these sections. What Effect Did the 1988 Legislation Allowing Cash Rentals by Surviving Spouses Have? Specific legislation was enacted in 1988 allowing surviving spouses to cash rent to family members. Again this was enacted in response to several specific situations ~ ought to be able to cash rent without recapture. Before I knew of the Kretschmar~i I asked that the committee reports state that no adverse inference should be drawn from this narrow statutory change. Obviously, I was concerned that the specific statutory change would result again in an unintended implication that the IRS qualified use test had validity in other family member cash rental contexts. I understood at the time that such language would have to be ~ The Kretschmar's have no idea what fateful meaning that had in their situation, but everyone else in the room üoes. It meant that Congress was unable to do the right thing. Conclusion Congress now has the opportunity to do the right thing again. Congress can give the Kretschmar's back their farms as they intended to do in 1976. Congress once again can send the message to the IRS that the technicalities should not be used to deprive farm families of the benefits of Section 2032A. We commend Representative Dorgan for his bill and ask the Subcommittee's support. PAGENO="0302" 292 Mr. DORGAN [presiding]. Thank you very much, and I thank the entire panel for the information they presented. I indicated prior to your testimony that I have been working on this issue for some while. It's been discouraging for me to see the interpretation of the IRS, particularly in the early 1980's, applying retroactively certain definitional approaches that they developed that catch people in a net from which they cannot escape. That, I think, does not comport with what Congress intended. And I continue to feel that there are some people at the Internal Revenue Service who have their own agenda in terms of what they want to happen. They interpret this provision in a very restrictive way to try to accomplish that agenda. That agenda is not in syn- chronization with what I think.we in Congress intended to do. The purpose of special use valuation was very specific. Nobody ran around here trying to figure out how we could give a special deal to people without any quo on the quid pro quo. What we wanted to do was provide a special opportunity in those instances where we could keep families on the farm or operating the small business. Frankly, I do not have any interest in seeing that somebody living in San Bernardino gets a check from farm land they inherit- ed in South Dakota or North Dakota. That is their business. It does not matter to me. If the family does not keep living on the farm, the estate tax obligation is whatever it is. And I really do not have very much concern about that. But under special use valuation, what we are trying to do is to provide incentives and encouragement for a member of that family to continue to operate that farm, and that was the purpose of it all. The Internal Revenue Service, it seems to me, has intersected that in a way that is very detrimental to some producers. And you, I think, have gotten caught in that web. I have here the comments from the Treasury Department in which they oppose my proposal on the grounds that it would apply retroactively. The sins of applying things retroactively are not original sins here in Congress. The application of a retroactive in terpretation is exactly why we are discussing this today. They in- terrupted with their own interpretation in the early 1980's and said, "Here is the way you are supposed to have done it," despite the fact that, as I researched this, there was not any way on God's Earth for people to have known prior to that time what the inter- pretation was going to be when we got to that early 1980 period. I have talked to folks in North Dakota that are caught in the same way that you are caught, and it is just flatout unfair. Mr. Dees, you are the attorney. I assume you agree with the tes- timony of Mr. Kretschmar that there was not any way for them to have been able to anticipate or determine what the IRS would sub- sequently say about the way they were doing business. Mr. DEES. Right. The IRS in fact repudiated its own test in 1980, but Congress went ahead and passed legislation that would retroac- tively kill that test forever. But it was done in such a way, or phrased in such a way, that it left the implication that there might be a different rule for certain situations on the fringe. And that theory was picked up in the legislative history in the blue book in 1982. PAGENO="0303" 293 And so it is ironic for the Kretschmars that congressional action put them in a worse situation than they would have been in litiga- tion than if Congress had never done anything, because the IRS had already repudiated the test. And I think that is why they are prepared to ask for congressional action today, because it is that action in the past that created part of the problem for them. Mr. DORGAN. I would encourage you to send your testimony to Mr. Gideon, the Assistant Secretary for Tax Policy, who is the author of the statement that says they oppose the proposal on the grounds of retroactivity. Treasury has no casual relationship with the Internal Revenue Service, and they know something about ret- roactivity. And I would encourage you to send your particular case history to Mr. Gideon and encourage him to rethink this. I will cer- tainly do that when we have the opportunity to discuss it at some point in the future. Let me add also that Senator Daschle is on the Senate Finance Committee, and I know has been interested in this subject. And I am hopeful that a combination of efforts here in the House and in the Senate on the part of those of us who want to do something to fix this will result in us getting this problem solved this year. We came fairly close to doing it last fall. This is not a large issue on the landscape out there, in terms of the agenda of Congress. It is a very significant issue for you and for the other folks who are caught in this web. And I am hopeful that in the process of moving forward this year, these hearings, which are hearings on miscella- neous provisions that were left out of the reconciliation bill last year, will result in our being able to try and fix this in a way that makes sense. So we appreciate very much the testimony of all of you. We ap- preciate your patience; waiting till late this afternoon to appear on the panel. And thank you very much for taking the time to come to Washington, Mr. and Mrs. Kretschmar. Thank you, panel mem- bers. The hearing is adjourned. [Whereupon, at 3:48 p.m., the subcommittee adjourned, to recon- vene at 10 a.m., Thursday, February 22, 1990.] PAGENO="0304" PAGENO="0305" MISCELLANEOUS REVENUE ISSUES THURSDAY, FEBRUARY 22, 1990 HOUSE OF REPRESENTATIVES, COMMITTEE ON WAYS AND MEANS, SUBCOMMITTEE ON SELECT REVENUE MEASURES, Washington, DC. The subommittee met, pursuant to notice, at 10:10 a.m., in room 1100, Longworth House Office Building, Hon. Charles B. Rangel (chairman of the subcommittee) presiding. Chairman RANGEL. Good morning, the Subcommittee on Select Revenue Measures meets again to review miscellaneous revenue issues. The issues under consideration today are again a part of a group of issues which revenues of the full Committee on Ways and Means raised last year, but were beyond the scope of the commit tee's action in last year's budget reconciliation. This subcommittee has already held 3 days of hearings on these miscellaneous issues. The hearing today will conclude the hearings planned for these issues. The purpose of these hearings is to focus attention on the specific issues raised by the members, and referred to this subcommittee. Through this review, the subcommittee will be in a position to make an informed decision as to what recommendations, if any, it should make to the full Committee on Ways and Means with re- spect to them. Because of the large numbers of issues to be covered in this hear- ing, the subcommittee requests that the public witnesses strictly limit their oral testimony to 5 minutes. Although it may not be possible to address all of the particulars in the 5 minutes, let me assure you that the subcommittee, the members here, the staff, and the full committee will give full and careful consideration to the written request. It is our goal to bring and restore equity to the tax system. We believe that it is not only good tax policy, but also would bring in higher degrees Of compliance. Our first group is headed by a former member of Congress, the Honorable Michael Strang, and he is the Washington representa- tive at the ATR Defense Group. We have with us Andrew Kadak, president and chief operating officer for the, Yankee Atomic Elec- tric Co. from Boston, representing the Edison Electric Institute, the National Association of Regulatory Utility Commissioners, William Badger, the National Association of Home Builders, Martin Perl- man, and the town of Clinton, CT, represented by the first Se- lectwoman, town of Clinton, Virginia Zawoy. (295) PAGENO="0306" 296 Let's start with our former member. We welcome you back to the old home town, and we anxiously await your testimony. STATEMENT OF MICHAEL L. STRANG, WASHINGTON REPRESENT- ATIVE, ATR DEFENSE GROUP (FORMER MEMBER OF CON- GRESS) Mr. STRANG. Thank you, Mr. Chairman, it is a pleasure to be back here. I appreciate the courtesy of the committee in hearing this testimony, and perhaps giving some justice to this group. I have with me Captain Thompson and Colonel Friand, who have spearheaded this thing for 10 years. In 1980, the IRS issued a retroactive ruling against veterans who, under previously rulings, had been allowed both to receive VA de- ductions, educational benefits for flight training, and to claim a de- duction for tuition expenses. The deduction was disallowed, and pilot veterans had to pay taxes plus interest on the benefits re- ceived in prior years. A 1983 ruling disallowed the deduction for other veterans, but only prospectively. Since they had acted in good faith by relying on previous IRS publications when they claimed the deduction, many pilot veterans sought to have the ruling overturned in Tax Court, district court, and, ultimately, in circuit court of appeals. In conflicting opinions from different circuit courts, 1983, Renokeo v. Commissioner of In- ternal Revenue; and 1985, Baker v. USA, the IRS first was allowed to collect back taxes and penalties in one geographical jurisdiction, and then in another jurisdiction compelled to refund them. After further legal setbacks, the IRS recognized that it could no longer succeed in court, and accordingly, conceded all remaining cases in 1986. This concession, however, did not automatically enti- * tle *a refund for the veterans that had already settled. Rather, they were obligated to file for a claim within a certain period after taxes were paid. By the time of the concession, those taxpayers who had lost the Renokeo case, and subsequently paid their taxes and penal- ties, were now deemed too late to file claims for a refund. Thus, through no fault of their own, some veterans, who bided by IRS rulings and court decisions, have no recourse to recover substantial sums, while others who live in different jurisdictions either recov- ered those sums or never paid them. In some cases, the amount of back taxes and interest paid is greater than the original tuition benefit received. In other words, the IRS, in effect, deprived veterans of an entitlement granted from Congress. Adding injury to insult, the interest accrued retro- actively for the year in which the tax obligation was incurred, rather than from the date of the 1980 retroactive ruling. The issue is that the tax claimed has been applied in conflicting ways based upon the geographical and chronological circumstances of various court cases, thus denying equal justice* under the law to a group of taxpayers that already have been treated unfairly. H.R. 2314, or similar language, would similarly grant a 1-year extension for these people to file and get their refunds. We have one request. They ask that the IRS be told that it may not go back on its word. I realize that if a bill is enacted, the IRS will not be able to take further action against them, but they are so distrustful, and who PAGENO="0307" 297 can blame them, that they would like some formal assurance. I would accordingly ask that the committee satisfy them perhaps by including language to this effect in this report. We have left one consideration out of this discussion. These are not ordinary taxpayers. They are veterans. They served their coun- try, in return for which they were promised cert~tin benefits. No citizen deserves to suffer what they went through, but that such treatment was accorded to veterans is especially shabby. To all the facts above which must appeal to your sense of fairness, I add an appeal to your sense of justice, and of gratitude, and we have a larger statement on file with the subcommittee, Mr. Chairman. Thank you. [The statement and attachment of Mr. Strang follow:] PAGENO="0308" 298 TESTIMONY OF HON. MICHAEL L. STRANG ATR DEFENSE GROUP I. INTRODUCTION Good morning, Mr. Chairman. My name is Mike Strang. I represented Colorado's Third District in the 99th Congress and am appearing here today on behalf of the ATR Defense Group. We are representing a small group of armed forces veterans who are simply trying to claim what.the courts have already said is due to them. Very simply, we are asking that these veterans be granted a grace period to file for refunds on taxes that the government mistakenly compelled them to pay. The amount of money involved is siniscule -- a total of less than $500,000 over five fiscal years, according to an estimate by the joint tax committee -- but the principles are most important. Themajority of their comrades have already either received the refunds after winning in court, or, because they chose to challenge the government by not paying the taxes in the first place, have no need for them. This small group, however, who paid their taxes when asked, and who have now been told that they really did not have to, cannot get a refund simply because the government took too long to decide that it was wrong. Since they paid up years ago, they are too late under IRS rules to file refunds. The people who I represent did exactly what the government told them to do every step of the way, no matter how unfair it was later judged to be by the courts, and despite a tacit admission of guilt by the IRS. Yet, now, without an Act of Congress, they are unable to claim what is due them. Those who chose to challenge the government have no need to ask your help. II. BACKGROUND The broad outlines of the case are not complicated. In 1980, the Internal Revenue Service issued a ruling against certain veterans who had previously been allowed both to receive Veterans Administration educational benefits and to claim a deduction for tuition expenses. We have no quarrel with the wish of the IRS to end this practice of "double-dipping". But it was allowed, and not only allowed but encouraged for 18 years. I would venture to say that in taking advantage of IRS policies, the veterans were doing exactly what everybody else in this room tries to do every year. So we grant the IRS the right to end double-dipping. But there were two serious problems with the way they proceeded. The first is that the ban on double-dipping applied only to veterans who had been pilots in the armed forces. Not all veteran pilots go on to become wealthy airline employees, by the way, and even if they did, that would not in itself be a reason to penalize them. There was no rational justification for the limitation of the ruling to pilots, as indeed the courts eventually ruled. The second problem is that because the ruling was not specifically non- retroactive, it was held to be retroactive. Thus one small group of veterans -- pilots -- was banned from receiving in the the future the same favorable treatment that all other veterans would receive, and moreover was compelled to disgorge the benefits that they had already received, beyond the normal statute of limitations. IRS Rev. Rul. 80-173, 1980-2 CB 60 It was expressly allowed by the IRS R.R. 62-213, 1962-2 C.B. 50: "Expenses for education paid or incurred by veterans which are properly deductible for Federal income tax purposes, are not required to be reduced by the non-taxable payments received during the taxable year from the Veterans Administration," It was expressly encouraged by the IRS Publication 508 (1976): "VETERANS: The deductible educational expanses of veterans of th Armed Forces are not required to be reduced by tax-exi t educational benefits received from the Veterans Admin. tration." See attached 1986 1 er from various Members of Congress to the Acting Commis~ ~ner of the IRS. It states that "the decision to appl~ levenue Ruling 80-173 retroactively is totally unfair, ~just, and has the practical effect of being an cx post fac, law for the taxpayers involved." PAGENO="0309" 299 It was only adding insult to injury that they were also assessed interest on their back taxes. In some cases, the taxes plus interest amounted to more than the original V.A. payment. Thus the IRS in effect deprived pilot veterans of an entitlement granted to all veterans by Congress. As you would expect, many pilot veterans sought to have the ruling overturned in Tax Court, District Court, and ultimately in circuit Court of Appeals. Depending on how the cases were framed and on the courts that heard them, a number of conflicting decisions were returned. Just as I do not wish to defend doubly-dipping, I also do not want to go into the virtues of the various cases, because in the end, the IRS was proven wrong. ~I have.however appended the final, definitive case of Baker v. United States. Some of the Veterans simply challenged the government from the start. That is, they refused to pay the taxes and sued to have the ruling overturned. Others -- those who now need your help -- paid the taxes, challenged the ruling, sought refunds, but lost in court. It is up to you to decide whether the latter group should continue to be penalized despite the fact that their position was vindicated in the end. For a certain period of time, the effect of the conflicting opinions was that the IRS was allowed to collect the back taxes in some jurisdictions, but in others was compelled to refund them. In itself, of course, this was unfair, because taxes should not be collected differently based upon g~çg~'aphical locations. Eventually, the IRS began to lose all its cases, in part because it had incomprehensibly issued another ruling that prospectively ended double-dipping for all veterans. That is, only ~ were assessed back taxes, and only ~j~g were litigated against. All other veterans were allowed to keep the benefits they had already received. Baker v. United States was heard in 1985 in the Eleventh Circuit Court of Appeals. The decision reads in part: There is simply no language in the statute to indicate that Congress was setting up two different kinds of benefits (that is, for pilots and non-pilots). This court finds that R.R. 80-173 creates an arbitrary classification devoid of any rational basis and thus the commissioner has abused his discretion... Following Baker, the IRS decided to dispose of its remaining cases without further litigatIon. An IRS internal memorandum of April 22, 1986 stated that this position was taken for three reasons: IRS Ré~nue Ruling ~3-3 ruled that only one-half of * general educational enefits is allocable to the costs of the education. PAGENO="0310" 300 First, only minor deficiency amounts remain outstanding; second, the issue itself is nonrecurring; and third, the Solicitor General's office had determined that it does not want to continue to defend the issue... In other words, the IRS appears to have realized that it did not have a case any more. But it held that it did not have to issue refunds to those who had lost previous cases. At this point, then, the pilots who had not paid now knew that they would not have to. Those who had paid, and who had successfully challenged, had received refunds. Those whose cases were still pending knew that the case would be dropped, and that they too would receive their refunds. But those who had paid, sued, and lost -- that is, those who did the right thing but lived in the wrong place -- were, incredibly, not eligible to get their money back. In a December 1986 letter to Congressman Sundquist, the IRS stated that the decision of the Service to cease pursuing this matter... does not automatically entitle a taxpayer to a refund. In order to be entitled to this remedy, the tax must have been paid and the claim must have been filed within the time limits prescribed in Section 6511(a)~ of the Code... In other words, the Internal Revenue Service intends to keep the money. Since the prescribed time limit is two years, those who had paid more than two years previously -- in other words, those who either paid promptly or who lost early court cases or who merely lived in the "wrong jurisdiction" -~ are ineligible for refunds. After years of.fighting and finally winning their cases, these veterans have been prevented-by a bureaucratic technicality from receiving what the courts have said is due to them. Their final hopes now rest with the Congress, which by the legislation now under consideration can compel a recalcitrant, ungracious, and indeed ungrateful bureaucracy to do the right thing. III. REMEDY Mr. Chairman, we.~are asking Congress to pass legislation that would create a one year grace period in which these veterans can file for the refunds that are due them. It really is .~s simple as that. The veterans are not asking for apologies, damages, or costs. They just want their money back. Such a bill would finally grant fair treatment to those men who mistakenly relied on IRS regulations and publications, complied with a retroactive ruling, sued and mistakenly lost, overpaid by as much as 100 percent (including interest), and finally were told that they were too late to get refunds because theyi~had paid promptly to begin with. Mr. Sundquist introduced a bill late in the last Congress, which, owing to the press. of business, was not acted upon. It has since been reintroduced in thit Congress. The veterans on whose behalf I am appearing are satisfied with this bill and would be satisfied with similar language included in another bill. They. have one request;. they:~respectfully ask that the IRS be told that it may not goisack on its word. I realize that if a bill is enacted, the IRS will not be able to take further action against them. But they are so distrustful -- and who can blame them? -- that they would like some further assurance. I would accordingly ask that the committee satisfy them, perhaps by including language to this effect in its report. We have left one consideration out of this discussion. These are not ordinary taxpayers. They are veterans. They served their ~country, in return for which they were promised certain benefits. -No citizen deserves to suffer what they went through. But that such treatment was accorded to veterans is especially shabby. To all the facts above, which must appeal to your sense of fairness, I add an appeal to your sense of justice, and of gratitude. See attached H.R. 2314 from the 101st Congress, 1st Session. PAGENO="0311" 301 I 101st CONGRESS T T 1% 1ST SESSION Ti. I'S. To provide that for taxable years beginning before 1980 the Federal income tax deductibility of flight training expenses shall be determined without regard to whether such expenses were reimbursed through certain veterans educational assistance allowances. IN TUE HOUSE OF REPRESENTATIVES MAY 10, 1989 Mr. SUNDQUThT introduced the following bill; which was referred to the Committee on Ways and Means A BILL To provide that for taxable years beginning before 1980 the Federal income tax deductibility of ifight training expenses shall be determined without regard to whether such ex- penses were reimbursed through certain veterans education- al assistance allowances. 1 Be it enacted by the Senate and House of Representa- 2 tives of the United States of America in Congress assembled, 3 SECTION 1. TREATMENT OF CERTAIN REIMBURSED FLIGHT 4 TRAINING EXPENSES. 5 (a) IN GE~RAI4.-In the case of a taxable year begin- 6 ning before January 1, 1980, the determination of whether a 7 deduction is allowable under section 162(a) of the Internal PAGENO="0312" 302 2 1 Revenue Code of 1954 for flight training expenses shall be 2 made without regard to whether the taxpayer was reim- 3 bursed for any portion of such expenses under section 1677(b) 4 of title 38, United States Code (as in effect before its repeal 5 by Public Law 97-35).. 6 (b) STATUTE OF LIMITATIONS.-If refund or credit of 7 any overpayment of tax resulting from the application of sub- 8 section (a) is prevented at any time before the close of the 1- 9 year period beginning on the date ~f:4he enactment of this 10 Act by the operation of any law or rule of law (including res 11 judicata), refund or credit of such overpayment (to the extent 12 attributable to the application of subsection (a)) may, never- 13 theless, be made or allowed if claim therefor is filed before 14 the close of such 1-year period. 0 PAGENO="0313" 303 Chairman RANGEL. Well, we support Mr. Sundquist's legislation, and we do believe that this inequity should be corrected, and we thank you for the eloquence in which you presented this to the sub- committee. Mr. STRANG. Thank you very much. Chairman RANGEL. Mr. Sundquist. Mr. STRANG. Thank you, Mr. Chairman, and thank you for your support. I just would like to thank our former colleague for his hard work on this, and to thank Captain Thompson and Colonel Friand. You know, they are trying to prove, Mr. Chairman, that the system works, that when there is an inequity, that they will fight to try to correct, and it is less than a half-million dollars to correct this, and they have probably spent a lot of their own money. I know they have spent a lot of money on this. The IRS is simply wrong. They said they can't do this. because of the statute of limitations. Well, the reason. the statute of limita- tions has failed is because they have fought us all this time. They could have corrected this in the interest of fairness, and here we have a group of veterans, a very small group, that are being treat- ed unfairly by the Federal Government, and I appreciate deeply this panel's support in terms of correcting an equity in the system, because the system-and I think these gentlemen will prove-the system does work. Thank you, Mr. Chairman. Chairman RANGEL. Mr. Kadak. STATEMENT OF ANDREW C. KADAK, PRESIDENT AND CHIEF OP- ERATING OFFICER OF YANKEE ATOMIC ELECTRIC CO., ON BEHALF OF THE EDISON ELECTRIC INSTITUTE, ACCOMPANIED BY MURRAY GOULD, TAX MANAGER, CAROLINA POWER & LIGHT CO., RALEIGH, NC Mr KADAK Thank you, Mr Chairman and members of the sub committee. I am Dr. Andrew C. Kadak, president and chief operat- ing officer of Yankee Atomic Electric Co. This morning, I am ac- companied by Murray Gould, who is from Carolina Power & Light. I appreciate the opportunity to appear before you today, represent- ing the Edison Electric Institute, the association of investor-owned electric companies, to present our views on H.R. 1317, the Nuclear Decommissioning Reserve Fund Act. EEl strongly endorses this act for the following reasons. First, it will help assure that adequate funds are available for decommis sioning nuclear powerplants Second, it will directly benefit electric utility customers by reducing the cost of setting funds aside for de commissioning, which are included in current electric rates Third, it will eliminate the existing tax rate bias against the es tablishment of qualified funds, and fourth, it will provide signifi cant benefits to the general publiô and to electricity consumers at a modest cost to the Federal Government. In the remainder of my testimony, I will discuss these reasons in greater depth. Under Federal and State law, utility companies that operate nuclear powerplants are obligated to decommission these plants at the end of their useful lives. Section 468A of the Internal PAGENO="0314" 304 Revenue Service Code allows~ a utility company to elect to deduct contributions made to a qualified decommissioning fund subject to certain limitations. A qualified fund's income is subject to the Fed- eral tax at a maximum corporate tax rate of 34 percent. The after- tax earnings of qualified funds are constrained because of the ap- plication of the 34-percent tax rate, and the investment restric- tions. This means that customers must provide greater amounts for contributions to qualified funds in the form of higher electric rates for no good reason. Presently, the assets of qualified funds are in- vested in tax-exempt securities to optimize the aftertax yield be- cause the tax rate of 34 percent is applied to the taxable income of the fund. In June 1988, the Nuclear Regulatory Commission issued a rule which requires each nuclear plant operator to establish an external fund by July 1990 for future decommissioning needs. Furthermore, the conference committee for the Deficit Reduction Act of 1984 stated that it might be appropriate for the tax-writing committees to study further the merits of providing tax incentives for estab- lishing decommissioning funds. We believe that H.R. 1317 is a proper response to the directives of the conference committee, and would enable licensees to comply more effectively with the NRC mandate. The act will lower the tax rate from 34 to 15 percent, and eliminate the current restrictions on investment choices. It is important to note that, as discussed more fully in our written testimony, the greater investment flexi- bility will not diminish the security of the assets of these funds. Cost estimates for decommissioning are escalating each year at a higher rate than the rate of inflation, making it difficult for owners of nuclear plants to adequately provide for future; decom- missioning costs. If enacted, the act will increase the aftertax yield of qualified funds, thereby allowing them to grow at a faster pace than under current law. We believe that encouraging the establish- ment of, and optimizing the yield of of such funds, will facilitate greater financial security to protect the health and safety of the public at a lower cost to electricity consumers. When code section 468A was first enacted, most owners of nude ar plants were not obligated to use external funding for future de- commissioning costs, but could rely upon internal funding which had a higher aftertax return, thereby reducing decommissioning collections required `from customers. The recent action, of the NRC, however, has changed external funding' from an option to a .re- quirement.' In many cases, `this transition to external funding will result in a tremendous economic burden for our customers. Clearly the act will maximize the aftertax yield and help assure that suffi- cient moneys will be available to decommission nuclear plants. In addition, as described in our' written testimony, the act will reduce the annual `amount of decommissioning costs charged to our customers. Current law imposes a disproportionately high tax burden on qualified funds and on customers whose moneys are de- posited' in these funds. Payments made by electric utilities to quali- fied funds represent amounts collected from their customers. Be- `cause the actual decommissioning costs will not be incurred for many years to come, these amounts are essentially advance pay- PAGENO="0315" 305 ments by the utility customers. If these advance payments were not required, utility customers could retain these moneys until such time as actual decommissioning costs were incurred, paying tax on any earnings at~ their average marginal tax rate. Accordingly, sound tax policy dictates that customers should not penalized by the application of a higher tax rate of 34 percent simply because they deposit moneys in an external' trust fund. Rather, the earnings of qualified funds should be subject to a rate of taxation comparable to the rate the customers would pay if they retained these advance payments. According to a recent EEl study, the composite marginal tax rate of electric utility customers is 16.61 percent. The analysis estab- lishes that the 15-percent tax rate proposed by the act is not sig- nificantly different from the composite tax rate of customers who actually bear the economic burden of the decommissioning obliga- tion. Therefore, the reduction to a rate of 15 percent for taxable income of qualified funds will ensure consistent and equitable tax- ation of electric utility customers. The act will also increase Feder- al revenue from qualified funds. It will encourage qualified funds to invest most of their assets in taxable obligations, because they will earn a higher aftertax return. This would significantly in- crease Federal taxes paid by qualified funds because most of the income would be subject to a tax at a rate of 15 percent, rather than the small percentage of such income being taxed at a rate of 34 percent. Price Waterhouse has estimated that if H.R. 1317 were enacted, the U.S. Treasury would collect an additional $62 million in Feder- al tax revenue in calendar years 1989 through 1991. Despite the fact that qualified funds ~would pay more Federal income taxes, some people predict there could be a modest overall revenue loss. I wish to point out that the annual savings to utility customers are nearly twice as high as the annual revenue loss projected by the staff of the joint conimittee~ We respectfully submit that this modest revenue loss is more than offset by the overall benefits from this act. This act will allow the eëonomic system to help gen- erate funds for decommissioning, rather than regressive, unproduc- tive taxation. It is a win-win, situation for electric consumers, the regulatory commissioners, environmentalists, and the U.S. Govern- ment. For the many reasons discussed here, we urge that the subcom- mittee endorse this act. Thank you very much. [The statement of Mr. Kadak follows:] PAGENO="0316" 306 STATEMENT OP DR. ANDREW C. KADAK PRESIDENT AND CHIEF OPERATING OFFICER YANKEE ATOMIC ELECTRIC COMPANY BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS U.S. HOUSE OP REPRESENTATIVES February 22, 1990 Mr. Chairman and Members of the Subcommittee: I am Dr. Andrew C. Kadak, President and Chief Operating Officer of Yankee Atomic Electric Company. I appreciate the opportunity to appear before you today representing the Edison Electric Institute (EEl) to present our views on H.R. 1317, The Nuclear Decommissioning Reserve Fund Act (Act). EEl is the association of electric companies. Its members serve 96 percent of all customers served by the investor-owned segment of the industry. They generate approximately 78 percent of all electricity in the country and provide electric service to 74 percent of the nation's electric customers. Yankee Atomic Electric Company is a pioneer in the nuclear industry, founded in 1954 as a result of the National Atoms for Peace Program, in order to generate nuclear-powered electricity for New England. The Yankee nuclear power plant marks 30 years of operation this summer and has earned a reputation for outstanding operation. In fact, our plant has one of the world's best operating records. H.R. 1317 provides significant benefits for electric utility customers by reducing the amount of funds collected in rates for future decommissioning and provides greater financial security for the protection of the health and safety to the American public by helping to assure that adequate funds are available to decOmmission nuclear plants in the next century. The Act will achieve these results by lowering the tax rate on the income of qualified nuclear decommissioning reserve funds (qualified funds) and by removing the current investment restrictions, allowing for a more rapid build-up of funds for decommissioning at a lower cost to current utility customers. EEl strongly endorses the Act for the following reasons: o It will provide greater financial security for the protection of health and safety by helping to assure that adequate funds are available for decommissioning nuclear power plants in the next century. o It will directly benefit electric utility customers by reducing the cost of setting funds aside for future decommissioning, which are included in current electric rates. o It will eliminate the existing tax rate bias against the establishment of qualified funds. PAGENO="0317" 307 o It will provide significant benefits to the general * public and to electricity consumers at a modest cost to the Federal government. In the remainder of my testimony I will discuss these reasons in greater depth. Background Under Federal and state law, utility companies that operate nuclear power plants are obligated to decommission (that is, close down or otherwise dismantle) the plants at the end of their useful lives. Presently there are over 100 commercial nuclear units in the United States that must be decommissioned at some point in the future. Section 468A of the Internal Revenue Code of 1986, as amended (Code), allows a utility company to elect to deduct contributions made to a qualified fund, subject to certain limitations. A qualified fund is a segregated trust fund to be used exclusively for the payment of nuclear decommissioning costs and administrative costs of the fund (including taxes). In addition, a qualified fund is allowed to invest in certain assets, known as "Black Lung" investments, which are limited, in general, to Federal, state, or local government obligations and bank and credit union deposits. Unlike a Black Lung trust, which is not subject to Federal tax on its income, a qualified fund constitutes a separate taxable entity and is subject to Federal tax on its income at the maximum corporate income tax rate (currently 34 percent). Because of the application of the 34-percent tax rate and the investment restrictions, the after-tax earnings of qualified funds are constrained. The reduced earnings mean that customers must provide greater amounts for contributions to qualified funds in the form of higher rates for their electric service. Although establishment of a qualified fund results in certain advantages for utility customers, the current provisions of Code Section 468A significantly limit the value of qualified funds. A utility company that establishes a qualified fund generally invests the assets of the fund in tax-exempt securities in order to optimize the fund's after- tax yield. Such investments are made because the maximum corporate income tax rate of 34 percent is applied to the taxable income of the qualified fund. The current investment limitations, although better suited to a tax-exempt entity such as a Black Lung trust, are inappropriate when applied to a taxable entity such as a qualified fund. In June, 1988, the Nuclear Regulatory Commission (NRC) promulgated a rule which, in essence, requires each licensee of a nuclear unit to establish* an. external fund by July, 1990, to accumulate monies currently for future decommissioning needs. 10 .C.F.R. §~ 50.33(k) and 50.75. Furthermore, the Conference Committee for the Deficit Reduction Act of 1984 stated that it might be~ appropriate for the tax writing committees to study further the merits of providing tax incentives for establishing decommissioning trust funds. H. Rep. No. 861, 98th Cong., 2d Sess., at 879 (1984). We believe that the Act responds to the directive of the Conference Committee and would enable the licensees to comply more effectively with the NRC mandate. PAGENO="0318" 308 The Act will lower the Federal tax rate on the income of a qualified fund from 34 to 15 percent and eliminate the current restrictions on investment choices. These modifications will encourage qualified funds to invest in taxable securities, including U.S. Treasury obligations, rather than tax-exempt securities. This resulting investment flexibility will directly benefit customers and provide greater assurance that adequate funds are available to decommission nuclear plants in the future when they have exhausted their useful lives. It is important to note that the greater investment flexibility afforded qualified funds under the Aôt will not diminish:the security of the assets of these funds. Pursuant to their enabling statutes, state utility commissions possess the necessary authority to establish investment guidelines when the current Black Lung investment restrictions are removed. Many state utility commissions have exercised this authority with respect to decommissioning trust funds that do not qualify under Code Section 468A. In addition, the trustee and investment manager appointed to administer and invest the assets of qualified funds are subject to the customary fiduciary obligations. Furthermore, the Act does not in any way alter existing Federal tax laws which prohibit self-dealing transactions involving qualified funds. Finally, utility companies lack any motivation to take undue investment risks with the assets of qualified funds because any windfall would remain in the fund until returned to ratepayers while any shortfall would be supplemented by shareholder dollars. Financial Security for Health and Safety Protection Nuclear power plants are built to generate electric power for 30 years or more. At the end of their useful lives, they must be decommissioned in a way that will assure long-term protection of the health and safety of the public. Because decommissioning involves the handling and disposition of radioactive materials, the decommissioning process is. expensive and will require billions of dollars on -an industrywide basis. To assure that monies are available for this decommissioning process in the next century, electric utilities are collecting money in rates from customers which will be used in the future to pay for decommissioning costs. Cost estimates for decommissioning nuclear plants are escalating each year at a higher rate than the rate of inflation, thus making it difficult for owners of nuclear plants to accumulate sufficient funds for future decommissioning costs. Moreover, some state utility commissions are reluctant to permit utilities to take inflation and other factors into account when computing the amounts to be collected because of the financial burden it would impose on current customers. We support the Act because it willhelp assure that sufficient monies will be set aside for decommissioning. The Act will provide greater assurance because it will encourage more owners of nuclear plants to establish qualified funds. Additionally, the Act will increase the after-tax yield of qualified funds thereby allowing them to growat a faster pace than under current law. We believe that encouraging the establishment of qualified funds and optimizing the yield of such funds will facilitate greater financial security for protecting the health and safety of the public at less cost to electricity consumers. PAGENO="0319" ~3O9 The importance of providing adequate decommissioning funding was recognized by members of the Conference Committee for the Deficit Reduction Act of 1984. In its report on the Deficit Reduction Act of 1984, the Conference Committee stated: "The conferees recognize the importance of ensu~ing that utilities comply with nuclear power plant decommissioning requirements. In view of this concern, the conferees believe that it may be appropriate for the tax-writing committees to study further the tax treatment of decommissioning costs, and the merits of providing tax incentives for establishing decommissioning funds." (Emphasis supplied.) H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 879 (1984).. We believe that the Act appropriately responds to this concern. When Code Section 468A was first enacted, most owners of nuclear plants were not obligated to use external funding for future decommissioning costs but could rely upon internal funding which had a higher after-tax return thereby reducing decommissioning collections required from customers. The recent action of the NRC, however, has changed external funding from an option to a requirement. In many cases, this transition to external funding will result in a tremendous economic burden for our customers. Clearly, the Act will maximize the after-tax yield on qualified funds and.thereby help assure that sufficient monies will be available to decommission nuclear plants at the end of their useful lives. Lower Customer Rates The Act will result in lower electricity rates for our customers. On April 20, 1989, Price Waterhouse issued a report on the Act. They estimated that, based on current law and the number of funds in existence in February, 1989, and projected to be created by the end of 1993, utility companies will contribute between $600 million and $700 million annually to qualified funds in calendar years 1989 through 1993. Although not included in the Price Waterhouse estimate, it is anticipated that utilities will continue to contribute nearly $700 million annually to qualified funds through 2004. These contributions will be included in the costs reflected in the electricity rates charged to customers. The Act will reduce the annual amount of decommissioning costs charged to customers. If the income tax rate for qualified funds were lowered to 15 percent and the current investment restrictions were eliminated, it was estimated by Price. Waterhouse that the~ average annual decommissioning collections from customers in calendar years 1990 through 1993 would drop by nearly .10 percent, or approximately $70 million per year. In addition, decommissioning collections from customers in years 1994 through 2004 would be reduced $70 to $96 million per year. This will directly benefit customers by lowering.the amount of decommissioning costs they otherwise will be charged. PAGENO="0320" 310 Tax Rate Bias * *Current law imposes a tax rate of 34 percent on the income of qualified funds. This rate imposes a dispropor- tionately high tax burden on qualified funds and on customers whose monies are deposited in these funds. Payments made by electric utilities to qualified funds represent amounts collected from their customers. Because the actual decommissioning costs will not be incurred for many years to come, these amounts are essentially advance payments by the utility customers. If these advance payments were not required, utility customers could retain these monies until such time as the actual decommissioning costs were incurred. If the customers invested these amounts until needed to pay decommissioning costs, the earnings on such investments would be subject to Federal taxation at the average marginal tax rate of the customers. Accordingly, sound tax policy dictates that customers should not be penalized by the application of an arbitrarily inflated tax rate on earnings of customer monies simply because they are segregated in an external trust fund. Rather, the earnings of qualified funds should be. subject to a rate of taxation comparable to the rate the customers would pay if they retained these advance payments of future decommissioning costs. EEl undertook a study to develop the composite marginal tax rate of electric utility customers. The study concluded that the average marginal tax rate is 16.61 percent. The analysis establishes that the tax rate proposed by the Act is not significantly different from the composite tax rate of the customers who actually bear the economic burden of the decommissioning obligation. This study has been presented to the Treasury Department and the Joint Committee on Taxation (Joint Committee) for their review and consideration. Sound tax policy warrants the reduction to a rate of 15 percent for taxable income of qualified funds to assure consistent and equitable taxation of electric utility customers. Federal Revenue Impact The Act will increase the Federal revenue from qualified funds. Currently, qualified funds invest approximately 90 percent of their assets in tax-exempt bonds and 10 percent in taxable securities. Investment in tax- exempt instruments generally limits the after-tax rate of return of a qualified fund because of the high Federal tax rate on the income of qualified funds. Consequently, despite the 34-percent tax rate, qualified funds now pay a relatively small amount of tax. The Act will encourage qualified funds to invest their assets in taxable obligations because they could earn a higher after-tax rate of return. With a lower tax rate it is anticipated that qualified funds would invest approximately 90 percent of their assets in taxable securities and 10 percent in tax-exempt instruments. This change in investments would significantly increase Federal taxes paid by qualified funds because 90 percent of the income of qualified funds would be subject to tax at a rate of 15 percent rather than only 10 percent of such income being taxed at a rate of 34 percent. PAGENO="0321" 311 Under the current restrictions placed on qualified funds, it was estimated by Price Waterhouse that the U.S. Treasury would collect approximately $23 million in tax revenue from qualified funds in calendar years 1989 through 1991. However, under the Act, the majority of the assets of qualified funds would be invested in taxable instruments, including U.S. Treasury obligations. Price Waterhouse estimated that the total Federal tax revenues from existing qualified funds would escalate to nearly $85 million for calendar years 1989 through 1991. This represents an increase over current law of approximately $62 million in Federal tax revenue from existing qualified funds. Despite the fact that qualified funds would pay more Federal income taxes than under current law, these funds would pay a lower rate of tax (15 percent) on income from taxable investments than do current holders of taxable investments. Based on the assumption utilized by Federal government revenue estimators that qualified funds would displace current holders (that are in tax brackets higher than 15 percent) of taxable investments, Price Waterhouse estimated that the Act would reduce overall Federal income tax revenue in fiscal~-years 1989 through 1992 by a total of approximately $55 million. In a "preliminary" revenue estimate dated June 28, 1989, the staff of the Joint Committee estimated that the Act would reduce overall Federal income tax revenue in fiscal-years 1990 through 1992 by a total of $105 million. It should be noted that the annual savings to customers, which are undisputed by the staff of the Joint Committee, are nearly twice as high as the annual Federal revenue loss projected by the staff of the Joint Committee. We respectfully submit that this small revenue loss is more than offset by (i) the greater financial security available to protect the health and safety of the public; (ii) the reduced decommissioning costs charged to electricity consumers; (iii) the reduced financial burden associated with complying with the new financial assurance requirement of the NRC; (iv) the application of sound tax policy to reduce the burdensome rate of tax presently imposed on qualified funds; and (v) the increased investment by qualified funds in taxable U.S. Treasury obligations. Conclusion For the many reasons discussed here, we urge that the Subcommittee endorse the Act. 30-860 0 - 90 - 11 PAGENO="0322" 312 Chairman RANGEL. Thank you, Mr. Kadak. The witnessess are going to have to stay within the 5-minute rule if we are going to complete these hearings today. Commissioner Badger. STATEMENT OF WILLIAM A. BADGER, FIRST VICE PRESIDENT, NATIONAL ASSOCIATION OF REGULATORY UTILITY COMMIS- SIONERS ENARUC], AND COMMISSIONER, MARYLAND PUBLIC SERVICE COMMISSION; ALSO ON BEHALF OF THE CAPITAL CONTRIBUTIONS IN AID OF CONSTRUCTION [CIAC] COALITION, ACCOMPANIED BY MICHAEL FOLEY, DIRECTOR OF FINANCIAL ANALYSIS AND CAROLINE CHAMBERS, DIRECTOR OF CON- GRESSIONAL RELATIONS [NARUC] Mr. BADGER. Thank you, Mr. Chairman, and members of the sub- committee. My name is William Badger. I am a commissioner from the Maryland Public Service Commission, and I also serve as first vice president of the National Association of Regulatory Utility Commissioners, or NARUC, as well as chair its Committee on Elec- tricity, and with me this morning is Michael Foley from NARUC, our director of financial analysis, and Caroline Chambers, our di- rector of congressional relations. NARUC, on whose behalf I appear today, represents the State of- ficials who regulate the rates and services of gas, electric, tele- phone, and water utilities. We very much appreciate this opportu- nity to present our views on two important tax policies that have a very direct impact on the prices consumers pay for utility services. The first is the taxable status of contributions in aid of construc- tion made to water utffities. On this particular issue, I am testify- ing not only on behalf of State utility regulators, but for the entire CIAC coalition, which is composed of over 20 organizations repre- senting utility consumers, water companies, public transit systems, home builders, labor unions, public and investor owned electric and gas utilities, realtors, contractors and builders. This coalition seeks to restore the pre-1986 tax law which, in our opinion, properly treated CIAC as capital payments not to be in- cluded in the gross income of regulated electric, gas, water and sewer utilities. The Tax Reform Act of 1986 reversed this tax treat- ment, and essentially created a new CIAC tax, which I want to stress is not being paid by utilities, but by utility consumers. * While this hearing is specifically limited to the question of re- pealing the CIAC tax for water utilities, we believe our arguments for a repeal equally apply to all utilities subject to this tax. As you are aware, CIAC are payments or transfers of property from a de- veloper, farmer, governmental body, or individual, to a utility to enable that utility to extend service to that customer. The use of this mechanism is an important and popular method by which util- ities raise capital for needed expansion of their facilities. Prior to 1986, regulators recognized CIAC as capital payments, and therefore not eligible for depreciation benefits or inclusion in the rate base from which utilities earn their profit. Traditionally, utilities have been able to collect from customers, in the form of rates, a dollar for dollar recovery of any tax liability incurred in providing service. With the creation of the CIAC tax, regulators PAGENO="0323" 313 have been forced to use 1 of 2 methods tO ensure that the utilities recover the cost of this tax liability. Most often, the utility custom- er who contributes the CIAC to its utility must now pay the entire cost of the contribution and the CIAC tax. For example, if a new service extension costs $100,000, now the contributor must pay a total of $150,000 in order to cover the new tax liability. The second method of recovery is to spread the new $50,000 in tax liability over all the utility's customers by ilicreasing its rates for services. Nowhere in the legislative history of the 1986 act does Congress acknowledge that the CIAC imposed on utilities would, by virtue of historic regulatory law and practice, be borne entirely by consumers. With your permission, let me just provide you with two examples of the impact of this tax. Low- and middle-income residents of Newton Square Development in Delaware County, PA, suffer from drought conditions which require water rationing at the slightest deficiency in rainfall. In addition, there is concern that the proxim- ity of their wells to their septic tanks has caused their water to be contaminated. The Philadelphia Suburban Water Co. could extend water service to this development for $118,000, but the CIAC tax raises that cost to $196,000, an amount which the community indi- cates it cannot afford. In Santa Clara, CA, the CIAC tax is dramatically increasing the cost of mass transit extensions. It has added more than $1.5 million to the cost of building 14 new substations. In addition, the CIAC tax adds $25 to $30 to the cost of each new traffic signal. These examples, we believe, demonstrate the tremendous disin- centive to move forward with needed projects to protect the health and safety of our citizens because of the adverse consequences of the CIAC tax. The slight revenue loss associated with restoring the tax-exempt status for CIAC is insignificant, in light of these public interest requirements. It is a tax on consumers, on capital, on growth and development, as well as the environment, and unneces- sarily impacts on the Nation's health and safety. In our opinion, the continued imposition of this tax is not in the public interest, nor does it represent sound tax policy, and we urge that you support its repeal. I have been asked to comment also, Mr. Chairman, on the nucle- ar decommissioning bill that is before you, H.R. 1317, and with your permission, I would just indicate NARUC's position with re- spect to the proposal. As has been indicated, under the current law, qualified decom- missioning funds may hold taxable Federal securities, but must pay a tax rate of 34 percent on the interest earned on such securities. For this reason, these funds currently invest, for the most part, in tax-exempt securities. In addition, the assets of qualified decommis- sioning trust funds may be invested in Federal, State, or local gov- ernment obligations, or in certain time or demand deposits in banks or credit unions. These are commonly known as black lung investments. We believe that these requirements unnecessarily increase the cost of electricity. By removing the black lung investment limita- tions, and applying a 15-percent income tax to the earnings decom- missioning funds would be permitted to earn a hi~i~e~ aftertax rate PAGENO="0324" 314 of return. Higher earnings would permit the funding of decommis- sioning liabilities with lower contributions by electric ratepayers. Repealing the black lung restrictions would allow more profita- ble investment without jeopardizing the safety of decommissioning funds. Under this proposal, the State commissions would be permit- ted to adopt and enforce their own investment guidelines for quali- fied funds. [The statement and attachment of Mr. Badger follow:] PAGENO="0325" 315 PART ONE OF A TWO PART STATEMENT STATEMENT BY THE HONORABLE WILLIAM A. BADGER Commissioner, Public Service Commission, State of Maryland and First Vice President National Association of Regulatory Utility Commissioners on behalf of the CIAC Coalition before the U. S. House of Representatives Ways and Means Subcommittee on Select Revenue Measures CAPITAL CONTRIBUTIONS IN AID OF CONSTRUCTION ("CIAC") February 22, 1990 MPMR~RS OF THE "C I A C COALITION' National Association of Regulatory Utility Commissioners Consumer Federation of America National Association of State Utility Consumer Advocates National Association of Home Builders International Brotherhood of Electrical Workers National Association of Realtors Texas Utilities Services Associated Builders and Contractors American Resort and Residential Development Association County Supervisors Association of California Pacific Gas and Electric Santa Clara County Edison Electric Institute American Gas Association National Association of Water Companies League of California Cities Commonwealth Edison (Illinois) U.S. Chamber of Commerce Florida Power & Light Utility CIAC Group [Gas and Electric] American Public Power Association Minnesota Power San Diego Gas and Electric National Association of Industrial and Office Parks PAGENO="0326" 316 I. INTRODUCTION A. Statement on Behalf of the CIAC Coalition I appear for the CIAC Coalition consisting of numerous organizations identified above. We have joined together because of our common concern over the impact of the CIAC tax on the nation's consumers and on important national policy objectives. We appreciate this opportunity to be heard. B. Summary of Position The CIAC Coalition seeks to restore the historic, pre-1987 Federal tax law which properly treated contributions in aid of construction ("CIAC") as capital payments not to be included in the income of regulated electric, gas, water, and sewerage disposal utilities. The Tax Reform Act of 1986 ("1986 Act"), by reversing this rule, essentially created a new "CIAC tax" on these utilities' customers where no tax had existed ever before. At first blush it night appear this new law taxes utilities. Not so! It just turns them into IRS agents passing tax bills on to consumers. For as a virtually inevitable consequence of the laws and historic practices of the state agencies that regulate utilities, the CIAC tax, as other Federal taxes, must be charged to consumers. And the ways in which this happens, as you will see, work against the interests of important Federal policies in such areas as price stability, economic growth and development, expansion of needed infrastructure facilities, timely production of affordable housing, protection of the environment, and furtherance of the health and safety of our people. Chairman Rangel's January 23 press release scheduled this hearing to consider repeal of the new CIAC taic for water utilities. However, H. R. 118, the underlying legislation which now enjoys cosponsorship by 131 Members of the House (including half of the Ways and Means Committee) and 32 Senators (on the companion 5. 435), would repeal the CIAC tax for all regulated - electric, gas, water, and sewerage disposal utilities. As our statement demonstrates, the arguments for repeal apply to all these utilities. Accordingly, the Coalition reaffirms its support for H. R. 118 and respectfully urges the Subcommittee to approve this needed bill to relieve the customers of all these utilities from an unfair burden. C. Outline of Statement In the statement which follows, I will: -- describe the typical CIAC transaction and its treatment by state public service commissions (sometimes called public utility commissions and referred to in this statement as PSCs) [section II]; -- summarize the history of the treatment of CIAC under the Federal tax laws, emphasizing congressional reversal of the historic rule in 1986 [section III]; -- highlight specific examples of the adverse impact which the CIAC tax visits upon consumers [section IV]; -- examine the policy considerations which demand that the CIAC tax be repealed [section VI; and -- discuss revenue implications [section VI]. We conclude, based on the specific examples of the impact of the CIAC tax and our analysis of the tax and other policy considerations, that the CIAC tax created in 1986 should be repealed. II. CIAC TRANSACTIONS AND STATE PSC REGULATION CIAC are cash payments or transfers of property to a utility to enable it to extend or expand service. These payments or transfers may be made by home buyers, commercial or office parks, plants, developers, farmers, or even PAGENO="0327" 317 units of government (for schools, hospitals, prisons, or military installations, for example). CIAC constitute a traditional and important method by which utilities raise capital needed for new or additional infrastructure facilities. CIAC are particularly important for areas of new growth and development. PSCs (whose members may be appointed by state governors or elected by the people) have long recognized CIAC as ~ payments. Because there is no economic cost to the utilities from these capital infusions, however, PSCs historically did not allow utilities to include the amount or value of CIAC to be included in their rate base for rate-making purposes, or allow utilities to earn, income on these assets. III. HISTORY OF FEDERAL TAX TREATMENT OF CIAC A. Historic Rule: Contributions to Capital Are Not Income Generally, contributions to the capital of a corporation, whether made by shareholders or others, are not includible in the gross income of regulated utilities. CIAC were covered under this historic rule pursuant to numerous court decisions to which IRS formally acquiesced. In the inid-1970s the IRS sought by administrative action to reverse the rule as to CIAC and include them in gross income. However, Congress acted swiftly in 1976, and again in 1978, to reaffirm that CIAC should not be taxable. In so doing, Congress also reiterated the requirements for non- taxabifity under the early cases and IRS rulings, namely: (1) the CIAC could not be included in the utility's rate base for rate-making purposes; (2) the CIAC must be used predominantly in the trade or business of a regulated utility; and (3) no'~depreciation could be claimed or investment tax credit taken with respect to property acquired with or by CIAC. B. 1986 Tax Reform Act: Reverse the Rule, Tax CIAC In the 1986 Act, Congress summarily reversed the historic rule it had so carefully reaffirmed in 1976 and 1978. The Administration had not proposed doing this in its reform initiatives, and the otherwise extensive hearings in the Ways and Means and Finance Committees did not focus on CIAC. In the end, the drastic action Congress took was girded by just this explanation: "The [Ways and Meansj committee believes that all payments that are made to a utility either to encourage, or as a prerequisite for, the provision of services should be treated as income of the utility and not as a contribution to the capital of the utility." That statement -- bereft of reasoning to explain the "committee belie[f}" -- fails to justify what Congress did. Indeed, it fails to mention, much less respond to, the rationale that led Congress in 1976 and 1978 to reaffirm the rule of nontaxability by enacting and expanding section 118(b) of the 1954 Code. Thus, with all due respect, the Coalition suggests Congress seems to have been motivated in 1986 principally if not exclusively by the modest Federal revenues the CIAC tax would generate, not by sound tax policy. C. How the CIAC Tax Works In any event, once the new CIAC tax was created, its handling by the various utilities became an issue for PSCs to resolve. The principal issue is one of cost recovery -- who should bear the burden of the new tax? Though regulations differ from jurisdiction to jurisdiction, all follow a similar formula -- a utility is entitled to earn sufficient revenues to recoup operating expenses and taxes, pay fixed capital costs, and realize a reasonable rate of return on capital invested by shareholders or owners. Under this formula, Federal tax costs are passed on to consumers as a cost of providing service, and the only question is how. Since 1986 most PSC5 have concluded that the increased cost resulting from the CIAC tax should be paid by the CIAC contributor. If, say, $100,000 is required to construct a service extension, now the contributor must pay $150,000 so that, after the utility has paid $50,000 (34 %) in Federal taxes, the utility will have $100,000 left to do the job! (Please note that the $50,000 PAGENO="0328" 318 figure is used just to illustrate the impact of taxing CIAC. In practice, the amount of tax depends on factors such as (a) possible additional state income or other taxes where state law follows the Federal model on CIAC, (b) the utility's applicable tax rates, and (c) possible downward adjustments in taxes to reflect the depreciability of CIAC-taxed assets.) Some PSCs have authorized utilities to spread CIAC tax costs among all their customers, often including those not benefitting from the CIAC-financed facilities, by increasing utility rates to all. Nowhere does the legislative history of the 1986 Act acknowledge that the CIAC tax, nominally laid on utilities, would -- as the virtually inevitable result of historic state regulatory law and practice -- be a tax on consumers! But that is how it works. IV. IMPACT OF THE TAX While the CIAC tax has raised some additional revenues for the Federal government, it has done so at the cost of imposing an unfair inflationary burden on consumers of certain utility services and has led to unintended consequences conflicting sharply with Federal policies in several areas. Before discussing these consequences in policy terms, we would like to set forth just a few examples of what this tax has wrought. A. Midwestern Town Suffers Tax-Induced Inflationary Costs To Get Safe Drinking Water A small midwestern town's municipal water supply contains fluoride in concentrations exceeding EPA's Safe Drinking Water Act standards. Fluoride is a suspected carcinogen. Also, there is a limited supply of ground water. The town's 2000 customers each consume an average of 84,000 gallons per year, paying $180 for this service. The most practical solution to the limited-quantity and poor-quality problems is for a nearby investor-owned water supplier to construct 15 miles of 12-inch pipe to serve this town with properly treated water. The estimated cost is $2.8 million with CIAC of $1.2 million, to be paid by a surcharge on each customer's bill of $170 per year. Of that amount, $43 is attributable to the CIAC tax. The investor-owned utility thus becomes a tax collector for the government while the town's customers are forced to pay a regressive tax almost lute a penalty for trying to improve the quality of their drinking water. B. Lawrence, Massachusetts Hous~g Auti~t:ffl her Housin~çcs~ Delay in Production of New Housing Bay State Gas Company (Canton, Massachusetts) delivered a proposal to the Lawrence, Massachusetts Housing Authority in early 1988 for extension of gas service to a housing project. The proposal required CIAC of approximately $249,000, which included a Federal income and Massachusetts excise tax gross- up of approximately $95,000. The Executive Office of Communities and Development, Commonwealth of Massachusetts, is funding the extension. At this date, the agency has not released the funds for this project, due to the tax gross-up portion of the contribution. It appears the agency is puzzled by the need to fund this additional burden. The delay is coating the agency an additional 4.6% due to the increase in the CPI of Boston area construction costs. This increase in turn will have to be grossed-up to the buyer with yet additional CIAC taxes. C. San Diqge Naval Medical CenterS. The Navy "Pays Taxes"! San Diego Naval Medical Center made contributions to San Diego Electric and Gas Company as reimbursement for costs incurred in the installation of a high voltage altetmate ct~cuit -to provide hack-uu service. IRS determined that evea l~e.~e ~-~ts c-au i~ctecL ta~abke C ~ ~i~U2, tL5~ l~avy hit~ to pay the tax costu to the utility which remitted the taxes to ~FS. PAGENO="0329" 319 D. Hall's Ridge Road, West Virginia: CIAC Tax Consumes 10 % of Company's Infrastructure Replacement Capital This was a $1.2 million project to construct 45,100 feet of water line to provide economic development opportunities to the Hall's Ridge Road area and water service to 138 customers. West Virginia-American Water Company made a $100,000 contribution to this "public/private partnership." Normally, the company would thus expect to own the first 10 % of the water line. Here, however, its commitment was used as part of local matching funds, so the company got no ownership of facilities. Still, because the company entered into a 40--year operating agreement, it was required to pay CIAC taxes of $480,000. This roughly off-set the Federal Economic Development Administration grant of $525,000 for the project! The company expects only a $35,000 annual gross before expenses from this project - West Virginia-American entered into this project simply to serve the community's economic development and quality of life. How fortunate this company was there -- especially given the amount of the CIAC tax, smaller ones could not have responded! Still, the CIAC tax on this project consumed approximately 10 % of the $5 million needed to support the company's annual capital requirements and will force up rates to other customers in West Virginia. The company's President aptly stated: "I would rather spend $480,000 in infrastructure replacement which would be in the better interest of the communitites we serve." E. ifigher Costs for Safe Drinking Water Act Compliance in Texas, Utility Losing Customers, Customers Giving Up Treated Water A significant problem the Texas Water Commission has encountered is the need for system improvements to meet standards required by the Safe Drinking Water Act. Given the economic and banking problems in Texas, investor-owned utilities simply cannot borrow funds for system improvements. These utifities have been coming to the commission for capital improver-eat surcharges, essentially customer contributed capital. Improvements installed with this money may not be depreciated or allowed in rate base for return. They are simply additional facilities for existing customers, for which the utilities cannot raise rates. Since the utility does not actually see any revenue increase, the tax burden must then come from the customer surcharge account. In other words, the customer pays for the improvements up front and then must also pay a tax on their contributions. This seems to be a situation of paying income taxes on something that is not income to anyone! A typical example is Oak Ridge Utility, also known as Pine Springs, with over 5,000 customers. It was allowed a surcharge of $7.28 per customer per month for three years, but then it lost almost 10% of its customers, experienced severe cash flow problems, and had to defer needed improvements. Many customers who left the system now use non-potable well and surface sources for water and sometimes bottled water for drinking and cooking. F. Jefferson County, Missouri: Sewage Effluent Creating Unhealthy Nuisance - In Jefferson County, Missouri, home septic tanks in Weber Hill Manor and Weber Hill Terrace are overflowing. The clay soil on which the homes are sited has absorbed as much as it can. Consequently, septic effluent is surfacing and polluting the groundwater. Even though this creates an unhealthy environment and a nuisance, the residents of these moderate-income housing units are unable to afford the necessary sewer trunk lines because of the CIAC tax which made them more expensive. G. Santa Clara County: Higher Cost of Transportation Service In Santa Clara County, California, the CIAC tax is affecting construction of extensions of the Guadalupe LRT to the San Jose Transit Mall. Due to the tax, Pacific Gas and Electric has had to add $1,407,000 to the cost of the 14 substations (seven already completed and seven to be built) which would be PAGENO="0330" 320 paid by the County over a three-year period. Other utility services to the southern extension that will be taxed include lighting the "Park and Ride" lots, building traffic signals, and enabling electricity to reach the cars. Said Mr. Rod Diridon, Chairman of the County Board of Supervisors: "the CIAC tax exemption needs to be vigorously pursued so local governments can afford to provide vital services such as reliable public transit." The County's highway and expressway projects are affected by the tax, too, which adds $25-30 to the cost of each installed traffic signal. H. Ohio Department of Mental Retardation: State Agency Pays Tax PSCs require utilities to collect CIAC tax costs from CIAC contributors, even government agencies. For example, Ohio Department of Mental Retardation is negotiating with an investor-owned water company for installation of about 1600 feet of water main for service to a new vocational workshop. The estimated cost is $35,000. Ohio Public Utilities Commission rules state that the utility cannot refund (over 15 years) more than 66 % of the amount of the Mental Retardation Department's contribution for this extension of service. Due to the CIAC tax, taxpayers would not be entitled to $12,000 of their refund. Prior to 1987, the full contribution would have been eligible for a refund. I. Texas: Proliferation of Small Systems, Questions of Economic Viability and Ability To Meet Environmental Regulations Texas has over 1000 water utilities, most of which have fewer than 1000 connections. Since these smaller companies cannot pay the CIAC tax when a developer contributes property for service extensions, they must require the developer to pay the tax, too. This has resulted in an even greater prolifer- ation of small systems as developers choose to create their own systems (i.e., drifi their own wells) rather than contribute facilities to established companies and pay taxes on top of that. This is an example of a growing problem highlighted in a recent letter by EPA Assistant Administrator for Water LaJuana S. Wilcher: "We are concerned about the impact that any tax related changes have on the capabilities of larger water and sewer companies to extend service to adjacent growing areas. Policies that erect significant barriers to larger companies extending their service create a situation conducive to the establishment of new small utilities. In many cases, these new small utilities are not economically viable over the long term in providing services that meet EPA's regulations." J. Newton Square, Pennsylvania and Hopewell Junction, New York: Water Quantity and Qualjty Newton Square development provides modest housing to lower and middle income families. Water and sewer services in the development are provided through individual wells and septic systems. The slightest deficiency in rainfall obliges residents to ration water. There is also concern about potential water contamination because of the proximity of wells to septic tanks. Philadelphia Suburban Water Company could extend service to this development for $118,648, but the CIAC tax raises that cost to $196,000, which the community cannot afford. This is similar to a situation in Hopewell Junction, New York, on which that state's Public Service Commission Chairman Peter A. Bradford commented in a January 11, 1990 letter to Senator Moynihan: "The [CIAC] tax serves as a major deterrent to the expansion of adequate sewage and water facilities to replace failed septic systems and - contaminated water supplies. Congress could not have intended these results. The minor impact this tax has on Treasury [revenues] does not warrant the potential risks to public health and safety." PAGENO="0331" 321 K. Montgomery Township, New Jersey: EPA Blocked from Superfund Action EPA considered funding (under the Comprehensive Environmental Response, Compensation, and Liability Act) a main extension by Elizabethtown Water Company in order to provide an alternate supply source to replace contaminated wells at the Montgomery Township Housing Development in New Jersey. However, since Federal acquisition regulations prohibit Federal agencies from including in the price of a contract with a private company the payment of any Federal taxes, EPA's Assistant Regional Counsel was forced to conclude: `[This situation] has put the EPA in the position of having selected a remedy which is the most appropriate based on public health, environmental and cost effectiveness criteria, but one which it cannot implement." L. Maxiznum-Securityi)rison in Thomaston, Maine: State's Payment for Water Line Extension Subject to CIAC Tax In responding to a request for an opinion submitted on behalf of the Bureau of Public Improvements of the State of Maine, IRS has ruled that the state's CIAC for extension of water service to its new maximum-security prison would be subject to the tax. M. Iffinois Towns: Project Held Up, Water Supply Contaminated with Radionucides Still Being Used Due to the presence of radionudides in their wells, the towns of Mapleton, Glassford, and Kingston Mines asked a nearby investor-owned water company about extending service. The extension was estimated to cost $3,000,000, of which the utility would invest $500,000. However, the remaining amount would have to come via CIAC, and the tax on that would be about $1,000,000. Primarily because of this additional tax cost, the project has not gone forward, and radionucide-contaminated water is still being used. N. Georgetown, Kentucky's Toyota Plant: State Efforts To Encourage Economic Development In 1985 the Commonwealth of Kentucky paid $6 million for extension of water service to the site of a new Toyota manufacturing plant in Georgetown. Had this happened after 1986, approximately $9 million would have been required to provide the sane incentive, the additional $3 million representing CIAC taxes for the state and Federal governments. There was considerable controversy in the state about the amounts of money its taxpayers were asked to devote to encouraging the Toyota project. Governor Martha Layne Collins persevered, however, and the new plant has proven to be a great economic boon to the Blue Grass Region. While we cannot say the additional $3 million would have made it impossible to go forward, this example suggests how the CIAC tax could interfere with efforts of the states to bring economic growth and development to their people. Such examples could hold for any utility -- gas, electric, and sewerage disposal, as well as water. V. POLICY CONSIDERATIONS FOR REPEALING THE CIAC TAX The foregoing cases -- merely examples of the deplorable impact of the CIAC. tax -- should alone persuade the Subcommittee to vote its repeal, for they show the CIAC tax is not a tax on the income of utilities, but rather: -- a tax on capital -- a tax on consumers -- a tax on growth and development -- a tax on infrastructure -- a tax on the environment -- a tax on health and safety PAGENO="0332" 322 The Coalition would like to expand on these policy considerations. The conceptual basis for repeal lies in the reality of CIAC as _____ contributions, not income. They are capital because they enable a business to create facilities used for the production of income. It merely emphasizes the point to remind you that PSCs would previously have allowed inclusion of CIAC- financed facilities in a utility's rate base (and thus allowed the utility to earn income on them) but for the fact that there is no economic cost to the utility's owners associated with the capital infusion provided by the CIAC. Second, as Congress recognized in 1976 and 1978, the immediate inclusion of CIAC in income causes a mismatching of income and related expense because the utility must increase its taxable income in the year in which it receives the contributions although most of the deductible expenses attributable to the facilities would not arise until subsequent years. Third, as Congress also recognized in 1976 and 1978, inclusion of CIAC in the gross income of utility companies leads to substantial increases in charges to utility customers. Because the increased charges must be approved by PSCs, the working capital of the utilities has been substantially reduced, resulting in considerable delays and curtailments in furnishing utility services. Nontaxable treatment of CIAC would assist a utility in meeting the demands for new and increased services. Fourth, because PSCs provide for passing the tax on, its inflationary impact falls on customers, home buyers and renters, new businesses, developers, farmers, government agencies, and others. Fifth, a clear example of the inflationary impact of the CIAC tax is its substantially detrimental effect on the housing affordability crisis. Already, millions of young, potential first-time home buyers cannot afford a down payment or monthly payments. The tax on CIAC exacerbates this problem by forcing an increase in the price of new homes, not uncommonly by as much as $1000 to $2000 per home~ For many potential buyers, particularly those of low or moderate income for whom it is already difficult to find affordable housing, the CIAC tax can be the last incremental cost increase that impedes or even prevents purchases. Further, many builders muSt curtail production because they can neither bear the tax nor pass it on to potential buyers. Thus, less housing is produced, and community development and growth are slowed. Sixth, we are here concerned with gas, electric, water, and sewerage disposal services -- fundamental components of the nation's infrastructure. By taxing expansion of these services, the Federal government has driven up costs and in many cases delayed or effectively stopped the capital infusions needed for building needed infrastructure facilities. Seventh, the inclusion of CIAC in gross income also imposes an additional tax burden on state entities, already hard pressed to provide services at a reasonable cost to consumers. For example, public and private power suppliers sometimes make joint purchases of large capital equipment, and in such transactions public power suppliers have had to pay large sums in CIAC tax costs. In effect, then, a Federal tax is imposed on a public agency of the state. Similarly, if a state or local government needs a utility to extend service to a new school, hospital, prison, or similar facility, again, it will be the state or local government that pays the Federal CIAC tax. Eighth, even more absurd, the tax will fall on a Federal agency which seeks to extend utility services to a new Federal facifity. Finally, of tremendous importance is the effect the taxation of CIAC has on environmental and health concerns. You have just seen examples of this where CIAC taxation delays or bars extension of water and sewer lines, leaving communities without adequate supplies of potable water, untreated or inai~equately treated sewage, and inadequate water service for fire service protection. For all these reasons, the Coalition believes that the CIAC falls far short of serving valid Federal tax policy and that it sharply conflicts with other Federal policies and concerns. PAGENO="0333" 323 VI. REVENUES Reinstating the historical rule of nontaxability would involve some loss of Federal tax revenues, true enough. Two points should be noted, however. A. Whose Money Is It? Because the CIAC tax runs afoul of tax and other Federal policies, there is scant rationale for arguing that the revenues the private sector would reg.iin by repealing the tax should be regarded as the government's to lose. We speak here of the difference between principle in the sense of what is right and principal in the sense of what part of the consumer's money ths government has taken without substantial policy reasons. We believe the moneiT belongs to the consumers that now bear the brunt of the CIAC tax, and they should be allowed to have it back, for the government has no good reason to keep it. B. How Much Money? Revenue Estimates Appear Overstated Based on our review of "official" revenue estimates in the past, the Coalition believes they overstate the seriousness of the government's anticipated revenue loss from CIAC tax repeal, because they ignore significant factors that would reduce that loss. For one thing, revenue estimators typically offer figures for just the first few years of a new law's operation. However, utilities will now be able to depreciate their CIAC accounts; thus, in the longer run, the Federal fisc will gain little, if anything, from the CIAC tax. The "official" revenue estimates apparently do not consider this. The official estimates we have seen for the CIAC tax also seem excessive when we consider those cases where utilities have recently become municipally owned, or where, for example, developers make CIAC to municipally-owned utffities. Since municipal utilities do not pay Federal income taxes at all, the CIAC tax would simply not be applied or collected in such instances. C O~ N C L U S I 0 N For the reasons detailed in this statement, we urge the Subcommittee to approve H. R. 118, the bill to repeal the CIAC tax as it applies to the electric, gas, and sewerage disposal industries as well as the water supply industry. PAGENO="0334" 324 PART TWO OP A TWO PART STATEMENT UNITED STATES HOUSE OP REPRESENTATIVES COMMITTEE ON WAYS AND MEANS SUBCOMMITTEE ON SELECT REVENUE MEASURES TESTIMONY OF THE HONORABLE WILLIAM A. BADGER COMMISSIONER, MARYLAND PUBLIC SERVICE COMMISSION ON BEHALF OP THE NATIONAL ASSOCIATION OF REGULATORY UTILITY COMMISSIONERS 1102 INTERSTATE COMMERCE COMMISSION BUILDING CONSTITUTION AVENUE AND TWELFTH STREET, N.W. POST OFFICE BOX 684, WASHINGTON, D.C. 20044 TELEPHONE (202) 898-2200 ON H.R. 1317 THE NUCLEAR DECOMMISSIONING RESERVE FUND ACT OF 1989 FEBRUARY 22, 1990 PAGENO="0335" 325 Mr. Chairman and members of the Subcommittee. My name is William Badger and I am a Commissioner on the Maryland Public Service Commission. I am also the First Vice President of the National Association of Regulatory Utility Commissioners and Chair of its Committee on Electricity. The NARtJC represents the State officials who regulate the rates and services of gas, electric, telephone and water utilities. The NARUC appreciates this opportunity to present its views on M.R. 1317, proposing the `Nuclear Decommissioning Reserve Fund Act of 1989'. The NARUC supports M.R. 1317 because it would have the effect of lowering the rates consumers pay for. electricity while continuing to ensure that the significant costs associated with dismantling nuclear power plants will be adequately covered (See Appendix for NARUC Resolution). Under curi~ent law, qualified funds, which serve to ensure payment of future nuclear decommissioning expenses, may be discouraged because the after-tax earnings of qualified funds are restricted by the combined effect of the current maximum Federal income tax rate of thirty-four percent applicable to their taxable income, and the "Black Lung" limitations on their investments. These factors unnecessarily increase the price of electricity for consumers. By amending section 468A of the Tax Code to reduce the Federal income tax rate applicable to taxable income earned by qualified funds to fifteen percent (15%) and to remove the existing "Black Lung" limitations on investments by qualified funds, Congress would provide a needed incentive for the establishment of such funds while reducing the long term costs of decommissioning to electricity customers -- which have been increasing in recent years at a rate higher than that of inflation. Fifteen percent is a more appropriate rate at which to tax the income of qualified funds because it is closer to the composite marginal tax rate of electric utility customers. Since decommissioning funds are collected from customers well in advance of when they will be spent, equitable tax treatment would apply the rate of taxation to these funds that utility customers would have paid if they retained the advance payments of future decommissioning costs. Repealing the "Black Lung" restrictions would allow for more profitable investments without jeopardizing the safety of decommissioning funds. Under this proposal, State commissions could adopt and enforce appropriate investment guidelines for qualified funds established by electric companies in their jurisdictions. State regulators have already done this in the case of funds that do not qualify under section 468A. Investment guidelines also could be established by the Federal Energy Regulatory Commission. It is important to note that the prohibition of self-dealing would remain intact under this legislation. Some day all of the over 100 nuclear power plants in the U.S. will need to be decommissioned. Today, electric utility customers are paying between $600 and $700 million annually to cover the significant costs that will entail. Now is the time to encourage the establishment of qualified funds to pay for that eventuality by making them more profitable. A Price Waterhouse study prepared for the electric utility industry estimates that H.R. 1317 would result in a ten percent drop in the amount that would need to be collected from ratepayers to pay for decommissioning annually. For these reasons the NARUC urges this Subcommittee to support M.R. 1317. Thank you for your attention. I would be happy to answer any questions. PAGENO="0336" 326 APPENDIX Resolution Supporting Legislation to Lower the Federal Income Tax Rate on Incone of Qualified Nuclear Decommissioning Reserve Funds and to Broaden the Investment Options of Such Funds WHEREAS, State regulatory commissioners recognize the importance of adequately providing for future decommissioning expenses of nuclear power plants; and WHEREAS, State regulatory commissioners realize that the establishment of qualified funds, which serve to ensure payment of future nuclear decommissioning expenses, nay be discouraged because the after-tax earnings of qualified funds are restricted by the combined effect of (i) the current maximum Federal income tax rate of thirty-four percent (34%) applicable to the taxable income of qualified funds, and (ii) the "Black Lung" investment limitations on qualified funds; and WHEREAS, State regulatory commissioners further realize that the combined effect of the thirty-four percent (34%) income tax rate and the "Black Lung" investment limitations on qualified fundo increases costs to consumers of electricity; and WHEREAS, Federal legislation which reduces the Federal income tax rate applicable to taxable income earned by qualified funds to fifteen percent (15%) and removes the existing `Black Lung" limitations on investments by qualified funds would permit investments into taxable securities and thus provide increased flexibility to the fiduciaries responsible for the administration and oversight of the qualified funds; now, therefore, be it RESOLVED, That the National Association of Regulatory Utility Commissioners (NARUC), assembled in its 100th Annual Convention in San Francisco, California, endorses Federal legislation which would benefit electric utility ratepayers by amending Code section 468A to reduce the Federal income tax rate applicable to taxable income earned by qualified funds to fifteen percent (15%) and to remove the existing "Black Lung" limitations on investments by qualified funds so as to defer the authority over investments to the appropriate state regulatory body; and be it further RESOLVED, That upon enactment of such Federal legislation, a state commission could adopt and enforce appropriate investment guidelines for qualified funds established by public utility companies which are regulated by the state commission; and be it further RESOLVED, That upon enactment of such legislation, if the Federal Energy Regulatory Commission (FERC) either (i) fails to adopt investment guidelines for qualified funds established by public utility companies which are regulated, in whole or in part, by the FERC, or (ii) adopts investment guidelines for such qualified funds which the NARUC determines are improper because they fail to assure the preservation of the assets of the qualified funds or fail to maximize the after-tax yield on the assets of the qualified funds, the NARUC shall petition the FERC to adopt, or amend as the case may be, investment guidelines for such qualified funds. Sponsored by the Committees on Electricity and Finance and Technology ~c~cptr~ ycvtr~er 2, 1988 PAGENO="0337" 327 Chairman RANGEL. The time of the gentleman has expired. We will hear from Martin Penman, president of the National Associa- tion of Home Builders. STATEMENT OF MARTIN PERLMAN, PRESIDENT, NATIONAL ASSO- CIATION OF HOME BUILDERS, PRESIDENT~ PERL HOMES, HOUSTON, TX Mr. PERLMAN. Thank you, Mr. Chairman, and members of the subcommittee. I am Martin Perlman, and I am president of the Na- tional Association of Home Builders, and a builder from Houston, TX. On behalf of our more than 157,000 member firms, represent- ing 8 million employees, Mr. Chairman, I congratulate you on call- ing this hearing. The Tax Reform Act of 1986 made dramatic changes to the way virtually every segment of the economy operated. Many of these changes were widely reported, and their impact carefully analyzed. Others received less scrutiny. Such is the case with the changes made in the tax treatment of contributions in aid of construction, known as CIAC. Few, if any, anticipated the dramatic impact in terms of increased construction costs that this change would engen- der in areas where new residential development is sorely needed. In sum, the change to CIAC resulted in a worsening of the afford- ability housing problem in this country. There are other provisions of the 1986 Tax Act that also have had a dramatic impact on housing; however, we will testify on those on your March 5 hearing. Prior to the 1986 act, the Internal Revenue Code section 118(a) excluded from gross income any contribution to the capital of a cor- poration. More specifically, code section 118(b) provided that a cor- porate regulated public utility that provides electric energy, gas, water or sewage disposal services could treat contributions in aid of construction as nontaxable contributions to capital. The 1986 act repealed section 118(b) requiring corporate regulated public utili- ties to report as an item of gross income cash or the value of any property received to provide services to the person transferring the cash or property. Thus, the value of this property or cash is subject to taxation. The Congress felt, quite simply, that such contributions repre- sented prepayments for services. As a result, CIAC received after 1986 are taxable to utilities in the year of receipt. In order to make the utility whole, that is, in a position equal to its position prior to the change, CIAC must be grossed up to compensate for taxes paid. The term "grossed up" is applied to the series of mathematical cal- culations required to determine the amount of money needed to offset the tax liability. It is important to note that most public utility companies prohib- it the inclusion of the cost of the added liability in the rate base. If this were allowed, the cost would be spread to all consumers. In re- ality, however, the utility compmier ~hrp~y c~nride: thcir in- creased tax liability as an increase in the cost of adding new cus- tomners. As a result, most utilities charge the builder-developer a fee for transferring capital contributions in aid of construction that is equi~aent to the tax. Builders often must pass these costs on to PAGENO="0338" 328. their buyers. Worse, the cost to the buyer is genth~ally greater than the tax because the builder must borrow these funds during devel- opment stages, but does not recoup them until sale. Hence, home costs are increased by a multiple of the gross-up to compensate for time and the risk to the lender. While the impacts vary across the country, depending on whether the particular area is served by a regulated public utility, or a tax-exempt municipal, or country utility, anecdotal evidence suggests that the costs are as much as $2,000 per home in some areas. Further, it must be noted that the tax on contributions in aid of construction falls more heavily upon moderate income families. Most capital expansions for utility service is related to the number of units, rather than the price of the units; hence, $1,000 extra cost per home in the affordable price range is a much higher percent- age of that cost than the same dollar increase to a luxury home. A thousand dollar increase, Mr. Chairman, in a home purchase price, translates to an extra $105 in mortgage payments per year. Such an increase could eliminate some 7,000 to 10,000 moderate income Americans from qualifying for their mortgage. Through a trickle-down effect, the repeal of section 118(b) has led to a dramatic increase in the cost of construction; hence, the cost of housing. While reinstating the tax exclusion for providers of water and sewer services would be a step in the right direction, it would be a small one. More appropriate would be the enactment of H.R. 118, introduced by Representative Bob Matsui of California, and co- sponsored by over 130 other Members of the House. This bill would reinstate section 118(b) in its entirety. The National Association of Home Builders urges passage of this legislation as soon as possible. Mr. Chairman, that concludes my remarks. I would be glad to answer any questions you have on my statement. [The statement of Mr. Perlman follows:] PAGENO="0339" 329 STATEMENT THE NATIONAL ASSOCIATION OF HOME BUILDERS before the SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS* AND MEANS U.S. HOUSE OF REPRESENTATIVES on CONTRIBUTIONS IN AID OF CONSTRUCTION February 22, 1990 Mr. Chairman and members of the Sub-Committee. My name~ is Martin Perlman. I am the President of the National Association of Home~ Builders (NAME) and a builder from Houston, Texas. On behalf of our more than 157,000 member firms, representing 8 million employees, I congratulate you for calling this hearing. The Tax Reform Act of 1986 (Public Law 99-514) made dramatic changes to the way virtually every segment of the economy operated. Many of these changes were widely reported and their impact carefully analyzed. Others received less scrutiny. Such is the case with the changes made to the tax treatment of contributions in aid of construction (CIAC). Few, if any, anticipated the dramatic impact, in terms of increased construction costs, that this change would engender in areas where new development is sorely needed. In sum, the change to CIAC resulted in a worsening of the affordable housing problem. There are other provisions of the 1986 Tax Act that also had a dramatic impact on housing. However, we will testify on these at your March 5, 1990 hearing. BACKGROUND Prior to the 1986 Act, Internal Revenue Code Section 118 (a) excluded from gross income any contribution to the capital of a* corporation. In order to be treated as a contribution to capital, an amount paid to a corporation had to be motivated either by donative intent, or a belief that the contributor would somehow be advantaged by the enlargement of the capital of the corporation. More specifically, Code Sec. 118 (b) provided that a corporate regulated public utility that provides electric energy, gas, water, or sewage disposal services could treat contributions received in aid of construction as nontaxable contributions to capital. Several requirements had to be met in order for a payment to a utility to be treated as a contribution to capital under Code Sec. 118 (b): First, the money or property transferred to the utility had to be a contribution in aid of construction. Second, any money received had to be spent for the intended purpose of the contribution within a specified period of time. Third, the contribution received in aid of construction (or any property constructed or acquired with such contribution) could not be included in the utility's rate base or rates allowable with respect to a contribution in aid of construction. Finally, property purchased with such a contribution had no depreciable tax basis and was not eligible for the investment tax credit. PAGENO="0340" 330 Over the years, a substantial body of case law developed sound legal and financial theories for the non-taxation of contributions in aid of construction. specifically, in Lib~y ~4ght and Power CompanY~ 4 B.T~A. 155 (1976); acq. VI-l C.B.4 (1927), it was determined that contributions of utility lines by future users were a contribution of capital and not prepayments for services. This line of thinking dominated the field until the 1970's when, in ~.v. Chicago, Burlington & Ouincv Rai~~ ~ 412 U_s. 401 (1973), the supreme Court held that if the property received could be traced to the provision of specific, quantifiable services, the value of such property was income. Initial Congressional response to the erosion of the capital contribution concept was displayed in both the Tax Reform Act of 1976 and the Revenue Act of 1978, wherein specific, language provided that contributions in aid of construction made to water and sewage companies (1976 Act), as well as gas and electric utilities (1978 Act) were nontaxable. The 1986 Act repealed 5ection 118 (b) to require corporate regulated public utilities to report as an item of gross income cash or the value of any property received to provide services to the person transferring the cash or property- Thus, the value of this property or cash is subject to taxation- The Congress felt, quite simply, that such contributions represented prepayments for services. As a result, CIAC received after 1986 are taxable to utilities in the year of receipt. In order to make the utility whole, that is, in a position equal to its position prior to the change, CIAC must be "grossed up" to compensate for taxes paid. The term "grossed up" is applied to the series of mathematical calculations required to determine the amount of money needed to. offset the tax liability. It is important to note that most public utility companies prohibit the inclusion of the cost of the added liability in the rate base. If this were allowed, the cost would be spread to all consumers. . In reality, however, the utility companies simply consider their increased tax liability as an increase in the cost of adding new customers- As a result, most utilities charge the builder/developer a fee for transferring capital contributions in aid of construction that is equivalent to the tax. Builders often must pass these costs on to the buyer. Worse, the cost to the buyer is generally greater than the tax because the builder must borrow these funds during development stages but does not recoup them until sale. Hence, home costs are increased by a multiple of the "gross up" to compensate for time and risk to the lender. IMPACT: While' the impacts vary across the country depending on whether the particular area is served by a regulated public utility (tax paying) or a tax-exempt municipal or county utility, anecdotal evidence suggests the costs are as much as $2,000.00 per home in some areas. What follows represent actual case studies of the impact of the repeal of section 118 (b): PAGENO="0341" 331 * ST. LOUIS COUNTY WATER COMPANY: St. Louis County area. The water company operates under the auspices of the Missouri Public Service Conunission. The company's Rules, Regulations and Tariffs are filed with the PSC. In January of 1986, St. Louis County Water Company requested all developers to sign an addendum to their contracts that would require the developer to pay `an additional 90% of the original contract price. CALCULATION OF CIAC "GROSS-UP" In order to make the utility whole, that is, in a position equal to its position prior to the change, CIAC, must be "grossed up" to compensate for taxes paid. However, one cannot merely add on the tax rate, for the gross up itself is taxable. For example, assume CIAC is $1,000 and the tax rate is 40%: CIAC $1,000 Gross up at 40% 400 Taxable Income 1,400 Tax Liability at 40% 560 Net Proceeds $ 840 This calculation does not provide the original $1,000 of CIAC; the difference of $160 ($1,000-$840) represents the tax on the gross up. Theref ore, the utility must also provide for this additional tax. This is accomplished by the formula: 1 - TAX RATE TAX RATE Assuming our previous example of $1,000 CIAC and a tax rate of 40%, the gross up is 66.67 (40% / [1 - 40%]): CIAC $1,000 Gross up at 66.67% ~667 Taxable Income 1,667 Tax Liability at 40% 667 Net Proceeds $1,000 In this situation, the utility is left in an equivalent position with $1,000 of CIAC. The actual increase would be $1,518.86, representing a gross up of 61.6%. The increase is figured on a federal income tax rate of 40%, a state income tax rate of 5.5%, and the pass through of the depreciation deduction benefits of 80.7%. Under these circumstances, the calculation is as follows: PAGENO="0342" 332 Calculation of CIAC Gross Up" (.055x [l-.40]) + .40 = .433 .433/(l-.433) = .764 .8066 x .764 = .616 Further, it must be noted that the tax on contributions in aid of construction falls more heavily upon moderate income families. Most capital expansion for utility service is related to the number of units rather than the price of units. Hence, a $1,000 extra cost per home in the affordable price range is a much higher percentage of cost than the same dollar increase to a luxury home. A $1,000 increase in a home purchase price translates into $105 extra in mortgage payments per year. Such an increase could eliminate about 7,000 to 10,000 moderate- income Americans from qualifying for their mortgage. CONCLUSION: Through a trickle down effect, the repeal of section 118 (b) has led to a dramatic increase in. the cost of construction, hence the cost of housing. While reinstating the tax exclusion for providers of water and sewer service would be a step in the right direction, it would be a small one. More appropriate, would be the enactment of H.R. 118. Introduced by Representative Bob Matsui (D-CA) and co-sponsored by one hundred thirty other Members of the House, this bill would reinstate section 118 (b) in its entirety. The National Association of Home Builders urges passage of this legislation as soon as possible. This concludes my remarks. I would be glad to answer any questions you have about my statement. Assuming this rate, the increase Sewer CIAC Water CIAC Total CIAC Gross up at 61.6 Taxable Income Tax Liability at 43.3% Plus: Dep. Benefit Net Proceeds is determined: $1,466.00 999.75 ~ 2, 465 . 75 1,518.86 3,984.61 1,725.34 206.48 $2,465.75 PAGENO="0343" 333 Chairman RANGEL. Thank you. We'll hear~ now from the first selectwoman from Clinton, CT, Virginia Zawoy. STATEMENT OF VIRGINIA D. ZAWOY, FIRST SELECTWOMAN, TOWN OF CLINTON, CT, ACCOMPANIED BY LAURA JENSEN, MEMBER, BOARD OF SELECTMEN Ms. ZAWOY. Thank you, Mr. Chairman, and members of the sub- committee. I am here today to speak on a miscellaneous bill con- cerning the taxability of contributions in aid of construction. I brought with me Laura Jensen, who is a member of my board of selectmen in Clinton. I am the chief executive officer of a town in southern Connecti- cut of `some 13,000 people, with a 1985 per capita income of $12,826. The State of Connecticut's average at that time was $14,000. Our annua4 budget is $22 million, and last year, partly due to reduced State and local revenues, we experienced our first deficit. State\ and Federal mandates continue to escalate, and because of fewer Federal and State dollars being supplied with those man- dates, local property taxes are also escalating. Clinton is currently under three State department of environmental protection orders, one for sewers, due to ground water pollution, and two, addressing contamination emanating from our closed landfill. The landfill has been cited as violating the Clean Water and Safe Drinking Water Acts, and has been reviewed as a potential Superfund site, as indi- cated in Environmental Protection Agency `Manual 540/1-89/001. The Connecticut State Department of Health Services has com- piled a list of over 150 chemicals which are harmful to human life. These chemicals are colorless, odorless, and tasteless, and are found in everyday, common household products. These chemicals leach through the soil into the underlying ground water. The con- taminants in the ground water, although not necessarily above the acceptable action levels, still violate the intent of the Clean Water Act. Some of the contaminants found in residential wells near the Clinton landfill include benzene and tolulene, components of gaso- line and other fossil fuels, and trichloroethylene, generally used as a degreasing agent. The Government orders against the town re- quires that a safe, potable water supply be provided to homes with contamination. Since many of the contaminants cannot be filtered by mechanical means, the options are very limited. Presently, the town is monitoring drinking wells at a cost of $35,000 to $50,000 per year, and providing bottled water `at a cost exceeding $20,000 per year. In addition to this, the town has con- ducted an inventory audit of all industrial depositors at the land- fill. In accordance with EPA guidance documents, the use of indus- trial depositing into municipal landfills was acceptable practice prior to 1979 by State and Federal agencies. The town is in the process of notifying the primary responsible parties, and conducting risk assessments, as defined in EPA manu- als. The State health department has taken an active stand against the drilling of any new wells within the area of the landfill due to the potential for contamination. Therefore, the town will have to PAGENO="0344" 334 construct water mains for a cost of $2.3 million, which will require a Federal tax to the community of almost $1 million. The cost would actually be more than this, since obviously, to a small mu- nicipality, we would have to borrow money to pay for those water mains. Also, due to the fact that we are under State orders, which have defined the town as the polluter as a result of our owning a land- fill, we cannot pass on to users any of the cost of the water main. Clearly, this is a burden that the local taxpayer should not have to bear, particularly when the town is meeting its obligations to pro- vide a healthy quality of life to its residents, and Mr. Chairman, should it be your decision to not repeal this particular tax, then I would request that you consider exempting municipalities, so that the scenario which I described above would not place an unneces- sary burden on the town of Clinton, and similar communities throughout the Nation. Thank you very much. [The statement of Ms. Zawoy follows:] PAGENO="0345" 335 TESTIMONY OF VIRGINIA D. ZAWOY, TOWN OF CLINTON, CT. I am here today to speak on a bill concerning the taxability of contributions in aid of construction. I am very cognizant of the fact that you are being inundated with information from many groups requesting repeal of what they consider unfair taxation. I believe, however, that the situation I will disclose to you today does justify the term "unfair". I am the Chief Executive Officer of a Town in southern Connecticut of some 13,000 people with a 1985 per capita income of $12,826. (State of Connecticut average per capita $14,090.) Our annual budget is $22,000,000 and last year, partly due to reduced state and local revenues, we experienced our first deficit. State and federal mandates continue to escalate, and because of fewer federal and s.tate dollars being supplied with those mandates, local property taxes are also escalating. Clinton is currently under three State Department of Environ- mental Protection orders; one for sewers due to groundwater pollution, and two addressing contamination emanating from our closed landfill. The landfill has been cited as violating the Clean Water and Safe Drinking Water Acts, and has been reviewed as a potential Superfund Site as indicated in Environmental Protection Agency Manual EPA/540/ 1-89/001 March 1989. The Connecticut State Department of Uealth Services has compiled a list of over 150 chemicals which are harmful to human life. These chemicals are colorless, odorless and tasteless and are found in everyday common hOusehold products. These chemicals leach through the soil into the underlying groundwater. `The contamin- ants in the groundwater, although *not necessarily above the acceptable action levels, still violate the intent of the Clean Water Act. Some of the contaminants found in residential wells nedr the Clinton landfill include benzene and toluene, components of gasoline and other fossil fuels; and trichloroethylene, generally used as a de- greasing agent. The goal of the orders against the Town requires that a safe potable water supply be provided to homes with d±ontamination. Since many of the contaminants cannot be filtered bymechanical. means, the options are very limited. Presently, the Town is monitoring drinking wells at a cost of $35,000 to $50,000 per year and providing bottled water at a cost exceeding $20,000 per year, In addition to this, the Town has conducted an inventory audit of all industrial depositors at the landfill'. In accordance with EPA/54O/G-89/004 Guidance Docu- ment, the use of industrial depositing into municipal landfills was acceptable practice prior to 1979 by State and Federal agencies. The Town is in the process of notifying the primery responsible parties (POP's) and conducting risk assessments as defined in EPA Manual EPA/540/I-89/001. The State Health'Department has taken en active stand `against the drilling of any new wails within the erea of the landfill due to the potential for contamination. Therefore, the only acceptable water source is the privately held water company. `The Town will have to construct water mains for a.cost of $2,320,000 which will require a federal tax to the `community of almost$l,000,000, The'cost would actually be more than this, since obviously as a small, municipality, we would have to Dorrow money to pay for these water mains. Also, due to the fact that we are under State orders which have defined the Town as the polluter as a result of our owning the landfill, we cannot pass on to users any of the cost of the water- main. ClOarly, this is a burden that the local taxpayer should ` not have to bear, particularly when the Town is meeting its obliga- tions to provide a healthy quality of life to its residents. Should it be your decision to not repeal this particular tax, the~I would request that you consider exempting municipalities so that the scenario which I describe above will not place an unnecessary cc tha Town of `lintcn and similer communities throughout the coun try. PAGENO="0346" 336 Chairman RANGEL. Thank you, are there any questions? Mr. MCGRATH. Did we finish everybody? Chairman RANGEL. I think so, yes. Mr. McGrath. Mr. MCGRATH. Thank you, Mr. Chairman. Mr. Kadak, yesterday we had Secretary Gideon here in regard to your nuclear decommissioning bill, and, of course, his testimony yesterday differed from Treasury's earlier position on this issue. Can you elaborate for us the efforts that you have made to address the tax rate problems discussed in your testimony? Mr. KADAK. Yes, thank you. It appears that Treasury has changed their position to acknowledge that there is a tax rate in- equity between a decommissioning trust at 34 percent and a mar- ginal tax rate of 15 percent, which we have suggested, and they have, in fact, suggested a number closer to 20 percent as being something that they could support. We at EEl have done a rather extensive study of our customers, which includes commercial, industrial, and residential, and we have determined, as I have said in my testimony, that that margin- al tax rate to those customers is approximately 16 percent, which is why we are proposing something on the order of 15 percent, so from our standpoint, we are encouraged to see the Treasury go to our direction, or go in our direction, and feel it would get rid of an inequity that currently exists, and would benefit consumers twice as much as any revenue loss that the administration may contem- plate. Mr. MCGRATH. The Treasury yesterday also testified that the tax advantages for nuclear power generation may create an advantage over other types of power generation. Can you respond to that? Mr. KADAK. Well, again, EEl has done another survey in re- sponse to that question, and they determined that the nuclear pow- erplants in this country now supply approximately 20 percent of the electricity, which services approximately 82 percent of the cus- tomers in the United States, and if you count all the power pooling arrangements, that number jumps up to over 90 percent, so it is not really any kind of inequity, it is really a recognition of the way electricity is distributed in this country. Mr. MCGRATH. Mr. Badger, certainly your position on contribu- tions in aid of construction are well thought of in the House by virtue of the number of cosponsors on Mr. Matsui's bill. I just want to point out that I believe that during reconciliation last year, the Matsui effort was toward water companies. To include all other utilities would require a revenue of $615 million over 5 years, and I'm just wondering how you think we can raise that amount. Mr. BADGER. I'm really, I guess, not in a position to comment on how that shortfall would be recovered. I think the difficulty is that we ought to recognize that, prior to the 1986 Tax Reform Act, this treatment was historically the practice in this country, and it had been followed by regulatory commissions throughout the 50 States, and our concern is one that there are communities that may expe- rience public health problems. It seems that these public health problems would override the need to seek that recovery through another form. PAGENO="0347" 337 As long as we have the ability, as we have always treated utili- ties, water and electric, to offset these contributions and rate base, then there is-it is neutral-but when you have to really divide them by effectively 66 percent to account for the tax, decisions appear to be made on the fact that that tax makes a project almost impossible to go forward. That does cause us some concern. Mr. McGiwm. How about the position of our first selectman from Connecticut. If we are unable to do this, maybe we should exempt municipalities? Mr. BADGER. I think that that would be a step in the right direc- tion, but unfortunately, I think what we have is, we have neighbor- hoods with people living next to each other, that are served by mu- nicipals, and the very next house is served by public investor- owned utilities, and I'm sure that is going to cause some concern about different treatment for people situated in identical circum- stances. That would be the only comment. Mr. MCGRATH. I would think Mr. Perlman probably would have another response to that. Could you, Mr. Perhnan, respond to that? Mr. PERLMAN. Congressman, in new development outside of cor- porate entities, it doesn't help builders at all. I think our position on the answer to your first question is that there is an affordability crisis in this country. Housing certainly, by virtue of being 5 per- cent of the gross national product of this country, causes a domino effect that over the long term could make up for the tax loss. Mr. MCGRATH. I thank the chairman. = Chairman RANGEL. Let me thank the panel for their contribution to this issue. We will make our recommendations to the full com- mittee. The next panel, Ray Green, president, National Automobile Dealers Association; John Cone, chairman, legislative committee for the National Independent Automobile Dealers; Don Alexander, our old friend, counsel, former IRS Commissioner, representing United Brands Co.; Glenn Graff, executive vice president and chief financial officer of Linbeck, Associated General Contractors of America; Robert Turner, past national president of the Associated Builders and Contractors; and John Sedlock, chief fmancial officer of Cushman & Wakefield, Inc. Let me ask those people that are conversing to please leave the hearing room. We'll start this panel off with the president, Ray Green, of the National Automobile Dealers. STATEMENT OF RAY GREEN, PRESIDENT, NATIONAL AUTOMOBILE DEALERS ASSOCIATION Mr. GREEN. Mr. Chairman- Chairman RANGEL. What's the problem, photographer? Thank you. Mr. GREEN. Mr. Chairman, and members of the subcommittee, good morning. My name is Ray Green. I am a Chevrolet dealer from Jacksonville, IL, and president of the National Automobile Dealers Association, a trade association representing approximate- ly 20,000 franchised car and truck dealers that sell both new and PAGENO="0348" 338 used vehicles. On behalf of the association, I would like to express my appreciation for the opportunity to. testify before you today in support of H.R. 2041, introduced by Congressman Ed Jenkins, to re- store .the use of the installment sales method of accounting for sales of older, lower priced automobiles. This is a matter of great importance to the retail . automobile industry, as well as to the low- income automobile consumers of this Nation. As a result of legislation enacted in 1987, retail sales of personal property, including automobiles, no longer qualify for installment sales treatment. Thus, under current law, a dealer that sells an older, lower priced car and provides the financing himself must report and pay all tax on all of the profit from the sale in the year in which the sale is made. This is true even if the dealer receives only a portion of the sales price during the year of the sale, and receives the remainder only as the note is paid in the following year, or the year after that. In many cases the amount of tax owed as a result of the sale will exceed the amount of money actually received during the first year. This rule obviously discourages deal- ers from financing sales of older, lower priced cars. The 1987 legislation has had perhaps its greatest impact on the low-income consumer. Usually, these consumers have no credit his- tory or are otherwise viewed as high-credit risks, and do not have access to other, more traditiOnal, sources of financing. I can recall a time not very long ago when banks and finance companies were willing to finance sales of inexpensive used cars to low-income con- sumers. However, as more profitable and less risky sources of busi- ness became available, these national institutions left this business behind, abandoning the low-income automobile consumer. Mr. Chairman, the absence of other sources of financing, togeth- er with these restrictions on the use of the installment method, make it very difficult for lower income consumers to finance pur- chases of cars. This creates a hardship for lower income consumers who need a source of transportation to get to and from work. Often, an inexpensive used car or truck is the only available means of transportation for these people. Congressman Jenkins' proposal would address the situation by restoring the use of the installment sales method for cars that are more than 3 years old, and that are sold for $6,000 or less. Even though Mr. Jenkins' proposal is limited in scope, we support it be- cause it covers the very cars typically purchased by low-income consumers who need an inexpensive source of transportation. Mr. Chairman, if Mr. Jenkins' amendment is enacted, it will by no means be the only exception to the original rule barring the use of the installment method for retail sales. The code already con- tains two exceptions to that rule. One is for equipment used in farming, and this is understandable. Farmers often need creative financing, and an exception such as this, which encourages loans for the purchase of farm equipment, is appropriate and wise. We see the exception for older and less expensive used cars as essen- tially equivalent to the exception for farm equipment. A majority of low-income consumers needs a vehicle to get to and from work. For them, a car is not a luxury, it is a necessity. The second exception under the current~ law is for timeshares and we find this a bit curious. With all due respect, I fail to see PAGENO="0349" 339 how Congress could provide an exception for timeshares and not for inexpensive transportation for the working poor. Let me note that these are not the best of times for America's automobile dealers. Nonetheless, to facilitate sales to consumers who cannot qualify for more traditional sources of financing, it is my judgment that a number of dealers would be willing to bear the risk of financing the vehicles if we are not forced to pay tax on the proceeds of the sale until we receive them. Congressman Jenkins, as well as Senators Boren and Pryor, have recognized this problem and should be commended for addressing it in H.R. 2041 and S. 567. On behalf of the dealers of this Nation, I thank you for your consideration and urge you to support H.R. 2041. [The statement of Mr. Green follows:] PAGENO="0350" 340 STATEMENT OF THE NATIONAL AUTOMOBILE DEALERS ASSOCIATION Mr. Chairman and Members of the Subcommittee: Good morning. My name is Ray Green. I am a Chevrolet dealer from Jacksonville, Illinois and President of the National Automobile Dealers Association, a trade association representing approximately 20,000 franchised car and truck dealers that sell both new and used vehicles. On behalf of the Association, I would like to express my appreciation for the opportunity to testify before you today in support of H.R. 2041, introduced by Congressman Ed Jenkins, to restore the use of the installment sales method of accounting for sales of older, lower priced automobiles. This is a matter of great importance to the retail automobile industry, as well as to the low income automobile consumers of this nation. As a result of legislation enacted in 1987, retail sales of personal property, including automobiles, no longer qualify for installment sales treatment. Thus, under current law, a dealer that sells an older, lower priced car and provides the financing himself must report and pay tax on all of the profit from the sale in the year in which he made the sale. This is true even if the dealer receives only a portion of the sales price during the year of the sale and receives the remainder only as the note is paid in the following year or the year after that. In many cases the amount of tax owed as a result of the sale will exceed the amount of money actually received during the first year. This rule obviously discourages dealers from financing sales of older, lower priced cars. The 1987 legislation has had perhaps its greatest impact on low income consumers. Usually these consumers have no credit history or are otherwise viewed as high risk credits, and do not have access to other, more traditional, sources of financing. I can recall a time not very long ago when banks and finance companies were willing to finance sales of inexpensive used cars to low income consumers. However, as more profitable and less risky sources of business became available, these national institutions left this business behind, abandoning the low income automobile consumer. Despite the risks inherent in this financing, I believe that many dealers would be willing to finance sales to low income consumers if the restrictions on the use of the installment sales method by dealers were removed. Under present law, these restrictions put dealers that offer this financing in the untenable position of having to pay tax on income they have not received, and may never receive. Mr. Chairman, the absence of other sources of financing, together with these restrictions on the use of the installment method, make it very difficult for low income consumers to finance purchases of cars. This creates a hardship for low income consumers who need a source of transportation to get to and from work. Often, an inexpensive used car or truck is the only available means of transportation for these people. Congressman Jenkins' proposal would address this situation by restoring the use of the installment sales method for cars that are more than three years old and that are sold for $6,000 or less. Even though Mr. Jenkins' proposal is limited in scope, we support it because it covers the very cars typically purchased by low income consumers who need an inexpensive source of transportation. * We understand that when you analyze this proposal you will need to consider its effect on Federal revenues. There are a number of reasons that lead us to believe that this bill will not have much, if any, cost to* the Treasury. First, the typical term of a loan for an inexpensive used car is only two years, and thus the tax deferral is very limited. Second, Mr. Jenkins' proposal would require that dealers pay the government interest on the deferred tax liability. Third, I am convinced that enactment will increase the level of sales to low income consumers and generate additional taxable income. In any event, the revenue impact of Mr. Jenkins' proposal could be reduced significantly if the effective date were changed so that the provision only applies to sales after the date of enactment. Mr. Chairman, if Mr. Jenkins' amendment is enacted, it will by no means be the only exception to the general rule barring the PAGENO="0351" 341 use of the installment method for retail sales. The Code already contains two exceptions to that rule. One is for equipment used in farming and this is understandable. Farmers often need creative financing and an exception such as this which encourages loans for the purchase of farm equipment is appropriate and wise. We see the exception for older and less expensive used cars as essentially equivalent to the exception for farm equipment. The U.S. Department of Transportation has estimated that of the people who earn less than $10,000 per year, 62 percent drive to work, For people earning between $10,000 per year and $40,000 per year, the figure jumps to 82 percent. In many cases this is because public transportation is unavailable. For these people, their car is very much a necessity. The second exception under current law is for timeshares and we find this a bit curious. With all due respect, I fail to see how Congress could provide an exception for timeshares and not for inexpensive transportation for the working poor. Let me note that these are not the best of times for America's automobile dealers. Nonetheless, to facilitate sales to consumers who cannot qualify for more traditional sources of financing, it is my judgement that a number of dealers would be willing to bear the risk of financing the vehicles, if we are not forced to pay tax on the proceeds of the sale until we receive them. Congressman Jenkins, as well as Senators Boren and Pryor, have recognized this problem and should be commended for addressing it in H.R. 2041 and S. 567. On behalf of the dealers of this nation, I thank you for your consideration and urge you to support H.R. 2041. PAGENO="0352" 342 Chairman RANGEL. Mr. Cone, would you like to share your views and that of the National Independent Automobile Dealers Associa- tion on this? STATEMENT OF JACK. CONE, COCHAIRMAN, LEGISLATIVE COM- MITTEE, NATIONAL INDEPENDENT AUTOMOBILE DEALERS AS- SOCIATION, ACCOMPANIED BY HENRY HELWIG, CHAIRMAN, AD HOC COMMITTEE ON INSTALLMENT SALES, HENRY JONES, CO.. CHAIRMAN, LEGISLATIVE COMMITTEE, AND MICHAEL LEMOV, WASHINGTON, DC,. COUNSEL Mr. CONE. Chairman Rangel, Congressman McGrath, and mem- bers of the subcommittee, thank you for inviting us here today to discuss the repeal of the installment method of accounting and the severe impact it has had on independent automobile dealers na- tionally. My name is Jack Cone. I am an independent automobile dealer from Fort Worth, TX, and cochairman of the legislative committee of the National Independent Automobile Dealers Association, known as NIADA. I am accompanied here today by two of my col- leagues in the car business from Cocoa Beach, FL, Henry Helwig, and Henry Jones from Norfolk, VA, and also our Washington, DC counsel, Mike Lemov. We are here today to urge your support for H.R. 2041, introduced by Congressman Jenkins and 63 cosponsors, 6 of them on this com- mittee, which will restore in a limited way the installment method of tax accounting for sales of used cars over 3 years old and less than $6,000. We feel this bill represents a fair solution to this seri- ous problem. The independent automobile dealers of this Nation provide a valuable service to American consumers, particularly low- and moderate-income people, and while we understand the desire of Congress to search for ways to increase revenue, this repeal of a 63-year-old method of accounting did not increase reve- nue to the Government, but only accelerated the payment of taxes, and it is, frankly, putting us out of business. NIADA's membership includes State associations with a mem- bership of over 15,000 independent automobile dealers, licensed by their respective States to buy, sell, or auction motor vehicles throughout the United States. There are more than 70,000 licensed used car dealers in the United States. Over 25 million used cars are sold annually. Mr. Chairman, we estimate the average length of the installment notes offered by NIADA dealers to be only 19 months, and thus, any tax acceleration caused by the repeal only results in a modest increase of funds to the Treasury for a year or so. But, Mr. Chairman, while the U.S. Treasury is effectively borrowing money from small busi- nesses, the result is to take from them their working capital, force them to borrow at exorbitant rates, if they can borrow at all, and require payment of Federal taxes before income is realized. Three of us sitting at this table are actively involved in selling used cars, both through the installment method and the cash method. We have about 60 combined years of experience in the used automobile business. As you know, the installment method sales provision of the Internal Revenue Code, which has been law PAGENO="0353" .343 for over 60 years, permitted dealers selling on the installment plan to pay. the tax on the profit from such sales as consumer payments were received. When the installment method was repealed, no hearings on the potential effect of the repeal were held. Now, a dealer selling a used car on the installment plan must pay Federal income taxes on 100 percent of the potential future profit when the sale is agreed to, even though no payments yet~-have been received. The rationale at the time was that dealers, indirectly, received cash from those sales through their potential ability to borrow, own, or sell the installment notes to a bank or other financial insti- tution. The reality is that installment notes on older cars bought by moderate and low income buyers, who are often less favorable credit risks, cannot usually be sold, and if sold, are substantially discounted, sometimes up to 50 percent. Such a charge erodes all profits from the transaction. For example, we have received a letter from a dealer in Rock- ledge, FL, `who tried to finance receivables, but was told by his banker, Joe, if this paper was of the quality to borrow against, you could put the customers through traditional lending sources. As I have stated before, the majority of our customers do not have access to ready cash, may not have regular jobs or adequate securi- ty, and cannot obtain outside financing. In addition, the repeal creates a competitive disadvantage for small dealers, virtually all of whom qualify as small businesses under the Small Business Administration's definition. Large deal- ers, who have established relationships with banks or who are better capitalized, may be able to complete the installment sales. Smaller dealers, however, do. not have this type of capitalization, or such relationship with financial institutions. They therefore must forego sales and are thus placed at a competitive disadvantage. The repeal has primarily hurt dealers who serve low and moder- ate income consumers. On. the board on my left, and attached as exhibit A, are nine pictures one of our dealers, Ken Loveless, of Manassas, VA, has taken of a representative group of the people he has sold used cars to on the installment method in the last 90 days. I think you can see who they are. They are young couples who, are just starting out, students, families, and people who, without dealer self-financing, would probably be unable to purchase a car. These consumers purchase transportation out of necessity to `get to jobs, to schools and doctors. Look at the cars they purchased. They are definitely not the luxury and late model cars that the financial institutions finance. Because ,of their often unfavorable or nonexistent credit history, lack of current in'come, or other reasons, these buyers are unable to qualify for loans from banks or finance companies, and while I don't want to sound overly dramatic, for some consumers, it can mean the difference between taking that job that is a little out of town or not working at all. As Don Scott, of Don Scott Motors in Ocala, FL, wrote, "My cus- tomers `don't understand why I can't help them with their trans- portation needs, especially the ones I have helped before. They don't want to hear about our tax problems. They want to get away to work in order for them to feed their families and keep a roof 30-860 0 - 90 - 12 PAGENO="0354" 1 over their head" Unfortunately, as of May 1989, 34 used car in stallment dealers have gone out of business in Ocala, FL, alone Prepayment of Federal income tax has forced many dealers to close, reduce the size of their business, lay off employees, or cancel expansion of their business. We have received many letters from dealers severely affected by the repeal. Mr William Bonner, a CPA from Austin, TX who has several dealers as clients, recently sent us a pro forma example of a deal- er's financial statement for one of his dealers, and is enlarged on the board to my left. As you can see, after the repeal, there is a tremendous increase in taxable income, tax liability,, and a de- crease in aftertax income and equity. H.R. 2041, introduced by Congressman Ed Jenkins and its Senate~ companion, S. 567, introduced by Senator David Boren and Senator David Pryor, would restore the installment method of accounting for licensed new and used car dealers in a limited way, would apply only to automobiles over 3 years of age, valued at $6,000. In conclusion, we ask you to carefully review the repeal of the installment method as it applies to older, used cars. It has become, as Senator Boren said, an interest-free loan from small business to the Government. We feel H.R. 2041 represents a fair approach to a devastating problem for small automobile dealers and their custom- ers. It will assist many small businesses currently. facing bankrupt- cy or severe economic problems this year because of this change. We need your help in rectifying this situation, which has already done serious damage to our industry and to the public, and we urge your support for passage of H.R. 2041. I would be happy `to answer any questions you might have, or provide the committee with any other information. [The statement of Mr. Cone and attachments follow:] PAGENO="0355" 345 Testimony of - Jack Cone Chairman, Legislative Committee National Independent Automobile Dealers Association onthe Small Automobile Dealer Installment Sales Act H.R. 2041 Accompanied by: D. T. Mosley, Houston, Texas Charles Tupper, Dallas, Texas Henry Helwig, Cocoa Beach, Florida Henry Jones, Norfolk, Virginia Michael R. Lemov, Washington, D.C. Before the House Ways and Means Subcommittee on Select Revenue Measures Honorable Charles B. Rangel, Chairman February 22, 1990 Chairman Rangel, Congressman Vander Jagt, and Members of the Subcommittee, thank you for inviting us here today to discuss the repeal of the installment method of accounting and the severe impact it has had on independent automobile dealers nationally. My name is Jack Cone. I am an independent automobile dealer from Ft. Worth, Texas and Co-chairman of the Legislative Committee of the National Independent Automobile Dealers Association known as NIADA. I am accompanied by D. T. Mosley of Houston, Texas, President of NIADA; Charles Tupper of Dallas, T2xas, Executive Vice President; Michael Lemov, NIADA's Washington, D.C. Counsel; Henry Helwig from Cocoa Beach, Florida, Chairman of our Ad Hoc Committee on Installment Sales'; and Henry - Jones from Norfolk, Virginia, my Co-chairman on the Legislative Committee. We are here today to urge your support for H.R. 2041, introduced by Congressman Jenkins and 63 cosponsors, many of them on this Committee, which will restore in a limited way the installment method of tax accounting for sales of used cars over 3 years old and valued at less than $6,000. We feel this bill represents a fair solution to this serious problem. The independent automobile dealers of this nation provide a valuable service to American consumers~, particularly low and moderate income people, and, while,'we~understand the desire of the Congress to search for waysto increase revenue, this repeal of a 63 year old method;of,~accounting ~ ~ increase revenue to the government, but only acce,ierates the payment of taxes. And it i's, frankly, putting manyof us out of `business. NIADA's membership includes state associations with a membership of over 15,000 independent automobile dealers, licensed by their respective states to buy, sell or auction motor vehicles throughout the United States. All our members subscribe'' to NIADAscode of business ethics and are committed to assuring' the consumer good automobiles at a fair price. NIADA is the only national trade association representing licensed used car dealers. There are more than 70,000 licensed used car dealers in the United States. `Over 25 million used cars are sold annually. Some states rely more heavily on installment dales by dealers than others. A survey by NIADA in 1988 showed that in Florida approximately 83% of the dealers sold ~ cars by the installment method, in Georgia, 80%; Missouri, 73%; and Texas, 75%. Obviously, in these areas, so dependent on inexpensive vehicular transportation, the repeal of the installment method is a particular hardship to dealers and consumers. The Northwest and upper Midwest probably have been less affected. Mr. Chairman, we estimate the average, length of the installment notes PAGENO="0356" 346 offered by NIADA dealers to be only 19 months, thus any tax acceleration caused by the repeal only results in a modest increase of funds to the Treasury for a year or so. But, Mr. Chairman, while the U.S. Treasury is effectively "borrowing" money from small businesses, the result is to take from them their working capital, force them to borrow at exorbitant rates (if they ~ borrow at all) and require payment of federal taxes before income is realized. Four of us sitting at this table are actively involved in selling used cars both through the installment method and for cash. We have about 100 combined years of experience in the used automobile business. We know the kinds of consumers who use the installment method and what has happened to our industry since its repeal by the Omnibus Reconciliation Act of 1987. REPEAL OF THE INSTALLMENT METHOD As you know, the installment sales provisions of the Internal Revenue Code, which had been law for over sixty years, permitted dealers selling on the installment plan to pay the tax on the profit from such sales as consumers' payments were received. In the last days of the first session of the 100th Congress, the Omnibus Budget Reconciliation Act was passed. Among the many amendments agreed to was a. repeal of this provision. No hearings on the potential effect of the repeal were held. Now, a dealer, selling a used car on the installment plan must pay federal income taxes on 100% of the potential future profit when the sale is agreed to even though no payment has yet been received. The rationale at the time was that dealers indirectly received cash from those sales through their potential ability to borrow on or sell the installment notes to a bank or other financial institution. Senate Finance Committee Report 100-63 (December 1987, p. 145) stated that: The current taxation of sales of inventory for notes receivable does not create the significant cash flow problems that the installment method is designed to alleviate, because a business generally is able to finance receivables. (Emphasis added.) The reality, however, is that installment notes on older cars, bought by moderate and low income buyers who are often less favorable credit risks, cannot usually be sold, and if sold, are substantially discounted, sometimes up to 50%. Such a charge erodes all profits from the transaction. For example, we received a letter from a dealer in Rockledge, Florida who tried to finance receivables, but was told by his banker, "Joe, if this paper was of the quality to borrow against, you could have put the customers through traditional lending sources." Moreover, the assumption that dealers could require their customers to choose other financing, alternatives without losing sales is false. As I have stated before, the majority of our customers do not have access to ready cash, may not have regular jobs or adequate security and cannot obtain outside financing. COMPETITIVE DISADVANTAGE FOR SMALL BUSINESS In addition, the repeal creates competitive disadvantages for small dealers, virtually all of whom qualify as small business under the Small Business Administration's definition. Large dealers who have established relationships with banks or who are better capitalized may be able to complete installment sales. Smaller dealers, however, do not have this type of capitalization or such relationships with financial institutions. They therefore must forego sales and are thus placed at a competitive disadvantage. PAGENO="0357" 347 WHO THE REPEAL HURTS The repeal has primarily hurt dealers who serve low and moderate income consumers. On the board on my right and attached as Exhibit A are nine pictures one-of our dealers, Ken Loveless, from Manassas, Virginia, has taken of a representative group of the people he has sold used cars to on the installment method in the last 90 days. I think you can see who ±hey are: young couples just starting out, students, families, and people who, without dealer self-financing, would probably be unable to purchase a car. These consumers purchase transportation out of necessity to get to jobs, to school, to doctors, etc. Look at the cars they purchased. These are definitely jjg~, the luxury and late model cars that the financial institutions finance. Because of their often unfavorable or nonexistent credit history, lack of current income or other reasons, these buyers are often unable to qualify for loans from banks or finance companies. Consumers in cities and states with limited mass-transit such as Texas, Florida and the Sun Belt have been particularly hard hit. Dealers who are willing to take on loans from these consumers are providing an essential service for which there is often no alternative in place. If the bank or finance company won't lend them money, or they do not have the cash for the purchase and independent dealers can no longer offer a financing plan, they.don't get a car. And while I don't want to sound overly dramatic, for some consumers it can mean the difference between taking that job that is a little out of town and not working. As Don Scott of Don Scott Motors in Ocala, Florida wrote us: "My customers don't understand [why I can't help them with transportation] especially the ones I helped before . . . . They don't want to hear about our tax problem, they want a way to get to work in order for them to feed their families and keep a roof over their head." Unfortunately, as of May 1989, 34 used car installment dealers have gone out of business in Ocala, Florida alone. The repeal of the installment method also hurts independent dealers. It requires dealers to pay taxes in cash on income that has not yet been received. The dealers are generally unable to finance or sell such paper or can only do so at a great discoun-t. Where financing is possible, the rates are so high that the transaction is unprofitable. Adding prepayment of federal income tax has forced many dealers to close, reduce the size of their business, lay off employees, or cancel expansion of their businesses. We have received many letters from dealers severely affected by the repeal. Mr. William Bonner, a CPA from Austin, Texas, who has several dealers as clients, recently sent us a pro forma example of a dealer's financial statement for one of his dealers before and after the repeal, which is attached as Exhibit B. As you can see, after the repeal there is a tremendous increase in taxable income, tax liability and a decrease in after-tax income and equity. Who benefits from the repeal? Good question. Our opinion is that no one benefits -- not even the government. The repeal does not actually result in any increase in federal tax revenues, since all federal tax payments would have been paid anyway as customer installment payments were received by dealers. And the consequences of the repeal -- lost jobs, small businesses being forced to close, and moderate and low income consumers' needs not being met --. are significant and will certainly result in real lost tax revenues to the government. H.R. 2041 H.R. 2041, introduced by Congressman Ed Jenkins, and its Senate companion, S. 567, introduced by Senator David Boren and Senator David Pryor, would restore the installment method of accounting for licensed new and used car dealers in a limited PAGENO="0358" 348 way. The bill would only apply to automobiles over 3 years of age, valued at $6,000 or less and the length of the installment note issued would be limited to 36 months. The bill would also limit the total amount of income deferred to $4,000,000 per dealer, per year. (The Senate bill limit is $2,000,000.) Thus, the legislation is specifically targeted at the category of dealer most affected by the repeal and the category of car most often sold to low and moderate income buyers. In September of 1988, Senator Boren requested a revenue estimate of this proposal. As you can see, although there is a deficit (-$76 million) in the first year, it is relatively small, and rapidly becomes positive revenue to the government. A second revenue estimate was furnished to Congressman Jenkins on January 19, 1990. (Both estimates are attached as Exhibit C.) It reflects positive revenues to the government in four out of five years and a modest revenue loss over five years. We continue to believe that there is no negative revenue effect in this legislation at all; however, even the claimed revenue loss of the joint committee must be weighed against the long-term cost to the government of small businesses closing, lost jobs, and low and middle income consumers restricted by the unavailability of transportation. In conclusion, we ask you to carefully review the repeal of the installment method as it applies to gj~, used cars. It has become, as Senator Boren said in his floor statement, `an interest-free loan from small business to the government." We feel H.R. 2041 represents a fair approach to a devastating problem for small auto dealers and their customers. It will assist many small businesses currently facing bankruptcy or severe economic problems this year because of this change. We need your help in rectifying this situation which has already done serious damage to our industry and to the public. We urge your support for passage of H.R. 2041. I would be happy to answer any questions you have or provide the Committee with any additional information it may need. PAGENO="0359" 349 PAGENO="0360" 350 EXHIBIT B Yld/jam .~J ~ Jy. ~,t~y~d ~3?3~j4~, ~ WHITNEY BLDG . SUITE 1QI MEMBER: .. KOGER EXECUTIVE CENTER AMERICAN INSTITUTE OFCPAS 7719 W000HOLLOW DRIVE TEXAS SOC1ETY OF CPA'S AUSTIN. TEXAS 79731 AUSTIN CHAPTER OF CPAS 5121 346-1185 February 16, 1990 .. . .. Mr. Michael Lemov Kelly, Drye & Warren 2300 M Street NW Washington, D.C. 20037 RE: Automobile Dealers * Installment method of accounting Dear Mr. Lemov: Thank you for selecting the information I submitted to be included in your presentation before the House Ways And Means Subcommittee on Select Revenue Measures. The enclosed financial information represents the results of operations of a corporate used car note dealer in Austin, Texas. The sole shareholder of the corporation elected to be taxed under Chapter 5 of the Inter- nal Revenue Code. Based on this electiOn, the shareholder computes federal income taxes by including the net income and other special deductions of the corporation and income and deductions from other sources on his personal income tax return. Since a tax computation including other items would tend to skew the actual tax ramifica- tions, the enclosed computations have been prepared as if the corporation is a Chapter C corporation, whereby. the corporation computes federal income taxes on its own profits without inclusion of other personal items. The information previously submitted on May 4, 1988, did not include all year-end adjust- ments. The enclosed schedules have been revised and include these items. If you need additional information or if I may be of assistance, please do not hesitate to contact me. .. Sincerely yours, -~ William A. Bonner, Jr. Enclosures PAGENO="0361" WHITNEY BLDG . SUITE 101 000ER EXECUTIVE CENTER 7719 W000HOLLOW DRIVE AUSTIN. TEXAS 78731 TEXAS USED CAR DEALER Based On Actual 1987 Financial Information SALES REVENUE -Cash Sales -Installment Sales -Other Income -Section 481 Income ______ Gross Sales COST OF GOODS SOLD -Cash Sales -Installment Sales _______ ________ Total Cost Of Goods Sold _______ _______ *Gross Profit OPERATING EXPENSES Operating Expenses _______ _______ Net Income Before Corporate Federal Income Tax Federal Income Tax _______ Net Income From Operations Footnotes: Income and expenses for both periods are based on 1987 sales data. Federal income taxes for 1987 and 1988 have been computed at the applicable rates for each respective period to provide net tax effect after tax rate reductions which occurred in reform act. 1 351 ~/elliarn ~J ~ /)e. (9q~),4~~ ~J1a~ ~hc~a'n~n1 MEMBER: AMERICAN INSTITUTE OF CPAS TEXAS SOCIETY OF CPAS AUSTIN CHAPTER OF CPAS 1988 Tax Law Accrual Method Income After Tax Law Revisions With Section 481 Phase-In 1987 Tax Law Installment Method Income Before Tax Law Revisions $ 406,891 828,426 6,837 ~ $ 1,242,154 $ 328,301 455,820 $. 784,121 $ 458,033 $ 406,891 1,171,583 6,837 55,098 $ 1,640,409 $ 328,301 571,579 $ 899,880 $ 740,529 $ 450,618 $ 450,618 $ 7,415 $ 6,303 $ 289,911 _92 , 566 $ 197,345 PAGENO="0362" We/ham ~J /n~n~e. ~ ~i~d ~4&~ ~/~cca~t&~nt MEMBER: AMERICAN INSTITUTE OF CPRS TEXAS SOCIETY OF CPAS AUSTIN CHAPTER OF CPUS Income Comparison Installment Method Income Vs Cash Method Income Column "A" - With Deferred Cost Of Sales Column "B" - Without Deferred Cost Of Sales Column "A" Column "B" 1987 Tax Law 1987 Tax Law Installment Method Cash Method (From Page 1. Cm ii~ 1987 Year Gross Sales $ 1,242,154 $ 1,242,154 Cost of Sales 7~4~121 899~88O Gross Profit $ 458,033 $ 342,274 operating Expenses & FIT 450,618 450,618 Corporate Federal Income Tax _~~JJZ Income (Loss) After Taxes $ 6,303 (S 109,456) This example provides the actual differences in corporate income which occur if the corporation computed income on the cash method of accounting. All other factors are identical in both computa- tions. All amounts are based on 1987 data & 1987 tax rates. Balance Sheet Comparison Cash Flows Based On Installment Vs Actual Cash Method Column "A" Column "B" 1987 Tax Law Dealer's Cash Installment Method Cash Method f~rom Above Datal From Above Data 100% $2.204,i95 100% $1,057,406 91% 2,014,988 108% 1,145,996 9% 190,919 ( 8%) ( 88,590) 100% $2,204,795 100% $1,057,406 2 352 WHITNEY BLDG . SUITE 1U1 ROGER EXECUTIVE CENTER 7719 WOODHOLLOW DRIVE AUSTIN.TEXAS 7R731 Total Assets Total Liabilities Total Equity PAGENO="0363" 353 / EXHIBIT C h. D / ~ Con~re~g of tbe ~n1ttb itate~ .I0sN? CODNITT cu Teavrno. 1011 L0N~ITW N0US$S~~I susaiws Wa~~ DC Dm15-1453 ~U54S21 S~P 23 1988 Honorable David L. Boren United States Senate Washington, DC 20510 Dear Senator Boren: This is in response to your requests of August 24, 1988, and September 14, 1988, that we review revenue estimates we provided you for proposals which would permit certain used car dealers to use the installment method of accounting. Tour proposals are attached. The broader proposal (requested on July 6, 1988) would permit dealers to use the installment method for sales of cars which are. more than three years old:and sold for less titan $6,000. The narrower proposal (referred to as amendment number two and.riquestsd on July 28, 1988) is more restrictive because it limits the mazisum annual deferral to $2 million per dealer, excludes dealers with gross revenues above $15 million, and applies only to installment notes which have terms of 24 months or less. In addition, this narrower amendment would expire on December 31, 1990. In both proposals, dealers wh~ use the installment method would be subject to the interest rules as provided under Section 453(A)(c), and both proposals are intended to be restricted to dealers who exclusively sell used cars. The estimates we sent you on August 2, 1988, assumed that the proposals covered all sales of used cars; that is, they were not restricted to those dialers who exclusively sell used cars. The estimates provided in this letter include this restriction. We estimate that these proposals would change budget receipts as follows, assuming that the amendments are effective for taxable years beginning after December 31, 1987: PAGENO="0364" 354 ___d rge ~n~ttb btatt~ Joili? CouMlYrU ON TaxaTioN U.*riIi~B.C. ~615 S~P 2~1988 Eonorabls David L. Boren United States Senate Page 2 ?iscal Tears tMilliOfls of Dollars] Item 1989 1990 1991 1992 1993 1989-91 1989-93 Broad .iigibility... -129 -9 -3 -3 -3 -141 -147 Narrow eligibility with sunset... -76 1 38 40 10 -37 13 I hope this information will be helpful to you. If vs can be of further assistance please let me know. Sincerely, Bonald A. Pearlman PAGENO="0365" 355 ,itp$~I - ~r~r ~IN CIfl~RJ1 of tbt Intttb btatti -~`.-~ -~`~`~ J0~ C0M*~$ IN t*M?I$N iou L0II$w0NTh ~usi oc~ci $UII.DSN$ We~*esm~ SC $0Sl$.445$ (20I~ 021.5521 *.J~N19~ ~onorab1e Zd Jenkins U.S. House of *epresentatiues 2427 Rayburn Souse Office suilding Washington, DC 20513 Dear )Ir. Jenkinis This is in response to your request dstsd Deceaber 25, 1959, for a revenue estimate of !.L 3041, a bill which would permit the usage of the installment sal. method for tax purposes by certain sellers of used cars. !our letter also requested an estimate of a ~savers ano investorsw proposal. We wilt provide an estimate for that proposal as soon as it becomes available. LR. 2041 would perwit th5 usage ot the installment method for cars which are at least three years old, are sold for 1... than $6000, and have associated imatallaLent obligations listing less than three years. In addition, the face amount of obligations held by an aligible dealer must not .zc.qd $4 million, we assume that there is no restriction on new car dealers who also sell used cars, and that the bill would be effective for sales made after December 31, 1987. we estimate that this proposal would change fiscal year budget receipts as follov~; [Kit].lo~bo1ia*B1 A!P1 Ufl A221 !~21 ~!2& ~W" .43 7 7 7 8 -64 I hope this information is helpful to you, If we can be of further assistance, please let m know. (~ Lncer4y, ~oJ MLL~ lena].6 A. Pearlasm PAGENO="0366" 356 Chairman RANGEL. Thank you, Mr. Cone. Mr. CONE. Thank you. Chairman RANGEL. Commissioner Alexander, representing the United Brands Co. STATEMENT OF DONALD C. ALEXANDER, COUNSEL, UNITED BRANDS CO., CINCINNATI, Oil, FORMER COMMISSIONER, IN- TERNAL REVENUE SERVICE Mr. ALEXANDER. Thank you, Mr. Chairman, Mr. McGrath, Mr. Archer. I am here on behalf of United Brands Co., which markets Chiquita bananas, and the purpose of my being here is to discuss with you the need to correct a technical correction in 1988 that made a large substantive change. I won't go through a lot of my statement with you, other than to point out that the Internal Revenue Service was concerned, back in the middle 1970's, with farm tax shelters, so in 1976, Congress en- acted some rules to help the Service deal with them, requiring cer- tain farmers to go on the accrual method of accounting. In 1976, an exception was made for those who are on the annual accrual method and who had been on it for 10 years, and who stayed on it since 1976. Basically, only sugar cane, bananas, and pineapples could qualify. And Congress, of course, has a lot of different rules for different types of farmers, and* different types of farm products, of course. The Treasury's suggestion of a uniform rule, defies, I think, a read- ing of section 263A of the code, among other things. But what happened in 1986 was that Congress took another look. at the rules regarding capitalization of pre-productive expenses, tightened them up, but stated specifically in the House report that those entitled to use the annual accrual method could continue to use it. However, in 1988, a technical correction limited the annual accrual method to sugar cane, which meant that bananas and pine- apples, which were entitled to the annual accrual method in 1986, and all years prior thereto,. suddenly found themselves deprived of that entitlement, and were required to capitalize their pre-produc- tive expenses. Now, that wasn't a technical correction, that was a substantive change masquerading as a technical correction. Last year, the Senate attempted to restore prior law in the Senate amendments which were, of course, eliminated in the grand compromise., Mr. Chairman, I hope that this committee will look into this situ- ation, and correct the technical correction which removed bananas and pineapples from the. list of three crops entitled to use the annual accrual method. [The statement of Mr. Alexander follows:] PAGENO="0367" 357 STATEMENT OF DONALD C * ALEXANDER CADWAL~DER, WICKERSHAN & TAFT BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS UNITED STATES HOUSE OF REPRESENTATIVES Mr. Chairman and Members of the Subcommittee: I appreciate the opportunity to discuss the proposal to amend section 447(g) of the Internal Revenue Code, relating to the use of the annual accrual method of accounting by certain farming corporations and partnerships. I am a partner in the law firm of Cadwalader, Wickersham & Taft, and am appearing today on behalf of the United Brands Company ("United Brands"). We support the proposal, which would clarify the intent of the drafters of the Tax Reform Act of 1986 (the "1986 Act") that any taxpayer satisfying the threshold requirements of section 447(g) and not subject to prior law section 278 would be eligible for the annual accrual method of accounting undet section 447 (g). Under the annual accrual method, preproductive expenses may be deducted rather than capitalized. This proposal would modify a revision to section 447(g) made by section 1008(b) (6) of the: Technical and Miscellaneous Revenue Act of 1988 ("TAMPA"), which purported to clarify section 447(g) as revised by the 1986 Act by restricting its scope to a "qualified farming trade or business." A "qualified farming trade or business" under current law consists only of the business of farming sugar cane. Under the proposal as approved by the Senate Finance Committee last October, a "qualified farming trade or business", would be redefined as the trade or business of farming "any crop with respect to which the taxpayer properly used the annual accrual method of accounting for its last taxable year ending before January 1, 1987." Section 6627, Revenue Reconciliation Act of :i9~89 (revenue measures approved by the Senate Finance Committee `on October 3, 1989). The provision would be effective as if included in the 1986 Act. United Brands is a major producer of bananas. Prior to the "clarification" of section 447(g) by TAMPA, United Brands was entitled to deduct its preproductive expenses related to the growing of bananas. There is no rational basis for allowing such deductions for sugar cane growers but not for banana growers. A' proper understanding of this issue requires some background. The Tax Reform Act of 1969 added section 278 to the Internal Revenue Code. Section 278(a) required the capitaliza- tion of costs associated with a citrus or almond1 grove during the first four years after planting. A new section 278(b) was added by the Tax Reform Act of ~l97~ (the "1976 Act"), providing a special capitalization requirement for farming syndicates (as defined in section 464(c)). Under this rule, costs associated with fruit or nut farming were required to be capitalized to the extent such costs were incurred prior to the first taxable year in which a crop was obtained in commerciai quantities.2 tfriited Brands was not subject to the restrictions of section 278. 1 The provisibn was extended to almond groves by P.L. 91-680, effective for taxable years beginning after January 12, 1971. - 2 A special exception to section 278(a) and (b) was provided in section 278(c) for costs associated. with replanting necessitated by a casualty loss. PAGENO="0368" 358 The Tax Reform Act of 1976 also added section 447 to the Internal Revenue Code. The general purpose of section 447 was to require a corporation (or a partnership with a corporate partner) engaged in a farming business to use the accrual method of accounting and to capitalize preproductive expenses associated with the farming activity. An exception to this capitalization requirement was provided in section 447(g). Under section 447(g) (1), a corporation that used an "annual accrual method of accounting" in its farming business for the 10-year period ending with the first taxable year beginning after December 31, 1975, was permitted to continue to use that method if (i) the crops raised in the farming operation were harvested not less than 12 months after planting, and (ii) the annual accrual method of accounting also was used for all taxable years after 1975. United Brands utilized the annual accrual method of accounting in its banana business for the requisite 10-year period and complied with the 12-month limitation. Accordingly; it properly continued to utilize such method under the authority of section 447(g) *after the 1976 Act. The 1986 Act repealed section 278 in connection with the promulgation of new uniform capitalization rules under section 263A. The requirement in section 447(a) that preproductive expenses must be capitalized was replaced by a cross-reference (in a new section 447(b)) to section 263A. Section 263A(d) contains exceptions to the capitalization requirements for certain farming activities. Under section 263A(d) (1), the capitalization requirements do not apply to (i) farming activities involving plants (with a preproductive period of 2 years or less) or animals, or (ii) crop replacement costs attributable to casualty losses (analogous to old section 278 (c)). Although the automatic~ exception. for certain plants and animals does not apply to taxpayers required to use an accrual method of accounting under section 447, section 263A(d) (1) (B), the 1986 Act also amended section 447(g) (1) to make clear that the special exception therein (relating to the current deductibility of preproductive expenses) continued to apply notwithstanding the capitalization rules of section 263A.3 The House Report for the 1986 Act described the relationship between section 263A(d) and 447(g) as follows: Persons or entities required to use the accrual method of accounting under section 447 are required to capitalize proproductive (sic] costs without regard to whether the preproductive period is more than two years. Consistent with the general capitalization rules, such taxpayers are required to capitalize taxes and, to the extent the preproductive period exceeds two years, interest incurred prior to production. The committee intends that taxpayers properly using the annual accrual method of accounting under section 447(g) will be allowed to continue to use that method. Under an elective exception to the capitalization requirements, a taxpayer raising plants in a farming business may elect. ~ncit to have the capitalization rules apply. Section 263A(d) (3). Again, however, this rule does not apply to taxpayers required to use an accrual method of accounting under section 447. Further, the rule does not apply with respect to costs previously subject to section 278(a) (relating to costs of citrus and almond groves during the first four years). PAGENO="0369" 359 H.R. Rep. No. 426, 99th Cong. 1st Sess. 629 (1985) (emphasis added) .~ The Bluebook for the 1986 Act included this paragraph virtually verbatim, except that the last sentence was revised to read as follows: "The Congress intended that sugar growers properly using the annual accrual method of accounting under section 447(g) will be allowed to continue to use that method." Joint Committee on Taxation, General Explanation Of the Tax Reform Act of 1986 514 (1987) (the "Bluebook") (emphasis added). The Bluebook language is in conflict with the House Report because sugar growers were not the only "taxpayers properly using the annual accrual method of accounting." We believe the language of the House Report reflects the intent of Congress in the 1986 Act, i. e * , that taxpayers pzeviously allowed - to currently deduct preproductive expenses under section 447 (g) (1), notwithstanding section 278, should be allowed to continue such treatment.: The Bluebook drafters may have been áoncerned that since section 278 was replaced by section 263A, and since section 447 (g) (1) was simultaneously revised to override any contrary provision in section 263A, a broader category of taxpayers arguably was eligible for treatment under section 447(g) after the 1986 Act than before that legislation. A closer analysis; however, shows this to be incorrect. A taxpayer not entitled, under prior law section 278, to expense preproductive costs could under no circumstance. qualify under section 447(g) by reason of the repeal of section 278, since a person that was prohibited from using the annual accrual method before 1986 could not, for that very reason, qualify under section 447 (g) .~ Notwithstanding the foregoing, the TANRA amendment to section 447(g) appeared to be based on the incorrect impression that the 1986 Act made section 447(g) available to a new category of taxpayers. However, in attempting to prevent a larger group of taxpayers from utilizing section 447(g)--which, as seen, was an unnecessary effort--TAMRA actually closed the door to taxpayers properly utilizing section 447(g) before 1986.6 The Senate~ .version excepted products produced in a farming business from the scope of the new capitalization rules. S. Rep. No. 313, 99th Cong., 2d Sess. 141 (1986). The Conference agreement followed the House bill. H.R. Rep. No. 841, 99th Cong., 2d Sess. 11-304 (1986). This result follows because such a person would not have used the annual accrual method for (i) the 10-year period ending with the first taxable year beginning after December 31, 1975, and (ii) all subsequent years. The 10-year limitation was included in the 1976 legislation specifically to prevent new categories of taxpayers from claiming an entitlement to the annual accrual method. Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1976 56 (1976) ("this 10- year requirement is designed to insure that the (annual accrual] method can not be used by new or growing taxpayers to achieve substantial future deferrals, while permitting taxpayers whS have had a substantial history of use of this method to continue its use") (emphasis added). The additional requirement that the annual accrual method be used for all taxable years subsequent to the 10-year period is a further safeguard against any claim that future legislation "opened the door" to that method for new categories of taxpayers. 6 The amendment was effective as if included in the 1986 Act. Since the amendment was treated as a technical correction, a revenue estimate was not made. PAGENO="0370" 360 The House and Senate Reports for TANRA described the amendment with identical language: Many taxpayers using the annual accrual method of accounting, other than taxpayers engaged in the trade or business of growing sugar cane, were required under section 278 of prior law to capitalize preproductive expenses (e.g., citrus growers). The Reform Act. repealed section 278. Under the bill, the ~:special rule that allows taxpayers using the `annual accrual method of accounting to expense preproductive expenses is limited to those taxpayers engaged in the trade or business of growing sugar cane. S. Rep. No. 445, 100th Cong., 2nd Sess. 105 (1988), H.R. Rep. No. 795, 100th Cong., 2d Sess. 99 (1988). The implication that only sugar cane growers were permitted to use section 447(g) before the 1986 Act without restriction under section 278 is, as seen, incorrect. The implication that the 1986 Act permitted a broader class of taxpayers to qualify under section 447(g) also is incorrect. In summary, the 1986 Act did not make section 447(g) available to a larger category of taxpayers, and no further amendment to section 447(g) was needed. In attempting to prevent new taxpayers from benefitting under section 447(g), TAMPA barred the use of that provision by taxpayers historically entitled to `it, notwithstanding section 278. Under these circumstances, it. would be sufficient simply to repeal the TAMPA amendment, effective as if the provision never had been enacted. H~.iever, the approach taken by the Senate Finance Committee in October, 1989--affirmatively limiting section 447(g) to taxpayers entitled to its benefits bef ore the 1986 Act--is unobjectionable. The foregoing discussion demonstrates that there is no technical basis for limiting section 447(g) to sugar cane growers. Nor is there any discernible policy basis for doing so. Because the distinction drawn by the TAMPA anendnent discriminates in favor of sugar cane growers for no valid reason, the proposal should be adopted. PAGENO="0371" 361 Chairman RANGEL. Thank you, Commissioner. We will hear now from Glenn Graff, representing the Associated General Contractors of America. STATEMENT OF GLENN GRAFF, CHIEF FINANCIAL OFFICER AND EXECUTIVE VICE PRESIDENT OF LINBECK CONSTRUCTION, HOUSTON, TX, REPRESENTING THE ASSOCIATED GENERAL CONTRACTORS OF AMERICA Mr. GRAFF. Thank you, Mr. Chairman. If I may, I'd like to take this opportunity to thank Mr. Archer for making a special effort to be here this morning. My name is Glenn Graff of Linbeck Construction, Houston, TX. I am here today on behalf of the Associated General Contractors of America, a construction trade association. AGC's members perform more than 80 percent of America's contract construction of com- mercial buildings, highways, bridges, industrial, and municipal utilities facilities. AGC appreciates this opportunity to present its views on the lookback rules, particularly as they apply to recover- ies from claims and disputes. The construction industry was hit hard by four major tax law changes in 4 years. A study in 1988 comparing the effects of the 1986 Tax Act on different industries, showed the construction in- dustry's effective tax rate more than doubled. The costs of comply- ing with the Tax Code have also risen dramatically. The adminis- trative difficulties that the construction industry is encountering, as firms struggle to implement the new rules, are far greater than originally estimated. Both large and small firms have found the amounts they pay to have their income tax returns prepared are double and triple what they paid in earlier years, a result of con- struction contractors having to account for contracts under as many as seven different sets of rules, and having to comply with complex provisions, such as the lookback rule. The lookback rule essentially requires a construction contractor to file a completely new tax return for every contract to which the lookback rule applies in the year the contract is completed, and to refile every time the costs or revenues associated with those con- tracts change. In the year a long-term construction contract is completed, the construction firm must go back and substitute for each year the contract was in progress the actual costs and revenues for the esti- mated costs and revenues used in prior years' tax computations. Then, taxes for all prior years must be recalculated for both regu- lar tax and alternative minimum tax purposes. Next, the difference between the taxes actually paid each year, and the taxes that would have been paid had actual figures rather than estimates been used, must be calculated. Finally, daily com- pounded interest, subject to rate change on a quarterly basis, must be calculated on that difference. The construction contraôtor either then pays interest to, or receives interest from, the Federal Government. The construction industry now has 3 years of experience in deal- ing with the lookback provision~ I would like to cite a few examples of the results of that experience. PAGENO="0372" 362 A large contractor in California completed its lookback calcula- tions for 2 years. The IRS lookback form along was eight pages long. It took 40 hours to complete, and the end result was that the contractor claimed a $16,000 interest refund. A construction contractor in Vermont, with taxable revenue of $230 million claimed a lookback interest refund of $1,800 for 1988. It took 56 hours just to do the lookback return. A small construction contractor in Massachusetts had 60 con- tracts that required computations under the lookback method. The contractor claimed an interest refund of $7,600, but the fee paid to the accountant was $4,200. A highway contractor in Kansas recently completed its calcula- tions for lookback involving six projects. Mr. MCGRATH. Mr. Graff, could you pull that microphone a little closer to you? I am having a hard time hearing you. Mr. GRAFF. I'm sorry. Mr. MCGRATH. Thank you. Mr. GRAFF. A highway contractor in Kansas recently completed its calculations for lookback involving six projects. There was an adjustment to reduce income for calculation purposes by $500,000. The procedure required preparation of 13 schedules. Tax prepara- tion costs of approximately $3,000 far exceeded the interest amount claimed. None of the examples cited above include the many hours re- quired just to accumulate the data in order to prepare the neces- sary schedules and forms. The treatment of recoveries from claims and disputes under lookback singles out one industry for inequita- ble treatment. A supplier and an AGC member contractor both sued in court on the same contract. When the lawsuit was over, the supplier and the contractor both recovered equally. The supplier took the recovery into income in the year of receipt. The contractor had to take the amount of recovery,, determine the appropriate Federal interest rate, discount the amount of the recovery back to the date of completion of the contract, then recalculate the change in revenue in the contract, and calculate the change in tax and the lookback interest amounts. Claims and disputes are generally unforeseen events. Claims arise for various reasons, and they may involve many different par- ties. Claims may need be negotiated to settlement, settled through a mediation, arbitration, or some other legal process. Recoveries from claims and suits may occur as long as 10 or 15 years after a contract is completed. AGC believes that the interests of fairness and simplification would best be served by complete repeal of the lookback provision. -~ At the very least, the application of lookback to claims and dis- putes should be. repealed. Alternatively, if, as we understand, look- back is a provision to help those using the percentage of comple- tion method, then we recommend that lookback be made elective, and subject to the same rules governing other changes in account- ing methods. Thank you, Mr~ Chairman. [The statement and attachments of Mr. Graff follow:] PAGENO="0373" 363 TESTIMONY OF GLENN GRAFF ASSOCIATED GENERAL CONTRACTORS OF AMERICA The Associated General Contractors of America is a construction trade association representing more than 32,500 firms, including 8,000 of America's leading general contracting companies, which are responsible for the employment of more than 3,500,000 employees. These member contraôtors perform more than 80% of America's contract construction of commercial buildings, bridges, highways, industrial and municipal-utilities facilities. AGC appreciates this opportunity to present its comments on the lookback method and the treatment of claims and disputes under the lookback method. The lookback rules require construction contractors to spend a great deal of time and money on a compliance proôess with little or no return to~eithér the federal government or the construction contractor. The House Ways and Means Committee has also asked for recommendations on simplifying the tax code and the effect of the tax code on international competitiveness. AGC believes repeal or at least simplification of the lookback rules would be an appropriate step on both accounts. AGO recommends that, in the interests of fairness and simplification, the lookback rules be repealed in their entirety as they apply to the construction industry. At the least, the rules should be repealed with regard to their application to claims and disputes. AGC believes claims and lawsuit recoveries should be treated separately and recognized as taxable income in the year in which the lawsuit or claim is settled. That treatment would be consistent with the treatment of similar recoveries for similarly situated taxpayers. AGC does not believe that there is a sufficient reason for requiring earlier recognition of these amounts for percentage of completion taxpayers. Taxing recoveries when the claim is resolved, rather than when the work was performed, would be a more accurate match with economic reality. AGC recommends that recoveries on claims and lawsuits after the completion of a contract be recognized at the time the claim or suit is settled and that they not be subject to the lookback rules. ACCOUNTING FOR LONG-TERM CONTRACTS The Tax Reform Act of 1986 extensively revised the method of accounting for long-term contracts. Generally, construction contractors with gross receipts exceeding $10 million were required to use either the percentage of completion method (PCM) or a hybrid percentage of completion/capitalized cost method (PC- CCM) to account for long-term contracts. If the contractor's gross receipts exceeded $10 million in one year, the construction contractor had to use PeN and the lookback method for the next three years. The percentage of completion of the contract is calculated by comparing total actual contract costs performed through the end of the year to the estimated contract costs for the life of the contract. Subsequent tax acts further restricted the use of the hybrid method so that now all long-term contracts must be accounted for by using PCM. - WRAT IS THE LOORBACK RULE? The 1986 Act also added a new provision called the "lookback" rule for long-term contracts accounted for by using either the PCM or PC-CON methods of accounting. The lookback rule essentially requires a construction contractor to file a -completely new tax return for every contract in the year the contract is completed. - Any and every cost associated with a long-term contract subject to lookback may cause a recalculation of the lookback amounts if and when there is a change. PAGENO="0374" ~64 In the year a long-term construction contract is completed, the construction firm-must go back and substitute for each year the contract was in progress the actuai costs and revenues for the estimated costs and revenues used in prior years tax computations. Then taxes for all prior years must be recalculated for both regular tax and alternative minimum tax purposes. Next, the differences between the taxes actually paid each year and. the taxes that would have been paid, had actual figures rather than estimates been used, must be calculated. Finally, daily compounded interest, subject to rate change on.a quarterly basis, must be calculated on that difference. The construction contractor then either pays interest to or receives interest from the government. The Office of Management and Budget estimated that nearly 14 hours is required to complete the lookback form. AGC believes that estimate only applies to the time needed to complete the lookback form for each contract to which lookback applies. The largest number of calculations that have to be made must be made before the taxpayer can reach the point of filling out the lookback form, and so do not even appear in the 0MB estimate. -In applying the lookback rule, amounts received or accrued after completion of the contract may be taken into account by discounting those amounts to their value as of the completion of the contract. The decision whether to discount the amounts is made on a contract-by-contract basis. The applicable discount rate is the Federal mid-term rate as of the time the amount is received or accrued. Costs received or accrued after the contract's completion may also be subject to the discounting process. A long-term contract is not subject to the lookback rule if (1) the contract is completed within two years of the contract commencement date and (2) the gross contract price does not exceed the lesser of $1 million or 1 percent of the taxpayer's. average annual gross receipts for the three years preceding the year the contract was entered into. There is also a simplified lookback rule that must be used by pass-through entities, including S corporations and partnerships, unless they are closely held. The taxes over or underpaid are determined by multiplying the top marginal tax rate for the year by the amount of contract income over or underreported. The calculation is made at the entity level. However, most S corporations are also closely held, so the simplified method is of limited use. WHY WAS THE LOORBACK METHOD ADDED? According to the Joint Committee on Taxation's General Explanation of the 1986 Act (the Bluebook), Congress believed that the completed contract method of accounting (CCMA) permitted an "unwarranted deferral" of the income from long-term contracts. The Bluebook noted that "large defense contractors" had large amounts of deferred taxes and low effective tax rates because they used CCMA. The conclusions were based in part on a study published in 1986 by the General-Accounting Office. The study showed that manufacturing companies, particularly aerospace companies, had deferred nearly $4.9 billion in taxes over -a five-year period. The same study showed that construction contractors had deferred $300 million over the same period of time by using CCMA. Congress concluded it was appropriate to limit the use of CCMA, but recognized that the PCM method could cause harsh results for some contractors. Accordingly, PCM was modified so variances could be accounted for by an-interest charge or credit to the taxpayer; i.e., the lookback rule. In 1988, Joint Tax Committee staff told AGC that the lookback rule was added to "help" construction contractors. AGC believes, however, that the administrative burdens it creates far exceed any benefit it conveys. The construction industry's costs of compliance are rising sharply. For example, a large construction contractor in California completed its lookback calculations for two years. The IRS form - for just lookback was eight pages long. It took forty hours to complete and the end result was that the contractor claimed a $16,000 interest refun". PAGENO="0375" 365 A construction contractor in Vermont with taxable revenue of $230 million claimed a lookback interest refund of $1,800 for 1988. It took 56 hours just to do the lookback return. A small donstruction contractor in Massachusetts had sixty contracts that required computations under the lookback method. The contractor claimed an interest refund of $7,600 but the fee paid to the accountant was $4,200. Another Massachusetts contractor paid $950 to the accountant to discover that he owed the IRS $26. A contractor who owed no lookback interest to. the IRS had to pay $800 for all the calculations to discover that. Another construction contractor received a refund of $7,649 but the fee paid to the accountant to determine that was $2,150. A highway contractor in -Kansas recently completed its calculations for lookback. The contractor was involved in six jobs. There was an adjustment to reduce income for calculation - purposes by $500,000.- The procedure required preparation of thirteen schedules, revised carrybacks of -net operating losses, new calculations of alternative minimum -tax and preparation costs of approximately $3,000, which far exceeded the interest amount - claimed. - - None of the examples cited above contain the many hours -- - require to research and accumulate the data in order to prepare the necessary schedules and forms. The 1989 budget reconciliation act changed the tax code so that the failure to-pay lookback interest is deemed a failure to pay taxes, leading to interest--and penalties. Even if the amounts owed are small, construction contractors must pay these fees to be sure they do not incur interest and penalties that - would vastly inflate those amounts. - WHAT ARE THE PROBLEMS OP THE LOOKBACK RULE? The problems involved in implementing the lookback rule relate primarily to the literally thousands of additional calculations that must be performed for any contract to which the lookback rules apply and to the complex-interrelationships of the lookback rules with the uniform capitalization rules, net operating losses, and the alternative minimum tax. - Generally the lookback rules apply to contracts with-- a gross price exceeding the lesser of $1 million or 1 percent of the taxpayer's average annual gross receipts for the three preceding taxable years. A construction contractor who averaged gross receipts of $11 million would be required to apply the lookback rules to any and every long-term contract that exceeded $110,000. Also, the construction contractor who had one year that took the company over the $10 million threshold would have to use the percentage of completion method and the lookback rules for the next three years, even if the company then went below the $10 million -level. - Once it is demonstrated that a contract is subject -to lookback, all the estimated costs in the contract, no matter how large- or small, have to be replaced by actual- costs. This involves- the substitution of numbers in literally thousands- of calculations. For example, a construction contractor with gross receipts. of $11 million-may have- entered into a nine-month contract that became a long-term contract when it went over the year's end. The contract's gross price was $150,000. At the end of the contract, the construction contractor would go back to the first year to substitute actual for estimated costs. What changes might have ~ Under estimated labor costs, the contractor would have estimated the number of laborers involved in the project. Estimated-costs would- include wages, fringe benefits and - insurance premiums. Actual costs may differ -for a variety of reasons. If the contract- provides for a cost of -living adjustment, the contractor wouldn't know the new figures or whether an adjustment was needed until the price indexes were - announced. Weather conditions may have forced work stoppages, lengthening the number of hours workers spent on the project. Extra workers may have been hired to make up lost time. PAGENO="0376" 366 Similarly, estimated equipment costs may vary from final equipment costs for a number of reasons. Site conditions may require ~ise of equipment that couldn't have been predicted. `There are many other direct and indirect costs that would have to be recalculated. It is easy to see why the lookback calculations are so costly. According to the Joint Tax Committee staff, lookback was designed to help with estimating errors. But the number of calculations needed to arrive at a final figure for even one year is too costly and burdensome. It costs the construction contractor far more to make the calculations than any amounts they would get back or that the government would receive. Once a contract is subject to the lookback rules, every change that comes in after completion of the contract will necessitate a recalculation of the lookback amounts. For example, workers' compensation insurance premiums may be retroactively altered for many years after the contract's completion. Issues relating to settlement of claims may take several years to resolve. contractors may choose on each contract whether to discount the amounts, but the lookback recalculations have to be done. The discounting process adds another layer of calculations, albeit a helpful one. Discounting the amount to the date of completion of the contract means that first the discounting process has to be done. Then the appropriate amounts have to be inserted back into total contract costs and revenues. Then all the lookback calculations have to be made. construction contracts do not always finish in a neat and orderly fashion. Increments of both costs and revenues related to a contract may continue to "dribble in" on a sporadic basis for years. The lookback rule requires, for each contract to which it applies, that all the calculations beredone each time this occurs. CLAIMS MW DISPUTES A supplier and a construction company both sued in court on the same contract. When the lawsuit was over, the supplier and the construction company both recovered equally. The supplier took the claim into income in the year of recovery. The construction company had to take the amount of the recovery, determine the appropriate federal interest rate, discount the amount of the recovery back to the date of completion of the contract, ~ recalculate the change in revenue in the contract and calculate the lookback interest amounts. Even though the supplier and the construction company had the same expenses in pursuing the lawsuit, the construction company is treated very differently. Claims and disputes are generally unforeseen events, claims may arise for various reasons involving the scope of the contract, contract performance and contract costs. They may involve different parties, including the project owner, subcontractors, suppliers and sureties. Claims may be negotiated to settlement, settled through arbitration, or settled by legal action from the end of a contract to six years after the completion of the contract. Recoveries from claims and suits typically occur after the contract is completed and closed. Recoveries may occur as long as ten or fifteen years after contract closing. In the attached example AGC has prepared, a contractor enters into a cost-plus-fixed-fee contract to build a sixty- story office building for $103 million, and agrees to complete the project in 30 months. The contractor's estimated cost for the project is $100 million and his fee is $3 million. During the first year, the project is on time and within budget; however, during the second year the contractor encounters difficulties and correctly estimates a cost, increase of $8 million will occur. PAGENO="0377" 367 The contractor considers the problems encountered on the project to have been caused by actions taken by the owner and the owner's agents during the construction period; and files suit for recovery of his additional cost and profit. The contractor retains outside counsel and incurs legal fees and expenses to pursue the lawsuit. For simplicity, the substantial in-house overhead costs associated with the litigation have not been included in this example. Also for simplicity, the discounting calculations do not appear in the example. The cbnstr~ecti.pp contractor may elect to discount the recovery using the applicable federal rate; however, the costs are also discounted. `The contractor finally recovers the $8,000,000 some years after the project has been completed. The example allows for the possibility that the recovery is made in any year from one through twelve years subsequent to contract completion. Four or five years is common for a lawsuit, and twelve years is not uncommon. Under the current lookback rules, the $8,000,000 recovery (possibly discounted) would be allocated to the years that the construction was in progress, and interest would be charged on the taxes due from that period forward. The problem, of course, is that due to events beyond the contractor's control he did not receive that income until the end of a lengthy lawsuit or arbitration process. In a few states, interest may sometimes be awarded in a judgment if a contractor can prove that he actually incurred the interest expense to carry the cost through to settlement. However, this is not the prevalent case. In some states, statutes are on the books which expressly prohibit the payment of interest on an award for any period prior to the date of the judgment. The summary table provided illustrates clearly the impact of a recovery in any of years one through twelve following contract completion. AGC befieves that this example is both conservative and takes into account any possible tax "savings" which accrue to the contractor from deduction of the cost overrun during contract completion. Despite this, the lookback interest which is owed substantially exceeds any tax savings in every year. More importantly, even in the unlikely event that the contractor can settle the lawsuit during the first year following the contract's completion, he will only retain $1,088,696 of the $3,000,000 profit recovered after payment of taxes and interest. In the second year, only $503,810 will remain, and in every year after the second the contractor will have to make a significant and rapidly rising outlay to recover his out-of-pocket costs from the owner. `The lookback rules, particularly as they involve claims and disputes, unfairly single out one industry for punitive treatment. All parties in a dispute are uncertain as to how the dispute will end. They may recover their entire amount claimed; they may recover nothing. The accrual basis taxpayer is just as uncertain as the percentage of completion taxpayer. They may even both be suing on the same claim. But the percentage of completion taxpayer is singled out for extensive, expensive calculations and additional taxes. AGC recommends that, in the interests of fairness and simplification, the lookback rules be repealed in their entirety as they apply to the construction industry. At the least, the rules should be repealed with regard to their application to reooveries from claims and disputes. PAGENO="0378" nN;;h~iuu U IMIAL! ~IflN COHIlOLI LIHIn UN LUWLUIt :UvEbe IS INULUDLU ;NDEN its toot tUft. no HOD ii! `UriS `rut eat ttO!,OoUUO the assuwptton is wade that percentage watt-H DUal tat toaptete tOU,U(O,Utl) of comptitton sathod is used for taw .rtractar s Fee 1hOtUU purposes. Conservative estsaates of legal Cast tOt,UUO,000 costs and n-house overhead required to ~fit Reported t5,000,000) pursue the lawsuit have been used A OX rate * ~overy on lawsuit 6,000,'tOU of interest has been used throughout for st.pttctty. PAGENO="0379" WORKShEET CONTRACT YEARS YEAR I YEAR 2 YEAR 3 COST INCURRED (25,000,000 841,500,000 $41500000 YEAR YEAR 2 YEAR 3 YEAR 4 YEAR 5 YEAR 6 YEAR 7 YEAR 8 YEAR 9 YEAR 10 TOTAL. FORALL YEAR 18 YEAR 12 YEARS $108,000,000 (5,000,000) PROFIT REPORTED 750000 2875000) (2875000) TAR ON PROFIT (LOSS) - DURING CONSTRUCTION 255,000 (977500) )R77,5u0( INTEREST ON RN) TALES AT (00 25 500 28,05A INTEREST UN YR2 TALES AT (00 (97,750) INTEREST ON YR3 TALES AT 02 30,855 (107,525) (97,750) 33,941 (118,278) ((07,525) 37,335 (130,105) ((18,278) 41,068 (143,116) (130,105) 45,175 (157,427) (143,116) 49,692 ((73,170) (157,427) 54,662 (190,407) (173,170) 60,128 (209,536) (190,487$ 66,140 (230,489) (209,536) 72,754 (253,538) (230,489) (1,700~000) 80,030 88,033 713,362 (278,892) (306,781) (2,397,095) TOTAL TAR ~SAYLNAS~ AND (278,892) (2,090,314) INTEREST FROM $5 000,UuD COST OVERRUN 255,000 (952,000) ((047,200) (174,420) (191,862) (211,048) (232,153) (255,368) (280,905) (308,996) (339,895) (373,885) (411273) . ALLOCATION OF RECOVERY (452,408) (497641) (5,474,047) ON LAWSUIT 1,852,000 3,074,00u 3,074,000 TAL AT 340 RATE ON 8,000,000 $0 000,000 AS ALLOCATED 629,680 1,045,160 1,u45,L60 INTE~EST OR RN) TALES AT 100 62,968 69,265 INTEREST ON. YR2 TAlES AT 102 1)4,516 INTEREST ON YR3 TAXES 89(00 76,19) 1(4,968 104,516 83,810 (26464 (14,968 92,191 139,111 126,464 101,4)1 153,022 139,111 111,552 108,324 153,022 122,707 185,157 168,324 134,978 203672 148,475 224,039 163,323 246,443 179,655 271,088 2,720,000 197,621 217,383 8,761,529 298196 328,016 2,563016 TOTAL TAR ON RECOVERY 000 LOOK-BACK INTEREST A 62,966 73,711 295,675 325,242 357,766 393,544 432,898 476,188 523,807 203,672 576,186 224,039 633,805 246,443 271,088 298,196 2,235,000 2,720,000 LEGAL FEES AND ELPENSES TAX DEDUCTION ON LEGAL FEES, AFTER-TAL LEGAL COSTS INTEREST COST ON LEGAL FEES 100,000 34,000 66,000 100,000 34,000 66,000 100,000 34,000 66,000 150,000 51,000 99,000 150000 51,000 99,000 250,000 05,000 165,000 300,000 102,000 198,000 350,000 119,000 231,000 400,000 136,000 264,000 400,000 136,000 264000 766,905 843595 6,559,545 400,000 300,000 3,000,000 136,000 102,000 1,020,000 264000 198,000 1,980,000 AND EXPENSES AT LOX 6,600 13,060 21,846 33,931 47,224 68446 - TOTAL AFTER-TAO LEGAL FEES AND INTEREST COST 0 66,000 72,600 7986) 120,046 132,931 212,224 266,446 326,091 127,700 391,700 66,870 209,957 257,352 1,048,875 INTEREST COST ON OUT-OF-POCKET . 430,870 473,957 455,352 3,028,875 COST OF $5,000,000 AT 100 250,000 525,000 577,500 635,250 690,775 TAR DENEFIT FROM INTEREST 768,653 845,518 930,070 1,023,076 1,125,304 1,237,923 1,361,715 1,497,086 81,476749 DEDUCTIONS ON FINANCING OF LEGAL FEES, $5,000,000 COST .__ (05,000) (178,500) (198,594) (220,697) (245,0)1) (272,070) (303,532) 1339,4951 (300,177) (426,040) 1477,629) TOTAL NET ANNUAL COST OF: (534,368) (4,258,7121 TAX SAVINGS AND INTEREST LOOK-RACK INTEREST ON TALES DUE ON RECOVERY AFTER-TAX LEGAL FEES AND INTEREST INTEREST COST ON OUT-OF-POCKET $5,000,000 Total includes $2 720 000 in taxes paid on recovery iii year l2~ V 255,000 (809,032) (700,4)9) 533,755 584,806 641,131 736,000 806,234 949,492 1,071,831 1,205,281 8,350,955 1,477076 -- CUMULATIVE ANNUAL COST (634,032) (1,342,450) (000,696) (223,010) 417,32) 1,153,322 1,959,556 2,909,048 3,980,879 5,186,160 1,702411 14,052,410 PAGENO="0380" SUMMARY OF CONTRACTORS RECOVERY bY YEAh TN WHICH LAWSUIT IS SETTLED If Recovery is Received YEARS SUISEOUENT TO CONTRACT COMPLETION in this year following contract co.pletxo 0 YEAR I YEAR 2 YEAR 3 YEAR 4 YEAR 5 YEAR 6 YEAR 7 YEAR 8 YEAR 9 YEAR 0 YEAR II YEAR 12 Contractor Recovers this asount ) 8000000 8,0,000 8,000,000 8,000,000 00,000 8,000,000 s,ooo,ooo a,ooo,ooo 8,000,000 8,000,000 8,000,000 8,000,000 Contractor deducted $5 xillion cost overrun prior to contract co.pletion and `saved' taxes by deducting $5,000,000 cost overru 0 1,700,000 1,700,000 1,700,000 1,700,000 1,100,000 8,100,000 11700,000 1,100,000 1,700,000 1,700,000 1,700,000 1,700,000 Contractor `saved interest on taxes `saved' due to $5,000,000 deductxo 18,620 410,482 621,530 853,683 1,109,052 1,389,957 1,6Y8,952 2,038,848 2,412,732 2,824,006 3,276,406 3,774,047 Contractor pays tax on $8,000,000 recoxer A 2,720,000) (2,720,000) (2,120,000) (2,720,000) (2,720,000) (2,720,0001 12,720,000) (2,720,000) 12,720,000) (2,720,000) (2,720,000) (2,720,0001 Contractor suit pay look-back interest which totals A 532,424) (857,666) 1,215,433) (1,608,911) (2,041,874) (2,518,062) (3,041,869) )3,618,055Y (4,251,860) (4,949,046) )5,115,950Y (6,559,545) Contractor has incurred legal fees to pursue clad. (after tax) 0 (66,000) (132,000) (198,0001 (297,000) (396,000) (561,000Y (759,000) (990,000) (1,254,000) (1,518,000) (1,782,000) (1,910,000) Contractor has incurred interest to pay for leqal fees and carry $5000000 coast 0 (775,000) (1,359,100) (2,008,210) (2,728,831) (3,531,414) (4,424,156) (5,422,671) (6,540,838) (7,7M3,922) )9,1R8,714t(l0,770,386)(12,525,624) Contractor has receiveA tax benefits (no. interest deductions abox 0 263,500 462,094 682,791 927,803 1,200,681 1,504,213 1,843,708 2,223,885 2,649,933 3,127,563 3,661,931 4,258,712 Contractor repays principal of $5,000,000 loan to carry cost ouerru (5,000,000) (5,000,000) (5,000,000) (5,000,000) (5,000,060) (5,000,000) (5,000,000) (5,000,000) 15,000,000) (5,000,000) (5,000,000) (5,000,000) Contractors recovery less taaes look-back, and cost 01 lawsuit 0 1,008,696 50~,0l0 (137,321) 1873,322) (1,679,5561 (2,629,048) (3,700,879) 14,90t,160( (6,257,116) (7,134,191) )9,349,990)(ll,052,410f PAGENO="0381" 371 Chairman RANGEL. And now we will hear from Robert Turner, who is the past national president of the Associated Builders and Contractors. STATEMENT OF ROBERT A. TURNER, PAST NATIONAL PRESI- DENT, ASSOCIATED BUILDERS AND CONTRACTORS, INC., AND SENIOR VICE PRESIDENT, PAISAN CONSTRUCTION CO., HOUS- TON, TX Mr. TURNER. Thank you, Mr. Chairman. I am Robert A~ Turner, senior vice president of Páisan Construction Co., a general con- tracting firm located in Houston, TX. I see, by the panels preceding mine, and this panel here, that Texas is well-represented, and espe- cially, Houston, TX. I also appreciate the attendance of Congressman Archer, and Congressman Andrews, who happens to be my Representative. I am representing the Associated Builders and Contractors, and my firm, particularly, with respect to the lookback method of ac- counting. The Associated Builders and Contractors represents ap- proximately 18,000 commercial and industrial contractors, subcon- tractors and suppliers, constructing building projects throughout the United States and in every State. Let me say it first: We abhor the tactics of certain large, govern- mental contractors, who shirk their responsibility by not paying the taxes in a timely fashion. We applaud the efforts of Congress to close loopholes which prevent these miscarriages, but the lookback method punishes the majority of contractors, who pay their taxes promptly, for the sins of a few. The IRS form 8697 states that the contract price is to be revised to reflect amounts received or accrued after the contraction com- pletion date as a result of disputes, settlements, or litigation, relat- ing to a contract. The rule, as we interpret it, requires a contractor not only to pay taxes on moneys received after a job is closed out, but the contractor must reopen his bOoks back to the first year of the contract, and pay an interest penalty on the pro rata distribu- tion of profits over the contract duration for revenues acquired through the judicial process. Thus, the contractor is responsible for paying another portion of this award to the Government as if received during the timeframe of the contract itself, when he or she clearly did not. Disputes and settlement awards are, unfortunately, common in the construction industry and occur for various reasons. A contractor may be forced to modify his work schedule, equip- ment needs, manpower, et cetera, through no fault of his own. For example, my company was awarded a contract to remodel some 350 apartments in Houston, TX, with the specific scope of work delin- eated within the contract documents. We manned the project in September 1986, and in 1 month, we were halted by the owner's desire to increase the scope of work. It took 14 months for the ar- chitect and owner to revise the scope of work drawings. In the meantime, we were manning the project with our supervi- sory personnel, around the clock security forces, along with con- tinuing job site office and utility costs. We were not allowed to in- PAGENO="0382" 372 corporate these costs into the various changes which numbered in excess of 300 that occurred over the 14 month period. Our only option was to file a claim in January 1988. The owner's representative demanded that we continue construction, stating that at the end of the project, they would negotiate a settlement. We proceeded in good faith, completing the four remaining phases of construction, which depleted the owner's revenues. We have been unable to negotiate a settlement, and consequently, have been forced to~retain counsel, and are filing our claim in court in an at- tempt to litigate a settlement of $237,000. The financial implica- tions of this case are critical to our firm. While we wait until 1992 or 1993 to be adjudicated a settlement, the reality is that my audi- tors will not allow me to carry this claim as an accounts receivable. My bank does not view this as collateral to be used in.. granting business loans. My bonding company not only does not view ~this as a financial asset to set my company's bonding limits, but is con- cerned about the financial drain as we pursue this litigation. Finally, we cannot list these moneys to show an improved finan- cial statement, which would enhance our ability to negotiate addi- tional work with clients or prospective clients. On top of all these negative financial aspects, if we do receive ~an award, the lookback rule dictates that we must pay interest penalties back to the begin- ning of the job. We must reopen our 1986, our 1987, and our 1988 books, to adjust our income for those years, and assess compound- ing interest penalties through the year of settlement to 1992 and 1993. The reopening of books and manipulating of percentage of reve- nue, itself, is burdensome and costly, but to add to this interest penalty, it. is contrary to the rules of equity and fair play. I have included in my written testimony exhibits which illustrate the complexity and tax penalties of the lookbackrule. This one particu- lar graph right here shows that through lookback, where we are negotiating a settlement, or be adjudicated a settlement, in 5 years, 16.4 percent additional taxes will be assessed my company. In closing, Mr. Chairman, sound tax and economic policy, let alone common sense, are turned upside down bythe present look- back provision. The concept of treating adjudicated awards as pen- alties, and recording settlements years before they are received, strikes us as a kind of Orwellian nightmare, where logic and lan- guage have been twisted. We therefore respectfully. request that the committee amend the lookbáck rule, so that it would not be applied to settlements after contract completion. Thank you. [The statement and attachments of Mr. Turner follow:] PAGENO="0383" 373 TESTIMONY OP ROBERT TURNER ON BEHALF OF ASSOCIATED BUILDERS AND CONTRACTORS My name is Robert Turner. I am Senior Vice President of Paisan Construction, a general contractor located in Houston, Texas. I am pleased to have the opportunity to speak before the Ways & Means Select Revenue Subcommittee today on a matter of great concern to Associated Builders & Contractors and my firm in particular -- the requirement that monies derived from settlements and disputes of long-term contracts be subject to the "look-back" method of accounting. Associated Builders & Contractors represents approximately 18,000 diverse commercial and industrial contractors, subcontractors and suppliers who share the Merit Shop philosophy of management. Merit shop, or open shop, contracting has.been the catalyst for rapid growth in this segment of the industry to the point where it now accounts for 75 percent of all construction work performed today. My firm, like thousands of other construction contractors engaged in long-term contracts, are constantly confronted with the inequities of the look-back provision. Our exasperation has reached the point where our representatives here in Washington have heard our plea and have made look-back a subject of these hearings -- which we greatly appreciate. Accounting for Long-term Contracts As you are aware, the look-back rule for long-term contracts using percentage of completion accounting techniques grew out of the 1986 Tax Reform Act. The rule requires that when a contract is completed, the contractor must "look-back" and substitute the actual costs and revenues for the estimated costs and revenues used in prior years' tax computations. This must be done for each year the contract was in progress under the percentage of completion method of accounting. Tax liability for all years' of the contract's life must be recalculated for both regular tax and alternative minimum tax purposes. Then, the differences are determined between the taxes paid each year and taxes that would have been paid had final figures rather than estimated costs been available. Then more calculations are required using daily compounded interest on the difference to. determine whether interest is owed to or due from the Treasury. The look-back calculations can number quite literally in the thousands. The Office of Management and Budget estimates that it takes 14 hours to prepare the look-back form -- and even that is optimistic. It also does not include the many more hours of calculations made before the contractor reaches the point of filling out the form. I could spend several hours just describing the suffocating complexity of this rule. I understand that the Committee will be examining tax simplification in the weeks ahead. I cannot think of a more deserving provision to undergo the Committee's scrutiny than look-back in general. This Committee inserted language in the 1989 Budget Reconciliation Act calling for a study by the Treasury Department of look-back and the "proper treatment" of long-term contracts for income tax purposes. Unfortunately, it was not included in the final conference report. Nevertheless, we appreciate your continued interest and hope that Congress will recognize the problems inherent in look-back will be addressed this year. PAGENO="0384" 374 Construction Disputes and Settlements -- An Example Disputes and settlement awards are common in construction and can occur for various reasons. A contractor may have to modify his work schedule, equipment needs, blueprints, etc. due to circumstances that could not have been foreseen when the bid was awarded. For example, my company was awarded a contract to remodel some 350 apartment units with a specific scope of work to be accomplished contained within the contract documents. We manned the project in September of 1986 and within one month our progress was halted due to the owners desire to upgrade the scope of work. It took 14 months for the architect and owner to define the revised scope of work, allowing us to complete the first phase of an eight-phase project. In the meantime, we were manning the project with our supervisory personnel, around-the-clock security forces, along with continuing jobsite office and utility costs. We were not allowed to incorporate these costs into the various changes which number in excess of 300, and occurred over a 14-month period. Our only option was to file a claim in January, 1988. The owner's representative demanded that we continue construction, stating that at the end of the project they would negotiate the settlement. We proceeded in good faith, completing~four remaining phases of construction which depleted the owner's revenues. We have been unable to negotiate a settlement and, consequently, have been forced to retain counsel and are ~filing our claim in court in an attempt to litigate a settlement of~$237,000. The Financial FalLout of Look-back The financial implications of the case described above are critical to our firm. While we wait until 1992 or `93 for a settlement, the following has occurred: - My auditors will not allow me to carry this claim as an accounts receivable. - My bank does not view this as collateral to be used in granting business loans. - My bonding company not only does not view this as a financIal asset to set company bonding limits, but is concerned about the financial drain as we pursue litigation. - We cannot list these monies to show an improved financial statement which would enhance our ability to negotiate additional work with clients or prospective clients. On top of all those negative financial effects, if we do receive an award, the look-back rule dictates that we must pay an interest penalty back to the beginning of the job. We must reopen our 1986-1988 books toadjust our income for those years and assess compounding interest penalties through the year of settlement -- 1992 or `93. Re-opening our books and manipulating the percentage of revenues itself is burdensome and costly. But to add this interest penalty is contrary to the rules of equity and fair play. Returning to the settlements and disputes issue, I want to walk the Committee members through an example in more detail of the present rule and its inequities, starting with the IRS form 8697. The form states that the "contract price is revised to reflect amounts received or accrued after the contract completion date as a result of disputes, settlements or litigation relating to the PAGENO="0385" 375 contract. The look-back method must be applied in the year such amounts are received or approved. " The rule, as we interpret it, requires a contractor not only to pay taxes on monies received after a job is closed out, but the contractor must reopen his books back ~o the first year of the contract and pay an interest penalty on the pro-rata distributed prof its over the contract duration for revenues acquired through- the judicial process. Thus, a contractoris~responsible for paying another portion of his award to the government as if received during a phase of the contract itself, when it clearly did not. Second, the contractor is punished as though he was withholding income during the Oonstruction period. Such disputes are Osually not instigated until after the contract is completed. How can contractors be expected or capable of predicting such an occurrence, or its amount, or the time of settlement? Obviously, they cannot. Examining Look-back's Impact ~The extent of the look-back rule's impact on a firm's financial condition can be illustrated in the following example and accounting exhibits I have prepared. Take a $105,000 contract, $100,000 of which is costs, and $5,000 profit. The project will require 18 months to complete spanning 3 fiscal years. In Exhibit One, using the percentage of completion method, the first 35% of the contract was completed in 1988, yielding $536 in federal taxes at the 34 percent corporate rate. In the second year, 40 percent was completed, yielding $612, and the third year the remaining 25 percent was finished yielding $552 in taxes. At this point, the $5,000 profit is realized, and $1700 in taxes are paid providing a net of $3300 Our work is not done on this contract, though. In Exhibit 2, it is 1993 and the contractor is finally awarded $5,000 for the payment he should have received in 1990. The rule requires that the same look-back computations extend to the settlement years, beginning at the start of the contract period. This results in $1700 Of taxes on the $5,000 settlement. The contractor's tax liability does not end there. Exhibit 3 shows the cumulative effect of paying compounded interest over the 5-year settlement period. The award, has now become a penalty in the IRS interpretation and has increased their tax liability by 25 percent, or $817. To further illustrate this absurdity, if the contract and settlement period lasted a total of 19 years, the interest penalty would absorb the entire award. Exhibit 4 reveals the final distribution of the award after all the look-back calculations are made. Slightly more than half of the $5,000 settlement was devoured by taxes and penalties -- 34 percent in taxes and 16.4 percent in interest penalties. It is clear that contractors with legitimate disputes that have been decided in their favor are losing a significant portion of awards unfairly due to look-back. Mr. Chairman, sOund tax and economic policy, let alone common sense, are turned upside down by the present look-back provision. The concept of treating adjudicated awards as penalties, and recording settlement payments years before they are received strikes us as a kind of Orwellian nightmare where logic and language have been twisted. ~e therefore respectfully request that the Committee amend the look-back rule so that it not be applied to revenues derived from a dispute after a contract is completed. ABC recognizes that when the 1986 Act was passed the current 30-860 0 - 90 - 13 PAGENO="0386" 376 inequity was not perceived by the Ways & Means Committee. And, we are pleased that it recognizes improvements to the present accounting procedures for long-term contracts should be examined. We understand that Treasury views the repeal of look-back as being revenue neutral. A survey, of our members confirms this. Contractors must rely on making accurate contracting estimates for those elements of construction within their control -- if they cannot, they will soon be. out of business. The balance between refunds owed for overpayment of estimated costs and taxes owed, for underpayment we would bet is virtually even. The-only winners are accountants and tax attorneys who spend costly hours interpreting and complying with-the rule. No significant additional revenue is provided by look-back, but it now takes longer to prove it. Contributions in Aid of Construction ABC would also like to take this opportunity to asnociate itself with CIAC Coalition and speak very briefly in support of another provision being discussed at these hearings -- restoring the historic treatment of contributions in aid of construction (CIAC) as capital allocations or payments, and ng~ as taxable income of regulated utilities. We appreciate Chairman Rangel and the Committee's reconsideration of the rule as passed in the 1986 Tax Reform Act. However, we are concerned that as currently proposed, reversing the rule would apply only to water utilities, not to all utilities, including gas, electric, sewerage. As you know, there is strong support for legislation to repeal the CIAC tax for all utilities. The bill has 131 cosponsors, and its companion bill in the Senate has 32 cosponsors. We hope that action by Congress on CIAC includes all utilities. Mr. Chairman, since public utility commissions require utilities to pass on the CIAC tax, its inflationary impact falls on consumers, i.e., renters, home buyers, builders, etc. Also, fewer or smaller constuction projects result due to the increased costs. Costs cannot be justified and financing is unobtainable because of the tax. Another result is that public utilities are being underutilized,, and proj ect developers are turning to water wells, septic tanks .or other secondary means. These make-shift facilities can result in seyere maintenance and capacity problems in future years, as well as harm the environment. ABC urges the Committee to restore the historic treatment of capital contributions to construction. Thank you. PAGENO="0387" Exhibit 1 Budget Year Revenue Cost Profit %Complete 1988 Sample Job 105000 100000 .5000 35 1989 Sample Job 105000 100000 5000 75 Previous Years 35 Current Year 40 1990 Sample Job 105000 100000 5000 100 Previous Years 75 Current Year 25 PCM 90% or 100% 90% or 100% 90% Federal of Cost of Revenue of Income Incurred E~i~ned Total Billings Tax Rate Tax 90% 31500 1575 33075 33075 34% 536 90% 67500 3375 70875 70875 <31500> <1575> <33075> <33075> 36000 1800 37800 37800 34% 612 100% - 100000 5000 105000 105000 <67500> <3375> <70875> <70875> 32500 1625 . 34125 34125 34% 552 100000 5000 105000 105000 34% 1700 NET 3310 PAGENO="0388" Look-Back Method Exhibit 2 5000 Settlement Received in 1993 Year Final Final Final Original Lookback Contract Contract Contract Year End Percent Amount Costs Profit Coats Complete 1988 110000 100000 10000 35000 35 1989 110000 100000 10000 75000 75 Previous Years 1990 110000 100000 10000 100000 100 Previous Years Gross Profit Recognized Tax Rate Federal Look-Back PCM Lookback Original Under Tax Gross Profit Over Due 3500 90 3150 1575 1575 34% 536 7500 90 6750 3375 3375 <3150> <1575> <1575> 3600 1800 1800 34% 612 10000 100 10000 50000 50000 <6750> <3375> <3375> / 3250 1625 1625 34% 552 10000 50000 50000 1700 PAGENO="0389" Exhibit 3 Look-Back Interest Compound Interest Factor Interest 1025 55 1025 123 1025 193 1025 212 1025 234 817 Interest Rate 10% Time Period 4-15-89/4-15-90 Tax Due 536 Prior Interest + Principal 0 Principal 536 10% 4-i5-90/4-15-91 612 591 1203 10% 4-15-91/4-15-92 552 1326 1878 10% 4-15-92/4-15-93 2071 2071 10% 4-15-93/4-15-94 2283 2283 PAGENO="0390" 380 EXHIBIT 4 DISTRIBUTION OF $5,000 SETTLEMENT SUBJECT TO LOOKBACK PAGENO="0391" 381 Chairman RANGEL. Thank you. John A. Sedlock. STATEMENT OF JOHN A. SEDLOCK, EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER, CUSHMAN & WAKEFIELD, INC., NEW YORK, NY Mr. SEDLOCK. Mr. Chairman, and members of the subcommittee, my name is John A. Sedlock, and I am executive vice president and chief financial officer of Cushman & Wakefield, Inc., a real estate services C corporation, which is headquartered in New York City. Cushman & Wakefield is a commercial real estate brokerage firm, with offices in 51 cities across the Nation. Cushman & Wake- field does not own any real estate, and derives its income strictly from the services provided by its employees. Prior to the enactment of section 448, Cushman & Wakefield re- ported income and expense using the cash method of accounting, which in the business judgment of Cushman & Wakefield, was and is the only method of accounting clearly reflecting its taxable income. Section 448 prevents a commercial real estate brokerage C corporation such as Cushman & Wakefield from continuing to uti- lize the cash method of accounting for tax purposes. This provision effectively compels such companies to adopt the accrual method of accounting for income tax purposes. However, for Cushman & Wakefield, an adverse and unintended result occurs when complying with this provision. The interaction of section 448 with section 404(a)(5), which deals with deferred com- pensation, has created a situation whereby Cushman & Wakefield must report 100 percent of its brokerage commission revenue in a given year, but at the same time is precluded from currently de- ducting, as an expense, those portions of the commissions that are subsequently payable to Cushman & Wakefield's real estate broker/employees who earned the commission revenue. IRS Regulations, as currently written, only allow a deduction for expenses which are actually paid within 2½ months after the close of the fiscal year. Since Cushman & Wakefield's commission reve- nues are generally received over a 3 to 5 year period, and in some cases as long as 15 years, and are paid out to its broker/employees over the same period, a mismatching of revenues and expenses is occurring. The resultant prepayment of Cushman & Wakefield's taxes has created a financing burden on Cushman & Wakefield. I will now attempt to fill in some of the details regarding this situa- tion. Commercial real estate brokerage is by far the principal compo- nent of Cushman & Wakefield's business. Cushman & Wakefield does no residential brokerage, owns no real estate, and is not in- volved in real estate syndication. Under a typical brokerage agree- ment, Cushman & Wakefield earns commission revenue for serv- ices rendered by its brokers to building owners in connection with leasing office and industrial space to tenants. Cushman & Wake- field's brokerage personnel are compensated out of the commis- sions generated by the leasing transactions which they have pro- cured. The compensation payable to broker/employees is equal to PAGENO="0392" 382 at least 50 percent, and can go as high as 65 percent, of the com- missions earned by Cushman & Wakefield. Depending upon the particular market in which the transaction takes place, the size of the transaction, and the nature of the use, either an office or industrial lease, the commissions earned by Cushman & Wakefield are payable in installments over periods of varying duration-usually 2 to 5 years, and on occasion, 10 years or more. Accordingly, the broker's share of such commissions is remit- ted to him or her over time in accordance with the provisions of the standard broker/salesperson employment contract. The em- ployment contract states that commissions will be paid to the broker/employee only when, as and if the commissions are received by Cushman & Wakefield. I want to stress here that the various local marketplaces in which Cushman & Wakefield does business determines the time pe- riods over which it will be paid, and it is not pursuant to any com- pany deferred compensation plan. Normally, the use of the accrual would not materially change this result, since the commission income accrued by Cushman & Wakefield at the time of execution of a lease would be partially offset by an expense accrual for a portion of the commissions pay- able to Cushman & Wakefield's brokers. However, and most impor- tantly, section 404(a)(5) of the code, which governs the deductibility of deferred compensation by accrual basis taxpayers, can be con- strued, although we believe erroneously, to prevent Cushman & Wakefield from deducting the portion of its fees payable to individ- üal brokers until such time as payment is made in cash. As noted previously, this payment of cash may not occur for an extended period, perhaps as long as 15 years, after the lease has been execut- ed, and the related income has been accrued. The interaction of section 404(a)(5) with section 448, therefore, effectively places Cush- man & Wakefield on the accrual method with respect to income, and on the cash method with respect to expense. This results in a serious mismatching of income and expense. In addition, a significant cost is imposed on Cushman & Wake- field's business operation. That is the time value and the use of cunds advanced by Cushman & Wakefield to pay taxes on income which it will receive only over multiyear periods. We submit that these results could not have been intended at the time of passage of section 448. We therefore urge that this unfair and completely unwarranted result be corrected by subsequent legislation permitting C corpora- ~ion real estate brokerage firms to continue to account for taxable income using the cash method of accounting or, at the very least, to allow such firms to deduct the full amount of commissions nay- able to its broker employees in the same period as the related ~ro- ierage revenue is recorded. Thank you. [The statement of Mr. Sedfock follows:I PAGENO="0393" 383 TESTIMONY OF CUSHMAN & WAKEFIELD INC BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS HOUSE OF REPRESENTATIVES My name is John A. Sedlock, and I am Executive Vice President and Chief Financial Officer of Cushman & Wakefield, Inc., a real estate services "C" corpora- tion, which is headquarterLd at 1166 Avenue of the Americas in New York City. Cushman & Wakefield is a commercial real estate brokerage firm with offices in 51 cities across the nation. Cushman & Wakefield does not own any real estate and derives its income strictly from the services provided by its employees. I am here today to present testimony concerning the effect of Section 448 of the Internal Revenue Code of 1986 on real estate brokerage `C' corporations which are required by the provisions of that section to adopt the accrual method of accounting for tax- able years beginning after December 31, 1986, and to support the modification of that provision as set forth in the Subcommittee's proposals. Prior to the enactment of Section 448, Cushman & Wakefield reported income and expense using the cash method of accounting, which in the business judgment of Cushman & Wakefield, was and is the only method of accounting clearly reflecting its taxable income. Section 448 prevents a commercial real estate brokerage "C" corporation, such as Cushman & Wakefield, from continuing to utilize the cash method of accounting for tax purposes. This provision effectively compels such companies to adopt the accrual method of accounting for income tax purposes. However, for Cushman & Wakefield an adverse and unintended result occurs when complying with this provision. The interaction of Section 448 with Section 404(a)(5), which deals~with deferred compensation, has created a situation whereby Cushman & Wakefield must report 100% of its brokerage commission revenue in a given year, but, at the same time, is precluded from currently deducting as an expense those portions of the commissions that are subsequently payable to Cushman & Wakefield's real estate broker employees, who earned the commission revenue. IRS regulations, as currently written, only allow a deduction for expenses which are actually paid within two and one-half months after the close of the fiscal year. Since Cushman & Wakefield's commission revenues are generally received over a three to five year period (and, in some cases, as long as 15 years) and are paid out to its broker employees over the same periods, a mismatching of revenues and expenses is occur- ring. The resultant prepayment of Cushman & Wakefield's taxes has created a financing burden on Cushman & Wakefield. I will now attempt to fill in some of the details regarding this situation. Commercial real estate brokerage is by far the principal component of Cushman & Wakefield's business. Cushman & Wakefield does jj~ residential broker- age, owns no real estate and is not involved in real estate syndication. Under a typical brokerage agreement, Cushman & Wakefield earns commission revenue for services rendered by its brokers to building owners in connection with leasing office and industrial space to tenants. Cushman & Wakefield's brokerage personnel are compensated out of the commissions generated by the leasing transactions which they have procured. The compensation payable to broker employees is equal to as least fifty percent and can go as high as 65% of the commissions earned by Cushman & Wakefield. Depending upon the particular market in which the transaction takes place, the size of the transaction and the nature of the use, either an office or industrial lease, the commissions earned by Cushman & Wakefield are payable in installments over periods of varying duration -- usually 2 to 5 years, and on occasion, 10 years or more. Accordingly, the broker's share of such commissions is remitted to him or her over time, in accordance with the provisions of the standard broker/salesperson employment contract. The employment contract states that commissions will be paid to the broker employee only "when, as and if' the commissions are received by Cushman & Wakefield. PAGENO="0394" .384 As an example, a commission on a large office lease recently negotiated is payable in three installments; the first payable upon execution and delivery of the lease; the second upon the first anniversary of lease commencement; and the third on the second anniversary of lease commencement. In some parts of the country local custom provides for extended payouts of commissions. In these situations, commis- sions are paid monthly over the 10 to 15 year term of the lease as monthly rent pay- ments are made by the tenants. Under the cash method of accounting, commissions earned by Cushman & Wakefield were taken into income when cash was received. Similarly, commission expense, was deducted when paid to the brokers. The cash method thus clearly reflected Cushman & Wakefield's income and expense as required by Section 446 of the Code. Normally, the use of the accrual method would not materially change this result, since the commission income accrued by Cushman & Wakefield at the time of execution of a lease would be partially offset by an expense accrual for. a portion of the commissions payable to Cushman & Wakefield's brokers. However, and most importantly, Section 404(a)(5) of the Code, which governs the deductibility of "deferred compensation" by accrual basis taxpayers, can be construed, although we believe erroneously, to prevent Cushman & Wakefield from deducting the portion of its fees payable to individual brokers until such time as payment is made in cash. As noted previously, this payment of cash may not occur for an extended period -- perhaps as long as two to fifteen years after the lease has been executed and the related income has been accrued. The interaction of Section 404(a)(5) with Section 448, therefore, effectively places Cushman & Wakefield on the accrual method with respect to income and on the cash method with respect to expense -- a result which we feel could not have been intended by the drafters of Section 448. I want to stress here that the various local marketplaces in which Cushman & Wakefield does busi- ness determines the time periods over which it will be paid and it is not pursuant to any company plan. At the time of enactment of Section 448, certain entities were excepted from the rule requiring taxable income to be computed on the accrual method. Exceptions to the rule are: (i) "farming businesses", (ii) a "service corporation" in health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and (iii) entities with receipts of not more than $5,000,000. We believe, however, that none of the entities which have received exemptions from the general rule of Section 448 would have suffered as greatly from the mismatching of income and expense referred to above had they been required to account for their income and expense on the accrual method as has Cushman & Wakefield. In most cases, the excepted service corporations are dealing with a deferral of income and/or expense of a year or less. Cushman & Wakefield, on the other hand, is required to wait for an extended period to deduct. the expenses related to the income it accrued when the contact generating the income was executed. In consesuence, a significant added cost is imposed on Cushman & Wakefield's business operations, that is, the time value of the use of funds advanced by Cushman & Wakefield to pay taxes on income which it will receive only over multi-year periods. We submit that this result could not have been intended at the time of passage of Section 448. We therefore urge that this unfair and completely unwarranted result be corrected . by subsequent legislation permitting C corporation real estate brokerage firms to continue to account for taxable income using the cash method of accounting or, at the very least, to allow such firms to deduct the full amount of commissions payable to its broker employees in the same period as the related brokerage revenue is recorded. PAGENO="0395" 385 Chairman RANGEL. Mr. McGrath. Mr. MCGRATH. Thank yOu, Mr. Chairman, and gentleman. We have heard an earful regarding the changes from the .cash method of accounting to accrual in different areas. I just want to make a point about the outcome following the 1984 through 1986 period when this subject was being discussed. I think you are right that a lot of unintended effects have come out of these changes. I believe the change in accounting provided for the largest increase in reve- nue in order to reduce-as an offset of reducing-the rates. 1 think it was in~exeess of $50 billion. Bat1iMr. SedlQck,~your situation seems to be an anomaly that needs to be redressed, along with some of the others. Am I correct that Cushman & Wakefield is the only real estate company doing business in this manner? Mr. SEDLOCK. To my knowledge, that is true. Mr. MCGRATH. And as a result of that, I suspect that the revenue estimate for revenues foregone would be somewhat diminished. Why does Cushman & Wakefield believe that the cash method of accountingis more appropriate than the accrual method? Mr. SEDLOCK. In our case, with the extended collection periods of up to 15 years, that is when we receive the cash, to have to pay tax on the~ revenue~ when we accrue it, 100 percent of the revenue, it creates~airdsmatching. Mr. MCGRATH. ~So in other words, you pay out commissions to your brokers over that 15-year period? Mr. SEDLOCK. Yes, sir. Mr. MCGRATH. And you have to realize the gain in the first year? Mr. SEDLOCK. Yes. Mr. MCGRATH. Are there any differences between the service cor- porations that have been granted an exemption from section 448 and your company? Mr. SEDLOCK. I think the major difference is the fact that the service companies generally-their receivables-are collectible as billed, and as a general course of business, probably would be paid in within 30 to 90 days. Again, in our situation, it is a longer, ex- tended period of time. Mr: MCGRATH. So, in effect, what you are telling me is that the change in accounting over these years since 1986 has forced your firm to pay taxes in advance, am I correct? Mr. SEDLOCK. Absolutely, and we have had to borrow funds to do that. Mr. MCGRATH. I thank you. Chairman RANGEL. Mr. Archer. STATEMENT OF HON. BILL ARCHER, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF TEXAS Mr. ARCHER. Thank you, Mr. Chairman. I want to welcome each of you gentlemen to the Ways and Means Committee. I'm sorry I was not here to hear some of the beginning testimony. It is good to have people come before us on behalf of tax simplification in sup- port of the 1986 Tax Simplification Act, which has brought all these wonderful goodies to us here in the United States. After all, that was one of the major purposes of that act, was tax simplifica- PAGENO="0396" 386 tion and I say that, of course, tongue in cheek, because clearly, all it did was make the Tax Code so complex that it cannot be admin- istered effectively. It requires untold number of hours on the part of the private sector, a tremendous cost to this Nation, with a minute flow of additional revenue coming into the Treasury. It will come as no surprise to you gentlemen that I led the oppo- sition to the 1986 Tax Reform Act, and I predicted that what you are telling us about today would come to pass. I am delighted that you are here to show us only a small tip of the iceberg of the prob- lems with this act. I would like to ask a couple of questions, particularly on the look-back method of accounting, or taxation, for a completed con- tract method of accounting. I am curious, and I will direct this question to Mr. Graff and Mr. Turner. The 0MB estimates that a taxpayer requires 14 hours to complete the look-back form. First off, is this an accurate estimate in your experience? Does this estimate account for the time spent performing the calcula- tions required to complete the form? Mr. GRAFF. It is the experience of the members of AGC that this is not an accurate estimate. It does not take into account the many, many hours required to accumulate the information and to prepare the schedules before you can even attempt to prepare the look-back form. Mr. ARCHER. What would you estimate would be a more accurate number of hours required to complete the form and all of the cal- culations preparatory to completing the form? Mr. GRAFF. Well, it would depend on the number of contracts that were being closed in a particular year. But if a contractor were closing 60 contracts in a particular year, it would require probably 120 hours, as a minimum, to go back and accumulate all of the information and if he is computerized then to put it into the computer and make those computations. Mr. ARCHER. Do you have any judgment as to the cost of compli- ance relative to the amount of income that the Federal Govern- ment receives in the way of additional revenues? Mr. GRAFF. Well, I question whether the Federal Government re- ceives any additional revenue. And, as a matter of fact, we have asked for a GAO study on that point, because we believe as far as the construction industry is concerned, look-back is generating neg- ative revenue to the Federal Government and, in the construction industry, we are incurring millions of dollars a year in additional administrative costs in trying to comply with look-back. Mr. ARCHER. Well, I would support GAO investigation so that we can get some objective information on this. Mr. Turner, how do you suggest that we stop the abuses of the big contractors that you mentioned, and still take care of this prob- lem? Can it be done by just repealing the application of the look- back rule to these later settlements? Will that do violence to the effort to stop abuses where, in effect, some of the bigger contractors, particularly on Government work, have been able to roll over and roll over and escape taxes, virtually ad infinitum? PAGENO="0397" 387 Mr. TURNER. I would imagine that legislation could be, or rules could be adopted that would require a contractor who has a dimin- ishing amount of financial involvement in a job, that he close that job for bookeeping purposes at that point in time, and satisfy his tax needs. - There are certain rules that could be passed to implement changes that would prevent these abuses. I do not pretend to know all of them at hand, because I am not one of these contractors that work for these large construction contracts. I would like to mention, with respect to our own company, the preparation of getting this material prepared so that the form can be filled out for IRS has reduced our accounting productivity by some 12 to 15 percent. Not only that, the cost of my auditors have increased by some 25 percent, because they must go back every year, reopen my books, and see to it that my accountant has done them properly for proper tax evaluation. So it is extremely costly to the individual companies, both from in-house, and from our auditors standpoint. Mr. ARCHER. I thank you, gentlemen, all of you, for your input today. I think it is very constructive and very helpful to the corn- mittee. Finally I want to underscore what you have just mentioned-rel- ative to the look-back method of accounting. The reform was intro- duced to the code to address the time value of money concept. In my opinion it is in many, many instances, strictly money grubbing on the part of the Federal Government, without regard to the ex- pense to society. And in my opinion, we cannot constructively have a tax law that does that and it does need to be reformed. So I thank you for your input. Chairman RANGEL. Mr. Andrews. Mr. ANDREWS. I have no questions, Mr. Chairman, but I do want to thank the panel and Bob Turner, it is good to have you here, from Houston, thank you very much, for your testimony. Mr. TURNER. Thank you, Congressman. Chairman RANGEL. Let me thank the panel for the full commit- tee and we certainly will take into consideration the inequities that you raise to the full committee. Chairman RANGEL. The next panel, Neil Milner, chairman of the board of directors of American Society of Association Executives; Gene Huxhold, eastern regional director for pension savings pro- grams of Kemper Financial Services; Willie L. Baker, Jr., interna- tional vice president and director of public affairs for United Food and Commercial Workers International Union, AFL-CIO; Steve Os- trander, vice president, Miller & Benz, Rockvifle, MD; Dan Bran- denburg, counsel, Printing Industries of America Consolidated Trust; C.A. "Mack" McKinney, legislative counsel, Non Commis- sioned Officers Association of the United States of America; and Vester T. Hughes, Jr., special trustee, for the Charles A. Sammons Estate. We will start off with Mr. Milner, and as I pointed out to the earlier panel, we are going to, without objection, accept the testi- mony in its entirety into the record, and ask that you spend 5 mm- PAGENO="0398" 388 utes in highlighting that testimony so that the members may get some questions in, if we are going to hear all of the panels. Chairman Mimer. STATEMENT OF NEIL MILNER, CHAIRMAN OF THE BOARD, AMERI- CAN SOCIETY OF ASSOCIATION EXECUTIVES, EXECUTIVE VICE PRESIDENT AND CHIEF EXECUTIVE OFFICER, IOWA BANKERS ASSOCIATION, DES MOINES, IA Mr. MILNER. Thank you, very much, Mr. Chairman. My name is Neil Milner, and I am the executive vice president and chief executive officer of the Iowa Bankers Association in Des Moines, IA, and this year's chairman of the American Society of Association Executives. ASAE is pleased to have this opportunity to present testimony regarding the extension of section 401(k) plans to tax-exempt em- ployers. And we appreciate your leadership in airing this issue. I was encouraged to note Treasury's qualified endorsement of the proposal in their testimony yesterday. Mr. Chairman, ASAE is a professional society of over 19,500 association executives represent- ing over 8,800 national, State, and local associations. This is important because most of our members work for associa- tions with less than 100 employees. ASAE members represent tax- exempt organizations, mostly under code sections 501(c)(6) and 501(c)(3). Many of our member associations currently sponsor or are con- templating sponsoring some form of qualified retirement plan, in- cluding 401(k) plans, if they would be permitted to do so by law. ASAE strongly supports permitting all tax-exempt employers to maintain these qualified cash or deferred arrangements and also supports a modification of the present law, applicable to voluntary employees' beneficiary associations or VEBA's. And most employers may establish programs that allow their employees to save for retirement on a tax-favored basis. For-profit employers may offer their employees the opportunity to participate in 401(k) plans and for smaller employers, salary reduction simpli- fied employee pensions, or SEP's. Code section 501(c)(3), tax-exempt organizations and certain other educational organizations may offer their employees tax-sheltered annuities under code section 403(b). Employees of State and local governments may participate in an eligible deferred compensation plan under section 457. Even the Federal Government has provided its employees with a funded, tax- deductible salary reduction retirement savings program. Employees of many 501(c)(6) trade associations, on the other hand, are precluded from participation in a broad-based tax-favOred savings program. There seems to be no logical reason or justifica- tion for this discrepancy. So, the situation as it currently stands is grossly unfair to our members and should be rectified. To further compound the problem, many individuals may not make tax-deductible contributions to their IRA's. The situation is also unfair to Our member associations because they are less able to provide the competitive benefits necessary to attract and retain a well-qualified work force. PAGENO="0399" 389 Certain Members of Congress have perceived the inequity of this :.~~ituation and sought to rectify it. In~i987, Senator Pryor introdUced the Small Business Retirement. and Extension Act, `which would have extended the ability of section 403(b) tax-sheltered annuities to all tax-exempt organizations. In 1987, the House of Representatives adopted the Omnibus Budget Reconciliation Act of ~i987, which contained~a~provision that would have permitted tax-exempt organizations to establish 401(k) plans, and unfortunately this provision was not enacted. Mr. Chairman, ASAE believes that `these legislative initiatives evidence continuing, congressional interest in fairness in tax policy and in the soundness of public policy regarding tax-favored retire- ment savings programs for all employees. Mr. Chairman, I will turn briefly to another topic of interest to ASAE and its members: voluntary employee beneficiary associa- tions. VEBA's represent an affordable means of obtaining health and other insurance on a `collective basis for small businesses. ASAE believes that their establishment. should be encouraged, in order to increase the availability of low-cost health insurance for its members. ASAE supports this legislation that would overturn the IRS im- posed geographic locale restrictions on VEBA's. ASAE also recom- mends that Congress amend the code to exempt 10 or more employ- er-funded welfare benefit. plans from the tax on excess reserves and finally, we support the rule under code section 419(a)(fXG) that ex- cludes from the definition of a 10-or-more employer-funded welfare benefit plan; those plans in which a single employer contributes greater than 10 percent of the total contributions made to the plan. To mitigate the likelihood of this occurring, we believe that the statute should be modified to~permit one employer's contribution to constitute up to 25 percent of the contributions to the funded wel- fare benefit plan, if the plan has more than 15 employees. Mr. Chairman, that concludes my remarks and with your permis- sion, we will extend our statement in the record, and file that with you, and I will be glad to answer questions at the appropriate time. Thank you. Chairman RANGEL. Thank you. [The statement of Mr. Milner follows:] PAGENO="0400" 390 WRITTEN STATEMENT OF NEIL I4ILNER CHAIRMAN OF THE BOARD OF THE AMERICAN SOCIETY OF ASSOCIATION EXECUTIVES INTRODUCTION Mr. Chairman, my name is Neil Milner. I am the Executive Vice President and Chief Executive Officer of the Iowa Bankers Associ- ation, and Chairman of the Board of the American Society of Asso- ciation Executives. The American Society of Association Executives ("ASAE") is pleased to have the opportunity to present a written statement for the February 22, 1990 hearing of the House Ways and Means Committee Select Revenue Measures Subcommittee, regarding the extension of Internal Revenue Code (`Code') section 401(k) plans to tax-exempt employers, announced in Press Release No. H-S issued on January 23, 1990. ASAE strongly supports permitting all tax-exempt employers to maintain qualified cash or deferred arrangements ("CODAS'), also known as 401(k) plans. ASAE believes that employees of trade associations and other tax-exempt employers are entitled to the same opportunity to save for their retirement on a tax-favored basis as employees of charitable and educational organizations, federal, state and local government and the private sector. It. is unfair and discriminatory to prevent one type of employer from being able to offer to its employees a particular type of employee benefit that is available in one form or another to employers in every other sector of the economy. It is ultimately the employees of those employers whose ability, to save for retirement is being restricted. ASAE also supports a legislative solution to the position that has been taken by the Internal Revenue. Service (IRS) since the passage of the Tax Reform Act of 1986 that subjects nonelective deferred compensation of trade association executives to Code section 457. ASAE believes it is patently unfair and contrary to present tax policy to currently tax compensation which an executive nay not elect to receive, has not received and may never receive in the future if he dies or his employer declares bankruptcy. Testimony will be presented on this issue next month before the full Committee on Ways and Means by Ken Kiss representing the Section 457 Task Force of which ASAE is a nember. ASAE also supports a modification~of present law restrictions applicable to voluntary employees' beneficiary associations (VEBA~s). ASAE seeks a legislative solution that would eliminate the geoqraphic restrictions on VEBA coverage, exempt 10-or-more employer funded welfare benefit plans from the tax on excess reserves and liberalize the 10% rule applicable to 10-or-more employer funded welfare benefit plans. The American Society of Association Executives ("ASAE) is headquartered at 1575 Eye Street, N.W., Washington, D.C. 20005 (202/626-2703) and is the professional society for executives who manage trade and professional associations as well as other oot- for-profit voluntary organizations in the United States and abroad. Founded in 1920 as the American Trade Association Executives with 67 charter members, ASAE now has a membership of over i9~500 individuals representing more than 8,800 national, state, and local associations. In turn, these business, professional, educational, technical and industrial associations represent an underlying force of hundreds of millions of people throughout the world. Many of ASAE's members work for associations which employ less than 100 employees. Approximately two-thirds of ASAE's members represent PAGENO="0401" 391 trade associations exempt from taxation under Code section 501(c)(6). Many of ASAE's member associations either sponsor or are contemplating sponsoring some form of qualified retirement plan, including 401(k) plans if they would be permitted by law. BACKGROUND It has long been recognized that an individual's retirement income should be derived from three sourôes: (1) Social Security benefit payments, (2) employer_sponsored retirement plan benefits and (3) individual savings. It also has been recognized that individuals in this country have not been saving in sufficient amounts for their long-term needs, including retirement. ASAE believes that the policy of providing tax-favored savings through employer-sponsored plans is an appropriate and efficient means of encouraging Americans to save. As this Subcommittee is aware, most employers may establish programs that allow their employees to save for retirement On a tax-favored basis.. For-profit employers may offer their employees the opportunity to participate in 401(k) plans and, if employing less than 25 employees, salary reduction simplified employee pensions ("SEPs ")* Organizations exempt under Code section 501(c)(3) and certain educational organizations may offer their employees tax-sheltered annuities under Code section 403(b). Employees of state and local governments may participate in an eligible deferred compensation plan under Code section 457 ("457 Plan'). And within the past few years, even the Federal government has provided its employees with a tax deductible salary reduction retirement savings program. Only tax-exempt organizations other than those described in Code section 501(c)(3) are unable to provide all of their employees with an opportunity to save for their retirement on a tax-favored basis. To further compound the problem, many individuals may no longer make tax-deductible contribut.ions to individual retirement accounts after the passage of Tax Reform Act of 1986. Prior to the Tax Reform Act of 1986, all tax-exempt organizations could sponsor 401(k) plans. In 1985, the President's Tax Proposals to the Congress for Fairness, Growth and Simplicity ("President's Proposal") proposed that private sector tax-exempt organizations and public sector emplOyers no longer be permitted to establish and maintain CODAs. The President also proposed to establish rules for deferred compensation arrangements of private sector tax-exempt organizations similar to those found in Code section 457. In its explanation of reasons for change, the President's Proposal stated that private sector tax-exempt organizations may offer their employees tax-sheltered annuIties under Code section 403(b). This, of course, was and is not true for the vast majority of employees of tax-exempt organizations. As the Subcommittee knows, and as stated above, tax-sheltered annuities are available only to employees of Code section 501(c)(3) organizations and certain educational organizations. Perhaps as a result of this misconception, Congress, in the Tax Reform Act of 1986, acted to prohibit all tax-exempt organizations from adopting 401(k) plans after July 1, 1986. ASAE ~~as active in the unsuccessful attempt to preserve new 401(k) plans for non-governmental tax-exempt organizations during the development and passage of the Tax Reform Act of 1986. Congress also brought under Code section 457 unfunded salary reduction ~rrangemerits of f-~red by private sector tax-e~enp,. ~ to a select group of management or highly compensated employees, Accordingly, the only retirement savings plan now available to amptoynas of tax-exempt organizations other than those described in Code section 50l(c)(3) is the 457 plan which, as dtscu~~~d helow. is no~; an adequate replacement vehicle for the 401~t) plan PAGENO="0402" 392 Certain members of Congress were quick to perceive the inequity of this situation, and sought to.rectify it. In 1987, Senator Pryor introduced the Small Business Retirement and Benefit Extension Act (S.1426), which would have extended the availability of Code section 403(b) tax-sheltered annuities to all tax-exempt organizations. Hearings were held before the Subcommittee on Private Retirement Plans and Oversight of the Internal Revenue Service of the Committee on Finance ~ which the particular inequities faced by employees of tax-exempt organizations, including trade associations, were thoroughly aired. ASAE presented oral testimony before the Subconuntttee at a hearing held on October 23, 1987. ASAE strongly supported this legislation, which unfortunately was not enacted. The Ways and Means Committee, and later the full House of Representatives adopted H.R. 3545, the Omnibus Budget Reconciliation Act of 1987, which contained a provision that would have permitted tax-exempt organizations not eligible to offer Code section 403(b) tax sheltered annuities to establish 401(k) plans. Unfortunately, this provision as well as many others were removed as the result of the deficit reduction agreement between Congress and the administration. The Code was ultimately amended by the Technical and Miscellaneous Revenue Act of 1988 ("TAMRA") to reinstate 401(k) plans for rural telephone cooperatives. More recently, in October, 1989, the Senate version of H.R. 3299, the Revenue Reconciliation Act of 1989, contained a provision to permit all tax-exempt organizations to again be able to sponsor a 401(k) plan. Although this provision was approved by the Senate Finance Committee, the version of H.R. 3299 submitted to the full Senate for a vote did not contain a provision to extend 401(k) plans to tax exempt organizations because most matters not germane to the budget were dropped from the bill. ASAE believes that these legislative actions evidence continuing Congressional interest in fairness in tax policy and in the soundness of public policy regarding tax-favored savings programs. REASONS TO PERMIT TAX-EXEMPT EMPLOYERS TO SPONSOR 401(k) PLANS The reasons why Congress should extend 401(k) plans to tax- exempt employers are rooted in the principle that employees of tax- exempt organizations should have the same opportunity to save on a tax-favored basis as employees who work in the private sector or for federal, state or - local governments. ASAE believes that eliminating this inequitable treatment between taxpayers would result in a more equitable tax policy. It also would foster the objective of increased private retirement savings. ASAE's members = support the extension of 401(k) plans to tax-exempt organizations primarily because it would benefit their employees and, by virtue of being able to hire the most qualified employees, the public which they serve. As indicated above, it is unfair and discriminatory to single out one employer group and, thereby, one group of employees who may not sponsor 401(k) plans. Because the employers do not derive a direct economic benefit from sponsoring a 401(k) plan, it is their employees who are being penalized. This unfair and discriminatory treatment is especially inappropriate when the inequity results from incorrect assumptions regarding the availability of alternative tax-favored savings plans. The first incorrect assumption is that Code section 403(b) tax-sheltered annuities are available to all tax-exempt organizations. They are not. They are available only to Code section 501(c)(3) charitable organizations and certain educational organizations. Trade associations and other Code section 501(c) organizations may not sponsor such plans for their employees. PAGENO="0403" 393 The other incorrect assumption is that 457 plans are comparable to 401(k) plans for retirement savings purposes. This -assumption is incorrect for two reasons. First, 457 plans do not provide the same level of retirement income security as a 401(k) plan. Qualified plan contributions and earnings, including those in a 401(k) plan, are held in trust for the exclusive benefit of participants and their beneficiaries. In contrast, a 457 plan must be unfunded, and amounts:heid under that plan are subject to the general creditors of the employer. This greatly reduces the retirement security of an employee who participates in a 457 plan because of the uncertainty of whether his employer will ultimately be able to provide his promised retirement income. In this regard, it would be wrong to assume that private sector tax-exempt organizations have the same ability to generate revenue as public sector tax-exempt organizations, since private sector tax-exempt organizations do not have the power to levy taxes to raise revenue. Second, as a result of the interplay between the Code and the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), 457 plans of private sector tax-exempt organizations may not be offered to all employees, as is the case with public sector organizations such as state, and local governments. Again, Code section 457 requires the plan to be unfunded. However, ERISA does not permit a plan of deferred compensation sponsored' by a nongovernmental private sector organization to be unfunded unless it is maintained primarily for a select group of management or highly compensated employees. This interplay results in the exclusion from a 457 plan of virtually all "rank and file" employees. This is clearly inconsistent with the underlying purposes of the amendments to Code section 401(k) by the Tax Reform Act of 1986; namely, to broaden coverage to non-highly compensated employees and to limit the benefits of highly compensated employees,'especjally relative to non-highly compensated employees. By limiting the availability of broad-based tax-favored savings to highly compensated and management employees, current law limiting the availability of broad-based tax-favored savings plans for tax- exempt organizations runs counter to both sound tax policy and the objectives of the Tax Reform Act of 1986. ASAE is not suggesting that an exemption from the funding rules be granted. ASAE does not want unfunded plans to be extended to all employees because deferred amounts would be subject to creditors of the employer; Another reason that tax-exempt orgaCizations should be able to sponsor 401(k) plans is competitiveness. ASAE's members are particularly sensitive to the tax incentives for employee benefits, like 401(k) plans, because these incentives affect the ability of the employers of ASAE members to attract and retain well-qualified personnel. Trade associations frequently compete within the' same' labor pool for employees as private industries that have 401(k) plans or organizations that have Code section `403(b) tax-sheltered annuities available to them. Not only must trade associations be competitive in relation to these employers, but they must also compete with .the Federal government which now provides a funded salary reduction plan for Federal employees. Furthermore, it appears that 457 plans offered by public sector employers work reasonably well because they are available to a broad cross-section of employees, and because public entities generally have the power to tax to secure the promise. Because most of our members work for associations that are small tax-exempt employers, they are concerned about tax incentives that favor for-profit employers or other segments of tax-exempt organizations, or that create tax disadvantages for small tax-exempt, employers. The change in the law to prohibit tax-exempts from establishing 401(k) plans has had a significant impact as evidenced by the fact that in 1988 only 16% of ASAE members currently maintained a 401(k) plan, in comparison to 49% of employers in the population at large who offer a 401(k) PAGENO="0404" 394 plan. These disparities create an often insurmountable handicap to attracting and keeping qualified employees. It is also unfair that our members, the employees of associations, have to do their savings for retirement on a different basis than the employees of virtually every other type of employer. VOLUNTARY EMPLOYEES' BENEFICIARY ASSOCIATIQ11~ VEBA's represent an affordable means of obtaining health and other insurance on a collective basis for small businesses. ASAE believes that their establishment should be encouraged, rather than discouraged, in order to increase the availability of low-cost health insurance for employees. In 1981, the IRS issued a regulation which required that the membership of a VEBA be restricted to a geographic area no larger than a state in order to qualify as a tax-exempt organization under Code section 50l(c)(9). Before 1981, the only such restriction applicable to a VEBA was that its members have a commonality of interests. Nothing in the statute or its legislative history prohibits tax-exempt status to a VEBA on the basis of the geographical dispersion of the members. In fact, the Seventh Circuit Court of Appeals in 1986 (Water quality Association Employee Benefit Corp. v. U.S.) overruled the IRS geographic locale regulation on the grounds that it was not in accordance with legislative intent. However, the IRS continues to enforce the restriction outside the Seventh Circuit. ASAE supports legislation that would overturn the IRS-imposed geographic locale restriction on VEBA's. ASAE also recommends that Congress amend Code section 4l9A(.g) to exempt 10-or-more employer funded welfare benefit plans from the tax on excess reserves. Under Code Section 419A(g), employers participating in a 10- or-more employer funded welfare benefit plan must include in income an amount based on the plan's unrelated income for the plan year ending within the employer's taxable year if the plan had income when there were excess reserves. This requirement serves to prevent funded welfare benefit plans from purposefully retaining unneeded reserves to avoid paying taxes. Since a 10-or-more employer funded welfare benefit plan, especially one established by a trade association to service an industry, has neither the tax avoidance motivation ascribed to the individual employer nor the flexibility of an individual employer, such plans should be exempted from the tax on excess reserves. Finally, ASAE supports a modification to the rule under Code section 41.9A(f)(6) that excludes from the definition of a 10-or- more employer funded welfare benefit plan those plans in which a single employer contributes greater than 10% of the total contributionsmade to the plan. Code section 4l9A(a)(f)(6) permits employer contributions to such a plan to remain deductible even if the plan has excess reserves. If the 10% rule is violated, all employers contributing to the plan lose their deduction. Such a result is inherently unfair and may arise due to unavoidable consequences. For example, an association trust designed to serve its members in a particular locality may well have a membership highlighted by one or two large employers. Yet it cannot afford to include them in a benefit trust if that would place at risk the deductions of all other employer participants. If the remaining group of employers is too small to provide a stable base for employee benefit coverage, that will prevent the institution of any industry plan at all, with consequent denial of employee benefit coverage at acceptable cost to the affected employees. The statute should be modified to permit an employer's contribution to constitute up to 25% of the contributions to the PAGENO="0405" 395 funded welfare benefit plan if the plan has more than 15 employers in it. CONCLUSION ASAE strongly urges Congress to extend the availability of 401(k) plans to tax-exempt employers. This would allow all tax- exempt employers the opportunity to offer salary reduction programs to all of their employees. It also would eliminate the disparate treatment between employees of private sector tax-exempt organizations and all other employers. Most importantly, it would help these employees save for their retirement. Alternatively, ASAE would support extending the availability of tax-sheltered annuities to all tax-exempt organizations. ASAE stands ready to provide any assistance to the Subcommittee that it can in order to achieve this fair and equitable result. ASAE further urges Congress to reverse the IRS' position that nonelective deferred compensation is subject to Code section 457. It is clear that Congress never intended such a result when it expanded coverage of Code section 457 to include tax-exempt organi- zations. This is evidenced by the special rules enacted by TAMRA that provide that nonelective deferred compensation provided to collectively bargained employees, certain state and local govern- ment employees and independent contractors will not be subject to Code section 457. If this exemption is appropriate for some employees of tax-exempt organizations, it should be appropriate for all. The present policy of the IRS that would tax nonelective deferred compensation on a current basis is discriminatory against employees of tax-exempt organizations and is contrary to sound tax policy. Finally, ASAE respectfully requests that Congress remove the unnecessary restrictions that hinder the effective utilization of VEBA's and 10-or-more funded employer welfare benefit plans. Associations and employers should be encouraged, rather than discouraged, to establish and utilize these cost-effective mechan- isms for providing health care benefits to their employees. PAGENO="0406" 396 Mr. ANDREWS [presiding]. We will now hear from Mr. Huxhold. STATEMENT OF GENE R. HUXHOLD, EASTERN REGIONAL DIREC- TOR FOR PENSION SAVINGS PROGRAMS, KEMPER FINANCIAL COMPANIES Mr. HUXHOLD. Thank you, Mr. Chairman. Members of the committee, I would like to thank you for allow- ing me this opportunity to testify before you concerning 401(k), or stated in a broader fashion, pretax salary deferral programs, in nonprofit organizations. I realize that you have many demands and interested parties with demands who require a share of your time and therefore, I am most appreciative that you are willing to listen to my thoughts on this particular topic. For your information, I am eastern regional director for~pension savings programs for Kemper, and in this capacity I am~charged with assisting in establishing and enhancing ~the~retirmnent pro- grams that are offered by srnal1~to medium~sized~employers. As a point of reference, this would include organizations with from 1 to 500 employees. It is from this frame of reference that I am submitting this testimony. The problem focuses on nonprofit, non-501(c)(3) organizations that wish to establish a pretax salary deferral program. In many instances, these organizations wish to either add this type of program to their existing retirement benefit package, or they wish to install it as their retirement benefit package. The organizations that fall into this category of nonprofit firms include associations, credit unions, and chambers of commerce. It should be noted, at the outset, that many of the employees of the aforementioned organizations have chosen to work for a nonprofit organization in order to benefit or assist others, often at a reduced pay level relative to the same job function at a for-profit employer. Prior to the Tax Reform Act of 1986, the status of pretax salary deferral programs, and this time I am referring to 401(k) plans spe- cifically, for nonprofit organizations was unclear. As a result, there were a number of State and local governments, nonprofit 501(c)(3) and nonprofit, non-501(c)(3) organizations that established 401(k) programs, often in addition to their existing pretax salary deferral programs, such as 457 and 403(b). It was also unclear as to whether or not an employee could defer salary up to the specific limits in each plan without taking into ac- count the amounts they were deferring in the other plans. TRA-86 clarified Congress' intent as to what the total level of de- ferral could be where multiple plans were available. The act also eliminated the 401(k) program for tax-exempt employers and made available the 457 plan, which thus far, had only been available to state and municipal governments. At first, it appeared that all organizations now had one basic type of pretax salary deferral plan available. Unfortunately the In- ternal Revenue Service quickly pointed out in IRS notice 87-13, that, Section 1107 of TRA-86 does not and was not intended to amend any provision of title I of ERISA as amended. Accordingly, a deferred compensation plan of a tax- exempt organization may be subject to certain of the requirements of such Title I. PAGENO="0407" 397 In the case of a deferred compensation plan that is subject to title I of J~RISA, com- pliance with the exclusive purpose, trust, funding and certain other rules, would cause the plan to fail to satisfy section 457(b)(6). For those of you who do not memorize all of the code section, sec- tion 457(b)(6) states that all amounts deferred under a 457 plan must remain the property of the employer, subject to the claims of the general creditors of the employer. The result has been to remove the possibility of allowing non- highly compensated employees in a tax-exempt non-501(c)(3) organi- zation from participating in a pretax salary deferral plan. Stated another way, we make it possible for these organizations to establish a pre-tax salary deferral plans for select group of em- ployees through traditional nonqualified plans, but if they wish to provide such a program on a unilateral basis among the work force, we must tell them that such a desire is admirable but illegal. The most obvious concern is what will be the impact on current revenues? And I must admit that I cannot offer a specific answer to the question, although I would be comfortable in stating, that as a group, the nonprofit, non-501(c)(3) organizations would make up a smaller number of employees in total, although there are many as- sociations. This may even be one reason why their plight has not been re- solved nearly 3½ years after TRA-86. I have noted in my written discussion that allowing the nonprofit, non-501(c)(3) organization to offer 403(b) programs would provide for continuity among the types of plans that an employer could offer, it would also have the great- est negative impact on revenues, while allowing 401(k) plans would have the least negative impact on revenues. In conclusion, it would appear to me that with regard to pre-tax salary deferral plans, in nonprofit,~ non-501(c)(3) organizations that Congress overlooked the fact that changes made by TRA-86, have prevented these organizations from allowing their nonhighly com- pensated employees from participating in such a program. It is also clear that by their continual refinement of these pro- grams that Congress wants to encourage these. plans as long as they do not discriminate in favor of highly compensated employees. I urge you to recommend legislation to correct this oversight at your earliest convenience, and I would like to once again, thank you, for taking the time to listen. Mr. ANDREWS. Thank you. [The statement of Mr. Huxhold follows:] PAGENO="0408" 398 TESTIMONY OF GENE R. HIJXHOLI) KEMPER FiNANCIAL SERVICES 401(k)/Pre-Tax Salary Deferral Programs in Non-Profit Organizations Introduction Ladies and Gentlemen of the Committee, I would like to thank you for al- lowing me this opportunity to testify before you concerning 401(k), or stated in a broader fashion, pre-tax salary deferral programs in non- profit organizations. I realize that you have many demands and inter- ested parties with demands who require a share of your time; and there- for, I am most appreciative that you were willing to listen to my thoughts on this particular topic. For your information, I am employed as a Regional Director for Pension and Savings Programs. In this capacity, I am charged with assisting in the establishment and enhancement of the retirement programs that are offered by small to medium sized employers. As a point of reference, this would include organizations with from 1 to 500 employees. It is from this frame of reference that I am submitting this testimony. ~p~çground The purpose of this testimony is to alert you to what appears to have been an oversight in the legislation that was developed for the Tax Reform Act of 1986 (TRA86) and then left uncorrected in the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). I have utilized the term "alert" because I have not noticed any references in the various reports that I receive that indicate that this topic has been discussed or con- sidered by the committee. The problem focuses on non-profit, non 50l(c)(3) organizations that wish to establish a pre-tax salary deferral program. In many instances these organizations wish to either add this type of program to their existing retirement benefit package or they wish to install it as their retirement benefit package. The organizations that fall into this category of non-profit firms include associations, credit unions and chamber of com- merce. While the lack of a 401(k) is not as critical to 50l(c)(3) organizations since they may establish and maintain a 403(b) plan, these organizations also have an interest in offering the 401(k) in order to ease the burden of offering and administering multiple programs within the same or- ganization. For example, if the firm already has an established profit sharing program, it would merely need to amend the profit sharing program to include a pre-tax salary deferral plan. Under current regulations, the only way to add the salary deferral plan would be to in- stall a 403(b) program. It should be noted at the outset that many of the employees of the forementioned organizations have chosen to work for a non-profit or- ganization in order to benefit or assist others -- often at a reduced pay level relative to the same j~b function at a for profit employer. Legislative Hist~pry Prior to the Tax Reform Act of 1986, the status of pre-tax salary defer- ral programs, this time I am referring to 401(k) plans specifically, for non-profit organizations was unclear. As a result there were a number of state and local governments, non-profit 50l(c)(3) and non-profit, non 501(c)(3) organizations that established 401(k) programs, often in addition to their existing pre-tax salary deferral programs, 457 and 403(b) plans to be specific. It was also unclear as to whether or not an employee could defer salary up to the specific limits in each plan without taking into account the amount deferred in the other. PAGENO="0409" 399 The 49~f~ç) Protected -- The 401(k) plan must be qualified under ERISA in order to allow employees the pre-tax salary feature. With a trust estab- lished, the employees may rest assured that their deferrals ~re protected no matter what happens to the employer's assets. Since the rank and file employees have nothing to do with the efficiency or inefficiency of the organization's management, it would only seem fair that they should be protected under the ERISA umbrella. Understood -- Publicity concerning the 401(k) has been great which has caused the general public to recognize the potential value of such plans. This higher awareness level coupled with the larger number of 40l(k)'s installed today certainly make it a favored op- tion among the typical American. Portabjflt~ Is Possible -- Since a 401(k) is an ERISA qualified plan, it does allow an employee to either transfer his assets to his new employers plan or to an IRA rollover account. ~g~jonsa~ well-defined -- While I am certain that over time modification to the existing laws and regulations will occur, I am merely noting here that we already have a good deal of guidance on 401(k) programs versus the 403(b) program discussed below. The 403(b) Protected -- In a salary deferral program only, employees are al- lowed to have an account for their exclusive benefit, however, it is subject to the same early distribution taxes and penalties as are IRA's. In a plan where the employer also makes contributions, the IRS has stated in Regulation 2510.3-2(f) that where employer contributions are made, the plan must comply with ERISA, Unfortunately, detailed guidance on how to operate such a program has not been defined, although it is generally interpreted that you should operate a 403(b). program, that has employer contributions, in accordance with the 401(k) regulations. Portab~,4~y -- Since, the employee has his own account under a 403(b) program, this plan offers maximum portability. When the employee leaves an employer, he does not rece:ve a distribution, He may either leave his account with the investment company with whom he has the account, he may roll it over to an IRA or he may transfer it to a different investment company (under 403(b)) that his new employer might offer. Continu4ty -- While the `403(b) is not as well known as the 401(k), it certainly accomplishes the same objective end by allowing non- profit, non-501(c)(3) organizations to offer a 403(b) program would facilitate the understanding of the different plans available; that is, all tax-exempt organizations could establish a 403(b) while all taxable employers could establish a 401(k) and finally, all state and municipal governments could establish a 457. ~ -- As noted in my discussion of the 401(k), the regulations surrounding 403(b) are not well defined when employer contributions are also offered within a 403(b) program.' PAGENO="0410" 400 TRA86. clarified Congress's intent as to what the total level of deferral could be where multiple plans were available. The Act also eliminated the 401(k) program for tax exempt employers and made available the 457 plan, which thus. far had only been available to state and municipal governments. At first it appeared that all organizations now had one basic type of pre-tax salary deferral program available: * Taxable Employers -- Had the 401(k) * Tax-Exempt, 50l(c)(3) Employers -- Had the 403(b) or the 457 * State and Municipal Governments -- Had the 457 * Tax-Exempt, non 50l(c)(3) Employers -- Had the 457 Unfortunately, the Internal Revenue Service quickly pointed out in IRS Notice 87-13,. question and answer 25, that, and I quote, "Section 1107 of TRA86 doe not (and was not intended to) amend any provision of Title I of the Employer Retirement Income Security Act of 1974, as amended (ERISA). Accordingly, a deferred compensation plan of a tax-exempt organization may be subject to certain of the requirements of such Title I. In the case of a deferred compensation plan that is subject to Title I of ERISA, compliance with the exclusive purpose, trust, funding and certain other rules will cause the plan to fail to satisfy section 457(b)(6)." For those who don't memorize all the code sections, section 457(b)(6) states that all amounts deferred under a 457 plan ~ remain the property of the employer subject to the claims of the employer's general creditors. The result has been to remove the possibility of allowing a non-highly com- pensated employee in a tax-exempt, non 501(c)(3) organization from par- ticipating in a pre-tax salary deferral plan. Stated another way, we make it possible for these organizations to establish a pre-tax salary deferral plan for a select (key) group of employees through traditional non-qualified plans, but if they wish to provide such a program on a unilateral basis among the workforce, we must tell them that such a desire is admirable but illegal. During the development of TAMRA, 457 plans were addressed but not with regard to the above issue. The discussions and subsequent legislation focused on whether the $7,500 limitation also applied to benefit programs such as health insurance. The Solution This is one situation where the answer is pretty obvious. Congress needs to recognize that an oversight was committed by preventing the non-profit, non-50l(c)(3) organization from providing a pre-tax salary deferral plan for their rank and file employees. The only question is what type of program would be the best to resolve the problem.. Let me review the key features or concerns with each program: The 457 No Exclusive Reserve -- The 457 program does not offer an employee the protection of Title I of ERISA. This means that an employee must have any deferrals subject to the general creditors of the organization. This practice is relatively acceptable for state and municipal governments, since their retirement programs are generally exempt from ERISA anyway and they have the ability to tax should they require the resources to fund benefit programs. Lack of Porta~4ty -- Since the 457 does not qualify as an ERISA program, any distributions from a 457 to a participant become im- mediately taxable. This prevents the employee from transferring his retirement account to an IRA in order to avoid taxes and penalties. Once again this has not been a major problem for state and municipal employers since even their traditional retirement programs are not portable. It should be noted that an employee may transfer his 457 plan account balance to another employer's 457 plan under TRA86. This is a plus, but once again is better suited for the government employee who traditionally stays with a public sector employer for many years of his or her career. PAGENO="0411" 401 Concerns The most obvious concern is what will be the impact on current revenues. I must admit that I cannot offer a specific answer to the question al- though, I would be comfortable stating that as a group~ the non-profit, non 501(c)(3) organizations would make up smallest type of employers in the nation. This may even be one reason why their plight has not been resolved nearly 3 1/2 years after TRA86. In my mind the issue comes down to whether or not ~py organization is allowed to provide its employees with a pre-tax salary deferral program. If Congress is to al- low the continued use of 457's, 403(b)'s and 401(k)'s (and I certainly recommend that they do) then it should not discriminate against the employees of one particular type of organization. Additionally, the revenue impact of allowing 401(k)'s in organizations which may offer 403(b) programs would be neutral, since the law already provides for a direct offset of the amount that may be deferred by the amount that has been deferred in another plan. While I have noted above in the plan discussion that allowing the non- profit, non-501(c)(3) organization to offer a 403(b) program would provide for continuity among the types of plans that an employer could offer, it would also have the greatest negative Impact on revenues. The maximum that may be deferred into a 403(b) program is $9,500 and with special catch-up provisions, the maximum could rise to $15,000. In contrast the 401(k) limitation is $7,979 with no catch-up provisions. The 457 plan also offers a special catch-up provision that could allow deferrals to rise as high as $15,000. CONCLUSION In conclusion, it appears to me that with regard to pre-tax salary defer- ral plans in non-profit, non-501(c)(3) organizations, that Congress over- looked the fact that changes made by TRA86 have prevented these or- ganizations from allowing their non-highly compensated employees from participating in such a program. It also is clear by their continual refinement of these programs that Congress wants to encourage these plans as long as they do not discriminate in favor of the highly compen- sated. I urge you to recommend legislation to correct this oversight at your earliest convenience and I would like to once again thank you for taking the time to liSten. PAGENO="0412" 402 Mr. ANDREWS. Mr. Baker, you are next to present your testimo- fly. STATEMENT OF WILLIE L. BAKER, JR., INTERNATIONAL VICE PRESIDENT AND DIRECTOR, PUBLIC AFFAIRS DEPARTMENT, UNITED FOOD AND COMMERCIAL WORKERS INTERNATIONAL UNION, AFL-CIO, ACCOMPAMED BY JEFF ENDICK, ATTORNEY Mr. BAKER. I. am accompanied today by Jeff Endick, attorney, who handles our 401(k) and other pension plans for the UFCW. My name is Willie Baker and I am the international vice presi- dent for the United Food and Commercial Workers International Union and director of our public affairs department. The UFCW represents over 1.3 million members in the commer- cial retail and service sectors. I am here today to urge this committee to support.. tax fairness by adopting an amendment to the Internal Revenue Code of 1986, to allow currently ineligible tax-exempt entities, such as labor unions, to establish 401(k) plans for all employees presently prevented from participating in this national savings effort. At the outset, it is important to note that we at the UFCW be- lieve defined benefit plans to be the mainstay of the private pen- sion system in the United States. Nonetheless, 401(k) plans are also an important part of that system in that they allow employees the ability to plan for retirement through elected deferral of wages. As part of an overhaul of the Internal Revenue Code, the Tax Reform Act of 1986 makes substantial revisions in the legal re- quirements governing private pension plans. Among the changes made by the Tax Reform Act were those affecting 401(k) plans. The Tax Reform Act prevents State and local government employers and employers exempt from Federal income tax, from establishing qualified cash or deferred arrangements. Thus, employees of tax- exempt organizations are precluded from saving for their retire- ment through this salary reduction mechanism. The UFCW believes that the discriminatory bar to the 401(k) plans is especially egregious in light of those changes in the 401(k) which were designed to provide more equitable distribution of ben- efits. The UFCW went to great effort to develop 401(k) plans that its local unions could offer. However, the application of the July 2, 1986 cutoff date meant that the overwhelming majority of our locals were unable to offer this plan to their employees. In our view, there was no rational basis for this exclusion. The UFCW believes that employees of labor unions are entitled to the same opportunity to save for their retirement as employees of charitable and educational organizations, the Federal Govern- ment and the private for-profit sector. Today, employees of State and local governments are entitled to 457 salary reduction plans, and Federal employees have available to them the Federal savings thrift plan and employees of charita- ble institutions and some educational organizations may take ad- vantage of 403(b) plans if they wish to save for their retirement. From a legislative standpoint, it is significant that repeal of the limitations on the ability of the tax-exempt employers to maintain PAGENO="0413" 403 cash or deferral arrangements has been approved by both the full Committee on Ways and Means and the Senate Finance Committee in recent years. The Committee on Ways and Means correctly reasoned that equi- ties were on the side of those tax-exempt entities currently barred from starting 401(k) plans. The report language focused on ERISA's preclusion of nongovernmental tax-exempt organizations from maintaining broad-based section 457 plans. Unfortunately, the change in the law was dropped in conference. Last year, the Senate Finance Committee adopted a measure re- pealing the current limits on 401(k) to allow currently excluded tax-exempt entities to maintain cash or deferral arrangements for their employees. While this provision, along with many others, failed to survive the 1989 somewhat unusual reconciliation process, the record of congressional support for equity in the context of 401(k) plans should encourage this body to ratify the full commit- tee's previously recorded position in support of broadening of op- portunities for 401(k) plan participation. It should also be noted for the record that the IRS' own favorable view, relative to tax-exempted employees establishing 401(k) plans, was stated in a general counsel memorandum issued in 1983, prior to the adoption of changes which are the subject of this testimony. In sharp contrast to the current unfair treatment under the Tax Code, IRS general counsel also concluded in its memorandum that compensation plans, including 401(k) plans, materially aid in in- creasing employee productivity, regardless of whether the employer is tax exempt or taxable. The UFCW strongly believes that extension of 401(k) plans to presently excluded tax-exempt entities would both reaffirm and strengthen the congressional intent to promote tax fairness, which was the basis of the 1986 Tax Reform Act. Thus, the UFCW urges this committee to exercise its authority in support of tax equity, and repeal the unfair limitations on the ability of tax-exempt employers to maintain these plans. Thank you, Mr. Chairman. Mr. ANDREWS. Thank you, Mr. Baker. [The statement of Mr~ Baker follows:] PAGENO="0414" 404 uFcw SUBMITTED TO THE SUBCOMMITTEE ON SELECT REVENUE MEASURES OF THE COMMITTEE ON WAYS~ AND MEANS OF THE `U.S. HOUSE OF REPRESENTATIVES ON THE EXTENSION OF 401K TAX PLANS TO TAX-EXEMPT ENTITIES FEBRUARY 22, 1990 My name is Willie Baker. I am Director of Public Affairs for the United' Food and Commercial Workers International Union. UFCW consists of over 1.3 million members in the commercial, retail, `and service sectors. I am here today to urge this committee to' support' tax fair'ness by adopting an amendment to the Internal Revenue Code of 1986 to allow currently'ineligible tax exempt entities, such as labor unions, to establish 401(k) plans for all employees presently proscribed from participating in this national savings `effort. ` , ` , At the outset, it is important to note that we at the UFCW believe defined benefit plans to be the, mainstay of the private pension plan system in the United States. Nonetheless, `401(k) plans are also an important part of that system in that `":they allow employees the ability to' plan for retirement through the elective deferral of wages. As part of anoverhaul~of the Internal Revenue Code, the Tax Reform Act of 1986 made substantia1~rEvi5i0n5 to the legal requirements governi'ng private pension pians. Among "the changes made by the Tax Reform Act were those affecting 401(k) plans. The Tax Reform Act prevents state and local government employers, and employers exempt from federal income tax, from establishing qualified cash or deferred arrangements. Thus, employees of tax-exempt organizations are precluded from saving for their retirement through this salary reduction mechanism. UFCW believes the discriminatory bar to `401(k) plans is especially egregious in light of those changes in 401(k) which were designed to provide more equitable distribution of benefits. In this regard, it should be noted that both the lowered limits on elective contributions from the lesser of $30,000 or 25 percent of compensation to $7,000 (as adjusted for inflation), as well as the' stricter nondiscrimination tests, were meant to ensure that 401(k) plans did not discriminate in favor of certain employees. It is somewhat of a paradox then that employees of tax-exempt organizations are denied the possibility of participating in 401(k) plans despite the law's overall goal to provide for a more even distribution of benefits. While section 1116 (f) (2) (B) of the Tax Reform Act provides an exception to the general rule in the form of a grandfather clause for plans adopted by tax exempt employers before July 2, 1986, and by government employers before May 6, 1986, the consequences for the subject entities can be anomalous in the extreme. PAGENO="0415" 405 For example, the UFCW went to great efforts to develop a 401(k) plan that its local unions could, offer. However, the application of the July 2 1986 cut-off date meant that the overwhelming majority of . our locals were unable to offer this plan to their employees. In our view there is no rational basis for this exclusion, In this regard it should not go unnoticed that the Technical and Miscellaneous Revenue Act of. 1988 expanded the transition rule for governmental employers. Yet, no relief was given to tax-exempt entities. The UFCW believes that employees of labor unions are entitled to the same opportunity to save for their retirement as employees of charitable and educational organizations, the federal government and the private for-profit sector. Today, employees of a state or locaL government are entitled to a 457 salary-reduction plan to save for retirement. Although the Tax Reform Act of 1986 extended this program to tax- exempt entities, an anomaly in the law makes 457 plans available only to a select group of management or highly compensated employees of a tax-exempt organization. Federal employees also have available to them the federal government's thrift plan to save for retirement in the same manner. Additionally, employees of charitable institutions and some educational organizations may take advantage of a 403(b) plan if they wish to save for their retirement on a tax-deductible basis. SECTION 457 PLANS Section 457 plans are not a viable alternative to 401(k) for the bulk of employees in those tax-exempt organizations which are the subject of this testimony. A critical feature of Section 457 plans is that the plan's assets remain the property of the employer, subject to the claims of the employer's creditors, This in effect means that this type of plan remains unfunded to provide participants' benefits. In contrast, the Department of Labor has stated in Announcement 86-527 that section 457 plans are `subject to the provisions of Title I of the Employee Retirement Income Security Act of 1974 (ERISA), such as funding and vesting, and that assets remain for the exclusive benefit of employees. The only exception from these Title I requirements is for plans maintained primarily for a select group of management or highly'compensated employees. . Thus, the result of the interaction of Title I of ERISA and Section 457 is that only selected management and highly compensated employees of a tax-exempt organization may benefit from a Section 457 plan. SECTION 403(b) PLANS Section 403(b) provides that employers of certain tax- exempt educational, charitable and religious organizations and public schools are given special tax treatment for annuities purchased for them by the exempt organization, Labor organizations are not included within the scope of this deferred compensation program. PAGENO="0416" 406 From a legislative standpoint, it is significant that repeal of the limitation on the ability of tax-exempt employers to maintain cash or deferred arrangements has been approved by both the full Committee On Ways and Means and the Senate Finance Committee in recent years.. The language in the Report for the Omnibus Budget Reconciliation Act of 1987, adopted by the full Ways and Means panel and passed by the House, reads as follows: The committee believes that tax-exempt organizations should be entitled to maintain broad- based, tax-favored retirement programs that allow elective deferrals. At that time, the Committee on Ways and Means correctly reasoned that the equities were on the side of those tax-exempt entities currently~ barred from starting 401(k) plans. The report language focused on:~ERISA's preclusion of "nongovernmental tax- exempt organizations from maintaining broad-based section 457 plans." Unfortunately, the change in~ law was dropped in conference. Last year, the Senate Finance Committee adopted a measure repealing the current limits on 401(k) to allow currently excluded tax-exempt entities to maintain cash or deferred arrangements for their employees. While this provision, along with many others, failed to survive 1989's somewhat unusual reconciliation process, the record of congressional support for equity in the context of 401(k) plans should encourage this body to ratify the full committee's previously recorded position in support of a broadening of opportunity for 401(k) planS participation. It should also be noted for the record that the IRS's own favorable view, relative to tax-exempt employees establishing 401(k) ~p1ans, was stated in a General Couzmsel Memorandum issued in 1983, prior to the adoption of changes which are~the subject of this testimony. The memorandum reads in per~ti~neTIt part as follows: Various types of exempt organizations may have a significant use for incentive compensation plans. Many others may simply wish to avoid possible adverse effects on exempt functions of a required yearly contribution to a pension plan. In either case, they should have the ability to qualify such plans.... (emphasis added) In sharp contrast to the current unfair treatment under the tax code, I~RS's General Counsel also concluded in the memorandum just-ci±ed that compensation plans, including 401(k) plans, nrate~rially aid. in increasing employee productivity, regardi~ess~nf/rw1'1ether the employer is tax-exempt or taxable. The UFCW strongly believes that extension of 401(k) plans to presently excluded tax-exempt entities would both reaffirm and strengthen the congressional intent to promote tax fairness, which was the basis of the Tax Reform Act of 1986. Thus the UFCW urges this committee to exercise its authority in support of tax equity, and repeal the unfair limitation on the ability of tax-exempt employers to maintain cash or deferred arrangements under Section 401(k) of the Internal Revenue Code. PAGENO="0417" 407 Mr. ANDREWS. Mr. Ostrander, we will hear from you next. STATEMENT OF STEVEN R. OSTRANDER, CPA, VICE PRESIDENT, MILLER & BENZ, P.C., ROCKVILLE, MD Mr. OSTRANDER. Thank you, Mr. Andrews. My name is Steve Ostrander and I am a certified public account- ant, and certified pension consultant. I come before you today as an individual taxpayer and citizen to speak on the proposals to permit nongovernmental tax-exempt employers to maintain 401(k) plans and to relax, certain rules relating to voluntary employees' beneficiary associations, or VEBA's. As a foundation for my comments, I offer the following: It is a fact that the lion's share of the tax expenditures which result from the provisions of the current Internal Revenue Code relate to pen- sions and employee benefit plans. Therefore, it is reasonable to conclude that this level of invest- ment indicates that the Congress continues to support the' gi~O*th of private employer sponsored plans. It is my considered opinion that both of the pension and employ- ee benefit proposals identified above are consistent with this con- gressional support for employer-sponsored plans. Consequently, I support both proposals and would like~ to explain my reasoning in detail. With respect to the permitting of nongovernmental tax-exempt employers to maintain 401(k) plans, this proposal appears to be the correction of an error which occurred during the deliberations with respect to the Tax Reform Act of 1986. In the interests of further- ing the growth of private employer sponsored pension plans, I sup- port this proposal. Further, assuming the Secretary of the Treasury did not find any basis for prohibiting the sponsoring of cash or deferred arrange- ments, by State and local governments, or tax-exempt organiza- tions, in his study of the tax treatment of deferred compensation plans `paid by. these types of employers, I respectfully. submit that State and local governments should also be allowed to offer plans of this nature. Any tax law that asks the question, what type of organization do you work for, before determining whether an employee will be ,al~ lowed to participate in a particular type of plan, must be chal- lenged. In light of the fact that organizations of all types must compete for many of the same qualified employees in today's' labor markets, such a tax law does not appear consistent with the objective of fos- tering the growth of effective and efficient private pension plans. Finally, I would also like to recommend that this proposal be ex- panded to ensure that nongovernmental tax-exempt organizations may also sponsor salary reduction simplified employee pension plans, or SEP's. With respect to the proposal to relax the certain rules concern- ing VEBA's, this proposal has ramifications that warrant serious consideration. In general, I understand this proposal to include the following: the elimination of the geographic locale restriction found in the Treasury Regulations concerning the objective test for the 30-860 0 - 90 - 14 PAGENO="0418" 408 existence of a common employment-related bond; the modification of the definition of a 10-or-more employer welfare benefit plan; and the efemption of these types of plans from the unrelated business income tax on excess set asides. Each of these proposals appears to make sense when one consid- ers the validity of geographic locale restriction contained in the Treasury Regulations compared to the~ statute, and also the back- ground and history of the Tax Reform Act of 1984 changes to the tax deduction treatment of VEBA's. With respect to the geographic locale restrictions, this is simply part of the facts and circumstances objective standards by which the IRS can determine with some degree of administrative ease, whether a common employment related bond exists. This is one of the critical attributes the IRS uses to satisfy them- selves as to whether or not a tax-exempt VEBA should. be consid- ered to exist. Assuming the support of Congress for the growth of private health and welfare plans, anticipates that free market competition generally results in the more efficient allocation of scarce re- sources, this proposal makes sense. For example, one possible result of this proposal being enacted by Congress could be that VEBA's could be sponsored, if you will, by banks or other financial institutions, for any specific industry type of employer, in direct competition with trade association-spon- sored VEBA's and insurance companies for health insurance pre- mium dollars. However, there are a number of critical related issues that will need to be addressed before any significant positive results can be expected. With respect to the changes to the definition of a 10-or-more em- ployer plan, as long as the other more relevant criteria are satis- fied, in order for a plan of this nature to be exempt from the deduc- tion restrictions of IRC sections 419 and 419(A), any plan that is funded by more than one true separate employer should be treated as the functional equivalent of the traditional employer relation- ship with an insurance company. The regular deductibility :rules for ordinary and necessary busi- ness expénses~ should control with respect to each individual em- ployer's tax deductions. There should be nothing in this proposal that needs to be consid- ered potentially abusive or inconsistent with congressional support. As long as Treasury provides explicit guidance concerning the deductibility issues by the time the proposal becomes law and as long as Treasury does provide some final regulations concerning the definition of a welfare benefit fund under section 419(e). Thank you. [The statement of Mr. Ostrander follows:] PAGENO="0419" 409 February 20, 1990 Steven R. Ostrander, CPA Certified Pension Consultant Miller & Benz, P.C. 2401 Research Blvd., Suite 101 Rockville, MD. 20850 Subcommittee on Select Revenue Measures House Committee on Ways and Means 1135 Longworth House Office Building Washington, D.C. Prepared Statement for Testimony February 22, 1990 Public Hearing RE: Pension and Employee Benefit Provisions To -- Permit Nongovernmental Tax-Exempt Employers to Maintain Section 401(k) Cash or Deferred Arrangements Relax Certain Rules Relating to Voluntary Employees Beneficiary Associations (VEBAs) Introduction and_Overview Thank you for the opportunity to testify before this Subcommittee today. I come before you as a United States citizen, a Certified Public Accountant and a Certified Pension Consultant. I am here to offer my personal and professional observations concerning the proposals to: (1) permit nongovernment~l tax-exempt employers to maintain, section 401(k) cash or deferred arrangements, and (2) relax certain rules relating to Voluntary Employees' Beneficiary Associations (VEBAs). I am not here as a representative of any Firm, Company, Organization, or Association; or any Client of my Firm. I speak only for myself. My purpose in testifying before you today is not to offer opinions as to what "should be" the purposes, goals or objectives of Congress in considering these proposals. The selection of the end results to be achieved by tax laws is not within my scope. I am here to offer observations concerning the viability of these proposals as the means chosen by Congress to achieve explicitly stated end results. I understand that the scope of these Subcommittee hearings is narrowly focused. This is not the proper forum in which to discus~s and debate fundamental tax policy or structural issues. The fact that these hearings cover such a wide range of miscellaneous tax proposals in just two days demands expedience and the efficient use of time. I accept these restrictions and I will use the greatest part of my allotted five minutes to address the specific proposals identified above. If time allows, I would also like to make one final and much more general observation. As the foundation for my comments, I offer the following -- FACT: The lion's share of the. "tax expenditures" which result from the provisions of the current Internal Revenue Code. ("IRC") r.e.late to pensions and employee benefit plans. CONCLUSION: This level of "investment" indicates that Congress continues to support the growth of private, employer-sponsored plans. It is my considered opinion that both of the pension and employee benefit proposals identified above are consistent with this Congressional support for employer-sponsored plans. Consequently, I support both proposals and would like to explain my reasoning. PAGENO="0420" 410 I would also like to offer the following hypotheses for your consideration: o "The end justifies the means" is a fallacious argument. As such, it is riot an acceptable way to rationalize the choosing of a particular "means" (including tax laws). This argument cannot be expected to withstand any test of time, or the objective scrutiny of sound reasoning. ~ "The end must exist in the means" is an accurate statement. For any chosen "means" (including tax laws) to be a viable approach to attaining an explicitly stated "end," the means must be consistent with such end. o If an explicitly stated end does not exist in the means chosen to achieve such end; either the wrong means have been chosen, or the explicitly stated end is not the end actually intended by the one who chose the means. p~çifi~~p~posal a The simple fact that these specific proposals are under consideration reflects the capacity of Congress to identify defects in existing tax laws and regulations, and to move to correct them. In that regard, I applaud the actions you are considering. However, I would like to point out that these proposals will correct only two of the numerous defects which exist in the tax laws and regulations related to pensions and employee benefit plans. With respect to the proposal to: Permit Nongovernmental Tax-Exempt Employers to Maintain Section 401(k) Cash or Deferred Arrangements -- This proposal appears to be the correction of an error which occurred during the deliberations related to the passage of the Tax Reform Act of 1986 ("TRA `86"). Given the history of how the employees of nongovernmental tax- exempt organizations had been treated by deferred compensation tax legislation in the Revenue Act of 1978, this error should not have come as much of a surprise. What is surprising is that these same employees were given IRC Section 457 statt~tory protection from the IRS invoking the constructive receipt doctrine with respect to "eligible deferred compensation plans" in TRA `86 (eight years late), while being prohibited from participating in cash or deferred arrangements by the same legislation. The Senate version of TRA `86 prohibited only State and local governmental employees from taking advantage of this valuable retirement funding vehicle. The House version, which included the prohibition for nongovernmental tax-exempt organizations as well as State and local governments, prevailed in conference. In the interest of furthering the growth of private, employer- sponsored pension plans I support this proposal. Further, assuming the Secretary of the Treasury did not find any basis for prohibiting the sponsoring of cash or deferred arrangements by State and local governments or tax-exempt organizations in his study of the tax treatment of deferred compensation paid by these types of employers (as required under the Technical and Miscellaneous Revenue Act of 1988), I respectfully submit that State and local governments should also be allowed to offer plans of this nature. PAGENO="0421" 411 Any tax law that asks the question: "What'type of organization do you work for?" before determining whether employees will be allowed to participate in a particular type of deferred compensation plan must be challenged. In light of the fact that organizations of all types compete for many of the same qualified employees in today s labor markets, such a tax law does not appear to be consistent with the objective of fostering the growth of effective and efficient private pension plans. Finally, I would like to recommend that this proposal be expanded to allow salary-reduction simplified Employee Pension Plans ("SEPs") to be maintained for the employees of nongovernmental tax- exempt organizations. With respect to the proposal to: Relax Certain Rules Relating to Voluntary Employees' Beneficiary Associations (VEBA5). -- This proposal has ramifications that warrant serious consideration. In general, I understand the proposal to include the following: (1) elimination of the geographic locale restriction found in Treasury regulations concerning the objective test for the existence of a "common employment-related bond," (2) modification of the definition of a "10 or more employer" welfare benefit plan to effectively allow individual employers to contribute up to 25% of all employer contributions if more than 15 employers contribute, and (3) exempt these "10 or more employer" plans from the unrelated business income tax on "excess" set-asides. Each of these proposals appears to make sense when one considers the validity of the geographic locale restriction contained in the Treasury regulations (in light of a recent Seventh Circuit Court of Appeals decision) and the background and history of the Tax Reform Act of 1984 changes to the tax deduction treatment of VEBAs. I will take each separate proposal in turn. The geographic locale restriction has always been part of the - "facts and circumstances objective standards" by which the IRS could determine with some degree of administrative ease whether a common employment-related bond existed. This is one of the critical attributes which must be satisfied in order for the IRS to determine whethera tax-exempt VEBA should be considered to exist. Assuming that the support of Congress for the growth of private health and welfare benefit plans anticipates that "free market competition" generally results in the more efficient allocation of scarce resources, this proposal makes sense. For example, one possible result of this proposal being enacted by Congress could be that VEBAs would be sponsored by banks and other financial institutions -- in direct competition with trade association- sponsored VEBAs and insurance companies for health insurance dollars. However, there are a number of critical related issues that will need to be addressed before any such significant positive * results can be expected from this change (such as: "Who may sponsor a VEBA?"). Please note also that the *Department of Labor recently issued a number of Advisory Opinion Letters in which they concluded that particular arrangements met the definition of "multiple employer welfare arrangements" as defined in ERISA Section 3(40), and that sucharrangements were subject to state laws regulating insurance (not covered by the ERISApreemption of state laws). PAGENO="0422" 412 With respect to the changes to the definition of a `10 or more employer" plan, I cannot help but ask: "Where did the impetus (and the specific numbers) for this proposal come from?" As long as the other criteria that must be met in order for a plan of this nature to be exempt from the deduction restrictions of IRC Sections 419 and 419A, ~py~ plan that is funded by more than one true "employer" should be treated as the functional equivalent of the traditional relationship between an "insurance company" (taking on the risk to provide benefits to employees) and the employers involved. The regular deductibility rules for "ordinary and negessary business expenses" should control the employers' tax deductions. There should be nothing in this proposal that needs to be considered potentially abusive or inconsistent with Congressional support for the growth of private employee benefit plans, as long as Trea~~y~ .p~g~des explicit guidance concerning the deductibility iss~~j~y~ ~_~ppp~a 1 becomes 1 aw. As for the exemption from the unrelated business income tax for "excess" set-asides, if the related "trust" or "fund" is considered to be the functional. equivalent of an independent, third party "insurance company" taking on risk, the unrelated business income tax should be considered inapplicable. This tax is actually more closely related to controlling the potential deduction abuse of the "single-employer" VEBA situation than in the "10 or more employer" situatio~i. General ~bservation I wish to state simply and for the record that the current status of our tax laws and regulations relating to pensions and employee benefit plans has produced a severely dysfunctional environment. In this environment, planning for any time period longer than "today and the immediate future" is much more difficult than it should be. Such an environment is not conducive to the growth of private pensions and employee benefit plans. It appears that this critical state of affairs may be related to the following: (1) Congressional intent concerning tax legislation related to pensions and employee benefit.. plans appears to have changed dramatically since 1974. This intent now seems to emphasize the raising.of federal revenues; eliminating the use (and abuse) of federal "tax expenditures" (allowable deductions, gross income exclusions, etc.,) by employers and "highly-compensated employees;" and mandating that the compensatioD paid by employers to employees include certain specific elements and benefits, instead of expanding the social programs funded directly with federal revenues. . - (2) Congress has delegated the responsibility to administer, interpret and enforce an overwhelming volume of pension and employee benefit -plans tax legislation to- the Treasury Department and the Internal Revenue Service without providing theresources necessary to do the job effectively Employers and employees are not nearly as free to contract with one another as they need to be in order to capitalize on market opportunities and meet the global and domestic economic challenges of the 1990's, or the 21st century. The current status of our tax laws and regulations do not foster cooperation, coordination or compromise between employers and employees. With the passage of ERISAin 1974 and subsequent legislation, these rules appear to be based on the premise that, -the goals and. objectives of employers and employees are naturally incompatible and mutually exclusive. It appears that a Win-Win situation is assumed to be impossible in any given relationship between employers and employees. PAGENO="0423" 413 SAnd now we compound the problem: the curren±v~federal budget deficit and the related search for additional federal revenues has begun to drive the amendments and modifications to these rules. We are expecting infinitely more from these tax laws and regulations than they are capabl.e of delivering. Rules designed to nurture the growth of employer-sponsored pensions - and benefit plans, by providing tax incentives to employers (tax deductions~) and employees (the deferral or elimination of taxable. income), must have an acceptable degree of' stability over the relevant time frame in order to be successful. This time frame cannot be measured in days or months, but more appropriately in decades. Since 1974, there' have been `at least ten major `legislative changes to these rules by Congress, many of which have yet to be effectively incorporated into final Treasury Regulations. Unfortunately these rules appear to incorporate the presumption that a homogeneous and generally `ignorant national workforce exists. These individuals are presumed to be incapable of making sound, independent decisions in their own best interests. At the risk of being accused of having a "keen perception of the obvious," I submit to you that our national workforce is definitely not homogeneous or generally ignorant; and in fact has become, and must continue to evolve into, a more educated and more productive-group of separate individuals. In order to survive, let alone grow and' `be successful in the workplaces of the 1990's and future years, `these individuals will be expected to be able to make sound, independent decisions. I thank you for your kind attention and consideration. Sincerely, ~~nR.Ostrande~~ (I PAGENO="0424" 414 Mr. ANDREWS. Thank you. Mr. Brandenburg. STATEMENT OF DAN S. BRANDENBURG, COUNSEL, PRINTING - INDUSTRIES OF AMERICA, INC. Mr. BRANDENBURG. Mr. Chairman, my name is Dan Branden- burg I am a private attorney representing the Printing Industries Association of America, Inc., regarding the Printing Industries Consolidated Trust The Printing Industries of America, Inc., is pleased to have the opportunity to present testimony regarding modifications of restric- tions applicable to voluntary employees beneficiary associations, or VEBA's. Printing Industries Association or Printing Industries of America is headquartered in Arlington, VA, and is the principal and nation- al association for printing firms and related industries~ The Printing Industries ConsOlidated Trust is a trust initially es- tablished by Printing Industries of America, which provides health and welfare benefits to employees of printing firms which are members of the association. The consolidated trust operates through 19 subtrusts scattered throughout the United States that administer annual contributions for health and welfare coverage exceeding $60 million~ Although two of the smaller subtrusts provide coverage through insurance carriers, the 17 other subtrusts self-fund their employee benefits. Many of the subtrusts have qualified as a VEBA. According to published surveys, small businesses are less likely to provide health coverage for their employees. The majority of the employers surveyed who offered no health coverage stated that one of the reasons for not doing so was the high cost of health insur- ance. The surveys also reported that premium costs for small business- es are substantially higher than for larger employers. We believe that, through the use of the association-sponsored VEBA, a small employer may significantly reduce this price differential by com- bining its purchasing power with other similarly situated employ- ers. Printing Industries of America supports a modification of present law restrictions applicable to VEBA's that have a detrimental impact on multiple employee health and welfare trusts, such as the affiliates of the consolidated trust. The Printing Industries of America specifically seeks a legislative solution that would elimi- nate the geographic restrictions on VEBA coverage, exempt 10 or more employer funded welfare benefit plans from tax on income when there are excess reserves, and liberalize the 10-percent rule applicable to 10 or more employer-funded welfare benefit plans. A brief review of the characteristics of the association's member- ship will help put our concerns in perspective. The association has continuou~h se ved the industiy ~i o rev 100 years The asso~ia ~ion's s~i ucuuie and function is ees gucci to cci vice c11~-~5 i ~ ~he in dus~iy foi numeious local associatiop~ vr~1oce geogiaphic juii~thc tion is based upon the geographic concentration of printing firms, hence the most efficient way to serve member employer needs. PAGENO="0425" 415 Printing Industries of America currently has 31 chartered affih ated local associations, which collectively have over 9,000 member firms, employing over 250,000 people. Although local associations have been chartered for more than 20 years, the local affiliated as- sociations have provided services to member firms throughout their assigned geographic regions with little change in their territories since they were first organized. While some affiliates are chartered to serve a single State, it is more common for an affiliate's charter to be the more expansive or more restrictive of that arbitrary locale. Local associations make available a range of business* services and employee relations and benefit services. Among services are environmental safety programs, a wide range of counseling and human resource programs, assistance in contract negotiations for unionized companies, the employment of merit recognition pro- grams, the employment of credit unions, and the employment of health and medical coverage. This range of services and longevity of the association's affiliates is solid *:evidence that the local associations were by no means formed for the purpose of offering VEBA coverages. The resulting irony is that the VEBA coverage is the one area of service in which local associations cannot assist all their members because of the statewide limitation for qualified status. Where there is not a suffi- cient number of printing companies in a single State to justify a single State association or a self-funded trust limited to employers in that State, the current IRS rule prevents small companies, which are often located in rural areas, from offering employee health benefits in situations where the benefit is most needed and the options are most limited. Mr. Chairman and other members of the subcommittee, the fol- lowing are the positions supported by Printing Industries of Amer- ica: One, elimination of geographic locale restrictions on VEBA's in 1981. The Internal Revenue Service issued final regulations which required that employees participating in a VEBA share an employ- ment-related common bond. This meant that employees of different employment-related employers could participate in a VEBA only if their employers were engaged in the same line of business in the same geographic locale. The IRS has interpreted such a geographical locale to be an area generally no larger than a State. Nothing in the statute or legisla- tive history acts to prohibit tax-exempt status to a VEBA based on the geographic dispersion of its members. In fact, the Seventh Circuit Court of Appeals has overruled the geographic locale provision of the regulation on the grounds that it was not in accordance with legislative intent. VEBA has represent- ed an affordable means of attaining health and other insurance on a collective basis for small businesses, and their establishment should be encouraged rather than discouraged in an effort to in- crease the availability of affordable health coverage. The second aspect deals with exemption from tax and excess re- serves for 10 or more employer funded welfare plans. And the third issue is modification of the 10-percent rule applica- ble to 10 or more employer-funded welfare plans. PAGENO="0426" 416 Both rules tend to avoid the prudent reserving necessary to have stable trust. And neither one of those rules when functioning within an industry would lead to the abuses that have sometimes been alleged to them. Mr. Chairman and other members of the subcommittee, this con- cludes my remarks. Thank you, and*1 will be glad to entertain any questions that you and other members of the subcommittee may have. [The statement and attachments of Mr. Brandenburg follow:] PAGENO="0427" 417 WRITTEN STATE}IENT OF DAN S. BRANDENBURG, ESQUIRE REPRESENTING PRINTING INDUSTRIES OF AMERICA, INC. INTRODUCTION Mr. Chairman, my name is Dan S. Brandenburg. I am a private attorney representing the Printing Industries of America, Inc. The Printing Industries of America, Inc. ("PIA") is pleased to have the opportunity to present a written statement for the February 22, 1990 hearing of the House Ways and Means Committee Select Revenue Measures Subcommittee, regarding modifications of restrictions applicable to voluntary employees' beneficiary associations ("VEBA's"), announced in Press Release No. H-8 issued on January 23., 1990. PIA is headquartered at 1730 North Lynn Street, Arlington, Virginia 22209-2009 (703/841-8100) and is the national association for printing firms and related industries. The Printing Industries Consolidated Trust ("PICT") is a trust, "initially established by PIA, which provides health and welfare benefits to employees of printing firms which are members of PIA. PICT holds tax-exempt .status as a voluntary employees' beneficiary association under.:section 501(c)(9) of the Internal Revenue Code ("Code). The -Internal Revenue Service ("IRS") approved such status in 1979. . P.ICT. acts as a conduit or buying agent for insurance for a number -of sub-trusts established in various localities and regions by local printing associations affiliated with PIA. In all, PICT operates through 17 sub-trusts, and receives annual employer contributions for health and welfare coverage exceeding $60,000,000. Although four of the smaller sub- trusts provide coverage through insurance carriers, the 13 other sub-trusts self-fund their employee benefits. Many of the sub- trusts have qualified as a VEBA. According to a survey conducted in 1986 by. the U.S. Small Business Administration ("SBA"), only 46%.of businesses with under 10 employees provide health coverage compared to 78% of businesses with 10-24 employees and 92% with 25-99 employees. Of those firms reporting that they of ferno health coverage, 62% stated that one of the reasons for not doing so was the high cost of~ health insurance. The same survey reported that premium costs for-small businesses run 10% to 15% higher than for large businesses. An analysis by the Health Insurance Association of America indicates the differential may be as great as 20% to 30%. We believe that through the use of an association-sponsored VEBA a small employer may significantly reduce this price differential by combining its purchasing power with other similarly situatedemployers. P.IA supports a modification of present law restrictions applicable to VEBA's that have a detrimental impact on multiple employer health and welfare trusts, such as PICT, that are exempt from taxation due to their status as VEBA's under Code section 50l(c)(9). PIA specifically seeks a legislative solution that would eliminate the geographic restrictions on VEBA coverage, exempt 10-or-more employer funded welfare benefit plans from the tax on excess reserves and liberalize the 10% rule applicable to 10-or-more employer funded welfare benefit plans. A brief review of the salient characteristics of the printing~ industry and PIA will help put our concerns in perspec.tive. The printing industry is characterized by the prevalence of a vast number of small employers, 80% employ fewer than 20 employees. There are over 40,000 establishments engaged in commercial printing, business forms printing, book printing, bookbinding, PAGENO="0428" 418 blankbooks and binders, trade services, engraving and platemaking. These firms employ over 800,000 workers. PIA has chartered 32 affiliated local associations, which collectively have over 9,000 member firms (some 12,000 including associate members whose total employment is not known) employing over 250,000 people. PIA is the principal national trade association representing the printing industry and has continuously served the industry for over 100 years. PIA's structure and function is designed to service firms in the industry through numerous local associations whose geographic jurisdiction is based upon the geographic concentration of printing firms and hence the most efficient way to service member employer needs. All local associations have been chartered for more than 20 years. The local affiliated associations have provided services to member firms throughout their assigned geographic regions with little change in their territories since they were first organized. As previously noted, a local association is chartered to serve the geographic area in which its services can most effectively and efficiently be delivered to its member firms. While some affiliates are chartered to serve a single state, it is more common for an affiliate's charter to be either more expansive or more restrictive than that arbitrary arrangement. The state of California, for example, is essentially subdivided into three geographic regions, each of which is serviced by a separate local association. In contrast, in view of the scattered locations of printing companies in the South, a local association, the Printing Industries of the South, includes the States of Alabama, Arkansas, Mississippi, Louisiana, Kentucky, Tennessee and West Virginia. The geographic regions established by PIA for each of its local associations have been established to permit sufficient numbers of eligible members to take advantage of economies of scale in the wide array of member services offered by the local associations. The Printing Industriesof New England ("PINE') is a good example. It services employers in the six New England states, with the heaviest concentration of member firms in the Commonwealth of Massachusetts. For all member firms, it makes available a range of business services and employee relations and benefit services. Among the latter-services are environmental and safety programs, a wide range of `counseling in human resource programs, assistance in contract negotiations for' unionized companies, employee merit recognition programs, employee credit unions, and employee health `and medical benefit coverage. The impracticality of establishing a local association restricted to delivering such services only to printing companies in Vermont, or New Hampshire, or Maine, is obvious. This range of services and the longevity of the PIA affiliates is solid evidence that the local associations were by no means formed for the purpose of offering VEBA coverages. The'local trusts (e.g., the PINE Health Benefit Trust) were established by those associations which wished to self-fund employee health benefits and had a large enough concentration of employers in a single state to be able to self-fund prudently. There are now. 17 PICT affiliated local trusts which self-fund the health benefits of employees of member firms and hold 50l(c)(9) qualification. The resulting irony is that VEBA' coverage is the one area of service in which the local associations cannot assist a].]. of their members because of the state-wide limitation for qualified status. Where there is not a sufficient number o'f printing companies in a single state to justify a single-state association (or a self- funded trust limited to employers in that state), the current IRS rule prevents small companies (which are often located in rural areas) from offering employee health benefits in situations where the benefit is most needed and the options are most limited. PAGENO="0429" 419 Exhibit I is enclosed which details (a) the distribution of printing firms on a state-by-state basis throughout the United States, (b) the state-by-state distribution of PIAmember firms, (c) the number and employee complement of firms which participate in local association-sponsored benefit trusts.. Other exhibits detail (a) the states and employment that would be eligible under a regional basis (Exhibit II), (b) an estimate of the new participants the regional trusts would produce (Exhibit III), (c) current participation by trust and firm size (Exhibit IV), and (d) the regions served by the:various PIA affiliates (Exhibit V). It is important to note that in many instances a single state may be served by more~than'one affiliate. The state will appear under each affiliate~ that is chartered to serve any portion of that state. The total employment has been included in the various exhibits which will cause the projected impact of.the regional VEBA to be overstated in some instances. An example would be the State of Nevada of which a few adjoining counties are served by either the Printing Industries of Northern California or the Printing Industries Association of Southern California while the biggest portion of the State has no affiliation with any local association and therefore would not be eligible until such time that an affiliation is established and eligibility is approved by the Internal Revenue Service under the guidelines proposed in this statement. The chart of trust participation (Exhibit IV) reveals the great preponderance of small firms participating in the local trusts and, the virtual absence of large participating firms. Thus, only two firms employing 250 or more employees currently participate in the locally sponsored trusts. These two firms total 774 employees. Only 30 firms with 100 to 249 employees participate. The absence of large employers is due to the fact that such employers are either attractive to commercial insurance carriers or have sufficient resources to self-fund independently. Such firms, then, are able to negotiate or establish their own rates, benefit levels and administrative procedures avoiding the conformity'required in a multiple'employer arrangement. A regional rather than a statewide approach would offer, no new attraction to these employers. We. are aware of similar coverages offered by five PIA affiliated local associations coveEing an estimated 10,000 employees who are not PICT participants. These employees are located in the states of Florida, Ohio, Maryland and Colorado. Including these states it is worth noting that `at present some 93% of the existing PIA membership and 88% of all firms are currently eligible for participation in a local trust, even if there were no .change in the current IRS standard, for they are located in a state already serviced by an existing `association-sponsored VEBA, or are members of a state-wide association not offering VEBA coverage and who would not be impacted `by the proposed regional VEBA qualification in any event. Thus, even if there were a proportional increase in the out-of-state participants' who would be newly eligible under a more liberal standard, that would amount to an increase of less than 6,000 lives. It may be noted from the attached Exhibit I that the 7th Circuit decision regarding multi- state VEBAs (Water Quality Association Employee Benefit Corp. v. ~ has resulted in VEBA coverage for only 674 of the 19,826 printing employees in the State of Indiana under the VEBA sponsored by the Printing Industries of Illinois `and Indiana. Because VEBA'.s represent `an affordable means of obtaining health and other insurance on `a collective basis `for small businesses, PIA believes that their establishment should be encouraged, rather than discouraged, in order to increase the availability of low-cost health insurance for employees. PAGENO="0430" 420 The following are the positions supported by PIA: 1. q~pgraphic Locale Restrictions Applicable to VEBA's Should Be Overturned. In 1981, the IRS issued regulations which required that employees participating in a VEBA share an employment-related common bond in order for the VEBA, to qualify as a tax-exempt organization under Code section 501(c)(9).' According to the regulations, this meant that employees of different employers could participate in. a VEBA only if their employers were engaged in the same line of business in the same geographic locale. The IRS has interpreted such a geographic locale to be an area generally no larger than a state, a Metropolitan Statistical Area or a Consolidated Metropolitan Statistical Area. Prior to the issuance of the 1981 regulations, the only restriction applicable to a VEBA's membership was that its members have a commonality of interests. Nothing in the statute or its legislative history acts to prohibit tax-exempt status to a VEBA based on the geographic dispersion of its members. In fact, in the Water Quality case decided in 1986, the Seventh Circuit Court of Appeals overruled the geographic locale provision of the regulation on the grounds that it was not in accordance with legislative intent. However, the IRS continues to enforce this provision as a requirement for obtaining tax-exempt status for VEBA's in jurisdictions outside of the Seventh Circuit As the law now stands, PICT sub-trusts are unable to provide employee coverage for a substantial number of printing employers because to do so would cause loss of the tax exempti'on. Many printing associations service members outside of the state in which the association is headquartered, but the benefit trusts established by the associations are precluded from providing benefit coverage to these members because `of the geographic locale restrictions 2. 10-Or-More Employer Funded Welfare Benefit Plans Should Be Exempted From Tax On Excess Reserves. Prior to the Deficit Reduction Act of 1984 ("DEFRA"), multiple employer health and welfare trusts were permitted to accumulate reserves without necessarily subjecting the reserves to taxation as unrelated business taxable income. This was essential for self- funded trusts such as the PICT sub-trusts because the build-up of needed reserves helped to. assure `that the trust could meet unexpected liabilities and enabled the trustees to be prudent in their trust administration. It is necessary for a VEBA to have sufficient reserves for it to adequately respond to the fiscal pressures imposed by such things as spiralling medical costs and expensive new medical' treatments, to name a few. DEFRA, however, enacted Code section 419A which established ``tight limitatiOns on the amount of ,reserves' that could be held without tax. The reason for imposing such limitations was to prevent individual employers from arbitrarily reducing their corporate' taxes by contributing unneeded amounts to employee benefit trusts that they had created and taking full tax deductions for' those payments. `Despite that limited purpose, DEFRA's scope reached multiple employer trusts as well as single employer trusts. A multiple employer trust, particularly one established by a trade association to serve' an industry, has neither the tax a'voidance motivation ascribed to the individual employer nor the `flexibility,to achieve that employer's objective. Its constituency is likely to be scores or `hundreds of employers, sO the tax avoidance objective attributable to `a single employer manipulating his own trust simply is not present., There is a built-in safeguard PAGENO="0431" 421 against trustees of an association-sponsored multiple employer trust raising reserves to unnecessary levels because non- competitive contribution levels would stifle employer participation. The arbitrary limits placed upon permissible reserve levels being held without being subject to taxation, coupled with unduly low `safe harbor" limits and transition rules which penalize expanding trusts, compromise the ability of the trustees to self-fund with assurance that all trust liabilities can be satisfied. Tax policy should encourage responsible -pre-funding these liabilities instead of discouraging it. 3. 10% Rule Applicable To 10-Or-More Employer -Funded Welfare Benefit Plans Should Be Modified Code Section 419A(f)(6) protects the deductibility of employer contributions to a 10-or-more employer funded welfare benefit plan in the event that the reserve limits are exceeded. However, this exception i-s only allowed to the extent that no employer inthe 10- or-more employer plan contributes greater than 10% of the total contributions made to the plan. If an employer's contribution exceeds the 10% limit and if the plan has excess reserves, every employer contributing to the plan will lose part or all of its deduction for its contribution (depending on the amount of excess reserves). This result is unfair to the employers who may not have any control over this if the 10% limit is exceeded as a result of the departure of a large employer. The 10% rule also acts as a disincentive to a plan with a small number of members from actively seeking larger employers who would enhance the fiscal soundness of the plan or to new plans being established. Often when an association-sponsored multiple employer trust is initially established there may be one or two major employers who participate. Frequently, an association-sponsored multiple employer trust is established in an area which has one major employer. The statute should be nodified to permit an employer's contribution to constitute up to 25% of the contributions to the funded welfare benefit plan if the -plan has more than 15 employers in it. CONCLUSION - PIA strongly urges Congress to act now to remove these unduly restrictive rules that must be satisfied for an association- sponsored multiple employer trust to qualify for tax-exempt status as a VEBA and to properly .pre-fund its expected -liabilities on a - tax-exempt -basis. Liberalization of these rules will serve to encourage the establishment and -maintenance of these cost-effective vehicles through which employers can offer their employees health coverage at an affordable price. This,- in turn, will enable some of the un-insured employed to -receive the health care benefits that their employers can neither afford or acquire at this time. PAGENO="0432" 422 ~1i4I3IT PtA ~ICT !A TOTAL NE~~ PAR1!CIPAT1~6 TOTAL ~EM95R FIRN `Icr STATE FIRNS FIRI~S FIRNS EMPS EMPLOYMENT ~c:~ATIos AK 33 2 ~1O 28 ` AL ~u 23 7532 .516 AR 185 15 4227 :391 AZ. 454 34 7810 752 CA *757 2492 1582 81395 *2504 8546 CO 651 86 3387 2209 CT 666 182 14232 1992 OC 159 *8 57 2629 393 683 3E 69 2 1304 60 FL 1724 230 27738 5*76 s~ 1600 336 239 22267 7522 3068 HI 93 22 1213 5*3 * A 40$ 117 0 9205 3813 879 10 92 19 1644 173 IL 2396 770 296 65881 375A2 5470 IN 737 205 30 22011 37042 674 KS 357 35 1012* 1329 KY .329 52 12056 171* * : LA 372 46 22 5051 SIt 387 MA 2~095 327 59 29.332 :3976 321 MO 656 325 61 3177 9630 02* ME ill 15 . 3 .3 ` 2568 :066 35. Ml . 12*9 67 20951 7*51. MN 7.54 229 25725 26040 MO 906 270 194 19992 7T36 1355 MS 164 13 1021 :75 MI 73 1 824 .3 . NC 765 L39 73 5 3~9 ~O 57 2 790 lOS NE 219 *6 17 U34 1751 ~92 NH 159 *0 10 10:' 4611 922 239 * NJ 1655 76 38199 5239 128 5 . 1570 110 . tOO 9 2468 39 : NY OH 3984 1632 356 422 IS 68675 *1*96 t3103 13067 2*0. OX 418 78 1829 2091 OR *64 123 . 3 3 * 7155 1651 35 PA 1633 68 *6582 11543 . RI 179 . 36 . 3 3 1 3699 1136 73 SC 262 95 . * 6009 1333 : SO 65 3 . . 941 . ~3 * TN 651 118 90 200*2 ~649 1501 TO 2219 977 540 39677 12319 3733 UT VA 193 669 26 249 31 . oILS 19660 1042 6708 692 VT 92 17 5 5 * .3235 2037 114 VA . 599 72 9217 2265 VI 784 155 26648 6308 VY 103 11 1920 326 VY * I~ir~d 42 2 by co~o~ci*1 ca~ior 35: .32 ,(~k *2896 ~ PAGENO="0433" 423 EMPLOYEES 3F PRINTIVG FIRR9 V140 ~OUL0 ~E MVLY EL16!BLE UMOER REGZOM4L VEJA STATUS PTA TOTAL ~EMBER FIRM STATE ~ENPS ENP1.O~!EMT AK 310 28 AL 7632 516 AR 1227 391 AZ 7810 752 CT :1232 1992 * 1219 * 513 ID 1611 173 1114 ME 1968 1066 MS 1)21 175 MT 921 3 MO 780 Nfl 1570 MV 2168 39 OR 7155 :~5I RI 3699 1136 SC 6009 1933 SO 19 VT 3135 1037 VA 9217 1255 :Szo 326 350 32 93297 1957.5 PAGENO="0434" 424 EX~I9~T It! ~ROJECTE0 ~V VEIA PARTICIPANTS ~ T~ P*INTIiS IKOUSTRY LSOER A ~1IO1IAL STATUS PtA FIRMS AS A ~ OF TOTAL FIRMS PICT IRMS AS A % OF TOTAL FIRMS PICT IRMS PS A I OF PtA FIRMS PTA MEMBER FIRM EMPLOYMENT AS A I OF TOTAL ~.MPLOYMENT 52211 PICT MEMBER FIRM EMPLOYMENT As A S OF TOTAL EMPLOYMENT PICT MEMBER FIRM EMPLOYMENT AS A S OF TOTAL P:A ~MPL5YMENT Nev Psrticipatio~ Based on Eristing i~ PICT Participation as a S of Total Eeoloyunt L,~99 2) PICT Participation as a S of PTA Meeber Esoloycent PAGENO="0435" 425 ~z~1aiT :v PRINTIN !~OU$TR!ES C SOLIO4TE3 TRUST PRRTTCIPAT!ON SUPPARY TRUST ~1RRS PARTICPANTS P116 239 3,06S PIAS 90 1,501 22 387 P1N*~ASS 59 921 P!NE~0THER 21 561 PIN*IOVA 47 ~73 P1~-NEI 17 592 P!STLIO3 151 1,585 PISTL-502 22 114 PISIL-SOl 21 ~86 PIASC 1,112 12,295 PINC £70 5251 ?1~T 540 5,7:33 ~1I-1LL ~96 S470 P11-INO 30 571 ~L9 2,399 ~1AN0 15 140 `ZCA 9 05 PPI 3 35f T0T~L ~,313 ~2,~96 * Insured oy cossercial i~sur~nce carrier PICT PART1CIPl1;~N 8Y SIZE FIPR SIZE OF SIRN FIRnS PA~TtCiPANTS 1 - 1 ,335 3,200 5-9 790 5~35 10 - 19 592 7,931 20 - £9 439 13,232 50 - 99 125 8,463 100 - 249 30 3,858 250-499 2 774 5~30- 1,000+ TOTAL 3,313 42,à96 PAGENO="0436" 426 3TATES 3E5V~O 5Y PIA OF SOUTHERN CALI1CRNIS PIA JF AN OIEGO ~I Q~ *~CRT~ERN CALIFO~SNIA - ~ouNrAlN OrA~!O `IA ONN~CTtCUT ~A~3ACk'):.,~ r C~NN~CrICJr =1 D~ ~E1~OFOLI'AN WN,T)N ~ F PtA 01 ~HE SOUTH Pt C~ J5W ~NGLANO ~`t OF ASRYLANO & SE. PENNSrLVMNIA I u~~tr1~t ~t ~.`(~tA ~":.~? ;~:~.o PtA OF NORTHERN OHIO PIA OF SOUTH CENTRAL U~lO PtA OF SOUTHERN OHIO Pt CF ST. LOUIS Pt OF CKLP~4OMA `Uf~U~ET *~AO'~Nt PtA O~ ~AN~A5 CITY ~IA CI WISTERN P~NNSVLV~iA PIG OF ~~XAS ~I OF UIAN ~I OF THtS VIRGINIAS Pt OF MICHIGAN Pt OF MINNESOTA Pt OF THI NIOLANOS PIG OF NEW YOi~I( ASSOCIATION OF THE GIGIHIC ANTS P1 OF THE CAROLINAS a ~A~jth LiakAt 4 N*w J~rs~y ~iew fArE N~rth CarA~tr~a P.:~AP~ C~'oLLr~. O~ ~3P~Am4 Vt'.it,'tI .~asr Vtr'~p~~ Pt OF WISCONSIN PAGENO="0437" 427 Mr. ANDREWS. Thank you, Mr. Brandenburg. Mr. Mack McKinney. STATEMENT OF C.A. "MACK" McKINNEY, LEGISLATIVE COUNSEL, NON COMMISSIONED OFFICERS ASSOCIATION OF THE UNITED STATES OF AMERICA Mr. MCKINNEY. Thank you, sir. Mr. Chairman, members, I appreciate this opportunity to address a couple of issues that are of importance to my organization. One is individual retirement account, and the other is the earned income tax credit. First, the individual retirement account. An active participant in an IRA, among others, includes a military member on active duty with the Armed Forces of the United States. As such, if that member participates in an IRA, he or she is entitled only to a lim- ited deduction. However, a member of a reserve force is not consid- ered an active participant, and rightfully so, is entitled to a máxi- mum deduction. There are three valid reasons listed in my prepared statement that originally excused reservists from consideration as an employ- ee of the United States, having a plan established by the Federal Government. But similar, if not identical, reasons apply equally to our members of the Active Forces. One of the major blockages in granting maximum deductions to active duty service members is establishing whether or not the military retirement system is a true retirement plan. The NCOA submits it isn't. There is a chart included in my prepared state- ment that compares certain Federal retirement plans. Certainly the military retirement plan has no relationship to either of them, and should convince anyone that the military retirement system is not a true retirement plan. But, instead it was designed originally as a selective incentive program for the retention of qualified per- sonnel. We lend further credence to this fact that the military retire- ment system is a selected incentive program when one considers that only 14 to 16 of every 100 service members remain in the Active Forces to qualify for military retirement. Next, Mr. Chairman, permit me briefly to address earned income tax credits for military personnel residing overseas and who are low income earners. The association has been in pursuit of such au- thorization since 1976. The association does salute the subcommittee and the Honorable Jim Slattery of Kansas for addressing this issue. A current law cre- ates a serious inequity for these young people who volunteer to man the ramparts in our foreign nations. It should be amended as quickly as possible to permit these junior service members to have the same tax privilege as provided their fellow citizens in the United States, both military and civilian. I thank you very much for your time. [The statement of Mr. McKinney follows:] PAGENO="0438" 428 4i"\NCoA Non Commissioned Officers Association of the United States of America 225N. Washington Street * Alexandria, Virginia 22314 * Telephone (703) 549-0311 STATEMENT OF SERGEANT MAJOR C. A. "MACK" MCKINNEY USMC RETIRED LEGISLATIVE COUNSEL V before the V V SUBCOMMITTEE on SELECTED REVENUES COMMITTEE on WAYS AND MEANS V U.S. HOUSE OF REPRESENTATIVES SECOND SESSION, 101ST CONGRESS FEBRUARY 22, 1990 V on V V V Individual Retirement Accounts (IRA) and Earned Income Tax Credit (EITC) V THE NON COMMISSIONED OFFICERS ASSOCIATION The Non Commissioned Officers Association of the U.S.A. (NCOA) is headquarters in San Antonio, Texas, with a National Capital Office V(NATCO) in Alexandria, Virginia. NATCO is staffed with six (6) noncommissioned and petty officers; four(4) retired and two (2) veteran; with a combined record of more than 145 years military service and over 50 years of representing the NCOA on governmental affairs. NCOA is representative of all branches and components of the Armed Forces, including the Active, Guard, Reserve, and Retired community, with a majority serving worldwide on active duty. Nost of the Association's chapters are located on or near military installations. This close relationship with the military is the cornerstone by which the Association builds its program of legislative initiatives. PAGENO="0439" 429 Mr. Chairman. The Non Commissioned Officers Association of the USA (NCOA) appreciates this opportunity to present its views on the issues of Individual Retirement Accounts (IRA), and Earned Income Tax Credit (EITC) for low-income military families residing overseas. INDIVIDUAL RETIREMENT ACCOUNTS (IRA) Sec. 219(g)(5)(A)(iii) defines an "Active Participant" as an individual who is an active participant in "a plan established for its employees by the United States, etc." This covers military personnel who are serving on active duty in the Armed - Forces of the United States. An "active participant" is one who, according to Sec. 219(g) has a limitation on deductions for any part of any plan year ending with or within a taxable year. Sec. 219(g)(6) provides that any individual who is a member of a reserve component of the Armed Forces shall not be treated as an "active participant" and, as a result, may be entitled to a maximum deduction pursuant to Sec. 219(b) or (c). Prior to 1976, military reservists were barred from participation in IRA. - The reason: They were potential recipients of a retirement annuity "established or maintained" by the U.S. government. In seeking a reversal to this restriction, proponents made three convincing arguments to repeal the restriction: 1) - The reserve retirement system offers no vested interest to the participant until he or she has 20 years of service and, will realize no benefits until he or she attains age 60 2) - The amount of retired pay can be so limited that many reservists may not be interested in reserve retirement_ many drop out long before completing 20 years of creditable service 3) - In the event of a national emergency reservists will constitute the principal and immediate source of trained military manpower; therefore, it is essential that our military reserves attract and retain high quality personnel, and by ending this form of discrimination, Congress will do much to keep strong and able reserve forces at the ready. In comparing reservists with active duty military personnel striking similar conditions exists. 1) - The regular retirement system offers no vested interest to the participant until he or she serves a minimum of 20 years of honorable active duty. In addition to no vested interest, enlisted personnel- unlike their commissioned officers, federal employees, and other governmental workers- are not entitled to any separation payment if not permitted to remain in the military service to complete the necessary years to be eligible for the receipt of retired pay. 2) - Military retired pay for the average servicemember reaching retirement eligibility is currently less than $1,000 monthly. For those entering the ~military on or after August 1, 1986, the amount (in current 1990 dollars) will be less. At present, only about 15 of every 100 persons entering the armed forces will remain long enough to qualify for retired pay. PAGENO="0440" 430 3) - In the event of a conflict between the United States and an aggressor nation, active duty military personnel will be the first to fight. Maintaining a strong and ready force of active duty servicemembers is a necessity and a principle concern of our nation's elected legislators. By amending the current code to allow active duty military personnel to fully participate in the IRA plan, as authorized military reservists, this Subcommittee will play an essential role in attracting and retaining the highest quality men and women for the Army, Navy, Marine Corps, Air Force, and Coast Guard. One of the major blockage to this recommendation is whether the military retirement system is a real retirement plan. NCOA submits that it isn't. Most governmental retirement plans have a severance payment or a deferred retirement plan should an individual employee be terminated prior to attaining retirement eligibility. In the case of active duty enlisted personnel, not only do th~ey not havea vested program but they are entitled to rio payment whatsoever if they fail to serve all of 20 full years on active duty. They are even treated discriminatly, in law, when seeking unemployment compensation. Ex-servicemembers must wait for a longer period before they can make application, and are entitled to half the benefits available to former federal civilian employees. There are ether comparisons in federal governmental plans, particularly ~those of the Civil Service Retirement System(CSRS), Federal Employees Retirement System (FERS), and the Military Retiremerit System (MRS). The broad disparities in the comparison, as noted below, lend validity that the latter is not a true retirement program. CSRS FERS MRS VESTED AT 5 yrs. 5 yrs. 20 yrs. THRIFT Yes Yes None SAVINGS Up to 5% of Up to 10% of PLAN pay earns pay; matching 8.75% interest gov't. contribution of 5 percent OPTIONAL Yes Yes Mo LOAN PROGRAM LUMP SUM Yes Yes Mo PAYMENTS INVOLUNTARY Yes Yes Mo EARLY RETIREMENT EMPLOYMENT Permanent Permanent For enlisted -- personnel 6 year enlistments at most. Retention dependent upon approval by superiors after each enlistment. PAGENO="0441" 431 DEFERRED Yes Yes No ANNUITY CONTRIBUTORY Yes Yes No Plan RESTRICTIVE No No Yes REFUND Yes Yes No OPTION ENTITLEMENT Legal Legal None In conclusion, NCOA avers unequivocally that themilitary retirement plan is sore of an incentive for retention than a bonified system designed to provide an annuity or a pension for military personnel ~when they retire.fros the armed forces. In this respect, the Association urges this distinguished subcommittee to amend Section219(g)(6)(A) to read: (A) Members of the Armed Forces of the United States. Participation in a plan described in subparagraph (A)(iii) of paragraph 5 by reason of service as a member of a component of the Armed Forces (as defined in section 101(4) of title 10), unless such individual has served in excess of 20 years on active duty and is eligible for retirement and the receipt ofretired pay, or in the case of a member of a reserve component of the Armed Forces (as defined~ in section 261(a) of title. 10) is in receipt of military retired pay.' EARNED INCOME TAX CREDIT (EITC) NCOA is delighted with this distinguished Subcommittee's announcement it will consider the issue of EITC for certain military families residing overseas as a result of governmental orders. The Association has been in pursuit of such authorization since December 1976 when one of its members cited the inequity effected by the then new law. The Association registered a formal protest that same month to the appropriate congressional oversight committee requesting reconsideration. Only the Senate responded in a somewhat positive manner. The chairman, Committee on Finance, wrote that he believed it was not the intent of Congress "to discriminate against lower grade enlistea personnel in limiting the (EITC) benefits." In 1978 the Department of Defense (DoD) proposed to submit to Congress legislation extending the tax benefit to low--income servicemembers overseas. The proposal was reputedly approved by the Treasury Department (~~y Times, May 22, 1978, Randall Shoemaker, "Tax Break for O'sea Troops Proposed"). The Treasury's spokesman was reported as recalling to mind the purpose of EITC; to "encourage employment of taxpayers living in the U.S." And so, it wasn't inconsistent with the goal of the credit, said the spokesman, if EITC was made available to taxpayers joining the military and, subsequently, transferred overseas with their families for active duty assignments. The proposal was sent in September 1979 to Congress for its consideration. The legislation sought to eliminate the PAGENO="0442" 432 requirement that a member of an armed force, on active duty, maintain a household in the United States in order to be eligible for EITC. That proposal, which is similar in its intent to that of H.R. 3949, introduced by the Honorable Jim Slattery, M.C., February 5, 1990, would have not only removed an inequity in the treatment of certain servicemembers, those serving in the United States and those overseas, but alleviate, what the Association believes to be, a gross discriminate act against certain servicemembers transferred overseas during a tax year. For example: Taxpaying members, eligible for EITC, who are assigned overseas accompanied by family members at anytime during the tax year or, first go overseas without the family and they join the servicemember later during the tax year, lose their entitlement to EITC. This occurs even if one of the above acts was accomplished on the last day of the tax year. The loss of the EITC entitlement, simply because an eligible servicemember must *go overseas under government orders and wants his or her family to be with him or her for the next 24-to-36 months, is patently unfair. The current law creates a serious inequity for military taxpayers in the junior enlistment grades compared to their civilian counter-parts and their peers stationed in the United States for the entire tax year. Since the proposal you have before you, H.R. 3949, will scuttle the inequity and. result in providing improved compliance in information related to the valuation of allowances while offsetting any loss of revenue (according to the Joint Committee on Taxation), NCOA endorses the Slattery bill and urges it's early adoption. Thank you. PAGENO="0443" 433 Mr. ANDREWS. Thank you; Mr. McKinney. Mr. Vester Hughes. STATEMENT OF VESTER T HUGHES, JR, ESQ DALLAS, TX SPECIAL TRUSTEE, CHARLES A. SAMMONS ESTATE Mr. HUGHES. Mr. Chairman, I would like to request that my pre- pared remarks be inserted in the record, and then to discuss briefly with the committee the subject matter of H.R. 2992. "Mr. ANDREWS. The prepared texts are submitted into the record by all the witnesses this morning. Mr~ HUGHES. Congress has `long recognized that it was in the public interest to encourage employee stock ownership. The matter evolved through the enactments beginning' in 1938 for pension and profit sharing plans, later stock bonus plans, and finally the ESOP. , Unfortunately, while this was the ~rule `for income taxation, it was not the rule for estate taxation. Although the estate tax was coordinated with the income tax in many respects, such as the fact that the costs of administering the estate, and `the amounts paid to executors, attorneys,' accountants, and others who perform services were similarly treated for estate tax purposes as they had been treated in the income t~x.~This was not done however, with respect to contributions to an ESOP. ` The proposal, H.R. 2992, attempts to rectify this incongruity. It was triggered by the desires and wishes of Mr. Charles A. Sam- mons who wanted to leave Sammons Enterprises to his employees in ESOP fashion, not to the employees as individuals' but to the exempt plan that was established for their benefit. There are some 2,700 employees of the company. There are no ,participants in the ESOP who are ~family members of Mr. Sam- mons. No employees of the company own 5 percent'of the stock. In fact, no employee, except through the ESOP, owns any stock of the company. So, the situation underlying H.R. 2992 is the classical situation of an employee stock ownership plan. Mr. Sammons died in 1988. He left the bulk of his estate to a charitable remainder trust with a provision `that should Congress decide to permit an ESOP to be permissible remainderman under a charitable remainder trust, that the estate then could be trans- ferred and distributed to the ESOP for the benefit of his employees. The ESOP will be the recipient of the estate if H.R. 2992 is en- acted. Otherwise, the stock will go to charities pursuant to the charitable remainder trust. In either event, there will be no tax difference to Mr. Sammons' estate. So, the bill is tax neutral insofar as his estate is concerned. Ultimately, however, the tax revenues will `benefit considerably if the provision is enacted because if there is no enactment, and the distribution is made solely to charities, then the charities will pay no tax on the value of the stock and that value will never come into the tax revenue stream. On the other hand, if the stock is distributed to the ESOP and subsequently to the employees, there will be taxation, at the time of PAGENO="0444" 434 distribution to the employees. So, the appreciation in value of the stock in the estate will ultimately reenter the revenue stream. H.R. 2992 was designed to meet the criteria ordinarily imposed with respect to contributions by a corporation to an employee stock ownership plan. There were some overlays that were thought nec- essary to protect against possible abuse of the provision. It is be- lieved that this provision can in no sense be abused by those who would try to indirectly benefit their. family, since a family member of the decedent cannot participate. Similarly, no 5 percent share- holders are allowed to benefit from contributions to the ESOP by the estate, so that gimmicks cannot be played by significant share- holders of the company. Finally, the deduction is limited to contri- butions of nontraded~ stocks and cannot become the vehicle for ma- nipulation by any type of Wall Street function. The same philosophy that underlies congressional ~approva1 of employee stock ownership plans within the income tax system ap- plies, in my judgment, equally well to the estate tax system. The philosophies of the estate tax system enhanced by this measure would further encourage the desire and aim of ESOP's generally- for employees to own stock in the company for which they work. This will encourage employees to become more efficient and be more productive to the society in which we live. I would be happy to try to answer any questions you may have at the appropriate time. * [The prepared statement and attachments follow] PAGENO="0445" 435 STATEMENT OF VESTER T. HUGHES, JR., ESQ. I. ~cxpi~n~c1 of the Prctbiem. Congress has long recognized that employee stock ownership should be encouraged. As early as 1938, Congress allowed a deduction for contributions to a ~trust to pay employee pensions. Congress later made clear that employer securities were proper investments for profit-sharing and pension plans, and added stock bonus plans to the list of tax-qualified retirement plans. Ultimately, the employee stock ownership plan or "ESOP" evolved. Congress wisely provided that the employer receives an income tax deduction for~ contributions to such plans and that the employee is not cuirently taxed either on the value of such contributions or on any increase in value until the plan actually makes distributions to the employee. Unfortunately, the estate tax treatment of contributions to an ESOP has not been made consistent with the incOme tax treatment described above. Individuals, who bequeath employer securities to ESOP5 suffer adverse estate tax cOnsequences because no estate tax deduction is available for such contributions. Our proposal to remedy, in part, this inconsistency is a generic one. However, it stems from the case of an individual who wanted to leave the bulk of his estate for the ultimate benefit of his employees. Mr. Charles A. Sammons wanted to leave stock of Sammons Enterprises, Inc. to an ESOP which currently has over 2,700 employees-participants. Mr. Sammons' desire is particularly commendable in that ~ of these employees are related to Mr. Sammons. Moreover, none of these employees own (other than through their participation in the ESOF) any stock of Sammons Enterprises, Inc. Thus, the direct beneficiary of Mr. Sammons' generosity is an ESOP in the classical sense. It is clear that Mr. Sammons intent was to benefit only his employees. However, because contributions to an ESOP are not deductible for federal estate tax purposes, Mr. Sammons left this stock to a trust. Under that trust, the stock will pass to the ESOP and/or to various named charities upon termination of a life estate. The trust provides that no stock iiiay pass to the ESOP if such ESOP is not a permissible beneficiary of a charitable remainder trust at the time of the distribution. As the law currently stands, the trust will be forced to distribute the stock to the various name charities because ESOPs are not currently permissible beneficiaries of charitable remainder trusts. H.R. 2992, however, would remedy this and allow Mi. Sammons' desired purposes in creating the trust to be fulfilled. II. Freviou~ Attempts at Solution. In 1984, the Senate adopted a provision, somewhat similar to H.R. 2992, which would have allowed a charitable deduction for the bequest of employer securities to an ESOP. There were problems with the Senate bill, in that it could make beneficiaries of the ESOP "instant millionaires." These problems have been solved in H.R. 2992 by its annual limitation on allo:ations. Nonetheless, the Senate bill is. illuminating. A copy of the 1984 statutory language and the Senate Finance Committee report is attached hereto as Exhibit A for your convenience. - PAGENO="0446" 436 Ill. ~oh'ti«=.ui.(H.P. 2992). On July 25, 1989, Congressman Andrews introduced a bill (H.P. 2992) that would make employee stock ownership plans permissible beneficiaries of charitable remainder trusts in certain limited circumstances. Under H.P. 2992, the securities must be left by a decedent to a charitable remainder trust, which then might be used to pass the securities to an ESOP. Once distributed to the ESOP, no allocation of such securities can be made to participants who are related to the donor or who own more than 5% of the stock of the issuing corporation. As a result, the proposed legislation cannot be manipulated to move assets to family members or significant shareholders. Nor could it become a tool for the financiers of Wall Street. `The Joint Committee on Taxation has determined that the effect of H.R. 2992 would be to "reduce fiscal year Federal budget receipts by less than $1 million annually." A copy of the Joint Committee's letter to Congressman Andrews is attached hereto as Exhibit B. Thus, under the Joint Committee's evaluation, only a ~ ~j~j~ja revenue effect would result. Furthermore, a' strong "case can be made that the effeCt of H.R. 2992 would be revenue positive. It is very unlikely that taxpayers will establish a charitable trust to benefit an ESOP unless they, like Mr. Sammons, would otherwise leave such assets to charities. Thus, H.R. 2992 will keep assets in the taxable sector that would otherwise move to the tax-exempt sector. As you know, the value of assets donated to charities leaves the tax revenue stream. In contrast, the value of assets which pass to an ESOP will ultimately be subject to taxation when the assets are distributed to the employees. In any event, any negligible revenue effects of this bill are well worth the added employee ownership that H.P. 2992 makes possible. It is important to keep in mind that H.P. 2992 will make no tax difference in the Sammons' situation. Mr. Sammons' stock WiU go to charities if it does not go to the ESOP. However, those associated with Mr. Sammons obviously want to carry out his wishes. Sammons Enterprises, Inc. has over 2,700 employees `who are located in 28 states. See `Exhibit C, attaChed hereto, for a list of those states and the number of such employees located in each state. These employees obviously would like to see `Mr. Sammons' stock pass to the ESOP. In conclusion, when a taxpayer chooses to leave stock to his employees, the philosophy of an estate tax deduction is supported strongly by the/same philosophy that lies behind the income tax deduction -- that employee ownership is a good thing. Thus, H.P. 2992 accords with the basic purposes of ESOPS, and in my mind presents an opportunity for sound legislative policy. `IV. Additioii&L1e nil fl~J1ie1Lt. The following technical amendment to H.P. 2992, as introduced on July 25, 1989, is offered to avoid inadvertent termination of private foundations as a result of distributions of qualified employer securities to ESOP5. PAGENO="0447" 437 Section 1(c) of the bill is amended by inserting after paragraph (6) the following new paragraph: (7) Section 4947(b) of such Code is amended by inserting after paragraph (3) thereof the following new paragraph: "(4) Section 507.--The provisions of Section 507(a) shall- not apply to a trust which is described in subsection (a)(2) by reason of a distribut:ion of qualified employer securities (as defined in section 664(d)(3)(C)) to an employee stock -ownership plan (as def~ned in section 4975(e)(7)) in a qualified gratuitous transfer (as defined by section 664(d)(3))." PAGENO="0448" 438 EXHIBIT A / / e1~o XIV ~ 7~( ~i&t4~' /Ite~~o. 11. ___________________ T~ :~:~ DEFICIT REDUC'FIO\ACTOF19S4 STA~RY LANGUAGE OF PROWSIONS APPROVED BY THE COMMITTEE ON MARCH 21 1984 COMMITTEE ON FINANCE - UNITED STATES SENATE %olumell - :1 PAGENO="0449" 439 131 I the date of enactment of ibis Act in taxable years ending 2 alter auth date. 3 IEC KS ASSt)I?TIOM OF ESTATE TAX UAIILTTY PY ~SOP 4 *ZCE5VL'~G EMPLOYER SECtTRITIU. 5 (a) b~ GEZ.e.L.-$ubcbapler C of cbapter 11 (relating 6 so miscellaneous estate tan provisions) La amended by adding 7 at the end thereof the following new section: B SEC ~2t LiABILITY FOR E~T D' CASE OF TR-&'~SFER 9 OF EMPLOYER SECL~RJTIES TO AB EMPLOYEE 10 170CM OW~IRSMIP PL.U(. 11 "(a)L'~GEstLtL.-If- 12 "(1) a qualifIed amount of employer securities- 13 "(A) are acquired by a.n.employee stocb own- 14 ership plan from the decedent, 15 "(B) pass from the decedent to such a plan 16 or 17 "(C) are transferred by the executor to such 18 aplanand 19 (2) the executor elects the applicatinn of this 20 section and files the agreements described in ubsection 21 (e) (in such manner as the Becretasy shall by regula. 22 tion, prescribe) at the time prescribed by section 23 6075(a) for filing the return of t&x imposed by section 24 2001 (including extensions thereoU, 30-860 0 - 90 - 15 PAGENO="0450" 340 1 (c) ErnCTIYR DAT*.-The amendments made by this 2 section shall apply with respect to those estates of decedenis 3 which are required to file returns on a date (including any 4 extensions) after the date of enactment of this Act. 5 SEC. W7. CERTAIN CONTRISUTIONR TO ESOP TREATED AR 6 CIIARITARLECONTR5SUTIONR. 7 (a) le OvuraAL.-'Subsection (c) of section 170 (del'.n" 8 big charitable contribution) is amended by inserting after 9 paragraph(S) th. following new paragraph: 10 16) A tan credit employee stock ownership plan 11 (as defined `a section 409A) or an employee stock own. 12 ership plan (as defined `a section 4975(eX7)) bat only 13 it.- 14 15 16 17 18 19 20 21 22 23 24 IA) such contribution or gift consists cads- sively of employer securities (within the meaning of section 409A(l)); "(B) such contribution or gift `a allocated (oxer a period not in excess of three plan years). pursuant to the terms of such plan, to the employ- ees participating under the plan `a a manner eec- sistent with section 401(aX4) "(C) no part of such contribution or gift is .1- located under the plan for the benefit of- "6) the donor, 341 "(it) any person who in a membergf the family of the Jonos' (with'a the meaning of section 267(eM4fl, or "(iii) any other person who owns unor than 25 pereen~ `a estee of any class of out. 6 standing employer secrgritie alder the p,ne4. 7 sionsof,ectJon3l~ 8 ~chcontnbvtioeorgihl'ama~~~, 9 pursuane to the pronisione it such tax credit em. 10 ployee stock ownership plait or aid, employee It stock ownership plaiq 12 13 ties as being att,lbutab~, ta employer eeet,ihu. 14 liner, "(9) so deduction under section 404 and as 16 credit andes' asctiou 38 or 446) `a allowed with,.. 17 "(0) any allocation andes' the plan if such 19 eontribu~ or gift which, `abased out compensa. 20 ho,, of the partiripai,s~ does not tale `ate accoont 21 any portion of tire compensation it a psrtidpai,t 22 that exceeds $100,000 per year."~ 23 (b) PESCRNTAOS LIRSTAI ONR...-.Bubparag,.pp, (A) of 24 section 170(b)fl) (relating to percentage limitations for bali. 25 `idusla)'a ainende,h... PAGENO="0451" 342 * (1) by striking out "or" at the end of clause.(vii), 2 (2) by inserting "or" at the end 01 clause (viii), S and 4 (3) by inserting after clause (vus) the following 5 new clausse 6 "(ix) a tax credit employee stock owner- ship plan (as defined in section 409A) or an employee stock ownership plan (as defined in section 4975(eX'fl),". (c) CoperosulNo AsranDasmers.- (1) Subsection (a) of section 2055 (relating to transfers for public, religious, and charitable uses) is amended- (A) by striking out "or" at the end of para- graph (3), (B) by striking out the period at the end of paragraph (4) and inserting is lieu thereof"; or", and (C) by inserting after paragraph (4) the fol- lowing new paragraph: 15) to a tax credit employee stock ownership plan (u defined in section 409A) or an employee stock ownership plan (so defined in section 4975(eWl)) but only if the requirements of section l70(cflll) are meL". 343 1 (2) Subsection (a) at seethe 2522 (relating to 2 charitable and similar gifta) Is snsmsded. 3 (A)bst_at~~01 4 paragraph (4) and inserting in llà thereof "; or", 5 and 6 (*1) by adding at the end thereat the (allow. 7. * ingnewparagrap~ "(5) a tax credit employee stock ownersblp plan 0 (an defined in section 409A) or an employee stock owe. 10 erekip plan (as defined `us seethe 4975(eX7)) but essly If II the requirements of section l70(c)(6) are meL", 12 (3) Beetion 415 (relating to limitations en benefita 13 and contributions under qualified plans), as amended by 14 th;, Act, is amended by adding at the end thereof the IS following new subsectio,s 10 "(m) CUARITARLS CoN?atatynoen ~The ren;tati,,,se 17 provided under thin section shall not apply with respect to 10 any contribution or gift described in section 170(cKO) if the 10 requirements of section 170(cX6) are sseL". 20 (4) Epexoriva D*~.-The ansendnsents made by this 21 section shall apply to taxable years kegisssing after the date 22 ofessaetnsentof~c~, 7 0 9 10 *1 12 13 14 15 16 17 18 19 20 21 22 23 24 PAGENO="0452" 442 - -. Li siI~' CO~UT~EEpRJYT - 181~169~ _____ DEFICIT REDUCTION ACT OF i984~ I I S *i* - I * I LO * * EXPLANATION OF PROVISIONS ~ S APPROVED BY THE .~ 7.. ~ COMMi11~EE~NMARCH2i,I984y,~.'. - :~-~ . -~ ~ COMM1T~EE ON FINANCE -~ ~ UNITED STATES SENATE ~o1umeI `V - APRILI.1981 ~-:-: - I HI *1 *1 :4 :1 .~ ~1 /. .--- -. - ,7- . -- - - PAGENO="0453" 443 D. Employee Stock Ownership Provisions (sees. 101-108 of the bill and sees. 170, 404, 415, 1202, 1361, 2002, and new sees. 132, 1011, and 2210 of the Code) Present 14w An employee stock ownership plan ("ESOP") is * qualified stock bonus plan or a combination stock bonus and money purchase pen- too plan under which employer stock is held for the benefit of em- plovees. The stock, which is he]d by one or more tax-exempt trusts an~er the plan, may be acquired through direct employer contribu- tons or with the proceeds of a loan to the trust (or trusts). Divi- dends paid on stock held in trust for employees may be distributed to employees or may be held iii the trust (or trusts). Gain realized on the sale of employer securities to an ESOP is generally taxed at mpithl Oslo rates. An Ei'OP under which an employer contributes stock or cash in order to qualify for a credit against income tax liability is referred to as a las credit ESOP; Under present law, the income tax credit is limited to a prescribed percentage of the aggregate compensation of all employees under the plan. For compensation paid or accrued in calendar years 1953 arid 195.4, the tax credit is limited to one- half of one percent. With respect to compensation paid or accrued in 1955, 1986, arid 1957, the limit is three-quarters of one percent. No credit is provided with respect to compensation paid or accrued afterDecernber 81, 1987. An ESOP that borrows to acquire employer stock is referred to as a leveraged ESOP. Under a leveraged ESOP, the employer is al- lowed a deduction, within limits, for contributions to the plan which are applied by the plan to repay loan principal. Such limits apply notwithstanding the deduction limits applicable to other tax- qualified pension plans sponsored by the employer. No deduction limit applies to an employer's £50? contributions that are applied by the plan to pay interest on the loan. Under present law, employer securities that have been allocated to participants' accounts under is f.a.a credit £50? may not be dis- tributed for 04 months after the date of allocation. The 84.month balding period requirement does not apply in the case of (1) death, dioabilsty, or separation from service, (2) certain transfers of par- ticipants to acquiring employers, and (3) certain sales of aubsidiar- Present law provides overall limits on annual additions under a qualified defined contribution plan. Generally, the limit on annual sdditions for a year equals the lesser of (1) $30,000 (for years before ISIS) or (2) 25 percent of compensation for the year. However, in the case of an ESOP under which no more than one-third of the employer contributions are allocated to employees who are officers, are l0percent shareholders, or have annual compensation exceed- (331) PAGENO="0454" 332 ing $60,000 (for years before 1988), the limit on annual additions equals the sum of (1) $30,000 (for years before 1988) and (2) the lesser of $30,000 (for years before 1988) or the value of employer securities contributed, or purchased with cash contributed, to the Lessees tar CArnage The committee believes that, in light of the current budget situa- tion, it is appropriate to postpone for one year the scheduled in- crease in the maximum tax credit for employer contributions to tax credit ESOI's. However, the committee also believes that alter- native tax incentives, applicable with rmpect to both tax credit liziOt's and leveraged 88101's, are important to encourage employee stock ownership, Lrplesetdes .thweisteas £ Flees. as sse.rtmsa credit Under the bill, the income tax credit for contributions to a tax credit £501' is limited to one-half of one percent for compensation paid or accrued in 1985 The limit for contributions in 1986 and 1987 remains at three-fourths of one percent. 2 Tax-tree wtteecres sate te esiptas,ecs The bill provides for nonrecognition of gain, at the election of the seller, from the sale of "qualified securities" if(1) the securities are sold to an 11501' or to an eligible worker-owned cooperative and (21 within a qualified period, the seller acquires securities of a domes- tic corporation, the income of which, for the taxable year in which the security is issued, consists of not more then 25 percent passive investment income. Ilowever, the acquisition of stock by an under- writer in the ordinary course of the trade or business as an under- writer is not an acquisition qualifying for this special treatment. Under the bill, the term "qualified securities" means eniplayer securities (within the meaning of sec. 409A(1)) that (1) are issued by a donimtic corporation that has ito readily tradable securities out- standing, (2) have been held by the seller for more that, one year, and (3) have not been received by the seller as a distribution from a qualified pension plan or as a transfer pursuant to on option ar other right to acquire slack granted by an employer. The qualified period during which the seller must acquire replacement securities begins 3 months hefore the date of the sale to the 11801' or coopera- tive and ends 12 munthe after the sale, The bill defines an eligible worker-owned cooperative to mean any organization if (1) it is described in sec. 1381, (2) a niajority ef the membership of which is comprised of ensployees of the organi- zation, (3)s majority of the voting stock of which is owned by nien' hers, (41 a majority of the board of directors of which is elected by the memhers, who each have a single vote, and (5) a majority of the allocated earnimigs and losses of which are allocated to members en the basis of patronage, capitol contributions, or some combiastias of pstronage Of capitol contributions. 333 The basis of the seller in replacement securities acquired during the qualified period is reduced by the amount of gain not recog- nized parsoant to the seller's election, Under the bill, if more then 1 item of replacement securities is acquired by the seller, an alloca- tion rule is provided to determined the seller's basis in each item. Under the bill, the seller's nonrecognition election is made by filing (as prescribed by the Secretory) an election no later than the due date of the seller's income lax return for the taxable year in which the sale occurs. In addition, the bill provides that the statute of limitation period with respect to the nonrecognition transaction does not expire hefore 3 years from the date on which the seller notifies the Secretory of (1) the seller's coot of acquiring replace- ment securities, (2) the seller's intention not to acquire replace- ment securities, or (3) the seller's failure to acquire replacement se- curities. The bill requires that securities acquired by an ESOP or an eligi- ble worker-owned cooperative in a nonrecognition transaction to which the bill applies must he held by the 1150? or cooperative for at least 84 months after the date of acquisition. Exceptions to this balding period requirement similar to the exceptions that currently apply to ESOPs required to hold securities for 84 monthe will apply. The con,mittee intends that, in prescribing regulations under this provision, the Secretary will require the seller to notify the 1150? or cooperative that the seller. is electing not to recognize gain on the sale. If the £50? or cooperative fuiis to satisfy the holding period requirement, a 10-percent excise tax is imposed on the £801' or the cooperative, This tax is applied to the fair market value of the securities acquired in the nonrecognition transaction, ln addition, if nmore than 25 percent of the qualified securities ac- quired by the £50? or by the cooperative are allocated or accrue to the benefit of the seller, a ntemher of the seller's family, or an em- ployee owning more than 25 percent in value of any class of out.- standing employer securities, an excise tax of 10 percent of the amount qualifying for the nonrecognition treatment is imposed on the £80? ar the cooperative. The committee intends that an £50? is meat to he considered to fail any of the n.'quireniente for tax quali- fication merely, because it allocates the qualifying securities in a manner designed to avoid imposition of this excise tax. 3. Deduction (or dividends pcmid en ESOP stock The bill permits a dedectinn for dividends paid on stock held by an £501' (including a tax credit £50?), provided the dividends are neher paid out currently to employees or used to repay an £50? loan. Dividends may either he paid directly to plan participant, by~ the corporation or may he paid to the plan and distributed to par- ticmpanla no later than 60 days after the close of the plan year in which paid. Alternatively, the dividends (or some portion thereof) will qualify for the deduction if applied by the plan to repay a loan incurred under the plan to acquire employer securities, Because such divi- dends are deductible to the employer corporation, they do not qual- ify for the partial exclusion from income otherwise permitte4 under Code section 116, a *1 PAGENO="0455" 334 335 t ?srlislexclasdea at Isleresi armed am £S0?leeas Under the bill,s bispk, insurance company, or other commercial lender that is a corpot$t$bil may exclude from inOome 50 percent of the interest received on loans to a leveraged ESOP, the proceeda of which are applied by the plan to acquire employer securities. For this purpose, the loan may be made directly to an l~OP or may be made to the sponsoring corporstien which, in turn, lends the pro- ceeds Wan LOOP. £ s'ledscee' lax sale (as' sales at sleek Is cerlels eerperaliesis In the case of a saId or exchange of securities acquired by a tax- payer as part of an original issue in a company with a specified degree of employee stack ownership by a taxpayer other than a cor- poration, the bill generally increases front 61) percent to 110 percent the amount of the gain (qualified corporate gain) on the sale that is allowed as a deduction (rem gross income. Similarly, a lower tax rate applies with reiqiect to the qualified corporate gain on a sale of securities by s corporation. The bill defines a qualified corporate gain as the net capital gain of the taxpayer for the taxable year from the sale or exchange of qualified securities in corporations with a specified degree of em- ployee ownership. Qualified securities mean any securities held by the taxpayer for at least 3 years. In order to qualify, the gain niast be realized on the sale of securities in a domestic corporation in which (1) not less than 50 percent of the total value of shares of all classes of stack is owned by, or on behalf of, qualified eaiployees and t2) not less than 50 percent of the qualilied employees own not less than 25 percent of such stack in the corporation. An employee of the corporation is a qualifies) emnployee only if the employee is not an officer or s membeç Ol~the board of direclars of the corpors- tion. In testing whether the Eorporation satisfies the employee own- ership tests, any stack owiilsil1by a seller who is also an employee of the corporation is disregarded. In addition, all employees of the cor- porstion who are related persons tsrc. 267lts~l)) are treated as a soigle qualified employee. in testing the stack ownership of employ- em, all shares of stock of the corporation held by a qualified pen- sion plan are considered to be owiied by the qualified eioployees of the corporation. Under the boll, whether a corperstion has the required degree of employee ownership is determined immediately after the sale of so- ciirities. In edditiomi, the corporation niost continue to meet the re- q imreiiients (or ensployes ownership during the 2~year peried fat- hi wiiig the date of sale. A corporstion is deemed to satisfy these re- qsiremnenta if the corporation meets these reqoiremneiita (or at least one day during each calendar quarter during the 2~yeor peried, Folure to astisfy the holding peried reqoireiiient triggers a l0~per' ant excise tax on the corporstisn, In addition, the failure of the ci.rporstion to cerm.tfy on its income tax return that it continues to satisfy the holding period requirement resutte in imposition of the e.ocise tax. The bill provides that all corporations that are niembers of a controlled group of corporations (witliiii the meaning of sec. 4t4(b)snd Ic)) are treated as a single corporation for purposes of & Assssipllea eteslele lax liabilily by £50? Another provision of the bill permits an LOOP to essome the lia- bility for estate taxes in return for a transfer from the estate of stock of an equal value, provided the sponsor ~ompisny guarantees payment of the tax and agrees to pay suctttex over a peried of years As under current law, this provision would permit an initial peried of deferral of payment of estate tax, with up to ten equal annual instalhmenta permitted after the deferral period The slit" iisl 4-percent interest rate of prç~ent law would apply to estalq taxes on the first $1 million of value of an interest in a closely lid business; on the balance, interest, would he paid st the adjuste prime rate as determined under Code section Gti2t. Under the bill, for purposes of computing the tirst $1 million in value of an inter- est in a closely held business, the value of the estate for which ho- bihity is assunsed by the ESOP is sggregatad with the balance of the estate and is determined as a percentage of such balance. Simi- larly, the provisions of current lOw would apply to sccelerate pay- ment of any remaining unpaid tax in the euent of a delinquent payment of either interest or tas~; The executer of the estate far which the ESOP agrees to assume estate tax lishility meat elect the'spplication of the provision at the time prescribed for filing the estate tax return in the manner prescribed by the Secretory by regulations. In addition, the bilt,pro' viules that the return filed by the executer to elect application of this special rule meat include a stateniemit a the portion of tax to be,paid by the plan administrator. Under the: bill, the Secretary niay prescribe regulations that require any statemente or informs- tion returns as may be necessary to assure compliance with the ce- qoiretnenta of this provision. 7. £slole lax exclssiemm (or soles Is employees The bitt permits an exclusion from the gross estate of 50 percent of the proceeds from the sale of employer securities to an ESOP or a worker-owned cooperative. The proceeds from such sale are disco' garded for this purpose to the extent that such securities are allo- cated under the plan to the donor tor decedent), family members of the donor (or decedent), or shareholders owning more than 25 per- cent in value of any class of outatanding employer securities. The psrtial exclusion does nut apply if the securities were received by the taxpayer as a distribution from a qualified pension plan or as a transfer pursuant to certain stock options. I, Cherilolsle cenlribslion.s Is £SOPs Under the bill. a taxpayer generally is allowed an income, gift, or estate tax deduction under the charitable cantribution rules for contributions of employer securities to an LOOP. However, no do' ductinn is allowed unless (1) the securities are, within three years, allocsted under the plan in s manner thst does not discriminate in favor of officers, shareholders or highly compensated employees, (2) no port of the contributed securities is allocated under the plan to the donor (or decedent), a member of the donor's family, or an em- ployee owning more than 25 percent in value of any class of outs stsuiding employer securities, and (3) no amounts are allocated to a a C;' PAGENO="0456" 446 any employee based on unopensation of the employee in ex~a of $100,000 for the year. Employer securities contributed to an ESOP pursuant to this provision of the bill may be allocated to an employee under the plan without regard to the qualified pension plan rules that ganer. ally limit an employee', annual addition under the plan. Under the bill, if the taxpayer is permitted a charitable contribu. tion deduction with respect to the contribution of stock to an £50?, no deduction Ii permitted for the contribution under the usual rules for deductions for employer contributions to a qualified pension plan and no portion of the amount contributed is eligible for any credit against income taxes. Ertectire Date The provisions of the bill are generally effective for years begin. ning after December 81, 1904. The provisions relating to the a.. sumption of estate tax liability and partial exclusion from estate tax apply with respect to those estates of decedents that are re~ quired to file returns after the dsteofenactrnent. P.evenueEffect It is estimated that these provisions will increase fIscal year revS enues by $301 million in 1985 and $160 million in 1986, and will decrease fiscal year revenues by $67 million in 1987, $158 million in 1988; and $266 million in 1989. PAGENO="0457" 447 EXHIBIT B `sue sa*~ ~`4~t'" ~ .Conreft of t~t ~nLttb itatt~ JOINT CoMMItiu ON ?AM?ION 5010 ~ONOWQNTh NOV05 OPPSCI IUII01t40 W'sNs~*~ DC $Q~1s-I4$5 (202) 2204521 ocy1c~e, 0CT61989 lioncrable Kichasi A, Andrews U.S. Souse of Representativea 322 Cannon Bous. Office Puildinq Washington, D.C. 20515 bear Mr. Andrews: This is in response to your request dated June 5, l9~9, for a revenue estimate of a proposal that would allow the bequest of the remainder interest in a charitable unitrust or charitable annuity trust to an Employee Stock Ownership Plan (ESOP). Under this proposal, the following restriction, would apply: (1) The assets in the trust must be securities in a domestic corporation which has no outstanding stock readily tradable on an established securities market. This is assumed to mean a privately-held corporation. (2) The ESOP receiving the trust issets may not distribute any stock to, or otherwise benefit, any member of the decedent's family. (3) The LOOP may not make distributions to, or other- wise benefit, any person owning more than 3 percent of either the total number of outstanding shares or total market value of the corporation or any corporate aff*liates covered by the £50,. It is our understanding that this proposal~.wcu1.d not effect the income tax or gift tax consequencea of the transactions described. Aesuming an effective date of October l,~lDC9, we estimate that thie proposal would reduce fiscal year Federal budget receipts by lasa than $1 million annually. ~ hops this information is helpful to you. If we CAn be of further assistance, please let me know. Sincerely, Ronald A. Peariman PAGENO="0458" 448 EXHIBIT C NUMBER OF SAMMONS STATE EMPLOYEES IN STATE Alabama 18 Arizona 4 Arkansas 43 California 132 Colorado 4 Connecticut 46 Florida 114 Georgia 16 Illinois 25 Indiana 10 Iowa 4 Kentucky : 13 Louisiana 108 Minnesota 4 Mississippi 45 New Jersey 69 New Mexico 2 New York 116 North Carolina 785 Ohio 6 Oklahoma 36 Pennsylvania 66 South Dakota 276 Tennessee 31 Texas 1884 Virginia 36 Washington 3 West Virginia 3 PAGENO="0459" 449 Mr. ANDREWS~ Well, Mr. Hughes, let me just direct a few specific questions to you. Would you give us your comments and thoughts about the reve- nue effect of this legislation, H.R. 2992, in the particular case of Sammons Enterprises, Inc.? Mr. HUGHES. In the particular case of Mr. Sammons, the meas- ure is revenue positive, because if the bill is not enacted, the entire estate will go to charity, and, hence, will leave the tax revenue stream. If, on the other hand, the measure is enacted, the estate will be transferred in significant measure to an ESOP which in turn will subsequently distribute the stock to the employees. The distribu- tion of the stock to the employees will give rise to a tax at the time of distribution and, therefore, the appreciation in value of the stock will reenter the revenue stream. So, with respect to Mr. Sammons' estate, the bill is without a doubt revenue positive. That is certain because the stock is already destined for distribution to the ESOP or to charities under the charitable remainder trust. There's no chance to change the trust because Mr. Sammons is dead. * Mr. ANDREWS. How many employees of Sammons Enterprises, Inc. will be benefitted by the legislation, and where do they reside?. Mr~LHUGHES. Well, Sammons Enterprises, Inc. has 2,700 employ- ~ees, ~k~c~ithd in 28 States. These States are located across the United States. Fot example, we have employees in COnnecticut and New York,~ mwing on down .to Tennessee,. Alabama, Texas, Arkansas, and then out to California. There are also employees up through the Midwest with a significant number of employees in South Dakota and elsewhere across the country. Attached to my testimony is a list of the 28 States and how many employees are in each of the 28 States. Mr. ANDREWS. What limitations are placed upon distributions by ESOP's of securities contributed via the legislation, H.R. 2992, and hownlO such limitations affect the Sammons ESOP? ~Mr. HUGHES. Well, the Sammons~ESOP is not particularly affect- kbecausathere'~are no familyLmembers who are employees-other than Mr. Sammons' widow aitcL~she- is not a participant in the ESOP. But, in order to protect~iinst the use of this bill as an .estate planning vehicle, ~or. abuse of the provision in an estate con- text, no family member of the decedent can participate in a dece- dent's bequest to an ESOP. Now, this is contEasted with the case where, if a corporation has an ESOP and is controlled by a family member, if that member of. the family is an employee, that member of the family can partici- pate in the ESOP. In the case of SammonsrEnterprises, there are no family mem- bers who are ESOP participants, and there are no ESOP partici- pants who are significant shareholders of the company because the only individual shareholders are family members of the decedent- who cannot participate in the ESOP-and former employees who have received their ESOP distribution and who preferred to retain the stock of the company rather than to turn that stock in for cash~ These former employees thought that it was a good investment and they wanted to keep it. PAGENO="0460" 450 Mr. ANDREWS. Finally, there has been argument made that the contributions made to an ESOP pursuant to this bill are really being made for the benefit of the stockholders of the company since the company may use the contributions to offset compensation that otherwise would have to be paid by the companies to their employ- ees. What are your thoughts about this? Mr. HUGHES. Well, there's an ESOP study that indicates that only 5 percent of the companies establishing an ESOP have re- duced the amount of employee compensation as a result of having set up the plan. So, that means 95 percent have not changed the amount of their employee compensation at all. * If one were to try to take the approach that said ESOP contribu- tions are indeed salary payments, or any other type of compensa- tion payments, then it must be remembered that Congress allows deductions for compensation payments and such deductions do ben- efit shareholders. Any corporate deduction benefits all the share- holders. However, in the instant case, the high probability is that any in- direct benefit generated by the contribution to the ESOP will bene- fit only, in any significant way, the employee shareholders because of the fact that they will own over half of the company if the amount of the estate stock is distributed to them. Finally, I must note that the notion that there are benefits to be derived from a contribution is not inconsistent with the notion of a charitable deduction. A gift to a university that is going to name a building for the donor directly benefits the donor, and indeed may enhance that donor's ability to function in the business community. Nonetheless, that type of benefit, the more or less intangible gener- al benefit, has never been deemed to lessen the availability of the charitable deduction. Mr. ANDREWS. Thank you very much, Mr. Hughes. Mr. McKinney, in listening to your proposal, as I understand what you are recommending is prorating the allowable deduction for hours for individuals who are in pension plans only part of the year. Am I correct? Mr. MCKINNEY. What I'm proposing is to allow~ active duty mili- tary members to have the same privilege as we give our reservists to participate in an IRA. As I indicated, the reason the reservists were excused in the be- ginning was because they are not considered to have a vested re- tirement program. So what I am saying is that neither does the active duty force have a vested retirement program. For example, you have to serve 20 years in the active duty force before you are entitled to any re- tirement. You don't get any before that. There is no way you can drop out and get money, say, at 5 years, 10 years, or 19 years, 11 months and 29 days. You've got to have that 20 years. So you really don't have a vested program. Mr. ANDREWS. The Treasury Department has testified, and there is some concern on the part of the committee, that your proposal may be too complex. That may come as a surprise to someone that the Ways and Means Committee would suddenly start with your proposal to try to simplify the Tax Code. PAGENO="0461" 451 But do you. think the extra tax advantage of your proposal is worth the complexity? Mr. MCKINNEY. Well, I really don't see any complexity to it~ For example, in the Tax Codeiitself, it reads specifically that a reservist is not considered an active participant. And.~I don't know why we just can't include an active duty military member since the reasons that reservists are in that category applies almost equally to those in the active forces. Mr. ANDREWS. ~Thank~y.ou very much. I would like to direct~one questiomtoithefour~of you, of the panel that testified initially, advocating tax-exempt organizations to maintain 401(k) plans. As I understand it, as you have testified, that provision was added in the conference. One of the reasons, as I understand it, was the revenue ~cost. I have not heartha compelling argument against your position based on~pó1icy~reasons.1The~revenue estimate, I be- lieve, is about $100 to $200'million ayear. I would like to ask all four of7ou, assuming that's the case, and assuming the committee was to agree with what you have suggest- ed, where would we go to find that additional revenue? What sug- gestions might you have to fulfill the revenue needs that will be made by making this change in the code? Mr. MILNER. Congressman, in that particular area of the ques- tion of the amount of revenue lost I think is being reviewed again. And we have some question as to whether or not specifically as it applies to the tax exempts that we are~ referring to whether or not that estimate is accurate. But be that as it may, we do support the fact that it should be a revenue neutral approach. And we will review the committee's rec- ommendations on how to balance that, reserving the right to dis- agree with the suggestions you've come up with, sir. Mr. BAKER. The numbers that we have from the Joint Tax Com- mittee revenue estimates show that over 5 years it's about $183 million. I don't know where that higher number comes from. And there is some question, even if this $183 million isn't slight- ly higher than it should be. We don't really think it is that amount. Mr. HUXHOLD. The number of organizations that end up adopting the plans too is something that's obviously a very major assump- tion. A lot, of this, as was stated earlier, the primary area pensions are defined benefits, profit sharing money purchase plans. And most of these plans are supplemental, or for smaller employers that maybe have 10 or 15 employees. And they just don't have enough revenues to come in and take care of things. They want to allow the employees to do something. So, I think that that is where I see more of the need. And I don't know that, again depending on the-I mean I would almost take debate with how they have~ arrived at `the revenue costs because of the fact that I just don't see a hue and cry going .where you are going to find every organization out there adopting the plans. Mr. ANDREWS. Thank you very much. The gentleman from New York. Mr. MCGRATH. Thank you very much, Mr. Chairman. PAGENO="0462" 452 Mr. McKinney, let me see if I understand your proposal correct- ly. Everybody else in an IRA does not get a deduction if they have another pension plan, or if their salary on a joint return exceeds $50,000. What you are suggesting to us is that reserve officers and active duty officers do not have a pension plan unless and until they vest that year 20? Mr. MCKINNEY. Yes, sir. Mr. MCGRATH. Mr. Baker, just a little aside here. Is it required that all members or officers of the United Food Commercial Work- ers International have the first name of Willie? Mr. BAKER. Yes; that's correct. [Laughter.] Mr. MCGRATH. I played golf with your international president down in Bal Harbor last week, and I just find it striking. Mr. BAKER. It's a great idea. [Laughter.] Mr. MCGRATH. Let me ask you this question. On your 401(k), are you talking about the employees of the union? Mr. BAKER. Yes. Mr. MCGRATH. OK. Not your union members? Mr. BAKER. No; employees only. Mr. MCGRATH. You are not worried about the $7,000 limitation? Mr. BAKER. No; there was no discussion of $7,000. We are just simply saying that those local unions that were not allowed in be- cause of the cutoff date of July 2, 1986, that they now be allowed to be in on the same basis as anyone else. Mr. MCGRATH. I was going to say that I would have a hard time saving $7,000 a year. The same is probably true for some of your members. But I thank the gentlemen for their testimony. Mr. ANDREWS. Well, I, too, want to thank the panel. Thank you very much. And if we could ask our next panel today to please take their seats. - Thank you for joining our committee this morning. I would ap- preciate it if each one of you, in turn, would introduce yourselves and who you represent before proceeding with, hopefully, a narra- tive of your testimony. Your formal statements will be submitted and made a part of the record. Mr. Beaty. STATEMENT OF ROBERT G. BEATY, CHAIRMAN, LEGISLATIVE COMMITTEE, AND PAST PRESIDENT, INTERNATIONAL FORMAL- WEAR ASSOCIATION AND CHAIRMAN OF THE BOARD, MITCH- ELL'S FORMAL WEAR, INC., ATLANTA, GA Mr. BEATY. My name is Robert Beaty, I am the chairman of the board of Mitchell's Formal Wear, the company that I have been as- sociated with for the last 37 years and the chief executive Officer for the last 15 years. I am also representing the International Formal Wear Association as the current chairman of their legisla- PAGENO="0463" 453 tive committee. The association is made up primarily of members across the United States in the business of renting tuxedos. Let me thank you very much for permitting me to testify here today on the subject of depreciating rental tuxedos. In the 1986 tax bill, Congress gave a mandate to the Treasury Department to study the depreciation of clothing held for rental. Two and one-half years later, the Treasury Department reported back to Congress. In that report, on page 29, it clearly states: "If a separate asset class for tuxedos is to be established, Treasury rec- ommends that it be assigned a class life of 2 years." It is also important to point out the administration position, which was submitted to this committee yesterday. It states: We found that tuxedos have an economic life of two years. We believe it is appro- priate for recovery periods to reflect actual economic life and therefore are not op- posed to the principle of allowing the cost of a tuxedo to be recovered over 2 years. The ACRS system, created by the 1981 Tax Act, had the effect of placing tuxedo rentals in the 5-year class, thus penalizing, though inadvertently, the approximately 1,300 small firms in the tuxedo rental industry. Their major assets were required to be depreciated at a rate slower than their actual economic life. This made the ef- fective tax rate on the income from renting tuxedos substantially higher than the statutory rate. As an example, I know of one com- pany which had a high tax rate of 69.9 percent. The House bill leading up to the Tax Reform Act of 1986, explic- itly placed clothing held for rental in a 3-year recovery period. The Senate bill dropped that provision with the expectation that the Treasury Department, based upon a study, would make the appro- priate reclassification. In the conference report on the 1986 act, no special depreciation rule was provided for clothing held for rental. These assets are classified under present law as assets used in wholesale and retail trade with a current class life of 9 years. This means a recovery period of 5 years for regular depreciation and 9 years under the al- ternative depreciation system used for alternative minimum tax purposes. The 1986 act, gave to the Treasury Department, authority to adjust class lives for most assets based upon studies of the actual depreciation and of particular assets. The statement of managers indicated that clothing held for rental should be studied to deter- mine whether a change in class life is appropriate. Before the mandated study was completed, the Technical and Miscellaneous Revenue Act of 1988 rescinded Treasury's authority to establish new class lives, though authority to conduct studies of depreciation was continued. I am confident you will agree, no industry in this Nation should be required to depreciate* their assets over a period 2½ times their actual economic life of 2 years. Even worse is requiring them to de- preciate their assets over a period of 4½ times their actual econom- ic life, for the alternative minimum tax purposes. No one should be required to depreciate a 2 year asset over a 5 year period or 9 year period for AMT purposes. It has now been 8 years since all other industries were afforded the benefits of the accelerated cost recovery system. The tuxedo PAGENO="0464" 454 rental industry, to the contrary, has been penalized for that same 8 years. It simply does not seem fair for this industry to be required to continue depreciating their assets over a period longer than their actual economic life of 2 years. We~ respectfully ask Congress to correct this inequity as rapidly as possible and in a way that will not require us to be phased in over the next 5 years. It seems to us, the past 8 years should be more than enough penalty for this small tuxedo rental industry. We are simply asking your help. Once again, let me thank you for allowing me to testify before this committee today. [An attachment to Mr. Beaty's statement follows:] PAGENO="0465" 455. DG~IBIT "A" Chapter 5. Conclusions A. The Class Life of Tuxedos The empirical results of this study of the depreciation of tuxedos are readily summar-iied. The useful life of tuxedos, which in the context of this study is essentially the average period over which tuxedos are rented, is 3.7 years. The equivalent economic life of tuxedos, which in the context of this study is that recovery period under the Alternative Depreciation System which generates depreciation allowances whose present value equals the average present value of the economic depreciation of tuxedos, is 1.9 years (2.1 years if the results for the individual styles of tuxedos are weighted by initial value-in-use, rather than cost). Treasury believes the equivalent economic life is more indicative of the actual. depreciation of tuxedos, and if a separate asset class for tuxedos is to be established, recommends that it be asstgned a class life of 2.0 years. The General Explanation notes that a change in the class life of an asset group is to reflect the anticipated useful life and the anticipated decline in value over time of. the assets in the group. Although the results noted above are based on historical information about assets acquired a number of years ago, industry representatives did not anticipate changes in the economics of tuxedo rental which might cause the depreciation of tuxedos acquired in the future to differ from the observed depreciation. The disparity between the estimated u~f~il life and the much shorter equivalent economic life of rental tuxedos is an important result of this study. Treasury believes that when, as in the present case, adequate information is available to reliably estimate the decline in economic value with age of the asset studied, such information should be used to determine the asset's class life. For assets whose productivity tends to decrease with age (as is true for rental tuxedos when productivity is measured by the number of turns), the equivalent economic life will usually be shorter than the useful life, and the faster the decline in productivity with age, the greater the disparity between the equivalent economic life and the useful life. In general, focusing on the useful life tends to bias the analysis towards an excessively long class 1if~. By contrast, reliance on the equivalent economic life does not give undue weightto the latter year's of an asset's life, when it may be retained primarily to perform an infrequently needed task. Although these considerations do not appear to be relevant in this study of tuxedos for which actual rentals, rather than retention, was reported, the decline in the frequency of rernal of a given style of tuxedo with age leads to an average economic life for tuxedos which is much shorter than their average useful life. This may, in part, reflect the rapidity with which the attractiveness of any style of fashion tuxedo may change, or the increasing impact of wear and tear with age on the firm's ability to rent a complete set of basic black tuxedos. Regardless of the reasons for the relatively PAGENO="0466" 456 Mr. ANDREWS. Thank you. Mr. Regan. STATEMENT OF WILLIAM V. REGAN III, CLU, CHAIRMAN, TASK FORCE ON POLICYHOLDER TAXATION, AND CHAIRMAN, ASSO- CIATION FOR ADVANCED LIFE UNDERWRITING TASK FORCE ON BUSINESS-OWNED LIFE INSURANCE, NATIONAL ASSOCIA- TION OF LIFE UNDERWRITERS, PRESIDENT, MANAGEMENT COMPENSATION GROUP, SAN FRANCISCO, CA Mr. REGAN. Mr. Chairman, members of the committee, I am Bill Regan here testifying on behalf of the National Association of Life Underwriters and in its conference, the Association for Advanced Life Underwriting., NALU and AALU represent 140,000 professional life insurance agents, most of whom work on a daily basis with businesses and businesses insurance needs. The proposal before the committee, number G-5 on your agenda, suggests that it is somehow inappropriate for a business to be the beneficiary of life insurance on the life of its employees. We appreciate the opportunity to explain how businesses use life insurance and why it is appropriate for businesses to be the benefi- ciaries of life insurance policies on the lives of their employees. American businesses, as you know, are exposed to an array of risks that are not directly related to their main business functions. They continually seek to shift the risk via insurance in order to free up capital and put it to productive use. This is why businesses insure their rolling stock, their inventories, their plants, and any asset that would cause a loss in productivity should something happen to it. Protection of the most important of a business' assets-its key people-heads the list of risks to insure. The death of a key em- ployee or owner creates a measurable economic loss, which ade- quate permanent life insurance can protect the business against. The death benefit proceeds are normally payable to `the business. Those life insurance proceeds frequently spell the difference be- tween the continued operation of the business when a key employ- ee or owner dies and its inability to continue with resulting loss of jobs and tax revenue. When a business commits to pay benefits to its employees, it is always concerned that it will have adequate funds to meet its long- term benefit obligations. Businesses today frequently use permanent life insurance to in- formally fund survivor, retirement, and postretirement benefits. The tax results of these plans are similar to the results that the employee could achieve if they were to own the insurance outright. The business ownership of the insurance is used for important nontax administrative and economic reasons. Life insurance thus enables employers to create substantial employee security and to attract and retain quality employees. PAGENO="0467" 457 Having said this much, it is important to point out how neces- sary it is to distinguish between the purposes of business owned in- surance and its structure, or how it is used. Life insurance can be used ~in ways that are inappropriate. But correcting such uses should not be done at the expense of compro- mising the essential purposes that business owned life insurance serves. Such a result would occur if the. current proposal were adopted To the extent that abusive uses exist, we concur with the Treas- ury's position, and I quote from their testimony yesterday, "that there may be a simpler and more direct means" of making sure that business Owned life insurance is used properly. NALU and AALU have adopted a policy statement that sets out the parameters of appropriate purposes and uses of business owned life insurance. That "Statement of Principles and Practices" is at- tached to our testimony. Where there are inappropriate uses of business owned insurance in the marketplace, we stand ready to assist Congress in fashioning effective but narrow responses to those excesses. We believe that our statement provides a good framework for that effort. In brief, as laid out more fully in our policy statement, NALU and AALU believe that business owned life insurance should be en- couraged within the following guidelines: First, that all those insured by business-owned policies must con- sent to be insured. Next, that all those insured in connection with a benefits pro- gram must be eligible to participate in those benefits. The substitution of an insured clause should continue to be avail- able, but with the understanding that any gain in the contract is taxable at the time the clause is used. And finally, that borrowing on policy values to meet business emergencies and future premiums, et cetera, should be done only in full compliance with the tax law. Borrowers' should also be sen- sitive to the significance of loan terms and market rates of interest in determining the amount of interest which is deductable. Borrow- ers should be sensitive to the significance for deductibility of loan interest of paying substantial cash premiums, including four full premiums out of the first seven with funds obtained from sources outside the policy. Again, Mr. Chairman, we are committed to assisting you in de- termining if there are abusive uses of life insurance, and if so, in determining the appropriate remedy. In the meantime, I will be happy to answer any questions. [The statement and attachments of Mr. Regan follow:] PAGENO="0468" 458 TESTIMONY OF THE NATIONAL ASSOCIATION OF LIFE UNDERWRITERS Mr. Chairman, members ofithe committee, thank you for this opportunity to explain the important benefits to the ecunomy, community and family provided by business-owned life insurance. My~name is BiILRegan;Iam chairman of the National Association of Life Underwriters' (NALU) Task Force on Policyholder Taxation. I am also chairman of NALU'sconference task force, The Association for Advanced Life Underwriting (AALU) Task Force on Business-Owned Life Insurance. AALU joins NALU in these comments. NALU is a trade association which represents some 140,000 professional life and health insurance salespeople who are members of over 1,000 local life underwriter associations located in virtually every community in the country. As providers of life insurance, together we represent the interests of literally millions of individuals and businesses that own and use permanent life insurance products. Th~ Pro~olal Reflects~Basic Misunderstxpding of the Role of Life Insurance As we understand the proposal before this committee,; there appears to be a basic misunderstanding of the appropriate use of life insurance in the business setting. According to the concerns of those who offered this proposal, a problem exists when the business itself is the beneficiary of the life insurance death benefits. Under the terms of the proposal, in order for a business life insurance policy to qualify for the usual tax rules governing life insurance, the ~olicyowner--uSually the business--would have to designate irrevocably the employee or his/her family as the beneficiary of the policy. Of course, it is rare indeed that a business-owned permanent life insurance policy names anyone other than the business itself as the beneficiary of the policy's death benefits. Thus, this proposal would change profoundly the practices of virtually llll businesses that currently own permanent life insurance. Before discussing the reasons that permanent life insurance, whether owned by business or individuals, is good for our country generally, and our communities and families specifically, a brief explanation of why the business is--and should be--the policy's beneficiary is in order. Most businesses have measurable economic interest in the continued production of their key employees and owners. Loss of that production causes a real, often very large, financial loss to the business itself. Thus, life insurance death benefits payable upon the death of the key employees and/or owners, is protection against that measurable economic risk. It is the operation of life insurance in its purest sense. We would like to discuss some specific examples of situations that illustrate the purpose of life insurance and how it is used in the business setting. However, before getting into these examples, let. us emphasize the essential difference between the p~~rpo~~ of life insurance, and issue of ~Q~y it is used. Congress may face the task of drawing legislative lines because the ppo~ of a policy--and its governing tax rules--are called into question because of jj~ life insurance is being used. It is essential that we acknowledge the underlying piiipuit~~ that business-owned life insurance serves, so that any attempt to restrict ~ a' policy is used does not undercut that underlying purpose. NALU and AALU have developed a policy statement, a copy of which is attached, that lays out what we believe are the parameters of the appropriate use of business-owned life insurance. It is our intention and commitment to assist Congress in making sure that the tax laws governing life insurance encourage the use of business-owned life insurance in ways that fallwithin the parameters described in our "Statement of Practices and Principles." As our statement indicates, we believe that businesses should purchase and use life insurance within the following guidelines: All of those insured by the policy should consent to be insured. All those insured by the policy should be eligible to participate in the benefits provided by the life insurance program. Businesses should continue to be able to substitute lives within a single policy to avoid duplication of policy acquisition costs, recognizing that any gain in the contract at the time the substitution of insured clause is triggered is subject to tax liability. Businesses should purchase and use the insurance in full compliance with tax laws relating to the policyowner's ability to borrow policy values to meet business emergencies, pay future premiums, etc., and should be sensitive to the significance of loan terms and market rates of interest in determining the amount of loan interest which is deducrible, and the significance for the deductibility of loan interest of PAGENO="0469" 459 paying substantial cash premiums, including four full annual premiums of the first seven premiums with funds obtained from sources outside the policy. Key~Person. Buy-Sell Plans Protect Jobs. Families Every business has one or more employees whose production is critical to the business' financial health. It could be key management personnel, or perhaps it is the salesperson who brings in the work for the business to perform. Other examples include those whose jobs demand the creativity of product development, or the extra-skilled technician who knows how to work the crucial computer or manufacturing system that is the heart of the business' performance. When one of these people dies, the business faces the enormous cost of replacing this worker's individual skills. During the time a replacement is sought and during the "learning curve" period during which the new worker gets up to speed, the firm is likely to lose both new business and productivity with respect to existing business. In this so-called `~key person" scenario, it is this measurable loss that life insurance death benefits replaces. - Similarly, life insurance protects a business against the financial devastation that occurs when one of several business owners dies. The `buy-sell' situation involves the use of life insurance proceeds by the business to pay the decedent owner's heirs the decedent's ownership interest. This avoids the need to use business assets-which may not be in liquid form-to meet this obligation. Where life insurance is not in place in a buy-sell situation, either the decedent's heirs will become potentially active participants in the business as they exercise their new ownership rights, or-in the worst case--the business itself might have to be sold in order to satisfy the financial obligation to the decedent owner's heirs. In each of these scenarios the existence of death benefits, payable to the business itself, could very well spell the difference between the continued operation of the business and its failure. The continued operation of the business, of course, means the continuation of the jobs that the business provides to its employees, and the continuation of the business' impact on other businesses in the community. It also means that that business will continue to pay j~ income taxes to the Federal and state governments and to contribute to our overall economic growth. In fact, the importance of the role of life insurance in protecting a business' continued ability to operate and grow was taught to professional life insurance salespeople as early as 1914, even before this country instituted an income tax. (See Minutes, NALU 25th Annual Convention, September 15, 1915.) Another purpose of life insurance is to help create funds to provide both death and post- retirement benefits to employees. The typical business-owned life insurance program guarantees either income paid to surviving spouses (or other family members), post- retirement benefits or both to employees. As will be shown later in this statement, the tax consequences of providing death and/or post-retirement benefits to employees via life insurance owned by the employee directly, or via a life insurance policy owned by and for the benefit of the business are essentially neutral, but for a variety of non-tax reasons it is often preferable to provide these benefits through the business. Facilitating the provision of death and post-retirement benefits to employees has been for many decades a traditional purpose of permanent life insurance owned by businesses. And, permanent business-owned life insurance contributes to the stability of families and communities just as much as does individually-owned permanent life insurance. Once in Place. Life Insurance Is Used as Any Business Asset Is Used Now that the life insurance need and purpose of businesses has been established, it is necessary to look at how the life insurance policy is used by the business once it is in place. Like any business asset, life insurance has a current economic value. That current economic value is used, day in and day out, in the standard fashion that businesses use ~i of their assets in running their concerns. Life insurance appears on the company's PAGENO="0470" 460 balance sheet as part of the business' underlying financial strength. It can be--and sometimes is--used as collateral for credit purposes. There is nothing unusual about borrowing against the increasing value of any business asset, be it a stock and bond portfolio, real estate, the art on the walls, inventory, accounts receivable, or life insurance. And in all of the examples just cited, that increasing asset value is not subject to income tax until and unless the asset is liquidated and the gain is realized. And, as for all assets, the g.~jii to borrow against life insurance values is itself a strength, even when--as is frequently the case--the~right to borrow is not exercised. Corporate Americais~increasiflgly facing vexing, human resources problems and resulting financial obligations that must be met. In response, businesses continually search for sources of funds that will free up their capital for use in making their businesses grow by running themain lines of their businesses. Just as businesses maintain adequate fire or casualty insurance to free their cash from the need to reserve for such contingent losses, they seek to insure the risk of losing their human assets, or to fund creatively againstthe need to meet people-related benefits obligations. As our Statement of Principles and Practices indicates, we believe that life insurance is an appropriate mechanism for businesses to use in meeting the needs of their employees and its use allows businesses to devote more resources to increasing their productivity. In addition, an analysis of the technical workings of tax rules governing employee compensation and corporate and individual income taxation leads to the conclusion that use of life insurance by a business to fund benefits~for their employees is generally tax- neutral vis-a-vis the tax consequences of the corporatioirpaying the employees taxable cash with which the employees purchase the benefstsilirectly. As an example,~consider a survivorship program. The employee and:~emp1oyer incur the same after-tax cost regardless of whether the employer buys the life insurance policy, collects thedeath benefit itself, and flows through survivorship benefits to the employee's-heirs as they would if the employer simply paid the employee the after-tax cost of the insurance and the employee purchased his/her own life insurance policy. Further, the Federal Government collects the same amount of tax revenue under both scenarios. The analysis shows either essentially or completely neutral tax results for any of the differing kinds of business-owned life insurance programs. if the Federal Government collects the same or essentially~the same tax income from the corporation that it would from its employees as a result of providing benefits to those employees, then the~structure of providing those benefits should not be of concern as a matter of tax policy. There are some~wha~argue that borrowing against life insurance policies directly risks loss of the death benefit for which the- policy was acquired--and because of which the policy qualifies for its current tax treatment. Again, this reflects a misunderstanding of the mechanics of life insurance programs. It is indisputable that where an insured dies with a loan outstanding against the life insurance policy on his/her life, the loan proceeds are deducted from the death benefit payment. However, the loan would rarely interfere substantially with the intended death benefits. The amount of money available for loan, especially in the first 15-20 years of a policy's life, is typically but a small fraction of the original death benefit. For example take a typical $250,000 whole life policy on a 50- year-old male. By the 15th policy year the death benefit will have risen to $375,000 and the loan value to $147,000. Even if this policy were borrowed against to the maximum amount possible, the net death benefit would be $228,000, over 90% of the original face amount, after the repayment amount had been deducted. Similar results can be shown for policies that feature "quick-pay" or `vanishing-pay" premium-paying arrangements. This illustrates the marginal impact on death benefit of life insurance borrowing. It is also true that some amount of interest payable on business-owned life insurance policy loans is deductible, and that the loan proceeds come from a source (the inside buildup) that has not yet been taxed. However, this is again not unusual. In fact, it's a bit less advantageous than the usual scenario. If the business were borrowing against the increasing value of its real estate holdings, for example, it would be deducting ~fi the PAGENO="0471" 461 interest it paid on the loan, and the increased value of the real estate, like the life insurance inside buildup, has not yet been taxed. In contrast, under current law rules, interest on business-owned life instirance policy loans is deductible only to the extent of the interest on $50,000 in loans per insured employee. Nonqualified Deferred Compensation Does Not Give Rise to Abusive Use ofj~ife Insurance The foregoing comments lay out the generalized purposes, uses and rationale of business- owned life insurance. However, due to expressed concern by several in the tax-writing community, it is worth pointing out that these generalized comments are specifically applicable to the arena of nonqualifled deferred compensation. Extra retirement compensation, above the limited amount that can be provided on a pre-tax basis under the qualified plan rules, is often provided (in compliance with labor as well as tax law) on an after-tax basis. (The business does not deduct as compensation the amount of deferred compensation as it would if that amount were taxable currently to the employee.) This deferred compensation is promised, but is ni~ funded (nor can it be if it is to comply with the law). Illustrations that show how life insurance values ~Qj~i~ be used to meet nonqualified deferred compensation obligations, when they mature, are common, as are illustrations using the appreciated values of other assets-like stock and bond portfolios, real estate holdings, etc. Summary: The Use of Business-Owned Life Insurance Is Not Abusive: Indeed It Is Well Within Standard Business Practices To summarize, businesses use life insurance to protect against measurable financial loss due to the death of key employees and owners, and to create funds to facilitate benefit programs for employees. Once in place, the life insurance policy is used as any other business asset is used: to underpin the business' financial strength, to increase credit availability, and to free cash for use in business-expanding activity rather than holding it in reserve to protect against contingent liabilities. The interest paid on life insurance policy loans is deductible to a limited extent which is not only ~ an unjUstified tax advantage, but a limitation on usual rules which allow full deductibility of interest paid on other business loans, regardless of the taxability of the asset against which the loan is taken. NAL1J and AALU Stand Ready To Help Remedy Any Abuses Having explained how and why business-owned life insurance operates within standard business practices and the intent of the tax law governing life insurance, we are confident that thoughtful participants in the tax-writing process will agree that any rule change that would impact on business-owned life insurance generally must be avoided. However, to the extent that there are any practices that do not comply with the purpose of life insurance tax rules or fall outside these usual business practices, NALU and AALU stand ready to assist the Congress in its efforts to remedy the situation. The attached Statement of Principles and Practices provides a framework for both identifying what kinds of practices would be abusive, and for potential remedies for abuses. Substitution of Insured aausea One final point must be made before summarizing these comments. Among the concerns expressed by those interested in this issue is the so-called "substitution of insured" clause. Such a clause is in virtually every business life insurance policy. Its purpose is not to avoid tax liability when/if the insured person in the sensitive job changes, but rather to avoid duplicative acquisition costs. While such clauses are universal, they are rarely used. NALU and AALU believe that under current law any gain in the contract is taxable at the time a policyholder exercises the rights granted under a substitution of insured clause. Marketplace activity reflects that belief. PAGENO="0472" 462 usion: Within Stated Principles and Practices the Use of Business-Owned Life Insurance Should Continue To Be Encnur~g~d To the extent that business-owned life insurance protects business and the jobs that business provides from financial loss due to death of key employees and owners, enables business to meet its benefits commitment to employees, and reflects .policy use in a manner consistent with usual business and tax practices and principles, there should be no change to current law governing business-owned life insurance. Where there are existing marketplace abuses of the usual principles and practices of tax law and/or business procedures, life underwriters stand ready to assist Congress in crafting narrowly-targeted rules to eliminate such abuses. Mr. Chairman and members of the committee, thank you for this opportunity to discuss this vitally important issue with you. I will be happy to answer any questions you might have. PAGENO="0473" 463 NATI0NALASs0aATI0N OFUFE UM)ERWRlTERS ASSOQA~oN FOR AD~AN~ED UFE URERWR~NG STATELIBIIOF PRINCIPLES AM) PRACTiCES IN CONPECTIOPi WITH LEGISLAIION AM) REGUI.ATION CONCERNiNG ThE BUSINESS USES OF UFE INSURANCE The National Association ci Life UnderwrIters and Its conference, the Association for Advanced Life Underwriting, support tax laws and regulations that enable businesses to purchase life Insurance to meet business needs. NALU and MLU will be gukied by the following statement of principles and practices when proposing, evaluating or reacting to legislation and/or legislative and regulatory proposals that may impact on the sale or use of business-owned life insurance. PREAMBLE Businesses have utilized life insurance for many decades as the most efficient means of alleviating financial risks and meeting long-term obligations associated with the death of employees and owners. Business life insurance thus provides a major element of job security and economic stability, benefitting employees, their families, their businesses, and their communities. The continued availability of business life insurance Is therefore vital to our society and economy. As the economy has expanded and businesses have developed new needs, the life insurance industry has responded with new products and new ways to use life insurance to meet those needs. This expansion and development, when combined with changing economic conditions and changing tax laws, has made the proper selection and use of life insurance amore complex process. That process needs clear rules and regulations. Tax legislation and regulations should be responsive to and consonant with the following principles and practices: PRINCIPLES TO BE ENCOURAGED * Businesses should be able to use life insurance as an important part of their financial plans, and the insurance industry should respond to new business needs. * Businesses, like Individuals, trusts, or other entities, should be able to use all products (term, whole life, universal life, variable life, etc.) which qualify as life insurance under applicable federal and state law. * Businesses should use life Insurance products in ways consistent with the public interest and the intent of thetax laws. * Businesses, in their use of life insurance, should have the benefit of consistent tax laws In order to facilitate reliable and effective long-range planning. When and if changes in the tax laws are required, those changes should apply prospectively. PRACTICES * Businesses should be able to use life insurance to protect against the financial loss of the insured's death, or to meet other financial needs or objectives, including but not limited to: - successful continuation of business operations following the death of an insured key employee, PAGENO="0474" 464 - purchase of a business interest, thereby enabling the Insured's family to obtain a fair value forJts business interest and permitting the orderly continuation of the business by new owners, - redemption of stock to satisfy estate taxes and transfer costs of an Insured stockhalder's estate, - creation of funds to facilitate benefit programs for long-term current and retired Insured employees, such as programs addressing needs for retirement income, disabilityincome, medical costreimbursement, long~term care, or similar needs, and - payment of life-Insurance or survIvor benefits to families or other beneficiaries of Insured employees. * ~Employees should consent to be Insured. * Businesses should purchase and use the Insurance In full compliance with tax laws relating to the policyowner's ability to borrow policy values to meet business emergencies, pay future premiums, etc., and should be sensitive to: - the sIgnificance of loan terms and market rates of interest in determining the amount of loan interest which is deductible, and - the significance for the deductibility of loan interest of paying substantial cash premiums, including four full annual premiums of the first seven premiums, with policyholder funds obtained from sources outside the policy; * Businesses should continue to be able to substitute lives within a single policy to avoid duplication of policy acquisition costs. PAGENO="0475" 465 Mr. ANDREWS. Thank you, Mr. Regan. Mr. McDavid. STATEMENT OF J. GARY McDAVID, CHAIRMAN, LEGAL TAX AND ACCOUNTING SUBCOMMIrrEE ON TAX LEGISLATION, NATION- AL COUNCIL OF FARMER COOPERATIVES Mr. MCDAVID. Thank you very much, Mr. Chairman. My name is Gary McDavid and I serve as chairman of the subcommittee on tax legislation for the National Council of Farmer Cooperatives, on whose behalf I appear here today. We are here because there have been an increasing number of controversies between farmer cooperatives and the Internal Reve- nue Service over the classification of gain or loss on the sale of assets that have been used in the patronage operation. These are such things as grain elevators, warehouses, processing equipment, and other assets that are used in the marketing and purchasing activities for farmer cooperatives. The issue is whether the gain or loss should be treated as patron- age or nonpatronage sourced. If the gain is patronage sourced, the cooperative can distribute it to its patrons and deduct or exclude these earnings from its taxable income, but the patrons are then taxed on the amount they receive. If the gain is~ nonpatronage sourced, it is taxable to a nonexempt cooperative whether or not it is distributed. Thus, the issue is whether the income is taxable to the nonexempt cooperative and how losses should be classified. In looking at the distinction between patronage and nonpatron- age income, nine court decisions have applied a relationship test to determine whether a particular type of income or loss is patronage sourced. If the activity which produces the income or loss is sufficiently related to the patronage operation, then the income will be consid- ered to be patronage sourced. This is described as the directly relat- ed or actually facilitates test. For example, if you had a plywood manufacturing cooperative and it acquired a stock interest in a glue manufacturing subsidiary, the glue being mportant to glue the pieces of wood together to make plywood, the ownership of stock in that subsidiary would be such that where dividends were paid from the subsidiary to the parent, those dividends would be considered to be patronage sourced because glue was an important component of and integral- ly related to the manufacturing of the plywood. Therefore, the divi- dends would be considered to be patronage sourced~ This is an example which deals with dividend income. There are other types of income that have been found by the courts to be pa- tronage sourced using this relationship test-interest, rental, and capital gain. The Service does not accept this relationship test. When the Service looks at gains from the sale of assets that have been used in the patronage operation, it simply says that if these assets can be classified as a capital asset, or the gain is treated as from the sale of a capital asset under section 1231, the gain is nonpatronage sourced. PAGENO="0476" 466 We disagree with this position. We think that the relationship test that has been set out in these nine court cases dealing with many types of income, including capital gain, and accepted by the Service with respect to certain types of income, but not capital gains, should be applied in the situation of a capital gain. We think H.R. 2353 is very important for two reasons. First, we think the rules need to be clarified and set out in advance. Coop- eratives are required to distribute their patronage income within 8'/2 months of the close of their taxable years. They need to know how the gain or loss on the sale of these assets is going to be treat- ed in order to make their patronage distributions accurately. Once the 8½-month period has passed, cooperatives cannot go back and recompute their patronage dividend distribution. Therefore, the rules need to be clear in advance. Second, we would like to put an end to this controversy. We would like to save the taxpayer cooperatives the time and expense of the litigation which we see brewing. We think the Internal Reve- nue Service should also be spared the time and expense of litigat- ing these issues. For these reasons, the National Council of Farmer Cooperatives strongly supports H.R. 2353, as introduced by Congressmen Dorgan and Brown, along with Congressmen Flippo, Andrews, and Vander Jagt of this subcommittee and Congressmen Anthony, Frenzel, and Matsui of the House Ways and Means Committee, and 54 other co- sponsors. Thank you, Mr. Chairman. We appreciate the opportunity to appear here today. [The statement of Mr. McDavid follows:] PAGENO="0477" 467 Statement of the National Council of Farmer Cooperatives in Support of H.R. 2353 tñtródüct~àñ The National Council of Farmer Cooperatives appreciates the opportunity to testify in support of H.R. 2353 introduced last year by Congressmen Byron Dorgan and Hank Brown, together with 60 cOsponsors. The National Council of Farmer Cooperatives is a nationwide association of cooperative businesses which are owned and~ controlled by farmers, Its membership includes over 100 agricultural marketing, supply and credit cooperatives, plus 32 state councils. National Council members handle practically every type of agricultural commodity produced in the U.S., market these commodities domestically and around the world, and furnish production supplies and credit to their farmer members and patrons. The National Council represents about 90 percent of the nearly 5,100 local farmer cooperatives in the nation, with a combined membership of nearly 2 million farmers. Overview In recent years, there have been an increasing number of disputes between farmer cooperatives and the Internal Revenue Service over the proper Federal income tax treatment of gain or loss resulting from the sale of assets used by cooperatives in their patronage operations. The issue in controversy is whether gains or losses from such dispositions should be considered to be derived from "patronage" or "nonpatronage" sources. This distinction is important because gain from patronage sources is eligible to be distributed to patrons as a patronage dividend which is deductible to a cooperative (and taxable to the patron). Nonpatronage sourced income is taxable to a nonexempt agricultural cooperative whether or not it is distributed to the farmer patrons, Over the years, agricultural cooperatives have taken different approaches toward the classification of gain or loss from the sale of assets used in the patronage operation. Some cooperatives, relying on a general standard that has been adopted by both the IRS and the courts, have treated this gain or loss as patronage sourced on the ground that the assets sold were "directly related to" or "actually facilitated" the marketing, purchasing, or service activities of the cooperative. Other cooperatives have treated gain or loss from the sale of assets used in the patronage operation as nonpatronage sourced in reliance on an example in Treasury Regulation Section 1.1382- 3(c)(2) and the IRS's administrative position that capital gain (or gain treated as capital gain under section 1231) is automatically nonpatronage sourced, Recent court decisions have consistently applied a "directly related/actually facilitates" test in distinguishing between patronage and nonpatronage income, finding in one case that gain from the disposition of a capital asset used in the patronage operation was "directly related" to the patronage operation and thus patronage sourced. Notwithstanding these decisions, the IRS has continued to assert deficiencies in such cases based on its administrative position or an overly narrow interpretation of the "directly related/actually facilitates" standard. H,R. 2353 is intended to put an end to this. controversy and avoid continuing audit disputes and court proceedings that are burdensome for farmer cooperatives and consume U.S. tax dollars in enforcement activity. PAGENO="0478" 468 Problems With Existing Law Generally speaking, a cooperative is a corporation which is requi red, under its governing corporate documents or by contract, to return its net earnings from patronage sources to its members and other participating patrons on an annual basis. Farmer cooperatives markuat the production of agricultural producers or purchase supplies and equipment for producers to use in their businesses ~ feed, fertilizer, petroleum products). For federal income tax purposes, so-called "non-exempt cooperatives" are allowed to deduct patronage dividend distributions under subchapter I of the Internal Revenue Code and are thus treated as a "conduit" with respect to patronage operations and earnings. The result of such treatment is that patronage earnings paid out or allocated to members and other participating patrons as "patronage dividends" are not taxed at the cooperative level (but are taxable to ~the patrons). Section. 1388(a) of~the~:Code-grovides that patronage dividends canbe.~paid only out ofcooperative net earnings "from business done.with or for its~p~a.trons." If a non-exempt cooperative has patTm*a~g~e.-earnirrgs which are not paid out, or which it is not obligated to pay out, as patronage dividends, it is taxable on such earnings at applicable corporate rates. It similarly is taxable with respect to income from nonpatronage sources. The term "net earnings from business done with or for its patrons" (i.e., "patronage sourced income") is not defined in the Code. However, the converse term -- "income from sources other than patronage" (i.e., "nonpatronage income") -- is defined by Treasury regulation as follows: "[I]ncome from sources other than patronage" means incidental income derived from sources not directly related to the marketing, purchasing, or service activities ofthe cooperative association. For example, income derived from the lease of premises, from investment in securities., or from the sale or exchange of capital assests, constitutes income derived from sources other than patronage. [Treas. Reg. Section 1.1382-3(c)(2) (emphasis added).] This regulation applies specifically to "exempt" cooperatives, which are described in section 521 of the Code and are permitted to deduct distributions from patronage and nonpatronage sources. Nevertheless, the courts and the IRS considered this regulation in developing the basic test for a nonexempt cooperative. Under the basic test, if the source of the income in question is directly related to or actually facilitates the marketing, purchasing, or service activities of the cooperative, the income is patronage sourced. In a 1969 revenue ruling involving a non-exempt cooperative, the IRS stated the basic test for distinguishing between patronage and nonpatronage income as follows: The classification of an item of income as from either patronage or nonpatronage sources is dependent on the relationship of the activity generating the income of the marketin~, purchasing, or service activities of the cooperative. If the income is produced by a transaction which actually facilitates the accomplisnment ot the cooperative~s marleting, purchasing, or service PAGENO="0479" 469 activities, the income is from patronage sources. However, if the transaction producing the income does not actually facilitate the accomplishment of these activities but merely enhances the overall 2!Qfitability oTfJie cooperative, being merel incidental to the association s ~perative operation, t e income is rom nonpatronage souij [Rev, Rul. 69-576, 1969-2 C.B. 166 (emphasis added).] The courts have consistently applied this basic test, and in particular factual contexts, items of income in the nature of interest, dividends, rentals and capital gains -- i.e., the "examples' of nonpatronage income items listed in ~i~T Section l.l382-3(c)(2) -- have all been held to constitute patronage sourced income. See, g,, Illinois Grain Corp. v. Comm'r, 87 T.C. 435 (1986)(intere~yi Cotter & Co. v. United Statei~765 F.2d 1102 (Fed. Cir. 1985)(ijfjrest; rent); St. Louis~Wjnk for Coo eratives v. United States, 624 F.2d 1O4Ff~. Cl. 1980J interest; section asset); Astoria Plywood Corp. v. United States, 79-1 USTC Para. 9197 (D~Dre, 1979) (capital gainf [iir~tön Plywood Assoc. v. United States, 410 F. Supp. 1100 CD. Ore. 1976) (dividend). Thus, the ~öii~ts have not viewed any of the `examples' in Reg. Section l.1382-3(c)(2) as automatically requiring nonpatronage treatment for the types of income items therein described. ~p~tronage Treatment of Gain on Sale of Assets Used in Patronage Operation, The IRS has taken the position that~ifth l~ièxception óUdipreciation recapture income, gain on the sale of a capital asset (or gain treated as gain from the sale of a capital asset under section 1231) is nonpatronage sourced based on Regulation Section l.1382-3(c)(2). See Rev. Rul, 74-160, 1974-1 C.B. 245; Rev. Rul. 74-84, 1974-rT.B, 244. This position reflects a literal reading of the regulation and has been followed by a number of cooperatives in reporting sales of non- inventory assets. There are practical non-tax reasons why these cooperatives have adopted and need to continue this practice. The proceeds from sales of non-inventory assets are often reinvested in replacement assets with expectation of indefinite retention in the business. In other cases,. such proceeds are retained in the business as an important source of equity capital which is used to reduce indebtedness. Allocating gains to patrons in such a case may create an expectation of redemption inconsistent with the need to retain the proceeds in the business. To these cooperatives, the treatment of the gains as nonpatronage income and payment of tax by the cooperative is consistent with the-~jntent to retain the after-tax proceeds In order to continue the operation of the business. Patronage Treatment of Gain on Sale of Assets Used in Patronage Operation. Other cooperatives have viewed gain on the ~i1~ of assets u~ë~d in the patronage operation as distributable or allocable to members and other participating patrons based on the court decisions applying the basic test (in particular, Astoria Plywood and St. Louis Bank) and Rev, Rul. 69-576. Many of these cooperatives customarily pay out only a portion of their patronage refunds in cash, issuing `notices of allocation' to patrons for up to 80 percent of the total patronage refund distribution. The non-cash portion is retained by the cooperative tofinance capital expansion or for working capital. However, these allocations cannot be viewed as permanent capital since they are subject to a reasonable expectation of redemption on the part of the patrons. Sales of non-inventory assets provide additional internal funds for these cooperatives, but they generally are required by their governing instrument as well as long-standing custom and practice to treat such sales as patronage sourced. PAGENO="0480" 470 Apart from its inflexible reliance on the nonpatronage examples in the Treasury regulation, the IRS otherwise tends to take an overly restrictive view of the factors to be considered in determining whether a particular item of income meets the directly related/actually facilitates test. In this regard, it often focuses on the particular `transaction" or type of "transaction" that gave rise to the income in question rather than on all facts and circumstances that demonstrate the historical relationship between the source of the income or loss to the overall conduct of the cooperative's patronage business. The controversies that continue to surface in this area are especially troublesome because of the fact that cooperatives are required by subchapter T of the Code to make patronage dividend distributions within 8-1/2 months of the close of the taxable year. Even though the cooperative may pay a patronage dividend based on a good faith determination of its patronage sourced income under the "actually facilitates" test, an examining IRS agent may attempt to recharacterize part of the income as non- patronage sourced and to tax the cooperative accordingly. If the agent ultimately prevails, the nonpatronage income thus created cannot be offset by the "excess" patronage dividend paid; and no part of that dividend can be recouped by the cooperative in order to fund payment of the increased tax liability. Even where the cooperative ultimately does prevail, the financial and other costs of contesting and perhaps having to litigate the issue can become extremely burdensome. Explanation of H.R. 2353 H. R. 2353 would provide cooperatives with a mechanism for avoiding the serious administrative uncertainties that continue to exist in connection with the determination of whether gain or loss from the disposition of cooperative assets should be classified as patronage or nonpatronage sourced. Specifically, cooperatives would be able to elect patronage sourced treatment for gain or loss from the sale or other disposition of any asset, provided that the asset in question "was used by the organization to facilitate the conduct of business done with or for patrons." This approach comes directly from the test used by the IRS and the courts for distinguishing between patronage and nonpatronage sourced income generally. As the IRS stated in Rev. Rul. 69-576: [t]he classification of an item of income as from either patronage or non- patronage sources is 4~pendent on *the relationship of the activity geni~i~i~i!ig~ ttie income to the marketing, purchasing, or service activities of the cooperative. 1T the income is produced by a transaction which actually facilitates the accomplishment öfthe cooperative's marketing, purchasing, or service activites, the income is from patronage sources. [Emphasis added]. Thus, in the case of an electing cooperative, the IRS could not deny patronage sourced treatment solely on the basis that the asset in question was held, or treated, as a capital asset for federal income tax purposes. The question of whether an asset is a "capital asset" would not be an issue. For example, under the election the entire gain on the sale of a depreciable "section 1231 asset" that had been used to facilitate the conduct of patronage activities -- including any gain over and above depreciation recapture -- would qualify as patronage income. Furthermore, the proposed statutory language makes clear that gain from a sale of stock or securities held by an electing cooperative might also qualify as patronage income. That result could follow, for example, where a cooperative sells the stock of a controlled subsidiary corporation the operations and activities of which related and contributed to the PAGENO="0481" 471 cooperatives overall conduct of business with or for the benefit of its member-patrons. In such a case, it is contemplated that the factual determination of whether the subsidiary's Stock `was used....to facilitate the conduct of business done with or for patrons" would be made with reference to the totality of all facts and circumstances relevant to the historical relationship between the cooperative and the subsidiary -- and not solely with reference to the stock sale transaction itself, viewed in isolation. In general, gain or loss treated as patronage sourced `pursuant to the statutory election would be characterized for all purposes of the Internal Revenue Code as ordinaryincome or loss, notwithstanding the fact that the asset disposed of might otherwise constitute or be treated as a capitalasset, Thus, if the amount of patronage income eligible for payment or allocation as a patronage dividend was to exceed for any reason the patronage dividend ultimately paid or allocated for the applicable period, the excess would be taxable at the cooperative level at whatever ordinary corporate rates might then be in effect. Moreover, qualifying patronage sourced losses would fully offset qualifying patronage income items irrespective of the nature or character of the assets from which such income or losses were derived -- i.e., the use of such losses against current or future income would not be subject to the capital loss deductibility or carryover limitations of the Code. H.R. 2353 would not affect the treatment of nonpatronage sourced capital gains and losses ~ from sales of portfolio securities), which are not subject to the special rules governing patronage sourced income. These items would continue to be taxable at the cooperative level as under existing law. Where an asset has been used for both patronage and nonpatronage purposes, the election to treat gain or loss from the sale of that asset as patronage sourced applies only to the amount of the gain or loss allocable to the patronage use. A cooperative may use any reasonable method for making allocations of income or expenses between patronage and nonpatronage `operations. The statutory election would be available generally with respect to taxable years beginning after 1989 and, unless revoked by the cooperative, for all taxable years subsequent to the first taxable year for which the election is made. 1/ However, an election which is made with respect to a t~xable year beginning before 1991 would, if the election so provided, apply also to prior taxable years of the electing cooperative. Any such retroactive election could not be selective -- i.e., it would have to apply to all prior years or to none, as well as to all asset dispositions within a particular year. An electing cooperative could at any time revoke its election effective for taxable years beginning after the date on which the revocation notice was duly filed with the IRS. Upon revoking an election, however, thecooperative would have to wait at least three (3) taxable years before making another election. It is contemplated that procedural rules relating to the content and filing of revocation notices would be provided by Treasury regul ati on. 1/ The statutory election years included in H.R. 2353 were applicable to enactment of the bill in 1989. This paper reflects the statutory election years applicable to 1990 enactment. 30-860 0 - 90 - 16 PAGENO="0482" 472 Non-electing cooperatives (including cooperatives which have revoked a prior election) would continue to determine the patronage v. nonpatronage classification of income or loss from asset dispositions as they have under existing law. H.R. 2353 expressly provides that no inference could be drawn therefrom regarding the proper application of existing law to non-electing cooperatives in particular factual contexts. Existing law similarly would apply with respect to prior years of cooperatives that make the election for a taxable year beginning before 1991, but which choose not to have such election apply retroactively. Compelling Reasons For Proposed Legislative Relief H.R. 2353 represents a reasonable approach toward resolving a very significant problem for the cooperative industry. Given the fundamental role of the patronage v. nonpatronage determination in the scheme of cooperative taxation, it is essential that cooperatives be able to know with reasonable certainty the tax consequences of the disposition of assets used in the patronage operation. This simply has not been the case under the conflicting interpretations that now exist. The electivity feature of H.R. 2353 will permit cooperatives to gain assurance that the "actually facilitates" test will govern their determination of patronage sourced gain or loss from the disposition of any asset. In order not to disturb legitimate industry practices, cooperatives that wish to continue relying on the capital gain example in the Treasury regulation will be able to do so by not making an election, as will electing cooperatives whose mode oT~perations or other business circumstances might change. The proposed 3-year waiting period for re-elections should provide an adequate safeguard against potentially abusive situations. The retroactivity feature of the election is essential to protect from IRS challenge good-faith determinations of patronage income that cooperatives have made as a basis for paying patronage dividends to member-patrons for which the cooperative is unable to require repayment. This determination is the cornerstone of the special "conduit/single tax" regime to which non-exempt cooperatives and their member-patrons are subject. The absence of consistent administrative guidance on such a fundamental issue is both unfortunate and unfair. If a cooperative can demonstrate that assets disposed of in earlier tax years satisfied the factual criteria of the "actually facilitiates" test, it should be spared the threat of double taxation and the very significant costs and uncertainties attendant to prolonged disputes with the IRS. The ultimate losers in these disputes, of course, are the millions of American farmers who belong to cooperatives. Their livelihoods and ability to operateeffectively are inextricably linked to the unique role that cooperatives play in helping to serve the enormous agricultural demands of the country. The proposed legislation will remove a major impediment that cooperatives now face in carrying out this important role. It will do so, moreover, without in any way frustrating the Government's legitimate interest in assuring that the statutory tax benefits enjoyed by cooperatives are not abused. In that regard, it is important to keep in mind that cooperatives will not be relieved from having to establish, on a factual level, a clear "facilitative" relationship between the historical use of the assets sold and the conduct of the cooperative's activities with or for the benefit of its member-patrons. Thus, in appropriate cases the IRS could, and no doubt would, continue to challenge patronage sourced income determinations believed to be erroneous. PAGENO="0483" 473 Cànclüsion Legislation s needed to clarify the tax treatment of gains and losses on the sale of assets by farmer cooperatives, eliminate existing uncertainty, and better target the limited resources of the IRS. H.R. 2353 will provide such relief in a fair and reasonable manner, and will enable the farmer cooperatives of this nation to continue their critical work more effectively. For these reasons, we strongly support H.R. 2353 and urge its enactment. PAGENO="0484" 474 Mr. ANDREWS. Thank you. STATEMENT OF JOEL DERETCHIN, PRESIDENT, WOODLANDS COMMUNITY ASSOCIATION, THE WOODLANDS, TX Mr. DERETCHIN. Members of the committee, Mr. Chairman, my name is Joel Deretchin and I am the president of the Woodlands Community Association, an organization with over 27,000 members in a community located about 30 miles north of downtown Hous- ton, TX. And I am here today to support the proposal to allow a deduction from income under section 164 of the Internal Revenue Code for annual property assessments paid to community associations which were established pursuant to the Urban Growth and New Commu- nity Act of 1970. I would like in my testimony, to augment my written testimony and provide you with some background on why we are in support of that proposal. The new communities program established under the act which I referred to, was created to demonstrate that there could be an al- ternative to disorderly urban and suburban growth in this country. In creating large master planned communities, the Federal Gov- ernment sought to establish communities which are socially, racial- ly, and economically balanced communities and which could be viewed as pilot programs for better planning in our cities in gener- al. These are large communities and, in this case, the Woodlands has an estimated potential population of 150,000 persons. And so, in the agreements which the Federal Government, through HUD, established with the developers of these communi- ties, HUD set out very specific requirements that basic governmen- ~tal/municipa1 type services would have to be provided in one form or another. Certainly, if the community were in a city or served by a city, the city would do that. Where they were not in cities but in coun- ties, and I would say parenthetically that there were 13 new com- munities under this program, if the counties provided those serv- ices that would suffice. Where neither cities or counties were avail- able to serve those communities with fire protection, police protec- tion, garbage collection, street lighting, parks and recreation, those things you would normally consider basic municipal services, the contract between HUD and the developer put it as a responsibility of the developer to create an entity which would provide those services. This contract with the Woodlands, which is a very thick docu- ment, speaks to the creation of quasi governmental entities to pro- vide basic municipal type services because the Woodlands, being lo- cated in the unincorporated area of Montgomery County, TX, could not look to a city or look to the county for those services. Montgomery County very specifically said that it was not able to provide those services and counties in Texas, in general, do not pro- vide those basic services. I would contrast the Woodland situation for illustrative purposes with some communities with which I am sure you are familiar PAGENO="0485" 475 with here in the Washington, DC area; namely, Columbia, MD and Reston, VA. They were not part of the HUD Program. They predat- ed the HUD Program. They are located in urban counties which provide those services which I just mentioned. So, their associations are more in the order of recreation associa- tions and common area maintenance associations. But in the. case of the Woodlands, the Woodlands Community As- sociation was created pursuant to this contract with HUD to pro- vide those basic municipal services. You might ask the question, "Why does not the Woodlands incor- porate to provide those services?" And the answer to that is that the Woodlands is also situated in the extraterritorial jurisdiction of the city of Houston. Cities in Texas are allowed to extend their influence to areas which they. believe sometime in the future they will annex and the city of Houston has done that to the Woodlands. When an area is in the extraterritorial jurisdiction of a city, it cannot incorporate without that city's permission and the city of Houston has a longstanding, well-stated policy of progressive an- nexation of new areas in order to maintain its economic viability and the Woodlands concurs with that policy. So, while we are in the position of being unincorporated but yet- not annexed by the city of Houston, we are, in effect, in a state of limbo where Houston provides no services to the Woodlands and the Woodlands Community Association has to provide those serv- ices on an interim basis. So, we find ourselves in a position where we have to provide those services, but the assessment which the property owners, resi- dential property owners, pay to the community association is not tax deductible as it would be if it were paid in the form of a city tax to a city. The scope of what we are talking about today is limited and I think the impact is limited. Of the original 13 HUD projects, only 4 remain carrying out the development in the fashion that was the objective of the act of 1970. And of those, one has incorporated~ So, we really only have three communities that would benefit from this proposal. Moreover, per- sons and companies who own commercial projects in these commu- nities are able today to deduct the assessment as a business ex- pense as opposed to a property tax. So, what we are really talking about are just the residential property owners, the people who own single-family houses, condos, and so forth. In conclusion, I would say that what we are seeking here today is * equity for those residential property owners in three of those com- munities who are less favorably treated by the Internal Revenue Code than people who are paying for the same services but happen to be living in a city. And, as I mentioned, business owners-owners of business prop- erties today can deduct those assessments. Thank you. [The statement of Mr. Deretchin follows:] PAGENO="0486" 476 Testimony Submitted to The Subcommittee on Select Revenue Measure~ Committee on Ways and Means United States House of Repreentatives February, 1990 Proposal With Respect To Annual Assessments Paid to Community Associations Established Under The Urban Growth and New Community Act of l970~ Mr. Chairman, my name is Joel Deretchin, and I am President of The Woodlands Community Association (WCA). The Woodlands is a planned community created ` under the Urban Growth and New Community Act of 1970 (the Act). It is located in Montgomery County, Texas about 27 miles north of the city, of Houston, Texas. We support the proposal by The Honorable Michael A. Andrews of Texas to allow a deduction from income under Section 164 of the Internal Revenue Code for annual property assessments paid to community associations established under the Act. The proposal limits the deduction to existing communities created by the Act, if the assessments are used to provide municipal-type services and if the assessments are uniformly imposed. We believe that an inequity exists because residents of communities established under the Act are not able to deduct annual assessments in the same manner as residents of municipalities are able to deduct property taxes. When the Congress and the Department of Housing and Urban Development (HUD) conceived ,the New Communities program, they knew that many of `the projects' would be developed in outlying areas not provided with basic services which would be needed by a rapidly urbanizing population, nor did they expect that the local ,units of government would be able to respond adequately to the need. So they developed the notion of a comprehensive community association which would have the `capabilities of providing essential municipal type services until the new community was annexed by an existing municipality or it became incorporated. In fact, to ensure that the residents of the emerging new communities would have these services, `HUD made it a requirement ~of the Project Agreement (the contract between the United States of America and the developer) that the developer, would create an entity or entities to provide such services. Exhibit "G" of the Project Agreement `for TheWoodlands states: "If police, fire, and other essential municipal services or `facilities are not available through the City (referring to the City of Houston) or other appropriate agency, the Developer will organize an entity, subject to the' Secretary's approval, to provide essential community-related functions at such , time as they , may be required." Under the contract between The Woodlands Corporation and the United States of America the federal government requires the delivery of a full range~ of municipal~ services. In this instance, these services cannot be provided by the Montgomery County government because of financial restrictions, and the limitations of legal authority imposed by the state constitution on county governments in the State of Texas. Furthermore, the laws of the State of Texas provide that a city such as the City of Houston has extraterritorial jurisdictional rights over large unincorporated areas beyond its corporate limits. This right of extraterritorial jurisdiction prohibits ~any other municipality PAGENO="0487" 477 from annexingz~ e claimed area, and imposes severe restrictions and burdensome requirements that make it virtually impossible for the residents of the claimed area to incorporate. Yet at the sane time, the state's annexation laws do not require the city exercising the right of extraterritorial jurisdiction to provide the residents of the area with municipal services, and the City of Houston provides no such services to The Woodlands or to other areas it~has claimed. Consequently, to satisfy the requirements of its contract with the federal government, the developer created the WCA as a means of providing for ~the municipal services and facilities normally provided by .a city. The WCA, a Texas non-profit corporation, funds its operations and capital program through an assessment on all real property in The Woodlands. The WCA assessment is similar to an ad valorem tax levied by cities. It is secured by a first lien on real property. The WCA uses the tax roll of Montgomery County for determining assessed valuation, and each year the Board of Directors of the WCA sets an assessment rate to finance its operations. The adoption of the WCA ~budget is subject to full public review by means of the public hearing process customarily used by municipal governments. Revenues received by the~WCA are used to provide basic municipal services, such as fire protection, police protection, street maintenance, trash removal, street lighting, and the development and operation of parks and recreational facilities. With respect to fire protection, the Montgomery County Commissioner's Court has determined that it will not provide fire protection, and consequently, the WCA has had to raise the funds necessary to provide this basic service. It does this by funding the Woodlands Fire Department which delivers a full range of fire protection and emergency medical services. The Woodlands Fire Department. maintains a full-time professional staff in order to carry out its function. Police protection is provided by the WCA through a contract with the Montgomery County Sheriff's Department. All of the parks owned iand operated by the .WCA are publ±c~ parks, available to all persons whether they live inside or outside The Woodlands. I want to emphasize the uniqueness of the situation in which we find ourselves. The Woodlands is, to the best of my knowledge, one of only four projects still developing in accordance with the original intent of the Federal New Communities Act. Eventually, we expect that The Woodlands will be annexed into the City of Houston, and the residents will be able to take advantage of their property tax deduction. However, the City of Houston will not annex The Woodlands in the near future. Montgomery County cannot and will not provide services. Certain provisions of the Constitution of the State of Texas and the laws of the State make it virtually impossible for us to incorporate on our own. The bottom line is that in this unique situation, the WCA is required by the federal government to provide municipal-type services; yet, the same federal government prohibits residents of The Woodlands from claiming a deduction for their assessment on their income tax returns. This unique situation imposes an unjust penalty on the residents of The Woodlands. By contrast, businesses that pay the WCA assessment are allowed to deduct the assessment from their federal income tax returns as a business expense. Therefore, we believe that the assessments paid to provide these required services should be eligible for deduction from income in the same manner that a municipal tax is deductible under Section 164 of the Internal Revenue Code. PAGENO="0488" 478 Mr. ANDREWS. Thank you very much. Mr. McDavid, the Treasury Department opposes your proposal, it particularly objects to making the proposal elective and to making it retroactive. Would you still support the proposal if these features were elimi- nated? Mr. MCDAVID. No; we would not. We believe that the elective fea- ture is absolutely crucial due to the fact that there is a divergence of practice in the industry. There are cooperatives out there today which are willing to. pay tax in order to be able to treat gains from the sale of this type of property as nonpatronage income which is not required to be dis- tributed to patrons after the close of the tax year. This is not a tax motivated decision. These cooperatives are willing to pay the tax because they would like to keep the after-tax gain for use in their businesses. There are other cooperatives in the industry that have historical- ly always treated gains and losses from the sale of assets used in the patronage operation as patronage sourced. The elective feature allows those cooperatives that have historically treated these gains and losses as patronage sourced to be able to continue to do so. We think it would be very disruptive to the industry to remove the electivity feature of the legislation.. Second, on the question of retroactivity, we believe that the legis- lation clarifies and restates the test that is already out there .under existing law. There are the nine court cases that have basically established the test to be used in determining whether gain or loss is patron- age or nonpatronage sourced. If cooperatives must litigate this issue, that test will be applied to open years, the past years, the so- called retroactive years, just as it is going to be applied in the future. What we want to do is remove the controversy. We do not want to have the same thing happen with respect to these kinds of gains and losses that has happened with respect to interest income. There have been six cases litigated since 1980 on the question of interest income. We are now experiencing the first audits dealing with the classi- fication of capital gain and loss. We would like to eliminate this controversy over the test to be applied for past and future years. We are not asking for legislation to determine whether any of this gain or loss is or is not patronage sourced. We want to clarify the test to be applied. Mr. ANDREWS. Mr. Deretchin, would you tell me what specific services are provided by the fees? Mr. DERETCHIN. Yes, sir, certainly. The Woodlands Community Association provides fire protection through the Woodlands Fire Department, which it funds in its entirety; police protection through a contract with Montgomery County sheriff's office; gar- bage collection; street lighting; street scape maintenance; and the development and operation of parks for the general public. Mr. ANDREWS. Is that all? Mr. DERETCHIN. Yes. Mr. ANDREWS. No other specific services? PAGENO="0489" 479 Mr. DERETCHIN. It has a design review function. Mr. ANDREWS. I am sorry. Mr. DERETCHIN. It has a design review function for new construc- tion, which would be analogous to a building department jn a city. Mr. ANDREWS. Water and sewer services? Mr DERETCHIN No, sir, those are provided by-- Mr. ANDREWS. Just the specific things you mentioned? Mr. DERETCHIN. Yes, sir. Water and sewage is provided by the municipal utility districts. Mr. MCGRATH. Would the gentleman yield? Mr. ANDREWS. Thank you. Gentleman from New York, Mr. McGrath. Mr. MCGRATH. The fees would not include the dues to the coun- try club? Mr. DERETCHIN. No, sir. No, we are not talking about luxury items, we are talking about essential services that a community needs in order to function and to provide for the safety and the welfare of the community. Mr. MCGRATH. Let me see If I can get your argument straight. You are contending that-and I know something about the deduct- ibility of State and local taxes-those contributions to the associa- tion constitute what ordinarily would be construed as a property tax based upon the services that you have articulated. And because of the anomaly in terms of how Texas cities can expand their sphere of influence beyond-I think it is a 5-mile zone from their city limit-that you are caught between not being able to incorporate. The fact that you are not able to incorporate means that your residents are not able to dedUct for services which ordi- narily would be deductible. Mr. DERETCHIN. Yes, sir, that is accurately stated. Mr. MCGRATH. Thank you. Go ahead. Mr. ANDREWS. No, Mr. McGrath, do you have any more ques- tions. Mr. MCGRATH. Yes, I have one for Mr. Regan. We were talking about the acronym "COLI." Am I correct, that it refers to corporate owned life insurance? Mr. REGAN. Right, but more broadly, business owned life insur- ance whether it is a corporation or partnership or any other entity. Mr. MCGRATH. Well, I have heard of this entity from your crack staff at NALU on a number of occasions. There have been some who would say that this is an abUsed kind of life insurance. They contend that the individuals who you insure, in many cases, never get the benefit of that insurance because for one reason-they leave or something-and then there is no portability. And what would your reaction be to an argument like that? Mr. REGAN. In our statement of principles and practices, we indi- cate that if the employee is being insured as part of a benefit pro- gram that the employee be eligible to receive those benefits. And we are totally opposed to insuring lots of people to provide benefits for a few. On the other hand, if an employee leaves midway through a normal term of employment and the employer at that point wants to continue to own the policy because it is an asset, it is paid up, it will eventually pay off, we do not see any PAGENO="0490" 480 problem with that. The insurable interest laws in the various States do not require it. But certainly any insuring of some employees to benefit others would be totally inappropriate and we are opposed to. Mr. MCGRATH. And you would, of course, want to require that the person who is insured knows that he is insured? Mr. REGAN. That is right. There are-again, that is part of our policy statement that the laws in quite a few of our States do not require that, we just believe it is good public policy to get some- body's consent before you insure them. Mr. MCGRATH. Well, I think that your testimony is refreshing in terms of curing some of the abuses. I know your crack staff at NALU will be coming up with proposals in order to close any loop- holes that may be out there. Mr. REGAN. That is our commitment. Mr. MCGRATH. Mr. Beaty, one question. Do you know of any other industry where the depreciation life exceeds the economic life of the asset? Mr. BEATY. I am sorry, I did not hear the question. Mr. MCGRATH. Do you know of any other industry where the de- preciation life exceeds the economic life. Mr. BEATY. I cannot believe there is any other industry remotely close to where we are. Mr. MCGRATH. And you are recommending a 2-year life on tuxedo rentals. Is that generally the life of a tuxedo? If we made it 2 years and somebody has 3 years or 1 year, how do we determine that that is the correct useful life. Mr. BEATY. The Treasury Department worked 2½ years on this study. [Laughter.] Mr. MCGRATH. And that is their determination. [Laughter.] Mr. BEATY. They studied 199 styles from 152 dealers across the country. That is their report, it is very very close to the experience that we have had because the usage is so heavily loaded on the front end of the life cycle. Mr. MCGRATH. And then the IRS says 4 years or 5 years. Mr. BEATY. Sir? Mr. MCGRATH. And after the Treasury report the IRS said five years? Mr. BEATY. No, it has been 5 years on depreciation since 1981. That was when ACRS was established to give everyone a tax break. Where other industries accelerated their. cost recoveries, we were required to decelerate. Mr. MCGRATH. Right. Mr. BEATY. Yes, we decelerated. Mr. MCGRATH. Well, I think present law is a little ludicrous. Thank you, Mr. Chairman. Mr. ANDREWS. Well, would you object to tuxedos being assigned a 3-year recovery period? Mr. BEATY. As I understand from the conversations I have had, it would be either 2-year straight line or 3-year double declining. Really there is not much difference between the two, so we would not object to that. What we would like to do, and I understand usually you put into effect a tax policy where it begins now and anything you purchase PAGENO="0491" 481 from now on would be depreciated-under the Tax Code-and it takes 5 years to go through that cycle to get back where we were. We have already been penalized 8 years. We would like for some- thing to be designed that would not require 5 years to get back to where we should have been since 1981. Mr. ANDREWS. Thank you very much. I want to thank the panel. I would like to ask the final panel to please take their seats. [Pause.] Mr. ANDREWS. All right, if we could ask this panel to please start. I would like each of you to identify yourselves before you give your testimony. Your prepared text will be made a part of the record and so I would like you to please briefly narrate your testimony, make the points that you think are the most important for the committee and for the record. Let us start on my right, Ms. McCarthy. STATEMENT OF COLLEEN McCARTHY, CHAIR, EMPLOYER COUN- CIL, ASSOCIATION FOR COMMUTER TRANSPORTATION, INC., AND MANAGER OF COMMUNITY IMPACT PROGRAMS, HEW- LETT~PACKARD CO., PALO ALTO, CA M5~MCCARTHY. Thank you, sir. Goad afternoon, my name is Colleen McCarthy, I am from Hew- lett-Packard Co. in Palo Alto, and I am here today representing the Association for Commuter Transportation [ACT] as chair of its em- ployer council. We are here today to urge your support for equity in the tax treatment of commute to work fringe benefits. We think transit and car pool van programs should be treated the same as free or subsidized parking. They~should be treated as working condition fringe benefits and specifically we urge this subcommittee~to. recommend legislation to accomplish three primary goals. First, to exempt employer's subsidized car, van, and bus pools from taxation as fringe benefits; second, to increase the current $15 limit on the tax free value of transit passes; and third, to treat transit passes as working conditions fringe benefits as you treat subsidized parking. Today employers are being asked to champion commute alter- nate programs in order to approve regional mobility and clean America's air. To achieve these goals we must enter an era of public private partnership with a level playing field. Currently there are more than 50 local ordinances requiring employees to provide a wide range of commute alternative programs to their employees, includ- ing car and van pool programs, transit programs, biking and walk- ing programs,~ and flexible work schedule programs. These 50 ordinances are just the beginning as other regions begin to address the issues of mobility and clean air. We are entering the era where the solo occupancy vehicle can no longer be the norm and our tax policies must reflect that change. PAGENO="0492" 482 It is important to ensure employers a level playing field by clas- sifying all parts of their commute alternative programs as working condition fringe benefits. This equal treatment of commute programs would be a step in the right direction toward ending unfair and inequitable skewing of the Federal tax policy towards a solo driver. Following the October 17 Loma Prietta [ph] earthquake, bay area industry learned the value of commute alternative programs. Be- cause of road closures, many employees found that transit or shared ride commutes were the only options available. This was especially true in our hard hit areas of Santa Cruz, Oakland, and San Francisco. The employers also discovered that by working with other em- ployers and transit and ride-sharing agencies, they could provide their employees with a way to work. To reach this transition, some employers wanted to subsidize these commute alternatives for their employees, but found them- selves hampered by the $15 tax cap on transit subsidies and by the fact that car, van, and bus pools were not eligible for any subsidy. In fact, all expenses were taxable. The employer council of ACT, urges you to increase the tax free level of transit passes to $60 per month, a figure much closer to the actual cost of commuting. This increase is embodied in legislation sponsored by Representa- tives Robert Matsui and Barbara Kennelly, and cosponsored by Chairman Rangel, along with several colleagues-his colleagues in the House. Some pending bills require that qualified transportation benefits be provided under a separate written plan that does not discrimi- nate in favor of high level employees, directors, and stockholders. First, this kind of discrimination just does not exist. Most com- mute program managers would love to have high level managers participate in their commute alternative programs to act as role models. However, it has been next to impossible to convince management to share the ride. Second, many mandated programs already require an extensive annual reporting process, additional layers of reporting seems un- necessary and counterproductive. In addition, the disparity between the current cap on transit sub- sidies and the lack of provisions for pooled commute alternatives versus the fact that employer provided free parking is tax exempt must be addressed to ensure we treat all commute needs equitably. Therefore, ACT urges you to increase the tax free level of transit passes to $60 per month, much closer, once again, to the actual cost of commuting, to exempt from taxation, the use of employer owned or subsidized vehicles of any size or cost that employees use for car, van, or bus pooling, and treat these fringes as working condition fringes as tax law now treats parking. Thank you very much for the opportunity to present this state- ment. We would be pleased to answer any questions. [The statement and attachments of Ms. McCarthy follow:] PAGENO="0493" 483 Testimony of Colleen McCarthy Hewlett Packard Palo Alto, CA representing the Association for~Commuter Transportation, Inc. and a coalition of organizations supporting equity in the tax treatment of commute-to-work fringe benefits Good morning. .~(y name ~is~Colleen~McCar.thy;'' I'm:~from Hewlett Packard in Palo Alto, CA. ~`I'm here today~representing the Associa- `tion~ for Commuter Transportation (ACT) as Chair of its Employer Council. ACT is~.a'national association whose mission is to make the commute easier, more convenient, and less costly. Members operate or promote car,, van, bus pools, public transit or other commute alternative programs. They include corporations, public agencies, non-profits, and others. We aim to reduce traffic congestion, ~ir~pollution,.~and energy~waste by promoting commute alternatives. We are here today to~urg~~your ~s~ipport for equity.~ in the tax .treatment of commute~to work. fringe benefits. We'~think transit and car/vanpool programs should be treated the same as free or. sub- sidized parking. They should be treated as "working condition" fringe benefits. `Specifically, we urge this Subcommittee to recommend' legislation to accomplish three primary goals. 1) Exempt employer-subsidized car/van/buspools from taxation as fringe benefits. 2) Increase the current $15 limit on. the tax-free value of transit passes. 3) Treat transit passes as working condition fringe benefits, as you treat subsi'dized parking. At Hewlett Packard, I operate a program that is similar to that of many companies throughout the United States. We started in 1985 with a survey of employee attitudes about commute alternatives in the Bay Area. We took the survey results and added the ideas of commute coordinators from within the company and from outside regional and state transportation agencies. From that we developed the HP Commute Alternatives Program (CAP). CAP is significant in its scope and depth. It covers all HP operations in the nation (plus our operation in Germany). Our major focus has been in California in response to the California Clean Air Act. The number of employees/commuters served totals 50,000. CAP involves a major effort' by Regional Commute Coordinators for both program design and for implementation. In implementing this program, HP will identify, train, and support over 100 employee transportation coordinators across the country. We set several program priorities: ` o Seek and encourage HP management support. o Build, train, motivate a Bay Area Commute Coordinator network. o Implement HP carpool/vanpool services. o Implement HP transit services. o Implement HP shuttle services. o Address HP employee parking issues. o Develop and provide project support components. o Develop and implement community outreach projects. Like most corporate programs, we offer a range of options to our employees. We provide transit information and a bi-annual $15 transit subsidy. We encourage flexible hours. We offer tele- commuting possibilities. * We provide a guaranteed ride home for those who leave `their car at home, so they can handle the rare family emergency. We provide preferential parking for pool PAGENO="0494" 484 vehicles. We provide shuttle service to public transit. Our programs are accessible for use by the disabled. The HP program, as most corporate programs, is 100 percent funded by our own company. No public funds are used, except for those that finance public transportation used by our employees who choose that mode. A recent survey conducted by ACT found that those companies that responded spent an average $213,840 to operate their commute programs. Most use their own funds. Over 50 percent reported an increase in their program budget ~in the past year. The average increase was 64 percent. The survey also explored reasons why employers~ set- up their programs. The largest percentage (62 percent) started their programs in response to ordinances or regulatory mandates. The corporate programs surveyed averaged five years in operation. Many that operated longer than that started during the energy crises of the `70's. At that time, Congress enacted an energy tax credit for companies that bought vans for their employees to use in commuting. 34 percent of our survey respondents started programs in response to those fuel shortages. Right.behind were 32 percent who cited traffic congestion. Another 27 percent cited air quality or growth/land use issues among reasons for setting up their programs. (The total exceeds 100 percent because companies could cite more than one reason for setting up their programs.) Reasons cited for continuing commute programs are more represen- tative of the latest trends. 1) 79 percent cited ordinances or regulatory mandates. 2) Another 39 percent cited air quality or growth/land use concerns, not necessarily enforced by regulation. 3) 46 percent responded to the frustrations of traffic conges- tion. 4) 41 percent responded to demands of employees. 5) 32 percent reacted to insufficient or inefficient public transit. Let's explore each of those reasons for companies to set up commute alternative programs. 1) 70 percent of private company survey respondents were from California. As a result, we see the significant impact of Regulation XV in Southern California. This regulation is the nation's strictest air quality regulation. It requires employers, of 100 or more to increase the vehicle occupancy coming into their worksites. On the other hand, California is only one area where local, state, and federal regulations aim to reduce the impact of drive-alone commuting on traffic congestion and air quality. ACT has identified over 50 local traffic reduction ordinances around the country. They require developers and others to develop traffic mitigation plans as a price of getting zoning for new or expanded developments ap- proved. 2) Land-use and air quality concerns can lead companies to undertake alternative commute programs, even in the absence of governmental requirements. One company in suburban Kansas City provides a good example. The company is expanding rapidly and has outgrown its property. In consolidating operations, it appeared that the company would have to go to considerable expense to construct a multi-story parking garage for employees. Instead, they expanded their vanpool program and saved the cost of the parking structure. PAGENO="0495" 485' 3) Traffic congestion is getting more attention in corporate America, as we see that the wonderful.. suburbs with their unlimited space for parking have created a new problem. At a company level, sales people, delivery people, and others waste inordinate amounts of time tied up in traffic. At the individual level, employees' level of frustration from simply getting to work interferes with their ability to function productively once they get there.. 4) As we in the private sector face increasingly competitive situations trying to attract. qualified employees, we have become more sensitive to employees' commute needs. Lower- paid employees, especially, desire or need commute alterna- tives. Typically, these are employees who are not eligible for free parking that companies so commonly offer to executives, especially in expensive downtown locations. 5) Finally, we need to improve public transportation for those who can use it and we need alternatives for those who cannot. By engaging private companies inthe support of transit as an alternative to drive-alone commuting, we can enhance this mode for all. More and more private employers, as our survey shows, are not only helping their employees identify viable transit options. They are also becoming advocates for increased transit service to their facilities. They are providing shuttles from worksite to transit center. In many cases, like Hewlett-Packard, they are subsidizing expanded transit, especially during the start up phase until ridership builds up to a point where the transit system can justify the service as part of the regular system. What do these lessons we've learned tell us about tax policy? They demonstrate that there is a new recognition of the need for alternatives to drive-alone commuting. They demonstrate that the needs are so significant that private companies are participating in solutions at their own expense. They demonstrate clearly the inappropriateness of a tax policy that supports a mode of commuting that other federal, state, and local policies and public funding programs are attempting to change. The disparity between available tax-free employer-subsidized parking benefits for drive-alone commuting versus transit or pooled commuting increases the usage of single occupant vehicles to the detriment of the entire community. In a survey conducted by the Port Authority of New York and New Jersey, 64 percent of drivers coming to work in Manhattan from New Jersey were subsidized by their employers. The most common subsidy was tax-free parking, worth over $2,600 in pre-tax dollars per year. Alternatively, employers are limited by current law to a maximum of $15 per month ($180 per year) in transit.passes. Even in the New York metropolitan area, where transit usage already is higher than any other area in the country, an increased transit subsidy would shift enough additional drive-alone commuters to transit to improve traffic flow and reduce air pollution. The agencies involved in planning and operating transit services in and around New York City conducted an extensive series of focus groups with auto commuters. They found that many of the drivers had chosen to drive alone mainly because their employers gave them free parking. Diverting only two to three percent of current drivers to transit would improve traffic flow and reduce air pollution in the New York metro area. These focus groups suggested what has been documented in a case study in Los Angeles. There, a survey in the downtown area showed that 25 percent fewer employees drove to work alone where they had to pay $40 or more to park, compared with those whose employers provided free parking. Currently, average monthly costs nationwide for using transit exceeds $60 per month. In the New York-New Jersey region, the largest transit market in the country, average monthly costs for commuting into Manhattan from the surrounding areas is over $125 per month. The present $15 per month tax-free benefit for transit PAGENO="0496" 486 covers approximately 12% of the cost of commuting each month in this market, and only 25% of the cost nationally. This is not a significant inducement to switch from driving alone to a fully subsidized and tax-free parking space. If the transit cap were increased to $60, a reasonable percentage of the monthly transit costs would be covered, resulting in greater usage of transit. As it affects the use of car, van, and buspools, the current law is equally inequitable. The de minimis provision does not cover such pooled arrangements. Any amount of subsidy for carpools, vanpools, and buspools is taxable. Not only that,. but the regulations are ridiculously complex. (We have attached a paper analyzing the latest version of these regulations, as they affect commute benefits.) The provision under consideration- today would move in the right direction. However, it falls far short of what we need. We need to end the unfair and inequitable skewing of federal tax policy. We need to stop favoring single occupants who receive free or heavily subsidized parking. We need to end the tax policy that discriminates against those choose alternative modes. We need a tax policy that supports federal, state and local public policy -initiatives and private sector actions aimed at reducing traffic congestion, air pollution, and energy waste. - We urge you to: 1) Increase the tax-free level of transit passes to $60 per month, much closer to the actual cost of commuting. 2) Exempt from taxation the use of employer-owned or subsidized vehicles of any size or cost that employees use for car/van! or buspooling. - 3) Treat these fringes as working condition fringes, as tax law treats parking. These provisions are similar to those in legislation sponsored by Reps. Robert Matsui and Barbara Kennelly and cosponsored by you, Mr. Chairman, along with several of your colleagues in the House. As you review these proposals, we urge you -to consider a couple technical considerations. - a) Any legislation exempting pooled vehicles from taxation should apply to carpools as well as van or buspools. Carpooling is becoming an increasingly easy and poppular means of traffic reduction and needs to be covered by this legislation. b) Some pending bills require. that "qualified transportation benefits" be provided under a separate written plan that does not discriminate in favor of employees who are officers, shareholders, or highly compensated employees. This require- ment is unnecessary, because by their very nature, commute benefits for alternate modes are most desired, most offered, and most used by lower paid employees. Discrimination in - - favor of highly paid employees is not a problem. We'd love to see more corporate executives join a vanpool or use public transportation! Besides, current law allows parking benefits to be provided on a discriminatory basis. - c) Ultimately, to level the playing field, we urge you to classify all commute benefits, whether they encourage transit, - carpools, vanpools, or buspools, as "working condition" fringe benefits. That's how you classify subsidized parking. That would further your efforts to simplify the tax code. Implementing a working condition fringe is much simpler than trying to comply with the complex procedures and requirements imposed by placing these benefits elsewhere in the code. - Mr. Chairman, thank you for the opportunity to present this statement. We would be pleased to attempt to answer any questions you may have. PAGENO="0497" 487 Association for Commuter Transportation Suite 521 1776 Massachusetts Ave., NW. Washington; D.C. 20036 202/659-0602 February 1990 IRS Regulations re Commute Benefits by Sandra Spence, CAE Sose provisions of final IRS fringe benefit regulations effective January 1, 1989, (but not published until July 6, 1989) provide greater flexibility in the provision of commute-to-work fringe bene- fits than temporary regulations issued in December 1985. In other areas, the IRS clarifications have worsened the effect of the law as we understood it. The 1985 regulations provided guidance on the tax treatment of taxable and nontaxable fringe benefits and general rules for the valuation of taxable fringe benefits, including employer-subsidized vanpools and transit passes. Former ACT President Frank Stolzenberg, from AEtna Insurance, tes- tified on behalf of ACT at an IRS hearing in March 1986, calling for increased administrative flexibility in interpreting the 1984 law that first provided for the taxation of these fringe benefits. IRS has responded to some of ACT suggestions, such as allowing the use of safe harbor valuation rules for pooled vehicle use for commuting. The temporary regulations applied to benefits received in 1985 through 1988. The amended regulations took effect January 1, 1989. Highlights of the regulations: (Changes or additions included in the 1989 final regulctions appear in brackets.) The concept of fair market value. The regulations require employers to determine the fair market value of the benefit, deduct any payments employees make toward the cost, and tax the difference as imputed income. (This tax must be withheld from the employee's pay and reported to IRS on the W-2.) The fair market value must be determined "on the basis of all the facts and circumstances. Specifically, the fair market value of a fringe benefit is that amount a hypothetical person would have to pay a hypothetical third party to obtain (i.e., purchase. or lease) the particular benefit." Use of special valuation ("safe harbor") rules. The regulation set up three "safe harbor" rules that employers can use to determine the fair market value of the transportation. These are: a lease valuation rule, a cents-per-mile rule, or a commuting valuation rule. (para- graphs 1.61-21(d), (e), and (f) of the regualtions, respectively). The employer is required to notify employees of the rule used, so that the employee can meet the relevant substantiation requirements. PAGENO="0498" 488 Lease valuation rule. The lease rule provides that the employer must determine the fair market value of the vehicle as of the first date on which it is made available to the employee and refer to an annual lease value table in the regulations (paragraph l.6l-2l(d)(2) (iii)). For a vehicle owned by the employer, the "safe harbor" value of the vehicle is the employer's cost of purchasing the vehicle, provided the purchase is made at "arm's length." (The fair market value of an automobile purchased by an employer has been revised in the final regulations to include sales tax, title fees, and other expenses attributable to the purchase.] This would thereby increase the market value and the tax owed by the employees. Leased vehicles. The final regulations provide that employers who lease vehicles may treat the manufacturer's suggested retail price of an automobile less eight percent as the fair market value of the automobile for purposes of calculating the annual lease value of a leased vehicle. Vehicle cents-per-mile valuation rule. IRS has made some changes in this rule apparently intended to allow use of this rule for car/van pool vehicles. However, remaining restrictions effectively prohibit use until technical corrections are made in the regulations. In general, this rule is intended to allow the value of transportation to be~determined based on the relevant IRS cents-per-mile value. How- ever, the vehicle had to meet very specific requirements. Originally, cars or vans used for pooling were ineligible for this safe harbor rule if they were not regularly used in the employer's trade or busi- ness throughout the year or if the value of the vehicle exceeded $12,800for 1988, increased for inflation. (The final regulations retain a prohibition against using the cents- per-mile rule if the vehicle is valued at more than $12,800 for 1988, increased for inflation.] IRS says this is necessary because "appli- cation of the cents-per-mile rule to the personal use of vehicles valued at greater than the threshold amount results in undervaluation of the benefit provided." ACT is writing to IRS seeking an exception from this ceiling for vanpool vehicles. The rules appear to be made more flexible for use for less expensive vehicles, however. [The final rags define use in the employer's trade or business to include use each workday to transport at least three employees of the employer to and from work in an employer-sponsored commuting vehicle pool.] [If the employer regularly provides a vehicle to employees for use by more than one employee at the same time, such as with an employer- sponsored vehicle commuting pool, the employer may use the vehicle cents-per-mile rule to value the use of the vehicle by each employee who shares such use.] [Unintentially, we think, another restriction effectively prohibits PAGENO="0499" 489 the use of this rule for existing programs. "Consistency" rules require that an employer must have adopted the cents-per-mile rule by January 1, 1989 or the first day on which the vehicle is ued by an employee for personal use, or, if the commuting valuation rule is used, the first day on which the commuting rule is not used. The temporary regulations in effect prior to the publication of the final rules clearly did not permit use of the cents-per-mile rule (nor did they permit use of the commuting rule, discussed below). Since the final regulations were not published until July 1989 and the other two rules could not be used prior to then, no employercould use the more flexible cents-per-mile rule for ongoing pool programs, but cruld apply it only when a new vehicle is provided to the employee.] ACT is writing to IRS to seek a technical correction in the regulations to correct this apparently unintentional consequence of invalidating this rule for existing programs. Commuting valuation rule. The original regulations provided a special commuting rule that allowed the employer to value the commuting use of a vehicle at $1.50 per one-way commute.. This rule was not available for pool vehicles because of provisions requiring the vehicle to be used in the employer's trade or business and the establishment by the employer of a policy requiring the employee to commute to and/or from work in the vehicle. (The final regulation specifically allows use of this rule where an employer-provided vehicle that is generally used each workday to transport at least three employees of the employer to and from work in an employer-sponsored commuting vehicle pool. If applied to pool vehicles, the $1.50 is the value of the one-way Commute for each employee who commutes in the vehicle.] [The final regs state that the $1.50 per one-way includes the value of any goods or services directly related to the vehicle (e.g. fuel).] Dc minimis fringes. Paragraph 1.132-6 provides that gross income does not include the value of a de minimis fringe provided to an employee. The term "de minimis" means "any property or service the value of which is (after taking into account the frequency with which similar fringes are provided by the employer to the employer's employees) so small as to make accounting for it unreasonable or administratively impracticable. [The regulation makes it clear that the provision of any cash fringe benefit is never excludable as a de minimis fringe benefit. Nor is a cash equivalent fringe benefit (a gift certificate or credit card) generally excludable even if the same property or service acquired (if provided in kind) would be excludable. (The example cited is that providing an employee with cash to buy a theater ticket -- that would itself be excludable -- is not excludable as a de miniinis benefit.) Paragraph 1.132-6(d) clarifies the de minimis rule for transit passes used for commuting (but not for personal travel). The original PAGENO="0500" 490 regulation allowed the employer to exclude from gross income a public transit pass if the discount does not exceed $15 in any month. The exclusion also applied to the provision of tokens or fare cards. [The final regulation also states that the exclusion applies to the provis- ion of a voucher or similar instrument that is exchangeable solely for tokens, farecards, or other instruments that enable the employee to use the public transit systent±f~the'value of such vouchers and other instruments does not exceed $15.] Th±s ensures that the New York model for the "TransitCheck" is~an acceptable manner of implementing the ta~free transit pass program. The regulation ~gives examples of specific benefits that are not excludable as de minimis fringe benefits, including the commuting use of an employer-provided vehicle more than one day a month. Provider of a fringe benefit. The final regulations indicate that a fringe benefit provided to an employee by someone other than the employer (such as a client or customer of the employer) must be included in the employee's income, unless otherwise excluded. This raises numerous questions. Many organizations are developing a wide variety of incentives for commuters to use alternatives to drive- commuting. In certain cases, the provider of the incentive might be judged by IRS to be providing a taxable fringe benefit. We have discussed several examples with IRS. It is clear that there is no clear answer on how IRS would interpret a specific case, for example, where a developer or building owner provides vanpools, transit passes, or other incentives to employees of tenant employers; where state and/or local governments make public subsidies available through employers to reduce congestion or air pollution; where a third party enters into arrangements with employees through programs set up by the employer, etc. These areas of major uncertainty will be addressed in ACT Testimony in Congress as reasons for simply exempting vanpool programs from this tax. Non-compliance. We have asked IRS to explain the consequences of non- compliance with the law on the commute tax. The employee is liable for income tax, interest and penalties on the value of transportation provided by the employer, regardless of whether he or she is aware of the tax consequences. The employer is liable for underwithholding on both the employer and the employee share of federal social security tax (FICA), including penalties and interest. Many states have conformed their own income tax laws to the federal law since these provisions were enacted in 1984. There may be addi- tional state tax liabilities. PAGENO="0501" 491 Association for Commuter Transportation Suite 521 1776 Massachusetts Ave.. NW. Washington, D.C. 20036 202/659-0602 RESOLUTION ON COMMUTE-TO-WORK FRINGE BENEFITS WHEREAS, the 1984 Tax Reform Act defined as a taxable fringe benefits, transit passes that are worth more than $15 per month and employer-provided vanpool programs, and WHEREAS, the same law continued the exemption of taxation for employer-subsidized parking, and WHEREAS, the tax on commute-to-work benefits, while exempting employer-subsidized parking, is discriminatory, inequitable, and inconsistent with important national policy objectives supporting energy security, air quality, and efficient utilization of the nation's highway system, and WHEREAS, the Joint Committee on Taxation has estimated that the federal government collects an inconsequential amount of revenue from the tax on vanpool programs, while forgoing an estimated $1.5 billion in FICA and employment tax receipts by exempting employer-subsidized parking, and WHEREAS, the tax is a significant disincentive for employees who might otherwise find sharing the commute a cost-effective alternative to drive-alone commuting, and WHEREAS, the administrative burden of complying with complex IRS regulations is a major disincentive to employers currently operating programs as well as those considering such programs to deal with air pollution problems and impending gridlock throughout urban America, and WHEREAS, few employers have offered subsidized transit passes to date, but equitable tax treatment would encourage many to initiate such programs to reduce parking costs to the employer and to provide important societal benefits in the form of reduced traffic congestion and air pollution from single-occupant automobiles, and WHEREAS, taxing such benefits is likely to raise an insignificant amount of revenue, for it will simply serve as a disincentive to employers considering such programs, and WHEREAS, encouraging employers to offer commute benefits will lower the future demand for very costly infrastructure in the form of highway construction, THEREFORE BE IT RESOLVED THAT THE Association For Commuter Transportation strongly supports legislation to correct the inequitable and inappropriate taxation of commute-to-work fringe benefits and urges all Members of Congress to support such legislation. Adopted September 20, 1987 Revised January 15, 1988 Revised January 12, 1990 ACT Board of Directors ACfl189~poirc*3:VP;KF PAGENO="0502" 492 Mr. ANDREWS. Thank you. STATEMENT OF MICHAEL J. CRETE, DDS, GRAND VILLE, MI, CHAIRMAN, COMMISSION ON THE YOUNG PROFESSIONAL, AMERICAN DENTAL ASSOCIATION Dr. CRETE. Mr. Chairman, my name is Michael Crete, I am a den- tist practicing in Grandville, MI, and I am also chairman of the American Dental Associations Commission on the Young Profes- sionals. You have our ~written statement. In the time allotted I will high- light the main points. Our association is seeking your support in restoring the tax de- duction of interest paid on qualified educational loans. Today, entry into the practice of dentistry requires a greater financial in- vestment than for any other professional career. Not only is a dental education itself. a substantial expense, aver- aging approximately $50,000, but the cost of beginning a practice is extremely expensive. In the most modest circumstance, ~for.~a small, single, operatory office, the starting cost averages $75ç000; largely due to the high cost of instruments and equipment. Therefore, at the point where dentists today first offer their serv- ices to the public, they have invested, on average, easily $125,000. For a dentist who to began a practice after the tax reform of 1986, the situation is this: They average approximately $38,000 ad- justed gross income, certainly a respectable, although hardly a re- markable average. On the other hand, half of today's young dentists earn under $35,000 and half of~those, 25 percent of all young dentists, earn $20,000 or less. At the same time, the average indebtedness of a dental student at graduation is over $43,000. This is strictly educational loan debt, which is then accompanied by the debt incurred in beginning a practice. Some dental students, less than 1 in 20, graduate debt free. These are individuals who either possess sufficient~ resources to fi- nance their education and to sustain themselves while they are in school or more commonly, have parents who. are able to do this for them. But, 95 percent or more of dental students are not in this envia- ble position. More than half of all dentaL students receive no assist- ance from their parents. For the majority of others, parental sup- port is limited and they, too, must borrow for their education. Encouraging~ savings for substantial purposes and discouraging making them through credit arrangements is generally sound public policy, but with respect to certain purchases, it is simply an unrealistic approach, as the Congress recognized in continuing in- terest deduction for home mortgages. Most middle income people, not to mention lower income people, cannot save the full cost of a home, nor can they save the full cost of a professional education for themselves or their children. PAGENO="0503" 493 This too is recognized by the Congress in support for graduate and professional student loan programs and loans for students demonstrating exceptional financial need. From another perspective, a strictly business perspective, a dental education is a prerequisite to dental practice. Its cost is an essential business expense. It seems reasonable to us that interest paid on the loans that fi- nance this substantial business expense should be deductible. There are thousands of beginning dentists and thousands more students who will soon be beginning practice who are in need of this deduction. Admittedly, every young dentist and dental student does not have the same need, but for many, the need is great. That is the personal-the individual perspective. From the broad perspective of our profession and in the future, the need is also a compelling one. The association I represent does not want dentistry to become a profession considered only by the student of affluent circumstances, nor only middle income students whose parents own homes of suffi- cient value that they can acquire interest deductible home equity loans to pay for a dental education. We want graduating dentists with a social conscience to work to- wards solving the most pressing oral health needs of our people, to be free to make those practice decisions that eventually we believe will solve the access problems of rural communities and inner cities. We do not want graduating dentists to be compelled to seek only the most renumerative practice situation out of the necessity to meet the obligations of their debt. Obviously, no one action of Congress will bring about the circum- stances we described, but equally obvious, we believe sound Federal policies can greatly assist in moving toward these goals. The tax policy, support that we are seeking is one significant way to assist new dentists to enter practices where .they may best re- spond to the most pressing oral health needs of our citizens. And needless to say, it would provide the most significant help to those dentists of the most modest economic background, those with the greatest debt burdens. . Thank you and I would be pleased to answer any questions as well. [The statement of Dr. Crete follows:] PAGENO="0504" 494 American Dental Association J'_~ f~ 1111 14th Street. NW. Suite 1201) Washington, D.C. 20005 (202) 898-2400 . - -. STATEMENT OF THE AMERICAN DENTAL ASSOCIATION ON MISCELLANEOUS REVENUE ISSUES DEDUCTIBILITY OF STUDENT LOAN INTEREST BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS U.S. HOUSE OF REPRESENTATIVES FEBRUARY 22, 1990 PRESENTED BY DR. MICHAEL CRETE Hr. Chairman and Members of the Subcommittee: My name is Michael, ..Crete. I am a dentist, practicing in Grandville, Michigan.. I am.~Chairman of the American Dental Association's Commission on the:.Young Professional. We appreciate this opportunity ,to testify at this hearing on Miscellaneous Revenue issues. The Association is seeking your, support in restoring , the tax deduction of interest paid on qualified educational loans. We do this specifically for the young men and women who have recently begun the practice of dentistry, for today's dental students, and for students who will choose this profession in years to cone. But in a more comprehensive sense, we seek this amendment to the tax laws. on behalf of dentistry itself,. We see this as an issue .`.~:of significance to the future of our profession. Today, entry into the practice of dentistry requires a greater financial investment than for any' other professional career. Not only is a dental education itself a substantial expense, averaging about $50,000, exclusive of normal living expenses over four years, but the cost of beginning practice is extremely expensive. In the most modest circumstances -- a small, single-operatory office -~ the starting costs average $75,000, largely due to the high cost of instruments and equipment. At the point where dentists today first offer their services to the public, they have invested, on average, easily $150,000. This does not consider the additional costs of forgone opportunities, costs that affect members of all professions requiring graduate study. Is such a substantial investment a , sound one? Obviously, we believe it is. The practice of dentistry provides societal, interpersonal and financial rewards over the longterm. Dentistry however, is not a profession that is, in all its aspects, immediately rewarding. Personal financial gain is often PAGENO="0505" 495 exceedingly slow to be realized, partly because of the investment I mentioned, and partly because it takes time to acquire the clinical proficiency and management skills necessary for a successful practice. And dentists, like everyone else, must earn their living in the here-and-now, not the longterm. The here-and-now for dentists who began practice after the tax reform of, 1986 is this: They average $38,200, adjusted gross income; certainly a respectable, although hardly a remarkable average, considering that we are discussing young men and women of academic excellence, who had multiple career options. And, in discussing men and women, averages are often misleading. As an example, half of today's young dentists do not earn $38,200; they earn under $35,000. And half of those -~ 25% of all young dentists -- earn $20,000 or less. Were these dentists starting from scratch, as it were, these incomes in their early practice years might be at least adequate. Most of them are not starting from scratch, however. The average indebtedness of a dental student at graduation is over $43,000. This is educational loan indebtedness. To be added to it is the indebtedness to be incurred in beginning a practice. And, again, these figures are averages. Some dental students -- less than one in twenty -- graduate debt- free. These are individuals who either possess sufficient resources to finance their education and to sustain themselves while they are in school, or more commonly, have parents who are able to do this for them. But 95% or more of dental students are not in this enviable position. More than half of all dental students -- 55.5% in 1989 -- are on their own. They receive no assistance from their parents.. For the majority of the others, parental support is limited and they, too, must borrow for their educations and to sustain themselves. One-third of dental school graduates have educational indebtedness of more than $50,000. Graduates of private schools average more than $60,000 in debts. These educational costs and these levels of indebtedness are contributing to the decline in dental school applications. The phase-out of the deductibility of interest also contributes to this decline. We understand the purpose of the interest deduction phase-out in the Tax Reform Act of 1986: to encourage savings for substantial purchases and to discourage making them through credit arrangements. This is generally sound public policy. But with respect to certain purchases it is simply an unrealistic approach, as the Congress recognized in continuing the interest deduction for home mortgages. Most middle-income people -- not to mention lower income people - - cannot save the full cost of a home. Nor can they save the full cost of a professional education for themselves or their children. This, too, is recognized by the Congress in its support for graduate and professional student loan programs and loans ior students demonstrating exceptiOnal financial need. This commendable action by the Congress accentuates the incongruity of the present tax policy. From another perspective, a strictly business perspective, a dental education is a requisite to dental practice. Its cost is an essential business expense. It seems to us reasonable that interest paid on loans that financed this substantial business expense should be deductible. There are thousands of beginning dentists and thousands more students who will soon be beginning practice who are in need of this deduction. Admittedly, every young dentist and dental student does not have the same need. But for many, the need is great. That is the personal, the individual perspective. PAGENO="0506" 496 From the broad perspective of the profession and its future, the need is also a compelling one. The Association I represent does not want dentistry to become a profession to be considered by only the student of affluent circumstances, nor only middle-income students, whose parents own homes of sufficient value that they can acquire interest-deductible home equity loans to~pay for a dental education. We want dentistry to be a profession open to anyone with the academic ability, the clinical potential, the considerahie industry and the dedication required to pursue it. We want graduating dentists, with the social conscience to work toward~ solving the ~ost pressing oral health needs of our people, to~be free to make those practice decisions that eventually -- we believe -- will solve the access problems of rural communities and inner cities. We do not want graduating dentists to be compelled to seek only the most remunerative practice situations out of the necessity to meet the obligations of their indebtedness. Obviously, no one action of Congress will bring about the circumstances we describe. But equally obviously, we believe, sound federal policies can greatly assist in moving toward these goals. Federal support for loan programs, as I mentioned, helps create more equal opportunities for professional education. Certainly, the degree of equality that now exists would be impossible without that support. The tax policy support that we are seeking is one significant way to assist new dentists to enter practices where they may best respond to the most pressing oral health needs of our citizens. And, needless to say, it would provide the most significant help to those dentists of the most modest economic backgrounds, those with the greatest debt burdens. It is important to describe the current composition of the nation's dental school student body. For this academic year, 16,413 students are enrolled in our nation's dental schools. Fifteen percent are black or Hispanic students. This is not yet * representative of the population at large, but it is clo~eYt~ being representative than at any time in the past. This * improvement is the result of many influences, not the least of which is that exerted by the schools themselves. Similar efforts have expanded opportunities for women. Now one in three dental students is a woman. Most significantly perhaps, 16% of this year's graduating dentists are from families with annual incomes of $15,000 or less. The American Dental Association is committed to the continuing improvement of these demographics -- not merely to be in a position to say that the profession is an accurate reflection of the national population, but rather because we are convinced that a representative dentist population is the key to assuring that we will meet the oral health care needs of all our people. Tax policy assistance to indebted dentists in their early practice years is one means of achieving this objective. Thank you for your attention. I would be pleased to respond to any questions you may have. PAGENO="0507" 497 Mr. ANDREWS. Thank you, Doctor. Dr. Litwin. STATEMENT OF MARK S. LITWIN, M.D., CHAIRPERSON, GOVERN- ING COUNCIL, RESIDENT PHYSICIAN SECTION, AMERICAN MEDICAL ASSOCIATION, ACCOMPANIED BY STACEY GARRY, M.D., RESIDENT PHYSICIAN, SALT LAKE CITY, UT; DAVID L. HEIDORN, J.D., DEPARTMENT OF FEDERAL LEGISLATION; AND TERRELL MITCHELL, DEPARTMENT OF RESIDENT PHYSICIAN SERVICES Dr. LrrwIN. Thank you. Mr. Chairman, Mr. McGrath, my name is Mark Litwin, I am a resident physician from Boston, MA. I am also chairman of the Governing Council of the American Medical Association Resident Physician Section. With me is Stacey Garry, a resident physician from Salt Lake City, UT, and accompanying us is David Heidorn of the AMA's De- partment of Federal Legislation and Terrell Mitchell of the AMA's Department of Resident Physician Services. We are here to express to you, the AMA's commitment to the principle that all qualified individuals should have the opportunity to become physicians, no matter what their financial backgrounds are. However, recent changes in Federal tax and budget policy are imposing unforeseen economic restraints on resident physicians. These changes~ will force many young physicians to establish practices in specialty fields and in geographical areas that offer in- comes needed to pay off large educational debt and may stop many bright young women and men from eventually even pursuing a medical education at all. First, the phase out of educational loan interest deductions took away the ability to soften the blow of paying back medical educa- tional debt, which has risen dramatically in recent years to a mean level of over $42,000 last year. H.R. 747 would reinstate the tax deductibility of educational loan interest, thereby partially offsetting the enormous debt which med- ical school graduates face during and immediately after their resi- dency training. Then, second, the OBRA Act of 1989, cut off the ability of most resident physicians to defer repayment of major student loans beyond the first two years of their residency training, which often lasts anywhere from 3 to 8 years. Contrary to their understanding when these loans were initially made, many resident physicians, this year, must begin making $500 to $700 a month loan repayments on typical incomes of less than $2,200 per month. Such payments threaten the ability of many to complete the nec- essary medical training. This Nation's tax laws reflect our national priorities and at a time when we hear much concern over educa- tion and access to health care, restoration of the interest deduction for educational loans is an investment in our Nation's future. We urge this subcommittee to help refocus our Nation's prior- ities in this area. PAGENO="0508" 498 Dr. Garry will share her thoughts and experiences on how these recent changes in Federal policy directly affect her life and her professional hopes. [The statement of Dr. Litwin follows:] PAGENO="0509" 499 STA1~~T of the AMFRICAN MEDICAL ASSOCIATION to the Subco~ittee on Select Revenue Measures Co.mittee on Ways and Means U.S. House of Representatives Restoration of the Deductibility of Interest on F4uc~'fionaI Loans February 22, 1990 Mr. Chairman and Members of the Subcommittee: My name is Mark S. Litwin, M.D. I am a resident physician in my fifth year of a six-year residency program in urological surgery at Brigham and Women's Hospital in Boston, Massachusetts. I am also Chairperson of the Governing Council of the American Medical Association's Resident Physicians Section, which represents the concerns of the Association's resident physician members. With me is Stacey Garry, M.D., a resident physician in her fourth year of a five-year residency program in pathology at the University of Utah Affiliated Hospitals in Salt Lake City. Accompanying us is David L. Heidorn, J.D., of the AMA's Department of Federal Legislation. I feel privileged to appear before you to say that the American~ Medical Association appreciates this opportunity to share with the Subcommittee on Select Revenue Measures the Association's concerns about how recent federal tax and budget measures threaten the ability of some otherwise excellently qualified individuals to become physicians. Unless these measures are reversed, the availability of physicians to deliver necessary medical care in some areas of the country and in some medical specialties could be severely limited. First, the phase-out of educational loan interest deductions instituted in the Tax Reform Act of 1986 -- which classified both educational loans and loans to purchase consumer goods as "consumer loans" ~- took away from resident physicians and young physicians starting up medical practices the ability to deduct interest payments on these loans. Interest deduction softened the blow of'~beginning to pay back medical educational debt that, in recent years, has risen beyond anyone's imagination -- from a mean level of $19,700 for each individual with such debt in 1981 to $42,200 in 1989. Now, just as these young physicians are beginning to feel the full extent of the Tax Reform Act's impact on their personal budgets, Congress, in an effort to find budget savings of its own through the Omnibus Reconciliation Act (OBRA) of 1989, reduced the ability of resident physicians to defer repayment of their major student loans while they complete their necessary medical education in residency programs. As a result, many resident physicians thisyear will have to begin making loan payments of between $500 and $700, which they did not expect when they entered the loan agreements. S We know that a great many resident physicians, including Dr. Carry, have incomes and living expenses that make such payments impossible and make it difficult for them to complete their residency training programs. Further, some bright, highly qualified young people now looking to medicine as a career and some medical students already in training will not be able to become physicians because they lack the financial resources to carry them through the long and, now, even more financially burdensome medical education process. PAGENO="0510" 500 We are well aware that the student loan deferment issue is not a direct responsibility of this Subcommittee. However, the AMA urges that, when considering the restoration of the student loan deduction, the members of this Subconunittee consider the overall financial situations in which many young physicians, especially resident physicians, now find themselves and how these recent changes will affect where young physicians decide to~practice medicine and the kinds of patients they will be able to serve:~ These economic issues will even determine whether some young people will choose to become physicians at all. Student Loan Interest ueuuckiuum The American Medical Association endorses the statement of the Student Loan Interest Deduction Restoration Coalition (SLIDRC), from whom you also are hearing testimony today. This nation's tax laws reflect in many ways our national character and concern, such as thesupport given families through tax exemptions for dependents and charitable giving through tax deductions. Home ownership is favored by allowing taxpayers to deduct interest on home mortgages. Through the Tax Reform Act of 1986, Congress, in part, sought to limit our reliance on debt by phasing-out deductions for interest on consumer loans. Unfortunately, the wide sweep of that policy treated educational loans the same as consumer loans for automobiles2fldidePartment store credit card purchases. We fail to see the similarity between consumer debt and educational debt. At a time of wide-spread concern over education and its importance to our competitiveness in a global economy, we cannot afford a message that educational loans are the same as consumer loans. As the SLIDRC statement points out, the estimated $700 million in revenue that would be lost over five years if the deduction were restored would be a cost- effective investment in the economic benefits that would follow from a better-educated workforce. Mr. Chairman, education loans are investments in our nation's human capital. Such investments in our future need to be encouraged through tax policy, not discouraged. Deferment of Resident Student Loans Prior to the enactment of the OBRA of 1989, resident physicians in training programs that had a major affiliation with a university -- about 75 percent of the more than 81,000 resident physicians on duty in the United States -- were able to be considered as having "in school" status, thus qualifying them, as others in school, for a full deferment of the Stafford Student Loans and other student loans under Title IV of the Higher Education Act during their residency training. As a budget measure projected to save the federal government $10 million a year, OBRA of 1989 prohibited resident physicians from being classified as "in school." As a result, resident physicians, who generally require between 3 and 6 years, even up to 7 years, of residency training, with fellowship programs that follow for some specialties, are limited to a two-year deferment under an internship classification. i~p~ci on Health Care Resident physicians and young physicians are disheartened by these recent changes in tax and budget policy. The denial of "in school" status, coupled with the elimination of student loan interest deductions, will make the repayment of loans during residency training that much more onerous. In turn, this will threaten the ability of many resident physicians to complete their medical training. It should follow that some young physicians will be forced to establish medical practices not where they are needed, in underserved rural and inner-city areas, but in areas where they are certain to earn higher incomes to pay off the large debts they have accumulated to become physicians. According to the American Association of Medical Colleges, in 1988, 83.4 percent of all medical graduates, or those who are ready to enter residency training programs, had educational debt, with an average total indebtedness of $38,489 ($42,200 in 1989). Of those with debt, 24 percent had a total educational debt of over $50,000. We have heard of some resident physicians with $90,000 in student loans. Monthly student loan repayments of at least $500 to $700 for resident physicians would not be uncommon on typical monthly salaries of $2200 to $2300. PAGENO="0511" 501 For resident physicians who do not receive financial support from their parents, who are raising families, or who have spouses who are students or who otherwise cannot provide adequate support, an extra $500 to $700 a month does not suddenly materialize in their budgets. This is especially true for those who may be in residency programs in urban areas or areas near large universities where housing costs can be especially high. Dr. Garry is one such resident physician who finds herself in an economic situation that, beginning in July, will be very difficult. She will share with you her thoughts and concerns on how these policy changes will affect her life and professional plans, which are to practice her specialty in pathology in an underserved area in the West. The AMA has spoken to many residents in similar circumstances and is in the process of finding out just how extensive their problems are. Conclusion The AMA is committed to the principle that qualified individuals who want to become physicians, no matter their financial or social backgrounds, should have the opportunity to do so. The inability to deduct student loan interest and to defer student loan repayment while completing a medical education will keep some otherwise deserving individuals from becoming physicians and force too many of those who are financially able to become physicians to choose medical practices in more lucrative specialties and in geographic areas that already may be well served. Mr. Chairman, the current tax policy on educational loans is short-sighted and should be changed. Restoring student loan interest deduction would be one way that this Subcommittee could help to ensure access to necessary health care in all areas of this country and to ensure that medical education is available to all those who are qualified, not an economically select few. PAGENO="0512" 502 Mr. ANDREWS. Dr. Garry. Dr. GARRY. Mr. Chairman and members of the subcommittee, my name is Stacey Garry and I am one of the many resident physi- cians affected by the recent changes in Federal tax and budget poli- cies that Dr. Litwin describes; I honestly do not know how I am going to complete my medical education or how I am going to begin a practice in the type of com- munity that I had pictured for my family. I am in my fourth year of a 5-year residency program in patholo- gy at the University of Utah Affiliated Hospitals in Salt Lake City. My goal has always been to practice pathology in a smaller town in the West. This most likely would be an underserved area as many of the areas in the West are. Let me give you an idea of the economic situation that I find myself. For my residency program, I am currently receiving a salary of $1,653 a month. My husband is a geologist and~ also an excellent finished carpenter, but a severe back injury a few years ago has limited him to geology consulting business that has an av- erage monthly income of $350. Our combined monthly income of $1,858 has been barely ade- quate to cover current monthly expenses that average $1,786 a month, including a mortgage payment of $586 a month. In July of this year, due to the sudden unexpected change in the student loan deferment policy, I am facing an additional monthly payment of $568 on my student loans, which have added up to a total of $26,600 in Government insured loans. Although I expect my monthly salary to be raised by $145, we are still facing a deficit of more than $350 a month. Forbearance, an option residents are given at the same time, in school deferment was taken away, may be a last resort to get me through one year of residency, but the interest accumulated through any forbearance period will drive up my monthly payments when I begin practicing. I also have close to $11,000 in non-Government loans from sever- al nonprofit organizations and private investors that need to be paid back within several years after my residency training is fin- ished. Given this situation, I do not know how I will be able to accept a position in a rural community where there is a higher need for pa- thologists and where my husband and I would like to settle. I look at the debt I have accumulated and my situation tells me to get a high paying position as much as possible. I hope this will not be true. It is not why I went into medicine, but it is beginning to seem like some of the disillusionment that I have heard from older physicians may be true. I will get through this somehow, but sometimes I wonder if it has all been worth it. I am also very concerned that potential physi- cians who are behind me in the education process are making career decisions that will decide that medicine is not worth these difficulties. We again urge this subcommittee to restore the student loan in- terest deduction. It will not solve every problem I have as a resi- dent physician or face as a young practitioning physician, but will help me address some of my financial concerns. PAGENO="0513" 503 It would also reflect the commitment to education and adequate access to health care that I know we all share. Dr. Litwin and I will be happy to answer any questions you have. Mr. ANDREWS. Thank you. Ms. Asihene. STATEMENT OF REGINA ASIHENE, MEDICAL STUDENT, MORE- HOUSE SCHOOL OF MEDICINE, ATLANTA, GA, ON BEHALF OF THE U.S. STUDENT ASSOCIATION AND THE STUDENT LOAN IN- TEREST DEDUCTION RESTORATION COALITION Ms. ASIHENE. Good afternoon, my name is Regina Asihene and I am a medical student at the Morehouse School of Medicine in At- lanta. I speak as a representative of the Student Loan Interest Deduc- tion Restoration Coalition. We believe that restoring this deduction supports and encourages investment in higher:education. Though a need for higher education is an important investment in the future, this investment differs from credit card~debt because it will stay with me for the rest of my life. Further, higher education benefits the Nation in that it makes us more competitive and productive. Borrowing is often the only means to finance an education, particularly in expensive graduate and professional programs. Many health professional students incur substantial debts in ob- taming their education~~with average debts exceeding $40,000 and many~much higher. Once out of school, we are faced with large repayments at a time when earnings are not likely to be high, especially during residen- cy training and for those who want to pursue positions in teaching, public service or research. Current tuition and fees at my school are $13,000, with yearly cost of $27,000, including living expenses. As a result, I have relied heavily on loans to finance my medical education and will owe nearly $65,000 when I graduate in 1991. Unfortunately, these high debt burdens~ deter many disadvan- taged and minority students from even considering a career in medicine. There is no doubt that a relationship exists between debt burden and specialty choice. I would like to practice family medicine in an underserved area in the United States. Many rural and inner city areas are where medical services are needed most. However, I must be realistic about my ability to repay my loans. I am aware that in rural family practice, the average salary falls far below that of specialists or those in wealthier suburban locales. Given my debt burden, my monthly loan payments during my first few years in practice would be approximately $1,000, with monthly interest exceeding $600. I am constantly debating between becoming a family practitioner and struggling to repay my student loans or choosing a more lucra- tive specialty. 30-860 0 - 90 - 17 PAGENO="0514" 504 Being able to deduct this interest will make a difference by making my monthly payments more reasonable, entering into de- fault less likely, and allowing me to fulfill my career goals. By restoring this deduction, you will be acknowledging the im- portance of higher education to society. Thank you. Mr. ANDREWS. Thank you very much. Ms. Lewis. STATEMENT OF ALAINA LEWIS, RECENT UNDERGRADUATE STU- DENT, EASTERN MICHIGAN UNIVERSITY, ON BEHALF OF THE U.S. STUDENT ASSOCIATION AND THE STUDENT LOAN INTEREST DEDUCTION RESTORATION COALITION Ms. LEwIs. Hello, my name is Alaina Lewis and I am here repre- senting the U.S. Student Association, a national organization repre- senting both graduate and undergraduate students which is a member of this coalition. USSA supports several changes in tax laws affecting students of which this issue is one. I am from a family farm, dairy farm in Britton, MI. Two months ago I graduated from Eastern Michigan University with a degree in political science and a $14,000 debt burden. Although our family is deep in debt due to the farming situation, I was still ineligible for need based aid, due to the estimated worth of our farm. I therefore relied on guaranteed student loans, as well as various full and part-time jobs to finance my undergraduate education. I had always planned on continuing my education by pursuing a masters degree, although now those plans have been put on hold due to my large debt burden. While there are other factors to consider, student loan interest deduction would contribute to my decision to pursue a graduate degree. Loan interest deduction would ease repayment, especially in the first few years after I receive my graduate degree at a time when I will be just starting out in a new job and struggling to repay my loans. The Government will have helped me with this investment in my education. I would like to request that you restore this deduction and I thank you for the opportunity to speak on behalf of students before this committee. [The prepared statement and attachments follow:] PAGENO="0515" 505 STATEMENT OF ThE STUDENT LOAN INTEREST DEDUCTION RESTORATION COALITION The Student Loan Interest Deduction Restoration Coalition (SUDRC) consists of a number ofgroups concerned about growing student indebtedness and its impact on access to education and post-graduation career choices. SUDRC believes restoring this deduction supports and encourages investment in higher education. We support the passage of HR 747 and 5.656, which would restore this important deduction. Impact of the Tax Reform Act of 1986 on Graduates The phase-out of consumer loan interest deductions under the Tax Reform Act of 1986 included educational loans in the same category as consumer loans. The policy rationale for eliminating the consumer loan interest deduction was to discourage over-reliance on credit and to encourage savings, but we believe this rationale does not apply to educational loans. Borrowing is often the only means to finance an education, particularly in expensive graduate and professionalprograms. Nearly 50% of graduate students rely on loans to finance their education. Borrowing for educational purposes is an investment in the future, rather than a discretionary debt for a non-essential consumer product. The remaining interest deduction -- for home equity loans used for educational purposes -- is not an adequate substitute, since most of the student population does not own a home and cannot benefit from this deduction. Furthermore, independent graduate students would notbeneflt even if their parents do own a home. The inequity~mithecurrent system is inadequate and discriminates against renters and urban~dwellerstwho incur heavier debtiburdens as a result. If the~fitiF-déduction was permanentlyrestored,ihe estimated revenue losswould be $700 million for the firstfive years. This sum issmall compared to the benefits of investing in the nation's education future. Since college-educated adults generally earnhigher wages than non-college graduates, the Treasury will eventually recoup in increased income taxes far more than the amount it might lose by allowing the student loan interest deduction. SLIDRC believes it is sound tax policy to allow tax deductions for such educational costs. Those who oppose restoring student loan interest deduction argue that as a whole, students and indebted graduates have benefited from changes enacted in4he Tax Reform Act of 1986. A comparison of tax rates before and after implementation of the Tax Reform Act of 1986 clearly illustrates that most recent lower to middle income graduates have not significantly benefited from the modified tax brackets. (see Table 1). The pre- 1986 tax-payer had other tax preferences under itemized deductions and other areas~ Significantly for students, all pre-1986 scholarship and grant money was not taxable-as income. It is unlikely~that lower tax rateshave compensated for these losses foranost students, and in-our opinion, students as a whole have not benefited under the Tax Reform Act. If we assume between a $100 to $2,500 yearly benefit from student loan interest deduction (depending on level of indebtedness), the loss of thisdeduction is significant. This is especially true for health professional students who ac~uinuiate large educational debts during many years of training. +While high-income individuals have benefited fromiower tax rates$such individuals are not likely to benefit from this deduction. As we emphasize below, the interest burden is greater during the first few years of repayment, whenincome is relatively low. Therefore, tax reform rate changes have provided little benefit for lower and middle-income recent graduates who had other benefits taken away, such as the student loan interest deduction. l~reasing Educational Debt The growing debt burden for students may discourage entry into higher education and the pursuit of additional degrees, especially for minority students and those considering professional and graduate degree programs (see Table 2). Such debt may also adversely affect career choices, deterring graduates from tatting lower- paying public service, teaching, or research jobs. Many health professional graduates who are committed to caring for underserved communities find this career path infeasible in light of their enormous debt burdens. As the supply of PhDs decreases, and our world competitiveness in technologic and scientific fields becomes compromised, the need to invest in higher education becomes even more important to the economic future of our country (1). PAGENO="0516" 506 We believe that restoring the student loan interest deduction will help ease this growing debt burden, especially for those just beginning their careers. The deduction will be a significant financial help in managing income and meeting loan payments, particularly in the first few years after graduation when earnings are low and interest makes up a greaterproportion of loan repayment. For example, consider a recent health professional school graduate with an educational debt of $43,000, including a Stafford Student Loan at 8% interest repayable over 10 years and a Health Education Assistance Loan (HEAL) repayable at 11% interest over ten years. The average monthly payment required to amortize this loan would be about $630. Total repayment would exceed $76,000, with over $33,000 accounting for interest over the life of the loan. In the first year of repayment, $4,536 out of the $7,644 yearly payment accounts for interest. The ability to fully deduct this interest would make monthly loan payments more reasonable, entering into default less likely, and allow the graduate his/her full consideration of career options. The following case examples illustrate the benefits of restoring the tax deductibility of student loan interest. The first two describe student witnesses who testified before the Subcommittee. The remaining four are hypothetical examples based on current data. A.L graduated with a bachelor's degree from a large midwestern university. Her father, a farmer, was in debt due to the falling farm economy, but the value of his farm and land disqualified her from scholarship programs available at her schooL As a result, she borrowed nearly $16,000 for educational expenses. Presently working for a public-interest advocacy organization, A.L is considering pursuing a degree in political science or histoiy. In seeking this advanced degree, A.L will likely accrue another $15,000 to $30,000 in loans. This potential debt burden, along with the inability to deduct loan interest, has deterred her from actually applying. R.I. is a medical student at Morehouse School of Medicine in Atlanta. Upon graduation, she will owe $65,000 in educational loans. During her first two summers in medical school, she directed a health fair in a rural Georgia community, and developed an educational slide show on substance abuse prevention for use at area schools. Considering a career in family practice in a rural, underserved area, she must also consider her significant debt burden and be realistic about her ability to repay her loans. During her first few years of repayment, R.I. will repay over $10,O0(i in interest. Being able to fully deduct this interest would not only result in a significant savings, but may also influence her decision to choose a less lucrative career in rural family practice where her services are needed. Mr. and Mrs. C. are parents of a freshman at a small private college in the Midwest. They live in an apartment in Chicago which they rent. Mrs. C. is a third grade teacher earning $32,000 and Mr. C. is a fireman who earns $35,000. Because of their combinec[income, this middle-class family is ineligible for assistance from federal or state student aid programs and must borrow $10,000 a year for four years to help pay for their son's education. They will face a similar situation with their daughter when she enters college in two years. This family expects to pay approximately $15,000 more in federal taxes over the 15-year life of the loan than their suburban counterparts who own theirhome and can take out a deductible home equity loan. C.K. is a senior at a Catholic girls' preparatory school considering several options for college. Her first choice is a small Cathohc women's college an hour from her home in Connecticut, however this college is considerably more expensive than state universities. C.K.'s parents are also helping support the secondary and higher education of her two brothers and three sisters with their combined income of $71,000. If they were able to include the deduction of interest on the children's educational loans in calculating the value of various financial assistancepackages, it might make C.K.'s preference to continue a Catholic education more affordable. J.P., a Hispanic dentist who graduated from dental school in 1989, financed his education with over $50,000 in student loans, a situation faced by one-third of all dental graduates. Enrolled in a one-year dental residency which provides no stipend, he has to borrow even more to finance his post-graduate training. He plans to pursue a career in geriatnc dental research, a major area of future dental care } need. However, his next fów years of loan repayment, largely comprised of interest, have caused him to reconsider his career plans. Even-with the earnings be could expect to receive in a research position, loan repayment during his first few years out of school will exceed 50% of his pre-tax income. PAGENO="0517" 507 J.T. is a 1989 black male graduate of an osteopathic medical school in New York. Like 40% of osteopathic medical students, he comes from a family whose annual income is less than $30,000. J.T.'s cultural background and experience in an occupational medicine clinic as a medical student led him to choose a career in urban family practice. Approximately 50% of osteopathic graduates practice primary care in rural andurban communities. He is presently an intern at an ~trsaffihiate inner city hospital in Brooklyn, pursuing a comprehensive family practice ~~r~nnareer. Married with two children, his total debt is $132,500. Despite his commitment to se~ng New York's poor, J.T.'s loan repayment requirements ~ll make it difficult for him to purchase a home, and meet other family expenses. Equity In Restoring the Interest Deduction In 1988, the Joint Tax Committee objected to restoring the student loan interest deduction on the basis that it would be a greater benefit to higher income individuals, and would be financially insignificant. We disagree with this assessment. - To benefit from student loan interest deduction, graduates must itemize deductions on their tax returns. Although higher standard deductions have decreased the number of itemizers in middle income ranges, we believe that many recent graduates with high debt will choose to itemize if this deduction were available. In many cases of high debt, yearly interest payments alone will exceed the standard deduction amount (see Table 3). We would hope that many low-income individuals would quali!~r for needs-based grants and be able to avoid incurring high debts. However, this is not always possible, and in such cases the interest deduction will provide a benefit. The deduction is most valuable for the individual when his or her earnings are low and interest payments are high; this is the situation faced by most graduates in the first few years after graduation. Student loans are generally repald over ten to twenty-five years,'with interest making up a greater proportion of the payments in the early years after graduation. Therefore, the further a student is from graduation the less interest there will be to deduct, presumab1~ at the same time the individual's earnings are increasing. Due to this `front-loading of interest, the largest benefit from student loan interest deduction goes to recent graduates who need it most. Any individual whose total deductions exceed the standard figure should elect to itemize. In 1989, the standard deduction under section 63 (b) (2) of the Internal Revenue Code was $5,200 for ajoint return, $4,550 for a head of a household, and $3,100 for single filers. In considering whether an individual would elect to itemize, it is likely that many middle income individuals will have sufficient additional deductions to push them over the standard deduction level. However, educational interest alone may exceed these standard figures (see Table 3). A recent graduate who borrowed $30,000 in loans with interest averaging 12% with a repayment period of ten years would accumulate enough earned interest in the early years of repayment to be able to take advantage of an itemized deduction of student loan interest, rather than taking a standard deduction. This is true even if the graduate has no other itemized deductions. For married couples filing joint returns, a student loan interest deduction would exceed the standard deduction when their combined debt exceeded $45,000. Restoration of the deduction would not encourage unnecessary borrowing Since a non-taxable grant to cover tuition and fees is inherently preferable to taking out a loan, one has little incentive to take loans for educational costs unless grant aid is not available. Needs analysis tests and income limits for low interest loan programs eliminate the possibilit~r of high income individuals using low-interest educational loans for non-educational purposes. Proper administrative safeguards and tax enforcement will prevent individuals seeking to classify non-educational loan interest as educational interest in order to obtaln a tax deduction. Commitment to Higher Education While student loan interest deduction is not the only solution or remedy to the debt problem, nor isit the only factor contributing to one's career choice, its effectiveness should not be discounteci. As federal funding for educational grants and scholarships decreases, students become more reliant on loans to finance their education. By restoring student loan interest deduction, the government acknowledges not only the costs incurred in making this investment, but the PAGENO="0518" 508 contribution higher education makes to society at large. SLIDRC urges restoration of the tax deduction for interest on educational loans. We support the passage of H.R. 747 and S. 656, which would restore this important deduction.. Thankyou for consideration of these comments on the need to restore the deductibility of interest on educational loans. (1) A recent studydocuments bowloans became an increasing proportion of student aid in the 1980s. Also noteworthy is the fart that me ottbe higher interest supplemental loan for students (a loan of last resort) has skyrocketed in recent yeara The College Board. Trenth in Student Aid. 1980 to 1989. August, 1989. PAGENO="0519" 509 Appendix Table 1. Tax Rates pre- and post-Tax Reform Act of 1986 Taxable Income 1989 Tax & % Pre-1986 Tax & % $15,000 $2,254 (15.63%) $2,001 (13.34%) 20,000 3,196 (15.98) 3,218 (16.05) 25,000 4,596 (18.38) 4,565 (18.26) 30,000 5,996 (19.99) 6,133 (20.38) 35,000 7,396 (21.13) 7,849 (22.42) 40,000 8,796 (21.99) 9,749 (24.37) 45,000 10,202 (22.67) 11,789 (26.20) Source: Tax Tables Table 2. Debt Burden by Degree Program Degree Program 1989 Average Graduating Debt Allopathic Medical 43,000 Dental 43,300 Podiatric Medical 69,150 Nurse 11,000 Optometiy 35,563 Osteopathic Medical 69,000 PhD, social science 9,920 (1988 PhD, overall average 7,471 (1988 PAGENO="0520" 510 Table 3. Educational indebtedness: Effect of Itemizing Student Loan Interest * Itemized Tax Returi ~2 Q~c~ Debt Burden $43,300 $60,300 $100,000 Adjusted gross income 30,000 30,000 30,000 - Full interest deduction 4,536 7,242 12,432 - Personal exemption 2,000 2,000 2,000 = Taxable income 23,464 20,758 15,068 Tax(a) 4,162 3,406 2,261 Non4temlzed Tax Return Debt Burden $43,300 $60,300 $100,000 Adjusted gross income 30,000 30,000 30,000 - Standard deduction 3,100 3,100 3,100 - Personal exemption 2,000 2,000 2,000 = Taxable income 24,900 24,900 24,900 Tax (b) 4,568 4,568 4,568 Estimated Tax savings from full Interest deduction $406 $1,162 $2,307 (b) - (a) 5Assumptions: (1) A full student loan interest deduction is available for tax year 1989. (2) The taxpayer is a single individual and a graduate of a health professions school. (3) Adjusted Gross Income (AG!) is $30,000. This is a rough estimate of a typical AG! for a recent graduate entering repayment. (4) The taxpayer itemizes deductions; the only itemized deduction is student loan interest. (5) One personal exemption is taken (6) Tax savings from the interest deduction is the amount of tax saved in one year due to the reduction of taxable income caused by this deduction; savings attributable to the interest deduction are a result of additional deductible amounts above the $3100 standard deduction for a single individual. Savings will be due to the interest deduction since this is the only itemized deduction in our assumptions. (7) The year analyzed is the first full year of loan repayment. (8) Type of Loans (based on computer analysis run by a health professional school financial aid office) (a) The first loan utilized is Stafford Student Loan (up to $7500 per year) at 8% interest. (b) The second loan utilized is Health Education Assistance Loan (HEAL) (up to $20,000 per year) at 11% interest with a 10 year repayment period for Cases land 2, and a 25 year repayment period for Case 3. NOTE: HEAL interest is a significant factor due not only to the higher interest rate but because HEAL interest, unlike Stafford loans, accrues and compounds during the in-school period. This period is four years for many health professional programs, as in this hypothetical example. The estimated tax savings above represents a maximum amount for each taxpayer, since the interest portion of loan repayment decreases each year as the loan is being paid off. PAGENO="0521" 511 The following organizations are represented by the Student Loan Interest Deduction Restoration Coalition: American Academy of Family Physicians American Association of Colleges of Osteopathic Medicine American Association of Colleges of Osteopathic Medicine- Council of Student Council Presidents American Association of Dental Schools American Council on Education American Medical Association American Medical Student AssOciation American Medical Women's Association American Osteopathic Association American Podiatric Medical Association American Podiatric Medical Students Association American Student Dental Association Association of American Medical Colleges Association of Schools and Colleges of Optometry Consortium on Financing Higher Education National Association of State Universities and Land-Grant Colleges National Federation of Housestaff Organizations United States Student Association PAGENO="0522" 512 Mr. ANDREWS. Well, thank you and thank all of you. Ms. McCarthy, just one question. Ms. MCCARTHY. Yes, sir. Mr. ANDREWS. Can you quantify the improvement in the quality of air in California as a result of mandated vehicle occupancy standards along commuter routes? Can you tell us whether or not there is an appreciable difference in the air quality? Ms. MCCARTHY. Because these are such new ordinances and we are really in the first 2 years, I do not have any facts at my finger- tips but I could get them to you. They do feel that the ordinances will have a very positive impact on the air. Mr. ANDREWS. It is hard to believe that it would not, since auto- mobile emissions cause over half of the air pollution in cities like Los Angeles, New York and Houston. Ms. MCCARTHY. Yes. In the bay area where we have had stronger emissions standards and more frequent testing than some other places in the State, we have noticed appreciable differences, still not bringing us up to the 1987 standards however. Mr. ANDREWS. Incidentally, do you think stronger tailpipe emis- sions would encourage alternative fuel use and van pooling and other innovative ways of commuting? Ms. MCCARTHY. I think it is part of a package. I think that for many people, yes. I think because of the really lack of availability right now of alternative fuels or alternative fuel vehicles have hampered that. Electric cars are working, but they are very difficult to get more than two people in them because of the size of the batteries. Right now we are trying to get fuel-methanol fuel vehicles in some of our sites in Los Angeles and we are planning on rolling those out. I think that will make an appreciable difference, although as we look at the alternative sources, we are still not sure what the long term effects will be. Mr. ANDREWS. Well, do you think tax incentives would encourage private vehicle owners to convert to alternative fuels, for instance, large fleet owners? Ms. MCCARTHY. Yes, I think it would definitely be in their inter- est. When you look at some of the requirements in the ordinances, regulation 15 in Los Angeles, and the whole California Clean Air Act, I think clean fuels is going to be a large portion of those com- mute programs and I think that this would be one way to help large employers, like Hewlett-Packard, with large fleets, roll those over. Mr. ANDREWS. Thank you very much. Mr. McGrath? Mr. MCGRATH. Thank you, Mr. Chairman. Ms. McCarthy, I live in an area close to a metropolitan area in New York. The cost of commuting from the closest area in my dis- trict is about $128 a month on a Long Island Railroad plus prob- ably another $80 a month on the subway system. PAGENO="0523" 513 So, $15 a month or you are suggesting $60 a month does not amount to much of a benefit here. You are suggesting a leveling of the playing field between those who commute by car and whatever. In the city of New York there are some companies who have parking benefits for their commuters, and I understand fully the argument that my colleague from Houston was making regarding air quality. Concerns have been raised that because New York has problems, my district has problems, too, the potential sanctions of a clean air act might be in terms of Government grants and whatever. Add to that the possibility that some people are talking about having a $10 toll on the bridges and tunnels getting into New York City. This all brings me to my question. Right now, I have no clue as to what are the revenue implica- * tions ofrincreashg the limit from $15 to $60 and exempting from taxationwans-and employer provided transit passes. * Do youkdaave any idea at all what the revenue impact of this ~~~*t1~What I suggest is probably a low ball estimate to finance what you are trying to accomplish. Ms. MCCARTHY. I think the-my assistant here has said that the-it would probably be very negligible; a $60 cap equals $70 mil- lion a year. Mr. MCGRATH. Is that all? Thank you. And to our friends in the professional and Student Loan interest Deduction Restoration Coalition, I have a son who is a junior in college. It is costing me a lot of additional money to finance his education and I am paying for those loans myself. Is anybody taking advantage of the ability to deduct your ex- penses through home equity. loans or is that something that cannot be used by those who are in the professional field? Mr. CRETE. 1 will respond to that. `I think that I mentioned in my statement that that is an avenue that we recognize that Congress did foresee as a benefit and that there are perhaps either upper income or moderately middle income families that are able to do that and perhaps provide that, but maybe the lower income and middle income do not have that. And also, if a student is independent, he may not do that. Mr. MCGRATH. I am just stuck here. Earlier we were talking about relief which I believe, in Ms. McCarthy's case, is inadequate for those kinds of mass transportation services in areas where I live, and which is going to cost somewhere in the neighborhood of $70 million a year. Now I am told that the ballpark estimate on your deduction would cost the Treasury somewhere in the neighborhood of $100 million to $150 million a year. As you know, we have had 4 or 5 days of hearings on all of these provisions which people have been bringing to us. If we added up the cost of every provision in everybody's testimony or submitted testimony, it would cost somewhere in the neighborhood of $6 bil- lion. So, we are going to need to make some judgments based on some equities here; I certainly am cognizant and I feel for you in terms of the education loan situation because I am stuck in it myself. PAGENO="0524" 514 But I want to thank you all for your testimony. I have no further questions for you. Thank you. Mr. ANDREWS. Thank you very much, this concludes our hear- ings. [Whereupon, at 1:35 p.m., the hearings were adjourned.] [Submissions for the record follow:] PAGENO="0525" 515 STATEMENT OF THE AMERICAN PETROLEUM INSTITUTE. BEFORE THE SUBCOMNITTEE ON SELECT REVENUES, COMMITTEE ON WAYS AND MEANS, U.S. HOUSE OF REPRESENTATIVES PUBLIC HEARINGS ON MISCELLANEOUS REVENUE ISSUES ON FEBRUARY 21, 1990 AND FEBRUARY 22, 1990 INTRODUCTION The American Petroleum Institute (API) is a trade association of over 200 companies involved in all phases of the petroleum industry. API welcomes this opportunity to present petroleum industry concerns with specific issues in foreign source income taxation that were listed for possible alleviating amendments in the Committees Hearing Notice. 1. EXTENSION OF CARRYFORWARD OF FOREIGN TAX CREDITS This proposal would extend the carryfórward period for foreign tax credits from 5 years to 15 years for credits generated in taxable years beginning after December 31, 1988. The API supports this proposal. Additionally, API believes that the carryback period should be extended from 2 to 3 years, for credits generated in taxable years beginning after December 31, 1991. Because of the changes made to the foreign tax credit provisions by the Tax Reform Act of 1986 (the 1986 Act), the length of the carryover period for unused foreign tax credits has become even more critical. Prior to the 1986 Act, the foreign tax credit limitation was applied separately with respect to two foreign source income categories: active business income and passive interest income. The 1986 Act significantly expanded the number of foreign source income categories ("baskets") to which the foreign tax credit limitation must be separately applied. This expansion results in a significant reduction in the amount of credits which can be utilized currently and within the seven year carryover period. In cases where such reduction results in foreign taxes not offsetting U.S. taxes on foreign source income, double taxation occurs and U.S. taxpayers are placed at a competitive disadvantage via a via their foreign counterparts. An extension of the carryover period to 18 years will create the equitable result of allowing U.S. taxpayers sufficient time to match their foreign tax credits to their U.S. tax on foreign source income and to reduce the significant tax costs to U.S. taxpayers caused by the application of a separate foreign tax credit limitation to the many categories of foreign source income under the 1986 Act. An extension of the carryover.period will also assure taxpayers of some certainty that their tax return audits will be closed before the foreign tax credits would otherwise expire. This extension is consistent with the objective of the foreign tax credit changes made by the 1986 Act: credits will continue to be available only to offset U.S. taxes incurred in respect to their applicable foreign tax credit limitation income basket In enacting the original provision for the carryover of foreign tax credits in the Technical Amendments Act of 1958, P.L. 85-866, Congress responded to concerns of double taxation caused by timing differences in reporting income in the United States and in the foreign country of operations. See H.R. Rep. N~. 775, 85th Cong., 1st Sess. 27-28 (1957). Such a concern has become more acute today. As noted above, the 1986 Act significantly expanded the foreign tax credit limitations. These limitations create a greater potential that timing differences between U.S. PAGENO="0526" 516 and foreign tax systems will prevent foreign tax credits from offsetting U.S. taxes on foreign income, resulting in double taxation. For these reasons, extension of the foreign tax credit carryforward period is not only warranted, but necessary. There is already precedent for such a change. In the Economic Recovery Tax Act of 1981, the carryover period for net operating losseS was extended to 15 years. For the same reason, API believes that the proposal should be modified to extend the carryback period for the credit from 2 to 3 years (applicable to credits generated in taxable years beginning after December 31, 1991). Such a change would be consistent with the carryback periods for the net operating loss and the business credit. 2. CARRYFORWARD OF PRE-1987 FOREIGN BASE COMPANY SHIPPING LOSSES The proposal would permit a pre-1987 foreign base company shipping loss of a controlled foreign corporation (CFC) to reduce post-effective date foreign base company shipping income of the CFC by allowing the carryforward of CFC shipping and other losses accumulated as of the effective date of the 1986 Act. The API supports this proposal. The 1986 Act substantially restricts the carryforward by CFCs of their shipping and other losses incurred after the 1986 Act's effective date (Internal Revenue Code section 952(c)). A post-1986 shipping loss, for example, may reduce Subpart F income earned by the CFC in later years only if that income derives from the same type of activity that gave rise to the loss, i.e., shipping. In addition, the 1986 Act prohibits the cSrryforward on any basis of CFC shipping and other losses accumulated as of the Act's effective date. Such losses may not reduce a CFC's post-effective date Subpart F income. The 1986 Act also repealed the reinvestment exception under which CFC shipping earnings reinvested in shipping operations were excluded from Subpart F taxation. The legislative history offers no rationale for the Act's blanket prohibition of the carryforward of pre-1987 CFC losses. The Technical and Miscellaneous Revenue Act of 1988 (TAMRA) reverses the prohibition for pre-1987 base company sales, services, and oil related losses, but not for shipping losses. The Joint Committee explanation of the technical corrections bill (at 280-81) defends the retention of the prohibition for shipping losses by stating that those categories of Subpart F income affected ~ shipping losses) generally avoided Subpart F taxation prior to the 1986 Act. Under the 1986 Act's Subpart F amendments, shipping losses of a CFC accumulated as of the Act's effective date are permanently lost, because pre-1987 losses, not utilized before 1987 to reduce Subpart F income, can never be so utilized. No sound policy basis exists for prohibiting the carryforward on any of pre-1987 shipping losses Shipping losses of a CFC could be carried forward to reduce its Subpart F income in later years under old law and may continue to be so carried under new law, albeit on a more restricted basis, if incurred after 1986. The 1986 Act's complete prohibition of the carryforward of shipping losses accumulated as of the end of 1986 is even harsher than the new law. Clearly, the prohibition is not an appropriate transition rule. TAMRA recognized this in the case of base company sales, services, and oil related losses. The distinction the Joint Committee explanation draws between those losses and shipping losses is faulty because, contrary to the assumption of the explanation, some pre-1986 Act shipping income was currently taxed under Subpart F. In any event, denying a CFC the use of pre-1987 Shipping losses as an offset against post-1986 shipping income is unfair because PAGENO="0527" 517 such losses arose in the course of active CFC àpe~rations, the expansion of which prior law - specifically, the reinvestment exception - encouraged. Taxpayers should not be penalized for incurring losses in operations that prior law tax rules gave taxpayers an incentive to enlarge. The repeal of the reinvestment exception itself seriously burdens CFC shipping activities. It is inequitable to compound that burden by prohibiting the carryforward of shipping losses that prior law iallowed CFCs to carry forward and new law also would so permit. 3. MODIFICATION OF CODE SECTION 956 RELATED TO THE CHARACTERIZATION OF SUCCESSIVE LOANS For purposes of section 956 of the Code, the proposal would retroactively revoke Revenue Ruling 89-73, l989-l~C.B. Z58. The principles of the Ruling would be inapplicable in determining whether two successive obligations or loans shall be treated as one obligation or loan. The API supports this-proposal. Revenue Ruling 89-73 addresses a situation where a CFC acquires obligations of its U.S. parent on February5, 1987; sells those obligations on November 15, 1987; and, subsequently purchases its U.S. parent's obligations on January 15, 1988 which it also sells to a third party later that year. The ruling holds that these obligations should be treated ~as a -single obligation for purposes of Code section 956, and, thus, represent an investment in U.S. property at the end of the CFC's--tax-able year (December 31,1987). This conclusion is based on the "brief period" between the termination of the CFC's first investment and-its entrance into the second. Revenue Ruling 89-73 also considers a CFC's acquisition-on February 1, 1987 of obligations of its U.S. parent that matured on June 30, 1987, and the CFC's acquisition of new obligations from its parent on January 15, 1988 and their sale in November of that year to a third party. The ruling holds that the period of time between the two obligations "is not brief compared to the overall period the debt obligations are outstanding." Therefore, the obligations are not considered to represent an investment in U.S. -property for purposes of Code-section 956 at the end of the CFC's 1987 taxable year. Revenue Ruling 89-73 purports to rely on the "substance over form" doctrine in reaching these holdings. Although Revenue Ruling 89-73 cites a number of case authorities, including Gregory v. Helvering, 293 U.S. 465 (1935), in support of the application of the "substance over form" doctrine to .iiivestments in U.S. property under section 956 and. insists that a review of all the facts and -circumstances is necessary, it fails to examine other evidence regarding the two loans, such as the reasons for their acquisition and sale. The ruling bases its holding solely on the length of the interval between the two obligations, as compared to the time the CFC held the obligations. In failing to examine other facts and circumstances, Revenue Ruling 89-73 seems to establish a new substantive rule which treats more than one obligation as a single loan for purposes of section 956, depending on the length of the interval between the tow loans. The API can find no support for such a rule in section 956, regulations thereunder, or the case and ruling precedent. If, however, it is not completely revoked, Revenue Ruling 89-73 should, at least, be made prospective as proposed. 4. EXCEPTIONS TO THE PASSIVE FOREIGN INVESTMENT COMPANY (PFIC) RULES Under a proposal, certain corporations with substantial manufacturing operations in a foreign country with a trade deficit with the United States would not betreated as passive foreign investment companies. Another proposal would exempt certain pre-1986 Act shareholders of certain publicly-traded companies.from the PFIC rules. In addition, certain anti-avoidance provisions would not apply to the appreciation in PAGENO="0528" 518 PFIC stock that is allocable to a taxpayer's holding period prior to effective date of the PFIC rules. The PFIC provisions should be applicable only to foreign corporations which would otherwise have U.S. tax deferral on passive income. Cf. General Explanation of the Tax Reform Act of 1986 p. 1021, noting under Reasons for Change that "Congress believed current taxation was more appropriate than continuation of deferral of tax on income derived from passive assets Controlled foreign corporations are subject to the complex and detailed Subpart F rules of the Code which cause the immediate U.S. taxation to the U.S. shareholder of passive income and other foreign base company income of the CFC. Therefore, the PFIC rules need not, and should not, apply to U.S. shareholders of CFCs. Also, the PFIC provisions should not apply to a foreign corporation which has a deficit in earnings and profitsorno taxable income. A foreign corporation actively engaged in manufacturing, natural resource exploration and production, marketing or service activities may experience a period(s) with losses from active business operations, but small amounts of gross passive income are earned on cash (which is treated as a passive asset under the PFIC rules, see Notice 88-22, 1988-11 I.R.B. 19, 20) and, therefore, the foreign corporation would be a PFIC. The definition of a PFIC should be modified to exclude foreign corporations with a deficit in earnings and profits or with no taxable income for the taxable year. PAGENO="0529" 519 0 Iliillilunifuti Iiimpwtq SERVING THE ENERGY INDUSTRIES WORLDWIDE Jack R. Skinner Vice President - Taxes February 19, 1990 Mr Rob J. Leonard Chief Counsel, Committee on Ways and Means U.S. House of Representatives 1102 Longworth House Office Building Washington, D.C. 20515 Dear Mr. Leonard: SELECT REVENUE MEASURES SUBCOMMITTEE SUBMISSION OF WRITTEN TESTIMONY On behalf of Halliburton Company (Halliburton), the following is submitted as written testimony for the reàord of the House Ways and Means Select Revenue Measures Subcommittee hearings of February 21 and 22, 1990. Halliburton Company greatly appreciates the opportunity to comment with regard to the matters under consideration and would be happy to discuss any of the matters at greater length. Extension of carryforward period for creditable foreign taxes It is the opinion of Halliburton that it would be both appropriate and desirable to extend to fifteen (15) years the carryforward period for creditable foreign taxes, for the following reasons: Double Taxation. The central concept in the allowance of the foreign tax credit is the elimination of the double taxation of foreign-sourced earnings of U.S. taxpayers. In the current global economic situation, many U.S. taxpayers have incurred significant domestic operating losses while generating foreign operating earnings. Given the length of economic cycles, it is possible (if not likely) that creditable foreign taxes will expire prior to their utilization by the taxpayer, given the current short carryforward period. Assuming that the taxpayer's domestic operation will recover its losses at a later point in time, the expiration of creditable foreign taxes will cause the taxpayer to be double taxed on its foreign income. The extension of the carryforward period would serve to reduce the likelihood of expiration of creditable taxes, hence reducing the incidence of double taxation of foreign earnings of U.S. taxpayers. 3600 LINCOLN PLAZA 500 NORTH AKARD STREET DALLAS, TEXAS 75201-3391 214/978-2600 PAGENO="0530" 520 Subsidiary/Branch neutrality The relatively short carryforward period for creditable foreign taxes creates an artificial incentive for a U.S. taxpayer to utilize the corporate form (a "controlled foreign corporation" or "CFC") for its overseas operations, as opposed to operating as a branch in the foreign jurisdiction. Operating as a CFC allows the U.S. corporation to achieve `deferral' of the recognition of foreign operating earnings by timing the repatriation of those earnings as actual or deemed~ dividends. In this manner the taxpayer corporation can `average' high-taxed and low-taxed foreign earnings to achieve complete elimination of double taxation of those earnings. If operating as a branch, however, the taxpayer has neither control over the recognition of foreign operating earnings nor the ability to effectively average the burden of creditable foreign taxes in the foreign earnings stream, other than by carryforward of excess credits. In 1960 and 1976, the Congress made an affirmative choice to allow the averaging of foreign earnings for purposes of the foreign tax credit. In 1986, consideration was given to the possibility of returning to the country-~by-country method of computing the foreign tax credit limitation; it was however, rejected. Although massive changes were made in the 1986 Tax Act with respect to foreign tax credit limitations, it remains clear that averaging is a valid and desirable concept. The obvious assumption is that U.S. taxpayers should not be burdened by double taxation on their overall foreign operating income. By lengthening the carryforward period for the foreign tax credit, the prejudice toward using CFC's, and against using branches, for foreign operations as a means of .achieving averaging should be greatly reduced. To the extent possible, the decision of operating form in foreign jurisdictions should be made in an environment as free from nonoperational concerns as possible. Corporations which operate as CFC's abroad bear great risks with respect to their investment therein. Deferring repatriation of CFC earnings in order to achieve foreign tax credit averaging, or to avoid loss of foreign tax credits, can create an increased currency exposure for the earnings-of the U.S. taxpayer/shareholder. In addition, deferring repatriation aggravates the imbalance of cash flows between the U.S. and its trading partners. The deferral of repatriation causes increased borrowing in the U.S. by the shareholders of the CFC's, increasing the already high debt incurred by U.S. corporations. Lengthening the carryforward period will PAGENO="0531" 521 serve both to (1) reduce the inclination to operate abroad as a CFC and (2) reduce the tendency of CFC's to defer repatriation of earnings to achieve averaging. Revocation of retroactivity of Revenue Ruling 89-73 It is the opinion of Halliburton that the retroactive application of Revenue Ruling 89-73 (the Rev. Rul.) should be legislatively revoked. The Rev. Rul. creates a clear expansion of the scope of the statute. In this particular case, there is reason for great concern, for reasons of both equity and policy. During the period to which the Rev. Rul. appears to apply, taxpayers relied upon the clear and unambiguous language Of the statute in structuring their transactions and affairs. In addition, during the period there were final regulations in place upon which taxpayers relied. In making what amounts to a retroactive change in the treatment of transactions during the period, IRS flies in the face of both statute and regulations. As a matter of equity in the interpretation and enforcement of the taxing statutes, it seems at best inappropriate that IRS should attempt, through `legislative interpretation', to change the basic framework upon which taxpayers transacted their business in prior years. The economic health and vitality of the U.S. depend, in part, upon a stable environment in which to do business. The retroactivity of the Rev. Rul. threatens that stability... As a matter of policy, the IRS is clearly overstepping its bounds with the issuance of the Rev. Rul. In the presence of clear and unambiguous statutory language, as well as final regulations which had been established and operative for some period of time, it is unthinkable that the IRS attempt to implement retroactively, through the issuance of the Rev. Rul., a test more strict than that intended by the Congress and embodied in the regulations. It is clear that the IRS has the authority to examine taxpayers' returns for each of the prior periods to which the Rev. Rul. may apply. That authority, combined with the existence of statute and regulations during such periods, should be sufficient to * allow the IRS to deal with prior years' transactions. The IRS should not attempt to avoid by administrative fiat the responsibility to review each prior transaction on its facts and circumstances PAGENO="0532" 522 Exceptions to the passive foreign investnent company (PPIC) rules Halliburton is in favor of the proposal which would provide that ~zx~eLtain corporations which engage in substantial manufacturing apei~ations in a fot~eign country which has a~deficit in its trade balance with the US.~wou1&be excluded from the PFIC provisions. In general, the provisions with respect to.PFIC's are an example of attempting to kill fli~es~with a shotgun. In order to put a. ..~rz~hàlt to~a~perceived abuse by a small group of companies, .~d egisl~ti~n~JaS~2eflacted:Which applies to a wide spectrum of -~compa~es~h±ch~ither (t) have nothing passive about them or (2) were already fully controlled in their deferral mechanisms by the provisions of the Subpart F rules. With respect to this particular case, the provision would allow a manufacturing company which leases its plant and equipment on an operating lease basis to operate in selected jurisdictions ~.without bé±i~g~classified as a PFIC due to running afoul of the. ~ this an appropriate result, but it ~oesn~t~go ~f~ar~aenouqh~±n resolving a major flaw in the PFIC ~rutes~~Any company whith is engaged primarily ma valid manufacturing activity~overseas should be exempt from the PFIC rules. Look-back method for long-term contracts It is the opinion of Halliburton that the look-back rule should be revised to eliminate its application to amounts received after the contract completion date as a result of disputes, litigation or settlements related to the contract, for the following reasons: . Administrative complexity In cases where long-term contracts result in deferred settlement as the result of disputes and disagreements, the eventual outcome can take several years to work its way out. It is unrealistic to put upon the contractor a burden of attempting to maintain `open' accounting for an unlimited number of contracts for a period of dispute which can easily run over ten years for a major piece of work. This is truly a paper and accounting nightmare. . Tax influence of business decisions In all of legitimate U.S. business enterprise, it is considered inappropriate to make decisions based upon tax impacts. However, by stretching out the look-back period to include disputed amounts, this result can easily be obtained. Given the relatively high rates of interest on prior years' PAGENO="0533" 523 `underpayments' in the look-back rules, it is easily conceivable that the amount of additional tax and interest to be paid upon settlement could exceed the amount of the settlement to be received. In such a case, an appropriate economic decision would be to walk away from the settlement; the tax law should not force this type of a decision or lend a `lever' to a party to a contract. Adverse parties.~ In the negotiation and dispute of contract terms, payments, etc., the parties are definitely adverse in the transaction. In dispute, the parties go to significant effort and expense to further their cause. The concept of these two parties conspiring to achieve a better tax answer is invalid. * ~* * *~ * Again, Halliburton Company appreciates the opportunity to provide written testimony with respect to the issues discussed above. If you have any desire to discuss any of these issues at greater length or desire further input, please call me at (214) 978-2600. R~sPectfully submitted, Jack R. Skinner PAGENO="0534" 524 Salomon B~thevs mc March 8,~ 1990 STATEMENT OF SALOMON BROTHERS INC REGARDING MISCELLANEOUS TAX PROPOSALS REFERRED TO THE SELECT REVENUE MEASURES SUBCOMMITTEE This statement is submitted by Salomon Brothers Inc for inclusion in the record of a hearing before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means on February 21-22, 1990 concerning certain miscellaneous tax proposals. Salomon's comments deal principally with the implications of the proposals for multinational securities businesses. The Subcommittee should be commended for its continued willingness to consider measures to alleviate the burdens created for multinational businesses by the Tax Reform Act of 1986. Although the proposals now under consideration might be criticized as piecemeal remedies that.do not address the fundamental problems created by the 1986 Act, they do provide some relief. The comments below are intended to ensure that the proposals under consideration operate fairly and effectively, without prejudice to the eventual need for a careful reevaluation of the United States tax rules applicable to U.S. companies with foreign business operations. In brief, Salomon: Supports the proposal to introduce an active financing exception to the definition of foreign personal~ holding company income, and advocates the adoption of a uniform exception for purposes of the rules governing controlled foreign corporations and foreign personal holding companies; * ~~4Qp~5~5 the proposal that the active financing ~~:~~cception be conditioned on satisfaction of a high- ~~z~taxed income test; Believes that any change in the interpretation or application of section 956 should be based on clearly articulated standards rather than on an essentially discretionary test, and should be prospective; Believes that the PFIC rules should not apply to controlled foreign corporations. Any more limited relief from the PFIC rules provided by Congress should be made available to all similarly situated taxpayers ,~ and should not be provided only to manufacturing companies; and Supports the extension of the foreign tax credit* carryover period to 15 years. PAGENO="0535" 525 BACKGROUND The 1986 Act significantly increased the effective tax cost of conducting an active business outside the United States for many U.S. taxpayers. In their efforts to curtail marginal abuses and achieve technical precision, the drafters of the 1986 Act lost sight of the paramount importance of practicality and fairness. In light of the increasingly competitive world economy, and the continuing efforts to integrate and rationalize the tax systems of EC member states in anticipation of 1992, the United States can ill afford a tax system that prices U.S. competitors out of the global marketplace. The 1986 Act has had particularly grave consequences for the international competitive position of the U.S. securities industry, principally because of the following special characteristics of multinational securities firms: Securities firms do not have the flexibility, available to many other U.S. businesses, to situate foreign business operations in low-tax jurisdictions. The effective conduct of an international securities business requires securities firms to base their principal foreign business operations in high-tax international financial centers such as London and Tokyo. Securities firms are subject to complex and rigorous non-tax regulation, and therefore cannot easily respond to changes in U.S. tax rules by changing the structure of their foreign operations. For example, securities firms frequently are required by local regulation to conduct a single integrated securities business in a single foreign country through a number of separately incorporated subsidiaries, which in the absence of an effective U.S. tax consolidation rule can produce unfair results Securities dealers necessarily operate on a highly leveraged basis. As a result, the mechanical application of interest allocation rules to U.S. securities firms can produce irrational and arbitrary distortions of the true cost of doing business overseas Foreign subsidiaries of U.S. securities dealers earn U~S. source income in the ordinary course of their business activitiCs (for example, in connection with acting as an underwriter and marketinakér for Eurobonds). As a result, the survival and continued * application to securities firms of resOurcing and special characterization rules for portfolio interest income -- after other legislative changes have effectively eliminated the policy rationale for these rules -- pose special problems for the foreign tax credit position of securities dealers. PAGENO="0536" 526 DISCUSSION OF LEGISLATIVE PROPOSALS 1. Treatment of Certain Interest Earned by Brokers or Dealers for Purposes of the Foreign Personal Holding Company Rules Prior to 1986, income derived in the active conduct of a banking, financing or similar business was excluded from the definition of foreign personal holding company. income for subpart F purposes. Securities firms and banks thus were treated equally with manufacturing and service enterprises, which are not subject to U.S. taxation on active business income derived by foreign subsidiaries until the income is repatriated to the United States. The 1986 Act eliminated the banking, financing or similar business rule. The change under consideration by the Subcommittee would restore an exclusion for certain active financing income derived by broker-dealers, but only for purposes of the foreign personal holding company rules of section 553, and only if the taxable income of the broker-dealer is subject to foreign tax at an effective rate greater than 90 percent of the U.S. rate. Salomon believes that the active financing exclusion should be restored for purposes of section 954 as well as section 553, and that the exclusion should not be subject to the condition that income has been subject to high foreign taxes, for the reasons set out lielow. A. Restore exclusion for subpart F purposes. The policy considerations that underlie the proposal to create an active financing exception to the definition of foreign personal holding company income for purposes of section 553 (the rules governing foreign corporations controlled by five or fewer U.S. individuals) apply with equal force to the definition of the same~term for purposes of section 954 (the rules governing foreign subsidiaries of U.S. companies). In.order to achieve evenhanded U.S. tax treatment of similarly situated taxpayers, coordinated legislative changes to secti~ons 553 and 954 should be made. Congress eliminated the exclusion for active financing income in an effort to curb abusive .claims.to the exclusion by passive investment vehicles owned by nonfinancial businesses. Although the Senate version of the legislation that became the 1986 Act would have preserved an exclusion for £j~g active financing businesses, the exclusion was eliminated in its entirety in conference because of the perceived difficulty of drawing an effective line between genuinely active securities firms and passive investment vehicles. The resulting change eliminated opportunities for abuse by persons n~ in an active financial services business, but at the expense of a severe and unfair burden on the international business activities of ~ £i~ securities firms. No policy justification exists for treating active securities businesses less favorably than manufacturing or service companies. PAGENO="0537" ~527 Developments since the 1986 Act confirm that the Internal Revenue Service can draw effective lines between active fi~ancial services enterprises and passive investment vehicles. Reinstatement of an exclusion for active financing income -- if appropriately limited to financial services entities that are members of financial services groups -- would restore equitable treatment for legitimate securities firms without undermining the 1986 Act's objective of precluding abusive transactions. B. The exclusion should not be conditioned on satisfaction of a high-tax requirement. As proposed for purposes of section 553, the exclusion for active financing income would apply only if income eligible for the exclusion is subject to foreign incone tax at an effective rate greater than 90 percent of the maximum U.S. rate. Unless and until the subpart F provisions are modified to take account of foreign tax consolidation principles, we believe that conditioning the availability of the exclusion ~n meeting such a high-tax requirement would be inappropriate. The existing exclusion for income subject to high foreign taxes, now provided for all classes of foreign personal holding company income in section 954(b) (4), fails to achieve its intended objective when applied to securities dealers. Although the foreign operations of U.S.. securities dealers generally are located in high-tax jurisdictions and are in fact subject to high~ foreign taxes, such dealers frequently derive no benefit from the high-taxed income exclusion. Foreign regulatory considerations often make it necessary to conduct a single integrated financial services business through a number of separately incorporated subsidiaries. Although such subsidiaries often are eligible for "group relief" or other foreign tax consolidation rules, each subsidiary is treated separately for purposes of the 90 percent test. In today's competitive and rapidly changing business environment, even very profitable securities businesses can incur losses in one or several business segments. For See, for example, the definition of "financial services entity", and particularly the special rule for affiliated groups, in Treasury regulation section 1.904-4 (e) (3), which applies for purposes of sections 904 and 952. 2 Moreover, no other class of local source active business income is required to satisfy a high-tax requirement as a condition to exemption from the subpart F rules. Salomon believes that restoring parity of treatment between active securities businesses and all other businesses is an important and desirable policy objective. There is no reason to impose more stringent requirements on active financial income than on manufacturing income. PAGENO="0538" 528 example, an integrated U.K. securities business conducted by several operating~ subsidiaries of a U.S. parent company may operate on a break-even basis (and thereby incur no U.K. tax liability) because losses from one subsidiary can be applied to reduce income earned by other subsidiaries for U.K.. tax purposes. Under present law, subpart F income .of the profitable members of the group will fail to. qualify for~ the high~~.taX exclusion provided by section 954(b) (4) because (viewed on a company-by-company basis) the profitable members earned income and paid no foreign taxes. The chain deficit rule was reenacted in 1988 to address similar problems. In its present form, however, it does not.provide meaningful relief. Section 952 (c) (1) (C) .permits- losses realized by one subsidiary to be applied against income earned by another subsidiary only if the two companies are linked in a vertical chain of ownership, and not when income is earned and an offsetting loss is incurred by sister. companies~ A~ active U.K. securities business may be structured, in order to comply with U.K. regulatory and tax requirements, as a parent .holding~cOmpafly with half a dozen or more directly owned. operating~isubsidiarieS. Significant relief could be provided by modifying the chain deficit rule (i) to permit losses incurred by one subsidiary to be used to reduce income realized by a sister company and (ii) to confirm that losses realized by a parent hothing company with no substantial business activities can be applied under the chain deficit rule against income earned by operating subsidiaries. Alternatively, Congress could provide that the 90 percent test may be applied on a consolidated basis to a group of foreign corporations conducting an integrated business in a foreign. country if the group files the equivalent of consolidated returns for foreign tax purposes. 2. Characterization of~Successive Loans (Section 9561 Under sections 951(a) (1) (B) and 956, a U.S. shareholder of a controlled foreign corporation is subject to current taxation on its pro rata share of the foreign `corporationts increase in earnings invested in "United States property." United States property for this purpose . includes obligations issued by a U.S. shareholder of the controlled foreign corporation. The amount of any increase in earnings invested in U.S. property `is measured "at the close of the taxable year." - Many responsible taxpayers and tax advisers relied on that apparently clear statutory language in concluding that investments in U.S. property should be measured at the close of the taxable year and not at any other time. Accordingly, U.S. parent companies structured arrangements with their foreign subsidiaries to~ ensure that the subsidiaries did not . hold parent company obligations at the close of the taxable year. Until recently, there was no indication that the Internal RevenueSerViCe disagreed with this reading of the statute. PAGENO="0539" 529 In Revenue Ruling 89-73, the Service applied a substance over form analysis to conclude that the "brief period" between a foreign subsidiary's sale of one debt obligation, on November 15 and its purchase of another debt obligation on January 15 should be disregarded. Under this approach, the subsidiary was deemed to hold parent debt obligations on December 31 for purposes of section 956. The ruling concluded that a six-month period (from June 30 to January 15) was not brief and would not be disregarded. The proposal under consideration by the Subcommittee would make Revenue Ruling 89-73 apply only prospectively. Salomon believes that significant changes in the interpretation and application of the tax law should be made prospectively, and therefore supports the proposal. In addition, Salomon believes that a policy-oriented application of section 956 unaccompanied by any meaningful guidelines will make it difficult for many multinational businesses, and particularly securities firms, to ascertain and correctly report their taxable income. Effective cash and liability management is fundamental to the successful operation of a multinational business. Every multinational group seeks to deploy cash that is not needed in one jurisdiction to satisfy funding requirements in another jurisdiction. Intercompany loans are essential to intelligent group cash management policy, and are the norm rather than the exception. In the case of a securities firm, the typical maturity for an intercompany extension of credit may be as short as one day. A foreign subsidiary may be a substantial net borrower from a U.S. parent on one day and a substantial net lender on the. next. Because intercompany payment Obligations can arise in connection with a diverse variety of transactions in the ordinary course of business, a parent may hold debt claims against a foreign subsidiary at the same time that the subsidiary hold unrelated debt claims against~the parent. - (These matching assets and liabilities generally may not be netted for purposes Of section 956.) Such intercompany obligations further legitimate business objectives having nothing to do with United States taxes. In view of the complexity and diveràity of intercompany funding arrangements, and the absence of any tax avoidance motive for many such arrangements, a bright-line test is required for the effective administration of sectiOn 956. If Congress ratifies the Internal Revenue Service's rejection of the year-end "snapshot" approach prescribed by section 956, it should adopt an alternative standard that U.S. taxpayers can interpret and apply, rather than the standardless and essentially discretionary test of Revenue Ruling 89-73. PAGENO="0540" 530 3. Exception to PFIC Rules for Manufacturing A foreign corporation generally will be characterized as a passive foreign investment company if 75 percent or more of its gross income is passive income (the "income test") or 50 percent or more of its assets are held for the production of passive income (the "asset test"). Passive income for this purpose is any income of a kind that would be foreign personal holding company income as defined in section 954 (C). Special exceptions from the PFIC rules are available to banks and insurance companies. The proposal under consideration by the Subcommittee would exempt from the asset test any controlled foreign corporation that engages in substantial manufacturing or* production activities in a foreign country which has a deficit in its balance of trade with the United States. Salomon continues to believe that no policy interest is served by applyinq the PFIC rules to controlled foreign corporationsiand supports the elimination of this unnecessary and. burdensome overlap between the subpart F and PFIC rules. However, to the extent more limited relief is contemplated, it should not be provided only to companies engaged in manufacturing or production activities. Any special exemption should be available to all controlled foreign corporations actively engaged in business in trade-deficit countries, including securities dealers. 4. Extension of Carryforward of Foreign Tax Credits Under present law, foreign tax credits in excess of the current-year limitation may be carried back for two years and carried forward for five years. The proposal under consideration by the Subcommittee would extend the carryforward period to. fifteen years. Salomon supports the proposed extension. The 1986 Act severely restricted the ability of many U.S. companies to make effective use of foreign tax credits. Extending the carryover period might at least give U.S. companies some hope of eventually being able to utilize credits, and thereby would provide partial relief from the unfavorable consequences of the 1986 Act for U.S. multinationals. PAGENO="0541" The Honorable Charles B. Rangel Chairman, Subcommittee on Select Revenue Measures Committee on Ways and Means U.S. House of Representatives 1135 Longworth House Office Building Washington, D.C. 20515 Dear Chairman Rangel: On behalf of Tax Executives Institute, I am pleased to provide the following comments on several revenue issues on which the Subcommittee on Select Revenue Measures held hearings on February 21 and 22, 1990. Background Tax Executives Institute (TEl) is the principal association of corporate tax executives in North America. The Institute's 4,300 members represent approximately 2,000 of the largest companies in the United States and Canada, and are responsible for coping with the tax laws -- from both a planning and a compliance perspective -- on a day-to-day basis. TEl represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting uniform and equitable enforcement of tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayer and government alike. As a professional association, TEl is firmly committed to working with the government in developing and maintaining a tax system that works -- one that is 531 Tax Executives Institute, Inc. Plnan~Ane., NW., Suite 320 Washington, D.C. 20004-2505 Telephone: 2021638-5601 Telecopier: 202/638-5607 March 9, 1990 Re: Miscellaneous Revenues Issues Considered at February 21-22, 1990, Hearings OFFICERS 1989.1990 President WILLIAM M. BURK CPC International Inc. Engfesoood Cliffs, NJ Senior Vuo President MICHAELJ. BERNARD Mobil Corporation New York,NY Secretary REGINALD W.KOWALCHUK The Back of Noca Scotia Toeottto,ON ROBERT H. PERLMAN Itttel Coepoeation Santa Ciara, CA Vice President -Region JAMES HIJTCHISON IBM Canada Ltd. Markham, ON Vice Presidestt.Region It DONALD 0. COUSTRA American Beands, Inc. Old Geeenscich, CF Vice Pretident-Region III PAUL H. FREISCHLAG, Jr. The Stop & Shop Companies, Inc. Beaintree, MA Vice Pretident-Region W GEORGE J. LEWIS The Haeta Mountain Corp. Haeruon, NJ Vice President-Region V ALBERT W. LUDLAM, Jr. Bureonghs WeEcome Co. Reneaech Triangle Path, NC Vice President-Region VI LARRY B. PECK The Kruger Co. Cincinnati, OH Vice President-Region Vll ARTHUR L. BANNERMAN National Car Rental System, Inc. Minneapolis, MN Vice President-Region VIII MICHAEL L. BROWNING International Coffee Corp. New Orleans, LA Vice President-Region IX MARTYJ. BRANDT Talley Industries, Inc. Phoenix, AZ Eoeculice Director THOMAS P. KERESTER Washington, DC Tax Counsel TIMOTHYJ. McCORMALLY Washington, DC PAGENO="0542" 532 consistent -with solid tax policy, taxpayers can comply with, and the Internal Revenue Service can audit. Foreign Tax Credit: Carryback and .Carryforward Rules (Item A.1.) TEl supports the enactment of legislation to lengthen from 5 to 15 years the carryforward period in respect of foreign tax credits. As explained below, we further recommend that the carryback period in respect of such credits be lengthened from 2 to 3 years and that the ordering rules for foreign `tax credits be modified to permit any carryover credit to be taken into account before the current year's credit. 1. Description of the Problem. Current law provides that any foreign tax credits (FTC5) not used against U.S. tax in the current year may be carried back 2 years and forward 5 years. The rUles for the general business tax credit (section 39) and net operatinglosses (section 172(b)) provide, however., for a 3- year carryback and a 15-year carryforward. The effect of the shortened time periods has--i-been to cause FTC5 to expire unused, thereby frustrating the ~xurese of the credit -- the prevention of double taxation. There is no- readily apparent policy reason for the harsher rules in the foreign tax credit area. In fact, when originally enacted as part of the .1954 Code, the carryback/carryforward provisions in respect of the net operating loss (NOL) and the FTC we-re identical -- t~io. ears back and five years forward. - Although the rules ha-ye been liberalized several times for net operating losses since 1954 (most recently in 1981 as part of the - Economic Recovery Tax Act), the FTC provisions have been ignored. In addition, the-ordering rules for FTC5 require that the current year's credits be utilized before any~car.ryovers are taken into account. By contrast, in respect of ~the general business tax credit, a carryover is to be used first, before the current year's credits, to afford the taxpayer the maximum opportunity for using the credit. - The current rules effectively penalize taxpayers that experience operat±ng losses, thereby creating a windfall for the federal governmen±~'that may "collect" a sitbstantial portion (if not all) of the~FTGs previously earned and claimed because of the unduly short.carxyback/carryfOrward period. Current law effects an especially harsh result in respect of taxpayers in -cyclical - industries whose ability to utilize FTC5 is~1imited because of income fluctuations. PAGENO="0543" 533 2. Response to the Treasury Department's Testimony. In its February 21 testimony, the Treasury Department opposed the proposal to conform the foreign tax credit carryforward period to that for net operating losses on the ground that the purpose of the foreign tax credit is more "limited" than the purpose of the Code's NOL provisions. TEl respectfully disagrees. The purpose of the foreign tax credit -- to ensure that a second tax is not exacted on income already subject to taxation -- is, or should be, of paramount importance as a matter of tax policy. Prevention of double taxation is especially important given Congress's well-founded concern over the effect of U.S. tax rules on the ability of American business to compete internationally. 3. TEl Recommendation. TEl recommends that the foreign tax credit carryback/carryforward periods be extended to conform with the periods allowed for net operating losses and general business tax credits (i.e., 3 years back and 15 years forward). In addition, the ordering rules for utilization of foreign tax credits should parallel the general business credit rules: any carryover credit should be taken into account before the current year's credit. TEl submits that adoption of its recommendations would limit those situations where the purpose of the foreign tax credit-- the elimination of double taxation -- is frustrated by unrealistically short carryback and carryforward periods. Amendment of Passive Foreign Investment Company Rules (Item A.5) TEl supports legislation to amend the passive foreign investment company (PFIC) rules of the Internal Revenue Code. Specifically, we believe that controlled foreign corporations (CFC5) subject to taxation under Subpart F of the Code should be exempted from the reach of the PFIC provisions. Alternatively, the so-called asset test for determining PFIC status should be refined to ameliorate the heavy compliance burdens imposed by the unexpectedly broad PFIC rules. 1. Description of the Problem. The PFIC rules, which were enacted as part of the Tax Reform Act of 1986, were intended to remove the economic benefit of tax deferral and the ability to convert ordinary income to capital gain which was available to U.S. investors in foreign investment funds. In addition, in enacting the PFIC rules Congress was also concerned that the tax rules not provide incentives to make investments outside the United States (current taxation is the order of the day for passive investments in the United States). PAGENO="0544" 534 a. Source of the Problem: The Definition of a PFIC. The definition of a PFIC is so broad that many corporations with active businesses have been classified as PFIC5, even in situations where the foreign corporation is subject to high rates of foreign tax. More fundamentally, foreign subsidiaries of U.S. companies (CFCs) are already subject to Subpart F of the Code, which governs when the income of foreign subsidiaries will be currently taxed even though such income is not repatriated by the U.S. parent company. Under current law, a foreign corporation is a PFIC if, for any taxable year, either -- o 75 percent of its gross income consists of passive income, or o at least 50 percent of the average value of its assets produce, or are held to produce, passive income. In addition, a look-through rule provides that if a foreign corporation owns 25 percent of the value of the stock of another corporation, that foreign corporation is treated as if it held its proportionate share of the assets of such other corporation and received directly its proportionate share of the income of such other corporation. Combined with the look-through rule, the gross-income and assets test creates a tremendous compliance burden for corporate taxpayers. First, corporate taxpayers must analyze both the income and assets of their active foreign subsidiaries. In addition, because of the look-through rule, the income and assets of lower-tier subsidiaries must be attributed to higher- tier subsidiaries, thereby compounding and complicating the analysis process. There are also definitional problems with. respect to both tests. For example, the income test is based upon gross income. An operating company could realize a loss from operations but, because it has passive income, be classified as a PFIC. The asset test is cumbersome because corporate taxpayers must periodically analyze the assets of their foreign subsidiaries to see if such subsidiaries meet the definitional test. Since the test is one of "average percentage," this analysis cannot be done on a year-end basis. b. The Result: Enormous Administrative Burdens. Even a corporation with a. modest number of active subsidiaries is required to devote substantial time to analyzing the applicability of the PFIC rules. For example, one TEl member, with only 30. active subsidiaries, devotes between 300~ and . 400 PAGENO="0545" 535 hours per year to such analysis. Obviously, the larger the number of a company's foreign subsidiaries, the larger and more complex its compliance burden. More to the point, such a compliance burden is unwarranted, particularly in connection with CFC5 whose shareholders must currently include the CFCs' Subpart F income in their income. The PFIC rules stand as an excellent example of overkill -- taxing not only passive income but also the operating income of foreign corporations. 2. Response to the Treasury Department's Testimony. In its February 22 testimony, the Treasury Department opposed the two specific PFIC reform proposals before the Subcommittee. At the same time, however, the Treasury expressed its continuing "concern about the scope and operation of PFIC regime." We respectfully submit it is time to translate the Treasury Department's long-expressed concern into concrete proposals for reform. Thus, in view of the Treasury Department's reservations about the proposals before the Subcommittee, the Treasury should be asked to comment on oth.er alternatives (such as those set forth below) or develop its own proposal. 3. TEl Recommendation. TEl recommends~.that the PFIC rules be amended to exempt CFCs, thereby reinstating an exemption originally included in the Senate version of the 1986 Act. Alternatively, Congress could eliminate the assets test altogether, narrowly crafting anti-deferral rules in respect of those companies that are not subject to Subpart F. One approach would be to couple. elimination of the asset test with the adoption~ of a modified incOme test (possibly paralleling that contained in the Code's foreign personal holding company provisions~s. Adoption of the Institute's recommendations will ameliorate ~substantial compliance burdens without doing violence to the congressional intent underlying the PFIC provisions. Repeal of Rev. Rul. 89-73: Treatment of Short-Term Loans under Section 956 (Item A.3) TEl supports legislation that would preclude the Internal Revenue Service from applying Rev. Rul. 89-73, 1989-1 C.B. 258, which relates to the treatment of short-term loans under section 956 of the Internal Revenue Code, on a retroactive basis. 1. Description of the Problem. Section 956 of the Code provides that U.S. shareholders of controlled foreign corporations are taxable on theIr pro rata shares of the CFC's. annual increase in its "investment in U.S. property," which includes debt obligations of U.S. persons. Temporary regulations issued by the IRS in June 1988 eliminate a 30-860 0 - 90 - 18 PAGENO="0546" 536 longstanding "one-year" rule which provided that, for purposes of determining the amount of.aCFC's earnings invested in "United States property," the definition of such property does not include a debt obligation of a related domestic corporation that either (a) is collected within o'ne year from the time it is incurred, or (b) matures within one year from the time it is incurred (but is not collected within such period solely by reason of the inability or unwillingness of the debtor to make payment within such period). The regulations apply in respect of investments made on or after June 14, 1988 -- the day after the regulations were issued. In Rev. Rul., 89-73, the IRS sets forth two examples addressing the circumstances under which a loan from a CFC will be deemed to be outstanding on the last day of the taxable year (even if the loan has been repaid). Specifically, the ruling considered when~ successive loans -- neither of which was outstanding at the end of the year -- should be collapsed for purposes of section 956. Because the ruling did not specify that it would be applied on a prospective-only basis, it applies to all open tax years. The effect of Rev. Rul. 89-73 is to disregard the language of section 956, which measures an investment in U.S. property "at the close of the taxable year." In addition, the ruling ignores congress's intent -- evidenced by the legislative history of the Revenue Act of 1962 -- to provide an exception from taxation for "normal commercial practices," which we submit includes short- term loans undertaken as a legitimate debt management tool. We submitthat such loans area far cry from the indefinite, long- term repatriation of earnings envisioned by Congress in enacting section 956. Finally, we believe the ruling can be properly criticized as,a back-door repeal of the one-year rule for years prior to the stated effective date of the 1988 regulations. The legislative proposal before the Subcommittee addresses not the IRS's authority to change its interpretation of section 956 (though we suggest such an issue is properly within Congress's purview), but rather the propriety of doing so on a retroactive basis. TEl submits that the retroactive application of Rev. Rul. 89-73, -- to years even before the issuance of the 1988 temporary regulations -- is improper. 2. Response to' the Treasury Department's Testimony. In its February 22 testimony, the Treasury Department opposed the legislation, arguing that the ruling represents a correct * interpretation of section 956 and, further, that the ruling is essential to prevent significant taxpayer abuses. The Treasury * Department acknowledged, however, that section, 956 had been a matter `of dispute for some years and recommended that Congress PAGENO="0547" 537 consider whether a statutory clarification is necessary. We submit that such an acknowledgement undercuts the Treasury's position that the Rev. Rul. 89-73 is correct. More fundamentally, we submit that retroactive application of the ruling cannot, by its very nature, deter perceived abuses; the transactions to which the retroactive ruling would apply have already occurred. 3. Recommendation. Absent a Treasury and IRS decision to apply Rev. Rul. 89-73 on a prospective-only basis, TEl recommends that legislation prohibiting the retroactive application of the ~ruling be enacted. * * * Tax Executives Institute appreciates the opportunity to present its views on the issties~ under consideration by the Subcommittee on Select Revenue 4Meaauxes and would be pleased to answer anyquestions you mayiiaveábout its position. In this regard, please do not hesitate to call either Bernard J. Jerlstrom, chair of TEl's International Tax Committee, at (216) ~4~34~42OO (ext. 2163) or the Institute's, professional staff .~(2Di~mothy J. McCormally or Mary L. Fahey) at (202) 638-5601. Respectfully submitted, TAX EXECUTIVES INSTITUTE, INC. By: _____________________________ William M. Burk International President PAGENO="0548" 538 WRITTEN STATEMENT OF GARY L. CONKLING DIREd]~OR PUBLIC AFFAIRS, TEKTRONIX, INC. BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES OF THE HOUSE COMMITTEE ON WAYS AND MEANS March 8, 1990 Mr. Chairman and Members of the Subcommittee: Tektronix appreciates the opportunity to ad- dress the Subcommittee on Select Revenue Measures regard- ing several of the miscellaneous revenue issues that your Subcommittee is considering. In particular, we would like to address the following three items: 1. Extension of the foreign tax credit carry- forward; 2. Modification of section 956 related to the characterization of successive loans; and 3. Exceptions to the passive foreign invest- ment company (PFIC) rules. I. Foreign Tax Credit Carryforward Tektronix strongly supports the proposal to extend the carryforward of foreign tax credits from five years to fifteen years for credits generated in taxable years beginning after December 31, 1988. Tektronix manufactures and distributes a vari- ety of electronics equipment throughout the world. Dur- ing the mid-l980s, Tektronix experienced a slowdown in its domestic sales. During this same period, however, our overseas sales have expanded. Tektronix has paid a significant amount of foreign tax on this overseas in- come. Because Tektronix has domestic net operating losses, we have been unable to use the foreign tax cred- its generated by our foreign income. The current foreign tax credit rules operate to penalize taxpayers who experience domestic operating losses. Under section 904(c) of the Code, foreign tax credits not used against U.S. tax in the current year may be carried back two years and forward five years. The rules for the general business tax credit and net operat- ing losses, in contrast, provide for a three-year carry- back and a 15-year carryforward. In addition, the order- ing rules in section 904(c) require that the current year's credits be utilized before any carryovers are taken into account. In contrast, the general business tax carryover is permitted to be used first, before the current year's credits must be used. The carryforward and carryback rules for net operating losses as well as for foreign tax credits were included in the Code to correct for distorted tax results caused by cyclical businesses. When the rules were first introduced, they were uniform for all credits and losses. In 1981, Congress liberalized the carryforward rules for PAGENO="0549" 539 net operating losses, without liberalizing the rules for the foreign tax credits. The combination of the shorter carryforward period and the last-in-first-out ordering rules for the foreign tax credit is contrary to the purposes of the foreign tax credit because it often results in expired foreign tax credits, double taxation and higher effective tax rates for U.S. companies experiencing domestic losses. In addition, the combination of these rules serves to discourage the repatriation of earnings abroad. Assistant Secretary Gideon told your Subcommit- tee that Treasury was opposed to conforming the foreign tax credit rules to those of operating losses and general business credits. He stated that his principal objection was the revenue cost of the proposal, which he stated would cost $300 million each year after five years. In addition, he stated that the policy behind the foreign tax credit carryover rules was not the same as that be- hind the net operating loss or business credit carryover rules. He stated that the policy behind the net operat- ing loss rules and the business credit carryover rules was to average income and losses over a number of years and to preserve the incentives associated with the busi- ness credits. In contrast, the policy behind the foreign tax credit carryover rules was to match income earned and taxed abroad with income taxed domestically. Thus, by extending the foreign tax credit carryforward rules, taxpayers can use their foreign tax against U.S. tax on income that was not subject to foreign tax. Tektronix disagrees with Mr. Gideon's charac- terization of the foreign tax credit rules. First, we believe that the proposal will have no short-term revenue impact to the federal budget and will have only a minimal impact on the budget in the long term. Indeed, the pro- posal will likely create an incentive to repatriate earn- ings for reinvestment. This reinvestment is not only~ good tax policy, but will likely enhance revenues over the long term. Second, as Treasury admits there is no bright- line that supports a five verses a 15-year carryforward period under either policy. Thus, even under Treasury~s matching policy, a 15-year carryforward would be justi- fied in some instances where accounting differences delay for more than five years the reporting of certain income or deductions. Third, under current law, the interaction of the net operating loss rules with the foreign tax rules actually works to increase the effective tax rate of a taxpayer struggling with a very large loss. Conforming the carryforward period would merely ensure that these taxpayers would pay the same effective rate of tax as their competitors. Finally, Treasury fails to address the economic policy implications associated with the shorter carryfor- ward rules. Under the current rules, if a company cannot utilize in the near future its foreign tax credits, it may defer dividends from foreign subsidiaries that would otherwise have been repatriated. This result could cause adverse cash flow problems and is particularly trouble- some where the net operating losses impair the domestic PAGENO="0550" MO~ company's ability to borrow funds. Moreover, the failure to repatriate earnings from foreign subsidiaries encour- ages overseas expansion, which costs the economy of the United States revenue and jobs. Thus, in addition to being good tax policy, extending the foreign tax credit carryover period from 5 to 15. years would have a benef i- cial economic impact. II. Section 956 A U.S. shareholder of a controlled foreign corporation (CFC) is generally taxed on his pro rata share of the CFC's increase for the year in earnings invested in U.S. property. An investment. in U.S. proper- ty includes a loan made to a U.S. shareholder of the CFC. The increased investment is measured by comparing the CFC's total amount of earnings invested in U.S. property at the end of the current taxable year, with the corre- sponding amount at the close of its preceding taxable year. Revenue Ruling 89-73, 1989-21 I.R.B. 19, holds that certain successive loans, which are not outstanding at the end of the taxpayer's taxable year, will be treat- ed as one continuous loan and, thus, counted as part of the CFC's investment in U.S. property. Under the ruling, a loan outstanding for 9 months, paid back 45 days prior to the close of the corporation's taxable year, followed by another 9-month loan between the parties 15 days into the next taxable year, will be considered to be one con- tinuous loan. In contrast, the ruling also provides that two loans would not be treated as continuous where the first loan is outstanding for only 5 months and is paid back 6 months before the close of the first taxable year, notwithstanding that a second loan is taken out 15 days into the next taxable year and remains outstanding for 10 months. .. Tektronix supports the revocation of Revenue Ruling 89-73 relating to the treatment of successive loans under section 956 because that ruling impairs the ability of U.S. companies to satisfy their short-tern cash flow needs in the. most efficient manner possible. Our company, for example, from time to time has a problem with cash flow within the United States because of our domestic losses. In these cases it is much more efficient for us to borrow on a short-term basis from our foreign affiliates than to be forced to borrow from an unrelatedbank. If these loans were determined to be investments in U.S. property under section 956, the tax result would be. disastrous because the inclusion would trigger the foreign tax credits associated with our CFC's income. Because we are experiencing large domestic losses, any foreign tax credits triggered would probably expire without ever being used. Assistant Secretary Gideon told your Subcommit- tee that Treasury was opposed to revoking Revenue Ruling 89-73 retroactively for several reasons. First, he stat- ed that Congress should not revoke revenue rulings be- cause these rulings are simply the Service's interpreta- tion of an existing law. Second, he was against the proposal because it was a retroactive change. Finally, on a substantive basis, he was opposed to the proposal PAGENO="0551" 541 because successive loans, he believes, thwarts the pur- poses behind section 956. Tektronix disagrees. First, Congress needs to revoke the ruling in this case because the Service's interpretation has al- ready caused inefficient borrowing. Without a clear message as to the absolute rule, short-term intercompany loans are too risky. In these circumstances Congress can and should adopt rules to help taxpayers know which short-term loans will be treated as continuous before the loans are made. Second, while we agree with Treasury that a retroactive change isgenerally not the best approach to tax policy, where as here the tax in question results solely from a Service position which is incorrect from a policy viewpoint, we believe that a retroactive change is warranted in fairness to those who would otherwise be faced with a significant retroactive increase in taxes. Finally, we do not agree that successive loans thwart.section 956 because that section imposes a bright line rule, which the ruling blurs. As a result, section 956 will unnecessarily interfere with normal business decisions. Moreover, we believe that these loans are good economic policy because short-term loans can satisfy legitimate cash flow needs with greatly reduced transac- tion costs. Without the ability to utilize excess cash generated overseas on a short-term basis, the ruling forces taxpayers to use their assets less efficiently, thus making U.S. companies less competitive. III. Passive Foreign Investment Companies (PFICs) Tektronix strongly supports the provision to exempt from PFIC treatment CFCs that engage in substan- tial manufacturing operations in foreign countries that have a deficit in its trade balance with the United States. The PFIC provisions were enacted to end the tax deferral on foreign passive investments that resulted when U.S. investors bought a non-controlling interest in foreign mutual funds. The tax deferral was already ended under the subpart F rules on these investments where the U.S. person purchased a controlling interest in such investments. Unfortunately, the final version of the statute was not drafted in accordance with the House and Senate bill language, which stated that the PFIC provi- sions were not to apply to investments that were already subject to the rules under subpart F. Under the PFIC provisions as enacted, a U.S. shareholder of a foreign corporation that qualifies as a PFIC must pay tax under special rules in the year of a distribution from a PFIC or a disposition of PFIC stock unless the shareholder elects to be taxed currently on his proportionate share of the PFIC's earnings. A compa- ny qualifies as a PFIC if it has a certain level of pas- sive income or a certain level of passive assets. The main problem with the PFIC rules is the asset test to determine if a foreign corporation is a PFIC. Under that test, an entity will be a PFIC if 50 percent or more of PAGENO="0552" 542 the average value of its assets consist of assets that produce, or are held for the production of, passive in- come. Because this definition is too broad, many active sales and manufacturing businesses with cash-on-hand to finance their projected growth will be subject to the PFIC rules. The proposal your Subcommittee is considering would waive the asset test where the foreign entity is located in a foreign country which has a deficit in its trade balance with the United States. Assistant Secre- tary Gideon testified that Treasury was opposed to this proposal as it was too narrow because it only applied to certain types of active businesses, namely manufacturing businesses. In addition, he testified that Treasury opposed the provision because of the negative balance of trade requirement. He stated that tax policy should not be determined by balance of trade results. Tektronix agrees that the proposal should be broadened, but believes that in the absence of a broader proposal this proposal is a positive first step toward solving the PFIC problems. First, although a complete elimination of the asset test for CFCs in any business would be the best approach, it may not be feasible, given the current budget~ restraints. This provision, because it only addresses a portion of the problem, is a positive first step with a significantly smaller price tag. Second, although we would strongly support a provision that was not limited to companies situated in certain countries, the trade balance distinction is not an altogether arbitrary one. The Code has long been used to provide economic incentives to activities that the government deems positive. When American companies lo- cate a manufacturing plant in an overseas country, it brings jobs and other economic benefits to that country. Because countries with negative trade balances with the United States often engage in unfair trade practices, the PFIC provisions simply provide a disincentive to move operations and jobs to these countries. These countries should then have a corresponding incentive to encourage the importation of U.S. products. Because the provision to exempt certain CFCs from PFICtreatment is a step in the right direction, Tektronix strongly supports that provision. Tektronix would also support any other provision which broadened this exemption from PFIC treatment for CFCs. In sum, we support each of the three proposals discussed above. We would be happy to respond to any questions or requests for further information you may have. Sincerely, Gar~"L. Conkling PAGENO="0553" 543 WRITTEN TESTIMONY OF JACK R. SILVERBERG VICE PRESIDENT, TAXES UNISYS CORPORATION The purpose of the foreign tax credit is to ensure that income earned from foreign sources by U.S. companies is not subject to double taxation, that is, the same income should not be taxed by both the foreign governments and the U.S. government. Generally, this is accomplished by reducing the U.S. tax on the foreign source income by the amount of foreign taxes paid on such income. Unfortunately, the current law fails in three respects to carry out this important policy goal, with the result that many taxpayers are subjected to the very double taxation the foreign tax credit was meant to prevent. 1. Carryforward and Carryback Current law provides a very limited 2 year carryback and 5 year carryforward period for foreign tax credits which cannot be used currently because of insufficient total taxable income or net foreign source income. Many companies who are experiencing reduced profits in these difficult times are unable to use the foreign taxes paid as credits against the U.S. taxes on their foreign source income. It is very likely that these foreign tax credits will expire unutilized, and double taxation will result. The foreign tax credit carryforward and carryback periods should be made to conform to. at least, the same 15 year carryforward and 3 year carryback provisions which apply to the general business credit and net operating losses. Carryforward and carryback provisions similar to other such provisions are called for. An additional policy reason for extending the foreign tax credit carryforward period is that multinational corporations experiencing a temporary decline in profits and working capital are unnecessarily punished when they repatriate foreign earnings. Such a repatriation would begin the current 5 year foreign tax credit carryforward period at a time when the multinational corporation is not in a position to use such credits because of low domestic earnings. If such a corporation's situation does not significantly turn around within the 5 year period, the credits would expire unused and result in double taxation. Faced with such a situation, the multinational corporation would naturally hold of f repatriating such foreign earnings, thus exasperating its cash flow problems and creating further balance of payment concerns for the United States economy. 2. First-inlFirst-out utilization of Foreign Tax Credits Today, if a taxpayer has both foreign tax credits carried forward from a prior year and foreign tax credits generated in the current year, the current year credits are considered msed first. Therefore if a taxpayer cannot use all of the credits available because of statutory limitations, -it must carryforward the prior year credits. This rule, coupled with the limited 5 year foreign-tax credit carryforward period, makes it difficult to fully utilize foreign tax credit carryovers, thereby increasing the possibility of double taxation of foreign income. To reduce the possibility of double taxation, foreign taxes should be allowed to be credited in the order in which the foreign tax credits arise that is, a first in-first out method. This change, would bring the treatment of foreign tax credits into conformity with the rules for the general business credit and net operating losses that are carried over to other years. - There appears to be no valid reason to distinguish between the order of utilizing foreign tax credits and general business credits. A mechanism is needed to effectuate the Code's objective to avoid double taxation on the same foreign earnings. - A FIFO rule would better achieve this goal by reducing the effect of the foreign tax credit carryover time limit. PAGENO="0554" 544 3. Overall Foreign Loss Recapture Under current law, .the limitation on the amount of foreign taxes which may be claimed as a credit is generally the U.S. tax rate applied to the lesser of net foreign source income or total taxable income of the company. If a taxpayer has a net foreign source loss in one year which reduces its U.S. tax liability for that year, such taxpayer must reduce its foreign source income in future years so that fewer foreign tax credits can be claimed in such future years. However, if a company has a net U.S. source loss in a year when it has net foreign source income, it is not permitted to increase the foreign source income of the company in later years, and thereby, allow the taxpayer to fully recover the foreign taxes which it paid. The tax law should provide a complimentary adjustment for the recapture of domestic source losses that would increase foreign source taxable income (thus increasing the foreign tax credit utilization) when the taxpayer subsequently earns domestic income. The 1986 Act heightened the need for an amelioration of the overall foreign loss recapture rules. Under the interest allocation rules enacted by the 1986 Act, many U.S. based multinational corporations are experiencing overall foreign losses. Those taxpayers could be limited in their ability to repatriate foreign earnings well into the next century. Equity calls for the adoption of overall domestic loss rules complimentary to the overall foreign loss rules. PAGENO="0555" 545 01 ADMINISTRATIVE CENTER CO~PQRA11ON BENTON HARBOR, MICHIGAN 49022 March 2, 1990 The Honorable Charles B. Rangel ~~Chairma~ ;~~~ouSe Select Revenue Measures Subcommittee 1111 LHOB U.S. House of Representatives Washington, DC 20515 Dear Chairman Rangel: We're very pleased the House Subcommittee on~ Select Revenue Measures has held hearings to discuss the import~ance of and need for statutory changes in the treatment of farei~gn tax credits. Of special interest to Whirlpool is the proposal that would permit excess ~foxeign tax credits to be carried forward for up to 15 years. Please enter this testimony for the legislative record. Until passage of the Tax Reform Act of 1986, Whirlpool had been able to utilize annually virtually all of its foreign tax credits (FTC5). Howevez~ enactment of the "86 Tax Act forced U.S. companies to~cons±der all expenses of their consolidated U.S. subsidiaries when computing their foreign tax 9redit limitations. This new formula used to apportion U.S. interest expense against foreign-sourced income has reduced significantly the amount of FTCs our company may use. Each year Whirlpool accumulates several million dollars in excess tax credits. Under current iaw~many or all will likely go unused. Whirlpool's inability to use all of its FTCs carries with it two adverse consequences we believe Congress did not intend when it passed the `86 Tax Act: 1. For Whirlpool, the tax change is tantamount to a tax increase. We are, in reality, prevented from reducing our U.S. tax liability on foreign source income by a portion of foreign taxes incurred in generating such income. In effect, this is a form of double taxation. PAGENO="0556" 546 This legal restriction puts us at a distinct disadvantage vis-a-vis our U.S. competitors whose companywide financing mix may not prejudice their complete use of similar FTC5. As such, our competitors gain a benefit not available to Whirlpool. 2. The `86 Tax Act, in context with Whirlpool's current financial profile, legislated a stiff tax penalty against the company's new, aggressive global business expansion program. In 1989, our acquisition of the European-based N.y. Philip's major household appliance division placed Whirlpool at the forefront of the world appliance industry. Our entry into the European appliance market puts us in a strategic position to prosper from the unified EC 92 market. The U.S. economy also stands to benefit from our expansion in several ways, but especially in terms of helping to~ trim the international trade deficit with our European trading partners. However, current tax policy diminishes the potential gains of this venture to Whirlpool and the U.S. economy. By capping our use of FPCs, the law weakens incentives to Whirlpool to expand into new global markets-- in Europe or elsewhere. The current proposal to lengthen the period for using excess FTC5 is a step in the right direction. But by no means would its passage eliminate all of the disincentives contained in the `86 Tax Act. It is only one, small part of a larger program needed to revamp U.S. tax policy to better reflect the new world economy and to ensure that U.S. businesses compete both domestically and in world markets on equal footing with their global partners. We urge you to give this matter your serious consideration and support. We would be most pleased to learn of your position and view on this important issue. Sincerely, yours, WHIRLPOOL CORPORATION PAGENO="0557" 547 SHANNON J. WALL TALMAGEESIMPK~S THE VOICE OF MARITIME LABOR 444 NORTH CAPITOL STREET, N.W., SUITE 820, WASHINGTON, D.C. 20001 (202) 347-5980 March 9, 1990 Response to Testimony by Philip Loree before the Subcommittee on Select Revenue Measures, House Ways and Means Committee, February 21, 1990, seeking: 1.. The repeal of the rule allowing tax on shipping income of controlled foreign corporations to be deferred if the tax- payer reinvests in qualified shipping assets, and 2. The complete denial of pre-1987 shipping deficits which otherwise would be carried forward against post-1986 shipping income of the controlled foreign corporation. *Mr. Philip Loree, Chairman of the Federation of American Controlled Shipping ("FAGS"), when he testified before the Subcommittee on Select Revenue Measures, House-Ways and Means Committee, on February 21, 1990, was neither factual nor honest. In his testimony he relies upon two basic assumptions in his call for reversing provisions of the Tax Reform Act of 1986 (the "1986 Act") as they apply to American-controlled foreign- flag vessels. Specifically, Loree cites pressures from foreign competition and "the vital role American controlled shipping plays in our national security strategic planning." The second of these issues is a smokescreen while the first cannot -and should not be addressed by throwing tax dollars at U.S. shipowners -who flag their vessels abroad to avoid the basic U.S. employment, safety and labor laws. - The smokescreen that Loree attempts to raise, preying on - Cold War fears, is flawed in two respects. - Firstly, -that the military relies heavily on foreign-flag vessels owned by U.S. controlled companies. At the present time, of the 1098 foreign- flag vessels owned by United-States companies, -616 qualify for Effective U.S. Control (EUSC) by -flag. Of these, only 78 are included in the contingency plans of the Navy for possible use by it in times of mobilization. These 78 are projected to decline to no more than 54 by 1992. Thus, subsidies were, in effect, being granted to 1098 vessels in order to support the possible use of less than 15 percent of them. The principal beneficiaries of this giveaway are the major U.S. oil companies whose vessels represent 221 of the EUSC eligible vessels. The whole concept of-the EUSC fleet is misleading. As of January 1, 1985, the EUSC was comprised of 378 vessels. - But this is not a fleet, rather only a list prepared by the Maritime Administration. The vast majority of vessels on this list are owned by foreign corporations in which United States companies have at least a 50 percent interest. PAGENO="0558" 548 MarAd merely goes through Lloyds Confidential Index to find vessels owned by companies which have an address in the United States. These companies are contacted to confirm that a U.S. company has at least a 50 percent ownership interest in the foreign corporation which is the listed owner of the ship. The only other requirement is that the vessel be registered in Panama, Liberia, Honduras or the Bahamas. Thus each time the EUSC list is prepared, the total number of vessels and the number of each types of vessel, e.g., freighters or tankers, will change reflecting the commercial interests of the owners of the vessels and not any military or national defense interests of the United States. The second fallacy is to claim that the United States could. rely on all of the vessels in the EUSC in times of national emergency. At no time are the owners of the vessels asked whether they would make their vessels available in times of national emergency, unless they also receive war risk insurance for their vessels. And there is a serious question whether the United States could requisition these vessels under Section 902 of the Merchant Marine Act (46 USC 1242) as claimed byMarAd. Section 902 only permits the requisitioning of vessels owned by "citizens of the United States," which is defined in 46 USC 802. For a corporation to be a citizen of the United States, under Section 802, it must, among other things, be organized under the laws of the United States or of a State, Territory, District or possession thereof. All, or almost all, of the vessels on the EUSC list are owned by foreign corpora- tions, none of which could be "citizens of the United States." The Comptroller General of the United States ruled in 1987 that for this reason these vessels are not requisitionable. Finally, there is a practical question whether these vessels would be available. All, or almost all, of them are manned by foreign crews which may not be sympathetic to the United States during the emergency. The British, after their recent experience in the Falkland Islands crisis, have expressed serious concern about relying upon foreign seamen to man vessels needed in times of national emergency. Because of the use of foreign-flag shipping, and the decline in U.S- flag shipping, there has also been a precipitous decline to less than 13,000 in the number of U.S. seamen, most of whom are now over 50 years of age. There would not be enough U.S. seamen to man the EUSC vessels even if the Department of Defense could physically get them. The EUSC list is limited to ships flying the flags of Panama, Liberia, Honduras or the Bahamas on the theory that these countries would not put their national interest in the way of the United States requisitioning these vessels. This, too, is questionable, and may depend entirely upon the military authorities in actual control of the government, as is the case in Liberia whose vessels make up over 70 percent of the EUSC list. Recent U.S. experience in Panama with the Noriega regime should also make it clear that any reliance on these vessels is misplaced. It is not surprising that the Navy places far -greater reliance on vessels in its own reserve fleets, those under the control of the Military Sealift Command; and upon U.S.-flag vessels, which are manned by U.S. crews and unquestionably may be requisitioned in times of national-emergency. Even if we were to accept Mr. Loree's false premises, his analysis of the 1986 Act is not persuasive. Mr. Loree focuses on two specific provisions of the 1986 Act: 1 The repeal of the rule allowing tax on shipping income of controlled foreign corporations to be deferred if the taxpayer reinvests in qualified shipping assets, and - 2. The complete denial of pre-1987 shipping deficits which otherwise would be carried forward against post-1986 shipping income of the controlled foreign corporation. Loree's testimony did not address the reinvestment issue in detail, indicating that FACS would be submitting written testimony for the full committee hearing. - For the present, we PAGENO="0559" 549 would only note that the reinvestment role~was basically an *unregulated tax subsidy of runaway vessels which never succeeded in maintaining the foreign-flag fleet. Owners were subsidized by the U.S. Treasury in their choice of investments. It was the equivalent of 100 percent depreciation in the first year. Quite a deal. With respect to the second issue, however, Mr. Loree's analysis is faulty. The 1986 Act did not deny operating loss carryforwards with respect to shipping income, rather it recognized that income which was subject to tax under subpart F income generally was limited to current earnings and profits. To * remain consistent with this benefit, and recognizing that shipping companies had artificially increased their deficits by the reinvestment rule in effect from 1975 to 1986, the Tax Reform Act of 1986 provided that qualified deficits in earnings and profits of a controlled foreign corporation for any prior taxable year beginning before 1987 would not be available to offset current subpart F income. Contrary to Mr. Loree's assertion that it is unfair to deny the use of pre-1987 CFC deficits to be carried forward against post-1986 CFC shipping income, it is basic fairness since the shareholders of the CFC were able to defer tax on otherwise taxable income in the earlier years which should now be taken into account for tax purposes. If earlier deficits are to be allowed to them, the income earned and reinvested prior to 1987 will be given a complete tax holiday rather than the deferral intended by the Internal Revenue Code. In his statement before the Subcommittee, Kenneth W. Gideon, Assistant Treasury Secretary (Tax Policy), presented the position of the Administration on the carryforward issue. Mr. Gideon noted that while the Treasury did not oppose the change, they warned of double dipping by the CFC shareholders who, having used the deficits to offset subpart F income in other categories, would now attempt to claim it again against shipping income. He also stressed that any deficit would have to be reduced by previously reinvested income before being carried fOrward. We suggest that giving away tax benefits to the runaway fleet on the sale of vessels, as Loree suggests, would allow them to escape any taxation on their profits. If Mr. Loree is concerned, as he says, about maintaining the fleet, the Internal Revenue Code provides for tax-deferred exchanges and other methods for allowing reinvestment, methods where the Internal Revenue Service can exercise appropriate control in the future. Mr. Loree claims that his .members are losing business in the international market which is questionable. He does not, however, mention how well his companies are doing in their competition with their primary competitors--the U.S.-flag ships. In this trade they are carrying approximately 45 percent of the cargo while U.S.-flag ships carry approximately 3 percent. We ask that you do not restore the tax loopholes which these runaways enjoyed prior to the tax rewrite of 1986. For every tax advantage extended to them, it means fewer U.S.-flag ships and fewer U.S. citizens employed. PAGENO="0560" 550 March 2, 2990 STATEMENT OF CHEVRON CORPORATION ON CARRYFORIIARD OF PRE-1987 FOREIGN BASE COMPANY SHIPPING LOSSES The Tax Reform Act of 1986 prohibits the carryforward against Subpart F income of shipping losses accumulated by U.S.-con- trolled foreign corporations before 1987. Chevron Corporation believes that the law should be amended to allow the shipping losses to be carried forward and applied against post-1986 Sub- part F shipping income particularly where the taxpayer~paid~ taxes on shipping income after such income became taxable under Subpart P in 1975. No sound tax policy exists for eliminating the right to carry- forward pre-1987 shipping losses. Before the 1986 Act, such losses could be carried forward. Under the 1986 Act, post-1986 shipping losses can be carried forward to reduce shipping in- come. The 1986 Act's complete prohibition of the carryforward of shipping losses accumulated as of the end of 1986 is thus harsher than either the old law or current law. This result is not only an anomaly but leaves an inequity with no justifica- tion. A complete lack of transition relief is an unreasonable penalty to impose particularly on companies that paid tax on all of their income from shipping operations. These companies were relying on well understood rules of foreign shipping taxation. It would appear reasonable that if Congress changes the law, it should allow taxpayers to utilize loss carryforwards properly accumulated prior to the change in the law. The only rationale that has been offered for the prohibition of shipping loss carryforwards is that shipping was one of the categories of subpart P income that generally avoided Subpart P taxation prior to the 1986 Act. j~ç~ Joint Committee PAGENO="0561" 551 explanation of the Technical and Miscellaneous Revenue Act of 1988 at page 280-81). This rational. is faulty, however, because some companies were taxed on their pre-1986 Act ship- ping income under Subpart F. In our case, Chevron was taxed on all of it. pre-1986 Act Subpart P shipping income. The Technical and Miscellaneous Revenue Act of 1988 corrected parallel inequities with respect to foreign base company sales, service, and oil-related losses. Losses from shipping opera- tions deserve similar treatment. At the February 21 hearings on this issue before the Subcoznntit- tee on Select Revenue Measures, the Treasury Department did not oppose this proposal, with the qualification that the provision be carefully drafted and that there be an acceptable revenue offset. Treasury went on to say that it supported similar provisions in the Technical and Miscellaneous Revenue Act of 1988 and suggested that the proposal was a similar type of correction. Taxpayers in the shipping industry Who paid tax on their Subpart F shipping income prior to 1987 should be allowed to carryforward their pre-1987 shipping losses to offset future shipping income. Internal Revenue Code Section 952(c) (1) (B)(ii)(II) should be amended to allow such a carryforward of pre-1987 accumulated foreign shipping losses, at least for taxpayers who took this Subpart F shipping income into account for income tax purposes during this period. Thank you for your comsideration of this issue. PAGENO="0562" 552 Submitted Statement of Robert T. Carney, Esq. Partner Dow, Lohnes & Albertson 1255 23rd Street, N.W. Washington, D.C. 20037 Hearing before the Subcommittee on Select Revenue Measures Committee on Ways and Means United States House of Representatives on Miscellaneous Revenue Issues February 21-22, 1990 Mr. Chairman: My name is Robert Carney. I am a partner in the firm of Dow, Lohnes & Albertson and am submitting this testimony on my own behalf as a tax practitioner who has extensive experience in international transactions. In this capacity, I have studied Revenue Ruling 89-73 (1989-1 C.B. 258, herein the "Ruling") and your Committee's proposal to provide prospective effect to that Ruling. I consider the proposal under consideration to be both a fair and a reasonable response to a very real practical problem. I hope it will be enacted in the event that the Service cannot be persuaded to provide this necessary relief administratively. INTRODUCTION The Ruling has been the subject of debate and criticism since its issuance on May 22, 1989. As discussed more fully below, the Ruling is likely to create substantial uncertainty in the future when U.S. multinational corporations engage in loan transactions with a controlled foreign corporation ("CFC"). This uncertainty would result from the potential application of Section 956 of the Internal Revenue Code of 1986 (the "Code") even though no loan was in fact outstanding at the end of the CFC's taxable year as required by the language of the statute. Section 956 was never intended to have the broad and imprecise effect that the Ruling would create. Instead, the drafters of Section 956 employed "bright line" tests in order that such uncertainty would be avoided. In addition, the retroactive application of the Ruling is particularly harsh because it invites revenue agents to challenge a broad range of loan transactions between a CFC and its U.S. parent corporation with little or no guidance as to which transactions are regarded by the National Office to be "abusive." Consequently, there is a strong likelihood of much controversy, and eventually litigation, with substantial burdens placed on taxpayers and very little in the way of a corresponding benefit to be derived by the Government. 1. The Ruling Invites Controversy The Ruling proposes to tax, under Section 956 of the Code, various loans from a CFC to its U.S. parent, even though the loan or loans in issue were not outstanding at the end of the taxable year as required by Section 956. Instead of the year-end test employed by Section 956, the Ruling applies a subjective "effective repatriation" of earnings test. Thus, the Ruling apparently would apply Section 956 whenever a loan from the CFC exists in one taxable year and another loan is found to exist after a "brief" period of time in the CFC's subsequent taxable year. The Ruling then states, without further guidance, PAGENO="0563" 553 that this situation constitutes a "repatriation", even though the two loans may be treated as separate obligations for other purposes of the Code. The lack of precision in the Ruling is obvious. It precludes examination of the business realities of the various loan transactions and does not even attempt to define the meaning of the term "brief" for these purposes. A specified time period nay be "brief" in one set of circumstances and may not be brief in other circumstances. Another serious substantive omission in the Ruling is its failure to define a precise formula for determining, on a consistent basis, the amount of income to be included when a series of loans occurs at various times during the preceding and subsequent years in issue. Indeed, the waters get very muddy once the statutory standard of Section 956 is abandoned. If the statute's year-end test is applied, the only issue is whether a loan has iii ~ been repaid by year end, or, if not, to what extent it actually or effectively remained outstanding. See, e.g., Gulf Oil Cori. v. Commission~, 87 T.C. 548 (1986). Any other time frame is purely arbitrary, inconsistent with the statute, and, as demonstrated by the Ruling, incapable of precise definition. The ~uif~oi]~ case illustrates some of the difficulties that can be encountered, even assuming that Section 956 is literally applied, in determining the correct income inclusion under Section 956 where open intercorpora'ce liability accounts are maintained during the course of various taxable years. The Ruling overlooks these difficulties and proposes, using overly simplified assumptions, that the taxable amount under Section 956 will be the lesser of the amount of the investment in U.S. property in the CFC's first taxable year or the amount of "the reinvestment" after an unspecified "brief" period in the next succeeding taxable year. This standard will obviously be unworkable in many situations, such as where an open account loan balance fluctuates during the course of the various taxable years in issue. In addition, the Ruling would allow taxpayers with few prior years remaining open under the statute: of limitations to escape taxation entirely on amounts that' would, *under the rationale of the Ruling, be deemed to be "effectively repatriated" in a'taxable year that is closed to further assessment. This result would enable previously untaxed earnings, otherwise taxable in a subsequent period, to escape taxation entirely There is simply no valid purpose to be served by encouraging, indeed mandating, that auditing agents challenge all loan transactions which appear to be similar to the facts outlined in Example (1) of the Ruling, or to apply income inclusion principles that are found neither in Section 956 or elsewhere in the Code. The time and effort to be'spent by the Service in pursuing all such'cases, and by taxpayers in defending their positions in perfectly legitimate loan transactions, is simply disproportionate to any potential gain to be derived by the Government.' To the extent that abusive situations or "sham transactions are detected on audit after a complete analysis of all the facts and circumstances, those situations can be dealt with on a case-by-case basis. The `"shotgun" approach" of the Ruling is clearly unnecessary and inappropriate. ` 2. In~no event should the Revenue Ruling be ` ~mtroactively apDlied. The approach taken in the Ruling is clearly contrary to the precise language of the statute and the interpretations that have, been given to that provision by the courts and the Service PAGENO="0564" 554 for more than 25 years. As noted above, the merits of the broad "effective repatriation" argument, as set forth in the Ruling, are questionable at best if intended to represent the essence of Section 956. The ability of the Service to override the unambiguoust "bright line" year-end test, which is incorporated ~dnto Section 956k. is even more questionable. At an absolute minimum, the Ruling represents a new and previously unforeseeable approach. Accordingly, retroactive application is inappropriate. Court~decision5 have gone so far as to preclude -ret.roactive application of Service positions where taxpayers have ~L~ied on~air informal Treasury publication. See Gehl Co. v. ~Comia±ssiOTier, 795 F.2d 1324 (7th Cir. 1986). In ~fb1, the Court of Appeals concluded that the taxpayer had reasonably relied on a Treasury publication entitled fi8fl~ook for Exporters. The Handbook provided explicit guidance regarding a DISC acting as a commission agent, but set forth no limitation as to the time~ period within which payment of the commissions had to be made by the DISC to its parent. Regulations subsequently imposed a 60 4a~ payment rule for such commissions. The Court in ~flj held ~ of discretion to apply that limitation period~retraactive1y. - The situation presented by the proposed retroactive application of the Ruling is possibly more unfair than the situation considc~ed in the Q8)1~. case. Here, the Ruling imposes a vague test in lieu of a previously understood and generally accepted "bright-line" test, while in Q~h1 the Service was substituting a specific bright-line payment period for a previously unspecified payment period. Thus, taxpayers who complied with the literal language of Section 956 could be subject to unforeseeable liabilities by the retroactive application of the Ruling, while in ~ii]. the taxpayer would have had at least some warning that it was acting in a highly. uncertain area. Retroactive application of the Ruling will also result in a substantial danger of inconsistent treatment of similarly situated taxpayers. This js precisely the type of improper retroactivity that the Court considered and found to constitute an abuse of discretion by the Commissioner in Farmers' & Merchants' Bank v. United States, 476 F.2d 406 (4th Cir. 1973). Prospective application of a clearly defined standard is the only way to avoid unfairness of the kind that was condemned in the ~8b.2. and Farmers' & Merchants' Bank decisions. The Service has ample authority under Section 7805(b) of the Code to make a new ruling position prospective only. Indeed, the Service generally issues rulings that are effective only on a prospective basis when the new ruling position substantially deviates from generally understood and accepted principles. That is precisely the case here. Nevertheless, Service representatives have indicated in informal meetings that they are firmly committed to applying the Ruling retroactively. A legislative solution, therefore, appears to be the only alternative to~ extensive litigation. Finally, there should be no negative revenue impact from the proposals outlined herein. *To the extent that some unfortunate taxpayer might be "trapped" by the Ruling, that event would constitute an unforeseen windfall to the Government. On the other hand, taxpayers with significant amounts of loans in closed taxable years would have earnings that would be deemed to be "effectively repatriated" in those closed years under the rationale of the Ruling. Those taxpayers would presustably escape taxation entirely on those previously repatriated amounts. Allowing Section 956 to function as written, at least until PAGENO="0565" 555 Congress has had an opportunity to study the matter, should be considered "revenue neutral." CONCLUSION It is respectfully submitted that the Congress should consider legislation to avoid the unfairness, and likely litigation, that will result from the retroactive application of Rev. Rul. 89-73. Specifically, the following proposals are made: (1) If a change to the current scheme of Section 956 is to be made, that change should be made by Congress on a prospective basis only. Any such legislation should continue to prescribe "bright-line" standards to alleviate the vague and *imprecise approaches proposed in the Ruling. (2) Congress should, by statute, suspend the operation of the Ruling until it has had an adequate opportunity to study this matter; at a minimum, legislation should limit the application of the Ruling to taxable years of CFCs beginning after May 23, 1989. PAGENO="0566" 556 Deloitte &. Touche / \ Suite 350N ITT Telex: 4995732 1001 Pennsylvania Avenue, N.W. Facsimile: (202) 879-5300 Washington, D.C. 20004-2505 Telephone: (2021879-5600 March 9, 1990 The Honorable Charles B. Rangel Chairman House Ways and Means Select Revenue Measures Subcommittee Longworth House Office Building Washington, D.C. 20515-6452 RE: February 21-22 Hearing on Miscellaneous Revenue Issues; Modification of Section 956 -- Successive Loans Dear Congressman Rangel: We are responding to your request for submissions on a proposal to eliminate the retroactivity of Revenue Ruling 89-73. Under the proposal, the position in Revenue Ruling 89-73 will not apply to the first taxable year ending after May 22, 1989, or to any prior taxable years, in determining whether two successive obligations or loans can be treated as one obligation or loan. . - We endorse the proposal. We would also endorse a proposal to revoke the ruling entirely. Revenue Ruling 89-73 establishes when successive investments made by a ~FC in ~.ti~bt obligations of its U.S. shareholder will be treated as one investment for purposes of ~z1eterminmg the CFC s mvestment in U S property under Internal Revenue Code Section In essence, Revenue Ruling 89-73 says that under Code Section 956 an investment in one debt obligation made within 60 days after a prior investment in another obligation was repaid is considered to be the same investment as the first one, even though the subsequent investment was made in the following year. The ruling suggests that IRS will take a similar view of successive loans with more than 60 days but less than six and one-half months between them. If there is a period of six and one-half months or more between theulme that one loan is repaid and a new loan is made, IRS agrees that the two will be treated as separate loans for purposes of Section 956. PAGENO="0567" 557 We recommend that Revenue Ruling 89-73bé applied prospectively only because: 1. Companies and their advisers reasonably believed, prior to the publication of Revenue Ruling 89-73, and given the authority in existence at the time, that loans of the type covered in the revenue ruling would be treated as separate loans and not cause an investment in U.S. property under Section 956." 2. The retroactive application of Revenue Ruling 89-73 will lead to needless litigation because companies cannot revise their affairs in compliance with IRS' position retroactively. Conversely, they can do so prospectively, if Congress does not revoke the ruling entirely. Alternatively, we believe that Revenue Ruling 89-73 should be revoked because: 1. Revenue Ruling 89-73 should be recognized and rejected for what it is, an attempt to change administratively an important Congressional policy decision made in 1962 in the Section 956 statute. The policy decision is that the amount of investments is measured at year end rather than, for example, based on the average amount of U.S. investments outstanding during the year. On February 21, Treasury testified before your Committee that the legislative year-end standard is "regrettable." We do not believe the statute is regrettable. The statute recognizes that many types of assets are temporarily in the United States (capital ships, drilling, rigs, etc.), and, as such, are not really "investments" in U.S. property. The year-end measuring point is also administratively simple. Even if the year-end result were regrettable, Congress should not accept IRS' and Treasury's attempt to undermine it in Revenue Ruling 89-73. If the statute and its policy must be changed, Congress, not IRS, has to act. 2. The Revenue Ruling 89-73 standard is not supj~orted by the language or legislative history of Code Section 956. There is no special rule in Section 956 allowing IRS to treat two separate investments or loans as one solely for purposes of Section 956, as Revenue Ruling 89-73 claims to do. * In Gulf Oil~(~p., 87 T.C. 548,573-4 (1986), the Court agreed with IRS that year-end loan balances in an account with many loans made as part of a CFC's cash management system created an "obligation of a U.S. person" and a deemed dividend under Section 956. In essence, said the Court, there was "nothing more than a sin~1e open account loan." The Court's conclusion was, however, based on a key factOrwhich is ignored in Rev. Rul. 89-73; the inability of the taxpayer inQj~jf to trace individualloans. In Rev. Rul 89-73, the loans ~ traceable and separately identifiable. Also, IRS has issued four letter rulings and one technical advice memorandum that respected loans as separate even whey they succeeded one another within brief periods of time. See PLR 8441041 (July 11, 1984); PLR 8534070 (May 29, 1985); PLR 8538034 (June 21, 1985); PLR 8504012 (July 3, 1984); TAM 8122006 (January 28, 1981). PAGENO="0568" 558 3. Revenue Ruling 89-73 is inconsistent with the analysis and treatment of successive loans under other tax provisions, such as Section 163* and Section 1001. In conclusion, current law has provided IRS with adequate means to prevent abuses in this area, as demonstrated in Gulf Oil Corp. If there is, however, widespread or substantial successive loan abuse requiring new positions (IRS has not established this), then there should be a more realistic and reasoned approach to the problem that is consistent with current law. IRS should accede to the requests of Congressmen* * and the public that successive loan standards be established by regulations, on a prospective-only basis. We would be pleased to answer any questions that the Committee may have on these issues. Sincerely, ~+~*Q~ ~ Steven P. Hannes cc: Robert J. Leonard Susan Rogers SPH:ala *111 Nobel v. Commissioner, 79 T.C. 751 (1982), the Tax Court refused to aggregate two loans even on one note document, because it found the two loans to be separately motivated and to have different terms. * * For example, Congressmen Archer, Frenzel and Schulze made such a request in an October 4, 1988, letter to then IRS Commissioner Gibbs. Congressman Schulze made an additional request in a January 30, 1989, letter to Mr. Gibbs. PAGENO="0569" 559 "Ernst &Young 1200 19th Street. N.W February 21, 1990 Washogton D C 20036 Telephone: (202) 663-9500 Mr. Robert J. Leonard Chief Counsel Committee on Ways and Means U.S. House of Representatives 1102 Longworth House Office Bldg. Washington, D.C. - Dear Mr. Leonard: We welcome - the opportunity to comment on the proposal which would require that Revenue Ruling 89-73 1 ("the ruling") be applied on a prospective basis only. We believe that the best course of action is to revoke the ruling altogether and would be glad to comment further on its revocation, however, in deference to the subject matter of the hearings, we will limit our discussion to the impropriety of the retroactive application of the ruling. Similarly, the American Electronics Association shares our concern and believes that the best course of action is revocation, but supports the following testimony questioning the retroactive application of the ruling. Rev. Rul. 89-~ Rev. Rul. 89-73 was issued on May 21, 1989 and provides, in general, that successive loans from a controlital foreign corporation (CFC) are to be treated as investments in U.S. property outstanding on the last day of the CFC's taxable year if the period of disinvestment between loans is sufficiently brief. The ruling sets forth a new standard that two consecutive loans, by a CFC to a U.S. related party, will be treated as one continuous loan if the time period between the first loan and the second loan is less than two months. - A period of disinvestment exceeding six and one-half months between loans will not cause the loans to be treated as one continuous loan. No guidance is given for a period of disinvestment between loans that is greater than two months and shorter than six and one-half months. Although the ruling states that the time lapse is only one factor and the time standards of the ruling may be overridden by certain facts and circumstances, the practical effect of the ruling, and how it will likely be applied by IRS examiners, is to base the determination solely on the length of the disinvestment period according to the guidelines set forth in this ruling. ~Close of the Taxable Year" Standard is Changed by the Ruling Under Subpart F of the Internal Revenue Code, a U.S. shareholder of a CFC must include in its income currently certain Subpart F income whether or not such - shareholder has actually received a distribution. Certain income invested by a CFC in U.S. property is considered Subpart F income. Subpart F, in general, looks only to the last day of the CFC's taxable year in order to determine which U.S. shareholders are subject to income inclusions and to measure the amount of the inclusions. For example, only U.S. shareholders that are shareholders Qn..th~ 1ast~day of the taxable year of such CFC must include in their gross income the Subpart F income of the CFC.2 Similarly, the qualified deficit rules3 provide that ~ 1989-21 LR.B. 19. 2 Treas. Beg. Sec. 1.951-1(aX2). 3 I.R.C. Section 952(c)(1)(B)(jv). 2 PAGENO="0570" 560 E?nst&Young the shareholder's pro rata share of any deficit for any prior taxable year is determined based on the close of the taxable year in which the deficit arose. The statutory language of Section 956 likewise focuses on the "close of the taxable year" as the measurement date of investments in U.S. property. Because the "close of the taxable year" standard is mandated by the statute, any interpretation by regulations or rulings should reflect the statute. Rev. Rul. 89-73 disregards the year end and institutes a new standard on a retroactive basis. For this reason, at a minimum, the significant impact of this new concept should be made prospective. Rev. Rul. 89-73 Changed Prior Treatment of Successive Loans Made by a CFC Whether or not a loan was an obligation with a maturity of less than one year or one successive long-term loan has always been determined based on facts and circumstances. Truly abusive loans were treated as one continuous loan and would, therefore, be subject to Subpart F. However, Rev. Rul. 89-73 mandates a standard which completely ignores transactions where there are no abuses. The successive loan issue has been adequately addressed by the Tax Court in Sherwood Properties4 and Gulf Oil Corp.5 In Gulf Oil Corp., the Court ruled that since the taxpayer could not substantiate the repayment of each particular intercompany payable, out of a large and continuous volume of intercompany transactions, the ~taxpayer was not entitled to claim the benefit of the one-year rule. Similarly in Sherwood Properties, the Court denied the benefit of the one- year rule where the taxpayer could. not substantiate that certain intercompany payments were, in fact, repayments of advances by the taxpayers CFC. In light of these major cases on this issue, taxpayers should not have reasonably been expected to anticipate the two month rule of Rev. Rul. 89~736; indeed, the Court, in Gulf Oil Corp., referred to the `nearly mechanical provisions of section 951 and 956(a)-in determining that an increase~in U.S. property had occurred from the beginning of the year to year end. Rev. Rul. 89-73 has, in practice, mandated a standard which ignores the facts and circumstances test.of case law and the clear reading of the statute. Long History of Taxpayer Reliance on Rules Under Section 956 ~The one-year rule7 excluded-obligations of less than one year from the definition of U.S. property prior to its repeal by temporary regulations.8 The IRS made the Temporary regulations apply prospectively because the one-year rule had been in effect since 1964. Even though the now repealed one-year exclusion was not expressly provided for in the statute, it yielded a sensible result and it remained unchanged by legislation or regulations for a twenty-six year period. The rule was simple and made no mention of any limitation resulting from successive loans. Since the IRS made the Temporary regulations apply prospectively, why should Rev. -Rul. 89.73, which dictates rules on a related issue, be applied retroactively? In addition, if Rev. Rul. 89-73 is applied retroactively it could be interpreted by IRS examiners as having the effect of retroactively changing the application of the one-year rule since the two month standard was not present in the regulations that contained the one-year rule. The arbitrary two month 4 89 T.C. 651 (1987). ~ 87 T.C. 548 (1986). 6 One standard that the taxpayer may have been reasonably expected to rely on is the continuous investment concept of the wash sale rules. The wash sale rules generally disallow losses on the sale of stock or securities where substantially identical stock or securities are reacquired within thirty days after the disposition. The wash sale concept is similar to that of the successive loan concept of Rev. Rul. 89-73 since both treat the investor as never having truly divested itself of the property in question. 7 Treas. Reg. Sec. 1.956-2(d)(2)(ii). 8 Temp. Treas. Reg. Sec. 1.956-2T(d)(2). PAGENO="0571" 561 Enist&Young standard, if applied to prior years, would, in effect, cause taxpayers who relied on the one year rule to suddenly have their loan considered to be a Section 956 investment and, therefore, subject to current tax. Unbalanced Application of Substance over Form Approach The premise underlying Notice 89-73 is that the CFC's investment in U.S. property is an "effective repatriation" of the CFC's earnings to the domestic parent corporation and that successive loans by a CFC to its domestic parent constitute a single investment and, therefore, should be considered outstanding at the dose of the CFC's taxable year. The application of Rev. Rul. 89-73 results in an unbalanced and one-sided use of the substance over form doctrine. The IRS, through the ruling, takes two independent transactions and combines them to create a Section 956 inclusion and concludes that the form of the separate legal instruments should be disregarded for the purposes of taxing the transactions. But, the taxpayer with a mirror transaction would not be allowed to similarly apply the substance over form doctrine to ~yj~jd a Section 956 inclusion. To be theoretically consistent in the converse situation, a brief period of investment by the CFC which crosses year-end should not be considered a Section 956 event if the CFC otherwise (before and after) makes no investment in U.S. property. This, however, would be in dear violation of the statute and would not be allowed except in the very limited cases permitted under the 30-day rule.9 Therefore, the taxpayer is unfairly subject to the worst case scenario in determining whether an investment in U.S. property exists. Conclusion The history of the tax law and regulations with respect to investment in U.S. property by controlled foreign corporations has been clearly established by the Congress and the Treasury. The tax treatment has been relied on by taxpayers to a great extent and it would cause uncertainty if the rules concerning successive loans contained in Rev. Rul. 89-73 were applied to years prior to the issuance of the ruling. The retroactive application of Rev. Rul. 89-73 will only serve to undermine the equity of a legal system based on precedent. We would be pleased to discuss any of these matters in greater detail at your convenience; please contact Harvey B. Mogenson, (202) 663-9773 or Mary Frances Pearson, (202) 663-9572.~ Very truly yours, 9 Notice 88-108, 1988-2 C.B. 445. PAGENO="0572" 562 TELECOPIER~ 202/6624643 FULBRIGHT JAWORS6I & REAVIS MCGRATH March 9, 1990 Mr. Robert J. Leonard Chief Counsel Committee on Ways and Means U.S. House of Representatives 1102 Longworth House Office Building Washington D.C. 20515 Re: Revenue Ruling 89-73 Dear Mr. Leonard: This letter is submitted in response to Press Release #8, issued by the Subcommittee on Select Revenue Measures on January 23, 1990, regarding miscellaneous revenue issues We wish to address the proposal to modify section 956 of the Internal Revenue Code of 1986, as amended (the Code), relating to the characterization of successive loans. As you recall, under this proposal Rev. Rul. 89-73, 1989-1 C.B. 258, which treats certain successive loans as a single loan for purposes of section 956, would be applied on a prospective basis only. We believe Congress should adopt this proposal. Rev. Rul. 89-73 embodies a novel position by the Internal Revenue Service (the "Service"), a position that taxpayers could not reasonably have anticipated. We have doubts about whether Rev. Rul. 89-73 is valid on the merits. In any event, we believe retroactive application of this ruling would be harsh and unfair. FULBRIGHT & JAWORSK~ 1150 CONNECTICUT AVENUE. NW. WASHINGTON, D.C. 20036 BY MESSENGER DELIVERY PAGENO="0573" 563 BACKGROUND Under section 956 of the Code, the earnings and profits of a controlled foreign corporation (a `CFC") are taxable to its U.S. parent to the extent the CFC holds U.S. parent debt instruments (along with other forms of investment in United States property) at the end of its taxable year. 1/ A CFC's `investment in United States property is measured only at its year-end. Thus; if a CFC holds U.S. parent debt obligations even briefly at year-end, the U.S. parent of the CFC may be subject to tax. Conversely, a CFC may hold such obligations during the year without consequence under section 956, provided the CFC does not hold the obligations at its year-end. This year-end "snapshot" has been a basic feature of section 956 since section 956 was enacted in 1962. Indeed, the Treasury Department added emphasis to this year-end "snapshot" feature in 1988, when it subjected short-term debt to section 956 for the first time. 2/ Until 1988, a CFC could hold a U.S. parent debt obligation at year-end without consequence under section 956, provided the debt obligation was collected within one year of issuance. Under current regulations, with only limited exceptions, any holding of a U.S. parent debt obligation by the CFC at year-end may subject the U.S. parent to tax. 3/ 1/ See I.R.C. §S 956(b)(l)(C) (defining "United States property" to include obligations issued by a U.S. person, including U.S. shareholders of a CFC), and 956(a)(l) and (2) (providing that the amount of a CFC's investment in U.S. property is determined as of the end of each taxable year of the CFC). See also I.R.C. § 956(b)(2)(F),' which excludes from the definition of United States property" stock and obligations issued by corporations unrelated to the CFC. 2/ T.D. 8209, 1988-2 C.B. 174, adopting Temp. Treas. Reg. S 1.956-2T(d)(2) and repealing Treas. Reg. § l.956-2(d)(2). 3/ In I.R.S. Notice 88-108, 1988-2 C.B. 445, the Service announced that final regulations under section 956 would permit a CFC to hold a debt obligation at year-end without adverse section 956 consequences, if (1) the obligation is collected within 30 days of being incurred, and (2) the CFC does not hold U.S. affiliate obligations (including those with a less-than-30-day term) for more than 60 days during the year. PAGENO="0574" 564 REV. RtJL. 89-73 DESCRIBED In Rev. Rul. 89-73, the Service introduced a new and unexpected concept into section 956 -- the concept that a loan not outstanding at year-end may result in tax under section 956. Rev. Rul. 89-73 discusses two situations involving successive loans: In the first situation, a calendar-year CFC purchased $200x of its U.S. parents. debt obligations on February 5, 1987; on November 15, 1987, the parent repaid the obligations; the CFC bought $225x of parent debt obligations on January 15, 1988, and sold them on November 10, 1988. The second situation is the same, except for the timing of the transactions. That is,in the second situation, the CFC purchased $200x of parent obligations on February 1, 1987, but here the obligations were repaid on June 30, 1987. The CFC purchased $225x of parent obligations on January 15, 1988, and sold them on NOvember 15, 1988. The &arv~i~e~ru1ed that, in the first situation, the CFC would be ~ to have $200x `investment in United States propert~"~ax~of December 31, 1987, because "the brief period of time" between November 15, 1987 (when the obligations were repaid) and January 15, 1988 (when the CFC purchased new obligations) would be `disregarded." In the second situation, however, the period of time between the repayment and the purchase of the new obligations was longer -- 6 1/2 months as compared with~:&0:-days -- and so was notdisregarded. Consequently, Rev. Rul. 89-73 focuses exclusively on the period of disinvestment around year-end, holding that "brief" periods of disinvestment (at least 60 days and perhaps up to more than 6 months) are to be disregarded for section 956 purposes. SERVICE PRACTICE BEFORE REV. RUL. 89-73 The Service's position stated in Rev. Rul. 89-73 is a reversal of its long-standing practice of respecting successive loans for section 956 purposes. Taxpayers reasonably relied on the Ser~ice's prior practice in structuring their PAGENO="0575" 565 transactions. Thus, retroactive application of Rev. Rul. 89-73 would be unreasonable and unfair. 4/ In testimony on February 21, 1990, before the Subcommittee on Select Revenue Measures, the Treasury Department opposed legislation to require prospective-only application of Rev. Rul. 89-73. Treasury's stated position is that Rev. Rul. 89-73 is "a correct interpretation of the law based on the same principles a responsible practitioner would have considered in opining on these facts.' 5/ We disagree with any implication that Rev. Rul. 89-73 reflects pre-existing law in this area, or that taxpayers had reasonable notice of the interpretation of section 956 expressed therein. On the contrary, Rev. Rul. 89-73 creates an unexpected interpretation of section 956 that was a surprise to taxpayers and practitioners. As mentioned above, the year-end "snapshot" feature of section 956 has existed since 1962. From 1962 until 1988, debt obligations collected within one year of issuance were excluded from section 956. Until publication of Rev, Rul. 89-73, the Service had never suggested that two loans which would be treated as separate transactions under normal standards could be treated as a single loan under the year-end "snapshot" or one-year. features of section 956. A. Private Rulings on Point In fact, during 1984 and 1985, the Service issued several private rulings that specifically allowed brief periods of disinvestment of the general type prohibited in Rev. Rul. 4/ The inequity of applying Rev. Rul. 89-73 retroactively has drawn attention from Congress. Indeed, within two months after Rev. Rul. 89-73 was published,~ Congressman Brown proposed legislation that would have limited Rev. Rul. 89-73 to prospective application and, for earlier years, would have made clear that the standards of section 1001 of the Code applied to `successive or other obligations or loans" under section 956. Also, both Chairman Rostenkowskj and Congressman Schulze have written to the Service and the Treasury Department regarding issues arising under Rev. Rul. 89-73. 5/ Statement of Assistant Secretary (Tax Policy) Kenneth W. Gideon before Subcommittee on Select Revenue Measures, House Committee on Ways and Means, February 21, 1990 at4. PAGENO="0576" 566 89-73. 6/ These rulings dealt with commercial paper issued by a u.s. corporation and acquired by a CFC. The commercial paper was paid within one year of issuance, and, immediately thereafter, the CFC reinvested the proceeds in new commercial paper of the same U.S. corporation. Under Treas. Reg. § 1.956-2(d), as then in effect, the Service ruled that the commercial paper held by the CFC was not subject to section 956, because the debt was collected within one year of issuance. That is, the Service respected the separate nature of the successive loans. B. Other Rulings in Related Areas Moreover, at the same time the Service was issuing these rulings, it was taking a strong substance-over-form approach in other areas involving section 956. For example, in 1983 the Service ruled that a CFC which owned a ship located in U.S. waters could not exclude the ship from its `investment in U.S. property" by causing the ship to leave U.S. waters for several hours on the last day of the CFC's year. 7/ Also, in the early l980s the Service issued two technical advice memorandums dealing with open account debt among foreign and domestic affiliates. In one TAM the Service concluded that the large number of open account transactions should be aggregated and treated as a single loan which was outstanding at the end of a CFC's year and not collected within one year. 8/ (This result is the same as the one reached by the~ Tax Court three years later in Gulf Oil Corp. v. Commissi~T~, 87 T.C. 548 (1986)). In the other TAM, also dealing with open account debt among affiliates, the Service concluded that the U.S. affiliate debt obligations held by a CFC-lender were collected within one year of issuance (and so did not constitute an "investment in U.S. property"), because all the open account debt balances were netted out at year-end. 9/ The open account debt balances would begin to build up again right after the beginning of the next year, but this fact did not change the result. 6/ Priv. Ltr. Rul. 8441041 (July 11, 1984); Priv. Ltr. Rul. 8534070 (May 29, 1985); Priv. Ltr. Rul. 8538034 (June 21, 1985); Priv. Ltr. Rul. 8504012 (July 3, 1984). 7/ Tech. Adv. Men. 8334003 (May 5, 1983). 8/ Tech. Adv. Men. 8332019 (April 29, 1983). 9/ Tech. Adv. Men. 8122006 (January 28, 1981). PAGENO="0577" 567 A review of these rulings reveals the Services consistent interpretation of section 956 as a technical statute. Section 956 is subject to traditional substance-over-form analysis, like other provisions of the Code. There is no indication, however, of any special rule that would disregard, for section 956 purposes only, transactions having real substance. Indeed, the technical advice memorandums dealing with open account debt underscore this point. C. Recent Developments Administrative developments during 1985 to 1988 indicated that the Service was changing its views on the issue of successive loans. But these developments did not suggest that the Service would aggregate these loans based only on a `brief period of disinvestment," as in Rev. Rul. 89-73. In late 1985, the Service withdrew the private rulings, discussed above, relating to successive loans. 10/ In withdrawing these rulings, however, the Service stated only that the issues presented were "too dependent on subsequent facts" for the Service to issue an advance ruling. The Service did not indicate what "subsequent facts" might be relevant. There was certainly no indication that the Service was even considering a sweeping approach like that adopted in Rev. Rul. 89-73. Moreover, in accordance with normal practice, the private rulings were withdrawn on a prospective basis only. At about the same time, the Service issued Rev. Proc. 85-59, 1985-2 C.B. 741, stating that it would'no longer issue advance rulings that a debt obligation was excluded from section 956, because the debt was collected within one year. The stated reason for this no-rule position was that the issue was "too dependent on subsequent facts for the Service to determine in advance the substance of the transactions." The Service did not repudiate the substance of the earlier rulings allowing successive loan transacitions. Nor did the Service 10/ Pr]v Ltr Rul 8612018 (December 18 1985) (withdrawing Priv. Ltr. Rul. 8441041 (July 11, 1984)); Priv. 2 Ltr. Rul. 8612019 (December 18, 1985) (withdrawing Priv. Ltr. Rul. 8534070 (May 29, 1985)); Priv. Ltr. Rul. 8612023 (December 18, 1985) (withdrawing Priv. Ltr. Rul. 8538034 (June 21, 1985)); and Priv. Ltr. Rul. 8612024 (December 18, 1985) (withdrawing Priv. Ltr. Rul. 8504012 (July 3, 1984)). 30-860 0 - 90 - 19 PAGENO="0578" 568 suggest that a brief period of disinvestment alone would cause two separate loan transactions to be disregarded. In the Preamble to the 1988 temporary regulations (T.D. 8209), the Service stated that it was "concerned that, under current regulations, CFC5 may make successive loans with a maturity of less than one year as a means of loaning their earnings to related U.S. corporations on a long term basis in avoidance of section 956." The regulations addressed this issue by prospectively repealing the exception for less-than--one-year loans. Even here, there is no indication of any retroactive change in prior interpretations of section 956. REV. RUL. 89-73 UNSUPPORTED BY AUTHORITIES On its face, Rev. Rul. 89-73 plainly states a novel theory. No meaningful authorities are cited. Indeed, other than general "substance-over-form" cases, the only authority cited is a quotation from the House Report on the Revenue Act of 1962, regarding a general objective of section 956 to prevent tax-free repatriation of CFC income. 1989-1 C.B. 258. But this language could not have put anyone on notice of an approach like the one taken in Rev. Rul. 89-73. Aside from its general nature, the language in the House Report does not even relate to section 956 as adopted. The Senate narrowed the statute considerably from the version adopted by the House, and the Senate version of section 956 was largely adopted in conference. Conf. Rep. No. 2508, 87th Cong., 2d Sess. 33 (1962). The Service's reliance in Rev. Rul. 89-73 on general committee report language, quoted out of context and regarding legislation that was substantially altered, makes it clear that taxpayers could not have anticipated this ruling. Moreover, Rev. Rul. 89-73 is not a true "substance-over-form" ruling. The "brief period of disinvestment" described in the ruling is ignored pp~y for section 956 purposes. The loans are still respected as separate transactions for other tax purposes. Consequently, even "substance-over-form" authorities do not support the ruling, and they provide no basis for its retroactive application. BENEFIT/RISK ANALYSIS BY TAXPAYERS In many instances, a U.S. parent benefits by borrowing from its CFC only to the extent that the rate of interest payable to the CFC is slightly lower than the rate an unrelated PAGENO="0579" 569 borrower would charge. This rate differential is likely to be between one-half and one percentage point. In contrast, if the loan is treated as an "investment in U.S. property," tax at a rate of 34% (46% until 1986) would result. It seems unlikely to us that a U.S. parent would choose to borrow from its CFC, rather than from an unrelated lender, if its management believed it was risking a tax many times greater than the benefit from such loans. CONCLUSION Because of the reasonable reliance by taxpayers on prior interpretations over an extended time period, we urge that Congress adopt the proposal to apply Rev. Rul. 89-73 only on a prospective basis. Very truly yours, fot~j~ (~1 . Robert H. Wellen PAGENO="0580" 570 the computer soft ware and services industry association STATEMENT OF LUANNE JAMES, EXECUTIVE DIRECTOR ADAPSO, THE COMPUTER SOFTWARE AND SERVICES INDUSTRY ASSOCIATION THE SUBCOMMITTEE ON SELECT REVENUE MEASURES HOUSE WAYS AND MEANS COMMITTEE FEBRUARY 21,1990 ADAPSO, the principal trade association of the computer software and services industry, supports an amendment to permit foreign subsidiaries of American companies to capitalize leases of tan- gible personal property for purposes of the passive assets test. Under the Tax Reform Act of 1986, a company is presumed active if at least fifty percent of its assets, such as plant and equip- ment, are "active." The purpose of this test was to distinguish between firms whose assets are intangible investments, such as dividend, interest and royalty income, from those which derive income from productive assets, such as factories and trucks. Un- der current law, computer services companies which lease equip- ment appear to be passive because less than fifty percent of their owned assets are plant and equipment, when in fact they are actively producing income from operations. Such businesses performing services on the customer's premises and are not likely to own substantial plant and equipment. The passive assets test does not accurately reflect the true na- ture of technology-based firms which lease plant and equipment and as a result fail the assets test. Firms operating abroad lease computers and telecommunications equipment to insure that their equipment is state of the art, and equally important, to encourage the transition to the next generation of equipment. Technological innovation is increasing so rapidly that the life span of a generation of computer hardware, software or system is decreasing at an exponential rate * As the shortened generational life span trend continues, more businesses will find it advan- tageous to lease individual components of plant and equipment for shorter periods than ever before. In order to continue innova- tion at this pace, it is essential that the tax code be amended to accurately reflect the nature of income produced from assets leased more than one year. For purposes of the passive income test, the correct policy ques- tion is whether income is derived from active business operations not who owns the assets used for production. ADAPSO, strongly urges the Committee on Ways and Means to amend Section 1235 of the Tax Reform Act of 1986 (which adds Internal Revenue Code Sections 1291 and 1293-97), effective December 31, 1989 50 that active business operations of computer software and service com- panies are accurately classified. PAGENO="0581" 571 Written Statement of Lawrence S. Pratt, President American Investment Services, Inc. Great Barrington, Massachusetts 01230 for the Hearing on Miscellaneous Revenue Measures Subcommittee on Select Revenue Measures of the House Committee on Ways and Means February 21-22, 1990 Mr. Chairman, I am pleased to submit this statement regarding certain proposals to simplify the operation of the PFIC rules for small investors, which have been included in the Subcommittee's hearing agenda. My name is Lawrence S. Pratt, and I am President of American Investment Services, Inc. ("AIS") of Great Barrington, Massachusetts. AIS is an investment advisory firm which was founded in 1978, and is a wholly owned subsidiary of the American Institute for Economic Research ("AIER"), a tax-exempt, educational research organization. AIS is an investment advisor -- we provide investment advice to individuals, investment companies, estates, trusts, pension and profit sharing plans, and charitable organizations. We also publish a monthly newsletter, called the Investment Guide. We are strictly an advisor, we do not sell stocks or other investments, nor are we affiliated with any dealers or brokerage firms. Neither AIS, nor any person affiliated with it, receives any commissions~ or fees of any kind from purchases or sales made as a result of its recommendations. AIS bases its investment strategy on the fundamental analysis of long term trends. Accordingly, we recommend long term purchases, rather than trading, short sales, margin transactions, option writing or other possible short term enhancements to investment returns. Over the course of the years, we have placed a strong emphasis in our investment recommendations on precious metals based investments with a strong current return, while at the same time protecting an investor against the risks of inflation. Often the investments we have recommended have been in foreign mining finance houses, because similar investments simply are not available in the domestic market. Our concern in this area, thus, stems from concerns raised by numerous, individual investors who have made long term investments in such foreign companies, and the bewilderment that they -- and we -- have faced in attempting to make sense of the PFIC rules. It is important to understand that many of these investors made their investments long before the notion of a PFIC existed, or the arrangements at which the rules were aimed became popular. It also is important to emphasize that their investments are in foreign companies whose stock is publicly traded, which are not located in a tax haven country, and which distribute substantial portions of their earnings each year. They are not, in other words, the type of closely held companies (with just less than a majority of U.S. owners), that accumulate their earnings and are located in offshore havens, at which the PFIC rules were essentially aimed. But they are caught up in the web of the PFIC rules, because the rules were broadly drafted to reach not only certain specific abuses, but also to catch any conceivable arrangement that might be devised to avoid them. The small investor about whom we are speaking must ask himself or herself the following: Is my investment in a PFIC? PAGENO="0582" 572 If so, should I retain my stock? And if I do retain it, should I make a so-called "QEF" election? As to the first question, the investor must determine whether 75% or more of the income of the foreign corporation is passive or at least 50% of its assets are passive. Our experience is that in some cases the question is easy to answer - the assets of the foreign corporation clearly consist largely of portfolio holdings in other companies. In other cases, however, it is impossible for the individual investor to answer the question. This is because the investment is in a parent company which is essentially a holding company for numerous operating subsidiaries; but its interests in those subsidiaries may range from 5% to 100%. The less than 25% holdings,~ therefore, could be substantial, and it is impossible on the basis of the financial statements available to an individual investor (which tell little about the underlying assets of the at least 25% owned subsidiaries), to determine whether or not the; company is a PFIC. Assuming that the stock is, or might be, PFIC stock, however, the investor then must decide what to do next. Many investors, we have found, when faced with the complexity of the rules, initially have considered disposing of their stock. But a large portion of our clients are elderly people who have held their stock for many years, and whose investments have appreciated considerably. Prior to the enactment of the PFIC rules, those investors could have held their stock until death, their heirs would have received a step-up in basis, and the stock could have been sold without incurring any taxable gain. But after enactment of the PFIC rules, even though the company has substantially distributed all of its earnings currently and even though the appreciation in the investor's stock is attributable principally to capital appreciation, his or her estate will be denied a step-up in basis for all of the appreciation in the PFIC stock -- regardless of the extent to which that appreciation accrued prior to the enactment of the PFIC rules. Furthermore, some investors have considered contributing their stock to charity -- but they are stymied even from doing this. This is because the PFIC rules do not allow a charitable deduction to be claimed for that portion of the fair market value in excess of basis of PFIC stock -- even though such a deduction could be claimed if the stock were in a similar domestic company. The only way for an investor to avoid such a result is to make what is called a "qualified electing fund," or "QEF," election. If the investor makes such an election, then he or she must report his or her entire share of the PFIC's earnings currently, whether or not such earnings are distributed. There are two major problems with this election, however. First, the election must be made by each shareholder, and many individual shareholders simply have been unable to grasp the ins and outs of making the election. As one investor, who had struggled at length over what to do, wrote to me: "My inability to understand this night stem from the fact that I am 78 years old. I normally do my own taxes, but I have asked two preparers and neither knows anything about PFIC or QEF." Second, the election may be made only if the PFIC agrees to provide the investor with information to enable him or her to report his or her share of earnings -- computed in accordance with U.S., not foreign, tax and accounting ~/ If a foreign corporation owns less than 25% of the stock of another corporation, the stock is considered a passive asset. If it owns 25% or more of such stock, then it is treated as owning a pro-rata share of the other corporation's assets, and receiving a pro-rata share of its income. This look-through rule applies with respect to second, third, etc. tier subsidiaries. PAGENO="0583" 573 principles. In the case of a foreign company, such as~one which is large and whose shares are publicly traded on foreign exchanges but not on a regulated exchange within the U.S., and in which U.S. shareholders are a minority, the company simply has no incentive or obligation to comply with such burdensome U.S. tax reporting rules. This leaves U.S. investors in such companies, particularly those who held their stock at the time of enactment of the PIle rules, effectively without any choice. They necessarily are subject to the rules applicable to nonelecting funds which are extremely penalizing, and were intended to be so in order to compel investors to elect the QEF regime. Lastly, there are cases where a foreign company clearly is a PFIC, is owned by a substantial majority of U.S. shareholders, it distributes all of its earnings currently, and it is able to provide its shareholders with the information necessary for them to make a QEF election. For investors in that company, the best course of action is to make a QEF election, yet, many do not, largely out of confusion over how to do so. It would be far simpler to replace the thousands of shareholder elections with a single regime under which all U.S. shareholders must report their share of the company's earnings (whether or not distributed) on a current basis. Even though this will mean some increase in current tax for shareholders who might not make the election, the advantage would be each individual's reporting obligations can be clearly and concisely explained. To remedy the operational problems described above, the proposal before this Committee includes three parts: -- firCt, a proposal to provide relief from the denial of a step-up in basis at death or a charitable contribution deduction with respect to appreciation in stock allocable to the period before the original effective date of the PFIC rules. This proposal avoids the unduly harsh, retroactive effect of these rules upon individuals who made investments prior to enactment of the PFIC rules. -- second, a proposal to exempt from the PFIC rules small shareholders who acquired stock in certain PFIC5 prior to the date of enactment. This exemption is.directed at investments which have none of the indicia of abuses at which the PFIC rules were aimed, and in which U.S. shareholders are a minority group and unable to make a QEF election because they cannot require the PFIC to provide them with the information to enable them to do so. -- third, a proposal to permit certain PFIC5 which have a majority of U.S. shareholders to make a special election under which the company would report to each shareholder, and each shareholder would report On his or her return, his or her share of earnings of the PFIC. Fundamentally, these proposals deal with situations as to which the PFIC rules simply should not apply. The investments covered by the second and third proposals involve cases where there is no real avoidance of current taxation, and costly application of the PFIC rules far outweighs the benefit of any revenue raised by the government. And it is our expectation that revenue estimates will show that overall these proposals raise revenue and improve compliance for the government. Each of the three proposals has been described in detail in the technical explanations prepared by staff in connection with this hearing, and I see no need to duplicate that explanation here. I do stand ready, however, to answer any additional questions, or provide any additional information which this Subcommittee may require in connection with its consideration of these proposals. PAGENO="0584" 574 STATEMENT on EXCEPTIONS TO THE PASSIVE FOREIGN INVESThENT COMPANY (PFIc) RULES for submission tc~ the SUBCOMMITTEE ON SELECT REVENUE MEASURES of the HOUSE WAYS AND MEANS COMMITTEE in its hearings on MISCELLANEOUS REVENUE *ISSUES EG&G, Inc. is pleased to provide comments on exceptions to the Passive Foreign Investment Company (PFIC) rules. EG&G urges Congress to amend the PFIC rules so that they do not tax income earned by certain overseas subsidiaries that are engaged in active manufacturing operations before such income is repatriated to the United States. We support H.R. 515, which would provide that these subsidiaries will not be treated as PFICs if they are located in a foreign country that has a deficit in its trade balance withthe United States. EG&G believes that as currently applied, the existing PFIC rules can impede progress in fulfilling the global positioning strategy of various EG&G business segments and offers the following cogent business facts and examples for the subcommittees consideration as you evaluate the merits of any exceptions to the PFIC rules. EG&G, Inc., is a technologically diversified Fortune 300 company of 30,000 employees, providing advanced scientific and technical products and services worldwide. The company's operating divisions are organized into èix business segments. Businesses in the INSTRUMENTS segment manufacture scientific equipment for airport and industrial security and for precise measurement of physical, chemical, and biological phenomena. Companies in the COMPONENTS segment manufacture mechanical, optical, and electronic devices for commercial markets. The EG&G TECHNICAL SERVICES businesses provide technical and management services in transportation and physical security to government agencies, analysis and testing services to the automotive industry, and other technical support to industry and government. The EG&G AEROSPACE group of companies produce components and subsystems for aviation and aerospace industries worldwide. The DEFENSE segment includes EG&G operations that support the national security with research, field services, and technical products. Finally, the corporation provides site management, engineering services, and precision instrument and component production for DEPARTMENT OF ENERGY SUPPORT. EG&G maintains approximately ilisales, service, and manufacturing facilities in about 27 states in the United States and in approximately 11 foreign countries. In addition, the company is involved in approximately ten joint ventures in nine countries. Because of EG&G's strong historical commitment to decentralization of its business operations, most of its divisions have their own independent factories that, until recently, were small in size and lacked the resources required to justify and support the latest technologies in manufacturing management and automation. EG&G recognized that these past practices did not serve it well in an increasingly competitive business environment and a revised strategy would be necessary to allow it to penetrate non-U.S. markets to enhance growth while also defending its historical U.S. markets against the increasing pressures of global competitors. With the objectives of cost reduction, improved delivery and quality, a strategy of worldwide facility consolidation is being implemented to improve the effectiveness of EG&G as a worldwide competitor. To date consolidated instruments manufacturing has been completed in the Republic of Ireland and the United States. Additional consolidations are planned to serve markets in Japan and the Pacific Basin. It is believed that having factories strategically located within the geography intended to be served contributes in many ways to overall competitiveness. Costs are minimized by locating factories where production costs are low, where parts can be sourced locally, and where transportation costs from suppliers and to customers can be reduced. Additionally, such a strategy will also reduce vulnerability to local limitations on foreign trade, such as high import duties. It is also believed that strategic selection of a PAGENO="0585" 575 few different manufacturing sites capable of producing identical products increases the ability to respond to fluctuations in currency valuations by moving manufacturing when a shift in currency positions makes it profitable to do so. EG&G's business strategy also included a plan to expand upon existing non-U.S. manufacturing locations and utilize the cash generated by the resulting manufacturing facilities .as the source of low cost short- and long-term capital necessary to build and expand targeted non-U.S. markets. Such financing would be necessary, in part, due to larger and well-financed non-U.S. competitors encountered in these markets.. Also, EG&G historically has used the cash generated by its non-U.S. business operations to provide the capital required for non-U.S. business expansion, whether expanding existing business operations or for the acquisition of strategically advantaged businesses. In order for EG&G to maintain a competitive position in the markets it serves, it is necessary to have manufacturing operations with convenient, duty-free access to that market. Forexample, an existing Republic of Ireland operation provides access to the European markets without excessive tax and duty burdensanrLwith sigiiificant other financial incentives as well. A European position is especially important in light of the impending 1992 single European market. ~Current and Luture facilities in North America, Asia and the Pacific Basin will serve similar functions. Historically, EG&G has operated in foreign countries utilizing 100%-owned subsidiaries, known as Controlled Foreign Corporations, CFCs. Generally, the ust of this structure is necessary due to legal, financial and other operating requirements posed by the host countries. For example, in order to meet local content requirements for product origin, to provide goods and services to support a country's national security efforts, or to participate in specified industrial markets such as aerospace, business must be conducted through the use of locally incorporated subsidiaries. U.S. tax policyprovides for "deferral" of U.S. taxation of a CFC's earnings. Generally, the U.S. tax law provides that shareholders of CFCs do not pay tax on the CFC's earnings until the shareholder receives such income in the form of a dividend. Tax deferral helps EG&G, as well as other U.S. based multinational companies, to be internationally competitive; especially vis-a-vis foreign competitors whose home country may not tax foreign source income at all. Furthermore, EG&G believes it is also inconsistent with U.S. tax policy to tax a shareholder on income of a subsidiary, at least so long as that income is reinvested by the subsidiary. EG&G has been able to operate in many foreign countries in part due to its ability to defer CFC earnings from U.S. taxation until they are repatriated. Unrepatriated income of our CFCs represents a source of low cost funds used to finance our foreign operations. As an example, funds internally generated and accumulated by one of EG&G's existing non-U.S. operations were an important contributing factor to the recent acquisition of a technologicelly advanced European instrument's manufacturer which will contribute significantly to EG&G's long-term business strategy in the world-wide instrument market. It is doubtful this could have been accomplished if we had to pay U.S. tax on these funds prior to their repatriation. Contrary to some opinions, deferral from U.S. taxation of a CFC's earnings is not always permanent. While EG&G does operate utilizing 100% owned subsidiaries, when a business decision is made to withdraw from a foreign market or to curtail foreign business operations as a result of uncontrollable circumstances, all excess cash is repatriated to the U.S. for redeployment in new U.S. or non-U.S. business opportunities. This was the case in the early 80's when EG&G withdrew from providing environmental services to the oil and gas exploration industries in Southeast Asia and Australia. The Tax Reform Act of 1986 added the PFIC rules to the Internal Revenue Code (the Code) which now, at a minimum, threaten our ability to remain internationally competitive. It seems clear to EG&G that the intent of Congress in enacting these rules was to subject to current taxation the passive income of certain foreign incorporated mutual or investment funds which for varying reasons were not subject to the Subpart F, foreign personal PAGENO="0586" 576 holding company, personal holding company or foreign investment company provisions of the Code. It is EC&G's belief that it was *not the intent of Congress to subject CFCs to the PF1C rules. However, without completely considering how to coordinate these rules with existing rules governing CFCs, the PFIC rules were broadly drafted and defined. As it now stands these rules encompass many CFC5 and effectively eliminate or penalize the CFC's ability to defer U.S. tax until the income is repatriated to the U.S. shareholder. In addition, EG&G believes the PFIC rules have introduced an unparalleled level of complexity in taxing the. income of EG&G's foreign affiliates. To dispel any misconceptions concerning the use of CFCs we would like to bring to your attention the following facts to consider as you evaluate the merits of eliminating the applicability of these FF10 rules. A. Various EG&G operating units do not currently have PFIC status, and it is expected that PFIC status can continue to be avoided in the future by restructuring certain business operations. Therefore, it is not likely that enactment of legislation restricting the applicability of FF10 rules will lessen EG&G's U.S~ tax burden but it would (1) eliminate costly restructurings which could affect EG&G's competitiveness in the markets it serves, especially in the EEC, and (2) enhance EG&G's ability to enter potential markets in Eastern Europe and the Pacific Basin. B. Various EG&G CFCs are currently subject to tax under the Subpart F provisions on their passive income. Thus, the abuses that the PFIC legislation sought to address are not present with respect to these CFCs. Moreover, it is solely by application of the asset test that some might be considered a PFIC. Thus, PFIC status would be obtained primarily as a result of passive assets, the income from which has already been subject to U.S. tax. Also, as previously noted, these short-term passive assets have been a source of low cost working capital for non-U.S. operations. C. Many of EG&G's foreign operations are almost entirely self-financed, with only minimal initial capital contributions from the United States. Moreover, certain operations like the Republic of Ireland operations are a source of funds for its European affiliates. Without this source the necessary funds would generally need to be borrowed from the United States. D. A major EG&G manufacturing operation located in the Republic of Ireland purchases goods and services from the United States totaling more than $9 million annually (based on 1988 figures). This figure is approximately equal to, if not slightly more than, goods and services sold to the United States. EG&G respectfully requests .that Congress and this Committee consider any and all alternative approaches that would redirect the FF10 rules to accomplish their intended purposes and not subject to current U.S. taxation the active business income earned abroad by foreign affiliates of U.S. companies. We think the best approach would be to eliminate the application of the PFIC rules to CFCs. However, if Congress determines that they cannot take this approach because of sensitivity to revenue concerns, EG&G would also support the following changes that could be enacted on a prospective basis only: o Passage of H.R. 515, which would exempt from the asset test any CFC that engages in substantial manufacturing production activities in a country that has a deficit in its balance of trade with the United States. o Exclusion from the definition of passive income under IRC Section 1296(b), any passive income of a CFC subject to a tax of 10% or greater whether or not imposed by a foreign jurisdiction. o Elimination of the asset test under IRO Section 1296(a). o Elimination of the asset test and inclusion of an income test applied to determine foreign personal holding company status. PAGENO="0587" 577 We appreciate the opportunity to provide you our views as to why the PFIC rules should not be applied to active business income of a CFC. We urge Congress to eliminate the punitive and unintended application of these rules so that the ability of U.S. taxpayers to compete in world markets is not further impeded. We would be pleased to provide additional information should it be required. Respectfully submitted, ~ Louis J. Williams Vice President PAGENO="0588" 578 STATEMENT ON BEHALF OF HERCULES INCORPORATED IN SUPPORT OF EXCLUDING EXPORT TRADE INCOME OF AN EXPORT TRADE CORPORATION FROM THE PASSIVE FOREIGN INVESTMENT COMPANY (PFIC) RULES The passive foreign investment company (PFIC) rules should not apply to export trade corporations (ETC5). ETCs operate under specially created export incentives set forth in Sections 970 and 971 of the Internal Revenue Code. Enacted in 1962, the ETC statute encourages export sales of U.S. products by permitting a deferral from U.S. taxation of qualifying Export Trade Income until such income is returned to the U.S. or is no longer devoted to export trade activity. Subsequent export trade legislation in 1971 and 1984 generally replaced the ETC export incentive system but specifically allowed existing ETCS to continue. After 1971 no new ETC could be created. The 1971 law allowed an ETC the option of transferring its assets to a Domestic International Sales Corporation (DISC) on a tax- deferred basis or continuing to operate as an ETC. The 1984 law permitted an ETC either to continue to operate as such or to elect the tax-free transfer of assets from the ETC to a Foreign Sales Corporation (FSC) or to its domestic parent. Code Section 971 (b) (1) provides that Export Trade Income of an ETC includes, among other things, income from fees, commissions, compensation or other income from the performance of commercial, financial, managerial or other services in respect of the sale of "export property" to an unrelated person for use outside the United States. Such income also includes interest from evidence of indebtedness executed in connection with payment for purchases of export property. Under Code Section 970 (a) an ETC is permitted to use a portion of such Export Trade Income to offset what would otherwise be currently taxable subpart F income. In this way, such income of a qualifying ETC that would otherwise constitute currently taxable income under Code Section 954 (c) is afforded the benefit of tax deferral. A PFIC is defined to include any foreign corporation if 75% or more of its gross income is "passive income" or 50% or more of its assets produce "passive income." Passive income is defined by reference to the foreign personal holding company rules of Code Section 954 (c). Tax deferral is ended on all income of a PFIC. The PFIC rules, as applied by reference to Code Section 954 (c), could conflict with the ETC rules. For purposes of the PFIC rules, Export Trade Income of an ETC that reduces currently taxable subpart F income under Code Section 954 (c) could also be "passive income" that is currently taxable, as the PFIC rules are interpreted under proposed and temporary regulations under Code Section 954 (C). Thus, the PFIC rules could interfere with an ETC'S use of intended tax benefits provided by Code Sections 970 and 971 for certain income earned in the conduct of its trading business that has long been, and continues to be, sanctioned as tax-deferred Export Trade Income. This result of the enactment of the PFIC rules is unintended. Nothing in the legislative history or purpose of the 1986 legislation directed at passive foreign investment companies indicates any intention on the part of Congress to affect ETC5 or to repeal the export incentive provisions of Sections 970 and 971. Moreover, this result is unjust because an existing ETC, specifically grandfathered since the 1971 DISC legislation, could also have declined the tax amnesty provided by the FSC legislation in 1984 in the reasonable expectation under those laws that it could continue to operate as an ETC. This unintended adverse effect on export trade incentives should be reversed by providing that the Export Trade Income of a qualifying ETC shall not be treated as "passive income" for purposes of the rules aimed at passive foreign investment companies. PAGENO="0589" 579 1212 Avenore of the Ameercas Noes York, Noes York 10036-1689 Telephone 212.3544480 Telee: 820864 United States Council for Serveng Amerecan Baseness as U U Ufhkafe of International Business The fete af:oeaihframberofCornnnpece The Beseness and fodubfr~ Adeesory Comreeeoee to the OECU The ATA Cornet Systeet February 23, 1990 The Honorable Charles B. Rangel Chairman, Subcommittee on Select Revenue Measures Committee on Ways and Means 1102 Longworth House Office Building Washington0 D.C. 20515 Dear Mr. Chairman: On behalf of the United States Council for International Business, I am pleased to respond to the Committee's request for a written statement for the record for your subcommittee's hearings on February 21, 1990 on miscellaneous revenue matters. One of the proposed amendments would provide an exception to the Passive Foreign Investment Company (PFIC) rules for controlled foreign corporations that engage in substantial manufacturing operations in a foreign country that has a deficit in its trade balance with the U.S. The U.S. Council is comprised of some 280 major corporations, law firms, and accounting firms with substantial experience in. foreign operations. The Council represents American Business in major international economic institutions such as the OECD and the International Chamber of Commerce. Its primary objective is to promote an open system of world trade, finance and investment. The application of PFIC provisions to U.S. controlled foreign corporations, which we believe was not an intended objective of the 1986 Tax Reform Act, is a significant problem for many members of the Council. The PFIC rules are exceptionally complicated from an administrative standpoint, and they can have the result of.accelerating U.S. taxation of the undistributed earnings of the income of operating subsidiaries aboard that would otherwise be entitled to deferral from U.S. taxation under the traditional tests of Subpart F of the Code. The situation addressed in the proposal before the subcommittee is but one of many potential fact patterns faced by U.S. companies engaged in active business abroad through controlled foreign corporations which can involve application of the PFIC provisions. We believe that corrective legislation should provide a broad exception so as to exclude U.S. shareholders of controlled corporations from the application of the PFIC provisions. We have already stated our views on this matter in previous written submissions to the full Committee on Ways and Means as well as to the Committee on Finance of the U.S. Senate. urs very truly, Richard M. Hammer Chairman, Tax Committee cc: The Honorable Daniel Rostenkowski, Chairman, House Ways & Means Committee The Honorable Lloyd Bentsen, Chairman, Senate Finance Committee The Honorable Nicholas Brady, Secretary of the Treasury PAGENO="0590" 580 STATEMENT BY CONGRESSMAN SCHULZE FEBRUARY 22, 1990 MR. CHAIRMAN: THANK YOU FOR HOLDING THIS HEARING TODAY. I HAVE THREE ISSUES THAT I WOULD LIKE TO BRING BEFORE THE COMMITTEE. IN THE INTEREST OF TIME, I WILL SUMMARIZE MY REMARKS BUT WILL ASK THAT THE FULL TEXT OF MY STATEMENT BE INCLUDED IN THE RECORD. PART I I HAVE INTRODUCED LEGISLATION, H.R. 747, WHICH WOULD AMEND THE 1986 TAX ACT TO RESTORE THE FULL TAX DEDUCTIBILITY OF INTEREST ON STUDENT LOANS. H.R. 747 HAS GARNERED THE BIPARTISAN SUPPORT OF 309 MEMBERS OF THE HOUSE AND 15 WAYS AND MEANS MEMBERS. SINCE 1986, THE FULL DEDUCTION OF LOAN INTEREST HAS BEEN PROGRESSIVELY PHASED OUT AND THIS YEAR MARKS THE LAST YEAR THAT STUDENTS CAN DEDUCT ANY PORTION OF THEIR STUDENT LOAN INTEREST. AS A RESULT OF TAX REFORM, STUDENT LOANS ARE NOW CLASSIFIED AS CONSUMER LOANS. THAT IS, CONGRESS AND THE INTERNAL REVENUE SERVICE NO LONGER DIFFERENTIATE BETWEEN A LOAN TO BUY A CAR AND A LOAN TO PAY FOR EDUCATIONAL EXPENSES. THE RATIONAL BEHIND ELIMINATING THE CONSUMER LOAN INTEREST DEDUCTION WAS TO DISCOURAGE OVER RELIANCE ON CREDIT AND TO ENCOURAGE SAVING. EDUCATION SERVES THE SAME PURPOSE AS INDIVIDUAL SAVING -- EDUCATION IS AN INVESTMENT IN THE AMERICAN PEOPLE AS WELL AS THE NATION AND SHOULD BE DEDUCTIBLE. BORROWING FOR EDUCATIONAL EXPENSES IS NOT ONLY A GOOD INVESTMENT, BUT IS IMPERATIVE FOR MOST YOUNG ADULTS. THE NUMBER OF STUDENT LOANS DISTRIBUTED BY THE FEDERAL GOVERNMENT HAS INCREASED BY 79 PERCENT IN THE LAST TEN YEARS. HIGHER EDUCATION IS PRICING ITSELF OUT OF THE HANDS OF LOW AND MIDDLE INCOME FAMILIES. OVER 50 PERCENT OF GOVERNMENT STUDENT LOANS WERE AWARDED TO INDIVIDUALS WITH INCOME UNDER $15,000. CONSIDERING THE AVERAGE DEBT UPON GRADUATION FROM MEDICAL SCHOOL RANGES FROM $50,000 - $100,000, STUDENT LOANS ARE CLEARLY NOT A LUXURY. THEY ARE A NECESSITY. INTEREST PAID ON THESE LOANS IS APPROXIMATELY $14, 000. THE CONSEQUENCE OF RISING EDUCATION COSTS AND NON- DEDUCTIBILITY OF INTEREST ON STUDENT LOANS IS SLIPPING ENROLLMENT IN OUR NATION'S COLLEGES AND UNIVERSITIES. FOR THOSE WHO QUESTION WHETHER INTEREST DEDUCTIBILITY TRULY AFFECTS FUTURE DECISIONS, LET ME READ YOU THE FOLLOWING LETTER: "] AMA THIRD YEAR MEDICAL STUDENT AT LOMA LINDA, CALIFORNIA. I HAVE RECENTLY BECOME AWARE OF YOUR EFFORTS TO RESTORE THE FEDERAL TAX DEDUCTION FOR STUDENT LOAN INTEREST, AND I WANT TO EXPRESS MY FULL SUPPORT FOR, AND APPRECIATION OF, SUCH EFFORTS." "MY PARENTS, MINISTER, AND TEACHER, HELP ALL THEY CAN WITH MY LIVING AND EDUCATIONAL EXPENSES, BUT I EXPECT TO BE ABOUT $70,000 IN DEBT BY THE TIME I FINISH IN 1991. THIS AMOUNTS TO APPROXIMATELY $15,000 IN INTEREST PAYMENTS. I NAVE ALWAYS BEEN INTERESTED IN RURAL AND/OR HUMANITARIAN MEDICINE, BUT 1 ADMIT, THAT PAYING OFF SUCH A HEAVY DEBT BURDEN WITH INTEREST IS A MAJOR CONCERN, AND MAY AFFECT MY CHOICE OF SPECIALTY AND LOCATION." "THANKS AGAIN FOR YOUR EFFORTS AND CONCERN." CHARLA NEAL THERE ARE SEVERAL MISUNDERSTANDINGS REGARDING THE DEDUCTIBILITY OF INTEREST ON STUDENT LOANS. ONE COMMON MISUNDERSTANDING IS THAT ONCE STUDENTS FINISH GRADUATE SCHOOL, THEY WILL BE IMMEDIATELY ELIGIBLE FOR HIGHER PAYING JOBS. AS FRANK CONTE, PRESIDENT OF GEORGETOWN MEDICAL SCHOOL CLASS OF 1989, POINTS OUT, "VERY FEW BEGINNING RESIDENTS NEXT YEAR MAKE AS MUCH AS $30,000 A YEAR. AT GEORGETOWN, RESIDENTS BEGIN AT $21,000 AND MUST PAY ON AVERAGE $1000 A MONTH IN LOAN PAYMENTS." PAGENO="0591" 581 CURRENT LAW PENALIZES LOW AND MIDDLE INCOME INDIVIDUALS PURSUING HIGHER EDUCATION. WHILE CURRENT LAW ALLOWS FOR INTEREST DEDUCTION ON HOME EQUITY LOANS USED FOR EDUCATIONAL EXPENSES, THE VAST MAJORITY OF THE STUDENT POPULATION CANNOT BENEFIT FROM THIS DEDUCTION SINCE MOST ARE NOT HOMEOWNERS. CONGRESS MUST ACT TO CORRECT THIS INEQUITY IN THE TAX REFORM ACT. THE FACT IS, MANY STUDENTS APPLIED FOR AND ACCEPTED LOANS UNDER THE IMPRESSION THAT INTEREST ON THESE LOANS WOULD BE DEDUCTIBLE. THERE ARE 309 MEMBERS OF THE HOUSE WHO RECOGNIZE THIS LEGISLATION AS NECESSARY AND GOOD POLICY. MR. CHAIRMAN, AS A COSPONSOR OF H.R. 747, I HOPE YOU CONSIDER THIS BILL WHEN FORMULATING COMMITTEE RECOMMENDATIONS. PART II ON MARCH 8, 1989, I INTRODUCED LEGISLATION WHICH WILL HAVE THE DUAL BENEFIT OF LOWERING ELECTRIC UTILITY RATES FOR CONSUMERS WHILE ADVANCING IMPORTANT NATIONAL ENVIRONMENTAL OBJECTIVES. THE NUCLEAR DECOMMISSIONING RESERVE FUND ACT, H.R. 1317, WILL ACHIEVE THESE RESULTS BY LOWERING THE APPLICABLE TAX RAPE ON THE INCOME OF QUALIFIED NUCLEAR DECOMMISSIONING RESERVE FUNDS AND BY REMOVING THE CURRENT INVESTMENT RESTRICTION ON QUALIFIED FUNDS. CURRENTLY, THIS LEGISLATION HAS RECEIVED EXTENSIVE BIPARTISAN SUPPORT WITH 52 COSPONSORS, INCLUDING 7 WAYS AND MEANS COMMITTEE MEMBERS. COMPANION LEGISLATION (5. 1808) HAS BEEN INTRODUCED IN THE SENATE. THIS LEGISLATION HAS BEEN ENDORSED BY A BROAD RANGE OF ENVIRONMENTAL, CONSUMER, REGULATORY, UTILITY INDUSTRY AND INVESTMENT INDUSTRY GROUPS, INCLUDING THE SIERRA CLUB, THE CONSUMER FEDERATION OF AMERICA, THE NATIONAL ASSOCIATION OF REGULATORY UTILITY COMMISSIONERS, THE PUBLIC SERVICE COMMISSIONS OF ARKANSAS, CALIFORNIA, FLORIDA, MICHIGAN, NEW JERSEY, NEW YORK, TEXAS, AND WISCONSIN, THE EDISON ELECTRIC INSTITUTE AND THE UTILITY DECOMMISSIONING TAX GROUP. BY WAY OF BACKGROUND, OWNERS OF NUCLEAR POWER PLANTS GENERALLY MUST DECOMMISSION, THAT IS CLOSE DOWN AND DISMANTLE, SUCH PLANTS AT THE END OF THEIR USEFUL LIVES. DECOMMISSIONING REQUIRES MAJOR EXPENDITURES TO SAFELY DISPOSE OF THE PARTS OF THE PLANTS THAT CONTAIN RESIDUAL RADIATION. EXPENDITURES FOR DECOMMISSIONING GENERALLY WILL OCCUR MANY YEARS AFTER THE PLANTS FIRST BECOME OPERABLE. THE COST OF DECOMMISSIONING ULTIMATELY IS PAID BY THE CUSTOMERS OF THE UTILITY COMPANIES OWNING THE NUCLEAR POWER PLANTS OR BY THE CUSTOMERS OF NONNUCLEAR UTILITY COMPANIES THAT PURCHASE WHOLESALE POWER PRODUCED BY NUCLEAR POWER PLANTS. SECTION 468A OF THE INTERNAL REVENUE CODE ALLOWS A UTILITY TO DEDUCT CONTRIBUTIONS TO A QUALIFIED FUND, SUBJECT TO CERTAIN LIMITATIONS. A QUALIFIED FUND IS A SEGREGATED FUND TO BE USED EXCLUSIVELY FOR THE PAYMENT OF NUCLEAR DECOMMISSIONING COSTS AND RELATED EXPENSES. THE QUALIFIED FUND CONSTITUTES A SEPARATE TAXABLE ENTITY AND IS SUBJECT TO TAX AT THE MAXIMUM CORPORATE INCOME TAX RATE, 34 PERCENT. THE ASSETS OF A QUALIFIED FUND, LIKE THOSE OF A TAX- EXEMPT BLACK LUNG DISABILITY TRUST FUND, MAY BE INVESTED ONLY IN FEDERAL, STATE, OR LOCAL GOVERNMENT OBLIGATIONS OR CERTAIN BANK OR CREDIT UNION DEPOSITS. THE CURRENT INVESTMENT LIMITATIONS, ALTHOUGH WELL-SUITED TO A TAX-EXEMPT BLACK LUNG TRUST, ARE INAPPROPRIATE WHEN APPLIED TO A TAXABLE ENTITY SUCH AS A QUALIFIED FUND. THE CURRENT RESTRICTIONS ON INVESTMENTS, COMBINED WITH THE MAXIMUM CORPORATE TAX RATE, CAUSE UTILITIES TO RESTRICT FUND INVESTMENTS TO TAX-EXEMPT SECURITIES. AS A RESULT, THE U.S. TREASURY IS DENIED SIGNIFICANT TAX REVENUE FROM THE QUALIFIED FUNDS. THE NUCLEAR DECOMMISSIONING RESERVE FUND ACT WILL CORRECT THESE PROBLEMS AND MAKE THE ESTABLISHMENT OF A QUALIFIED FUND MORE ATTRACTIVE, BY LOWERING THE TAX RATE ON INCOME OF SUCH A FUND FROM 34 TO 15 PERCENT AND ELIMINATING THE CURRENT RESTRICTIONS ON FUND INVESTMENTS. THESE MODIFICATIONS WILL ENCOURAGE UTILITY COMPANIES WITH A QUALIFIED FUND TO INVEST IN TAXABLE SECURITIES SUCH AS U.S. TREASURY OBLIGATIONS RATHER THAN TAX-EXEMPT SECURITIES. THIS REVISED INVESTMENT PROGRAM WILL BENEFIT UTILITY CUSTOMERS AND INCREASE TAX REVENUES FROM EXISTING QUALIFIED FUNDS. PAGENO="0592" 582 THIS LEGISLATION WILL REDUCE THE ANNUAL AMOUNT OF DECOMMISSIONING COSTS CHARGED TO CUSTOMERS. BASED OH A PRICE WATERHOUSE STUDY, IF THE TAX RATE WERE LOWERED TO 15 PERCEHT AND THE CURRENT INVESTMENT RESTRICTION WERE ELIMINATED, THE ANNUAL DECOMMISSIONING COLLECTIONS IN CALENDAR YEARS 1990 TO 2004 FROM CUSTOMERS OF UTILITIES WHICH ALREADY HAVE ESTABLISHED A QUALIFIED FUND WOULD DECREASE BY APPROXIMATELY $70 TO $96 MILLION ANNUALLY. THIS DECREASE WOULD DIRECTLY BENEFIT CUSTOMERS BY LOWERING THE ELECTRICITY RATE THEY OTHERWISE WOULD BE CHARGED. THE SAVINGS WOULD BE SHARED BY CUSTOMERS OF UTILITIES THAT OWN NUCLEAR POWER PLANTS AND CUSTOMERS OF UTILITIES THAT DO NOT OWN NUCLEAR POWER PLANTS. FURTHERMORE, BASED ON THE SAME STUDY, IF THE INCOME TAX RATE WERE DECREASED TO 15 PERCENT AND THE CURRENT INVESTMENT LIMITATIONS WERE REMOVED, IT IS ESTIMATED THAT TOTAL TAX REVENUES FROM EXISTING QUALIFIED FUNDS WOULD ESCALATE TO APPROXIMATELY $174 MILLION FOR CALENDAR YEARS 1990 THROUGH 1993. THIS REPRESENTS AN ESTIMATED INCREASE OF MORE THAN $129 MILLION INFEDERAL TAX REVENUE FROM EXISTING QUALIFIED FUNDS OVER CURRENT LAW. EXISTING LAW IMPOSES A DISPROPORTIONALLY HIGH TAX BURDEN ON QUALIFIED FUNDS AND ON CUSTOMERS WHOSE MONIES ARE DEPOSITED IN THESE FUNDS. A QUALIFIED FUND ACTUALLY REPRESENTS AN ADVANCE PAYMENT BY CUSTOMERS FOR FUTURE DECOMMISSIONING COSTS. AS SUCH. THE INCOME OF A QUALIFIED FUND SHOULD BE TAXED AT A RATE COMMENSURATE WITH THE RATE THAT WOULD BE APPLIED IF THE MONIES WERE HELD AND INVESTED BY THESE CUSTOMERS UNTIL NEEDED FOR DECOMMISSIONING, I.E., THE COMPOSITE MARGINAL TAX RATE APPLICABLE TO THE INCOME OF THE CUSTOMERS. IT HAS BEEN ESTIMATED BY THE EDISON ELECTRIC INSTITUTE THAT THE COMPOSITE MARGINAL TAX RATE ON THE INCOME OF ALL CUSTOMERS OF ELECTRIC UTILITY COMPANIES IS 16.61 PERCENT, WHICH IS ONLY SLIGHTLY HIGHER THAN THE 15 PERCENT RATE SOUGHT BY THE ACT. ACCORDINGLY, THE ACT SEEDS TO IMPOSE A MORE APPROPRIATE TAX RATE ON THE INCOME OF QUALIFIED FUNDS THAN THE RATE CURRENTLY IN EFFECT. THE NUCLEAR DECOMMISSIONING RESERVE FUND ACT WILL ACHIEVE THE FOLLOWING: (1) ADVANCE THE IMPORTANT ENVIRONMENTAL OBJECTIVE OF ENSURING THAT ADEQUATE MONIES WILL BE AVAILABLE TO DECOMMISSION THE NATION'S NUCLEAR POWER PLANTS; (2) CREATE A SUBSTANTIAL MARKET FOR U.S. TREASURY OBLIGATIONS AND OTHER TAXABLE SECURITIES; (3) INCREASE TAX REVENUE FROM EXISTING QUALIFIED FUNDS; AND (4) BENEFIT CUSTOMERS THROUGH LOWER UTILITY RATES. FINALLY, THE BILL WILL ACHIEVE TAX POLICY OBJECTIVES BY IMPOSING A MORE APPROPRIATE TAX RATE ON THE INCOME OF QUALIFIED FUNDS. I AM HOPEFUL THAT MY COLLEAGUES, RECOGNIZING THE MERITS OF THIS LEGISLATION, WILL SUPPORT THIS BILL. PART III FINALLY, I WOULD ASK THE COMMITTEE TO GIVE SERIOUS CONSIDERATION TO AMENDING THE IRS CODE TO MAKE CERTAIN CONVENTIONS HELD ON CRUISE VESSELS IN THE CARIBBEAN TAX DEDUCTIBLE. AS YOU KNOW, MR. CHAIRMAN, BOTH CONGRESS AND THE ADMINISTRATION IN THE PAST DECADE HAVE HAD A STRONG COMMITMENT TO PROVIDING ECONOMIC ASSISTANCE TO OUR FRIENDS IN THE CARIBBEAN BASIN. MR. CHAIRMAN, YOU YOURSELF HAVE BEEN ONE OF THE LEADERS IN THIS AREA. UNFORTUNATELY, CBI I AND CBI II OVERLOOKED THE CARIBBEAN'S NUMBER ONE INDUSTRY, THE TOURISM INDUSTRY. THE CRUISE INDUSTRY REPRESENTS A MAJOR CONTRIBUTOR TO THE TOURISM REVENUES WHICH ARE CRUCIAL TO ECONOMIC DEVELOPMENT IN THE CARIBBEAN. LAST YEAR, OVER 2.5 MILLION CRUISE PASSENGERS BOARDED IN U.S. OR CARIBBEAN PORTS BOUND FOR CARIBBEAN DESTINATIONS. THESE PASSENGERS REPRESENTED APPROXIMATELY $450 MILLION IN REVENUES FOR THE ISLANDS OF THE CARIBBEAN. WITH ITS 40 TO 50 VESSELS OFTEN UTILIZING AS MANY AS THREE CARIBBEAN PORTS OH A VOYAGE IN THE YEAR, THE CRUISE INDUSTRY IS A VITAL BUILDING BLOCK TO THE ECONOMIES IN THE CARIBBEAN THROUGH THE RAPID INFUSION OF NEW DOLLARS. THIS ECONOMIC ADVANTAGE CAN BE ENHANCED BY ALLOWING THE DEDUCTIBILITY, UNDER LIMITED CIRCUMSTANCES, ON CRUISE VESSELS IN THE REGION WHICH IN TURN WILL CREATE MORE JOBS FOR CARIBBEAN NATIONALS AND MUCH NEEDED ECONOMIC STIMULUS TO THE NATIONS OF THE CARIBBEAN BASIN REGION. PAGENO="0593" 583 MY PROPOSAL WOULD ALLOW CONVENTIONEERS TRAVELING ON VESSELS SERVING TME CARIBBEAN AND EMPLOYING AT LEAST 20% CARIBBEAN NATIONALS TO RECEIVE A DEDUCTION FOR CONVENTIONS MELD ON BOARD QUALIFYING VESSELS. IN ADDITION, MY LEGISLATION WOULD LIMIT THE SIZE OF THOSE CONVENTION GROUPS TO NO LARGER THAN BOO PEOPLE. THE CONVENTION DEDUCTION IS CURRENTLY ALLOWED FOR HOTELS LOCATED IN SOME CARIBBEAN COUNTRIES. THE JOINT COMMITTEE ON TAXATION HAS ESTIMATED THAT THIS CONVENTION DEDUCTION PROPOSAL WOULD RESULT IN A NEGLIGIBLE LOSS OF REVENUE TO THE TREASURY. I PROPOSE WE TAKE THIS STEP TO ALLOW THE DEDUCTIBILITY OF CERTAIN CONVENTIONS ABOARD CRUISE SNIPS IN THE CARIBBEAN IN ORDER TO ALLOW OUR FRIENDS IN THAT REGION TO PROSPER, IN ADDITION TO TNE THREE MAJOR ISSUES I ADDRESSED IN MY TESTIMONY TODAY, DTNERS CLEARLY DESERVE MENTION. FIRST, THE RETROACTIVE NATURE OF SECTION 9B6 SUCCESSIVE LOAN IRS REGULATIONS, SNOULD BE REPEALED. SECOND, THE COMMITTEE SHOULD OPPOSE EFFORTS TO INCREASE THE EXCISE TAX ON PROPERTY AND CASUALTY INSURANCE CEDED ABROAD. TNIRD, SMALL PROPERTY AND CASUALTY. INSURANCE COMPANIES SNOULD BE RELIEVED OF ALTERNATIVE MINIMUM TAX (ANT) CALCULATIONS ON AN ELECTIVE BASIS. FOURTH, GIFTS OF APPRECIATED PROPERTY SHOULD BE REMOVED AS A PREFERENCE ITEM UNDER THE AMT. FINALLY, TNE DEPARTMENT OF TNE TREASURY'S ACRS STUDY CLEARLY SNOWS TNAT TUXEDOS SHOULD BE GIVEN A REDUCTION IN CLASS LIFE TO TWO OR THREE YEARS. I NOPE THE COMMITTEE GIVES SERIOUS CONSIDERATION TO THE ISSUES THAT I NAVE DISCUSSED TODAY, SPECIFICALLY, THE TAX DEDUCTIBILITY OF INTEREST ON STUDENT LOANS, THE NUCLEAR DECOMMISSIONING ACT, AND FINALLY, THE CARIBBEAN BASIN INITIATIVE. GIVEN THE WIDE SUPPORT OF EACH OF THESE PROPOSALS, THEY DESERVE CONSIDERATION BY THE CONGRESS. PAGENO="0594" 584 JOSEPH F ADA DEPAATMENTOF FRANK F. BIAS REV~1IIIE &IA)(~1Ot1 L~t~~.t GOVERNMENT OF GUAM JOAQUIN G. BLAZ, Dfr~d~ V.M. CONCEPUON. D,pdy Diue~ The Honorable Charles B. Rangel Chairman, Subcommittee on Select Revenue Measures Committee on Ways and Means - FE B 1 9 1990 U.S. House of Representatives 1102 Longworth Building Washington, D.C. 20515 -. Mr. Chairman and Members of the Select Committee: I am Joaquin G. Blaz, the Director of the Department of Revenue and Taxation for the Territory of Guam. I am also the Tax Commissioner of Guam and member of the Guam Tax Reform Commission. I am presenting this testimony on behalf of Frank F. BIas, the Lieutenant Governor of Guam, who is the Chairman of the Guam Tax Reform Commission. The Chairman sends his regrets that he is not able to personally testify on the Bill, but urgent local matters prevent him from appearing. The TAX REFORM ACT OF 1986 granted Guam the authority to develop its own tax code and effectively delink from the Internal Revenue Code and the Mirror Tax. In response to this, the Governor of Guam, Joseph F. Ada, exercising the authority granted to him by the Organic Act, issued an Executive Order creating the Guam Tax Reform Commission. The Commission held many meetings to study options for the Guam Tax Code. It became obvious early in the Commissions deliberations that two major hurdles had to be overcome in the quest for tax autonomy. First of all, developing a code suitable to the economic climate of Guam would be an immense task for the Commission to tackle without expert help. The second problem was the desire of the Commission to have an orderly transition to the Guam Code. The first issue was resolved by securing funds to be utilized to retain experts in the field of taxation to help the Commission develop the Guam Code. The second problem is the focus of the Bill now before this Committee. The Tax Reform Act of 1986 conditioned the effective date of the delinkage to the signing of an implementation agreement with the Department of the Treasury. Once the implementation agreement is effective, Guam would have its own code. 855 WRO M&1RR OK'R Ag~, O~R 96910 Td: (671) 477-1040 T6~: 721-6218 GOVOIJAM . F~: (671) 472-2643 PAGENO="0595" 585 Guam does indeed need the implementation agreement for effective tax administration. The agreement allows Guam to exchange information with the Internal Revenue Service. The information is vital to Guam's program for tax compliance. We want the implementatior, agreement. But once the agreement goes into effect, the present Internal Revenue Code wouldessentially become the Guam Tax Code and would immediately be subject to piecemeal changes. This would create havoc in our desire to have an orderly transition. Furthermore, Section 935 of the Internal Revenue Code which allows for the filing of one return would be repealed once the Mirror system is eliminated. A majority of Guam residents would be required, therefore, to file two returns - a requirement that would certainly be an unnecessary burden to the taxpayers of Guam. This would still occur even though Guam would have substantially the same tax code as the United States. The passage of the Bill now before you would relieve Guam of the adverse effects of immediate delinkage. The Bill would give Guam the time necessary to study options towards the development of the Guam code. At the same time, it would safeguard the "Mirror Code" from piecemeal legislation.. This is the only way an orderly transition to the new code can be accomplished. The Department of the Treasury has no objections to the Bill. In a memorandum to the Legal Counsel, Joint Committee on Taxation, dated August 14, 1989, the Office of the International Counsel supported Guam's desire to postpone the effective date of the authority to develop a code. In fact, the Treasury memorandum provided that "From the perspective of tax administration, it makes sense to permit Guam to stay on the current mirror system (with single filing) until it develops its own comprehensive tax law and plans an orderly transition to the new system". This Bill, if passed, would not have a measurable impact on the revenues of the United States. I urge the Chairman and Members of this Select Committee to vote favorably on the Bill and recommend its passage by the Full House. Thank you Mr. Chairman and Members of the Select Committee for giving me a chance to testify in favor of this Bill on behalf of the people of the Territory of Guam. Sincerely, epartment of Revenue and Taxation PAGENO="0596" 586 WRITTEN STATEMENT OF THE ASSOCIATION OF BRITISH INSURERS The Association of British Insurers represents 454 insurance companies in the United Kingdom, who write insurance and reinsurance of both property/casualty and life risks. Together, these companies write 90% of the premiums written by insurance companies in the U.K.,,' and 68% of all insurance premiums in the U.K. The remainder of U.K. premiums are written by Syndicates at Lloyd's of London and non-member companies. The Reinsurance Association of America ("RAA") has proposed that Congress should increase the excise tax on property/casualty reinsurance placed abroad from 1% to 4% and should override waivers of the federal excise tax ("FET") in exiáting treaties, if there is a finding that reinsurers in the treaty country are nOt subject to a "reasonable" amount of tax. In its revised proposal, the RAA has at last acknowledged that waivers of the excise tax are appropriate where a foreign reinsurer is subject to substantial taxes in its home country. Regrettably, it has not been objective in its application of this standard. In order to bring into question existing waivers of the FET, it has failed to distinguish high tax and low tax jurisdictions, and has alleged that reinsurers in the U.K. and other European countries are subject to special tax treatment in their own countries. The RAA focused upon the U.S. - U.K. double tax treaty, in particular, and alleged that the unconditional waiver in the U.K. treaty permits "fronting" --- the use of a U.K. insurer as a `frOnt" for coverage ultimately placed with a foreign reinsurer in a non-exempt country --- a charge examined and rejected by Treasury and Congressional staff in 1984 and 1986. The RAA proposal is a self-serving, protectionist measure, which is contrary to the interests of U.S. insurance companies and policyholders. As the "liability crisis" of 1984-86 made clear, domestic companies need additional reinsurance capacity to meet the needs of U.S. insurance consumers. The "London market", in particular, provides high quality reinsuranCe and sophisticated underwriting of novel and hard-to-place risks. The observation that foreign reinsuranCe supplements coverage available from U.S. reinsurers is well documented, both from the testimony of executives of U.S. companies and brokerage firms, and from studies of the U.S. market. In the General Accounting Office report on the FET, executives of Mortgage Guaranty Insurance Company stated that during 1983 and 1984 they were unable to find domestic reinsurance. Without foreign reinsurance, the company would have been forced to stop writing new business. In testimony before the Ways and Means Committee, an executive of the American Agricultural Insurance Company pointed out that foreign reinsurance was indispensable to his company's coverage of losses from Hurricane Hugo. In a 1987 study of reinsurance placed with U.K. companies, professor R. L. Carter, an economist at the University of Nottingham, found that more than 50% of the business placed with U.K. companies was reinsurance for which U.S. insurers did not compete.2 These statistics do not include overseas subsidiaries of U.K. insurance companies. 2 "The Effects of the Tax Reform Act of 1986 and the Tax Treaty Between United States and the United Kingdom on the Competitive Position of U.S. Reinsurers," a paper by Robert L. Carter, Norwich Union professor of Insurance Studies, University of Nottingham, May, 1987, Secs. 4.10-4.13 (hereinafter, the "1987 study"). PAGENO="0597" 587 There is no question that, because of the regulations governing credit for non-admitted reinsurance, U~S. insurance conpanies would prefer to purchase coverage fron a domestic reinsurer. However, when U.S. reinsurers are unwilling to write reinsurance providing the type of coverage or the volume necessary, U.S. carriers must have the option of turning to foreign reinsurers if they are to meet the needs of the U.S. market. If adopted, the excise tax increase would inevitably increase the cost of insurance forU.S. insurance companies and their policyholders. In the current environment, when commercial and individual policyholders have repeatedly challenged insurance costs, it is hardly surprising that ~j. domestic trade associations representing primary insurers have opposed the excise tax increase. In addition, associations representing commercial policyholders and brokers strongly object to a measure whOse primary purpose is to allow dOmestic reinsurers to increase premiums. Data on Foreign Reinsurance in the U.S. Contradicts RAA's Assertions that the `86 Act Has Created a Competitive Imbalance In projecting that the U.S. reinsurers will inevitably lose market share to foreign.reinsurers unless excise tax barriers are erected to protect the domestic industry, the RAA plays upon fears of unfair competition but ignores reality First U S insurers have a strong preference for domestic réinsurers. U.S. insurers turn to foreign reinsurers only when domestià reinsurance is unavailable or is offered at too great a price. Second the growth of foreign reinsurance is not attributable, solely or primarily, to tax increases imposed by the 1986 Act. Commerce Department data3 shows that reinsurance placed foreign reinsurers' market share has grown from 26.3% of total reinsurance premiums in 1975 to 36.9% in 1988 (based upon revisions to Commerce Department data not available until ~ita~ the GAO report's publication). In January, 1990,. Professor Robert L. Carter of the University of Nottingham prepared an analysis of reinsurance premiums written by U.S. and foreign reinsurers using data collected by the U. S. Department of Commerce,. a trade publication The National Underwriter, and the Insurance Information Institute.4 The data shows: 1) Long before the Tax Reform Act of 1986 there was a steady upward trend in the premiums ceded to foreign reinsurers. 2) The most recent Commerce Department data shows that contrary to the RAA's allegations, a large part of the rise in premiums between 1984 and 1987 occurred in 1985 and 1986 --- before the `86 Act increases had any effect on the competitive position of U.S. reinsurers. 3) The U.K. market share has declined steadily, even though foreign reimsurers' share overall has increased. "i~einsurance Transactions of U.S. Insurance Companies with Insurers Resident Abroad," . U.S. Dèpartmeñt of Commerce, Bureau of Economic Analysis, September 20, 1989. The Effects of the Tax Reform Act of 1986 and the Tax Treaty Between the United States and the United Kingdom on the Competitive Position .of U. S. Reinsurers," Addendum January, 1990, No.. 2,. Professor Robert L. Carter, University of Nottingham (hereinafter, "Addendum No. 2"). PAGENO="0598" 588 a. The U.K. share of U.S. reinsurance premiums ceded abroad dropped from 56.59% in 1975 to 23.27% in 1988. b. In 1987, the 10.1% increase in premiums ceded to U.K. reinsurers was substantially less than the 17.0% rise in foreign reinsurers' premiums overall. c~ The provisional figures for 1988 show a 5.0% decline in U.S. reinsurance premiums paid to U.K. companies,' even though total premiums paid abroad rose by 6.7%. On the basis of this data, Professor Carter has concluded that the F.E.T. waiver in the U.S. - U.K. treaty has failed to halt the decline in `U.K. reinsurers' share of U.S. reinsurance premiums paid to foreign reinsurers, and has not given U.K~ reinsurers any significant competitive~ advantage. Excise Tax Waivers With High Tax jurisdictions are Sound Tax The Treasury has waived the excise. tax in treaties with several European countries - the U.K., France and Italy - and in the pending treaty with Germany. Treaty waivers are intended to relieve insurers in jurisdictions with `substantial levels of taxation from a double-tax burden --- the U.S. excise tax in addition to domestic taxes. If the excise tax were not waived, and particularly if it were increased to 4%, foreign reinsurers would face an undeniable barrier to entry in the U.S. market, and, under the burden of the double tax, would be placed at a competitive disadvantage with U.S. reinsurers. Waiving the excise tax in treaties with jurisdictions having a comparable level of taxation is appropriate and beneficial to american insurers and policyholders. The BAA has erred in charging that the U.K. should not be included in the group of high tax jurisdictions to receive treaty waivers. `We do not dispute the fact that the `86 Act made a substantial increase in the taxation of U.S. property/casualty reinsurers. We merely wish to point out that, even after the increases of the 1986 Act, U.K. insurers still pay a higher'level of tax than U.S. insurers.5 The 1986 Act narrowed, but did not eliminate the competitive advantage of U.S. reinsurers over U.K. reinsurers. In attempting to show that U.K. companies have low effective tax rates, the BAA has alleged that U.K. reinsurers receive special bene±its by virtue of the ~three year deferral of income tax'on all reinsurance profits and a current deduction of any losses. .6 The BAA'S allegation is inaccurate and misleading. The UK Inland Revenue have confirmed that the three-year accounting period used by some U.K. insurance companies provides no deferral of taxes due. The three-year account is used where it is not possible to determine with certainty the annual profit at the end of `the annual accounting period without an unacceptably Addendum, "The Effects of the Tax Reform Act of 1986 and the Tax Treaty Between the' United States and the United~ Kingdom on the Competitive Position of U.S. Reinsurers," Professor Robert L. Carter, University of Nottingham, November, 1988 (hereinafter "Addendum No. 1") and the 1987 study. 6 Letter frOm Craig Witcher, Patton, Boggs & Blow, to Peter Barnes, Treasury Department, Office of International Tax Counsel, January 5, 1990. PAGENO="0599" 589 high level of estimation Instead the accounts for each year are kept open until the following two years have elapsed. Only then are the income and loss expenses for that year finally determined and the profit computed. However, for tax purposes, an estimate of the profit for each year must nonetheless be made at the end of that year and tax is payable on the normal due date for the year. Subsequent adjustments to the estimate (for example, when profits are finally determined two years later) are subject to the same interest charges as adjustments to profits calculated by reference to the one year account. Moreover, U.K. insurers do not currently receive special favorable reserve treatment, a fact the RAA has conceded. The Inland Revenue is currently seeking to impose discounting of loss reserves upon U.K. property/casualty companies, but without granting them the benefit of the "fresh start" available to U.S. insurers. If adopted in the U.K~., discounting of loss reserves would only increase the margin in favor of U. S. reinsurers. The U.K. Treaty The U.K. treaty contained the first waiver of the excise tax. In return, the U.S. received significant treaty benefits, most noticeably, rights to payment of the tax credit on dividends paid by a U.K. corporation, whose value to U.S. companies dwarfs that of the PET waiver to U.K. insurers. The adoption of an unconditional waiver was not the result of a mere oversight by U.S. negotiators.7 Inland Revenue officialé familiar with the negotiations have stated that the conditional waiver was rejected by U.K. negotiators as inappropriate for the London market, one of the world's largest international insurance markets. British insurers advised the treaty negotiators that a conditional waiver would unnecessarily hobble the customary reinsurance operations of British companies. U.K. companies would have been required to identify foreign reinsurance placements as exempt or non-exempt, and then to make an allocation of all reinsurance between the two. This ratio would then have been applied to U.S. risks, so that a proportion of the tax waived by the treaty would nonetheless be due, because of the assumption that there had been a subsequent reinsurance of the U.S. risk. The allocation required would be complex: a reinsurance company will have an even more complex retrocession. program than a primary company with the -number of individual retrocessionaires typically exceeding 100 companies internationally. The conditional waiver or "anti-conduit" rule is intended to prevent avoidance of the excise tax by insurers in non-exempt countries. The Senate RepOrt on the Deficit Reduction Act of 1984, 98th Cong., 2dSess., S. PRT. 98-169, v.1, 395,- provided a simple example of the way in which abuse of the waiver might occur. It assumed that a U.S. insurance contract would be written by a U.K. company, and then would be reinsured with a non-U.K. company which would have been required to pay the excise tax if it had written the contract directly. The model assumes that this simplified transaction is representative of the way in which fronting might occur. In reality, it is simplistic and misleading Ordinarily, a U.K. insurance company reinsures its entire book of business or a particular line of business, such as marine, aviation or transport. Reinsurance may be allocated among one or more reinsurers, who accept a specified percentage of the An unconditional- waiver was also included in the treaties with the Soviet Union and Hungary. PAGENO="0600" 590 company's business (proportional reinsurance). Alternatively, reinsurance nay be written for liability in excess of an agreed amount, with the reinsurer taking all or a portion of the company's losses up to a specified maximum (excess of loss reinsurance). Reinsurance nay be obtained from reinsurers with whom a company has longstanding arrangements or through "market placements," the purchase of reinsurance.in the openmarket, as needed. Generally, an individual risk becomes part of the insurance company's account; that is, the risk is pooled by the company along with other risks it underwrites and loses the original geographic identity of that risk.8 In these typical reinsurance arrangements,. it would be inaccurate to say that a U.S. source contract had been reinsured or that any specific proportion of the original premium has been passed to the reinsurer. For example,. assume that a U.K. ~±nsurer has obtained from a non-exempt reinsurer excess-of-loss reinsurance covering aggregate losses in one year in excess of 50 million pounds, but not exceeding 75 million pounds. If the U.S. policyholder makes a~ claim, but total losses never reach the layer reinsured, should the U.S. risk be allocated to the excess-of-loss policy provided by a non-exempt reinsurer? What if the claim on the U.S. policy was made after reinsurance on the non-exempt excess-of-loss coverage had been exhausted? How can a U.K. company determine the extent to which U.S. policies are reinsured after they have been commingled with all other risks in the company's portfolio and reinsured on an excess-of--loss basis? Although these questions seem inappropriate and picayune to anyone familiar with reinsurance, they provide a clear illustration of the fallacy on which the anti-conduit rule is based. With few exceptions, reinsurance is not arranged on a contract by contract basis, so that U.S. risks may be traced to an exempt or non-exempt reinsurer. All risks written by the company are pooled, and reinsurance is obtained on a large scale, through proportional or excess-of-loss coverage. The single transaction model on which the anti-conduit rule was based breaks down when applied to the complex reinsurance arrangements made by. insurance companies in the London market. British companies reinsure their portfolios without regard to the existence of an excise tax waiver between the reinsurer and the U.S. Their primary consideration in selecting a reinsurer is the financial security of the reinsurer, and there is. no tax avoidance purpose. . . The RAA has proposed that the U.K.. treaty. should be amended immediately by unilateral legislation which adds an "anti-conduit' clause to the treaty waiver. A unilateral override of the treaty would violate internationalr~comity and would inevitably impair the Treasury's~ability to negotiate future treaties. In a 1989 interview, then-International Tax.Counsel Leonard Terr commented: I think there is no question that overrides damage the treaty program in the sense that they make it more difficult to negotiate treaties. They damage our credibility, diminish the confidence of our treaty partners in U.S. commitments, and erode the certainty and stability in bilateral fiscal and commercial 8 This classification would be consistent with the regulations of the U.S. Department of Trade and Industry ("DTI"), which regulates insurance. Under DTI rules, it is the domicile of the ceding insurer which determines the source. Accordingly, a U.S. Risk retroceded by a U.K. assuming reinsurer would be classified as a U.K., and not a U.S., risk. PAGENO="0601" 591 relations which a tax treaty is supposed to promote and ensure. I don't think there has been a single negotiating round or OECD plenary or working party meeting or group of four conference, not to mention many other similar inter-governmental fora, occurring over the past year and a half in which the subject of U~S. treaty overrides has not been made a major issue.9 But the RAA has not provided sufficient evidence even to justify a change in the FET waiver through the usual process of negotiation. The U.K. and, indeed, all European countries, have substantial levels of domestic taxation of insurers, even by comparison to the 1986 Act increases. Granting an FET waiver to these high tax countries is appropriate. In addition, the question of treaty abuse was considered by Congress in 1984 and 1986, and amendments to the U.K. treaty were rejected each time. In the course of those reviews, the BritIsh Government presented extensive evidence to the Treasury Department that there was no evidence of treaty abuse.1° The insurance rules of the U.K. Department of Trade and Industry, effectively discourage fronting (1) through solvency margin requirements which deny credit for reinsurance in excess of 50% of gross written premiums; (2) by monitoring reinsurance arrangements; and (3) by requiring insurers and reinsurers to list their major reinsurers (and ceding companies) in their annual supervisory returns in order to control excessive dependence on any one company or related group of companies. In effect, DTI regulations require a fronting company to devote capital to meeting the solvency margin requirements which night be used more profitably writing additional business. The profit from fronting, if any, could not match that earned by writing additional business. The U.K. government note has also demonstrated that there is no economic incentive for a U.K. insurer to front an individual contract, because the potential tax savings on even a large reinsurance contract are too small to justify the liability which the U.K. reinsurer would assume. RAA Proposal is Contrary to U.S. Policy in Current Round of GATT Negotiations Increasing the excise tax by 300% would create a barrier to foreign reinsurance which would clearly be contrary to U.S. efforts to liberalize trade-in-services in the Uruguay Round of GATT negotiations, one of the U.S. `s principal objectives. Because it would strike hardest at European reinsurers, who pay substantial domestic taxes, it would also impair efforts to maintain access to the European Community. At the worst, an increase of the tax or a unilateral override of the treaty would invite retaliation against U.S. insurers doing business in Europe, which would impair their ability to compete in the unified European Community after 1992. The RAA has not adequately considered the detriments to U.S. insurers and reinsurers doing business abroad if its proposal were adopted. Summary The RAA proposal ignores the importance of foreign reinsurers in meeting the needs of domestic insurance companies and policyholders. The U.K. market, in particular, provides high quality reinsurance to U.S. insurers. Much of the coverage Interview with Leonard Terr, Tax Notes, January 9, 1989, p. 159. 10 U.K. Government Note on Reinsurance Placements to Treasury Assistant Secretary Roger Mentz, 2 January, 1986. PAGENO="0602" 592 written by the U.K. is business for which U.S. reinsurers do not compete, because they do not have adequate capacity or because they are unwilling to write certain novel or difficult-to-place risks. Adopting the 300% rate increase proposed by the RAA would only increase the cost of insurance to American policyholders. Congress should not adopt the unilateral override of the U.K. treaty advocated by the BAA. The BAA's assertions of competitive imbalance or treaty abuse are so riddled with inaccuracies and colored by self-interest that their statements are not a sufficient basis for a treaty override. Even if the normal treaty negotiation process were followed, it would not be appropriate to impose the anti-conduit clause on the U.K. treaty waiver. The complex reinsurance arrangements typically made by a large insurer writing international risks are not undertaken in order to evade the excise tax. They serve a valid.risk-spreading function that is central to the concept of insurance. The conditional waiver is based upon an erroneous model of insurance company operations, and should never be applied to a large international market like the U.K. To require a U.K. insurer to trace and allocate its U.S. source business to. exempt and non-exempt reinsurers would be unworkable. The network of reinsurance arrangements is too complex. Moreover, the tracing requirement is founded on a fundamental misunderstanding of the nature of insurance. Once policies written by a U.K. company have been pooled with other business in its account, the risks reinsured have become U.K. risks, and are no longer properly identified as U.S. source. Statement of the Associatiom of British Insurers on the Proposal to Increase the Excise Tax on Insurance Placed Abroad and to Override Waivers of the Tax in Existing Treaties Submitte&bv: Keith E. Loney Deputy Chief Executive Association of British Insurers London, England Desianated Representative: Brenda R. Viehe-Naess Lord Day and Lord, Barrett Smith 1201 Pennsylvania Avenue,N.W. Washington, D.C. 20004 Telephone: (202) 393-5024 PAGENO="0603" 593 WRITTEN STATEMENT OF ASSOCIATION OF ITALIAN INSURANCE COMPANIES (ASIA) Submitted by Mr. Renzo Capotosti MEMORANDUM ON CERTAIN ASPECTS OF THE FISCAL TREATMENT OF ITALIAN REINSURERS The Reinsurance Association of America (RAA) proposal concerning an increase from 1 to 4% of the F.E.T. on reinsurance business ceded abroad was submitted last year to the U.S. Congress and it was reiterated lately. The Italian insurers and reinsurers believe that if such a proposal was passed, it would prove heavily restrictive in respect of GATT and OECD liberalization objectives and entirely contrary to the international treaty on double taxation signed by the U.S. and the Italian Governments. To clarify and to explain our position on this matter, we wish to submit the present statement. 1. In Italy the profits of a reinsurance company are taxed at 36% which is the rate applied to the profits of all corporations. Taxation increases to 46.368% if the impact of another tax, also imposed on corporations,(j.~ ILOR, the local income tax), is taken into consideration. All profits either distributed or undistributed are subject to the aforesaid tax of 46.368%. Likewise, taxation applies to all profits wherever produced by the Company, ~ both the profits originating from the activity carried out in Italy and those deriving from the overseas transactions (principle of taxation on world-wide profits). All profits either distributed or undistributed are subject to the~~ aforesaid tax of 46.368%. 2. Investment income is not subject to specific taxation; it concurs to determine the company's profit which is taxed as stated in paragraph. 1. above. 3. According to our fiscal law, the technical reserves the insurance and reinsurance companies are bound to set up in application of the legislation regulating insurance and reinsurance transactions, are tax-deductible. Whenever minimum technical reserves are prescribed by the insurance law, such limits shall be deemed to constitute the maximum deductible for tax purposes. Tax deductible technical reserves are restricted to: a. unearned premium and loss reserves in the non-Life classes; PAGENO="0604" 594 b. mathematical and loss reserves in Life business. The unearned premium reserve is calculated pro rata temporis or at a flat 35% of premiums written, gross of commission. Loss reserves are accounted for the amounts which, based on prudent technical assessment, are required to cater for settlement of the losses still unpaid which occurred in the current or in the preceding underwriting years. Incurred But Not Reported ~(IBNR) reserves are not specifically provided for in the insurance law and therefore are not eligible for tax deduction. 4. Provision is made in Italy for a foreign tax credit system however subject to very strict terms and conditions. The Convention between the Government of. the Republic of Italy and the Government of the U.S. for the Avoidance of Double Taxation specifically extends its applicability to the federal excise tax (F.E.T.) for which the foreign tax credit system applies. However, because of the limitation provided for in Art. 23 of the Convention, credit against local taxation for F.E.T. eventually paid on reinsurance premium, is far from being a "dollar for dollar" tax credit. 5. In the 44th session of the OECD Insurance Committee (Paris, October 27, 1989), some European delegations raised the problem concerning the proposed increase of the F.E.T. on reinsurance business acquired by foreign undertakings in the U.S. These delegations stressed that such measure would have heavily restrictive effects on these international transactions, which by their own nature should enjoy full freedom on a world-wide scale. Nevertheless, the U.S. delegate Mr. J.P. Corcoran, Superintendent of the Insurance, State of New York, and Chairman of the International Insurance Relations Committee of the NAIC, answered underlining that: this discriminatory tax has been brought to the attention of the U.S. trade negotiators. An attempt by the Reinsurance Association of America (BAA) to expand the tax to the reinsurance market, where the foreign share of the U.S. market is just under 40%, was recently dismissed by the U.S. General Accounting Office." According to this. statement to the OECD Insurance Committee, we understood, and all delegations understood with us, that: o the U.S. authorities had recognized that the proposed increase of the F.E.T. and the overriding of international treaties would be discriminatory towards foreign reinsurers. * and, therefore, that it had been finally rejected. For the above reasons, the ANIA recommends that the proposal should not be passed. Desianated Repre8efltatiV~ Brenda R. Viehe-NaesS, Esq. Suzanne C. Lacampagne, Esq. Lord Day & Lord, Barrett Smith 1201 Pennsylvania Avenue, N.W. Washington, D.C. 20004 Tel: 202-393-5024 ~ PAGENO="0605" 595 [BY PERMISSION OF THE CHAIRMAN:] March 9, 1990 The Honorable Charles B. Rangel Chairman, Subcommittee on Select Revenue Measures Committee on Ways and Means 2252 Rayburn House Office Building Washington, D.C. 20515 Re: Subcommittee on Select Revenue Measures Hearing on February 21, 1990; Statement of Gesamtverband der Deutschen - Versicherungswirtschaft e.V Opposing Increase in Foreign Reinsurance Excise Tax Dear Mr. Chairman: We appreciate the opportunity to submit testimony to your Subcommittee on. this issue. We are a trade association that represents nearly all German primary insurance and reinsurance companies. We strongly urge you and your Subcommittee to reject a proposal by the Reinsurance Association of America ("RAA proposal") to increase the excise tax on reinsurance of U.S. risks by foreign reinsurers from 1% to 4% and override all existing tax treaty exemptions pertaining to the reinsurance excise tax. We believe that this proposal would raise costs for U.S. insurers, diminish the availability and affordability of insurance in the United States and lessen prospects for the liberalization of trade in services (including insurance) that the United States seeks in the current GATT negotiations. It would also violate international law as a unilateral abrogation of existing treaty provisions. We request that you include this statement in the record of the Select Revenue Measures Subcommittee hearing on February 21, 1990 concerning the RAA proposal. Following are our specific comments. 1. The excise tax increase would raise costs for U.S. insurers. This proposal would impose a substantial increase, in the costs of reinsurance offered by foreign reinsurers. Primary insurers select their reinsurers on the basis of quality as well as cost. Factors bearing on quality include a. reinsurer's financial strength and earning power, the extra, services it provides, its ability to pay promptly, and its capacity. for accepting abnormally high risks. U.S. primary companies that continue' to choose quality `foreign reinsurers will have to pay more for their coverage under this proposal, which will increase U.S. insurance costs in general. At a time when the U.S. insurance industry is beset from all sides with calls to decrease the costs of insurance, proposals such as this that increase the cost of insurance are counterproduôtive. 2. U.S. companies could lose capacity in specialty liability lines, causing a decrease in capacity and availability and affordability problems. Large foreign reinsurers provide much of the worldwide market for catastrophe coverages, large individual risks, high liability exposures and other difficult-to-place risks. To the extent the foreign reinsurers that provide this market are driven out of the U.S. market by the higher costs associated with an increased excise tax, the harder it will be for U.S. primary insurers to insure these risks. Most large U.S. insurers that write the casualty lines of business reinsure much of their business with reputable foreign reinsurers. PAGENO="0606" 596 This is particularly true of specialty lines where only a few primary companies provide the bulk of the market. If one or more of those companies is forced either to raise prices or leave the market entirely because its foreign reinsurance has either become more expensive or entirely unavailable, the availability and affordability of any insurance in those lines will be severely diminished. During the mid-19805, the American economy saw the dislocations that can result when casualty insurance becomes unavailable, even in specialty lines like municipal liability or nurses and midwives liability. It would be regrettable if a short- sighted tax increase is enacted and causes some of the same effects. 3. There is no evidence of any tax disadvantage that U.S. reinsurers suffer with respect to foreign reinsurers. Although advocates of the proposal argue that foreign reinsurers have a tax advantage, they have never been able to demonstrate it, and the u.s. General Accounting Office was unable to find any evidence of it (see The Insurance Excise Tax and Competition for U.S. Reinsurance Premiums, GAO/GGD-89-115BR, September 1989). Reinsurers domiciled in the Federal Republic of Germany are subject to an average earnings tax burden of approximately 60% (corporation tax plus municipal trade tax) on both nnderwriting and investment income, a marginal tax rate certainly higher than any faced by U.S. reinsurers. Although the RAA makes much of the fact that certain reserves are deductible for tax purposes by some foreign insurers that would not be deductible in the U.S., it has never demonstrated that they have anysignificant effect on tax liability. Reserves deductible under German law which would not be deductible in the U.S. make up only 4% to 5% of German insurers' total underwriting reserves. 4. The RAA proposal would make liberalization of trade~i~ ~ryices more difficuit~ The United States is pursuing a policy to liberalize international trade in services, including insurance, in the GATT Uruguay Round negotiations. Proposals such as the excise tax increase contradict the principles of nondiscrimination and low trade barriers that the U.S. seeks to have included in the GATT. One of the particular areas where the U.S. is trying to lower trade barriers is insurance, and it would certainly be ironic if the U.S. raises insurance trade barriers at home while it is trying to lower them abroad. 5. The treaty, overric~e provision would yio1at~e ~ The proposal to unilaterally eliminate the provisions in several tax treaties that waive the reinsurance excise tax would be an attempt to give national law priority over international law. This violates international law. It is unconscionable, we believe, to override by domestic legislation solemn obligations which the United States and a foreign country have bound themselves to honor. Moreover, it could lead to retaliation by affected foreign countries, or trigger similar proposals in other countries, thus raising trade barriers around the world, rather than lowering them. 6. ~~j~AA proposal would unfairly discriminate against foreign reinsureI~5. Foreign reinsurers would either be forced to leave the u.s. market or to increase the price of the coverage they offer, which would severely harm their competitive position. Reinsurance is a highly competitive business, and an increase of this nature could cause foreign reinsurers to lose a significant portion of their market share. To our knowledge, neither Germany nor any other European country taxes reinsurance premiums on domestic risks PAGENO="0607" 597 paid to foreign reinsurers. It would certainly be unfair for the United States to increase the tax it imposes on similar premiums, and especially to tax them by unilaterally disregarding tax treaty provisions. We would be happy to discuss our position with you at any convenient time, or provide any further explanation that you would like. Sincerely, Gesamtverband der Deutschen Versicherungswirtschaft e . V. PAGENO="0608" 598 STATEMENT OF GUY CARPENTER .& COMPANY, INC. This statement is submitted on behalf of Guy Carpenter & Company, Inc., the world's largest reinsurance intermediary. This firm has sixty-eight years of experience in dealing with insurers and reinsurers both in the U.S.and internationally. Guy Carpenter does business with large numbers of companies ranging from the very small to the very large. Carpenter believes that they are uniquely able to comment on the proposed change to the Federal Excise Tax (FET) and elimination of treaty exemptions relating to premiums paid to foreign reinsurers. Guy Carpenter strongly believes that the Reinsurance Association of America's proposals to increase from 1% to 4% the Federal Excise Tax on reinsurance premiums paid to foreign reinsurers and to eliminate the exemptions to the tax in many treaties is not in the best interests of U.S. insurers, reinsurers and the ultimate insurance consumer. Guy Carpenter's experience indicates the FET really does not deter U.S. insurers from reinsuring overseas as most U.S. Property & Casualty insurers would prefer to place their reinsurance with U.S. companies. This is because domestic reinsurers are subject to much closer scrutiny and more uniform regulation than foreign companies, reporting in a uniform format prescribed by the National Association of Insurance Commissioners while foreign reporting and regulation tends to be uneven and less encompassing. Ceding companies are able to evaluate the security of domestic companies much more readily. In spite of this, overseas reinsurance markets are utilized because they offer needed additional capacity. They also offer expertise and capacity not available here for unusual risks, especially in the areas of excess of loss, special, and catastrophic coverages. Therefore, the FET increase will not serve to aid the U.S. reinsurers but only make insurance for the ultimate insured more expensive and difficult to obtain. Other concerns regarding an increase in the FET are: 1. Most foreign reinsurance goes to companies in high tax rate countries . While some reinsurance is placed with companies that have low or even zero tax rates, most of these reinsurers are "captive" or otherwise "Controlled Foreign Corporation" companies. In these cases restrictive U.S. tax laws make it very difficult for U.S. insurers to realize significant benefits from such companies. 2. Most foreign companies have their own income tax burdens, so that the "playing field" is not only already level, it may very well be tilted in favor of the U.S. reinsurers. In addition to its own country's income tax on net profits, the foreign reinsurer is paying an excise tax on gross premiums whether it eventually realizes a net profit or not. Further, foreign companies frequently must bear the cost of Letters of Credit, unlike U.S. companies. 3. The RAA gives no rational argument for their proposed increase to the 4% rate. It appears that they have arbitrarily adopted the rate applicable to primary insurance in requesting this 300% increase. In fact, the RAA has gone on record that they would require a 7.3% increase in premiums to compensate for the effect of the TRA of 1986 on their net profits. We see no basis for the proposed 300% increase in FET. PAGENO="0609" 599 4. The proposal is plainly a protectionist measure and would doubtless provoke retaliatory measures. Apart from the preceding objections to increasing the tax, an argument can be made that there is some reinsurance which perhaps should not be taxed at all. Specifically, Property Catastrophe, a category which is extremely important to our clients, is reinsurance which the U.S. market has all the aggregate accumulation it can support and the best spread of risk is achieved through worldwide placement, particularly of high excess layers. Since these property catastrophe layers do not carry significant unearned premium reserves or loss reserves, the Tax Reform Act of 1986 has had little impact on the domestic carriers for these lines. In fact, the lower tax rates have probably reduced U.S. taxes for this class of reinsurance and it should be exempt from FET altogether, as should catastrophe reinsurance or perhaps all property excess of loss reinsurance, both per risk and per occurrence, as well. Turning to the proposal to eliminate all exemptions to the FET from existing and future tax treaties, we believe this concept is seriously flawed for the following reasons: 1. To eliminate the exemption from existing treaties would be a unilateral abrogation of the treaty on the part of the U.S. 2. Treaty terms are generally the result of years of negotiations, with careful consideration given to the quid pro quo. For example, in the treaty with the United Kingdom, the U.S. exempts the income tax and the FET on insurance premiums, while the U.K. exempts the income tax, capital gains tax, the corporation tax and the petroleum revenue tax. Similar trade of fs are included in other treaties. 3. With an economically unified Europe about to emerge, a stable tax environment in the U.S. in respect to our tax relationships with European countries is vital. In conclusion, the proposed changes appear to~ be without merit and would clearly be opposed to the best interests of the U.S. insurance consumer, as well as the U.S. insurance and reinsurance industries. We strongly urge that the changes not be adopted. N. 30-860 0 - 90 - 20 PAGENO="0610" 600 STATEMENT OF THE MORTGAGE GUARANTY INSURANCE COMPANY BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS UNITED STATES HOUSE OF REPRESENTATIVES The Mortgage Guaranty Insurance Company ("MGIC") appreciates this opportunity to express its views in opposition to the proposal to increase the reinsurance excise tax under section 4371 from 1 percent to 4 percent and to apply the tax notwithstanding any treaty waiver. In this statement, we would like to explain what brought NGIC to the foreign reinsurance market and what the likely consequence of an excise tax increase would be. We also would like to respond to various contentions made by proponents of the excise tax increase. I. FOREIGN REINSURANCE IS CRUCIAL TO MGIC'S BUSINESS MGIC is in the business of underwriting mortgage guaranty insurance' throughout the United States. In the early l980s, MGIC experienced a severe shortage of capital and consequently was rapidly approaching the point at which it no longer could write new business. This problem could be cured only through an infusion of capital or the reinsurance2 of some of MGIC's existing business. After a nationwide search for a substantial new investor, MGIC in mid-1984 turned for relief to the reinsurance market. None of the domestic reinsurers approached by MGIC expressed any serious interest in EGIC's proposal, largely because they considered such business unattractive in view of the applicable state law reserve requirements. Thus, the foreign reinsurance market literally was the last resort for MGIC (as is the case with many primary insurers). All of the foreign reinsurers with which MGIC subsequently entered into reinsurance agreements3 were and are substantial insurance companies domesticated in France, Sweden, Switzerland, and West Germany. None are related to MGIC. The 1 percent federal excise tax is remitted by MGIC on substantially all of its reinsurance. (Tax treaty waivers of the excise tax apply to less than 3 percent of MGIC's insurance written.) The purpose of such insurance is to protect banks and savings and loan associations from losses in the event that a homeowner fails to meet his mortgage payments. Such insurance is necessary for a healthy mortgage market which, in turn, is crucial to an adequate supply of affordable housing. 2 Reinsurance essentially is an insurance arrangement between the existing insurer (the "ceding company") and another insurer (the "reinsurer"), whereby all or a portion of the risk of existing business is taken on by the reinsurer. Because the ceding company's risk is reduced, the reserve required by state law to cover the risk also is reduced, thereby allowing the ceding company to write new business without the need for additional capital in reserve. The agreements involved coinsurance of the risk for the period of the underlying insurance contracts. The typical policy is in force for 7 to 8 years, with a significant amount of insurance in force for more than 12 years. PAGENO="0611" 601 II. AN EXCISE TAX INCREASE WOULD BE BORNE BY MGIC OR ITS CUSTOMERS, NOT THE FOREIGN REINSURERS As MGIC's experience demonstrates, foreign reinsurers are willing to assume risks considered undesirable by domestic reinsurers.4 At least in MGIC's case, moreover, it cannot be argued that the Internal Revenue Code contributed to this situation, since EGIC turned to the reinsurance market in the early l980s, before the Tax Reform Act of 1986 (the "1986 Act") amended the law relating to the taxation of property and casualty companies. Even the proponents of the excise tax increase agree that the tax law did not create a competitive imbalance before that time. Thus, even if one assumed that the 1986 Act created a competitive imbalance (which, as discussed below, we do not believe to be the case), there is no reason to expect that the elimination of that imbalance would make domestic reinsurers more willing to write this type of business. And as the General Accounting Office ("GAO") noted in its recent study of the reinsurance excise tax, "(i)f coverage is not available from domestic reinsurers, foreign reinsurers are better able to pass the burden of the excise tax to consumers in the form of higher reinsurance premiums." GAO, The Insurance Excise Tax and Competition for U.S. Reinsurance Premiums 3 (GAO/GGD-89-115BR, Sept. 1989) ("GAO Report"). The GEO Report also cited MGIC's calculation that, on the basis.. of MGIC's 1989 business plan, "increasing the excise tax and eliminating tax treaty waivers would increase EGIC's excise tax bill from about $1.5 million to approximately $6.5 million." GAO Report at 31. In summary, it would be a mistake not to recognize the proposed excise tax increase as a tax increase for U.S. taxpayers. III. PROPONENTS OF THE PROPOSAL HAVE NOT MET THEIR BURDEN OF SHOWING A NEED FOR THE INCREASE Proponents of an excise tax increase base their entire case on the unproven assumption that the provisions of the 1986 Act, particularly the unpaid loss discounting rules of section 846, have "shattered" the competitive equilibrium between domestic and foreign reinsurers, resulting in a flood of foreign reinsurers into the domestic market and a flood of premium dollars out of the United States. Both the General Accounting Office (the "GAO") and the Treasury Department have studied this issue, and neither agrees with this assumption. The GAO: Available date are limited and insufficient for supporting a conclusion regarding whether the competitiveness of U.S. reinsurers in the domestic market has been affected positively or negatively by the provisions of the Tax This view recently was endorsed by the president of the Brokers and Reinsurance Markets Association, whose members represent about 25 percent of the domestic reinsurance market: The [reinsurance] business that goes abroad tends to be more experimental--the higher risk business. The overseas market tends to be the more entrepreneurial and sometimes the market of last resort. National Underwriter, June 19, 1989, at 28. PAGENO="0612" 602 Reform Act of 1986. Although the foreign share of the U.S. reinsurance market has grown since tax reform--from 26.1 percent in 1986 to 32.6 percent in 1987 to a projected 38.6~ percent in 1988--the foreign industry's share was also relatively high during the l960s. During that period, foreign rein- surers garnered, on average, about 37.4 percent of the U.S. reinsurance premiums. GAO Report at 2. Further, the Treasury Department emphatically rejected the central premise of the proponents of an excise tax increase in its testimony before this Subcommittee: We oppose the proposal, for reasons which are set forth at length in a forthcoming report to be submitted to this Committee. As that report will state, we do not believe that the economic evidence supports the need for a four percent excise tax to maintain the competitiveness of U.S. reinsurers, at least in the case of foreign countries that are not tax havens with respect to insurance companies. Statement of Kenneth W. Gideon, Assistant Secretary (Tax Policy), Department of the Treasury, Before the Subcommittee on Select Revenue Measures, Committee on Ways and Means, United . States House of Representatives, at 14 (February 21, 1990) (Treasury Statement) (emphasis added). MGIC's analysis of the impact of the 1986 Act on its business supports Treasury's conclusion. Proponents of the increase assert that the key provision of the 1986 Act causing the competitive imbalance was the new unpaid loss discounting rule. MGIC has found, however, that this rule has had a very * limited impact on the mortgage guaranty insurance business, since the typical claim is paid in less than 9 months. The discount with respect to claims of such short duration is not significant. Indeed, MGIC has found that the combined adverse tax effect on * the mortgage guaranty business of discounting and other changes in the 1986 Act has been offset by the positive tax effect of the reduction in the. corporate tax rate from 46 percent to 34 -. percent. . Thus, there is~ no direct evidence of a competitive imbalance resulting from the 1986 Act. Nor is there convincing. indirect evidence. As the GAO Report noted, the increase in market shar.e garnered by foreign reinsurers since 1986 is not unusual from a historical perspective. Indeed, the current foreign share of the market is significantly below the levels of the early l960s. If there has been a decline in business for domestic reinsurers, that decline is more likely attributable to increased retention by primary insurers.6 Ironically, an ~ The 38.6 percent figure for 1988 was a preliminary Department of Commerce statistic based on incomplete data. The most recent Department of Commerce statistics revise that number down to 36.9 percent. Also, as one Department of Commerce official stated to the GAO, some part of the 1988 increase may be due to improved data collection techniques. GAO Report at 23. 6 The primary proponent . of. an excise tax increase, the Reinsurance Association of America ("RAA"), has itself recognized that retention is the true problem faced by domestic reinsurers: PAGENO="0613" 603 increase in the cost of reinsurance would exacerbate rather than alleviate any such retention problem. IV. THE PROPOSED TREATY OVERRIDE CANNOT BE JUSTIFIED Although only a small portion of the reinsurance premiums paid by NGIC to foreign reinsurers are eligible for relief from the excise tax by treaty, MGIC strongly opposes the treaty override provision as a matter of basic international tax policy. In this connection, we endorse the position taken by Treasury in its testimony before this Subcommittee (W)e object to the treaty override aspect of this proposal for two reasons. As a matter of principle, we believe that overriding treaties in this manner is very counterproductive for U.S. tax policy. Furthermore, we believe that the existing treaty waivers are generally appropriate because of the taxation imposed by the other countries on their domestic insurance companies and because of the reciprocal benef its to U.S. taxpayers achieved by the treaties Treasury Statement at 14-15. V. THE PROPOSAL AS A WHOLE IS PROTECTIONIST LEGISLATION The proposed increase in the excise tax rate has the same effect as an increase in a tariff on foreign goods. Such protectionism restricts competition by building a wall around the U.S. market. Ultimately, it has a boomerang effect on U.S. consumers and U.S. trade, since the protected product becomes more costly and since the tariff invites retaliation Proponents of the increase argue that their proposal really is protectionism "in reverse," on the theory that domestic reinsurers were disadvantaged vis-a-vis foreign reinsurers as a result of the 1986 Act. They contend that the proposal simply restores a level playing field and does not make the foreign product more expensive than the domestic product. This argument assumes, however, that a competitive imbalance as a result of the 1986 Act has been proven. It has not. Treasury has flatly rejected that assertion, and MGIC's analysis of its own line of business demonstrates that Treasury's position is correct. The decrease in net written premium reported by the companies (domestic reinsurers.) for 1988 continues a trend which began in early 1987. This decrease is the result of higher retentions by primary insurers, as well as a decrease in premium written by excess and surplus line carriers RAA, Underwriting Results for Year End 1988 (News. Release, March 3, 1989) (emphasis added). It is interesting to note that no reference is made to the 1986 Act in this document. PAGENO="0614" 604 SWISS. INSURANCE ASSOCIATION STATEN NT The Swiss Insurance Association represents the Swiss insurance market. it is a voluntary association composed of 76 insurance and reinsurance companies which underwrite 98% of. the insurance written by Swiss companies. Its members write both life and non-life business. .. The Reinsurance Association of America ("RAA') testified on February 21 in support of its proposal to increase the excise tax on property/casualty reinsurance from 1% to 4%. In testimony before the Select Revenue Measures Subcommittee of the House Ways and Means Committee, the RAA charged that the increase in the federal excise tax ("FET") was necessary to offset a "competitive imbalance * between U.S. and foreign reinsurers which~ the RAA alleges was created by the tax increases imposed upon property/casualty reinsurers by the Tax Reform Act of 1986. We urge Congress to reject the proposal, which would needlessly increase costs for American insurers and consumers. Indeed, in.many cases, it would impair U.S. companies' ability to obtain reinsurance from the only sources willing to write the large or difficult-to-place risks which U.S. reinsurers have been unwilling to write. Reinsurance from foreign carriers has proven essential for the American insurance market, and unjustified barriers to reinsurance would only restrict the operation of American insurance companies. Foreign Reinsurers Provide Additional Camacity to U.S. Companies. and Offer Coverage For Hard-to Place Risks Foreign reinsurers play a special role in the U.S. market, because they provide reinsurance to carriers unable to obtain adequate coverage or affordable coverage from domestic reinsurers. In testimony before the Ways and Means . Committee, an executive of the American Agricultural Insurance Company noted that foreign reinsurers were an indispensable part of their.. reinsurance program, and had covered the company's substantial payments to farmers for losses arising from Hurricane Hugo. American insurance companies have frequently turned to foreign reinsurers for coverage of large, catastrophe risks in commercial lines such as energy, product liability, aviation and marine insurance. These special risks frequently exceed the level which a single domestic company is able to write. However, by obtaining additional .capacity from foreign reinsurers, American insurers are able to maintain relationships with policyholders and producers, even though the value of the primary coverage exceeds the company's underwriting limits. By reinsuring high liability exposures, foreign reinsurers provide worldwide risk distribution and reduce the impact of catastrophes upon the American economy. Foreign reinsurers, in turn, cede substantial reinsurance into the U.S. This international network for spreading liability is essential to the risk-distribution function of insurance, and should be maintained without disruption by tax barriers like that proposed by the RAA. PAGENO="0615" 605 An Excise Tax Increase Would Increase Coats to ~rican Insurance Ccpanies and Cons~ers - Without Providing any Offsetting Benefit The 300 percent increase in the excise tax sought by the RAA would inevitably lead to an increase in the rates of foreign reinsurance, and these premium increases would be passed on to~ insurance cons~rs. Since the capacity shortages of the mid-' 80's, American insurers ~have been under intense: examination from consumer groups, state regulators, Congressional comeittees, as well as large corporate policyholders. Adopting a tax increase which would increase costs and further strain relations with consumers would be clearly inappropriate. After considering the adverse impact of an excise tax increase, all of the domestic trade associations representing primary insurers writing property/casualty insurance have opposed the RAA proposal. They have been joined by trade associations representing large corporate policyholders and insurance brokers. These groups recognize that an excise tax increase benefits no one, other than a handful of domestic reinsurers. The RAA Has Not Provided Convincing Evidence that U.S. Reinaurers Are At a Coiauetitive Disadvantaae vie-a-vis Eoreign Reinsurers The GAO reviewed the contention that American reinsurers are at a disadvantage in competition with foreign reinsurers because of increases imposed by the 1986 Act, an assertion critical to the RAA's proposal. Although there is no question ~:that the 1986 Act imposed substantial increases upon U.S. property/casualty insurers, the GAO did not support the RAA's claims. Instead, the GAO pointed out that the level of domestic taxation is only one of several factors which the Congress should consider in determining whether to raise the excise tax. The GAO suggested two additional factors: the effect of operating gains and losses upon the level of domestic taxes, and the level of taxation in the foreign reinsurer' s own country. Switzerland, and indeed most European countries, impose substantial taxes upon their domestic insurers. Corporate income tax rates in Switzerland are progressive and vary from Canton to Canton. In case of a reinsurance company located in the City of Zurich the maximum rate (combined for Federal Income Tax and Cantonal/Communal Income Taxes) is 34% and the minimum rate is 12%. As a rule the total tax charge of .a reinsurer on profits is likely to be in the range Of 20 - 34%. In addition, Swiss companies are liable to a tax on capital (paid-in capital, open reserves and other reserves). The total capital tax payable by a reinsurance company in Zurich amounts to Sw. frcs. 4,60 per thousand Swiss Francs of taxable capital Contrary to RAA assertions in letters to Treasury of ficials, Switzerland does not provide Special additional reserves which materially reduce the tax burden on Swiss reinsurers. Loss reserves in Switzerland are deductible only if they cover incurred losses (including losses incurred but not reported - IBNR). Equalization reserves, catastrophe reserves and similar reserves, for losses which have not yet been incurred cannot be built-up tax-free. In its submissions, the RAA has failed to distinguish between reinsurers in high tax jurisdictions such as Switzerland and those in tax havens. Swiss reinsurers pay a level of tax roughly comparable to that of U.S. reinsurers, so that there is no competitive imbalance. Yet the RAA has repeatedly illustrated charges of unfair competition from foreign reinsurers by using examples from tax haven countries, and then tried to extend these arguments to European reinsurers. This effort to sweep reinsurers PAGENO="0616" 606 in high tax. jurisdictions into the same category as those in tax havens is misleading and inequitable. Such misleading allegations are not a sound basis for Congressional action which would have a clear adverse impact upon American insurers and consumers. Much of the growth of foreign reinsurance in the 1980's can be attributed to the demands of American companies for additionaireinsurancé to meet the capacity shortage of 1984-86, when American insurers were forced to deny or curtail coverage in many lines of business. Revised Commerce Department figures on foreign reinsurance, which became available~ only after the GAO report was published, show that foreign reinsurers' market share remained stable from 1981 to 1987. Foreign reinsurers' share declined from 31.6% in 1981 to.V28 .8% in 1984, and then turned slightly upward in 1985 and 1986 --- before the `86 Act increases took effect. This pattern contradicts the RAA assertion that the 1986 Act led to significant increases in foreign reinsurers' market share. On the contrary, it suggests that U.S. insurers turned to foreign reinsurers in the mid-'80's to bring an end to the "liability crisis." A detailed examination of the most recent Commerce Department data also reveals that much of the increase in business ceded to foreign reinsurers has gone to tax haven countries, rather than European reinsurers. This growth can be directly attributed to the expansion of risk management programs by large corporate policyholders and trade associations disillusioned by the drastic swings in:cost and availability of insurance that result from the property/casualty underwriting cycle. The RAA Errs in Asserting that Reinsurance is `Fungible". and that Foreign Reinsurers' Market Share Will Expand Without Limitation In its testimony and in submissions to Treasury, the RAA has contended that reinsurance is "fungible", and argued that if tax barriers are erected to protect domestic reinsurers, a large part of the U.S. reinsurance market will be lost to foreign reinsurers. This is simply wrong. The excise tax is imposed upon reinsurance provided by foreign carriers who are not admitted to do business within the U.S. Neptune Mutual Ass'n~ Ltd.Vv. U.S., 13 Ct. Cl. 309 (1987). American insurers have an understandable preference for .reinsurance provided by domestic carriers, since they do not face the difficulties in obtaining credit for reinsurance from admitted carriers that they face when they utilize non-admitted carriers. Ordinarily, U.S. insurance companies purchase coverage from mon-admitted foreign reinsurers only after they have been unable to obtain coverage from domestic carriers. In addition, the selection of a reinsurer is not a matter of price, alone. In the wake of a growing number of insurance company insolvencies, domestic insurers are placing increasing emphasis upon the quality of the reinsurer. Insurance company executives and regulators consider the financial soundness of the reinsurer, the ease of obtaining claims payments, the terms of coverage,, and its availability over the long term, as well as cost, when selecting a V reinsurer. Taken together with V regulatory restrictions on credit for reinsurance, these factors explain a V strong preference on the part of domestic insurers for reinsurance from admitted carriers. Contrary to the RAA'5 assertions, it is V unrealistic to project an unlimited shift of market share from domestic to foreign reinsurance. V V PAGENO="0617" 607 An Excise Tax Increase Would Be Contrary to the U.S. Efforts_to Obtain Liberalized Trade-In-Services in GA!I9~ Negotiations The RAA proposal is clearly protectionist, and would undermine U.S. efforts to obtain liberalized trade-in-services in the Uruguay Round of GATT negotiations. Ironically, it comes at just the time U.S. carriers are expanding their operations in Europe and the Pacific Rim, and it would invite retaliation through tax increases or other trade barriers from foreign countries. It would be an unfortunate signal for the U.S. to adopt such a protectionist measure, at the same time that it seeks to enhance the ability of U.S. companies to compete internationally. We urge the Congress to reject the RAA's proposal to increase the excise tax on property/casualty reinsurance. The proposal would increase the cost of insurance to primary carriers and insurance consumers, at a time-when the domestic industry seeks to avoid any further strains on its relations with consumers. Enacting the increase would ignore the significant contributions of foreign reinsurers to_the needs of American companies for additional capacity. In many cases, foreign reinsurers provide the only source for domestic:companies to obtain reinsurance. For large, catastrophe risks, they are essential to the distribution of U.S. risks worldwide, and to the mitigation of the impact of disasters, such as hurricanes, oil spills, and atrl'ine crashes, upon the American economy. Finally, an excise tax increase would be protectionist, and clearly contrary to the U.S. Efforts to liberalize trade-in-services. -~-;~Statement of the Swiss Insurance Association on the Proposal to Increase the Excise Tax on Insurance Placed Abroad and to Override Waivers of the Tax in Existing Treaties Submitted by: Mr. Christoph Blanc Zurich, Switzerland ~p~esemtimQ The Swiss Insurance Association Designated Representative: Brenda R. Viehe-Naess, Esq. Lord Day & Lord, Barrett Smith 1201 Pennsylvania Avenue, N.W. Washington, D.C. 20004 Tel: 202-393-5024 PAGENO="0618" 608 STATEMENT ON BEHALF OF CASTLE & COOKE, INC./DOLE SUBMITTED TO THE SUBCOMMITTEE ON SELECT REVENUE MEASURES THE COMMITTEE ON WAYS AND MEANS U.S. HOUSE OF REPRESENTATIVES "Preserving the Annual Accrual Accounting Method" March 8, 1990 * * * * * * * * *~. Introduction and Overview This statenent is submittedl' on behalf of the Castle & Cooke, Inc. fanily of companies, which grow and market pineapples and bananas under the Dole label. The companies urge adoption of an amendment which restores the annual accrual method of accounting for taxpayers which, until 1988, traditionally used this method ~~ith respect to their pineapple and banana farming businesses .~I The annual accrual method of accounting has been an accepted accounting method for growers of three crops -- pineapples, bananas and sugar cane -- for more than 35 years. The method was originally approved by the Internal Revenue Service (the "Service") and then codified by the Tax Reform Act of 1976. It is consistent with the Internal Revenue Code (the "Code") requirement that most farmers use an accrual accounting method with respect to-their farming activities. In addition, it takes into account the peculiarities of producing certain tropical crops by permitting the current deduction of "preproductive period expenses" with respect -to such crops. A provision of the Technical and Miscellaneous Revenue Act of 1988 has restricted the use of the annual accrual method of accounting under Code section 447(g) to corporations and certain partnerships engaged in the production of sugar ôane. However, the current deduction of preproduçtive period expenses also continues to be an appropriate feature of an accrual method for computing taxable income for growers of pineapples and bananas. Dole urges that the 1988 restriction be revised to restore the annual accrual method for use by taxpayers which had properly 1/ The statement is submitted by Cliff MaLsa III of Patton, Boggs & Blow as counsel to Dole Fresh Fruit Company. 2/ Various companies within the Castle & Cooke, Inc. group participate in the growing of these crops. For simplicity, all references in this statement are made to "Dole" rather than to the specific U.S. companies involved. PAGENO="0619" 609 used the method with respect to particular crops -- specifically pineapples and bananas -- prior to enactment of the restriction. A. TheHistory of the Annual Accrual Method of Accounting 1. Origination of the Method Prior to the early l950s, most of the major Hawaiian pineapple and sugar cane growers computed income using a variation of the "crop method" of accounting. Now codified under section 447, the crop method requires that revenues and expenses be recognized on an accrual basis and that the costs incurred in growing crops be capitalized. In the early l950s, accountants required growers to change their method of accounting for financial reporting purposes with respect to tropical crops which had"preproductive" periods of more than one year between planting and the harvesting of the first marketable crop resultingIrom such planting. A combination of factors peculiar to the growing of certain tropical crops-- namely, the long preproductive period, the uncertainties of tropical storms/pests/diseases, and the volatility of prices-- created two significant accounting problems. First, putting preproductive period expenses on the balance sheet meant that the~ taxpayer would have an asset on its books that might never be realized due to tropical storms, pests, and diseases. Recording an asset on the balance sheet that might never be realized is contrary to standard accounting practices and could be misleading to lenders, shareholders and others who rely on the balance sheet to obtain an accurate picture of the financial position of a~company. Second, capitalization of preproduction expenses~also distorts a grower's income statement since it does not result in a proper matching of revenue and expense. The current deduction of preproduction expenses results in a proper matching of expenses and revenues at comparable price levels. With the consent of the Commissioner of the Service, most of the major Hawaiian gzowers of pineapples and sugar cane changed to the annual accrual method in the -early~l95Os and began expensing preproductive period expenses. Dole continued tO ~ the "static value" method with respect to its pineapple and sugar businesses because it had entered into an agreement with the Service in 1938 to use that method of accounting. (The static value method produced essentiaily the same result as the annual accrual method.) The annual accrual accounting method was also adopted by Dole's banana-growing companies in the l950s. 2. Tax Reform Act of 1976 ~In 1976, Congress enacted Code section 447, entitled "Method of Accounting for Corporations Engaged in Farming," to curb perceived accounting abuses by the then new form of tax shelter -- syndicated farming operations. Prior to the enactment of section 447, all farmers were permitted to use the cash method of accounting. While the cash method worked well for small farmers, it was thought to result in serious mismatching of income with related expenses for larger entities. This mismatching was seen as creating tax losses which deferred current tax liabilities on both farm and nonfarm income. As enacted, section 447 provided that corporations and certain partnerships engaged in farming shalluse an accrual PAGENO="0620" 610 method of accounting with the capitalization of certain preproductive period expenses. Section 447(g) providedan exception, however, for corporations which had used an "annual" accrual method of accounting for a ten-year period prior to the date of enactment of section 447. Those corporations were permitted to continue to use the annual accrual method. Because the static value method was essentially identical to the annual accrual method, Dole was allowed to change to the latter method by the 1976 Act. 3. Recent Legislative History Restricting the Annual Accrual Accounting Method The Tax Reform Act of 1986 enacted the uniform cap~tali- zation rules for inventory and other tangible personal property in new Code sectiOn 263A. Special uniform capitalization rules. for farmers nOw provide that persons or entities required to use an accrual accounting method under section 447 generally must capitalize all preproductive period costs. However, the statutory language of the Tax Reform Act Of 1986 explicitly continuedthe rule in section 447(g) as an exception .to the new capitalization rules. The House Ways and Means Committee report confirmed the intention to allow taxpayers properly using the annual accrual method of accounting under section 447(g) to continue using that method. The Committee's position was consistent with the original proposal by the Reagan Administration in May 1985, which stated that "[w]ith respect to preproductive period expenses, the rules of section 447 would continue to apply to the taxpayers currently covered by that provision," except for orchards and vineyards covered by Code section 278. Neither the Senate Finance Committee report nor the Conference Committee report commented further. It was a surprise, therefore, when the Joint Committee Staff's bluebook on the 1986 Act stated, without further elaboration, that Congress intended that sugar cane growers be allowed to continue to use the annual accrual method of accounting; pineapple and banana growers were not included. In 1988, section l008(b)(6) of the Technical and Miscellaneous Revenue Act ("TAMRA"), amended section'-447'(g') .to..read as described in the bluebook -- i.e., that only sugar cane growers were allowed to use the annual accrual method -- rather than as enacted in 1986 and `as described in the House Ways and Means Committee report. Pineapple and banana growers suddenly found themselves outside the purview of the annual accrual method of accounting for the first time in some 35 years. B. The Annual Accrual Method Should Be Restored for Those Taxpayers Which Have Historically Used the Method The annual accrual method was adopted by pineapple, banana and sugar cane growers in the early 1950's for sound financial accounting reasons. With the consent of the Commissioner of the Service, the affected taxpayers also used this method to more correctly reflect their income for tax purposes. This particular accrual method addresses the, peculiarities which are inherent in the growing of the three tropical crops to which it has long been applied. As an accrual method, it avoids the income distortion which Congress determined was prevalent prior to 1976 when farming entities used a cash method of accounting to delay recognition of income while accelerating deductions for farming supplies which were paid for in taxable years prior to their use. Dole an'd other ,affected companies recognize income when PAGENO="0621" 611 their right to payment for sold crops is fixed. Similarly, prepayment of expenses does not create a current deduction. The only special rule in the case of the annual accrual method is the current deduction of preproductive period costs. While approximately forty years have passed since the need for the annual accrual accounting method was first recognized and the method was adopted, the natural disasters encountered in the growing and harvesting of pineapples, bananas and sugar cane have not been eliminated. The volatility of prices has not been stabilized. Nature's long growing periods have not been shortened. In fact, nothing fundamental has changed. The sound accounting reasons which first forced companies to switch from the crop method of accounting to the annual accrual accounting method still exist today. It is no easier now to calculate whether a capitalized expense will be realized than it was in the early 1950's. The volatility of prices and the uncertainties of weather and natural pests in the tropics continue to render the growing of pineapples, bananas and sugar cane somewhat uncertain as financial ventures. The annual accrual method has proven over time to be a sound and reasonable accounting practice for the production of these crops. Not only is the rationale for the annual accrual accounting method as strong as ever, it applies equally and consistently to eachof the crops to which it has been traditionally applied -- to pineapples, to bananas and to sugar cane. While it is understood that the TAMRA provision may have been enacted to prevent the expansion of the category of taxpayers eligible for section 447(g) treatment, a closer analysis proves that concern to be unmerited. In attempting to prevent an abuse, TAMRA actually closed the door on taxpayers that were appropriately, and that had been historically, using the method. C. Conclusiom The annual accrual method of accounting continues to be the appropriate method for computing income for the production of pineapples, bananas and sugar cane. Dole urges that Congress restore the annual accrual method for use by taxpayers which had properly used the method with respect to particular crops -- specifically pineapples and bananas -- prior to the 1988 amendment. PAGENO="0622" 612 COMMMENTS OF ANDREW W. SINGER, COVINGTON & BURLING, SPECIAL TAX COUNSEL TO MAUI PINEAPPLE COMPANY, ON A PROPOSAL TO RESTORE THE ANNUAL ACCRUAL METHOD TO HAWAII'S PINEAPPLE INDUSTRY I. INTRODUCTION The Maui Pineapple Company ("Maui") has been consistently using the annual accrual method of accounting for its pineapple growing business on the island of Maui, Hawaii, since 1953. The annual accrual method, under which preproductive expenses incurred during the year are charged to harvested crops or expensed, was developed by the accounting profession as a practical means of accomodating aácrual principles to the unique growing and economic conditions of tropical agriculture. It is a generally accepted method of accounting approved by the Internal Revenue Service for tax purposes and by the Securities and Exchange Commission for financial reporting to shareholders and the public. Congress, in section 447(g) of the Internal Revenue Code, made annual accrual a statutorily approved accounting method for all taxpayers that can meet three requirements: (1) the taxpayer must have been using the annual accrual method for at least 10 years prior to 1976, (2) the taxpayer must have consistently used that method in all subsequent years, and (3) the crop must take at least 12 months to mature. The sugar and pineapple growers of Hawaii, including Maui, have always satisfied these requirements. Indeed, section 447(g) was added to the Code in 1976 specifically at the request of Hawaii's Congressional representatives, as well as the Pineapple Growers Association of Hawaii and the Hawaiian Sugar Planters Association.1 In 1988, however, a serious misunderstanding regarding section 447(g) produced an obscure, so-called "technical correction" to the Tax Reform Act of 1986 that retroactively (as of 1987) prohibited Hawaii's pineapple growers from using the annual accrual method, though the right of Hawaii's sugar growers to continue using that method remains undisturbed. See Technical and Miscellaneous Revenue Act of 1988 ("TAMPA"), section 1008(b) (6). There was and is no good reason to require pineapple growers to change from the annual accrual method under which they have accurately and consistently reported their income and financial results for many years. The indefensible distinction between pineapple and sugar created by the TANRA "technical correction" actually conflicts with this Committee's statement of intent regarding section 447(g) when it reported the Tax Reform Act of 1986: "The committee intends that taxpayers properly using the annual accrual method of accountin~ under section 447(g) will be allowed to 1See Hearings Before the Senate Finance Committee on H.R. 10612 (Tax Reform Act of 1976), 94th cong., 2nd Sess. (1976), pp. 3115 g5,, ~ PAGENO="0623" 613 ~~~nue to use that method."2 The Committee's statement referred to ~J. taxpayers properly, using the annual accrual method under sectjon 447(g), ~ just taxpayers growing sugar cane.. If the 1988 TAMRA amendment is not corrected, Hawaii's pineapple industry and its more than 1,100 employees face calamitous consequences. Maui is currently suffering record losses in the pineapple business due to competition from abroad and worldwide overproduction. It must compete in the world market with foreign producers that already enjoy significant labor and regulatory cost advantages. But capital expenditures that had been planned to improve Maui's productivity will have to be sacrificed if Maui is required to pay the heavy retroactive taxes resulting from the `!technical correction" in TAMRA. Further, Maui's administrative expenses will increase significantly to administer the expensive and unsuitable capitalization method erroneously imposed by TANRA. Maui's pineapple business cannot remain viable under these conditions. The Senate Finance Committee, in section 6627 of its original version of the Revenue Reconciliation Act of 1989, voted to correct the 1988 TAMRA mistake and restore as originally intended the annual, accrual method to Maui and. others properly using the annual accrual method, along with sugar cane growers, when the Tax Reform Act.ôf 1986 was passed.3 For reasons entirely unrelated to the merits of the provision, however, the Finance Committee later deleted this and many other revenue provisions from the Revenue Reconciliation Act in order to produce a "clean" budget reconciliation bill., Maui urges the `Ways `and Means Committee to adopt this `provision and restore the right to continue using the annual accrual method to taxpayers that were properly using it immediately prior to passage. of the Tax Reform Act of l986,~ a right this Committee assured such taxpayers it intended to preserve when it approved the.Tax Reform Act of 1986. II. THE STATED RATIONALE OF TANRA'S "TECHNICAL CORRECTION" DID NOT JUSTIFY THE EXCLUSION OF PINEAPPLE GROWERS; MOREOVER. THE RATIONALE ITSELF WAS UNSOUND The rationale of the so-called "technical correction" to section 447(g) in TAMPA was that "many taxpayers using the annual accrual method of accounting, other than taxpayers engaged in the trade or business of growing sugar cane, were required under section 278 of prior law to capitalize preproductive period expenses (e.g., citrus growers) ." ~g S. Rept. No. `100-445, 100th Cong., 2d Sess. (1988), p.124. It was mistakenly thoüghtthat a "technical correction" limiting 447(g) to sugar cane growers was necessary to prevent these "many taxpayers" from deducting, under the annual accrual method, costs they had previously been required to capitalize under section 278. A major problem with this rationale, so far as pineapple growers are concerned, is that Section 278 had 2See HR. Rep. No. 426, 99th Cong. 1st Sess. 629 (ençhasis added). 3The Language of section 6627 as approved by the Senate Finance Coemittee is attached as an Appendix to this Statement. 4Apart from the three pineappLe growers in Hawaii, Maui is aware of onLy one other taxpayer, the United Brands Conpany, that was using the annuaL accruaL method (to account f or net income from its banana growing operations) in 1986. See Statement of DonaLd C. ALexander before the Subconmittee on SeLect Revenue Measures of the Coo~nittee on Ways and Means, February 22, 1990. PAGENO="0624" 614 never applied to pineapple; it applied only to growers of citrus and almond groves. Pineapple growers, like sugar cane growers, were ~ required by section 278 to. capitalize preproductive period expenses. Thus, there was no reason to restrict section 447(g) onlyto sugar cane growers and not also to include pineapple growers. In addition, the rationale of the TANRA amendment was unsound, for there was in reality no danger that any taxpayer formerly subject to section 278 would be able to deduct preproductive period expenses under the annual accrual method after 1986. Taxpayers that ~ formerly required to capitalize preproductive costs under section 278 could not have used the annual accrual method to deduct their preproductive period expenses after 1986, as the draftsman of the TANRA "technical correction" had feared, because those taxpayers could not satisfy section 447(g)'s threshold consistency requirement: the taxpayer must have used the annual accrual method (which by definition requires the deduction of preproductive period expenses) consistently for at least 10 years prior to 1976, and in all years thereafter. Any taxpayer that had been required to capitalize preproductive period expenses under section 278 (enacted in 1969) for any year up to and including 1986 could not have met this stringent consistency test, and therefore could not have deducted preproductive period expenses after 1986. The repeal of section 278 did not, therefore, create a potential loophole under section 447(g) of the code, and the TANRA, "technical correction" was unnecessary III. THERE IS NO POSSIBLE JUSTIFICATION FOR TREATING HAWAII'S PINEAPPLE GROWERS DIFFERENTLY THAN HAWAII'S SUGAR CANE GROWERS While the 1988 TAMBA amendment retroactively required Maui and other pineapple growers to discontinue using the annual accrual method, it allowed Hawaii's sugar growers to continue using that method. Such disparate treatment of sugar and pineapple growers, both of which grow crops under similar agricultural and economic conditions and have consistently used the annual accrual method for some 40 years, cannot be defended on any rational ground. -- The annual accrual method was developed in response to agricultural and economic conditions facing both sugar ~ pineapple growers in Hawaii. Both sugar ~ pineapple growers applied for and received permission from the Internal Revenue Service to change to the annual accrual method in the early l950s. -- Congress enacted section 447(g) of the Code in 1976 specifically in response to the needs of both sugar ~ pineapple growers in Hawaii. A joint statement in support of section 447(g) submitted to the Senate Finance Committee in 1976 by Hawaii's then Senators, Hiram Fong and Daniel Inouye, sought statutory approval of the annual accrual method on behalf of both the sugar ~ pineapple growers PAGENO="0625" 615 of Hawaii.5 The stateme~it concluded: "We believe that our amendment for the annual accrual method will continue to provide the Federal Government with tax revenues computed on an equitable and realistic basis on sugar and Dineapple operations in Hawaii."0 There has been no change in circumstances since 1976 to warrant terminating pineapple's right to use the annual accrual.method while sugar growers remain eligible to use that method. Indeed, with Maui experiencing the largest pineapple growing losses in its history, the consequences of an involuntary change from the annual accrual method would be even more calamitous now than in 1976. One of the principal goals of tax policy is to maintain "horizontal eqUity;". similarly situated taxpayers should be taxed similarly. Indeed,; the Treasury Department, after having told the Senate Finance Committee that it had no objection to a provision restoring the annual accrual method to pineapple growers, recently invoked the horizontal equity principle as a justification for changing its position and opposing any exceptions to the uniform capitalization rules.7 Yet the TANRA amendment creates an intolerable horizontal inequity between the sugar and pineapple growers of Hawaii. Though their crops are not directly competitive in the marketplace, both industries compete for the same pool of labor in Hawaii. Operating under similar agricultural and economic risks, both compete in the same capital markets. Permitting sugar but not pineapple growers to use the annual accrual method will give sugar growers an important tax-conferred competitive advantage -- through lower taxes and lower administrative costs -- which may ultimately, lead to the elimination of Hawaii's pineapple industry. Most important, both crops `have long utilized the annual accrual method for the same reason: it is the most practical and efficient method of accurately reflecting income and assets in the tropical agriculture conditions under which both pineapple and sugar are grown. There is absolutely no basis for permitting use of the annual accrual method by growers of one crop but not the other. IV. THE ANNUAL ACCRUAL METHOD CLEARLY REFLECTS THE INCOME OF HAWAII'S PINEAPPLE GROWERS. The distinguishing feature, of the annual'accrual method of accounting, ~contrasted with a general accrual method, is that preproductive crop costs are expensed against current year's income rather than capitalized. This is a practical and cost-effective method of accounting that' produces an accurate measurement of income and assets for Hawaii's 5See Joint Statement of U.S. Senators Hiram L. Fong and Daniel K. lnouye (Both Hawaii) Proposing Amencknents to `Section 204. Method of Accounting for Corporations Engaged in Farming of H.R. 10612, Tax Reform Act, Hearings Before the Senate Finance Comnittee on H.R. 10612, 94th Cong., 2nd Sess. (1976), pp. 3115-23. Both the Pineapple Growers Association of Hawaii and the Hawaiian Sugar PLanters' Association also submitted written statements in stçport of section 447(g). See Hearings, supra, at pp. 3123, 3134. 6Hearings, supra, at 3122. TSee pp. 6-7, 10fJa. PAGENO="0626" 616 pineapple and sugar growers, both by matching current costs against current revenues (analogously to a LIFO inventory method of accounting) and by avoiding a serious overstatement of pineapple and sugar growers' assets. Both pineapple and sugar plants require a growing period of about 18 months before producing a marketable crop, which may be followed by one or possibly two additional "ratocin" crops producing smaller fruit at approximately 9 to 12 month intervals.8 The pineapple plant and its fruit are subject to many natural hazards during the preproductiVe period, including insect pests and weather. The fruit is perishable and absolutely worthless until harvested and canned.9 The fruit's ultimate value depends upon prices that are volatile and consequently uncertain until the crop is actually harvested, processed and ready for sale.10 Capitalizing the cost of the maturing fruit and treating it as equivalent to inventory in these circumstances would be like considering eggs as inventory -before the chickens have laid them. Capitalizing costs incurred during the preproductive growing period would be an extremely expensive proposition for Hawaii's pineapple and sugar cane growers, requiring extensive record-keeping. Unlike crops grown on the mainland, there is no specific growing season or seasons for pineapple or sugar. Hence, preproductive costs are not easily identified and there is no "fall harvest" permitting the books to be closed. Since the tropical conditions of Hawaii allow for continual planting and harvesting throughout the year, at any particular time there can be thousands of "blocks" or areas of pineapple plantings in Maui's 400 fields, each at varying stages of maturity. The additional administrative costs of keeping track of the costs associated with each of these blocks would constitute a significant burden on any business, but especially one that experiences long periods of marginal or deficit operations like pineapple. The substantial additional costs involved in capitalizing growing crop costs in tropical agriculture are unnecessary when, without incurring these costs, the annual accrual method reflects income with sufficient accuracy to be acceptable to certified public accountants, the Internal Revenue Service, and the SEC. The annual accrual method does not distort income for pineapple and sugar because the growing period of both crops, approximately a year and a half, is not unduly lengthy. (By comparison, the -growing period for fruit and nut plants, the preproductive expenses of which were formerly required to be capitalized under section 278, can be four or five years). Thus, the difference between the time for expensing preproductive period costs under a general accrual method and under the annual accrual method is generally only a year, and over time the difference between net incomes arrived at under the two methods will not be significant. The annual accrual method is recognized under generally half the time, the pineapple plant is pLowed under after the first ratoon crop. 9Pineappte is a highly perishable coeanodity that has value as fresh fruit or for canning for a period of only a few days. At any time prior or subsequent to this short time span the pineapple plant and its fruit are useless. 10The prices of pineapple products processed by Maui are subject to the vicissitudes of market prices for pineapple and coqueting fruits which are outside the grower's control. Moreover, it is not current prices but market prices a year or two in the future, when the pineapple crop matures and is processed for sale, that wiLl deatermine whether costs incurred currently in connection with growing crops will be fully recovered. PAGENO="0627" 617 accepted accounting principles and has long been used by Hawaii's pineapple and sugar companies for financial reporting to stockholders and creditors, as well as for tax purposes. Their financial statements (including those of Maui) have been consistently and unqualifiedly certified by major national accounting firms for almost 40 years. The annual accrual method is not a tax gimmick but a practic~al and essential method of accounting `in Hawaii. V. THE WAYS AND MEANS COMMITTEE SHOULD RESTORE THE ANNUAL ACCRUAL METHOD TO THE HAWAIIAN PINEAPPLE INDUSTRY. Section 6627 of the Senate Finance Committee's original version of the Revenue Reconciliation Act of 1989 (see Appendix to this statement) would have restored the annual accrual method to Maui and the few other taxpayers who were properly using the annual accrual method in 1986. This provision was drafted after consultations with the staffs of the Joint Committee on Taxation, the House Ways and Means Committee, and the Senate Finance Committee. It addressed the on]~y substantive concern raised by staff members by expres~ly limiting the annual accrual method not just to taxpay$rs properly using that method but to the specific crops that were accounted for by those taxpayers under the annual accrual method immediately prior to enactment of the Tax Reform Act of 1986. This additional limitation is acceptable to Maui. The Treasury Department was asked for its position on section 6627 in the Finance Committee's markup last Fall and responded that it had no objection. Before this Committee's Subcommittee on Select Revenue Measures, however, Assistant Secretary (Tax Policy) Gideon submitted a prepared statement in which he advised, without acknowledging the Treasury's former position, that the Treasury opposed the proposal because it believes "as a general matter" that the uniform capitalization rules result in a more accurate measurement of income, and that "exempting particular groups of taxpayers from these capitalization requirements increases the inequities which the uniform capitalization rules were designed to eliminate." The notion underlying Treasury's most recent position, that the uniform capitalization rules constitute the only acceptable means of clearly reflecting income and should admit of no exception, is clearly mistaken. Congress determined in 1986, particularly in the case of farming, that in many cases accounting methods other than the uniform capitalization rules may result in an acceptable measurement of income that is at least as accurate as, and far less costly and complex than, uniform capitalization. Thus, the uniform capitalization rules have exceptions for unincorporated farmers raising any animal, or any plant having a preproductive period of 2 years or less, section 263A(d) (1), for timber, section 263A(c) (5), and for corporate farmers having gross receipts of less than $1 million or "family corporations" with gross receipts of less than $25 million, section 447(d) (2). Most important, Congress saw fit to continue as an exception to section 263A's uniform capitalization rules the permission it had granted in 1976 to taxpayers meeting the requirements of section 447(g) to use the annual accrual method. TANRA's limitation of this exception to sugar cane~ growers was, as explained above, the clear result of mistake. Neither Treasury nor anyone else has offered any policy reason why the annual accrual method is appropriate for sugar cane growers but not for pineapple growers. PAGENO="0628" 618 Contrary to Treasury's statement, it is not the restoration of the annual accrual method to pineapple that would increase "inequities" but the perpetuation of the mistake made in TAMRA which created an indefensible horizontal inequity between farmers of similar crops. Pineapple growers, as well as sugar cane growers, should be allowed to continue to use the annual accrual method as Congress, and this Committee, has always intended. PAGENO="0629" 619 APPENDIX TO STATEMENT OF MAUI PINEAPPLE COMPANY TEXT OF SECTION 6627 OF THE REVENUE RECONCILIATION ACT OF 1989 AS APPROVED BY THE SENATE FINANCE COMMITTEE ON OCTOBER 4, 1989 SEC. 6627. M4NUAL ACCRUAL ACCOUNTING METHOD. (a) IN GENERAL. -- Subparagraph (B) of section 447(g) (4) is amended by striking "sugar cane" and inserting "any crop with respect to which the taxpayer properly used the annual accrual method of accounting for its last taxable year ending before January 1, 1987". (b) EFFECTIVE DATE. The amendments made by this section shall apply as if included in the amendments made by the Tax Reform Act of 1986. PAGENO="0630" 620 John C. Cushman, III FEDERAL EXPRESS President and Chief Execative Officer March 5, 1990 Mr. Robert J. Leonard Chief Counsel Committee on Ways & Means U.S. HOUSE OF REPRESENTATIVES 1102 Longworth House Office Building Washington, D.C. 20515 RE: Accounting Provisions Accrual Method of Accounting Dear Sir: We are submitting our written statement insupport of the following proposal: Accrual Method of Accounting: The proposal would amend section 448(d) of the Code to permit a corporation to use the cash method of accounting if (a) more than 50 percent of the firm's income over the taxable year and two immediately preceding taxable years is commission income; (b) the firm pays at least 25 percent of the commission to brokers; and (c) the commission income will be received in installments due in more than one taxable year. We feel the issuance of regulations on June 16, 1987, limiting the use of the cash method of accounting unfairly overburdened office leasing brokers such as our company, Cushman Realty Corporation. Our transaction cycle for significant transactions extends over more than two tax years. (In our company without significant transactions, we would not be profitable). As a broker,we represent clients relocating their office premises and are paid by the Landlord. The fee arrangements provide for payment, one half upon execution of the lease and/or funding of a construction loan with the balance due the earlier of occupancy, rent commencement or a specified outside date. Since many office buildings do not commence construction until a certain amount of preleasing is achieved, receipt of both the first and second installments could be deferred. The deferral period can be one tax year different for the first installment and as much as three to four tax years different on the second installment from the time the Broker completed the transaction. As a result of these regulations, we are required to pay tax on 100% of the revenue even if it will not be received for three to four years. To exasperate this situation, we are prohibited from deducting the related commission expense of 50% to 65% of the revenue, payable by contract to our brokers/salesmen, until they are paid. We do not feel that the regulators were aware of our business cycle or could have understood the severe financial impact this provision produces. Our company has begun to realize the impact of this provision which has put a serious strain on operating cash. We support the above proposal and hope our letter crystalizes the necessity of its adoption. If we could be of any further assistance on this matter, please feel free to call me at (213)613-1544. Respectfully submitted, Jo n C. ~ Pr sident PAGENO="0631" ~621 ~tatdhHnt of the Honorable Andy Jacobs, Jr. February 21, 1990 TESTIMONY BEFORE THE SELECT REVENUE SUBCOMMITTEE OF WAYS AND MEANS HONORABLE CHARLES RANGEL, CHAIRMAN Re: Small electing property and casualty insurance companies and the alternative minimum tax. Mr. Chairman, the small mutual property and casualty insurance companies have for decades been dealt with for federal taxation under Section 56 of the Internal Revenue Code. In essence, the small mutuals are permitted to elect whether to pay taxes on their investment income or pay taxes on their operating income. So far as I can tell, the government and the mutuals come out about even with a minimum of complication. The problem arises with reference to the alternative minimum tax. Under that calculation, the small mutuals are denied the option given them traditionally. What we would like to see is an amendment to Section 56 of the Internal Revenue Code to exclude underwriting income and expense from alternative minimum taxable income for small insurance companies that elect to be taxed on taxable investment income under Section 831(b). Additionally, in recent years the small mutuals have been required to supply information to the U.S. Treasury which is at substantial variance from the information about their businesses which they must file with state regulatory agencies. The information filed with the state regulatory agencies is comprehensive. And it would save an awful lot of money for some awfully small businesses if they could simply use this same information as the basis for completing their federal income tax returns. PAGENO="0632" 622 TransWorld Insurance Company, Inc. 1220 16th Street South Birmingham, Alabama 35205 March 9, 1990 Mr. Robert J. Leonard, Chief Counsel Committee on Ways and Means U.S. House of Representatives 1102 Longworth Mouse Office Building Washington, D.C. 20515 RE: PROPOSAL TO ALLOW SMALL ELECTING INSURERS TO COMPUTE ALTERNATIVE MINIMUM TAX BASED ON INVESTMENT INCOME Gentlemen: I appreciate the opportunity to file these comments with the the committee supporting the proposal that would allow small property and casualty insurers which elect to be taxed only on investment income for regular tax purposes to extend the application of that election to the computation of alternative minimum tax (ANT). Based on the historically recognized differences -in the tax treatment of small insurers versus other corporations, the dramatic increase in tax burden and administrative complexity caused by the imposition of ANT and the failure of the ANT exemption to adequately protect smal], insurers from the harsh effects of the ANT, I support the above proposal. p~cicground At the time the income tax was enacted, mutual property and casualty insurers were generally small companies which assessed a related group of- policyholders for insured losses. Because of the economic risks underwritten by insurance companies, Congress recognized that the general measure of taxable income was not appropriate. Accordingly, the Revenue Act of 1921 exempted mutual property and casualty insurers from income tax. By the 1940's, mutual property and casualty insurers had begun to grow in size and Congress re-examined their tax treatment. Congress recognized that small mutual companies were especially vulnerable to catastrophic losses because of their low capitalization and, in the case of new companies, the absence of a strong earnings history. Larger mutuals, however, were perceived to be better able to withstand large insurance losses and -thus -should pay some tax. Accordingly, Congress restricted the tax exemption- to those mutual property and casualty - insurers with gross receipts of less than -$75,000 under the Revenue-Act-of 1942. For - mutual property and casualty insurers - with - -gross receipts in excess of $75,000, investment income was subject to tax under various formulas. Again, Congress recognized a need-for special tax treatment for small insurance companies - - in order take into account the economic risks borne by these companies and to free them from the burden of making the complex calculations necessary to compute taxable underwriting income. By the late 1950's, larger mutual property and casualty insurers were beginning to compete with stock insurance companies. Consequently, in the Revenue Act of 1962, Congress subjected mutual property and casualty insurers with total receipts in excess- of a certain amount to taxation on both underwriting and investment income. Further, because -of the insurance losses which some mutuals -.. were incurring, Congress provided for the deduction of underwriting losses by these companies. Again, however, complete exemption or the taxation of only investment income for small mutual property and casualty insurers was retained asCongress did not want to force these small insurers to - bear the complex burden of computing - taxable underwriting income. PAGENO="0633" 623 Prior to the Tax Reform Act of 1986 the same basic structure remained, as mutual property and casualty insurers with gross receipts under $150,000 were tax-exempt. In general, small mutual insurers with gross receipts greater than $150,000 but less than $500,000 were taxed solely on investment income. Mutual property and casualty insurers with gross receipts in excess of $500,000 were taxed On both underwriting and investment income. The Tax Reform Act of 1986 eliminated most of the differences in taxation between mutual and stock insurers. The tax-exemption benefit was granted to insurers whose net (or , if greater, direct) written premiums did not exceed $350,000. The ability to be taxed only on investment income was given to insurers with a premium level of greater than $350,000 but less than. $1,200,000. Both of these benefits were continued for small mutual property and ` casualty insurers and were extended to small stock insurers as well. The Technical and Miscellaneous Revenue Act of 1988 clarified that the election to be taxed only on investment income was irrevocable. The relevant Committee Reports provide "Congress' intent that the election not be used as a means of eliminating tax liability (e.g., by making the election only for years when the taxpayer does not have net operating losses), but rather as a simplification for small companies." Thus, since the Revenue Act Of 1921, Congress has recognized the difference between small insurance companies and other corporations in the application of the tax law. Because small insurers are in the business of covering the economic risk of loss for many policyholders and may not have the expertise to compute taxable underwriting income (which now requires loss reserve discounting, unearned premium adjustments, etc.), they continue to be taxed only on investment income if they so elect. The Effect of ANT The Tax Reform Act of 1986 enacted the ANT to ensure that "no taxpayer with substantial economic income can avoid significant tax liability by using exclusions,, deductions, and credits." Congress felt is was "inherently'unfair for high-income taxpayers to pay little or no tax due to their ability to utilize tax preferences." General Explanation of the Tax Reform Act of 1986 Pp. 432-433. In order to measure "economic income", Congress enacted the 50% Book-Income adjustment for tax years 1987, 1988 and `1989 and the 75% Adjusted Current Earnings (ACE) adjustment for tax years beginning after 1989. As explained in Technical Advice Memorandum 9006001, the ANT as currently constructed adds back 50% of underwriting income during pre-1990 years' and 75% of underwriting income for post-1989 years in determining alternative minimum taxable income (ANTI). `The following examples illustrate the increase in total tax liability caused by the imposition of ANT in 1989 and 1990: Underwriting Income $600,000 Investment Income ________ Book Income `, PAGENO="0634" 624 1989 1990 Taxable Investment Income $100,000 $100,000 50% Book-InCome Adjustment 300,000 N/A, 75% ACE Adjustment _~~JiLA 450~QQ0 Subtotal 400,000 550,000 Less: Exemption (phased out) -0- -~Q~ ANTI 400,000 550,000 ANT Rate 20% 20% TMT 80,000 110,000 Less: Regular Tax(investment income only)J~~,,250) ~ ANT (underwriting and investment income) ~_~,7,750 ~~1~LQ Total Tax $80~~00 $l25~QQ0 Effective Tax Rate on Investment Income ~ 125% `The dramatic impact of ANT on the tax liability of a small insurer is reflected in the effective tax rates on investment income that are shown above. As previously mentioned, congress' purpose in enacting the ANT was to prevent "high-income" taxpayers with "substantial economic income" from,avoiding a significant tax liability. While the 50% Book-Income adjustment and the 75% ACE adjustment work relatively well in fulfilling this purpose with regular corporations, these' adjustments do not fulfill this purpose when applied to small, insurers. This is because these' adjustments fail to consider that a regular corporation and a small insurer may both have "substantial economic income", but only the insurance company has a "substantial economic risk of loss." This risk, which is inherent to the insurance industry, is not accounted for in the measurement of "economic income" as computed by either the 50% Book-Income adjustment or the 75% ACE adjustment. Consequently, small insurers which have been shielded from such harsh tax effects since the enactment of the Revenue Act of 1921,' must pay an egregious amount of extra taxes not, because they unfairly avoided taxes before, but because the new system of taxation fails to consider the specialized nature of the industry in which they operate. Inadequacy of ANT Exemption to Protect Small Insurers The Internal Revenue Code provides a $40,000 exemption for corporations in computing ANTI. This exemption, which is phased out when ANTI exceeds $310,000, provides little relief to the small insurer with $1,000,000 in gross premium revenues that records a $600,000 underwriting gain and has taxable investment income of $100,000. A small insurer could have $600,000 of underwriting income but still be subject to the risk of catastrophic losses beyond those ordinarily reflected in its loss reserves due to its low level of capitalization. Unfortunately, the ANT provision's safe-harbor for small regular corporate taxpayers phases out based on a measure of "economic income" that, again, fail$ to consider the "economic risks" inherent to the business of a small insurance company. ANT and "Simplicity" for Small Insurers Further, the previously discussed Congressional intention for simplicity on behalf of small insurers is not fulfilled by current law. The failure of the current statutory framework to consider the economic risk which is especially significant to small insurance companies which do not have years of accumulated surplus to cover catastrophic losses, forces `these small insurers to compute ANT as explained above. While the examples given above are straightforward for purposes of illustration, the actual computation of ANT is far from simple. The segregation of tax-exempt bonds into `private-activity and non-private activity categories, the adjustment of book income for "equity" type adjustments, and the adjustment of Adjusted Current Earnings for alternative depreciation on real estate are some of the more complex items found in the `Internal Revenue Code. Therefore,. if Congress wanted to retain the simplicity of computing taxable income for small insurers as it indicated as late as 1988, the imposition of ANT on such small insurers is at odds with this purpose. PAGENO="0635" 625 Effects of the ANT Credit Because of the reserve discounting provisions of IRC Section 846 and the "20% haircut" on unearned premium deductions found in IRC Section `832(b)'(4), most large property and casualty insurers are subject to regular tax instead of ANT. Thus, if a small insurer's premiums grow to a level in excess of $1,200,000, ANT paid in prior years can be used to offset regular tax to the extent it exceeds Tentative Minimum Tax. This is because ANT paid in pre-1990 years will be attributable to the 50% Book-Income adjustment which is deemed to be a deferral type adjustment for purposes of determining the minimum tax credit. Further, all ANT paid in post-1989 years now generates a minimum tax credit under the provisions of the Revenue Reconciliation Act of 1989. Thus, for small insurers that grow into a large insurers, any ANT paid in the early years of operations will be refunded in later years via the minimum tax credit vehicle. For small insurers that remain small insurers, any ANT paid is a permanent cost to the insurer. However, a small insurer that is trying to establish a satisfactory surplus to cover potentially catastrophic losses may suffer undue financial hardship if it has to pay the extra ANT in the years in which it is most vulnerable to such a risk. To the Treasury, the ANT produces a favorable interest result with growth companies and a permanent tax for insurers whose premiums never exceed $1,200,000. To the small insurer, ANT restricts its ability to cover insurance losses which may threaten its ability to grow and expand its business. The imposition of ANT on small property and casualty insurance companies which have eleáted to be taxed only on investment income produces a dramatic increase in the tax burden of these companies. This increased tax burden causes a direct decrease in the insurer's surplus and thus, limits the, ability of the small insurer to protect its policyholders from insured `losses. Consequently, the extra tax imposed under the current statutory framework directly conflicts with the historical tax treatment of small insurers which has considered the economic risks inherent in the insurance industry and provided for simplicity in computing taxable income. Further, the methods used in measuring "economic income" for ANT purposes fail to consider the economic risks to which small insurers are subject. Therefore, I respectfully support the proposal to allow the IRC Section 831(b) election to be taxed solely on investment income for regular tax Purposes to apply to the computation of alternative minimum tax as well. Respectfully submitted, Mrs. Susan Lazarus, Accountant TransWorld Insurance Company LEONARD . MAR PAGENO="0636" 626 E~geee C Dccec NDEPENDENT SECTOR Willi~ee L. Boedc~et Vice Ch,~iepeccc Arnee L. Beam Vice Ch,eiePeeeoe March 5, 1990 Heeeae B. Callegos Vice Chaiepeeoss Loda Hjll Vice Chaiepeesoss frssa Faah loses The Honorable Dan Rostenkowski lAce Chaepeescoe Chairman, Committee on Ways and Means Eo~se~Wdsoc U.S. House of Representatives Casol B Tsoesdelt Washington, DC 20515 AstssdMesget Dear Mr. Chairman: lo~ssHs~:i~::PastChaieeesoe On behalf of the member organizations of Boos OCossell INDEPENDENT SECTOR, I am writing to urge the Ways and Peesidesst Means Subcommittee on Select Revenue Measures to amend the alternative minimum tax (ANT) by removing the ID ~ B k appreciated portion of property gifts from that tax Lisle Castes INDEPENDENT SECTOR is a coalition of more than 700 corporate, foundation, and voluntary organization Dessis A. Collies members created to preserve and enhance the tradition ~C0ttY of giving, volunteering, and not-for-profit initiative. (ohs E: Echohaok MaRFsessost-Sseith Certain changes made in the Tax Reform Act of john W.Gaedsee 1986, particularly the placement of gifts of l~etg appreciated property as a tax preference item in the PaolGsogas ANT, have increased the "price" of making charitable ed~hM~Goeeost contributions, creating a negative impact on giving to Fsosces Hesselbeis nonprofit organizations. Isa S. Hisschfield Nonprof its now report significant declines in teo~ll~tlOs~t property giving as a result. The Association of Art Stasleo N. Katz Museum Directors found that from 1987 to 1988, the W~esaPMnkilles dollar value of donations decreased 28.8 percent. The wayseeseisel Council for Aid to Education (CFAE) found a 10.6 Ch TPP g Ilk percent decline in property giving to schools and a PasockF.Noosas 16.0 percent decline inproperty giving to colleges and universities during those same years. GasvQoehl T While individuals do not make the decision to give lasses P. Shassos because of tax considerations, the amount they give is B hop Joseph Solloas significantly influenced by tax incentives. Taxpayers Alfred H. Taylos. Is. with incomes above $50,000 are most likely to make Is gifts of property. Statistics of Income data from the AdassYatesolisaky Internal Revenue Service indicate a decline both in the ~ average contribution per return among upper income A NATIONAL FORUM TO ENCOURAGE GIVING, VOLUNTEERING AND NOT * FOR * PROFIT INITIATIVE 1828 L Street, N.W. * Washington, D.C. 20036 * (202) 223.8100 SUCCESSOR TO THE C0ALm0N OF NATIONAL VOLUNTARY ORGANPA11ONS AND THE NATIONAL COUNOL ON PHRANTHROPY PAGENO="0637" 62? taxpayers and a decline in total giving in this group, amounting to an 11 percent loss ~ inflation from 1986 to 1987. The IRS data also shows that even when giving surged as a result of anticipated changes due to tax reform, the average contribution of taxpayers in income categories of $1 million or more never reached its 1980 level. In 1980 when top income taxpayers were in the 70 percent tax bracket, the average contribution per return from these taxpayers was $207,089. In 1987, it was $93,297. By removing gifts of appreciated property from the ANT, Congress would once again encourage giving of property such as stocks, other securities, real estate, works of art and historical pieces to serve public purposes. In addition, these gifts are critically important, because they can be showcased by charities as lead gifts to establish credibility and build momentum for capital campaigns. Government has long recognized the importance of policy that strengthens the tradition of private giving, including support through tax legislation. We urge the committee to support the removal of gifts of appeciated property from the ANT. Sincerely, Brian O'Connell cc: Robert J. Leonard PAGENO="0638" 628 ~ NANTUCKET CONSERVATION FOUNDATION, INC. POST OFFICE BOX 13'118 CLIFF ROAD, NANTUCKET, MASSACHUSETTS 02554-0013~ TEL 508-228-2884 March 8, 1990 Mr. Robert J. Leonard, Chief ~Un~ei Committee on Ways and Means U.S. House of Representatives 1102 Longworth House Office Building Washington, District of Columbia 20515 RE: Senate 1577/House 173 Dear Mr. Leonard: I am writing to you on behalf of the Nantucket Conservation Foundation, Inc., a membership-supported nonprofit organization located in Nantucket, Massachusetts. On behalf of our nearly 2,500 members and land donors, I urge your Committee's favorable consideration of Senate 1577/House 173. The elimination of charitable gifts of appreciated prop- erty as an Alternative Minimum Tax preference item is essential to the continuation of our mission and the mission of nonprofit land trusts across the country--namely, to preserve and protect our nation's natural heritage for generations yet to come. The Tax Reform Act of 1986 has severely affected all organiza- tions that rely on voluntary contributions, but the impact on land trusts like the Foundation has been particularly devastat- ing. When we lose unique natural features to development, they are lost forever. Our defeats are defeats shared by Nantucket residents and those people from throughout the United States who travel to the Island either as summer residents or short- term visitors. I offer you our Foundation as an illustration of both the need for organizations such as ours as well as for changes to our current tax laws. The Foundation's conservation program began 26 years ago with a single donation of nine-tenths of an acre. Since then, the Foundation has expanded the land under its stewardship. to include 7,780 acres, more than a quarter of Nan- tucket's total area. (The enclosed map vividly illustrates our achievements and those of the other conservation groups on Nantucket.) Approximately 70 percent of the Foundation's prop- erty was acquired by gifts, with the balance coming from pur- chases negotiated at below-market rates. Thanks to those ac- quisitions, land that was once in danger of being bulldozed and built on is now preserved forever, available for everyone's en- joyment and education. Although the Foundation has built up a dedicated corps of sup- porters over the years, it would never have been able to amass such an impressive record of voluntary support without the in- centive provided by tax benefits that depended upon a prop- erty's full fair market value at the time it was given. Rapidly appreciating values of undeveloped land on Nantucket has meant, unfortunately, that with such gifts now subject to the Alternative Minimum Tax, contributions of property are now of no interest except to a few taxpayers with tremendous in- comes. A charitable gift of appreciated land that is subject to the ANT means that most of the Foundation's supporters can no longer afford to donate the land necessary to further the PAGENO="0639" 629 Foundation's goals. The alternative is for the Foundation to purchase land at dramatically inflated prices if it can afford to do so or see it developed and lost forever. One of our members who has been a regular land donor notes in the enclosed letter, "The present laws seriously impair govern- ment policy to deal with the conservation issue through private initiative." This message has been regularly repeated by those who have unselfishly supported the Foundation's conservation program through gifts of land. In 1987--the year immediately following the enactment of the ANT provision for gifts of appreciated land--the effects of changing tax incentives became apparent to us. Land contribu- tions to the Foundation plummeted to an all-time low with a single gift totalling 8,462 square feet. (Our experience with gifts of appreciated securities was identical.) Indeed, strip- ping charitable incentives cost the Town of Nantucket's pi- oneering Land Bank Commission $2.5 million on one 26-acre prop- erty, land that we were confident would have come to the Foun- dation as a gift under pre-1987 rules. As you can see, despite its enviable record, the Foundation can not reston its laurels. Even with the current slowdown in Nantucket's real estate economy, this small island community is still facing major threats to its delicate balance of natural and historic resources. Without the lure of its unspoiled open spaces -- its rolling moorlands, sandy beaches, and secluded ponds -- Nantucket will cease to inspire residents and tanta- lize visitors with that unmistakable specialness which we still cling to, however tenuously, today. The Foundation and other like-minded island organizations and town agencies have proved their determination to preserve Nan- tucket for future generations. With current reductions in governmental spending for the acquisition of public open spaces and a bleak outlook for the future, we strongly believe that incentives for private, voluntary efforts must be restored. What we ask of Congress today is to return to us one of the most effective tools we had in pursuing our goal. Sincerely, ~ /1 ~ J es F. Lentowsk~. E cutive Secretary JFL:kct Enclosures [ONE OF THE ATTACHMENTS TO THIS LETTER IS BEING MAINTAINED IN THE COMMITTEE FILES.) PAGENO="0640" 630 PaineWebberGroup Inc. 1285 Avenue of the Americas New York, NY 10019 r~ r'\ ~ ~ LEi.f~LL~i ~ E. Garrett Bewkes,Jr. 11 MAR 081990 PaineW~bber March 6, 1990 Mr. James F. Lentowski Executive Secretary Nantucket Conservation Foundation, Inc. P.O. Box 13 Nantucket, Massachusetts 02554-0013 Dear Jim: There is no question that my gifts of appreciated property to the Foundation would have been greater were it not for the changesin the tax law that discourage such gifts. I do not refer to the lower rate but rather to the AMT which practically eliminates any tax benefit from a large gift of appreciated property unless one has a staggering amount of annual income to offset the limitation. Sincerely, /147 PAGENO="0641" 631 THEODORE L.CROSS 200 WEST S7THSTREET NEW YORK, N.Y. 40019 February 6, 1990 ~ FEB 0 8 1990 irE5~- uT~ Mr. James F. Lentowski Executive Secretary Nantucket Conservation Foundation, Inc. Post Office Box 13 118 Cliff Road Nantucket, Mass. 02554-0013 Dear Mr. Lentowski: I strongly urge that you or another representative of the Nantucket Conservation FOundation go before the House Ways and Means Committee on the issue of the matter of charitable gifts of conservation property. The present laws seriously impair government policy to deal with the conservation issue through private initiative You have a record of the gifts of open land I have made over the years. At one time they were substantial in size and number. They ceased altogether when the tax laws on charitable gifts were changed a few years ago. ~ Also I would note that the Internal Revenue Service is extremely hostile to land conservation gifts. On this issue, the IRS seems to be on a mindless "automatic pilot" and challenges all valuations, no matter how reasonable. Sinc rely, L~'c 30=860 0 - 90 - 21 PAGENO="0642" In a last-minute, cooperative ef- fort during the final days o11988, the Nantucket Conservation Foun- dation and the Town's Land Bank Commission protected 75 acres of critical moorland property in North Pasture. Located at the north end of Nantucket Memorial Airport's main runway, north of Milestone Road, the property abuts large tracts of cx- isitug Foundation land in the Mid- die Moors. NCF contributed $1 mil- lion toward the $2-2 million purchase and received title to 34.2 acres, with the Land Bank Commis- sion buying the balance. The Nature Conservancy played the crucial role in protecting this property when it was originally put on the market in 1986. By agreeing to "pro-acquire" the 75-acre tract, The Conservancy kept the land from development at that time. Their in- volvement was conditioned specifi- cally upon the understanding that prior to December 31,1988, they would be relieved of their "holding action" either by the Town's Airport Commission or Land Bank Commis- sion. (continued on page 4) "This is the territory that invites encroachment. Here, half embraced by progress, is the soil we must protect, encompass, defend, and take care of." (From the Foundations First Report to Its Members) We began with an initial dona~ tion of less than one acre and a commitment to provide future generations with the same oppor- tunity to appreciate the spectacular natural beauty Nantucket provides us. Now, 25 years later, we have cause to celebrate the Nantucket - ,~ ~ Conservation Foundations incred Fd - G g F wlk ible success in safeguarding more reviewing with Mrs. W. Ripley Nelson a than 7,750 acres of the lsland's most resolution marking the organization's beautiful beaches, moorlands, 25th Anniversary. The Foundation was marshes, ponds, and forests. established in the Nelson house on Dc- December28, 1988 marked the cember 28, 1963. twenty-fifth year since the Foundation's incorporation, giving us the opportunity to honor and recommit our efforts to the goals of ~ur original Incorporators. Encouragement, received from island residents and visitors alike, is the driving force behind the Foundation's success. Beginning with the support of 423 individuals, we havegrown to include over 2,500 annual members~ Voluntary giftsof property--totaling 143, from generous individuals, organizations, estates, bequests, and trusts- have provided the momentum that continues to propel NCF to- wards its goal of "assisting in the preservation of Nantucket's charac- ter through the conservation, preservation and maintenance" of its fragile and varied natural areas, Often described as the most effective force for saving Nantucket's open land, the FoundatiOn was created with the understanding that the best way to protect land is to own it. Beginning with. the earliest gifts were very encouraging indications that there was enough inter- est by individuals and groups within the community to ensure that significant portions of Nantucket would never be lost to develop- ment. In 1963, the Foundation's Incorporators-Messrs. Walter Bei- necke Jr., Tell Bema, Alcon Chadwick, Frederick W. Haffenreffer, Roy E. Larsen, John L, Lyman, Robert F. Mooney, W. Ripley Nelson, and Charles C. Snow-organized what was to become an aggressive land conservation program. Within the first five years, hundreds of acres were acquired at Coatue, Eel Point, Little Neck, Cisco, the Mid- dle Moors, Milestone Cranberry Bog, Tom Nevers, and Head of the (contiitued on page 2) 632 4 insicrht News and Information for Members and Friends of the Nantucket Conservation Foundation, Inc. -~ Spring 1989/No. 1 Cooperative Effort Foundation Produôes Middle Celebrates 25th Moors Purchase Anniversary PAGENO="0643" 633 Foundation Celebrates 25th Anniversary (continued from page 1) Plains. Under the leadership of four presidents (John L. Lyman, Roy E. Larsen, Alfred F. Sanford II, and George A. Fowikes) the Founda- lion's acquisitions have increased rapidly, bringing our current own- ership to approximately 26 percent of the Island's land area. In order for land to be fully appreciated as an irreplaceable resource worthy of protection, the Foundation has participated in and encour- aged educational programs and research. As early as 1972, a curricu- lum--called the Environmental Studies Program (ESP)--was created to offer young people. the opportunity to learn about Nantucket's un- usual natural and historical heritage. Since then, ESP has brought over 3,000 secondary students to the island, where they have learned about natural resource conservation, coastal ecology, history, archi- tecture, archaeology, and crafts from island experts in these fields. Through the. sponsorship of scientific research, we have increased our knowledge of Nantucket. Some studies have included: research on the rare and endangered short-eared owl, water supply testing, ge- ological and archaeological surveys, and the historical trends of shoreline erosion. Furthermore, early studies of vehicular traffic over sensitive plant cover prompted efforts to carefully supervise the use of all vehicles on Foundation properties. On Coatue, these ef- forts have led to dramatic revegetation of many open sand areas, strengthening six miles of the barrier beach that forms Nantucket Harbor. Nantucket is the site of one of the few examples of lowland heaths in the United States. Fortunately, a substantial portion of the island's heathland plant community lies within Foundation property. Through the exceptional generosity of individuals like Mrs. Tabitha T. Krauthoff--with gifts totalling more than 1,400 acres--the Middle Moors will remain forever undeveloped. Elsewhere at Foundation properties like The Sanford Farm and Ram Pasture, contributors to our Land Fund have given researchers, scientists, amateur botanists, and birders the opportunity to study the often rare plants and ani- mals that are present. These studies were shared in May of 1988 at the first "International Conference on Lowland Heaths," cosponsored by the Foundation, the University of Massachusetts Nantucket Field Station, and the Massachusetts Audubon Society. Our efforts to acquire, protect, and understand Nantucket's fragile environment have resulted in a growing appreciation and respect for our holdings--all of which are open to the public. Anyone who has walked the isolated beaches of Coatue, observed the fiery reds of the moors in October, explored the hardwood forests, witnessed the cran- berry harvest, or stopped to marvel at the aerial maneuvers of a hawk in search of prey understands why the efforts of the Founda- lion are so important to the long-tenn health and well-being of the .~~isIand. Twenty-five years of intense work, dedication, generosity, -`-and a love and sensitivity to Nantucket have yielded results that are the envy of conservation groups across the country. Frequently working to acquire. unspoiled tracts that are under the intense scrutiny of development interests means the Foundation is involved in a race against the clock. As always, everyone's participa- tion is needed and welcomed. Please, invite your friends and your acquaintances to join us in facing the challenges that remain ahead. 1988-89 BOARD OF TRUSTEES OFFICERS President George A. Fowlkes* Vice-Presidents Amos B. l-lostetter Jr.* Robert R. Larsen* Treasurer John M. Felleman* Clerk Albert G. Brock* Assistant Clerk Mark D. Amold * *ExeclLtivc Committee TRUSTEES Susan D. Akers Mark D. Arnold Daniel J. Bills William C. Cox Jr. Alexander M. Craig Jr. Lee D. Gillespie Thomas H.Gosnell John M. Greenleaf Amos B. Hostetter Jr. Louis C. Krauthoff II Robert R. Larsen Richard L. Menschel F. Philip Nash Jr. Fannette H. Sawyer Charles F. Sayle Sr. Stephen R. Swift Susanna B. Weld ADVISORY COUNCIL Walter Beinecke Jr. Frederick W. 1-laffenreffer Allen P. Mills H. Ward Reighlcy PAGENO="0644" Altar Rock Power Lines to be Placed Underground An agreement to eliminate the overhead electrical lines between Polpis Road and Altar Rock was ne- goliated this winter for the mutual benefit of the Foundation and the Nantucket Electric Company. * In order to assure more reliable electrical service into the airport's remote instrument landing beacon near Altar Rock, the Federal Avia- tion Administration requested that the Electric Company consider relo- cating all of its overhead wires un- derground. (The utility lines would be safe from the effects of damaging salt spray, ice storms, and strong winds.) After reviewing the merits* of the Electric Company's request for the easement, the Foundation's Board of Trustees authorized the voluntary action. Board members were encouraged that not only would instrument-guided air traffic be served more reliably by the pro- posed underground utility lines, but also the long-hoped-for removal of these highly visible wires and poles would mean that the Foundation's heathland properties could be en- joyed in a more natural condition. New Board Member The Foundation welcomed Mr. William C. Cox Jr. to the Board of Trustees on January 27,1989. Foundation Summer Jobs Applications are being accepted for the following summer positions: * Wauwinet Gatehouse Attendant * Office Assistant/Receptionist * Properly Maintenance Assistant Ranger (Middle Moors) Contact Mark Beale-between 8:30am and noon at (508) 228-2884 634 - P0181 881. F ~~.BEWKES~EWKES SURF5IPE Access to Squam Swamp Improved-- Conflict Avoided Our Trustees began 1989 with another demonstration of their determina- tion to protect Nantucket's threatened open spaces by authorizing the $187,250 purchase of a 75-acre property abutting Squam Swamp. ThisJanuary acquisition is important for a number of reasons. The proper- ty's location will provide visitors with foot access to some of the highest points on 298 acres of Squam Swamp already owned by the Foundation. Until now, access into this large, densely vegetated property were limited, causing problems for visitors and Foundation employees alike. The new parcel'sfrontage on the Old Quidnet Milk Route gives the Founda- tion an opportunity to establish a small area where visitors can leave their vehicles. From here walkers will be able to penetrate the edge of this vast conservation area. Stands of hardwood'trees-including swamp red maple (Acer rubrum); American beech (Fagus grandifolia), with trunk diameters ex- ceeding 24 inches; and American holly (Illex opaca), up to 40 feet in height- are found on the new purchase. It is not surprising that birders have been at- traded to the property. Some often search for the saw-whet owl (Aegolius acadicus), a small noctumal bird that is found only in the Island's forest habi- tat. Furthermore, this purchase eliminated a controversy surrounding the possi- ble disturbance of the rare spotted turtle (Clemmys guttata). When Mr. and Mrs. Stephen R. Swift (the previous owners of the property) filed a "Notice of Intent" with the Nantucket Conservation Commission to see (high ground on the lot could be used by them as a building site, they were told that the spot- ted turtle-suspected to occur within the boundaries of Squam Swamp.-had of- ficial status as a "species of special concern." This information first came to light following the Massachusetts Natural Heritage Program's review of the Swift's proposal. The state agency reported that they considered the Squans Swamp wetlands as the turtle's preferred habitat on Nantucket. The turtle, identified by yellow spots on its shell, head, neck, and limbs, is extremely sensitive to any alterations in or in close proximity to its habitat. Opting not tobecome involved in a costly and lengthy entanglement that would delve into the scientific, engineering, and legal issues related to the proposed use of their land, the Swifis chose to discuss with the Foundation the possibility of a sale. Our purchase created a solution that addressed the Swifts needs white, at the same time, it preserved a property rich in uncom- mon vegetation and rare wildlife for everyone's enjoyment and appreciation. Annual Meeting Date - The Nantucket Conservation Founda- lion's Annual Meeting of Members - will be held August 19th at the Cof- fin School at lOam. This meeting is open to all Foundation members. PAGENO="0645" Endangered plants and wildlife were given a fightingchance to survive when 30 acres of oceanfront moorland were purchased for conservation purpos- es by the Town's Land Bank Commission in late December. Located one-half mile east of Cisco Beach in an area sometimes called Smooth Hummocks, the tract abuts a 1986 gift of 1.9 acres (shown as No. 155 on the NCF Map), given to the Foundation by Mr. E. Garrett Bewkes, Jr. The parcel, purchased from Mr. Bewkes, was acquired following intense ne- gotiations during the final days of 1988. When it seemed likely that theap- proved 20-lot subdivision would be sold to a developer the Foundation (with major financial participation from the Massachusetts Natural Heritage Pro- gram) launched an effort to purchase all 40 acres from Mr. Bewkes. Although late-December budget cuts eliminated the Natural Heritage Program's com- mitment, The Nature Conservancy--knowing of this property's importance- offered to provide substitute funding. As it finally tumed out, Mr. Bewkes agreed to sell 15 of the subdivision's lots, for a total of 30 acres, to the Land Bank Commission. The purchase price was $2.5 million. This area has been of great interest to both state and national conservation groupsbecause--together with other nearby grasslands--it serves as a nesting, breeding, and hunting ground for the short-eared owl (Asio flammeus). Re- *quiring anywhere from 40 tb 200 acres of open space before it wilt breed, the short-eared owl has declined in numbers primarily due to the effects of human encroachment on its habitat. Placed on the Commonwealth's Endangered Spe- cies List in 1984 by the Massachusetts Division of Fisheries and Wildlife, only 25 pairs have been identified in the state. Fourteen of these are known to visit Nantucket-at Eel Point, near Altar Rock, in the Cisco/Miacomet area, as welt as on Tuckernuck arid Muskeget. In addition, a variety of rare plants and wildflowers-including sandplain blue-eyed grass (Sisyrinchium arenicola), bushy rockrose (Helianthemum du- mosum), and sandplain flax (Linum intercursum)-have been identified on the Land Bank's newest Smooth Hummocks property, making the Bewkes pur- chase even more exciting and important. Publications PrcsL'rvhlg Family Lands:A Landott',ter" Cmzsidecatioats..by Attorney Stephen J. Small is available through the Foun- dation for landowners who are considering the alternatives available to them in safeguarding family ownership and the conservation values of their prop- erty. The Foundation has a limited number of these informative booklets and would be pleased to provide a complimentary copy to those who have a seri- ous interest in the subject. 635 Coastal Grasslands Preserved Cooperative Effort - c Produces Middle Moors Purchase (continued from page 1) The Airport Commission hoped that funds from the Federal Avis- lion Administration (FAA) would be used to enable the Commission to purchase all 75 acres. It was shortly after the FAA announced that mon- ey was not available for the acquisi- tion of this property that the Foun- dation was approached for help by the Land Bank Commission. Knowing the importance of this property from NCFs long-term in- volvement in the Middle Moors, the Foundation's Board voted to assist the Land Bank Commission with this costlypurchase. Having volun- tarily committed $1 million of its Land Fund towards this unforeseen project-with a major portion of this amount coming from a generousbe- quest of Mr. Scott Maclain--NCF's Trustees helped save a significant part of the Land Bank's financial re- serves, enabling its Commissioners to go forward with negotiations on oth- er acquisitions important to the com- munity. As property values rise on Nantucket, the cooperative efforts of conservation agencies and organi- zations are approaches that may be used more frequently to preserve and protect key open spaces for future generations. For the Foundation, this moorland acquisition had strategic importance as well because of its contiguity to the large tracts of land it already - inrroduction fo Tax Issues attd Other owns in the Middle Moors. The pur- chase with the Land Bank Commifr- - sion preceded (by just a few days) an NCF payment, to Mr. andMrs. Frank Low and Mr. Julius Jensen lit, of $137,500--the third installnsent on 125 acres (shown as parcel No. 158cm the NCF Map). The 125 acres are a "Lyme Disease: What it is And Hotv To Avoid Getting it" is an informative portion of the 269 acres that the flyer that will be distributed by the Foundation this Spring (andis also Foundation has negotiated to buy available at The Larsen-Sanford Center). We encourage-everyone who visits over an extended period of linac from the Foundation's properties to take a moment and review thisimporlant in- the Losvs and Mr. Jensen. NCF is formation, hopeful to complete all its payments on the 269 acres in 1996, having paid $1,462,750 for the preservationol this critical area in Nantucket's Middle Moors. PAGENO="0646" Cliff Road Bike Path Nears Completion The removal of unsightly over- head utility lines fronting a spec- tacular Foundation property and dramatically improved visibility for motorists are the results of the construction of a bike path-thanks to the cooperation among the Nan- tucket Conservation Foundation, the Town of Naritucket, Nantucket Elec- tric Company, and New England Telephone. Last year when the Town pro- posed the construction of a bike path on Cliff Road, the Foundation's Board of Trustees was approached by the Town for the voluntary grant of a bike path easement. (Forty- five percent of the planned bicycle route ran alongthe Foundation's "Tupancy' properties.) After care- fully considering the request and how the impact on our properties could be minimIzed, the Board granted an easement, but not before it had received commitments from Nantucket Electric Company and New England Telephone for the re- moval of all overhead power and telephone lines along Cliff Road fromCrooked Lane to WashingPond Road. Both companies readily agreed to eliminate a one-mile seg- - - ment of overhead service that had been a frequent cause of outages due to its exposed location. Not only does undergrounding improve service to customers, but it greatly improves the aesthetic experience of motorists and bicydists as they take in the views across the Foundation's Tupancy properties. Beginning at Crooked Lane, the new path runs westerly along Cliff Road where it connects with the Ma- daket Road bike path. Looking across the Foundation's property, one can see Nantucket Sound, which was previously hidden by a roadside line of dense shrubbery. By encouraging the Town to cling to the edge of the Foundation's property (thus having a substantially smaller impact on our land than a meandering path I would), not only is cy- cling safer for bicyclists, but the selective removal of existing vege- tation has greatly improved visibil- ity of the path (for added bicyclist safety) and enjoyment of the proper- ty for all passersby. In addition to getting bicyclists and pedestrians off of the road, mot- orists are benefiting, too. At the Foundation's request and with its cooperation, two high banks-which had severely obstructed the driver's view-have been removed, resulting in improved driving safety. The finish coat of asphalt is scheduled to be applied in late- spring/early summer, at which time the shoulders of the bike route will be finish graded and seeded. This winter, the path has already at- tracted joggers and bikers braving the cold winds. For the rest of us timid souls, springtime temperatures prorniseto coax usout of ourcars and onto the path to enjoy a leisurely ride or walk along yet another beautiful conservation property. 636 Beach and Visitors Benefit From Angler's Club Planting ~________ - The 17th annual `Christmas Tree Planting" by the Nantucket Angler's Club was held February 19th-a wintry Sunday morning-with over 60 volunteers ` e lncr ses for and 25 four-wheel drive vehicles taking part in the Coatue-Coskata-Great Point event. Foundation Executive Secretary Jim Lentowski, Properties Main- Oversand Vehicle Permit tenance Supervisor Bob McGrath, and his assistant Charlie Dunton coordinat- ed and assisted Dick Bellevue (Refuge Manager for The Trustees of Reserva- Fifteen years ago the oversand ye- tions) in directing volunteers of all ages to help stabilize damaged sand dunes hide permit system was established that have bome the brunt of winter storms and thoughllesa drivers. as a user fee to generate income for By planting Christmas trees in "blowouts" (wind-swept breaks in the dune the management and maintenance of : line whereAmerican beach grass or other coastal plants are not growing), the Coatue, Coskata, and Great branches collect wind-blown sand. In addition to discouraging pedestrians and Point wildlife refuges. Requiring vehicles from disturbing the area, the trees give existing beach grass runners a permits has also given us the oppor- chance to revegetate these problem areas. Angler's Club members, with the tunity to pass the message to visitors help of Miles Reis Trucking. had been stockpiling discarded trees on the Foun- that the refuges are special places dation's Squam Swamp property since Christmas and were able to accumulate -that must be treated with care. nearly 1,500 of them for this year's planting. S With increased costs in mainte- After spending several frigid hours working to protect the Island's east nance, the Foundation and The Trus- beach (between the Haulover and Great Point), the volunteers headed back to tees of Reservat ons have found t a hot lunch at the Angle x Club W thout regula efforts like th s to repa necessary to implement a modest in- and protect coastal barrierbeaches and dunes, major sand erosion would occur crease for this year's annual sticker, in areas all over the island. The Foundation and The Trustees of Reservations which expires on June 15, 1990. The truly appreciate the continuing concem and commitment of the Nantucket An- price is $40. gler's Club in taking the initiative to organize regular volunteer work parties S for the benefit of the beaches and all those who enjoy them. PAGENO="0647" Quaise Hilltop Protected On January 6, 1989, the Foundation paid the second of three $25,000 in- stallments for the purchase of a 2.8 acre hilltop parcel, located about one-quarter mile south of Polpis Road. Exercising a "Right of First Refusal" given to it in 1985 by Mr. Leeds Mitchell (the owner), the Foundation's Board of Trustees au- thorized the purchase because of the property's relationship to existing NCF holdings located to the south and east. Situated on Potpis Road across from the University of Massa- chusetts Nantucket Field Station, this parcel abuts properties shown on the Foundation's map as Nos. 61 (a gift from Mrs. Tabitha T. Krauthoff) and 139 (a gift from Mr. Mitchell). The site-perched atop a grassy hill with a dramatic 360' vista--was originally subdivided for use as a house site. The construction of even a 1-story house on this lot would have seriously affected surroundingconser- vation properties because of its 71- foot elevation and openness. Looking south from the property, the Middle Moors may be seen in all their splendor; to the northeast lies a freshwater marsh bordered by tu- pelo trees (Nyssa sylvatica). Not far from Altar Rock Road (referred to by many as `The Gateway to the Moors"), this purchase calls atten- tion to the enormous financial com- mitment necessary to preserveNan- tucket's once openheathlands from additional encroachment. .l%4.'uch of floe unspoiled openness we associate with Nan- tucket today is the way it is--and the way it will remain--thanks to the hard work of the Nantucket Conservation Foundation and the voluntary support of its nearly 2,500 members. The Foundation's primary purpose continues to be to ac- quire--through gifts, bequests, and, when necessary, purchase-- the Island's crucial open spaces to be maintained forever in an unspoiled state. Protected are many of the-unparalleled scenic . vistas and unusual natural assets which are the essence of the island That it has come a long way toward reaching its goal of "Conservation is not permanently5conserving a diverse ;znventory of undeveloped ~ just a luxi~rij, but land is readily apparent This land which is open to the puWic absolutely essential for its education and enjoyment is easily identified bsy the road i ~ i side maroon posts topped by the Foundation s wave and sea `~fff 1° ine sanity oj ule gull logo Visitors are welcome to discover and explore these'%~ generations to dunes and marshes scrublands and grassy plains ponds and ,~,~follow" bogs and moorlands and forests ,~ Roy E Larsen 1967 EJ NANTUCKErCONSERVA1lONFOUNDATtON,lNc~ Post Office Box 13, Nantucket, Massachusetts 02554-0013 Nonprofit Org. U.S. POSTAGE I PAID NANTUCKET, MAI PERMIT N~2Jj 637 PAGENO="0648" 638 ND~ Nantucket Land Council, Inc. Nantucket Mas::chusettS 02554 February 23, 1990 Hr. Robert J. Leonard Chief Council Commission on Ways and Means 1102 Longworth House Office Bldg. Washington, DC 20515 RE: House Bill 173 - Law to provide that charitable contributions of appreciated property not be treated as a tax preference item under the Alternative Minimum Tax Dear Mr. Leonard: As you know, the natural environment of Nantucket Island is very much worth preserving. Because it is such a special place, with miles of unspoiled coastline and acres of open moors, the Island is under substantial development pressure. The Nantucket Land Council is a private, non-profit environmental organization supported by members. The Land Council is working diligently to permanently preserve open land with conservation value for future generations and for rare and endangered species by accepting grants of Conservation Restrictions from private landowners. We currently hold permanent conservation restrictions on 205 acres of 900 acre Tuckernuck Island. Unfortunately, we conservationists are in a fast-paced race with development to secure open land. If this extraordinary land on Nantucket is not protected in the near future it will be irrevocably lost. Conversely, if landowners who are inclined to protecting land and providing public benefit can enjoy substantial tax benefits, the land will more likely be preserved in its natural state in perpetuity. The irony is that preserved open land benefits the development industry by enhancing the Island. In addition, our tourism industry greatly benefits from our protected opeh land, and our resident community enjoys benefits such as groundwater protection from conservation land. I am writing to tell you that the effect of Congress' making the appreciated portion of a gift of appreciated property a tax preference item for purposes of the alternative minimum tax by the 1986 Tax Act has had a most definite negative effect in Nantucket. In House Bill 173 there is now an opportunity for Congress to correct that damaging law. Landowners who grant conservation restrictions give up significant permanent value. For doing so they should be entitled to significant tax savings. The deleterious effect of the 1986 ANT provision on land preservation was not intended by Congress. I urge you to strongly support and sponsor House Bill 173. Sin rely, C Lyrfh Zimmerman As,s~ciate Director cc. The Land Trust Alliance Senator John F. Kerry Senator Edward Kennedy PAGENO="0649" 639 NATIONAL ASSOCIATION OF INDEPENDENT SCHOOLS 11 Dupont Circle, Suite 210, Washington, D.C. 20036 (202) 265-3500 On behalf of the National Association of Independent Schools (NAIS), I am pleased to, submit a statenent in support of H.R. 173, a bill to eliminate the provisions of the Internal Revenue Code that now subject charitable gifts of appreciated assets to the alternative minimum tax. NAIS is a voluntary member organization of over 1,000 schools and associations in the U.S. and abroad representing 355,000 elementary and secondary school students, 37,600 teachers and 6,000 administrators. The schools are coeducational and single sex, boarding and day, nontraditional as well as traditional. Membership is limited to nonprofit schools that have racially nondiscriminatory admissions and employment policies. Private schools have been a part of our' nation's `educational system since colonial times. Today they help fulfill ~the American ideal of pluralism in education by meeting the diverse philosophical and educational priorities of over three million families. Nationally, private schools make up twenty-four percent of all schools, educate twelve percent of the K-l2 student population, and employ thirteen percent of the teachers in the U.S. The children served in private schools come from all strata of society. Twenty-one percent of families sending their children to private schools earn under $20,000 a year and thirty-nine percent earn under $30,000. Students of color' comprise approximately nine percent of all private school enrollment. In NAIS member schools over twelve percent of the student school population is minority. The importance of philanthropy to our schools cannot be overestimated. If schools are to maintain realistic tuition levels and student populations representative of middle-income and low-income families, they need to raise funds to bridge the gap between the tuitions they charge and the real costs of education. Appreciated assets account for a significant amount of all gifts to independent schools and are essential to any major fundraising campaign. Schools rely upon gifts of appreciated~assets tO lead capital campaigns and major gift drives which fund scholarships and financial aid, improvements to the campus, new program development, meaningful increases in faculty salaries or benefits, and endowments, among other things. As our school community suspected, the inclusion of gifts of appreciated property in the alternative minimum tax calculation has had a negative effect on `giving to independent schools. The most recent data from the Council for Aid to Education show that after years of substantial increases in giving to independent schools, overall giving decreased by .11% in 1987-88 and then was flat~ in 1988-89. Gifts of other property (typically' appreciated property) showed a `decline of 10% in 1987-88 and 43% in 1988-89. Nntional'office: 75 Federal Street, Boston, Massachusetts 02110 PAGENO="0650" 640 * Simply stated, when tax incentives are replaced with disincentives, there are fewer donors to make the major gifts that are so crucial to our schools' existence. While a donor's decision to make a contribution almost always reflects a commitment to the institution, the decisions about what, when, and how much to give are generally made with tax implications often determining the ultimate size of the gift The accounts we are hearing from our member schools and your constituents support other evidence of a decline in giving of appreciated assets nationwide. We can point to a number of situations where donors approached schools with an intent of making large gifts but found when reviewing the tax consequences of the proposed gifts they needed to reduce the level of their gift or they decided not to give at all. Also, it is important to emphasize in the debate on the merits of this issue that there are laws that limit the percentage of income that can be deducted for appreciated gifts, so no one can escape taxation (zero out) through such gifts. Donors must also comply with detailed rules for appraisal and disclosure, designed to ensure proper valuation. Additionally, those who choose to give less generously because of this provision may very well hold on to their assets thereby depriving the government of any tax revenues from them, while precluding their use to support charitable purposes. Historically, our government has honored pluralistic values. If we are to maintain any sort of educational diversity in this country we must do so by making sure that both the public and private sector are able to operate ma manner commensurate with their individual and different missions. Will the amount of federal revenue generated by including gifts of property as an item of tax preference in the alternative minimum tax outweigh the negative effect on giving to independent schools and other charitable institutions? We think not. We believe, furthermore, that the focus of debate on this i~sue should surround the public policy implications of the societal benefits rather than the donor's financial status. In conclusion, we believe that repeal of the provision of the 1986 Tax Reform Act to include gifts of property in the alternative minimum tax is crucial to the future of many independent schools. We enthusiastically recommend your support in restoring the full deductibility of gifts of appreciated assets. Respectfully submitted, John W. Sanders Vice President PAGENO="0651" ENTERTAINMENT, ARTS AND SPORTS LAW SECTION 5039-199O~ STANDING COMMITTEE CHAIRPERSONS ADVERTISING AND MARKETING Leonand 0th/n 1740 Bnoadonay NeoYonk, NY 10019 212/4684800 AMATEUR AND OLYMPIC SPORTS EdosendG. Williants 156 West 56th SIted NeaYonk,NY 10519 212/237-1500 BROADCASTING ANDCABLE Many Ann Tmntnen S55FifthAoenae, 10th Float Nets Yank, NY 10017 212/210-0545 COPYRIGHTANDTRADEMARK Alan J.Hantniok 79 MadisonAoennae, 655 Floon NetsYonk,Ny 10016 212/532-5155 FINE ARTS Sasan Oaks Siedennnsn 575 MadisonAoenae, State 1006 Nets Yank NY 1 5622 212/605-0477 LEGISLATION NeatYank, NY 10006 212/587-0350 LITERARY WORKS AND RELATED RIGHTS Eagene H. Winick 3l0MadjsonAcsnce, Sate6O7 Nets Yank, NY 1 0017 212/687-7405 LITIGATION SamaelL Pittkas OneLincoln Place Nsa'thnk, NY 10023 212/595-3555 MOTIONPICTURES AND VIDEO Ronald S. Taft Nets Yank, NY 10019 212/506-8044 MUSIC AND RECORDING INDUSTRY Haassnd Siegel 410 PatkAaenue, 10th Floon NsaYank,NY 15622 212/326-0156 PROFESSIONAL SPORTS CteigFosten 323 Centne Acetnue NeaRoohelle, NY 10805 212/541-8641 PROGRAMS John R.Kettle,lll 251 LibentyStneet Blaonttleld, NJ 07003 201/748-0572 PUBLICATIONS Edo M. Sentnat 5O36JetiohoTunnpike P.O. Ooe-49 Camnttack,NY 11725 516/462-1793 TALENT AGENCIES AND TALENT MANAGEMENT Phi6pM. Coaent 477 Madison Aoenue NeaYonk, NY 15022 212/750-7474 641' March 8, 1990 Robert J. Leonard, Chief Counsel United States House of Representatives 1102 Longworth, House Office Building Washington, D.C. 20515 Re: Repeal of the Treatment of Charitable Contributions of Appreciated Property As an Item of Tax Prefe~~ç~ Dear Mr. Leonard: The Fine Arts Committee of the New York State Bar Association (Entertainment, Arts and Sports Law Section) strongly endorses the repeal of Section 57(a)(6) of the Internal Revenue Code and urges the Select Revenue Subcommittee to recommend the repeal of that provision. In this regard we submit this letter for the record. The Fine Arts Committee is comprised of practicing attorneys who represent tax-exempt organizations and individuals involved in the visual arts, either as creators or collectors. We are thus intimately aware of the detrimental effect upon charitable contributions that has occurred as a result of the enactment of the Tax Reform Act of 1986. It has been our collective experienze that the lowering of the income tax rate to its current levels did not impact on the very dramatic and unfortunate drop in charitable contributions of appreciated property being made by individuals. Further, we believe that the provision in Section 57 (a)(6) which provides that the appreciation in value of items contributed to charity shall now be treated as an item of tax preference has discouraged many taxpayers from making charitable contributions. (We believe this disincentive exists even though the making of a charitable contribution of appreciated property will not always incur the alternative minimum tax; many individuals have been dissuaded simply because of the oft-held belief that when the alternative minimum, tax does apply, an individual's contribution is limited to his or her cost. This includes potential contributions of appreciated THEATRE AND PERFORMING ARTS 11111 212/003-0400 PAGENO="0652" 642 stock and bonds as well as works of art.) Because the inter- relationship of the alternative minimum tax and the regular tax calculation involves rather intricate calculations, even the advisors to individuals are discouraging their clients from making contributions because of the potential impact of the alternative minimum tax. The churches, synagogues, universities and museums in the United States are by and large supported by private contributions. The abuses thought to be remedied by the alternative minimum tax are already addressed by The Internal Revenue Code in a vast number of safeguards. This includes those provisions involving the regulation of contributions of tangible personal property, j,~., the rules requiring a qualified appraisal by a qualified appraiser. The Fine Arts Committee of the New York State Bar Association strongly endorses the House Bill that would repeal Section 57 (a)(6) so that an individual in deciding whether or not to make a charitable contributionof appreciated property will not have to base this decision on whether or not the alternative minimum tax applies. Respectfully submitted, Susan DukeBiederman, Esq. Chair, Fine Arts Committee New York State Bar Association SDK/oa 0817K PAGENO="0653" TRUST FORNEW HAMPSHIRE LANDS 54Po,te~w,thSt,82, Coooo'd, N~ H~wp~h0o0330l-5486 603 2284717 It iS tip~,6! - - 643 March 1, 1990 Robert J. Leonard, Chief Counsel Committee on Ways and Means U.S. House of Representatives 1102 Longworth House Office Building Washington DC 20515 RE: H.R. 173 Dear Mr. Leonard: I am writing to submit the following as a statement for the printed record for hearings on H.R. 173 relative to the Alternative Minimum Tax and gifts of appreciated property. The Trust for New Hampshire `lands was created in 1986 to assist the State of New Hampshire and its municipalities in protecting its outstanding conservation and recreational lands. We are a private non-profit organization supported by private contributions. We serve as land agent for the state in its premier land acquisition program, the Land Conservation Investment Program. In the course of this work, we have negotiated land and conservation easement acquisitions with hundreds of landowners covering over 80,000 acres. Almost every one of these acquisitions is a "bargain sale." Sometimes the gift made by the landowner is 50% or more of the land's appraised value. By relying upon these landowner gifts, we have been able to protect $2 worth of land for every $1 of state funds spent. Needless to say, this track record of landowner generosity has been very important in maintaining public and legislative support for our program's funding. Despite this good news, we know that we could do even better. The Alternative Minimum Tax has been a significant impediment for many of our landowners. The provision of the tax that treats a gift of land or easement value as a tax preference item has severely affected the tax picture of many of our landowners. Because we must compete with developers and because land values have appreciated so much in recent, years, any tax deduction that we can offer through a bargain sale has been anessential competitive advantage for us. PAGENO="0654" 644 Since the AMT provision has gone into effect, any tax-deductable donation is limited to the landowner's basis. In our region, anyone who has held their land more than a decade or two (most of our large farmers and forestlanci owners) has a very small basis. This provision of the AMT has left many with no incentive at all to make a bargain sale. To further complicate matters, the gift itself may kick the landowner into the AMT category. The provisions of the AMT are so complicated that most landowners and their country tax advisors and attorneys are unable to predict what the benefits of any charitable gift would be ahead of time. Therefore, many simply through up their hands and walk away. In light of constrained federal and state funding for land conservation, it is critical to promote charitable land conserving action. The passage of H.R. 173 and 5. 1577 will stimulate landowners to conserve more land at a lower public cost in New Hampshire and across the nation. Thank you for your consideration of this important matter. Sincerely -~ r Sarah Thorne'~ Acquisition Director cc: Senator Warren Rudman Senator Gordon Humphrey Congressman Charles Douglass Congressman Robert Smith Jean Rocker, Land Trust Alliance PAGENO="0655" 645 the com;uter software and services industry association February 27, 1990 The Honorable Dan Rostenkowaki The Committee on Ways and Means 1102 Longworth House Office Building Washington, D.C. 20515 Dear Mr. Chairman: On behalf of ADAPSO, the computer software and services industry association, I urge you to restore the right of certain tax- exempt organizations to offer 401(K) tax deferred retirement plans to their employees. The Tax Reform Act of 1986 revoked this right, apparently because of the incorrect assumptiom that another type of plan was avail- able to the employees of trade and professional associations. Unfortunately, this is not the case and ADAPSO employees are un- able to use a savings plan enjoyed by millions. As a result of not using a 401(K) plan, ADAPSO employees, as well as those of other non-profits, are likely to save less. ~ADAPSO, in comparison to employers who offer 401(K) plans, is ~unable to match employee contributions and thus both employee and employer are disadvantaged. Employees prefer to be compensated with tax deferred savings plans, rather than taxable wages. The inability to participate in a 401(K) plan is a substantial com- petitive disadvantage when working for a tax-exempt organization. Thus, ADAPSO, as an employer is less able to attract and retain qualified employees who are apt to leave to join the for profit sector. Since, not-for-profit organizations are rarely able to match the salaries and benefits of the for profit sector, the restoration of 401(K) plans will improve ADAPSO's ability to at- tract and retain the most qualified employees. Surely, discriminatory tax policy is not what Congress intended. I respectfully request that you vote to restore the right of tax exempt organizations to offer its employees 401(K) retirement plan. ~neJam&~ Executive Director PAGENO="0656" 646 STATEMENT OF AMERICAN BANKERS ASSOCIATION The American Bankers Association is pleased to have the opportunity to express the view of bank trust departments concerning a proposal relating to employee benefit plans. The American Bankers Association ("ABA') is the national trade and, professional association for the United States' commercial banks. Assets of ABA members are about 95% of the industry total. Approximately 3,500 bank trust departments provide fiduciary services for their customers. Bank trust departments have investment management responsibility for more than $500 billion in employee benefit funds and, in addition, serve as custodian or trustee without investment discretion of more than $1 trillion of employee benefit assets. Thus bank trust departments are familiar with and vitally interested in the pension and employee benefit areas. The ABA supports the proposal to modify present law to permit tax-exempt employers to maintain qualified cash or deferred arrangements, or code section 401(k) plans. The proposal would allow the broadening and expansion of the voluntary retirement system which has become the, vehicle for the majority of the population's funding for retirement. The idea behind the changes in this area through the Tax Reform Act of 1986 was that qualified cash or deferred vehicles should be supplementary retirement savings arrangements for employees; such arrangements should not be the primary employer-maintained retirement plan. Congress sought this result by attempting to reduce the shifting of the burden of retirement saving to employees. One way to reduce this shifting was to limit the number of employers that can maintain cash or deferred arrangements. Thus, Congress believed it was necessary to preclude the availability of qualified cash or deferred arrangements to State and local governments and tax-exempt employers. Trends in the growth of plans and participants show that there is a dramatic growth in primary defined contribution plans. In explaining the, trend, the Department of Labor has proposed that legislative requirements under ERISA have become more burdensome and costly for sponsors of defined benefit plans. Defined contribution plans are not subjectto funding standards and payment of increasingly burdensome benefit insurance premiums and.are, therefore, less costly for plan sponsors to maintain. By allowing tax-exempt employers to'maintain qualified'cash, deferred compensation or 401(k) plans, it would increase the number of participants that are' covered by a private retirement plan whether it would be their primary or a supplemental plan. Savings for retirement should be encouraged. Employees who choose to work for state and local governments or other tax. exempt organizations should be afforded the same encouragement as employees who choose to work for private industry. Enactment of this proposal'would assist these employers in attracting and retaining highly qualified individuals. Competitiveness in hiring practices was part of the reasoning for the establishment in 1986 of the Thrift Savings Plan, a tax deferred savings plan for federal employees. In its discussion of the Thrift Savings Plan, the Committee on Governmental Affairs concluded that a Federal retirement plan should continue to offer incentives to build a career workforce. Any employer must have a cadre of employees to provide stability, continuityand the institutional memory to run an organization effectively. It would be inequitable to allow corporate American and the federal government to offer these attractive employee benefits and continue to disallow state, local and other tax exempt employers to do so. PAGENO="0657" 647 Credit Union National AssOciation, Inc. * ft 805 15th Street, NW, Suite 300, Washington. DC 20005-2207. 682-4200 a Charles 0. Zuver Senior Vice President Governmental Affairs Division Home Phone: (703) 768-1155 March 6, 1990 The Honorable Charles B. Rangel Chairman, Subcommittee on Select Revenue Measures Committee on Ways and Means U.S. House of Representatives 1102 Longworth Building Washington, D.C. 20515 Dear Chairman Rangel: The Credit Union National Association and Affiliates (CUNA) supports modifying present law, to permit tax-exempt employers to maintain qualified cash or deferred arrangements under Code Sec. 401(k). We request that this letter be made part of your Subcommittee's record on this issue. CUNA represents over 15,000 United States credit unions through 52 state credit union leagues. Credit unions are non-profit financial cooperatives serving over 60 million members and employing over 113,000 people full-time. Federally chartered credit unions are exempt from federal income taxes under §501(c) (1) of the Internal Revenue Code and state chartered credit unions are exempt under §501(c) (14) - The Tax Reform Act of 1986 prohibited a tax-exempt employer from maintaining a 401(k) cash or deferred arrangement for its employees unless the employer had adopted such a plan prior to July 2, 1986. Relatively few credit unions had established 401(k) plans by mid 1986 The Tax Reform Act did theoretically allow credit union employees and those employees of other tax-exempt organizations to participate for the first time in "457 plans." Section 457 plans have been available to employees of state and local governments since 1978. For all practical purposes, however, rank and file employees of most tax exempt organizations have been effectively denied deferred compensation arrangements since 1986. The Ways and Means Committee recognized in its report on the tax reform bill in 1985 that individual retirement savings play an important role in providing for the retirement income security of employees. This philosophy was echoed by the Senate Finance Committee and recognized by the Administration in the President's Tax Proposals to the Congress for Fairness, Growth and Simplicity made on May 29, 1985. Further, Congress and the Administration PAGENO="0658" 648 both expressed concern that the legislation existing at the time was inequi- table because it permitted excessive tax-favored benefits for highly compen- sated employees without insuring that there is adequate savings by rank and file employees. The elimination of §401(k) p]ans and replacement of them with §457 plans removed tax-favored elective retirement savings for rank and file employees of most tax-exempt employers. A small group of ta~-exempt organizations which receive their exemption under Code §501(c)(3) and public schools may offer §403(b) tax-sheltered annuities, and of course employees of a state or local government may participate in §457 unfunded deferred compensation plans. Unfunded deferred compensation plans under §457 are considered "employee retirement benefit plans" under §3(2) (A) of the Employee Retiremetit Income Secwity Act of 1974 as amended (ERISA). Such plans must meet the labor provisions of ERISA. While government plans are totally exempt from Title I of ERISA, other tax-exempt employers can only maintain 457 plans if they are unfunded and maintained for a select group of management or highly compensated employees. In spite of the expressions by Congress and the Administration that the then-existing system favored tax~she1teredsavings by highly compensated employees at the expense of non-highly compensated employees, the end result of the Tax Reform Act of 1986 significantly accentuated the problem for most tax-exempt employers, including credit unions. Moreover, §457 deferred compensation plans are an inadequate substitute for §401(k) plans. Since these are "unfunded" plans, plan assets are subject to the employer's general creditors until paid out to participants. While the possibility of default would typically be of little or no concern in the case of a state or local government with its taxing authority, employees of tax-exempt organization could run the risk of forfeiture, a risk totally unfair and unwarranted by only providing employees of tax-exempt organizations with the option of unfunded, non-qualified deferred compensation plans. Moreover, the Federal Deposit Insurance Corporation is now examining whether §457 plans will be provided the same deposit insurance coverage as §401(k) plans. After reviewing the legislative history surrounding the trade-off of 457 plans for 401(k) plans, we can find no logic for the discriminatory treatment of employees of tax-exempt organizations. It is clearly an anomaly that an area of the law which has so many checks and balances built into it to prevent discrimination in favor of highly compensated employees would mandate such a contrary discriminatory result for employees of tax-exempt organizations. We hope the members of the Subcommittee on Select Revenue Measures will take a close look at the concerns which we have outlined and recommend the reinstatement of 401(k) cash or deferred arrangements for tax-exempt employers. Perhaps the best course of action in light of the §457 plans that have been established by tax exempt organizations since 1986 is to allow employers the choice of plan options. We appreciate the opportunity to submit this letter for the record. Sincerely, Charles 0. Zuver Senior Vice President Governmental Affairs Division PAGENO="0659" 649 WRITTEN STATEMENT The Cultural Institutions Retirement System One World Trade Center, Suite 3969, New York, NY 10048 (212)524-2477 Section 401(k) cash or deferred arrangements should be made available to all non governmental tax-exempt employers. Under the Tax Reform Act of 1986 ("TRA' 86W) tax-exempt employers were prohibited from establishing new 401(k) plans after July 2, 1986. The Cultural Institutions Retirement System ("CIRS') is the plan sponsor of a multiemployer 401(k) savings plan for over 7,000 active employees from 340 tax-exempt cultural institutions and day care centers in the New York City area. As a result of TRA 86, CIRS has been grappling with the admini~stration of the savings plan with two distinct categories of participation for similarly situated employers and their union represented employees. One group of tax-exempt employers are covered by the before-tax grandfather date of July 2, 1986. The second set of employers are relegated to after-tax participation~ in the savings plan as a result of the TRA 86 provision. Attached to this written statement is a more.detailed discussion of the specific impact on the CIRS savings plan. The fairness and equity arguments that embodied the comprehensive provisions of TRA 86 as described by the Joint Committee on Taxation failed to answer the questions raised by members of the tax-exempt community on why 401(k) plans have been limited. 501(c)(3) organizations may offer employees the opportunity to participate in tax. deferred annuities under Section 403(b). However other tax-exempt organizations are unable to make either 403(b) or 401(k) savings plans available to their employees. Section 457 arrangements do not provide employees of tax-exempt organizations with the same protections and broad, rank and file coverageas plans that meet the standards of qualified 401(k) plans. An extension of 401(k) plans to non governmental tax-exempt employers has been approved by both the House. Ways and Means Committee and Senate Finance Committee in connection with previous legislation. Despite the broad support of-Members and staff, this provision has not yet been enacted. - - The sentiment that existed then continues -today. Assistant Treasury Secretary Kenneth W. Gideon advocated in his February 21, 1990 testimony before the House ways and Means Select Revenue Measures Subcommittee Hearing that the proposal to permit all tax-exempt organizations ` to maintain qualified cash or deferred arrangements is fair and eliminates the `inequities of current law. PAGENO="0660" 650 Some additional arguments that support the extention of 401(k) plans to all non governmental tax-exempt organizations are as follows: 1) The attraction, recruitment and retention of employees into the tax-exempt arena remains hindered by the lack of 401(k) plans. Non-profits compete for staff against for-profit employers that have no restriction on offering 401(k) plans. 401(k) plans are veiwed by tax-exempt employers as widely accepted vehicles to encourage employees to save for retirement. 401(k) plans can serve two purposes for tax-exempt employees. First, with some organizations 401(k) plans can function as savings plans to supplement qualified pension plans. Second, with other organizations 401(k) plans may act as the sole source of retirement income with some type of employer contribution or match. 2) As part of the universal appeal of 401(k) plans, permitting tax-exempt organizations to sponsor 401(k) plans will enable employees during their working careers to ~rollover" distributions from one 401(k) plan to another or from a rollover IRA. The ;ollover feature also plays a positive role in trying to lure talented personnel from the for-profit sector to change jobs and join the ranks of the tax-exempt employees. 401(k) distributions can not he rolled over into 403(b) or 457 plans. Portability would be enhanced by extending qualified 401(k) plans to tax-exempt organizations. 3) The discrimination tests to which 401(k) plans are subject provides an automatic check and balance between higher paid and lower paid employees' elective contributions. Coupled with the dollar maximum of $7979 in 1990 and the lower salaries prevalent in non-profit organizations, 401(k) plans are more likely to minimize potential revenue loss. On the other hand 403(b) plans, if they are an option for an employer, have a dollar maximum of $9500 or higher depending upon the method for calculating the maximum exclusion allowance, and far less restrictive non-discrimination rules for elective contributions. 4) It is inappropriate for any short term projection of revenue loss to preclude enactment of fair and equitable access to 401(k) plans. The salary deferral contribution to 401(k) plans should more accurately be described as taxable income that is postponed until it is distributed at termination, death or retirement. *The amounts contributed to 401(k) plans eventually work their way back into the revenue stream. 5) collectively bargained 401(k) plans covering employees of non governmental tax-exempt employers, such as cips, are forced to discriminate against employees of new employers that join plans after the July 2, 1986 grandfather date even though such employers are covered by the same collective bargaining agreement. Two classes of covered employees are created: post July 2, 1986 employers whose employees are restricted to after-tax contributions and pre July 2, 1986 employers whose employees are permitted to participate on a before-tax basis. PAGENO="0661" - 651 This distinction creates problems for unions that represent employees at grandfathered employers and those members at employers who are excluded from before-tax treatment. The dichotomy is aggravated when an employee transfers to an excluded employer or accepts a promotion that now places that person at a competitive disadvantage as far as saving for retirement. The rationale for eliminating the distinction is based on the laws governing multiemployer plans which are designed to enable workers to move from one employer to another within an industry without suffering a loss or diminution in their benefits. We believe the scope of the problem i.e. the availability of 401(k) plans to all non governmental tax-exempt employers is fairly narrow. The extension of 401(k) plans to the tax-exempt community would provide a level playing field for tax-exempt employers and and the for-profit sector. Th~ early enactment of a prospective change would enable Congress to right a wrong that was never intended. We strongly urge Congress to seriously consider and enact a provision extending 401(k) plans to all tax-exempt employers. PAGENO="0662" 652 The Cultural Institutions Retirement System The Cultural Institutions Savings and Security Plan - Background Information The Board of Trustees of The Cultural Institutions Retirement System ("CIRS") maintains three multiemployer plans, The Cultural Institutions Pension Plan, The Cultural Institutions Savings and Security Plan, and The Cultural Institutions Group Life Insurance Plan. Approximately 340 employers participate in the three plans, with 7,000 participating employees. Participation in CIRS plans is limited to non-profit organizations. Current participating employers include museums, performing arts organizations, botanical gardens, zoos, and an aquarium, plus approximately 315 day care centers in the New York metropolitan area. The three CIRS plans are collectively bargained, and the bulk of the plans' participating members are union represented. Three unions, namely, District Council 37, American Federat~ion of State, County and Municipal Employees, AFL-CIO; Community and Social Agency Employees Union, District Council 1707, American Federation of State, County and Municipal Employees, AFL-CIO; and the Council of Supervisors and Administrators, Local 1, American Federation of School Administrators, AFL-CIO represent these employees. The Cultural Institutions Savings and Security Plan (the `Savings Plan") is a tax-qualified profit sharing plan, containing a cash or deferred arrangement described in Section 401(k) of the Internal Revenue Code of 1986 (the `Code'). As required under applicable collective bargaining agreements members of the Plan are currently required to contribute 2% of salary on a before-tax basis, and may elect to make additional before-tax contributions of up to 13% of salary, and after-tax contributions of up to 10% of salary, subject to the applicable non-discrimination tests and other statutory limitations. Participating employers may also make additional, discretionary contributions on behalf of their member employ~es. Prior to the establishment of the Savings Plan, participating members were required, in most instances as a condition of employment, to contribute 2% of salary on an after-tax basis to The Cultural Institutions Pension Plan (the "Pension Plan"). ~s a result of collective bargaining, the Savings Plan was established to supplement the Pension Plan benefits payable at retirement. Future mandatory contributions were required to be made ` to the Savings Plan as member contributions to the Pension Plan were discontinued. Accounts representing member contributions to the Pension Plan plus interest were transferred to the Savings Plan, with no diminution of Pension Plan benefits. The defined benefit Pension Plan was continued, but on a totally employer-paid basis. PAGENO="0663" 653 The Cultural Institutions Retirement System The Cultural -Institutions Savings and Security Plan Impact on the Savings Plan of the exclusioi1 of tax-exempt employers who had not adopted the cash or deferred Section 401(k) arrangement prior to July 2, 1986 Section 40l(k)(4)(B) of the Code, as enacted by Section 1116(b)(3) of the Tax Reform Act of 1986 and as described in the General Explanation of the Tax Reform Act of 1986 prepared by the Joint Committee, generally precludes the establishment and maintenance of Section 401(k) cash or deferred arrangements by non governmental tax-exempt employers unless the plan was established prior to July 2, 1986. The Savings Plan was adopted by currently participating employers and ratified by the three unions prior to July 2, 1986. Thus, before-tax contributions continue to be permitted, but only with respect to employees of these employers. Given its unique circumstances a~s a muiltiemployer collectively-bargained plan, this raises serious administrative concerns and creates grave inequities with respect to the Savings Plan. Employees of new non-profit employers adopting the Plan on or after July 2, 1986 are not permitted to make before-tax contributions. Thus, the negotiated mandatory 2% contribution of the employees of institutions adopting the Savings Plan on or after July 2, 1986 have to be made on an after-tax basis. Employees of newly entering cultural institutions are therefore precluded from making before-tax contributions to their collectively-bargained Savings Plan, while those employees who work at institutions which adopted the Savings Plan prior to July 2, 1986 continue to be able to make before-tax contributions, regardless of the date their employment or plan membership commenced. Aside from the inequities that this creates among otherwise similar groups of participating members, it has increased the administrative, recordkeeping and other burdens of the Retirement System -itself which in turn unnecessarily increased the costs of maintaining the Plan The CIRS plans provide benefits to a tremendous number of employees providing desperately needed services to the metropolitan area of New York- City,- and the Savings Plan provides a means for these employees to save on a tax-preferred basis. - The Retirement System enables employees of many small, struggling day care centers and cultural institutions to participate in plans which, because of the administrative costs involved, could not otherwise be offered on an individual employer basis. PAGENO="0664" 654 GREATER WASHINGTON SOCIETY OF ASSOCIATION EXECUTIVES STATE248NT OF STEPHEN W. Q½REY, PhD, CAE, SICNDUI'IVE VICE PRESIDENT, GREATER WAS}tfl~1tt~ SOCIE'EY OF ASSOCIATION E~tYPIVES SUHIITI'ED ~IO THE NDUSE WIhYS AND }STINS SB~+IIT1'EE ON OVERSIOFT, HEARING ON ERPIOYRE BENEFITS AND PENSION PLANS OF TAX S2CENPT OI~NIZATIONS FEB1~RY 28,1990 Mr. Chairman and Distinguished Members of the Ccnssittee: Thank you for providing the Greater Washington Scx~iety of Association Executives (ONSAE) an opportunity to subsit testimony on the extension of section 401(k) plans to tax exempt employers. GqSAE, a 501(6) tax exempt organization with a membership of 3,500, represents other tax exempt organizations in the Greater Washington metropolitan area. Our members represent over 1,000 local, state, national and international tax exempt organizations -- with 90 percent of than falling into the t~ latter categories. As you know, tax exeapt organization's ~iere denied the opportunity to establish 401 (k) plans in the Tax Reform Act of 1986. If a tax exempt organization had a 401(k) plan prior to July 1, 1986, they could continue to offer the plan to employees. The tax law permits tax exempt organizations to establish 403(b) savings plans, however, only organizations exempt under IRE code 501(c) (3) axe eligible for this type of plan. That leaves all 501 (c) (6) organizations out - and there are many organizations which are denied both plans. ONEAE's feels that it is discrntininatory to exclude one type of employer fran offering an employee benefit already available through other employers. Enployees of associations are entitled to the same right to save for their retirement, on a tax deduntible basis, as employees of other organizations. Congress should correct this inequity through language in tax legislation which wuld permit tax exempts not eligible for tax deferred annuity progress to establish 401(k) plans. GNDAE believes this change ~uld result in mare equitable tax treatment of these benefits for association employees and their families and s~uld su~rt current poblic policy of encouraging personal retirement savinga. Again, ~SAE appreciates the opportunity to catunent on this very isportant issue. 1426 21st Street, N.W., Suite 200 Washington, DC 20036-5901 . (202) 429-9370 FAX (202) 833-1129 Springtime in the Park * May 31, 1990 Annual Meeting * June 21, 1990 PAGENO="0665" 655 URW INTERNAI1ONAL UNION, UNIID AIJTOMOBLE~ A~OSPAcE & AGRICULTURAL IMPLEMENT WORKERS OF AMERICA-UAW OWEN F. BIEBER, P~ESX,ENT BILLCASSTEVENS.SECRETM9.TTJR~R VICE PRESIDENTS March 5, 1990 TELEPIIONE'(202)828.0500 FAX (202) 293.3457 .~, The Honorable Charles B. Rangel Chairman, Subcommittee on Select Revenue Measures Comittee on Ways and Means 1102 Longworth House Office Building Washington, D. C. 20515 Dear Mr. Chairman: This statement is being submitted by the VAW in connection with the hearing conducted by the Subcommittee on Select Revenue Measures on February 22 on various miscellaneous revenue issues. In particular, the (JAW would like to coment on proposal 0. 1. in the hearing notice, which would extend section 401(k) plans to tax exempt organizations. The (JAW strongly supports this proposal. It would merely give tax exempt organizations the same rights which are currently enjoyed by most private employers. There is no reason to treat tax exempt organizations different from taxable employers. This represents an arbitrary distinction which unfairly discriminates against workers who happen to be employed by a tax exempt organization. Section 401(k) plans represent an important means of providing employees with retirement income. The employees of tax exempt organizations should be able to take advantage of this type of program, just as most employees in the private sector. Extending section 401(k) plans to tax exempt organizations will not result in a significant loss of revenue. Accordingly, from the point of view of fairness and equity, the (JAW urges the Subcommittee on Select Revenue Measures to give favorable consideration to this proposal. Your consideration of our views on this issue will be appreciated. We ask that this communication be included in the hearing record. Thank you. Sincerely, Dick Warden Legislative Director DW:njk opeiu494 PAGENO="0666" * 656 EXTENSION OF SECTION 401(K) PLANS TO TAX-EXEMPT EMPLOYERS Fraternal tax-exempt organizations need the added benefit that the extension of Section 401(k) Plans to tax- exempt employers would provide. Historically fraternal organizations have operated at a very conservative level in terms of salaries and benefits. In order that we might better attract young, career oriented employees, we feel it vitally necessary that our benefit package be extended to include a Section 401(k) Plan. Recruitment of qualified job applicants can be dramatically improved with benefit packages that allow employees to contribute to their pension program in the fashion dictated by a Section 401(k) Plan. Employees of nonprofit corporations, who do pay income taxes, should not be considered second-class employees. The effect of the addition of Section 401(k) Plan to the benefit package of an organization such as Loyal Order of Moose cannot be overemphasized. The fact that such a plan has been unavailable to tax-exempt organizations should be corrected as quickly as possible in order that such an important benefit be extended to all employees without regard to tax status. Thank you for your consideration:- Respectfully submitted, Paul 1. 0'~llaren Director ~heral Loyal Order of Moose PJO/dw PAGENO="0667" 657 ~omr STATEMENT TO THE SUBCOENITTEE ON SELECT REVENUE MEASURES OF THE COMMITTEE ON WAYS AND MEANS U.S. HOUSE OF REPRESENTATIVES PUBLIC HEARINGS ON MISCELLANEOUS REVENUE ISSUES February 21, 1990 Chairman Rangel and members of the Subcommittee thank you for consideration of the merits of this proposal. The National Education Association ("NEA") is an association representing about two million public school employees throughout the United States. It works routinely with fifty affiliated state associations on matters relating to the quality of public education in the United States. Nationwide, these state affiliates employ over five thousand employees. I am also writing on behalf of the Michigan Education Association ("MEA"), one of the fifty state associations affiliated with the NEA. The MEA and its affiliated companies employ about 600 people who provide services to MEA's 117,000 public school employee members. As a labor union exempt from tax under Section 50l(c)(5) of the Internal Revenue Code of 1986 (the "Code"), the MEA's primary role is to improve the quality of public education in Michigan through the collective bargaining process and the ongoing employment relationship. The NEA, the MEA and their affiliates share with the Subcommittee a strong interest in the success and expansion of the private sector pension system and commend the Subcommittee for holding this hearing on the important issue of permitting tax exempt employers to maintain qualified cash or deferred arrangements satisfying the requirements of Code Section 401(k) for their employees. DISCUSSION Over the past decade, the private sector has expanded its involvement in the provision of retirement income for employees. This undertaking developed in response to the public's realization that thC federal social security system was not intended (and is unable) to provide employees adequate retirement income, and that for most employees the employer will be the primary source of this retirement income. Before enactment of the Tax Reform Act of 1986 ("TRA `86"), it appeared that employed in all sectors of the economy were permitted to save for retirement with voluntary pre-tax payroll deductions from their regular paychecks. For example, employees of governmental entities were permitted to save for their retirement under a deferred compensation arrangement satisfying the requirements of Code Section 457. Employees of public schools and employees of entities exempt from taxation under Code Section 50l(ç~)(3) were permitted to make pre-tax payroll deduction deposits into a Code Section 403(b) annuity, and all employees were permitted to save for retirement under a Code Section 401(k) plan. TEA .` 86 amended the pre-tax elective deferral rules in a way which prevented rank and file employees of tax exempt empioyers other than those exempt from tax under Code Section 50l(c)(3) from having any elective employee pre-tax contribution plan. Under this chang~, 401(k) plans were no longer available to rank and file employees of tax exempt employers. Although Code Section 457 elective deferral plans were simultaneously extended to employees of tax exempt entities, the constraints of Title I of ERISA prohibited extending such arrangements to the rank and file employees of such employers. (See IRS Notice 874,3, Q&k-25.) These TEA `86 restrictions had minimal impact on (l)~private sector employees, who could continue to defer compensation for retirement under Code Section 401(k) plan, (2) governmental employees, who could continue to defer compensation for retirement under a Code Section 457 plan, (3) employees of Code Section 501(c)(3) tax exempt entities, who could continue to defer compensation for retirement under a Code Section 403(b) annuity and (4) select management ("top hat") employeesof other tax exempt entities who, pursuant to TEA `86, were eligille to defer compensation for retirement under a Code Section 457 plan. However, TEA `86 left the rank and file employees of tax exempt entities (other than Code Section 501(c) (3) PAGENO="0668" 658 entities) as the only employees in America who cannot contribute pre-tax dollars to a voluntary payroll deduction retirement plan. Given the widespread (and sound) policy of encouraging employee pre-tax savings for retirement, we commend the Subcommittee for considering a solution to this unfair treatment of one group of rank and file employees. PROPOSAL Under current law, employees of tax exempt entities (other than Code Section 501(c)(3) organizations) are prevented from making pre-tax employee contributions to a retirement plan. This unfairness could be el±minated by legislative action. The necessary legislative action wou~ld involve replacing Code Section 401(k)(4)(B) as currently written with the~following: "(B) State and local governments and organizations - exempt from tax under section 501(c)(3) are not eligible. A cash or deferred arrangement shall not be treated as a qualified cash or deferred arrangement if it is part of a plan maintained by- (i) A State or local government or political subdivision thereof, Or any agency or instrumentality thereof, or (ii) Any organization exempt from .tax under section 501(c)(3) of this subtitle. -This subparagraph shall not apply to a rural cooperative plan." CONCLUSION Responsible planning for retirement is important to employees, employers and, ultimately, taxpayers. Congress has wisely encouraged such planning through tax rules enabling most employees to save pre-tax earnings for retirement. For reasons not clear to the NEA or the MEA, those tax rules are not available to rank and file employees of non-50l(c)(3) tax exempt employers. The change proposed would eliminate that disparate treatment of such employees. The NSA and the MEA appreciate the opportunity to provide these comments to the Subcommittee and would be pleased to provide the Subcommittee and its staff with any additional information or analysis that would be helpful regarding this matter. PAGENO="0669" 659 TAX EXEMPT ORGANIZATIONS AND SECTION 401(k) PLANS The Principal Financial Group is pleased to provide the following written statement for the Subcommittee to consider. The Principal provides full recordkeeping and investment services to over 25,000 retirement plans that cover over 950,000 employees nationwide. In addition, we provide services to over 7,000 401(k) plans alone that cover in excess of 375,000 employees so are very aware of the strong demand for section 401(k) plans. The Principal feels that Code Section 401(k) cash or deferred arrangements (CODAs) should be extended to employees of tax-exempt organizations. As the Subcommittee is aware, those tax-exempt organizations which did not have a CODA in force on Nay 5, 1986 are precluded by the Tax Reform Act of 1986 from. establishing such a plan. Over the past several years, The Principal has been approached by many tax-exempt organizations across the nation about starting a new deferred compensation plan. Unfortunately, after the changes made in the Tax Reform Act of 1986, the only types of employer-sponsored deferred compensation plans available to employees of these organizations are either (i) Code Section 457 plans, (ii) profit. sharing plans, or (iii) Code Section 403(b) tax deferred annuity plans. Each type of plan has its own unique drawbacks that limits its use by non-profit organizations. Because of these drawbacks, many employees of tax-exempt organizations cannot participate in a tax-deferred compensation plan. Thus, they are denied the same opportunity to pre- fund for their retirement that is offered to many employees of for-profit organizations merely because they work for a tax-exempt organization. For example, the funds of a plan established under Code Section 457 must remain subject to the general creditors of the organization. This creates two problems- - (1) most employees aren't willing to set aside part of their compensation in the plan if those contributions and earnings may be claimed by the creditors of the tax exempt organization, in the event it experiences financial difficulties, and (2) since these contributions remain the general property of the tax-exempt organization, and since these organizations are generally subject to Title I of ERISA, these plans would be in violation of ERISA's exclusive benefit rule that requires plan assets to be used for the exclusive benefit of plan participants. The Tax Reform Act of 1986 allowed employers or organizations that do not have current profits to establish a "profit sharing" plan anyway. However, we've found that many tax-exempt organizations are so financially strapped- -for various budgetary reasons- -that they cannot afford to make a discretionary "profit sharing" contribution for their employees. That means the employees are on their own if they want to put aside some tax-deferred money for retirement. Also, another shortcoming of the changes made in the Tax Reform Act of 1986 is that employer sponsored Code Section 403(b) tax-deferred annuity plans are available only to Section 501(c)(3) organizations or to public schools. Unfortunately, that leaves many other tax- exempt organizations- ~certain civic leagues, employee-run credit unions, and chamber of commerce organizations, to name a few- -which are unable to establish a Section 403(b) tax deferred annuity plan. . For these reasons, then, we recommend that full Section 401(k) qualified cash or deferred arrangements be once again made available to all employees of tax-exempt organizations. In the interest of fairness and to help all Americans pre-fund on a tax-deferred basis for their retirement years, we urge that Code Section 401(k) (4) (B) be amended to delete the references to tax-exempt organizations. Employees.of all tax- exempt organizations should be given equal opportunity to participate in a tax- deferred compensation program. Thank you for your consideration. If there are any questions, please contact: William F. Gould . Jack Stewart~ Vice President . Manager, Pension Development Services Principal Mutual Life Insurance Company. Principal Mutual Life Insurance Company Principal Financial Group Principal Financial Group Des Moines, Iowa 50392 Des Moines, Iowa 50392 Phone (515) 247-5395 Phone (515) 247-6389 PAGENO="0670" 660 Testimony of W. DENNIS BOLLING On Behalf of PRODUCERS LIVESTOCK ASSOCIATION GOOD MORNING, MR. CHAIRMAN. IT IS INDEED AN HONOR TO HAVE THE OPPORTUNITY TO PRESENT TESTIMONY BEFORE THIS DISTINGUISHED SUBCOMMITTEE WITH RESPECT TO THE ISSUE OF WHETHER TO PERMIT THE EXTENSION OF CASH OR DEFERRED ARRANGEMENTS UNDER SECTION 401(K) OF THE INTERNAL REVENUE CODE TO EMPLOYEES OF ORGANIZATIONS WHICH ARE EXEMPT FROM TAXATION UNDER THE INTERNAL REVENUE CODE. MY NAME IS W. DENNIS BOLLING AND I AM SPEAKING ON BEHALF OF THE PRODUCERS LIVESTOCK ASSOCIATION, A LIVESTOCK MARKETING COOPERATIVE WHICH IS~-EXEMPT FROM FEDERAL TAXATION UNDER SECTION 521 OF THE INTERNAL REVENUE CODE. FOR THOSE OF YOU WHO ARE UNFAMILIAR WITH OUR ORGANIZATION, WE SERVE OVER 30,000 FARMERS THROUGHOUT FIVE MIDWESTERN STATES. OUR OPERATIONS ARE BASED IN EIGHTEEN DIFFERENT LOCATIONS ~INi~THE STATES OF OHIO AND INDIANA. AT THE PRESENT TIME, WE ARE~ONE or THE TOP ONE HUNDRED COOPERATIVES IN THE UNITEDSTATES. I AM HERE TODAY TO POINT OUT CERTAIN INEQUITIES WHICH NOW EXIST UNDER THE PROVISIONS OF THE INTERNAL REVENUE CODE APPLICABLE TO RETIREMENT SAVINGS AS THEY APPLY TO OUR EMPLOYEES AND THE EMPLOYEES OF OTHER TAX EXEMPT EMPLOYERS. UNDER SECTION4O1(K) (4) (B) OF THE INTERNAL REVENUE CODE, AS AMENDED BY THE ~TAX REFORM ACT OF 1986, EMPLOYERS WHICH ARE EXEMPT FROM TAXATION URDER~SIJBTITLE A OF THE CODE ARE NOT PERMITTED TO PROVIDE THEIR EMPLOYEES WITH A CASH OR DEFERRED ARRANGEMENT. LIKE MANY EMPLOYERS, BOTH TAX EXEMPT AND NON TAX EXEMPT, WE AT PRODUCERS LIVESTOCK VIEW CASH OR DEFERRED ARRANGEMENTS AS AN OPPORTUNITY FOR EMPLOYEES TO SAVE, ON A TAX DEFERRED BASIS, FOR THEIR RETIREMENT. SINCE ACCESS TO INDIVIDUAL RETIREMENT ACCOUNTS, ON A PRE-TAX BASIS, HAS BEEN SEVERELY LIMITED FOR EMPLOYEES OF EMPLOYERS WHICH MAINTAIN QUALIFIED RETIREMENT PLANS, WE BELIEVE THAT THE EXCLUSION OF TAX EXEMPT EMPLOYERS FROM MAINTAINING CASH OR DEFERRED ARRANGEMENTS UNFAIRLY PREVENTS THEIR EMPLOYEES FROM ACCESS TO AN IMPORTANT RETIREMENT SAVINGS VEHICLE. GIVEN THE PRESENT UNCERTAINTY WITH THE SOCIAL SECURITY SYSTEM, MANY EMPLOYEES IN THE UNITED STATES WISH TO SUPPLEMENT THEIR RETIREMENT BENEFITS PROVIDED TO THEM BY THEIR EMPLOYERS THROUGH ERIVATE RETIREMENP~PLAN5. EMPLOYEES OF NON~TAX EXEMPT ORGANIZATIONS ARE~PERMITTED TO ~SIJPPLEMENT THEIR RETIREMENT BENEFITS THROUGH CASH OR DEFERRED ARRANGEMENTS. INDEED, THE WIDESPREAD GROWTH OF THESE TYPES OF ARRANGEMENTS DEMONSTRATES THE GREAT INTEREST THAT BOTH EMPLOYERS AND EMPLOYEES HAVE IN RETIREMENT SAVINGS. HOWEVER, EMPLOYEES OF A TAX EXEMPT ORGANIZATION, SINCE 1986, HAVE BEEN PUT AT A COMPETITIVE DISADVANTAGE WITH. RESPECT S~O THEIR COUNTERPARTS AT NON TAX EXEMPT ORGANIZATIONS WHEN IT~COMES TO SUCH RETIREMENT SAVINGS. BECAUSE OF THE PRESENT LAW, WE AT PRODUCERS LIVESTOCK HAVE BEEN FORCED TO IMPLEMENT A RETIREMENT PLAN UNDER WHICH OUR EMPLOYEES MAY ONLY SUPPLEMENT THEIR BENEFITS THROUGH AFTER-TAX CONTRIBUTIONS. AS YOU WELL KNOW, TO ACHIEVE THE SAME DEGREE OF SAVINGS UNDER A RETIREMENT PLAN, AN EMPLOYEE MUST MAKE A SIGNIFICANTLY LARGER CONTRIBUTION, ON AN AFTER-TAX BASIS, TO THE PLAN THAN HE WOULD BE REQUIRED TO MAKE TO THE SAME PLAN, IF SUCH CONTRIBUTION WERE MADE ON A PRE-TAX BASIS. FOR THESE REASONS, BECAUSE THERE SHOULD BE NO DISTINCTION BETWEEN EMPLOYEES OF A TAX EXEMPT ORGANIZATION AND EMPLOYEES OF A NON TAX EXEMPT ORGANIZATION WITH RESPECT TO RETIREMENT SAVINGS, WE BELIEVE THAT THE EXCLUSION OF TAX EXEMPT EMPLOYERS FROM MAINTAINING CASH OR DEFERRED ARRANGEMENTS SHOULD BE DROPPED FROM THE LAW. THEREFORE, WE URGE CONGRESS TO AMEND SECTION 401(K) (4) (B) OF THE INTERNAL REVENUE CODE TO DELETE THE REFERENCE TO TAX EXEMPT ORGANIZATIONS. IN ADDITION TO THE UNFAIR SITUATIONS DESCRIBED ABOVE, THE EMPLOYEES OF OUR ORGANIZATION, BECAUSE IT IS EXEMPT UNDER SECTION 521 OF THE INTERNAL REVENUE CODE, HAVE BEEN SUBJECTED TO FURTHER INEQUITIES. FOR MANY TAX EXEMPT EMPLOYERS, AN ALTERNATIVE TO A PAGENO="0671" 661 CASH OR DEFERRED ARRANGEMENT UNDER SECTION 401(K) OF THE CODE IS THE ESTABLISHMENT OF A TAX DEFERRED. ANNUITY PROGRAM UNDER SECTION 403 (B) OF THE CODE. UNDER SUCH AN ARRANGEMENT, EMPLOYEES ARE PERMITTED TO MAKE CONTRIBUTIONS TO AN ANNUITY CONTRACT, ON A PRE-TAX BASIS, TO SUPPLEMENT THEIR RETIREMENT INCOME. UNDER PRESENT LAW~ CONTRIBUTIONS TO SUCH AN ARRANGEMENT MAY EVEN EXCEED THE MAXIMUM CONTRIBUTIONS PERMITTED BY~ AN EMPLOYEE UNDER A CASH OR DEFERRED ARRANGEMENT. UNFORTUNATELY, THIS TYPE OF TAX DEFERRED ANNUITY PROGRAM MAY ONLY BE MAINTAINED BY AN EMPLOYER DESCRIBED IN SECTION 501(C) (3) OF THE CODE WHICH IS EXEMPT FROM TAXATION UNDER SECTION 501(A) OF THE CODE, AS WELL AS, EMPLOYERS WHICH QUALIFY AS EDUCATIONAL ORGANIEATIONS OR CERTAIN GOVERNMENTAL EMPLOYERS. AS A RESULT, BECAUSE OUR ORGANIEATION IS EXEMPT FROM TAXATION UNDER SUBTITLE A OF THE CODE, IT MAY NOT MAINTAIN A CASH OR DEFERRED ARRANGEMENT FOR ITS EMPLOYEES; HOWEVER, BECAUSE, ALTHOUGH EXEMPT UNDER SUBTITLE A, OUR ORGANIEATION IS NOT EXEMPT UNDER SECTION 501(C) (3) OF THE CODE, IT MAY NOT MAINTAIN, FOR THE BENEFIT OF ITS EMPLOYEES, A TAX DEFERRED ANNUITY PROGRAM. THEREFORE, BECAUSE OF THIS INCONSISTENCY WITH RESPECT TO REFERENCE TO TAX EXEMPT EMPLOYERS CONTAINED IN SECTIONS 401(K) AND 403(B) OF THE CODE, OUR ORGANIEATION MAY NOT PROVIDE ANY MECHANISM FOR ITS EMPLOYEES TO SUPPLEMENT THEIR RETIREMENT INCOME ON A PRE-TAX BASIS. AS PREVIOUSLY MENTIONED, BECAUSE OUR EMPLOYEES HAVE A STRONG DESIRE TO SUPPLEMENT THEIR RETIREMENT INCOME, WE MAVE IMPLEMENTED A RETIREMENT PLAN WHICH PERMITS THEM TO DO SO ON AN AFTER-TAX BASIS. AS A RESULT, IF CONGRESS IS UNWILLING TO AMEND SECTION 401(K) OF THE CODE TO ALLOW TAX EXEMPT EMPLOYERS TO MAINTAIN CASH OR DEFERRED ARRANGEMENTS, WHICH IS OUR PRIMARY OBJECTIVE FOR TESTIFYING TODAY, WE URGE IT TO AT LEAST CORRECT THE INCONSISTENCY BETWEEN THE PROVISIONS CONTAINED IN SECTION 401(K) (4) (B) AND THOSE CONTAINED IN SECTION 403(B). IN SUCH A CASE, WE BELIEVE TEAT THE PROVISIONS CONTAINED IN SECTION 403(B), ENUMERATING ORGANIEATIONS ELIGIBLE FOR TAX DEFERRED ANNUITY PROGRAMS, SHOULD BE AMENDED TO ALLOW ALL EMPLOYERS EXEMPT FROM TAXATION UNDER SUBTITLE A OF THE INTERNAL REVENUE CODE TO / MAINTAIN SUCH PROGRAMS FOR THEIR EMPLOYEES. IN THIS WAY, AT LEAST ALL EMPLOYEES OF TAX EXEMPT ORGANIEATIONS WOULD BE PLACED IN THE SAME POSITION WITH RESPECT TO RETIREMENT SAVINGS. I APPRECIATE TME OPPORTUNITY TO TESTIFY AND I WOULD BE PLEASED TO ANSWER ANY QUESTIONS WHICH YOU, MR. CHAIRMAN, OR OTHER MEMBERS OF THE SUBCOMMITTEE MIGNT HAVE. THANK YOU. PAGENO="0672" 662 TELEPHONE (312) $787700 FAX (312) 993-9787 TELEPHONE (213) 485-1234 FAX (213) 891-8783 TELEPHONE (212) 908-1200 FAX (212) 751-4864 LATHAM & WATKINS ATTORNEYS AT LAW 1001 PENNSYLVANIA AVENUE. NW. SUITE 1300 WASHINGTON. D.C. 20004-2505 TELEPHONE (202) 637-2200 FAX (202) 637-2201 TLX 590775 ELN 62793269 February 16, 1990 PAUL 8. WATKINS (1899-1973) DANA LATHAM (1898.1974) TELEPHONE (714) 540-1235 FAX (714) 755-8290 TELEPHONE (619) 236-1234 FAX (619) 698.7419 BY MESSENGER Mr. Robert J. Leonard Chief Counsel U.S. House of Representatives* Committee on Ways and Means 1102 Longworth House Office Building Washington, D.C. 20515 Dear Mr. Leonard: We understand that the House Ways and Means Subcommittee on Select Revenue Measures will hold hearings on pension and other employee benefit matters on Wednesday, February 21 and Thursday, February 22. We further understand that the hearings will focus on proposals to allow tax-exempt employers to maintain 401k plans, among other things. This is an extremely critical issue in the light of the fact that the Internal Revenue Service takes the position that a tax-exempt organization cannot provide an opportunity for deferred compensation under Code § 457 if the deferred compensation plan covers more than a select group of management or highly compensated employees. See Private Letter Ruling 895006 to that effect, basing the decision on the interplay of ERISA § 403(c)(1) and Internal Revenue Code § 457(b)(6). This position is in accordance with Department of Labor News Release 86-527, dated December 19, 1986 and IRS Notice 87-13. If the position of these two federal agencies is correct, it will mean very plainly that rank and file employees of Code § 501(c) organizations will be deprived of the opportunity to defer compensation in any matter similar to that now afforded to employees of taxable corporations. While that distinction may be "revenue-driven," it seems highly discriminatory. Consequently, we recommend that Internal Revenue Code § 401(k)(4)(B)(ii) be deleted, especially in the light of the fact that rural cooperatives are not subject to the same discrimination. We would appreciate your making this letter a part of the record of the hearings on the proposals to allow tax-exempt employers to maintain 401k plans and including this letter with any other submissions that are published as part of the record of those hearings. wish. We will be pleased to discuss this matter with you further should you Very truly yours, CGJJCJOQ C1L~~. John S. Welch C. Cabell Chinnis. Jr. PAGENO="0673" 663 American Association of Advertising Agencies Insurance Trust 666 Third Avenue, New York, N.Y. 10017 (212) 682-2500 Jo. And.rsos Wild.r Bak., ChsnI.H. Hood D.Iano W. add, Jr. JackP&nt.r March 13, 1990 Administrator Donald S. Lawis Mr. Robert J. Leonard Chief Counsel Committee on Ways and Means U.S. House of Representatives 1102 Longworth House Office Building Washington. D.C. 20515 Subject: Modification of VEBA restrictions Dear Sir: The purpose of this letter.is to support the proposal to eliminate the geographic restrictions on VEBA coverage. We believe our case history, described below, emphasizes the obsurdity of the geographical restrictionstand,the lack of any economic or tax-based justification for their continuance. The American Association of Advertising Agencies is a 501(C)(3) i-rust and functions as the trade association for the advertising agency industry. Many years ago, the association ~estab1ished the A.A.A.A. Insurance Trust which has offered insurance~programs to its member agencies. Programs offered by the Insurance Trust are fully insured with insurance carriers; however, they are experience-rated and in a policy year with favorable claim experience, a refund of premiums paid to the insurance carrier may occur. The objective of operating the Insurance Trust in a VEBA is so that any return of premiums flowing back to the Trust will not be subject to income tax. Rather, these funds are held in reserve and are passed back to the participating agencies through reduced rates in the future. All member agencies are in the same line of business (advertising agency). However, in establishing the Trust in the form of a VEBA, we were confronted by the geographic locale criteria: On advice of counsel, we established 42 different VEBAs, one for each state in which the Trust does business with its member agencies. This required the drawing up and execution of 42 Trust Agreements, 42 Request for Favorable Determination that the VEBA is exempt (at $450 per application), requires the accounting to be allOcated to the 42 VEBAs, and requires the annual filing of 42 Form 990s and 42 Form 5500s. The result is exactly the same as if the operation were carried under one VEBA i.e. income received is tax-exempt and is held by the VEBA and returned to the agency in future periods through a reduction of rates. We respectfully submit that the above represents an unreasonable and unnecessary administrative burden to the Trust and is without any justification. Thus, we urge the Committee to act favorably on the proposal to eliminate the geographic restrictions. Sincerely, ff' Donald S. Lewis enior Vice President Administrator, A.A.A.A. Plans 30-860 0 - 90 - 22 PAGENO="0674" 664 WRITTEN STATEMENT OF THE NATIONAL RURAL ELECTRIC COOPERATIVE ASSOCIATION For the Printed Record of the Hearings held February 22, 1990 by the Subcommittee on Select Revenue Measures of the House Ways and Means Committee on Miscellaneous Revenue Measures Introduction This written statement is submitted by the National Rural Electric Cooperative Association ("NRECA") in connection with the hearings held on February 22 by the Subcommittee on Select Revenue Measures of the House Ways and Means Committee. Specifically, this statement addresses the proposal, identified in the press release announcing the hearing, to clarify that employers in the same line of business need not be in the same geographic locale in order to maintain a common voluntary employees' beneficiary association ("VEBA'). NRECA NRECA is the national service organization of the approximately 1,000 rural electric service systems operating in 46 states. These systems serve over 25 million farm and rural individuals in 2,600 of our nation's 3,100 counties. Various programs administered by NRECA provide pension and welfare benef its to over 125,000 rural electric employees, dependents, directors, and consumer-members in those localities. NRECA has for many years been deeply interested in health care policy, including the core issue of expanding the access to affordable health insurance. In this regard, NRECA has sponsored studies of the health care area, such as "Health Care Needs, Resources, and Access in Rural America," "The NRECA Survey of Health Coverage in Smaller Firms," and "The NRECA Plans and the Minimum Health Benefit." NRECA has made these studies available to Members of Congress and their staffs, as well as to officials within the Administration. NRECA plans to continue to be active in the health care area and hopes that it can contribute to the legislative development of health care, proposals. The Role of VEBAs A VEBA is an organization, typically a trust, through which employers may provide wélf are benefits, such as health insurance, to their employees. There are two primary advantages to the use of a VEBA. The most important advantage of a VEBA `is not found in the tax laws but rather in the fact that VEBAs provide a means for small employers to obtain health insurance at a lower cost. This can be accomplished in two ways. First, the VEBA can function as a conduit through which small employers obtain lower premiums from insurance companies by virtue of pooling their buying power. Second, the VEBA can use employer and employee contributions to pay out health claims directly to the employees. In this way, small employers are able to pool their risks and self-insure in the same ,way `as large. employers. Such self-insurance generally produces significant savings. , It hardly needs saying that small employers desperately need ways to obtain health insurance at lower costs. According to various studies, the cost' of health insurance is at least 10% higher for small employers than it is for large employers. There is also little doubt that these costs are in large part responsible for the low coverage rates of small employers. Our analysis of `health care coverage in smaller rural firms found that fewer than 40 percent of employers with under 10 employees provide coverage and that' cost is the major deterrent. PAGENO="0675" 665 Although this written statement focuses on health insurance as the largest be~ef it provided through VEBAs, VEBA5 also play a similarly significant role in making other important employee benefits, such as life insurance, available to small businesses at a lower cost. The second advantage of a VEBA is that it enjoys certain tax benefits with respect to the deductibility of contributions to it and the taxation of the income it earns. These tax benefits, however, were significantly curtailed by the Deficit Reduction Act of 1984 ("DEFRA"). ,This written statement does not seek to reopen any tax issue addressed in 1984 or to ease any restriction imposed by DEFRA. On the contrary, this statement asks only for legislation that would enable small employers to use VEBAs sublect to all the DEFRA rules. Geographic Locale Issue In general. Under Treasury regulations,~the employees who receive benefits under a VEBA must share~an "employment-related common bond." The regulations provide examples of such a bond, including the following: (1) Employment by a common employer (or affiliated employers); (2) Coverage under one ~or mor~collective bargaining agree- ments; (3) Membership in a labor union or in one or more locals of a national or international labor union; or (4) Employment by employers in the same lineof business jj~ the same geographiciocale. The IRS has interpreted "geographic locale" to mean a single state or metropolitan area. NRECA believes that the geographic locale requirement is inconsistent with sound health policy. In addition, the requirement does not~ serve any. legitimate tax policy objective. Health policy. The geographic locale requirement is inconsistent with sound health policy because it frustrates the efforts of small employers to band together to obtain health insurance at lower costs. The ability to.~pool buying power with employers in other states or metropolitan ~arèas can make a very significant difference in a smali~empl~yer's effort to reduce its health costs. This is especially~true in lines of business in which there are not enough employees in a state or metropolitan area for the pooling of buying power to yield sufficient results to justify the formation of a VEBA. Small employers can particularly benefit from the ability to pool risks arross areas. Their health care use patterns can be more variabie~ than those of larger firms. With a larger scope for pooling, this variability becomes more manageable. Tax policy. The Administration, in its written statement opposing elimination of the geographic locale requirement, focuses on tax policy, rather than on health policy. The Administration is concerned that elimination of the requirement "would permit a VEBA to perform many of the functions of a nationwide insurance company, on a tax-exempt basis." NRECA respectfully disagrees with this conclusion. There is one similarity between a VERA and an insurance company. Both provide a means of pooling health risks. However, this same similarity to an insurance company also exists with PAGENO="0676" 666 respect to a multiple employer VEBA within a single state (or within three contiguous states under a proposal suggested by the Administration).. More importantly, the Administration is overlooking the requirements applicable to VEBA5 that justify tax treatment different from that of insurance companies. The most significant such requirement is that a VEBA must be controlled by (1) the employees eligible to participate in it; (2) an independent trustee acting solely in the interests of the eligible employees; or (3) fiduciaries at least some. of whom are designated by, or on behalf of, the eligible employees. In other words, a VEBA must be operated on behalf of the employees.: In practice, this requirement is generally satisfied by the use of an independent trustee. For this purpose, an independent trustee is considered to exist if the VEBA is an "employee welfare benefit plan' subject to the extensive fiduciary and other rules of the Employee Retirement Income Security Act of 1974 ("ERISA"). These requirements make a VEBA markedly different from a stock insurance company, which is a commercial enterprise that must act on behalf of its owners, whose financial interest is directly opposed to that of the insureds. It is also different from a mutual insurance company that is not subject to ERISA's extensive network of fiduciary and other rules aimed at protecting the rights of employees. This distinction between a VEBA and an insurance company is emphasized in Treasury's own regulations. The regulations provide a lengthy example in which a purported VEBA is not operated on behalf of the employees; accordingly, the example concludes: (M]embership (in the organization] is neither more than nor different from the purchase of an insurance policy from a stock insurance company. [The organization] is not a (VEBA]. This distinction -- that a VEBA must represent the employees -- has also been focused on by the courts. For example, one court disqualified a VEBA for failing to meet this requirement. American Association of Christian Schools Voluntary Employees Beneficiary Association Welfare Plan Trust v. U.S., 850 F.2d 1510 (11th Cir. 1988). Anothercase, which was decided by the U.S~ Court of Appeals for the Seventh Circuit and which is discussed further below, emphasized this distinction between a VEBA and an insurance company in holding the geographic locale requirement to be an invalid regulation. Although the requirement that aVEBA be maintained on behalf Thf the employees is the main distinction between a VEBA and an insurance company, it is not the only distinction justifying different tax treatment. VEBAS are subject to nondiscrimination rules preventing benefits from being provided in a manner that favors highly compensated employees. Health insurance provided directly by an insurance company is generally not subject to any such nondiscrimination rules. In addition,the earnings of a VEBA may not inure to the benefit of any individual other than through the provision of welfare benefits. No such prohibition applies to insurance companies. Although NRECA finds the Administration's insurance company argument unpersuasive for the reasons set forth above, NRECA is not suggesting that unrelated employers in different lines of business across the country should be able to form a common VEBA. We understand that Treasury could be concerned that at some point, the diversity of the different employees could make it difficult for the VEBA to be operated on behalf of all of them. However, the geographic locale restriction is not a rational means of addressing this concern. Employees in the same line of business, such as rural electric cooperatives across the country, share a common employment experience. The commonality of interests among such employees is indisputably greater than that of certain PAGENO="0677" 667 employees permitted to participate in a common VEBA. For example, the regulations clearly permit a single VEBA to be maintained by a national conglomerate that is, for example, in the oil business, the department store business, and the fast food business and that operates all such businesses nationally. Three-state proposal. The Administration, in its written statement, suggested that a "better alternative Ito deleting the geographic locale requirement] would be to limit VEBA5 to a three- contiguous-state area, or possibly a larger area if the Secretary determined that the employer group~'in the three-state area was too small to make self-insurance economical." NRECA believes that this would only substitute one inappropriate rule for another. Health care objectives would not be served by such a rule, asthe rule would still prevent the greater economies of scale that could be achieved through a national group of employers. Moreover, limiting a group of employers in the same line of business to three states preserves the same sort of anomalies discussed in the prior paragraph. Finally, NRECA believes that enactment of the Administration's three-state rule would be worse than Congres- sional inaction. As discussed below, NRECA believes that, under present law, the Seventh Circuit position -- that the geographic l~cale rule is completely invalid -- is correct and would be followed by other courts if litigated by the IRS. In summary, `NRECA believes that deleting the geographic locale requirement would serve important health policy objectives. Moreover, the Administration's concern that VEBA5 would become indistinguishable from insurance companies is directly contrary to Treasury's own regulations. Finally, even if it is considered necessary to limit the scope of VEBA5, the geographic locale rule is an irrational limit, since it creates anomalous contrasts between employees permitted to participate in a single VEBA and employees prohibited from doing so. Revenue Concerns NRECA is not unmindful of the need to consider the effect of any proposal on the budget deficit. The question, however, is whether the deletion of the geographic locale rule would have any significant effect on tax revenues. For convenience, this statement refers to the geographic locale "rule" or "requirement" as though it were clearly present law. In reality, it is far from clear that the geographic locale rule is present law. In the only case to consider this issue, it was held that the geographic locale rule was invalid and thus not part of present law. Water Quality Association Employees' Benefit Corp. v. U.S., 795 F.2d 1303 (7th Cir. 1986). Certainly any revenue estimate of the effect of a Congressional elimination of the geographic locale rule should take into account the Seventh Circuit position. Moreover, it would certainly seem reasonable to assume, for revenue estimating purposes, that at least some other circuits would follow the Seventh Circuit position. In fact, the most reasonable basis for a revenue estimate would be to assume that the only case to *address the issue represents present law. In this light, Congressional elimination of the geographic locale rule would be little more than a clarification of present law that would have little or no effect on Federal tax revenues. Furthermore, it is by no means clear that, even if the geographic locale rule were present law, its elimination would result in reduced tax revenues. Intrastate groups of employers could form their own VEBAs though at a higher cost per employer. The larger contributions to such VEBA5 would result in more tax benefits, rather than less. The only revenue gain would be from small employers eliminating or reducing health or other benefits, hardly a desirable result. If Congressional revenueestimators disagree with the above analysis and believe that Congressional elimination of the geographic locale rule would result in reduced tax revenues, we PAGENO="0678" 668 would be pleased to work with Members of Congress, their staffs, and Administration officials to design safeguards to minimize the revenue loss. Foi~ example, a strict definition of a line of business could be imposed to ensure that the employees eligible for the VEBA share a commonality of interests. Moreover, it could be required that the employers maintaining the VEBA demonstrate that they have a significant relationship beyond simply maintaining a common VEBA. This relationship could be demonstrated, for example, through the existence of a trade association in which they are active members or through the maintenance of a common retirement plan. Another possible restriction would be to allow a national VEBA to be maintained only by employers substantially all of which are exempt from Federal income tax. Such a rule would eliminate any revenue loss attributable to increased deductible contributions to VEBAS. It would also, by definition, limit the tax-exempt status of a national VEBA to employers that were themselves tax-exempt. In summary, NRECA believes that Congressional elimination of the geographic locale rule serves health policy objectives without undermining tax policy or budgetary concerns. NRECA also emphasizes its willingness to provide Congress and the Administration with any help that it can in addressing this important issue. PAGENO="0679" 669 NATIONAL TIRE DEALERS AND RETREADERS ASSOCIATION, INC., Insurance Trust 12501 ST., NW., SU1TE'~0, WASHINGTON, D.C. 20005 p02) 709.2006 March 9, 1990 BY MESSENGER Mr. Robert J. Leonard Chief Counsel Committee on Ways and Means U.S. House of Representatives Room 1102 Longworth House Office Building Washington, D.C. 20515 Re: Miscellaneous Tax Proposals Dear Mr. Leonard: Our attorney has provided us with the Joint Committee on Taxation Staff Explanation (JCS-4-90) on Miscellaneous Tax Proposals Scheduled for Hearings February 21-22, 1990, before the House Ways and Means Committee's Subcommittee on Select Revenue Measures. I would like to take this opportunity to express our support for two of the tax proposals relating to voluntary employees' beneficiary associations ("VEBAs"); (Section D.2. of JCS-4-90); namely: 1. Elimination of the geographic locale restriction contained in the Treasury Regulations; and 2. Exemption of 10-or-more employer VEBAs from the unrelated business income tax ( UBS Tax The NTDRA, Inc. Insurance Trust ("Insurance Trust") is a multi- employer VEBA exempt from tax pursuant to Internal Revenue Code ("I.R.C.") Section 5Ol(c)(9). The Insurance Trust was originally established on July 10, 1952 by the National Tire Dealers and Retreaders Association ("Association"), an I.R.C. Section 50l(c)(6) trade association whose members are retailers and distributors in the tire and retreading industry. The members of the Association are small businessmen located throughout the United States. The typical Association member participating in the Insurance Trust program has fewer than ten full-time employees. With such a small number of employees, the average Association member found it quite expensive to provide insurance protection'for its employees, if, in fact, such insurance protection was provided. The Insurance Trust operates as a vehicle for the pooling'of employer and employee premium dollars so that insurance protection can be maximized and cost minimized. The Insurance Trust is an insured VEBA in that all benefits are provided through purchase of insurance policies' from commercial insurance companies. The insurance policies purchased by the Insurance Trust for `participants coOsist of group life, accidental death and dismemberment, medical care and dental care. The Insurance Trust collects contributions from employer and employee participants and, in turn, pays insurance premiums to the commercial insurance company. With the exception of groUp life insurance policy dividend rebates, contributions to the Insurance Trust are irrevocable. These contributions and investment income earned on the Trust's reserves must be used to provide' employee benefits. ~Notwithstanding the geographic locale restriction of the Treasury Regulations, the Internal Revenue Service has continued to recognize the exempt status of the Insurance Trust. Nevertheless, the Insurance Trust strongly supports the statutory proposal to eliminate the restriction, for the following reasons: 1. The geographic locale restriction irrationally discriminates against non-union VEBAs. While thousands of members of a national labor union may form a tax exempt VEBA, the 10 or fewer employees of the typical Association member may not associate with the 10 or fewer employees of another typical Association member. 2. The geographic locale restriction irrationally discriminates ~ non-union VEBA5. While 10,000 employees of a national corporation may form a tax exempt VEBA, a smaller number of Association member em- ployees may not. PAGENO="0680" 670 3. Most~ir~portantly, however, the geographic locale restriction does not further the stated administrative objective of distinguishing between true employee VEBA5 and entrepreneurially-controlled VEBA5, as that distinction is already provided for by Treasury Regulation Section l.50l(c)(9)-2(c)(3), which denies tax exemption unless the employees control the entity. As indicated above, the Insurance Trust remains exempt under I.R.C. Section 501(c)(9). However, with the Deficit Reduction Act of 1984 (DEFRA) changes to the Unrelated Business Income Tax ("UBI Tax') provisions of. I.R.C. Section 512 effective January 1, 1986, the Insur- ance Trust no longer derives a benefit from its tax exemption as all of its investment income is now subject to UBI Tax. In DEFRA, Congress dealt with t.he problem of small single-employer plans which were abusing the VEBA tax exemption by over-funding their VEBA5, by enacting new I.R.C. Sections 419 and 4l9A and by amending the UBI Tax provisions. Pursuant to I.R.C. Sections 419 and 4l9A, the employer's deduction for contributions to over-funded VEBAs is now disallowed and, pursuant to I.R.C. Section 512, the over-funded VEBA now pays tJBI Tax on investment income.~ In DEFRA, Congress recognized that multi-employer plans have no incentive to over-fund their VEBA5. Therefore, Congress exempted 10- or-more employer VEBAS from I.R.C. Sections 419 and 4l9A. However, Congress did not extend this exemption to the UBI Tax. As a result, beginning in 1986, 10-or-more employer VEBA5 that were insured ~, such as the Insurance Trust, became subject to the UBI Tax on their investment income earned on fund reserves. The imposition of the UBI Tax on the Insurance Trust has made it more expensive to provide health insurance and other benefits to the employees of the small Association members who utilize the Insurance Trust to provide these benefits to their employees. The UBI Tax on 10-or-more employer insured VEBA5 is predicated on two erroneous assumptions. First, it is assumed that an insured VEBA such as the Insurance Trust has no need for a reserve. This has not been the experience of the Insurance Trust as its reserve has served three vital purposes: 1. Most importantly, with the uneven and often dramatic increases in health insurance costs, the reserve enables the Insurance Trust to absorb portions of rate increases in particularly bad years. Con- sequently, only a portion of insurance premium rate increases in bad years is passed on to the participants, resulting in a much more stable insurance program. 2. Acting as a conduit for large sums of money between the par- ticipants and the insurance company, the reserve is necessary to ensure that premium and administrative expenses are timely paid not- withstanding a delinquency in member contributions. 3. The existence of the reserve provides leverage to the Insurance Trust in its rate negotiations with the insurance company as the insurance company knows that any group deficits can be immediately settled. Without the reserve, the insurance company premiums would almost certainly be higher. The second erroneous assumption is that without the UBI Tax, the employer would have an incentive to over-fund the VEBA. While this might be true in the case of a single employer VEBA, it is certainly not the case in a VEBA such as the Insurance Trust with over 500 participating small employers. As Senator Bentsen, then tanking minority member of the Senate Finance Committee, stated to Senator Packwood, then Chairman of the Senate Finance Committee, in a June 24, 1986 colloquy on the floor of the Senate: "The 10-or-more [employerl plans provide a nec- cessary avenue for many smaller businesses to obtain medical and other benefit ccverage for their employees through their trade association. The businesses that participate in these plans would otherwise be unable to obtain coverage at group rates for their employees. In order to facilitate coverage for these businesses, the present Tax Code excludes these plans from the limitation rules on employer deductions for plan contributions. PAGENO="0681" 671 "These plans are unique in several ways. First, the participating employers do not control the opera- tion of the plan. Because the member employers can come and go, the plans have a built-in incentive to keep their reserves and premiums lower to remain com- petitive. Most of these plans prohibit reversions of surplus assets to the contributing employers. These plans, then, would not be candidates for abuse if the exemption form taxation of the surplus reserves is maintained. "In summation, I am concerned that, by subjecting these plans to taxation on the income from their excess reserves, we would raise the cost to businesses of maintaining important insurance coverage for their employees. Therefore, I request the chairman's assurance that this important issue will be revisited in conference." Congress, however, has not reconsidered the UBI Tax exemption, and, as Senator Bentsen feared, the Tax is having a significantly adverse impact on multi-employer VEBAs such as the Insurance Trust, as health care costs are once again undergoing dramatic increases. In closing, it would seem that the imposition of the UBI Tax on 10-or-more employer VEBAs frustrates Congress' goal of ensuring that all Americans have affordable health insurance protection. It is respectfully submitted that be extending the 10-or-more employer exemption to the I.R.C. Section 512 UBI Tax, Congress can advance its goal of increasing the availability of health insurance, without jeopardizing the anti-abuse goals of DEFRA. Very truly yours, NTDRA INSURANCE TRUST )4P~~edl~nder~J/ ana~,Lng Trustee PAGENO="0682" 672 ~P3~ SOCIETY OF PROFESSIONAL BENEFIT ADMINISTRATORS 2033 M Street, NW * Suite 605 * Washington, D.C. 20036 * (202) 223-6413 Testimony to the U.S. House of Representatives Committee on Ways & Means Subcommittee on Select Revenue Measures February 21-22, 1990 by Frederick D. Hunt, Jr. President of the Society of Professional Benefit Administrators on Modifications of Voluntary Employees' Benel'icary Associations SPBA is the national association of independent Third Party Ad~ninistrationfirms (TPAs) of client employee benefit plans. It is estimated that 1/3 of all U.S. workers,from every size and format of employment are covered by employee benefit plans managed by such TPAfir,ns. Over 90% ofthe firms known to be eligiblefor SPBA have joined, and SPBA membership has grown more than 850% in the past 8years, which mirrors the growth in demandfor TPAs' services and the leading role SPBA members have played in successful cost-efficient benefit plan management techniques. TPAs are independent service providers to their client plans. They should. not be confused with the official `plan administrator" defined in ERISA or confused with insurance companies. SPBA member TPA firms operate much like independent CPA or law firms...providing ongoing professional outside claims and benefit administration for several client employers and benefit plans. Most of the plans include some degree of self-funding. SPBA works closely behind the scenes wit/s government agencies and congressional staff in a brain-storming role because it has experience and insight on every type and size of benefit plan...and arm's length independence. * ** **** * **** * **** Mr. Chairman, we appreciate the opportunity to endorse and encourage the efforts of this committee to modify and correct Voluntary Employees' Beneficiary Associations (VEBAs) restrictions. The proposals are both timely and important. SPBA along with the American Society of Association Executives (ASAE) has worked on this issue for nearly 10 years. It is odd that the hundreds of government officials to whom we explained the common sense of the situation agreed with us. It is only you, today, who have taken the step to rectify the wrongs. We thank and congratulate you! (a). Eliminating the geographic restrictions arbitrarily imposed on association-sponsored VEBAs is both an act of fairness and common sense. We read daily of the desire of the Congress to expand access to health coverage for workers...especially employees of small firms. Ironically, many of the small employers are eager to offer employee benefits...but find obstacles imposed by their government. The most popular and efficient mechanism for offering benefits to small employers is to allow them to band together as a larger buying unit. This is often a role played by their trade association. A "widget" maker may have only a few employees, but if all the widget makers in the nation get together, they have a large group which can negotiate for cost-effective benefits. Since the association was formed for common interests, an association plan can incorporate special patterns or customs of coverage desired for employees of widget manufacturers. M.n,,, Y, Sb ~p,Ch.fr, .1 Si. B..,i - j.,,,., Hill & M,s,~ E~~.pbs~ Bs,,,1u, - S*,~,,.h. GA WUll., H. Bo1d,~bs,b - H,.hl, Pl.~, j,,~ - W,,s,,~,,, MA k, ch.g,.,.. - s.,~, p, ~ ,e w-.~ - B,,Sil~,id, ~ J. D,~l Oltr~d - C@~p~~ B~St S~,ios (A,,,Si,. - Mb..~,p,l.. MN ~ B..~d ~ - RE. ~ ~ - ~ 5, Fs'd'&k L*~ - E.pb,y,, H',,sll, M.,q~...i S,,,',. - Bi5i"g,. MT Aflb~J. ~ & -R,y,M.b~ OH Sb ~ - F"~ CA P.:r ~ R,bs~j H. K~IIy - c~,, B. ~ Gk~ IL S1s~gbt,, - W. Rkb.,d P~kl,, J..~, M D,,,~ - R,,b,n B. S~k~ - Jb* ~ - W. Mbky H'~d,. - WIIIIs~ C. E~b*~i PAGENO="0683" 673 In 1981, the IRS totally arbitrarily (with no legislative or regulatory language) decided that such trade association plans would not have "commonality of business interest" unless they were all in the same metropolitan area (even though a trade association, is, by definition created for a commonality of business interest). This not only stamped out the hopes of thousands of employers to offer benefits in this manner...but it was also clearly discriminatory. The IRS did not apply such geographic limitations to union-sponsored plans which a single union plan might cover airline attendants to food workers. IRS also did not apply didnot apply the geographic commonality limitations to corporate conglomerates who might have subsidiaries in a wide range of dissimilar businesses. Associations were clearly a target. The net effect is that employers and associations who wasted to work together to offer benefits felt a chilling rebuff. This was both silly and counter-productive. VEBA geographic limits should be eliminated immediately and retroactively to 1980. Since IRS never issued anything in writing anyway, this committee could simply inform the IRS of its displeasure and clarify Congressional intent not to impose such arbitrary limits. (b) & (c). The role of IRS is to limit revenue loss. That is a legitimate role, but should not be taken to illogical or-counter-productive extremes. Critics of association-sponsored plans (Multiple Employer Trusts! "METs" or Multiple Employer Welfare Arrangements! "MEWAs") inevitably mention their concem that they have insufficient reserve funding in case of significant clalms or withdrawals from the program. You, of course, can see the irony. Associations don't want to see their plans go belly-up. However, DEFRAITRA `84 insists that all funded welfare benefit plans always walk onthe brink of bankruptcy. We suggest that such nit.picking be removed. Allow plans to accumulate as much in reserves as they see fit. This has several automatic safety valves: ~j~t,employers are never eager to give up more working cash than they absolutely necessary. ~ money put into a VEBA can never revert back to the employer, so there is no incentive to overpay.. IJijt~, if current employers have a significant stake in the reserves, they are less apt to be fickle and dropout of the plan on a whim (which is one of the frequent worries expressed by critics of MET/MEWAs). Thus, with a few very simple changes, you achieve a host of very desirable goals to strengthen and broaden access to health care for employees. - May I make another suggestion? The other major obstacle to the growth of these associationfMETfMEWA plans has been their bastardized ERISA status. They have some ERISA responsibilities and some state duties. It is an unmitigated mess that has frustrated plans, employers, states, and everyone-else. While ERISA status is not directly the purview of this committee, your work on the VEBAs would be greatly enhanced if you could go on record as suggesting thaLsuch assoçiationfMET/MEWA plans and those who provide fiduciary services to them be made full ERISA plans (similar to the union- management multi-employer plans). We heartily thank and congratulate the committee for taking the initiative on these important points. We have always sald that if such plans are allowed to maximize their efforts and coverage, the access.to.health problem would shrink substantially...and for far less cost than some fo the more radical proposals. We stand ready to be of whatever service we can be to help and speed your work in this area. PAGENO="0684" 674 ~W~er March 8, 1990 EXPRESS MAIL Mr. Robert J. Leonard Chief Counsel Committee on Ways and Means U.S. House of Representatives Room 1102 - Longworth House Office Building Washington, D.C. 20515 Re: Miscellaneous Tax Proposals Dear Mr. Leonard: Our attorney has provided us with the Joint Committee on Taxation Staff Explanation (JCS-4-90) on Miscellaneous Tax Proposals Scheduled for Hearings February 21-22, 1990, before the House Ways and Means Committee's Subcommittee on Select Revenue Measures. I would like to take this opportunity to express our support for two of the tax proposals relating to voluntary employees' beneficiary associations ("VEBAs"); (Section D. 2. of JCS-4-90); namely: 1. Elimination of the geographic locale restriction contained in the Treasury Regulations; and 2. Exemption of 10 or more employer VEBAs from the unrelated business income tax ("UBI Tax"). The Water Quality Association Employees' Benefit Corporation is a multi-employer VEBA exempt from tax pursuant to Internal Revenue Code ("I .R. C.") Section 501(c) (9). The sponsor of the Benefit Corporation VEBA is the Water Quality Association ("WQA"), an I.R.C. Section 501(c) (6) trade association whose members are retail and wholesale distributors of point of use water conditioning equipment such as water softeners. The average WQA member employs five employees. Members are located in all 50 states. Through WQA, the Benefit Corporation VEBA was established so that WQA members could pool their limited insurance premium resources so that the cost of insurance could be decreased while the insurance protection afforded their employees increased. The Benefit Corporation is a fully insured VEBA; that is, the Benefit Corporation collects contributions from employer and employee participants and pays premiums to the insurance company. While enrollment in the Benefit Corporation VEBA insurance program is not a prerequisite to membership in WQA, only WQA members and their employees are eligible to participate in the Benefit Corporation VEBA. Because of the savings to the Benefit Corporation participants, which resulted from the underwriting of a large group, the program grew to where today over six hundred- fifty (650) small employer members of WQA, their employees and families are insured for health insurance, accident and sickness insurance, and life insurance. Prior to the promulgation of the final VEBA Treasury Regulations effective January 1, 1981, the Benefit Corporation (i) paid no regular income taxes because it had applied for and received recognition of its tax exemption from the Internal Revenue Service under I.R.C. Section 501(c) (9); and (ii) paid no UBI Tax because all of the Benefit Corporation's investment income was used to pay insurance premiums or plan administration costs or reserved and set aside to pay future benefits and administrative costs. PAGENO="0685" 675 The final VEBA Treasury Regulations were a disaster for the Benefit Corporation. Since our employer participants are located throughout the United States, it was clear to us that we failed to satisfy the new geographic locale restriction. At a time when the investment income from our reserves was desperately needed to help moderate insurance rate increases to our members, such income was now subject to income taxes. As a result, the Benefit Corporation decided to challenge the validity of the new Treasury Regulations in court. This legal challenge culminated in the overturning of the geographic locale restriction by the Seventh Circuit Court of Appeals in Water Quality Association Employees' Benefit Corporation v. U.S., 795 F.2d 1303 (7th Cir. 1986). We certainly support the proposal to incorporate the Seventh Circuit's decision into the I.R.c. Section 501(c) (9) statutory language. Unfortunately, the benefits to our members of our legal victory in the Seventh Circuit were short-lived. Prior to the Deficit Reduction Act of 1984 (DEFRA), investment income earned by the Benefit Corporation was not subject to the UBI Tax because such income was used to pay insurance premiums or plan administration costs or reserved and set aside to pay future benefits and administrative costs. In DEFRA, Congress dealt with the problem of small single- employer plans which were abusing the VEBA tax exemption by over- funding their VEBA5, by enacting new I.R.C. Sections 419 and 419A and by amending the UBI Tax provision of I.R.C. Section 512. Pursuant to I.R.C. Sections 419 and 419A, the employer's deduction for contributions to over-funded VEBA5 is now disallowed and, pursuant to I.R.C. Section 512, the over-funded VEBA pays UBI Tax on investment income. In DEFRA, Congress recognized that multi-employer plans have no incentive to over-fund their VEBA5. Therefore, Congress exempted l0-or-mol-e employer VEBA5 from I.R.C. Sections 419 and 4l9A. However, Congress did not extend this exemption to I.R.C. Section 512. As a result, beginning in 1986, 10-or-more employer VEBA5 that were insured pj~j~, such as the Benefit Corporation, became subject to UBI Tax on their investment income earned on fund reserves. The imposition of the UBI Tax on the Benefit Corporation has created a financial hardship in providing health insurance and other benefits to the employees of the small WQA member employers who use the Benefit Corporation to provide these benefits to their employees. Why does the Benefit Corporation have reserves and what role do they play in the financial stability of the Benefit Corporation's VEBA program? Besides the reserve for incurred but unpaid claims, there was very little need for other. reserve funds in the 1950's and early 1960's where inflation in the cost of the medical delivery system was modest and predictable. Beginning in the middle sixties, however, health insurance pricing became cyclical - two or three years of modest inflationary increases followed by periods of substantial rates of inflation. Prior to the cyclical health insurance pricing it was the practice of most funds to pay a dividend to participants. The dividend was earned when the insurance company's claims and expenses were less than anticipated. If a deficit occurred it was recovered by the insurance company through rate increases. A deficit occurred when claims and expenses exceeded contributions. In the middle sixties the Benefit Corpore~ion's Board of Directors discontinued paying member refunds. Insurance company experience rating dividends were reserved. The Board aOtion was prompted by the impact of inflation on the medical delivery sys- tem. More often than not the medical delivery system rate of inflation was higher than the rate of inflation as expressed by the Consumer Price Index (CPI) for all goods and services. Under these circumstances, the likelihood of~ deficits., i.e., claims and ~expenses in excess of premium, was great. The reserve could be used to pay off deficits which could result in lower and more stable member rates. PAGENO="0686" 676 The reserve enabled the Benefit Corporation to absorb deficits in 1970, 1971, and 1972.. The ability to absorb deficits significantly reduced the insurance company's demand for rate increases which would have been required to fund the deficit. Thus, participants received modest increases which kept the program affordable. owing to rapidly accelerating inflation, the program sustained a loss of $434,787 in 1980, a loss of $287,147 in 1981 and a loss of $146,438 in 1982. These losses were partially absorbed by the reserve. I should also point out that during this period the whole health insurance industry sustained heavy losses. There were many plans similar to Benefit Corporation which became insolvent. They did not have the resources to offset heavy unanticipated losses. The rate of inflation on medical delivery systems exploded beginning with the last quarter of 1985 and ôontinues today at a rate considerably higher than the national rate of inflation as expressed by the CPI. As a result of this explosion of health care costs, the Benefit corporation's health insurance program generated a loss of $286,494 in 1986, a loss of $534,569 in 1987, and a loss of $283,951. Notwithstanding these significant losses, because of the DEFRA amendment to I.R.C. Section 512, the Benefit corporation paid UBI Taxes in excess of $300,000 during this three year period. 1989 will be similar. In the absence of reserves beyond the incurred but unpaid claim reserve, the cost of the health insurance program to the Benefit Corporation participants would have been higher. Besides inflation, reserves play another important role. The existence of fund reserves gives the Benefit Corporation's Board of Directors leverage in their rate negotiations with the underwriter for the underwriter knows the fund has the wherewithal to settle deficits immediately. Finally, underwriting an association insurance program insuring 3,250 employees represented by 650 employers is not the same as underwriting a single employer with the same number of.. employees. A single employer will have employment practices common to all employees, a common benefit contribution policy and a common wage or salary policy. An association program has hundreds of individual decision makers. Some of them may have very high employment standards, others may not; some may pay high wages, others may not; some may make substantial benefit contributions, some may not. Employment practices, wage scales and employer contributions directly affect the claim experience. Group insurance underwrit- ers expect an association group will have poorer claim experience and less predictable loss ratios than a single employer group of the same size. Today, major group insurance underwriters are wary of underwriting association programs that are not well financed through reserves. The Board of Directors of the Water Quality Association Employees' Benefit Corporation acknowledge that Congress had to take action against those small single employer plans who used the VEBA tax exemption as a tax shelter by over-funding their plans. However, multi-employer benefit plans such as the one described above have not abused the VEBA exemption, but acted in a very prudent manner to the benefits of the participants. As Senator Bentsen, then ranking minority member of the Senate Finance Committee, stated to Senator Packwood, then Chairman of the Senate Finance Committee, in a June 24, 1986 colloquy on the floor of the Senate: "The 10-or-more [employer] plans provide a nec- essary avenue for many smaller businesses to obtain medical and other benefit coverage for their employees through their trade association. The businesses that participate in these plans would otherwise be unable to PAGENO="0687" 677 obtain coverage at group rates for their employees. In order to facilitate coverage for these businesses, the present Tax Code excludes these plans from the limitation rules on employer deductions for plan contributions. These plans are unique in several ways. First, the participating employers do not control the opera- tion of the plan. Because the member employers can come and go, the plans have a built-in~Ancentive to keep their reserves and premiums lower to remain com- petitive. Most of these plans prohibit reversions of surplus assets to the contributing employers. These plans, then, would not be candidates for abuse if the exemption from taxation of the surplus reserves is maintained. In summation, I am concerned that, by subjecting these plans to taxation on the income from their excess reserves, we would raise the Cost to buSinesses of maintaining important insurance coverage for their employees. Therefore, I request the chairman's assurance that this important issue will be revisited in conference." Regrettably, however, Congress has not reconsidered the UBI Tax exemption, and, as Senator Bentsen feared, the Tax is having a severely adverse impact on multi-employer VEBAs such as the Bene- fit Corporation, right at the time of rapidly escalating health care costs. Finally, in closing, it is interesting to note that one of the important issues presently before Congress ishowto finance and guarantee every person's right to enter the medical delivery system. See, e.g., S.l265 and H.R. 2508 ("Kennedy-Waxman Bill"). How can Congress, at the same time, enact a tax law which penalizes those small employers who have been working toward that objective? It is respectfully submitted that by extending the 10- or-more employer exemption to the I.R.C. Section 512 UBI Tax, Congress can advance its goal of increasing the availability of the medical delivery system, without jeopardizing the anti-abuse goal of DEFRA. Sincerely, WATER QUALITY ASSOCIATION EMPLOYEES' BENEFIT CORPORATION By: Peter H. Davis, for Jerry J. Hurley Insurance Manager 07l\0070800l. 308 PAGENO="0688" 678 STATEMENT OF MR. BRUCE CHEEVER FEDERAL EXPRESS CORPORATION AIR PILOT AND CHAIRMAN OF THE FLIGHT ADVISORY BOARD TO THE SUBCOMMITTEE ON SELECT REVENUE MEASURES HEARINGS ON MISCELLANEOUS REVENUE ISSUES REGARDING A PROPOSAL TO AMEND SECTION 410(b) (3) (B) OF THE CODE March 9, 1990 Mr. Chairman and Members of the Subcommittee: INTRODUCTION I am Bruce Cheever, an airline pilot employed by Federal Express Corporation. I have been with Federal Express since 1978. and am currently serving as a Captain on the Boeing 727 aircraft. During my twelve years with the Company I have served in various capacities in addition to flying. My job duties have included serving as a flight instructor, check pilot, Chief Flight Instructor andY Flight Safety Advisor to the Vice President of Flight Operations. Currently, I am serving as the Chairman of the Flight Advisory Board (FAB). The FAB is a steering committee of Federal Express pilots, elected by their fellow airmen at Federal Express. The FAB's function is to represent the Federal Express pilots' interests with the company and the airline industry in all matters attendant to their professional lives. The scope of the FAB encompasses such areas as work rules, compensation, benefits, training, flight safety and line operations. In my capacity as Chairman of the FAB I will endeavor to present to you the interests and needs of my fellow pilots at Federal Express as they pertain to a proposal pending before the Ways and Means Committee to amend Section 410(b) (3) (B) of the Internal Revenue Code (the Code). As it exists today, Section 410(b) (3) (B) of the Code permits an airline employer to script a tax-qualified pension package for its air pilots that is tailored to their unique occupational and disability requirements. However, existing Section 410(b) (3) (B) allows this result only where the air pilots have entered into a collective bargaining agreement in accordance with Title II of the Railway Labor Act. In other words, under existing Section 410(b) (3) (B), air pilots who have chosen to be represented by a union can have a tax-qualified pension plan tailored to their -specific needs, but air pilots who have chosen not to be represented by a union cannot. The proposed amendment pending before the Ways and Means Committee is designed simply to eliminate this union-representation requirement of Section 410(b) (3) (B) to allow ~J. air pilots the opportunity to have tax-qualified plans tailored to pilots' needs, whether or not the air pilots are represented-by a union. POSITION OF FEDERAL EXPRESS PILOTS It is the position of the Federal Express pilots that the unique, restrictive professional requirements applicable to airline pilots totally justify the core intent of Section 410(b) (3) (B) as it applies to tax-qualified pension plans for airline pilots. However, it is further our position that this section's union- representation requirement interferes with the core intent of 410(b) (3) (B) by discriminating unfairly against and penalizing non- union airline pilots and their airline employers. Therefore, the Federal Express pilots support the proposal to amend Section 410(b) (3) (B) to eliminate its union representation requirement. PAGENO="0689" 679 DISCUSSION In considering Section 410(b) (3) (B) and the proposed amendment to eliminate its union-representation requirement, it is important to first address three decidedly unique aspects of the airline pilot profession. FEDERAL REGULATION OF OCCUPATIONAL REQUIREMENTS AND STANDARDS. There are very few professions whose membership is so strictly mandated and governed by an entire body of specific government regulations. I am referring to the Federal Aviation Regulations. Of course, many industries are closely monitored by the Federal Government.. Rarely, however, are the professional ski]ls and qualifications of individuals within these industries subject to such stringent licensing and recurrent monitoring requirements. At least annually, and. in some categories semi-annually, the airline pilots' professional capabilities and competence are rigidly examined by FAA designated check pilots. The current., FAA regulations require mandatory retirement for airline pilots at age 60, unlike other professional occupations. PHYSICAL AND HEALTh REQUIREMENTS. The airline pilots *profession has strict, semi-annual medical/health requirements mandated by statute. Failure to pass comprehensive medical examinations results in the loss of an Airman's Medical Certificate with the corresponding prohibition from performing duties as an airline pilot. There is another facet `of the pilots medical/health risk which is less obvious, but equally debilitating. The skies in which the aviator performs his profession are uniquely and historically, a hostile environment. Nothing quite the same is encountered in any other licensed occupation. This hostile environment can impact an aviators' health' and subsequent participation with severe consequences. The results stemming from temporary, everyday medical anomalies can be vastly different, and more costly for an airline `pilot because of his operating environment. Fatigue, stress and other similar disabilities can easily have fatal impact in, the life of an airline pilot. In no other private sector profession can health/medical variances create such immediate, total and terminal loss of income and career. IMPEDIMENTS TO LATERAL MOBILITY Within the airline industry an airline pilot's experience and seniority is defined and respected only within the professional ranks of his individual company. He enjoys no professional rank or status with any other airline Qompany in the industry. His skills, experience,' or competence are not transferable laterally to another airline. Should an airline cease operation for whatever reason, the airline pilot may seek employment within the industry. But his only option trill be to start completely over at the bottom of the profession. The loss of compensation, benefits, and prestige is unparalled by any other professional group. The airline pilots' strict professional competence requirements, special medical/health qualifications, and peculiar industry requirements create a definitely unique professional environment. Airline pilots' careers can indeed suffer a dramatic, unplanned degeneration caused by such factors. Thus, in reality, airline pilots do have a much greater risk of a disabled career than employees in other occupations. It is proper, therefore, and in the spirit of fairness and equity, that Section 410(b) (3) (B) " provide an airline employer the capability to provide their unique PAGENO="0690" 680 high-risk employees with a separate disability and retirement program. However, it is clear that the factors enumerated above which justify a rule like Section 410(b) (3) (B) for airline pilots apply equally to ~fl airline pilots, whether or not they are represented by a union. To digress briefly and make an important point, Federal Express and her pilots are not anti-union, and the Federal Express pilots see no downside effect on their fellow airmen who are union members as a result a proposal to amend 4l0(b)(3) (B) to eliminate its union-representation requirement. Our support for this matter is simply a matter of requesting that members of a common profession receive equal status and treatment under the Code, regardless of their choice of labor affiliation. Whether or not a group of professional airmen choose collective bargaining has absolutely no impact on the risk exposures to which all professional pilots are subject. Both groups of airline pilots face equal professional, medical, and economical risks under the Federal Aviation Requirement's and the rulemaking of the Federal Aviation Administration Certainly the qualifications performance criteria and penalties are the same for both union and non-union aviators. Whether or not a group of employers choose to be represented by a union depends on a variety of employment factors that go well beyond federal income tax considerations. Federal Express enjoys a national reputation for fostering a corporate culture that totally honors individual employees and addresses their needs. The Federal Express philosophy of People-Service-Profit, its' internal employee grievance procedures, the Guaranteed Fair Treatment (GFT), its employer compensation and benefits packages, are all benchmarks in the industry. The Federal Express pilot* group has the highest percentage of minority and women aviators in the airline industry. As a result of the recent Federal Express acquisition of Flying Tiger, the combined pilot force of the merged carrier had the opportunity in the fall of 1989 to elect union representation. The factors described above led the combined pilot force to vote to remain non-union by over sixty percent (60%). To the Flight Advisory Board, the Federal Express pilots, and Federal Express Corporation, the issue of the proposed amendment to Section 410(b) (3) (B) is not a labor issue; it is strictly a tax and pension issue. The Federal Express pilotS believe Federal Express is the type of employer who, if the law permitted, would choose to take advantage of the provisions of Section 410(b) (3) (B) in order to provide security and benefits to offset the unique high risks of its' aviators. However, as a result of our employer having created a work environment in which we, as air pilots, have chosen not to elect union representation, the tax laws have placed us and our employer at an immense fiscal disadvantage in terms of our ability, as a group of high risk employees, to be protected through separate disability and pension plans. The Federal Express pilots, and the Federal Express Corporation strongly support the proposal before the Ways and Means Committee to amend Section 410(b) (3) (B) of the Internal Revenue Code to allow separate testing for air pilots tax-qualified pension plans regardless of union representation. In closing, the Federal Express pilot's and the Corporation would like to take this opportunity to thank all members of the Ways and Means Committee for their consideration of this proposal. Particular thanks to Messrs. Ford, Anthony and Sundquist for their sponsorship and effort on this proposed amendment. PAGENO="0691" 681 INTERNATIONAL ASSOCIATION OF FIRE FIGHTERS ALFRED K. WHITEHEAD VINCENT J. BOLLON President Secretary-Treasurer HAROLD A. SCHAITBERGER EXECUTWE ASSISTANT TO THE PRESIDENT My name is Harold A. Schaitberger. Executive Assistant to the President of the international Association of Fire Fighters. affiliated wIth the AFL-CIO. On behalf of the Nation's 180.000 paid, professional fire fighters, allow me to raise an Issue relating to our pensions that can directiy affect au our members. During Congressional consideration of the 1986 Tax Reform Act (TRA), a provision was added to the Internal Revenue Code establishing certain minimum qualification rules for defined benefits plans that qualified under Section 401 of the Code. That provision required that, in order to be considered a qualified plan, the plan must contain at least 50 employees of an employer or 40% of the employees of the employer, which ever was less. The strict application of that provision as passed in the IRA would have inadvertently disqualified hundreds of small municipal retIrement plans which have separate retirement programs for special classes of employees; particularly those engaged In fire protection and law enforcement activities. if those separate plans (fire fighter/police retirement plans) contained less than 50 participants and at the same time those participants In that special plan did not represent at least 40% of employees of the employer (in most cases the municipal government), then the plan could be jeopardized as far as maintaining a tax-exempt status. As the Committee is aware, the impact of losing the tax-exempt status for fire fighter retirement systems would result in the taxation of contributions made on behalf of the employee bythe employer to the plan and the taxation of profits made from the Investment of the assets of the plan, it was the IAFF's understanding that Congress' original Intent in establishing Section 401(a)(26) was to prevent highly compensated employees from establishing special individualized retirement programs. In our attempt to correct this oversight and inadvertent application, the IAFF was successful in securing an amendment In TAMPA. which would provide a special application of the minimum qualification rules to those plans providing benefts to employees engaged in fire fighting and law enforcement actMties. The special provision allowed that if a plan contained less than 50 members, then the 40% rule would be applied to the employees of that particular category within the municipal government as opposed to all employees of that municipal government. For example. prior to TAMPA. if a fire department had a special retirement plôn for fire fighters and the participants in that retirement plan numbered less than 50 and those participants did not represent 40% of all the employees of that municipal government, then the plan would fail to meet the minimum qualification rule. Under the amendment Included In TAMRA, if the fire department plan contained less than 50 employees and those employees represented at least 40% of the employees of the fire department, then the plan would meet the minimum qualification rule. Unfortunately, although the IAFF believed that this would correct the problems associated with 401(a)(26) to our profession, subsequent to the passage of TAMRA two additional problems were brought to light which could Jeopardize many retirement programs around the country. both large and small. The first problem is created in municipalities where there are tiered retirement systems. Many municipal governments have several retirement plans for employees depending on the dote of hire, in older retirement plans. as the number of active participates dwindle and ultimately fall below the 50 employee requirement, the tax exempt status of the tiered plan could be jeoparctzed since even with the use of the new special rule (as enacted in TAMPA) participants in the oldertiered plan may not meet the new 40% rule even wthin the category of employees covered by the plan. The second problem is raised concerning supplemental retirement plans. A description of the problem toilows. A large municipality has sponsored a pension plan system for a specific group of employees since the 1930s. Over the years the benefit formula has changed several times resulting in the evolution of a series of three basic plans referred to herein as Plan 1, Plan 2 and Plan 3. An individual's date of employment governs his or her entry date into the respective plans which in turn governs availability of any particular benefit formula. A recent restructuring is used as the basis to compute-a member's benefit, such as members highest civil service rate of pay. A separate (supplemental plan) was established at the same time to provide a benefit for those higher ranking members of the department whose rate of pay exceeded the civil service pay ceiling. Such supplemental plan merely provided a benefit (based on the exact same percentage of pay formula as Plan 3) on the difference between the higher ranking officers' PAGENO="0692" 682 actual compensation over the highest cMl service rate of pay. These supplemental benefit plans in this example could cover less than 50 actIve employees (officers of the department) and eventually cover the older benefit formulatIons In Plan 1 and 2 whIch could also fall below these minimum coverage requirements. The IAFF therefore believes that legislation isneeded to protect both older tiered retirement plans and supplemental retirement plans in order to protect our members from the harsh penalties that could result from disqualification of a plan due to noncompliance with Section 401(aX26). Finally, the IAFF would like to bring to the attention of the Committee a related problem concerning qualification rules as established under 401(a)(4). In May of last year. the Department of the Treasury released a proposed regulation (EE-128-86) that would require public employee retirement systems (PERS) of state and local governments to meet the pre- ERISA nondiscrimination rules found In 401(a). These regulations reversed a 1977 decision by the Department not to apply this section of the Internal Revenue Code to public employee retirement systems. Over decades of time, various retirement benefit structures have emerged within units of state and local government to address the needs and the unique characteristics of certain groups of covered employees which lead to issuance of the 1977 notice (IR-1869) and made compliance with EE-128-86 virtually impassible for public systems. The Committee should be aware that many state systems cover a signficarrt dwersity of public * employees within one statè.system and therefore those groups tend to have different benefit - formulas as follows. Public safety employees, who operate In an environment which requires a younger workforce, has lead to retirement programs for them which In many respects parallel the U.S. military retirement system. Legislators frequently have low-based compensation, which produce Inordinately low benefits, and tend to have shorter service lives than other employees because of the electoral process. Judges tend to be appointed or elected to their position late in their working careers with relatively brief periods allowed for the accrual of retirement benefits. In addition to the groups described above, there may be many other groups, which for justifiable policy reasons. are in need of special retirement provisions which deviate from mainstream plans. The existence of such justifiable long-standing differences in benefits may now couse certain employee retirement systems to be in technical violation of the pre-ERISA nondiscrimination provisions of the Internal Revenue Code. Recognizing the problems associated with applying the nondiscrimination provisions, the IRS Issued its 1977 notice. The notice effectively exempted public employer retirement plans from the nondiscrimination provision of Section 401(a). The exemption was to apply until such time as the IRS hod an opportunity to review the pertinent issues. We are not aware, nor convinced, that the Treasury Department has conducted such a review but simply has determined that the conditions that led to the 1977 policy have changed. The IAFF strongly disagrees and would encourage the Congress to utilize its authority to either legislate or instruct the IRS to reconsider its position arid continue the effects of Notice IR-1869. To do otherwise would be exceptionally disturbing to the structure of the public employee retirement system universe and particularly to many fire fighter plans that are a part of a larger state retirement system. The AFF, therefore, coils upon the Committee to include In its technical corrections legislation language that will protect fire fighter pension plans from being disqualified on the basis of minimum participation. PAGENO="0693" 683 STATEMENT OF THE HONORABLE LEON E. PANETTA BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS REGARDING H R 809 FEBRUARY 21, 1990 Mr. Chairman and Members of the Subcommittee, thank you for this opportunity to appear before you today to discuss my bill H.R. 809. I introduced H.R. 809 to address a problem faced by many retired members of the clergy, whose pensions are artificially limited by a technical provision of the tax code. My bill would enable them to receive the full pension to which they should be entitled based on their pre-retirement compensation. The problem for many members of the clergy is that they receive a considerable portion of their usually modest compensation as a nontaxable payment for room and board, often knownas a parsonage allowance. Section 107 of the Internal Revenue Code specifically gives this allowance tax-free status. The law gives the Internal Revenue Service flexibility in deter- mining what constitutes compensation for purposes of determining maxi- mum pension payments. However, the IRS has chosen not to include par- sonage allowances in this definition. Thus, I believe Congress must act. For many members of the clergy who participate in defined benefit pension plans, taxable compensation may be below $10,000, while the combination of taxable compensation and parsonage allowance, which truly reflects their actual compensation, might be considerably greater than $10,000. The intent of the law - to limit overly generous pension benefits - is grossly distorted when it does not even permit these retired clergy members to receive an amount equal to their actual pre-retirement compensation. The result is that many retired clergy members who have put in decades of service are arbitrarily limited to a $10,000 annual pen- sion, when in fact they would be entitled under their pension plans to more - if they were permitted to include their parsonage allowance in determining their pre-retirement compensation. The consequence is both unfair and unjustified. These are individuals who have committed themselves to service to their parishioners and the church and enjoy very little compensation. To penalize them further in retirement makes little sense fiscally or morally. My bill addresses this problem in a very simple way. It includes in pre-retirement compensation, for purposes of determining maximum pension benefits, the value of a clergy member's parsonage allowance. Let me emphasize that this bill does not mandate any specifid- pension benefit for a clergy member. It simply allows ahigherbene- fit to be paid for those who have worked long enough and been compen- sated enough to qualify for that higher benefit. I believe that this is the only fair and equitable way to provide the clergy their true level of pension benefits. PAGENO="0694" 684 AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS STATEMENT SUBMITTED FOR THE COMMITTEE ON WAYS & MEANS SELECT REVENUE MEASURES SUBCOMMITTEE HEARINGS February. 21-22, 1990 F. Estate & Gift Taxes l.a. Spec~a1 use valuatjofl election unde~r~ § 2Q3~2~Q U~e Code (imperfect The AICPA questions a policy of general retroactive validation of untimely (or imperfect) elections under §2032A. The AICPA supports the validation of an untimely election based on negligence of the attorney for the estate. We propose that a correction procedure be established permitting a decedent's estate to validate an untimely or otherwise imperfect special use valuation action within a 90-day period after notification from the Internal Revenue Service of an apparent invalid election. In the alternative, we propose that § 2O32A be amended to provide a broad waiver authority for the Internal Revenue Service and that legislative intent be provided in committee reports that the standards of Rev. Proc. 79-63, § 4.01 be used by the IRS to pass on applications for waivers of untimely or invalid elections. We acknowledge that an inference can be made from the analysis by the Supreme Court in the case of ~obert~W.,, Boyle ~ 469 U.S. 241 (1985), 85-1 USTC ¶13,602 that a decedent's personal representative might be protected by a tax practitioner's erroneous advice that a return need not be filed but is not protected by erroneous advice as to the due date of the return. We believe that the self assessment tax system is fostered by measures which encourage compliance by taxpayers and assistance by practitioners and not pro- cedures that create conflicts between taxpayers and tax practitioners. There are precedents for a correciOn period in the 1984 Deficit Reduction Act (Tax Reform Act Title) § 1025 and 1986 Tax Reform Act §1421 which provided 90-day correction periods. Our proposal is that a permanent provision be added to the Code for a correction by a decedent's estate of an imperfect election for (d) (1) or recapture agreement by the parties in interest for (d) (2) under § 2032A. In the alternative, the IRS should be given authority to waive defects in or untimely filing of a special use valuation election recapture agreement based on the standards of Rev. Proc. 79-63, § 4.01. These provide for due di'igence of the taxpayer to determine the existence of and requirements for an. election, prompt action by the taxpayer aftera defect in the election has been identified, intent of the taxpayer to make the election (prevent a look-back disavowal of an election), absence of prejudice to the interests of the government as ~toiTindsight opportunities, and fulfillment of statutory regulatory ~objective5, viz, to permit a personal representative of a decedent's estate to make a special use valuation election for qualified property. After the limited relief provision provided in Regs. § 20.2O32A8 expired, Congress enacted successive relief measures including the 1981 ERTA (P.L. 97-34) § 421(j) (3) amendment to § 2032A(d)(l) and § 421(k) (5); the 1984 Deficit Reduction Act (P.L. 98-369) § 1025 adding § 2032(A) (d) (3) and the 1986 Tax Reform Act § 1421. In the interest of equitable and efficient administration of a special use valuation provision, a procedure for notification and correction or IRS waiver authority is appropriate. Ata minimum, either a correction period or IRS waiver authority should be provided for a decedent's estate filing on any version of estate tax Form 706 prior to the October 1988 version which contained for the first time a place on the form in Schedule A-l, parts 2 and 3 for the special use valuation election and the agreement of the parties in interest. PAGENO="0695" 685 -,,--- l.b. ~p~ia1 use valuation election (cash leases) We support a clarification of the qualified use definition to include a cash lease of § 2032A property by family members to another family member. *** The proposed extension or clarification of the definition of `qualified use" appears to overrule the recent cases of ~j,~oth~6~ Hefflev (Opal P. Heffley Estate), 884 F.2d 279 (7th Cir. 1989), 89-2 USTC ¶13,812 and Bervl T. Williamson, 93 T.C. 242; No. 23 (1989). We support this proposal. A cash lease often is the only practical solution where one co-owner beneficiary of the estate is unable to purchase property held by his sibling co-owners and therefore leases their interests in order to continue the farm or ranch operation. 2. Disclaimers of Gifts The AICPA supports the exemptions from gift tax of the four dis- claimers of contingefit future interests where the disclaimers were valid, timely and effective under local law and made immediately after the disclaimant's interests beôame vested. * ** In general, we believe that dissenting opinion in the case of ~Q~gt F. Jewett, Jr., 455 U.S. 305 (1982), 82-1 USTC ¶13,453 was better reasoned and a more equitable interpretation of the then Rags. § 2511- 1(c) (1981) for years prior to addition by the 1976 Tax Reform Act § 2009(b) (1) of § 2518 to the Code. We believe disclaimants and their advisers for pre-1976 transactions properly relied upon the case of Pauline Keinath, transferee (Cargill MacMillant, 480 F.2d 57 (8th Cir. 1973), 73-1 USTC ¶12,928. 3.a. Estate tax modifications (change "Crummey" rule) The AICPA supports with modifications the proposal for substitution of a vested interest requirement to qualify for the annual, gift tax exclusion. We recognize that there have been questionable practices in applica- tion of the demand power procedure for annual gift tax exclusion taken from the case of 0. Clifford Crummey, 397 F.2d 82 (9th Cir. 1968), 68-2 USTC ¶12,541 and approved in Rev. Rul. 75-415. For example, we agree with the reasoning in TAN 87-27-003 that no exclusion should be allowed for a "Crummey" powerholder who is not otherwise a primary beneficiary in the gift trust. In addition, we recognize that there have been omissions of procedures to implement the "Crummey" powers such as the notification to the beneficiary required in Rev. Rul. 83-108. We recommend that other procedures be provided in addition to the general power of appointment in order to vest-the donee's interest in the gift trust. Specifically, we propose that the annual gift tax exclusion be allowed where the interest of the beneficiary of the gift trust is vested by (1) a general power of appointment held by the beneficiary (either lifetime or testamentary), (2) designating the beneficial interest as payable to the beneficiary's estate (estate trust) and (3) a qualified terminable interest property (QTIP) provision expanded to non-spousal gifts by electionof the donor. In all of the cases the beneficial interest will be included in the donee's estate if the beneficiary dies before the trust terminates. We note complications from the interplay of the "Crummey" power with § 678 regarding Subpart E trusts for income tax purposes, the § 2041(b) (2) limited general power of appointment powers previously mentioned, as well as § 2036(a) for transferred property. Creation of PAGENO="0696" 686 the "Crummey" power makes the gift trust a Subpart E trust first under § 678 and then under § 677(a) (1) when the power lapses. In addition, where theexclusion exceeds the greater of $5,000 or 5% of the trust property, the inclusion rules of § 2041(b) (2) apply. Furthermore, when a § 677(a) (1) trust is involved § 2036 may apply upon death of the "Crummey" holder. An illustration of these rules appears in PLR 86-13-054 which treats a gift trust as a permitted s corporation shareholder under § 1361(b) where the value of the S corporation shares transferred to the trust fell entirely within the "Crummey" power. Another complication arises in determination of the transferor for generation skipping transfer tax purposes, i.e., the donee beneficiary of the trust may become the transferor rather than the trustor. In general, these refinements and complications have been overlooked or ignored by donors. We recommend the following improvements in the trust income and estate taxation rules for gift property, in coordination with the proposal that a vested interest rule be substituted for the present interest rule to qualify for the annual gift tax exclusions: a. Where the transfer in trust on a per-year basis is smaller than the annual gift tax exclusion (see our recommendation below for retention of the per-donee gift tax exclusion), the vested interest of the beneficiary should be exempted from the operation of § 678 and § 677, i.e., the beneficiary should not be treated as the owner of that portion of the trust. b. If a vested interest is substituted for the "Crummey" power, no lapse will occur and § 2041(b) (2) will not apply. c. The gift trust donor should be considered the transferor of property for generation skipping transfer tax purposes and not the vested donee beneficiary of the gift trust. d. Termination of the gift trust when the donee becomes age 21 should no longer be required, in view of the vested interest in the trust that will be taxable in the donee's estate if the beneficiary dies before the trust terminates. e. In like manner, there should be no requirement that income distributions commence to the beneficiary when the beneficiary attains the age of 21 years. For example, if the grandchild direct skip gift trust provision in 1986 Act § 1433 is restored, the age 21 income distribution requirement should not be imposed. f. A gift in trust should be treated as vested even though the trust will be redivided for an afterborn beneficiary. 3.b. Estate tax modifications (cap on state death tax credit) The AICPA opposes the proposed 8.8% cap or ceiling rate for the state death tax credit. We note that 8.8% is the marginal state death tax credit rate for a taxable estate exceeding $2,600,000. This taxable estate level is said to be the threshold of the top brackets. However, many estates will be subject to higher rates after exceeding the $3,000,000 and $10,000,000 taxable estate levels. consequently, a revenue loss will be sustained by states which impose only an estate tax or gap tax, unless these states enact a supple- mental state inheritance tax to capture what would have been the higher estate death tax credit amount. Most states have repealed their state inheritance taxes and have accepted the amount of the Federal estate state death tax credit. To offset this revenue loss, many states will restore their inheritance tax systems with resulting complicationsin tax planning and compliance. In addition, wealthy individuals may relocate from these states to states which continue with the pure estate or gap tax system. We believe interference by the Congress in state inheritance tax policies is unwise and inconsistent with the Federal system. PAGENO="0697" 687 3.c. Estate tax modifications (per-donor gift tax exclusion) The AICPA opposes the proposal that a flat annual $30,000 per-donor exclusion be substituted for the annual $10,000 per-donee gift tax exclusion. A major target of the proposal to repeal the "Crummey" annual gift tax exclusion appears to be the life insurance trust whose beneficiaries are the children of the insured parent. The 1988 TAMRA 1014(g) (17)- (A) amended ~ 2642 (c) (2) to prevent an annual exclusion for a transfer to a skip trust unless the trust is for a single beneficiary and the trust gift is vested. This requirement was effective for transfers after March 31, 1988 and impaired a life insurance trust whose beneficiaries are grandchildren of the insured. No grandfather or transitional protection was provided in the TANRA changes. We recommend that transitional protection be allowed for transfers to a life insurance trust which is irrevocable on the date of enactment, if the per-donor exclusion is enacted, to the extent the transfers to the trust do not exceed the premiums on the insurance policy held in the trust or the enactment date. Consideration should also be given to similar relief for a grandchildren insurance trust which was irrevocable on March 31, 1988. A significant difficulty attends the per-donor exclusion, related to small gifts which are not intended to augment the wealth of the donee, e.g., holiday and birthday gifts, payment for expenses of donees accompanying the donor on vacation travel, etc. One of the historic purposes of the annual per-donee gift tax exclusion was to sake unnecessary a determination as to whether a particular transaction should be considered a gift for gift tax purposes, and if a gift, whether transfers in small amounts should be controlled for entry into the transfer tax system. We perceive a "social engineering" tinge to the proposal, reminiscent of a proposal some years ago that large families be discouraged by making the dependent exemptions available only for a limited number of the taxpayer's children. We believe decisions as to family size, gifts to children and gifts to grandchildren should be determined by the taxpayer donor and not by Congressionalmandate, i.e., this proposal is too intrusive into personal and family relationships. If the per-donor annual exclusion is enacted, we recommend an unused exclusion carryover provision in order to accommodate a donor of moderate wealth who may be unable to make gifts each year which would utilize the annual exclusion amount. Furthermore, we presume that the unlimited tuition and medical exclusion of existing law for payments to providers of college education and medical services would be continued. We note further that with the continuing lengthening of life expectancy, many persons inclined to make gifts have adult grandchildren and for valid non-tax reasons wish to make gifts to their grandchildren as well as their children. This demographic factor makes the $30,000 per-donor annual exclusion even more inappropriate. The subcommittee may wish to consider the addition of an annual exclusion for the generation skipping distribution tax imposed on the distributee from a skip gift trust. The annual and tuition/medical exclusions of existing law apply the direct skip gift tax but do not apply to a skip trust where distributions are made to a grandchild (third generation beneficiary) while the donor's child (second generation beneficiary) is still living. The gift trust (and testamentary trust) distribution tax has not yet been implemented. It would be timely to provide at least a de minimis exclusion in order to prevent the need for expensive return compliance on distributions of small amounts of trust principal or income to the donor's grandchild. PAGENO="0698" 688 STATEMENT OF SENATOR TOM DASCHLE (SOUTH DAKOTA) For the past couple of years, I have studied the effects on family farmers of asmail provisiowin the estate tax law--Section 2032A. I am pleased that this committee has chosen to include Section 2032A on its agenda today. Section 2032A, which bases the estate tax on a family farm on its farming use, rather than on its market value, reflects the intent of Congress to help families keep their farms. A family that.has worked hard to maintain a farm should not have to sell it to a third party solely to pay stiff estate taxes resulting from increases in the value of the land. At the time Section 2032A was enacted, it was common practice for one or more family members to cash lease the farm from the other members of the family. This practice made sense where one family member was more involved than the other family members in the day-to-day farming of the land. Typically, however, the other family members would continue to be at risk as to the value of thefarm and to participate in decisions affecting the farm's operation. Cash leasing among family members remained a common practice after the enactment of Section 2032A. An inheriting child would cash Ie~se from his or her siblings, withno reason to suspect from the statute or otherwise that the cash leasing arrangement might jeopardize the farm's qualification for special use valuation. Due primarily to some language that I am told was included ma Joint Committee on Taxation publication in early 1982, the Intemal Revenue Service has taken the position that cash leasing among family members will disqualify the farm for special use valuation. The matter has since been the subject of numerous audits and some litigation. In 1988, Congress provided partial clarificatiOn of this issue for surviving spouses who cash lease to their children. Due to revenue concerns, however, no clarification was made of the situation where surviving children cash lease among themselves. My concern is that many families in which inheriting children have cash leased to each other may not even bertware of the IRS's position on this issue. At some time in the future, they are going to beaudited and fmd themselves liable for enormous amounts in taxes, interest and penalties. For those who cash leased in the late 1970s, this cOuld be devastating because the taxes they owe are based on the inflated land values that existed at that time. Janet and Craig Kretschrnar have traveled here from South Dakota today to tell you how the IRS's interpretation of Section 2032A hasdramatically impacted their lives. I hope you will listen carefully to their story. Perhaps the most frustrating aspect of the Kretschmars' experience is the fact that their cash lease began prior to 1982. For those who inherited property and entered into cash leasing arrangements prior to 1982, the IRS's interpretation of Section 2032A is perplexing, to say the least. Even assuming that a staff publication constitutes sufficient warning of how a law will be interpreted, these people cash leased prior to any such waming. They were never notified of the change in interpretation of the law and had no reason to believe that their arrangements would no longer be held valid by the IRS for purposes of qualifying for special use valuation. The fact is that, if they had known this, they would have re-assessed their situation. I believe it is critical that we take a close look at Section 2031k and the way it is being interpreted by the IRS. I am not convinced that the IRS interpretation is consistent with the original intent of the law. If not, we should clarify the proper intent. In any event, I think it would be highly appropriate to provide relief to inheriting children who cash leased prior to 1982. I trust that these issues will be more fully explored here today, and I look forward to the comments of my colleagues in the House on this issue. Thank you. PAGENO="0699" 689 Statement of K. Martin Worthy Before the Select Revenue Measure Subcommittee House Ways and Means Committee February 21-22, 1990 My name is K. Martin Worthy. I am a lawyer in the firm of Hopkins & Sutter in Washington, D.C. and have practised tax. law for more than 35 years. I was Chief Counsel for the IRS for three years and have been Chairman of the Tax Section of the American Bar Association. I am presenting this statement in support of Mr. Russo's amendment, which would correct a serious inequity which has resulted in the retroactive application of federal gift tax. The amendment relates to disclaimers of four specific remainder interests in properties, all originally created before 1942 (Specific statutory language which we support is included as the last section of this statement.) It has been accepted for over fifty years that a disclaimer or renunciation refusing to accept a gift or transfer by will is not itself a transfer subject to gift tax if the disclaimer is valid and properly made. Although until 1976 the Internal Revenue Code ("Code") contained no provisions governing the gift tax effect of disclaimers, in 1958 the Treasury published a Regulation recognizing this court-established principle. Section 2518 of the Code (the disclaimer provision first adopted in 1976) applies only to disclaimers of interests created after 1976, so that disclaimers of earlier interests, including all the interests covered by the proposed amendment, are governed solely by the 1958 Regulation and case law I represent the Estate of Mrs. Helen W. Halbach, who died while a resident of New Jersey in 1972. Mrs. Halbach's disclaimer is one of the four disclaimers covered by the proposed amendment. The families affected by the other disclaimers join in and fully support my statement. I believe the following chronology of our case will demonstrate the unfairness of the situation both for Mrs. Halbach's estate specifically and for the other disclaimants generally. Mrs. Halbach's father died in 1937, and by his will established a trust with the income to be paid to Mrs. Halbach's mother for life, with the remainder to be divided later equally between Mrs. Halbach and her sister in the event of their survival of their mother. Thus, Mrs. Halbach's interest was wholly contingent and would not vest or become possessory in any sense until after hermother's death. Mrs. Halbach's mother died on April 14, 1970, and Mrs. Halbach, four days later, executed a document in which she irrevocably renounced and disclaimed all her right, title and interest in the one-half share of the trust to which she would otherwise have been entitled. The bank administering the trust thereupon brought anaction in the New Jersey courts to determine the effect ~f the disclaimer, and the Chancery court of New Jersey, in a carefully developed opinion (274 A2d 614), held in late 1970 that the disclaimer, having been executed promptly after the death of the life tenant, was effective to prevent any passage of title toMrs. Halbach. The Court thus required distribution of the half interest in the trust, to which Mrs. Halbach would otherwise have been entitled, just as if Mrs. Halbach had not survived. Significantly, the Court noted not only that this was the accepted law of New Jersey, but also that the Court had been unable to turn up any court decision anywhere that to be effective a remainderman's renunciation must occur (as the Internal Revenue Service would later contend) within a reasonable time after learning that a remainder interest had been created. Thus, the Court concluded that it was sufficient if renunciation occured within a reasonable time after termination of any preceding life interest. PAGENO="0700" 690 As I will discuss, Mrs. Halbach had no reason to believe, when she executed her disclaimer in 1970, that she had in any way made a transfer of property subject to gift tax. However, by reason of the Supreme Court's 1982 decision in Jewett v. Commissi~n~ and the failure of Congress in enacting section 2518 to deal specifically withdisclaimers of interests created before 1976, Mrs. Halbach's estate is faced with a gift tax on the value of the trust interest which she disclaimed in 1970, just as if she had accepted it and then later voluntarily transferred it to persons of her own choosing.* Before the 1958 Regulation the courts of appeals had made it clear that a disclaimer which was valid and effective under state law did not result in a taxable gift. Although there was some variance in state disclaimer statutes and some states had no disclaimer statutes at all, it was clear from the authorities (such as Page on Wills) that as a general rule a disclaimer of an interest was valid under state law if it was unequivocal~ made without prior acceptance, and made within a reasonable time. Furthermore -- just as later held by the New Jersey court in connection with Mrs. Halbach's disclaimer -- in the case ofan interest which did not take effect in immediate possession, a disclaimer did not have to be made before the termination of the preceding interest to meet the "reasonable time" requirement. * In the Jewett case, however, the Supreme Court held that under the 1958 Regulation a disclaimer after 1958 of a pre-1976 interest (i.e, one created before the effective date of section 2518 of the Code) will be recognized as free from gift tax only if the disclaimer is made shortly after the disclaimant obtains knowledge of the creation of such inte~~~ rather than after knowledge of its ves~g, as the courts had previously held. Under this interpretation future interests must have been disclaimed soon after their creation, no matter how unlikely or contingent the possibility that anything would ever be received. This interpretation of the 1958 Regulation is clearly contrary to accepted case law before 1958 (and contrary to what many justifiably understood the law still to be even after the Regulation was promulgated in 1958 and until well after Mrs. Halbach executed her disclaimer in 1970). Accordingly, application of the Supreme Courts decision to Mrs. Halbach and other holders of pre-1958 contingent interests is very unfair. Under existing case law before the ~ decision in 1982, they had no reason to disclaim a pre-1958 contingent interest until after they obtained knowledge that the interest had vested, even if they had knowledge of the existence of the interest from its creation... Yet the 1958 Regulation, as interpreted by the Supreme Court in Jewett, gave such holders no opportunity to disclaim their pre-1958 *The other disclaimers coveredby the amendment were made in similar circumstances. One contingent remainderman made her disclaimer in May 1977, shortly before the death of the life. tenant and before her interest became vested and possessory her interest had been created under her grandfather's will in 1924 (prior to the enactment of the gift tax in 1932), when she was less than a year old. The remaining disclaimers were made by members of a single family with respect to their contingent future interests in a 1934 inter-vivos trust and a related 1941 testamentary trust. In 1941, one of the persons who was later to disclaim was 12 years older (another was 9 years older) than the life tenant whom she would have to survive in order to take anything under the trusts; at the time the other remaindermen ranged in age from 3 to 17. Their disclaimers were made in May and June of 1974, shortly after the March death of the predecessor life tenant. All the disclaimers covered by the amendment were determined to be timely and effective under local law by the respective local courts. Thus, these taxpayers have suffered from the same unfair, retroactive effect of Jewett as Mrs. Halbach's estate. PAGENO="0701" 691 interests without. gift tax, since it was already too late to do so when the Regulation was. promulgated. The proposedamendment would correct the very unfair effect of the Supreme Court decision in the Jewett case, for both estate and gift tax purposes, by providing that each of the specified disclaimers will be treated as made within a reasonable time, provided it meets the other requirements of the Regulation. The amendment would allow a grace period of one year after enactment of the provision for making a refund claim with respect to each of the specified disclaimers, regardless of the statute of limitations or finality of any prior decision. The legislation is drafted narrowly because the revenue estimate for a generic amendment has been criticized as too great. It should be emphasized that Mrs. Halbach had no reason to know at the time of her disclaimer in 1970 that the Service would claim that such disclaimer was subject to gift tax. The Supreme Court acknowledged in its opinion in Jewett that it was not entirely clear even after 1958 whether the Regulation required that the disclaimer be made upon creation of a contingent remainder interest or upon subsequent vesting on death of the life tenant. (1) In fact, the position taken by the Service. in the Jewett litigation with respect to the meaning of the 1958 Regulation is specifically inconsistent with the Service's interpretation of such Regulation in Private Letter Ruling 6612201590A, which was issued by the Service prior to Mrs. Halbach's disclaimer in 1970. We have been unable to find why this ruling was not called to the Supreme Court's attention in Jewett, and the Court, in making its conclusion, mistakenly found that "the CommissiOner's interpretation of the regulation has been consistent over the years" and concluded that it was therefore "entitled to respect." (2) In truth, as acknowledged by counsel for the Commissioner of Internal Revenue in oral argument on December 1, 1981, it was not until litigation in the Tax Court in 1972 that the Service first publicly stated that it interpreted the Regulation as it now does, as requiring the holder of a future contingent interest to disclaim shortly after knowledge of its creation rather than after knowledge of the termination of the preceding interest. (3) That the taxpayer knew or should have known that the Regulation meant what the Service now claims it means was certainly not obvious to the United States Court of Appeals for the Eighth Circuit as late as 1973, when it held that the interpretation now claimed by the Internal Revenue Service and the Treasury Department was incorrect. Keinath v. Commissioner, 480 F.2d 57 The Eighth Circuit reaffirmed this view in 1980 in Cotrell v. Commissioner, :628 F.2d 1127, holding that Mrs. Halbach's sister's disclaimer of her identical interest in the same trust at the same time was not subject to gift tax. Mrs. Halbach and the other disclaimants were simply operating within the law in effect at the time of their disclaimers -- the law as interpretedin the Keinath and Cotrell cases. The Treasury Department opposes this proposal because it is retroactive. It is ironic that they put so much emphasis on retroactivity of the proposed legislation and do not express the same concern about the retroactivity of the Government's interpretation of the 1958 Regulation, first announced in 1972, saying that Mrs. Halbach, whose contingent remainder interest was created in 1937, should have made her disclaimer 21 years before the 1958 Regulation imposing the new test was issued. PAGENO="0702" 692 Surely, the ex p~ facto nature of this RegulationS retroactively changing the rules, without any grace period, as to when a pre-1958 contingent interest may be disclaimed without gift tax, cries out for Congressional redress. Treasury also opposes the amendment on the ground that the rule for disclaimer of post-1975 interests under section 2518 is consistent with the Jewett interpretation of the 1958 Regulation for pre-1976 interests, that timeliness for both is gauged from the time the interest is created. However, the legislative history of the 1976 Act (which adopted section 2518) indicates to the contrary that Congress believed that the Court of Appeals in the ~~ath case stated the proper interpretation of the rule for pre-1976 interests. ~ ~ H. Rept. 94-1380, 66, 1976-3 C.B. 800. In conclusion, it is our contention that it is only fair and equitable for this Congress to provide relief to taxpayers who in good faith relied on existing case law and never had an opportunity to make a timely disclaimer of their pre-1958 contingent interests, as the Supreme Court has interpreted the requirements of the 1958 Regulation. Congressional relief from the imposition of the Federal gift tax on the disclaimer of pre-1958 interests is particularly appealing in the instant case under a "basic fairness test, since my client madethe identical disclaimer at the same time as her sister who has been relieved from such gift tax by the Eighth Circuit. TECHNICAL ANALYSIS AND BACKGROUND CONCERNING PROPOSAL ON THE TAX TREATMENT OF DISCLAIMERS OF CERTAIN REMAINDERdINTERESTS I. BACKGROUND As noted above, although until 1976 the Internal Revenue Code of 1954 (`the Code") contained no provisions governing the gift tax effect of disclaimers, in 1958 the .Treasury published a Regulation recognizing this court-established principle. However, even under the Regulation, the effectiveness of a disclaimer for federal tax purposes varied according to applicable state law. By the 1970's it had become apparent to members of the tax bar and others that a uniform definition of disclaimers would be desirable for federal tax purposes. ~ H. Rept. No. 94-1380, 66, 1976-3 C.B. 735, 800. In response to the movement for a uniform disclaimer rule, Congress enacted new section 2518 of the Code in the Tax Reform Act of 1976. That section generally requires that a "qualified disclaimer" for Federal estate and gift tax purposes, i.e., a disclaimer that does rot constitute a taxable gift, be made (a) in writing, (b) before acceptance of the interest being disclaimed or any of its benefits, and (c) within 9 months after the laterof the date on which the transfer creating the interest is made or the day on which the disclaimant attains age 21. Section 2518 was subsequently amended in 1978 and 1981 to perfect and~clarifY the uniform rule. Under present law section 2518 applies only to disclaimers of interests created after December 31, 1976. Thus, the broad class of disclaimants of interests in trusts created before 1958 remains subject to the law in effect before section 2518 was enacted, irrespective of when the interests become possessory and when the disclaimers are made -- even 40 or 50 or more years from now. PAGENO="0703" 693 II. REASONS FOR PROPOSED AMENDMENT In Jewett v. Commissioner, 102 S. Ct. 1082 (1982), the Supreme Court of the United States, interpreting section 25.2511-1(c), Gift Tax Regs., held that a disclaimer after 1958 of an interest created before 1977 will be recognized as free from federal gift tax only if it is made shortly after the initial transfer from which the interest sought to be disclaimed eventually emerged. Under this interpretation, future interests must have been disclaimed soon after their creation, no matter how unlikely or contingent the possibility that anything would ever be received. Such an approach is contrary to the view, widely held before the Supreme Court decided Jewett, that the 1958 Regulation permits a tax-free disclaimer within a reasonable time after the death of the preceding life tenant, i.e. after the disclaimed interest becomes present and possessory. Moreover, as interpreted by the Supreme Court, the Regulation represents a sharp departure from the law in effect prior to 1958 Under which the effect of such a disclaimer was generally governed solely by State law. Thus, the application of the Supreme Court's decision to holders of interests created before 1958 is very unfair; they - had no reason to disclaim before that time and never had an opportunity to disclaim without gift tax -- even "within a reasonable time -- after the Regulation was promulgated. Law Before 1958 Prior to the 1958 Regulation there were few cases involving the federal estate and gift tax effect of disclaimers. Nevertheless those fewcases made clear that disclaimers which were valid and effective under state law did not result in a taxable gift. In 1933, the Sixth Circuit decided Brown v. Routzahn, 63 F.2d 914, cert. den. 290 U.S. 641 (1933). In Brown decedent's wife died in 1912 and left decedent one-third of all her property. An April 1920, before any distribution was made, decedent filed with the proper probate court a renunciation of his right to the third of the estate, and the court, ordering distribution to the remaining heirs, recognized the renunciation. However, at decedent sdeath the Commissioner contended that the value of the renounced property should be included in decedent's estate for federal estate tax purposes. as a transfer made in contemplation of death. In analyzing the issue, the Court of Appeals began from the `obvious' premise that unless the decedent accepted the gift of one-third of his wife's estate or became owner of such interest before April 1920, there could be no transfer of such interest in contemplation of death within the meaning of the tax statute. The court, looked to.state"law and found that under Ohio law a rejection of a gift'by will made any time before distribution wOuld be valid and that decedent therefore had never become owner of the property involved. Accordingly, the court concluded that his renunciation of the property could not be a taxable transfer for federal tax purposes. There was no indication by the Internal Revenue Service of its intent not to follow the Brown decision. No other decision bearing significantly upon the issue arose until 1952, when the Eighth Circuit decided Hardenbergh v. Commissioner, 198 F.2d 63, cert. den. 344 U.'S~ 836 (1952). In Hardenbergh the . ` taxpayers attempted to renounce their interest in the estate of a decedent who had died intestate, and the Internal Revenue Service claimed that the disclaimer.constituted a taxable . gift. The Eighth Circuit found that immediately upon the death of the decedent title to the'disclaimants'.interèsts'had vested in them by operation' of Minnesota law whichneither disclaimant had the power to prevent, with the result that their subsequent disclaimers constituted transfers of such interests for federal gift tax purposes. Thus Hardenbergh reinforced the principle PAGENO="0704" 694 that validity of a disclaimer under state law controlled for federal estate and gift tax purposes. Indeed, Hardenbergh cited ~p~p with approval with respect to disclaimers of testamentary gifts, carefully distinguishing Brown on the basis of the testate/intestate law difference. 198 F.2d at 66. A number of commentators during this period recognized the principle that state law controlled in determining the tax effect of disclaimers. See, e.g., Ekman, "Can A Transferee Avoid Gift or Estate Tax Liability by Renouncing A `Transfer By Operation of Law, " 11 N.Y.U. Inst. on Fed. Tax'n 527, 532-534 (1953); Sayles, "Renunciations -- Estate and Gift Tax Problems," 1953 S. Cal. Tax Inst. 531, 536-539. There was some variance in state disclaimer statutes, and some states, in fact, had no disclaimer statute at all. Nevertheless, as a general rule a discla'imer of an interest was valid under state law if it was unequivocal, made without previous acceptance, and made. within a reasonable time. 6 Bowe-Parker, Page on Wills § 49.9, 49.1, 49.8 (1962); 96 C.J.S. § 1151(b), 1151(a) (1957). In the case of an interest which did not take effect in immediate possession, a disclaimer did not have to be made before the termination of the preceding interest to meet the "reasonable time" requirement. See 6 Bowe-Parker, Page on Wills § 49.8 (1962). Also see Estate of Page, 74 A.2d 614, 615-616 (N.J. Super. 1970). A review of these cases and commentary reveals that prior to 1958 nothing in federal estate or gift tax law would require the holder of a remainder interest created by will to disclaim immediately upon the creation of the interest. Generally under state law the holder could wait until a reasonable time after the termination of the preceding interest, and the decided cases indicated that federal tax consequences of the disclaimer were controlled by state law. Against this historical background, section 25.2511-1(c), Gift Tax Regs., was issued in final form on November 15, 1958. The 1958 Regulation Section 25.2511-1(c), Gift Tax Regs., which has not been changed since it was promulgated in final form in 1958, provides in pertinent part as follows: "Where the law governing the administration of the decedent's estate gives a beneficiary, heir, or next-of-kin a right to completely and unqualifie~~y refuse to accept ownership of property transferred from ~ (whether the transfer is effected by the decedent's will or by the law of descent and distribution of intestate property), a refusal to accept ownership~ does not constitute the making of a gift if the r~fusa~I_is made within a reasonable~4p~ after knowledge of the existence of the transfer. The refusal must be u~equivocab1~L~c] and effective under the local law. There can be no refusal of ownership of proper~y~~ter acceptance. Where the local law does not permit o~ch a refusal, any disposition by the beneficiary, he:r or next-of-kin whereby ownership is transferred gratuitously to another constitutes the making of a gift by the beneficiary, heir or next-of-kin, In anycase where a refusal is purported to relate to only a part of the property, the determination of whether or not there has been a complete and unqualified refusal to accept ownership will depend on all of the facts and circumstances in each particular case, taking into account the recognition and effectiveness of such a purported refusa1'~under the local law. In the absence of facts to~the contrary, if a person fails to refuse to accept a transfer to him of ownership of a decedent's property within a reasonable time after learning of the existence of the transfer, he will be presumed to have PAGENO="0705" 695 accepted the property. In illustration, if Blackacre was devised to A under the decedents will (which also provided that all lapsed legacies and devises shall go to B, the residuary beneficiary), and under the local law A could refuse to accept ownership in which case title would be considered as never having passed to A, As refusal to accept Blackacre within a reasonable time of learning of the devise will not constitute the making of a gift by A to B. However, if a decedent who owned Greenacre died intestate with C and D as his only heirs, and under local law the heir of an intestate cannot by refusal to accept, prevent himself from becoming an owner of intestate property, any gratuitous disposition by C (by whatever term it is known) whereby he gives up his ownership of a portion of Greenacre and D acquires the whole thereof iconstitUtes the making of a gift by C to D." Emphasis added. This version of the Regulation is somewhat different from a draft initially proposed on January 3, 1957, which required a renunciation to be made !`wj±hin a reasonable time after knowledge of the existence of the interest' (emphasis added), rather than after knowledge of the existence of the "transfer, as provided in the final Regulation. The word "interest" would clearly include a contingent remainder even though the creation of that remainder by will did not effect a "transfer" to the disclaimant. Thus., under the Regulation as originally proposed, the holder of a future interest would only have had a reasonable time after the creation of the interest in which to disclaim and would not have been permitted to wait until the interest became present and possessory by transfer of the property to him. On its face, this difference between the proposed and final regulations suggests that the final Regulation was a rejection of the requirement of the proposed regulation that a disclaimer of a-contingent interest be made within a reasonable time after its creation rather than a reasonable time after it became possessory. However, in its Jewett opinion the Supreme Court considered the change in language and concluded, based on a Memorandum from the Commissioner of Internal Revenue to the Secretary of the Treasury, dated October 1, 1958, that the reason for the change was unrelated to the issue of when a future interest must be disclaimed. With respect to the disclaimer Regulation, the Memorandum provides in part as follows: - - "In what was intended to be the application of the rules in Brown v. Routzahn (-1~33) 63 F.2d 914, cert. denied 290 U.S. 641,~and Hardenbergh v. Commissioner (1952) 19S F,2d~6-3-~cert,-~denied 344 U.S. 836, it-was stated that where title to the property did not vest in the beneficiary or heir immediately upon the decedent's death, the renunciation of the property did not constitute the making of a gift, but that, where title - -vested in the beneficiary or heir immediately upon the decedent's death. the act of the benef.iciary or heir in giving up what passed to him from the decedent - - constituted the making of a gift. . . Protests on these provisions were received. After reviewing these protests, we have reconsidered our position and now - believe that the proper distinction between these- two court cases turns on the question of whether under the applicable State law.a beneficiary of heir can or cannot refuse to accept ownershi-p of the property which passed from the decedent. Accordingly, we have revised paragraph (c) of section 25.2511-1 to reflect this change of position." XIII Tax Notes 203, July 27, 1981. Two things are apparent: (1) Even if it is assumed that - the drafters -of the final Regulation were not intentionally trying-to state a different rule for contingent interests than 30-860 0 - 90 - 23 PAGENO="0706" 696 set forth in the proposed regu1ation~ this would not have been apparent to holders of contingent interests at the time, since the Memorandum was not made public until June 15, 1981. (2) The Memorandum clearly indicates that the drafters were trying to soften the inflexibility of the proposed rules and to provideS instead, that, state law would apply in every situation. And, as previously noted, under the law applicable in most states, in the case of an interest which did not take effect in immediate possessionS a disclaimer did not have to be made before the termination of the preceding interest to meet the `reasonable time" requirement. It was not immediately apparent that the 1958 Regulation was intended to make a change in the Treasury position as to when a valid disclaimer must occur. Although it specified three requirements not mentioned in ~ -- that a disclaimer be unequivocal~ that it be made before acceptance of the interest, and that it be made within a reasonable time of knowledge of the existence of the transfer, the Eighth Circuit subsequently observed that the conditions in the Regulation were "but a codification of common law principles applicable to the doctrine of disclaimers." Keinath v. Commissioner, 480 F.2d 57, 61 (1973). What taxpayers and the tax bar did not then know was that the IRS would eventually introduce a new concept by contending that when it said a taxpayer must disclaim within a reasonable time after "the transfer," it meant in the case of a contingent interest, a reasonable time after creation of the interest rather than a reasonable time after the interest became possessory. It was in litigation of j~p~)~ v. CommissI,cIl~ in the Tax Court in 1972, that the Service first publicly took the position that the Regulation required the holder of a future interest to disclaim shortly after the interest was created rather than after the termination of the preceding interest. See statement of counsel for the Commissioner of Internal Revenue in oral argument before' the U.S. Supreme Court in Jewett v. Commissioner, No. 80-1614, 44-45 (December 1, 1981). This position of the Service was inconsistent with the ~p~p case, which the Memorandum indicates was intended to be embodied in the RegulationS and contrary to the general principle of `state law that disclaimers could be made after termination of the preceding life interest. It now further appearsthat the position the IRS took in Keinath was also inconsistent with its own position in an earlier private' letter ruling (66l220l590A) dated December 20, 1966. (Although private rulings were confidential at that time, since 1976 they have been released to the public, and this particular ruling was made open to public inspection on August 28, 1978.) In that. rulingthe IRS held'that a taxpayer's proposed disclaimer of' a contingent interest in a trust created 33 years earlier would not,, be taxable as a gift'. The taxpayer had a present possessory interest in a portion of the trust from its creation, and on the death of other life tenants without "issue' the taxpayer became eligible for additional fractional income interests. The Service ruled that if the taxpayer executed a disclaimer `within a `reasonable time' from the time that'she first received notice ~by reason of a court decision that the income interest had vested in her) of'her right to the additional income interest," the requirements of the Regulation would~be satisfied and no gift tax would be due. Because the' taxpayer already held another interest in the trust from which she had received income for nearly 30 years, she had'obvioUslY long been aware of the creation of the trust 33'years'earlier and of her contingent -` interests in the additional shares in the event of survivorship. Thus, the above quoted language of the ruling means that she had a reasonable p'eriod from the time she received notice that her additional contingent income interest had vested or become possessory~ even though that interest had been created 33 years'earlier. PAGENO="0707" 697 Although this private letter ruling was public when the Jewett case was briefed and argued before the Supreme Court, the Court was apparently not made aware of the inconsistent interpretation of the Regulation made by the IRS. In fact, the Court expressly noted in upholding the Commissioner's interpretation of the Regulation that the Service had been consistent in its interpretations over the years (102 S.Ct. 1090) -- which is simply not so.1 Conclusion This examination of the federal gift tax law on disclaimers before and after 1958 demonstrates that under the Brown and Hardenbergh cases the validity of the disclaimer under state law determined the federal gift tax result. Thus, before 1958 the holder of a contingent remainder had no reason to disclaim prior to the death of the preceding life tenant. `After the promulgation of the 1958 Regulation it was not apparent that that had been any change in the law. First of all, the deletion of language from the proposed regulation which required disclaimer "within a reasonable time after knowledge of the existence of the interest" suggested that a disclaimercould be delayed until indefeasible vesting. Furthermore, the October 1, 1958, Memorandum from the Commissioner to the Secretary of the Treasury shows that the drafters of the Regulation were trying to follow the existing law of the Brown, and Hardenbergh cases. In addition, the IRS itself, in Private Ruling 6612201590A, issued December 20, 1966, ruled that a disclaimer of a contingent future interest would satisfy the Regulation if made after notice that the interest had vested and become possessory. Indeed, it was not until litigation of the Keinath case in the Tax Court in 1972, after Mrs. Halbach's 1970 disclaimer, that the IRS first pUb1ic~ly took the position that a defeasible future interest must:be.disclaimed shortly after its creation. Despite these indications of the meaning of the Regulation, the Supreme Court in Jewett adopted the Commissioner's current contrary interpretation.2 Thus, under the Supr~eme Court's interpretation, the IRS, by promulgating the 1.958 Regulation, changed the rules for a taxpayer owning an interest created before 1958 in the middle of the game, contrary to any reasonable notion of justice or fair play. In rejecting a similar unfairness argument by the taxpayer in Jewett, the Court noted that the 1958 Regulation was made well in advance of the disclaimers in that case.3 However, 1 Even though section 6llO(j)(3) of the Code provides that private rulings ordinarily "may not be used or cited as precedent," the Supreme Court -- in refusing to accept the government's interpretation of a long-standing regulation in Rowan Companies. Inc. `. Jnited States, 101 S. Ct. 2288, 2296, n. 17 (1981) --has said that private rulings may be cited as evidence that the Internal Revenue Service has taken a position inconsistent with its present contentions as to the meaning of the law and regulations. 2One commentator has criticized the Court's construction of the Regulation as "visibly flawed." Jewett v. Commissioner: tinforseen Crisis of Disclaimers, 14 Loy. L. Rev. 167, 186 (1982). See also M. Wolfson, "Disclaimers -- A Device Whose Time Has Come?,' 41 N.Y.U. Inst. on Fed. Tax'n 43-1, 43-23 to 43-27 (1983). 3The Court made the puzzling comment that the taxpayer's argument would have more appeal if the disclaimer had been made immediately after the adoption of the 1958 Regulation, rather than 14 years later. 102 S.Ct. 1090, n. 20. The logic of this statement is difficult to understand if, in fact, the Regulation required disclaimer in 1939 when the disclaimed interest was created. PAGENO="0708" 698 what is important here is that the interest to which the proposed legislation would apply was created before 1958, not that it was disclaimed after 1958. The Regulation did not provide a grace period for disclaimers after it was promulgated, and as Jewett reads the Regulation, at that point it was already too late. Thus, holders of pre-1958 interests were Unfairly and unjustifiably prevented from ever disclaiming without, incurring a gift tax. Congress recognized this very transition problem when it made the rules of section 2518 applicable only to disclaimers of interests created after 1976. See Section 2009(e) of the Tax Reform Act of 1976, P.L. 94-455, 90 Stat. 1520. The proposed amendment would correct the unfair effect of Jewett on these holders of pre-1958 future interests by providing that their disclaimers will be treated as timely, but only if the other requirements of the Regulation are met. As the discussion above shows, the equities weigh heavily in favor of such relief. PROPOSED STATUTORY LANGUAGE SEC. __________ TRANSITIONAL RULE FOR CERTAIN DISCLAIMERS OF PROPERTY INTERESTS CREATED BY GIFTS, DEVISES OR BEQUESTS MADE BEFORE PROMULGATION OF REGULATIONS ON NOVEMBER 15, 1958. With respect to an interest in property created under the terms of (1) the last will of a decedent `who died on or about August 8, 1924,. (2) the last will of a decedent who died on or about January 22, 1937, (3) the last will of a decedent who died' on or about September 16, 1941, or (4) an inter' vivos trust agreement dated on or about December 10, 1934, a disclaimer by a person of such interest (in whole or in part) shall not be treated as a transfer for purposes of chapter 11 and 12 of subtitle B of the Internal Revenue Code if such disclaimer satisfies the requirements set forth in Treasury Regulation Section 25.2511-1(c) as in effect at the time the disclaimer was made. For purposes of this section, the requirement of such regulation that the disclaimer be made within a reasonable time after knowledge of the existence of the transfer shall be satisfied if such disclaimer was made in writing and filed, with respect to (1) above, in the Circuit Court of the Tenth Judicial Circuit of Illinois,- Peoria County, on or about May 27, 1977, with respect to (2) above, in the Surrogates Court of Essex County, New Jersey on or about June 15, 1970, with respect to (3) above, in the Surrogates Court of Steuben County, New York on or about May 24. 1974, and/or in said Court on or about June 13, 1974, `or with respect to (4) above, in the Supreme Court of Steuben County, New York on or about May 13, 1974. This section - shall apply notwithstanding any law or rule of law (including but not limited to section 7481 of the Internal Revenue Code of' 1986 as amended) concerning the finality of court decisions or other determinations, barring multiple suits on one cause of action, or limiting the time when a claim or suit for refund of tax may be brought, provided that the benefit of this section is claimed within one year of the date of enactment of this Act. 4761e PAGENO="0709" 699 Written Testimony of James M. Sizemore, Jr. Alabama Commissioner of Revenue I submit the following written testimony in opposition to the proposed federal legislation which seeks to cap the state death tax credit at 8.8 percent rather than allowing it to range up to 16 percent as provided in current law. The effect of such legislation, if passed, would be one of a significant revenue loss to the State of Alabama. Specifically, we have projected a 6.2 percent loss or in actual figures, a $750,000.00 to $1,000,000.00 revenue loss to the state, based upon the average amounts of estate taxes collected over the past three-year period. This projected revenue loss could vary since the estate and inheritance tax collected by the Internal Revenue Service is based upon a graduated scale. In Alabama, the state revenue that is generated from the estate tax is earmarked for the State General Fund. The general fund supports the majority of services provided by the Sta'te with the exception of its educational services which are provided for by a separate funth The consequences of such legislation upon Alabama's tax revenues cannot be overemphasized. The State General Fund is dependent upon the majority of Alabama's low-growth taxes. Any potential revenue loss to this fund would indeed be detrimental to current and future state funding capabilities. Consequently, I must go on record in opposition to any proposal to cap the state death tax credit at 8.8 percent rather than allowing it to range up to 16 percent as provided in current law. JMS~ca PAGENO="0710" 700 Statement of the American Council of Life Insurance to the Select Revenue Measures Subcommittee House Ways and Means Committee on Miscellaneous Revenue Issues March 9,1990 The purpose of this statement is to comment on two of the proposals described in the Subcommittee Press Release #8 dated January 23, 1990: (1) the proposal on business-owned life insurance described in section G.5 and (2) the proposal on estate and gift tax modifications described in section F.3(a) and (c). The American Council of Life Insurance is the major trade association for the life insurance business, representing 616 life insurance companies. Together these companies hold approximately 92% of the assets of all U.S. life insurance companies. Business Life Insurance Description of the Proposal Our comments are directed to the aspect of the proposal that would deny the deduction of interest on business life insurance loans if the beneficiary of the policy is not a member of the insured's family. Summary of Position The ACLI strongly opposes the proposal. In this regard, we support the testimony given by the National Association of Life Underwriters on February 22, 1990 on this issue. In virtually all circumstances where a business owns life insurance, the business is the beneficiary. Thus, the proposal would remove the deductibility of policy loan interest for. virtually all situations where business life insurance is used for collateral. By so doing, the proposal would discourage businesses from purchasing life insurance for legitimate business purposes. This would be tru~ even though no borrowing may ever actually be needed and despite the fact that business life insurance is often unique in its ability to assure the continuation and viability of the business. Moreover, the proposal would completely override specific and carefully targeted rules already in the law. Reasons For Position 1. Business uses of permanent life insurance have existed for nany years and serve an important and unique role in providing essential financial protection. These uses of life insurance should not be discouraged by the imposition of unnecessary and overly broad tax penalties. Following is a description of significant roles played by life insurance in a business setting. -- ~y Employee: Many businesses, particularly small businesses, are built and continue because of the efforts of an owner, a key manager or uniquely talented individual. When this is so, life insurance nay be purchased by a business on the life of the key employee with the business as beneficiary. The key employee may be an important link to customers or clients, and if the key employee dies, there may be a direct loss of money coming into the company. During the tine needed to reestablish those contacts and the income that flows from them, there are normal expenses that must be paid. In other situations, the key employee's work may have directly affected the ability of other employees to perform, such as the work of a key manager. The key employee's death * may result in a drop in the productivity of the company, resulting in both lower income and increased expenses. Also, the search for a new employee may entail unanticipated expenses and very possibly a higher salary to attract specialized talent. PAGENO="0711" 701 If the key employee dies,~ the life insurance proceeds from the key employee policy will compensate for the financial losses directly attributable to his or her death. Life insurance is unique in its ability to protect the company from such financial losses. -- Business Purchase or Stock Redemption Arrangement: For many small and medium size businesses, business life insurance is used to provide the funds for a smooth transfer of ownership on the death of an owner or partner. Without these funds, if the owner!s heirs are not able to operate the business, the business will have to be sold by the heirs to an outsider (possibly at a forced-sale price) or dissolved. -- Key Employee Compensation: Businesses often need to provide supplemental compensation packages to attract and retain key employees, and business life insurance is used, particularly by small employers, to help offset the cost. One example is `split dollar" life insurance where, typically, the employer and employee share in the payment of premiums and the death benefit is shared by the employer and the employee's designated beneficiary. On the employee's retirement, the employer's ownership interest in the policy can be transferred to the employee so he or she will own the policy individually. A business may also:purchase life insurance on the lives of employees covered under deferred compensation arrangements. The business is the beneficiary and the proceeds of the policies are used to help offset the deferred compensation payments. These arrangements rarely substitute for a broader based "qualified plan", but instead are part of a specially designed compensation package for key employees. Funding Employee Benefits: Life insurance also plays a significant role in helping business to create -assets to provide the financial wherewithal to meet the spiralling costs of employee benefits, particularly retiree health insurance coverage. In general, under such an arrangement, the business takes out permanent life insurance policies on the lives of employees in the group that will receive the post-retirement benefit. The business is the beneficiary. While it is unlikely that the life insurance policies will produce enough benefits to fund the health benefits on a current basis, they can significantly assist the business in meeting its future retiree health costs. Moreover, these policies represent business assets which serve to offset retiree health care liabilities which the business may be required to carry on its books under accounting rules. 2. All businesses face times when they need to borrow and must pledge business assets as collateral. Often the need is unexpected or at a time of financial difficulty. There is currently no general limitation on deductibility of interest on business loans. The proposal would single out loans where business life insurance is used as collateral and deny an interest deduction, thereby raising the net cost of the borrowing. Other assets that are often used for collateral, such as real estate, are not subject to any such constraints. With this in mind, many businesses, small ones in particular, will not tie up assets in life insurance knowing that they cannot use these assets as collateral on a loan except at interest rates that have been made prohibitively high by unfair tax rules. Such a broad sweeping result is not justified, particularly since business life insurance is often unique in its ability to serve various important-business needs. 3. Term insurance, which involves smaller initial outlays and has no loan values, is not a plausible alternative in many situations. As is true for families, many businesses rely on the level premiums of permanent life insurance to assist in managing their cash flow. The cost of term insurance, on the other hand, rises rapidly as the insured ages and, thus, the insurance may become PAGENO="0712" 702 difficult, if not impossible, to maintain in later years. Moreover, permanent insurance can be kept in force in lean times through borrowing against the policy to pay premiums where term insurance may have to be canceled. 4. The Internal Revenue Code already includes substantial limitations regarding business life insurance loans. For example, at least four of the first seven annual premiums must be paid in cash for any policy loans under a policy to qualify for an interest deduction. Moreover, interest is nondeductible on loan amounts in excess of $50,000~for each insured. - The proposal would, in effect, override these specific and targeted rules with a broad interest deduction prohibition for virtually all business policy loans. Such a broad approach should be rejected. Conclusion By denying the deductibility of interest on virtually all business policy loans, the proposal would substantially increase a business's net cost of borrowing if business life insurance is used as collateral instead of other forms-of corporate assets. In so doing, the proposal would unfairly, and unnecessarily discourage business from purchasing life insurance for legitimate business purposes and even though life insurance is often unique in its ability to assure the continuation and viability of the business. - amendments to the Gift Tax Provisions Description of the Proposals Under current law, gifts to a donee of up to $10,000 per year are not subject to the Federal gift tax. The gift must be of a present interest to qualify for this exclusion. The proposals would change this provision in two respects which would significantly impac.~t life insurance trusts. First, in the case of gifts made through a trust where the present interest requirement is satisfied by giving the beneficiary the right to withdraw the funds at the time they are * contributed, the proposals would require that this withdrawal right be available to the beneficiary continually for the rest of his or her life. Second, an overall annual cap of $30,000 would be imposed on the gift tax exclusion available to an individual donor, regardless of how many persons he or she makes gifts to or the size of those gifts. Summary of Position ACLI opposes these two proposals. Besides presenting very difficult technical and practical problems, they appear to represent an attempt to discourage life insurance trusts, which have long been - used to enable families to pass on a family business or farm from generation to generation despite having to pay substantial estate tax liabilities. Without such trusts, many of these businesses, which represent the livelihood of the family, would have to be sold, if a buyer can be found, or liquidated.' - Reasons for Position -- What exactly would happen under the proposals. For. an owner of a small to mid-size business or farm, the business often constitutes most, if not all, of his estate. When the owner dies, an estate tax may be due, or debts may be owing on the business. If cash funds are not available, the estate may then be forced to sell the business or farm to raise the funds to pay the tax or other amounts. Since a business or farm is a highly illiquid asset, the sale may be under -distress circumstances if market conditions are not right. Moreover, no matter what the market conditions, the result will be that the family will have lost the business or farm. -- The problem of forced sales of family businesses and farms is alleviated in many situations by the establishment of life insurance trusts by the owners to provide the cash funds necessary to pay the estate tax or-other amounts. The life PAGENO="0713" 703 insurance proceeds are available to lend to the estate or to buy the business from the estate at a fair market price. Because of its guaranteed death benefit, life insurance is the only vehicle which can insure that adequate funds will be on hand at the tine of death. -- The proposals will reduce these arrangements which have been so valuable in preserving small businesses in this country. If beneficiaries must have the continuing right to withdraw the trust funds in order for the gift tax exclusion to apply to the business owners' contributions, it will be very difficult for the trustee to commit to a long-term life insurance program. Likewise, if the total annual gift tax exclusion is capped, individuals with multiple beneficiaries will be discouraged from establishing these trusts. -Insurnmary, we urge that these proposals be rejected as an unwarranted impediment to long-standing arrangements for preserving familybusinesses in the face of large estate tax liabilities. In this regard, we endorse the comments filed by the Association for Advanced Life Underwriting. These comments include a very good discussion of the severe technical and practical problems involved. PAGENO="0714" 704 STATEMENT OF THE ASSOCIATION FOR ADVANCED LIFE UNDERWRITING PRESENTED ON MISCELLANEOUS REVENUE ISSUES OF THE SUBCOMMITTEE.ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS UNITED STATES HOUSE OF REPRESENTATIVES February 21, 1990 The Association for Advanced LIfe Underwriting (AALU) is a nationwide organization of life insurance agents and others engaged in the use of life insurance and related products in the fields of business continuation planning, estate planning, retirement plans and employee benefits. This statement is submitted on behalf of our members and, more significantly, on. behalf of our millions of policyholders who rely upon the protection they receive from billions of dollars of life insurance coverage. We believe we can accurately convey to the Subcommittee the response that can be expected from our policyholders once they fully understand the effects of the proposed estate tax modifications under consideration by the Subcommittee. This statement sets forth AALU's comments on two of the proposed estate tax modifications that will have particular impact on the life insurance industry and the people it serves. We are joined in this statement by our parent organization, the National Association of Life Underwriters, which represents some 140,000 professional life and health insurance salespeople who are members of over 1,000 local life underwriter associations located *in virtually every community in the country. A. PROPOSALS RELATED TO GIFT TAX MODIFICATION 1. Use of Withdrawal Power to Create a Presefl~ Interest in Transfers to Trust ("Proposal l~J One of the proposals referred to the Subcommittee would "[r]equire that, to qualify as a present interest for purposes of the annual gift tax exclusion, a contribution to a trust must give the donee a power to withdraw the contribution that lasts until the donee'.s death and must allow the donee to retain a general power of appointment over the trust assets." . Under present law, the first $10,000 of a gift of a present interest is excluded from the federal gift tax. We understand that Proposal 1 is intended to address trust contributions which qualify as present interests on the basis of a withdrawal power granted to the beneficiary that lapses PAGENO="0715" 705 if not exercised within a stated period of time. As the proposal is drafted, however, it totally disregards other means of creating a present interest in transfers to trust, and, if adopted, might possibly eliminate them. If we correctly understand the drafters' intent, Proposal 1 should more properly be stated as follows: "Require that a transfer of property to a trust subject to. a beneficiary's withdrawal power be treated as a present interest f~r purposes of the annual gift tax exclusion ~only if the withdrawal power will not lapse during the beneficiary's lifetime, and, if, in addition, the donee retains a general power of appointment over the trust assets." 2. Limitation on the $10,000 Per-Donee Exclusion L~'Proposal 2") A second proposal to the Subcommittee would "[l]imit the annual $10,000 per~-donee gift tax exclusion to a flatannual per-donor exclusion of $30,000." Although the language of Proposal 2 is unclear, we understand that the intent of this proposal is to retain the annual $10,000-per donee maximum exclusion amount, sothat the nontaxable and nonreportable annual gifts will be measured both by the amount received by the donee as well as by the aggregate amount given by the donor. B. COMNENTS RELATED TO PROPOSAL 1 1. Proposal 1 Would Prevent Effective Long-term Planning by Trustees and Would Unwisely Discourage the Use of Life Insurance Trusts If adopted, Proposal 1, by validating a withdrawal power as a present interest only if it lasts for the lifetime of the beneficiary, virtually guarantees limitations on the use of trusts for long-term investments, which include, but are not limited to, policies of life insurance. It is difficult, if not impossible, for a trustee to commit funds to a continuing long-term investment for the ultimate benefit of the powerholders/beneficiaries if the accumulated trust property will be subject, year after year, to inva~ion at any time at the whim of a beneficiary. Generally, the annual transfers to a trust with withdrawal powers consist of relatively modest sums, and the typical beneficiary finds it unnecessary to exercise his withdrawal rights on an annual basis. However, as trust assets accumulate and as the property of any beneficiary subject to the nonlapsing hanging power increases in value over a period of years, it is not difficult to imagine a beneficiary's demanding the immediate withdrawal of $100,000 or $200,000--especially a beneficiary whose visions of immediate gratification are more appealing than the rewards of long-term benefits. PAGENO="0716" 706 Investment in long-tern instruments, such as life insurance policies, to accomplish estate planning goals requires reasonable assurances of permanency and continuity. Those assurances will not be possible if *the Congress mandates that the withdrawal power must endure indefinitely. The result is to discourage the use of trusts for long-term investments in estate planning. The value of trusts as a vehicle for investments that willprovide liquidity to an estate at the death of the settlor has long been recognized in estate planning. Such trusts, typical among them being life insurance trusts, make it possible to channel family savings and investments to property that will provide a means for the beneficiaries of an estate to retain small illiquid family businesses, the family farm, or the family home, upon the death of the settlor. The proceeds of such trusts make it possible for the beneficiaries to meet estate tax obligations without forced sales of family assets that will be used productively to support surviving family members. Thus, such trusts particularly of the life insurance variety, not only are responsive to the needs of those family members, but directly assist in, and reduce the government's cost of, estate tax collection. The use of trusts to support such worthwhile purposes should be encouraged through the tax system. The Subcommittee should reject this proposal. 2. Proposal 1 Is Unlikely to Accomplish Its Stated Purpose of Preventing Possession of a Withdrawal Power by Persons Who Have No Other Interest in the Trust, since Few Trusts now Seek to Separate the Trust Beneficiary from the Powerholder We understand that the rationale for Proposal 1 was stated when the same proposal was introduced as an option to increase revenues by the Joint Committee on Taxation in 1987. Page 269 of the Joint Committee Option Paper published June 27, 1987 contains this argument: "One reason for limiting the annual gift tax exclusion to gifts of present interests is to insure that the donee obtains sufficient control over the interest so that the gift does not inure to another person. A power of withdrawal that is effective for only a very short duration does not insure that the gift will not be given to another beneficiary of the trust." The quoted statement appears to stem from a belief that holders of withdrawal rights, or Crumme~ powers (after the case of the same name, 397 F.2d 82 (9th Cir. 1968)), with respect to transfers to trust have no other beneficial interests in such trusts. However, typically, few trust agreements seek to separate the beneficiary of trust property from the powerholder. Indeed, the position of the Revenue Service with respect to this issue, as expressed in Technical Advice Memorandum 8727003 (March 16, 1987), reflects the view that the holder of a Cruinme~y power should have a meaningful beneficial interest ultimately in the trust property. It has been our experience that, in practice, virtually all trusts that involve Crummey powers and that have been formed since the issuance of the TAM comply with the Service's requirements. PAGENO="0717" 707 Typically, a trust may have one or multiple beneficiaries, each of whom may be given an unrestricted power to enjoy his proportionate share of contributions to the trust. Individual powerholders may exercise those powers or allow then to lapse within a stated period of tine. However, whether those powers are exercised or lapse, the powerholder is taxable on the income from the trust property subject to the power of withdrawal. ~ ~ PLR 8521060, February 26, 1985.) If the power hasmeaning sufficient to produce an income tax, it is difficult to perceive that powerholders have no continuing interest in the trust property. There may be trusts in which the administration and management result in no recognizable taxable income, but that does not diminish the effect of the powerholder/ beneficiary's continuing interest in the trust property. It is conceivable that, in 1987, when Proposal 1 was first introduced, the separation of the identity of powerholders and beneficiaries in trust agreements may have been more common. However, at the present time trust agreements typically grant withdrawal powers to the ultimate beneficiaries of the trust property. Thus, this proposal and the argument articulated for requiring a nonlapsing "hanging power," designed as they are to counteract practices that do not seem to exist to any great extent today, are anachronistic. 3. Proposal 1 Seeks Unnecessarily and with Added Complexity to Impose a Duplicative Estate Tax on a Donee/Beneficiary Whose Estate Would Otherwise Most Likely Be Burdened with an Estate Tax Under present law, the property contributed to a trust with a Crummey power will most likely inure to the powerholder/beneficiary and will be subject to the transfer tax system. Therefore, we seriously doubt that enactment of Proposal 1 would raise new revenues by reason of giving greater control over trust property to the powerholder. Under the unified gift and estate tax system, either a portion of the amount subject to the withdrawal power or all of the trust property will be subject to a transfer tax at the death of the powerholder who is a beneficiary. In the typical irrevocable trust situation with multiple beneficiaries, a trust powerholder/beneficiary is designated to receive a ~ rata share of trust property during his or her lifetime, generally, at least, by age 40. Until the time for such distribution, the beneficiary may have an income interest in a portion of the trust property. Since the trust powerholder/beneficiary in most situations (including most life insurancesituations) is the child of the grantor and his spouse, it is more likely than not that this beneficiary will survive both parents and receive the intended ~ ~ share of trust principal (which can often consist of life insurance proceeds). When the beneficiary receives his or her share of the trust property, it augments the beneficiary's estate, which will be subject to taxation at the beneficiary's death. PAGENO="0718" 708 Even if the powerholder/beneficiary dies before the trust property is distributed, under present law there will be a taxable event. To the extent that the power of withdrawal lapses with respect to amounts in excess of the "5 and 5" power, the lapse is a gift transfer from the powerholder to the trust. The property so transferred by the powerholder will be subject to a tax in the beneficiary's estate as if it were a transfer of property held at death. Moreover, if the powerholder/beneficiary is a life income beneficiary, his constructive transfers to the trust through the lapse of his withdrawa,l power (again, with respect to amounts in excess of the "5 and 5" power) would be includible in his gross estate upon his death as a retained right to income. However, Proposal 1 seems to be built on the premise that under current law the holder of the withdrawal power escapes taxation. The proposal, then, by granting a "hanging power" ~ a power that never lapses) over each transfer and a general power of appointment over trust property, ostensibly is designed to "correct" this assumed lapse in the transfer tax system and insure that the donee would pay a tax on the trust assets. The premise, however, is faulty, and the proposal to reconstruct a present interest fails at its objective of finding new and presently untapped sources of tax revenues. It appears to us, therefore, that proponents of Proposal 1 would seek to impose an estate tax burden where in the vast majority of situations one already exists, creating futile and duplicative legislation resulting in very little additional revenue at the cost of increased and esoteric technical complexity. This is not only needless; it is strangely at odds with the Congress's articulated objective of simplifying the tax code. C. COMMENTS RElATED TO PROPOSAL 2 1. Capping the Annual Exclusion Amount Appreciably Increases Gift Tax Burdens for Relatively Small Gifts Under present law a donor may exclude from taxable gifts each year the first $10,000 of gifts of present interests to each donee. There is no limit on the aggregate amount a donor may exclude each year by use of the annual exclusion. We understand that the purpose of an annual per donee exclusion amount is to keep relatively small gifts from burdening the gift tax system. The concept of measuring the exclusion by the amount received by the donee,. which has long been the standard, assures that gifts of insignificant amounts will not be registered for purposes of the gift tax. Proposal 2 would maintain the concept of a $10,000 maximum per.. donee exclusion but cap the annual exclusion amount on the basis of the donor's gifts in the aggregate at $30,000. The practical effect of this proposal, if enacted, would be to sweep numerous gifts of relatively insignificant amounts into the transfer tax system. It would PAGENO="0719" 709 require reporting of heretofore unrecognized levels of gift- giving. When the reportable gifts are measured by the amount received by a donee, no aggregation of gifts to a donee under $10,000 is required. Under the proposal, however, once a donor's.annual gifts approach a value of $30,000, each snail gift for birthdays, holidays, weddings, and the like to every incidental donee takes on added importance because of its potential for overloading the donors maximum annual exclusion. One predictable effect of ~ncreasing the tax burden would be to increase the public's hostility to continuous and chaotic changes in the tax laws, even if the Subcommittee adopted both a maximum and a minimum per donee exclusion. We believe that the public would find the additional burdens imposed by Proposal 2 both confusing and unmanageable, as well as subject to derision, especially when viewed in the context of tax simplification efforts. 2. Capping the Annual Exclusion Amount Discriminates against Large Families Proposal 2 would have disparate effects on persons of relatively equivalent economic circumstances on the basis of potential natural donees. If the donor's reportable gifts were to be measured in the aggregate, Proposal 2 would clearly favor the donor with a small family. Consider, for instance, the effect of this proposal on donors with families of different sizes who have been accustomed to making equal gifts in the amount of the per donee annual exclusion to family members. The donor with six married adult children, each of whom in turn has at least one child, must cut his gift-givingby 75 percent, while a donor with three children would be unaffected by the change inithe law. If enacted the proposal would interfere with the long-term estate plans of the donor with a large family; similar plans of a donor with a small family would be unaffected.~ There is simply no policy justification in treating persons of similar means so differently within the tax system with clearly discriminatory effect 3. Capping the Annual Exclusion Amount Exacerbates the Effects of Inflation For many years limited to $3,000 per donee, the annual per donee exclusion was increased in 1981 to $10,000 to recognize the effect~ of. inflation on ~ minimis gifts. The amount of the exclusion has thus been maintained at the same level for nearly a decade. We estimate that during the same period of time the value of $10,000 has decreased by at least half. ~ Generally speaking, -inflationary pressures would support an increase in the amount excludible from taxation, rather than a reduction. Yet Proposal 2, by maintaining the same level of the p'~ donee exclusion, not only fails to respond to the dislocation caused by these pressures, but also exacerbates them by creating a cap on the aggregate PAGENO="0720" 710 amount of a donor's gifts. The net effect of the cap is to reduce the amount of nonreportable and nontaxable annual gifts and, we believe, to include within the transfer tax system those donors whose relatively small gifts have not previously been considered taxable. The Subcommittee should avoid this result by rejecting Proposal 2. D. COMMENTS APPLICABLE TO BOTH PROPOSALS 1 AND 2 1. Both Proposals Discourage Saving by Individuals and Militate against the Social Policy of Encouraging a Private Death Benefit System Increasing the savings of individuals has been a goal enunciated by successive Administrations, including the present one. Life insurance continues to be an attractive vehicle for individuals to save for their retirement years, for increasing liquidity, and for private death benefits. The existing system of taxation of life insurance encourages savings and makes possible a private death benefit structure consisting of billions of dollars that relieves pressure on the public purse and on private employers.. The Congress, through repeated legislative judgments, has consistently agreed that a life insurance system which, in contrast to other forms of savings, is specifically designed to protect beneficiaries (whether individuals, trusts, or business entities) following a death is of sufficient importance to warrant strong encouragement by the taxing system. Far from removing such, encouragement of saving through life insurance, Proposals 1 and 2 actively militate against life insurance by discouraging the life insurance trust as an estate-planning and savings tool. The proposal appears to be mOtivated by an affirmative intention to create a disincentive for life insurance trusts. It is safe to predict that the combined effect of limiting the annual exclusion for gifts and imposing lifelong withdrawal rights of beneficiaries on contributions' made to life insurance trusts will be drastically to reduce the use of life insurance products in trust. The tradeoff anticipated is of relatively minor budgetary impact (j~, estimated at $33 million per year,, in the Joint Committee Options Paper issued in 1987) considering the large dollar figures with which the Congress is working. The Subcommittee must seriously consider whether the benefits of this private savings and death benefit system can be sacrificed, with the public dissatisfaction that would accompany the adoption of Proposals 1 and 2, for relatively minor amounts of revenue to be gained. 2. Both Proposals Discriminate against Small Business and Farm Owners One of the major functions of the life insurance trust is to provide liquidity to the large, illiquid estate of a farmer or small business owner that is faced with a `large federal estate tax at the death of the survivor of such PAGENO="0721" 711 owner and spouse. Joint and survivor policies are excellent investments for such a trust, since the proceeds of life insurance nay be used to permit the trust to purchase assets from the estate. This technique allows the family farm or the family business to be kept in the family and protects both the family and the business from the devastating effects of losing it through a forced sale. By discouraging a trust's purchase of life insurance, Proposals 1 and 2 would :tend to deprive those institutions of American business--family businesses and family farms--of the major source of the liquidity necessary to support the continuity of family ownership. , There is something intrinsically wrong with proposals that produce such an effect. 3. Both Proposals Add Complexity to an Already Complex. System of Estate and Gift Tax Laws The present unified structure of the estate and gift tax system is highly complex and technical in its interrelationships. Any potential changes to any part of this system require intricate, and often minute analyses to determine what effect those changes will have on other provisions of the system and whether the system can accommodate them. It is difficult enough for experienced tax professionals to maintain some semblance of understanding of this continually changing system (witness the speculation engendered by the enactment of section 2036(c) and its amendments and the new generation-skipping tax provisions, for example); it is literally impossible for members of the public to do so.' The Revenue Service itself is' no exception, being well behind in issuing explanations or promulgating regulations for new and complex Code provisions It is unreasonable for the COngress to anticipate that the portion of the public affected by modifications to the estate and gift tax laws will either be able or amenable to conform its estate planning to continual changes: to already complex estate and gift tax rules. Changes of such far-reaching nature as those embodied in Proposals 1 and 2 impede, both individuals and businesses ` from planning meaningful and' responsible future courses of action that are often required to meet the burdens of taxation by thosevery laws that are in constant flux. We suggest that the costs of increasing complexity and confusion by adopting Proposals 1 and 2 are too great to incur in exchange for the relatively minor revenue gains anticipated, and we urge the Subcommittee to reject these proposals. PAGENO="0722" 712 February 28, 1990 Mr. Chairman and Members of the Subcommittee: We are submitting this written testimony as individuals. Although we are committee members, committee chairs, council members or officers of the Real Property, Probate and Trust Law Section of the American Bar Association or of the Section of Taxation of the American Bar Association, this testimony contains the views of the undersigned in their individual capacities only. The testimony is not filed on behalf of either Section or the American Bar Association. The testimony is with respect to miscellaneous tax proposals before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means on which hearings were held on February 21-22, 1990. The testimony deals with proposed estate and gift tax changes set forth in the Explanation of Miscellaneous Tax Proposals prepared by the Staff of the Joint Committee on Taxation, February 14, 1990 ("the Explanation"). At its Annual Meeting in August, 1988, the House of Delegates of the American Bar Association adopted a resolution calling for stability in the transfer tax system. This written testimony is, therefore, consistent with the current American Bar Association position which recognizes the fundamental need for stability in the transfer tax system. 1. Cap on State Death Tax Credit. The proposal would cap the State death tax credit at 8.8%, eliminating the credit at higher percentages available to estates exceeding $3,000,000. The current maximum credit is 16% for taxable estates exceeding $10,100,000. Historical Background. The state death tax credit * originally was enacted to discourage certain states from lowering their state death tax rates or repealing their state death tax * entirely as an incentive to encourage the migration of wealthy persons to those states. In the 1920's, both Florida and Nevada repealed their state death taxes, allegedly for the purpose stated above. The state death tax credit removed this incentive by allowing decedents in other jurisdictions to divide their tax burden between the Federal government and the state, while decedents in low or no death tax states paid their full Federal estate tax. Policy Considerations. In support of the existence of the state death tax credit is its lengthy tenure in the estate tax law, having first been enacted in 1924. Moreover, most states now utilize a form of "pick-up" tax which is dependent upon the Federal state death tax, credit. The move by many states to a pick-up tax system has resulted in more uniformity among the states, a significant easing in the administrative burden both on state tax departments and on decedent's estates, and a corresponding furtherance of the oft-stated poliOy of - * simplification of the transfer tax system. Larger societal goals of efficiency and economy are furthered to the extent states no longer are required to maintain, or, in other cases, have been able to scale back, bureaucratic structures which existed for the sole purpose of administering complex death tax structures. With the current level of the state death tax credit many states, as mentioned above, have eliminated their state inheritance taxes in favor of a pick-up tax, thereby greatly simplifying estate administration. ~ Recommendation. The state death tax credit should be left at its current level to avoid states reverting to the introduction of inheritance tax systems which would greatly increase state bureaucracy and estate administration complexity. PAGENO="0723" 713 2. Limitation on Annual Exclusion. The proposal would retain current law with respect to allowing a $10,000 per donee annual exclusion from gift tax, but would impose .a cap on excluded transfers of $30,000 per donor per year. Thus, if the proposal is implemented, a donor with four children either could give $10,000 to each of three children or could give $7,500 to each of four children. Moreover, this would leave no annual exclusion amount for the donor to set aside in UGMA or UTMA custodianship or trust accounts to assure the education of his several grandchildren. Historical Persnective. The original purpose of the annual exclusion from gift tax was to "obviate the necessity of keeping an account of and reporting numerous small gifts and * * * to fix the amount sufficiently large to cover in most cases wedding and Christmas gifts and occasional gifts of relatively small amounts." H. R. Rep. No.708, 72nd Cong., 1st Sess. 29 (1932). The amount of the annual exclusion has varied over the years, with the initial exclusion amount set at $5,000 for gifts made prior to January 1, 1939. That amount was reduced to $4,000 for gifts made between January 1, 1939 and December 31, 1942, and then further reduced to $3,000 for gifts made after December 1, 1942 and before January 1, 1982. The amount was increased to its present level of $10,000 for gifts made after December 31, 1981. While the historical purpose of the annual exclusion was the reduction of the administrative burden involved in tracking and taxing small. gifts, the House Ways and Means Committee Report on the Estate and Gift Tax Reform Act of 1976 also appeared to consider the annual exclusion to be an incentive for making lifetime transfers (to modestly offset repeal by that Act of the separate gift tax. lower rates which had been an incentive for lifetime transfers in favor of our present unified transfer tax system). H.Rep.No.94-l380, 94th Cong., 2nd Sess. 12 (1976). Policy Considerations. In support of the annual exclusion is the initial policy consideration of avoiding the necessity of tracking and taxing "small" transfers. Many believe that it is undesirable and intrusive for the government to tax transfers of a "personal" nature, such as wedding, birthday, and Christmas gifts. Enactment of a tax that purported to tax such transfers would result in widespread failure to comply, with a resultant undermining of the transfer tax system. While the setting of the amount of the, annual exclusion is. a political decision, arguably there is historical support for the current level of $10,000. As noted above, the original annual exclusion amount was $5,000 for transfers made prior to 1939, and $4,000 for transfers made between 1939 and January 1, 1943. It is most likely that amount, adjusted for inflation, would exceed the current level. The 1981 rise in the level from $3,000 to $10,000 was a recognition by congress of "the substantial increases in price levels since (1942)." H.Rep.No.97-201, 97th Cong., 1st Sess. 193 (1981). Recommendation. The present structure of the annual exclusion as a per donee exclusion is consistent with the original policies which led to the enactment of the annual exclusion, and the current level can' be justified as a realistic, reflection of changed economic conditions since the enactment of the original statute. It should be left as it is. It has historically been a per donee exclusion and should'not be altered. Changing to a. per donor exclusion is inconsistent with avoiding the undesirable and `intrusive taxing by the government of relatively small transfers of a "personal nature" where the $30,000 per donor exclusion has been exhausted. PAGENO="0724" 714 3. Present Interest Requirement. As described in the Explanation, the proposal would revise the Crummey doctrine to provide that a gift of property in trust which is subject to a right of withdrawal would be treated as a gift of a future interest unless the right of withdrawal lasted for the lifetime of the donee (or, presumably, termination of the trust, whichever~ occurs sooner). Note that the press release described the proposal as requiring both a continuing right of withdrawal ~ the possession by the donee of a general power of appointment. According to a telephone conversation with a member of the staff of the Joint Committee,~thelatter requirement was dropped in the Explanation because the staff had been advised that both requirements "were unnecessary." Historical Background. To qualify for the annual exclusion from gift tax, a gift must constitute a "present interest." The Committee Reports to the Revenue Act of 1932 indiôate that the annual exclusion should be "available only insofar as the donees are ascertainable at the time of transfer, and that the exclusion must be denied in the case of future interests because of the apprehended difficulty, in many instances, of determining the number of eventual donees and the values of their respective gifts." H.Rep.No.708, 72nd Cong. 1st Sess. 29 (1932). The question as to whether gifts to trusts could (and should) constitute "present interests" has enjoyed a long debate. From 1939 to 1942, the annual exclusion was not available for transfers to trusts. Prior Proposal. American Bar Association Legislative Recommendation No. 1958-11 (a copy of which is attached) suggested that the Internal Revenue Code be amended to allow the annual exclusion with respect to "any gift where the donee is identifiable, even though possession and. enjoyment of the gift by such donee may be postponed until a future time." It was proposed that § 2503(c) be amended to include transfers to all persons (deleting any reference to minors or persons under the age of 21), that §~ 2503(c) (1) and (2) be deleted, and that the language of § 2503(c) be amended to provide that a gift shall not be considered a gift of a future interest if the property and all of its income "will, to the extent not distributed to or expended by, or for the benefit of, the donee during his life, be payable on his death either to his estate, or as he may appoint under a general power of appointment as defined in Section 2514 (C) ." The Recommendation argued that the original purpose of the present interest requirement (determining the number of donees and the values of their gifts) could be preserved so long as the property given to a donee would be used for the exclusive benefit of that donee during his or her lifetime and would be subject to Federal estate tax upon the donee's death. Under the Recommendation, gifts over to third parties would be permitted so long as the property was taxable inthe estate of the original donee. Recommendation. American Bar Association Legislature Recommendation No. 1958-11 should be supported. If the Recommendation is not accepted, mandating a general power of appointment will be sufficient to satisfy concerns about the abuse of Cruimney powers and is preferable to requiring a continuing right of withdrawal. A continuing right of withdrawal is not necessary to achieve the transfer tax goals sought and nullifies many of the legitimate non-tax reasons for having property in trust and beyond the reach of the beneficiary and the beneficiary's creditors. The treatment of a continuing right of withdrawal and a section 2041 testamentary general power of appointment in the hands of the donee are the same in all significant respects for gift and estate tax purposes. Effective Date Issues. The Explanation proposes the date of Committee action as the effective date for both gift tax provisions. Due to the extensive reliance on the annual exclu- sion by estate planning practitioners and by individuals who do PAGENO="0725" 715 not seek the advice of counsel with regard to such gifts, as well as the existence of countless trusts which are funded on an on-going basis with annual exclusion gifts subject to Crummey powers, a prospective effective date should be selected. Preferably, a date no earlier than the January 1 following the date of enactment should be chosen to reduce the substantial risk of inadvertent noncompliance. Moreover, existing trust arrange- ments should be grandfathered with respect to contributions made even after the effective date. A retroactive date affecting future contributions to an irrevocable trust is unfair where an irrevocable trust needs future funding to meet the initial planning objectives or avoid an economic loss. The terms of an irrevocable trust cannot now be changed to comport with changes in the law We appreciate the opportunity afforded us to submit this written testimony. John J. Lombard, Esq. 2000 One Logan Square Philadelphia, PA 19103 215/963-4922 John A. Wallace, Esq. 2500 Trust Company Tower Atlanta, GA 30303 404/572-4600 Stephen E. Martin, Esq. P.O. Box 129 Idaho Falls, ID 83402 208/523-0620 Lloyd Leva Plaine, Esq. Suite 800 1275 Pennsylvania Avenue, N.W. Washington, D.C. 20004 202/383-0155 Lynn P. Hart, Esq. 3 Embarcadero Center * San Francisco,, CA 94111 415/434-1600 PAGENO="0726" 716 ABA LEGISLATIVE RECOMMENDATION No. 1958-11 APPLICATION OF ANNUAL GIFT TAX EXCLUSION TO CERTAIN GIFTS OF FUTURE INTERESTS Resolved That the American Bar Association recommends to the Congress that the Internal Revenue Code-of 1954 be amended to allow the $3,000 annual gift tax exclusion with respect to any gift where the donee is identifiable, even though possession and enjoyment of the gift by such donee may be postponed until a future time; and Be It Further Resolved, That the Association proposes that this result be effected by amending section 2503(c) of the 1954 Code; and Be it FurtherResolved, That the Section of Taxation be directed to urge the following amendment or its equivalent in purpose and effect upon the proper committees of Congress. Sec. 1. Section 2503(c) of the Internal Revenue Code of 1954 is amended to read as follows (eliminate matter struck through and insert new matter in italics): (c) Ta~',risren roe mc Bcucrrr orMmee CERTAIN TRANSFERS NOT CON- SIDERED FUTURE INTERESTS-NO part of a gift to-an individual who has not attained the age of 21 yeats en the date of such transfer shall be considered a gift of a future interest in property for purposes of subsection (b) if the property and the income therefrom will, to the extent not distributed to or expended by. or for the benefit of, the donee during his ljfe, be payable on his death either to his estate, or as he may appoint under a general power of appointment as defined in section 2514(c). (1) may be ettpended by, er for the benefit of, the dance before his attaining the isge of 21 yeors-asd ~-will to the entent not so espended ~ u `lie deere on hisatsainina the ace of 21 years, and eat-the donéed~s netore anatmng be-payable to use estate efthe doneeerasise may appetnt under a general powerof appointment as defined in section 21-l4(e} Sec. 2. Effective Date. This amendment shall be applicable to all gifts made aubsequent to the date of its enactment. EXPLANATION Summary This will grant the annual $3,000 gift tax exclusion to all gifts of future - interests (to both minors and adults) where the property will be used solely for the benefit of a specified donee during his life and the remainder of the property, if any, will on his death, be incltided in his gross estate. Section 2503(c) of the 1954 Code (the so-called giftstominors provision) will be amended to eliminate the present requirement foiz,distribution to the donee stage 21 and to permit a gift-over to third persons should the donee die prior to termination of the interest. Discussion Criticism of § 2503(c) has been directed mainly to its requirement for complete distribution at age 21 and to the impossibility of providing for a gjft-over to a third person upon the minor's death prior to termination. Congress has told us that the original purpose of the future interest exception to the annual exclusion was the "apprehended difficulty, in many instances, of determining the number of eventual donees and the values of their respective gifts." This policy can be preserved, however, no long as the property given to a donee will be used by or for him alone during his life and will be subject to federal estate tax at his death. It should not be material when the donee will receive the benefit from the property or who will receive it after his death. Under this approach the donor could provide for termination at any particular age or even run the trust through the donee's entire lifetime. He could (but need not) provide for gifts-over to third persons on the donee'n death, so long as the property was includible in the donee's gross estate. Minor and adult donees would thus be treated alike. The proposal would apply to gifts whetheroutright to, or in trust for the benefit of, the donee and whether the donee is a minor or an adult. It is not intended that this amendment provide an exclusive method of creating a present interest. Nor is it intended to affect the application of the annual exclusion to outright gifts, whether or not the donee is under disabilities arising under local law by reason of minority or otherwise. No retroactive application is sought. PAGENO="0727" 717 Written Testimony House Ways and Means Subcommittee on Select Revenue Measures Proposed Cap on State Death Tax Credit for Federal Estate and Gift Tax I understand your committee, House Ways and Means Subcommittee on Select Revenue Measures, is considering a proposal to cap the State death tax credit for federal estate and gift tax at 8.8%. As estate tax administrator for the State of Wyoming, would encourage your opposition to this change. In Wyoming our sole estate tax for decedents with a date of death after January 1, 1983, is a "pick-up" or "sponge" tax equal to all or a portion of the federal state death tax credit. Although by some standards our collections (as indicated below) are not large, they are an important contribution to the general fund of the State of Wyoming. In light of the fiscal stress facing many states, including Wyoming, reduced federal aid along with increasing mandates on state and local governments, now is an extremely inappropriate time to reduce state revenues in any manner, no matter how "insignificant" that reduction may appear. The proposed cap disrupts a balance and coordination that has been present in the state-federal death tax system for almost fifty-five years. It is in addition not really a substantive tax policy change but rather merely a shift in revenue from the states to the federal government, quite possibly in an attempt to increase revenues without increasing taxes. The unfortunate victims of such achange would be almost all states and their citizens. Once again, I would strongly encourageyo opposition to this proposed 8.8% cap on the federal credit for state death tax. Thank you. ThomasD Roberts * Estate Tax Administrator State of Wyoming P. 0. Box 448 Cheyenne, WY 82003-0448 307/777-5206 Estate Tax Collections, Wyoming * Fiscal Year Collections 1983 $3,193,431 1984 * 2,769,433 1985 9,408,208 1986 3,581,998 * 1987 3527570 1988 1,456,716 1989 *1,704,236* PAGENO="0728" 718 STATEMENT OF RENE ANSELMO, CHAIRMAN PAN AMERICAN SATELLITE BEFORE SUBCOMMITTEE ON SELECT REVENUE MEASURES HOUSE WAYS AND MEANS COMMITTEE March 9, 1990 I am Chairman of Pan American Satellite ("PAS") which is the first privately-owned international communications satellite system. I appreciate the opportunity to submit testimony on the need to clarify and update Section 1071 of the Internal Revenue Code ("Section 1071") as it applies to a new, emerging telecommunications industry in the United States. Section 1071 was enacted in 1954 and authorizes the deferral of taxable gain from the "sale or exchange" of property when the "sale or exchange" is necessary and appropriate to effectuate a new or changed policy of the Federa~ Co~nications Commission ("FCC") with respect to the .~ownership and control of "radio broadcasting stations." 26 U.S.C. § 1071(a). ~The changes I propose are designed to end the haphazard, inconsistent application of Section 1071 which has created a veritable crazy quilt of case law on the subject. As discussed in more detail below, I believe there is a need to clarify Section 1071 in two principal ways: 1. The term "radio broadcasting stations" should be changed to reflect not only the technological advances in the telecommunications industry that have taken place since the 195Os, but also the expanded interpretation adopted by the FCC. There is a confusing divergence between the plain meaning of the term and the way the FCC has applied it. The FCC has, from time to time, enlarged the term to include television broadcasting networks, telephone companies, cellular radio systems, and cable television systems. This has led to confusion and inconsistency in the application of Section 1071. Accordingly, I recommend that the term "radio broadcasting stations" be amended to include new communications services regulated by the FCC. This will bring the law into conformity with existing FCC practice as well as with the technological advances made in the nearly thirty-six years since the law was originally drafted. 2. The statutory term "sale or exchange of property" should similarly be amended to encompass the reinvestment of proceeds from a sale or exchange of property if the reinvestment effectuates a new or changed FCC policy. Here again, the statute has been applied in a confusing, inconsistent manner. This has resulted in an ambiguity that requires clarification. While the legislative history for Section 1071 is scant, its principal purpose is to promote a competitive market structure. Consistent with this, the FCC has granted tax certificates for transactions that further this policy goal of promoting competition. The FCC's position on whether causality is required and whether the reinvestment of sales' proceeds qualifies for a tax certificate is unclear. Accordingly, I urge that this question be resolved by making it clear that a reinvestment of sales' proceeds qualifies for a tax certificate as long as the reinvestment fosters a new or changed FCC policy. I have an interest in this because I have been a part of the development of new U.S. policy to promote competition in international satellite communications. I believe the proposed statutory changes are in the national interest and my own situation illustrates the point. I was a founder and the president of the Spanish International Netowrk ("SIN") which pioneered the establishment of Spanish-language television in the U.S. I also held ownership interests in PAGENO="0729" 719 several Spanish-language television stations of the Spanish International Communications Corporation ("SICC".). I sold my 51CC interests in 1988 and, in order to obtain FCC~launch authority,* committed the proceeds to PAS, the first international satellite venture to compete against the Intelsat monopoly. Because the venture implemented the new U.S. policy to promote competition in international satellite communications, and given the enormous cost of the venture, I applied to the FCC for a Section 1071 tax certificate in March 1988, so that I could defer the gain on my stations' sale which had been reinvested in PAS. That request remains pending. Hopefully, this congressional review of the statute will leave little doubt that Section 1071 was meant to cover situations like my own which clearly serve our national and international competitive interests. My commitment to creating a competitive market stemmed from my own experience as a television broadcaster. At the time this policy was being debated and subsequently adopted, I was involved in television broadcasting. As a broadcaster, I saw the efficiencies and technical advantages of transmitting television signals by satellite. Accordingly, SIN was the first television network to use satellites to. transmit its programming in the U.S. I became extremely frustrated, however, when I tried to transmit programming by satellite internationally, particularly to South America where SIN news programs were in great demand. At the time, there was only one provider of international satellite services, Intelsat, which had little interest in or suitable capacity for carrying such television programming. When the U.S. government adopted a new policy to open up this international market to alternatives to Intelsat, I stepped up and decided to help implement this much-needed pro- competitive policy. I. Section 1071 Of the Internal Revenue Section 1071 authorizes the deferral of taxable gain from the sale or exchange of property when the sale is "necessary or appropriate" to effectuate a new or changed FCC policy with respect to the ownership and control of "radio broadcasting stations." Since Section 1071 was enacted, dramatic and innovative technological advances beyond radio broadcasting have taken place in the field of telecommunications which have completely revolutionized the way in which the world communicates. These changes have had a profound effect on the world's economy and politics as they have enhanced the free flow of information and ideas among nations. To a certain extent, application of Section 1071 has evolved to reflect the innovations in telecommunications technology. For example, the term "radio broadcasting stations" has beOn interprnted by the FCC. ~to include not only radio stations, but also new technologies such as television broadcasting networks, telephone companies, cellular radio systems and cable television systems. I believe Congress should make it clear that, given today's communications environment, "radio broadcasting" should encompass any regulated FCC service such as international satellite communications. While this interpretation appears to be consistent with prior cases in which the term "radio broadcasting" has been expanded and updated to include new *See Pan American Satellite, 2 FCC Rcd 7011 at ¶6 (1987) ("based on PanAmSat's assertion that it was awaiting final Commission approval of the sale of the various television broadcast stations owned by . . . SICC . . . the proceeds from which are essential to completion of PanAmSat's financing.") PAGENO="0730" 720 communications industries that did not~ex±st at the time Section 1071 was enacted. As a result of the uncertainty surrounding the definition, however, there is a need to clarify the scope of Section 1071 as it applies to new communications industries such as international satellite systems. Section 1071 tax certificate-policy has developed in an interesting, somewhat confusing, manner. The FCC has revised its tax certificate policy several times over the years, often in response to federal court decisions. Originally, the FCC only issued tax certificates.totaxpayers who were expressly ordered to dispose of overlapp~ing ownership of broadcasting properties. In 1969, this interpretation was expanded when a federal court found that a sale need not be ordered by the FCC or be involuntary to be eligible under Section 1071. Jefferson Standard Broadcasting Co. v. FCC, 305 F. Supp. 744 (W.D.N.C. 1969). The court ruled that a certificate should issue because the èale was appropriate, even though not necessary, to further or effectuate new or changed FCC policy. Accordingly, the FCC has issued tax certificates for voluntary or. involuntary sales which further new or changed policies or are the result of "practical economic necessity" in light of new or changed FCC policy. ~ Continental Telephone Corp., 51 FCC 2d 284, 288 (1975); Pierson, Ball & flQ~Lç~, 36 RR 2d 1507 (1976). While the FCC has issued somewhat contradictory decisions on the issue of "causality," Section 1071 has also been interpreted to apply whether or not a sale is caused by a change of policy. See Public Notice, Issuance of Tax Certificates, 59 FCC 2d 91 (1976). The Internal Revenue Service has specifically accepted the view that causality is not required. ~ General Counsel Memorandum re Rev. Rul. 78-269, G.C.M. 37,430 (Feb. 28, 1978). Thus, applicants have qualified for tax certificates when a sale of property has effectuated or promoted a new or changed FCC policy regardless of whether the sale was caused by or was the result of the new or changed policy. The FCC has also used Sectfron 1071 to encourage minority ownership of broadcast facilities by issuing tax certificates to licensees who sell to minority broadcasters. This policy was adopted to provide an incentive to transfer a broadcast station to a minority-owned or controlled entity. ~ ~ Minority Ownership in Broadcasting, 52 RR 2d 1469 (1982). In recent years, the FCC has awarded a tax certificate for transactions which were analagous to reinvestments of proceeds, and which effectuated or promoted new or changed policy. Thus, it appears that the use of the funds from a sale, rather than the sale itself, may effectuate or promote new FCC policy and thereby qualify for a tax certificate. ~ ~ Minority Ownership in Broadcasting, gpp~; in»=~ Certificates (Nonwireline Cellular Transf~rmI, 58 RR 2d 1443, 1448 (1985). II. A Case Study--New International Communications Satellite Systems Policy A. ~ç~çground In 1984, over twenty years after the international telecommunications industry was established on a monopoly model, the U.S. government determined that "international communications satellite systems are required in the national PAGENO="0731" 721 interest." Presidential Determination No. 85-2 (Nov. 28, 1984). This marked the hope of a new era of competition in worldwide satellite communications. Heretofore, international satellite communications services were provided by Intelsat, an international consortium of national, largely foreign government-owned, telecommunications monopolies known as postal, telegraph and telephone entities or PTT5. The determination to authorize private, competitive satellite systems was endorsed by Congress in 1985. Foreign Relations Authorization Act, FY 1986-1987, Pub.L. 99-93 S 146, 99 Stat. 425-26 (Aug. 16, 1985). The Federal Communications Commission ("FCC") subsequently adopted new policies and procedures to implement this determination to establish and promote U.S. competition in the international satellite communications marketplace. PAS was the first U.S. company to implement this new telecommunications policy. Until PAS was in operation, there had never before been a private U.S. international satellite communications system. The PAS satellite was built in the U.S. and was launched in June 1988. It provides primarily television, video, data, electronic mail :and facsimile services linking up the U.S., Latin America and Europe. A second private company has been authorized. These companies and future systems like them will provide consumers with competitive alternative choices for the first time in fulfillment of newly adopted telecommunications policy. While the development of this new industry may seem slow, we must consider not only how difficult it is to introduce competition for the first time in an historically monopoly-controlled marketplace, but also the inherent natural obstacles and barriers to entry. Launching a satellite requires a very long lead time. For example, it typically takes approximately three to four years to construct a satellite. In addition, satellite launches have become extremely expensive and difficult to obtain since the Challenger disaster and the other subsequent launch failures ~ Arianespace). These difficulties are compounded by the large capital requirements, lack of financing, and the requirement to undertake coordination with the Intelsat system and to obtain the cooperation and authorization of foreign governments and their telecommunications monopolies. The first entrants into the market encounter formidable obstacles and delays in terms of capital requirements, regulatory requirements and foreign trade barriers. The international market is controlled by foreign government- owned telecommunications monopolies which vigorously opposed U.S. policy creating a competitive market. Before U.S. satellite systems can operate in foreign markets, they must obtain the authorization and approval of these very same foreign entities. In sum, entry into this marketplace, particularly for the first time, has been extraordinarily time-consuming and cumbersome. B. Benefits to the U.S. This new telecommunications policy to introduce private U.S. competition in the international satellite communications market is vital to U.S. interests. Looking only at international telephone calls, in 1988 alone, the U.S. had a deficit of $2 billion in favor of foreign PTT5. This accounted for 2% of the total trade deficit in 1988. In its first year in operation, PAS has seen the trade benefits this industry promises for the U.S. In addition to the direct revenue PAS brings to the U.S. when it leases a channel or circuit to a foreign customer, there are many indirect benefits. There is a substantial market for PAGENO="0732" 722 telecommunications equipment and services which is tied to a U.S. satellite such as PAS. For example, in 1989, our first year in operation, our sale of satellite capacity to two foreign telephone companies led to $36 million in purchases of earth stations (satellite dishes) from U.S. companies. This can be compared to total earth station exports of $37 million in all of 1988--prior to the inauguration of the international satellite system industry in the U.S. Similarly, U.S. customers of PAS ~ CNN, ESPN) earn hard revenues in foreign markets in the form of program license fees from distribution of their networks abroad. Advertisers in those networks also extend their market reach abroad. This is all in addition to the benefit to U.S. companies who can use PAS' low cost, operationally-flexible satellite capacity in their businesses to compete mOre effectively in the world market. Thus, new U.S. telecommunications satellites will foster the economic and technological growth of the U.S. telecommunications industry and help achieve a more open world trading market. C. Application of Section 1071 In 1985, pursuant to the Presidential Determination, the FCC initiated an inquiry and rulemaking regarding private international satellite systems. 50 Fed. Reg. 1570 (1985). In its Separate Systems Decision, the FCC adopted new policy and procedures relating to the establishment of a competitive market structure for international satellite systems. Separate Systems Decision, 101 FCC 2d 1046 (Sept. 3, 1985). The FCC received several applications for construction and operation of such systems. The FCC recognized that the speculative nature of launching and establishing a competitive international satellite system, coupled with the need to undertake the cumbersome process of coordination with Intelsat and to obtain the cooperation and authorization of foreign governments and their telecommunications monopolies, would make financing such a satellite system difficult. Accordingly, it adopted very strict financial standards requiring an international satellite system to affirmatively demonstrate its "financial responsibility" before the FCC would authorize the construction, launch and operation of a satellite. The FCC did not grant the license to PAS until I formally pledged the proceeds from the sale of SICC broadcast properties to the satellite project. This new satellite policy should be considered a policy relating to the "ownership and control of radio broadcasting stations" for purposes of Section 1071. Moreover, the reinvestment of the proceeds of the stations' sale to fund the satellite venture should be considered part of the "sale or exchange" of properties to effectuate new policy. Although Section 1071 appears to apply here, the outdated terms of the statute, coupled with its inconsistent and often contradictory application, call for clarification in two ways: 1. update the term "radio broadcasting stations"; and 2. include reinvestment of sales proceeds within the scope of the statute. As previously discussed, the term "radio broadcasting stations" has been substantially expanded on an ~ )~g~ basis to include new technologies. Thus, as communications technology has developed and expanded, so has the application of Section 1071. Prior to the Separate Systems Decision, competitive U.S.-owned international satellite systems were not authorized. The FCC's licensing procedures and policies to authorize, for the first time, the construction, launch and operation of international communications satellite PAGENO="0733" 723 systems, directly relate to "ownership and control" of the systems. Moreover, noting that the legislative history of Section 1071 is "relatively, sparse," the FCC has stated that "the principal goal of the provision is to facilitate the promotion of a competitive market structure. . . ." ~ç Certificates (Nonwireline Cellular Transfers), 58 RR 2d 1443, 1448 (1985). The new FCC policy authorizes private ownership of international satellite systems for the first time. This amendment will assist PAS by allowing the deferral of taxes due on the capital gains derived from the sale of television stations because the proceeds of the stations' sale were fully and immediately reinvested in the PAS project. It creates opportunities for other companies entering the newly- opened international satellite communications marketplace and will encourage reinvestment of the proceeds from a sale of - broadcasting interests in international communications satellite systems. This unquestionably will facilitate the promotion of a competitive market structure for the first time in furtherance of new U.S. telecommunications policy. III. Revenue Impact There should be no significant revenue loss to the Treasury as a result of the proposed changes. The tax certificate does not eliminate or forgive the obligationsto pay the tax but rather allows the taxpayer to defer such payment for a period of time or to reduce the basis of a depreciable asset so that the tax is collected by the Treasury over several years. In fact, the revenue estimate for this provision shows it to be revenue-neutral over a four-year period. While this results in a revenue loss in the first year, there is a revenue gain in each subsequent year. Any revenue loss would be negligible, particularly given the national interest in establishing a competitive international market structure for the first time, as well as the offsetting benefits in terms of balance of telecommunications trade, increased economic activity, and the expansion of U.S. telecommunications industries globally. The experience of my company in its first year of operation clearly tells the story of how the U.S. will gain from a competitive market. PAS' foreign sales have led directly to foreign purchases from other U.S. vendors of related high technology equipment such as earth stations, resulting in more export revenues to the U.S. and creating substantial ~ economic activity which should lead to increased tax revenues. IV. Conclusion As a result of inconsistencies in the award of tax certificates, there is a need to clarify the scope of Section 1071 as it applies to new U.S. communications industries such as international communications satellite systems. The changes advocated will clarify the FCC's authority to use Section. 1071 to implement important new ventures which foster new or changed FCC pro-competitive policies. The amendment allows a tax deferral and provides use of working capital during the critical start-up stages of such new, capital- intensive industries. In conclusion, this amendment will update Section 1071 to reflect technological developments and effect new policy to establish a competitive international market. In view of these considerations, I urge that the Committee favorably consider the proposed amendment to clarify Section 1071. PAGENO="0734" 724 March 9, 1990 WRITTEN STATEMENT OF AVATAR UTILITIES INC. SUBMITTED TO THE SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS U.S. HOUSE OF REPRESENTATIVES IN CONNECTION WITH THE FEBRUARY 22, 1990 HEARING ON CONTRIBUTIONS IN AID OF CONSTRUCTION Mr. Chairman and Members of the Subcommittee: My name is Robert B. Gordon, and I am President of Avatar Utilities Inc. ("Avatar"). We appreciate this opportunity to share with this Subcommittee our views on the appropriate Federal income tax treatment of contributions in aid of construction ("CIACs"). Avatar is an investor-owned public utility providing water and wastewater service to a wide range of residential, commercial and industrial customers in small and medium-sized communities in Florida, Indiana, Michigan, Missouri, and Ohio, having a combined population of over 500,000. These communities range in size from small towns such as Brunswick, Missouri, with a population of 1,500, to medium-sized metropolitan areas such as the Jeffersonville/New Albany area of Indiana, where service is provided to a population of 100,000. We operate 37 water and 15 wastewater treatment plants servicing about 142,000 water and 41,000 wastewater customer accounts. In addition, we provide gas service to one community in Florida. Regulated public water utilities are highly capital-intensive businesses. Traditionally, they have obtained a substantial portion of the capital needed for the construction of facilities through CIAC5, rather than by accessing the equity or debt markets. Absent CIAC5, the only way of building facilities is by passing the cost to the general body of consumers. Thus, the Federal income tax treatment of CIAC5 has a direct impact on Avatar and our ability to serve water consumers effectively and economically. We strongly support H.R. 118, which would treat CIAC5 as they have historically been treated by the Congress and the courts: as contributions to capital which are excluded from the gross income of regulated public utilities. H.R. 118 would repeal the amendment to section 118(b) of the Internal Revenue Code enacted in the Tax Reform Act of 1986 (the "1986 Act") *and reinstate in its place prior law section 118(b). We are very concerned by the adverse economic impact which the 1986 Act change has had on our company, particularly because this change is contrary to basic principles of tax policy, regulatory policy and, more broadly, public policy. In the water and wastewater arena, the 1986 Act is having the adverse effect of driving customers away from investor-owned public utilities and toward municipal systems or individual wells or septic systems. This result has a negative impact on Federal, state and local tax revenues. In the PAGENO="0735" 725 case of individualized systems, it also may have a negative environmental impact. ~~al and Legislative Background In general, contributions to the capital of a corporation, whether or not contributed by a shareholder, are not taxable. CIAC5 were so treated from the earliest days of the Federal income tax law. In cases such as Appeal of Liberty Light & Power Co., 4 B.T.A. 155 (1926) ("Liberty Light"), the Board of Tax Appeals held that amounts contributed by customers to a public utility for the cost of constructing service lines to enable the customers to be served were to be treated as contributions to capital, and not as income, to the utility. In a 1958 ruling, the Internal Revenue Service announced that it would continue to follow the case law with respect to CIACs to regulated public utilities. Rev. Rul. 58-555, 1958-2 C.B. 25. In 1975, however, the IRS revoked its 1958 ruling, withdrew its acquiescence to the cases, and held that amounts paid by the buyer of a home in a new subdivisiOn as a connection fee to obtain water service were includable in the utility's gross income. Rev. Rul. 75-557, 1975-2 C.B. 33. In response to the 1975 ruling, Congress in 1976 amended section 118 to assure continuation of the historic treatment of CIAC5: Contributions in aid of construction to regulated public water and wastewater utilities, such as Avatar, were treated as nontaxable contributions to capital. Congress provided that a water or wastewater utility that receives CIAC5 was not entitled to depreciation deductions or investment tax credits on property acquired through such contributions. Importantly, connection fees remained fully taxable. In 1978, Congress extended to gas and electric utilities the same treatment of CIAC5 accorded to water and wastewater utilities. Thus, prior to the 1986 Act, section 118(b) of the Code provided that a CIAC to a public utility such as Avatar would be treated as a contribution to capital and would be exempt from tax if certain qualifying requirements were met, including a requirement that the CIAC be excluded from the utility's rate base for rate- making purposes. Further, since the utility was precluded from claiming either tax depreciation or the investment credit with respect to the CIAC property, the CIAC had no effect on the utility's tax liability in the current or any subsequent year and therefore the Federal income tax treatment of CIACs had no effect on rates charged to consumers. The 1986 Act retained the general rule that contributions to the capital of a corporation are tax exempt, but provided that CIAC5 are excepted from the general rule and so are taxable. The effect of the 1986 change is to tax us on the CIAC in the year we receive the contribution, and then allow us to depreciate that amount over future years. Thus, the economic burden of the 1986 change can be measured by the difference between the total tax we pay oh a CIAC and the net present value of our future tax savings from the depreciation of the CIAC. In 1986, the Ways and Means Committee stated that it "believes" CIACs amount to prepayments for future services to be received by the contributor. Congress held no hearings on section 118 and gave no explanation PAGENO="0736" 726 for this belief and the resulting departure from the historic exclusion of CIAC5 from income. Like other public utilities, Avatar is a regulated company. Generally, public utility commissions do not require the tax on CIAC5 levied by the 1986 Act to be borne by our shareholders. Instead, the CIAC áontributor now must make a substantially larger contribution than he or she would have made prior to the 1986 Act in order to reimburse us for the additional tax burden. And the contributor must also reimburse us for the "tax on the tax" which is reimbursed. If the CIAC contribution were not "grossed up" in this manner, we would ask the regulatory commission to increase general consumer rates to fund the added tax burden levied on the utility. Either through the reimbursement mechanism, or an increase in rates, the 1986 Act directly and substantially increases the cost of providing utility services to our customers. Reasons for Excluding cIACs from Gross Income The 1986 Act~ change was incorrect Federal policy for a number of significant reasons. 1. clAcs are capital infusions, for which a utility is not required to pay, either in money or in the provision of future services. CIAC contributors are required to pay for future services furnished to them at the regular rates paid by consumers who contribute nothing toward the construction of the facilities. CIAC contributors do not get more or better service because of their contributions toward the construction of facilities. As a public utility, the amounts we can charge our customers -- and thus our ability to earn revenues -- are regulated by public utility commissions. Because public utility commissions do not allow us to earn any return on CIACs, we do not derive any gain present or future -- from a CIAC. Both the older and the modern court interpretations confirm our view. As the court stated in Liberty Light, contributions to a utility are "certainly not payments for services rendered or to be rendered." While CIAC5 increase the value of the utility's capital, they do not increase its income. "The increased value of capital as such constitutes in one sense a gain or profit, but not income." Liberty Lig)it, at 159-160. Treating a CIAC by analogy to a prepayment for future services is. simply incorrect. In the prepayment case, the utility is obligated to provide future services and the customer has a legal right to receive the services for which hehas already paid. No such legal relationships exist in the case of a CIAC. The utility is obligated to provide future services Q~~y if the customer contracts for such services and pays for them in the future. As a result of the CIAC, the customer is under no legal obligation to purchase future services from the utility (although he typically will do so, at least for a time). Indeed, if the customer chooses not to purchase service (for example, because a shopping center developer cannot secure sufficient tenants to open the center), the utility has no possibility of earning a profit; the utility may instead be burdened with maintenance costs and property taxes on the CIAC. Under consistent regulatory treatment, the utility has no right to earn a profit on the CIAC and it never does so. The utility has no unfettered "dominion" over the money at the time of the payment of the CIAC. PAGENO="0737" See Commissioner V. Indianapolis Power & Light Co., U.S. , 58 L.W. 4098 (January 9, 1990). 2. CIAC5 are not income in the sense of funds flowing into our coffers that we may use to pay shareholder dividends or for any other purpose. In a 1976 Senate floor debate, Senator Curtis noted that CIAC5 are "not income in the sense (utilities) could take that money and .pass it on to shareholders through dividends. This money is paid in order to replace or to carry on a capital construction." 122 Cong. Rec. Sl2,839 (daily ed. July 29, 1976). We receive the contribution subject to a binding restriction on its use: the contribution must be used as reimbursement for the capital costs associated with the construction of the facility for which the funds were received. Most state regulatory agencies and Federal rules require that contributions be credited to the account of the specific facility for which the funds were received. Public utilities are closely regulated and must strictly account for the receipt and disbursement of all contributions. With these restrictions on the use, enjoyment and disposition of the CIAC, such contributions are not properly regarded as taxable income. 3. CIAC5 are one alternative mechanism for the financing of utility facilities. From a tax policy perspective, the law should be as fair and neutral as possible in treating the different alternatives. The 1986 Act departs from this principle. Normally, a public utility finances construction of its plant and equipment with the proceeds of stocks and bonds issued to investors. However, because of the highly capital intensive nature of water utilities and the desire of regulatory commissions to provide safe and adequate service at the lowest possible coat -- since water is a life-sustaining commodity -- CIACs are a major source of cost free capital. Additionally, extension of service to new developments carries a substantial risk in that customers may be a long time in connecting to the system, if ever. Thus, the use of CIACs places this economic risk on the developer, where it properly belongs. From a financial and regulatory accounting perspective, a CIAC is treated as a cost-free capital contribution. That is to say, the contributed property is an asset,but its value is offset by the non- shareholder contribution to capital. Regulatory commissions typically have prohibited us from including the value of the contributed property in our rate base and thus recovering from our customers a rate of return on its value. That is to say, but for the significant adverse income tax effects under the 1986 Act, the CIAC would have no effect on utility rates charged our customers. Until 1986, the tax treatment of CIACs was consistent with their accounting and regulatory treatment. Although the legal burden of the 1986 tax change may fall on the utility, the economic burden will typically be shifted to the developer, or to consumers generally. In setting the rates charged to customers, regulatory commissions generally allow us to recover not only our current operating expenses, but also: Depreciation of plant and equipment; Interest paid on borrowed funds; 727 30-860 0 - 90 - 24 PAGENO="0738" 728 Allowance to pay Federal and state income taxes and other taxes `not levied on income; Allowed after-tax return on equity capital. With respect to the 1986 changed tax treatment of CIAC5, public utility commissions have generally required the contributor to reimburse the utility for the additional tax the utility will have to pay as a result of the CIAC (including the "tax on the tax"). For example, in September 1987 the California Public Utilities Commission ruled: "This decision authorizes the methods which utilities may adopt to recover the federal tax imposed upon contributions-in-aid-of-construction and `advances for construction pursuant to the Tax Reform Act of 1986. Prior to 1987 contributions and advances were not taxed. This decision places the burden of the tax on the contributor or advancer and is based on the premise that the person who causes the tax pays the tax. No contribution or advance, no tax. This decision authorizes, as the principal method of recovering the tax, a method by which the' contributor of the property or cash or the person making the advance pays the tax by paying, in addition to the contribution or advance, the present value of the future tax burden." ~ Tax Reform Act of~ 1986, Decision 87-O9-~265, 1.86-11-019, September 10, 1987, reprinted in Public Utilities Reports, 86 PUR 4th-No. 3, December 18, 1987, 519-573. Similar types of specific commission orders -- placing all or a significant portion of the negative impact of the CIAC tax on developers and ultimately consumers -- have been issued in the states served by Avatar. Obviously, any portion of the tax funded by the utility will result in increased rates to consumers, as the utility must recover its,investment in taxes and earn a return on~ that~ investment. What are the economic consequences of the regulatory shifting of the burden of the adverse tax treatment of' CIACs from the utility to the contributor? From a developer's perspective, the additional payment to a utility to provide for the tax on the CIAC represents an additional cost of development. In our experience, developers will not undertake a project unless they have a reasonable expectation of recovering their investment plus a profit thereon. Accordingly, `the additional CIAC tax payment will have one of the following consequences: 1. The development becomes uneconomic and is abandoned at the outset; or 2. The cost of the development to the eventual owners or lessees (typically individual home owners) is increased by the amount of the additionaltax reimbursed by the developer; or 3. The developer does not contribute the property to a utility, but instead: PAGENO="0739" 729 a. Forms its own utility which constructs the property and charges ratepayers for its use; or b. Opts not to connect to a central water or wastewater system, but instead provides only individual facilities, g.g., wells and/or septic systems. The latter alternatives are not as environmentally sound as are central systems. c. Contributes the property to a government agency, which is tax exempt. (The issue of competition between investor-owned and municipal utilities is discussed below.) As a matter of tax policy, the present .tax treatment of CIAC5 makes little sense. A CIAC represents either the contribution of, or reimbursement for, capital construction. For both financial-reporting and regulatory purposes, CIAC5 continue to be classified as capital contributions, not receipts of income. A fundamental proposition of income taxation is that capital transactions -- capital contributions, issuance of debt, etc. -- are not taxable. There is no sound tax policy basis for making CIAC5 taxable, rather than tax-exempt capital transactions. As a matter of tax equity, it makes little sense to impose a tax when property is contributed bya developer to an existing utility, such as Avatar, but not to impose a similar tax when we finance the construction of that same property with our own capital (in turn financed with debt or equity) and charge all our customers with the regulated cost of providing that service. Thus, where CIAC5 have become uneconomic under the 1986 Act, the effect is either that no development will be undertaken, or that the utility will finance the project itself. To the extent a utility is forced to self-finance, the current tax law bias in favor of debt financing (since interest payments are deductible and dividends are not) may lead to additional.debt financing of utilities. 4. The present tax treatment of a CIAC exaggerates the advantages that tax-exempt government agencies have over taxable public utilities and thus distorts competition between taxable and tax-exempt entities. This anti-competitive effect is more pronounced in the case of water utilities than other types of utilities. According to the U.S. Energy Information Administration, just under 80 percent of electric power in recent years was generated by investor-owned utilities, with the remaining .20-plus percent generated by municipal, federal, or cooperative- owned utilities. .. By contrast, according to the National Association of Water Companies, just over 20 percent of consumers served by community water systems (a community owned water system is one serving 25 or more water customers) are served by investor-owned utilities, with the remaining 80 percent served by government or cooperatively owned systems. Thus, developers and homeowners have a real economic choice between municipal and privately-owned water and wastewater systems; this is typically not the case with regard to electric and gas utilities. Faced with the punitive tax effects of the 1986 Act, developers naturally will seek to do business with tax-exempt municipal water companies, rather than investor-owned companies. We have been faced with PAGENO="0740" 730 concrete instances of this effect in areas we service. For example, in two recent cases developers annexed their projects to cities adjacent to our service area in order to avoid the CIAC tax. Other potential developments nearby also will be served by the municipalities. In yet another case, a-developer has taken elaborate and perhaps uneconomic steps to avoid our Company's service area, solely because of the CIAC tax. The developer obtained permission to "deannex" from our service area. As business is driven to the municipal sector, Federal tax revenues are decreased. We are able and eager to compete effectively with municipal water systems. They are tax-exempt; Avatar is not. But we should be taxable only on our true economic income, not on our capital. The tax law should seek to maintain a competitive balance between municipal and investor-owned water utilities. (We would note here the positive * experience of the United Kingdom in encouraging privatization of water utilities.) 5. Administration of the pre-1986 Act law by the Internal Revenue Service was relatively straightforward. The Treasury and IRS were able to distinguish non-taxable CIAC5 from taxable customer connection fees. To the best of our knowledge, - this was not an area of controversy or abuse. If new regulations are needed under H.R. 118, they can be effectively written and implemented. - -- - 6. If-it were clear that CIAC5 constitute only prepaynents for future services, and not capital contributions-, then it would be arguable that they should be taxed upon receipt. We believe CIAC5 are clearly not prepayments. Accordingly, even assuming that the premise of the 1986. Act change is partially correct -- ~.g., that in some limited sense CIAC5 represent taxable income -- including CIAC5 in gross income overstates economic and taxable income in the year the contribution is received.- Since eductions attributable to the expenditure of the contributions are allowable only in years subsequent to the year of receipt, income and expenses are mismatched under the 1986 Act. Instead, the utility should properly be subject to tax only in the years in which service is actually rendered with respect to the CIAC received. 7. There are also broader public policy reasons for excluding CIACs from gross income. The tax law should promote the orderly development of utility services without adverse consequences to existing rate payers. Increasing the required contribution amount - means fewer contributions made and fewer facilities constructed. This may result in reduced growth in service. As other witnesses have explained to the Subcommittee, the 1986 Act increases the cost of homes because developers pass the additional tax burden on to individual families. So long as it is consistent with sound tax policy, the tax law should facilitate the construction and purchase of homes, not make homes less accessible to potential buyers. Revenue Impacts - - - We recognize that repealing section 118(b) may result in some loss of revenue. However, we would point out that because of the punitive tax impact of the 1986 Act change, expansion of water and wastewater - facilities and the associated real estate development may well be less in amount than would otherwise have been the case. PAGENO="0741" 731 As noted above, potential customers of tax-paying utilities may be motivated by the 1986 Act provision to do business instead with tax-exempt municipal systems, resulting in a decrease in Federal, state and local tax collections. Conclusions Contributions in aid of construction do not constitute true economic income, and they should not be taxable to public water and wastewater utilities. Sound tax policy and public policy both support this result. Not taxing CIAC would lower the cost of constructing new facilities, encourage the building and purchase of homes, and contribute to the upgrading and expansion of the nation's infrastructure. Avatar, and our counsel, Stuart E. Seigel and Kenneth J. Krupsky of Arnold & Porter, would be happy to answer any questions which the Subcommittee or staff may have. We look forward to working with the Congress to enact H.R. 118. PAGENO="0742" 732 Testimony of The Edison Electric Institute and the Utility CIAC Group For the Subcommittee on Select Revenue Measures Committee on Ways & Means U.S. House of Representatives March 9, 1990 Mr. Chairman and Members of the Subcommittee: The following statement has been prepared and submitted by the Edison Electric Institute (EEl) and the Utility CIAC Group to present our views on H.R. 118, which is sponsored by Representative Robert Matsui, 17 other members of the Ways & Means Committee and an overall total of 133 Representatives. Enactment of H.R. 118 would rein- state the historical exclusion from income for contributions in aid of construction (CIAC). EEl is the association of electric companies. Its members serve 96 percent of all customers served by the investor-owned segment of the industry. They generate approximately 78 percent of all electricity in the country and provide electric service to 74 percent of the nation's electric customers. The Utility CIAC Group is a group of 13 electric and gas utilities that have joined together to support legislation to repeal the current tax imposed on customer contributions to pay for new or expanded utility service, and to reinstate prior section 118(b) of the Internal Revenue Code which properly excluded such contributions from gross income as contributions to capital. A list of the companies comprising the Utility CIAC Group is attached as appendix A of this written statement. EEl and the Utility CIAC Group strongly endorse H.R. 118 because it will restore the pre-1987 tax law which properly treated CIAC as customer contributions to capital and because this bill will eliminate the significant inequities and problems caused by the provisions of present law. Chairman Rangel's press release dated January 23, 1990 stated that this hearing was scheduled to consider the repeal of the tax on CIAC for water utilities. H.R. 118, as introduced, is intended to repeal the tax on CIAC for electric, gas and sewerage utilities as well as water utilities. Because the problems resulting from this unfair tax arise also with respect to contributions to electric and gas utilities, we urge the Subcommittee to consider the repeal of the tax imposed on CIAC for all electric, gas, water and sewerage utilities. Background CIAC are cash payments or transfers of other property that enable utilities to extend or expand utility services to customers. CIAC is an important method utilities use to raise the capital required to construct the basic infrastructure needed to provide utility services in response to the growth and development of homes, commercial buildings, factories and farms as well as schools, hospitals, prisons and military facilities. PAGENO="0743" 733 Federal and sta~ utility regulators have historically recognized the need to raise the necessary capital for gros~th and expansion from the new customers demanding service.. This enables utilities to obtain the capital required to expand utility infrastructure without increasing the cost of service to unaffected utility customers. Because there is no economic cost to utilities or their shareholders on amounts collected from the customers, the property financed by. CIAC is~excluded from a utility's rate base for ratemaking purposes resulting in no cost to other utility customers. Generally, contributions to the capital of a corporation, whether made by. shareholders or other parties, are not included in income. CIAC was historically covered by this general rule and specifically excluded from the taxable income of regulated utilities until 1987. The CIAC Tax Has A Discriminatory Effect The tax imposed on CIAC unfairly discriminates against customers who are served by taxpaying utilities as opposed to customers of municipal and other utilities that are exempt from Federal income tax. The significant increase in cost resulting from the tax imposed on CIAC can influence commercial, industrial and residential developers to seek ways to avoid the tax by locating their developments in areas served by tax-exempt utilities or by encouraging adjoining tax-exempt utilities to annex their area to provide electric services free from the tax on CIAC. Those business and residential developers that do not have this option are burdened with a discriminatory cost that places them at a competitive disadvantage. The discriminatory application of the tax on CIAC is another factor which places taxpaying utilities at an economic disadvantage with tax-exempt utilities providing the same service. This can lead to annexation and condemnation of taxpaying utility systems which will erode the Federal tax base and reduce tax revenue to the Treasury. - The ClAd Tax Is::Imposed on Utility Customers Any tax imposed on CIAC is transferred to the customers that contribute capital to pay for the expansion of the utility system. Consistent with the historic regulatory policy of protecting existing customers from the increased cost of expanding utility service, many utility regulators have responded to the new tax imposed on CIAC by requiring utilities to recover this ta~ from the same customers that contribute the capital.-' As a result, these customers are forced to pay for the upfront cost of constructing the basic system necessary to provide utility services plus the added cost of the tax that is imposed on the contribution. In order to obtain the net after-tax amounts required to install facilities, utilities must charge customers a grossed-up amount sufficient to pay for both the CIAC and the cost of the tax on the CIAC because this additional charge is also taxable income to the utility. To illustrate the effect of this gross up, if a utility needs $100,000 to construct a service extension, the contributing customer must pay approximately $151,000 so 1 In certain jurisdictions, utilities have been authorized by their regulators to recover the tax imposed on CIAC from all customers by including the increased cost in the rates charged for electric or gas services. PAGENO="0744" 734 that, after the utility pays $51,000 in Federal taxes ($151,000 x 34%) it will have $100,000 left to pay for the construction. This example merely illustrates the impact of the tax imposed on CIAC. In practice, the amount of additional charge to customers depends on the specific jurisdiction as well as the Federal tax treatment of CIAC and the possible offset for the future depreciation benefits of taxable CIAC. As an alternative way of recovering the tax on CIAC, many utilities charge contributing customers a "loading" of approximately 25 to 30 percent of the CIAC based on the net present value of the tax imposed on CIAC offset by the future benefits. of tax depreciation on the CIAC assets. Overall, it is clearly evident that the tax imposed on CIAC is a tax on utility customers as opposed to a tax on utilities. The utility is merely a conduit in collecting the tax from its customers and paying the tax to the Federal government. The Impact of Tax Imposed on CIAC Is Detrimental The tax imposed on CIAC results in increased costs to homebuyers, renters, commercial and industrial businesses as well as various Federal, state and local governmental agencies. Residential real estate developers who pay for the extension of the utility system to provide electricity, gas, water, sewer lines and street lighting for new homes and apartment buildings are now paying an additional charge ranging from 25 to 50 percent of the CIAC in order to pay the new tax. This increased tax, which can amount to several thousand dollars per residential unit, increases the cost of new homes as well as the rent charged to residential tenants. The tax imposed on CIAC has a detrimental effect on housing affordability, making it increasingly difficult for potential first-time buyers in low or moderate income groups to make a down payment and monthly payments. The tax on CIAC also increases the cost of basic utility services required for the protection of health, safety and the environment. In many cases, new or expanded utilities are required to provide safe drinking water and sewage treatment for expanding-communities or to resolve contamination problems. In other cases, communities need to expand street lighting, traffic signals and fire and police facilities to provide increased safety and protection for their citizens. The increased cost imposed on these communities to provide the utility, infrastructure strains the local budgets available for these purposes and in many cases results in delays or the curtailment of essential services. The tax on CIAC also restricts the capital necessary to expand the nation's infrastructure for commercial and industrial business and inflates the costs of products and services they provide. This increased cost is inflationary and places an additional burden on businesses that are trying to upgrade and modernize production facilities to compete in a world market. The economic burden of this tax on CIAC also is imposed on Federal, state and local governmental agencies that are required to contribute capital to utilities to provide or expand electric, gas, water and sewerage services to publicly-owned facilities such as hospitals,1libraries, schools, civic centers, police and fire stations, and jails as well as military bases and housing facilities. ` PAGENO="0745" 735 The Administration Would Not Discriminate Among Types of Utilities In the hearings before this Subcommittee Ofl February 22, 1990, the Administration made it clear that if current law is to be changed by Congress to reinstate the income exclusion for CIAC, that it should be changed for electric, gas, water and sewerage utilities. The Administration indicated that they do not support the limited proposal that "draws an unjustifiable distinction between water companies and other utilities." See Statement of Mr. Kenneth W. Gideon dated February 21, 1990, before the Subcommittee on Select Revenue Measures, at page 32. The Administration essentially deferred to Congress to decide whether an income exclusion should be provided for the contributions paid by customers to reimburse utilities for the cost of equipment that must be installed to serve customers, but stated that if such an exclusion were provided, it should apply for all utility services. The Administration did, however, express concern over the revenue impact of a change in the law and indicated that -: ~Congress should also provide an appropriate revenue offset. Revenue Impact of H.R. 118 The increased revenue generated from the tax imposed on CIAC beginning in 1987 is collected from ratepayers, not from utilities. Therefore, in the event that `~ revenue offset is required in connection with enactment of H.R. 118, the revenue should be generated from a broad taxpayer base and not focused on utilities. Summary of Position EEl and the Utility CIAC Group strongly endorse H.R. 118, which will repeal the current tax on CIAC and restore the historic income exclusion- for customer contribution, for the following reasons: 1. CIAC is a contribution to capital and does not represent income that should be subject to tax to either the utility or the customer. 2. The tax imposed on CIAC unfairly discriminates against the customers of taxable utility companies as compared to the customers of tax-exempt utilities. 3. The tax imposed on CIAC results in an inequitable increase in cost to customers already burdened with the cost of expanding utility Systems. 4. The tax on CIAC has a detrimental effect on housing affordability. 5. The tax on CIAC restricts the capital necessary to expand the nation's infrastructure required for the expansion of commercial and industrial business, residential housing and essential governmental services. 6. The tax on CIAC results in the imposition of the economic burden of this tax on Federal, state and local governmental agencies. PAGENO="0746" 736 7. The tax on CIAC can result in the delay and curtailment of-utility services necessary for health and safety and environmental protection. Conclusion For the reasons presented in this statement, we urge the Subcommittee to endorse H.R. 118 and restore the income exclusion for CIAC for all electric, gas, water and sewer companies. Appendix A UTILITY CIAC GROUP MEMBER LIST Carolina Power & Light Company Central & Southwest Services, Inc. Commonwealth Edison Company Florida Power & Light Company Florida Power Corporation Houston Industries, Inc. Pacific Gas and Electric Company San Diego Gas & Electric Company Southern California Edison Company Southern California Gas Company Southern Company Services, Inc. Texas Utilities Services, Inc. Union Electric Company PAGENO="0747" 737 WRITTEN STATEMENT OF HR. S.MHENRY BROWN, JR. VICE PRESIDENT, GOVERNMENTAL AFFAIRS ENTERGY SERVICES, INC. PRESENTED TO THE SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS U.S. HOUSE OF REPRESENTATIVES March 2, 1990 Mr. Chairman and -Members of the Subcommittee: Entergy Corporation submits the following written comments with regard to H.R. 1317, the Nuclear Decommissioning Reserve Fund Act. Entergy Corporation is a holding company organized under the Public Utility Holding Company Act of 1935. Subsidiaries of Entergy Corporation include Arkansas, Power & Light, Louisiana Power & Light, MississippiPower & Light, New Orleans Public Service, Inc. and System Energy Resources, Inc. These subsidiaries provide electrical service to customers in a 91,000 square mile area that extends throughout parts of Arkansas, Louisiana, Mississippi and Missouri. Entergy Corporation subsidiaries currently own and operate a total of four nuclear power plants. We support H.R. 1317, The Nuclear Decommissioning Reserve Fund Act because we believe that it helps to insure that sufficient funds will be available toAeccmmission nuclear plants at the appropriate time in the future. ~The. proposed Act will allow these funds to accumulate while plmc±ng~iess burden on the electric ratepayer than is possible under current law. Currently, Internal Revenue Code Section 468A allows a tax deduction for contributions to a qualified fund that is established to provide funds for the decommissioning (dismantling) of a nuclear plant. A qualified decommissioning fund is a trust fund which is to be used .exclusively for the payment of nuclear decommissioning costs plus administrative costs and taxes of the fund. However, the benefit of this tax deduction is substantially reduced by the other provisions of §468A. -- A qualified decommissioning fund restricts the deduction for the actual cost of decommissioning to the present value of ~such cost. This is accomplished by allowing the taxpayer a deduction for the contributions- to the fund (the present value of ~the future decommissioning cost), but effectively no deduction is~allowed for the earnings accumulated in -the fund despite the -~ fact that those earnings are subject to tax at the maximum càrporate tax rate (currently 34%). Thus, there is little, if any, tax incentive for establishing a qualified decommissioning *fund, while certain investment limitations actually act as a disincentive. Under current law, a qualified -decommissioning fund can only invest in assets commonly known as "Black Lung" investments. Black Lung investments are limited to certain Federal, state, or local government obligations and certain bank and credit union deposits. These investments carry a relatively low rate of return. While these may be appropriate investments for a.±ax exempt trust, such as a Black Lung trust, the after-tax return for a taxable fund is much lower than is desirable. Due to the high rate of tax imposed on the earnings of qualified decommissioning funds (currently 34%) a higher yield is generally obtained by investing in tax exempt investments, such as state and local government obligations. If this tax rate were reduced, then taxable investments would become more attractive. This increase in the level of taxable investments would probably more than offset any revenue losses from the fund attributable to the decrease in the tax rate. PAGENO="0748" 738 Beginning in July 1990, each licensee of a nuclear unit must establish an external fund to provide for future decommissioning needs. Some of the Entergy affiliated companies had been relying on internal funding to provide for this future liability since it enables them to earn a higher after-tax rate of return and therefore places a smaller burden on electric customers. The increase in electric rates from switching from an internal funding methodology to an external funding methodology will be mitigated by enactment of H.R. 1317. Although H.R. 1317 will not allow a qualified fund to earn at rates which match internal funding, it will allow earnings in excess of current law. In recent years, the cost of decommissioning nuclear plants has escalated more rapidly than the cost of other goods and services. If the funds set aside for decommissioning are underemployed (i.e., not earning an appropriate rate of return), then there is an increase in the cost to provide electric service. If these funds are not restricted to low yield investments and not subjected to high tax rates, then they will grow more rapidly and electric customers will have to pay less for electricity because the earnings of the fund investments will be able to cover a larger portion of the costs of decommissioning. H.R 1317 proposes to decrease the tax rate imposed on the earnings of qualified decommissioning funds and at the same time increase the flexibility allowed in investing these funds. This combination of provisions will effectively increase the earnings of these funds and thereby, relieve some of the burden on the ratepayer. The proposed Act makes it possible to adequately provide for the escalating costs of decommissioning nuclear plants without creating an undue hardship on electric customers. The argument that relaxing investment restrictions will lead to risky investments by the utility companies who are responsible for the decommissioning funds has little merit. Even if the investment restrictions of IRC Section 468A are lifted, the utility companies are still subject to the general accountability requirements for fiduciaries of trusts. In addition, state and federal regulatory commissions have the authority to oversee the management of nuclear decommissioning funding whether done through an external mechanism, or an internal one. * The loss in federal revenue that will result from the decreased tax rate will be small in comparison to the benefits to be derived from the decrease. Studies done by Price Waterhouse and the staff of the Joint Committee indicate that the revenue that would potentially be lost by the decreased tax rate would be between $55 million and $105 million. This decrease is small compared with the benefit to be realized by the general public. The Nuclear Decommissioning Reserve Act would help to insure that adequate funds are available to decommission nuclear plants without substantially increasing the cost to our customers. We hope that the Subcommittee will recommend the enactment of H. R. 1317, the Nuclear Decommissioning Reserve Fund Act, into law as expeditiously as possible. If you any questions concerning these comments, please contact either myself or James P. Higgins, Executive Director, Tax Services at (202) 785-8444 or (504) 569- 4326, respectively. PAGENO="0749" 739 WRITTEN STATEMENT OF THE INVESTMENT COMPANY INSTITUTE ON MISCELLANEOUS REVENUE ISSUES BEFORE THE SUBCOMMITTEE ON SELECT~REVENUE MEASURES, COMMITTEE ON WAYS AND MEANS, U.S.' HOUSE OF~REPRESENTATIVES March 9, 1990 The Investment Company Institute±J, the national association of the American investment company industry, supports relaxing the investment restrictions applicable to nuclear decaznmissioning trust funds. Under present law, the assets of a nuclear decommissioning trust fund that are not currently required for decommissioning purposes must be invested directly in (1) public debt securities of the United States, (2) obligations of a state or local government that are not in default as to principal or interest, or (3) time or demand deposits in a bank or an insured credit union located in the United States. ~. Regulated investment companies (RIC5) that invest in these permissible assets are not permissible investments. The Institute believes that, to the extent nuclear decommissioning trust funds may invest directly. in particular. assets, they should also be able to hold these assetsindirectly through a `RIC. No public policy reason can support denying nuclear decommissioning trust funds the alternative of investing in permissible securities indirectly ~through .RICs rather than investing in such securities directly. Thus, the definition of permissible assets should be clarified to include the shares of RIC5 investing solely in the three types of permissible securities and cash or cash equivalents, such as repurchase agreements on such permissible securities. We would be pleased to work with this Committee to draft appropriate language for this proposal. ~J The Investaent CoiRpany Institute is the national association of the American investment company industry. Its membership includes 2,961 open-end investment companies `("mutual funds"), 177 closed-end investment companies and 13 sponsors of unit investment trusts. Its open-end investment company members have assets of about $947 billion, accounting for' approximately 90% of total industry assets, and have over 30 million shareholders. PAGENO="0750" 740 Testimony of the Utility Decommissioning Tax Group for the Subcommittee on Select Revenue Measures Committee on Ways and Means U.S. House of Representatives March 9, 1990 Mr. Chairman and Members of the Subcommittee: The Utility Decommissioning Tax Group appreciates the opportunity to submit testimony that represents the Group's views on H.R~ 1317, the Nuclear Decommissioning Reserve Fund Act (Act). A list of the members of the Utility Decommissioning Tax Group is attached as Exhibit A. A list of other organiza- tions that also support and endorse the Act is attached as Exhibit B. The members of the Utility Decommissioning Tax Group that are electric utility companies collectively own (directly or through their affiliates) interests in over 70 nuclear power plants located in 23 states. The remaining members of the Utility Decommissioning Tax Group are professional investment managers and trustees. Together the members of the Utility Decommissioning Tax Group are committed to safely removing nuclear power plants from service at the end of their useful lives at a cost that is fair and reasonable to electric utility customers. As explained in more detail below, the Utility Decommissioning Tax Group submits that the provisions of the Act will be an added incentive for electric utility companies that own nuclear generating units to fulfill this commitment. The Act provides greater financial security for the protection of the health and safety of the American public by helping to assure that adequate funds will be set aside to decommission nuclear plants in the future. The Act will achieve this result by lowering the tax rate on the income of qualified nuclear decommissioning reserve funds (qualified funds) and by removing the current investment restrictions on qualified funds. The provisions of the Act will accelerate build-up of funds for decommissioning which, in turn, will lower the cost of decommis- sioning to utility customers. Background Under Federal and state law, utility companies that operate nuclear power plants are obligated to decommission (that is, close down or dismantle) the plants at the end of their useful lives. Presently there are over 100 commercial nuclear plants in operation in the United States that must be decommissioned at some point in the future. Section 468A of the Internal Revenue Code of 1986, as amended (Code), allows a utility company to elect to deduct contributions made to a qualified fund, subject to certain limitations. A qualified fund is a segregated trust fund to be used exclusively for the payment of nuclear decommissioning costs and administrative costs of the fund (including taxes). In addi- tion, a qualified fund is allowed to invest in certain assets, PAGENO="0751" 741 known as "Black Lung" investments, which are limited, in general, to Federal, state, or local government obligations and bank and credit union deposits. Unlike a Black Lung trust, which is not subject to Federal tax on its income, a qualified fund consti- tutes a separate taxable entity and is subject to Federal tax on its income at the maximum corporate income tax rate (currently 34 percent). Because of the application of the 34-percent tax rate and the investment restrictions, the after-tax earnings of qualified funds are constrained. The reduced earnings mean that customers must provide greater amounts for contributions to qualified funds in the form of higher rates for their electric service. Although establishment of a qualified fund results in certain advantages for utility customers, the tax rate and investment restrictions place an unnecessary burden on those customers that contribute to the fund. A utility company that establishes a qualified fund generally invests the. assets of the fund in tax-exempt securities in order to optimize the fund's after-tax yield. Such investments are made because the applica- tion of the .34-percent tax rate to income generated by taxable securities results in a lower after-tax yield of the taxable securities than the yield of tax-exempt securities. Thus, the current investment limitations are inappropriate when applied to a taxable entity such as a qualified fund. H.R. 1317 In June, 1988, the Nuclear Regulatory Commission (NRC) promulgated a rule which, in essence, requires each licensee of a nuclear power plant to establish an external decommissioning fund by July, 1990. 10 C.F.R. §S 50.33(k) and 50.75. Furthermore, the Conference Committee for the Deficit Reduction Act of 1984 expressed its intent for Congress to consider providing additional tax incentives for establishing decommissioning trust funds. The Conference Committee stated: "The conferees recognize the importance of ensuring that utilities comply with nuclear power plant decommissioning requirements. In view of this concern, the conferees believe that it may be appropriate for the tax- writing committees to study further the tax treatment of decommissioning costs, and the merits of providing tax incentives for establishing~ decommissioning funds." (Emphasis supplied.) H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 879 (1984). To that end, the Act responds to the directive of the Conference Committee and would enable the licensees to comply more effectively with the NRC mandate. The Act will lower the Federal tax rate on the income of a qualified fund from 34 to 15 percent and eliminate the current restrictions on investment choices. These modifications will encourage qualified funds to invest in taxable securities, including U.S. Treasury obligations, rather than tax-exempt securities. This resulting investment flexibility will directly benefit customers and provide greater assurance that adequate funds are available to decommission nuclear plants in the future when their useful lives are exhausted. It is important to note that the greater investment flexibility afforded qualified funds under the Act will not diminish the security of the assets of these funds. Pursuant to their enabling statutes, state utility commissions possess the necessary authority to establish investment guidelines. The PAGENO="0752" 742 National Association of Regulatory Utility Commissioners recognizes this authority and has endorsed the Act. Many state utility commissions already have exercised this authority with respect to decommissioning trust funds that do not qualify under Code Section 468A. In addition, the trustees and investment managers appointed to administer and invest the assets of quali- fied funds are subject to the customary fiduciary obligations. Furthermore, the Act does not alter existing Federal tax laws which prohibit self-dealing transactions. involving qualified funds. Finally, utility companies lack any motivation to take undue investment risks with the assets of qualified funds because any windfall would remain in the fund until returned to rate- payers while any shortfall would be made up by additional contributions. Financial Security for Health and Safety Protection Nuclear power plants are built to generate electric power for 30 years or more. At the end of their useful lives, they must be decommissioned in a way that will assure long-term protection of the health and safety of the public. Because decommissioning involves the handling and disposition of radio- active materials, the decommissioning process is expensive and will require billions of dollars on an industry-wide basis. To assure that monies are available for this decommissioning process in the next century, electric utilities currently are collecting money in rates from customers which will be used in the future to pay for decommissioning costs. Cost estimates for decommissioning nuclear plants are escalating each year at a higher rate than the rate of inflation, thus making it difficult for owners of nuclear plants to accumulate sufficient funds for future decommissioning costs. MoreoVer, some state utility commissions have been reluctant to permit utilities to take inflation and other factors into account when computing the amounts to be collected because of the financial burden it would impose on current customers. The Act will help assure that sufficient monies will be set aside for decommissioning because it will increase the after-tax yield of qualified funds thereby allowing them to grow at a faster pace than under current law. The establishment of additional qualified funds and the increased yield of such funds will facilitate greater financial security to protect the health and safety of the public at less cost to electricity consumers. Lower Customer Rates The Act will result in lower electricity rates for electric utility customers. On April 20, 1989, Price Waterhouse issued a report on the Act. Price Waterhouse estimated that, based on current law, utility companies will contribute between $600 million and $700 million ann~ally to qualified funds in calendar years 1989 through 1993. It is anticipated that utilities will continue to contribute nearly $700 million annually to qualified funds for the next 20 to 30 years. These contributions will continue to be included in the costs reflected in the electricity rates charged to customers. The Act will reduce the annual amount of decommission- ing costs charged to customers. If the income tax rate for qualified funds were lowered to 15 percent and the current investment restrictions were eliminated, it was estimated by Price Waterhouse that the average annual decommissioning collec- tions from customers in calendar years 1989 through 1993 would drop by nearly 10 percent, or approximately $70 million per year. 1 The Price Waterhouse study assumed that the Act would be effective on July 1, 1989. PAGENO="0753" 743 In addition, decommissioning collections from customers in years 1994 through 2004 would be reduced $70 to $96 million, per. year. This will directly. benefit customers by lowering the amount of decommissioning costs they otherwise will be charged. Tax Rate Bias Current law imposes a tax rate of 34 percent on the income of qualified funds. This rate imposes a disproportion- ately high tax burden on qualified funds and therefore on customers whose monies are deposited in these funds. Payments made by electric utilities to qualified funds represent amounts collected from their customers. Because the actual decommissioning costs will not be incurred for many years to come, these amounts are essentially advance payments by the utility customers. If these advance payments were not required, utility customers could retain these monies until such time as the actual decommissioning costs were incurred. If the customers invested these amounts until needed to pay decommissioning costs, the earnings on such investments would be subject to Federal taxation at the average marginal tax rate of the customers. Accordingly, sound tax policy dictates that customers should not be penalized by the application of an.arbitrarily inflated tax rate on earnings of customer monies simply because they are segregated in an external trust fund. Rather, the earnings of qualified funds should be subject to a rate of taxation compara- ble to the marginal rate the customers would pay if they retained these funds. The Edison Electric Institute ("EEl"), the trade organ- ization of investor-owned electric utility companies, undertook a study to develop the~composite marginal tax rate of electric utility customers. The study concluded that the average marginal tax rate is 16.61 percent. The analysis establishes that the tax rate proposed by the Act is not significantly different from the composite tax rate of the customers who actually bear the economic burden of the decommissioning obligation. This study has, been presented to the Treasury Department and the Joint Committee on Taxation (Joint Committee) for their review and consideration. Sound tax policy warrants the reduction to a rate of 15 percent for taxable income of qualified funds to assure consist- ent and equitable taxation of electric utility customers. Federal Revenue Impact The Act will increase the Federal revenue from qualified funds. Currently, qualified funds invest approximately 90 percent of their assets in tax-exempt bonds and 10 percent in taxable securities. Investment in tax-exempt instruments generally yields a higher after-tax rate of return as compared to investments in taxable instruments which then are subject to a Federal tax rate of 34 percent. Consequently, despite the 34-percent tax rate, qualified funds now pay a relatively small amount of tax. The Act will encourage qualified funds to invest their assets in taxable obligations because they could earn a higher after-tax rate of return. With a lower tax rate, it is antici- pated that qualified funds would invest approximately 90 percent of their assets in taxable securities and 10 percent in tax- exempt instruments. This change in investments would signifi- " cantly increase Federal taxes paid by qualified funds which would be subject to tax at a rate of 15 percent, rather than only 10 percent of such income being taxed at a rate of 34 percent. PAGENO="0754" 744 Under the current restrictions placed on qualified funds, it was estimated by Price Waterhouse that the U.S. Treasury would collect approximately $36 million intax revenue from qualified funds in calendar years 1989 through 1992. How- ever, under the Act, the majority of the assets of qualified funds would be invested in taxable instruments, including U.S. Treasury obligations. Price Waterhouse estimated that the total Federal tax revenues from existing qualified funds would escalate to approximatelY $132 million for calendar years 1989 through 1992. This represents an increase over current law of approxi- mately $96 million in Federal tax revenue over three years from existing qualified funds. Despite the fact that qualified funds would pay more Federal income taxes than under current law, these funds would pay a lower rate of tax (15 percent) on income from taxable investments than do current holders of taxable investments. Based on the assumption utIlized by Federal government revenue estimators that qualified funds would displace current holders (that are in tax brackets higher than 15 percent) of taxable investments, Price Waterhouse estimated that the Act would reduce overall Federal income tax revenue in fiscal-years 1989 through 1992 bya total of approximatelY $61 million ($6 to $24 million annually). In a "preliminary" revenue estimate dated June 28, 1989, the staff of the Joint Committee estimated that the Act would reduce overall Federal income tax revenue in fiscal-years 1990 through 1992 by a total of $103 million ($31 to 37 million annually). It should be noted that the annual savings to customers (approximately ~io million annually in fiscal-years 1989 through 1992), which are undisputed by the staff of the Joint Committee, are approximately twice as high as the annual Federal revenue loss projected by the staff~of the Joint Committee. We respect- fully submit that this small revenue loss is more than offset by (i) the greater financial security available to protect the health and safety of the public; (ii) the reduced decommissioning costs charged to electricity consumers; (iii) the reduced financial burden associated with complying with the new financial assurance requirement of the NRC; (iv) the application of sound tax policy to reduce the burdensome rate of tax presently imposed on qualified funds; and (v) the increased investment by qualified funds in taxable u.s. Treasury obligations. u.s. Treasury Testim~py On February 21, 1990, Kenneth W. Gideon, Assistant secretary of Treasury (Tax Policy), testified before this Subcommittee and presented Treasury's view on H.R. 1317. According to Assistant Secretary Gideon's written statement before the Subcommittee, Treasury does not oppose the removal from the Internal Revenue Code of the current investment restrictions on qualified funds. Although Treasury does not support a reduction of the income tax rate to 15 percent for qualified funds, if Congress decides to reduce the rate, Treasury believes that the appropriate tax rate would be approximately 20 percent, based on the premise that a 20-percent income tax rate is consistent with the average marginal tax rate of electricity consumers who ultimately bear the costs of decommissioning. The Subcommittee on Select Revenue Measures should understand that Treasury developed this 20-percent income tax rate before it received the study that was prepared by the EEl (described above in the Section "Tax Rate Bias"). The study prepared by Treasury does not reflect all of the relevant data that were incorporated into the EEl study. Thus, if Treasury were to revise its study of the composite marginal income tax rate of electricity consumers by using all relevant data, it is PAGENO="0755" 745 reasonable to expect that the revised study would support an income tax rate of less than 20 percent. Further, Treasury opposed the reduction of the income tax rate for qualified funds because of the significant revenue effect to the U.S. Treasury and because the reduction would "disproportionately benefit one industry segment." As explained above in the section "Federal Révénue Impact," the expected revenue loss to the U.S. Treasury is not significant. It is the view of the Utility Decommissioning Tax Group that the benefits of the Act to electricity customers, in the form of lower rates, financial security and public safety, far outweigh the estimated revenue loss. Additionally, EEl has determined that approximately 82 percent of the total number of customers of investor-owned electric utilities purchase electricity from a company that either (1) has a direct interest in a nuclear power plant, or (2) purchases electricity from an affiliated company that has a direct interest in a nuclear power plant. Because of interconnections among electric utility companies across the nation, the remaining electricity customers indirectly receive electricity that is generated by nuclear power plants. Thus, Treasury is incorrect when it states that the benefits of the Act would disproportionately benefit one industry segment. The Act would benefit virtually all users of electricity. Conclusion In summary, the Utility DecommissioningTax Group endorses the Act because: o It will provide greater financial security for the protection of health, safety and the environment by assuring that adequate funds are available for decommissioning nuclear power plants in the next century. o It will directly benefit-electric utility customers by reducing the cost of setting monies aside for future decommissioning, which are included in current electric rates. The amount of the benefit to customers will be more than twice the revenue loss associated with the Act. o It will eliminate the existing tax rate bias against the establishment of qualified funds. o It has received some support by the U.S. Treasury Department. Thus, for the reasons discussed herein, the Utility Decommissioning Tax Group urges the Subcommittee to support the Act. PAGENO="0756" 746 Exhibit A Members of the Utility Decommissioning Tax Group ELECTRIC UTILITY COMPANIES Arizona Public Service Company Arkansas Power & Light Company Carolina Power & Light Company Central & Southwest Services, Incorporated Commonwealth Edison Company Duke Power Company Entergy Corporation - Florida Power Corporation Florida Power & Light. Company Houston Industries, Incorporated Illinois Power Company Iowa Electric Light & Power Company Iowa-Illinois Gas & Electric Company Kansas~ Gas and Electric Company Long Island Lighting Company Louisiana Power & Light Company Northeast Utilities Service Company Northern States Power Company * Pacific Gas & Electric Company Public Service Company of Colorado Public Service Company of New Mexico Public Service Electric & Gas Company Rochester Gas and Electric Corporation San Diego Gas & Electric Company Southern California Edison Company Southern Company Service, Incorporated System Energy Resources, Incorporated Texas Utilities Services, Incorporated Vermont Yankee Nuclear Power Corporation Wisconsin Public Service Corporation FINANCIAL INSTITUTIONS Axe-Houghton Management, Inc. Bank of New York Bank South, N.A. Brown Brothers Harriman & Company Delmarva Investment Advisers Fiduciary Trust Company International Harris Trust & Savings Bank J&W Seligman Trust Company Johnson & Higgins J., P. Morgan Investment Management, Incorporated Monitor Capital Advisors National Investment Services of America, Incorporated Pacific Mutual Life Insurance Company PittsburcTh National Bank Scuader, Stevens & Clark, incorporated Stein Roe & Farriham Incorporated The Travelers * T. Rowe Price Associates Trust Company Bank PAGENO="0757" 747 Exhibit B Other Organizations That Support and Endoi'he H.R. 1317 ASSOCIATIONS Consumer Federation Of America Edison Electric Institute National Association of Regulatory Utility Commissioners Sierra Club PUBLIC SERVICE COMMISSIONS Arkansas Public Service Commission California Public Utilities Commission Connecticut Department of Public Utility Control Florida Public Service Commission Michigan Public ServiOe Commission New Jersey Board of Public Utilities V New York Public Service Commission Texas Public Utility Commission Wisconsin Public Service Commission PAGENO="0758" 748 Statement of the Massachusetts Mutual Life Insurance Company on Miscellaneous Revenue Issues Massachusetts Mutual Life Insurance Company is the eleventh largest life insurer in the United States. With overall assets of approximately $25 billion, the Company is actively involved in developing and marketing traditicinal life insurance products to meet a variety of individual, estate and business needs, as well as pension and health insurance products. As such, we are concerned about one of the proposals contained in the Subcommittee's MiscellaneousTaX Proposals announced in its Press Release #8, dated January 23, 1990. We appreciate the opportunity to offer testimony with respect to this area of concern. Item G.5: Business-Owned Life Insurance According to the proposal before the Subcommittee, a business policyowner would not be eligible to obtain any interest deduction for policy loans under Code §264 unless certain conditions were met. First, the policy must irrevocably designate the insured life. Secondly, the death benefit under the policy must be made payable to the insured's family. These requirements would apply in addition to the present restrictions under Section 264 concerning premium payment patterns and the $50,000 maximum policy indebtedness per insured. As a practical matter, this proposal would create some fairly far-reaching results. In general, any premium paid by the business policyowner would constitute currently taxable income or compensation to the insured since the insured's family must be the named beneficiary (see, Treas. Reg. §l.6l-2(d)(2)(ii)). If the policyowner cannot substitute insureds, it will have to absorb the costs of acquiring new insurance whenever a covered individual terminates employment ~and is replaced by another individual. Under present law, a substitution of insureds causes the policyowner to recognize any existing gain on the policy, but there are no additional costs incurred for acquiring a new policy. While the proposal would not change the tax consequences, it would increase the costs of keeping insurance current with changes in personnel. Finally, the proposal would establish new conditions to qualify policy loans for an interest deduction. Yet, in many states, these conditions would effectively preempt the policyowner's ability to borrow against the policy. If the insured's family must be named in effect the irrevocable beneficiary, the policyowner may be unable to take a policy loan or to make a valid collateral assignment to a third-party lender. In an attempt to qualify a policy for a potential interest deduction, a business would have to sacrifice control over a vaLuable asset. We are concerned that the proposed amendments to Section 264 will unduly restrict a business policyowner's ability to borrow against one particular form of business asset. We are, however, more greatly concerned by the apparent overriding perception that business-owned life insurance is a leveraging device which serves few legitimate social purposes. In actual practice, businesses purchase life insurance on their owners or their key personnel in order to meet specific legitimate business needs. It must be acknowledged that certain abuses have arisen with respect to business-owned life insurance. We believe that these abuses, discussed more extensively later in our testimony, call for examination and reform. We would willingly offer our services in any endeavor to stem such abuses. PAGENO="0759" Because the insurance is designed to offset an anticipated loss or. to satisfy a known obligation, it is unusual for the policy to name someone other than the business policyowner as the beneficiary. The proposed amendment would affect, therefore, the insurance arrangements of essentially all businesses that hold life insurance on their owners or key personnel. Yet, while there are a variety of reasons why a business might purchase life insurance, the chief purpose is not - nor should it be - to obtain a limited interest deduction for possible future loans. One principal use of life insurance is to protect the business from the financial drain caused by the death of a key employee or officer. Such "key employee" insurance has long been recognized as a legitimate use of life insurance under state law and has been upheld when subjected to federal tax scrutiny. Key employee insurance represents a significant market for Mass Mutual and other insurers. For many businesses, one individual or a small group of individuals is vital to the ongoing operation of the concern. Whether the individual possesses special managerial or technical skills,'or whether the individual is a driving force in developing products or sales, the loss of that key person could create a financial crisis for the business. For many businesses, their very stability within their community or market may depend on certain key personnel. This particular phenomenon is not reserved to the smaller businesses alone. It is notable that many commercial lenders insist as a condition of a business loan that the transaction be covered by insurance on key personnel. On the loss of a key person, a business must absorb the cost of finding and training a. replacement. During the transition period, the business may experience additional costs in attempting to maintain productivity, or market standing; the business may also suffer from reduced revenues. Many businesses purchase life insurance to provide the funds necessary to assure their continued survival after the loss of a key individual. The death proceeds which the business collects as beneficiary serve to offset the increased costs of maintaining the business. . . In many small businesses life insurance is also used to enable the business to survive the death of an owner, by allowing the decedent's.. share of the business to be purchased or transferred. For example, the owners of a business, whose heirs may have no inclination or ability to manage the business, can enable the business to buy out their heirs at a fair price through a plan funded with business-owned life insurance.. Without life insurance proceeds, the business may lack the. liquidity with which to purchase the interest-of the heirs and thus maintain the integrity of the business. As with. key employee insurance, insurance to fund business buy-outs represents an important and, socially useful purpose.~ Many businesses also utilize life insurance to .provide survivor and post-retirement benefits for.employees. These.~arrangements are supplemental compensation packages designed to retain those individuals who are critical to the ongoing success of the business., The business is typically the owner and bene'ficiary of such policies; the policy proceeds create a source of funds'~ from which the business can satisfy its obligations to the covered employees. it is a misconception that such ` arrangements are substituted for broad-based qualified, plans. Nonqualified deferred compensation plans, and survivor benefits, typically form only part of an overall compensation program. PAGENO="0760" 750 It is certainly true that any of these legitimate uses of business owned life insurance are not dependent on the ability to obtain an interest deduction for policy loans. While borrowing against the life insurance should not be taken lightly, as a loan may disrupt the purpose for the insurance, the availability of the asset *to meet unanticipated business exigencies is clearly a matter of significance. A policy's loan feature is especially important to a corporate financial officer who must be concerned with- the liquidity of corporate assets. As noted before, many commercial lenders will not extend credit to a small business for its ongoing needs unless the business insures a key individual or owner and assigns the insurance as collateral to the lender. Unlike indebtedness with respect to other business assets, policy loans-~are already circumscribed by substantial restrictions. ~Any interest deduction is subject to premium qualification requirements and a cap on the amount of indebtedness. Businesses must also contend with serious disincentives to using overly investment-oriented policies in planning to meet their, business insurance needs. Since the early l950s, no interest deduction has been available for loans against single premium policies or those treated as single premium contracts. - With the 1988 tax amendments, heavily investment-oriented life products have become prohibitive for most businesses. A business' access to the gain' in a modified endowment contract would incur both income tax and an automatic penalty tax. The exceptions from the additional penalty tax afford protection to only individual policyholders under certain limited áircumstances. There is no need to extend these distributional rules, or other restrictions, to life insurance policies which are not overly investment-oriented, Busthes~sowned life insurance must remain a liquid asset if itis to be,useful in the financial structure of a corporation. With respect to nonqualified employee benefit plans, we are, however, aware of one particular abuse, We have heard of employers purchasing life insurance on large groups of employees in order to maximize available interest deductions. By spreading insurance over numerous lives, and not just those of key employees, these arrangement's sidestep the $50,000 limit on indebtedness per insured. Most distressingly,, these plans provide for no benefits or only insignificant benefits to be paid to the' ±majority of insureds. It is Mass Mutual's belief that these'p~ans in most cases violate the traditional state ,Law~req-a±rement that the person procuring insurance on a life `-"must~iiave an insurable interest in that life. The issue of whether these arrangements qualify for an interest deduction should be subordinate to the question of whether the insurance satisfies the'definition of life insurance. It is a characteristic of life insurance that it involves the shifting and distribution of risk. As recognized by'most states, a contract entered into despite the lack of an insurable interest does- not shift or distribute risk, and, therefore, does not qualify' as insurance. We would support corrective action which addresses this problem. It is an abuse of state insurance and federal tax laws to insure rank and file' employees with the goals of maximizing potential leverage and providing benefits to only a select few. We do not believe, however, that this particularized abuse calls for a general change in the existing rules for policy loans or for the imposition of new rules which will interfere with the traditional, legitimate uses of business-owned life insurance. PAGENO="0761" 751 Conclusion While some business insurance arrangements àlearly represent an abuse of the tax and insurance laws, any solution should be tailored, so as not to disrupt the legitimate uses of life insurance. Life insurance serves a valid social purpose in providing businesses with the means to plan for their future. As with individuals, businesses must be able to assure themselves of available funds to meet exigent circumstances or to satisfy incurred obligations. It is an abuse to insure an employee for the principal purpose of increasing the potential for interest deductions. Yet, Congress should be aware that such arrangements do not reflect the vast majority of business-owned life insurance policies. PAGENO="0762" `752 VD FARMERS PETREN~EUM COOPERATIVE, INC. 7373 WestSaginowH4ghwa~i Box 30960. Lansing, MIchigan 46909-8460 Phone (517) 323-7000 February 22, 1990 The Honorable Charles Rangel Chairman, Select Revenue Measures Subcommittee House Ways and Means Committee U. S. House of Representatives Washington, 0. C. 20515 Dear Mr. Chairman and Subcommittee Members: I am writing to you in support of HR2353 as introduced by Congressmen Byron Dorgan and Hank Brown. I would ask that this correspondence be included in the hearing record of the House Ways and Means Select Revenue Measures Subcommittee's hearing on miscellaneous revenue measures held on February 2.1-22, 1990. Our cooperative, Farmers Petroleum Cooperative, Inc., was formed in 1948 as a supplier of.petroleum and related products to Michigan agriculture. As a part of the Michigan Farm Bureau Family of Companies, we serve over 100,000 members in Michigan. We operate thirteen retail locations directly, while serving forty-two local cooperatives across the state. Our product line includes most petroleum fuels, lubricants, tires, batteries, automotive accessories, and some general farm supplies. Our cooperative, along with others, is faced with some gray" areas of interpretation in application of tax regulations that exhibits a real need for HR2353. Cooperatives, different from stock corporations, pay patronage dividends on a member-use basis. - not on ownership. Therefore, most all decisions to sell assets or invest in other cooperatives or related industry arise from operating or patronage related activity. Since the value of "stock' or ownership in a cooperative is constant, and all income is prorated out on a patronage basis, there is no need to guard against capital manipulation as could happen in stock corporations. Cooperative boards, representing the member- patrons, direct management to enter into certain transactions, investments, Or activities for the benefit of operations. A member.of the Michigan Farm Bureau Familyof Companies PAGENO="0763" 753 HR2353 is very important for cooperatives to allow patronage sourced treatment for gain or loss from asset activity, providing that the asset activity was, carried out to aid, or intended to aid, the business done with or for the member-patron of the cooperative. Cooperatives are created to join members together to enhance a particular business activity. By their structure, all activity relating to gain or sale of assets is usually based on decisions to develop operations. On behalf of Farmers Petroleum Cooperative, Inc. and its membership across Michigan, we are very appreciative of the committees conducting hearings on this subject. We are honored to be allowed the opportunity to submit a written statement on behalf of HR2353. Sincerely, ~ /\~i~. (;`i .L~ John M. Feland Executive Vice President Chief Executive Off icér JMF:aw PAGENO="0764" 754 F41?MLA/V~ IfV~ (JSTF?IES. /IVC. pOst ~ffic~ b~ 73O5/k~~ Aty. 64116 JAMES L. RAINEY February 23, 1990 The Honorable Charles Rangel Chairman, Select Revenue Measures Subcommittee House Ways and Means Committee u.s. House of Representatives Washington, D.C. 20515 Re: Federal Income Tax Treatment of Sales of Assets by Farmer Cooperatives Dear Mr. Chairman and Subcommittee Members: On behalf of Farmland Industries Inc., I respectfully request that this letter be included in the published record of the February 21-22, l990.Subcommittee hearings on miscellaneous revenue measures. It relates specifically to the above-referenced proposed legislation, which was introduced last session (as H.R. 2353) by Congressmen Byron Dorgan and Hank Brown. Farmland is a regional agricultural cooperative, whose immediate members include over 2,100 local cooperatives. Its ultimate patrons and owners are more than 250,000 farmers who live and produce in 19 states throughout America's Heartland. Under subchapter T of the Internal Revenue Code, it is necessary to determine whether income or loss items of farmer cooperatives derive from "patronage" as opposed to "non-patronage" sources. The distinction is crucial, since patronage sourced items are not subject to tax at the co-op level if distributed to the co- op's member-patrons. For so-called "non-exempt" cooperatives like Farmland, non-patronage income is taxed to the co-op.whether or not distributed to patrons. The patronage v. non-patronage question is frequently raised by examining IRS agents in cases involving sales of assets held by cooperatives for use in connection with patronage operations. Treasury regulations and key IRS rulings send conflicting signals on the issue. Moreover, while a number of these cases have been litigated, the IRS disturbingly continues to take positions at odds with the basic legal theory that the courts have repeatedly endorsed. The continuing uncertainty in this area has left cooperatives in a "Catch-22" position regarding very important recurring decisions as to how much can be distributed as patronage dividends. The Internal Revenue Code requires that patronage distributions be made within 8-1/2 months after the end of each taxable year. If an item thought to be patronage-related is later challenged successfully by the IRS, the result is a "double whammy": both the patrons and the co-op get taxed on the reclassified income; and the co-op is foreclosed from using any portion of the previously distributed income to pay the additional tax due, and even when the co-op prevails, the financial and other costs associated with waging a lengthy dispute with the IRS are, by no means insignificant. PAGENO="0765" 755 H.R. 2353 simply would codify the so-called "facilitative" test that the courts have consistently applied in making the patronage v. non-patronage determination. Farmer co-ops could assure application of this test by electing to treat gain or loss from the disposition of any asset as patronage sourced to the extent that such asset was in fact used "to facilitate the conduct of business done with or for patrons." Patronage treatment would follow in such circumstances regardless of whether the particular asset involved is tangible or intangible, depreciable or non- depreciable, or capital or non-capital. The statutory election would thus be available, for example, with respect to the sale by a cooperative of a grain storage facility; it likewise would extend to a sale of stock in a subsidiary that conducts activities integrally related with the co-op's overall patronage operations. Subject to certain conditions and limitations, cooperatives could also elect to be governed by the factual facilitative test for prior taxable years. Sales of non-inventory assets by the 5,000-plus farmer cooperatives in this country are commonplace occurrences; and thousands of these transactions have doubtless occurred in prior years now under or still subject to IRS audit. Farmland and numerous other cooperatives are presently in the midst of, or potentially subject to, costly, prolonged disputes with the IRS in which their good faith determinations of patronage sourced income have been or may be challenged. It is grossly unfair to penalize these organizations given the conflicting administrative pronouncements that exist in this area -- particularly since the clear trend of the case law has been to support patronage treatment in all of the contexts which the IRS stubbornly continues to dispute. Farmer cooperatives, and the approximately two million American farmers who own and patronize cooperatives, play a unique role in meeting the enormous agricultural demands 01 this country. Enactment of H.R. 2353 would remove a substantial and unnecessary impediment that cooperatives and their member-patrons now face in carrying out that important role. We very much appreciate the opportunity to submit this statement. Very truly yours, James L. Rainey President & Chief Executive Officer JLR/SPD/jm PAGENO="0766" 756 MAR ~ g REC~ tel ~S~A~A ~ ,r~i ~ L1~I~~ P.O. 80X2500. CLOOMINGTON. L617022500.OO9)5576000 March 2, 1990 The Honorable Charles Rangel Chairman, Select Revenue Measures Subcommittee House Ways and Means Committee U.S. House of~'Represefltatives Washington, DC 20515 Dear Mr. Chairman and Subcommittee Members: GROWMARK, Inc. is writing to you in support of the Cooperative Sale of Assets Legislation (H.R. 2353) as introduced by Congressmen Byron Dorgan and Hank Brown. GROWMARX, Inc. is a farm supply and grain originating cooperative operating predominately in the three state area of Illinois, Iowa, and Wisconsin. We operate on a federated basis, and thus sell to (or buy from) and are owned by over 200 member cooperatives in the three states. Cooperatives need H.R. 2353 to clarify the tax treatment of gains or losses from the sale of assets used in patronage operations. The IRS has taken the position that gain-or loss from the sale of assets is always nonpatronage sourced, while recent court decisions indicate that the characterization of -income or loss should be determined by whether the asset directly relates to the patronage .peration of the cooperative. Without this legislation, cooperatives will continue to be subjected to IRS challenge when an asset sale results in a gain or loss which the cooperative classifies as patronage sourced. H.R. 2353 perr.its cooperatives to elect patronage sourced - ordinary income treatment for gains or losses from the sale or other disposition of any asset, provided that the asset was used by the organization to facilitate the conduct of business done with or for patrons. *GROWMARK thanks the stbcommittee for holding hearings on this subject and appreciates the opportunity to submit a written statement on this subject. GROWMARK requests this letter to be included in the hearing record of the House Ways and Means Select Revenue Measures Subcommittee hearing on miscellaneous revenue measures held February 21-22. Sincerely, GROWMARX, Inc. Chief Executive Officer NJ: jsm PAGENO="0767" .757 4001 LEXINGTON AVE. N., ARDEN HILLS, MINNESOTA Mailing adcVess: P.O. Boa 116, M~nneapoIis, MN 55448-0116 Telephone: (612)481.2222 March 6, 1990 The Honorable Charles Rangel Chairman, Select Revenue Measures Subcommittee House Ways and Means Committee U.S. House of Representatives Washington, D.C. 20515 Dear Mr. Chairman and Subcommittee Members: I am writing to express Land O'Lakes' support for HR 2353 which would clarify tax treatment of gains and losses on the sale of assets by farmer cooperatives. I would like to have my comments included in the hearing record of the House Ways and Means Select Revenue Measures Subcommittee hearing on miscellaneous revenue measures held February 21 and 22. Land OLakes is a regional farm supply and marketing cooperative with headquarters in Minneapolis, Minnesota. We market milk for our members and process, manufacture and market dairy products that are sold to consumers throughout the United States. We also market feed, seed, fertilizer, and agronomy, products through 1,200 locally-owned and controlled cooperatives. These .cooperatives are located mainly in Minnesota, Wisconsin,' Iowa, Nebraska, the Dakotas, Montana, Idaho, Washington and. Oregon. More than 350,000 farmers and ranchers are represented in this cooperative system. We agree with the explanation of the need for this legislation as presented in Mr. J. Gary McDavid's testimony on February 22. Cooperatives need a clarification of conflicting' positions taken by the IRS and the tax courts and consistency in the law regard- ng tax treatment on gains and losses realized by the sale of assets. Without legislation, we would expect. continued challenges by the IRS whenever a cooperative chooses to classify a gain or loss on asset sales as patronage-sourced. Reps. Byron Dorgan and Hank Brown recognized the need to resolve this problem and `intro- duced HR 2353. When enacted, the legislation will provide cooperatives with the flexibility to effectively manage their assets for the benefit of their farmer members. They will be able to elect to treat gains or losses on asset sales as patron-sourced for purposes of tax treatment so long as the asset was used by the organization to facil itate conducting business with members. We wish to thank you for holding hearings on this subject and for the opportunity to submit a written statement. We would very much like to see this legislation enacted by Congress this year. Sin rely, . erty P esident and hief Executive ficer JEG/pb PAGENO="0768" 758 ~MFA~ Incorporated ~ B. L. Frew President and CEO 615 Locust Street Columbia, MO 65201 (314) 876-5458 March 2, 1990 The Honorable Charles Rangel Chairman, Select Revenue Measures Subcommittee House Ways and Means Committee u.s. House of Representatives Washington, DC 20515 Dear Mr. Chairman and Subcommittee Members: MFA Incorporated supports H.R. 2353 as introduced by Congressmen Byron Dorgan and Hank Brown. Please include this letter in the record of the House Ways and Means Select Revenue Measures Subcommittee held February 22, 1990. MFA incorporated is a purchasing and marketing cooperative which sells agricultural inputs such as feed, fertilizer, seed, and chemicals to its members. MFA also buys grain from its members for resale. MFA has 40,000 active farmer- members, primarily in Missouri, and annual sales volume of approximately $500 million. H.R. 2353 is needed to clarify the tax treatment of gains or losses from the saleof assets used by cooperatives in their patronage operations. Patronage operations are directly related to the activities of the cooperative with its members. Recent court decisions have held that the characterization of gain or loss should be determined by whether the asset directly relates to the patronage operations of the cooperative. The Internal Revenue Service has taken inconsistent positionm where they have classified such gains as non-patronage sourced and in other cases they have combidered losses to be patronage losses or captial losses. H.R. 2353 permits cooperatives to elect patronage sourced treatment for gains or losses on the sale of assets that were used by the cooperative to facilitate the conduct of its business with its members. Without this legislation, cooperatives will continue to be subjected to IRS challenge when an asset sale results in a gain or loss which the cooperative classifies as patronage sourced. Thank you for holding hearings on this topic which is important to cooperatives and their members and the opportunity to submit a written statement in support of the proposed legislation. sincerely, MFA INCORPORATED ~ ,. ~. B. L. Frew president and CEO BLF/ lm PAGENO="0769" 759 S. MFC SERVICES (AAL) / BOX 500/ HWY. 51 N / MADISON, MS 39130-0500/ PH. (601) 856-2400 TELEX 58-5410/ FACS (601) 856-3979 J. L. HARPOLE president and general manager February 20, 1990 The Honorable Charles Rangel Chairman, Select Revenue Measures Subcommittee House Ways and Means Committee U.S. House of Representatives Washington, D.C. 20515 RE: H.R. 2353 Dear Chairman and Subcommittee Members: MFC Services AAL ("MFC") supports H.R. 2353 which was introduced by Congressmen Byron Dorgan and Hank Brown. Please include this letter in the hearing record of the House Ways and Means Select Revenue Measures Subcommittee hearing on miscellaneous revenue held on February 21-22, 1990. MFC is a federation of agricultural cooperatives organized, chartered, and existing under the Agricultural Association Law of the State of Mississippi. We do busi~ess in Western Alabama, Mississippi, and Louisiana where we have approximately sixty-five (65) member cooperatives. Those cooperatives serve thousands of farmers. Our sales volume in 1989 was roughly $150 million. Cooperatives need H.R. 2353 to clarify the tax treatment of gain or loss from the sale of assets used in patronage operations. The IRS has taken the position that gain or loss from the sale of assets is always nonpatronage sourced. Recent court decisions indicate that the characterization of income or loss should be determined by whether the asset directly relates to the patronage operation of the cooperative. Without this legislation, cooperatives will continue to be subject to IRS challenge when an asset sale results in a gain or loss which the cooperative classifies as patronage sourced. H.R. 2353 will permit cooperatives to elect patronage sourced treatment for gain or loss from the sale or other disposition of any asset, provided that the asset was used by the organization to facilitate the conduct of business done with or for patrons. Thank you for holding hearings on this subject. We appreciate the opportunity to submit this statement. Sincerely yours, J. t~. Harpole President and General Manager JHO22Ocs 30-860 0 - 90 - 25 PAGENO="0770" 760 Southern States Cooperative Inc. 6606 West Broad Street Post Office Boo 26234 Richmond. Viginia 23260 Telephone 604 28t-t000 February 15, 1990 Southern States The Honorable Charles Rangel Chairman, Select Revenue Measures Subcommittee House Ways and Means Committee U.S. House of Representatives Washington, PC 20515 RE: H.R. 2353 Dear Mr. Chairman and Subcommittee Members: We at Southern States Cooperative strongly support H.R. 2353, as introduced by Congressmen Byron Dorgan and Hank Brown. We ask, therefore, that this letter be included in the hearing record of your Subcommittee meeting scheduled for February 21-22. Southern States is a farm supply purchasing and grain marketing cooperative, serving farmers primarily in a six- state area: Delaware, Kentucky, Maryland, North Carolina, Virginia and West Virginia. We have some 575 retail stores, backed by manufacturing and distribution facilities, and 13 grain marketing elevators. We have some 173,000 farmermembers, with membership in our managed member cooperatives reaching 216,000. H.R. 2353 would clarify a farmer cooperative's right to treat gains or losses from the sale of assets as patron-sourced or non-patron-sourced, for tax purposes. While the Internal Revenue Service assumes all such gains or losses to be non-patron-sourced, the courts have consistently ruled in favor of co-ops, based on whether the specific asset relates to the patronage operation of the cooperative. Passage of H.R. 2353 simply permits cooperatives to elect patron-sourced treatment for gain or loss from asset sales, provided that the asset were used by the organization to facilitate the conduct of business with or for patrons. Thus, it will protect our farmer-members from having to pay court costs to defend against an IRS challenge on the issue. Thank you for holding hearings on this issue and for the opportunity to submit this written statement. Sincerely, `~2bir~'ctor of Corporate Communications ~nd Public Relations PAGENO="0771" 761 T A TEXAS AGRICULTURAL COOPERATIVE COUNCIL Cooperatives WonQing `Together P.O. BOX 9527 8140 BLJRNET ROAD AUSTIN, TEXAS 78766 (512) 454-3569 February 13, 1990 The Honorable Charles Rangel Chairman, Select Revenue Measures Subcommittee House Ways and Means Committee U. S. House of Representatives Washington, D. C. 20515 Dear Hr. Chairman and Subcommittee Members: I am writing this letter in support of HR-2353 as introduced by Congressmen Byron Dorgan and Hank Brown. I would like for this letter to be included in the record of the House Ways and Means Select Revenue Measures Subcommittee hearing on miscellaneous revenue measures to be held on February 21 and 22, 1990. Our association, Texas Agricultural Cooperative Council, is composed of 310 cooperatively-organized agricultural businesses `operating in the state of Texas. Well over 100,000 Texas farmers hold. memberships and patronize these businesses. There are cotton gins, grain elevators, farm supply stores, marketing, processing, and financial institutions among our membership, involving a wide variety of agricultural commodities. As businesses, they are constantly faced with a variety of tax problems at all levels from local schools, municipalities, county, state and the federal government. Although most of the tax rules written by the Internal Revenue Service are concise and clear, there are occasional challenges by staff that cause problems of clearly defining certain instances of taxation. Such is~ the case that has brought about the introduction of HR-2353. This resolution is desperately needed to clarify the tax treatment of gain or loss from the sale of assets used in our cooperatives' patronage operations. The IRS has taken the position that gain or loss from the sale of assets is always non-patronage sourced, while. recent court decisions indicate that the characterization of income or loss should be determined by whether the asset directly relates to the patronage operation of the cooperative. This has been clearly stated by the court-and yet IRS continues their challenges. Without legislation in HR-2353, our cooperatives will continue to be subjected to these challenges when an asset sale results in a gain or loss which the cooperative classifies as patronage sourced. HR- 2353 permits cooperatives to elect patronage sourced treatment for gain or loss from the sale or other disposition of any asset, provided- that the asset was used by the organization to facilitate the conduct of business done with or for their patrons. - Our -Council. supports HR-2353 unanimously and urges you to look favorably upon it for passage. We appreciate the subcommittee holding hearings on this important subject and also appreciate the opportunity afforded us to~ submit this written statement. Sincerely, ~ COUNCIL illy L Conner Executi e Vice-President BLC: pfc PAGENO="0772" 762 UNION EQUITY CO-OPERATIVE EXCHANGE - CABLE CODE: IJNECO-TELEX: 747169 March 9, 1990 The Honorable Charles Rangel Chairman, Select Revenue Measures Subcommittee House Ways and Means Committee U.S. House of Representatives Washington, DC 20515 Dear Mr. Chairman and Subcommittee Members, We're writing to voice our support forH.R. 2353 and would appreciate having our comments included in the hearing record of the House Ways and Means Select Revenue Measures Subcommittee hearing on / miscellaneous revenue measures held Feb. 21-22. 1 Union Equity is a regional grain marketing cooperative owned by some 480 local cooperatives in a ten-state area extending from Texas to South Dakota and from Missouri to Colorado. Together, Union Equity and its member cooperatives market grain produced by more than 200,000 farm families. -We believe H.R. 2353 is important because it will provide needed clarification and flexibility on the tax treatment of cooperative asset sales. While it has no immediate impact on Union Equity, we believe the issue is one that should be addressed in the interest of all cooperative organizations. Absent such clarification, cooperatives will continue to be subject to IRS challenge when an asset sale results in a gain or loss that the cooperative classifies - as patronage-sourced. Sincerely, Edwin Wallace Vice President and Chief Financial Officer PAGENO="0773" 763 WRITTEN STATEMENT OF THE HONORABLE BILL ARCHER BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES HOUSE COMMITTEE ON WAYS AND MEANS FEBRUARY 21, 1990 I welcome the opportunity to address what I believe is a serious oversight of the 1986 Tax Reform Act relating to the tax rate which is applied to unearned income of minor children -- the so-called "kiddie tax." As a result of the Tax Reform Act of 1986, unearned income in excess of $1,000 of children under 14 years of age is taxed at the parents' highest rate. The concerns which brought onthis change related to the ability of some families to "shift" income to children, whose marginal rates were considerably lower. That potential for abuse presented problems of fairness and equity to many in Congress. Whether or not the principle underlying the 1986 reform is one that is adhered to by all, its application to all forms of unearned income is inherently unfair. The kiddie tax looks at all types of unearned income, from whatever source derived. This means there are no exceptions, including income earned on amounts which represent settlements or court awards for disabling injuries and illness. I believe it is difficult to find where a motive exists to "income shift" in cases where a minor child becomes an unfortunate victim of accident or malpractice. Some may argue that most children will not be affected since, as a general rule, only unearned income in excess of $1,000 is taxed at the higher parental tax rate. However, I would point out that in most injury or compensation awards, the amount is determined by the degree of Injury. Consequently, the children impacted by the 1986 law will be those who have suffered substantial harm. Further, it is this group, namely children who have been incapactitated for life, who are most deserving of legislative relief. My bill, HR 2656, would provide an exception from the 1986 law so that unearned income of a child that is attributable to illness and injury awards is taxed at the child's rate, not the parents. To minimize the potential revenue loss, the bill limits legislative relief tolump-suim settlements occurring before October 22, 1986 -- the date of enactment of the 1986 Tax Reform Act. Such "grandfather" relief is especially warranted since many of those compensation awards were structured to provide a specific amount of income at some future time, often when the minor is considered an adult. Because of the tax increase imposed on those disabled children in the 1986 Act, however, many settlements will fall short of previously agreed-upon amounts of income. H.R. 2656 would negate the retroactive impact of the 1986 law on settlements which used prior law tax rules as a basis for negotiations. I urge this Subcommittee to act favorably and promptly on my proposal. Last year, Senator Mitchell introduced similar relief which later was incorporated~ into the Senate Finance Committee budget reconciliation recommendations. Unfortunately, this amendment and other extraneous provisions were dropped from the final Senate bill. I hope this degree of interest in both Chambers of Congress signals an opportunity to correct this flaw and, in. the process, add a little compassion to the tax law. Thank you very much. PAGENO="0774" 764 Action Committee for Transit P.O. Box 7074 Silver Spvin& MD 20907 US. HOUSE OF REPRESENTATIVES WAYS AND MEANS COMMITFEE STATEMENT OF NICHOLAS M. BRAND CHAIRMAN OF THE ACTION COMMI'ITEE FOR TRANSIT BEFORE THE SUBCOMMITFEE ON SELECT REVENUE MEASURES HEARING ON TAXATION OF TRANSIT PASSES AND VAN POOL BENEFITS FEBRUARY 21, 1990 * Mr. Chairman and Members of the Subcommittee: My name is Nicholas M. Brand, and I am the chairman of the Action Committee for Transit (ACT), an eighty-member citizens' group based in Montgomery County, Maryland. Our goals are to increase the quality, amount, and cost-effectiveness of transit in the region. ACT members are fortunate to be working in a county where concerted local efforts are being made to increase the use of transit. Parking under the control of the county is priced at near-market rates, and in areas around Metro stations is being deliberately limited in order to encourage transit use. In special instances, very elaborate efforts are required of private office developers before they are allowed to build, with some extraordinarily successful results. Unfortunately we are all swimming against the tide of the IRS code, which makes it more difficult to balance transit and auto use. One of the most important policy disincentives to increased transit use in our area is the existence of significant subsidized and untaxed parlcing at work for single drivers. This free parking contrasts with a notable lack of available transit subsidy. Often this disparity results from the reluctance of employers to add to their record keeping for income tax purposes. One of our members, a Federal government employee has been told that such passes can't be issued because it would require additional space on the forms that the agency uses! And as we know, changing forms (for everyone except the IRS) is an Herculean task. By removing an important barrier to issuing employees transit passes, and by bringing costs closer to their true level relative to parking, significant increases in transit use will occur. Recent work done for the County's proposed Silver Spring to Bethesda trolley shows that a 50% rise in parking cost would add 30% to trolley ridership. A similar, but lower effect was demonstrated for existing but much slower bus service Looking strictly at an individuals decision if offered a transit pass or free parking, removing the tax penalty on transit use would decrease transit's cost by some 30%, depending on one's tax bracket. In areas such as ours where there is lots of reasonable transit this should in and of itself raise transit use on the order of 10 to 15%. In conjunction with other actions the transit pass provision can be even more powerful in making transit more attractive. In a recent instance where County land use policy required that a suburban developer on Rockville Pike near Metro provide subsidized transit, preferential parking forvan and car pools, and charge the going market rate for all cars parking, more than 50% of all employees arrive by transit and car pools; and this is in an area where that figure is normally 5%! Unfortunately the specific circumstances that allowed the County to impose such stringent requirements cannot be duplicated; a voluntary approach must be used much more often, and the lowering of barriers and cost imposed by the inequal taxation is essential to success. What would the effect of granting transit and van pool users equal status on the Federal budget? I suspect that because of the very limited use of transit passes today, there will be minimal revenue loss. On the other hand, our Federal transit spending, amounting to billions of Federal dollars in aid to transit systems would be more effectively used, and would increase the cost recovery ratios of* our transit systems. PAGENO="0775" 765 In these months of debate over Federal air quality~standerds, acid rain, imported oil and the trade deficits, I need not belabor the importance of actions at all levels to increase car and van pooling and transit use. Removing the inequitable treatment in the tax code of employer-provided auto incentives (i.e. parking) and employer-provided transit incentives is an important part of the package of actions. I would like to suggest a change in one of the specific proposals of HR. 2265. As drafted the bill would limit the value of the pass to be tax-free ta $60. A limitis unfair for two reasons. First the parkingthat may be provided tax-free is often worth $100 to $140per month in our central business districts. (If you were to limit the value ottransit passes, you should limit the value of parking. Otherwise the competition remains tilted in favor of the auto.) Secondly the cost of commuting bytransit can easily exceed $60 in our area. .1 take a bus and the Metrorail to work in the morning asid the reverse at night, and spend $3.70 per day, or $74 a month. This is by no means a long commute (5 miles) and there are many more transit users for whom the tab is more expensive. By imposing an arbitrary cap at $60 you introduce record-keeping complications for many people and undercut the goal of equality of tax treatment among the various modes. Thank you for the opportunity to comment on this important issue. PAGENO="0776" 766 House Ways and Means Committee Subcommittee~ on Select Revenue Measures February 21, 1990 Testimony of Carolyn DiMambro CARAVAN for Commuters, Inc. Boston, MA My name is Carolyn DiMambro. I am Executive Director of CARAVAN For Commuers, Inc., a private, non-profit company working with 1000 Massachusetts businesses to implement commuter service programs fostering shared ride and transit commuting. The 1984 Tax Reform Act made employer-provided commuter programs such as vanpools and transit fare subsidies a taxable fringe benefit while provision of free employee parking remains untaxed. The result is an incentive for people to drive alone to work instead of sharing rides and using transit. Traffic congestion, with its costs in delay and pollution, is increasing at the same time that public funds for roadway expansion are seriously constrained. Clearly, we must maximize use of our existing infrastructure's capacity by encouraging commuters to share the ride to work. Legislative revisions to reinstate the exemption from tax for vanpools and tax only the value of transit passes exceeding $15 per month would help us reach our goals for cleaner air, reduced energy consumption, and less traffic congestion. PAGENO="0777" 767 Commuter Transportation Services, Inc. CommuterComputer TESTIMONY IN SUPPORT OF H.R. 2265 (MATSUI) HOUSE WAYS AND MEANS SUBCOMMITTEE ON SELECT REVENUE MEASURES WASHINGTON, DC FEBRUARY 21-22, 1990 Commuter Transportation Services, Inc. (also known as Commuter Computer) is the oldest and largest commute management company in the nation. We currently serve over 3,000 employment sites, as well as the ~.general public, in a four-county area of Southern Cati±ornia compris±ng over 12 million people. One of the most persistent issues CTS and our clients must deal with is the inconsistency of federal tax policy regarding employer-prow±ded commute benefits. The following are some key provisions of current federal law: o Employer-provided parking is considered a tax-free fringe benefit, the value of~°which may be as much as $300 per month in some urban areas. (At the same time, employer-provided parking is regarded as a cost of doing business and can be claimed as a business deduction.) o Employer-provided mass transit subsidies must be $15 or less. A penny more and the entire mass transit subsidy becomes taxable, not just that amount over $15. *(This is referred to as the "cliff".) o Employers operating or sponsoring commuter vanpool operations must first determine the fair market value of the transportation, deduct any payments made by the employee, and then report the difference as imputed income on the employee's W-2 form. Current law is confusing, inequitable, and administratively burdensome. It also works counter to local, state, and federal efforts to manage traffic, clean the air, and conserve energy. Congressman Robert Natsui's bill, H.R. 2265, would go a long way to correct and simplify current law. In its amended version, the Natsui bill would delete the tax "cliff" on employer-provided mass transit subsidies, thereby protecting the first $15 from taxation regardless of the total amount of the subsidy. It would also reinstate the exemption for vanpool operations. 3550 Wilshire Boulevard Suite 300 Los Angeles, CA 90010 PAGENO="0778" `768 Benefits accrued from this bill will easily offset the cost. For example, in 1986, the Hughes Aircraft Company vanpool program served more than 2,500 employees with nearly 300 vans. Hughes estimated that their vanpool program conserved over 5 million gallons of gasoline, prevented the emission of nearly 700 tons of pollutants, and reduced employee commuting expenses by roughly $6 million. Employers are increasingly called upon to reduce commuter trips. The effectiveness of the financial incentives they offer to encourage ridesharing is diminished due to the fact that rideshare incentives are taxed and parking is not. Continuing to classify parking as a working-condition fringe benefit while classifying transit as a ~a inJ.nimu~ benefit, -also represents regressive distribution of employee benefits. In urban central business districts, those earning above average wages tend to benefit most from parking subsidies. In contrast, the majority of transit users in the same area are likely to receive lower wages and their transportation subsidy, if any, is most likely much lower. - We encourage Congress to take the lead in working with the IRS and 0MB to establish complementary, sensible tax policy and not let transportation policy be set by the IRS, somewhat by default. I respectfully urge this committee to approve H.R. 2265, which supports clean air and mobility efforts and makes more equitable the treatment of employer-provided commute benefits. Thank you. JI SIMS - P sident PAGENO="0779" 769 ~ EL SEGUNDO P.O. Box 547 ~ EMPLOYERS El Segundo, CA 90245 ASSOCIATION AX(213)3919764 March 6, 1990 Mr. Robert 3. Leonard Chief Counsel Committee on Ways & Means U.S. House of Representatives 1102 Longworth House Office Building Washington, D.C. 20515 Dear Mr. Leonard: The El Segundo Employers Association (ESEA) supports repealing the Federal tax on vanpools and raising the tax-exempt portion of transit passes to $60.00 per month. A non-profit~coa1ition of major aerospace and defense employers and commercial property owners located south of the Los Angeles International Airport, ESEA was established in 1981 to address the increasing traffic and transportation situation in the El Segundo employment center. Our current inembarship exceeds 75,000 employees. ESEA member corporationr.vollectively operate approximately 500 vanpools; subsidize ~prxb1tc :transit. passes for employees; subsidize the purchase of v~s;~and~offer preferential parking for car/van pools. The majority~of ESEA members are currently increasing their existing fleet of vanpools and adopting more wide-spread use of transit pass subsid±zation in order to comply with Regulation XV, a regionally mandated trip reduction measure for employers with 100 or more employees. Under the jurisdiction of the Southern California Air QualityManagement District (SCAQMD), Regulation XV is designed to reduce vehicle emissions throughout the L.A. basin. Ouratembers are committed to improving regional air quality through the reduction of traffic and will continue~to provide incentives to encourage employee ridesbaring; however, the tax provisions which currently apply to vanpools and transit pass~ subsidization are a significant deterrent to the axpansion ~ofthese programs in an era where employers throughout America rmore and more are being held legislatively responsthle for the reduction of traffic and the improvement of the environment. ESEA urges members of Congress to repeal the taxation of commute-to-work fringe benefits contained in the 1984 Tax Reform Act and strongly supports legislation to correct this inequitable and inappropriate taxation. Si erely, Donald H. Camph Executive Director KM:ss :l15:Leonard THE GREEN LIGHT FOR COMMUTERS PAGENO="0780" 770 The Greater -bin of Trade A Regional Chamberof Commerce forthe Districtof Colombia. Northern Virginia and Suborban Maryland Board otTtadn Bailditg 1129 20th Street. NW. Wastsngtott,D.C. 20036 March 9, 1990 FAX: 202-223-2648 The Honorable Chatles B. Rangel Chairman Subcommittee on Select Revenue Measures Committee on Waya and Means US House of Representatives 1102 Longworth Building Washington, DC 20515 RE: H.R.2265 Dear Congressman Rangel: The Greater Washington Board of Trade Is a regional chamber of commerce, focusing on business needs and concema. We are addressing the need for skilled labor In this area so that we can maintain our economic growth. One of the most important factors affecting an adequate labor force is the availability of an efficient and affordable transportation system. As a part of the Board's adopted Employment Agenda, the Employment Committee Is examining barriers to employment for area residents. The Committee believes a significant barrier Is transportation, specifically the cost of getting to the worksite. The Greater Washington Board of Trade supports the concept of a bill that would Increase the allowable employer-provided subsidy for public transit and provide a full exemption from income tax for employer-provided van pools. lila our belief that the passage of such a bill would encourage more employers to provide public transit subsidies and van pools to their employees, thus helping to reduce transportation as a barrier to employment and begin utilizingtransportatiOn as a recruitment tool. We believe that an example of a bill which takes an Important first step toward achieving this goal Is H.R.2265, which was Introduced by Congressman Matsui. in addition, the Board of Trade recognizes that a valuable ancillary benefit of encouraging employers to provide transportation subsidies will be a reduction of the number of single occupant vehicles, lessening gridlock on our roads and improving the region's air quality. We encourage you to support H.R.2265 and other legislation with these goals. It will benefit all of the nation's metropolitan areas including the nation's capital. Thank you. Sincerely, ~ Richard Berendzen W. Don Ladd Chairman Chairman Employment/Education Bureau Legislative Burea 4:::::.: PAGENO="0781" 771 Testimony of John H. Carman and Robert S. McGarry President, Keep Montgomery County Moving Committee and Director, Montgomery County, Maryland, Department of Transportation Rockville, Maryland for February 21, 1990, Hearing on H.R. 2265 Weare writing on behalf of the Ke~p~Montgomery' County ~ioving Committee (KMCM). *This is a group of business, civic, and educational leaders which develops innovative solutiens to transportation challenges in Montgomery County, Maryland. We are submitting the following comments to the Committee on Ways and Means regarding H.R. 2265, Representative Robert Matsui's bill that would drop taxation of vanpools and increase the allowable employer subsidy of transit passes for employees to $60 a month. The bill would also eliminate the `cliff' aspect of current tax regulations so that employees who received more than $60 a month subsidy would be required to declare as income only subsidy amounts that exceeded $60. The KMCM Committee, the Montgomery County Department of Transportation, and some 500 employers in the countyhave been working hard to address traffic congestion, promote air quality, and encourage energy conservation. In particular, 112 employers have signed up for the County's FARE SHARE program which offers County discounts to match employer discounts on transit fare media (passes, tickets, or fare cards). This program provides on-site, discounted transit fare media to almost 3,000 employees, two thirds of whom were driving alone before the program started three years ago. Our employers also operate more than 50 vanpools for their commuting employees, representing more than 650 commuters. These programs are really working to the benefit of both our county and the nation~ Although we have had some success, we find ourselves fighting the provisions of the 1986 Internal Revenue Code law which have resulted in the taxation of employer-sponsored vanpools and discounted transit passes. In addition, the administrative burden of complying with the complex IRS regulations has become a major disincentive for additional employers to offer such programs. Current IRS regulations are working counter to national environmental policies and are hindering our local efforts to maintain the mobility of our citizens. Noted Senator Alphonse D'Amato, "The tax code allows an employer to subsidize one hundred percent of an employee's parking costs tax free . (it) says if you drive to work and if you park there that parking cost can be absorbed as a legitimate business deduction, a fringe benefit to the employee We talk about having an environmental crisis with these automobiles coming into the major centers and yet we are subsidizing them to do that." We believe as many as 500 Montgomery employers would ultimately become active in discounting~transit fares and promoting vanpools if this IRS regulation could be modified. Many employees feel a $15 per month incentive is insufficient for them to change their commuting habits. While employers may be interested in subsidizing their employees more than $15 a month, the administrative burden under current IRS regulations is seen by them as too great to warrant their involvement. Therefore, we urge the Committee on Ways and Means to lend its support to Representative Matsui's bill. PAGENO="0782" 772 STATEMENT OF METROPOOL, INC. STATEMENT IN SUPPORT OF H.R. BILL 2265 My name is Carol Dee Angell. I am the President of MetroPool, Inc., a non-profit commuter transportation management company. MetroPool's mission is to reduce the number of cars on the road in the Lower Hudson Valley of New York and Southwestern Connecticut. Many of the programs MetroPool offers requires employers to support and participate in changing the way in which their employees commute to and from work. It is essential to have employer support in order to effectively reach employees. I would therefore request that the current 1984 Tax Act be amended to provide employers the opportunity to offer equal incentives to those employees who are willing to leave their cars at home and take mass transit or vanpool. In our area the average parking space costs approximately $65 per month. The current law allows for the employer to subsidize parking tax free for those employees who drive alone and limits the employer's ability to subsidize other more beneficial commuting modes, such as mass transit, or vanpooling. I wish to encourage members of this group to seriously consider the ramifications of continuing to allow for such inequities. The more cars we have on the road the more quickly we will deteriorate our environment through the useless consumption of energy and its' disastrous effect on our air quality. Please help those of us who are working toward reversing those trends. Help us to offer incentives to employers and employees that send the right message to conserve our precious natural resources. Support H.R. Bill 2265 which repeals the tax on vanpools and raises the tax-exempt portion of transit passes to $60 per month. Thank you for allowing me the opportunity to express my views. PAGENO="0783" 773 STATEMENT OF JAMES P. MORAN, JR. IN SUPPORT OF HR 2265 COt4IITTEE ON WAYS ANT) MEANS U. S. HOUSE OF REPRESENTATIVES MARCH 7, 1990 My name is James P. Moran, Jr. I am Mayor of the City of Alexandria, Virginia and Chairman of the Northern Virginia Transportation Commission. The Commission has asked me to provide for the record NVTC's strong endorsement of TNT. 2265. The bill would increase the current $15 monthly restriction on employer-provided assistance to employees for public transit purposes to a new level of $60 monthly. It would also make employer-provided assistance for vanpooling subject to the same $60 limit (currently any vanpooling assistance is fully taxable). The bill would also eliminate the so-called "cliff" that now is in effect. At present, employer contributions for transit in excess of $15 monthly cause the entire contribution to be taxable to employees and not deductible to employers. This provides a double bias toward the use of the private automobile in our heavily congested cities since parking subsidies are not subject to any tax-related restrictions Consequently employers are encouraged by the current tax code to provide free parking to employees (worth $60, $80 or even $100 monthly in our area) but prevented from providing tax-free transit passes worth any more than $15 monthly. In Alexandria our commuter arteries are clogged each morning and evening. Even access to our Metrorail stations is so choked with automobiles that our buses have a difficult time meeting sthedules. In our City we have adopted an innovative ordinance that requires developers to plan and implement strict measures to control automobile traffic at their facilities. Yet, the existing Federal tax code removes from the arsenal of these private developers a very effective weapon-the use of prices to positively influence employees to use public transit and vanpooling instead of driving alone. To meet the requirements of the ordinance (which calls for up to a 30 percent reduction in forecast auto traffic for each development), developers are creating Transportation Management Associations, promoting ridesharing, encouraging flexible working hours and even buying buses to enable our local transit system to operate more routes with greater frequencies. Sadly, the- powerful tool of free bus passes or cash vanpool incentives to match (or exceed) parking subsidies provided to automobile drivers is not available to these developers. They are forced to turn to second-best solutions. - We know that transit and vanpooling use helps to relieve congestion, and preserve our fragile environment. Why, then, do we permit Federal regulations to stand in the way of private sector efforts encouraging commuters to take actions that will bring tangible benefits to -themselves and their neighbors? - Citing possible Federal tax revenue losses from passage of HR 2265 as a reason to oppose it - would be a truly short-sighted attitude. In fact, HR 2265 will encourage more employer-provided transit passes, more use of buses, subways, and vanpools, and less automobile use. The result will be cleaner air, less congestion, energy savings, less need for costly new highways, and more effective transit systems. In Northern Virginia, a careful study of the benefits of our Metrorail system revealed a 13 percent rate of return on state investments in construction of the popular rail network. Thus, it is reasonable to expect that actions by the Federal government to remove tax impediments to Metrorail-use will generate measurable benefits to all levels of government through increased economic activity. Passage of HR 2265 will benefit the entire United States because the bill encourages the private sector to do the right -and efficient thing by removing a serious economic distortion that has remained too long in our tax code. PAGENO="0784" 774 Statement of Mr. David A. Ross, President Reston Board of Commerce Reston Virginia Membership in the Reston Board of Commerce has identified transportation as one of the major issues that it would like to have the Board of Directors~become more involved with in l990~ With that in mind, the Board has strengthened its Transportation Committee to include representatives of many of Reston's largest employers including Sprint, Telenet, USAA, the U. S. Geological Survey and the Reston Hospital Center. One of the issues that the Committee has studied is the federal tax on commute-to-work benefits. The 1984 tax legislation overruled reasonable transportation policy by making transit passes worth more than $15 per month, employer-provided vanpool discounts and employee transportation allowances taxable fringe benefits. The same law specifies that free parking is not a taxable fringe benefit The Reston Board of Commerce finds that the tax on commute-to- work benefits is inconsistônt with local and national policy objectives directed at encouraging greater use of public transit and encouragining carpooling and vanpooling. We must make more efficient use of our existing highway network. We support efforts being made locally to encourage employers to offer commute benefits which will lower future demand for very costly highway infrastructure construction. The Reston, Board of. Commerce is pleased that our Congressman Frank R. Wolf supports H. R. Bill 2265 that would reinstate the exemption from tax for vanpools and would raise the tax-exempt level of transit pass fringe benefits from the present $15 per month to $60 per month. We urge all members of Congress to support legislation such as H. R. Bill 2265 and correct the present inequitable and inappropriate taxation of commute-to-work fringe benefits. PAGENO="0785" 775 , ~ RICHMOND AREA METROPOLITAN TRANSPORTATION PLANNING ORGANIZATION do RICHMOND REGIONAL PLANNING DISTRICT COMMISSION 2104 WEST LA8URNUM AVENUE. SUITE 101 - RICHMOND, VIRGINIA 23227 (804) 358-3684 March 8, 1990 Mr. Robert J. Leonard Chief Counsel Committee on Ways and Means U.S. House of Representatives 1102 Longworth House Office Building Washington, D.C. 20515 Dear Mr. Leonard: Enclosed for consideration of the Subcommittee on Select Revenue Measures is a Resolution passed by the Richmond Area Metropolitan Transportation Planning Organization (MPO) indicating its support for amendment to the Internal Revenue Code, to exclude from gross income the value of certain transportation furnishedby an employer. Please submit this letter and the attached resolution as part of the Subcommittee's February 21 public hearing record, that addressed a provision sponsored by Representative Robert T. Matsui, that would drop the tax on vanpools and tax only the value of transit passes exceeding $15 a month. The subcommittee's consideration of our statement is appreciated. Please call me at (804) 358-3684 should you have any questions or need further information. Sincerely, ~1~L~1 Daniel N. Lysy c~'~ MPO Secretary DNL/rf Enclosures Pc: Honorable Thomas J. Bliley, Jr. Honorable Norman Sisisky Richmond Area MPO Members Vot~og Mooboo: ToooofAsdlaod Ho~ñoo Co.oty G~ooto~ RiChd~ddd T~o~sitCo~~paoy Chesto~fioId Coooty Pooh~t~~ Coudty R~oh~oodd MoVdpohtdd A~tho4ty Goochladd coo~ty Cityof Riyhtttottd RiohtttottdRogiooalPlotto4gDist4otCootttissioo HonodotCoitttty C~pito? Rogiott Aitpytt Cyttttyitsi~tt Vitgittio Dopotttt,otttofTtottspottotiot PAGENO="0786" 776 Up. RICHMOND AREA METROPOLITAN TRANSPORTATION PLANNING ORGANIZATION do RICHMOND REGIONAL PLANNING DISTRICT COMMISSION 2201 WEST BROAD STREET RICHMOND, VIRGINIA2322O 1804)358-3684 RESOLUTION PROPOSED FEDERAL LEGISLATION TAXATION OF EMPLOYEE COMMUTE PROGRAM On motion of John McKenney, seconded by Angela Moore, the Richmond Area Metropolitan Transportation Planning Organi- zation unanimously adopted the following Resolution: RESOLVED, That the Richmond Area Metropolitan Transportation Planning Organization supports the amendment to the Internal Revenue Code of 1986 to exclude from gross income the value of certain transportation furnished by an employer, as introduced: in the U.S. House of Representatives by Representative Barbara Kennelly, and to further pro- vide the region's congressional delegation and MPO affiliated organizations with statements of support and- request their support of the Bill. * * * * * * * * * * This is to certify that the above Resolution was unanimously adopted by the Richmond Area Metropolitan Transportation Planning Organization at its meeting held on October 8, 1987. WITNESS: ~~ineE~ Office Manager, RRPDC ~LJ 4-~ ~iniel N. Lysy MPO Secretary Capital Region Aiepoat Commissioo Geeatm Richmond Tsansit Company Richmond Meneopolitan Aushonity Richmond Regional Planning Disteict Commission Vieginia Depaoment of Highmoys & TeanspoctatiOn Voting Mncnbncs: Ch,stecfield County Gonchiand County HanoceeC000ty Hencico Cocnty City of Richmond PAGENO="0787" 777 Statement from RIDES for Bay Area Commuters 60 Spear Street, Suite 650 San Francisco, CA 94105-1512 RE: Commute-to-work benefits RIDES for Bay Area Commuters has provided commute transportation services to~ individuals, employers and governmental agencies for over twelve years. As the San Francisco Bay Area's only regional ridesharing agency, serving ten counties with over two million commuters, RIDES has in-depth knowledge of the factors which motivate commuters to stop driving alone. One significant factor which contributes to an individual's choice of commute modes is cost. In the 1970's, the oil crisis caused an unprecedented use of transit and carpools, primarily due to the high cost of gasoline. Most commuters who switch from driving alone cite monetary savings as their primary motivational factor. When employers subsidize transit passes or vanpools, or provide cash incentives for people who do not drive alone, the use of ridesharing and transit climbs significantly. The State of California now considers any employer-sponsored commute benefits non-taxable. Many corporations and individuals wish to take advantage of this new tax law but cannot because of the tax penalties incurred at the federal level. The federal tax laws are inconsistent with efforts to reduce air pollution and with efforts to address the effect of traffic congestion on the health and well-being of our citizens and communities. Additionally, they provide significant incentives via free parking subsidies for those who choose to drive alone. RIDES urges you to repeal taxes on employer provided commute-to-work fringe benefits for those who carpool, vanpool, bicycle or walk to work, and to raise the tax-exempt portion of transit' passes to a minimum of $60.00 per month with no "tax-cliff". We are' certain that `many more commuters are ready to switch from driving solo if they are given adequate incentives from their employers and favorable tax treatment from the Internal Revenue Service. Thank you for the opportunity to present this statement. ` By Eunice E. Valentine, Executive Director PAGENO="0788" 778 TB-COUNTY METROPOLITAN TRANSPORTATETN DISTRICT OF OREGON I Robert J. Leonard, Chief Counsel -Committee on Ways and Means U.S. House of Representatives 1102 Longworth House Office Bldg. Washington, DC 20515 Dear Mr. Leonard: The existing commute-to-work benefit allows an employer to provide a tax-free $15 monthly contribution toward the employee purchase of a transit pass. However, once the contribution exceeds this amount, the total subsidy then becomes taxable income to the employee. As such, I strongly urge the Committee to consider technical corrections to this legislation. The intent is to assure that the first $15 of the monthly benefit remain tax-free, regardless of whether an additional benefit is received. Employer-provided vanpool programs should be considered as part of this tax-free commute-to-work benefit. The language correction represents a first step in a longer-range objective to increase the allowable monthly contribution. An increase would not only result in a greater use of bus and rail, but would bring the transit tax treatment more in line with that now given to employer-provided parking. Thank you for your consideration. Sincer J me E. Cowen Ge eral Manager JEC:SG:et February 28, 1990 PAGENO="0789" 779 STATEMENT OF DUANE BERENTSON, SECRETARY WASHINGTON STATE DEPARTMENT OF TRANSPORTATION My name is Duane Berentson. I am the Secretary of the Wash- ington State Department of Transportation (WSDOT). This statement is submitted on behalf of WSDOT and my remarks rep- resent the position of WSDOT on this issue I appreciate the opportunity to submit WSDOT's statement re- questing that the U.S. House of Representatives Ways and Means Committee take the first step to eliminate the so called $15 per month cliff for employer subsidized transit passes and to re-establish the tax exemption for employer sponsored carpool and vanpool programs. Hopefully this com- mittee will give serious consideration in raising the tax- exempt level of transit pass fringe benefits to the level of $60 per month. WSDOT is faced with very large increases in the number of vehicles and vehicle miles traveled, especially within our state's larger urbanized areas. It is not financially, socially, or environmentally feasible to rely primarily on the construction or expansion of freeways and other highways to meet present and future traffic demands. In order to continue to provide the necessary transportation mobility for our citizens, WSDOT recognizes the importance of moving numbers of people rather than numbers of vehicles. For example, in the fast-growing Puget Sound area, we are in the midst of a large comprehensive transportation demand- management program consisting of high occupancy vehicle lanes (HOV), park and ride lots; freeway surveillance control and driver information systems; freeway ramp metering; and the encouragement of ridesharing options such as public transit, vanpooling, and carpooling. When completed, the planned NOV system within the Puget Sound region will consist of 156 miles, the largest such system in the U.S. In order to encourage drivers of single-occupant vehicles (SOV) to use alternative means of travel, incentives related to decreasedtravel time or reduced transportation costs are usually necessary. The more incentives available to the SOy the more likely that person will utilize these alternative transportation modes. The present tax code penalizes commuters who ride transit, with fares partially or totally subsidized by their employer, if the subsidy is over $15 per month. This same employer can provide unlimited untaxed subsidy for employee parking. In many cases, this parking is free to the employee. In order that the two groups are treated in a more equal manner, WSDOT supports Representative Matsui's proposal of not taxing the first $15 per month of a transit pass if the amount of em- ployer subsidy is over the $15 per month cliff. To provide an even greater incentive to use alternative transportation. modes, WSDOT supports an increase in the tax-exempt portion of the transit pass to $60 per month. Another inequity in the present tax code is the tax imposed upon employees who participate in an employer-sponsored carpool or vanpool program while at the same time no tax is owed if the same employee~ who drives oneself is provided subsidized free parking from the employer. If we are to have any chance at all of adequately addressing present and future urban congestion, I urge congress to repeal the above described provision to help encourage the movement of people rather than vehicles. PAGENO="0790" 780 STATEMENT OF DAVID RODRICK, CHAIRPERSON WASHINGTON STATE RIDESHARING ORGANIZATION My name is David Rodrick. I am the Chairperson of the Washington State Ridesharing Organization (WSRO). This statement is. submitted on behalf of WSRO and my remarks represent the position of WSRO on this issue. I appreciate the opportunity to submit WSRO's statement requesting that the U.S. House of Representatives Ways and Means Committee takethe first step to eliminate the so called $15 per month cliff for employer subsidized transit passes and to re-establish the tax exemption for employer sponsored carpool and vanpool programs. In addition, it is our sincere hope that this committee will give serious consideration to raising the tax-exempt level of transit pass fringe~benefits to $60 per month. The mission of the WSRO is to advocate, promote and support high-occupancy vehicle transportation options throughout the State of Washington. The organization's primary focus is on commuter transportation involving shared-expense vehicles and volunteer drivers. In order to achieve our goals, and the goals of the commuting public around the state who use and/or benefit from the transportation services our individual organizations provide, we must find stronger incentives to encourage our citizens to share the ride. The present tax code penalizes commuters who ride transit, and currently have their fares partially or totally subsidized by their employer by $15 or more per month. This \ same employer can provide unlimited untaxed subsidy for employee parking. In many cases, this parking is free to the employee. In order that the two groups are treated in a more equal ~manner, WSRO supports Representative Matsui' s proposal of not taxing the first $15 per month of a transit pass if the amount of employer subsidy is over the $15 per month cliff. In fact, to provide an even greater incentive to use alternative transportation modes, WSRO further supports an increase in the tax-exempt portion of the transit pass to $60 per month. Another inequity in the present tax code is the tax imposed upon employees who participate in an employer-sponsored carpool or vanpool program. No tax is owed if the same employee drives alone and is provided subsidized free parking from the employer. This situation clearly provides incentive for both employers and employees to commute to work alone in single-occupant vehicles (SOV) - compounding urban traffic congestion and air quality problems. In general, WSRO member organizations are pleased with the highway system we have in Washington State. Our state Department of Transportation (DOT) has strong policies which make provisions for the necessary transportation mobility elements required by our citizens. Policies promote the movement of people rather than vehicles and multi-modal solutions to transportation problems. Public and private organizations in the state work together with the DOT and each other to preserve mobility by promoting Transportation Demand Management (TDM) options. For example, in the urban areas of the Puget Sound Region there is a comprehensive TDM program in place. It utilizes high occupancy vehicle (HOV) lanes, freeway HOV ramp metering, driver information systems, park and ride lots, and the encouragement of ridesharing options such as public transit, buspooling, vanpooling, and carpooling. The elements of the HOV System work together offering the HOV user the incentive of PAGENO="0791" 781 decreased travel time. When complete, the planned SOy System in the Puget Sound Region will be the largest HOV lane system in the United States, consisting of about 156 miles. However, like most states, Washington State is faced with very large increases in the number of vehicles and vehicle miles traveled, especially within our larger urban areas. WSRO understands andacknowledges that it is not financially, socially, or environmentally feasible to expect or rely primarily on the construction or expansion of freeways and other highways to meet present and future traffic demands. Nor is it fiscally, socially or environmentally responsible to have national policy which acts as disincentive to TDM programs which are designed to encourage our citizens to use public transportation and other ridesharing options. In order to encourage drivers of SOy to use alternative means of travel, incentives related to decreased travel time or reduced transportation costs are usually necessary. The more incentives available to the SOy user, the more likely that person will change and utilize these alternative transportation modes. If we are to have any chance at all of adequately addressing present and future urban congestion, I urge congress to repeal the above described provisions to help encourage the movement of people rather than vehicles. PAGENO="0792" 782 STATEMENT BY COLONEL ERIK G. JOHNSON, JR., USA RET. DIRECTOR OF LEGISLATIVE AFFAIRS ASSOCIATION OF THE UNITED STATES ARMY Mister Chairman and Members of the Subcommittee: Thank you for this opportunity to express the views of the Association of the United States Army concerning proposed changes to the Earned Income Tax Credit as defined in Section 32 of the Internal Revenue Code of 1986. Our Association is especially~pieased that an opportunity is now present which will resolve a serious inequity in the tax code. That inequi- ty is, of course, the ineligibility for earned income tax credit that our younger service men and women incur while serving their country overseas. It is difficult for our soldiers to understand the loss of this feder- al benefit solely because they have been assigned outside of the fifty states. Service personnel are accustomed to reassignment brought about by official government orders, but they are dismayed to discover that in addi- tion to the cost of a household move that they will lose a tax credit that has been allowed -while they were serving at a stateside military installa- tion. According to the Department of Defense there are approximately 115,000 enlisted personnel in pay-grades El thru E5 presently eligible for the Earned Income Tax Credit. Of this number, about 25,000 are overseas at any particular time and therefore not eligible for the credit. Young men and women in the lowest ranking enlisted grades lose over four percent of their federal, entitlement just because they are overseas. In the case of an El that means $603 in annual income, not a small amount when a young family is trying to make ends meet. While military pay has improved \over the past decade it nevertheless has not kept pace with the rest of oi~r economy. The loss of any amount of pay at these lower paygrades is felt immediately by the soldier. We understand the rationale for including the basic allowances for quarters and subsistence in the gross reportable income of service person- nel when determining their eligibility for the benefit. However, we have some concern over the inclusion oLcombat pay in the reporting require- ment. It seems a little disingenuoux to insist that soldiers be asked to lay their life on the line -`and at tIre same time be taxed for the privilege of doing so. The~easag!Ls~C.3ear, remain in the states where duty may be safer and at the same time retain more of your gross income entitlements. Surely this isn't the message we want to send to our service personnel and we believe that it is worth reconsidering whether the Congress wants to include combat pay as reportable income for earned income tax credit purpos- es. With the exception of our concerns about combat pay we are in general agreement with all aspects of the changes that have been brought before your committee by the Department of Defense and H.R. 3949. It is essential that we provide equity among our soldiers so that there is no monetary pen- alty because of the location of duty assignments. Should we have occasion for another "Just Cause" operation it should not be diminished in the minds of our soldiers by inequitable tax treatment of their earnings simply because they answered the call of duty. Mister Chairman, on behalf of our more than 85,000 active duty members who appreciate your concern for their welfare, -this completes my prepared statement. PAGENO="0793" 783 Statement of THE NATIONAL MILITARY FAMILY ASSOCIATION, INC. The National Military Family Association (NMFA) is a volunteer, non profit organization composed of members from the seven uniformed services, active duty, retired,. and reserve, and their family members and survivors. NMFA is the only national organization whose sole focus is the military family and whose goal is to influence the development and implementation of policies which will improve the lives of those family members. NMFA appreciates this opportunity to express itS views. In 1975 the Earned Income Tax Credit (EITC) was enacted to provide relief from the Social Security payroll tax for employed low income tax- payers with children. For fourteen years, young military families serving overseas by order of the U.S. Government have been prohibited from bene- fiting from this tax relief, simply because of their location. These young families, who qualify in every other way for the EITC, may live on an overseas installation with more senior service families whose income is sufficient to incur a U.S. tax liability. No tax relief is accorded military families stationed overseas. Under the provisions in H.R. 3949, only E-4s and below would qualify for EITC, when housing and subsistence allowances are added to base pay. Currently there are approximately 25,000 young military families stationed overseas who are being denied the Earned Income Tax Credit. The Non Commissioned Officers Association, the Department of Defense, and several Members of Congress have made attempts to cOrrect this inequity since 1975. None of these efforts has been successful. What does the loss of EITC mean in real terms to the individual family? A young man entered the Army in late 1987 and was sent to Basic Training at Fort Jackson, South Carolina. At the end of that training he married and was sent to Infantry training at Fort Benning, Georgia. While in Georgia his wife had a baby. Since their baby was born in May of 1988, this Army E-1 was eligible for the EITC for the taxable year of 1988. If both his housing allowance and his basic allowance for subsistence were added to his base pay, he was eligible for an earned income tax credit for 1988 of $542. The soldier next received orders to the 2nd Infantry Division in Korea. He, his wife and their child transferred on their orders to the new duty station. It is 1990, and the young Army Private, now an E-2, is anxious to file his income tax form, eagerly looking forward to the $463 he is entitled to in earned income credit. His permanent change of station to Korea has typically produced costs substantially above his reimbursement from the Army Because the family is on foreign soil it is almost impossible for his wife to find employment and add to the family income. Imagine his surprise and lack of enthusiasm when he discovers that because he is overseas, he no longer qualifies for this credit. Translated into monthly income, his EITC for 1989 is worth $38.58 per month. That amountwou.ld purchase approximately 11 quarts of milk, 28 jars of baby food, 6 lbs. of ground meat, 7 lbs. of chicken, 10 lbs. of potatoes, 7 cans of vegetables, 5 lbs. of flour, and 5 lbs. of bananas. Whether it is the young Airman assigned to the 3rd Law Enforcement Squadron at Clark Air Base in the Philippines, the Marine Lance Corporal on Guam, the young Seaman Apprentice assigned to the USS St. Louis (LKA 116) homeported in Sasebo, Japan, or the Army Private in Korea, the dollars lost equal a degradation in their quality of life. Overseas tours of duty are often costly for military families due to decreased opportunities for spousal employment, the status of the dollar relative to foreign currency, and the difficulty and expense of locating hous- ing off base. For these young families, overseas tours can be financially devastating. Every penny that they spend must be carefully prioritized. Denying them the EITC simply because they are serving their country at an overseas post is not only an inequity, it is punitive. The National Military Family Association urges you to reverse this fourteen year old discriminatory policy by enacting H.R. 3949. PAGENO="0794" 784 I1I1~ THE I ~ RETIRED 201 North Washington Street ~ ilj OFFICERS Alexandria, Virginia 22314-2529 4p ASSOCIATION (703) 549-2311 STATEMENT OF THE RETIRED OFFICERS ASSOCIATION BEFORE THE SUBCOMMITTEE ON SELECT REVENUE MEASURES COMMITTEE ON WAYS AND MEANS U.S. HOUSE OF REPRESENTATIVES PRESENTED BY COLONEL CHRISTOPHER J. GIAIMO DEPUTY DIRECTOR, LEGISLATIVE AFFAIRS MR. CHAIRMAN AND MEMBERS OF THE COMMITTEE: I am Colonel Christopher J Giaimo, USAF-Retired, Deputy Director of Legislative Affairs for The Retired Officers Association (TROA), which has its national headquarters at 210 North Washington Street, Alexandria, Virginia. Our Association ~has a membership of more than 365,000 active duty, retired and reserve officers of the seven uniformed services. This figure includes about 54,000 auxiliary members who are survivors of former members. I wish to thank the Chairman, and members of the committee for holding these hearings on miscellaneous revenue issues. One of these proposals, Earned Income Tax Credit (EITC) for military personnel stationed overseas has a direct impact on retention, morale and welfare and overall force quality; issues of vital concern to my Association. On the subject of Earned Income Tax Credit for military personnel stationed overseas, TROA strongly supports the proposal made by Congressman Slattery in H.R. 3949. Mr. Chairman, while this credit would obviously apply only to those 25,000 young enlisted members and their families stationed overseas, those are precisely the people most in need of it. These young people are in many instances barely living above the subsistence level. The case of the young enlisted member who, after serving 10 or 11 months in the United States is abruptly moved overseas illustrates the point the best. Under today's rules he would be denied the tax credit. His civilian counterpart would not face such a circumstance, yet each is a law-abiding citizen willing to pay his taxes. Mr. Chairman, whatever tax credit they can receive is most needed and deserving. We applaud the Committee's efforts and concerns with regard to this tax credit and especially those efforts directed at streamlining and clarifying the administrative quagmire that has surrounded an application for this credit. Thank you Mr. Chairman. This completes my testimony 0 30-860 (800)