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)
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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
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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
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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
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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
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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"
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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.
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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.
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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:]
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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
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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.
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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
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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
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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.
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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.
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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.
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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.
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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"
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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.
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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).
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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
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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
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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
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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.
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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.
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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
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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"
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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.
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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"
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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
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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"
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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.
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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.
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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:]
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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. -
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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:]
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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.
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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:]
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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
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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)
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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.
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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).
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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.
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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.
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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.
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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.
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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.
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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:]
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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"
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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:]
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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.
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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.
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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.
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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"
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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
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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:]
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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
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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
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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
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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:]
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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.
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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
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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.
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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.
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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
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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.
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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
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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
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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
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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.
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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
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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.
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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,
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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.
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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:]
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* 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.
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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).
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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.
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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.
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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.
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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.
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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
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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
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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"
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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
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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.
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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.
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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
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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.
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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,
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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.
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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
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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.
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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.
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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.
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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.
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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
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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
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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:]
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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 ~
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00 c~MO~ o~btot~Ot~t3t3 ~-~W ~OtJ~i~0 O~t~) ~J~OO
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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.
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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.
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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:]
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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
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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
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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.
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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
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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):
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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
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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.
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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.
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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.]
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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
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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:]
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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."
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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
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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
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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
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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.
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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
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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."
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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
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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.
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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.
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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
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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.
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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
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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
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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
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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
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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.
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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:]
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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.
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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)
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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
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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.
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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.
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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
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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
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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
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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.
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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.
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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,
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- 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.
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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.
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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:]
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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.
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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
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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.
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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:]
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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.
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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.
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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
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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.
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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
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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:]
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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).
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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.
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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
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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.
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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
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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.
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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.
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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.
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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:]
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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.
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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"
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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
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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.
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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
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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.
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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.
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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).
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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.
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"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
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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).
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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.
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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
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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.
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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
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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.
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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).
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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"
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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"
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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").
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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").
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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.
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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.
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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.
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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.
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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
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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;
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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 ~
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[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.
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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.
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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
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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
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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
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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.
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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.
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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
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* 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
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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
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