Tax Reform Act of 1986 (P.L. 99-514)

II. SUMMARY OF THE BILL

III. GENERAL REASONS FOR THE BILL

IV. REVENUE EFFECTS

V. EXPLANATION OF PROVISIONS

VII. Vote of the Committee and Other Matters To Be Discussed Under House Rules

VIII. Dissenting Views of the Hon. John J. Duncan, Hon. Bill Archer, Hon. Guy Vander Jagt, Hon. Philip M. Crane, Hon. Bill Frenzel, Hon. Richard T. Schulze, Hon. W. Henson Moore, Hon. Carroll A. Campbell, Hon. William M. Thomas, Hon. Hal Daub, and Hon. Judd Gregg

IX. Additional Dissenting Views of the Hon. Bill Frenzel

Included in the committee's tax reform hearing consideration this year was the President's tax reform proposal made in May 1985 ("The President's Tax Reform Proposals to the Congress for Fairness, Growth, and Simplicity").

The bill provides a new 4-bracket tax rate schedule based on taxable income, which will become effective on July 1, 1986. The Secretary of the Treasury is instructed to prepare blended tax schedules for 1986 tax returns which will incorporate half of the present law structure (as indexed for inflation) and half of the new tax rate structure. The new tax rate structure, which will be fully effective on January 1, 1987, is shown below.

                               Taxable income

2. Increase in standard deduction

The standard deduction replaces the zero bracket amount. Effective in 1987, the standard deduction amounts are $4,800 for joint returns of married couples and for surviving spouses, $4,200 for heads of households, $2,950 for unmarried individuals, and $2,400 for married individuals filing separate returns. These amounts are indexed for inflation beginning in 1988.

An additional standard deduction amount of $600 is allowed for an elderly or blind individual. For these taxpayers only, the new standard deduction amount and the additional $600 standard deduction amount are effective on January 1, 1986.

For all individual taxpayers other than elderly or blind individuals, the standard deduction amounts for 1986 are $3,670 for joint returns, $2,480 for heads of households and single persons, and $1,835 for married individuals filing separately.

Individuals who itemize deductions will reduce their total itemized deductions by $500 times the number of personal exemptions claimed.

3. Increase in personal exemption

The personal exemption is raised to $2,000 for each individual, individual's spouse, and dependent, effective January 1, 1986. (The additional exemption under present law for a blind or elderly individual is repealed.) The personal exemption amount is indexed for inflation beginning in 1987.

4. Two-earner deduction

The deduction for two-earner married couples is repealed after December 31, 1985. Adjustments made in the standard deduction for married couples filing joint returns and in the relationship of the rate schedules for unmarried individuals and married couples filing joints returns compensate for the repeal of this provision.

Currently, an eligible individual is allowed a refundable income tax credit equal to 11 percent of the first $5,000 of earned income, for a maximum credit of $550. The maximum allowable credit is phased down, however, as adjusted gross income (or, if greater, earned income) rises above $6,500. Also, the credit is not allowed for taxpayers with adjusted gross income (AGI) or, if greater, earned income over $10,000. Currently, the credit is not adjusted for inflation.

The bill increases the maximum allowable credit to 14 percent of the first $5,000 of earned income (for a maximum credit of $700), for taxable years beginning on or after January 1, 1986. The phase-out levels for 1986 are adjusted so that the credit phases out between $6,500 and $13,500 of AGI. For taxable years beginning on or after January 1, 1987, the phaseout of the credit begins at $9,000 of AGI; it is totally phased out at $16,000 of AGI. Also, the maximum amount of the credit and the phaseout income levels are adjusted for inflation.

2. Repeal of political contributions credit

The tax credit allowed to individuals under present law for one half the amount of contributions to political candidates and certain political campaign organizations, up to a maximum of $50 ($100 on a joint return), is repealed. The repeal is effective for taxable years beginning after December 31, 1985.

The bill limits the exclusion for employer-provided child care assistance to $5,000 a year ($2,500 in the case of a married individual filing separately), effective for taxable years beginning after December 31, 1985.

2. Unemployment compensation benefits

Under present law, a portion of unemployment compensation benefits is includible in gross income if the sum of the recipient's benefits and adjusted gross income exceeds specified amounts. The bill provides that all unemployment compensation benefits are includible in gross income, for taxable years beginning after December 31, 1985.

3. Scholarships and fellowships

The bill limits the exclusion for degree candidates to the amount of a scholarship or fellowship grant required to be used for tuition and fees, books, supplies, and equipment required for courses. The bill repeals the exclusion for grants received by nondegree candidates, but does not affect whether their unreimbursed educational expenses may be deductible as trade or business expenses. The bill also provides that the exclusion does not apply to any portion of amounts received as a scholarship or a tuition reduction which represents payment for teaching, research, or other services required as a condition of receiving the grant. The bill repeals the present law exclusion for certain Federal grants where the recipient is required to perform future services as a Federal employee. The provision is effective for scholarships and fellowships granted after September 25, 1985.

4. Exclusion for prizes and awards

The exclusion for certain prizes and awards is repealed, except where the winner assigns the award to charity (see also the description above of the scholarship exclusion). Awards by employers to employees are includible in income unless qualifying for the present-law exclusion for de minimis items (such as certain traditional retirement gifts). The provision applies to taxable years beginning after December 31, 1985.

A one-percent floor is placed under itemized deductions for miscellaneous employee, investment, and certain other expenses, and nonreimbursed employee travel and other expenses that presently are deductible "above-the-line" are included in the miscellaneous itemized deduction. The provision is effective for taxable years beginning after December 31, 1985.

2. Charitable contribution deduction for nonitemizers

The bill makes permanent the deduction for charitable contributions made by individuals who do not itemize deductions. The bill modifies the deduction by providing that for taxable years beginning after 1985, the deduction is subject to a $100 floor.

3. Adoption expenses

Currently, an individual is allowed an itemized deduction for up to $1,500 of expenses incurred in the adoption of certain handicapped ("special needs") children. The bill repeals this deduction for taxable years after December 31, 1986, and modifies the Adoption Assistance Program of Title IV-E of the Social Security Act to provide assistance through that program for such adoption expenses (see also Title XIV, item 7.)

The income averaging provision is repealed, effective for taxable years beginning after December 31, 1985.

2. Travle and entertainment expenses

The bill provides that 80 percent of meal and other entertainment expenses, to the extent otherwise allowable, can be deducted. Certain legal and substantiation requirements are added for business meal deductions. Deductions for tickets are limited to face value, and luxury "skybox" deductions are restricted. No deductions are allowed for travel as a form of education, charitable travel that serves vacation purposes, or expenses for attending investment seminars. Deductions for luxury water travel are limited. The provision applies to taxable years beginning after December 31, 1985.

3. Changes in treatment of hobby losses

Under present law, an activity other than horse breeding, training, showing, or racing is presumed not to be a hobby if it is profitable in 2 out of 5 consecutive years. Under the bill, the presumption is changed so that an activity (other than one involving horses) is presumed not to be a hobby if it is profitable in 3 out of 5 consecutive years. The provision is effective for taxable years beginning after December 31, 1985.

4. Deduction for business use of home

The bill makes several changes regarding limitations on deductions for business use of one's home. First, no deduction arises for costs associated with business use of the home (except for items allowable without reference to such use, e.g., home mortgage interest) in the case of an employee who rents a portion of the home to the employer. Second, home office costs are deductible only to the extent of net income from the business activity (rather than certain gross income, as under present law). Third, deductions disallowed because in excess of such net income can be carried forward.

The provision is effective for taxable years beginning after December 31, 1985.

5. Housing allowances for ministers and military personnel and deductions for property taxes and mortgage interest

The bill provides that the receipt of tax-free housing allowances by ministers or military personnel does not result in loss of deductions for interest or real property tax on the individual's home, effective for past and future years.

IDS groups assets into ten classes, generally according to their present class life (or "ADR midpoint life"). Assets in the same IDS class are depreciated over a common period, ranging from 3 to 30 years. The 200-percent declining balance method, switching to the straight-line method, is used for classes 1-9; the straight-line method is used for class 10, which includes primarily real property other than low-income housing.

2. Regular investment tax credit

3. Finance leasing

Finance leasing is repealed, effective for property placed in service after December 31, 1985, subject to transition rules.

The bill retains and makes permanent the present law election to amortize over 60 months certain qualifying costs for rehabilitation of low-income housing. The bill replaces the present law limit of $20,000 per dwelling unit ($40,000 in some cases) with a single $30,000 per dwelling unit limit. The bill also extends for two years the present law election to expense qualified expenditures to remove architectural and transportation barriers to the handicapped and elderly.

The bill provides for a two-year extension (through 1987) of the present-law provision that allows the expensing of costs attributable to the removal of architectural and transportation barriers to the handicapped and elderly.

The bill extends the credit for increasing research activities for an additional three years, i.e., for qualified research expenditures paid or incurred through December 31, 1988. In addition, the bill modifies the credit as follows, effective for taxable years beginning after 1985:

The present-law rule allowing an augmented charitable deduction for donations of newly manufactured scientific equipment to universities for research use is extended to such donations made to certain tax-exempt scientific research organizations, effective for taxable years beginning after 1985.

3. Tax creidt for rehabilitation expenditures

The bill replaces the existing three-tier rehabilitation credit with a two-tier credit for qualified rehabilitation expenditures. The credit percentage is 20 percent for expenditures incurred in rehabilitation of certified historic structures and 10 percent for rehabilitation of buildings (other than certified historic structures) built before 1936. In general, the bill retains the structure of the existing rehabilitation credit, except the external walls requirement is tightened in the case of non-historic buildings and relaxed in the case of certified historic structures. In addition, the bill requires a basis adjustment for the full amount of the rehabilitation credit in the case of both historic and non-historic buildings.

The modifications to the rehabilitation credit are generally applicable to property placed in service after December 31, 1985.

4. Merchant marine capital construction fund

The Merchant Marine Act of 1936, as amended, provides Federal income tax incentives for U.S. taxpayers who own or lease vessels operated in the foreign or domestic commerce of the United States or in U.S. fisheries. The bill coordinates the application of the Internal Revenue Code of 1985 with the capital construction fund program of the Merchant Marine Act of 1936, as amended. In addition, new requirements are imposed, relating to (1) the tax treatment of nonqualified withdrawals, (2) certain reports to be made by the Secretaries of Transportation and Commerce to the Secretary of the Treasury, and (3) a time limit on the amount of time monies can remain in a fund without being withdrawn for a qualified purpose.

These rules are effective for taxable years beginning after 1985.

The bill provides a deduction for 50 percent of long-term capital gain for taxable years beginning in 1986 and 42 percent for taxable years beginning after 1986. In conjunction with the changes in the top regular individual rates, this produces a maximum long-term capital gain tax rate of 22 percent for taxable years beginning in 1986 (50 percent of 44 percent) and 22.04 percent thereafter (58 percent of 38 percent).

These provisions apply to capital gain reportable under the taxpayer's method of accounting in taxable years beginning after 1985, regardless of whether the sale or other transaction giving rise to the gain occurred in a prior year.

2. Royalty income from coal an domestic iron ore

The bill phases out the special capital gain rules for coal and domestic iron ore royalties over a three year period, beginning January 1, 1986. The provision applies to royalties taken into account after 1985.

3. Recapture of certain amounts previously reducing taxable income

The bill expands the amount of gain that must be treated as ordinary income on the disposition of oil, gas or geothermal property to include the amount of depletion deductions that have previously reduced basis, in addition to the excess intangible drilling costs which are recaptured under present law. The bill applies similar rules for mining exploration and development costs. The new provisions generally apply to property placed in service by the taxpayer after 1985.

Under present law, intangible drilling and development costs (IDCs) generally may be expensed or capitalized at the election of the operator of an oil, gas or geothermal property. IDCs qualify for this treatment whether incurred in the United States or in a foreign country. In the case of integrated producers, 80 percent of IDCs may be expensed and the remaining 20 percent must be amortized over a 36-month period. Costs with respect to a nonproductive well ("dry hole") may be deducted by any taxpayer in the year the dry hole is completed.

Under the bill, domestic IDCs that are incurred prior to the beginning of the installation of production casing may be expensed as under present law. (For integrated producers, 80 percent of these IDCs may be expensed and the remaining 20 percent must be amortized over a 36-month period). IDCs associated with the installation of production casing, or that are incurred after the commencement of such installation, are to be amortized over a 26-month period, beginning with the month in which the costs are paid or incurred. (This rule does not apply below the lowest production level.) Unamortized IDCs associated with dry holes may be expensed in the year in which the dry hole is completed. These rules apply to oil, gas and geothermal properties.

IDCs incurred outside the United States are to be recovered (i) using 10-year, straight-line amortization, or (ii) at the taxpayer's election, as part of the basis for cost depletion.

These provisions are effective for costs paid or incurred after 1985.

2. Percentage depletion

Present law allows percentage depletion for up to 1,000 barrels of daily crude oil production (or the equivalent amount of natural gas) by an independent producer or royalty owner. The percentage depletion rate for oil and gas is equal to 15 percent of the taxpayer's gross income from the property, not to exceed (1) 50 percent of net income from the property, or (2) 65 percent of the taxpayer's overall taxable income. Percentage depletion is also allowed at a 15 percent rate for geothermal properties.

The bill generally phases out percentage depletion for oil, gas and geothermal properties over a three-year period. Taxpayers will thereafter be required to use the cost depletion method. Percentage depletion is retained at a 15 percent rate for stripper well oil (as defined for purposes of the crude oil windfall profit tax) and gas (as defined under the Natural Gas Policy Act of 1978). No percentage depletion is allowed for lease bonuses, advance royalties, or any other amounts payable without regard to the actual production from an oil, gas or geothermal property.

The phaseout of percentage depletion applies to production after December 31, 1985 (in the case of geothermal properties, in taxable years beginning after that date). The denial of percentage depletion for lease bonuses and advance royalties is effective on January 1, 1986.

3. Windfall profit tax exemption for certain exchanges of crude oil

The bill provides that certain crude oil is exempt from the crude oil windfall profit tax if it is exchanged for an equal amount of residual fuel oil which is be [sic] used on the property in enhanced recovery processes. This exception is limited to production attributable to an operating mineral interest. No depletion deduction (including cost or percentage depletion) is available with respect to oil qualifying for this exception. The exception is applicable to residual fuel used, and crude oil removed, after the date of enactment.

Under present law, acquisition and related costs of mineral deposits must be recovered in any taxable year through cost or percentage depletion, whichever results in a larger deduction for that year. Depletion rates range from 5 to 22 percent of gross income. The depletion deduction for any property may not exceed 50-percent of net income from the property.

For most minerals, the bill ratably phases down the depletion rate to 5 percent over 3 years. In the case of minerals that have a 5-percent depletion rate under present law, the bill ratably phases down the depletion rate to zero over 3 years. Present law depletion rates are retained for dimension stone and minerals used in the production of fertilizer or animal feed. The 50 percent income limitation ratably is phased down to 25 percent over 3 years.

The phase down of depletion rates is effective for production after December 31, 1985. The phase down of the income limitation is effective for tax years beginning after 1985.

2. Exploration and development costs

Under present law, hard mineral exploration and development costs may be expensed by individual taxpayers. In the case of corporations, 80 percent of these costs may be expensed, and the remaining 20 percent is recovered in the same manner as 5-year depreciable property. At the taxpayer's election, once a mine begins production, expensed exploration (but not development) costs either (1) reduce depletion deductions, or (2) are recaptured in income and then recovered through depletion deductions.

Under the bill, the treatment of development costs generally is conformed to the treatment of exploration costs under present law. For domestic mines, development costs that are expensed would be recaptured when the mine reaches the producing stage. Recaptured amounts (and development costs incurred after production commences) would be recovered in the same manner as depreciable property in class 1 (3-year recover period). (Alternatively, these amounts could be applied to reduce depletion deductions.) The 20 percent of corporate exploration and development costs that are not expensed would be recovered in the same manner as class 2 property (5-year recovery period), beginning in the year the costs are paid or incurred.

In the case of foreign mines, exploration and development costs are recovered by (1) 10-year straight-line amortization or (2) at the election of the taxpayer, as part of the basis for cost depletion.

These provisions are effective for costs paid or incurred after December 31, 1985.

The solar energy tax credit is extended for three years at reduced credit rates--30 percent in 1986 and 20 percent in 1987 and 1988. Expenditures for solar hot water property are limited to $5,000. The credit may not be used to create a sun room, greenhouse, or similar structure. The insulation, energy conservation, and wind energy tax credits are allowed to expire at the end of 1985.

2. Business tax credits

Business solar and geothermal energy tax credits are extended for three years at reduced credit rates; solar credits will be 15 percent in 1986, 12 percent in 1987, and 8 percent in 1988; geothermal credits will be 15 percent in 1986 and 10 percent in 1987 and 1988. The other business energy tax credits are allowed to expire as scheduled in present law; these credits covered wind energy, ocean thermal energy and biomass properties, intercity buses, and small-scale hydroelectric projects.

3. Tax credit for fuels from nonconventional sources

Production credits for fuels from nonconventional energy sources are repealed after 1985, except for fuels produced from wells drilled or facilities placed in service before January 1, 1986, and sold before January 1, 1990. An exception is made for methane gas produced from wood in facilities placed in service before January 1, 1990, and sold before January 1, 2001.

4. Alcohol fuels

The 9-cents-per-gallon exemption from the gasoline and motor fuels excise taxes for neat alcohol and methanol fuels is reduced to 6 cents per gallon. The 60-cents-per-gallon non-refundable income tax credit for blending alcohol with gasoline is repealed after December 31, 1985. The 6-cents-per-gallon excise tax exemption for gasohol is unchanged from present law.

5. Taxicab fuel tax exemption

The 4-cents-per-gallon exemption from the excise taxes on gasoline and motor fuels for qualified taxi cabs is reinstated as of October 1, 1985 for three years, through September 30, 1988.

Under present law, the targeted jobs credit is available with respect to individuals who begin work for the employer before 1986. The credit generally is equal to 50 percent of the first $6,000 of qualified first-year wages and 25 percent of the first $6,000 of qualified second-year wages paid to a member of a targeted group. A credit equal to 85 percent of the first $3,000 of qualified first-year wages of any disadvantaged summer youth employee is also allowed.

The bill extends the targeted jobs credit for two more years with several modifications. The bill eliminates the credit for second-year wages, reduces the first-year credit to 40 percent of the first $6,000 of qualified first-year wages (except in the case of disadvantaged summer youth employees), eliminates the credit for wages paid to an individual who works for the employer for fewer than 14 days, and extends the authorization for appropriations for administrative and publicity expenses through fiscal year 1987. Under the bill, the credit is available for wages paid to individuals who begin work for an employer before 1988. The amendments to the targeted jobs credit rules apply to taxable years beginning after 1985.

2. Orphan drug tax credit

The income tax credit for clinical testing of orphan drugs is extended for one additional year through December 31, 1988.

 Taxable Income:                      Tax rate (percent)

The 28-percent alternative tax rate for net capital gains of corporations is increased to 36 percent--the regular tax rate applicable to large corporations.

The graduated income tax rates are effective for tax years beginning on or after July 1, 1986. The rate schedule for taxable years including July 1, 1986 will reflect blended rates.

The increase in the alternative tax rate on corporate capital gain's generally is effective for tax years ending after December 31, 1985. Under a transition rule, the present maximum 28-percent rate will apply to net capital gain recognized before January 1, 1986 or pursuant to a binding contract in effect on September 25, 1985.

The deduction is available for taxable years beginning after January 1, 1987 and is phased in over a ten-year period.

Effective Dates

In general, the bill applies to changes in ownership that occur after December 31, 1985 (unless pursuant to plans of tax-free reorganization adopted before January 1, 1986).

Under the bill, nonrecognition is also allowed on certain liquidating sales of property to the same extent nonrecognition would have been available had the property been distributed.

Effective Dates

In general, the bill applies to distributions and sales and exchanges occurring on and or after November 20, 1985. An exception is provided in the case of certain distributions and sales made pursuant to a plan of liquidation adopted before that date. Special rules apply for purposes of determining whether a plan of liquidation has been adopted for this purpose.

The deduction for nonbusiness interest expense of noncorporate taxpayers, in excess of their net investment income, is the sum of (a) interest on debt secured by the taxpayer's principal residence, as well as a second residence, to the extent of their fair market value, plus (b) $10,000 ($20,000 for a joint return).

2. Interest subject to limitation

Nonbusiness interest subject to the limitation means all interest (including consumer interest) not incurred in a trade or business, including the taxpayer's share of interest expense attributable to certain passive investments.

3. Investment income defined

Net investment income includes dividends, interest, rents, royalties, and similar items, the taxpayer's share of income attributable to certain passive investments and the taxable portion of capital gains. Investment expenses, which are netted against this income to determine net investment income, include expenses and depreciation and depletion actually deducted.

4. Net leases

Property subject to a net lease is considered an investment, unless the business deductions exceed 15 percent of the rental income. If the taxpayer performs personal services with respect to certain leased property, the value of his services may be included with his business deductions, in calculating 15 percent of rental income.

Effective Date

Subject to a phase-in rule, the limitation will be effective for interest paid or incurred in taxable years beginning on or after January 1, 1986, regardless of when the obligation was incurred. Interest not disallowed under present law, but which would [sic] disallowed under the bill, would become subject to disallowance ratably (10 percent per year) over 10 years commencing with taxable years beginning in 1986. Thus, the provision will be fully effective in 1995.

The overall foreign tax credit limitation of present law is retained. The separate limitation for interest income is replaced with separate limitations for passive income, shipping income, foreign currency translation gain, and banking and insurance income. Passive income includes certain categories of income subject to current taxation under the anti-tax haven rules.

These rules are effective for taxable years beginning after 1985.

2. Creditability of gross withholding taxes on interest

Foreign gross withholding taxes on interest paid to financial institutions are treated as creditable taxes only up to the amount of the U.S. tax on the interest income.

This provision is generally effective for taxes paid in taxable years beginning after 1985, but certain transition relief is provided.

3. Deemed-paid credit

4. Effect of losses on foreign tax credit

Present law is generally retained with a clarification that foreign source losses reduce all types of foreign source income before reducing U.S. source income.

This provision applies to losses incurred in taxable years beginning after 1985.

Source is generally determined by the country of residence of the seller (the place-of-title-passage source rule of present law is repealed). When a seller has a fixed place of business outside his residence country that participates materially in a sale to an unrelated party, the sales income generally is sourced in the country in which that fixed place of business is located.

2. Income from manufacture and sale of inventory-type property

At least 50 percent of such income must be allocated to manufacturing activity, which is sourced where the manufacturing occurs. The portion of such income allocated to sales activity is sourced under the rules for sales income described immediately above.

3. Income from intangible property

With respect to royalty income, the bill retains the place-of-use source rule of present law. With respect to sales income, the bill generally follows the rule, described above, for income from the purchase and sale of inventory-type property, which generally depends upon the residence of the seller.

4. Income derived from sale of other personal property

Under the bill, recapture income derived from sales of personal property used by the seller in a business is sourced where deductions with respect to such property previously offset income. Income in excess of those deductions is sourced like income from sales of inventory-type property. Income derived from sales of other personal property, including passive investment property, is sourced in the country of residence of the seller.

5. Transportation income

The bill sources transportation income from United States-foreign routes as 50-percent U.S. source income and 50-percent foreign source income. (Present law generally treats most transportation income earned on such routes as foreign source income.) The special U.S. sourcing rule for income and expenses associated with vessels or aircraft constructed in the United States and leased to U.S. persons is repealed. The bill also repeals a similar rule for transportation income earned in leasing certain aircraft used on United States-U.S. possessions routes. The repeal of both special rules is subject to a grandfather rule for currently leased assets.

Under the bill, the reciprocal tax exemption for foreign persons' shipping and aircraft income is available only if a foreign person's country of residence gives U.S. persons an equivalent foreign tax exemption; in addition, a four-percent gross basis tax is imposed on U.S. source shipping income of foreign persons.

6. Other offshore income and income earned in space

The bill sources other offshore income and income earned in space in the recipient's country of residence.

7. Dividend and interest income

For withholding tax purposes, the bill generally treats interest paid to unrelated parties by a U.S. corporation that earns more than 80 percent of its income from foreign sources (an "80/20" company) as foreign source to the extent that the company's income is derived from foreign sources in the active conduct of a trade or business outside the United States. Dividend and other interest payments to foreigners by an 80/20 company are generally subject to U.S. withholding tax. For foreign tax credit purposes, the bill treats 80/20 companies' dividends as U.S. source, and their interest payments as U.S. source unless they are connected with an active financing business of an unrelated U.S. payee conducted outside the United States. The bill also restructures certain interest income exemptions.

8. Allocation of interest and other expenses

The bill generally requires corporate members of affiliated groups to allocate all expenses between U.S. and foreign income on a consolidated group basis. Certain corporations that cannot join in filing consolidated returns can continue to allocate expenses on a separate company basis, as can some financial and similar companies, if their borrowing and lending activities are independent from their affiliates' other operations. The asset method of allocating interest expense is modified and the optional gross income method is eliminated. Tax-exempt income and assets are not taken into account for purposes of allocating expenses. The new interest allocation rules will be phased in over three years in the case of interest paid on preexisting debt amounts. Other transitional relief is provided.

9. Allocation of R&D expenses

For two years, taxpayers are to allocate half the expenses for U.S.-performed R&D to U.S. source income, and the other half on the basis of sale or gross income. After two years, starting with taxable years beginning after August 1, 1987, a suspended Treasury Regulation generally requiring allocation on the basis of sales or gross income will take effect.

Effective Date

The rules governing the source of income are generally effective for taxable years beginning after 1985, although the bill provides certain transitional relief.

Interest, dividends, and gains received by banks and insurance companies, insurance income, income earned in space or outside any country, base company rents and royalties, and gains from transactions in commodities, foreign currency, and certain other property generally are taxed currently if earned by controlled foreign corporations. Certain exceptions to the Code's rules that currently tax certain "tax-haven" income of foreign subsidiaries of U.S. companies are repealed, including the exclusion for reinvested shipping income. The subjective tax-avoidance safe-harbor rule is replaced with an objective test.

2. Determination of U.S. control of foreign corporations

The U.S. ownership requirement for imposition of the anti-tax haven rules is amended. For the anti-tax haven rules to apply to a foreign corporation, 50 percent or more (rather than more than 50 percent) of the vote or value (not merely vote) of that corporation must belong to 10-percent U.S. shareholders. Similarly, for the foreign personal holding company rules to apply, 50 percent or more of the vote or value of a foreign corporation must be owned by five or fewer U.S. individuals. Transitional relief is provided.

3. De minimis tax haven income rule

Present law is amended to apply the de minimis and 70-percent rules for foreign base company income on the basis of earnings and profits instead of gross income.

4. Foreign investment companies (FICs)

Present law is amended to require either current recognition of income earned by U.S. investors through passive FICs or payment of an interest charge on eventual recognition, and to apply FIC rules to U.S. investors irrespective of the degree of aggregate U.S. ownership. Transitional relief is provided.

5. Possessions-chartered corporations

The exception to the anti-tax haven rules for possessions-chartered corporations is repealed, with appropriate transition rules provided.

Effective Date

The bill's rules applicable to income earned through foreign corporations are generally effective for taxable years beginning after 1985.

2. Other rules with respect to U.S. possessions

3. Taxation of U.S. employees of Panama Canal Commission

The bill clarifies that the Panama Canal Treaty and its implementing agreements do not exempt U.S. taxpayers from U.S. tax. The bill provides that Commission employees are entitled to certain tax-free allowances like those available for State Department employees.

The bill's clarification of the effect of the Panama Canal treaty is effective for all taxable years. The rule concerning taxation of employees' allowances applies for taxable years beginning after 1985.

4. Foreign sales corporations (FSCs)

The bill changes the reduction in taxable income for FSC shareholders from 16 percent to 14 percent of export income (from 15 percent to 13 percent for corporate shareholders). Corresponding changes are made to DISC rules. This provision is effective for taxable years beginning after 1985.

5. Private sector earnings of Americans abroad

The bill reduces the maximum annual exclusion for foreign earned income of Americans working abroad, from the present $80,000 to $75,000. The provision is effective for taxable years beginning after 1985.

The branch-level tax proposed by the President as a substitute for the present dividend and interest withholding taxes is generally adopted. The bill retains present law when a treaty allows present law to apply but would not allow a branch-level tax to apply. The bill provides anti-treaty shopping rules. These rules are effective for taxable years beginning after 1985.

2. Retain character of effectively connected income

The bill treats income or gain as effectively connected with a U.S. trade or business if it is attributable to a different taxable year and would have been so treated if it had been taken into account in the other year. This rule applies to taxable years beginning after 1985.

3. Application of accumulated earnings tax (AET) and personal holding company (PHC) tax to foreign corporations

Present law is amended to allow foreign corporations a net capital gain deduction for purposes of calculating the AET or PHC tax only if the gains are taxed by the United States at the corporate level. This provision applies to transactions occurring after November 15, 1985.

4. Tax-free exchanges by expatriates

The tax-avoidance expatriate rules under present law are applied to gains on the sale of property the basis of which was determined by reference to U.S. property. This rule applies to sales or exchanges of property received in exchanges after September 25, 1985.

5. Excise tax on insurance premiums paid to foreign insurers

The bill makes the excise tax on casualty reinsurance premiums paid to foreign insurers for U.S. risk coverage equal to that on similar casualty insurance premiums (4 percent), makes the foreign insurer liable for the tax, and requires the U.S. insured or broker obligated to transmit the premiums to withhold the tax. This rule applies to premiums paid after 1985.

Effective Date

These rules are effective for taxable years beginning after 1985.

Interest on State and local government bonds used to finance traditional government operations is tax-exempt. Interest on bonds to provide conduit financing for nongovernmental persons is taxable unless a specific exception is provided in the Code. A bond generally is viewed as for nongovernmental conduit financing if (a) more than 25 percent of the proceeds are used in a trade or business of a nongovernmental person (and a security interest test is satisfied), or (b) an amount equal to 5 percent or more of the bond proceeds is used to finance loans to such a person.

The bill provides that bonds are for nongovernmental conduit financing if either (a) an amount equal to or exceeding the lesser of 10 percent or $10 million of bond proceeds is used in a trade or business of a nongovernmental person or (b) an amount equal to or exceeding the lesser of 5 percent or $5 million of bond proceeds is used to finance loans to such a person. Bonds for governmental activities are referred to collectively as essential function bonds under the bill.

2. Exceptions for certain nonessential function bonds

Present law includes several exceptions permitting tax-exemption for interest on bonds for nongovernmental conduit financing. These exceptions are for (a) industrial development bonds (IDBs); (b) student loan bonds issued in connection with certain Department of Education guarantees; (c) qualified mortgage bonds and qualified veterans' mortgage bonds; (d) bonds for section 501(c)(3) organizations; and (e) certain bonds issued under non-Code statutes enacted before 1984, if the bonds satisfy all Code requirements for bonds the proceeds of which are used for a comparable activity.

The bill continues many of the exceptions permitting tax-exempt financing for activities of nongovernmental persons. Bonds for these activities are referred to collectively as nonessential function bonds. Activities for which nonessential function bonds may be issued are (a) exempt-facility bonds (bonds for airports, docks and wharves, mass commuting facilities, certain water furnishing facilities, sewage and solid waste disposal facilities, and qualified multifamily residential rental projects); (b) qualified mortgage bonds and qualified veterans' mortgage bonds; (c) qualified small-issue bonds; (d) section 501(c)(3) organization bonds; (e) qualified student loan bonds (expanded to include certain bonds not issued in connection with Department of Education guarantees); and (f) qualified redevelopment bonds. Additionally, the bill retains the option for States and local governments to elect to exchange qualified mortgage bond authority and issue mortgage credit certificates.

3. Unified State volume limitation

Present law provides three separate State volume limitations for (a) IDBs and student loan bonds, (b) qualified mortgage bonds, and (c) qualified veterans' mortgage bonds. Certain types of IDBs and bonds for section 501(c)(3) organizations are not subject to State volume limitations.

The bill provides a unified State volume limitation for all nonessential function bonds and the nongovernmental portion (in excess of $1 million) of essential function bonds. States (and local issuers therein) may issue an aggregate annual amount of such bonds not exceeding the greater of $175 per resident of the State or $200 million.

An amount equal to $25 per capita ($30 million in the case of a State having a $200 million volume limitation) is permanently set-aside for section 501(c)(3) organization bonds. Additional set-asides are provided for bonds to finance housing and for qualified redevelopment bonds; these additional set-asides may be overridden by State legislation. Bonds for certain airport, dock, and wharf facilities are not subject to this volume limitation. In general, the new unified volume limitation is administered in a manner similar to the present-law volume limitations on IDBs and student loan bonds and on qualified mortgage bonds.

4. Arbitrage restrictions

Interest on arbitrage bonds is taxable under present law. Arbitrage bonds are bonds more than a minor portion of the proceeds of which are invested in materially higher yielding obligations. IDBs and qualified mortgage bonds are subject to additional arbitrage restrictions that require rebates to the Federal Government of arbitrage profits on obligations unrelated to the purpose of the borrowing and restrict the amount of bond proceeds that may be invested in such obligations.

The bill makes numerous technical amendments to the general arbitrage restrictions presently applicable to all tax-exempt bonds; extends to all such bonds both a requirement that certain arbitrage profits be rebated to the Federal Government and a limitation on the amount of bond proceeds that may be invested in nonpurpose obligations; restricts or prohibits advance refundings of all tax-exempt bonds; and restricts the early issuance of tax-exempt bonds; and provide that the purchase of annuity contracts with bond proceeds to fund pension plans will be subject to arbitrage restrictions in the same manner as if bond proceeds were used directly to fund such plans.

5. Modification and extension of miscellaneous restrictions

The bill extends to all nonessential function bonds present law requirements applicable to certain types of such bonds that require (a) that all net proceeds of the bonds be used for the exempt purpose of the borrowing; (b) that the maturity date of the bonds not exceed 120 percent of the economic life of any bond-financed property; (c) that substantial users of bond-financed facilities not own the bonds used in the financing; and (d) that certain public approvals occur before issuance of the bonds.

6. Changes in use of bond-finance facilities

The bill provides that in addition to loss of tax-exemption on bond interest where provided under present law, certain amounts paid in connection with bond-financed property that ceases to be used in a use qualifying for tax-exempt financing many not be deducted for Federal income tax purposes. In general, the nondeductible amount is the interest (or the equivalent thereof) paid on bond-financed loans.

7. Ownership and cost recovery deductions for bond-financed property

The bill requires certain facilities financed with tax-exempt bonds to be owned by or on behalf of a governmental unit. Exceptions are provided for sewage and solid waste disposal facilities, for qualified multifamily residential rental projects, for bond-financed owner-occupied residences, and for property financed with qualified redevelopment bonds and small-issue bonds. Additionally, facilities financed with section 501(c)(3) organization bonds may be owned either by a section 501(c)(3) organization or a governmental unit. The determination of ownership is made using general Federal income tax concepts.

Cost recovery deductions for bond-financed property generally are determined using the straight-line method and the recovery period for property in the next higher class of property under the new depreciation system included in the bill. Costs of real property are recovered over a 40-year period. Special recovery periods and methods are provided for qualified multifamily residential rental property.

8. Information reporting requirements

The bill extends to all tax-exempt bonds information reporting requirements similar to the requirements that presently apply to IDBs, student loan bonds, bonds for section 501(c)(3) organizations, and tax-exempt mortgage subsidy bonds.

9. Effective dates

The provisions of the bill generally apply to all bonds issued after December 31, 1985. Transitional exceptions are provided for certain of the amendments included in the bill.

Commercial banks may continue to compute their deductions for losses on bad debts under present law, except in the case of "large banks." "Large banks" must use the specific charge off method to compute the deduction for bad debts. A bank is considered to be a "large bank" if, for any taxable year beginning after 1985, the sum of the average adjusted bases of the assets of the bank (or of the assets of any controlled group to which the bank belongs) exceeds $500 million. Large banks required to change their method of accounting for bad debts are required to recapture the balance in reserve for bad debts over a period not to exceed five years, or are required to account for bad debts on existing loans under a "cutoff" method.

2. Thrift institutions

Thrift institutions that use the reserve method to compute their deductions for losses on bad debts may do so using either the experience method allowed to small banks or the percentage of taxable income method with the percentage reduced to 5 percent from 40 percent as under present law. In order to be eligible for the special treatment of bad debt reserves, at least 60 percent of the assets of the financial institution must be invested in qualifying assets.

The excess of the bad debt deduction of thrift institutions computed under the percentage of taxable income method over the deduction computed under the experience method is treated as a tax preference for alternative minimum tax purposes. The excess will not, however, constitute a preference item for purposes of the 20% reduction of present law for corporate tax preferences.

Effective Date

These provisions apply to taxable years beginning on or after January 1, 1986.

The repeal of the rules providing relief under the reorganization and net operating loss carryover provisions is effective for acquisitions or mergers occurring after December 31, 1985. The repeal of the exclusion for certain FSLIC payments is effective for payments received in taxable years beginning on or after January 1, 1986, except for payments made pursuant to an agreement entered into before that date.

The bill provides an election to use a simplified method of computing LIFO inventory values for taxpayers with average annual gross receipts of $5 million or less, effective for taxable years beginning after December 31, 1985. The method uses inventory pools established in accordance with general categories of inventory items published by the Bureau of Labor Statistics.

2. Limitations on the use of the cash method of accounting

The bill prohibits, with certain exceptions, the use of the cash method of accounting to any C corporation, partnership that has a C corporation as a partner, or tax-exempt trust with unrelated business income. Excepted entities, that can continue to use the cash method, are farming businesses, qualified personal service corporations, and entities with average annual gross receipts of $5 million or less. In the case of services, the time of accrual of income by the provider and deduction by the recipient generally is the time of billing. The provision is effective for taxable years beginning after December 31, 1985.

3. Pledges of installment obligations

The bill provides that the proceeds of a loan for which an installment obligation is pledged as collateral generally is treated as a payment on the obligation, resulting in the recognition of a proportionate part of the deferred gain. Exceptions are provided for the pledge of all of the assets of an active trade or business pursuant to a general lien in favor of a financial institution and for certain other situations. The provisions of the bill apply to pledges after December 31, 1985, and pledges before that date of installment obligations arising after September 25, 1985. Certain transitional rules are provided.

4. Accounting for production costs and long-term contracts

5. Reserves for bad debts

The bill generally repeals the reserve method of computing deductions for bad debts. Under the bill, taxpayers, other than certain financial institutions, are allowed a deduction for bad debts when the debt becomes wholly or partially worthless. Wholly worthless debts must be treated as worthless on a taxpayer's books in order to be allowed as a deduction for Federal income tax purposes, as is the case under present law for partially worthless debts. The balance of any reserve for bad debts or guarantees is taken into income ratably over a period of five years. The provision is effective for taxable years beginning after December 31, 1985.

6. Accrued vacation pay

The bill limits the deduction for additions to a reserve for vacation pay to amounts that are paid within the taxable year and eight and one-half months after the close of the taxable year. The provision is effective for taxable years beginning after December 31, 1985.

7. Contributions in aid of construction

The bill provides that utilities must include in gross income the value of any property, including money, that it receives to encourage it to provide services to, or for the benefit of, the person transferring the property. The provision of present law that allows certain utilities to treat these amounts as contributions to capital is repealed effective for taxable years beginning after December 31, 1985.

The bill provides that, in the case of dispositions after December 31, 1988, capital gains treatment is available only for natural persons, estates, and trusts, all of the beneficiaries of which are natural persons or estates. A modified corporate alternative capital gains rate is provided for dispositions of timber by corporate taxpayers prior to that date. Dispositions of timber grown on Federal lands do not qualify for capital gains treatment after December 31, 1985.

2. Reforestation expenditures

The bill repeals the provisions of present law allowing an election for 7-year amortization and an investment tax credit with regard to certain reforestation expenditures, effective for expenditures made after December 31, 1985.

The bill amends the provision allowing current deductions for certain soil and water conservation expenditures to limit current deductions to costs of improvements consistent with a soil or water conservation plan adopted by the U.S. Department of Agriculture, or in the absence of such, by a comparable State agency. The bill also repeals the provisions permitting current deductions for land clearing expenses and for certain soil conditioning activities. These provisions apply to expenditures incurred after December 31, 1985.

2. Dispositions of converted wetlands and erodible croplands

The bill provides that gain from the disposition of highly erodible land that is converted to agricultural use (other than livestock grazing) is not eligible for capital gain treatment, effective for dispositions after December 31, 1985.

3. Netting for cooperatives

Cooperatives (including tax-exempt farmers' cooperatives) are permitted to offset patronage earnings and losses in computing net earnings for the purpose of paying patronage dividends. Cooperatives that do so are required to notify affected members. The provision relating to netting is effective for taxable years beginning after December 31, 1962. The provision relating to the notice requirement is effective for taxable years beginning after the date of enactment of the bill.

4. Treatment of certain plant variety protection certificates as patents

The bill provides that plant protection certificates issued under the Plant Variety Protection Act of 1970 are treated as patents for determining the character of gain on their disposition, effective for dispositions after December 31, 1985.

The bill repeals the provision of present law under which the income on the proceeds of life insurance that are paid to a surviving spouse in periodic payments are includible in gross income only to the extent that the amount of income paid during any taxable year exceeds $1,000. The provision is effective for amounts received with respect to deaths occurring after December 31, 1985.

2. Deduction for nonbusiness casualty losses

Under the bill, in the case of a loss covered (wholly or partially) by insurance, a taxpayer is permitted to deduct a casualty loss for damages to property not used in a trade or business or in a transaction entered into for profit only to the extent of losses not covered by insurance and only if the taxpayer files a timely insurance claim with respect to damage to that property. The provision applies to losses sustained in taxable years beginning after December 31, 1985.

3. Exclusion from income for structured settlements limited to cases involving physical injury

The bill limits the exclusion from income for qualified assignments under structured settlement agreements to those assignments requiring the payment of damages on account of a claim for personal injuries or sickness involving physical injury or sickness (including death). The provision is effective for assignments entered into after December 31, 1985.

Under the bill, the special life insurance company deduction equal to 20 percent of tentative life insurance company taxable income (LICTI) is repealed, effective for taxable years beginning after December 31, 1985.

2. Status for certain organizations providing commercial-type insurance

The bill provides, for taxable years beginning after December 31, 1985, that certain organizations (described in sec. 501(c)(3) or (4)) are entitled to tax exemption only if no substantial part of their activities is providing commercial-type insurance (including the issuance of annuity contracts). In addition, the commercial-type insurance activities of an otherwise tax-exempt organization are treated as an unrelated trade or business which is subject to tax under Subchapter L.

Commercial-type insurance does not include insurance provided at substantially below cost to a class of charitable recipients, incidental health insurance provided by a health maintenance organization of a kind customarily provided by such organizations, or property and casualty insurance (such as fire insurance) provided directly or through a wholly-owned corporation by a church or convention or association of churches.

In the case of Blue Cross and Blue Shield organizations, the bill authorizes the issuance of regulations to provide special treatment in the case of insurance provided to high risk individuals and small groups. This special treatment is not available to the extent that applicable State law requires the provision of insurance to such individuals or groups.

Further, the bill requires the Department of the Treasury to conduct a study of fraternal beneficiary associations (sec. 501(c)(8)) that received gross annual insurance premiums in excess of $25 million in 1984.

Transition rules are provided for certain organizations with respect to their pension businesses.

3. Operations loss deduction of insolvent companies

The bill permits a life insurance company to apply unused net operating loss carryovers against the increase in its taxable income attributable to the amount deemed to be distributed from its policyholders surplus account. This provision only applies if (1) the company was insolvent on November 15, 1985, (2) the company is liquidated pursuant to a court order, and (3) as a result of the liquidation, the company's tax liability would be increased by policyholder surplus account distributions. This provision is effective for liquidations occurring after or on November 15, 1985.

Under the bill, a property and casualty insurance company is required to reduce its deduction for unearned premium reserves by twenty percent. This provision is phased in over a five year period commencing with taxable years beginning after December 31, 1985. For the five taxable years beginning after that date, a total of 20 percent (4 percent each year) of a company's unearned premium reserve for its most recent taxable year beginning before January 1, 1986, is included in income. For all taxable years beginning after December 31, 1985, a company also takes into account only 80 percent of the difference in the reserve for unearned premiums at the end of the preceding year and at the end of the current year.

2. Treatment of certain dividends and tax-exempt interest

For taxable years beginning after December 31, 1985, a property and casualty insurance company's deduction for losses incurred is reduced by a portion of the company's tax-exempt income and the deductible portion of dividends received (with special rules for dividends from affiliates). The portion taken into account is 10 percent of tax-exempt income and the deductible portion of dividends received from investments made after November 14, 1985 (increasing to 15 percent in taxable years beginning after December 31, 1987).

3. Taxable income must bear certain relationship to net gain from operation

For taxable years beginning after December 31, 1987, the regular taxable income of a property and casualty insurance company shall not be less than 20/36 of its adjusted net gain from operations, and its regular taxable loss shall not be greater than 20/36 of its adjusted net loss from operations. Adjusted net gain or loss from operations means the net gain or loss from operations required to be set forth on the company's annual statement approved by the National Association of Insurance Commissioners, determined with regard to policyholder dividends but without regard to Federal and foreign income taxes, adjusted to exclude certain tax-exempt income and the deductible portion of certain dividends received attributable to investments made before November 15, 1985.

4. Study of treatment of loss reserves

The Treasury Department is required to conduct a study of the tax treatment of loss reserves of property and casualty insurance companies, to be submitted no later than January 1, 1987.

5. Repeal of protection against loss account

Effective for taxable years beginning after December 31, 1985, the deduction for contributions to the protection against loss account for mutual property and casualty companies is repealed. Balances in the account are includable in income no less rapidly than ratably over the first five years beginning after December 31, 1985, or, if more rapidly as such amounts would have been included over the five years had the PAL account provision not been repealed.

6. Revision of special tretament for small companies

Under the bill, property and casualty companies (whether stock or mutual) with net written premiums or direct written premiums (whichever is greater) which do not exceed $500,000 for the taxable year are exempt from tax. Property and casualty companies (whether stock or mutual) with net written premiums or direct written premiums (whichever is greater) that exceed $500,000 but do not exceed $2,000,000 may elect to be taxed only on taxable investment income. In the case of a controlled group, these amounts are determined on a group basis. The provisions are effective for taxable years beginning after December 31, 1985.

7. Study of treatment of policy holder dividends by mutual property and casualty insurance companies

Under the bill, the Treasury Department is required to conduct a study of the treatment of policyholder dividends of mutual property and casualty insurance companies, to be submitted no later than January 1, 1987.

The bill provides that an individual's IRA deduction limit is reduced, dollar for dollar, by the amount of the individual's elective deferrals under a qualified cash or deferred arrangement or tax-sheltered annuity.

In addition, the bill provides special rules to ensure that electing spouses with some earned income are not precluded from receiving spousal IRA contributions.

2. Qualified cash or deferred arrangements

The bill generally provides that an employee will be treated as highly compensated for a plan year if, during the current plan year, or either of the two preceding plan years he or she was:

3. Employer matching contributions and employee contributions

The bill provides that employee contributions and qualifying employer matching contributions, as a percentage of compensation for highly compensated employees, may not exceed 125 percent of the average of such contributions as a percent of compensation for the nonhighly compensated employees. Alternatively, the average percentage for the highly compensated employees may not exceed 200 percent of the average percentage for the nonhighly compensated employees, or the average percentage for the nonhighly compensated employees plus two percentage points, if less.

The average of nonqualifying employer matching contributions as a percent of compensation for the employer's highly compensated employees may not exceed 110 percent of the average of nonqualifying employer contributions as a percent of compensation for the nonhighly compensated employees. Alternatively, the average percentage for the highly compensated employees may not exceed the lesser of 150 percent of the average percentage of the nonhighly compensated employees, or the average percentage of the nonhighly compensated employees plus one percentage point.

Excess contributions generally are subject to a 10-percent excise tax, unless the excess, plus earnings, are distributed (or, if nonvested, forfeited) in a timely manner.

4. Unfunded deferred compensation arrangements of State and local governments and tax-exempt employers

The bill applies the rules governing eligible unfunded deferred compensation plans of State and local governments to unfunded deferred compensation plans for employees of tax-exempt employers.

In addition, the bill modifies the distribution requirements applicable to pre-death and post-death distributions from an eligible deferred compensation plan. Under the bill, distributions commencing during a participant's lifetime must satisfy a payout schedule under which benefits projected to be paid to the participant during life are at least two-thirds of the total benefits payable with respect to the participant. If the entire interest has not been distributed before the participant's death, the remainder must be distributed no more slowly than under the lifetime schedule in effect on the date of death. Distributions commencing after death generally must commence within a year of death and be paid over a period not to exceed 15 years, or over the life expectancy of a surviving spouse who is a beneficiary. If any benefits are payable over a period longer than one year, they must be paid on a substantially nonincreasing basis, not less frequently than annually.

5. Deferred annuity contracts

Effective for amounts invested in deferred annuity contracts after September 25, 1985, the bill provides that a nonindividual owner of a deferred annuity contract must include in income any increase in the cash surrender value of the deferred annuity contract over the contract's basis during the taxable year. The owner of a deferred variable annuity contract is treated as owning a pro rata share of the assets and income of any separate account underlying the variable contract. As a result, the owner is not taxed on the unrealized appreciation of assets underlying a variable contract.

The bill also conforms the additional income tax on amounts withdrawn from deferred annuity contracts before age 59-1/2 to the 15-percent tax on early withdrawals from IRAs and other tax-favored retirement arrangements.

These provisions generally apply for years beginning after December 31, 1985. However, with respect to a plan maintained on November 22, 1985, pursuant to one or more collective bargaining agreements, these provisions will apply for years beginning after the earlier of (a) the date on which the last of the collective bargaining agreements terminates, or (b) December 31, 1990. In addition, a special effective date is provided for certain plans maintained by state and local governments.

With respect to elective contributions to tax-sheltered annuity programs (other than programs maintained by churches), the bill requires that any entity offering the opportunity to make elective deferrals available to any employee must make the election to all employees without a minimum contribution requirement.

2. Certain Social Security benefits earned with prior employers

The bill revises the manner in which a pension plan may be integrated with social security, effectively precluding an employer from taking into account benefits attributable to OASDI contributions of former employers of an employee. Pursuant to regulations to be issued by the Secretary of the Treasury, the maximum amount of social security benefits that may be taken into account by any employer may not exceed 1/40 of the total social security benefits permitted to be taken into account multiplied by the number of years of service with that employer.

3. Top-heavy plans

The bill provides that a uniform benefit accrual rule must be applied in testing whether a defined benefit plan is top heavy. Solely for the purpose of determining whether a plan is top heavy or super top heavy, benefits will be considered to accrue no more rapidly than permitted under the fractional benefit accrual rule.

4. Modification of rules for benefit forefeitures effective for years beginning after December 31, 1985

The bill creates uniform rules for forfeitures under any defined contribution plan. The bill permits, but does not require, forfeitures to be reallocated to other participants in a money purchase pension plan.

These provisions generally apply for years beginning after December 31, 1985. However, with respect to a plan maintained on November 22, 1985, pursuant to one or more collective bargaining agreements, these provisions will apply for years beginning after the earlier of (a) the date on which the last of the collective bargaining agreements terminates, or (b) December 31, 1990.

The bill establishes a uniform commencement date for benefits under all qualified plans, IRAs, tax-sheltered annuities and custodial accounts. Under the bill, distributions under a qualified retirement plan must commence no later than April 1 of the calendar year following the calendar year in which the participant or owner attains age 70-1/2, without regard to the actual date of retirement.

In addition, the bill establishes a new sanction in the form of an excise tax for failure to satisfy the minimum distribution rules.

2. Withdrawal restrictions

The bill provides that no withdrawals may be made under any tax-sheltered annuity prior to the time an employee attains age 59-1/2, dies, becomes disabled, or separates from service. However, the bill does permit hardship withdrawals of elective contributions.

3. Additional income tax on early withdrawals

The bill applies a 15-percent additional income tax to withdrawals from a qualified plan, qualified annuity, tax-sheltered annuity, or IRA, made before death, disability, or attainment of age 59-1/2. An exception to this rule is provided for any distribution that is part of a scheduled series of level payments under an annuity for the life of the participant (or the joint lives of the owner and the owner's beneficiary).

A transitional rule makes this tax inapplicable to distributions made to certain participants whose benefits were in pay status on November 6, 1985.

4. Taxation of distributions

The bill (a) repeals the rule that owners of tax-sheltered annuities are subject to tax when amounts under the annuities become available, (b) repeals the present-law pre-1974 capital gains provisions; (c) replaces the present-law 10-year forward averaging with a new provision permitting one election after age 59-1/2 to claim five-year forward averaging, (d) reorders the present-law basis recovery rules for amounts withdrawn prior to a participant's annuity starting date; (e) eliminates the special three-year basis recovery rule of present law effective for participants whose annuity starting date is after July 1, 1986; and (f) modifies the general basis recovery rules for amounts paid as an annuity.

Special transition rules applicable to individuals who will have attained age 50 on or before January 1, 1986, (1) permit such individuals to make one additional election to claim five-year forward averaging treatment before attainment of age 59-1/2 and (2), solely with respect to such individuals, separately phase out over six years the pre-1974 capital gains provisions.

5. Loans

Generally effective for loans made after December 31, 1985, the bill (a) reduces the present-law $50,000 limit on loans not treated as distributions by the highest outstanding loan balance of the prior 12 months; (b) provides an exception to the five-year repayment rule only for loans applied to the purchase of the participant's principal residence; and (c) requires level amortization of a loan over the permissible repayment period.

In addition, also effective for loans made after December 31, 1985, the bill provides a deferral of the deduction for interest paid by employees on loans secured by elective deferrals from a 401(k) plan or tax-sheltered annuity (403(b) plan), and also by key employees on loans from any qualified plan. Under the bill, the deferral would be accomplished by denying a deduction for interest, and increasing the participant's basis under the plan by the amount of nondeductible interest paid.

Except as otherwise noted, these provisions apply for years beginning after December 31, 1985.

The bill makes several changes to the overall limits on contributions and benefits under qualified plans, tax-sheltered annuity programs, and SEPs of private and public employers. The dollar limit on annual additions under defined contribution plans is decreased from $30,000 to the greater of $25,000, or 25 percent of the defined benefit plan dollar limit. In applying this limit, the bill provides that all employee contributions are treated as annual additions.

The bill also reduces the dollar limit on the annual benefit payable under defined benefit plans from $90,000 to $77,000. If the retirement benefit under a defined benefit plan begins before age 62, the $77,000 limitation generally is reduced so that it is the actuarial equivalent of an annual benefit of $77,000 beginning at age 62. Special rules are provided for commercial airline pilots, police and firefighters under transitional rules provided by the bill, benefits already accrued by a plan participant under an existing plan are not affected by the reductions.

In addition, the bill (1) permits contributions to a qualified cost-of-living arrangement, (2) provides a limit on compensation that may be taken into account under any qualified plan (an amount equal to seven times the defined contribution plan limit), and (3) adds a new 15-percent excise tax on certain excess retirement distributions.

2. Limits on employer deductions

The bill makes several changes to the limits on employer deductions for contributions to qualified plans. The bill (1) repeals the limit carryforward applicable to profit-sharing and stock bonus plans; (2) extends the combined plan deduction limit to any combination of a defined benefit pension plan and a money purchase pension plan; (3) requires that certain social security taxes be taken into account in applying the 15 percent and 25 percent of compensation deduction limits; and (4) imposes a 10-percent excise tax on excess contributions to qualified plans.

3. Excise tax on reversion of qualified plan assets

The bill imposes a 10-percent nondeductible excise tax on a reversion from a qualified plan. The tax is imposed on the person who receives the reversion. Under the bill, the tax applies to amounts received as a reversion pursuant to the termination of a plan occurring after December 31, 1985.

These provisions generally apply for years beginning after December 31, 1985. However, with respect to a plan maintained on November 22, 1985, pursuant to one or more collective bargaining agreements, these provisions will apply for years beginning after the earlier of (a) the date on which the last of the collective bargaining agreements terminates, or (b) December 31, 1990.

Under the bill, the provisions affecting qualified plans generally apply as of the separately stated effective date (generally years beginning after December 31, 1985). However, a plan will not fail to be a qualified plan for any year beginning before January 1, 1988, provided

2. Penalty for overstatement of pension liabilities

Effective for returns filed after December 31, 1985, the bill provides a new penalty in the form of a graduated addition to tax applicable to certain income tax overstatements of deductions for pension liabilities. As an addition to tax, this penalty will be assessed, collected, and paid in the same manner as a tax. This addition to tax applies only to the extent of any income tax underpayment that is attributable to such an overstatement. The penalty is similar to the present-law penalty for overvaluations of liabilities.

Generally effective for years beginning after December 31, 1985, the bill establishes comprehensive nondiscrimination rules as to coverage and benefits for statutory fringe benefit plans. Statutory fringe benefit plans include employer-maintained group-term life insurance plans, health benefit plans (whether self-insured or funded through an insurance company), qualified group legal services plans, educational assistance programs, and dependent care assistance programs. In the case of accident or health plans, the provisions apply for years beginning after December 31, 1986.

2. Nondiscrimination rules for welfare benefit funds and cafeteria plans

Generally effective December 31, 1985, the bill extends to welfare benefit plans and cafeteria plans nondiscrimination rules similar to those applicable to statutory fringe benefit plans. The bill also modifies the rules governing the year in which benefits under a discriminatory cafeteria plan must be included in income by highly compensated and key employees.

3. Study

The bill requires that Treasury conduct a study of abuses of the health insurance provisions and make recommendations for changes in the nondiscrimination rules. No later than July 1, 1986, Treasury is required to report the results of the study, together with any recommendations it deems advisable, to the Committee on Ways and Means, the Committee on Finance and the Joint Committee on Taxation.

4. Reporting requirements

Generally effective for years beginning after December 31, 1985, the bill imposes new reporting requirements with respect to certain fringe benefits paid as wages.

5. Exclusions for 2-year extension of educational assistance and group legal service benefits

The bill extends for two years the present law exclusions from income for benefits provided under certain employer-maintained educational assistance programs and group legal service plans. The exclusions were scheduled to expire for taxable years beginning after December 31, 1985. Under the bill, exclusions expire for taxable years beginning after December 31, 1987.

The bill repeals the special ESOP tax credit for years after 1985. Thus, under the bill, no tax credit is provided for compensation paid or accrued after December 31, 1985.

In addition, effective for terminations after December 31, 1984, the bill amends the tax credit ESOP distribution provisions to permit total distributions upon plan termination.

2. Termination of certain additional tax benefits

Generally effective for taxable years beginning after December 31, 1988, the bill repeals (a) the special deduction for dividends paid on employer securities allocated to participants' accounts under an ESOP; (b) the provision permitting deferred recognition of gain on certain sales to an ESOP or eligible worker-owned cooperative, and (c) the provision permitting an ESOP or eligible worker-owned cooperative to assume estate tax liability.

In addition, effective for loans made after December 31, 1988, the bill repeals the 50-percent interest exclusion for interest earned in certain securities acquisition loans.

3. Changes in qualification requirements

Under the bill, additional qualification requirements are provided for ESOPs. These additional qualification requirements (a) require more rapid (ten-year graded) vesting; (b) modify the ESOP nondiscrimination rules to limit the annual amount of employer contributions that may be allocated to employees who are officers, shareholders, or highly compensated; (c) expand the pass-through voting requirements applicable to employer securities held by an ESOP; (d) permit an eligible plan participant to direct the ESOP trustee to diversify a portion of the participant's ESOP account balance; and (e) modify the distribution and put option requirements, including the timing of the employer's payment of the put option price.

These provisions generally apply to ESOPs adopted after December 31, 1985 and, for ESOPs in existence on that date, to amounts contributed after that date.

If one beneficiary is entitled to all distributions from a trust and all undistributed amounts are ultimately subject to the control of the beneficiary (called a "qualified beneficiary trust"), the income of that trust is taxed at the marginal tax rate of the beneficiary.

If all beneficiaries of the trust are children of a grantor (called a "qualified children's trust"), the income of the trust may be taxed at the marginal rate of any child for any year that the child is minor.

A grantor of a trust is treated as the owner of the trust if the grantor retains a power to revoke the trust, if the grantor (or grantor's spouse) retains the right to receive the trust income or the power to use the trust income, and if the grantor retains certain administrative powers over the trust.

The provisions of the bill are effective for trusts created, and trust contributions made, on or after September 25, 1985. In the case of estates, the provisions are effective for decedents dying on or after September 25, 1985.

The bill consolidates the present-law penalty for failure to file an information return with the IRS and the present-law penalty for failure to supply a copy of the information return to the taxpayer. The bill also provides a new penalty for failure to include correct information on an information return. This applies to information returns the due date for which is after December 31, 1985.

2. Increase in penalty for failure to pay tax

The bill increases the penalty for failure to pay taxes from one-half of one percent under present law to one percent after the IRS notifies the taxpayer that the IRS will levy upon the assets of the taxpayer. This applies to amounts assessed after December 31, 1985.

3. Negligence and fraud penalties

The bill expands the scope of the negligence penalty by making it applicable to all taxes under the Code. The bill also provides that failure to report on a tax return any amount reported on an information return is considered negligence in the absence of clear and convincing evidence to the contrary. The bill modifies the fraud penalty by increasing the rate to 75 percent but applying the penalty only to the amount of the underpayment attributable to fraud. This is effective for returns the due date of which is after December 31, 1985.

The bill extends through the end of 1989 the provision of present law authorizing awards of attorney's fees in tax cases where the Government's position was unreasonable. The bill also provides that all or a portion of that award may be assessed against an IRS employee if the court determines that that employee's arbitrary or capricious act caused the lawsuit to occur. This applies generally to proceedings commenced after December 31, 1985.

2. Exhaustion of administrative remedies

If a taxpayer does not use reasonable efforts in good faith to resolve a dispute through administrative proceedings (such as, for example, meeting with the Appeals Division of the IRS), the Tax Court may award damages of $120 to the United States. This applies to any action or proceeding in the Tax Court commenced after December 31, 1986.

The bill gives the IRS authority, if the taxpayer consents, to rescind a statutory notice of deficiency.

2. Authority to abate interest

The bill gives the IRS the authority to abate interest attributable to error or delay by an IRS employee in performing a ministerial act.

3. Suspension of compounding when underlying interst is suspended

The bill suspends the compounding of interest in circumstances in which the underlying interest on the deficiency is also suspended.

4. Additional exemption from levy

The bill exempts from IRS levy military service disability benefits.

5. Modification of amounts subject to administrative forefeiture

The bill increases the value of property subject to administrative forfeiture because it has been used in violating Internal Revenue laws to the level applicable to similar Customs offenses.

6. Certain recordkeeping requirements

The bill provides that IRS special agents are subject to the same income inclusion and recordkeeping rules that other law enforcement officers are with respect to use of an automobile.

The bill provides that the Government pays interest to taxpayers at the three-month Treasury bill rate plus 2 percentage points, and that taxpayers pay interest to the Government at the threemonth Treasury bill rate plus 3 percentage points. These rates are adjusted quarterly, and apply to interest for periods after December 31, 1985.

2. Interest on accumulated earnings tax

The bill provides that interest is imposed on underpayments of the accumulated earnings tax from the due date of the tax return with respect to which that tax is imposed. This applies to returns the due date for which (determined without regard to extensions) is after December 31, 1985.

The bill provides that the settlement attorney or other stakeholder must provide an information report on real estate transactions. This is effective on January 1, 1986.

2. Information reporting on persons receiving Federal contracts

The bill requires Federal executive agencies to provide information reports on contracts that they enter. Reporting is required beginning on January 1, 1986.

3. Information reporting on State and local taxes

The bill (sec. 145) requires that State and local governments provide information reports on income taxes, real property taxes, or personal property taxes they collect, effective with respect to payments received after December 31, 1986.

4. Tax-exempt interest

The bill requires every person who files an income tax return to report on that return the amount of tax-exempt interest received or accrued during the taxable year. This applies to taxable years beginning after December 31, 1985.

Currently, a foster parent may exclude from gross income reimbursements for expenses of caring for a foster child. The bill modifies the exclusion to apply to foster care payments, rather than expense reimbursements, so that detailed recordkeeping by the foster parents will not be necessary. This provision is effective for tax years beginning after December 31, 1985.

2. Reinstatement of rules for spouses of Vietnam MIA'S

Under the bill, certain tax relief provisions applicable with respect to Vietnam MIA's (and their spouses) that expired after 1982 are retroactively reinstated and made permanent.

3. Olympic Trust fund and excise tax on U.S. television and radio Olympic broadcast rights

4. Exemption from UBIT for certain activities

The bill provides exemptions from the unrelated business income tax (UBIT), in the case of certain tax-exempt organizations eligible to receive charitable contributions, for income from (a) exchanges or rentals of mailing lists with or to other such organizations, and (b) certain distributions of low cost articles incidental to soliciting charitable contributions, effective on the date of enactment.

5. Allocation of cooperative housing corporations

Cooperative housing corporations that charge tenant-stockholders with a portion of the cooperative's interest and taxes in a manner that reasonably reflects the cost to the cooperative of the interest and taxes allocable to each tenant-stockholder's dwelling unit, may elect to have such tenant-stockholders deduct the separately allocated amounts for income tax purposes (rather than amounts based on proportionate ownership of the shares of the cooperative). The provision is effective for taxable years beginning after December 31, 1985.

6. Personal holding companies

An exception from the definition of personal holding company income is provided for computer software royalties that are received by certain corporations that are actively engaged in the business of developing computer software. Another exception is provided from the definition of personal holding company income for interest on securities held in the inventory of a dealer in securities. In addition, a dealer in securities may deduct interest on "off-setting loans" in computing its interest income. The provisions are effective for royalties and interest received after December 31, 1985.

7. Adoption assistance program of the Social Security Act

The bill modifies the Adoption Assistance Program under Title IV-E of the Social Security Act to provide assistance for certain expenses incurred in adopting a child with special needs. These are the same expenses as qualify for the present-law itemized deduction which is repealed in Title I of the bill.

The committee has observed that, as narrowly focused incentives proliferate, the income tax loses its ability to collect tax revenues and becomes increasingly intrusive in economic affairs. Erosion of the tax base creates a need for higher marginal tax rates in order to maintain tax revenues. Higher marginal tax rates discourage work effort and discourage saving relative to consumption. Tax incentives, even if individually designed to promote desired objectives, collectively cause significant economic distortions and increase the burden of the tax system in other sectors of the economy. Incentives designed to encourage investment and increase pro ductivity often have unintended results, such as the substitution of less productive, but tax-favored, assets for more productive investments. For example, excessive tax incentives have encouraged the construction of office buildings in communities with already record high office vacancy rates. Tax incentives designed to aid farmers have shifted the ownership of farm property from family farmers to investors with higher marginal rates, since the latter obtain greater benefits from the tax deductions provided. In many cases, such investments are made only because they produce large deductions and credits that may be used to offset other income, and, importantly, not because there is a market demand for the services provided by these investments. Over the history of the Federal income tax, the tax code has become overloaded with provisions that fail to accomplish the objectives for which they were originally intended.

The committee believes the tax system is nearing a crisis point. The committee has grasped an historic opportunity to restore confidence in the tax system and to assure the productive use of our resources. Unless decisive action is taken now, compliance with the tax system will further erode and the inefficiencies introduced by the tax system will restrict the potential growth of the economy.

To correct the many problems of the present tax system, the committee believes that it is of utmost importance to reduce marginal tax rates. Lower rates reduce the tax burden on many taxpayers, the predominance of tax considerations in business and personal decisions, and the bias in favor of consumption over saving. The goal of lower marginal rates can best be achieved by reducing and eliminating inefficient subsidies and unintended preferences in the Code. By closing loopholes and eliminating abuses, this bill helps ensure that no individual or corporation will excessively transfer tax burdens to other taxpayers by manipulating the tax system. The bill contributes greatly to improving the equity of the tax system and the efficiency of the economy, without altering the total tax revenues collected.

The committee has observed that certain tax provisions allow many corporations to pay relatively little Federal income tax, without stimulating investment and production as intended. While the statutory corporate tax rate is 46 percent, studies have shown that the average tax rate on corporations is far lower. Many firms have made use of tax provisions to reduce their tax liability to zero, and, in some cases, corporations with substantial book income obtain tax refunds.

Between 1950 and 1985, the corporate income tax as a percentage of total budget receipts has declined from 27 percent to only 8 percent. Over the same period, the corporate income tax as a percentage of total income tax receipts has declined from 40 percent to only 16 percent, despite a slower decline in the relative share of income earned by corporations. To restore the traditional balance of the income tax between individuals and corporations, the committee has greatly restricted the ability of corporations to eliminate their tax liability. For example, the committee has adopted a broad-based corporate alternative minimum tax, including a wide range of preference items and applying at a rate of 25 percent. This provision replaces the present add-on minimum tax, which has failed to prevent substantial corporate tax avoidance due to its structural defects and the limited range of preferences to which it applies.

Tax provisions that have been used by various industries to reduce substantially their tax liabilities have been carefully reviewed by the committee, and many such provisions have been eliminated, restricted, or allowed to expire. Under the bill, for example, large commercial banks will no longer be allowed to take deductions for bad debts before the underlying loan is determined to be wholly or partially worthless. Defense contractors and large construction firms will no longer be permitted to defer income to the future, while they take current deductions for expenses. Abuses of the installment method of accounting will be reduced, and other accounting provisions will be substantially tightened. The taxation of property and casualty insurers is altered to measure income more accurately. Certain charitable and social welfare organizations that engage in insurance activities will not be treated as tax-exempt if a substantial part of their activities is providing commercial-type insurance.

Under the bill, the share of total income tax receipts paid by corporations will increase relative to present law, but will generally remain below pre-1980 levels. The tables below show the historical percentages of total budget and total income tax receipts paid by corporations and the projected percentages under present law and under the bill. As shown, the share of total taxes paid by corporations is estimated to increase by an average of 2.9 percentage points over the next five years. While this increase is significant relative to the present law projections, the estimated share of taxes paid by corporations is still modest in comparison to historical levels. The committee believes the increase in the corporate share of taxes helps correct an unwarranted shift in the tax burden to individuals, while maintaining the necessary incentives for growth in the corporate sector.

         CORPORATE INCOME TAX AS A PERCENTAGE OF TOTAL BUDGET

The committee also desires to restrict the ability of individual taxpayers to eliminate their tax liabilities through participation in tax shelters. The committee bill provides an expanded alternative minimum tax for individuals. The committee has expanded the preferences included in this calculation, and has increased the tax rate on this alternative tax base to 25 percent, as with the corporate minimum tax. The alternative minimum tax provided by this bill places a direct limitation on the ability of high-income taxpayers to use tax shelter losses to reduce tax on income from unrelated activities. The committee bill also places limits on the interest deductions provided by tax shelters.

The committee is concerned that, under present law, some taxpayers can exclude or deduct from income certain items that differ little from items that are treated as taxable compensation or nondeductible expenditures for other taxpayers. Fairness requires that these items be treated similarly. Therefore, the committee placed limits on certain business deductions that partially serve personal purposes. Business meal and entertainment expenses are only 80 percent deductible under the bill. The bill retains present law deductions for most business travel expenses, but eliminates certain abuses such as deductions for attending investment seminars and the treatment of certain vacation expenses as charitable deductions. The bill also provides that unemployment benefits may no longer be excluded from income. Additionally, the committee has limited the current exclusions from income for certain scholarships and prizes and awards.

The present tax system provides highly favorable treatment for pensions and certain other deferred compensation plans. Individuals may postpone income tax on current compensation set aside for retirement, and on the investment earnings of those savings, under qualifying plans. The committee has taken steps to ensure that the preferential tax treatment of these plans is limited to encouraging savings for retirement purposes. The committee has increased the tax on preretirement distributions from such funds and limited the ability to borrow from these funds. The committee has also imposed a tax on the reversion of a plan's assets to the employer, in order to prevent employers from exploiting provisions designed solely to encourage retirement savings. The bill imposes stricter limitations on the amount of income that may be contributed to salary reduction (401(k)) plans, and establishes more uniform nondiscrimination rules to prevent the use of such plans only for highly compensated employees. Similarly, the bill imposes nondiscrimination rules as a condition for favorable tax treatment for health insurance benefits, and tightens existing nondiscrimination rules for other benefits to insure that favorable tax treatment for these benefits is available only if the benefits are provided to a substantial portion of the workforce.

The committee also desires to restrict a technique used by some high-income individuals with children to take undue advantage of the graduated rate schedules. Under the bill, unearned income of a child under 14 years old, attributable to property received from the parents, is to be taxed at the top marginal rate of the parents.

The committee believes that another important aspect of fairness is the tax treatment of low-income and middle-income households. The committee has designed the provisions dealing with the personal exemption, standard deduction, and individual tax rates to provide an equitable distribution of tax relief. Under present law, many families below the poverty level pay income taxes. The large increases in the standard deduction (formerly the zero bracket amount), the personal exemption, and the expansion of the refundable earned income credit, under the committee bill, will raise the tax threshold and ensure that no families below the poverty level will have Federal income tax liability. Under the expanded earned income credit, the maximum credit is $700 and the credit is not totally phased out until an AGI of $16,000. More than 6 million low-income individuals will be removed from the tax rolls as a result of these provisions.

Most elderly and blind taxpayers will also receive a reduction in the taxes they pay under the bill. The increased personal exemption and standard deduction received by all taxpayers, in combination with an extra $600 standard deduction for the elderly and blind, provide tax relief for these individuals. The committee has also retained the present law credit for the elderly and the permanently and totally disabled.

The committee bill eliminates the two-earner deduction and income averaging provisions. Lower marginal rates, in addition to the increases in the standard deduction and personal exemption, reduce the need for these complicated provisions.

The committee bill includes a number of provisions to aid compliance and tax administration. The bill also instructs the Internal Revenue Service to study the feasibility of implementing a return-free system and to report the results to Congress within 6 months.

One of the bill's primary accomplishments is the reduction in personal and corporate marginal tax rates. The committee bill reduces the top personal income tax rate from 50 percent to 38 percent. Nearly all taxpayers in lower tax brackets will also experience marginal tax rate reductions. The top corporate rate is similarly reduced from 46 percent to 36 percent. These rate reductions will increase the returns to saving and investment, as well as the after-tax returns to entrepreneurial initiative and productive work effort. The committee's actions in broadening the tax base, by eliminating inefficient tax provisions and curtailing abuses, allow these rate reductions.

Another significant accomplishment of the bill is to provide for more equal taxation of diverse economic activity. The tax system can reduce the efficiency of the economy by not taxing all business sectors similarly. Excessive tax preferences for certain industries result in too much investment in those industries and force other industries to pay too high of a tax burden. The total output obtainable from the economy's stock of capital is maximized when investment is taxed equally in all sectors.

The committee bill improves the efficiency with which investment is allocated by providing a depreciation system that more accurately reflects the actual productive lives of equipment and structures, while retaining incentives for investment in productive plant and equipment. Additionally, the committee has repealed the investment tax credit, which had created a bias against investment in plant and favored investment in quickly depreciating equipment over longer-lived assets. Provisions favorable to a variety of industries that currently allow the deferral of income for tax purposes or that result in excess deductions have been modified by the committee to measure more accurately the economic accrual of income.

The committee bill restricts tax benefits available to oil and gas. The percentage depletion method is phased-out for all oil and gas wells other than stripper wells owned by independent producers and royalty owners. This phase-out of percentage depletion method will not reduce the incentive for oil and gas exploration due to the large tax rate reductions. Given the importance of energy resources for our national security, the committee wishes to provide an incentive to operate marginal wells for longer periods by maintaining the current depletion allowance for certain stripper wells, rather than losing these wells through premature shutdowns. The committee has also extended the period over which intangible drilling costs are deducted to reflect more closely the productive period of these investments. The committee believes that, despite these restrictions, incentives for oil and gas exploration remain high.

The committee bill makes several modifications to the treatment of foreign income. The committee desires to limit the present law incentives for firms to move income offshore. The changes made by the committee bill limit the ability of firms to use tax havens and other devices to reduce U.S. taxes on U.S. income.

The committee has also taken steps to limit the unintended tax incentives that favor mergers and acquisitions. Many of these transactions are highly leveraged due to the favorable tax treatment of debt relative to equity. The lower corporate marginal rates provided by the bill reduce the benefit derived from deducting interest payments, thereby lessening the existing incentive to finance acquisitions through the issuance of high yielding, low quality debt instruments. Another feature reducing the incentive for debt finance is a new provision that permits a corporate tax deduction for a portion of dividends paid. The bill also repeals the General Utilities doctrine, which allows gains from corporate liquidations to escape tax at the corporate level. The General Utilities doctrine created a bias favoring acquisitions as a technique for tax-free realization of corporate gains and at the same time achieving a higher basis for purposes of depreciation and depletion. The bill additionally reduces the incentive for tax-motivated corporate acquisitions by limiting the use of net operating losses obtained through an acquisition to offset income of the acquiring firm.

The committee has maintained incentives that were found to continue to promote useful objectives and that were highly valued by many taxpayers. For individual taxpayers, the committee has retained the preferential treatment of capital gains and the deductions for State and local taxes, medical expenses, casualty losses, and charitable contributions. Moreover, the bill permanently allows taxpayers who do not itemize deductions to deduct charitable contributions in excess of $100. Interest paid on mortgages of up to two residences remains deductible, as well as the first $20,000 ($10,000 for single returns) of nonbusiness interest paid in excess of net investment income. The child care credit is also retained.

Given the importance of small business in providing new jobs and in improving the productivity of the economy through innovations, the committee wishes to encourage these fruitful enterprises. The reduction in personal income tax rates and the reduced and graduated corporate income tax schedule benefit small business partnerships, proprietorships, and corporations. The reduction in tax rates is intended to encourage small business capital formation and entrepreneurial innovation. The administrative burden in complying with certain tax provisions is also believed to be proportionately larger for small firms. The committee bill provides a simplified inventory accounting method for small business to relieve these businesses from some of the complexity of the tax code. Small business is also exempted from some of the new restrictions adopted by the committee.

The committee has preserved a number of other business incentives that were found to be beneficial to the economy and society. In general, given the tax rate reductions, the rates of credits and certain other incentives can be reduced and still offset tax liability on the same amount of income. The research and development credit is retained at a reduced rate of 20 percent. The social benefits and increases in productivity from the knowledge obtained through research and development are widespread. Because the private return from research may be less than the benefits to society, the credit helps ensure that sufficient research and development is undertaken. The targeted jobs credit, which encourages businesses to hire economically disadvantaged and disabled individuals, is also retained at a reduced rate for two years. This program offers productive opportunities to many individuals who otherwise might not find work.

The rehabilitation credit has been shown to encourage the preservation and restoration of older buildings and the revitalization of commercial and residential areas. The committee believes it is important to maintain the incentive to preserve our historic past and has continued this tax credit at a reduced rate.

The committee is also concerned about the proliferation of tax-exempt financing for nongovernmental purposes. Tax-exempt bonds for private activities promote an inefficient allocation of capital and increase the cost of financing traditional government activities. The committee bill places limits on the types of nongovernmental activities that may be financed through tax-exempt bonds. The committee believes it is important to allow tax-exempt financing for certain specified types of nongovernmental activities, but has placed limits on the overall volume of most nongovernmental bonds.

In conclusion, the committee believes the changes made by the bill will result in a fairer distribution of the tax liability and a more efficient allocation of the economy's resources. The committee has carefully preserved incentives that are truly beneficial, while curtailing provisions found to be ineffective or abusive. This bill earns the confidence of Americans in our tax system by restoring the principles of equity and evenhandedness.

Over the five-year period, 1986-1990, the committee tax reform bill is estimated to be close to revenue neutral, reducing total revenues by $364 million (or by less than 0.1 percent of total estimated tax revenues) over the five-year period.

[Estimate Tables not reproduced.]

In general, when a statute and a treaty provision conflict, the one adopted later controls. When Congress enacted the Internal Revenue Code of 1954, it included in that Code (sec. 7852(d)) a statement that no provision of the Idternad Revenue title, i.e., the Internal Revenue Code, was to apply in any case where its application would be contrary to any treaty obligation of the United States in effect on the date of enactment of the 1954 Code (August 16, 1954). The intent of that provision was to provide a transitional rule to ensure that the substitution of the 1954 Code for the preexisting 1939 Code did not operate to override then-existing treaty provisions.

Reenactment of the rule of section 7852(d)--that no provision of the Internal Revenue title is to apply in any case where its application would be contrary to any treaty obligation in effect on the date of enactment--could lead to an unwarranted inference: that the committee intended to disturb the relationship between existing statutory law and existing treaties.

For example, if the committee had not altered this language, a literal reading of the unaltered language might lead to the inference that the committee intended that existing statutory law that takes priority over existing treaties would thereupon yield priority to treaties. To clarify its intent on this matter, the committee changes the language of section 7852(d).

In connection with this recodification, the committee modifies the 1954 transition rule covering the relationship between treaties and the Code to clarify that it does not prevent application of the general rule providing that the later in time of a statute or a treaty controls. The bill provides that no provision of the Internal Revenue title that was in effect on August 16, 1954, shall apply in any case where its application would be contrary to any treaty obligation of the United States in effect on the date of enactment of the 1954 Code (August 16, 1954). This provision makes it clear that treaty provisions that were in effect in 1954 and that conflict with the 1954 Code as originally enacted are to prevail over then-existing statutes but not over later-enacted statutes. The committee does not intend that this codification of U.S. tax law affect existing treaty relationships. That is, treaty benefits that are now properly available under the 1954 Code will remain available under the 1985 Code.

Except as mentioned in the bill or this report, the committee is not aware of confLicts between any treaty and the changes (from the 1954 Code as amended) that this bill makes. The committee in-tends that this bill be interpreted so as not to conflict with the policy embodied in treaties where possible So that the policy goals of both treaties and this bill can be carried out. The committee expects that such harmonious interpretations will be the rule rather than the exception. In any event, the committee is making substantive modifications to present law with clear policies in mind, and does not intent those policies to be defeated by literal interpretations of existing treaties.

^{The term "head of household" means an unmarried individual (other than a surviving spouse) who pays more than half of the household expenses for himself or herself and a child or dependent relative who lives with the taxpayer, or for the taxpayer's dependent parents. A "surviving spouse," who may use the schedule for married individuals filing jointly, is an individual whose spouse died during one of the two immediately preceding taxable years and who maintains a household that includes a dependent child.}

Under present law, tax rates in each schedule start at 11 percent in the first taxable income bracket above the ZBA and rise to a maximum tax rate of 50 percent in the top bracket. Three of the schedules have 14 tax rates and brackets; the schedule for single individuals has 15 rates and brackets. Each tax rate applies only to income in that bracket. Income greater than the amount defining the upper end of each bracket is taxed at a higher rate.

For married individuals filing joint returns and for surviving Spouses in 1985, the 11-percent bracket starts at $3,540 of taxable income, and the 50-percent bracket at $168,896; for married individuals filing separate returns, the first and last brackets begin at half these amounts, i.e., $1,770 and $84,448, respectively. Those dollar figures are applicable for 1985 and have been indexed to reflect approximately a four-percent inflation rate in the preceding year. For 1986 and later years, present law provides that all dollar figures defining the tax brackets for these and the other rate schedules are to be adjusted annually according to annual percentage changes in the consumer price index.

Unmarried individuals are taxed in 1985 initially at 11 percent on the first $1,150 of taxable income over $2,390, and at 50 percent on taxable income in excess of $85,070. For a head of household, the 11-percent rate also begins at $2,390, and the 50-percent rate at $112,630. The tax rates applicable to a head of household are lower than those applicable to other unmarried individuals on taxable income above $3,540. Thus, a head of household in effect receives a portion of the benefits of the lower rates accorded to a married couple filing a joint return.

The ZBA has been incorporated into the tax tables and tax rate Schedules as the first tax bracket with a zero tax rate since 1977. Since the ZBA is the counterpart of the former standard deduction, nonitemizers only have to reduce adjusted gross income (AGI) by the amount of personal exemptions and use the tax table to find the tax liability. The ZBA also serves as a floor under the amount of itemized deductions. Itemizers reduce AGI by personal exemptions and the excess of itemized deductions over the ZBA, in order to avoid doubling the benefit of the ZBA, and then use the tax tables or tax rate schedule to find tax liability.

Personal exemption

The personal exemption for an individual, the individual's spouse, and each dependent is $1,040 for 1985. Under present law, one additional personal exemption is allowed for an individual who is age 65 or older, and for an individual who is blind.

Beginning with 1985, the amount of the personal exemption is indexed annually for inflation during the preceding year. The consumer price index in the one-year period that ended on September 30, 1985, increased by an amount sufficient to raise the personal exemption to $1,080 for 1986. Prior to 1985, the personal exemption amount had been $1,000 during 1979-84, $750 during 1972-78, $675 for 1971, $625 for 1970, and $600 for 1948-69.

Two-earner deduction

Couples filing a joint return are allowed a deduction when computing adjusted gross income which is equal to 10 percent of the lesser of the earned income of the lower-earning spouse or $30,000, for a maximum deduction of $3,000. This provision has served to reduce the increase in tax liability that occurs when two individuals with relatively equal incomes marry and file a joint return.

Dependents with income

In general, a person with gross income in excess of the personal exemption amount may not be claimed as a dependent on another taxpayer's return, even though the taxpayer satisfies the general support requirement by furnishing over half the dependent's support for the year. However, parents may claim a full dependency exemption for their dependent child who has income above the personal exemption amount, if the dependent child is (1) under age 19, or (2) a full-time student. In addition, an individual, including a child, for whom a dependency exemption may be claimed on another taxpayer's return also may claim a personal exemption on his or her own tax return, but may claim the ZBA only to the extent of his earned income.

Tax threshold

An overriding goal of the committee was to relieve those with the lowest incomes from Federal income tax liability. The committee realized that by increasing the amounts of both the personal exemption and the standard deduction, as well as the earned income credit, the income level at which individuals begin to have tax liability (tax threshold) will be raised sufficiently to free millions of poverty-level individuals from Federal income tax liability. This will restore to the tax system an essential element of fairness which had been eroded since the last increase in the personal exemption in 1978. In addition, the committee bill will reduce the burden of the Federal tax system on families with modest means, who also are subject to payroll taxes and various State and local government taxes. About 6.5 million taxpayers will be relieved of tax liability as a result of these changes.

The ZBA and personal exemption have been unchanged since set at present levels in the Revenue Act of 1978, except for an indexing adjustment in 1985. Since that time, inflation has reduced the real value of the standard deduction and personal exemption in setting a threshold level below which income is not taxed. Although the rate reductions in 1981 reduced tax liabilities partly in recognition of the burdens of inflation and social security taxes, those reductions did not extend the same adjustments to marginally taxable individuals who previously had not been taxed on the same amounts of real income. The personal exemption increase, the first statutory increase in the exemption since 1978, also contributes to removing the poor from the tax roles. The personal exemption increase also recognizes the significant cost of bringing up children. The benefit of these increases is not confined to the poor, but they reduce the tax burden for all families by raising the tax threshold for everyone.

In the committee bill, all tax thresholds other than that for single individuals are higher than the estimated poverty level for 1987. In Table 1 below, the columns without the earned income credit reflect the fact that the threshold for heads of households is raised proportionately more for them than it is raised for single individuals, married individuals filing jointly, or elderly individuals. In addition, married individuals receive a larger proportionate increase in the threshold than single individuals, in order to offset the effect of the repeal of the two-earner credit. With the addition of the earned income credit to the computation, the tax threshold rises even further for those eligible for the credit. Although the committee is concerned about the tax burden on low-income unmarried individuals, the bill does not raise their tax threshold above the poverty line for two principal reasons. First, further increases in the standard deduction for these taxpayers would cause significant marriage penalties for two single individuals who marry. Second, because the income tax does not combine the income of family members (other than spouses) in computing tax liability and does not recognize economies of sharing household costs with other individuals, income of unmarried individuals is not a good measure of whether or not living conditions of these persons are impoverished. More than two-thirds of all unmarried individuals with income less than $10,000 are under age 25 and thus are likely to be receiving significant support from other family members that is not reflected on the tax return. In addition, the majority of unmarried individuals between ages 25 and 64, inclusive, live with other individuals, and thus share household costs. Thus, within the existing framework of defining the unit of tax liability, the committee believes that the poverty line is not an accurate guide to the true circumstances of the majority of those who file tax returns as unmarried individuals.

          TABLE 1--INCOME TAX THRESHOLDS UNDER PRESENT LAW

Equitable distribution of tax burden

The committee also believes that it is necessary to provide tax reduction that is distributed equitably among the vast majority of individuals who bear the tax burden. The next three tables show the changes made by the committee in the distribution of the tax burden. These tables reflect the effect of major provisions affecting individuals, including the rate reductions, changes in itemized deductions, and increases in the standard deduction and personal exemption.

Table 2 below shows the changes in tax liabilities and after-tax income of the committee bill from present law among all income classes. The committee bill reduces total tax liability of individuals by 9.0 percent. The largest tax liability reductions occur in the below $10,000 and the $10,000 to $20,000 income classes, reflecting the decision to increase the tax threshold above the poverty line. In the four income classes between $20,000 and $75,000, the committee bill also produces significant reductions in tax liability. The same pattern is reflected in the column which shows the tax liability change as a percentage of social security and income taxes combined. For all taxpayers, the decrease in combined tax liability is 6.6 percent, and the largest deductions still are in the two income classes below $20,000. The last column shows the percentage change in after-tax income, i.e., the increase in individual income after tax. Generally, the committee bill has a neutral distributional effect on after-tax income. Below $100,000, the increases range between 1.0 and 1.2 percent, except for a 1.5-percent increase for incomes from $10,000 to $20,000. The two income classes above $100,000 receive a 1.9 percent increase in after-tax income. For all taxpayers, after-tax income is increased by 1.3 percent.

  TABLE 2--PERCENTAGE CHANGES IN INCOME TAX LIABILITY AND AFTER-TAX

Table 3 below shows that individuals with less than $75,000 of income will receive 72 percent of the reduction for individuals; these individuals make up more than 95 percent of income tax filers. The committee bill distributes 28 percent of the total tax reduction among taxpayers with incomes above $75,000.

    TABLE 3--DISTRIBUTION OF TAX CHANGES IN COMMITTEE BILL,

These tables reflect tax cuts for 1987, the first full year in which the changes in the tax rates and standard deduction are fully effective. By virtue of restructuring the tax schedules and broadening the tax base for individuals, the committee bill produces substantial reductions in income tax liabilities.

       TABLE 4--AVERAGE INCOME TAX LIABILITY AND TAX RATE,

Rate schedules, ZBA, and standard deduction

The changes in the distribution of the tax burden were made by revising tax rate schedules, converting the zero bracket amount back into the standard deduction, and by increasing the personal exemption amount.

The tax rate schedules in present law are lengthy and more complicated than is desirable. The relatively narrow intervals between taxable income brackets cause an individual's marginal tax rate to be increased in response to relatively small increases in compensation or profits resulting from economic success and improved efficiency.

In its deliberations, the committee sought to modify the present-law rate structure to make the individual income tax fairer and simpler and to reduce disincentives to economic efficiency and growth. Greater simplicity was achieved by reducing the tax rate structures to four taxable income brackets. The four filing statuses were retained because they are the fewest classifications that can be implemented to provide for the distinctive individual and familial circumstances of a diverse population characterized by strong family ties and individualism.

The four-bracket tax structure includes only positive tax rates because the committee decided to delete the present-law ZBA from the tax structure and instead to restore the standard deduction. The committee understands that many individuals find the ZBA to be confusing and do not view it as a device that simplifies calculation of income tax liability. Under the committee bill, taxpayers will deduct certain expenses (the standard deduction or a total of separately itemized amounts) in order to determine taxable income. Unlike the ZBA, the standard deduction enables the taxpayer to know directly how much income is subject to tax and to understand more clearly that taxable income is the base for determining tax liability.

Further, the difference between the standard deduction for an unmarried head of household and that for a married couple is narrowed, in recognition that the costs of maintaining a household for an unmarried individual and a dependent more closely resemble the situation of a married couple than that of a single individual without children.

The committee modified the provision for the deduction of itemized deductible expenses by placing a floor under the deductible amount. Under present law, there is some inconsistency between the adjustment for family size for nonitemizers and itemizers. Both nonitemizers and itemizers subtract from income personal exemptions for each taxpayer and dependent to reflect the additional costs of larger families. In addition, itemizers may subtract actual expenses for significant expenses which also vary by family size, Such as housing costs (interest and property taxes), medical costs and consumer interest. Under present law, therefore, itemizers receive a larger family size adjustment than nonitemizers. In order to achieve more equity between nonitemizers and itemizers, especially in view of the doubling of the personal exemption, the bill provides a floor under itemized deductions equal to $500 times the number of personal exemptions claimed.

The increases in the standard deduction, modifications to specific deduction provisions, and the floor under itemized deductions will Simplify the tax system by substantially reducing the number of itemizers. As a result of these changes, about 13 million itemizers will shift to using the standard deduction, a reduction of approximately 30 percent in the number of itemizers relative to present law.

Marriage penalty

The adjustment of the standard deduction and the rate schedule in the committee bill also makes it possible to minimize the marriage penalty while repealing the complicated two-earner deduction. As a result, single individuals who marry will retain more of the total standard deduction for two single individuals than under present law.

Table 5, which follows, presents a comparison of the marriage tax penalty under present law and the committee bill for couples with varying individual income levels. In spite of the repeal of the two-earner deduction, marriage penalties generally are either smaller than present law or only a nominal amount under the committee bill. The only exceptions to this result occur for certain relatively high income couples, e.g., where the two spouses have incomes of $100,000 and $30,000.

      TABLE 5--MARRIAGE TAX PENALTY FOR TWO-EARNER COUPLE UNDER

Elderly and blind taxpayers

The tax burden on elderly or blind taxpayers is eased by the committee bill apart from the effect of rate reductions. The income tax credit for the elderly or disabled is left unchanged from present law. The present-law personal exemptions and ZBA (standard deduction) are restructured by increasing the standard deduction and exemptions (as previously discussed) and eliminating the extra exemption for the elderly and blind. In addition, the higher standard deduction goes into effect one year earlier (in 1986) for elderly or blind individuals than it does for all other taxpayers (in 1987), and it is augmented by an additional $600 for each elderly or blind individual.

The bill provides a completely new tax rate schedule, with four taxable income brackets, for each of the four present-law filing status. Each of the four new schedules begins at zero taxable income, which reflects the subtraction of the deductions for personal exemptions and the filer's standard deduction amount (which replaces the ZBA) or excess itemized deductions that were made in the calculation of taxable income. The tax rates in each of the schedules are identical at 15, 25, 35, and 38 percent.

The new schedules, shown below, go into full effect for taxable years beginning in 1987. For taxable years beginning in 1986, the Secretary of the Treasury is instructed in the bill to prepare blended tax rate schedules for 1986 tax returns constructed by assuming that present law is in effect for one-half of 1986 and that the new rate schedules are in effect for the other half of the year. The blended schedule essentially will adjust the tax liability for the year on any given level of taxable income so that it is the sum of one-half of the tax liability calculated under the present law schedules, and one-half of the tax liability calculated under the new rate schedules. Fiscal year taxpayers will use the same rate schedules as calendar year taxpayers. The rules relating to proration in section 15 will not apply.

     TABLE 6--TAX RATES AND TAXABLE INCOME BRACKETS FOR FOUR

In the bill, the standard deduction amount, which replaces the ZBA, is increased substantially, and is deducted by a nonitemizer from AGI to determine taxable income. As shown by the table above, taxable income brackets will begin at zero ($0) in the lowest bracket (15 percent).

A different standard deduction amount is provided for each filing status in an amount generally appropriate to a typical filer in each status. The standard deduction amount for each filing status will be higher in 1987, when the increase becomes effective, than the present-law level of the ZBA.

The amount for heads of households is between the amount for joint return filers and the amount for unmarried individuals. Under present law, the ZBA is the same amount for heads of households and unmarried individuals.

The new standard deduction amounts for 1986 and 1987 and zero bracket amounts for 1985 are shown below. For all taxpayers other than the blind or elderly, the standard deduction amounts for 1986--i.e., $3,670 and $2,480--are identical to the indexed ZBA that would be in effect under present law in 1986.

  TABLE 7--ZERO BRACKET AMOUNTS AND STANDARD DEDUCTION AMOUNTS

The standard deduction amounts (including the additional amount for the elderly and blind) will be indexed, beginning in 1988, to reflect increases in the consumer price index.

Individuals may continue to deduct the total of their itemized deductions, if the amount is greater than the standard deduction, but under the bill, the itemized total is reduced by an amount equal to $500 times the number of personal exemptions claimed. For example, if itemized deductions of $7,800 are claimed on a return of a four-person family (two spouses and two dependent children), the itemized deductions would be reduced by $2,000; thus, adjusted gross income on the return would be reduced by itemized deductions of $5,800. Beginning in 1987, the $500 will be indexed for inflation.

3. Personal exemption

The personal exemption amount for each individual, individual's spouse, and each dependent is increased to $2,000. Indexing of this amount to reflect increases in the consumer price index will continue, beginning in 1987.

The additional exemption under present law for the elderly and for blind individuals is repealed. As stated above, the standard deduction is increased by $600 for each elderly individual and for each blind individual.

4. Personal exemption and standard deduction for dependents

Limitations will apply with regard to use of the standard deduction or personal exemption by an individual who is eligible to be claimed as a dependent by another taxpayer. In such cases, the dependent may use the standard deduction only to the extent there is earned income; this is similar to the present law rule applicable to the ZBA. Further, in order to avoid the increase in the amount of unearned income of a dependent which otherwise would be offset by the personal exemption at the higher $2,000 level, the bill provides that only $1,000 of the personal exemption may be used to reduce the taxable amount of unearned income. Thus, the personal exemption of the dependent is limited to the sum of (a) $1,000 and (b) the excess (but not more than $1,000) of (1) the amount of earned income over (2) the standard deduction. The $1,000 figures also will be indexed for inflation concurrently with the indexing of the personal exemption amount.

5. Two-earner deduction

The bill repeals the deduction for two earner married couples. Adjustments made in the standard deduction for married couples filing joint returns and in the relationship of the rate schedules for unmarried individuals and married couples filing joint returns compensate for the repeal of this provision.

6. Indexing

The indexing provision is amended by measuring the annual rate of inflation as the percentage change in the Consumer Price Index from August 31 of a year to August 31 of the succeeding year.

For taxable years beginning on or after January 1, 1986, the indexed zero bracket amounts in present law become standard deduction amounts. The increases in the standard deduction amounts are effective for taxable years beginning on or after January 1, 1987. For elderly or blind individuals, the increased standard deduction amounts (including the additional standard deduction amounts for these individuals) are effective for taxable years beginning on or after January 1, 1986, instead of the January 1, 1987, effective date applicable to other taxpayers. The limitation on the amount allowed for the itemized deductions is effective for taxable years beginning on or after January 1, 1986.

The increase in the personal exemption amount is effective for taxable years beginning on or after January 1, 1986.

Repeal of the deduction for two-earner married couples is effective for taxable years beginning on or after January 1, 1986.

The changes in the income tax rates are estimated to decrease fiscal year budget receipts by $5.8 billion in 1986, $24.9 billion in 1987, $31.5 billion in 1988, $33.9 billion in 1989, and $38.0 billion in 1990.

Standard deduction

The restoration of the standard deduction and increase in standard deduction amounts above the ZBA are estimated to decrease fiscal year budget receipts by $4.9 billion in 1986, $6.4 billion in 1987, $6.6 billion in 1988, $7.1 billion in 1989, and $7.5 billion in 1990.

Floor under itemized deductions

The floor under itemized deductions of $500 per exemption is estimated to increase fiscal year budget receipts by $1.9 billion in 1986, $7.5 billion in 1987, $9.8 billion in 1988, $10.5 billion in 1989, and $11.3 billion in 1990.

Personal exemption

The increase in the personal exemption amount and repeal of the additional exemption for the elderly and blind are estimated to decrease fiscal year budget receipts by $9.2 billion in 1986, $27.6 billion in 1987, $34.4 billion in 1988, $36.8 billion in 1989, and $39.4 billion in 1990.

Two-earner deduction

The repeal of the deduction for two-earner married couples is estimated to increase fiscal year budget receipts by $1.4 billion in 1986, $6.1 billion in 1987, $6.1 billion in 1988, $6.5 billion in 1989, and $6.8 billion in 1990.

(sec. 111 of the bill and secs. 32 and 3507 of the Code)

The credit is available to (1) married individuals filing joint returns who are entitled to a dependency exemption for a child; (2) surviving spouses (who, by definition, must maintain a household for a dependent child); and (3) unmarried heads of households who maintain a household for a child. In each case, the credit is available only if the child resides with the taxpayer.

In order to relieve eligible individuals of the burden of computing the amount of credit to be claimed on their returns, tables are used for determination of the credit amount. Eligible individuals may receive the benefit of the credit in their paychecks throughout the year by electing advance payments (sec. 3507).

The committee believes that further increases in the maximum amount and phase-out level of the credit are necessary to offset past inflation and increases in the social security tax. In addition, the committee believes that an automatic adjustment to the credit to reflect future inflation should be provided, just as it is provided for the personal exemption, the standard deduction, and rate brackets, in order to eliminate the reduction in the real value of the credit caused by inflation.

In addition, the income levels over which the credit is phased out are higher than under present law. For taxable years beginning on or after January 1, 1986, the income level at which phase-down begins is $6,500; thus, no credit will be available for individuals with AGI or earned income of $13,500 or more. For taxable years beginning on or after January 1, 1987, the phase-down begins at income of $9,000; thus, no credit will be available at AGI or earned income exceeding $16,000. Effective for taxable years beginning on or after January 1, 1986, the $5,000 maximum amount of earned income for which the credit is allowed and the $6,500 and $9,000 income levels defining the phase-out of the credit will be adjusted for inflation occurring after the 12-month period ending on August 31, 1984.

2. Repeal of political contributions tax credit

(sec. 112 of the bill and sec. 24 of the Code)

The committee was informed by Treasury that the credit creates administrative and compliance problems for the IRS. The small credit amount allowable per return under the dollar limitations makes verification costly in relation to the tax liability in issue.

In view of the limited effectiveness and use of the credit, the committee believes that the administrative problems and tax return complexity resulting from the credit outweigh the rationale for retaining it.

(sec. 121 of the bill and sec. 129 of the Code)

This exclusion is subject to several limitations: (1) the amount excluded may not exceed the employee's earned income (or, if the employee is married, the lower of the earned income of the employee or the employee's spouse); (2) the exclusion is only provided for expenses for household services or care of qualifying individuals (dependents under the age of 15 or physically or mentally incapacitated dependents or spouses) that are incurred to enable the taxpayer to be gainfully employed; (3) no exclusion is available for amounts paid for qualifying services rendered by the employee's dependent or child of the employee who is under the age of 19; (4) no exclusion is available if the dependent care assistance program discriminates in favor of employees who are officers, owners, or highly compensated individuals (or their dependents); and (5) no exclusion is available if more than 25 percent of the total benefits paid are for the group consisting of employees who own more than five percent of the stock or of the capital or profits interest in the employer (or their spouses or dependents).

Consequently, the committee concluded that it is desirable to place a dollar limit on the annual exclusion for employer-provided dependent care assistance benefits to coordinate the exclusion with the tax incentives provided to individuals through the child care credit.

The bill provides a special rule for determining the value of child care in a facility on the employer's premises (on-site facility). Under this rule, the value of the benefit is measured by the value of services provided to employees who actually use the facility.

2. Treatment of unemployment compensation benefits

(sec. 122 of the bill and sec. 85 of the Code)

If the sum of the individual's unemployment compensation benefits and adjusted gross income (AGI) does not exceed a defined base amount, then no unemployment compensation benefits are included in gross income. The base amount is $12,000, in the case of an unmarried individual; $18,000, in the case of a married couple filing a joint return; and zero, in the case of a married couple filing joint returns. If the sum of unemployment compensation benefits and AGI exceeds the base amount, the amount of unemployment compensation that is included in gross income generally is limited to the lesser of (1) one-half the excess of the individual's (a) AGI plus benefits over (b) the base amount, or (2) the amount of the unemployment compensation benefits received.

3. Scholarships and fellowships

(sec. 123 of the bill and sec. 117 of the Code)

Performance of services

Amounts paid to an individual to enable him or her to pursue studies or research are not excludable from income if they represent compensation for past, present, or future services, or if the studies or research are primarily for the benefit of the grantor or are under the direction or supervision of the grantor (Reg. sec. 1.117-4(c)). These regulations have been upheld by the U.S. Supreme Court, which described excludable grants as "relatively disinterested, 'no-strings' educational grants, with no requirements of any substantial quid pro quo from the recipients" (Bingler v. Johnson, 394 U.S. 741 (1969)).

In the case of degree candidates, the statute also provides that the exclusion does not apply to any portion of an otherwise qualifying scholarship or fellowship grant that represents payment for teaching, research, or other services in the nature of part-time employment required as a condition of receiving the scholarship or fellowship grant (sec. 117(b)(1)). However, under a special rule, such services are not treated as employment for this purpose if all degree candidates must perform such services; in that case, the recipient may exclude the portion of the scholarship or fellowship grant representing compensation for such services.

Another special rule provides that amounts received by an individual as a grant under a Federal program that would be excludable from gross income as a scholarship or fellowship grant, but for the fact that the recipient must perform future services as a Federal employee, are not includible in gross income if the individual establishes that the amount was used for qualified tuition and related expenses (sec. 117(c)).

Tuition reduction plans

Section 117(d) provides that a reduction in tuition provided to an employee of an educational institution is excluded from gross income if (1) the tuition is for education below the graduate level provided by the employer or by another educational institution; (2) the education is provided to a current or retired employee, a spouse or dependent child of either, or to a widow(er) or dependent children of a deceased employee; and (3) certain nondiscrimination requirements are met. P.L. 98-611 provided that, through taxable years ending on or before December 31, 1985, this exclusion also applies to graduate-level education provided by an educational institution to a graduate student who is employed by that institution in teaching or research activities.

Under present law, controversies have arisen over whether a particular stipend made in an educational setting constitutes a scholarship or compensation for services. In particular, numerous court cases have involved resident physicians and graduate teaching fellows who seek--often notwithstanding substantial case authority to the contrary--to exclude from income payments received for caring for hospitalized patients, for teaching undergraduate college students, or for doing research which inures to the benefit of the grantor. The limitation on the section 117 exclusion made by the bill, and the repeal of the special rule relating to degree candidates who must perform services as a condition of receiving a degree, should lessen these problems.

The committee believes that the section 117 exclusion should not apply to amounts representing payment for teaching, research, or other services by a student required as a condition for receiving a scholarship or tuition reduction. Thus, where cash stipends received by a student who performs services would not be excludable under the bill as a scholarship even if the stipend is used to pay tuition, the exclusion should not become available merely because the compensation takes the form of a tuition reduction otherwise qualifying under section 117(d).

The committee believes that it is inappropriate for recipients of certain Federal grants who are required to perform future services as a Federal employee to obtain special tax treatment which is not available to recipients of other types of grants who are required to perform services as a condition of receiving the grants. Thus, under the bill, the general exclusion rule and the limitations apply equally to all recipients.

The bill limits the section 117 exclusion for degree candidates to the amount of a scholarship or fellowship grant that is required to be used, and in fact is used, for (1) tuition and fees required for enrollment or attendance at an educational institution (within the meaning of sec. 170(b)(l)(A)(ii)), and (2) fees, books, supplies, and equipment required for courses of instruction at the educational institution. For this purpose, the committee intends that amounts of scholarship or fellowship grants received that do not exceed this amount are excludable without the need to trace particular grant dollars to particular expenditures for tuition and equipment, provided that the grant requires the recipient to use the grant funds for such purposes. Amounts received by degree candidates in excess of the amount of qualified tuition and equipment expenses are not excludable under section 117. Similarly, amounts not in excess of qualified tuition and equipment costs, but designated or earmarked for other purposes (such as room and board), are not excludable as a scholarship or fellowship grant.

The bill also repeals the present-law exclusion under Section 117 for grants received by nondegree candidates. This provision does not affect whether the section 127 exclusion may apply to employer-provided educational assistance to nondegree candidates, or whether unreimbursed educational expenses of some nondegree candidates may be deductible as trade or business expenses if the requirements of section 162 are met.

Performance of services

The bill repeals the special rule of present law permitting scholarship or fellowship grants received by degree candidates to be excludable, even where such amounts represent payment for services, if all candidates for the particular degree are required to perform such services. Thus, the general rule applies requiring inclusion in gross income of amounts received which represent payment for services required as a condition of receiving the grant.

To prevent circumvention of this general rule, the rule is intended to apply not only to cash amounts received, but also to amounts (representing payment for services) by which the tuition of the person who performs services is reduced, whether or not pursuant to a tuition reduction plan described in section 117(d). The bill therefore explicitly provides that the section 117 exclusion does not apply to that portion of the amount received which represents payment for teaching, research, or other services by the student required as a condition of receiving the scholarship or tuition reduction.

The committee intends that employees who perform required services for which they include in income reasonable compensation should continue to be eligible to exclude the amounts of the tuition reduction. (In addition, section 1161 of the committee bill extends the availability of the tuition reduction exclusion for certain graduate students an additional two taxable years beyond its scheduled expiration for taxable years beginning after December 31, 1985, as part of the extension of section 127 under the bill.)

The bill also repeals the special rule permitting the exclusion of certain Federal grants as scholarships or fellowship grants, where the recipient is required to perform future service as a Federal employee. Thus, the general rule applies in such circumstances. If the amount received (or a portion of it) represents payments for past, present, or future services required to be performed as a condition of the grant, then the amount received (or a portion of it) is not excludable. As a result, services performed as a Federal employee are not entitled to more favorable tax treatment than services performed for another employer.

4. Tax treatment of prizes and awards

(sec. 123(b) of the bill and secs. 74, 102, and 274 of the Code)

Section 74(b) provides a special exclusion from income for certain prizes and awards that are received for achievements in fields such as charity, the sciences, and the arts. This exclusion does not apply unless the recipient (1) has not specifically applied for the prize or award (for example, by entering a contest), and (2) is not required to render substantial services as a condition of receiving it. Treasury regulations state that the section 74(b) exclusion does not apply to prizes or awards from an employer to an employee in recognition of some achievement in connection with employment.³

^{While section 74 determines the includibility in income of prizes and awards, the treatment of other items provided by an employer to an employee may be affected by section 61, defining gross income, and section 102, under which gifts may be excluded from gross income. Section 61 provides in part that "gross income means all income from whatever source derived," including compensation for services whether in the form of cash, fringe benefits, or similar items. However, an item transferred from an employer to an employee, other than a prize or award that is includible under section 74, may be excludable from gross income if it qualifies as a gift under section 102.}

^{The U.S. Supreme Court, in a case involving payments made "in a context with business overtones," has defined excludable gifts as payments made out of "detached and disinterested generosity" and not in return for past or future services or from motives of anticipated benefit (Comm'r v. Duberstein, 363 U.S. 278 (1960)). Under this standard, the Court said, transfers made in connection with employment constitute gifts only in the "extraordinary" instance.4}

^{Under certain circumstances, if an award to an employee constitutes an excludable gift, the employer's deduction may be limited pursuant to section 274(b). That section expressly defines the term "gift" to mean any amount excludable from gross income under section 102 which is not excludable under another statutory provision.}

^{Section 274(b) generally disallows business deductions for gifts to the extent that the total cost of all gifts of cash, tangible personal property, and other items to the same individual from the taxpayer during the taxable year exceeds $25. Under an exception to the $25 limitation, the ceiling on the deduction is $400 in the case of an excludable gift of an item of tangible personal property awarded to an employee for length of service, safety achievement, or productivity. In addition, the ceiling on the employer's business gift deduction is $1,600 for an excludable employee award for such purposes when provided under a qualified award plan, if the average cost of all plan awards in the year does not exceed $400.}

^{A further rule that may be relevant with respect to a prize or award arises under section 132(e), which provides that de minimis fringe benefits are excludable from income. A de minimis fringe is generally defined as "any property or service the value of which is (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."}

Prizes and awards generally increase an individual's net wealth in the same manner as any other receipt of an equivalent amount that adds to the individual's economic well-being. For example, the receipt of an award for scientific or artistic achievement in the amount of $10,000 increases the recipient's net wealth and ability to pay taxes to the same extent as the receipt of $10,000 in wages, dividends, or prizes and awards that are taxable under current law. Accordingly, the committee believes that prizes and awards should generally be includible in income even if received due to achievement in fields such as the arts and sciences.

In addition, the committee is concerned about problems of complexity that have arisen as a result of the present-law exclusion under Section 74(b). The questions of what constitutes a qualifying form of achievement, whether an individual took action to enter a contest or proceeding, and whether or not the conditions of receiving a prize or award involve rendering "substantial" services, have all caused some difficulty in this regard. Finally, the present-law exclusion may in some circumstances serve as a possible vehicle for the payment of disguised compensation.

At the same time, the committee recognizes that in some instances an award recipient may wish to assign the award to charity, rather than claiming it for personal use. Accordingly, the bill provides that a prize or award meeting the present-law exclusion requirements under section 74(b) is excludable from gross income if the prize or award is transferred by the payor, pursuant to a designation made by the winner of the prize or award, to a governmental unit or to a tax-exempt charitable organization contributions to which are deductible under section 170(c)(1) or section 170(c)(2), respectively.

Employee awards

An additional reason for change relates to the tax treatment of employee awards of tangible personal property given by reason of length of service, productivity, or safety achievement. These items are not excludable, and the deduction of their cost by the employer is not limited under section 274(b), if they cannot qualify as gifts due either to the "detached generosity" standard applicable under section 102 or to the rule of section 74(a) that prizes and awards generally are includible in income.

The committee understands that uncertainty has arisen among some taxpayers concerning the proper tax treatment of an employee award. This uncertainty could lead some employers to seek to replace amounts of taxable compensation with "award" programs of tangible personal property, which the business and the employee might contend are not subject to income or social security tax. In the case of highly compensated employees, who often may not be significantly inconvenienced by the fact that the awards are made in the form of property rather than cash, an exclusion for transfers of property with respect to regular job performance could serve as a means of providing tax-free compensation.

Accordingly, the committee believes that it is desirable to provide expressly that an award to an employee made for reasons arising out of a business context does not constitute an excludable gift. At the same time, the committee believes that no serious potential abuse arises from transfers by employers to employees of items of low value. Therefore, the committee wishes to clarify that the rule under present law whereby de minimis fringe benefits may be deductible by the employer but are not taxable to the employee can apply to employee awards of low value, including traditional awards (such as a gold watch) upon retirement after lengthy service for an employer.

Under the bill, the present-law exclusion under section 74(b) is generally repealed. However, a prize or award may qualify for exclusion under section 74(b) as amended by the bill only if (1) it meets the present-law requirements for exclusion and (2) the recipient designates that the prize or award be transferred by the payor to a governmental unit or tax-exempt charitable organization contributions to which are deductible under section 170(c)(1) or 170(c)(2), respectively. In such case, the prize or award is not included in the winner's gross income, and no charitable deduction is allowed to the winner or to the payor.

For purposes of determining whether a prize or award that is so designated qualifies as excludable under the bill, the present-law rules concerning the scope of section 74(b) are retained without change. In order to qualify for the exclusion, the designation must be made by the taxpayer, and carried out by the party making the award, before the taxpayer uses the item that is awarded (e.g., in the case of an award of money, before the taxpayer spends, deposits, or otherwise invests the money). Disqualifying uses by the taxpayer include use of the property with the permission of the taxpayer or by one associated with the taxpayer (e.g., a member of the taxpayer's family).

b. Employee awards

Under the provision in the bill relating to employee awards, no amount transferred by or for an employer to, or for the benefit of, an employee may qualify as an excludable gift. Thus, for example, an item awarded in recognition of a work-related achievement (such as length of service, productivity, or safety achievement) cannot qualify as an excludable gift and hence is includible in income.⁵ This rule applies whether or not (1) the item constitutes a prize or award, (2) the employer is entitled to deduct its cost, or (3) the item would qualify as a gift if the section 102 standard of "detached generosity" were applicable. In view of this provision, the deduction limitation provisions of section 274 (i.e., section 274(b)(1)(C) and 274(b)(3)) have no application and are therefore repealed.

The committee bill does not modify section 132(e), under which de minimis fringe benefits are excluded from gross income. Thus, an employee award is not includible in income if its fair market value, after taking into account the frequency with which similar benefits are provided by the employer to the employer's employees, is so small as to make accounting for it unreasonable or administratively impracticable.

The committee anticipates that this exception will apply, under appropriate circumstances, to items presented to employees upon retirement. Thus, traditional retirement gifts presented upon retiring after completing lengthy service may qualify as excludable de minimis fringe benefits. For example, in the case of an employee who has worked for the employer for 25 years, a retirement gift of a gold watch may qualify for exclusion as a de minimis fringe benefit even though gold watches given throughout the period of employment could not so qualify for exclusion.

(sec. 132 of the bill and sec. 62 and new sec. 67 of the Code)

The list of itemized deductions on Schedule A of Form 1040 includes a category labeled miscellaneous deductions, following the listings for medical expenses, charitable expenses, interest, taxes, and casualty and theft losses. Under present law, this category generally includes four types of deductions: (1) certain employee business expenses (sec. 162); (2) expenses of producing income (sec. 212); (3) expenses related to filing tax returns (sec. 212); and (4) expenses of adopting children with special needs (sec. 222).

Employee business expenses

An employee business expense is a cost incurred by an employee in the course of performing his or her job. Examples of such costs include unreimbursed expenditures for subscriptions to professional journals or continuing education courses, union or professional dues, costs of professional uniforms, costs of looking for new employment, and expenses allowable for business use of the taxpayer's home. Ordinary and necessary employee business expenses generally are deductible, on the ground that they are costs of earning income.

Employee business expenses generally can be claimed only as itemized deductions. However, four types of employee business expenses are deductible above-the-line in calculating adjusted gross income, and thus are directly available to nonitemizers: (1) expenses paid by an employee and reimbursed by the employer; (2) employee travel expenses incurred while away from home; (3) employee transportation expenses incurred while on business; and (4) business expenses of employees who are outside salespersons. For taxpayers in a trade or business other than being an employee (e.g., as sole proprietors and partners), all business expenses are deductible above-the-line.

Certain deductions for employee business expenses also are subject to specific limitations or restrictions. For example, a taxpayer's business use of his or her home (whether or not the taxpayer is in the business of being an employee) does not give rise to a deduction for the business portion of expenses related to operating the home (e.g., rent, depreciation, and repairs) unless the taxpayer uses a part of the home regularly and exclusively as the principal place of business or as a place of business used by patients, clients, or customers (sec. 280A).⁶ Educational expenses are deductible only if the education (1) is required by the employer, by law, or by regulations, or (2) maintains or improves skills required to perform the taxpayer's present occupation. Costs of looking for new employment are deductible only if they relate to employment in the taxpayer's present occupation.

Investment expenses

In general, expenses of producing income other than rental royalty income are treated as itemized deductions if the related activity does not constitute a trade or business. (Trade or business expenses and expenses of producing rental or royalty income are deductible above-the-line.) Among the types of investment expenses that may be eligible, in particular circumstances, for deduction are investment counsel fees, subscriptions to investment advisory publications, and attorneys' fees incurred in collecting income.

Other miscellaneous itemized deductions

Tax counsel and assistance fees, as well as appraisal fees paid to determine the amount of a casualty loss or a charitable contribution of property, may be claimed as itemized deductions (sec. 212(3)). Also, expenses incurred with respect to a hobby--i.e., an activity that may generate some gross income but that the taxpayer conducts for personal recreational reasons, rather than with the goal of earning a profit--are deductible to the extent such expenses would be deductible regardless of profit motivation (e.g., certain interest and taxes) or to the extent of income from the hobby.⁷ Gambling losses are deductible to the extent of gambling gains.

^{Since many taxpayers incur some expenses that are allowable as miscellaneous itemized deductions, but these expenses commonly are small in amount, the committee believes that the complexity created by present law is undesirable. At the same time, the committee believes that taxpayers with unusually large employee business or investment expenses should be permitted an itemized deduction reflecting that fact. Similarly, in the case of medical expenses and casualty losses, a floor is provided under present law to limit those deductions to unusual expenditures that may significantly affect the individual's disposable income.}

^{Accordingly, the committee believes that the imposition of a one-percent floor on miscellaneous itemized deductions constitutes a desirable simplification of the tax law. This floor will relieve taxpayers of the burden of recordkeeping unless they expect to incur expenditures in excess of the percentage floor. Also, the floor will relieve the Internal Revenue Service of the burden of auditing deductions for such expenditures when not significant in aggregate amount.}

^{The committee also believes that the distinction under present law between employee business expenses (other than reimbursements) that are allowable above-the-line, and such expenses that are allowable only as itemized deductions, is not supportable. The reason for allowing these expenses as deductions (i.e., the fact that they may constitute costs of earning income) and the reasons for imposing a percentage floor apply equally to both types of expenses.}

Other provisions in the bill affect the allowability of particular miscellaneous deductions.⁹ To the extent that any limitation is placed on the amount of a miscellaneous deduction, either under present law or under the bill, that limitation applies prior to the application of the one-percent floor. For example, if an employee incurs deductible expenses relating to business meals away from home, and these expenses are not reimbursed by the employer, the employee must first reduce the amount of the expenses by 20 percent (pursuant to section 142 of the bill) and then add the remaining portion of the expenses to the other miscellaneous deductions that he or she has incurred during the year for purposes of applying the one-percent floor. Similarly, the deductibility of expenses relating to a hobby or a home office must first be determined pursuant to the applicable rules before application of the one-percent floor.

2. Charitable contribution deduction for nonitemizers

(sec. 133 of the bill and sec. 170(i) of the Code)

Under the phase-in, for taxable years beginning in 1982-1984, the amount of contributions that nonitemizers were allowed to take into account was subject to a maximum dollar limit. In addition, for the years 1982-1985, only a portion of the amount of contributions otherwise deductible is allowed as a deduction for nonitemizers. These percentages and dollar limits are shown in the following table:

 Year contribution made    Percentage     Contribution

For 1985 and 1986, nonitemizers may deduct 50 and 100 percent of their charitable contributions, respectively, without regard to a contribution limit (other than the general percentage limitations applicable to charitable contribution deductions). Under present law, nonitemizers will not be able to deduct any amount of charitable contributions made after December 31, 1986.

The Code provides expressly that a charitable contribution is deductible only if verified in the manner required by Treasury regulations (sec. 170(a)(1)). Pursuant to this statutory rule, certain substantiation requirements have been set forth in regulations, including additional information that must be attached to the donor's return in the case of certain donations of property.

At the same time, the committee recognizes that donations of relative small amounts (such as regular giving to religious institutions, or small contributions in response to door-to-door solicitations) may occur in the absence of any tax incentive. Also, allowing a nonitemizer deduction for relatively low levels of giving may impose recordkeeping burdens and complexity for many short-form filers, and create enforcement problems for the Internal Revenue Service. Accordingly, the committee has concluded that the non-itemizer deduction should be available only to the extent that the taxpayer's total charitable contributions for the year exceed $100.

As under present law, the deduction for nonitemizers for post-1985 years will continue to be subject to the tax rules generally applicable to charitable deductions, including the 20/30/50-percent limitations (based on a percentage of the donor's adjusted gross income), the reduction rules applicable to contributions of appreciated property, and the rule that no deduction is allowable (to itemizers or nonitemizers) unless the contribution is substantiated as required by Treasury regulations. Also, as under present law, a charitable deduction for a payment to a charitable organization is allowed only to the extent exceeding the fair market value of any goods or services received in exchange for the payment.

3. Repeal of deduction for certain adoption expenses

(sec. 134 of the bill and sec. 222 of the Code)

A "child with special needs" is a child with respect to whom adoption assistance payments may be made under section 473 of the Social Security Act. In general, this is a child who (1) the State has determined cannot or should not be returned to the home of the natural parents, and (2) cannot reasonably be expected to be adopted unless adoption assistance is provided, on account of a specific factor or condition (such as ethnic background, age, membership in a minority or sibling group, medical condition, or physical, mental, or emotional handicap).

(sec. 141 of the bill and secs. 1301-1305 of the Code)

In order to use income averaging, an individual (1) must meet one of several alternative standards generally intended to restrict the availability of income averaging to individuals who were self-supporting during the base years, and (2) must have been a United States citizen or resident during the taxable year and the three base years. An individual who has not been self-supporting during one or more of the base years nonetheless may be eligible for income averaging if he or she has attained the age of 25 and was not a full-time student during at least four years after attaining the age of 21.

The complexities of income averaging under present law derive both from the arithmetical calculations that it requires and also from the rules governing eligibility. For example, the determination of whether an individual was self-supporting during each of the base years can be difficult; this issue has been a frequent source of controversy between individuals and the Internal Revenue Service. In addition, application of the income averaging rules can be particularly complex for an individual whose marital status has changed during one of the three base years.

2. Limitations on deductions for meals, travel, and entertainment

(sec. 142 of the bill and secs. 162, 170, 212, 274, and 6653 of the Code)

In general, deductions are allowable for ordinary and necessary expenditures paid or incurred in carrying on a trade or business or for the production or collection of income (Code secs. 162, 212). Travel expenses incurred while away from home in the pursuit of a trade or business, including amounts expended for meals and lodging (other than amounts that are lavish or extravagant under the circumstances), generally qualify for the deduction (sec. 162(a)(2)).

The taxpayer bears the burden of proving both the eligibility of an expenditure as a deduction and also the amount of any such eligible expenditure.¹⁰ In addition, certain limitations and special substantiation requirements apply to travel and entertainment deductions (sec. 274). Taxpayers are subject to penalties if any part of an underpayment of tax (e.g., because of improperly claimed deductions) is due to negligence or intentional disregard of rules or regulations (sec. 6653(a)) or due to fraud (sec. 6653(b)).

No deduction is allowed for personal, family, or living expenses (sec. 262). For example, the costs of commuting to and from work are nondeductible personal expenses.¹¹

^{The Code also provides that no deduction is allowed for a payment that is illegal under any Federal law or State law (but only if such State law is generally enforced) that subjects the payor to a criminal penalty or the loss of a license or privilege to engage in a trade or business. For example, if paying more than the face value for a ticket ("scalping") is illegal under an enforced State law, this rule would disallow any otherwise available deduction of such payments as business entertainment expenses.}

^{Entertainment activities}

These special requirements apply, subject to ten statutory exceptions under present law (including an exception for meals, and discussed in greater detail below), to expenses of the taxpayer and the taxpayer's guests such as expenses incurred at nightclubs, cocktail lounges, theaters, country clubs, golf and athletic clubs, and sporting events, and on hunting, fishing, or vacation trips or yachts, as well as to expenses of providing food or beverages, lodging not used for business purposes, or the personal use of employer-provided automobiles. If either statutory test is met or an exception applies, entertainment expenses of the taxpayer as well as entertainment expenses of the taxpayer's business guests (Such as present or potential customers or clients, legal or business advisors, suppliers, etc.) are deductible (assuming all generally applicable requirements are satisfied).

The regulations presume that the "active business discussion" test is not met if the entertainment occurred under circumstances where there was little or no possibility of engaging in business. For example, the test is presumed not to have been met if there were substantial distractions, e.g., because the entertainment took place at a nightclub or a cocktail party, or if the taxpayer met with a group including nonbusiness-related individuals at a vacation resort.

Even if the "active business discussion" test is not met, entertainment expenses are deemed "directly related" to business and hence satisfy the special section 274 limitation if incurred in a "clear business setting" directly in furtherance of the taxpayer's business. For example, the "clear business setting" test is met for expenses of entertainment taking place in a hospitality room at a convention, where business goodwill may be generated through the display of business products, or where civic leaders are entertained at the opening of a new hotel or theatrical production, provided that the clear purpose is to obtain business publicity. However, because of distracting circumstances, entertainment is presumed not to have occurred in a clear business setting in the case of a meeting or discussion taking place at a nightclub, theater, or sporting event, or during a cocktail party.

The "associated with" test does not require that business actually be transacted or discussed during the entertainment, that the discussion and entertainment take place on the same day, that the discussion last for any specified period, or that more time be devoted to business than to entertainment. Thus, if a taxpayer conducts negotiations with a group of business associates and that evening entertains them and their spouses at a restaurant, theater, concert, or sporting event, the entertainment expenses generally are deductible as "associated with" the active conduct of the taxpayer's business, even though the purpose of the entertainment is merely to promote goodwill. Entertainment taking place between business Sessions or during evening hours at a convention is treated as directly preceding or following a business discussion.

Entertainment facilities

The section 274 rules were amended by the Revenue Act of 1978 to disallow any deduction (or the investment tax credit) for the cost of entertainment facilities, unless one of the specific statutory exceptions applies. This general disallowance rule applies to property such as luxury "skyboxes" in sports arenas, tennis courts, bowling alleys, yachts, swimming pools, hunting lodges, fishing camps, and vacation resorts.

Dues or fees paid to a social, athletic, or sporting club are deductible provided that more than half the taxpayer's use of the club is in furtherance of the taxpayer's business and the item is directly related to the active conduct of the taxpayer's business. The expenses of box seats and season tickets to theaters and sporting events are not disallowed as expenses related to entertainment facilities. Instead, such costs are fully deductible if they meet the tests applied to entertainment activities. Under present law, the cost of " leasing" a skybox in a sports arena for an entire season or year is treated as an entertainment activity expense, rather than an entertainment facility expense.

Exceptions for certain entertainment

These exceptions are for (1) business meals (discussed below), (2) food and beverage furnished to employees on the taxpayer's business premises, (3) entertainment expenses treated by the employer and employee as compensation to the employee, (4) expenses paid by the taxpayer under a reimbursement or other expense allowance arrangement in connection with the performance of services, (5) expenses for recreational, social, or similar facilities or activities for the benefit of employees generally, (6) entertainment expenses directly related to bona fide meetings of a taxpayer's employees, stockholders, or directors, (7) entertainment expenses directly related to and necessary to attendance at a business meeting or convention of a tax-exempt trade association, (8) expenditures for entertainment (or a related facility) made available by the taxpayer to the general public, (9) expenses for entertainment sold by the taxpayer to the public, and (10) expenses includible in the income of persons who are not employees.

The regulations under section 274 provide that entertainment expenditures are not deductible to the extent they are lavish or extravagant. The Internal Revenue Service has not interpreted this provision to disallow deductions merely because entertainment expenses exceed a fixed dollar amount, are incurred at expensive restaurants, hotels, nightclubs, or resorts, or because they involve first-class accommodations or services (see Rev. Rul. 63-144, 1963-2 C.B. 129).

There is no requirement that business actually be discussed either before, during, or after the meal. For example, if the taxpayer takes a potential customer to breakfast, lunch, or dinner at a restaurant or hotel, or to a bar for drinks, the costs of the food and beverages are deductible whether or not any business is discussed. The legislative history of the 1962 Act indicates that this "business meals' exception to section 274(a) thus exempts a significant portion of business "goodwill" entertaining from the restrictions generally applicable to entertainment expenses.

Under the exception, meals in a restaurant or hotel dining room are deductible in the absence of distractions such as floor shows. Business entertaining at the taxpayer's home also qualifies if the taxpayer shows that the expenditure was commercially, rather than socially, motivated. In such situations, expenditures for meals of a customer's spouse, and for the taxpayer's spouse who helps entertain a business customer, are deductible if they meet the general "ordinary and necessary" standard. However, entertainment at a night club, sporting event, or large cocktail party generally does not qualify for the business meal exception.

Travel expenses

Deductions for conventions held on cruise ships are limited to $2,000 per taxpayer per year, and are wholly disallowed unless the cruise ship is registered in the United States and stops only at ports of call in this country (including United States possessions) (sec. 274(b)(2)). Also, special rules apply in the case of travel outside the United States that lasts for more than one week (sec. 274(c)).

General substantiation requirements

As a general rule, deductions for travel, entertainment, and certain gift expenses are subject to stricter substantiation requirements than most other business deductions (sec. 274(d)). These stricter rules were enacted because Congress recognized that "in many instances deductions are obtained by disguising personal expenses as business expenses."¹²

^{Under the Section 274 rules, the taxpayer must substantiate by adequate records, or sufficient evidence corroborating the taxpayer's statement, the amount of: (1) the expense or item subject to section 274(d); (2) the time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift; (3) the business purpose of the expense or other item; and (4) the business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift. These substantiation rules apply to: (1) traveling expenses (including meals and lodging while away from home); (2) expenditures with respect to entertainment, amusement, or recreation activities or facilities; and (3) business gifts. In addition, the Tax Reform Act of 1984 made additional property subject to the section 274(d) rules, including automobiles used for local travel.13}

Since the 1960's, the Congress has sought to address various aspects of deductions for meals, entertainment, and travel expenses that the Congress and the public have viewed as unfairly benefiting those taxpayers who are able to take advantage of the tax benefit of deductibility. In his 1961 Tax Message, President Kennedy reported that "too many firms and individuals have devised means of deducting too many personal living expenses as business expenses, thereby charging a large part of their cost to the Federal Government." He stated: "This is a matter of national concern, affecting not only our public revenues, our sense of fairness, and our respect for the tax system, but our moral and business practices as well."

The committee shares these concerns, and believes that these concerns are not addressed adequately by present law. In general, present law requires some heightened showing of a business purpose for travel and entertainment costs, as well as stricter substantiation requirements than those applying generally to all business deductions. However, the present-law approach fails to address a basic issue inherent in allowing deductions for many travel and entertainment expenditures--the fact that, even if reported accurately and having some connection with the taxpayer's business, such expenditures also convey substantial personal benefits to the recipients.

The committee believes that present law, by not focusing sufficiently on the personal-consumption element of deductible meal and entertainment expenses, unfairly permits taxpayers who can arrange business settings for personal consumption to receive, in effect, a Federal tax subsidy for such consumption that is not available to other taxpayers. The taxpayers who benefit from deductibility under present law tend to have relatively high incomes, and in some cases the consumption may bear only a loose relationship to business necessity. For example, when executives have dinner at an expensive restaurant following business discussions and then deduct the cost of the meal, the fact that there may be some bona fide business connection does not alter the imbalance between the treatment of those persons, who have effectively transferred a portion of the cost of their meal to the Federal Government, and other individuals, who cannot deduct the cost of their meals.

The significance of this imbalance is heightened by the fact that business travel and entertainment often may be more lavish than comparable activities in a nonbusiness setting. For example, meals at expensive restaurants and season tickets for luxury boxes at sporting events are purchased to a significant degree by taxpayers who claim business deductions for these expenses. This disparity is highly visible, and contributes to public perceptions that the tax system is unfair. Polls indicate that the public identifies the deductibility of normal personal expenses such as meals to be one of the most significant elements of disrespect for and dissatisfaction with the present tax system.

In light of these considerations, the committee bill reduces by 20 percent the amount of otherwise allowable deductions for business meals and entertainment. This reduction rule reflects the fact that meals and entertainment inherently involve an element of personal living expenses, but still allows an 80 percent deduction where such expenses also have an identifiable business relationship. The bill also tightens the requirements for establishing a bona fide business reason for claiming meal and entertainment expenses as deductions. The committee provided various exceptions in the bill to the general percentage reduction rule, including exceptions for certain traditional employer-paid recreational expenses for employees, de minimis fringe benefits, promotional activities made available to the general public, and costs for certain sports events related to charitable fundraising.

Required business purpose for meals

In certain respects, more liberal deduction rules are provided under present law with respect to business meals than other entertainment expenses, both as to the underlying legal requirements for deductibility and as to substantiation requirements. The committee believes that more uniform deduction rules should apply. In addition, the committee believes that business meals should be deductible only if the meal has a clear business purpose presently related to the active conduct of the taxpayer's trade or business. In addition, the committee believes that special penalties should apply when taxpayers fraudulently or negligently claim business meal deductions to which they are not entitled.

Skybox rentals

Under present law, taxpayers generally cannot claim deductions or credits for the cost of entertainment facilities, including private luxury boxes ("skyboxes") at sports arenas. However, a taxpayer may be able to circumvent this rule by leasing a skybox instead of purchasing it. Accordingly, the committee bill disallows deductions for the costs of leasing a skybox for more than one event.

Excess ticket costs

In some cases, taxpayers may claim entertainment expense deductions for ticket purchases that exceed the face value of the tickets. For example, a taxpayer may pay an amount in excess of the face price to a "Scalper" or ticket agent. The committee believes that deductions for ticket costs in excess of the face value amount generally should not be allowed. However, this limitation does not apply to ticket expenses for sports events meeting certain requirements under the bill relating to charitable fundraising.

Luxury water travel

The committee believes that present law may allow excessive deductions for business travel undertaken by luxury water travel (e.g., by cruise ship). Taxpayers who engage in luxury water travel ostensibly for business purposes may have chosen this means of travel for personal enjoyment over other reasonable alternatives that may better serve business purposes by being faster and less expensive. Also, the costs of cruise ship travel may include elements of entertainment and meals (not separately charged) that are not present in other transportation. Accordingly, the committee bill generally places per diem dollar limitations on deductions for luxury water transportation.

Travel as a form of education

The committee is concerned about deductions claimed for travel as a form of "education." The committee believes that any business purpose served by traveling for general educational purposes, in the absence of a specific need such as engaging in research which can only be performed at a particular facility, is at most indirect and insubstantial. By contrast, travel as a form of education may provide substantial personal benefits by permitting some individuals in particular professions to deduct the cost of a vacation, while most individuals must pay for vacation trips out of after-tax dollars, no matter how educationally stimulating the travel may be. Accordingly, the committee bill disallows deductions for travel that can be claimed only on the ground that the travel itself is "educational", but permits deductions for travel that is a necessary adjunct to engaging in an activity that gives rise to a business deduction relating to education.

Charitable deductions for travel expenses

The committee is also concerned about charitable deductions claimed by some persons for expenses of travel away from home to vacation sites, etc. Recently, there has been a proliferation of widely publicized programs implying that individuals can travel to appealing locations and claim charitable deductions for their travel and living costs, on the ground that the taxpayers perform services assisting the charities. In many cases, however, the value of the services performed may be minimal compared to the amount deducted. Accordingly, the committee believes that charitable deductions for travel expenses away from home should be denied where the travel involves a significant element of personal recreation or vacation; this same rule applies under present law for travel expenses claimed as medical deductions. However, deductions for such expenses as the out-of-pocket expenditures incurred by a troop leader on a youth group camping trip would be allowed.

Expenses for nonbusiness conventions

The committee is concerned about deductions claimed for travel and other costs of attending conventions or other meetings that relate to financial or tax planning, rather than to a trade or business of the taxpayer. For example, individuals claim deductions for attending seminars about investments in securities or tax shelters. In many cases, these seminars are held in locations (including some that are overseas) that are attractive for vacation purposes, and are structured so as to permit extensive leisure activities on the part of attendees. Since investment purposes do not relate to the taxpayer's means of earning a livelihood (i.e., a trade or business), the committee believes that these abuses, along with the personal consumption issue that arises with respect to any deduction for personal living expenses, justify denial of any deduction for the costs of attending a nonbusiness seminar or similar meeting that does not relate to a trade or business of the taxpayer.

For purposes of this rule, meals and entertainment activities generally are defined as under present law. Thus, 20 percent of an otherwise allowable deduction for food or beverages, including food or beverage costs incurred in the course of travel away from home, is disallowed. Similarly, the cost of a meal furnished by an employer to employees on the employer's premises is subject to the rule. An entertainment activity is defined for purposes of this rule, in accordance with section 274(a)(1)(A), i.e., as an activity which is of a type generally considered to constitute entertainment, amusement, or recreation. (See discussion below of certain exceptions to the percentage reduction rule.)

In determining the amount of the otherwise allowable deduction that is subject to reduction under this rule, expenses for taxes and tips relating to a meal or entertainment activity are included. For example, in the case of a business meal for which the taxpayer pays $50, plus $4 in tax and $10 in tips, the amount of the deduction cannot exceed $51.20 (80 percent of $64). Expenses such as cover charges for admission to a night club, the amount paid for a room which the taxpayer rents for a dinner or cocktail party, or the amount paid for parking at a sports arena in order to attend an entertainment event there, likewise are deductible only to the extent of 80 percent under the rule. However, an otherwise allowable deduction for the cost of transportation to and from a business meal (e.g., cab fare to a restaurant) is not reduced pursuant to the rule.

The percentage reduction rule is applied only after determining the amount of the otherwise allowable deduction under sections 162 and 274. Meal and entertainment expenses first are limited to the extent (if any) required pursuant to other applicable rules set forth in section 162 or section 274, and then are reduced by 20 percent.¹⁴

^{For example, if a travel meal costs $100, but, under section 162(a)(2), $40 of that amount is disallowed as "lavish and extravagant," then the remaining $60 is reduced by 20 percent, leaving a deduction of $48. Similarly, when a taxpayer buys a ticket to an entertainment event for more than the ticket's face value, the deduction cannot exceed 80 percent of the face value of the ticket. However, the effect of the percentage disallowance rule is determined prior to application of deduction limits other than those contained in sections 162 and 274 (e.g., the one percent floor on miscellaneous deductions imposed by section 132 of the bill, described above).}

First, the cost of a meal or of an entertainment activity is fully deductible if the full value thereof is taxed as compensation to the recipients (whether or not they are employees) or is excludable under section 132, pursuant to either the subsidized eating facility exclusion or the exclusion for de minimis fringe benefits. For example, a transfer for business purposes of a packaged food or beverage item (e.g., a holiday turkey or ham, fruitcake, or bottle of wine) is not subject to the percentage reduction rule where the de minimis fringe benefit exclusion applies.

Second, in the case of a taxpayer who is reimbursed for the cost of a meal or of entertainment, the percentage reduction rule instead applies to the party making the reimbursement. This exception may apply, for example, in the case of a salesperson who pays for a lunch with a customer at which a sales contract is discussed and then is reimbursed by his or her employer.

Third, the percentage reduction rule does not apply in the case of certain traditional recreational expenses for employees that are paid by employers. For example, this exception may apply in the case of an employer's deduction for reasonable costs of a year-end holiday party or a summer outing for employees and their spouses.

Fourth, the reduction rule does not apply in the case of items, such as samples and promotional activities, that are made available to the general public. For example, if the owner of a hardware store advertises that tickets to a baseball game will be provided to the first 50 people who visit the store on a particular date, or who purchase an item from the store during a sale, then the full amount of the face value of the tickets is deductible by the owner. Similarly, a wine merchant who permits potential customers to sample wine of the type that the merchant is offering for sale may deduct in full the cost of wine used as a sample, along with reasonable costs that are associated with the winetasting (e.g., food that is provided with the wine to demonstrate the suitability of the wine for particular types of meals.)

Fifth, expenses for attendance at a sports event, to the extent otherwise allowable as a business deduction, are not subject to the percentage reduction rule if the event meets certain requirements related to charitable fundraising. In order for such costs to be fully deductible as a business expense under this rule, the event must (1) be organized for the primary purpose of benefiting a tax-exempt charitable organization (described in sec. 501(c)(3)), (2) contribute 100 percent of its net proceeds to charity, and (3) utilize volunteers for substantially all work performed in carrying out the event. This rule applies to the cost of a ticket package, i.e., the amount paid both for seating at the event, and for related services such as parking, use of entertainment areas, contestant positions, and meals furnished at and as part of the event.

For example, a golf tournament that donates all of the net proceeds from the event to charity is eligible to qualify under this exception. Such a tournament would not fail to qualify solely because it offered prize money to golfers who participated, or used paid concessionaires or security personnel. However, the committee intends that tickets to college or high school football or basketball games or other similar scholastic events will not qualify under the exception. Such games generally do not satisfy the requirement that substantially all work be performed by volunteers, if the institutions (or parties acting on their behalf) pay individuals to perform such services as coaching or recruiting.

Finally, the cost of providing meals or entertainment is fully deductible to the extent that it is sold by the taxpayer in a bona fide transaction for an adequate and full consideration in money or money's worth. For example, a restaurant may deduct the full amount of its ordinary and necessary expenses in providing meals to paying customers.

b. Additional requirements relating to meals

The committee bill also makes certain changes in the legal and substantiation requirements applying to deductions for business meals.

First, the bill provides that a meal expense, like other entertainment expenses under present law, is not deductible unless the taxpayer establishes that the item was directly related to the active conduct of the taxpayer's trade or business, or, in the case of an item directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or otherwise), that the item was associated with the active conduct of the taxpayer's trade or business. Under this standard, a business meal expense generally is not deductible unless there is a substantial and bona fide business discussion during, directly preceding, or directly following the meal. However, in the case of an individual who is away from home in the pursuit of a trade or business and who eats alone, the absence of a business discussion does not preclude satisfying the "directly related" or "associated with" requirement.

For purposes of deducting meal expenses, the business discussion requirement (applying to any business meal other than one consumed alone by an individual who is away from home in the pursuit of a trade or business) is deemed not to have been met if neither the taxpayer nor any employee of the taxpayer is present at the meal. Thus, for example, if the taxpayer reserves a table at a business dinner but neither the taxpayer nor an employee of the taxpayer attends the dinner, no deduction will be allowed. Similarly, if one party to a contract negotiation buys dinner for other parties involved in the negotiations, but does not attend the dinner, the deduction is denied even if the other parties engage in a business discussion.¹⁵

^{For purposes of this rule, an independent contractor who renders significant services to the taxpayer (other than attending meals on the taxpayer's behalf, or providing services relating to meals) is treated as an employee, if he or she attends the meal in connection with such performance of services. Thus, for example, an attorney who was retained by a taxpayer to represent the taxpayer in a particular legal proceeding would be treated as an employee of the taxpayer for purposes of this rule, if the attorney represented the taxpayer at a business meal at which the legal proceeding was discussed.}

^{Second, the bill provides that the cost of a business meal is not deductible unless the meal has a clear business purpose presently related to the active conduct of a trade or business. This requirement is stricter than the generally applicable requirement for deducting meal and entertainment expenses (described above). Thus, the clear business purpose requirement is not satisfied in the case of a meal at which the business discussion does not concern a specific business transaction or arrangement. In addition, the cost of a meal is not deductible if it serves non-trade or business purposes of the taxpayer (e.g., investment purposes) rather than trade or business purposes and thus under present law would give rise to a deduction (if at all) under section 212 rather than section 162.}

^{Third, the bill makes explicit that the statutory rule under present law disallowing deductions for certain lavish and extravagant travel expenses (including for meals) applies to all business meals. Thus, it applies whether or not the expense is incurred while the taxpayer is away from home, and whether or not the taxpayer incurs the expense alone or with others.}

^{Finally, under the bill, to the extent that a taxpayer claims business meal deductions to which the taxpayer is not legally entitled, a special penalty rule applies if the error is negligent or fraudulent. If the erroneous deduction was due to negligence or disregard of rules and regulations, the otherwise applicable negligence penalty will not be less than 50 percent of the underpayment resulting from the improperly claimed deduction. If the error is due to fraud, the penalty equals 100 percent of the extra amount of tax due.}

^{The rules of the bill reflect the committee's concerns about deductions claimed for meals that do not clearly serve business purposes or are not adequately substantiated. In keeping with these concerns, the committee expects the Treasury to adopt regulations providing, to the extent reasonable, stricter substantiation requirements for business meal deductions. For example, such regulations could relate to the need for documentary evidence, such as a restaurant receipt, substantiating business meal expenses, including expenses of less than $25 per day. The committee also emphasizes that, under present law, as well as under the bill, courts may not apply the so-called "Cohan rule," allowing approximation of the amount of an expense, to any business meal or other entertainment expense.}

^{c. Deductions for tickets limited to face value}

^{Under the bill, a deduction (if otherwise allowable) for the cost of a ticket for an entertainment activity is limited (prior to application of the 20 percent reduction rule) to the face value of the ticket. The face value of a ticket includes any amount of ticket tax on the ticket. Under this rule, for example, a payment to a "scalper" for a ticket is not deductible (even if not disallowed under present law as an illegal payment) to the extent that the amount paid exceeds the face value of the ticket. Similarly, a payment to a ticket agency for a ticket is not deductible to the extent in excess of the face value of the ticket.}

^{However, the face value limitation does not apply to an expense that is excepted under the bill from the percentage reduction rule because it relates to a sports event that meets certain requirements related to charitable fundraising (see description above).}

^{d. Disallowance of deductions for certain "skybox" rentals}

^{The bill also generally disallows deductions relating to rental or similar payments for use of a "skybox." The latter term means any private luxury box or other facility at a sports arena that is separated from other seating, and is available at a higher price (counting all applicable expenses, e.g., rental of the facility, as well as separate charges for food and seating) than the price generally applicable to other seating.}

^{The disallowance rule does not apply unless the taxpayer (or a related party, including one engaged in a reciprocal rental arrangement with the taxpayer) rents a skybox at the same sports arena for more than one event. For purposes of this rule, a single game or other performance counts as one event. Thus, for example, a taxpayer who rents a skybox for two World Series games in the same stadium is treated as renting a skybox for two events. The deductibility of a single-event rental is determined under the rules generally applicable to entertainment activities.}

^{In determining whether a taxpayer has rented a skybox for more than one event, all skybox rentals by the taxpayer in the same arena, along with any related rentals, are considered together. For example, rentals of different skyboxes in the same stadium, or rentals by the same taxpayer pursuant to separate rental agreements, constitute related rentals. In addition, rentals by related parties are considered related rentals. For example, this rule applies where members of the same family, corporations with common ownership, or taxpayers who have made a reciprocal arrangement involving sharing skyboxes, respectively lease skyboxes for different events.}

^{If the disallowance rule applies, two types of expenses related to the Skybox still may be deductible. First, the deductibility of separately stated charges for food or beverages is determined under the rules generally applying to business meals (described above), including the percentage reduction rule. Second, an amount not exceeding the face values of non-luxury box seat tickets for the number of seats in the luxury box may be deducted (subject, however, to further reduction under the percentage reduction rule).}

^{For example, in a stadium where box seats (other than in luxury boxes) are sold for between $8 and $12, a taxpayer subject to the skybox disallowance rule may treat the deductible amount as equal to $12 multiplied by the number of seats in the luxury box. This method applies whether or not the luxury box is fully occupied during an event, and without regard to whether amounts paid for the luxury box nominally constitute payments for the seats, or rentals for the luxury box. However, in determining the amount charged for non-luxury box seats, only prices charged for a genuine category of such seats are taken into account. Consider, for example, the case of a sports arena which, in order to increase the deductions allowable with respect to skyboxes, reserved a small group of seats for which it charged $50 even though those seats were not significantly better than the seats which it offered for $12. In such a case, the $50 price would be disregarded as not bona fide.}

^{e. Travel as a form of education}

^{Under the bill, no deduction is allowed for travel as a form of education. This rule applies when a travel deduction would otherwise be allowable only on the ground that the travel itself serves educational purposes (for example, in the case of a teacher of French who travels to France in order to maintain general familiarity with the French language and culture). This disallowance rule does not apply when a deduction is claimed with respect to travel that is a necessary adjunct to engaging in an activity that gives rise to a business deduction relating to education (for example, where a scholar of French literature travels to Paris in order to do specific library research that cannot be done elsewhere, or to take courses that are offered only at the Sorbonne, in circumstances such that the nontravel research or course costs are deductible).}

^{f. Charitable deductions for travel expenses}

^{The bill places limitations on charitable deductions for the cost of travel away from home. Under this rule, no charitable deduction is allowed for transportation and other traveling expenses (including costs for meals and lodging) incurred in performing services away from home for a charitable organization unless there is no significant element of personal pleasure, recreation, or vacation in the travel away from home. The same limitation applies as under present law with respect to medical deductions for lodging costs away from home (sec. 213(d)(2)(b)).}

^{This rule applies only with respect to expenses relating to travel by the taxpayer or by a person associated with the taxpayer (e.g., a family member). The rule does not apply to the extent that the taxpayer pays for travel by third parties who are participants in the charitable activity (for example, expenses for travel by children unrelated to the taxpayer, personally incurred by the troop leader for a tax-exempt youth group who takes children belonging to the group on a camping trip). However, the disallowance rule applies in the case of any reciprocal arrangement (e.g., when two unrelated taxpayers pay each other's travel expenses, or members of a group contribute to a fund that pays for all of their travel expenses).}

^{The disallowance rule applies whether the travel expenses are paid directly by the taxpayer, or indirectly through reimbursement by the charitable organization. For this purpose, any arrangement whereby a taxpayer makes a payment to a charitable organization and the organization pays for his or her travel expenses is treated as a reimbursement.}

^{In determining whether travel away from home involves a significant element of personal pleasure, recreation, or vacation, the fact that a taxpayer enjoys providing services to the charitable organization will not lead to denial of the deduction. For example, a troop leader for a tax-exempt youth group who takes children belonging to the group on a camping trip may qualify for a charitable deduction with respect to his or her own travel expenses if he or she is on duty in a genuine and substantial sense throughout the trip, even if he or she enjoys the trip or enjoys supervising children. By contrast, a taxpayer who only has nominal duties relating to the performance of services for the charity, or who for significant portions of the trip is not required to render services, is not allowed any charitable deduction for travel costs.}

^{The disallowance rule in the bill has no effect on deductions other than charitable deductions that may be claimed with respect to travel on behalf of a charitable organization. For example, the rule does not affect the deductibility under section 162 of an employee business expense incurred by an employee of a charitable organization.}

^{g. Expenses for nonbusiness conventions, etc.}

^{Under the bill, no deduction is allowed for expenses related to attending a convention, seminar, or similar meeting unless such expenses are deductible under section 162 as ordinary and necessary expenses of carrying on a trade or business. Thus, the bill disallows deductions for expenses of attending a convention, etc. where the expenses, but for the provision in the bill, would be deductible under section 212 (relating to expenses of producing income) rather than section 162. The expenses to which the provision relates typically include such items as travel to the site of such a convention, fees for attending the convention, and personal living expenses, such as meals, lodging, and local travel, that are incurred while attending the convention or other meeting.}

^{h. Luxury water travel}

^{The bill also places limitations on allowable deductions for travel by ocean liner, cruise ship, or other form of luxury water transportation. This rule applies, for example, in the case of a taxpayer who has business reasons for traveling from New York City to London and who travels by ocean liner.}

^{Under the bill, the deduction allowable in the case of luxury water travel cannot exceed twice the highest amount generally allowable with respect to a day of travel to employees of the executive branch of the Federal Government while away from home but serving in the United States, multiplied by the number of days the taxpayer was engaged in luxury water travel. For example, if during a particular taxable year the applicable Federal per diem amount is $75, a taxpayer's deduction for a six-day trip cannot exceed $900 ($150 per day times six days). The applicable per diem amount generally is the highest travel amount applying for an area in the conterminous United States; however, any limited special exception to this amount (e.g., a higher limit that applied only to high-ranking executive personnel) would be disregarded.}

^{If the expenses of luxury water travel include separately stated amounts for meals or entertainment, the amounts so separately stated are reduced by 20 percent, under the percentage reduction rule, prior to application of this per diem limitation. However, in the absence of separately stated meal or entertainment charges, taxpayers are not required to allocate a portion of the total amount charged to meals or entertainment unless the amounts to be allocated are clearly identifiable.}

^{The per diem rule does not apply in the case of any expense allocable to a convention, seminar, or other meeting which is held on any cruise ship. Thus, the per diem rule does not alter the application of the present-law rule under which deductions for conventions held aboard cruise ships are wholly denied or, in certain special cases, allowed to the extent not in excess of $2,000 per individual. Also, it is intended under the bill that the statutory exceptions to the business meal percentage reduction rule (described above) are also exceptions to the per diem rule with respect to luxury water travel.}

3. Changes in treatment of hobby losses

(secs. 143(a) and 143(b) of the bill and sec. 183 of the Code)

A facts and circumstances test generally applies to determine whether a particular activity constitutes a hobby. However, statutory rules provide that if the gross income from an activity exceeds the deductions attributable thereto for two or more out of five consecutive years (seven consecutive years in the case of an activity which consists in major part of the breeding, training, showing, or racing of horses), then the activity is presumed to be engaged in for profit rather than as a hobby. The presumption that an activity is not a hobby if it is profitable in two out of five consecutive years (or seven consecutive years, for certain activities) can be overcome by the Internal Revenue Service under the general facts and circumstances test.

As in the case of other expenses deductible as miscellaneous itemized deductions, deductible hobby expenses--other than costs that are deductible without reference to whether they are incurred in an activity designed to produce income (such as certain interest and taxes)--are subject to section 132 of the bill, establishing a one-percent floor under miscellaneous itemized deductions.

4. Changes in deduction for business use of home

(sec. 143(c) of the bill and sec. 280A of the Code)

A taxpayer's business use of his or her home may give rise to a deduction for the business portion of expenses related to operating the home (e.g., rent, depreciation, and repairs). However, no deduction is allowed unless the taxpayer uses part of the home regularly and exclusively either as the principal place of business of the taxpayer or to meet patients, clients, or customers (Code sec. 280A). In addition, a deduction may be permissible if the part of the home used for business purposes constitutes a separate structure. For an employee, a further requirement for a deduction is that the business use of the home must be for the convenience of the employer.

These general business-use requirements need not be met in the case of rental use of a part of the home (e.g., when the taxpayer rents a room to a lodger). In a recent Tax Court case, Feldman v. Commissioner, 84 T.C. 1 (1985), this rental exception was applied, and the general requirements for the deduction held inapplicable, where an employer nominally rented a portion of the employee's home used by the employee in performing services for the employer. The court permitted the taxpayer to deduct home office expenses without requiring regular and exclusive use of the home either as the taxpayer's principal place of business or as a place to meet patients, clients, or customers, notwithstanding the court's finding that the rental was not an arm's length arrangement and was made for more than the fair rental value of the space that nominally was rented.

Limitations on deductions

Deductions for home office costs that are allowed solely because there is a qualifying business use of the home are limited to the amount of the taxpayer's gross income derived from the business use of the home during the taxable year. Costs in excess of the limitation cannot be carried over and used as deductions in other taxable years. This limitation has no effect on deductions (such as home mortgage interest and real property taxes) that are allowable in the absence of business use.

The Internal Revenue Service has issued proposed regulations defining gross income derived from the business use of the home as gross income from the business activity in the unit reduced by expenditures required for the activity but not allocable to the use of the unit itself, such as expenditures for supplies and compensation paid to other persons.¹⁶ However, in Scott v. Commissioner, 84 T.C. 683 (1985), the Tax Court rejected this interpretation, holding that gross income from the use of the home means gross income from the business activity itself, i.e., not reduced by any outside expenditures required for the activity.

Under the Tax Court's interpretation, deductions for business use of one's home could be used to create or increase a net loss from the activity and thus, in effect, to offset income from unrelated activities. For example, assume that a taxpayer derived gross income of $1,000 from an activity, and incurred expenses of $1,500 that related to the activity but that did not relate to use of the home (e.g., expenses for supplies, secretaries, and messengers). Under the Tax Court's interpretation, the taxpayer would be permitted to deduct up to $1,000 in home office costs that are not otherwise deductible (e.g., rent or depreciation), despite the fact that there was no net income from the activity.

The committee believes that taxpayers should not be able to circumvent the limitations on home office deductions by arranging for their employers to rent portions of their homes. The allowance of such arrangements would significantly narrow the applicability of Section 280A and could encourage tax avoidance of the sort that that section was intended to prevent.

Section 280A was enacted due to concern that some taxpayers were converting nondeductible personal and living expenses into deductible business expenses simply because they found it convenient to perform some work at home.¹⁷ The committee recognizes that in some instances a legitimate cost resulting from business use of a home could conceivably be disallowed under the restrictions of section 280A; however, any such instances would be difficult to identify and define. Further, the committee believes that allowing deductions for use of a taxpayer's residence inherently involves the potential for abuse. In enacting section 280A, the Congress concluded that absent limitations, taxpayers could claim home office deductions even when no marginal cost of maintaining the home was incurred by the taxpayer as a result of the business use. Thus, the Congress concluded that home office deductions should be disallowed in the absence of specified circumstances indicating a compelling reason for business use of the home, and in any event should not be permitted to offset taxable income derived from unrelated activities.

Under the interpretation of section 280A applied by the Tax Court in Feldman, the committee believes the statute would fail to achieve its intended purpose. Allowing employees to use lease arrangements with employers as a method of circumventing the restrictions on home office deductions might encourage some taxpayers to arrange sham transactions whereby a portion of salary is paid in the form of rent. Moreover, it is questionable whether lease transactions between an employer and employee are generally negotiated at arm's length, particularly if such a transaction could provide added tax deductions to the employee at no additional cost to the employer. Accordingly, the committee believes that no home office deductions should be allowable (except for expenses such as home mortgage interest and real property taxes that are deductible absent business use) if the employee rents a portion of his or her home to the employer.

Limitations on deduction

The bill provides that no home office deduction is allowable by reason of business use where the taxpayer leases a portion of his or her home to an employer. For this purpose, an individual who is an independent contractor is treated as an employee, and the party for whom such individual is performing services is treated as an employer. In the case of a lease that is subject to this rule, no home office deductions are allowed except to the extent that they would be allowable in the absence of any business use (e.g., home mortgage interest expense and real property taxes).

Limitations on deduction

5. Deductibility of mortgage interest and taxes allocable to tax-free allowances for ministers and military personnel

(sec. 144 of the bill and sec. 265 of the Code)

In January 1983, the Internal Revenue Service ruled that section 265(1) precludes a minister from taking deductions for mortgage interest and real estate taxes on a residence to the extent that such expenditures are allocable to a tax-free housing allowance (under sec. 107) received by the minister (Rev. Rul. 83-3, 1983-1 C.B. 72). This ruling revoked a 1962 ruling which had taken a contrary position. In its 1983 ruling, the Revenue Service stated that where a taxpayer incurs expenses for purposes for which tax-exempt income was received, permitting a full deduction for such expenses would lead to a double benefit not allowed under section 265(1) as interpreted by the courts.

The 1983 ruling generally was made applicable beginning July 1, 1983. However, for a minister who owned and occupied a home before January 3, 1983 (or had a contract to purchase a home before that date), the deduction disallowance rule was delayed with respect to such home until January 1, 1985, by IRS Ann. 83-100; until January 1, 1986, by P.L. 98-369; and until January 1, 1987, by Rev. Rul. 85-96.

The Economic Recovery Tax Act of 1981 ("ERTA") enacted the Accelerated Cost Recovery System ("ACRS") for tangible depreciable property placed in service after 1980. Under ACRS, the cost or other basis of eligible property (without reduction for salvage value) is recovered using an accelerated method of depreciation over a predetermined recovery period that is generally shorter than, and otherwise unrelated to, the asset's useful life (sec. 168). Under prior law, an asset's cost (less salvage value) was recovered over its estimated useful life (sec. 167). Prior law rules remain in effect for property placed in service by a taxpayer before 1981, and for property not eligible for ACRS.

ACRS

Under ACRS, the allowable recovery deduction in each recovery year is determined by applying a statutory percentage to the property's original cost (adjusted, as described below, for investment tax credit allowed) (sec. 168(b)(1)).

The cost of eligible personal property is recovered over a three-year, five-year, 10-year, or 15-year recovery period, depending on the recovery class of the property.

Property with an ADR midpoint life of four years or less (such as automobiles, light general purpose trucks, certain special tools, and over-the-road tractor units), racehorses more than two years old when placed in service and other horses more than 12 years old when placed in service, and property used in connection with research and experimentation are included in the three-year class. The 10-year class includes long-lived public utility property with an ADR midpoint life from 18.5 to 25 years, certain burners and boilers; and railroad tank cars. Longer-lived public utility property having an ADR midpoint life over 25 years is in the 15-year class. Most other personal property is assigned to the five-year class. The ADR midpoint lives used to assign assets to ACRS classes and for other purposes were initially established by the Treasury Department in 1971 and have been modified several times since then.

Taxpayers are required to reduce the basis of assets by 50 percent of the amount of regular or energy investment tax credits allowed with respect to personal property (and the reduced basis is used to compute recovery deductions) (sec. 48(q)(1)). With respect to the regular investment tax credit, a taxpayer can elect a 2-percentage point reduction in the credit in lieu of the half-basis adjustment (sec. 48(q)(4)).

For real property placed in service after May 8, 1985, the cost of real property is recovered over a 19-year recovery period (15 years for low-income housing), although longer recovery periods may be elected (sec. 168(b)(2) and (4)).

Generally, low-income housing includes projects eligible for various Federal, State, and local housing programs and projects where 85 percent of the tenants are eligible for, but do not necessarily receive, subsidies under Section 8 of the Housing Act of 1937.

Under ACRS, component cost recovery is not permitted. Thus, the same recovery period and method must be used for the building as a whole, including all structural components. A substantial improvement (generally, one that is made over a two-year period at a cost that is at least 25 percent of a building's unadjusted basis) is treated as a separate building, the cost of which must be separately recovered when the improvement is placed in service.

If the 15-percent or 20-percent investment tax credit for rehabilitation expenditures is allowed, the basis of real property is reduced by the amount of credit earned (and the reduced basis is used to compute recovery deductions) (sec. 48(q)(1) and (3)). The basis of real property is reduced by 50 percent of the 25-percent credit allowed for the rehabilitation of a certified historic structure (sec. 48(q)(1)). In addition, if a credit for rehabilitation expenditures is allowed, the straight-line method of cost recovery must be used with respect to the rehabilitation expenditures.

Recapture

With certain limited exceptions, gain from the disposition of depreciable property is "recaptured" as ordinary income to the extent of previously allowed ACRS deductions (sec. 1245). For residential real property that is held for more than one year, gain is treated as ordinary income only to the extent the depreciation deductions allowed under the prescribed accelerated method exceed the deductions that would have been allowed under the straight-line method (sec. 1250(b)(1)). In addition, recapture for qualified low-income housing is phased out after such property has been held for a prescribed number of months, at the rate of one percentage point per month (sec. 1250(a)(1)(B)). For nonresidential real property held for more than one year, there is no recapture if the taxpayer elected to recover the property's cost using the straight-line method over the applicable ACRS recovery periods (sec. 1245(a)(5)(C)). If accelerated depreciation is claimed with respect to nonresidential real property, the full amount of the depreciation deductions previously taken (to the extent of the gain) is recaptured. Because the benefits of capital gains treatment on gains attributable to previously claimed depreciation often exceed the additional benefit derived from accelerated depreciation, investors frequently choose to claim straightline depreciation on nonresidential real property.

Application of different depreciation methods for certain purposes

In general, ACRS recovery allowances are reduced for property that is (1) used predominantly outside the United States ("foreign-use property") (sec. 168(f)(2)), (2) leased to a tax-exempt entity, including a foreign person, unless more than 50 percent of the gross income derived from the property is subject to U.S. tax ("tax-exempt use property") (sec. 168(j)), or (3) financed with industrial development bonds the interest on which is exempt from taxation (sec. 168(f)(12)).

Different depreciation methods are also used for purposes of computing earnings and profits of a domestic corporation and applying the minimum tax provisions.

Communications satellites, as defined in Code section 48(a)(2)(B), are excluded from the definition of foreign-use property. Other spacecraft (and interests therein) are not specifically excluded from the definition of foreign-use property.

Depreciation deductions for tax-exempt use property are computed using the straight-line method and disregarding salvage value. The cost of tax-exempt use personal property is generally recovered over the longer of the asset's ADR midpoint life (12 years if the property has no ADR midpoint life) or 125 percent of the lease term. However, the recovery period for qualified technological property subject to these rules is five years. The recovery period for tax-exempt use real property is the longer of 40 years or 125 percent of the lease term. A taxpayer may elect to recover the cost of tax-exempt use property over an optional extended recovery period. The rules for tax-exempt use property override the rules relating to foreign-use property.

The extended recovery periods used to compute earnings and profits are: (1) five years for three-year property, (2) 12 years for five-year property, (3) 25 years for 10-year property, (4) 35 years for 15-year public utility property, and (5) 40 years for 19-year real property and low-income housing.

Lessee-leashold improvements

In general, if a lessee makes improvements to property, the lessee is entitled to recover the cost of the improvement over the shorter of the ACRS recovery period applicable to the property or the portion of the term of the lease remaining on the date the property is acquired (sec. 178). If the remaining lease term is shorter than the recovery period, the cost is amortized over the remaining term of the lease. For purposes of these rules, if the remaining term of a lease is less than 60 percent of the improvement's ACRS recovery period, the term of a lease is treated as including any period for which the lease may be renewed pursuant to an option exercisable by the lessee, unless the lessee establishes that it is more probable that the lease will not be renewed (sec. 178(a)). In any case, a renewal period must be taken into account if there is a reasonable certainty the lease will be renewed (sec. 178(c)).

Public utility property

In general, a regulatory commission allows a public utility to charge customers rates that are sufficient to recover the utility's cost of service. A public utility's cost of service includes its annual operating expense and the capital expense allocable to a year. The capital expense that can be passed through as higher prices to customers consists of an annual depreciation charge for equipment and also a rate of return on the capital invested in the equipment and other property (which capital is referred to as the "rate base").

ACRS distinguishes between long-lived public utility equipment and other equipment. Further, as described below, public utilities are required to use a "normalization" method of accounting for ACRS deductions (sec. 168(e)(3)).

Normalization prevents the immediate lowering of rates charged to customers as a result of the cost savings from ACRS. Rather, current tax reductions are flowed through to customers over the period of tax deferral.

Expensing of up to $5,000 of personal property

A taxpayer (other than a trust or estate) can elect to deduct the cost of up to $5,000 of qualifying personal property in the year the property is placed in service, in lieu of recovering the cost under ACRS (sec. 179). In general, qualifying property must be acquired by purchase for use in a trade or business, and must be eligible for the investment tax credit (although no investment credit is allowed for the portion of the cost expensed under this rule). The $5,000 limit is scheduled to increase to $7,500 for taxable years beginning in 1988 and 1989, and to $10,000 for years beginning after 1989.

Regular investment tax credit

Generally, the investment credit is claimed for the taxable year in which qualifying property is placed in service. However, in certain cases where property is constructed over a period of two or more years, an election is provided under which the credit may be claimed on the basis of qualified progress expenditures ("QPEs") made during the period of construction before the property is completed and placed in service. Investment credits claimed on QPEs are subject to recapture if the property fails to qualify for the investment credit when placed in service.

The amount of income tax liability that can be reduced by investment tax credits in any year is limited to $25,000 plus 85 percent of the liability in excess of $25,000 (sec. 38(c)). Unused credits for a taxable year can be carried back to each of the three preceding taxable years and then carried forward to each of the 15 following taxable years (sec. 39).

Under the ratable flow-through method (sec. 46(f)(2)), utilities pass through to customers a pro rata portion of the credit during each year of the useful life of the asset. The regulatory commission may not require that the utility reduce its rate base by the amount of the credit. Therefore, even though the credit itself is flowed through to customers over the life of the asset, the utility's shareholders are allowed to earn a return on that amount of the cost of the equipment which has, in effect, been supplied by the Federal government through the regular investment credit.

Under the rate base reduction method (sec. 46(f)(1)), the utility's rate base is reduced by the amount of the credit, so that the shareholders are prevented from earning a return on that part of the cost of the equipment which is, in effect, paid for by the credit. Under this method, the regulatory commission may not require that the utility flow through to customers any part of the credit itself, and it must allow the utility to charge customers for the depreciation expense on the entire cost of the equipment, including the part paid for by the investment credit.

Finance leases

A qualified agreement must be a lease determined without taking into account the fact that it contains a 10-percent fixed price purchase option or that the property is limited use property. Thus, the transaction must have economic substance independent of tax benefits. The lessor must reasonably expect to derive a profit independent of tax benefits. In addition, the transaction, without taking into account the fact the agreement contains a fixed price purchase option or that the property is limited use property, must not otherwise be considered a financing arrangement or conditional sale.

The finance lease rules were to have been generally effective for agreements entered into after December 31, 1983, with three temporary restrictions intended to limit the tax benefits of finance leasing in 1984 and 1985. First, no more than 40 percent of property placed in service by a lessee during any calendar year beginning before 1986 was to qualify for finance lease treatment. Second, a lessor could not have used finance lease rules to reduce its tax liability for any taxable year by more than 50 percent. This 50-percent lessor cap was to apply to property placed in service on or before September 30, 1985. Third, the investment tax credit for property subject to a finance lease and placed in service on or before September 30, 1985, was only allowable ratably over 5 years, rather than entirely in the year the property is placed in service.

Notwithstanding these general rules, finance leasing was to be available for up to $150,000 per calendar year of a lessee's farm property for agreements entered into after July 1, 1982, and before 1984. Furthermore, the 40-percent lessee cap, 50-percent lessor cap, and 5-year spread of the investment credit did not apply to this amount of farm property.

The Tax Reform Act of 1984, however, postponed the effective date of the finance lease rules to generally apply to agreements entered into after December 31, 1987, and extended the three restrictions. Thus, the 40-percent lessee cap was extended to property placed in service by a lessee during any calendar year beginning before 1990; the 50-percent lessor cap was extended through September 30, 1989; and the 5-year spread of the investment credit for property subject to a finance lease was extended to property placed in service on or before September 30, 1989.

The Tax Reform Act of 1984 provided transitional rules which exempted property from the 4-year postponement if, before March 7, 1984, (1) a binding contract to acquire or construct the property was entered into by or for the lessee, (2) the property was acquired by the lessee, or (3) construction of the property was begun by or for the lessee. In addition, the Act exempted from the 4-year postponement property which is placed in service before 1988 and is (1) a qualified lessee's automotive manufacturing property (limited to an aggregate of $150 million of cost basis per lessee) or (2) property that was part of a coal-fired cogeneration facility for which certification and construction permit applications were filed on specified dates. The special rules relating to the availability of finance leasing for up to $150,000 per calendar year of a lessee's farm property were extended to cover agreements entered into before 1988.

The committee believes that reform of the capital cost recovery rules is essential for the achievement of more equitable taxation.

The present rules have two major components: the investment tax credit and depreciation (ACRS) deductions. The credit is available when an asset is placed in service, and ACRS deductions, which begin at the same time, are allowed over a period that is generally much shorter than the actual service life of the asset. In combination, the credit (measured as a deduction of equal tax-reducing effect) and ACRS give taxpayers writeoffs that exceed the cost of an asset and concentrate the writeoffs in the early years of the asset's service life. For example, a corporation in the top tax bracket can now write off about 110 percent of the cost of a new car in just three years, even though the car, as noted in government and industry reports, will on average remain in operation for an additional seven or eight years.

The committee is very concerned about the significant inequities that result from the amount and concentration of these tax benefits. Individuals and corporations who have considerable amounts of economic income are permitted to pay little or no tax by using the credit and ACRS, while others with equal or lesser incomes are left fully exposed to high tax rates. The committee believes that inequities of this magnitude should not continue as a regular feature of the tax system, whose orderly functioning rests squarely on popular opinion that it is operating fairly. Therefore, the committee bill goes to the source of the problem by repealing the investment tax credit and providing for generally longer depreciation periods that are more systematically related to service lives.

Economic growth

The committee believes that these reforms, in conjunction with lower marginal tax rates, lay a more certain foundation for growth of the nation's economy.

Proponents of massive tax benefits for depreciable property have theorized that these benefits would stimulate investment in such property, which in turn would pull the entire economy into more rapid growth. The committee perceives that nothing of this kind has happened. First, the average annual compound rate of real growth in equipment spending since 1980 has been very close to the historical trend dating from the early 1960's, and the rate of overall economic growth has been smaller. Second, the growth which has occurred in equipment spending has been heavily concentrated in computers and automobiles, assets which by standard measures of investment incentives received no boost from the 1981 Act. Third, the benefits provide no immediate expansionary stimulus to new or rebuilding enterprises that lack the taxable income to turn credits and deductions into tax savings. These enterprises have resorted to a maze of secondary transactions (such as sale-leasebacks) in order to realize a portion of the tax benefits, stimulating a diversion of highly trained resources to the business of marketing tax benefits and away from the more efficient production of goods and services. Fourth, the investment tax credit and ACRS deductions provide little expansionary stimulus to the service, small business, high technology and other important sectors of the economy that do not make extensive use of depreciable assets but do contribute to economic growth and will benefit from lower tax rates.

But the committee's fundamental view, embodied also in contemporaneous proposals for tax reform, is that the tax system makes the greatest contribution to economic growth when it has the lowest possible tax rates and does not try to prescribe how growth will happen. The strategy that any particular business might choose as most promising--whether to employ more or less equipment or labor, adopt different management practices, alter marketing and purchasing procedures, and so on--is a matter the committee feels is best left to private decisionmaking, undistorted by large tax preferences which presume that one answer fits all cases. This is another reason for the committee's decisions to scale back special tax benefits for expenditures on depreciable assets and to lower marginal tax rates.

The committee is not of the view, however, that the current tax advantages for investment in depreciable property should be replaced by a system having no preferences at all. Rather, the committee believes that the intermediate degree of acceleration that was available prior to 1981 under the ADR system is generally the right target. Therefore, the committee bill permits the 200-percent declining balance method of depreciation and generally uses ADR midpoint lives for assigning assets to recovery classes and for determining recovery periods.

The committee also believes that the depreciation system should be amended to afford taxpayers limited protection against loss of real value in depreciation deductions due to excessive inflation.

The committee is aware that commitments have already been made on the basis of present law capital cost recovery rules. The committee bill provides for equitable transition rules in such cases, which are estimated to cover more than 50 percent of the new personal property to be placed in service in the first year the bill is effective.

Simplicity

The committee believes that the restructured depreciation system should operate as simply as is possible. The committee bill consolidates the numerous different depreciation treatments of present law into two basic integrated systems. Moreover, a factor in the committee's decision to use the asset classifications of ADR is taxpayers' prior experience and familiarity with those classifications. Finally, the committee believes that small businesses should be able to expense larger amounts than at present, so that fewer of them need enter into depreciation computations.

The bill's incentive system is mandatory for all eligible property, although a taxpayer can elect to use a nonincentive system and recover capital costs using the straight-line depreciation method over an asset's present class life. The entire cost or other basis of eligible property is recovered under IDS, without regard to salvage value.

The bill includes a provision for limited expensing of eligible property, and a nonincentive depreciation system for (1) assets used abroad, (2) assets used by nontaxable entities, (3) computing earnings and profits of a corporation, (4) assets financed with the proceeds of tax-exempt obligations, (5) certain assets predominantly used in the business of a timber producer, (6) assets used by farmers who elect to deduct certain preproductive period expenses, and (7) computing the alternative minimum tax applicable to corporations and individuals. The bill also includes normalization requirements for assets used by public utilities.

Under the bill, if a lessee makes improvements to leased property, the cost of the leasehold improvement is recovered under the same rules that apply to an owner of property.

For tangible property placed in service after the date of enactment, depreciation deductions will be subject to adjustments for inflation, beginning in 1988.

Except for Class 1 and Class 10, the recovery period for each IDS class is generally equal to the ADR midpoint life of the asset with the lowest ADR midpoint in the class. For example, IDS Class 2 includes personal property with ADR midpoint lives of at least 5 but less than 7 years, and the recovery period for IDS Class 2 property is 5 years. The recovery period for IDS Class 1 is 3 years, and the recovery period for IDS Class 10 is 30 years.

Personal property that has no ADR midpoint life and is not otherwise assigned to an IDS class is included in IDS Class 4.

Eligible property

Under the bill, property eligible for IDS generally includes tangible depreciable property (both real and personal), whether new or used, placed in service after December 31, 1985. Eligible property does not include (1) the portion of the basis of any property that is amortized under section 167(k) (relating to expenditures for the rehabilitation of low-income rental housing), (2) property the taxpayer properly elects to depreciate under the unit-of-production method or any other method not expressed in terms of years (other than the retirement-replacement-betterment method or similar method), (3) any property used by a public utility (within the meaning of section 167(1)(3)(A)) if the taxpayer does not use a normalization method of accounting, (4) any motion picture film or video tape, (5) any sound recording described in section 280(c)(2), or (6) any property subject to ACRS or pre-ACRS depreciation rules (by application of an effective date rule).

Normalization requirements for public utility property

The bill provides that public utility property is eligible for IDS only if the tax benefits of IDS are normalized in setting rates charged by utilities to customers and in reflecting operating results in regulated books of account.

If a normalization method of accounting for IDS deductions is not used with respect to property placed in service after December 31, 1985, such property is not eligible for the bill's accelerated depreciation method. If a normalization method of accounting is not used, the bill provides that a depreciation allowance for such property is to be determined under Code section 167(a), using a depreciation method the same as, and a useful life no shorter than, the depreciation method and useful life used to compute the depreciation allowance for the property for purposes of setting rates and reflecting operating results in regulated books of account. For this purpose, averaging conventions and salvage value limitations are considered part of the ratemaking depreciation method.

Under the bill, the benefits of the bill's depreciation allowances that must be normalized include those attributable to the bill's prescribed depreciation method, the recovery period, the averaging convention, the salvage value rules, and inflation indexing (described below). Therefore, ratemaking depreciation methods, useful lives, placed in service rules, and salvage value rules are to be used in determining the amount of deferred taxes that result from using the Incentive Depreciation System.

The bill does not restrict the authority of regulatory bodies to treat the deferred taxes as zero-cost capital or as a reduction in rate base in setting rates. The amount of capital treated as zero-cost capital and the amount of rate base reduction are not to exceed the amount of deferred taxes that result from the taxpayer's use of IDS.

In addition to requiring that IDS deductions must be normalized, the bill provides for the normalization of the excess deferred tax reserve resulting from the reduction of corporate income tax rates (with respect to prior depreciation or recovery allowances taken on assets placed in service before 1986). The bill provides that if the excess deferred tax reserve is reduced more rapidly or to a greater extent than such reserve would be reduced under the average rate assumption method, the taxpayer is not considered to be using a normalization method of accounting with respect to any of its assets. Thus, if the excess deferred tax reserve is not normalized, the taxpayer must compute its depreciation allowances using the depreciation method, useful life determination, averaging convention, and salvage value limitation used for purposes of setting rates and reflecting operating results in regulated books of account.

The bill provides that the excess deferred tax reserve is the reserve for deferred taxes computed under prior law over what the reserve for deferred taxes would be if the tax rate in effect under the bill had been in effect for all prior periods. The average rate assumption method is the method which reduces the excess deferred tax reserve over the remaining regulatory lives of the property which gave rise to the reserve for deferred taxes. Under this method, the excess deferred tax reserve is reduced as the timing differences (i.e., differences between tax depreciation and regulatory depreciation with respect to each asset or group of assets in the case of vintage accounts) reverse over the life of the asset. The reversal of timing differences generally occurs when the amount of the tax depreciation taken with respect to an asset is less than the amount of the regulatory depreciation taken with respect to the asset. Under the bill, the excess deferred tax reserve is multiplied by a formula that is designed to help insure that the excess is reduced to zero at the end of the regulatory life of the asset that generated the reserve.

The committee does not intend that the provisions apply retroactively to the excess deferred tax reserve generated from previous reductions in corporate tax rates. The committee intends that such previous excess deferred tax reserves will continue to be treated under prior law.

Classification of assets and recovery periods

IDS Class 1

IDS Class 1 includes all property with an ADR midpoint life of less than 5 years, other than automobiles, taxis, and light general purpose trucks (described in ADR class #241). This class also includes any clothing held for rental (which would otherwise be included in IDS Class 3 by virtue of a 9-year ADR midpoint life).

The cost of property included in IDS Class 1 is recovered using the double declining balance method, switching to the straight-line method at the time which maximizes the deduction, and a 3-year recovery period.

IDS Class 2

IDS Class 2 includes property with ADR midpoint lives of at least 5 but less than 7 years. This class also includes (1) light general purpose trucks (described in ADR c1ass #241), automobiles, and taxis, (2) any "qualified technological equipment," (3) any computer-based telephone central office switching equipment described in ADR class 48.12, and (4) racehorses.

The committee's decision to assign cars and light trucks to Class 2 was based on clear information that the 3-year recovery period of class 1 would be much too short for these assets. According to industry information, the expected median lifetime of a new car is nearly 11 years, and more than 93 percent of new cars will have a lifetime of 5 years or more. Similarly, the expected median lifetime of a new light truck is nearly 15 years, and more than 94 percent of the trucks will have a lifetime of 5 years or more. About two-thirds of new car buyers who financed their purchase with debt chose a payback period of 4 to 5 years. This also appears to be the range of common lease terms advertised by new car dealers. These data indicate to the committee that a recovery period of at least 5 years is appropriate.

The term "qualified technological equipment" generally has the same meaning as under the tax-exempt leasing rules of present law: any computer or peripheral equipment, high-technology telephone station equipment installed on the customer's premises (described in ADR class 48.13), and high-technology medical equipment (i.e., any electronic, electromechanical, or computer-based high technology equipment used in the screening, monitoring, observation, diagnosis, or treatment of human patients in a laboratory, medical, or hospital environment).

Telephone central office switching equipment is computer-based only if it could function as a computer and peripheral equipment (as defined in section 168(j)(4)(B)) in uses other than as telephone central office switching equipment. The identical qualities of this computer-based equipment and computers are the committee's basis for placing the computer-based equipment in IDS Class 2 (rather than IDS Class 6, which would otherwise follow from its 18-year ADR midpoint life) along with computers. The committee bill assigns racehorses to Class 2 to overt the 10-year recovery period, which the committee perceives would be unreasonable, that would otherwise follow because racehorses have no present class life under present law.

The cost of property included in IDS Class 2 is recovered using the double declining balance method, switching to the straight-line method at the time which maximizes the deduction, and a 5-year recovery period.

IDS Class 3

IDS Class 3 includes property with ADR midpoint lives of at least 7 but less than 10 years. The cost of property included in IDS Class 3 is recovered using the double declining balance method, switching to the straight-line method at the time which maximizes the deduction, and a 7-year recovery period.

IDS Class 4

IDS Class 4 includes property with ADR midpoint lives of at least 10 but less than 13 years. Personal property that has no ADR midpoint life and is not assigned otherwise is included in IDS Class 4. Examples of property without an ADR midpoint life are ship containers, railroad track, and recreational vehicles. IDS Class 4 also includes all horses other than racehorses.

The cost of property in IDS Class 4 is recovered using the double declining balance method, switching to the straight-line method at the time which maximizes the deduction, and a 10-year recovery period.

IDS Class 5

IDS Class 5 includes property with ADR midpoint lives of at least 13 but less than 16 years. This class also includes any single-purpose agricultural or horticultural structure. A single-purpose agricultural or horticultural structure is defined in section 48(p) to include (1) any enclosure or structure specifically designed, constructed, and used for housing, raising, and feeding a particular type of livestock and their produce, and (2) a greenhouse specifically designed, constructed, and used for the commercial production of plants.

The cost of property included in IDS Class 5 is recovered using the double declining balance method, switching to the straight-line method at the time which maximizes the deduction, and a 13-year recovery period.

IDS Class 6

IDS Class 6 includes property with ADR midpoint lives of at least 16 years but less than 20 years. The cost of property in IDS Class 6 is recovered using the double declining balance method, switching to the straight-line method at the time which maximizes the deduction, and a 16-year recovery period.

IDS Class 7

IDS class 7 includes property with ADR midpoint lives of at least 20 years but less than 25 years, plus "very low-income housing." Very low-income housing is low-income housing (discussed below) in which 40 percent or more of the units are occupied by individuals whose income is 60 percent or less of median gross income. The assignment of very low-income housing to Class 7 reflects the committee's decision that depreciation deductions for this property should be approximately 50 percent greater (in present value terms) than depreciation deductions for rental housing that does not qualify as low-income housing.

The cost of property in IDS Class 7 is recovered using the double declining balance method, switching to the straight-line method at the time which maximizes the deduction, and a 20-year recovery period.

IDS Class 8

IDS Class 8 includes property with ADR midpoint lives of at least 25 but less than 30 years. It also includes any telephone distribution plant (as described in ADR Class 48.14) and comparable equipment used by other transmitters of information (e.g., cable television operators). The committee intends that equipment be treated as comparable to telephone distribution plant if the equipment has substantially the same useful life as telephone distribution plant and performs (or is suitable for performing) substantially the same function as telephone distribution plant.

The cost of an asset in IDS Class 8 is recovered using the double declining balance method, switching to the straight-line method at the time which maximizes the deduction, and a 25-year recovery period.

IDS Class 9

IDS Class 9 includes property with ADR midpoint lives of at least 30 years but less than 36 years plus low-income housing that is not very low-income housing. The assignment of low-income housing to Class 9 reflects the committee's decision that depreciation deductions for this property should be approximately 25 percent greater in present value terms than depreciation deductions for rental housing that does not qualify as low-income housing.

The cost of property in IDS Class 9 is recovered using the double declining balance method, switching to the straight-line method at the time which maximizes the deduction, and a 30-year recovery period.

IDS Class 10

IDS Class 10 includes property with an ADR midpoint life of at least 36 years plus any real property that does not have a class life and is not low-income housing (referred to as "30-year real property").

The cost of property included in IDS Class 10 is recovered using the straight-line method and a 30-year recovery period.

Rules relating to low-income housing

In general, low-income housing is defined as any real property that is part of a residential rental project, if (at the taxpayer's election when the property is placed in service) either 20 percent or more of the units are occupied by individuals whose income is 70 percent or less of median gross income, or 25 percent or more of the units are occupied by individuals whose income is 80 percent or less of median gross income. Property will not fail to qualify as residential rental property merely because part of the building in which such property is located is used for purposes other than residential rental purposes. Further, rules similar to the rules of paragraphs (2), (3), and (4) of section 142(c), relating to holding-period and annual-certification requirements for low-income housing financed with tax-exempt bonds, apply for purposes of determining whether property is low-income housing.

Changes in classifications

The Secretary, through an office established in the Treasury Department (including the Internal Revenue Service), is authorized to monitor and analyze actual experience with all tangible depreciable assets, to prescribe a new class life for any property or class of property when appropriate, and to prescribe a class life for any property that does not have a class life. If the Secretary prescribes a new class life for property (other than 30-year real property or low-income housing), including property that is assigned a class life under the bill, such life will be used in determining the classification of the property.

Any class life prescribed under the Secretary's authority must reflect the anticipated useful life, and the anticipated decline in value over time, of an asset to the industry or other group. Thus, useful life means the economic life span of property over all users combined and not, as under prior law, the typical period over which a taxpayer holds the property. Evidence indicative of the useful life of property which the committee intends the Secretary will take into account in prescribing a class life includes the depreciation practices followed by taxpayers for book purposes with respect to the property. It also includes useful lives experienced by taxpayers, according to their reports. It further includes independent evidence of minimal useful life--the terms for which new property is leased, used under a service contract, or financed--and independent evidence afforded by resale price data. The committee intends that the prescribed class lives should not incorporate adjustments for inflation; appropriate inflation adjustments to depreciation deductions are provided by the bill.

The committee believes that the proper operation of IDS depends heavily on keeping current the class lives of all assets. Therefore, the bill contemplates that, pursuant to the authority to prescribe or revise class lives, the Secretary will give priority to the following items: (1) machine tools (described in Standard Industrial Classification Codes 3541 and 3542), (2) scientific instruments for laboratory research, production, quality control, and regulatory compliance, (3) telephone distribution plant and comparable equipment used by other transmitters of information, (4) single purpose agricultural structures, and (5) mobile homes and offices. The Secretary is expected to determine the appropriate class lives for the noted property within one year of the date of enactment of the bill. The committee also expects that initial studies will concentrate on property which now has no ADR midpoint life and property which the bill assigns to a different IDS class than would follow from its present ADR midpoint life.

Averaging conventions

The following averaging conventions apply to depreciation computations made under both the incentive and nonincentive depreciation systems provided by the bill.

Half-year convention

In general, a half-year convention applies under which all property placed in service or disposed of during a taxable year is treated as placed in service or disposed of at the mid-point of such year. As a result, a half-year of depreciation is allowed for the first year property is placed in service, regardless of when the property is placed in service during the year, and a half-year of depreciation is allowed for the year in which property is disposed of or is otherwise retired from service.

To illustrate the half-year convention, assume that a taxpayer places in service in taxable year 1 a $100 asset assigned to Class 2 by reason of a 5-year class life. IDS deductions, beginning with taxable year 1 and ending with taxable year 6, are $20, $32, $19.20, $11.52, $11.52, and $5.76. If the asset were disposed of in taxable year 2, the IDS deduction for that year would be $16.

Mid-month convention

In the case of low-income housing and any property included in IDS Class 10, a mid-month convention applies. Under the mid-month convention, the depreciation allowance for the first year property is placed in service is based on the number of months the property was in service, and property placed in service at any time during a month is treated as having been placed in service in the middle of the month. Further, property disposed of by a taxpayer at any time during a month is treated as having been disposed of in the middle of the month.

Special rule where substantial property placed in service during last quarter of year

Except as provided in regulations, the mid-month convention applies to all property a taxpayer places in service during a taxable year if more than 40 percent of the aggregate bases of that property is placed in service during the last quarter of the taxable year. For purposes of applying the 40-percent test, low-income housing and IDS Class 10 property are not taken into account.

In general, a taxpayer's depreciation deduction (inclusive of any increase for inflation) for an item of property is that deduction (exclusive of any such increase) multiplied by the product of the allowable inflation adjustments for the taxable year and each prior taxable year during the taxpayer's holding period of the property. An inflation adjustment is computed for a taxable year only if inflation for the calendar year in which the taxable year begins exceeds 5 percent (expressed in decimal terms). In that event, the inflation adjustment is the sum of (1) one, plus (2) one-half of the inflation rate in excess of 5 percent. For this purpose, inflation in a calendar year is the percentage increase in the CPI (defined under sec. 1(e)(4)) over the one-year period ending with August 31 of that calendar year.

No inflation adjustment is allowed for any taxable year (1) in which property is placed in service or disposed of or (2) beginning in a calendar year before 1988. Moreover, an asset is not eligible for an inflation adjustment until it is placed in service in a trade or business or for the production of income. For example, if an asset is held for personal use and then converted to business use, no inflation adjustment is taken into account for the period prior to the time the asset is converted to business use.

The bill provides that for all other purposes of the Code, the additional deduction resulting from the inflation adjustment is treated as a depreciation deduction. For example, the additional deduction is treated as a tax preference item, reduces net investment income for the purposes of the limitation on the deductibility of investment interest, counts toward luxury car depreciation limitations, and is subject to the normalization requirements for public utility property. With regard to the latter, the committee intends that the additional deduction resulting from the inflation adjustment shall not be flowed through to ratepayers more rapidly than ratably over the remaining regulatory life of the asset in order for the taxpayer to be considered as using a normalization method of accounting.

The committee intends that inflation adjustments applicable to an asset will carry over to a transferee in a nonrecognition transaction where the basis of the asset acquired is determined by reference to the basis of the asset transferred.

In general, IDS deductions are reduced for property that (1) is used predominantly outside the United States ("foreign-use" property), (2) is leased to or otherwise used by a tax exempt entity, including a foreign person unless more than 50 percent of the gross income derived from the property by such person is subject to U.S. tax ("tax-exempt use" property), (3) is financed directly or indirectly by an obligation, the interest on which is exempt from taxation under section 103(a) ("tax-exempt bond financed" property), (4) is imported from a foreign country with respect to which an Executive Order is in effect because the country maintains trade restrictions or engages in other discriminatory acts, or (5) with respect to which an election to decelerate depreciation deductions is made.

In these cases, depreciation allowances are computed under the nonincentive depreciation system, which provides for straight-line recovery (without regard to salvage value) and use of the applicable averaging conventions described above. In general, the recovery period under the nonincentive system is equal to the property's ADR midpoint life (12 years for personal property with no ADR midpoint life, and 40 years for real property). For an asset that is classified under a special rule in the bill (e.g., computer-based telephone switching equipment that has an ADR midpoint life of 18 years but is included in a class of property with ADR midpoint lives of 5 to 6.5 years), the recovery period applicable to such property under the incentive system is treated as the property's ADR midpoint life for purposes of the nonincentive system. Similarly, the applicable recovery period is 20 years (the recovery period for IDS Class 7) for very low-income housing and 30 years (the recovery period for IDS Class 9) for low-income housing. Special rules apply for determining the recovery period of tax-exempt bond financed property and certain tax-exempt use property.

The nonincentive depreciation system is used for purposes of computing the earnings and profits of a foreign or domestic corporation, as well as for purposes of computing the portion of depreciation allowances treated as an item of tax preference under the alternative minimum tax applicable to corporations and individuals. The nonincentive depreciation system also applies to an electing farmer who deducts currently preproductive costs (provided in sec. 905 of the bill), and qualified small timber producers who elect to amortize costs rather than add them to the basis of the timber (provided in sec. 911 of the bill).

Foreign-use property

As under ACRS, foreign-use property is property that is used outside the United States more than half of a taxable year. In addition to the exceptions to this general rule that are applicable for purposes of ACRS, the bill provides a new exception for any satellite or other space craft (or any interest therein) held by a U.S. person if such property is launched from within the United States.

Tax-exempt use property

In the case of any tax-exempt use property subject to a lease, the recovery period used for purposes of computing nonincentive depreciation is increased to a period not less than 125 percent of the lease term, if this period would be longer than the nonincentive depreciation period otherwise applicable to the property. This rule is inapplicable to qualified technological equipment (other than equipment that is (1) leased to a tax-exempt entity or a related party after a sale or other transfer from one of such persons, if the equipment was used by such person before the disposition, (2) financed with tax-exempt obligations, or (3) used by the Federal Government or an agency or instrumentality of the United States).

Tax-exempt bond financed property

In the case of tax-exempt bond financed property (other than any low-income housing), the recovery period used for purposes of nonincentive depreciation is equal to the period determined by ascertaining the IDS class into which such property would fall otherwise, and then using the IDS recovery period for the next longer class (40 years for IDS Class 9 or 10 property). For example, if IDS Class 8 property is financed with the proceeds of tax-exempt bonds, the recovery period used for purposes of nonincentive depreciation would be 30 years (the IDS Class 9 recovery period). The proceeds of a tax-exempt obligation are treated as used to finance property acquired in connection with the issuance of such obligation in the order in which the property was acquired.

Certain imported property

The bill authorizes the President to provide by Executive Order for the application of the nonincentive depreciation system to certain property that is imported from a country maintaining trade restrictions or engaging in discriminatory acts. For purposes of this provision, the term imported property means any property that is completed outside the United States, or less than 50 percent of the basis of which is attributable to value added within the United States. In applying this test, the term "United States" is treated as including the Commonwealth of Puerto Rico and the possessions of the United States.

The bill authorizes reduced depreciation for property that is imported from a foreign country that (1) maintains nontariff trade re strictions that substantially burden U.S. commerce in a manner inconsistent with provisions of trade agreements, including variable import fees, or (2) engages in discriminatory or other acts or policies unjustifiably restricting U.S. commerce (including tolerance of international cartels). If the President determines that a country is engaging in the proscribed actions noted above, he may provide for the application of nonincentive depreciation to any article or class of articles manufactured or produced in such foreign country for such period as may be provided by Executive Order.

In general, the terms of the provision relating to certain imported property are substantially identical to those of section 48(a)(7) relating to the investment tax credit (which is repealed by sec. 211 of the bill).

Election to use nonincentive depreciation system

A taxpayer may irrevocably elect to apply the nonincentive system to any IDS class of property for any taxable year. If the election is made, the nonincentive system applies to all property in the IDS class placed in service during the taxable year. The increase in depreciation deductions for inflation (discussed above) is available to property for which the nonincentive system is elected (and not required).

In the case of property that qualified as low-income housing before a change in status (including ceasing to be very low-income housing), (1) previously claimed "excess depreciation deductions" are recaptured (i.e., included in the gross income of the holder of such property in the year of change of status), and (2) the adjusted basis as increased by the amount recaptured is depreciated over the remaining recovery period that would have applied to the property if it had not qualified as low-income housing when placed in service. For purposes of this rule, the term "excess depreciation deductions" means the excess of (1) the depreciation deductions previously allowable while the property qualified as low-income housing, over (2) the "depreciation deductions" that would have been allowable if such property had been treated as 30-year real property when placed in service.

Under the first modification, the dollar limitation on the amount that can be expensed is $10,000 a year ($5,000 in the case of a married individual filing a separate return). The second modification provides that the election to expense qualifying property is unavailable to any taxpayer for any taxable year in which the aggregate cost of qualifying property placed in service during such taxable year exceeds $200,000.

In the case of 30-year real property and low-income housing, only the excess of accelerated deductions over straight-line deductions, using the recovery period applicable to such property, is recaptured, and the phaseout of recapture applicable to low-income housing under present law is repealed. For example, for very low-income housing that is depreciated over a 20-year period using the double-declining balance method, the excess of the accelerated deductions over straight-line deductions--using a 20-year recovery period--is subject to recapture. If low-income housing is sold and leased back by a taxpayer, and the property is not used as low-income housing after the leaseback, the Secretary is authorized (by regulation) to determine the amount subject to recapture by reference to the excess of (1) accelerated depreciation using the recovery period and method applicable to low-income housing over (2) straight-line depreciation over 30 years.

2. Regular investment tax credit

The bill repeals the regular investment tax credit.

3. Finance leases

The bill repeals the finance leasing rules.

The bill provides certain exceptions to the general effective dates, in the case of property constructed, reconstructed, or acquired pursuant to a written contract that was binding as of September 25, 1985 or in other transitional situations discussed below. Except in the case of certain qualified solid waste disposal facilities (described below), the application of the bill's transitional rules is conditioned on property being placed in service by a prescribed date in the future. In addition, special rules are provided for investment credits claimed on transitional property, tax-exempt bond financed property, the finance lease rules, and the application of depreciation recapture rules to certain real property.

The transitional rules described below do not apply to any property unless the property is placed in service before the applicable date, determined according to the following: (1) for property that would be in IDS Class 1, July 1, 1986, (2) for property that would be in IDS Class 2, January 1, 1987, (3) for property that would be in IDS Class 3, 4, 5, or 6, January 1, 1989, and (4) for property that would be in IDS Class 7, 8, 9, or 10, January 1, 1991.

For purposes of the placed-in-service requirement, light general purpose trucks (described in ADR class #241), automobiles and taxis are treated as IDS Class 1 property.

For purposes of the general effective date, if at least 80 percent of a target corporation's stock is acquired before December 31, 1985, and the acquiring corporation makes a section 338 election to treat the stock purchase as an asset purchase after that date, then the deemed new target corporation is treated as having purchased the assets before the general effective date.

Binding contracts

The bill does not apply to property that is constructed, reconstructed, or acquired by a taxpayer pursuant to a written contract that was binding on September 25, 1985, and at all times thereafter. If a taxpayer transfers his rights in any such property under construction or such contract to another taxpayer, the bill does not apply to the property in the hands of the transferee, as long as the property was not placed in service before the transfer by the transferor. For purposes of this rule, if by reason of sales or exchanges of interests in a partnership, there is a deemed termination and reconstitution of a partnership under section 708(b)(1)(B), the partnership is to be treated as having transferred its rights in the property under construction or the contract to the new partnership.

The general binding contract rule applies only to contracts in which the construction, reconstruction, erection, or acquisition of property is itself the subject matter of the contract.

A contract is binding only if it is enforceable under State law against the taxpayer, and does not limit damages to a specified amount (e.g., by use of a liquidated damages provisions). A contractual provision that limits damages to an amount equal to at least five percent of the total contract price is not treated as limiting damages.

For purposes of the general binding contract rule, a contract under which the taxpayer is granted an option to acquire property is not to be treated as a binding contract to acquire the underlying property. In contrast, a contract under which the taxpayer grants an irrevocable put (i.e., an option to sell) to another taxpayer is treated as a binding contract, as the grantor of such an option does not have the ability to unilaterally rescind the commitment.

In general, a contract is binding even if subject to a condition, as long as the condition is not within the control of either party or a predecessor (except in the limited circumstances described below). For example, a binding contract to build an ethanol plant comes within the scope of the rule, even though the parties are awaiting a federal guarantee. A contract that was binding on September 25, 1985, will not be considered binding at all times thereafter if it is substantially modified after that date. A waiver of a right to cancel upon a price change is an example of a substantial modification.

A binding contract to acquire a component part of a larger property will not be treated as a binding contract to acquire the larger property under the general rule for binding contracts. For example, if a written binding contract to acquire an aircraft engine was entered into on September 25, 1985, there would be a binding contract to acquire only the engine, not the entire aircraft.

The committee agreed that the general binding contract rule is to include property that is the subject matter of a certain letter agreement between a party acting as a general contractor and two automobile manufacturers, which agreement was entered into in a time zone outside of the United States as of September 25, 1985, in the Eastern Daylight Time Zone in the United States. The property eligible for this treatment consists of an automobile manufacturing facility (and equipment and incidental appurtenances) to be located in the United States. In such case, the letter agreement for the party to act as the general contractor for construction of the facility is to be treated as a binding contract even if the agreement is subject to conditions within the control of one party, as long as that party used best efforts to secure their occurrence, and the agreement is in fact finalized.

Self-constructed property

The bill does not apply to property that is constructed or reconstructed by the taxpayer, if (1) the lesser of $1 million or five percent of the cost of the property was incurred or committed, (i.e., required to be incurred pursuant to a written binding contract in effect) as of September 25, 1985, and (2) the construction or reconstruction began by that date. For purposes of this rule, the construction of property is considered to begin when physical work of a significant nature starts. Construction of a facility or equipment is not considered as begun if work has started on minor parts or components. Physical work does not include preliminary activities such as planning or designing, securing financing, exploring, researching, or developing.

Equipped buildings

Under the bill, where construction of an equipped building began on or before September 25, 1985, pursuant to a written specific plan, and more than one-half the cost of the equipped building (including any machinery and equipment for it) was incurred or committed before September 26, 1985, the entire equipped building project and incidental appurtenances are excepted from the bill's application. Where the costs incurred or committed before September 26, 1985, do not equal more than half the cost of the equipped building, each item of machinery and equipment is treated separately for purposes of determining whether the item qualifies for transitional relief.

Under the equipped building rule, the bill will not apply to equipment and machinery to be used in the completed building, and also incidental machinery, equipment, and structures adjacent to the building (referred to here as appurtenances) which are necessary to the planned use of the building, where the following conditions are met:

The equipped building rule can be illustrated by an example where the taxpayer has a plan providing for the construction of a $100,000 building with $80,000 of machinery and equipment to be placed in the building and used for a specified manufacturing process. In addition, there may be other structures or equipment, here called appurtenances, which are incidental to the operations carried on in the building, that are not themselves located in the building. Assume that the incidental appurtenances have further costs of $30,000. These appurtenances might include, for example, an adjacent railroad siding, a dynamo or water tower used in connection with the manufacturing process, or other incidental structures or machinery and equipment necessary to the planned use of the building. Of course, appurtenances, as used here, do not include a plant needed to supply materials to be processed or used in the building under construction. In this case, if the building qualified as transition property but no equipment had been ordered, and the appurtenances had not been constructed or placed under binding order, the equipped building rule would apply. This is true because the building cost represents more than 50 percent of the total $180,000. As a result, the machinery and equipment, even though not under binding contract, is eligible for the rule. In this connection, it should be noted that the additional cost of appurtenances, $30,000, is not taken into account for purposes of determining whether the 50-percent test is met. Nevertheless, the bill would not apply to these appurtenances since the 50-percent test is met as to the equipped building.

In general, costs are committed if they are required to be incurred pursuant to a written contract that was binding as of September 25, 1985. The committee agreed, however, that the equipped building rule is to apply to an automobile manufacturing facility (and equipment and incidental appurtenances) constructed pursuant to a plan approved by an automobile manufacturer's board of directors before August 1, 1985, and in connection with an arrangement involving a second automobile manufacturer that agrees to purchase 50 percent of the output from the facility (and to supply the engines for the output so purchased). In such case, 50 percent of the cost of the equipped building is to be treated as incurred before September 25, 1985.

Plant facilities

The bill also provides a plant facility rule that is comparable to the equipped building rule (described above), for cases where the facility is not housed in a building.

If pursuant to a written specific plan of a taxpayer in existence on September 25, 1985, the taxpayer constructed, reconstructed, or erected a plant facility, the construction, reconstruction, or erection commenced before September 26, 1985, and the 50-percent test is met, then the bill will not apply to property that makes up the facility. For this purpose, construction, etc., of a plant facility is not considered to have begun until it has commenced at the site of the plant facility. (This latter rule does not apply if the facility is not to be located on land and, therefore, where the initial work on the facility must begin elsewhere.) In this case, as in the case of the commencement of construction of a building, construction begins only when actual work at the site commences; for example, when work begins on the excavation for footings, etc., or pouring the pads for the facility, or the driving of foundation pilings into the ground. Preliminary work, such as clearing a site, test drilling to determine soil condition, or excavation to change the contour of the land (as distinguished from excavation for footings), does not constitute the beginning of construction, reconstruction or erection.

Special rule for sale-leasebacks within 90 days

Property is treated as meeting the requirements of the general binding contract rule, the equipped building rule, or the plant facility rule, if (1) the property is placed in service by a taxpayer who acquired the property from a person in whose hands the property would qualify under such transitional rules, (2) the property is leased back by the taxpayer to such person, and (3) the leaseback occurs within 90 days after such property was originally placed in service, but no later than the applicable date. The committee intends that the special rule for sale-leasebacks apply to any property that qualifies for transitional relief under the bill. For purposes of this rule, a leaseback to a taxpayer's wholly-owned subsidiary included in the same affiliated group is to be treated as a leaseback to the taxpayer.

Special rule for tax-exempt bond financed property

The provision restricting IDS deductions for property financed with tax-exempt bonds applies to property placed in service after December 31, 1985, to the extent that such property is financed by the proceeds of bonds issued after September 25, 1985. The restrictions on IDS deductions do not apply to facilities placed in service after December 31, 1985, if--

The restrictions on cost recovery deductions for bond-financed property do not apply to property placed in service after December 31, 1985, to the extent that the property is financed with tax-exempt bonds issued before September 26, 1985. Cost recovery deductions for such property may be determined, however, under the new cost recovery rules generally provided by the bill. For purposes of this exception, a refunding issue issued after September 25, 1985, generally is treated as a new issue and the taxpayer must use the slower recovery methods and periods for costs that are unrecovered on the date of the refunding issue.

In cases where a change of recovery method is required because of a refunding issue, only the remaining unrecovered cost of the property is required to be recovered using the slower method and recovery period. Therefore, no retroactive adjustments to cost recovery deductions previously claimed are required when a pre-September 26, 1985, bond issue is refunded where no significant expenditures are made with respect to the facility after December 31, 1985.

Contract with persons other than a person who will construct or supply the property

The bill provides transitional relief for certain situations where written binding contracts require the construction or acquisition of property, but the contract is not between the person who will own the property and the person who will construct or supply the property. This rule applies to written service or supply contracts and agreements to lease entered into before September 26, 1986. An example of a case to which this rule would apply is that of a taxpayer who entered into a written binding power sales contract before September 26, 1985, and is required to construct (or have constructed) two facilities that will produce the power necessary to fulfill the contractual obligation. Another example would be lease agreements under which a grantor trust is obligated to provide property under a finance lease (to the extent continued under the bill).

This transitional rule is applicable only where the specifications of the property are readily ascertainable from the terms of the contract, or from related documents. A supply or service contract or agreement to lease must satisfy the requirements of a binding contract (discussed above). This rule does not provide transitional relief to property in addition to that covered under a contract described above, which additional property is included in the same project but does not otherwise qualify for transitional relief.

Development agreements relating to large-scale multi-use urban projects

The bill does not apply to property that is included in a "qualified urban renovation project." The term qualified urban renovation project includes certain projects that satisfy the following requirements on or before September 25, 1985: the project is described in the bill and (1) was publicly announced by a political subdivision, for the renovation of an urban area in its jurisdiction, (2) was either the subject of an agreement for development or a lease between such political subdivision and the primary developer of the project, or was undertaken pursuant to the political subdivision's grant of development rights to a primary developer-purchaser; (3) was identified as a single unitary project in the internal financing plans of the primary developer, and (4) is not substantially modified at any time after September 25, 1985. Properties described in the bill include six projects of a single primary developer, and a seventh project that was the subject of a development agreement between a political subdivision and a bridge authority on December 19, 1984.

Federal Energy Regulatory Commission action

The requirements of the general binding contract rule will be treated as satisfied with respect to a project if, on or before September 25, 1985, the Federal Energy Regulatory Commission ("FERC") licensed the project or certified the project as a "qualifying facility" for purposes of the Public Utility Regulatory Policies Act of 1978. This rule will not apply if a FERC license or certification is substantially amended after September 25, 1985. On the other hand, minor modifications will not affect the application of this rule (e.g., technical changes in the description of a project, extension of the deadline for placing property in operation, changes in equipment or in the configuration of equipment).

Qualified solid waste disposal facilities

The bill does not apply to a qualified solid waste disposal facility if, before January 1, 1986, (1) there is a written binding contract between a service recipient and a service provider, providing for the operation of such facility and the payment for services to be provided by the facility, or (2) a service recipient, governmental unit, or any entity related to such an entity made a financial commitment of at least $200,000 to the financing or construction of the facility.

For purposes of this rule, a qualified solid waste disposal facility is a facility that provides solid waste disposal services for residents of part or all of one or more governmental units, if substantially all of the solid waste processed at such facility is collected from the general public. This rule does not apply to replacement property. For example, assume a taxpayer/service provider enters into a long-term service contract before January 1, 1986, and a facility is initially placed in service after that date. Assume that the taxpayer finds it necessary to replace the facility 20 years later, pursuant to its obligation to provide continuing services under the pre-1986 service contract. The special rule will apply only to the first facility necessary to fulfill the taxpayer's obligations under the service contract.

Under a special rule applicable to the Tri-Cities Solid Waste Recovery Project (involving three cities in California), the rule for solid waste disposal facilities applies if the facility receives an authority to construct from the Environmental Protection Agency (or from its designee authorized to issue air quality permits under the Clean Water Act) before January 1, 1986.

For purposes of this provision, a contract is to be considered as binding notwithstanding the fact that the obligations of the parties are conditioned on factors such as the receipt of permits, satisfactory construction or performance of the facility, or the availability of acceptable financing.

A service recipient or governmental unit or a related party is to be treated as having made a substantial financial commitment to a facility if one or more entities have issued bonds or other obligations aggregating more than 10 percent of the anticipated capital cost of such facility, the proceeds of which are identified as being for such facility or for a group of facilities that include the facility, or if one or more entities have expended in the aggregate at least $200,000 of their funds, or utilized or committed at least $200,000 of their assets, toward the development or financing of such facility. If a governmental entity acquires a site for a facility by purchase, option to purchase,¹ purchase contract, condemnation, or entering into an exchange of land, it shall be considered to have made a financial commitment equal to the fair market value of such site for purposes of this rule. For purposes of this provision, entities are related if they are described in Section 168(i)(4)(A)(i).

Other exceptions

The bill does not apply to (1) those mass commuting vehicles exempted from the application of the tax-exempt leasing rules under DEFRA, (2) property described in section 216(b)(3) of TEFRA, or (3) a qualified lessee's automotive manufacturing property that was exempted from the deferral of the finance lease provisions under DEFRA. Property that qualifies under this transitional rule is also excepted from the requirements that investment credit claimed on transitional property be spread ratably over five years and that a full basis adjustment be made (discussed below).

The bill also provides other special transitional rules of limited application. Under the special rule for certain leasehold improvements placed in service by a lessee, the committee intends that the provision apply to property placed in service by the lessee or by the lessee's wholly-owned leasing subsidiary that is included in the lessee's affiliated group. Under the special rule for master plans for integrated projects, the committee intends that, (1) in the case of multi-step plans described in sec. 203(d)(5)(F) of the bill, the rule will include executive approval of a plan, if there has also been executive authorization of expenditures under the plan before September 26, 1985, and (2) in the case of single-step plans described in sec. 203(d)(5)(F) of the bill, the rule will include project-specific designs for which expenditures were incurred or committed before September 26, 1985.

Special rules applicable to the investment credit

Special rules for television and motion picture films

Special transitional rules apply to television and motion picture films for purposes of the investment credit (but not depreciation). For purposes of the general binding contract rule, (1) construction is treated as including production, (2) in accordance with industry practice, written contemporaneous evidence of a binding contract is treated as a written binding contract, and (3) in the case of any television film, a license agreement between a television network and a producer is treated as a binding contract to produce property. In addition, a special rule is provided for certain films produced pursuant to a permanent financing arrangement described by the bill. For purposes of the placed-in-service requirement, films and sound recordings are treated as IDS Class 4 property.

Finance leases

The finance lease rules continue to apply to any transaction permitted by reason of Section 12(c)(2) of DEFRA or section 209(d)(1)(B) of TEFRA.

(sec. 221 of the bill and sec. 177 of the Code)

2. Five-year amortization of pollution control facilities

(sec. 222 of the bill and sec. 169 of the Code)

In general, a certified pollution control facility is a treatment facility used to abate or control water or air pollution, in connection with a plant or other property that was in operation before January 1, 1976, if (1) the facility is certified by the appropriate authorities as meeting certain pollution control standards, (2) the facility does not significantly increase the output, extend the life, or reduce the operating costs of the plant or other property, and (3) the costs of the facility are not expected to be recovered over its useful life.

3. Five-year amortization of rehabilitation expenses for low-income housing

(sec. 223 of the bill and sec. 167(k) of the Code)

4. Fifty-year amortization of qualified railroad grading and tunnel bores

(sec. 224 of the bill and sec. 185 of the Code)

5. Expensing for removal of architectural barriers to the handicapped and elderly

(sec. 225 of the bill and sec. 190 of the Code)

This election is not available in taxable years beginning after December 31, 1985.

(sec. 231 of the bill and sec. 30 of the Code)

A taxpayer may elect to deduct currently the amount of research and experimental expenditures incurred in connection with its trade or business (sec. 174), notwithstanding the general rule that business expenditures to develop or create an asset which has a useful life extending beyond the taxable year must be capitalized. (Alternatively, the taxpayer may treat these expenditures as deferred expenses and deduct them over a period of not less than 60 months on a straight-line basis.) This provision was enacted in the 1954 Code in order to eliminate the need to distinguish research from business expenses for deduction purposes, and to encourage taxpayers to carry on research and experimentation activities.¹

^{The Code does not specifically define "research or experimental expenditures" eligible for the section 174 deduction election, except to exclude certain costs. Treasury regulations (sec. 1.174-2(a)) define "research or experimental expenditures" to mean "research and development costs in the experimental or laboratory sense." The regulations provide that this includes generally "all such costs incident to the development of an experimental or pilot model, a plant process, a product, a formula, an invention, or similar property, and the improvement of already existing property of the type mentioned." Other research or development costs--i.e., research or development costs not "in the experimental or laboratory sense"--do not qualify under section 174.}

^{The present regulations provide that qualifying research expenditures do not include expenditures "such as those for the ordinary testing or inspection of materials or products for quality control or those for efficiency surveys, management studies, consumer surveys, advertising, or promotions." Also, the section 174 election cannot be applied to costs of acquiring another person's patent, model, production, or process or to research expenditures incurred in connection with literary, historical, or similar projects (Reg. sec. 1.174-2(a)).}

^{Incremental tax credit}

^{Under a provision enacted in the Economic Recovery Tax Act of 1981, the taxpayer also may claim a nonrefundable 25-percent income tax credit for certain research expenditures paid or incurred in carrying on an existing trade or business (sec. 30). The credit applies only to the extent that the taxpayer's qualified research expenditures for the taxable year exceed the average amount of the taxpayer's yearly qualified research expenditures in the specified base period (generally, the preceding three taxable years). Under present law, the credit will not be available for expenses paid or incurred after December 31, 1985.}

^{Research expenditures eligible for the incremental credit consist of (1) in-house expenditures by the taxpayer for research wages and supplies used in research, plus certain amounts paid for research use of laboratory equipment, computers, or other personal property; (2) 65 percent of amounts paid by the taxpayer for contract research conducted on the taxpayer's behalf; and (3) if the taxpayer is a corporation, 65 percent of the taxpayer's expenditures (including grants or contributions) pursuant to a written research agreement for basic research to be performed by universities or certain scientific research organizations.}

^{The credit provision adopts the definition of research used for purposes of the section 174 expensing provision, but subject to three exclusions: (1) expenditures for research which is conducted outside the United States; (2) research in the social sciences or humanities; and (3) research to the extent that it is funded by any grant, contract, or otherwise by another person (or any governmental entity).}

^{Under present law, the incremental research credit is not subject to the general limitation on use of business credits (85% of tax liability over $25,000).}

When the incremental research credit was enacted in 1981, the Congress expressed serious concern about the then substantial relative decline in total U.S. expenditures for research and experimentation. The purpose of enacting the credit was to encourage business firms to perform the research necessary to increase the innovative qualities and efficiency of the U.S. economy. An expiration date for the credit was deemed desirable in order to enable the Congress to evaluate the operation of the credit, and to determine whether it should be extended and what modifications would be necessary to make the credit more effective.

The committee believes that an additional three-year extension of the credit is desirable in order to obtain sufficient data and information to evaluate whether or not the credit should be further extended or made permanent. In the context of other tax reform provisions of the bill, and the continued allowance of full expensing of research expenditures, the committee bill reduces the credit rate to 20 percent.

Eligibility of rental costs

Under present law, expenditures for renting research equipment are eligible for the credit, but depreciation allowances for purchased research equipment are not eligible. The committee believes that this inconsistent treatment is not desirable, and that the taxpayer's investment decision to purchase or lease should not be skewed by the credit provisions. The committee bill makes such rental costs, etc. ineligible for the credit, except for certain payments by the taxpayer to another person for the use of computer time in research.

Credit use limitation

The committee believes that the general limitation on use of business credits (under the bill, 75 percent of tax liability over $25,000) should apply to the research credit.

Clarification and modification of research definition for credit purposes

After reviewing available information and testimony on the actual use of the credit to date, the committee believes that it should clarify and modify the definition of qualified research expenses for purposes of the credit. The committee believes that the definition has been applied too broadly in practice, and some taxpayers have claimed the credit for virtually any expenses relating to product development. According to early data on the credit, the Treasury has reported, many of these taxpayers are in industries that do not involve high technology or its application in developing technologically new and improved products or methods of production.

Because the committee bill amends present law to extend the research credit for an additional three years, the committee concluded that it was appropriate and desirable to provide more explicit guidance as to the scope of the term "qualified research" as used in the credit provision. Accordingly, the committee decision clarifies the distinction between research expenditures and certain nonresearch activities (post-research activities, adaptation, and surveys and studies). Also, the committee decision targets the extended credit to research undertaken for the purpose of discovering information which is (1) technological in nature and (2) intended to result in a new or improved item for sale or use in the taxpayer's trade or business. In addition, research will be eligible for the extended credit only where substantially all the activities undertaken in developing or improving the business item constitute elements of a process of experimentation relating to functional aspects of the business item. Finally, the committee decision will limit allowance of the credit for the costs of developing internal-use software to such software meeting a high threshold of innovation. No inference is intended from these rules as to the scope of the term "research or experimental" for purposes of the section 174 expensing deduction.

University basic research

The committee believes it is desirable to provide increased tax incentives for corporate cash expenditures for university basic research where such expenditures do not merely represent a switching of donations from general university giving and where certain other maintenance-of-effort levels are exceeded.

The bill extends the incremental research tax credit for three additional years, i.e., for qualified research expenditures paid or incurred through December 31, 1988, at a credit rate of 20 percent.

Eligibility of rental costs

The bill generally repeals the present-law provision treating amounts paid for the right to use personal property in qualified research as eligible for the credit, but continues credit eligibility for amounts paid by the taxpayer to another person for the use of computer time in the conduct of qualified research. The latter provision is intended to benefit smaller businesses which cannot afford to purchase or lease their own computers for research purposes, and hence is intended to apply where the taxpayer is not the principal user of the computer. Consistently with the present-law limitations on credit-eligibility of rental costs, computer-use payments are not eligible for the credit to the extent that the taxpayer (or a person with which the taxpayer must aggregate expenditures in computing the credit) receives or accrues any amount from any other person for computer use.

In computing the research credit for a taxable year beginning after 1985 (when rental costs will not be eligible for the credit), a taxpayer may exclude from the base-period amount with respect to such year any rental costs, etc. (other than for computer-use costs of a type remaining eligible for the credit in post-1985 years) that were allowable as qualified research expenses under section 3O(b)(2)(A)(iii) (as then in effect) in a base-period year.

Clarification and modification of research definition for credit purposes

By way of further illustration, the credit is not available for costs of additional clinical testing of a pharmaceutical product after the product is made commercially available to the general public. However, the clinical testing in the United States of a product prior to production for sale in this country, or clinical testing seeking to establish new functional uses, characteristics, combinations, dosages, or delivery forms as improvements to an existing product, is eligible for the credit. Thus, for example, testing a drug presently used to treat hypertension for a new anti-cancer application would be eligible. Similarly, testing an antibiotic in combination with a steroid to determine its therapeutic value as a potential new anti-inflammatory drug would be eligible for the credit.

Modification of credit-eligible research definition

In extending the incremental research credit for an additional three years, the committee intends to limit the credit to research activities designed to produce technologically new or improved business items, where substantially all the taxpayer's activities in developing or improving the item constitute elements of a process of experimentation relating to functional aspects of the business item.

Thus, for example, costs of developing a new or improved business item are not eligible for the credit if the method of reaching the desired objective (the new or improved product characteristics) is readily discernible and applicable as of the beginning of the research activities, so that true experimentation in the scientific or laboratory sense would not have to be undertaken to develop, test, and choose among viable alternatives. On the other hand, costs of experiments undertaken by chemists or physicians in developing and testing a new drug are eligible for the credit because the researchers are engaged in scientific experimentation. Similarly, engineers who design a new computer system, or who design improved or new integrated circuits for use in computer or other electronic products, are engaged in qualified research because the design of those items is uncertain at the outset and can only be determined through a process of experimentation relating to specific design hypotheses and decisions as described above.

A business item will not be considered as developed through a process of experimentation if the predominant portion of the development activity consists of duplication, i.e., the reproduction of an existing business item of another person from a physical examination of the item itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such item.

Thus, the "technologically new or improved" requirement is applied first at the level of the entire product, etc. to be offered for sale, etc. by the taxpayer. If all aspects of that requirement are not met at that level, the test applies at the most significant subset of elements of the product, etc. This "shrinking back" of the product is to continue until either a subset of elements of the product that satisfies the requirement is reached, or the most basic element of the product is reached and such element fails to satisfy the test.

Internal-use computer software

Under the committee modification, the research credit will not be available for the costs of routine development of computer software for the taxpayer's own internal use (e.g., for payroll, bookkeeping, or personnel management functions). The development of computer software will not be considered routine only if the taxpayer can establish, in addition to satisfying the general requirements for credit eligibility, (1) that the software is innovative (as where the software results in a reduction in cost, or improvement in speed, that is substantial and economically significant); (2) that the software development involves significant economic risk (as where the taxpayer commits substantial resources to the development and also there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period); and (3) that the software is not commercially available for use by the taxpayer (as where the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the first two requirements just stated).

Effect on section 174 definition

No inference is intended from the above definitional rules as to the scope of the term "research or experimental" for purposes of the section 174 expensing deduction.

University basic research credit

Under the bill, qualifying expenditures include both grants or contributions by the corporation that constitute charitable contributions under section 170, and also payments for contract research to be performed by the qualified organization on behalf of the corporation. Such expenditures are not eligible for a credit unless and until actually paid by the corporation to a qualified organization. Thus, an accrual-basis corporation may not claim the credit for amounts incurred, but not actually paid, for university basic research.

Under the bill, only cash payments may qualify as a basic research payment. No amount (basis or value) on account of contributions or transfers of property is eligible for either the incremental credit or the basic research credit, whether or not such property constitutes scientific equipment eligible for an augmented charitable deduction under section 170(e)(4).

As under present law, the term "basic research" is defined in the bill as any original investigation for the advancement of scientific knowledge not having a specific commercial objective, other than basic research in the social sciences, arts, or humanities or basic research conducted outside the United States.

The first category of qualifled organizations consists of educational institutions that both are described in section 170(b)(l)(A)(ii) and constitute institutions of higher education within the meaning of section 3304(f). The second category consists of tax-exempt organizations that (1) are organized and operated primarily to conduct scientific research, (2) are described in section 501(c)(3) (relating to exclusively charitable, educational, scientific, etc., organizations), and (3) are not private foundations. Also, certain tax-exempt grant funds that qualify under present law continue to qualify under the bill.

In addition, the bill treats as qualified any tax-exempt organization that is organized and operated primarily to promote scientific research by colleges or universities pursuant to written research agreements, that expends on a current basis substantially all its funds (or all the basic research payments received by it) through grants and contracts for basic research by colleges and universities, and that is either (a) described in section 501(c)(3) and is not a private foundation or (b) described in section 501(c)(6) (trade associations).

Computation rules for revised basic research credit

The university basic research credit applies to the excess of (1) 100 percent of corporate cash expenditures for basic research over (2) the sum of the minimum basic research amount plus the maintenance-of-effort amount.

The minimum basic research amount is the greater of two fixed floors--

The maintenance-of-effort amount is the excess of (1) the average of the nondesignated university donations paid or incurred by the taxpayer during the three taxable years immediately preceding the taxable year beginning after December 31, 1983, as adjusted under the bill to reflect inflation, over the amount of nondesignated university donations paid by the taxpayer in the taxable year. The term "nondesignated university donation" means all amounts paid by the taxpayer to all colleges or universities for which a charitable deduction was allowable and that were not taken into account in computing the research credit.

The amount of credit-eligible basic research expenditures to which the new credit applies does not enter into the computation of the incremental credit. The remaining amount of credit-eligible basic research expenditures--i.e., the amount to which the new credit does not apply--enters into the incremental credit computation (and in subsequent years enters into the base period amounts for purposes of computing the incremental credit).

Credit limitations

The bill makes the research credit subject to the general business credit limitation, as amended by the bill.

2. Augmented charitable deduction for certain donations of scientific equipment

(sec. 231(f) of the bill and sec. 170(e)(4) of the Code)

3. Tax credit for rehabilitation expenditures

(sec. 232 of the bill and secs. 46(b), 48(g), and 48(q) of the Code)

The rehabilitation credit is available only if the taxpayer elects to use the straight-line method of cost recovery with respect to the rehabilitation expenditures. If the 15- or 20-percent investment credit is allowed for qualified rehabilitation expenditures, the basis of the property is reduced by the amount of credit earned (and the reduced basis is used to compute cost recovery deductions) (sec. 48(q)(1) and (3)). The basis is reduced by 50 percent of the 25-percent credit allowed for the rehabilitation of certified historic structures.

Qualified rehabilitation expenditures are eligible for the credit only if incurred in connection with a substantial rehabilitation that satisfies an external-walls requirement. The test of substantial rehabilitation generally is met if the qualified expenditures during a 24-month measuring period exceed the greater of the adjusted basis of the building as of the first day of the 24-month period, or $5,000. (In phased rehabilitations, the 24-month measuring period is extended to 60 months.)

The external-walls requirement provides generally that at least 75 percent of the existing external walls of the building must be retained in place as external walls in the rehabilitation process. An alternative test provides that the external-walls requirement is met if (1) at least 75 percent of the external walls are retained in place as either internal or external walls, (2) at least 50 percent of such walls are retained in place as external walls, and (3) at least 75 percent of the building's internal structural framework is retained in place.

In the case of rehabilitations of certified historic structures, certain additional rules apply. In particular, the Secretary of the Interior must certify that the rehabilitation is consistent with the historic character of the building or the historic district in which the building is located. In fulfilling this statutory mandate, the Secretary of the Interior's Standards for Rehabilitation are applied. See 36 CFR Part 67.7 (March 12, 1984).

Qualified rehabilitation expenditures generally include any amounts properly chargeable to capital account of a building in connection with a rehabilitation, but do not include the following:

The rehabilitation credit is subject to recapture if the rehabilitated building is disposed of or otherwise ceases to be qualified investment credit property with respect to the taxpayer during the five years following the date the property is placed in service. If the Department of the Interior decertifies a rehabilitation of a certified historic structure during the recapture period, the property ceases to be qualified investment credit property.

The committee has concluded the incentives granted to rehabilitations in 1981 remain justified. The committee believes that such incentives are needed because the social and aesthetic values of rehabilitating and preserving older structures are not necessarily taken into account in investors' profit projections. Additionally, a tax incentive is needed because market forces might otherwise channel investments away from such projects because of the extra costs of undertaking rehabilitations of older or historic buildings.

The committee also sought to focus the credit particularly on historic and certain older buildings and to ensure that the credits accomplish their intended objectives of preserving such historic and older buildings. In addition, the committee was concerned that the existing credit percentages would be too high in the context of the lower overall rates provided in the bill. For example, the 25-percent credit in present law offsets 50 cents of income for every $1 of rehabilitation expenditures made by a taxpayer in the top 50-percent bracket. A credit of 19 percent would accomplish the same offset to income with a top bracket of 38 percent. Similarly reduced credits would reproduce the same offsets to income as the current 15-percent and 20-percent rehabilitation credits.

The committee bill replaces the existing three-tier rehabilitation credit with a two-tier credit for qualified rehabilitation expenditures. The credit percentage is 20 percent for rehabilitations of certified historic structures and 10 percent for rehabilitations of buildings (other than certified historic structures) originally placed in service before 1936.

Retention of certain rules

As under present law, the 10-percent credit for the rehabilitation of buildings that are not certified historic structures is limited to nonresidential buildings, but the 20-percent credit for rehabilitation of historic buildings is available for both residential and nonresidential buildings.

The present law provisions that determine whether rehabilitation expenditures qualify for the credit were generally retained in the bill. In general, no changes were made regarding the substantial rehabilitation test, the specific types of expenditures that do not qualify for the credit, the provisions applicable to certified historic structures and tax-exempt use property, or the recapture rules. No expenditure would be eligible for credit unless the taxpayer elects to recover the costs of the rehabilitation using the straight-line method of depreciation. Further, expenditures incurred by a lessee would not qualify for the credit unless the remaining lease term, on the date the rehabilitation is completed, is at least as long as the applicable recovery period under the incentive depreciation system (generally 30 years; 20 years for very low-income housing).

External-walls requirement

The external-walls requirement was significantly modified by the bill. The existing provision that requires 75 percent of the existing external walls to be retained in place as external walls was deleted and replaced by the alternative test provided in present law that requires the retention in place of (1) at least 75 percent of the existing external walls (including at least 50 percent as external walls) as well as (2) at least 75 percent of the building's internal structural framework. Thus, unlike the situation that can occur under present law, a building that is completely gutted cannot qualify for the rehabilitation credit under the committee bill. In general, a building's internal structural framework includes all load-bearing internal walls and any other internal structural supports, including the columns, girders, beams, trusses, spandrels, and all other members that are essential to the stability of the building.

Because the committee believes that the Secretary of the Interior's Standards for Rehabilitation ensure that certified historic structures are properly rehabilitated, the external-walls requirement for such buildings was deleted by the bill in order to provide the Secretary of the Interior with appropriate flexibilty. The committee intends, however, that rehabilitations eligible for the 20-percent credit should continue to be true rehabilitations and not substantially new construction. The committee expects, therefore, that the Secretary of the Interior will continue generally to deny certification to rehabilitations during which less than 75 percent of the external walls are not retained in place.

Basis reduction

The bill deletes the limited exception in current law that requires a basis reduction for only 50 percent of the credit in the case of certified historic structures. Thus, a full basis adjustment is required for both the ten-percent and 20-percent rehabilitation credits.

A general transitional rule provides that the modifications to the rehabilitation credit (other than certain reductions in the credit percentage--see below) will not apply to property placed in service before January 1, 1994, if the property is placed in service (as rehabilitation property) as part of either a rehabilitation completed pursuant to a written contract that was binding (under applicable state law) on September 25, 1985. This rule also applies to a rehabilitation with respect to property (including any leasehold interest) that was acquired before September 26, 1985, or was acquired on or after such date pursuant to a written contract that was binding on September 25, 1985, if (1) the rehabilitation was completed pursuant to a written contract that was binding on November 22, 1985, parts 1 (if necessary) and 2 of the Historic Preservation Certification Application were filed with the Department of the Interior (or its designee) before November 23, 1985, or (2) the lesser of $1,000,000 or five percent of the cost of the rehabilitation (including only qualified rehabilitation expenditures) is incurred before November 23, 1985, or is required to be incurred pursuant to a written contract that was binding on November 22, 1985. The committee intends the transitional rules described above to apply to all of the individual components of a single project involving the rehabilitation of over 60 individual buildings listed on the National Register at the Franford Arsenal; therefore, the commencement of construction or execution of a binding contract before the relevant date as to buildings included in the project will qualify the entire project.

The modifications to the rehabilitation credit also do not apply to any property placed in service as part of a rehabilitation if an urban development action grant was first approved on September 30, 1983, with respect to such rehabilitation, such grant was further amended and approved by the Department of Housing and Urban Development on December 14, 1984, and there was a binding contract with a municipality as of February 15, 1985.

Further, modifications do not apply to the following specific rehabilitation projects: the rehabilitation of eight bathhouses within the Hot Springs National Park or of buildings in the Central Avenue Historic District adjacent to such Park, any rehabilitation conducted pursuant to Public Law 97-125, the rehabilitation of Union Station in Indianapolis, Indiana, and the rehabilitation of the Upper Pontalba Building in New Orleans, Louisiana.

If a taxpayer transfers his rights in property under rehabilitation or under a binding contract to another taxpayer, the modifications do not apply to the property in the hands of the transferee, as long as the property was not placed in service before the transfer by the transferor. For purposes of this rule, if by reason of sales or exchanges of interests in a partnership, there is a deemed termination and reconstitution of a partnership under section 708(b)(1)(B), the partnership is to be treated as having transferred its rights in the property under rehabilitation or the binding contract to the new partnership.

If property that qualifies under any of the foregoing transitional rules is placed in service after December 31, 1985, the applicable credit percentages are reduced from 25, 20, and 15 to 20, 13, and ten, respectively, and a full basis adjustment in required.

Property that qualifies for transitional relief under one of the rules described above is also excepted from the depreciation changes made by section 201 of the bill.

4. Merchant marine capital construction fund

(sec. 13 of the bill and new sec. 7518 [of the Code])

The Merchant Marine Act of 1936, as amended, provides federal income tax incentives for U.S. taxpayers who own or lease vessels operated in the foreign or domestic commerce of the United States or in U.S. fisheries; these provisions are not contained in the Internal Revenue Code of 1954.

In general, qualified taxpayers are entitled to deduct from income certain amounts deposited in a capital construction fund pursuant to an agreement with the Secretary of Transportation or, in the case of U.S. fisheries, the Secretary of Commerce. Earnings from the investment or reinvestment of amounts in a capital construction fund are excluded from income.

The tax treatment of a withdrawal from a capital construction fund depends on whether it is "qualified." A nonqualified withdrawal of previously deducted or excluded monies by a taxpayer from a fund will generate income to the taxpayer. A qualified withdrawal does not generate income to the taxpayer. A qualified withdrawal is a withdrawal for the acquisition, construction, or reconstruction of a qualified vessel, or for the payment of principal on indebtedness incurred in connection with the acquisition, construction, or reconstruction of such a vessel. A qualified vessel is a vessel (including barges and containers) constructed or reconstructed in the United States, documented under U.S. laws, and which is to be operated in the U.S., foreign, Great Lakes, or noncontiguous domestic trade, or in U.S. fisheries.

A nonqualified withdrawal of previously deducted or excluded monies from a fund will generate income to the taxpayer. In addition, interest on the tax liability attributable to a nonqualified withdrawal is payable from the date of deposit.

Capital cost recovery

Because provision is made for the deduction (or exclusion) of certain amounts deposited in a capital construction fund and their tax-free withdrawal in the case of a qualified withdrawal, the amount of funds withdrawn reduces the tax basis of the qualified vessel. This provision is designed to prevent double deductions, which would occur if a taxpayer was permitted to take depreciation deductions for amounts the taxpayer had already deducted from--or never included in--income.

Investment tax credit

In general, the amount of investment tax credit for eligible property is determined with reference to the basis. A taxpayer may compute the investment tax credit for a qualified vessel (i.e., one that was financed in whole or in part by qualified withdrawals from a capital construction fund) by including at least one-half of qualified withdrawals in basis.

The committee became aware during its tax reform hearings that Treasury's proposal to terminate the Capital Construction Fund (CCF) could have a serious adverse impact on the financial reporting requirements of CCF holders. The committee intends that its modifications to the CCF program be viewed as not requiring any change in the financial statement presentation of income taxes by CCF holders. This will allow these taxpayers to provide future financial statements necessary for ship financing on a basis consistent with that anticipated at the time these taxpayers entered into CCF agreements with the Federal government.

For purposes of the definition of the term "qualified withdrawals," under new section 7518(e) (sec. 607(f) of the Merchant Marine Act, 1936), the committee intends the phrase, "acquisition, construction, or reconstruction of a qualified vessel" to be interpreted as including acquisition through either purchase or lease of an agreement vessel for a period of five years or more. This interpretation parallels the structure of: (1) the scope of eligibility to establish a capital construction fund under sec. 607(a) of the Merchant Marine Act, 1936 (which permits deposits into a CCF fund by either an owner/lessor or the lessee of an eligible vessel, or both, subject to certain limitations), and (2) the scope of qualified withdrawals for vessel acquisition through either purchase (in the form of a downpayment toward the purchase price) or payment of long-term indebtedness on an agreement vessel. This interpretation is also consistent with current industry acquisition practices reflecting a long-term trend toward vessel acquisition through lease rather than purchase.

Inclusion in Internal Revenue Code

The tax provisions relating to capital construction funds are recodified as part of the Internal Revenue Code of 1985. For purposes of the Internal Revenue Code of 1985, defined terms shall have the meaning given such terms in the Merchant Marine Act of 1936, as amended, as in effect, on the date of enactment of the bill.

Tax treatment of nonqualified withdrawals

The maximum rate of tax (36 percent for corporations and 38 percent for individuals) is to be imposed on nonqualified withdrawals made after December 31, 1985; This penalty is in addition to interest payable from the date the amount withdrawn was reported.

If a taxpayer makes a nonqualified withdrawal out of a capital construction fund, the income tax payable by the taxpayer for the year of withdrawal is generally to be increased by such amount as is necessary to assure that the tax liability with respect to the nonqualified withdrawal is determined by reference to the top marginal tax rates applicable to ordinary income and capital gains. Special rules are provided to limit the application of this provision in cases where the taxpayer derived no tax benefit from depositing the funds.

Capital Construction Fund reports to Treasury

The Secretary of Transportation and the Secretary of Commerce are required to certify to the Secretary of Treasury that the monies in a fund are appropriate for vessel construction requirements. If it is determined that the fund balances exceed what is appropriate to meet vessel construction program objectives, the fundholder would be required to develop appropriate program objectives within three years or treat the excess as a nonqualified withdrawal.

Ten-year limit on deposits

The bill imposes a ten-year limit on the amount of time monies can remain in a fund without being withdrawn for a qualified purpose. This rule applies to all deposits, including those made before the general effective date. The ten-year period begins to run on the later of the date of deposit or January 1, 1986.

Monies that are not withdrawn after a ten-year period--other than amounts that have been committed to the construction or acquisition of identified vessels pursuant to contracts that are binding as of the last day of the ten-year period--are to be treated as nonqualified withdrawals, according to the following schedule: for the eleventh year, the fundholder would be treated as having withdrawn 20 percent; for the twelfth year, 40 percent; for the thirteenth year, 60 percent; for the fourteenth year, 80 percent, and for the fifteenth year, 100 percent. For purposes of this rule, if a taxpayer enters into a binding contract before the close of a taxable year, the amount so committed is not treated as remaining in the fund.

The following is an exchange of correspondence between the Chairman of the Committee on Ways and Means and the Committee on Merchant Marine and Fisheries concerning this provision of the bill.

DECEMBER 3, 1985.

Hon. DAN ROSTENKOWSKI, Chairman, Committee on Ways and Means, U.S. House of Representatives, Washington, DC.

DEAR MR. CHAIRMAN: Pursuant to our earlier conversation, I have reviewed the provisions of H.R. 3838, the Tax Reform Act of 1985, which have an impact on the Capital Construction Fund program. It is certainly an accomplishment for which I sincerely congratulate you, and I take this opportunity to express my gratitude for the cooperation between our committees. As you know, several members of my committee testified before you on the matters contained within the Capital Construction Fund. Their testimony was reflective of the position on the tax effects of the Capital Construction Fund program adopted by the Committee on Merchant Marine and Fisheries. As you well know, the retention of this most valuable capital appreciation provision was, and still is, of the utmost importance, not only to this committee but more importantly to the maritime promotional program of which the Capital Construction Fund is only one part.

It is therefore most gratifying that you have agreed not only to retain the Capital Construction Fund, but also that you have agreed that the Capital Construction Fund should not be treated apart from the other promotional elements in the Merchant Marine Act, 1936. At the same time, we certainly understand and agree with the positioning, in parallel, of certain portions of this program in the Internal Revenue Code.

I appreciate our understanding that my Committee's cooperation in expediting key tax reform legislation in no way prejudices any of its jurisdictional rights regarding the Capital Construction Fund under section 1(n) of House Rule X.

In the future there should be no difficulty in our committees cooperating fully when considering amendments to the Capital Construction Fund program whether the amendments are to section 7518 of the Internal Revenue Code or to section 607 of the Merchant Marine Act, 1936. I am certain that consideration by our committees of legislation dealing with either section 607 of the Merchant Marine Act, 1936, or section 7518 of the Internal Revenue Code will be conducted in the spirit of cooperation that existed during the pendency of consideration of the Tax Reform Bill, and further that neither committee will utilize any device to frustrate the consideration by the House of Representatives of any measure that may be referred jointly to the Committee on Merchant Marine and Fisheries and the Committee on Ways and Means.

Once again, Mr. Chairman, please accept my sincere gratitude for the way in which our committees functioned in developing the legislative changes which will, I am certain, be beneficial to both sound tax policy and sound maritime policy.

Sincerely, WALTER B. JONES, Chairman.

DECEMBER 4, 1985.

Hon. WALTER B. JONES, Chairman, Committee on Merchant Marine and Fisheries, U.S. House of Representatives, Washington, DC.

DEAR MR. CHAIRMAN: Thank you for your letter of December 3, regarding your review of provisions of H.R. 3838, the Tax Reform Act of 1985, which embodies the new Internal Revenue Code of 1985.

As you know, contained within this legislation are provisions dealing with the Capital Construction Fund, a promotional program designed to encourage the investment of capital in the construction of merchant vessels in United States shipyards. As you stated, with your Committee's concurrence, certain conforming amendments were added to harmonize amendments proposed by the Committee on Ways and Means to these Capital Construction Fund provisions with the Merchant Marine Act, 1936. Again with your concurrence, the conforming amendments amended section 607 of the Merchant Marine Act, 1936, to reflect these changes. These changes are very similar to changes in legislation (H.R. 3164) that have been before your committee. In addition, a new section 7518 has been added to the Internal Revenue Code to reflect those provisions of the Capital Construction Fund that have direct tax policy or tax administration effect. I appreciate the cooperation of the Committee on Merchant Marine and Fisheries in achieving what I view to be a most acceptable result.

By cooperating with the Committee on Ways and Means in this effort, the Committee on Merchant Marine and Fisheries has aided the process of bringing key tax legislation to the House floor promptly without in any way prejudicing its jurisdictional rights regarding the Capital Construction Fund under section 1(n) of House Rule X.

As in this instance, I have every expectation that our committees will continue to cooperate fully when considering amendments to the Capital Construction Fund program whether the amendments are to section 7518 of the Internal Revenue Code or to section 607 of the Merchant Marine Act, 1936. In this way both tax policy and maritime policy will be well served by the committees of Congress charged with their development and oversight.

Once again, Mr. Chairman, let me express my thanks for your Support in this most difficult but worthwhile effort.

Sincerely, Dan Rostenkowski, Chairman.

(sec. 241 of the bill and sec. 1202 of the Code)

This deduction is included in the minimum tax base as a preference. However, since the alternative minimum tax rate is 20 percent, the alternative minimum tax does not increase the maximum Federal income tax rate on net capital gains alone.

The committee believes it is desirable to retain a reduced rate for net capital gains of individuals. In the context of the general reduction of regular individual tax rates under the bill, however, the committee does not believe that it is necessary to retain the same degree of differential between regular rates and capital gains rates as is afforded under present law.

In conjunction with the changes made by the bill to the top regular tax rates, the changes in the net capital gain deduction will produce a maximum tax rate of 22 percent (i.e., 50 percent of 44 percent) for net capital gains of individuals in taxable years beginning in 1986 and 22.04 percent (i.e., 58 percent of 38 percent) in taxable years beginning after 1986.

The deduction will be an item of tax preference for purposes of the individual alternative minimum tax; however, under the bill the impact of that tax on net capital gains alone will not result in a greater than 22 percent Federal income tax rate.

The bill coordinates the increased capital gains deduction with the rules applicable to charitable contributions of appreciated property. It provides that the amount of certain charitable contributions of capital gains property is reduced by the percentage of long term capital gain that would have been taxable if the property contributed had been sold by the taxpayer at its fair market value.

2. Royalty income from coal and domestic iron ore

(sec. 242 of the bill and sec. 631(c) of the Code)

If capital gain treatment applies under these rules, the royalty owner is not entitled to percentage depletion with respect to the coal or iron ore disposed of.

3. Recapture of certain amounts previously reducing taxable income

(secs. 243 and 262 of the bill and secs. 616(c) and 1254 of the Code)

The bill also provides similar rules for mining exploration and development costs (sec. 616(c)). Under these rules, all expensed mining exploration and development costs (to the extent not included in income upon reaching the producing stage) as well as depletion, to the extent it reduced basis, will be subject to recapture upon disposition of mining property.

(sec. 251 of the bill and sec. 263 of the Code)

Costs incurred by an operator to develop an oil, gas, or geothermal property are of two general types: (1) intangible drilling and development costs, and (2) depreciable costs.¹

^{Under present law, intangible drilling and development costs ("IDCs") may either be deducted in the year paid or incurred ("expensed") or else may be capitalized and recovered through depletion or depreciation deductions (as appropriate), at the election of the operator. In general, IDCs include expenditures by the operator incident to and necessary for the drilling and the preparation of wells for the production of oil or gas (or geothermal energy), which are neither for the purchase of tangible property nor part of the acquisition price of an interest in the property. IDCs include amounts paid for labor, fuel, repairs, hauling, supplies, etc., to clear and drain the well site, construct an access road, and do such survey and geological work as is necessary to prepare for actual drilling. Other IDCs are paid or incurred by the property operator for the labor, etc., necessary to construct derricks, tanks, pipelines, and other physical structures necessary to drill the wells and prepare them for production. Finally, IDCs may be paid or accrued to drill, shoot, fracture, and clean the wells. IDCs also include amounts paid or accrued by the property operator for drilling or development work done by contractors under any form of contract.}

^{Depreciable costs are amounts paid or accrued during the development of a property to acquire tangible property ordinarily considered to have a salvage value. For example, the costs of drilling tools, pipe, casing, tubing, engines, boilers, machines, etc., fall into this category. This class of expenditures also includes amounts paid or accrued for wages, fuel, repairs, etc., in connection with equipment or facilities not incidental or necessary for the drilling of wells, such as structures to store or treat oil or natural gas. These expenditures must be capitalized and depreciated in the same manner as ordinary items of equipment, and they are treated in the same manner for both independent and integrated producers.}

^{Only persons holding an operating interest in a property are entitled to deduct IDCS. This includes an operating or working interest in any tract or parcel of oil or gas-producing land either as a fee owner, or under a lease or any other form of contract granting working or operating rights. In general, the operating interest in an oil or gas property must bear the cost of developing and operating the property. The term operating interest does not include royalty interests or similar interests such as production payment rights or net profits interests.}

^{Generally, if IDCs are capitalized, they can be recovered through depletion or depreciation, as appropriate. However, if IDCs generally are capitalized, a separate election may be made to deduct currently IDCs paid or incurred with respect to a nonproductive well ("dry hole"), in the taxable year in which the dry hole is completed. Thus, a taxpayer has the option of capitalizing IDCS for productive wells while expensing those relating to dry holes.}

^{Twenty-percent reduction for integrated producers}

^{In the case of a corporation which is an "integrated" producer2} (i.e., which is not an "independent" producer), the allowable deduction with respect to IDCs that the taxpayer has not elected to capitalize is reduced by 20 percent. The disallowed amount must be added to the basis of the property and amortized over a 36-month period, starting with the month in which the costs are paid or accrued. Amounts paid or accrued with respect to non-productive wells (dry hole costs) remain fully deductible when the non-productive well is completed.

Treatment of foreign IDCs

Foreign and domestic IDCS generally are subject to the same rules under present law.

In approaching IDCs, the committee noted that a majority of presently expensible IDCs are for expenditures which are incurred before the actual decision to proceed to completion of a well is made. The present law treatment of these IDCs is retained by the bill. However, a significant fraction of IDCs are incurred after the decision to complete and produce from a well is made (i.e., when it is determined that the risk of a nonproductive well is sufficiently small). The decision to complete a well generally is evidenced (in the case of onshore wells) by the installation of production casing in the well. Thus, the committee believes that tax incentives to compensate investors for the risks of drilling, and to encourage the discovery of new deposits, are less warranted with respect to expenditures for installing the production string of casing and subsequent development activities.

The bill provides a 26-month amortization period for IDCs which are incurred at or after the production casing point. This is a shorter recovery period than that provided for any depreciation class, and considerably shorter than the asset depreciation range ("ADR") midpoint of oil and gas drilling equipment (i.e., 14 years generally, 6 years for contract drillers, and 7.5 years for offshore wells). The bill also continues to allow any previously unrecovered IDCs to be written off in the year that a dry hole is completed.

The committee believes that the tax incentive provided for IDCs is appropriate only with respect to domestic exploration. Accordingly, the bill requires that IDCs incurred outside the United States be recovered using 10-year amortization or (at the taxpayer's election) as part of the cost depletion basis.

The 20-percent reduction for integrated producers does not apply to IDCS for which 26-month amortization is applicable under the bill. Thus, unless capitalization has been elected, 100 percent of these IDCs are to be amortized over 26 months by all taxpayers.

The bill does not affect the ability to deduct unrecovered IDCs with respect to a dry hole (including those IDCs otherwise subject to 26-month amortization) in the year the dry hole is completed. If expensing of these costs is elected, the unamortized balance of IDCs incurred at or subsequent to the production casing point is to be deducted in the year in which the dry hole is completed. For example, if an amortizable cost is incurred in September of year 1, and the dry hole is completed in year 2, then (assuming a calendar year taxpayer) 4/26 of the relevant cost would be recovered in year 1 and the balance (22/26) would be recovered in year 2.

The bill provides that the 26-month amortization rule does not apply below the lowest production level. The committee understands that, in certain cases, it may be impossible to determine at the time that casing is installed whether production will occur below a certain level. In these cases, it may also be impossible to determine whether a particular casing eventually will Serve as production (as opposed to intermediate) casing. This may occur, for example, when a well is plugged-back and completed at a higher producing level after a deeper deposit, which may have been the original drilling objective, proves nonproductive. The committee intends that, in such cases, IDCs incurred subsequent to the commencement of installation of casing which eventually serves as production casing, are to be amortized over the 26-month period provided in the bill. IDCs associated with the unsuccessful deeper drilling may (at the taxpayer's election) be written off as an ordinary business loss in the year the well is plugged-back. The committee recognizes that these rules may require the filing of amended returns in cases in which the determinations above cannot be made prior to the close of the taxable year. See, Rev. Rul. 77-136, 1977-1 C.B. 167 (regarding treatment of plugged-back wells for percentage depletion purposes).

These provisions apply with respect to oil, gas, and geothermal properties.

b. Foreign IDCs

Under the bill, IDCs incurred outside the United States are recovered (1) over a 10-year straight-line amortization schedule beginning in the year the costs are paid or incurred, or (2) at the taxpayer's election, by adding these costs to the basis for cost depletion. For this purpose, the United States includes the 50 states, the District of Columbia, and those continental shelf areas which are adjacent to United States territorial waters and over which the United States has exclusive rights with respect to the exploration and exploitation of natural resources (sec. 638(1)). The 20-percent reduction for integrated producers does not apply to these costs.

c. Coordination with recapture provision

IDCs deductible under the 26-month amortization rule or the rules regarding foreign IDCs are taken into account for purposes of determining the amount of recapture on the disposition of certain oil, gas, or geothermal properties (sec. 1254).⁴

2. Depletion for oil, gas, and geothermal properties

(sec. 252-54 of the bill and sec. 613 and 613A of the Code)

Certain costs incurred prior to drilling an oil- or gas-producing property are recovered through depletion deductions. These include costs of acquiring a lease or other interest in the property, and geological and geophysical costs (in advance of actual drilling). Depletion is available to any person having an economic interest in a producing property (including royalty interests).

Two methods of depletion currently are allowable under the Internal Revenue Code: the cost depletion method, and the percentage depletion method. Under the cost depletion method, the taxpayer deducts that portion of the adjusted basis of the property⁵ which is equal to the ratio of units produced and sold from that property during the taxable year to the number of units at the beginning of the taxable year. The amount recovered under cost depletion cannot exceed the taxpayer's basis in the property.

Under percentage depletion, 15 percent of the taxpayer's gross income from an oil- or gas-producing property is allowed as a deduction in each taxable year. The amount deducted may not exceed 50 percent of the net income from that property in that year (the "net income limitation"). Additionally, the deduction for all oil and gas properties may not exceed 65 percent of the taxpayer's overall taxable income. Because percentage depletion is computed without regard to the taxpayer's basis in a property, it may result in eventual recovery of an amount greater than the taxpayer's basis in the property.

A taxpayer is required to determine its depletion deduction for each oil and gas property under both the percentage depletion method (if the taxpayer is entitled to use this method) and the cost depletion method. If the cost depletion deduction is larger, the taxpayer must utilize that method for the taxable year in question.

Limitation to independent producers, etc.

The Tax Reduction Act of 1975 repealed percentage depletion with respect to much oil and gas production. (This provision does not apply to geothermal wells.) Under that Act, independent producers and royalty owners⁶ (as contrasted to integrated oil companies) are allowed to take percentage depletion for up to 1,000 barrels of average daily production of domestic crude oil or an equivalent amount of domestic natural gas (including wells located in U.S. possessions).⁷ For producers of both oil and natural gas, this limitation applies on a combined basis.

For purposes of percentage depletion, an independent producer is any producer who is not a "retailer" or "refiner." A retailer is any person who directly, or through a related person, sells oil or natural gas or any product derived therefrom (1) through any retail outlet operated by the taxpayer or related person, or (2) to any person obligated to market or distribute such oil or natural gas (or product derived therefrom) under the name of the taxpayer or related person. In determining whether or not a person is a retailer, bulk sales to commercial or industrial users, and bulk Sales of aviation fuel to the Department of Defense, are excluded. Further, a person is not a retailer within the meaning of this provision if the combined gross receipts of that person and all related persons from the retail sale of oil, natural gas, or any product derived therefrom, do not exceed $5 million for the taxable year.

A refiner is any person who directly or through a related person engages in the refining of crude oil, but only if such taxpayer or related person has a refinery run in excess of 50,000 barrels on any day during the taxable year.

To prevent proliferation of the independent producer exception, all production owned by businesses under common control and members of the same family must be aggregated. Each group is then treated as one producer for application of the 1,000-barrel amount. Further, if an interest in a proven oil or gas property is transferred after 1974 (subject to certain exceptions), the production from such interest does not qualify for percentage depletion. The exceptions to this rule include transfers at death, certain transfers to controlled corporations, and transfers between controlled corporations or other business entities.

Depletion of geothermal deposits

Percentage depletion also is allowed at a 15-percent rate for geothermal deposits located in the United States or U.S. possessions. This treatment is applied without regard to the 1,000 barrel per day limitation or the restriction to independent producers which apply in the case of oil and gas; additionally, there is no limitation to 65 percent of overall taxable income. (A limitation to 50 percent of net income from the property remains applicable.)

Percentage depletion for lease bonuses and advance royalties

Following the 1975 depletion amendments, disagreement arose whether lease bonuses, advance royalties, and other amounts paid in advance of actual production from an oil or gas property continued to be entitled to percentage depletion.

In January, 1984, the Supreme Court held that a bonus or advance royalty paid to a lessor in a year in which no oil or gas is produced is subject to percentage depletion, notwithstanding the 1,000 barrel per day limitation contained in the 1975 legislation (Commissioner v. Engle, 464 U.S. 206 (1984)). The Court left open the possibility that the Treasury Department could promulgate regulations giving effect to the 1,000 barrel per day limitation in such cases.

In June, 1984, the IRS announced the manner for determining percentage depletion by recipients of bonuses and advance royalties. According to this announcement, a bonus or advance royalty is taken into account for depletion purposes in the same year that the payment is includible in income (i.e., generally the year received). Bonus or advance royalty payments are converted to barrel-equivalents based on the average price of oil or gas produced from the property during the taxable year (if no oil or gas is produced or sold from the property, based on representative market or field prices), with percentage depletion being allowed only for the equivalent of 1,000 barrels per day of oil production. No percentage depletion allowance is provided for in any year other than the year in which the bonus or advance royalty is includible in income (I.R. Ann. 84-59, IRB 1984-23, June 4, 1984).

The bill provides substantial rate reductions applicable to all income. Thus, percentage depletion generally is phased out. However, the committee decided to retain it for so called "stripper" wells of independent producers and royalty owners. The committee was concerned that the elimination of percentage depletion would cause economic hardships to many small producers and royalty owners.

In retaining percentage depletion for royalty owners, the committee wished to provide an incentive only with respect to actual production from stripper wells. Accordingly, the committee decided to specify that no percentage depletion is available for lease bonuses, advance royalties, or other payments which are not directly related to the actual production from a property. This provision reverses a 1984 Supreme Court decision which requires that some form of percentage depletion be allowed for such payments.

The bill phases out percentage depletion for oil, gas and geothermal properties, other than stripper wells, over a 3-year period. This is accomplished by reducing the applicable percentage depletion rate by 5 percentage points in each of the next 3 calendar years (i.e., the percentage depletion rate will be 10 percent for production in calendar year 1986, 5 percent in 1987, and 0 percent in 1988 and thereafter). As under present law, taxpayers will be required to use the higher of cost or percentage depletion for any year in which both are available. Beginning in 1988, taxpayers will be required to use cost depletion.

Exception for domestic stripper wells

Percentage depletion is retained under the bill for domestic stripper well properties of independent producers and royalty owners (subject to the limitations in Section 613A). The term "stripper well property" is defined (in the case of oil-producing properties) as it is for purposes of the crude oil windfall profit tax (secs. 4994(g)(1)(B) and 4991(d)(1)(A)) (i.e., generally those properties whose average daily production has been 10 barrels or less of crude oil per day during a specified period). Stripper well gas generally is defined as it is under section 108(b) of the Natural Gas Policy Act of 1978. The committee specifically intends that, in the case of oil-producing properties, the "once a stripper, always a stripper" rule of present law, under which later increases in production do not disqualify a property from stripper well status, will be retained for percentage depletion purposes.

The bill specifies that, for calendar year 1986 and 1987, the 1,000 barrel per day limitation for independent producers and royalty owners (or its natural gas equivalent) is to be reduced by any stripper well oil or gas which is attributable to the taxpayer. Thus, percentage depletion will be allowed at the applicable phase-out rate (10 percent in 1986 and 5 percent in 1987) for 1,000 barrels of average daily production reduced by the amount of stripper well production which qualifies for a full 15 percent rate.

Denial of depletion for bonuses and advance royalties

The bill provides that percentage depletion is not allowed for lease bonuses, advance royalties, or any other amount payable without regard to actual production from the property. This rule applies both to stripper well properties and to other independent producers and royalty owners during the 3-year phaseout period. The rule applies to oil, gas, and geothermal properties.

The denial of percentage depletion for bonuses and advance royalties is effective on January 1, 1986.

3. Exemption from windfall profit tax for certain crude oil exchanged for residual fuel oil

(sec. 255 of the bill and sec. 4991 of the Code)

The Joint Statement of Managers for the Crude Oil Windfall Profit Tax Act of 1980 indicated that "powerhouse" fuel (i.e., fuel used to power production equipment or a production process) which is produced on one section of a single undivided piece of land is not taxable if it is used on another section of the same piece of land as powerhouse fuel and never leaves the piece of land on which it is produced.⁸ Present law thus does not impose the windfall profit tax on such crude oil used in enhanced recovery processes on the property from which it was produced.

Present law does impose the windfall profit tax in a situation in which crude oil is exchanged at a refinery for residual fuel which is used to power a production process on the property. See, Rev. Rul. 82-160, 1982-2 C.B. 349.

Because the windfall profit tax applies to any crude oil which is removed from the property, the committee understands that many operators have ceased to exchange crude oil for residual fuel, instead burning crude oil produced on the same property in order to power enhanced recovery processes. (But for the tax, it is generally more cost efficient to burn residual rather than crude oil in such processes.)

The committee amendment corrects this by exempting certain exchanges of crude oil for residual fuel oil from the windfall profit tax. To prevent abuse, the provision is subject to various limitations. First, the provision applies only to residual fuel which is to be used in enhanced recovery processes, not including processes that have the sole purpose of lifting fluids to the well bore. Second, the provision is limited to production attributable to operating mineral interests in the producing property. The provision is further limited to cases in which the acquired residual oil is used in enhanced recovery processes during the same quarter or the quarter following that in which the crude oil is removed from the property. These restrictions are intended to limit the effect of the provision to exchanges which have the purpose described above, i.e., of burning residual fuel oil rather than lease crude for use in enhanced recovery processes, as generally would have been the case in the absence of the windfall profit tax. Restrictions are also included to ensure that the proper amount of oil will be subject to the tax; this is accomplished by requiring untaxed lease crude to be exchanged barrel-for-barrel with either previously taxed residual oil or residual oil produced from lease crude.

The committee believes that, if exchanged crude oil is exempted from the windfall profit tax, it should be treated for all tax purposes as if it were not produced on the property. Accordingly, under the bill, crude oil which is subject to the exception is excluded from the computation of depletion deductions.

A person's share of residual fuel oil used on the property is to be the same as that person's share of production from the property for the quarter in question. (Only production attributable to operating mineral interests is taken into account for this purpose.) The bill authorizes the Treasury Department to prescribe rules for allocating a person's exempt production among and within the various tiers of taxable crude oil provided under the windfall profit tax.

The exemption in the bill is limited to cases in which residual fuel oil is used in enhanced recovery processes. For example, the exemption will apply if residual fuel is used to create steam for use in an enhanced recovery process with respect to heavy crude oil. The exemption does not apply if residual fuel is used to power production equipment or a production process which are not part of an enhanced recovery process. An enhanced recovery process is defined as any process for increasing the ultimate total recovery of oil from a reservoir by modifying any property of any fluid in the reservoir or reservoir rock, or any process for displacing or controlling the flow rate or pattern in the reservoir. Enhanced recovery processes do not include any process the sole purpose of which is to aid in lifting fluids to the well bore.

Residual fuel oil is defined to include No. 4, No. 5, or No. 6 fuel oil, Bunker C oil, Navy Special Fuel Oil, or any other fuel which has a 50-percent boiling point in excess of 1700 degrees Fahrenheit in the ASTM D-86 standard distillation test.

The exemption does not apply to any oil attributable to nonoperating mineral interests such as royalty interests.

The bill specifies that no depletion (including cost or percentage depletion) is available with respect to oil exempt from the windfall profit tax as a result of the exception.

(sec. 261 of the bill and sec. 613 of the Code)

Under the cost depletion method, the taxpayer deducts that portion of the adjusted basis of the property which is equal to the ratio of units sold from that property during the taxable year, to the number of units remaining as of the beginning of that year. As a result of the method of computation, the amount recovered under cost depletion cannot exceed the taxpayer's basis in the property.

Under the percentage depletion method, a deduction is allowed in each taxable year for a statutory percentage of the taxpayer's gross income from the property, ranging from 5 to 22 percent. Generally, percentage depletion is allowed for all minerals except soil, dirt, turf, water, mosses, or minerals from sea water.

The amount deducted for any mineral may not exceed 50 percent of the net income from the property in any taxable year (the "net income limitation").

Unlike cost depletion (or the general rules for recovering costs of depreciable and amortizable property), percentage depletion is computed without regard to the taxpayer's basis in the property. One consequence is that percentage depletion deductions can exceed the amount expended by the taxpayer to acquire the property.

In the case of a corporation, the amount of percentage depletion for coal (including lignite) and iron ore is reduced by 15 percent to the extent in excess of the adjusted basis of the property.⁹

The bill phases down most depletion rates to 5 percent, which creates a more uniform tax incentive for these minerals. In several instances, the committee departed from the general 5-percent rate. First, with respect to minerals that are accorded the lowest depletion rate (5 percent) under present law (e.g., sand and gravel) the committee believes that there is little justification for retaining any depletion incentive. These minerals generally are in abundant supply and have little strategic value. Consequently, the committee decided to phase out completely percentage depletion with respect to these minerals.

Second, with respect to minerals that are used as or in fertilizer or animal feed, the committee decided to retain present law depletion rates. The principal reason for the more favorable treatment of agriculture minerals is the committee's desire to avoid a further squeeze on farm income.

Third, with respect to dimension stone (primarily granite, limestone, sandstone, and marble used for ornamental purposes) the committee also decided to retain present law rates. The committee was concerned about the depressed state of the U.S. dimension stone industry, which is in part due to intense foreign competition.

While retaining some amount of percentage depletion for most minerals, the committee was concerned that taxpayers not be able to escape tax on profits from mineral production. For this reason, the present law income limitation was phased down from 50 to 25 percent, except for agricultural minerals and dimension stone. As a result, under the bill, the percentage depletion deduction generally cannot be used to shield from tax more than 25 percent of otherwise taxable income from a property (computed without allowance for depletion). For a large corporation, the rate of tax on mineral income generally would be at least 27 percent (75 percent of the 36-percent corporate rate).

Minerals that are accorded a 5-percent depletion rate under present law are phased down ratably to a zero depletion rate in 1988. (From 5 percent under present law, to 3-1/3 percent for production in 1986, to 1-2/3 percent for production in 1987, and to zero for production after 1987.)

Minerals that are used in the production of fertilizer and animal feed ("agricultural minerals") retain their present law percentage depletion rates. Agricultural minerals include minerals used by the mine owner for the production of fertilizer or animal feed, sold for use (or resale for use) in the production of fertilizer or animal feed, or sold for direct application as fertilizer or animal feed.

Minerals that are used or sold for use as dimension stone also retain their present law percentage depletion rates. Dimension stone generally is defined as stone that is not crushed, and is used for ornamental purposes.

Under the bill, the present law net income limitation is phased down ratably from 50 to 25 percent for tax years beginning in 1988. Thus, the limitation would be 41-2/3 percent for tax years beginning in 1986, 33-1/3 percent for tax years beginning in 1987, and 25 percent for tax years beginning after 1987.

The 50-percent net income limitation in present law is retained for minerals used in fertilizer and animal feed and dimension stone. In situations where only some minerals from a property qualify for the present law 50-percent net income limitation (i.e., minerals used in the production of fertilizer or animal feed and dimension stone), the bill provides that the net income limitation shall be determined by taking into account nonqualified production first. For example, if a mine in 1990 produces Sulphur used for both agricultural and industrial purposes, the percentage depletion on the latter sulphur may be deducted up to 25 percent of net income from the property, and the percentage depletion on the former sulphur may be used to offset remaining net income up to 50 percent of net income (determined before depletion deductions) from the property.

The present law 15-percent reduction in corporate coal and iron ore depletion deductions in excess of adjusted basis is retained.

2. Treatment of mining exploration and development costs

(sec. 262 of the bill and secs. 616 and 617 of the Code)

Under present law, taxpayers may elect to expense (i.e., to deduct currently) exploration costs associated with hard mineral deposits (sec. 617). Taxpayers also may expense development costs associated with the preparation of a mine for production (sec. 616).

Mining exploration costs are expenditures for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore or other depletable mineral, which are paid or incurred by the taxpayer prior to the development of the mine or deposit. When, the mine reaches the producing stage, adjusted exploration expenditures (but not development costs) either: (1) are included in income (i.e., recaptured) and recovered through cost depletion; or (2) at the election of the taxpayer, reduce depletion deductions with respect to the property. Adjusted exploration expenditures with respect to a property are expensed exploration costs attributable to the property, reduced by the excess of percentage over cost depletion. Exploration costs also are subject to recapture if the property is disposed of by a taxpayer after expensing these amounts (secs. 1245 and 1250). Foreign exploration costs may not be expensed to the extent that the taxpayer's total costs of foreign and domestic exploration exceed $400,000 for the taxable year.

Development costs include expenses incurred for the development of a property after the existence of ores in commercially marketable quantities has been determined. These costs generally include costs for construction of shafts and tunnels and, in some cases, costs for drilling and testing to obtain additional information for mining operations.

Twenty-percent reduction for corporations

For corporations, 20 percent of exploration and development costs that the taxpayer has elected to expense are required to be capitalized and recovered using the Schedule for 5-year accelerated cost recovery System ("ACRS") property (sec. 291). For deposits located in the United States, such expenses also qualify for the investment tax credit.

The committee decided to take an intermediate position between expensing of mine exploration and development costs, on the one hand, and capitalization, on the other hand. Under the bill, these costs are expensed (with a 20-percent cutback for corporations), but are subject to recapture if the mine reaches the producing stage, and then recovered as expenditures for depreciable property in class 1. This treatment conforms the tax treatment of development and exploration costs, and provides tax benefits that fall between expensing and capitalization treatment. The bill also simplifies present law, since there is no longer any need to distinguish for tax purposes between exploration and development costs.

Under the bill, the treatment of pre-productive mining development costs generally is conformed to the treatment of exploration costs under present law. Thus, the option initially to expense these costs is retained. At the time that a mine reaches the producing stage, all exploration and development costs with respect to a mine that were expensed in any taxable year (after the effective date), (1) will be recaptured and recovered in the same manner as depreciable property in class 1 (i.e., 3-year double-declining balance with a half-year convention), or (2) at the election of the taxpayer, will reduce the amount of otherwise allowable depletion deductions. Development costs incurred after the mine reaches the producing stage are capitalized and recovered in the same manner as depreciable property in class 1.

The bill retains the cutback in present law which requires that corporations capitalize 20 percent of mineral exploration and development costs that the taxpayer has elected to expense. However, this amount is to be recovered in the same manner as depreciable property in class 2 (i.e., 5-year double-declining balance with a half-year convention), beginning in the year paid or incurred.

The present law rules regarding recapture on disposition of mining property are expanded to require recapture of previously deducted development as well as exploration costs. The recapture rule also is expanded to cover previous depletion deductions which reduced the basis of the disposed property. This is consistent with a similar change with respect to oil and gas properties (sec. 251 of the bill).

Foreign expenditures

The bill requires capitalization of all exploration and development costs with respect to minerals located outside of the United States. These costs are to be recovered over a 10-year straight-line amortization schedule, or at the election of the taxpayer, as part of the basis for cost depletion.

The amendments to the recapture rules upon disposition of certain mining property apply to dispositions of property in commercial production during 1986 or later years. A transitional exception is provided for property placed into production after December 31, 1985 and acquired pursuant to a written contract entered into before September 26, 1985, and binding at all times thereafter. (Property not subject to these amendments remains subject to the present law recapture rule (sec. 617(d) of present law)).

(sec. 271 of the bill and sec. 23 of the Code)

Individuals are allowed a 15-percent credit on the first $2,000 of qualifying expenditures, up to a maximum credit of $300, for installations of eligible insulation and other energy conservation items made through 1985 in or on a taxpayer's principal residence that was substantially completed before April 20, 1977. Each conservation item, listed below, must be capable of reducing heat loss or gain, increasing the efficiency of the heating system, or reducing fuel consumption. Unused credits may be carried over to subsequent taxable years but not to any taxable year beginning after 1987.

In addition to insulation, energy conservation items specified in the statute include (1) a furnace replacement burner, (2) a device to modify flue openings, (3) an electrical or mechanical furnace ignition system to replace a gas pilot light, (4) exterior storm or thermal windows or doors, (5) an automatic setback thermostat, (6) exterior caulking or weatherstripping, (7) an energy usage display meter, or (8) any additional item specified in regulations by the Secretary as increasing energy use efficiency of the dwelling.

Renewable energy credit

Individuals are allowed a 40-percent credit on expenditures up to $10,000, for a maximum credit of $4,000, for renewable energy source property. This provision applies to expenditures made through 1985.

Installations of qualified renewable energy source property, which include solar, wind, photovoltaic and geothermal energy sources, must be made in connection with a taxpayer's principal residence. Unused credits for renewable energy source equipment may be carried over to subsequent taxable years but not to any taxable year beginning after 1987.

As defined in the regulations issued by the Treasury Department, renewable energy source property includes equipment (and parts solely related to the functioning of such equipment) necessary to transmit or use energy from a geothermal deposit. A geothermal deposit is defined as a geothermal reservoir consisting of natural heat, which is from an underground source and is stored in rocks or in an aqueous liquid or vapor, having a temperature exceeding 50 degrees Celsius, which is 122 degrees Fahrenheit. The regulations also provide that equipment which serves both a geothermal function and a nongeothermal function does not qualify as geothermal energy property.

The intent of the Energy Tax Act was to encourage residential and business energy users to conserve petroleum and natural gas through more efficient uses and to develop and encourage a broad variety of alternative sources of domestic energy supply. The energy conservation credit was designed to stimulate households to take the steps to prevent heat loss during cold weather and heat gain of air conditioned houses during hot weather. This was reflected in the conservation credit being made available for insulation, caulking, storm doors and windows, programmed thermostats and efficient replacement burners. Solar, wind and geothermal energy sources were to be stimulated through the renewable energy source credit. These alternate energy sources were not expected to become complete replacements for petroleum and natural gas products, but there was optimism that they would substantially reduce the quantities of oil and gas consumed for residential purposes.

After seven years of experience with the residential credit, the committee evaluated the extent to which the objectives of the legislation have been realized. Generally, it found that the energy conservation credit has achieved its purpose. Residential housing eligible for the credit has benefited from the addition of items eligible for the credit which quickly provided greater cost savings than their relatively modest purchase prices. In addition, new housing has been constructed with insulation and other energy conservation items in response to market factors and without eligibility for the credit. Consequently, the committee decided that renewal of the conservation credit would not be needed.

Experience with the renewable energy credit demonstrates that solar energy uses, and primarily solar hot water systems, have been the only generally used renewable credits. Residential geothermal systems are limited geographically to a small number of local areas, and geothermal use technology has not been readily and economically adaptable to residential use. Residential wind systems apparently have not been feasible except possibly in certain local areas that meet very specific environmental requirements. Solar systems, however, have been adaptable to a wide variety of regional conditions and to a variety of modifications in the systems that satisfy personal and local conditions. Each installed solar system, however, involves several thousand dollars of investment in equipment, piping and specialized media used for heat exchange purposes. Therefore, the committee provided a transition rule that allows an extension for three years and a phaseout of the credit rates of the residential solar energy tax credit.

The committee modified the credit So that it is applicable during the extension period only to equipment installed and used in a residential solar energy system. A frame or wall which contains transparent glass, plastic or their counterparts and which encloses an area and creates, in effect, a sunroom or a greenhouse will not be treated as solar energy equipment. Glazing material that is attached directly to solar equipment, e.g., the covering of a heat absorber placed on a roof or suspended from a wall, is treated as a constituent component of the heat absorbing equipment unit and eligible for the credit as a component of the heat absorber.

The present law two-year carryforward rule for the solar energy credit also is extended for an additional three years, thus making it possible to carryforward unearned residential solar credits through 1990. The provision in present law which allows carryforward of unused residential geothermal and wind energy credits through 1987 is continued and will terminate as scheduled.

The residential energy tax credits for insulation and other energy conservation property, geothermal property, wind energy property, and photovoltaic property are allowed to expire after December 31, 1985, as Scheduled in present law. The two-year carry-forward of unused credits is continued through 1987, as in present law.

2. Business energy tax credits

(sec. 272 of the bill and secs. 46 and 48 of the Code)

Solar or wind energy property

A 15-percent energy tax credit is allowed for placing in service before January 1, 1986, solar or wind energy property, which is defined to include any equipment which uses solar or wind energy to generate electricity, to heat or cool a structure or provide hot water for use within the structure, or to provide solar process heat. Generally, these functions are accomplished by the use of such equipment as collectors which absorb sunlight and create hot liquids or air, storage tanks to store hot liquids, rockbeds to store heat, thermostats to activate pumps, fans to circulate hot air, and heat exchangers. The business solar energy credit does not apply to passive solar applications.

Geothermal and ocean thermal property

Energy credits of 15 percent also are allowed for ocean thermal property only at 2 locations designated by the Secretary and geothermal property. The credit for geothermal property covers equipment used to produce, distribute, or use energy derived from a geo thermal deposit, but in the case of electricity generated by geothermal power, only up to (but not including) the electrical transmission stage. The term geothermal deposit has the same meaning for the business energy investment credit as that provided in Treasury regulations for the residential renewable energy credit, which is summarized above.

Ocean thermal property includes equipment which converts ocean thermal energy through a heat exchange system into energy usable for generation of electricity. The credit was made available for equipment that could be placed in service at the locations which would be designated by the Secretary of the Treasury after consultation with the Secretary of Energy.

Small-scale hydroelectric generating property

An 11-percent energy credit has been allowed for equipment placed in service at a qualified hydroelectric Site. A qualified site is one at which there is a dam that was completely constructed before October 18, 1979, and not significantly enlarged after that date, or where electricity can be generated without any dam or other impoundment of water. Eligible property includes equipment to generate electricity (but not equipment for electrical transmission) and structures for housing the generating equipment and fish passageways. The full credit is limited to equipment that provides 25 or more megawatts of generating capacity, and the credit phases out as generating capacity is increased from 100 to 125 megawatts. A qualified site and equipment may not have installed generating capacity greater than 125 megawatts. This credit expires after 1985, but it continues to be available through 1988 for property for which an application has been docketed by FERC by December 31, 1985.

Biomass property

A 10-percent business credit is available for biomass property placed in service before January 1, 1985. In general, biomass property is defined as a boiler or burner that uses an alternate substance and as equipment for converting an alternate substance into a qualified fuel. An alternate substance with respect to biomass property means any property other than oil or natural gas, or any product of oil or natural gas, except that an alternate substance does not include any inorganic substance and does not include coal (including lignite) or any product of such coal. Qualified fuel is defined as any synthetic solid fuel, and alcohol for fuel purposes, if the primary source of energy for the facility producing the alcohol is not oil or natural gas (or a product of oil or natural gas).

Qualified intercity buses

A 10-percent credit is allowed only for the acquisition of an intercity passenger bus that produces an increase in the operating seating capacity of the taxpayer's bus fleet for the taxable year over the preceding year. The bus must be placed in service by a taxpayer which is a common carrier regulated by the Interstate Commerce Commission or an appropriate State agency and which is engaged in the trade or business of furnishing intercity passenger transportation or intercity charter service by bus. A qualified bus must have seating capacity of more than 35 passengers (in addition to the driver), and 1 or more baggage compartments, separated from the passenger area, with a capacity of at least 200 cubic feet.

Experience with the credits indicates that primarily two alternative energy sources, business solar energy property and geothermal property, have demonstrated responsiveness to the credit and warrant additional limited support through a phaseout of the credit, rather than a full extension of the credits. The credits for the other alternative energy sources or uses are not extended or phased out because they have not demonstrated that the stimulation to demand from a tax credit is necessary. The absence of favorable technological developments in other renewable energy areas or the inability to find ways to reduce potentially high capital or operating costs have convinced the committee that the energy tax credits for most of the other renewable energy property are premature and have failed to stimulate a meaningful level of demand.

The committee found, in addition, that some of the expiring business energy credits were used in conjunction with other tax subsidy provisions in the Code to create generous tax shelters. Furthermore, renewable energy systems used to produce electricity have been able to sell the electricity to electric utility systems at avoided cost--i.e., the utility's cost of generating electricity--which means that in addition to generous tax provisions, the projects were guaranteed a high price for sale of their output. The committee decided to allow these credits to expire as scheduled.

The business energy tax credit for solar energy systems is extended for three years at declining rates: 15 percent in 1986; 12 percent in 1987; and 8 percent in 1988. The credit will terminate after December 31, 1988. Business photovoltaic cell equipment continues to be eligible for the phased down credit as a form of solar energy. No other changes are made in present law with respect to business solar energy systems.

b. Geothermal energy property

The energy tax credit for geothermal energy systems is extended for a 3-year period at a declining rate: 15 percent in 1986, and 10 percent in 1987 and 1988. The credit will terminate after December 31, 1988. No other changes are made in present law with respect to business geothermal energy systems.

c. Expiring credits

The energy tax credits for wind energy property, ocean thermal energy property, intercity buses, biomass property, and small-scale hydroelectric projects are allowed to expire after December 31, 1985, as is scheduled in present law. With respect to the hydroelectric projects for which applications are docketed by FERC before January 1, 1986, the credit will continue to be available with respect to such docketed projects for equipment placed in service before January 1, 1989.

d. Affirmative commitment

Present law affirmative commitment provisions are continued for energy projects that meet the statutory requirements but, as with the general investment credit, only 20 percent of the credits allowable after 1985 may be used in any one taxable year to reduce tax liability.

3. Nonconventional sources fuels production tax credit

(sec. 273 of the bill and sec. 29 of the Code)

The credit equals $3 for each 5.8 million Btu's of energy. (One barrel of crude oil contains approximately 5.8 million Btu's.) All Btu measurements must be made without regard to any Btu's attributable to materials or energy sources other than the qualified fuel. Except for gas produced from a tight formation, the $3 amount is indexed for post-1979 increases in the GNP deflator.

The credit phases out as the annual average wellhead price of uncontrolled domestic oil rises from $23.50 to $29.50 a barrel. The phaseout range is adjusted for post-1979 changes in the GNP deflator and has risen to $32.10 and $40.30, respectively, in 1984 prices.

The credit is available for production and sale of the following fuels:

Because investors in existing facilities relied on the production credits when committing their funds, the committee provides a transitional rule under which the credit continues for the sale of fuels from wells or facilities placed in service before 1986.

An exception is made for a new technology with which wood is used to produce methane gas for fuel, if the gas-producing facility is installed on the premises of a facility which will use the methane as a fuel. For installations of this technology, the production credit will be available for fuel sold before 2001 from a facility placed in service before January 1, 1989.

The production tax credit for methane gas fuel produced from wood is available through December 31, 2000, for fuel production from a domestic facility placed in service before January 1, 1989.

4. Alcohol fuels credit and related excise tax exemptions

(secs. 274 and 275 of the bill and secs. 40, 4041, 4081, and 6427 of the Code)

A 60-cents-per-gallon tax credit is allowed for alcohol used in certain mixtures of alcohol and gasoline (i.e., gasohol), diesel fuel, or any special motor fuel if the mixture is sold by the producer for use as a fuel or is used as a fuel by the producer. The credit also is permitted for alcohol (other than alcohol used in a mixture with other taxable fuels) if the alcohol is used by the taxpayer as a fuel in a trade or business or is sold at retail by the taxpayer and placed in the fuel tank of the purchaser's vehicle.

The amount of any person's allowable alcohol fuels credit is reduced to take into account any benefit received with respect to the alcohol under the excise tax exemptions for alcohol fuels mixtures or alcohol fuels.

The credit is scheduled to expire after December 31, 1992.

Excise tax exemptions for alcohol fuels mixtures and alcohol fuels

Duty on imported alcohol fuels

Alcohol imported into the United States for use as a fuel is subject to an additional tariff of 60 cents per gallon from most sources. However, under the Caribbean Basin Economic Recovery Act (CBERA), such alcohol produced in a beneficiary country and imported directly into the United States from a beneficiary country would be eligible for duty-free treatment. The same is true under General headnote 3(a) of the Tariff Schedules of the United States (TSUS) for alcohol produced in U.S. insular possessions.

The CEBRA established stringent rules of origin criteria to determine eligibility for duty-free treatment under the Caribbean Basin Initiative (CBI) program in order to discourage the establishment of simple pass-through operations in CBI countries. The U.S. Customs Service has ruled that the distillition of non-CBI beverage grade alcohol via the azeotropic distillation process (which in effect removes the final 5 percent of water in the alcohol bringing it from 190 proof to 199.5 proof) satisfies the substantial transformation criteria required by the CBERA for the alcohol to be considered a product of the CBI country. Therefore the ethyl alcohol which is merely dehydrated/distilled in the CBI country is entitled to duty-free treatment upon import into the United States. Similar rulings have been issued with regard to alcohol from U.S. insular possessions.

The committee is concerned that the simple distillation process for dehydrating ethyl alcohol does not represent the type of economic activity that will increase employment and productivity in the Caribbean area in the way that was intended in the CBI program.

The 60-cents-per-gallon nonrefundable income tax credit allowed for alcohol mixed with gasoline, diesel fuel or any special motor fuel is repealed effective after December 31, 1985.

b. Excise tax exemptions for alcohol fuels and mixtures

Gasoline and motor fuels excise tax exemption for mixtures with alcohol and for alcohol fuels are continued in effect as in present law, with one exception. The excise tax exemption for neat ethanol and methanol fuels is reduced from 9 cents per gallon to 6 cents per gallon. As in present law, these exemptions will continue in effect until the scheduled expiration after December 31, 1992.

c. Alcohol import duty

The committee agreed on the need to establish a rule with respect to CBI imports of alcohol which would permit orderly growth in such imports while at the same time phasing out use of the program of merely removing the water from alcohol transferred from other countries. The committee recognized that the U.S. Customs Service made a factual determination that the azeotropic distillation process is sufficient to meet the existing substantial transformation requirements of the CBI and that certain parties have relied in good faith on that ruling. However, the committee finds that this process should be reexamined because it does not represent the real economic investment in the Caribbean region that was envisioned by the committee in establishing the CBI program. The committee has been provided with information which indicates a simple dehydration facility requires only 5-10 percent of the capital investment and far fewer employees to operate than is the case with an "A to Z" ethanol plant which converts the raw agricultural product into fuel grade alcohol. Therefore allowing the azeotropic distillation process to qualify the alcohol for duty-free entry may actually be retarding economic development in the region by discouraging others from establishing full fermentation operations in the Caribbean. It should also be noted that merely closing the loop-hole in the CBERA is insufficient if the corresponding loophole is not addressed allowing for the same tariff treatment of azeotropically distilled alcohol from the insular possessions. Therefore, the committee directed the Trade Subcommittee to develop a rule, after receiving the views of interested parties through a public hearing, which would not only encourage imports of fuel alcohols from CBI countries and U.S insular possessions but also encourage meaningful economic investment in these regions by discouraging "pass-through" operations. Such a change should provide transition rules for existing operations which have relied on the Customs Service ruling. The subcommittee was directed to move expeditiously on this matter.

The provision reducing the excise tax exemption for neat ethanol and methanol fuels from 9 cents per gallon to 6 cents per gallon is effective on and after January 1, 1986.

5. Three-year extension of refund of taxes on fuels used in qualified taxicabs

(sec. 275 of the bill and sec. 6427 of the Code)

A partial 4-cents-per-gallon exemption from the motor fuels taxes was provided for fuel used in certain taxicabs. The exempt portion of the tax was refunded (without interest) to the ultimate purchaser of the fuel. To qualify for this refund, the taxicab had to be operated by a licensed person who was not prohibited by company policy from furnishing shared transportation and generally must not have been of a type with below-average fuel economy. This partial exemption expired on October 1, 1985.

Individuals who will be eligible for refunds from October 1, 1985, will be able to follow the same refund procedure that was in effect before October 1, 1985.

(sec. 282 of the bill and sec. 51 of the Code)

The targeted jobs tax credit (Code sec. 51) was enacted in the Revenue Act of 1978 to replace the expiring credit for increased employment. AS originally enacted, the targeted jobs credit was scheduled to terminate after 1981.

The availability of the credit was successively extended by the Economic Recovery Tax Act of 1981 (ERTA) for one year, the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) for two years, and the Deficit Reduction Act of 1984 (the 1984 Act) for one year. Under present law, the credit will not apply with respect to individuals who begin work for the employer after December 31, 1985. For individuals beginning work before 1986, the credit is available for wages paid during the following 24 months of employment (see below).

ERTA, TEFRA, and the 1984 Act altered the targeted group definitions and made several technical and administrative changes in the credit provisions. In addition, TEFRA authorized the appropriation of such sums as may be necessary for the expenses of administering the system for certifying targeted group membership and for the expenses of providing publicity to employers regarding the targeted jobs credit. The 1984 Act extended the authorization for appropriations for administrative and publicity expenses to fiscal year 1985.

Targeted jobs credit rules

The targeted jobs tax credit is available on an elective basis for hiring individuals from one or more of nine targeted groups. The targeted groups are (1) vocational rehabilitation referrals; (2) economically disadvantaged youths (ages 18-24); (3) economically disadvantaged Vietnam-era veterans; (4) SSI recipients; (5) general assistance recipients; (6) economically disadvantaged cooperative education students (ages 16-19); (7) economically disadvantaged former convicts; (8) AFDC recipients and WIN registrants; and (9) economically disadvantaged summer youth employees (ages 16-17).

The credit generally is equal to 50 percent of the first $6,000 of qualified first-year wages plus 25 percent of the first $6,000 of qualified second-year wages paid to a member of a targeted group. Thus, the maximum credit is $3,000 per individual in the first year of employment and $1,500 per individual in the second year of employment. With respect to economically disadvantaged summer youth employees, however, the credit is equal to 85 percent of up to $3,000 of wages, for a maximum credit of $2,500. The employer's deduction for wages must be reduced by the amount of the credit.

The credit may not exceed 90 percent of the employer's tax liability after being reduced by certain other non-refundable credits. Excess credits may be carried back three years and carried forward 15 years.

Although the committee has limited the credit in certain respects, the resulting reduction in tax benefits to some employers will be wholly or partially offset in many cases by the tax savings arising from the bill's general reduction in tax rates.

The bill also limits the credit in three respects. First, the 25-percent credit for qualified wages paid in the second year of a targeted individual's employment is eliminated. Second, the 50-percent credit for qualified first-year wages generally is reduced to a 40-percent credit. Thus, the bill, generally reduces the maximum credit per employee from $4500 (50 percent of $6000 plus 25 percent of $6000) to $2400 (40 percent of $6000). The bill does not reduce, however, the credit presently allowed for wages of economically disadvantaged summer youth employees (85 percent of up to $3,000 of qualified first-years wages).

Third, under the bill, no wages are to be taken into account for credit purposes with respect to any individual if that individual is employed by the employer for less than 14 days.

The bill also extends the authorization for appropriations for administrative and publicity expenses to fiscal years 1986 and 1987.

2. Extension of tax credit for orphan drug clinical testing

(sec. 283 of the bill and sec. 28 of the Code)

Rare diseases in this program are identified by the Food and Drug Administration, which initially finances laboratory and small-scale clinical testing by independent researchers. These tests provide data which establish the basis for a research-oriented drug firm to decide to undertake more extensive testing. The tax credit is allowable for the more extensive testing.

Testing expenditures eligible for the 50-percent credit may not be expensed as research and experimental expenditures under section 174, without reduction for the amount of the credit. A taxpayer may not claim the 25-percent credit for incremental research activities (sec. 30) with respect to expenditures for which the orphan drug credit is claimed. Present law provides that the orphan drug credit will not be available for amounts paid or incurred after December 31, 1987.

Corporate taxable income is subject to tax under a five-step graduated tax rate structure. The top corporate tax rate is 46 percent on taxable income over $100,000. The corporate taxable income brackets and tax rates are presented in the table, below.

      PRESENT LAW CORPORATE TAX RATES

An additional 5-percent corporate tax is imposed on a corporation's taxable income in excess of $1 million. The maximum additional tax is $20,250. This provision phases out the benefit of graduated rates for corporations with taxable between $1 million and $1,405,000: corporations with taxable income in excess of $1,405,000, in effect, pay a flat tax at a 46-percent rate. This provision was enacted in the Deficit Reduction Act of 1984, effective for taxable years beginning after 1983.¹

^{Corporate capital gains tax rate}

^{An alternative tax rate of 28 percent applies to a corporation's net capital gain (the excess of net long-term capital gain over net short-term capital loss) if the tax computed using that rate is lower than the corporation's regular tax (sec. 1201). Corporate capital losses are deductible only against capital gain. Capital losses generally can be carried back 3 years and forward 5 years.}

The committee retained graduated rates for small corporations. The present law graduated rates for lower income corporations are intended to encourage growth in small business by easing the tax burden on such businesses. In many provisions of the bill, the committee has found it appropriate to provide special relief to small business. However, the committee more narrowly targeted the beneficiaries of this provision by phasing out the benefit of graduated rates for corporations with taxable income in excess of $365,000, as compared to $1,405,000 under present law. In addition, the committee simplified the present graduated rate structure for corporations by reducing the number of brackets from 5 to 3.

Under present law, large corporations obtain preferential treatment of capital gains income (28-percent alternative rate compared to 46-percent regular rate). The committee is of the view that corporate capital gain should not be taxed at preferential rates. Thus, the bill conforms the corporate capital gains rate with the regular tax rate for large corporations.

Under the bill tax would be imposed on corporations under the Schedule shown in the following table.

        CORPORATE TAX RATES IN BILL

Corporate capital gains

The alternative tax rate for net capital gains of corporations is increased to 36 percent--the top corporate tax rate for ordinary income. Present law limitations on the deduction of capital losses are retained.

The increase in the alternative tax rate on corporate capital gain generally is effective for tax years ending after December 31, 1985. Under a transition rule, the 28-percent rate would be retained for "pre-1986" net capital gain. Pre-1986 net capital gain is measured as the lesser of: (1) net capital gain for the taxable year; and (2) net capital gain attributable to dispositions of property on or before September 25, 1985 (or pursuant to a written binding contract in effect on that date) or that is included in income under the taxpayer's method of accounting, before January 1, 1986. The effect of this transition rule generally is to tax, at a 28-percent maximum rate, net gain recognized before 1986 or pursuant to a binding contract in effect on September 25, 1985. The effect of limiting pre-1986 net capital gain to the net capital gain for the taxable year is to stack post-1986 capital losses first against capital gain still eligible for the 28-percent maximum rate.

Under a transition rule, the capital gains rate applicable to timber, coal, and domestic iron ore royalties is phased up to 30 percent for tax years beginning in 1986, 31 percent in 1987, 32 percent in 1988, and 36 percent for tax year beginning in or after 1989 (see sec. 243 of the bill).

Under present law, corporations and their shareholders generally are treated as separate taxable entities. Subject to certain exceptions, the corporation's taxable income is subject to a corporate income tax; then dividends distributed to individual shareholders are taxable as ordinary income.² Thus, corporate income that is distributed as dividends to shareholders generally is subject to two tiers of taxation.

In contrast, amounts distributed by a corporation as interest payments to creditors rather than as dividends to shareholders generally are not taxed at the corporate level, since the corporation generally may deduct interest payments from its taxable income (sec. 163). In addition, since no income tax generally is imposed at the shareholder level with respect to corporate income prior to its distribution, corporate income that is not distributed to shareholders is subject to current tax at the corporate level only.³ Further, income earned outside of corporate solution is subject to only one level of tax.

Corporate income not subject to two tier taxation

Income earned by certain corporations is not subject to the general regime of two tier taxation of corporate earnings. Such corporations are corporations electing under subchapter S ("S Corporations") (secs. 1361 et seq.), regulated investment companies ("RICs") (secs. 851 et seq.), real estate investment trusts ("REITs") (secs. 856 et seq.), and cooperatives subject to subchapter T of the Code (secs. 1381 et seq.).

S corporations are corporations that meet restrictions on the number of shareholders as well as certain other requirements, and that also elect special treatment under subchapter S. RICs and REITs are entities that derive a substantial portion of their income from essentially passive investments and that absent special provisions in the Code otherwise would be taxed as ordinary corporations. Cooperatives generally are corporations that either market products or purchase goods for its members, or that otherwise are operated on a cooperative basis.

Income earned by an S corporation is allocated among and taxed directly to its shareholders regardless of whether such income is distributed. Income earned by a RIC or a REIT is subject to a tax at the corporate level, but both RICs and REITs are permitted deductions for dividends paid, in effect eliminating the corporate tax on earnings that are distributed. Moreover, in order to maintain the status of a RIC or a REIT, such entities are required to distribute most of their income currently.

Cooperatives generally are subject to tax at the corporate level but may exclude from income the amount of dividends paid out of profits derived from transactions with their members. Additionally, a cooperative may exclude income attributable to qualified per-unit retain allocations and redemptions of nonqualified per-unit retain certificates. As a result, cooperatives generally pay corporate tax only on profits that are not distributed or otherwise allocated to shareholders, and on profits not derived from transactions with members.⁴ Cooperative members who receive dividends or have other amounts paid or allocated to them generally treat such amounts as income, reduction of basis, or some other characterization that is appropriate based on the nature of the members' transactions with the cooperative.

Distributions to foreign shareholders

Dividends paid by a U.S. corporation to foreign shareholders generally are subject to a 30 percent tax (secs. 861, 871, 881), which the distributing corporation (or appropriate agent) is required to withhold (secs. 1441, 1442). The rate of the U.S. tax may be substantially reduced pursuant to various income tax treaties, however.

A portion of dividends paid by a foreign corporation to its foreign shareholders is also subject to the U.S. tax (and the withholding requirement) if at least 50 percent of the foreign corporation's income earned in a specified period is effectively connected with the conduct of a trade or business within the United states. The portion of the dividend that is subject to the U.S. tax is that portion of the dividend that bears the same ratio to the total dividends paid that the foreign corporation's income effectively connected with its U.S. trade or business bears to its total income (see sec. 861(a)(2)(B)).

Distributions to tax-exempt shareholders

In general, an organization exempt from tax under section 501 of the Code has no tax liability on account of dividends received. However, such a tax-exempt entity generally is subject to tax on its "unrelated business income" (sec. 511). In addition, for such an entity, dividend income derived from "debt-financed property" is treated as taxable unrelated business income (sec. 514).

Policyholder dividends paid by mutual life insurance companies

Under present law, the deduction for policyholder dividends of mutual life insurance companies is reduced by an amount referred to as the differential earnings amount (sec. 809). Because a mutual company's policyholders are also the owners of the enterprise (which is not the case for stock companies, whose stockholders are its owners), the policyholder dividends paid represent, in part, a return of the company's profits. The differential earnings amount generally is the measure of the amount that is a distribution of profits to the policyholders as owners.

The differential earnings amount is determined by multiplying a company's average equity base for the taxable year by the differential earnings rate for the taxable year. The computation of such amount takes into account the fact that policyholder dividends generally are not includible in policyholders' income. The differential earnings amount for any taxable year is recomputed when sufficient tax return information is available to determine the average mutual earnings rate for the calendar year in which the taxable year begins. If the recomputed differential earnings amount computed with respect to a given taxable year exceeds or is less than the differential earnings amount reported on the company's tax return for that year, then the difference is includable (or deductible) in the succeeding taxable year.

Since such distortions occur only to the extent that corporate tax is borne by a corporation, the committee believes that the deduction should be limited to distributions of earnings that have borne a corporate level tax. Moreover, since the income of certain corporations is generally not subject to two tiers of tax (e.g., S corporations and cooperatives), the committee does not believe that it would be appropriate to extend any relief to such corporations.

Further, the committee believes that, to the extent mutual life insurance company policyholder dividends represent nondeductible distributions of earnings that have been subject to tax at the corporate level, an appropriate portion of such policyholder dividends should be eligible for a deduction equivalent to the deduction for dividends paid out of such earnings available to stock companies. Therefore, the committee has added a provision intended to accomplish this result.

Nevertheless, the committee believes that the granting of a dividends paid deduction should not have the effect of lowering the total tax collected on income earned through U.S. corporations by foreign persons (not subject to U.S. tax), particularly where the foreign county may unfairly discriminate against the U.S. in granting similar relief from a two-tier tax system, or where the foreign country does not cooperate with the U.S. to prevent treaty shopping. Thus, the committee bill imposes a compensatory withholding on dividends paid to foreign shareholders in certain circumstances.

The committee also believes that the dividends paid deduction should not have the effect of eliminating completely the tax on business income. Thus, the committee bill treats a portion of dividends paid to significant tax-exempt shareholders as taxable unrelated business income where the dividends are eligible for the deduction.

The committee bill adds new sections 231 through 234 to the Code. Under these new provisions, which are phased in over ten years, a domestic corporation generally is entitled to a deduction equal to 10 percent of its dividends paid from earnings that have been subject to tax at the corporate level. The deduction is not available to regulated investment companies, real estate investment trusts, S corporations, cooperatives subject to subchapter T, DISCs or FSCs. Distributions in redemption of stock (including transactions deemed to be redemptions under section 304), in liquidation, or in a reorganization are not eligible for the dividends paid deduction regardless of whether any portion of the distribution is treated as a dividend distribution to which section 301 applies.

Under the committee bill, the dividends paid deduction is treated like an ordinary business deduction for the purpose of determining the corporation's income tax liability, including the liability for estimated tax payments. The dividends paid deduction does not, however, reduce earnings and profits, which is otherwise reduced by the full amount of a dividend, whether or not deductible. Net operating losses attributable to the dividends paid deduction are available to be carried back and forward to the extent permitted for net operating losses generally under present law.

The qualified dividend account

Under the committee bill, dividends are eligible for the dividends paid deduction only to the extent that such dividends do not exceed the amount of a "Qualified Dividend Account" ("QDA"). Generally, the QDA consists of the amount of corporate earnings that have been subject to the corporate tax, less the amount of deductible dividends paid.

At the end of each taxable year, a corporation adds to its QDA its "adjusted taxable income" for the year. Adjusted taxable income generally is equal to the taxpayer's taxable income (i.e., gross income less deductible expenses), with certain adjustments that are intended to ensure that the QDA properly reflects the amount of earnings on which a corporate tax has been paid.

Accordingly, the following adjustments are made to taxable income in arriving at the adjusted taxable income. First, taxable income is computed without regard to the dividends paid deduction. Second, taxable income is reduced by the "deduction equivalent" of any available credit (including the foreign tax credit), other than the credit under section 34 (relating to credits for certain uses of gasoline and special fuels) (i.e., amounts on which no corporate tax was paid as a result of such credits). Third, taxable income is increased by the amount of any 70 percent or 90 percent dividends received deduction.⁵ Finally, to reflect the payment of any minimum tax, which is based on an alternative computation of taxable income, an amount equal to 10O/36ths of the minimum tax liability is added to taxable income; the amount of this adjustment is made in the subsequent taxable year, however.⁶

In the event of an adjustment to any element of the corporation's adjusted taxable income for a taxable year (whether by reason of any carryback to such year or otherwise), the adjustment is treated as having been made as of the end of such taxable year. For example, suppose a calendar year corporation has a total QDA of $100 at the end of 1988 after adding adjusted taxable income of $100 for that year, and before deducting the amount of any dividends paid. The corporation paid $100 of dividends during the year and, accordingly, took a $1 dividends paid deduction. In 1989 the corporation suffers a $100 net operating loss that is carried back to 1988. Since this adjustment is treated as having been made in 1988, the corporation's dividends paid deduction for that year would be disallowed since its QDA at the end of the year (before reduction for dividends paid) would have been reduced to zero.

The QDA is treated as a carryover item under section 381 in certain merger or acquisition transactions. In the case of complete liquidations (other than liquidations of controlled subsidiaries under section 332), a corporation's QDA is eliminated completely. In the case of redemptions or partial liquidations, the QDA is reduced proportionately with the amount of stock redeemed or portion of the stock liquidated, but not in excess of the amount of redemption or liquidation proceeds distributed to shareholders. This is analogous to the treatment of the earnings and profits account upon redemptions or partial liquidations (sec. 312(h) and sec. 312(n)(7)).

Treatment of foreign corporations and foreign shareholders of foreign corporations

Under the committee bill, a foreign corporation is entitled to the dividends paid deduction in certain circumstances. To be eligible for the dividends paid deduction, a foreign corporation must meet the requirements of section 245(a), regarding whether the dividends it pays are eligible for any dividends received deduction. Thus, certain foreign corporations, at least 50 percent of whose income is effectively connected with a U.S. trade or business, may receive the dividends paid deduction. The deduction is available, however, only with respect to a pro rata portion of the dividends paid, i.e., that portion which bears the same ratio to the dividends paid as the corporation's income effectively connected with a U.S. trade or business bears to its total income as computed for purposes of section 245(a).

Foreign shareholders

Under the committee bill, a corporation is entitled to the dividends paid deduction without regard to whether the dividends are paid to domestic or foreign shareholders. However, the committee bill adds new section 898 to the Code, which imposes an additional tax on dividends paid to foreign shareholders in certain circumstances. Under new section 898, a tax in addition to that imposed by sections 871 or 881, is imposed on dividends received from sources within the United States by a nonresident alien or foreign corporation. The tax is subject to the withholding requirements of section 1441 or 1442, whichever is applicable.

The amount of tax imposed under section 898, is equal to the percentage dividends paid deduction that would be allowed to the payor for the taxable year in which it pays the dividend, times the top corporate income tax rate. Thus, when the dividends paid deduction is fully phased in, the additional withholding tax would be equal to 3.6 percent of the amount of dividends. The tax is imposed whether or not the dividends paid deduction is actually allowed with respect to the dividends paid.

The additional tax under 898 generally is imposed on all foreign shareholders regardless of whether any treaty provides a limit on the amount of tax to which the foreign shareholder may be subject. However, the additional tax is not imposed on dividends paid to foreign shareholders if at the time such dividends are paid, there is an income tax treaty in effect between the U.S. and the recipient shareholder's country that would prevent the imposition of the additional tax, and there is also in effect a certification by the Secretary of the Treasury that (a) such treaty has adequate provisions to prevent treaty shopping, and (b) if such country has a two-tier tax on corporate income similar to that of the U.S., and such country grants relief from such tax to national shareholders, that it also grants to U.S. shareholders relief equivalent to that provided by the dividends paid deduction.

Distributions to tax-exempt shareholders

Under the committee bill, a portion of dividends paid to certain tax-exempt entities, with respect to which the payor is entitled to a dividends paid deduction, is treated as "unrelated business income" that is subject to tax under section 511 of the Code. The shareholders whose dividends are so treated are organizations exempt from tax under section 501, that own five percent or more (by value) of the outstanding stock of a corporation, or stock possessing five percent or more of the total combined voting power of all stock of the corporation. The stockholdings of certain related tax-exempt entities are aggregated for this purpose.

The portion of such dividends that is treated as unrelated business income is the portion that bears the same ratio to the dividends received that the amount of dividends paid by the corporation in the taxable year with respect to which the dividends paid deduction is allowable to the payor corporation bears to the total dividends paid. Thus, the recipient five-percent tax-exempt shareholder must determine whether and to what extent the payor corporation is entitled to the dividends paid deduction with respect to its distributions during the year. In addition, during the phase-in period, the recipient shareholder must determine the taxable year of the distributing corporation in order to determine the appropriate percentage of the dividend to include in income.

Under the committee bill, whether dividends received by a five-percent tax-exempt shareholder are subject to the tax is determined solely on the basis of the dividends paid deduction that is allowable based on the return filed by the payor corporation for the year that the distribution was made.⁷ Thus, if a payor corporation initially claims a dividends paid deduction with respect to the dividends paid to the five-percent tax-exempt shareholder, but the deduction is later disallowed or not claimed, whether on account of the filing of an amended return, the making of an audit adjustment, or the carryback of net operating losses, there would be no adjustment of the tax liability of the recipient shareholder.⁸

^{Source rules}

^{The committee intends that the dividends paid deduction is to be allocated between U.S. and foreign source income and that the Secretary of the Treasury will provide appropriate regulations relating to the exact method of allocation. The committee anticipates that the allocation to a particular source generally is to be proportionate to the amount of earnings from the particular source in the QDA out of which the dividend was paid. The committee intends that these regulations would properly account for the source of adjustments made to taxable income in arriving at adjusted taxable income; for example, the amount by which the QDA is reduced on account of the foreign tax credit should be allocated entirely to foreign source income since this adjustment is attributable only to such income. Moreover, the committee intends that the allocation of the source of a dividend is to be made for this purpose on an aggregate, rather than a year-by-year basis.}

^{Policyholder dividends by mutual life insurance companies}

^{Under the committee bill, a portion of the policyholder dividends paid by a mutual life insurance company is treated as a dividend that is eligible for the 10 percent dividends paid deduction. For this purpose, the portion of such policyholder dividends treated as a dividend eligible for the 10 percent deduction for any taxable year is 80 percent of the differential earnings amount for the taxable year. The committee intends that such portion of policyholder dividends is eligible for the dividends paid deduction only if all other requirements for the deduction are met (e.g., sufficient amounts in the QDA). Moreover, all other provisions of the committee bill relating to the dividends paid deduction, such as the additional tax under section 898, also apply with respect to the deduction for the portion of policyholder dividends treated as dividends eligible for the 10 percent deduction. Under the committee bill, the Secretary of the Treasury is authorized to prescribe regulations applying rules regarding the dividends paid deduction for mutual life insurance companies, including rules with respect to the treatment of an appropriate portion of the recomputed differential earnings amount as an adjustment to the amount treated as dividends paid by such companies.}

The additional tax on dividends paid to certain foreign shareholders generally is imposed on dividends paid after December 31, 1987. However, for foreign shareholders who are otherwise entitled to a lower rate under a treaty, and not eligible to be excepted from the additional tax, such tax is imposed only on dividends paid after December 31, 1988. This tax is also phased in to coincide with the dividends paid deduction available to the payor.

In general, dividends received by a U.S. corporation from a foreign corporation are not eligible for the dividends received deduction, even though the foreign corporation may have paid U.S. income tax. However, a portion of the dividends paid by such corporation to a U.S. corporate shareholder is eligible for the dividends received deduction, where at least 50 percent of a foreign corporation's gross income is effectively connected with a U.S. trade or business during an uninterrupted period of 36 months ending with the close of the year in which the dividends are paid (or for the period of the corporation's existence, if shorter). That portion generally is based on the percentage of the foreign corporation's income that is effectively connected with its U.S. trade or business (sec. 245).

Where a foreign corporation is wholly owned by a U.S. corporation and all of its income is effectively connected with a U.S. trade or business, dividends paid by such corporation generally are eligible for a 100 percent dividends received deduction. In addition, certain dividends paid by a corporation that is or was a foreign sales corporation also are eligible for a 100 percent dividends received deduction.

The dividends received deduction does not apply to certain dividends, including dividends received from a thrift institution that was entitled to a deduction under section 591 for dividends paid (sec. 243(c)(1)), dividends received from a REIT (sec. 243(c)(3)), dividends on certain public utility preferred stock (sec. 243(c)(4)), dividends received from certain corporations that were exempt from tax under section 501 or section 521 in the year of the distribution or the preceding year (sec. 246(a)(1)), and certain dividends received from a Federal Home Loan Bank Bank (sec. 246(a)(2)). The availability of the dividends received deduction is limited with respect to dividends received from a RIC (sec. 243(c)(2)).

The dividends received deduction is also not available with respect to dividends received on stock that is not held (with a substantial risk of loss) for a specified period, generally more than 45 days (90 days in the case of certain preferred stock) (sec. 246(c)), dividends from a DISC or former DISC (sec. 246(d)), and certain dividends distributed pursuant to the provisions of section 936 of the Code (relating to the Puerto Rico and possessions tax credit) (sec. 243(e)). The deduction is also limited for dividends received on certain "debt-financed portfolio stock" (sec. 246A) and for dividends received by certain thrift institutions that compute bad debt reserves under the percentage of income method (sec. 596). In addition, there is an overall limit on the availability on the dividends received deduction generally equal to 85 percent of the recipient's taxable income subject to certain adjustments (sec. 246(b)).

Under the committee bill, the 85 percent dividends received deduction is lowered to 80 percent. In addition, after a phase in period, a corporation that receives dividends eligible for a dividends received deduction under present law generally is entitled either to a 100 percent, a 90 percent, or a 70 percent dividends received deduction. Generally, the shareholder's dividends received deduction depends on whether or not the dividend is received from an affiliated corporation (as defined in section 243(b)(5)), and if so, whether the affiliate was entitled to a dividends paid deduction. The provisions of the committee bill are phased-in in a manner that roughly corresponds to the phase-in of the dividends paid deduction.

Dividends from affiliates

Under the committee bill, as fully phased in, where a corporate shareholder receives a qualifying dividend from an affiliate that would be eligible for the 100 percent dividends received deduction under present law, and the payor corporation is entitled to a dividends paid deduction with respect to such dividend, the shareholder is entitled to a 90 percent dividends received deduction. Where a corporate shareholder receives such a qualifying dividend and no dividends paid deduction is available with respect to such dividend (because the distributing corporation did not pay any corporate tax on the distributed earnings), the recipient shareholder is entitled to a 100 percent dividends received deduction under the bill.⁹

^{To comply with these rules, the shareholder corporation must determine the amount of the dividends it received with respect to which a dividends paid deduction was allowed to the payor corporation.10}

^{Dividends from non-affiliates}

^{Under the committee bill, dividends eligible for the 85 percent dividends received deduction under present law are eligible for an 80 percent dividends received deduction at the beginning of a phase in period. During the phase in period, the deduction is decreased to 70 percent of dividends received. Further, under the committee bill as fully phased in, a corporation that receives a dividend from a small business investment company, which dividend would be eligible for the 100 percent dividends received deduction under present law section 243(a)(2), is entitled to a 90 percent dividends received deduction. The percentage of the dividends received deduction in either case does not vary depending on whether the payor received any dividends paid deduction.}

^Limitations

^{The committee bill does not alter any of the provisions of present law that limit or deny the dividends received deduction in certain circumstances (e.g., sec. 246). Accordingly, in such circumstances, the full amount of the dividend would be taken into account in computing the recipient corporate shareholder's taxable income, no dividends received deduction would be allowed to the shareholder, and no special rules would be used to compute the amount to be added to the shareholder's QDA. The payor corporation, if otherwise eligible, remains entitled to the 10 percent deduction for the dividend paid, however.}

The provision of the committee bill modifying the dividends received deduction for qualifying dividends (and for dividends eligible for the the dividends received deduction under section 245(b)) generally is effective for taxable years of the payor corporation beginning after January 1, 1987 and is phased in over a ten-year period corresponding to the phase in of the dividends paid deduction. The phase in of this provision is based on the taxable year of the payor and the percentage dividends paid deduction the payor is entitled to with respect to the dividend. Thus, for example, the dividends received deduction for qualifying dividends from affiliates with respect to which the payor receives a one percent dividends paid deduction in its taxable year ending June 30, 1988, is 99 percent. As the dividends paid deduction increases in one percent increments in subsequent taxable years, the dividends received deduction for such qualifying dividends in each case decreases in one percent increments, until the dividends paid deduction has been fully phased in at 10 percent and the dividends received deduction reduced to 90 percent.

The dividends exclusion for individuals does not apply to dividends received from an organization that was exempt from tax under section 501 or a tax-exempt farmers' cooperative in either the year of distribution or the preceding year (sec. 116(b)(1)), dividends received from a REIT (sec. 116(b)(2)), dividends received from a mutual savings bank that received a deduction for the dividend under section 591 (sec. 116(c)(1)), or to an ESOP dividend for which the corporation received a deduction (sec. 116(e)). The exclusion is limited with respect to dividends received from a RIC (sec. 116(c)(2)).

The purchase of stock, including the repurchase by an issuing corporation of its own stock, is generally treated as a capital transaction that does not give rise to a current deduction. Although one case suggests that in certain extraordinary circumstances amounts paid by a corporation to repurchase its stock may be fully deductible under section 162,¹¹ subsequent cases have strictly limited the holding in that case to its peculiar facts, with the result that no deduction was allowed.¹² Furthermore, the validity of this case has been questioned.¹³

^{The Supreme Court has held that the requirement that stock redemption expenses be capitalized extends not only to amounts representing consideration for the stock itself, but also to expenses such as legal, brokerage, and accounting fees incident to the acquisition.14}

In making this clarification, the committee does not intend to create any inference that the payments covered by this section would be deductible under present law.

Under present law, the operation of the special limitations on the use of carryforwards turns on whether the transaction that causes the limitations to apply takes the form of a taxable sale or exchange of stock in the loss corporation or one of certain specified tax-free reorganizations in which the loss corporation's tax attributes carry over to a corporate successor. After a purchase (or other taxable ownership change) of a controlling stock interest in a loss corporation, NOL and other carryforwards are disallowed unless the loss corporation continues to conduct its historic trade or business. In the case of a tax-free reorganization, NOL and other carryforwards are generally allowed in full if the loss corporation's shareholders receive stock representing at least 20 percent of the value of the acquiring corporation.

NOL and other carryforwards

Although the Federal income tax system generally requires an annual accounting, a corporate taxpayer is allowed to carry NOLs back to the three taxable years preceding the loss and then forward to each of the 15 taxable years following the loss year (sec. 172). The rationale for allowing the deduction of NOL carryforwards (and carrybacks) is 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.¹⁶

^{In addition to NOLS, other tax attributes eligible to be carried back or forward include unused investment tax credits (secs. 30 and 39), excess foreign tax credits (sec. 904(c)), and net capital losses (sec. 1212). Like NOLs, unused investment tax credits are allowed a three-year carryback and a 15-year carryforward. Subject to an overall limitation based on a taxpayer's U.S. tax attributable to foreign-source income, excess foreign tax credits are allowed a two-year carryback and a five-year carryforward. For net capital losses, generally, corporations have a three-year carryback (but only to the extent the carrybacks do not increase or create a NOL) and a five-year carryforward.}

^{NOL and other carryforwards that are not used before the end of a carryforward period expire.}

^{Carryovers to corporate successors}

^{In general, a corporation's tax history (e.g., carryforwards and asset basis) is preserved as long as the corporation's legal identity is continued. Thus, under the general rules of present law, changes in the stock ownership of a corporation do not affect the corporation's tax attributes. Following are examples of transactions that effect ownership changes without altering the legal identity of a corporation:}

Acquisitions to evade or avoid income tax

The Secretary of the Treasury is authorized to disallow deductions, credits, or other allowances following an acquisition of control of a corporation or a tax-free acquisition of a corporation's assets if the principal purpose of the acquisition was tax avoidance (sec. 269). This provision applies in the following cases:

Consolidated return regulations

To the extent that NOL carryforwards are not limited by the application of section 382 or section 269, after an acquisition, the use of such losses may be limited under the consolidated return regulations. In general, if an acquired corporation joins the acquiring corporation in the filing of a consolidated tax return by an affiliated group of corporations, the use of the acquired corporation's pre-acquisition NOL carryforwards against income generated by other members of the group is limited by the "separate return limitation year" ("SRLY") rules (Treas. reg. sec. 1.1502-21(c)). An acquired corporation is permitted to use pre-acquisition NOLs to offset its own income. Section 269 is available to prevent taxpayers from avoiding the SRLY rules by diverting income-producing activities (or contributing income-producing assets) from elsewhere in the group to a newly acquired corporation (see Treas. reg. sec. 1.269-3(c)(2), to the effect that the transfer of income-producing assets by a parent corporation to a loss subsidiary filing a separate return may be deemed to have tax avoidance as a principal purpose).

Applicable Treasury regulations provide rules to prevent taxpayers from circumventing the SRLY rules by structuring a transaction as a "reverse acquisition" (defined in regulations as an acquisition where the "acquired" corporation's shareholders end up owning more than 50 percent of the value of the "acquiring" corporation) (Treas. reg. sec. 1.1502-75(d)(3)). Similarly, under the "consolidated return change of ownership" ("CRCO") rules, if more than 50 percent of the value of stock in the common parent of an affiliated group changes hands, tax attributes (such as NOL carryforwards) of the group are limited to use against post-acquisition income of the members of the group (Treas. reg. sec. 1.1502-21(d)).

Treasury regulations also prohibit the use of an acquired corporation's built-in losses to reduce the taxable income of other members of an affiliated group (Treas. reg. sec. 1.1502-15). Under the regulations, built-in losses are subject to the SRLY rules. In general, built-in losses are defined as deductions or losses that economically accrued prior to the acquisition but are recognized for tax purposes after the acquisition, including depreciation deductions attributable to a built-in loss (Treas. reg. sec. 1.1502-15(a)(2)). The built-in loss limitations do not apply unless, among other things, the aggregate basis of the acquired corporation's assets (other than cash, marketable securities, and goodwill) exceeds the value of those assets by more than 15 percent.

Allocation of income and deductions among related taxpayers

The Secretary of the Treasury is authorized to apportion or allocate gross income, deductions, credits, or allowances, between or among related taxpayers (including corporations), if such action is necessary to prevent evasion of tax or clearly reflect the income of a taxpayer (sec. 482). Section 482 can apply to prevent the diversion of income to a loss corporation in order to absorb NOL carryforwards.

Libson Shops doctrine

In Libson Shops v. Koehler, 353 U.S. 382 (1957) (decided under the 1939 Code), the U.S. Supreme Court adopted a test of business continuity for use in determining the availability of NOL carryovers. The court denied NOL carryovers following the merger of 16 identically owned corporations (engaged in the same business at different locations) into one corporation, on the grounds that the business generating post-merger income was not substantially the same business that incurred the loss (three corporations that generated the NOL carryovers continued to produce losses after the merger).

There is uncertainty whether the Libson Shops doctrine has continuing application as a separate nonstatutory test under the 1954 Code. Compare Maxwell Hardware Co. v. Commissioner, 343 F.2d 713 (9th Cir. 1965) (holding that Libson Shops is inapplicable to years governed by the 1954 Code) with Rev. Rul. 63-40, 1963-1 C.B. 46, as modified by T.I.R. 773 (October 13, 1965), (indicating that Libson Shops may have continuing vitality where, inter alia, there is a shift in the "benefits" of an NOL carryover).¹⁷

^{Present law special limitations}

^{The application of the special limitations on NOL carryforwards is triggered by specified changes in stock ownership of the loss corporation (sec. 382). In measuring changes in stock ownership, section 382(c) specifically excludes "nonvoting stock which is limited and preferred as to dividends." Different rules are provided for the application of special limitations on the use of carryovers after a purchase and after a tax-free reorganization. Section 382 does not address the treatment of built-in losses.}

^{If the principal purpose of the acquisition of a loss corporation is tax avoidance, section 269 could apply to disallow NOL carryforwards even if section 382 is inapplicable. Similarly, the SRLY rules could apply even if a transaction passes muster under section 382.}

^{Taxable purchases}

^{If the special limitations apply after a purchase, NOL carryforwards are disallowed entirely. The rule for purchases applies if (1) one or more of the loss corporation's ten largest shareholders increase their common stock ownership within a two-year period by more than 50 percentage points, (2) the change in stock ownership results from a purchase or a decrease in the amount of outstanding stock, and (3) the loss corporation fails to continue the conduct of a trade or business substantially the same as that conducted before the proscribed change in ownership (sec. 382(a)). An exception to the purchase rule is provided for acquisitions from related persons.}

^{Tax-free reorganizations}

^{After a tax-free reorganization to which section 382(b) applies, NOL carryovers are allowed in full so long as the loss corporation's shareholders receive stock representing 20 percent or more of the value of the successor corporation (and section 269 does not apply). For each percentage point less than 20 percent received by the loss corporation's shareholders, the NOL carryover is reduced by five percent (e.g., if the loss corporation's shareholders receive 15 percent of the acquiring corporation's stock, 25 percent of the NOL carryover is disallowed). The reorganizations described in section 382(b) are those referred to in section 381(a)(2), in which the loss corporation goes out of existence and NOL carryforwards carry over to a corporate successor. Where an acquiring corporation uses stock of a parent corporation as consideration (in a triangular reorganization), the 20-percent test is applied by treating the loss corporation's shareholders as if they received stock of the acquiring corporation with an equivalent value, rather than stock of the parent corporation. An exception to the reorganization rule is provided for mergers of corporations that are owned substantially by the same persons in the same proportion (thus, the result in theLibson Shops case is reversed).}

^{Bankruptcy proceedings and stock-for-debt exchanges}

^{In the case of a G reorganization, a creditor who receives stock in the reorganization is treated as a shareholder immediately before the reorganization. Thus, NOL carryforwards are generally available without limitation following changes in stock ownership resulting from a G reorganization.}

^{If security holders exchange securities for stock in a loss corporation, the transaction could qualify as an E reorganization or a section 351 exchange. If unsecured creditors (e.g., trade creditors) exchange their debt claims for stock in a loss corporation, such creditors recognize gain or loss: (1) indebtedness of the transferee corporation not evidenced by a security is not considered as issued for property for purposes of section 351, and (2) the definition of an E reorganization requires an exchange involving stock or securities. Thus, a stock-for-debt exchange by unsecured creditors is treated as a taxable purchase that triggers the special limitation.}

^{Transactions involving "thrifts"}

^{The general rules apply to taxable purchases of stock in a savings and loan association or savings bank (referred to as a "thrift"). Thus, after an ownership change resulting from a taxable purchase, a thrift's NOL carryforwards are unaffected if the thrift continues its business.}

^{Where the acquisition of a thrift results from a reorganization described in section 368(a)(3)(D)(ii),18} depositors are treated as stockholders for purposes of the special limitations applicable to reorganizations (sec. 382(b)(7).

Special limitations on other tax attributes

Section 383 incorporates by reference the same limitations contained in section 382 for carryforwards of investment credits, foreign tax credits, and capital losses.

1976 Act amendments

The Tax Reform Act of 1976 extensively revised section 382 to provide more nearly parallel rules for taxable purchases and tax-free reorganizations and to address technical problems under present law. The 1976 Act amendments were to be effective in 1978; however, the effective date has been delayed several times. The 1976 Act amendments to the rule for purchases are scheduled to become effective for taxable years beginning after December 31, 1985. The amended reorganization rules are to apply to reorganizations pursuant to plans adopted on or after January 1, 1986.

The primary purpose of the special limitations on the use of NOL carryforwards is to restrict the function of carryforwards to that of an averaging device. This purpose is not well served by present law rules that present opportunities for tax benefit transfers.²⁰ The committee concluded that the special limitations on the use of NOL carryforwards should be revised to reduce the number of circumstances in which NOL carryforwards can be used as a device for transferring tax benefits.

The committee's amendments address three general concerns: (1) the approach of present law (viz., the disallowance or reduction of NOL and other carryforwards), which is criticized as being too harsh where there are continuing loss-corporation shareholders, and ineffective to the extent that NOL carryforwards may be available for use without limitation after substantial ownership changes, (2) the discontinuities in the present law treatment of taxable purchases and tax-free reorganizations, and (3) defects in the existing rules that present opportunities for tax avoidance.

General approach

After reviewing various options for identifying events that present the opportunity for a tax benefit transfer (e.g., changes in a loss corporation's business), the committee concluded that changes in a loss corporation's stock ownership continues to be the best indicator of a potentially abusive transaction. Thus, under the bill, the special limitations generally apply when shareholders who bore the economic burden of a corporation's NOLs no longer hold a controlling interest in the corporation. In such a case, the possibility arises that new shareholders will contribute income-producing assets (or divert income opportunities) to the loss corporation, and the corporation will obtain greater utilization of carryforwards than it could have had there been no change in ownership.

The committee was persuaded that the complete disallowance of losses after a change in ownership of less than 100 percent would be too harsh. On the other hand, the committee believed that reliance on continuity of shareholder interest to measure the extent to which NOL carryforwards may be used following an ownership change is improper and recognized that an approach that allows NOL carryforwards to the extent of the loss-corporation shareholder's continuing interests, as was done in the 1976 Act amendments, would continue to present opportunities for tax avoidance and would otherwise be improper.

The limitation on earnings approach is intended to approximate the results that would occur if a loss corporation's assets were combined with those of a profitable corporation in a partnership. This treatment can be justified on the ground that the option of contributing assets to a partnership is available to a loss corporation. In such a case, only the loss corporation's share of the partnership's income could be offset by the corporation's NOL carryforward. Presumably, except in the case of tax-motivated partnership agreements, the loss corporation's share of the partnership's income would be limited to earnings generated by the assets contributed by the loss corporation.

For purposes of determining the income attributable to a loss corporation's assets, the bill prescribes an objective rate of return on the value of the corporation's equity. The committee was informed of the arguments made in favor of computing the prescribed rate of return by reference to the gross value of a loss corporation's assets, without regard to outstanding debt. The committee concluded that it would be inappropriate to permit the use of NOL carryforwards to shelter earnings that are used (or would be used in the absence of an acquisition) to service a loss corporation's debt. Because interest paid on indebtedness is deductible in its own right (thereby deferring the use of a corresponding amount of NOLs), the effect of taking a loss corporation's gross value into account would be to accelerate the rate at which NOL carryforwards would be used had there been no change in ownership. Further, there is a fundamental difference between debt capitalization and equity capitalization: true debt represents a claim against a loss corporation's assets.

Annual limitation

In general, the annual limitation on the use of pre-acquisition NOL carryforwards is the product of the prescribed rate and the value of the loss corporation's equity immediately BEFORE a proscribed ownership change. In the case of an ownership change effected by a redemption, which results in a contraction of the loss corporation's assets, the committee concluded that it would be more appropriate to refer to the value of the loss corporation's assets immediately after the ownership change.

The committee selected the average yield for long-term marketable obligations of the U.S. government, adjusted to take account of tax exemption for interest, as the measure of a loss corporation's expected return on its assets. The committee chose the tax-exempt rate because it was concerned that if a taxable rate were used, the purchasers of a loss corporation would benefit from the grant of a rate on the portion of the loss corporation's equity value attributable to the NOL carryforward, thereby accelerating the use of pre-acquisition NOLs.

Anti-abuse rules

The committee realized that the mechanical rules described above could present unintended tax-planning opportunities and might foster certain transactions that many would perceive to be violative of the committee's intent. Therefore, the committee adopted various rules that are intended to prevent taxpayers from circumventing the special limitations or otherwise trafficking in loss corporations by (1) reducing a loss corporation's assets to cash or other passive assets and then selling off a corporate shell consisting of only NOLs and cash or other passive assets, or (2) making preacquisition infusions of assets to inflate artificially a loss corporation's value (and thereby accelerate the use of NOL carryforwards). In addition, the committee's bill retains the present law rules that are intended to limit tax-motivated acquisitions of loss corporations (e.g., section 269, relating to acquisitions to evade or avoid taxes, and the SRLY and CRCO rules).

The committee also was made aware of transactions in which an acquisition group desiring to acquire a profitable business through a leveraged buyout has entered into a partnership or other arrangement with another taxpayer with NOL carryforwards. For example, where a partnership is used as a vehicle, the partnership purchases the business, largely with borrowed funds. During the period in which it is using its available cash flow to repay the acquisition indebtedness, the partnership allocates a large portion of its income to the NOL partner, creating an excess capital account for that partner. After the acquisition indebtedness is retired, the partnership's income is allocated largely to the acquisition group, and the NOL partner receives prearranged distributions of cash to reduce the NOL partner's excess capital account. Typically, the NOL partner is not paid a market rate of interest on its excess capital account. As a result, the present value of its right to be repaid that amount is equal to or somewhat less than the taxes saved by the acquisition group as a result of the allocation to the NOL partner of the partnership's income during the period in which the acquisition indebtedness was being paid off. Thus, in essence, the acquisition group has purchased the NOL partner's NOLs for deferred payments.

The committee believes that the sale of NOLs in the manner described above is inconsistent with the limits placed on the use of NOLS by section 382 of the Code and therefore is improper. The committee believes the partnership allocations involved in certain of such transactions do not have substantial economic effect under section 704(b), and the Treasury Department has authority to deal with such transactions through regulations.

Technical problems

The committee's bill addresses the technical problems of present law by (1) coordinating the rules for taxable purchases with the rules for tax-free transactions, (2) expanding the scope of the rules to cover economically similar transactions that effect ownership changes (such as capital contributions, section 351 exchanges, and B reorganizations), (3) refining the definition of the term "stock," and (4) applying the special limitations to built-in losses.

Discontinuities

Because the current threshold for purchases is 50 percent, but the threshold for reorganizations is 20 percent, present law presents the possibility that economically similar transactions will receive disparate tax treatment. Further, the special limitations apply after a purchase only if a preacquisition trade or business is discontinued, while the reorganization rule looks solely to changes in ownership. Finally, if the purchase rule applies, all NOL carryforwards are disallowed. In contrast, the rule for reorganizations merely reduces NOL carryforwards in proportion to the ownership change.

Continuity-of-business enterprise

The requirement that a loss corporation continue substantially the same business after a purchase presents potentially difficult definitional issues. Specifically, taxpayers and the courts are required to determine at what point a change in merchandise, location, size, or the use of assets should be treated as a change in the loss corporation's business. It is also difficult to identify a particular business where assets and activities are constantly combined, separated, or rearranged. Further, there is a concern that the present law requirement may induce taxpayers to continue uneconomic businesses.

The committee's bill eliminates the existing business continuation rule; however, the continuity-of-business-enterprise rule applicable to tax-free reorganizations is extended to all other transactions that trigger the special limitations. The expansion of the scope of the continuity-of-business-enterprise requirement reflects the committee's view that the ongoing business enterprise (or the use of a portion of the historic assets) is an essential element of a corporation's identity. Therefore, the bill disallows NOL carryforwards entirely if this requirement is not satisfied for a two-year period.

Participating stock

In addition, the bill addresses the treatment of transactions in which the beneficial ownership of a NOL carryforward does not follow stock ownership. This problem is illustrated by the case of Maxwell Hardware Co., in which a loss corporation's old shareholders retained common stock representing more than 50 percent of the corporation's value, but new shareholders received specially tailored preferred stock that carried with it a 90-percent participation in the corporation's earnings attributable to income-producing assets contributed by the new shareholders.²¹ To address the problem, the bill defines stock to exclude stock that does not participate in a corporation's growth to any significant extent. The application of this definition to the facts of Maxwell Hardware would result in the application of special limitations (because the loss corporation's shareholders would not be viewed as retaining a significant interest in "stock").

Built-in gains and losses

The committee concluded that built-in losses, particularly depreciation deductions resulting from built-in losses, should be subject to special limitations because they are economically equivalent to pre-acquisition NOL carryforwards. If built-in losses were not subject to limitations, taxpayers could reduce or eliminate the impact of the general rules by causing a loss corporation (following an ownership change) to recognize its built-in losses free of the special limitations (and then investing the proceeds in assets similar to the assets sold).

The committee's bill also provides relief for built-in gains. Built-in gains are often the product of special tax provisions that accelerate deductions or defer income (e.g., accelerated depreciation or installment sales reporting). Absent a special rule, the use of NOL carryforwards to offset built-in gains recognized after an acquisition would be limited, even though the carryforwards would have been fully available to offset such gains had the gains been recognized before the change in ownership occurred. (Similarly, a partnership is required to allocate built-in gain or loss to the contributing partner).

Although the special treatment of built-in gains and losses will generally require valuations of a loss corporation's assets, the bill limits the circumstances in which valuations will be required by providing a de minimis rule. The committee's bill also provides a simplifying presumption in the case of certain stock acquisitions where it is reasonable to equate the value of the consideration used to acquire the stock with the value of a corporation's assets.

Other technical gaps

The committee's bill also corrects the following defects in present law: (1) only NOL deductions from prior taxable years are limited; thus, NOLs incurred in the year of a substantial ownership change are unaffected, (2) the rule for purchases is inapplicable to ownership changes resulting from section 351 exchanges, capital contributions, the liquidation of a partner's interest in a partnership that owns stock in a loss corporation, and nontaxable acquisitions of interests in a partnership (e.g., by contribution) that owns stock in a loss corporation, (3) the reorganization rule is inapplicable to B reorganizations, (4) the measurement of the continuing interest of a loss corporation's shareholders after a triangular reorganization enables taxpayers to circumvent the 20-percent-continuity-of-interest rule, and (5) taxpayers take the position that the reorganization rule does not apply to reverse mergers (where an acquiring corporation's subsidiary merges into a loss corporation and the loss corporation's shareholders receive stock of the acquiring corporation in the exchange).

Insolvent corporations

Finally, the committee reviewed the treatment of ownership changes of insolvent corporations. Under the general rule of the committee's bill, no carryforwards would survive the acquisition of an insolvent corporation because the corporation's equity value immediately before the acquisition would be zero. In such a case, the loss corporation's creditors are the true owners of the corporation, although it may be impossible to identify the point in time when ownership shifted from the corporation's shareholders.²² While the committee concluded that relief from a strict application of the general rule should be provided, as the creditors of an insolvent corporation frequently bear the losses reflected in a NOL carryforward, the committee discerned no tax policy reason that would justify a blanket exception from the special limitations. The former creditors of an insolvent loss corporation are as likely as any other new owners to attempt to accelerate the use of preacquisition NOLs. The committee was also concerned about the potential for abusive transactions if an exception made. For example, if there were a general stock-for-debt exception, an acquiring corporation could purchase a loss corporation's debt immediately before or during a bankruptcy proceeding, exchange the debt for stock without triggering the special limitations, and then use the loss corporation's NOL carryforwards immediately and without limitation. The committee also believes that allowing favorable tax treatment for creditors of insolvent corporations could divert lending away from solvent corporations, including start-up corporations, that may contribute more to the productivity of the economy.

For these reasons, the committee's bill provides that the annual limitation after a G reorganization or a stock-for-debt exchange that occurs as part of a Title 11 or similar proceeding is computed by reference to the value of the loss corporation's equity immediately AFTER the end of a bankruptcy proceeding (when ownership is formally shifted) (similar to the treatment of redemptions under the bill). In this manner, the use of NOL carryforwards after a G reorganization or qualified stock-for-debt exchange will be limited to the equity value that remains after the discharge of a loss corporation's debts, subject to the bill's anti-abuse rules relating to passive assets and capital contributions.

Transactions involving thrifts

In the case of financially troubled thrifts, typically, a profitable financial institution assumes the thrift's obligations, in exchange for payments from a regulatory body such as FSLIC, and the right to utilize the thrift's NOLs and assume the thrift's basis in its assets (which generally consist of mortgage loans with a book value substantially in excess of market value). Generally, no consideration is paid to the thrift's shareholders or depositors; rather, the consideration used to acquire control is paid to the thrift itself. Also, the thrift may receive financial assistance from a regulatory authority. After reviewing this state of affairs, the committee determined that no special rules should apply to acquisitions of thrift institutions.

The bill alters the character of the special limitations on the use of NOL carryforwards. After a change in ownership of more than 50 percent of the value of stock in a loss corporation, however effected, the taxable income available for offset by pre-acquisition NOLs is limited to a prescribed rate times the value of the loss corporation's equity. In addition, NOLs are disallowed unless the loss corporation satisfies the continuity-of-business-enterprise rule that applies to tax-free reorganizations for the two-year period following an ownership change, regardless of the type of transaction that results in the change of control (i.e., the continuity-of-business enterprise doctrine is made applicable to purchase transactions for NOL carryover purposes). The bill also expands the scope of the special limitations to include built-in losses and takes into account built-in gains. The bill includes other changes, of a more technical nature, including rules relating to the measurement of beneficial ownership. The bill applies similar rules to carryforwards other than NOLs, such as net capital losses and excess foreign tax credits.

Trigger events

Under the bill, special limitations apply after a "trigger." A "trigger" occurs if there is an "owner shift" of more than 50 percent or an "equity structure change" of more than 50 percent during a three-year testing period.

Determinations of the percentage of stock in a corporation held by any person are made on the basis of value. Under regulations to be prescribed by the secretary, changes in proportionate ownership attributable solely to fluctuations in the relative fair market values of different classes or amounts of stock are not taken into account.

In determining whether a trigger has occurred, changes in the holdings of certain preferred stock are disregarded. Thus, all "stock" (other than stock described in section 1504(a)(4), relating to stock that is excluded in determining whether affiliated corporations are eligible to file consolidated tax returns) is taken into account. Under this standard, the stock to be disregarded is stock that (1) is not entitled to vote, (2) is limited and preferred as to dividends and does not participate in corporate growth to any significant extent, (3) has redemption and liquidation rights that do not exceed the stock's issue price upon issuance (except for a reasonable redemption premium), and (4) is not convertible to any other class of stock.²³ Under this rule, preferred stock carrying a dividend rate materially in excess of a market rate when issued would not be disregarded.

Owner shift

An "owner shift" is defined to include any change in the holdings of stock in a corporation, other than by an "equity structure change" (defined below). Examples of transactions that effect owner shifts include the following:

An equity structure change is defined to include any tax-free reorganization other than a divisive reorganization. An equity structure change of more than 50 percent occurs if the continuing interest of a loss corporation's shareholders (identified immediately before the reorganization) is less than 50 percent after the reorganization. For purposes of this definition, the continuing interest of a loss corporation's shareholders is generally measured by reference to the percentage of the value of the stock in the acquiring corporation owned (immediately after the reorganization) as the result of owning stock in the loss corporation. If there has been an increase in the holdings of the loss corporation's five-percent shareholders during the three-year period ending immediately before an equity structure change, then the continuing interest percentage determined under the general rule is adjusted to take account of such increase.

Attribution of stock ownership

In determining ownership of stock for purposes of determining whether a trigger has occurred, the constructive ownership rules of section 318 are applied, except (1) the rules for attributing ownership among family members are applied by assuming that family status as of the close of a testing period was the same as that at the beginning of a testing period, (2) the rules for attributing ownership among corporations and their shareholders are applied without regard to the condition that a shareholder own 50 percent or more of a corporation's stock, (3) a corporation is considered as owning stock (other than stock in such corporation) owned by or for any shareholder of the corporation, in the proportion that the value of the stock owned by such shareholder in the corporation bears to the value of all stock in the corporation, and (4) to the extent provided in regulations, the rules relating to the ownership of stock subject to an option will not apply. Further, stock in any corporation that is treated as owned by such corporation by reason of the rules relating to the attribution of ownership from partnerships, estates, trusts, and corporations, is not treated as outstanding stock. By application of the constructive ownership rules, the acquisition of one corporation by another corporation under common control does not constitute a trigger.

Three-year testing period

In general, the relevant testing period is the three-year period preceding an owner shift or an equity structure change. A shorter period is applicable where there has been a prior trigger. In such a case, the testing period for determining whether a subsequent trigger has occurred with respect to such carryforward does not begin before the prior trigger.

Effect of trigger

Trigger value

Generally, the trigger value of a loss corporation is the fair market value of the corporation's equity immediately before the trigger. The price at which stock in the loss corporation changes hands would be evidence, but not conclusive evidence, of the value of the corporation's stock. For example, assume that an acquiring corporation purchased 40 percent of stock in a loss corporation over a 12-month period. Six months after the end of the initial acquisition period, the acquiring corporation purchases an additional 20-percent of the loss corporation s stock at a price that reflects a premium over the stock's fair market value; the premium is paid because the 20-percent block carries with it effective control of the loss corporation. On these facts, it would be inappropriate to include the premium paid for the 20-percent interest in the measure of the corporation's equity value.

Long-term tax-exempt rate

The "long-term tax-exempt rate" is the rate that is (1) determined by the secretary under section 1274 (relating to debt instruments issued for property), based on the average yield for long-term marketable obligations of the U.S. Government, as adjusted pursuant to section 1288 (relating to original issue discount on tax-exempt bonds) to take into account tax exemption for interest on the obligation, and (2) in effect on the trigger day. The committee anticipates that the Treasury Department will publish the long-term tax-exempt rate with the same frequency and applicability as the applicable Federal rates under section 1274.

Generally, the trigger value is reduced by an amount equal to the aggregate capital contributions received by the loss corporation during the three-year testing period. For purposes of this rule, the term "capital contribution' generally includes any amount received by a corporation for stock in the corporation or as a capital contribution. The committee intends the term capital contribution to be interpreted broadly to encompass any direct or indirect infusion of capital into a loss corporation. An exception is provided for amounts received by a corporation pursuant to an employee stock option plan or a dividend reinvestment plan that meets standards prescribed by the secretary. In addition, the secretary is authorized to issue regulations that set forth a de minimis exception to the general definition of a capital contribution. The committee expects that these regulations will allow small contributions made in the ordinary course of the loss corporation's business (i.e., to fund operating expenses).

Reduction in trigger value for corporations having substantial nonbusiness assets

If at least one-third of the fair market value of a corporation's assets consists of nonbusiness assets, then the trigger value is reduced by the excess of the value of the nonbusiness assets over the portion of the corporation's indebtedness attributable to such assets. For purposes of this rule, the term "nonbusiness assets" is defined as cash, marketable stock or securities, and any other asset not held for active use in a trade or business or disposed of (other than in the ordinary course of the corporation's business) pursuant to a plan or arrangement in existence before the trigger day. The amount of a corporation's indebtedness attributable to nonbusiness assets is the amount that bears the same ratio to such indebtedness as the value of the nonbusiness assets bears to the value of all of the corporation's assets.

Stock or securities in a subsidiary corporation are excluded from the definition of marketable stock or securities. Instead, the parent corporation is deemed to own its ratable share of the subsidiary's assets. A corporation is treated as holding stock in a subsidiary if the corporation owns 50 percent or more of the combined voting power of all classes of stock entitled to vote, or 50 percent or more of the total value of all classes of stock.

Losses subject to limitation

The term "pre-trigger loss" includes (1) for the taxable year in which a trigger occurs, the portion of the loss corporation's NOL that is allocable (determined on a daily pro rata basis) to the period in such year before the trigger day, (2) NOL carryforwards that arose in a taxable year preceding the taxable year of the trigger, and (3) certain recognized built-in losses and deductions (described below).

For any taxable year in which a corporation has income that, under section 172, may be offset by both a pre-trigger loss (i.e., an NOL subject to limitation) and an NOL that is not subject to limitation, taxable income is treated as having been first offset by the pre-trigger loss. This rule minimizes the NOLs that are subject to the special limitations.

Built-in losses

If a loss corporation has a net unrealized built-in loss, the recognized built-in loss for any taxable year ending within the ten-year period following the trigger (the "recognition period") is treated as a pre-trigger loss.

Built-in gains

If a loss corporation has a net unrealized built-in gain, the trigger amount for any taxable year ending within the recognition period is increased by the recognized built-in gain for the taxable year.

If the last component of a trigger is a redemption, the determinations described in the preceding paragraph are made as of the time immediately after the trigger.

Effect of certain capital contributions

For purposes of the de minimis exceptions applicable to built-in gains and losses, certain capital contributions received by a corporation during the three-year testing period are excluded from the value of the corporation assets. The capital contributions subject to this rule are the same amounts that are excluded from a corporation's trigger value (discussed above). Further, to the extent capital contributions of property are identifiable as of the trigger, they are not taken into account for any purpose under the special rules for built-in gains and losses (e.g., the rule for netting built-in gains and losses).

General regulatory authority

The Secretary is authorized to prescribe such regulations as may be necessary or appropriate, including (but not limited to) regulations (1) providing rules for the treatment of successive triggers, (2) treating warrants and obligations convertible to stock as stock, and (3) treating options as having been exercised.

Carryforwards other than NOLs

The bill also amends section 383, relating to special limitations on unused business credits and research credits, excess foreign tax credits, and capital losses. Under regulations to be prescribed by the Secretary, capital loss carryforwards and the deduction equivalent of credit carryforwards will be limited to an amount determined on the basis of the tax liability that is attributable to so much of the taxable income as does not exceed the trigger amount for the taxable year, with the same ordering rules that apply under present law.

Tax-motivated transactions

Nothing in the bill affects the continuing application of section 269, relating to acquisitions made to evade or avoid taxes. Similarly, the SRLY and CRCO rules under the regulations governing the filing of consolidated returns continue to apply.

Libson Shops

The committee intends that the Libson Shops doctrine will have no application to transactions subject to the provisions of the bill. 1976 Act Amendments

1976 Act amendments

The bill generally repeals the amendments made by the Tax Reform Act of 1976.

If a purchase or reorganization that occurs after December 31, 1985 is not affected by the bill (because, for example, an insufficient ownership change occured after October 28, 1985), the existing provisions of section 382 will remain applicable to the transaction. The bill contemplates that the Secretary will prescribe the long-term tax-exempt rate (pursuant to existing authority in section 1288) before January 1, 1986.

Special transitional rules are provided, under which present law continues to apply to ownership changes after January 1, 1986, if:

As a general rule, corporate earnings from sales of appreciated property are taxed twice, first to the corporation when the sale occurs, and again to the shareholders when the net proceeds are distributed as dividends. At the corporate level, the income is taxed at ordinary rates if it results from the sale of inventory or other ordinary income assets, or at capital gains rates if it results from the sale of a capital asset held for more than six months. With certain exceptions, shareholders are taxed at ordinary income rates to the extent of their pro rata share of the distributing corporation's current and accumulated earnings and profits.

An important exception to this two-level taxation of corporate earnings is the so-called General Utilities rule.¹ The General Utilities rule permits nonrecognition of gain by corporations on certain distributions of appreciated property² to their shareholders and on certain liquidating sales of property. Thus, its effect is to allow appreciation in property accruing during the period it was held by a corporation to escape tax at the corporate level. At the same time, the transferee (the shareholder or third-party purchaser) obtains a stepped-up, fair market value basis under other provisions of the Code, with associated additional depreciation, depletion, or amortization deductions. Accordingly, the "price" of a step up in the basis of property subject to the General Utilities rule is typically a single capital gains tax paid by the shareholder on receipt of a liquidating distribution from the corporation.

Although the case involved a dividend distribution of appreciated property by an ongoing business, the term "General Utilities rule, is often used (and will be used herein) in a broader sense to refer to the nonrecognition treatment accorded in certain situations to liquidating as well as nonliquidating distributions to shareholders and to liquidating sales. The rule is reflected in section 311, 336, and 337 of the Code. Section 311 governs the treatment of nonliquidating distributions of property (dividends and redemptions), while section 336 governs the treatment of liquidating distributions in kind. Section 337 provides nonrecognition treatment for certain sales of property pursuant to a plan of complete liquidation.

Numerous limitations on the General Utilities rule, both statutory and judicial, have developed over the years. Some directly limit the statutory provisions embodying the rule, while others, including the collapsible corporation provisions, the recapture provisions, and the tax benefit doctrine, do so indirectly.

Case law and statutory background

General Utilities declared a dividend in an amount equal to the value of the Islands Edison stock, payable in shares of that stock. The corporation distributed the Islands Edison shares and, four days later, the shareholders sold the shares to the buyer on the terms previously negotiated by the company's officers.

The Internal Revenue Service took the position that the distribution of the Islands Edison shares was a taxable transaction to General Utilities. Before the Supreme Court, the Commissioner argued that the company had created an indebtedness to its shareholders in declaring a dividend, and that the discharge of this indebtedness using appreciated property produced taxable income to the company under the holding in Kirby Lumber Co. v. United States.³ Alternatively, he argued, the sale of the Islands Edison stock was in reality made by General Utilities rather than by its shareholders following distribution of the stock. Finally, the Commissioner contended that a distribution of appreciated property by a corporation in and of itself constitutes a realization event. All dividends are distributed in satisfaction of the corporation's general obligation to pay out earnings to shareholders, he argued, and the satisfaction of that obligation with appreciated property causes a realization of the gain.

The Supreme Court held that the distribution did not give rise to taxable income under a discharge of indebtedness rationale. The Court did not directly address the Commissioner's third argument, that the company realized income simply by distributing appreciated property as a dividend. There is disagreement over whether the Court rejected this argument on substantive grounds or merely on the ground it was not timely made. Despite the ambiguity of the Supreme Court's decision, however, subsequent cases interpreted the decision as rejecting the Commissioner's third argument and as holding that no gain is realized on corporate distributions of appreciated property to its shareholders.

Five years after the decision in General Utilities, in a case in which the corporation played a substantial role in the sale of distributed property by its shareholders, the Commissioner successfully advanced the imputed sale argument the Court had rejected earlier on procedural grounds. In Commissioner v. Court Holding Co.,⁴ the Court upheld the Commissioner's determination that in substance the corporation rather than the shareholders had executed the sale and, accordingly, must recognize gain.

In United States v. Cumberland Public Service Co.,⁵ the Supreme Court reached a contrary result where the facts showed the shareholders had in fact negotiated a sale on their own behalf. The Court stated that Congress had imposed no tax on liquidating distributions in kind or on dissolution, and that a corporation could liquidate without subjecting itself to corporate gains tax notwithstanding the primary motive is to avoid the corporate tax.⁶

^{In its 1954 revision of the Internal Revenue Code, Congress reviewedGeneral Utilities and its progeny and decided to address the corporate-level consequences of distributions statutorily. It essentially codified the result inGeneral Utilities by enacting section 311(a), providing that no gain or loss is recognized to a corporation on a nonliquidating distribution of property with respect to its stock. Congress also enacted section 336, which in its original form provided for nonrecognition of gain or loss to a corporation on distributions of property in partial or complete liquidation. As discussed below, section 336 no longer applies to distributions in partial liquidation, though in certain limited circumstances a distribution in partial liquidation may still qualify for nonrecognition at the corporate level.}

^{Finally, Congress in the 1954 Act provided that a corporation does not recognize gain or loss on a sale of property if it adopts a plan of complete liquidation and distributes all of its assets to its shareholders within twelve months of the date of adoption of the plan (sec. 337). Thus, the distinction drawn inCourt Holding Co. andCumberland Public Service Co., between a sale of assets followed by liquidating distribution of the proceeds and a liquidating distribution in kind followed by a shareholder sale, was in large part eliminated. Regulations subsequently issued under section 311 acknowledged that a distribution in redemption of stock constituted a "distribution with respect to... stock" within the meaning of the statute.7} The 1954 Code in its original form, therefore, generally exempted all forms of nonliquidating as well as liquidating distributions to shareholders from the corporate-level tax.

^{Second, an exception from the general gain recognition rule is provided for a distribution with respect to qualified stock that constitutes a "qualified dividend." A "qualified dividend" for this purpose is a dividend of property (other than inventory or receivables) used in the active conduct of certain "qualified businesses."10} A "qualified business" is any trade or business that has been actively conducted for the five-year period ending on the date of the distribution and was not acquired in a transaction in which gain or loss was recognized in whole or in part during such period.¹¹ Thus, nonrecognition under this exception does not apply to distributions from holding companies or consisting of ordinary income property, and is limited to distributions to certain long-term, 10-percent shareholders other than corporations.

Third, an exception is provided for distributions with respect to qualified stock of stock or obligations in a subsidiary if substantially all of the assets of the subsidiary consist of the assets of one or more qualified businesses, no substantial part of the subsidiary's nonbusiness assets were acquired in a section 351 transaction or as a capital contribution from the distributing corporation within the five-year period ending on the date of the distribution, and more than 50 percent in value of the stock of the subsidiary is distributed with respect to qualified stock.¹²

^{Finally, exceptions are provided for redemptions to pay death taxes, certain distributions to private foundations, and distributions by certain regulated investment companies in redemption of stock upon the demand of a shareholder.13}

^{Section 311 also provides under separate rules that a corporation recognizes gain on the distribution of encumbered property to the extent the liabilities assumed or to which the property is subject exceed the distributing corporation's adjusted basis;14} on the distribution of LIFO inventory, to the extent the basis of the inventory determined under a FIFO method exceeds its LIFO value;¹⁵ and on the distribution of an installment obligation, to the extent of the excess of the face value of the obligation over the distributing corporation's adjusted basis in the obligation.¹⁶

Section 337 provides that if a corporation adopts a plan of complete liquidation and within twelve months distributes all of its assets in complete liquidation, gain or loss on any sales by the corporation during that period generally is not recognized. Section 337 does not apply, and recognition is required, on sales of inventory (other than inventory sold in bulk), stock in trade, and property held primarily for sale to customers in the ordinary course of business. If the corporation accounts for inventory on a LIFO basis, section 337 requires that the LIFO recapture amount be included in income.

Prior to 1983, shareholders of corporations making a Subchapter S election were taxed on actual cash dividend distributions of current earnings and profits of the corporation, and on undistributed taxable income as a deemed dividend. Accordingly, all of the taxable income of a corporation taxable under Subchapter S passed through to its shareholders as dividends. A shareholder increased his basis in his stock by the amount of his pro rata share of undistributed taxable income.

The Subchapter S Revision Act of 1982 substantially modified these rules. The dividends-earnings and profits system was abandoned in favor of a pass-through approach based more closely on the system under which partnership income is taxed. Under these new rules, gain must be recognized by an S corporation (which gain is passed through to its shareholders) on a nonliquidating distribution of appreciated property as if it had sold the property for its fair market value (sec. 1363(d)). The purpose of this rule is to assure that the appreciation does not escape tax entirely. A shareholder in an S corporation generally does not recognize gain on receipt of property from the corporation, but simply reduces his basis in his stock by the fair market value of the property, taking a basis in the property equal to that value. The shareholder can then sell the property without recognizing any gain. Thus, unless the distribution triggered gain at the corporate level, no current tax would be paid on the appreciation in the distributed property.

Liquidating distributions by an S corporation are taxed in the same manner as liquidating distributions of C corporations. Thus, no gain is recognized by the corporation (sec. 1363(e)). Although the General Utilities rule in this context is not responsible for the imposition of only a single, shareholder-level tax on appreciation in corporate property,¹⁸ it may allow a portion of the gain that would otherwise be ordinary to receive capital gains treatment.

Statutory law and judicial doctrines affecting application of General Utilities rule

^{The depreciation recapture rules (sec. 1245) require inclusion, as ordinary income, of any gain attributable to depreciation deductions previously claimed by the taxpayer with respect to "section 1245 property" -- essentially, depreciable personal property -- disposed of during the year,20} to the extent the depreciation claimed exceeds the property's actual decline in value.

A more limited depreciation recapture rule applies to real estate. Under section 1250, gain on disposition of residential real property held for more than one year is recaptured as ordinary income to the extent prior depreciation deductions exceed depreciation computed on the straight-line method (sec. 1250). Gain on disposition of nonresidential real property held for more than one year, however, is generally subject to recapture of all depreciation unless a straight-line method has been elected, in which case there is no recapture.²¹

^{A number of other statutory recapture provisions may apply to a liquidating or nonliquidating distribution of property, including section 617(d) (providing for recapture of post-1965 mining exploration expenditures), section 1252 (soil and water conservation and land-clearing expenditures), and section 1254 (post-1975 intangible drilling and development costs).}

Under section 341, if a shareholder disposes of stock in a collapsible corporation in a transaction that would ordinarily produce long-term capital gain, the gain is treated as ordinary income. Likewise, any gain realized by a shareholder on a liquidating distribution of appreciated property from a collapsible corporation will be ordinary income. Finally, section 337 is inapplicable in the case of a collapsible corporation. Thus, liquidating sales of appreciated inventory or other property held by the corporation for sale to customers generate ordinary income which is fully recognized at the corporate level.²²

Prior to the enactment of section 338, similar results could be achieved under section 332 and former section 334(b)(2) by liquidating the acquired corporation into its parent within a specified period of time. One abuse Congress sought to prevent in enacting section 338 was selective tax treatment of corporate acquisitions. Taxpayers were able to take a stepped-up basis in some assets held by a target corporation or its affiliates while avoiding recapture tax and other unfavorable tax consequences with respect to other assets.²³ Section 338 contains elaborate "consistency" rules designed to prevent selectivity with respect to acquisitions of stock and assets of a target corporation (and its affiliates) by an acquiring corporation (and its affiliates). All such purchases by the acquiring group must be treated consistently as either asset purchases or stock purchases if they occur within the period beginning one year before and ending one year after the twelve-month acquisition period.²⁴

^{Judicially created doctrines}

^{The courts have applied nonstatutory doctrines from other areas of the tax law to in-kind distributions to shareholders. For example, it has been held that where the cost of property distributed in a liquidation or sold pursuant to a section 337 plan of liquidation has previously been deducted by the corporation, the tax benefit doctrine overrides the statutory rules to cause recognition of income.25} The application of the tax benefit doctrine turns on whether there is a "fundamental inconsistency" between the prior deduction and some subsequent event.²⁶

^{The courts have also applied the assignment of income doctrine to require a corporation to recognize income on liquidating and nonliquidating distributions of its property.27}

Second, the General Utilities rule tends to undermine the corporate income tax. Under normally applicable tax principles, nonrecognition of gain is available only if the transferee takes a carryover basis in the transferred property, thus assuring that a tax will eventually be collected on the appreciation. Where the General Utilities rule applies, assets generally are permitted to leave corporate solution and to take a stepped-up basis in the hands of the transferee without the imposition of a corporate-level tax.²⁸ Thus, the effect of the rule is to grant a permanent exemption from the corporate income tax.

Although the committee believes that some relief from the two tier tax on corporate earnings should be provided, and understands that the General Utilities rule serves this purpose, the committee believes that there is a more efficient and equitable method of providing relief. Partial relief from the two-tier tax in the case of earnings distributed as dividends is provided elsewhere in the bill in the form of a dividends paid deduction.²⁹ The committee has also provided relief from recognition in this provision for liquidating distributions in situations similar to those for which relief is provided under present law for nonliquidating distributions of corporate property.

The bill provides that gain or loss generally is recognized by a corporation on liquidating distributions of its property as if the property had been sold at fair market value. Gain or loss is also recognized by a corporation on liquidating sales of its property. An exception is provided for gain or loss on specified types of property allocable to shares held by certain noncorporate shareholders, under rules similar to present-law rules applicable to nonliquidating distributions. Exceptions are also provided for distributions by a controlled subsidiary in a liquidation under section 332 (to the extent gain or loss is allocable to shares held by the parent corporation), and distributions and exchanges involving property that may be received tax-free under the reorganization provisions of the Code.

Distributions in liquidation

An exception to the recognition rule is provided for liquidations in which a 100-percent controlled subsidiary is liquidated into its parent corporation in a liquidation to which section 332 applies.³¹ If the stock of the liquidating corporation is owned both by an 80-percent or more corporate shareholder qualifying under section 332 (an "80-percent distributee")³² and minority shareholders, nonrecognition applies to that portion of each gain and loss that is allocable to the controlling corporation's stock. Thus, nonrecognition in this situation is limited to the controlling shareholder's percentage ownership by value in the distributing corporation multiplied by the amount of gain or loss realized on each asset distributed, irrespective of whether the asset is received by the controlling shareholder or a minority shareholder. The balance of each gain and loss is recognized except to the extent the qualified stock exception described below applies.

The percentage ownership of a controlling corporation is determined as of the date of the adoption of plan of liquidation. The committee intends that, in general, the date of adoption of the plan is the date on which a resolution authorizing the liquidation is formally adopted by the corporation's shareholders.³³ A special rule permits the 80-percent distributee to include in its ownership percentage as of the date of adoption of the plan any stock in the subsidiary that is (1) purchased by the 80-percent distributee for cash after adoption of the plan of liquidation or (2) redeemed for cash by the subsidiary in the liquidation. Stock is not eligible for this special rule, however, if it is redeemed by the subsidiary (or purchased by the controlling corporation) for cash following a "qualified section 332 liquidation." A qualified section 332 liquidation in general is one in which a lower-tier subsidiary sells its assets within a twelve-month period following the adoption of a plan of liquidation, and the subsidiary and all corporations above it in the chain are liquidated.

^{In addition, any person who inherits stock or otherwise acquires stock upon the death of an individual may include the holding period of the decedent in determining the period of ownership. The bill provides that "look through" rules that are similar to those under section 311 shall apply for determining qualification of stock held by partnerships, estates, and other pass-through entities.}

Tax-free reorganizations and distributions

The bill provides that the general rule requiring recognition of gain or loss on distributions in liquidation does not apply with respect to any exchange or distribution of property to the extent there is nonrecognition of gain or loss to the distributee under the provisions of the Code relating to corporate reorganizations and distributions. For example, if a corporation transfers its assets to another corporation in a type "C" reorganization, receiving only stock of the acquiring corporation, and distributes all of the stock in liquidation to its shareholders, the liquidating corporation will recognize no gain or loss on the distribution of the stock.

If the liquidating corporation transfers substantially all (but not all) of its assets to the acquiring corporation, however, and distributes the remaining assets to its shareholders along with the acquiring corporation's stock, the assets will constitute " boot" and will be taxable to the distribute-shareholder. Accordingly, the general recognition rule for corporate distributions will apply to the boot unless a portion of the gain is allocable to qualified stock and the other requirements of the qualified stock exception are satisfied.

Similarly, in a "split-up" under section 355, no gain is recognized to the liquidating corporation with respect to the stock or securities of the controlled subsidiary distributed to shareholders. Gain generally is recognized, however, to the extent the distribution includes appreciated property constituting boot.³⁹

^{Recognition under other rules}

^{In providing exceptions to this provision requiring recognition of gain on corporate liquidations, the committee does not intend to supersede other existing statutory rules and judicial doctrines (including, but not limited to, section 1245 and section 1250 recapture, the tax benefit doctrine, and the assignment of income doctrine). The committee intends that these rules will continue to cause recognition of income or gain on distributions of property where they are otherwise applicable.}

^{Liquidating sales of property (sec. 337)}

^{The bill amends section 337 to provide for nonrecognition of gain or loss to a liquidating corporation on a sale of assets to the same extent nonrecognition would have been available on a liquidating distribution, with certain modifications. As under present law, in order for this provision to apply, the corporation must adopt a plan of complete liquidation and distribute all of its assets (except assets retained to meet claims) within twelve months after adoption of the plan.}

^{If the liquidating corporation does not have a controlling corporate shareholder, gain or loss from the sale of assets is not recognized to the extent allocable to qualified stock (subject to the restrictions set forth in section 336). If the liquidation is of a controlled subsidiary that would qualify for the section 332 liquidation exception to section 336, nonrecognition is available only if the liquidation is a "qualified section 332 liquidation." A qualified liquidation is one in which the liquidating corporation, and each corporate distributee above it in the chain that is entitled to receive a distribution without recognition of gain under section 332, liquidates (other than in a section 333 liquidation) within the twelve-month period following adoption of a plan of liquidation.40}

^{In the case of a qualified section liquidation, the corporation selling its assets and each corporate distributee in the chain required to be liquidated are deemed to have received a distribution of the assets disposed of in the liquidating sale or sales, if more than one subsidiary in the chain sells assets), and to have distributed those assets in liquidation. Thus, gain or loss on the sale or exchange of assets by any controlled subsidiary in an affiliated group will be recognized to the same extent gain or loss would have been recogized if such assets had been actually distributed up the chain to the last 80-percent distributee in section 332 liquidations, and then distributed to the shareholders of such corporation in liquidation.41}

^{The bill provides that loss is not recognized to the corporation on any sale or exchange of property during the one-year period ending on the date of the adoption of a plan of liquidation, or at any time after the adoption of such a plan, to the extent the corporation would be eligible for nonrecognition under one of the exceptions to section 336 if the property had been distributed. Thus, for example, if the applicable percentage in a liquidation were 40 percent, a sale of an asset, whose adjusted basis exceeded its fair market value, at any time following the adoption of the plan would result in 40 percent nonrecognition of the loss. This loss disallowance rule does not apply to sales or exchanges in the ordinary course of the corporation's business.}

^{Consistent with present law, the bill provides that nonrecognition treatment is not available in the case of a sale or exchange by a collapsible corporation within the meaning of section 341, or by a corporation that has adopted a plan of liquidation to which section 333 applies. Also consistent with present law, inventory items and other property held for sale to customers, and installment obligations acquired in a sale or exchange of such property (whether acquired before or after the adoption of the plan of liquidation), are not eligible for nonrecognition treatment.42} Installment obligations received in liquidating sales within the twelve-month period are eligible for nonrecognition only to the extent a distribution of the property for which they were received would have qualified for nonrecognition. The special rule under present law that allows nonrecognition treatment for certain involuntary conversions preceding adoption of a plan of liquidation is also preserved.

Stock purchases treated as asset purchases (sec. 338)

Under the bill, section 338 of present law is retained, but in general no longer allows nonrecognition of gain or loss on the deemed sale of the target corporation's assets. An exception is provided for qualified stock purchases within the meaning of section 338 of present law where one or more shareholders of the target corporation hold qualified stock and the target is an active business corporation. Where this exception applies, the amount of gain or loss recognized on the deemed asset sale is determined as if the target corporation had distributed all of its assets in liquidation on the acquisition date. The rules of section 336 therefore determine the amount of gain or loss recognized.^42a However, the exception to recognition under section 336 for gain or loss allocable to the shares of an 80-percent corporate shareholder is not available in this situation. Accordingly, a purchase of stock from an 80-percent or more corporate shareholder followed by a section 338 election will result in recognition of gain or loss to the target corporation to the full extent gain or loss is allocable to such stock (assuming the 80-percent corporate shareholder does not liquidate in a qualified section 332 liquidation and the stock of the corporate shareholder is not qualified stock). If the 80-percent corporate shareholder liquidates in a qualified section 332 liquidation, the committee intends that the target stock will be deemed to have been distributed through the entire corporate chain and then sold by the parent's shareholders to the acquiring corporation. Therefore, if the parent's shareholders own qualified stock, no gain would be recognized as a result of the section 338 election.

S corporations

The bill provides a special rule for liquidations of S corporations where the corporation was formerly a C corporation and the liquidation occurs before the close of the second taxable year following the year in which the election to be an S corporation took effect. In this case, the subchapter S election is terminated retroactively to the first taxable year for which it was effective. The bill extends the statute of limitations for any deficiency attributable to this termination to the date one year after the date the liquidation is completed.

The bill applies to distributions or sales and exchanges occurring on or after November 20, 1985, and to any transaction described in section 338 of the Code for which the acquisition date occurs on or after November 20, 1985.

Thus, the bill does not apply to deemed sales under a timely section 338 election that is made on or after November 20, 1985, if the acquisition date occurred before November 20, 1985.

Transitional rules

The bill has several date transitional rules. The general transitional rule is that the bill does not apply to distributions or sales and exchanges made pursuant to a plan of liquidation adopted before November 20, 1985.

Special rules apply for purposes of determining whether a plan of liquidation has been adopted for this purpose and whether a distribution, sale, or exchange is made pursuant to such a plan of liquidation. In general, the rules are intended to provide relief in situations in which a decision to liquidate has clearly been made regarding an acquisition, or a decision regarding acquisition has been made and the essential terms have been determined. Some transactions may qualify for relief under more than one provision.

The committee also intends that the requisite board or shareholder approval would be deemed to have occurred, if a company has, before November 20, 1985, entered into a binding contract to sell substantially all of its assets, or has entered into a letter of intent with a buyer specifying the essential terms of such a contract.⁴⁴

The committee also intends that distributions, sales or exchanges will generally be considered pursuant to and contemplated by an acquisition transaction if a formal plan of liquidation is adopted within one year after the acquisition is consummated and the distributions, sales or exchanges commence within that time. However, the committee intends that if such actions commence more than one year after the acquisition, a determination whether the distributions, sales or exchanges are pursuant to or were contemplated by the terms of the offer will be determined on the basis of all the facts and circumstances. Such circumstances include, but are not limited to, references to or statements regarding the possibility of a liquidation made in the acquisition documents, proxy material or other correspondence with shareholders, public announcements, or requests for governmental approvals, as well as internal documentation and correspondence with attorneys or others involved in the acquisition.

Related corporations

In applying the transitional rules, action (as described above) taken by the board of directors or shareholders of a corporation with respect to a subsidiary of such corporation is treated as taken by the board of directors or shareholders of such subsidiary. For example, if the board of directors of a parent corporation has adopted a resolution approving the sale of substantially all the assets and subsequent liquidation of the subsidiary, that action would be considered action of the shareholders and board of the subsidiary regardless of how many tiers below the parent the subsidiary may be (so long as the parent has effective control over the subsidiary).

In certain instances involving a group of several tiers of subsidiaries, even though the parent corporation has not formally adopted such a resolution, the action of a lower-tier subsidiary may be considered evidence of implicit action by the parent. For example, in the case of the liquidation of a group of corporations constituting an affiliated group involving sales under present law section 337, all distributee members of the group must liquidate within one year. If one member of such group has prior to November 20, 1985, taken board or shareholder action of the type qualifying for transition relief (as described above) and if that member and the other members do liquidate within the required one year period, it is intended that timely approval by the board or shareholders of the parent corporation of the group will generally be presumed. In other situations involving pre-November 20 action by only one member of a group of commonly controlled corporations, whether that action can be attributed to members of the group other than an effectively controlled subsidiary of the acting corporation will be determined on the basis of all the facts and circumstances.

Present law (Code sec. 465) provides an at-risk limitation on losses from business and income-producing activities other than real estate and certain corporate active business activities, applicable to individuals and to certain closely held corporations.¹ The rule is designed to prevent a taxpayer from deducting losses in excess of the taxpayer's actual economic investment in an activity.

Under the loss limitation at-risk rules, a taxpayer's deductible. losses from an activity for any taxable year are limited to the amount the taxpayer has placed at risk (i.e., the amount the taxpayer could actually lose) in the activity. The initial amount at risk is generally the sum of (1) the taxpayer's cash contributions to the activity; (2) the adjusted basis of other property contributed to the activity; and (3) amounts borrowed for use in the activity with respect to which the taxpayer has personal liability or has pledged as security for repayment property not used in the activity. This amount is generally increased each year by the taxpayer's share of income and is decreased by the taxpayer's share of losses and withdrawals from the activity.

A taxpayer is generally not considered at risk with respect to borrowed amounts if (1) the taxpayer is not personally liable for repayment of the debt (nonrecourse loans); or (2) the lender has an interest (other than as a creditor) in the activity (except to the extent provided in Treasury regulations). The taxpayer is also not considered at risk with respect to amounts for which the taxpayer is protected against loss by guarantees, stop-loss arrangements, insurance (other than casualty insurance) or similar arrangements. Losses which may not be deducted for an taxable year because of the loss limitation at-risk rule may be deducted in the first succeeding year in which the rule does not prevent the deduction.

The loss limitation at-risk rule is applicable to individuals and to closely held corporations more than 50 percent in value of the stock in which was owned, at anytime during the last half of the taxable year, by or for 5 or fewer individuals. Stock ownership is generally determined according to the rules applicable for purposes of identifying a personal holding company (sec. 542(a)(2)). In the case of a partnership or S corporation, the rules apply at the partner or shareholder level respectively.

Generally, a taxpayer's amount at risk is separately determined with respect to separate activities. Nevertheless, activities are treated as one activity (i.e., aggregated) if the activities constitute a trade or business and (1) the taxpayer actively participates in the management of that trade or business, or (2) in the case of a trade or business carried on by a partnership or S corporation, 65 percent or more of losses is allocable to persons who actively participate in the management of the trade or business. The Treasury has authority to prescribe regulations under which activities are aggregated or treated as separate activities.² In addition, an exception from the at-risk rules is provided for certain active business activities of closely held corporations, and for this purpose, the component members of an affiliated group are treated as a single taxpayer (sec. 465(c)(7)(F)).

Investment tax credit rules

Present law also provides rules requiring the taxpayer to be at-risk with respect to property in order to qualify for the investment tax credit (sec. 46(c)(8)). These rules provide an exception where the property is financed by certain third party nonrecourse loans.

The bill therefore extends the present law at-risk rules to real estate, with an exception for certain arm's-length third party nonrecourse financing. This is intended to reduce the incentive for overvaluation of property.

Nonrecourse financing by the seller of real property (or a person related to the seller) is not treated as an amount at risk under the bill, because there may be little or no incentive to limit the amount of such financing to the value of the property. In the case of arm's length third party commercial financing secured solely by the real property, however, the lender is much less likely to make loans which exceed the property's value or which cannot be serviced by the property; it is more likely that such financing will be repaid and that the purchaser consequently has or will have real equity in the activity.

Qualified nonrecourse financing

The exception provided for qualified nonrecourse financing is similar to the rules for qualified commercial financing under the investment tax credit at-risk rules under present law. Qualified nonrecourse financing generally includes financing (other than convertible debt) that is secured by real property used in the activity and that is loaned or guaranteed by any Federal, State, or local government, or borrowed by the taxpayer from a qualified person, with respect to the activity of holding real property (other than mineral property), provided such amounts are not used to acquire an interest in property from a related person.

For this purpose, nonrecourse financing means financing with respect to which no person is personally liable, except to the extent otherwise provided in regulations. Regulations may set forth the circumstances in which guarantees, indemnities, or personal liability (or the like) of a person other than the taxpayer will not cause the financing to be treated as other than qualified nonrecourse financing.

Qualified persons include any person actively and regularly engaged in the business of lending money. However, qualified persons do not include (1) any person related to the taxpayer; (2) any person from which the taxpayer acquired the property (or a person related to such person); or (3) any person who receives a fee (e.g., a promoter) with respect to the taxpayer's investment in the property (or a person related to such person). For these purposes, the bill adopts the definition of related person applicable under the investment tax credit at-risk rules, which is set forth in section 461(i)(6) as amended by the bill. Under this rule, related persons generally include family members, fiduciaries, and corporations or partnerships in which a person has at least a 10-percent interest.

A special rule for partnerships provides that partnership-level qualified nonrecourse financing may increase a partner's (including a limited partner's) amount at risk, determined in accordance with his share of the liability (within the meaning of section 752), provided the financing is qualified nonrecourse financing with respect to that partner as well as with respect to the partnership. For the purpose of determining whether partnership borrowings are treated as qualified nonrecourse financing with respect to the partnership, the partnership is treated as the taxpayer. For the purpose of determining whether a share of partnership borrowings is treated as qualified nonrecourse financing with respect to a partner, the partner is also treated as the borrower. The amount for which partners are treated as at risk under this rule may not exceed the total amount of the qualified nonrecourse financing at the partnership level.

In the case of property taken subject to a nonrecourse debt which constituted qualified nonrecourse financing in the hands of the original borrower, such debt may be considered as qualified nonrecourse financing as to the original borrower's transferee, provided that all the criteria for qualified nonrecourse financing are satisfied for that debt with respect to the transferee. The same rule applies to subsequent transfers of the property taken subject to the debt, and to the admission of new partners to a partnership (or sale or exchange of a partnership interest), so long as the debt constitutes qualified financing with respect to each transferee or new partner.

Aggregation rules

The present law at-risk aggregation rules (sec. 465(c)(3)(B)) generally apply to the activity of holding real property. Under these rules, it is intended that if a taxpayer actively participates in the management of several partnerships each engaged in the real estate business, the real estate activities of the various partnerships may be aggregated and treated as one activity with respect to that partner for purposes of the at-risk rules. Also it is intended that the regulations relating to the treatment of at-risk amounts in the case of an affiliated group of corporations (Treasury reg. sec. 1.1502-45) be appropriately modified, in the case of an affiliated group which is engaged principally in the real estate business, to allow aggregation of the real estate activities, where the component members of the group are actively engaged in the management of the real estate business (not including real estate financing other than between members of the affiliated group).

Under present law (Code sec. 163(d)), in the case of a noncorporate taxpayer, deductions for interest on indebtedness incurred or continued to purchase or carry property held for investment are generally limited to $10,000 per year, plus the taxpayer's net investment income. Investment interest paid or accrued during the year which exceeds this limitation is not permanently disallowed, but is subject to an unlimited carryover and may be deducted in future years (subject to the applicable limitation) (sec. 163(d)(2)). Interest incurred to purchase or carry certain property that is subject to a net lease generally is treated as investment interest, if certain trade or business deductions are less than 15 percent of the rental income, or if the lessor is guaranteed a specific return or is guaranteed against loss of income.

Income and interest of partnerships and S corporations generally retain their entity level character (as either investment or non-investment interest or income) in the hands of the partners and shareholders. The present-law treatment of interest incurred to purchase or carry a partnership interest or S corporation stock is not entirely c1ear.³

^{Under present law, no limitation is imposed under section 163(d) on the deductibility of either interest on indebtedness incurred to purchase or carry consumption goods, (i.e., personal (consumer) interest), or interest on indebtedness incurred in connection with the taxpayer's trade or business.}

^{Investment income and expenses}

For purposes of this determination, depreciation with respect to any property is taken into account on a straight-line basis over the useful life of the property, and depletion is taken into account on a cost basis.

The committee recognizes that under present law, the current deduction of interest on indebtedness relating to property, the income from which is not taxed or is taxed only at some future time, results in the deferral and conversion to capital gain income of any gain resulting from an increase in value in the property. This mismeasurement of income can be corrected at least in part by deferral of the interest deductions.

In addition, the committee recognizes that the status of a passive investor in a limited partnership or an S corporation is more like that of a taxpayer holding corporate stock than that of a taxpayer actively conducting a trade or business, because of the investor's limited liability and lack of active participation in management. Limited partnership interests, for example, are generally treated as "securities" for purposes of Federal and State securities laws.

The committee finds it appropriate to treat such interests in enterprises in whose management the taxpayer does not actively participate as investment property. To the extent that the dividing line between an investment activity and a business activity depends upon the status of the taxpayer as an active participant in the underlying trade or business, an interest in an enterprise held by a limited entrepreneur, who does not actively participate in the management of the enterprise, also should be treated as investment property for this purpose. Accordingly, interest deductions relating to such investment property are subject to the limitation on the deductibility of nonbusiness interest under the bill.

While the committee recognizes that the imputed rental value of owner-occupied housing may be a significant source of untaxed income, the committee nevertheless believes that encouraging home ownership is an important policy goal, achieved in part by providing a deduction for residential mortgage interest. Therefore, the interest limit does not affect the deductibility of interest on debt secured by the taxpayer's principal residence or on a second home, to the extent of the fair market value of the principal residence (or second home).

Under present law, the computation of net investment income measures depreciation using straight-line depreciation over the useful life of the property. Thus, any reduction in taxable investment income attributable to incentive depreciation deductions is allowable in full without reducing net investment income and, accordingly, without reducing the amount of investment interest currently deductible. The effect of the provision is that availability of tax shelters may not be sufficiently restrained under present law since passive investors are able to take advantage of both the deductibility of interest in full plus the full depreciation deductions, which together may provide substantial mismeasurement of income.

Under present law, leased property is treated as investment property if certain out-of-pocket trade or business deductions attributable to the property are less than 15 percent of the rental income from the property. If, in an effort to reduce out-of-pocket costs, an owner of rental property performs management and repair services, the costs deductible as trade or business expenses may be reduced below 15 percent of rental income, even though the taxpayer may be actively managing the property. The problem may be particularly acute for taxpayers who have relatively small amounts of rental property. In such circumstances, the committee believes, it would be appropriate to permit the taxpayer to include the value of his personal management and repair services along with actual out-of-pocket expenses for purposes of the 15 percent test.

The bill expands the scope of the interest limitation, and alters the calculation of the amount of the limitation. Under the bill, all nonbusiness interest is subject to the limitation on deductibility, including consumer interest and certain interest that is not treated as investment interest subject to limitation under present law. Nonbusiness interest subject to the limitation under the bill does not include interest on debt secured by the taxpayer's principal residence (to the extent of its fair market value), and interest on debt secured by a second residence of the taxpayer (to the extent of its fair market value). Interest expense that is paid or incurred in carrying on a trade or business (except for interest attributable to certain limited business interests not involving low-income housing), is not subject to the interest deduction limitation under the bill.

In general, under the bill the deduction for all nonbusiness interest is limited to the sum of (1) net investment income; and (2) $10,000 ($20,000 in the case of a joint return).

Residences of the taxpayer

Interest on debt secured by a security interest perfected under local law on the taxpayer's principal residence and a second residence of the taxpayer is not treated as nonbusiness interest subject to the limitation under the bill. The taxpayer's principal residence is intended to be the residence that would qualify for rollover of gain under section 1034 if it were sold. A principal residence may be a condominium or cooperative unit.⁵

^{A second residence of the taxpayer includes a residence used by the taxpayer as a dwelling unit during any part of the year (gain on which could qualify for rollover treatment under section 1034 if the residence were used as a principal residence). In the case of a joint return, it includes a residence used by the taxpayer or his spouse and which is owned by either or both spouses. Under the bill, up to six weeks of taxpayer use of residential property pursuant to a time-sharing arrangement for such property may qualify as a single second residence. Interest expense attributable to periods when the taxpayer (or his spouse, in the case of a joint return) is not personally using the residential property is not within the exception for residential interest.}

^{A second residence for purposes of the interest limitation also includes a residential lot (i.e., vacant land), provided that within a reasonable time after the date the lot was acquired by the taxpayer, a residence has been constructed on the lot and the taxpayer has occupied it as a residence. To the extent the lot is subdivided and sold, however, any interest deduction claimed with respect to the subdivided land will be treated as nonbusiness interest.}

^{Interest not treated as nonbusiness interest under the provision includes interest on debt secured by the taxpayer's stock in a housing cooperative unit that is a residence of the taxpayer, or by his proprietary lease with respect to the unit, to the extent such debt, in the aggregate, does not exceed the fair market value of the cooperative unit. In addition, interest not treated as nonbusiness interest under the provision includes the taxpayer's share under section 216 of interest expense of the housing cooperative allocable to his unit and to his share of common residential (but not commercial) areas of the cooperative.}

^{In the case of a husband and wife filing separate returns, each spouse may deduct interest on debt secured by one residence. Alternatively the spouses may consent in writing to allow one spouse to claim interest on debt secured by two residences at least one of which is a principal residence. In the latter case, any interest of the other spouse on debt secured by a residence is treated as nonbusiness interest which may be subject to disallowance under section 163(d).}

^{In the case of a taxpayer who owns more than two residences, the taxpayer may designate each year which residence (other than the taxpayer's principal residence) the taxpayer wishes to have treated as the second residence, the interest relating to which is not subject to limitation under the provision.}

^{Interest subject to the limitation}

^{Under the bill, interest subject to the limitation is all interest on debt not incurred in connection with the taxpayer's trade or business, other than debt secured by the taxpayer's residences (as described above). Thus, interest subject to limitation generally includes investment interest subject to the section 163(d) limitation under present law and consumer interest, such as interest paid or incurred to purchase an automobile for personal use. Also subject to the limitation under the bill is interest expense attributable to a limited business interest, including interest paid or incurred on debt of the entity in which the taxpayer has a limited business interest and interest paid or incurred to purchase or carry a limited business interest.6} A limited business interest includes an interest as a limited partner in a partnership, an interest as a shareholder of an S corporation in whose management the taxpayer does not actively participate, as well as an interest in an enterprise as a limited entrepreneur⁷ (who does not actively participate in the management of the enterprise). Interest from a limited business interest attributable to any very low income housing project (within the meaning of section 168(j)(3)(B)), a low income housing project described in section 142(c) and financed from the proceeds of tax-exempt obligations, or low income housing described in section 167(k) is not treated as investment interest by reason of the limited business interest provision.

Net investment income

Under the bill, the definition of investment income is expanded to include the taxpayer's share of income or loss (without regard to interest expense) attributable to any limited business interest (e.g., a limited partnership interest, stock of an S corporation in whose management the taxpayer does not actively participate, or any interest in other enterprises in which the taxpayer is a limited entrepreneur). It also includes the nondeductible portion of net long-term capital gain on investment property. Net investment income is increased by certain out-of-pocket expenses attributable to net leased property, as under present law.

As under present law, net investment income is the excess of investment income over investment expense. Under the bill, investment expense is determined utilizing the actual depreciation or depletion deductions allowable.

Net lease

The bill modifies the 15-percent test of present law, which determines whether leased property is subject to a net lease, and therefore constitutes a limited business interest in the hands of the lessor. Under the bill, in determining whether certain expenses constituting trade or business deductions are less than 15 percent of the rental income from the leased property, the value of the personal management and repair services performed with respect to the leased property by an individual taxpayer who is a direct owner of the property may be counted. Management and repair services of a general partner in a general partnership that directly owns the leased property may also be counted. In the case of services by the general partners, to qualify for this rule, the property must be managed exclusively by such general partners, with no substantial payments to third parties for management services (other than for accounting and tax preparation services and repairs). The value of legal services may not be counted.

Rental use

Under the bill, if property is used partly for rental purposes and partly for personal purposes (such as a vacation home used by the taxpayer as a residence and also rented out for part of the year), the interest on debt attributable to such property is first allocated to the rental use and the personal use under allocation rules similar to section 280A(e)(l) of present law. Interest is allocated to the rental use (rather than residential use) in the ratio of the number of days the property is rented at fair rental to the number of days the property is used during the taxable year. The interest allocated to the rental use will be allowed to the extent it does not exceed gross income (net of taxes and other deductions which would be allowed whether or not the property was used as rental property). Any interest allocable to the rental use in excess of such amount will then be treated as nonbusiness interest and will be allowed to the extent section 163(d) does not disallow the interest.

Thus, for example, in 1987 the taxpayer would calculate (1) the amount of the interest disallowed for the year under the pre-1986 rule, and then (2) the amount of interest disallowed for the year (as if fully phased in) under the post-1985 rule (as if fully phased in). Interest disallowed for 1987 would not exceed the amount calculated under (1), plus 20 percent of the amount by which (2) exceeds (1). If in any year, the amount of the interest disallowed under the new limitation (if fully phased in) would be less than the amount subject to the old limitation, the interest disallowed will be the amount determined as if the new rule were fully effective in that year. Thus, the taxpayer receives the benefit of the new rule in any year when it would give him a greater interest deduction than would the old rule.

Under present law, corporations pay a minimum tax on certain tax preferences. The tax is in addition to the corporation's regular tax. The amount of the minimum tax is 15 percent of the corporation's tax preferences, to the extent that the aggregate amount of these preferences exceeds the greater of the regular income tax paid or $10,000.

Tax preference items

The tax preference items included in the base for the minimum tax for corporations are:

When a corporation has a regular tax net operating loss attributable to minimum tax preference items in excess of $10,000, no immediate add-on minimum tax liability is incurred with respect to those preference items. Minimum tax liability is incurred with respect to those preference items when the "preferential" portion of the net operating loss is used to offset regular taxable income, treating this portion as used only after nonpreferential net operating losses have been exhausted.

Cutback in certain preferences

In addition to imposing an add-on minimum tax, present law (Sec. 291) imposes a cutback in the use of certain corporate tax preferences for regular tax purposes. Adjustments are made to the corporate minimum tax to prevent the combination of that tax and the cutback provision from unduly reducing the tax benefit from a preference. The cutback applies, with differing percentage reductions, to the following items: (1) certain excess depletion for coal and iron ore, (2) the portion of bad debt reserves deducted by financial institutions that exceeds deductions allowable under the experience method, (3) certain interest deductions of financial institutions that are allocable to purchasing or holding certain tax-exempt obligations, (4) a foreign sales corporation's (FSC) exempt foreign trade income, (5) the reduction of recapture, under Section 1250, for depreciation deductions relating to real estate, (6) for pollution control facilities, the excess of the amortization deductions allowed over the depreciation deductions that would otherwise apply, (7) intangible drilling cost deductions of integrated oil companies, and (8) the expensing of mineral exploration and development costs.

Individual minimum tax

Under present law, individuals are subject to an alternative minimum tax which is payable, in addition to all other tax liabilities, to the extent that it exceeds the individual's regular tax owed.² The tax is imposed at a flat rate of 20 percent on alternative minimum taxable income in excess of the exemption amount. However, the amount so determined is reduced by the foreign tax credit and the refundable credits.

Alternative minimum taxable income is generally equal to regular tax adjusted gross income, as increased by certain tax preferences and decreased by the alternative tax itemized deductions. The exemption amount, which is subtracted from alternative minimum taxable income before applying the 20 percent rate, is $40,000 for joint returns, $20,000 for married individuals filing separately, and $30,000 for single returns.

Tax preference items

The tax preference items that are added to the adjusted gross income basis for purposes of the alternative minimum tax on individuals are:

Alternative tax itemized deductions

Certain of the itemized deductions allowable in calculating regular taxable income are allowable as well for purposes of calculating alternative minimum taxable income. The alternative tax itemized deductions are: