Senators Oppose Disallowance Of Exempt Income Expense.

A bi-partisan group of 35 senators has written Treasury to express opposition to an administration proposal to extend the pro rata disallowance of tax-exempt interest expense and eliminate the 2 percent de minimis rule. The senators argue that the proposal would discourage companies from investing in state and local municipal bonds because it "would make it impractical economically for many of these corporations to continue this critical investment." They say this would ultimately lead to state and local governments incurring higher borrowing costs for financing public activities.

In response, Treasury states that the de minimis rule is used by nonfinancial corporations to extend the benefits of exempt interest income to debt-financed holdings. Because nonfinancial corporations hold only 5 percent of the outstanding exempt bonds, Treasury says the proposal will have a minimal effect on the borrowing costs of state and local governments. Treasury also says extending the pro rata disallowance rule will not increase the recordkeeping burdens on corporations holding exempt bonds.

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March 6, 1996

The Honorable Robert E. Rubin

Dear Mr. Secretary:

[1] We are writing to express our opposition to an Administration budget proposal that would be harmful to state and local governments. The provision to which we refer is the extension of the pro rata disallowance of tax-exempt interest expense to all corporations and the elimination of the related two percent de minimis rule. While at first glance this proposal may seem to target corporations, it would, in reality, be state and local governments that would suffer from its enactment.

[2] There are many industries in the corporate world that invest in tax-exempt municipal bonds: equipment leasing companies and companies subject to state regulatory requirements such as property and casualty insurers and issuers of travelers checks and money orders. Together, they make up a significant portion of the demand for municipal bonds. It is primarily the current law's treatment of tax-exempt securities that makes them attractive to these investors, and an alteration of the code disturbing this relationship would make it impractical economically for many of these corporations to continue this critical investment.

[3] The Administration's proposal attempts to equate the tax treatment for these companies with the policy now applied to banks, which disallows a deduction for interest expense proportionate to the amount of tax-exempt obligations held by the institution. However, because the operations of these corporations differ significantly from banks, the current tax law provides them separate treatment. we believe this treatment is appropriate and should continue.

[4] Extending the pro rata requirement to all corporations and eliminating the two percent de minimis rule would have several negative effects on investments in municipal bonds. By disallowing interest deductions on a pro rata basis, this proposal would lower the effective rate of return on municipal bonds. Therefore, current corporate purchasers would elect to invest in other securities that offer a higher after-tax yield. The absence of these companies from the municipal bond market could cause a serious decline in the demand for these bonds. To compensate for such a shift, governments would have to raise the rate of return an their bonds resulting in an increase in their cost of borrowing.

[5] Similar situations would occur with other investors in the municipal bond market. For instance, less attractive municipal bond rates would also cause equipment leasing companies to charge higher rates to state and local governments. Even companies with relatively small investments in municipal bonds could be forced into other investments because of the repeal of the two percent de minimis rule.

[6] Because state and local budgets are tight, an increase in the expenses of these governments would have to be passed on to taxpayers in some way. For instance, the rise in the cost of student loans would not be absorbed by the issuer but shifted to the borrower. By changing the tax treatment of corporations holding municipal bonds, the Administration would actually defeat many of its own goals by creating a financial strain on state and local government programs.

[7] We urge you to reconsider this proposal to extend the pro rata disallowance of tax-exempt interest in lieu of current law. In the end, it is the state and local governments that would be burdened and would incur higher borrowing costs for financing public activities.

Sincerely,

Max Baucus

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April 23, 1996

The Honorable Max Baucus

Dear Max:

[8] Thank you for your and your colleagues' letter regarding elimination of the 2 percent de minimis rule for corporate investments in tax-exempt bonds. This rule is an exception to the long-standing Code provision disallowing interest deductions on debt incurred to acquire or carry tax-exempt bonds.

[9] The 2 percent de minimis rule is used by non-financial corporations to extend the benefits of exempt interest income to debt-financed holdings. These benefits are not available, nor should they be, to banks, securities brokers and dealers, or insurance companies.

[10] Eliminating the de minimis rule, and applying the pro rata disallowance rule currently used by banks and securities brokers and dealers to non-financial corporations, will result in all corporations being treated in a more even-handed manner. The Administration proposal would raise about $0.5 billion over fiscal years 1996-2002.

[11] The Administration has concluded that eliminating the 2 percent de minimis rule will not materially affect the costs of borrowing for State and local governments. The supporting analysis is based on several factors. Non-financial corporations, according to the latest information from the Federal Reserve System's Flow-of- Funds data, hold only about 5 percent of outstanding tax-exempt bonds. This includes amounts held by corporations that would be unaffected by the proposal, either because they are not highly leveraged or because, as provided for in our proposal, they hold nonsalable tax-exempt obligations, e.g., installment sales contracts, acquired in payment for goods provided to State and local governments. Additionally, the special rules for insurance companies that disallow extra tax benefits from holding tax-exempt bonds would not be altered by the Administration's proposal.

[12] The pro rata disallowance rule will not result in significant additional record-keeping burdens on those corporations that continue to hold tax-exempt bonds. The pro rata rule applies the same fraction of assets currently calculated to determine whether a corporation is within the 2 percent de minimis exception to the interest expense calculated by a corporation for general tax purposes.

[13] Thank you again for writing to share your views on this matter. Your concerns will be considered carefully as we continue to analyze the economic effects of this proposal and work toward a balanced budget.

Sincerely,

Robert E. Rubin