JCT Describes Obama 2011 Budget Proposals

JCT Describes Obama 2011 Budget Proposals

News story posted in Congressional Correspondence on 19 August 2010| comments
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Summary

The Joint Committee on Taxation on August 16th released its description of President Obama's fiscal year 2011 budget proposals. The proposals include making permanent and modifying certain tax cuts from 2001 and 2003; temporary recovery measures; tax cuts for individuals, families and businesses, other revenue and loophole closers; upper-income tax provisions; capital investment for inland waterways; and other initiatives.

Citation: JCS-2-10

Full Text:


DESCRIPTION OF REVENUE PROVISIONS CONTAINED IN THE PRESIDENT'S
FISCAL YEAR 2011 BUDGET PROPOSAL


[JOINT COMMITTEE PRINT]

Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION

August 16, 2010

U.S. Government Printing Office
Washington: 2010

JCS-2-10

SENATE

Max Baucus, Montana
Chairman

John D. Rockefeller IV, West Virginia
Kent Conrad, North Dakota
Charles E. Grassley, Iowa
Orrin G. Hatch, Utah

HOUSE

Sander M. Levin, Michigan
Vice Chairman

Charles B. Rangel, New York
Fortney Pete Stark, California
Dave Camp, Michigan
Wally Herger, California

Thomas A. Barthold, Chief of Staff
Bernard A. Schmitt, Deputy Chief of Staff

CONTENTS

 INTRODUCTION

 I. INDEX THE INDIVIDUAL ALTERNATIVE MINIMUM TAX AMOUNTS FOR INFLATION

 II. MAKE PERMANENT AND MODIFY CERTAIN TAX CUTS ENACTED IN 2001 AND
 2003

      A. Dividends and Capital Gains Tax Rate Structure
      B. Extend Temporary Increase in Expensing for Small Business
      C. Marginal Individual Income Tax Rate Reductions
      D. Child Tax Credit
      E. Increase of Refundable Portion of the Child Credit
      F. Marriage Penalty Relief and Earned Income Tax Credit
         Simplification
      G. Education Incentives
      H. Modify and Make Permanent the Estate, Gift, and Generation
         Skipping Transfer Taxes After 2009
      I. Other Incentives for Families and Children (includes
         extension of the adoption tax credit, employer-provided child
         care tax credit, and dependent care tax credit)
      J. Reinstate the Overall Limitation on Itemized Deductions and
         the Personal Exemption Phase-out

 III. TEMPORARY RECOVERY MEASURES

      A. Extend the Making Work Pay Credit for One Year
      B. Provide $250 Economic Recovery Payment and Special Tax Credit
      C. Extend COBRA Health Insurance Premium Assistance
      D. Provide Additional Tax Credits for Investment in Qualified
         Property Used in a Qualifying Advanced Energy Manufacturing
         Project
      E. Extend Temporary Bonus Depreciation for Certain Property
      F. Extend Option for Cash Assistance to States in Lieu of Low-
         Income Housing Tax Credit for 2010

 IV. TAX CUTS FOR FAMILIES AND INDIVIDUALS

      A. Increase in the Earned Income Tax Credit
      B. Expand the Child and Dependent Care Tax Credit
      C. Automatic Enrollment in Individual Retirement Arrangements
      D. Saver's Credit
      E. Extend American Opportunity Tax Credit

 V. TAX CUTS FOR BUSINESSES

      A. Increase Exclusion of Gain on Sale of Qualified Small
         Business Stock
      B. Make the Research Credit Permanent
      C. Remove Cell Phones from Listed Property

 VI. OTHER REVENUE CHANGES AND LOOPHOLE CLOSERS

      A. Reform Treatment of Financial Institutions and Products

           1. Impose a financial crisis responsibility fee
           2. Require accrual of the time-value element on forward
              sale of corporate stock
           3. Require ordinary treatment for dealer activities with
              respect to section 1256 contracts
           4. Modify the definition of control for purposes of the
              section 249 deduction limitation

      B. Reinstate Superfund Excise Taxes and Corporate Environmental
         Income Tax
      C. Permanent Extension of Federal Unemployment Surtax
      D. Repeal Last-In, First-Out Inventory Accounting Method
      E. Repeal Gain Limitation on Dividends Received in
         Reorganization Exchanges
      F. Reform U.S. International Tax System

           1. Defer deduction of interest expense related to deferred
              income.
           2. Determine the foreign tax credit on a pooling basis
           3. Prevent splitting of foreign income and foreign taxes
           4. Tax currently excess returns associated with transfers
              of intangibles offshore
           5. Limit shifting of income through intangible property
              transfers
           6. Disallow the deduction for excess nontaxed reinsurance
              premiums paid to affiliates
           7. Limit earnings stripping by expatriated entities
           8. Repeal 80/20 company rules
           9. Prevent the avoidance of dividend withholding taxes
          10. Modify the tax rules for dual capacity taxpayers

      G. Combat Under-Reporting of Income on Accounts and Entities in
         Offshore Jurisdictions

           1. Require reporting of certain transfers of assets to or
              from foreign financial accounts
           2. Require third-party information reporting regarding the
              transfer of assets to or from foreign financial accounts
              and the establishment of foreign financial accounts

      H. Reform Treatment of Insurance Companies and Products

           1. Modify rules that apply to sales of life insurance
              contracts
           2. Modify dividends received deduction for life insurance
              company separate accounts
           3. Expand pro rata interest expense disallowance for
              company-owned life insurance ("COLI")
           4. Permit partial annuitization of a nonqualified annuity
              contract

      I. Eliminate Fossil Fuel Tax Preferences
      J. Treat Income of Partners for Performing Services as Ordinary
         Income
      K. Modify the Cellulosic Biofuel Producer Credit
      L. Eliminate Advance Earned Income Tax Credit
      M. Deny Deduction for Punitive Damages
      N. Repeal the Lower-of-Cost-or-Market Inventory Accounting
         Method
      O. Reduce the Tax Gap and Make Reforms

           1. Require information reporting on payments to corporations
           2. Require information reporting for rental property
              expense payments
           3. Require information reporting for private separate
              accounts
           4. Require a certified taxpayer identification number from
              contractors and allow certain withholding
           5. Increased information reporting for certain government
              payments for property and services
           6. Increase information return penalties
           7. Require e-filing by certain large organizations
           8. Implement standards clarifying when employee leasing
              companies can be held liable for their clients' Federal
              employment taxes
           9. Increase certainty with respect to worker classification
          10. Codify economic substance doctrine
          11. Allow assessment of criminal restitution as tax
         12. Revise offer-in-compromise application rules
          13. Allow Internal Revenue Service expanded access to
              information in the National Directory of New Hires
          14. Make repeated willful failure to file a tax return a
              felony
          15. Facilitate tax compliance with local jurisdictions
          16. Extension of statute of limitations where state tax
              adjustment affects Federal tax liability
          17. Improve investigative disclosure statute
          18. Clarify that the bad check penalty applies to electronic
              checks and other payment forms
          19. Impose a penalty on failure to comply with electronic
              filing of returns
          20. Require consistency in value for transfer and income tax
              purposes
          21. Modify rules on transfer tax valuation discounts
          22. Require minimum term for grantor retained annuity trusts
              ("GRATs")

 VII. UPPER-INCOME TAX PROVISIONS

      A. Limit the Tax Rate at Which Itemized Deductions Reduce Tax
         Liability

 VIII. SUPPORT CAPITAL INVESTMENT IN THE INLAND WATERWAYS

 IX. OTHER INITIATIVES

      A. Extend and Modify the New Markets Tax Credit
      B. Reform and Extend Build America Bonds
      C. Restructure Transportation Infrastructure Assistance to New
         York City
      D. Implement Unemployment Insurance Integrity Legislation
      E. Authorize Post-Levy Due Process
      F. Increase Levy Authority to 100 Percent for Vendor Payments
      G. Allow Offset of Federal Income Tax Refunds to Collect
         Delinquent State Income Taxes for Out-of-State Residents
INTRODUCTION

This document,1 prepared by the staff of the Joint Committee on Taxation, provides a description and analysis of the tax provisions that are included in the President's fiscal year 2011 budget proposal, as submitted to the Congress on February 1, 2010.2 The document generally follows the order in which the provisions are set forth in the table providing estimates of the revenue effects of the revenue proposals contained in the President's budget proposals.3 For each provision, there is a description of present law and the proposal (including effective date), a reference to relevant prior budget proposals or recent legislative action, and an analysis of policy issues related to the proposal.

I. INDEX THE INDIVIDUAL ALTERNATIVE MINIMUM TAX AMOUNTS FOR
INFLATION

Present Law

Present law imposes an alternative minimum tax ("AMT") on individuals. The AMT is the amount by which the tentative minimum tax exceeds the regular income tax. An individual's tentative minimum tax is the sum of (1) 26 percent of so much of the taxable excess as does not exceed $175,000 ($87,500 in the case of a married individual filing a separate return) and (2) 28 percent of the remaining taxable excess. The taxable excess is so much of the alternative minimum taxable income ("AMTI") as exceeds the exemption amount. The maximum tax rates on net capital gain and dividends used in computing the regular tax are used in computing the tentative minimum tax. AMTI is the individual's taxable income adjusted to take account of specified preferences and adjustments.

The exemption amounts are: (1) $70,950 for taxable years beginning in 2009 and $45,000 in taxable years beginning after 2009 in the case of married individuals filing a joint return and surviving spouses; (2) $46,700 for taxable years beginning in 2009 and $33,750 in taxable years beginning after 2009 in the case of other unmarried individuals; (3) $35,475 for taxable years beginning in 2009 and $22,500 in taxable years beginning after 2009 in the case of married individuals filing separate returns; and (4) $22,500 in the case of an estate or trust. The exemption amount is phased out by an amount equal to 25 percent of the amount by which the individual's AMTI exceeds (1) $150,000 in the case of married individuals filing a joint return and surviving spouses, (2) $112,500 in the case of other unmarried individuals, and (3) $75,000 in the case of married individuals filing separate returns or an estate or a trust. These amounts are not indexed for inflation.

Present law provides for certain nonrefundable personal tax credits (i.e., the dependent care credit, the credit for the elderly and disabled, the child credit, the credit for interest on certain home mortgages, the Hope Scholarship and Lifetime Learning credits, the credit for savers, the credit for certain nonbusiness energy property, the credit for residential energy efficient property, the credit for certain plug-in electric vehicles, the credit for alternative motor vehicles, the credit for new qualified plug-in electric drive motor vehicles, and the D.C. first-time homebuyer credit).

For taxable years beginning before 2010, the nonrefundable personal credits are allowed to the extent of the full amount of the individual's regular tax and alternative minimum tax.

For taxable years beginning after 2009, the nonrefundable personal credits (other than the child credit, the credit for savers, the credit for residential energy efficient property, the credit for certain plug-in electric drive motor vehicles, the credit for alternative motor vehicles, and credit for new qualified plug-in electric drive motor vehicles) are allowed only to the extent that the individual's regular income tax liability exceeds the individual's tentative minimum tax, determined without regard to the minimum tax foreign tax credit. The remaining nonrefundable personal credits are allowed to the full extent of the individual's regular tax and alternative minimum tax.4


Description of Proposal

The proposal provides that the individual AMT exemption amounts, the thresholds for the phaseout of the exemption amounts, and the threshold amounts for the beginning of the 28percent bracket are indexed for inflation from the levels in effect for 2009.

The proposal allows an individual to offset the entire regular tax liability and alternative minimum tax liability by the nonrefundable personal credits.

Effective date. -- The proposal is effective for taxable years beginning after 2009.


Analysis

Allowing the nonrefundable personal credits to offset the regular tax and alternative minimum tax, and increasing the exemption amounts, will substantially reduce the number of taxpayers affected by the AMT. In addition to the reduction in tax liability as a result of this change, there will be significant simplification benefits. Substantially fewer taxpayers will need to complete the alternative minimum tax form (Form 6251), and the forms and worksheets relating to the various credits can be simplified.

By permanently establishing the AMT exemption levels and ability to take nonrefundable credits against the AMT, the proposal provides greater certainty for taxpayers as to their tax obligation resulting from the AMT, in comparison to the practice over the past years of annually adjusting the exemption levels to prevent their reversion to the levels in effect prior to EGTRRA. Additionally, by indexing the AMT system for inflation, as is done in the regular tax system, the proposal prevents tax increases in real terms for the portion of one's income growth that merely accounts for inflationary growth. By doing so, the proposal substantially slows the rate of growth in the number of taxpayers subject to the AMT over time.

A number of analysts argue that the proposal does not go far enough, advocating instead the abolition of the AMT. Their argument rests on the observation that the AMT system has outlived its original purpose of requiring taxpayers engaged in substantial sheltering of income to pay at least some minimum tax. Instead, taxpayers today are mainly ensnared by the AMT as a result of their income level, payment of state and local taxes, and presence of dependents. Such analysts argue that requiring such taxpayers to calculate their liability two ways is needlessly complex and serves no discernible policy objective that the regular tax alone couldn't provide.


II. MAKE PERMANENT AND MODIFY CERTAIN TAX CUTS ENACTED IN 2001
AND 2003

A. Dividends and Capital Gains Tax Rate Structure

Present Law

Dividends

    In general

A dividend is the distribution of property made by a corporation to its shareholders out of its after-tax earnings and profits.

    Tax rates before 2011

An individual's qualified dividend income is taxed at the same rates that apply to net capital gain. This treatment applies for purposes of both the regular tax and the alternative minimum tax. Thus, for taxable years beginning before 2011, an individual's qualified dividend income is taxed at rates of zero and 15 percent. The zero-percent rate applies to qualified dividend income which otherwise would be taxed at a 10- or 15-percent rate if the special rates did not apply.

Qualified dividend income generally includes dividends received from domestic corporations and qualified foreign corporations. The term "qualified foreign corporation" includes a foreign corporation that is eligible for the benefits of a comprehensive income tax treaty with the United States which the Treasury Department determines to be satisfactory and which includes an exchange of information program. In addition, a foreign corporation is treated as a qualified foreign corporation for any dividend paid by the corporation with respect to stock that is readily tradable on an established securities market in the United States.

If a shareholder does not hold a share of stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date (as measured under section 246(c)), dividends received on the stock are not eligible for the reduced rates. Also, the reduced rates are not available for dividends to the extent that the taxpayer is obligated to make related payments with respect to positions in substantially similar or related property.

Dividends received from a corporation that is a passive foreign investment company (as defined in section 1297) in either the taxable year of the distribution, or the preceding taxable year, are not qualified dividends.

Special rules apply in determining a taxpayer's foreign tax credit limitation under section 904 in the case of qualified dividend income. For these purposes, rules similar to the rules of section 904(b)(2)(B) concerning adjustments to the foreign tax credit limitation to reflect any capital gain rate differential will apply to any qualified dividend income.

If a taxpayer receives an extraordinary dividend (within the meaning of section 1059(c)) eligible for the reduced rates with respect to any share of stock, any loss on the sale of the stock is treated as a long-term capital loss to the extent of the dividend.

A dividend is treated as investment income for purposes of determining the amount of deductible investment interest only if the taxpayer elects to treat the dividend as not eligible for the reduced rates.

The amount of dividends qualifying for reduced rates that may be paid by a regulated investment company ("RIC") for any taxable year in which the qualified dividend income received by the RIC is less than 95 percent of its gross income (as specially computed) may not exceed the sum of (1) the qualified dividend income of the RIC for the taxable year and (2) the amount of earnings and profits accumulated in a non-RIC taxable year that were distributed by the RIC during the taxable year.

The amount of dividends qualifying for reduced rates that may be paid by a real estate investment trust ("REIT") for any taxable year may not exceed the sum of (1) the qualified dividend income of the REIT for the taxable year, (2) an amount equal to the excess of the income subject to the taxes imposed by section 857(b)(1) and the regulations prescribed under section 337(d) for the preceding taxable year over the amount of these taxes for the preceding taxable year, and (3) the amount of earnings and profits accumulated in a non-REIT taxable year that were distributed by the REIT during the taxable year.

The reduced rates do not apply to dividends received from an organization that was exempt from tax under section 501 or was a tax-exempt farmers' cooperative in either the taxable year of the distribution or the preceding taxable year; dividends received from a mutual savings bank that received a deduction under section 591; or deductible dividends paid on employer securities.5


    Tax rates after 2010

For taxable years beginning after 2010, dividends received by an individual are taxed at ordinary income tax rates.

Capital gains


    In general

In general, gain or loss reflected in the value of an asset is not recognized for income tax purposes until a taxpayer disposes of the asset. On the sale or exchange of a capital asset, any gain generally is included in income. Any net capital gain of an individual generally is taxed at rates lower than rates applicable to ordinary income. Net capital gain is the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for the year. Gain or loss is treated as long-term if the asset is held for more than one year.

Capital losses generally are deductible in full against capital gains. In addition, individual taxpayers may deduct capital losses against up to $3,000 of ordinary income in each year. Any remaining unused capital losses may be carried forward indefinitely to another taxable year.

A capital asset generally means any property except (1) inventory, stock in trade, or property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business, (2) depreciable or real property used in the taxpayer's trade or business, (3) specified literary or artistic property, (4) business accounts or notes receivable, (5) certain U.S. publications, (6) certain commodity derivative financial instruments, (7) hedging transactions, and (8) business supplies. In addition, the net gain from the disposition of certain property used in the taxpayer's trade or business is treated as long-term capital gain. Gain from the disposition of depreciable personal property is not treated as capital gain to the extent of all previous depreciation allowances. Gain from the disposition of depreciable real property is generally not treated as capital gain to the extent of the depreciation allowances in excess of the allowances available under the straight-line method of depreciation.


    Tax rates before 2011

Under present law, for taxable years beginning before January 1, 2011, the maximum rate of tax on the adjusted net capital gain of an individual is 15 percent. Any adjusted net capital gain which otherwise would be taxed at a 10- or 15-percent rate is taxed at a zero rate. These rates apply for purposes of both the regular tax and the AMT.

Under present law, the "adjusted net capital gain" of an individual is the net capital gain reduced (but not below zero) by the sum of the 28-percent rate gain and the unrecaptured section 1250 gain. The net capital gain is reduced by the amount of gain that the individual treats as investment income for purposes of determining the investment interest limitation under section 163(d).

The term "28-percent rate gain" means the excess of the sum of the amount of net gain attributable to long-term capital gains and losses from the sale or exchange of collectibles (as defined in section 408(m) without regard to paragraph (3) thereof) and the amount of gain equal to the additional amount of gain that would be excluded from gross income under section 1202 (relating to certain small business stock) if the percentage limitations of section 1202(a) did not apply, over the sum of the net short-term capital loss for the taxable year and any long-term capital loss carryover to the taxable year.

"Unrecaptured section 1250 gain" means any long-term capital gain from the sale or exchange of section 1250 property (i.e., depreciable real estate) held more than one year to the extent of the gain that would have been treated as ordinary income if section 1250 applied to all depreciation, reduced by the net loss (if any) attributable to the items taken into account in computing 28-percent rate gain. The amount of unrecaptured section 1250 gain (before the reduction for the net loss) attributable to the disposition of property to which section 1231 (relating to certain property used in a trade or business) applies may not exceed the net section 1231 gain for the year.

An individual's unrecaptured section 1250 gain is taxed at a maximum rate of 25 percent, and the 28-percent rate gain is taxed at a maximum rate of 28 percent. Any amount of unrecaptured section 1250 gain or 28-percent rate gain otherwise taxed at a 10- or 15-percent rate is taxed at the otherwise applicable rate.


    Tax rates after 2010

For taxable years beginning after December 31, 2010, the maximum rate of tax on the adjusted net capital gain of an individual is 20 percent. Any adjusted net capital gain which otherwise would be taxed at the 15-percent rate is taxed at a 10-percent rate.

In addition, any gain from the sale or exchange of property held more than five years that would otherwise have been taxed at the 10-percent capital gain rate is taxed at an 8-percent rate. Any gain from the sale or exchange of property held more than five years and the holding period for which began after December 31, 2000, that would otherwise have been taxed at a 20-percent rate is taxed at an 18-percent rate.

The tax rates on 28-percent gain and unrecaptured section 1250 gain are the same as for taxable years beginning before 2011.


Description of Proposal

Under the proposal, the tax rates in effect before 2011 are made permanent. In addition, a 20-percent tax rate will apply to adjusted net capital gain and qualified dividend income for married individuals filing a joint return with adjusted gross income over $250,000 and unmarried taxpayers with adjusted gross income over $200,000. These dollar amounts are indexed for inflation.

Effective date. -- The proposal applies to taxable years beginning after December 31, 2010.


Analysis

Dividends

Under present law, the United States has a "classical" system of taxing corporate income. Under this system, corporations and their shareholders are treated as separate persons. A tax is imposed on the corporation on its taxable income, and after-tax earnings distributed to individual shareholders as dividends are included in the individual's income and taxed at the individual's tax rate. This system creates the so-called "double taxation of dividends." Prior to 2003, corporate dividends received by an individual taxpayer were taxed at the same rate as ordinary income. By reducing the tax rate applicable to dividends in 2003, the Congress hoped to mitigate the double taxation of dividends and the implicit bias in favor of returns received from ownership of corporate equity in the form of capital gains. This was intended to reduce economic distortions.

The classical system, it is argued, results in economic distortions. Economically, the issue is not that dividends are taxed twice, but rather the total tax burden on income from different investments. Business investments in entities not subject to corporate tax, such as partnerships, limited liability companies, and S corporations generally are taxed more favorably. An investment in a C corporation that returned $100 would pay a $35 corporate income tax and then, if the remaining $65 were paid out as a dividend to a shareholder in the highest individual income tax bracket (presently 35 percent), the shareholder would net $42.25. Had the investment been made through a partnership, the taxpayer would have received $65 ($100 - ($100 multiplied by 35 percent)) after tax. Thus, analysts observe that because a classical system creates different after-tax returns to investments undertaken in different legal forms the choice of legal entity is distorted and economic efficiency is reduced.

Critics of a classical system argue that a classical system distorts corporate financial decisions. They argue that because interest payments on the debt are deductible, while dividends are taxable, a classical system encourages corporations to finance using debt rather than equity. They observe that the increase in corporate leverage, while beneficial to each corporation, may place the economy at risk to more bankruptcies during an economic downturn.

Similarly, a classical system encourages corporations to retain earnings rather than to distribute them as taxable dividends. Drawing on the example above, if the corporation had retained the $65 of income net of the corporate income tax, the value of the corporation should increase by $65. If shareholders sold their shares, under present law they would recognize the $65 as a capital gain and generally incur a $9.75 income tax liability. Thus, a retention policy could result in net income to the shareholder of $55.25 as opposed to $42.25 if income were paid out as a dividend.6 This difference in effective tax burden may mean that shareholders prefer that corporate management retain and reinvest earnings rather than pay out dividends, even if the shareholder might have an alternative use for the funds that could offer a higher rate of return than that earned on the retained earnings. This is another source of inefficiency as the opportunity to earn higher pre-tax returns is passed up in favor of lower pre-tax returns. The present-law reduced rate of tax on qualified corporate dividends narrows the difference in effective tax burden between a policy of dividends and a policy of retaining earnings.

Proponents of the reduced rates of tax on dividend income under present law observe that by reducing the aggregate tax burden on investments made by corporations, the proposal would lower the cost of capital needed to finance new investments and may increase investment in the aggregate as well as investment by C corporations. Increased investment ultimately should lead to increased labor productivity, higher real wages, and increased long-term economic growth. However, there is no consensus about the magnitude of the long-run responsiveness of investment to changes in the cost of capital.

The simple examples used above to illustrate potential sources of economic inefficiency in a classical system may overstate the aggregate tax burden on investments made by C corporations. Critics of present law have questioned whether there is a substantial effect on corporate investment because persons not subject to the individual income tax (e.g., foreign persons and tax-exempt institutions such as pension funds) hold substantial amounts of corporate equity. If these shareholders are the providers of incremental investment funds, present law generally does not change the aggregate tax burden on an investment made by a C corporation. Critics of present law also observe that, in the early years, much of the tax reduction from reduced taxes on dividend income accrues to returns to investments made by C corporations in the past and not new investment. Moreover, critics observe that, as corporate stock when held by individuals outside of tax-favored retirement accounts is generally held more extensively by taxpayers above the median income, the benefit of the present-law reduced rates of tax most directly benefits higher-income taxpayers.

Capital gains

Both present law and the Administration's proposal would provide for a maximum tax rate on income from realized capital gains that is less than the tax rate applicable to a taxpayer's income from labor income (wages and salary) and from other types of capital income (for example, interest, dividends, and rental income). The differential in tax rates between income from realized capital gains and other sources of income raises several policy issues.

  • Does a differential rate promote improved efficiency of the capital markets?
  • Does a differential rate promote the socially optimal level of risk taking?
  • Does a differential rate promote long-run economic growth?
  • Is income from capital gains properly measured?
  • Is a differential in rates consistent with policy maker's equity goals?

    Does a differential rate promote improved efficiency of the capital markets?


Many argue that higher tax rates discourage sales of assets. For individual taxpayers, this "lock-in effect" is exacerbated by the rules that allow a step-up in basis at death and defer or exempt certain gains on sales of homes. As an example of what is meant by the lock-in effect, suppose a taxpayer paid $500 for a stock that now is worth $1,000, and that the stock's value will grow by an additional 10 percent over the next year with no prospect of further gain thereafter. Assuming a 20-percent tax rate, if the taxpayer sells the stock one year or more from now (when it is worth $1,100), he or she will net $980 after payment of $120 tax on the gain of $600. With a tax rate on gain of 20 percent, if the taxpayer sold this stock today, he or she would have, after tax of $100 on the gain of $500, $900 available to reinvest. The taxpayer would not find it profitable to switch to an alternative investment unless that alternative investment would earn a total pre-tax return in excess of 11.1 percent. With a tax rate on gain of 28 percent, the alternative investment would need to earn a total pre-tax return in excess of 11.6 percent to justify a switch, while the required rate of return with a 15-percent tax rate is only 10.8 percent. Preferential tax rates on capital gains impose a smaller tax on redirecting monies from older investments to projects with better prospects, in that way contributing to a more efficient allocation of capital.

A preferential tax rate on capital gains would both lower the tax imposed when removing monies from old investments and increase the after-tax return to redirecting those monies to new investments. When the tax imposed on removing monies from old investments is reduced, taxpayers would not necessarily redirect their funds to new investments when their monies in older investments are unlocked. Taxpayers might instead choose to consume the proceeds. Some have suggested that the lock-in effect could be reduced without lowering taxes on old investments. For example, eliminating the step-up in basis upon death would reduce lock-in.

To the extent that preferential rates may encourage investments in stock, and more specifically stock that offers its return in the form of capital gain rather than dividends, opponents have argued that the preference tilts investment decisions toward assets that offer a return in the form of asset appreciation rather than current income such as dividends or interest. Non-neutral treatment generally is not consistent with capital market efficiency. On the other hand, it is argued that asset neutrality is not an appropriate goal because risky investments that produce a high proportion of their income in the form of capital gains may provide a social benefit not adequately recognized by investors in the marketplace.


    Does a differential rate promote the socially optimal level of risk taking?

Some maintain that a preferential capital gains tax rate encourages investors to buy corporate stock, and especially to provide venture capital for new companies, stimulating investment in productive business activities. In theory, when a tax system accords full offset for capital losses, a reduction in tax rates applicable to capital gains would reduce risk taking. This is because with full loss offset the government acts like a partner in the investment, bearing an equal share of the risk, both good and bad. The reduction in tax rates reduces the government's share in gains and losses such that less risk is necessary to generate the same amount of after-tax income and the investor bears more of any loss.7 However, the present-law limitation on taxpayers' ability to offset capital losses against other income creates a bias against risk taking by implicitly reducing the value of any loss by deferring its inclusion in income. A reduction in the tax rate on realized gain, proponents argue, therefore should increase risk taking. Proponents argue that the preference provides an incentive for investment and capital formation, with particular importance for venture capital and high technology projects.

Others argue that the capital gains preference may be an inefficient mechanism to promote the desired capital formation. They argue that a preferential capital gains tax rate, broadly applied, is not targeted toward any particular type of equity investment. They note that a broad capital gains preference affords capital gains treatment to non-equity investments such as gains on municipal bonds and certain other financial instruments. They observe that present-law section 1202 (that provides individual holders of certain small businesses with a reduced tax on realized capital gains) and present-law section 1244 (that provides expanded loss offset for investments in certain small business stock) more specifically target risk-taking activities.

The President's budget proposal also would expand the tax benefit under section 1202 by creating a tax rate of zero for qualified investments.8 Proponents aver that it is important to provide a preference to equity investments in small businesses as they create the industries of the future. Opponents of such a capital gains preference point out that a tax preference could have only a small incentive effect on investment because a large source of venture capital and other equity investment is tax-exempt or partially tax-exempt entities (for example, pension funds and certain insurance companies and foreign investors). For example, in 2008, tax-exempt entities (including public pension funds, endowments, foundations, sovereign wealth funds, and union pension funds) contributed nearly 44 percent of new venture capital funds.9 On the other hand, proponents argue that preferential capital gains treatment for venture capitalists who are taxable is important. They argue that this is particularly acute for the entrepreneur who often contributes more in time and effort than in capital. They further observe that initial investors in new ventures are frequently friends and family of the entrepreneur, all of whom are taxable. The organized venture capitalists are more prevalent at later stages of financing. They observe that small businesses face a higher cost of capital than do larger, established businesses. However, a higher cost of capital does not necessarily indicate a market failure for which a tax subsidy might be justified. Small businesses are inherently risky. The majority of small businesses do not survive their first year. A higher cost of capital may only reflect market realities in assuming risk by investors and not a flaw in the capital markets. Others note that the Federal government has developed loan programs administered through the Small Business Administration to address the higher cost of capital faced by many small businesses. Proponents of a reduced capital gains tax rate on equity investments in small businesses argue that unlike the programs of the Small Business Administration, the proposed tax benefit is not limited by the appropriations process and is open to all businesses that meet the qualifying standards. They note that the market would still remain the judge of where to allocate investments among qualifying small businesses.

Opponents of a capital gains preference argue that creating a preference for capital gains could encourage the growth of debt and the reduction of equity throughout the economy. When debt is used in a share repurchase program or leveraged buyout transaction the taxpayers who hold the original equity securities must realize any gain that they might have. A lower tax rate on gains could make holders of equity more likely to tender their shares in a leveraged buyout transaction or share repurchase program. On the other hand, the capital gains preference may make equity more attractive than debt, the returns on which are taxed at ordinary income tax rates.


    Does a differential rate promote long-run economic growth?

The United States has a low rate of household saving, averaging less than five percent of disposable income for more than the past decade.10 This rate is low both in comparison to other industrialized countries and in comparison to prior United States experience. At the aggregate level, a low saving rate is a concern because saving provides the wherewithal for investment in productivity-enhancing equipment and technology. At the household level, a low saving rate may imply households are accumulating insufficient assets for retirement, emergencies, or other uses. By reducing the tax on realized capital gains, the after-tax return to household saving is increased.

Theoretically, the effect on saving of a reduction of taxes on capital income is ambiguous. There are two effects. First, the increased return to saving should encourage people to save more. Second, the increased return people receive on assets they have already accumulated and on saving they had already planned increases their income. This increased income may encourage them to increase their consumption and may reduce their saving. Empirical economic evidence also is ambiguous on whether, or if at all, household saving responds to changes in the after-tax rate of return.

In addition, reduction in only the tax applicable to capital gains may prove to be an inefficient saving incentive. By favoring certain types of assets (those that generate returns in the form of accrued gains) over other types of assets (those that generate returns in the form of interest, dividends, or royalties), taxpayers may reallocate their holdings of assets to obtain higher after-tax returns without saving new funds. Such portfolio reallocations also represent reduced efficiency of capital markets as choices have been distorted. As noted above, the application of a reduced tax on capital gains to those who currently hold assets with accrued gains could lead to reduced saving as households sell those assets and increase consumption from the proceeds.


    Is income from capital gains properly measured?

Some proponents of lower tax rates on income from capital gain observe that the preference may provide taxpayers some rough compensation for inflation. Part of the gain represents the effects of inflation and does not constitute real income.

Others note that a preferential tax rate is a very crude adjustment for inflation. In addition, as income taxed upon realization, generally at the taxpayer's discretion, a taxpayer realizing income from a capital gain enjoys a tax benefit from the deferral of tax on accrued appreciation until the asset is sold. The following example illustrates the benefit of deferral. Assume a taxpayer in the 15-percent tax bracket has $1,000 to invest and may choose between two investment alternatives, each of which generates a return of 10 percent annually. Assume the one investment is a certificate of deposit that pays the 10-percent return out annually as interest on which the taxpayer must pay tax. After paying tax, the taxpayer reinvests the principal and net proceeds in a new certificate of deposit. The other investment, stock in a company that pays no dividends, accrues the 10-percent return untaxed until a capital gain is realized. After eight years the after-tax value of the taxpayer's certificate of deposit would be $1,920.11 After selling the stock and paying tax on the realized gain, the taxpayer would have $1,972.12 Another way to characterize the benefit of deferral is that the effective rate of taxation on realized capital gains is less than the rate of taxation applicable to assets that pay current income. In this particular example, the effective rate of taxation on the realized capital gain is 11.4 percent, rather than the statutory tax rate of 15 percent.13 On the other hand, proponents of a preference for capital gains contend that the benefit of deferral is insufficient to make up for more than very modest inflation.


    Is a differential in rates consistent with policy maker's equity goals?

A lower rate of tax for income from capital gains compared to the tax rate applicable to other income will benefit directly those taxpayers who hold assets with accrued capital gains. Information is somewhat scant regarding the distribution of assets with accrued capital gains among different taxpayers. Tax return data contain information on which taxpayers have realized capital gains in the past. These data reveal that many taxpayers realize a capital gain from time to time, but the majority of the dollar value of gains realized is by taxpayers who frequently realize capital gains. Thus, while many taxpayers may benefit from an exclusion or indexing for capital gains, the bulk of the dollar value of any tax reduction will go to those taxpayers who realize the bulk of the dollar value of gains.

The data also suggest that taxpayers who infrequently realized capital gains generally have lower incomes than those taxpayers who frequently realized capital gains. These findings have been criticized because income is sometimes measured including the realized gain. However, attempts to account for this problem by measuring income less realized gains or by using a measure of income averaged over a period of years generally reveal that a large portion of the dollar value of gains are realized by higher-income taxpayers while a large portion of the transactions in which gains are realized are undertaken by the remaining taxpayers. Such findings are consistent with information on the ownership of assets in the United States. Higher-income taxpayers generally hold a larger proportion of corporate stock and other capital assets than do other taxpayers. Thus, while many taxpayers may benefit from a lower rate of tax on income from capital gains, a larger proportion of the dollar value of a lower tax rate on capital gain income will go to those higher-income taxpayers who realize the bulk of the dollar value of gains.

Complexity and tax rate differentials for income from dividends and capital gains

The combination of present law and the proposed changes of the President's Fiscal Year 2010 budget proposal creates a complex structure of tax rates for different types of investments.

Tables 1 through 3, below, detail the tax rates applicable to income from different investments yielding income from dividends and capital gains.

Table 1. -- Individual Tax Rates Applicable Under Present Law to
                    Certain Categories of Income, 2010

Minimum Tax
                              Regular Tax Rate Bracket        Rate Bracket
                           ________________________________   _______________

 Category of income         10%  15%   25%   28%   33%   35%   26%     28%
 Dividend income             0    0    15    15    15    15      same as
                                                                regular tax
 Short-term capital gain1   10   15    25    28    33    35    26      28
 Long-term capital gain2     0    0    15    15    15    15      same as
                                                                regular tax
 Section 1250 gain3         10   15    25    25    25    25    25      25
 Collectible gain           10   15    25    28    28    28    26      28
 Small business stock4       0    0    12.5  14    14    14   13.91    14.98
 Empowerment zone small
 business stock5             0    0    10    11.2  11.2  11.2 11.592   12.376
 D.C. Enterprise Zone
 stock/Renewal
 Community stock6            0    0     0     0     0     0    0        0

Table 2. -- Individual Tax Rates Applicable Under Present Law
           to Certain Categories of Income, 2011 and Thereafter

Minimum Tax
                              Regular Tax Rate Bracket        Rate Bracket
                           ________________________________   _______________

 Category of income          15%   28%   31%   35%   39.6%     26%     28%
 Dividend income             15    28    31    35    39.6      26      28
 Short-term capital gain1    15    25    31    35    39.6      26      28
 Long-term capital gain2     10    20    20    20    20          same as
                                                                regular tax
 Section 1250 gain3          15    25    25    25    25        25      25
 Collectible gain            15    28    28    28    28        26      28
 Small business stock
 issued before February 18,
 2009, or after December
 31, 2010.4                  7.5   14    14    14    14        18.467  19.887
 Empowerment zone small
 business stock issued
 before February 18, 2009,
 or after December 31,
 2010                        6     11.2   1.2  11.2  11.2      14.768  15.904
 Small business stock
 issued after February 17,
 2009, and before January
 1, 2011                     3.75   7     7     7     7        11.76   12.88
 Five-year gain acquired
 before 2001                 8     20     20   20    20          same as
                                                                regular tax
 Five-year gain acquired
 after 2000                  8     18     18   18    18          same as
                                                                regular tax
 D.C. Enterprise Zone
 stock/Renewal
 Community stock6            0      0      0    0     0         0       0

Table 3. -- Individual Tax Rates Applicable Under Administration
      Proposal to Certain Categories of Income, 2011 and Thereafter

Minimum Tax
                              Regular Tax Rate Bracket        Rate Bracket
                           ________________________________   _______________

 Category of income          10%  15%  25%  28%  36%  39.6%     26%      28%
 Dividend income              0    0   15   15   20   20           same as
                                                                  regular tax
 Short-term capital gain1    10   15   25   28   36   39.6      26       28
 Long-term capital gain2      0    0   15   15   20   20           same as
                                                                 regular tax
 Section 1250 gain3          10   15   25   25   25   25        25       25
 Collectible gain            10   15   25   28   28   28        26       28
 Small business stock
 issued before February 18,
 20094                        0    0   12.5 14   14   14        13.91    14.98
 Empowerment zone small
 business stock issued
 before February 18, 2009     0    0   10   11.2 11.2 11.2      11.592   12.376
 Small business stock
 issued after February 17,
 2009                         0    0    0    0    0    0         0        0
 D.C. Enterprise Zone
 stock/Renewal
 Community stock6             0    0    0    0    0    0         0        0

FOOTNOTES TO TABLES 1, 2 AND 3

1 Gain from assets held not more than one year.

2 Gain from assets held more than one year not included in
 another category.

3 Capital gain attributable to depreciation on section 1250
 property (i.e., depreciable real estate).

4 Effective rates after application of 50-percent exclusion for
 small business stock held more than five years.

5 Effective rates after application of 60-percent exclusion for
 small business empowerment zone stock held more than five years.

6 D.C. Enterprise Zone stock issued after December 31, 1997, and
 before January 1, 2010, and Renewal Community stock issued after December 31,
 2001, and before January 1, 2010. The stock must be held for more than five
 years.

7 If the holding period for the stock begins after 2000, the
 rates are 16.64% and 17.92%, respectively.

END OF FOOTNOTES TO TABLES 1, 2 AND 3

Beyond any difficulties the various rates may create for a taxpayer's calculation of his or her tax liability, opponents of a preferential capital gains rate point out that the application of different tax rates to different sources of income inevitably creates disputes over which assets are entitled to the preferential rate and encourages taxpayers to mischaracterize their income as derived from the preferred source. Litigation involving holding period, sale or exchange treatment, asset allocation, and many other issues has been extensive in the past. A significant body of law, based both in the tax code and in judicial rules, has developed in response to conflicting taxpayer and IRS positions in particular cases. Its principles are complicated in concept and application, typically requiring careful scrutiny of the facts in each case and leaving opportunities for taxpayers to take aggressive tax return positions. It has been argued that the results derived in particular cases lack even rough consistency, notwithstanding the substantial resources consumed in this process by taxpayers and the Internal Revenue Service.

Furthermore, it is argued that so long as a limitation on deductions of capital loss is retained, some areas of uncertainty and dispute will continue to exist (for example, whether property was held primarily for sale to customers in the ordinary course of business). Because limitations on the deductibility of capital or investment losses may be desirable to limit the selective realization of losses without realization of gains, the potential for simplification and consistency may be limited.


Prior Action

The American Recovery and Reinvestment Tax Act of 2009 changed the applicable tax rates for qualified small business stock issued after February 17, 2009, and before January 1, 2011.

B. Extend Temporary Increase in Expensing for Small Business

Present Law

Subject to certain limitations, a taxpayer that invests in certain qualifying property may elect under section 179 to deduct (or "expense") the cost of qualifying property, rather than to recover such costs through depreciation deductions.14 For taxable years beginning after 2007 and before 2011, the maximum amount that a taxpayer may expense is $250,000 of the cost of qualifying property placed in service for the taxable year. The $250,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $800,000.15 Off-the-shelf computer software placed in service in taxable years beginning before 2011 is treated as qualifying property.

The amount eligible to be expensed for a taxable year may not exceed the taxable income for a taxable year that is derived from the active conduct of a trade or business (determined without regard to this provision). Any amount that is not allowed as a deduction because of the taxable income limitation may be carried forward to succeeding taxable years (subject to similar limitations). No general business credit under section 38 is allowed with respect to any amount for which a deduction is allowed under section 179. An expensing election is made under rules prescribed by the Secretary.16

For taxable years beginning in 2011 and thereafter, a taxpayer with a sufficiently small amount of annual investment may elect to deduct up to $25,000 of the cost of qualifying property placed in service for the taxable year. The $25,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $200,000. The $25,000 and $200,000 amounts are not indexed. In general, qualifying property is defined as depreciable tangible personal property that is purchased for use in the active conduct of a trade or business (not including off-the-shelf computer software).


Description of Proposal17

The proposal increases permanently the amount a taxpayer may deduct under section 179.18 The proposal provides that the maximum amount a taxpayer may expense, for taxable years beginning after 2010, is $125,000 of the cost of qualifying property placed in service for the taxable year. The $125,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $500,000. The $125,000 and $500,000 amounts are indexed for inflation.

In addition, off-the-shelf computer software is treated as qualifying property. Further, a taxpayer is permitted to make or revoke an election for a taxable year under section 179 on an amended Federal tax return for that taxable year without the consent of the Commissioner.

Effective date. -- The proposal is effective for taxable years beginning after 2010.


Analysis

The proposal lowers the after-tax cost of capital expenditures made by businesses within a certain size range by permitting the immediate depreciation of the full amount of the capital expenditure (i.e., expensing), rather than depreciation of the expenditure over the recovery period. With a lower cost of capital, it is argued that eligible businesses will invest in more equipment and employ more workers, thus serving to stimulate economic growth among eligible businesses taxable in the United States.

Expensing of capital investments is the appropriate treatment if the policy objective is to tax consumption, because expensing effectively eliminates tax on the returns to investment, subject to certain assumptions.19 If the objective is to tax income, then depreciation deductions should coincide with the economic depreciation of the asset to measure economic income accurately. A depreciation system more generous than economic depreciation, but less generous than full expensing, results in an effective tax rate on the income from capital that is less than the statutory tax rate.

In addition to promoting investment, advocates of expensing assert that increased expensing eliminates depreciation recordkeeping requirements with respect to expensed property. Under the proposal, Federal income tax accounting could be simplified by increasing the portion of capital costs that are expensed in one taxable year and concomitantly reducing those that are recovered through depreciation over the recovery period. It could be argued that the simplification benefit of expensing is not fully realized, however, so long as property is partially depreciated, or so long as some but not all of the taxpayer's property that is eligible for cost recovery is expensed; the taxpayer must still keep records for that property that is subject to depreciation over a period of years.

The proposal increases the $200,000 phaseout threshold amount that would apply for taxable years beginning after 2010 to $500,000, which has the effect of generally permitting larger businesses to obtain the tax benefit of expensing. Some may argue that this result is inconsistent with the idea of limiting expensing to small businesses, as under the present-law provision. They might alternatively argue that in an income tax system, expanding the availability of expensing is not appropriate because it results in a less accurate measurement of economic income. On the other hand, it could be argued that there is no rationale for limiting expensing to businesses below a particular size or with capital expenditures below a certain level.

An advantage of making the increase in the expensing amounts permanent is that it reduces uncertainty with respect to the tax treatment of future investment, thus permitting taxpayers to plan capital expenditures with greater focus on the underlying economics of the investments, and less focus on the tax-motivated timing of investment. Removing tax-motivated distortions in the timing of investment may promote more efficient allocation of economic resources. On the other hand, legislative changes to the expensing rules (principally temporary increases in the amount that can be expensed) have been frequent in the past decade, and there is nothing to prevent additional legislative changes to the expensing rules, regardless of whether the current expensing rules are permanent or temporary. Additionally, to the extent that the rationale for the original increase in the amounts that may be expensed was to provide a counter-cyclical short-term economic stimulus, it can be argued that it is important that such provisions in fact be temporary. If there is uncertainty that a provision providing temporary tax relief may not ultimately be temporary, it can be argued that the stimulative effect of the provision is compromised because the taxpayer need not act within the originally specified time frame of the provision to benefit from it.


Prior Action

A similar proposal was included in the President's budget proposals for fiscal years 2007, 2008, 2009, and 2010.

C. Marginal Individual Income Tax Rate Reductions

Present Law

In general

The Economic Growth and Tax Relief Reconciliation Act of 200120 created a new 10percent regular income tax bracket for a portion of taxable income that was previously taxed at 15 percent. EGTRRA also reduced the other regular income tax rates. The otherwise applicable regular income tax rates of 28 percent, 31 percent, 36 percent and 39.6 percent were reduced to 25 percent, 28 percent, 33 percent, and 35 percent, respectively. These provisions of EGTRRA shall cease to apply for taxable years beginning after December 31, 2010.

Tax rate schedules

To determine regular tax liability, a taxpayer generally must apply the tax rate schedules (or the tax tables) to his or her regular taxable income. The rate schedules are broken into several ranges of income, known as income brackets, and the marginal tax rate increases as a taxpayer's income increases. Separate rate schedules apply based on an individual's filing status. For 2010, the regular individual income tax rate schedules are as follows:

Table 4. -- Federal Individual Income Tax Rates for 2010

 If taxable income is:                Then income tax equals:

                               Single Individuals

 Not over $8,375                      10% of the taxable income
 Over $8,375 but not over $34,000     $837.50 plus 15% of the excess over
                                      $8,375
 Over $34,000 but not over $82,400    $4,681.25 plus 25% of the excess over
                                      $34,000
 Over $82,400 but not over $171,850   $16,781.25 plus 28% of the excess over
                                      $82,400
 Over $171,850 but not over $373,650  $41,827.25 plus 33% of the excess over
                                      $171,850
 Over $373,650                        $108,421.25 plus 35% of the excess over
                                      $373,650

                              Heads of Households

 Not over $11,950                     10% of the taxable income
 Over $11,950 but not over $45,550    $1,195 plus 15% of the excess over
                                      $11,950
 Over $45,550 but not over $117,650   $6,235 plus 25% of the excess over
                                      $45,550
 Over $117,650 but not over $190,550  $24,260 plus 28% of the excess over
                                      $117,650
 Over $190,550 but not over $373,650  $44,672 plus 33% of the excess over
                                      $190,550
 Over $373,650                        $105,095 plus 35% of the excess over
                                      $373,650

         Married Individuals Filing Joint Returns and Surviving Spouses

 Not over $16,750                     10% of the taxable income
 Over $16,750 but not over $68,000    $1,675 plus 15% of the excess over
                                      $16,750
 Over $68,000 but not over $137,300   $9,362.50 plus 25% of the excess over
                                      $68,000
 Over $137,300 but not over $209,250  $26,687.50 plus 28% of the excess over
                                      $137,300
 Over $209,250 but not over $373,650  $46,833.50 plus 33% of the excess over
                                      $209,250
 Over $373,650                        $101,085.50 plus 35% of the excess over
                                      $373,650

                  Married Individuals Filing Separate Returns

 Not over $8,375                      10% of the taxable income
 Over $8,375 but not over $34,000     $837.50 plus 15% of the excess over
                                      $8,375
 Over $34,000 but not over $68,650    $4,681.25 plus 25% of the excess over
                                      $34,000
 Over $68,650 but not over $104,625   $13,343.75 plus 28% of the excess over
                                      $68,650
 Over $104,625 but not over $186,825  $23,416.75 plus 33% of the excess over
                                      $104,625
 Over $186,825                        $50,542.75 plus 35% of the excess over
                                      $186,825

Description of Proposal

The proposal permanently extends the 10-percent, 15-percent, 25-percent and 28-percent individual income tax rates. For taxable years beginning after December 31, 2010, the 33-percent rate and the 35-percent rate brackets become 36-percent and 39.6 percent, respectively.

The proposal widens the tax rate bracket for the 28-percent rate so that individuals with less than $195,550 of taxable income in 2011 ($200,000 of adjusted gross income ("AGI"), assuming one personal exemption and the basic standard deduction, indexed from 2009) will not be subject to the new 36-percent rate.

For married individuals filing joint returns and surviving spouses, the dollar threshold for the new 36-percent bracket is set so that married couples and surviving spouses with taxable income below $237,300 in 2011 ($250,000 of AGI, assuming two personal exemptions and the basic standard deduction, indexed from 2009), currently subject to the 33-percent rate, will not become subject to the new 36-percent rate.

For head of household filers, the starting point of the 36-percent bracket is set at the midpoint of the starting points for single filers and married joint filers, rounded down to the nearest $50, or $216,400.

A comparison of Table 5, below, with Table 4, above, illustrates proposed tax rate changes. Note that Table 5 also incorporates the President's proposal to retain the marriage penalty relief with respect to the size of the 15 percent rate bracket, as discussed in section II.F.

Table 5. -- Federal Individual Income Tax Rates for 2011 Under the
                           President's Proposal

 If taxable income is:                Then income tax equals:

                               Single Individuals

 Not over $8,575                      10% of the taxable income
 Over $8,575 but not over $34,850     $858 plus 15% of the excess over $8,575
 Over $34,850 but not over $84,350    $4,799 plus 25% of the excess over
                                      $34,850
 Over $84,350 but not over $195,550   $17,174 plus 28% of the excess over
                                      $84,350
 Over $195,550 but not over $382,650  $48,310 plus 36% of the excess over
                                      $195,550
 Over $382,650                        $115,666 plus 39.6% of the excess over
                                      $382,650

                              Heads of Households

 Not over $12,250                     10% of the taxable income
 Over $12,250 but not over $46,650    $1,225 plus 15% of the excess over
                                      $12,250
 Over $46,650 but not over $120,500   $6,385 plus 25% of the excess over
                                      $46,650
 Over $120,500 but not over $216,400  $24,848 plus 28% of the excess over
                                      $120,500
 Over $216,400 but not over $382,650  $51,700 plus 36% of the excess over
                                      $216,400
 Over $382,650                        $111,550 plus 39.6% of the excess over
                                      $382,650

         Married Individuals Filing Joint Returns and Surviving Spouses

 Not over $17,150                     10% of the taxable income
 Over $17,150 but not over $69,700    $1,715 plus 15% of the excess over
                                      $17,150
 Over $69,700 but not over $140,600   $9,598 plus 25% of the excess over
                                      $69,700
 Over $140,600 but not over $237,300  $27,323 plus 28% of the excess over
                                      $140,600
 Over $237,300 but not over $382,650  $54,399 plus 36% of the excess over
                                      $237,300
 Over $382,650                        $106,725 plus 39.6% of the excess over
                                      $382,650

                  Married Individuals Filing Separate Returns

 Not over $8,575                      10% of the taxable income
 Over $8,575 but not over $34,850     $857.50 plus 15% of the excess over
                                      $8,575
 Over $34,850 but not over $70,300    $4,799 plus 25% of the excess over
                                      $34,850
 Over $70,300 but not over $118,650   $13,661.50 plus 28% of the excess over
                                      $70,300
 Over $118,650 but not over $191,325  $27,199.50 plus 36% of the excess over
                                      $118,650
 Over $191,325                        $53,362.50 plus 39.6% of the excess over
                                      $191,325

Effective date. -- The proposal applies to taxable years beginning after December 31, 2010.


Analysis

The proposal provides tax relief to a large percentage of taxpayers, which will provide incentives for these taxpayers to work, to save, and to invest and, thereby, will have a positive effect on the long-term health of the economy. The proposal also results in increased marginal tax rates on upper income taxpayers (as is provided for by the present-law sunset of EGTRRA), which will correspondingly reduce incentives for these taxpayers to work, to save, and to invest. Opponents of this latter aspect of the proposal often note that many small businesses, and a large fraction of small business income, will be adversely impacted by an increase in the top two tax rates. The staff of the Joint Committee on Taxation estimates that in 2011 just under 750,000 taxpayers with net positive business income (3 percent of all taxpayers with net positive business income) will have marginal rates of 36 or 39.6 percent under the President's proposal, and that 50 percent of the approximately $1 trillion of aggregate net positive business income will be reported on returns that have a marginal rate of 36 or 39.6 percent.21

Some argue that an increase in the top two tax rates may lead to a greater disincentive to take entrepreneurial risks as the government will take a larger share of any marginal gains from successful ventures. On the other hand, proponents of the proposal observe that, despite these negative consequences, it is appropriate to allow the rates to rise for relatively few upper income taxpayers on account of pressing needs for Federal revenues, deficit reduction and distributional concerns.

Some opponents of any extension of the EGTRRA rates argue that the projections for prolonged Federal deficits should be dealt with more aggressively even if it requires allowing more of the EGTRRA tax relief to expire. They argue that the long-term economic effects of the increased Federal debt needed to support projected spending and tax relief will adversely affect the United States' long-term economic prospects. Further, they argue that the tax cuts will reduce the ability of the Federal government to pay down the public debt, fund priorities such as education and defense, and secure the future obligations of Social Security and Medicare.


Prior Action

Proposals to extend permanently the 10-percent, 15-percent, 25-percent, and 28-percent individual income tax rates were contained in the President's fiscal year 2003, 2004, 2005, 2006, 2007, 2008, 2009 and 2010 budget proposals.

D. Child Tax Credit

Present Law

An individual may claim a tax credit for each qualifying child under the age of 17. The maximum amount of the credit per child is $1,000 through 2010 and $500 thereafter. A child who is not a citizen, national, or resident of the United States cannot be a qualifying child.

The aggregate amount of child credits that may be claimed is phased out for individuals with income over certain threshold amounts. Specifically, the otherwise allowable aggregate child tax credit amount is reduced by $50 for each $1,000 (or fraction thereof) of modified adjusted gross income ("modified AGI") over $75,000 for single individuals or heads of households, $110,000 for married individuals filing joint returns, and $55,000 for married individuals filing separate returns. For purposes of this limitation, modified AGI includes certain otherwise excludable income earned by U.S. citizens or residents living abroad or in certain U.S. territories.

The credit is allowable against the regular tax and, for taxable years beginning before January 1, 2011, is allowed against the alternative minimum tax ("AMT"). To the extent the child tax credit exceeds the taxpayer's tax liability, the taxpayer is eligible for a refundable credit (the additional child tax credit) equal to 15 percent of earned income in excess of a threshold dollar amount (the "earned income" formula). EGTRRA provided, in general, that this threshold dollar amount is $10,000 indexed for inflation from 2001. The American Recovery and Reinvestment Act of 2009 set the threshold at $3,000 for both 2009 and 2010. After 2010, the ability to determine the refundable child credit based on earned income in excess of the threshold dollar amount expires.

Families with three or more qualifying children may determine the additional child tax credit using the "alternative formula" if this results in a larger credit than determined under the earned income formula. Under the alternative formula, the additional child tax credit equals the amount by which the taxpayer's social security taxes exceed the taxpayer's earned income tax credit ("EITC"). After 2010, due to the expiration of the earned income formula, this is the only manner of obtaining a refundable child credit.

Earned income is defined as the sum of wages, salaries, tips, and other taxable employee compensation plus net self-employment earnings. Unlike the EITC, which also includes the preceding items in its definition of earned income, the additional child tax credit is based only on earned income to the extent it is included in computing taxable income. For example, some ministers' parsonage allowances are considered self-employment income, and thus are considered earned income for purposes of computing the EITC, but the allowances are excluded from gross income for individual income tax purposes, and thus are not considered earned income for purposes of the additional child tax credit since the income is not included in taxable income.


Description of Proposal

The proposal permanently extends the $1,000 child tax credit and allows the child tax credit against the individual's regular income tax and AMT.22 The provision also extends the EGTRRA repeal of a prior-law provision that reduced the refundable child credit by the amount of the AMT. The proposal permanently extends the earned income formula for determining the refundable child credit, with the earned income threshold of $10,000 (indexed for inflation from 2001). Finally, the proposal permanently extends the rule that the refundable portion of the child tax credit does not constitute income and shall not be treated as resources for purposes of determining eligibility or the amount or nature of benefits or assistance under any Federal program or any State or local program financed with Federal funds.

Effective date. -- The proposal applies to taxable years beginning after December 31, 2010.


Analysis

This provision doubles the child tax credit (from $500 to $1,000) to provide additional tax relief to families to help offset the costs of raising a child. Proponents embrace the original arguments made for the EGTRRA provisions as support for permanently extending the provisions. Their principal argument is that a tax credit for families with children recognizes the expense of raising children and the importance of helping families raise children. Further, they argue that the refundable child credit should remain widely available to families regardless of the number of children (rather than only families with three or more children), and thus it is important to extend the earned income formula for determining the refundable credit. Additionally, they believe that the child credit should be allowed to offset the AMT.

Most observers recognize that dependent children affect a taxpayer's ability to pay tax, and believe that fact should be reflected in a taxpayer's tax liability. However, some opponents raise concerns over the cost of the extension. They also note that the dependent exemption, which provides tax relief to many of the same families with dependents as receive the child tax credit, is already part of the Code. In general, opponents argue that the EGTRRA sunset provisions, including the child credit provisions, should be addressed in the context of an overall reform of the tax Code that simultaneously addresses long-term revenue requirements.


Prior Action

Similar proposals were contained in the President's fiscal year 2003, 2004, 2005, 2006, 2007, 2008, 2009 and 2010 budget proposals.

E. Increase of Refundable Portion of the Child Credit

Present Law

An individual may claim a tax credit for each qualifying child under the age of 17. The amount of the credit per child is $1,000 through 2010 and $500 thereafter. A child who is not a citizen, national, or resident of the United States cannot be a qualifying child.

The credit is phased out for individuals with income over certain threshold amounts. Specifically, the otherwise allowable child tax credit is reduced by $50 for each $1,000 (or fraction thereof) of modified adjusted gross income over $75,000 for single individuals or heads of households, $110,000 for married individuals filing joint returns, and $55,000 for married individuals filing separate returns. For purposes of this limitation, modified adjusted gross income includes certain otherwise excludable income earned by U.S. citizens or residents living abroad or in certain U.S. territories.

The credit is allowable against the regular tax and the alternative minimum tax. To the extent the child credit exceeds the taxpayer's tax liability, the taxpayer is eligible for a refundable credit (the additional child tax credit) equal to 15 percent of earned income in excess of a threshold dollar amount (the "earned income" formula). Prior to the enactment of the American Recovery and Reinvestment Act of 2009 ("ARRA"), the threshold dollar amount was $12,550 (for 2009), and is indexed for inflation. Under the ARRA, the threshold amount (beginning in 2009 and 2010) is $3,000. After 2010 the pre-ARRA rules shall apply.

Families with three or more children may determine the additional child tax credit using the "alternative formula," if this results in a larger credit than determined under the earned income formula. Under the alternative formula, the additional child tax credit equals the amount by which the taxpayer's social security taxes exceed the taxpayer's earned income tax credit ("EITC").

Earned income is defined as the sum of wages, salaries, tips, and other taxable employee compensation plus net self-employment earnings. Unlike the EITC, which also includes the preceding items in its definition of earned income, the additional child tax credit is based only on earned income to the extent it is included in computing taxable income. For example, some ministers' parsonage allowances are considered self-employment income and thus, are considered earned income for purposes of computing the EITC, but the allowances are excluded from gross income for individual income tax purposes and thus, are not considered earned income for purposes of the additional child tax credit.

Any credit or refund allowed or made to an individual under this provision (including to any resident of a U.S. possession) is not taken into account as income and shall not be taken into account as resources for the month of receipt and the following two months for purposes of determining eligibility of such individual or any other individual for benefits or assistance, or the amount or extent of benefits or assistance, under any Federal program or under any State or local program financed in whole or in part with Federal funds.


Description of Proposal

The proposal permanently extends the lower threshold dollar amount ($3,000) for calculation of the refundable child tax credit. Also, the proposal stops indexation for inflation of the $3,000 earnings threshold.23

Effective date. -- The proposal applies to taxable years beginning after December 31, 2010.


Analysis

Proponents argue that the ARRA expansion of the refundable child tax credit helps offset other Federal tax liabilities to reduce the overall tax burden on working families. Opponents question whether the proliferation of refundable credits unnecessarily contributes to the complexity of the tax system. Others have also expressed concern about compliance issues with respect to refundable credits. The EITC has special rules related to taxpayers who have improperly claimed the credit in prior years, and consideration could be given to similar rules for the refundable child credit.

Prior Action

A similar provision was included in the President's fiscal year 2010 budget proposal.

F. Marriage Penalty Relief and Earned Income Tax Credit
Simplification

Present Law

Marriage penalty

A married couple generally is treated as one tax unit that must pay tax on the couple's total taxable income. Although married couples may elect to file separate returns, the rate schedules and other provisions are structured so that filing separate returns usually results in a higher tax than filing a joint return. Other rate schedules apply to single persons and to single heads of households.

A "marriage penalty" exists when the combined tax liability of a married couple filing a joint return is greater than the sum of the tax liabilities of each individual computed as if they were not married. A "marriage bonus" exists when the combined tax liability of a married couple filing a joint return is less than the sum of the tax liabilities of each individual computed as if they were not married.

Basic standard deduction

EGTRRA increased the basic standard deduction for a married couple filing a joint return to twice the basic standard deduction for an unmarried individual filing a single return. The basic standard deduction for a married taxpayer filing separately continued to equal one-half of the basic standard deduction for a married couple filing jointly; thus, the basic standard deduction for unmarried individuals filing a single return and for married couples filing separately are the same.

Fifteen percent rate bracket

EGTRRA increased the size of the 15-percent regular income tax rate bracket for a married couple filing a joint return to twice the size of the corresponding rate bracket for an unmarried individual filing a single return.

Earned income tax credit

The earned income tax credit ("EITC") is a refundable tax credit available to certain lower-income individuals. Generally, the amount of an individual's allowable earned income credit is dependent on the individual's earned income, adjusted gross income, and the number of qualifying children.


Description of Proposal

Basic standard deduction

The proposal permanently increases the basic standard deduction for a married couple filing a joint return to twice the basic standard deduction for an unmarried individual filing a single return.

15 percent rate bracket

The proposal permanently increases the size of the 15-percent regular income tax rate bracket for a married couple filing a joint return to twice the 15-percent regular income tax rate bracket for an unmarried individual filing a single return. Finally, for married couples who file a joint return, the proposal permanently increases the beginning and ending points of the EITC phase-out by $5,000.24

Earned income tax credit

The proposal permanently extends certain EITC provisions adopted by EGTRRA. These include: (1) a simplified definition of earned income; (2) a simplified relationship test; (3) a simplified tie-breaking rule; (4) additional math error authority for the Internal Revenue Service; (5) a repeal of the prior-law provision that reduced an individual's EITC by the amount of his alternative minimum tax liability; and (6) increases in the beginning and ending points of the credit phase-out for married taxpayers.

Effective date. -- The proposal applies to taxable years beginning after December 31, 2010.


Analysis

Basic standard deduction and 15-percent rate bracket

Proponents of the extension of these provisions are concerned about the inequity that arises when two working single individuals marry and experience a tax increase solely by reason of their marriage (a "marriage penalty"). Proponents argue that the expansion of the standard deduction and the 15-percent rate bracket for married couples filing joint returns would eliminate the effects of the marriage tax penalty for most taxpayers, and alleviate the effects for others.

Some analysts have suggested that the marriage penalty may alter taxpayers' decisions to work. As explained above, a marriage penalty exists when the sum of the tax liabilities of two unmarried individuals filing their own tax returns (either single or head of household returns) is less than their tax liability under a joint return (if the two individuals were to marry). This is the result of a tax system with increasing marginal tax rates. The marriage penalty not only means the total tax liability of the two formerly single taxpayers is higher after marriage than before marriage, but it also generally may result in one or both of the formerly single taxpayers being in a higher marginal tax rate bracket. That is, the additional tax on an additional dollar of income of each taxpayer is greater after marriage than it was when they were both single. Economists argue that changes in marginal tax rates may affect taxpayers' decisions to work. Higher marginal tax rates may discourage household saving and labor supply by the newly married household. For example, suppose a woman currently in the 28-percent tax bracket marries a man who currently is unemployed. If they had remained single and the man became employed, the first $9,350 of his earnings would be tax-free.25 However, because he marries a woman in the 28-percent income tax bracket, if he becomes employed he would have a tax liability of 28 cents on his first dollar of earnings, leaving a net of 72 cents for his labor.26 Filing a joint return may distort the man's decision regarding whether to enter the work force. If he chooses not to work, society loses the benefit of his labor. The preponderance of economic evidence shows that the labor supply decision of the lower earner or "secondary earner" in married households may be quite sensitive to the household's marginal tax rate.27 In addition to fairness arguments, proponents argue for continued marriage penalty relief on economic efficiency grounds.

Any attempt to address the marriage tax penalty involves the balancing of several competing principles, including equal tax treatment of married couples with equal incomes, the determination of equitable relative tax burdens of single individuals and married couples with equal incomes, the degree of progressivity of the tax system, and the goal of simplicity in compliance and administration. It is not possible to have a tax system that has a progressive rate structure, taxes married couples with equal incomes equally, and is neutral with respect to marriage. Opponents of the extension argue that it goes too far in creating marriage bonuses while attempting to alleviate marriage penalties, and imposes too high a relative tax burden on single individuals.

Earned income tax credit

Large marriage penalties exist in the EITC, because the parameters of the credit are based on earned income and numbers of qualifying children and not on marital status (other than the one provision that delays the phase-out of the credit for married taxpayers). Proponents argue that extending the EGTRRA provisions are necessary for two reasons. First, they argue that the reduction in the marriage penalty for EITC filers is particularly important for this low-income population, such that credit recipients are not discouraged from marrying on account of the loss or reduction in credit that marriage could entail. Second, they believe the simplification provisions have been effective and are worth maintaining. Others respond that simplification proposals should be addressed as part of a more comprehensive reform of the credit to reduce or eliminate high error rates by tax filers.


Prior Action

Similar proposals were contained in the President's fiscal year 2003, 2004, 2005, 2006, 2007, 2008, 2009 and 2010 budget proposals.

G. Education Incentives

Present Law

Income and wage exclusion for awards under the National Health Service Corps Scholarship Program and the F. Edward Hebert Armed Forces Health Professions Scholarship and Financial Assistance Program

Section 117 excludes from gross income amounts received as a qualified scholarship by an individual who is a candidate for a degree and used for tuition and fees required for the enrollment or attendance (or for fees, books, supplies, and equipment required for courses of instruction) at a primary, secondary, or post-secondary educational institution. The tax-free treatment provided by section 117 does not extend to scholarship amounts covering regular living expenses, such as room and board. In addition to the exclusion for qualified scholarships, section 117 provides an exclusion from gross income for qualified tuition reductions for certain education provided to employees (and their spouses and dependents) of certain educational organizations. Amounts excludable from gross income under section 117 are also excludable from wages for payroll tax purposes.28

The exclusion for qualified scholarships and qualified tuition reductions does not apply to any amount received by a student that represents payment for teaching, research, or other services by the student required as a condition for receiving the scholarship or tuition reduction. An exception to this rule applies in the case of the National Health Service Corps Scholarship Program (the "NHSC Scholarship Program") and the F. Edward Hebert Armed Forces Health Professions Scholarship and Financial Assistance Program (the "Armed Forces Scholarship Program").

The NHSC Scholarship Program and the Armed Forces Scholarship Program provide education awards to participants on the condition that the participants provide certain services. In the case of the NHSC Scholarship Program, the recipient of the scholarship is obligated to provide medical services in a geographic area (or to an underserved population group or designated facility) identified by the Public Health Service as having a shortage of health care professionals. In the case of the Armed Forces Scholarship Program, the recipient of the scholarship is obligated to serve a certain number of years in the military at an armed forces medical facility.

Under the sunset provisions of EGTRRA, the exclusion from gross income and wages for the NHSC Scholarship Program and the Armed Forces Scholarship Program will no longer apply for taxable years beginning after December 31, 2010.

Income and wage exclusion for employer-provided educational assistance

If certain requirements are satisfied, up to $5,250 annually of educational assistance provided by an employer to an employee is excludable from gross income for income tax purposes and from wages for employment tax purposes.29 This exclusion applies to both graduate and undergraduate courses.30 For the exclusion to apply, certain requirements must be satisfied. The educational assistance must be provided pursuant to a separate written plan of the employer. The employer's educational assistance program must not discriminate in favor of highly compensated employees. In addition, no more than five percent of the amounts paid or incurred by the employer during the year for educational assistance under a qualified educational assistance program can be provided for the class of individuals consisting of more than five-percent owners of the employer and the spouses or dependents of such more than five-percent owners.

For purposes of the exclusion, educational assistance means the payment by an employer of expenses incurred by or on behalf of the employee for education of the employee including, but not limited to, tuition, fees, and similar payments, books, supplies, and equipment. Educational assistance also includes the provision by the employer of courses of instruction for the employee (including books, supplies, and equipment). Educational assistance does not include (1) tools or supplies that may be retained by the employee after completion of a course, (2) meals, lodging, or transportation, or (3) any education involving sports, games, or hobbies. The exclusion for employer-provided educational assistance applies only with respect to education provided to the employee (e.g., it does not apply to education provided to the spouse or a child of the employee).

In the absence of the specific exclusion for employer-provided educational assistance under section 127, employer-provided educational assistance is excludable from gross income and wages only if the education expenses qualify as a working condition fringe benefit.31 In general, education qualifies as a working condition fringe benefit if the employee could have deducted the education expenses under section 162 if the employee paid for the education. In general, education expenses are deductible by an individual under section 162 if the education (1) maintains or improves a skill required in a trade or business currently engaged in by the taxpayer, or (2) meets the express requirements of the taxpayer's employer, applicable law, or regulations imposed as a condition of continued employment. However, education expenses are generally not deductible if they relate to certain minimum educational requirements or to education or training that enables a taxpayer to begin working in a new trade or business. In determining the amount deductible for this purpose, the two-percent floor on miscellaneous itemized deductions is disregarded.

The specific exclusion for employer-provided educational assistance was originally enacted on a temporary basis and was subsequently extended 10 times.32 EGTRRA deleted the exclusion's explicit expiration date and extended the exclusion to graduate courses. However, those changes are subject to EGTRRA's sunset provision so that the exclusion will not be available for taxable years beginning after December 31, 2010. Thus, at that time, educational assistance will be excludable from gross income only if it qualifies as a working condition fringe benefit (i.e., the expenses would have been deductible as business expenses if paid by the employee). As previously discussed, to meet such requirement, the expenses must be related to the employee's current job.33

Deduction for student loan interest

Certain individuals who have paid interest on qualified education loans may claim an above-the-line deduction for such interest expenses, subject to a maximum annual deduction limit.34 Required payments of interest generally do not include voluntary payments, such as interest payments made during a period of loan forbearance. No deduction is allowed to an individual if that individual is claimed as a dependent on another taxpayer's return for the taxable year.

A qualified education loan generally is defined as any indebtedness incurred solely to pay for the costs of attendance (including room and board) of the taxpayer, the taxpayer's spouse, or any dependent of the taxpayer as of the time the indebtedness was incurred in attending an eligible educational institution on at least a half-time basis. Eligible educational institutions are (1) post-secondary educational institutions and certain vocational schools defined by reference to section 481 of the Higher Education Act of 1965, or (2) institutions conducting internship or residency programs leading to a degree or certificate from an institution of higher education, a hospital, or a health care facility conducting postgraduate training. Additionally, to qualify as an eligible educational institution, an institution must be eligible to participate in Department of Education student aid programs.

The maximum allowable deduction per year is $2,500. For 2010, the deduction is phased out ratably for single taxpayers with AGI between $60,000 and $75,000 and between $120,000 and $150,000 for married taxpayers filing a joint return. The income phaseout ranges are indexed for inflation and rounded to the next lowest multiple of $5,000.

Effective for taxable years beginning after December 31, 2010, the changes made by EGTRRA to the student loan provisions no longer apply. The EGTRRA changes scheduled to expire are: (1) increases that were made in the AGI phaseout ranges for the deduction and (2) rules that extended deductibility of interest beyond the first 60 months that interest payments are required. With the expiration of EGTRRA, the phaseout ranges will revert to a base level of $40,000 to $55,000 ($60,000 to $75,000 in the case of a married couple filing jointly), but with an adjustment for inflation occurring since 2002.

Coverdell education savings accounts

A Coverdell education savings account is a trust or custodial account created exclusively for the purpose of paying qualified education expenses of a named beneficiary.35 Annual contributions to Coverdell education savings accounts may not exceed $2,000 per designated beneficiary and may not be made after the designated beneficiary reaches age 18 (except in the case of a special needs beneficiary). The contribution limit is phased out for taxpayers with modified AGI between $95,000 and $110,000 ($190,000 and $220,000 for married taxpayers filing a joint return); the AGI of the contributor, and not that of the beneficiary, controls whether a contribution is permitted by the taxpayer.

Earnings on contributions to a Coverdell education savings account generally are subject to tax when withdrawn.36 However, distributions from a Coverdell education savings account are excludable from the gross income of the distributee (i.e., the student) to the extent that the distribution does not exceed the qualified education expenses incurred by the beneficiary during the year the distribution is made. The earnings portion of a Coverdell education savings account distribution not used to pay qualified education expenses is includible in the gross income of the distributee and generally is subject to an additional 10-percent tax.37

Tax-free (including free of additional 10-percent tax) transfers or rollovers of account balances from one Coverdell education savings account benefiting one beneficiary to another Coverdell education savings account benefiting another beneficiary (as well as redesignations of the named beneficiary) are permitted, provided that the new beneficiary is a member of the family of the prior beneficiary and is under age 30 (except in the case of a special needs beneficiary). In general, any balance remaining in a Coverdell education savings account is deemed to be distributed within 30 days after the date that the beneficiary reaches age 30 (or, if the beneficiary dies before attaining age 30, within 30 days of the date that the beneficiary dies).

Qualified education expenses include "qualified higher education expenses" and "qualified elementary and secondary education expenses."

The term "qualified higher education expenses" includes tuition, fees, books, supplies, and equipment required for the enrollment or attendance of the designated beneficiary at an eligible education institution, regardless of whether the beneficiary is enrolled at an eligible educational institution on a full-time, half-time, or less than half-time basis.38 Moreover, qualified higher education expenses include certain room and board expenses for any period during which the beneficiary is at least a half-time student. Qualified higher education expenses include expenses with respect to undergraduate or graduate-level courses. In addition, qualified higher education expenses include amounts paid or incurred to purchase tuition credits (or to make contributions to an account) under a qualified tuition program for the benefit of the beneficiary of the Coverdell education savings account.39

The term "qualified elementary and secondary education expenses," means expenses for: (1) tuition, fees, academic tutoring, special needs services, books, supplies, and other equipment incurred in connection with the enrollment or attendance of the beneficiary at a public, private, or religious school providing elementary or secondary education (kindergarten through grade 12) as determined under State law; (2) room and board, uniforms, transportation, and supplementary items or services (including extended day programs) required or provided by such a school in connection with such enrollment or attendance of the beneficiary; and (3) the purchase of any computer technology or equipment (as defined in section 170(e)(6)(F)(i)) or Internet access and related services, if such technology, equipment, or services are to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in elementary or secondary school. Computer software primarily involving sports, games, or hobbies is not considered a qualified elementary and secondary education expense unless the software is predominantly educational in nature.

Qualified education expenses generally include only out-of-pocket expenses. Such qualified education expenses do not include expenses covered by employer-provided educational assistance or scholarships for the benefit of the beneficiary that are excludable from gross income. Thus, total qualified education expenses are reduced by scholarship or fellowship grants excludable from gross income under section 117, as well as any other tax-free educational benefits, such as employer-provided educational assistance, that are excludable from the employee's gross income under section 127.

Effective for taxable years beginning after December 31, 2010, the changes made by EGTRRA to Coverdell education savings accounts no longer apply. The EGTRRA changes scheduled to expire are: (1) the increase in the contribution limit to $2,000 from $500; (2) the increase in the phaseout range for married taxpayers filing jointly to $190,000-$220,000 from $150,000-$160,000; (3) the expansion of qualified expenses to include elementary and secondary education expenses; (4) special age rules for special needs beneficiaries; (5) clarification that corporations and other entities are permitted to make contributions, regardless of the income of the corporation or entity during the year of the contribution; (6) certain rules regarding when contributions are deemed made and extending the time during which excess contributions may be returned without additional tax; (7) certain rules regarding coordination with the Hope and Lifetime Learning credits; and (8) certain rules regarding coordination with qualified tuition programs.

Amount of governmental bonds that may be issued by governments qualifying for the "small governmental unit" arbitrage rebate exception

To prevent State and local governments from issuing more Federally subsidized tax-exempt bonds than is necessary for the activity being financed or from issuing such bonds earlier than needed for the purpose of the borrowing, the Code includes arbitrage restrictions limiting the ability to profit from investment of tax-exempt bond proceeds.40 The Code also provides certain exceptions to the arbitrage restrictions. Under one such exception, small issuers of governmental bonds issued for local governmental activities are not subject to the rebate requirement.41 To qualify for this exception the governmental bonds must be issued by a governmental unit with general taxing powers that reasonably expects to issue no more than $5 million of tax-exempt governmental bonds in a calendar year.42 Prior to EGTRRA, the $5 million limit was increased to $10 million if at least $5 million of the bonds are used to finance public schools. EGTRRA provided the additional amount of governmental bonds for public schools that small governmental units may issue without being subject to the arbitrage rebate requirements is increased from $5 million to $10 million.43 Thus, these governmental units may issue up to $15 million of governmental bonds in a calendar year provided that at least $10 million of the bonds are used to finance public school construction expenditures. This increase is subject to the EGTRRA sunset.

Issuance of tax-exempt private activity bonds for public school facilities

Interest on bonds that nominally are issued by State or local governments, but the proceeds of which are used (directly or indirectly) by a private person and payment of which is derived from funds of such a private person is taxable unless the purpose of the borrowing is approved specifically in the Code or in a non-Code provision of a revenue act. These bonds are called "private activity bonds."44 The term "private person" includes the Federal government and all other individuals and entities other than State or local governments.

Only specified private activity bonds are tax-exempt. EGTRRA added a new type of private activity bond that is subject to the EGTRRA sunset. This category is bonds for elementary and secondary public school facilities that are owned by private, for-profit corporations pursuant to public-private partnership agreements with a State or local educational agency.45 The term school facility includes school buildings and functionally related and subordinate land (including stadiums or other athletic facilities primarily used for school events) and depreciable personal property used in the school facility. The school facilities for which these bonds are issued must be operated by a public educational agency as part of a system of public schools.

A public-private partnership agreement is defined as an arrangement pursuant to which the for-profit corporate party constructs, rehabilitates, refurbishes, or equips a school facility for a public school agency (typically pursuant to a lease arrangement). The agreement must provide that, at the end of the contract term, ownership of the bond-financed property is transferred to the public school agency party to the agreement for no additional consideration.

Issuance of these bonds is subject to a separate annual per-State private activity bond volume limit equal to $10 per resident ($5 million, if greater) in lieu of the present-law State private activity bond volume limits. As with the present-law State private activity bond volume limits, States can decide how to allocate the bond authority to State and local government agencies. Bond authority that is unused in the year in which it arises may be carried forward for up to three years for public school projects under rules similar to the carryforward rules of the present-law private activity bond volume limits.


Description of Proposal

The proposal repeals the EGTRRA sunset as it applies to the NHSC Scholarship Program and the Armed Forces Scholarship Program, the section 127 exclusion from income and wages for employer-provided educational assistance, the student loan interest deduction, and Coverdell education savings accounts. The proposal also repeals the EGTRRA sunset as it applies to the expansion of the small government unit exception to arbitrage rebate and allowing issuance of tax-exempt private activity bonds for public school facilities. Thus, all of these tax benefits for education continue to be available after 2010.

Effective date. -- The proposal is effective on the date of enactment.


Analysis

Individual benefits

The present-law education tax benefits for individuals that are scheduled to expire under the EGTRRA sunset provision are intended to provide taxpayers with some financial relief for education expenses previously incurred (the modifications to the deduction for student loan interest), for current education expenses (the income and wage exclusion for awards under the NHSC Scholarship Program and the Armed Forces Scholarship Program and the income and wage exclusion for employer-provided educational assistance), and for future education expenses (the modifications to Coverdell education savings accounts). If these provisions are not extended, some of the tax benefits will be completely eliminated (the income and wage exclusion for awards under the NHSC Scholarship Program and the Armed Forces Scholarship Program and the income and wage exclusion for employer-provided educational assistance), while the others will be substantially narrowed (the modifications to the deduction for student loan interest and to Coverdell education savings accounts).

Some people may observe that permanently extending these provisions may lessen the financial burden of obtaining an education for a number of taxpayers. These people may further argue that there is a distinct government interest in having a well-educated populace in the United States, and, as such, it is important for the government to continue programs that encourage the development of such a populace. Other people may observe that there are already substantial nontax incentives to obtaining additional education (e.g., greater lifetime earning potential and increased job opportunities), and these incentives are sufficient to encourage individuals to obtain an appropriate level of education.

An additional argument that some people may make is that permanently extending these provisions will remove from the Code some of the considerable uncertainty inherent in provisions with a temporary existence, which may or may not be extended at some future date. In this particular case, this uncertainty may make it difficult for taxpayers to make optimal decisions today as to the total amount that they should spend on education since they cannot be certain whether tax benefits that may currently be available to them will be available to them in the future, after they have committed themselves to pursuing additional education. As a result, they may overinvest in education, on the assumption that tax benefits will be extended when, ultimately, they are not, or underinvest in education, on the assumption that tax benefits will not be extended when, ultimately, they are. One possible response to this argument is that Congress is aware of the potential for this type of uncertainty whenever it enacts temporary provisions and deems it acceptable for any of a number of possible reasons. For example, Congress may want to revisit the issue in the future, may have insufficient support for a permanent provision, or may feel that a permanent provision is too costly. A second possible response to the argument above is that permanently extending present law is not the only way to achieve certainty; certainty may also be achieved by letting the temporary provisions expire or by enacting a permanent law today that provides for something other than a mere extension of present law.

Bonds for public school facilities

The policy underlying the arbitrage rebate exception for bonds of small governmental units is to reduce complexity for these entities because they may not have in-house financial staff to engage in the expenditure and investment tracking necessary for rebate compliance. It is argued that the exception further is justified by the limited potential for arbitrage profits at small issuance levels and limitation of the provision to governmental bonds, which typically require voter approval before issuance. Opponents respond that issuers have sufficient financial sophistication that the exceptions are unwarranted.

Proponents of public-private partnerships to improve educational opportunities argue that the new category of private activity bonds allows public-private partnerships to reap the benefit of the implicit subsidy to capital costs provided through tax-exempt financing. Opponents may respond that expansions of allowable private activity bonds can lead to increased borrowing costs for all private activity bonds.


Prior Action

Similar proposals were contained in the President's fiscal year 2003, 2004, 2005, 2006, 2007, 2008, 2009, and 2010 budget proposals.

H. Modify and Make Permanent the Estate, Gift, and Generation
Skipping Transfer Taxes After 2009

Present and Prior Law

In general

In general, a gift tax is imposed on certain lifetime transfers and an estate tax is imposed on certain transfers at death. A generation skipping transfer tax generally is imposed on certain transfers, either directly or in trust or similar arrangement, to a "skip person" (i.e., a beneficiary in a generation more than one generation younger than that of the transferor). Transfers subject to the generation skipping transfer tax include direct skips, taxable terminations, and taxable distributions.

The estate and generation skipping transfers taxes are repealed for decedents dying and gifts made during 2010, but are reinstated for decedents dying and gifts made after 2010.

Exemption equivalent amounts and applicable tax rates


    In general

Under present law in effect through 2009 and after 2010, a unified credit is available with respect to taxable transfers by gift and at death.46 The unified credit offsets tax computed at the lowest estate and gift tax rates.

Before 2004, the estate and gift taxes were fully unified, such that a single graduated rate schedule and a single effective exemption amount of the unified credit applied for purposes of determining the tax on cumulative taxable transfers made by a taxpayer during his or her lifetime and at death. For years 2004 through 2009, the gift tax and the estate tax continued to be determined using a single graduated rate schedule, but the effective exemption amount allowed for estate tax purposes was higher than the effective exemption amount allowed for gift tax purposes. In 2009, the highest estate and gift tax rate was 45 percent. The unified credit effective exemption amount was $3.5 million for estate tax purposes and $1 million for gift tax purposes.

For 2009 and after 2010, the generation skipping transfer tax is imposed using a flat rate equal to the highest estate tax rate on cumulative generation skipping transfers in excess of the exemption amount in effect at the time of the transfer. The generation skipping transfer tax exemption for a given year (prior to and after repeal, discussed below) is equal to the unified credit effective exemption amount for estate tax purposes.


    Repeal of estate and generation skipping transfer taxes in 2010; modifications to gift tax

Under EGTRRA, the estate and generation skipping transfer taxes are repealed for decedents dying and generation skipping transfers made during 2010. The gift tax remains in effect during 2010, with a $1 million exemption amount and a gift tax rate of 35 percent. Also in 2010, except as provided in regulations, certain transfers in trust are treated as transfers of property by gift, unless the trust is treated as wholly owned by the donor or the donor's spouse under the grantor trust provisions of the Code.

    Reinstatement of the estate and generation skipping transfer taxes for decedents dying and generation skipping transfers made after December 31, 2010

The estate, gift, and generation skipping transfer tax provisions of EGTRRA sunset at the end of 2010, such that those provisions (including repeal of the estate and generation skipping transfer taxes) will not apply to estates of decedents dying, gifts made, or generation skipping transfers made after December 31, 2010. As a result, in general, the estate, gift, and generation skipping transfer tax rates and exemption amounts that would have been in effect had EGTRRA not been enacted will apply for estates of decedents dying, gifts made, or generation skipping transfers made in 2011 or later years. A single graduated rate schedule with a top rate of 55 percent and a single effective exemption amount of $1 million indexed for inflation for generation skipping transfer tax purposes will apply for purposes of determining the tax on cumulative taxable transfers by lifetime gift or bequest.

Basis in property received


    In general

Gain or loss, if any, on the disposition of property is measured by the taxpayer's amount realized (i.e., gross proceeds received) on the disposition, less the taxpayer's basis in such property.47 Basis generally represents a taxpayer's investment in property, with certain adjustments required after acquisition. For example, basis is increased by the cost of capital improvements made to the property and decreased by depreciation deductions taken with respect to the property.

    Basis in property received by lifetime gift

Property received from a donor of a lifetime gift generally takes a carryover basis.48 "Carryover basis" means that the basis in the hands of the donee is the same as it was in the hands of the donor. The basis of property transferred by lifetime gift also is increased, but not above fair market value, by any gift tax paid by the donor. The basis of a lifetime gift, however, generally cannot exceed the property's fair market value on the date of the gift. If the basis of property is greater than the fair market value of the property on the date of the gift, then, for purposes of determining loss, the basis is the property's fair market value on the date of the gift.

    Basis in property received from a decedent who died in 2009

Property passing from a decedent who died during 2009 generally takes a "stepped-up" basis.49 In other words, the basis of property passing from such a decedent's estate generally is the fair market value on the date of the decedent's death (or, if the alternate valuation date is elected, the earlier of six months after the decedent's death or the date the property is sold or distributed by the estate). This step up in basis generally eliminates the recognition of income on any appreciation of the property that occurred prior to the decedent's death. If the value of property on the date of the decedent's death was less than its adjusted basis, the property takes a stepped-down basis when it passes from a decedent's estate. This stepped-down basis eliminates the tax benefit from any unrealized loss.50

    Basis in property received from a decedent who dies during 2010

The rules providing for date-of-death fair market value ("stepped-up") basis in property acquired from a decedent are repealed for assets acquired from decedents dying in 2010, and a modified carryover basis regime applies.51 Under this regime, recipients of property acquired from a decedent at the decedent's death receive a basis equal to the lesser of the decedent's adjusted basis or the fair market value of the property on the date of the decedent's death. The modified carryover basis rules apply to property acquired by bequest, devise, or inheritance, or property acquired by the decedent's estate from the decedent, property passing from the decedent to the extent such property passed without consideration, and certain other property to which the prior law rules apply, other than property that is income in respect of a decedent. Property acquired from a decedent is treated as if the property had been acquired by gift. Thus, the character of gain on the sale of property received from a decedent's estate is carried over to the heir. For example, real estate that has been depreciated and would be subject to recapture if sold by the decedent will be subject to recapture if sold by the heir.

An executor generally may increase (i.e., step up) the basis in assets owned by the decedent and acquired by the beneficiaries at death, subject to certain special rules and exceptions. Under these rules, each decedent's estate generally is permitted to increase the basis of assets transferred by up to a total of $1.3 million. The $1.3 million is increased by the amount of unused capital losses, net operating losses, and certain "built-in" losses of the decedent. In addition, the basis of property transferred to a surviving spouse may be increased by an additional $3 million. Thus, the basis of property transferred to surviving spouses generally may be increased by up to $4.3 million. Nonresidents who are not U.S. citizens may be allowed to increase the basis of property by up to $60,000.


    Repeal of modified carryover basis regime for determining basis in property received from a decedent who dies after December 31, 2010

As described above, the estate, gift, and generation skipping transfer tax provisions of EGTRRA sunset at the end of 2010, such that those provisions will not apply to estates of decedents dying, gifts made, or generation skipping transfers made after December 31, 2010. As a result, the modified carryover basis regime in effect for determining basis in property passing from a decedent who dies during 2010 does not apply for purposes of determining basis in property received from a decedent who dies after December 31, 2010. Instead, the law in effect prior to 2010, which generally provides for date-of-death fair market value ("stepped-up") basis in property passing from a decedent, will apply.

State death tax credit; deduction for State death taxes paid


    State death tax credit under prior law

Before 2005, a credit was allowed against the Federal estate tax for any estate, inheritance, legacy, or succession taxes ("death taxes") actually paid to any State or the District of Columbia with respect to any property included in the decedent's gross estate.52 The maximum amount of credit allowable for State death taxes was determined under a graduated rate table, the top rate of which was 16 percent, based on the size of the decedent's adjusted taxable estate. Most States imposed a "pick-up" or "soak-up" estate tax, which served to impose a State tax equal to the maximum Federal credit allowed.

    Phase-out of State death tax credit; deduction for State death taxes paid

Under EGTRRA, the amount of allowable State death tax credit was reduced from 2002 through 2004. For decedents dying after 2004, the State death tax credit was repealed and replaced with a deduction for death taxes actually paid to any State or the District of Columbia, in respect of property included in the gross estate of the decedent.53 Such State taxes must have been paid and claimed before the later of: (1) four years after the filing of the estate tax return; or (2) (a) 60 days after a decision of the U.S. Tax Court determining the estate tax becomes final, (b) the expiration of the period of extension to pay estate taxes over time under section 6166, or (c) the expiration of the period of limitations in which to file a claim for refund or 60 days after a decision of a court in which such refund suit has become final.

    Reinstatement of State death tax credit for decedents dying after December 31, 2010

As described above, the estate, gift, and generation skipping transfer tax provisions of EGTRRA sunset at the end of 2010, such that those provisions will not apply to estates of decedents dying, gifts made, or generation skipping transfers made after December 31, 2010. As a result, neither the EGTRRA modifications to the State death tax credit nor the replacement of the credit with a deduction applies for decedents dying after December 31, 2010. Instead, the State death tax credit as in effect for decedents who died prior to 2002 will apply.

Exclusions and deductions


    Gift tax annual exclusion

Donors of lifetime gifts are provided an annual exclusion of $13,000 (for 2010) on transfers of present interests in property to any one donee during the taxable year.54 If the non-donor spouse consents to split the gift with the donor spouse, then the annual exclusion is $26,000 for 2010. The dollar amounts are indexed for inflation.

    Transfers to a surviving spouse

In general. -- A 100-percent marital deduction generally is permitted for estate and gift tax purposes for the value of property transferred between spouses.55 In addition, transfers of "qualified terminable interest property" also are eligible for the marital deduction. "Qualified terminable interest property" is property: (1) that passes from the decedent; (2) in which the surviving spouse has a "qualifying income interest for life"; and (3) to which an election applies. A "qualifying income interest for life" exists if: (1) the surviving spouse is entitled to all the income from the property (payable annually or at more frequent intervals) or has the right to use the property during the spouse's life; and (2) no person has the power to appoint any part of the property to any person other than the surviving spouse to be effective during the life of the surviving spouse.

Transfers to surviving spouses who are not U.S. citizens. -- A marital deduction generally is denied for property passing to a surviving spouse who is not a citizen of the United States.56 A marital deduction is permitted, however, for property passing to a qualified domestic trust of which the noncitizen surviving spouse is a beneficiary. A qualified domestic trust is a trust that has as its trustee at least one U.S. citizen or U.S. corporation. No corpus may be distributed a qualified domestic trust unless the U.S. trustee has the right to withhold any estate tax imposed on the distribution.

For years when the estate tax is in effect, there is an estate tax imposed on (1) any distribution from a qualified domestic trust before the date of the death of the noncitizen surviving spouse and (2) the value of the property remaining in a qualified domestic trust on the date of death of the noncitizen surviving spouse. The tax is computed as an additional estate tax on the estate of the first spouse to die.


    Conservation easements

For years when an estate tax is in effect, an executor generally may elect to exclude from the taxable estate 40 percent of the value of any land subject to a qualified conservation easement, up to a maximum exclusion of $500,000.57 The exclusion percentage is reduced by two percentage points for each percentage point (or fraction thereof) by which the value of the qualified conservation easement is less than 30 percent of the value of the land (determined without regard to the value of such easement and reduced by the value of any retained development right).

Before 2001, a qualified conservation easement generally was one that met the following requirements: (1) the land was located within 25 miles of a metropolitan area (as defined by the Office of Management and Budget) or a national park or wilderness area, or within 10 miles of an Urban National Forest (as designated by the Forest Service of the U.S. Department of Agriculture); (2) the land had been owned by the decedent or a member of the decedent's family at all times during the three-year period ending on the date of the decedent's death; and (3) a qualified conservation contribution (within the meaning of sec. 170(h)) of a qualified real property interest (as generally defined in sec. 170(h)(2)(C)) was granted by the decedent or a member of his or her family. Preservation of a historically important land area or a certified historic structure does not qualify as a conservation purpose.

Effective for estates of decedents dying after December 31, 2000, EGTRRA expanded the availability of qualified conservation easements by eliminating the requirement that the land be located within a certain distance of a metropolitan area, national park, wilderness area, or Urban National Forest. A qualified conservation easement may be claimed with respect to any land that is located in the United States or its possessions. EGTRRA also clarifies that the date for determining easement compliance is the date on which the donation is made.

As described above, the estate, gift, and generation skipping transfer tax provisions of EGTRRA sunset at the end of 2010, such that those provisions will not apply to estates of decedents dying, gifts made, or generation skipping transfers made after December 31, 2010. As a result, the EGTRRA modifications to expand the availability of qualified conservation contributions do not apply for decedents dying after December 31, 2010.

Provisions affecting small and family-owned businesses and farms


    Special-use valuation

For years when an estate tax is in effect, an executor may elect to value for estate tax purposes certain "qualified real property" used in farming or another qualifying closely-held trade or business at its current-use value, rather than its fair market value.58 The maximum reduction in value for such real property was $1 million for 2009. Real property generally can qualify for special-use valuation if at least 50 percent of the adjusted value of the decedent's gross estate consists of a farm or closely-held business assets in the decedent's estate (including both real and personal property) and at least 25 percent of the adjusted value of the gross estate consists of farm or closely-held business real property. In addition, the property must be used in a qualified use (e.g., farming) by the decedent or a member of the decedent's family for five of the eight years immediately preceding the decedent's death.

If, after a special-use valuation election is made, the heir who acquired the real property ceases to use it in its qualified use within 10 years of the decedent's death, an additional estate tax is imposed in order to recapture the entire estate-tax benefit of the special-use valuation.


    Family-owned business deduction

Prior to 2004, an estate was permitted to deduct the adjusted value of a qualified family-owned business interest of the decedent, up to $675,000.59 A qualified family-owned business interest generally is defined as any interest in a trade or business (regardless of the form in which it is held) with a principal place of business in the United States if the decedent's family owns at least 50 percent of the trade or business, two families own 70 percent, or three families own 90 percent, as long as the decedent's family owns, in the case of the 70-percent and 90-percent rules, at least 30 percent of the trade or business.

To qualify for the deduction, the decedent (or a member of the decedent's family) must have owned and materially participated in the trade or business for at least five of the eight years preceding the decedent's date of death. In addition, at least one qualified heir (or member of the qualified heir's family) is required to materially participate in the trade or business for at least 10 years following the decedent's death. The qualified family-owned business rules provide a graduated recapture based on the number of years after the decedent's death within which a disqualifying event occurred.

In general, there is no requirement that the qualified heir (or members of his or her family) continue to hold or participate in the trade or business more than 10 years after the decedent's death. However, the 10-year recapture period can be extended for a period of up to two years if the qualified heir does not begin to use the property for a period of up to two years after the decedent's death.

EGTRRA repealed the qualified family-owned business deduction for estates of decedents dying after December 31, 2003. As described above, the estate, gift, and generation skipping transfer tax provisions of EGTRRA sunset at the end of 2010, such that those provisions will not apply to estates of decedents dying, gifts made, or generation skipping transfers made after December 31, 2010. As a result, the qualified family-owned business deduction will apply to estates of decedents dying after December 31, 2010.


    Installment payment of estate tax for closely held businesses

Estate tax generally is due within nine months of a decedent's death. However, an executor generally may elect to pay estate tax attributable to an interest in a closely held business in two or more installments (but no more than 10).60 An estate is eligible for payment of estate tax in installments if the value of the decedent's interest in a closely held business exceeds 35 percent of the decedent's adjusted gross estate (i.e., the gross estate less certain deductions). If the election is made, the estate may defer payment of principal and pay only interest for the first five years, followed by up to 10 annual installments of principal and interest. This provision effectively extends the time for paying estate tax by 14 years from the original due date of the estate tax. A special two-percent interest rate applies to the amount of deferred estate tax attributable to the first $1.34 million61 (as adjusted annually for inflation occurring after 1998; the original amount for 1998 was $1 million) in taxable value of a closely held business. The interest rate applicable to the amount of estate tax attributable to the taxable value of the closely held business in excess of $1.34 million is equal to 45 percent of the rate applicable to underpayments of tax under section 6621 of the Code (i.e., 45 percent of the Federal short-term rate plus two percentage points). Interest paid on deferred estate taxes is not deductible for estate or income tax purposes.

Under pre-EGTRRA law, for purposes of these rules an interest in a closely held business was: (1) an interest as a proprietor in a sole proprietorship; (2) an interest as a partner in a partnership carrying on a trade or business if 20 percent or more of the total capital interest of such partnership was included in the decedent's gross estate or the partnership had 15 or fewer partners; and (3) stock in a corporation carrying on a trade or business if 20 percent or more of the value of the voting stock of the corporation was included in the decedent's gross estate or such corporation had 15 or fewer shareholders.

Under present and pre-EGTRRA law, the decedent may own the interest directly or, in certain cases, indirectly through a holding company. If ownership is through a holding company, the stock must be non-readily tradable. If stock in a holding company is treated as business company stock for purposes of the installment payment provisions, the five-year deferral for principal and the two-percent interest rate do not apply. The value of any interest in a closely held business does not include the value of that portion of such interest attributable to passive assets held by such business.

Effective for estates of decedents dying after December 31, 2001, EGTRRA expands the definition of a closely held business for purposes of installment payment of estate tax. EGTRRA increases from 15 to 45 the maximum number of partners in a partnership and shareholders in a corporation that may be treated as a closely held business in which a decedent held an interest, and thus will qualify the estate for installment payment of estate tax.

EGTRRA also expands availability of the installment payment provisions by providing that an estate of a decedent with an interest in a qualifying lending and financing business is eligible for installment payment of the estate tax. EGTRRA provides that an estate with an interest in a qualifying lending and financing business that claims installment payment of estate tax must make installment payments of estate tax (which will include both principal and interest) relating to the interest in a qualifying lending and financing business over five years.

EGTRRA clarifies that the installment payment provisions require that only the stock of holding companies, not the stock of operating subsidiaries, must be non-readily tradable to qualify for installment payment of the estate tax. EGTRRA provides that an estate with a qualifying property interest held through holding companies that claims installment payment of estate tax must make all installment payments of estate tax (which will include both principal and interest) relating to a qualifying property interest held through holding companies over five years.

As described above, the estate, gift, and generation skipping transfer tax provisions of EGTRRA sunset at the end of 2010, such that those provisions will not apply to estates of decedents dying, gifts made, or generation skipping transfers made after December 31, 2010. As a result, the EGTRRA modifications to the estate tax installment payment rules described above do not apply for estates of decedents dying after December 31, 2010.

Generation-skipping transfer tax rules


    In general

For years before and after 2010, a generation skipping transfer tax generally is imposed on transfers, either directly or in trust or similar arrangement, to a "skip person" (as defined above).62 Transfers subject to the generation skipping transfer tax include direct skips, taxable terminations, and taxable distributions.63 An exemption generally equal to the estate tax exemption amount is provided for each person making generation skipping transfers. The exemption may be allocated by a transferor (or his or her executor) to transferred property.

A direct skip is any transfer subject to estate or gift tax of an interest in property to a skip person.64 Natural persons or certain trusts may be skip persons. All persons assigned to the second or more remote generation below the transferor are skip persons (e.g., grandchildren and great-grandchildren). Trusts are skip persons if (1) all interests in the trust are held by skip persons, or (2) no person holds an interest in the trust and at no time after the transfer may a distribution (including distributions and terminations) be made to a non-skip person. A taxable termination is a termination (by death, lapse of time, release of power, or otherwise) of an interest in property held in trust unless, immediately after such termination, a non-skip person has an interest in the property, or unless at no time after the termination may a distribution (including a distribution upon termination) be made from the trust to a skip person.65 A taxable distribution is a distribution from a trust to a skip person (other than a taxable termination or direct skip).66 If a transferor allocates generation skipping transfer tax exemption to a trust prior to the taxable distribution, generation skipping transfer tax may be avoided.

The tax rate on generation skipping transfers is a flat rate of tax equal to the maximum estate tax rate in effect at the time of the transfer multiplied by the "inclusion ratio." The inclusion ratio with respect to any property transferred in a generation skipping transfer indicates the amount of "generation skipping transfer tax exemption" allocated to a trust. The allocation of generation skipping transfer tax exemption effectively reduces the tax rate on a generation skipping transfer.

If an individual makes a direct skip during his or her lifetime, any unused generation-skipping transfer tax exemption is automatically allocated to a direct skip to the extent necessary to make the inclusion ratio for such property equal to zero. An individual can elect out of the automatic allocation for lifetime direct skips.

Under pre-EGTRRA law, for lifetime transfers made to a trust that were not direct skips, the transferor had to make an affirmative allocation of generation skipping transfer tax exemption; the allocation was not automatic. If generation skipping transfer tax exemption was allocated on a timely filed gift tax return, then the portion of the trust that was exempt from generation skipping transfer tax was based on the value of the property at the time of the transfer. If, however, the allocation was not made on a timely filed gift tax return, then the portion of the trust that was exempt from generation skipping transfer tax was based on the value of the property at the time the allocation of generation skipping transfer tax exemption was made.

An election to allocate generation skipping transfer tax to a specific transfer generally may be made at any time up to the time for filing the transferor's estate tax return.


    Modifications to the generation skipping transfer tax rules under EGTRRA

Generally effective after 2000, EGTRRA modifies and adds certain mechanical rules related to the generation skipping transfer tax. First, EGTRRA generally provides that generation skipping transfer tax exemption will be allocated automatically to transfers made during life that are "indirect skips." An indirect skip is any transfer of property (that is not a direct skip) subject to the gift tax that is made to a generation skipping transfer trust, as defined in the Code. If any individual makes an indirect skip during the individual's lifetime, then any unused portion of such individual's generation skipping transfer tax exemption is allocated to the property transferred to the extent necessary to produce the lowest possible inclusion ratio for such property.

Second, EGTRRA provides that, under certain circumstances, generation skipping transfer tax exemption can be allocated retroactively when there is an unnatural order of death. In general, if a lineal descendant of the transferor predeceases the transferor, then the transferor can allocate any unused generation skipping transfer exemption to any previous transfer or transfers to the trust on a chronological basis.

Third, EGTRRA provides that a trust that is only partially subject to generation skipping transfer tax because its inclusion ratio is less than one can be severed in a "qualified severance." A qualified severance generally is defined as the division of a single trust and the creation of two or more trusts, one of which would be exempt from generation skipping transfer tax and another of which would be fully subject to generation skipping transfer tax, if (1) the single trust was divided on a fractional basis, and (2) the terms of the new trusts, in the aggregate, provide for the same succession of interests of beneficiaries as are provided in the original trust.

Fourth, EGTRRA provides that in connection with timely and automatic allocations of generation skipping transfer tax exemption, the value of the property for purposes of determining the inclusion ratio shall be its finally determined gift tax value or estate tax value depending on the circumstances of the transfer. In the case of a generation skipping transfer tax exemption allocation deemed to be made at the conclusion of an estate tax inclusion period, the value for purposes of determining the inclusion ratio shall be its value at that time.

Fifth, under EGTRRA, the Secretary of the Treasury generally is authorized and directed to grant extensions of time to make the election to allocate generation skipping transfer tax exemption and to grant exceptions to the time requirement, without regard to whether any period of limitations has expired. If such relief is granted, then the gift tax or estate tax value of the transfer to trust would be used for determining generation skipping transfer tax exemption allocation, and the relief would be retroactive to the date of the transfer.

Sixth, EGTRRA provides that substantial compliance with the statutory and regulatory requirements for allocating generation skipping transfer tax exemption will suffice to establish that generation skipping transfer tax exemption was allocated to a particular transfer or a particular trust. If a taxpayer demonstrates substantial compliance, then so much of the transferor's unused generation skipping transfer tax exemption will be allocated as produces the lowest possible inclusion ratio.


    Sunset of EGTRRA modifications to the generation skipping transfer tax rules

As described above, the estate and generation skipping transfer taxes are repealed for decedents dying and gifts made in 2010. The estate, gift, and generation skipping transfer tax provisions of EGTRRA sunset at the end of 2010, such that those provisions will not apply to estates of decedents dying, gifts made, or generation skipping transfers made after December 31, 2010. As a result, the generation skipping transfer tax again will apply after December 31, 2010. However, the EGTRRA modifications to the generation skipping transfer tax rules described above will not apply to generation skipping transfers made after December 31, 2010. Instead, in general, the rules as in effect prior to 2001 will apply.

Description of Proposal

The proposal generally makes permanent the estate, gift, and generation skipping transfer tax laws in effect for 2009, retroactive to the beginning of 2010. Under the proposal, the applicable exclusion amount for estate tax purposes generally is $3.5 million for decedents dying during 2010 and later years. The applicable exclusion amount for gift tax purposes is $1 million for 2010 and later years. The highest estate and gift tax rate under the proposal is 45 percent, as under 2009 law.67

As under present law, the generation skipping transfer tax exemption for a given year is equal to the applicable exclusion amount for estate tax purposes ($3.5 million for 2010 and later years), and the generation skipping transfer tax rate for a given year will be determined using the highest estate tax rate in effect for such year.

The proposal makes permanent the repeal of the State death tax credit; as under 2009 law, the proposal allows a deduction for certain death taxes paid to any State or the District of Columbia. In addition, the proposal makes permanent the repeal of the qualified family-owned business deduction.

The proposal also repeals the modified carryover basis rules that, under EGTRRA, would apply for purposes of determining basis in property acquired from a decedent who dies in 2010. Under the proposal, a recipient of property acquired from a decedent who dies after December 31, 2009, generally will receive date-of-death fair market value basis (i.e., "stepped up" basis) under the basis rules that applied to assets acquired from decedents who died in 2009.

Under the proposal, the sunset of the EGTRRA estate, gift, and generation skipping transfer tax provisions scheduled to occur at the end of 2010, is repealed. As a result, the proposal makes permanent the above-described EGTRRA modifications to the rules regarding (1) qualified conservation easements, (2) installment payment of estate taxes, and (3) various technical aspects of the generation skipping transfer tax.

Effective date. -- The proposal is effective for estates of decedents dying, generation skipping transfers made, and gifts made after December 31, 2009.


Analysis

Transfer tax planning issues

    Stability and consistency in the law

As described above, under EGTRRA the estate tax exemption amount and the estate and gift tax rates changed on an almost annual basis between 2002 and 2009. The estate and generation skipping taxes are repealed temporarily in 2010, followed by reinstatement of the taxes in 2011 with a lower exemption amount and a higher top marginal tax rate. Present law provides for two distinct sets of rules for determining basis of assets received from a decedent, depending on whether the decedent dies in 2010 or in a different year. The credit for succession taxes paid to a State was phased out and replaced with a deduction. In addition, increases in the estate tax exemption amount resulted in a phase-out and effective repeal of the deduction for qualified family-owned business interests under section 2057, but section 2057 again will be operative for 2011 and later years. Certain other modifications to the estate and gift tax laws under EGTRRA are scheduled to expire at the end of 2010.

Commentators have advocated a stable and more predictable estate and gift tax system -- without constantly changing parameters, phase-outs, or sunsets -- arguing that the complexity of current law has made estate planning difficult and costly. The American Bar Association's Task Force on Federal Wealth Transfer Taxes argued that, because of the complexity of current law, "[a] significant number of individuals likely will have estate plans with provisions that are inappropriate."68 This could arise, for example, because estate planners fail to plan properly for changes in law, taxpayers are reluctant to incur the transaction costs associated with repeatedly modifying estate plans, or taxpayers choose to delay further planning in the hope that they will not die before the estate tax is permanently repealed or substantially reduced. As another example, the ABA Task Force notes that some taxpayers wish to maintain life insurance only if they will have an estate tax liability, but this is difficult to determine when the estate tax laws are unsettled and changing.69


    Differences in estate and gift tax exemption amounts

Under the budget proposal, the gift tax exemption amount remains $1 million, while the estate tax exemption amount is $3.5 million. Commentators have argued that this decoupling of the estate and gift tax exemption amounts complicates wealth transfer tax planning and raises administrability issues, and that the exemption amounts, therefore, should be reunified.

For example, some commentators argue that, as a result of the lower gift tax exemption amount, taxpayers are likely to engage in complicated and costly planning to avoid gift tax.70 They argue that the lower gift tax exemption (and resulting higher cost of the gift tax) could encourage taxpayers to create complicated long-term trusts at death designed to avoid gift tax on transfers to successive generations. They further argue that the lower gift tax exemption will encourage taxpayers to delay transfers until death, "encouraging family wealth to remain 'locked in' older generations."71

The extent to which such practices have increased in use since the exemption amounts were decoupled in 2004 is uncertain. In addition, the effect of the lower gift tax exemption amount from 2004 through 2009 is partially mitigated by a structural difference between the estate tax and the gift tax that generally benefits taxpayers who make inter vivos gifts: the gift tax is "tax exclusive," whereas the estate tax is "tax inclusive." In other words, under the estate tax, the assets used to pay the tax are included in the estate tax base. Thus, if the estate and gift taxes were fully reunified, the gift tax would be a less costly tax.

Furthermore, the gift tax often is viewed as being necessary to protect the income tax base. In the absence of a gift tax, it may be possible for a taxpayer to transfer an asset with built-in gain or that produces income to a taxpayer who is in a lower tax bracket, where the gain or income would be realized and taxed at a lower rate before the asset is gifted back to the original holder. Therefore, if the gift tax effective exemption amount were increased to equal the higher estate tax exemption amount, the effectiveness of the gift tax as a tool to protect the income tax base may be diminished.


    Treatment of State death taxes for Federal estate tax purposes

Prior to 2002, Federal law allowed for a credit against the Federal estate tax for any estate, inheritance, legacy or succession taxes (referred to as "State death taxes") actually paid to any State or the District of Columbia.72 The credit was determined under a graduated rate table set forth in section 2011(b), which ties the maximum credit amount to the "adjusted taxable estate," which is the taxable estate reduced by $60,000. Under EGTRRA, the amount of the allowable credit was reduced from 2002 through 2004. For decedents dying after 2004, the credit is replaced with a deduction from the gross estate for State death taxes actually paid to any State or the District of Columbia.73 The budget proposal reinstates and makes permanent the State death tax deduction.

Before the credit was repealed, many States imposed "soak-up" or "pick-up" taxes, i.e., State taxes designed to impose a tax equal to the maximum amount of the Federal credit allowed to a decedent. Such taxes had the effect of shifting revenue to States from the Federal government, without changing the overall amount of estate tax liability (Federal and State) of a taxpayer. Under prior law, all of the States imposed a tax at a level at least equal to the amount of the State death tax credit allowed under section 2011.74 As of July 1, 2009, however, 27 States imposed no State death taxes.75

Some argue that the State death tax credit should be reinstated rather than retaining the present-law deduction. They argue, for example, that the credit served as a powerful funding mechanism for States; because States are struggling financially in the current economy, the States are in critical need of such funding. Furthermore, because it is politically difficult to enact new taxes in many States, some State legislatures have been unable or unwilling to replace existing soak-up taxes (which in some cases now lie dormant because such laws operate only to the extent Federal law allows a credit for State death taxes) with new estate or inheritance taxes, leaving such States without an annual stream of revenue. Some advocates of reinstating the State death tax credit also argue that the absence of Federal credit increases the disparity in estate taxes imposed by the various States, which can (1) lead to competition between States to attract wealthy residents and (2) result in disparate tax treatment of similarly situated individuals, depending only on an individual's State of residence at the time of death.76

Others argue that the State death tax credit should not be reinstated. Some argue, for example, that estate or other succession taxes, whether Federal or State, are undesirable and that the allowance of a Federal credit for State death taxes is a subsidy to States that encourages the enactment or retention of State-level death taxes. Some might also argue that if the intended policy is to provide a funding mechanism for State governments, it would be more direct and efficient to provide a direct Federal government subsidy instead of making a tax expenditure through the tax system.


    Federal estate tax and basis of transferred assets

Present law includes two sets of rules for determining the basis of property acquired from a decedent's estate. The basis of property acquired from estates of decedents dying anytime before or after 2010 generally is the property's fair market value at the time of the decedent's death. As a result of this basis step-up (or step-down if property declined in value while owned by the decedent) when a taxpayer sells inherited property, the taxpayer generally does not recognize gain or loss attributable to appreciation or depreciation in the property that occurred during the decedent's holding period. Present law provides a different rule for property acquired from estates of decedents dying in 2010. For this property, there is no Federal estate tax, but heirs generally take a carryover basis. This carryover basis preserves in the hands of an heir taxable gain or loss attributable to increases or decreases in the value of property during the decedent's holding period. The one-year change from an estate tax coupled with basis step-up (or step-down) to estate tax repeal with carryover basis raises several behavioral and administrative issues. A few significant issues are described below.

Carryover basis may affect a taxpayer's willingness to sell an appreciated asset. In general, a realization-based tax system creates "lock-in," a behavioral distortion that may be described as the reluctance of an individual to sell property and thereby incur tax on the recognition of accrued appreciation in the property. This lock-in reduces the mobility of capital to potentially higher return investments. Proponents of carryover basis argue that allowing inherited property to receive a basis step-up accentuates lock-in. Because income taxes on accrued appreciation can be avoided entirely if the basis of property that passes at death is stepped up to its fair market value at the time of death, an individual may choose not to sell appreciated property before death. Under this argument, carryover basis would reduce lock-in because holding assets until death would not permit avoidance of income tax liability on pre-death appreciation when assets eventually are sold by heirs. Conversely, opponents of carryover basis argue that it perpetuates lock-in because income tax liability for pre-death gains carries over to the heir. Thus, under carryover basis the decedent's beneficiary also may refrain from selling an asset because of the adverse income tax consequences from sale. Opponents of carryover basis argue that the stepped-up basis rule removes the lock-in effect once each generation.

Under carryover basis, taxpayers will be required to establish a decedent's historical cost basis in inherited assets. Commentators have argued that establishing this historical cost basis may be difficult in many cases.77 The difficulty may be acute in part because the decedent is no longer available to remember the history of assets and where records of transactions affecting basis might be located. This problem may be especially troublesome in the case of personal residences for which there may be many transactions that affect basis; personal effects such as jewelry; assets such as classic cars that appreciate in value and to which many improvements may be made; and unique assets such as paintings and stamp collections. It may be possible to use presumptions to ameliorate the difficulty of establishing historical cost basis. For example, a rule that presumed the decedent purchased an asset at its value on the date of its acquisition would in some cases limit the necessary knowledge to the date the decedent acquired the asset. In the absence of statutory presumptions, if an heir is unable to establish a decedent's basis in property, a question is whether the IRS will consider the heir to have a zero basis in the property.

A related issue under a carryover basis regime is the role of the executor of an estate in determining the decedent's basis in the assets over which the executor has control.78 When carryover basis rules were adopted in 1976, the executor was required to obtain information about basis and to provide that information to heirs. No such requirement was included in the carryover basis rules adopted in 2001. If rules required executors to provide basis information to beneficiaries or if executors provided information in the absence of a requirement, a question would be whether beneficiaries would be permitted to rely on the information and whether executors would be subject to penalties for failure to report correct or complete information. Although the 2001 rules do not require an executor to provide basis information to beneficiaries, they do provide that an executor must allocate the permitted basis increases (the $1.3 million and $3 million amounts described previously) among estate assets, and they permit broad discretion in making the allocation (subject to a prohibition on using basis additions to create a built-in loss in any single asset). This broad discretion may create difficulties for executors concerned about fiduciary obligations and may create uncertainty for beneficiaries if an executor fails to make an allocation.

Change from a step-up basis rule to a carryover basis regime raises a question whether the change should be accompanied by transition rules. Some individuals may have purchased and held appreciating or depreciable property with the expectation that the basis of the property would be stepped-up upon the individuals' deaths. These individuals may argue that it would be unfair to repeal the stepped-up basis rule at least with respect to amounts of appreciation that have occurred before the time of the rule change. The carryover basis rules adopted in 1976 provided a grandfather rule under which the basis of an inherited asset could not be less than its value on December 31, 1976. Establishing the value of all assets that could be inherited proved to be a difficult and time consuming exercise. EGTRRA's carryover basis rules do not provide a grandfather for pre-carryover basis appreciation.

Retroactive application of the estate and generation skipping transfer taxes

The proposal makes permanent the estate, gift and generation skipping tax laws that were in effect in 2009, effective for decedents dying and gifts made after December 31, 2009. The estate and generation skipping taxes thus would be reinstated for all estates of decedents dying and gifts made during 2010, even with respect to transfers that occurred prior to the enactment of the proposal. Similarly, the modified carryover basis rules for assets acquired from a decedent who dies in 2010 would be repealed retroactively and replaced with the 2009 step-up in basis rules.

Some may argue that retroactive imposition of the estate and generation skipping taxes is inappropriate, because such retroactivity may be unconstitutional or is simply unfair. Although the outcome of any constitutional challenge is uncertain, some believe that a constitutional challenge itself is a virtual certainty, "calling the tax law into question while litigation and appeals, maybe all the way to the Supreme Court, are ongoing."79 In other words, the likelihood of litigation, even if ultimately unsuccessful, could result in years of uncertainty for taxpayers, heirs, and fiduciaries.

With regard to fairness, some may argue that taxpayers rely on the law that is in effect when planning wealth transfers, and that it is inappropriate for Congress to change the applicable rules after the fact. A taxpayer, for example, may choose to make an outright gift to a great-grandchild in early 2010, when there is no generation skipping transfer tax. Had the taxpayer known that the generation skipping transfer tax would apply to the transfer, it is possible that he or she would not have made the outright gift or would have structured the gift in a different way.

On the other hand, some may argue that retroactive application of the 2009 transfer tax and basis rules is both appropriate and fair. First, lawmakers widely discussed the prospect of retroactivity prior to the end of 2009, such that taxpayers and estate planners had some prior knowledge that the transfer tax and basis rules could be retroactively modified. Furthermore, some may argue that a greater number of taxpayers will be affected negatively by the law currently in effect for 2010; in other words, a smaller number of taxpayers would face an increased tax liability if the 2009 rules were extended retroactively. Specifically, under 2010 law, assets acquired from a decedent do not receive a full step up in basis. As a result, many heirs will incur capital gains tax liability upon a sale or other disposition of an inherited asset. If the 2009 rules instead applied, the same asset would receive a full step up in basis as of the decedent's death, such that the heir would not incur capital gains tax liability upon a subsequent disposition of the asset with respect to appreciation that occurred before the decedent's death. The number of heirs who have the potential for greater capital gains tax liability under 2010 law likely far exceeds the number of decedents' estates that will benefit from the absence of an estate tax under 2010 law.

Economic issues


    Wealth taxes, saving, and investment

Some may argue that a reduction in the estate tax for years after 2010, as under the proposal, would affect taxpayers' saving and investment behavior. Taxes on accumulated wealth are taxes on the stock of capital held by the taxpayer. As a tax on capital, issues similar to those that arise in analyzing any tax on the income from capital arise. In particular, there is no consensus among economists on the extent to which the incidence of taxes on the income from capital is borne by owners of capital in the form of reduced returns or whether reduced returns cause investors to save less and provide less capital to workers, thereby reducing wages in the long run. A related issue is to what extent individuals respond to increases (or decreases) in the after-tax return to investments by decreasing (or increasing) their saving. Again, there is no consensus in either the empirical or theoretical economics literature regarding the responsiveness of saving to after-tax returns on investment.

Some economists believe that an individual's bequest motives are important to understanding saving behavior and aggregate capital accumulation. If estate and gift taxes alter the bequest motive, they may change the tax burdens of taxpayers other than the decedent and his or her heirs.80 It is an open question whether the bequest motive is an economically important explanation of taxpayer saving behavior and level of the capital stock. For example, theoretical analysis suggests that the bequest motive may account for between 15 and 70 percent of the United States' capital stock.81 Others believe the bequest motive is not important in national capital formation,82 and empirical analysis of the existence of a bequest motive has not led to a consensus.83 Theoretically, it is an open question whether estate and gift taxes encourage or discourage saving, and there has been limited empirical analysis of this specific issue.84 By raising the after-tax cost of leaving a bequest, a more expansive estate tax may discourage potential transferors from accumulating the assets necessary to make a bequest. On the other hand, a taxpayer who wants to leave a bequest of a certain net size might save more in response to estate taxation to meet that goal. For example, some individuals purchase additional life insurance to have sufficient funds to pay the estate tax without disposing of other assets in their estate.


    Wealth taxes and small business

Regardless of any potential effect on aggregate saving, the scope and design of the transfer tax system may affect the composition of investment. In particular, some observers note that the transfer tax system may impose special cash flow burdens on small or family-owned businesses. They note that if a family has a substantial proportion of its wealth invested in one enterprise, the need to pay estate taxes may force heirs to liquidate all or part of the enterprise or to encumber the business with debt to meet the estate tax liability. If the business is sold, while the assets generally do not cease to exist and remain a productive part of the economy, the share of business represented by small or family-owned businesses may be diminished by the estate tax. If the business borrows to meet estate tax liability, the business's cash flow may be strained. There is some evidence that many businesses may be constrained in the amount of funds they can borrow. If businesses are constrained, they may reduce the amount of investment in the business and this would be a market inefficiency.85 One study suggests that reduction in estate taxes may have a positive effect on an entrepreneur's survival.86

Others argue that potential deleterious effects of the estate tax on investment by small or family-owned businesses are limited. The 2009 (and proposed) exemption value of the unified credit is $3.5 million per decedent. As a result, small business owners can obtain an effective exemption of up to $7.0 million per married couple, and other legitimate tax planning can further reduce the burden on such enterprises. Also, as described above, Code sections 2031A, 2057,87 and 6166 are provided to reduce the impingement on small business cash flow that may result from an estate tax liability. Some analysis questions whether, in practice, small businesses need to liquidate operating assets to meet estate tax liabilities. A recent study of 2001 estate returns shows that many estates that claimed benefits under sections 2032A, 2057, or 6166 held liquid assets nearly sufficient to meet all debts against the estate. The study found only 2.4 percent of estates that reported closely held business assets and agricultural assets elected the deferral of tax under section 6166.88 Others have argued that estate tax returns report a small fraction of the value of decedents' estates thereby mitigating any special burden that the estate tax may impose on small business.89


    Wealth taxes and labor supply

As people become wealthier, they have an incentive to consume more of everything, including leisure time. Some, therefore, suggest that, by reducing the amount of wealth transferrable to heirs, transfer taxes may reduce labor supply of the parent, although it may increase labor supply of the heir. Over 100 years ago, Andrew Carnegie opined that "the parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would . . . ."90 While, in theory, increases in wealth should reduce labor supply, empirically economists have found the magnitude of these effects to be small.91

Conversely, by reducing the amount of wealth transferrable to heirs, the estate tax could increase work effort of heirs as the benefits of the installment payment method, special-use valuation, and the exclusion for qualified family-owned business interests will be lost and recaptured if the assets fail to remain in a qualified use. In addition, the estate tax also could distort, in either direction, the labor supply of the transferor if it distorts his or her decision to make a bequest.


    Wealth taxes, the distribution of wealth, and fairness

Some suggest that, in addition to their role in producing Federal revenue, Federal transfer taxes may help prevent an increase in the concentration of wealth. Overall, there are relatively few analyses of the distribution of wealth holdings in the economic literature.92 Conventional economic wisdom holds that the Great Depression of the 1930s and World War II substantially reduced the concentration of wealth in the United States, and that there had been no substantial change at least through the 1980s. Most analysts assign no role to tax policy in the reduction in wealth concentration that occurred between 1930 and 1945. Nor has any analyst been able to quantify what role tax policy might have played since World War II.93

Income tax does not tax all sources of income. Some suggest that by serving as a "backstop" for income that escapes income taxation, transfer taxes may help promote overall fairness of the U.S. tax system. Still others counter that to the extent that much wealth was accumulated with after-(income)-tax dollars, as an across-the-board tax on wealth, transfer taxes tax more than just those monies that may have escaped the income tax. In addition, depending upon the incidence of such taxes, it is difficult to make an assessment regarding the contribution of transfer taxes to the overall fairness of the U.S. tax system.

Even if transfer taxes are believed to be borne by the owners of the assets subject to tax, an additional conceptual difficulty is whether the tax is borne by the generation of the transferor or the generation of the transferee. The design of the gift tax illustrates this conceptual difficulty. A gift tax is assessed on the transferor of taxable gifts. Assume, for example, a mother makes a gift of $1 million to her son and incurs a gift tax liability of $450,000. From one perspective, the gift tax could be said to have reduced the mother's current economic well-being by $450,000. However, it is possible that, in the absence of the gift tax, the mother would have given her son $2 million, so that the gift tax has reduced the son's economic well-being by $1 million. It also is possible that the economic well-being of both was reduced. Of course, distinctions between the donor and recipient generations may not be important to assessing the fairness of transfer taxes if both the donor and recipient have approximately the same income.94


    Federal estate taxation and charitable bequests

The two unlimited exclusions under the Federal estate tax are for bequests to a surviving spouse and for bequests to a charity. Because the proposed marginal tax rate under the estate tax is 45 percent, while marginal income tax rates range from 10 to 35 percent (39.6 percent after 2010), the after-tax cost of a charitable bequest is lower than the after-tax cost of a charitable gift made during one's lifetime.95 Economists refer to this incentive as the "price" or "substitution effect." In short, the price effect says that if something is made cheaper, people will do more of it. Some analysts have suggested that the charitable estate tax deduction creates a strong incentive to make charitable bequests and that changes in Federal estate taxation could alter the amount of funds that flow to charitable purposes. The decision to make a charitable bequest arises not only from the incentive effect of a charitable bequest's deductibility, or "tax price," but also from what economists call the "wealth effect." Generally the wealthier an individual is, the more likely he or she is to make a charitable bequest and the larger the bequest will be. Because the estate tax diminishes the value of wealth to an heir, the wealth effect would suggest repeal of the estate tax could increase charitable bequests.

A number of studies have examined the effects of estate taxes on charitable bequests. Most of these studies have concluded that, after controlling for the size of the estate and other factors, deductibility of charitable bequests encourages taxpayers to provide charitable bequests.96 Some analysts interpret these findings as implying that reductions in estate taxation, as under the budget proposal, could lead to a reduction in funds flowing into the charitable sector. This is not necessarily the case, however. Some charitable bequests may substitute for lifetime giving to charity, in part to take advantage of the greater value of the charitable deduction under the estate tax than under the income tax that results from the lower marginal income tax rates and limitations on annual lifetime giving. If this is the case, reductions in the estate tax could lead to increased charitable giving during the taxpayer's life. On the other hand, some analysts have suggested that a more sophisticated analysis is required recognizing that a taxpayer may choose among bequests to charity, bequests to heirs, lifetime gifts to charity, and lifetime gifts to heirs and recognizing that lifetime gifts reduce the future taxable estate and consumption. In this more complex framework, reductions in estate taxation could reduce lifetime charitable gifts.97


    Federal transfer taxes and complexity

Critics of Federal transfer taxes document that these taxes create incentives to engage in avoidance activities. Some of these avoidance activities involve complex legal structures and can be expensive to create. Incurring these costs, while ultimately profitable from the donors' and donees' perspective, is socially wasteful because time, effort, and financial resources are spent that lead to no increase in productivity. Such costs represent an efficiency loss to the economy in addition to whatever distorting effects Federal transfer taxes may have on other economic choices such as saving and labor supply discussed above. For example, in the case of family-owned businesses, such activities may impose an ongoing cost by creating a business structure to reduce transfer tax burdens that may not be the most efficient business structure for the operation of the business. Reviewing more complex legal arrangements increases the administrative cost of the Internal Revenue Service. There is disagreement among analysts regarding the magnitude of the costs of avoidance activities.98 It is difficult to measure the extent to which any such costs incurred are undertaken from tax avoidance motives as opposed to succession planning or other motives behind gifts and bequests.

Alternatives to the current U.S. estate tax system

Some argue that, rather than modifying and making permanent the present U.S. estate tax system, Congress should consider an alternative structure. The choice of one form of wealth transfer tax system over another necessarily will involve tradeoffs among efficiency, equity, administrability, and other factors. A determination whether one system is preferable to another could be made on the basis of each system's relative success in achieving one or a majority of these goals, without sacrificing excessively the achievement of the others. Alternatively, such a determination could be made based on which system provides the best mix of efficiency, equity, and administrability.

The United States, State governments, and foreign jurisdictions tax transfers of wealth in many different ways. Some wealth transfer tax systems, for example, impose a tax on the transferor. Such systems include the U.S. estate and gift tax system, which imposes a gift tax on certain gratuitous lifetime transfers, an estate tax on a decedent's estate, and a generation-skipping transfer tax on certain transfers that skip generations. Another approach that involves imposition of a tax on a transferor is a "deemed-realization" approach, under which a gratuitous transfer is treated as a realization event and the gain on transferred assets, if any, generally is taxed to the transferor as capital gain.

Other wealth transfer tax systems tax the transferee of a gift or bequest. Such systems include inheritance (or "accessions") tax systems, under which a tax is imposed against the recipient of a gratuitous transfer. Some jurisdictions do not impose a separate tax, but instead treat receipts of gifts or bequests as gross income of the recipient (an "income inclusion approach").

Regardless of whether the tax is imposed against the transferor or the transferee, some commentators assert that the real economic burden of any approach to taxing transfers of wealth falls on the recipients, because the amount received effectively is reduced by the amount of tax paid by the transferor or realized by the transferee.99 Some commentators argue that systems that impose a tax based on the circumstances of the transferee -- such as an inheritance tax or an income inclusion approach -- are more effective in encouraging dispersal of wealth among a greater number of transferees and potentially to lower-income beneficiaries. Others assert that such systems promote fairness in the tax system. However, the extent to which one form of transfer tax system in practice is more effective than another in achieving these goals is not clear.

Wealth transfer tax systems other than an estate tax also may present benefits or additional challenges in administration or compliance. Inheritance taxes or income inclusion systems, for example, may reduce the need for costly tax planning in the case of certain transfers between spouses. At the same time, to the extent such systems are effective in encouraging distributions to multiple recipients in lower tax brackets, they may be susceptible to abuse such as through the use of multiple nominal recipients as conduits for a transfer intended for a single beneficiary.


Prior Action

The proposal was contained in the President's fiscal year 2010 budget proposal. The President's fiscal year 2002 through 2009 budget proposals included a proposal to make permanent after 2010 the repeal of the estate and generation skipping taxes, as scheduled to be in effect in 2010 under EGTRRA.

I. Other Incentives for Families and Children
(includes extension of the adoption tax credit, employer-provided
child care tax credit, and dependent care tax credit)

Present Law

Adoption credit and exclusion from income for employer-provided adoption assistance

Present law for 2010 provides: (1) a maximum adoption credit of $13,170 per eligible child (both special needs and non-special needs adoptions); and (2) a maximum exclusion of $13,170 per eligible child (both special needs and non-special needs adoptions). These dollar amounts are adjusted annually for inflation. These benefits are phased-out over a $40,000 range for taxpayers with modified adjusted gross income ("modified AGI") in excess of certain dollar levels. For 2010, the phase-out range is between $182,520 and $222,520. The phaseout threshold is adjusted for inflation annually, but the phaseout range remains a $40,000 range.

For taxable years beginning after December 31, 2011, the adoption credit and employer-provided adoption assistance exclusion are available only to special needs adoptions and the maximum credit and exclusion are reduced to $6,000, respectively. The phase-out range is reduced to lower income levels (i.e., between $75,000 and $115,000). The maximum credit, exclusion, and phase-out range are not indexed for inflation.

Employer-provided child care tax credit

Taxpayers receive a tax credit equal to 25 percent of qualified expenses for employee child care and 10 percent of qualified expenses for child care resource and referral services. The maximum total credit that may be claimed by a taxpayer cannot exceed $150,000 per taxable year.

Qualified child care expenses include costs paid or incurred: (1) to acquire, construct, rehabilitate or expand property that is to be used as part of the taxpayer's qualified child care facility; (2) for the operation of the taxpayer's qualified child care facility, including the costs of training and certain compensation for employees of the child care facility, and scholarship programs; or (3) under a contract with a qualified child care facility to provide child care services to employees of the taxpayer. To be a qualified child care facility, the principal use of the facility must be for child care (unless it is the principal residence of the taxpayer), and the facility must meet all applicable State and local laws and regulations, including any licensing laws. A facility is not treated as a qualified child care facility with respect to a taxpayer unless: (1) it has open enrollment to the employees of the taxpayer; (2) use of the facility (or eligibility to use such facility) does not discriminate in favor of highly compensated employees of the taxpayer (within the meaning of section 414(q) of the Code); and (3) at least 30 percent of the children enrolled in the center are dependents of the taxpayer's employees, if the facility is the principal trade or business of the taxpayer. Qualified child care resource and referral expenses are amounts paid or incurred under a contract to provide child care resource and referral services to the employees of the taxpayer. Qualified child care services and qualified child care resource and referral expenditures must be provided (or be eligible for use) in a way that does not discriminate in favor of highly compensated employees of the taxpayer (within the meaning of section 414(q) of the Code.

Any amounts for which the taxpayer may otherwise claim a tax deduction are reduced by the amount of these credits. Similarly, if the credits are taken for expenses of acquiring, constructing, rehabilitating, or expanding a facility, the taxpayer's basis in the facility is reduced by the amount of the credits.

Credits taken for the expenses of acquiring, constructing, rehabilitating, or expanding a qualified facility are subject to recapture for the first ten years after the qualified child care facility is placed in service. The amount of recapture is reduced as a percentage of the applicable credit over the 10-year recapture period. Recapture takes effect if the taxpayer either ceases operation of the qualified child care facility or transfers its interest in the qualified child care facility without securing an agreement to assume recapture liability for the transferee. The recapture tax is not treated as a tax for purposes of determining the amount of other credits or determining the amount of the alternative minimum tax. Other rules apply.

This tax credit expires for taxable years beginning after December 31, 2010.

Dependent care tax credit

The maximum dependent care tax credit is $1,050 (35 percent of up to $3,000 of eligible expenses) if there is one qualifying individual, and $2,100 (35 percent of up to $6,000 of eligible expenses) if there are two or more qualifying individuals. The 35-percent credit rate is reduced, but not below 20 percent, by one percentage point for each $2,000 (or fraction thereof) of adjusted gross income above ("AGI") $15,000. Therefore, the credit percentage is reduced to 20 percent for taxpayers with AGI over $43,000.

The level of this credit is reduced for taxable years beginning after December 31, 2010, under the EGTRRA sunset.


Description of Proposals

Adoption credit and exclusion from income for employer-provided adoption assistance

The proposal permanently extends these two tax benefits at current levels.

Employer-provided child care tax credit

The proposal permanently extends this tax benefit.

Expansion of dependent care tax credit

The proposal permanently extends the dependent care tax credit at current levels. A separate budget proposal, described in section IV.B. of this document, expands the dependent care tax credit.

Effective date. -- The proposals all apply to taxable years beginning after December 31, 2010.


Analysis

Adoption credit and exclusion from income for employer-provided adoption assistance

The adoption credit and exclusion reduce the after-tax cost of adoption for eligible taxpayers. Proponents of the benefits for adoption have argued that increasing the size of both the adoption credit and exclusion and expanding the number of taxpayers who qualify for the tax benefits have encouraged more adoptions and allowed more families to afford adoption.

Some question whether the Code is the appropriate means to subsidize adoption, for reasons including whether the benefits are most appropriately targeted and whether the IRS has the ability to monitor the claims of taxpayers. They argue that such subsidization should be via direct outlay programs, perhaps administered by the States. However, while States might reasonably administer adoption programs for domestic adoptees, it is an open question whether arranging or subsidizing foreign adoptions is an appropriate State function. Some too might argue that it is not an appropriate Federal function to subsidize foreign adoptions through Federal tax credits.

Some express concern that availability of two separate tax benefits for adoptions raises horizontal equity, complexity and compliance issues. While the credit is broadly available, the exclusion applies only to those whose employers provide adoption assistance programs. Comparable tax benefits could be provided to all if the exclusion were eliminated and the credit were allowed to be claimed on any employer-provided adoption assistance. This would have the effect of treating employer-provided assistance as ordinary compensation and of treating the payment of adoption expenses as paid by the employee from ordinary compensation. The elimination of the exclusion would also simplify the treatment of adoption expenses under the Code.

Employer-provided child care tax credit and dependent care tax credit

While certain tax benefits for children are not dependent on employment (the child credit and dependent exemption for example), the employer-provided child credit and dependent care tax credit are intended to subsidize child care needs related to employment.

Some question whether the Code should provide any child-related tax benefits, on the grounds that having children is a personal choice of private consumption. Others note that the future health of the economy is dependent on the productivity of the next generation of workers, who will also provide the resources that fund the current working generation's Social Security and Medicare benefits, and thus they argue that supporting families that choose to have children is an appropriate public function. Furthermore, they argue, a tax system premised on ability to pay must make allowances for the number of individuals in a tax filing unit.

A separate argument exists for child-care-related tax benefits that relate to child care expenses necessary for employment. The argument is that these child care expenses are an expense of earning income, and thus should essentially be deductible by analogy to general business tax principles that permit deductions for expenses (such as wages paid) necessary to earn income. Furthermore, many economists would argue that a deduction for these expenses would provide income tax treatment that is comparable to the treatment provided home production of child careíi.e, the value of home production is untaxed since the Code does not impute income to the household that provides child care services. Such households are treated as if they had income imputed to them for the services provided, but coupled with a deduction for such expenses, resulting in no increase in net income. If a worker were provided similar treatment via deductibility of child care expense, his net taxable income would rise only to the extent that his compensation exceeded that of his child care expenses.

The dependent care tax credit generally provides tax benefits less valuable than those that a full deduction for child care expense would provide. The principal reason for this is that expenses eligible for the credit are limited to an amount that is substantially less than day care costs for many taxpayers. Additionally, the credit rate for some taxpayers is less than their marginal tax rate, meaning that the deduction for the expense would provide a greater benefit than does a lower-rate credit. For a taxpayer with modest daycare expenses (if, for example, a parent only needs part-time daycare), his expenses might not be limited by the caps, and if he is a low-income taxpayer, he is likely to have a marginal income tax rate below that of the credit rate. Such taxpayer thus receives a tax benefit from the credit that is more generous than a deduction for expenses would provide at his low marginal tax rate.

Arguments for the employer-provided child care tax credit are less clear, as the benefits are not broadly available. While the credit provides benefits to employees and improves the day-care options for employees whose employers utilized the credit, a tax policy rationale for subsidizing this form of employee compensation over other forms is not immediately apparent when the dependent care tax credit is available. In the absence of the credit for employer-provided child care, an employer may still choose to provide on-site day care if it provides an advantage in recruiting and retaining valued employees. The existence of the employer subsidy and the dependent care benefit arguably provides double benefits for certain taxpayers.

Finally, while many might support the idea that families with children, specifically those with child care costs related to employment earnings, should face a lower tax burden, many among this group would prefer to see a reform of the tax system that simplifies these benefits along traditional tax policy principles, rather than extending provisions set to expire.


Prior Action

Similar proposals were contained in the President's fiscal year 2003, 2004, 2005, 2006, 2007, 2008, 2009 and 2010 budget proposals.

J. Reinstate the Overall Limitation on Itemized Deductions and the
Personal Exemption Phase-out

Present Law

Overall limitation on itemized deductions ("Pease" limitation)

Unless an individual elects to claim the standard deduction for a taxable year, the taxpayer is allowed to deduct his or her itemized deductions. Itemized deductions generally are those deductions which are not allowed in computing adjusted gross income ("AGI"). Itemized deductions include unreimbursed medical expenses, investment interest, casualty and theft losses, wagering losses, charitable contributions, qualified residence interest, State and local income and property taxes, unreimbursed employee business expenses, and certain other miscellaneous expenses.

Prior to 2010, the total amount of otherwise allowable itemized deductions (other than medical expenses, investment interest, and casualty, theft, or wagering losses) was limited for upper-income taxpayers. In computing this reduction of total itemized deductions, all limitations applicable to such deductions (such as the separate floors) were first applied and, then, the otherwise allowable total amount of itemized deductions was reduced by three percent of the amount by which the taxpayer's AGI exceeded a threshold amount which was indexed annually for inflation. The otherwise allowable itemized deductions could not be reduced by more than 80 percent.

The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") repealed this overall limitation on itemized deductions with the repeal phased-in over five years. EGTRRA provided: (1) a one-third reduction of the otherwise applicable limitation in 2006 and 2007: (2) a two-thirds reduction in 2008, and 2009; and (3) no overall limitation on itemized deductions in 2010. Thus in 2009, for example, the total amount of otherwise allowable itemized deductions (other than medical expenses, investment interest, and casualty, theft, or wagering losses) was reduced by three percent of the amount of the taxpayer's AGI in excess of $166,800 ($83,400 for married couples filing separate returns). Then the overall reduction in itemized deductions was phased-down to 1/3 of the full reduction amount (that is, the limitation was reduced by two-thirds).

Pursuant to the general EGTRRA sunset, the phased-in repeal of the Pease limitation sunsets and the limitation becomes fully effective again in 2011. Adjusting for inflation, the Joint Committee Staff estimates the AGI threshold would be $171,100 for 2011.

Personal exemption phase-out for certain taxpayers ("PEP")

Personal exemptions generally are allowed for the taxpayer, his or her spouse, and any dependents. For 2010, the amount deductible for each personal exemption is $3,650. This amount is indexed annually for inflation.

Prior to 2010, the deduction for personal exemptions was reduced or eliminated for taxpayers with incomes over certain thresholds, which were indexed annually for inflation. Specifically, the total amount of exemptions that could be claimed by a taxpayer was reduced by two percent for each $2,500 (or portion thereof) by which the taxpayer's AGI exceeded the applicable threshold. (The phase-out rate was two percent for each $1,250 for married taxpayers filing separate returns.) Thus, the personal exemptions claimed was phased-out over a $122,500 range (which was not indexed for inflation), beginning at the applicable threshold.

In 2009, for example, the applicable thresholds were $166,800 for single individuals, $250,200 for married individuals filing a joint return and surviving spouses, $199,950 for heads of households, and $125,100 for married individuals filing separate returns.

EGTRRA repealed PEP with the repeal phased-in over five years. EGTRRA provided: (1) a one-third reduction of the otherwise applicable limitation in 2006 and 2007: (2) a two-thirds reduction in 2008, and 2009; and (3) no PEP in 2010. However, under the EGTRRA sunset, the PEP becomes fully effective again in 2011. According to Joint Committee Staff estimates the PEP thresholds for 2011 would be: (1) $171,100 for unmarried individuals; (2) 256,700 for married couples filing joint returns; and (3) $213,900 for heads of households.


Description of Proposal

Overall limitation on itemized deductions ("Pease" limitation)

The proposal would modify the overall limitation on itemized deductions. Specifically, the overall limitation on itemized deductions would apply with a new AGI threshold beginning in 2011.100 For 2011, the AGI threshold would be determined by taking a 2009 dollar amount and adjusting for subsequent inflation. This 2009 dollar amount is $200,000 ($250,000 for joint returns). Future years would be adjusted for inflation.

Personal exemption phase-out for certain taxpayers ("PEP")

The proposal would modify the personal exemption phase-out. Specifically, the personal exemption phase-out would apply with a new AGI threshold beginning in 2011.101 For 2011 the AGI threshold would be determined by taking a 2009 dollar amount and adjusting for subsequent inflation. This dollar amount is: (1) $200,000 for unmarried individuals; (2) $250,000 for joint returns; and (3) $125,000 for married couples filing separately. Future years would be adjusted for inflation.

Effective date. -- The proposal applies to taxable years beginning after December 31, 2010.


Analysis

Overall limitation on itemized deductions ("Pease" limitation)

The general limitation on itemized deductions increases the effective marginal tax rate for affected taxpayers. This limitation reduces (subject to the 80 percent limitation) the amount of certain itemized deductions that may be claimed by an amount equal to 3 percent of each dollar of income in excess of the threshold. Thus, if a taxpayer who is above the threshold earns an additional $1.00 of income, the taxpayer's taxable income increases by $1.03 because the taxpayer's income goes up by $1.00 and the itemized deductions are reduced by 3 cents. For a taxpayer in the 36 percent tax bracket, the increase in tax liability resulting from the $1.00 increase in income will be $0.37 (the $1.03 in additional taxable income multiplied by 36 percent). Generally, the effective marginal tax rate for taxpayers subject to the limitation on itemized deductions is 3 percent higher than the statutory tax rate. That is, the taxpayer's effective marginal tax rate equals 103 percent of the statutory marginal tax rate. However, once the taxpayer's itemized deductions are reduced by 80 percent, the taxpayer's effective marginal tax rate again equals his or her statutory marginal tax rate.

Some argue that the limitation on itemized deductions diminishes a taxpayer's incentive to make charitable contributions. While there may be a psychological effect, generally there is little or no difference in the tax motivated economic incentive to give to charity for a taxpayer subject to the limitation compared to a taxpayer not subject to the limitation. This is because while the limitation operates effectively to increase the marginal tax rate on the income of affected taxpayers, the value of the tax benefit of deductibility of the charitable deduction is determined by the statutory tax rate. For taxpayers beyond the threshold, a specified dollar amount of itemized deductions are denied. The specified dollar amount is determined by the taxpayer's income, not by the amount of itemized deductions the taxpayer claims. Hence, the value of an additional dollar contributed to charity increases by exactly one dollar times the total amount of itemized deductions that the taxpayer may claim. Because the statutory rates apply to taxable income (income after claiming permitted itemized deductions), the value of the additional contribution to charity is determined by the statutory tax rate. Economists would say that the "tax price" of giving is not altered by the limitation.102

Proponents of the reinstatement of the Pease limitation (as provided by the sunset provisions of EGTRRA) argue that those who are relatively well-off should be restricted in their ability to benefit from itemized deductions, and that raising more revenue from the relatively well-off is appropriate given the magnitude and growing size of the Federal deficit.

Opponents of the reinstatement of the Pease limitation argue that the overall limitation on itemized deductions is an unnecessarily complex mechanism for imposing taxes and that the "hidden" way in which the limitation raises marginal tax rates undermines respect for the tax laws. The overall limitation on itemized deductions is reflected in a 12-line worksheet. Moreover, the first line of that worksheet requires the adding up of seven line items from Schedule A of the Form 1040, and the second line requires the adding up of five line items of Schedule A of the Form 1040. The legislative history for EGTRRA states that reducing the application of the overall limitation on itemized deductions would significantly reduce complexity for affected taxpayers.

Personal exemption phase-out for certain taxpayers ("PEP")

The personal exemption phase-out would increase effective marginal tax rates for affected taxpayers. The personal exemption phase-out would operate by reducing the amount of each personal exemption that the taxpayer could claim by two percent for each $2,500 (or portion thereof) by which the taxpayer's income exceeded the designated threshold for his or her filing status. Thus, for a taxpayer who was subject to the personal exemption phase-out, earning an additional $2,500 would reduce the amount of each personal exemption he or she could claim by two percent, or by $73 in 2011 (0.02 times the $3,650103 personal exemption). The taxpayer's additional taxable income would be equal to the $2,500 plus the $73 in denied exemption for each personal exemption. For a taxpayer in the 36 percent statutory marginal tax rate bracket, the effective marginal tax rate on the additional $2,500 of income equals the statutory 36 percent plus an additional 1.05 percent ($73 times the statutory rate of 0.36, divided by the $2,500 in incremental income) for each personal exemption. Thus, if this taxpayer claims four personal exemptions, his or her effective marginal tax rate is 40.2 percent (the statutory 36 percent rate plus four times 1.05 percent). More generally, for 2011 a taxpayer's effective marginal tax rate equals the taxpayer's statutory marginal rate multiplied by one plus the product of 2.92 percentage points (the $73 in denied personal exemption divided by the incremental $2,500 in income) multiplied by the number of personal exemptions claimed. Thus, a taxpayer claiming four personal exemptions would have an effective marginal tax rate approximately 111.7 percent of the statutory marginal tax rate (or 40.2 percent).

Proponents of the reinstatement of the phase-out of the personal exemption (as provided by the sunset provisions of EGTRRA) argue that those who are relatively well-off should be restricted in their ability to benefit from personal exemptions, and that raising more revenue from the relatively well-off is appropriate given the magnitude and growth of the Federal deficit.

Opponents of the reinstatement argue that the high cost of raising children should properly be reflected at all levels of the income distribution, on the grounds that those who are relatively well-off but have no children should face a higher tax burden than those who are relatively well-off but with children, in the same manner that a couple earning $50,000 without children is required to pay more tax than a couple earning $50,000 with children. Opponents further argue that the personal exemption phase-out imposes excessively high effective marginal tax rates on families with children, is an unnecessarily complex mechanism for imposing income taxes, and that the "hidden" way in which the phase-out raises taxes undermines respect for tax laws.


Prior Action

Proposals to repeal the EGTRRA sunset with regard to the personal exemption phase-out and the limitation on itemized deductions were contained in the President's fiscal year 2003, 2004, 2005, 2006, 2007, 2008, 2009 and 2010 budget proposals.

III. TEMPORARY RECOVERY MEASURES

A. Extend the Making Work Pay Credit for One Year

Present Law

In general

The making work pay credit is a temporary refundable income tax credit available to eligible individuals for two years (taxable years beginning in 2009 and 2010).

The credit is the lesser of: (1) 6.2 percent of an individual's earned income; or (2) $400 ($800 in the case of a joint return). For purposes of calculating an eligible individual's credit, the definition of earned income is the same as for the earned income tax credit with two modifications. First, earned income does not include net earnings from self-employment which are not taken into account in computing taxable income. Second, earned income includes combat pay excluded from gross income under section 112.

The credit is phased out at a rate of two percent of the eligible individual's modified adjusted gross income above $75,000 ($150,000 in the case of a joint return). For purposes of the phase-out, an eligible individual's modified adjusted gross income is the eligible individual's adjusted gross income increased by any amount excluded from gross income under sections 911, 931, or 933. An eligible individual is any individual other than: (1) a nonresident alien; (2) an individual with respect to whom another individual may claim a dependency deduction for a taxable year beginning in a calendar year in which the eligible individual's taxable year begins; and (3) an estate or trust.

In 2009, the otherwise allowable making work pay credit allowed was reduced by the amount of any payment received by the taxpayer pursuant to the provisions of the American Recovery and Reinvestment Act of 2009104 providing economic recovery payments from the Veterans Administration, Railroad Retirement Board, and the Social Security Administration and a temporary refundable tax for certain government retirees.105 Each tax return on which the credit is claimed must include the social security number of the taxpayer (in the case of a joint return, the social security number of at least one spouse).

Present law treats the failure to reduce the making work pay credit by the amount of such payments or credit, and the omission of the correct social security number, as clerical errors. This allows the IRS to assess any tax resulting from such failure or omission without the requirement to send the taxpayer a notice of deficiency allowing the taxpayer the right to file a petition with the Tax Court.

Treatment of the U.S. possessions


    Mirror code possessions106

In the case of mirror code possessions, the U.S. Treasury makes two payments (for 2009 and 2010, respectively) to each mirror code possession, each in an amount equal to the aggregate amount of the making work pay credits allowable by reason of the provision to that possession's residents against their income tax. This amount is determined by the Treasury Secretary based on information provided by the government of the respective possession. A possession is a mirror code possession if the income tax liability of residents of the possession under that possession's income tax system is determined by reference to the U.S. income tax laws as if the possession were the United States.

    Non-mirror code possessions107

In the case of possessions that do not have a mirror code tax system, the U.S. Treasury makes two payments (for 2009 and 2010, respectively) each in an amount estimated by the Secretary as being equal to the aggregate credits that would have been allowed to residents of that possession for the taxable year if a mirror code tax system had been in effect in that possession. Accordingly, the amount of each payment to a non-mirror Code possession is an estimate of the aggregate amount of the credits that would be allowed to the possession's residents if the credit provided by the provision to U.S. residents were provided by the possession to its residents. This payment is not made to any U.S. possession unless that possession has a plan that has been approved by the Secretary under which the possession will promptly distribute the payment to its residents.

    General rules

No credit against U.S. income tax is permitted for any person to whom a making work pay credit is allowed against possession income taxes (for example, under that possession's mirror income tax). Similarly, no credit against U.S. income tax is permitted for any person who is eligible for a payment under a non-mirror code possession's plan for distributing to its residents the payment described above from the U.S. Treasury.

For purposes of the payments to the possessions, the Commonwealth of Puerto Rico and the Commonwealth of the Northern Mariana Islands are considered possessions of the United States.

For purposes of the rule permitting the Treasury Secretary to disburse appropriated amounts for refunds due from certain credit provisions of the Code, the payments required to be made to possessions under the provision are treated in the same manner as a refund due from the making work pay credit.

Federal programs or Federally-assisted programs

Any credit or refund allowed or made to an individual under this provision (including to any resident of a U.S. possession) is not taken into account as income and is not taken into account as resources for the month of receipt and the following two months for purposes of determining the eligibility of such individual or any other individual for benefits or assistance, or the amount or extent of benefits or assistance, under any Federal program or under any State or local program financed in whole or in part with Federal funds.


Description of Proposal

The proposal extends the making work pay credit for one year (through December 31, 2011).

Effective date. -- The proposal is effective on the date of enactment.


Analysis

Proponents of the proposal argue that the tax burdens on working families eligible for the making work pay credit are too high, and that an extension is justified to reduce this burden and offset the regressivity of the Social Security payroll taxes. Proponents argue that this reduction in the overall tax liability for working Americans will encourage work, savings and investment, contributing to the long-term health of the economy.

Critics of the proposal note that, while Social Security payroll taxes are regressive, the Social Security system as a whole, when benefits are considered, is progressive. Further, they note that other refundable credits that have in the past been justified as offsetting the regressivity of the payroll taxes, notably the earned income tax credit, already offset more than the payroll tax liability for many lower income taxpayers. These critics may also prefer that any further income tax based offsets to payroll taxes be part of comprehensive reform of the Social Security system.

Critics further note that the long-term fiscal picture of the United States is bleak, and new revenues will be needed to meet the needs of an aging population. Thus, further tax cuts should not be contemplated at this time in their view. Proponents recognize the need to address long term fiscal imbalances, but argue that the proposal is a temporary one year extension, necessary at this time to help sustain the continuing economic recovery.

Critics of the proposal further note that the credit will provide little in the way of work or saving incentives, because the credit is "inframarginal" for most taxpayers?that is, while the credit reduces tax liability, it does not change the marginal tax rate at which most credit recipients pay tax on an additional dollar of labor or capital income, and thus it does not change incentives to work or save since it does not change the after-tax return to labor or saving. This is because the credit reaches its maximum value at earnings of $12,903 for married taxpayers filing jointly and only $6,452 for other taxpayers, providing no further incentive to work if one's earnings already exceed those levels, which is the case for the vast majority of recipients of the credit.


Prior Action

A proposal to permanently extend the making work pay credit was included in the President's fiscal year 2010 budget proposal.

B. Provide $250 Economic Recovery Payment and
Special Tax Credit

Present Law

Making work pay credit

The making work pay credit is a temporary refundable income tax credit available to eligible individuals for two years (taxable years beginning in 2009 and 2010).

The credit is the lesser of: (1) 6.2 percent of an individual's earned income; or (2) $400 ($800 in the case of a joint return). For purposes of calculating an eligible individual's credit, the earned income definition is the same as for the earned income tax credit with two modifications. First, earned income does not include net earnings from self-employment which are not taken into account in computing taxable income. Second, earned income includes combat pay excluded from gross income under section 112.

The credit is phased out at a rate of two percent of the eligible individual's modified adjusted gross income above $75,000 ($150,000 in the case of a joint return).

In 2009, the otherwise allowable making work pay credit was reduced by the amount of any payment received by the taxpayer pursuant to the provisions of the American Recovery and Reinvestment Act of 2009 ("ARRA")108 providing one-time economic recovery payments to certain retirees and disabled individuals and a temporary refundable tax for certain government retirees.

American Recovery and Reinvestment Act of 2009


    Economic recovery payments

In general, ARRA provided a one-time economic recovery payment of $250 in 2009 to adults eligible for Social Security benefits, Railroad Retirement benefits, veteran's compensation or pension benefits or to individuals eligible for Supplemental Security Income (SSI) benefits (excluding individuals who receive SSI while in a Medicaid institution).

Economic recovery payments were made to individuals whose address of record was in one of the 50 states, the District of Columbia, Puerto Rico, Guam, the United States Virgin Islands, American Samoa, or the Northern Mariana Islands. If an individual who was eligible for an economic recovery payment had a representative payee, the payment was made to the representative payee and the entire payment was required to be used for the benefit of the individual who was entitled to the economic recovery payment.

Under ARRA, an individual was eligible for only one $250 economic recovery payment regardless of whether the individual was eligible for a benefit from more than one of the four Federal programs. If the individual was also eligible for the making work pay credit in 2009 that credit was reduced by the economic recovery payment.

Individuals who were otherwise eligible for an economic recovery payment did not receive a payment if their Federal program benefits had been suspended because they were in prison, a fugitive, on probation or a parole violator, had committed fraud, or were no longer lawfully present in the United States.

Economic recovery payments are not to be taken into account as income, or taken into account as resources for the month of receipt and the following nine months, for purposes of determining the eligibility of such individual or any other individual for benefits or assistance, or the amount or extent of benefits or assistance, under any Federal program or under any State or local program financed in whole or in part with Federal funds.

Economic recovery payments are not includible in gross income for income tax purposes and the payments are protected from the assignment and garnishment provisions of the four federal benefit programs. The payments are subject to the Treasury Offset Program.


    Special credit for certain government retirees

ARRA created a $250 refundable credit ($500 for a joint return where both spouses are eligible) against income taxes owed for tax year 2009 for individuals who receive a government pension or annuity from work not covered by Social Security, and who are not eligible to receive an economic recovery payment. If the individual is also eligible for the making work pay credit, that credit is reduced by the special ARRA credit. Each tax return on which the credit is claimed is required to include the social security number of the taxpayer (in the case of a joint return, the social security number of at least one spouse).

The ARRA special credit or refund is not taken into account as income, or taken into account as resources for the month of receipt and the following two months for purposes of determining the eligibility of such individual or any other individual for benefits or assistance, or the amount or extent of benefits or assistance, under any Federal program or under any State or local program financed in whole or in part with Federal funds.


Description of Proposal

Economic recovery payments

Under the proposal, a one-time economic recovery payment of $250 for 2010 ($500 for a joint return where both spouses are eligible) is provided to adults who are eligible for Social Security benefits, Railroad Retirement benefits, or veteran's compensation or pension benefits; or individuals who are eligible for SSI benefits (excluding individuals who receive SSI while in a Medicaid institution). If an individual is also eligible for the making work pay credit in 2010, that credit is reduced by the amount of the 2010 economic recovery payment.

Special credit for certain government retirees

Under the proposal, a $250 refundable income tax credit ($500 for a joint return where both spouses are eligible) for 2010 is allowed for individuals who receive a government pension or annuity from work not covered by Social Security, and who are not eligible to receive an economic recovery payment. If the individual is also eligible for the making work pay credit in 2010, that credit is reduced by this credit.

Effective date. -- The proposal is effective on the date of enactment.


Analysis

The Administration believes that providing these benefits to retirees is necessary to help stimulate consumption in order to assure that the present economic recovery does not falter. The Administration further believes that assistance provided under these two proposals helps ensure equal treatment between retirees under these proposals and non-retirees receiving the making work pay credit.

Some might argue against these two proposals on the grounds that the Federal government's fiscal position is sufficiently perilous that adding to the deficit at this time may not provide the hoped-for stimulus if investors retrench on fears concerning the level of U.S. debt. Others may additionally object that these payments are not well targeted. Many retirees are in a better position economically than young families, and the payment and credit are not restricted based on income, in contrast to the making work pay credit.


C. Extend COBRA Health Insurance Premium Assistance

Present Law

The Consolidated Omnibus Reconciliation Act of 1985 ("COBRA")109 generally requires that a group health plan offer continuation coverage to qualified beneficiaries in the case of a COBRA qualifying event (such as a loss of employment). There are certain exceptions to the general requirement to offer continuation coverage, including exceptions for small employers, government and church employers, and employers that cease to provide any group health plan to any employee.110 A plan may require payment of a premium for any period of continuation coverage. The amount of such premium, however, generally may not exceed 102 percent of the applicable premium for such period and the premium must be payable, at the election of the payor, in monthly installments.

Section 3001 of the American Recovery and Reinvestment Act of 2009 ("ARRA"),111 as amended by the Department of Defense Appropriations Act for Fiscal Year 2010 ("DOD Act"),112 the Temporary Extension Act of 2010 ("TEA"),113 and the Continuation Extension Act of 2010 ("CEA"),114 provides that, for a period not exceeding 15 months,115 an assistance eligible individual is treated as having paid any premium required for COBRA continuation coverage if the individual pays 35 percent of such premium. Thus, if the assistance eligible individual pays 35 percent of the premium, the group health plan must treat the individual as having paid the full premium required for COBRA continuation coverage, and the individual is entitled to a subsidy for 65 percent of the premium (the "COBRA continuation coverage subsidy"). An assistance eligible individual generally is any qualified beneficiary who elects COBRA continuation coverage and the qualifying event with respect to the covered employee for that qualified beneficiary is a loss of group health plan coverage on account of an involuntary termination of the covered employee's employment (for other than gross misconduct).116 In addition, the qualifying event must occur during the period beginning on September 1, 2008, and ending on May 31, 2010.117

The COBRA continuation coverage subsidy also applies to temporary continuation coverage elected under the Federal Employees Health Benefits Program and to continuation health coverage under State programs that provide coverage comparable to COBRA continuation coverage. The COBRA continuation coverage subsidy is generally delivered by requiring employers to pay the subsidized portion of the COBRA continuation coverage premium for assistance eligible individuals. The employer then treats the payment of the subsidized portion as a payment of Federal employment taxes and offsets its Federal employment tax liability by the amount of the subsidy. To the extent that the aggregate amount of the subsidy for all assistance eligible individuals for which the employer is entitled to a credit for a quarter exceeds the employer's Federal employment tax liability for the quarter, the employer can request a tax refund or can claim the credit against future Federal employment tax liability.

ARRA, as amended, also contains heightened notice requirements. The notice of COBRA continuation coverage that a plan administrator must provide to qualified beneficiaries with respect to a qualifying event must contain information about the qualified beneficiary's right to the COBRA continuation coverage subsidy. ARRA also provides for an expedited 10day review process by the Department of Labor ("DOL"), under which an individual may request review of a denial of treatment as an assistance eligible individual by a group health plan.

There is an income limit on the entitlement to the COBRA continuation coverage subsidy. Taxpayers with modified adjusted gross income exceeding $145,000 (or $290,000 for joint filers), must repay any subsidy received by them, their spouse, or their dependant, during the taxable year. For taxpayers with modified adjusted gross incomes between $125,000 and $145,000 (or $250,000 and $290,000 for joint filers), the amount of the subsidy that must be repaid is reduced proportionately. The subsidy is also conditioned on the individual not being eligible for certain other health coverage. To the extent that an eligible individual receives a subsidy during a taxable year to which the individual was not entitled, the subsidy overpayment is repaid on the individual's Federal income tax return as additional tax. The COBRA continuation coverage subsidy may only be claimed through the employer and cannot be claimed at the end of the year on an individual tax return.


Description of Proposal

The proposal extends the eligibility period for the COBRA continuation coverage subsidy by allowing individuals who qualify for COBRA coverage as the result of an involuntary termination of employment prior to January 1, 2011, to qualify for the subsidy.

The proposal calls for a subsidy period of 12 months.

Effective date. -- The proposal is effective on date of enactment.


Analysis

The COBRA continuation coverage subsidy is an attempt to help ease the financial impact on low- and moderate-income individuals who are unemployed as a result of the recession that began in late 2008. The proposal recognizes that, although the economy has begun to recover, unemployment rates remain elevated in certain sectors of the American workforce as a result of the economic downturn.

Despite initial hesitation from employers during and after passage of ARRA, early reports regarding the COBRA continuation subsidy have been generally positive.118 Studies indicate both that enrollment in COBRA has increased substantially as a result of the subsidies, and that there has been less adverse selection among the individuals that choose to enroll in COBRA continuation coverage.119 Less adverse selection may have the result of lowering employers' average cost per COBRA beneficiary, since healthier individuals usually incur less medical costs and help to subsidize less healthy enrollees. Traditionally, enrollment in COBRA has been subject to high rates of adverse selection since, generally, only less healthy individuals have been willing to pay the dramatically higher costs of COBRA continuation coverage (on average, for the period between 1999 and 2009, employees paid 17 percent of the premium of employer sponsored health care for self-only coverage, while COBRA premiums were 102 percent).120

Some argue that the subsidy's complex eligibility requirements and detailed enrollment process create excessive compliance, paperwork, and recordkeeping responsibilities for employers and individuals, resulting in increased costs for employers and in limited enrollment by individuals.121 In particular, some view the requirement that employers track which employees were involuntarily terminated as overly burdensome. TEA addresses that particular concern by, in most circumstances, deeming an employer's attestation of involuntary termination to be accurate. Critics have also noted that DOL often requires additional information from employers in connection with an individual's appeal of his or her denial of eligibility for the COBRA continuation coverage subsidy and employers have too limited a time in which to gather the information and respond to DOL.

Additional complexity has been necessitated by the retroactivity of the DOD Act, TEA and CEA. Such retroactivity is arguably necessary, however, so as not to unfairly disadvantage individuals who lost their jobs during the brief time periods between expiration of one of eligibility period and enactment of extending legislation. There is little doubt, however, that retroactivity creates increased administrative burdens and costs for employers and confusion about eligibility among individuals. These burdens would, arguably, be increased because the proposal calls for a subsidy period of 12 months, rather than the 15 months currently available under present law (after passage of the DOD Act, TEA, and CEA). Reverting to a 12 month period only for individuals eligible for the subsidy after May 31, 2010, may present certain administrative complexities that, some might argue, would make it less desirable than keeping the subsidy period at 15 months.

Others point out that the subsidies were rapidly implemented with few problems and at minimal cost. They argue that individuals appear to be well informed about the availability of the COBRA continuation coverage subsidy, evidenced in part by the 170,000 ARRA-related inquiries DOL has responded to as of December 21, 2009.122 In addition, as of the end of 2009, there were over 52,000 subscribers and over 2 million visitors to the DOL COBRA web page.123

Some argue that the government has unnecessarily assumed a cost that was formerly born by employers at less cost to taxpayers. They point out that prior to the availability of the COBRA continuation coverage subsidy many employers offered severance packages that included health insurance premium contributions. Once the COBRA continuation coverage subsidy became available, however, employers stopped offering such generous severance packages. There is insufficient data, however, on the prevalence, or dollar value, of severance packages prior to ARRA's enactment to draw any conclusions on the effect of the subsidy on employers' practices. In addition, although employers may no longer offer health insurance premium contributions to terminated employees they may choose to make severance payments in cash, resulting in overall more generous severance benefits to unemployed individuals.124

There are those who argue that the COBRA continuation coverage subsidy does not help those in the most need of financial assistance. Despite the increase in the take-up rate of COBRA continuation coverage due to the subsidy, only a minority of those eligible for COBRA continuation coverage actually enroll. Even with the availability of the subsidy, many eligible individuals, particularly those at the lowest end of the economic spectrum, are unable to afford 35 percent of their COBRA premium. There is evidence that the benefit of the subsidy is accruing primarily to middle-class families.125 Additionally, the subsidy does not help individuals who are not eligible for COBRA continuation coverage because their employer is exempt from COBRA (for example, because the employer ceased operations and stopped providing group health coverage to any employee)126 or because the individual him or herself was not eligible for, or could not afford, employer provided health coverage while employed.127 Individuals at the lowest income levels may be the least likely to be eligible for COBRA, since they are less likely than other employees to have been eligible for health benefits through their employer while employed (or to have been able to afford the premiums even if eligible for coverage). Those making these arguments might favor better targeted government expenditures.


Prior Action

No prior action.

D. Provide Additional Tax Credits for Investment
in Qualified Property Used in a Qualifying
Advanced Energy Manufacturing Project

Present Law

Present law provides a 30-percent credit for investment in qualified property used in a qualifying advanced energy manufacturing project. A qualifying advanced energy project is a project that re-equips, expands, or establishes a manufacturing facility for the production of: (1) property designed to be used to produce energy from the sun, wind, or geothermal deposits (within the meaning of section 613(e)(2)), or other renewable resources; (2) fuel cells, microturbines, or an energy storage system for use with electric or hybrid-electric motor vehicles; (3) electric grids to support the transmission of intermittent sources of renewable energy, including storage of such energy; (4) property designed to capture and sequester carbon dioxide; (5) property designed to refine or blend renewable fuels (but not fossil fuels) or to produce energy conservation technologies (including energy-conserving lighting technologies and smart grid technologies); (6) new qualified plug-in electric drive motor vehicles, qualified plug-in electric vehicles, or components which are designed specifically for use with such vehicles, including electric motors, generators, and power control units; or (7) other advanced energy property designed to reduce greenhouse gas emissions as may be determined by the Secretary. A qualifying advanced energy project does not include any part of a project for the production of any property for use in the refining or blending of any transportation fuel other than renewable fuels.

Qualified property must be depreciable (or amortizable) property used in a qualifying advanced energy project. Only tangible personal property and other tangible property (not including a building or its structural components) are credit-eligible. The basis of qualified property must be reduced by the amount of credit received. No credit is allowed for any qualified investment that is allowed a credit under sections 48, 48A, or 48B.

Credits are available only for projects certified by the Secretary of Treasury, in consultation with the Secretary of Energy. The Secretary of Treasury has established a certification program for this purpose,128 and may allocate up to $2.3 billion in credits.

Certifications are issued using a competitive bidding process. Current Treasury guidance requires taxpayers to apply for certification with respect to their entire qualified investment in a project.129

In selecting projects, the Secretary may consider only those projects with a reasonable expectation of commercial viability. In addition, the Secretary must consider other selection criteria, including which projects: (1) will provide the greatest domestic job creation; (2) will provide the greatest net impact in avoiding or reducing air pollutants or anthropogenic emissions of greenhouse gases; (3) have the greatest potential for technological innovation and commercial deployment; (4) have the lowest levelized cost of generated or stored energy, or of measured reduction in energy consumption or greenhouse gas emission; and (5) have the shortest project time from certification to completion.

Each project application must be submitted during the two-year period beginning on the date the certification program was established. An applicant for certification has one year from the date the Secretary accepts the application to provide the Secretary with evidence that the requirements for certification have been met. Upon certification, the applicant has three years from the date of issuance of the certification to place the project in service. Not later than four years after February 17, 2009 (the date of enactment of the American Recovery and Reinvestment Act of 2009), the Secretary is required to review the credit allocations and redistribute any credits that were not used either because of a revoked certification or because of an insufficient quantity of credit applications.


Description of Proposal

The proposal authorizes an additional $5 billion of credits for investments in eligible property used in a qualifying advanced energy project. The proposal also modifies the guidance that requires taxpayer to apply for the credit with respect to their entire qualified investment to permit credit applications with respect to only part of such investment. This second element of the proposal will be accomplished through administrative guidance and does not require legislative action. If a taxpayer applies for a credit with respect to only part of the qualified investment in the project, the taxpayer's increased cost sharing and the project's reduced revenue cost to the government will be taken into account in determining whether to allocate credits to the project.

Effective date. -- The proposal is effective on the date of enactment.


Analysis

The proposal expands the amount of investment tax credits that may be allocated for investment in manufacturing facilities that produce specified products, many of which are also subsidized on the consumption side of the market via tax credits for their purchase. The manufacturing projects that may qualify generally have in common the feature that they produce goods whose use would displace the consumption of fossil fuels.

Economists are generally skeptical of government interventions in markets that alter prices from those that would otherwise prevail in a free market, but most would agree that a valid economic rationale for government intervention in certain markets (including many aspects of energy markets) can exist when there are "externalities" in the consumption or production of certain goods that lead to "market failures," wherein either too little or too much of certain economic activity occurs relative to what is the socially optimal level of activity.

Pollution is an example of a negative externality, because the costs of pollution are borne by society as a whole rather than solely by the polluters themselves. In the case of pollution, there are various ways the government could intervene in markets to limit pollution to more economically efficient levels. One approach is to control pollution directly through regulation of polluters, such as by requiring coal burning electric utilities to install scrubbers to limit their emissions of various pollutants. Other more market oriented approaches to achieving socially optimal levels of pollution control are also possible, such as by setting a tax on the polluting activity that is equal to the social cost of the pollution.

In the case of a positive externality, the appropriate economic policy would be to impose a negative tax (i.e., a subsidy) on the consumption or production that produces the positive externality, such that the socially optimal level of consumption or production results. An example where such a positive externality is thought to exist is in basic scientific research, as the social payoffs to such research are not fully captured by private parties that undertake, and incur the cost of, such research. As a result, a socially sub-optimal level of such research is undertaken. The provision of a subsidy for such research can correct this market inefficiency and lead to socially optimal levels of research.

It could be argued that the manufacturing credit is designed to correct inefficiently low investment in these manufacturing facilities that stems from the facilities producing positive externalities that are not captured in private investment decision making. There are problems with this argument however. There is no clear evidence that positive externalities exist from the domestic production of (a separate notion from the domestic use of) these favored items relative to production of other goods not so favored. In the absence of such externalities, government intervention that distorts investment via subsidies will lead to an inefficient and less productive allocation of resources in the society as a whole.

To the extent that positive externalities exist from the domestic use of the favored production items, the existing subsidy mechanism for the purchase of these goods should be sufficient to address any positive externality related to the use of these goods. Even in this case, economists do not generally argue that consuming wind energy, or driving an electric car, produces positive externalities and thus merits subsidy. Rather, it is thought that subsidizing these activities will divert consumption from other, less desirable consumption of fossil fuels that produce pollution and other negative externalities. However, economists generally agree that the most efficient means of addressing pollution would be a direct tax on the creation of the pollution, rather than an indirect approach that provides targeted tax credits for certain technologies.130

The allocation of a fixed amount of tax credits for a given activity can be criticized as leading to unfair tax results. In general, Federal tax credits are available to all taxpayers who meet the statutory eligibility requirements, and are not limited in the aggregate. A tax system that provides only a fixed amount of credits in the aggregate can lead to a situation where two taxpayers of similar means face different tax liabilities, if one has been granted an allocation of credits and the other not. While other Federal disbursements are similarly limited, many have noted that these allocated tax credits are in essence grant programs, and have questioned whether such programs should be run through the tax code, rather than funded directly by grants made under the auspices of other Federal departments.

When there is a limited amount of credit to allocate, providing a fixed percentage credit for the entirety of a qualifying project is not the most cost effective way for the Federal government to utilize the tax code to stimulate desirable manufacturing projects. As the Treasury Department notes in its explanation of the Administration's revenue proposal, the original $2.3 billion credit allocation funded less than one-third of technically acceptable applications. The fact that the program was oversubscribed at the 30 percent credit suggests that the credit was too generous, and that the credit rate could have been lowered while funding more projects on the same budget. Ideally, to efficiently utilize a fixed amount of credit, the government would operate some form of auction whereby applicants bid on the credit rate they would need in order to go forward with a project, and the lowest bidders would obtain the credit until the $2.3 billion were allocated. This is analogous to how the Treasury Department auctions its securities -- it sets a borrowing target and elicits bids in order to obtain the lowest borrowing rate that the market will accept. The allocated credit approach is analogous to a hypothetical, and inefficient, security auction in which the Treasury Department announces it plans to borrow a fixed amount of money at a high interest rate, finds its offer oversubscribed, and then chooses to borrow from the lucky few. This would be an expensive way for the government to borrow.

The Administration proposal notes that guidance for applying for the credit will be revised to no longer require that an applicant apply for the credit with respect to their entire qualified investment, and states that "if a taxpayer applies for a credit with respect to only part of the qualified investment in the project, the taxpayer's increased cost sharing and the project's reduced revenue cost to the government will be taken into account in determining whether to allocate credits to the project." This approach will yield efficiencies similar to the auction concept outlined above, as applicants will now in general have the incentive only to bid for as much credit as they need to make their project economically viable, less they bid for too high an allocation and lose out to a competitor, thus getting no allocation.


E. Extend Temporary Bonus Depreciation for Certain Property

Present Law

In general

A taxpayer is allowed to recover, through annual depreciation deductions, the cost of certain property used in a trade or business or for the production of income. The amount of the depreciation deduction allowed with respect to tangible property for a taxable year generally is determined under the modified accelerated cost recovery system ("MACRS"). Under MACRS, different types of property generally are assigned applicable recovery periods and depreciation methods. The recovery periods applicable to most tangible personal property (tangible property other than residential rental property and nonresidential real property) range from three to 25 years. The depreciation methods generally applicable to tangible personal property are the 200percent and 150-percent declining balance methods, switching to the straight-line method for the taxable year in which the depreciation deduction would be maximized.131 In general, the recovery periods for real property are 39 years for non-residential real property and 27.5 years for residential rental property. The depreciation method for real property is the straight-line method.

Under MACRS, the entire basis of depreciable property is recovered by the taxpayer over the applicable recovery period; there is no need to estimate salvage value. Further, under MACRS, the applicable recovery period need not (and typically does not) correspond to the actual economic life of the asset subject to depreciation. However, MACRS generally provides for longer recovery periods for longer lived assets.

Additional first-year depreciation deduction ("bonus depreciation")

An additional first-year depreciation deduction is allowed equal to 50 percent of the adjusted basis of qualified property placed in service during 2008 and 2009 (2009 and 2010 for certain longer-lived and transportation property).132 The additional first-year depreciation deduction is allowed for both regular tax and alternative minimum tax purposes, but is not allowed for purposes of computing earnings and profits. The basis of the property and the depreciation allowances in the year of purchase and later years are appropriately adjusted to reflect the additional first-year depreciation deduction. In addition, there are no adjustments to the allowable amount of depreciation for purposes of computing a taxpayer's alternative minimum taxable income with respect to property to which the provision applies. The amount of the additional first-year depreciation deduction is not affected by a short taxable year. The taxpayer may elect out of additional first-year depreciation for any class of property for any taxable year.

The interaction of the additional first-year depreciation allowance with the otherwise applicable depreciation allowance may be illustrated as follows. Assume that in 2009, a taxpayer purchased new depreciable property and places it in service.133 The property's cost is $1,000, and it is five-year property subject to the half-year convention. The amount of additional first-year depreciation allowed is $500. The remaining $500 of the cost of the property is depreciable under the rules applicable to five-year property. Thus, 20 percent, or $100, is also allowed as a depreciation deduction in 2009. The total depreciation deduction with respect to the property for 2009 is $600. The remaining $400 adjusted basis of the property generally is recovered through otherwise applicable depreciation rules.

Property qualifying for the additional first-year depreciation deduction must meet all of the following requirements. First, the property must be (1) property to which MACRS applies with an applicable recovery period of 20 years or less; (2) water utility property (as defined in section 168(e)(5)); (3) computer software other than computer software covered by section 197; or (4) qualified leasehold improvement property (as defined in section 168(k)(3)).134 Second, the original use135 of the property must commence with the taxpayer after December 31, 2007.136 Third, the taxpayer must purchase the property within the applicable time period. Finally, the property must be placed in service after December 31, 2007, and before January 1, 2010. An extension of the placed in service date of one year (i.e., to January 1, 2011) is provided for certain property with a recovery period of ten years or longer and certain transportation property.137 Transportation property is defined as tangible personal property used in the trade or business of transporting persons or property.

The applicable time period for acquired property is (1) after December 31, 2007, and before January 1, 2010, but only if no binding written contract for the acquisition is in effect before January 1, 2008, or (2) pursuant to a binding written contract which was entered into after December 31, 2007, and before January 1, 2010.138 With respect to property that is manufactured, constructed, or produced by the taxpayer for use by the taxpayer, the taxpayer must begin the manufacture, construction, or production of the property after December 31, 2007, and before January 1, 2010. Property that is manufactured, constructed, or produced for the taxpayer by another person under a contract that is entered into prior to the manufacture, construction, or production of the property is considered to be manufactured, constructed, or produced by the taxpayer. For property eligible for the extended placed in service date, a special rule limits the amount of costs eligible for the additional first-year depreciation. With respect to such property, only the portion of the basis that is properly attributable to the costs incurred before January 1, 2010 ("progress expenditures") is eligible for the additional first-year depreciation.139

Property does not qualify for the additional first-year depreciation deduction when the user of such property (or a related party) would not have been eligible for the additional first-year depreciation deduction if the user (or a related party) were treated as the owner. For example, if a taxpayer sells to a related party property that was under construction prior to January 1, 2008, the property does not qualify for the additional first-year depreciation deduction. Similarly, if a taxpayer sells to a related party property that was subject to a binding written contract prior to January 1, 2008, the property does not qualify for the additional first-year depreciation deduction. As a further example, if a taxpayer (the lessee) sells property in a sale-leaseback arrangement, and the property otherwise would not have qualified for the additional first-year depreciation deduction if it were owned by the taxpayer-lessee, then the lessor is not entitled to the additional first-year depreciation deduction.

The limitation under section 280F on the amount of depreciation deductions allowed with respect to certain passenger automobiles is increased in the first year by $8,000 for automobiles that qualify (and for which the taxpayer does not elect out of the additional first-year deduction). The $8,000 increase is not indexed for inflation.

Election to claim research or minimum tax credits in lieu of bonus depreciation140

A corporation otherwise eligible for additional first year depreciation under section 168(k) may elect, for its first taxable year ending after December 31, 2008 and each subsequent taxable year, to claim additional research or minimum tax credits in lieu of claiming depreciation under section 168(k) for "extension property."141 "Extension property" is property that is eligible qualified property solely by reason of the extension of the additional first-year depreciation deduction pursuant to the amendments made by section 1201(a) of the American Recovery and Reinvestment Tax Act of 2009.142 Eligible qualified property generally is property placed in service during 2008 or 2009 (2009 or 2010 in the case of certain longer-lived and transportation property) that is otherwise eligible for the additional first-year depreciation deduction.

A corporation making the election forgoes the depreciation deductions allowable under section 168(k) and instead increases the limitation under section 38(c) on the use of research credits or section 53(c) on the use of minimum tax credits.143 The increases in the allowable credits are treated as refundable for purposes of this provision. The depreciation for qualified property is calculated for both regular tax and AMT purposes using the straight-line method in place of the method that would otherwise be used absent the election under this provision.

The research credit or minimum tax credit limitation is increased by the bonus depreciation amount, which is equal to 20 percent of bonus depreciation144 for certain eligible qualified property that could be claimed absent the election. The bonus depreciation amount is limited to the lesser of: (1) $30 million, or (2) six percent of the sum of research credit carryforwards from taxable years beginning before January 1, 2006 and minimum tax credits allocable to the adjusted minimum tax imposed for taxable years beginning before January 1, 2006. All corporations treated as a single employer under section 52(a) are treated as one taxpayer for purposes of the limitation, as well as for electing the application of this provision.


Description of Proposal

The proposal extends the additional first-year depreciation deduction for one year to apply to qualified property acquired and placed in service during 2010 (or placed in service during 2011 for certain long-lived and transportation property). The proposal also extends for one year the election to claim additional research or minimum tax credits in lieu of claiming the additional first-year depreciation. Under the proposal, a corporation would be allowed to choose whether or not to make an election with respect to eligible qualified property placed in service in 2010, regardless of prior-year elections.

Effective date. -- The proposal is effective for qualified property placed in service after December 31, 2009.


Analysis

The proposal lowers the after-tax cost of capital expenditures made by businesses by permitting the immediate depreciation of 50 percent of the amount of the capital expenditure rather than depreciating the full cost of the expenditure over the recovery period. With a lower cost of capital, it is argued that eligible businesses will invest in more equipment and employ more workers, thus serving to stimulate economic growth among businesses taxable in the United States.

Reducing the cost of capital investments is the appropriate treatment if the policy objective is taxation of consumption, because expensing 50 percent of the cost of the capital expenditure effectively reduces the tax on the returns to investment, subject to certain assumptions.145 If the policy objective is taxation of income, then depreciation deductions should coincide with the economic depreciation of the asset to measure economic income accurately. A depreciation system more generous than economic depreciation, but less generous than full expensing, results in an effective tax rate on the income from capital that is less than the statutory tax rate.

Some economic studies suggest that bonus depreciation has limited effect on investment spending.146 One economist has estimated that for every one dollar reduction in Federal tax revenue associated with bonus depreciation there is a 27 cent change in real gross domestic product,147 leading some commentators to assert that bonus depreciation is "a poor candidate for inclusion in an economic stimulus package designed to achieve the best bang-for-the-buck."148

Possible explanations for the modest stimulative effect of bonus depreciation include that the size of the incentive was relatively small given the present accelerated depreciation provisions, companies typically plan their capital spending budgets in advance and could not adapt to take advantage of the bonus deprecation, and the costs of making any such adjustments was not worth the benefit.149 One study noted that bonus depreciation was not claimed with respect to approximately 40 percent of eligible investments.150 The author suggested that the low takeup rate could be the result of companies with significant losses and loss carryovers, as well as the fact that many states did not allow bonus depreciation, making bonus depreciation less beneficial.

One study found that bonus depreciation significantly affected the composition of investments made by companies, with companies investing in equipment with long tax lives.151 While another study concluded that bonus depreciation stimulates investment by firms with more domestic investments and that pay more taxes.152

Another commentator contends that bonus depreciation provisions in stimulus legislation contribute to a jobless recovery.153 The commentator notes that incentives like bonus depreciation encourage firms to shift funds from labor to capital to take advantage of provisions like bonus depreciation that favor capital investment.154 However, shifting from labor to capital should make labor more productive leading to higher wages.


Prior Action

None.

F. Extend Option for Cash Assistance to States in Lieu of Low-
Income Housing Tax Credit for 2010

Present Law

Tax credits

    In general

The low-income housing credit may be claimed over a 10-year period by owners of certain residential rental property for the cost of rental housing occupied by tenants having incomes below specified levels.155 The amount of the credit for any taxable year in the credit period is the applicable percentage (70 percent for a new non-federally subsidized building; otherwise 30 percent) of the qualified basis of each qualified low-income building. Generally, a new building is considered federally subsidized if it also receives tax-exempt bond financing. The qualified basis of any qualified low-income building for any taxable year equals the applicable fraction of the eligible basis of the building.

    Volume limits

Generally, a low-income housing credit is allowable only if the owner of a qualified building receives a housing credit allocation from the State or local housing credit agency. Each State has a limited amount of low-income housing credit available to allocate. This amount is called the aggregate housing credit dollar amount. The aggregate housing credit dollar amount for each State has four components: (1) the unused housing credit ceiling, if any, of such State from the prior calendar year; (2) the credit ceiling for the year; (3) any returns of credit ceiling to the State during the calendar year from previous allocations; and (4) the State's share, if any, of the national pool of unused credits from other States who failed to use them (only States which allocated their entire credit ceiling for the preceding calendar year are eligible for a share of the national pool). For calendar year 2010, each State's credit ceiling is $2.10 per resident, with a minimum annual cap of $2,430,000 for certain small population States.156 These amounts are indexed for inflation.

Certain buildings that also receive financing from proceeds of tax-exempt bonds do not require an allocation of the low-income housing credit. Generally, these buildings are buildings where 50 percent or more of the aggregate basis of the building and the land on which the building is located is financed with obligations tax exempt under section 103 and subject to the private activity bond volume limits under section 146.


    Federal grants

The eligible basis of a qualified building must be reduced by the amount of any Federal grant with respect to such building.

Grants in lieu of tax credits for 2009


    Low-income housing grant election amount

Under a special rule, in 2009 the Secretary of the Treasury makes a grant to the State housing credit agency of each State in an amount equal to the low-income housing grant election amount.

The low-income housing grant election amount for a State is an amount elected by the State subject to certain limits. The maximum low-income housing grant election amount for a State may not exceed 85 percent of the product of ten and the sum of: (1) the State's unused housing credit ceiling for 2008; (2) any returns to the State during 2009 of credit allocations previously made by the State; (3) 40 percent of the State's 2009 credit allocation; and (4) 40 percent of the State's share of the national pool allocated in 2009, if any.

These grants are not taxable income to recipients.


    Subawards to low-income housing credit buildings

A State electing to receive a grant must use these monies to make subawards to finance the construction, or acquisition and rehabilitation of qualified low-income buildings as defined under the low-income housing credit. A subaward may be made to finance a qualified low-income building regardless of whether the building has been allocated a low-income housing credit. However, in the case of qualified low-income buildings that have not received a low-income housing credit, the State housing credit agency must make a determination that the subaward with respect to such building will increase the total funds available to the State to build and rehabilitate affordable housing. In conjunction with this determination the State housing credit agency must establish a process in which applicants for the subawards must demonstrate good faith efforts to obtain investment commitments from potential investors before the agency makes such subawards.

Any building receiving grant money from a subaward must satisfy the low-income housing credit rules. The State housing credit agency is required to perform asset management functions to ensure compliance with the low-income housing credit rules and the long-term viability of buildings financed with these subawards.157 Failure to satisfy the low-income housing credit rules results in recapture of the subaward enforced by means of liens or other methods that the Secretary (or his delegate) deems appropriate. Any such recapture will be payable to the Secretary for deposit in the general fund of the Treasury.

Any grant funds not used to make subawards before January 1, 2011 and any grant monies from subawards returned on or after January 1, 2011 must be returned to the Secretary.


    Grants received under this election

A grant received under a State's grant election does not reduce eligible basis of a qualified low-income building.

    Reduction in low-income housing credit volume limit for 2009

The otherwise applicable component or components of the aggregate housing credit dollar amounts for any State for 2009 are reduced by the amount taken into account in determining the low-income housing grant election amount.

    Appropriations

Present law appropriates to the Secretary such sums as may be necessary to carry out the grant provision.

Description of Proposal

The proposal extends for one year (2010) the ability of States to elect to substitute grants for nonrefundable tax credits.

For 2010, the maximum low-income housing refundable credit election amount for a State may not exceed 85 percent of the product of ten and the sum of: (1) the State's unused housing credit ceiling for 2009; (2) any returns to the State during 2010 of credit allocations (other than credit allocations denied, directly or indirectly under section 1400N(c) of the Code) previously made by the State; (3) 40 percent of the State's 2010 credit allocation; and (4) 40 percent of the State's share of the national pool allocated in 2010, if any.

Any refundable tax credits allowed under this provision not used to make grants before January 1, 2012 and any grant monies to taxpayers under this provision returned on or after January 1, 2012 must be returned to the Secretary.

The payments made under the proposal do not reduce the tax basis of a qualified low-income building.

A Federal agency other than the Internal Revenue Service (the "IRS") will continue to administer elections by State housing agencies. An electing State's housing credit agency will continue to perform asset management functions to ensure compliance with the low-income housing credit rules and the long-term viability of buildings financed with these subawards. Any noncompliance will be reported to the IRS. Failure to satisfy the low-income housing credit rules will result in recapture of the subaward enforced by means of liens or other methods that the Secretary (or his delegate) deems appropriate. Any State lien or regulatory agreement will be assigned to the IRS for collection by Federal authorities. Any such recapture will be payable to the Secretary for deposit in the general fund of the Treasury.

No change is made to the operation of the 2009 election.

Effective date. -- The provision is effective on the date of enactment.


Analysis

Proponents argue that the need for additional low-income housing stock is ongoing in this country. They contend that the temporary economic downturn and attendant reductions in tax liability for many taxpayers have resulted in a reduced appetite for tax credits by many potential low-income housing tax credit investors. In addition, Freddie Mac and Fannie Mae, the two largest investors in low-income housing credit projects, suspended new investment in such projects. The possibility that Freddie Mac and Fannie Mae might transfer some or all of their holdings in low-income housing credit projects may also create uncertainty in the market and discourage other new investment. Proponents argue that this program allows the States the flexibility they need to encourage investment in the short-term while retaining the tax credit structure for future years.

Opponents may question whether the delay in enacting this proposal (e.g., in the last six months of calendar year 2010) reduces its efficacy.

Opponents voice concern that the Federal Government, rather than the individual States, has the most incentive to ensure compliance with any Federal tax subsidy. Proponents may respond that the proposal returns more of this compliance responsibility to the IRS.

Another argument against the proposal is that the conversion of tax benefits to cash usurps the traditional role of direct Federal appropriations and the continuing Congressional oversight attendant with such appropriated monies. Proponents may respond that such concern is less warranted in the case of a short-term program.


IV. TAX CUTS FOR FAMILIES AND INDIVIDUALS

A. Increase in the Earned Income Tax Credit

Present Law

Overview

Low- and moderate-income workers may be eligible for the refundable earned income tax credit ("EITC"). Eligibility for the EITC is based on earned income, adjusted gross income, investment income, filing status, number of children, and immigration and work status in the United States. The amount of the EITC is based on the presence and number of qualifying children in the worker's family, as well as on adjusted gross income and earned income.

The EITC generally equals a specified percentage of earned income158 up to a maximum dollar amount. The maximum amount applies over a certain income range and then diminishes to zero over a specified phaseout range. For taxpayers with earned income (or adjusted gross income (AGI), if greater) in excess of the beginning of the phaseout range, the maximum EITC amount is reduced by the phaseout rate multiplied by the amount of earned income (or AGI, if greater) in excess of the beginning of the phaseout range. For taxpayers with earned income (or AGI, if greater) in excess of the end of the phaseout range, no credit is allowed.

An individual is not eligible for the EITC if the aggregate amount of disqualified income of the taxpayer for the taxable year exceeds $3,100 (for 2010). This threshold is indexed for inflation. Disqualified income is the sum of: (1) interest (both taxable and tax exempt); (2) dividends; (3) net rent and royalty income (if greater than zero); (4) capital gains net income; and (5) net passive income that is not self-employment income (if greater than zero).

The EITC is a refundable credit, meaning that if the amount of the credit exceeds the taxpayer's Federal income tax liability, the excess is payable to the taxpayer as a direct transfer payment. Under an advance payment system, eligible taxpayers may elect to receive a portion of the credit in their paychecks, rather than waiting to claim a refund on their tax returns filed in the following year.159

Filing status

An unmarried individual may claim the EITC if he or she files as a single filer or as a head of household. Married individuals generally may not claim the EITC unless they file jointly. An exception to the joint return filing requirement applies to certain spouses who are separated. Under this exception, a married taxpayer who is separated from his or her spouse for the last six months of the taxable year is not considered to be married (and, accordingly, may file a return as head of household and claim the EITC), provided that the taxpayer maintains a household that constitutes the principal place of abode for a dependent child (including a son, stepson, daughter, stepdaughter, adopted child, or a foster child) for over half the taxable year,160 and pays over half the cost of maintaining the household in which he or she resides with the child during the year.

Presence of qualifying children and amount of the earned income credit

Four separate credit schedules apply: one schedule for taxpayers with no qualifying children, one schedule for taxpayers with one qualifying child, one schedule for taxpayers with two qualifying children, and one schedule for taxpayers with three or more qualifying children.161

Taxpayers with no qualifying children may claim a credit if they are over age 24 and below age 65. The credit is 7.65 percent of earnings up to $5,980, resulting in a maximum credit of $457 for 2010. The maximum is available for those with incomes between $5,980 and $7,480 ($12,490 if married filing jointly). The credit begins to phase out at a rate of 7.65 percent of earnings above $7,480 ($12,480 if married filing jointly) resulting in a $0 credit at $13,460 of earnings ($18,470 if married filing jointly).

Taxpayers with one qualifying child may claim a credit in 2010 of 34 percent of their earnings up to $8,970, resulting in a maximum credit of $3,050. The maximum credit is available for those with earnings between $8,970 and $16,450 ($21,460 if married filing jointly). The credit begins to phase out at a rate of 15.98 percent of earnings above $16,450 ($21,460 if married filing jointly). The credit is completely phased out at $35,535 of earnings ($40,545 if married filing jointly).

Taxpayers with two qualifying children may claim a credit in 2010 of 40 percent of earnings up to $12,590, resulting in a maximum credit of $5,036. The maximum credit is available for those with earnings between $12,590 and $16,450 ($21,460 if married filing jointly). The credit begins to phase out at a rate of 21.06 percent of earnings above $16,450 ($21,460 if married filing jointly). The credit is completely phased out at $40,363 of earnings ($45,373 if married filing jointly).

A temporary provision enacted by the American Recovery and Reinvestment Act of 2009162 ("ARRA") allows taxpayers with three or more qualifying children to claim a credit of 45 percent for 2009 and 2010. For example, in 2010 taxpayers with three or more qualifying children may claim a credit of 45 percent of earnings up to $12,590, resulting in a maximum credit of $5,666. The maximum credit is available for those with earnings between $12,590 and $16,450 ($21,460 if married filing jointly). The credit begins to phase out at a rate of 21.06 percent of earnings above $16,450 ($21,460 if married filing jointly). The credit is completely phased out at $43,352 of earnings ($48,362 if married filing jointly).

Under another provision of ARRA, the phase-out thresholds for married couples were raised to an amount $5,000 above that for other filers for 2009 (and indexed for inflation). The increase is $5,010 for 2010. Formerly, the phase-out thresholds for married couples were $3,000 (indexed for inflation from 2008) greater than those for other filers as provided for in EGTRRA.

If more than one taxpayer lives with a qualifying child, only one of these taxpayers may claim the child for purposes of the EITC. If multiple eligible taxpayers actually claim the same qualifying child, then a tiebreaker rule determines which taxpayer is entitled to the EITC with respect to the qualifying child. Any eligible taxpayer with at least one qualifying child who does not claim the EITC with respect to qualifying children due to failure to meet certain identification requirements with respect to such children (i.e., providing the name, age and taxpayer identification number of each of such children) may not claim the EITC for taxpayers without qualifying children.


Description of Proposal

The proposal permanently extends the EITC at a rate of 45 percent for three or more qualifying children.

The proposal permanently extends the higher phase-out thresholds for married couples filing joint returns enacted as part of ARRA.

Effective date. -- The proposal applies to taxable years beginning after December 31, 2010.


Analysis

Proponents argue that the EITC is generally structured to provide greater tax benefits to families with more children, and thus they believe it is appropriate to extend the additional benefits that were recently made available on a temporary basis to larger families with three or more children.

A "marriage penalty" exists when the combined tax liability of a married couple filing a joint return is greater than the sum of the tax liabilities of each individual computed as if they were not married. Large marriage penalties exist in the earned income credit, primarily because the ranges of earned income over which the credit is phased in and phased out are not adjusted for marital status (other than the one provision that delays the phase-out of the credit for married taxpayers). Proponents argue that extending the higher phase-out thresholds for married taxpayers filing jointly thus reducing marriage penalties is particularly important for this low-income households so that credit recipients are not discouraged from marrying on account of the loss or reduction in credit that marriage could entail.

Some opponents may argue that the combined expansions above provide the earned income tax credit to individuals who some may not consider low- or moderate-income taxpayers since eligibility for the credit can extend past $48,000163 of income.


Prior Action

A similar provision was included in the President's fiscal year 2010 budget proposal.

B. Expand the Child and Dependent Care Tax Credit

Present Law

A taxpayer who maintains a household that includes one or more qualifying individuals may claim a nonrefundable credit against income tax liability for up to 35 percent of a limited amount of employment-related dependent care expenses. Eligible child and dependent care expenses related to employment are limited to $3,000 if there is one qualifying individual or $6,000 if there are two or more qualifying individuals. Thus, the maximum credit is $1,050 if there is one qualifying individual and $2,100 if there are two or more qualifying individuals. The applicable dollar limit is reduced by any amount excluded from income under an employer-provided dependent care assistance plan. The 35-percent credit rate is reduced, but not below 20 percent, by one percentage point for each $2,000 (or fraction thereof) of adjusted gross income above $15,000. Thus, for taxpayers with adjusted gross income above $43,000, the credit rate is 20 percent. The phase-out point and the amount of expenses eligible for the credit are not indexed for inflation.

Generally, a qualifying individual is: (1) a qualifying child of the taxpayer under the age of 13 for whom the taxpayer may claim a dependency exemption, or (2) a dependent or spouse of the taxpayer if the dependent or spouse is physically or mentally incapacitated, and shares the same principal place of abode with the taxpayer for over one half the year. Married taxpayers must file a joint return in order to claim the credit.

After 2010, the maximum credit will fall, and other parameters of the child and dependent care credit will change, as a result of the sunset provisions of EGTRRA.164


Description of Proposal

Under the proposal, the AGI level at which the credit rate begins to phase down is increased from $15,000 to $85,000. Thus, the credit rate is decreased by one percentage point for every $2,000 (or part thereof) of AGI over $85,000 until the percentage reaches 20 percent (at incomes above $113,000). As under current law, there are no further income limits and the phase-out point and the amount of expenses eligible for the credit is not indexed for inflation.

Effective date. -- The proposal is effective for taxable years beginning after December 31, 2010.


Analysis

By increasing the income levels at which the credit rate begins to phase down, the proposal increases the effective credit rate for eligible child and dependent care expenses by up to 15 percentage points (yielding a $900 maximum credit increase) for a substantial number of taxpayers. As a result, the proposal reduces the tax burden for workers with employment-related child care expenses. Additionally, by increasing the after-tax return to employment for nonworking individuals with child care responsibilities, the proposal could encourage these individuals to seek work outside of the home.

All taxpayers with qualifying expenses and AGI between $15,000 and $113,000 would experience an increase in their credit rate, but to varying degrees. Taxpayers with AGI between $43,000 and $85,000 would experience a rise in their credit rate from 20 percent to 35 percent. Taxpayers formerly in the phasedown range (those with AGI between $15,000 and $43,000), who thus had credit rates between 20 percent and 35 percent, would have their credit rate increased to 35 percent. Taxpayers in the new phasedown range (those with AGI between $85,000 and $113,000) would have credit rates between 20 percent and 35 percent, up from 20 percent previously. Taxpayers experiencing the full increase in the credit rate would experience an increase in their potential credit of $450 (from 20 percent of $3,000 to 35 percent of $3,000) for one qualifying child or $900 for two or more qualifying children (from 20 percent of $6,000 to 35 percent of $6,000).

The proposal represents a substantial expansion of the child and dependent tax credit, and if such significant changes to the credit are contemplated by Congress, consideration could be given to other or additional alterations to the credit. For example, an increase in the cap on qualifying expenses would assist those with greater child care expenses, such as those who work full time and/or live in high cost areas. Raising the cap could occur in addition to the contemplated changes to the credit rate or in lieu of them. For the same budgetary cost as the proposal, the caps could be raised with some paring back of the proposed increases to the credit rate. Consideration could also be given to indexing the cap on qualifying expenses and the AGI threshold for the phasedown of the credit rate. Lastly, as the credit is designed to help offset certain costs of earning income, consideration could be given to whether a deduction is the more appropriate tax treatment for an employment-related expense when the tax rate structure is progressive.


Prior Action

None.

C. Automatic Enrollment in Individual Retirement Arrangements

Present Law

Contribution limits

    In general

There are two basic types of individual retirement arrangements ("IRAs") under present law: traditional IRAs,165 to which both deductible and nondeductible contributions may be made,166 and Roth IRAs, to which only nondeductible contributions may be made.167 The principal difference between these two types of IRAs is the timing of income tax inclusion. For a traditional IRA, an eligible contributor may deduct the contributions made for the year, but distributions are includible in gross income. For a Roth IRA, all contributions are after-tax (no deduction is allowed) but, if certain requirements are satisfied, distributions are not includable in gross income.

An annual limit applies to contributions to IRAs. The contribution limit is coordinated so that the aggregate maximum amount that can be contributed to all of an individual's IRAs (both traditional and Roth IRAs) for a taxable year is the lesser of a certain dollar amount ($5,000 for 2010)168 or the individual's compensation. In the case of a married couple, contributions can be made up to the dollar limit for each spouse if the combined compensation of the spouses is at least equal to the contributed amount.

An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions to an IRA. For this purpose, the aggregate dollar limit is increased by $1,000. Thus for example, if an individual over age 50 contributes $6,000 to a Roth IRA for 2010 ($5,000 plus $1,000 catch-up), the individual will not be permitted to make any contributions to a traditional IRA for the year. In addition, deductible contributions to traditional IRAs and after tax contributions to Roth IRAs generally are subject to AGI limits. IRA contributions generally must be made in cash.


    Traditional IRAs

An individual may make deductible contributions to a traditional IRA up to the IRA contribution limit if neither the individual nor the individual's spouse is an active participant in an employer-sponsored retirement plan. If an individual (or the individual's spouse) is an active participant in an employer-sponsored retirement plan, the deduction is phased out for taxpayers with AGI for the taxable year over certain indexed levels. In the case of an individual who is an active participant in an employer-sponsored plan, the AGI phase-out ranges for 2010 are: (1) for single taxpayers, $56,000 to $66,000; (2) for married taxpayers filing joint returns, $89,000 to $109,000; and (3) for married taxpayers filing separate returns, $0 to $10,000. If an individual is not an active participant in an employer-sponsored retirement plan, but the individual's spouse is, the deduction is phased out for taxpayers with AGI for 2010 between $167,000 and $177,000.

To the extent an individual cannot or does not make deductible contributions to a traditional IRA or contributions to a Roth IRA for the taxable year, the individual may make nondeductible contributions to a traditional IRA, subject to the same limits as deductible contributions, including catch-up contributions. An individual who has attained age 70 1/2 prior to the close of a year is not permitted to make contributions to a traditional IRA.


    Roth IRAs

Individuals with AGI below certain levels may make nondeductible contributions to a Roth IRA. The maximum annual contribution that can be made to a Roth IRA is phased out for taxpayers with AGI for the taxable year over certain indexed levels. The AGI phase-out ranges for 2010 are: (1) for single taxpayers, $105,000 to $120,000; (2) for married taxpayers filing joint returns, $167,000 to $177,000; and (3) for married taxpayers filing separate returns, $0 to $10,000. Contributions to a Roth IRA may be made even after the account owner has attained age 70 1/2.

Separation of traditional and Roth IRA accounts

Contributions to traditional IRAs and to Roth IRAs must be kept in completely separate IRAs, meaning arrangements with separate trusts, accounts, or contracts, and separate IRA documents. Except in the case of a conversion or recharacterization, amounts cannot be transferred or rolled over between the two types of IRAs.

Taxpayers generally may convert a traditional IRA into a Roth IRA.169 The amount converted is includible in income as if a withdrawal had been made,170 except that the early distribution tax (discussed below) does not apply. However, the early distribution tax is recouped if the taxpayer withdraws the amount within five years of the conversion.

If an individual makes a contribution to an IRA (traditional or Roth) for a taxable year, the individual is permitted to recharacterize (in a trustee-to-trustee transfer) the amount of that contribution as a contribution to the other type of IRA (traditional or Roth) before the due date for the individual's income tax return for that year.171 In the case of a recharacterization, the contribution will be treated as having been made to the transferee plan (and not the transferor plan). The amount transferred must be accompanied by any net income allocable to the contribution and no deduction is allowed with respect to the contribution to the transferor plan. Both regular contributions and conversion contributions to a Roth IRA can be recharacterized as having been made to a traditional IRA. However, Treasury regulations limit the number of times a contribution for a taxable year may be recharacterized.172

Excise tax on excess contributions

To the extent that contributions to an IRA exceed the contribution limits, the individual is subject to an excise tax equal to six percent of the excess amount.173 This excise tax generally applies each year until the excess amount is distributed. Any amount contributed for a taxable year that is distributed with allocable income by the due date for the taxpayer's return for the year will be treated as though not contributed for the year.174 To receive this treatment, the taxpayer must not have claimed a deduction for the amount of the distributed contribution.

Taxation of distributions from IRAs


    Traditional IRAs

Amounts held in a traditional IRA are includible in income when withdrawn, except to the extent that the withdrawal is a return of the individual's basis in the contract in the form of nondeductible contributions or rolled over after tax employee contributions. All traditional IRAs of an individual are treated as a single contract for purposes of recovering basis in the IRAs. The portion of the individual's basis that is recovered with any distribution is the ratio of the amount of the aggregate basis in all the individual's traditional IRAs to the amount of the aggregate account balances in all the individual's traditional IRAs.

    Roth IRAs

Amounts held in a Roth IRA that are withdrawn as a qualified distribution are not includible in income. A qualified distribution is a distribution that (1) is made after the five-taxable year period beginning with the first taxable year for which the individual first made a contribution to a Roth IRA, and (2) is made after attainment of age 59-1/2, on account of death or disability, or is made for first-time homebuyer expenses of up to $10,000.

Distributions from a Roth IRA that are not qualified distributions are includible in income to the extent attributable to earnings; amounts that are attributable to a return of contributions to the Roth IRA are not includable in income. All Roth IRAs are treated as a single contract for purposes of determining the amount that is a return of contributions. To determine the amount includible in income, a distribution that is not a qualified distribution is treated as made in the following order: (1) regular Roth IRA contributions (including contributions rolled over from other Roth IRAs); (2) conversion contributions (on a first in, first out basis); and (3) earnings. To the extent a distribution is treated as made from a conversion contribution, it is treated as made first from the portion, if any, of the conversion contribution that was required to be included in income as a result of the conversion. Thus, nonqualified distributions from all Roth IRAs are excludable from gross income until all amounts attributable to contributions have been distributed.


    Early distribution tax

Early withdrawals from an IRA generally are subject to an additional tax.175 This additional tax applies to distributions from both traditional and Roth IRAs. The tax is calculated by reference to the amount of the distribution that is includable in AGI.176 Includible amounts withdrawn prior to attainment of age 59 1/2 are subject to an additional 10-percent tax unless another exception applies. Other exceptions include for withdrawals: due to death or disability; made in the form of certain periodic payments; used to pay medical expenses in excess of 7.5 percent of AGI; used to purchase health insurance for certain unemployed individuals; used for higher education expenses; used for first-time homebuyer expenses of up to $10,000; or made to a member of a reserve unit called to active duty for 180 days or longer.

Deemed IRAs

Certain types of employer-sponsored retirement plans are essentially allowed to provide IRAs to employees as a part of the employer-sponsored retirement plan. This option is available to tax qualified retirement plans, section 403(b) plans, and governmental section 457(b) plans. The Code permits these plans to allow employees to elect to make contributions to a separate account or annuity under the plan that are treated as contributions to a traditional IRA or a Roth IRA. To receive this treatment, under the terms of the plan, the account or annuity must satisfy the requirements of the Code for being a traditional or Roth IRA.177 Implementing the basic provision that the account satisfy the requirements to be an IRA, Treasury regulations require that the trustee with respect to the account be a bank or a nonbank trustee approved by the IRS.178

Payroll deduction IRA

Under current law, an employer is permitted to establish a program under which each employee can elect to have the employer withhold an amount each pay period and contribute the amount to an IRA established by the employee. In the Conference report to the Taxpayer Relief Act of 1997, Congress indicated that "employers that chose not to sponsor a retirement plan should be encouraged to set up a payroll deduction system to help employees save for retirement by making payroll deduction contributions to their IRAs."179 Congress encouraged the Secretary of the Treasury to "continue his efforts to publicize the availability of these payroll deduction IRAs."180 In response to that directive, the IRS published Announcement 99-2,181 which reminds employers of the availability of this option for their employees.

In 1975, the Department of Labor ("DOL") issued a regulation describing circumstances under which the use of an employer payroll deduction program for forwarding employee monies to an IRA will not constitute an employee pension benefit plan subject to the Employee Retirement Income Security Act ("ERISA").182 Interpretive Bulletin 99-1183 restated and updated the DOL's positions on these programs. Under the DOL guidance, the general rule is that, in order for an IRA payroll program not to be a pension plan subject to ERISA, the employer must not endorse the program. To avoid endorsing the program the employer must maintain neutrality with respect to an IRA sponsor in its communication to its employees and must otherwise make clear that that its involvement in the program is limited to collecting the deducted amounts and remitting them promptly to the IRA sponsor and that it does not provide any additional benefit or promise any particular investment return on the employee's savings.184

Employer retirement plans using IRAs


    SIMPLE IRA plan

Under present law, a small business that employs fewer than 100 employees who earned $5,000 or more during the prior calendar year can establish a simplified tax-favored retirement plan, which is called the savings incentive match plan for employees ("SIMPLE") retirement plan. A SIMPLE retirement plan is generally a plan under which contributions are made to an individual retirement arrangement for each employee (a "SIMPLE IRA").185 A SIMPLE retirement plan allows employees to make elective deferrals to a SIMPLE IRA, subject to a limit of $11,500 (for 2010). An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions under a SIMPLE retirement plan up to a limit of $2,500 (for 2010).

In the case of a SIMPLE retirement plan, the group of eligible employees generally must include any employee who has received at least $5,000 in compensation from the employer in any two preceding years and is reasonably expected to receive $5,000 in the current year. A SIMPLE retirement plan is not subject to the nondiscrimination rules generally applicable to tax qualified retirement plans.

Employer contributions to a SIMPLE IRA must satisfy one of two contribution formulas. Under the matching contribution formula, the employer generally is required to match employee elective contributions on a dollar-for-dollar basis up to three percent of the employee's compensation. The employer can elect a lower percentage matching contribution for all employees (but not less than one percent of each employee's compensation); however, a lower percentage cannot be elected for more than two years out of any five year period.186 Alternatively, for any year, an employer is permitted to elect, in lieu of making matching contributions, to make a nonelective contribution of two percent of compensation on behalf of each eligible employee with at least $5,000 in compensation for such year, whether or not the employee makes an elective contribution.

The employer must provide each employee eligible to make elective deferrals under a SIMPLE retirement plan a 60-day election period before the beginning of the calendar year and a notice at the beginning of the 60-day period explaining the employee's choices under the plan.187

No contributions other than employee elective contributions, required employer matching contributions or employer nonelective contributions can be made to a SIMPLE retirement plan, and the employer may not maintain any other qualified retirement plan.


    Simplified employee pensions

A simplified employee pension ("SEP") is an IRA to which employers may make contributions up to the limits applicable to tax qualified defined contribution plans ($49,000 for 2010). All contributions must be fully vested. Any employee must be eligible to participate in the SEP if the employee has (1) attained age 21, (2) performed services for the employer during at least three of the immediately preceding five years, and (3) received at least $550 (for 2010) in compensation from the employer for the year. Contributions to a SEP generally must bear a uniform relationship to compensation.

Effective for taxable years beginning before January 1, 1997, certain employers with no more than 25 employees could maintain a salary reduction SEP ("SARSEP") under which employees could make elective deferrals. The SARSEP rules were generally repealed with the adoption of SIMPLE retirement plans. However, contributions may continue to be made to SARSEPs that were established before 1997. Salary reduction contributions to a SARSEP are subject to the same limit that applies to elective deferrals under a section 401(k) plan ($16,500 for 2010). An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions to a SARSEP up to a limit of $5,500 (for 2010).

Automatic enrollment

Under a section 401(k) plan, employees may elect to receive cash or to have contributions made to the plan by the employer on behalf of the employee in lieu of receiving cash. Contributions made to the plan at the election of the employee are referred to as "elective deferrals" or "elective contributions." A section 401(k) plan may be designed so that the employee will receive cash compensation unless the employee affirmatively elects to make contributions to the section 401(k) plan. Alternatively, a plan may provide that elective contributions are made at a specified rate (when the employee becomes eligible to participate) unless the employee elects otherwise (i.e., affirmatively elects not to make contributions or to make contributions at a different rate). Arrangements that operate in the second manner are sometimes referred to as "automatic enrollment" plans.

In a section 401(k) plan, the employee must have an effective opportunity to elect to receive cash in lieu of contributions. Treasury regulations provide that whether an employee has an effective opportunity to receive cash is based on all the relevant facts and circumstances, including the adequacy of notice of the availability of the election, the period of time during which an election may be made, and any other conditions on elections.188

Pension Protection Act of 2006

The Pension Protection Act of 2006 ("PPA")189 added a number of special rules to the Code and ERISA with respect to automatic enrollment in section 401(k) plans as well as section 403(b) plans and section 457(b) plans. Use of any of the special rules is predicated on a default contribution that is a stated percentage of compensation which applies uniformly to all participants. In addition, a notice must be provided to participants explaining the choice between making or not making contributions and identifying the default contribution rate and investment, and each participant must be given a reasonable period of time after receipt of the notice to make an affirmative election with respect to contributions and investments.

PPA also made changes to ERISA to permit the DOL to provide a safe harbor default investment option and to preempt State laws if certain requirements are satisfied.190 Specifically, PPA amended ERISA to provide that a participant in an individual account plan with automatic enrollment is treated as exercising control over the assets which in the absence of an investment election are invested in accordance with regulations prescribed by the Secretary of Labor.

Under the DOL's PPA regulations, which were issued October 24, 2007, the default investment option for those automatically enrolled must be a qualified default investment alternative ("QDIA").191 The choices for a QDIA include: (1) a product with a mix of investments that takes into account the individual's age or retirement date (an example of such a product could be a life-cycle or targeted-retirement-date fund); (2) an investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual's age or retirement date (an example of such a service could be a professionally-managed account); (3) a product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (an example of such a product could be a balanced fund); and (4) a capital preservation product for only the first 120 days of participation (an option for plan sponsors wishing to simplify administration if workers opt-out of participation before incurring an additional tax). In addition, a QDIA must be managed by an investment manager, plan trustee, plan sponsor, a committee comprised primarily of employees of the plan sponsor that is a named fiduciary, or an investment company registered under the Investment Company Act of 1940. Further, a QDIA generally may not invest participant contributions in employer securities.

Tax credit for small employer plan pension start-up costs

Present law provides for a tax credit under section 45E for small employer plan pension start-up costs for the first three years of the plan. The credit is limited to the lesser of $500 per year or 50 percent of the start-up costs for a qualified plan meeting the requirements of section 401(a), an annuity plan described in 403(a), a SEP or a SIMPLE retirement plan. Start-up costs associated with a payroll deduction IRA are not eligible for the tax credit.


Description of Proposal

Automatic payroll deduction IRA program

Under the proposal, employers that have been in existence for at least two years, have more than 10 employees, and do not sponsor a qualified retirement plan for their employees would be required to offer an automatic enrollment payroll deduction IRA program to their employees ("automatic payroll deduction IRA program"). If an employer sponsors a retirement plan, but excludes certain employees (other than excludable employees192) under the plan, the otherwise non-excludable employees must be offered the opportunity to participate in an automatic payroll deduction IRA program.

Employers offering an automatic payroll deduction IRA program would give employees a standard notice and election form informing them of the automatic payroll deduction IRA option and allowing them to elect to participate or to opt-out. For any employee who fails to make an affirmative election in writing under the payroll deduction IRA program, the proposal includes a default under which payroll deduction contributions for the employee automatically begin to be made to an IRA established for the employee. Under the proposal, the automatic enrollment contribution rate for employees who fail to make an affirmative election would be three percent of compensation (but not more than the IRA dollar limit for the year). Employees could opt for a lower or higher contribution rate up to the IRA dollar limit for the year. Employee contributions to automatic IRAs would qualify for the saver's credit under section 25B (to the extent the employee and the contributions otherwise qualify for the credit), and an employee's saver's credit193 could be deposited to the IRA to which the eligible individual contributed.

Employers making automatic payroll deduction IRAs available would not be responsible for opening IRAs for employees. Payroll deduction contributions from participating employees may be transferred, at the employer's option, to a single private sector IRA trustee or custodian designated by the employer or, if permitted by the employer, to the IRA provider designated by each participating employee. Alternatively, the employer could designate that all contributions would be forwarded to a savings vehicle specified by statute or regulation.

Similarly, employers would not be responsible for choosing or arranging default investments. Instead, a low-cost, standard type of default investment and a handful of standard, low-cost investment alternatives would be prescribed. The proposal generally does not involve employer contributions, employer compliance with plan qualification requirements, or employer liability under ERISA. A national web site would provide information and basic educational material regarding saving and investing for retirement, including IRA eligibility, but, as under current law, individuals (not employers) would bear ultimate responsibility for determining their IRA eligibility.

Under the proposal, the default under an automatic payroll deduction IRA program is a Roth IRA, though employees may elect to direct their contributions to a traditional IRA. The proposal also specifies a number of administrative requirements that must be satisfied, including a mandated notice of the right to opt out or contribute a different amount, an election period, and specific timing requirements for the employer to make contributions. However, administrative rules would be designed to minimize administrative costs.

An excise tax, equal to $100 for each participant to whom the failure relates, applies to the failure of any employer to satisfy the automatic IRA requirements for any year.

Tax credit for automatic payroll deduction IRA program start-up costs

The proposal provides a tax credit for employers for the first two years in which the employer maintains an automatic payroll deduction IRA program. The amount of the credit is equal to $25 multiplied by the number of applicable employees for whom contributions are made, not to exceed $250 for the year.

The proposal also increases the tax credit under section 45E for small employer plan pension start-up costs from the current maximum of $500 per year for three years to $1,000 per year for three years. The increased credit does not apply to an automatic payroll deduction IRA program or other payroll deduction IRAs.

Effective date. -- The proposal is effective January 1, 2012.


Analysis

In general

Advocates of this proposal argue that the proposal will promote retirement savings by employees who do not have access to an employer sponsored retirement plan. Advocates point out that the use of automatic enrollment increases employee participation in section 401(k) plans because providing contributions to the employee's account under the section 401(k) plan rather than cash in the employee's paycheck as a default takes advantage of the inertia of employees who fail to take action and simplifies the process for employees by eliminating the need for employees to make decisions as to the rate of contribution or the investment of the contributions.194 They argue that this same inertia will increase saving in IRAs if employers are required to automatically enroll employees in payroll deduction IRAs. In addition, employees would not need to make a decision as to the financial institution at which to establish an IRA or whether to contribute to a Roth or traditional IRA. Advocates for the proposal also argue that an employer mandate for automatic IRAs will involve little cost to employers because the employer is merely a conduit for the IRA contribution, similar to direct deposit of an employee's paycheck to the employee's bank account.195

Potential employee behavior

In addition to producing a general increase in participation comparable to that associated with automatic enrollment in section 401(k) plans, advocates for the proposal believe that mandatory automatic payroll deduction IRAs can be expected to increase contributions to IRAs by low-income and middle-income employees in particular.196 They believe that, once these employees actually begin the "habit" of retirement savings, they are likely to continue to make contributions. The theory is that to the extent that these employees are not saving for retirement due to inertia (simple failure to take initiative), that same failure to take initiative may prevent them from electing out of the automatic contributions. By requiring an affirmative decision not to save in order to stop the contributions, advocates argue the proposal, at a minimum, would force employees to think about retirement savings. In the case of employees who can and want to save for retirement, the proposal will simplify implementing this decision. Advocates also point out that the use of payroll deduction means the individual is not required to come up with a substantial amount of funds at a single time to meet minimum deposit requirements imposed by many financial institutions offering IRAs. However, many financial institutions require no more than $500 to open an IRA, which is not necessarily substantial. This requirement could be satisfied if an individual saves $40 a month during the year and then opens the account with this savings.

Others point out that there is also evidence that lower-income and middle-income employees participating in present law section 401(k) plans with automatic enrollment who do not opt out of contributing are the most likely to remain at the default contribution rate rather than electing a higher contribution rate.197 Advocates respond that proposed changes to the savers credit, which provide for a fully refundable credit to be deposited automatically in certain retirement accounts, including IRAs, may work in conjunction with the proposal in increasing participation, and contribution rates above the default rate, by low-income and middle-income individuals. They also point out that many who remain at the default rate might not have elected to participate at all without the automatic feature.

Nevertheless, some argue that certain employees currently do not save for retirement because they need all of their income to meet their basic needs, or retirement savings may be trumped by current savings, or repayment of loans, or for other purposes, such as the purchase of a home or a durable good (e.g., an automobile). They also argue that other employees may choose to spend their current income to finance a lifestyle that they wish to maintain. They point out that an automatic IRA may not change this behavior, especially to the extent that it is easy for an individual to opt out of participation; however, one empirical study found the likelihood of opting out to be small.198 Opting out may be particularly likely in the case of individuals who are already in a negative savings position.

Some argue that automatic enrollment in payroll deduction IRAs is not likely to raise the same employee liquidity concerns that are associated with automatic enrollment in section 401(k) plans due to the distribution restrictions under 401(k) plans,199 making it less likely that employees will elect out of automatic enrollment under a payroll deduction IRA program. For example, contributions to an IRA for a year are permitted to be withdrawn from an IRA (with allocable income) without tax consequence until the individual's due date for filing the income tax return for the year.200 Even after that the deadline, amounts can be withdrawn, although the early distribution tax may apply for distributions before age 59 1/2. In addition, unlike section 401(k) plan contributions, a payroll deduction contribution to a traditional IRA is deductible without regard to the timing of the election to make the contribution.

Some argue that the ultimate success of an automatic payroll deduction IRA program is not only how much money employees contribute to IRAs through the program, but how much is retained as savings for use in retirement. Others point out that there may be social benefits from pure savings, regardless of whether they are used in retirement. National savings may increase as a result; individuals can be better prepared for unanticipated expenses or changes in their financial situation, such as a job loss. However, national saving does not necessarily increase under the proposal to the extent that other planned saving is diverted into the automatic IRA. Others point out that savings alone do not provide for a secure retirement if the savings are not retained for consumption during retirement.

Historically, there have been significant withdrawals over time from IRAs, as reflected in the distributions made that are subject to the early distribution tax.201 These withdrawals do not include distributions made pursuant to an exception to the tax. Opponents of the proposal argue that those forced to save through the inertia of automatic enrollment may be more likely to take distributions even if they are required to pay the 10-percent early distribution tax. In the case of a Roth IRA, to the extent that only the amount of contributions is withdrawn, any tax-based deterrent to withdrawal is reduced because the distributed amounts are not includable in gross income or subject to the 10-percent early distribution tax. Others respond that a counter-balance against withdrawal from an IRA, in contrast to withdrawal from a section 401(k) account, is that there is no natural withdrawal event, such as termination from employment, which is likely to precipitate a withdrawal. Thus, inertia also may help keep the funds in the IRA.

Potential employer behavior

Some argue that the success of the program may depend, at least in part, on how it is received by employers. The employers that would be required to establish an automatic IRA program are generally employers that do not currently sponsor any retirement plan for their employees.

Advocates for the proposal argue that, for some employers, the failure to offer a plan may be the result of the same inertia that causes employees to fail to set up an IRA. They further argue that other employers may desire to establish a plan, but do not because of administrative cost or potential liability issues. For these employers, a mandated program may facilitate action that they already wanted to take. Advocates are optimistic that such participation may introduce these employers to retirement plan service providers who may in turn more easily induce them to set up an employer-sponsored retirement plan, such as a SIMPLE IRA plan or a section 401(k) plan.202

Not everyone agrees, however, with the argument that there will be little cost to employers. Some view the cost as being potentially significant. The ultimate cost to employers will likely depend on how the proposal is designed.203 While the cost may be less significant than the cost associated with qualified employer plans, administrative costs and issues will be relevant in the establishment of an automatic IRA program. An employer will need to take action to establish a program. The employer will need to have a procedure for establishing default IRAs for employees and must institute notice procedures to inform employees that automatic enrollment will occur absent their affirmative election. In addition, the employer must have resources to address employee concerns and questions about the program. In response to these arguments, the proposal is designed to minimize these administrative costs, but will not eliminate them entirely. It also provides a tax credit with a maximum of $250 for the first two years for small employers to reduce this cost. Some have noted, however, that this tax credit, similar to most business tax credits (including the present law credit for small employer plan start up costs), will be of no benefit to small employers who are tax-exempt or who do not have a Federal tax liability for a given year (except to the extent the employer can use the permitted carry forward).

Advocates of the proposal recognize that the success of the program depends on streamlining compliance requirements for employers so that the cost of compliance is relatively low, and that success may depend on the implementation of the program by the Internal Revenue Service or other responsible agency. Advocates argue that the proposal is designed to be as administratively streamlined as possible, including a provision under which employers will not be required to open IRAs on behalf of employees. They point out that the proposal indicates that a low-cost standard default investment will be provided, which will help to lower employer cost of administration because the employer will not need to select a default investment and will limit the employer's potential liability for a poor choice.

Opponents argue that some employers may have made a conscious decision not to maintain an employer sponsored retirement plan for their employees. Under current law, other than withholding and paying payroll taxes to fund social security benefits, sponsorship of a retirement plan by an employer is voluntary. Opponents argue that the low level of voluntary establishment of payroll deduction IRA programs by employers who do not sponsor qualified retirement plans is not entirely due to inertia. An employer might have made a judgment that further payroll deductions of any kind, let alone an automatic program, is not a program that their employees, particularly minimum wage employees, would value. The employer might assume that these employees will not be able to afford any further reduction in take-home pay.

Some argue that the mandatory element of the proposal might generate resentment by certain employers and resistance to embracing the program as a benefit for their employees. They argue that the level of compliance among these employers may depend on the level of enforcement by the IRS. They further point out that an employer could present the option to employees in a way that is more likely to generate an election not to contribute than an election to make contributions.

Advocates of the proposal acknowledge that the program must be carefully designed so as not to result in the elimination or scaling back of existing employer-sponsored retirement plans, such as 401(k) or SIMPLE IRA plans, or the failure to adopt such plans. Some have argued that, because the proposal is designed to relieve employers of many of the burdens associated with sponsoring a qualified plan, small businesses may decide to limit employees' opportunity to save for retirement on a tax-favored basis to their ability to contribute to the automatic IRA program. Because the limits on contributions to the program are lower than those that apply to contributions to other qualified plans, this would have a negative impact on the amount of retirement savings some individuals would otherwise accumulate under an employer-sponsored plan.

Others have noted, however, that the desire of small business owners to take advantage of the greater tax-deferred savings offered under a qualified plan (allocations up to $49,000 for 2010 are permitted) will continue to provide an incentive to sponsor such plans, regardless of any relative cost savings associated with offering only the automatic IRA program. The rules prohibiting discrimination in favor of owners and other highly compensated employees prevent small-business owners from taking advantage of this higher limit on contributions without providing benefits for rank and file employees. Finally, the proposal doubles the current start-up cost credit available under section 45E to $1,000 per year for three years. Advocates believe that this expanded credit will encourage small employers to adopt a new employer-sponsored retirement plan, rather than an automatic IRA program.

Financial institutions

In the absence of a proposal that mandates a Federal or State program to accommodate the new small IRAs that will be established, some argue that the financial community would need to embrace the program to make it feasible. Many of the employees who elect, or default into, participation will have no preexisting IRAs. Some will have no current relationship with any financial service provider. For low-income and middle-income employees, the initial contributions will be very small. For example, three percent of weekly pay of $500 is only $15. Most financial institutions charge small annual fees for IRA maintenance and many require minimum contributions to establish an IRA.204 These fees and minimums may be a significant barrier to making default IRAs attractive to low-income or even middle-income taxpayers. Thus, even advocates of the proposal recognize that providing low-cost options as suggested in the proposal may be a critical element in a successful program.

Paternalism

The proposal makes mandatory an option that is already available under present law. Individuals are free to contribute to IRAs, subject to certain qualifications, and employers are free to establish payroll deduction IRAs. Employers may even be able to enroll employees in payroll deduction IRAs automatically under PPA changes to ERISA.205 However, the proposal simplifies some of these opportunities. Proponents have expressed the belief that targeted individuals save insufficiently for retirement despite these opportunities. By mandating automatic enrollment, proponents hope to increase the take up rate of IRAs among the targeted employees in a way that they believe will improve their well being. Some make a case for paternalistic intervention on the grounds that individuals do not act in their own best interest because of limits on individual rationality, a lack of information, or inertia.206 Some argue that setting the default rule to contribute to an IRA with the ability to opt out, as opposed to the default rule being nonparticipation with the option of affirmative action to contribute, may be viewed as an example of soft, or libertarian, paternalism.207 Advocates define paternalism as choosing a policy with the goal of influencing the choices of affected parties in a way that will make those parties better off, and such paternalism is libertarian if no coercion is involved. Others would argue that only voluntarily entered rules are free from coercion.208 One might view the desirability of a policy differently, or hold it to a higher standard to judge its desirability, if coercion is involved. Some argue that "flaws in human cognition," such as those identified above, "should make us more, not less, wary about trusting government decisionmaking" and that while "soft paternalism is less damaging than hard paternalism....[, s]oft paternalism is neither innocuous or obviously benign."209

Protection of employees against employer retaining deducted contributions

The DOL has found numerous instances where employers have deducted amounts from an employee's pay for contribution to a section 401(k) plan but failed to contribute the amount to the plan.210 In the case of a section 401(k) plan, such failure can result in excise taxes, civil penalties, and even criminal prosecution.211 The DOL has found that the employee may not be aware that the contributions are not being made until the employee receives his or her account statement.212 As a result, some argue that it is important that any proposal include comparable protection for employees to those provided to participants under a section 401(k) plan against these potential abuses by employers. One approach advocated by some is to mandate that all default contributions be made to a government-sponsored IRA and that all employees have a government sponsored IRA as an investment option. They argue that such a requirement could make it easier to establish a mechanism for regularly monitoring whether contributions were being made in a timely manner.

Traditional or Roth IRA as the default

Under the proposal, the default is a Roth IRA. The designation of Roth IRAs as a default removes one potential complexity for employers and employees, but may also have immediate and long-term tax consequences for employees. For example, as discussed above, the maximum contribution that can be made to a Roth IRA is phased out for taxpayers with AGI over certain levels (for 2010, for single taxpayers, $105,000 to $120,000, and for married taxpayers filing jointly, $167,000 to $177,000). There is no income limit for nondeductible contributions to a traditional IRA and no income limit for deductible contributions if the taxpayer (or, if married, both taxpayer and spouse) does not participate in an employer-sponsored plan. Thus, many argue that, to the extent no default is provided, an employer is likely to choose a traditional IRA as a default so that higher income employees will not be subject to excise taxes for excess contributions.

However, some argue that, for many taxpayers, a Roth IRA may be a better choice. Lower income taxpayers may have a lower marginal rate currently than when they receive distributions, making a deduction today for a traditional IRA less valuable and less of a motivation for retirement savings than would be the alternative exclusion for income from a Roth IRA in retirement. While it is generally the case that the lower one's income, the lower one's marginal tax rate, some lower income taxpayers can have a quite high effective marginal tax rate as a result of the phaseout of the earned income tax credit. These same taxpayers may face further increases in their effective marginal tax rates as a result of the phaseout of the newly-enacted tax credit for individuals and families who purchase health insurance through a State health insurance exchange. Hence, many low and middle income taxpayers might be better off if the default is a traditional IRA rather than a Roth IRA.

Additionally, lower income employees may prefer to contribute to a Roth IRA because funds in a Roth IRA may be distributed prior to retirement age with fewer penalties than distributions from traditional IRAs. Roth distributions are allocated first to basis and received tax free (and thus also not subject to the 10 percent early distribution tax) until all contributions are distributed. In contrast, any distribution attributable to deductible contributions is fully includible in gross income and subject to the early-distribution tax unless an exception applies.

Finally, even for individuals who benefit from the ability to make deductible contributions to a traditional IRA (i.e., higher income employees), a contribution to a Roth IRA of the maximum amount (to the extent allowed by the income limits) will produce more income at retirement because a dollar contributed to a Roth account represents greater after-tax savings than a dollar contributed to a traditional deductible IRA, because the former is contributed on an after-tax basis while the latter is contributed on a pre-tax basis. Still, higher-income employees may be unable to make regular Roth contributions because of the income limits. In addition, taxpayers making contributions to a Roth IRA are required to include the amount of the contributions in AGI rather than being allowed to deduct it, further diminishing the individual's current after-tax disposal income, a potentially greater concern for lower income taxpayers.


Prior Action

A similar proposal was included in the President's fiscal year 2010 budget proposal.

D. Saver's Credit

Present Law

Present law provides a nonrefundable tax credit for eligible taxpayers for qualified retirement savings contributions.213 The maximum annual contribution eligible for the credit is $2,000 per individual. The credit rate depends on the adjusted gross income ("AGI") of the taxpayer. For this purpose, AGI is determined without regard to certain excludable foreign-source earned income and certain U.S. possession income.

For taxable years beginning in 2010, married taxpayers filing joint returns with AGI of $55,500 or less, taxpayers filing head of household returns with AGI of $41,625 or less, and all other taxpayers filing returns with AGI of $27,750 or less, are eligible for the credit. As the taxpayer's AGI increases, the credit rate available to the taxpayer is reduced, until, at certain AGI levels, the credit is unavailable. The credit rates based on AGI for taxable years beginning in 2010 are provided in Table 6, below. The AGI levels used for the determination of the available credit rate are indexed for inflation.

Table 6. -- Credit Rates for Saver's Credit

    Joint Filers     Heads of Households    All Other Filers     Credit Rate

      $0 -- $33,500       $0 -- $25,125          $0 -- $16,750     50 percent
 $33,501 -- $36,000  $25,126 -- $27,000     $16,751 -- $18,000     20 percent
 $36,001 -- $55,500  $27,001 -- $41,625     $18,001 -- $27,750     10 percent
 Over $55,500        Over $41,625           Over $27,750            0 percent

The saver's credit is in addition to any deduction or exclusion that would otherwise apply with respect to the contribution. The credit offsets alternative minimum tax liability as well as regular tax liability. The credit is available to individuals who are 18 years old or older, other than individuals who are full-time students or who are claimed as a dependent on another taxpayer's return.

The credit is available with respect to: (1) elective deferrals to a qualified cash or deferred arrangement (a "section 401(k) plan"), a tax-sheltered annuity (a "section 403(b)" annuity), an eligible deferred compensation arrangement of a State or local government (a "section 457 plan"), a savings incentive match plan for employees (a "SIMPLE"), or a simplified employee pension (a "SEP"); (2) contributions to a traditional or Roth IRA; and (3) voluntary after-tax employee contributions to a tax-sheltered annuity or qualified retirement plan. Under the rules governing these arrangements, an individual's contribution to the arrangement generally cannot exceed the lesser of an annual dollar amount or the individual's compensation that is includible in income. In the case of any IRA contributions made by a married couple, the combined includible compensation of both spouses may be taken into account. In addition, for purposes of determining the IRA contribution limit, an individual's includible compensation is determined without regard to the exclusion for combat pay.214 Thus, excluded combat pay received by an individual is treated as includible compensation for purposes of determining the amount that the individual (and the individual's spouse) can contribute to an IRA.

The amount of any contribution eligible for the credit is reduced by distributions received by the taxpayer (or by the taxpayer's spouse if the taxpayer filed a joint return with the spouse) from any retirement plan to which eligible contributions can be made during the taxable year for which the credit is claimed, during the two taxable years prior to the year the credit is claimed, and during the period after the end of the taxable year for which the credit is claimed and prior to the due date (including extensions) for filing the taxpayer's return for the year. Distributions that are rolled over to another retirement plan do not reduce the amounts of the taxpayer's contributions eligible for the credit.


Description of Proposal

The proposal makes the saver's credit fully refundable and provides for the credit to be deposited automatically in the qualified retirement plan account or IRA to which the eligible individual contributed.

In place of the current 10-percent/20-percent/50-percent credit for qualified retirement savings contributions up to $2,000 per individual, the proposal provides a credit of 50 percent of such contributions up to $500 (of contributions) per individual (indexed annually for inflation beginning in 2011). The income threshold for eligibility is increased to $65,000 for married couples filing jointly, $48,750 for heads of households, and $32,500 for singles and married individuals filing separately, with the amount of savings eligible for the credit phased out at a five-percent rate for AGI exceeding those levels.

Effective date. -- The proposal is effective for taxable years beginning after December 31, 2010.


Analysis

The current law saver's credit is intended to encourage low-income taxpayers to save by subsidizing the return to saving, but many have criticized its effectiveness.215 The principal criticisms of the effectiveness of the saver's credit have focused on the low use of the credit, owing to: (1) its lack of refundability, (2) the complexity of the credit rate structure combined with taxpayer uncertainty regarding eligibility, (3) lack of awareness of the credit, and (4) the relatively low AGI thresholds for eligibility.

Those who have criticized the complexity of the credit rate structure note that many taxpayers will not know their precise AGI in order to know what their credit rate will be, or even to know if they will be eligible for any credit given that the credit amount drops precipitously to zero once the relevant AGI threshold is crossed. Others have observed that, because the credit is non-refundable, and the AGI eligibility thresholds fairly low, many taxpayers simply cannot benefit from the credit as they have no tax liability to offset.216 By making the credit refundable and raising the income eligibility limits, the proposal is likely to increase utilization of the credit. Also, the revised structure should make it easier for most taxpayers to have a better sense of the amount of credit for which they will be eligible, which could increase use of the credit to the extent that existing uncertainly limits the use of the credit.

While many taxpayers are saving insufficiently for their future needs, some might criticize the saver's credit on the grounds that low-income taxpayers should not necessarily be encouraged to save (for example, a single parent with young children who is eligible for the saver's credit should probably devote available resources to current needs rather than forgoing current consumption in favor of saving). Others might argue that the public resources devoted to encouraging saving via this credit could be better used to meet unmet current needs of the low-income population in general, or those specifically of the elderly poor who have saved insufficiently for retirement.

As noted above, the President's proposal increases eligibility for the saver's credit by raising the AGI eligibility thresholds and making the credit refundable. As such, the proposal should be more effective at encouraging additional private saving, but at commensurate additional public cost. Additionally, while a payment to save in the form of a tax credit may encourage additional saving, some of the credit will be paid to those who are saving in any case.217 If the loss in tax revenues (i.e., public dissaving) due to the credit is large relative to net additional private savings that result from the credit, national saving (the sum of private and public saving) might not increase much, or at all.

The present law saver's credit, as well as the proposed credit, condition credit eligibility on AGI. While use of AGI is a common way to limit eligibility based on economic need, consideration could be given to limiting eligibility using a better measure of a taxpayer's ability to save, such as taxable income (which accounts for the presence of dependents, for example). The current use of AGI might result in a disproportionate amount of the credit going to taxpayers with greater ability to save, while conditioning the credit on taxable income might better target the incentive at taxpayers with more similar ability to save.

Under the proposal, some taxpayers could be made worse off, because the amount of contributions eligible for the credit is reduced to $500 per individual, rather than present law's $2,000 limit. Thus, for example, an individual eligible for the 20 percent credit under present law is potentially eligible for a credit of $400 (20 percent of $2,000), while under the proposal the maximum credit is 50 percent of $500, or $250. To the extent that the main purpose of the saver's credit is to encourage small amounts of retirement saving for those who might not otherwise do any saving, the proposed reorientation of credit resources might be appropriate. On the other hand, by lowering the maximum amount of savings that are subsidized, the marginal incentive to save amounts greater than that are reduced for taxpayers eligible for the subsidy under present law. By extending eligibility further up the income distribution, the proposal increases the marginal incentive to save for taxpayers currently saving less than $500 for retirement, though it provides a windfall and no additional incentive to save for taxpayers saving $500 or more for retirement.

The provision providing for the option to have the credit deposited into the retirement savings account of the taxpayer might also encourage additional saving. However, additional complexities could result for employers if they are required to set up mechanisms to accept the deposit of the tax credit to an employer plan. The administrative costs of such mechanisms may be disproportionately large for small credit amounts.

Additional complexities could result more generally for deposits of the tax credit into qualified retirement savings accounts. Depending how such direct deposits are treated, such direct deposits could reduce the magnitude of the credit available to the taxpayer, at least with respect to the tax year that gave rise to the credit. For example, a contribution of $200 to an IRA would generate a tax credit of $100, which, if the tax credit is directly deposited into the account, results in a net cost to the taxpayer of $200 for the total $300 that is contributed to the IRA. If, on the other hand, the taxpayer had contributed the full $300 to the IRA himself, the taxpayer would have been eligible for a $150 tax credit which, if paid directly to him, would imply a net cost to the taxpayer of only $150 for the $300 IRA. To the extent the directly deposited tax credit is allowed as a qualified retirement saving contribution for the taxable year in which the deposit actually occurs (which in general will be the taxable year following the taxable year that gave rise to the credit), the taxpayer would ultimately be able to claim a credit (and a deduction if otherwise allowed) for the contribution.

Other technical issues that need to be addressed include: (1) how direct deposit credit amounts would be allocated among qualified retirement plan accounts and IRAs for taxpayers that make qualified retirement savings contributions to more than one such account or arrangement, and (2) whether and how any credit amounts that are directly deposited into a taxpayer's qualified retirement plan account or IRA would count towards the annual contribution limits that apply to such accounts and arrangements.


Prior Action

A similar proposal was included in the President's Fiscal Year 2010 budget proposal.

E. Extend American Opportunity Tax Credit

Present Law

Hope credit

For taxable years beginning before 2009 and after 2010, individual taxpayers are allowed to claim a nonrefundable credit, the Hope credit, against Federal income taxes of up to $1,800 (for 2008) per eligible student per year for qualified tuition and related expenses paid for the first two years of the student's post-secondary education in a degree or certificate program.218 The Hope credit rate is 100 percent on the first $1,200 of qualified tuition and related expenses, and 50 percent on the next $1,200 of qualified tuition and related expenses; these dollar amounts are indexed for inflation, with the amount rounded down to the next lowest multiple of $100. Thus, for example, a taxpayer who incurs $1,200 of qualified tuition and related expenses for an eligible student is eligible (subject to the adjusted gross income phaseout described below) for a $1,200 Hope credit. If a taxpayer incurs $2,400 of qualified tuition and related expenses for an eligible student, then he or she is eligible for a $1,800 Hope credit.

The Hope credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified AGI between $48,000 and $58,000 ($96,000 and $116,000 for married taxpayers filing a joint return) for 2008. The beginning points of the AGI phaseout ranges are indexed for inflation, with the amount rounded down to the next lowest multiple of $1,000. The size of the phaseout ranges are always $10,000 and $20,000 respectively.

The qualified tuition and related expenses must be incurred on behalf of the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer. The Hope credit is available with respect to an individual student for two taxable years, provided that the student has not completed the first two years of post-secondary education before the beginning of the second taxable year.

The Hope credit is available in the taxable year the expenses are paid, subject to the requirement that the education is furnished to the student during that year or during an academic period beginning during the first three months of the next taxable year. Qualified tuition and related expenses paid with the proceeds of a loan generally are eligible for the Hope credit. The repayment of a loan itself is not a qualified tuition or related expense.

A taxpayer may claim the Hope credit with respect to an eligible student who is not the taxpayer or the taxpayer's spouse (e.g., in cases in which the student is the taxpayer's child) only if the taxpayer claims the student as a dependent for the taxable year for which the credit is claimed. If a student is claimed as a dependent, the student is not entitled to claim a Hope credit for that taxable year on the student's own tax return. If a parent (or other taxpayer) claims a student as a dependent, any qualified tuition and related expenses paid by the student are treated as paid by the parent (or other taxpayer) for purposes of determining the amount of qualified tuition and related expenses paid by such parent (or other taxpayer) under the provision. In addition, for each taxable year, a taxpayer may elect either the Hope credit, the Lifetime Learning credit, or an above-the-line deduction for qualified tuition and related expenses with respect to an eligible student.219

The Hope credit is available for "qualified tuition and related expenses," which include tuition and fees (excluding nonacademic fees) required to be paid to an eligible educational institution as a condition of enrollment or attendance of an eligible student at the institution. Charges and fees associated with meals, lodging, insurance, transportation, and similar personal, living, or family expenses are not eligible for the credit. The expenses of education involving sports, games, or hobbies are not qualified tuition and related expenses unless this education is part of the student's degree program.

Qualified tuition and related expenses generally include only out-of-pocket expenses. Qualified tuition and related expenses do not include expenses covered by employer-provided educational assistance and scholarships that are not required to be included in the gross income of either the student or the taxpayer claiming the credit. Thus, total qualified tuition and related expenses are reduced by any scholarship or fellowship grants excludable from gross income under section 117 and any other tax-free educational benefits received by the student (or the taxpayer claiming the credit) during the taxable year. The Hope credit is not allowed with respect to any education expense for which a deduction is claimed under section 162 or any other section of the Code.

An eligible student for purposes of the Hope credit is an individual who is enrolled in a degree, certificate, or other program (including a program of study abroad approved for credit by the institution at which such student is enrolled) leading to a recognized educational credential at an eligible educational institution. The student must pursue a course of study on at least a halftime basis. A student is considered to pursue a course of study on at least a half-time basis if the student carries at least one half the normal full-time work load for the course of study the student is pursuing for at least one academic period that begins during the taxable year. To be eligible for the Hope credit, a student must not have been convicted of a Federal or State felony consisting of the possession or distribution of a controlled substance.

Eligible educational institutions generally are accredited post-secondary educational institutions offering credit toward a bachelor's degree, an associate's degree, or another recognized post-secondary credential. Certain proprietary institutions and post-secondary vocational institutions also are eligible educational institutions. To qualify as an eligible educational institution, an institution must be eligible to participate in Department of Education student aid programs.

Effective for taxable years beginning after December 31, 2010, the changes to the Hope credit made by EGTRRA no longer apply.220 The principal EGTRRA change scheduled to expire is the change that permits a taxpayer to claim a Hope credit in the same year that he or she claims an exclusion from a Coverdell education savings account. Thus, after 2010, a taxpayer cannot claim a Hope credit in the same year he or she claims an exclusion from a Coverdell education savings account.

American opportunity tax credit

The American Opportunity Tax Credit refers to modifications to the Hope credit that apply for taxable years beginning in 2009 or 2010. The maximum allowable modified credit is $2,500 per eligible student per year for qualified tuition and related expenses paid for each of the first four years of the student's post-secondary education in a degree or certificate program. The modified credit rate is 100 percent on the first $2,000 of qualified tuition and related expenses, and 25 percent on the next $2,000 of qualified tuition and related expenses. For purposes of the modified credit, the definition of qualified tuition and related expenses is expanded to include course materials.

Under the provision, the modified credit is available with respect to an individual student for four years, provided that the student has not completed the first four years of post-secondary education before the beginning of the fourth taxable year. Thus, the modified credit, in addition to other modifications, extends the application of the Hope credit to two more years of post-secondary education.

The modified credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified AGI between $80,000 and $90,000 ($160,000 and $180,000 for married taxpayers filing a joint return). The modified credit may be claimed against a taxpayer's AMT liability.

Forty percent of a taxpayer's otherwise allowable modified credit is refundable. However, no portion of the modified credit is refundable if the taxpayer claiming the credit is a child to whom section 1(g) applies for such taxable year (generally, any child who has at least one living parent, does not file a joint return, and is either under age 18 or under age 24 and a student providing less than one-half of his or her own support).


Description of Proposal

The proposal expands the present law Hope credit so as to make permanent the temporary modifications to the Hope credit for taxable years beginning in 2009 and 2010 that are known as the American Opportunity Tax Credit. In addition, the proposal renames the Hope credit the American Opportunity Tax Credit.

The dollar amounts to which the 100-percent and 25-percent credit rates are applied are indexed for inflation, with the amounts rounded down to the next lowest multiple of $100. The AGI phaseout ranges are also indexed for inflation, with the amounts rounded down to the next lowest multiple of $1,000.

Effective date. -- The proposal is effective for taxable years beginning after December 31, 2010.


Analysis

The present-law modifications to the Hope credit, referred to as the American Opportunity Tax Credit, are intended to provide some financial relief to taxpayers faced with increasing tuition costs. The proposal makes the American Opportunity Tax Credit modifications permanent. By increasing the amount of the credit, the phaseout levels, and the number of years of education with respect to which the credit may be claimed, the modifications increase the number of taxpayers who may claim the credit and the amount of credit that those taxpayers may claim. In addition, because the modifications make a portion of the credit refundable, additional people (i.e., those with no Federal income tax liability) may benefit from the credit.

Some people observe that the cost of post-secondary education has increased at a rate in excess of the rate of inflation for nearly 30 years, with the result that it is becoming an ever greater financial burden for individuals to pursue a college education. These people contend that making the American Opportunity Tax Credit permanent will help to mitigate some of this burden. Other people observe that the acquisition of a college degree provides enormous benefits to an individual (e.g., greater lifetime earning potential and increased job opportunities) that are sufficient to justify the cost of acquiring the degree, and that these benefits have increased over time.221 If the cost of obtaining a college degree were to exceed the resulting benefits, one would expect to see a decrease in the number of individuals pursuing a degree until such time as the costs decrease and/or the benefits increase. As of yet, such a decline in college attendance has not occurred.222

Other people argue that some individuals who desire to go to college are unable to do so because they do not have the funds to pay for the education and are unable to borrow the necessary amounts (because, for example, it is difficult to pledge increased future earning potential as security for a loan). For these potential students, a generous government subsidy in the form of the American Opportunity Tax Credit may make up for the deficiency in funding and enable them to pursue the college degree that they desire. In response to this argument, some people observe that there already exist a large variety of programs, available from both the public and private sectors, that are designed to help students to afford college, including various loan programs, merit-based assistance programs, and need-based assistance programs (e.g., the Pell Grant program).

Another aspect of the proposal that merits discussion is that it provides for permanent, partial refundability of the credit. Some argue that credits for education expenses should be refundable to subsidize education for low-income individuals who need the subsidy the most but may have insufficient tax liability to realize the benefit of the Hope credit (without the temporary modifications of the American Opportunity Tax Credit). Others argue that refundable tax credits are administratively complex and that there are Federal spending programs, such as the Pell Grant program, that provide direct grants for education to a demographic group of individuals that is generally similar to the group that would be eligible for the permanent, refundable credit.223 They also argue that the Pell Grant has the advantage of providing its subsidy at the time the education expense is incurred, whereas a refundable credit, unless made advanced-refundable, would provide the subsidy after the education expenses are incurred when the tax return is filed and processed.224

Lastly, an issue that affects tax incentives, such as the American Opportunity Tax Credit, as well as direct expenditures to subsidize education, concerns the ultimate economic incidence of the subsidies as compared to the statutory beneficiary. For example, it has been observed that the various individual tax benefits for education (such as the present-law Hope credit) provide incentives for educational institutions to capture some of the benefit by raising their tuition and fees. This observation is particularly true for community colleges that charge less than the amount that is fully subsidized by the Hope credit (e.g., the first $1,200 of tuition in 2008 is eligible for a 100-percent credit for Hope eligible students), because tuition can be raised to $1,200 without the student paying more out of-pocket on an after-tax basis, provided the student or parent has tax liability to offset.225 Additionally, State and local governments may choose to appropriate fewer funds to the public educational institutions or to financial aid programs in response to the increased support provided by the Federal government via individual tax incentives.226 These responses by educational institutions and/or State and local governments have the potential to undermine the benefit provided at the Federal level. In particular, to the extent that colleges raise tuition in response to a Federal nonrefundable (or only partially refundable) credit, students or parents without Federal tax liability to offset are unambiguously made worse off.

This last issue of who is the ultimate economic beneficiary of a particular tax benefit for education may be an even greater concern under the American Opportunity Tax Credit and the proposal to make it permanent because this credit provides an even larger subsidy than the present-law Hope credit. In particular, the American Opportunity Tax Credit increases the amount of tuition that is fully subsidized to $2,000 per year (from $1,200 in 2008). As a result of this change, a college that wishes to capture as much of the subsidy as possible may now have an incentive to raise tuition to at least $2,000. In addition, the American Opportunity Tax Credit substantially raises the income phaseout amounts. Thus, a college that wishes to capture as much of the subsidy as possible now may need to be less concerned that students will be ineligible for the credit (due to their high income) and face increased out-of-pocket costs -- the vast majority of Americans have incomes below the new phaseout amounts. Finally, the American Opportunity Tax Credit makes 40 percent of the credit refundable. This change means that a college that wishes to capture as much of the subsidy as possible now may need to be less concerned that students will not benefit from the credit because they have no tax liability. In fact, a college that wishes to leave these students with no increased out-of-pocket costs (e.g., by providing increased scholarship amounts to offset subsidy-capturing tuition increases), may nevertheless be able to capture the refundable portion of the credit.


Prior Action

A similar proposal was included in the President's fiscal year 2010 budget proposal.

V. TAX CUTS FOR BUSINESSES

A. Increase Exclusion of Gain on Sale of Qualified
Small Business Stock

Present Law

In general

Individuals may exclude 50 percent (60 percent for certain empowerment zone businesses) of the gain from the sale of certain small business stock acquired at original issue and held for more than five years.227 The portion of the gain includible in taxable income is taxed at a maximum rate of 28 percent under the regular tax.228 A percentage of the excluded gain is an alternative minimum tax preference;229 the portion of the gain includible in alternative minimum taxable income ("AMTI") is taxed at a maximum rate of 28 percent under the alternative minimum tax ("AMT").

Thus, under present law, gain from the sale of qualified small business stock is taxed at effective rates of 14 percent under the regular tax230 and under the AMT at (i) 14.98 percent for dispositions before January 1, 2011; (ii) 19.88 percent for dispositions after December 31, 2010, in the case of stock acquired before January 1, 2001; and (iii) 17.92 percent for dispositions after December 31, 2010, in the case of stock acquired after December 31, 2000.231

The amount of gain eligible for the exclusion by an individual with respect to any corporation is the greater of (1) ten times the taxpayer's basis in the stock or (2) $10 million. To qualify as a small business, when the stock is issued, the gross assets of the corporation may not exceed $50 million. The corporation also must meet certain active trade or business requirements.

Special rules for certain stock issued in 2009 and 2010

For stock issued after February 17, 2009, and before January 1, 2011, the percentage exclusion for qualified small business stock sold by an individual is increased to 75 percent.

As a result of the increased exclusion, gain from the sale of qualified small business stock to which the provision applies is taxed at maximum effective rates of seven percent under the regular tax232 and 12.88 percent under the AMT.233


Description of Proposal

Under the proposal all gain from the sale or exchange of qualified small business stock is excluded from gross income. The AMT preference is eliminated. Other current law limitations on exclusion and the requirement that the small business stock be held for five years continue to apply. Additional documentation is required to insure compliance with these limitations.

Effective date. -- The proposal is effective for qualified small business stock acquired after February 17, 2009.


Analysis

For analysis of this proposal, as well as capital gains in general, see Analysis under "Dividends and Capital Gains Tax Rate Structure."

Prior Action

The American Recovery and Reinvestment Tax Act of 2009 provided the rule described under present law relating to stock issued after February 17, 2009, and before January 1, 2011.

B. Make the Research Credit Permanent

Present Law

General rule

A taxpayer may claim a research credit equal to 20 percent of the amount by which the taxpayer's qualified research expenses for a taxable year exceed its base amount for that year.234 Thus, the research credit is generally available with respect to incremental increases in qualified research.

A 20-percent research tax credit is also available with respect to the excess of (1) 100 percent of corporate cash expenses (including grants or contributions) paid for basic research conducted by universities (and certain nonprofit scientific research organizations) over (2) the sum of (a) the greater of two minimum basic research floors plus (b) an amount reflecting any decrease in nonresearch giving to universities by the corporation as compared to such giving during a fixed-base period, as adjusted for inflation. This separate credit computation is commonly referred to as the university basic research credit.235

Finally, a research credit is available for a taxpayer's expenditures on research undertaken by an energy research consortium. This separate credit computation is commonly referred to as the energy research credit. Unlike the other research credits, the energy research credit applies to all qualified expenditures, not just those in excess of a base amount.

The research credit, including the university basic research credit and the energy research credit, expires for amounts paid or incurred after December 31, 2009.236

Computation of allowable credit

Except for energy research payments and certain university basic research payments made by corporations, the research tax credit applies only to the extent that the taxpayer's qualified research expenses for the current taxable year exceed its base amount. The base amount for the current year generally is computed by multiplying the taxpayer's fixed-base percentage by the average amount of the taxpayer's gross receipts for the four preceding years. If a taxpayer both incurred qualified research expenses and had gross receipts during each of at least three years from 1984 through 1988, then its fixed-base percentage is the ratio that its total qualified research expenses for the 1984-1988 period bears to its total gross receipts for that period (subject to a maximum fixed-base percentage of 16 percent). All other taxpayers (socalled start-up firms) are assigned a fixed-base percentage of three percent.237

In computing the credit, a taxpayer's base amount cannot be less than 50 percent of its current-year qualified research expenses.

To prevent artificial increases in research expenditures by shifting expenditures among commonly controlled or otherwise related entities, a special aggregation rule provides that all members of the same controlled group of corporations are treated as a single taxpayer.238 Under regulations prescribed by the Secretary, special rules apply for computing the credit when a major portion of a trade or business (or unit thereof) changes hands. Under these rules, qualified research expenses and gross receipts for periods prior to the change of ownership of a trade or business are treated as transferred with the trade or business that gave rise to those expenses and receipts for purposes of recomputing a taxpayer's fixed-base percentage.239

Alternative incremental research credit regime

Taxpayers are allowed to elect an alternative incremental research credit regime.240 If a taxpayer elects to be subject to this alternative regime, the taxpayer is assigned a three-tiered fixed-base percentage (that is lower than the fixed-base percentage otherwise applicable under present law) and the credit rate likewise is reduced.

Generally, for amounts paid or incurred prior to 2007, under the alternative incremental research credit regime, a credit rate of 2.65 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of one percent (i.e., the base amount equals one percent of the taxpayer's average gross receipts for the four preceding years) but do not exceed a base amount computed by using a fixed-base percentage of 1.5 percent. A credit rate of 3.2 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of 1.5 percent but do not exceed a base amount computed by using a fixed-base percentage of two percent. A credit rate of 3.75 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of two percent. Generally, for amounts paid or incurred after 2006, the credit rates listed above are increased to three percent, four percent, and five percent, respectively.241

An election to be subject to this alternative incremental research credit regime can be made for any taxable year beginning after June 30, 1996, and before January 1, 2009. Such an election applies to that taxable year and all subsequent years unless revoked with the consent of the Secretary of the Treasury. The alternative incremental credit regime is not available for taxable years beginning after December 31, 2008.

Alternative simplified credit

Generally, for amounts paid or incurred after 2006, taxpayers may elect to claim an alternative simplified credit for qualified research expenses.242 The alternative simplified research credit is equal to 12 percent (14 percent for taxable years beginning after December 31, 2008) of qualified research expenses that exceed 50 percent of the average qualified research expenses for the three preceding taxable years. The rate is reduced to six percent if a taxpayer has no qualified research expenses in any one of the three preceding taxable years.

An election to use the alternative simplified credit applies to all succeeding taxable years unless revoked with the consent of the Secretary. An election to use the alternative simplified credit may not be made for any taxable year for which an election to use the alternative incremental credit is in effect. A transition rule applies which permits a taxpayer to elect to use the alternative simplified credit in lieu of the alternative incremental credit if such election is made during the taxable year which includes January 1, 2007. The transition rule applies only to the taxable year which includes that date.

Eligible expenses

Qualified research expenses eligible for the research tax credit consist of: (1) in-house expenses of the taxpayer for wages and supplies attributable to qualified research; (2) certain time-sharing costs for computer use in qualified research; and (3) 65 percent of amounts paid or incurred by the taxpayer to certain other persons for qualified research conducted on the taxpayer's behalf (so-called contract research expenses).243 Notwithstanding the limitation for contract research expenses, qualified research expenses include 100 percent of amounts paid or incurred by the taxpayer to an eligible small business, university, or Federal laboratory for qualified energy research.

To be eligible for the credit, the research not only has to satisfy the requirements of present-law section 174 (described below) but also must be undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and substantially all of the activities of which constitute elements of a process of experimentation for functional aspects, performance, reliability, or quality of a business component. Research does not qualify for the credit if substantially all of the activities relate to style, taste, cosmetic, or seasonal design factors.244 In addition, research does not qualify for the credit if: (1) conducted after the beginning of commercial production of the business component; (2) related to the adaptation of an existing business component to a particular customer's requirements; (3) related to the duplication of an existing business component from a physical examination of the component itself or certain other information; or (4) related to certain efficiency surveys, management function or technique, market research, market testing, or market development, routine data collection or routine quality control.245 Research does not qualify for the credit if it is conducted outside the United States, Puerto Rico, or any U.S. possession.

Relation to deduction

Under section 174, taxpayers may elect to deduct currently the amount of certain research or experimental expenditures paid or incurred in connection with a trade or business, notwithstanding the general rule that business expenses to develop or create an asset that has a useful life extending beyond the current year must be capitalized.246 However, deductions allowed to a taxpayer under section 174 (or any other section) are reduced by an amount equal to 100 percent of the taxpayer's research tax credit determined for the taxable year.247 Taxpayers may alternatively elect to claim a reduced research tax credit amount under section 41 in lieu of reducing deductions otherwise allowed.248


Description of Proposal

The proposal makes the research credit permanent.

Effective date. -- The proposal is effective for amounts paid or incurred after December 31, 2009.


Analysis

Overview

Technological development is an important component of economic growth. However, while an individual business may find it profitable to undertake some research, it may not find it profitable to invest in research as much as it otherwise might because it is difficult to capture the full benefits from the research and prevent such benefits from being used by competitors. In general, businesses acting in their own self-interest will not necessarily invest in research to the extent that would be consistent with the best interests of the overall economy. This is because costly scientific and technological advances made by one firm maybe cheaply copied by its competitors. Research is one of the areas where there is a consensus among economists that government intervention in the marketplace may improve overall economic efficiency.249 However, this does not mean that increased tax benefits or more government spending for research always will improve economic efficiency. It is possible to decrease economic efficiency by spending too much on research. However, there is evidence that the current level of research undertaken in the United States, and worldwide, is too little to maximize society's well-being.250 Nevertheless, even if there were agreement that additional subsidies for research are warranted as a general matter, misallocation of research dollars across competing sectors of the economy could diminish economic efficiency. It is difficult to determine whether, at the present levels and allocation of government subsidies for research, further government spending on research or additional tax benefits for research would increase or decrease overall economic efficiency.

If it is believed that too little research is being undertaken, a tax subsidy is one method of offsetting the private-market bias against research, so that research projects undertaken approach the optimal level. Among the other policies employed by the Federal government to increase the aggregate level of research activities are direct spending and grants, favorable anti-trust rules, and patent protection. The effect of tax policy on research activity is largely uncertain because there is relatively little consensus regarding the magnitude of the responsiveness of research to changes in taxes and other factors affecting its price. To the extent that research activities are responsive to the price of research activities, the research and experimentation tax credit should increase research activities beyond what they otherwise would be. However, the present law research credit contains certain complexities and compliance costs.

Scope of research activities in the United States and abroad

In the United States, private for-profit enterprises and individuals, non-profit organizations, and the public sector undertake research activities. Total expenditures on research and development in the United States are large, representing 2.6 percent of gross domestic product in 2005 and 2006.251 This rate of expenditure on research and development exceeds that of the European Union and the average of all countries that are members of the Organisation for Economic Co-operation and Development ("OECD"), but is less than that of Japan. See Figure 1, below. In 2005, expenditures on research and development in the United States represented 42.2 percent of all expenditures on research and development undertaken by OECD countries, were 40 percent greater than the total expenditures on research and development undertaken in the European Union, and were more than two and one half times such expenditures in Japan.252 Expenditures on research and development in the United States have grown at an average real rate of 3.69 percent over the period 1995-2005. This rate of growth has exceeded that of France (1.52 percent), the United Kingdom (1.86 percent), Japan (2.46 percent), Italy (2.50 percent), and Germany (2.57 percent), but is less than that of Canada (4.95 percent), Spain (7.34 percent), and Ireland (7.40 percent).253


Figure 1. -- Gross Domestic Expenditure on R&D as a
Percentage of GDP, United States, Japan, the European Union,
and the OECD, 1995-2005



Source: OECD, Main Science and Technology Indicators, 2007, vols. 1 & 2.

A number of countries, in addition to the United States, provide tax benefits to taxpayers who undertake research activities. The OECD has attempted to quantify the relative value of such tax benefits in different countries by creating an index that measures the total value of tax benefits accorded research activities relative to simply permitting the expensing of all qualifying research expenditures. Table 7, below, reports the value of this index for selected countries. A value of zero would result if the only tax benefit a country offered to research activities was the expensing of all qualifying research expenditures. Negative values reflect tax benefits less generous than expensing. Positive values reflect tax benefits more generous than expensing. For example, in 2008 in the United States qualifying taxpayers could expense research expenditures and, in certain circumstances, claim the research and experimentation tax credit. The resulting index number for the United States is 0.07.254

             Table 7. -- Index Number of Tax Benefits for
            Research Activities in Selected Countries, 2008

  Country                        Index Number1
  _______                        _____________

  Germany                            -0.03

  Italy                              -0.02

  Ireland                             0.05

  United States                       0.07

  United Kingdom                      0.11

  Japan                               0.12

  Canada                              0.18

  France                              0.37

  Spain                               0.39

FOOTNOTE TO TABLE 7

1 Index number reported is only that for "large firms."
 Some countries have additional tax benefits for research activities of
 "small" firms.

END OF FOOTNOTE TO TABLE 7

 Source: OECD, OECD Science, Technology and Industry Outlook, 2008.

Scope of tax expenditures on research activities

The tax expenditure related to the research and experimentation tax credit was estimated to be $4.9 billion for 2008. The related tax expenditure for expensing of research and development expenditures was estimated to be $3.1 billion for 2008, growing to $7.8 billion for 2012.255 As noted above, the Federal Government also directly subsidizes research activities. Direct government outlays for research have substantially exceeded the annual estimated value of the tax expenditure provided by either the research and experimentation tax credit or the expensing of research and development expenditures. For example, in fiscal 2008, the National Science Foundation gross outlays for research and related activities were $4.6 billion, the Department of Defense's budget for research, development, test and evaluation was $84.7 billion, the Department of Energy's science gross outlays were $3.9 billion, and the Department of Health and Human Services' budget for the National Institutes of health was $28.9 billion.256 However, such direct government outlays generally are for directed research on projects selected by the government. The research credit provides a subsidy to any qualified project of an eligible taxpayer with no application to a grant-making agency required. Projects are chosen based on the taxpayer's assessment of future profit potential.

Tables 8 and 9 present data for 2006 on those corporations that claimed the research tax credit by industry and asset size, respectively. Over 17,000 corporations (counting both C corporations and S corporations) claimed more than $7.6 billion of research tax credits in 2006.257 Corporations whose primary activity is manufacturing account for just more than one-half of all corporations claiming a research tax credit. These manufacturers claimed more than 70 percent of all credits. Firms with assets of $50 million or more account for almost 17 percent of all corporations claiming a credit but represent more than 80 percent of the credits claimed. Nevertheless, as Table 9 documents, a large number of small firms are engaged in research and were able to claim the research tax credit. C corporations claimed almost $7.3 billion of these credits and, furthermore, nearly all of this $7.3 billion was the result of the firm's own research. Only $137 million in research credits flowed through to C corporations from ownership interests in partnerships and other pass-through entities.

For comparison, individuals claimed $388 million in research tax credits on their individual income tax returns in 2006. This $388 million includes credits that flowed through to individuals from pass-through entities such as partnerships and S corporations, as well those credits generated by sole proprietorships.

   Table 8. -- Percentage Distribution of Corporations Claiming Research Tax
            Credit and Percentage of Credit Claimed by Sector, 2006

                                          Percent of               Percent of
                                          Corporations             Total
 Industry                                 Claiming Credit          R & E Credit
 ________                                 _______________          ____________

 Manufacturing                                  50.7                   71.6

 Professional, Scientific, and
 Technical Services                             23.4                   10.0

 Information                                     6.6                    9.8

 Wholesale Trade                                 8.6                    3.5

 Finance and Insurance                           1.7                    1.7

 Holding Companies                               2.8                    1.1

 Retail Trade                                    1.8                    0.6

 Health Care and Social Services                 0.8                    0.4

 Utilities                                       0.3                    0.4

 Administrative and Support and Waste
 Management and Remediation Services             1.1                    0.2

 Mining                                          0.2                    0.2

 Transportation and Warehousing                  0.5                    0.1

 Construction                                    0.4                    0.1

 Agriculture, Forestry, Fishing, and Hunting     0.5                    (1)

 Real Estate and Rental and Leasing              0.4                    (1)

 Arts, Entertainment, and Recreation             0.2                    (1)

 Educational Services                            0.1                    (1)

 Other Services                                  (2)                    (2)

 Accommodation and Food Services                 (2)                    (2)

 Wholesale and Retail Trade not Allocable        (2)                    (2)

 Not Allocable                                   (2)                    (2)

1 Less than 0.1 percent.

2 Data undisclosed to protect taxpayer confidentiality.

 Source: Joint Committee on Taxation staff calculations from Internal Revenue
 Service, Statistics of Income data.

   Table 9. -- Percentage Distribution of Corporations Claiming Research Tax
             Credit and of Credit Claimed by Corporation Size, 2006

                               Percent of Firms           Percent of
 Asset Size ($)                Claiming Credit            Credit Claimed
 ______________                ________________           ______________

 0                                    2.1                        0.9

 1 to 99,999                          5.0                        (1)

 100,000 to 249,999                   1.6                        (1)

 250,000 to 499,999                   4.5                        0.1

 500,000 to 999,999                   9.1                        0.3

 1,000,000 to 9,999,999              39.9                        5.4

 10,000,000 to 49,999,999            20.9                       12.4

 50,000,000 +                        16.9                       80.7

 Notes:

      Totals may not add to 100 percent due to rounding.

      (1) Less than 0.1 percent.

 Source: Joint Committee on Taxation staff calculations from Internal Revenue
 Service, Statistics of Income data.

Flat versus incremental tax credits

For a tax credit to be effective in increasing a taxpayer's research expenditures, it is not necessary to provide that credit for all the taxpayer's research expenditures (i.e., a flat credit). By limiting the credit to expenditures above a base amount, incremental tax credits attempt to target the tax incentives to have the largest effect on taxpayer behavior.

Suppose, for example, a taxpayer is considering two potential research projects: Project A will generate cash flow with a present value of $105 and Project B will generate cash flow with a present value of $95. Suppose that the research cost of investing in each of these projects is $100. Without any tax incentives, the taxpayer will find it profitable to invest in Project A and will not invest in Project B.

Consider now the situation where a 10-percent flat credit applies to all research expenditures incurred. In the case of Project A, the credit effectively reduces the cost to $90. This increases profitability, but does not change behavior with respect to that project, since it would have been undertaken in any event. However, because the cost of Project B also is reduced to $90, this previously neglected project (with a present value of $95) would now be profitable. Thus, the tax credit would affect behavior only with respect to this marginal project.

Incremental credits do not attempt to reward projects that would have been undertaken in any event, but rather to target incentives to marginal projects. To the extent this is possible, incremental credits have the potential to be far more effective per dollar of revenue cost than flat credits in inducing taxpayers to increase qualified expenditures. In the example above, if an incremental credit were properly targeted, the government could spend the same $20 in credit dollars and induce the taxpayer to undertake a marginal project so long as its expected cash flow exceeded $80. Unfortunately, it is nearly impossible as a practical matter to determine which particular projects would be undertaken without a credit and to provide credits only to other projects. In practice, almost all incremental credit proposals rely on some measure of the taxpayer's previous experience as a proxy for a taxpayer's total qualified expenditures in the absence of a credit. This is referred to as the credit's base amount. Tax credits are provided only for amounts above this base amount.

Since a taxpayer's calculated base amount is only an approximation of what would have been spent in the absence of a credit, in practice, the credit may be less effective per dollar of revenue cost than it otherwise might be in increasing expenditures. If the calculated base amount is too low, the credit is awarded to projects that would have been undertaken even in the absence of a credit. If, on the other hand, the calculated base amount is too high, then there is no incentive for projects that actually are on the margin.

Nevertheless, the incentive effects of incremental credits per dollar of revenue loss can be many times larger than those of a flat credit. However, in comparing a flat credit to an incremental credit, there are other factors that also deserve consideration. A flat credit generally has lower administrative and compliance costs than does an incremental credit. Probably more important, however, is the potential misallocation of resources and unfair competition that could result as firms with qualified expenditures determined to be above their base amount receive credit dollars, while other firms with qualified expenditures determined to be below their base amount receive no credit.

Fixed base versus moving base credit

With the addition of the alternative simplified credit, taxpayers effectively have the choice of three different research credit structures for general research expenditures.258 Each of the credit structures is an "incremental" credit. However, the base is determined differently in each case. The regular credit and the alternative incremental credit (which expired after 2008) are examples of "fixed base" credits. With a fixed base credit, the incremental amount of qualified research expenditures is determined without reference to the qualified research expenditures of a prior year. The alternative simplified credit is a "moving base" credit. With a moving base credit, the incremental amount of qualified research expenditures for a given year is determined by reference to one or more prior year's qualified research expenditures. The distinction can be important because, in general, an incremental tax credit with a base amount equal to a moving average of previous years' qualified expenditures is considered to have an effective rate of credit substantially below its statutory rate. On the other hand, an incremental tax credit with a base amount determined as a fixed base generally is considered to have an effective rate of credit equal to its statutory rate.

To see how a moving base creates a reduction in the effective rate of credit, consider the structure of the alternative simplified credit. The base of the credit is equal to 50 percent of the previous three years' average of qualified research expenditures. Assume a taxpayer has been claiming the alternative simplified credit and is considering increasing his qualified research expenditures this year. A $1 increase in qualified expenditures in the current year will earn the taxpayer 14 cents in credit in the current year but it will also increase the taxpayer's base amount by 16.7 cents (50 percent of $1 divided by three) in each of the next three years. If the taxpayer returns to his previous level of research funding over the subsequent three years, the taxpayer will receive two and one-third cents less in credit than he otherwise would have. Assuming a nominal discount rate of 10 percent, the present value of the one year of credit increased by 14 cents followed by three years of credits reduced by two and one-third cents is equal to 8.19 cents. That is, the effective credit rate on a $1 dollar increase in qualified expenditures is 8.19 percent.

An additional feature of the moving average base calculation of the alternative simplified credit is that it is not always an incremental credit. If the taxpayer never alters his or her research expenditures, the alternative simplified credit is the equivalent of a flat rate credit with an effective credit value equal to one half of the statutory credit rate. Assume a taxpayer spends $100 per year annually on qualified research expenses. This taxpayer will have an annual base amount of $50, with the result that the taxpayer will have $50 of credit eligible expenditures on which the taxpayer may claim $7 of tax credit (14 percent of $50). For this taxpayer, the 14-percent credit above the defined moving average base amount is equivalent to a seven-percent credit on the taxpayer's $100 of annual qualifying research expenditures.

The moving average base calculation of the alternative simplified credit also can permit taxpayers to claim a research credit while they decrease their research expenditures. Assume as before that the taxpayer has spent $100 annually on qualified research expenses, but decides to reduce research expenses in the next year to $75 and in the subsequent year to $50, after which the taxpayer plans to maintain research expenditures at $50 per year. In the year of the first reduction, the taxpayer would have $25 of qualifying expenditures (the taxpayer's prior three-year average base is $100) and could claim a credit of $3.50 (14 percent of the $75 current year expenditure less half of three year average base). In the subsequent four years, the taxpayer could claim a credit of $0.58, $1.75, $2.92, and $3.50.259 Of course, it is also the case that a taxpayer may claim a research credit as he or she reduces research expenditures under a fixed base credit as long as the taxpayer's level of qualifying expenditures is greater than the fixed base.

Some have also observed that a moving base credit can create incentives for taxpayers to "cycle" or bunch their qualified research expenditures. For example, assume a taxpayer who is claiming the alternative simplified credit has had qualified research expenditures of $100 per year for the past three years and is planning on maintaining qualified research expenditures at $100 per year for the next three years. The taxpayer's base would be $50 for each of the next three years and the taxpayer could claim $7 of credit per year. If, however, the taxpayer could bunch expenditures so that the taxpayer incurred only $50 of qualified research next year, followed by $150 in the second year and $100 in the third, the taxpayer could claim no credit next year but $15.17 in the second year and $7 dollars in the third. While the example demonstrates a benefit to cycling, as the majority of qualified research expenditures consist of salaries to scientists, engineers, and other skilled labor, the potential for cycling most likely would be limited in practice.

The responsiveness of research expenditures to tax incentives

Like any other commodity, the amount of research expenditures that a firm wishes to incur generally is expected to respond positively to a reduction in the price paid by the firm. Economists often refer to this responsiveness in terms of price elasticity, which is measured as the ratio of the percentage change in quantity to a percentage change in price. For example, if demand for a product increases by five percent as a result of a 10-percent decline in price paid by the purchaser, that commodity is said to have a price elasticity of demand of 0.5.260 One way of reducing the price paid by a buyer for a commodity is to grant a tax credit upon purchase. A tax credit of 10 percent (if it is refundable or immediately usable by the taxpayer against current tax liability) is equivalent to a 10-percent price reduction. If the commodity granted a 10-percent tax credit has an elasticity of 0.5, the amount consumed will increase by five percent. Thus, if a flat research tax credit were provided at a 10-percent rate, and research expenditures had a price elasticity of 0.5, the credit would increase aggregate research spending by five percent.261

While all published studies report that the research credit induced increases in research spending, early evidence generally indicated that the price elasticity for research is substantially less than one. For example, one early survey of the literature reached the following conclusion:


    In summary, most of the models have estimated long-run price elasticities of demand for R&D on the order of -0.2 and -0.5. . . . However, all of the measurements are prone to aggregation problems and measurement errors in explanatory variables.262

If it took time for taxpayers to learn about the credit and what sort of expenditures qualified, taxpayers may have only gradually adjusted their behavior. Such a learning curve might explain a modest measured behavioral effect. A more recent survey of the literature on the effect of the tax credit suggests a stronger behavioral response, although most analysts agree that there is substantial uncertainty in these estimates.

    [W]ork using US firm-level data all reaches the same conclusion: the tax price elasticity of total R&D spending during the 1980s is on the order of unity, maybe higher. . . . Thus there is little doubt about the story that the firm-level publicly reported R&D data tell: the R&D tax credit produces roughly a dollar-for-dollar increase in reported R&D spending on the margin.263

However, this survey notes that most of this evidence is not drawn directly from tax data. For example, effective marginal tax credit rates are inferred from publicly reported financial data and may not reflect limitations imposed by operating losses or the AMT. The study notes that because most studies rely on "reported research expenditures" that a "relabelling problem" may exist whereby a preferential tax treatment for an activity gives firms an incentive to classify expenditures as qualifying expenditures. If this occurs, reported expenditures increase in response to the tax incentive by more than the underlying real economic activity. Thus, reported estimates may overestimate the true response of research spending to the tax credit.264

Apparently there have been no specific studies of the effectiveness of the university basic research tax credit.

Other policy issues related to the research and experimentation credit

Perhaps the greatest criticism of the research and experimentation tax credit among taxpayers regards its temporary nature. Research projects frequently span years. If a taxpayer considers an incremental research project, the lack of certainty regarding the availability of future credits increases the financial risk of the expenditure. A credit of longer duration may more successfully induce additional research than would a temporary credit, even if the temporary credit is periodically renewed.

An incremental credit does not provide an incentive for all firms undertaking qualified research expenditures. Many firms have current-year qualified expenditures below the base amount. These firms receive no tax credit and have an effective rate of credit of zero. Although there is no revenue cost associated with firms with qualified expenditures below the base amount, there may be a distortion in the allocation of resources as a result of these uneven incentives.

If a firm has no current tax liability, or if the firm is subject to the AMT or the general business credit limitation, the research credit must be carried forward for use against future-year tax liabilities. The inability to use a tax credit immediately reduces its present value according to the length of time between when it actually is earned and the time it actually is used to reduce tax liability.265

Except for energy research, firms with research expenditures substantially in excess of their base amount are subject to the 50-percent base amount limitation. In general, although these firms received the largest amount of credit when measured as a percentage of their total qualified research expenses, their marginal effective rate of credit was exactly one half of the statutory credit rate of 20 percent (i.e., firms subject to the base limitation effectively are governed by a 10-percent credit rate).

Although the statutory rate of the research credit is 20 percent, it is likely that the average effective marginal rate may be substantially below 20 percent. Reasonable assumptions about the frequency that firms are subject to various limitations discussed above yield estimates of an average effective rate of credit between 25 and 40 percent below the statutory rate, i.e., between 12 and 15 percent.266

Since sales growth over a long time frame will rarely track research growth, it can be expected that over time each firm's base will drift from the firm's actual current qualified research expenditures. Therefore, if the research credit were made permanent, increasingly over time there would be a larger number of firms either substantially above or below their calculated base. This could gradually create an undesirable situation where many firms would receive no credit and have no reasonable prospect of ever receiving a credit, while other firms would receive large credits (despite the 50-percent base amount limitation). Thus, over time, it can be expected that, for those firms eligible for the credit, the average effective marginal rate of credit would decline while the revenue cost to the Federal government increased.

As explained above, because costly scientific and technological advances made by one firm may often be cheaply copied by its competitors, research is one of the areas where there is a consensus among economists that government intervention in the marketplace, such as the subsidy of the research tax credit, can improve overall economic efficiency. This rationale suggests that the problem of a socially inadequate amount of research is not more likely in some industries than in other industries, but rather it is an economy-wide problem. The basic economic rationale argues that a subsidy to reduce the cost of research should be equally applied across all sectors. As described above, the Energy Policy Act of 2005 provided that energy-related research receive a greater tax subsidy than other research. Some argue that it makes the tax subsidy to research inefficient by biasing the choice of research projects. They argue that an energy-related research project could be funded by the taxpayer in lieu of some other project that would offer a higher rate of return absent the more favorable tax credit for the energy-related project. Proponents of the differential treatment for energy-related research argue that broader policy concerns such as promoting energy independence justify creating a bias in favor of energy related research.

Complexity and the research tax credit

Administrative and compliance burdens result from the research tax credit. The Government Accountability Office ("GAO") has testified that the research tax credit is difficult for the IRS to administer. According to the GAO, the IRS reports that it is required to make difficult technical judgments in audits concerning whether research is directed to produce truly innovative products or processes. While the IRS employs engineers in such audits, the companies engaged in the research typically employ personnel with greater technical expertise and, as would be expected, personnel with greater expertise regarding the intended application of the specific research conducted by the company under audit. Such audits create a burden for both the IRS and taxpayers. The credit generally requires taxpayers to maintain records more detailed than those necessary to support the deduction of research expenses under section 174.267 An executive in a large technology company has identified the research credit as one of the most significant areas of complexity for his firm. He summarizes the problem as follows.


    Tax incentives such as the R&D tax credit . . . typically pose compliance challenges, because they incorporate tax-only concepts that may be only tenuously linked to financial accounting principles or to the classifications used by the company's operational units. . . . [I]s what the company calls "research and development" the same as the "qualified research" eligible for the R&D tax credit under I.R.C. Section 41? The extent of any deviation in those terms is in large part the measure of the compliance costs associated with the tax credit.268

In addition to compliance challenges, with the addition of the alternative simplified credit, taxpayers now have three research credit structures to choose from, not including the energy research credit and the university basic research credit. The presence of multiple research credit options creates increased complexity by requiring taxpayers to make multiple calculations to determine which credit structure will result in the most favorable tax treatment.

Prior Action

The President's budget proposals for fiscal years 2003 through 2006 contained an identical proposal. The President's budget proposal for fiscal year 2007 contained a similar proposal, but did not extend or make permanent the energy research credit. The President's budget proposals for fiscal years 2008 through 2010 contained an identical proposal.

C. Remove Cell Phones from Listed Property

Present Law

Employer deduction

Property, including cellular telephones and similar telecommunications equipment (hereinafter collectively "cell phones"), used in carrying on a trade or business is subject to the general rules for deducting ordinary and necessary expenses under section 162. Under these rules, a taxpayer may properly claim depreciation deductions under the applicable cost recovery rules for only the portion of the cost of the property that is attributable to use in a trade or business.269 Similarly, the business portion of monthly telecommunication service is generally deductible, subject to capitalization rules, as an ordinary and necessary expense of carrying on a trade or business.

In the case of certain listed property, special rules apply. Listed property generally is defined as (1) any passenger automobile; (2) any other property used as a means of transportation; (3) any property of a type generally used for purposes of entertainment, recreation, or amusement; (4) any computer or peripheral equipment; (5) any cellular telephone (or other similar telecommunications equipment);270 and (6) any other property of a type specified in Treasury regulations.271

For listed property, no deduction is allowed unless the taxpayer adequately substantiates the expense and business usage of the property.272 A taxpayer must substantiate the elements of each expenditure or use of listed property, including: (1) the amount (e.g., cost) of each separate expenditure and the amount of business or investment use, based on the appropriate measure (e.g., mileage for automobiles), and the total use of the property for the taxable period; (2) the date of the expenditure or use; and (3) the business purposes for the expenditure or use.273 The level of substantiation for business or investment use of listed property varies depending on the facts and circumstances. In general, the substantiation must contain sufficient information as to each element of every business or investment use.274

With respect to the business use of listed property made available by an employer for use by an employee, the employer must substantiate that all or a portion of the use of the listed property is by employees in the employer's trade or business.275 If any employee used the listed property for personal use, the employer must substantiate that it included an appropriate amount in the employee's income.276 An employer generally may rely on adequate records maintained and retained by the employee or on the employee's own statement if it is corroborated by other sufficient evidence, unless the employer knows or has reason to know that the statement, records, or other evidence are not accurate.277

Taxation of employee

Gross income includes all income unless a specific exclusion applies.278 An exclusion from gross income is provided in the case of certain working condition fringe benefits.279 A working condition fringe benefit is any property or services provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowable as a deduction under section 162 or 167.280 An employee may not exclude from gross income as a working condition fringe benefit, the value of listed property provided by an employer to the employee, unless the employee substantiates for the period of availability the amount of the exclusion in accordance with the substantiation requirements discussed above.281

Cost recovery

A taxpayer is allowed to recover through annual depreciation deductions the cost of certain property used in a trade or business or for the production of income. The amount of the depreciation deduction allowed with respect to tangible property for a taxable year is determined under the modified accelerated cost recovery system ("MACRS"). Under MACRS, different types of property generally are assigned applicable recovery periods and depreciation methods. The recovery periods applicable to most tangible personal property range from three to 25 years. The depreciation methods generally applicable to tangible personal property are the 200-percent and 150-percent declining balance methods, switching to the straight-line method for the taxable year in which the taxpayer's depreciation deduction would be maximized.

In the case of certain listed property, special depreciation rules apply. First, if for the taxable year that the property is placed in service the use of the property for trade or business purposes does not exceed 50 percent of the total use of the property, then the depreciation deduction with respect to such property is determined under the alternative depreciation system.282 The alternative depreciation system generally requires the use of the straight-line method and a recovery period equal to the class life of the property.283 Second, if an individual owns or leases listed property that is used by the individual in connection with the performance of services as an employee, no depreciation deduction, expensing allowance, or deduction for lease payments is available with respect to such use unless the use of the property is for the convenience of the employer and required as a condition of employment.284


Description of Proposal

The proposal removes cell phones from the definition of listed property and excludes from an employee's income the fair market value of the personal use of a cell phone provided by the employer primarily for business purposes. Under the proposal, the heightened substantiation requirements and special depreciation rules that apply to listed property do not apply to cell phones. Additionally, the proposal eliminates the need for documentation by the employee of personal use of an employer-provided cell phone, where such phone is used primarily for business by the employee.

Effective date. -- The proposal is effective for taxable years ending after date of enactment.


Analysis

Special rules for "listed property," originally enacted in the Tax Reform Act of 1984, limited depreciation and other tax benefits for business property that was likely to be used for personal purposes.285 Listed property initially was limited to automobiles and computers in TEFRA, but was expanded to include cell phones in the Revenue Reconciliation Act of 1989.286 At that time, the cost of cell phones and the cost of cell phone services were expensive. One wireless industry survey estimated the number of wireless subscribers at approximately 2.7 million in June 1989 and at approximately 276.6 million in June 2009.287

As cell phones have become ubiquitous and calling plans have changed from per-minute to unlimited calling plans for a fixed fee (often with plans providing free nights/weekends or free calls between certain parties), the listed property designation of cell phones has been questioned. Commentators argue that the documentation requirements for listed property are no longer appropriate for cell phones as a result of the price declines, changes in calling plans, and the fact that cell phones are used on a daily basis by businesses to promote productivity and efficiency.288 These commentators note that cell phone usage is the expected "norm" and the prevalent use of cell phones has made them "the equivalent of a landline phone, for which detailed recordkeeping has never been required."289

The IRS has also recognized the growing concern regarding compliance with the listed property substantiation requirements for cell phones. In June 2009, the IRS issued Notice 200946 requesting comments regarding various proposals to simplify the procedures under which employers substantiate an employee's business use of employer-provided cell phones. Commentators have commended the IRS for its simplification efforts, but noted that a legislative change would be the best simplification.290


Prior Action

None.

VI. OTHER REVENUE CHANGES AND LOOPHOLE CLOSERS

A. Reform Treatment of Financial Institutions and Products

1. Impose a financial crisis responsibility fee

Present Law

Corporations generally

Corporations organized under the laws of any of the 50 States (and the District of Columbia) generally are subject to the U.S. corporate income tax on their worldwide taxable income. The taxable income of a C corporation291 generally is comprised of gross income less allowable deductions. Gross income generally is income derived from any source, including gross profit from the sale of goods and services to customers, rents, royalties, interest (other than interest from certain indebtedness issued by State and local governments), dividends, gains from the sale of business and investment assets, and other income.

Corporations that make a valid election pursuant to section 1362 of Subchapter S of Chapter 1 of the Code, referred to as S corporations, are taxed differently. In general, an S corporation is not subject to corporate-level income tax on its items of income and loss. Instead, an S corporation passes through to shareholders its items of income and loss. The shareholders separately take into account their shares of these items on their individual income tax returns. To prevent double taxation of these items upon a subsequent disposition of S corporation stock, each shareholder's basis in such stock is increased by the amount included in income (including tax-exempt income) and is decreased by the amount of any losses (including nondeductible losses) taken into account. A shareholder's loss may be deducted only to the extent of his or her basis in the stock or debt of the S corporation. To the extent a loss is not allowed due to this limitation, the loss generally is carried forward with respect to the shareholder.

To qualify for S corporation status, a corporation must be a small business corporation as defined in section 1361(b)(1) and not be an ineligible corporation as defined in section 1361(b)(2). A corporation qualifies as a small business corporation if it has 100 or fewer shareholders, has only individuals or certain trusts and estates as shareholders, has no nonresident aliens as shareholders, and has only one class of stock. Ineligible corporations include any financial institution using the reserve method of accounting for bad debts (discussed below) and any insurance company subject to Subchapter L of the Code.

Banks, Thrifts, and Credit Unions


    In general

Financial institutions are subject to the same Federal income tax rules and rates as are applied to other corporations or entities, with certain specified exceptions. There is no sector-specific Federal income tax currently applied to financial institutions, and there are currently no corporate taxes assessed on the balance sheet liabilities of an entity.

Certain special rules and exceptions that are applicable to determining the Federal income tax liability of banks and thrifts, certain other financial institutions, insurance companies, and broker dealers are discussed below.


    C corporation banks and thrifts

A bank is generally taxed for Federal income tax purposes as a C corporation. For this purpose a bank generally means a corporation, a substantial portion of whose business is receiving deposits and making loans and discounts, or exercising certain fiduciary powers.292 A bank for this purpose generally includes domestic building and loan associations, mutual stock or savings banks, and certain cooperative banks that are commonly referred to as thrifts.293 Prior to 1951, thrifts were exempt from Federal taxation. In 1951, mutual savings banks and savings and loan associations lost their tax exemption because they were viewed as being "in active competition with commercial banks and life insurance companies for the public savings."294

    S corporation banks

A bank is generally eligible to elect S corporation status under section 1362, provided it meets the other requirements for making this election and it does not use the reserve method of accounting for bad debts as described in section 585.

    Special bad debt loss rules for small banks

Section 166 provides a deduction for any debt that becomes worthless (wholly or partially) within a taxable year. For taxable years beginning before 1987, section 166(c) allowed taxpayers to deduct annual reasonable additions to a reserve established for bad debts (in lieu of deducting specific debts as worthless in the year in which the bank determined the debt was worthless). The reserve method of accounting for bad debts was repealed in 1986295 for most taxpayers, but is allowed under section 585 for any bank (as defined in section 581) other than a large bank. For this purpose, a bank is a large bank if for the taxable year (or for any preceding taxable year after 1986) the average adjusted basis of all its assets (or the assets of the controlled group of which it was a member) exceeds $500 million. Deductions for reserves are taken in lieu of a worthless debt deduction under section 166. Accordingly, a small bank is able to take deductions for additions to a bad debt reserve. Additions to the reserve are determined under an experience method that looks to the ratio of (1) total bad debts sustained during a taxable year to (2) the total bad debts over the five preceding taxable years. A large bank is allowed a deduction for specific bad debts charged off during a taxable year.

Prior to 1996, thrifts (mutual savings banks, domestic savings and loan associations, and cooperative banks) had separate bad debt reserve rules under section 593. The special rules for thrifts were repealed for tax years beginning on or after January 1, 1996.


    Credit unions

Credit unions are exempt from Federal income taxation.296 The exemption is based on their status as not-for-profit mutual or cooperative organizations (without capital stock) operated for the benefit of their members, who generally must share a common bond. The definition of common bond has been expanded to permit greater utilization of credit unions.297 While significant differences between the rules under which credit unions and banks operate have existed in the past, most of those differences have disappeared over time.298

Gains and losses with respect to securities held by financial institutions

In general, gain or loss reflected in the value of an asset is not recognized for income tax purposes until a taxpayer disposes of the asset. On the sale or exchange of a capital asset, any gain generally is included in income. Any net capital gain of an individual generally is taxed at maximum rates lower than the rates applicable to ordinary income. Net capital gain of a corporation is currently taxed at a rate not to exceed 35 percent, which is also the maximum corporate income tax rate. Net capital gain is the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for the year. Gain or loss is treated as long-term if the asset is held for more than one year.

Capital losses generally are deductible in full against capital gains. Individual taxpayers may deduct capital losses against up to $3,000 of ordinary income in each year. Section 1211 provides that, in the case of a corporation, losses from sales or exchanges of capital assets are allowed only to the extent of gains from such sales or exchanges. Thus, in taxable years in which a corporation does not recognize gain from the sale of capital assets, its capital losses do not reduce its income. However, in general, corporations (other than S corporations) may carry capital losses back to each of the three taxable years preceding the loss year and forward to each of the five taxable years succeeding the loss year.

In the case of an S corporation, net capital losses flow through to the corporation's shareholders and could be considered losses attributable to a banking business in such shareholders' hands. Banks hold a wide range of financial assets in the ordinary course of their banking business. For convenience, those assets often are described as "loans" or "investments," but both serve the same overall purpose (to earn a return on the bank's capital and borrowings consistent with prudent banking practices). A bank's investments are subject to the same regulatory capital adequacy supervision as are its loans, and a bank may acquire only certain types of financial assets as permitted investments. Banks determine how much of their assets to hold as loans or as investments based on the exercise of their commercial and financial judgment, taking into account such factors as return on the assets, liabilities, relative liquidity, and diversification objectives. As a result, for Federal income tax purposes, gains and losses on a bank's investment portfolio would be considered an integral part of the business operations of the bank, and ordinary losses that pass through to the shareholder of a bank that is an S corporation therefore could comprise part of such shareholder's net operating loss for the year attributable to that banking business. Any remaining unused capital losses may be carried forward indefinitely to another taxable year.

A capital asset generally means any property except: (1) inventory, stock in trade, or property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business; (2) depreciable or real property used in the taxpayer's trade or business; (3) specified literary or artistic property; (4) business accounts or notes receivable; (5) certain U.S. publications; (6) certain commodity derivative financial instruments; (7) hedging transactions; and (8) business supplies. In addition, the net gain from the disposition of certain property used in the taxpayer's trade or business is treated as long-term capital gain. Gain from the disposition of depreciable personal property is not treated as capital gain to the extent of all previous depreciation allowances. Gain from the disposition of depreciable real property is generally not treated as capital gain to the extent of the depreciation allowances in excess of the allowances available under the straight-line method of depreciation.

Under section 582(c)(1), the sale or exchange of a bond, debenture, note, or certificate or other evidence of indebtedness by a financial institution described in section 582(c)(2) is not considered a sale or exchange of a capital asset. Thus, generally, as a manufacturer receives ordinary income treatment on sale of its inventory, so does a financial institution on the sale or exchange of its loans under section 582. A financial institution described in section 582(c)(2) includes: (1) any bank (including any corporation which would be a bank except for the fact that it is a foreign corporation); (2) any financial institution referred to in section 591, which includes mutual savings banks, cooperative banks, domestic building and loan associations, and other savings institutions chartered and supervised as savings and loan or similar associations under Federal or State law; (3) any small business investment company operating under the Small Business Investment Act of 1958; and (4) any business development corporation, defined as a corporation which was created by or pursuant to an act of a State legislature for purposes of promoting, maintaining, and assisting the economy and industry within such State on a regional or statewide basis by making loans to be used in trades and businesses which would generally not be made by banks within such region or State in the ordinary course of their business (except on the basis of a partial participation) and which is operated primarily for such purposes. In the case of a foreign corporation, section 582(c)(1) applies only with respect to gains or losses that are effectively connected with the conduct of a banking business in the United States.

Stock (including preferred stock) is not considered indebtedness for tax purposes and therefore is not treated as an asset entitled to ordinary gain or loss treatment under section 582.299 However, under section 301 of Division A of the Emergency Economic Stabilization Act of 2008,300 gain or loss recognized by an "applicable financial institution" from the sale or exchange of "applicable preferred stock" is treated as ordinary income or loss. An applicable financial institution is a financial institution referred to in section 582(c)(2) or a depository institution holding company, as defined in the Federal Deposit Insurance Act.301 Applicable preferred stock is preferred stock of Fannie Mae or Freddie Mac that was (1) held by the applicable financial institution on September 6, 2008, or (2) sold or exchanged by the applicable financial institution on or after January 1, 2008, and before September 7, 2008.302

Insurance companies

Present law provides special rules for determining the taxable income of insurance companies (subchapter L of the Code). Separate sets of rules apply to life insurance companies and to property and casualty insurance companies. An insurance company is subject to tax as a life insurance company if its life insurance reserves plus unearned premiums and unpaid losses on noncancellable life, accident, or health policies not included in life insurance reserves comprise more than 50 percent of its total reserves.303 All other taxable insurance companies are treated as property and casualty insurance companies for Federal income tax purposes. Insurance companies are subject to tax at regular corporate income tax rates.

A life insurance company is subject to tax on its life insurance company taxable income.304 Life insurance company taxable income is the sum of premiums and other consideration on insurance and annuity contracts, decreases in certain reserves, and other amounts includible in gross income, reduced by allowable deductions for all claims and benefits accrued and all losses incurred during the taxable year, increases in certain reserves, policyholder dividends, dividends received, operations losses, certain reinsurance payments, and other deductions allowable for purposes of computing taxable income.305

The taxable income of a property and casualty insurance company is determined as the sum of the amount earned from underwriting income and from investment income (as well as gains and other income items), reduced by allowable deductions.306 For this purpose, underwriting income and investment income are computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Association of Insurance Commissioners.

Certain special rules apply to both life insurance and property and casualty companies. These rules relate to foreign tax credits, foreign companies carrying on insurance business within the United States, annual accounting period, special loss carryovers, certain reinsurance agreements, discounted unpaid losses, special estimated tax payments, and capitalization of certain policy acquisition expenses.307

Broker-dealers

For Federal income tax purposes, a person is a securities dealer if such person is regularly engaged in the purchase and resale of securities to customers.308 The determination of dealer status is made based on all facts and circumstances. The courts and the IRS have considered the following factors in evaluating dealer status: (1) being licensed as a dealer;309 (2) holding oneself out to the public as a dealer;310 (3) selling inventoried securities to customers;311 (4) the frequency, extent, and regularity of securities transactions;312 (5) profiting from commissions as opposed to appreciation in the value of securities;313 and (6) ownership of a securities exchange membership.314

Securities dealers must account for their securities inventory using the mark-to-market accounting method.315 In general, under that method, securities held by a dealer in its inventory are marked to fair market value at the close of the taxable year, with any resulting difference between value and basis included as ordinary income or loss in computing taxable income for such year. For this purpose a security is defined as any share of stock in a corporation, partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust, note, bond, debenture, or other evidence of indebtedness, interest rate, currency, or equity notional principal contract, and evidence of an interest in, or a derivative financial instrument in any of the foregoing, or any currency, including any option, forward contract, short position, and any similar financial instrument in such a security or currency.316 Additionally, a security includes a position that is not one of the foregoing, but is a hedge with respect to such security, and is clearly identified in the dealer's records as a security before the close of the day on which it was acquired.317

Special rules apply to gains and losses of a securities dealer with respect to "section 1256 contracts."318 Any gain or loss with respect to a section 1256 contract is subject to a mark-to-market rule and generally is treated as short-term capital gain or loss, to the extent of 40 percent of the gain or loss, and long-term capital gain or loss, to the extent of the remaining 60 percent of the gain or loss.319 Gains and losses upon the termination (or transfer) of a section 1256 contract, by offsetting, taking or making delivery, by exercise or by being exercised, by assignment or being assigned, by lapse, or otherwise, also generally are treated as 40 percent short-term and 60 percent long-term capital gains or losses.320

A securities dealer may also hold securities for investment rather than as inventory (such securities are not subject to mark-to-market accounting, and any gains or losses with respect thereto treated as capital rather than ordinary).321 Additionally, a dealer is not subject to mark-to-market accounting for debt securities originated or entered into in the ordinary course of its trade or business that are not held for sale.322 For either of these exceptions to apply, the dealer must clearly identify that the security is either held for investment or not held for sale by the close of the day the security is acquired and the security may not at any time thereafter be held primarily for sale to customers.323


Description of Proposal

The proposal imposes an annual financial crisis responsibility fee based on certain liabilities of banks, thrifts, bank and thrift holding companies, brokers and securities dealers, as well as on U.S. companies owning or controlling such entities as of January 14, 2010. The proposed rate has not been determined, but is expected to be approximately 0.15 percent of an applicable financial firm's covered liabilities. Covered liabilities are defined as total balance sheet assets minus capital, deposits subject to assessments by the Federal Deposit Insurance Corporation (the "FDIC") (in the case of banks), certain insurance policy-related liabilities (in the case of insurance companies) and other (unspecified) exceptions. 324 The fee is assessed on the worldwide consolidated liabilities of firms headquartered in the United States, and the consolidated liabilities of U.S. subsidiaries of non-U.S. financial firms. The fee only applies to firms with consolidated assets in excess of $50 billion. Firms with consolidated assets of less than $50 billion would not be subject to the fee for the period when their assets are below the threshold.

The fee is reported on a firm's Federal income tax return. The fee is payable through payments on the same schedule as estimated income tax payments.

Effective date. -- The proposal is effective as of July 1, 2010. Thus, calendar year taxpayers would pay the fee with respect to two quarters of the year when filing their 2010 returns.


Analysis

Significant details of the Administration's proposal are unclear, including both the firms subject to the tax and the intended tax base. The uncertainty makes evaluating the technical details of the proposal difficult, but may also be used to highlight issues in need of further consideration.

    Covered institutions

The universe of covered institutions is not entirely clear from the initial proposal. For example, the fact sheet released in conjunction with the Administration's initial announcement of the fee explains that covered institutions "would include firms that were insured depository institutions, bank holding companies, thrift holding companies, insurance or other companies that owned insured depository institutions, or securities broker-dealers as of January 14, 2010, or that become one of these types of firms . . . "325 This sentence is perhaps best read to mean that only an insurance company that owns an insured depository subsidiary (or broker-dealer) qualifies as a covered institution, but it can also be read to mean any insurance company is covered. The Administration's description further suggests that an insurance company is a covered institution only if it owns a bank, broker or securities dealer, providing that "the fee would be applied to banks, thrifts, bank and thrift holding companies, brokers and securities dealers [and] U.S. companies owning or controlling these types of entities . . . "326

Some may argue it is arbitrary to apply the fee to an insurance company that happens to have a small bank subsidiary, but to exempt an otherwise similarly situated insurance company that does not have a bank subsidiary, or to exempt an insurance company with less than $50 billion in assets but with a larger banking subsidiary than an insurance company with assets exceeding $50 billion. In response, others may argue that the tax is intended to apply to the largest, most systemically significant entities that were eligible to receive TARP benefits, whether or not they actually received TARP funds. Thus, the argument goes, insurance companies that owned a thrift, or acquired one in order to qualify for TARP benefits, are properly subject to the fee. However, it is also possible that defining a covered institution as any company owning any of these other entities could subject unintended entities to the fee. For example, unless otherwise exempted, mutual fund groups owning captive securities broker-dealers to service fund trading requirements would be subject to the fee.

Another ambiguity is presented by the $50 billion consolidated asset threshold. The fee applies to firms with more than $50 billion in consolidated assets and would not apply to otherwise eligible entities for the period when their assets are below this threshold. Some may argue that the $50 billion in consolidated assets threshold establishes an arbitrary line. Opponents may note that a bright line threshold can alter the behavior of taxpayers operating near the threshold. In addition, it is not clear what is intended by "consolidated." The meaning of, and requirements for, consolidation differs in the financial reporting and U.S. Federal income tax contexts. Further, it is uncertain whether the proposal intends a more comprehensive definition which might, for instance, look through to the assets and liabilities of entities owned or controlled by the affected entities but which are not typically consolidated Federal income tax purposes, but the assets of which might be included for financial statement purposes.


    Tax base

Under the Administration's proposal, the fee applies to the "worldwide consolidated liabilities" of covered firms, but as described above, the meaning of "consolidated" is not clear and could vary significantly in scope. Moreover, the proposal contemplates exceptions to the tax, including FDIC-assessed deposits and "certain policy-related liabilities." It is not clear from the proposal which liabilities would be subject to the fee, which would be excluded, or the method for determining inclusion or exclusion.

One rationale for the fee is that it would provide a deterrent against excessive, and potentially risky, leverage for the largest firms. Risk in this context has various meanings.327 Financial institutions face systemic risk commonly described as risk an institution faces as a market participant against which it cannot diversify. Financial institutions may also contribute to systemic risk, that is, risk that the linkages between institutions in the financial system might affect the economy as a whole. Various risks may also be identified on both sides of a financial institution's balance sheet. On the asset side, each originated or held loan involves credit risk (whether the borrower pays) and interest rate risk (generally, when interest rates increase and the value of the loan drops, or rates decrease and borrowers accelerate their repayments).

With respect to the liabilities side of the balance sheet, liquidity risk includes the sudden withdrawal or unavailability of funds. A financial institution commonly faces varying degrees of durational risk, that is, a mismatch in the terms and timing of cash flows of its assets and its obligations. Banks typically raise money for long-term loans, such as 30-year residential mortgages, by borrowing short-term from depositors who can withdraw their money at any time. Thus, a sudden withdrawal of capital (e.g., a run on a bank) could result in an insolvent bank regardless of the quality of its assets if such assets cannot be liquidated quickly enough. A nondepository institution that relies on other forms of short-term capital with long-term assets faces a similar risk. Managing these risks is the principal business of financial intermediaries, and for which investors in these institutions are compensated. Bank regulatory capital requirements are generally intended to address these solvency risks.

It could be argued that the Administration's proposal contributes to the stability of the financial system to the extent it provides a disincentive to raise funds using certain types of risky leverage. Others might counter that the proposal, in effect, imposes a fee on all leverage other than FDIC assessed deposits (or certain policy reserve related assets) which may or may not be particularly risky or even possible to avoid. For example, general trade liabilities such as accounts payable would be subject to the fee. The fee would also be applied without regard to duration of the liability. For certain nonbank entities during the recent financial crisis, short-term wholesale liabilities drove a liquidity crunch when the short-term lenders lost confidence in such institutions' credit worthiness.328 However, the fee would apply to such potentially risky short-term debt and to long-term investment grade corporate debt issuances equally.

On the other hand, some might argue the proposal has little effect on risk insofar as it taxes all liabilities other than a narrowly identified group, and does nothing to address risk taken on the asset side of the balance sheet. Exceedingly risky positions can be financed with liabilities that the proposal would exclude from the tax base. Banking regulations attempt to address the risks to a bank's creditors posed by holding risky assets by requiring institutions with riskier assets to hold more of a particular type of regulatory capital referred to as "Tier 1 capital." However, to the extent banks only hold capital sufficient to comply with regulations, exempting Tier 1 capital from the tax base (as in the Administration's proposal) could have the effect of imposing a lower tax burden on riskier institutions. This may result because a bank holding riskier assets must hold more Tier 1 capital than an otherwise similarly situated bank with less risky assets. Therefore, removing Tier 1 capital from the tax base effectively imposes a greater tax liability on a bank with less risky assets.

Some might contend that a tax measured as a fixed percentage of assets or liabilities may actually encourage institutions to undertake riskier investments in pursuit of higher returns to offset the cost of the tax. However, one can counter that those higher risk and higher return investments were also available in the absence of the tax. Having rejected a higher risk/higher return portfolio when its costs were lower, it is not clear why a profit maximizing firm would choose such a portfolio in the face of the tax. On the other hand, if the tax increased the likelihood that the firm would become insolvent given its current investment choices, a firm may be willing to increase the risk of its portfolio in pursuit of higher returns to stave off bankruptcy.


Prior Action

No prior action.

2. Require accrual of the time-value element on forward sale of corporate stock


Present Law

A corporation generally recognizes no gain or loss on the receipt of money or other property in exchange for its own stock (including treasury stock).329 Furthermore, a corporation does not recognize gain or loss when it redeems its stock, with cash, for less or more than it received when the stock was issued. In addition, no gain or loss is recognized by a corporation with respect to any lapse or acquisition of an option to buy or sell its stock (including treasury stock).

In general, a forward contract means a contract to deliver at a set future date (the "settlement date") a substantially fixed amount of property (such as stock) for a substantially fixed price. Gains or losses from forward contracts generally are not taxed until the forward contract is closed. A corporation does not recognize gain or loss with respect to a forward contract for the sale of its own stock. A corporation does, however, recognize interest income upon the current sale of its stock for a deferred payment.

With respect to certain "conversion transactions" (transactions generally consisting of two or more positions taken with regard to the same or similar property, where substantially all of the taxpayer's return is attributable to the time value of the taxpayer's net investment in the transaction), gain recognized that would otherwise be treated as capital gain may be recharacterized as ordinary income.330


Description of Proposal

The proposal requires a corporation that enters into a forward contract for the sale of its own stock to treat a portion of the payment received with respect to the forward contract as a payment of interest.

Effective date. -- The proposal is effective for forward contracts entered into on or after December 31, 2011.


Analysis

Under a traditional forward contract, the purchase price generally is determined by reference to the value of the underlying property on the contract date and is adjusted (1) upward to reflect a time value of money component to the seller for the deferred payment (i.e., for holding the property) from the contract date until the settlement date and (2) downward to reflect the current yield on the property that will remain with the seller until the settlement date.

Strategies have been developed whereby a corporation can obtain favorable tax results through entering into a forward sale of its own stock, which results could not be achieved if the corporation merely sold its stock for a deferred payment. One such strategy that might be used to increase a corporation's interest deductions could involve a corporation borrowing funds (producing an interest deduction) to repurchase its own stock, which it immediately sells in a forward contract at a price equal to the principal and interest on the debt for settlement on the date that the debt matures. Taxpayers may be taking the position that the interest on the debt is deductible, while the gain and loss from the forward contract (including any interest component) is not taxable to the corporation. Although the leveraged purchase illustrates the problem, the borrowing is not necessary to achieve the tax benefits. A corporation could simply use excess cash (which otherwise would be earning a taxable return) to purchase its own outstanding stock and contemporaneously enter into a forward contract to sell the same amount of its stock at a price that reflects a return that is substantially based on the time value of money.331 In either case, the corporation arguably has achieved a tax-free return on investment.

Advocates of the proposal argue that there is little substantive difference between a corporation's current sale of its own stock for deferred payment (upon which the corporate issuer would accrue interest332) and the corporation's forward sale of the same stock. The primary difference between the two transactions is the timing of the stock issuance. In a current sale, the stock is issued at the inception of the transaction, while in a forward sale, the stock is issued on the settlement date. In both cases, a portion of the deferred payment economically compensates the corporation for the time-value element of the deferred payment. Proponents of the proposal argue that these two transactions should be treated the same. Additionally, some would argue that the proposal is a logical extension of the conversion rules of section 1258 (discussed below) which treat as ordinary income the time-value component of the return from certain conversion transactions.

Opponents of the proposal argue that there is, in many cases, a substantive difference between a corporation's forward sale of its stock and a current sale for a deferred payment. Under a forward sale, the stock is not outstanding until it is issued on the settlement date. The purchaser does not actually own stock that it can transfer free of its obligation to make payment under the forward contract. The purchaser has no current dividend rights, voting rights or rights in liquidation. The forward price may reflect expected dividends on the underlying stock, but that price is generally established in advance and actual dividends may vary from expected dividends. The purchaser of stock for a deferred payment, on the other hand, actually owns the stock and the attendant rights thereto. Therefore, the current sale of stock for deferred payment and the forward sale of stock for future delivery may not be equivalent transactions, but the proposal would treat them the same. Conversely, the proposal would treat differently a forward sale of stock and an issuance in the future of stock for the same price on the same date as the settlement date, which in many respects may be viewed as similar transactions.

In addition, any forward sale by its very nature has a time-value component: that feature is not unique to a corporate issuer of its own stock. The time-value component should compensate the holder for its carrying costs with respect to the property. One could argue that if it is appropriate to impute interest on a forward contract, it should be done for all forward contracts and not just forward contracts involving a corporation's own stock. In other words, as a policy matter it may be inappropriate to address forward sales of a corporation's own stock without addressing the broader question of taxation of the time-value component of forward contracts in general.

The conversion rules of section 1258 provide the closest analog under present law to the proposal. There are, however, several important distinctions between section 1258 and the proposal. Unlike the proposal, the conversion rules (1) do not affect the timing of recognition of the ordinary income and (2) apply only to forward contracts that are part of a conversion transaction. In addition, some also might argue that the policy rationale underlying the conversion rules is not present with respect to the issuance of corporate stock because there is no conversion of ordinary income to capital gain. For example, assume a taxpayer buys gold today for $100 and immediately enters into a forward contract to sell that gold in the future for $110 ($10 of which represents the time value of money). Upon closing of the forward sale, the taxpayer (and its shareholders if it is a corporation) would recognize an economic gain of $10. Absent the conversion rules, the $10 gain on that transaction may be treated as capital gain notwithstanding that substantially all of the taxpayer's return is with respect to the time value of money. The taxpayer is in the economic position of a lender with an expectation of a return from the transaction that is in the nature of interest and with no significant risks other than those typical of a lender. That arguably is not the case (at least with respect to the economic position of the existing shareholders) with respect to a corporation that enters into a forward sale of its own stock (or certainly not all forward sales of a corporation's own stock). A corporation's ownership of its own stock arguably has no economic significance to the corporation or its shareholders. The purchase or issuance by a corporation of its own stock at fair market value does not affect the value of the shareholders' interests in the corporation. The economic gain or loss, if any, to the existing shareholders of the corporation on the forward sale of its stock would depend on the fair market value of the corporation's stock on the settlement date. If the fair market value of the corporation's stock on the settlement date equals the contract price under the forward sale, then there is no economic gain or loss to the corporation or its shareholders. On the other hand, if the forward price does not equal the fair market value, there could be situations in which the corporation suffers an economic loss (because, for example, the value of the stock is greater than the forward price). Even in situations in which there is an economic loss, however, the proposal would tax the corporation on the imputed time-value element.333

Some have suggested that a more narrowly tailored solution could be developed to address the perceived abuse of a corporation in essence being able to make a tax-free, fixed-income investment in its own stock (i.e., the "cash and carry transaction"). Under such an approach, the corporation would recognize taxable gain only if it acquired its own stock and on a substantially contemporaneous basis entered into a forward contract to sell its own stock and substantially all of its expected return from the transaction was attributable to the time value of money invested.334

Finally, some would argue that the provision narrowly focuses on one type of derivative contract with respect to a corporation's own stock and that a broader approach addressing the treatment under section 1032 of derivative contracts and other techniques for using a corporation's own stock would be more appropriate. Otherwise, the inconsistent treatment of economically equivalent transactions under section 1032 and the uncertainty as to its scope, in particular with respect to its applications to derivative contracts in a corporation's own stock, could result in whipsaw against the government. Those who espouse this view would argue that consideration should be given to a range of alternative approaches for addressing the issue of derivatives and section 1032, including (1) expanding the scope of section 1032 to cover all derivatives in a corporation's stock, or (2) contracting the scope of section 1032 to cover only transactions in which a corporation issues or purchases its own stock for fair market value.335


Prior Action

An identical proposal was included in the President's fiscal year 2000, 2001, and 2010 budget proposals.

3. Require ordinary treatment for dealer activities with respect to section 1256 contracts


Present Law

In general

In general, gain or loss on the sale of stock in trade of a taxpayer or other property of a kind that properly would be included in inventory, or property that is held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, is treated as ordinary income.336 Consistent with this general rule, a taxpayer's status as a "dealer" in a particular type of property generally means that the taxpayer recognizes ordinary gain or loss when it engages in its day-to-day dealer activities, namely selling or exchanging the type of property for which it is a dealer.

A dealer in securities must compute its income pursuant to the mark-to-mark method of accounting.337 Any security that is inventory in the hands of the dealer must be included in inventory at its fair market value; in the case of any security that is not inventory and that is held at the end of the taxable year, the dealer must recognize gain or loss as if the security had been sold for its fair market value. The resulting gain or loss generally is treated as ordinary gain or loss.338

Section 1256 contracts

Notwithstanding the general rule applicable to dealers, special rules apply to gains and losses of commodities dealers, commodities derivative dealers, dealers in securities, options dealers, and dealers in securities futures contracts or options with respect to "section 1256 contracts." Any gain or loss with respect to a section 1256 contract is subject to a mark-tomarket rule and generally is treated as short-term capital gain or loss, to the extent of 40 percent of the gain or loss, and long-term capital gain or loss, to the extent of the remaining 60 percent of the gain or loss (the "60/40 rule").339 Gains and losses upon the termination (or transfer) of a section 1256 contract, by offsetting, taking or making delivery, by exercise or by being exercised, by assignment or being assigned, by lapse, or otherwise, also generally are treated as 40 percent short-term and 60 percent long-term capital gains or losses.340 A taxpayer other than a corporation may elect to carry back its net section 1256 contracts loss for three taxable years.341

A "section 1256 contract" is any (1) regulated futures contract; (2) foreign currency contract; (3) nonequity option, (4) dealer equity option, and (5) dealer securities futures contract.342 The term "section 1256 contract" does not, however, include (1) any securities futures contract or option on such a contract unless such contract or option is a dealer securities futures contract, or (2) any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement.343

Dealers in section 1256 contracts

A "commodities dealer" is any person who is actively engaged in trading section 1256 contracts and is registered with a domestic board of trade which is designated as a contract market by the Commodities Futures Trading Commission.344 Commodities dealers recognize capital gains and losses with respect to their section 1256 contracts unless they elect to have the rules of section 475 apply.345

A "commodities derivatives dealer" is a person that regularly offers to enter into, assume, offset, assign, or terminate positions in "commodities derivative financial instruments" with customers in the ordinary course of a trade or business.346 Commodities derivative financial instruments held by a commodities derivatives dealer generally are not capital assets, and the sale or exchange of such instruments by a commodities derivatives dealer results in ordinary gain or loss.347 However, the definition of "commodities derivative financial instruments" excludes section 1256 contracts.348 As a result, the gains and losses of commodities derivatives dealers with respect to section 1256 contracts typically are capital under the general rules of section 1256.

A "dealer in securities" is a taxpayer who (1) regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business, or (2) regularly offers to enter into, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business.349 The general rules applicable to securities dealers do not apply to section 1256 contracts held by security dealers. As a result, the gains and losses of dealers in securities with respect to section 1256 contracts typically are capital under the general rules of section 1256.

An "options dealer" is any person registered with a national securities exchange as a market maker or specialist in listed options, as well as any person whom the Secretary determines performs similar functions.350 An option dealer's transactions with respect to both non-equity options and dealer equity options, both of which are section 1256 contracts, give rise to capital gain or loss under section 1256.351

A person is treated as a "dealer in securities futures contracts or options on such contracts" if the Secretary determines that such person performs, with respect to such contracts or options, as the case may be, functions similar to functions performed by an options dealer.352 Dealer securities futures contracts are section 1256 contracts, and the transactions of a dealer in securities futures contracts with respect to such contracts give rise to capital gain or loss.353


Description of Proposal

The proposal requires commodities dealers, commodities derivatives dealers, dealers in securities, and options dealers to treat the income from their day-to-day dealer activities with respect to section 1256 contracts as ordinary in character, not capital. The proposal does not affect the application of the mark-to-market rules with respect to such gains and losses.

Effective date. -- The proposal is effective for tax years beginning after the date of enactment.


Analysis

The proposal provides that a commodities dealer's, commodities derivative dealer's, securities dealer's, and an option dealer's gains and losses with respect to section 1256 contracts are treated as ordinary income. The proposal thus denies such dealers the benefits of the 60/40 rule, but allows net losses to be taken into account without regard to any capital loss limitations. The proposal does not otherwise affect the present-law requirement that such dealers report their section 1256 gains and losses under the mark-to-market method.

The 60/40 rule provides favorable treatment for certain dealers with respect to income that otherwise would not qualify for preferential capital gains treatment. This special treatment is not currently relevant in the case of corporate dealers because corporate capital gain is taxed at the same tax rates as ordinary income. For individuals, however, the 60/40 rule results in a maximum tax rate of 26 percent on their business income. Proponents argue that eliminating the 60/40 rule for dealers is appropriate, because their business income should be taxed in the same manner as dealers of other types of property.354

On the other hand, Congress implicitly has acknowledged that the day-to-day activity of commodities dealers and options dealers with respect to section 1256 contracts is in fact "trading."355 And section 1256(f)(3)(A), which provides that "trading" section 1256 contracts gives rise to capital gain or loss, is arguably nothing more than a codification of a basic tax principle. Thus, the Administration's proposal also could be viewed (at least with respect to commodities dealers and options dealers) as creating a special character rule for certain categories of traders.

Furthermore, some will contend that the 60/40 rule, which was enacted in 1981 and expanded in 1984 and 2000, was intended to provide the benefit of a lower rate for these taxpayers who, by virtue of the enactment of the mark-to-market regime, were being required to pay tax with respect to gains prior to their realization. For purposes of determining a taxpayer's holding period, applying a mark-to-market method to capital assets creates uncertainty and complexity if a mark when the asset is still short term is followed by a second mark after the long-term holding period has been reached.356 The 60/40 rule could be viewed as ameliorating these aspects of the mark-to-market regime and, therefore, its retention may be appropriate. Others would respond by noting that these concerns have become less significant since the 1993 enactment of section 475, which mandates mark-to-market treatment (and ordinary gain or loss) for dealers in securities.357


Prior Action

A similar proposal was included in the President's fiscal year 2001 and 2010 Budget Proposals.

4. Modify the definition of control for purposes of the section 249 deduction limitation


Present Law

In general, where a corporation repurchases its indebtedness for a price in excess of the adjusted issue price, the excess of the repurchase price over the adjusted issue price (the "repurchase premium") is deductible as interest.358 However, in the case of indebtedness that is convertible into the stock of (1) the issuing corporation, (2) a corporation in control of the issuing corporation, or (3) a corporation controlled by the issuing corporation, section 249 provides that any repurchase premium is not deductible to the extent it exceeds "a normal call premium on bonds or other evidences of indebtedness which are not convertible."359

For purposes of section 249, the term "control" has the meaning assigned to such term by section 368(c). Section 368(c) defines "control" as "ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation." Thus, section 249 can apply to debt convertible into the stock of the issuer, the parent of the issuer, or a first-tier subsidiary of the issuer.


Description of Proposal

The proposal modifies the definition of "control" in section 249(b)(2) to incorporate indirect control relationships, of the nature described in section 1563(a)(1). Section 1563(a)(1) defines a parent-subsidiary controlled group as one or more chains of corporations connected through stock ownership with a common parent corporation if (1) stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote or at least 80 percent of the total value of shares of all classes of stock of each of the corporations, except the common parent corporation, is owned (within the meaning of subsection (d)(1)) by one or more of the other corporations; and (2) the common parent corporation owns (within the meaning of subsection (d)(1)) stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote or at least 80 percent of the total value of shares of all classes of stock of at least one of the other corporations, excluding, in computing such voting power or value, stock owned directly by such other corporations.

Effective date. -- The proposal is effective on the date of enactment.


Analysis

Section 249 was added to the Code in 1969, and has not been altered substantially in 40 years. The reason for the original provision was explained by the staff of the Joint Committee on Taxation in 1969: "A corporation which repurchases its convertible indebtedness is, in part, repurchasing the right to convert the bonds into its stock. Since a corporation may not deduct the costs of purchasing its stock as a business expense, the Congress believed that the purchase of what, in effect, is the right to purchase its stock should be treated in the same manner."360 The extension of the basic rule of section 249 to the stock of a corporation in control of the issuer or a corporation controlled by the issuer can be viewed simply as an anti-avoidance measure.

The Administration now proposes to bolster the anti-avoidance rule by expanding the definition of "control." According to the Administration: "The definition of 'control' in section 249 is unnecessarily restrictive, and has resulted in situations in which the limitation in section 249 is too easily avoided. Indirect control relationships (e.g., a parent corporation and a second-tier subsidiary) present the same economic identity of interests as direct control relationships, and should be treated in a similar manner."

Similar changes have been proposed by others in the past. For instance, a 1987 report of the Tax Section of the New York State Bar Association noted: "Section 249 applies only to debt instruments convertible into stock of the issuer or a corporation controlled by or controlling the issuer, using the section 368(c) definition of control. This definition is overly narrow in some respects (e.g., a class of nonvoting preferred stock held by a third party would avoid a finding of control, and ownership attribution is not taken into account), and a statutory amendment to adopt a broader definition seems warranted."361


Prior Action

The same proposal was included in the President's 2010 fiscal year budget proposal.

B. Reinstate Superfund Excise Taxes and Corporate Environmental
Income Tax

Present Law

The Superfund program addresses cleanup activity of hazardous substances at contaminated sites. Before January 1, 1996, four taxes were imposed to fund the Hazardous Substance Superfund Trust Fund ("Superfund"):

    1. An excise tax on petroleum and imported refined products;362

    2. An excise tax on certain hazardous chemicals, imposed at rates that varied from $0.22 to $4.87 per ton;363

    3. An excise tax on imported substances made with the chemicals subject to the tax in (2), above;364 and

    4. An income tax on corporations calculated using the alternative minimum tax rules.365


The taxes expired at the end of 1995. At the time the taxes expired, the Superfund Trust Fund had an unobligated balance of $4 billion.366 By Fiscal Year 2004, the unobligated balance was zero.367 As a result, the Superfund program has had to rely on general fund appropriations to fund the program.

The Environmental Protection Agency ("EPA") compiles the National Priorities List, which includes sites that the EPA has identified as having the greatest risk to human health and the environment. In many cases, potentially responsible parties ("PRPs") pay for the cleanups. Potentially responsible parties are responsible for more than 70 percent of the sites on the National Priorities List.368 At approximately 30 percent of the National Priorities List sites, the EPA cannot locate the PRPs for these properties or the PRPs that are located do not have the financial resources to cover the cleanup.369 For this group of sites ("orphan sites"), the EPA uses funds from the Superfund to conduct cleanup activities.


Description of Proposal

The proposal reinstates the three Superfund excise taxes for periods after December 31, 2010. It would also reinstate the corporate environmental income tax for taxable years beginning after December 31, 2010. Both the excise and corporate income taxes would sunset after December 31, 2020.

Effective date. -- The proposals are effective for periods after December 31, 2010 (for the Superfund excise taxes) and for taxable years beginning after December 31, 2010 (for the corporate environmental income tax).


Analysis

Some contend that the Superfund program has been underfinanced since the taxes that supported it expired in 1995 and that such underfunding has slowed the progress of cleaning up hundreds of orphan sites.370 Thus proponents assert that the taxes dedicated to the trust fund should be reinstated to meet the continuing cleanup needs of orphan sites.

Opponents of the reinstatement of the taxes argue that the persons bearing the burden of the taxes are not the ones directly responsible for the contamination. They argue that the cleanup of orphan sites is a broad societal problem that should be paid for by general revenues instead of levy on particular industries.371 In contrast, some proponents argue that under a "polluter pays" principle, cleanup of the orphan sites should come from the industries that profited from the sale or use of the chemicals being cleaned up, even if those parties are not directly related to a particular release of a hazardous substance. Some have taken a more narrow view of "polluter pays" to include only those directly responsible for the contamination and assert that it is unfair to impose a tax on a person to compensate for another's transgression. Some would argue that even under the broader theory of "polluter pays," the corporate environmental income tax is inconsistent with this theory because the tax is imposed without regard to the particular product the corporation manufactures.


Prior Action

The same proposals were included in the President's fiscal year 2010 budget proposal.372

C. Permanent Extension of Federal Unemployment Surtax

Present Law

The Federal Unemployment Tax Act ("FUTA") imposes a 6.2 percent gross tax rate on the first $7,000 paid annually by covered employers to each employee. Employers in States with programs approved by the Federal Government and with no delinquent Federal loans may credit 5.4 percentage points against the 6.2 percent tax rate, making the minimum, net Federal unemployment tax rate 0.8 percent. Since all States have approved programs, 0.8 percent is the Federal tax rate that generally applies. This Federal revenue finances administration of the unemployment system, half of the Federal-State extended benefits program, and a Federal account for State loans. The States use the revenue turned back to them by the 5.4 percent credit to finance their regular State programs and half of the Federal-State extended benefits program.

In 1976, Congress passed a temporary surtax of 0.2 percent of taxable wages to be added to the permanent FUTA tax rate. Thus, the current 0.8 percent FUTA tax rate has two components: a permanent tax rate of 0.6 percent, and a temporary surtax rate of 0.2 percent. The temporary surtax subsequently has been extended through the first six months of 2011.


Description of Proposal

The proposal permanently extends the temporary surtax rate.

Effective date. -- The proposal is effective for labor performed after June 30, 2011.


Analysis

The proposal reflects the belief that a surtax extension is needed in order to increase funds for the Federal Unemployment Trust Fund to provide a cushion against future Trust Fund expenditures. The monies retained in the Federal Unemployment Account of the Federal Unemployment Trust Fund can then be used to make loans to the 53 State Unemployment Compensation benefit accounts as needed.

As a tax on labor, the FUTA tax is thought to be borne by labor in the long run in the form of lower wages, rather than borne by the employers, who have the statutory obligation to pay the tax. Though the economic incidence of the tax falls on labor, so too do the benefits, in the form of unemployment compensation paid during future spells of unemployment.


Prior Action

No prior action.

D. Repeal Last-In, First-Out Inventory Accounting Method

Present Law

In general

In general, for Federal income tax purposes, taxpayers must account for inventories if the production, purchase, or sale of merchandise is a material income-producing factor to the taxpayer.373

Under the last-in, first-out ("LIFO") method, it is assumed that the last items entered into the inventory are the first items sold. Because the most recently acquired or produced units are deemed to be sold first, cost of goods sold is valued at the most recent costs; the effect of cost fluctuations is reflected in the ending inventory, which is valued at the historical costs rather than the most recent costs.374 Compared to first-in, first-out ("FIFO"), LIFO produces net income which more closely reflects the difference between sale proceeds and current market cost of inventory. When costs are rising, the LIFO method results in a higher measure of cost of goods sold and, consequently, a lower measure of income when compared to the FIFO method. The inflationary gain experienced by the business in its inventory is generally not reflected in income, but rather, remains in ending inventory as a deferred gain until a future period in which sales exceed purchases.375

Dollar-value LIFO

Under a variation of the LIFO method, known as dollar-value LIFO, inventory is measured not in terms of number of units but rather in terms of a dollar-value relative to a base cost. Dollar-value LIFO allows the "pooling" of dissimilar items into a single inventory calculation. Thus, depending upon the taxpayer's method for defining an item, LIFO can be applied to a taxpayer's entire inventory in a single calculation even if the inventory is made up of different physical items. For example, a single dollar-value LIFO calculation can be performed for an inventory that includes both yards of fabric and sewing needles. This effectively permits the deferral of inflationary gain to continue even as the inventory mix changes or certain goods previously included in inventory are discontinued by the business.

Simplified rules for certain small businesses

In 1986, Congress enacted a simplified dollar-value LIFO method for certain small businesses.376 In doing so, the Congress acknowledged that the LIFO method is generally considered to be an advantageous method of accounting, and that the complexity and greater cost of compliance associated with LIFO, including dollar-value LIFO, discouraged smaller taxpayers from using LIFO.377

To qualify for the simplified method, a taxpayer must have average annual gross receipts of $5 million or less for the three preceding taxable years.378 Under the simplified method, taxpayers are permitted to calculate inventory values by reference to changes in published price indexes rather than comparing actual costs to base period costs.

Special rules for qualified liquidations of LIFO inventories

In certain circumstances, reductions in inventory levels may be beyond the control of the taxpayer. Section 473 of the Code mitigates the adverse effects in certain specified cases by allowing a taxpayer to claim a refund of taxes paid on LIFO inventory profits resulting from the liquidation of LIFO inventories if the taxpayer purchases replacement inventory within a defined replacement period. The provision generally applies when a decrease in inventory is caused by reduced supply due to government regulation or supply interruptions due to the interruption of foreign trade.


Description of Proposal

The proposal repeals the LIFO inventory accounting method. Taxpayers that currently use LIFO would be required to write up their beginning LIFO inventory to its FIFO value in the first taxable year beginning after December 31, 2011. The resulting increase in income is taken into account ratably over 10 taxable years beginning with the first taxable year beginning after December 31, 2011.

Effective date. -- The proposal is effective for taxable years beginning after December 31, 2011.


Analysis

In general, assuming rising prices, taxpayers using LIFO have an incentive to maintain or build inventory levels rather than allowing them to fall. So long as inventory levels are steady or growing the taxpayer never is deemed to have sold any of its older, lower-cost inventory, and inflationary gain is deferred indefinitely. However, in a period in which the inventory level falls, the taxpayer necessarily will (absent a special rule) be deemed to have sold some units purchased in a prior period, and the inflationary gain in those periods will be recognized in taxable income.379

Proponents of the LIFO method argue that in periods of rising costs, the method provides the most accurate reflection of current-period economic income because it matches current costs against current sales revenues. They point out that the taxpayer will have to replace the inventory to continue in business and that by including the most recent additions to the inventory in cost of goods sold, the required cost of replacing the inventory is more closely projected.380

Alternatively, proponents of the FIFO method argue that LIFO permits deferral of inflationary gains in a taxpayer's inventory even when those gains arguably have been realized by the business. They note that outside of the inventory context, inflationary gains are generally taxed when the gain is realized (i.e., upon sale of the appreciated asset) and LIFO offers self-help against inflation that is not available in other contexts. FIFO proponents further assert that the use of earlier acquired items to value ending inventory understates net worth in times of rising prices resulting in an understatement of the income that measures the change in net worth for a given period.381

Proponents of FIFO also argue that a business whose inventory turns over with regularity during a taxable year should not value inventory as if it includes items purchased in prior years. However, LIFO advocates counter that, although there may be inventory turnover, it is highly unlikely that there is a time when there are no units in inventory. They view this perpetual inventory "layer" as a required condition of doing business and best valued at the time the layer was established, which is accomplished under LIFO. Thus, supporters of LIFO argue that during inflationary periods, using LIFO enables a business to finance its increasing need for capital to maintain physical inventory levels. In this respect, they note that LIFO functions much like accelerated depreciation for capital investment in productive machinery and equipment.382

Commentators contend that LIFO and, more specifically dollar-value LIFO (the most commonly used method of valuing inventory under LIFO), does not simply isolate changes in inventory cost resulting from inflation, but includes increases and decreases due to other factors outside of normal inflation such as changes in technology and changes in relative values as market supply and demand changes.383 These commentators also note that a taxpayer's definition of an "item" for purposes of establishing its dollar-value LIFO pools can result in changes to inventory costs that are not attributable solely to inflation.384 For example, a broad item definition generally results in fewer pools lessening the likelihood that a previously established LIFO layer will be liquidated, which has the effect of deferring gain which results not from inflation, but from a change in the goods that comprise a particular dollar-value LIFO pool.

Supporters of LIFO have also pointed out the potential adverse economic effects of the recapture of the LIFO reserve, especially for those businesses that have used LIFO for decades. The tax imposed on the recapture of the reserve, even where the recapture is spread over a period of years (e.g., eight as is currently proposed), could be substantial, and could severely restrict the ability of such taxpayers to invest in capital, including maintaining their current physical inventory levels.385

Unlike U.S. Generally Accepted Accounting Principles ("GAAP"), international financial reporting standards ("IFRS") do not treat LIFO as a permitted method of accounting.386 The Securities and Exchange Commission ("SEC") recently indicated its support for global accounting standards and it continues to work toward making a determination by 2011 as to whether to incorporate IFRS into the U.S. financial reporting system. SEC staff also noted that if the SEC were to decide to move to IFRS, the transition date for U.S. issuers would be no earlier than 2015.387 The seemingly inevitable shift from GAAP to IFRS raises the issue of whether companies will be able to continue using LIFO for tax purposes in light of the conformity requirement.388


Prior Action

A similar proposal for the repeal of LIFO was included in the President's budget proposal for fiscal year 2010.389

E. Repeal Gain Limitation on Dividends Received in Reorganization
Exchanges

Present Law

Distributions and stock redemptions in general

If a corporation distributes cash (or other property not permitted to be received without tax)390 to its shareholders who do not surrender stock in a redemption, the distribution is generally treated as a dividend to the shareholders, to the extent of the corporation's current and accumulated earnings and profits.391 Amounts in excess of such earnings and profits are treated as recovery of a shareholder's stock basis, and then as capital gain to the extent in excess of such basis.

If a corporation redeems its stock and one of four tests is satisfied, the redeemed shareholder treats the redemption as a sale or exchange.392 This allows the shareholder to reduce the amount included in income by his basis in the redeemed stock and also entitles the shareholder to capital gain (or loss) treatment. If none of the tests is met, the redemption is treated as a dividend to the extent that the distribution is either out of accumulated earnings and profits or out of earnings and profits for the current year.

The four tests are: (1) the redemption is not essentially equivalent to a dividend; (2) the distribution is substantially disproportionate with respect to the shareholder (i.e., the shareholder's ownership of voting stock and common stock declines by more than 20 percent as a result of the redemption and the shareholder owns less than 50 percent of the voting stock after the redemption); (3) the shareholder's interest is completely terminated; and (4) a shareholder (other than a corporation) is redeemed in partial liquidation of the distributing corporation.

Whether dividend treatment or sale treatment is more advantageous to the recipient depends upon the recipient's tax situation. Dividend treatment (outside of the special rules applicable in a corporate reorganization, discussed later below) does not allow a shareholder to limit its income by the benefit of any stock basis recovery. However, dividend treatment can be advantageous to a corporate shareholder, depending upon the circumstances, because in the domestic context a corporate recipient generally would be entitled to a dividends-received deduction of at least 70 percent, and possibly all, of the amount of the dividend, depending on stock ownership393 (or would eliminate the dividend if it is filing a consolidated return with the payor).394 If the recipient is a foreign person and the payor is a U.S. corporation, dividends are generally subject to withholding tax, a result generally less favorable than non-taxed capital gain treatment from a stock redemption treated as a sale of the stock. However, the amount of withholding tax on dividends is reduced under many treaties. If the payor is a foreign corporation, U.S. shareholders may be entitled to foreign tax credits with respect to a dividend. On the other hand, if basis is allowed to offset the amount of income from the distribution, then the transfer of stock with a high basis for cash or other property may be largely or entirely nontaxable.

The earnings and profits of a corporation paying a distribution that is a dividend are reduced by the entire amount of the dividend. If a distribution in redemption of stock is treated as a sale or exchange, then the amount of the distribution properly chargeable to earnings and profits is limited to the ratable share of the earnings and profits attributable to the redeemed stock.395

Section 304

Under section 304(a)(1), if one or more persons are in control of each of two corporations, and in return for property, one of the corporations acquires stock in the other corporation (the "target") from the person (or persons) so in control, then for purposes of section 302 and 303, the property shall be treated as a distribution in redemption of the stock of the acquiring corporation. The tests described above to determine the tax treatment of a stock redemption apply to determine whether the transfer is treated as an exchange or as a distribution of property. To the extent the deemed property distribution is treated as a distribution to which section 301 applies, the transferor and the acquiring corporation are treated in the same manner as if (1) the transferor had transferred the acquired stock of the target corporation to the acquiring corporation in exchange for stock of the acquiring corporation in a transaction to which section 351(a) applies, and (2) the acquiring corporation had then transferred the property to the transferor in redemption of the stock it is deemed as having issued.396 In the case of a section 304 transaction, both the amount and source of any dividend are determined as if the property were distributed by the acquiring corporation to the extent of its earnings and profits, and then by the target (i.e., issuing) corporation to the extent of its earnings and profits.397

Special rules apply if the acquiring corporation in a section 304 transaction is a foreign corporation.398 The foreign acquiring corporation's earnings and profits that are taken into account to determine the amount and source of a dividend are limited to the portion of such earnings and profits that (1) are attributable to stock of the foreign acquiring corporation held by a corporation or individual who is the transferor (or a person related thereto) of the target corporation and who is a U.S. shareholder (within the meaning of section 951(b)) of the foreign acquiring corporation and (2) were accumulated while such stock was owned by the transferor (or a person related thereto) and while the foreign acquiring corporation was a controlled foreign corporation ("CFC").

Boot in reorganizations and certain 355 distributions

In general, gain or loss is not recognized with respect to exchanges of stock and securities by a shareholder in corporate reorganizations (or section 355 divisive stock distributions). However, if such an exchange also involves the receipt of nonqualifying consideration ("boot"), then the shareholder must recognize gain (if any) to the extent of the boot received in the exchange. No loss is allowed.399 Further, part or all of that gain may be taxable as a dividend if the exchange has the effect of a distribution of a dividend. Unlike the rules that apply to ordinary dividends, under the boot dividend rules of section 356(a)(1), the amount of a dividend recognized by the exchanging shareholder is limited to the amount of gain recognized by the shareholder on the exchange. Also, under the boot dividend rules, a shareholder's dividend income recognized is limited to "such an amount of the gain recognized as is not in excess of his ratable share of undistributed earnings and profits of the corporation accumulated after February 28, 1913."400 The remainder of the gain recognized, if any, is treated as gain from the exchange of property.

The courts and the IRS have held that the principles developed in interpreting the rules relating to stock redemptions are applicable in determining whether boot received in a reorganization exchange or a section 355 exchange is treated as a dividend. In Clark v. Commissioner,401 the Supreme Court explicitly applied the substantially disproportionate test of the stock redemption rules in the reorganization context by analyzing whether the distribution is substantially disproportionate with respect to the shareholder (i.e., the shareholder's ownership of voting stock and common stock declines by more than 20 percent as a result of the redemption and the shareholder owns less than 50 percent of the voting stock after the redemption). This test was applied by treating the boot as being paid in redemption of additional stock hypothetically received by the exchanging shareholder and applying the tests under section 302. Nevertheless, there is no explicit statutory coordination between the stock redemption rules and the rules relating to the treatment of boot received in a reorganization exchange or section 355 exchange.

As discussed above, under section 356(a) boot will only be treated as a dividend to the extent of the exchanging shareholder's ratable share of the corporation's undistributed earnings and profits. The IRS has ruled, and at least one circuit court has held under present law that, for purposes of determining the deemed dividend under section 356(a)(2), the earnings and profits of the target (i.e., transferor) and the acquiring (i.e., transferee) corporation should both be taken into account when the corporations are commonly owned.402 Other courts, however, have held that only the earnings and profits of the target corporation are taken into account even in the case of common ownership.403

If an exchange described in section 356(a)(1) has the effect of a distribution of a dividend, the earnings and profits from which it is considered to be paid are reduced by the entire amount that is taxable as a dividend to the shareholder. In a ruling issued prior to the enactment of section 312(n)(7), which limits the reduction of earnings and profits in a section 302 redemption to the ratable share attributable to the redeemed stock, the IRS ruled that in a dividend equivalent transaction under section 356(a)(2), earnings and profits are also reduced by the amount that exceeds the shareholder's ratable share of earnings and profits and that is taxed to the shareholder as capital gain.404 There is a lack of clarity under present law whether the limitation on the reduction of earnings and profits under section 312(n)(7) applies in the case of a reorganization.

Some reorganizations (under sections 368(a)(1)(D),405 (E),406 and (F)407) necessarily involve corporations under common control, or a single corporation. Other reorganizations also may involve continuing common ownership such that as to a particular shareholder, boot received may be treated as a dividend.

Certain cross-border reorganizations under section 367

In general, to the extent that transactions include certain cross-border transfers, the provisions of section 367(a) and (b) apply to (i) preserve the U.S. ability to tax gains attributable to the accrued appreciation in assets that leave the U.S. tax system and (ii) require the inclusion of previously untaxed foreign earnings of certain foreign subsidiaries (hereinafter the "earnings repatriation purpose").408 Thus, section 367(a)(1) provides that if, in connection with certain exchanges under subchapter C of the Code, a United States person transfers property to a foreign corporation, such foreign corporation shall not, for purposes of determining the extent to which gain shall be recognized on such transfer, be considered a corporation.409 By deeming the foreign corporation not to be a corporation, the provision precludes the transfer from qualifying as tax-free under subchapter C. The Secretary has broad regulatory authority under section 367(a)(2), (3) and (6) to provide that section 367(a)(1) will or will not apply to certain transfers described therein.

Section 367(b) applies to certain exchanges in which there is no transfer of property described in section 367(a)(1).410 Section 367(b)(1) provides that a foreign corporation shall be considered to be a corporation, except to the extent provided in regulations in order to prevent the avoidance of Federal income taxes. Section 367(b)(2) provides that the regulations prescribed pursuant to section 367(b)(1) shall include (but shall not be limited to) regulations dealing with the sale or exchange of stock or securities in a foreign corporation by a United States person, including regulations providing, among other things, the circumstances under which gain is recognized, amounts are included in gross income as a dividend, adjustments are made to earnings and profits, or adjustments are made to basis of stock or securities.

In recent years, Treasury has focused on certain transaction structures that are inconsistent with section 367(a) and (b). Two recent examples include the transactions commonly referred to as "Killer B" transactions and transactions referred to as "Deadly D" transactions.411


    "Killer B" guidance

Notices 2006-85 and 2007-48 and temporary Treasury regulations subsequently issued under section 367(b)412 apply to certain triangular reorganizations413 involving a parent corporation ("parent") and subsidiary corporation ("subsidiary"), at least one of which is foreign. Pursuant to the reorganization, the subsidiary acquires from the parent, in exchange for property, parent stock that is then used by the subsidiary to acquire the stock or assets of a target corporation ("target") (which may be related or unrelated to the parent and the subsidiary before the transaction) in a tax-free reorganization. Prior to the guidance, taxpayers took the position that no gain or loss was recognized on the exchange of parent stock for property under section 1032 and the regulations thereunder, even if the subsidiary acquired the parent stock for cash or a note and had significant previously untaxed earnings and profits. In general, section 1032(a) provides that a corporation will not recognize any gain or loss to the extent it receives any money or other property in exchange for its own stock. To prevent the use of such transactions to inappropriately repatriate previously untaxed earnings without an income inclusion, the regulations provide that the transfer of property by the subsidiary to the parent in exchange for the parent stock shall be treated as a transaction separate from, and occurring immediately before, the triangular reorganization. Therefore, the parent shall not be treated as receiving the property from the subsidiary in exchange for the parent stock and the separate distribution is subject to section 301.414

    "Deadly D" guidance

Notice 2008-10 and recently issued proposed regulations under section 367(a)(5)415 address certain transactions designed to repatriate cash or other property from foreign subsidiaries without the recognition of gain or a dividend inclusion, in certain authorized reorganizations, by virtue of the application of the basis adjustment rule of section 367(a)(5).416 The notice describes a fact pattern in which the U.S. parent ("USP"), wholly owns a foreign acquiring corporation ("FA"), and USP's basis in its FA stock is $100. USP also wholly owns U.S. target ("UST"), and USP's basis in its UST stock equals its fair market value of $100. UST owns property with zero tax basis such as self-created intangibles and fully depreciated tangible property. UST sells its property to FA in exchange for $100 cash and, in connection with the transaction, UST liquidates. FA then transfers all of the property acquired from UST to a U.S. Newco ("USN"), a newly formed U.S. domestic corporation, in exchange for 100 percent of the USN stock.

In this and similar fact patterns, taxpayers took the position that the transfer of property by UST to FA was not subject to gain recognition under section 367(a) or (d), because the basis adjustment rule of 367(a)(5) allowed USP to reduce by $100 its basis in the FA stock that it held immediately prior to the transaction.417 The result of this position was that USP was effectively able to repatriate FA's previously untaxed earnings and profits with little or no U.S. taxation. Notice 2008-10, however, provided that the basis adjustment rule of section 367(a)(5) could not be applied to the stock of FA held by USP immediately prior to the transaction, so that, under the facts within this notice, the transfer of property by UST to FA was subject to the gain recognition provisions of sections 367(a) and (d).

The preamble to the proposed regulations issued under section 367(a)(5) announced that the IRS and Treasury Department were considering whether the gain limitation rule of Section 356(a)(1) should apply in an acquisitive asset reorganization involving a foreign acquiring corporation, considering that section 367(b) is intended to protect against U.S. tax avoidance upon the repatriation of previously untaxed foreign earnings. The preamble requested comments in this regard, including whether any guidance should apply only to cases in which section 356(a)(2) would otherwise apply to the shareholder's receipt of non-qualifying property (i.e., if the exchange has the effect of a distribution of a dividend).418 Some comments have been received, but no further action has been taken to date.


Description of Proposal

The proposal repeals the boot-within-gain limitation of current law in the case of any reorganization transaction if the exchange has the effect of the distribution of a dividend, as determined under section 356(a)(2).

Effective date. -- The proposal is effective for taxable years beginning after December 31, 2010.


Analysis

Present law allows significant flexibility to structure distributions of cash or other property to shareholders as dividends in full, or as dividends limited by stock gain, depending upon whether or not the transaction is structured as a reorganization. Furthermore, because of the lack of certainty regarding the earnings and profits that would support dividend treatment in a reorganization (whether those of both the acquiring and acquired corporation or rather only those of the acquired corporation) and because of other uncertain or different rules for reorganization dividends compared to non-reorganization dividends (such as whether there is a dividend to the extent of accumulated earnings and profits only, or also including current earnings and profits for reorganizations, compared to the use of both current and accumulated earnings and profits outside of a reorganization), taxpayers may have significant flexibility as to the extent to which they report a distribution as a dividend on the one hand, or as a recovery of basis and capital gain on the other hand.

The transaction identified by the Administration's proposal

In cross-border reorganizations, the boot-within-gain limitation under section 356(a)(2) can permit U.S. shareholders to repatriate property from their foreign subsidiaries with minimal or no U.S. tax consequences, even if the foreign subsidiaries have sufficient untaxed earnings and profits to treat the repatriated property as a dividend. To the extent the exchanging shareholder's stock in the target corporation has little or no built-in gain at the time of the exchange, the shareholder will recognize minimal gain even if the exchange has the effect of the distribution of a dividend and/or a significant amount (or all) of the consideration received in the exchange is boot. This result applies even if the acquiring corporation has previously untaxed earnings and profits equal to or greater than the amount of the boot.

The check-the-box regulations have enabled taxpayers more easily to avail themselves of this strategy. Making a check-the-box election to treat the target corporation as an entity disregarded as separate from the owner can convert what would otherwise have been a transfer taxable under section 304(a)(1) into an asset reorganization in which the taxable amount is limited under the boot-within-gain rule of section 356(a).

For example, assume that P, a U.S. domestic corporation, wholly owns CFC 1 and CFC 2. P's shares in CFC 1 have a tax basis of $400 and a FMV of $500. CFC 1 and CFC 2 each have previously untaxed E&P of $200 and $300, respectively. Assume CFC 2 purchases the shares of CFC 1 from P for $500 cash. If a check-the-box election is made to treat CFC 1 as a disregarded entity pursuant to the same plan in which CFC 1 is transferred to CFC 2 and if the other requirements for a reorganization are satisfied,419 the transaction is treated as a cross-border reorganization to which the boot-within-gain rule applies to limit taxable gain to $100 ($500 FMV less $400 tax basis). If a check-the-box election were not made for CFC 1, or CFC 1 were not otherwise liquidated, section 304(a)(1) would apply to the transaction and the $500 in cash would be treated as a dividend to the extent of the previously untaxed E&P of CFC 2 ($300) and then CFC 1 ($200). The example is illustrated below.




As illustrated above, in a transaction involving commonly-owned corporations, a taxpayer with nonpreviously taxed E&P in its CFCs may, at its option, prevent application of the section 304 requirement of full dividend inclusion to the extent of earnings and profits, and instead invoke the boot-within-gain limitation under section 356(a)(2), by choosing to liquidate the target corporation as part of the transfer. Therefore, eliminating the application of the boot-within-gain limitation in the case of any reorganization in which there is a foreign acquirer and in which the exchange has the effect of distribution of a dividend under section 356(a)(2) is consistent with the principle that previously untaxed earnings and profits of a foreign subsidiary should be subject to U.S. tax upon repatriation. It has been suggested that under present law, any previously untaxed earnings and profits not deemed distributed by virtue of the boot-within-gain limitation rule may, in certain circumstances, be preserved for future taxation.420

Comments provided to Treasury responding to preamble in proposed regulations

The limited comments provided to Treasury in response to its announcement in the preamble to the proposed regulations under section 367(a)(5) raise questions regarding the interaction of section 356(a)(2) with section 367(b) and other provisions. One commentator suggested two alternative views for consideration but only in the context of outbound reorganizations.421 The first is that, in certain cases, there may be no sufficiently compelling reason of international tax policy to require that the rules of section 356 be displaced by the section 367(b) rules in the context of an outbound asset reorganization. Considerations supporting this view include the fact that the treatment of any boot received in an outbound reorganization (at least in situations where there is an outbound transfer of United States property within the meaning of section 956(c) to a CFC) would need to be coordinated with the rules of section 956. In particular, to the extent that the outbound transfer of United States property would result in subsequent subpart F inclusions under section 951(a)(1)(B),422 the untaxed earnings and profits of the acquiring CFC would remain subject to U.S. taxation and, accordingly, there may be no compelling need to recharacterize the boot received pursuant to an outbound reorganization as a dividend. The same commentator noted also that, in other situations in which a U.S. parent disposes of its shares of a target corporation (excluding transfers to which section 304 applies), the U.S parent would be entitled to reduce the amount of gain realized on the sale by its basis. The commentator suggested that it is not clear why the presence of an outbound reorganization should displace this concept in favor of taxation of the non-previously taxed earnings of a foreign acquiring corporation. On the other hand, it could be argued that reorganization treatment is an exception to sale treatment, based in part on the concept of continuing ownership, thus justifying different treatment. If the closely held nature of the participants to these types of outbound transactions is a particular concern, the commentator suggested that concern could be addressed through more traditional means (e.g., a finding that the transaction lacked a business purpose).

The second alternative suggested by the same commentator is that, consistent with previously issued guidance under section 367(b) addressing cross-border reorganizations, section 367(b) should override section 356(a)(1) and require all boot received by a U.S. corporation in the context of an outbound asset reorganization to be subject to current U.S. federal income taxation without regard to the amount of gain realized by target shareholders. More specifically, all boot received in these types of reorganizations could be treated as a severable, pre-reorganization dividend from the foreign acquiring corporation.423

Another commentator suggested it would be inappropriate to issue guidance under section 367, because Congress has determined when gain shall be recognized and the amount of such gain constituting a dividend under section 356. This commentator also urged that any previously untaxed earnings and profits not deemed distributed by virtue of the boot-within-gain limitation rule will be preserved for future taxation, and any value attributable to the assets transferred will be maintained, suggesting that there has not been a constructive distribution.424

Scope of the proposal

A general premise of the transaction discussed above is that there is a foreign acquiring/transferee corporation that is acquiring the property of a target/transferor corporation (presumably foreign) from its U.S. parent in return for cash or other boot. By acquiring the other corporation's assets from its U.S. parent, the foreign acquirer is able to repatriate cash with little or no U.S. taxation under the boot-within-gain limitation of section 356(a). The proposal, however, also would apply to any other transaction under section 356(a)(1) where the exchange has the effect of a distribution of a dividend, as determined under section 356(a)(2). Thus, the proposal may apply to domestic-to-domestic reorganizations with a foreign shareholder where there may be the potential for withholding tax avoidance. Additionally, the proposal may also apply to domestic-to-domestic reorganizations with a U.S. shareholder, where there may be no withholding tax avoidance intended but where the proposal would increase the amount treated as a dividend. In those circumstances in which the U.S. shareholder is only entitled to a dividends received deduction of less than 100 percent, the result may be an increase in U.S. taxation.425

Other technical considerations

Under the proposal, if the boot received by any exchanging shareholder in a reorganization transaction or section 355 distribution, whether domestic or foreign, has the effect of a distribution of a dividend, then the amount treated as a dividend would not be limited to gain on the transaction. However, it is not clear to what extent the dividend treatment would otherwise be consistent with the rules for identifying and measuring nonreorganization dividends.

While the proposal is clear in its intent to repeal the boot-within-gain limitation under the aforementioned circumstances, it does not specifically discuss the manner in which the boot will be taxed to the extent it is not subject to the boot-within-gain limitation. As discussed above, section 356(a)(2) requires treating the gain as a dividend to the extent of accumulated earnings and profits with any additional gain being treated as gain from the exchange of property. Since the intent of the proposal is only to repeal the applicability of the boot-within-gain limitation rule and not the treatment of the transaction as one to which sections 354, 355 and 356 apply, one could conclude that section 356(a)(2) would still apply but would treat the entire amount of boot as a dividend to the extent of accumulated earnings and profits not limited by gain. To the extent the boot received exceeds the accumulated earnings and profits and there is any remaining gain realized, such gain would be recognized and treated as gain from the sale or exchange of property. To the extent there is any remaining boot over and above the gain, presumably it would be treated as a tax-free return of basis. Nonetheless, the intended treatment of this additional boot may require further clarification. In addition, consideration might be given to whether it would be desirable to more closely conform the treatment of dividends in reorganization transactions to the treatment of other dividends.

Another issue that may require clarification is the source of the accumulated earnings and profits from which the deemed dividend is generated under section 356(a)(2). As discussed above, conflicting positions exist under present law as to whether the accumulated earnings and profits taken into account should be that of both the transferor and acquiring corporation or, instead, be limited to only that of the transferor corporation. To the extent that the boot-within-gain limitation rule is repealed for such transactions, it will undoubtedly create more scenarios in which the boot amount will exceed the accumulated earnings and profits of either the transferor or acquiring corporation on a stand-alone basis. Therefore, additional guidance may be necessary to determine the source of any deemed dividend under section 356(a)(2). While one of the two approaches discussed above could be pursued, an alternative would be to adopt a rule similar to that which applies to boot received in an intercompany reorganizations within a consolidated group that would otherwise be covered under section 356(a)(2).426 Such a rule would require that the boot be taken into account after completion of the reorganization which would be based on the combined earnings and profits of the acquiring corporation and target corporation.427

In addition, as discussed above, there is a potential lack of clarity under present law whether a reference to "earnings and profits accumulated" includes current earnings and profits for the year of the distribution, and whether a limitation on the reduction of earnings and profits under section 312(n)(7) applies in the case of a reorganization distribution that is not treated as a dividend to the shareholder. Additional guidance may be desirable regarding these issues.

Finally, it can be argued that, while the repeal of the boot-within-gain limitation when there is a foreign acquiring corporation will limit the ability of taxpayers to repatriate earnings with little or no tax, it may have other unintended consequences that may be used affirmatively by taxpayers for planning purposes. By way of example, section 304 was enacted to prevent what were deemed to be abusive transactions by taxpayers to convert what would otherwise be dividends into capital gain transactions. Today, taxpayers typically only trigger section 304 when they are affirmatively using it for foreign tax credit and cash repatriation planning purposes. Depending on the manner in which the repeal of the boot-within-gain limitation rule is implemented, it may be expected that similar tax planning opportunities will arise (e.g., if the earnings and profits sourcing and ordering rules differ from those under section 304).


Prior Action

The President's fiscal year 2010 budget proposal contained a similar proposal, but limited that proposal to asset reorganizations involving a foreign acquiring corporation.

F. Reform U.S. International Tax System

1. Defer deduction of interest expense related to deferred income

Present Law

In general

The United States employs a "worldwide" tax system under which U.S. resident individuals and domestic corporations generally are taxed on all income whether derived in the United States or abroad. Income earned in the United States and foreign income earned directly or through a pass-through entity such as a partnership is generally taxed as the income is earned. By contrast, active foreign business earnings that a U.S. person derives indirectly through a foreign corporation generally are not subject to U.S. tax until such earnings are repatriated to the United States through a dividend distribution of those earnings to the U.S. person. This ability of U.S. persons to defer income is circumscribed by various regimes intended to restrict or eliminate tax deferral with respect to certain categories of passive or highly mobile income. One of the main anti-deferral regimes is the controlled foreign corporation ("CFC") regime of sections 951 - 965 (referred to generally as "subpart F").

The subpart F regime taxes on a current basis a 10-percent U.S. shareholder's pro rata share of certain earnings of a foreign corporation in which more than 50 percent of the vote or value of a foreign corporation, a CFC, is owned by 10-percent U.S. shareholders. The income to which the subpart F rules apply include foreign personal holding company income (e.g., certain dividends, interest, rents, and royalties) as well as foreign base company sales and services income which include sales and services income from certain related party transactions. Subpart F also generally requires current taxation of certain foreign earnings when a CFC invests its earnings in U.S. property.428

The subpart F regime does not apply to a foreign corporation that is not a CFC, even if the foreign corporation has one or more 10-percent U.S. shareholders (commonly referred to as a "10/50 company"). Unless the foreign corporation is taxable under one of the other anti-deferral regimes,429 the earnings of such a foreign corporation are generally taxable only upon distribution to the U.S. shareholder.

Deductibility of interest expense

As a general rule, there is allowed as a deduction all interest paid or accrued within the taxable year with respect to indebtedness.430 An exception to this general rule provides that interest on indebtedness incurred or continued in connection with the purchase or carrying of certain assets that generate tax-exempt interest or dividends is not deductible.431 In contrast to this exception for interest attributable to tax-exempt income, no similar rules apply to limit the ability of a U.S. taxpayer with foreign operations to deduct its interest expense currently. As a result, a U.S. taxpayer may claim a current deduction for interest expense that it incurs to produce tax-deferred income through a foreign subsidiary.

Allocation and apportionment of interest expense

For the purpose of computing the foreign tax credit limitation, a taxpayer must determine the amount of its taxable income from foreign sources. As part of this determination, the taxpayer must allocate and apportion deductions between U.S. -- source gross income and certain categories ("baskets") of foreign-source income (e.g., general limitation income and passive limitation income).

In the case of interest expense, the current rules generally are based on the concept that money is fungible, such that interest expense is properly attributable to all business activities and property of a taxpayer, regardless of any specific purpose for incurring a specific obligation on which interest is paid. For interest allocation purposes, all members of an affiliated group of corporations generally are treated as a single corporation (the so-called "one-taxpayer rule") and allocation must be made on the basis of assets, rather than gross income.432 An affiliated group in this context generally is defined by reference to the rules for determining whether corporations are eligible to file consolidated returns.433 As with the rules for filing a consolidated return, the definition of affiliated group for interest allocation purposes generally also excludes foreign corporations.434 Thus, while debt generally is considered fungible among the assets of a group of domestic affiliated corporations, the same rules do not apply between the domestic and foreign members of a group.

In applying the asset method of interest apportionment, the taxpayer must apportion interest expense between U.S. -- source income and the various baskets of foreign-source income based on the average total value of assets in each grouping for the year. For purposes of determining the value of its assets, the taxpayer may elect to value its assets based on (1) the tax book value method, (2) the alternative tax book value method, or (3) the fair market value method.435 The taxpayer then determines the average value for the year based on the beginning and end of the year asset values unless such an approach results in a substantial distortion of asset values.436

Regardless of the method elected to value the assets, the taxpayer must determine whether the assets generate U.S. -- source income, foreign-source income, or both. The Treasury regulations provide that the taxpayer must attribute assets to statutory groupings based on the source and type of income (e.g., manufacturing, sales, services, interest, and dividends) that the assets generate, have generated, or may be reasonably expected to generate.437 The taxpayer will categorize its assets into one of three categories. The first category of assets is single category assets that generate income that is exclusively within a single statutory or residual group (e.g., general limitation foreign-source income, passive limitation foreign-source income, or U.S.source income).438 The second category is composed of multiple category assets that generate income in more than one limitation category (e.g., U.S. manufacturing assets that produce export property that generates partly general limitation foreign-source income and partly U.S. -- source income under section 863(b)).439 The third category is composed of assets without an identifiable yield. These assets either produce no directly identifiable income or contribute equally to the generation of all the income of the taxpayer (e.g., overhead related assets) and are excluded from asset-based apportionment.440

After the taxpayer categorizes the assets for purposes of determining whether they generate U.S. -- source income or income in one of the baskets of foreign-source income, the taxpayer multiplies the apportionable interest expense by a ratio in which the numerator is foreign assets in each such group and the denominator is total domestic and foreign assets of the taxpayer (hereinafter "the foreign asset ratio"). The resulting interest expense apportioned to each basket of foreign-source income then reduces gross foreign-source income in that basket accordingly for purposes of determining the foreign tax credit limitation in that basket.441


    Banks, savings institutions, and other financial affiliates

The affiliated group for interest allocation purposes generally excludes "financial corporations."442 A financial corporation includes any corporation, otherwise a member of the affiliated group for consolidation purposes, that is a financial institution (described in section 581 or section 591), the business of which is predominantly with persons other than related persons or their customers, and which is required by State or Federal law to be operated separately from any other entity that is not a financial institution.443 The category of financial corporations also includes bank holding companies (including financial holding companies), subsidiaries of banks and bank holding companies (including financial holding companies), and savings institutions predominantly engaged in the active conduct of a banking, financing, or similar business.444

Instead of treating a financial corporation as a member of the regular affiliated group for purposes of applying the one-taxpayer rule to other nonfinancial members of that group, all such financial corporations that would be so affiliated are treated as a separate single corporation for interest allocation purposes.


    Worldwide interest allocation

The American Jobs Creation Act of 2004 ("AJCA")445 modified the interest expense allocation rules described above by providing a one-time election (the "worldwide affiliated group election") under which the taxable income of the domestic members of an affiliated group from sources outside the United States generally is determined by allocating and apportioning interest expense of the domestic members of a "worldwide affiliated group" on a worldwide-group basis (i.e., as if all members of the worldwide group were a single corporation).446 If a group makes this election, the taxable income of the domestic members of a worldwide affiliated group from sources outside the United States is determined by allocating and apportioning the third-party interest expense of those domestic members to foreign-source income in an amount equal to the excess (if any) of (1) the worldwide affiliated group's worldwide third-party interest expense multiplied by the ratio that the foreign assets of the worldwide affiliated group bears to the total assets of the worldwide affiliated group,447 over (2) the third-party interest expense incurred by foreign members of the group to the extent such interest would be allocated to foreign sources if the principles of worldwide interest allocation were applied separately to the foreign members of the group.448

    Financial institution group election

Similar to the general rules for allocating and apportioning interest expense that allow for treating financial corporations as members of a separate affiliated group, taxpayers are allowed to apply the bank group rules to exclude certain financial institutions from the affiliated group for interest allocation purposes under the worldwide affiliated group approach. The rules also provide a one-time "financial institution group election" that expands the bank group. At the election of the common parent of the pre-election worldwide affiliated group, the interest expense allocation rules are applied separately to a subgroup of the worldwide affiliated group that consists of (1) all corporations that are part of the bank group, and (2) all "financial corporations."449

    Effective date of worldwide interest allocation

The common parent of the domestic affiliated group must make the worldwide affiliated group election or financial institution group election where applicable. It must be made for the first taxable year beginning after December 31, 2020, in which a worldwide affiliated group exists that includes at least one foreign corporation that meets the requirements for inclusion in a worldwide affiliated group.450 Once the election is made, it applies to the common parent and all other members of the worldwide affiliated group or to all members of the financial institution group, as applicable, for the taxable year for which the election is made and all subsequent taxable years, unless revoked with the consent of the Secretary of the Treasury.

Description of Proposal

The proposal defers the deduction of interest expense that is properly allocated and apportioned to a taxpayer's foreign-source income that is not currently subject to U.S. tax. For purposes of the proposal, foreign-source income earned by a taxpayer through a branch is considered currently subject to U.S. tax; thus, the proposal does not apply to interest expense properly allocated and apportioned to such income. Other directly earned foreign-source income (for example, royalty income) is similarly treated.

For purposes of the proposal, the amount of a taxpayer's interest expense that is properly allocated and apportioned to foreign-source income is generally determined under current Treasury regulations. The Treasury Department, however, will revise existing Treasury regulations and propose such other statutory changes as necessary to prevent inappropriate decreases in the amount of interest expense that is allocated and apportioned to foreign-source income.

Under the proposal, deferred interest expense is deductible in a subsequent tax year in proportion to the amount of the previously deferred foreign-source income that is subject to U.S. tax during that subsequent tax year. Treasury regulations may modify the manner in which a taxpayer can deduct previously deferred interest expense in certain cases.

Effective date. -- The proposal is effective for taxable years beginning after December 31, 2010.


Analysis

Overview

The Administration states that the ability to deduct interest expense attributable to foreign investments while deferring U.S. tax on the income from the investments may cause U.S. businesses to shift their investments and jobs overseas, harming the domestic economy.451 To address this concern, the proposal eliminates a U.S. person's ability to deduct currently interest expense to the extent that it relates to foreign-source income on which U.S. tax is deferred. The deduction for such interest expense is deferred until the income to which it relates is subject to U.S. tax. By taking this approach, the proposal seeks to match more closely the timing of interest expense deductions with income inclusion.

The analysis that follows discusses: (1) the matching of the timing of interest expense recognition to the taxation of foreign source income sought by this proposal and whether it is appropriate from a policy perspective; (2) the effect of deferral on investment decisions at present and the impact this proposal may have on U.S. multinational corporations ("MNCs"); (3) the effect of deferral on residence choice and the impact this proposal may have; (4) the manner in which deferred interest expense will be determined under the proposal, and (5) certain technical considerations.

Matching

As noted above, the proposal seeks to more closely match the timing of interest expense deductions apportioned to foreign-source income with the recognition of such income. In this respect, the proposal is consistent with other Code provisions that require capitalization of costs, with recovery over a period of time to clearly reflect taxable income for a particular taxable year.452 The Supreme Court recognized this matching concept in INDOPCO, Inc. v. Commissioner, noting that "the Code endeavors to match expenses with the revenues of the taxable period to which they are properly attributable, thereby, resulting in a more accurate calculation of net income for tax purposes."453 Additionally, various provisions of the Code require matching of items of a similar character through the delay of otherwise deductible amounts to future years in which income is realized.454

By deferring the deduction for interest expense until the foreign-source income to which it relates is currently subject to U.S. taxation, such interest expense deductions arguably would be more closely matched with the revenues of the taxable period to which they are attributable, resulting in a more accurate calculation of taxable income for the taxable period. As discussed above in the present law section, the current rules for interest expense apportionment are based on the concept that money is fungible and require the use of an asset method for the allocation and apportionment of interest expense. Therefore, some may contend that any "matching" would lack the direct correlation of the related income and expense as is the case with other Code provisions that impose a matching requirement.

If the asset method of interest expense apportionment is used as a proxy for a true matching of interest expense to deferred foreign income, one commentator has suggested that the results may be harsh and excessive compared with a true application of the matching principle since the approach would not differentiate between taxpayers with deferred foreign income that are benefiting from deferral (i.e., as a result of the foreign tax rate on the deferred foreign income being lower the U.S. tax rate applicable to those earnings) and those taxpayers that are not benefiting from such deferral (i.e., as a result of their being little or no differential between the U.S. and foreign tax rate). To derive a better matching, the commentator suggests limiting the deferred interest expense deduction to the amount of interest expense attributable to deferred foreign income in a jurisdiction multiplied by a percentage equal to the excess of the U.S. statutory tax rate over the applicable foreign tax rate divided by the U.S. statutory tax rate.455 For example, if the deferred foreign income were in a CFC in Ireland where the statutory rate is 12.5-percent, the percentage of interest expense attributable to deferred foreign income at the Irish CFC that would be deferred would only be 64 percent ((35 percent - 12.5 percent)/35 percent).

While this modified approach to the interest expense deferral proposal may raise significant administrative concern (e.g., determining the applicable tax rates), its consideration has value at the conceptual level. Specifically, it highlights the point that policymakers may want to first consider whether more closely matching the timing of interest expense deductions with foreign income inclusions is the appropriate policy. If it is determined that this is the appropriate policy, consideration should then be given as to what is the best method to accomplish this matching.

Due to the lack of matching relating to the deduction of interest expense attributable to foreign income under present law, a U.S. MNC making an overseas investment may be in a better after-tax position as compared with a U.S. MNC making a similar U.S. domestic investment because of the deduction yielding low (and, in some cases, negative) effective tax rates on foreign income that is deferred for U.S. tax. An analogous situation arises in connection with the allocation of expenses between exempt and nonexempt income in a territorial tax system. This effect of failing to allocate expenses against exempt foreign-source income has been described as facilitating negative effective tax rates for overseas investments, by permitting taxpayers to earn income in low-tax foreign countries while claiming the related deductions in the United States.456 As a consequence, recent proposals for the adoption of an exemption system in the United States have stressed the increased importance of expense allocation rules and the need to ensure that expenses attributable to the production of exempt foreign income do not inappropriately reduce U.S. tax on domestic source or other nonexempt income.457

It is noteworthy that none of the jurisdictions that provide for either the deferral or exemption of active foreign subsidiary income (i.e., the other OECD member countries) have a rule that seeks to achieve a matching similar to this proposal that defers or disallows expenses, such as interest, attributable to deferred or exempt foreign income. As a result, if the proposal is enacted, some may argue the United States would move even further from international norms. Nonetheless, although other jurisdictions may not have expense disallowance regimes in place that specifically defer or disallow interest expense attributable to deferred or exempt foreign income, some do have regimes in place that limit the deductibility of interest attributable to cross-border activity that may approximate an impact similar to that of a regime that would defer or disallow expenses attributable to deferred or exempt foreign income.458 An example of such a regime is the United Kingdom's recently enacted worldwide debt cap limitation in conjunction with the enactment of a dividend exemption regime. This worldwide dept cap limitation restricts the deductibility of interest and other finance expense on intra-group debt of U.K. companies in cases in which the interest is found to be excessive by reference to such expense in the worldwide group.459 In addition, rather than formally implementing expense disallowance rules, some jurisdictions with territorial regimes (e.g., France, Germany and Japan) instead, provide less than a full dividend exemption (95 percent rather than 100 percent) as a proxy for taking into account expenses associated with the earning of exempt foreign income.460

Although the proposal may make investment in foreign jurisdictions less attractive, to the extent a U.S. MNC undertakes that investment, the U.S. MNC will face the same general barrier to repatriating earnings that it faces under present law --it will be subject to residual U.S. tax on those earnings, subject to possible reduction by a foreign tax credit. Nonetheless, a U.S. MNC may be encouraged to repatriate earnings under the proposal if doing so would allow the taxpayer to take foreign-related interest deductions that previously had been deferred. If, however, the proposal is analyzed in combination with the Administration's proposal to determine the amount of the foreign tax credit on a blended basis (described below), in some circumstances taxpayers may face a greater tax burden on repatriation than they do under present law.461

Effect of deferral on investment decisions


    Comparison of U.S. MNCs to domestic taxpayers

When evaluating the aspects of present law that permit a U.S. MNC to defer from U.S. taxation active foreign earnings of its foreign subsidiaries, some may believe it is most appropriate to consider the ability of a U.S. MNC to defer the U.S. taxation of income earned in connection with a foreign investment opportunity as compared to that of another U.S. taxpayer that invests only in the United States.462

The principal advantage of deferral, when comparing one U.S. taxpayer's foreign investment opportunity to another U.S. taxpayer's domestic investment opportunity, is the ability to retain and invest low-taxed earnings in a foreign subsidiary on a pre-U.S. tax basis. Suppose that a U.S. taxpayer in the 35-percent tax bracket is considering whether to make an investment in an active enterprise in the United States or in an equivalent investment opportunity in a country in which the income tax rate is zero. Assume the U.S. taxpayer chooses to make the investment in the foreign country through a CFC that earns $100 of active income today, and the U.S. taxpayer defers that income for five years by re-investing it in the CFC. Assume further that the CFC can invest the money and earn a 10-percent return per year, and the income earned is not subject to foreign tax and nor does it generate subpart F. The taxpayer would then have $161.05 and pay tax of $56.37 on repatriation, for an after-tax income of $104.68.

If, instead, the U.S. taxpayer pursues the equivalent investment opportunity in the United States, such an investment will not be eligible for deferral. As a result, the taxpayer receives $100 in income today, pays tax of $35, and has only $65 to invest. The taxpayer invests that amount at an after-tax rate of 6.5 percent (this is a 10-percent pre-tax rate less 35 percent tax on the earnings each year). At the end of five years, this taxpayer will have only $89.06. The result is that the foreign investment option to defer the income for five years (and whose deferred income in turn compounded at 10-percent per year) is greater by $15.62 in economic wealth (or 64.9 percent higher) than the domestic investment option that would require the taxpayer to pay tax on the income immediately (and whose after-tax income thus compounded at just 6.5 percent per year). As a result, the foreign investment would be the preferred choice (all else being equal).

The disparity in after-tax effects described above means that there may be foreign investments that earn less on a pre-tax basis than an investment in the United States, but may, nonetheless, result in a greater return on an after-tax basis. Thus, deferral may distort the investment choice when it creates an incentive to choose an overseas investment that yields a lower pre-tax rate of return over a domestic investment that yields a higher pre-tax rate of return. When the lower earning investment is chosen, society as a whole loses the opportunity for greater total income. Economists label such an outcome a social welfare loss from an inefficient allocation of investment.

Generally, the greater the foreign effective marginal tax rate, the closer the rate of return on the investment must be to the rate on the U.S. investment to yield a superior after-tax return. As the foreign tax rate approaches the U.S. tax rate, the distortion approaches zero. However, the longer the residual U.S. income tax is deferred, the less the foreign investment has to earn relative to a U.S. -- based investment and the greater the distortion.463

While there are many nontax motivations for foreign direct investment, if a taxpayer has made an investment abroad and that investment is in a country with a tax rate lower than that of the United States, this may create a second-order distortion in that it can be to the taxpayer's advantage to attribute as much income as possible to that investment in order to exploit the possible benefit of deferral. This may put pressure on the determination and administration of transfer pricing rules.464

By deferring the deduction of interest expense related to tax-deferred foreign income, the proposal would eliminate the reduction of effective tax rates on foreign investment currently available under present law due to the allowance of current deductions for interest expense attributable to such deferred foreign income. To the extent that differentials between effective tax rates on foreign investment and on U.S. investment are reduced, the distortion of the choice of where to invest, the United States or abroad, and the related second-order distortions may be reduced.

If the proposal has the effect of reducing incentives to invest abroad rather than in the United States, it is possible that investment in the United States by U.S. taxpayers may increase. However, empirical research has not produced definitive conclusions about the effect of foreign direct investment on U.S. labor productivity, wages, and aggregate national income.465

Proponents of this proposal may point to the above example as illustrating how present law provides inequitable treatment favoring U.S. MNCs that invest abroad over U.S. domestic taxpayers with only domestic investments. This argument, however, assumes that the foreign investment is profitable and that it is subject to a tax rate that is less than the U.S. tax rate.466

Others may challenge the general premise that pre-tax returns on overseas investment options will generally be lower than comparable domestic investment options. Arguably, for U.S. MNCs in relatively mature U.S. markets, there may be more opportunities for higher pretax rates of return abroad than in the United States where there may be less competition. Furthermore, for those U.S. MNCs, the only significant investment opportunities may be in foreign markets because comparable domestic markets have been saturated.

In general, the tax analysis described above may be only part of a broader evaluation that U.S. firms engage in when considering whether to invest in the United States or abroad. There are many reasons that may motivate a U.S.MNC to make an outbound foreign direct investment. Building a plant abroad may be the most cost efficient way for a U.S. MNC to gain access to a foreign market. Trade barriers or transportation costs could make it prohibitively costly to serve the foreign market via direct export from a U.S. location. Foreign direct investment may put the U.S. MNC physically closer to its customers, allowing better customer service and providing a better understanding of the foreign market, which can serve as the basis for improved future marketing of goods and services. A U.S. MNC may make an outbound foreign direct investment to lower operating costs by exploiting less expensive, or more skilled, foreign labor, less expensive access to important raw materials or components from suppliers, or to permit operation in a less burdensome regulatory environment. In addition, foreign direct investment may provide access to foreign-developed technology.

The relative importance of tax and nontax considerations may vary among different kinds of investments. Mobile investments requiring relatively low expenditures on tangible capital or labor, including investments in intellectual property, may be more sensitive to tax rates than investments in plants and other operations that are closely tied to the economic environments in the localities in which those investments are made.


    Comparison of U.S. MNC taxpayers to foreign MNCs

Others may believe that the proposal should, instead, be evaluated by comparing the tax treatment of a U.S. MNC considering a foreign investment to that of a foreign MNC evaluating a similar investment in a third country (i.e., not the country in which the foreign investor is tax resident).467 In making this comparison to foreign MNCs resident in countries that provide for the exemption of active foreign subsidiary income, it is argued that the ability of a U.S. MNC to defer U.S. taxation of active overseas earnings should not be viewed as a competitive advantage. Rather, they argue the ability of a U.S. MNC to defer U.S. taxation of active foreign earnings is a critical factor in allowing the U.S. MNC to compete with a foreign competitor based in a jurisdiction that has a territorial or exemption regime that exempts active foreign subsidiary income from taxation.

Advocates of this perspective note that, of the 30 countries that make up the Organisation for Economic Cooperation and Development (the "OECD"), 25 now have territorial tax systems, including Japan and the United Kingdom which were added to this list in 2009.468 Thus, only four OECD countries, other than the United States, have worldwide tax systems (Ireland, Korea, Mexico and Poland). Unlike the United States, these four jurisdictions have significantly less outbound foreign direct investment and relatively low statutory corporate tax rates (an unweighted average of 20.9 percent in 2009).469 They may argue the United States is already an outlier with its present regime of worldwide taxation with deferral for U.S. taxpayers. They maintain that residual U.S. taxation on foreign earnings puts a U.S. MNC in a worse position relative to a foreign competitor based in a country with an exemption regime. Consequently, any proposal that increases U.S. residual taxation only enhances this disadvantage.

Arguably, this proposal may have an impact similar to a partial repeal of deferral for U.S. corporate taxpayers to the extent they have significant U.S. debt. Hence, this may lead some to raise concerns as to how the proposal will affect the competitiveness of U.S. MNCs. Although these competitiveness arguments have been espoused in different ways, the fundamental aspects of the arguments have a common thread focusing on how a proposal to repeal deferral will increase the cost of capital to U.S. MNCs. Consider a U.S. MNC that is subject to tax in the United States at a 35-percent rate on the worldwide income it earns directly, as well as on its active foreign income when repatriated, and a foreign MNC that is resident in a jurisdiction that exempts from taxation active foreign income upon its repatriation. Assume the corporate income tax rate everywhere outside the United States is 25 percent. The income of the foreign MNC from operations in the United States is taxed at the prevailing U.S. corporate income tax rate, 35 percent, as is the income earned by the U.S. MNC. On the other hand, the income earned by the foreign MNC from operations outside the United States is taxed at 25 percent. Under present law, the U.S. MNC arguably may achieve a similar result through deferral.

Absent deferral, however, the income earned by the U.S. MNC from operations in the United States would continue to be taxed at the prevailing U.S. corporate tax rate, generally 35 percent, and the income earned by the U.S. MNC from operations outside the United States would also be taxed at 35 percent. All else being equal, the foreign MNC may have a higher after-tax return than the U.S. corporation. Shareholders, regardless of residence, may view the shares of the foreign MNC as more valuable, because the foreign MNC could pay higher dividends from its after-tax income.470 As a result, the foreign MNC may have a greater ability to raise capital and that could affect whether the U.S. corporate taxpayer or its foreign competitor wins a competitive bid. If capital investment is shifted from U.S. MNCs to foreign MNCs (e.g., U.S. persons buying shares in foreign-headquartered firms as opposed to U.S. -- headquartered firms), some argue this could lead to (1) U.S. MNCs having greater difficulty growing; (2) foreign competitors of U.S. MNCs gaining market share and other business advantages by virtue of being the first to market in certain sectors; and (3) U.S. MNCs becoming more attractive acquisition targets for foreign acquirers to the extent that U.S. MNCs can only capitalize on their global synergies at higher costs due to the U.S. tax on foreign investment.471

If the proposal were enacted, in the short run a U.S. MNC would, in general, have two options: (1) continue to defer its overseas active earnings and forgo the portion of the interest expense deduction attributable to the deferred foreign income resulting in an increase in its U.S. tax liability (35 percent multiplied by the forgone current deduction); or (2) repatriate the overseas active earnings and subject such earnings to full U.S. taxation (with offset for a foreign tax credit, as limited) so that it can continue to deduct fully its U.S. interest expense. Perhaps for this reason, some suggest that the proposal should only be considered in the context of broader corporate international tax reform.472

Proponents of this proposal may, however, challenge this general assertion that there is a competitiveness problem stemming from the current U.S. international tax regime that would be further exacerbated by this proposal. They may point to the successes of U.S. MNCs in foreign markets and that the lack of empirical data supporting such competitiveness concerns makes these arguments questionable. Moreover, if there are issues of competitiveness in certain U.S. industries, they may challenge the assertion that these issues are primarily attributable to U.S. international tax policy rather than labor cost differentials, product quality differences, regulatory differences, and other nontax factors.473

Effect of deferral on residence choice

The U.S. tax treatment of a multinational corporate group depends significantly on whether the top-tier "parent" corporation of the group is domestic or foreign. For purposes of U.S. tax law, a corporation is treated as domestic if it is incorporated under the laws of the United States or of any state. All other corporations (i.e., those incorporated under the laws of foreign countries) are generally treated as foreign. Only U.S. corporations are subject to U.S. tax on a worldwide basis. Foreign corporations are taxed only on income that has sufficient nexus in the United States. As a result, present law contains powerful tax incentives for a new firm to opt out of U.S. residence for its top-tier entity.

These tax incentives may lead to an economic distortion that consists of two components. First, an enterprise that in the absence of the prevailing tax policy would have naturally chosen to incorporate in the United States chooses to incorporate elsewhere. This decision creates a "second order" distortion in that, by incorporating outside the United States, the U.S. tax base is not enhanced by tax on the enterprise's future earnings. The impact of this economic distortion on the U.S. tax base may result in higher taxes elsewhere in the economy. Increasing other taxes will increase the economic distortions inherent in those other taxes.

To the extent the proposal increases the effective U.S. tax rate on foreign investment by U.S. firms, firms with U.S. and overseas operations will have an added incentive to conduct their overseas operations not through foreign subsidiaries of U.S. domestic corporations but instead through firms that are owned by foreign persons.474 If this incentive were strong, it would be possible that over time, the only significant business operations carried out through U.S. -- headed firms would be U.S. business operations dealing directly with unrelated U.S. customers. Assuming, however, that anti-inversion rules are effective, existing U.S. firms may be limited in their ability to migrate their existing operations into foreign-headed firms, as the U.S. anti-inversion rules would either prevent the successful migration of these operations or require these U.S. firms to incur significant tax costs to accomplish the migration.475 Consequently, if the proposal increases the incentive to conduct foreign operations through foreign-headed groups, a possible scenario would be that existing U.S. -- headed businesses would remain U.S. -- owned (or be acquired by foreign firms) and new foreign business operations would be organized with foreign corporations as the parent entities. Under this scenario, the proposal would impose additional U.S. tax on existing capital investment but, over time, would fail to capture returns from new capital investment in foreign business operations.

Nonetheless, as discussed above in the context of competitiveness, it may be argued that the existing U.S. worldwide tax regime has long created a disincentive to conduct foreign operations through U.S. -- headed firms. In spite of this disincentive -- which predated and served as the impetus for the enactment in AJCA of the anti-inversion rules -- U.S. MNCs have accounted and still account for a significant portion of cross-border economic activity.476 A possible explanation is that nontax reasons for organizing global operations under a U.S. parent corporation dominate the tax consequences of such a structure. Regardless, if, in response to the proposal, firms conduct new foreign operations through entities organized in foreign jurisdictions, this may not be so much an argument against the proposal as it may be a suggestion of the malleability of corporate residence based on the U.S. place-of-incorporation rule.477

To the extent the proposal has the effect of encouraging new foreign business operations to be conducted through foreign-headed rather than U.S. -- headed firms, this effect could be exacerbated if the proposal were enacted in combination with other Administration proposals such as the proposals to determine the foreign tax credit on a blended basis and to tax currently excess returns associated with transfers of intangibles offshore.


    Determination of interest expense to be deferred

Analysis of this proposal requires consideration of the methodology to determine the portion of interest attributable to foreign income not currently subject to U.S. tax as well as the pool of earnings that will be considered as not currently subject to U.S. tax. The proposal anticipates using current Treasury regulations, with some modifications, for the purpose of allocation and apportionment of interest expense between currently taxed and noncurrently taxed foreign-source income. As to the pool of earnings considered not currently subject to U.S. tax, the proposal states that it would defer interest expense attributable to a taxpayer's foreign source income that is not currently subject to U.S. tax suggesting that the pool of applicable earnings includes both the earnings of CFCs and 10/50 companies attributable to the taxpayer.

    Use of existing Treasury regulations for interest allocation and apportionment

The proposal places a greater emphasis on the location of borrowing and, arguably, would have a disproportionate effect on U.S. MNCs that have relatively high degrees of U.S. borrowing to fund offshore operations, most notably firms in the financial sector. Under present law, a U.S. MNC, all else being equal, can choose to locate its borrowing in the country where the interest expense deduction will produce the largest tax benefit, i.e., the country with the highest tax rate and the fewest restrictions on deductibility. As previously discussed, the fact that a U.S. MNC can claim a current U.S. tax deduction for borrowing to invest in low-taxed countries increases the after-tax return of those investments above their pre-tax returns, a result that some believe may encourage investments that would not otherwise be made.

The proposal arguably may result in an overcorrection, however, since the worldwide interest allocation rules do not take effect until 2021. As noted above, under present law, interest expense is generally allocated and apportioned based on the taxpayer's ratio of foreign or domestic (as applicable) assets to its worldwide assets, with all members of an affiliated group of corporations (excluding foreign corporations) treated as a single corporation for determining apportionment ratios.478 As a result, the allocation under present law does not take into account the extent to which foreign members of the group may have borrowed outside the United States to finance their own operations. Instead, the present rules assume that debt incurred by U.S. group members disproportionately funds the operations of foreign subsidiaries and over-allocates interest expense to foreign-source income (an effect commonly referred to as "water's edge fungibility"). The effect of these rules is to understate the taxpayer's foreign tax credit limitation in circumstances where the taxpayer has significant borrowing at its foreign subsidiaries.

As the proposal is silent on the treatment of other provisions of the Code, it is reasonable to conclude that the proposal assumes that the worldwide interest allocation rules would take effect in 2021 as provided in present law. Until such time, however, the over allocation of interest expense to foreign source income under the present "water's edge" allocation rules would result in overstatement of the amount of interest expense subject to deferral í an effect that could be more costly than understatement of the foreign tax credit limitation if the taxpayer's offshore investments are located in relatively low-tax countries.

Opponents of the proposal argue that the magnitude of interest expense that may be properly allocated and apportioned to deferred foreign income under current Treasury regulations could result in the shifting of not only debt but also jobs offshore. To the extent taxpayers can refinance their existing third-party obligations by replacing debt of the U.S. group with new debt at its CFCs, such a strategy may reduce the interest expense deferred under "water's edge" interest apportionment. Furthermore, to the extent a U.S. taxpayer's foreign asset ratio under the interest apportionment rules is expected to be significant, some contend that a taxpayer planning to build a new manufacturing facility may be compelled to finance and build the new facility overseas to avoid the increase to its cost of capital that may otherwise result from its inability to deduct currently the entire interest expense properly attributable to the expansion.479 The ability and desire to pursue either course of action, however, may also be affected by nontax factors, including increased borrowing costs for foreign borrowing, the availability of cash flow to service such debt, access to qualified employees, proximity to suppliers, and proximity to customers.

The proposal contemplates that current Treasury regulations apply to determine the amount of a taxpayer's interest expense to be allocated and apportioned to foreign-source income. Although not explicitly stated, the proposal would seem to look to present-law regulations to determine the amount of such foreign-source interest expense to be allocated between currently taxed foreign-source income and noncurrently taxed foreign-source income. Applying the current Treasury regulations may be a logical approach given that the methodologies therein are well known and would ensure consistency with the approach taken for sourcing interest expense for purposes of the foreign tax credit limitation.

Nonetheless, the proposal clearly anticipates changes to the existing regulations "as necessary to prevent inappropriate decreases in the amount of interest expense that is allocated and apportioned to foreign-source income." This language suggests that the Administration believes that taxpayers may be engaging in strategies that, in Treasury's view, may under allocate interest expense to foreign-source income for purposes of determining the foreign tax credit limitation.480 To the extent that this proposal is acted on by Congress in a manner that contemplates use of the existing Treasury regulations, it may be appropriate at such time to perform a broader review of these regulations and modify them as necessary to help ensure they reach a result that is neither over-or under-inclusive when used to determine the interest expense attributable to deferred foreign income.


    Inclusion of 10/50 company earnings

The proposal does not distinguish between the deferred foreign income of CFCs and that of 10/50 companies. Some may question the appropriateness of including the earnings of 10/50 companies because the U.S. shareholders of 10/50 companies are, by definition, minority shareholders that may have little control over the decision to repatriate earnings.481

    Technical considerations

The proposal acknowledges that foreign-source income earned by a taxpayer through a branch as well as other directly earned foreign-source income, such as royalty income, is currently subject to U.S. tax. Therefore, the proposal does not apply to interest expense properly allocated and apportioned to such income. Allowing a current deduction for interest expense allocated to income subject to current U.S. taxation is appropriate as it follows the basic policy rationale of the proposal -- to match the timing of expense recognition and income inclusion.482

The proposal does not explicitly address subapportionment of foreign-source income between foreign-source income that is currently subject to U.S. tax and income that is not currently subject to U.S. tax. However, this subapportionment arguably may be accomplished with only minor modification to the current Treasury regulations. For example, once the taxpayer determines the amount of foreign-source interest expense that is attributable to its investment in includable foreign subsidiaries (i.e., CFCs and 10/50 companies to the extent applicable), such foreign-source interest expense could then be allocated between currently taxed foreign income and deferred foreign income based on a ratio of distributed to undistributed nonpreviously taxed earnings and profits ("E&P").

For purposes of determining the amount of interest expense previously deferred that would be deductible in a subsequent tax year, the proposal states that the amount deductible will be in proportion to the amount of the previously deferred foreign-source income that is subject to U.S. tax during that subsequent year.

The proposal leaves certain technical questions unresolved. For example, the proposal does not address how foreign-source income on which U.S. tax is deferred should be computed. While the universe of foreign-source income on which U.S. tax is deferred for purposes of this proposal would presumably include the nonpreviously taxed earnings of a CFC or 10/50 company, it is unclear whether such nonpreviously taxed earnings would be determined on a consolidated basis, with elimination of the effects of intercompany transactions, or as the sum of separately computed company results. Implicit in this question are technical issues such as the treatment of transactions between two foreign subsidiaries for purposes of determining the earnings of each that are includible as foreign subsidiary income not currently subject to tax, and the treatment of deficits, including whether the earnings deficit of one foreign subsidiary should offset the positive earnings of other foreign subsidiaries.483

Other technical considerations not addressed by the proposal include the need for currency translation rules for determining the nonpreviously taxed CFC and 10/50 corporation earnings on which U.S. tax is deferred, and whether the earnings of entities below the sixth tier that are not included in the section 902 qualified group should be excluded from the computation of foreign-source income on which U.S. tax is deferred.484

Tax reporting requirements would also necessarily increase under the proposal. Under present law, annual information reporting relating to E&P is required only with respect to CFCs. Under the proposal, however, the E&P of every CFC and 10/50 company could affect the computation of interest that must be deferred as a result of being attributable to foreign-source income not currently subject to U.S. tax, regardless of the amount of actual or deemed distributions. Thus, it likely will be necessary to provide for additional information reporting with respect to 10/50 companies so that the IRS can verify the accuracy of this computation.

Moreover, although E&P and foreign tax information with respect to 10/50 companies is already required under present law to compute deemed-paid credits, apply the look-through rules to dividends paid by 10/50 companies, and, in many cases, to apportion interest expense in calculating the foreign tax credit limitation,485 this information can be difficult to obtain if U.S. shareholders do not control the company. Under existing Treasury regulations, a U.S. shareholder must track E&P and foreign tax information for a CFC or 10/50 company beginning only with the first taxable year in which the computation of E&P is significant for U.S. tax purposes with respect to its controlling domestic shareholder.486 Under present law, this computation often is not significant until the controlling domestic shareholder is required to include income in respect of the CFC or 10/50 company. However, as E&P might be a key component in the computation of the interest deductions attributable to foreign-source income on which U.S. tax is deferred, this information could be significant under the proposal for all CFCs and 10/50 companies every tax year.


Prior Action

A similar proposal was included in the President's fiscal year 2010 budget proposal. The prior proposal would have applied more broadly to defer deductions for expenses (other than research and experimentation expenditures) of a U.S. person that are properly allocated and apportioned to foreign-source income to the extent the foreign-source income associated with the expenses is not currently subject to U.S. tax.

2. Determine the foreign tax credit on a pooling basis


Present Law

The United States employs a "worldwide" tax system under which U.S. resident individuals and domestic corporations generally are taxed on all income, whether derived in the United States or abroad; the foreign tax credit provides relief from double taxation. Subject to the limitations discussed below, a domestic corporation is allowed to claim a credit against its U.S. income tax liability for the foreign income taxes that it pays. In addition, a domestic corporation that owns at least 10 percent of the voting stock of a foreign corporation is allowed a "deemed-paid" credit for foreign income taxes paid by the foreign corporation that the domestic corporation is deemed to have paid when the related income is distributed or is included in the domestic corporation's income under the provisions of subpart F.487

A foreign tax credit is available only for foreign income, war profits, and excess profits taxes, and for certain taxes imposed in lieu of such taxes. Other foreign levies generally are treated as deductible expenses. Treasury regulations under section 901 provide detailed rules for determining whether a foreign levy is a creditable income tax. In general, a foreign levy is considered a creditable tax if it is substantially equivalent to an income tax under U.S. tax principles. Under the present Treasury regulations, a foreign levy is considered a tax if it is a compulsory payment under the authority of a foreign country to levy taxes and it is not compensation for a specific economic benefit provided by a foreign country.488

The foreign tax credit generally is limited to a taxpayer's U.S. tax liability on its foreign-source taxable income (as determined under U.S. tax accounting principles).489 This limit is intended to ensure that the credit serves its purpose of mitigating double taxation of foreign-source income without offsetting U.S. tax on U.S. -- source income. The limit is computed by multiplying a taxpayer's total U.S. tax liability for the year by the ratio of the taxpayer's foreign-source taxable income for the year to the taxpayer's total taxable income for the year. If the total amount of foreign income taxes paid and deemed paid for the year exceeds the taxpayer's foreign tax credit limitation for the year, the taxpayer may carry back the excess foreign taxes to the previous taxable year or carry forward the excess taxes to one of the succeeding 10 taxable years.490

The U.S. foreign tax credit limitation provisions include rules that restrict availability of the credit in order to preserve the U.S. tax base. In its most restrictive (or theoretically purest) form, the limitation would function on an item-by-item basis, so that foreign tax imposed on any item of income could offset only the U.S. tax on that item. Historically, however, the limitation rules have operated instead with respect to more administrable groupings of similar items of income.491

The present foreign tax credit limitation is generally applied separately for income in two different categories (often referred to as "baskets"), passive basket income and general basket income.492 Passive basket income generally includes investment income such as dividends, interest, rents, and royalties.493 General basket income is all income that is not in the passive category. Because the foreign tax credit limitation must be applied separately to income in these two baskets, credits for foreign tax imposed on income in one basket cannot be used to offset U.S. tax on income in the other basket.

Income that would otherwise constitute passive basket income is treated as general basket income if it is earned by a qualifying financial services entity (and certain other requirements are met).494 Passive income is also treated as general basket income if it is high-taxed income (i.e., if the foreign tax rate is determined to exceed the highest rate of tax specified in section 1 or 11, as applicable).495 Dividends (and subpart F inclusions), interest, rents, and royalties received from a controlled foreign corporation ("CFC") by a U.S. person that owns at least 10 percent of the CFC are assigned to a separate basket by reference to the basket of income out of which the dividend or other payment is made.496 Dividends received by a 10-percent domestic corporate shareholder from a foreign corporation that is not a CFC are also categorized on a look-through basis.497

Under the present two-basket system, unintended opportunities exist with respect to general basket income of different types and from different countries to maximize one's credit. Thus, tax on income from a high-tax country in one basket can be credited against U.S. tax on income in the same basket derived in a low-tax jurisdiction. Moreover, the general basket encompasses a wide variety of types of active business income that may be taxed at very different effective rates í even within the same country.


Description of Proposal

Under the proposal, a U.S. corporate taxpayer determines its deemed-paid foreign tax credit on a consolidated manner based on the aggregate foreign taxes and earnings and profits ("E&P") of all of the foreign subsidiaries with respect to which the U.S. taxpayer can claim a deemed-paid foreign tax credit (including lower-tier subsidiaries described in section 902(b)). The deemed-paid foreign tax credit for a taxable year is determined based on the amount of the consolidated E&P of the foreign subsidiaries repatriated to the U.S. taxpayer in that taxable year. The Secretary is granted authority to issue any Treasury regulations necessary to carry out the purposes of the proposal.

Effective date. -- The proposal is effective for taxable years beginning after December 31, 2010.


Analysis

Background

If business income is taxed in the country in which it is derived (the source country), the residence country has two broad options for relieving potential double taxation on the foreign business income of its domestic taxpayers -- exempt foreign-source income from home country taxation (an exemption or "territorial" system) or tax foreign-source income but provide a credit against home country taxation for foreign tax paid on that income (a "worldwide" system).498 The United States has a worldwide system, although the U.S. tax on active foreign earnings derived through foreign subsidiaries is generally deferred until the earnings are repatriated in the form of a dividend distribution. As discussed above, the United States grants a credit (subject to limitations) for foreign taxes paid on foreign earnings, both directly by the domestic taxpayer (for example, on the income of a foreign branch) and indirectly by a foreign subsidiary, to the extent the subsidiary's earnings are distributed.499

The basic structure of the U.S. rules reflects several competing considerations. The first, reflected in the general rule of worldwide taxation and the granting of the foreign tax credit, is to ensure that a taxpayer's choice whether to invest in the home country or abroad is not affected by tax considerations. Thus, for instance, if the U.S. tax rules were completely neutral, those rules would not affect a U.S. multinational corporation's decision whether to invest in the United States or in a foreign jurisdiction.500

Complete neutrality would require, however, both an unlimited foreign tax credit and full inclusion of all foreign earnings. Assume, for example, that a U.S. multinational corporation has operations in the United States and Country A. For simplicity, assume initially that the corporation carries out its Country A operations directly through a branch rather than through a CFC. The corporation has $1 million of U.S. -- source income and $1 million of Country A-source income, for total worldwide income of $2 million. Assume the U.S. tax rate is 35 percent, and the Country A tax rate is 50 percent. The U.S. tentative tax liability, before taking into account the foreign tax credit, is $700,000 (35 percent of $2 million). The Country A tax liability is $500,000 (50 percent of $1 million). An unlimited foreign tax credit would allow the corporation a credit against its tentative U.S. tax liability for the entire $500,000 Country A tax. After this $500,000 credit, the corporation would pay $200,000 in U.S. tax and $500,000 in Country A tax, for a total tax liability of $700,000 on $2 million of worldwide income. As a result of this full foreign tax credit, the U.S. corporation would be subject to tax on its worldwide income at the U.S. 35-percent rate. The corporation would be in the same position it would have been in had its income been entirely U.S-source.

An unlimited foreign tax credit, however, would permit U.S. taxpayers to use the credit to offset U.S. tax on U.S., rather than foreign, source income. In the example above, the U.S. tax on Country A-source income is $350,000 (35 percent of $1 million). An unlimited foreign tax credit for the $500,000 of Country A tax would permit the corporation to eliminate this $350,000 of U.S. tax on Country A-source income and an additional $150,000 of U.S. tax on U.S. -- source income. Stated differently, if the United States allowed an unlimited foreign tax credit, other countries could increase their tax rates on U.S. taxpayers' earnings in those countries without increasing those taxpayers' worldwide tax burdens; the only party made worse off would be the U.S. fisc. If, for instance, in the example above Country A raised its tax rate on U.S. corporations investing in Country A to 70 percent, the corporation with $1 million of Country A-source income would pay $700,000 of Country A tax, would eliminate entirely its U.S. tentative tax liability of $700,000, and would have $700,000 of worldwide (Country A) tax liability, the same amount of tax it would be liable for had it invested only in the United States.

The foreign tax credit limitation of present law preserves the U.S. tax base by allowing the foreign tax credit in broad terms to offset only U.S. tax on foreign-source income.501 Thus, in the preceding example, present law permits the corporation to credit only $350,000 of Country A tax (the U.S. 35-percent tax rate multiplied by the corporation's $1 million of Country A-source income) against its tentative U.S. tax liability of $700,000. After the $350,000 foreign tax credit, the corporation has a worldwide tax liability of $850,000, comprised of $500,000 of Country A tax and $350,000 of U.S. tax. The corporation pays tax on its Country A-source income at the Country A tax rate -- $500,000 of tax is 50 percent of $1 million of income -- and its overall tax rate on its worldwide income, 42.5 percent, is higher than the 35-percent rate that would have applied if all of its income had been U.S. -- source.

Given the absence of an unlimited foreign tax credit, a taxpayer that invests abroad in a high-tax jurisdiction may pay a higher rate of tax on its worldwide income than it would pay if it operated only in the United States. As discussed above, complete neutrality would require not only an unlimited foreign tax credit, but would also require that the foreign business income of U.S. taxpayers be subject to full U.S. taxation as the income is earned. In fact, however, U.S. taxation of foreign business income derived through foreign subsidiaries is delayed until the income is paid to the U.S. parent corporation. A U.S. multinational corporation deriving income in a foreign jurisdiction effectively pays tax on that income at the foreign tax rate if it has the ability to keep the earnings offshore, indefinitely deferring U.S. tax. Thus, a taxpayer that invests abroad in a low-tax jurisdiction may pay a lower rate of tax on its worldwide income than it would pay if it operated only in the United States.

The basic construct of the U.S. international tax regime has remained the same since the 1960s. Three relatively new features of the current rules -- the explicitly elective (or "check-the-box") entity classification rules promulgated in 1997, the CFC look-through rules enacted in 2006, and the existence of only two foreign tax credit limitation categories effective in 2007 -- facilitate the selective repatriation of both earnings and foreign taxes in a manner designed to increase available foreign tax credits after the operation of the foreign tax credit limitation. A simple strategy to reduce taxes by using foreign tax credits might involve, for example, repatriating highly-taxed foreign earnings and using credits generated by this highly-taxed income to offset U.S. tax on other lightly taxed foreign income (so-called "cross-crediting"). More complex credit utilization strategies involve the use of hybrid entities to separate foreign tax credits from the related, deferred foreign-source income, or to create foreign tax credits with respect to income that is not taxable in the United States, to use those credits to shelter other currently taxable foreign-source income. In addition, the availability of hybrid entities has facilitated avoidance of the anti-deferral rules in connection with certain foreign tax minimization strategies that enhance the benefits of deferral. Some commentators have argued that as a result of deferral and selective repatriation strategies, some U.S. taxpayers may have a lower worldwide tax burden than they would have if the United States adopted an exemption system.502

Overview

The proposal limits opportunities for selective cross-crediting of foreign subsidiary taxes by establishing mandatory cross-crediting for all foreign subsidiary taxes within the same foreign tax credit basket. In other words, by determining the amount of deemed-paid taxes on an aggregate or blended basis under section 902, the proposal would require that foreign taxes imposed at high rates be used to offset potential U.S. tax liability on lower-taxed foreign earnings, without regard to the timing or source of any particular distribution of foreign earnings.

Specifically, the proposal revises section 902 so that a domestic corporation would determine the amount of foreign taxes that it is deemed to have paid under section 902 with respect to dividends received from a foreign subsidiary (and, correspondingly, under section 960 with respect to subpart F income inclusions) on an aggregate, rather than subsidiary-by-subsidiary, basis. Thus, a U.S. corporation would be required to aggregate its proportionate shares of the foreign taxes and the E&P of all foreign subsidiaries with respect to which the U.S. corporation can claim a deemed-paid foreign tax credit (including lower-tier subsidiaries described in section 902(b)).503 Under the proposal, the amount of foreign taxes deemed paid in a taxable year is computed by multiplying the corporation's proportionate share of foreign taxes by the ratio of the corporation's currently taxed income derived from its foreign subsidiaries (dividends and subpart F income inclusions for the current taxable year) and the sum of the U.S. corporation's proportionate shares of the total E&P of each foreign subsidiary. This computation would be performed separately for each foreign tax credit limitation basket.

Once the amount of foreign taxes that the U.S. corporation is deemed to have paid is determined for each basket under the modified rules of section 902, that amount is added to the amount of foreign taxes in that basket for which the U.S. corporation is entitled to claim a direct credit under section 901. The section 904 foreign tax credit limitation (i.e., the amount of pre-credit U.S. tax payable with respect to income in the relevant basket) is then applied to the total amount of such foreign taxes, as under present law.

Under the proposal, therefore, the foreign taxes deemed paid with respect to dividends and subpart F income inclusions reflect the weighted average of the foreign tax rates paid by each foreign subsidiary. Thus, a dividend paid to a U.S. parent by a subsidiary organized in a low-tax jurisdiction would typically carry deemed-paid foreign taxes in excess of the foreign taxes actually paid to that low-tax jurisdiction with respect to the distributed earnings. In contrast, a dividend paid to a U.S. parent by a subsidiary organized in a high-tax jurisdiction would typically carry deemed-paid foreign taxes in an amount that is less than the foreign taxes actually paid to that high-tax jurisdiction with respect to those earnings.

To illustrate this effect, consider a domestic corporation, Parent Co., that owns 100 percent of the shares of each of Alpha Co. and Bravo Co., CFCs organized in countries A and B, respectively. Alpha Co. has pre-tax earnings of $1,000 in the general basket, pays foreign taxes of $125 (a 12.5-percent tax rate), and has net E&P of $875. Bravo Co. also has pre-tax earnings of $1,000 in the general basket, but pays foreign taxes of $410 (a 41-percent tax rate) and has net E&P of $590. The aggregate amount of net E&P of Alpha Co. and Bravo Co. is $1,465 ($875 + $590),504 and the aggregate amount of foreign taxes paid is $535 ($125 + $410).

Under present law, if Alpha Co. distributes $500 to Parent Co. as a dividend, the amount of foreign taxes that Parent Co. would be deemed to have paid would be $71 ($125 x ($500/$875), but if the $500 distribution was made instead from Bravo Co., Parent Co. would be deemed to have paid $347 ($410 x $500/590). Under the proposal, Parent Co.'s decision regarding whether the $500 is remitted from Alpha Co. or Bravo Co. would not be influenced by the amount of foreign tax credits, as a $500 distribution from either Alpha Co. or Bravo Co. would result in a deemed-paid foreign tax amount to Parent Co. of $183 ($535 x ($500/$1,465)).505

Cross-crediting through selective repatriation

As described earlier, the present foreign tax credit limitation rules permit cross-crediting of foreign tax that is imposed at a rate higher than the applicable U.S. tax rate against residual U.S. tax on income in the same limitation basket that is subject to foreign tax at a rate lower than the U.S. rate. Historically, the U.S. foreign tax credit rules have restricted cross-crediting to varying degrees. The per-country limitation that applied in various forms prior to 1976, and the nine-basket regime that applied from 1986 through 2006, represented fairly stringent, although conceptually different, limitations on cross-crediting. The reduction in the number of baskets to two (passive and general) by AJCA increased the extent to which cross-crediting is feasible between income of different types and from different sources.506 Consequently, planning to maximize the use of foreign tax credits has assumed increasing importance in determining whether and when to repatriate foreign earnings.

Under present law, foreign tax credit planning typically involves selective repatriation of particular pools of foreign earnings, e.g., timing the repatriation of high-taxed income to coincide with the inclusion of low-taxed income. For example, excess foreign taxes (i.e., foreign taxes in excess of the U.S. 35-percent corporate rate), such as those arising in connection with the receipt of dividends from a foreign subsidiary in a high-tax jurisdiction, may be used to offset U.S. tax on royalties received for the use of intangible property in a low-tax jurisdiction. According to one study, even before AJCA took effect, almost two-thirds of all foreign-source royalties were sheltered by excess foreign tax credits in 2000, meaning that no residual U.S. tax was due.507 In addition, multinational corporations engage in a variety of techniques that utilize the entity classification rules to direct the source of foreign earnings, the time at which the earnings are subject to U.S. tax, or the amount of associated foreign tax.

The proposal limits the benefits of selective repatriation strategies by disassociating the amount of deemed-paid foreign taxes under section 902 from the actual amount of foreign tax paid on distributed earnings. Under the proposal, earnings distributed by a foreign subsidiary in any jurisdiction carries with them foreign taxes deemed paid at the same average effective rate. In effect, the proposal requires universal cross-crediting of foreign taxes paid by foreign subsidiaries, across both countries and income types (within each basket) and without regard to the timing of repatriation; taxpayers would no longer be able to selectively cross-credit.

The proposal represents a significant departure from traditional efforts to tailor limitation categories to be administrable yet sufficiently precise to approximate the results of an item-by-item limitation.508 Instead, the proposal adopts a precisely opposite aggregation approach in an effort to make taxpayers indifferent (from a foreign tax credit perspective) as to the source from which foreign subsidiary earnings are repatriated and the time at which foreign subsidiary taxes are eligible to be claimed as a credit.

The proposal would not, however, eliminate opportunities for foreign tax credit planning. Because the proposal applies only for determining deemed-paid taxes creditable under section 902, incentives would exist for structural planning to manage the effective tax rate of income earned through subsidiaries. Such planning could be designed to remove high-taxed foreign earnings from the blending regime, e.g., by converting foreign subsidiaries located in high-tax jurisdictions into branches or partnerships, so that foreign taxes associated with those earnings would be considered directly paid taxes under section 901 rather than section 902. Alternatively, taxpayers could plan to remove low-taxed earnings from the blending regime, e.g., by placing low-taxed subsidiaries below the sixth-tier foreign corporations described in section 902(b)(2).

Under present law, sections 902 and 78 establish parity between the treatment of foreign taxes paid with respect to branch income and those paid with respect to income earned in foreign subsidiaries. Foreign-source income earned through a foreign branch is fully includible by a U.S. corporation, without reduction for foreign taxes paid on that income, and the full pre-tax amount is reflected in the section 904 limitation fraction. The amount of foreign-source income earned through a foreign subsidiary that can be distributed as a dividend for U.S. tax purposes (and thus can actually be received by a U.S. corporation) will necessarily be an after-tax amount, i.e., earnings reduced by the amount of the foreign taxes paid by the subsidiary on those earnings.509 Section 78 requires, however, that a U.S. corporation claiming a foreign tax credit under section 902 include, as additional dividend income, an amount equal to the foreign taxes that it is deemed to have paid under section 902 (or section 960). This section 78 "gross-up" ensures that the full amount of the earnings on which the foreign taxes were paid is reflected in the calculation of the section 904 limitation. The result parallels the treatment of income earned through a branch, which is fully includible in income without reduction for foreign taxes (assuming that the taxpayer elects to claim a credit rather than a deduction for the foreign taxes paid).

Under the proposal, however, foreign taxes paid by a foreign branch would be fully available for credit, subject only to the section 904 limitations applicable to general basket income and passive basket income, while foreign taxes paid by a foreign subsidiary would be creditable only to the extent of the average effective foreign tax rate (determined by taking into account all foreign subsidiaries). The section 78 gross-up mechanism provides parity in the computation of taxable income earned through a branch and through a subsidiary, but does not address this timing disparity. Consequently, U.S. corporate taxpayers may have an incentive to earn high-taxed foreign-source income through a branch rather than a subsidiary. The result may be to encourage the conversion of existing subsidiaries into branch form, or the establishment of new branches rather than new subsidiaries in countries with relatively high foreign tax rates. To the extent that a U.S. corporation is able to place high-taxed foreign-source income in branches, it could be expected that any foreign-source income remaining in its foreign subsidiaries will be subject to a relatively lower foreign tax rate. Over time, the foreign taxes associated with undistributed foreign subsidiary income could diminish, increasing the expected U.S. tax liability associated with repatriation of that income and, thus, the disincentive to repatriation. Such an effect should be considered in conjunction with the Administration's Proposal to "Defer Deduction of Interest Expense Related to Deferred Income," which is intended to encourage repatriation of foreign earnings.

Technical and administrative considerations

The proposal requires resolution of a number of additional technical and administrative questions, either by statute or by regulation. Most importantly, it would be necessary to develop rules for allocating subsidiary earnings and foreign taxes proportionally among multiple shareholders (direct and indirect), including in situations in which shareholders' proportionate interests change as a result of acquisitions, dispositions, dilutions, mergers, and other corporate events. Addressing these events would likely require the establishment of shareholder-level accounts to which the earnings and foreign taxes of a foreign subsidiary would be allocated annually, based on the shareholder's proportionate ownership of the subsidiary during the year. The rules would need to consider the treatment of the accounts upon a change in ownership of the shares.510

Another significant consideration is the manner in which the pools of foreign subsidiary earnings would be determined: whether on a consolidated basis, with elimination of the effects of intercompany transactions, or as the sum of separately computed company results. Implicit in this question are technical considerations such as: (1) the treatment of transactions between two foreign subsidiaries for purposes of determining the earnings of each that are includible in the aggregate pool of earnings; (2) the treatment of deficits, including whether the earnings deficit of one foreign subsidiary should offset the positive earnings of other foreign subsidiaries; (3) ordering rules for determining the extent to which an earnings deficit in one basket should reduce positive earnings in another basket of the same foreign subsidiary or other foreign subsidiaries; and (4) whether the amount and separate limitation character of dividends and subpart F inclusions should be determined by reference to the aggregate blended E&P pool or on a separate-entity basis.

Additional technical considerations include: (1) integration of the proposal with the rules of section 905(c) addressing foreign tax redeterminations; (2) currency translation rules for determining the amounts included in the blended pools of foreign taxes and foreign earnings, and for translating into U.S. dollars and computing exchange gain or loss on distributions from those blended pools; (3) treatment of foreign earnings and foreign taxes in foreign subsidiaries below the sixth-tier that are not included in the section 902 qualified group;511 (4) the interaction between the rules for determining the taxable distribution under sections 301 and 302, under which E&P is determined on an entity-by-entity basis, and the proposal's determination of the available foreign tax credit, under which E&P is determined on an aggregate basis; and (5) whether the available foreign tax credit for a particular taxable year (before application of the section 904 limitation) is determined on the basis of a single, carryforward calculation.

Tax reporting requirements would also necessarily increase under the proposal. Under present law, annual information reporting relating to E&P and foreign taxes is required only with respect to CFCs. Under the proposal, however, every foreign subsidiary's E&P and foreign taxes would affect the current year section 902 credit of the U.S. parent corporation, regardless of the amount of actual or deemed distributions from that subsidiary. Thus, it will likely be necessary to provide for additional information reporting with respect to 10/50 companies so that the IRS can verify the amount of section 902 credits claimed on taxpayers' returns.

Moreover, although E&P and foreign tax information with respect to 10/50 companies is required under present law to compute deemed-paid credits, apply the look-through rules to dividends paid by 10/50 companies, and, in many cases, to apportion interest expense in calculating the foreign tax credit limitation,512 this information can be difficult to obtain if U.S. shareholders do not control the company. Under existing Treasury regulations, a U.S. shareholder must maintain E&P and foreign tax information for a CFC or 10/50 company beginning only with the first taxable year in which the computation of E&P is significant for U.S. tax purposes with respect to its controlling domestic shareholder.513 Under present law, this information often is not significant until the controlling domestic shareholder is required to include income in respect of the CFC or 10/50 company. Under the proposal, however, this information would likely be significant for all CFCs and 10/50 companies every taxable year.

Transition considerations

The proposal does not provide for a transition rule, with the result that all foreign taxes and all earnings of foreign subsidiaries, including amounts attributable to periods prior to the enactment of the proposal, may be subject to the blending rule. This approach would be simpler than a phased-in effective date rule because separate tracking of pre- and post-effective date earnings and taxes pools would not be required. However, complex rules would be required for merging earnings and taxes accounts of foreign subsidiaries acquired by U.S. shareholders and subject to the pooling rules on different dates, or that presently maintain layered earnings and taxes accounts resulting from pre-effective date merger and acquisition activity.

An alternative approach, similar to that adopted with respect to the section 902 amendments made by the Tax Reform Act of 1986514 (establishing the multi-year pooling rules), would be to establish separate pools of pre- and post-enactment date foreign taxes and earnings. This approach would require ongoing maintenance of separate pre- and post-effective date earnings and foreign tax accounts and, by implication, two sets of foreign tax credit rules. It would also require a dividend ordering rule for determining the amount of any dividend paid from pre-effective date earnings versus the amount paid from post-effective date earnings.515

Treaty considerations

It is conceivable that U.S. income tax treaty partners and commentators may argue that the proposal is inconsistent with the U.S. obligations under the relief from double taxation provisions of its income tax treaties. Such provisions generally require the United States to relieve double taxation by allowing its citizens and residents a credit against U.S. income tax liability for income tax paid or accrued directly by those citizens or residents to the other treaty country. Typical U.S. tax treaties also require the United States to allow a domestic corporation that owns at least 10 percent of the voting stock of a corporation resident in the other treaty country that receives dividends from the other corporation a credit (an "indirect credit") against U.S. tax for the tax that the other corporation pays to the other treaty country with respect to the profits out of which such dividends are paid.516

As described earlier, in situations in which the domestic corporation is a 10-percent-or-greater shareholder in two or more foreign corporations located in different countries with different effective tax rates, the amount of foreign taxes that a domestic corporation would be deemed to have paid under the proposal with respect to distributed earnings of a foreign subsidiary may not correspond directly to the amount of taxes paid by the subsidiary on those earnings. Rather, the amount of taxes deemed paid would reflect a weighted average of the effective tax rates paid by each of those subsidiaries. Thus, in the case of a foreign subsidiary located in a country with a relatively high tax rate, the amount of taxes deemed paid by the U.S. corporation could be lower than the amount actually paid by the subsidiary on the distributed earnings. Conversely, in the case of a foreign subsidiary located in a country with a relatively low tax rate, the amount of taxes deemed paid by the U.S. corporation could be higher than the amount actually paid by the subsidiary on the distributed earnings. Either case raises a question as to whether the foreign tax credit allowed as a result of the proposal is strictly consistent with a treaty's relief from double tax requirement that credit be allowed for "the" income tax paid to the treaty country in question. In particular, a treaty country whose income tax rate is relatively high may argue that the disassociation of the deemed-paid tax amount from the amount of tax actually paid or accrued by the subsidiary to that treaty country on the distributed earnings is a violation of the treaty.

In cases in which potential technical arguments could allege the existence of a conflict between U.S. domestic law and U.S. treaties, there is precedent for providing an express treaty override to forestall litigation.517 In the absence of an express treaty override, the legislation would be expected to take precedence over an income tax treaty based on the "last-in-time" principle if the proposal were not consistent with the treaty's relief from double taxation requirements.518

The proposal may be viewed as consistent with the U.S. treaty obligations because it does not deny a foreign tax credit for the full amount of foreign taxes paid on earnings distributed from higher-tax countries. Rather, in the case of foreign taxes paid at a relatively high rate (i.e., a rate higher than the weighted average rate paid by all of the domestic corporation's subsidiaries), the effect of the proposal is to defer the availability of the full credit until all earnings, in the aggregate, have been distributed to the domestic corporation by its foreign subsidiaries. In this respect, the proposal is somewhat similar to the foreign tax credit limitation rules of section 904, which are expressly contemplated by U.S. income tax treaties. The purpose of the section 904 rules is to limit the extent to which foreign taxes may be credited in a particular year to ensure that U.S. tax on U.S. -- source income is not offset by direct and deemed-paid credits, as well as to mitigate cross-crediting across different types of foreign-source income. The rules do not deny a foreign tax credit to the extent that taxes in excess of the current year limitation can be used in a carryforward or carryback year.

On the other hand, the proposal would function differently from the section 904 limitation in the sense that section 904 restricts a taxpayer's ability to credit one country's tax against U.S. income tax on other income (i.e., income other than the income on which that tax was paid). In contrast, the proposal would limit a domestic corporation's ability to credit foreign tax against the U.S. income tax imposed on the same income on which the foreign tax was paid, which some treaty partners may view as a conflict with the U.S. treaty obligations.

The effect of the proposal on a particular domestic corporation would vary depending on the locations of its foreign subsidiaries, their relative sizes, and the extent to which the domestic corporation chooses to repatriate each subsidiary's earnings.

Other considerations

Some argue that this proposal to determine the foreign tax credit on a pooling basis will only exacerbate the competitive disadvantages they view as inherent in the U.S. international tax system. They argue that the United States is an outlier as one of the only OECD countries that has retained a worldwide tax regime.519 They argue that under present law, the existence of a residual U.S. tax liability, even if deferred, reduces after-tax returns from offshore investments below that obtained by foreign-based MNCs. The lower after-tax return places U.S. MNCs at a competitive disadvantage in developing or expanding foreign markets. To the extent that the proposal increases the tax rate on foreign earnings, a U.S. MNC's residual tax liability on active foreign business earnings increases, further reducing after tax returns to investment abroad.

Others challenge the general assertion that there is a competitive disadvantage inherent in the U.S. international tax system. They argue that that there is no empirical evidence of such a competitive disadvantage and that such claims are questionable given the success of many U.S. businesses overseas. Moreover, if there are issues of competitiveness in certain U.S. industries, they may challenge the assertion that the issues are attributable to the U.S. international tax system rather than labor cost differentials, product quality differences, regulatory differences, and other nontax factors.520 Additionally, proponents of the proposal argue that the U.S. international tax system provides a competitive advantage to U.S. MNCs over their U.S. competitors by creating an incentive to move jobs and business operations overseas.521 See the discussion above on the Administration's Proposal to "Defer deduction of interest expense related to deferred income," for a more detailed discussion of the arguments.


Prior Action

The President's fiscal year 2010 budget contained a substantially similar provision.

3. Prevent splitting of foreign income and foreign taxes

A provision substantially similar to the President's fiscal year 2011 budget proposal was included in H.R. 1586, which was signed into law by the President on August 10, 2010.

4. Tax currently excess returns associated with transfers of intangibles offshore


Present Law and Background

In general

The United States employs a "worldwide" tax system under which U.S. resident individuals and domestic corporations generally are taxed on all income, whether derived in the United States or abroad. Subject to certain limitations, a domestic corporation is allowed to claim a credit against its U.S. income tax liability for foreign taxes paid. The foreign tax credit provides relief from double taxation.

Income earned directly or through a pass-through entity (such as a partnership) is taxed on a current basis. By contrast, active foreign business earnings that a U.S. person derives indirectly through a foreign corporation generally are not subject to U.S. tax until such earnings are repatriated to the United States through a dividend distribution of those earnings to the U.S. person. This ability of U.S. persons to defer income is circumscribed by various regimes intended to restrict or eliminate tax deferral with respect to certain categories of passive or highly mobile income. One of the main antideferral regimes is the controlled foreign corporation ("CFC") rules of subpart F,522 which limits tax deferral with respect to certain categories of passive or highly mobile income.

The United States also has extensive rules designed to preserve the U.S. tax base by ensuring that income properly attributable to the United States is not shifted to a foreign controlled party through inappropriate pricing of related party transactions. The statutory authority for those rules is found in section 482, and the principal measure by which that authority is exercised is the arm's-length standard.523

Foreign tax credit

A domestic corporation is allowed to claim a credit against its U.S. income tax liability for the foreign income taxes that it pays, subject to certain limitations. A domestic corporation that owns at least 10 percent of the voting stock of a foreign corporation is allowed a "deemed paid" credit for foreign income taxes paid or accrued by the foreign corporation that the domestic corporation is deemed to have paid when the related income is distributed or included in the domestic corporation's income under subpart F.524

The foreign tax credit generally is limited to a taxpayer's U.S. tax liability otherwise due on its foreign-source taxable income (as determined under U.S. tax accounting principles). This limit is intended to ensure that the credit serves its purpose of mitigating double taxation of foreign-source income without offsetting U.S. tax on U.S. -- source income.525

Historically, the U.S. foreign tax credit limitation provisions have included various alternative approaches to limiting cross-crediting in order to preserve the U.S. tax base.526 Presently, the foreign tax credit limitation regime applies separately for income in two different categories (referred to as "baskets"), passive category income and general category income.527 Passive category income generally includes (with certain exceptions, including when income is earned as part of an active business) investment income such as dividends, interest, rents, and royalties.528 General category income is all income that is not in the passive income category. Because the foreign tax credit limitation must be applied separately to income in these two baskets, credits for foreign tax imposed on income in one category cannot be used to offset U.S. tax on income in the other category.

Subpart F inclusions of a United States shareholder are assigned to the appropriate separate limitation category by reference to the category of income out of which the dividend or other payment was made.529 Under the present two-basket system, general category income of different types or from different countries may be credited against other general category income. Thus, foreign tax on income from a high-tax country in one category can be credited against U.S. tax otherwise due on income in the same category derived in a low-tax jurisdiction.

Subpart F

Under the subpart F rules, a 10 percent-or-greater U.S. shareholder ("United States shareholder") of a CFC is subject to U.S. tax currently on its pro rata shares of certain income earned by the CFC, whether or not such income is distributed to the shareholder. A CFC is defined generally as a foreign corporation with respect to which United States shareholders own more than 50 percent of the combined voting power or total value of the stock of the corporation. Income subject to current inclusion under subpart F includes foreign base company income.530 Foreign base company income includes foreign personal holding company income,531 foreign base company sales income,532 and foreign base company services income.533


    Foreign personal holding company income

Foreign personal holding company income generally consists of the following: (1) dividends, interest, royalties, rents, and annuities; (2) net gains from the sale or exchange of (a) property that gives rise to the preceding types of income, (b) property that does not give rise to income, and (c) interests in trusts, partnerships, and real estate mortgage investment conduits ("REMICs"); (3) net gains from commodities transactions; (4) net gains from certain foreign currency transactions; (5) income that is equivalent to interest; (6) income from notional principal contracts; (7) payments in lieu of dividends; and (8) amounts received under personal service contracts. There are several exceptions to the general rule of current taxation on foreign personal holding company income.534

    Foreign base company sales income

Foreign base company sales income generally consists of income derived by a CFC in connection with: (1) the purchase of personal property from a related person and its sale to any person; (2) the sale of personal property to any person on behalf of a related person; (3) the purchase of personal property from any person and its sale to a related person; or (4) the purchase of personal property from any person on behalf of a related person. In each of the situations described in items (1) through (4), the property must be both manufactured outside the CFC's country of incorporation and sold for use outside of that same country for the income from its sale to be considered foreign base company sales income.535 Certain exceptions to this general rule may apply. For example, income from sales of property involving a related person may be excluded under section 954(d) if a prescribed manufacturing exception applies.

    Foreign base company services income

Foreign base company services income generally consists of income from services performed outside the CFC's country of incorporation for or on behalf of a related party,536 including cases where substantial assistance contributing to the performance of services by a CFC has been furnished by a related person or persons.537 Substantial assistance consists of assistance furnished (directly or indirectly) by a related U.S. person or persons to the CFC if the assistance satisfies an objective cost test. For purposes of the objective cost test, the term "assistance" includes, but is not limited to, direction, supervision, services, know-how, financial assistance (other than contributions to capital), and equipment, material, or supplies provided directly or indirectly by a related U.S. person to a CFC. The objective cost test is satisfied if the cost to the CFC of the assistance furnished by the related U.S. person or persons equals or exceeds 80 percent of the total cost to the CFC of performing the services.538

Pricing for transfers of intangible property between related persons

The United States has extensive rules designed to preserve the U.S. tax base by ensuring that income properly attributable to the United States is not shifted to a related foreign company through aggressive transfer pricing that does not reflect an arm's-length result. Similarly, the domestic laws of most U.S. trading partners include rules on transfer pricing.

Section 482 authorizes the Secretary of the Treasury to allocate income, deductions, credits or allowances among related business entities when necessary to clearly reflect income or otherwise prevent tax avoidance, and comprehensive Treasury regulations under that section adopt the arm's-length standard as the method for determining whether allocations are appropriate. Thus, the regulations generally attempt to identify the respective amounts of taxable income of the related parties that would have resulted if the parties had been unrelated parties dealing at arm's length.

There is an additional test for transactions resulting in the transfer of intangible property, which provides that the income with respect to any transfer (or license) of certain intangible property to a related person must be commensurate with the income attributable to the intangible property.539 Section 367(d) provides a related rule under which compensation, in the form of an imputed royalty stream, is required for an outbound transfer of intangible property in the context of an otherwise nontaxable reorganization transaction.


    Commensurate-with-income principle

As discussed above, Congress responded to concerns regarding the effectiveness of the arm's-length standard with respect to intangible property -- including, in particular, high-profit-potential intangible property -- by amending section 482 to include the commensurate-with-income principle.540 The legislative history to this provision states that transfer pricing problems are "particularly acute" in the case of high-profit-potential intangible property.541 The House Committee on Ways and Means Report (the "Committee Report") identified, as a recurrent problem, the absence of comparable arm's-length transactions between unrelated parties, and the inconsistent results of attempting to impose an arm's-length concept in the absence of real comparables.542 The Committee Report concluded that, because of the "extreme difficulties" in determining whether arm's-length transfers between unrelated parties are comparable, it was appropriate to require payments made on a transfer of intangible property to a foreign affiliate to be commensurate with the income attributable to the intangible property.543

The commensurate-with-income principle was intended to address these problems by shifting the focus of transfer pricing analysis to the income actually derived from exploitation of the transferred intangible property, and away from the identification of questionably comparable third-party transactions. In particular, Congress intended that compensation for intangible property be determined by taking into account actual profit experience, and that pricing adjustments be made upon major variations in the annual amounts of revenue. While the legislative history did not address the relationship between the commensurate-with-income principle and the arm's-length standard, some commentators interpreted the principle as an "ex post" rule (i.e., actual profits would be used as the basis for re-determining the transfer price retroactively) which conflicted with the arm's-length standard.544

The Conference Report for the 1986 Act also directed the Internal Revenue Service (the "IRS") to conduct a comprehensive study of the transfer pricing rules.545 Treasury and the IRS published the findings of this study in a notice commonly referred to as the "White Paper."546 An important consequence of this conclusion, reflected in subsequently issued Treasury regulations, was that comparable third-party transactions would continue to play a role in determining appropriate transfer prices, at least in the case of "normal intangible property."547 Normal intangible property was described as intangible property that is widely available to producers (such as the technology employed in pocket calculators, digital watches or microwaves) and for which "exact" comparables are more common. The White Paper concludes that in the case of high-value intangible property, transactions between unrelated parties involving comparable intangible property "almost never exist."548

The White Paper characterizes the commensurate-with-income principle as a clarification of prior law that it is consistent with the arm's-length standard.549 In addition, the IRS applies the commensurate-with-income principle on an "ex ante" basis, meaning that actual profits are taken into account for purposes of determining if the initial transfer price was appropriate. Thus, the IRS view is that commensurate with the income attributable to the intangible property "refers generally to the operating profits that the taxpayer would reasonably and conscientiously have projected at the time it entered into the controlled transaction."550


    Methods of transferring intangible property

A U.S. person that develops or purchases intangible property generally can make that intangible property available to a related person (typically, a foreign affiliate) in four ways. The first is through an outright transfer of all substantial rights in the intangible property, either by sale or through a non-recognition transaction (for example, a capital contribution of the intangible property to the affiliate in an exchange that meets the requirements of section 351, or an exchange made pursuant to a plan of reorganization that is described in section 361). The second is through a license of the intangible property, in which the U.S. person transfers less than all substantial rights in the intangible property to the foreign affiliate.551 The third is the provision of a service using the intangible property.

In the fourth, intangible property is made available through a cost-sharing arrangement. In one example of a cost-sharing arrangement, a U.S. company and one or more foreign affiliates make resources available and contribute funds (through a combination of cash and existing intangible property rights) toward the joint development of a new marketable product or service. The U.S. company makes available all, or a substantial portion, of the rights to use and further develop existing intangible property, and the foreign affiliate (typically organized in low-tax jurisdiction) generally contributes cash. The arrangement provides that the U.S. company owns legal title to, and all U.S. marketing and production rights in, the developed property, and that the other party (or parties) owns rights to all marketing and production for the rest of the world.552 Reflecting the split economic ownership of the newly developed asset, no royalties are paid between cost sharing participants when the product is ultimately marketed and sold to customers. However, the U.S. company receives a buy-in payment553 (such as periodic royalties or a lump sum payment at the outset) from the other cost-sharing participant with respect to its "platform contribution."554

The mechanism used for transferring intangible property to a foreign affiliate frequently dictates whether the authority for determining the compensation received by the U.S. person in the transaction is under section 482 or section 367(d). Generally, a license or a sale of intangible property, or the provision of a service that uses intangible property, is subject to section 482. An exchange of intangible property in connection with certain nonrecognition transactions is subject to section 367(d), which overrides the general nonrecognition rules of sections 351 and 361 to require that the transferor of intangible property include imputed income from annual payments over the useful life of the intangible property, as though the transferor had sold the intangible property (at whatever stage of development it is, from an entirely undeveloped idea through, and including, a completely developed and exploitable item of intangible property), at times in exchange for contingent payments. The appropriate amounts of those imputed payments are determined under section 482 and the regulations thereunder. Transfers of foreign goodwill or going concern value are specifically exempt from the income recognition provisions of section 367(d).555 With respect to cost-sharing arrangements, specified rights to existing intangible property can be transferred to other cost-sharing participants either through a sale or a license.556


    Section 482 regulations

    In general


A transaction between related parties meets the arm's-length standard if the results of the transaction are consistent with the results that would have been realized if unrelated taxpayers had engaged in the same transaction under the same circumstances.557 Because identical transactions between unrelated parties are rare, whether a transaction produces an arm's-length result generally is determined by reference to the results of transactions deemed to be comparable under circumstances deemed to be comparable.558 To evaluate comparability, the regulations require an analysis of all factors that could affect prices or profits in uncontrolled transactions. Each method requires an analysis of all the factors that affect comparability under that method, and a specific comparability factor may be particularly important to a particular method.559 The comparability factors include: (1) functions; (2) contractual terms; (3) risks; (4) economic conditions; and (5) the property or services transferred.560

Transfer pricing rules do not require that a comparable transaction be identical to the related party transaction, but it must be sufficiently similar to the related-party transaction to provide a reasonable starting point for determining the arm's-length price.561 If there are material differences between the related-party transaction and the comparable transaction, adjustments are be made to the relevant formulas, but only if it is possible to determine the impact of those differences on prices or profits with sufficient accuracy.562 If it is not possible to determine the impact of those differences on prices or profits with sufficient accuracy, the comparable transaction may be taken into account in establishing the arm's-length price, but it is considered a less-reliable measure of an arm's-length result.

In many cases, risk can be assigned by contract within an affiliated group to entities with the objective ability to bear such risk. However, whether the risks in the related party transaction and in the comparable transaction are, in fact, comparable may be difficult to ascertain. Nonetheless, the respect given to contractual agreements between related companies is derived from the longstanding doctrine of Moline Properties v. Commissioner,563 in which the Supreme Court rejected the taxpayer's attempt to disregard the corporate form.564 Under the doctrine of corporate entity articulated in Moline Properties, the corporation remains a separate taxable entity, provided the purpose of the corporation is the equivalent of a business activity or the carrying on of a business by the corporation.565


    Transfers of intangible property

Treasury regulations issued in 1994 set forth the basic rules for determining income in connection with a transfer of intangible property.566 These regulations generally provide that the arm's-length consideration for the transfer of intangible property in a controlled transaction (i.e., a transaction between related entities) must be commensurate with the income attributable to the intangible property, and it requires taxpayers to apply one of four methods to meet this requirement.567

Comparable uncontrolled transaction method. -- The comparable uncontrolled transaction method evaluates the amount charged for intangible property in a controlled transaction by reference to the amount charged in a comparable uncontrolled transaction (i.e., a transaction between unrelated parties).568 The regulations provide that if an uncontrolled transaction involves the transfer of the same intangible property under the same, or substantially the same, circumstances as the controlled transaction (i.e., an exact comparable), the comparable uncontrolled transaction method generally is the most direct and reliable measure of the arm's-length result for a controlled transaction.569 Exact comparables are rare, however, in the case of high-value intangible property. If an exact comparable uncontrolled transaction cannot be identified, uncontrolled transactions that involve the transfer of comparable intangible property under comparable circumstances (i.e., inexact comparables) may be used to apply the comparable uncontrolled transaction method, but the reliability of the method will be reduced. The regulations require that a taxpayer consider whether the intangible property that is the subject of the uncontrolled transaction has "similar profit potential" to the taxpayer's intangible property in determining whether the uncontrolled transaction is comparable.570 However, this method does not otherwise consider or directly reflect the income attributable to the taxpayer's intangible property.

The remaining methods require an examination of the income actually derived from the transferred intangible property. They differ, however, in the extent to which they rely on comparable uncontrolled transactions.

Comparable profits method. -- The comparable profits method evaluates the amount charged in a controlled transaction by comparing the operating profit of the "tested party" (generally, the licensee) to the operating profits of uncontrolled taxpayers that engage in similar business activities under similar circumstances. For example, where a U.S. parent company licenses intangible property to a foreign manufacturing subsidiary, the royalty payable by the subsidiary to the parent is evaluated under this method by comparing the operating profit of the subsidiary to the operating profits of comparable uncontrolled manufacturers. If the subsidiary's profit level differs meaningfully from the profit levels of the uncontrolled manufacturers, the royalty rate paid by the subsidiary is adjusted as necessary to bring the profit level within an acceptable range. In effect, this method limits the extent to which income from the intangible property can be retained by the licensee to the amount that an uncontrolled licensee would be permitted to retain; the remainder of that income is required to be paid to the licensor through the royalty.571

Profit split methods. -- The regulations also provide two profit split methods, under which the relative values of each controlled party's contribution to the combined profits from use of intangible property are used to determine an arm's-length "profit split." The arm's-length charge for the intangible property is the amount required to achieve the appropriate split of the combined profits.

The comparable profit split method relies exclusively on external market data to determine the appropriate profit split; thus, the combined operating profits of controlled taxpayers are split based on the split of combined operating profits of uncontrolled taxpayers with similar transactions and activities in the relevant business activity.572

The residual profit split method relies on external transactions principally in order to determine the amount appropriately allocable to routine contributions and, in some cases, to determine the split of residual nonroutine return amongst the parties.573 Under this method, income is first allocated to the routine contributions of the controlled parties (including contributions of routine intangible property) based on market returns, and the residual income is then allocated based on the relative value of each party's contribution of nonroutine property.

Periodic adjustments. -- Periodic adjustments may be necessary to comply with the commensurate-with-income requirement.574 When intangible property is transferred in an arrangement that covers more than one year, the consideration charged for each taxable year may be adjusted by the IRS (in the context of an examination of that year) to ensure that it is commensurate with the income from the intangible property. No adjustment will be required if the taxpayer satisfies various requirements, including that the profits earned (or cost savings) realized by the related taxpayer from the exploitation of the intangible property is not less than 80 percent, nor more than 120 percent, of the profits projected (or cost savings) at the time the related party arrangement was established.


    Application of section 482 principles to unidentified intangible property

For purposes of sections 482 and 367(d), "intangible property" is defined by reference to section 936(h)(3)(B) and means any: (1) patent, invention, formula, process, design, pattern, or know-how; (2) copyright, literary, musical, or artistic composition; (3) trademark, trade name, or brand name; (4) franchise, license, or contract; (5) method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; or (6) any similar item. The term "intangible property" contemplates that any such item must have substantial value independent of the services of any individual.575

Because they are not specifically mentioned in section 936(h), whether goodwill, going concern value and workforce in place are intangible property for which compensation must be provided is unsettled.576


Description of Proposal

The proposal to tax currently excess returns associated with transfers of intangible property offshore (the "subpart F proposal" or the "proposal") provides a new category of subpart F income, as well as a new separate foreign tax credit limitation basket. Under the proposal, if a U.S. person transfers intangible property from the United States to a related CFC that is subject to a low effective foreign tax rate in circumstances that evidence excessive income shifting, then an amount equal to the excessive return is treated as subpart F income. This excessive return income is currently includible in the income of the CFC's United States shareholders.

Effective date. -- The subpart F proposal is effective for taxable years beginning after December 31, 2010.


Analysis

Policy rationale

    Overview

The proposal seeks to reduce the financial incentive for transferring intangible property to a low-tax CFC that, after such transfer, derives the income associated with its exploitation of the intangible property. The policy concern is that such transfers have shifted income outside of the United States that would otherwise be subject to U.S. tax, resulting in erosion of the U.S. tax base. Transfer pricing rules provide a mechanism for protecting the U.S. tax base from artificial income shifting. However, the potential financial incentives of certain related-party transactions (particularly the financial incentives from those transactions involving transfers of intangible property to low-tax CFCs) have put significant pressure on the enforcement and effective application of transfer pricing rules. The subpart F proposal adopts a new approach to address this issue. In most situations, the net effect of the proposal is current U.S. taxation with little or no foreign tax credits on income where intangible property is transferred from the United States by a U.S. person to a related CFC (a covered transfer) organized in low-tax jurisdiction -- which may approximate the tax consequences of retaining that intangible property in United States.

    Minimum threshold of taxation as the prerequisite for deferral

The proposal increases the U.S. tax liability of affected taxpayers because it denies deferral for certain active business earnings that have previously enjoyed deferral from U.S. tax. The subpart F proposal could be viewed as effectively establishing a base foreign-tax threshold for deferral, such that certain foreign earnings that do not bear some minimum threshold level of source taxation are taxed currently in the United States. Although views differ, it has been observed that the U.S. deferral system approximates the exemption regimes of U.S. trading partners, thereby leveling the competitive landscape for U.S. companies in the global economy. 577 Arguably, the additional limitations on deferral imposed by the proposal may reduce the ability of some U.S. companies to compete against foreign rivals, raising the question whether the proposal fits better within a broader approach to overall tax reform.578

The presence of a causal connection between the actual intangible property transferred from the United States and the excessive return is not relevant under the proposal. Thus, the subpart F proposal does not distinguish between transfers of high-value intangible property and other types of intangible property. For example, if a CFC directly acquires a patent from an unrelated party (a transfer that is outside the scope of the proposal) for a process that revolutionizes widget manufacturing and significantly reduces its cost of goods sold, but it also uses other manufacturing know-how579 that is important -- but not nearly as valuable -- the CFC may enjoy a high rate of return that is primarily derived from the patented process. However, if the other manufacturing know-how is transferred to the CFC by a related U.S. person, the CFC may be subject to testing -- and possible current taxation -- under the proposal. If there is little or no demonstrable correlation between the intangible property transferred and the CFC's excessive return, it is unclear why the transfer of that manufacturing know-how adversely impacts the U.S. tax base.

There is precedent for imposing a minimum threshold of taxation for foreign income as a prerequisite to deferral. Under section 963, deferral of U.S. taxation was permitted on subpart F income only where sufficient earnings and profit ("E&P") were distributed to U.S. shareholders so as to produce an overall effective tax on current foreign profits equal to approximately 90 percent of the tax that would have been paid had the CFC been taxable as a domestic corporation.580 As with the subpart F proposal, the minimum distribution level was determined based on the effective foreign tax rate of the CFC.581 The proposal is also similar to section 963 in that, under the proposal, there may be taxpayers that are denied some measure of deferral even though the substance of their CFC activities match the form of their contractual arrangements, and the transfer price is in all respects an appropriate measure of an arm's-length result.582

On the other hand, if the proposal is revised and the intangible property transfer is eliminated as a threshold requirement, implementation and tax administration (discussed below) of the rule is streamlined. Eliminating the taint that the proposal imposes on intangible property transfers from the United States may reduce the incentive to both migrate intangible property development to CFCs and to have CFC's use offshore funds to acquire intangible property. However, eliminating the intangible property transfer as a prerequisite to subpart F treatment under the proposal broadens the proposal beyond its stated policy objective (reducing the financial incentive to shift income to low-tax jurisdiction through outbound transfers of intangible property) and exposes the proposal to increased controversy as a limited repeal of deferral.583


    No direct changes to the arm's-length standard

Transfer pricing issues are among the more significant faced by the IRS in its tax administration efforts.584 Among the difficulties is the intensive case-by-case intervention required to resolve factual disputes in transfer pricing cases. Although the effectiveness of the arm's-length standard as the measure of transfer prices is sometimes debated,585 the proposal avoids this debate by addressing excessive income shifting through subpart F, rather than through any direct changes to the transfer pricing rules of section 482. To the extent the proposal avoids changing transfer pricing rules, proponents may view it as complementing section 482 and providing a targeted antiabuse rule.

A rationale for taking this approach -- rather than modifying the arm's-length standard586 -- is that such a modification could be criticized as disruptive to relations with U.S. trading partners.587 Following the leadership of the United States, most countries (including all of the member countries of the Organisation of Economic Co-operation and Development, the "OECD") adopted and now follow the arm's-length standard.588

Another view of the proposal is that it is consistent with the arm's-length standard, but serves indirectly to reduce the importance of risk in determining comparability. Some have argued that accounting for assignment of risk in transactions between related parties is a weak point in the arm's-length standard.589 Arguably, transfers to related parties normally do not involve the bona fide shifting of economic risk that would occur in transactions between unrelated parties. This is because the separate existence of each company in the group is respected, therefore risk can be assigned by contract to any member of the group with the objective ability to bear that risk, even though risk does not leave the affiliated group.

Outbound transfers of intangible property tend to be accompanied by assignment of risk related to the commercialization of the intangible property transferred. These concurrent transfers of intangible property and risk to the CFC highlight that risk (and the associated profit) is very mobile.590 Mobility of income is addressed under present law by the subpart F rules, which are designed to prevent the diversion of certain income (including both passive and mobile income) from U.S. taxation. The proposal adopts the mechanics of subpart F to tax currently the mobile profits associated with assigned risk.591

However, some may criticize the proposal's distinction between normal and excessive returns because it is not clear that the distinction is based on a measurement of the profits associated with assigned risk. As a result, active business profits derived by a CFC from a transaction that is appropriately priced under the arm's-length standard could be taxed currently in the United States.


    Potential incentive to repatriate foreign earnings

Once the CFC's earnings have been taxed as an excessive return under subpart F, there is no tax incentive to retain those earnings outside of the United States. Thus, the proposal may have the effect of encouraging repatriation of some previously-taxed foreign income.

On the other hand, a taxpayer in a low-tax jurisdiction, which would otherwise be subject to the proposed subpart F inclusion, may find it beneficial to expand its activities in the low-tax jurisdiction, rather than repatriate income or increase royalty payments. Some taxpayers both hold intangible property and manufacture at the same low-tax CFC. The rate of return attributed to the manufacturing enterprise generally is lower than the rate of return attributed to the intangible property. If such a taxpayer were subject to a subpart F inclusion for an excessive return based on its current operations, expansion of its manufacturing (or other lower-rate of return operations) in the low-tax jurisdiction could cause the taxpayer's overall rate of return to fall below the proposal's excessive return threshold. Such an expansion of manufacturing operations could come from shifting operations into the low-tax jurisdiction from other foreign jurisdictions or from the United States. If the CFC takes such steps to expand its investment base, there would be no increase in foreign-source income paid back into the United States, and there could be an increase in the taxpayer's overall foreign-source income compared to U.S. source income.

The subpart F proposal establishes a separate limitation category for an excessive return taxed currently; however, the proposal does not otherwise modify the foreign tax credit rules. Thus, a foreign tax credit is provided with respect to any source country taxes paid by the transferee. It is not clear whether the proposal contemplates one excessive return basket, or a separate excessive return basket for each CFC. However, cross-crediting592 opportunities with respect to excessive return income may be effectively limited by the one-basket approach because this income is, by definition, low-tax. In addition, subpart F income from an excessive return is not included in any limitation basket income when repatriated, including general basket income, because it is previously taxed income. Consequently, the proposal may also diminish cross-crediting opportunities for higher-taxed income in the general limitation basket on future distributions.

The proposal may lead some taxpayers to choose to receive royalty income (currently taxable when received in the United States) rather than income subject to current inclusion under subpart F as an excessive return. Royalty payments are generally a deductible expense in the country from which they are paid. Therefore, royalty payments reduce the measured return attributable to the foreign jurisdiction. A reduced investment return in the foreign jurisdiction reduces the likelihood that the taxpayer would be subject to the proposed subpart F inclusion. Although additional royalty payments to the United States, like subpart F income from an excessive return, are taxed currently, the U.S. tax consequences may not be equal. This is because cross-crediting for royalty income is not affected by the proposal, as royalty income is not included in the excessive return basket for foreign tax credit purposes.593 Moreover, a number of U.S. tax treaties reduce or eliminate withholding taxes on royalties. Therefore, any additional tax liability that results from increased royalty income to the United States is likely to be less than the additional tax liability that results from recognizing subpart F income on an excessive return. However, the taxpayer must substantiate any increased royalty payment under the arm's-length standard, possibly by reducing the risks and functions undertaken by the CFC.

The net tax consequences to a taxpayer that increases royalty payments to other (non-U.S.) jurisdictions would depend on many factors, but taxpayers can be expected to structure their royalty payments to minimize or eliminate withholding tax on royalty payments from the CFC, minimize or eliminate income tax to the recipient of the royalty, and avoid inclusion in U.S. income (based on the look-through rule of section 956(c)(6)) under subpart F.

Technical issues not addressed by the proposal

The subpart F proposal provides only the basic framework for identifying subpart F income from an excessive return. The proposal articulates a three-part test, the elements of which need to be further defined, to determine if the CFC has income that is subject to tax currently: (1) a low effective foreign tax rate; (2) an excessive return; and (3) a covered transfer (i.e., the transfer of intangible property from the United States by a U.S. person to a related CFC). Where this three-part test is met, the taxpayer is subject to tax currently on subpart F income from an excessive return.


    Low effective foreign tax rate threshold

The proposal does not state the threshold at which an effective tax rate is considered low. There are two principal considerations with respect to determining this threshold. The first is identifying the basis on which to select the threshold rate. The second is the method for calculating that rate.

    Selecting the threshold rate

Selecting the threshold tax rate at which to trigger application of the provision appears aimed at requiring that earnings be subject to some minimum level of tax in the year earned. The subpart F proposal is designed as a cliff, such that at or below a threshold effective foreign tax rate, the excessive return of a CFC to which intangible property has been transferred by a U.S. person are taxed currently; above that threshold, the same returns are not considered as evidence of excessive income shifting, and are not taxed currently.

Some countries with participation exemption regimes (i.e., territorial tax systems) impose tax on foreign earnings that have not already been subject to some minimum level of tax. In selecting the rate at which to establish this threshold, analyzing this feature of these participation exemption regimes could provide informative examples of how other countries address income shifting.594

One may expect taxpayers to adjust investment decisions in response to whatever threshold is selected. For example, taxpayers may be willing to accept a somewhat higher foreign statutory tax rate if doing so provides insurance against unintentionally falling below the effective foreign tax rate threshold and triggering subpart F income. Over time, this potential for avoiding the provision could cause taxpayers to migrate operations to countries with a somewhat higher statutory tax rate. If the objective of the proposal is to ensure that a specified minimum threshold of tax is paid on certain foreign income, this migration would effectuate that objective. On the other hand, if the objective is to forestall covered transfers, this migration may perpetuate the existing problem, albeit with CFCs organized in different jurisdictions. Further, depending on the threshold rate that is selected, this could include migration from countries which are treaty partners. As a result, a treaty partner with a low statutory tax rate could argue that the subpart F proposal discourages future investment in that particular treaty country, and possibly -- over time -- encourage disinvestment by some taxpayers.


    Method of calculating the CFC's effective foreign tax rate

By basing a subpart F inclusion on a low effective foreign tax rate, rather than a low statutory tax rate, the proposal focuses on the CFC's actual tax liability in the foreign jurisdiction. Current U.S. tax is potentially imposed under the proposal where the CFC has little or no tax liability in the jurisdiction in which the income is earned. While basing the threshold on the effective foreign tax rate imposes a greater administrative burden on taxpayers and the IRS, statutory foreign tax rates can be unreliable indicators as a result of negotiated tax grants or tax rulings. A taxpayer with a CFC that negotiates or is otherwise entitled to a preferential tax regime may enjoy an effective tax rate that is potentially well below the statutory tax rate in such jurisdictions.

As the proposal intends to use an effective tax rate standard, there are three primary design features to consider: (1) over what period of time to calculate the effective tax rate; (2) whether to use U.S. or foreign tax principles to calculate the effective foreign tax rate; and (3) the treatment of transfers to disregarded entities and actual branches.

Time period of the calculation. -- A taxpayer may have a low effective tax rate in any particular year for a variety of reasons. For example, the taxpayer may have incurred losses in a prior year that the taxpayer is carrying forward to offset current earnings. Similarly, if effective foreign tax rate is determined under U.S. tax principles (discussed below), timing differences (e.g., temporary timing differences resulting from disparate depreciation allowances) may cause variations that may not be present if the effective foreign tax rate is determined under foreign tax principles. While over time such differences reverse, in some circumstances the taxpayer may have already borne the burden of current U.S. taxation resulting from an excessive return. If the proposal's policy rationale is to discourage the transfer of intangible property to low-tax jurisdictions, consideration should be given to whether a one-year, or a multi-year, measure of an effective tax rate more accurately identifies low-tax jurisdictions.

U.S. or foreign tax principles. -- The subpart F proposal could determine the effective foreign tax rate based on either U.S. or foreign tax principles. Both approaches are reflected in current subpart F rules. For example, the high-tax exception of section 954(b)(4) determines the effective tax rate imposed on income based on the taxes deemed paid under section 960,595 a U.S. tax principle. In contrast, the sales and manufacturing branch rules apply a tax rate disparity test to determine if the use of a branch in a different country for such activities has substantially the same effect as if it were a subsidiary of the CFC.596 The tax rate disparity test is based on foreign law principles.597

Arguably, the policy behind the subpart F proposal is closer to that of the high-tax exception than to that of the tax rate disparity test. Under the tax rate disparity test, the goal is to determine whether there is an undue advantage in using a branch to segregate certain activities into separate (non-U.S.) countries. Thus, the tax rate disparity test is intended to identify the difference that actually results under local tax, thereby making it logical to apply foreign law concepts. On the other hand, the high-tax exception implies that a current income inclusion is not required in advance of repatriation if the foreign tax credit on the relevant income indicates the income-producing property was not moved to the CFC because of the tax rate in the CFC's country of organization. This is similar to the underlying objective of the subpart F proposal, which is targeting transfers of intangible property to low-tax jurisdictions. Specifically, under the proposal, there is no evidence of excessive income shifting if the intangible property is transferred to a relatively high-tax jurisdiction. This similarity suggests that U.S. tax principles should be applied when determining the effective foreign tax rate of the CFC.

Moreover, if the CFC's effective foreign tax rate is determined based on foreign principles, the IRS would be required to audit effective foreign tax rate calculations based on unfamiliar rules. This imposes additional burdens on the IRS, which it has intentionally avoided in the past.598

However, taxpayers can be expected to selectively structure their transactions to take advantage of differences between the foreign tax base (on which the CFC's actual tax liability is determined) and the U.S. tax base. Such strategies likely will be designed to decrease the U.S. tax base in comparison to the foreign tax base. As a result, the foreign tax would be greater as a relative percentage of E&P, which has the effect of increasing the effective foreign tax rate.

Transfers to disregarded entities and actual branches. -- The third consideration is how to measure the effective foreign tax rate with respect to transfers to either: (1) an eligible entity that has "checked-the-box" and elected to be disregarded as separate from its owner (a so-called "disregarded entity"); (2) an actual foreign branch; or (3) a CFC with pass-through investments. If either a disregarded entity or the actual foreign branch is respected, then the transfer may be treated as a transfer to the CFC. When determining the effective foreign tax rate of the CFC owner, the calculation is made based on the blended effective foreign tax rate incorporating the income and taxes of the actual CFC plus any pass through investments, such as: (1) the disregarded entity or the actual foreign branch; (2) any other disregarded entities or actual branches owned by the CFC and (3) any partnership items attributable to the CFC.

If a taxpayer were to contribute assets to the CFC to increase its effective foreign tax rate and thereby avoid application of the proposal, the taxpayer would be engaged in a practice referred to as "stuffing." For an example of stuffing, assume that a CFC with a low-tax rate has only one investment, intangible property that it acquired in a covered transfer. The low-tax CFC owns no subsidiaries, nor any other disregarded entities or actual branches. At the beginning of the tax year, the taxpayer determines that the low-tax CFC will have both a low effective tax rate and an excessive return. To avoid a subpart F inclusion for an excessive return, the taxpayer contributes a group of wholly-owned CFCs, each of which is a relatively high-tax CFC, to the low-tax CFC in exchange for shares; each of the high-tax CFCs then elect to be disregarded as separate from their owner (the low-tax CFC). The transactions qualify for nonrecognition treatment for U.S. tax purposes. Without an "antistuffing" rule, the annual tax liability of high-tax CFCs would be combined with any tax paid by the low-tax CFC when computing the effective tax rate of the low-tax CFC. If the blended effective tax rate exceeds the threshold, then there is no possibility of an income inclusion for an excessive return under subpart F. Arguably, this is not consistent with the intent of the proposal.

In contrast, if a disregarded entity or actual foreign branch is treated as a separate corporation, then a covered transfer to that disregarded entity or actual foreign branch may be treated as a covered transfer to a CFC. When determining the effective foreign tax rate of the transferee on a stand-alone basis, the local tax implications of the covered transfer could be isolated and more precisely determined.599 This approach prevents taxpayers from selectively avoiding the application of the subpart F proposal by blending high-tax and low-tax operations within a CFC so as to exceed the threshold effective foreign tax rate.


    Excessive return

The second element of the subpart F proposal is a determination that there is an excessive return to the CFC. A threshold question is whether returns are determined on a pre-tax or after-tax basis. The proposal does not describe the base against which the return is to be measured as normal or excessive. Further, the proposal does not require any causal connection between the transferred intangible property the excessive return earned by the CFC. To the extent a CFC is able -- based on its own unique circumstances -- to produce returns in excess of whatever threshold were to be selected, the use of such threshold may be perceived as subjecting income to current U.S. tax where such income was not artificially shifted from the United States.

    Determining an excessive return by reference to returns on investment

One reason to transfer intangible property outside the United States is to make it available to a foreign manufacturer that makes and sells the goods that are produced based on the intangible property. Taxpayers employ various approaches for transferring intangible property.600 In some cases, intangible property is transferred to a jurisdiction that does not impose any tax; typically, taxpayers do not make substantial investments in plant, property and equipment in such jurisdictions. In these situations, a low effective tax rate threshold may be a sufficient basis for targeting income shifting.

In other cases, intangible property is transferred to a jurisdiction that either imposes a relatively low tax on business income or in which taxpayers are able to negotiable favorable tax rulings that reduce or substantially eliminate local tax. While it may be more common for taxpayers to invest in plant, property and equipment and establish operations that generate high profit margins in these countries, there is no universal formula that prescribes how any given taxpayer will structure its legal form, capitalize its structure with cash and assets, or operate its business in such countries. In these situations, a low effective tax rate threshold may not be a sufficient basis for targeting income shifting because it does not distinguish between taxpayers that have made substantial investments in local operations and those that have minimal presence.

The excessive return threshold could be viewed as making this distinction. For example, the excessive return could be determined based on a CFC's measurable investment in the jurisdiction, with any return in excess of a normal return on this investment constituting an excessive return. However, whether a universal standard applied equally across all businesses and industries could, in fact, do so in a manner that could be readily administrable by the IRS is unclear.

As an initial matter, the time period over which the return on investment is measured must be determined. For example, the return on investment could be determined on an annual basis, such that each year's return and each year's investment is isolated and stands alone. Alternatively, returns and investments could be averaged over a specific time period. This alternative approach takes into account that, for a successfully developed product, there is typically some lead time between (1) the initial investment, (2) initial commercialization, and (3) profitability. It also takes into account that profitability can be cyclical. As lead times and profit cycles vary both by industry and by product, it may be appropriate to permit taxpayers to elect either annual testing or testing based on a multi-year rolling average.

In addition, some may assume that the proposal intends to tax currently an excessive return derived specifically from the transferred intangible property, yet this is not stated in the proposal. Thus, another initial matter is whether an excessive return should be measured broadly, by reference to a CFC's earnings in aggregate, or in a more limited and targeted manner. If measured in a targeted manner, an excessive return could be measured by reference to earnings related to a specific transfer of intangible property, and the products derived from the use of that intangible property. This approach has the advantage of more closely linking the proposal to its stated purpose, but could be complicated to administer to the extent a CFC's business extends across multiple product lines and activities, and includes shared resources. If measured broadly, an excessive return could be diluted by combining high- and low-margin products in the same CFC. While easier to administer, this broad approach provides taxpayers a route for planning around, and thwarting the intent of, the subpart F proposal.

Measuring investment. -- Defining an excessive return by reference to a CFC's return on investment requires careful consideration in defining the term "investment." Under a "balance sheet" approach, the investment base could be limited to those items reflected on the U.S. GAAP balance sheet of the tested CFC. Balance sheets for both CFC's and disregarded entities are reported on annual information reports.601 Accordingly, limiting the calculation to investments reflected on the CFC's balance sheet provides a readily determinable and, within the subjective limits permitted by U.S. GAAP accounting principles, an objective basis for calculating an excessive return. However, a "balance sheet" approach leaves out potentially relevant expenses that the CFC incurs to earn the return on investment. In other words, the CFC's profits are derived not only by those tangible and intangible assets recorded on its balance sheet, but also by deductible expenses that are reflected in its income statement.

Under an "all monies expended" approach, the return on investment could take into account any expenses incurred to generate the tested CFC's return. The base of investment expenses includes the U.S. GAAP balance sheet of the tested CFC plus expenses that are not reflected on the balance sheet. For example, research and development ("R&D") costs that are deducted currently are generally not recorded as intangible property on the balance sheet. Similarly, a CFC may license complementary intangible property from a third party. A CFC that invests in developing its own intangible property or licenses complementary intangible property may enjoy high returns on those expenditures. Thus, an "all monies expended" approach may mitigate the potential for overstating an excessive return attributable to a transfer of intangible property from a related U.S. person. On the other hand, the "all monies expended" approach is more difficult to administer than a "balance sheet" approach.

Whether to include an antistuffing rule is also a consideration with respect determining an excessive return. In the example above, the balance sheets (and, in an all monies expended approach, any relevant expenses) of the high-tax CFCs would be combined with that of the low-tax CFC when computing the excessive return of the low-tax CFC. If the blended rate of return is normal, then there is no excessive return to include in current income under subpart F based on the proposal. Arguably, this is not consistent with the intent of the proposal. In contrast, with an antistuffing rule, an excessive return is measured as if disregarded entities or actual foreign branches are separate corporations. As with an antistuffing rule in the context of the effective foreign tax rate calculation, this approach prevents taxpayers from selectively avoiding the application of the subpart F proposal by blending high-return and low-return operations.

If return on investment is the basis of determining if there is an excessive return, there could be potentially disparate implications to basic business decisions. A fundamental business decision is whether to (1) build a factory (which results in a balance sheet asset) and "make" a product internally or (2) outsource production to an unrelated contract manufacturer (where no balance sheet asset results) and only "sell" the product. These "make or sell" decisions are often based on comparative internal rate of return calculations. Depending on how the excessive return is calculated, the subpart F proposal could distort the make or sell decisions. If the taxpayer makes the product, the measured rate of return may be lower than if the taxpayer were to choose only to sell it after production by a contract manufacturer. A lower effective tax rate could result from choosing to make the product, even if the contract manufacturer were the more economically efficient producer. As a result, a return on investment approach to distinguishing between a normal and an excessive return could increase the relative importance of tax liabilities in analyzing "make or sell" decisions.


    Determining an excessive return by reference to returns to risk

Another approach is to define an excessive return by reference to the profits associated with the risk that is assigned to the CFC in the intangible property transfer. Total return (i.e., the total profit earned by the CFC with respect to its sale of a good or service) is comprised of two components, a risk-free rate of return (commonly thought of as the yield on a U.S. Treasury bond) plus a risk premium (the return to compensate for undertaking the risk underlying the investment).

As stated above, an important component in income shifting through intangible property migration is the mobile nature of risk. Commercialization of intangible property is speculative, as the success or failure of the product in which it is deployed (in its development, launch, continued market demand, and pricing) is inherently uncertain. In addition, other uncertainties exist, such as the potential that a product design is intrinsically flawed. Thus, under the arm's-length standard, risk is one of the primary factors on which comparability602 -- and therefore entitlement to system profits -- is based.603 As a result, the extent to which each party bears the underlying risks is a primary factor when evaluating whether there is an arm's-length result. This is true even for a related-party transaction occurring entirely within an affiliated group, where arrangements can be designed to shift risk (and therefore income) among distinct legal entities while, nonetheless, remaining inside the group. To address the mobile nature of risk, the subpart F proposal could be designed to target returns to risk as an excessive return.

Risk-adjusted transfer price. -- To deny deferral for returns to risk, one approach is to use a risk-adjusted transfer price as the threshold between a normal and an excessive return. Specifically, the taxpayer's transfer price would be calculated "with," and "without," taking into account risk borne by the CFC in the "with" calculation; the difference is then taxed currently as a subpart F item. Implicit in this approach is that an excessive return is linked to a specific intangible property transfer and specific products derived from the use of that intangible property, assumptions not explicit in the proposal. This approach has the dual benefits of precisely targeting the highly mobile nature of risk and building on existing administrative documentation requirements, such that current transfer pricing documentation could be expanded to incorporate the new "without risk" analysis. On the other hand, this approach could be viewed as increasing complexity by mandating additional transfer pricing analysis and documentation.

Residual profit split. -- Another approach is to define an excessive return by reference to the residual profit split method, applied without regard to any assignment of risk to the CFC. Under the residual profit split method, the value of the routine contributions of the CFC and the taxpayer (which has transferred intangible property) should be readily ascertainable, leaving only the residual profit associated with the parties' nonroutine contributions to allocate. Routine contributions include contributions of tangible property and services. The excessive return would be determined by subtracting the CFC's residual profit split (determined without regard to any assignment of risk to the CFC) from the CFC's actual return.

The advantage of this approach is that it accounts for high-value intangible property (and the risks taken thereon, if any) and other functions that the CFC contributes to the production of revenue. In addition, an excessive return is linked to a specific intangible property transfer and specific products derived from the use of that intangible property. On the other hand, this approach may result in an additional administrative burden -- to both the IRS and to taxpayers -- in those situations in which the transfer price is not initially established based on the residual profit split method. In these cases, taxpayers are required to complete, and the IRS to audit, a second transfer pricing analysis.


    Covered transfers

The subpart F proposal applies to any CFC to which intangible property is transferred if the additional effective foreign tax rate and excessive return requirements were also met. Its application is based solely on: (1) the transfer from the United States; (2) of any intangible property; (3) from a U.S. person; (4) to a related CFC. The proposal does not enumerate the types of transfers that are covered, thus, in the absence of any limitations, it covers all transfers, including (1) transfers made by license arrangements, (2) the provision of services using embedded intangible property,604 and (3) any transfer of intangible property from the United States, without regard to whether that intangible property was originally developed in the United States.

By its terms, the subpart F proposal does not appear to include the output that results from contract research performed in the United States at the expense of a foreign affiliate. Thus, if a CFC acquires intangible property from an unrelated third party or engages a U.S. affiliate to perform contract R&D services, the proposal does not apply.


    Retroactivity to pre-effective date transfers

In many instances, intangible property is made available to a CFC pursuant to an agreement covering multiple years. For example, a CFC that is required to build facilities and develop supporting plant, property and equipment to make and sell a patented product may have a long-term license with the owner of the patent. Similarly, where the intangible property is made available pursuant to an outright transfer of rights, the useful life of the intangible property likely extends beyond the initial year in which it was transferred. Under the subpart F proposal, it is unclear whether a multi-year, or an outright, transfer made prior to the effective date is exempt from the proposal. Resolution of this question depends, in part, on the definition of "transfer" for this purpose.

One approach is to define a transfer solely by reference to the relevant contract -- in other words, the provisions of the agreement that characterize the conditions imposed on the transfer. For example, this approach could start from the premise that outright transfers are not subject to the proposal, but continuing licensing are subject to the proposal. A conclusive determination as to either, however, would be determined based on the terms of the agreement that effected the transfer, whether those terms are written or implied by the actions of the taxpayer and the CFC. In addition to the administrative difficulty inherent in this fact-based approach, it could also provide an incentive to taxpayers to transfer as much intangible property possible to CFCs -- through structured transactions designed to mitigate income recognition on the outbound transfer -- prior to the effective date, with the goal of avoiding application of the proposal.

Units of production. -- A transfer could be defined at a level reflecting its most basic component, such that each specific use of intangible property in conjunction with the production of each unit of the good or service reflects a distinct transfer of the underlying intangible property. With this definition, any pre-effective date transfers (whether the method of transfer was by multi-year agreement or by outright transfer) give rise to post-effective transfers for purposes of the subpart F proposal as long as units continue to be produced. This approach facilitates administration of the proposal by basing a transfer of intangible property solely on the use of that intangible property by the CFC, which should be a readily ascertainable and objective fact. It may have the added benefit of precluding the development of strategies which avoid the intent of the subpart F proposal based on the conditions and form of the transfer prior to the effective date.

Inherent in this approach is that the CFC is subject to effective tax rate and excessive return testing during the useful life of the transferred intangible. It is not clear whether the CFC is subject to testing once the intangible property has been disposed of, is no longer in use, or has reached the end of its useful life. If a CFC that receives a covered transfer is permanently tainted, such that this element of the test is irrevocably satisfied, the proposal may achieve its objective of reducing the financial incentive to shift income to low-tax jurisdiction through outbound transfers of intangible property. In addition, the risk of a permanent taint may provide an incentive to taxpayers to divert intangible property away from low-tax jurisdictions, an objective of the proposal.

Cost sharing arrangements. -- Transfers made in conjunction with cost-sharing arrangements present a unique issue. With cost sharing, an important "use" of the transferred intangible property may be as the platform from which the next generation is developed. For example, with respect to the transfer of Version 1.0 intangible property, the buy-in agreement might entitle the CFC to (1) the foreign "make and sell" rights during the useful life of Version 1.0, (2) the right to develop Version 2.0 from Version 1.0, and (3) economic ownership of the foreign rights to Version 2.0. To the extent that the CFC avails itself of the intangible property by making and selling Version 1.0 products, the use of Version 1.0 in production subjects that transfer to the subpart F proposal. On the other hand, upon the successful development of Version 2.0, it is unclear whether production of Version 2.0 products should be considered as a successor to the use of Version 1.0 intangible property.

One approach is to deem the transfer of Version 1.0 as being made with respect to each Version 2.0 product manufactured on the theory that Version 1.0 is inherently incorporated in Version 2.0. While the nexus between Version 1.0 and Version 2.0 may be sufficient to warrant this approach, it is unclear whether it should also continue in perpetuity as subsequent versions (3.0, and so forth) are developed. Arguably, a covered transfer that the proposal treats as continuing in perpetuity during the useful life of any Version 1.0 progeny, without regard to the actual useful life or usefulness of Version 1.0, mitigates the financial incentive to cost share intangible property development. On the other hand, if the proposal does not specify how to treat subsequently developed versions, determining, on a case-by-case basis, whether a subsequently developed version has sufficient nexus to the original covered transfer to be considered a successor to the covered transfer may impose significant administrative burdens on both taxpayers and the IRS.


    Limited to intangible property that is transferred from the United States

The subpart F proposal applies only to intangible property that is transferred from the United States. As a result, taxpayers may perform more R&D activities outside the United States at their CFCs from inception to avoid its application. In addition, CFCs may hire related U.S. affiliates to perform contract R&D services on their behalf more frequently.

Intangible property developed by a CFC. -- Income from intangible property developed by a CFC is outside the scope of the subpart F proposal. Accordingly, CFC income derived from intangible property developed and owned by a CFC organized in a low-tax jurisdiction is not subject to excessive return testing unless predicated on some other intangible property transfer to the CFC by a related U.S. person (as discussed above).

Within a taxpayer's affiliated group, R&D is often performed in the United States. Contract R&D services are sometimes provided to a CFC pursuant to an R&D service agreement or a cost-sharing arrangement. The CFC compensates the taxpayer for services performed at an arm's-length mark-up (typically within the range of five percent to 10 percent).605 Thus, the taxpayer commits its U.S.-based intellectual capital resources to the R&D effort, but the CFC takes the financial risk on the R&D project, and therefore is entitled to ownership (as well as any above-normal returns) if the R&D efforts are successful. If, instead, these services are provided in the context of a cost-sharing arrangement, the only benefit to the taxpayer from the commitment of its R&D resources is the right to exploit the new intangible property consistent with the rights assigned to the taxpayer in the cost-sharing arrangement (e.g., the taxpayer is assigned the right to exploit the U.S. market). In addition, the taxpayer may be entitled to claim the R&D credit provided by section 41 under such contract R&D arrangements. In exchange, the taxpayer shares in the development cost pro rata, based on the reasonably anticipated benefits of each cost-sharing participant (e.g., the taxpayer's share is based on the expected U.S. sales as a percentage of expected total sales). In either case, under present rules there is no transfer of intangible property to the CFC under the R&D services agreement or cost-sharing arrangement because the CFC owns the output that results from the contract R&D services from inception.

There are also important nontax considerations in selecting the physical location for R&D, as well as the legal entity that funds and bears the risk of R&D. For example, access to, and retention of, qualified scientists may be important reasons to locate R&D activities in the United States. In addition, because the U.S. GAAP financial statement tax "benefit" from any loss that results from R&D performed in a low-tax jurisdiction that is not successful is recorded as a detriment, taxpayers may not make a wholesale shift of R&D to low tax jurisdictions. The detriment reflects the value of the foreign losses computed at the low tax rate, which is less than the value of those same losses computed at the 35-percent U.S. statutory tax rate. Therefore, taxpayers are generally selective when identifying projects for foreign development, choosing only those projects with the highest likelihood for success. Nonetheless, taxpayers may increase foreign R&D activities by CFCs to avoid current taxation under the subpart F proposal.

Intangible property acquired outside the United States. -- Under current U.S. tax rules, there are several reasons why taxpayers acquiring intangible property, directly or indirectly, may consider making the acquisition through a CFC.606 First, the 35-percent U.S. tax rate imposes a relatively high cost on income earned from intangible property in comparison to the tax liability that would be incurred if the same income were earned in another jurisdiction, most of which now have lower statutory tax rates on business income.607 Second, the United States imposes tax on any built-in gain when intangible property is transferred outside the United States, which makes even temporary ownership of newly acquired intangible property a potentially costly decision.608 Third, the lock-out effect of deferral609 means that companies may have funds available offshore to invest in such acquisitions. Indeed, foreign acquisitions are often an important use of CFC cash. The subpart F proposal adds another consideration to this list, and favors acquiring certain intangible property through a CFC.

Treaty considerations

The subpart F proposal requires certain active business income earned by a CFC to be taxed currently in the United States to the United States shareholder. To the extent that the CFC is organized in a jurisdiction with which the United States has a tax treaty, some treaty partners may argue that the proposal is inconsistent with the obligations established by the treaty.


    Source and residency taxation

Under the U.S. Model Tax Treaty, the primary right to tax income attributable to intangible property is granted to the owner's country of residence.610 This granting of primary rights is accomplished by operation of provisions commonly found in bilateral tax treaties (which typically eliminate or reduce withholding taxes on royalties paid) in conjunction with the deductibility of royalties in the country of exploitation. Thus, even though the intangible property owner treats the source of a royalty as the country of its exploitation for U.S. tax purposes, income arising from the intangible property may be subject to little or no tax in that jurisdiction. The income that remains after payment of the royalty is generally considered business profits, which reflect a return on the transferee's contributions. In general, the United States does not tax the business profits of a company that is a resident of a treaty partner, even where that company is controlled by a U.S. person, unless that foreign treaty resident derives income that is effectively connected with a permanent establishment in the United States.

While treaties generally allocate the primary right to tax business profits to the source country, this general rule does not preclude concurrent (but residual) taxation (i.e., the imposition of residual U.S. tax in excess of the statutory tax rate in the country of exploitation for the year that the income is earned) by the residence country provided that a foreign tax credit is available to avoid double taxation. The contemporaneous expansion -- both within and outside of the United States -- of residence taxation of specific types of undistributed earnings is consistent with the notion of the widespread acceptance by U.S. treaty partners of concurrent (but residual) taxation of subpart F type income, and that these provisions are not viewed by treaty partners as repudiating the intent or the terms of tax treaties. The OECD concurs with this view.611

Concurrent (but residual) taxation by the United States has been limited to situations predominantly involving income from: (1) insurance or reinsurance of U.S. risks; (2) passive income; (3) "the purchase and sale of property without any appreciable value being added to the product by the selling corporation;"612 and (4) the performance of certain services outside the CFC's country of incorporation (the latter two of which are referred to as the "base company" rules). Arguably, the first two types of income are each passive in nature, while base company services income is active because value is generated by the bona fide performance of services. Base company sales income may be active, if value is being added to the property that is purchased. In this way, taxing active income currently under the subpart F proposal is within the established framework of concurrent (but residual) U.S. taxation because, as with the proposal, in some circumstances active income is subject to concurrent (but residual) U.S. taxation under present law.

On the other hand, residual active services income is concurrently taxed by the United States when it is presumed, based on the fact that the services are performed outside the country in which the CFC is organized, as being derived from a largely artificial arrangement. A similar construct applies to base company sales income, but the applicable provisions turn on whether activities have been shifted outside the country in which the CFC is organized to achieve a lower tax rate on selling activities.613 Under the subpart F proposal, concurrent (but residual) U.S. taxation may apply to active income even where the CFC makes bona fide, substantive, contributions to the production of active business profits in the same country in which it is organized. Accordingly, some treaty partners may be concerned that the subpart F proposal conflicts with negotiated treaty rights to the extent that it is viewed as the residence jurisdiction "taking away [the source jurisdiction's] right to effectively grant tax holidays to foreign investors"614 or attract investment through low tax rates. However, the U.S. has never sanctioned tax sparing agreements in treaties (i.e., provisions that preserve tax incentives granted by lower-income jurisdictions to induce foreign direct investment by limiting residual taxation of earnings upon repatriation to a higher-income jurisdiction) and tax sparing agreements have been the impediment to concluding treaty negotiations.

Tax administration


    In general

The proposal does not include any provisions for penalties or reporting. The proposal may require taxpayers to adopt new record keeping practices to identify and track each transfer of intangible property from the United States that could potentially result in a subpart F inclusion for an excessive return. In many instances, such transfers are documented in contracts, as the contracts help ensure the deductibility of royalties or other forms of compensation paid for the use of intangible property and also support profit allocations for transfer pricing purposes. However, as a practical matter, the level and detail of documentation varies by taxpayer. In addition, if the intangible property covered by the proposal is defined broadly, there may be some intangible property transferred to CFCs without documentation. The proposal presents administrative challenges to the IRS as well, as the IRS is required to examine taxpayer self-assessment of subpart F income from excessive returns.

For example, assume a taxpayer encounters production problems at its low-tax CFC manufacturing facility as it starts producing a new biologic drug on a commercial scale. To resolve these problems, the taxpayer sends a group of scientists from the U.S.-based pilot plant. Over the course of a week, the scientists use know-how previously developed at the pilot plant to resolve production problems, and in the process, this know-how (which is intangible property) is informally conveyed to the local operations team. Nonetheless, there may not be a contract between the CFC and the taxpayer that identifies and tracks the valuable information imparted from the scientists to the CFC during that week. Further, the taxpayer may not even be aware that the trip had potential significance under the proposal.

However, implicit in the proposal may be the expectation that, despite some increase in compliance necessary to accurately report subpart F income from an excessive return -- including, possibly, the identification and tracking of previously informal transfers of intangible property -- current taxation of an excessive return will reduce transfers of intangible property from the United States, resulting in a net decrease in the aggregate administrative burden.


    Information asymmetry

The proposal resorts to subpart F as the principle mechanism for minimizing factual disputes in addressing the issue of excessive income shifting, rather than relying on transfer pricing adjustments under section 482. Use of subpart F permits the proposal to operate mechanically, and function as an antiabuse provision without the labor-intensive prerequisite of finding an abusive transaction. Instead, the proposal posits that, as a policy matter, (based on administrative experience and studies), that excessive income shifting is typically accompanied by the presence of: (1) a low effective foreign tax rate; (2) a relatively high ratio of income to physical assets or other measures of investment; and (3) intangible property transfers from the United States. As a result, taxpayers cannot avoid an income inclusion under subpart F by proving that there is no actual excessive income shifting, nor any intent to shift excessive income. The effect is to treat dissimilar taxpayers the same, such that some taxpayers with legitimately high rates of return are taxed currently as if they had engaged in excessive income shifting.

However, the difficulties that the IRS currently faces in transfer pricing disputes due to information asymmetry (i.e., the fact that the taxpayer inherently has more complete knowledge of its own facts than does the IRS) may continue under the proposal. While the proposal can be structured with observable, objective criteria for determining the effective foreign tax rate and what constitutes an excessive return, taxpayers control information regarding transfers of intangible property. Further, as demonstrated by the example above, taxpayers may not have adequate controls in place to identify and document information regarding formal and informal transfers of intangible property.

On the other hand, the information that must be ascertained by the IRS during an audit -- whether there has, or has not, been a transfer of intangible property by a U.S. person from the United States -- is binary in nature. In some instances, this may reduce the level of intervention necessary to determine if a taxpayer has appropriately excluded excessive returns identified at CFCs with low effective tax rates on the basis that there was no covered transfer.

Opponents contend that providing taxpayers with the opportunity to establish that their circumstances do not evidence excessive income shifting (i.e., that the taxpayer is in compliance with the arm's-length standard) is necessary to ensure a more equitable approach since the proposal does not distinguish between industries or take into account the diverse rates of return typically earned by different industries. Without such opportunity, industries with traditionally high rates of return could find that the industry, as a whole, is disproportionately subject to the proposal's current taxation on excessive returns when compared to other industries.


Prior Action

No prior action.

5. Limit shifting of income through intangible property transfers


Present Law

Pricing for transfers of intangible property between related persons

Within a group of related entities,615 there are often no market pressures that impose market pricing on transactions between the related parties, and goods and services are transferred between related parties at self-derived prices. Absent transfer pricing rules, the lack of external market forces would permit multinational groups to shift income in any manner they choose among group members. Thus, the United States has extensive rules designed to preserve the U.S. tax base by ensuring that income properly attributable to the United States is not shifted to a related foreign company through aggressive transfer pricing that does not reflect an arm's-length result. Similarly, the domestic laws of most U.S. trading partners include rules on transfer pricing.

Section 482 authorizes the Secretary of the Treasury to allocate income, deductions, credits or allowances among related business entities when necessary to clearly reflect income or otherwise prevent tax avoidance, and comprehensive Treasury regulations under that section adopt the arm's-length standard as the method for determining whether allocations are appropriate. Thus, the regulations generally attempt to identify the respective amounts of taxable income of the related parties that would have resulted if the parties had been unrelated parties dealing at arm's length. In 1986, Congress added an additional test for transactions resulting in the transfer of intangible property, which provides that the income with respect to any transfer (or license) of certain intangible property to a related person must be commensurate with the income attributable to the intangible property. Section 367(d) provides a related rule under which compensation, in the form of an imputed royalty stream, is required for an outbound transfer of intangible property in the context of an otherwise nontaxable reorganization transaction.616


    Methods of transferring intangible property

A U.S. person that develops or purchases intangible property generally can make that intangible property available to a related person (typically, a foreign affiliate) in four ways. The first is through an outright transfer of all substantial rights in the intangible property, either by sale or through a non-recognition transaction (for example, a capital contribution of the intangible property to the affiliate in an exchange that meets the requirements of section 351, or an exchange made pursuant to a plan of reorganization that is described in section 361). The second is through a license of the intangible property, in which the U.S. person transfers less than all substantial rights in the intangible property to the foreign affiliate.617 The third is the provision of a service using the intangible property, rather than a direct transfer of the property.

In the fourth, intangible property is made available through a cost-sharing arrangement. In a typical cost-sharing arrangement, a U.S. company and one or more foreign affiliates make resources available and contribute funds (through a combination of cash and existing intangible property rights) toward the joint development of a new marketable product or service. The U.S. company makes available all, or a substantial portion, of the rights to use and further develop existing intangible property, and the foreign affiliate (typically organized in low-tax jurisdiction) generally contributes cash. The arrangement provides that the U.S. company owns legal title to, and all U.S. marketing and production rights in, the developed property, and that the other party (or parties) owns rights to all marketing and production for the rest of the world.618 Reflecting the split economic ownership of the newly developed asset, no royalties are paid between cost sharing participants when the product is ultimately marketed and sold to customers. However, the U.S. company receives a buy-in payment619 (such as periodic intercompany royalties or a lump sum payment at the outset) from the other cost-sharing participant with respect to its "platform" contribution.620

The mechanism used for transferring intangible property to a foreign affiliate frequently dictates whether the authority for determining the compensation received by the U.S. person in the transaction is under section 482 or section 367(d). Generally, a license or a sale of intangible property, or the provision of a service that uses intangible property, is subject to section 482. An exchange of intangible property in connection with certain nonrecognition transactions is subject to section 367(d), which overrides the general nonrecognition rules of sections 351 and 361 to require that the transferor of intangible property include imputed income from annual payments over the useful life of the intangible, as though the transferor had sold the intangible (at whatever stage of development it is, from an entirely undeveloped idea through, and including, a completely developed and exploitable item of intangible property), at times in exchange for contingent payments. The appropriate amounts of those imputed payments are determined under section 482 and the regulations thereunder. Transfers of foreign goodwill or going concern value are specifically exempt from the income recognition provisions of section 367(d).621 With respect to cost-sharing arrangements, specified rights to existing intangible property can be transferred to other cost-sharing participants either through a sale or a license.622


    Application of section 482 principles to unidentified intangible property

For purposes of sections 482 and 367(d), "intangible property" is defined by reference to section 936(h)(3)(B) and means any: (1) patent, invention, formula, process, design, pattern, or know-how; (2) copyright, literary, musical, or artistic composition; (3) trademark, trade name, or brand name; (4) franchise, license, or contract; (5) method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; or (6) any similar item. The term "intangible property" contemplates that any such item must have substantial value independent of the services of any individual.623

A definition of workforce in place is set forth in the regulations under section 197, which define it as a separate asset that includes "the composition of a workforce (e.g., the experience, education, or training of a workforce), the terms and conditions of employment, whether contractual or otherwise, and any other value placed on employees or any of their attributes."624 Prior to the promulgation of these regulations,625 the Tax Court held that workforce in place "is not separate and distinct from going concern value" because it is not a wasting asset.626 Later, following the Supreme Court decision in Newark Morning Ledger, the Court of Appeals in Ithaca noted that it was no longer appropriate to deny a deduction on the basis on an intangible asset's resemblance to the classic conception of goodwill or going-concern value. However, the decision of the Tax Court was affirmed, as the useful life of the workforce in place was not ascertainable. The 2008 cost sharing regulations treat workforce in place as separately compensable if the U.S. parent's workforce in place is reasonably expected to contribute to the development of cost-shared intangibles; in this situation, the workforce in place is considered a platform contribution for which the foreign subsidiary must compensate the U.S. parent.627


    Valuation methods

The Treasury regulations under section 482 require that the "arm's-length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm's-length result."628 Taxpayers must use not only the best method, but also the most reliable application of that method.629 "Aggregation" and "realistic alternative" are valuation concepts prescribed by the transfer pricing regulations. These valuation methods are to be used when they provide the most reliable measure of an arm's-length result. When these methods are used in those circumstances, then the taxpayer will have used the best method as is required by the transfer pricing rules. As with all section 482 rules, this principle of reliability as articulated in section 482 regulations is applied to the valuation of outbound intangible property transfers under section 367(d).630

    Aggregation

Treasury regulations under section 482 provide that multiple transactions may be considered in the aggregate if doing so provides the most reliable means of determining the arm's-length consideration for the related-party transaction.631 For example, assume that a pharmaceutical company makes ten patents (each of which is a critical, unique component in the manufacture of its blockbuster drug, ABC) available to other cost-sharing participants through a cost-sharing arrangement. Those patents could be valued, for purposes of determining an appropriate buy-in payment, on either an asset-by-asset approach, or an aggregation approach. The taxpayer may take the position that an arm's-length result is achieved by valuing intangible property on an asset-by-asset basis; in this example, each individual patent may have only marginal value when considered in isolation. When considered in aggregate (particularly in light of the success of the ABC drug), the valuation may be materially higher than the sum of the individual patents.

    Realistic alternative

The realistic alternative principle is reflected in Treasury regulations, which provide that the Commissioner will evaluate the results of a transaction as actually structured by the taxpayer unless its structure lacks economic substance, but that the Commissioner may also consider the alternatives available to the taxpayer in determining whether the terms of the related-party transaction would be acceptable to an unrelated-party taxpayer faced with the same alternatives and operating under comparable circumstances.632 As with specified methods, unspecified methods should reflect a consideration of the realistic alternatives to the actual transaction in connection with a transfer of intangibles.633 Similar rules apply with respect to unspecified methods for transfers of tangible property,634 cost-sharing arrangements635 and intercompany services.636 Although the examples in the regulations emphasize the analysis of available, but not undertaken, internal transactions entirely within the related-party group,637 the realistic alternative principle is not limited to such transactions.638

    Recent litigation

Both the identification of intangibles and the appropriate valuation of such intangibles were in dispute in Veritas v. Commissioner.639 The issue was the adequacy of the lump-sum payment made by a cost-sharing participant for use of the intangibles the taxpayer had made available through a cost-sharing arrangement. The taxpayer's Irish affiliate made a buy-in payment of $118 million as a royalty for the use of a full-range of pre-existing intangible property. The royalty was determined based on internal comparable transactions, in which the taxpayer had licensed the same intangible property to unrelated parties. However, none of the internal comparables licensed the same full-range of rights as were bundle together and made available under the cost-sharing arrangement, although collectively the agreements involved essentially the same intangible property. The IRS challenged the comparability of the internal transactions on which the taxpayer based its determination of the transfer price, contending that the rights granted in of each third-party license were materially narrower than those made available through the Irish affiliate through the cost-sharing arrangement. The IRS also argued that the most reliable method for valuing the bundle of rights that were transferred was as an aggregation of rights. Further, the IRS also contended that the taxpayer should have been compensated for the transfer of existing goodwill, going-concern value, and workforce in place to the Irish affiliate.

Description of Proposal

The proposal states that it clarifies that the definition of intangible property for purposes of sections 367(d) and 482 includes workforce in place, goodwill and going concern value. The proposal also states that it clarifies that in a transfer of multiple intangible properties, the Commissioner may value such properties on an aggregate basis where doing so achieves a more reliable result. Finally, the proposal states that it clarifies that the Commissioner may value intangible property taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction undertaken.

Effective date. -- The proposal is effective for taxable years beginning after December 31, 2010.


Analysis

In recent years, transfer pricing audits and proposed adjustments with respect to transfers of intangible property have emphasized two particular issues. The first is the adequacy of the buy-in payment for existing intangible property made available to related affiliates pursuant to cost-sharing arrangements; these transfers are typically subject to section 482.640 The second is the adequacy of compensation paid by a CFC for intangible property transferred in connection with recent outbound restructurings of U.S. manufacturing operations that preceded the expiration of the section 936 possessions credit rules; these transfers are typically subject to sections 367(d) and 482.641 The proposal does not modify the basic approach of the existing transfer pricing rules with regard to income from intangible property. Instead, its scope is limited to addressing certain definitional and methodological issues that have arisen in IRS examinations of the value attributed to intangible property at the time it is transferred outside the United States.

Definition of intangible property

The proposal affirmatively answers the question of whether an outbound transfer to related-party of goodwill, going concern value, and workforce-in-place may require compensation. In casting the proposal as a clarification, the Administration continues to support the position it has taken in recent litigation and regulations that workforce in place, goodwill, and going concern value are intangible property listed in section 936(h)(3)(B) as "similar items."642 On the other hand, taxpayers deny that compensation is required for any price is required goodwill, going concern value, and workforce-in-place under present law.

While the proposal states that it is intended to clarify present law, some commentators have expressed the view that the proposal represents a significant change to present law.643 In addition, the U.S. Tax Court rejected this characterization, stating that the Administration had, when it made the same proposal in 2009, "proposed to change the law."644 Although that question may have relevance to the resolution of disputes under present law, it seems likely that the proposal, if enacted, would establish that the compensable proportion of the value inherent in many outbound transfers of intangibles would be larger under the proposal than the amount believed by many to be compensable under present law.


    Goodwill and going concern value

With regard to goodwill and going concern value, IRS audit disputes concern the threshold treatment of these items as intangibles, the scope of the exception under section 367(d) for foreign goodwill or going concern value, and the extent to which the exception under section 367(d) should be imputed to section 482. Questions in this regard include how to distinguish foreign goodwill or going concern value from U.S. goodwill and going concern value, where both are transferred,645 and whether foreign goodwill or going concern value is an attribute of foreign operations that develops over time. The IRS asserts that foreign goodwill or going concern value has no value at the start-up of foreign operations.646

Taxpayers have contended that the exceptions from compensation under section 367(d) must be imputed to transfers of intangibles under section 482 (even though this exception is not referenced in the section 482 statute, legislative history, or the regulations) on the basis that sections 482 and 367(d) must be read together, because the transactions to which they apply are economically similar and should receive similar tax treatment. Commentators have also stated that adding goodwill and going concern value to the definition of intangible property under section 936(h)(3)(B) obsoletes the exception for foreign goodwill or going concern value set forth in Temp. Treas. Reg. sec. 1.367(d)-1T(b).647 This conclusion is predicated, however, on the position that specifically identifying goodwill and going concern value as intangible property under section 936(h)(3)(B) is a change in law, rather than a clarification of present law, because only a change in the law would obsolete the (earlier-promulgated) regulation. The description of the proposal as a clarification of (and not as a change to) present law suggests that the proposal is not intended to revoke the exception. In any event, the question could easily be addressed by incorporating an explicit exception for transfers of foreign goodwill or going concern value in the implementing legislation, if Congress wishes to preserve the exception.


    Workforce in place

With regard to workforce in place, IRS audit disputes include both whether it is a "similar item" under section 936(h)(3)(B)(vi) and, if so, whether it is a component of goodwill or going concern value or a separately identifiable asset. Some taxpayers argue that, if it exists at all (as intangible property beyond its physical element), workforce in place is a component of goodwill and going concern value and, consequently, transfers of a foreign workforce in place are noncompensable under section 367(d).648 In contrast, the IRS takes the position that any identifiable intangible with substantial value independent of the services of any particular individual is, by definition, not goodwill or going concern value.649 Thus, any workforce in place (such as a research and development team that is made available -- whether by transfer or through a service commitment -- to a cost-sharing arrangement) that has substantial value independent of the services of any individual member of that workforce also has an intangible component that is distinct from goodwill and going concern value and compensable by the person for whose benefit it is used.650

Valuation issues


    Overview

A second set of IRS audit issues arise in situations where the taxpayer agrees that a compensable intangible asset has been transferred offshore, but the IRS believes that the taxpayer has not applied the most reliable valuation technique.651 In certain cases, for example, a taxpayer may believe that the most reliable method is to value intangible properties individually, on an asset-by-asset basis, without reflecting the enhanced value that may arise from their interrelationship. Where the IRS believes this method leads to unreliable results, the IRS disputes this asset-by-asset valuation approach. For example, the IRS may believe that the individual assets are so closely related that the individual pieces cannot be reliably valued on an asset-by-asset basis because the relevant intangible property is the complex comprised of the related parts.

In other cases, a taxpayer may assert a transfer price as an arm's-length result without also considering realistic alternatives to the transaction actually undertaken, such as the alternatives of making a product directly or outsourcing production. If the taxpayer fails to consider realistic alternatives, the IRS may assert that the taxpayer has not achieved an arm's-length result, because the taxpayer has assumed that an unrelated person at arm's-length would be willing to engage in a particular transaction, even if an available alternative would yield a greater economic return.652


    Aggregation

The proposal confirms that the additional value that results from the interrelation of intangible assets can be properly attributed to the underlying intangible assets in the aggregate, where doing so yields a more reliable result. This approach is consistent with Tax Court decisions in cases outside of the section 482 context, where collections of multiple, related intangible assets were viewed by the Tax Court in the aggregate.653 It is also consistent with the position taken in the recently issued cost-sharing regulations.654

The question presented in aggregate valuation cases is whether the enhanced value that, in some situations, results from the interrelation of identifiable intangible assets when they are grouped together can be attributed properly to those intangible assets. In the cost-sharing context, attributing the enhanced value to identifiable intangible assets results in a greater buy-in payment. If the enhanced value cannot be attributed to identifiable intangible assets, then the enhanced value is instead attributed to goodwill or going concern value. In the context of an outbound reorganization, the improper attribution of enhanced value to foreign goodwill or going concern value may, in many cases, understate the actual value of the underlying intangible assets and result in inadequate compensation under section 367(d).655

In Veritas v. Commissioner, the Tax Court rejected the use of the aggregation by the IRS for purposes of valuing a transfer of intangible property. The Court noted that the use of the aggregation approach is permitted if it produces the most reliable means of determining the arm's-length consideration in related party transactions. The Court stated that the effect of aggregation was to value assets with short lives as if they had perpetual lives, as well as to value subsequently developed assets that were not transferred. As a result, the Court concluded that the aggregation approach did not, in that case, produce the most reliable result.656

There is no indication that the Court's decision in Veritas would have been different if the aggregation principle had been adopted by statute, rather than by regulations. The Administration may believe that taxpayers will be more likely to apply aggregation in the first place, and that IRS field agents may meet less resistance in applying the aggregation on audit if it is codified. However, the Court observed in Veritas that the effect of aggregation was to convert the license of intangible property into a sale, which would have dramatically increased the buy-in payment due from the Irish affiliate.657 To the extent aggregation generally has the effect of converting a license into a sale and dramatically increasing the transfer price (in this case, the proposed adjustment exceeded $2 billion), taxpayers have a financial incentive to find that some other valuation method is the most reliable application of that method. This is the case whether aggregation is codified or not. Thus, in the absence of any challenge to the validity of the regulations, it is unclear why codification of aggregation is required to reinforce the existing regulation.


    Realistic alternative

The proposal also codifies the realistic alternative principle with respect to intangible property. The realistic alternative principle is predicated on the notion that a taxpayer will only enter into a particular transaction if none of its realistic alternatives is economically preferable to the transaction under consideration. As a result, the existing regulations provide the IRS with the ability to determine an arm's-length price by reference to a transaction (such as the owner of an intangible property using it to make a product itself) that is different from the transaction that was actually completed (such as the owner of that same intangible property licensing the manufacturing rights and then buying the product from the licensee). In other words, the realistic alternatives principle assumes that taxpayers act in an economically rational manner and uses this assumption as the basis for identifying transfer pricing that does not reflect an arm'slength result.

For example, if a taxpayer reports income of only $100 under one pricing method with respect to a transaction with a related party, but the IRS can demonstrate that a realistic alternative available to the taxpayer would have generated $1,000, all else being equal, the IRS will propose an adjustment. As the basis for its adjustment, the IRS will assert that the taxpayer's $100 of income is not an arm's-length result because unrelated parties, dealing at arm's-length, would not settle for less than $1,000. Otherwise, the taxpayer would be an irrational economic actor -- a possibility that is rejected under basic economic and valuation theory.

In making its determination, the Commissioner evaluates the data provided by any available internal comparables (actual transactions between the taxpayer and third parties) and external comparables (actual transactions between unrelated parties), as well as information regarding the return to the property owner that could have been realized if the property owner had taken an alternative, but realistic, course of action in deploying the asset internally. If, when considering the data it is determined that the transfer price of a non-existent internal transaction differs materially from the transfer price of the actual controlled party transaction, the Commissioner may conclude that the taxpayer's transfer pricing of the actual transaction does not reflect an arm's-length result.

The "realistic alternative" principle was first adopted in final regulations issued in 1994,658 following taxpayer-favorable court decisions. In Bausch & Lomb,659 for example, the IRS disputed the comparability of the uncontrolled transactions proffered by the taxpayer, and argued that the Irish licensee of the "spin cast" method of manufacturing soft contact lenses was only entitled to a contract manufacturer return because its U.S. parent, the licensor, would not have been willing to pay an independent third party much more than the cost of producing the contact lenses itself. This so-called "make or buy" argument was rejected by the court, in part due to the preference given to one method over another in the then-existing regulations.660 However, the example provided in the Treasury regulations (issued subsequently) to illustrate the realistic alternative rule for intangible property involves similar facts -- specifically, the license of a proprietary process for making a product ("Longbond") from a taxpayer to its foreign subsidiary.661 The example demonstrates that, in determining whether consideration paid with respect to the license is arm's-length, the IRS may expressly consider (subject to the best method rule) the taxpayers alternative of producing and selling "Longbond" itself.662

OECD Transfer Pricing Guidelines (the "Guidelines") include the realistic alternative principle. For example, the OECD's general guidance for analyzing comparability under the arm's-length standard incorporates the realistic alternative concept, stating that "[i]ndependent enterprises, when evaluating the terms of a potential transaction, will compare the transaction to the other options realistically available to them, and they will only enter into the transaction if they see no alternative that is clearly more attractive."663 Similarly, in the context of business restructurings, a recent OECD discussion draft concludes that the factors relevant to determining whether a transfer is an arm's-length transaction include "the options that would have been realistically available to the transferor and transferee at arm's-length, based on the rights and other assets of each at the outset of the restructuring, that determine the profit/loss potential of either."664

If the IRS believes that a taxpayer has not applied the best method or the most reliable application of that method, the realistic alternative is a tool available for testing what the transfer price would have been under different circumstances. To date, there are no legal decisions that analyze or discuss the realistic alternative provisions of the regulations, and no known controversy as to the validity of this regulation. Accordingly, it is unclear how codification of this regulation will advance administration of the transfer pricing cases or why codification is necessary to reinforce these particular existing regulations.


Prior Action

A similar proposal was included in the administration's fiscal year 2010 revenue proposal.

6. Disallow the deduction for excess nontaxed reinsurance premiums paid to affiliates


Present Law

Insurance companies in general

Subchapter L of the Code provides special rules for determining the taxable income of insurance companies. Separate sets of rules apply to life insurance companies and to property and casualty insurance companies. Insurance companies are subject to tax at regular corporate income tax rates.

Property and casualty insurers

Under present law, the taxable income of a property and casualty insurance company is determined as the sum of the amount earned from underwriting income and from investment income (as well as gains and other income items), reduced by allowable deductions.665 For this purpose, underwriting income and investment income are computed on the basis of the underwriting and investment exhibit of the annual statement approved by the NAIC.666


    Deduction for unpaid loss reserves

Underwriting income means premiums earned during the taxable year less losses incurred and expenses incurred.667 Losses incurred include certain unpaid losses (reported losses that have not been paid, estimates of losses incurred but not reported, resisted claims, and unpaid loss adjustment expenses). Present law provides for the discounting of the deduction for loss reserves to take account partially of the time value of money.668 Thus, present law limits the deduction for unpaid losses to the amount of discounted unpaid losses. Any net decrease in the amount of unpaid losses results in income inclusion, and the amount included is computed on a discounted basis.

The discounted reserves for unpaid losses are calculated using a prescribed interest rate that is based on the applicable Federal mid-term rate ("mid-term AFR"). The discount rate is the average of the mid-term AFRs effective at the beginning of each month over the 60-month period preceding the calendar year for which the determination is made.

To determine the period over which the reserves are discounted, a prescribed loss payment pattern applies. The prescribed length of time is either the accident year and the following three calendar years, or the accident year and the following 10 calendar years, depending on the line of business. In the case of certain "long-tail" lines of business, the 10-year period is extended, but not by more than five additional years. Thus, present law limits the maximum duration of any loss payment pattern to the accident year and the following 15 years. The Treasury Department is directed to determine a loss payment pattern for each line of business by reference to the historical loss payment pattern for that line of business using aggregate experience reported on the annual statements of insurance companies, and is required to make this determination every five years, starting with 1987.

Under the discounting rules, an election is provided permitting a taxpayer to use its own (rather than an industry-wide) historical loss payment pattern with respect to all lines of business, provided that applicable requirements are met.


    Reinsurance premiums deductible

In determining premiums earned for the taxable year, a property and casualty company deducts from gross premiums written on insurance contracts during the taxable year the amount of premiums paid for reinsurance.669

    Unearned premiums

Further, the company deducts from gross premiums the increase in unearned premiums for the year.670 The company is required to reduce the deduction for increases in unearned premiums by 20 percent. This amount serves to represent the allocable portion of expenses incurred in generating the unearned premiums, so as to provide a degree of matching of the timing of inclusion of income and deduction of associated expenses.

    Proration of deductions relating to untaxed income

In calculating its reserve for losses incurred, a property and casualty insurance company must reduce the amount of losses incurred by 15 percent of (1) the insurer's tax-exempt interest, (2) the deductible portion of dividends received (with special rules for dividends from affiliates), and (3) the increase for the taxable year in the cash value of life insurance, endowment, or annuity contracts the company owns.671 This rule reflects the fact that reserves are generally funded in part from tax-exempt interest, from wholly or partially deductible dividends, or from other untaxed amounts.

Treatment of reinsurance


    In general

Present law includes a rule enacted in 1984 providing authority to the Treasury Department to reallocate items and make adjustments in reinsurance transactions to prevent tax avoidance or evasion.672

The rule permits the Treasury Department to make reallocations in related party reinsurance transactions. The rule was amended in 2004 to provide the Treasury Department with additional authority to allocate among the parties to a reinsurance agreement or to recharacterize income (whether investment income, premium, or otherwise), deductions, assets, reserves, credits, and any other items related to the reinsurance agreement, or to make any other adjustment to reflect the proper source, character, or amount of the item.673 In expanding this authority to the amount (not just the source and character) of any such item, Congress expressed the concern that "reinsurance transactions were being used to allocate income, deductions, or other items inappropriately among U.S. and foreign related persons," and that "foreign related party reinsurance arrangements may be a technique for eroding the U.S. tax base."674

The rule also provides that if the Secretary determines that a reinsurance contract between insurance companies, whether related or unrelated, has a significant tax avoidance effect on any party to the contract, the Secretary may make an adjustment to one or both parties to eliminate the tax avoidance effect, including treating the contract as terminated on December 31 of each year and reinstated on January 1 of the next year. The legislative history provides that in determining whether a reinsurance agreement between unrelated parties has a significant tax avoidance effect with respect to one or both of the parties, appropriate factors for the Treasury Department to take into account are (1) the duration or age of the business reinsured, which bears on the issue of whether significant economic risk is transferred between the parties, (2) the character of the business (as long-term or not), (3) the structure for determining potential profits, (4) the duration of the reinsurance agreement, (5) the parties rights to terminate and the consequences of termination, such as the existence of a payback provision, (6) the relative tax positions of the parties, and (7) the financial situations of the parties.675


    Reinsurance premiums received by foreign persons

The United States employs a worldwide tax system under which U.S. persons (including U.S. citizens, U.S. resident individuals, and domestic corporations) generally are taxed on all income, whether derived in the United States or abroad. In contrast, foreign persons (including nonresident alien individuals and foreign corporations) are taxed in the United States only on income that has a sufficient nexus to the United States.

Foreign persons are subject to U.S. tax on income that is effectively connected with the conduct of a trade or business in the United States.676 Such income may be derived from U.S. or foreign sources. This income generally is taxed in the same manner and at the same rates as income of a U.S. person. For this purpose, deductions are allowed only if and to the extent that they are connected with the income that is effectively connected with the conduct of a trade or business within the United States. In addition, foreign persons generally are subject to U.S. tax withheld at a 30-percent rate on certain gross income (such as interest, dividends, rents, royalties, and premiums) derived from U.S. sources.677

A foreign company carrying on an insurance business in the United States that would be treated as a life insurer or a property and casualty insurer for Federal tax purposes if it were a domestic corporation is subject to U.S. tax under subchapter L on its income effectively connected with its conduct of any trade or business within the United States.678 Special rules apply to calculate the minimum effectively connected net investment income for this purpose.679 Other U.S.-source income of such a foreign company carrying on an insurance business in the United States is subject to the 30-percent gross-basis withholding tax applicable generally to U.S.-source income of any foreign corporation.

Treasury regulations provide, however, that insurance premiums subject to the insurance or reinsurance excise tax (described below) are not subject to the 30-percent gross-basis withholding requirement applicable for income tax purposes.680


    Securities trading safe harbor

Detailed rules govern whether trading in stocks or securities or commodities constitutes the conduct of a U.S. trade or business.681 Under these rules (colloquially referred to as trading safe harbors), trading in stock or securities or commodities by a foreign person through an independent agent such as a resident broker generally is not treated as the conduct of a U.S. trade or business if the foreign person does not have an office or other fixed place of business in the United States through which the trading is effected. Trading in stock or securities or commodities for the foreign person's own account, whether by the foreign person or the foreign person's employees or through a resident broker or other agent (even if that agent has discretionary authority to make decisions in effecting the trading) also generally is not treated as the conduct of a U.S. business provided that the foreign person is not a dealer in stock or securities or commodities.

    Exemption from 30-percent withholding for certain investment income

The United States generally does not tax capital gains of a foreign corporation that are not connected with a U.S. trade or business. Although payments of U.S.-source interest that is not effectively connected with a U.S. trade or business generally are subject to the 30-percent withholding tax, there are significant exceptions to that rule. For example, interest from certain deposits with banks and other financial institutions is exempt from tax.682 Original issue discount on obligations maturing in six months or less is also exempt from tax.683 An additional exception is provided for certain interest paid on portfolio obligations.684 Portfolio interest generally is defined as any U.S.-source interest (including original issue discount), not effectively connected with the conduct of a U.S. trade or business, (1) on an obligation that satisfies certain registration requirements or specified exceptions thereto, and (2) that is not received by a 10-percent shareholder.685 This exception is not available for any interest received either by a bank on a loan extended in the ordinary course of its business (except in the case of interest paid on an obligation of the United States), or by a controlled foreign corporation from a related person.686 Moreover, this exception is not available for certain contingent interest payments.687

    Subpart F

Under the subpart F rules,688 10-percent U.S. shareholders of a controlled foreign corporation ("CFC") are subject to U.S. tax currently on certain income earned by the CFC, whether or not such income is distributed to the shareholders. The income subject to current inclusion under the subpart F rules includes, among other things, insurance income and foreign base company income (including foreign personal holding company income). The subpart F rules generally do not apply in the case of a foreign corporation that is controlled by foreign persons.

Temporary exceptions from foreign personal holding company income, foreign base company services income, and insurance income apply for subpart F purposes for certain income that is derived in the active conduct of a banking, financing, or similar business, or in the conduct of an insurance business (so-called "active financing income").689 In general, the availability of the exception for income derived in the active conduct of a banking, financing, or similar business requires that the CFC directly receive at least 70 percent of its gross income from the active and regular conduct of a lending or finance business from transactions with customers who are unrelated persons. Similarly, the exception for income derived in the active conduct of an insurance business generally applies only to income received from unrelated persons.


    Branch level taxes

A U.S. corporation owned by foreign persons is subject to U.S. income tax on its net income. In addition, the earnings of the U.S. corporation are subject to a second tax, this time at the shareholder level, when dividends are paid. As discussed above, when the shareholders are foreign, the second-level tax is imposed at a flat rate and collected by withholding. Similarly, as discussed above, interest payments made by a U.S. corporation to foreign creditors are subject to a U.S. withholding tax in certain circumstances. Pursuant to the branch tax provisions, the United States taxes foreign corporations engaged in a U.S. trade or business on amounts of U.S. earnings and profits that are shifted out of, or amounts of interest deducted by, the U.S. branch of the foreign corporation.690 The branch level taxes are comparable to these second-level taxes. In addition, where a foreign corporation is not subject to the branch profits tax as the result of a treaty, it may be liable for withholding tax on actual dividends it pays to foreign shareholders.

Insurance and reinsurance excise tax

An excise tax applies to premiums paid to foreign insurers and reinsurers covering U.S. risks.691 The excise tax is imposed on a gross basis at the rate of one percent on reinsurance and life insurance premiums, and at the rate of four percent on property and casualty insurance premiums. The excise tax does not apply to premiums that are effectively connected with the conduct of a U.S. trade or business or that are exempted from the excise tax under an applicable income tax treaty. The excise tax paid by one party cannot be credited if, for example, the risk is reinsured with a second party in a transaction that is also subject to the excise tax.


    Exemption from the excise tax

The United States has entered into comprehensive income tax treaties with more than 50 countries, including a number of countries with well-developed insurance industries such as Barbados, Germany, Switzerland, and the United Kingdom. The United States has also entered into a tax treaty with Bermuda, another country with a significant insurance industry, which applies only with respect to the taxation of insurance enterprises.692

Certain U.S. tax treaties provide an exemption from the excise tax, including the treaties with Germany, Switzerland, and the United Kingdom.693 To prevent persons from inappropriately obtaining the benefits of exemption from the excise tax, the treaties generally include an anti-conduit rule. The most common anti-conduit rule provides that the treaty exemption applies to the excise tax only to the extent that the risks covered by the premiums are not reinsured with a person not entitled to the benefits of the treaty (or any other treaty that provides exemption from the excise tax).694

The U.S. tax treaties with Barbados and Bermuda also provide an exemption from the excise tax, although the Senate's ratification of the U.S.-Bermuda treaty was subject to a reservation with respect to the treaty's application to the excise tax. Moreover, section 6139 of the Technical and Miscellaneous Revenue Act of 1988 provides that neither the U.S.-Barbados nor the U.S.-Bermuda treaty will prevent imposition of the excise tax on premiums, regardless of when paid or accrued, allocable to insurance coverage for periods after December 31, 1989.695 Accordingly, no exemption from the excise tax is available under those two treaties with respect to premiums allocable to insurance coverage beginning on or after January 1, 1990.

Earnings stripping rules

A foreign parent corporation with a U.S. subsidiary may seek to reduce the group's U.S. tax liability by having the U.S. subsidiary pay deductible amounts such as interest, rents, royalties, and management service fees to the foreign parent or other foreign affiliates that are not subject to U.S. tax on the receipt of such payments. Although the United States generally subjects foreign corporations to a 30-percent withholding tax on the receipt of such payments, this tax may be reduced or eliminated under an applicable income tax treaty. Consequently, foreign-owned domestic corporations may seek to use certain treaties to facilitate earnings stripping transactions without having their deductions offset by U.S. withholding taxes.696

Present law limits the ability of corporations to reduce the U.S. tax on their U.S.-source income through earnings stripping transactions. A deduction for "disqualified interest" paid or accrued by a corporation in a taxable year is generally disallowed if two threshold tests are satisfied: the payor's debt-to-equity ratio exceeds 1.5 to 1 (the so-called "safe harbor" ratio); and the payor's net interest expense exceeds 50 percent of its "adjusted taxable income" (generally taxable income computed without regard to deductions for net interest expense, net operating losses, and depreciation, amortization, and depletion).697 Disqualified interest includes interest paid or accrued to: (1) related parties when no Federal income tax is imposed with respect to such interest; or (2) unrelated parties in certain instances in which a related party guarantees the debt ("guaranteed debt"). Interest amounts disallowed under these rules can be carried forward indefinitely. In addition, any excess limitation (i.e., the excess, if any, of 50 percent of the adjusted taxable income of the payor over the payor's net interest expense) can be carried forward three years.

The earnings stripping rules generally apply to interest, but do not apply to other deductible payments such as insurance or reinsurance premiums.


Description of Proposal

General rule

The proposal disallows any deduction to covered insurance companies for a certain fraction of reinsurance premiums with respect to U.S. risks paid to foreign affiliated insurance companies that are not subject to U.S. income taxation.

Covered insurance company

A covered insurance company for this purpose is any company subject to tax imposed by section 831 of the Code. Thus, for example, a property and casualty insurance company subject to tax in the United States is considered a covered insurance company under the proposal. The fact that a company subject to tax under section 831 has no tax liability for the taxable year (for example, due to losses) does not cause the company not to be considered as subject to tax under section 831. All domestic members of a controlled group of corporations (as defined in section 1563, but using a 50-percent ownership threshold) of which a covered insurance company is a member are treated as one corporation.

The excise tax under section 4371 is disregarded for purposes of determining whether an affiliated insurance company is subject to U.S. income taxation.698 Thus, for example, a foreign insurer or reinsurer that issues policies, premiums on which are subject to the excise tax under section 4371, and that is not subject to tax under section 831, is not considered an affiliated insurance company subject to U.S. income taxation for purposes of this proposal.

Deduction disallowed for certain reinsurance premiums

Under the proposal, the deduction for certain reinsurance premiums is disallowed. The amount disallowed for each line of business is the amount of reinsurance premiums paid (net of ceding commissions) in excess of 50 percent of premiums received by the taxpayer and its U.S. affiliates for direct insurance of U.S. risks.

Election to treat specified reinsurance income as effectively connected

The proposal provides an election for affiliated foreign reinsurers to be subject to U.S. tax on premiums and net investment income that is associated with affiliated reinsurance transactions. This election is intended to provide that these foreign affiliates are not treated less favorably than U.S. reinsurers, in the event that the proposal could be viewed as discriminatory under the nondiscrimination article of any U.S. tax treaty.

The election provides that an affiliated corporation may elect for any taxable year to treat certain premiums and certain net investment income as effectively connected with the conduct of a trade or business in the United States, and to be treated as carrying on an insurance business within the United States. Thus, an electing company is subject to the rules of present-law section 842 governing effectively connected income of foreign insurance companies carrying on an insurance business in the United States. As under present law, for purposes of this election, deductions are allowed only if and to the extent that they are connected with the income that is treated under this election as effectively connected with the conduct of a trade or business within the United States.

For purposes of the election, specified reinsurance income means, with respect to any taxable year, (1) all reinsurance premiums for which (but for this election) a deduction would be disallowed and that are received by a corporation during the taxable year directly or indirectly from covered insurance companies with respect to which the corporation is affiliated, and (2) the net investment income (within the meaning of section 842(b)) for the taxable year allocable to reinsurance premiums with respect to which an election applies (whether for the current or a prior taxable year). The election may be revoked only with the consent of the Secretary.

Effective date

The proposal is effective for taxable years beginning after December 31, 2010.


Analysis

Earnings stripping

The proposal reflects a concern with earnings stripping through the use of reinsurance transactions between related parties. Earnings stripping reduces the U.S. tax base through transactions involving deductible payments to foreign entities that are not subject to U.S. tax, generally to those that are related to the U.S. payor. Reinsuring risks with insurance affiliates generally can have the effect of reducing U.S. tax on earnings on reserves set aside to cover losses incurred with respect to those risks.

Because U.S. tax accounting rules applicable to insurance companies provide a deduction for additions to insurance reserves, investment earnings on insurance company reserves can be viewed as tax-favored.699 The proposal addresses the point that the use of affiliated reinsurers is a means by which U.S. insurance risks migrate to offshore reinsurance markets so as to avoid U.S. tax on reserve earnings. The proposal provides for disallowance of the deduction for premiums for reinsurance with foreign affiliates that exceed a certain percentage of directly insured business.

Primary insurers have a variety of reasons for reinsuring some of their business. A principal reason is to shift risk, because an insurer's pool of risks is too concentrated in some manner. Additional nontax reasons for engaging in reinsurance transactions -- whether assuming or ceding risks through reinsurance transactions -- involve reduction in business volatility by managing exposure to extremely large losses,700 compliance with State regulatory requirements for capital and surplus, financing for growth of existing and new lines of business,701 and diversification by acquisition or divestiture of blocks of business or entire lines of business.702

Further, there are nontax reasons for reinsurance transactions with affiliates, including foreign affiliates. These nontax reasons include moving or centralizing capital within a corporate group to maximize efficient capital management, as well as reduction in the cost of reinsuring risks because the affiliates know more about each other and about the risks than do unrelated parties. There may be economies of scale in managing risk through reinsurance that may make it attractive to use reinsurance to consolidate the risks of an affiliated group in one entity, before subsequently shifting the risk to third parties or managing risk within the group. For example, risks that may partially or fully offset each other may serve to minimize volatility when the offsetting risk pools are centralized in one entity rather than being dispersed in separate affiliated entities. Affiliated groups may also experience transaction cost savings in financing risks.703

Tax benefits may also provide a reason for reinsurance transactions, including reinsurance transactions with affiliates. In general, premiums ceded for reinsurance are deductible in determining a company's Federal income tax.704 Present law does not disallow this deduction if the affiliate to which the risks are ceded does not pay U.S. income tax on associated earnings. Thus, it is possible that a reinsurance transaction can be viewed as an earnings stripping transaction in some circumstances. Arguably, the earnings stripping concern arises if the reinsurer is an affiliate of the ceding company, and the parent of the affiliated group is not a U.S. corporation. In the reinsurance transaction, risks may be ceded to the foreign reinsurer, and along with the risks, earnings on the reserves relating to the ceded risks are shifted to the foreign reinsurer. In this circumstance, U.S. tax is not paid on the earnings on the reserves that are shifted overseas, even though these earnings remain within the affiliated group. This type of transaction has been criticized as tax-motivated.705

The approach taken in the proposal acknowledges that reinsurance has essential risk management and other functions. At the same time, the approach is structured to discourage reinsurance transactions that are likely to be motivated by avoidance of U.S. taxation because they exceed a fairly high threshold.

Technical aspects of the operation of the proposal


    50-percent threshold for deduction denial rule

The proposal imposes a 50-percent threshold for each line of business. If the portion of direct business reinsured with a foreign affiliate exceeds 50 percent, no deduction is allowed for reinsurance premiums in excess of this threshold under the proposal. The 50-percent threshold is unrelated to industry norms or recent industry practices relating to the portion of a line of business that is reinsured, whether with foreign affiliates or with third-party reinsurers, and exceeds the portion of business reinsured in many lines of business. A rationale for this approach may be to ensure that the proposal cannot possibly limit the deduction for reinsurance that is motivated by any reason other than avoidance of U.S. taxation, so that the proposal has little or no likelihood of overbreadth.

The proposal's 50-percent thresholds for each line of business could be criticized as either too generous for most lines of business, or as arbitrary at best. Arguably, the failure of the proposal to relate the disallowance to industry norms for reinsurance prevents the proposal from accurately distinguishing between reinsurance that is likely to be motivated by U.S. tax avoidance, and reinsurance that is typical and could be motivated by business, regulatory, or other nontax considerations. That is, without knowing what industry patterns of reinsurance in each line of business have been, it may be impossible to ascertain a base level of reinsurance that is fairly likely to reflect a need for risk-shifting, the most fundamental purpose for reinsurance. Thus, the 50-percent rule makes the proposal inefficient or perhaps ineffective at identifying earnings stripping reinsurance transactions. Further, based on industry data, the 50-percent threshold may be higher than the percentage of reinsurance in most lines of business, so the proposal has no effect at all in those lines of business. Nevertheless, in a few lines of business where industry norms for reinsurance have exceeded 50 percent, the proposal arbitrarily limits the deduction for reinsurance premiums.

The treatment of ceding commissions in determining the portion of reinsurance premiums for which no deduction is allowed can also be criticized as unrelated to the underlying business transaction. It is understood that the proposal permits the reduction of reinsurance premiums by the amount of all ceding commissions paid to foreign reinsurers. However, this measure of ceding commissions may be broader than the amount of ceding commissions that are included in the taxpayer's income under U.S. tax rules and that relate to foreign reinsurance premiums for which a deduction is disallowed under the proposal. Thus, an arbitrary portion (based on the level of ceding commissions in unrelated transactions) of reinsurance premiums is disallowed. In effect, the company is credited for ceding commissions on the portion of the premium for which it is not denied a deduction.


    Treatment of assumed risks

It is understood that the proposal does not address the reinsurance of assumed U.S. risks, but rather, addresses only the reinsurance of directly insured U.S. risks. A rationale for this limited approach may be a concern about overbreadth, in that if the proposal applied to reinsurance of both directly insured and assumed U.S. risks, it could limit deductions for reinsurance that is not motivated by tax avoidance. A related rationale might be that it could be difficult to separate U.S. risks from other risks if assumed business included U.S. risks and other risks commingled in a block before being assumed; if this were the case, applying the proposal (which covers only U.S. risks) to assumed risks could be difficult for the government and taxpayers to administer and could involve additional recordkeeping.

An argument can be made, however, that applying a deduction disallowance rule only to direct business, and not to assumed risks, ignores the manner in which insurers do business and makes the proposal ineffective. Such an approach would create an incentive for fronting transactions in which U.S. direct insurers reinsure each other's U.S. risks before reinsuring the business with affiliates of the reinsured company. This simple avoidance technique could reduce the effectiveness of the proposal and arguably render it no more than a trap for the unwary. Further, it is unlikely that U.S. and other risks are commingled without records under current industry practice, so that administrability concerns are arguably misplaced.


    Discussion of stacking rule

In determining whether a company has breached the 50-percent threshold, premiums to unaffiliated, or third-party, reinsurers is effectively stacked first, though a deduction for premiums paid to third-party reinsurers is never disallowed. This has the effect of making for a stricter rule, as the maximum amount of deduction would be disallowed for a given portfolio of reinsurance. Each dollar of third-party reinsurance increases the likelihood that an additional dollar of affiliate reinsurance is over the threshold. This has the potential to create perverse incentives for companies subject to the disallowance rule. This stacking rule could have the effect on the margin of encouraging more affiliate reinsurance for some companies. For example, a company that reinsures more than 50 percent of its direct business, but less than 50 percent with third-party reinsurers, may have an incentive to substitute affiliate reinsurance below the threshold for third-party reinsurance, as there is a potential to gain some of the benefits of affiliate reinsurance with no additional deduction disallowance. A company that reinsures more than 50 percent of its direct business with third-party reinsurers would not face the same incentive, as every dollar of third-party reinsurance above the threshold switched to an affiliated reinsurer would result in additional deduction disallowance.

Other issues


    Nondiscrimination

The proposal provides an election for affiliated foreign reinsurers to be subject to U.S. tax on premiums and net investment income that is associated with affiliated reinsurance transactions. Nondiscrimination articles of U.S. tax treaties generally prohibit nationals of one treaty country from being subjected to more burdensome taxation (or any connected requirement) in the other treaty country than are nationals of that other treaty country in the same circumstances. It is believed that the proposal does not violate any nondiscrimination article of any applicable U.S. tax treaty.

Some may argue that the proposal violates these treaty requirements by denying deductions to U.S. affiliates of foreign companies when they reinsure with their foreign affiliates, but not applying a comparable deduction disallowance rule to U.S. companies reinsuring with their U.S. affiliates. Others may respond that the proposal does not violate any nondiscrimination article of any applicable U.S. tax treaty because the proposal provides an election for affiliated foreign reinsurers to be subject to U.S. tax on premiums and net investment income that is associated with affiliated reinsurance transactions. By making this election, any foreign reinsurance company can insure that it is treated at least as well as any U.S. insurance company.

In addition, U.S. tax treaties generally provide that the nondiscrimination article does not apply in certain cases involving transactions between related persons. One of these circumstances arises in cases in which paragraph 1 of Article 9 (Associated Enterprises) of a U.S. tax treaty applies. That paragraph applies in cases in which an enterprise of a treaty country is related to an enterprise of the other treaty country, and there are arrangements or conditions imposed between the enterprises in their commercial or financial relations that are different from those that would have existed in the absence of the relationship.706 The proposal sets forth a standard for determining reinsurance premiums in an arm's-length fashion. Thus, any reinsurance premiums that are disallowed under the proposal do not, by definition, satisfy the arm's-length standard and may properly be disallowed under U.S. tax treaties.707


    Transfer pricing issues

Due to the variation in tax rates and tax systems among countries, a multinational enterprise, whether U.S.-based or foreign-based, may have an incentive to shift income, deductions, or tax credits among commonly controlled entities in order to arrive at a reduced overall tax burden. Within a controlled group, there are no market pressures that impose market pricing on transactions between related parties. The lack of an identifiable market price provides opportunities for companies to shift income among group members through controlled transactions at off-market prices.

To preserve the U.S. tax base, section 845 authorizes the Secretary of the Treasury to (1) allocate between or among two or more related persons (within the meaning of section 482) items of income (whether investment income, premium, or otherwise), deductions, assets, reserves, credits, and other items); (2) recharacterizes any such items; or (3) make any other adjustment to reflect the proper amount, source, or character of the taxable income (or any item described in (1) relating to such taxable income) of each person. Section 842 generally does not prescribe any specific reallocation rules. Rather, it establishes the general standards of preventing tax evasion and clearly reflecting income. Treasury regulations under section 482 adopt the concept of an arm's length standard as the method for determining whether reallocations are appropriate. Thus, the regulations generally attempt to identify the respective amounts of taxable income of the related parties that would have resulted if the parties had been uncontrolled parties dealing at arm's length.

The premium and ceding commission on reinsurance may be analogous to a transfer price for the underlying insurance risk. Following this analogy, a concern about excess affiliate reinsurance may be viewed as a concern about the transfer price. Opponents of the proposal may argue that Treasury authority under section 845, along with the presence of comparable third-party reinsurance transactions, is sufficient to combat any abuse in this area.

However, one of the purposes of affiliate reinsurance is to mitigate the effect of asymmetric information on increasing the price charged for reinsurance risk. That is, a third party may need to charge a higher premium to compensate itself for the uncertainty regarding the true nature of the risk being transferred.708 This asymmetry suggests that third-party reinsurance may be an imperfect standard by which to judge the appropriateness of the transfer price for the insurance risk. To the extent that the third-party reinsurance premium is too high (or the ceding commission is too low) as a standard of comparison, it would lead to an understatement of income for the ceding company and an overstatement of income for the assuming company in the case of affiliated reinsurance.

A transfer pricing concern is also raised in statements in the legislative history of the 2004 amendment to section 845(a) with respect growth of offshore affiliate reinsurance.709 If this analysis is accurate, the IRS may be able to apply section 845 in a particular case to reallocate income and deductions between such related parties on the basis of the argument that an unrelated party would not have reinsured such a large proportion of its U.S. risks. However, the IRS might be unsuccessful in challenging the questioned transactions. Further, it is difficult to obtain consistent results on a case by case basis applying transfer pricing concepts.

7. Limit earnings stripping by expatriated entities


Present Law

A U.S. corporation with a foreign parent may reduce the U.S. tax on the income derived from its U.S. operations through the payment of deductible amounts such as interest, rents, royalties, premiums, and management service fees to the foreign parent or other foreign affiliates that are not subject to U.S. tax on the receipt of such payments.710 Generating excessively large U.S. tax deductions in this manner is known as "earnings stripping." Although foreign corporations generally are subject to a gross-basis U.S. tax at a flat 30-percent rate on the receipt of such payments if they are from sources within the United States, this tax may be reduced or eliminated under an applicable income tax treaty.

Although the term "earnings stripping" may be broadly applied to the generation of excessive deductions for interest, rents, royalties, premiums, management fees, and similar types of payments in the circumstances described above, more commonly it refers only to the generation of excessive interest deductions.711 In general, earnings stripping provides a net tax benefit only to the extent that the foreign recipient of the interest income is subject to a lower amount of foreign tax on such income than the net value of the U.S. tax deduction applicable to the interest, i.e., the amount of U.S. deduction times the applicable U.S. tax rate, less the U.S. withholding tax. That may be the case if the country of the interest recipient provides a low general corporate tax rate, a territorial system with respect to interest, or reduced taxes on financing structures.

Earnings stripping limitations

Present law limits the ability of foreign corporations to reduce the U.S. tax on the income derived from their U.S. subsidiaries' operations through earnings stripping transactions. If the payor's debt-to-equity ratio exceeds 1.5 to 1 (a debt-to-equity ratio of 1.5 to 1 or less is considered a "safe harbor"), a deduction for "disqualified interest" paid or accrued by a corporation in a taxable year is generally disallowed to the extent that the payor's "net interest expense" (i.e., the excess of interest paid or accrued over interest income) exceeds 50 percent of its "adjusted taxable income" (generally taxable income computed without regard to deductions for net interest expense, net operating losses, depreciation, amortization, and depletion).712 Disqualified interest includes interest paid or accrued to (1) related parties when no Federal income tax is imposed with respect to such interest;713 or (2) unrelated parties in certain instances in which a related party guarantees the debt ("guaranteed debt"). Interest amounts disallowed under these rules can be carried forward indefinitely and are allowed as a deduction to the extent of excess limitation in a subsequent tax year. In addition, any excess limitation (i.e., the excess, if any, of 50 percent of the adjusted taxable income of the payor over the payor's net interest expense) can be carried forward three years.

Corporate inversion transactions

The United States employs a "worldwide" tax system, under which U.S. resident individuals and domestic corporations generally are taxed on all income, whether derived in the United States or abroad. Foreign corporations are taxed by the United States only on income that has sufficient nexus to the United States. As a consequence, the U.S. tax treatment of a multinational corporate group depends significantly on whether the top-tier "parent" corporation of the group is domestic or foreign. Tax rates vary by country, and not all countries choose a worldwide system of income taxation. Thus, depending upon its particular circumstances, a multinational group may be able to increase the after-tax returns to its investments by locating its parent corporation outside the United States.

For purposes of U.S. tax law, a corporation is treated as domestic if it is incorporated under the laws of the United States or of any State.714 All other corporations are generally treated as foreign.715 Thus, the place of incorporation determines whether a corporation is treated as domestic or foreign for purposes of U.S. tax law, irrespective of other factors that might be thought to bear on a corporation's "nationality," such as the location of the corporation's management activities, employees, business assets, operations, revenue sources, the exchanges on which the corporation's stock is traded, or the residence of the corporation's shareholders.

Until recently, some U.S. multinational groups sought to take advantage of the differential treatment of U.S. and foreign domiciled top-tier companies through transactions commonly referred to as "inversions." A U.S. parent corporation could reincorporate in a foreign jurisdiction, potentially without any exit tax to compensate the U.S. for the loss of future tax revenue from the departing company. Under prior law, these inversion transactions could produce a variety of tax benefits, including the removal of a group's foreign operations from U.S. tax jurisdiction and, as discussed further below, the potential for reduction of U.S. tax on U.S.-source income through subsequent "earnings stripping" transactions (e.g., large payments of deductible interest or royalties from a U.S. subsidiary to the new foreign parent). It was not always clear, however, whether these inversions had a significant nontax purpose or effect, or whether the corporate group had a significant business presence in the new country of incorporation.

AJCA included provisions designed to curtail inversion transactions.716 Most significantly, AJCA added section 7874 to the Code. That section defines two different types of corporate inversion transactions and establishes a different set of consequences for each type. In an inversion transaction, a U.S. parent company is replaced with a foreign parent. The first type of inversion is a transaction in which (1) a U.S. corporation becomes a subsidiary of a foreign-incorporated entity or otherwise transfers substantially all of its properties to such an entity in a transaction completed after March 4, 2003;717 (2) the former shareholders of the U.S. corporation hold (by reason of holding stock in the U.S. corporation) 80 percent or more (by vote or value) of the stock of the foreign-incorporated entity after the transaction; and (3) the foreign-incorporated entity, considered together with all companies connected to it by a chain of greater than 50percent ownership, does not have substantial business activities in the entity's country of incorporation, compared to the total worldwide business activities of the expanded affiliated group. Section 7874 denies the intended tax benefits of this type of inversion ("80-percent inversion") by deeming the top-tier foreign corporation to be a domestic corporation for all tax purposes, notwithstanding any other provision of the Code or a tax treaty.

The second type of inversion is a transaction that would meet the definition of an inversion transaction described above, except that the 80-percent ownership threshold is not met. In such a case, if a 60-percent ownership threshold is met, then a second set of rules applies to the inversion ("60-percent inversion"). Under these rules, the inversion transaction is respected (i.e., the foreign corporation is treated as foreign), but any applicable corporate-level "toll charges" for establishing the inverted structure are not generally offset by tax attributes such as net operating losses. Specifically, any applicable corporate-level income or gain required to be recognized under sections 304, 311(b), 367, 1001, 1248, or any other provision with respect to the transfer of controlled foreign corporation stock or the transfer or license of other assets by a U.S. corporation as part of the inversion transaction or after such transaction to a related foreign person is taxable, generally without offset by any tax attributes (e.g., net operating losses). This rule does not apply to certain transfers of inventory and similar property. These measures generally apply for a 10-year period following the inversion transaction.718

In both types of inversions, the domestic corporation (or partnership) that becomes a subsidiary of a foreign-incorporated entity or otherwise transfers substantially all of its properties to such an entity after March 4, 2003, or any U.S. person related to such a domestic corporation (or partnership), is referred to as an "expatriated entity."719


Description of Proposal

The proposal tightens the earnings stripping deduction limitations as applied to expatriated entities. Under the proposal, expatriated entities may not utilize the 1.5-to-1 debt-toequity ratio safe harbor. In addition, the 50-percent of adjusted taxable income threshold for the limitation is reduced to 25 percent. The carryforward for disallowed interest is limited to 10 years and the carryforward of excess limitation is eliminated.

An expatriated entity is defined by applying the rules of section 7874 and the regulations thereunder as if section 7874 were applicable for taxable years beginning after July 10, 1989.720 This special rule does not apply, however, in the case of an 80-percent inversion in which the top-tier foreign corporation is treated as a domestic corporation for all tax purposes under section 7874.

Effective date. -- The proposal is effective for interest paid or accrued in taxable years beginning after December 31, 2010.


Analysis

The number of corporate inversion transactions prior to the enactment of section 7874 led some, including the Treasury Department, to question the efficacy of the present-law earnings stripping rules.721 In the case of some prominent, pre-AJCA corporate inversions, it appeared that the earnings stripping benefit achieved when a U.S. subsidiary paid deductible amounts to its new foreign parent or other foreign affiliates constituted the primary intended tax benefit of the inversion transaction, which should not have been the case if the earnings stripping rules had been functioning properly.722 Thus, AJCA required the Secretary of the Treasury to submit a report to the Congress by June 30, 2005, examining the effectiveness of the earnings stripping provisions of present law, including specific recommendations as to how to improve the provisions of the Code applicable to earnings stripping.723 The report, which was submitted to Congress on November 28, 2007,724 is discussed in more detail below.725

In summary, however, the 2007 Treasury report concludes that "[t]here is strong evidence that [inverted corporations] are stripping a significant amount of earnings out of their U.S. operations and, consequently, it would appear that section 163(j) is ineffective in preventing them from engaging in earnings stripping."726 In reaching this conclusion, the report largely relies on an outside study of 12 inverted corporations727 and a supplemental Treasury Department analysis of payments declared on Form 5472.728 The Treasury earnings stripping report also concludes, however, that the evidence that foreign-controlled domestic corporations are engaged in earnings stripping is not conclusive,729 and that it is not possible to determine with precision whether section 163(j) is effective generally in preventing earnings stripping by foreign-controlled domestic corporations.730 Consistent with those conclusions, the proposal would change the earnings stripping rules for expatriated entities only. By eliminating the debt-equity safe harbor,731 reducing the adjusted taxable income threshold from 50 percent to 25 percent for interest on related-party debt, limiting the carryforward of disallowed interest to 10 years, and eliminating the carryforward of excess limitation, the proposal significantly strengthens rules that appear ineffective in preventing certain recent earnings stripping arrangements in the context of corporate inversion transactions.732

Earnings stripping by foreign-controlled domestic corporations-the conclusions of the Treasury report

The Treasury earnings stripping report presents three separate analyses using tax data to test whether foreign-controlled domestic corporations are engaging in earnings stripping outside the context of inversion transactions. First, the report examines the relative profitability of foreign-controlled domestic corporations and domestic-controlled corporations by comparing the ratios of net income to total receipts, concluding that foreign-controlled domestic corporations are generally less profitable than their domestic-controlled counterparts.733

Second, the Treasury earnings stripping report compares the ratios of "operating income" to total receipts for foreign-controlled domestic corporations to the corresponding ratios for domestic-controlled corporations. Operating income is defined as net income plus interest expense, depreciation, and similar items, and minus interest income, dividends, and royalties received. The report finds that, after adjusting for these items, foreign-controlled domestic corporations are generally more profitable than their domestic-controlled counterparts.734 The data in this part of the study show that domestic-controlled corporations have greater interest expense as a proportion of total receipts than do foreign-controlled domestic corporations.735

It is unclear whether these findings with respect to profitability tend to support or refute the proposition that foreign-controlled domestic corporations engage in earnings stripping. Some might argue that even if the findings with respect to operating income suggest that foreign-controlled domestic corporations in the nonfinancial and, more specifically, the manufacturing sectors are more profitable than comparable domestic-controlled corporations before interest income and expense (and other non-operating items) are taken into account, the data presented do not identify how much of the interest income is received from, and interest expense is paid to, foreign-related parties, and, therefore, it is difficult to conclude that foreign-controlled domestic corporations are engaging in earnings stripping rather than utilizing third-party debt.736

Third, the Treasury earnings stripping report analyzes the relationship between interest expense and cash flow.737 The report determines that, on average, foreign-controlled domestic corporations in the nonfinancial sector and the manufacturing industry have interest expense relative to cash flow that is virtually the same as comparable domestic-controlled corporations. The report also determines that foreign-controlled domestic corporations in these sectors are less likely to be above the section 163(j) threshold of 50 percent of adjusted taxable income than are comparable domestic-controlled corporations.738 In the financial sector, the report determines that foreign-controlled domestic corporations in some industries appear to have significantly higher interest expense relative to cash flow than their domestic-controlled counterparts. However, the Treasury earnings stripping report states that "the comparison is not completely unambiguous and it is difficult to draw firm conclusions from the data because of the possibility of alternative explanations and the problems with using domestic-controlled corporations as a comparison group."739

Thus, the Treasury earnings stripping report concludes that the evidence that foreign-controlled domestic corporations are engaged in earnings stripping is not conclusive,740 and that it is not possible to determine with precision whether section 163(j) is effective in preventing earnings stripping by foreign-controlled domestic corporations.741 The Treasury Department recommends gathering additional information from taxpayers relating to earnings stripping to determine whether it would be appropriate to modify the proposal with respect to foreign-controlled domestic corporations. Accordingly, on November 28, 2007, the Treasury Department and the IRS issued a proposed tax form, Form 8926, Disqualified Corporate Interest Expense Disallowed Under Section 163(j) and Related Information, to gather additional information from corporate taxpayers relating to the determinations and computations under section 163(j).742 In December 2008, Form 8926 was issued in final form.

Discussion of wider points raised by Treasury earnings stripping report


    Effects of debt financing

Like any business, a foreign corporation has the option of financing its U.S. subsidiaries through equity or some combination of debt and equity. There are certain advantages to utilizing some degree of debt financing -- for example, debt financing may allow a business to raise funds at a lower cost (for example, the return to investors may be lower because debt is a less risky investment than an equity investment in the same business) and without surrendering ownership. Depending on the differences between the U.S. tax rate and the rate of tax imposed on the recipient of the interest by the applicable foreign country, the use of substantial debt financing, even if not rising to the level of earnings stripping, may facilitate lowering the aggregate burden of U.S. tax on the U.S. operations, thereby lowering the foreign parent corporation's overall tax rate on its worldwide operations. Moreover, even if the full 30-percent U.S. withholding tax is imposed upon the interest payment, there remains a five-percent taxpayer-favorable difference, if the interest expense is deductible at the highest U.S. corporate rate of 35 percent. In addition, the interest recipient may be able to take a credit for the U.S. withholding tax, in whole or in part, against its tax in the applicable foreign country, or the interest may be tax-exempt in such country. Although a foreign tax credit might also be available for withheld taxes on a dividend and the underlying U.S. corporate tax, in general there is a greater possibility of double taxation in the case of dividends paid by foreign-controlled domestic corporations to their parents than in the case of interest. Moreover, debt principal may be repaid on a tax-free basis, while redemption of equity by a foreign parent is generally treated as a dividend distribution unless the corporation paying the dividend has no earnings and profits.743

Studies have determined that, with some exceptions, greater investment is linked to overall higher labor compensation.744 The Treasury earnings stripping report suggests that income shifting may support increased investment into high-tax jurisdictions (such as the United States) by lowering the effective tax rate.745 Whether the ability of U.S. businesses to pay interest to related foreign debt-holders should be further abated may be part of a larger policy discussion that balances revenue and other needs in an international context.746 It is difficult to determine the optimal rate of U.S. tax on foreign-controlled domestic corporations (or conversely, the appropriate level of leverage) that would maximize the overall economic benefit to the United States. However, the best way to encourage increased investment in the United States (by foreign or domestic investors) is to increase the after-tax return to investment, and that outcome is more efficiently achieved by, for example, lowering the U.S. corporate income tax rate than by narrower policies such as the facilitation of earnings stripping.


    Earnings stripping and tax treaties

Earnings stripping generally provides a net tax benefit only to the extent that the foreign recipient of the interest income is subject to a lower amount of foreign tax on such income than the net value of the U.S. tax deduction applicable to the interest, i.e., the amount of U.S. deduction times the applicable U.S. tax rate, less the U.S. withholding tax. That may be the case if the country of the interest recipient provides a low general corporate tax rate, a territorial system with respect to interest, or a special tax regime for financing structures, and if that country has entered into a tax treaty with the United States that provides a reduced U.S. withholding tax rate on interest.

Thus, the applicable foreign tax rate and the U.S. withholding tax rate on the interest payment are two factors that affect the ability of foreign-controlled domestic corporations to effectively engage in earnings stripping. These two factors are interrelated. While a low foreign tax rate relative to the U.S. rate is critical to effective earnings stripping, if the general foreign tax rate is zero, it is not likely that the United States would now enter into a tax treaty with that foreign country that lowers the U.S. withholding tax rate on interest. Therefore, such a foreign corporation may attempt to utilize a U.S. tax treaty with another foreign country to obtain a lower U.S. withholding tax rate. This practice is known as treaty shopping.747

As described in detail in the Treasury income tax treaty report issued with the Treasury earnings stripping report, the Treasury Department has taken significant steps since 2000 to combat treaty shopping by negotiating new and stricter limitation-on-benefit ("LOB") provisions with several U.S. treaty partners, as well as including a similar new LOB provision in the United States Model Income Tax Convention of November 15, 2006. These stricter LOB provisions include a series of complex objective tests to determine whether a resident of a treaty country is sufficiently connected economically to that country to warrant receiving treaty benefits.748


    Limitation of the scope of the proposal to expatriated entitaies

As discussed elsewhere in this document, certain of the Administration's other proposals may reduce somewhat the incentive that may exist under present law for certain U.S. persons to make investments outside of the United States, instead of within the United States, because of the more favorable U.S. tax treatment available for such foreign investments.749 The same proposals may make corporate structures with a domestic parent relatively less attractive than corporate structures with a foreign parent because those proposals are more likely to raise the U.S. tax liability for the domestic parent structure than for the foreign parent structure. This proposal may counteract some of the U.S. tax advantage perceived to exist for foreign parent structures vis-à-vis domestic parent structures by significantly reducing opportunities for certain foreign parent structures (specifically, those involving domestic parent structures that inverted) to reduce their U.S. tax liability by engaging in earnings stripping using deductible interest. However, the effectiveness of this counterbalancing may be limited due to the fact that the proposal applies only to certain expatriated entities and not to, for example, newly established foreign-controlled domestic corporations.

Section 7874 appears to have significantly reduced the opportunity for domestic-controlled corporations to engage in earnings stripping by engaging in new inversion transactions.750 However, both incentive and opportunity remain for foreign-controlled domestic corporations (including new enterprises that opt out of U.S. residence for their top-tier entities), corporations that engage in 60-percent inversions, and corporations that inverted on or before March 4, 2003, to engage in earnings stripping. The proposal would further restrict earnings stripping for corporations that engage in 60-percent inversions and the pre-March 3, 2003 inverters,751 but not for the much larger group of foreign-controlled domestic corporations that have not inverted.

Although recent legislative and treaty developments have removed some significant opportunities for earnings stripping, and notwithstanding that the Treasury earnings stripping report does not conclusively determine that foreign-controlled domestic corporations that are not expatriated entities are engaging in earnings stripping, some argue that, as a matter of tax policy, the earnings stripping rules should treat foreign-controlled domestic corporations in the same manner as expatriated entities because both types of corporations have the same incentives and capabilities to erode the U.S. tax base, and may do so in the same manner. Proponents of this argument observe that it should not be surprising that the available information clearly demonstrates that expatriated entities are engaging in earnings stripping because expatriated entities comprise an easily-identifiable subclass of foreign-controlled domestic corporations and have demonstrated a propensity for aggressive tax planning. Proponents of stricter across-the-board earnings stripping rules also argue that there is sufficient evidence of earnings stripping to justify implementing such a regime, and that significant erosion of the U.S. tax base will continue until the earnings stripping rules are strengthened for all foreign-controlled domestic corporations.

Others agree with the conclusion of the Treasury earnings stripping report that there is insufficient evidence to justify legislative action outside the context of inversions at this time, and that it would be more prudent to await the receipt and analysis of taxpayer data on earnings stripping submitted through the new Form 8926. Proponents of this view may also believe that the implementation of the new form should increase compliance with section 163(j). In response, some argue that it will be at least several years before careful analyses can be performed on any data submitted through Form 8926, and that there is currently sufficient concern and anecdotal evidence regarding earnings stripping by foreign-controlled domestic corporations to justify strengthening the substantive earnings-stripping rules now, while continuing to analyze data as it becomes available.


    Other types of earnings stripping

The proposal does not address earnings stripping transactions involving the payment of deductible amounts (by expatriated entities or foreign-controlled domestic corporations) other than interest (e.g., rents, royalties, and service fees), or the payment of deductible amounts by taxpayers other than corporations.752 These transactions also may erode the U.S. tax base, and thus some argue that a more comprehensive response to earnings stripping is needed. The Treasury Department's examination of payments declared on Form 5472 by seven expatriated entities suggests that, although the majority of earnings stripping by expatriated entities is through interest, some earnings stripping occurs through royalties.753 Indeed, as opportunities for earnings stripping through interest payments are reduced, taxpayers may find it increasingly attractive to strip earnings through other means. On the other hand, earnings stripping may be more readily achieved through the use of debt than through other means.754

Prior Action

The President's fiscal year 2009 and 2010 budget proposals contained a similar earnings stripping proposal, except that it provided that the 50-percent of adjusted taxable income threshold generally continued to apply to interest on guaranteed debt. The President's fiscal year 2005, 2006, 2007, and 2008 budget proposals contained a similar, but broader, proposal that would have applied regardless of whether an inversion had occurred. The President's fiscal year 2004 budget proposals contained a different earnings stripping proposal that would have modified the safe harbor provision, reduced the adjusted taxable income threshold, added a new disallowance provision based on a comparison of domestic to worldwide indebtedness, and limited carryovers.

Earlier this year, the House passed a provision providing that the amount of U.S. withholding tax imposed on a deductible payment made to a foreign related party may not be reduced under a U.S. treaty unless such withholding tax would be reduced under a U.S. treaty if such payment were made directly to the foreign parent corporation.755 The House passed the same provision in 2008 and 2009.756 In 2007, the House passed a similar, but somewhat broader provision providing that the amount of U.S. withholding tax imposed on a deductible payment made to a foreign related party may not be less than the amount which would be imposed if the payment were made directly to its foreign parent corporation.757 In each of these cases, the provision would apply to all deductible payments to foreign related parties, and not solely to interest.

In 2006, the Senate passed a provision applicable to certain expatriated entities that would have eliminated the safe harbor and reduced the present-law threshold of 50 percent of adjusted taxable income to 25 percent for both net interest expense and excess limitation.758

In 2004, prior to AJCA's enactment, the Senate passed a provision that would have tightened the interest stripping rules for corporations that had engaged in certain inversions. For these corporations, the proposal would have eliminated the debt-to-equity safe harbor, reduced the threshold for excess interest expense to 25 percent of adjusted taxable income, and modified the excess limitation threshold so that 25 percent of adjusted taxable income over a corporation's net interest expense for a year could be carried forward three years.759

8. Repeal 80/20 company rules

A provision substantially similar to the President's fiscal year 2011 budget proposal was included in H.R. 1586, which was signed into law by the President on August 10, 2010.

9. Prevent the avoidance of dividend withholding taxes

A provision substantially similar to the President's fiscal year 2011 budget proposal was enacted as part of the Hiring Incentives to Restore Employment Act.760

10. Modify the tax rules for dual capacity taxpayers


Present Law

The United States taxes its citizens and residents (including U.S. corporations) on their worldwide income. Because the countries in which income is earned also may assert their jurisdiction to tax the same income on the basis of source, foreign-source income earned by U.S. persons may be subject to double taxation. To mitigate this possibility, the United States generally provides a credit against U.S. tax liability for foreign income taxes paid or accrued.761

A foreign tax credit is available only for foreign income, war profits, and excess profits taxes, and for certain taxes imposed in lieu of such taxes. Other foreign levies generally are treated as deductible expenses. Treasury regulations under section 901 provide detailed rules for determining whether a foreign levy is a creditable income tax. In general, a foreign levy is considered a creditable tax if it is substantially equivalent to an income tax under U.S. tax principles. Under the present Treasury regulations, a foreign levy is considered a tax if it is a compulsory payment under the authority of a foreign country to levy taxes and is not compensation for a specific economic benefit provided by a foreign country.762


    Dual capacity taxpayers

A taxpayer that is subject to a foreign levy and also receives a specific economic benefit from the foreign country is considered a "dual capacity taxpayer."763 A "specific economic benefit" is broadly defined as an economic benefit that is not made available on substantially the same terms to substantially all persons who are subject to the income tax that is generally imposed by the foreign country, or, if there is no such generally imposed income tax, an economic benefit that is not made available on substantially the same terms to the population of the country in general.764 An example of a specific economic benefit includes a concession to extract government-owned petroleum. Other examples of economic benefits that may be specific if not provided on substantially the same terms to the population in general, include property; a service; a fee or other payment; a right to use, acquire or extract resources, patents, or other property that a foreign country owns or controls (as defined within the regulations); or a reduction or discharge of a contractual obligation.

Treasury regulations addressing payments made by dual capacity taxpayers were developed in response to the concern that payments which purported to be income taxes imposed on U.S. oil companies by mineral-owning foreign governments were at least partially, in substance, royalties or some other business expense.765 To the extent that a taxpayer meets the definition of a dual capacity taxpayer, the taxpayer may not claim a foreign tax credit for the portion of the foreign levy that is paid for the specific economic benefit.766 Treasury regulations require that a dual capacity taxpayer, similar to other taxpayers, must establish that the foreign levy meets the requirements of section 901 or section 903.767 However, the regulations require that a dual capacity taxpayer use either a facts and circumstances method or a safe harbor method in establishing the foreign levy is an income tax.768

Under the facts and circumstances method, a separate levy is creditable to the extent that the taxpayer establishes, based on all the relevant facts and circumstances, the amount of the levy that is not paid as compensation for the specific economic benefit.769 For purposes of applying the facts and circumstances method, the foreign country need not have a generally imposed income tax.

A dual capacity taxpayer alternatively may choose to apply the safe harbor method on a country-by-country basis to determine whether a levy is a creditable tax.770 Under the safe harbor method, if the foreign country has a generally imposed income tax, the taxpayer may credit the portion of the levy that application of the generally imposed income tax would yield provided that the levy otherwise constitutes an income tax or an in lieu of tax. The balance of the levy is treated as compensation for the specific economic benefit.771 If the foreign country does not generally impose an income tax, the portion of the payment that does not exceed the applicable U.S. federal tax rate, applied to net income, is treated as a creditable tax.772 In general, a foreign tax is treated as generally imposed for this purpose even if it applies only to persons who are not residents or nationals of that country.773

After the promulgation of the regulations, many dual-capacity taxpayers elected the safe harbor method for determining what portion, if any, of the separate foreign levy they paid would be treated as a creditable income tax. However, in 1999, the Tax Court in Exxon Corp. v. Commissioner determined that the entire amount of the petroleum revenue tax paid by Exxon to the U.K. government did not constitute compensation for a specific economic benefit and would thus qualify as tax for purposes of the foreign tax credit.774 The Court considered that Exxon entered into an arm's length licensing agreement with the U.K. government to gain access to the North Sea oil fields prior to the enactment of the petroleum revenue tax, and determined that Exxon's right to explore, develop and exploit petroleum resources was dependent on the licensing agreement and payment of license fees under that agreement and not in exchange for payment of the tax. Subsequent to the decision in Exxon, anecdotal evidence suggests that a significant number of dual-capacity taxpayers revoked their safe harbor elections and adopted the facts and circumstances method to argue for tax treatment for the entire amount of the qualifying levy.

Limitation on the use of foreign tax credits

The foreign tax credit generally is limited to a taxpayer's U.S. tax liability on its foreign-source taxable income (as determined under U.S. tax accounting principles). This limit is intended to ensure that the credit serves its purpose of mitigating double taxation of foreign-source income without offsetting U.S. tax on U.S. -source income.775 The limit is computed by multiplying a taxpayer's total U.S. tax liability for the year by the ratio of the taxpayer's foreign-source taxable income for the year to the taxpayer's total taxable income for the year. If the total amount of foreign income taxes paid and deemed paid for the year exceeds the taxpayer's foreign tax credit limitation for the year, the taxpayer may carry back the excess foreign taxes to the immediately preceding taxable year or carry forward the excess taxes forward 10 years.776

In addition, this limitation is calculated separately for various categories of income, generally referred to as "separate limitation categories." The total amount of foreign taxes attributable to income in a separate limitation category that may be claimed as credits may not exceed the proportion of the taxpayer's total U.S. tax liability which the taxpayer's foreign-source taxable income in that separate limitation category bears to the taxpayer's worldwide taxable income. The separate limitation rules are intended to reduce the extent to which excess foreign taxes paid in a high-tax foreign jurisdiction can be "cross-credited" against the residual U.S. tax on low-taxed foreign-source income.777


    Special rule for foreign oil and gas income

A special limitation applies with respect to taxes on combined foreign oil and gas income applied prior to the foreign tax credit limitation discussed above.778 This limitation was adopted prior to the issuance of the regulations providing the rules discussed above for dual capacity taxpayers to address the concern that payments made by oil companies to many oil-producing nations were royalties disguised as tax payments.779 Additionally, the limitation sought to prevent the crediting of high foreign taxes on foreign oil and gas income against the residual U.S. tax on other types of lower-taxed foreign source income.780

Under this special limitation, amounts claimed as taxes paid on combined foreign oil and gas income are creditable in a given taxable year (if they otherwise qualify as creditable taxes) only to the extent they do not exceed the applicable U.S. tax on that income. The applicable U.S. tax is determined for a corporation as the product of the amount of such combined foreign oil and gas income for the taxable year and the highest marginal tax rate for corporations.781 Any excess foreign taxes may be carried back to the immediately preceding taxable year and carried forward 10 taxable years and credited (not deducted) to the extent that the taxpayer otherwise has excess limitation with regard to combined foreign oil and gas income in a carryover year.782 Amounts that are not limited under section 907 (relating to combined foreign oil and gas income discussed above) are included in the general basket or passive basket (as applicable) for purposes of applying the section 904 limitation.


Description of Proposal

In the case of a dual capacity taxpayer, the proposal allows a taxpayer to treat as a creditable tax the portion of a foreign levy that does not exceed the foreign levy that the taxpayer would pay if it were not a dual-capacity taxpayer. The proposal replaces the current regulatory provisions, including the safe harbor, that apply to determine the amount of a foreign levy paid by a dual-capacity taxpayer that qualifies as a creditable tax. The proposal also converts the special foreign tax credit limitation rules of section 907 into a separate category within section 904 for foreign oil and gas income. The proposal yields to U.S. treaty obligations to the extent that they allow a credit for taxes paid or accrued on certain oil or gas income.

Effective date. -- The proposal is effective for taxable years beginning after December 31, 2010.


Analysis

The proposal addresses the distinction between creditable taxes and non-creditable payments that are made in exchange for a specific economic benefit by denying a foreign tax credit for amounts paid by a dual-capacity taxpayer that exceed the foreign tax that would be paid if the taxpayer were not a dual-capacity taxpayer. Thus, the proposal would create a non-rebuttable presumption that a tax paid by a dual-capacity taxpayer to a foreign government is for a specific economic benefit to the extent the tax exceeds the tax that would be paid by a non-dual-capacity taxpayer.

As discussed above, the catalyst for the present regulations governing the creditability of payments made by dual-capacity taxpayers was a concern that payments purported to be income taxes imposed on U.S. oil companies by mineral-owning foreign governments were at least partially, in substance, royalties or some other business expense. The present regulations mitigate this concern, but under either the facts and circumstances or safe-harbor method, a foreign levy is treated as a creditable tax, despite there being a lower or no generally imposed income tax on persons other than dual-capacity taxpayers.783 Thus, under the present regulatory regime, there is a general presumption that the foreign levy represents a tax, even where the levy is either imposed at a higher rate or imposed solely on dual-capacity taxpayers. The proposal effectively reverses that presumption by allowing a dual-capacity taxpayer to treat as income tax only the portion of the foreign levy that the dual-capacity taxpayer would pay had it not been a dual-capacity taxpayer.

Although primarily applicable to oil and gas producers (and other companies engaged in mineral extraction businesses), the "dual-capacity" taxpayer provisions are broadly applicable to any taxpayer that is treated under the regulations as receiving a specific economic benefit from a foreign government.784 Thus, for example, a corporation engaged in a banking business that loans funds to a foreign government may meet the definition of a dual-capacity taxpayer and therefore be subject to the provisions in the Administration's proposal. As a result, if the foreign country imposes no income tax on persons other than dual-capacity taxpayers, the taxes paid by the bank would not be creditable.785

Present law arguably fails to achieve the appropriate allocation between a payment for specific economic benefit and a creditable tax in those cases where the foreign country either imposes a levy on an item, but does not otherwise generally impose an income tax, or imposes a higher levy on dual-capacity taxpayer than the levy imposed on non-dual-capacity taxpayers. Thus, the proposal would ensure that the levy is not a payment for a specific economic benefit.786

Moreover, the proposal provides a clear, objective test to determine what portion of the foreign levy, if any, reflects payment for a specific economic benefit. Thus, unlike the facts and circumstances test which has been the subject of controversy between the IRS and taxpayers, the proposal provides for a more objective standard that would be easier to administer.

Nonetheless, the proposal could create situations in which double taxation may arise. Instead, if the dual-capacity taxpayer can establish that it is paying fair compensation to the foreign country for the economic benefit received from that country, amounts paid pursuant to the foreign levy on net income or a levy on excess profits should constitute a creditable tax, notwithstanding that the foreign country imposes lower or no income tax on non-dual-capacity taxpayers.787

Furthermore, a fundamental assumption behind the proposal, that countries generally seek to impose an equal tax burden on all taxpayers and therefore any additional tax burden imposed solely on dual-capacity taxpayers reflects payment for a specific economic benefit, is arguably incorrect. Taxing jurisdictions often impose different levels of tax burden on different industries according to various factors including the relative mobility of a particular industry.788 A taxpayer in a relatively immobile industry, such as a company engaged in a natural resource extraction industry, is compelled to operate within the natural resource's jurisdiction notwithstanding a relatively high tax rate. In contrast, a taxpayer in a relatively mobile industry may have more flexibility in choosing the taxing jurisdiction in which it is established. To attract in-country investments of mobile industries, taxing authorities may offer incentives to such industries, including a lower tax rate. Thus, the additional tax burden on oil companies, as well as others operating in immobile industries, is arguably not a payment for a specific economic benefit, but simply reflects the jurisdiction's ability to impose a higher tax on an immobile industry.

Those opposing the proposal also point out that the major U.S. based oil companies would be disadvantaged relative to foreign competitors in bidding for new projects as a result of the increased costs.789 This reduced competitiveness could, it is contended, impair energy security in the United States.

The proposal also includes a separate foreign tax credit limitation category that applies to combined foreign oil and gas income and eliminates the present-law special limitation for combined foreign oil and gas income under section 907. Some have argued that the original concerns that gave rise to the section 907 rules -- royalties being disguised as foreign levies and the cross-crediting of taxes paid at high rates on foreign oil and gas related income against U.S. tax on other low-taxed income -- have been sufficiently addressed by other provisions and that section 907 adds unnecessary complexity and should be repealed.790 Arguably, the disguised royalties issue was addressed by the dual-capacity taxpayer rules. However, as discussed above, the present law dual-capacity taxpayer rules permit certain foreign levies to be treated as creditable even though the foreign country imposes lower or no levies on non-dual-capacity taxpayers. If the proposed modifications to the dual-capacity taxpayer rules were enacted, these changes may render section 907 unnecessary in preventing crediting of disguised royalties. However, the cross-crediting of high taxes paid on extraction income against other income is a section 904 concern that is not addressed by changes to the amount of the foreign levy that qualifies under section 901.

Furthermore, the recent change combining FOGEI and FORI into combined foreign oil and gas income allows for substantial cross-crediting of extraction taxes against U.S. tax on low-taxed downstream FORI income. By replacing section 907 with a separate section 904 limitation category for foreign oil and gas income, the proposal would restrict cross-crediting of oil and gas related taxes against other general category income as well as prevent the use of excess credits on other general category income from offsetting U.S. tax on low-taxed FORI for taxpayers that do not have extraction income. At the same time, the proposal would simplify credit calculations because present law requires that the special section 907 limitation be applied first, followed by application of the section 904 limitation.


Prior Action

Proposals revising the treatment of dual-capacity taxpayers have been included in the President's fiscal year 1998, 1999, 2000, 2001 and 2010 budget proposals. The proposal in the fiscal year 1998 budget proposal included an additional modification with respect to the treatment of foreign oil and gas income under subpart F of the Code which is not included in this proposal.

G. Combat Under-Reporting of Income on Accounts and Entities in
Offshore Jurisdictions

Provisions substantially similar to several of the President's fiscal year 2011 budget proposals on combating under-reporting of income on accounts and entities in offshore jurisdictions were enacted as part of the Hiring Incentives to Restore Employment ("HIRE") Act,791 on March 18, 2010.

The proposals enacted as part of the HIRE Act are as follows:

  • Require Increased Reporting on Certain Foreign Accounts
  • Require Increased Reporting with Respect to Certain Recipients of FDAP Income or Gross Proceeds
  • Repeal Certain Foreign Exceptions to Registered Bond Requirements
  • Require Disclosure of Foreign Financial Assets to be Filed with Tax Return
  • Impose Penalties for Underpayments Attributable to Undisclosed Foreign Financial Assets
  • Extend Statute of Limitations for Significant Omission of Income Attributable to Foreign Financial Assets
  • Permit the Secretary to Require Electronic Filing by Financial Institutions of Certain Withholding Tax Returns
  • Establish Presumption of U.S. Beneficiary in Case of Transfers to Foreign Trusts by a U.S. Person
  • Treat Certain Uncompensated Uses of Foreign Trust Property as a Distribution to U.S. Grantor or Beneficiary
  • Improve Foreign Trust Reporting Penalty

1. Require reporting of certain transfers of assets to or from foreign financial accounts

Present Law

Various self-reporting requirements apply to U.S. persons who engage in cross-border activities. The obligations to report are established by both the Code and Title 31 of the United States: "Title 31 of the United States Code, the Bank Secrecy Act," as described below.

Reporting required by the Code

For all U.S. persons, the Code requires self-reporting on the formation and funding of foreign entities. The Foreign Account Tax Compliance Act ("FATCA"), enacted as subtitle A of Title V of the Hiring Incentives to Restore Employment (HIRE) Act,792 added section 6038D, which requires that individuals disclose certain foreign financial assets and imposes penalties for failure to disclose such assets.

To the extent that a U.S. person engages in foreign activities indirectly through a foreign business entity, the Code imposes certain other self-reporting requirements. Upon the formation, acquisition or ongoing ownership of certain foreign corporations, U.S. persons that are officers, directors, or shareholders must file a Form 5471, "Information Return of U.S. Persons with Respect to Certain Foreign Corporations,"793 identifying the foreign corporation, amount of stock held, principal business and functional currency of the corporation. Similar information with respect to interests in a controlled foreign partnership is required to be reported on Form 8865, "Return of U.S. Persons with Respect to Certain Foreign Partnerships." Form 8858, "Information Return of U.S. Persons With Respect To Foreign Disregarded Entities," must be filed with respect to a foreign disregarded entity.794 As part of the initial formation of a foreign business entity, the foreign business entity is often capitalized with cash as well as other assets and liabilities. If the foreign entity receiving such contributions is a foreign corporation, the U.S. person capitalizing the entity will be required to file Form 926, "Return by a U.S. Transferor of Property to a Foreign Corporation."795


    New section 6038D reporting by individuals

An individual taxpayer with an interest in a "specified foreign financial asset" during the taxable year is required to attach a disclosure statement to his or her income tax return for any year in which the aggregate value of all such assets is greater than $50,000 or such other higher amount as the Secretary may prescribe. Although the nature of the information required is similar to the information required to be disclosed on the form TD F 90-22.1, "Report of Foreign Bank and Financial Accounts," it is not identical.796 For example, a beneficiary of a foreign trust who is not within the scope of the FBAR reporting requirements because his interest in the trust is less than 50 percent may nonetheless be required to disclose the interest in the trust with his tax return under this provision if the value of his interest in the trust together with the value of other specified foreign financial assets exceeds the aggregate value threshold. Compliance with section 6038D is not a substitute for compliance with the FBAR reporting requirements.

"Specified foreign financial assets" are interests in depository or custodial accounts at foreign financial institutions and, to the extent not held in an account at a financial institution, (1) stocks or securities issued by foreign persons, (2) any other financial instrument or contract held for investment that is issued by or has a counterparty that is not a U.S. person, and (3) any interest in a foreign entity. The information to be included on the statement includes identifying information for each asset and its maximum value during the taxable year. For an account, the name and address of the institution at which the account is maintained and the account number are required. For a stock or security, the name and address of the issuer, and any other information necessary to identify the stock or security and the class or issue of which it is a part must be provided. For all other instruments or contracts, or interests in foreign entities, the information necessary to identify the nature of the instrument, contract or interest must be provided, along with the names and addresses of all foreign issuers and counterparties. An individual is not required under this provision to disclose interests held in a custodial account with a U.S. financial institution. An individual need not separately identify any stock, security instrument, contract, or interest in a foreign financial account disclosed under the provision. In addition, the provision permits the Secretary to issue regulations that would apply the reporting obligations to a domestic entity in the same manner as if such entity were an individual if that domestic entity is formed or availed of to hold specified foreign financial assets, directly or indirectly.


    Enforcement of section 6038D

Individuals who fail to make the required disclosures without reasonable cause are subject to a penalty of $10,000 for the taxable year. Foreign law prohibitions against disclosure of the required information cannot be relied upon to establish reasonable cause. An additional penalty may apply if the Secretary notifies an individual by mail of the failure to disclose and the failure to disclose continues. If the failure continues beyond 90 days following the mailing, the penalty increases by $10,000 for each subsequent 30-day period (or a fraction thereof), up to a maximum penalty of $50,000 for one taxable period. The computation of the penalty is similar to that applicable to failures to file reports with respect to certain foreign corporations under section 6038. Thus, for example, an individual who is notified of his failure to disclose with respect to a single taxable year under this provision and who takes remedial action on the 95th day after such notice is mailed incurs a penalty of $20,000 comprising the base amount of $10,000, plus $10,000 for the fraction (i.e., the five days) of a 30-day period following the lapse of 90 days after the notice of noncompliance was mailed. An individual who postpones remedial action until the 181st day is subject to the maximum penalty of $50,000: the base amount of $10,000, plus $30,000 for the three 30-day periods, plus $10,000 for the fraction (i.e., the single day) of a 30-day period following the lapse of 90 days after the notice of noncompliance was mailed.

To the extent the Secretary determines that the individual has an interest in one or more foreign financial assets but the individual does not provide enough information to enable the Secretary to determine the aggregate value thereof, the aggregate value of such identified foreign financial assets will be presumed to have exceeded the applicable reporting threshold for purposes of assessing the penalty.

Self-reporting on foreign financial accounts under the Bank Secrecy Act

U.S. persons who transfer assets to, and hold interests in, foreign bank accounts or foreign trusts are required to report their foreign financial interests on an annual FBAR, which is principally governed by Title 31 of the United States Code (the "Bank Secrecy Act"). The Bank Secrecy Act has expanded beyond its original focus on large currency transactions, while retaining its broad purpose of obtaining reports with "a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings."797 The statute was explicitly intended to provide enforcement tools necessary "to cope with the problems created by the so-called secrecy jurisdictions."798

As the reporting regime has expanded,799 it has imposed reporting obligations on both financial institutions and the account holders. With respect to the latter, the obligation to report with respect to their foreign accounts is set forth in regulations promulgated pursuant to broad regulatory authority granted to the Secretary, as supplemented by other guidance. The statute specifies only that the required reports shall contain information about the identity and address of participants in a transaction or relationship; the legal capacity in which a participant is acting; the identity of real parties in interest; and a description of the transaction "in the way and to the extent the Secretary prescribes."800 A citizen, resident, or person doing business in the United States is required to keep records and file reports when that person enters into a transaction or maintains a relationship (e.g., an account) with a foreign financial entity,801 to the extent that the value of all assets within all such accounts in which the person has an interest exceeds $10,000 at any time during the year. The FBAR report must disclose any account in which the filer has a financial interest or as to which the filer has signature authority (in which case the filer must identify the owner of the account).

The FBAR, due by June 30 of the year following the year in which the $10,000 threshold is met,802 is filed by mailing to the Department of the Treasury at the IRS Detroit Computing Center. Failure to file the FBAR is subject to both criminal803 and civil penalties.804 Since 2004, the civil sanctions have included a penalty of up to $10,000 for failures that are not willful, and a penalty of the greater of $100,000 or 50 percent of the balance in the account for willful failures. Although the form is received and processed by the IRS, it is neither part of the income tax return that the individual files with the IRS nor filed in the same office as the return. As a result, it is not considered "return information," and its distribution to other law enforcement agencies is not limited by the nondisclosure rules of the Code.805

Although the obligation to file an FBAR arises under Title 31, most individual taxpayers subject to the reporting requirements are alerted to the existence of the requirements when preparing annual Federal income tax returns by the questions regarding foreign bank accounts that are included in Part III of Schedule B of IRS Form 1040, "Foreign Accounts and Trusts." The responses to these questions do not in themselves discharge one's obligations under Title 31. In addition, they constitute "return information"806 and may not be routinely disclosed to those charged with enforcing Title 31.

In October 2008, the Treasury Department and the IRS revised the form and its accompanying instructions. The revisions explained how the filing requirement applies to new types of financial transactions and attempted to ensure that transactions intended to be covered do not fall outside the literal language of the instructions. The revised instructions track the language of the statute in stating that a person in or doing business in the United States is within its purview. Thus, the revisions are arguably mere clarifications. However, questions about the extent to which the revisions expanded the FBAR filing requirements with respect to non-U.S. persons, the treatment of commingled funds and the definitions of financial interest,807 led the IRS to announce that people may rely on earlier, unrevised instructions to determine whether they are required to file an FBAR, pending publication of guidance on the scope of the statute. In addition, the IRS granted administrative relief to persons with only signature authority over foreign financial accounts as well as signatories or owners of a financial interest in a foreign commingled fund.808 Proposed regulations, including newly revised instructions for the FBAR, were published in the Federal Register on February 26, 2010.809 The proposed regulations provide new definitions of United States person, specify the types of interest that may constitute a foreign financial interest, provide special rules for persons with multiple accounts, and create an anti-avoidance rule to prevent use of an entity created for the purpose of evading the reporting requirements.


Description of Proposal

A U.S. individual would be required to report, on the individual's income tax return, any transfer of money or property made to, or receipt of money or property from, any foreign bank, brokerage, or other financial account by the individual. Additionally, any entity of which a U.S. individual owns, directly or indirectly, more than 25 percent of the ownership interest would be required to report any transfer of money or property made to, or receipt of money or property from, any foreign bank, brokerage, or other financial account by the entity. Such an entity would also be required to report the name, address, and taxpayer identification number of any U.S. individual with a more than 25-percent ownership interest in the entity. This reporting requirement would not apply if the cumulative amount or value of transfers, and the cumulative amount or value of receipts that would otherwise be reportable for a given year, were each less than $50,000.

The Treasury Department would receive regulatory authority to require the reporting of additional information, including classifying transfers and receipts as "for investment" or "for arm's-length payments in the ordinary course of business for services or tangible property," or such other categories as the Secretary may prescribe. The Treasury Department would also receive regulatory authority to issue rules to prevent abuse of the reporting exemptions and to provide exceptions to the reporting requirement.

The proposal also includes a penalty for failure to report a covered transfer. The failure to report as required under the proposal would result in the imposition of a penalty equal to the lesser of $10,000 per reportable transfer or 10 percent of the cumulative amount or value of the unreported covered transfers. No penalty would be imposed for a failure to report due to reasonable cause.

Effective date. -- The proposal would be effective for transfers made after December 31, 2012.


Analysis

A requirement to report on one's tax return all transfers to or receipts from a foreign financial account appears to overlap significantly with the disclosure requirements of both the recently enacted section 6038D and FBAR. Because the disclosure requirements of section 6038D are not yet in effect, their effectiveness has not yet been tested. As a result, one could argue that introduction of any new self-reporting requirements is premature. It may result in reporting of information that is duplicative or of little additional value, thus increasing administrative and processing burden on the IRS, while at the same time increasing the compliance burdens on individuals who pose little risk of tax evasion.

A review of the provenance of this proposal is helpful in understanding whether it complements the recently enacted FATCA provisions. This proposal to report on transfers was included in last year's budget proposal, as one of a number of provisions intended to combat offshore tax avoidance. It was one of two provisions requiring a taxpayer to self-report foreign holdings on his Federal income tax return. The other self-reporting provision required disclosure of FBAR filings with the tax return. While other offshore compliance proposals were refined to form the nucleus of FATCA, neither of the proposals to require self-reporting with respect to foreign accounts was included in that legislation. Instead, a third version of a self-reporting requirement was crafted, and resulted in the requirement in section 6038D to disclose on Federal tax returns the value of foreign financial assets held during a taxable year, rather than transfers. FATCA was pending at the time this year's President Budget was published. In its proposals, the Administration included a new proposal for a self-reporting provision similar to that included in FATCA, as well as a revised version of last year's proposal to require reporting of transfers.

The reasons given in support of these proposals refer to concern about the use of foreign accounts by U.S. citizens and residents to evade U.S. tax, but do not explain whether the proposals should be viewed as alternative or complementary proposals. The proposals are not identical, but it is not clear the extent to which one enhances the other. With the enactment of FATCA, individuals are now required to disclose their ownership of foreign financial assets and the value of such assets. The breadth of the statutory definition of foreign financial assets under new section 6038D is significant. If the dollar value in an account or foreign instrument or entity at any time exceeds $50,000, it must be disclosed, without regard to the percentage ownership interest in the account, instrument or entity. Thus, without an exception for a de minimis ownership interest under section 6038D, that provision may require greater disclosure than this proposal, which limits reporting to those entities in which the individual holds an interest of 25 percent or more. However, the detail that this proposal requires may be significantly greater than that required by new section 6038D.

Transfers or receipts that would be required to be aggregated and disclosed in order to comply with a statute based on this proposal may relate to an asset that is also subject to reporting under section 6038D. The extent to which this proposal provides information that is not disclosed under section 6038D is difficult to determine, as is the incremental value of such information. It is possible that aggregate transfers in and out of an account may exceed $50,000 in one year, although the balance of the account at no time reaches that threshold. In such cases, this proposal would capture information that section 6038D would not. Whether the value of the nonredundant information outweighs the increased administrative complexity and problems with filtering redundant information is more difficult to determine. The extent to which reports on transfers and receipts are of value depends in part upon the ability to determine the validity of the information by comparison with another source of information, preferably a disinterested third-party information report. Without third-party information reporting on transfers and receipts, the value of an individual's report lies in the disclosure of the existence of the asset, not the volatility of transactions with respect to the asset. The proposal does not specify contemporaneous reporting of the transfers throughout the year, but annual reporting of transfers and receipts would require tracking such transactions throughout the year in order to ascertain whether a taxpayer met the threshold that triggers the reporting obligation.

In determining whether the proposal strikes an appropriate balance between the government need for information, the burden of providing such information, and possible privacy concerns, it is helpful to consider whether the proposals reach their intended targets. It would seem that high-net worth individuals, whose ability to exploit international structures to minimize tax may have a significant influence on the overall perception of the integrity of a tax system, are the intended target. By requiring reporting on both the existence of foreign assets as well as transfers, the use of complex structures to avoid the reporting threshold may be curtailed. If such persons are assumed to present a higher risk of avoidance behavior, they may fairly be viewed as appropriate targets of the enhanced reporting requirements, and the costs that higher risk taxpayers would incur in complying with the requirements may be appropriate.

Nevertheless, the reporting on transfers and receipts could result in a high volume of information of limited use to tax authorities because it is duplicative of other information reports. In addition, the proposal as currently formulated may unintentionally reach large classes of taxpayers who pose relatively little risk of tax evasion. These groups include first or second generation immigrants who send money to their families in their country of origin; beneficiaries of employee plans of multinational companies; and U.S. expatriates working overseas as employees of foreign entities and having signature authority over foreign accounts in that capacity but no financial interest in such accounts. The controversy concerning the scope of an FBAR obligation of the latter group of individuals has led to suspension of certain FBAR deadlines, pending promulgation of final regulations, as explained above,810 but is close to resolution in the FBAR context. The Administration proposal may engender a similar controversy.

It is also not clear whether the presumption under section 6038D that an undisclosed foreign financial asset has a value of at least $50,000 dollars would automatically trigger application of the proposed reporting requirement for transfers and receipts. Under section 6038D, the $50,000-value presumption applies if the IRS learns of a foreign financial asset and is not provided information sufficient to determine whether it should have been the subject of reporting under that provision. If the 6038D presumption applied for purposes of the proposal, an asset that never had a value in excess of $50,000 during the year and with respect to which there is little activity could be subject to the requirements of the proposal in addition to a penalty under section 6038D.

One difference from last year's proposal is the absence of an explicit exception for transfers to or from financial institutions that are parties to qualified intermediary ("QI") agreements with the IRS. Such an exception from reporting for transfers to a QI or foreign financial institutions ("FFI") with agreements under new sections 1471 and 1473 could have the effect of promoting participation in the QI program and the new FFI agreements. Investors who know of the reporting requirements may prefer to invest with a QI or compliant FFI, in order to avoid reporting, and, collectively, could exert market pressure on institutions to participate. However, if the institutions in a particular jurisdiction were to conclude that the benefits of such status were insufficient to warrant the compliance costs, or if the local jurisdiction were unable to satisfy the know-your-customer rules that are a predicate to QI approval, the option for the U.S. person in such locations may be limited to foreign financial institutions that do not report. In response to last year's proposals, Treasury received comments to the effect that investors would find it less burdensome to report all transfers than to try to determine whether a foreign entity was a QI and in compliance with its QI agreement.

Although the broad regulatory authority requested in the description could be exercised to craft such an exception, it is not clear that such an exception is intended.


    Penalty proposal and stacking

The proposed penalty for failure to comply with the new reporting requirement is similar to the civil FBAR penalties applicable to non-willful failures to file in that it would generally be capped at $10,000. However, the proposed penalty differs in that it permits a lesser fine equal to 10 percent of the unreported transfer if such amount would be less than $10,000. To the extent that enacting a penalty similar to the FBAR penalties is appropriate, the use of an amount different from the applicable amounts under Title 31 is difficult to rationalize.

Nevertheless, the flexibility in determining the amount of a penalty under the proposal relieves the proposal of the chief criticism applied to the FBAR penalty, i.e., that it is often disproportionate to the offense in the case of a non-filer who appropriately reported all income related to the account for which an FBAR filing was required. In that case, the penalty can pose a significant disincentive to a person who mistakenly fails to file and subsequently wishes to take remedial action. To the extent that a taxpayer's failure to file was willful, it is doubtful that the taxpayer will undertake remedial action without some assurance of leniency.

Because the filing obligations of FBAR, new section 6038D and this proposal overlap, separate penalties under each of those provisions could apply, with the result that otherwise reasonable penalties may prove to be disproportionate in amount unless stacking of the penalties is limited or prohibited.

In recognition of these disincentives, the IRS waived the civil FBAR penalties on two previous occasions in an effort to promote settlements. First, in announcing the Offshore Voluntary Compliance Initiative in 2003811 the IRS encouraged the voluntary disclosure of previously unreported income placed by taxpayers in offshore accounts and accessed through credit card or other financial arrangements similar to those targeted by an IRS enforcement program known as the Offshore Credit Card Program. The IRS agreed to waive the civil fraud penalty and certain penalties relating to failure to file information and other returns, including the FBAR,812 but held taxpayers liable for back taxes, interest, and certain accuracy-related and delinquency penalties.813 Under the terms of the 2009 voluntary disclosure initiative announced by the Commissioner on March 26, 2009, the IRS proposed, in certain cases, to waive those penalties in significant part.814 In guidance issued to field agents, the IRS instructed agents handling cases arising under the voluntary disclosure initiative to impose an "offshore penalty" in lieu of FBAR penalties to those who were not in compliance with the tax laws but voluntarily disclosed and submitted delinquent FBARs and other information returns by September 23, 2009.815


Prior Action

A similar proposal was included in the President's fiscal year 2010 budget proposal.

2. Require third-party information reporting regarding the transfer of assets to or from foreign financial accounts and the establishment of foreign financial accounts


Present Law

The recently enacted Hiring Incentives to Restore Employment ("HIRE") Act816 provides for reporting of specific information by third parties for certain U.S. accounts held in foreign financial institutions ("FFIs").817 Information reporting is enforced through the withholding of tax on payments to FFIs unless the FFI enters into and complies with an information reporting agreement with the Secretary.818

The HIRE Act does not require third-party information reporting with regard to the transfer of money or property to, or receipt of money or property from, a foreign bank, brokerage, or other financial account on behalf of a U.S. person, or with regard to the establishment of a foreign bank, brokerage, or other financial account on behalf of a U.S. person.


Description of Proposal

Any U.S. financial institution that during the year transfers to, or receives from, a foreign bank, brokerage, or other financial account money or property with an aggregate value of more than $50,000 on behalf of a U.S. individual, or on behalf of any entity of which a U.S. individual owns, directly or indirectly, more than 25 percent of the ownership interest, would be required to file an information return regarding such transfer or receipt (including, in the case of a transfer by an entity, the name, address, and taxpayer identification number of any U.S. individual who owns more than 25 percent of the ownership interest in such entity). Any U.S. financial institution that opens a foreign bank, brokerage, or other financial account on behalf of a U.S. individual, or on behalf of any entity of which a U.S. individual owns, directly or indirectly, more than 25 percent of the ownership interest, would be required to file an information return with the IRS regarding such account, including reporting any amounts of money or property transferred by the financial institution to, or received by it from, such account.

In addition to filing an information return with the Internal Revenue Service, the U.S. financial institution would be required to send a copy of such return to the U.S. individual, or entity, as to which the return is made.

Reporting would not be required where the U.S. financial institution determined the entity making or receiving the transfer was: a publicly traded corporation, or a subsidiary thereof; an organization exempt from tax under section 501; an individual retirement plan; the United States or any wholly owned agency or instrumentality thereof; any State, the District of Columbia, any possession of the United States, any political subdivision of any of the foregoing, or any wholly owned agency or instrumentality of any one or more of the foregoing; any bank (as defined in section 581); any real estate investment trust (as defined in section 856); any regulated investment company (as defined in section 851); any common trust fund (as defined in section 584(a)); any trust which is exempt from tax under section 664(c) or is described in section 4947(a)(1); or an entity engaged in an active trade or business (other than the business of investing or similar activities).

Failure to file a required information return or to provide a copy of such return to the U.S. individual would result in the imposition of a penalty of $50 with respect to each such failure. In the case of a failure to file due to intentional disregard, the penalty would be the greater of $100 or five percent of the amount of the items required to be reported. No penalty would be imposed for a failure to report due to reasonable cause.

The Treasury Department would receive regulatory authority to provide additional exceptions (including where the Secretary determines that the reporting would be duplicative of other reporting requirements), to limit the types of transfers subject to the reporting requirement, to require that certain additional information be reported, and to permit U.S. financial institutions to report additional transfers of money or property to or from a foreign bank, brokerage, or other financial account on behalf of a U.S. individual (or on behalf of an entity of which the U.S. individual owns, actually or constructively, more than 25 percent of the ownership interest).

Effective date. -- The proposal applies to amounts transferred and accounts opened beginning after December 31, 2012.


Analysis

This proposal focuses on transfers made to, or received from, a foreign financial account on behalf of a U.S. person. It is intended to give the IRS an additional line of sight to foreign financial accounts that might not otherwise be available under the other Administration proposals aimed at accounts and entities in offshore jurisdictions. This proposal provides the IRS with the ability to match the third-party information with the information required to be filed on a taxpayer's tax return under the Administration's proposal relating to transfers to or from a foreign financial account by a U.S. taxpayer. The current reporting regime for offshore financial accounts relies primarily on self-reporting, but the Administration is concerned that U.S. persons are failing to comply with these self-reporting requirements. The Administration believes that this proposal, which establishes a third-party reporting requirement with respect to transfers to or from foreign financial accounts, receipts from such accounts, and the establishment of such accounts, would lead to greater disclosure of foreign financial accounts, and consequently would discourage the evasion of U.S. taxation.

While one may agree in principle that the problem of tax evasion by U.S. individuals through the use of foreign financial accounts is serious, and that conceptually some form of third-party information reporting to the IRS may deter such evasion, one may question whether this specific provision, which requires third-party reporting on certain transfers to and receipts from a foreign financial account, is an effective and efficient solution.

By way of background, the Financial Crimes Enforcement Network, commonly known as FinCEN, is the agency within the Treasury Department responsible for patrolling the nation's financial system. Its primary purpose is to fight money laundering and terrorist financing. At the request of Congress, FinCEN studied and issued a feasibility report in 2007, discussing the building of a cross-border information reporting system that would store and report information on cross-border wire transfers.819 The information received by this system would be provided by U.S. financial institutions that send wire transfer instructions to or receive wire transfer instructions from non-U.S. financial institutions. It could then be used by various law enforcement agencies such as the Secret Service, the Drug Enforcement Administration, the Federal Bureau of Investigation, and other U.S. intelligence agencies. The feasibility study concluded that although the construction of such a system is possible, it would cost approximately $32.6 million and take over three years to implement. To date, this reporting system has not been implemented.

Proponents of third-party information reporting of certain offshore transfers such as the Administration's proposal believe that such a system or similar system, if developed, could be used for tax information reporting purposes. The expectation is that the IRS would be able to look at the flow of funds out of the United States and see to what extent they are being sent directly to foreign accounts that may not have been properly reported. It could then identify and investigate anomalies such as disproportionate funds to one country or institution, or irregular and one-time transfers. Additionally, the IRS could link new cross-border fund transfer information with tax return information to identify suspicious activity. Moreover, this information could be used for matching purposes to determine whether the appropriate information returns, including the FBAR, were filed by the taxpayer.820

Various differences exist between the FinCEN proposal as contemplated and the Administration's proposal. First, the FinCEN proposal only applies to certain wire transfers, whereas this proposal applies to cross-border transfers whether or not by wire transfer. Second, the FinCEN proposal did not contemplate the need for obtaining taxpayer identification numbers for the relevant parties involved in the transfer. Such information is important to assure that reporting is of maximum usefulness for tax administration purposes. These differences would need to be bridged if a single system were to be used for tax and non-tax purposes.

Representatives of the financial services sector, however, have suggested that this proposal will generate a large volume of information reports that capture routine, legitimate business transactions of U.S. persons making payments for goods and services to foreign persons who are not subject to U.S. taxes. They have also asserted that the systems required to comply with the reporting requirements under the Administration's proposal would be even more challenging to implement than those necessary to implement the proposal studied by FinCEN. In general, the proposal studied by FinCEN required the identification of all wire transfers to or from a foreign financial account. The Administration's proposal is more complex from an administrative standpoint, because it requires the identification of a subset of all cross-border transactions. This subset of transactions would then require processing and reporting, including reporting additional information, such as taxpayer identification numbers, to the IRS.

Proponents of this and other recent similar proposals argue that some of the information necessary to meet the third-party information reporting requirements is already collected by financial institutions to facilitate compliance with anti-money laundering laws. However, these systems are not necessarily compatible. A firm's tax reporting system requires automation of as much information as possible; whereas information gathered in compliance with anti-money laundering laws requires significant manual processes.

Some consider the proposal's effective date (i.e., effective for amounts transferred and accounts opened beginning after December 31, 2012) ambitious, arguing that the implementation of such a third-party information reporting requirement could take several years to complete.


Prior Action

A similar proposal was included in the President's fiscal year 2010 budget proposal.

H. Reform Treatment of Insurance Companies and Products

1. Modify rules that apply to sales of life insurance contracts

Present Law

An exclusion from Federal income tax is provided for amounts received under a life insurance contract paid by reason of the death of the insured.821

Under rules known as the transfer for value rules, if a life insurance contract is sold or otherwise transferred for valuable consideration, the amount paid by reason of the death of the insured that is excludable generally is limited.822 Under the limitation, the excludable amount may not exceed the sum of: (1) the actual value of the consideration; and (2) the premiums or other amounts subsequently paid by the transferee of the contract. Thus, for example, if a person buys a life insurance contract, and the consideration he pays combined with his subsequent premium payments on the contract are less than the amount of the death benefit he later receives under the contract, then the difference is includable in the buyer's income.

Exceptions are provided to the limitation on the excludable amount. The limitation on the excludable amount does not apply if: (1) the transferee's basis in the contract is determined in whole or in part by reference to the transferor's basis in the contract;823 or (2) the transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer.824

In the case of certain accelerated death benefits and viatical settlements,825 special rules treat certain amounts as amounts paid by reason of the death of an insured (that is, generally, excludable from income). The rules relating to accelerated death benefits provide that amounts treated as paid by reason of the death of the insured include any amount received under a life insurance contract on the life of an insured who is a terminally ill individual, or who is a chronically ill individual (provided certain requirements are met). For this purpose, a terminally ill individual is one who has been certified by a physician as having an illness or physical condition which can reasonably be expected to result in death in 24 months or less after the date of the certification. A chronically ill individual is one who has been certified by a licensed health care practitioner within the preceding 12-month period as meeting certain ability-related requirements. In the case of a viatical settlement, if any portion of the death benefit under a life insurance contract on the life of an insured who is terminally ill or chronically ill is sold to a viatical settlement provider, the amount paid for the sale or assignment of that portion is treated as an amount paid under the life insurance contract by reason of the death of the insured (that is, generally, excludable from income). For this purpose, a viatical settlement provider is a person regularly engaged in the trade or business of purchasing, or taking assignments of, life insurance contracts on the lives of terminally ill or chronically ill individuals (provided certain requirements are met).

IRS guidance sets forth more details of the tax treatment of a life insurance policyholder who sells or surrenders the life insurance contract and the tax treatment of other sellers and of buyers of life insurance contracts.

In Rev. Rul. 2009-13,826 the IRS ruled that income recognized under section 72(e) on surrender of a life insurance contract with cash value to the life insurance company is ordinary income. In the case of sale of a cash value life insurance contract, the insured's (seller's) basis is reduced by the cost of insurance, and the gain on sale of the contract is ordinary income to the extent of the amount that would be recognized as ordinary if the contract were surrendered (the "inside buildup"), and any excess is long-term capital gain. Gain on the sale of a term life insurance contract (without cash surrender value) is long-term capital gain.

In Rev. Rul. 2009-14,827 the IRS ruled that under the transfer for value rules, a portion of the death benefit received by a buyer of a life insurance contract on the death of the insured is includable as ordinary income. The portion is the excess of the death benefit over the consideration and other amounts (e.g., premiums) paid for the contract. Upon sale of the contract by the purchaser of the contract, the gain is long-term capital gain, and in determining the gain, the basis of the contract is not reduced by the cost of insurance.


Description of Proposal

The proposal imposes reporting requirements on the buyer in the case of the purchase of an existing life insurance contract with a death benefit equal to or exceeding $500,000. The proposal also imposes reporting requirements on the issuing insurance company in the case of the payment of benefits under a purchased contract.

Under the reporting requirement, the buyer reports information about the purchase to the IRS, to the insurance company that issued the contract, and to the seller. The information reported by the buyer about the purchase is: (1) the purchase price; (2) the buyer's and seller's taxpayer identification numbers; and (3) the name of the issuer of the contract and the policy number.

When a policy benefit is paid under the contract, the payor insurance company is required to report information about the payment to the IRS and to the payee. Under this reporting requirement, the payor reports: (1) the gross amount of the payment; (2) the taxpayer identification number of the payee; and (3) the payor's estimate of the buyer's basis in the contract.

In addition, the proposal modifies the present-law rules providing exceptions to the limitation on the excludable amount of a death benefit. Under the proposal, the exceptions do not apply to buyers of policies.

Effective date. -- The proposal is effective for sales or assignments of interests in life insurance contracts and payments of death benefits for taxable years beginning after December 31, 2010.


Analysis

Reporting

The proposal is directed to the issue of collection of tax on amounts that are includable in income with respect to a life insurance contract that has been transferred for value. Because information about the identity of parties to transfers of contracts, amounts paid for transferred contracts, and payments under transferred contracts is not now reported, enforcement of present-law income inclusion requirements is needlessly difficult. Taxpayers who are parties to transfers of life insurance contracts may have a reduced incentive accurately to measure gain on transfers and on payments under transferred contracts, or even to include any amount in income, because they believe enforcement of the requirement of inclusion is impaired by the lack of reporting. Thus, it is argued, the reporting provisions are needed to improve voluntary compliance with present law.

Purchasers of life insurance contracts (such as viatical settlement or life settlement companies, or others that securitize purchased life insurance contracts) should not be more easily able to escape tax on their business income than other business taxpayers because enforcement may be difficult due to lack of reporting. The perception that taxpayers might not include income because enforcement of the inclusion requirement may be difficult can be corrected, advocates argue, by making it very clear that enforcement of the inclusion requirement is easy using the reported information.

Opponents of the reporting requirement may argue that the reporting requirements are burdensome. They may argue that processing and putting to use all the information that would be required by the proposal is an inefficient use of IRS resources, which might be better employed addressing other, more pressing tax issues. They may further argue that the level of detail of the reporting under the proposal is excessive, and that if any reporting of transfers of life insurance contracts is proposed, it should be more limited than that proposed. On the other hand, some might point to present-law reporting requirements applicable to banks and mutual funds, and could argue that the reporting under the proposal is no more burdensome.

The mechanics of the reporting requirement could be criticized as not fully developed. The proposal does not address the mechanism for reporting the purchase price in the case of periodic payments for the purchase of an insurance contract. On the other hand, these details could be developed either as Congress drafts the proposal, or as it is implemented by the IRS.

The reporting requirement on payment of a death benefit under a contract could also be criticized as somewhat complex, because it applies to payments with respect to only those contracts, the death benefit under which equals or exceeds $500,000. This dollar threshold requires taxpayers to distinguish among contracts for reporting purposes. If, by contrast, the reporting requirement applied to any payment under a contract, regardless of the size of the death benefit, then this determination would be eliminated, and the payor would report the taxable portion (if any) of the payment. Nevertheless, those opposed to the proposal's reporting requirements generally on the grounds that they are unduly burdensome might argue that expanding the circumstances in which reporting applies would exacerbate the problem.

Opponents might argue that it is inconsistent to modify the reporting requirements only for purchases of an existing life insurance contract with a death benefit equal to or exceeding $500,000, while modifying the exclusion rules regardless of the amount of the death benefit under the contract. If reporting is inadequate under present law, it could be argued, it should be applied to all cases in which income should be reported, not just some; or alternatively, the modifications of the exclusion rules should parallel the reporting rules, if the underreporting is principally a problem at that level of death benefits under purchased contracts.

On the other hand, most reporting requirements under present law require reporting only for amounts over a dollar threshold, and this proposal is arguably consistent with that approach.

Modifying exceptions to transfer for value rule

Opponents of the modification to the present-law exceptions may argue that the proposal is not sufficiently detailed or specific, and that a vague proposal to modify the exceptions could have a chilling effect on legitimate business transactions that are not intended to be covered by the proposal. On the other hand, it could be noted that the proposal would become specific during the legislative process, before any provision would be enacted.

The promulgation of guidance by the IRS in Rev. Ruls. 2009-13 and 2009-14 may prompt the argument that legislative change to the transfer for value rule is not needed, as these rulings address all the important open questions of determining the basis of a life insurance contract and determining the character of gain on transactions involving the contract. It is not necessary to repeal the exceptions to the transfer for value rules in the case of purchased contracts, once these issues are clarified for taxpayers.

Nevertheless, basis and character are not the issues involved in the exceptions: instead, the issue is whether gain is recognized at all. The exceptions may have arisen long ago when transfers of life insurance contracts were relatively rare and often took place among family members or owners of closely held businesses. In the past 10 or 20 years, however, an enormous and growing secondary market for life insurance contracts has developed.828 Transfers of life insurance contracts are significantly more common and typically involve transactions among parties that are not family members or involved in a closely held business together. Rather, buyers of life insurance contracts are typically participants in a market for financial intermediation. The exceptions to the transfer for value rule should not apply in this context, it is argued.


Prior Action

A similar proposal was included in the President's fiscal year 2010 budget proposals.

2. Modify dividends received deduction for life insurance company separate accounts


Present Law

Dividends received deduction

A corporate taxpayer may partially or fully deduct dividends received.829 The percentage of the allowable dividends received deduction depends on the percentage of the stock of the distributing corporation that the recipient corporation owns.

Life insurance company proration rules

A life insurance company is subject to proration rules in calculating its taxable income.

The proration rules reduce the company's deductions, including reserve deductions and dividends received deductions, if the life insurance company has tax-exempt income, deductible dividends received, or other similar untaxed income items, because deductible reserve increases can be viewed as being funded proportionately out of taxable and tax-exempt income.

Under the proration rules, the net increase and net decrease in reserves are computed by reducing the ending balance of the reserve items by the policyholders' share of tax-exempt interest.830 Similarly, under the proration rules, a life insurance company is allowed a dividends-received deduction for intercorporate dividends from nonaffiliates only in proportion to the company's share of such dividends,831 but not for the policyholders' share. Fully deductible dividends from affiliates are excluded from the application of this proration formula, if such dividends are not themselves distributions from tax-exempt interest or from dividend income that would not be fully deductible if received directly by the taxpayer. In addition, the proration rule includes in prorated amounts the increase for the taxable year in policy cash values of life insurance policies and annuity and endowment contracts.

The life insurance company proration rules provide that the company's share, for this purpose, means the percentage obtained by dividing the company's share of the net investment income for the taxable year by the net investment income for the taxable year.832 Net investment income means 95 percent of gross investment income, in the case of assets held in segregated asset accounts under variable contracts, and 90 percent of gross investment income in other cases.833

Gross investment income includes specified items.834 The specified items include interest (including tax-exempt interest), dividends, rents, royalties and other related specified items, short term capital gains, and trade or business income. Gross investment income does not include gain (other than short term capital gain to the extent it exceeds net long-term capital loss) that is, or is considered as, from the sale or exchange of a capital asset. Gross investment income also does not include the appreciation in the value of assets that is taken into account in computing the company's tax reserve deduction under section 817.

The company's share of net investment income, for purposes of this calculation, is the net investment income for the taxable year, reduced by the sum of (a) the policy interest for the taxable year and (b) certain policyholder dividends.835 Policy interest is defined to include required interest at the greater of the prevailing State assumed rate or the applicable Federal rate (plus some other interest items). Present law provides that in any case where neither the prevailing State assumed interest rate nor the applicable Federal rate is used, "another appropriate rate" is used for this calculation. No statutory definition of "another appropriate rate" is provided; the law is unclear as to what rate or rates are appropriate for this purpose.836

In 2007, the IRS issued Rev. Rul. 2007-54,837 interpreting required interest under section 812(b) to be calculated by multiplying the mean of a contract's beginning-of-year and end-of-year reserves by the greater of the applicable Federal interest rate or the prevailing State assumed interest rate, for purposes of determining separate account reserves for variable contracts. However, Rev. Rul. 2007-54 was suspended by Rev. Rul. 2007-61, in which the IRS and the Treasury Department stated that the issues would more appropriately be addressed by regulation.838 No regulations have been issued to date.

Life insurance company tax treatment of variable contracts

A variable contract is generally a life insurance (or annuity) contract whose death benefit (or annuity payout) depends explicitly on the investment return and market value of underlying assets.839 The investment risk is generally that of the policyholder, not the insurer. The assets underlying variable contracts are maintained in separate accounts held by life insurers. These separate accounts are distinct from the insurer's general account in which it maintains assets supporting products other than variable contracts.

For Federal income tax purposes, a life insurance company includes in gross income any net decrease in reserves, and deducts a net increase in reserves.840 Methods for determining reserves for tax purposes generally are based on reserves prescribed by the National Association of Insurance Commissioners for purposes of financial reporting under State regulatory rules.

For purposes of determining the amount of the tax reserves for variable contracts, however, a special rule eliminates gains and losses. Under this rule,841 in determining reserves for variable contracts, realized and unrealized gains are subtracted, and realized and unrealized losses are added, whether or not the assets have been disposed of. The basis of assets in the separate account is increased to reflect appreciation, and reduced to reflect depreciation in value, that are taken into account in computing reserves for such contracts.


Description of Proposal

The proposal generally has the effect of reducing the amount treated as the life insurance company's share of dividends received under the proration rules in the case of a separate account. Under the proposal, amounts retained by a life insurance company are treated as derived proportionately from items included in net investment income and items not so included (such as capital gain). The result of the proposal is that the company's share of the dividends received deduction approximates the ratio of (1) the surplus (including seed money) in the separate account to (2) the total assets of the account. The amount of surplus and of total assets is determined as an annual mean for this purpose.

Effective date. -- The proposal is effective for taxable years beginning after December 31, 2010.


Analysis

In general

The proposal is directed towards improving the accuracy of measurement of income of life insurance companies by modifying the proration rules that limit deductions associated with untaxed income. The proposal also serves to simplify these proration rules, which are rather complex. The proposal aims to improve the clarity of the law and resolve interpretive issues that have arisen in recent years, thus reducing controversies between the IRS and taxpayers.

In analyzing the proposal, it is useful to compare the life insurer proration rules to other present-law rules limiting deductions associated with untaxed income of taxpayers other than life insurers. A further question is why the life insurance company proration rules involve such complex calculations, and whether complexity is inevitable. In addition, analysis of the proposal may be aided by examining other possible options for modifying the life insurance company proration rules.

Expenses and interest relating to tax-exempt income of taxpayers generally

For taxpayers other than insurance companies, present-law section 265 disallows a deduction for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is exempt from tax (tax-exempt obligations).842 The interest expense disallowance rules are intended to prevent taxpayers from engaging in tax arbitrage by deducting interest on indebtedness that is used to purchase tax-exempt obligations. Similarly, present law disallows a deduction for expenses allocable to tax-exempt interest income.

These present-law limitations are expressions of the concept that, under an income tax, expenses are deductible only if related to the production of income subject to tax. This policy concept is not expressed uniformly throughout the tax law, it may be observed. Examples of the failure of the tax law to match deductible expenses with taxable income can be cited, such as the allowance of home mortgage interest as a deduction though the imputed rental value of residence in the home is not includable in income for individuals. However, these instances may reflect nontax social policies that are implemented through the tax law, practical difficulties of valuation or administrability, or historical norms that are broadly accepted even though inconsistent with fundamental tax policy. The proration rule applicable to property and casualty insurers could also be cited as perhaps a partial failure to match deductible expenses with taxable income. That rule disallows a deduction for expenses of earning untaxed income at a flat 15 percent rate. If untaxed income represents more than 15 percent of after-tax income, the rule may not operate effectively to prevent tax arbitrage.843 On the other hand, the two insurance company proration rules, because of their different operation as currently structured, are not necessarily connected. It may be argued that the proposal to modify the life insurance proration rule does not necessarily implicate the other rule, is consistent with the corresponding broadly applicable rule of section 265, and is in line with fundamental income tax policy concepts.

Historical background


    In general

Proration rules limiting deductions associated with untaxed income of life insurance companies were adopted as part of the earliest Federal income tax rules applicable to life insurers in 1921.844 Those rules required that the reserve deduction for investment income be reduced by tax-exempt interest. In 1928, however, the Supreme Court held that this deduction limitation rule was unconstitutional because it indirectly imposed Federal tax on State obligations.845

In subsequent legislation, the proration rule was restructured,846 and ultimately in 1959 a further revised proration rule was adopted providing that taxable investment yield of a life insurance company was reduced by the company's share of tax-exempt interest and deductible dividends received.847 The 1959 provision included the notions of required interest and an amount retained by the company in determining the company's share of investment income for separate accounts. More generally, the 1959 Act provided for a three-phase system of taxation of life insurers, under which, generally, gain from operations was taxed only if it exceeded the company's taxable investment income. The rules for taxing life insurance companies were substantially revised in 1984 to eliminate the three-phase system and generally to tax both operating income and investment income.848 The 1984 revisions retained proration rules for life insurers, and generally retained the 1959 notion that the proration rules are based on a determination of the company's share of income and deductions.

In 1988, the Supreme Court held that imposing Federal tax on interest earned on State bonds does not violate the intergovernmental tax immunity doctrine, and so is not unconstitutional.849 The life insurance company proration rules have not been substantially modified since the 1988 Supreme Court decision.

The current proration formula may provide a benefit independent of the amount of any reserve deduction or tax-exempt interest and deductible dividend income because of the way the calculation treats investment expenses. The company's share increases when the actual net investment income is less than the statutorily defined net investment income. That is, a company receives a benefit from the proration rules for a separate account if the amount retained by the company is greater than five percent of defined gross investment income. This may be particularly true of separate accounts that attribute more of their appreciation to items excluded from the definition of gross investment income, such as capital gains.


    Sources of complexity

It could be argued that the complexity of the rules and the calculations under the life insurance company proration provisions is largely attributable to the origin of the rules over 90 years ago and Congress' multiple attempts during the period to express tax policy in a manner that did not violate Constitutional doctrine. The complexity of the current proration rules may be exacerbated by the application of a few details of the 1959 Act three-phase system under modern rules shorn of that context.

The company's share served multiple purposes under the 1959 Act. It served to prorate the deduction for tax-exempt interest and dividends received as under present law. It also determined the amount of taxable investment yield included in taxable investment income. While an increase in the company's share under present law necessarily lowers taxable income, an increase in the company's share under prior law had a differing effect on taxable income depending on whether a company's gain from operations exceeded taxable investment income and the importance of tax-exempt interest and deductible dividends in investment yield.

Similarly, under the 1959 Act, gross investment income served multiple purposes. Not only did it determine the company's share for proration, but also it provided the basis for calculation of investment yield and taxable investment income. Gross investment income includes only positive ordinary income items, perhaps to avoid having to interpret and allocate negative amounts. It may be argued that the selection of items included in the current definition of gross investment income stem primarily from this function under prior law, rather than the present law proration function, and that the definition of gross investment income should now be tailored to mesh with the proration rule where it is used today.

Furthermore, retention of the 1959 Act concepts arguably is no longer necessitated by concern for potential unconstitutionality. The Federal income tax policy not to allow a deduction for expenses of earning amounts that are not included in income could be expressed more simply in the life insurance tax rules. An explicit statutory statement of the operation of the proration of the dividends received deduction would be simplifying. Administrability of the law would be enhanced, and disputes would be reduced, if reliance on arcane, layered pre-1984 regulations were no longer an interpretive option.

If the problem is incorrect or aggressive taxpayer positions under the proration rule (as under any present-law rule), the IRS can address this through enforcement action. If this is the situation, perhaps legislative change is not needed. To the extent that the problem arises from aggressive interpretation of the current rules, it could be countered that a case by case approach, potentially leading to the expense of litigating each taxpayer's case, may be an inefficient use of government and taxpayer resources, without effectively clarifying the law in all circuits or giving a near-term answer to all taxpayers.

Nevertheless, enforcement of the law may not be the sole or even the principal issue: rather, clarification of, or change to, the law arguably is needed to eliminate uncertainty about how to determine interest when present law refers to "another appropriate rate" (in the flush language of section 812(b)(2)). In short, a change is needed to the legislative language to state a clear rule. Alternatively, Treasury Department guidance is needed to clarify application of the current rules.850 However, further administrative guidance may be viewed as insufficient or inadequate without a legislative pronouncement of the rules.

Operation of the proposal

The proposal could be criticized as insufficiently detailed; however, a response is that the result of the proposal is clearly stated to be that the company's share of the dividends received deduction approximates the ratio of (1) the surplus (including seed money) in the separate account to (2) the total assets of the account.

On substantive grounds, an arguably simpler and more rational proposal might be to eliminate more of the pieces of the present-law rules that were imported from pre-1984 law. Under this type of approach, one option would be to eliminate the investment income-base rules of section 812, and to substitute a proration rule for life insurance company separate accounts stating that the ratio of (1) mean surplus in the account to (2) mean assets in the account851 determines the company's share of the dividends received deduction with respect to the separate account. Under this approach, the earnings rate of the separate account would not be a part of the calculation. Rather, the ratio would be based on assets, not earnings, of the separate account. Using this simple formula makes amounts retained, as well as investment expenses, or any other reduction to investment income, irrelevant. The company's share would reflect the company's economic interest in the separate account assets, but would not include any portion of the policyholder's economic interest. Under this approach, the company would receive the tax benefits to which it is entitled under the economic arrangement of the separate account.

While it could be argued that the proposal could motivate taxpayers to shuffle assets between the separate account and the general account to maximize the Federal tax benefit, current State regulatory rules prevent shifting of assets (or income from assets) between separate accounts, or between a separate account and the general account of a life insurer. However, a life insurer could respond by charging higher fees for separate account products or by changing its product offerings.

Another option could be to require proration only for separate accounts, not for general accounts. The obligation of the life insurer to policyholders of general account products is more attenuated than its obligation to credit separate account dividends received directly to variable contracts. Thus, perhaps like other corporate taxpayers that are not required to prorate their deduction for dividends received, the general account of life insurers arguably should not be subject to proration. Because life insurers tend to have a relatively low proportion of dividend-paying assets in the general account, imposing a complex proration rule on general account assets may not be worthwhile.

On the other hand, money is fungible, and proration of untaxed income is appropriate in any case in which the insurer has a reserve deduction with respect to amounts ultimately payable to a policyholder. Further, under present law, no dividends received deduction is allowed to corporate taxpayers for any dividend to the extent the taxpayer is under an obligation to make related payments with respect to similar property.852 Thus, the concept exists outside the insurance context.

A possible criticism of the proposal, or of any proposal that reduces deductions pursuant to a change in the proration rule with respect to separate account products, is that the price of the products could increase. The insurer could pass some or all of the increased tax cost through to shareholders, employees, or customers. In fact, if the proration rule does not accurately measure the insurer's income by allowing either too great, or too little, a deduction, the company can share with product purchasers, or pass along to purchasers, the unintended benefit or detriment of income mismeasurement. If it is not intended to provide either a Federal tax subsidy, or an excessive tax burden, that would affect the price of separate account products of insurance companies, then improving the accuracy and administrability of the life insurance proration rule is a desirable improvement in the tax law.

Taxpayers may argue, on horizontal equity grounds, that the proration rules for life insurance companies should not give rise to any reduction in the dividends received deduction, by analogy to nonlife corporations that are not subject to any rule reducing their dividends received deduction. On the other hand, dividend income of life insurance companies is arguably most analogous to operating income of nonfinancial-intermediation businesses. The normal rationale for the dividends received deduction -- that it eliminates multiple applications of tax on the same income items while they remain in corporate solution -- does not apply if the business the firm engages in includes the earning of dividends on the customers' behalf. Under this view, no portion of the dividends received deduction should be allowed for what is effectively business income or operating income.


Prior Action

A similar proposal was included in the President's fiscal year 2010 budget proposal.

3. Expand pro rata interest expense disallowance for company-owned life insurance ("COLI")


Present Law

Inside buildup and death benefits under life insurance contracts generally tax-free

No Federal income tax generally is imposed on a policyholder with respect to the earnings under a life insurance contract853 ("inside buildup").854 Further, an exclusion from Federal income tax is provided for amounts received under a life insurance contract paid by reason of the death of the insured.855

Premium and interest deduction limitations with respect to life insurance contracts


    Premiums

Under present law, no deduction is permitted for premiums paid on any life insurance, annuity or endowment contract, if the taxpayer is directly or indirectly a beneficiary under the contract.856

    Interest paid or accrued with respect to the contract857

In addition, no deduction is allowed for interest paid or accrued on any debt with respect to a life insurance, annuity or endowment contract covering the life of any individual,858 with a key person insurance exception.859

    Pro rata interest deduction limitation

A pro rata interest deduction disallowance rule also applies. This rule applies to interest, a deduction for which is not disallowed under the other interest deduction disallowance rules relating to life insurance, for example, interest on third-party debt that is not with respect to a life insurance, endowment or annuity contract. Under this rule, in the case of a taxpayer other than a natural person, no deduction is allowed for the portion of the taxpayer's interest expense that is allocable to unborrowed policy cash surrender values.860 Interest expense is allocable to unborrowed policy cash values based on the ratio of (1) the taxpayer's average unborrowed policy cash values of life insurance, annuity and endowment contracts, to (2) the sum of the average unborrowed cash values of life insurance, annuity, and endowment contracts, plus the average adjusted bases of other assets.

Under the pro rata interest disallowance rule, an exception is provided for any contract owned by an entity engaged in a trade or business, if the contract covers only one individual who is an employee or is an officer, director, or 20-percent owner of the entity of the trade or business. The exception also applies to a joint-life contract covering a 20-percent owner and his or her spouse.

In 2006, additional rules for excludability of death benefits under a life insurance contract were added in the case of employer-owned life insurance contracts861 (generally, those contracts insuring employees that are excepted from the pro rata interest deduction limitation). These rules permit an employer to exclude the death benefit under a contract insuring the life of an employee if the insured was an employee at any time during the 12-month period before his or her death, or if the insured is among the highest paid 35 percent of all employees. Notice and consent requirements must be satisfied.


Description of Proposal

The proposal eliminates the exception under the pro rata interest deduction disallowance rule for employees, officers and directors. The exception for 20-percent owners is retained, however.

Effective date. -- The proposal is effective for contracts issued after December 31, 2010.


Analysis

The proposal is directed to the issue of borrowing against life insurance contracts to achieve tax arbitrage. Businesses that own life insurance on employees and borrow from a third-party lender or from the public can achieve tax arbitrage by deducting interest that funds the tax-free inside buildup on the life insurance (or the tax-deferred inside buildup of annuity and endowment contracts). This opportunity for tax arbitrage results from the exception under the pro rata interest deduction limitation for insurance covering employees and others, it is argued. This tax arbitrage opportunity is being utilized particularly by financial intermediation businesses which often have a relatively large amount of debt in the ordinary course of business. Thus, it is argued, the exception should be repealed.

Some would point to the 2006 legislation as having addressed any undesirable aspects of company-owned life insurance ("COLI"), obviating any need for further tax legislation. By adding a notice and consent requirement, the 2006 legislation removed the risk that insured employees would never know that they were insured by their employers. Similarly, the 2006 requirement that the insured must have been an employee within 12 months before death for the employer to be able to exclude from income the death benefit received means that there would no longer be a huge pool of former employees in whose lives the employer has a financial interest. Lastly, because the pool of employees that can be insured is limited to the highest paid 35 percent if the employer is to exclude the death benefits under the policies, the employer has no incentive to insure individuals who are not central to the operation of the business but may be lower paid, fungible workers whose life the employer has little incentive to protect. Due to these limitations on excludable death benefits under employer COLI, it is argued, there is no longer a need to resuscitate the 1999 proposal, which was made shortly after the perception that the 1996 and 1997 legislation had failed to stem the growth of COLI but before the improvements made by the 2006 legislation. Similarly, some might argue that the 1999 proposal was previously rejected (or, certainly, not adopted) by Congress, and that it is not appropriate to continue to raise it.

On the other hand, it could be asserted that the 2006 improvements do not address the tax policy issue of tax arbitrage. The tax policy issue of COLI, it is argued, is the tax arbitrage opportunity it creates to deduct expenses such as interest with respect to tax-free inside buildup of life insurance contracts. The allowance of deductible expenses with respect to untaxed income is inconsistent with the concept of an income tax. While social policy benefits arise from the 2006 legislation limiting employer opportunities to collect death benefits on insured individuals whom the employer has no economic incentive to protect, it can be argued that the tax arbitrage effect of COLI remains to be addressed.

Proponents of the proposal also point out that the 2006 legislation may not serve as a practical limitation on the overall amount of COLI that any particular taxpayer acquires. Limiting the group of individuals that may be insured generally to 35 percent of the employer's workforce arguably creates an incentive to insure each covered individual for a larger amount than without such a limitation, but may have little impact on the overall face amount of life insurance that an employer can maintain on its books. Rather, as a practical matter, the face amount of life insurance of the employer is limited by the underwriting practices of the insurer. Thus, it is argued, the 2006 legislation has not slowed the growth of COLI.862

The proposal could be criticized on the grounds that it fails to take into account the concern that retaining an exception from the pro rata interest disallowance rule for employees, officers, and directors is important for small businesses. Small businesses might argue that they need access to cash, in particular the cash value of life insurance on key employees, and that it would be inappropriate to reduce the tax subsidy stemming from the exception in their case, regardless of the application of the proposal to others. A more targeted proposal, whether limited to financial intermediaries or to large employers, or alternatively a narrower employee exception structured like the 20-key-person exception under the 1996 legislation, might address the tax arbitrage concern without negatively impacting the cash needs of small business.

On the other hand, it could be countered that in most cases the cash needs of small businesses have already been addressed by the proposal's continuation of the exception for 20-percent owners. In addition, it can be argued that insuring the lives of key employees can be accomplished by purchasing term life insurance, which is not affected by the proposal, and that cash needs arising from loss of a key employee can be addressed without the purchase of cash value life insurance. Further, because of the extension of the average person's expected life span in recent decades, it is argued that the purchase of term life insurance on a key employee through his or her likely retirement age is no longer difficult or expensive.

Opponents of the proposal argue that the funds borrowed under the life insurance contracts are used for tax-advantaged pre-funding of expenses such as retiree health benefits and supplemental pension benefits. Congress has already provided special tax-favored treatment specifically to encourage businesses to provide health and pension benefits. It was not intended that tax arbitrage with respect to investments in COLI be used to circumvent statutory limits that Congress enacted for these tax-favored health and pension benefits, it is argued. Further, the assertion that particular sources of funds are used by corporations for particular expenses can be countered by pointing out that money is fungible.

A related argument is that COLI is accepted as tier 1 capital for banks, an important incentive for banks to hold COLI, and that limiting its tax advantages negatively impacts these financial institutions. Arguably, limiting this source of tier 1 capital may be a particularly inappropriate side effect of the proposal at the current time of economic downturn, illiquidity, unavailability of credit, and instability among some banks. Conceivably the proposal is inconsistent with efforts of the Federal government to stabilize and temporarily provide capital to the financial sector. On the other hand, it could be questioned whether a heavy investment in life insurance is a stabilizing influence on bank capital. Further, these nontax policy arguments could be criticized as unrelated to the tax policy issue addressed by the proposal.

Some might criticize the proposal as somewhat ineffective because it would not impose any dollar limitation on the amount of insurance an employer would be permitted to purchase with respect to a 20-percent owner, nor on the amount of interest expense allocable to unborrowed policy cash values with respect to such insurance that would remain deductible under the proposal. It could be argued that the proposal would not effectively deter undesirable tax arbitrage in many cases, without any such limitations.863 On the other hand, it could be argued that State law concepts of insurable interest could operate as limits (but some might say these concepts would not impose any significant limit). It could also be argued that businesses with 20-percent owners might tend to be small businesses, and that encouraging the economic success of small businesses is more important than limiting their tax arbitrage opportunities. Some might respond that a test based on the ownership percentage of shareholders is not actually targeted to small businesses, and that a more appropriate test would be focused on the assets or income of the business. Another response might be that 20-percent owners do not necessarily have any connection to the business, so the death of such a person might have no significant impact that would create a business need to insure the person's life. Further, it could be argued that any tax incentives provided to a sector of the economy, such as small business, should not be structured as arbitrage opportunities denied to other taxpayers, but rather as positive incentives towards socially or economically desirable goals.


Prior Action

A similar proposal was included in the President's fiscal year 1999, 2000, 2001, and 2010 budget proposals.

4. Permit partial annuitization of a nonqualified annuity contract


Present Law

Treatment of annuity contracts

In general, earnings and gains on a deferred annuity contract are not subject to tax during the deferral period in the hands of the holder of the contract. 864 When payout commences under a deferred annuity contract, the tax treatment of amounts distributed depends on whether the amount is received as an annuity (generally, as perio