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JCT PRESENTS OPTIONS FOR COMPLIANCE IMPROVEMENT, TAX EXPENDITURE
REFORM.
AUTHOR: Joint Committee on Taxation
GEOGRAPHIC: United States
REFERENCES:
Subject Area:
Appraisals and valuations;
Benefits and pensions;
Budgets;
Compliance;
Employment taxes;
Information reporting;
Legislative tax issues;
Tax policy issues;
Tax system administration issues
TEXT:
OPTIONS TO IMPROVE TAX COMPLIANCE AND REFORM TAX EXPENDITURES
Release Date: JANUARY 27, 2005
Notwithstanding the intent of the 1996 legislation to treat all S corporation income allocated to a
tax-exempt entity as unrelated business taxable income, there nevertheless may be certain income
that is not subject to tax. The IRS has listed as a tax avoidance transaction, the use of certain
tax-exempt entities, claiming that their allocated taxable income from an S corporation is not
subject to the tax on unrelated business income, to shift income to the taxexempt entity./368/ The
proposal solidifies the intent of Congress that all income of the S corporation be subject to
tax.
Since losses of tax-exempt organizations may be created by misallocation of deductions between
exempt and non-exempt income of the entity, the limitation on the use of losses of taxexempt
entities to offset S corporation income is proposed.
E. Modify Safe Harbor for Allocation of Nonrecourse Deductions and Exclude Nonrecourse
Liabilities From Outside Basis (secs. 704 and 752)
Present Law
In general, the income, gain, loss, deduction, or credit of a partnership must be allocated among
the partners in accordance with the partnership
agreement./369/ If, however, the allocation in the partnership agreement does not have
substantial economic effect (or there is no partnership agreement), then a partner's distributive
share of income, gain, loss, deduction, or credit must be determined in accordance with the
partner's interest in the partnership./370/
An allocation has substantial economic effect if the allocation has (1) economic effect that is (2)
substantial./371/ In order for an allocation to have economic effect, generally the partnership
must properly maintain capital accounts, liquidate in accordance with positive capital accounts,
and a partner with a deficit capital account on liquidation must be unconditionally obligated to
restore the deficit./372/ An alternative test for economic effect is provided if a partner is not
unconditionally obligated to restore a deficit capital account on liquidation./373/ Under the
alternative test, an allocation may not create a deficit capital account or increase a deficit beyond
what the partner has agreed to restore. An allocation is substantial if there is a reasonable
possibility that the allocation will affect substantially the dollar amounts to be received by the
partners from the partnership, independent of tax consequences./374/
The term "partner's interest in the partnership" refers to the manner in which the partners have
agreed to share the economic benefit or burden corresponding to the income, gain, loss,
deduction, or credit that is allocated./375/ It is determined by taking into account all facts and
circumstances relating to the economic arrangement of the partners including: (1) the partners'
relative contributions to the partnership; (2) interests of the partners in economic profits and
losses (if different from their interests in taxable income or loss); (3) interests of the partners in
cash flow and other nonliquidating distributions; and (4) partners' rights to distributions of capital
upon liquidation. A rebuttable presumption provides that all partners' interests are presumed to
be equal (determined on a per capita basis)./376/
A partnership may incur a liability (referred to as a "nonrecourse liability") for which no partner
(or related person) bears the economic risk of loss. Partnership property may or may not secure
the liability. For example, a partnership may purchase a building using nonrecourse financing for
which the building secures the debt, or an entity such as a limited liability company ("LLC")/377/
may simply borrow money in which no property secures the borrowing and the members of the
LLC have limited liability under State law. Allocations of deductions attributable to partnership
nonrecourse liabilities (referred to as "nonrecourse deductions") cannot have economic effect
because the lender, rather than the partners, bears the economic cost attributable to the
deductions./378/ In addition, allocations of the gain (referred to as "partnership minimum gain")
that would be realized if the property securing the debt were disposed of for no consideration
other than full satisfaction of the liability cannot have economic effect because these allocations
do not reflect any economic gain but merely constitute a recapture of the nonrecourse deductions.
As a result, Treasury regulations require that nonrecourse deductions be allocated in accordance
with the partners' interests in the partnership and partnership minimum gain be allocated to the
partners that were allocated the nonrecourse deductions. The amount of nonrecourse deductions
for a partnership taxable year generally equals the net increase in partnership minimum gain
during the year./379/ The amount of partnership minimum gain is determined by first computing
for each partnership nonrecourse liability any gain the partnership would realize if it disposed of
the property subject to
that liability for no consideration other than full satisfaction of the liability, and then aggregating
the separately computed gains./380/
The regulations contain a four-prong safe harbor that, if satisfied, deems allocations of
nonrecourse deductions to be in accordance with the partners' interests in the partnership./381/ In
order to meet the safe harbor, the following four requirements must be met: (1) the primary or
alternate test for economic effect must be met throughout the full term of the partnership; (2)
nonrecourse deductions must be allocated in a manner that is reasonably consistent with
allocations that have substantial economic effect of some other significant partnership item
attributable to the property securing the nonrecourse liabilities; (3) the partnership agreement
contains a minimum gain chargeback provision (i.e., if there is a net decrease in partnership
minimum gain, each partner must be allocated income and gain equal to its share of the net
decrease in partnership minimum gain): and (4) all other material allocations and capital account
adjustments under the partnership agreement are recognized under section 704(b).
In the preamble to the regulations, the Treasury acknowledged that a partnership may have a
liability that is not secured by any property, is recourse to the partnership as an entity, and with
respect to which no partner bears the economic risk of loss (i.e., an exculpatory liability)./382/ As
noted, an exculpatory liability is treated as a nonrecourse liability. The calculation of partnership
minimum gain is difficult in the case of an exculpatory liability because the liability is not
secured by specific property and the adjusted bases of partnership property may fluctuate. As a
result, the Treasury has not prescribed precise rules for exculpatory liabilities and states that
taxpayers should treat allocations attributable to exculpatory liabilities in a manner that reflects
the principles of section 704(b).
A partner's basis in a partnership interest (the "outside basis"), is treated as including the
partner's share of the partnership's liabilities./383/ Outside basis includes the partner's share of
recourse liabilities as well as nonrecourse liabilities. A partner's share of a partnership recourse
liability is the portion of that liability, if any, for which the partner or a related person bears the
economic risk of loss./384/ A partner's share of the nonrecourse liabilities of a partnership
includes that partner's share of partnership minimum gain./385/ To the extent that partnership
nonrecourse liabilities exceed partnership minimum gain, the excess is allocated among the
partners in accordance with the partner's share of partnership profits, taking into account all facts
and circumstances relating to the economic relationship of the partners./386/
Reasons for Change
Present law with respect to the allocation of nonrecourse deductions is ineffective in requiring
taxpayers to allocate nonrecourse deductions in a manner consistent with their overall economic
arrangement. This issue has become more serious as a result of the dramatic increase in the use
of LLCs which has occurred since the nonrecourse deduction rules were originally promulgated.
Partners have significant flexibility to allocate nonrecourse deductions in a taxmotivated manner
which is inconsistent with their overall economic arrangement. Because the allocation of
nonrecourse deductions is generally free of any non-tax economic consequences, partnerships
may use such allocations to shift taxable income from one partner to another in a manner which
reduces the
tax liability of the partners in the aggregate. Further restrictions on the allocation and utilization
of nonrecourse deductions are necessary to curtail certain forms of tax-motivated
allocations.
Description of Proposal
In general
Under the proposal, the present-law rules for nonrecourse deductions are generally maintained;
however, the second prong of the present-law safe harbor (requiring allocations to be reasonably
consistent with the allocation of some other significant item) is modified to provide certainty to
partnerships and partners while also reducing the potential for abuses that may be available under
the current safe harbor. In addition, the proposal recognizes that some nonrecourse liabilities may
not be secured by any partnership property (e.g., exculpatory liabilities). As a result, the new safe
harbor, unlike the present-law four-prong safe harbor, is applicable to nonrecourse deductions
attributable to nonrecourse liabilities that are secured by partnership property as well as those that
are unsecured. In addition, the proposal provides that nonrecourse liabilities of a partnership are
excluded from a partner's outside basis.
Under the proposal, nonrecourse deductions must still, as a general rule, be allocated in
accordance with the partners' interests in the partnership. Nonrecourse deductions are defined as
under present law to include items of loss, deduction, or section 705(a)(2)(B) expenditures/387/
attributable to nonrecourse liabilities of the partnership. A nonrecourse liability refers to a
partnership liability for which no partner (or related person) bears the economic risk of loss. As a
result, under the proposal, nonrecourse deductions may arise from exculpatory liabilities, which
may be common in entities such as limited liability companies, and may also arise in the more
traditional sense from nonrecourse liabilities that are secured by partnership property (e.g.,
nonrecourse liability secured by a building owned by the partnership).
Modification of safe harbor
Under the proposal, the first, third, and fourth prongs of the current regulatory safe harbor for
allocations of nonrecourse deductions are retained. The second prong, however, is modified. As
under current law, partnerships must satisfy all four prongs in order to be able to rely on the safe
harbor.
Under the new second prong, if the aggregate capital account balances and recourse liabilities of
the partnership constitute at least 20 percent of the total capitalization of the partnership at the
time the nonrecourse liability arises (using book values), then the partners may allocate
nonrecourse deductions in accordance with the relative capital account balances of the partners.
Alternatively, if there is a reasonable expectation of significant residual (or catch-all) profits,
then the partners may allocate the nonrecourse deductions in accordance with the residual profit
sharing arrangement of the partners. In addition, any allocation arrangement which falls between
relative capital account percentages and residual profit sharing percentages is acceptable if the
required minimum capitalization and residual profit sharing expectation are both met.
Nonrecourse liabilities excluded from outside basis
In addition to the safe harbor modification, the proposal provides that nonrecourse liabilities of
the partnership are excluded from a partner's outside basis. As a result, a partner's outside basis
would only be increased by contributions of money or property, distributive shares of income,
gain, and tax-exempt income, and a portion of any recourse liability of the partnership.
Effective Date
The modified safe harbor proposal is effective for partnership taxable years beginning after the
date of enactment. The proposal to exclude nonrecourse liabilities from outside basis is effective
for nonrecourse liabilities incurred after date of enactment.
Discussion
In general
The four-part safe harbor in the regulations does not adequately restrict allocations of
nonrecourse deductions to arrangements that are consistent with the partners' overall economic
arrangement (i.e., partners' interests in the partnership). In particular, the requirement that the
allocation of nonrecourse deductions be reasonably consistent with some significant item
attributable to the partnership property that secures the liability has not been effective in
restricting allocations to the partners' overall economic arrangement. Some partnerships have
provided for a special allocation of a significant partnership item to support the allocation of the
nonrecourse deduction. In addition, requiring the allocation of nonrecourse deductions to merely
be reasonably consistent (as opposed to identical) with some significant item has led some
partnerships to believe that a fairly wide range is permissible.
The regulations do not specifically address deductions attributable to exculpatory liabilities.
With the increasing popularity of LLCs coupled with the greater limited liability protection given
to all types of partners in both general and limited partnerships, there is an increasing need to
provide clear guidance for the tax treatment of deductions attributable to exculpatory liabilities.
The proposal retains the general guidance that deductions attributable to exculpatory liabilities
need to be allocated in accordance with the partners' interests in the partnership. But the proposal
also provides a new safe harbor that, if satisfied, deems allocations to be in accordance with the
partners' interest in the partnership.
Modified safe harbor
Under the proposal, the modified safe harbor may be satisfied if the allocations are made in
accordance with relative capital account balances at the time the nonrecourse liability arises.
However, the relative capital account method may only be used if the capital accounts and
recourse liabilities are at least 20 percent of the total capitalization of the partnership. For
example, assume A contributes $ 5,000 and B contributes $ 15,000 to partnership AB, which
purchases an office building (its only asset) for $ 100,000. The balance of the purchase price ($
80,000) is financed through nonrecourse debt. The aggregate capital accounts represent 20
percent of the total capitalization of the partnership. As a result, the partnership may allocate the
nonrecourse deductions 25 percent to A and 75 percent to B and meet the safe harbor.
Alternatively, if partnership AB expects to have significant residual profits at the time the
nonrecourse liability arises, then it may allocate the nonrecourse deductions in accordance with
the partners' residual profit sharing ratio. Assume the residual profit sharing ratio is 50 percent to
A and 50 percent to B. Under the safe harbor, partnership AB may allocate the nonrecourse
deductions in a 50/50 sharing ratio. If both the 20 percent capitalization rule and the residual
profits expectation rule are met, partnership AB may allocate the nonrecourse deductions in any
ratio between 50/50 and 25/75. Assuming the other prongs of the safe harbor are also met, the
allocation will be deemed to be in accordance with the partners' interest in the partnership.
Partnerships whose capital accounts and recourse liabilities do not constitute at least 20 percent
of the total capitalization and that do not reasonably expect to have significant residual profits are
not eligible for the safe harbor. It is appropriate to deny a safe harbor in such cases because
partnerships whose partners have proportionately less at risk are more likely to be used in tax
motivated transactions. Under the general rule of the proposal, their allocations of nonrecourse
deductions must be consistent with the partners' interests in the partnership, and it is anticipated
that such partnerships will allocate nonrecourse deductions consistent with the most likely
allocation of marginal profits (i.e., the last dollar of reasonably expected profits) unless such
allocation is not reflective of the partners' interests in the partnership.
Nonrecourse liabilities excluded from outside basis
While the proposed modification to the safe harbor should be more effective than present law in
requiring partners to allocate nonrecourse deductions in a manner consistent with their overall
economic arrangement, it will not prevent all potential abuses. Thus, the exclusion of
nonrecourse liabilities from partners' outside basis functions as a backstop which should prevent
the most serious abuses, in which a partner with no economic risk at all is allocated nonrecourse
deductions. Because a partner may not deduct allocated losses in excess of its outside basis, the
proposal assures that partners benefit from the allocation of nonrecourse deductions only to the
extent that they bear economic risk with respect to capital contributions, recourse liabilities, or
undistributed partnership income. As under present law, any nonrecourse deductions allocated to
a partner with insufficient outside basis are suspended and become deductible only when the
partner's outside basis is increased to a sufficient amount.
In addition to its role in preventing abuses, this proposal brings the tax treatment of partners
closer to the tax treatment of S corporation shareholders. In an S corporation, liabilities of the S
corporation to persons other than the S corporation shareholders usually have no effect on the
shareholders' adjusted bases for their stock or debt claims against the S corporation./388/ Under
the proposal, a similar result is achieved for partners in a partnership with respect to nonrecourse
liabilities. A partner is still able to include in its outside basis its share of a recourse liability,
defined as a partnership liability for which one or more partners bear the economic risk of
loss./389/ A partner's share of a recourse liability equals that portion of the liability for which that
partner bears the economic risk of loss./390/ A liability may be part recourse and part
nonrecourse in which case only the recourse portion may be included in a partner's outside basis
to the extent the partner bears the economic risk of loss for the liability.
The proposal has the additional benefit of allowing recourse liabilities to be included in a
partner's outside basis without regard to whether the recourse liability is treated as such because a
partner loaned the money to the partnership or whether a partner guaranteed the partnership
liability. In the S corporation context, there has been much confusion and litigation with respect
to the distinction between a liability of the S corporation guaranteed by a shareholder and a
liability of the S corporation to a shareholder. In the former case, the liability is not included as
part of a shareholder's debt claim against the corporation while in the latter case the shareholder
includes the liability as part of its debt claim. The advantage of inclusion in debt claim is that the
shareholder is able to deduct a greater amount of losses flowing through the S corporation to the
shareholder.
Under the proposal, no distinction is made between a liability of the partnership guaranteed by a
partner and a liability of the partnership to a partner. To the extent a partner bears the economic
risk of loss for the liability, however arising, then the partner includes the recourse liability in its
outside basis. As a result, the proposal has some similarity to the rules for S corporations (i.e., no
inclusion of nonrecourse liabilities in outside basis) while eliminating a perceived weakness of
the S corporation regime (i.e., distinguishing between guaranteed debt and shareholder
debt).
The proposal is consistent with the holding of the Supreme Court in Crane v.
Commissioner/391/while at the same time acknowledging the increasing adoption of the entity
theory of partnership law. A partnership that purchases property using nonrecourse financing
includes the nonrecourse debt in its basis in the property. The partnership will compute its
depreciation deductions using a basis that includes the nonrecourse debt. The partners are,
however, treated as separate from the partnership for purposes of the nonrecourse liability, which
represents economic reality. The nonrecourse creditor's remedy in the event of partnership default
is limited solely to one or more assets of the partnership, and the partners are not personally
liable for the liability under State law or under the contractual terms of the debt (or both). The
proposal serves to minimize the flexibility partners may have to allocate deductions relating to
debt for which no partner bears the economic risk of loss.
Finally, if the outside basis restrictions prove effective in preventing abuses, it may eventually be
possible to modify or replace the existing allocation restrictions, resulting in significant
simplification benefits for partners and partnerships.
F. Modify Adjustment Rules for Basis of Undistributed Partnership Property (sec. 734)
Present Law
Present law provides that the basis of partnership property is to be adjusted as the result of a
distribution of property if the partnership has so elected under section 754, or if there is a
substantial basis reduction with respect to the property distributed (i.e., a basis reduction in
excess of $ 250,000)./392/ If adjustments are made, the basis of partnership property is to be
increased by any gain recognized to the distributee partner, and also to the extent the distributed
property had an adjusted basis to the partnership
greater than the basis attributed to the property in the hands of the distributee. The basis of
partnership property is decreased by any loss recognized to the distributee partner, and also to the
extent the distributed property had an adjusted basis to the partnership that is less than the basis
attributed to the property in the hands of the distributee.
Reasons for Change
The measurement of the basis adjustment is inaccurate in some cases under present law. The
amount of the adjustment does not consistently keep the amount of unrealized partnership gain or
loss unchanged with respect to the remaining partnership interests in a partnership, following a
distribution of property when basis adjustments are made to partnership property. The adjustment
should reflect the difference between the partnership's adjusted basis in the property distributed,
and the reduction in the distributee partner's share of the adjusted basis of partnership property.
This would more accurately adjust for basis that is shifted to or away from the partnership (and
remaining partners) as a result of the property distribution.
Description of Proposal
The method of making the adjustment to remaining partnership property after a distribution of
property, when the adjustments are made under section 734, is changed to reflect the difference
between the basis to the partnership of the distributed property and the reduction which occurs in
the distributee partner's proportionate share of the adjusted basis of the partnership
property./393/
Effective Date
The proposal applies to distributions made after the date of enactment.
Discussion
The rules contained in section 734(b) are intended to permit a partnership to maintain the same
adjusted basis for partnership property in the aggregate, as is represented by the aggregate of the
adjusted bases of all the partnership interests. However, because this relationship may already
have become distorted before the partnership made the election under section 754 (or makes a
distribution involving a substantial basis reduction), increasing the basis of partnership property
by the amount of gain recognized to the distributee partner or the excess of the basis of the
partnership property over the amount of the basis assigned to it in the hands of the distributee
may not give the correct result, if upward adjustments are required. Similarly, adjustments for
losses or the excess of the basis of a property in the hands of the distributee over the basis to the
partnership may not give the correct result, if downward adjustments in the basis of partnership
property are required. A more accurate result can be obtained by making an adjustment in the
manner recommended by the proposal. Further, the proposal would conform the operation of
section 734(b) to that of the similar provision in section 743(b), which provides for an
adjustment to the basis of partnership property following the transfer of a partnership
interest.
The problem involved can be illustrated by the following examples.
Example 1. -- Assume that the assets of the equal partnership ABD had a
basis of $ 9,000 and a fair market value of $ 15,000. D, who recently purchased his interest in the
partnership from C for $ 5,000 has a $ 5,000 basis for his partnership interest. A and B each has a
basis for his partnership interest of $ 3,000. Under present law, if a $ 5,000 cash distribution is
made by the partnership to either A or B in liquidation of its partnership interest, the partnership
would be entitled to an upward adjustment of $ 2,000 to the basis of the remaining partnership
assets. However, a similar distribution to D would result in no adjustment. Under the proposal,
there would be a $ 2,000 upward adjustment regardless of which partner received the
distribution.
Example 2. -- Assume that the assets of the equal partnership ABD had a basis of $ 9,000 and a
fair market value of $ 6,000. D, who recently purchased his interest in the partnership from C for
$ 2,000 has a $ 2,000 basis for his partnership interest. A and B each has a basis for his
partnership interest of $ 3,000. Under present law, if a $ 2,000 cash distribution is made by the
partnership to either A or B in liquidation of its partnership interest, the partnership would be
required to make a downward adjustment of $ 1,000 to the basis of the remaining partnership
assets. However, a similar distribution to D would result in no adjustment. Under the proposal,
there would by a $ 1,000 downward adjustment regardless of which partner received the
distribution.
G. Treat Guaranteed Payments to Partners as Payments to Nonpartners (sec. 707)
Present Law
In general
Under present law, a partner's treatment of items of income, gain, loss, deduction, and credit
arising in respect of the partnership depends on several factors.
In general, a partner includes on its own Federal income tax return its distributive share of items
of partnership income, gain, loss, deduction, or credit. A partner's distributive share of an item is
determined under the partnership agreement. The allocations provided in the partnership
agreement will be respected if the allocations have substantial economic effect or are in
accordance with the economic interests of the partners. Generally, allocations of partnership tax
items are treated as having substantial economic effect if the partnership maintains capital
accounts for its partners in accordance with regulations, distributions are made in accordance
with the capital accounts, and any partners with a deficit balance in its capital account must make
a capital contribution upon liquidation of its interest in the partnership.
Generally, under timing rules applicable to partnership items, the items are included in income
for the taxable year of the partner in which the partnership's taxable year ends./394/
Guaranteed payments
If a partner receives a payment that is determined without regard to the income of the
partnership, the payment is considered a guaranteed payment rather than a distributive share of
partnership income./395/ This provision was adopted in 1954 to clarify the situation in which the
amount of the payment exceeded
the net income of the partnership and would have resulted in the payment being out of the capital
of the partners rather than from partnership income./396/ The 1954 treatment of guaranteed
payments as different from a distributive share of partnership income provided the relatively
narrow clarification that such payments are includable in the partner's income (not treated as a
return of capital).
The rules for guaranteed payments provide that a partner receiving a guaranteed payment is
treated as a third party (rather than as a partner), but only for purposes of income inclusion by the
partner (sec. 61) and deduction of the payment by the partnership (sec. 162(a), subject to
capitalization requirements of section 263)./397/
The partnership deducts guaranteed payments in determining partnership income. Present law
provides a specific rule that matches the timing of inclusion of guaranteed payments and the
deduction of such payments by the partnership. The timing rule is that guaranteed payments are
included in gross income in the taxable year of the partner that ends within, or ends at the same
time as, the taxable year of the partnership in which the partnership deducts the
payment./398/
Payments made to a partner in a nonpartner capacity
A partner who engages in a transaction with a partnership, other than in its capacity as a partner,
is treated as if it was not a member of the partnership with respect to the transaction. This rule
applies both to performance of services for a partnership by a partner, and transfers (including
indirect transfers) of property between the partnership and the partner./399/ Thus, the partnership
and the partner are treated in the same manner as if the transaction were between the partnership
and a third party.
The partnership is allowed a deduction with respect to a nonpartner payment in accordance with
its method of accounting (provided capitalization rules do not apply); the partnership may deduct
such a payment to a cash-basis partner no earlier than the day that the amount is includible in the
partner's income./400/ The partner includes the payment in income in accordance with its own
method of accounting (provided exclusion rules do not apply). For example, a cash method
partner generally includes the payment upon receipt; an accrual method partner generally
includes the amount when the right to the payment accrues. These timing rules differ from the
timing rule for inclusion and deduction of guaranteed payments.
Reasons for Change
The statutory distinction between guaranteed payments and nonpartner payments may have little
continuing purpose. Eliminating the distinction between the two sets of rules would conform the
income and deduction timing rules applicable to all payments to partners that are not based on
partnership net income to the more generally applicable timing rules applicable to other
taxpayers, and would eliminate opportunities for manipulation of the tax rules and provide
simplification benefits.
Description of Proposal
Under the proposal, all compensation for services or use of capital that
is not based on the net income (or an item of net income) of the partnership is treated as arising
from a transaction between a partnership and a nonpartner. Under the proposal, the income and
deduction timing rule for guaranteed payments is repealed and such payments are subject to the
income and deduction timing rules for nonpartner payments. In determining whether an amount
is a nonpartner payment, the proposal applies a standard of whether the amount is determined by
reference to net income (or an item of net income) of the partnership, in lieu of the present-law
standard of whether the partner is acting in its capacity as a partner. Thus, the proposal clarifies
the treatment of all payments made to a partner that are not determined by reference to the net
income of the partnership.
Effective Date
The proposal applies to taxable years beginning after the date of enactment.
Discussion
The present-law rules relating to guaranteed payments and nonpartner payments give rise to
confusion, uncertainty and needless complexity in several respects. The treatment of guaranteed
payments as nonpartner payments only for income inclusion and deduction purposes, but not for
other tax purposes, has given rise to conflicting regulatory and judicial interpretations. The
difference in the timing rules for deduction and income inclusion with respect to the two types of
payments is confusing and may create opportunities for manipulation of the tax law. Further,
there is uncertainty as to the scope of the application of the nonpartner payment rules of section
707(a) because it may be unclear whether a partner is acting in its capacity as a partner. Both
guaranteed payments for capital, and guaranteed payments for services, have counterparts in the
section 707(a) rules for nonpartner payments. Several commentators have questioned the
continued viability of a concept of guaranteed payments separate from the concept of payments
treated as made to a partner in a nonpartner capacity./401/
Eliminating the guaranteed payment rules would eliminate the confusion resulting from
third-party status for some purposes and distributive share status for other purposes, as well as
the confusion arising from the application of two sets of income and deduction timing rules to
payments to partners. Choosing the more generally applicable timing rules applicable to
nonpartner payments, rather than the partnership-specific rule for guaranteed payments that is
provided under present law, promotes neutrality in the tax law as between comparably situated
taxpayers.
The proposal would apply to all payments made to a partner that are not determined by reference
to the net income of the partnership, rather than requiring a factual inquiry as to whether a partner
is acting in its capacity as a partner with respect to the payment. A net income test would in many
circumstances require a simpler factual determination than would the present-law test relating to
the partner's capacity as a partner.
VI. INTERNATIONAL PROVISIONS
A. Amend the Employer-Provided Housing Exclusion and Impose a Stacking Rule with Respect
to Non-Excludable Income
(sec. 911)
Present Law
In general
U.S. citizens generally are subject to U.S. income tax on all their income, whether derived in the
United States or elsewhere. A U.S. citizen who earns income in a foreign country also may be
taxed on such income by that foreign country. The United States generally cedes the primary
right to tax income derived by a U.S. citizen from sources outside the United States to the foreign
country where such income is derived. Accordingly, a credit against the U.S. income tax imposed
on foreign source income is generally available for foreign taxes paid on that income, to the
extent of the U.S. tax otherwise owed on such income. If the foreign income tax rate is lower
than the U.S. income tax rate, then the United States generally provides a credit up to the amount
of the foreign tax and imposes a residual tax to the extent of the difference.
U.S. citizens living abroad may be eligible to exclude from their income for U.S. tax purposes
certain foreign earned income and foreign housing costs, in which case no residual U.S. tax is
imposed to the extent of such exclusion, regardless of the foreign tax paid on such income (if
any). In order to qualify for these exclusions, an individual must be either: (1) a U.S. citizen who
is a bona fide resident of a foreign country for an uninterrupted period that includes an entire
taxable year;/402/ or (2) a U.S. citizen or resident present overseas for 330 days out of any
12-consecutive-month period. In addition, the individual must have his or her tax home in a
foreign country.
Exclusion for compensation
The foreign earned income exclusion generally applies to income earned from sources outside
the United States as compensation for personal services rendered by the taxpayer. The maximum
exclusion amount for foreign earned income is $ 80,000 per taxable year for 2005 and thereafter.
For taxable years beginning after 2007, the maximum exclusion amount is indexed for
inflation.
Exclusion for housing costs
The amount of the employer-provided housing exclusion is equal to the excess of the taxpayer's
"housing expenses" over a base housing amount. The term "housing expenses" means the
reasonable expenses paid or incurred during the taxable year with respect to the taxpayer's
housing in the foreign country. The term includes expenses attributable to housing, such as
utilities and insurance, but does not include interest and taxes, which are separately deductible. If
the taxpayer maintains a second household outside the United States for a spouse or dependents
who do not reside with the taxpayer because of adverse living conditions, then the housing
expenses of the second household are also eligible for exclusion. Under present law, the base
housing amount is 16 percent of the annual salary earned by a GS-14, Step 1, U.S. government
employee. For 2005, this salary is $ 76,193 and thus the current base housing amount is $
12,190.
In the case of housing costs that are not paid or reimbursed by the taxpayer's employer, the
amount that would be excludible is treated instead as a deduction.
Exclusion limitation amounts
The combined foreign earned income exclusion and housing cost exclusion may not exceed the
taxpayer's total foreign earned income for the taxable year. The taxpayer's foreign tax credit is
reduced by the amount of such credit that is attributable to excluded income.
Reasons for Change
Under present law, an individual working abroad has the potential to exclude significant
amounts of housing benefits. The employer-provided housing exclusion is equal to the excess of
an individual's housing expenses over a base amount, but substantial amounts above the base
may be excluded from income because the exclusion is limited to "reasonable housing expenses,"
which allows for generous interpretation by the taxpayer. The proposal would establish an
objective cap to determine "reasonable housing expenses." The proposal would also tie the
employer-provided housing exclusion to the foreign earned income cap to bring the two
exclusions into conformity.
Under present law, individuals working abroad can also benefit from being subject to low
income tax rates on their non-excludible income. The taxable income of section 911 beneficiaries
is subject to rates that ordinarily are applicable to taxpayers with substantially less economic
income. The proposal would impose a stacking rule that requires individuals with section 911
benefits to stack their taxable income after their section 911 exclusion amounts, thereby
subjecting such individuals to the same rates applicable to individuals living and working in the
United States who have the same amount of economic income.
Description of Proposal
Exclusion for compensation
The foreign earned income exclusion remains capped at $ 80,000 per annum, but is indexed for
inflation every year instead of only taxable years after 2007.
Exclusion for housing costs
The employer-provided housing exclusion is modified by tying it to the foreign earned income
cap and applying an objective standard to the term "reasonable housing expenses." 176 Under the
proposal, the base housing amount used to calculate the employer-provided housing exclusion is
set at 16 percent of the foreign earned income exclusion cap, instead of 16 percent of the GS-14,
Step 1 amount. As under present law, amounts below the base housing amount would be subject
to U.S. tax because the base housing amount represents an estimate of expenditures that
taxpayers would incur on housing regardless of whether they were relocated abroad. For 2005,
the proposed base housing amount is $ 12,800 (=$ 80,000 x .16).
Employer-provided housing amounts in excess of the base housing amount are excluded from
U.S. tax, but under the proposal such amounts are limited to 30 percent of the $ 80,000 (indexed
for inflation). The proposal applies an objective standard to determine "reasonable housing
expenses." The Department of Housing and Urban Development ("HUD") considers maximum
affordable housing to be 30 percent of an individual's annual income. For 2005, the proposed
maximum housing exclusion is therefore $ 11,200 (= ($ 80,000 x .30) - ($ 80,000 x
.16)).
Stacking rule
Under present law, a taxpayer with excludable income under section 911 is subject to tax on the
taxpayer's other income, after deductions, starting in the lowest tax rate bracket. Under the
proposal, the taxpayer's other income, after deductions, is stacked on top of the section 911
exclusion amounts to arrive at the appropriate tax bracket. Thus, the income exempt under
section 911, while not taxed in the United States, is still considered in determining the section
911 beneficiary's appropriate tax rate bracket under the U.S. progressive rate schedule.
Effective Date
The proposal is effective for taxable years beginning after date of enactment.
Discussion
Housing allowance
As opposed to present law, the proposal establishes an objective standard for excludable housing
costs. Under present law, the employer-provided housing exclusion is provided for expenses
above the base amount and capped at "reasonable housing expenses." As the HUD standard for
maximum affordable housing, the 30-percent cap imposes an objective upper-limit on what is
considered "reasonable housing expenses." A criticism of this approach may be that the objective
cap does not account for the possibility that housing expenses in some foreign locales may
exceed costs of housing in the United States. Thus, it may be appropriate to include some type of
cost-of-housing adjustment factor to take into account the disparate cost of housing around the
world. While the proposal does not include a cost-of-housing adjustment factor, the $ 80,000
amount used to cap employer-provided housing is more beneficial than using the median wage
and salary amount for a family of four. Median wages and salaries for a family of four (married
filing jointly with two dependents) was $ 56,085, as reported by taxpayers on Form 1040, in
2002. Thus, using $ 80,000 for the employer-provided housing calculation is generous in
comparison to using wages and salaries for the median family.
The employer-provided housing exclusion is also tied to the foreign earned income cap. Thus,
the housing exclusion is calculated by taking $ 80,000, indexed per annum, and applying a 16
percent floor and 30 percent cap. The foreign earned income exclusion cap is the threshold set by
Congress to determine the amount of foreign earnings exempt from U.S. tax. Tying the
employer-provided housing exclusion to the foreign earned income exclusion cap brings the two
exclusions into conformity.
The modifications to the exclusion for employer-provided housing costs may reduce the current
tax benefit provided to certain individuals under section 911 . Income not eligible for the housing
exclusion under the proposal would be treated the same as income earned by U.S. citizens living
in the United States; U.S. citizens living abroad would be taxed on their worldwide income and a
foreign tax credit would be allowed for foreign taxes paid. U.S. citizens living in countries that
have tax rates higher than those in the United States would
generally still not owe U.S. tax on the portion of their foreign earned income no longer eligible
for section 911, because such taxes would be covered by the foreign tax credit. U.S. citizens
living in countries that have tax rates lower than the United States would generally be made
worse off relative to present law because the United States would impose a residual tax on the
portion of their foreign earned income no longer eligible for section 911.
Stacking rule
Under present law, taxpayers with excludable income as a result of section 911 are taxed on any
taxable income at rates that ordinarily are applicable only to taxpayers with substantially less
economic income. The proposed stacking rule corrects this situation by subjecting taxpayers with
section 911 excludable income to the same rates applicable to taxpayers with the same amount of
economic income but who live and work only in the United States. For example, consider a
taxpayer who has an $ 80,000 foreign earned income exclusion under section 911, a $ 10,000
employer-provided housing exclusion under section 911, $ 35,000 of other gross income, and $
20,000 in deductions (including standard or itemized deductions and/or personal exemptions).
The taxpayer has $ 90,000 in exclusions under section 911 and $ 15,000 of other income (after
deductions). Under present law, the $ 15,000 of other income is taxed starting in the lowest rate
bracket. Under the proposal, the $ 15,000 of other income is stacked after the $ 90,000 section
911 exclusion amounts. Therefore, under the proposal, the $ 15,000 of other income is taxed in
the rate bracket that corresponds with $ 105,000. The proposed stacking rule is also applicable
for purposes of the alternative minimum tax.
In cases where the excludable foreign income is subject to foreign taxes, the stacking rule
prevents taxpayers from benefiting twice from graduated rate structures, once in the foreign
country in the determination of the foreign tax liability on their foreign income, and again in the
United States in the determination of their U.S. tax liability on any other income. Under the
proposal, taxpayers can avoid the stacking rule by forgoing utilization of section 911 altogether
and simply claiming a foreign tax credit for any foreign taxes paid.
B. Amend Rules for Determining Corporate Residency (sec. 7701)
Present Law
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./403/ All other corporations (i.e., those incorporated under the laws of foreign
countries) are treated as foreign./404/ Thus, 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. Only domestic corporations are subject to tax on a worldwide basis. Foreign
corporations are taxed only on income that has sufficient nexus in the United States.
Until recently, a U.S. parent corporation could reincorporate in a foreign jurisdiction, and this
reincorporation could be respected for U.S. tax purposes, even in cases in which the
reincorporation had no significant non-tax purpose or effect, and the corporate group had no
significant business presence in the new country of incorporation. These transactions were
commonly referred to as "inversion" transactions, and they could produce a variety of tax
benefits, including the removal of a group's foreign operations from U.S. taxing jurisdiction and
the reduction of U.S. tax on U.S.-source income through earnings-stripping transactions (e.g.,
large payments of interest from a U.S. subsidiary to the new foreign parent).
The American Jobs Creation Act of 2004 ("AJCA")/405/ included provisions designed to curtail
inversion transactions. Most significantly, section 801 of AJCA added section 7874 to the Code,
which denies the intended tax benefits of a typical inversion transaction by deeming the new
top-tier foreign corporation to be a domestic corporation for all Federal tax purposes. This
sanction generally applies to a transaction in which, pursuant to a plan or a series of related
transactions: (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; (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 50-percent
ownership (i.e., the "expanded affiliated group"), 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./406/
While AJCA created an exception to the place-of-incorporation test for determining corporate
residency in cases involving defined inversion transactions, AJCA left that test in place with
respect to all other cases. Thus, newly incorporated businesses, as well as businesses that
completed inversion transactions prior to the effective date of the AJCA rules, remain subject to
the place-of-incorporation rule as before.
Reasons for Change
The present-law test of determining corporate residency based solely on where the company is
incorporated is artificial, and allows certain foreign corporations that are economically similar or
identical to U.S. corporations to avoid being taxed like U.S. corporations. Determining corporate
residency based on the location of the corporation's management activities would be a more
meaningful standard.
AJCA included provisions that should curtail inversion transactions. In passing these provisions,
the Congress addressed the most glaring deficiencies of the present-law place-of-incorporation
test. However, ACJA's effective date permanently grandfathered most known inverted structures
already in place. AJCA also did not address newly incorporated entities that establish corporate
charters in a foreign jurisdiction, fail to establish substantial presence overseas, and effectively
manage their business from within the United States, thereby achieving tax results similar to
those achieved by pre-existing companies via inversion. However, in fall 2004, the Senate
ratified a
U.S.-Netherlands tax treaty protocol (the "Dutch protocol"),/407/ which included a substantial
presence test that looks to primary place of management and control to determine corporate
residency. Revising the general U.S. corporate residency rules to test for primary place of
management and control would produce a more meaningful test than that of present law and
would present a comprehensive response to the problem identified and addressed by the
Congress in 2004.
Description of Proposal
The proposal would be an overlay on present law, as amended by AJCA. Under the proposal, if
a company is incorporated in the United States, it is still considered a domestic corporation and
does not have to look any further to determine its residence. For publicly traded
foreign-incorporated entities, however, the proposal adds new rules that look to a corporation's
primary place of management and control.
Under the proposal, a company's residence is based on the location of its primary place of
management and control. A corporation's primary place of management and control is where the
executive officers and senior management of the corporation exercise day-to-day responsibility
for the strategic, financial and operational policy decision making for the company (including
direct and indirect subsidiaries).
In determining which individuals are considered executive officers and senior management
employees, the decision-making activities of all executive officers and senior management
employees are taken into account. Under a centralized management structure, these employees
would generally be those individuals who have executive officer positions and report to the
corporate headquarters office. However, some companies may operate under a more
decentralized management structure, where many strategic policy decisions are delegated to
individuals who are directors of subsidiary companies. In this situation, individuals who are not
executive officers and senior management employees of the corporate headquarters may be
carrying on the strategic, financial and operational policy decisions for the company. The
decision-making activities of these individuals are taken into consideration in determining the
company's residence.
Effective Date
The proposal is effective for taxable years beginning at least two years after the date of
enactment, in order to allow affected companies sufficient time to complete any necessary
restructuring.
Discussion
The proposal retains present law but adds new rules with respect to publicly traded
foreign-incorporated companies that are managed and controlled in the United States. Under
present law, corporate residency is determined by place of incorporation. Thus, companies can
avoid U.S. taxation on a worldwide basis by merely incorporating in a foreign jurisdiction. The
proposal applies a more meaningful corporate residency test by requiring that a publicly traded
foreign-incorporated company be treated as resident in the United States if it is managed and
controlled in the United States.
The proposal determines corporate residence based on the location of the company's primary
place of management and control. The proposal differs from the traditional management and
control concept, defined by other countries as the location where the board of directors meets.
The weakness in adopting the traditional management and control concept is that the board of
directors is generally required to meet no more than a few times a year. Thus, a company could
operate the majority of its business from the United States and meet the traditional management
and control requirement simply by holding its board meetings in the foreign country a couple
times a year.
The day-to-day management of a business is more difficult to manipulate. Moving the
management of a company generally requires the physical relocation of top executives and their
families to an office in a foreign jurisdiction. It also requires the movement of support staff and
administrative functions that are normally performed at the corporate headquarters office.
The concept of primary place of management and control is similar to the substantial presence
test included in the recently ratified Dutch protocol. The substantial presence test in the Dutch
protocol tests for corporate residence based on the location of the headquarters offices and senior
management employees. The proposal does not adopt all aspects of the substantial presence test
used in the Dutch protocol because some aspects lack relevance outside the treaty context.
Under present law, the corporate residency rules are easy to administer because determining
residency is a bright line test. Under the proposal, corporate residency is based on a facts and
circumstances test. The new rules would require the IRS to gather data on foreign incorporated
entities to ascertain whether they have a substantial presence in the United States. Not only does
this require an increase in the IRS's resources, but it also raises issues for foreign incorporated
entities with respect to how they conduct business in the United States.
While the argument can be made that the new rules compromise the clarity and consistency of
current law, the benefits related to preserving the U.S. tax base may offset these concerns. The
new rules provide objective standards for companies that incorporate in the United States, but
when a foreign company takes the position that it is not incorporated here, these rules allow the
United States to test for management and control by looking at where the executive
decision-making of the company is being conducted. In view of the high threshold of activity
required under the proposal, only publicly traded foreign-incorporated companies that are
effectively headquartered in the United States will need to contend with the new rules. Close
cases should be few, thus limiting the scope of any problems relating to uncertainty and
administrability.
C. Modify Entity Classification Rules to Reduce Opportunities for Tax Avoidance (sec.
7701)
Present Law
In order to apply the various substantive rules of the Code to transactions involving business
entities, the entities first must be classified, typically as corporations, partnerships, or branches.
The classification of a business
entity carries significant Federal tax consequences. For example, corporations generally are
subject to tax at the entity level, whereas partnerships and branches generally are not.
Transactions between a branch and its owner generally are disregarded for Federal tax purposes
(including the anti-deferral rules of subpart F), subject to several important
exceptions./408/
Prior to 1997, entity classification for Federal tax purposes was determined on the basis of a
multi-factor test provided in regulations issued under section 7701 of the Code. In distinguishing
between a corporation and a partnership, these regulations set forth four characteristics indicative
of status as a corporation: continuity of life, centralization of management, limited liability, and
free transferability of interests. If a business entity possessed three or more of these
characteristics, then it was treated as a corporation; if it possessed two or fewer, then it was
treated as a partnership./409/ Thus, in order to achieve characterization as a partnership under
this system, taxpayers needed to arrange the governing instruments of an entity in such a way as
to eliminate two of these corporate characteristics. For example, a taxpayer desiring partnership
classification for an entity might include transferability restrictions and dissolution provisions in
order to eliminate the corporate characteristics of free transferability and continuity of life.
Partnerships also needed to have at least two members, as the term suggests.
Since January 1, 1997, new entity classification regulations have been in effect that generally
allow taxpayers simply to elect the desired classification for many types of entities, including
certain limited-liability entities that are available under the laws of many foreign
jurisdictions./410/ These regulations are commonly referred to as the "check the box"
regulations. The "check the box" regulations generally eliminate the need for modifications to the
terms of governing documents in order to secure a particular entity classification, and they make
it possible for a taxpayer to elect branch treatment for a single-member limited-liability entity,
thus enabling the taxpayer to achieve both flow-through taxation and limited liability with
respect to a foreign entity without adding a second member. These entities are often referred to as
"disregarded entities," or "tax nothings."
Reasons for Change
It has been widely observed that the "check the box" regulations, while producing some
simplification benefits with respect to both domestic and foreign entities, also have created some
unintended tax-avoidance opportunities as applied to foreign entities. In particular, it appears that
the availability of single-member disregarded entities has rendered it easy in many cases to avoid
current taxation under subpart F.
Description of Proposal
Under the proposal, an organization must be treated as a corporation for Federal tax purposes if
the organization: (1) is a separate business entity organized under foreign law; and (2) has only a
single member. This proposal overrides any contrary result that may have been obtained under
the current entity classification regulations. In all other respects, those regulations remain in
force.
If a branch, local office, or other organization does not rise to the level of a separate business
entity (e.g., if it is not established as a separate
legal entity under the relevant local law), then the branch, office, or organization is not subject to
this proposal, and thus is not treated as a corporation for Federal tax purposes.
Domestic business entities and non-single-member foreign business entities are generally not
subject to the proposal and thus remain eligible for elective entity classification to the extent so
eligible under the current regulations. However, the Treasury Secretary may issue regulations
extending the application of this provision to: (1) a non-single-member foreign business entity, in
cases in which a membership interest is issued to a person related to another member, with a
principal purpose of preventing the entity from being classified as a corporation under the
provision;/411/ or (2) a domestic business entity that has a CFC as its sole member.
Effective Date
The provision applies to taxable years beginning one year or more after the date of
enactment.
Discussion
As noted above, although the "check the box" regulations have produced some simplification
benefits with respect to both domestic and foreign entities, the regulations also have created some
unintended tax-avoidance opportunities as applied to foreign entities. In particular, it appears that
the availability of single-member disregarded entities has facilitated the avoidance of current
taxation under subpart F in situations in which subpart F normally would apply.
For example, payments of interest, dividends, rent, and royalties between CFCs often generate
subpart F income, but similar payments between a disregarded entity and a CFC do not, even if
the disregarded entity is treated as a separate corporation under applicable foreign tax law, and
thus may be deducting the payment for foreign tax purposes. In these cases, commonly referred
to as "hybrid branch arrangements," the ability to avoid subpart F may combine with favorable
results under foreign tax law to distort investment decisions, arguably making it more attractive
in some cases to locate investments abroad than in the United States. Ensuring that these
transactions are taxed under subpart F could both correct the misallocation of capital away from
the United States and raise additional revenue. On the other hand, some would argue that this sort
of inconsistent treatment of a transaction by the countries concerned is an inevitable result of
cross-border activity in a world with diverse tax systems, that the appropriate U.S. tax treatment
of a transaction should not depend on the results that a taxpayer might be able to achieve under
foreign tax law, and that capital import neutrality is promoted by allowing these transactions to
avoid taxation under subpart F./412/ Regardless of whether these particular tax results are viewed
with approval or disapproval, hybrid branch arrangements illustrate well how a "check the box"
election may be used to secure tax results that would have appeared difficult or impossible to
achieve under the current statutory subpart F rules.
While hybrid branch arrangements are perhaps the first and best-known example of how a
"check the box" election can be used to circumvent subpart F, other similar uses for the election
have been found. For example, the sale of stock of an operating company by a CFC generally
would give rise to subpart F income, but if an election to disregard the company is in effect, then
the transaction may
be treated as a sale of operating assets, thus avoiding the creation of subpart F income./413/ As in
the case of hybrid branch arrangements, a mere election, with no non-tax economic effect, may
transform what would have been subpart F income into an item exempt from subpart
F./414/
While a certain degree of electivity already prevailed as a practical matter under the pre-1997
entity classification rules, and tax results similar to those described above may have been
attainable under some circumstances before 1997, the expressly elective approach of the current
regulations has removed some frictions that may have acted as a brake on some of the tax
planning involving the classification of entities. In particular, the ability to disregard
singlemember foreign business entities may have impaired the intended functioning of subpart F
in some respects.
The proposal strikes a balance between the goal of simplification and the policies reflected in the
substantive provisions of the Code by generally retaining the elective approach of the current
entity classification regulations, but providing that single-member business entities organized
under foreign law must be treated as corporations for Federal tax purposes. This approach will
not prevent every arrangement that might be thought to be abusive, as not all abuses require the
use of a separate disregarded entity, but the approach will render it considerably more difficult in
many cases for taxpayers to use the entity classification rules to frustrate the intent of the
international tax provisions of the Code. A wide range of potentially abusive transactions that are
currently disregarded for purposes of the substantive rules of the Code would be "regarded"
under the proposal, thereby providing a greater opportunity to apply and adjust those rules in an
appropriate manner, whether that be to allow or to disallow a particular tax result.
While the overall structuring flexibility available to taxpayers under this approach is
considerably less than what prevails under the current entity classification regulations, it is
generally still greater than the flexibility that prevailed before 1997. Because this approach would
have the effect of upsetting taxpayer expectations that have developed over the last several years
of experience with the current regulations, the proposal includes a delayed effective date, in order
to enable taxpayers to restructure arrangements that were established in reliance on the current
regulations.
D. Adopt a Dividend Exemption System for Foreign Business Income
Present Law
"Worldwide" vs. "territorial" taxation of business income
The tax systems of the world generally reflect two basic approaches to the taxation of
cross-border business income, often referred to as "worldwide" and "territorial" approaches.
Under a pure worldwide tax system, resident corporations are taxable on their worldwide income,
regardless of source, and the potential double taxation arising from overlapping sourcecountry
and residence-country taxing jurisdiction is mitigated by allowing a foreign tax credit. In
contrast, under a pure territorial tax system, a country taxes only income derived within its
borders, irrespective of the residence of the taxpayer. Thus, foreign-source income earned by a
resident corporation is exempt from tax under a pure territorial tax system.
Each type of system may be said to promote a particular conception of economic efficiency. A
pure worldwide tax system promotes capital export neutrality, a norm that holds that tax
considerations should not influence a taxpayer's decision of whether to invest at home or abroad.
Under a pure worldwide tax system, the after-tax return to an otherwise equivalent investment
does not depend on whether the investment is made at home or abroad, since in either case the
income from the investment generally will be subject to tax at the residence-country rate. Thus,
investment-location decisions are governed by business considerations, instead of by tax law. A
pure territorial system, on the other hand, promotes capital import neutrality, a norm that holds
that all investment within a particular source country should be treated the same, regardless of the
residence of the investor. Thus, if a residence country adopts a pure territorial system, residents
of that country, when investing abroad in a particular source jurisdiction, will not receive a lower
after-tax return than other investors by virtue of their country of residence.
In a world with diverse tax systems and rates, it is impossible fully to achieve both capital
import neutrality and capital export neutrality at the same time. For example, suppose a source
country offers a lower tax rate on a particular investment than the U.S. rate on a similar
investment in the United States. Capital export neutrality would dictate that the United States
impose a residual residence-based tax on the foreign investment at a level sufficient to make a
U.S. investor indifferent on an after-tax basis between the two investment locations; however,
doing so would violate capital import neutrality, as a U.S. investor in the source country would
earn a lower after-tax rate of return compared to non-U.S. investors in the same source country,
to the extent that such investors' residence countries did not assert a similar residual tax on the
income. As long as different countries maintain different tax systems and rates, the two goals will
remain in tension with each other.
The tax systems of all large, industrialized countries may be said to reflect varying compromises
between these competing goals. Accordingly, no large, industrialized country employs a pure
worldwide or pure territorial system. Existing systems may be accurately characterized as
predominantly worldwide or territorial, but all systems share at least some features of both the
worldwide and territorial approaches. Thus, systems commonly described as "worldwide" in fact
include many territorial-type elements that promote capital import neutrality, such as indefinite
deferral of tax on most types of foreign business income earned through 187 foreign subsidiaries
in the case of the United States. Similarly, systems commonly described as "territorial" include
many worldwide-type features that promote capital export neutrality, such as residence-country
taxation of passive income earned through foreign subsidiaries in lower-tax countries.
Many countries tax resident corporations on a predominantly territorial basis by exempting
dividends received from foreign subsidiaries from residence-country tax./415/ This exemption
typically applies only where the parent company's ownership in the subsidiary exceeds a certain
threshold (commonly five to 10 percent), and the exemption may be total or partial (e.g., only 95
percent, or 60 percent, of qualifying dividends might be exempted, as a proxy for disallowing
expenses allocable to exempt income). A number of restrictions generally apply, in order to limit
the exemption to certain categories of income (e.g., active business income) and to address
concerns about shifting income to lower-tax countries in order to avoid tax. These exemption
systems generally
do impose tax on foreign-source royalties and portfolio-type income.
The U.S. system: worldwide, deferral-based taxation of foreign business income
The United States employs a "worldwide" tax system, under which domestic corporations
generally are taxed on all income, whether derived in the United States or abroad. Income earned
by a domestic parent corporation from foreign operations conducted by foreign corporate
subsidiaries generally is subject to U.S. tax when the income is distributed as a dividend to the
domestic corporation. Until such repatriation, the U.S. tax on such income generally is deferred,
and U.S. tax is imposed on such income when repatriated.
However, under anti-deferral rules, the domestic parent corporation may be taxed on a current
basis in the United States with respect to certain categories of passive or highly mobile income
earned by its foreign subsidiaries, regardless of whether the income has been distributed as a
dividend to the domestic parent corporation. The main anti-deferral provisions in this context are
the controlled foreign corporation ("CFC") rules of subpart F/416/ and the passive foreign
investment company ("PFIC") rules./417/
A foreign tax credit generally is available to offset, in whole or in part, the U.S. tax owed on
foreign-source income, whether earned directly by the domestic corporation, repatriated as a
dividend from a foreign subsidiary, or included in income under the anti-deferral rules./418/ The
foreign tax credit generally is limited to the U.S. tax liability on a taxpayer's foreign-source
income, in order to ensure that the credit serves its purpose of mitigating double taxation of
foreign-source income without offsetting the U.S. tax on U.S.-source income./419/
The foreign tax credit limitation is applied separately to different types of foreign-source
income, in order 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. For example, if a taxpayer pays foreign tax at an effective rate of 40 percent on certain
active income earned in a high-tax jurisdiction, and pays little or no foreign tax on certain passive
income earned in a low-tax jurisdiction, then the earning of the untaxed (or low-tax) passive
income could expand the taxpayer's ability to claim a credit for the otherwise uncreditable excess
foreign taxes paid to the high-tax jurisdiction, by increasing the foreign tax credit limitation
without increasing the amount of foreign taxes paid. This sort of cross-crediting is constrained by
rules that require the computation of the foreign tax credit limitation on a category-by-category
basis./420/ Thus, in the example above, the rules would place the passive income and the active
income into separate limitation categories, and the low-tax passive income would not be allowed
to increase the foreign tax credit limitation applicable to the credits arising from the high-tax
active income. A significant degree of cross-crediting may be achieved within a single limitation
category, however. For example, a high-tax dividend from a CFC and a low-tax royalty from
another CFC may both fall into the general limitation category,/421/ with the result that potential
excess credits associated with the dividend effectively may reduce the residual U.S. tax owed
with respect to the royalty.
Reasons for Change
It has long been recognized that the worldwide, deferral-based system of present law distorts
business decisions in a number of ways. By establishing repatriation as the system's principal
taxable event, the worldwide, deferral-based system creates incentives in many cases to redeploy
foreign earnings abroad instead of in the United States, thereby distorting corporate
cash-management and financing decisions. At the same time, basing the system on repatriation
renders the payment of U.S. tax on foreign-source business income substantially elective in many
cases, because repatriation itself is elective. By maintaining deferral indefinitely, a taxpayer may
achieve a result that is economically equivalent to 100-percent exemption of income, with no
corresponding disallowance of expenses allocable to the exempt income, provided that the
taxpayer does not repatriate the earnings or run afoul of subpart F or other anti-deferral
rules./422/ In addition, taxpayers that repatriate high-tax earnings may be able to use excess
foreign tax credits arising from these repatriations to offset the U.S. tax on lower-tax items of
foreign-source income, such as royalties received for the use of intangible property in a low-tax
country.
For these reasons, in many cases, the present-law "worldwide" system actually may yield results
that are more favorable to the taxpayer than the results available in similar circumstances under
the "territorial" exemption systems used by many U.S. trading partners, as these systems
generally fully tax foreign-source royalties and portfolio-type income, and often exempt less than
100 percent of a dividend received from a subsidiary, as a proxy for disallowing expenses
allocable to the exempt income. At the same time, however, the potential for taxation under the
U.S. system by reason of either repatriation or application of the highly complex U.S.
anti-deferral rules arguably forces U.S.-based multinationals to contend with a greater degree of
complexity, and to engage in a greater degree of tax-distorted business planning, than many of
their foreign-based counterparts resident in countries with exemption systems.
The present-law system thus creates a sort of paradox of defects: on the one hand, the system
allows tax results so favorable to taxpayers in many instances as to call into question whether it
adequately serves the purposes of promoting capital export neutrality or raising revenue; on the
other hand, even as it allows these results, the system arguably imposes on taxpayers a greater
degree of complexity and distortion of economic decision making than that faced by taxpayers
based in countries with exemption systems, arguably impairing capital import neutrality in some
cases.
The Congress recognized and addressed some of these problems in AJCA, but significant
problems remain. Replacing the worldwide, deferral-based system with a dividend exemption
system arguably would mitigate many of these remaining problems, while generally moving the
system further in the direction charted by the Congress in 2004.
Description of Proposal
Overview
Under the proposed dividend exemption system, income earned abroad by foreign subsidiaries
of U.S. parent corporations would fall into one of two categories: (1) passive and other highly
mobile income, which would be taxed to the U.S. parent on a current basis under subpart F; or
(2) all other income -- i.e., active, less-mobile income not subject to subpart F -- which would be
exempt
from U.S. tax and thus could be repatriated free of any tax impediment. The deferral and
repatriation tax at the heart of the present-law system would be eliminated, and the foreign tax
credit system would serve a more limited function than it does under present law.
CFC-parent dividends exempt from tax
A U.S. corporation that holds 10 percent or more of the stock of a CFC would exclude from
income 100 percent of the dividends received from the CFC. This exclusion would be
mandatory, and no foreign tax credits would arise with respect to foreign taxes attributable to the
excluded dividend income (including both corporate-level income taxes and dividend
withholding taxes). In addition, a special rule would provide that no subpart F inclusions would
be created as a dividend moves up a chain of CFCs, to the extent that the dividend is attributable
to a 10 percent or greater direct or indirect interest in the dividend-paying CFC owned by the
U.S. parent. This rule would ensure that dividends could be repatriated from lower-tier CFCs
without losing the benefit of dividend exemption, and it also would make it easier to redeploy
CFC earnings in different foreign jurisdictions without triggering subpart F, thus promoting
neutrality as to the decision of how to dispose of CFC earnings.
Under the dividend exemption system, CFC earnings would constitute a predominantly
tax-exempt stream of income for the U.S. parent corporation. Accordingly, deductions for
interest and certain other expenses incurred by the U.S. corporation would be disallowed to the
extent allocable to exempt (non-subpart-F) CFC earnings. These allocations would be made as
the earnings are generated, as opposed to when they are distributed. Thus, for expense allocation
purposes, CFC earnings would be treated as giving rise to foreign-source income as they are
earned.
Interest expense would first be allocated between U.S. and foreign-source income under rules
similar to those of present law, including the interest allocation changes made by AJCA./423/
The amount of interest expense allocated to foreign-source income under these rules then would
be further allocated between exempt CFC earnings and other foreign-source income on a pro rata
basis, based on assets. Research and experimentation expenses would first be allocated between
U.S. and foreign-source income under rules similar to those of present law./424/ The amount of
research and experimentation expenses allocated to foreign-source income then would be further
allocated first to taxable royalties and similar payments (e.g., cost-sharing or royalty-like sale
payments) to the extent thereof, then to CFC earnings to the extent thereof (with this amount
divided on a pro rata basis between exempt CFC earnings and non-exempt CFC earnings), and
then finally to other foreign-source income. General and administrative expenses would be
allocated to exempt CFC earnings in the same proportion that exempt CFC earnings of the group
bears to overall earnings of the group. Other expenses, such as stewardship expenses, may be
directly allocable to exempt CFC earnings in some cases. With respect to all of these categories
of expenses, as under present law, it will be necessary for the Treasury Department to provide
detailed expense allocation rules by regulation.
Other foreign-source income fully taxed
Non-dividend payments from the CFC to the U.S. corporation (e.g., interest, royalties, service
fees, income from intercompany sales) would be fully subject to tax, and this tax generally would
not be offset by cross-crediting as it
often is under present law. In addition, dividends from non-CFCs, or from CFCs with respect to
which the U.S. corporation is not at least a 10-percent shareholder, would be fully subject to
tax.
Anti-avoidance rules retained
Subpart F would be retained in its current form. Thus, notwithstanding the general rule of
dividend exemption, a U.S. corporation that holds a 10-percent or greater stake in a CFC would
still face current income inclusion when the CFC earns certain types of passive or highly mobile
income. As under present law, a subpart F inclusion would carry with it a credit for any foreign
taxes associated with the subpart F income. The PFIC rules also would be retained in their
current form.
Treatment of gain or loss on sale of CFC stock
A U.S. corporation's gain on the sale of CFC stock would be excluded from income to the extent
of undistributed exempt earnings. Any excess of gain over this amount would be taxable, even
though some of this gain may relate to appreciation of assets that would have generated exempt
income./425/ Deductions for losses on the sale of CFC stock would be disallowed.
Foreign branches
Foreign branch income would be exempt to the same extent as it would be if earned by a CFC,
under rules that would treat foreign trades or businesses conducted directly by a U.S. corporation
as CFCs for all Federal tax purposes. Thus, subpart F would apply to branch operations, branch
losses would not flow directly onto a U.S. corporation's tax return, and transactions between the
U.S. corporation and the foreign branch would be subject to the full range of rules dealing with
intercompany transactions. Except as provided in regulations, all trades or businesses conducted
predominantly within the same country would be treated as a single CFC for this purpose. The
Treasury Secretary would be given regulatory authority to issue the rules necessary to place
branches and CFCs on an equal footing for these purposes.
Transition and collateral issues
Transition
The exemption system would apply only with respect to CFC earnings generated after the
effective date, thus requiring ongoing separate tracking of earnings pools. With respect to
pre-effective-date earnings, the present-law system would continue to apply in all respects.
Dividends would be treated as coming first from exempt, post-effective-date earnings and then
from pre-effective-date earnings.
Collateral change to subpart F
The deemed-repatriation rules of section 956 would be repealed, as these rules are merely a
backstop to the present-law repatriation tax, which would be eliminated under the proposed
system. (However, as indicated above, these and all other relevant rules of present law would
continue to apply to pre-effective-date earnings.)
Collateral changes to the foreign tax credit
The foreign tax credit would remain in place with respect to: (1) income that is included on a
current basis under the subpart F or PFIC rules; and (2) other foreign-source income that is not
eligible for exemption (e.g., dividends received on a portfolio investment in a foreign
corporation, foreign-source royalty income earned directly by the U.S. corporation).
The indirect foreign tax credit of section 902 would be repealed, except insofar as it applies to
subpart F inclusions. This rule would eliminate the indirect foreign tax credit for noncontrolled
section 902 corporations ("10-50 companies"). A foreign tax credit generally would remain
available with respect to withholding taxes imposed on dividends received from 10-50
companies, as these dividends generally would remain subject to U.S. tax under the proposal.
However, a U.S. corporation would be allowed to elect to treat its investment in a 10-50
company as an investment in a CFC for Federal tax purposes, thus rendering the investment both
eligible for dividend exemption and subject to subpart F. Thus, the U.S. corporation effectively
would choose between treating the 10-50 investment as a portfolio-type investment or as a direct,
CFC-type investment.
The separate limitation categories of section 904 would be repealed, and thus the foreign tax
credit limitation would apply on an overall basis. By removing most foreign business income
from the foreign tax credit system altogether, most high-tax foreign-source income would be
removed from the computation, greatly reducing the potential for cross-crediting relative to
present law. Under these conditions, it would no longer be necessary to apply the limitation on a
separate-category basis.
No change would be made to the export source rule under section 863(b), but the benefits of this
rule would be significantly reduced or eliminated in most cases, in view of the narrowed scope of
the foreign tax credit and the likelihood that most taxpayers will be in excess-limitation positions
under the new system (because most high-tax foreign income will be exempted, leaving mostly
low-tax or untaxed foreign-source income in the foreign tax credit system).
Treaties
The proposed system would require the renegotiation of existing income tax treaties, which are
premised on the assumption that the United States will continue to operate a worldwide tax
system. For example, existing treaties generally require the United States to allow foreign tax
credits for foreign corporate income taxes and dividend withholding taxes under 193 certain
circumstances. These treaties would have to be revised to reflect the conversion from a credit
mechanism to an exemption mechanism.
Effective Date
The proposal is generally effective for taxable years of foreign corporations beginning after the
date of enactment, and for taxable years of U.S. shareholders with or within which such taxable
years of such foreign corporations end. The rules dealing with foreign branches are effective for
taxable years of U.S. corporations beginning after the date of enactment.
Discussion
As described above, the present-law deferral system arguably imposes on taxpayers a greater
degree of complexity and distortion of economic decision making than that faced by taxpayers
based in countries with exemption systems, arguably impairing capital import neutrality in some
cases. At the same time, the system allows tax results so favorable to taxpayers in many instances
as to call into question whether it adequately serves the purposes of promoting capital export
neutrality or raising revenue. Although the Congress recognized and addressed some of these
problems in AJCA, significant problems remain. Replacing the worldwide, deferral-based system
with a dividend exemption system arguably would mitigate many of these remaining problems,
while generally moving the system further in the direction charted by the Congress in 2004.
For example, recognizing that deferral-based taxation created an impediment to repatriating
certain foreign earnings, the Congress in 2004 provided a temporary window during which
foreign earnings could be repatriated at a reduced rate of tax. This legislation reduced the tax
impediment to repatriating existing earnings, but as a temporary provision, it left this impediment
in place with respect to future earnings. Indeed, to the extent that taxpayers may expect the
provision to be adopted again as a fiscal stimulus response to a future downturn, they may be
even less likely to repatriate earnings at full tax cost after the temporary window than they were
before the window. Adopting a dividend exemption system would remove the repatriation
disincentive permanently, in a manner generally consistent with steps that the Congress has
already taken on a temporary basis.
More broadly, the Congress made a number of changes to the international tax provisions of the
Code that will promote greater capital import neutrality. Most significantly in this regard, the
foreign tax credit rules were amended in a number of ways in order to reduce the burden on U.S.
taxpayers of the foreign tax credit limitation./426/ More limited changes were made outside the
foreign tax credit area, but these changes also generally moved the system in the direction of
greater capital import neutrality./427/ Adopting a dividend exemption system would further
promote capital import neutrality in many cases, as U.S. corporations no longer would need to
contend with the possibility of residual U.S. taxation with respect to most types of foreign
business income. Adopting a dividend exemption system also would specifically promote the
Congress's demonstrated goal of further simplifying the foreign tax credit regime, as the regime
would be rendered inapplicable to most foreign business income, which would simply be exempt
from U.S. tax under the system. Application of the foreign tax credit regime on a more limited
basis would reduce the amount of income and activity subject to these complex rules, and would
allow further simplifying changes to be made to them, including the elimination of separate
limitation categories.
While the Congress made sweeping changes to the foreign tax credit regime in 2004, the
Congress made no similarly sweeping changes with respect to the anti-deferral regimes. The
complexity of these regimes, the distortions that they produce, and their diminishing
effectiveness in promoting capital export neutrality are all problems that remain to be solved. The
seriousness of these problems, and the appropriateness of various possible solutions, are not
significantly affected by moving to a dividend exemption system. Under either type of system,
effective regimes are needed to prevent the avoidance of tax through shifting income into low-tax
jurisdictions, without unduly interfering
with the operation of nontax-motivated business structures. Accordingly, the desirability of
various proposals that the Congress may wish to consider in this area is largely independent of
the question of whether to adopt a dividend exemption system or to retain the present-law
worldwide, deferral-based system -- in either case, certain categories of passive or highly mobile
foreign income must be defined and subjected to immediate U.S. tax./428/
Although moving from the present-law system to a dividend exemption system broadly
promotes capital import neutrality, such a move also should serve to promote capital export
neutrality in a few respects. For example, in cases in which indefinite deferral and cross-crediting
of high-tax dividends with low-tax royalties may produce results more advantageous to a
taxpayer than the results available under a typical dividend exemption system, capital export
neutrality may be improved by shifting to dividend exemption. In addition, the disallowance of
deductions for interest and overhead expenses allocable to exempt income may have the effect of
promoting capital export neutrality, although this effect would be offset to some extent by
exemption itself./429/
Thus, like any other system, the proposed system would result in a compromise between these
two efficiency norms, but arguably a better compromise, involving less complexity and fewer
distortions than the present-law system. On the other hand, the continued need for provisions like
subpart F and the inter-company pricing rules means that significant complexity will remain, and
the transition from the present-law system to the proposed system will create significant
complexities of its own./430/
Some have expressed a concern that switching from a deferral system to an exemption system
might cause U.S. investment to flow out of the United States and into lower-tax countries,
because permanent exemption is thought to be significantly more attractive than the deferral
available under present law. While such an incentive may arise in certain circumstances, there is
little evidence that this would generally be the case. First, as discussed above, the indefinite
deferral available under present law is in many cases no worse a tax result for taxpayers than the
tax results available under a dividend exemption system. Second, as long as the exemption
system maintains anti-avoidance provisions of present law, such as subpart F and the transfer
pricing rules of sections 482 and 367(d), problems of tax avoidance should be similar under both
types of system./431/ Third, the disallowance of deductions for expenses allocable to exempt
income should serve as a brake on any incentive to move investments and activities offshore, as
the exemption achieved by such a shift may come at a cost of greater deduction
disallowance.
Economists who have studied how moving to a dividend exemption system might affect the
location incentives of U.S. corporations find no definitive evidence that incentives would be
significantly changed. Two recent studies examine how the incentive to invest in low-tax
locations abroad would be affected if the United States were to move to a dividend exemption
system similar to the one described here./432/ In both studies, the authors consider dividend
exemption systems that impose allocation rules similar to those of present law so that some
portion of deductions for interest and overhead expenses incurred by the U.S. parent company
and allocated to exempt foreign income are disallowed as deductions from U.S. taxable income.
One study concludes that under dividend exemption, the effective tax rate on U.S. investment in
low-tax locations would actually increase relative to the system in place prior to AJCA./433/
Although active foreign business income would avoid U.S. residual taxation, the loss of
the ability to shield U.S. tax on foreign royalties through cross-crediting and to claim deductions
for overhead and interest expense at home (or in other high-tax locations) results in higher tax
burdens in low-tax locations. The second study presents hypothetical effective tax rates for
incremental investment by a U.S. taxpayer in a low-tax subsidiary abroad under the U.S. tax
system in place prior to AJCA and under dividend exemption with expense allocation rules./434/
This study also finds that the tax burden of investing in low-tax countries may increase under
dividend exemption. In addition, the study uses two other approaches to investigate how location
decisions may change under dividend exemption: a comparison of foreign direct investment
patterns for the United States and for two countries which exempt dividends received from
foreign affiliates resident in countries with which they have tax treaties (Germany and Canada)
and an empirical analysis of the extent to which residual U.S. taxes on low-tax foreign earnings
impact the location decisions of U.S. corporations. Neither approach yielded results that would
suggest that location decisions would be significantly altered if the United States were to exempt
dividends from residence country taxation./435/
VII. OTHER BUSINESS PROVISIONS
A. Disallow Deduction for Interest on Indebtedness Allocable to Tax-Exempt Obligations (sec.
265)
Present Law
In general
Present law 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)./436/ This
rule applies to tax-exempt obligations held by individual and corporate taxpayers. The rule also
applies to certain cases in which a taxpayer incurs or carries indebtedness and a related person
acquires or holds tax-exempt obligations./437/ There are two methods for determining the
amount of the disallowance. One method, which applies to all taxpayers other than financial
corporations or dealers in tax-exempt obligations, asks whether a taxpayer's borrowing can be
traced to its holding of exempt obligations. A second method, which applies to financial
corporations and dealers in exempt obligations, disallows interest deductions based on the
percentage of a taxpayer's assets comprised of exempt obligations.
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.
Rules for nonfinancial corporations
General rules
Under IRS rules,/438/ for every taxpayer other than a financial corporation or a dealer in
tax-exempt obligations, an interest deduction generally is disallowed only if the taxpayer has a
purpose of using borrowed funds to purchase or carry tax-exempt obligations (the "tracing rule").
This purpose may be established by direct or circumstantial evidence.
Direct evidence of a purpose to purchase tax-exempt obligations exists if the proceeds of
indebtedness are used for and are directly traceable to the purchase of tax-exempt obligations.
Direct evidence of a purpose to carry tax-exempt obligations exists if tax-exempt obligations are
used as collateral for indebtedness. In the absence of direct evidence, the interest disallowance
rule applies only if the totality of facts and circumstances supports a reasonable inference that the
purpose to purchase or carry tax-exempt obligations exists. In general terms, the tracing rule
applies only if the facts and circumstances establish a sufficiently direct relationship between the
borrowing and the investment in tax-exempt obligations.
Two-percent de minimis exception
Under IRS rules, an interest deduction generally is not disallowed to an individual if during the
taxable year the average adjusted basis of the individual's tax-exempt obligations is two percent
or less of the average adjusted basis of the individual's portfolio investments and trade or
business assets. For a corporation an interest deduction generally is not disallowed if the average
adjusted basis of the corporation's tax-exempt obligations is two percent or less of the average
adjusted basis of all assets held in the active conduct of the corporation's trade or business. These
two-percent safe harbors do not apply to dealers in tax-exempt obligations or to financial
institutions.
Interest on installment sales to State and local governments
If a corporation holds tax-exempt obligations (installment obligations, for example) acquired in
the ordinary course of its business in payment for services performed for, or goods supplied to,
State or local governments, and if those obligations are nonsalable, the interest deduction
disallowance rule generally does not apply./439/ The theory underlying this rule is that a
corporation holding tax-exempt obligations in these circumstances has not incurred or carried
indebtedness for the purpose of acquiring those obligations.
Rules for financial corporations and dealers in tax-exempt obligations
A financial institution generally is denied a deduction for that portion of its interest expense (not
otherwise allocable to tax-exempt obligations) that equals the ratio of the financial institution's
average adjusted basis of tax-exempt obligations acquired after August 7, 1986 to the average
adjusted basis of all the taxpayer's assets (the "pro-rata rule")./440/ In the case of an obligation of
an issuer that reasonably expects not to issue more than $ 10 million in tax-exempt obligations
within a calendar year (a "qualified small issuer"), the general pro-rata rule does not apply.
Instead, only 20 percent of the interest allocable to the tax-exempt obligations of a qualified
small issuer is disallowed./441/ The special rule for qualified small issuers also applies to certain
aggregated issuances of tax-exempt obligations in which more than one governmental entity
receives benefits./442/ A rule similar to the pro-rata rule applies to dealers in tax-exempt
obligations, but there is no exception for qualified small issuers, and the 20-percent disallowance
rule does not apply./443/
Reasons for Change
The tracing rule requires an inquiry into a taxpayer's intent in borrowing. A taxpayer's deduction
for the interest expense of borrowing is subject to the
tracing rule only if the taxpayer intends to use the proceeds of the borrowing to buy or carry
tax-exempt obligations. Because intent is difficult to determine, and because a firm's funds are
fungible, the tracing rule has proven difficult to administer and easy to avoid. In particular,
related corporations have avoided the tracing rule by engaging in borrowing through one
corporation and the holding of exempt obligations by another corporation. Moreover, the
two-percent de minimis exception provides a safe harbor for a certain amount of tax
arbitrage.
Description of Proposal
The proposal extends to all corporations (other than insurance companies) the pro-rata rule
applicable to financial institutions under present law. Accordingly, except in limited
circumstances (described below), the proposal repeals the tracing rule, and it repeals the
two-percent de minimis exception provided by IRS guidance. The proposal retains the
present-law scope of the qualified small issuer exception. The proposal retains the present-law
exception for interest on installment sales to State and local governments and extends the
exception to taxpayers that become subject to the pro-rata rule under this proposal.
The proposal applies the pro-rata rule to related persons by treating (1) all members of the same
affiliated group as one taxpayer/444/ and (2) any interest in a partnership held by the taxpayer as
a direct ownership interest by the taxpayer in its allocable share of partnership assets and
liabilities. In addition, the proposal applies the present-law tracing rule to all other related
persons by treating those persons and the taxpayer as a single entity./445/ For example, if one
taxpayer borrows with the purpose that a related person will hold tax-exempt obligations (and the
taxpayer and related person are not members of an affiliated group),/446/ the tracing rule applies
to the taxpayer's borrowing.
Effective Date
The proposal is effective for taxable years beginning on or after the date of enactment.
Discussion
The proposal reflects the fact that money is fungible and, therefore, all debt of the taxpayer
finances its proportionate share of all of the taxpayer's assets, including tax-exempt obligations.
The proposal offers at least two specific advantages over present law. First, because the proposal
replaces a subjective inquiry into the taxpayer's purpose for borrowing (that is, the tracing rule)
with an objective formulary rule (that is, the pro-rata rule), the proposal is easier than present law
for the IRS and taxpayers to apply. Second, the proposal more effectively prevents taxpayers
from avoiding interest deduction disallowance through the use of related parties./447/
As a general matter, curtailing the amount of debt capital available for the purchase of
tax-exempt obligations requires issuers of those obligations to pay higher yields to attract
purchasers -- in particular, purchasers for whom the tax exemption is less valuable than it is to
taxpayers subject to the highest marginal tax rate. Consequently, disallowing interest expense
deductions for leveraged purchases of tax-exempt obligations may erode the subsidy to State
and local governments provided by tax-exempt obligations, and strengthening the rules could
further reduce the subsidy by increasing those governments' borrowing costs.
There are three related responses to this argument. First, without the interest disallowance rules,
tax arbitrage would be permitted. Analysts note that unrestricted arbitrage opportunities should
make the implicit subsidy of tax-exempt bond finance fully efficient in the sense that the revenue
loss of the Federal government would exactly equal the reduced interest cost of the State or local
issuer. However, given the uniqueness of many tax-exempt bond issues, the practice of private
placement without competitive bidding, and several other factors, some doubt that full efficiency
of the subsidy to interest cost would ever be achieved. If full efficiency is not attained,
opportunities for tax arbitrage remain. Many observers view arbitrage transactions in which tax
deductions support the earning of wholly or partially exempt income by profitable corporations
and high-income individual taxpayers (both high marginal tax rate taxpayers) as corrosive to
voluntary compliance and respect for the fairness of the Code, even if those taxpayers, at the
margin, are not materially better off than if they had not engaged in tax arbitrage transactions.
Any such arbitrage creates revenue loss to the Federal government. Second, although arbitrage
intended to be curbed by the proposal exists under present law, strengthening the interest expense
disallowance rule might not raise borrowing costs significantly. At least one study suggests that
most non-financial corporations do not hold debt and tax-exempt bonds simultaneously or do so
at a level below the two-percent de minimis exception described above./448/ Thus, any change in
demand for tax-exempt bonds that results from the proposal may have little (if any) effect on the
price and yields of tax-exempt bonds. Third, if the impact on State and local governments is
minimal, this impact might be outweighed by the advantages of replacing a subjective rule (that
is, the tracing rule) that has proven avoidable and difficult to apply with an objective rule (that is,
the pro-rata rule) that is less avoidable and easier to apply.
Extending the pro-rata rule to all corporations may increase the compliance burden by forcing
corporations, including firms with small holdings of tax-exempt bonds, to engage in annual
calculations of the proportion of their assets represented by exempt obligations. On the other
hand, the two-percent de minimis exception and the difficulty of applying the tracing rule permit
corporations under present law to engage in tax arbitrage, albeit on a limited scale. The pro-rata
rule will prevent this arbitrage.
The proposal neither extends to non-financial corporations nor repeals the qualified small issuer
exception./449/ The present law exception is intended to ensure that small borrowers do not face
additional obstacles to debt financing due to the insignificant volume of their issuances. The
exception allows qualified small issuers, which may not have access to State bond banks, to
borrow funds directly from financial institutions without the application of the interest
disallowance rule. Nonfinancial corporations do not participate in small issuances to the same
extent as financial institutions.
The proposal retains the present-law exception for interest on installment sales to State and local
governments and extends it to taxpayers that become subject to the pro-rata rule under this
proposal. A taxpayer that makes an installment sale to a State or local government might have
outstanding borrowings and therefore may be engaged in the arbitrage that the pro rata
rule generally is intended to prevent. The taxpayer in this situation, however, is holding an
installment obligation as payment for services, not for investment. Although the pro-rata rule
generally does not inquire into a taxpayer's purposes in borrowing and in holding exempt
obligations, lack of investment intent makes the installment sale context fundamentally different
from the ordinary holding of exempt obligations. Consequently, an exception from the pro-rata
rule is appropriate.
B. Modify Recapture of Section 197 Amortization (sec. 1245)
Present Law
Taxpayers are entitled to recover the cost of amortizable section 197 intangibles using the
straight-line method of amortization over a uniform life of fifteen years./450/ With certain
exceptions, amortizable section 197 intangibles generally are purchased intangibles held by a
taxpayer in the conduct of a business./451/
Gain on the sale of depreciable property must be recaptured as ordinary income to the extent of
depreciation deductions previously claimed,/452/ and the recapture amount is computed
separately for each item of property. Section 197 intangibles, because they are treated as property
of a character subject to the allowance for depreciation,/453/ are subject to these recapture
rules.
Reasons for Change
Under present law, it is difficult for the IRS to ensure that taxpayers recognize the appropriate
amount of ordinary income recapture when multiple intangible assets are sold as part of a single
transaction. Because ordinary income is recaptured only to the extent of ordinary deductions
previously claimed with respect to each individual asset, taxpayers have an incentive to allocate
less of the sales proceeds to intangible assets with respect to which significant amortization
deductions have been claimed. Congress enacted section 197 to reduce controversies between
taxpayers and the IRS with respect to acquisition of intangible assets,/454/ but the potential for
controversy remains with respect to the subsequent disposition of section 197 intangibles.
Description of Proposal
Under the proposal, if multiple section 197 intangibles are sold (or otherwise disposed of) in a
single transaction or series of transactions, the seller must calculate recapture as if all of the
section 197 intangibles were a single asset. Thus, any gain on the sale (or other disposition) of
the intangibles is recaptured as ordinary income to the extent of ordinary depreciation deductions
previously claimed on any of the section 197 intangibles. The proposal applies regardless of
whether the intangibles were acquired as part of the same acquisition.
If the sale transaction includes an intangible whose adjusted basis exceeds its fair market value,
such intangible is not subject to recapture and is excluded from this aggregate calculation. The
loss on such intangible continues to be permitted to the extent it is permitted under present
law./455/
Effective Date
The proposal is effective for dispositions of property after the date of enactment.
Discussion
Section 197 was enacted in 1993 to minimize disputes regarding the proper treatment of
acquired intangible assets by creating a uniform method and period for cost recovery. Where a
taxpayer acquires multiple intangible assets as part of a single acquisition of a trade or business,
the uniform 15-year amortization period minimizes the incentive for taxpayers or the IRS to
manipulate or challenge the valuation of (or allocation of basis among) the various intangible
assets. However, upon disposition of multiple intangible assets, the sales price allocation affects
the amount of recapture. Because income is recaptured only to the extent of deductions
previously claimed with respect to each individual asset, taxpayers have an incentive under
present law to allocate less sales proceeds to intangible assets with respect to which significant
amortization deductions have been claimed.
The following example illustrates present law and the proposal:
Example. -- In year 1, a taxpayer acquires two section 197 intangible assets for a total of $ 45.
Asset A is assigned a cost basis of $ 15 and asset B is assigned a cost basis of $ 30. The
allocation is irrelevant for amortization purposes, as the taxpayer will be entitled to a total of $ 3
per year ($ 45 divided by 15 years).
In year 6, the basis of A is $ 10 and the basis of B is $ 20. Taxpayer sells the assets for an
aggregate sale price of $ 45, resulting in gain of $ 15. The character of this gain depends on the
recapture amount, which depends in turn on the relative sales prices of the individual assets.
Taxpayer has claimed $ 5 of amortization, and therefore has $ 5 of recapture potential, with
respect to A. Taxpayer has claimed $ 10 of amortization, and therefore has $ 10 of recapture
potential, with respect to B.
Under present law, if the sale proceeds are allocated $ 15 to A and $ 30 to B, the gain on assets
A and B will be $ 5 and $ 10, respectively. These amounts match the recapture potential for each
asset, so the full amount of the gain will be recaptured as ordinary income. However, if the sale
proceeds instead are allocated $ 25 to A and $ 20 to B, the full $ 15 gain will be recognized with
respect to A, and only $ 5 (full recapture potential with respect to A) will be recaptured as
ordinary income. The remaining $ 10 of gain attributable to A will be treated as capital gain. No
gain (and thus no recapture) will be recognized with respect to Asset B, and only $ 5 of the $ 15
recapture potential is recognized. This distinction creates an incentive to manipulate the sales
price allocation and increases the potential for disputes, which is the specific circumstance
Congress sought to eliminate with the enactment of section 197.
Under the proposal, the taxpayer calculates recapture as if assets A and B were a single asset.
For purposes of the
calculation, the proceeds are $ 45 and the gain is $ 15. Because a total of $ 15 of amortization
has been claimed with respect to assets A and B, the full $ 15 gain is recaptured as ordinary
income.
This issue is similar to the one addressed by present-law section 197(f)(1), which disallows a
loss on any section 197 intangible if any other section 197 intangible acquired as part of the same
acquisition is retained. While section 197(f)(1) can sometimes operate to defer real economic
losses, it eliminates the potential for disputes over valuation issues. Similarly, the policy of
section 197 is best served by eliminating the significance of the allocation of basis (and sale
proceeds) among individual intangible assets with respect to recapture.
Like section 197 itself, the proposal will not entirely eliminate the controversies in this area.
Specifically, valuation of intangible assets could still be controversial (as it is under present law)
with respect to whether an individual intangible asset is sold at a loss and, therefore, not subject
to the recapture provisions. However, applying the proposal to intangibles sold at a loss would
create an opportunity for taxpayers to circumvent the recapture rules by combining gain and loss
properties in a single transaction to avoid recapture on the gain intangibles. The proposal serves
to eliminate controversies in situations where it is clear that all assets have appreciated in value
relative to their adjusted bases.
A possible alternative approach would require taxpayers to calculate recapture as if the sale
proceeds were allocated such that the gain on each asset was proportional to each asset's
recapture potential. Thus, for recapture purposes only, intangibles with respect to which the
taxpayer had taken the most amortization deductions would be allocated an amount of proceeds
resulting in the greatest gain. The primary benefit of this alternative approach is that it is more
effective in eliminating disputes between the IRS and taxpayers because it applies to all
intangibles, regardless of whether sold at a gain or a loss. However, the proposal is simpler, is
consistent with present-law section 197(f)(1), and does not require taxpayers to calculate
recapture on the basis of an allocation which may be different from the one agreed to by the
parties to the transaction.
C. Modify Application of Income Forecast Method of Depreciation (sec. 167)
Present Law
The cost of motion picture films, sound recordings, copyrights, books, and patents are eligible to
be recovered using the income forecast method of depreciation. Under the income forecast
method, a property's depreciation deduction for a taxable year is determined by multiplying the
adjusted basis of the property by a fraction, the numerator of which is the gross income generated
by the property during the year, and the denominator of which is the total forecasted or estimated
gross income expected to be generated prior to the close of the tenth taxable year after the year
the property was placed in service. Any costs that are not recovered by the end of the tenth
taxable year after the property was placed in service may be taken into account as depreciation in
such year. In general, the adjusted basis of property that may be taken into account under the
income forecast method only includes amounts that satisfy the
economic performance standard of section 461(h). An exception to this rule applies to
participations and residuals.
Under the American Jobs Creation Act of 2004 ("AJCA"), solely for purposes of computing the
allowable deduction for property under the income forecast method of depreciation,
participations and residuals may be included in the adjusted basis of the property beginning in the
year such property is placed in service (even if economic performance has not yet occurred) if
such participations and residuals relate to income to be derived from the property before the close
of the tenth taxable year following the year the property is placed in service./456/ For this
purpose, participations and residuals are defined as costs the amount of which, by contract, varies
with the amount of income earned in connection with such property.
Alternatively, rather than accounting for participations and residuals as a cost of the property
under the income forecast method of depreciation, the taxpayer may deduct those payments as
they are paid, consistent with the Associated Patentees/457/ decision. This may be done on a
property-by-property basis and must be applied consistently with respect to a given property
thereafter.
The inclusion of participations and residuals in adjusted basis beginning in the year the property
is placed in service applies only for purposes of calculating the allowable depreciation deduction
under the income forecast method. For all other purposes, the general basis rules of sections 1011
and 1016 apply. Thus, in calculating the adjusted basis for determining gain or loss on the sale of
an income forecast property, participations and residuals are treated as increasing the taxpayer's
basis only when such items are properly taken into account under the taxpayer's method of
accounting./458/
Reasons for Change
In some cases, the present-law rule relating to participations and residuals allows taxpayers to
deduct costs before they have been paid or incurred. This is because the basis used for calculating
the income forecast deduction can differ from the property's actual adjusted basis. Taxpayers
should not be permitted to deduct costs prior to the time such costs are paid or incurred, under
principles of economic performance that are generally applicable in determining the timing of
deductions.
Description of Proposal
Under the proposal, depreciation deductions under the income forecast method would be
disallowed to the extent that they would cause the adjusted basis for purposes of determining
gain or loss on sale to become negative./459/ Any disallowed deductions will effectively be
carried over by operation of the income forecast formula in subsequent years.
Effective Date
The proposal is effective for property placed in service after the date of enactment.
Discussion
The present-law rule permitting the inclusion of participations and residuals in basis when the
property is placed in service generally is appropriate because the income to which the
participations and residuals relate is included in the denominator of the formula. Effectively, one
must use this "hypothetical basis" rather than the actual basis (for gain or loss purposes) in order
for the formula to work correctly. However, the result becomes inappropriate when the income
forecast depreciation deductions exceed the actual adjusted basis of the property (used to
determine gain or loss) because taxpayers should not be permitted to deduct costs prior to the
time the costs are paid or incurred by the taxpayer. The proposal attempts to prevent this
result.
The operation of the proposal is illustrated in the following example:
Example. -- A taxpayer creates a film with negative costs (i.e., production costs) of $ 100. The
expected revenue stream over each of the next five years is: $ 300, $ 40, $ 40, $ 10, and $ 10,
respectively, for a total of $ 400 expected revenue. The taxpayer is contractually obligated to pay
participations equal to 80 percent of all revenue from the film in excess of $ 350. Thus, the
taxpayer expects to pay a total of $ 40 of participations over the course of years three through
five. Accordingly, the taxpayer uses a basis of $ 140 for purposes of its income forecast
calculation.
For year one, under present law, the taxpayer's income forecast calculation is $ 140 multiplied
by (300/400), which equals $ 105. However, under the proposal the deductible amount is limited
to $ 100 of deductions in year one because economic performance has occurred only with respect
to the first $ 100 of "hypothetical basis" used in the calculation. Because the taxpayer's adjusted
basis in the film is reduced only by the $ 100 allowable deduction, the disallowed $ 5 is carried
over by operation of the income forecast formula to subsequent years.
The proposal allows taxpayers to use the "hypothetical basis" to determine their tentative income
forecast deduction as under present law, but disallows the tentative deduction to the extent it
would cause the taxpayer's true adjusted basis in the property to go below zero. The disallowed
amount is allowed in a future year when the true adjusted basis would not be reduced below zero,
when the taxpayer has paid or incurred the costs and included them in basis, consistent with
principles of economic performance.
D. Apply Luxury Automobile Limitations to Sport Utility Vehicles (sec. 280F)
Present Law
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, passenger
automobiles generally are recovered over five years.
In lieu of depreciation, a taxpayer with a sufficiently small amount of annual investment may
elect to expense such investment under section 179. The Jobs and Growth Tax Relief
Reconciliation Act of 2003 ("JGTRRA")/460/ increased the amount a taxpayer may deduct, for
taxable years beginning in 2003 through 2005, to $ 100,000 of the cost of qualifying property
placed in service for the taxable year. 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.
The $ 100,000 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 $ 400,000. The American
Jobs Creation Act of 2004 ("AJCA")/461/ extends the temporary $ 100,000/$ 400,000
modifications to section 179 through 2007. Prior to the enactment of JGTRRA (and for taxable
years beginning in 2008 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 $
200,00