Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647)

VIII. ACCOUNTING PROVISIONS (sec. 108 of the bill)

The bills are divided into two titles: Title I provides technical corrections to the Tax Reform Act of 1986 ("Reform Act") (P.L. 99-514); and Title II provides technical corrections to other recently enacted tax legislation: the Superfund Revenue Act of 1986 (P.L. 99-499), the Harbor Maintenance Revenue Act of 1986 (P.L. 99-662), the Omnibus Budget Reconciliation Act of 1986 (P.L. 99-509), and the Omnibus Budget Reconciliation Act of 1987 (which includes the Revenue Act of 1987, the Pension Protection Act, the vaccine excise tax provisions, and Social Security Act amendments) (P.L. 100-203). Provisions in the bills for which no descriptions are provided are clerical in nature or are transition rules.

The amendments made by the Technical Corrections Act of 1988 are intended to correct, clarify, or conform various recently enacted tax provisions. Provisions in the bills are generally effective as if included in the original legislation, unless otherwise indicated.

1. Rate of tax with respect to certain unclaimed cash

(sec. 101(a)(1) of the bill, sec. 101 of the Reform Act, and sec. 6867 of the Code)

These rules provide that the cash is presumed to represent gross income of a single individual and that the collection of tax will be jeopardized by delay. Under present law, such income is taxable to the possessor of the unclaimed cash at a 50-percent rate (sec. 6867(b)), i.e., the highest income tax rate imposed by Code section 1 as in effect immediately prior to the rate reductions made by the Act.

2. Rate of accumulated earnings tax

(sec. 101(a)(2) of the bill, sec. 101 of the Reform Act, and sec. 531 of the Code)

3. Phaseout of personal exemptions for married taxpayer filing separate return

(sec. 101(a)(3) of the bill, sec. 101 of the Reform Act, and sec. 1(g) of the Code)

4. Standard deduction and filing requirement for elderly or blind dependents

(secs. 101(b)(1)-((2) of the bill, sec. 102 of the Reform Act, and secs; 63(c)(5) and 6012(a) of the Code)

The additional standard deduction amount is $600 for an elderly or blind individual who is married (whether filing jointly or separately) or is a surviving spouse; the additional amount is $1,200 for such an individual who is both elderly and blind. An additional standard deduction amount of $750 is allowed for a head of household who is elderly or blind ($1,500, if both), or for a single individual (i.e., an unmarried individual other than a surviving spouse or head of household) who is elderly or blind ($1,500, if both). Thus, for example, for 1987 and 1988 a single elderly individual is entitled to a basic standard deduction of $3,000 plus an additional standard deduction of $750, for a total of $3,750.

Under the Act, the standard deduction for an individual who may be claimed as a dependent on another taxpayer's return is limited to the greater of $500 or the amount of the individual's earned income (Code sec. 63(c)(5)). The filing threshold for such an individual is the amount of standard deduction that is allowable (sec. 6012(a)(1)(C)).

Accordingly, an elderly or blind individual who may be claimed as a dependent on another taxpayer's return may claim a basic standard deduction up to the greater of $500 or the amount of earned income, plus the additional standard deduction amount (e.g., $600 for a married taxpayer). Since this additional standard deduction amount is not limited by the amount of the dependent's earned income, it may be applied against any remaining income (earned or unearned) that has not been offset by the allowance of the basic standard deduction as described above.

Section 6012(a)(1)(C)(i), which relates to the filing threshold for certain individual taxpayers, is amended to conform to the modification to section 63(c)(5). Thus, for example, an unmarried elderly individual who may be claimed as a dependent on her daughter's tax return was required to file a return for 1987 only if the elderly individual either (1) had total gross income exceeding $3,750 or (2) had unearned income exceeding $1,250.

5. Third-party reimbursements

(sec. 101(b)(3) of the bill, sec. 132 of the Reform Act, and secs. 62 and 527 of the Code)

The bill also includes a conforming change to the provision relating to the tax treatment of political organizations (sec. 527). Thus, for example, a State-elected official could be reimbursed by an account authorized under State law (and properly qualified under the Code) to pay the official's office expenses. To the extent those expenses are otherwise deductible business expenses and the reimbursement does not exceed those expenses, the State official would be permitted an above-the-line deduction for those expenses.

6. Rule for inflation adjustments to earned income credit

(sec. 101(c) of the bill, sec. 111 of the Reform Act, and sec. 32(i) of the Code)

7. Cross-references to scholarship exclusion provisions in private foundation rules

(sec. 101(d)(1) of the bill, sec. 123 of the Reform Act, and secs. 4945(g)(1) and 4941(d)(2)(G) of the Code)

8. Treatment of certain scholarship or fellowship grants to nonresident aliens

(sec. 101(d)(2) of the bill, sec. 123 of the Reform Act, and secs. 1441(b) and 871(c) of the Code)

Under prior law, a nondegree candidate could exclude from gross income under section 117 a limited amount of a scholarship or fellowship granted by an educational institution or other tax-exempt organization described in section 501(c)(3), a foreign government, certain international organizations, or a Federal, State, or local government agency. The prior-law exclusion for a nondegree candidate in any one year could not exceed $300 times the number of months in the year for which the recipient received scholarship or fellowship grant amounts, and no further exclusion was allowed after the nondegree candidate had claimed exclusions for a total of 36 months (i.e., a maximum lifetime exclusion of $10,800). However, this dollar limitation did not apply to that portion of the scholarship or fellowship received by the nondegree candidate for travel, research, clerical help, or equipment.

The Act repeals the limited prior-law exclusion under section 117 for grants received by nondegree candidates. As a result, scholarship or fellowship grants received by nonresident aliens who are nondegree candidates are subject to withholding at a 30-percent rate, and to U.S. tax on a gross income basis, since no amount of such grants is "incident to a qualified scholarship to which section 117(a) applies."

The Act also provides that in the case of a scholarship or fellowship grant received by a degree candidate, an exclusion under section 117 is available only to the extent the individual establishes, in accordance with the conditions of the grant, that the grant was used for (1) tuition and fees required for enrollment or attendance of the student at an educational institution (within the meaning of sec. 170(b)(1)(A)(ii)), and (2) fees, books, supplies, and equipment required for courses of instruction at the educational institution.

As under present law, withholding at 14 percent and taxation on a net income basis apply to amounts received by a nonresident alien who is a degree candidate that are incident to a qualified scholarship or fellowship to which section 117(a) applies, but only to the extent includible in gross income (e.g., amounts received for room, board, or travel).

The bill applies the above rules to "M" visa holders as well as "F" and "J" visa holders.²

9. Coordination of two-percent floor and certain other deduction limitation provisions

(sec. 101(f)(1) of the bill, sec. 132 of the Reform Act, and sec. 67 of the Code)

This clarification is consistent with the general rule under the Act to apply certain deduction limitation provisions in the following order: first, provisions disallowing a percentage of a deduction (e.g., sec. 274(n), generally limiting meal and entertainment deductions to 80 percent of the amount otherwise allowable); second, provisions disallowing a fixed dollar amount of certain deductions (e.g., the two-percent floor on miscellaneous itemized deductions); and third, provisions establishing a deduction ceiling (e.g., the $3,000 limit in the last sentence of sec. 162(a) and certain dollar limitations in sec. 217 on deductions for moving expenses).

10. Application of two-percent floor to trusts and estates

(secs. 101(f)(2), (3), and (4) of the bill, sec. 132 of the Reform Act, and sec. 67 of the Code)

Section 67(e) provides that, for purposes of section 67, adjusted gross income (AGI) of an estate or trust is computed in the same manner as for an individual, except that certain costs paid in connection with the administration of the estate or trust are treated as allowable in arriving at AGI. The provision does not state the treatment, for purposes of section 67, of deductions under sections 651 and 661 (relating to certain amounts distributed by a trust or estate).

Section 67(c) provides that Treasury regulations generally are to (1) prohibit the indirect deduction through pass-through entities of amounts that are not allowable as a deduction if paid or incurred directly by an individual, and (2) contain such reporting requirements as are necessary to accomplish this object. Such regulatory authority does not, however, apply with respect to estates or trusts.

In addition, the bill provides that the distribution deductions allowable to an estate or trust under sections 651 and 661 are treated as allowable in computing AGI of the estate or trust. Similarly, deductions for costs paid or incurred in connection with the administration of an estate or trust, and which would not have been incurred if the property were not held in such trust or estate, are treated as allowable in computing AGI of the estate or trust. Thus, deductions under sections 651 and 661, and such administrative costs of an estate or trust, are not limited under the new two-percent floor, and are treated as allowable in arriving at AGI of the trust or estate for purposes of section 67.

The bill modifies sections 67(c) and 67(e) to provide that the regulatory authority of the Treasury with regard to indirect deductions through pass-through entities shall not, except as provided in regulations, apply to estates and trusts. Under this provision, the Treasury has regulatory authority to apply the two-percent floor at the beneficiary level, rather than at the entity level, with respect to trusts required to distribute income currently.

11. Clarification of exceptions to certain rules limiting meal and entertainment deductions

(secs. 101(g)(1), (2), and (3) of the bill, sec. 142 of the Reform Act, and secs. 274(k)(2), 274(m)(1), and 274(n)(2) of the Code)

The bill also provides that the Treasury has regulatory authority to provide additional exceptions to the taxpayer-presence requirement in section 274(k)(2). For example, an exception could be provided for meal expenses of the taxpayer's spouse and children incurred by them as moving expenses deductible pursuant to section 217, even though the taxpayer traveled separately to the new job location. As a further example, the taxpayer-presence requirement could be waived by Treasury regulations in the situation in which a business reimburses away-from-home meal expenses of a job applicant who travels to the business location the night before his or her job interview and has a meal alone in the hotel where he or she is staying.

12. Applicability of percentage reduction rule to meal costs deductible as moving expenses

(sec. 101(g)(4) of the bill, sec. 142 of the Reform Act, and secs. 274(n), 3121(a)(11), 3306(b)(9), and 3401(a)(15) of the Code)

Also, the bill resolves a problem involving circular provisions concerning application of the percentage reduction rule with respect to certain reimbursed meal costs deductible as moving expenses, under which the meal reimbursement is excluded from wages for employment tax purposes to the extent it is deductible, but the extent of deductibility depends on whether or not the reimbursement is treated as wages. Under the bill, meal reimbursements are excludable from wages for employment tax purposes to the extent that at the time of payment of such remuneration, it is reasonable to believe that a corresponding deduction is allowable under section 217 as determined without regard to the percentage reduction rule.

13. Home office deduction rules

(sec. 101(h) of the bill, sec. 143 of the Reform Act, and sec. 280A(c) of the Code)

Under the mid-quarter convention, property that is placed in service during any quarter of a taxable year (or disposed of during any quarter of a taxable year) is treated as placed in service (or disposed of) on the mid-point of the quarter. The mid-quarter convention applies only to property that is subject to the accelerated cost recovery system as modified by the Act ("modified ACRS").

The bill also provides that property that is placed in service and disposed of within the same taxable year is disregarded for purposes of making the 40 percent determination. In applying the 40 percent test, depreciable basis is to be used rather than cost or any other measure of property placed in service.

Further, the anti-churning rule is inapplicable to property to which modified ACRS applied in the hands of the transferor.

Finally, with respect to property that is subject to the anti-churning rule, the depreciation deduction is to be determined under the law in effect before the enactment of the Tax Reform Act of 1986. Thus, in the case of property that was placed in service by the transferor before January 1, 1981, the transferee would be subject to the pre-1981 depreciation rules. Similarly, for property that was subject to ACRS (before amendment by the Act) in the hands of the transferor, the transferee would be subject to the pre-1987 ACRS rules (including the pre-1987 ACRS anti-churning rules).

The bill clarifies that the "step in the shoes" rule applies to transactions between members of an affiliated group of corporations filing a consolidated return. In addition, the Act was not intended to apply to a mere change in form of ownership not involving a sale or exchange. For example, the change from ownership as tenants-in-common to condominium ownership not involving percentage ownership would not require the owners to begin depreciating the property over a new period.

The bill deletes the exception for transactions to which the anti-churning rule applies.

The bill also clarifies the application of the expensing limitations for taxable years (other than a calendar year) that include January 1, 1987. First, the cost of any qualifying property that is placed in service before January 1, 1987, and that is expensed under the law in effect before the effective date of the amendments made by the Act reduces the amount of qualifying property that is eligible to be expensed under the Act. For example, if a fiscal year taxpayer elects to expense $4,000 of qualifying property that is placed in service before January 1, 1987, then the maximum amount of qualifying property placed in service during the same taxable year and on or after January 1, 1987, that is eligible to be expensed is $6,000.

Second, all qualifying property that is placed in service during a fiscal year that includes January 1, 1987, is to be taken into account in determining whether the $200,000 limitation has been exceeded for such fiscal year. If the $200,000 limitation has been exceeded for a fiscal year the includes January 1, 1987, only the amount of property placed in service during the same taxable year and on or after January 1, 1987, that is eligible to be expensed would be reduced by the excess. Finally, the taxable income derived from an active trade or business for purposes of the taxable income limitation equals the taxable income for the entire fiscal year reduced by the cost of property that was expensed for that year under the law in effect before the effective date of the amendments made by the Act.

The Act provides certain exceptions to the general effective date. Under these exceptions, transition property generally must be placed in service by a prescribed date that is determined by reference to the ADR midpoint for the property. Property that is described in a transition rule contained in section 204(a) of the Act is treated as having an ADR midpoint of 20 years and, thus, generally must be placed in service before January 1, 1991.

The bill also clarifies that the transitional rule for sale-lease-backs applies to property that would have qualified for transitional relief in the absence of the sale-leaseback (e.g., property that is not placed in service by the original owner before the sale-leaseback) and to property where the original owner is a sublessee if all the other requirements for transitional relief are satisfied.

The bill also clarifies that modified ACRS applies to any real property, including a personal residence, that was acquired before January 1, 1987, and converted from personal use on or after such date to a use for which depreciation is allowable without regard to the rules for churning transactions.

For purposes of the general transitional rules, all members of the same affiliated group of corporations (within the meaning of section 1504 of the Code) filing a consolidated return are treated as one taxpayer.

For purposes of the binding contract rule, a purchase order will be treated as a binding contract even if not captioned as such, provided it is an order under a supply agreement for a specific number of properties based on the pricing provisions of the supply agreement. Clauses specifying settlement charges and adjustment charges to be paid by a buyer who purchases less than a minimum quantity of items under a volume supply agreement are not liquidated damages clauses unless the volume supply agreement defines them as the sole remedy of the seller and the sole liability of the buyer.

The bill makes other clarifying amendments to transitional rules of more limited application, including -- but not limited to -- clarifications that (1) the general rule for property financed with tax-exempt bonds does not override more specific transitional rules (such as the transitional rule for solid waste disposal facilities); and (2) the rule for finance leases of farm equipment incorporates the amendments made by the Tax Reform Act of 1984.

2. Investment tax credit

The bill also clarifies that the 35-percent reduction applies to ITC carryforwards used in a taxable year ending after June 30, 1987, irrespective of when the property with respect to which the credit is claimed was placed in service. For taxable years that straddle July 1, 1987, the bill clarifies that the amount added to carryforwards bears the same ratio to the carryforwards from the taxable year (before inclusion of the additional amount) as the reduction of the credit bears to the sum of the current year credit for the taxable year and the carryforwards to the taxable year, less the reduction of the credit under section 49(c)(3).

The bill clarifies that the order in which the components of the general business credit and the subcomponents of the investment tax credit arising during any taxable year are used generally is the order in which the credits are listed in the applicable Code section as of the close of the taxable year in which the credit is used. This ordering rule applies, for example, for purposes of determining the portion of a current year business credit or business credit carryforward that is subject to the 35-percent reduction. The bill repeals section 49(c)(5)(C) because the enactment of the general ordering rule renders unnecessary the ordering rule contained in section 49(c)(5)(C).

The bill also makes clarifying amendments to transition rules of limited application.

The amount of ITC carryforwards that are taken into account in determining the amount treated as a payment of tax is not taken into account under section 38 for any other taxable year. For example, if the available ITC carryforwards are $100,000 and the net tax liability during the carryback period is $40,000, then the amount of ITC carryforwards available for future taxable years would equal $20,000.

In the case of an electing corporation that is a member of an affiliated group of corporations that filed a consolidated tax return during any portion of the carryback period, the Act contemplates that the Internal Revenue Service will reduce the administrative burden of complying with this requirement -- for example, by permitting the use of pro forma statements.

(sec. 102(i) of the bill, sec. 241 of the Reform Act, and sec. 167 of the Code)

No amortization or depreciation deduction is intended to be allowed for trademark or trade name expenditures.

2. Railroad grading or tunnel bores

(sec. 102(i) of the bill, sec. 242 of the Reform Act, and sec. 167 of the Code)

No amortization or depreciation deduction is intended to be allowed for such expenditures.

(sec. 102(k) of the bill and sec. 251 of the Reform Act)

Under a provision included in the capital cost recovery section (discussed above), the bill clarifies that property eligible for a 25-percent credit under a transitional rule is not subject to the full basis adjustment requirement.

The bill also includes amendments with respect to other transitional rules of more limited application.

2. Tax credit for low-income rental housing

(sec. 102(l) of the bill, sec. 252 of the Reform Act, and sec. 42 of the Code)

New construction and rehabilitation expenditures for low-income housing projects placed in service in 1987 are eligible for a maximum nine percent credit, claimed annually for ten years. The acquisition cost of existing buildings and the cost of newly constructed buildings receiving other Federal subsidies (e.g., tax-exempt bond financing) placed in service in 1987 are eligible for a maximum four percent credit, also claimed annually for ten years. For buildings placed in service after 1987, these credit percentages will be adjusted to maintain a present value of 70 percent and 30 percent for the two types of credits, and will be determined monthly for property placed in service in each month.

To qualify, a low-income housing project must satisfy a low-income set-aside requirement of either (1) 20 percent of the units occupied by persons having incomes of 50 percent or less of area median income, or (2) 40 percent of the units occupied by persons having incomes of 60 percent or less of such area income. A special additional requirement applies to projects satisfying a specified rent-skewing requirement.

The credit amount is based on the qualified basis of the housing units serving the low-income tenants. Qualified basis is the portion of the basis of the building (eligible basis) attributable to low-income housing units. Basis of units whose cost is disproportionate to that of the low-income housing units is excluded from eligible basis.

Rents that may be charged families in units on which a credit is claimed may not exceed 30 percent of the applicable income qualifying as "low", adjusted for family size. Section 8 payments are excluded in determining the amount of rent a tenant pays for purposes of this 30-percent limit.

To qualify for the credit, residential rental property must comply continuously with all requirements of the credit throughout a 15-year compliance period, ² and, in the case of a credit for acquisition, may not have previously been placed in service for at least 10 years (the 10-year rule). A credit allocation from the appropriate State credit authority must be received by the owner of property eligible for the low-income housing tax credit, unless the property is substantially financed with the proceeds of tax-exempt bonds subject to the new private activity bond volume limitation. Allocations are charged against the issuer's credit authority for the year of the allocation. Carryforwards of unused credit authority are not permitted.

The bill provides that, in addition to the method of determining the credit percentage under present law, for buildings placed in service by a taxpayer after 1987 the taxpayer (with the consent of the housing credit agency) may irrevocably elect to determine the credit percentage applicable to the building in advance of the building's placed-in-service date. Such an election will be binding for Federal income tax purposes on the taxpayer, the credit agency, and all successors in interest. The election must be made at the time a binding commitment is received by the taxpayer from the credit agency as to the housing credit dollar amount to be allocated to the building. In the case of a building financed with the proceeds of tax-exempt bonds for which no allocation from a credit agency is required, the election must be made by the taxpayer at the time the tax-exempt bonds are issued. The election must be filed with the Treasury Department by the fifth day of the month following the date the binding commitment is made or the bonds are issued. This election is applicable to credits attributable to new construction, rehabilitation, and acquisition expenditures.

Determination of gross rent

The bill provides that in determining the gross rent that may be paid by a tenant in a low-income unit, payments of State and local rental assistance programs comparable to section 8 of the United States Housing Act of 1937 are not considered. The bill further provides that this definition of gross rent is used for purposes of determining the rent that may be charged to a low-income tenant when applying the elective deep-rent skewing set-aside requirement for certain projects (see sec. 142(d)(4)). (The bill retains the definition of gross rent, which includes all rental assistance payments, used in the determination of the 3:1 rent skewing test also provided for those projects.)

The bill further provides that if a Federal rental assistance payment is made with respect to a low-income unit and the Federal statute (as in effect on October 22, 1986) governing that assistance payment requires that the gross rent paid by the occupants for that unit increase as the income of the occupants increases and that any such increase in the occupants' gross rent reduce equally the Federal rental assistance payment, then the gross rent paid by the tenant may exceed 30 percent of the applicable income limit to the extent required under the applicable Federal housing program statute.

Special rules for multiple building projects

The bill provides new rules for determining whether a building is part of a qualified low-income housing project in the case of multiple building projects. In such a project, buildings need not meet the minimum low-income set-aside requirement only by reference to the order that the buildings are placed in service. If within 12 months of the placed-in-service date of a prior building the project meets the set-aside requirement with respect to the first building and any subsequent buildings placed in service within the 12-month period, then the first building and included subsequent buildings are part of a qualified low-income project. Subsequent buildings not included in determining whether the project satisfies the set-aside requirement with respect to prior buildings have their own 12-month period before they are required to be included in the set-aside determination for the project.

De minimis exception to disproportionate cost limit

The bill permits a portion of the basis of housing units whose cost is disproportionate to that of the low-income units to be included in eligible basis. Unless otherwise provided by Treasury regulations, to be eligible for this exception, the cost per square foot of the disproportionate unit may not exceed by 15 percent the average cost per square foot of the low-income units. If cost differentials exceed 15 percent, the cost of the entire disproportionate unit must be excluded from eligible basis, as under present law.

The bill further provides that costs with respect to which an election was made by the taxpayer to deduct rehabilitation expenditures under prior law section 167(k) may not be included in eligible basis.

Exceptions to 10-year rule

The bill provides several exceptions to the restriction that buildings eligible for an acquisition credit may not have been previously placed in service within 10 years of the date of acquisition. Under these exceptions, a placement in service is disregarded if it is as a result of (1) death, (2) acquisition by a governmental unit or certain qualified 501(c)(3) or 501(c)(4) organizations whose acquisition of the property was at least 10 years after it was previously placed in service, or (3) a foreclosure occurring at least 10 years after the previous placed-in-service date, provided the property is resold within 12 months of such foreclosure.

Amendments affecting State credit authority

The bill provides that the State low-income housing credit authority must allocate credits to a building in the calendar year it is placed in service, unless (1) credits are allocated as the result of additions to qualified basis or (2) the authority makes a binding commitment no later than the last day of such year to allocate a specified amount of credits to the building in a later year. An allocation in a later calendar year pursuant to a binding commitment is counted against the State's credit authority limitation in such later year. Such later allocation does not defer the start of the credit period or the compliance period.

The bill further provides that, if for reasons unforeseen and beyond the control of the taxpayer which occur after an allocation of credit authority to a building, a building cannot be placed in service in the year for which an allocation was made, then upon approval by the Treasury Department, the credit allocation will be valid for that building if the building is placed in service in the first succeeding year after the year of the original allocation. This provision is effective beginning in 1988.

The bill provides that if a corporation is wholly owned by one or more qualified nonprofit organizations and such corporation materially participates in the development and operation of a qualified low-income project, the qualified nonprofit organization(s) will be treated as materially participating in the development and operation of such project for purposes of this section.

Recapture

The bill makes modifications to the rules regarding recapture of the credit. First, the bill provides that there will be no recapture for certain de minimis changes in the qualified basis by reason of changes in floor space of low-income housing units. Second, for partnerships more than 50 percent of which are owned by 35 or more natural persons or estates, the presence of a corporate partner will not exclude the partnership from a special rule under which recapture is determined at the partnership, rather than the partner, level.

Other amendments

The bill clarifies that, similar to other Federally subsidized loans, the proceeds of an issue of tax-exempt obligations used to finance a building may be excluded from eligible basis and the building will not be treated as federally subsidized.

The bill provides that tax-exempt financing or a below market loan used to provide construction financing for a building will not be treated as a Federal subsidy if such loan is repaid and any underlying obligation (e.g., tax-exempt bond) is redeemed before the building is placed in service.

The bill clarifies that designation of a de minimis portion of the gross rent of a low-income housing unit for use towards purchase of the unit by the tenant after expiration of the minimum compliance period for credit projects does not affect a housing project's eligibility for the low-income housing credit.

The bill modifies the at-risk provisions applicable to certain financing from qualified nonprofit organizations in the case of certain federally assisted buildings in which a security interest is not permitted by a Federal agency.

The bill provides certain information reporting requirements on owners of qualified low-income housing projects and imposes a penalty for failure to provide required information.

The bill clarifies that the sunset of credit authority to buildings placed in service after 1990 also applies to buildings financed with the proceeds of tax-exempt bonds not requiring an allocation of credit authority.

The bill provides that credits may not be carried back to taxable years ending before January 1, 1987.

The bill makes clarifying amendments to certain transitional rules of limited application.

The bill also corrects other minor clerical and technical errors.

1. Individual and corporate capital gains

(sec. 103(a)-(c) of the bill, secs. 301-311 of the Reform Act, and various secs. of the Code)

2. Incentive stock options

(sec. 103(d) of the bill, sec. 321 of the Reform Act, and sec. 422A of the Code)

The bill also deletes the $100,000 requirement added by the Act and instead provides that to the extent the aggregate fair market value (determined at the time the option is granted) of stock with respect to which options meeting the requirements of section 422A(b) are exercisable for the first time by any individual during any calendar year (under all plans of the individual's employer corporation and its parent and subsidiary corporations) exceeds $100,000, then such options shall not be treated as incentive stock options. This rule is applied by taking options that meet the requirements of section 422A(b) and are exercisable for the first time in the calendar year into account in the order granted.

1. Treatment of discharge of indebtedness income of certain farmers

(sec. 104(a) of the bill, sec. 405 of the Reform Act, and secs. 108 and 1017 of the Code)

The Reform Act provides that, in the case of a solvent taxpayer who realizes income from the discharge by a "qualified person" of "qualified farm indebtedness," the discharge is treated in the same manner as if incurred while the taxpayer was insolvent. Qualified farm indebtedness is indebtedness incurred directly in connection with the operation of a farming business by a taxpayer who satisfies a specified gross receipts test. The gross receipts test is satisfied if 50 percent or more of the taxpayer's average annual gross receipts for the three taxable years preceding the taxable year in which the discharged indebtedness occurs is attributable to the trade or business of farming. A qualified person is one regularly engaged in the business of lending money and meeting certain other requirements.

Any amount excluded from income under the special rules for qualified farm indebtedness must be used first to reduce tax attributes; then to reduce basis of property other than land used or held for use in a farming business; and finally to reduce the basis of land used or held for use in a farming business (sec. 1017).

The bill provides that, after reducing tax attributes in the order prescribed for insolvent taxpayers, amounts excluded from income under the qualified farm indebtedness provision may be applied to reduce basis in assets used or held for use in a trade or business or for the production of income (i.e., in "qualified property"). Basis reduction occurs first with respect to depreciable property, then with respect to land used in the business of farming, and then with respect to other qualified property.

The amount excluded under this provision may not exceed the taxpayer's total available attributes and basis in qualified property. Accordingly, to the extent there is unabsorbed discharge of indebtedness income after the taxpayer has reduced tax attributes and basis in qualified property, income will be recognized.

2. Retention of capital gains treatment for sales of dairy cattle under milk production termination program

(sec. 104(b) of the bill and sec. 406 of the Reform Act)

The transition provision applies only to gains that would be capital gains under the generally applicable provisions of the law. See, e.g., IRS Notice 87-26, 1987-10 IRB 16. (February 26, 1987). The transition provision does not recharacterize any payments that would not otherwise be capital gains.

3. Recapture of mining exploration expenses

(sec. 104(c) of the bill, sec. 413 of the Reform Act, and sec. 1254 of the Code)

1. Passive loss rules

(sec. 105(a) of the bill, sec. 501 of the Reform Act, and sec. 469 of the Code)

The provision applies to individuals, estates, trusts, and personal service corporations. A special rule prohibits the use of passive activity losses and credits against portfolio income in the case of closely held corporations. Losses and credits attributable to a limited partnership interest generally are treated as arising from a passive activity (except as provided in regulations). Rental activities are defined as passive activities. Special rules provide that up to $25,000 of losses and (deduction equivalent) credits from rental real estate activities (those in which the taxpayer actively participates, with an exception for certain credits) are allowed against other income for the year. Losses from certain working interests in oil and gas property are not limited by the provision. The provision is effective for taxable years beginning after 1986. For certain pre-enactment interests in passive activities, the provision is phased in, and becomes fully effective for taxable years beginning in 1991 and thereafter.

The bill clarifies that amounts not treated as from a passive activity include gain or loss that is not derived in the ordinary course of a trade or business, in the case of a disposition of property held for investment or property that generally produces income in the nature of interest, dividends, annuities or royalties. Gain or loss upon disposition of such property, where the gain or loss is derived in the ordinary course of a trade or business, is not automatically treated as not from a passive activity under this rule; rather, the general rules applicable to determining whether an activity is passive (e.g., whether the taxpayer materially participates) apply.

Dispositions

The bill restates the rules applicable to the allowance of suspended losses upon a disposition of an interest in a passive activity.

In addition, the bill provides that, pursuant to regulations, to the extent necessary to prevent avoidance of the provision, income or gain from a passive activity in taxable years preceding the taxpayer's disposition of the activity is taken into account in determining the amount of the loss allowed against non-passive income upon disposition. Regulatory authority might appropriately be exercised, for example, in situations where passive activities produce taxable passive income in the initial years of an investment and then a loss upon disposition, such as where the investment is structured so that income is recognized in years prior to the allowance of related deductions.

The bill also makes several clerical amendments to the provisions relating to dispositions.

Special rule for rental real estate activities

The bill clarifies the application of the active participation requirement for the allowance of up to $25,000 of losses (or deduction equivalent credits, where applicable) from certain rental real estate activities. The bill provides that the active participation requirement applies both in the year when the loss arose, and in the year when the loss is allowed under the $25,000 allowance. (The active participation requirement does not apply to low income housing or rehabilitation credits otherwise allowable under the $25,000 allowance.)

The bill also modifies the rule that an interest in an activity as a limited partner is not treated as an interest with respect to which the taxpayer actively participates. Under the bill, this rule applies except as otherwise provided in regulations.

The bill also clarifies the application of the passive loss phase-in rule to taxpayers with amounts allowed under the $25,000 rental real estate rule. Under the bill, the general loss disallowance rule of section 469(a) does not apply to the applicable percentage (for example, 65 percent in 1987) of the passive activity loss (or credit) attributable to pre-enactment interests. For this purpose, the portion of the passive activity loss (or credit) attributable to pre-enactment interests is the lesser of (1) the amount of the passive activity loss (or credit) which would be disallowed without regard to the phase-in rules or (2) the amount of the passive activity loss (or credit) which would be disallowed by taking into account only pre-enactment interests and by disregarding both the phase-in rules and the carryover of disallowed loss rules. Thus, for example, assume that in 1987 an individual with a full $25,000 exemption available had a $15,000 loss from pre-enactment rental activities in which the individual actively participated, a $15,000 loss from post-enactment rental activities in which the individual actively participated, and no other income or loss from passive activities. The individual is entitled to deduct $25,000 under the rental real estate rule of section 469(i) but is not entitled to a further deduction under the phase-in rules of section 469(m). This is because the amount of the passive activity loss attributable to pre-enactment interests is the lesser of (1) the amount disallowed without regard to the phase-in rules (i.e. $5,000) or (2) the amount which would be disallowed if only pre-enactment interests were taken into account (i.e. zero, since none of the $15,000 loss attributable to pre-enactment interests would be disallowed if only those interests were taken into account).

Coordination with rental use of dwelling

The bill provides that income, deductions, gain or loss from rental use of a dwelling that the taxpayer uses as a residence (or from certain other business uses of a dwelling), for any taxable year in which deductions from such use are limited to the amount of income from such use under Code section 280A(c)(5), are not taken into account in determining the taxpayer's passive activity loss for the year. This provision eliminates the partial overlap of the deduction limitations imposed by section 280A(c)(5) and by the passive loss rules, principally in the circumstance of rental use of residences, and thus tends to simplify the application of these rules.

Affiliated groups

The bill clarifies that for purposes of the passive loss rule, all members of an affiliated group that files a consolidated tax return are treated as one corporation, except as otherwise provided in regulations.

Trusts and estates

The bill provides that if a trust or estate distributes its entire interest in a passive activity to the beneficiary of the trust or estate, the basis of the property immediately before the distribution shall be increased by the amount of the passive activity losses allocable to the activity. Gain or loss to the trust or estate and the basis of the property in the hands of the beneficiary will then be determined under the usual rules applicable under the Code.

Certain installment sales

The bill treats as income from a passive activity, gain that is recognized in a taxable year beginning after 1986 from the disposition (in a taxable year beginning before 1987) of an interest in an activity that would have been treated as a passive activity within the meaning of section 469. Thus, under the bill, income from passive activities includes post-1986 gain from the pre-1987 installment sale of an activity that the taxpayer can show would have been treated as a passive activity if the passive loss rule had applied in the year of disposition.

The bill also makes clerical amendments to the definition provisions of the passive loss rule.

2. Investment interest limitation

(sec. 105(c) of the bill, sec. 511 of the Reform Act, and sec. 163(d) of the Code)

Investment interest is defined to include interest paid or accrued on indebtedness incurred or continued to purchase or carry property held for investment. For this purpose, property held for investment includes an interest in a trade or business activity that is treated as not a passive activity, but in which the taxpayer does not materially participate, within the meaning of the passive loss rule. Investment interest also includes interest expense allocable to portfolio income under the passive loss rule. Investment income is defined under present law as gross income from, and gain from the disposition of, property held for investment, to the extent such amounts are not derived from the ordinary conduct of a trade or business.

The provisions of the Reform Act affecting the investment interest limitation are phased in, so that the amended provisions become fully effective for taxable years beginning in 1991 and thereafter.

The bill conforms the language of the definition of investment interest to the language of a related provision that allocates interest expense to portfolio income under the passive loss rule. Thus, under the bill, investment interest is that which is properly allocable to property held for investment. This change results in consistency in the language of the provisions allocating interest expense to the category of investment interest, and permits consistent application of a standard for allocation of interest. This change is not intended to suggest that the adoption of any particular method of allocation is required, but rather to give Treasury the ability to devise allocation rules as simple as possible consistent with the objectives of the provision. For example, the Treasury could consider rules relating to the securing of property to mitigate some of the complexities of tracing where simplicity is desirable, so that, for example, any interest on a loan secured by personal use property could be considered personal interest, and any interest on a loan secured by investment assets could be considered investment interest.

Investment income

The bill conforms the definition of investment income to the definition of investment interest, by deleting the provision that amounts are treated as investment income only to the extent such amounts are not derived from the conduct of a trade or business.

Transitional rules

The bill clarifies the operation of the phase-in rule. The bill provides that the amount of current year's investment interest disallowed during any taxable year in the phase-in period shall not exceed the sum of (1) the amount that would be disallowed if (a) the net investment income were increased by the ceiling amount (generally $10,000), (b) the reduction of net investment income by passive losses allowed under the passive loss phase-in rule did not apply, and (c) an interest in any activity that is not treated as passive and in which the taxpayer does not materially participate were not treated as held for investment; and (2) the applicable percentage for such year (e.g., 35 percent in 1987) of the amount which would be disallowed, under the fully phased-in investment interest limitation, over the amount determined under (1) above.

The bill also provides that any amount disallowed as a deduction as investment interest under prior law which would have been treated as investment interest paid or accrued in the taxpayer's first taxable year beginning after 1986 (under section 163(d)(2) of prior law) shall, to the extent attributable to a passive loss activity (e.g. interest incurred to purchase property subject to a net lease), be treated as a deduction under section 469 allocable to such activity and not as a deduction for investment interest. The passive loss phase-in rules shall not apply to such amount.

3. Personal interest limitation

(sec. 105(c) of the bill, sec. 511 of the Reform Act, and sec. 163(h) of the Code)

Present law provides that qualified residence interest is not subject to the limitation on personal interest. Qualified residence interest is interest on debt secured by a security interest valid against a subsequent purchaser on the taxpayer's principal residence or a second residence of the taxpayer. Interest on such debt is deductible to the extent that the debt does not exceed the amount of the taxpayer's basis for the residence (including the cost of home improvements), plus the amount of qualified medical and qualified educational expenses, and to the extent the amount of the debt does not exceed the fair market value of the residence. A grandfather rule is provided in the case of debt incurred on or before August 16, 1986 and secured by the taxpayer's principal or second residence. Interest on such debt (reduced by any principal payments thereon) is generally treated as qualified residence interest, provided the amount of the debt does not exceed the fair market value of the residence. /1/

The personal interest limitation is phased in for taxable years beginning after 1986, and becomes fully effective for taxable years beginning in 1991 and thereafter.

The bill conforms the language of the definition of personal interest to the language of related provisions (the passive loss rule and the investment interest limitation) under which interest expense may be allocated. Thus, the bill provides that personal interest does not include interest that is properly allocable to a trade or business. This change results in consistency in the language of several significant provisions under which interest is likely to be allocated, and permits consistent application of a standard for allocation of interest.

Refinancing of grandfathered debt

The bill provides that interest on indebtedness secured by a qualified residence and incurred after August 16, 1986, to refinance grandfathered indebtedness (for example, to obtain a lower interest rate) will be treated as qualified residence interest if certain requirements are met.

Indebtedness secured by the qualified residence and incurred after August 16, 1986 to refinance pre-August 17, 1986 grandfathered indebtedness qualifies under this rule to the extent that the principal amount of the refinancing does not exceed the principal amount of the pre-August 17, 1986 grandfathered indebtedness immediately before the refinancing. The refinancing exception will cease to apply, however, after the expiration of the period of the pre-August 17, 1986 indebtedness. Thus, if the pre-August 17, 1986 indebtedness was scheduled to be repaid at the end of 1992, interest on any refinancing of that debt, to the extent not otherwise deductible, will not be deductible for any period after 1992. Where the pre-August 17, 1986 debt was not amortized over its term (e.g., a "balloon" note), interest on any otherwise qualified refinancing of that debt will be deductible for the term of the first refinancing of the pre-August 17, 1986 indebtedness (but not for more than 30 years after that refinancing). A refinancing of indebtedness originally incurred after August 16, 1986 to refinance pre-August 17, 1986 grandfathered indebtedness (e.g., a second refinancing of such pre-August 17, 1986 debt) can also qualify under this rule subject to these requirements.

Thus, under the provision, the current balance (taking into account all amortization of principal) of the debt secured by the taxpayer's residence and incurred on or before August 16, 1986, that was grandfathered under the Reform Act, can be refinanced. ²

Use of residence

The bill clarifies the definition of a residence of the taxpayer that is treated as a qualified residence, interest on debt secured by which may be treated as deductible qualified residence interest. Under the bill, a residence may be treated as a qualified residence even if the taxpayer does not use it as such at least 14 days a year or 10 percent of the time it is rented (whichever is greater), provided that the residence is not rented at all during the year.

Unenforceable security interest

The bill provides that interest on a loan secured by a recorded deed of trust, mortgage, or other security interest in a taxpayer's principal or second residence, in a State such as Texas where such security instrument will be rendered ineffective or the enforceability of such instrument will be otherwise restricted by State and local homestead or other debtor protection law such as the Texas homestead law, shall be treated as qualified residence interest, provided that such interest is otherwise qualified residence interest.

Transfer incident to divorce

For taxable years beginning in 1987, the bill provides that in certain circumstances involving a transfer of a qualified residence between spouses incident to a divorce or legal separation, the basis limitation on debt, interest on which may be deductible, may be increased by the amount of secured indebtedness incurred by a spouse in connection with the acquisition of the other spouse's interest in the residence. The amount of such debt may not, however, exceed the fair market value of the interest in the residence that is being acquired.

Estates and trusts

The bill allows interest paid or accrued by a trust or estate on indebtedness secured by a qualified residence of a beneficiary of a trust or estate to be treated as "qualified residence interest" if the residence would be a qualified residence (i.e., the principal residence or the second residence selected by the beneficiary) if owned by the beneficiary. The bill also clarifies that interest payable on the estate tax deferred under prior law section 6166A is not personal interest.

Certain other provisions of the Code require a determination of the maximum corporate tax rate under section 11 for a particular taxable year, for purposes other than imposing a tax by reference to such rate. Such provisions include the "high-taxed income" provisions of sections 904(d)(2)(F) and 954(b)(4) of the Code, which provide special treatment for certain income that is subject to foreign taxes exceeding the highest rate of tax under sections 1 or 11 of the Code (or 90 percent of such rate, in the case of section 954).

Under prior law, an 85 percent dividends received deduction was allowed to a domestic corporation for certain dividends attributable to qualified interest and carrying charges received or accrued by the payor corporation while it was a foreign sales corporation (FSC).

The bill makes certain other conforming and clerical amendments.

The Act provided a holding period requirement, under which basis reduction is required if the stock is not held subject to a risk of loss for more than two years before the dividend announcement date. The dividend announcement date is defined in the Act as the date on which the corporation declares, announces, or agrees to the payment of the dividend, whichever is the earliest. 3

Similarly, if preferred stock provides for a cumulative dividend of a specified percentage of annual profits, the dividends attributable to the first 2 years profits are subject to the extraordinary dividends rule and basis reduction is required with respect to such dividends if the threshold percentage is exceeded, even if the dividends are not paid until the third year.

The basis reduction rules also apply in other situations that avoid the threshold amount or holding period requirements by deferring or staggering dividend payments.

The Act also provided that certain distributions are treated as extraordinary dividends without regard to the recipient's holding period or the amount of the dividend. The distributions subject to this rule are any non pro-rata redemption and any redemption in partial liquidation constituting a dividend.

The Act provided a special relief provision applicable to certain qualifying preferred dividends. Under this provision, certain dividends that would otherwise require basis reduction because the more than two-year holding period is not met, may be eligible for a reduced amount of basis reduction or no basis reduction if the stock is either held for five years or if the dividends received do not exceed the dividends "earned," based on the stock's stated rate of return. This relief provision applies only in the case of certain preferred dividends on stock which provides for fixed dividends payable at least annually, with respect to which the taxpayer's actual rate of return does not exceed 15 percent. Furthermore, relief is available only to the extent the taxpayer's actual rate of return does not exceed the stated rate of return.

The Act provided an exception under which no basis reduction is required in the case of an otherwise extraordinary dividend received with respect to stock of a corporation if: (i) the taxpayer has held the stock during the entire period such corporation was in existence, (ii) the only earnings and profits of the corporation were earnings and profits accumulated during such period, and (iii) the application of the exception is not inconsistent with the purposes of the extraordinary dividend provision.

The Act also provided an exception under which no basis reduction is required in the case of any qualifying dividend within the meaning of section 243(b)(1) of the Code. This provision was also intended to apply only where earnings and profits would directly or indirectly be solely attributable to the distributee shareholders in the case of distributions that constitute qualifying dividends within the meaning of section 243(b)(1). It was not intended that the extraordinary dividend provision duplicate any reductions in basis required under the consolidated return regulations with respect to dividend distributions (or deemed dividend distributions) between members of an affiliated group filing consolidated returns.

Under the Act, the Treasury Department is directed to prescribe such regulations as may be appropriate to carry out the purposes of the provision, including regulations providing for the application of the provision in the case of stock dividends, stock splits, reorganizations, and other similar transactions.

The bill clarifies that the nontaxed portion of any dividend that is a non pro-rata distribution or a partial liquidation distribution reduces basis, without regard to whether the two-year holding period requirement has been met.

The bill also clarifies the application of the special exception for dividends on stock that has been held during the entire existence of a corporation. This relief provision was intended to permit distributions without basis reduction, even through the distributions exceed the threshold percentage and are declared, announced or agreed to within the two-year holding period, only in those cases in which the earnings and profits of the corporation paying the dividend could not have been attributable, directly or indirectly, to any person other than the original shareholder receiving the distribution. For this purpose, earnings and profits are not considered attributable solely to such shareholder if any more than a de minimis part of such earnings and profits is derived, directly or indirectly, from any other entity in which the shareholder was not an original shareholder with an interest at least as great as such shareholder's original and continuing interest in the distributing corporation at the time of the distribution.

Thus, for example, the relief provision does not apply if any more than a de minimis part of the earnings and profits of the corporation paying the dividend were derived directly or indirectly from another corporation (e.g., through a dividend distribution, a transaction described in sec. 381, a sale of assets received in a section 332 liquidation or other carryover basis transaction, or by virtue of the consolidated return regulations increasing the earnings and profits of the corporation that is paying the dividend on account of earnings and profits of another corporation which is a subsidiary) in which the original shareholder did not at all times hold at least as great an interest as such shareholder's interest in the distributing corporation at the time of the distribution.

However, the fact that the distributing corporation directly or indirectly received de minimis amounts of earnings and profits from other entities (such as non-extraordinary dividends received from temporary portfolio investments of funds), would not generally be expected to preclude the application of the relief provision.

The bill clarifies that earnings and profits would be indirectly attributable to a person other than the shareholder receiving the distribution if they are attributable to transfers from or earnings and profits of any corporation that is not a "qualified corporation". A qualified corporation is one in which the shareholder receiving the dividend holds, directly or indirectly, at least as great an interest, throughout the entire existence of such corporation, as such shareholder has held throughout the period the corporation paying the dividend in question was in existence. In addition, a qualified corporation must have no earnings and profits which were earned by any person, or are attributable to gain on property which accrued during a period in which any person held such property, if the shareholder did not, throughout such corporation's or other person's existence, hold the requisite interest in such corporation or other person.

The bill similarly clarifies the exception for dividends that qualify under section 243(b)(1) of the Code, providing that such dividends do not qualify for the exception to the extent they are attributable to earnings and profits earned by a corporation during a period it was not a member of the affiliated group, 4 or attributable to gain on property which accrued during a period the corporation holding the property was not a member of the affiliated group.

It is expected that the application of the provision to distributions between members of an affiliated group filing consolidated returns will be consistent with the principles of the exceptions relating to qualifying dividends and dividends with respect to stock which the distributee has held throughout the distributor's entire existence. It is understood that, in most instances, the consolidated return regulations achieve results that are consistent with the purposes of the extraordinary dividend rules. For example, the regulations require a negative basis adjustment in the stock of a subsidiary to the extent the distribution represents preaffiliation earnings and profits of the subsidiary. A negative adjustment is not required with respect to all dividend distributions, however.

It is recognized that the failure of the consolidated return regulations to require a negative adjustment to stock for dividend distributions received from a member is, in some situations, consistent with the principles of the extraordinary dividend provision. It is not intended that this provision will require a basis reduction in such situations. For example, a distribution during a consolidated return year out of earnings and profits accumulated during a prior year, throughout which the distributing corporation was affiliated with the distributee but did not join the distributee's consolidated return and not attributable to gain on property that accrued prior to affiliation, would not result in a reduction in the basis of the distributee's stock in the distributing corporation. Likewise, a distribution out of current year earnings to a member of the affiliated group with which the distributing corporation files a consolidated return does not cause a basis reduction under the consolidated return rules. If such earnings are not attributable to gain on property accrued during a period the corporation holding the property was not a member of the group, the result in most instances would not be inconsistent with the purposes of this provision.

However, to the extent results produced under the consolidated return regulations are inconsistent with the purposes and principles of the extraordinary dividend provision, it is intended that a basis reduction may be required under this provision notwithstanding the fact that no reduction is mandated under the consolidated return regulations.

The bill clarifies that only fixed dividends (i.e., dividends that do not vary in amount from period to period) are eligible for the special relief provision for qualified preferred dividends.

The bill clarifies that the regulatory authority to carry out the purposes of the provision extends to cases where stock is held by pass-thru entities.

The bill deletes section 1059(d)(5) of the Code as deadwood.

(sec. 106(d)(1) of the bill, sec. 621(a) of the Reform Act, and sec. 382(e) of the Code)

The bill also clarifies that if the old loss corporation is a foreign corporation, its value shall be determined taking into account only assets and liabilities treated as connected with the conduct of a trade or business in the United States. 5

2. Definition of ownership change: Owner shift involving five-percent shareholder and equity structure shift

(sec. 106(d)(2) of the bill, sec. 621(a) of the Reform Act, and sec. 382(g)(4)(C) of the Code)

An owner shift involving a five-percent shareholder is defined as any change in the respective ownership of stock in a corporation that affects the percentage of stock held by any person who holds five percent or more of stock in the corporation before or after the change. An equity structure shift is defined as any tax-free reorganization within the meaning of section 368, other than a divisive "D" or "G" reorganization or an "F" reorganization. For purposes of these definitions, all less-than-five-percent shareholders are aggregated and treated as a single five-percent shareholder.

In determining whether an equity structure shift has occurred, the rule that aggregates less-than-five-percent shareholders is applied separately with respect to each group of shareholders of each corporation that is a party to the reorganization ("segregation rule"). Except as provided in regulations, the segregation rule applies in determining whether there has been an owner shift involving a five-percent shareholder; the regulatory authority in section 382(m) augments this rule for cases that involve only a single corporation. To the extent provided in regulations, transactions in which it is feasible to identify changes in ownership involving less-than-five-percent shareholders will be treated under the rules for equity structure shifts.

The regulatory authority in section 382(g)(3)(B) -- to treat transactions under the rules for equity structure shifts -- does not limit the scope of section 382(g)(4)(C). Section 382(g)(4)(C), by its terms, generally causes the segregation of the less-than-five-percent shareholders of separate entities where an entity other than a single corporation is involved in a transaction. Section 382(g)(3)(B) merely provides additional authority, as does section 382(m), for cases in which only one corporation is involved.

3. Special rules for built-in gains and losses and section 338 gains

(secs. 106(d)(3) and (22) of the bill, sec. 621(a) of the Reform Act, and sec. 382(h) of the Code)

The section 382 limitation is increased by the excess of (1) gain recognized by reason of an election under section 338, over (2) the portion of such gain taken into account in computing recognized built-in gains for a taxable year. A recognized built-in gain is any gain recognized during the recognition period on the disposition of any asset, if the corporation establishes that the asset was held immediately before the ownership change, and to the extent the gain does not exceed the excess of the asset's fair market value over the adjusted basis on such date.

If an ownership change occurs during a taxable year, the section 382 limitation does not apply to the utilization of losses against the portion of the corporation's taxable income allocable to the period before the change. For this purpose, except as provided in regulations, taxable income realized during the taxable year is allocated ratably to each day in such year. Under the allocation rule, taxable income is computed without regard to recognized built-in gains and losses.

If a corporation has a net unrealized built-in loss, built-in losses recognized within a 5-year recognition period are subject to the section 382 limitation. The Act provides that the disallowed loss is carried forward to subsequent taxable years under rules similar to the rules for the carrying forward of a net operating loss, and is subject to limitation in those years in the same manner as a pre-change loss.

Also, regarding the allocation rule for the taxable year in which an ownership change occurs, taxable income is computed without regard to recognized built-in gains to the extent such gains increased the section 382 limitation for the year, and without regard to recognized built-in losses to the extent such losses are treated as pre-change losses. That is, such gains or losses are disregarded for this purpose only to the extent they did not exceed the limitations on the total amount of recognized built-in gain or loss, as the case may be, for the year of recognition.

The amendment clarifies that under regulations any item of income which is properly taken into account during the recognition period but that is attributable to periods before the change date shall be treated as a recognized built-in gain for the taxable year in which it is properly taken into account. Also, any amount which is allowable as a deduction during the recognition period but which accrued before the change date shall be treated as a recognized built-in loss for the taxable year for which it is allowable as a deduction. The amount of net unrealized built-in gain or loss shall be properly adjusted to include items of income attributable to periods before the change date and deductions which accrued before the change date. It is expected that under this provision, in computing net unrealized built-in gain or loss for purposes of determining whether the 25 percent threshold applies, receivables will be treated as cash items only if they were properly taken into account for tax purposes under the taxpayer's method of accounting prior to the date of the ownership change.

Finally, the bill clarifies that a recognized built-in loss that is disallowed retains its character as a capital loss or ordinary loss and is carried forward under the rules applicable to a loss of that character.

4. Testing period: Shorter period where all losses arise after three-year period begins

(sec. 106(d)(4) of the bill, sec. 621 of the Reform Act, and sec. 382(i)(3) of the Code)

5. Definitions of loss corporation, old loss corporation, and new loss corporation

(secs. 106(d)(5), (10), and (21) of the bill, sec. 621(a) of the Reform Act, and secs. 382(k) and 382(l)(8) of the Code)

An "old loss corporation" is a corporation with respect to which there is an ownership change, which was a loss corporation before the ownership change, or with respect to which there is a prechange loss. A pre-change loss is any net operating loss carryforward of an old loss corporation to the taxable year ending with or in which the ownership change occurs, and the net operating loss of an old loss corporation for the taxable year in which the ownership change occurs (to the extent allocable to the period on or before the change date).

In determining whether an ownership change has occurred, the percentage of stock in the new loss corporation is compared to the lowest percentage of stock in the old loss corporation (or any predecessor) owned by a shareholder during the testing period.

Except as provided in regulations, any entity and any predecessor or successor of such entity is treated as one entity. As an example, if a corporation purchases 100 percent of the stock of an unrelated loss corporation, the loss corporation would become a new loss corporation. If the new loss corporation liquidates in a tax-free transaction pursuant to section 332 (so the new loss corporation's net operating loss carryforwards carry over to the acquiring corporation), the acquiring corporation -- as successor -- will continue to be treated as a new loss corporation.

The bill also modifies the definition of ownership change by eliminating the references to "old" and "new" loss corporations. This change merely eliminates circularity in the definition of ownership change, and is not intended to have any substantive effect.

6. Operating rules relating to ownership of stock

(sec. 106(d)(6) of the bill, sec. 621(a) of the Reform Act, and sec. 382(l)(3) of the Code)

One modification to the rules of section 318 relates to options and similar interests. Except as provided in regulations, the holder of an option is treated as owning the underlying stock if such presumption would result in an ownership change. Thus, the stock underlying an option or similar interest may be taken into account on and after the date on which the interest is acquired or later transferred. The subsequent exercise of an option is disregarded if the holder of the option has been treated as owning the underlying stock. On the other hand, if the holder of an option was not treated as owning the underlying stock, the subsequent exercise will be taken into account in determining whether there is an owner shift at time of exercise. Similarly, except as provided in regulations, a person is treated as owning stock that may be acquired pursuant to any contingent purchase, warrant, convertible debt, put, stock subject to a risk of forfeiture, contract to acquire stock, or similar interest, if such a presumption results in an ownership change. 6

The Act does not provide rules for attributing stock that is owned by a government. For example, stock that is owned by a foreign government is not treated as owned by any other person. Thus, if a government of a country owned 100 percent of the stock of a corporation and, within the testing period, sold all of such stock to members of the public who were citizens of the country, an ownership change would result. Governmental units, agencies, and instrumentalities that derive their powers, rights, and duties from the same sovereign authority will be treated as a single shareholder.

The bill also clarifies that the rule with respect to options extends beyond options that have been subject to section 318(a)(4).

7. Bankruptcy proceedings

(secs. 106(d)(7), (8), and (18) of the bill, sec. 621(a) of the Reform Act, and sec. 382(l)(5) of the Code)

A new loss corporation may elect to forgo the special bankruptcy rule described above, in which case, the general rules will apply except the value used for purposes of computing the section 382 limitation will be the value of the new loss corporation immediately after the ownership change.

A modified version of the bankruptcy exception applies to a thrift involved in an equity structure shift that is a reorganization described in section 368(a)(3)(D)(ii), or any other equity structure shift or transaction to which section 351 applies that occurs as an integral part of a transaction involving a reorganization described in section 368(a)(3)(D)(ii). The bankruptcy exception is applied to qualified thrift reorganizations by requiring shareholders, creditors, and depositors to retain a 20-percent (rather than 50-percent) interest. For this purpose, the fair market value of the outstanding stock in the new loss corporation includes deposits that become deposits of the new loss corporation.

The bill clarifies the attribute reduction that occurs with respect to amounts that would be cancellation of indebtedness income. The amount of the reduction is 50 percent of the amount that (but for section 108(e)(10)(B)) would have been applied to reduce tax attributes under section 108(b), that is, the excess of the amount of cancelled debt over the fair market value of stock issued in satisfaction of the debt. The bill also clarifies that the amount of the debt outstanding for this purpose does not include previously accrued but unpaid interest that has already been deducted from net operating loss carryforwards under the rule requiring reduction for interest deducted during the three-year period prior to the ownership change.

The bill also clarifies that if an election to forgo the bankruptcy rule is made, the value of the new loss corporation will reflect any increase in value resulting from the surrender or cancellation of creditors' claims in the transaction.

Regarding qualified thrift reorganizations, the bill clarifies that the fair market value of the outstanding stock of the new loss corporation includes the amount of deposits in such corporation immediately after the change. Also, it is clarified that the voting power requirement will not cause a failure of the 20-percent test solely because deposits do not carry adequate voting power.

8. Effective dates

(sec. 106(d)(11) of the bill and sec. 621(f) of the Reform Act)

The earliest testing period under the Act begins on May 6, 1986. If an ownership change occurs after May 5, 1986, and before January 1, 1987, and the provisions of the Act do not apply, then the earliest testing period will not begin before the day following the date of such ownership change.

Under the general rules of section 382, if a public offering is performed by an underwriter on a "firm commitment" basis, the underwriter is treated as owning the stock for purposes of determining whether an owner shift involving a 5-percent shareholder has occurred.

By treating equity structure shifts pursuant to plans of reorganization that were adopted before January 1, 1987 as occurring when the plan was adopted, the bill clarifies that no equity structure shift pursuant to a plan adopted after 1986, and no other owner shift involving a 5-percent shareholder occurring after 1986, is protected under the transition provisions, even though such shifts may occur before the completion of a pre-1987 plan of reorganization; i.e., such shifts are not grandfathered by virtue of the pre-1987 plan. If however, an ownership change occurs within the testing period prior to the end of 1986 when any equity structure shift pursuant to a pre-1987 plan is considered together with other pre-1987 owner shifts, that ownership change is grandfathered and a new testing period starts. Any equity structure shift pursuant to a plan adopted after 1986, and any post-1986 owner shift involving a 5-percent shareholder, that occurs before the completion of the pre-1987 plan of reorganization will count for purposes of determining when or whether a later ownership change occurs, under section 382(i).

If, applying the foregoing provisions and the rule in section 382(1)(3) (described below), an ownership change occurs immediately following an equity structure shift pursuant to a post-1986 plan of reorganization, or immediately following any other post-1986 owner shift involving a 5-percent shareholder, the ownership change is subject to the provisions of section 382 as amended by the Act.

The bill clarifies that the May 6, 1986, testing date applies for purposes of determining whether an ownership change occurred after May 5, 1986, and before January 1, 1987. For purposes of determining whether shifts in ownership occurred between May 5, 1986, and January 1, 1987, the rule in section 382(1)(3) for options and similar interests applies. Thus, in the case of such an interest issued on or after May 6, 1986, and before January 1, 1987, the underlying stock could be treated as acquired at the time the interest was issued. For this transition period, however, in addition to the Treasury Department's general regulatory authority under the rule in section 382(l)(3), the Treasury Department may provide for different treatment in the case of an acquisition of an option or similar interest that is not in fact exercised, as appropriate where the effect of treating the underlying stock as if it were acquired would be to cause an ownership change that would start a new testing period (and thus result in relief under the transitional rules). No inference is intended as to how pre-May 6, 1986 options or similar interests would be treated.

The 1954 Code version of section 382(a), relating to nonreorganization transactions, has continuing application to any increase in percentage points of stock ownership to which the provisions of the Act do not apply by reason of any transitional rule -- including the rules prescribing measurement of the testing period by reference only to transactions after May 5, 1986, and the rules that disregard ownership changes following or resulting from certain transactions. The 1954 Code version of section 382(b), however, does not apply to any reorganization occurring pursuant to a plan of reorganization adopted after December 31, 1986.

Any regulations that have the effect of treating a group of shareholders as a separate five-percent shareholder by reason of a public offering will not apply to any public offering before January 1, 1989, for the benefit of institutions described in section 591. Further, unless the corporation otherwise elects, an underwriter of any offering of stock of a corporation before September 19, 1986 (January 1, 1989 in the case of an offering for the benefit of an institution described in section 591) will not be treated as acquiring stock in the institution by reason of a firm commitment underwriting, but only to the extent such stock is disposed of no later than 60 days after the initial offering and pursuant to the offering.

9. Treasury Department regulatory authority with respect to property transferred in nonrecognition transactions

(sec. 106(d)(23) of the bill, sec. 621(a) of the Reform Act and sec. 382(h)(9) of the Code)

It is expected, as one example, that built-in gain with respect to property transferred in a nonrecognition transaction (including, for example, a tax-free reorganization as well as a section 351 contribution to capital) may in appropriate cases be disregarded for purposes of determining the amount of net unrealized built-in gain and for purposes of determining the addition to the section 382 limitation following an ownership change. It is expected that cases where such built-in gain will be disregarded may include transactions in which the value transferred to the corporation would be disregarded under section 382(1)(1) if the transaction had been a contribution to capital.

10. Treasury Department regulatory authority with respect to certain related corporations

(sec. 106(d)(24) of the bill, sec. 621(a) of the Reform Act and sec. 382(m) of the Code)

The bill defines such corporations under common ownership to include any group of corporations described in section 1563(a) (determined by substituting "50 percent" for "80 percent" each place it appears and without regard to section 1563(a)(4)).

(secs. 106(e)(1) and (2) of the bill, sec. 631(a) of the Reform Act, and secs. 336(d)(2) and 336(d)(3) of the Code)

Congress intended that the Treasury Department will issue regulations generally providing that the presumed prohibited purpose for contributions of property within two years of the adoption of a plan of liquidation will be disregarded unless there is no clear and substantial relationship between the contributed property and the conduct of the corporation's current or future business enterprises.

A clear and substantial relationship between the contributed property and the conduct of the corporation's business enterprises would generally include a requirement of a corporate business purpose for placing the property in the particular corporation to which it was contributed, rather than retaining the property outside the corporation. If the contributed property has a built-in loss at the time of contribution that is significant in amount as a proportion of the built-in corporate gain at that time, special scrutiny of the business purposes would be appropriate.

Congress expected that such regulations will permit the allowance of any resulting loss from the disposition of any of the assets of a trade or business (or a line of business) that are contributed to a corporation where prior law would have permitted the allowance of the loss and the clear and substantial relationship test is satisfied. In such circumstances, application of the loss disallowance rule is inappropriate assuming there is a meaningful (i.e., clear and substantial) relationship between the contribution and the utilization of the particular corporation form to conduct a business enterprise. If the contributed business is disposed of immediately after the contribution it is expected that it would be particularly difficult to show that the clear and substantial relationship test was satisfied. Congress also anticipated that the basis adjustment rules will generally not apply to a corporation's acquisition of property as part of its ordinary start-up or expansion of operations during its first two years of existence. However, if a corporation has substantial gain assets during its first two years of operation, a contribution of substantial built-in loss property followed by a sale or liquidation of the corporation would be expected to be closely scrutinized.

In the case of any liquidation to which section 332 of the Code applies, the Act provides that no loss shall be recognized in such liquidation.

The bill also clarifies that the provision denying recognition of loss to the distributing corporation in a section 332 liquidation is intended to apply to a distribution to the corporation meeting the control requirement of section 332 only if the distribution does not result in gain recognition to the distributing corporation, pursuant to section 337(a) or (b)(1). Thus, the provision denies loss recognition on a taxable distribution to minority shareholders in such a liquidation. If the section 332 liquidation is not described in section 337(b)(1) or (2) (for example, in the case of certain liquidations into a tax exempt parent corporation) the special loss disallowance provision of section 336(d)(3) does not apply. Such a transaction would be subject to any other applicable loss disallowance provisions, however.

2. Election to treat certain stock sales and distributions as asset transfers

(sec. 106(e)(3) of the bill, sec. 631(a) of the Reform Act, and sec. 336(e) of the Code)

3. Treatment of distributing corporation where the 80-percent distributee is a tax-exempt organization

(sec. 106(e)(4) of the bill, sec. 631(a) of the Reform Act, and sec. 337(b)(2) of the Code)

4. Basis adjustment in taxable section 332 liquidation

(sec. 106(e)(6) of the bill and sec. 334 of the Code)

5. Use of installment method by shareholders in certain liquidations

(sec. 106(e)(6) of the bill, sec. 631(a) of the Reform Act, and sec. 453(h)(1)(B) of the Code)

6. Certain distributions of partnership or trust interests

(sec. 106(e)(7) of the bill, sec. 631 of the Reform Act, and secs. 386 and 311 of the Code)

7. Losses on transactions between related taxpayers

(sec. 106(e)(8) of the bill, sec. 631 of the Reform Act, and sec. 267 of the Code)

8. Distributions of property to corporate shareholders

(secs. 106(e)(9), (10), and (11) of the bill, sec. 631 of the Reform Act, and sec. 301 of the Code)

If gain is recognized to the distributing corporation on a nonliquidating distribution, the holding period of the property in the hands of the distributee begins on the date of the distribution.

The Act provides that, on a nonliquidating distribution of property to a shareholder (including to a corporate shareholder), gain (but not loss) is recognized to the distributing corporation as if the property had been sold to the distributee at fair market value. On a liquidating distribution, gain or loss is generally recognized (though loss is not recognized in certain instances). Provisions of the Code other than section 301 generally provide for the basis of property received in a liquidation (secs. 331 and 334).

9. Certain transfers to foreign corporations

(sec. 106(e)(13) of the bill, sec. 631(d) of the Reform Act, and secs. 367(a) and 367(e)(2) of the Code)

10. Gain from certain sales or exchanges of stock in certain foreign corporations

(sec. 106(e)(14) of the bill, sec. 631(d) of the Reform Act, and sec. 1248 of the Code)

Section 1248(d)(2) also contains a provision that was intended to assure that a foreign corporation that sold property in a liquidation would not experience an increase in earnings and profits to the extent that gain would not be recognized under section 337(a) of the Code on such a sale. This provision was originally written with reference to prior law section 337(a), which was repealed by the Act.

Under the Act, a distributing corporation generally recognizes gain on a liquidating or nonliquidating distribution of property with a fair market value in excess of basis as if the property distributed had been sold to the distributee at fair market value, and earnings and profits of the distributing corporation are accordingly increased. There are certain exceptions in the case of distributions that would be tax-free to a recipient under the tax-free reorganization provisions of the Code or under section 355 of the Code, and in the case of certain liquidating distributions to an 80-percent corporate distributee.

It is contemplated that the Treasury Department may exercise its regulatory authority under section 1248(f) to provide that, in cases where a distribution that would be tax-free but for section 1248(f)(1) occurs within a controlled group, and section 1248(f)(2) does not otherwise apply, the recipient corporation may be required to take a carryover basis in the stock received (rather than a substituted basis under section 358, for example, in the case of a section 355 or 361 distribution) and section 1248(f)(1) will not apply to such distribution.

The bill repeals sections 1248(f)(3) and 1248(d)(2) as deadwood.

The bill makes certain other related clerical and conforming amendments.

11. Tax imposed on certain built-in gains of S corporations

(sec. 106(f) of the bill, sec. 632 of the Reform Act, and sec. 1374 of the Code)

The Act provided that the amount of recognized built-in gains taken into account for any taxable year shall not exceed the excess (if any) of 1) the net unrealized built-in gain, over 2) the recognized built-in gains for prior years beginning in the 10-year recognition period. Also, recognized built-in gain is not taxed in a year to the extent that it exceeds the taxable income of the corporation for the year computed as if the corporation were a C corporation.

Under the Act, the corporation may take into account certain subchapter C tax attributes in computing the amount of tax on recognized built-in gains. Thus, for example, it may use unexpired net operating losses to offset the gain and may use business credit carryforwards to offset the tax.

The bill clarifies that the built-in gain provision applies not only when a C corporation converts to S status but also in any case in which an S corporation acquires an asset and the basis of such asset in the hands of the S corporation is determined (in whole or in part) by reference to the basis of such asset (or any other property) in the hands of the C corporation. In such cases, each acquisition of assets from a C corporation is subject to a separate determination of the amount of net built-in gain, and is subject to the provision for a separate 10-year recognition period. The bill clarifies that the Treasury Department has authority to prescribe regulations providing for the appropriate treatment of successor corporations -- for example, in situations in which an S corporation engages in a transaction that results in carryover basis of assets to a successor corporation pursuant to subchapter C of the Code.

The bill clarifies that the amount of recognized built in gains taken into account for any taxable year shall not exceed the excess, if any, of 1) the net unrealized built-in gains at the time of the conversion, over 2) the recognized built-in gains for prior years beginning in the recognition period to the extent such gains were subject to the built-in gains tax.

The bill clarifies that, for purposes of this built-in gains tax under section 1374, any item of income which is properly taken into account for any taxable year in the recognition period but which is attributable to periods before the first taxable year for which the corporation was an S corporation is treated as a recognized built-in gain for the taxable year in which it is properly taken into account. Thus, the term "disposition of any asset" includes not only sales or exchanges but other income recognition events that effectively dispose of or relinquish a taxpayer's right to claim or receive income. For example, the term "disposition of any asset" for purposes of this provision also includes the collection of accounts receivable by a cash method taxpayer and the completion of a long-term contract performed by a taxpayer using the completed contract method of accounting.

Similarly, the bill clarifies that amounts that are allowable as a deduction during the recognition period but that accrued before the first S corporation taxable year are thus treated as recognized built-in losses in the year of the deduction.

The bill clarifies that capital loss carryforwards may also be used to offset recognized built-in gains.

Finally, the bill makes certain clerical and conforming changes.

12. Distributions by S corporations

(secs. 106(f)(8) 106(e)(22) of the bill and secs. 1363(d) and (e) and sec. 453B(h) of the Code)

The distribution rules generally require recognition of gain on the distribution of any property (including installment obligations) as if the corporation had sold the property at fair market value.

The special distribution rules provided in Code section 1363(d) and (e) of the Code are repealed as deadwood. Thus, for example, it is clarified that, pursuant to section 1371 of the Code, the provisions of subchapter C of the Code apply to determine the recognition of gain and loss in the case of a distribution by an S corporation.

13. Regulatory authority to prevent circumvention of provisions

(sec. 106(e)(5) of the bill, sec. 631 of the Reform Act, and sec. 337(d) of the Code)

It is expected that Treasury shall also prevent the avoidance of the section through contributions of property with built-in loss to a corporation before it becomes an S corporation.

It is also expected that the Treasury Department will prevent the manipulation of accounting methods or other provisions that may have the result of deferring gain recognition beyond the 10 year recognition period -- for example, in the case of a C corporation with appreciated FIFO inventory that converts to S status and elects the LIFO method of accounting.

Section 704(c) of the Code generally requires that gain attributable to appreciated property contributed to a partnership by a partner be allocated to that partner; it is expected that this rule would generally prevent the use of a partnership to avoid the purposes of the amendments made by subtitle D of Title VI of the Act (for example, by attempting to shift the tax on C corporation appreciation to another party or to a non-C corporation regime). However, if and to the extent that partners might utilize allocation rules or other partnership provisions (including the so-called "ceiling rule" contained in the regulations under section 704(c)) to defer the recognition of built-in gain to a corporate partner by shifting the incidence of current gain recognition, it is intended that the Treasury Department may exercise its authority to prevent such results.

14. Transition provisions

(sec. 106(g) of the bill and sec. 633 of the Reform Act)

The bill clarifies that a 34-percent tax rate applies to capital gain that is subject to prior law section 1374 in taxable years beginning after December 31, 1986.

In addition, the amendments made by the Act do not apply to any transaction described in section 338 with respect to any target corporation if a qualified stock purchase of such target corporation was made on or after August 1, 1986, pursuant to a written binding contract in effect before such date, and the acquisition date is before January 1, 1988.

A clarification is made regarding the exception for a qualified stock purchase pursuant to a binding contract in effect before August 1, 1986. For purposes of this exception, a modification of a contract for the purchase of stock in more than one corporation that arises because of third party rights in the stock to be acquired (such as a right of first refusal), or because of the rules and rulings of government agencies or courts, is not intended to cause a contract to be deemed nonbinding, so long as the stock acquired was a part of the original contract. This clarification is not intended to create any inference regarding the meaning of binding contract in other contexts.

The Act provides that a corporation eligible for this rule may also become an S corporation for a taxable year beginning before January 1, 1989. In such a case, the corporation is not subject to the new rules of section 1374 relating to built-in gains except with respect to ordinary income and short-term capital gain property. 15 The Act repealed section 333 of the Code. However, the amendments made by the Act do not apply to the applicable percentage of each gain or loss which would otherwise be recognized by reason of the Act. The applicable percentage is 100 percent if the applicable value of the qualified corporation is less than $5 million, and phases down to 0 percent if the applicable value of the corporation exceeds $10 million.

For distributions prior to January 1, 1989, qualifying corporations continue to be eligible for relief under the rules relating to nonliquidating distributions in effect prior to the Act (prior law sec. 311(d)(2)). However, this relief does not apply to distributions of ordinary income property or short-term capital gain property.

The Act provides that a corporation is eligible for these special delayed effective dates if it was in existence on August 1, 1986, its value does not exceed $10 million, and more than 50 percent (by value) of the stock is held by 10 or fewer qualified persons. The conference report states that such 10 or fewer qualified persons must have held their stock for five years or longer.

The Act provides that a qualified person is an individual, an estate, or any trust described in clause (ii) or (iii) of section 1361(c)(2)(A) of the Code. Specified attribution rules are provided for purposes of determining ownership.

The Act provides that all members of the same controlled group (as defined in section 267(f)(1) of the Code) are treated as one corporation for purposes of the small corporation transitional rules.

The Act provides that the small corporation transition rules shall also apply in the case of a transaction described in section 338 of the Code where the section 338 acquisition date is before January 1, 1989.

It is intended that a taxpayer that purchases the stock of a qualified corporation in a qualified stock purchase prior to January 1, 1989, is entitled to apply prior-law rules (modified as in the case of actual liquidations) with respect to an election under section 338, even though in the hands of the acquiring corporation the qualified corporation no longer satisfies the stock holding period requirements and may not satisfy the size or shareholder requirements due to the size or shareholders of the acquiring corporation.

The bill clarifies that, although the Act repealed section 333 of the Code, in the case of a liquidating distribution to which section 333 of prior law would apply, a shareholder of a qualified corporation electing such treatment is entitled to apply section 333 without any phase-out of shareholder level relief under the Act. However, an increase in shareholder-level gain could result from an increase in corporate earnings and profits resulting from application of the corporate-level phase-out of relief.

The bill clarifies that for distributions before January 1, 1989, qualifying corporations continue to be eligible for relief under prior-law rules relating to nonliquidating distributions with respect to qualified stock, (prior law sec. 311(d)(2)), without regard to whether the corporation liquidates before January 1, 1989. However, this relief does not apply to distributions of ordinary income property or short-term capital gain property.

The bill provides that a corporation is not a qualified corporation unless more than 50 percent (by value) of the stock of such corporation is owned (on August 1, 1986 and at all times thereafter before the corporation is completely liquidated) by the same 10 or fewer qualified persons who at all times during the 5-year period ending on the date of the adoption of the plan of liquidation (or, if shorter, the period during which the corporation or any predecessor was in existence) owned (or were treated as owning under the attribution rules) more than 50 percent (by value) of the stock of such corporation. This change to the statutory language of the Act, incorporating a holding period requirement, does not apply to nonliquidating distributions before March 31, 1988 (the date of introduction of the bill), to liquidating sales or distributions pursuant to a plan of liquidating adopted before March 31, 1988, or to deemed liquidating sales pursuant to an election under section 338 where the acquisition date under section 338 occurs before March 31, 1988. Also, for purposes of applying section 1374 in the case of a qualified corporation, the provision does not apply if the S election was filed before March 31, 1988.

Where stock passes to an estate, the holding period of the estate includes that of the decedent. Also, the "look-through" attribution rules that apply under this provision do not apply in the case of trusts qualifying under section 1361(c)(2)(ii) or (iii), just as they do not apply under the Act in the case of estates. Thus, stock held by such entities, like stock held by an estate, is to be treated as held by a single qualified person, so that the 10-shareholder test will not cease to be satisfied merely because a decedent's stock passes to such a trust. (In the case of other trusts holding stock, the "lookthrough" attribution rules apply to determine whether more than 10 qualified persons ultimately own the stock).

The bill also clarifies that the holding period of a decedent's estate (or a section 1361(c)(2)(A)(ii) or (iii) trust) is tacked with that of any beneficiary, as well as with that of the decedent, for purposes of determining the holding period. However, except in the case of beneficiaries who are treated as being "one person" with the decedent, once stock has been distributed to beneficiaries, the 10-shareholder requirement might fail to be satisfied due to an increase in the number of shareholders. Property acquired by reason of the death of an individual is treated as owned at all times during which the property was treated as owned (in addition to actually owned) by the decedent (as one example, property treated as owned by the decedent under the grantor trust rules, as well as property treated as owned by the decedent pursuant to attribution rules, would have a tacked holding period for this purpose).

In the case of indirect ownership through an entity, the rules described above are the only rules that apply to determine ownership and holding period. Thus, it is not intended that holding periods could otherwise be "bootstrapped" through analogy to or application of any provision of section 1223. For example, if a partnership owns all the stock of a corporation, a new partner who contributes other property to the partnership in exchange for a partnership interest is deemed under section 1223 to have a holding period in the partnership interest that includes such person's holding period for the property contributed. However, such a person would not be deemed thereby to have owned stock in the corporation that the partnership owned for any period prior to the time the person became a partner. In such cases, under the attribution and other holding period rules of the transitional provision a qualified person's holding period for the underlying stock is the lesser of (1) the period during which the entity held the stock in the qualified corporation, or (2) the period during which the qualified person held the interest in the entity. In other situations, the basic attribution and holding period rules of the transitional rule provision may provide a different result. 16

The bill clarifies that the rule that all members of a controlled group of corporations (as defined in section 267(f)(1)) are treated as a single corporation applies solely for purposes of determining whether the corporation meets the size requirements for relief. Thus, it is clarified that it is not necessary for all members of a group that, in the aggregate, meets the size requirements for a qualified corporation, to liquidate before January 1, 1989, in order for the liquidation of one member of the group to qualify for relief. It is not intended that an S corporation be included as a member of the group unless such corporation was a C corporation for its taxable year including August 1, 1986 or was an S corporation that was not described in section 1374(c)(1) or (2) of prior law for such taxable year.

The bill also provides a rule to prevent the use of qualified corporations as conduits for the sale of assets by corporations that are not qualified. It is expressly provided that the transition rules do not apply where a principal purpose of a carryover basis transfer of an asset to a qualified corporation is to secure the benefits of the special transition rules. This provision is not intended to limit the application of the step transaction doctrine or other doctrines that would prevent the use of the transition rules. It is expected that a similar step transaction approach would be applied in the case of any transfer of assets to any corporation that qualified for transition under any of the other provisions of the Act, if a principal purpose of the transfer was to secure the benefit of transition for an otherwise non-qualified transaction.

The bill makes certain other clerical and conforming changes.

The Treasury Department is authorized to require information reporting by the parties to an applicable asset acquisition.

The bill provides that any information reporting required by the Treasury Department pursuant to this provision constitutes an information return for purposes of the penalty provisions of the Code.

The bill makes certain other clerical and conforming changes.

Related parties include a person and all entities more than 50 percent owned, directly or indirectly, by that person. Related parties also generally include entities more than 50 percent owned, directly or indirectly, by the same persons.

The bill also provides that related parties, for purposes of these installment sale provisions, include partnerships that are more than 50 percent owned, directly or indirectly, by the same persons.

The provision is effective for obligations acquired after October 22, 1986. For taxpayers who have elections in effect as of October 22, 1986, the statute provides that such elections will apply to obligations issued after that date only if the taxpayer so chooses (in such manner as may be prescribed by the Secretary).

The bill provides that, for taxpayers who have elections to amortize bond premium (under prior law) in effect as of October 22, 1986, such elections will apply to obligations acquired after that date (rather than to obligations issued after that date) only if the taxpayer so chooses (in such manner as may be prescribed by the Secretary).

In order to qualify as a regulated investment company ("RIC"), an entity must derive at least 90 percent of its income from certain specified sources, including income that is derived with respect to its business of investing in stocks, securities or currencies (the "90-percent test"). By regulation, the Secretary of the Treasury may exclude from such income foreign currency gains not ancillary to the company's business of investing in stock or securities. In addition, a RIC must derive less than 30 percent of its gross income from the sale or other disposition of stock or securities held for less than 3 months (the "30-percent test"). In the case of RICs that have so-called "series funds," the above tests are applied to each fund separately.

A corporation that is registered as a business development company under the Investment Company Act of 1940, is eligible to be a RIC.

Excise tax on undistributed income

Section 4982 imposes an excise tax on the undistributed income of RICs. In order to avoid paying this tax, a RIC generally must, during the calendar year, distribute 97 percent of its ordinary income for the calendar year and 98 percent of its capital gain net income for the one-year period ending on October 31 of such calendar year. The amount of capital gain net income is not reduced by the amount of any net operating loss of the RIC.

A RIC is deemed to have sufficient earnings and profits so that any distribution that is otherwise treated as a dividend by the RIC qualifies as a dividend. No additional earnings and profits are created, however, for redemption distributions that otherwise may qualify for a dividends paid deduction.

Taxation of RICs and their shareholders

In order to be taxed as a RIC, a RIC generally must distribute 90 percent of its taxable income. If a RIC is so taxed, its taxable income and net capital gain are taxed. To the extent provided in Treasury regulations, net capital gain is determined without regard to net capital loss attributable to transactions after October 31 and is treated as arising on the first day of the next taxable year.

Dividends declared by a RIC in December and made payable to shareholders of record on a specified date in that month are deemed to have been paid by the RIC, and received by its shareholders, on that date so long as they are actually paid before February 1 of the following year.

The bill clarifies that income derived by a RIC from a partnership or trust shall be treated as derived with respect to the RIC's business of investing in stocks, securities or currencies, only to the extent that such income is attributable to items of income which would be derived with respect to that business if realized by the RIC in the same manner as by the partnership or trust. ²¹

The bill provides that the Secretary of the Treasury may be regulation exclude foreign currency gains not directly related to the company's principal business of investing in stock or securities from qualifying under the 90-percent test. In addition, the bill provides that the 30-percent test applies to sales or dispositions of (1) stock or securities; (2) options, futures or forward contracts (other than those on foreign currencies); or (3) foreign currencies (or options, futures or forward contracts on foreign currencies) not directly related to the company's principal business of investing in stock or securities.

The bill modifies the application of the 30-percent rule in two situations. First, the bill provides that gains after the adoption of a plan of complete liquidation are not to be taken into account under the test if the RIC liquidates during the year in which the plan is adopted.

Second, under the bill, a fund that belongs to a series will not be disqualified under the 30-percent test by reason of sales resulting from, and occurring within five days of, abnormal redemptions if (1) the sum of abnormal redemptions on that day and on prior days during the taxable year exceed 30 percent of net asset value and (2) all funds in the series would meet the test if treated as a single RIC. Abnormal redemptions occur if net redemptions on any day exceed one percent of the fund's net asset value. Sales of stock or securities held less than 3 months will be deemed to have resulted from abnormal redemptions until the cumulative proceeds from such sales (plus cumulative net cash flow of the fund) exceed the amount of net redemptions on the day with abnormal redemptions. The net cash flow of a fund is the money received from any source, reduced by money paid out.

The bill provides that a corporation that elects to be treated as a business development company under the Investment Company Act of 1940 is eligible to be a RIC.

Excise tax on undistributed net income

The bill provides that, in determining a RIC's ordinary income under the excise tax imposed under section 4982, gain or loss attributable to a section 988 transaction which would properly be taken into account for the portion of the calendar year after October 31 is taken into account in the following year. In the case of a company electing to use a taxable year ending November 30, gain or loss attributable to a section 988 transaction which would properly be taken into account in December is taken into account in the following year.

Under the bill, for purposes of determining the amount that a RIC must distribute in order to avoid the excise tax under section 4982, a RIC may reduce its capital gain net income (as computed for purposes of section 4982) by the amount of any "net ordinary loss" but not below its "net capital gain." The "net ordinary loss" of the RIC is equal to the amount that would be the net operating loss of the RIC for the calendar year, with certain modifications. The "net capital gain" of the RIC for this purpose is the excess of the net-long term capital gain over the net short-term capital loss for the one-year period ending on October 31 of the calendar year (or such other one-year period used by the RIC for purposes of section 4892).

Under the bill, earnings and profits of a RIC are determined without regard to any net capital loss or net foreign currency loss attributable to transactions after October 31 of such year and with other adjustments provided in Treasury regulations. This treatment applies only to the extent that the amount distributed during the calendar year does not exceed the required distribution for such calendar year (as determined under section 4982 by substituting 100 percent for the percentages set forth therein). Such determination of earnings and profits does not apply to a RIC that (1) does not have a taxable year ending on October 31, and (2) except as provided in Treasury regulations, has not elected to use its own taxable year for purposes of computing the excise tax under section 4982.

The bill creates an exception to the excise tax under section 4982 when the RIC is owned predominantly by specified tax-exempt entities. The tax does not apply to any RIC for any calendar year if all its shareholders at all times during such year were qualified trusts or segregated asset accounts of insurance companies held in connection with variable contracts. Shares attributable to an investment of less than $250,000 made in connection with the organization of a RIC will not prevent the RIC from qualifying for this exception.

Taxation of RICs and their shareholders

The Secretary of the Treasury is granted authority in the bill to waive the distribution requirement applicable to RICs where failure to meet that requirement is due to distributions made in a prior year that were necessary to avoid imposition of the excise tax imposed under section 4982.

The bill grants regulatory authority to the Secretary of the Treasury to determine the taxable income of a RIC without regard to net foreign currency losses attributable to transactions after October 31 and to treat such losses as arising on the first day of the following year. This authority would not extend to a RIC which elects to use its taxable year for purposes of computing the excise tax imposed under section 4982.

In addition, under the bill, the amount of net capital gain would be determined without respect to net long-term losses occurring after October 31 and such net long-term capital losses would, for the purposes of determining capital gain dividend (and, to the extent provided in Treasury regulations, for purposes of determining taxable income) be treated as arising on the first day of the next taxable year.

The bill provides that dividends declared in October, November, or December and made payable to shareholders of record in such a month are deemed to have been paid by the RIC and received by its shareholders on December 31 of such year, so long as the dividends are actually paid during January of the following year.

Moreover, with certain exceptions, less than 30 percent of the gross income of a REIT must be derived from the sale or exchange of certain properties, including real property held for less than four years (the "30-percent test").

A REIT generally may not treat amounts as rents from real property if the determination of such amounts depends in whole or in part on the income or profits of any person from such property. An exception is provided where a REIT receives or accrues amounts with respect to real or personal property from a tenant that derives substantially all of its income with respect to such property from the subleasing of substantially all of such property, and such tenant receives or accrues only amounts that would be treated as rents from real property if received by the REIT. A similar rule is provided for interest.

In order to be taxed as a REIT, a REIT must generally distribute 95 percent of its taxable income. In addition, section 4981 imposes on REITs an excise tax on the excess of the required distributions over the "distributed amount" for the calendar year. Net income from foreclosure property is not a required distribution, but amounts attributable to such income are included in the "distributed amount."

Income from a shared appreciation provision of a loan held by a REIT that is secured by real property is treated as gain from the sale of the real property that secures the loan, effective for taxable years beginning after December 31, 1986.

Dividends declared by a REIT in December and made payable to shareholders of record on a specified date in that month are deemed to have been paid by the REIT, and received by its shareholders, on that date so long as they are actually paid before February 1 of the following year.

The bill provides that, for purposes of the 30-percent test, the REIT does not take into account in the year in which it is completely liquidated gain from the sale, exchange, or distribution of property after the adoption of a plan of complete liquidation. The bill also provides that the provisions of the Reform Act relating to the treatment of shared appreciation mortgages apply to taxable years beginning after December 31, 1986, but only with respect to obligations acquired after October 22, 1986.

The bill also clarifies that if a REIT receives or accrues amounts with respect to real or personal property from a tenant that derives substantially all of its income with respect to such property from the subleasing of substantially all of such property, and a portion of the amount that the tenant receives or accrues with respect to such property would be treated as rents from real property if received by the REIT, then the amounts received or accrued by the REIT from the tenant would not fail to be treated as rents from real property by reason of being based on the net income or profits of the tenant, to the extent that the amounts received or accrued by the REIT are attributable to amounts received by the tenant that would be treated as rents from real property if received by the REIT. A similar rule is provided for interest. In determining the portion of the rent (or interest) received from the tenant that may qualify as rent from real property (or interest) in these circumstances, allocation rules similar to those applicable under section 856(d)(4) (or section 856(f)(2)) are intended to apply.

Under the bill, for purposes of determining the amount that a REIT must distribute in order to avoid the excise tax under section 4981, a REIT may reduce its capital gain net income by the amount of any "net ordinary loss" of the REIT. The net ordinary loss of the REIT is the amount of the net operating loss of the REIT for the calendar year, with certain modifications. In addition, in order to assure a consistent treatment of net income from foreclosure property, dividends attributable to such property are excluded from the definition of "distributed amount" for purposes of the excise tax under section 4981. The Secretary of the Treasury is granted authority in the bill to waive the distribution requirement for taxation as a REIT where failure to meet that requirement is due to distributions necessary to avoid imposition of the excise tax.

The bill provides that dividends declared in October, November, or December and made payable to shareholders of record in such a month are deemed to have been paid by the REIT and received by its shareholder on December 31 of such year, so long as the dividends are actually paid during January of the following year.

The bill provides rules governing the treatment of interest rate swap or cap agreements, i.e., agreements which protect the REIT from interest rate fluctuations on variable debt incurred to acquire or carry real property. Such agreements are treated as securities under the 30-percent test and payments under them are treated as qualifying under the 95-percent test. No inference is intended regarding the treatment of interest rate swaps or caps under other provisions of the Code.

To qualify as a real estate mortgage investment conduit ("REMIC"), substantially all of an entity's assets must consist of "qualified mortgages" and "permitted investments" as of the close of the fourth month ending after the "startup day" and each calendar quarter ending thereafter (the "asset test").

A qualified mortgage is an obligation principally secured directly or indirectly by an interest in real property. It is unclear whether loans secured by stock in a cooperative housing corporation and debt instruments that are secured by other debt instruments, which other debt instruments are secured principally by interests in real property, may be treated as qualified mortgages. In general, a qualified mortgage must be transferred to a REMIC on or before the startup day, or purchased by the REMIC within three months of the startup day.

Permitted investments consist of cash flow investments, qualified reserve assets, and foreclosure property. A qualified reserve asset is intangible property which is held for investment and is part of a qualified reserve fund. A qualified reserve fund is any reasonably required reserve to provide for full payment of expenses of the REMIC or amounts due on regular interests in the event of defaults on qualified mortgages.

Foreclosure property is property that would be foreclosure property if acquired by a real estate investment trust ("REIT") and which is acquired in connection with the default of a qualified mortgage. Property ceases to be foreclosure property on the date which is one year after the date the REMIC acquired such property. No tax is imposed on the REMIC with respect to income from foreclosure property.

All interests in the REMIC must be "regular interests" or "residual interests." A regular interest is an interest the terms of which are fixed on the startup day, which unconditionally entitles the holder to receive a specified principal amount, and which provides that interest amounts are payable based on a fixed rate (or a variable rate to the extent provided in Treasury regulations). A residual interest is any interest that is so designated and that is not a regular interest in a REMIC. The startup day is any day selected by the REMIC that is on or before the first day on which regular interests in the REMIC are issued.

Taxes on the REMIC

A REMIC is required to pay a tax equal to 100 percent of its net income from prohibited transactions. With certain exceptions, a disposition of a qualified mortgage is a prohibited transaction. No exception is provided for the repurchase of a defective mortgage in lieu of its substitution. In addition, any disposition of a cash flow asset is treated as a prohibited transaction.

Taxation of holders of residual interests

Generally, the holder of a residual interest in a REMIC takes into account his daily portion of the taxable income or net loss of such REMIC for each day during which he held such interest. With certain exceptions, the taxable income of a REMIC is determined in the same manner as in the case of an individual.

The taxable income of any holder of a residual interest in a REMIC for any taxable year shall not be less than the excess inclusion for that year. Thrift institutions are excepted from this requirement and therefore may offset excess inclusions with net operating losses. The effect of these rules on affiliated groups is unclear.

If a tax-exempt organization subject to the tax on unrelated business income holds a residual interest, its excess inclusion is treated as unrelated business taxable income. The tax consequences of the holding of a residual interest by a tax-exempt organization which is not subject to the tax on unrelated business taxable income are uncertain.

If a residual interest in a REMIC is held by a REIT, the excess of aggregate excess inclusions over REIT taxable income is allocated to the REIT shareholders in proportion to the dividends received by such shareholders and the amount so allocated is treated as an excess inclusion with respect to each such shareholder.

Signing of return

For procedural purposes, a REMIC is treated as a partnership, and holders of a residual interest are treated as partners. As such, the REMIC is required to file certain returns, which must be signed by a holder of a residual interest.

Other provisions

An interest in a REMIC is treated as a qualifying asset for purposes under sections 593(d)(4), 856(c)(6)(E) and 7701(a)(19)(C)(xi) in the same proportion that the assets of the REMIC would be treated as qualifying for those purposes. In addition, an entire interest in a REMIC is treated as a qualifying asset under these provisions if 95 percent of the assets in the REMIC would so qualify (the "95-percent test"). The application of the 95-percent test to tiered REMICs is unclear.

In addition, to qualify as a REMIC, the entity must make available information necessary for the application of the tax on certain transfers of residual interests. ²³ Such information would include a computation of the present value of the excess inclusions of a residual interest transferred to a disqualified organization. The REMIC would not fail to satisfy the qualification requirement simply because it charged the person liable for the tax a reasonable fee for providing such information. The failure of such a person to pay such fee will not, however, affect the obligation of the REMIC to provide such information to the Internal Revenue Service.

The bill also provides that a regular interest in a REMIC must be issued on the startup day with fixed terms and must be designated as a regular interest. Under the bill, a residual interest also must be issued on the startup day. Under the bill, the startup day is any day in which the REMIC issues all of its regular and residual interests. In addition, to the extent provided in Treasury regulations, all interests issued and all transfers to the REMIC during any period (not exceeding 10 days) permitted in such regulations may be treated as occurring on the startup day.

Taxes on the REMIC

The bill provides that the repurchase of a defective mortgage in lieu of substitution is not treated as a prohibited transaction even if it occurs more than two years after the startup day. It also provides that the sale of cash flow investments required to prevent defaults on a regular interest where the threatened defaults result from a default on one or more qualified mortgages, or to facilitate a "clean-up call" is not treated as a prohibited transaction.

In addition, if any property is contributed to the REMIC after the startup day, the bill imposes a tax on the REMIC for the taxable year in which the contribution is received equal to 100 percent of the amount (by value) of such contribution. Exceptions to this tax are made for cash contributions made to facilitate a clean-up call or a qualified liquidation, made during the three months following the startup day, or made to a qualified reserve fund by a holder of a residual interest. Also excepted are cash payments in the nature of a guarantee and cash contributions as permitted in Treasury regulations.

A clean-up call is the prepayment of the remaining principal balance of a class of regular interests when, by reason of prior payments with respect to those interests, the administrative costs associated with servicing that class outweigh the benefits of maintaining the class. It typically occurs when there is no more than a small percentage of the particular class of interests outstanding. It does not include the retirement of a class undertaken in order to profit from a change in interest rates.

Under the bill, a REMIC is subject to tax at the highest rate applicable to corporations on its "net income from foreclosure property." Net income from foreclosure property is the amount that would be the REMIC's net income from foreclosure property under section 857(b)(4)(B) if the REMIC were a REIT. Thus, if a REMIC acquires foreclosure property and receives amounts with respect to such property that would not be treated as certain types of qualifying income if received by a REIT, then the REMIC would be subject to tax on such amounts. Property eligible for treatment as foreclosure property would be so treated for a period of two years, with possible extensions. The amount of the REMIC's taxable income is reduced by any tax paid with respect to income from foreclosure property.

Taxation of holders of residual interests

Under the bill, the Secretary of the Treasury is granted regulatory authority to determine the taxable income of a REMIC in a manner other than as in the case of an individual. It is intended that this authority be used to permit the REMIC generally to treat bad debts as other than nonbusiness bad debts and, as appropriate, to permit a deduction for capital losses without limitation, but not to take the dividends received deduction. It is also intended that the Secretary of the Treasury use its authority to prevent individuals from using the REMIC election to circumvent their limitations on bad debt and capital loss deductions. ²⁶

The bill clarifies that all members of an affiliated group are treated as one taxpayer for purposes of the rule requiring that taxable income be no less than excess inclusions. Thus, net operating losses of the group cannot be used to offset excess inclusions. The bill also clarifies that, except as provided below, the exception for thrift institutions is available only if the institution itself, and not any affiliate of the institution, holds the residual interest. Thus, net operating losses of a thrift institution may offset excess inclusions only in the case of residual interests held by the thrift institution.

Notwithstanding the above, a thrift and a qualified subsidiary will be treated as a single corporation under the excess inclusion rule. Consequently, losses of the thrift institution may offset excess inclusions of the subsidiary. A qualified subsidiary of a thrift institution is any corporation all the stock and substantially all of the debt of which is directly owned by the thrift institution and which is organized and operated exclusively for the purpose of organizing and operating one or more REMICs.

Excess inclusions attributable to residual interests held by regulated investment companies ("RICs"), common trust funds, and subchapter T cooperatives will be allocated to shareholders of such entities using rules similar to those applied to a REIT and its shareholders.

The bill also clarifies that, with respect to a variable contract (within the meaning of sec. 817), there is no adjustment in the reserve of an insurance company taxable under subchapter L of the Code to the extent of any excess inclusion. Thus, the insurance company would be taxed currently on the excess inclusion.

Tax on certain transfers of residual interests

The bill imposes a tax on any transfer of a residual interest in a REMIC to a disqualified organization. The amount of the tax is equal to the top corporate rate times an amount (determined under Treasury regulations) equal to the present value of the total anticipated excess inclusions with respect to such interests for periods after such transfer. It is expected that such Treasury regulations will provide that the amount of the anticipated excess inclusions will be determined based on events which have occurred up to the time of the transfer and the prepayment assumption used to determine the accrual of original issue discount under section 1272(a)(6). It is anticipated that the present value of such amount will be determined on the basis of the applicable Federal rate.

The bill defines a disqualified organization as the United States, any State or political subdivision thereof, any foreign government, any international organization or agency or instrumentality of the foregoing; any tax-exempt entity (other than a section 521 cooperative) not subject to the tax on unrelated business income; and any rural electrical and telephone cooperative.

The tax shall be paid by the transferor or, where the transfer is through an agent of the disqualified organization, such agent. The term "agent" includes a broker, nominee, or other middleman. The transferor, or agent as the case may be, will be relieved of liability for this tax if the transferee furnishes an affidavit that it is not a disqualified organization and the person does not have actual knowledge that the affidavit is false. ²⁷

In addition, the bill provides that the Secretary of the Treasury has the authority to waive the tax in appropriate circumstances where the disqualified organization no longer holds the residual and the transferor (or agent) pays such amount as the Secretary of the Treasury may require. It is expected that such amount will be based on the amount of excess inclusions which accrued with respect to the residual interest while such interest was held by the disqualified organization.

Tax on pass-through entities and nominees

If a disqualified organization is a record holder of an interest in a pass-through entity in any taxable year, a tax is imposed on the pass-through entity equal to the amount of excess inclusions allocable to the disqualified organization for such taxable year multiplied by the highest corporate tax rate. A pass-through entity is any RIC, REIT, common trust fund, partnership, trust, estate, or subchapter T cooperative. Except as provided in Treasury regulations, a person holding an interest in a pass-through entity as a nominee for another person will be treated as a pass-through entity and the holder of the residual interest in the first pass-through entity will be treated as the record holder in the deemed pass-through entity.

Any tax imposed on a pass-through entity by this provision shall be deductible against the gross amount of ordinary income of the entity. Thus, for example, in the case of a REIT, the tax shall be deductible both in determining real estate investment trust taxable income under section 857 and in determining the REIT's ordinary income under section 4981.

It is contemplated that a pass-through entity seeking to assure holders of its interests that it will not incur this tax will adopt measures preventing it from acquiring residual interests. It is also contemplated that a pass-through entity seeking to invest in residual interests without incurring this tax will adopt measures prohibiting ownership of its interests by disqualified organizations (or, where possible, allocating the tax to such entities). The bill provides delayed effective dates to allow certain large pass-through entities time for the adoption of such amendments.

Signing of return

The bill clarifies that the REMIC has the obligation to file the REMIC return. ²⁸ Although a REMIC is generally treated as a partnership for procedural purposes, the bill provides that the REMIC return would be required to be signed by any person who could sign the return of the entity in the absence of the REMIC election. Thus, the return of a REMIC which is a corporation or trust would be required to be signed by a corporate officer or a trustee, respectively. For REMICs which consist of segregated pools of assets, the return would be required to be signed by any person who could sign the return of the entity which owns the assets of the REMIC under applicable State law.

Other provisions

The bill clarifies that an interest in a REMIC shall be treated as a real estate asset, and that income from the interest shall be treated as interest on an obligation secured by a mortgage on real property, for REIT qualification purposes under section 856. If less than 95 percent of the assets of the REMIC are real estate assets, the REIT is treated as holding directly its proportionate share of the assets of the REMIC and receiving its proportionate share of the income of the REMIC.

The bill clarifies that, where one REMIC owns interests in a second REMIC, the character of the second REMIC's assets flow through for purposes of determining whether interests in the first REMIC constitute qualifying assets to a building and loan association under section 7701(a)(19).

The bill clarifies that the 95-percent test under sections 593(d)(4), 856(c)(6)(E) and 7701(a)(19)(C)(xi) is applied only once with respect to a REMIC which is part of a tiered structure. Thus, for example, if a REIT owns an interest in a REMIC which owns an interest in a second REMIC, the 95-percent test is applied to the REIT's interest in the first REMIC, but not with respect to the REMIC's interest in the second REMIC. Two REMICs are part of a tiered structure if it was contemplated when both REMICs were formed that some or all of the regular interests of one REMIC would be held by the other.

The bill clarifies that certain provisions relating to REMICs are effective as of January 1, 1987. Thus, for example, interests in a REMIC are eligible to be treated as qualifying assets for a thrift institution, regardless of the institution's taxable year. In addition, the bill makes certain clerical and technical amendments to the statute.

Regulatory Authority

The bill also grants authority to the Secretary of the Treasury to provide appropriate rules for the treatment of transfers of qualified replacement mortgages to a REMIC where the transferor holds any interest in the REMIC. It is intended that these regulations may provide rules for determining the basis of mortgages transferred to, or received from, a REMIC as part of a replacement of qualified mortgages, and also may provide rules for determining or adjusting the basis of qualified mortgages held by the REMIC before or after the replacement. In addition, the bill grants authority to the Secretary of the Treasury to provide that a mortgage will be treated as a qualified replacement mortgage only if it is part of a bona fide replacement and is not part of a swap of mortgages. Thus, the Secretary of the Treasury is authorized to issue regulations which prevent a taxpayer from avoiding recognition on the exchange of appreciated mortgages by contributing such mortgages to a REMIC, and then having the REMIC (which will have a fair market value basis in the mortgages), exchange the mortgages for other mortgages.

The provision requiring REMICs to adopt reasonable arrangements designed to ensure that residual interests in such entities not be held by disqualified organizations is effective for REMICs formed after March 31, 1988, except for REMICs formed pursuant to a binding written contract (i.e., priced) before that date. The tax on transfers of residual interests generally applies to transfers after March 31, 1988. The tax on pass-through entities would generally apply to excess inclusions after March 31, 1988, except for interests in pass-through entities (and residual interests) acquired before that date. The application of the tax on pass-through entities to REITs, RICs, common trust funds and publicly traded partnerships would be effective December 31, 1988. Binding contract exceptions are provided to the transfer and pass-through entity taxes. Unless otherwise elected, the provision relating to the filing of returns is effective for REMICs with a start-up day after the date of enactment of the bill.

Adjustments and preferences are provided for accelerated depreciation, mining exploration and development costs, certain long-term contracts, pollution control facilities, installment sales, circulation and research and experimental expenditures of individuals, miscellaneous itemized deductions, itemized deductions for State and local taxes, Merchant Marine Capital Construction Funds, special insurance deductions, percentage depletion in excess of basis, excess intangible drilling costs, incentive stock options, excess bad debt reserves of financial institutions, tax-exempt interest on certain bonds, appreciated property charitable deductions, farm losses, and passive losses.

In addition, for 1987 through 1989, one-half of the excess of pretax book income of a corporation over other alternative minimum taxable income is a preference. For taxable years beginning after 1989, three-fourths of the excess of adjusted current earnings over other alternative minimum taxable income is a preference.

These provisions are effective for taxable years beginning after December 31, 1986.

The bill provides that a taxpayer's regular tax will be reduced by the possessions tax credit under section 27(b) since income eligible for the credit is not included in the minimum tax base.

The bill clarifies that a taxpayer subject to the regular tax is also subject to the minimum tax (if the tentative minimum tax exceeds the regular tax), and that where the taxpayer's tax base is measured by something other than taxable income, such as unrelated business taxable income, real estate investment trust taxable income, or life insurance company taxable income, alternative minimum taxable income is determined using that tax base. The bill also clarifies that for nonresident aliens and foreign corporations, the alternative minimum tax applies only to income subject to net basis taxation (secs. 871(b), 877, and 882).

In order to prevent an incentive for separate filing by married persons, the bill provides, in effect, that the maximum amount of the exemption phase-out will be the same as for married taxpayers filing jointly. 1 More specifically, the bill provides that for taxable years ending after the date of enactment of this bill, alternative minimum taxable income of a married person filing a separate return is increased by the lesser of (1) 25 percent of the excess of alternative minimum taxable income (determined without regard to this adjustment) over $155,000 (i.e. the amount at which the exemption phase-out ends on a separate return) or (2) $20,000 (i.e. the maximum exemption amount of the taxpayer's spouse).

Adjustments

The bill provides that in the case of small construction contracts described in section 460(e)(1), the percentage of the contract completed shall be determined by using the simplified procedures for allocation of costs as added by the bill. The bill also provides that the amount includible in gross income with respect to the alcohol fuels credit (sec. 87) will not be included in alternative minimum taxable income since that credit is not allowed against the minimum tax.

The bill clarifies that the deduction for regular tax purposes for personal exemptions is not allowed under the minimum tax, since a minimum tax exemption amount is provided. Further, the bill provides that only interest which is qualified residence interest for purposes of the regular tax may qualify as deductible housing interest for purposes of the minimum tax ², clarifies that minimum tax investment interest and minimum tax passive losses do not include minimum tax housing interest, and provides that investment income for purposes of the minimum tax takes into account the minimum tax preferences and adjustments.

Book income

The bill provides that an income statement that is filed with a Federal, state, or local government must be prepared for a substantial nontax purpose in order to be an applicable financial statement. Thus, an income tax return, franchise tax return or other similar return prepared for the purpose of determining any tax liability that is filed with Federal, State, or local authorities does not constitute an applicable financial statement. In addition, an income statement used by a government for statistical purposes only is not prepared for a substantial nontax purpose. The bill also provides that if a taxpayer has two or more financial statements with the same priority, the applicable financial statement shall be the one specified in regulations promulgated by the Secretary of the Treasury.

The gross amount of dividends (i.e. gross of any withholding taxes) received from a section 936 corporation, like dividends received from other nonconsolidated corporations, are included in the recipient's adjusted net book income. To the extent that the alternative minimum taxable income of the recipient is increased by reason of the inclusion of such dividends in adjusted net book income, the bill clarifies that a pro rata portion of withholding or income taxes is treated, for minimum tax purposes, as creditable foreign taxes paid by the recipient. The maximum amount of withholding or income taxes that may be treated as creditable foreign taxes is 50 percent of the taxes. However, this amount is reduced on a proportionate basis if a lesser amount of the dividends from the 936 corporation is taken into account in computing alternative minimum taxable income.

The bill also clarifies that if a taxpayer does not choose to take the benefit of section 901 with respect to income, war profits, or excess profits taxes imposed by a foreign country or possession of the United States, or is prohibited from taking the benefit of section 901 (i.e. taxes described in section 901(j)), adjusted net book income is reduced by only those taxes. That is, taxes which are not deductible for regular tax purposes (for example, withholding or income taxes imposed by a U.S. possession on dividends received from a section 936 corporation) are not deductible for this purpose. Similarly, the related income is to be reflected gross of any of these nondeductible taxes.

Adjusted current earnings

The bill clarifies that the rule providing that income on an annuity contract is included in adjusted current earnings does not apply to a qualified annuity contract held under a plan described in section 403(a).

The bill provides an elective alternative to the general rule requiring depreciation for adjusted current income purposes to be computed using whichever of two methods yields deductions with the smallest present value. The two methods are the alternative depreciation system described in section 168(g) and the method used for book purposes. Instead, a taxpayer may elect to compute depreciation for adjusted current earnings purposes by taking a deduction equal to the amount necessary to increase the amount of accumulated depreciation (for adjusted current earnings purposes) on the property to the lesser of the accumulated depreciation allowed as of the end of the taxable year under either the alternative depreciation system described in section 168(g) or the method used for book purposes. The election does not affect the depreciable basis allowed for purposes of the adjusted current earnings provision.

A taxpayer may elect to use the alternative method for any taxable year beginning after 1989. The election applies to all property placed in service during that taxable year, and is irrevocable with respect to such property. If an election is made for the first taxable year for which the adjusted current earnings provision is effective, the election applies to all property placed in service during that taxable year and all previous taxable years. A taxpayer is not required to use the alternative method for property placed in service during any subsequent taxable year by reason of having made the election for a prior taxable year.

The bill also provides a special rule in the case of any property subject to a lease where the income of the taxpayer for book purposes with respect to such property is determined without regard to an allowance for depreciation. This situation may arise, for example, where a taxpayer leases property in a transaction that is treated for book purposes as a direct financing lease under FAS 13 (as amended).

In such a situation, the excess (if any) of the income from the lease for adjusted current earnings purposes (determined without regard to this provision or any other allowance for depreciation) over the income from the lease reported for book purposes is treated as the depreciation deduction determined with respect to such property for book purposes.

The adjusted current earnings depreciation for such property for any taxable year is to be determined using the special rule described above. This use of the special rule is not intended to be considered as an election of the alternative method applicable to all property placed in service during the taxable year.

The bill additionally provides that, in the case of property described in paragraphs (1), (2), (3), or (4) of section 168(f), the amount of depreciation allowable for regular tax purposes shall be treated as the amount allowable under the alternative system of section 168(g) for the purpose of determining adjusted current earnings depreciation. It is normally anticipated that the alternative method (described above) will be used and that such use will not be considered as an election of the alternative method applicable to all property placed in service during that taxable year.

Preferences

The bill clarifies that the preference for bond interest only applies to tax-exempt bonds and the exception for refunding bonds includes both current and advance refundings. The bill also clarifies that the charitable contribution preference applies to trusts and estates as well as all other taxpayers.

The bill provides that for purposes of the individual minimum tax, stock acquired pursuant to the exercise of an incentive stock option exercised after October 16, 1987, will be treated without regard to the rules of section 421. Instead the rules of section 83 will apply to the stock in determining the individual's alternative minimum taxable income. For example, if a taxpayer acquires stock pursuant to the exercise of an incentive stock option and disposes of the stock in the same taxable year, the tax treatment under the regular tax and the minimum tax will be the same; if the stock is disposed of in a disqualifying disposition in a subsequent taxable year, the "spread" between the option price and fair market value of the stock (determined in accordance with the rules of section 83) will be included in alternative minimum taxable income in the first taxable year and in taxable income (but not in alternative minimum taxable income) in the subsequent taxable year. In addition, if the stock acquired is subject to a lapse restriction, amounts will be included in the alternative minimum taxable income in accordance with the rules of section 83. (For options exercised on or before October 16, 1987, and disposed of in a disqualifying disposition, the minimum tax treatment and the regular tax treatment will be the same for both the year of exercise and the year of disposition.)

Investment tax credits

The bill clarifies that the total amount of the general business credit allowable to a C corporation for a taxable year in which the regular tax exceeds the tentative minimum tax is determined as if the portion of the general business credit not attributable to the regular investment tax credit first offset the regular tax, and the regular investment credits (to the extent otherwise available) then reduced the net tax to 75 percent of the tentative minimum tax. This rule affects only the determination of amount of the general business credit allowable in a taxable year and does not change the usual ordering rules of section 38.

Foreign tax credits

The bill clarifies that for purposes of determining whether any income is high-taxed income in applying section 904(d)(2) in computing the alternative minimum tax foreign tax credit, the alternative minimum tax rate is to be used in lieu of the regular tax rate. The bill also clarifies that foreign taxes paid or accrued in a taxable year beginning after December 31, 1986, which are carried back to offset tax in a taxable year beginning before January 1, 1987, may not be used in computing the alternative minimum tax foreign tax credit for years beginning after 1986.

Clerical amendments

The bill makes numerous clerical amendments and corrects several cross references to these provisions.

Transitional provisions

The bill provides that, for property that is depreciated under the new ACRS system during a taxable year of the taxpayer that begins before 1987, the new minimum tax depreciation (or pollution control facility amortization) rules apply to measure the preference, but the preference applies only to property to which the prior law rules of paragraphs (4) and (12) of section 57(a) applied. The bill also provides that in the case of a fiscal year trust or estate beginning in 1986 and ending in 1987, the prior law apportionment rules will apply notwithstanding that a beneficiary's taxable year begins in 1987. The bill also contains certain transition rules that were inadvertently amended or deleted in enrolling the Act.

1. Limitation on the use of the cash method of accounting

(sec. 108(a) of the bill, sec. 801 of the Reform Act, and secs. 448, 461, and 464 of the Code)

The ownership test is met if substantially all (i.e., 95 percent) of the value of the outstanding stock in the corporation is owned, directly or indirectly, by employees performing services for the corporation in connection with the qualified services performed by the corporation, retired individuals who performed such services for the corporation or its predecessor(s), the estate of such an individual, or any other person who acquired stock by reason of the death of such an employee (for the two-year period beginning with the death of such employee).

A special rule is provided allowing the common parent of an affiliated group (within the meaning of sec. 1504(a)) to elect to treat all members of such affiliated group as one taxpayer for the purpose of determining if the ownership test is met, provided that substantially all of the activities of the members of such affiliated group involve the performance of services in the same field satisfying the function test.

The bill also provides that a common parent of an affiliated group may elect to treat all members of such group as one taxpayer for the purpose of determining if the ownership test is met where 90 percent or more of the activities of such affiliated group involve the performance of services in the same field satisfying the function test. Thus, if 90 percent or more of the activities of the affiliated group, taken as a whole, are the performance of services in a field satisfying the function test, an election is available to apply the ownership test to the group as a whole. The function test, however, must still be applied to each separate corporation.

Under section 461(i), in the case of tax shelters, no deduction is allowed with respect to an item until there has been economic performance with respect to that item. Under a special rule applicable to tax shelters in oil and gas, economic performance with respect to drilling of an oil or gas well is deemed to occur at the time of spudding.

In the case of a partnership, a partner's deduction of drilling expenses that are treated as economically performed by reason of the spudding rule is limited to the partner's cash basis in the partnership. A partner's cash basis is equal to the adjusted basis of it's interest in the partnership, determined without regard to amounts related to certain borrowings. These amounts are (1) any liability of the partnership, (2) any amount borrowed by the partner with respect to the partnership which was either arranged by the partnership or any participant in the organization, sale or management of the partnership, and (3) any amount borrowed by the partner if such borrowing was secured by any assets of the partnership.

The bill also clarifies the definition of tax shelter for purposes of the denial of the cash method of accounting. Under the bill, an S corporation is not treated as a tax shelter for this purpose merely by reason of the filing of a notice of exemption from registration with a State agency that has the authority to regulate the offering of securities for sale. It is anticipated that an S corporation that is prohibited from using the cash method of accounting under present law solely by reason of having filed such a notice of exemption and, consequently, has changed to a method of accounting other than the cash method for its first taxable year beginning after 1986, will be allowed, under this technical amendment, to retain its prior method of accounting.

Under section 464(a), farming syndicates are allowed a deduction for amounts paid for feed, seed, fertilizer, or other similar farm supplies no earlier than the taxable year in which such feed, seed, fertilizer, or other supplies actually are used or consumed.

Under section 464(b), farming syndicates are required to capitalize the cost of poultry purchased for use in a trade or business and to deduct such cost ratably over the lesser of 12 months or the useful life of such poultry in the trade or business. In addition, a farming syndicate may deduct only the cost of poultry purchased for sale in the taxable year in which the poultry is disposed of.

The Reform Act applies section 464(a) and 464(b) to certain persons prepaying 50 percent or more of certain farming expenses, with respect to the portion of such expenses exceeding 50 percent.

2. Capitalization rules for inventory, construction, and development costs

(sec. 108(b) of the bill, sec. 803 of the Reform Act, and sec. 263A of the Code)

The uniform cost capitalization rules apply to the manufacture or construction of all tangible property and to the purchasing and holding property for resale. Exceptions to these rules are provided for property produced by the taxpayer for personal use, research and experimental costs allowable as a deduction under section 174, certain development and other costs of oil and gas wells and mineral property deductible under section 263(c), 616(a), or 617(a), property produced pursuant to a long-term contract, and the production of timber and certain ornamental trees.

Simplified method for taxpayers acquiring property for resale

Taxpayers with gross receipts in excess of $10 million who acquire personal property for resale and all taxpayers who acquire real property for resale are required to apply the uniform capitalization rules with respect to such property. The uniform capitalization rules require that all direct costs of such property and such property's proper share of those indirect costs, part or all of which are allocable to such property, be absorbed into the inventory costs of the property, rather than currently expensed. Included in the costs required to be absorbed into inventory cost are off-site storage costs and related handling costs. The Secretary of the Treasury is directed to prescribe regulations providing for simplified procedures for the application of the uniform capitalization rules in the case of property acquired for resale.

Capitalization of interest

Interest costs are subject to special rules. Capitalization of interest is required only if the taxpayer is engaged in the manufacture or construction of property (i.e., resellers are exempt), and only if the property produced is real property or personal property that is long-lived or has an extended production period. Interest costs are allocable to the production or construction of property if they are directly attributable to production expenditures incurred in producing the property, or could have been avoided if the production expenditures had not been incurred. Interest incurred or continued in connection with property used to produce property is also subject to capitalization.

Special rules for farmers

Special rules also apply to the production of farm products. In general, the uniform capitalization rules apply to such production only if the product has a preproductive period of more than two years. This exception for property with a preproductive period of less than two years does not apply to taxpayers required to use an accrual method of accounting under section 447 or 448. Except for taxpayers using an annual accrual method of accounting, taxpayers required to use an accrual method of accounting must capitalize preproductive expenses. The costs required to be capitalized with respect to farming animals may be determined using the unit livestock method. 1

Certain farmers otherwise required to capitalize preproductive period costs may elect to deduct such costs currently, provided the alternative cost recovery system is used on all farm assets and the expensed costs are recaptured upon disposition of the product. The election is not available to taxpayers required to use the accrual method of accounting or engaged in the production of pistachios. Moreover, the election is not available with respect to certain costs attributable to citrus or almond groves.

Costs incurred in replanting edible crops following loss or damage due to freezing temperatures, disease, drought, pests, or casualty may be deducted currently. This exception may apply to costs incurred by persons other than the taxpayer who incurred the loss or damage, provided (1) the taxpayer who incurred the loss or damage retains an equity interest of more than 50 percent in the property on which the loss or damage occurred and (2) the person claiming the deduction materially participates in the planting or maintenance of the property during the four-taxable year period beginning with the year of the loss or damage.

Effective dates

In the case of inventories, the provisions generally are effective for taxable years beginning after December 31, 1986. In the case of self-constructed property, the rules apply to costs incurred after December 31, 1986, unless incurred with respect to property on which substantial construction (whether by the taxpayer or by another person) occurred before March 1, 1986. In the case of noninventory property held for sale, the rules apply to costs incurred after December 31, 1986.

The bill adds to the list of costs specifically exempted from the uniform capitalization rules costs incurred in connection with oil and gas wells or mineral property that are subject to amortization pursuant to section 291(b)(2), 263(c), 263(i), 616, or 617, and costs (other than circulation expenditures) subject to ten-year amortization under section 59(e).

Simplified method for taxpayers acquiring property for resale

The Secretary of the Treasury is directed to issue regulations providing for simplified procedures for the application of the uniform capitalization rules in the case of property acquired for resale. It is anticipated that such regulations will provide a method for computing allocation ratios for the purpose of assigning a portion of total costs to ending inventory or cost of sales. The allocation ratio for assigning storage costs and related handling costs is to be determined by dividing the gross amount of such costs by the sum of beginning inventory balances plus purchases for the taxable year.

Capitalization of interest

The bill also clarifies that, in determining the amount of interest that must be capitalized in connection with an asset used to produce property, the methods applied under the general interest allocation rules are applied to the full cost of the asset. ² Accordingly, any interest specifically traceable to such an asset must first be allocated to the produced property; interest on other debt of the taxpayer is then allocated to the extent required under the avoided cost method. ³

Finally, the bill clarifies that a cost is subject to capitalization under this provision only to the extent it is otherwise taken into account in computing taxable income for any taxable year. Thus, for example, the portion of a taxpayer's interest expense that is allocable to personal loans, and hence is disallowed under section 163(h), may not be included in a capital or inventory account and recovered through depreciation or amortization deductions, as a cost of sales, or in any other manner.

Special rules for farmers

The special rule for costs incurred by persons other than the taxpayer in connection with replanting a crop of the taxpayer following loss or damage due to freezing temperatures, etc., is modified. Under the bill, such costs may be deducted without regard to whether they were incurred (or the persons' material participation occurs) within the four-taxable year period following the loss or damage.

Many taxpayers using the annual accrual method of accounting, other than taxpayer's engaged in the trade or business of growing sugar cane, were required under section 278 of prior law to capitalize preproductive expenses (e.g., citrus growers). The Reform Act repealed section 278. Under the bill, the special rule that allows taxpayers using the annual accrual method of accounting to expense preproductive expenses is limited to those taxpayers engaged in the trade or business of farming sugar cane.

3. Long-term contracts

(sec. 108(c) of the bill, sec. 804 of the Reform Act, and sec. 460 of the Code)

In the taxable year in which a contract reported under the percentage of completion method is completed, a determination is made whether the taxes paid with respect to the contract in each year of the contract were more or less than the amount that would have been paid if gross income had been computed by using the actual gross contract price and the actual total contract costs, rather than the anticipated contract price and costs. Interest must be paid by the taxpayer if, applying this "lookback" method, there is an underpayment by the taxpayer with respect to a taxable year. Similarly, interest must be paid to the taxpayer by the Internal Revenue Service if there is an overpayment.

Under the percentage of completion-capitalized cost method, the taxpayer must take into account 70 percent of the items with respect to the contract under the percentage of completion method. The remaining 30 percent of the items under the contract must be taken into account under the taxpayer's normal method of accounting (e.g., completed contract method, accrual shipment method). ⁵

Costs that directly benefit, or are incurred by reason of, a taxpayer's long-term contract activities must be allocated to its long-term contracts in the manner provided in the Treasury regulations under section 451 for extended period long-term contracts. This method of allocation is required irrespective of whether the contract is reported under the percentage of completion-capitalized cost method or the percentage of completion method. While costs may be deducted in the year incurred if they relate to a contract (or portion of a contract) reported under the percentage of completion method, whether costs are allocable to such a contract is nonetheless relevant because it affects the determination of the percentage of the contract completed during the year.

The bill also provides that, in applying the look-back method, amounts received or accrued after completion of the contract are taken into account by discounting such amounts to their value as of the completion of the contract. The Federal mid-term rate as of the time the amount was received is the applicable discount rate. The bill exempts a long-term contract from application of the lookback method if the taxpayer expects to complete the contract within two years of the contract commencement date and the gross contract price does not exceed the lesser of $1 million or 1 percent of the taxpayer's average gross receipts for the three taxable years preceding the year the contract was entered into.

4. Taxable years of certain entities

(sec. 108(e) of the bill, sec. 806 of the Reform Act, and secs. 706, 1378, 441, and 267 of the Code)

The majority interest rule does not apply unless the period that constitutes the taxable year of partners owning a majority interest in partnership profits and capital has been the same for the three-taxable-year period of such partners ending on or before the beginning of such taxable year of the partnership. If the partnership has not been in existence for all of such three-taxable-year period, the period that constitutes the taxable year of the partners owning a majority interest in profits and capital must have been the same for the taxable years of such partners ending with or within the period of the partnership's existence.

The majority interest taxable year is the taxable year (if any) that, on the testing day, constituted the taxable year of one or more partners having (on the testing day) an aggregate interest in partnership profits and capital of more than 50 percent. Generally, the testing day is the first day of the partnership's taxable year. The Secretary of the Treasury may provide that an alternate, representative period be used as the testing day, rather than the first day of the taxable year, if such period is more representative of the ownership of the partnership. A partnership that is required to change its taxable year to its majority interest taxable year is not required to change to another taxable year for either of the two taxable years following the year of change.

The bill further provides that, if a corporation is a member of an affiliated group filing a consolidated return, all members of such group shall be taken into account in determining whether such corporation is a personal service corporation.

The Internal Revenue Service has issued a revenue procedure which sets forth rules under which the Service will permit electing S corporations to adopt taxable years other than a calendar year. Rev. Proc. 83-25, 1983-1 C.B. 689. Under the so-called "25-percent test" of that revenue procedure, an electing S corporation generally may adopt, retain, or change to a taxable year if, among other tests, 25 percent or more of the gross income of the taxpayer is realized in the last two months of that year.

The adjusted basis of a partner in a partnership interest or of an S Corporation shareholder in stock is determined as if all of the income to be taken into account over the four year spread period were included in gross income in the first taxable year. Thus, current distribution of an amount equal to the amount of income attributable to the partner or S corporation shareholder in the short taxable year will not result in capital gain, unless the distribution would have had such an effect had there been no four year spread. If any interest in a partnership or stock in an S corporation is disposed of before the last taxable year in the spread period, any income attributable to the interest or stock disposed of that remains to be recognized pursuant to the spread is included in the gross income in the same taxable year as the interest or stock is disposed of.

The bill provides that the four year spread for income attributable to a short taxable year will apply only once in the case of a passthrough or tiered item.

The bill provides that the Internal Revenue Service is not required to permit taxpayers to have an automatic change of a taxable year. Thus, taxpayers meeting the "25-percent test" of Rev. Proc. 83-25 are not automatically permitted to adopt or change to a year allowed under that revenue procedure.

5. Treatment of installment obligations

(sec. 108(f) of the bill, sec. 811 of the Reform Act, and secs. 453 and 453C of the Code)

In addition, the 1987 Act repealed the proportionate disallowance rule for nondealer real property installment obligations arising out of dispositions occurring in taxable years beginning after December 31, 1987. Nondealer real property installment obligations arising out of dispositions occurring after August 16, 1986, in taxable years beginning before January 1, 1988, are subject to the proportionate disallowance rule in any later taxable year for which a taxpayer has allocable installment indebtedness. A taxpayer may elect early application of the interest and pledge rules contained in the 1987 Act, in which case the proportionate disallowance rule does not apply to nondealer real property installment obligations.

Applicable installment obligations include installment obligations arising from certain specified types of sales, which installment obligations are held by the seller or a member of the same affiliated group (within the meaning of sec. 1504(a) without regard to sec. 1504(b)) as the seller. Obligations arising from sales of personal property pursuant to a revolving credit plan or obligations arising from the sale of publicly traded property may be treated as applicable installment obligations. Personal use property and indebtedness secured primarily by such property are not taken into account for purposes of applying the proportionate disallowance rule of section 453C to applicable installment obligations arising from dealer sales.

Taxpayers who are required to change their method of accounting for sales pursuant to a revolving credit plan because of section 812 of the Reform Act must take into income any adjustment arising under section 481 over a period of four years, with specified percentages for each of the four years.

The bill clarifies that the term "applicable installment obligation" includes installment obligations arising from certain specified types of sales, which installment obligations are held by the seller or any person if the basis of such obligation in the hands of such person is determined (in whole or in part) by reference to the basis of such obligation in the hands of another person and such obligation was an applicable installment obligation in the hands of such other person. Thus, for example, if an applicable installment obligation is transferred to a partnership or a trust in a nonrecognition transaction and the partnership or trust has a carryover basis in the installment obligation, then the obligation is treated as an applicable installment obligation in the hands of the partnership or trust.

The bill also clarifies that installment obligations arising from the sale of personal property pursuant to a revolving credit plan or from the sale of publicly traded property are not treated as applicable installment obligations. Thus, such installment obligations are not subject to the proportionate disallowance rule. In addition, the bill clarifies that the provision denying the use of the installment method for sales of publicly traded property applies with respect to sales of such property after December 31, 1986.

In addition, the bill clarifies how the proportionate disallowance rule is applied with respect to applicable installment obligations arising after February 28, 1986, but in a taxable year prior to the first taxable year ending after December 31, 1986. The bill specifies that any such applicable installment obligations are treated as arising on the first day of the first taxable year of the taxpayer ending after December 31, 1986.

The bill provides that if a taxpayer's last taxable year beginning before January 1, 1987, was the taxpayer's first taxable year in which sales were made under a revolving credit plan, then all adjustments under section 481 are taken into account in the taxpayer's first taxable year beginning after December 31, 1986. The bill also provides that the adjustment under section 481 required by the repeal of the installment method for revolving credit plans is to be taken into account no slower than the rate of contraction of the taxpayer's revolving credit installment obligations. For this purpose, the rate of contraction equals a fraction the numerator of which is the amount by which (1) the aggregate face amount of revolving credit obligations outstanding as of the close of the last taxable year beginning before January 1, 1987, exceeds (2) the aggregate face amount of revolving credit obligations outstanding as of the taxable year under consideration and the denominator of which is the aggregate face amount of revolving credit obligations outstanding as of the close of the last taxable year beginning before January 1, 1987.

The bill also provides that if a taxpayer sells any receivables that arose pursuant to a revolving credit plan and that were taken into account in computing the adjustment under section 481 relating to the change from the installment method to the accrual method, then the taxpayer may not recognize any loss on the sale of such receivables. If a loss is realized on any such sale, however, then the taxpayer may reduce the aggregate amount of the adjustment under section 481 for the fourth taxable year beginning after December 31, 1986, by the amount of such loss; to the extent that the loss exceeds the aggregate adjustment for such fourth taxable year, then the adjustment for the third taxable year is reduced, and so on.

Further, the bill corrects certain clerical and technical errors.

6. Income attributable to utility services

(sec. 108(i) of the bill, sec. 822 of the Reform Act, and sec. 451 of the Code)

For any taxable year beginning before August 16, 1986, a method of accounting that took into account income from the furnishing or sale of utility services on the basis of the period in which the customer's meters were read is deemed to be proper for Federal income tax purposes.

In providing that a method of accounting which takes into account income from the providing of utility services on the basis of the period in which the customers' meters are read will be deemed proper for Federal income tax purposes for any period, no inference of propriety was intended for any method that did not strictly adhere to the meter reading method for all customers of the utility. In addition, no inference was intended with regard to other questions of law, including but not limited to the treatment of prepaid income amounts for the provision of utility services at a future date, the treatment of deposits made by utility customers, or the treatment of amounts received or accrued by the utility under a "budget-billing" procedure.

1. Limitations on bad debt reserves

(sec. 109(a) of the bill, sec. 901 of the Reform Act, and sec. 46(e)(4) of the Code)

Section 901 of the Reform Act reduced the portion of taxable income that thrift institutions (mutual savings banks, domestic building and loan associations, and cooperative banks) may deduct as an addition to reserves for bad debts from a maximum of 40 percent to eight percent. In addition, an institution otherwise meeting the definition of a thrift institution is required to hold at least 60 percent of its assets in qualifying assets in order to meet the definition of a thrift institution.

Prior and present law limits the amount of investment eligible for the investment tax credit in the case of a thrift institution to 50 percent of the amount otherwise allowable. Where a thrift institution is the lessee of property that is eligible for the investment tax credit, the lessor is treated as a thrift institution with respect to such property, unless the thrift institution has elected to compute its deduction for bad debts using the experience method. Such an election is binding on the thrift institution for all subsequent years.

Commercial banks

Section 901 of the Reform Act also repealed the use of the reserve method in computing the deduction for bad debts of "large banks." A bank is considered to be a "large bank" if, for the current taxable year or any taxable year beginning after December 31, 1986, the sum of the average adjusted bases of all assets of such bank (or any controlled group of which the bank is a member) exceeds $500 million.

A large bank that has previously used the reserve method in computing its deduction for bad debts generally is required to include in income the balance of any reserve for bad debts over a period of four taxable years, beginning with the disqualification year. Ten percent of the reserve balance is included in income in the disqualification year, 20 percent in the first taxable year following the disqualification year, 30 percent in the second following year, and 40 percent in the third taxable year following the disqualification year. An election may be made to include more than 10 percent of the reserve in the disqualification year, in which case 2/9ths of the remainder of the reserve balance is included in income in the first taxable year following the disqualification year, 1/3rd of the remainder in the second following year, and 4/9ths of the remainder of the reserve in the third year following the disqualification year.

A bank, that is recapturing its existing bad debt reserve by including an amount in taxable income, must, except for the election described below, suspend the inclusion in income of its bad debt reserve for any year in which it is a "financially troubled bank." In the case of a bank that is a member of a controlled group described in section 1563(a)(1), the determination of whether the bank is a financially troubled bank is made with respect to all members of that controlled group. If a bank is troubled in its first disqualification year, an election may be made to recognize in income all or a portion of the amount of its reserves that otherwise would be recaptured in such year.

In lieu of the recapture of a bad debt reserve by its inclusion in income, an election may be made to use the cut-off method. A bank using the cut-off method is required to segregate its outstanding loans into two accounts. One account consists of loans created on or after the first day of the disqualification year. The specific charge-off method is required to be used in computing the deduction for bad debts attributable to the loans in this account. The second account consists of loans that were outstanding on the last day of the taxable year before the disqualification year. The deduction for bad debts attributable to the loans in this account continues to be determined using the reserve method. However, no deductions are allowed for additions to this reserve. The rules providing for the suspension of recapture of the bad debt reserve by a bank that is a financially troubled bank are inapplicable if the cut-off method is elected.

The bill provides that an election by a lessee thrift institution to use the experience method of computing its deduction for bad debts shall terminate effective with respect to the first taxable year of the electing organization beginning after 1986 and during which such organization (or any successor organization) was not the lessee under any lease of regular investment tax credit property. Regular investment tax credit property is any section 38 property if the regular percentage applied to such property and the amount of qualified investment with respect to such property would have been reduced but for the election by the organization.

The effect of the provision is to allow a thrift institution that had committed to the use of the experience method of accounting for bad debts in order to avoid certain reductions in investment tax credit to use the percentage of income method in taxable years beginning after 1986, provided the thrift institution is not a lessee of property that was eligible for investment tax credit without reduction as a result of the prior election.

Commercial banks

In the case of a "large bank", the bill provides that an election made by a member of a parent-subsidiary controlled group is binding on all banks that are members of such parent-subsidiary controlled group for the taxable year of the election. A parent-subsidiary controlled group is any controlled group of corporations described in section 1563(a)(1).

If, for example, an election is made to use the cut-off method in lieu of including the bad debt reserve in income, such election is binding upon all of the banks in the parent-subsidiary controlled group. Furthermore, if a member of a parent-subsidiary controlled group makes an election to include more than 10 percent of the bad debt reserve in income for the disqualification year, such election is binding upon all of the banks in the parent-subsidiary controlled group, and each such bank must include the same percentage of its bad debt reserve in income in that year.

In the case of a bank (or parent-subsidiary controlled group) that elects the cut-off method, the bill provides for inclusion in income of any portion of the bad debt reserve that exceeds the outstanding balance of loans that were created prior to the disqualification year. For example, a bank that elects the cut-off method has outstanding loans of $500 million and a bad debt reserve of $3 million as of the last day of the year preceding the disqualification year. Of such loans, $498 million are collected and $1 million are charged-off in the disqualification year. Thus, at the end of the disqualification year, the $2 million bad debt reserve exceeds the $1 million outstanding balance of loans. The difference ($1 million) is required to be included in income in the taxable year the difference arises.

2. Interest on debt used to purchase or carry tax-exempt obligations

(sec. 109(b) of the bill, sec. 902 of the Reform Act, and secs. 265 and 291 of the Code)

An exception to the proportional disallowance rule is provided for qualified tax-exempt obligations acquired by a financial institution. Qualified tax-exempt obligations include any tax-exempt obligation which (1) is not a private activity bond, as defined under Title XIII of the Reform Act, ² and (2) is issued by an issuer which reasonably anticipates to issue not more than $10 million of tax-exempt obligations (other than private activity bonds, as defined above) during the calendar year. Qualified tax-exempt obligations must be designated as such by the issuer; not more than $10 million of obligations may be so designated for any calendar year.

For purposes of applying the limitations with respect to qualified tax-exempt obligations, an issuer and all subordinate entities are treated as one issuer.

Qualified tax-exempt obligations are treated as if they had been acquired by the financial institution on August 7, 1986. As a result, interest allocable to such obligations remains subject to the 20 percent disallowance rule contained in pre-1986 law.

Application of $10 million limit

The bill clarifies that, in applying the $10 million limitation with respect to qualified tax-exempt obligations, all tax-exempt obligations (other than private activity bonds, as defined above) which the issuer reasonably anticipates to issue during the calendar year are taken into account. Thus, only an issuer that reasonably anticipates to issue $10 million or less of such obligations during the calendar year (including designated and undesignated issues) may designate any of these obligations for purposes of the exception.

Treatment of composite issues

The bill specifies the treatment of composite issues (i.e., combined issues of bonds for different entities) for purposes of the exception. An issue is a composite issue if the separate lots are sold under a common marketing arrangement that effectively provides the issuers of the separate lots access to the capital markets in a manner similar to the issuance of one issue. In order for separate lots to be treated as a composite issue, all lots need not have the same collateral or security for the lots or have cross-collateralization among lots.

Under the bill, composite issues qualify for the exception only if the requirements of the exception are met (1) with respect to the composite issue as a whole (determined by treating the composite issue as a single issue), and, additionally, (2) with respect to each separate lot of obligations which is a part of the issue (determined by treating each separate lot of obligations as a separate issue). Thus, a composite issue may qualify for the exception only if the composite issue itself does not exceed $10 million, and if, additionally, each issuer benefiting from the composite issue reasonably anticipates to issue not more than $10 million of tax-exempt obligations (other than private activity bonds, as described above) during the calendar year, including bonds issued through the composite arrangement. The conditions under which bonds of different issuers are aggregated for purposes of the $10 million limit are described below.

Aggregation of issuers

The bill clarifies the operation of the provision under which an issuer and all subordinate entities are aggregated for purposes of the $10 million limitation. The following rules are provided:

Under the bill, the treatment of refunding bonds also is clarified. Specifically, the following rules would apply to refundings.

Designation of certain bonds issued in reliance on House bill

The bill specifies that only obligations issued after August 7, 1986, may be designated for purposes of the exception. For obligations issued after August 7, 1986, and before January 1, 1987, the period for making a designation is not to expire before January 1, 1989.

A special rule is provided for certain obligations issued before August 8, 1986, in reliance on a similar exception contained in the House version of the 1986 Act. 5 Under this rule, if (1) an obligation was issued after December 31, 1985, and before August 8, 1986, (2) when the obligation was issued, the issuer designated that it intended the obligation to qualify under section 802(e)(3) of the House bill, and (3) the issuer reaffirms its election under the 1986 Act, then the obligation is treated as issued on August 8, 1986.

1. Treatment of certain market discount bonds

(sec. 110(a) of the bill and sec. 1011(d) of the Reform Act)

The Deficit Reduction Act of 1984 generally required income attributable to market discount to be treated as ordinary income rather than capital gain on disposition of a bond (Code sec. 1276). However, the 1984 Act grandfathered market discount gain on bonds issued before July 19, 1984.

Under the Reform Act, a special rule is provided for gain with respect to certain bonds of certain specified life insurance companies. Pursuant to this rule, gain representing market discount recognized by such companies on the redemption at maturity of any bond which was issued before July 19, 1984, and acquired by the company on or before September 25, 1985, is subject to tax at the rate of 28 percent.

2. Status of certain organizations providing commercial-type insurance

(sec. 110(b) of the bill and sec. 1012 of the Reform Act)

Amounts derived from the activity of providing commercial-type insurance are taken into account in determining the amount of income of an exempt organization that is treated as gross income from an unrelated trade or business under the look-through rule of section 512(b)(13). The look-through rule of section 512(b)(13) is applied in the case of all payors of amounts required to be included in gross income under section 512(b)(13), whether the payor of such amounts is foreign or domestic. For example, if an exempt educational organization has a wholly owned Bermuda subsidiary (that is treated as a "controlled organization" under section 512(b)(13)), and the subsidiary is engaged in the activity of providing commercial-type insurance such that some or all of its income would have been subject to taxation under subchapter L had it been earned directly by the educational organization, then the appropriate portion of the amount of any interest, annuities, royalties, and rents paid by the subsidiary to the educational organization is included in the gross income of the educational organization as unrelated business income.

Commercial-type insurance does not include insurance provided at substantially below cost to a class of charitable recipients. Commercial-type insurance also does not include health insurance provided by a health maintenance organization (i.e., any health maintenance organization, tax-exempt under prior law, which is substantially the same as a Federally chartered health maintenance organization), if such health insurance is of a kind customarily provided by such organizations and is incidental to the organization's principal activity of providing health care. Commercial-type insurance also does not include property and casualty insurance provided by certain church organizations or conventions or associations of churches, if certain requirements are met.

The provision does not apply to certain organizations, including Delta Dental Plans Association and the Missouri Hospital Association.

The bill also provides Treasury regulatory authority to prescribe rules providing proper adjustments in the case of organizations that have a fiscal taxable year and that become subject to tax by reason of the provision, if the organization has a short taxable year that begins during 1987 by reason of rules requiring property and casualty insurance companies generally to have a calendar taxable year. It is intended that these regulations will allow a plan having a net operating loss in its first taxable year to utilize the loss fully in subsequent years rather than being required to pro rate the loss. In addition, for purposes of calculating adjusted surplus and unpaid losses, the relevant time for determination of the prior year's closing balances is the close of the last fiscal year ending before the plan's first taxable year.

3. Inclusion in income of 20 percent of unearned premium reserve

(sec. 110(c) of the bill, sec. 1021 of the Reform Act, and sec. 832(b)(7) of the Code)

The provision requiring ratable inclusion of the pre-1987 unearned premium reserve applies to a company without regard to whether the company had computed its taxable income by taking into account additions to an unearned premium reserve. Thus, the ratable inclusion rule applies, under the Reform Act, to organizations that were exempt from Federal income tax prior to 1987 and to small companies that were taxed solely on investment income.

The Reform Act did not provide special rules for reciprocal insurers.

The bill provides that if, at all times prior to its 1987 taxable year, a company was exempt from tax under section 501(a) by virtue of being described in a paragraph of section 501(c), or was a small company subject to tax only on investment income, then the ratable inclusion rule does not apply. This clarification reflects the intent that no inclusion of prior reserve amounts is appropriate if the company received no tax benefit from the reserve amounts due to its former fully or partially tax-exempt status.

Phase-in treatment

The bill also adjusts the period over which inclusion of 20 percent of the outstanding balance of the unearned premium reserve is required in the case of a company that (1) is exempt from tax under section 501(a) by virtue of being described in any paragraph of section 501(c), or is subject to tax only on investment income for its first taxable year beginning after 1986; and (2) was subject to tax as a property and casualty insurance company in a year beginning before 1987. Such companies generally computed taxable income taking into account a reserve for the gross amount of unearned premiums. In such a case, the 20-percent ratable inclusion rule applies for the 6-year period that begins with the first taxable year after 1986 in which the company is subject to tax under section 831(a). Thus, if a company was taxable at some time before 1987, is tax exempt in 1987, and again becomes taxable in a year after 1987, it is appropriate to apply the ratable inclusion rule to the company to provide treatment consistent with other companies that were taxable before 1987.

Treatment of reciprocal insurers

The bill provides that, in the case of an interinsurer or reciprocal underwriter (within the meaning of sec. 835) that is required under applicable State law to report on its annual statement reserves for unearned premiums net of premium acquisition expenses, the amount of the unearned premiums is to be treated as including an amount equal to such expenses for purposes of the decrease in the deduction for unearned premiums. Absent such a rule, reciprocals and interinsurers would be subject to ratable inclusion of a portion of the unearned premium reserve that did not give rise to mismatching of income and deductions under prior law, which the ratable inclusion rule was intended to address.

4. Treatment of certain dividends and tax-exempt interest

(sec. 110(d) of the bill, sec. 1022 of the Reform Act, and sec. 832(b)(5) of the Code)

In the case of dividends from affiliates that are 100 percent deductible, the 15-percent reduction applies only to the portion of the dividend that is attributable to tax-exempt interest and the deductible portion of dividends received (sec. 832(b)(5)(D)(ii)(II)). This "look through" rule applies to a dividend received by a foreign corporation from a domestic corporation that would have been 100 percent deductible if the foreign corporation had been a domestic corporation. Thus, for example, if a foreign property and casualty company receives a dividend from a wholly owned subsidiary that would be eligible for the 100 percent dividend received deduction of section 243(a) but for section 243(b)(5), the dividend is subject to the look through rule. That is, the reserve deduction of the recipient corporation is reduced to the extent the dividend represents tax-exempt interest or deductible dividends received (directly or indirectly) by the payor corporation.

The same rule applies under the present-law life insurance company proration provisions (see sec. 805(a)(4)(E)). Both section 832(b)(5)(D)(ii)(II) and section 805(a)(4)(E) operate to include dividends received by foreign corporations under the proration look through rules; they do not give foreign corporations a deduction for dividends received.

The proration rule applies to tax-exempt interest and the deductible portion of dividends received or accrued on stock or obligations acquired after August 7, 1986. In the case of affiliates, special rules apply to determine the date of acquisition of stock or obligations. One of the special rules provides that the transfer of tax-exempt bonds among affiliates after August 7, 1986, is treated as an acquisition of the bonds after August 7, 1986.

The bill clarifies the treatment of dividends received for purposes of applying the proration provision in the case of a property and casualty insurance company that files a consolidated return. Under the bill, the determination with respect to any dividend paid by a member to another member of an affiliated group filing a consolidated return is made as if the group were not filing a consolidated return.

Lower tier subsidiaries

The bill also clarifies that the deductible portion of any dividends received from a subsidiary, including those received directly or indirectly from a lower tier subsidiary, are subject to the proration rules in the hands of the property and casualty insurance affiliate. These provisions conform to the application of the proration rules generally to all property and casualty insurance companies.

Transfers of stock or obligations among property and casualty company affiliates

The bill also modifies the special rules applicable for purposes of determining under the proration rule whether any stock or obligation (the interest on which is exempt from tax) acquired from an affiliate was acquired after August 7, 1986. The bill provides that stock or obligations transferred between property and casualty insurance companies that are members of the same affiliated group filing a consolidated return are treated as acquired on the date acquired by the transferor company, if (1) the transferor company acquired such stock or obligation before August 8, 1986, and (2) the two companies were members of the same affiliated group filing a consolidated return at all times after the transferor company first acquired the stock or obligation and before the transferor company transferred it to the affiliate.

The date on which a transferor company is treated as acquiring stock is determined with regard to any prior transfer of stock qualifying for treatment under the preceding sentence.

These rules apply only in the case of property and casualty insurance companies that are members of the same affiliated group filing a consolidated return. Thus, for example, any stock or obligation that is transferred by an affiliate that is not a property and casualty insurance company is treated as acquired by the transferee on the date of the transfer.

It is intended that the separate return limitation year ("SRLY") provisions of the consolidated return regulations (Treas. Reg. sec. 1.1502-1 et seq.) apply to limit the use of transferor company (or other affiliate) losses arising in any year prior to the time that the transferor and acquirer companies were members of the same consolidated group, following a transfer of stock or obligations treated as occurring before August 8, 1986, under this provision.

It is intended that stock or obligations of a property and casualty company that undergoes a mere change in identity, form, or place of organization (an "F" reorganization within the meaning of sec. 368(a)(1)(F)) after August 7, 1986, not be treated as acquired after such date solely by reason of the reorganization. Similarly, it is not intended that an F reorganization of a property and casualty company that is a member of an affiliated group filing a consolidated return cause the company to be treated as a new member of the group after the F reorganization, for purposes of the requirement that the company be a member of the group for the entire period after the transferor acquires stock or obligations and before it transfers stock or obligations to another property and casualty member of the group.

5. Loss reserves

(sec. 110(e) of the bill, sec. 1023 of the Reform Act, and sec. 846 of the Code)

The bill provides that the Secretary may prescribe regulations to determine appropriate adjustments in the application of the unpaid loss discounting provisions, in the case of a taxpayer having a taxable year other than the calendar year. Although most property and casualty companies have a calendar taxable year, some companies filing a consolidated return with noninsurance companies may have a fiscal taxable year. The Reform Act did not provide special rules that are to be used in applying the discounting rules to such fiscal year taxpayers.

The regulations also are to provide appropriate adjustments in the application of the discounting provisions in cases in which the Reform Act resulted in a required change in a company's period of accounting (e.g., if the Reform Act results in the application for the first time of sec. 843, which generally requires property and casualty insurance companies to utilize a calendar taxable year).

The bill also clarifies the application of the fresh start provision in the case of an insurance company that (1) is exempt from tax under section 501(a) by virtue of being described in any paragraph of section 501(c) or, under section 831(b), is taxed only on investment income, in a year beginning after 1986, and (2) later becomes subject to tax under section 831(a) as a regular property and casualty insurance company. The rules relating to the fresh start under the discounting provisions are to be applied by treating the last taxable year before the year in which such a company becomes subject to tax under sec. 831(a) as the company's last taxable year beginning before 1987.

6. Election to be taxed only on investment income

(sec. 110(f) of the bill, sec. 1024 of the Reform Act, and sec. 831(b) of the Code)

7. Treatment of Physicians' and Surgeons' Mutual Protection Associations

(sec. 110(g) of the bill and sec. 1031 of the Reform Act)

8. Special rule for a mutual life insurance company

(sec. 110(h) of the bill and sec. 217(i) of the Deficit Reduction Act of 1984)

9. Annuity diversification requirements

(sec. 110(i) of the bill, sec. 1821(m) of the Reform Act, and sec. 817(h) of the Code)

10. Treatment of alternative minimum tax with respect to shareholders surplus account

(sec. 110(j) of the bill and sec. 815(c) of the Code)

11. Treatment of certain items as not interest for source rules

(sec. 110(k) of the bill, sec. 1215 of the Reform Act, and sec. 818(f) of the Code)

12. Technical corrections to the Deficit Reduction Act of 1984

(secs. 118(h) and (j) of the bill, secs. 1821 and 1825(a)(4) of the Reform Act, and secs. 812(e) and 7702 of the Code)

Present law provides that the policyholders' share of tax-exempt interest reduces a life insurance company's deduction for certain reserves. For purposes of determining the policyholders' share, section 812(e) provides that gross investment income excludes any dividend received by the life insurance company that is a 100-percent dividend. Whether a dividend is a 100-percent dividend is determined by reference to the definition in section 805(a)(4)(C), not including dividends described in section 805(a)(4)(D). The Reform Act modified the provisions of sections 805(a)(4)(C) and (D).

Certain policies to cover burial or funeral expenses

Present law, as amended by the Reform Act, provides that future increases in death benefits may be taken into account in determining whether the definition of a life insurance contract is satisfied with respect to certain policies to cover payment of burial expenses or in connection with prearranged funeral expenses. Such contracts can qualify as life insurance contracts, provided that certain requirements (relating to limitations on increases in the death benefit) are satisfied. The Reform Act provided no specific effective date for the provision.

The bill clarifies that the prior-law definition of 100-percent dividends continues to apply for purposes of determining gross investment income within the meaning of section 812. Thus, the provision is intended to retain the definition as under prior law.

Certain policies to cover burial or funeral expenses

The bill provides that the rule that future increase in death benefits may be taken into account under the definition of a life insurance contract, with respect to certain policies to cover payment of burial expenses or in connection with prearranged funeral expenses, is effective for contracts entered into on or after October 22, 1986. Congress intended that the provision be prospectively effective.

(sec. 111(a) and (b) of the bill, secs. 1101 and 1102 of the Reform Act, and secs. 219, 408, 4973, and 6693 of the Code)

In order to eliminate this incentive for a married couple living together, the bill provides that, for purposes of determining whether an IRA contribution is deductible for a taxable year, if the couple lives together at any time during the year, the active participant status of both spouses is taken into account for purposes of calculating the IRA deduction limit. If the spouses file separate returns, the applicable dollar amount is $0 and only the AGI of the spouse making the IRA contribution is taken into account.

Also under the bill, a taxpayer is not considered married for a year if the taxpayer and the taxpayer's spouse (1) did not live together at any time during the taxable year, and (2) did not file a joint return for the taxable year. A taxpayer meeting these requirements for a taxable year is treated as an unmarried individual for the taxable year. Accordingly, for purposes of determining the taxpayer's deduction limit, only the taxpayer's AGI and status as an active participant is taken into account, and the applicable dollar amount is $25,000.

These provisions apply to contributions for taxable years beginning after December 31, 1987, except that a taxpayer may elect to have the provisions apply to contributions for taxable years beginning after December 31, 1986. The election may be made by treating IRA contributions in a manner consistent with these provisions on the taxpayer's income tax return for any taxable year beginning before January 1, 1988.

An individual who makes a designated nondeductible contribution to an IRA for a taxable year or who receives a distribution from an IRA during a taxable year is required to provide such information as the Secretary may prescribe on the individual's tax return for the taxable year and, to the extent required by the Secretary, for succeeding taxable years (or on such other form as the Secretary may prescribe). The information that may be required includes, but is not limited to, (1) the amount of designated nondeductible contributions for the taxable year, (2) the amount of distributions from individual retirement plans for the taxable year, (3) the aggregate amount of designated nondeductible contributions for all preceding taxable years which have not previously been withdrawn, and (4) the aggregate balance of all IRAs of the individual as of the close of the calendar year with or within which the taxable year ends. An individual who overstates the amount of designated nondeductible contributions for a year is subject to a penalty of $100 for each overstatement unless it is shown that the overstatement is due to reasonable cause.

In order to take into account taxpayers with fiscal year taxable years, the bill provides that the information that the Secretary may require to be included on the form or return includes the aggregate balance of all IRAs of the individual as of the close of the calendar year in which the taxable year begins (rather than the calendar year with or within which the taxable year ends).

Under present law (sec. 408(d)(4)), the normal rules for the taxation of distributions (sec. 72) do not apply to a distribution of contributions to an IRA (and, consequently, the contributions are not taxed upon distribution) if (1) the contributions exceed the amount allowable as a deduction under section 219, (2) the distribution is received on or before the due date (including extensions) for the individual's return for the taxable year, (3) no deduction is allowed under section 219 with respect to the excess contributions, and (4) the distribution is accompanied by the amount of net income attributable to the excess contributions. The net income on the contributions is deemed to have been earned and receivable in the taxable year in which the excess contributions were made.

Distribution after due date of return

If the total contributions made to all IRAs for a year (excluding rollover IRAs) does not exceed $2,250, then, under present law, the normal rules for the taxation of distributions (sec. 72) do not apply to a distribution of contributions in excess of the amount allowable as a deduction under section 219 if the excess contributions are distributed after the due date (including extensions) for filing the individual's tax return for the year the contributions were made (sec. 408(d)(5)). For purposes of this rule, the amount allowable as a deduction under section 219 (after application of section 408(o)(2)(B)(ii)) is increased by the nondeductible limit under section 408(o)(2)(B).

Excise tax

Present law provides a 6-percent nondeductible excise tax on contributions to an IRA in excess of the amount allowable as a deduction under section 219 for a taxable year, if the excess contributions are not timely distributed (sec. 4973(b)). For purposes of this rule, the amount allowable as a deduction under section 219 (after application of section 408(o)(2)(B)(ii)) is increased by the nondeductible limit under section 408(o)(2)(B).

The bill amends the rules relating to distributions of excess contributions to take into account the fact that nondeductible contributions may be made to an IRA. The bill permits any IRA contributions to be distributed without income or excise tax consequences prior to the due date (including extensions) for filing the individual's income tax return for the year the contributions are made. Thus, under the bill, the normal rules for the taxation of IRA distributions do not apply to a distribution of any contributions to an IRA if (1) the distribution is received on or before the due date (including extensions) for the individual's return for the taxable year for which the contributions were made, (2) no deduction is allowed under section 219 with respect to the contributions, and (3) the distribution is accompanied by the amount of net income attributable to the contributions. As under present law, net income on the contributions are deemed to have been earned and receivable in the taxable year in which the contributions were made.

Distribution after due date of return

The bill clarifies that certain IRA contributions not in excess of $2,250 may be withdrawn by providing that, for purposes of the rule relating to return of excess contributions after the due date of the individual's return for the year for which the contributions were made, the amount allowable as a deduction under section 219 is computed without regard to the AGI phaseout for active participants (sec. 219(g)).

Excise tax

The bill provides that, for purposes of the excise tax on excess contributions to an IRA, the amount allowable as a deduction under section 219 is computed without regard to the AGI phaseout for active participants (sec. 219(g)).

2. Qualified cash or deferred arrangements

(sec. 111(c) and (l) of the bill, secs. 1105, 1116, and 1879 of the Reform Act, and secs. 401(k), 402, and 4979 of the Code)

Present law provides that the maximum amount that an employee can elect to defer for any taxable year under all cash or deferred arrangements in which the employee participates is limited to $7,000. This $7,000 limit is indexed for inflation at the same time and in the same manner as the indexing of the dollar limit on benefits under section 415(d). For 1988, the indexed limit is $7,313. The limit applies to the employee's taxable year, regardless of the employer's taxable year or the plan year applicable to the cash or deferred arrangement. The limit is coordinated with other plans to which elective deferrals are made.

To ease the administrative burden on employees, employers, and the IRS, the elective deferral arrangements maintained by any single employer may preclude an employee from making elective deferrals under such arrangements for a taxable year in excess of $7,000 (indexed)

Treatment of excess deferrals

If, for any taxable year, the total amount of elective deferrals contributed on behalf of an employee to all qualified cash or deferred arrangements and other plans subject to the limit exceeds $7,000 (indexed), then the amounts in excess of $7,000 (indexed) (the excess deferrals) are included in the employee's gross income for the taxable year to which the deferral relates. In addition, with respect to any excess deferrals, by March 1 after the close of the employee's taxable year, the employee may allocate the excess deferrals among the qualified cash or deferred arrangements and other plans subject to the limit and notify the administrator of each plan of the portion of the excess deferrals allocated to that plan. Not later than April 15 after the close of the employee's taxable year, each plan may (but is not required to) distribute to the employee the amount of the excess deferrals (plus income attributable to the excess deferrals) allocated to the plan.

Generally, the distribution may be made without regard to the terms of the plan until the close of the first plan year for which an amendment is required (Act sec. 1140) and notwithstanding any other provision of law. In addition, the Secretary is to prescribe a model plan amendment that permits the distribution of excess deferrals. Distribution pursuant to such amendment is to be treated as in accordance with the plan.

Income on excess deferrals distributed by the applicable April 15 date is treated as earned and received in the taxable year to which the excess deferral relates. Excess deferrals (and earnings thereon) distributed by the applicable April 15 date are not subject to the additional income tax on early withdrawals (sec. 72(t)). Deferrals are not subject to the 10-percent excise tax on nondeductible contributions (sec. 4972) merely because they are excess deferrals.

Reporting requirements

Under the Act, the employer is required to report to an employee and to the IRS the amount of elective deferrals made by the employee and the amount of compensation deferred under section 457 (sec. 6051(a)).

The bill provides that income on excess deferrals is includible in gross income in the year distributed, rather than in the year of the deferral. To prevent individuals from electing to make excess deferrals in order to defer current taxation of income, the bill requires, as a condition of qualification, that a plan that has a cash or deferred arrangement provide that elective deferrals under the arrangement and under all other plans, contracts, or arrangements of the employer maintaining the plan for a calendar year may not exceed the limitation on elective deferrals in effect for taxable years beginning in such calendar year. A similar restriction is required to be included in a simplified employee pension (SEP) (sec. 408(k)), tax-sheltered annuity contract (sec. 403(b)), or section 501(c)(18) plan that permits elective deferrals. The bill provides that, for purposes of the required plan provision, the limit on elective deferrals need not be explicitly set forth, but can be incorporated by reference.

The provision is generally effective with respect to plan years beginning after December 31, 1987. A delayed effective date applies in the case of certain plans maintained pursuant to a collective bargaining agreement with respect to contributions made pursuant to the bargaining agreement.

Treatment of excess deferrals

Under the bill, income on excess deferrals distributed before the applicable April 15 date, including income earned during and after the year to which the deferral relates, is includible in income in the year distributed, rather than in the year to which the deferral relates. The bill clarifies that any distribution of less than the entire amount of excess deferrals plus income attributable to such deferrals is treated as a pro rata distribution of excess deferrals and income.

The bill clarifies that excess deferrals (and income on such deferrals) distributed by the applicable April 15 are not subject to the 15-percent tax on excess distributions (sec. 4980A).

Reporting requirements

The Act did not contain an effective date for the reporting requirement relating to elective deferrals. The reporting requirement was intended to be effective at the same time the Act's limit on elective deferrals was effective. Accordingly, the bill provides that the requirement is effective with respect to calendar years beginning after December 31, 1986.

If the special nondiscrimination rules are not satisfied for any year, present law provides that the qualified cash or deferred arrangement will not be disqualified if the excess contributions (plus income allocable to the excess contributions) are distributed before the close of the following plan year. In addition, instead of receiving an actual distribution of excess contributions, an employee may elect to have the excess contributions treated as an amount distributed to the employee and then recontributed by the employee to the plan on an after-tax basis. Such recharacterization is not permitted in the absence of regulations. A plan may provide that an employee is required to make such a recharacterization election as a condition of plan participation.

Generally, distribution of excess contributions may be made notwithstanding any provision of the plan until the first plan year for which plan amendments are required (Act sec. 1140) and notwithstanding any other provision of law. In addition, the Secretary is to prescribe a model plan amendment that permits the distribution of excess contributions. Distribution pursuant to such amendment is to be treated as a distribution made in accordance with the plan. The amount distributed is not subject to the 10-percent additional income tax on early withdrawals (sec. 72(t)). Contributions are not subject to the 10-percent excise tax on nondeductible contributions (sec. 4972) merely because they are excess contributions.

Prior to the Deficit Reduction Act of 1984 (DEFRA), proposed Treasury regulations permitted a cash or deferred arrangement that failed the special nondiscrimination test to be qualified if the arrangement satisfied the general nondiscrimination rules (sec. 401(a)(4)). DEFRA provided that a cash or deferred arrangement is not qualified unless it satisfies the special nondiscrimination test, with an exception provided in DEFRA section 527(c)(1)(B). Although the Act modified the nondiscrimination requirements, it did not change the rule enacted in DEFRA section 527(c)(1)(B).

For a discussion of the excise tax on excess contributions and excess aggregate contributions (sec. 4979), see below.

The bill provides that, for purposes of determining whether matching contributions may be used to satisfy the special nondiscrimination test for elective deferrals and for purposes of the vesting rules (sec. 411), a matching contribution is not treated as forfeitable merely because the matching contribution is forfeited because the contribution to which it relates is an excess deferral (sec. 402(g)(2)(A)), an excess contribution (sec. 401(k)(8)(B)), or an excess aggregate contribution (sec. 401(m)(6)(B)). The bill clarifies that excess contributions distributed (or treated as distributed) by the end of the plan year following the year the excess contributions arose are not subject to the excise tax on excess distributions (sec. 4980A).

In addition, under the Act, distributions may be made from a qualified cash or deferred arrangement upon (1) termination of the plan without the establishment of a successor plan, (2) the date of sale by a corporation of substantially all of the assets used by the corporation in a trade or business if the employee continues employment with the corporation acquiring the assets, or (3) the date of the sale by a corporation of the corporation's interest in a subsidiary if the employee continues employment with the subsidiary. The Statement of Managers for the Act provided that a distribution upon any of these 3 events is permitted only if the distribution constitutes a total distribution of the employee's balance to the credit in the cash or deferred arrangement.

The bill incorporates statutorily the requirement that a distribution must be a total distribution in order for the exceptions for dispositions of assets or subsidiaries or for termination of a plan to apply. Under the bill, with respect to distributions after March 31, 1988, these exceptions only apply if the distribution is a "lump sum distribution." For this purpose, "lump sum distribution" means a lump-sum distribution under the income averaging rules (sec. 402(e)(4)), but without regard to (1) the required events (such as attainment of age 59-1/2) for eligibility for income averaging, (2) the election requirement, and (3) the minimum period of plan participation requirement. Thus, for this purpose, a distribution can constitute a lump-sum distribution even though, for example, the employee receives the distribution prior to age 59-1/2, has already elected lump-sum treatment for a prior distribution, or has not been a participant in the plan for at least 5 years.

The bill also provides that with respect to distributions after October 16, 1987, the exception to the withdrawal restrictions for the termination of the plan is conditioned on the employer not establishing or maintaining another defined contribution plan for a reasonable period established by the Secretary.

The Act prohibits (1) tax-exempt organizations and (2) State and local governments and political subdivisions thereof, and agencies and instrumentalities thereof, from establishing qualified cash or deferred arrangements.

The prohibition does not apply to plans adopted before (1) May 6, 1986, in the case of an arrangement maintained by a State or local government (or political subdivision of a State or local government), or (2) July 2, 1986, in the case of an arrangement maintained by a tax-exempt organization. The grandfather treatment is limited to the employers who adopted the plan before the dates specified above. However, the grandfather treatment is not limited to employees (or classes of employees) covered by the plan as of the date the grandfather treatment is provided. Similarly, plans that are grandfathered may be amended in the future. Most such plans will, of course, have to be amended to take into account the new requirements relating to qualified cash or deferred arrangements. Other plan amendments may also be made. For example, a grandfathered plan may be amended in the future to provide for employer matching contributions, to modify the level of employer matching contributions, or to provide that the qualified cash or deferred arrangement is part of a cafeteria plan.

The Act provides that a qualified cash or deferred arrangement can be part of a rural electric cooperative plan, but does not explicitly exempt such plans from the prohibition on maintenance of cash or deferred arrangements by tax-exempt and State and local government employers. The Act defines a rural electric cooperative plan as a defined contribution plan (as defined in sec. 414(i)) that is established and maintained by a rural electric cooperative (as defined in sec. 457(d)(9)(B)) or a national association of such rural electric cooperatives.

The bill modifies the grandfather rule applicable to section 401(k) plans maintained by governmental employers. Under the bill, the prohibition on section 401(k) plans does not apply to (1) an employer that is a State or local government or political subdivision thereof, or agency or instrumentality thereof, if the employer adopted a section 401(k) plan before May 6, 1986, and (2) an employer that is a tax-exempt governmental unit other than a governmental unit described in (1) (e.g., the Tennessee Valley Authority), if the employer adopted a section 401(k) plan before July 2, 1986. Because the grandfather rule in the bill applies to the employer and not merely the plan, an employer that satisfies the conditions of the grandfather may adopt a new section 401(k) plan.

Because the identity of the employer is more likely to change in the case of tax-exempt employers that are not governmental entities (such as through a merger of unrelated tax-exempt organizations), the bill limits this expansion of the grandfather rule to tax-exempt governmental units.

The bill clarifies that the prohibition against cash or deferred arrangements maintained by tax-exempt and State and local government employers does not apply to a rural electric cooperative plan. The bill also modifies the definition of rural electric cooperative. A change in the definition is necessary because the Code section reference in the Act defining a rural electric cooperative was repealed by the Act. Under the bill, a rural electric cooperative is (1) any organization that (i) is engaged primarily in providing electric service on a mutual or cooperative basis, and (ii) either is (I) a State or local government or political subdivision thereof, or any agency or instrumentality thereof, or (II) an organization exempt from tax under Subtitle A; (2) any organization described in paragraph (4) or (6) of section 501(c) that is exempt from tax under section 501(a) and at least 80 percent of the membership of which are organizations described in (1); and (3) an organization that is a national association of organizations described in (1) or (2). The exemption does not apply to a member of an organization described in (3), solely by reason of such membership, if the member is not itself an organization described in (1) or (2). Similarly, the exemption does not apply to a member of an organization described in (2), solely by reason of such membership, if the member is not itself an organization described in (1).

3. Nondiscrimination requirements for employer matching contributions and employee contributions

(sec. 111(m) of the bill, sec. 1117 of the Reform Act, and secs. 401(m) and 4979 of the Code)

Under present law, a special nondiscrimination test is applied to matching contributions and employee contributions, including employee contributions under a qualified cost-of-living arrangement (sec. 415(k)). This special nondiscrimination test is similar to the special nondiscrimination test applicable to qualified cash or deferred arrangements.

The term "matching contributions" means any employer contribution made to the plan on behalf of an employee on account of an employee contribution or an elective deferral under a qualified cash or deferred arrangement. Forfeitures under a plan that are reallocated to participants' accounts on the basis of employee contributions or elective deferrals are, of course, also treated as matching contributions.

Required aggregation

If 2 or more plans of an employer to which matching contributions, employee contributions, or elective deferrals are made are treated as a single plan for purposes of the coverage requirements for qualified plans (sec. 410(b)), then the plans are treated as a single plan for purposes of the special nondiscrimination test. In addition, if a highly compensated employee participates in 2 or more plans of an employer to which matching contributions, employee contributions, or elective deferrals are made, then all such contributions are aggregated for purposes of the special nondiscrimination test.

Under the bill, the special nondiscrimination test applicable to matching contributions and employee contributions only applies to contributions to defined contribution plans within the meaning of sec. 414(k). Also under the bill, the definition of "matching contributions" includes any contribution to a defined contribution plan made on account of an employee contribution or an elective deferral under a qualified cash or deferred arrangement, whether such contributions are made to the same plan or a different plan. Contributions to a defined benefit pension plan may be employee contributions or matching contributions to the extent treated as contributions to a defined contribution plan (sec. 414(k)).

In accordance with the Statement of Managers with respect to the Act, the bill provides that contributions to tax-sheltered annuities that are treated as elective deferrals for purposes of the dollar limit on elective deferrals (sec. 402(g)) are also to be treated as elective deferrals for purposes of the nondiscrimination rules applicable to employer matching contributions and employee contributions (sec. 401(m)). Under the bill, this provision is subject to the effective date provisions in the Act, as amended, with respect to the application of nondiscrimination rules to tax-sheltered annuities (Act sec. 1120(c)). Thus, for example, employer contributions to any type of plan that match an elective deferral to a tax-sheltered annuity are subject to the nondiscrimination requirements of section 401(m) in years beginning after December 31, 1988 (or later under the special effective date applicable to plans maintained pursuant to a collective bargaining agreement).

As under the rules applicable to elective deferrals under a cash or deferred arrangement, elective deferrals under a tax-sheltered annuity may be used to help satisfy the nondiscrimination test applicable to matching contributions with respect to a tax-sheltered annuity. (Similarly, consistent with the rules applicable to cash or deferred arrangements, elective deferrals to a tax-sheltered annuity may not be used to help a tax-sheltered annuity program satisfy the applicable coverage tests (sec. 410(b) without regard to sec. 410(c)) except for purposes of the average benefits test.)

Under the bill, matching contributions that are treated as elective deferrals for purposes of the special nondiscrimination test applicable to cash or deferred arrangements are not subject to the special test applicable to matching contributions and employee contributions.

Required aggregation

The bill modifies the requirement with respect to aggregation of plans in which a highly compensated employee participates. Under the bill, if a highly compensated employee participates in 2 or more plans of an employer to which contributions subject to the special nondiscrimination test (sec. 401(m)) are made, then all such contributions are aggregated for purposes of the test. For example, assume an employer maintains a plan with a cash or deferred arrangement under which matching contributions are made, and a thrift plan providing for after-tax employee contributions and matching contributions. Highly compensated employees participate in both plans. Under the bill, matching contributions that are not treated as elective deferrals in applying the special section 401(k) nondiscrimination test and after-tax contributions under the plans are aggregated for purposes of the special nondiscrimination test. The elective deferrals, however, are not required to be aggregated with the matching contributions and employee contributions.

An excise tax is imposed on the employer with respect to excess contributions and excess aggregate contributions (sec. 4979). The tax is equal to 10 percent of the excess contributions and excess aggregate contributions (but not earnings on those contributions) under the plan for the plan year ending in the taxable year.

However, the tax does not apply to any excess contributions or excess aggregate contributions that, together with income allocable to such contributions, are distributed (or, if nonvested, forfeited) no later than 2-1/2 months after the close of the plan year in which the contributions arose.

Excess matching contributions (plus income), excess elective deferrals (plus income), excess qualified nonelective contributions (plus income), and income on excess employee contributions distributed within the applicable 2-1/2 month period are to be treated as received and earned by the employee in the employee's taxable year to which such contributions relate. Excess matching contributions are deemed to relate to the same taxable year to which the employee's mandatory contribution relates, i.e., mandatory contributions that are elective deferrals relate to the taxable year in which the employee would have received (but for the deferral election) the deferral as cash, and mandatory contributions that are employee contributions relate to the taxable year of contribution. For purposes of this rule, the first contributions (of the type distributed) for a plan year are deemed to be excess contributions or excess aggregate contributions.

In addition, to be consistent with the rules applicable to excess deferrals and excess contributions, the bill provides that generally such distributions may be made without regard to the terms of the plan until the close of the first plan year for which an amendment is required (Act sec. 1140). The bill similarly provides that the Secretary is to prescribe a model amendment that allows a plan to distribute excess aggregate contributions and that a plan distribution in accordance with such amendment is to be treated as in accordance with the terms of the plan. It is understood that the Secretary has already prescribed model amendments under the Act; accordingly, it is not intended that the Secretary be required to prescribe a new amendment regarding excess aggregate contributions.

The Act provides that excess contributions and excess aggregate contributions that are distributed within 2-1/2 months after the end of the plan year are treated as received and earned by the recipient in the taxable year to which the contribution relates in order to prevent deferral of income. Such deferral is not of major concern, however, where the amount involved is not significant. Accordingly, the bill provides an exception to the general rule. Under this exception, if the total distributions of excess contributions and excess aggregate contributions under a plan for a plan year with respect to an individual are less than $100, then the distributions are treated as earned and received by the individual in the taxable year in which the distributions were made.

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

(sec. 111(e) of the bill, sec. 1107 of the Reform Act, and sec. 457 of the Code)

Under the Act, distributions cannot be made available to participants or beneficiaries under a section 457 plan before the participant is separated from service with the employer or is faced with an unforeseeable emergency. In addition, distributions under a section 457 plan are required to comply with the provisions of section 401(a)(9). Under section 401(a)(9) as amended by the Act, distributions are required to begin no later than the April 1 of the calendar year following the calendar year the participant attains age 70-1/2, regardless of whether the participant is still employed. Thus, section 401(a)(9) may require that distribution is to begin before the time that distributions are permitted under section 457.

With respect to section 457 plans, the Act imposes distribution requirements in addition to those imposed by section 401(a)(9). Pursuant to one such requirement, in the case of a distribution beginning before the death of the participant, such distribution is required to be made in a form under which at least 2/3 of the total amount payable with respect to the participant will be paid during the life expectancy of such participant (determined as of the commencement of the distribution) (sec. 457(d)(2)(B)(i)(I)). This provision was modeled after the incidental death benefit rule applicable under section 401(a)(9), but was intended to require more rapid distribution than such rule.

When the Act was enacted, the incidental death benefit rule provided that the present value of benefits payable to a participant's beneficiaries generally may not exceed 50 percent of the present value of the total benefits payable with respect to the participant. Subsequently, however, the Treasury Department issued proposed regulations modifying the incidental death benefits rule. Generally, the proposed regulations contain tables providing guidelines for the form in which distributions are required to be made.

The Act provides that benefits are not treated as made available under an eligible deferred compensation plan merely because an employee is allowed to elect to receive a lump-sum payment within 60 days of the election. The 60-day rule only applies if the employee's total deferred benefit does not exceed $3,500 and no additional amounts may be deferred with respect to the employee.

The bill deletes the rule contained in section 457(d)(2)(B)(i)(I). In lieu of this rule, the bill instructs the Secretary to issue tables that implement the incidental death benefit rule and that are similar to those applicable under section 401(a)(9) but require more rapid distributions. Generally, the extent to which more rapid distributions are to be required is to be similar to the extent to which the former section 457(d)(2)(B)(i)(I) rule required more rapid distributions than the former version of the incidental death benefit rule.

The bill clarifies that the exception to the constructive receipt rule with respect to an election to receive a lump-sum distribution does not override the distribution restrictions otherwise applicable to eligible deferred compensation plans. Thus, the bill provides that the exception is not available for distributions payable prior to separation from service.

Accordingly, the bill provides that, for purposes of determining whether an unfunded deferred compensation plan is an eligible plan under section 457, the rule requiring coordination of the deferred compensation limit with other plans is disregarded. Of course, if the limit (as so coordinated) is exceeded, the deferral of income inclusion provided by section 457 does not apply to the excess; instead, the rules of section 457(f) apply to such excess.

In order to prevent avoidance of the limit on deferred compensation under a section 457 plan by, for example, the use of affiliated service groups or leasing arrangements, the bill provides that the Secretary's general regulatory authority to prevent avoidance of certain requirements (sec. 414(o)) applies to section 457 plans.

It is intended that with regard to amounts deferred from taxable years beginning before January 1, 1987, the grandfather rule applies without regard to whether the organization maintaining the deferred compensation plan was tax-exempt when the plan was established. For example, assume that a deferred compensation plan is established on January 1, 1985, by a taxable organization with respect to individuals all of whose taxable year is the calendar year. The organization becomes tax-exempt on January 1, 1987. If the amounts deferred under the plan from taxable years beginning before January 1, 1987, otherwise meet the requirements of the grandfather rule, then the application of the grandfather rule to such amounts will not be affected by the fact that the organization was not tax-exempt when the plan was established. This rule is not intended to create any inference with respect to the effect of a change in taxable status for other purposes relating to section 457.

The bill also clarifies that the grandfather rule only applies to individuals who were covered under the plan and agreement on August 16, 1986. Thus, for example, the grandfather does not apply to a new employee hired after August 16, 1986, or an employee who was hired on or before such date, but who was not a participant in the deferred compensation plan until after August 16, 1986.

5. Deferred annuity contracts

(sec. 111A(i) of the bill, sec. 1135 of the Reform Act, and sec. 72(u) of the Code)

The provision does not apply to any annuity contract that (1) is acquired by the estate of a decedent by reason of the death of the decedent; (2) is held under a qualified plan (sec. 401(a) or 403(a)), as a tax-sheltered annuity (sec. 403(b)) or under an IRA; (3) is a qualified funding asset for purposes of a structured settlement agreement (as defined in sec. 130(d), but without regard to whether there is a qualified assignment); (4) is purchased by an employer upon the termination of a qualified plan and is held by the employer until the employee separates from service; or (5) is an immediate annuity. Under the Act, an immediate annuity contract is an annuity contract (1) that is purchased with a single premium or consideration, and (2) the annuity starting date of which commences no later than 1 year from the date of purchase of the contract.

The bill also provides that, with respect to the exception to the rule regarding treatment of annuity contracts held by nonnatural persons for an annuity that is purchased by an employer upon termination of a qualified plan, the exception applies to an annuity that is held until all amounts are distributed to the employee for whom such contract was purchased or to the employee's beneficiary.

The bill modifies the definition of an immediate annuity contract to prevent the structuring of a contract that appears to be an immediate annuity contract, but that is in substance a deferred annuity. Accordingly, the bill provides that an annuity is an immediate annuity only if the annuity provides for a series of substantially equal periodic payments (to be made not less frequently than annually) during the annuity period. An annuity will not be treated as failing to satisfy this requirement if it is an annuity payable over the joint lives of 2 or more individuals and the amounts paid to a survivor after the death of the first annuitant are less than the amounts paid during the joint lives of the annuitants.

6. Elective contributions under tax-sheltered annuities

(sec. 111(c) of the bill, sec. 1105 of the Reform Act, and sec. 402 of the Code)

Thus, the limit on elective deferrals to a tax-sheltered annuity for a year is the least of the following amounts: (1) $9,500, (2) the exclusion allowance under section 403(b), or (3) the limit on annual additions under a defined contribution plan (sec. 415(c)) without regard to the catch-up rules for tax-sheltered annuities (sec. 415(c)(4)).

The $9,500 limit applies until the cost-of-living adjustments to the annual limit on elective deferrals under a qualified cash or deferred arrangement raise that limit from $7,000 to $9,500, at which time the limit on elective deferrals under a tax-sheltered annuity is also indexed at the same time and in the same manner as the indexing of the annual limit for elective deferrals under a qualified cash or deferred arrangement.

The Act provides an exception to the $9,500 annual limit (but not to the otherwise applicable exclusion allowance (sec. 403(b)) or the limit on contributions and benefits (sec. 415)) in the case of employees of an educational organization, a hospital, a home health service agency, a health and welfare service agency, a church, or a convention or association of churches. Under this exception, any eligible employee who had completed 15 years of service with the employer would be permitted to make additional salary reduction contributions under the following conditions:

This special catch-up rule provides the only rule under which elective deferrals by an individual may exceed the limit on elective deferrals for a year.

It is intended that the definition of years of service for purposes of the special catch-up election will include principles similar to the principles of section 414(a). For this purpose, an employee's years of service will be determined by including all years of service with a predecessor employer (within the meaning of sec. 414(a)). Thus, years of service with a denomination of a church that merges into or combines with another denomination generally are to be aggregated with years of service with the surviving denomination.

It is recognized that it may be difficult for employers to calculate whether an individual's lifetime elective deferrals exceed the individual's lifetime limit for purposes of the catch-up rule because employers may not have records for prior years with respect to the portion of contributions to tax-sheltered annuities that were elective deferrals. Accordingly, under the bill, for purposes of calculating an individual's lifetime elective deferrals under the catch-up rule, elective deferrals for prior years are to be determined in the manner prescribed by the Secretary. Under this provision, it is expected that the Secretary will provide administrable methods that employers can use to calculate elective deferrals for prior years.

7. Special rules for simplified employee pensions

(sec. 111(f) of the bill, sec. 1108 of the Reform Act, and secs. 408(k) and 3401 of the Code)

The Act provides that the tax treatment described above of the election to have amounts contributed to a SEP or received in cash is available only if at least 50 percent of the employees of the employer elect to have amounts contributed to the SEP. In addition, this exception to the constructive receipt principle is available for a taxable year only if the employer maintaining the SEP had 25 or fewer employees at all times during the prior taxable year.

In addition, under the Act, the amount eligible to be deferred as a percentage of each highly compensated employee's compensation (i.e., the deferral percentage) is limited by the average deferral percentage (based solely on elective deferrals) for all nonhighly compensated employees who are eligible to participate. The deferral percentage for each highly compensated employee cannot exceed 125 percent of the average deferral percentage for all eligible nonhighly compensated employees.

If the 125-percent test is not satisfied, rules similar to the rules applicable to excess contributions to a cash or deferred arrangement are to apply.

The bill clarifies that, in determining whether the employer maintaining a salary reduction SEP had more than 25 employees in the prior taxable year, only employees who were eligible to participate in the SEP (or would have been required to be eligible to participate if a SEP were maintained) are taken into account. This rule is consistent with the eligibility rules for SEPs, that is, individuals who are not required to be eligible to participate in the SEP may be disregarded in determining whether the 25-employee rule is satisfied.

The bill adds provisions designed to ensure that excess contributions to a salary reduction SEP are distributed. These rules are different from the rules relating to excess deferrals in cash or deferred arrangements because, in the case of a SEP, the employer may not force an employee to take a distribution of excess deferrals because the SEP contributions are held in an IRA which the employee controls.

The bill specifically authorizes the Secretary to prescribe appropriate rules, including rules requiring that the excess contributions (plus income) be distributed, reporting requirements, and rules providing that contributions to a SEP (plus income) may not be withdrawn until a determination that the special nondiscrimination test has been satisfied is made. In addition, the bill provides that, until such a determination has been made, any transfer or distribution from a SEP of salary reduction contributions (or income on such contributions) is subject to tax in accordance with section 72 and to the early withdrawal tax (sec. 72(t)(1)), regardless of whether an exception to the tax would otherwise be available.

Consistent with the inclusion of SEP contributions that are made pursuant to a salary reduction agreement for purposes of FICA (sec. 3121(a)(5)) and FUTA (sec. 3306(b)(5)), the bill would include such contributions for purposes of determining benefits under the Social Security Act.

The Act provided that qualified plans may not take into account more than $200,000 of annual compensation. This limit is to be adjusted, beginning in 1990, for post-1988 cost-of-living increases at the same time and in the same manner as the dollar limit on benefits under a defined benefit pension plan. This provision generally applies to benefits accruing in years beginning after December 31, 1988.

(sec. 111(h) of the bill, sec. 1112 of the Reform Act, and sec. 410(b) of the Code)

In addition, it is intended that the Secretary is to exercise his authority with respect to the application of the coverage rules to former employees to except, in appropriate cases, retiree benefit increases from the general rule of separate testing.

The bill does not change the definition of salary reduction agreement for purposes of section 3121(a)(5)(D). This amendment also does not affect the definition of elective deferrals other than with respect to tax-sheltered annuities.

2. Minimum participation rule

(sec. 111(h) of the bill, sec. 1112 of the Reform Act, and sec. 401(a)(26) of the Code)

Under present law, a plan is not a qualified plan unless it benefits no fewer than the lesser of (a) 50 employees of the employer, or (b) 40 percent of all employees of the employer. This requirement may not be satisfied by aggregating comparable plans. Also, this requirement applies on an employer-wide basis and may not be satisfied on a line of business or operating unit basis.

Sanction

If a plan ceases to be qualified because of this minimum participation rule, it is subject to the generally applicable sanctions, one of which is that employer contributions made to the trust during the corresponding taxable year of the employer are includible in employees' incomes under rules applicable to nonqualified arrangements (sec. 83). Under present law, in the case of a plan that fails to be qualified solely because it does not satisfy the coverage requirements (sec. 410(b)), the employee's vested accrued benefit (other than employee contributions), to the extent that such amount has not been previously taxed to the employee, is includible in income, rather than the employer's contribution for the year. Also, nonhighly compensated employees are not taxable on amounts contributed to or earned by the trust merely because a plan fails to satisfy the coverage requirements.

Special transition rule

For purposes of the coverage rules, but not the minimum participation rule, a special transition rule applies in the case of certain dispositions or acquisitions of a business (sec. 410(b)(6)(C)).

Reversion tax and interest rate

The minimum participation rule is generally effective for plan years beginning after December 31, 1988.

Under a special rule, if (1) a plan is in existence on August 16, 1986, (2) the plan would fail to meet the requirements of the minimum participation rule if such rule were in effect on August 16, 1986, and (3) there is no transfer of assets to or liabilities from the plan, or merger or spinoff involving the plan, after August 16, 1986, that has the effect of increasing the amount of assets available for an employer reversion, such plan may be terminated or merged prior to the first plan year to which the minimum participation rule applies and the 10-percent excise tax on the reversion of assets (sec. 4980) will not be imposed on any employer reversion from such plan by reason of such termination or merger. Such a termination and reversion are permissible even though the terminating plan relies on another plan that is not terminated for qualification. In determining the amount of any such employer reversion, the present value of the accrued benefit of any highly compensated employee is to be determined by using an interest rate that is equal to the maximum interest rate that may be used for purposes of calculating a participant's accrued benefit under section 411(a)(11)(B). The Secretary is to prescribe rules preventing avoidance of this interest rate rule through distributions prior to or in lieu of a reversion.

Under the bill, the Secretary may permit, under appropriate circumstances, the minimum participation rule to be applied separately to separate lines of business, as defined under section 414(r) without regard to section 414(r)(7). Thus, for this purpose, separate operating units are not considered to be separate lines of business.

In determining whether to permit this separate testing, the Secretary is to consider whether the separate lines of business are related. For example, a football team and a manufacturing business are totally unrelated, so that it may be appropriate to allow separate testing in such circumstances.

Sanction

The bill modifies the sanction applicable to a plan that ceases to be qualified based on a failure to satisfy either the minimum participation rule or the coverage rules. Under the bill, if a plan is not qualified and one of the reasons is the failure to satisfy the minimum participation rule or the coverage rules (either directly or indirectly through the application of sec. 401(a)(4)), any highly compensated employee is to include in income such employee's vested accrued benefit (other than such employee's investment in the contract). (This modification does not affect the application of the general rules of sec. 402(b)(1) regarding issues other than the amount includible in the year of disqualification, such as the application of sec. 72 to distributions from the disqualified plan.)

In addition, if a plan is not qualified solely because it does not satisfy either the minimum participation rule or the coverage rule (either directly or indirectly through the application of sec. 401(a)(4)) or both, the bill provides that there is to be no inclusion in income by reason of such failure to qualify with respect to any employee who was not a highly compensated employee at any time during the trust year in which the plan became disqualified or during any prior year for which service was creditable to such employee under the plan (or a predecessor plan). For purposes of determining whether an employee was a highly compensated employee in any year, the definition of highly compensated employee applicable with respect to such year for purposes of the coverage rules is to apply.

Except for these changes, the sanctions applicable under present law, including the rules regarding the disallowance of an employer's deduction for contributions to a disqualified plan, continue to apply.

These modifications of the sanctions for disqualification are intended to fulfill the intent of the Act with respect to (1) ensuring that the disqualification sanction is adequate with respect to highly compensated employees, and (2) reducing the sanction with respect to nonhighly compensated employees in appropriate circumstances.

Applicability of affiliated service group and employee leasing rules

In order to prevent avoidance of the minimum participation rule, the bill provides that the affiliated service group rules (sec. 414(m)) and the employee leasing rules (sec. 414(n)) apply for purposes of the minimum participation rule. The bill further clarifies that the Secretary's general regulatory authority to prevent avoidance of certain requirements (sec. 414(o)) applies to the minimum participation rule.

Special transition rule

Under the bill, the special transition rule applicable in the case of certain dispositions or acquisitions of a business (sec. 410(b)(6)(C)) is to apply to the minimum participation rule. This is intended to prevent the minimum participation rule from disrupting business transactions by allowing a grace period following certain transactions for the new entities to comply with the minimum participation rule.

Reversion tax and interest rate

With respect to the rule under present law regarding the exemption from the reversion tax in the case of the termination or merger of certain plans not satisfying the minimum participation rule, the interest rate required to be used in determining the accrued benefit of any highly compensated employee and the corresponding reversion to the employer will in many cases understate the value of the employee's accrued benefit and thus represent an inappropriate reduction in the employee's accrued benefit. In order to avoid this result, the bill modifies the rule referred to above in several respects.

First, the bill clarifies that for purposes of determining the amount to be distributed from a plan to an employee, the value of an employee's accrued benefit is not to be affected by this transitional rule regarding the minimum participation rule. Thus, for this purpose, the accrued benefit is to be determined under the interest rate used by the plan, if otherwise permissible under the Code.

Second, the bill provides a rule regarding the permissible interest rate to be used for certain purposes. The interest rate rule applies in the case of a termination, asset transfer, or asset distribution with respect to a plan that would have failed to satisfy the requirements of the minimum participation rule had the effective date of such rule been August 16, 1986.

If the interest rate rule applies to a plan, the interest rate used in determining an "eligible amount" is to be no less than the highest of:

(No inference is intended, based on (2) above, that within a plan (or plans aggregated for purposes of section 410) a higher interest rate may be used in determining the present value of the accrued benefit of a nonhighly compensated employee than is used with respect to any highly compensated employee.)

The term "eligible amount" means the amount that with respect to a highly compensated employee:

In the case of a termination of or distribution from a plan to which the interest rate rule applies, the excess (if any) of (1) the amount distributed to a highly compensated employee by reason of the termination or distribution over (2) the amount determined by using the lowest interest rate permitted in determining an eligible amount, also is disregarded for purposes of the early withdrawal tax and the excess distribution tax.

Former employees

It is further intended that for purposes of the minimum participation rule, former employees generally are to be tested separately under rules similar to those applicable for purposes of the coverage rules.

3. Vesting standards

(sec. 111(i) of the bill and sec. 1113 of the Reform Act)

In the case of a multiemployer plan, a participant's accrued benefit derived from employer contributions is required to be 100-percent vested no later than upon the participant's completion of 10 years of service. This exception applies only to employees covered by the plan pursuant to a collective bargaining agreement.

Prior to the Act, special vesting rules applied to class-year plans. A class-year plan was a profit-sharing, money purchase, or stock bonus plan that provided for the separate vesting of employee rights to employer contributions on a year-by-year basis. The minimum vesting requirements were satisfied under prior law if the plan provided that a participant's rights to amounts derived from employer contributions with respect to any plan year were nonforfeitable not later than the close of the fifth plan year following the plan year for which the contribution was made.

The imposition of the new vesting rules described above, including the repeal of class-year vesting, generally apply to plan years beginning after December 31, 1988, with respect to participants who have at least 1 hour of service after the effective date.

Plans that fall within the above category are to apply a special rule to any employee that has an hour of service (1) before the adoption of any amendment eliminating class-year vesting, and (2) on or after the first day of the first plan year for which the repeal of class-year vesting is applicable to such employee with respect to the plan. Under this special rule, for the year described in (2) above and any subsequent year, the employee's nonforfeitable right to the employee's accrued benefit derived from employer contributions is to be determined under the class-year vesting schedule that was eliminated if such schedule would yield a larger nonforfeitable right than the new vesting schedule.

4. Application of nondiscrimination rules to integrated plans

(sec. 111(g) of the bill, sec. 1111 of the Reform Act, and secs. 401(a)(5) and (1) of the Code)

In the case of a defined benefit excess plan, certain special tests apply if the integration level is above covered compensation. For this purpose, the term "covered compensation" means, with respect to an employee, the average of the taxable wage bases in effect for each year during the 35-year period ending with the year the employee attains age 65, assuming no increase in such wage base for years after the current year and before the employee actually attains age 65.

An integrated defined benefit plan is required to base benefits on average annual compensation.

To fulfill Congressional intent to conform certain qualified plan rules to the social security system, the bill modifies the definition of "covered compensation," so that the references to age 65 are replaced by references to social security retirement age (sec. 415(b)(8)), which can be age 65, 66, or 67, depending on the date of birth of the employee.

The bill also clarifies that "average annual compensation" means the participant's highest average annual compensation for any period of at least 3 consecutive years (or, if shorter, the participant's full period of service). Thus, defined benefit plans providing benefits based on career average compensation are not prevented from integrating.

5. Definitions of highly compensated employee and of line of business

(sec. 111(j) and (k) of the bill, secs. 1114 and 1115 of the Reform Act, and sec. 414(q) and (r) of the Code)

An individual is considered a family member if, with respect to an employee, the individual is a spouse, lineal ascendant or descendant, or spouse of a lineal ascendant or descendant of the employee.

Even if a family member is excluded for purposes of determining the number of employees in the top-paid group (as discussed below), such family member is subject to the aggregation rule.

For purposes of this special rule, an employer may elect to apply numbers (1), (2), (3), and (5) above by substituting any shorter period of service or lower age than is specified in (1), (2), (3), or (5), as long as the employer applies the test uniformly for purposes of determining its top-paid group with respect to all its qualified plans and employee benefit plans and for purposes of the line of business or operating unit rules described below.

Line of business or operating unit rules

Generally, if an employer is treated as operating separate lines of business or operating units for a year, the employer may apply the new coverage rules applicable to qualified plans and the new nondiscrimination rules applicable to statutory employee benefit plans separately to each separate line of business or operating unit for that year.

Under a special rule, a line of business or operating unit will not be treated as separate unless it satisfies certain requirements, one of which is that the line of business or operating unit have at least 50 employees.

In addition, an affiliated service group (within the meaning of sec. 414(m)) may not be treated as consisting of separate lines of business or operating units. Because generally section 414(b) and (c) applies before section 414(m), a group that is treated as aggregated under section 414(b) and (c) is not treated as an affiliated service group even if such group also could have been aggregated under section 414(m).

In addition, the bill provides the Secretary with regulatory authority to prevent the application of the special family member rule to inappropriate, clearly unintended situations. This regulatory authority is only to be used, however, in a manner consistent with the general policy underlying the family member rule, i.e., that, for purposes of all rules relating to nondiscrimination (or deductibility), the members of the family constitute one economic unit and thus are to be treated as one employee.

Line of business or operating unit rules

Under the bill, the Secretary is to prescribe rules providing certain minimum standards regarding the age and service requirements that are to apply for purposes of determining which employees are taken into account in determining if a line of business or operating unit may be treated as separate. (The standards are to apply, for example, for purposes of determining if a line of business or operating unit has 50 employees.) Under this authority, the Secretary could provide that, for such purpose, section 414(q)(8) is to be applied without regard to the last sentence thereof, i.e., the employer may not elect to reduce the age or service requirements specified in the statute.

The primary purpose for this provision of the bill is to prevent the use of nominal age or service requirements to avoid the effect of the requirement that, to be treated as separate, a line of business or operating unit is required to have 50 employee.

6. Definition of compensation

(sec. 111(k) of the bill, sec. 1115 of the Reform Act, and sec. 414(s) of the Code)

The employer may elect whether to include elective deferrals (under secs. 125, 402(a)(8), 402(h), or 403(b)) as part of compensation. In addition, the Secretary is directed to provide certain alternative definitions of compensation that do not favor highly compensated employees.

An employee who at any time during the plan year or any of the 4 preceding plan years is a 1-percent owner of the employer and has annual compensation from the employer of more than $150,000 is a key employee.

Although the general definition of compensation under section 414(s) is to be the same one used under section 415(c)(3), it is intended that the definitions vary in certain ways. First, it is not intended that, for purposes of section 414(s), the general definition of compensation be required to be determined on the basis of the plan's limitation year under section 415. Second, it is not intended that the general definition of compensation under section 414(s) be an employee's accrued compensation. Third, with respect to defined contribution plans, the general definition of compensation for purposes of section 414(s) is not to include amounts received while an employee is not a participant.

The bill also clarifies that the definition of compensation provided in section 414(s) only applies to provisions that specifically refer to it. Thus, for example, the definition does not apply for purposes of the limits on deductions (sec. 404) or on contributions and benefits (sec. 415).

Under the bill, for purposes of determining whether an employee is a key employee by virtue of having annual compensation over $150,000, compensation means compensation as defined in section 415(c)(3) plus elective deferrals under sections 125, 402(a)(8), 402(h), and 403(b). This is the same definition used for purposes of determining whether an employee is highly compensated (sec. 414(q)(7)), a determination that is similar to the determination of who is a key employee. This provision of the bill applies to years beginning after December 31, 1988.

(sec. 111A(a) of the bill, sec. 1121 of the Reform Act, and secs. 402(a)(5), 402(e)(1)(B), and 408(d)(3)(A) of the Code)

The Act provided that if an employee is a 5-percent owner at the time a qualified plan distribution is made, such distribution may not be rolled over to a qualified plan or to a section 403(a) annuity plan (sec. 402(a)(5)(F)(ii)). Such prohibition applied to distributions made after October 22, 1986. A different part of the Act repealed this rule for distributions made in years beginning after December 31, 1986. However, the Act did not repeal the provision that prohibited a 5-percent owner from rolling over a qualified plan distribution into a conduit IRA and subsequently rolling the distribution over into another qualified plan.

Also, under the bill, section 402(a)(5)(F)(ii), during the period in which it applied, is not to apply to amounts attributable to benefits accrued before January 1, 1985. Thus, to the extent that a qualified plan distribution to a 5-percent owner is attributable to benefits accrued before January 1, 1985, section 402(a)(5)(F)(ii) during its period of application does not prohibit such distribution from being rolled over to a qualified plan or to an annuity plan.

In addition, the bill deletes the IRA rollover restriction under which certain distributions from IRAs with respect to 5-percent owners are not treated as rollover distributions for purposes of the IRA rules. This provision is effective for rollover distributions made in taxable years beginning after December 31, 1986. Thus, the bill clarifies that, as is the case with other taxpayers, 5-percent owners may roll over a qualified plan distribution into an IRA and subsequently roll the amount distributed from the IRA into another qualified plan. Different rules for 5-percent owners and other taxpayers are no longer necessary under the Act because all distributions from qualified plans are generally subject to the early withdrawal tax formerly applicable only to distributions to 5-percent owners.

Further, the bill provides that, notwithstanding any other provision of law, a plan or contract is permitted (except as provided in regulations prescribed by the Secretary) to incorporate by reference the uniform benefit commencement date and the required distribution rules for qualified plans (sec. 401(a)(9)).

It is further intended that an employee who has not retired from an employer prior to 1989, but has attained age 70-1/2 prior to 1989, is considered to have attained age 70-1/2 in 1989 for purposes of determining the new uniform benefit commencement date with respect to a plan maintained by the employer.

2. Tax treatment of distributions

(sec. 111A(b) of the bill, sec. 1122 of the Reform Act, and secs. 72, 402, and 414 of the Code)

The Act generally (1) phased out long-term capital gains treatment over 6 years (except for certain grandfathered individuals); (2) eliminated 10-year forward averaging (except for certain grandfathered individuals) and allowed 5-year forward averaging under more limited circumstances; (3) modified the prior-law basis recovery rules for amounts distributed prior to a participant's annuity starting date; (4) repealed the special 3-year basis recovery rule; (5) modified the general basis recovery rules for distributions from an annuity; (6) provided basis recovery rules for distributions from an IRA when an individual has made nondeductible IRA distributions; (7) repealed the constructive receipt rule for tax-sheltered annuities; and (8) modified the rules relating to rollovers of partial distributions.

Further, present law limits the total amount that an employee may exclude from income as a recovery of basis to the total amount of the employee's basis. If benefits cease prior to the date the basis has been fully recovered, the amount of unrecovered basis is allowed as a deduction to the annuitant for his or her last taxable year. These modifications of the basis recovery rules are effective with respect to an individual whose annuity starting date is after July 1, 1986.

Under the Act, employee contributions to a defined contribution plan (and the income attributable thereto) may be treated as a separate contract for purposes of the basis recovery rules.

Under present law, a special basis recovery rule applies with respect to a plan substantially all the contributions to which are employee contributions (sec. 72(e)(7)). Under this special rule, distributions from such a plan are treated first as a return of taxable amounts under the plan.

The bill repeals the special basis recovery rules that apply in the case of a plan substantially all of the contributions to which are employee contributions.

The bill clarifies that transfers from one contract (as defined under sec. 72) to another contract are to be treated as consisting of a pro rata amount of income and basis in the same manner as if the transfer had been a distribution prior to the annuity starting date. This rule applies to transfers in any form, such as plan divisions, mergers, etc.

The bill provides that the effective date of the provision allowing a deduction in the last taxable year of the annuitant for unrecovered basis is effective for individuals whose annuity starting date is after July 1, 1986. Thus, in the case of an individual whose annuity starting date is after July 1, 1986, and before January 1, 1987, the rule limiting the amount of basis recovered does not apply, but the rule providing a deduction at death for unrecovered basis does apply. This rule is provided because it would be unfair to deny individuals who lost the benefit of the 3-year basis recovery rule the benefit of the deduction for unrecovered basis at death.

The bill provides a special rule with respect to plans maintained by a State that, on May 5, 1986, provided for withdrawals by the employee of employee contributions (other than as an annuity). In the case of such plans, the modifications in the basis recovery rules for distributions prior to the annuity starting date apply only to the extent that the amount distributed exceeds the employee's basis as of December 31, 1986. In addition, amounts received (other than as an annuity) before or with the first annuity payment are treated as having been recovered before the annuity starting date.

The Act contained a special rule permitting certain amounts deposited in certain financially distressed financial institutions to be rolled over notwithstanding that the rollover does not occur within 60 days of the date of the original distribution. Under this rule, the 60-day period does not include periods while the deposit is frozen. In addition, the individual has a minimum of 10 days after the release of the frozen deposit to complete the rollover.

The Act also provided that distributions from an ESOP made pursuant to the diversification requirements applicable to ESOPs (added by the Act) are treated as partial distributions eligible for rollover treatment.

It is intended that, for purposes of the rule denying rollover treatment in the case of a distribution that is part of a series of periodic payments, the mere fact that payments to an employee are made in more than one taxable year does not automatically mean that they constitute a series of periodic payments. For example, it is not uncommon for an employer to make a lump-sum distribution to an employee in one taxable year and discover a calculation error in the following taxable year that requires another distribution to the employee. It is further intended, under these circumstances, that the first distribution is to be treated as a lump-sum distribution (as under present law) and the second distribution is to be treated as a partial distribution eligible for rollover treatment. The partial distribution rollover rules were originally enacted because of employer errors in calculating the lump-sum distributions to which employees are entitled and it is expected that the Secretary's interpretation of the rules will be consistent with this intent.

The bill retains the rule permitting rollover of a distribution made to satisfy the diversification requirements (sec. 401(a)(28)) if an employee elects such treatment and provides that if amounts are rolled over pursuant to these rules an employee is not prohibited from electing income averaging for a subsequent lump-sum distribution.

The bill clarifies that the special rule for frozen deposits applies only to amounts that are frozen within 60 days of the date that the amounts are distributed from the plan.

In addition, the Act provided a special transition rule under which an individual who had attained age 50 by January 1, 1986, is entitled to make 1 election to use 5-year averaging (under the new tax rates) or 10-year averaging (under the prior-law tax rates) with respect to a single lump-sum distribution. Similarly, such a grandfathered individual could elect capital gains treatment with respect to a lump-sum distribution without regard to the 6-year phaseout of capital gains treatment. Under this special capital gains election, the portion of a lump-sum distribution entitled to capital gains treatment is taxed at a rate of 20 percent, regardless of the maximum effective capital gains rate under prior law.

Under prior law, the amount subject to tax under the income averaging rule was calculated by adding in the zero bracket amount. This addition was eliminated by the Act because the zero bracket amount is eliminated generally.

The bill also clarifies that, for purposes of 5-year income averaging, the phaseout of the 15-percent bracket applies.

Further, under the bill, the election under the special transition rule of 10-year averaging (under the prior-law tax rates) is to take into account the prior-law zero bracket amount. This change is needed to preserve the prior-law treatment for persons who elect the grandfather rule.

The bill clarifies that a capital gains election made under either of the special transition rules is treated as an income averaging election (within the meaning of sec. 402(e)(4)(B)) for all purposes under the Code (including, for example, sec. 4980A relating to the 15-percent tax on excess distributions).

The bill also provides that a distribution made to satisfy the diversification requirements (sec. 401(a)(28)) will not affect whether a subsequent distribution qualifies as a lump sum distribution eligible for averaging.

3. Additional income tax on early withdrawals

(sec. 111A(c) of the bill, sec. 1123 of the Reform Act, and sec. 72 of the Code)

The Act (1) modified the withdrawal restrictions applicable to qualified cash or deferred arrangements, tax-sheltered annuities, and tax-sheltered custodial accounts, and (2) imposed a 10-percent additional income tax on certain early withdrawals from qualified retirement plans.

A qualified retirement plan is defined to include (1) a qualified plan (sec. 401(a)), (2) a qualified annuity plan (sec. 403(a)), (3) a tax-sheltered annuity or custodial account (sec. 403(b)), or (4) an individual retirement arrangement (IRA) (sec. 408).

In all cases, the exception applies only if the participant has attained age 55 on or before separation from service. Thus, for example, the exception does not apply to a participant who separates from service at age 52 and begins receiving benefits at or after age 55.

The modified early retirement exception continues to apply if the employee returns to work for the same employer (or for a different employer) as long as the employee did, in fact, separate from service before the plan distribution. Of course, any short-term separation is to be closely scrutinized to determine if it is a bona fide, indefinite separation from service that would qualify for this exception to the early withdrawal tax.

As under present law, this exception does not apply to IRA distributions.

Under the bill, an ESOP includes both an ESOP described in section 4975(e)(7) and a tax-credit ESOP (within the meaning of sec. 409).

Certain exceptions to the 10-percent early withdrawal tax are provided. An exception is provided for a distribution that is part of a series of substantially equal periodic payments (not less frequently than annually) made over the life or life expectancy of the taxpayer or the lives or life expectancies of the taxpayer and the taxpayer's beneficiary.

If distributions to an individual are not subject to the tax because of application of the substantially equal payment exception, the tax will nevertheless be imposed if the employee changes the distribution method prior to age 59-1/2 to a method that does not qualify for the exception. The additional tax will be imposed in the first taxable year in which the modification is made and will be equal to the tax (as determined under regulations) that would have been imposed had the exception not applied.

In addition, the recapture tax will apply if an employee does not receive payments under a method that qualifies for the exception for at least 5 years, even if the method of distribution is modified after the employee attains age 59-1/2. Thus, for example, if an employee begins receiving payments in substantially equal installments at age 56, and alters the distribution method to a form that does not qualify for the exception prior to attainment of age 61, the additional tax will be imposed on amounts distributed prior to age 59-1/2 as if the exception had not applied. The additional tax will not be imposed on amounts distributed after attainment of age 59-1/2.

The modifications to the additional income tax on early withdrawals under a deferred annuity apply to all distributions made under the annuity in taxable years beginning after December 31, 1986.

Further, the bill clarifies that the additional income tax applicable to early withdrawal from a deferred annuity (sec. 72(q)) does not apply if a distribution is otherwise subject to the early withdrawal rules for qualified plans (sec. 72(t)), whether or not an exception to the additional income tax on early withdrawals from a qualified plan applies under section 72(t)(2).

The bill modifies the effective date of the provision relating to the additional income tax on early withdrawals under a deferred annuity so that the changes in the early withdrawal tax do not apply to any distribution under an annuity contract if (1) as of March 1, 1986, payments were being made under such contract pursuant to a written election providing a specific schedule for the distribution of the taxpayer's interest in such contract, and (2) such distribution is made pursuant to such written election.

Under present law, in addition to the additional income tax on early withdrawals under qualified plans (sec. 72(t)), a 10-percent additional income tax is also imposed on early withdrawals of QVECs (sec. 72(o)).

Under the Act, the provisions restricting distributions attributable to elective deferrals (and earnings thereon) under a tax-sheltered annuity are effective for taxable years beginning after December 31, 1988.

4. Transition rule

(sec. 111A(d) of the bill and sec. 1124 of the Reform Act)

The bill also clarifies that, for purposes of the transition rule, the 5-years-of-participation requirement (sec. 402(e)(4)(H)) and the election requirement (sec. 402(e)(4)(B)) applicable to lump-sum distributions do not apply.

5. Loans from qualified plans

(sec. 111A(h) of the bill, sec. 1134 of the Reform Act, and sec. 72(p) of the Code)

Subject to certain exceptions, a loan to a plan participant is treated as a taxable distribution of plan benefits under present law.

Present law provides for the disallowance of the deduction for interest paid on a loan from a qualified plan by (1) all employees on loans secured by elective deferrals (or the income attributable thereto) under a qualified cash or deferred arrangement or tax-sheltered annuity or custodial account, and (2) key employees with respect to loans from any qualified plan or tax-sheltered annuity or custodial account.

(sec. 111(d) of the bill, sec. 1106 of the Reform Act, and secs. 404 and 415 of the Code)

The Act revised the overall limits on contributions and benefits under qualified plans, tax-sheltered annuity programs, and SEPs. In addition, the Act (1) provides special rules with respect to plans of governmental employers and tax-exempt employers, (2) permitted a defined benefit pension plan to maintain a qualified cost-of-living arrangement under which employer and employee contributions may be applied to provide cost-of-living increases to the primary retirement benefit under the plan, (3) imposed a limit on the amount of compensation that may be taken into account for deduction purposes, and (4) modified the rules relating to the phasein of the limits on annual benefits under a defined benefit pension plan.

This $200,000 limit is to be adjusted, beginning in 1990, for post-1988 cost-of-living increases at the time and in the manner provided for the adjustment of the limits on annual benefits under a qualified defined benefit pension plan (sec. 415(d)).

Further, the bill makes it clear that the $200,000 cap on includible compensation does not apply, under present law, in the case of an employer's deduction for benefits provided under a nonqualified deferred compensation plan.

The Act provides that, to the extent provided in regulations, the reduction based on years of participation is to be applied separately with respect to each change in the benefit structure of a plan by a plan amendment or otherwise as if such change is a new plan. Such regulations are to take into account whether the change is a benefit improvement or reduction. The phasein for each change in benefit structure begins on the date a plan amendment creating the change is effective.

A separate phase-in rule applies to the 100-percent of compensation limit (sec. 415(b)(1)(B)) and to the $10,000 limit on de minimis benefits (sec. 415(b)(4)). Under this rule, those limits are phased in on the basis of years of service rather than years of participation.

The bill further provides that, for purposes of the combined limit on contributions and benefits (sec. 415(e)), the dollar limit on benefits under a defined benefit pension plan is to be phased in over 10 years of service, rather than 10 years of participation. Correspondingly, the rule requiring a separate phasein for each change in benefit structure does not apply for purposes of the combined limit.

The Act permitted a defined benefit pension plan to maintain a qualified cost-of-living arrangement under which employer and employee contributions may be applied to provide cost-of-living increases to the primary benefit under the plan. If the arrangement is qualified, then an employee contribution under the arrangement is not to be treated as an annual addition in applying the separate limit on annual additions under defined contribution plans (sec. 415(c)), but is to be treated as an annual addition for purposes of applying the combined plan limit (sec. 415(e)). Further, under a qualified arrangement, the benefit attributable to an employee's contribution is to be treated as a benefit derived from employer contributions for purposes of applying the limit on annual benefits (sec. 415(b)). Under the Act, a qualified cost-of-living arrangement is required to comply with the dollar limits, election procedures, and nondiscrimination requirements of the Act.

Limit requirement

A qualified cost-of-living arrangement satisfies the limit requirement provided by the Act if it (1) limits cost-of-living adjustments to those cost-of-living increases occurring after the annuity starting date, and (2) bases the cost-of-living adjustment on average cost-of-living increases determined by reference to 1 or more indices prescribed by the Secretary, except that the plan can provide a minimum increase for each year of 3 percent of the original retirement benefit. It was unclear, under the Act, whether a plan could provide for a minimum increase for each year of 3 percent of the retirement benefit as adjusted under the cost-of-living arrangement in prior years.

Election requirement

A qualified cost-of-living arrangement meets the election requirements if it provides that participation in the qualified cost-of-living arrangement is elective and permits participants to make an election in (1) the year in which the participant attains the age at which retirement benefits are first available under the defined benefit pension plan; (2) the year in which the participant separates from service; or (3) both such years.

The bill clarifies that a plan will not fail to satisfy the limit requirement if it provides for a minimum increase for each year of 3 percent of the retirement benefit (determined without regard to the current year's increase). Thus, the minimum increase may be 3 percent of the retirement benefit as adjusted under the cost-of-living arrangement in prior years.

Election requirement

Under the bill, a plan may permit participants to make an election under the qualified cost-of-living arrangement during any year, as long as the plan permits elections to be made at least in the year in which the participant (1) attains the earliest retirement age under the defined benefit pension plan (determined without regard to any requirement of separation from service), or (2) separates from service.

2. Deduction limits for qualified plans

(sec. 111A(e) of the bill, sec. 1131 of the Reform Act, and sec. 4972 of the Code)

Under present law, a 10-percent nondeductible excise tax is imposed on nondeductible contributions to a qualified plan (secs. 401(a) and 403(a)) or simplified employee pension (SEP) (sec. 408(k)).

Amount of nondeductible contributions

The contributions to a plan that are subject to the excise tax on nondeductible contributions are (1) the amounts contributed to a qualified employer plan by the employer for the taxable year in excess of the amount allowable as a deduction for the taxable year, plus (2) the unapplied amounts in the preceding taxable year. The unapplied amounts in the preceding taxable year are the amounts subject to the excise tax in the preceding year reduced by the sum of (1) the portion of the amounts that are returned to the employer during the taxable year, and (2) the portion of such unapplied amounts that are deductible during the current taxable year.

Time for determination of nondeductible contributions

Nondeductible contributions for a year are determined as of the close of the employer's taxable year. A contribution made on account of a year that is made after the close of the year is to be taken into account in determining the level of excess contributions for the year with respect to which the contribution is made.

Nondeductible contributions to underfunded plans

Under the Act, the excise tax on nondeductible contributions applies to nondeductible contributions to underfunded plans.

Definition of employer

The excise tax on nondeductible contributions is imposed on the employer. Under present law, in the case of a plan that provides contributions or benefits for employees some or all of whom are self-employed individuals (sec. 401(c)(1)), an individual who owns the entire interest in an unincorporated trade or business is treated as the employer. Also, under present law, a partnership is to be treated as the employer of each partner who is considered to be an employee (sec. 401(c)(1)).

Under the Act, an employer to whom the excise tax on nondeductible contributions applies includes an employer that is a tax-exempt organization.

Combinations of pension and other plans

Under present law, if an employer contributes to 1 or more qualified defined contribution plans (i.e., 1 or more qualified money purchase pension plans, profit-sharing plans, or stock bonus plans) and 1 or more qualified defined benefit pension plans for a taxable year, then the amount deductible in that taxable year (under sec. 404(a)(7)) is not to exceed the greater of (1) 25 percent of the compensation otherwise paid or accrued during the taxable year to the employees who benefit under the plans, or (2) the amount of contributions made to or under the defined benefit pension plan or plans to the extent necessary to meet the minimum funding standard for that plan (sec. 412).

Present law coordinates the deduction limits for employer contributions to a simplified employee pension (SEP) with the deduction limit applicable to profit-sharing or stock bonus plans.

Under the bill, the definition of nondeductible contributions includes, for purposes of the excise tax, contributions allocable to the purchase of life, accident, health, or other insurance on behalf of a self-employed individual, but only to the extent that the contributions would be nondeductible without regard to the special rule limiting deductions for such contributions (sec. 404(e)).

The bill clarifies that the amount allowable as a deduction (without regard to sec. 404(e)) for any taxable year is treated as coming first from carryforwards to the taxable year from preceding taxable years (in order of time) and then from employer contributions made during the taxable year.

Further, under the bill, the unapplied amounts in the preceding taxable year do not include nondeductible contributions made for years prior to the effective date of the excise tax on nondeductible contributions. However, carryforwards from pre-effective date years are applied first against the deduction limit (without regard to sec. 404(e)) in determining whether contributions after the effective date are subject to the excise tax.

Time for determination of nondeductible contributions

Because the determination of nondeductible contributions as of the end of a taxable year includes contributions made after the close of the taxable year with respect to the year, the bill provides that contributions that are returned (together with the income allocable thereto) to an employer (to the extent permitted under sec. 401(a)(2)) by the due date of plan contributions for the year (sec. 404(a)(6)) are not treated as nondeductible contributions subject to the excise tax.

Nondeductible contributions to underfunded plans

Under the bill, the excise tax on nondeductible contributions does not apply in the case of a plan that is underfunded and to which Title IV of ERISA applies. A plan is underfunded if, as of the close of the plan year with or within which the taxable year begins, (1) the liabilities of the plan (determined as if the plan were terminated on that date) exceed (2) the assets of the plan. In the case of such an underfunded plan, contributions for a plan year up to the excess calculated under the preceding sentence are not subject to the excise tax even if such contributions are not deductible by the employer. This provision does not apply to years beginning after December 31, 1987. In such years, section 404(a)(1)(D), added by the Omnibus Budget Reconciliation Act of 1987, generally permits certain employers to deduct contributions to defined benefit pension plans that raise the level of plan assets up to current liability.

Definition of employer

The bill provides that the excise tax on nondeductible contributions does not apply in the case of an employer that has been exempt from income tax at all times. Under rules to be prescribed by the Secretary, this exception does not apply to the extent that the employer has been subject to unrelated business income tax or has otherwise derived a tax benefit from the qualified plan.

The original rationale for the excise tax was that, by making nondeductible contributions to qualified plans, often the benefit of tax-free growth on the amounts contributed outweighed the delay in the employer's deduction for plan contributions. Such an incentive to make nondeductible contributions increased the likelihood that employers would use qualified plans as a tax-favored savings vehicle, particularly in the case of small plans that primarily benefit the owners of the employer. The excise tax on reversions may not offset the value of the deferral of tax on earnings on nondeductible contributions to qualified plans.

Such a rationale does not apply in the case of contributions to plans maintained by governments or tax-exempt organizations. In the case of such plans, the employer generally has no incentive to make plan contributions solely to receive the benefit of tax-free growth because the employer could hold the funds directly without incurring current income tax. Thus, an incentive to use a qualified plan as a tax-favored savings vehicle generally does not exist in the case of a qualified plan maintained by a government or tax-exempt employer.

Combinations of pension and other plans

The bill clarifies that the limit on an employer's deduction for contributions to a combination of qualified plans (sec. 404(a)(7)) also applies in the case of (1) a combination of a profit-sharing or stock bonus plan and a money purchase pension plan or an annuity plan (sec. 404(a)(2)), and (2) a money purchase pension plan and an annuity plan. In addition, for purposes of section 404(a)(7), the bill treats a simplified employee pension (SEP) as a separate profit-sharing or stock bonus plan. Thus, a combination of a SEP and certain qualified plans is subject to section 404(a)(7).

3. Excise tax on reversion of qualified plan assets to employer

(sec. 111A(f) of the bill, sec. 1132 of the Reform Act, and sec. 4980 of the Code)

Under present law, a 10-percent excise tax is imposed on a reversion from a qualified plan. The excise tax is imposed on the employer maintaining the plan.

Present law defines a reversion as the amount of cash and the fair market value of other property received (directly or indirectly) by an employer from a qualified plan. No inference is to be drawn from the definition of a reversion as to the income tax consequences and the effect on a plan's qualified status of a transfer of assets from a qualified plan that has not been terminated to another qualified plan.

Special rule for assets transferred to ESOPs

Present law provides an exception to the excise tax on reversions in the case of asset reversions that are transferred from a qualified plan to an employee stock ownership plan (ESOP). The amount transferred is not includible in the income of the employer, nor is the amount transferred deductible by the employer as a plan contribution. No inference is to be drawn from this exception as to the circumstances in which asset transfers will or will not satisfy the exclusive benefit rule and any other applicable qualification requirements (e.g., sec. 401(a)(2) and 414(1)).

Under present law, the amount transferred to the ESOP is required to be used, within 90 days after the transfer, to acquire employer securities (as defined in sec. 409(1)) or to repay a loan the proceeds of which are or were used to acquire employer securities.

Employer securities acquired with the amounts transferred are to be allocated immediately under the plan to ESOP participants, subject to the limits under section 415. As provided under the plan, the amount transferred but not allocated in the year of transfer (by reason of the limitation of sec. 415) may be held in a suspense account pending allocation (provided allocations of the amounts in the suspense account are made no more slowly than ratably over a 7-year period).

The employer securities acquired with the transferred assets are to be held under the plan until distributed to plan participants.

The special exception for transfers to an ESOP does not apply to transfers occurring on or after January 1, 1989, unless the transfer occurs on account of a plan termination before January 1, 1989.

The bill provides an exception to the rule that the employer securities acquired with transferred assets are to be held under the plan until distributed to plan participants. Under this exception, the transferred amounts are not required to be held in employer securities if a plan participant elects to diversify a portion of the participant's account balance (under the rules of sec. 401(a)(28)) that includes such employer securities and diversification cannot be accomplished through the use of nontransferred assets.

The bill also clarifies that amounts attributable to the employer securities acquired with the transferred assets are also subject to the requirements that (1) such amounts, within 90 days, be invested in employer securities (as defined in sec. 409(1)) or used to repay loans used to acquire such securities, and (2) subject to the exception discussed above, such employer securities remain in the plan until distribution to participants in accordance with the provisions of the plan.

In addition, the bill provides that, with respect to the allocation of employer securities acquired with transferred amounts (and amounts attributable thereto), the minimum amount required to be allocated to participants' accounts in the ESOP in the year in which the transfer occurs is not to be less than the lesser of (1) the maximum amount that could be allocated without violating the requirements of section 415, or (2) 1/8 of the shares acquired with the amounts transferred (and amounts attributable to such amounts). Thus, the requirement in the Act that stock acquired with amounts transferred to an ESOP is required to be allocated in the year of transfer up to the maximum amount permitted to be allocated under the limits on contributions (sec. 415) is repealed.

If employer securities are held in a suspense account pending allocation under the foregoing rule, the bill clarifies that dividends on such securities are to be (1) allocated to the accounts of participants and beneficiaries in proportion to their account balances, (2) paid to participants and beneficiaries in proportion to their account balances, or (3) used to repay any loans the proceeds of which were used to purchase employer securities.

The bill clarifies the exception for transfers to ESOPs to the general rule that the employer is required to include the amount of any reversion in income. Under the bill, the exception to the income inclusion requirement applies to any reversion occurring after March 31, 1985, if the reversion is transferred to an ESOP, subject to the January 1, 1989, termination of the ESOP exception.

Finally, the bill clarifies, by statute, that an employer is not entitled to any deduction or credit for any amount transferred to an ESOP to the extent that the special exception to the reversion tax applies to the transfer. This rule is added to prevent an employer from gaining a double tax benefit (i.e., granting a deduction or credit for previously deductible contributions) by transferring assets to an ESOP.

4. Excise tax on excess distributions from qualified retirement plans

(sec. 111A(g) of the bill, sec. 1133 of the Reform Act, and sec. 4980A of the Code)

Under the Act, an excise tax is imposed on excess distributions from qualified retirement plans, tax-sheltered annuities, and IRAs. To the extent that aggregate annual distributions paid to a participant from such tax-favored retirement arrangements are excess distributions, the Act generally imposes an excise tax equal to 15 percent of the excess. The excise tax will be reduced by the amount of tax on the distribution under the provision applying a 10-percent additional income tax on early withdrawals (sec. 72(t)).

The Act provided a special elective grandfather rule with respect to benefits accrued as of August 1, 1986. If this grandfather rule is not elected, then the definition of excess distributions is the greater of (1) $112,500 (indexed) or (2) $150,000.

Under the Act, however, certain amounts are excluded in determining such aggregate annual distributions. Excludable distributions include (1) amounts representing a return of an employee's after-tax contributions (but not earnings thereon) or other amounts that are treated as part of the employee's investment in the contract, (2) amounts excluded from the recipient's income because they are rolled over into another plan or an IRA, and (3) amounts excluded from the participant's income because they are payable to a former spouse pursuant to a qualified domestic relations order (sec. 414(p)) and includible in the spouse's income.

In addition, the bill provides that, in the case of an annuity contract that is distributed to an individual and not included in the individual's income when the contract is distributed, the distribution of the contract is disregarded in applying this excise tax. Rather, payments made under or received for such an annuity contract are treated as retirement distributions subject to the excise tax to the extent they are excess distributions.

In order to identify only those qualified plan distributions that represent a payment of a benefit under the plan, the bill provides that certain amounts returned to an employee under a qualified cash or deferred arrangement or a plan subject to the special non-discrimination requirements for employee contributions and employer matching contributions are not treated as part of the aggregate annual distributions under a plan. Thus, under the bill, aggregate annual distributions do not include a distribution, with respect to an individual, of excess deferrals (as defined in sec. 402(g)) (and income allocable thereto), excess contributions (as defined in sec. 401(k)(8)) (and income allocable thereto), excess aggregate contributions (as defined in sec. 401(m)(6)) (and income allocable thereto), or certain amounts withdrawn from an IRA before the due date of the return (sec. 408(d)(4)).

Under the bill, the operation of community property laws is disregarded in determining the amount of aggregate annual distributions subject to the excise tax. Thus, just as a nonemployee spouse's interest in an employee spouse's pension benefit is not taken into account in determining the taxable income of an employee upon distribution from or under a qualified plan, a nonemployee spouse's interest in such distributions is also disregarded in determining aggregate annual retirement distributions subject to the excise tax.

If the grandfather rule is elected, then, for all purposes, the threshold for retirement distributions that are excess distributions is $112,500 (indexed), rather than the greater of $112,500 (indexed) or $150,000.

The election to use the grandfather rule is to be made on a return for a year beginning no later than January 1, 1988, and is to be made in such form and contain such information as the Secretary may prescribe. The election, once made, applies generally to all retirement distributions made with respect to an individual, including amounts subject to the special estate-level tax after the individual's death. In addition, if an individual dies before the end of the election period, the executor of the individual's estate may make the grandfather election.

The grandfather rule may only be elected with respect to an individual if, as of August 1, 1986, the present value of the individual's interests subject to the excess distribution tax (if such tax were in effect on that date) exceeds $562,500.

The bill clarifies that the grandfather rule is available if amounts are received with respect to an individual under (1) the general rule applicable to lifetime distributions, (2) the special rule for lump-sum distributions, or (3) the special estate tax rule discussed below. Further, the bill provides that an election may be made with respect to the grandfather treatment either on an income or estate tax return of the individual.

The excess retirement accumulation is defined as the excess (if any) of the value of the decedent's interests in all qualified retirement plans, annuity plans, tax-sheltered annuities, and IRAs, over the present value of annual payments equal to the annual excess distribution ceiling for a period equal to the life expectancy of the individual immediately before death.

In calculating the amount of the excess retirement accumulation, the value of the decedent's interest in all qualified plans, tax-sheltered annuities, and IRAs will be taken into account regardless of the number of beneficiaries.

In addition, under the bill, benefits that represent the decedent's investment in the contract or amounts payable to an alternate payee and includible in the alternate payee's income are disregarded in determining the excess retirement accumulation.

The bill redefines the excess retirement accumulation to be the excess (if any) of the present value of the decedent's interests in all qualified retirement plans, annuity plans, tax-sheltered annuities, and IRAs, over the present value (as determined under rules prescribed by the Secretary as of the applicable valuation date) of a single life annuity with annual payments equal to the annual excess distribution limit (as in effect for the year in which death occurs and as if the individual had not died). The bill provides that a decedent's interest in a plan or arrangement subject to the excess distribution tax generally does not include the decedent's interest as a beneficiary in a plan or arrangement for purposes of determining the excess retirement accumulation (other than a spousal beneficiary who makes the special election described below).

Under the bill, the excess retirement accumulation with respect to an individual does not include amounts that are death benefits payable with respect to such individual. Therefore, the bill provides that the excess retirement accumulation does not include the value of any death benefits payable by the plan immediately after death with respect to a decedent to the extent that the sum of such death benefits plus other benefits payable with respect to the decedent exceeds the total value of benefits payable with respect to the decedent immediately prior to death.

The bill clarifies that, with respect to this special estate-level tax, the tax may not be offset by any credits against the estate tax (such as the unified credit).

Further, the bill provides an exception to the general rule that the special estate-level tax applies to all excess retirement accumulations with respect to an individual and that, after the estate-level tax is imposed, a beneficiary receiving distributions with respect to the individual is not required to aggregate the amounts received with any other retirement distributions received by the beneficiary on the beneficiary's own behalf. Under this exception, if the spouse of an individual is the beneficiary of all retirement accumulations with respect to the individual, the spouse may elect, on a form attached to the estate tax return, (1) not to have the special estate-level tax apply and (2) for purposes of the general rule, to have the distributions received with respect to the individual aggregated with any distributions that the spouse receives on the spouse's own behalf. Thus, the amounts received with respect to the individual would be subject to the general excise tax on excess distributions to the extent that the amounts, when aggregated with the spouse's own benefits from or under qualified plans, tax-sheltered annuities, and IRAs, exceed the threshold for the excise tax. Because the spouse is treated as a participant, rather than as a beneficiary, if the election is made, the special rule that disregards a decedent's interests as a beneficiary in a plan or arrangement does not apply in determining the spouse's excess retirement accumulation.

For purposes of this exception to the estate-level tax, if 1 or more persons other than the spouse are beneficiaries of a de minimis portion of the interests with respect to the individual that otherwise would be subject to the estate-level tax, then the spouse is not treated as failing to receive all excess retirement accumulations with respect to the individual. Further, such de minimis amounts are not subject to the excise tax on excess distributions with respect to the decedent nor to the special estate-level tax if the spouse makes the election described above. For purposes of this rule, an amount will not be considered de minimis if it exceeds 1 percent of the decedent's retirement accumulation.

The bill clarifies that the special estate tax on a decedent's excess retirement accumulation is not deductible against income in respect of the decedent (sec. 691). Rather, the bill provides that a deduction is allowed from the gross estate of the decedent for the special estate tax.

Under the bill, an executor of a decedent's estate is required to file an estate tax return if the special tax on excess retirement accumulations applies and without regard to whether a return would otherwise be required to be filed.

(sec. 111A(j) of the bill, sec. 1136 of the Reform Act, and sec. 401(a)(27) of the Code)

2. Time required for plan amendments

(sec. 111A(1) of the bill and sec. 1140 of the Reform Act)

In addition, the bill provides that a collective bargaining agreement is not to be treated as terminated merely because a plan is amended pursuant to the agreement to meet the requirements of Title XI or Title XVIII of the Act. The bill does not intend to create an inference that such an amendment otherwise would be considered a termination, or that an amendment made solely to conform a plan to a requirement added by another Act is considered a termination.

3. Federal Thrift Savings Plan

(sec. 111A(n) of the bill, sec. 1147 of the Reform Act, and secs. 3121(v) and 7701(j) of the Code)

4. Effective dates for collectively bargained plans

(secs. 111(c), (g), (h), and (n), and 111A(e) of the bill, and secs. 1105, 1111, 1112, 1120, and 1131 of the Reform Act)

The provisions subject to the delayed effective date generally do not apply to years beginning before the earlier of

Also, the bill modifies the delayed effective date with respect to the amendments made by section 1105, relating to the $7,000 (indexed) limit on elective deferrals. Under present law, the $7,000 (indexed) limit does not apply to contributions under a collectively bargained plan made pursuant to 1 or more of the collective bargaining agreements relating to the plan for taxable years beginning before the earlier of--

The bill also provides a delayed effective date for collectively bargained plans with respect to 2 additional sections of the Act. First, the amendments made by section 1120, applying nondiscrimination rules to tax-sheltered annuity programs (sec. 403(b)), are not to apply to collectively bargained plans in plan years beginning before the earlier of--

In addition, the amendments made by section 1131, relating to the limits on deductions for contributions under a qualified plan and to the excise tax on nondeductible contributions under a qualified plan, are not to apply to contributions under a collectively bargained plan made pursuant to any of the collective bargaining agreements relating to the plan for taxable years beginning before the earlier of--

(sec. 111B(a) of the bill, sec. 1151 of the Reform Act, sec. 209 of the Social Security Act, and secs. 89, 125, 129, 414, 3121, 3231, 3306, 3401, and 6652 of the Code)

In general

Under present law, new nondiscrimination rules apply to statutory employee benefit plans (sec. 89). The term "statutory employee benefit plans" includes accident or health plans and group-term life insurance plans. At the election of the employer, the term also includes qualified group legal services plans, educational assistance programs, and dependent care assistance programs.

Under the new nondiscrimination rules, a plan generally is required to satisfy 3 eligibility tests -- a 50-percent test, a 90-percent/50-percent test, and a nondiscriminatory provision test -- and a benefits test. Alternatively, a plan may satisfy an 80-percent coverage test, provided it also satisfies the nondiscriminatory provision test.

Nondiscrimination tests

For purposes of this 90-percent/50-percent test, available salary reduction is not taken into account.

This alternative test applies only to accident or health plans and group-term life insurance plans. For purposes of this alternative test, an individual will only be considered to benefit under a plan if such individual receives coverage under the plan; eligibility to receive coverage is not considered benefiting under the plan.

Valuation

The Secretary is to prescribe rules regarding valuation of different benefits. With respect to health coverage, the Secretary is to establish tables prescribing the relative values of different types of health coverage.

Definitions

For purposes of applying the new nondiscrimination rules, present law provides generally applicable definitions of the following: (1) highly compensated employee (sec. 414(q)); (2) employer (including the employee leasing rules (sec. 414(b), (c), (m), (n), (o), and (t))); (3) line of business or operating unit (as present law permits the new nondiscrimination rules to be applied separately to separate lines of business or operating units (sec. 414(r))); and (4) employees who are excluded from consideration. These definitions, other than the line of business or operating unit rule, apply generally to all employee benefit plans, not only to statutory employee benefit plans.

Qualification and reporting requirements

Employee benefit plans generally are subject to new qualification and reporting requirements (sec. 89(k) and (l)).

For both of these purposes, the value of an employee's employer-provided benefit under an accident or health plan is the value of the coverage provided to or on behalf of the employee to the extent attributable to contributions made by the employer. For example, the value of a health plan, whether insured or self-insured, is the value of the insurance coverage, not the value of the services or the amount of claims proceeds received by a particular employee.

With respect to the valuation of any particular accident or health coverage, the Secretary is to promulgate tables that establish the relative values of accident or health coverage with any set of characteristics. Such tables may use an identifiable standard plan as a reference point. These tables are to provide the exclusive means of valuing accident or health coverage.

Such tables are to be adjusted in certain instances to take into account the specific coverage and group involved. For example, in determining the value of discriminatory coverage, the actual costs expended by the employer may be taken into account and allocated among all coverages, including the discriminatory coverage on the basis of the relative values of such coverages, as determined under the tables.

The bill further provides a temporary special valuation rule for accident or health coverage. This special rule applies prior to the effective date of valuation rules that are issued by the Secretary to replace such special rule. If the Secretary issues valuation rules that are intended to replace only part of such special rule, then the remaining portion of such special rule is not to be affected by such issuance.

These provisions are intended to ensure that taxpayers have timely guidance with respect to valuation issues so that they may plan for compliance with the nondiscrimination rules.

Pursuant to the special valuation rule under the bill, the value of the employer-provided benefit under an accident or health plan may, for purposes of determining if a plan is discriminatory, be calculated under any actuarially reasonable valuation method adopted by the employer. In addition, unlike under present law, an employer may, under a reasonable valuation method, use its cost in providing accident or health coverage as the value of such coverage. In such cases, the employer's cost is to be determined in the same manner that the employer determines the applicable premium for purposes of the health care continuation rules (sec. 162(k)).

This special valuation rule also permits an employer to use, as the value of accident or health coverage, the cost of such coverage modified in certain ways specified below.

First, to facilitate planning, an employer may use, as the employer cost of accident or health coverage for a plan year, the average annual cost (determined in the manner described above) of substantially similar coverage provided during the immediately preceding one or two years.

The employer may also make reasonable adjustments to its cost to eliminate cost differences between coverages attributable to (1) differences in the cost of accident or health coverage in different geographic areas, and (2) the demographic characteristics of the covered employees. For example, assume that the employer provides individual coverage to employees in State X that costs $1,000 per employee, but that would cost $1,200 per employee in State Y. Assume further that the employer also operates in State Y and tests its State X employees with its State Y employees under section 89. In such case, the employer may, for example, treat the individual coverage provided in State X as costing $1,200 for purposes of testing such coverage with the coverage provided in State Y.

Another example of a permissible adjustment under the above rule would be an age-related adjustment. For example, assume that the employer provides individual coverage to a group of young employees that costs $800 per employee, but if provided to a group of the employer's older employees would cost $1,100. In such a case, the employer may, for example, treat the individual coverage provided to the young employees as costing $1,100 for purposes of testing such coverage with the coverage of the older employees.

The employer may also adjust its cost to eliminate differences in costs between coverages that are attributable to differences in utilization of certain health care features that are common to the different coverages. For example, if all of an employer's cancer cases arise under a specific health plan and the cancer-relevant health features of such plan are common to other health plans, the costs of such plans may be adjusted to eliminate this utilization distortion. This adjustment is to be made after the adjustments described above and is to be made by estimating the cost of each plan with the common features as if the utilization had been evenly distributed among the plans.

All of an employer's accident or health plans that are tested together under section 89 are to be valued under the same actuarially reasonable valuation method. Thus, if an employer uses cost as its valuation method and adjusts its cost under one or more of the rules described above, the employer must use cost and make the same adjustments to all plans tested together under section 89. In addition, as is the case with all other aspects of the nondiscrimination rules, the employer must maintain records of its valuation method and the basis for this method (including the basis for the adjustments described above).

This rule, requiring an employer to use the same valuation method for all of its plans, means that, for example, 2 health plans with identical costs (if cost is used) or coverages (if a non-cost valuation method is used) may not be assigned different values merely because one is a health maintenance organization and one is an indemnity plan. Similarly, the same valuation method should be used for valuing, for example, dental plans, hearing care plans, vision plans, physical examination plans, substance abuse programs, etc.

The valuation method described above is, as noted, applicable in determining if an accident or health plan is discriminatory. Once this determination is made, the determination of the discriminatory excess, if any, that is includible in the incomes of the highly compensated employees is similar to the determination under present law. The first step is to determine the percentage of any coverage that is discriminatory. This percentage is then multiplied by the employer's actual cost in providing the entire coverage to determine the discriminatory excess. The bill clarifies that such actual cost is to be determined in the same manner that the employer determines the applicable premium for purposes of the health care continuation rules. The bill modifies present law by allowing cost to be adjusted for this purpose for differences in utilization in the manner described above. None of the other adjustments described above is permitted for this purpose.

If an employer uses the special rule described above, and employee-purchased coverage is not treated as employer-provided, then the amount of employer-provided group-term life insurance coverage with respect to any employee is the amount that bears the same relationship to the total coverage for such employee as the employer's contribution (determined on an age-rated basis) bears to the age-rated cost of such employee's total coverage. For example, if an employee contributes one quarter of the age-rated cost of $100,000 of coverage, and employee-purchased coverage is not treated as employer-provided, the employer-provided group-term life insurance coverage with respect to such employee is $75,000.

If the employer does not use the special rule described above, and employee-purchased coverage is not treated as employer-provided, the amount of employer-provided group-term life insurance coverage with respect to any employee is determined in the same manner except that the total cost of any employee's coverage and the employer's contributions with respect to such coverage are to be determined without regard to the employee's age.

If an employer uses the special rule described above with respect to any group-term life insurance, then the employer is required to use the special rule with respect to all group-term life insurance coverage of the employer. Thus, with respect to such an employer, coverage available for a required employee contribution that does not vary according to age would not be considered a single plan. Of course, this rule applies separately to any line of business or operating unit if the employer applies the rules of section 89 separately to such line of business or operating unit pursuant to section 89(g)(5).

Under the bill, family coverage (i.e., coverage of an employee's family, which is considered separate from coverage of the employee) may be considered to be available (if otherwise available) or provided (if otherwise provided) to an employee despite the fact that the employee does not have a family. The purpose of this rule is to relieve employers from the burden of determining which employees have families.

This rule alone, however, could produce inappropriate results in certain very limited circumstances and it is intended that the nondiscriminatory provision test be applied to prevent such results. Thus, if, under the facts and circumstances, it is clear that the employer is, by using the above rule that allows family coverage to be considered to be available or provided to an employee who does not have a family, evading the other nondiscrimination tests, the nondiscriminatory provision test is not to be considered satisfied with respect to the relevant plan or plans.

Under present law, with respect to an employer that elects to disregard individuals covered (or deemed covered under the rule described above) by another employer's core health benefits, in the absence of a sworn statement, a highly compensated employee is treated as (1) covered by a plan of another employer providing core health benefits, and (2) not having a spouse or dependent. Thus, the special rule under the bill described above only affects nonhighly compensated employees.

With respect to an employer electing the latter special rule described above, in the absence of a sworn statement, a highly compensated employee is treated as, inter alia, not having a spouse or dependent. If an employee is treated as not having a spouse or dependent, any coverage provided to any spouse or dependent of that employee generally is disregarded. For purposes of applying the benefits test, however, the family of a highly compensated employee may not be disregarded nor may coverage provided to such family be disregarded if the coverage provided with respect to such family has a value in excess of 133-1/3 percent of the average employer-provided benefit provided with respect to families of nonhighly compensated employees.

For purposes of the 80-percent test, the general rule is that a group of plans are comparable and may be aggregated if the value of the employer-provided coverage provided to each covered employee in the plan with the lowest such value is at least 95 percent of the value of the employer-provided coverage provided to each covered employee in the plan with the highest such value. However, if a plan with a greater value than permitted under the previous sentence satisfies section 89(d)(2) based on actual coverage provided rather than on eligibility, such plan may be aggregated with the group of less valuable plans for purposes of the 80-percent test.

Under the analogue to the 133-1/3-percent rule, for purposes of the 80-percent test, the family of a highly compensated employee may not be disregarded nor may coverage provided to such family be disregarded if the coverage provided to any spouse and dependents of such employee is provided under a plan that would need to rely on the section 89(d)(2) test to be aggregated with a group of plans satisfying the 80-percent test. Of course, under the 80-percent test, if no group of plans satisfies the 80-percent test, no coverage provided to family members of highly compensated employees may be disregarded.

An employer is to exclude an employee, on the grounds that such employee has not satisfied the required period of initial service, during the period prior to the first day of the calendar month immediately following the actual satisfaction of the initial service requirement. In general, this exclusion does not apply if any employee is eligible under any plan of the same type prior to the first day of the calendar month immediately following the actual satisfaction of the initial service requirement.

In addition, the legislative history of the Act provided certain rules of convenience, relating to the time at which the nondiscrimination rules are to be applied, that were intended to reduce the administrative burden of applying the nondiscrimination rules.

The Secretary is to provide corresponding changes to the rules of convenience relating to the time for testing described in the legislative history of the Act.

This amendment, allowing use of a period of less than 31 days, provides employers with flexibility without adversely affecting the policy of the nondiscrimination rules.

In addition, an individual who owns the entire interest in an unincorporated trade or business is to be treated as his or her own employer. A partnership is to be treated as the employer of each partner who is treated as an employee under the rule described above.

These rules do not affect whether a self-employed individual may exclude a benefit provided under a statutory employee benefit plan. For example, group-term life insurance provided to a self-employed individual may not be excluded by the self-employed individual because section 79 does not apply to self-employed individuals. The effect of this provision of the bill is to count a self-employed individual as an employee even though such individual is not eligible for the exclusion. Generally, this will facilitate compliance with the nondiscrimination rules, since self-employed individuals, who generally are highly compensated employees under the applicable definition (sec. 414(q)), are taken into account but treated only as eligible for and receiving benefits that are excludable or deductible. Thus, for example, with respect to health benefits, a self-employed individual is treated as receiving (or eligible for) a benefit equal to 25 percent of the amount paid (or payable) for health insurance, since that is the only amount that is tax-favored with respect to a self-employed individual (secs. 106 and 162(m)).

Under present law, if a plan is discriminatory in a plan year, highly compensated employees are taxable on the value of the discriminatory excess in their taxable year in which or with which the plan year ends.

Discriminatory excess

The discriminatory excess is defined as the amount of the otherwise nontaxable employer-provided benefit (including benefits purchased with elective contributions) that would have to have been purchased with after-tax employee contributions by the highly compensated employees in order for all of the nondiscrimination tests to be satisfied. In the case of group-term life insurance, the value of discriminatory coverage is the greater of the cost of coverage under section 79(c) or the actual cost of coverage.

Of course, as is generally the case, the taxpayer has the burden of proof with respect to establishing the discriminatory excess. Thus, the discriminatory excess includes all employer-provided benefits for highly compensated employees except to the extent that the taxpayer maintains sufficient records to demonstrate to the Internal Revenue Service that such benefits do not constitute discriminatory excess.

Qualification rule sanction

If a plan fails to satisfy the new qualification requirements (sec. 89(k)), employees covered under the plan generally are to include in gross income the employer-provided benefit under the plan. For this purpose, even in the case of an insurance-type plan, an employee's employer-provided benefit is the value of the benefits, not the coverage, attributable to employer contributions.

Employer sanction

If the employer does not report the discriminatory excess (or other amounts includible under sec. 89) in a timely manner, the employer may be subject to an employer-level sanction (sec. 6652(1)). This sanction applies without regard to whether the relevant benefit was automatically subject to section 89 or whether it was only subject to section 89 due to an election by the employer under section 89(i)(2).

Welfare benefit funds

In general, if a voluntary employees' beneficiary association (VEBA) (sec. 501(c)(9)) or group legal services organization (GLSO) (sec. 501(c)(20)) is part of a discriminatory plan, the VEBA or GLSO is not to be exempt from tax under section 501(a) (sec. 505). With respect to employee benefits subject to the new nondiscrimination rules of section 89, a discriminatory plan for this purpose is a discriminatory employee benefit plan within the meaning of section 89(c).

In addition, if an employer maintains a welfare benefit fund and there is a disqualified benefit provided during any taxable year, a tax is imposed on the employer equal to 100 percent of the disqualified benefit. The term "disqualified benefit" includes any post-retirement medical benefit or life insurance benefit provided with respect to a highly compensated employee under a discriminatory plan (within the meaning of sec. 505).

Under present law, if a plan is discriminatory and the plan year is, for example, the calendar year, the employer has only 1 month to determine the discriminatory excess with respect to the highly compensated employees in order to file accurate Forms W-2 in a timely manner. In many cases, this is not a sufficient period of time. Thus, the bill provides a special rule with respect to plans with a plan year ending after September 30 and on or before December 31 of a calendar year.

Under this special rule, an employer may elect to have the discriminatory excess included in the incomes of highly compensated employees in their taxable year following the taxable year with or within which the plan year ends. If an employer makes such an election, however, the employer's deduction relating to such discriminatory excess is to be allowable only in the employer's taxable year with or within which ends the plan year following the plan year in which the discriminatory excess occurred. It is not intended, however, that an employer be permitted to avoid the deferral of the deduction through the use of a short plan year following the plan year in which the discriminatory excess occurred.

Discriminatory excess

For purposes of determining and allocating the discriminatory excess with respect to a group-term life insurance plan, employer-provided coverage over $50,000 will be treated as nontaxable under the bill. Thus, to the extent that the discriminatory coverage does not exceed the total coverage over $50,000, the effect of a finding of discrimination is simply the inclusion in income of the excess, if any, of the actual cost of the discriminatory coverage over the cost of such coverage under section 79(c).

If a plan to which section 505 applies -- generally, a plan part of which is a VEBA or a GLSO -- violates the new qualification requirements (sec. 89(k)), the VEBA or GLSO is not to be exempt from tax under section 501(a). A plan failing to satisfy the new qualification requirements is not the type of plan for which the VEBA or GLSO tax exemption was established.

In addition, the bill provides that in the case of a group-term life insurance plan that fails the qualification rule, the benefits provided under the plan are to be included in the beneficiary's income rather than the employee's.

The bill further provides for the coordination of the sanction for failure to satisfy the qualification rules with the sanction for discrimination. Generally, any amount included in the income of a highly compensated employee attributable to discriminatory coverage is to offset the amount includible under section 89(k) with respect to the same highly compensated employee for the same coverage. Thus, for example, assume a highly compensated employee includes $100 in income under section 89(a) for discriminatory health coverage provided during a plan year, and such health coverage does not satisfy section 89(k). The only health benefits that are includible under section 89(k) attributable to the coverage provided during that plan year are amounts in excess of $100.

If, however, any discriminatory excess would be included in the income of a highly compensated employee for a year subsequent to the year of inclusion under section 89(k) with respect to the same coverage, the coordination described above is to work in reverse, i.e., the section 89(k) inclusion is to offset the inclusion of the discriminatory excess.

Employer sanction

If an employer does not report a discriminatory excess (or other amount includible under sec. 89) in a timely manner, the employer may be subject to an employer-level sanction. Under the bill, it is clarified that the employer-provided benefit subject to the employer sanction is determined under the general rules applicable under section 89 except that the special rule relating to group-term life insurance plans, under which employees are assumed to be age 40, does not apply. Of course, the adjustment of the employer-provided benefit under a group-term life insurance plan based on the employee's compensation also does not apply.

Welfare benefit funds

The sanctions of present law with respect to discriminatory VEBA's, GLSO's, and other welfare benefit funds are inconsistent with the general approach under section 89 to apply the sanction solely with respect to the discriminatory amount. The bill modifies the sanctions accordingly.

Under the bill, if section 89 applies to a plan, a VEBA or GLSO that is part of the plan does not lose its tax-exempt status under section 501(a) merely because the plan is a discriminatory employee benefit plan (within the meaning of sec. 89(c)). In lieu of this sanction, the bill imposes an excise tax on an employer maintaining a welfare benefit fund if a discriminatory employee benefit plan is part of the fund for the plan year. The tax applies to the taxable year of the employer with or within which the plan year ends.

The amount of this excise tax is determined as follows. The first step is to determine the lesser of (1) the aggregate excess benefits (within the meaning of sec. 89(b)) provided under the plan for the plan year, or (2) the taxable income of the fund for the plan year. For this purpose, the taxable income of the fund is determined without regard to an exemption from tax pursuant to section 501(c)(9) or (c)(20). The lesser of those 2 amounts is then multiplied by the highest rate applicable to taxable income under section 11. This product then is offset by the amount of income tax imposed on the fund for the plan year determined under rules prescribed by the Secretary. This result is the amount of the excise tax.

The bill also modifies the 100-percent excise tax applicable to disqualified benefits in the case of a post-retirement medical benefit or life insurance benefit that is subject to section 89. The bill provides that the amount of the disqualified benefit subject to the tax is not to exceed the aggregate excess benefits (within the meaning of sec. 89(b)) provided under the plan.

Under present law, the definition of a cafeteria plan includes a plan only offering a choice between nontaxable benefits (sec. 125).

Qualified benefits

To qualify as a cafeteria plan, a plan may not offer benefits other than cash and qualified benefits. The term "qualified benefits" generally means any benefit that, with the application of section 125(a), is excludable from an employee's income by reason of a provision of Chapter 1 of the Code (other than secs. 117, 124, 127, or 132). In addition, the term includes (1) any group-term life insurance coverage that is includible in income only because it is in excess of $50,000, and (2) any other benefit permitted under regulations.

The bill amends the definition of a cafeteria plan so that a choice only between nontaxable benefits is not a cafeteria plan. The inclusion of a choice between nontaxable benefits as a cafeteria plan would require, to make the provision effective as a practical matter, additional amendments not intended by Congress. For example, under present law, a choice between nontaxable benefits, one of which constituted deferred compensation, would generally not be a cafeteria plan in light of the prohibition on deferred compensation in a cafeteria plan. Thus, an employer could simply add to any choice between nontaxable current benefits the choice of a nominal nontaxable deferred benefit; this would at least arguably remove the arrangement from the definition of a cafeteria plan. Although this and other problems with the new definition could have been individually addressed with additional rules, such rules would have added complexity not contemplated by Congress.

Sanctions

The bill also clarifies that, in the case of a cafeteria plan that fails the cafeteria plan nondiscrimination test (sec. 125(b)(1)), only highly compensated employees are taxable on the available taxable benefits. In the case of a cafeteria plan that fails the key employee concentration test (sec. 125(b)(2)), the bill clarifies that only key employees are taxable on the available taxable benefits.

Qualified benefits

In addition, the bill modifies the definition of qualified benefits. Under the bill, the term "qualified benefits" includes benefits that would be qualified benefits but for the fact that they are includible in an employee's income under section 89(a). Thus, if, for example, there is a discriminatory excess with respect to a health plan offered under a cafeteria plan, such discriminatory excess will not cause the cafeteria plan to cease to be a cafeteria plan.

The bill also modifies the special definition of qualified benefits used for purposes of determining whether under the key employee concentration test (sec. 125(b)(2)), the qualified benefits provided to key employees under a cafeteria plan exceed 25 percent of the aggregate of such benefits provided to all employees under the plan. For this purpose, benefits that are includible in income (without regard to the key employee concentration test of sec. 125(b)(2)) are disregarded.

Under the bill, this extension and the application under the Act of the same aggregation and leasing rules to section 106 (relating to the exclusion from income of employer-provided accident or health coverage) and to the continuation-of-health-care rules of ERISA are effective for years beginning after 1986.

2. Deductibility of health insurance costs of self-employed individuals

(sec. 111B(b) of the bill, sec. 1161 of the Reform Act, and sec. 162(m) of the Code)

The deduction is limited to the taxpayer's earned income (within the meaning of sec. 401(c)).

Under the bill, the deduction under section 162(m) is limited to the earned income derived by the taxpayer from the trade or business with respect to which the plan providing the health insurance is established.

3. $5,000 limit on dependent care assistance exclusion

(sec. 111B(c) of the bill, sec. 1163 of the Reform Act, and sec. 129 of the Code)

These provisions with respect to the $5,000 limit generally apply to taxable years beginning after December 31, 1987, with 2 modifications. First, a taxpayer may elect to have the provisions apply to taxable years beginning after December 31, 1986. The election may be made by a taxpayer by filing an income tax return in a manner consistent with these provisions for any taxable year beginning before January 1, 1988.

The second modification applies to any taxpayer who does not make the election described above. Such taxpayers are subject to the following transition rule. Any dependent care services covered by a dependent care assistance program that are received by the taxpayer in a taxable year beginning in 1987 are to be treated as provided in the taxpayer's first taxable year beginning after December 31, 1987, if the employer payment for such services is not received in the year in which the services are received.

(sec. 111B(e) of the bill, sec. 1166 of the Reform Act, and sec. 7701(a)(20) of the Code)

5. Exclusion of cafeteria plan elective contributions from wages for purposes of employment taxes

(sec. 111B(a) of the bill, sec. 1151(d) of the Reform Act, sec. 209(e) of the Social Security Act, and secs. 3121(a)(5) and 3306(b)(5) of the Code)

For example, no amount is included in any employee's wages for FICA and FUTA tax purposes attributable to the employee's election under a cafeteria plan that satisfies the applicable discrimination test and key employee concentration test of a health benefit that is otherwise excludable from wages. Of course, a collectively bargained plan that is deemed to be nondiscriminatory for income tax purposes (sec. 125(f)) is deemed to meet the cafeteria-plan discrimination test (sec. 125(b)(1)) for purposes of this rule.

An example of a benefit that would not be excludable from wages would be employer-provided group-term life insurance that would, pursuant to the amendment made by section 9003 of the Omnibus Budget Reconciliation Act of 1987, be includible in wages if provided outside of a cafeteria plan.

6. Tax treatment of qualified campus lodging

(sec. 111B(d) of the bill, sec. 1164 of the Reform Act, and sec. 119(d) of the Code)

The purpose of this provision is to avoid disputes between educational institutions and the Internal Revenue Service regarding whether an individual has income attributable to the use, for a specified rent, of employer-furnished lodging located on a campus of, or in the proximity of, the educational institution.

The bill modifies the date on which the appraised value is determined in the case of a rental period not greater than 1 year. In such case, the appraised value may be determined at any time during the calendar year in which the rental period begins.

7. Military fringe benefits

(sec. 111B(f) of the bill, sec. 1168 of the Reform Act, and sec. 134 of the Code)

Of course, benefits provided in connection with an individual's status or service as a member of the uniformed services may be excluded from income under other sections of the Code if the requirements for exclusion under such other sections are satisfied, even if such benefit does not qualify as a qualified military benefit.

The bill also provides that the term "qualified military benefit" does not include personal use of a vehicle. This amendment applies to taxable years beginning after December 31, 1986.

Under the bill, it is further intended that qualified military benefits that are provided in kind may be modified or adjusted after September 9, 1986, without affecting the excludability of such benefit under section 134.

In addition, the bill modifies the general effective date of section 134 to apply to taxable years beginning after December 31, 1984 (rather than beginning after December 31, 1986).

1. Changes in qualification requirements relating to ESOPs

(sec. 111B(i), (j), and (k) of the bill, secs. 1174-1176 and 1854 of the Reform Act, and secs. 401, 415, and 409 of the Code)

Under the Act, an ESOP is required to provide an annual diversification election period for the 90-day period following the close of the ESOP plan year. Thus, for 90 days after the end of a plan year, an ESOP is to permit an election by those qualified participants who become or remain eligible to make a diversification election during the plan year. Under the Act, any participant who has attained at least age 55 and completed at least 10 years of participation in the plan is a qualified participant. For purposes of the 10-year rule, participation in a predecessor plan is taken into account.

A qualified participant may modify, revoke, or make a new election at any time during the 90-day election period. Any qualified participant is permitted to make a diversification election during each diversification election period following each plan year in the participant's qualified election period.

No later than 90 days after the close of the election period, the plan is to complete diversification pursuant to participant elections. The diversification requirement can be satisfied by (1) offering to distribute to the participant an amount equal to the amount for which the participant elected diversification, (2) substituting for the amount of the employer securities for which the participant elected diversification an equivalent amount of other assets, in accordance with the participant's investment direction, or (3) providing the participant the option to transfer (in accordance with applicable qualification rules) the portion of the account balance for which diversification is elected into a qualified plan that provides for employee-directed investment and in which the required diversification options are available. The ESOP, or the transferee plan in the case of a transfer described in (3), is to offer at least 3 investment options (not inconsistent with regulations prescribed by the Secretary).

For example, in the case of an ESOP using the calendar year as the plan year, a participant who completes 10 years of plan participation before attaining age 55 and who attains age 55 in 1990, becomes a qualified participant in the plan year beginning January 1, 1990. That participant is eligible to direct diversification during the 90-day election period beginning January 1, 1991, and remains eligible to direct diversification during the annual election periods in 1992, 1993, 1994, 1995, and 1996.

Similarly, if the participant completes 10 years of participation in 1990 when the participant is 58, the participant becomes a qualified participant in the plan year beginning January 1, 1990. The participant is eligible to direct diversification during the election periods in 1991, 1992, 1993, 1994, 1995, and 1996.

Under the bill, the qualified election period of any participant does not begin before the first plan year beginning after December 31, 1986. Thus, for example, under the bill, if a participant in a calendar year ESOP attained age 55 and had 10 years of plan participation in 1986, the participant is eligible to make a diversification election during the election periods in 1988, 1989, 1990, 1991, 1992, and 1993.

It is understood that some plans already may have provided for diversification elections in 1988, whereas some plans may not have done so pending the enactment of this bill or the issuance of guidance by the Secretary. Accordingly, the Secretary may provide flexibility with respect to diversification elections in 1988 by, for example, permitting plans to comply with the diversification rules within a certain period following the issuance of guidance by the Secretary.

The bill also clarifies that diversification is to be completed no later than 90 days after the close of the election period, regardless of the method used to implement diversification elections. Thus, diversification is to be completed within the 90-day period regardless of whether diversification is implemented by means of distribution, transfer to another qualified plan which offers the requisite investment options, or reinvestment of employer securities in other assets.

Tax-credit ESOPs are subject to the requirements generally applicable to qualified plans and ESOPs. In addition, tax-credit ESOPs are subject to special qualification requirements. In general, under present law, employer securities allocated to an employee's account under a tax-credit ESOP may not be distributed before the end of the 84th month after the month in which the securities were allocated. This limitation does not apply to distributions of securities in the case of the employee's separation from service, death, or disability, or in the case of certain corporate acquisitions. In addition, under the Act, the 84-month rule does not apply to distributions upon termination of the tax-credit ESOP, effective with respect to plan terminations after December 31, 1984.

In order to coordinate the 84-month rule with the new diversification rules, the bill provides that the 84-month rule does not apply to the extent that a distribution is made to satisfy the diversification requirement. This exception to the 84-month rule applies only to the extent that the diversification requirement cannot be satisfied by distributing employer securities that have already met the 84-month rule.

Unless the participant elects otherwise, distribution is to be made in substantially equal payments (not less frequently than annually) over a period not longer than 5 years. Additional time to distribute the account balance is provided if the balance is greater than $500,000, indexed to take into account increases in the cost-of-living. For 1988, the indexed figure is $522,350. This rule does not preclude more rapid payment.

The rules added by the Act accelerate the otherwise applicable benefit commencement date. Accordingly, if the general rules (secs. 401(a)(9) and 401(a)(14)) require the commencement of distributions at an earlier date, those general rules override the special ESOP rules.

Of course, the special ESOP rules do not permit the employee to elect a form or time of distribution not provided or required to be provided under the plan.

The special ESOP distribution rules create a conflict with the rules added by the Retirement Equity Act of 1984, which provide that benefits in excess of certain amounts cannot be distributed without the consent of the participant (sec. 411(a)(11)), and that, in certain cases, benefits must be paid in the form of a joint and survivor annuity (secs. 401(a)(11) and 417). The bill provides that the provisions of sections 411(a)(11), 401(a)(11) and 417 are controlling. Thus, for example, distribution to a participant cannot commence under the special ESOP rules unless the applicable consent requirements of sections 411(a)(11), 401(a)(11), and 417 are satisfied.

In addition, all ESOPs are required to pass through certain voting rights to plan participants. The circumstances under which participants are entitled to exercise voting rights depend on whether the employer has a registration-type class of securities. The Act provides that these voting requirements may be satisfied if the plan permits each participant 1 vote with respect to the issue in question and the plan trustee votes the shares held by the plan in the proportion determined by the votes of participants.

The bill replaces the term "not publicly traded" in section 401(a)(22) with the term "not readily tradable on an established market" to conform to the term used in section 409. This change is not intended as a substantive change in the rules of section 401(a)(22).

The bill conforms the 1-vote-per-participant rule to the legislative history by providing that it applies only where the employer does not have a registration-type class of securities.

2. Estate tax deduction for sales to an ESOP

(sec. 111B(g) of the bill, sec. 1172 of the Reform Act, and secs. 409 and 2057 of the Code)

Under the Act, certain penalties apply if any portion of the assets attributable to employer securities acquired in a qualified sale (or assets in lieu thereof) accrue or are allocated during the nonallocation period for the benefit of (1) a decedent whose estate makes such a sale, (2) any person who is related to the decedent in one of the ways described in section 267(b), or (3) any other person who owns (after application of the attribution rules of sec. 318(a) as modified for this purpose) more than (a) 25 percent (by number) of any class of outstanding stock of the corporation (or certain related corporations) that issued such qualified securities, or (b) more than 25 percent of the total value of any class of outstanding stock of the corporation (or certain related corporations).

There are 2 sanctions for failure to comply with the allocation restriction. First, the Act requires that an ESOP that acquires securities in a qualified sale is required to provide that the restriction on the allocation of securities (or assets in lieu thereof) to the sellers, family members, and 25-percent shareholders will be satisfied. Failure to comply with this requirement results in disqualification of the plan with respect to those participants who received prohibited allocations. Thus, failure to comply results in income inclusion for those participants of the value of their prohibited allocations on the date of such allocations. Second, if there is a prohibited allocation or accrual, then a 50-percent excise tax is imposed on the amount involved in the prohibited allocation (sec. 4979A).

The bill also provides that individuals who are ineligible to receive an allocation of securities (or other assets) solely because they are lineal descendants of the decedent can receive an allocation of the securities acquired in a qualified sale provided that the total amount of such securities (or assets in lieu thereof) allocated to all such lineal descendants is not more than 5 percent of all employer securities acquired in the decedent's qualified sale.

Finally, the bill clarifies that, in the case of a plan that fails to comply with the nonallocation rules, the statutory period for the assessment of the excise tax imposed with respect to such failure (sec. 4979A) is extended.

3. Partial exclusion of interest earned on ESOP loans

(sec. 111B(h) of the bill, sec. 1173 of the Reform Act, and sec. 133 of the Code)

Under present law, a bank, an insurance company, regulated investment company, or a corporation actively engaged in the business of lending money may exclude from gross income 50 percent of the interest received with respect to a securities acquisition loan. A "securities acquisition loan" is generally defined as a loan to a corporation or to an ESOP to the extent that the proceeds are used to acquire employer securities (within the meaning of section 409(1)) for the ESOP. There has been some uncertainty as to the availability of the partial interest exclusion with respect to refinancings of the various types of securities acquisition loans.

Back-to-back loans

The Act clarified the definition of a securities acquisition loan in the case of a loan to a corporation with a corresponding loan to an ESOP that is exempt under section 4975 (a back-to-back loan). The Act provides that a loan to a sponsoring corporation will qualify as a securities acquisition loan if the terms of such loan are substantially similar to the terms of the corresponding exempt loan from the corporation to the ESOP. In addition, the Act provides that, if the terms of the 2 loans are not substantially similar, the loan to the sponsoring corporation will still qualify as a securities acquisition loan if (1) the corresponding loan to the ESOP provides for more rapid payment of principal or interest than the loan to the sponsoring corporation; (2) the allocations of stock within the ESOP attributable to the difference in payment schedules do not result in discrimination in favor of highly compensated employees; and (3) the total commitment period of the loan to the sponsoring corporation is not more than 7 years.

The 7-year limitation applies to the total commitment period. Thus, provided the final maturity of the credit arrangement is not greater than 7 years, the funds may be provided by 1 or more lenders in a series of shorter maturity loans, each of which (other than the first) is used to repay the preceding loan.

The 7-year limitation on the term of the loan does not apply to loans directly from a commercial lender to an ESOP or to back-to-back loans if the terms of the loans are substantially similar. For example, assume a bank makes a loan to employer X with a term of 10 years and employer X in turn makes a loan to its ESOP. If the terms of the 2 loans are substantially similar, then the partial interest exclusion is available for the entire 10-year commitment period of the loan. Similarly, the partial interest exclusion applies for the entire commitment period of the loan if the loan is made directly from the bank to the ESOP.

Immediate allocation loans

The Act extended the definition of "securities acquisition loan" to include certain loans to a corporation that are used by the corporation to purchase employer securities that are immediately allocated to employees' accounts. Thus, the partial exclusion is available with respect to interest paid on a loan to a corporation to the extent that (1) within 30 days of the date of the loan, employer securities are transferred to the ESOP in an amount equal to the proceeds of the loan, (2) such contributions are allocable to accounts of plan participants within 1 year of the date of the loan, and (3) the total commitment period of the loan does not exceed 7 years.

As in the case of other loans to which the 7-year limitation applies, the limitation applies to the total commitment period. Thus, provided the final maturity of the credit arrangement is not greater than 7 years, the funds may be provided by 1 or more lenders in a series of shorter maturity loans, each of which (other than the first) is used to repay the preceding loan.

Refinancings

The Act provided that, in certain cases, the refinancing of a securities acquisition loan (other than an immediate allocation loan or a back-to-back loan that has terms that are not substantially similar, which are discussed above) may also qualify as a securities acquisition loan.

All refinancings, including refinancings of back-to-back loans that are not substantially similar, are required to comply with section 4975.

The bill clarifies the availability of the partial interest exclusion in the case of refinancings of the various types of securities acquisition loans.

Back-to-back loans

The bill provides that, with respect to back-to-back loans the terms of which are not substantially similar, if the total commitment period of the loan is extended beyond 7 years, the partial exclusion will be available, but for the first 7 years of the loan only. This 7-year period begins as of the date of the original loan. The provision is effective with respect to a loan used to acquire employer securities after July 18, 1984, and a loan made after July 18, 1984, that is used (or is part of a series of loans used) to refinance a loan that (1) was used to acquire employer securities after July 18, 1984, and (2) met the requirements of section 133 as in effect at the time the loan was made.

Immediate allocation loans

The bill provides that, with respect to immediate allocation loans, if the total commitment period is extended beyond 7 years, the partial interest exclusion will be available, but for the first 7 years of the loan only. This 7-year period begins as of the date of the original loan. This provision is effective as if included in the Act.

Refinancings

The bill provides that a loan to an ESOP (other than an immediate allocation loan or a back-to-back loan that has terms that are not substantially similar) after July 18, 1984, that is used (or is part of a series of loans used) to refinance a loan will qualify as a securities acquisition loan provided that (1) the original loan met the requirements of section 133 as in effect on the date of the loan, or, if later, July 19, 1984; and (2) the original loan was used to acquire employer securities after May 23, 1984. Immediate allocation loans and back-to-back loans that have terms that are not substantially similar are described above.

Under the bill, if a securities acquisition loan (other than an immediate allocation loan or a back-to-back loan that has terms that are not substantially similar) is refinanced and as a result the total commitment period exceeds the greater of the original commitment period or 7 years, then the partial exclusion would continue to apply, but only during the first 7 years of the commitment period (measured from the date of the original loan) or the original commitment period, whichever is greater. For example, if an otherwise qualified securities acquisition loan to an ESOP with an original commitment period of 5 years is refinanced and the commitment period is extended for 2 years (for a total commitment period of 7 years), the partial exclusion would apply during the entire 7 years of the loan.

Under the bill, as under the Act, if the terms of the back-to-back loans are no longer substantially similar as a result of the refinancing, the partial exclusion would be available only during the first 7 years of the loan.

4. Sales of stock to an ESOP

(sec. 118(s)(4) of the bill, sec. 1854 of the Reform Act, and secs. 404, 409, and 1042 of the Code)

Prior to the Act, nonrecognition treatment was not available if any portion of the assets attributable to employer securities acquired in a qualified sale (or assets in lieu thereof) accrued or were allocated during the nonallocation period for the benefit of (1) the taxpayer involved in the nonrecognition transaction, (2) any member of the taxpayer's family (within the meaning of sec. 267(b)), or (3) any other person who owned (after application of the sec. 318 attribution rules) more than 25 percent in value of any class of outstanding securities. Temporary Treasury regulations provided that, for purposes of determining whether an individual is a 25-percent shareholder, stock that is owned directly or indirectly by or for a qualified plan is not treated as outstanding (Temp. Treas. reg. sec. 1042-1T Q&A 2(a)(3)).

The Act made several changes with respect to the nonallocation requirement. In particular, for purposes of determining whether an individual is a 25-percent shareholder, the Act provides that the allocation rules of section 318(a) are applied without regard to the employee trust exception in paragraph (2)(B)(i). Thus, all allocated securities held by an ESOP are treated as securities owned by the ESOP participant and are also treated as outstanding securities. This provision is effective with respect to sales of securities after October 22, 1986.

An excise tax is imposed with respect to certain dispositions of employer securities within 3 years of the date of a sale to which section 1042 applies (sec. 4978).

In some situations, the rules for determining whether an individual is a 25 percent shareholder may be more favorable under the Act than under prior law. The provision of the Act, however, is effective prospectively only. The bill provides that, for purposes of determining whether an individual is a 25-percent shareholder with respect to sales occurring before October 22, 1986, in taxable years beginning after July 18, 1984, all allocated securities held by qualified plans may be treated as outstanding with respect to the individual if securities allocated to the individual under the qualified plans are treated as securities owned by the individual. This rule applies consistently to all individuals with respect to any sales to which section 1042 applies.

The bill provides that the excise tax on certain distributions (sec. 4978) does not apply to employer securities which are required to be disposed of pursuant to the new diversification rules.

5. Dividends paid deduction

(sec. 111B(h) of the bill, sec. 1173 of the Reform Act, and sec. 404(k) of the Code)

The bill also provides that use of dividends to repay an acquisition loan in accordance with section 404(k) does not violate the prohibited transaction rules of section 4975(d)(3).

The Code provides rules with respect to procedures applicable to and taxation of benefits under qualified domestic relations orders (QDROs). The QDRO rules do not apply to plans that are not subject to the assignment or alienation restrictions of the Code and, therefore, do not apply to governmental plans or to tax-sheltered annuities (sec. 403(b)).

This provision is effective for distributions after the date of enactment of the bill.

The bill provides that the QDRO rules, including the rules relating to taxation of distributions pursuant to a QDRO, apply to tax-sheltered annuities except as provided in regulations. This extension of application of the QDRO rules will provide more certainty with respect to treatment of domestic relations orders and will provide for uniform tax treatment of such orders with respect to qualified plans and tax-sheltered annuities. Because the nonalienation provision of the Code do not apply to tax-sheltered annuities, it may be appropriate for the Secretary to exempt such annuities from some of the procedural requirements applicable to QDRO's.

(sec. 118(s)(7) of the bill, sec. 1895 of the Reform Act, sec. 162(k) of the Code, secs. 602 and 607 of ERISA, and secs. 2202 and 2208 of the Public Health Service Act)

Pursuant to this provision, for purposes of the health care continuation rules, references to employer or employee in the statute are considered to include persons receiving or performing services other than in an employer-employee relationship. In addition, persons receiving services are subject to the employer aggregation rules of section 414(t) and the employee leasing rules of section 414(n) to the same extent as if such persons were employers with respect to the service performer.

This provision applies to plan years beginning after December 31, 1988. Of course, this provision does not apply to a plan prior to the date that the health care continuation rules generally apply to the plan.

This provision is intended to carry out the purpose of the health care continuation rules, which was to reduce the extent to which certain events, such as the loss of one's job, could create a significant gap in health coverage. If a qualified beneficiary receiving group health coverage from another employer is willing to pay up to 102 percent of the applicable premium for continuation coverage (which he or she may be required to pay by the employer providing the continuation coverage), this is a strong indication that the new employer group health coverage has left a significant gap in the qualified beneficiary's health coverage. This is especially true when the new employer group health coverage excludes coverage for a preexisting condition that is covered by the continuation coverage.

This provision applies to plan years beginning after December 31, 1988. Of course, this provision does not apply to a plan prior to the date that the health care continuation rules generally apply to the plan.

2. Miscellaneous pension technical corrections

(sec. 203(e) of the bill, sec. 9202 of the Omnibus Budget Reconciliation Act of 1986, and sec. 411(a)(8) of the Code)

Under the foreign tax credit system, the United States reserves the right to collect full U.S. income tax on U.S. persons' foreign income, less a limited amount of foreign income tax imposed on that income. The mechanics of the foreign tax credit are such that the United States may collect little or no residual U.S. tax -- after aggregate foreign taxes are credited -- on income that is taxed abroad at below the U.S. rate. This results where the law permits a cross-crediting of taxes, sometimes referred to as "averaging": that is, where taxpayers are permitted to credit high foreign taxes paid on one stream of income against the residual U.S. tax otherwise due on other, lightly taxed foreign income.

While the Code does not eliminate all cross-crediting among types of differently taxed income, it has in the past separated types of income for credit purposes, most recently based on the character, rather than the country of origin, of income. The Act further separated certain income into the following newly defined "baskets": passive income, high withholding tax interest, financial services income, shipping income, and dividends from each noncontrolled section 902 corporation.

1. Separate application of foreign tax credit provisions to financial services income

The financial services income basket applies not only to income earned by an entity predominantly engaged in the active conduct of a banking, insurance, financing, or similar business, but also to income earned by a person in the active conduct of a banking, financing, or similar business, or earned in connection with certain insurance activities, even if that person is not predominantly so engaged. The types of income that the Act places in the financial services income basket of a "predominantly engaged" entity are not limited to the types of income included in the financial services basket of a person not predominantly engaged. For example, income that would otherwise be passive is treated as financial services income in the hands of a predominantly engaged entity, but remains passive in the hands of an entity that is not predominantly engaged.

On the other hand, Congress intended that dividends from each noncontrolled section 902 corporation would be subject to their own separate limitation regardless of whether those dividends also met the definition of financial services income (or of passive income or shipping income or of any other separate limitation type of income).

Generally, the Act places certain export financing interest in the overall limitation basket, that is, outside the separately defined limitation baskets, regardless of whether the entity deriving the interest is engaged in financial services. In addition, the financial services income basket excludes high withholding tax interest. Where a predominantly engaged entity earns interest qualifying as export financing interest that is subject to a 5-percent or greater gross basis tax, however, Congress intended that such interest be treated as financial services income.

Modification of the look-through rule to prevent avoidance of the purpose of the separate limitations

Under the Act's look-through provisions for characterizing certain types of income that a U.S. shareholder derives from a controlled foreign corporation, interest income of the shareholder is generally to be treated as financial services income (without regard to high withholding taxes or other circumstances that would ordinarily shift such interest out of the shareholder's financial services income basket) to the extent that the interest payment is properly allocable to financial services income of the controlled foreign corporation. At the same time, the Act requires the IRS to prescribe such regulations as may be necessary or appropriate to prevent manipulation of the character of income the effect of which is to avoid the purposes of the separate limitations. In granting this regulatory authority Congress intended that the IRS invoke it to modify, in some cases, the application of the look-through rule.

For example, if a U.S. person lends funds directly to an unrelated foreign person whose country of residence imposes a withholding tax of at least 5 percent on the interest paid on the loan, then the interest is high withholding tax interest subject to the separate limitation for such interest. United States banks might take the position, however, relying upon the look-through rule for interest, that they can avoid the separate limitation for high withholding tax interest by lending funds to such a borrower through a subsidiary that is a controlled foreign corporation incorporated in the borrower's country, rather than lending those funds directly. Taxpayers might argue that, under the look-through rule for interest, interest received in turn by the U.S. bank from the foreign subsidiary will not be high withholding tax interest, even though it attracts the foreign country's high withholding tax.

Because such a result would undermine the separate limitation for high withholding interest, Congress intended that it be precluded under the anti-avoidance regulations. It was expected that such regulations might treat the interest received by the U.S. bank from the foreign subsidiary in this example as high withholding tax interest.

Overall basket treatment of highly taxed financial services income of a controlled foreign corporation

Where the taxpayer establishes to the satisfaction of the Secretary, pursuant to Code section 954(b)(4), that income of a controlled foreign corporation was taxed at over 90 percent of the maximum federal rate, the Act provides that dividends paid by the controlled foreign corporation out of its financial services income (as well as dividends paid out of the controlled foreign corporation's passive income and shipping income) are to be treated as overall basket income to the taxpayer.

Under the bill only income of persons predominantly engaged in the active conduct of a banking, insurance, financing, or similar business is treated as financial services income. The bill therefore simplifies the foreign tax credit somewhat, relieving taxpayers from the necessity of computing a separate limitation with respect to a very limited type of income (i.e., non-passive, financial services income of an entity not predominantly engaged in providing such services).

The bill clarifies that dividends from a noncontrolled section 902 corporation which would otherwise meet the definition of financial services income are placed in the separate basket for that corporation's dividends. Thus the bill prevents banks and other financial businesses from receiving unintended relief from the 902 basket provisions not available to non-financial businesses.

Where a predominantly engaged U.S. person earns export financing interest (as defined by the Act) that is subject to a 5-percent or greater gross basis tax, the bill clarifies that the interest is financial services income, rather than overall limitation income. In general, this treatment makes it clear that the Code allows cross-crediting of high taxes on such income against U.S. tax on lower-taxed financial services income, supplementing the favored treatment provided in the Act that allows cross-crediting of high taxes on overall basket income against U.S. tax on lower-taxed export financing interest.

Modification of the look-through rule to prevent avoidance of the purpose of the separate limitations

The bill partially eliminates the look-through treatment of interest subject to 5-percent or greater gross basis tax that is paid to a U.S. shareholder by a controlled foreign corporation out of income that would otherwise be treated under the look-through rules as financial services income. In these circumstances look-through treatment would apply only to that portion of the interest payments that exceed the payor's interest income (or its equivalent) that would be treated as financial services income under the look-through rule. This provision makes it clear that lenders are prevented from shifting high withholding tax interest into the financial services basket by the mere interposition of a controlled local entity between themselves and foreign borrowers. At the same time, however, if a controlled foreign corporation's interest payments to its U.S. shareholder are subject to a 5-percent or more gross-basis tax, and they exceed by, for example, $100 the foreign corporation's interest income (or its equivalent) that would, under a look-through approach, be treated at the U.S. shareholder level as financial services income, then the U.S. shareholder would be afforded look-through treatment on that $100 of interest received from the subsidiary.

Overall basket treatment of highly taxed financial services income of a controlled foreign corporation

The bill provides for separate basket treatment of dividends paid by controlled foreign corporations where paid out of the latter's financial services income (or shipping income), even where it has been established pursuant to section 954(b)(4) that the controlled foreign corporation's income was taxed by a foreign government at more than 90 percent of the maximum U.S. rate. Thus, for example, a dividend from a highly taxed banking subsidiary will be available for cross-crediting against U.S. tax on other lower-taxed financial services income of the parent.

2. Shipping income

As in the case of financial services income described above, where the taxpayer establishes to the satisfaction of the Secretary that income of a controlled foreign corporation was taxed at over 90 percent of the maximum federal rate, the Act provides that dividends paid by the controlled foreign corporation out of its shipping income are to be treated as overall basket income to the taxpayer.

As in the case of financial services income, the bill provides for separate basket treatment of dividends paid by a controlled foreign corporation out of its shipping income when the taxpayer established to the satisfaction of the Secretary that the income was taxed by a foreign government at more than 90 percent of the maximum U.S. rate. Thus, taxpayers may cross-credit taxes on any highly taxed shipping income against the U.S. tax on other shipping income they may earn.

3. High withholding tax interest

The Act defines high withholding tax interest generally as any interest (other than export financing interest) subject to a foreign withholding tax (or other tax determined on a gross basis) of 5 percent or more. The Act further states that the Secretary may by regulations provide that amounts (not otherwise high withholding tax interest) will be treated as high withholding tax interest where necessary to prevent avoidance of the purposes of the separate limitations. Congress intended these rules to encompass foreign gross-basis taxes and other taxes that are substantially similar in the sense that their imposition results in heavier taxation by the levying country of foreign lenders than of residents.

Transition rule for high withholding tax interest on qualified loans

Generally for taxable years beginning after December 31, 1986, interest income subject to a foreign withholding tax or other gross basis tax of 5 percent or more (other than export financing interest) is "high withholding tax interest" subject to its own separate foreign tax credit treatment. A special transition rule applies, however, to certain interest on certain loans to any of 33 foreign countries or to any resident of one of those countries for use in that country. The applicability of the transition rule turns on the amount of loans held by the taxpayer on November 16, 1985 and during subsequent taxable years.

The bill gives the Secretary authority to exclude from the definition of withholding taxes, for these purposes, those taxes that are in the nature of a prepayment of a tax imposed on a net basis, where the tax in question is otherwise free of those characteristics of a gross-basis tax that would warrant treatment as high withholding taxes. Thus, the bill makes clear that where a foreign taxing authority uses withholding simply as a collection mechanism (as does the United States in the cases of ordinary wage withholding and backup withholding on certain interest, dividend, and other reportable payments under Code section 3406), it will not necessarily follow that the mechanism results in interest being treated as high withholding tax interest.

Transition rule for high withholding tax interest on qualified loans

The bill provides that for purposes of this transition rule, all members of an affiliated group of corporations filing a consolidated return shall be treated as one corporation. (Under this rule, inter-company loans are eliminated.) Thus, for members of a consolidated group, the transition relief will be available regardless of, and will be limited without regard to, the particular group member holding qualified loans on November 16, 1985, or during the relevant subsequent taxable year.

4. Passive income

Under the related party factoring rules of the Tax Reform Act of 1984, any income of a controlled foreign corporation from a loan to a person for the purpose of financing the purchase of inventory property of a related person was interest for separate foreign tax credit limitation purposes without regard to the exceptions to prior law's separate limitation for interest. Under the 1986 Act, such income of a controlled foreign corporation is also ineligible for the export financing exception to the new separate limitations (sec. 864(d)(5)(A)(i)). In the case of passive income, this result follows because the Act defines passive income generally as income "of a kind which would be foreign personal holding company income" (Code sec. 904(d)(2)(A)(i)); if export financing interest fits that description, the related party factoring rules make unavailable the export financing exception from passive basket treatment which would otherwise be available.

Congress did not intend that the availability of the export financing exception for interest received directly by U.S. persons (rather than by controlled foreign corporations) be restricted by the 1984 factoring rule governing loans made to finance inventory property purchases, or by the analogous 1986 rule. However, the phrase "of a kind which would be foreign personal holding company income" arguably leads to an inference that interest income earned directly by U.S. persons (i.e., interest that would be foreign personal holding company income if the recipient was a controlled foreign corporation) is ineligible for overall basket treatment under the export financing exceptions.

Income inclusions under sections 551 and 1293

Foreign personal holding company inclusions (under Code sec. 551) and passive foreign investment company inclusions (under new Code sec. 1293) are passive income. In the case of a passive foreign investment company inclusion, Congress intended that the high-tax kick-out shift the inclusion to the overall limitation basket, however, if the creditable foreign tax with respect to the inclusion exceeds the U.S. tax on the inclusion.

The bill clarifies that in determining whether income is "of a kind which would be foreign personal holding company income" the related person factoring rules applicable to controlled foreign corporations shall apply only in the case of an actual controlled foreign corporation. Thus, income earned directly by a U.S. person may be eligible for the applicable export financing exceptions.

Income inclusions under sections 551 and 1293

The bill clarifies that income inclusions under section 1293 are subject to recharacterization (e.g., by virtue of the high-tax kick-out), as are other kinds of income generally categorized as passive.

5. Dividends from noncontrolled section 902 corporations

Dividends from a controlled foreign corporation are not subject to the separate limitation when the former come from income the corporation earned as a controlled foreign corporation. Generally, Congress intended the look-through rules for distributions by controlled foreign corporations to apply to those dividends.

The bill also provides that dividends from a controlled foreign corporation, out of earnings for periods during which the dividend recipient was not a U.S. shareholder with respect to the corporation, will be treated as dividends from a noncontrolled section 902 corporation. Thus, the bill implements the Act's policy of preventing cross-crediting of taxes between income earned by a taxpayer and income derived by an entity within which the taxpayer does not hold a majority interest, either alone or in combination with other U.S. shareholders. For example, a U.S. person that becomes a U.S. shareholder of a controlled foreign corporation cannot use the look-through rule to cross-credit foreign taxes paid (or deemed paid) by the corporation prior to the taxpayer's stock ownership against U.S. tax on the taxpayer's other income. Nor can the taxpayer cross-credit foreign withholding taxes paid on dividends out of earnings from the pre-ownership period against U.S. taxes on income other than dividends from that corporation. By the same token, the taxpayer cannot credit its other foreign taxes against U.S. tax on those dividends.

6. Separate application of foreign tax credit limitation to income of controlled foreign corporations under the look-through rules in general

A payment of interest, rent, or a royalty is ordinarily characterized as separate or overall limitation income under the general rules defining the new separate limitation categories (sec. 904(d)(2)). Under the look-through rules of new Code section 904(d)(3), however, any interest, rent, or royalty which is received or accrued from a controlled foreign corporation by a U.S. shareholder will be treated as separate category income to the extent it is properly allocable to separate category income of the controlled foreign corporation.

Without a mechanism to determine which set of rules takes precedence, the application of the look-through rules, on the one hand, and the general definitions of 904(d)(2), on the other, could produce conflicting results. For example, interest paid to a U.S. shareholder by a controlled foreign corporation earning only overall limitation income may be subject to a high withholding tax. Also, interest may be paid by a controlled foreign corporation to its U.S. shareholder to finance sales by the U.S. shareholder. On the one hand, this interest may qualify as export finance interest; on the other hand, the interest may be properly allocable to the controlled foreign corporation's income unrelated to export financing.

Congress intended that the question whether interest received from a controlled foreign corporation by a U.S. shareholder of the corporation is overall limitation income or a separate limitation type of income generally depend upon the look-through rules, not upon whether the payment was made to finance an export or upon whether the payment bore a high withholding tax. In the case of high withholding tax interest, Congress expected the IRS to promulgate regulations specifying circumstances where it might be necessary to reverse the priority of the look-through rule in order to forestall abuse of the separate basket rules, as described above.

Under the high-tax kick-out of section 904, the passive income basket generally excludes high-taxed income, that is, income subject to foreign taxes paid or deemed paid by the taxpayer at rates higher than the maximum federal rates. As with financial services income and shipping income discussed above, the Act provides that for purposes of applying the dividend look-through rule, income that would otherwise be passive basket income will instead go into the overall limitation basket if shown to be subject to an effective foreign tax rate greater than 90 percent of the maximum federal tax rate.

In the case of payments of interest, rents, and royalties to the U.S. shareholder out of income of a controlled foreign corporation that would otherwise be passive, the combined effect of the look-through and high-tax kick-out rules may have been unclear.

De minimis exception

If a controlled foreign corporation has no foreign base company income or subpart F insurance income in a taxable year because the subpart F de minimis rule (Code sec. 954(b)(3)(A), as amended by the Act) is satisfied for that year, then interest, rents, or royalties paid by the corporation during that year and dividends, to the extent treated as paid from that year's earnings and profits, are not treated as income in a separate limitation category.

The bill clarifies the Act's general rule that income of a U.S. shareholder allocable to separate category income of a controlled foreign corporation will retain that character in the hands of the U.S. shareholder, subject to the high-tax kick-out (and to another exception, described above, relating to interest paid by a controlled foreign corporation bearing a high withholding tax but attributable to financial services income). For example, the bill makes it explicit that interest that technically may qualify as export financing interest paid by a controlled foreign corporation to a U.S. shareholder out of the corporation's passive income will be in the shareholder's passive basket rather than its overall basket.

The bill makes it clear that the high-tax kick-out applies only at the U.S. shareholder level, not at the controlled foreign corporation level. Income of the U.S. shareholder out of the controlled foreign corporation's passive income will be subject to the kick-out based on the entire amount of foreign tax imposed on the U.S. shareholder's income. Thus, where a withholding tax is imposed on royalties paid by a controlled foreign corporation to a U.S. shareholder out of the corporation's passive income, the shareholder's income will be in the overall basket if the withholding tax is high enough to trigger the high-tax kick-out after allocation of U.S.-borne expenses.

De minimis exception

The bill limits the effect of the provision that treats income satisfying the de minimis rule as non-separate limitation income. Under the bill, this treatment applies only to the controlled foreign corporation's foreign base company income (determined without regard to deductions otherwise taken into account for subpart F purposes under sec. 954(b)(5)) and gross insurance income for the taxable year, as that term is generally used for subpart F purposes.

7. Deemed-paid credit

The Act clarifies that the rules for credits deemed paid on the receipt of dividends (Code sec. 902) and the subpart F deemed-paid credit rules (sec. 960), as well as the general foreign tax credit limitation rules (sec. 904(a)-(c)) and the separate foreign oil and gas limitation rules (sec. 907), apply separately to categories of income subject to the separate limitations. The Act also gives the Secretary authority to provide such regulations as may be necessary or appropriate to carry out both sets of deemed-paid credit rules, but in so doing, refers to specific authority to regulate the separate computation of taxes deemed paid on separate limitation categories of income only in the case of taxes deemed paid on account of dividends.

Fresh start for computing discounted unpaid losses

The Act provides that for purposes of computing the deemed-paid foreign tax credit, dividends or subpart F inclusions are considered made first from the post-1986 pool of all the distributing corporation's accumulated earnings and profits. Act amendments to subchapter L of the Code that limit the unpaid loss deductions of property and casualty insurance companies to the amount of their discounted unpaid losses (new sec. 846 of the Code) may result in a one-time increase in earnings for such a company.

In general, the new discounting provisions apply to taxable years beginning after December 31, 1986. A fresh start is provided with respect to undiscounted loss reserves applicable to the last taxable year beginning before January 1, 1987. Under this fresh start rule, the difference between the amount of undiscounted loss reserves and the discounted balances is not taken into income. For purposes of calculating any adjustment to earnings and profits, by contrast, the fresh start adjustment is to be taken into account in full in the first taxable year to which the discounting provisions apply.

Blocked income

In the case of taxes deemed paid under section 902 on dividends, the Act defines the term "post-1986 undistributed earnings" by reference to the definitions of earnings and profits in sections 964 (prescribing rules for the computation of earnings and profits of a foreign corporation) and 986 (prescribing rules for the translation of a foreign corporation's foreign currency denominated earnings into dollars).

Section 964 has three parts. The first part provides generally for the computation of earnings of foreign corporations in a way substantially similar to the earnings of a domestic corporation, with some exceptions. The second part excludes blocked income, for purposes of sections 952, 955, and 956, from earnings and profits of a controlled foreign corporation. Blocked income is income that is shown, to the satisfaction of the Secretary of the Treasury, to be unavailable for distribution by a controlled foreign corporation to United States shareholders due to currency or other restrictions or limitations imposed under the laws of any foreign country. The third part provides record-keeping and record disclosure rules for purposes of enforcing subpart F and subpart G (relating to export trade corporations).

Earnings and profits of corporations with qualified foreign plans

Special rules govern the timing of deductions for contributions to, and additions to reserves for, deferred compensation programs that are "qualified foreign plans" (sec. 404A). A qualified foreign plan is one in which, among other things, 90 percent or more of the amounts annually taken into account are attributable to services performed by individuals who are not citizens or residents of the United States, the compensation for which is not subject to U.S. Federal income tax (sec. 404A(e)(2)).

Contributions and additions to a qualified foreign plan will typically relate to income subject to foreign taxes on a net basis, and may implicate foreign laws on the timing and amount of deductions with respect to deferred compensation plans, as well as U.S. rules for computing the amounts of foreign tax payments by subsidiaries that are creditable at the shareholder level. Section 404A contains internal limits on annual contributions and additions analogous to the limits governing domestic plans (e.g., secs. 404A(b), (c), (g)(1) and (g)(3)). The deductions allowed by section 404A, however, take into account the interactions between these limits, applicable deduction rules of foreign law, and the Code rules for computing indirect foreign tax credits.

There are two ways in which these interactions determine the deduction under section 404A. The first involves a multiyear comparison between foreign deductions and U.S. limits. The employer computes "the aggregate amount determined with respect to the plan under" section 404A without regard to section 404A(d)(1): generally, the sum of the amounts for each taxable year to which section 404A applies that would not exceed the internal limits of 404A. This is called "the cumulative United States amount." The employer also computes the aggregate amount allowed as a deduction under foreign law for the same period. This is called "the cumulative foreign amount." Then the employer subtracts any prior-year deductions taken under 404A from both the cumulative United States amount and the cumulative foreign amount. The section 404A deduction for the current year generally equals the lesser of the two differences (sec. 404A(d)(1)).

Indirect credits determined by current foreign earnings and taxes

A further limitation can reduce the deduction below the lesser of the above two amounts. This limitation represents the second way in which section 404A takes into account the interaction between the domestic and foreign plan contribution limits and the indirect credit rules. The limitation provides that the deduction allowed in computing the earnings and profits or the accumulated profits of any foreign corporation with respect to a qualified foreign plan is not in any event to exceed the amount allowed as a deduction under the appropriate foreign tax laws for such taxable year (sec. 404A(d)(3)). This limitation was imposed in 1980, simultaneously with the enactment of section 404A, in response to possibilities for distortion of a taxpayer's indirect foreign tax credit which were presented by the annual system, then in effect, for determining the amount of the foreign taxes paid by a subsidiary which were brought up with dividends paid to its U.S. shareholders.

In the 1980-81 period, foreign law allowed a deduction of 50 units, and the limits in 404A(b) would not have been exceeded by a deduction of 50 units. However, for that same period, 404A(d) actually allows a deduction from earnings and profits of only 40 units. There is no mechanism for making up this difference in future years.

Pooling foreign earnings and taxes for indirect credits

In the legislative history of section 404A, Congress noted that the potential for distortion of the indirect credit, to which section 404A(d)(3) was targeted, "might be eliminated if the indirect credit were computed with reference to the subsidiary's accumulated foreign taxes and undistributed accumulated profits for all years." Sen. Rep. No. 1039, 96th Cong., 2d Sess. 15 (1980). In the 1986 Act Congress amended the indirect credit to achieve the type of multiyear pooling referred to in the legislative history of 404A. The indirect credit on distributions by foreign corporations out of earnings and profits for taxable years beginning after 1986 are computed with reference to the post-1986 pool of all the subsidiary's accumulated earnings and profits, and the accumulated foreign taxes paid by the subsidiary on or with respect to the accumulated earnings in the pool. Any dividends paid in the first taxable year beginning after December 31, 1986 (or, if later, the first taxable year beginning after 1986 in which there is a 10-percent U.S. shareholder who would qualify for the deemed-paid credit) and subsequent years are generally treated as made out of the pool of post-1986 undistributed earnings, to the extent thereof.

The bill clarifies that the Secretary's authority to provide regulations to carry out the provisions of the subpart F deemed-paid credit rules is to include authority to provide for, inter alia, separate computations of taxes deemed paid upon inclusions under subpart F (as well as separate computations of taxes deemed paid in connection with dividends) to reflect the separate limitations applicable to separate types of income and loss.

Fresh start for computing discounted unpaid losses

The bill provides that any increase in earnings and profits under the discounting fresh start provision of the Act would be phased in ratably over 10 years for purposes of computing the post-1986 undistributed earnings of a foreign corporation paying dividends, or earning income, that bring up to its shareholders deemed-paid foreign tax credits. Thus, the one-time increase in current earnings and profits of a controlled foreign corporation under the discounting fresh start provision will not result in a sudden dilution of creditable foreign taxes as a percentage of dividends and subpart F inclusions.

Blocked income

The bill provides that for purposes of the deemed-paid credit on dividends, "post-1986 undistributed earnings" of a foreign corporation are computed without reference to the blocked income rules. Thus, the bill clarifies that the percentage of foreign taxes brought up by a dividend is unaffected by the portion of earnings, if any, that represent blocked income.

Earnings and profits of corporations with qualified foreign plans

The bill gives the Secretary authority to provide exceptions to section 404A(d)(3) by regulation. It is intended that in the case of earnings to which pooling applies, the deduction from earnings and profits for contributions or additions to reserves under section 404A(d)(1) not be limited by the current foreign law deduction. With respect to pre-1987 earnings and taxes, however, it is intended that existing law continue to apply.

Thus in example 2 above, 1991 earnings and profits of the foreign corporation would be 50 and post-1986 undistributed earnings would be 112.50. Because post-1986 foreign income taxes are 37.50, any distribution will bring up one-third the net distribution amount in credits, for an effective rate of 25 percent.

By analogy to the overall foreign extraction loss recapture rules of section 907(c)(4), the Act further provides a loss recharacterization rule that applies to subsequent income. Where a basket previously showed a separate limitation loss which was allocated against income in other baskets, subsequent income in the loss basket will be recharacterized as income of the type that it previously offset, in proportion to the prior loss allocation not previously taken into account under this recharacterization provision.

In addition to the Act's new separate basket loss recapture provision and the overall foreign extraction loss recapture rules upon which the former is based, the Code provides a third rule, in effect since 1976, for recapture of overall foreign losses. This rule is designed to prevent taxpayers from benefiting from a combination of forgiveness of U.S. tax on a portion of current U.S. income (resulting from the use of an overall foreign loss to reduce worldwide taxable income below U.S. taxable income) and an allowance of a foreign tax credit with respect to the full amount of subsequent years' foreign income. Under the rule, a portion of foreign taxable income earned after an overall foreign loss year is treated as U.S. taxable income for foreign tax credit purposes (sec. 904(f)(1)-(4)).

Section 904(f)(3) contains gain recognition and characterization rules to ensure the recapture of an overall foreign loss where property which was used in a trade or business, and which was used predominantly outside of the United State, is disposed of prior to the time the loss has been recaptured by recharacterizing foreign income as U.S. taxable income. Under section 904(f)(3), gain on such a disposition is viewed as foreign source income to be recharacterized as U.S. source income until the loss is fully recaptured. Recapture occurs regardless of whether gain would otherwise have been recognized on the disposition. There is no provision analogous to section 904(f)(3) in the recapture rules for foreign oil and gas extraction losses, or in the Act's new separate limitation loss recapture provision.

9. Transitional rule for excess credit carryforwards

However, the Act provides that pre-effective date excess credits for taxes on overall limitation income can be carried to post-effective date years to reduce the U.S. tax on shipping income to the extent that the taxpayer establishes to the satisfaction of the Secretary that the overall limitation income on which the taxes were paid would have been classified as shipping income had it been earned after the Act's effective date. Similarly, in the case of an entity predominantly engaged (in both the carry-from and carry-to years) in the active conduct of a banking, insurance, financing, or similar business the Act provides that pre-effective date excess credits for taxes on overall limitation income can be carried to post-effective date years to reduce the U.S. tax on financial services income to the extent that the taxpayer establishes to the satisfaction of the Secretary that the overall limitation income on which the taxes were paid would have been classified as financial services income had it been earned after the Act's effective date.

(sec. 112(d) of the bill, sec. 1211 of the Reform Act, and secs. 864 and 865 of the Code)

Prior to the Act, the source of income derived from the sale of personal property generally was determined by the place of sale (commonly referred to as the "title passage" rule). While the Act did not change the place-of-sale rule for most inventory sales, the Act generally did replace the place-of-sale rule for sales of other personal property with a residence-of-the-seller rule.

Under the residence-of-the-seller rule (new sec. 865), income derived by U.S. residents from the sale of personal property, tangible or intangible, generally is sourced in the United States. Similarly, income derived by a nonresident of the United States from the sale of personal property, tangible or intangible, generally is treated as foreign source. For purposes of determining source, the term sale does not include a sale of intangible property to the extent payments received in consideration for the sale are contingent on the productivity, use, or other disposition of the property. Payments that are so contingent are treated like royalties in determining their source.

Definition of resident

The Act provided new definitions of a U.S. resident and nonresident for source rule purposes (sec. 865) that differ somewhat from the existing resident alien definitions (see, e.g., sec. 7701(b)).

An individual is a resident of the United States for purposes of section 865 if the individual has a tax home (as defined in sec. 911(d)(3)) in the United States. Any corporation, partnership, trust, or estate which is a United States person (as defined in sec. 7701(a)(30)) is a U.S. resident for this purpose. Other individuals and entities generally are nonresidents for purposes of these source rules. A U.S. citizen or resident alien can be treated as a nonresident for purposes of these source rules if he or she has a tax home outside the United States. The same individual can also be treated as a nonresident if he or she has no tax home (a condition that might be possible, for example, in the case of a traveling salesperson). This latter result may occur even if the individual pays only a minimal foreign tax on income covered by these source rules.

Under the Act, regulations are to be prescribed by the Secretary carrying out the purposes of the Act's source rule provisions. One area where it was contemplated that regulations may be required is to prevent persons from establishing partnerships or corporations, for example, to change their residence to take advantage of the new rules. It was anticipated that the establishment of an anti-abuse rule to treat, for example, a foreign partnership as a U.S. resident to the extent its partners are U.S. persons would be appropriate.

United States citizens and resident aliens who have tax homes outside the United States are nevertheless considered U.S. residents in one case. This case occurs when income from a sale is not subject to an effective foreign income tax of 10 percent or more. This level-of-tax rule prevents U.S. citizens and resident aliens from generating zero- or low-taxed foreign source income that might otherwise escape all tax. As a consequence of retaining prior law's place-of-sale rule for income derived from the sale of inventory and gain in excess of recapture derived from the sale of depreciable personal property, the level-of-tax rule does not apply to sales of these types of personal property but does apply to sales of all other types of personal property.

Exceptions to residence rule

Depreciable personal property is any personal property if the adjusted basis of the property includes depreciation adjustments. Thus, intangible property for which an amortization deduction is allowable is considered depreciable personal property. With respect to sales of intangible property, however, it is unclear under the Act whether the recapture rule applies to gain to the extent of amortization recapture, and whether the general intangible rules or the place-of-sale rule as retained under the Act applies to gain in excess of amortization recapture.

For U.S. residents, this office rule applies to certain income derived from the sale of personal property when the sale is attributable to an office or other fixed place of business maintained by the taxpayer outside the United States but only if an effective foreign income tax of 10 percent or more is paid to a foreign country on the income from the sale. It is unclear under the Act if the office rule applies to income (in the form of noncontingent payments) derived from the sale of intangible property by a U.S. resident when the sale is attributable to a fixed place of business in a foreign country and the U.S. resident pays an income tax at an effective rate of 10 percent or more.

Other rules

Prior to the Act, foreign source income derived from the sale of inventory property by a foreign person generally was treated as effectively connected with the conduct of a U.S. trade or business if the sale was attributable to a U.S. office (or other fixed place of business) and sold through the U.S. office. The Act repealed this rule but generally made income derived from the sale of any personal property (including inventory property) by a nonresident (as defined in section 865 for personal property source rule purposes) U.S. source when the sale is attributable to a U.S. office (or other fixed place of business). Because the Act also generally retains the place-of-sale rule for sales of inventory property by residents (as defined in section 865), the repeal of the effectively connected rule would allow these residents who are treated for general purposes (outside section 865) as nonresident aliens to avoid U.S. tax on income attributable to a U.S. office by placing sales of inventory property outside the United States.

The Act's legislative history indicated that Congress intended that the Act's source rule changes prevail over treaty source rules for foreign tax credit limitation purposes to the extent necessary to insure that income not taxed by a foreign country not escape U.S. tax as well. This policy was to apply to all the source rule changes in the Act, not just those applicable to personal property. Although the Act and its legislative history did not specifically address cases where some foreign tax may be paid on income treated as U.S. source under the Act, application of the later-in-time principle would result in the Act's rules prevailing over any conflicting pre-existing treaty provisions.

The bill modifies the definition of resident for source rule purposes in the case of individuals and partnerships. First, the bill treats any U.S. citizen or resident alien as a U.S. resident if he or she does not have a tax home in a foreign country and, as under present law, it treats any nonresident alien as a U.S. resident if he or she has a tax home in the United States. A U.S. citizen or resident alien who has a tax home in a foreign country is treated as a nonresident for source rule purposes as is a nonresident alien who does not have a tax home in the United States.

Second, whereas the Act generally determined the source of income derived from sales of personal property by treating a partnership as a U.S. resident or nonresident based on its situs, the bill makes these determinations at the partner level, except as provided in regulations. In determining source, it is intended that, consistent with the attribution of a U.S. trade or business under section 875, a U.S. office or other fixed place of business of the partnership will be attributed to its partners.

The bill provides regulatory authority to determine source at the partnership level, for example, in cases where it is not administratively possible to apply the rules at the partner level. For example, it may be appropriate to determine source at the partnership level in the case of a publicly traded partnership which has hundreds of partners.

The bill modifies the 10-percent tax payment requirement (applicable to U.S. citizens and resident aliens maintaining tax homes in a foreign country) for bona fide residents of Puerto Rico. The 10-percent tax payment requirement is waived for an individual who is a bona fide resident of Puerto Rico for the entire taxable year on the sale of stock of a corporation which (directly or indirectly) (1) is engaged in an active trade or business in Puerto Rico, and (2) derives from the active conduct of a trade or business in Puerto Rico more than 50 percent of its gross income for the 3 years preceding the year of sale. Under this rule, bona fide residents of Puerto Rico who sell stock in certain corporations doing business in Puerto Rico generate Puerto Rican source income and, thus, retain the benefits of section 933.

The bill provides the Internal Revenue Service with authority to waive the 10-percent tax payment requirement by regulation for purposes of determining the source of income from any other sales of personal property by bona fide residents of Puerto Rico and for purposes of determining the source of income from sales of personal property by bona fide residents of Guam, American Samoa, and the Northern Mariana Islands, thus preserving benefits otherwise available under sections 931 and 933. Under this authority, for example, the Service may provide that in appropriate circumstances, gross income of a U.S. citizen who is a bona fide resident of Puerto Rico, Guam, American Samoa, or the Northern Mariana Islands does not include the individual's otherwise untaxed (or low-taxed) income from sales of personal property in the possession. However, it is intended that regulations promulgated under this authority provide the exception only in the case where the possession has "delinked" from the mirror Code. Moreover, it is intended that regulations limit the exception to bona fide residents of one of these possessions and not to U.S. citizens or residents who may be only temporarily resident in the possession. For this purpose, it is anticipated that rules analogous to the special tax rules for nonresident aliens who are U.S. tax-avoidance expatriates (sec. 877), to the extent those provisions do not already apply because of section 1277(e) of the 1986 Act (which extends sec. 877 to certain U.S. citizens who move to certain territories), be applied.

Exceptions to residence rule

The bill also clarifies that gain derived from the sale of intangible property in excess of amortization recapture is sourced under the residence-of-the-seller rule when the payments in consideration for the sale are not contingent on the productivity, use, or disposition of the property. When payments are so contingent, the source rule for royalties applies to the gain.

The bill provides the Internal Revenue Service regulatory authority to waive the office rule's 10-percent tax payment requirement for purposes of determining whether a domestic corporation has sufficient possession-source income to be eligible for the possessions tax credit (sec. 936).

The bill also modifies the office rule to conform with the Act's source rules governing space and ocean activities. This modification provides that the office rule applies to U.S. persons only if they maintain an office in a foreign country, rather than outside the United States. The bill makes similar conforming amendments to the Act's other source rule provisions.

Other rules

The bill reinstates the provision repealed by the Act that treats foreign source income derived from certain sales of inventory property by a foreign person as effectively connected with the conduct of a U.S. trade or business. This provision is necessary to ensure that foreign persons who have a substantial presence in the United States, who may be treated as U.S. residents for source rule purposes but as nonresidents for general purposes, are taxed on income derived from sales of inventory property.

The bill codifies and expands upon the Act's legislative history by providing (in connection with the changes to sec. 7852(d)) that the Act's source rule changes generally prevail over any conflicting treaty source rules under the general later-in-time rule. The bill does provide, however, an exception to the general later-in-time rule. Under this exception, a taxpayer may elect to apply treaty source rules to treat as foreign source any gain derived from the sale of stock in a treaty country corporation or of an intangible which would otherwise be treated as U.S. source under the Act. In this case, foreign taxes on that gain cannot offset U.S. tax on any other item of income, and foreign taxes on any other item of income cannot offset U.S. tax on that gain. For example, under the Act, gain from the sale of stock in a less-than-80-percent owned foreign corporation by a U.S. resident is U.S. source. A treaty may treat that income as foreign source. Under the bill, that income is subject to U.S. tax as foreign source income, but the U.S. resident may credit only foreign tax imposed on that income against the U.S. tax imposed on that income.

The bill also makes clerical and conforming amendments.

2. Special rules for exemption from U.S. tax on U.S. source transportation income

(sec. 112(e) of the bill, sec. 1212 of the Reform Act, and secs. 862, 872, 883, and 887 of the Code)

A foreign corporation, in addition to having to be organized in a country that grants U.S. persons an equivalent exemption, must also satisfy a residence-based requirement to obtain U.S. tax exemption. Under the residence-based requirement, the ultimate individual owners of more than 50 percent of the value of the stock of the foreign corporation must be residents of a foreign country that grants U.S. citizens and domestic corporations an equivalent exemption. Thus, it is not enough for the foreign corporation to be organized in a foreign country which grants U.S. citizens and domestic corporations an equivalent exemption: individuals ultimately owning most of its stock must reside in such a country as well. Ultimate individual ownership is determined by treating stock owned directly or indirectly by or for any entity (for example, a corporation, partnership, or trust) as being actually owned by the stockholder (or partner, grantor, or beneficiary, as the case may be) of that entity and by further attributing that ownership to its owners if necessary to reach individual owners.

The residence-based requirement does not apply to any foreign corporation organized in a foreign country that exempts U.S. persons from its tax if the stock of the corporation is primarily and regularly traded on an established securities market in that foreign country. This publicly traded exception also covers a foreign corporation that is wholly owned by a second corporation organized in the same country as the first foreign corporation if the stock of the second foreign corporation is primarily and regularly traded on an established securities market in that country.

The Act also enacted a gross basis tax on certain transportation income derived by foreign persons. The tax was intended to apply to income the source of which was modified by the Act. That is, the tax was intended to apply to transportation income derived by foreign persons that is treated as 50 percent U.S. source under the Act. Moreover, it was intended that the income on which the gross basis tax would be imposed would be the same income that would be eligible for the reciprocal exemption.

The bill also modifies the publicly traded exception to the residence-based requirement. Under the bill, a foreign corporation qualifies for the reciprocal exemption if it is organized in a country which exempts U.S. corporations from that country's tax and the foreign corporation's stock is primarily and regularly traded on an established securities market in that country, another foreign country that grants U.S. corporations the appropriate exemption, or the United States. In addition, if stock of one foreign corporation, organized in a country which exempts U.S. corporations from that country's tax, is owned by a second, publicly traded corporation organized in either the same foreign country, a second foreign country that exempts U.S. corporations from that country's tax, or the United States, and the second corporation's stock is primarily and regularly traded on an established securities market in its country of organization, another foreign country that grants U.S. corporations the appropriate exemption, or the United States, then the bill treats the stock of the first corporation as owned by individuals who are resident in the country in which the second corporation (i.e., the shareholder) is organized.

The bill further clarifies that the transportation income on which the gross basis tax is imposed is that income that is treated as 50 percent U.S. source by the Act. In addition, the bill provides that under regulations transportation income on which the tax is imposed may be reduced to correspond to income that is eligible for the reciprocal exemption.

3. Source rule for space and certain ocean activities

(sec. 112(f) of the bill, sec. 1213 of the Reform Act, and sec. 863 of the Code)

4. Limitations on special treatment of 80/20 corporations

(sec. 112(g) of the bill, sec. 1214 of the Reform Act, and secs. 861, 864, 907, 1442, and 2105 of the Code)

The active foreign business requirement is satisfied if at least 80 percent of the U.S. corporation's gross income for the 3-year period preceding the year of the payment is derived from foreign sources and is attributable to the active conduct of a trade or business in one or more foreign jurisdictions (or U.S. possessions).

The 80-percent active foreign business requirement may be met by the U.S. corporation alone or, instead, may be met by a group including domestic or foreign subsidiaries in which the U.S. corporation owns a controlling interest. It is intended that at least a 50-percent ownership interest be required for a subsidiary's business to be attributed to a U.S. shareholder. In allowing attribution of a subsidiary's active foreign business to a controlling corporate shareholder, the character (i.e., active foreign business income) of the subsidiary's gross income is intended to be attributed to the corporate shareholder only on the actual inclusion of income from the subsidiary, for example, dividends, interest, rents, or royalties, and for the purpose of determining the percentage of dividends paid by the shareholder that are subject to U.S. withholding tax. Thus, for example, dividends received by a corporate shareholder from controlled U.S. subsidiaries, though treated as U.S. source in the hands of the corporate shareholder, are to be characterized as active foreign business income for the purpose of this look-through rule in the same proportion that the controlled subsidiaries' active foreign business income bears to their total income. With respect to other items of income received from controlled subsidiaries, those amounts are to be characterized as active foreign business income to the extent they are allocated against active foreign business income of the payor.

Prior to the Act, certain income paid by U.S. persons to foreign persons was effectively exempted from U.S. withholding tax because the income was treated as foreign source income. Under the Act, the income is treated as U.S. source, but the exemption from U.S. withholding tax is made explicit. The interest affected includes interest on deposits with persons carrying on the banking business, interest on deposits or withdrawable accounts with a Federal or State chartered savings institution as long as such interest is a deductible expense to the savings institution under section 591, and interest on amounts held by an insurance company under an agreement to pay interest thereon, but, in each case, only if such interest is not effectively connected with the conduct of a trade or business within the United States by the recipient of the interest. The Act also made an explicit exemption from U.S. withholding tax for income derived by a foreign central bank of issue from bankers' acceptances. By treating the interest on deposits as U.S. source, it is not intended that the principal amounts which generate the income be includible in a foreign person's estate.

The bill also clarifies that, for purposes of attributing a lower-tier corporation's active foreign business income to an upper-tier U.S. corporation, the source of the lower-tier corporation's income, as well as its character, is attributed to the upper-tier corporation. Thus, for example, if an upper-tier U.S. corporation receives a dividend from a qualifying lower-tier U.S. corporation, the dividend shall, for purposes of determining whether any withholding tax will be imposed on the upper-tier corporation's dividend distributions, be considered as having both the character and the source of the lower-tier corporation's income. For foreign tax credit purposes, the dividend from the lower-tier corporation is U.S. source, however.

The bill clarifies that the change in source for certain interest on deposits does not change its treatment for estate tax purposes. Thus, for example, bank deposits the interest on which is not effectively connected with a U.S. trade or business, though such interest is treated as U.S. source income, are not treated as property within the United States.

Further, the bill clarifies that the Act's provisions are generally effective for payments made in taxable years of the payor beginning after December 31, 1986.

The bill also makes clerical and conforming amendments.

5. Rules for allocation of interest, etc., to foreign source income

(sec. 112(h) of the bill, sec. 1215 of the Reform Act, and sec. 864(e) of the Code)

When the tax book value method of expense apportionment is used, the Act provides a new rule to allocate and apportion expenses on the basis of assets when the asset is stock in one of certain corporations. If a 10-percent or more owned corporation is not included in the group treated as one taxpayer, then, in general, the adjusted basis of the stock owned in such corporation in the hands of a U.S. shareholder is increased by the amount of the earnings and profits of the corporation attributable to that stock and accumulated during the period the taxpayer held it. Earnings and profits are not limited to those accumulated in post-enactment years. (In general, two kinds of 10-percent owned corporations are not included in the one-taxpayer group: foreign corporations, and U.S. corporations that are more than 10-, but less than 80-percent owned.) In the case of a deficit in earnings and profits of the corporation that arose during the period when the U.S. shareholder held the stock, that deficit reduces the adjusted basis of the asset in the hands of the shareholder. In that case, however, the deficit cannot reduce the adjusted basis of the asset below zero.

Under prior law and under the Act, subpart F inclusions increase stock basis in but do not decrease earnings and profits of a controlled foreign corporation (secs. 961 and 959). Congress did not intend that the addition of such amounts to stock basis by virtue of a subpart F inclusion (or another inclusion with an equivalent effect on basis) result in double counting.

Allocation of expenses to deductible dividends

The Act provides that for purposes of allocating or apportioning any deductible expense, any tax-exempt asset (and any income from such an asset) shall not be taken into account. A similar rule applies in the case of any dividend from a U.S. corporation that is eligible under section 243 for the 80-percent dividends received deduction (but not in the case of a dividend from a U.S. corporation that is eligible for the 100-percent dividends received deduction) and in the case of any dividend from a foreign corporation a fraction of which (that reflects its U.S. earnings) is eligible under section 245(a) for an 80-percent dividends received deduction.

Treatment of bank holding companies and banks

While the Act generally requires an affiliated group to be treated as if all members of the group were one taxpayer for purposes of allocating and apportioning interest expense, that general rule does not apply to any financial institution (described in section 581 or 591) if the business of the financial institution is predominantly with persons other than related persons or their customers, and if the financial institution is required by State or Federal law to be operated separately from any other entity which is not a financial institution. A bank to which this exception applies is not treated as a member of the group for applying the Act's general one-taxpayer rule for interest expense allocation and apportionment to other members of the group; instead, that bank and all other banks in the group are to be treated as one taxpayer (rather than each bank being treated as a separate taxpayer for this purpose).

Although treated separately from other group members for interest expense allocation, banks were intended to be treated as part of the overall group that the Act treats as one taxpayer for expenses other than interest.

Direct allocation of interest expense when deduction is denied

The Act provides that the Secretary is to prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section, including regulations providing for direct allocation of interest expense incurred to carry out an integrated financial transaction to any interest (or interest-type income) derived from such transaction.

In certain cases, the dividends received deduction is reduced in cases where portfolio stock is debt financed (sec. 246A). In addition, a life insurance company is allowed a dividends received deduction for its share of dividends received, but this deduction is not allowed for the policyholders' share of dividends received. Further, the reserve deduction and other deductible payments to policyholders of a life insurance company are reduced by the policyholders' share of tax exempt interest. Moreover, in the case of a property and casualty insurance company, 15 percent of the sum of tax exempt interest and the deductible portion of dividends received reduces the deduction for losses incurred (sec. 832(b)(4)).

Scope of expense allocation rules

For purposes of subchapter N of chapter 1 of the Code (secs. 861-999), except as provided in regulations, the Act provides a series of rules governing expense allocation and apportionment. The intent of the grant of regulatory authority was to allow regulations to identify provisions of this subchapter to which the new rules would not apply. The Act's rules literally apply for the determination of taxable income from sources outside the United States. With one exception, however, these rules were intended to apply for all determinations under subchapter N of chapter 1, whatever the source (U.S. or foreign) of the income against which expenses are allocated. The exception relates to the possessions tax credit: Congress did not intend that new section 864(e)(1) apply for purposes of computations under section 936(h).

Transition rules

The Act provides a number of transition rules designed to phase in the application of the new expense allocation rules insofar as they relate to interest expenses.

The bill clarifies the Act's rule governing the allocation and apportionment of expenses when the tax book value method is used and the asset at issue is stock in one of certain corporations. The adjusted basis of any stock in a nonaffiliated 10-percent owned corporation is increased by the amount of earnings and profits of that corporation attributable to that stock and accumulated during the period the taxpayer held the stock, or reduced, but not below zero, by any deficits in earnings and profits in that corporation attributable to that stock for that period. For this purpose, a "nonaffiliated 10-percent owned corporation" is one that is not included in the taxpayer's affiliated group, and in which members of the affiliated group own 10 percent or more of the voting power. The bill makes it clear that the adjustment to asset value on a look-through basis is also applied to stock of foreign corporations that is not directly held by U.S. taxpayers but that is indirectly 10-percent owned by U.S. taxpayers. Stock owned directly or indirectly by a corporation, partnership, or trust is treated as being owned proportionately by its shareholders, partners or beneficiaries. When a taxpayer is treated under this look-through rule as owning stock in a lower-tier corporation, the adjustment to the basis of the upper-tier corporation in which the taxpayer actually owns stock is to include an adjustment for the amount of the earnings and profits (or deficit in earnings and profits) of the lower-tier corporation which were attributable to the stock the taxpayer is treated as owning and to the period during which the taxpayer is treated as owning that stock.

The bill provides that, for purposes of section 864(e), proper adjustment is to be made to the earnings and profits of any corporation to take into account any earnings and profits included in gross income under the subpart F current inclusion rules (or under any other provision) that are reflected in the adjusted basis of the stock. Thus, a subpart F inclusion, which increases stock basis but does not decrease earnings and profits of a controlled foreign corporation, is not to result in double counting.

Allocation of expenses to deductible dividends

The bill makes it clear that to the extent any dividend benefits from the dividends received deduction under section 243 (allowing an 80-percent dividends received deduction for certain dividends from U.S. corporations) or section 245(a) (allowing an 80-percent dividends received deduction for the U.S. source portion of certain dividends from foreign corporations), that portion of the dividend is treated as tax exempt income for the purpose of the Act's expense allocation rules and that portion of the related asset is treated as a tax exempt asset.

Treatment of bank holding companies and banks

The bill provides that, to the extent provided in regulations, a bank holding company (within the meaning of section 2(a) of the Bank Holding Company Act of 1956), and any subsidiary of a bank holding company (or of a financial institution described in section 581 or 591) that is predominantly engaged (directly or indirectly) in the active conduct of a banking, financing, or similar business, shall be treated as a financial institution for purposes of the exception that applies in certain cases to financial institutions described in section 581 or 591. The bill also makes it clear that any financial institution that is excluded from the general one-taxpayer group and is included in a one-taxpayer group covering financial institutions is not so treated for purposes of expenses other than interest. That is, financial institutions and all other affiliated entities are treated as one taxpayer under the Act for expenses other than interest.

Direct allocation of interest expense when deduction is denied

The bill provides that the Secretary is to prescribe regulations for direct allocation of interest expense in the case of indebtedness resulting in a disallowance under section 246A, which reduces the dividends received deduction in cases where portfolio stock is debt financed. Thus, to the extent that an interest deduction reduces the amount of the dividends received deduction, the interest expense generating the loss of the dividends received deduction is to be treated as directly allocable to the income resulting from the loss of the dividends received deduction.

The bill also provides that the Secretary is to prescribe regulations that make appropriate adjustments in the application of the rule that disregards tax-exempt assets and income derived therefrom in the case of an insurance company.

Scope of expense allocation rules

The bill provides that new section 864(e) (relating to expense allocation) shall not apply for purposes of any provision of subchapter N of chapter 1 of the Code (secs. 861-999) to the extent the Secretary determines under regulations that the application of this subsection for such purposes would not be appropriate. In a conforming amendment, the bill deletes the provision for exceptions to new section 864(e) in the introductory language to that subsection.

With one exception, the bill makes it clear that these rules apply for all determinations under subchapter N of chapter 1, whatever the source of the income against which expenses are allocated. The exception relates to the possessions tax credit: section 936(h) is to apply as if new section 864(e)(1) had not been enacted.

Transition rules

The bill clarifies the operation of the Act's transition rules.

One set of the bill's provisions clarifies the Act's phase-in of the new rules governing interest expense allocation generally. (This set of the bill's provisions does not affect the Act's phase-in of the one-taxpayer rule of new Code sec. 864(e)(1), which is described below.) These clarifications, the bill's "general" phase-in provisions, apply to the aggregate amount of indebtedness of the taxpayer outstanding on November 16, 1985. In the case of the first three taxable years of the taxpayer beginning after December 31, 1986, the Act's amendments relating to interest expense allocation (other than the one-taxpayer rule of new sec. 864(e)(1)) do not apply to interest expenses paid or accrued by the taxpayer during the taxable year with respect to an aggregate amount of indebtedness which does not exceed the general phase-in amount. Except for certain reductions in indebtedness, the consequences of which are described below, the general phase-in amount is the applicable percentage of the taxpayer's debt outstanding on November 16, 1985. In the case of the first taxable year, the applicable percentage is 75; in the case of the second taxable year, the applicable percentage is 50; in the case of the third taxable year, the applicable percentage is 25.

The general phase-in amount eligible for relief for any period, however, is not to exceed the lowest amount of indebtedness of the taxpayer outstanding as of the close of any preceding month beginning after November 16, 1985. This limitation is designed to implement the Act's intent to target transitional relief to corporate groups that had borrowed in reliance on prior law and to deny transitional relief to the extent that the level of debt increases. To the extent provided in regulations, the average amount of indebtedness outstanding during any month is to be used in lieu of the amount outstanding as of the close of such month for this purpose. This grant of regulatory authority is designed to allow the Internal Revenue Service to disallow transition relief to taxpayers whose month-end debt levels are not representative of their monthly debt levels generally. Reductions in debt as of a month's end are not to reduce phase-in relief for prior months, however. For example, if a calendar year taxpayer's outstanding debt is $100 on November 16, 1985 and at all times thereafter until December 1, 1987, at which time it pays off all its debt, the taxpayer is entitled to general phase-in treatment for interest on $75 during the first 11 months of 1987.

In addition, the bill's "special" phase-in rules clarify the Act's provisions that phase in the one-taxpayer rule (new sec. 864(e)(1)). In the case of the taxpayer's first 5 taxable years beginning after December 31, 1986, the Code's new one-taxpayer rule (sec. 864(e)(1)) is not to apply to interest expenses paid or accrued by the taxpayer during the taxable year with respect to an aggregate amount of indebtedness that does not exceed the special phase-in amount. The special phase-in amount is generally the sum of three separate amounts: the general phase-in amount, described above, the 5-year phase-in amount, and the 4-year phase-in amount. The special phase-in amount, however, like the general phase-in amount, cannot exceed the lowest amount of indebtedness of the taxpayer outstanding as of the close of any preceding month beginning after November 16, 1985.

The 5-year phase-in amount is the lesser of two amounts. The first amount is an applicable percentage of the "5-year base." The 5-year base is the excess (if any) of the amount of a taxpayer's outstanding indebtedness on May 29, 1985, over the amount of the taxpayer's outstanding indebtedness as of the close of December 31, 1983. For this purposes, however, the 5-year base cannot exceed the aggregate amount of indebtedness of the taxpayer outstanding on November 16, 1985. The applicable percentage, in each year, is the excess of the percentage granted relief under the Act's 5-year phase-in over the percentage granted relief under the Act's general (3-year) phase-in. In the case of the first taxable year beginning after December 31, 1986, the applicable percentage is 8-1/3 (83-1/3 - 75); in the case of the second taxable year, the applicable percentage is 16-2/3 (66-2/3 - 50); in the case of the third taxable year, the applicable percentage is 25 (50 - 25); in the case of the fourth taxable year, the applicable percentage is 33-1/3; and in the case of the fifth taxable year, the applicable percentage is 16-2/3.

The 5-year phase-in amount cannot exceed a second amount. That second amount, which is in the nature of a limitation, caps the 5-year phase-in amount in cases where reductions of indebtedness ("paydowns") reduce the taxpayer's debt below the amount that would have been eligible for 5-year relief had no paydown occurred. More specifically, the second amount is the 5-year base, reduced (but not below zero) by paydowns of debt, and then multiplied by a percentage. The paydowns that reduce the 5-year base for this purpose are defined as the excess of the taxpayer's November 16, 1985, debt over the lowest amount of indebtedness of the taxpayer outstanding as of the close of any preceding month beginning after November 16, 1985 (or to the extent provided in regulations, as under the general phase-in, the average amount of indebtedness outstanding during any such month).

To compute this second amount, the (possibly reduced) 5-year base is multiplied by a fraction the numerator of which is the applicable 5-year percentage (the excess of the 5-year percentage under present law over the 3-year percentage), and the denominator of which is the sum of the applicable percentage under the general (3-year) rule and the applicable percentage under the 5-year rule. This second amount limits the 5-year base only in cases where paydowns reduce the amount of the 5-year base below the amount of relief that would be granted if no paydown had occurred. In the case of the first taxable year beginning after December 31, 1986, this percentage is 10, i.e., 8-1/3 divided by the sum of 8-1/3 and 75; in the case of the second taxable year, this percentage is 25, i.e., 16-2/3 divided by the sum of 50 and 16-2/3; in the case of the third taxable year, this percentage is 50, i.e., 25 divided by 50; in the case of the fourth taxable year, this percentage is 100, i.e., 33-1/3 divided by 33-1/3; and in the case of the fifth taxable year, this percentage is 100, i.e., 16-2/3 divided by 16-2/3.

This second amount preserves the full 5-year benefit in cases where the taxpayer's lowest debt is equal to or greater than the product of the 5-year base (unreduced by paydowns) and Act's 5-year percentage. (The Act's 5-year percentage is restructured under the bill as the sum of two applicable percentages: the applicable percentage for the purpose of the general (3-year) rule and the add-on applicable percentage for the purpose of the 5-year rule.) If paydowns have reduced outstanding debt below the amounts that would have obtained full benefit under the 5-year rule had no paydowns occurred, this second amount reduces the 5-year benefit on a linear basis.

The 4-year phase-in amount is the lesser of two amounts. These amounts parallel the principles set forth above in connection with the 5-year amounts. The first amount is the applicable percentage of the "4-year base." The 4-year base is the excess (if any) of the amount taxpayer's outstanding indebtedness on December 31, 1983, over the amount of the taxpayer's outstanding indebtedness as of the close of December 31, 1982. For this purpose, however, the 4-year base cannot exceed the excess of the aggregate amount of indebtedness of the taxpayer outstanding on November 16, 1985 over the 5-year base. The applicable percentage, in each year, is the excess of the percentage granted relief under the Act's 4-year phase-in over the percentage granted relief under the Act's general (3-year) phase-in. In the case of the first taxable year beginning after December 31, 1986, the applicable percentage is 5 (80 - 75); in the case of the second taxable year, the applicable percentage is 10 (60 - 50); in the case of the third taxable year, the applicable percentage is 15 (40 - 25); and in the case of the fourth taxable year, the applicable percentage is 20.

The 4-year phase-in amount cannot exceed a second amount. That second amount is intended to reduce the 4-year phase-in amount to the extent that paydowns reduce the taxpayer's debt below the amount that would be eligible for 4-year relief had no paydown occurred. More specifically, the second amount is the 4-year base, reduced (but not below zero) by certain paydowns of debt, multiplied by a percentage. The paydowns that reduce the 4-year base for this purpose are generally defined as the excess of the taxpayer's November 16, 1985, debt, over the lowest amount of indebtedness of the taxpayer outstanding as of the close of any preceding month beginning after November 16, 1985 (or to the extent provided in regulations, as under the general phase-in, the average amount of indebtedness outstanding during any such month). This paydown amount for 4-year purposes is reduced, but not below zero, by the amount of the 5-year base.

For purposes of this second amount, the (possibly reduced) 4-year base is multiplied by a fraction the numerator of which is the percentage added to general relief under the 4-year rule and the denominator of which is the percentage granted relief after the application of both the 4-year rule and the general (3-year) relief. In the case of the first taxable year beginning after December 31, 1986, this percentage is 6.25, i.e., 5 divided by (5 + 75); in the case of the second taxable year, this percentage is 16-2/3, i.e., 10 divided by 60; in the case of the third taxable year, this percentage is 37.50, i.e., 15 divided by 40; and in the case of the fourth taxable year, this percentage is 100, i.e., 20 divided by 20.

The bill provides that, to the extent possible, the general and special phase-in rules are to apply to the same amount of indebtedness.

The bill clarifies that amounts eligible for relief under the Act's phase-in rules are determined on the basis of indebtedness rather than interest expense. The bill is not intended to require that specific interest expense be traced to specific indebtedness.

The following examples involve the application of the special phase-in rule for one-taxpayer treatment and the general phase-in rule for the Act's other interest expense allocation rules.

Finally, in view of the relative complexity of these transition rules, the bill allows taxpayers to elect out of their application in prescribed circumstances.

1. Captive insurance companies

Under subpart F of the Code, certain types of income of U.S.-controlled foreign corporations are included currently in shareholder income and taxed by the United States regardless of whether the income is actually distributed currently to shareholders. A taxpayer is generally subject to income inclusion under subpart F only if the taxpayer is a "U.S. shareholder" in a "controlled foreign corporation." Since the enactment of the subpart F rules in 1962, the term "U.S. shareholder" has generally been limited to those U.S. persons owning (directly, indirectly, or by attribution) 10 percent or more of a foreign corporation's combined voting power. The term "controlled foreign corporation" has generally been limited to those foreign corporations more than half of the stock of which is owned by U.S. shareholders (under the Act, more than half by vote or by value).

The Act introduced new subpart F rules for taxing the income of so-called captive foreign insurance companies. Under the new rules, related person insurance income of these companies is currently taxable to an expanded category of U.S. persons. The statute achieves this result first by treating as a "U.S. shareholder" any U.S. person who owns directly or indirectly any stock in a foreign corporation, whether or not the amount of stock owned meets the 10 percent threshold; and second by lowering the U.S. shareholder ownership threshold for controlled foreign corporation status to 25 percent or more. These modifications apply only for purposes of taking into account related person insurance income under subpart F.

The Act provides three exceptions to the new subpart F rules for captive insurers. Under one of these exceptions, a foreign corporation may avoid the application of the new subpart F rules for captives by electing to treat related person insurance income that would not otherwise be taxed on a net basis (i.e., as effectively connected with the conduct of a U.S. trade or business) as income that is effectively connected with the conduct of a U.S. trade or business. The income deemed to be effectively connected under this election will be excluded from subpart F income.

Congress intended the election to be available only in two cases: (a) where the corporation is a controlled foreign corporation solely by virtue of the new rules for captive insurers and (b) where the corporation is a controlled foreign corporation regardless of the new captive rules but does not have a 10-percent U.S. shareholder that owns directly or indirectly (other than by attribution under section 958(b)) stock in the controlled foreign corporation. The Act provides that the election is to be made at such time and in such manner as the Secretary may prescribe. The election is effective in the year made and in all future years. The election is not effective if the electing corporation fails to meet such requirements as the Secretary shall prescribe to ensure that the tax imposed on its related person insurance income is paid.

To make the election, the foreign corporation must waive all U.S. income tax treaty benefits with respect to its related person insurance income. Treaty benefits with respect to the branch profits tax newly created by the Act are irrelevant to income with respect to which the election is properly made, however, because the Act excludes from the imposition of branch profits tax the earnings and profits attributable to income treated as effectively connected solely because of the election.

Amount of subpart F inclusion

When a controlled foreign corporation earns subpart F income, the United States generally taxes the corporation's U.S. shareholders currently on their pro rata share of the subpart F income. Related person insurance income (as defined by the Act) is a type of subpart F income.

In the case of a corporation that is a controlled foreign corporation for its entire taxable year, and a U.S. shareholder that owns the same proportion of stock in the corporation throughout the corporation's taxable year, the U.S. shareholder's pro rata share of subpart F income is the amount that would have been distributed with respect to the shareholder's stock if on the last day of the taxable year the controlled foreign corporation had distributed all of its subpart F income pro rata to all of its shareholders.

The pro rata share definition provides for adjustments where the corporation is a controlled foreign corporation for less than the entire year or where actual distributions are made with respect to stock the shareholder owns for less than the entire year. The latter adjustment, contained in section 951(a)(2)(B), reduces a U.S. shareholder's pro rata share by a fraction of the dividends distributed to any other person during the controlled foreign corporation's taxable year on stock owned by the U.S. shareholder at year-end. The fraction equals the proportion of the taxable year during which the U.S. shareholder did not own the stock.

Primary insureds

The Act defines related person insurance income as any insurance income attributable to a policy of insurance or reinsurance with respect to which the primary insured is either a U.S. shareholder (as defined above) in the foreign corporation receiving the income or a person related to such a shareholder.

It was Congress's intent that related person insurance income include income attributable to policies of reinsurance issued by a foreign corporation to its U.S. shareholders that previously insured the risks covered by such policies or to persons related to such shareholders that previously insured the risks covered by such policies. In addition, Congress gave the Secretary authority under the Act to prevent the avoidance of the captive insurance rules through cross insurance arrangements or otherwise.

The new subpart F rules for captive insurers do not apply if less than 20 percent of the stock of the corporation (by vote or by value of both stock and policies) is owned (directly or indirectly) by persons who are the primary insureds under any policies of insurance or reinsurance issued by the corporation, or by persons related to such primary insureds.

Gross insurance income

Under a de minimis exception to the new subpart F rules for captive insurers, these rules do not apply to income of a foreign corporation whose related person insurance income for the taxable year is less than 20 percent of its insurance income for the year. Congress intended that this computation be performed on a gross basis. Insurance income is defined for this purpose as it is generally for subpart F purposes under the Act, except that the exclusion of income attributable to same-country risks does not apply.

Definition of related person

The application of the new captive insurance rules turns on the distinction between persons who are and are not related to U.S. shareholders (within the meaning of section 954(d)(3) as amended by the Act). A person is related to a controlled foreign corporation if the person controls, is controlled by, or is under common control with the controlled foreign corporation.

Congress intended that related person insurance income include income attributable to officers' or directors' insurance where the U.S. shareholders of the foreign corporation receiving such income (or persons related to such shareholders) directly or indirectly pay the premiums and the insureds are officers or directors of the U.S. shareholders (or persons related to such shareholders).

Definition of related person insurance income

As stated above, the Act defines related person insurance income as a type of "insurance income." The Code provides special rules for computing tax haven insurance income that is subject to current taxation under subpart F. Section 953(b) states that for these purposes all items of income, expenses, losses, and deductions shall be properly allocated or apportioned under regulations prescribed by the Secretary. Section 953(b) also eliminates or limits the applicability of certain provisions of subchapter L of the Code ("Insurance Companies") for these purposes. Congress intended that these special rules for computing tax haven insurance income apply in computing related person insurance income.

Information returns

Under the Code, U.S. persons who own or acquire 5 percent or more of the value of the stock of a foreign corporation, others who become U.S. persons while owning that percentage of the stock of a foreign corporation, and U.S. citizens and residents who are officers or directors of foreign corporations with such U.S. ownership are required to file information returns concerning the corporation and its shareholders (sec. 6046; see Schedule O (Form 5471) (previously Form 959)). Regulations excuse any shareholder from furnishing required information if it is furnished by another person having an equal or greater stock interest in the corporation (Reg. sec. 1.6046-1(e)(5)). Due to its 5 percent stock ownership threshold, this reporting requirement generally applied to all U.S. shareholders in controlled foreign corporations prior to the Act. Under the new captive rules, however, a person owning less than 5 percent of the stock of a controlled foreign corporation may also be a U.S. shareholder. Generally Congress did not intend to treat such less-than-5-percent U.S. shareholders any differently from other U.S. shareholders in controlled foreign corporations for reporting purposes.

Sales of captive company stock

Generally, a U.S. shareholder in a controlled foreign corporation receives an income inclusion under subpart F when the shareholder owns stock in the corporation on the last day of the taxable year on which the corporation is a controlled foreign corporation (sec. 951(a)(1)). Prior to the Act, any U.S. shareholder that sold or exchanged stock in a controlled foreign corporation (or received a distribution which was treated as an exchange of stock in the corporation) before the last day of the year generally would have been required to treat the gain on the sale as a dividend, to the extent of the earnings and profits of the corporation attributable to such stock and accumulated since 1962 during periods in which the corporation was a controlled foreign corporation and in which the U.S. person held the stock sold or exchanged (sec. 1248). Thus a mid-year stock sale would result in shareholder dividend income similar to an income inclusion under subpart F.

Under present and prior law, this rule for treating gains as dividends applies only to the class of U.S. shareholders defined under the usual 10 percent ownership threshold of subpart F -- that is, the class of U.S. shareholders as that term was defined prior to the Act. The Act's captive insurance rules, however, created a new class of U.S. shareholders that need not satisfy this 10 percent threshold. Congress did not intend to treat this new class of U.S. shareholders differently from 10-percent U.S. shareholders for purposes of the existing rule for treating gains as dividends.

Uninsured, unrelated shareholders

Under the new captive insurance rules, the term U.S. shareholder includes a U.S. person that owns any stock in a foreign corporation that owns (directly or indirectly) any stock in a foreign corporation that earns related person insurance income.

The bill supplements the Code provisions describing the election to treat related person insurance income as effectively connected with the conduct of a U.S. trade or business in order to clarify that the election is not available to a corporation that, without applying the special subpart F rules for captive insurance companies, is a controlled foreign corporation for an uninterrupted period of 30 days or more during the taxable year with a U.S. shareholder that owns directly or indirectly (other than by the attribution rules of 958(b)) stock in the foreign corporation, or that was such a controlled foreign corporation for such a period for any pre-election taxable year beginning after 1986. The bill further provides that if a corporation is entitled to make the election in one year, but in a later year becomes a controlled foreign corporation with such a U.S. shareholder as defined by the general subpart F rules, an election made for the earlier year shall not apply to any taxable year after the later year. Thus, the bill clarifies that the election is available only in situations where a foreign corporation and its shareholders are subject to subpart F treatment by virtue of the Act's special captive insurance rules, and not where subpart F treatment results from application of the rules that are generally applicable outside the captive insurance context.

The bill also provides that in making the election the foreign corporation must waive all benefits granted by the United States (other than benefits with respect to the branch profits and branch interest taxes newly imposed by the Act) under any treaties between the United States and any foreign country. Thus, for example, U.S. tax benefits claimed under a friendship, commerce, and navigation treaty would have to be waived by a foreign corporation making the election. However, the bill clarifies that treaty benefits with respect to the branch taxes need not be waived with respect to related person insurance income when that income is effectively connected without regard to the election.

Amount of subpart F inclusion

The bill provides a special definition of "pro rata share" for purposes only of taking into account related person insurance income. For these purposes, the special pro rata share definition is the lesser of (i) the amount which would be determined under the general subpart F definition of pro rata share if only related person insurance income were taken into account, if stock owned by U.S. shareholders on the last day of the taxable year were the only stock in the foreign corporation, and if only distributions received by U.S. shareholders were taken into account under section 951(a)(2)(B); or (ii) the amount which would be determined under the general subpart F definition of pro rata share if the entire earnings and profits of the corporation for the taxable year were subpart F income.

The effect of the bill's pro rata share definition is to ensure that if related person insurance income of a controlled foreign corporation is at all currently taxable to U.S. shareholders under subpart F, then the full amount of the controlled foreign corporation's related person insurance income will be currently taxable, up to the U.S. shareholders' proportionate share of the controlled foreign corporation's earnings and profits. Where the corporation earns a sufficient level of income that is not related person insurance income, partial ownership of the corporation by foreign persons will not reduce the portion of the corporation's related person insurance income that is currently taxable in the United States. As used in the bill's pro rata share definition, the term "U.S. shareholder" has the meaning that it has when taking into account related person insurance income: i.e., as modified by section 953(c)(1)(a) (which dispenses with the 10 percent threshold).

The bill further provides the Secretary with authority to modify the other rules of subpart F where necessary to permit an appropriate computation of pro rata share under the bill's special rule. For example, it may be necessary or appropriate for the Secretary to coordinate this rule with the general pro rata share definition where the controlled foreign corporation has other types of subpart F income; or regulations may be appropriate for determining how the various types of subpart F income are to be reduced to account for the earnings and profits limitation on subpart F income.

Primary insureds

The bill eliminates the word "primary" from the references to "primary insureds" in the definition of related person insurance income and in the exception from the special captive insurance rules for corporations less than 20 percent of whose owners are insureds or related to insureds. Thus the bill clarifies that these references are intended to cover policies of reinsurance issued to U.S. shareholders and related persons, regardless of whether the contracts being reinsured were issued to unrelated persons. The bill also clarifies that insurance income from contracts insuring indirectly (as well as directly) shareholders or persons related to shareholders of the foreign corporation is included in the definition of related person insurance income and that such persons indirectly (as well as directly) insured are included in the group of insured shareholders and shareholders related to insureds for purposes of determining whether the foreign corporation is less than 20 percent owned by insureds or persons related to insureds.

For example, if a foreign corporation reinsures the risk of a U.S. insurance company that insures a U.S. individual and stock of the foreign corporation is owned by the U.S. individual, then the foreign corporation's income on the reinsurance of the U.S. individual is related person insurance income under the bill because one of its U.S. shareholders is indirectly an insured of the foreign corporation. In addition, if a foreign corporation reinsures the risk of a U.S. insurance company that insures a U.S. individual and stock of the foreign corporation is owned by the U.S. insurance company, then the foreign corporation's income on the reinsurance contract is related person insurance income under the bill because one of its U.S. shareholders is directly an insured of the foreign corporation.

The foregoing amendments affecting the types of insureds whose insurance and reinsurance policies give rise to related person insurance income subject to the new captive rules generally apply to taxable years of foreign corporations beginning after 1987. However, to the extent those amendments simply eliminate the word "primary" from the references to "primary insureds," the amendments are effective as if included in the 1986 Act. That is, effective in taxable years of foreign corporations beginning after December 31, 1986, the word "primary" is dropped from sections 953(c)(2) and 953(c)(3)(A). The Secretary retains regulatory authority to identify instances where a stockholder of a foreign corporation (or a related person) is the indirect insured under a policy of insurance or reinsurance issued by the corporation, and to extend related person insurance income treatment to income from reinsurance issued to unrelated parties, in those cases where doing so is necessary to prevent the avoidance of the captive insurer rules.

Gross insurance income

The bill clarifies that for purposes of applying the de minimis exception to the captive insurance rules, comparison of a foreign corporation's related person insurance income to its insurance income is made on a gross basis. Thus, the de minimis rule is applied without regard to the relative profitability of the foreign corporation's related person insurance income, on the one hand, and its total insurance income, on the other.

Definition of related person

The bill modifies the definition of related person for purposes of the captive insurance rules, making it clear that in the case of any insurance policy covering liability arising from services performed as a director, officer, or employee of a corporation or as a partner or employee of a partnership, the person performing the services and the entity for which the services are performed will be treated as related persons. (As discussed below, the bill also raises the control threshold for related person status generally from 50 percent to more than 50 percent.)

Definition of related person insurance income

The bill refines the definition of related person insurance income so that it specifically refers to insurance income as that term is defined in section 953(a), thus incorporating the special rules set forth in section 953(b) for computing tax haven insurance income.

Information returns

The bill extends the information reporting requirements for U.S. persons who are 5 percent-or-more shareholders of foreign corporations and U.S. citizens or residents who are officers or directors of such corporations so that they apply to all persons who are U.S. shareholders in controlled foreign corporations by virtue of the new captive insurance company rules and all U.S. officers and directors of companies that are controlled foreign corporations by virtue of those rules.

Sales of captive company stock

The bill modifies the treatment of gains on sales of stock in foreign corporations that are controlled foreign corporations under the captive insurance rules to conform to the dividend treatment accorded to gains on sales of controlled foreign corporation stock in general. Thus, when a person that is a U.S. shareholder solely by virtue of the captive rules sells captive company stock to another U.S. person, for example, before the end of the taxable year, buyer and seller will each be treated as having received dividend income only with respect to that part of the year that it owned the stock.

Uninsured, unrelated shareholders

The bill gives the Secretary authority to provide regulations under which U.S. persons who are neither insured or reinsured by a foreign corporation (directly or indirectly), nor related to a person insured or reinsured (directly or indirectly) by the corporation will not be treated as U.S. shareholders of the foreign corporation.

It is anticipated that the Secretary will exercise this authority to provide exemptions from the captive rules for instances where it is administratively impracticable to identify noninsureds with insignificant, indirect shareholdings in foreign corporations as U.S. shareholders. Moreover, it is anticipated that the Secretary may excuse such a U.S. person from treatment as a U.S. shareholder of the captive company even if a U.S. person can be identified as the indirect owner of stock of a captive insurance company, if the captive stock represents an insignificant enough portion of the assets of its direct owner. For example, where a publicly traded, widely held, foreign corporation incidentally owns stock (directly or indirectly) in a foreign corporation with related person insurance income, U.S. investors who own small proportions of the stock of the first corporation and who have no relationship to the second may technically be U.S. shareholders under the statute. In these circumstances, however, it might be appropriate for regulations to exclude such investors from the definition of U.S. shareholder.

2. Insurance companies in general

To take partial account of the time value of money, the Act amends subchapter L of the Code to provide for the discounting of the deduction for loss reserves of property and casualty insurance companies. Thus, the Act limits the deduction for unpaid losses to the amount of discounted unpaid losses (new sec. 846 of the Code).

In general, the new discounting provisions apply to taxable years beginning after December 31, 1986. A fresh start is provided with respect to undiscounted loss reserves applicable to the last taxable year beginning before January 1, 1987. Under this fresh start rule, the difference between the amount of undiscounted loss reserves and the discounted balances is not taken into income.

The Act provides that the fresh start adjustment is to be taken into account in full in the first taxable year to which the discounting provisions apply (generally, taxable years beginning in 1987) for purposes of calculating any adjustment to earnings and profits. The current earnings and profits of a controlled foreign corporation serve as a limitation on the amount of the corporation's subpart F income for the current taxable year.

Definition of United States risk

Section 861(a)(7) (unchanged by the Act) treats as U.S. source income amounts received as underwriting income derived from the insurance of U.S. risks as defined in section 953(a). Prior to the Act, section 953(a) defined the term "income derived from the insurance of U.S. risks" as income that would (subject to certain modifications described in section 953(b)) be taxed under subchapter L if the income were that of a domestic insurance company, and that is attributable to the reinsuring or the issuing of any insurance or annuity contract (1) in connection with property, activities, or the lives or health of individuals resident in the United States, or (2) under any arrangement where another corporation receives a substantially equal amount for covering such risks.

In connection with the Act's expansion of the subpart F tax haven insurance definition, extending current taxation to any income attributable to the issuing (or reinsuring) of any insurance or annuity contract in connection with risks in a country other than that in which the insurer is created or organized, the definition of U.S. risk was no longer relevant for section 953(a) purposes. Congress did not intend to alter the substance of the related source rule in section 861(a)(7).

Allocation of insurance company expenses

In connection with prior law's shareholder-level taxation of controlled foreign corporation income from insurance of U.S. risks, the Code provided for tax on all of the underwriting income and net investment income from insuring such risks. Certain deductions generally allowed domestic insurance companies were not allowed in the case of these foreign operations, and other allowed deductions were to be taken into account only to the extent they were in respect of contracts insuring U.S. risks. All other deductions, as well as all items of income, were to be properly allocated or apportioned under regulations between income from insuring U.S. risks and income from insuring foreign risks. Under this regime, for example, the regulations generally allocated reserve deductions to underwriting income (see Reg. sec. 1.953-4(h)).

The Act not only imposed on U.S. shareholders current taxation on all of the controlled foreign corporation's net underwriting income from insuring foreign risks outside its home country ("non-same-country risks"), but also subjected income derived from the corporation's investments of funds generally to current U.S. taxation under subpart F, regardless of the extent to which the corporation receiving such income is engaged in the business of insuring same-country risks. Congress intended that, under the existing statute calling for regulations to allocate and apportion deductions with respect to insurance income, reserve and other deductions would be allocated and apportioned, where appropriate, to investment income so as to result in current taxation of net investment income and deferral of tax on same-country underwriting income without, in the latter case, reduction for expenses, losses, or reserves properly allocable to investment income.

Carryover of insurance company deficits

Under the Act, a U.S. shareholder's inclusion of subpart F insurance income of a controlled foreign corporation may be reduced by post-1986 accumulated deficits in that corporation's earnings and profits attributable to activities that give rise to subpart F insurance income, provided that the controlled foreign corporation receiving such income was a qualified insurance company. A qualified insurance company is a controlled foreign corporation predominantly engaged in the active conduct of an insurance business in both the year in which the corporation earned the income and the year in which the corporation incurred the deficit. Thus, subpart F inclusions of a qualified insurance company's investment income attributable to non-same country insurance (which is a type of subpart F insurance income) may be eligible for reduction by accumulated deficits.

A qualified insurance company's investment income attributable to same country insurance is generally foreign personal holding company income. Inclusions of foreign personal holding company income may sometimes be reduced by accumulated deficits under a rule similar to that for subpart F insurance income, but generally not if the income is earned by an insurance company eligible for the benefits of the insurance income deficit rule. Rather, the opportunity to reduce inclusions of foreign personal holding company income by accumulated deficits is available only if the controlled foreign corporation receiving such income was predominantly engaged in the active conduct of a banking, financing, or similar business in both the year in which the corporation earned the income and the year in which the corporation incurred the deficit.

The bill provides that for purposes of computing the earnings and profits limitation on subpart F income, current earnings and profits are determined without regard to the increase in current earnings and profits under the discounting fresh start provision of the Act. Thus, the one-time increase in current earnings and profits of a controlled foreign corporation under the discounting fresh start provision will not result in any increase in subpart F income of that corporation.

Definition of United States risk

The bill reinstates for purposes of section 861(a)(7) the pre-Act definition of income from U.S. risks. The bill treats as U.S. source income amounts received as underwriting income derived from the issuing (or reinsuring) of any insurance or annuity contract (1) in connection with property, activities, or the lives or health of individuals resident in the United States, or (2) under any arrangement where another corporation receives a substantially equal amount for covering such risks.

Allocation of insurance company expenses

The bill clarifies that regulations are to provide for the proper allocation and apportionment of all insurance company expenses, losses, and deductions between income that is subject to current U.S. shareholder taxation under subpart F (such as investment income) and income that is not (namely, same-country underwriting income). Generally, it is anticipated that amounts not specifically allocable are to be apportioned on the basis of premiums and investment income.

Carryover of insurance company deficits

The bill conforms the treatment of foreign personal holding company income of qualified insurance companies, for accumulated deficit purposes, to that of subpart F insurance income of such companies. Thus, U.S. shareholder inclusions of same country and non-same country investment income of a controlled foreign corporation predominantly engaged in the insurance business are both eligible for reduction by post-1986 accumulated deficits under the same terms. However, deficits in same country underwriting income continue to be ineligible to reduce subpart F inclusions of same country investment income and non-same country underwriting and investment income earned in later years for subpart F purposes.

3. Withdrawals of qualified shipping reinvestments that pre-Act law excluded from subpart F income

4. Definition of related person

A related person is one which controls, is controlled by, or is under common control with the controlled foreign corporation. The Act amended the definition of control for this purpose. In the case of a corporation, control means the direct or indirect ownership of 50 percent or more of the total combined voting power of all classes of stock entitled to vote or of the total value of such corporation. In the case of a partnership, trust, or estate, control is defined as direct or indirect ownership of 50 percent or more of the total value of the beneficial interests in the entity.

Whether income is subject to the separate foreign tax credit limitation for passive income may also turn on whether it is received from a related person. The definition of the passive income basket is generally based on the definition of foreign personal holding income under subpart F, which in turn uses the concept of "related person" to provide certain exceptions from foreign personal holding company income, such as rents and royalties derived in an active business, and certain same-country dividends and interest. In addition, if a corporation is a controlled foreign corporation, payments that it makes to its U.S. shareholders may be characterized for purposes of the foreign tax credit baskets by reference to the character of the income of the controlled foreign corporation.

In contrast to the definition of control for purposes of defining a related person, the Code treats a foreign corporation as a controlled foreign corporation only if more than 50 percent of its stock (by vote or value) is owned (directly, indirectly, or by attribution) by U.S. shareholders. Prior to the Act, the ownership threshold for related party status was, similarly, more than 50 percent of the total combined voting power of a corporation's voting stock.

Different thresholds for defining "control" in the definitions of controlled foreign corporation, on the one hand, and related person, on the other, may produce unintended anomalies in the operation of the foreign tax credit limitation baskets, especially where look-through treatment may be involved. For example, assume that a foreign corporation owned 50-50 by two unrelated persons, one foreign and one U.S., derives all of its income from manufacturing, and that it pays royalties to its U.S. shareholder, which derives the royalties in the active conduct of its trade or business. This income of the shareholder is ineligible for the active royalty exception from foreign personal holding company income because the payor is a "related person." However, the foreign corporation is not a controlled foreign corporation, and therefore the royalty income of the shareholder cannot be recharacterized under the look-through rules to reflect the overall limitation character of the foreign corporation's income. Thus, the royalty is passive basket income of the shareholder, even though it would not have been if the U.S. shareholder owned either more or less than 50 percent of the foreign corporation's stock.

In the case of royalties derived in the active conduct of a trade or business, for example, the bill prevents treatment of a 50-percent U.S.-owned foreign corporation in a manner which is different than the treatment of both foreign corporations owned more than 50 percent by U.S. persons and foreign corporations owned less than 50 percent by U.S. persons. The bill eliminates, by contrast, the opportunity for a controlled foreign corporation to exclude from foreign personal holding company income, under section 954(c)(3)(A)(i), same-country dividends from a 50-percent owned foreign corporation.

5. Treatment of gains as foreign personal holding company income

The Act retained certain exceptions to foreign personal holding company treatment from prior law, and added new exceptions to such treatment, in connection with gains of regular dealers; gains on inventory property (sec. 1221(1)); active business gains or losses in connection with certain commodity transactions by any controlled foreign corporation substantially all of the business of which is as an active producer, processor, merchant, or handler of commodities; and foreign currency gains and losses related to the business needs of the controlled foreign corporation. For example, the Act retained prior law's subpart F exception for gains and losses of a producer, processor, merchant, or handler of a commodity which arise from bona fide hedging transactions reasonably necessary to the conduct of its business in the manner in which such business is customarily and usually conducted by others. Congress also did not intend that net losses from the class of transactions the gains on which are covered by the regular dealer and inventory exceptions would be available to reduce foreign personal holding company income.

The bill provides that the use of losses to reduce gains on sales or exchanges of property subject to foreign personal holding company treatment does not apply to loss from sales or exchanges of inventory property or from any other property by a regular dealer in that property. Thus the bill clarifies that any losses on such sales or exchanges do not reduce foreign personal holding company income.

The bill also provides a new hedging exception for regular dealers in property, under which gains and losses arising out of bona fide hedging transactions reasonably necessary to the conduct of the business of being a dealer in such property are excluded from the computation of foreign personal holding company income. Thus, where a regular dealer in bonds, for example, uses forwards, futures, options, or similar instruments in which it is not a regular dealer to hedge its exposure to losses on its bonds, the bill permits netting of gains and losses from both bonds and hedging instruments in arriving at the dealer's non-subpart F income.

6. Losses from foreign base company sales and services income

Foreign base company sales income and foreign base company services income cannot be reduced by accumulated deficits. Since 1963, U.S. shareholders of controlled foreign corporations earning current income in these subpart F categories have been likely to be taxed currently on that income.

As is true for the other categories of income entitled to similar treatment, accumulated deficits from foreign base company sales and services may be used only once, but those that cannot be utilized in one year may be carried over indefinitely for possible use in later years. To be eligible for use under the rule, an accumulated deficit must be attributable to a year for which the foreign corporation incurring such deficit was a controlled foreign corporation. Moreover, the deficit can reduce the subpart F inclusion of only those U.S. persons that were U.S. shareholders in the controlled foreign corporation when the deficit was incurred.

7. Chain deficit rule

Thus, where a U.S. multinational engages in one qualified activity in a foreign country, using two or more foreign corporations in a chain of ownership to do so, the current year qualified deficits of one foreign corporation may reduce the subpart F income of the other from the same qualified activity. For example, assume that a U.S. corporation owns all the stock of a banking corporation organized in a foreign country, and that the latter owns all the stock of a second banking corporation organized in the same country. The parent foreign bank has foreign personal holding company income of $100 and earnings and profits of $50. After application of the earnings and profits limitation of section 952(c)(1)(A), the parent bank has subpart F income of $50. The subsidiary foreign bank has a loss of $100 attributable to activities that, when profitable, generate foreign personal holding company income, and has a deficit in earnings and profits of $60. Under the bill, the parent foreign corporation may elect to reduce its subpart F income to zero reflecting the subsidiary's deficit.

It is believed that this provision affords taxpayers a reasonable measurement for their taxable income from foreign operations without the degree of potential for mismatching that prompted the 1986 Act's repeal of the chain deficit rule. For example, use in this provision of the "qualified activity" definition of the accumulated deficit rules (as amended by the 1986 Act) avoids the problem perceived by Congress that a loss could have eliminated U.S. tax on income earned elsewhere in the chain even though the loss might have been in a non-subpart F income category or borne little or no relation to the income it offset.

8. Measurement of earnings and profits

The Tax Reform Act of 1984 introduced several provisions to make a corporation's earnings and profits more closely conform to its economic income where economic income diverged from taxable income. Under the 1984 Act, for example, a corporation using the LIFO method of accounting for inventory adjusts earnings and profits under rules designed to eliminate the impact of LIFO on earnings and profits (current sec. 312(n)(4)). A corporation's earnings and profits for a year in which the corporation sells property on the installment basis generally are to be computed as if the corporation did not use the installment method to account for the installment sale (current sec. 312(n)(5)).

A corporation that accounts for income and expenses attributable to a long-term contract on the completed contract method of accounting generally recognizes income and expense in the year in which the contract is completed. Under the 1984 Act, a corporation that accounts for income and expense on this method is required to compute earnings and profits as if it were accounting for income and expense attributable to long-term contracts on a percentage of completion basis (sec. 312(n)(6)).

The effect of these provisions is generally to accelerate the inclusion of amounts in earnings and profits, reducing to some extent amounts of earnings and profits that can be treated as current earnings in future taxable years. In the case of a domestic corporation computing taxable dividends, this reduction in subsequent years' current earnings and profits does not generally reduce the tax on amounts distributed in the subsequent year, because the distribution of accumulated earnings is also taxed.

In the case of computing the subpart F limitation, on the other hand, acceleration of earnings under these provisions generally has the effect of raising the subpart F limitation in an earlier year than the year in which those earnings would be included in taxable income of U.S. shareholders.

The Act put new limits on the amounts by which prior year deficits in earnings and profits, or deficits in non-subpart F income, can be used to reduce subpart F inclusions (sec. 952(c)). Those provisions generally do not, however, provide for increasing the earnings and profits limitation by a prior year excess of earnings and profits over subpart F income, even if those earnings and profits relate to subpart F income categories.

The modification also provides, however, that under regulations, if the earnings and profits arising from inventory assets, an installment sale, or a completed contract are distributed prior to the year that they would otherwise be included in earnings and profits for purposes of computing the earnings and profits limitation on subpart F income (e.g., the year in which the installment receivable is collected or the contract is completed), those earnings are not to be included in earnings and profits in the later year. This treatment may be necessary to eliminate the potential for those earnings to be taxed twice.

9. Effective date of accumulated earnings tax amendments

10. Dividends received deduction

The Act disallowed indirect foreign tax credits (sec. 902) to the extent the taxes are attributable to the portion of dividends from foreign corporations that is eligible for the dividends received deduction. In addition, for foreign tax credit limitation purposes, the portion of any dividend from a foreign corporation that is eligible for the dividends received deduction is treated as U.S. source.

Under section 1248, where a U.S. person sells or exchanges stock in a foreign corporation (or receives a distribution which is treated as an exchange of stock in a foreign corporation) which was, during the previous 5 years, a controlled foreign corporation in which the U.S. person was a U.S. shareholder, the gain recognized on the sale or exchange is treated as dividend income of the U.S. person to the extent of the earnings and profits of the foreign corporation attributable to such stock and accumulated since 1962 during periods in which the corporation was a controlled foreign corporation and in which the U.S. person held the stock sold or exchanged. For these purposes, certain income items, including generally amounts effectively connected with a U.S. trade or business of the controlled foreign corporation and not exempt from tax (or subject to a reduced tax rate) by treaty, are excluded from earnings and profits. Thus, amounts treated as dividends under section 1248 are generally derived from earnings not subject to U.S. corporate income tax, and therefore generally are not eligible for the dividends received deduction under the Act.

In addition, to the extent that a treaty obligation of the United States requires the United States to treat dividends from a foreign corporation that are eligible for the dividends received deduction as foreign source, the bill allows any recipient of such dividends to elect the treaty source rule, but the bill subjects the portion of dividends from that corporation that would be treated as U.S. source income absent a treaty to their own separate foreign tax credit limitation, and denies the benefits of the dividends received deduction.

(sec. 112(n) of the bill, sec. 1231 of the Reform act, and sec. 936 of the Code)

The bill also makes clerical amendments.

2. Effective date of provision governing transfers of intangibles to related parties

(sec. 112(n) of the bill, sec. 1231 of the Reform Act, and sec. 482 of the Code)

In view of the fact that the objective of these provisions -- that the division of income between related parties reasonably reflect the relative economic activity undertaken by each -- applies equally to inbound transfers, Congress concluded that it would be appropriate for these principles to apply to transfers between related parties generally (via sec. 482) if income must otherwise be taken into account. However, in the case of a transfer of the type that is covered by the Act but that would not have been affected by the House version of H.R. 3838, Congress intended to apply the above effective date provision substituting "August 16, 1986" for "November 16, 1985."

3. Information returns on resident status

(sec. 112(o) of the bill, sec. 1234 of the Reform Act, and sec. 6039E of the Code)

The Immigration Reform and Control Act of 1986 became law after the Tax Reform Act of 1986. This new immigration law established a legalization program (section 245A of the Immigration and Nationality Act; 8 U.S.C. sec. 1255a). Under the program the U.S. Attorney General is to accord eligible applicants who were undocumented aliens the status of aliens lawfully admitted to the United States for permanent residence. Applicants are to provide the Justice Department with information establishing their eligibility for legalization. The new immigration law contains confidentiality rules, violation of which is punishable as a felony, that generally preclude government employees involved in the legalization program from sharing or disseminating outside the confines of the program information furnished pursuant to an application for legalization.

4. Treatment of certain passive foreign investment companies

(sec. 112(p) of the bill, sec. 1235 of the Reform Act, and secs. 864, 904, 1246, 1248, and 1291-1297 of the Code)

The Act established rules for passive foreign investment companies (PFICs) and established separate rules for each of two types of PFICs. One set of rules applies to PFICs that are "qualified electing funds," where each U.S. shareholder includes currently in gross income his or her share of a PFIC's total earnings, with an election to defer payment of tax, subject to an interest charge, on income not currently received. The second set of rules applies to PFICs that are not qualified electing funds ("nonqualified funds"), whose U.S. shareholders pay tax on income realized from a PFIC and an interest charge which is attributable to the value of deferral.

Definition of passive foreign investment company

Although the Act incorporated the definition of passive income that is applied for foreign tax credit limitation purposes, it is unclear whether the look-through rules contained therein (i.e., secs. 904(d)(3) and (d)(5)), are, to the extent applicable, to be used in determining whether income is passive for PFIC purposes as well.

Except as provided in regulations, passive income does not include income derived by a bona fide insurance company that would be subject to taxation under subchapter L if the company were a U.S. corporation. It was intended that regulations provide that entities engaged in the business of providing insurance derive passive income and, thus, may be PFICs in certain cases where the entities maintain financial reserves in excess of the reasonable needs of their insurance business.

General rule--nonqualified funds

Qualified electing funds

The amount currently included in income is divided between a shareholder's pro rata share of the ordinary income of a PFIC and net capital gain income of a PFIC. The characterization of income, and the determination of earnings and profits, is made pursuant to general Code rules. Pro rata share of income is determined by aggregating a PFIC's income for the taxable year and attributing that income ratably over every day in the PFIC's year. United States persons then include in income for the period in which they hold stock in the PFIC their daily ownership interest in the PFIC multiplied by the amount of income attributed to each day.

For foreign tax credit purposes, the Act provided that amounts included currently in income from a qualified electing fund are subject to the separate foreign tax credit limitation for passive income.

The Act provided that the election to be a qualified electing fund for any taxable year must be made before the fifteenth day of the third month of the following taxable year.

Certain events cause an extension of time to pay tax on undistributed earnings to terminate. One of those events is the disposition of stock in a PFIC, which terminates all previous extensions of time to pay tax with respect to the earnings attributable to that stock. It is intended that disposition for this purpose mean any transfer of ownership, regardless of whether the transfer constitutes a realization or recognition event under general Code rules. For example, a transfer at death or by gift of stock in a qualified electing fund is to be treated as a disposition for these purposes.

Special rules applicable to both types of funds

Distributions received from a PFIC in a year the PFIC is a qualified electing fund are also intended not to be taxed under section 1291 if the PFIC is a qualified electing fund for each of the fund's taxable years which begin after December 31, 1986, and which include any portion of an investor's holding period. The section 1291 coordinating provision as it relates to distributions is intended to prevent a fund from retaining its annual income, electing to be a qualified electing fund in a subsequent year, and then distributing the accumulated income without the imposition of an interest charge.

Any U.S. person who owns stock in a PFIC which previously was not a qualified electing fund for a taxable year but which becomes one for the subsequent taxable year may elect to be taxed on the unrealized appreciation inherent in his or her PFIC stock up through the first day of the subsequent taxable year, pay all prior deferred tax and interest, and acquire a new basis and holding period in his or her PFIC investment. Thereafter, the shareholder is subject to the rules applicable to qualified electing funds.

One example where regulations may be necessary to carry out the purposes of the Act's provisions is where the ownership attribution rules impute stock ownership in a PFIC to a U.S. person through an intervening entity and the U.S. person disposes of his interests in the intervening entity. In these cases, the intervening entity may not be a PFIC, so that the U.S. person could technically avoid the imposition of any interest charge. In this instance, regulations are intended to treat the disposition of interests in the intervening entity as a disposition of the PFIC stock. Similarly, if necessary to avoid circumvention of the Act's interest charge, it may be necessary under regulations to treat distributions received by an intervening entity as being received by the U.S. person.

The bill also provides a set of look-through rules to characterize amounts received from related persons as passive or nonpassive income. (These new look-through rules are substantially similar to the look-through rules under the foreign tax credit provisions, which were intended to apply for PFIC purposes as well.) These PFIC look-through rules are in addition to the Act's rule that treats assets held by, and income received by, certain 25-percent-owned corporations as being held by, and received by, those corporations' shareholders (sec. 1296(c)). Under the bill's new PFIC look-through rules, interest, dividends, rents, and royalties received from related persons that are not subject to section 1296(c) look-through treatment are treated as passive income to the extent that, under regulations prescribed by the Secretary, those amounts are allocable to income of the payor that is passive income. As a corollary, the characterization of the assets that generate the income will follow the characterization of the income so that, for example, a loan to a related person will be treated as a nonpassive asset if the interest on the loan is treated as nonpassive income. It is anticipated that the regulations will follow the approach of the foreign tax credit allocation rules in making these allocations for PFIC purposes. Thus, it is anticipated that, in the case of interest, or a payment of a rent or a royalty, the amount treated as passive will be that amount which is allocated against passive income of the payor. In the case of dividends, it is intended that the dividend be prorated between passive and nonpassive income on the basis of the passive and nonpassive earnings and profits of the payor. The bill defines a related person by reference to the related person definition in subpart F (that is, sec. 954(d)(3)).

The bill also provides an election to a foreign corporation in determining whether it is a PFIC. Under the election, a foreign corporation can apply the asset test using the adjusted bases of the corporation's assets, rather than the fair market value of its assets, in determining whether it is a PFIC. Under this election then, a foreign corporation with less than 50 percent passive assets by adjusted basis will not be a PFIC (assuming the income test is not met), even if its assets are 50 percent or more passive by fair market value. It is anticipated that the Secretary will prescribe regulations concerning the time and manner of making such an election. The election, once made, is revocable only with the consent of the Secretary.

The bill also clarifies the exception from passive income for income received by bona fide insurance companies. This exception from passive income extends only to income derived by insurance companies that are predominantly engaged in the active conduct of an insurance business and that would be taxed under the special rules applicable to domestic insurance companies if they were domestic corporations. Thus, income derived by entities engaged in the business of providing insurance will be passive income to the extent the entities maintain financial reserves in excess of the reasonable needs of their insurance business.

The bill further treats stock of certain U.S. corporations owned by another U.S. corporation which is at least 25-percent owned by a foreign corporation as a non-passive asset. Under this rule, in determining whether a foreign corporation is a PFIC, stock of a regular domestic C corporation owned by a 25-percent owned domestic corporation is treated as an asset which does not produce passive income (and is not held for the production of passive income), and income derived from that stock is treated as income which is not passive income. Thus, a foreign corporation, in applying the look-through rule available to 25-percent owned corporations, will be treated as owning nonpassive assets in these cases. This rule does not apply, however, if, under a treaty obligation of the United States, the foreign corporation is not subject to the accumulated earnings tax, unless the corporation agrees to waive the benefit under the treaty. This rule is designed to mitigate the potential disparate tax treatment between U.S. individual shareholders who hold U.S. stock investments through a U.S. holding company and those who hold those investments through a foreign holding company. If a foreign investment company attempts to use this rule to avoid the PFIC provisions, it will be subject to the accumulated earnings tax and, thus, the shareholders of that company will be subject to tax treatment essentially equivalent to that of the shareholders of PFICs.

Nonqualified funds

The bill makes several modifications and clarifications to the rules applicable to PFICs that are not qualified electing funds.

The bill also repeals the Act's provision which denies U.S. corporate shareholders in PFICs that are not qualified electing funds benefit of the indirect foreign tax credit under section 902. Thus, if a U.S. corporation owns at least 10 percent of the voting stock in a PFIC, the corporation is treated as paying its share of the PFIC's foreign income taxes imposed on the earnings the PFIC distributes to the U.S. corporation. It is anticipated that appropriate adjustments to the section 902 rules will be made in the case of excess distributions.

The bill clarifies the determination of a taxpayer's holding period as it relates to receipt of an excess distribution. This clarification provides that a taxpayer's holding period is considered to end on the date of receipt of an excess distribution but only with respect to that distribution. Thus, the taxpayer's holding period in its stock to which the excess distribution is attributable does not end on the date of receipt of the excess distribution.

Qualified electing funds

The bill also modifies and clarifies the rules applicable to PFICs that are qualified electing funds.

The bill modifies the determination of a PFIC's earnings and profits in two respects. The first modification provides that earnings and profits are computed using the installment method of accounting (and the completed contract method of accounting and the LIFO inventory method, if applicable) if a PFIC is permitted to and in fact does use the method to compute its income. For example, if a PFIC uses the installment method of accounting in computing its income, U.S. investors' pro rata shares of income will take into account that method. This modification only affects earnings and profits for income inclusion purposes. Thus, it does not change earnings and profits for purposes of determining, for example, if a distribution is a dividend. The modification also provides, however, that, under regulations, if the earnings and profits arising from the installment method and considered deferred for income inclusion purposes are distributed prior to the year that they would otherwise be included in income (e.g., the year in which the installment receivable is collected), those earnings are not to be included in income in the later year. This latter rule is necessary to eliminate the potential for double taxation of those earnings.

The second modification applies only when the qualified electing fund is also a controlled foreign corporation and the U.S. investor in the fund is also a U.S. shareholder in the controlled foreign corporation (as both terms are defined under subpart F). Under this modification, if the U.S. investor establishes to the satisfaction of the Secretary that an item of income derived by a fund was subject to an effective rate of income tax imposed by a foreign country greater than 90 percent of the maximum rate of U.S. corporate tax, then that item of income is excluded from the ordinary earnings and net capital gain income of the fund for purposes of determining the U.S. investor's pro rata share of income. It is anticipated that, as with the parallel rule in subpart F (sec. 954(b)(4)), regulations will be prescribed to allow grouping of items of income in appropriate cases. It is further anticipated that regulations will be prescribed to segregate earnings between earnings that have been included currently in income and earnings that have not been so included (because they are highly taxed) and to prescribe ordering rules for characterizing distributions of these earnings.

The bill also provides regulatory authority to insure that the same item of income of a qualified electing fund will not be included in the gross income of a U.S. person more than once. One case where relief is anticipated is where a U.S. person owns stock in a foreign corporation that is a PFIC and a controlled foreign corporation, and the foreign corporation in turn owns stock in a second foreign corporation that is not a PFIC but is a controlled foreign corporation. For example, assume in this case that the PFIC elects to be a qualified electing fund, the U.S. person's stock ownership in both foreign corporations is such that it is a U.S. shareholder in the corporations, and the second-tier controlled foreign corporation derives subpart F income that is included currently in the income of the U.S. person. Under the Act, when the second-tier controlled foreign corporation distributes its earnings, the PFIC's ordinary earnings, which will be included in the U.S. person's income as well as any other U.S. investors' incomes, will include the subpart F income that the U.S. person has included previously in income under subpart F, thus resulting in that income being included twice. In this case, it is intended that regulations coordinate these provisions to prevent the double inclusion. For example, regulations may provide that the subpart F income distributed by the second-tier controlled foreign corporation is, for income inclusion purposes, to be excluded from the qualified electing fund's ordinary earnings on a shareholder-by-shareholder basis.

The bill further modifies the Act's rules in characterizing income inclusions from qualified electing funds for foreign tax credit purposes. In the case of a qualified electing fund that is also a controlled foreign corporation, where the U.S. person that has the income inclusion is a U.S. shareholder in the corporation (as defined under the subpart F rules), look-through treatment determines the foreign tax credit limitation characterization of the income inclusion. In addition, where the qualified electing fund is a noncontrolled section 902 corporation (as defined in sec. 904(d)(2)(E)) with respect to the taxpayer, the income inclusion is treated for foreign tax credit purposes as a dividend, and thus, is subject to the separate limitation applicable to those dividends. Where neither of the above conditions is satisfied, the income inclusion is characterized as passive income for foreign tax credit purposes.

The bill also provides regulatory authority to allow the election to be a qualified electing fund to be made at a time later than the general time period required by the Act. This authority is limited, however, to cases where the foreign corporation failed to make a timely election because the corporation reasonably believed that it was not a PFIC for the year for which the election should previously have been made. A corporation may reasonably believe that it is not a PFIC for a taxable year, for example, where the corporation makes a reasonable valuation of its assets, which shows that the corporation does not meet the 50 percent passive asset threshold, while in a later year the Internal Revenue Service on audit determines that the corporation did meet the passive asset threshold. In this case, it may be appropriate for regulations to allow the corporation to make a retroactive qualified electing fund election.

The bill also delays the general time period by which an election to be a qualified electing fund must be made. Under this provision, the general time period by which to make the election shall in no event expire before 60 days after the date of the enactment of the technical corrections bill to the 1986 Act.

The bill provides for another event that terminates an extension of time to pay tax on undistributed PFIC earnings. This provision is designed to reflect the Act's policy that tax on an income inclusion should be payable when the shareholder receives the income from the PFIC. Under this provision, if the PFIC lends money or other property, directly or indirectly, to the U.S. investor, the loan is treated as a distribution and the extension of time to pay tax on the undistributed PFIC earnings to which the loan is attributable is terminated. In addition, the deemed distribution will, to the extent an actual distribution would not be taxed, reduce the shareholder's PFIC stock basis and the subsequent actual distribution of those earnings generally will be treated as a distribution that is not a dividend to the extent the shareholder establishes that fact with the Secretary. An indirect loan may occur under this provision where the PFIC lends property to a U.S. corporation in which the U.S. person owns, for example, a 50-percent interest. An indirect loan may also occur under this provision where the PFIC guarantees a loan by a third person to its U.S. investor or where the PFIC pledges its assets as surety for a loan by a third person to its U.S. investor.

Special rules applicable to both types of funds

The bill also modifies the Act's rule that allows a shareholder in a nonqualified fund to elect to recognize the gain inherent in the value of his or her stock owned in the PFIC where the PFIC becomes a qualified electing fund. Under this modification, instead of recognizing the entire gain in the value of his or her stock, a U.S. person that holds stock (directly or indirectly under the attribution rules) in a controlled foreign corporation (as defined for subpart F purposes) that is a PFIC and that becomes a qualified electing fund can elect to include in gross income as a dividend his or her share of the corporation's earnings and profits accumulated after 1986 and since the corporation was a PFIC. Upon this election, the U.S. person's stock basis is increased by the amount included in income and the shareholder is treated as having a new holding period in his or her stock. Thereafter, the shareholder is subject to the rules applicable to qualified electing funds. The bill also makes it explicit that the total amount treated as a dividend under the above election is an excess distribution and is to be assigned, for purposes of computing the deferred tax and interest charge, to the shareholder's stock interest on the basis of post-December 31, 1986 ownership.

The bill also provides regulatory authority for the Secretary not to treat the pledge of stock in a PFIC as a disposition of that stock. For example, it is anticipated that regulations may provide that a pledge in effect prior to 1987 shall not be treated as a disposition.

Second, the bill provides that, in the case of a PFIC that is a qualified electing fund and that owns stock in a second-tier PFIC that is also a qualified electing fund, amounts distributed by the second-tier fund to the first-tier fund that have been included previously in income by U.S. investors -- because they are deemed to own stock in the second-tier fund -- are not to be included in the ordinary earnings of the first-tier fund. This rule prevents U.S. persons from including amounts in income twice. This relief provision also applies in the case of a second- (or lower-) tier PFIC that is a qualified electing fund and that is also a controlled foreign corporation. In this case, amounts that are included in a U.S. person's income under the subpart F provisions and that would have been included under the qualified electing fund provisions (but for the coordination provision of sec. 951(f)) are prevented from being included in income again under this relief provision.

Third, in the case of a PFIC that is not a qualified electing fund, the bill eliminates the potential for double taxation by providing for proper adjustments to excess distributions for amounts that are taxed currently under the Code's other current inclusion rules. Thus, for example, excess distributions will not include any amounts that are treated as previously taxed income under section 959(a) when distributed by a controlled foreign corporation that is also a PFIC that is not a qualified electing fund.

The bill also makes clerical and conforming amendments to the Act's PFIC provisions.

(sec. 112(q) of the bill, sec. 1241 of the Reform Act, and secs. 26, 861, 884, 904, 906, and 2104 of the Code)

The Act imposed branch-level taxes on profits of foreign corporations operating businesses in the United States and on interest paid or deducted by U.S. businesses operated by foreign corporations. The Act also reduced the U.S. business threshold that triggers the withholding tax on dividends paid by foreign corporations (applicable where the branch profits tax cannot be applied).

Branch profits tax

A tax of 30 percent is imposed on a foreign corporation's "dividend equivalent amount." The "dividend equivalent amount" is the earnings and profits of a U.S. branch of a foreign corporation attributable to its income effectively connected (or treated as effectively connected) with a U.S. trade or business, subject to two adjustments (detailed below). The determination of effectively connected earnings and profits is made without reduction for dividend distributions made by a foreign corporation during a year, so that tax is imposed on a foreign corporation that has current earnings (which are not reinvested in a branch's trade or business, as detailed below).

In arriving at the dividend equivalent amount, a branch's effectively connected earnings and profits are adjusted in two circumstances. These adjustments identify changes in a branch's U.S. net equity (the difference between a branch's assets that are treated as connected with its U.S. trade or business and its liabilities that are so treated) that reflect profit remittances during a taxable year. The first adjustment to the dividend equivalent amount reduces the tax base to the extent the branch's earnings are reinvested in trade or business assets in the United States (or reduce trade or business liabilities). This reduction is measured by the increase in the U.S. net equity of the branch: the difference between (1) the excess of the money and adjusted basis of the branch's assets over its liabilities at the end of the year and (2) the excess of the money and adjusted basis of its assets over its liabilities at the end of the preceding year. The second adjustment increases the tax base to the extent prior reinvested earnings are considered remitted to the home office of the foreign corporation. This adjustment is measured by the reduction in the U.S. net equity of the branch: the difference between (1) the excess of the money and adjusted basis of the branch's assets over its liabilities at the end of the preceding year and (2) the excess of the money and adjusted basis of the branch's assets over its liabilities at the end of the year. The increase in the tax base because of a decrease in U.S. net equity was intended to be limited to the amount of prior earnings that have not previously been remitted to the home office.

For purposes of determining whether the tax on the excess interest is to be reduced or eliminated by treaty, the applicable income tax treaty is the one between the United States and the country of the corporation's home office, subject, however, to the prohibition against treaty shopping. In the case of U.S. withholding tax on interest actually paid by a branch to a foreign recipient, the appropriate treaty will be that between the United States and the country of the recipient, subject again to the prohibition against treaty shopping.

A foreign corporation generally is treaty shopping in two cases: First, treaty shopping occurs if more than 50 percent (by value) of the stock of the foreign corporation is owned (determined by looking through corporations, partnerships, estates, and trusts to ultimate individual ownership) by individuals who are not residents of the treaty country. U.S. citizens and resident aliens are treated as residents of the treaty country for this purpose.

Second, where 50 percent or more of a foreign corporation's income is used to meet liabilities to persons who are not residents of the country in which the corporation is a resident or of the United States, then the corporation is treaty shopping (a "base erosion" rule).

If a foreign corporation's stock is primarily and regularly traded on an established securities market in the country under whose treaty it claims benefits as a resident, then the corporation is considered a qualified resident of that country. Similarly, if a foreign corporation's parent is organized in the same country as its subsidiary corporation, and the parent corporation's shares are primarily and regularly traded on an established securities market in that country, then the subsidiary corporation is considered a qualified resident of the country for purposes of the country's treaty with the United States. Under the Act, the publicly-traded exception does not automatically treat a foreign corporation that is wholly owned by a U.S. corporation whose stock is primarily and regularly traded on an established securities market in the United States as a qualified resident of the country in which it is a resident. A domestic corporation in this instance has to determine (in addition to meeting the base erosion rule) if it is more than 50-percent owned by either U.S. residents or residents of the country of the domestic corporation's subsidiary in order to be treated as a qualified resident.

Other rules

The Act reduced to 25 percent prior law's business income threshold for imposition of the withholding tax on dividends. The Act also provided that the withholding tax on dividends is not applicable where the branch profits tax generally may be imposed, even though no branch tax may be due in a particular taxable year.

For U.S. branches of foreign corporations that have undistributed accumulated earnings and profits as of their first taxable year beginning on or after January 1, 1987, the branch profits tax provisions are intended to apply only to earnings and profits generated in taxable years beginning after December 31, 1986, that are considered distributed from the branch to the home office (limited by post-effective date earnings and profits). Prior law's withholding tax on dividends is intended to apply to the pre-effective date accumulated earnings and profits that are distributed after the effective date. Thus, if a branch's income did not constitute at least 50 percent of the corporation's income for the base period prescribed under prior law, there is no withholding tax imposed on dividends paid in, for example, 1987 that represent pre-effective date earnings. Similarly, pre-effective date deficits in earnings and profits are not intended to be eligible to reduce post-effective date earnings in applying the branch profits tax. Post-effective date deficits in earnings and profits do not reduce pre-effective date earnings in applying prior law's withholding tax to distributions after 1986 where the distributions are attributable to pre-effective date earnings.

The bill clarifies that the dividend equivalent amount is limited to the post-1986 accumulated effectively connected earnings and profits of the U.S. branch that have not previously been remitted to the branch's home office.

The bill provides that for purposes of determining a foreign corporation's dividend equivalent amount, effectively connected earnings and profits do not include the increase in earnings and profits under the discounting fresh start provision of the Act. (See Part XII.C.2., above, for further discussion of the fresh start provision.) Thus, the one-time increase in current earnings and profits of a foreign corporation under that provision will not result in any increase in branch tax. Moreover, the bill excludes from the dividend equivalent amount earnings and profits arising from the adjustment that was required by the Act to the unearned premium reserves outstanding at the end of the most recent taxable year beginning before January 1, 1987. (See Part X.3., above, for further discussion of this adjustment.)

The bill also modifies the taxation of interest paid by a U.S. trade or business. First, the bill excludes interest paid by international organizations (as defined in sec. 7701(a)(18)) from the scope of the provision. Second, to the extent provided in regulations, the bill will limit U.S. sourcing, and hence U.S. withholding, to the amount of interest reasonably expected to be deducted in arriving at the branch's effectively connected taxable income.

More importantly, however, Congress was concerned that foreign persons resident in one country would attempt to use another country's tax treaty with the United States to avoid the branch profits tax. The bill addresses this concern by not allowing treaties to prevail in treaty shopping cases.

The bill clarifies that the prohibition against treaty shopping of a foreign corporation with respect to interest paid or deducted by its U.S. trade or business applies to any person attempting to claim benefits under the interest articles of the treaty of the country in which that foreign corporation is a resident. The bill continues to allow, however, the recipient to claim benefits under the treaty in the country in which the recipient is a resident, unless the recipient is treaty shopping as well.

The bill modifies the definition of treaty shopping in two respects. First, the bill provides that if nonresidents of a treaty country own 50 percent or more of the value of stock of a corporation the corporation is considered treaty shopping. This modification generally accords with the ownership limitation in recent U.S. income tax treaties. Second, the bill modifies the publicly traded exception to treaty shopping to provide that a foreign corporation that is wholly owned by a domestic corporation whose stock is primarily and regularly traded on an established securities market in the United States is to be treated as a qualified resident of its country of residence. This modification accords with the Act's presumption that corporations whose stock is primarily and regularly traded on a local securities market is more than 50 percent owned by local residents and with the Act's treatment of U.S. persons as treaty-country residents.

Other rules

The bill clarifies that the withholding tax on dividends is not imposed for any taxable year with respect to dividends paid out of earnings and profits of the corporation for that year if the branch profits tax may be imposed for that year (even if no branch profits tax may be due in that year). Thus, the withholding tax on dividends may be imposed in two cases. First, the withholding tax may be imposed on dividends that are attributable to pre-1987 earnings and profits. Second, the withholding tax may be imposed on dividends that are attributable to any earnings and profits when the branch profits tax is prohibited by a treaty with the United States, regardless of when the dividends are distributed. Thus, in this latter case, the withholding tax on dividends may be imposed in a year a foreign corporation is subject to the branch profits tax if the dividends are attributable to years in which the branch tax is prohibited, for example, by a treaty.

The bill also makes clerical and conforming amendments.

2. Excise tax on insurance premiums paid to foreign insurers and reinsurers

(sec. 112(q)(13) of the bill and sec. 4373 of the Code)

Present law (sec. 4373) provides exemptions from the excise tax in the case of policies signed or countersigned by an officer or agent of the insurer in a State or the District of Columbia, within which such insurer is authorized to do business.

The excise tax may be waived under certain U.S. tax treaties, as it is in the United States-United Kingdom Income Tax Treaty and the United States-France Tax Treaty. Although premiums received by certain persons may be exempt from the excise tax (whether by treaty or by statutory exception), such exceptions generally do not waive the excise tax for subsequent reinsurance transactions covering insurance of U.S. risks under which premiums are paid to and received by a nonexempt person. The U.S.-U.K. treaty does not follow this latter approach, however.

This provision is effective for premiums paid after 30 days after the date of enactment. No inference is intended about the effect of this provision on existing law.

3. Treatment of deferred payments and appreciation arising out of business conducted within the United States

(sec. 112(r) of the bill, sec. 1242 of the Reform Act, and sec. 864(c) of the Code)

A foreign corporation engaged in a trade or business during the taxable year is taxable on a net basis on its income which is effectively connected with the conduct of a trade or business within the United States (sec. 882(a)). The same treatment applies to nonresident alien individuals (sec. 871(b)).

4. Withholding tax on amounts paid by partnerships to foreign partners

(sec. 112(s) of the bill, sec. 1246 of the Reform Act, and secs. 872, 882, and 1446 of the Code)

Prior to the Act, partnerships that conducted a trade or business in the United States generally were not required to withhold U.S. tax on distributions to foreign persons that were attributable to the U.S. business income of the partnership. Under the Act, however, partnerships must withhold in these circumstances. This withholding requirement supplements other withholding requirements applicable to certain generally passive types of U.S. source income derived by partnerships that have foreign partners.

Under the Act, the following withholding rules apply to distributions to foreign partners in U.S. or foreign partnerships that have any income effectively connected with the conduct of a U.S. trade or business. First, withholding at 30 percent (sometimes reduced or eliminated under treaties) is required with respect to distributions attributable to certain U.S. source fixed or determinable annual or periodical income not effectively connected with the conduct of a U.S. trade or business. It is intended that any distribution by the partnership be considered to come first out of these types of income received by the partnership.

Second, any partnership distribution in excess of the amounts described immediately above is subject to withholding at a 20-percent rate. The amount withheld is creditable against the U.S. income tax liability of the foreign partner. Amounts withheld in excess of a foreign person's tax liability are treated as an overpayment of tax.

Third, if a partnership's gross income effectively connected with a U.S. trade or business over a three-year period (or shorter period if the partnership is not in existence for three years) is less than 80 percent of the total gross income of the partnership over that period, then withholding is required only on the proportion of current distributions that the partnership's gross income effectively connected with its U.S. trade or business bears to the partnership's total gross income over its previous three taxable years (or shorter period if the partnership is not in existence for three years).

Fourth, the Act provides that, unless otherwise provided in regulations, withholding is not required if substantially all of the U.S. source income and substantially all of the income effectively connected with a partnership's U.S. trade or business is allocable to U.S. partners pursuant to a valid special allocation under section 704(b) and the regulations thereunder. This provision exempting amounts from withholding is not intended to apply to a partnership which has only U.S. source income and in which foreign persons hold only a minority interest such that, on a straight allocation, "substantially all" of the partnership's income could be considered to be allocated to U.S. persons. Instead, it is intended to apply only to a partnership which specially allocates its U.S. source income to U.S. persons and its foreign source income to foreign persons.

Taxation of foreign persons

Nonresident alien individuals and foreign corporations generally are subject to U.S. tax only on their gross income which is derived from U.S. sources and which is not effectively connected with the conduct of a trade or business in the United States and on their gross income which is effectively connected with the conduct of a trade or business in the United States (secs. 872(a) and 882(b)). United States tax on the former type of gross income generally is collected by withholding whereas U.S. tax on the latter type of gross income generally is collected by the filing of a U.S. tax return and payment of estimated taxes.

The bill replaces the Act's withholding provision with a provision imposing U.S. withholding tax on partnerships in amounts equal to U.S. tax on foreign partners' distributive shares of effectively connected income. Because the Act has the potential to impose a withholding tax on distributions that include little, or in some cases no, income that would be subject to U.S. tax, a provision that accomplishes the objectives of the Act more accurately and that results in less over-withholding is more appropriate.

The bill provides that if a partnership, whether domestic or foreign, has "effectively connected taxable income" for any taxable year, and any of this income is allocable to any foreign partner under section 704, the partnership shall pay a withholding tax in the manner and at the time prescribed by regulations. The amount of the withholding tax is the applicable percentage (which is dependent on the corporate or noncorporate status of the foreign partners) of the effectively connected taxable income of the partnership that is allocable to foreign partners. For this purpose, the applicable percentage is the highest rate of U.S. tax to which each foreign partner is subject.

The bill provides that effectively connected taxable income is the partnership's taxable income, as computed under Subchapter K, with the following adjustments: (1) items that normally are separately stated for Subchapter K purposes (i.e., items described in sec. 702(a)) are included if they give rise to income that is effectively connected (or is treated as effectively connected); (2) the partnership is allowed a cost depletion deduction; and (3) any other item of income, gain, loss, or deduction is not taken into account to the extent the item is included in the distributive share of any U.S. partner. (Since this withholding tax is being computed and imposed at the partnership level, any other deduction, such as percentage depletion, that is not taken into account in arriving at effectively connected taxable income that a foreign partner is entitled to can still be claimed by the foreign partner.)

The bill further provides that each foreign partner is to treat its share of the tax paid by the partnership as a credit against its tax liability for the partner's taxable year in which (or with which) the partnership's taxable year (for which the tax was paid) ends. Moreover, the amount of credit allocable to a foreign partner is treated as distributed to the partner on the last day of the partnership's taxable year for which the tax was paid, thus reducing the partner's basis in the partnership.

Further, the bill provides the Secretary the authority to prescribe regulations necessary to carry out the purposes of the provision. For example, special rules may be necessary in identifying a publicly traded partnership's partners as U.S. or foreign. In addition, rules may be necessary in the case of tiered partnerships to prevent the imposition of more tax than will be properly due (for example, rules to prevent the tax from being imposed on more than one partnership and rules to determine the applicable percentages).

The bill's provisions are effective for taxable years beginning after December 31, 1987. Any amount that would otherwise be required to be deducted and withheld under section 1446 is no longer so required.

Taxation of foreign persons

The bill clarifies the meaning of gross income for nonresident alien individuals and foreign corporations. Under the bill, sections 872(a) and 882(b) are modified so that, for those persons, unless the context clearly indicates otherwise, gross income includes only gross income which is derived from sources within the United States and which is not effectively connected with the conduct of a trade or business within the United States, and gross income which is effectively connected with the conduct of a trade or business within the United States. For example, when the taxpayer at issue is a nonresident alien individual or a foreign corporation, gross income subject to direct U.S. income tax includes only that gross income which is derived from U.S. sources and which is not effectively connected with the conduct of a U.S. trade or business and that gross income which is effectively connected with the conduct of a U.S. trade or business.

5. Income of foreign governments

(sec. 112(t) of the bill, sec. 1247 of the Reform Act, and secs. 892 and 893 of the Code)

In certain cases, wages, fees, or salary of an employee of a foreign government received as compensation for official services to such government is excluded from gross income and is exempt from income taxation (sec. 893).

In addition, the bill clarifies that the Code's exclusion from gross income and exemption from taxation do not apply to income received indirectly from a controlled commercial entity (as well as to income received directly from such an entity). For example, assume that a foreign government owns all the shares of a U.S. holding company that owns all the shares of a U.S. operating company. The U.S. holding company deducts all the dividends it receives from the operating company by virtue of the 100-percent dividends received deduction. Under the bill, dividends from the holding company to the foreign government are not exempt, because they are received indirectly from a controlled commercial entity.

The bill codifies the rule that a foreign government, for income tax treaty purposes, is treated as a corporate resident of its country if it grants equivalent treatment to the U.S. government. In addition, for purposes of the Internal Revenue Code, a foreign government is treated as a corporate resident of its country (whether or not it treats the U.S. government as a U.S. resident).

The bill conforms the gross income exclusion and tax exemption for wages, fees, or salary of an employee of a foreign government to the exclusion and exemption for governments themselves. Under the bill, the exclusion and exemption are not available to an employee of a foreign government whose services are primarily in connection with a commercial activity (whether within or outside the United States) of the foreign government, or to any employee of a controlled commercial entity of a foreign government.

6. Dual resident companies

(sec. 112(u) of the bill, sec. 1249 of the Reform Act, and sec. 1503 of the Code)

The bill also provides that the Secretary shall prescribe such regulations as may be necessary or appropriate to prevent the avoidance of the dual consolidated loss provision by a contribution of assets to the corporation with the dual consolidated loss after the corporation sustained it. This provision is designed to protect the integrity of the Act's rule that prevents the income generated by assets of one related corporation from being offset by losses incurred with respect to assets of another related corporation, the losses of which were also within another country's tax jurisdiction. Under the Act, a U.S. corporation with a dual consolidated loss can use that loss to offset income generated by its assets only, and cannot use that loss to offset income generated by assets of affiliates. This provision of the bill should prevent an affiliate from transferring assets the income of which could not be sheltered under the Act to the company that has the dual consolidated loss in an attempt to shelter those assets' income. On the other hand, the provision is not designed to prevent the replacement of existing assets, for example, in the case of a corporation operating a trade or business that replaces its assets because of depreciation.

1. Foreign currency translation

Subpart J of the Code, as added by the Act, provides rules for the translation of foreign income taxes that enter into various computations involving the foreign tax credit. Foreign income taxes are defined for purposes of subpart J as any income, war profits, or excess profits taxes paid to any foreign country or any possession of the United States. For foreign tax credit and foreign tax deduction purposes, income, war profits, and excess profits taxes include a tax paid in lieu of a tax on income, war profits, or excess profits otherwise generally imposed by any foreign country or by any possession of the United States.

Generally for purposes of computing either the direct or indirect foreign tax credit, the amount of foreign income taxes paid to a foreign government or U.S. possession is translated, under subpart J, using the exchange rate in effect as of the time of payment; any refund or credit of a foreign income tax is translated using the exchange rate in effect as of the time of the original payment; and any increase in the amount of a foreign income tax is intended to be translated using the exchange rate in effect when the increase is paid. (Congress did not intend the payment date rule to prevent the allowance of a credit based on accrued foreign taxes where those taxes are unpaid when the credit must be computed.)

Translation of section 956 income inclusions

On the actual distribution of earnings and profits from a foreign corporation to a U.S. taxpayer, the latter is required to translate such amounts (if necessary) at the current exchange rate on the date the distribution is included in income. In the case of deemed distributions under section 951(a) of subpart F, the required income inclusion is first calculated in the functional currency and then translated at the weighted average exchange rate for the foreign corporation's taxable year. The Secretary may adjust these translation rates by regulation.

Where earnings of a controlled foreign corporation are repatriated, the Code generally aims at achieving similar tax results whether the repatriation is in the form of a dividend or of an increase in investment in U.S. property (see secs. 951(a)(1)(B) and 956). However, the translation rules described above provide for computing translation rates differently depending on the form of repatriation. Congress did not intend to provide taxpayers their choice of tax results based on translation method where a similar economic result is achieved in either case.

The bill clarifies that in applying the foreign income tax translation rules of new subpart J (as well as the other foreign provisions of the Code), foreign taxes imposed in lieu of income taxes are treated the same as foreign income taxes.

The bill also clarifies that the exchange rate to be used for determining the dollar cost of any payment of foreign income tax (including a payment constituting an adjustment to a payment of foreign tax) is the exchange rate as of the time the taxes are paid to the foreign country or U.S. possession. The bill applies this rule whether the entity paying the tax to the foreign government or U.S. possession is the taxpayer or (as in the case where the taxpayer claims an indirect foreign tax credit) a corporation of which the taxpayer is a shareholder, and whether or not the tax is paid by a qualified business unit.

Translation of section 956 income inclusions

The bill provides that subpart F inclusions under section 951(a)(1)(B), relating to increases in investments in U.S. property, are to be translated at the same rates as actual distributions made on the last day of the taxable year, i.e., using the spot rate on that day. This reduces the opportunity for taxpayers to manipulate tax liability based on the foreseeable difference between the weighted average annual rate and the spot rate as of the date when earnings repatriation is to occur. The Secretary retains authority to further adjust translation rates, under regulations, where regulatory adjustments can usefully promote the aim of achieving similar translation results regardless of whether the repatriation takes the form of dividends or investments in U.S. property.

2. Foreign currency transactions

Section 988(c) defines the term "section 988 transaction" to include, among other things, (1) the acquisition of (or becoming the obligor under) a debt instrument, (2) the disposition of nonfunctional currency, and (3) entering into or acquiring any forward contract, futures contract, option, or similar financial instrument (such as a currency swap), if such instrument is not marked to market at the close of the taxable year under section 1256. Congress did not intend to change generally the treatment of bank forward contracts, regulated futures contracts, or other contracts subject to the mark-to-market rule under section 1256. Therefore, Congress intended to exclude such instruments from the definition of a section 988 transaction.

Measurement and recognition of foreign currency gain or loss

Section 988(b) defines foreign currency gain or loss as gain or loss on a section 988 transaction, but only to the extent the gain or loss is realized by reason of a change in exchange rates between the booking date with respect to that transaction and the payment date of the transaction. In the case of any disposition of nonfunctional currency, the relevant period for measuring rate changes is the time between acquisition and disposition of the currency.

For transactions involving forward contracts or similar positions, the booking date is the date on which the position is entered into or acquired; the payment date includes the date on which a taxpayer's rights are terminated with respect to the position (e.g., by entering into an offsetting position). The definition of foreign currency gain or loss is intended to apply to gain or loss attributable to exchange rate movements between those dates affecting the value of forward contracts or similar instruments, regardless of the particular transaction in which the gain or loss is realized.

The Secretary has general authority to provide the regulations necessary or appropriate to carry out the purposes of new subpart J. For example, where a debt instrument, the acquisition of which is a section 988 transaction, is converted to stock, the sale of which is not a section 988 transaction, the Act gives the Secretary the authority to prevent any foreign currency gain inherent in the debt instrument from escaping subpart J treatment.

Section 988 hedging transactions

The Act authorizes the issuance of regulations that address the treatment of transactions that are part of a section 988 hedging transaction. To the extent provided in regulations, in the case of any transaction giving rise to foreign currency gain or loss that is part of a section 988 hedging transaction (determined without regard to whether any position in the hedge would be marked to market under section 1256), all positions in the hedging transaction are integrated and treated as a single transaction, or otherwise treated consistently (e.g., for purposes of characterizing the nature of income or the sourcing rules). In the case of a foreign currency borrowing fully hedged with a series of forward purchase contracts, for example, Congress intended that regulations treat the entire package as a dollar borrowing with dollar interest payments subject to the rules of section 1271 et seq. and section 163(e) for determining the appropriate interest deduction.

Sourcing rules

In general, foreign currency gain is sourced, and foreign currency losses are allocated, by reference to the residence of the taxpayer or qualified business unit on whose books the underlying financial asset or liability is properly reflected. For purposes of these rules, an individual's residence is defined as the country in which the "tax home" (as defined in sec. 911(d)(3)) is located. The residence of any U.S. person (as defined in sec. 7701(a)(30)) other than an individual is the United States. In the case of a foreign corporation, partnership, trust, or estate, the residence is treated as a foreign country.

The Secretary has authority to prescribe regulations carrying out the purposes of the Act's currency sourcing provisions as well as regulatory authority under the rules introduced by the Act for determining generally the source of income derived from the sale of personal property. Under the latter it was contemplated that regulations may be required to prevent persons from establishing partnerships or corporations, for example, to change their residence to take advantage of the new rules. It was anticipated that the establishment of an anti-abuse rule to treat, for example, a foreign partnership as a U.S. resident to the extent its partners are U.S. persons would be appropriate.

The bill provides that if a forward contract, futures contract, option, or similar financial instrument would have been marked to market under section 1256 were it held on the last day of the taxable year, then the instrument is not a "section 988 transaction" even if it is not actually marked to market under section 1256 at the close of the taxable year. This amendment clarifies that taxpayers who acquire 1256 contracts cannot elect 988 rules for characterizing, timing, and sourcing or allocating the income or loss on such contracts simply by disposing of the contracts prior to the last day of the taxable year.

Measurement and recognition of foreign currency gain or loss

The bill provides that any gain or loss from a section 988 transaction is a foreign currency gain or loss if the transaction is a disposition of nonfunctional currency or a forward contract, futures contract, option, or similar financial instrument with respect to a nonfunctional currency. This makes it clear that any gain or loss on such an instrument due to forward premium or forward discount is subject to the Act's rules for foreign currency gains and losses, regardless of movements in the spot rates of exchange between the booking and payment dates. Further, any gain or loss on a nonfunctional currency disposition is foreign currency gain or loss regardless of whether the difference between acquisition and disposition prices is due to spot rate movements between acquisition and disposition dates, forward discount or premium, bid-asked spreads, or other factors.

The bill provides that making or taking delivery under a section 988 transaction that is a forward contract, futures contract, option, or similar financial instrument is a gain or loss recognition event (cf. sec. 1256(c)). This rule prevents taxpayers from opting for alternate treatment on such a transaction by selling or otherwise closing out the position, on the one hand, or taking or making delivery, on the other. Under a transitional provision, this rule will not change the treatment of deliveries taken by a taxpayer on or before the date of the bill's introduction.

Where an option or similar instrument gives its owner the right to make or take multiple deliveries of currency at different times during the life of the instrument, it is intended that the bill's recognition rule will generally treat the taxpayer as having sold an instrument representing that portion of the rights exercised at the time a particular delivery under the instrument is made or taken. It is anticipated that the Secretary will exercise his regulatory authority under subpart J to provide rules for the allocation of any basis in the instrument for these purposes, to prevent the artificial acceleration of loss in such a case, and to impose any other requirements necessary or appropriate to carry out the purposes of the bill's recognition rule.

Section 988 hedging transactions

The bill provides that where all transactions that are part of a section 988 hedging transaction are integrated and treated as a single transaction or otherwise treated consistently under regulations, such treatment applies for purposes of all provisions in subtitle A of the Code. Thus the bill makes clear Congress's intent that Code provisions other than section 988 are to be applied to the components of a section 988 hedging transaction in their integrated or otherwise combined state (where regulations provide for such integration or combination).

Sourcing rules

For purposes of the currency sourcing rules as well as the general source rules for income derived from the sale of personal property, the bill treats any U.S. citizen or resident alien as a U.S. resident if he or she does not have a tax home in a foreign country. Thus the bill prevents such an individual from being treated as a nonresident if he or she has no tax home (which may be the case, for example, for a traveling salesperson).

The bill also clarifies that the Secretary's regulatory authority to determine the source of foreign currency gains encompasses authority to determine the source of a partnership's foreign currency gains by reference to the residence of the partners. It is anticipated that this authority will be exercised where necessary to prevent persons from establishing partnerships to change their residence to take advantage of the new rules.

The Act contains a new provision coordinating U.S. and Virgin Islands income taxes (Code sec. 932). That Code section does not apply for purposes of determining income tax liability incurred to the Virgin Islands. The intent of Congress in not having that provision apply for V.I. tax purposes was to prevent any argument that 48 U.S.C. 1397 (the provision of the Naval Appropriations Act of 1922 that holds the U.S. income tax laws, as amended, to be "likewise in force in the Virgin Islands") or the Revised Organic Act of the Virgin Islands could require "mirroring" of the new coordination provision for internal Virgin Islands purposes.

Treatment of Virgin Islands residents

The Act provides that in the case of an individual who is a bona fide resident of the Virgin Islands at the close of the taxable year and who, on his or her return of income tax to the Virgin Islands, reports income from all sources and identifies the source of each item shown on such return, for purposes of calculating income tax liability to the United States, gross income shall not include any amount included in gross income on the V.I. return. The Act indicates that such an individual is to file his income tax return with the Virgin Islands.

Effective date of prohibition of branch tax

The provisions of the Act applicable to Guam, American Samoa, and the Northern Mariana Islands generally apply only if and so long as an implementing agreement under Act section 1271 is in effect between the United States and such possession. The Act provides that for certain corporations created or organized in Guam, American Samoa, the Northern Mariana Islands, or the Virgin Islands, the branch tax does not apply. This provision is to be mirrored, so that the branch tax does not apply to U.S. corporations with operations in any of those possessions.

The bill provides that in applying Code section 932 (the provision coordinating U.S. and Virgin Islands income taxes) for purposes of determining income tax liability incurred to the Virgin Islands, the provisions of section 932 are not to be affected by any provision of Federal law described in section 934(a), i.e., the Naval Appropriations Act or the Revised Organic Act. Thus, while there is not to be "mirroring" of this provision, this provision, insofar as it determines the taxable income of Virgin Islands residents, has effect for V.I. tax purposes.

Treatment of Virgin Islands residents

The bill adds to the bona fide resident requirement and the reporting requirement a third requirement for exclusion of items reported on a V.I. return. That further requirement is that the individual seeking the exclusion fully pay his or her tax liability (referred to in sec. 934(a)) to the Virgin Islands with respect to income from all sources. In addition, the bill provides that in the case of an individual whose gross income excludes amounts included on a V.I. return, allocable deductions and credits are not to be taken into account. The bill also makes it clear that such an individual is to file "an" income tax return with the Virgin Islands, rather than filing "his" return with the Virgin Islands, to make it clear that individuals who do not comply with all requirements for U.S. tax exemption will have to file a U.S. return.

Effective date of prohibition of branch tax

The bill makes it clear that the rule prohibiting the imposition of the branch tax on certain corporations organized in the possessions (and thus the prohibition of imposition of the branch tax by a possession on a U.S. corporation) applies for taxable years beginning after December 31, 1986.

(sec. 112(aa) of the bill, Title VII and Title XII of the Reform Act, and sec. 7852 of the Code)

In a number of respects, the Act (and its legislative history) did not specifically address its interaction with U.S. treaties. Many recent tax Acts, by contrast, have specifically addressed interaction with treaties. "[I]n the interest of forestalling any possible litigation," the Revenue Act of 1962 expressly provided that it took precedence over any prior treaty obligation (H.R. Rep. No. 1447, 87th Cong., 2d Sess. 96 (1962); Pub. L. No. 87-834, sec. 31). One major conflict between that Act and treaties, not identified in the legislative history of that Act, was the conflict between the Act's separate foreign tax credit limitation for interest income and treaties that (at least literally) required the United States to retain the foreign tax credit limitation rules that it used at some earlier date.

The Foreign Investors Tax Act of 1966 took the opposite approach. Although that Act reduced the burdens on foreign investors and thus no treaty violations were found, the Act (sec. 110) specifically provided that it did not apply in any case where its application would be contrary to any U.S. treaty obligation. In more recent years, Congress has specifically indicated that it intended that tax Acts prevail over treaties in the case of conflicts. Congress took this approach with respect to the foreign tax credit changes in the Tax Reform Act of 1976 (H.R. Rep. No. 94-658, 94th Cong., 2d Sess. 226 (1975); S. Rep. No. 94-938, 94th Cong., 2d Sess. 237 (1976)) and with respect to the Crude Oil Windfall Profit Tax Act of 1980 (H.R. Rep. No. 96-817, 96th Cong., 2d Sess. 106 (1980) (conference report)). In connection with the Deficit Reduction Act of 1984, Congress resolved certain conflicts in favor of treaties but indicated that, in the event of unidentified treaty conflicts, the legislation is to prevail (see description of technical corrections made to the 1984 Act by the 1986 Act, H.R. Rep. No. 99-426, 99th Cong., 1st Sess. 917 (1985); S. Rep. No. 99-313, 99th Cong., 2d Sess. 935 (1986)).

The bill clarifies the interaction between the 1986 Act and provisions of U.S. treaties. The bill provides that the following provisions of the 1986 Act will not apply to the extent that their application would be contrary to any income tax treaty obligation of the United States in effect on the date of enactment of the 1986 Act (October 22, 1986): section 123 of the Act (imposing tax on certain scholarship and fellowship grants); subsections (b) and (c) of section 1212 of the Act (imposing a 4-percent gross withholding tax on certain transportation income earned by foreign persons and amending the rules that allow a reciprocal exemption for certain transportation income earned by foreign persons); section 1247 of the Act (relating to the exemption that the United States provides to foreign governments in some cases); and section 1242 of the Act insofar as it relates to new Code section 864(c)(7) (treating gain from sale of assets used in a U.S. trade or business as effectively connected income after cessation of the trade or business in certain cases). In addition, in the event of conflict with an income tax treaty, the source rules of section 1212(a) of the Act (governing the source of certain transportation income) and of section 1214 of the Act (governing the source of payments from 80/20 companies) will not apply except for purposes of the foreign tax credit limitation. Further, the provisions of section 1241 of the Act that relate to new Code section 884(f)(1)(A) (to the extent that that provision treats interest paid in excess of interest deducted as U.S. source) and to Code section 861(a)(2)(B) (reducing the fraction of U.S. income that exposes a foreign corporation to U.S. withholding tax on dividend payments it makes) will not apply in the event of a treaty conflict. In addition, in the event of conflict with an income tax treaty, the source rules of section 1211 of the Act (determining the source of income from certain sales of personal property) will not apply to individuals treated as residents of a treaty country under a U.S. treaty.

Moreover, to the extent that the source rule of Code section 865(e)(2) conflicts with a U.S. income tax treaty, the bill provides that the treaty will prevail. A conflict may arise with this source rule because, under the Act, income derived by a foreign person from the sale of inventory property that is attributable to a U.S. office is U.S. source. This result occurs even though the sale may occur outside the United States and a foreign country may tax the sale on a source basis. By contrast, a U.S. resident who sells inventory property outside the United States may not pay any U.S. tax on the income because the income is considered foreign source. Thus, the nonresident may incur more burdensome taxation than a similarly situated U.S. resident. If this occurs, the bill allows a nonresident with nondiscrimination protection to treat this income as foreign source.

Moreover, the bill provides that the Act's imposition of tax in certain cases on "excess interest" (i.e., the amount of a foreign corporation's U.S. interest deduction in excess of the amount of interest its U.S. trade or business has paid) will not apply in the event of a treaty conflict.

The bill's amendments to Act section 1211, described in Part XII. B.1., above, provide a coordination rule for cases where sales of stock and certain intangibles yield foreign source income under an income tax treaty and U.S. source income under new Code section 865.

The bill provides that the following provisions of the 1986 Act will apply notwithstanding any treaty provision in effect on the date of enactment of the 1986 Act (October 22, 1986): section 1201 of the Act, amending the foreign tax credit limitation, and section 701 of the Act (as it relates to the limitation on the use of foreign tax credits against minimum tax liability).

Except for cases that have been identified in the bill or in the Act, no cases are known where a harmonious reading of the Act and U.S. treaties is not possible. Congress intended harmonious construction of the Act and U.S. income tax treaties to the extent possible. Thus, in some cases, despite the existence of technical arguments alleging the existence of a conflict, it is understood that no conflict exists. For example, it is understood that no nondiscrimination provision of any U.S. treaty bars the application of reasonable collection mechanisms designed to ensure the collection of a tax, the imposition of which is permitted by the treaty. Thus, it is understood that the Act's partnership withholding provision and the bill's replacement provision (new Code sec. 1446), which allow for refunds in appropriate cases, constitute such a reasonable collection mechanism, and thus are fully consistent with existing U.S. treaty obligations.

Similarly, it is understood that the Act's imposition of tax on installment gains received after a foreign person ceases a U.S. trade or business (Act section 1242) is fully consistent with existing U.S. treaty obligations. Some treaties prevent imposition of U.S. tax on business profits of a foreign person unless those profits are attributable to a permanent establishment through which the foreign person carries on business in the United States. It is understood that these treaties do not prevent imposition of U.S. tax on income that was, when realized, attributable to a permanent establishment, even though that income is recognized after the permanent establishment no longer exists. Under a similar analysis, it is understood that the Act creates no conflict with treaties in taxing amounts earned for personal services in the United States which are paid after the person earning the income no longer maintains a U.S. presence.

Other Act provisions that are understood to be fully consistent with U.S. treaty obligations include the Act's dual residence company provisions (Act sec. 1249).

Similarly, requiring recognition of gain by a domestic corporation that is liquidating into a foreign parent corporation or engaging in a tax-free reorganization where the domestic corporation's assets are being removed from U.S. taxing jurisdiction does not violate any nondiscrimination clause. In some cases, provisions based on capital ownership prohibit imposition of more burdensome taxes on foreign-owned U.S. enterprises than on similar U.S.-owned U.S. enterprises. For this purpose, however, a U.S. enterprise transferring assets to a shareholder who will bear U.S. corporate level tax on the income generated by those assets is not similar to a U.S. enterprise transferring assets to a shareholder who will not bear U.S. corporate level tax on the income generated by those assets. Thus, the Act's provision recognizing gain in these cases (sec. 631(d)), and the bill's provision making modifications thereto, are fully consistent with U.S. treaty obligations. Nonetheless, in view of an Internal Revenue Service announcement (subsequently withdrawn) indicating that certain liquidations were treaty-protected, it is intended that the Reform Act's amendments to Code section 367(e)(2) not apply in the case of a corporation completely liquidated into a treaty-country parent before June 10, 1987, the date of the bill's original introduction.

If, in any of the cases described above where conflicts are understood not to exist, any treaty is somehow read to bar operation of the Act, the Act is to be effective notwithstanding the treaty.

Notwithstanding Congress' intent that the Act and income tax treaties be construed harmoniously to the extent possible, conflicts other than those addressed in this bill or in the Act ultimately may be found or alleged to exist. Therefore, to prevent any uncertainty and to prevent assertion of treaty claims whose merit is not now known, the bill provides that except as otherwise provided by the bill or the Act, the provisions of the 1986 Act will apply notwithstanding any treaty provision in effect on the date of enactment of the 1986 Act (October 22, 1986). It is believed that this residual later-in-time rule will lead to the early discovery of now-unknown treaty conflicts and to their appropriate resolution. If any such now-unknown conflict is ultimately found, it is expected that full legislative consideration of that conflict will take place to determine whether application of the general later-in-time rule is consistent with the spirit of the treaty (namely, to prevent double taxation by an agreed division of taxing jurisdiction, and to prevent fiscal evasion) and the proper expectations of the treaty partners.

If further conflicts requiring reversal of the later-in-time rule are found after enactment of this bill, retroactive liberalization will be appropriate. See, e.g., section 112(bb)(4) of this bill, reversing retroactively and application of the residual later-in-time rule applicable to the Deficit Reduction Act of 1984. Retroactive increases in tax burdens, by contrast, raise Constitutional issues. See, e.g., United States v. Darusmont, 449 U.S. 292 (1981).

It is noted that this residual later-in-time rule was a part of the introduced technical corrections bill in each House of Congress (H.R. 2636, S. 1350), and that during the legislative process considering this bill, a number of previously unknown treaty conflicts became known. It is believed that the residual later-in-time rule of the introduced bill may have encouraged taxpayers to raise potential conflicts that might have violated the spirit of U.S. treaty obligations. In any event, in each case where a conflict became known after original introduction of the bill, the bill provides that the treaty is to prevail. It is believed that, in view of this incentive to bring meritorious cases to light, the residual later-in-time rule may have allowed the identification of virtually all cases where there would have been an application of that rule that violates the spirit of a treaty, so that the residual later-in-time rule actually conflicts with treaties in very few if any inappropriate cases. It is believed that retention of the residual later-in-time rule will prevent assertion of hypertechnical treaty claims that have no basis in the spirit of the treaty.

In addition, except as indicated in this bill, the 1987 Budget Reconciliation Act or its legislative history, or in other portions of the legislative history of this bill, this bill and the 1987 Budget Reconciliation Act are understood not to conflict with any treaty. Again, should a conflict ultimately appear, the bill's and the Act's provisions are to take effect.

2. Foreign personal holding companies

(sec. 112(bb)(1) of the bill, sec. 1810(h) of the Reform Act, and secs. 551 and 552 of the Code)

United States shareholders in a foreign personal holding company (FPHC) are subject to current U.S. tax on their pro rata share of the company's undistributed FPHC income. The FPHC rules were enacted in 1937 to prevent U.S. taxpayers from accumulating income tax-free in foreign "incorporated pocketbooks."

In 1937 there was no statutory definition distinguishing estates and trusts that were U.S. taxpayers (for revenue act purposes in general) from those that were not. For purposes of the FPHC rules, an estate or trust was considered a "U.S. shareholder" in an FPHC unless gross income of the estate or trust for federal income tax purposes included only income from U.S. sources. Subsequently, the Code was amended to include generally applicable definitions of the terms "foreign estate" and "foreign trust." (Under current law, these terms mean an estate or trust, as the case may be, the income of which, from sources outside the United States which is not effectively connected with a U.S. trade or business, is not includible in gross income under the Code's income tax provisions (sec. 7701(a)(31)).)

The foreign personal holding company rules contain a tracing rule, added by the Tax Reform Act of 1984, to make it clear that U.S. taxpayers cannot avoid the FPHC rules by interposing foreign entities between themselves and a FPHC. The 1984 Act grants regulatory authority to the Secretary of the Treasury to provide for such adjustments in the FPHC rules as may be necessary to carry out the purposes of this tracing rule. The 1986 Act included a technical amendment to the tracing rule to clarify that the tracing rule applies to all foreign trusts and estates (as defined for Code purposes generally) interposed between U.S. taxpayers and FPHCs.

Same country dividend and interest exception

The 1984 Act provided that dividends and interest received by a foreign corporation from a person (1) related to the recipient, (2) organized in the same country as the recipient corporation, and (3) having a substantial part of its assets used in its trade or business located in that same country, generally do not count in either the numerator or the denominator of the fraction that is used in determining whether the foreign corporation is an FPHC. The 1986 Act provided a definition of related person for this purpose.

Under the bill, estates and trusts that are shareholders in an FPHC are U.S. shareholders for purposes of the FPHC rules unless they are foreign estates or trusts under the general Code definitions of those terms. The bill clarifies that the 1986 Act's amendment to the FPHC tracing rules treats estates and trusts as intervening foreign entities if and only if they are foreign estates and foreign trusts under the general Code definitions.

The bill provides that, in making adjustments to the tracing rules by regulation, the Secretary may impose rules similar to the rules of Code section 1297(b)(5) (as amended by the bill) applicable to passive foreign investment companies (PFICs). These rules will provide for similar treatment, under regulations, of distributions from FPHCs, on the one hand, and entities through which FPHC ownership is attributed, on the other. For example, where stock ownership in a FPHC is attributed to a U.S. person through an intervening entity, it is anticipated that regulations will treat distributions received by the intervening entity as being received by the U.S. person. These regulations will prevent reduction of FPHC income by virtue of distributions that result in no U.S. tax.

Same country dividend and interest exception

The bill makes amendments to the 1984 and 1986 Act provisions relating to the same country dividend and interest exception to FPHC income treatment. One such amendment defines a new term, "related person dividend or interest," as a same country dividend or same country interest of the type excluded from FPHC income under the 1984 Act. The bill restores related person dividend and related person interest to the denominator of the fraction used in determining whether a foreign corporation is an FPHC. The bill also restores FPHC income treatment of a related person dividend or interest if the dividend or interest is attributable to income of the related person which would be FPHC income.

Thus, for example, where the entire amount of a foreign corporation's income is related person dividends and related person interest, and in any taxable year some of that income, but less than 60 percent (assuming the corporation has never been an FPHC), is attributable to income of the related person which would be FPHC income, the bill prevents the foreign corporation from being treated as an FPHC.

Attribution of dividends and interest to income of the related person is to be determined under rules similar to the foreign tax credit look-through provisions for dividends and interest paid to a U.S. shareholder by a controlled foreign corporation. Under these rules, a dividend paid out of the earnings and profits of a corporation is to be treated by the recipient as FPHC income in proportion to the FPHC earnings and profits out of which the dividend was paid, divided by the total earnings and profits out of which the dividend was paid (cf. sec. 904(d)(3)(D)). Similarly, interest received or accrued from a corporation is to be treated as FPHC income to the extent properly allocable (under regulations prescribed by the Secretary) to FPHC income of the corporation (cf. sec. 904(d)(3)(C)).

All of the bill's provisions described above regarding foreign personal holding companies apply to taxable years of foreign corporations beginning after December 31, 1986.

3. Withholding on pensions, annuities and certain other deferred income

(sec. 112(bb)(2) of the bill, sec. 1234(b) of the Reform Act, and sec. 3405 of the Code)

In addition, the bill restricts automatic withholding under the Act to those benefits and payments that are delivered outside both the United States and its possessions. Thus, recipients of benefits and payments delivered in any U.S. possession would continue to be eligible to elect to forego withholding on the same terms available to taxpayers whose payments or benefits are delivered in the United States. These amendments would apply to distributions made after the date of the bill's enactment.

4. Information exchange

(sec. 112(bb)(3) of the bill, sec. 1876(e) of the Reform Act, and sec. 6103 of the Code)

In 1983, the Caribbean Basin Economic Recovery Act authorized the Secretary of the Treasury to negotiate and conclude bilateral and multilateral agreements for the exchange of information with designated "beneficiary countries" under the Caribbean Basin Initiative (CBI). Congress expected that these agreements would generally become effective on signature, without need of prior approval by the Senate. The Code treats these agreements with CBI beneficiary countries as income tax conventions for return and return information disclosure purposes.

The Compact of Free Association Act of 1985 gave approvals to compacts subsequently entered between the United States and the Federated States of Micronesia, the Republic of the Marshall Islands, and the Republic of Palau that provide for their self-government. Congress provided that under those compacts the Federated States of Micronesia, the Republic of the Marshall Islands, and the Republic of Palau would be treated as if they were U.S. possessions for purposes of the possessions tax credit (Code sec. 936), but that this treatment would not apply for any period after 1986 in which there is not in effect an exchange of information agreement of the kind described in the Caribbean Basin Economic Recovery Act. The Federated States of Micronesia, the Republic of the Marshall Islands, and the Republic of Palau are not CBI beneficiary countries.

The 1986 Act provided that a country may qualify as a host country for foreign sales corporations (FSCs) by entering into an exchange of information agreement of the type provided for in the Caribbean Basin Economic Recovery Act, whether or not that country is eligible to be a CBI beneficiary country.

In addition, the bill provides that the Federated States of Micronesia, the Republic of the Marshall Islands, and the Republic of Palau are not to be treated as "states" for purposes of the disclosure provisions of the Code. Thus, an authorized disclosure under a bilateral information exchange agreement between the United States and one of those governments will be subject only to the rules embodied in that agreement and the usual rules for information exchanges with foreign governments, and will not be subject to any additional rules that might apply to exchanges of tax returns and return information between the federal government and state governments or certain U.S. possessions.

5. Maintaining the source of U.S. source income

(sec. 112(bb)(4) of the bill, sec. 1810(a) of the Reform Act, and sec. 904(g) of the Code)

The 1984 Act added to the foreign tax credit new "resourcing" rules that prevent U.S. taxpayers from converting U.S. source income into foreign source income through the use of an intermediate foreign payee. These rules apply to 50-percent U.S.-owned foreign corporations only. They treat certain payments from, and income inclusions (e.g., under the subpart F anti-tax haven provisions) arising on account of, 50-percent U.S.-owned foreign corporations, as U.S. source.

The 1986 Act made it clear that the source maintenance rules apply notwithstanding any contrary U.S. treaty obligation.

6. Stock sales treated as asset sales

(sec. 112(bb)(5) of the bill and sec. 338 of the Code)

A sale of stock in a U.S. corporation is sourced under the residence-of-the-seller rule. By contrast, a sale of stock in a foreign corporation, or a sale of assets other than corporate stock, is sourced under the residence-of-the-seller rule, the place-of-sale rule, the rules relating to intangible property, the recapture rule, or the dividend rules, depending on the type of asset sold, the income generated therefrom and, in the case of stock in a foreign corporation, the earnings of the corporation. Thus, if an election under section 338 is made, the income of the seller or the selling consolidated group inherent in the appreciation of the stock may or may not be sourced under the residence-of-the-seller rule. This may result in income being treated as foreign source even though no foreign country asserts any jurisdiction over the income, a result contrary to the Act's source and foreign tax credit rule changes.

To the extent that any regulations prescribed under section 336(e) extend the principles of section 338 to a sale of stock in a foreign corporation, it is anticipated that those regulations will not affect inappropriately the determination of source and of a taxpayer's foreign tax credit limitation. For example, it is not appropriate to allow the conversion of foreign source passive income into overall limitation income on the sale of stock of a controlled foreign corporation by means of an election under section 338. It is intended that regulations ensure that the objectives of the Act's foreign tax credit limitation changes are preserved.

The bill's modification to section 338 is generally effective for qualified stock purchases that occur after the date of the bill's introduction. As it applies to elections under section 338(h)(10), however, the bill is effective for qualified stock purchases that occur after June 10, 1987.

7. Tax-exempt shareholders of DISCs

(sec. 112(bb)(6) of the bill and sec. 995 of the Code)

8. Treatment of certain amounts previously taxed under section 1248

(sec. 112(bb)(7) of the bill and sec. 959 of the Code)

Under the Tax Reform Act of 1984, a U.S. shareholder that purchases stock from a U.S. shareholder in a controlled foreign corporation is allowed to treat distributions received from the corporation as previously taxed income to the extent of the dividend income recognized by the seller (sec. 959(e)). Under this rule, a U.S. shareholder that purchases stock in a U.S. corporation that is formed principally to hold the stock of a controlled foreign corporation is entitled to the previously taxed income treatment, even though the U.S. corporation whose stock is sold is the actual shareholder in the controlled foreign corporation.

The bill's amendment is effective for transactions to which section 1248(e) applies and that occur after December 31, 1986.

9. Shared Foreign Sales Corporation (FSC)

(sec. 112(bb)(8) of the bill and secs. 922, 924, 927 of the Code)

1. Qualified small-issue bonds

Qualified small-issue bonds may be issued to finance manufacturing facilities through December 31, 1989. Authority to issue qualified small-issue bonds for nonmanufacturing facilities expired after December 31, 1986.

The Reform Act allows qualified small-issue bonds issued after August 15, 1986, to be refunded after the applicable sunset date of authority to issue the type of bond involved, if--

$40-million-per-beneficiary limit

Interest on small-issue bonds is not tax-exempt if the aggregate face amount of exempt-facility and qualified small-issue bonds (including equivalent prior-law IDBs) allocated to any beneficiary of the small-issue bonds exceeds $40 million. An exception to this rule is provided for certain current refundings of qualified small-issue bonds, under the same conditions as apply to post-sunset date refundings of such bonds (as described above). ¹

The bill clarifies that post-sunset date current refundings (including a series of such refundings) of qualified small-issue bonds (including small-issue IDBs), which bonds are originally issued before the applicable sunset date for the type of small-issue bond involved, qualify for tax-exemption, without regard to whether the refunded (original) bonds were issued before August 16, 1986, and without regard to the requirement included in the Reform Act that the interest rate on the refunding bonds be lower than the rate on refunded bonds. Such refundings of bonds originally issued after August 15, 1986, are permitted under sec. 144(a)(12) of the 1986 Code, as modified by the bill. Refundings of bonds originally issued before August 16, 1986, are permitted under a parallel rule which is added by the bill to the 1954 Code. Under this latter rule, bonds may qualify to be refunded if they could have been originally issued on August 15, 1986 (e.g., the "substantially all" (90 percent) requirement of the 1954 Code applies rather than the new 95 percent use requirement).

Post-sunset date refundings of qualified small-issue bonds are permitted under the bill provided that--

The bill also extends the 1954 Code sunset date for small-issue IDBs for manufacturing facilities, from December 31, 1988, to December 31, 1989. This change permits bonds for manufacturing facilities which were issued before August 16, 1986 to be refunded through December 31, 1989, without regard to the special limitations (described above) that apply to post-sunset date refundings.

$40-million-per-beneficiary limit

In conjunction with the amendments described above, the bill makes conforming changes to the refunding exception from the $40-million-per-beneficiary limit on qualified small-issue bonds. Thus, for purposes of this exception also, the weighted average maturity of the refunding bonds is compared to that of the refunded bonds, and the requirement that the refunding bonds have a lower interest rate than the rate on the refunded bonds is deleted. The bill further clarifies that a series of refundings may qualify under this exception. As under the rules for post-sunset date refundings, refunding bonds issued before July 1, 1987, which complied with the maturity requirement as contained in the Act, are treated as meeting the new requirement.

2. Student loan bonds

The bill clarifies that an issue may not qualify as an issue of qualified student loan bonds if the issue satisfies the trade or business use and security interest tests contained in the Reform Act (Code secs. 141(b)(1) and (2)). For purposes of this provision, "use" by a section 501(c)(3) educational institution solely by reason of its administration of a student loan program does not affect the tax-exempt status of an issue, provided such use does not constitute an unrelated trade or business of the institution.

3. Qualified 501(c)(3) bonds

In the case of pre-August 16, 1986 bonds, only the nonhospital portion of a mixed-use bond counts toward the $150-million limitation. Whether such allocations are permitted for mixed-hospital/nonhospital-use bonds issued after August 15, 1986, is not specified in the Reform Act.

The bill also adds a statutory reference clarifying that related party rules, similar to those applied for purposes of the $40-million-per-beneficiary limitation on qualified small-issue bonds, are to apply under the $150-million limitation.

4. Mortgage revenue bonds and mortgage credit certificates

Current refundings (including a series of refundings) of qualified mortgage bonds originally issued before August 16, 1986, remain subject to the 1954 Code. (See, Reform Act sec. 1313(a).) Thus, bonds originally issued before August 16, 1986, may not be refunded after December 31, 1987.

The Reform Act generally amends the provisions governing issuance of mortgage credit certificates (MCCs) to parallel the qualified mortgage bond provisions. However, the Reform Act inadvertently retained the 1987 termination date for the MCC program, rather than extending it to parallel the 1988 termination of authority to issue qualified mortgage bonds.

Authority to elect to issue mortgage credit certificates is extended through December 31, 1988, to parallel the qualified mortgage bond expiration date.

5. Private activity bond volume limitation

State volume authority may be carried forward for up to three years for certain specified purposes.

Allocations with respect to governmental bonds are permitted only if the State's share of the use (or output) of the private use portion of the bond-financed facility equals or exceeds the State's share of volume authority allocated to the facility. Further, unlike the general rule that bond volume authority may not be allocated to an issuer that is not within or subordinate to the same State as the issuer, these allocations may, in certain cases, be made to another State. For example, assume that a governmental power generation facility is located in Nevada, but is owned by a California municipality. Assume further that the California municipality issued bonds to be advance refunded, but that the private use portion of those bonds is attributable to use by an investor-owned utility in Nevada. In such a case, Nevada may allocate its bond volume authority to the California municipality's advance refunding issue in an amount sufficient to cover the Nevada private use of the refunded (and thereby refunding) bonds.

6. Public approval requirement for private activity bonds

The bill further includes a special rule for cases where the office of the elected official responsible for approving issuance of private activity bonds is vacated (e.g., by reason of death). In such a case, a successor appointed by the chief executive officer of the State and approved by the legislative body of the State (if any) may approve issuance of bonds until a new election for the office is held with a new elected official thereafter taking office.

7. Limitation on bond-financing of issuance costs

This provision is effective for bonds issued after June 30, 1987.

8. Arbitrage requirements

The Reform Act continued and expanded general restrictions on the ability to invest bond proceeds at yields materially higher than the yield on the issue. In addition, the Act expanded the types of investments subject to the arbitrage restrictions from securities generally to all investment-type property. 5 The term investment property does not include tax-exempt bonds.