Anti-Tax-Shelter and Other Revenue-Raising Tax Proposals Considered in the 108th Congress

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ROCUMENT S

. Doc 2095-3898 (27 pgs) Order Code RL32193

CRS Report for Congress

Received through the CRS Web

Anti-Tax-Shelter and Other Revenue-Raising

Tax Proposals Considered in the 108" Congress

Updated February 7, 2005

Jane G. Gravelle

Senior Specialist in Economic Policy

Government and Finance Division

TAB 150

Congressional Research Service * The Library of Congress AMERICAN JOBS

CREATION ACT. H.R. 4520,

PL 108-357

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Anti-Tax-Shelter and Other Revenue-Raising Tax

Proposals in the 108" Congress

Summary

Several bills introduced in the 108" Congress included revenue-raising

provisions, particularly those aimed at tax shelters that are generally used by

corporations. In 2003 anti-sheltering provisions were included in bills introduced by

Representative Lloyd Doggett (H.R. 1555), in the Senate version of the 2003 tax cut

(H.R. 2), in the Senate version of the Care Act (S. 476), and in both the House (H.R.

2896) and Senate (S. 1637) reported versions and final enacted version (H.R. 4520)

of bills which eliminate the extraterritorial income provision (ETI) — which has been

found to contravene World Trade Organization (WTO) restrictions on export

subsidies — and provide tax cuts. The number and size of the revenue-raising

provisions were much greater in S. 1637 ($56 billion over a 10-year period) than in

H.R. 2896 ($26 billion). The Senate bill was revenue neutral overall, while the

House bill lost revenue over the period FY2004-FY2013. The President also

proposed several tax shelter provisions in his FY2005 budget proposals. In 2004, a

somewhat different House bill (H.R. 4520) passed the House (June 17, 2004). The

final legislation was enacted as H.R. 4520 (P.L. 108-357), although not all of the tax

shelter provisions were included. This bill contained $82 billion in revenue raisers

over FY2005-2014, and was also revenue neutral.

Several types of revenue increases in the bills were (1) generic anti-shelter

provisions (including increased penalties and, in the Senate bill, changes in the

economic substance doctrine), (2) provisions related to corporate inversions and

expatriations, and the associated earnings stripping, (3) other provisions targeted at

specific tax abuses, (4) provisions that involve explicit changes in tax policy, and (5)

fees. Fees (basically customs fees), were the single largest revenue producers in the

initial bills; the leasing provision gained the most revenue in the final bill.

The Senate bill’s largest revenue raiser outside of customs fees is a codification

and strengthening of the economic substance doctrine which is used to determine

when an activity’s tax benefits are denied because they are aimed solely at tax

sheltering. This provision is one that has been controversial, with proponents arguing

that is a crucial tool in the battle against corporate tax shelters and opponents

suggesting it will not be effective and will adversely affect ordinary transactions. It

was not enacted but may be reconsidered in the future.

Inversions occur when U.S. firms move the parent corporation abroad to reduce

taxes, often accomplished by earnings stripping methods where domestic income is

shifted abroad. The Senate bill had more stringent provisions directed to U.S.

inverted firms; H.R. 2896 had generic earnings stripping provisions that apply to all

U.S. subsidiaries of foreign parents, not included in H.R. 4520.

A number of specific anti-shelter provisions was included in the bills, some

arising from the investigation of the Enron failure or from other issues raised by

failed firms. There were also some explicit tax policy changes which related

primarily to deferred compensation in the House bill, but touched on a variety of

other areas in the Senate bill. This report will not be updated.

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Contents

General Anti-Shelter Provisions ........... cc cece u cee eu cee eeeneeneeees 6

Penalties for Non-Disclosure and Other Purposes ..................05. 8

Economic Substance Doctrine ....... 0.0... cece cece eee eee eens 9

Corporate Inversions, Earnings Stripping, and Expatriation ................ 12

Specific Provisions Aimed at Shelters ......... 0.00... cc cece eee cece eee 14

Built in Losses 2... eee eee nent nen e eee nees 15

Property and Casualty Insurance Companies ..................00000 15

Disallowance of Interest on Convertible debt ..................00048. 15

Lease term to Include Service Contracts .......... 0... c ce cece ee eee 15

Disallowance of Partnership Loss Transfers .............. 000000000. 16

Lessors to Tax Exempt Entities 20... 2 cc eee eee 16

Mismatching of Items with Related Corporations .................... 16

Basis Reduction for Partnerships ........ 20... 0... ccc cee cence ees 16

Straddle Rules 20... . ccc eee eee eee e eee naes 17

Installment Sales 0.0.0... eect eee e eee e ees 17

Non-Recognition of Gain in Liquidation ............ 0.0... 0c cee v eee 17

Like Kind Exchanges for Residences .......... 0... cece cece ee enee 18

Clarification of Banking Business ........... 0.0.0.0 cc eee eee ee eae 18

Estimated Tax on Deemed Asset Sales ............ 0.00. cece eevee 18

Expanded Authority to Disallow Benefits Under Section 269 .......... 18

Modification of the CFC-PFIC Rules .............. 000. c ce eee eee 18

Limit on Transfer of Losses in REMICs ......... 0... ...0 0c ce eceeuee 19

Reduction of Fuel Tax Evasion ......... 00... cece eee eee teens 19

Charitable Contributions for Vehicles ......... 0... 0c cece eee ees 19

Limit Entertainment Expense Deductions .............0.0 0c cee eees 19

Freeze of Provisions Suspending Interest Payments .................. 19

Application of Basis Rules to Nonresident Aliens ................... 20

Tax on Gasoline Blendstocks ...... 0.0.0... cece ce eee tenes 20

Increase Withholding on Supplemental Wages ..................0005 20

Increase Continuous Levy for Certain Federal Payments .............. 20

Tax Policy Changes .... 0... 0... ccc ee cence nent e nents 20

House Bill 2... eee eee ee eee eee e nae 20

Deferred Compensation ......... 0... cece eee eee 21

Overpayments and Underpayments of Tax .................000. 21

Senate Bill oo. cec ee e eee e en teen eee ees 22

Charitable Contributions of Patents ........... 0.0.0. cece eee 22

Intangibles 2.0... eee eee ene e eens 22

Increase in Age Limit for Section 1(g ) (“Kiddie Tax”) ........... 22

Repeal Rehabilitation Credit ....... 0.0... cece eee 22

Private Debt Collection ..... 0... ... cece cee ee eens 22

Utility Grading Costs 2... 0... cee eens 23

Corporate Governance Provisions: Denial of Deductions .......... 23

Only in Final Legislation as Enacted ......... 0.0... cece eee eee 23

Tax on Influenza Vaccine ...........ec ec eee eens 23

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Extensions of Fees 2.0... cee cc eee ene cette ene ene e ens 23

List of Tables

Table 1. Revenue Raisers in H.R. 2896 as Passed by the House

Raising $100 Million or More, FY2004-FY2013 ...............0.008. 3

Table 2. Revenue Raisers in S. 1637 as Reported Raising $100 Million

or More, FY2004-FY2013 2.0.0... ccc ee ee tenet e nee 4

Table 3. Revenue Raisers in H.R. 4520 (As Enacted) Raising $100 Million

or More, FY2005-FY2015 1.0... ccc tee teen eens 5

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Anti-Tax-Shelter and Other Revenue-

Raising Tax Proposals in the 108" Congress

Several bills introduced in the 108" Congress included revenue-raising

provisions, particularly those aimed at tax shelters that are generally used by

corporations. Anti-sheltering provisions were included in bills introduced by

Representative Lloyd Doggett (H.R. 1555), in the Senate version of the 2003 tax cut

(H.R. 2), and in the Senate version of the Care Act (S. 476). In 2003, the House

reported H.R. 2896 and the Senate S. 1637, both of which proposed to eliminate the

extraterritorial income provision (ETI) — which has been found to contravene World

Trade Organization (WTO) restrictions on export subsidies — and provide other tax

cuts and were reported from their respective committees. The number and size of the

revenue-raising provisions were much greater in S. 1637 ($56 billion over a 10-year

period) than in the H.R. 2896 ($26 billion). The Senate bill was revenue neutral

overall, while the House bill would have lost revenue over the period FY2004-

FY2013. The Senate passed its bill with amendments in 2004 and the House passed

subsequently passed a new measure as H.R. 4520 (P.L. 108-357), the bill that after

revision in conference was ultimately enacted. This bill contained $82 billion in

revenue raisers and was also revenue neutral.

This report is an overview of the revenue raising provisions in the original

reported versions of H.R. 2896 and S. 1637 and the final bill as enacted. It therefore

addresses both those changes that have been enacted, and those that were proposed,

but not enacted, and thus may be considered in the future. A particularly significant

proposal that was advanced but not adopted, but may be considered in the future, is

a codification of the economic substance doctrine. General earnings stripping

provisions in H.R. 2896 also were not enacted.

Note that there were other interim legislative changes that are not detailed here,

other than a brief mention of major revisions. The Senate bill was amended on the

floor. In addition, a later version of the House bill that was significantly different

from H.R. 2896 was adopted in 2004 (H.R. 4520), and this bill was the basis for the

decisions in conference. The reader is directed to the Committee reports (H.Rept.

108-393 for H.R. 2896, S. Rept. 108-192 for S. 1637, H.Rept. 108-548 for the

House-passed version of H.R. 4520, and H.Rept.108-755 for the conference report

on H.R. 4520) for more detailed descriptions.

The bills had numerous (and complex) provisions, many of which had minor

consequences. To provide an overview, only provisions raising $100 million or more

of revenue over 10 years will be discussed. Tables 1, 2, and 3 list these provisions

in order of descending revenue gain. Table 1, containing the original House

provisions, lists 17 measures. Table 2, containing the original Senate provisions,

lists over twice as many measures, and the final version, H.R. 4520 in Table 3,

shows a similar number. The enacted version also included some additional

provisions from proposed energy legislation, including some revenue raisers.

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To begin the discussion, it is helpful to organize the provisions into basic

categories. The five categories (in the order in which they will be discussed) are (1)

generic anti-shelter provisions, (2) provisions related to corporate inversions and

expatriations, and the associated earnings stripping, (3) other provisions targeted at

specific tax abuses, (4) provisions that involve explicit changes in tax policy, and (5)

fees. Fees (basically customs fees) were actually the single largest revenue producers

in the original bills and accounted for about 30% of the gain in the initial Senate bill

and 60% of the gain in the initial House bill.

On the Senate floor several amendments relating to tax shelters were adopted

when S. 1637 was passed on May 11, 2004, which are not reflected in Table 2. They

included tougher penalties on tax shelter promoters, taxation of stock options in

corporate inversions, and modifications in charitable donations and deferred

compensation. There has been a significant increase in the projected revenue gain

from restrictions on leasing to tax exempt entities, so that the original revenue

estimates may have been understated. The House-passed version of H.R. 4520

contained a $19.6 billion (2004-2014) leasing provision over an 11 year period, while

dropping the earnings stripping provision in H.R. 2896. H.R. 4520, as enacted, also

contained a significant leasing revenue raiser and omitted earnings stripping. The

leasing provision is the single largest revenue producer in H.R. 4520.

The provisions that were not ultimately enacted in H.R. 4520 may be

reconsidered in the 109" Congress if legislation needing offsetting revenue raisers

is considered. Legislation providing additional tax incentives for charitable

contributions was considered but not enacted in the 108" Congress. There may also

be potential legislation making tax cuts permanent and addressing the growing

problem of the alternative minimum tax. Finally, President Bush has indicated an

interest in fundamental tax reform. And, while codifying the economic substance

doctrine is controversial, some observers consider future legislation in this area to be

likely.

Note also that the President proposed some anti-shelter provisions in his

FY2005 budget plan, amounting to $44 billion over 10 years. The largest provision

was one addressing leasing transactions, accounting for $33 billion. Other major

provisions included limiting interest deductions for related party transactions,

preventing excess valuations for charitable contributions of property, addressing the

small property and casualty insurance firm issue, and providing increased regulatory

authority for monitoring abusive tax shelters. See the Treasury Department’s

February 2004 General Explanation of the Administration’s Fiscal Year 2005

Revenue Proposals for further explanation, online at [http://www.treas.gov/offices

/tax-policy/], page 111.

' An extensive discussion of leasing provisions is contained in CRS Report RL32479, Tax

Implications of SILOs, QTEs, and Other Leasing Transactions with Tax-Exempt Entities,

by Maxim Shvedov.

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Table 1. Revenue Raisers in H.R. 2896 as Passed by the House

Raising $100 Million or More, FY2004-FY2013

(in millions of dollars)

1. Extension of customs fees 16,916

2. Earnings Stripping 2,726

3. Tax Shelters: Penalties for Non-Reporting 1,559

4, Small property and casualty companies 1,179

5. Non-qualified deferred compensation 800

6. Corporate inversions 450

7. Mismatching of items with related corporations 444

8. Basis reduction for partnerships 364

9. Extension of IRS user fees 345

10. Individual expatriations 327

11. Extension of provision allowing DB plan transfers 298

12. Like-kind exchange for residences 171

13. Clarification of banking business 154

14. Estimated taxes on deemed asset sales 123

15. Exclusion of interest on overpayments 115

16. Prepayment of interest on underpayments 101

17. Limit on transfer of losses on REMIC residuals 100

Source: Joint Committee on Taxation, JCX-95-03, October 24, 2003.

Note: See text for revisions in H.R. 4520; earnings stripping provisions were dropped and a significant

leasing provision added.

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Table 2. Revenue Raisers in S. 1637 as Reported Raising $100

Million or More, FY2004-FY2013

(in millions of dollars)

1. Extension of customs fees 17,139

2. Economic substance doctrine 13,322

3. Charitable contributions of patents 3,851

4. Intangibles, broader application of rules 3,291

5. Corporate inversions 2,747

6. Built in losses 1,800

7. Tax shelters: penalties for non-reporting 1,559

8. Qualification rules (tax exempt and casualty insurance) 1,273

9. Increase age limit for section 1(g) 1,180

10. Repeal rehabilitation credit, non-historic buildings 1,013

11. Private debt collection 973

12. Disallowance of interest on convertible debt 891

13. Lease term to include service contracts 864

14. Disallowance of partnership loss transfers 705

15. Establish specific class lives for utility grading costs 701

16. Individual expatriation (mark to market) 700

17. Lessors to tax exempt entities 519

18. Mismatching of items with related corporations 444

19, Extend IRS user fees 386

20. Basis reduction for partnership 368

21. Denial of deduction for punitive damages 333

22. Earnings stripping applied to Subchapter S and individuals 244

23. Straddle rules 230

24. Installment sale treatment 215

25. Denial of deduction for fines 191

25. Non-recognition of gain in liquidation 189

27. Like-kind sales of residences 171

28. Clarification of banking business 166

29. Estimated tax on deemed assets sales 123

30. Expanded authority to disallow benefits under Section 269 108

31. Modification of CFC/PFIC rules 106

32. Deposits to stop interest running on underpayments 101

Source: Senate Finance Committee Report 108-292. See text for revisions on floor.

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Table 3. Revenue Raisers in H.R. 4520 (As Enacted) Raising

$100 Million or More, FY2005-FY2015

(in millions of dollars)

1. Leasing provisions 26,560

2. Extension of customs fees 18,614

3. Reduction of fuel tax evasion 9,138

4. Charitable contributions of patents 3,653

5. Intangibles, broader application of rules 3,467

6. Charitable contributions for vehicles 2,379

7. Limit entertainment expense deductions 2,292

8. Built-in losses 1,851

9. Tax shelters: penalties for non-reporting 1,620

10. Freeze of provisions suspending interest payments 1,545

11. Private debt collection 1,017

12. Disallowance of interest on convertible debt 1,004

13. Corporate inversions 932

14. Establish specific class lives for utility grading costs 806

15. Disallowance of partnership loss transfers 581

16. Mismatching of items with related corporations 475

17. Clarification of banking business 404

18. Extend IRS user fees 396

19. Individual expatriation 377

20. Straddle rules 331

21. Tax on influenza vaccine 314

22. Basis reduction for partnership 249

23. Application of basis rules for nonresident aliens 241

24. Installment sale treatment 221

25. Repeal reduced excise rate for gasoline used in blends 220

26. Like-kind sales of residences 200

27. Increase withholding from supplemental wages 186

28. Increase continuous levy for certain federal payments 185

29. Estimated tax on deemed assets sales 117

30. Modify treatment of creditors in certain reorganizations 105

Source: Joint Committee on Taxation, JCX-69-04, October 7, 2004.

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General Anti-Shelter Provisions

The term “tax shelter” is not easily defined and the usage of the term varies.

Sometimes it refers to any method of shielding income from tax including provisions

that were explicitly adopted by Congress as incentives. Sometimes it refers to

practices that meet the letter of the law (often by combining provisions in different

parts of the tax code) but are unintended by the law. In some cases, they are activities

that do not clearly meet the letter of the law. The provisions in the tax bills are

largely aimed at what might be called “abusive” tax shelters — activities set up to

take advantage of the strict letter of the law but whose purpose is to avoid taxes

rather than engage in any meaningful economic activity, and whose benefits were not

intended by Congress.

Tax shelters today are different from those that attracted attention in the 1970s,

and the legislation enacted to address those shelters does not address today’s

shelters.” Most of the earlier tax shelters were in real estate or some other type of

physical investment (oil and gas, farming) and involved limited partnership interests

in highly leveraged assets which benefitted from both interest deductions and

deductions for accelerated depreciation (or other deductions for costs). Before

generic anti-shelter provisions directed at this type of shelter were enacted, a high

income taxpayer could take deductions many times his actual investment as his claim

to deductions (or his basis) included not only the amount financed by his cash

investment but also any associated debt (for which he would not be personally at

risk). These shelters were largely sold to high tax rate individuals. A series of law

changes (slowing depreciation, lowering tax rates, and enacting limits on deductions

through at-risk rules and passive loss restrictions) and economic changes (a decline

in inflation and in interest rates) have made those shelters obsolete.

Today’s tax shelters do not follow a consistent pattern and they are highly

varied.* They are largely corporate shelters. Often, they do not involve investments

in real assets but rather in financial instruments that are highly liquid, held for a short

period of time, and structured to avoid risk. One paper discussing a court case

referred to the underlying stock asset held by the company “which, under a charitable

view of the facts, it owned for an hour.”* This case was a dividend stripping case

where a tax exempt entity owned stock in a foreign firm and could not use foreign

tax credits; the entity arranged to sell a block of stock to a taxable firm just before

the dividend was paid; the taxable firm then sold the stock at a loss (because it was

worth the original price less the dividend) which wiped out the taxable income but

left the firm with a foreign tax credit attached to the dividend.

* For a discussion of old and new style tax shelters and their interaction with “at risk” rules,

see James Whitmire and Bruce Lemons, “Putting Tax Shelters at Risk — Discussion and

Proposal for Change,” Tax Notes, Jan. 27, 2003, pp. 585-596.

* See Gerald R. Miller, “Corporate Tax Shelters and Economic Substance: An Analysis of

the Problem and Its Common Law Solution,” Texas Tech Law Review, vol. 34, 2003, pp.

1015-1069 for a discussion of some of the common features of tax shelters.

* Daniel Shaviro, “Economic Substance, Corporate Tax Shelters, and the COMPAQ Case,”

Tax Notes, July 10, 2000, p. 222.

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The general objective of most tax shelters is to generate tax deductions, often

by contriving to increase the basis of the taxpayer in assets, or to shift losses or

deductions from tax indifferent parties (those not subject to U.S. tax such as foreign

corporations or tax exempt organizations) to taxable parties. Tax shelters may take

advantage of the flexibility allowed to partnerships in allocating income and assets,

may take advantage of related parties that are incorporated abroad and not subject to

current U.S. tax, may involve leasing arrangements to tax exempt organizations, and

have even involved firms’ buying life insurance on their rank and file employees (socalled “janitors” insurance).* Some of the shelters are put together by promoters who

then sell them to firms; these promoters include prestigious accounting firms and

financial institutions. (Some accounting firms have indicated that they have closed

these operations.)°

Measuring the amount of revenue lost from tax shelters is difficult, although

some data suggest that the loss is substantial. The role of tax shelters is especially

difficult to monitor since these shelters may lead to mismeasurement of pre-tax

profits and make their magnitude difficult to detect. Several studies comparing book

and tax income have noted the widening gap between the two that cannot be

explained by the traditional measures of depreciation, stock options, and foreign

source income retained abroad. A study by Desai found $155 billion of unexplained

discrepancies in 1998,’ implying lost taxes that could be up to $54 billion (ata 35%

tax rate). This amount could be lower because some firms are operating at a tax loss,

some firms do not pay the top marginal tax rate, and some firms have unused credits.

But the amount is significant.

Some of this gap between book and taxable income was due to intended tax

benefits, and examining tax expenditures — which measure the revenue cost of

explicit special tax deductions, exclusions, and credits not considered to be part of

a normal income tax — may help to adjust for that effect. Our calculations suggest

that about $23 billion of such a gap would be attributable to tax expenditures.’ While

* See CRS Report RS21498, Corporate-Owned Life Insurance: Tax Issues, by Don

Richards, for a discussion.

® See Sheryl Stratton, “KPMG Skewered at Senate Shelter Hearing,” Tax Notes, Nov. 24,

2003, pp. 942-946.

” Mehir Desai, “The Corporate Profit Base, Tax Sheltering Activity and the Changing

Nature of Employee Compensation,” National Bureau of Economic Research, Working

Paper 8866, April 2002.

* In the same year for which Desai estimated the $155 billion gap, the projected tax

expenditures for corporations were about $72 billion according to the Joint Committee on

Taxation. Almost half ($33.5 billion) was due to accelerated depreciation, largely for

equipment (and including expensing of research and development, or R&D, costs), which

Desai accounted for. Another $1.2 billion was retained earnings of controlled foreign

corporations, which he also accounted for. (These earnings are profits of subsidiaries of

U.S. firms incorporated under the laws of foreign countries and not paid as dividends to the

U.S. parent company). If one also eliminates $2.5 billion for tax deductions for charitable

contributions which were probably deducted as a book expense, $4.2 billion lost because

of graduated tax rates, and $7.6 billion of credits, the remaining tax expenditures account

(continued...)

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there are many possible errors in calculating these effects, there nevertheless appears

to be significant potential for a relatively large size of unintended corporate tax base

reductions given the potential size of the book tax difference discovered by Desai.

Of course, not all of these differences represent illegal, or even abusive, tax shelters.

For example, there are certain types of preferred securities that are treated as debt for

tax purposes but as equity for book purposes, whose treatment for tax purposes has

been tested in court.

The general scope of this potential loss (i.e., a discrepancy of up to $54 billion

reduced by $23 billion leaving a potential of $31 billion unaccounted for)

accommodates estimates made by a Internal Revenue Service (IRS) contractor and

reported in a GAO study that suggested a loss from abusive tax shelters of $13.6 to

$17.3 billion for that same year.’ This study also reports an IRS database covering

the period 1989-2003 with a cumulative estimate of $85 billion. Additionally, the

study explains the efforts that IRS has been making to address these abusive tax

shelters, including listing specific transactions it found to be illegal and requiring

disclosure.

Setting aside the explicit provisions adopted by Congress, tax sheltering

activities raise two types of challenges for tax administration — and anti-shelter

legislation addresses one or both of these issues. First, in order for the IRS to collect

taxes avoided illegally, it is necessary to detect the tax shelters. Because of the

complexity of these operations, the elements of the tax shelter may be buried in other

deductions. IRS has engaged in an aggressive enforcement program against tax

shelter operations, including requiring disclosure of shelters. The penalties for nondisclosure, included in both bills, were designed to provide more incentives to

comply with disclosure rules. Secondly, when a tax activity technically meets the

requirements of the statute, it may nevertheless be disallowed in the courts under

certain doctrines of common law. These doctrines include examining the activity to

determine if it is a sham transaction, if it has no economic substance, and/or if it has

no business purpose. A provision clarifying and codifying the economic substance

doctrine was included in the Senate bill and was the largest revenue raiser after

customs fees in that bill (although there is some uncertainty about the amount of

revenue that might be raised).

Penalties for Non-Disclosure and Other Purposes

New initiatives and Treasury regulations require taxpayers to report information

about certain categories of “reportable transactions” which include those that are

similar to tax transactions already disallowed, those offered under conditions of

confidentiality, those contingent on tax treatment, those generating losses of a certain

size, those where tax treatment differs from book treatment, and those resulting in a

significant tax credit while being held a short period of time. There are no specific

8 (...continued)

for about $23 billion.

Internal Revenue Service: Challenges Remain in Combating Abusive Tax Shelters,

Statement of Michael Brostek, Government Accountability Office, before the Senate

Finance Committee, Tuesday, Oct. 21, 2003.

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penalties for not reporting these transactions, and both H.R. 2896 and S. 1637

imposed a penalty on failure to provide required information on reportable

transactions (items 3 in Table 1, 7 in Table 2, and 9 in Table 3 respectively); this

provision accounts for the bulk of the $1.6 billion in revenue gain from penalties,

although there are some changes in other penalties. Some critics objected to certain

aspects of the penalty provisions, including the flat rate shelter disclosure penalty that

applies regardless of whether the taxpayer’s position is upheld and a new higher

penalty on understatement that applies to transactions lacking economic substance

in the Senate bill (because of uncertainty regarding the definition of economic

substance).!°

Economic Substance Doctrine

The provision in the Senate bill codifying the economic substance doctrine was

the largest revenue raiser in the Senate bill after customs fees, accounting for $13.3

billion over 10 years.

As noted above, even when transactions meet the letter of the tax law, tax

benefits may be disallowed by the courts if the activity is found to be a type of sham

transaction; in the particular case of tax shelters the related issues of economic

substance or business purpose are often used. '' That is, if an activity does not have

economic substance or there is no business purpose, the tax benefits are disallowed.

The Senate bill would have recognized these doctrines in the tax law itself and

provided a number of specific guidelines. For example, if the court found the

economic substance doctrine to be relevant, the bill provided that the taxpayer must

meet both the objective test of economic substance and the subjective test of having

a non-tax business purpose to keep the tax benefit. Requiring both is referred to as

a conjunctive rule, while requiring either is referred to as a disjunctive rule. The

objective is to strengthen the rule and to bring more uniformity to court decisions.

Some court cases have required both aspects to be met and others only one. The bill

also set out specific rules for determining when the taxpayer meets the economic

substance test through demonstrating profit potential, by requiring that the return

outside the tax benefits exceed the riskless rate of return; it also provided that the

transactions must be a reasonable means of achieving the business purpose.

The purpose of the provision regarding economic substance (according to the

Committee report) was:'”

'° See letter written to Chairman William F. Thomas by Andrew Berg, Tax Section, New

York State Bar Association, Sept. 24, 2003, reprinted in Tax Notes, Oct. 20, 2003, pp. 401-

403. See Berg’s letter to Chairman Thomas and Senator Grassley on the economic

substance doctrine dated Aug. 5, 2003.

"' Fora general background on the economic substance doctrine see Joseph Bankman, “The

Economic Substance Doctrine,” Southern California Law Review, vol. 74, Nov. 2000, pp.

5-30; Miller, “Corporate Tax Shelters and Economic Substance,” op. cit, and Martin J.

McMahon, Jr. “Economic Substance, Purposive Activity, and Corporate Tax Shelters,” Tax

Notes, Feb. 25, 2002, pp. 1017-1026.

'2 §.Rept. 108-192, to accompany S. 1637, p. 85.

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The Committee is concerned that many taxpayers are engaging in tax avoidance

transactions that rely on the interaction of highly technical tax law provisions.

And the report goes on to add in a footnote:

These transactions usually produce surprising results that were not contemplated

by Congress. Whether these transactions are respected usually hinges on whether

the transaction had sufficient economic substance. The Committee is concerned

that in addressing these transactions the courts, in some cases, are reaching

conclusions inconsistent with Congressional intent. In addition, the Committee

is concerned that in determining whether a transaction has economic substance,

taxpayers are subject to different legal standards based on the circuit in which the

taxpayer is located. Thus, the Committee believes it is appropriate to clarify for

the courts the appropriate standards to use in determining whether a transaction

has economic substance.

There has been a great deal of controversy about the economic substance

doctrine legislation. While the proposal was in the Senate bill, it was not in the

House bill. It was opposed by Treasury officials in the current Bush Administration.

Many firms, practicing tax attorneys, and tax executives in businesses objected to the

provision, both individually and formally through organizations such as the Tax

Executives Institute, the Tax Section of the American Bar Association and the Tax

Section of the New York State Bar Association.”

At the same time, there was much support for the codification of the economic

substance doctrine, in addition to the position taken by the Finance Committee. The

Clinton Administration supported the bill, and Chairman Thomas’s 2002 bill in the

107" Congress (H.R. 5095) included an economic substance provision. There are a

number of attorneys and law professors who have taken the view that codification of

the economic substance doctrine, as was in the Senate provision or with some

modification is advisable and even necessary to stem the tide of tax shelters."

'? Pamela Olson (at her nomination hearings for Assistant Secretary of Treasury for Tax

Policy) commented on economic substance in answer to a question; these comments are

reported in Samuel C. Thompson Jr. and Robert Allen Clary 11, “Coming in from the Cold:

The Case for ESD Codification” Tax Notes, May 26, 2003, pp. 1270-1274. See also, as

noted above, the letter from Andrew Berg to Chairman Thomas and Senator Grassley on the

economic substance doctrine and the Apr. 24 letter to Chairman Grassley and Ranking

Member Baucus from Herbert Beller of the American Bar Association (reprinted in the

Bureau of National Affairs, Daily Tax Report, Apr. 28, 2003). See also New York State Bar

Association Tax Section, “Economic Substance Codification,” Tax Notes, June 23, 2003;

Peter L. Faber, letter to the Chairman Thomas, reprinted as “Practitioner to Congress: Don’t

Try to Codify Economic Substance,” Tax Notes, Oct. 21, 2002, pp. 423-424; James M.

Peaslee, letter to the Finance Committee, reprinted as “More Thoughts on Proposed

Economic Substance Clarification,” Tax Notes, May 5, 2003, pp. 747-750, May 5, 2003.

'* Lawrence M. Stone, Letter to Chairman Thomas, reprinted as “Congress Should Codify

Economic Substance,” in Tax Notes, Nov. 18, 2002; Samuel C. Thompson Jr. and Robert

Allen Clary II, “Coming in from the Cold: The Case for ESD Codification” Tax Notes, May

26, 2003, pp. 1270-1274; Terrill A. Hyde and Glen Arlen Kohl, “The Shelter Problem is

(continued...)

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In general, the arguments for codification in these discussions and commentary

include the need to take more aggressive action to stem the tide of tax shelter cases,

since a stricter rule would change the cost-benefit calculus faced in this area and

strengthen the position of the tax authorities. The argument is also made that in the

face of aggressive tax sheltering, even compliant taxpayers will be pressured into

these activities unless Congress (or the Supreme Court) takes action to clarify

economic substance. Moreover, in addition to creating more conformity in court

decisions, putting the doctrine into the code would allow the Treasury to write more

detailed regulations.

The criticisms of the proposal include both criticisms of any codification of the

economic substance doctrine, as well as the particular ones used in the provision.

Pam Olson, answering a question at her nomination hearing as Assistant Secretary

of Treasury for Tax Policy,'* made the case against codification roughly as follows:

such an approach is too wooden and rigid (not flexible enough), it will be both too

broad (presumably covering unintended transactions) and too narrow (presumably

leaving ways for individuals to get around the rules), and that it will increase

complexity for the IRS and slow audits. In general, in the discussion by many of the

critics several themes emerge. One is that the courts are the proper place to

adjudicate complex technical issues. Another is that the legislation as written would

also be applicable to perfectly common transactions that have long been occurring

and whose benefits are intended by the Congress — even ordinary actions like

electing Subchapter S (a small corporation electing to be taxed as a partnership) or

incorporating a foreign branch operation (which allows deferral of U.S. tax on active

income). Critics also argue that the new language would still have significant

ambiguities that would require adjudication and that designers of shelters will simply

devise new ways to get around the rules.

Supporters have written rejoinders, for example suggesting that too much

flexibility is the underlying problem with tax shelters and that more rigid rules are

needed, and that clearer rules would simplify IRS administration and enforcement.

The rejoinders also argue that the claims about interference with ordinary accepted

transactions are greatly exaggerated: the Committee report makes it clear that the

intent is not to deny deliberate benefits bestowed by Congress, and that the legislation

applies only to cases where the court decides economic substance is an issue. They

also contend out that the tax authorities would not press cases of this nature in any

event.

While the economic substance doctrine revisions were not a part of H.R. 4520,

as enacted, there are some indications that the issue may arise again. The Joint

Committee on Taxation’s recent tax study includes a proposal for statutory revisions

'4 (...continued)

Too Serious Not to Change the Law,” Tax Notes, July 7, 2003, pp. 119-122; Lawrence

Stone, “Economic Substance Codification: Naysayers Can Help Make it Work,” Tax Notes,

Aug. 4, 2003, pp. 730-731. A paper supporting the general notion is Martin J. McMahon,

“Economic Substance, Purposive Activity, and Corporate Tax Shelters,” op cit.

'S Reported in Thompson and Clary, “Coming in from the Cold,” op. cit.

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including requiring both the subjective and objective tests.'° In addition, the IRS

recently lost several tax cases and in one the fact that Congress did not act to codify

the doctrine was cited by the judge in finding for the taxpayer.!’ These outcomes

may increase pressure to codify and strengthen the economic substance doctrine.

Corporate Inversions, Earnings Stripping,

and Expatriation

Anti-tax sheltering provisions include provisions that are directly related to an

activity called corporate inversion and also provisions dealing with individual

expatriates (individuals who change residence or renounce citizenship to avoid U.S.

tax). The provisions discussed in this section are items 2, 6 and 10 in Table 1, items

5, 16 and 22 in Table 2, and items 13 and 20 in Table 3.'* Actions after the original

bills were reported reduced the impact of the House bill and expanded the impact of

the Senate bill. Earnings stripping provisions (item 2) were dropped from the House

bill, H.R. 4520. A provision taxing stock options in inversions was adopted on the

Senate floor. The final version had smaller effects than either of the two initial bills.

Corporate inversion occurs when a U.S. company sets up a foreign incorporated

firm to become the parent corporation (and the current U.S. firm now becomes the

subsidiary corporation). This inversion confers two related tax advantages: avoiding

tax on foreign earnings and earnings stripping which allows a reduction of tax on

domestic earnings.

First, any income earned abroad would be beyond the ambit of the U.S. tax

system. Foreign subsidiaries of U.S. parent companies are subject to tax on certain

types of passive income even if not paid back to the U.S. parent (this income is called

Subpart F income), and the U.S. is stricter than many other countries in taxing this

income. However, income of foreign subsidiaries of a foreign parent company (and

the parent company’s income) is not subject to this tax (even if the shareholders are

U.S. citizens). Thus an inversion would permit a company to avoid the tax on

passive earnings of foreign operations. (The tax on active earnings does not apply

in any case until the income is repatriated as a dividend. Note also that the tax

avoidance matters in countries that have no taxes or low taxes where foreign tax

credits cannot be used to offset the additional U.S. tax).

The second advantage is that setting up the firm with a foreign parent allows

more scope for reducing tax on U.S. source income by allowing the U.S. subsidiary

to rely heavily on debt held by a foreign related company. Interest is deductible and

while interest paid to a related foreign corporation is subject to a withholding tax, tax

'© Joint Committee on Taxation, Options to Improve Tax Compliance and Reform Tax

Expenditures, JCS-02-05, January 27, 2005.

'7 See Kenneth A. Gary and Sheryl Stratton, “Economic Substance: Will Congress Have to

Intercede?” Tax Notes, Nov. 15, 2004, pp. 907-910.

'® See also CRS Report RL31444, Firms That Incorporate Abroad for Tax Purposes:

Corporate “Inversions” and “Expatriation,” by David Brumbaugh for further discussion.

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treaties often eliminate or greatly reduce that withholding tax. Some inversion

operations are set up with three related firms: the U.S. firm, the new foreign parent

firm in a country without a treaty, and another subsidiary in a country with a treaty

to receive and transmit the interest payments. Reducing U.S. tax with debt or other

deductible payments to related firms is referred to as “earnings stripping” and it is an

issue not just with inverted firms, but with U.S. subsidiaries of foreign parent firms

in general. Because of the potential for abuse, the current tax code has a restriction

on deductibility of interest for thinly capitalized U.S. firms (with more than 60% of

assets held in debt and with more than 50% of earnings paid in interest).

The tax benefits of inversions are limited by the possibility that stockholders

will pay individual capital gains tax on the appreciation that occurred from the time

they purchased the stock to the time of the inversion. However, increasingly large

shares of stock are held in tax exempt form (e.g., pensions, IRAs) and the capital

gains tax rate is relatively low (currently only 15%).

Individuals can also act to limit their tax liability by changing their citizenship

to a low tax country.

The responses to these issues vary across bills in the 18" Congress. Under H.R.

2896 the general earnings stripping rules would have been tightened (item 2 in Table

1) by dropping the asset share test (i.e., disallowing interest based only on the

interest as a share of income) and lowering the interest share (to 25% for ordinary

debt and 50% for guaranteed, or 30% overall). This provision, which had a broader

scope than on firms with inversions, would have raised much of the $3.5 billion

revenue gain for 2004-2013 in this area — $2.726 billion. However, this provision

was eliminated from H.R. 4520. H.R. 2896 had some provisions focused directly on

inversions as well (item 6) which would prevent use of foreign tax credits or net

operating losses from offsetting taxes on inversion transactions (this and other items

are grouped in item 5). It would also impose a 15% excise tax on stock options

related to inversions. The limits on credits and loss offsets raise about $340 million

and the stock option tax $78 million. There were also small gains estimated from a

provision to require reporting of mergers and acquisitions and to allocate items for

reinsurance contracts.

The other significant revenue raiser in this group was a $327 million provision

imposing taxes on expatriate individuals (item 10 in Table 1). US. citizens or

residents are taxed on worldwide income (but are allowed a foreign tax credit for

taxes paid on foreign source income); nonresidents who are not citizens are subject

to a 30% withholding tax that may be lowered or eliminated through a tax treaty.

Individuals who renounce citizenship or residency for the purpose of avoiding tax

must pay tax on U.S. source income at ordinary tax rates, if they exceed certain

thresholds with respect to tax liability in the past and assets. H.R. 2896 would

replace this subjective determination of intent with an objective test based on prior

taxes paid and assets.

S. 1637 focused on inverted firms and would not have altered the general

earnings stripping rules. The inverted firms provisions (item 5 in Table 2) would

tax inverted firms as if they were domestic firms if 80% of the new foreign parent is

owned by former shareholders of the U.S. firm (for inversions occurring after March

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20, 2002 and where the company had no existing substantial interest in the foreign

country). For other inversions, a “toll” tax equal to the top corporate (or individual,

in the case of a partnership) rate would be imposed (and could not be offset by

foreign tax credits or carryover of net operating losses). For earnings stripping, S.

1637 had provisions to eliminate the asset test and reduce the interest share test to

25% but the bill applied these stricter rules only to inverted corporations. These

provisions together accounted for $2.6 billion over FY2004-FY2013. In additional

revenue provisions added to the bill, there is a 20% excise tax on stock options linked

to the inversion and an extension of earnings stripping rules to Subchapter S

corporations (corporations taxed as partnerships) and partnerships; their bill

strengthens them for inverted corporations. Individual expatriates would be taxed

immediately under a mark to market rule (1.e., the individual must pay tax as ifhe or

she had sold the asset).

Overall, the original House bill focused much more heavily on general revenues

from tightening the earnings stripping rules for all corporations, and is less targeted

to inverted companies, while the Senate bill has much stricter tax provisions for

inversions and did not contain a general provision for earnings stripping. The Senate

bill’s provision for individual expatriates required an immediate tax on accumulated

gain from assets through a mark to market provision. H.R. 4520 does not include the

major revenue raiser, the earnings stripping provision.

The enacted legislation (H.R. 4520) generally follows the Senate provisions in

treating inversions with 80% identical ownership; for firms with 60% to 80%

ownership, any firm-level capital gains tax will not be offset by net operating losses

or foreign tax credits. There are no earnings stripping provisions. For individual

expatriates, the provisions are similar to the H.R. 2896.

Specific Provisions Aimed at Shelters

This section discusses specific provisions aimed at practices that many agree

may require a legislative remedy but may still be thought of as tax shelters. They

vary in the fundamentals, but as one can see from the following discussion, many of

them involve transactions, sometimes between related parties, where one party is

exempt from the U.S. tax and the other is not. Arrangements involve ways of

reducing taxable income by increasing debt (since interest is deductible) as in the

case of earnings stripping, increasing basis (the part of an asset’s price that is exempt

when the asset is sold), increasing other deductions, or excluding or reducing income.

The following discussions are brief explanations; the reader is directed to the

committee reports for more detailed information. Provisions are arrayed from

highest to lowest revenue gain.

The Senate bill also singled out certain provisions as relating to Enron — a

report by the Joint Committee on Taxation investigating Enron uncovered some of

the methods used to avoid taxes. When provisions fall into these categories, they will

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Built in Losses

This largest of the provisions in this section in projected revenue gains ($1.8

billion) arose from the Enron investigation, and was in the Senate bill and the final

bill. It addresses the situation when firms or other parties exchange assets for stock

and control the corporation after the exchange; under current law this is generally a

tax free transaction, that is, no gain or loss is recognized. If one party to the

exchange is an exempt foreign entity and the asset has a loss (i.e., basis, that is, the

amount deducted on sale, is above market value), and the U.S. corporation takes the

foreign party’s basis, the domestic taxable firm can benefit from this transaction

(because when the asset is sold, a loss will be recognized). The provision requires

basis to be fair market value in these cases.

Property and Casualty Insurance Companies

This item was included in both initial bills (item 4 in Table 1 and 8 in Table 2)

and would have raised about $1.2 billion. It basically addresses a provision that has

been in the tax law for a long time that allows tax exemptions for very small property

and casualty companies. These firms are entirely tax exempt if they receive less than

$350,000 in premiums. They are taxable only on investment income if premiums are

less than $1 million. This provision had been used to exempt large amounts of

investment income by setting up a firm with nominal premiums but huge investment

reserves.'’ The new provision would require more than 50% of gross receipts from

premiums to be eligible for these tax benefits; the House bill also raises the

exemption level for firms that do qualify. The 50% was increased to 60% in the

Senate bill prior to conference.

The final bill does not include this provision because the issue was addressed

in the Pension Funding Equity Act passed in April of 2004. This provision provided

for the 50% test and increased the ceiling to $600,000.

Disallowance of Interest on Convertible debt

This provision is also an Enron-related one, and is in the Senate bill and the

final legislation; it raises about $1 trillion over the ten year period. Under prior law

interest including original issue discount (the difference between issue cost and face

value of a security on maturity, which is equivalent to interest paid at the end),

cannot be deducted if it is contingent on the value of securities of the issuer or a

related party (involving ownership of 50% or more). This provision applies the

restrictions without regard to the 50% rule.

Lease term to Include Service Contracts

This provision, initially projected to raise almost $800 million and subsequently

$4.3 billion, was originally only in the Senate bill. To prevent tax exempt entities

'° This activity was described in David Cay Johnston, “From Tiny Insurers Big Tax

Breaks,” New York Times, Apr. 1, 2003, Sect. C, p. 1

- a ating, By

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from transferring accelerated depreciation to taxable entities via leases, the useful life

of property that is leased to tax exempt entities is a life that is the longest of the

specified tax life or 125% of the lease term. Some attempts have been made to

bypass this rule by using service contracts; this provision requires that the length of

service contracts be included in determining lease term. The final legislation

includes combined leasing provisions (including a separate item below) that raise $26

billion. While the revenue cost depends on the actual design, part of the increase is

due to changes in estimated revenue gain.

Disallowance of Partnership Loss Transfers

This $700 million provision is highly technical and contained originally only in

the Senate bill. Many tax shelters are associated with partnerships, which have a lot

of flexibility. This flexibility includes assigning basis to individual partners.

Currently when property is distributed or a partnership interest transferred, the

partnership is not required to make an adjustment to basis, and when property is

distributed to other partners later, the basis adjustments may be made in a way that

permits double recognition of losses or transfers of losses. This provision would

have disallowed that outcome. The final bill contains restrictions but limited to noncontributing partners.

Lessors to Tax Exempt Entities

This $500 million provision was originally only in the Senate bill, and an

updated estimate yielded $4.7 billion. Combined leasing provisions in the substitute

Senate bill would have raised about $24 billion, and the provision in H.R. 4520 as

passed by the House would have raised $19.6 billion. The final bill includes leasing

provisions of a similar magnitude. Leasing to tax exempt entities by taxable firms

(who receive accelerated depreciation deductions) has figured heavily in a number

of tax shelter arrangements. This provision limits deductions to income received

from the lease, imposing a treatment much like the passive loss restrictions that apply

to passive individual investors.

Mismatching of Items with Related Corporations

This provision, raising about $450 million, is included in both bills (item 7 in

Table 1 and Item 18 in Table 2) and in the final legislation (item 16 in Table 3). It

corrects a circumstance where U.S. companies who are creditors do not include

original issue discount on behalf of their foreign subsidiaries even though the

deductions themselves are reflected in current income.

Basis Reduction for Partnerships

This $400 million provision came out of the Enron investigation and is included

in all bills (item 8 in Table 1, item 20 in Table 2, and item 22 in Table 3). It also

arises from the flexibility allowed partnerships. When partners contribute assets to

a partnership or the partnership distributes assets to a partner, there is no gain or loss

realized. However, it may be necessary to adjust the basis of the asset (which

determines how much of an asset is return on capital and exempt from taxes when

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the taxpayer does sell the property). For example, if a partner contributed a building

for which he had paid $100,000 to the partnership, his basis in the partnership is

$100,000, but if the partnership returns the building to him in a distribution and also

pays him $20,000, then he has to reduce his basis to $80,000 so that when he sells the

property, he will pay tax on the $20,000. The partnership may elect to adjust the

basis of its assets in a corresponding manner and is required to group assets of a

similar type in allocating basis. The grouping rules have permitted partnerships in

such situations to reduce the basis of stock and increase the basis of physical assets,

which is advantageous for corporate partners who do not include cash from the sale

of stock in income but do include such gains on real assets.

Straddle Rules

This provision is in the Senate bill and the final legislation. Straddles occur

when individuals hold (generally two) assets that move in opposite directions (such

as an option to buy, or call, along with an option to sell, or put, at a fixed price). If

one of the assets is sold for a loss, current law allows the loss only in excess of the

gain of the other asset, with unused loss carried over. Some stock positions are

exempt from this treatment and there is some confusion regarding circumstances

when the parts of the straddle are not identified.

The provision makes a number of detailed changes in the straddle rule including

repeal of the stock exemptions, providing that taxpayers identify the components of

straddles, and changing the rule from a deferral of loss to a change in basis.

Installment Sales

This provision is in the Senate bill and the final legislation, raising slightly over

$200 million. Under present law, individuals who sell property with payments to be

received as installments only recognize gain when the payments are actually made.

If the taxpayer also receives a readily tradable debt instrument from a corporation or

government, this instrument is considered the payment and gain is taxed

immediately. This provision extends this rule to debt issued by partnerships and

individuals.

Non-Recognition of Gain in Liquidation

This provision was only in the Senate bill, and would have raised slightly under

$200 million. U.S. subsidiaries of foreign parents pay U.S. corporate tax on their

earnings and when they transfer profits to the foreign parent pay a withholding tax

of 30% unless there is a tax treaty; there is a similar tax on the shifting of branch

earnings abroad. However, if a subsidiary or branch is closing down (a liquidation)

assets may be transferred tax free (if certain restrictions are met). There is a concern

that firms may create U.S. holding companies to obtain the earnings of the domestic

operation and then transfer them tax-free. This provision would have denied tax free

treatment to a U.S. holding company that has been in existence less than five years.

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Like Kind Exchanges for Residences

This provision raises around $200 million and is in all bills (item 12 in Table

1, item 27 in Table 2, and item 26 in Table 3). Under current law married couples

can exclude $500,000 of gain ($250,000 for singles) when they sell their residence

as long as they have lived in it for two of the past five years. This provision denies

this exclusion if they acquired the house in a like kind exchange with no recognition

of gain. For example, this provision would tax gain that arose from rental properties

converted into residences.

Clarification of Banking Business

This provision is in all bills (item 13 in Table 1, item 28 in Table 2, and item

17 in Table 3); it raises about $400 million in the final bill. Under current law,

income from foreign incorporated subsidiaries (other than earnings of certain types

of passive assets) is not taxed until paid to the U.S. shareholder. However,

investments of the foreign subsidiary in the United States are subject to tax (as they

can be equivalent to a distribution). There are a series of exceptions to this rule, and

one of them is for bank deposits. In a recent court case, payments to a shareholder

for purposes of carrying on a department store credit card business were found to be

banking by the courts; this provision bases the definition of banking on the taxpayer’s

being subject to banking regulations.

Estimated Tax on Deemed Asset Sales

This $120 million provision is in all bills (item 14 in Table 1, item 29 in Table

2, and item 29 in Table 3). In some circumstances a company acquiring another

company may elect to treat the transactions as a sale of assets by the acquired

company rather than stock. Apparently some taxpayers have interpreted a related

provision about estimated taxes to require no estimated tax payments; this provision

provides that effects of an asset sale must be reflected in estimated tax payments.

Expanded Authority to Disallow Benefits Under Section 269

This $100 million provision relates to the Enron investigation and was only in

the Senate bill. Present law (Section 269) provides that a taxpayer who acquires

control of another corporation cannot use the acquired firm’s tax benefits if the

acquisition was for the purposes of avoiding tax. This provision would have

expanded the scope of present law by not requiring that the acquisition of assets

establishes control.

Modification of the CFC-PFIC Rules

This provision is related to the Enron investigation and raises about $100

million; it was only in the Senate bill. Under current law shareholders in controlled

foreign corporations, or CFCs, are taxed currently on certain tax haven income

(Subpart F income). There are also rules requiring current taxation of income of

passive foreign investment companies (PFICs) that have most of their assets in a

passive form. To prevent overlap, a CFC cannot also be treated as a PFIC and

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shareholders are not subject to the rules even if they are expected to pay no tax on

Subpart F income. This provision would have applied the PFIC rules in those cases.

Limit on Transfer of Losses in REMICs

This $100 million provision was only in the House bill and relates to the Enron

investigation. Because of rules recognizing no gain or loss in a transfer of property

for stock, Enron was able to use REMICs (real estate mortgage investment conduits,

which are used to convert mortgages to securities) to duplicate losses. This provision

would have limited the basis of certain interests in REMICs (residual interests, which

are the remainder after subtracting regular interests that involve fixed payments) that

are transferred to corporations to the fair market value in cases where the basis of a

REMIC residual is greater than fair market value.

Reduction of Fuel Tax Evasion

These provisions are included only in the final bill and they are a series of

provisions designed to reduce evasion of fuel taxes that are generally applied for

transportation purposes. They include a variety of measures such as codifying the

definition of off-highway vehicles that are exempt from highway fuel and other taxes,

changing the stage of production/distribution at which taxes are collected, improving

control over dyeing fuel (used to separate non-transport fuel from transport fuel) and

similar measures.

Charitable Contributions for Vehicles

This provision is only in the final bill. Studies had indicated that many

taxpayers were donating used vehicles to charities with an inflated value. These

donations were often made to entities that sold the cars and then provided the cash

to charities. The new bill requires that the deduction equal the actual amount of the

sales price in these cases.

Limit Entertainment Expense Deductions

This provision is only in the final bill. A recent court case found for the

taxpayer who deducted the cost of providing private company airline flights, although

that cost was in excess of the income includible to the companies employees. This

provision limits the deduction to the amount includible in income in the case of

individuals who are officers, directors or owners of a 10% or more share.

Freeze of Provisions Suspending Interest Payments

This provision is only in the final bill. Interest and penalties accrue on unpaid

taxes whether or not the taxpayer is aware that they are due, but cease after a year if

a notice is not sent (except in certain cases, such as fraud). This period has been

temporarily increased to 18 months. This provision makes the 18 months permanent.

It also excludes from the suspension tax deficiencies related to gross misstatements

and officially identified (reportable) transactions.

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Application of Basis Rules to Nonresident Aliens

This provision is only in the final bill. When distributions from retirement plans

are made they are taxable to the individuals except to the extent that the individual

made contributions that were not excludible from income. For certain nonresident

aliens, some of this excluded income was not taxed under U.S. law because it was

not from U.S. sources. This provisions includes these untaxed contributions in

income if the income was not taxed by the United States or by any other country.

Tax on Gasoline Blendstocks

This provision is only in the final bill. This provision taxes certain blended

fuels unless it can be established they were not used in making gasoline.

Increase Withholding on Supplemental Wages

This provision is only in the final bill. Currently withholding on supplemental

wages is at the third highest tax rate; this provision withholds supplemental wages

in excess of $1 million at the top tax rate.

increase Continuous Levy for Certain Federal Payments

This provision is only in the final bill. Currently, the government may attach

(collect prior to individual receipt) up to 15% of payments for tax deficiencies. This

amount in increased to 100% if the payment is made by the federal government.

Tax Policy Changes

Many of the provisions listed thus for were in both the House and Senate bills;

however, in the area of actual tax policy changes — items that change provisions of

the income tax without seeming to be directed at a tax shelter abuse, the focus was

quite different. The larger revenue raisers in the House bill were focused on deferred

compensation, and, to a lesser degree, underpayments and overpayments of tax. The

Senate bill, while including the underpayment provision, had several significant

changes in tax provisions that were different from those in the House bill.

Accordingly, in this section, we discuss first the House bill provisions and then the

Senate bill provisions. In some cases these provisions would have actually provided

benefits, and the revenue gain only reflects timing. We note whether these changes

are in the final legislation as well and conclude with provisions in the final legislation

that were in neither the House nor the Senate original bills.

House Bill

The House bill contained about $1.3 billion of tax increases resulting from tax

policy changes, $800 million of which was due to the deferred compensation

provision discussed immediately below. These provisions were not in the final bill,

but the provision allowing transfer of excess benefits into employee health plans was

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included in the Pension Funding Equity Act of 2004, with a sunset of 2013 and a

more limited provision dealing with rabbi trusts (discussed below) was included.

Deferred Compensation. The House bill contained two revisions to the

treatment of deferred compensation (compensation that accrues to individuals but is

not paid out to them) — items 5 and 11 in Table 1, respectively raising $800 million

and $300 million. Non-qualified deferred compensation is taxable to an individual

on a facts and circumstances basis designed to determine whether an individual has

really obtained a right to the compensation. Firms had set up “rabbi trusts” (so called

because the first case that came to the attention of the IRS was set up for a rabbi)

where deferred compensation in the trust could be used to satisfy creditors if the firm

became insolvent and this feature was used to justify not taxing the compensation

currently. The bill would have eliminated this use of exposure of trust fund assets

to creditors in the case of insolvency as a justification for not taxing deferred

compensation.

This provision clearly involves a tax increase; the gain from this provision

represents in part, therefore, a speeding up of tax payments, since at some point in

the future, the taxes which would otherwise occur on deferred compensation will not

materialize.

The second provision extended a current provision that allows firms to avoid

plan disqualification (if made prior to termination) or penalties (if made on plan

termination) when taking excess assets out of defined benefit pension plans, by

transferring them to a retiree health benefits plan. The excise tax is 20% or 50%,

depending on whether a replacement plan or certain benefit increases occur. The

excise tax applies in addition to regular income tax on the withdrawal. When

transfers are made, no deduction can be taken for the transfers or the expenditures

they fund. If all the funds are not used currently, they revert and are subject to the

20% excise tax. This change involved providing a tax benefit, not a penalty. The

provision was projected to raise revenue, however, presumably because the increased

transfers from the funds would have paid for costs while not permitting a deduction

and because a penalty is applied to unused funds. This provision would have

eventually lost revenue, however, by reducing the size of plans (and the eventual

individual tax on pension recipients) or by reducing the amount of future

contributions that must be made to fund benefits.

Overpayments and Underpayments of Tax. The House bill included two

other policy changes that related to tax administration and which raised revenue

during the budget horizon — items 15 and 16 in Table 1 (raising about $100 million

each). The first was the elimination of taxes on interest accrued on overpayments of

tax. This provision also established a benefit, and presumably resulted in a revenue

gain because it increased the likelihood of overpayments, although it should have led

to a long term loss. The other provision also provided a benefit and a speedup in

collections by allowing more flexibility for taxpayers to prepay amounts to stop

interest payments on tax underpayments; this gain would also be transitory.

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Senate Bill

The Senate bill also contained the provision on underpayments (item 32, Table

2), but there are five other provisions that were permanent increases in most cases:

altogether these provisions accounted for $11.6 billion in revenue, almost ten times

the size of the provisions in the House bill. All references are to Table 2 unless

otherwise noted.

Charitable Contributions of Patents. The largest revenue raiser ($3.9

billion) involved limiting deductions for charitable contributions of patents (item 3).

Under certain circumstances, donors of property to charitable organizations are able

to deduct the entire fair market value of an asset even though they have not been

taxed on the gain. For certain other types of contributions, such as contributions to

foundations or contributions of certain created property, they can only deduct the

basis — what they paid for it or spent creating it. The Senate bill’s provision,

reflecting concerns that the fair market value of patents is not easily determined and

may be inflated, limits the contribution to the basis. However, it also allows an

exception to the general rule disallowing benefits for contributions of partial

interests, by permitting the donor to receive a share of the royalties. This provision

was also included in the final enacted legislation.

Intangibles. The second provision involved the treatment of intangibles (item

4), raising $3.3 billion. Under current law acquired intangibles are deducted over a

15 year period —- a compromise to prevent disputes and allocational issues across

intangibles including some (such as good will) which were previously not deductible

at all, and others (such as patient lists) that taxpayers had successfully made a case

in court for deducting over shorter periods of time. In the Senate bill, two intangibles

provisions would have added organizational and certain start up costs (currently

deductible over five years) and sports franchises (which had a variety of rules,

including special rules for player contracts) to the 15 year category. The bill also

permitted the first $5,000 for organization and start-up costs to be deducted

immediately. This provision was also in the final bill.

Increase in Age Limit for Section 1(g ) (“Kiddie Tax”). A third

provision (item 9), raising $1.2 billion, expanded coverage of the “kiddie tax” that

requires unearned income to be taxed at the parent’s rate. The bill increased

coverage from those under age 14 to those under age 18. This provision was not in

the final legislation.

Repeal Rehabilitation Credit. A fourth change (item 10) repealed the 10%

credit for rehabilitation expenditures on buildings constructed before 1936, gaining

$1 billion. No change was made in the 20% rehabilitation credit for historic

buildings. This provision was not in the final legislation.

Private Debt Collection. This provision (item 11) projected to raise almost

$1 billion authorized the IRS to use private debt collection services, This provision

was in the final legislation.

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Utility Grading Costs. Utility assets (such as transmission or distribution

lines) are placed in classes that allow them to be depreciated over 15 or 20 years.

However, because certain regulations were never adopted, grading and preparing

property for these lines is not assigned a class and by default is depreciated over

seven years. This provision placed the grading and land preparation costs for

transmission and distribution lines into the same class as the assets themselves,

raising about $700 million. This provision was in the final legislation.

Corporate Governance Provisions: Denial of Deductions. The Senate

bill included several provisions on corporate governance that reflected concerns

arising from the collapse of Enron and other firms. Two of the provisions were

projected to raise revenues of about $330 million (item 21) and $190 million (item

25) respectively. The first would have disallowed firms’ deductions for punitive

damages (normally all settlements are considered a cost of doing business and are

deductible). The second related to deductions for fines. Taxpayers are not allowed

to deduct the costs of fines. This provision clarified that payments made to the

government or at the direction of the government pursuant to an investigation,

including those made to avoid further investigation, were not deductible unless they

are determined to provide restitution. These provisions were not in the final

legislation.

Only in Final Legislation as Enacted

Tax on Influenza Vaccine. Certain vaccines are taxed and used to provide

a fund for compensation for those injured by vaccines. This provision adds the

influenza vaccine to the list (hepatitis A is also added, but its revenue effect is

negligible).

Treatment of Creditors in a Divisive Reorganization. Under current

law, in certain circumstances, gain in a reorganization will not be recognized if the

proceeds are used to pay creditors. This provision requires that gain will be

recognized in these distributions

Extensions of Fees

In both original bills, the largest revenue raiser was the extension of customs

fees (merchandising, passenger and conveyance processing fees), accounting for

about $17 billion, accounting for about 60% of the revenue gain in the House bill and

about 30% of the gain in the Senate bill. This provision was also in the final bill. A

fee extension with a smaller gain is the IRS user fee (item 9 in Table 1, item 19 in

Table 2, and item 18 in Table 3), which accounts for about $400 million.