For other versions of this document, see http://wikileaks.org/wiki/CRS-RL32193 ------------------------------------------------------------------------------ Order Code RL32193 CRS Report for Congress Received through the CRS Web Anti-Tax-Shelter and Other Revenue-Raising Tax Proposals Considered in the 108th Congress Updated February 7, 2005 Jane G. Gravelle Senior Specialist in Economic Policy Government and Finance Division Congressional Research Service ~ The Library of Congress Anti-Tax-Shelter and Other Revenue-Raising Tax Proposals in the 108th Congress Summary Several bills introduced in the 108th 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. Contents General Anti-Shelter Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Penalties for Non-Disclosure and Other Purposes . . . . . . . . . . . . . . . . . . . . . 8 Economic Substance Doctrine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Corporate Inversions, Earnings Stripping, and Expatriation . . . . . . . . . . . . . . . . 12 Specific Provisions Aimed at Shelters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Built in Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Property and Casualty Insurance Companies . . . . . . . . . . . . . . . . . . . . . . . . 15 Disallowance of Interest on Convertible debt . . . . . . . . . . . . . . . . . . . . . . . 15 Lease term to Include Service Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Disallowance of Partnership Loss Transfers . . . . . . . . . . . . . . . . . . . . . . . . 16 Lessors to Tax Exempt Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Mismatching of Items with Related Corporations . . . . . . . . . . . . . . . . . . . . 16 Basis Reduction for Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Straddle Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Installment Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Non-Recognition of Gain in Liquidation . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Like Kind Exchanges for Residences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Clarification of Banking Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Estimated Tax on Deemed Asset Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Expanded Authority to Disallow Benefits Under Section 269 . . . . . . . . . . 18 Modification of the CFC-PFIC Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Limit on Transfer of Losses in REMICs . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Reduction of Fuel Tax Evasion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Charitable Contributions for Vehicles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Limit Entertainment Expense Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Freeze of Provisions Suspending Interest Payments . . . . . . . . . . . . . . . . . . 19 Application of Basis Rules to Nonresident Aliens . . . . . . . . . . . . . . . . . . . 20 Tax on Gasoline Blendstocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Increase Withholding on Supplemental Wages . . . . . . . . . . . . . . . . . . . . . . 20 Increase Continuous Levy for Certain Federal Payments . . . . . . . . . . . . . . 20 Tax Policy Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 House Bill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Deferred Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Overpayments and Underpayments of Tax . . . . . . . . . . . . . . . . . . . . . 21 Senate Bill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Charitable Contributions of Patents . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Intangibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Increase in Age Limit for Section 1(g ) ("Kiddie Tax") . . . . . . . . . . . 22 Repeal Rehabilitation Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Private Debt Collection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Utility Grading Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Corporate Governance Provisions: Denial of Deductions . . . . . . . . . . 23 Only in Final Legislation as Enacted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Tax on Influenza Vaccine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Treatment of Creditors in a Divisive Reorganization . . . . . . . . . . . . . 23 Extensions of Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 List of Tables Table 1. Revenue Raisers in H.R. 2896 as Passed by the House Raising $100 Million or More, FY2004-FY2013 . . . . . . . . . . . . . . . . . . . . . 3 Table 2. Revenue Raisers in S. 1637 as Reported Raising $100 Million or More, FY2004-FY2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Table 3. Revenue Raisers in H.R. 4520 (As Enacted) Raising $100 Million or More, FY2005-FY2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Anti-Tax-Shelter and Other Revenue- Raising Tax Proposals in the 108th Congress Several bills introduced in the 108th 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. CRS-2 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.1 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 109th Congress if legislation needing offsetting revenue raisers is considered. Legislation providing additional tax incentives for charitable contributions was considered but not enacted in the 108th 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. 1 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. CRS-3 Table 1. Revenue Raisers in H.R. 2896 as Passed by the House Raising $100 Million or More, FY2004-FY2013 (in millions of dollars) Provision Revenue Gain 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. CRS-4 Table 2. Revenue Raisers in S. 1637 as Reported Raising $100 Million or More, FY2004-FY2013 (in millions of dollars) Provision Revenue Gain 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. CRS-5 Table 3. Revenue Raisers in H.R. 4520 (As Enacted) Raising $100 Million or More, FY2005-FY2015 (in millions of dollars) Provision Revenue Gain 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. CRS-6 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.2 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.3 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."4 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. 2 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. 3 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. 4 Daniel Shaviro, "Economic Substance, Corporate Tax Shelters, and the COMPAQ Case," Tax Notes, July 10, 2000, p. 222. CRS-7 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 (so- called "janitors" insurance).5 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.)6 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 1998,7 implying lost taxes that could be up to $54 billion (at a 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.8 While 5 See CRS Report RS21498, Corporate-Owned Life Insurance: Tax Issues, by Don Richards, for a discussion. 6 See Sheryl Stratton, "KPMG Skewered at Senate Shelter Hearing," Tax Notes, Nov. 24, 2003, pp. 942-946. 7 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. 8 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...) CRS-8 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.9 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 non- disclosure, 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. 9 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. CRS-9 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).10 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. 11 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:12 10 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. 11 For a 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. 12 S.Rept. 108-192, to accompany S. 1637, p. 85. CRS-10 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.13 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 107th 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.14 13 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. 14 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...) CRS-11 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,15 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 14 (...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. 15 Reported in Thompson and Clary, "Coming in from the Cold," op. cit. CRS-12 including requiring both the subjective and objective tests.16 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.17 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 3.18 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 16 Joint Committee on Taxation, Options to Improve Tax Compliance and Reform Tax Expenditures, JCS-02-05, January 27, 2005. 17 See Kenneth A. Gary and Sheryl Stratton, "Economic Substance: Will Congress Have to Intercede?" Tax Notes, Nov. 15, 2004, pp. 907-910. 18 See also CRS Report RL31444, Firms That Incorporate Abroad for Tax Purposes: Corporate "Inversions" and "Expatriation," by David Brumbaugh for further discussion. CRS-13 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 18th 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). U.S. 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 CRS-14 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 (i.e., the individual must pay tax as if he 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 be noted. CRS-15 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.19 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 19 This activity was described in David Cay Johnston, "From Tiny Insurers Big Tax Breaks," New York Times, Apr. 1, 2003, Sect. C, p. 1 CRS-16 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 non- contributing 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 CRS-17 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. CRS-18 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 CRS-19 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. CRS-20 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 CRS-21 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. CRS-22 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. CRS-23 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. ------------------------------------------------------------------------------ For other versions of this document, see http://wikileaks.org/wiki/CRS-RL32193